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784681_1993.txt

784681_1993

1993

784681

Item 1. Business. 3 2. Properties. 31 3. Legal Proceedings. 31 4. Submission of Matters to a Vote of Security Holders. 31 Part II - -------- 5. Market for the Registrant's Common Equity and Related Stockholder Matters. 32 6. Selected Financial Data. 33 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 35 8. Consolidated Financial Statements. 50 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 87 Part III - --------- 10. Directors and Executive Officers of the * Registrant. 11. Executive Compensation. * 12. Security Ownership of Certain Beneficial Owners and Management. * 13. Certain Relationships and Related Transactions. * Part IV - -------- 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. 87 * These items are omitted because the registrant intends to file with the Securities and Exchange Commission, not later than 120 days after the close of its fiscal year, a definitive proxy statement or an amendment on Form 8 to this report containing the information required to be disclosed under Part III of Form 10-K. (2) PART I ITEM 1. BUSINESS THE COMPANY Cablevision Systems Corporation, a Delaware corporation and its majority owned subsidiaries (the "Company") own and operate cable television systems in six states with approximately 1,379,000 subscribers at December 31, 1993. The Company also has ownership interests in and/or manages other cable television systems which served an aggregate of approximately 853,000 subscribers at December 31, 1993 and has interests in companies that produce and distribute national and regional programming services and that provide advertising sales services for the cable television industry. Cable television is a service that delivers multiple channels of television programming to subscribers who pay a monthly fee for the services they receive. Television and radio signals are received over-the-air or via satellite delivery by antennas, microwave relay stations and satellite earth stations and are modulated, amplified and distributed over a network of coaxial and fiber optic cable to the subscribers' television sets. Cable television systems typically are constructed and operated pursuant to non-exclusive franchises awarded by local governmental authorities for specified periods of time. The Company's cable television systems offer varying levels of service which may include, among other programming, local broadcast network affiliates and independent television stations, satellite-delivered "superstations" such as WTBS (Atlanta), certain other news, information and entertainment channels such as Cable News Network ("CNN"), CNBC, ESPN and MTV: Music Television and certain premium services such as HBO, Showtime, The Movie Channel and Cinemax. The Company's cable television revenues are derived principally from monthly fees paid by subscribers. In addition to recurring subscriber revenues, the Company derives revenues from installation charges, from the sales of pay-per-view movies and events, and from the sale of advertising time on advertiser supported programming. Certain services and equipment provided by substantially all of the Company's cable television systems are subject to regulation. See "Business - Cable Television Operations - Regulation - 1992 Cable Act." For financing purposes, the Company is structured as a restricted group, consisting of Cablevision Systems Corporation and certain of its subsidiaries (the "Restricted Group"), and an unrestricted group of subsidiaries, consisting primarily of V Cable, Inc. ("V Cable"), Cablevision of New York City ("CNYC"), Rainbow Programming Holdings, Inc. ("Rainbow Programming") and Rainbow Advertising Sales Corporation ("Rainbow Advertising"). In addition, the Company has an unrestricted group of investments, consisting of investments in A-R Cable Services, Inc. ("A-R Cable"), U.S. Cable Television Group, L.P. ("U.S. Cable"), Cablevision of Boston Limited (3) Partnership ("Cablevision of Boston"), Cablevision of Chicago and Cablevision of Newark. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" for a discussion of the financing of the Company including a discussion of restrictions on investments by the Restricted Group. The Company's consolidated cable television systems are concentrated in the New York City greater metropolitan area (80.9% of the Company's total subscribers) and the greater Cleveland metropolitan area (14.3% of total subscribers). The Company believes that its cable systems on Long Island comprise the largest group of contiguous cable television systems under common ownership in the United States (measured by number of subscribers). RECENT DEVELOPMENTS On March 11, 1994, Cablevision of Cleveland, L.P. ("Cablevision Cleveland"), a partnership comprised of subsidiaries of the Company, purchased substantially all of the assets and assumed certain liabilities of North Coast Cable Limited Partnership, which operated a cable television system in Cleveland, Ohio. The purchase price aggregated $133.0 million which amount includes: (i) approximately $98.8 million paid in cash; (ii) $4.0 million paid in a short-term promissory note secured by a letter of credit; (iii) approximately $13.2 million paid by the surrender of the Company's 19% interest in North Coast and the satisfaction of certain management fees owed to the Company; and (iv) approximately $17.0 million paid by the assumption of certain capitalized lease obligations and certain other liabilities. The net cash purchase price of the acquisition was financed by borrowings under the Company's Credit Agreement (as hereinafter defined) and Cablevision Cleveland is part of the Restricted Group. At December 31, 1993 North Coast Cable served approximately 82,900 basic subscribers. The partnership agreement relating to one of Rainbow Programming's businesses, American Movie Classics Company ("AMCC"), contains a provision allowing any partner to commence a buy-sell procedure by establishing a stated value for the AMCC partnership interests. On August 2, 1993, Rainbow Programming received a notice from the AMCC partner affiliated with Liberty Media Corporation initiating the buy-sell procedure and setting a stated value of $390 million for all the partnership interests in AMCC. The partnership agreement provides that the non-initiating partner has a period of 45 days from receipt of the buy-sell notice to elect to purchase the initiating partner's interest at the stated value or sell its interest at the stated value. On September 16, 1993, Rainbow Programming notified its partners in AMCC that it had elected to purchase Liberty Media's 50% interest in AMCC at the stated value. The Company anticipates that the transaction will be consummated in the second quarter of 1994. On October 26, 1993, Cablevision MFR, Inc. ("Cablevision MFR"), a wholly-owned subsidiary of the Company, entered into agreements to purchase substantially all of the assets of Monmouth Cablevision Associates, L.P. ("Monmouth Cablevision"), (4) Riverview Cablevision Associates, L.P. ("Riverview Cablevision") and Framingham Cablevision Associates, L.P. ("Framingham Cablevision"), each a limited partnership operated by Sutton Capital Associates. Each of Monmouth Cablevision and Riverview Cablevision own and operate cable television systems in New Jersey. Framingham Cablevision owns and operates a cable television system in Massachusetts. It is anticipated that Cablevision MFR will be an unrestricted subsidiary of the Company. On January 12, 1994 Cablevision MFR assigned its rights and obligations under its agreement to purchase the assets of Framingham Cablevision to Cablevision of Framingham Holdings, Inc. ("CFHI"), currently a wholly-owned subsidiary of the Company. The Company has entered into an agreement with Warburg, Pincus Investors, L.P. ("Warburg Pincus"), pursuant to which Warburg Pincus will (i) purchase 60% of the common stock of CFHI for cash and (ii) purchase preferred stock of CFHI, from time to time, for a purchase price sufficient to pay 70% of the interest and principal payments on the Framingham Cablevision promissory note described below. The Company agreed to purchase preferred stock of CFHI, from time to time, for a purchase price sufficient to pay 30% of the interest and principal payments on the Framingham Cablevision promissory note. Agreements between the Company and Warburg Pincus with respect to management of Framingham Cablevision and purchase and sale rights are substantially similar to those reached with respect to Warburg Pincus' investment in A-R Cable, which arrangements are described under "Cable Television Operations - Other Cable Affiliates" below. The aggregate purchase price for the two New Jersey systems is expected to be $422.3 million. The Company expects that $244.6 million of such purchase price will be financed by senior credit facilities in newly formed unrestricted subsidiaries of the Company secured by the assets of the systems. The remaining $177.7 million of such purchase price will be paid by the issuance, by Cablevision MFR, of promissory notes due in 1998 and bearing interest at 6% until the third anniversary and 8% thereafter (increasing to 8% and 10%, respectively, if interest is paid in shares of the Company's Class A Common Stock). The purchase price for the Framingham Cablevision assets is expected to be $41.1. The Company expects that approximately $22.8 million of such purchase price will be financed by a senior credit facility of a wholly-owned subsidiary of CFHI secured by the assets of such system. Approximately $13.3 million of such purchase price will be paid by the issuance by CFHI of a promissory note issued on the same terms as the promissory note of Cablevision MFR described above. The remaining approximately $5.0 million will consist of a $1.0 million loan to CFHI from its stockholders and an approximate $4.0 million capital contribution to CFHI from its stockholders. Principal and interest on the notes, which may be paid, at the maker's election, in cash or in shares of the Company's Class A common stock, will be guaranteed by the Company. The Company's obligations under the guarantee will rank pari passu with the Company's public subordinated debt. Under the Company's senior credit facility, the Company is only permitted to pay such amount in common stock. In certain circumstances, Cablevision MFR or CFHI (as the case may be) may extend the maturity date of the promissory notes until 2003 for certain additional consideration. (5) Consummation of the transaction is subject to the receipt of necessary regulatory approvals and other customary closing conditions. There can be no assurance that this transaction will be successfully consummated. As of December 31, 1993, the two New Jersey systems served approximately 155,400 subscribers, in the aggregate, and Framingham Cablevision served approximately 16,200 subscribers. On November 5, 1993, A-R Cable Partners, a partnership comprised of subsidiaries of the Company and E.M. Warburg, Pincus & Co., Inc., entered into an agreement to purchase certain assets of Nashoba Communications ("Nashoba"), a group of three limited partnerships which operate three cable television systems in Massachusetts. A-R Cable Partners is controlled in a manner substantially similar to the way A-R Cable Services, Inc. is controlled. The purchase price is $90.0 million, subject to certain adjustments, of which up to $55.0 million is expected to be provided by a senior credit facility provided to A-R Cable Partners secured by the assets of such system. The remainder will be provided by equity contributions from the partners in A-R Cable Partners. The Company will provide 30% of such equity through drawings under its senior credit facility. Consummation of the transaction is subject to regulatory approval, as well as other customary closing conditions. As of December 31, 1993, Nashoba served approximately 34,800 basic subscribers. On March 31, 1994, the Company issued and sold 100,000 shares of a new series of preferred stock (the "Preferred Shares") to Toronto-Dominion Investments, Inc. in a private transaction. The Preferred Shares were sold for a purchase price of $1,000 per share and carry a liquidation preference of a like amount plus accrued and unpaid dividends. Dividends accrue at a floating rate of LIBOR plus 2.5 percent and are payable, at the Company's option, either in cash or in registered shares of Class A common stock with a value equalling 105 percent of the required dividend. Additional dividend payments may be required with respect to the availability of the dividend received deduction. The Preferred Shares are redeemable at any time at the option of the Company at par plus accrued and unpaid dividends to the redemption date and are convertible after March 31, 1995 into Class A common stock, at the option of the holder, at a conversion rate based on 95 percent of the average closing price of the Class A Common Stock for the twenty business days prior to conversion. Additionally, the holders of the Preferred Shares have the right to convert their shares in connection with certain change in control transactions (regardless of when they occur) into a number of shares of Class A Common Stock which would yield $100,000,000 based upon an auction process involving the Class A Common Stock issuable on such conversion or, at the holder's election, at a conversion rate based on 95 percent of the average closing price of the Class A Common Stock for the twenty business days prior to conversion. The Company has the right to suspend the conversion of the Preferred Shares from March 31, 1995 through March 31, 1997 as long as it is in compliance with its Restricted Group financial covenants and is current in dividend payments on the Preferred Shares. The Preferred Shares are not transferrable except with the Company's consent, not to be unreasonably withheld. The Preferred Shares are exchangeable, at the option of the holder, into a separate series of preferred stock with terms substantially identical to the (6) Preferred Shares, except that such series (i) are not convertible into common stock or exchangeable for any other class of securities, and (ii) are freely transferable. The Company has granted registration rights with respect to the common stock issuable upon a conversion of the Preferred Shares and with respect to the series of preferred stock into which the Preferred Shares are exchangeable. Also, if the Company completes an offering on non-convertible, non-exchangeable shares of preferred stock, Preferred Shares, if not previously exchanged or converted, also may be converted into a new series of preferred stock having terms identical to or based upon the other series issued by the Company. The Preferred Shares do not have voting rights, other than as required by law, except that (i) the vote of 60% of such shares is necessary to authorize the issuance of capital stock ranking senior to the Preferred Shares, or certain mergers or consolidations, in each case unless provision is made to redeem the Preferred Stock; (ii) if the Company misses four consecutive quarterly dividends in the Preferred Stock or in the event that certain covenants are breached, the holders of the Preferred Stock have the right to cause an increase in the size of the Company's Board of Directors and to elect one director during the continuation of such default in dividend payments or covenant breach. The Company also has the right to require conversion by the holders of the Preferred Shares in certain circumstances. On February 22, 1994 the Federal Communications Commission ("FCC") ordered a further reduction in rates for the basic service tier in effect on September 30, 1992. See "Cablevision Television Operations -- Regulation", below. (7) CABLE TELEVISION OPERATIONS GENERAL. As of December 31, 1993, the Company's consolidated cable television systems served approximately 1,379,000 subscribers in New York, Ohio, Connecticut, New Jersey, Michigan, and Massachusetts. The following table sets forth certain statistical data regarding the Company's consolidated cable television operations (1): (8) The following table sets forth certain statistical data regarding the Company's managed, unconsolidated cable television operations (1): (9) SUBSCRIBER RATES AND SERVICES; MARKETING AND SALES. The Company's cable television systems offer a package of services, generally marketed as "Family Cable", which includes, among other programming, broadcast network local affiliates and independent television stations, satellite-delivered "superstations" and certain other news, information and entertainment channels such as CNN, CNBC, ESPN and MTV: Music Television. For additional charges, the Company's cable television systems provide certain premium services such as HBO, Showtime, The Movie Channel and Cinemax, which may be purchased either individually (in conjunction with Family Cable) or in combinations or in tiers. In addition, the Company's cable television systems recently introduced a basic package which includes broadcast network local affiliates and public, educational or governmental channels and certain public leased access channels. The Company offers premium services on an individual basis and as components of different "tiers". Successive tiers include additional premium services for additional charges that reflect discounts from the charges for such services if purchased individually. For example, in most of the Company's cable systems, subscribers may elect to purchase Family Cable plus one, two or three premium services with declining incremental costs for each successive tier. In addition, most systems offer a "Rainbow" package consisting of between five and seven premium services, and a "Rainbow Gold" package consisting of between eight and ten premium services. Since its existing cable television systems, other than the CNYC system, are substantially fully built, the Company's sales efforts are primarily directed toward increasing penetration and revenues in its franchise areas. The Company sells its cable television services through door-to-door selling supported by telemarketing, direct mail advertising, promotional campaigns and local media and newspaper advertising. Certain services and equipment provided by substantially all of the Company's cable television systems are subject to regulation. See "Business -- Cable Television Operations -- Regulation -- 1992 Cable Act." SYSTEM CAPACITY. The Company is engaged in an ongoing effort to upgrade the technical capabilities of its cable plant and to increase channel capacity for the delivery of additional programming and new services. The Company's cable television systems have a minimum capacity of 35 channels and 70% of its subscribers are currently served by systems having a capacity of at least 52 channels. As a result of currently ongoing upgrades, the Company expects that by December 1995 virtually all of its subscribers will be served by systems having a capacity of at least 52 channels and 66% by systems having a capacity of at least 77 channels. A substantial portion of the system upgrades either completed or underway will utilize fiber optic cable. (10) PROGRAMMING. Adequate programming is available to the Company from a variety of sources. Program suppliers' compensation is typically a fixed per subscriber monthly fee based, in most cases, either on the number of total subscribers of the cable systems of the Company and certain of its affiliates, or on the number of subscribers subscribing to the particular service. The Company's programming contracts are generally for a fixed period of time and are subject to negotiated renewal. The Company's cable programming costs have increased in recent years and are expected to continue to increase due to additional programming being provided to most subscribers, increased costs to produce or purchase cable programming and other factors. Management believes that the Company will continue to have access to programming services at reasonable price levels. FRANCHISES. The Company's cable television systems are operated primarily under nonexclusive franchise agreements with local governmental franchising authorities, in some cases with the approval of state cable television authorities. Franchising authorities generally charge a fee of up to 5% based on a percentage of certain revenues of the franchisee. In 1993 franchise fee payments made by the Company aggregated approximately 3.9% of total revenues. The Company's franchise agreements are generally for a term of ten to fifteen years from the date of grant, although recently renewals have often been for five to ten year terms. Some of the franchises grant the Company an option to renew. Except for the Company's franchise for the Town of Brookhaven, New York which expired in 1991, the expiration dates for the Company's ten largest franchises range from 1995 to 2001. In certain cases, including the Town of Brookhaven, the Company is operating under temporary licenses while negotiating renewal terms with the franchising authorities. Franchises usually require the consent of the franchising authority prior to the sale, assignment, transfer or change in ownership or operating control of the franchisee. The Cable Communications Policy Act of 1984 (the "1984 Cable Act") and the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") provide significant procedural protections for cable operators seeking renewal of their franchises. See "Business -- Cable Television Operations -- Regulation". In connection with a renewal, a franchising authority may impose different and more stringent terms. The Company has never lost a franchise as a result of a failure to obtain a renewal. (11) COMPETITION. The Company's cable television systems generally compete with the direct reception of broadcast television signals by antenna and with other methods of delivering television signals to the home for a fee. The extent of such competition depends upon the number and quality of the signals available by direct antenna reception as compared to the number and quality of signals distributed by the cable system. The Company's cable television systems also compete to varying degrees with other communications and entertainment media, including movies, theater and other entertainment activities. The 1984 Cable Act, Federal Communications Commission ("FCC") regulations and the 1982 federal court consent decree (the "Modified Final Judgment") that settled the 1974 antitrust suit against American Telephone & Telegraph Company regulate the provision of video programming and other information services by telephone companies. A federal district court in 1991 issued an opinion, upheld on appeal, lifting the Modified Final Judgment prohibition on the provision of information services by the seven Bell Operating Companies ("BOCs"), allowing the BOCs to acquire or construct cable television systems outside of their own service areas. Several BOCs have purchased or made investments in cable systems outside their service areas in reliance on this decision. The 1984 Cable Act codified FCC cross-ownership regulations which, in part, prohibit local exchange telephone companies, including the BOCs, from providing video programming directly to subscribers within their local exchange service areas, except in rural areas or by specific waiver of FCC rules. The statutory provision and corresponding FCC regulations are of particular competitive importance because these telephone companies already own much of the plant necessary for cable television operations, such as poles, underground conduit, associated rights-of-way and connections to the home. One telephone company has been successful in a lawsuit in a Virginia federal court challenging the constitutionality of the existing statutory ban on unrestricted telephone company ownership of cable systems. The federal government has appealed this decision. The ruling applies to telephone company ownership of cable systems in one state in which the Company owns systems. Similar lawsuits have been filed in several other states in which the Company owns systems. Legislation to repeal this ban, subject to certain regulatory requirements, has been introduced in the U.S. Senate and House of Representatives; repeal has also been endorsed by the Clinton Administration. The bills would also, inter alia, preempt state and locally-imposed barriers to the provision of intrastate and interstate telecommunications services by the Company and other cable system operators in competition with local telephone companies. In July 1992, the FCC voted to authorize additional competition to cable television by video programmers using broadband common carrier facilities constructed by telephone companies. The FCC allowed telephone companies to take ownership interests of up to 5% in such programmers. The FCC also reaffirmed an earlier holding, currently on appeal to a federal court, that programmers using such a telephone company-provided "video dial tone" system would not need to obtain a state or municipal franchise. Several telephone companies have sought approval from the FCC to build such "video (12) dial tone" systems. Such a system has been proposed in several communities in Connecticut in which the Company currently holds a cable franchise and approval of one such system has been granted in a franchise area adjoining a cable television system of the Company. Cable television also competes with the home video industry. Owners of videocassette recorders are able to rent many of the same movies, special events and music videos that are available on certain premium services. The availability of videocassettes has affected the degree to which the Company is able to sell premium service units and pay-per-view offerings to some of its subscribers. Multipoint distribution services ("MDS"), which deliver premium television programming over microwave superhigh frequency channels received by subscribers with a special antenna, and multichannel multipoint distribution service ("MMDS"), which is capable of carrying four channels of television programming, also compete with certain services provided by the Company's cable television systems. By acquiring several MMDS licenses or subleasing from several MMDS operators and holders of other types of microwave licenses, a single entity can increase channel capacity to a level more competitive with cable systems. MDS and MMDS systems are not required to obtain a municipal franchise, are less capital intensive, require lower up-front capital expenditures and are subject to fewer local and FCC regulatory requirements than cable systems. The ability of MDS and MMDS systems to serve homes and to appeal to consumers is affected by their less extensive channel capacity and the need for unobstructed line of sight over-the-air transmission. Satellite master antenna systems ("SMATV") generally serve large multiple dwelling units. The FCC has preempted all state and local regulation of SMATV operations. SMATV is limited to the buildings within which the operator has received permission from the building owner to provide service. The FCC has recently streamlined its MDS regulations and opened substantially more microwave channels to MDS and SMATV operators, which could increase the strength of their competition with cable television systems. In January 1993, the FCC proposed establishing a new local multipoint distribution service ("LMDS", sometimes referred to as "cellular cable") in the virtually unused 28 GHz band of the electromagnetic spectrum that could be used to offer multichannel video in competition with cable systems, as well as two-way communications services. The FCC has proposed issuing two LMDS licenses per market, using auctions or lotteries to select licensees. Suite 12 Group, the originator of this service, currently holds an experimental license and has constructed a video transmission service using the 28 GHz band in a portion of the Company's New York City service area. The 1984 Cable Act specifically legalized, under certain circumstances, reception by private home earth stations of satellite-delivered cable programming services. By law, dish owners have the right to receive broadcast superstations and network affiliate (13) transmissions in return for a compulsory copyright fee. Cable programmers have developed new marketing efforts to reach these viewers. Direct broadcast satellite ("DBS") systems currently permit satellite transmissions from the low-power C-Band to be received by antennae approximately 60 to 72 inches in diameter at the viewer's home. New higher power DBS systems providing transmissions over the Ku-Band will permit the use of smaller receiver antennae and thus may be more appealing to customers. A consortium of cable operators (other than the Company), formed PrimeStar, a joint venture to operate a medium power Ku-Band DBS system which began operations in 1990. In addition, other mid- and high-power DBS ventures have announced their intentions to begin operations during 1994. Both C-Band and Ku-Band DBS delivery of television signals are competitive alternatives to cable television. Other technologies supply services that may compete with certain services provided by cable television. These technologies include translator stations (which rebroadcast signals at different frequencies at lower power to improve reception) and low-power television stations (which operate on a single channel at power levels substantially below those of most conventional broadcasters and, therefore, reach a smaller service area). The full extent to which developing media will compete with cable television systems may not be known for several years. There can be no assurance that existing, proposed or as yet undeveloped technologies will not become dominant in the future and render cable television systems less profitable or even obsolete. In particular, certain major telephone companies have demonstrated an interest in acquiring cable television systems or providing video services to the home through fiber optic technology. Changes in the laws and regulations mentioned above governing telephone companies could allow these companies in the future to provide information and entertainment services to the home. Although substantially all the Company's cable television franchises are non-exclusive, most franchising authorities have granted only one franchise in an area. Other cable television operators could receive franchises for areas in which the Company operates or a municipality could build a competing cable system. One company has applied for a franchise to build and operate a competing cable television system in several communities in Connecticut in which the Company currently holds a cable franchise. The state regulatory authority is currently conducting hearings on this application and a decision is expected during the second or third fiscal quarters of this year. The 1992 Cable Act described below prohibits municipalities from unreasonably refusing to grant competitive franchises and facilitates the franchising of second cable systems or municipally-owned cable systems. See "Regulation -- 1992 Cable Act," below. (14) REGULATION. 1984 CABLE ACT. In 1984, Congress enacted the 1984 Cable Act, which set uniform national guidelines for cable regulation under the Communications Act of 1934. While several of the provisions of the 1984 Cable Act have been amended or superseded by the 1992 Cable Act, described below, other provisions of the 1984 Act, including the principal provisions relating to the franchising of cable television systems, remain in place. The 1984 Cable Act authorizes states or localities to franchise cable television systems but sets limits on their franchising powers. It sets a ceiling on cable franchise fees of 5% of gross revenues and prohibits localities from requiring cable operators to carry specific programming services. The 1984 Cable Act protects cable operators seeking franchise renewals by limiting the factors a locality may consider and requiring a due process hearing before denial. The 1984 Cable Act does not, however, prevent another cable operator from being authorized to build a competing system. The 1992 Cable Act prohibits franchising authorities from granting exclusive cable franchises and from unreasonably refusing to award an additional competitive franchise. The 1984 Cable Act allows localities to require free access to public, educational or governmental channels, but sets limits on the number of commercial leased access channels cable television operators must make available for potentially competitive services. The 1984 Cable Act prohibits obscene programming and requires the sale or lease of devices to block programming considered offensive. 1992 CABLE ACT. On October 5, 1992, Congress enacted the 1992 Cable Act. The 1992 Cable Act represents a significant change in the regulatory framework under which cable television systems operate. After the effective date of the 1984 Cable Act, and prior to the enactment of the 1992 Cable Act, rates for cable services were unregulated for substantially all of the Company's systems. The 1992 Cable Act reintroduced rate regulation for certain services and equipment provided by most cable systems in the United States, including substantially all of the Company's systems. On April 1, 1993, the FCC adopted rules implementing the rate regulation provisions of the 1992 Cable Act. The 1992 Cable Act requires each cable system to establish a basic service package consisting, at a minimum, of all local broadcast signals and all non-satellite delivered distant broadcast signals that the system wishes to carry, and all public, educational and governmental access programming. The rates for the basic service package are subject to regulation by local franchising authorities. Under the FCC's April 1, 1993 rate regulation rules, a cable operator whose per channel rates as of September 30, 1992 exceeded an FCC established benchmark was required to reduce its per channel rates for the basic service package by up to 10% unless it could justify higher rates on the basis of its costs. On February 22, 1994, after reconsideration, the FCC ordered a further reduction of 7% in rates for the basic service tier in effect on September 30, 1992, for an overall reduction of 17% from those rates. The amount of this 17% decrease that is below a new per channel benchmark need not be implemented pending (15) completion of FCC studies of the costs of below-benchmark cable systems. In the interim, however, the amount of the 17% decrease that is below this benchmark must be computed by the cable system and must be offset against otherwise allowable rate increases by these systems. Franchise authorities (local municipalities or state cable television regulators) are also empowered to regulate the rates charged for the installation and lease of the equipment used by subscribers to receive the basic service package (including a converter box, a remote control unit and, if requested by a subscriber, an addressable converter box or other equipment required to access programming offered on a per channel or per program basis), including equipment that may also be used to receive other packages of programming, and the installation and monthly use of connections for additional television sets. The FCC's rules require franchise authorities to regulate rates for equipment and connections for additional television sets on the basis of an actual cost formula developed by the FCC, plus a return of 11.25%. No additional charge is permitted for the delivery of service to additional sets unless the operator incurs additional programming costs in connection with the delivery of the regulated service to multiple sets. The FCC may, in response to complaints by a subscriber, municipality or other governmental entity, reduce the rates for service packages other than the basic service package if it finds that such rates are unreasonable. Under the FCC's April 1, 1993 rules, a cable operator whose per channel rates for such service packages as of September 30, 1992, exceeded an FCC established benchmark was required to reduce its per channel rates for such packages by up to 10% unless it could justify higher rates on the basis of its costs. On February 22, 1994, the FCC also determined on reconsideration to authorize a further rate reduction of 7% applicable to FCC-regulated tiers, subject to the same interim constraints on further decreases in the basic tier rates below new benchmarks discussed above. The FCC will in response to complaints also regulate, on the basis of actual cost, the rates for equipment used only to receive these higher packages. Services offered on a per channel or per program basis or packages comprised only of services that are also available on a per channel or per program basis are not subject to rate regulation by either municipalities or the FCC. The FCC on February 22, 1994 adopted criteria to assess whether certain discounted packages of "a la carte" or per channel offerings should be regulated as a tier of services by the FCC, or treated as unregulated per channel offerings. The regulations adopted by the FCC on April 1, 1993, including the original rate benchmarks, became effective on September 1, 1993. The new rate regulations adopted by the FCC on February 22, 1994, including the new benchmarks, are expected to become effective in May, 1994. The FCC's rules provide that, unless a cable operator can justify higher rates on the basis of its costs, increases in the rates charged by the operator for the basic service package or any other regulated package of service may not exceed an inflation indexed amount, plus increases in certain costs beyond the cable operator's control, such as taxes, franchise fees and increased programming costs that exceed the inflation index. A cable operator may not pass through to subscribers any amounts paid by the operator on or before October 6, 1994, to broadcast stations for the retransmission of their (16) signals. Increases in retransmission fees above those in effect on that day may be passed through to subscribers. As part of the implementation of its rate regulations, the FCC has frozen all cable service rates in effect on April 5, 1993 until May 15, 1994. Challenges to rates then in effect were required to be filed within six months from September 1, 1993. On February 22, 1994, the FCC adopted guidelines for cost-of-service showings that establish a regulatory framework pursuant to which a cable television operator may attempt to justify rates in excess of the benchmarks. Such justification would be based upon (i) the operator's costs in operating a cable television system (including certain operating expenses, depreciation and taxes) and (ii) a return on the investment the operator has made to provide regulated cable television services in such system (such investment being referred to as its "ratebase", which includes working capital and certain costs associated with the construction of such system). The guidelines (1) create a rebuttable presumption that excludes from a cable television operator's ratebase any "excess acquisition costs" (equal to the excess of the purchase price for a cable television system over the original construction cost of such system, or its book value at the time of acquisition), (2) include in the rate base the costs associated with certain intangibles such as franchise rights and customer lists, (3) set a uniform rate of return for regulated cable television service of 11.25% after taxes, and (4) include a "productivity offset feature" that could reduce otherwise justifiable rate increases based on a claimed increase in a cable television system's operational efficiencies. Under the 1992 Cable Act, systems may not require subscribers to purchase any service package other than the basic service package as a condition of access to video programming offered on a per channel or per program basis. Cable systems are allowed up to ten years to the extent necessary to implement the necessary technology to facilitate this access. In addition, the 1992 Cable Act (i) requires cable programmers under certain circumstances to offer their programming to present and future competitors of cable television such as MMDS, SMATV and DBS, and prohibits new exclusive contracts with program suppliers without FCC approval, (ii) directs the FCC to set standards for limiting the number of channels that a cable television system operator could program with programming services controlled by such operator, (iii) bars municipalities from unreasonably refusing to grant additional competitive franchises, (iv) requires cable television operators to carry ("Must Carry") all local broadcast stations (including home shopping broadcast stations), or, at the option of a local broadcaster, to obtain the broadcaster's prior consent for retransmission of its signal ("Retransmission Consent"), (v) requires cable television operators to obtain the consent of any non-local broadcast station prior to retransmitting its signal, and (vi) regulates the ownership by cable operators of other media such as MMDS and SMATV. In connection with clause (ii) above concerning limitations on affiliated programming, the FCC has established a 40% limit on the number of channels of a cable television system that can be occupied by programming services in which the system operator has an attributable interest and a national limit of 30% on the number of households that any cable company can serve. In connection with clause (iv) above concerning (17) retransmission of a local broadcaster's signals, a substantial number of local broadcast stations are currently carried by the Company's systems and have elected to negotiate with the Company for Retransmission Consent. Although the Company has obtained Retransmission Consent agreements with all broadcast stations it currently carries, a number of these agreements are temporary in nature and the potential remains for discontinuation of carriage if an agreement is not ultimately reached. The FCC has imposed new regulations under the 1992 Cable Act in the areas of customer service, technical standards, equal employment opportunity, privacy, rates for leased access channels, obscenity and indecency, and disposition of a customer's home wiring. The FCC has also issued a report to Congress on proposals for compatibility with other consumer electronic equipment such as "cable ready" television sets and videocassette recorders and has issued a notice of proposed rulemaking seeking comments on proposed equipment compatibility regulations. A number of lawsuits have been filed in federal court challenging the constitutionality of various provisions of the 1992 Cable Act. A challenge to the constitutionality of the 1992 Cable Act's Must Carry rules was denied by a federal court in April 1993. A stay of the rules pending an appeal to the United States Supreme Court was denied. Argument on those rules was heard by the United States Supreme Court in January 1994. Other lawsuits filed challenging the application of the Must Carry rules to particular cable television systems have been unsuccessful. Most other challenged provisions of the 1992 Cable Act have been upheld at the federal district court level, including provisions governing rate regulation and retransmission consent, but an appeal to the District of Columbia Court of Appeals of that decision has been filed. Other challenges to the FCC rate freeze and other provisions of the FCC's rate regulation scheme have been separately brought directly to the D.C. Circuit. The Company cannot predict the outcome of any of the foregoing litigation affecting the 1992 Cable Act. OTHER FCC REGULATION. In addition to the rules and regulations promulgated by the FCC under the 1984 Cable Act and the 1992 Cable Act, the FCC has promulgated other rules affecting the Company. FCC rules require that cable systems black out certain network and sports programming on imported distant broadcast signals upon request. The FCC also requires that cable systems delete syndicated programming carried on distant signals upon the request of any local station holding the exclusive right to broadcast the same program within the local television market and, in certain cases, upon the request of the copyright owner of such programs. These rules affect the diversity and cost of the Company's programming options for their cable systems. The FCC has the authority to regulate utility company rates for cable rental of pole and conduit space. States can establish preemptive regulations in this area, and the states in which the Company's cable television systems operate have done so. The FCC's technical guidelines for signal leakage became substantially more stringent in 1990, requiring upgrading expenditures by the Company. Two-way radio stations, microwave-relay stations and satellite earth stations used by the Company's cable television systems are licensed by the FCC. (18) FEDERAL COPYRIGHT REGULATION. There are no restrictions on the number of distant broadcast television signals that cable television systems can import, but cable systems are required to pay copyright royalty fees to receive a compulsory license to carry them. The United States Copyright Office has increased the royalty fee from time to time. The FCC has recommended to Congress the abolition of the compulsory licenses for cable television carriage of broadcast signals. Any such action by Congress could adversely affect the Company's ability to obtain such programming and could increase the cost of such programming. CABLE TELEVISION CROSS-MEDIA OWNERSHIP LIMITATIONS. The 1984 Cable Act prohibits any person or entity from owning broadcast television and cable properties in the same market. The 1984 Cable Act also bars co-ownership of telephone companies and cable television systems operating in the same service areas, with limited exceptions for rural areas. The FCC may also expand the rural exemption for telephone companies offering cable service within their service areas. The FCC has modified its rule that formerly barred the commercial broadcasting networks (NBC, CBS and ABC) from owning cable television systems. The FCC rule does not allow the networks to acquire cable systems in markets in which they already own a broadcast station, and sets limitations on the percentage of homes that can be passed, both nationally and locally, by network-owned cable systems. There is no federal bar to newspaper ownership of cable television systems. The 1992 Cable Act imposed limits on new acquisitions of SMATV or MMDS systems by cable operators in their franchise areas. The Company does not have any prohibited cross-ownership interests. STATE AND LOCAL REGULATION. Regulatory responsibility for essentially local aspects of the cable business such as franchisee selection, system design and construction, safety, and consumer services remains with either state or local officials and, in some jurisdictions, with both. The 1992 Cable Act expands the factors that a franchising authority can consider in deciding whether to renew a franchise and limits the damages for certain constitutional claims against franchising authorities for their franchising activities. New York law provides for comprehensive state-wide regulation, including approval of transfers of cable franchises and consumer protection legislation. State and local franchising jurisdiction is not unlimited, however, and must be exercised consistently with the provisions of the 1984 Cable Act and the 1992 Cable Act. Among the more significant restrictions that the Cable Act imposes on the regulatory jurisdiction of local franchising authorities is a 5% ceiling on franchise fees and mandatory renegotiation of certain franchise requirements if warranted by changed circumstances. (19) CONSOLIDATED CABLE AFFILIATES V CABLE. On December 31, 1992, the Company consummated a significant restructuring and reorganization involving its unrestricted subsidiary V Cable, U.S. Cable and General Electric Capital Corporation ("GECC"), V Cable's principal creditor (the "V Cable Reorganization"). In the V Cable Reorganization, V Cable acquired, for $20.0 million, a 20% partnership interest in U.S. Cable, and U.S. Cable acquired, for $3.0 million, a 19% non-voting interest in a newly incorporated subsidiary of V Cable ("VC Holding") that was formed to hold substantially all of V Cable's assets. As a result, V Cable now owns an effective 84.8% interest in VC Holding. GECC then provided new long-term credit facilities to each of V Cable, VC Holding and U.S. Cable. The debt of V Cable and VC Holding is guaranteed by, and secured by a pledge of all of the assets of, V Cable, VC Holding and each of their subsidiaries, including a pledge of all direct and indirect ownership interests in such subsidiaries. The debt of U.S. Cable is guaranteed by all subsidiaries of U.S. Cable, and secured by all the assets of each subsidiary of U.S. Cable; U.S. Cable's debt is also guaranteed (and cross-collateralized in most cases) by each of V Cable, VC Holding and each of their subsidiaries. All of the V Cable, VC Holding and U.S. Cable credit facilities are non-recourse to the Company other than with respect to the common stock of V Cable owned by the Company. The Company manages the U.S. Cable properties and the V Cable systems under management agreements that provide for cost reimbursement, including an allocation of overhead charges. In connection with the V Cable Reorganization, V Cable will assume, on December 31, 1997, approximately $121.0 million face value of debt of U.S. Cable ($78.3 million present value as of December 31, 1993), which amount is subject to adjustment, upward or downward, depending on U.S. Cable's ratio of debt to cash flow (as defined) in 1997. Each year thereafter, until the final adjustment upon occurrence of an exchange described below, the amount of U.S. Cable debt assumed by V Cable may be similarly adjusted, upward or downward. V Cable has the option to exchange its interest in U.S. Cable for all of U.S. Cable's interest in VC Holding and thus recover full ownership of the V Cable systems from and after January 1, 1998. Upon such an exchange, the guarantee and cross collateralization by V Cable and VC Holding of any portion of the U.S. Cable senior credit facilities not assumed by V Cable would terminate. Such option may not be exercised prior to November 30, 2001 unless the U.S. Cable systems have been sold for a net purchase price sufficient to repay to GECC certain of the U.S. Cable loans not assumed by V Cable, as well as a fixed additional amount. In addition, V Cable may exercise the option prior to January 1, 1998 if the U.S. Cable systems have been sold, all outstanding indebtedness of V Cable, VC Holding and U.S. Cable to GECC (other than junior subordinated debt and certain other excluded indebtedness) is repaid, and an additional fixed amount is paid to GECC. The Company accounts for its investment in U.S. Cable using the equity method of accounting. (20) CABLEVISION OF NEW YORK CITY. In July 1992, the Company acquired (the "CNYC Acquisition") substantially all of the remaining interests in Cablevision of New York City -- Phase I through Phase V ("CNYC"), the operator of a cable television system that is under development in The Bronx and parts of Brooklyn, New York. Prior to the CNYC Acquisition, the Company had a 15% interest in CNYC and Charles F. Dolan, the chief executive officer and principal shareholder of the Company, owned the remaining interests. Mr. Dolan remains a partner in CNYC, with a 1% interest and the right to certain preferential payments. CNYC holds franchises that permit construction of the franchised areas in specified phases. Construction of the systems in the Brooklyn and The Bronx franchises will take place in five and four phases, respectively. Construction of Phases I, II, III and IV in Brooklyn and Phases I, II and III in The Bronx has been substantially completed. Construction of Phase IV in The Bronx and Phase V in Brooklyn is scheduled to be substantially fully built by the end of 1995. Under the agreement between the Company and Mr. Dolan, a new limited partnership ("CNYC LP") was formed and holds 99% of the partnership interests in CNYC. The remaining 1% interest in CNYC is owned by the existing corporate general partner, which is a wholly-owned subsidiary of the Company. The Company owns 99% of the partnership interests in CNYC LP and Mr. Dolan retains a 1% partnership interest in CNYC LP plus certain preferential rights. Mr. Dolan's preferential rights entitle him to an annual cash payment (the "Annual Payment") of 14% multiplied by the outstanding balance of his "Minimum Payment". The Minimum Payment is $40.0 million and is to be paid to Mr. Dolan prior to any distributions from CNYC LP to partners other than Mr. Dolan. In addition, Mr. Dolan has the right, exercisable on December 31, 1997, and as of the earlier of (1) December 31, 2000 and (2) December 31 of the first year after 1997 during which CNYC achieves an aggregate of 400,000 subscribers, to require the Company to purchase (Mr. Dolan's "put") his interest in CNYC LP. The Company has the right to require Mr. Dolan to sell his interest in CNYC LP to the Company (the Company's "call") during the three-year period commencing one year after the expiration of Mr. Dolan's second put. In the event of a put, Mr. Dolan will be entitled to receive from the Company the Minimum Payment, any accrued but unpaid Annual Payments, a guaranteed return on certain of his investments in CNYC LP and a Preferred Payment defined as a payment (not exceeding $150.0 million) equal to 40% of the Appraised Equity Value (as defined) of CNYC LP after making certain deductions including a deduction of a 25% compound annual return on approximately 85% of the Company's investments with respect to the construction of Phases III, IV and V of CNYC and 100% of certain of the Company's other investments in CNYC, including Mr. Dolan's Annual Payment. In the event the Company exercises its call, the purchase price will be computed on the same basis as for a put except that there will be no payment in respect of the Appraised Equity Value amount. The Company has the right to make payment of the put or call exercise price in the form of shares of the Company's Class B Common Stock or, if Mr. Dolan so elects, Class A Common Stock, except that all Annual Payments must be paid in cash to the (21) extent permitted under the Company's Credit Agreement (as defined below). Under the Credit Agreement, the Company is currently prohibited from paying the put or call exercise price in cash and, accordingly, without the consent of the bank lenders, would be required to pay it in shares of the Company's Common Stock. The Company has agreed to invest in CNYC LP sufficient funds to permit CNYC LP to make the required Annual Payments to Mr. Dolan and to make certain equity contributions to CNYC. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources -- Restricted Group." The subsidiaries of the Company that own all of the Company's interests in CNYC have succeeded to the rights and obligations of Mr. Dolan under a security agreement relating to CNYC's credit agreement and in connection therewith have pledged all of the Company's interests in CNYC and CNYC LP to secure the obligations to the bank lenders under the CNYC credit agreement. Recourse against these subsidiaries, which are members of the Restricted Group, is limited solely to the pledged interests in CNYC and CNYC LP. OTHER CABLE AFFILIATES A-R CABLE. On May 11, 1992, A-R Cable purchased approximately $237 million principal amount of its Senior Subordinated Deferred Interest Notes due December 30, 1997 (the "A-R Cable Notes") representing approximately 86.9% of the principal amount of A-R Cable Notes outstanding. Concurrent with the purchase of the A-R Cable Notes, Warburg, Pincus Investors, L.P. ("Warburg Pincus") purchased a new Series A Preferred Stock of A-R Cable for a cash investment of $105.0 million, and the Company purchased a new Series B Preferred Stock of A-R Cable for a cash investment of $45.0 million. The Company acquired the funds for its investment in A-R Cable through borrowings under the Company's credit agreement. In addition, GECC provided A-R Cable with an additional $70.0 million under a secured revolving credit line. The proceeds from the sale of the Series A and Series B Preferred Stock and the additional GECC loans were used to purchase the A-R Cable Notes. In connection with Warburg Pincus' investment in A-R Cable, upon the receipt of certain franchise approvals, Warburg Pincus will be permitted to elect three of the six members of the A-R Cable board of directors, will have approval rights over certain major corporate decisions of A-R Cable and will be entitled to 60% of the vote on all matters on which holders of capital stock are entitled to vote (other than the election of directors). A wholly-owned subsidiary of the Company continues to own the common stock, as well as the Series B Preferred Stock, of A-R Cable and the Company continues to manage A-R Cable under a management agreement that provides for cost reimbursement, an allocation of overhead charges and a management fee of 3-1/2% of gross receipts, as defined, with interest on unpaid annual amounts thereon at a rate of 10% per annum. The 3-1/2% fee and interest thereon is payable by A-R Cable only after repayment in full of its senior debt and certain other obligations. Under certain circumstances, the fee is subject to reduction to 2-1/2% of gross receipts. (22) After May 11, 1997, either Warburg Pincus or the Company may irrevocably cause the sale of A-R Cable, subject to certain conditions. In certain circumstances, Warburg Pincus may cause the sale of A-R Cable prior to that date. If Warburg Pincus initiates the sale, the Company will have the right to purchase A-R Cable through an appraisal procedure. The Company's purchase right may be forfeited in certain circumstances. Upon the sale of A-R Cable, the net sales proceeds, after repayment of all outstanding indebtedness and other liabilities, will be used as follows: first, to repay Warburg Pincus' original $105.0 million investment in the Series A Preferred Stock; second, to repay the Company's original investment of $45.0 million in the Series B Preferred Stock; third, to repay the accumulated unpaid dividends on the Series A Preferred Stock (19% annual rate); fourth, to repay the accumulated unpaid dividends on the Series B Preferred Stock (12% annual rate); fifth, to pay the Company for all accrued and unpaid management fees together with accrued but unpaid interest thereon; sixth, pro rata 60% to the Series A Preferred Stockholders, 4% to the Series B Preferred Stockholders and 36% to the common stockholder(s). Also in connection with the purchase of the A-R Cable Notes, A-R Cable retired its previously outstanding preferred stock (undesignated as to series) which it had purchased from an affiliate for nominal consideration. In connection with the purchase of the preferred stock, a transaction fee agreement between A-R Cable and GECC was terminated and A-R Cable's obligations thereunder were extinguished. As a result of the rights to which Warburg Pincus is entitled discussed above, the Company no longer has financial or voting control over A-R Cable's operations. Accordingly, the Company no longer consolidates the financial position or results of operations of A-R Cable. For reporting purposes, the deconsolidation of A-R Cable became effective on January 1, 1992 and the Company is accounting for its investment using the equity method of accounting. The Company continues to guarantee the debt of A-R Cable to GECC under a limited recourse guarantee wherein recourse to the Company is limited solely to the common stock and Series B Preferred Stock of A-R Cable owned by a wholly-owned subsidiary of the Company. In October and November 1992, A-R Cable repurchased approximately an aggregate $6.9 million principal amount of the A-R Cable Notes at an average price of $98.60 per $100 principal amount. The funds for such repurchase were obtained by additional borrowings under A-R Cable's secured revolving credit line. In February 1993, A-R Cable redeemed the remaining principal amount of A-R Cable Notes and accrued interest thereon in the aggregate amount of $29.3 million. The funds for such redemption were obtained from an additional revolving credit line provided by GECC. CABLEVISION OF BOSTON. Cablevision of Boston, a Massachusetts limited partnership, is engaged in the construction, ownership and operation of cable television systems in Boston and Brookline, Massachusetts. The Company had advanced net funds to Cablevision of Boston as of December 31, 1993 amounting to approximately $52.0 million. Due to uncertainties existing during 1985 (which subsequently were resolved), (23) the Company wrote off for accounting purposes its entire investment in and advances to Cablevision of Boston of $34.5 million as of September 30, 1985. Subsequent to 1985, a subsidiary of the Company exchanged $45.7 million of advances, consisting of amounts previously written off of $34.5 million, interest of $3.2 million that had not been recognized for accounting purposes, and $8.0 million of subsequent advances, for $45.7 million of preferred equity in Cablevision of Boston. After this exchange, the Company advanced an additional $9.5 million to Cablevision of Boston; in addition, at December 31, 1993, $81.2 million of unpaid distributions had accrued on the Company's preferred equity. At December 31, 1993, as a result of the write-off referred to above and non-recognition for accounting purposes of the unpaid distributions, the Company's consolidated financial statements reflected $17.5 million due from Cablevision of Boston. The Company's preferred equity is subordinated to the indebtedness of Cablevision of Boston (including the Company's $9.5 million of advances not converted to preferred equity) and accrued but unpaid management fees due to a corporation owned by the managing general partner, which indebtedness and management fees aggregated approximately $92.2 million at December 31, 1993, and any working capital deficit incurred in the ordinary course of business. In addition to the Company's preferred equity interest in Cablevision of Boston, the Company is a limited partner in Cablevision of Boston and currently holds a 7% prepayout interest and a 20.7% postpayout interest. Mr. Dolan holds directly or indirectly a 1% prepayout general partnership interest and a 23.5% postpayout general partnership interest in Cablevision of Boston. With respect to Cablevision of Boston, "payout" means the date on which the limited partners are distributed the amount of their original investment. CABLEVISION OF CHICAGO. Cablevision of Chicago owns cable television systems operating in the suburban Chicago area. The Company does not have a material ownership interest in Cablevision of Chicago but had loans and advances outstanding to Cablevision of Chicago in the amount of $12.4 million (plus $10.1 million in accrued interest which the Company has fully reserved) as of December 31, 1993, which loans and advances are subordinated to Cablevision of Chicago's senior credit facility. Mr. Dolan currently holds directly or indirectly an approximate 1% prepayout and a 32.7% postpayout general partnership interest in the cable television systems owned and operated by Cablevision of Chicago. With respect to Cablevision of Chicago, "payout" means the date on which the limited partners in Cablevision of Chicago are distributed the amount of their original investment, plus interest thereon, if applicable. In February, 1993 Cablevision of Chicago amended its credit facility, increasing the maximum amount available under such facility to $85.0 million and obtaining the ability to pay certain subordinated debt. CABLEVISION OF NEWARK. In April 1992, Cablevision of Newark, a partnership 25% owned and managed by the Company and 75% owned by an affiliate of Warburg Pincus, acquired cable television systems located in Newark and South Orange, New Jersey ("Gateway Cable") from Gilbert Media Associates, L.P. for a cash purchase price of approximately $76.5 million. The Company's total capital contributions to Cablevision of Newark were approximately $6.0 million. The Company manages the (24) operations of Cablevision of Newark for a fee equal to 3-1/2% of gross receipts, as defined, plus reimbursement of certain costs and an allocation of certain selling, general and administrative expenses. U.S. CABLE. In connection with the V Cable Reorganization (see Note 2 of Notes to Consolidated Financial Statements), V Cable acquired for $20.0 million a 20% interest in U.S. Cable. The Company has managed the properties of U.S. Cable since June 1992 under management agreements that provide for cost reimbursement, including an allocation of overhead charges. (25) PROGRAMMING OPERATIONS GENERAL. The Company conducts its programming activities through Rainbow Programming, its wholly owned subsidiary, and through subsidiaries of Rainbow Programming in partnership with certain unaffiliated entities, including National Broadcasting Company, Inc. ("NBC") and Liberty Media Corporation ("Liberty"). Rainbow Programming's businesses include eight regional SportsChannel services, two national entertainment services (American Movie Classics Company ("AMCC") and Bravo Network ("Bravo")), News 12 Long Island (a regional news service serving Long Island, New York) and the national backdrop sports services of Prime SportsChannel Networks ("Prime SportsChannel"). Rainbow Programming also owns an interest in Courtroom Television Network. Rainbow Programming's SportsChannel services provide regional sports programming to the New York, Philadelphia, New England, Chicago, Cincinnati, Cleveland, San Francisco and Florida areas. AMCC is a national program service featuring classic, unedited and non-colorized films from the 1930s through the 1970s. Bravo is a national program service offering international films and performing arts programs, including jazz, dance, classical music, opera and theatrical programs. Rainbow Programming acts as managing partner for each of these programming businesses, other than Courtroom Television Network (which is managed by Time Warner), and reflects its share of the profits or losses in these businesses using the equity method of accounting. Rainbow Programming may from time to time sell equity interests in certain of these businesses, which sale(s) would reduce Rainbow Programming's ownership interests therein. Certain of Rainbow Programming's programming interests are held through Rainbow Program Enterprises ("RPE"), which is substantially wholly owned by Rainbow Programming. In December 1992, Rainbow Programming, NBC and Liberty entered into an agreement to form Prime SportsChannel, a partnership to supply national sports programming, including live and taped sports events and sports news, to regional sports markets in the United States. The partnership, which is owned 50% by an affiliate of Liberty and 25% each by affiliates of Rainbow and NBC, delivers two national sports program services: Prime Network, consisting primarily of live and taped events, and SportsChannel America, featuring sports news and occasional events. In addition, an affiliate of Liberty concurrently acquired a one-third partnership interest in SportsChannel Prism Associates ("Prism"), which operates two regional sports and entertainment programming services in Philadelphia. Following this transaction, affiliates of Liberty, Rainbow Programming and NBC are equal one-third partners in Prism. In January 1993, Liberty exercised the remainder of its option to purchase an additional 0.1% interest in SportsChannel Chicago Associates equally from both Rainbow Programming and NBC. Accordingly, Liberty now has a 50% ownership interest while Rainbow and NBC each have a 25% interest in the company. (26) As previously announced, the Company is considering possible transactions that could result in Rainbow Programming, or another entity holding the Company's programming interests, becoming a publicly-held company, including a spin-off of all or a portion of Rainbow Programming or such entity to the Company's common stockholders. Rainbow Programming and NBC formed a venture to exploit the pay-per-view television rights to the 1992 Summer Olympics. Rainbow Programming's share of the losses of the venture amounted to its maximum obligation of $50 million and this payment was made to NBC in January 1993. On August 2, 1993, Rainbow Programming received a notice from the AMCC partner affiliated with Liberty Media Corporation initiating the buy-sell procedure and setting a stated value of $390 million for all the partnership interests in AMCC. The partnership agreement provides that the non-initiating partner has a period of 45 days from receipt of the buy-sell notice to elect to purchase the initiating partner's interest at the stated value or sell its interest at the stated value. On September 16, 1993, Rainbow Programming notified its partners in AMCC that it had elected to purchase Liberty Media's 50% interest in AMCC at the stated value. The Company anticipates that the transaction will be consummated in the second quarter of 1994. Rainbow Programming's financing needs have been funded by the Restricted Group's investments in and advances to Rainbow Programming, by sales of equity interests in various programming businesses and, to a limited extent, through separate, external debt financing. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources". COMPETITION. There are numerous programming services with which Rainbow Programming competes for cable television system distribution and for subscribers, including network television, other national and regional cable services, independent broadcast television stations, television superstations, the home videocassette industry, and developing pay-per-view services. Rainbow Programming and the other programming services are competing for limited channel capacity and for inclusion in the basic service tier of the systems offering their programming services. Many of these program distributors are large, publicly-held companies which have greater financial resources than Rainbow Programming. Rainbow Programming also competes for the availability of programming, through competition for telecast rights to films and competition for rights agreements with sports teams. The Company anticipates that such competition will increase as the number of programming distributors increases. (27) In general, the programming services offered by Rainbow Programming compete with other forms of television-related services and entertainment media on the basis of the price of services, the variety and quality of programming offered and the effectiveness of Rainbow Programming's marketing efforts. REGULATION. Cable television program distributors such as Rainbow Programming are not regulated by the FCC under the Communications Act of 1934. To the extent that regulations and laws, either presently in force or proposed, hinder or stimulate the growth of the cable television and satellite industries, the business of Rainbow Programming will be directly affected. As discussed above under "Business - Cable Television Operations - Regulation", the 1992 Cable Act limits in certain ways the Company's ability to freely manage the Rainbow Programming services or carry the Rainbow Programming services on their affiliates' systems or could impose other regulations on the Rainbow Programming companies. The 1984 Cable Act prohibits localities from requiring carriage of specific programming services, providing a more open market for Rainbow Programming and other cable program distributors. The 1984 Cable Act limits the number of commercial leased access channels that a cable television operator must make available for potentially competitive services but the 1992 Cable Act empowers the FCC to set the rates and conditions for such leased access channels. The reimposition of the FCC's rules requiring blackout of syndicated programming on distant broadcast signals for which a local broadcasting station has an exclusive contract opened new channels for Rainbow Programming's services. Satellite common carriers, from whom Rainbow Programming and its affiliates obtain transponder channel time to distribute their programming, are directly regulated by the FCC. All common carriers must obtain from the FCC a certificate for the construction and operation of their interstate communications facilities. Satellite common carriers must also obtain FCC authorization to utilize satellite orbital slots assigned to the United States by the World Administrative Radio Conference. Such slots are finite in number, thus limiting the number of carriers that can provide satellite service and the number of channels available for program producers and distributors such as Rainbow Programming and its affiliates. Nevertheless, there are at present numerous competing satellite services that provide transponders for video services to the cable industry. All common carriers must offer their communications service to Rainbow Programming and others on a nondiscriminatory basis (including by means of a lottery). A satellite carrier cannot unreasonably discriminate against any customer in its charges or conditions of carriage. (28) ADVERTISING SERVICES Rainbow Advertising represents certain of the Company's cable television systems in the sales of advertising time to regional and local advertisers. Rainbow Advertising also represents each of the SportsChannel regional programming services and the News 12 Long Island programming service in the sales of advertising time to national and regional advertisers. Rainbow Advertising represents cable television systems unaffiliated with the Company in the sales of spot advertising to national and regional advertisers. Rainbow Advertising also has contracted with certain unaffiliated cable television operators to act as their exclusive representative for the sales of advertising time to local advertisers. OTHER AFFILIATES ATLANTIC PUBLISHING. Atlantic Cable Television Publishing Corporation ("Atlantic Publishing") holds a minority equity interest and a debt interest in a company that publishes a weekly cable television guide which is offered to the Company's subscribers and to other unaffiliated cable television operators. As of December 31, 1993, the Company had advanced an aggregate of approximately $18.3 million to Atlantic Publishing, of which approximately $0.7 million was advanced during 1992 and approximately $0.5 million was paid back during 1993. The Company has written off all of its advances to Atlantic Publishing other than $4.0 million. Atlantic Publishing is owned by a trust for certain Dolan family members; however, the Company has the option to purchase Atlantic Publishing for an amount equal to the owner's net investment therein plus interest. The current owner has made only a nominal investment in Atlantic Publishing to date. RADIO STATION WKNR. In 1990, the Company and a partner purchased Cleveland Radio Associates ("WKNR"), an AM radio station serving the Cleveland metropolitan area. The Company purchased its partner's interest and its total purchase price for its 100% interest in the radio station was $2.5 million. The Company has implemented a change for WKNR to an all-sports format. The Company purchased WKNR in order to explore possible synergies that may exist between radio and its cable television systems and regional sports channel service in the Cleveland market. EMPLOYEES AND LABOR RELATIONS As of December 31, 1993, the Company had 3,197 full-time, 370 part-time and 69 temporary employees. During 1991, the International Brotherhood of Electrical Workers ("IBEW") conducted an organizing campaign among employees involved in the operation of News 12 Long Island. In connection with that campaign, the IBEW claimed that various unfair labor practices were committed. An NLRB administrative law judge found that News 12's downsizing of its work force in 1991 was based upon valid economic factors and was not an unfair labor practice. The IBEW intends to appeal this determination. The administrative law judge has also found that News 12 offered improper promises to certain employees and improper threats of retaliation to (29) others. News 12 intends to appeal this determination. As of December 31, 1993, News 12 Long Island had 40 full-time, 7 part-time and 102 temporary employees. In January 1993, IBEW Local 3 filed a Petition seeking to organize certain employees in CNYC's engineering department. At an election held on March 23, 1994, the employees voted not to be represented by the union. CNYC currently employs 642 employees of whom approximately 145 comprise the proposed bargaining unit. There are no collective bargaining agreements with employees in effect, and the Company believes that its relations with its employees are satisfactory. (30) ITEM 2. ITEM 2. PROPERTIES The Company generally leases the real estate where its business offices, microwave receiving antennae, earth stations, transponders, microwave towers, warehouses, headend equipment, hub sites, program production studios and access studios are located. Significant leasehold properties include eleven business offices, comprising the Company's headquarters located in Woodbury, New York with approximately 248,000 square feet of space, and the headend sites. The Company believes its properties are adequate for its use. The Company generally owns all assets (other than real property) related to the cable television operations of the Restricted Group, including its program production equipment, headend equipment (towers, antennae, electronic equipment and satellite earth stations), cable system plant (distribution equipment, amplifiers, subscriber drops and hardware), converters, test equipment, tools and maintenance equipment. Similarly, the unconsolidated entities managed by the Company generally own such assets related to their cable television operations. The Company generally leases its service and other vehicles. Substantially all of the assets of the Restricted Group, CNYC, V Cable and VC Holding are pledged to secure borrowings under their respective credit agreements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is party to various lawsuits, some involving substantial amounts. Management does not believe that the resolution of such lawsuits will have a material adverse impact on the financial position of the Company. See Note 12 of Notes to Consolidated Financial Statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. (31) PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Class A Common Stock, par value $.01 per share ("Class A Common Stock"), is traded on the American Stock Exchange under the symbol "CVC". The following table sets forth the high and low sales prices for the last two years of Class A Common Stock as reported by the American Stock Exchange for the periods indicated. As of March 15, 1994, there were 719 holders of record of Class A Common Stock. There is no public trading market for the Company's Class B Common Stock, par value $.01 per share ("Class B Common Stock"). As of March 15, 1994, there were 23 holders of record of Class B Common Stock. DIVIDENDS. The Company has not paid any dividends on shares of Class A or Class B Common Stock. The Company intends to retain earnings to fund the growth of its business and does not anticipate paying any cash dividends on shares of Class A or Class B Common Stock in the foreseeable future. The Company may pay cash dividends on its capital stock only from surplus as determined under Delaware law. Holders of Class A and Class B Common Stock are entitled to receive dividends equally on a per share basis if and when such dividends are declared by the Board of Directors of the Company from funds legally available therefor. No dividend may be declared or paid in cash or property on shares of either Class A or Class B Common Stock unless the same dividend is paid simultaneously on each share of the other class of common stock. In the case of any stock dividend, holders of Class A Common Stock are entitled to receive the same percentage dividend (payable in shares of Class A Common Stock) as the holders of Class B Common Stock receive (payable in shares of Class B Common Stock). In addition, the Company is restricted from paying dividends on its capital stock, other than the Company's 8% Series C Cumulative Preferred Stock, under the provisions of its debt agreements. Under the most restrictive of these provisions, cash dividends could not be paid on Class A or Class B Common Stock at December 31, 1993. Dividends may not be paid in respect of shares of Class A or Class B Common Stock unless all dividends due and payable in respect of the preferred stock of the Company have been paid or provided for. (32) ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED FINANCIAL AND STATISTICAL DATA The operating and balance sheet data included in the following selected financial data have been derived from the consolidated financial statements of the Company. Acquisitions made by the Company were accounted for under the purchase method of accounting and, accordingly, the acquisition costs were allocated to the net assets acquired based on their fair value, except for assets owned by Mr. Dolan or affiliates of Mr. Dolan which were recorded at historical cost. Acquisitions are reflected in operating, balance sheet and statistical data from the time of acquisition. The operating data for 1992 reflects the deconsolidation of the Company's A-R Cable subsidiary for reporting purposes, effective January 1, 1992. The selected financial data presented below should be read in conjunction with the financial statements of the Company and notes thereto included in Item 8 of this Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION RECENT CABLE REGULATORY DEVELOPMENTS As a result of the initial FCC rate regulations, significant rate reductions were required in a number of the Company's cable television systems. The Company estimates that rate changes and other adjustments, effective September 1, 1993, made in compliance with the initial FCC regulations, caused revenues and operating cash flow (operating profit before depreciation and amortization) to decline $14.9 million and $13.4 million, respectively, for the period from September 1, through December 31, 1993 from those that would have existed absent such adjustments. On February 22, 1994, the FCC ordered a further reduction in rates in effect on September 30, 1992 for the basic service tier. For a further description see Item 1 - "Business - Cable Television Operations - Competition and Regulation". The Company is currently in the process of attempting to analyze the impact of the revised rate regulations announced by the FCC in February 1994. Because the Company has not yet had an opportunity to review the formal text of the revised regulations, it is not possible at this time to predict the ultimate financial impact of these rate regulations on the Company and its subsidiaries; however, the Company expects further rate reductions will be required in a number of its cable television systems. In connection with the implementation of its revised rate structure resulting from the initial FCC rate regulation, the Company introduced a number of measures, including the provision of alternate service offerings and repackaging of certain services in order to mitigate the negative impact of FCC regulation on the Company's rate structure. Following the latest FCC rate regulation, the Company intends to introduce additional marketing measures. The Company is not able to predict fully the extent of the effect any of such measures will have in mitigating the impact of rate regulation. RECENT ACQUISITIONS AND RESTRUCTURINGS The Company's high levels of interest expense and depreciation and amortization, largely associated with acquisitions made by the Company in the past, have had and will continue to have a negative impact on the reported results of the Company. Consequently, the Company expects to report substantial net losses for at least the next several years. For a description of the Company's recent acquisitions and restructurings, see Item 1 - "Business - Consolidated Cable Affiliates and Other Cable Affiliates" and Note 2 of Notes to Consolidated Financial Statements. For a description of the Company's pending acquisitions see Item 1 - "Business - Recent Developments". (35) RESULTS OF OPERATIONS The following table sets forth on a historical basis certain items related to operations as a percentage of net revenues for the periods indicated. The results of operations of CNYC are included in 1992 from the date of acquisition. COMPARISON OF YEAR ENDED DECEMBER 31, 1993 VERSUS YEAR ENDED DECEMBER 31, 1992. NET REVENUES for the year ended December 31, 1993 increased $94.2 million (16%) as compared to net revenues for the prior year. Approximately $45.8 million (8%) of the increase is attributable to the CNYC Acquisition on July 10, 1992; approximately $37.1 million (6%) to internal growth of over 112,700 (9%) in the average number of subscribers during the year; and approximately $11.6 million (2%) resulted from an increase in other revenue sources such as advertising. These increases were offset slightly by a decrease of approximately $0.3 million attributable to decreased revenue per subscriber resulting primarily from compliance with FCC regulations. See "Recent Cable Regulatory Developments" above. TECHNICAL EXPENSES for 1993 increased $37.4 million (18%) over the 1992 amount. Approximately 11% of the 18% increase is attributable to the CNYC Acquisition (whose programming costs reflect high premium service penetration); the remaining (36) 7% is attributable to increased costs directly associated with the growth in subscribers and revenues discussed above. As a percentage of net revenues, technical expenses increased less than 1% during 1993 as compared to 1992; excluding the effect of the CNYC Acquisition, such expenses would have remained relatively constant during 1993. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES increased $52.3 million (43%) for 1993 as compared to the 1992 level. Approximately 13% of this 43% increase is directly attributable to the CNYC Acquisition, 17% to expense adjustments related to an incentive stock plan and 13% to general cost increases, including higher administrative and sales and marketing costs (a portion of which was attributable to compliance with FCC regulation during the third quarter of 1993). As a percentage of net revenues, selling, general and administrative expenses increased 5%; excluding the effects of the CNYC Acquisition and the incentive stock plan expense adjustments, such expenses, as a percent of net revenues, would have decreased 1% during 1993. OPERATING CASH FLOW (operating profit before depreciation and amortization) increased $4.5 million (2%) to $252.2 million for 1993 from $247.7 million for 1992. A $7.8 million (3%) increase, attributable to the CNYC Acquisition, was partially offset by the combined effect of the revenue and expense changes, primarily the impact of the higher selling, general and administrative expenses, noted above. DEPRECIATION AND AMORTIZATION EXPENSE increased $26.4 million (16%) during 1993 as compared to the 1992 amount. The acquisition of CNYC contributed $8.6 million (5%) of this increase. The components of the remaining increase in depreciation and amortization of $17.8 million (11%) are as follows: Depreciation expense for the Company, excluding CNYC, increased $10.7 million during 1993 resulting primarily from depreciation charges on capital expenditures made during 1993 and 1992. Amortization expense, excluding CNYC, increased $7.1 million, reflecting an increase of $10.1 million due to the implementation of SFAS 109 during 1993 offset to some extent by a decrease of $3.0 million primarily due to certain intangible assets becoming fully amortized. NET INTEREST EXPENSE increased $36.9 million (19%) during 1993 compared to 1992. Approximately $3.7 million (2%) of the increase is attributable to the CNYC Acquisition. An increase of $18.2 million (9%) is due to the net effect of the repayment of bank debt, bearing lower average interest rates with the issuances of a series of senior subordinated debentures as well as to an increase in average debt levels in 1993. An additional $15.0 million (8%) increase resulted from V Cable's debt restructuring on December 31, 1992, primarily from amortization of deferred interest expense incurred in connection therewith. SHARE OF AFFILIATES' NET LOSSES of $61.0 million for 1993 and $47.3 million for 1992 consist primarily of the Company's share of A-R Cable's net losses ($56.4 million in 1993 and $30.3 million in 1992), the Company's net share of the profits and losses in certain programming businesses in which the Company has varying ownership interests, (amounting to an $8.8 million profit in 1993 and a $12.4 million loss in (37) 1992) and the Company's share of the net losses of other entities, primarily U.S. Cable (in 1993) and Cablevision of Newark (in 1993 and 1992), which amounted to $13.4 million and $4.6 in 1993 and 1992, respectively. MINORITY INTEREST in 1993 represents U.S. Cable's share of the losses of VC Holding, limited to its $3.0 million investment. At December 31, 1992, as part of a restructuring and reorganization involving the Company's unrestricted subsidiary V Cable, V Cable acquired a 20% interest in U.S. Cable for $20 million, and U.S. Cable acquired a 19% interest in VC Holding (a subsidiary of V Cable formed to hold substantially all of V Cable's assets) for $3.0 million. OTHER ITEMS During 1993, net deferred financing charges of approximately $1.0 million associated with the reduction of the Company's credit facility with proceeds from the issuance of the Company's $150 million debentures in April, were written off. In connection with the acquisition of CNYC, for the year ended December 31, 1993, the Company expensed $5.6 million representing the proportionate amount due with respect to the Annual Payment. For the year ended December 31, 1993, the Company has provided for an additional $22.7 million due Mr. Dolan in respect of the Preferred Payment that would be due him in the event he exercises his "put" as further described under "Business - Cable Television Operations - Consolidated Cable Affiliates - Cablevision of New York City". the additional provision is based on management's estimate of the Appraised Equity Value of the system at December 31, 1993 and has been charged to par value in excess of capital contributed in the accompanying consolidated financial statements. The total amount due Mr. Dolan as of December 31, 1993 in respect of the Preferred Payment amounted to $91.6 million, reflecting a reduction of $3.7 million in 1993 representing Mr. Dolan's obligation to reimburse the Company in connection with certain claims paid or owing by CNYC. See Note 2 of Notes to Consolidated Financial Statements. In May 1993, the Financial Accounting Standards Board (FASB) issued SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities". SFAS 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair values, other than those accounted for under the equity method or as investments in consolidated subsidiaries, and all investments in debt securities. SFAS 115 is effective for fiscal years beginning after December 15, 1993. The effect of initially adopting SFAS 115 will be reported in a manner similar to a cumulative effect of a change in accounting principle. Management of the Company believes that the implementation of SFAS 115 will not have a material effect on the financial position and results of operations of the Company. In November 1992, the FASB issued SFAS No. 112 "Employers Accounting for Postemployment Benefits". This statement is effective for fiscal years beginning after December 15, 1993 and management of the Company believes that the implementation (38) of this statement will not have a significant impact on the results of operations or financial position of the Company. INFLATION. The effects of inflation on the Company's costs have generally been offset by increases in subscriber rates. COMPARISON OF YEAR ENDED DECEMBER 31, 1992 VERSUS YEAR ENDED DECEMBER 31, 1991, AS ADJUSTED. As a result of the A-R Cable Restructuring discussed above, effective January 1, 1992, the Company no longer consolidates the financial position and results of operations of A-R Cable, but rather is accounting for its investment in A-R Cable using the equity method of accounting. Accordingly, in order to provide comparability between the 1992 and 1991 periods presented, the following table reflects adjustments made to 1991 to deconsolidate and show on the equity basis the results of operations of A-R Cable for the year ended December 31, 1991. The results of operations of CNYC are included in 1992 from the date of acquisition. The following discussion and analysis of financial condition and results of operations refers to the adjusted results reflected in the table except as otherwise noted. (39) NET REVENUES for the year ended December 31, 1992 increased $69.4 million (14%) as compared to adjusted net revenues for the prior year. Approximately $35.8 million (7%) of the increase is attributable to the CNYC Acquisition on July 10, 1992; approximately $17.3 million (3%) to an increase of over 40,300 (3.8%) in the average number of subscribers during the year; approximately $9.3 million (2%) to increased revenue per subscriber resulting primarily from rate increases; and approximately $7.0 million (2%) resulted from an increase in non-recurring revenues such as advertising. TECHNICAL EXPENSES for 1992 increased $25.5 million (14%) over the adjusted 1991 amount. Approximately 10% of the increase is attributable to the CNYC Acquisition (whose programming costs reflect high premium service penetration) and 4% is attributable to increased costs directly associated with the other growth in revenues and subscribers discussed above, together with increased rates paid for certain programming services. As a percentage of net revenues, technical expenses remained relatively constant in 1992 as compared to 1991; excluding the effect of the CNYC Acquisition, such expenses would have declined 0.8% during 1992. SELLING, GENERAL AND ADMINISTRATIVE expenses increased $15.8 million (15%) for 1992 as compared to the adjusted 1991 level (11% of this increase is directly attributable to the CNYC Acquisition); excluding the effects of the CNYC Acquisition, such expenses would have increased approximately $3.7 million (4%), primarily due to general cost increases. As a percentage of net revenues, selling, general and administrative expenses remained relatively constant; excluding the effect of the CNYC Acquisition, such expenses would have declined 0.6%, as a percent of net revenues, during 1992. OPERATING CASH FLOW (operating profit before depreciation and amortization) increased $28.1 million (13%) to $247.7 million for 1992 from $219.6 million for 1991, as adjusted. Approximately $6.0 million (3%) of the increase is attributable to the CNYC Acquisition; the remaining $22.1 million (10%) increase is attributable to the combined effect of the revenue and expense increases noted above. DEPRECIATION AND AMORTIZATION EXPENSE increased $3.8 million (2%) during 1992 as compared to the adjusted 1991 amount. The acquisition of CNYC contributed an increase of $8.6 million (5%) in depreciation and amortization during 1992. Depreciation expense for the Company, excluding CNYC, increased $3.2 million (2%) during 1992 resulting from depreciation charges on capital expenditures made during 1992 and 1991. Amortization expense, excluding CNYC, decreased $8.0 million (5%) as the result of certain intangible assets becoming fully amortized during 1992 and 1991. NET INTEREST EXPENSE increased $5.6 million (3%) during 1992 compared to 1991, as adjusted. Interest expense increased by $11.4 million ($3.1 million (2%) attributable to the CNYC Acquisition; $6.9 million (4%) to increasing amortization of the original issue discount on the subordinated notes payable of V Cable; and $1.4 million (1%) to interest incurred on a special funding revolver). These increases were partially offset by a net reduction of approximately $5.8 million (4%) attributable primarily to lower average interest rates during 1992 on the Company's bank debt and on the term loans (40) of V Cable. Included in the calculation of the net $5.8 million reduction is $21.2 million of interest on the Company's $275 million 10-3/4% Senior Subordinated Debentures issued in April 1992, the proceeds of which were used to repay bank debt, on which an estimated $17.8 million of interest would have been charged. SHARE OF AFFILIATES' NET LOSSES of $47.3 million for 1992 and $100.6 million for 1991, as adjusted, consist primarily of the Company's share of A-R Cable's net losses ($30.3 million in 1992 and $76.8 million in 1991, as adjusted), $12.3 million and $4.9 million due to the Company's share of losses in a regional sports programming business which was discontinued on December 31, 1992 and its net share of the profits and losses in other entities, primarily certain programming businesses in which the Company has varying ownership interests, which amounted to an aggregate net loss of $4.7 million and $18.9 million in 1992 and 1991, respectively. OTHER ITEMS During the year ended December 31, 1992, the Company recorded gains of $7.1 million on the sale of certain programming interests and $0.7 million on the sale of marketable securities. During 1991, the Company recorded gains on the sale of certain programming interests approximating $15.5 million, and on the sale of marketable securities approximating $5.8 million. In 1992, the Company provided for the loss it incurred, $50.0 million, with respect to Rainbow Programming's agreement with NBC relating to the telecast of the 1992 Summer Olympics. This amount was paid in January 1993 with borrowings under the Company's Credit Agreement. See Note 8 of Notes to Consolidated Financial Statements. In connection with the V Cable Reorganization described above, the Company recognized a loss on sale of preferred stock amounting to $20.0 million in the year ended December 31, 1992. The cost of debt restructuring, for the year ended December 31, 1992 includes the write-off of deferred financing charges of approximately $4.8 million associated with that portion of bank debt that was repaid ($267 million) with the proceeds of the Company's 10-3/4% subordinated debentures issued in April 1992. In addition, $7.5 million of deferred financing costs was written off in relation to the debt that V Cable carried before the V Cable Reorganization was consummated on December 31, 1992. See Item 1 - "Business - Consolidated Cable Affiliates - V Cable" and Note 2 of Notes to Consolidated Financial Statements. In 1992, the Company provided an additional $5.7 million for settlement of claims and potential claims related to certain litigation that had been pending against Mr. Dolan and the Company, as described in Note 12 of Notes to Consolidated Financial Statements. (41) In connection with the acquisition of CNYC, the Company provided for the $40.0 million minimum payment due Mr. Dolan and, for the year ended December 31, 1992, expensed $2.7 million representing the proportionate amount due with respect to the Annual Payment. As of December 31, 1992, the Company has provided for an additional $27.0 million due Mr. Dolan in respect of the Preferred Payment that would be due him in the event he exercises his "put" as further described under "Business - Cable Television Operations - Consolidated Cable Affiliates - Cablevision of New York City". The additional provision is based on management's estimate of the Appraised Equity Value of the system at December 31, 1992 and has been charged to par value in excess of capital contributed in the accompanying consolidated financial statements. See Note 2 of Notes to Consolidated Financial Statements. INFLATION. The effects of inflation on the Company's costs have generally been offset by increases in subscriber rates. LIQUIDITY AND CAPITAL RESOURCES For financing purposes, the Company is structured as the Restricted Group, consisting of Cablevision Systems Corporation and certain of its subsidiaries and an unrestricted group of certain subsidiaries which includes V Cable (including VC Holding), CNYC, Rainbow Programming, WKNR and Rainbow Advertising. The Restricted Group, V Cable and CNYC are individually and separately financed. Equity funding for CNYC will, however, be provided by the Restricted Group. Rainbow Programming does not have external financing and its cash requirements have been financed to date by the Restricted Group, although one of the programming businesses in which Rainbow Programming invests has separate financing. WKNR and Rainbow Advertising do not have external financing and havebeen financed to date by the Restricted Group. (42) The following table presents selected historical results of operations and other financial information related to the captioned groups or entities for the year ended December 31, 1993. (Rainbow Programming, Rainbow Advertising, and WKNR are included in "Other Unrestricted Subsidiaries"). (43) At December 31, 1993, the Company's consolidated debt was $2,235.5 million (excluding the Company's deficit investment in A-R Cable of $307.8 million), of which $833.0 million represented V Cable's debt and $220.7 million represented CNYC's debt including the $91.6 million obligation to a related party. RESTRICTED GROUP The Company is party to a credit facility with a group of banks led by Toronto-Dominion (Texas) as agent, (the "Credit Agreement"). The maximum amount available to the Restricted Group under the Credit Agreement is $695.6 million with a final maturity at December 31, 2000. The facility consists of a $291.0 million term loan, which begins amortizing on a scheduled quarterly basis beginning December 31, 1993 with 68% being amortized by December 31, 1998; and a $404.6 million revolving loan with scheduled facility reductions starting on December 31, 1993 resulting in a 66.25% reduction by December 31, 1998. On March 18, 1994, the Restricted Group had outstanding bank borrowings of $427.0 million. An additional $18.4 million was reserved under the Credit Agreement for letters of credit issued on behalf of the Company. Unrestricted and undrawn funds available to the Restricted Group under the Credit Agreement amounted to approximately $250.2 million at March 18, 1994. The Credit Agreement contains certain financial covenants that may limit the Restricted Group's ability to utilize all of the undrawn funds available thereunder, including covenants requiring the Restricted Group to maintain certain financial ratios and restricting the permitted uses of borrowed funds. The amount outstanding under a separate credit agreement for the Company's New Jersey subsidiary ("CNJ"), which is part of the Restricted Group, was $58.5 million as of March 18, 1994. The Company and CNJ are jointly and severally liable for this debt. On March 31, 1993, the CNJ revolving facility converted to an amortizing term loan. The CNJ facility began amortizing on a scheduled quarterly basis on June 30, 1993 with 68.25% being amortized by December 31, 1998. As of March 18, 1994 the Company had entered into interest exchange (swap) agreements with several of its banks on a notional amount of $200.0 million, on which its pays a fixed rate of interest and receives a variable rate of interest for periods ranging from one to four years. The average effective annual interest rate on all bank debt outstanding at February 28, 1994 was approximately 8.2%. On February 17, 1993, the Company issued $200.0 million of its 9-7/8% senior subordinated debentures due 2013. The net proceeds of $193.1 million were initially used to repay borrowings under the Company's Credit Agreement. With respect to such issuance the Company had obtained the consent of its bank lenders to waive the provisions of the Credit Agreement that require the Company to reduce the facility by 50% of the gross proceeds of any debenture issue. (44) In April 1993, the Company issued $150,000 of its 9-7/8% senior subordinated debentures due 2023. Approximately $105.0 million of the net proceeds of $145.9 million was used to repay borrowings under the Credit Agreement. As a result of such issuance, the maximum amount available under the Credit Agreement was reduced by $75.0 million. The Restricted Group made capital expenditures of $106.4 million during 1993 and $65.3 million in 1992, primarily in connection with system upgrades, the expansion of existing cable plant to pass additional homes and other general capital needs. The cable systems located in New York State that are owned by the Restricted Group and VC Holding are subject to agreements (the "New York Upgrade Agreements") with the New York State Commission on Cable Television (the "New York Cable Commission"). The New York Upgrade Agreement applicable to the Restricted Group requires the substantial upgrade of its systems, ultimately to a 77 channel capacity by 1995-1996, subject to certain minor exceptions. As part of this planned upgrade of the Restricted Group's New York systems, the Company expects to use fiber optic cable extensively in its trunk and distribution networks. The Company believes that the remaining portion of the upgrade to 77 channels will cost up to an additional $80 million which would be spent during the period 1994 to 1996. In addition, the Company anticipates upgrading certain of its New York systems beyond the level required by the New York Upgrade Agreements along with upgrading certain other of its Restricted Group systems. The Company anticipates that the capital costs of these additional upgrades may be substantial. In July 1992, the Company acquired substantially all of the remaining interests in CNYC. CNYC is separately financed by a $185 million bank credit agreement. Under an agreement with the City of New York, the Company undertook to make aggregate equity contributions in Phases III, IV and V of CNYC of $71.0 million or such lesser amount as the CNYC banks deem necessary. Recourse by the City of New York with respect to such obligation is limited to remedies available under the CNYC franchises. As of March 1, 1994, the Restricted Group had advanced $48.2 million of equity to CNYC and had the ability to invest the balance of the $71.0 million in CNYC. Under the CNYC purchase agreement, the Restricted Group has guaranteed an annual payment to Mr. Dolan of $5.6 million (the "Annual Payment" as defined) and a $40.0 million minimum payment (the "Minimum Payment", as defined). The Minimum Payment can be made in either cash or stock at the Company's option. Under its Credit Agreement, the Company is currently prohibited from paying the Minimum Payment and any amounts in respect of the Preferred Payment in cash. See Item 1 -- "Business -- Consolidated Cable Affiliates -- Cablevision of New York City". In March 1994, the Company purchased the assets of North Coast Cable for an aggregate purchase price of $133 million. The Company's cash requirement for this acquisition amounted to approximately $98.8 million. The remainder of the purchase price was paid with distributions owed the Company with respect to its existing minority interest and accrued management fees owing from North Coast Cable, through the assumption of certain liabilities of North Coast Cable and certain other (45) adjustments. The net cash purchase price was provided by borrowings under the Restricted Group's Credit Agreement. See "Business -- Recent Developments". The Company believes that, for the Restricted Group, and based upon a preliminary analysis of the impact of the revised FCC rate regulations referred to above, as announced by the FCC in February 1994, internally generated funds together with funds available under its existing Credit Agreement, as well as the proceeds from the issuance of the Preferred Shares, will be sufficient through December 31, 1995 (i) to meet its debt service requirements including its amortization requirements under the Credit Agreement, (ii) to fund its normal capital expenditures, including the required upgrades under the New York Upgrade Agreement, and (iii) to fund its anticipated investments, including its $75 million investment in Rainbow Programming in connection with Rainbow Programming's purchase of Liberty Media's 50% interest in AMCC, the $5.6 million annual payments to Charles Dolan in connection with the CNYC Acquisition and the equity requirements in connection with the build out of the CNYC cable systems. Further acquisitions and other investments by the Company, if any, will be funded by undrawn borrowing capacity and by possible increases in the amount available under the Credit Agreement, additional borrowings from other sources, and/or possible future sales of debt, equity or equity related securities. The senior secured indebtedness incurred by A-R Cable and V Cable is guaranteed by the Restricted Group, but recourse against the Restricted Group is limited solely to the common stock of A-R Cable and of V Cable pledged to A-R Cable's and V Cable's senior secured lenders, respectively. Under the terms of the agreement relating to Warburg Pincus' investment in A-R Cable, the Company pledged the stock of the subsidiary which owns all of the A-R Cable common stock and the A-R Cable Series B Preferred Stock as collateral for the Company's indemnification obligations under such agreement. Under the terms of its Credit Agreement, as amended, the Company is permitted to make unspecified investments of up to $200 million, which include the Company's planned investment in Rainbow Programming, in the remaining equity contributions to CNYC and any equity contributions the Company may make to A-R Cable and V Cable. The terms of the instruments governing A-R Cable's and V Cable's indebtedness prohibit transfer of funds (except for certain payments related to corporate overhead allocations by A-R Cable and V Cable and pursuant to an income tax allocation agreement with respect to V Cable) from A-R Cable and V Cable to the Restricted Group and are expected to prohibit such transfer of funds for the foreseeable future. Payments to the Restricted Group in respect of its investments in and advances to Cablevision of Chicago and Cablevision of Boston are also presently prohibited by the terms of those companies' applicable debt instruments and are expected to be prohibited for the foreseeable future. The Restricted Group does not expect that such (46) limitations on transfer of funds or payments will have an adverse effect on the ability of the Company to meet its obligations. V CABLE The new long-term credit facilities extended by GECC to V Cable and VC Holding in connection with the V Cable Reorganization refinanced all of V Cable's pre-existing debt on December 31, 1992. Under the credit agreement between V Cable and GECC (the "V Cable Credit Agreement"), GECC has provided a term loan (the "V Cable Term Loan") in the amount of $20.0 million to V Cable, which accretes interest at a rate of 10.62% compounded semi-annually until December 31, 1997 (the reset date) and is payable in full on December 31, 2001. In addition, GECC has extended to VC Holding a $505 million term loan (the "Series A Term Loan), a $25 million revolving line of credit (the "Revolving Line") and a $202.6 million term loan (the "Series B Term Loan") all three of which comprise the VC Holding Credit Agreement. The Series A Term Loan and any amounts drawn under the Revolving Line pay current cash interest and mature on December 31, 2001. The Series B Term Loan does not pay cash interest but rather accretes interest at a rate of 10.62% compounded semi-annually until December 31, 1997 (the reset date) and is payable in full on December 31, 2001. On March 18, 1994 VC Holding had no outstanding borrowings under the Revolving Line but did have letters of credit issued approximating $2.0 million. Accordingly, unrestricted and undrawn funds under the VC Holding Revolving Line amounted to approximately $23.0 million on March 18, 1994. The VC Holding Credit Agreement also provides for the assumption by VC Holding of certain loans of U.S. Cable, as described under Item 1 -- "Business -- Consolidated Cable Affiliates -- V Cable". The outstanding principal amount of the V Cable Term Loan is payable in full, with accreted interest, at maturity on December 31, 2001. VC Holding is obligated to make principal payments on a portion of the Series A Term Loan beginning on June 30, 1997 totalling $18 million, $20 million, $30 million, $40 million and $56 million for the years ending December 31, 1997, 1998, 1999, 2000 and 2001, respectively. The remaining balance of the Series A Term Loan, as well as any amounts borrowed under the VC Holding Revolving Line, is due December 31, 2001. In addition, VC Holding and V Cable are required to apply all consolidated available cash flow (as defined), as well as the net proceeds of any disposition of assets, to the reduction of the VC Holding Term Loans and the V Cable Term Loan. V Cable made capital expenditures of approximately $20.3 million in 1993 and $17.6 million in 1992, primarily in connection with the expansion of existing cable plant to pass additional homes and for system upgrades and other general capital needs. The New York Upgrade Agreement applicable to V Cable requires the substantial upgrade of its systems in New York State, ultimately to a 77 channel capacity in 1995. In 1992 V Cable completed the first phase of this required upgrade, under which it expanded all of its New York cable systems to a 52 channel capacity. The Company (47) believes that the upgrade of V Cable's New York systems from 52 to 77 channels will cost up to an additional $9.9 million, which would be spent during 1994 and 1995. V Cable anticipates that its cash flow from operations and amounts available under the VC Holding Revolving Line will be sufficient to service its debt, to fund its capital expenditures and to meet its working capital requirements through 1995. However, after taking into account the anticipated reductions to regulated revenue arising from the latest round of FCC regulation, V Cable believes that it is likely that it will be unable to meet several of its financial covenants during such period. To remedy the anticipated covenant defaults, V Cable may request waivers and/or amendments to its credit agreement and/or seek equity contributions from the Restricted Group. There can be no assurance as to V Cable's ability to accomplish any of these alternatives or the terms or timing of such alternatives. CABLEVISION OF NEW YORK CITY CNYC is party to an $185 million credit facility with a group of banks led by the Chase Manhattan Bank, N.A. as agent (the "CNYC Credit Agreement") which is restricted to the construction and operating needs of Phases I through V in Brooklyn and The Bronx. In Brooklyn, CNYC has completed construction of Phases I through IV. In The Bronx, CNYC has completed construction of Phases I, II and III. For additional information concerning the CNYC acquisition, see Item I -- "Business -- Consolidated Cable Affiliates -- Cablevision of New York City" and Note 2 of Notes to Consolidated Financial Statements. At March 18, 1994 CNYC had outstanding bank borrowings of $140.0 million and an additional $7.2 million was reserved under the CNYC Credit Agreement for letters of credit issued on behalf of CNYC. Unrestricted and undrawn funds available to CNYC under the most restrictive borrowing condition of the CNYC Credit Agreement amounted to approximately $37.6 million at March 18, 1994. As of March 18, 1994, the Restricted Group had contributed $48.2 million. The CNYC Credit Agreement requires that the Restricted Group contribute $55 million of equity for Phases III and IV. CNYC made capital expenditures of approximately $86.7 million in 1993 and $31.1 million in 1992 (from the date of acquisition). At December 31, 1993, the cost to complete CNYC construction was estimated at $122.0 million. CNYC expects the remaining costs for all CNYC construction will be financed by the amounts available under the CNYC Credit Agreement, committed equity contributions and cash flow generated from operations. To eliminate the need for further equity contributions, CNYC expects to refinance the CNYC Credit Facility in 1994 to provide for additional amounts to complete construction. If CNYC fails to complete construction of the systems after construction of Phase IV in The Bronx and Phase V in Brooklyn has commenced, the City of New York could (48) (among other remedies under the franchises) revoke the franchises, upon which CNYC would have 180 days to find a buyer for the system acceptable to the City. Substantially all of the assets of the Phase Partnerships (as well as the interests in the Phase Partnerships held directly or indirectly by the Company and Mr. Dolan) are pledged to secure the obligations to the banks under the CNYC Credit Facility. The Company is party to a management agreement with CNYC which requires the Company to provide management assistance to CNYC in exchange for 3-1/2% of gross revenues, as defined, plus reimbursement of general and administrative expenses and overhead. Payment of the 3-1/2% management fee is restricted under the CNYC Credit Facility, although a one time payment of $2.4 million was made to the Company in 1992 as permitted by the CNYC bank group. Unpaid management fees accrue interest at a rate equal to 2% above the average borrowing rate of CNYC under the CNYC Credit Agreement, compounded quarterly. As of December 31, 1993, CNYC owed the Company approximately $7.1 million for unpaid management fees and accrued interest thereon. RAINBOW PROGRAMMING Rainbow Programming's financing needs have been funded by the Restricted Group's investments in and advances to Rainbow Programming, by sales of equity interests in the programming businesses and in the case of one of the programming businesses, through separate external debt financing. The Company expects that the future cash needs of Rainbow Programming's current programming partnerships will increasingly be met by internally generated funds, although certain of such partnerships will at least in the near future rely to some extent upon their partners (including Rainbow Programming) for certain cash needs. The partners' contributions may be supplemented through the sale of additional equity interests in, or through the incurrence of indebtedness by, such programming businesses. On September 16, 1993 Rainbow Programming notified its partners in AMCC that it has elected to purchase Liberty Media's 50% interest in AMCC at the stated value. As described above, the Company anticipates that $75 million will be contributed to Rainbow Programming by the Company through drawings under its senior credit facility. Rainbow Programming has obtained an underwriting commitment from a commercial bank for the balance of the funds required. The Company anticipates that the transaction will be consummated in the second quarter of 1994. (49) ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS. CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Independent Auditors' Report . . . . . . . . . . . . . . . . . . 51 Consolidated Balance Sheets -- December 31, 1993 and 1992. . . . 52 Consolidated Statements of Operations -- years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . 54 Consolidated Statements of Stockholders' Deficiency -- years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . 55 Consolidated Statements of Cash Flows -- years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . 56 Notes to Consolidated Financial Statements . . . . . . . . . . . 58 (50) INDEPENDENT AUDITORS' REPORT The Board of Directors Cablevision Systems Corporation We have audited the accompanying consolidated balance sheets of Cablevision Systems Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' deficiency and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the consolidated financial statements, we also audited the financial statement schedules as listed in Item 14(a)(2). These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cablevision Systems Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As described in Note 6 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", on a prospective basis in 1993. /s/ KPMG Peat Marwick ------------------------- KPMG Peat Marwick Jericho, New York March 4, 1994 (51) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (Dollars in thousands) See accompanying notes to consolidated financial statements. (52) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (Dollars in thousands) See accompanying notes to consolidated financial statements. (53) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except per share data) See accompanying notes to consolidated financial statements. (54) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) See accompanying notes to consolidated financial statements. (55) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 (Dollars in thousands) See accompanying notes to consolidated financial statements. (56) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 (Dollars in thousands) (continued) See accompanying notes to consolidated financial statements. (57) CABLEVISION SYSTEMS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Cablevision Systems Corporation and its majority owned subsidiaries (the "Company"). All significant intercompany transactions and balances have been eliminated in consolidation. REVENUE RECOGNITION The Company recognizes revenues as cable television services are provided to subscribers. MARKETABLE SECURITIES Marketable securities are recorded at cost. At December 31, 1993 and 1992, the market value of such securities exceeded their cost by approximately $3,575 and $3,881, respectively. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment, including construction materials, are carried at cost, which includes all direct costs and certain indirect costs associated with the construction of cable television transmission and distribution systems, and the costs of new subscriber installations. DEFERRED FINANCING COSTS Costs incurred in obtaining debt are deferred and amortized, on the straight-line basis, over the life of the related debt. SUBSCRIBER LISTS, FRANCHISES, AND OTHER INTANGIBLE ASSETS Subscriber lists are amortized on the straight-line basis over varying periods (2 to 8 years) during which subscribers are expected to remain connected to the systems. Franchises are amortized on the straight-line basis over the average remaining terms (7 to 11 years) of the franchises. Other intangible assets are amortized on the straight-line basis over the periods benefited (2 to 20 years). Excess costs over fair value of net assets acquired are being amortized over periods ranging from 7 to 20 years on the straight line basis. The Company assesses the recoverability of such excess costs based upon undiscounted anticipated future cash flows of the businesses acquired. (58) INCOME TAXES Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires the liability method of accounting for deferred income taxes and permits the recognition of deferred tax assets, subject to an ongoing assessment of realizability. Adoption of SFAS 109 had no material impact on the operations of the Company. LOSS PER SHARE Net loss per common share is computed based on the average number of common shares outstanding after giving effect to dividend requirements on the Company's preferred stock. Common stock equivalents were not included in the computation as their effect would be to decrease net loss per share. CASH FLOWS For purposes of the Consolidated Statements of Cash Flows, the Company considers short-term investments with a maturity at date of purchase of three months or less to be cash equivalents. The Company paid cash interest expense of approximately $173,073, $142,807 and $179,246 during 1993, 1992 and 1991, respectively. During 1993, 1992 and 1991, the Company's noncash investing and financing activities included capital lease obligations of $2,695, $5,953 and $760, respectively, incurred when the Company entered into leases for new equipment, preferred stock dividend requirements in 1991 of $3,579 and the present value of debt to be assumed by V Cable in 1997 of $70,238 recorded in 1992 (see Note 4). INVESTMENTS IN AND ADVANCES TO AFFILIATES The Company accounts for its investments in affiliates using the equity method of accounting whereby the Company records its appropriate share of the net income or loss of the affiliate. The Company's advances to affiliates are carried at cost adjusted for any known diminution in value (see Note 8). NOTE 2. ACQUISITIONS, RESTRUCTURINGS AND DISPOSITIONS 1993 ACQUISITIONS: In December 1986, the Company had purchased substantially all the limited partnership interests in Cablevision of Connecticut. In November 1993, the Company purchased (59) the remaining interests in exchange for 164,051 shares of the Company's Class A Common Stock which had a fair market value of approximately $10,725. Such amount was charged to excess cost over fair value of net assets acquired and will be amortized over the remaining original amortization period. In November 1993, the Company purchased the business of CATV Enterprises, Inc. ("CATV") in Riverdale, The Bronx, New York following the expiration of CATV's temporary permit to operate its cable television system in Riverdale. The cost of $8,500 is included in excess cost over fair value of net assets acquired. 1992 RESTRUCTURINGS: V CABLE, INC. On December 31, 1992, the Company consummated a significant restructuring and reorganization (the "V Cable Reorganization") involving its subsidiary, V Cable, Inc. ("V Cable"), U.S. Cable Television Group, L.P. ("U.S. Cable") and General Electric Capital Corporation ("GECC"), V Cable's principal creditor. In the V Cable Reorganization, V Cable acquired a 20% interest in U.S. Cable for $20,000 and U.S. Cable acquired a 19% non-voting interest in a newly incorporated subsidiary of V Cable that holds substantially all of V Cable's assets ("VC Holding") for $3,000. As a result, V Cable now owns an effective 84.8% interest in VC Holding. GECC has provided new long-term credit facilities to each of V Cable, VC Holding and U.S. Cable, secured in each case by the assets of the borrower and in most cases cross-collateralized by the assets of the other two entities. The credit facilities are non-recourse to the Company other than with respect to the common stock of V Cable owned by the Company (see Note 4). The Company has management responsibility for the U.S. Cable properties, and for the V Cable systems. The Company accounts for its investment in U.S. Cable using the equity method of accounting and accordingly its share of losses in U.S. Cable for 1993 amounted to $8,566. Also in 1993, included in the accompanying consolidated statements of operations is U.S. Cable's share of losses in VC Holding, limited to its $3,000 investment described above. In contemplation of the V Cable Reorganization, in May, 1992 GECC provided a $20,000 loan to V Cable, which lent the proceeds to one of its operating subsidiaries. Also in May, 1992, the operating subsidiary of V Cable paid GECC an aggregate of $20,000 in order to acquire all of the then outstanding shares of A-R Cable Services, Inc. ("A-R Cable") preferred stock from GECC and to obtain the termination of the transaction fee agreements between each of V Cable and A-R Cable, on the one hand, and GECC, on the other, pursuant to which GECC was entitled under certain circumstances to receive payments from V Cable and A-R Cable. On May 11, 1992, A-R Cable purchased, for a nominal amount, the shares of A-R Cable preferred stock held by the operating subsidiary of V Cable. For the purposes of these consolidated financial statements, the Company recognized a net loss of $20,000 on the purchase and retirement of the shares of A-R Cable's preferred stock. (60) In consideration of V Cable's assumption of U.S. Cable debt in 1997 (see Note 4) and the cross-collateralization of U.S. Cable debt by V Cable and VC Holding, V Cable has the option to exchange its interest in U.S. Cable for all of U.S. Cable's interest in VC Holding and thus recover full ownership of the V Cable systems from and after January 1, 1998, subject to certain limitations. Upon such an exchange, the guarantee by V Cable and VC Holding of any portion of the U.S. Cable senior credit facilities not assumed by V Cable, as well as the guarantee and cross-collateralization by U.S. Cable of the V Cable and VC Holding credit facilities, would terminate. The V Cable Reorganization resulted in significant changes to V Cable's debt levels and maturities. See Note 4. A-R CABLE. In May 1992 the Company and A-R Cable consummated a restructuring and refinancing transaction (the "A-R Cable Restructuring") that had the effect of retiring a substantial portion of A-R Cable's subordinated debt and reducing the Company's economic and voting interest in A-R Cable. Among other things, this transaction involved an additional $45,000 investment in A-R Cable by the Company to purchase a new Series B Preferred Stock, the purchase of a new Series A Preferred Stock in A-R Cable by Warburg Pincus Investors, L.P. ("Warburg Pincus") for $105,000, and GECC providing an additional $70,000 to A-R Cable under a secured revolving credit line. After the receipt of certain pending franchise approvals, the Company will have a 40% economic and voting interest in A-R Cable. As a result of the A-R Cable Restructuring, the Company no longer has financial or voting control over A-R Cable's operations. Accordingly the Company no longer consolidates the financial position or results of operations of A-R Cable. For reporting purposes, the deconsolidation of A-R Cable became effective on January 1, 1992 and the Company is accounting for its investment in A-R Cable using the equity method of accounting. Included in share of affiliates' net loss in the accompanying consolidated statements of operations for the year ended December 31, 1993 and 1992 is $56,420 and $30,326, respectively, representing A-R Cable's net loss plus dividend requirements for the Series A Preferred Stock of A-R Cable, which is not owned by the Company. The deficit investment in affiliate of $307,758 and $251,679, respectively, represents A-R Cable losses and external dividend requirements recorded by the Company in excess of amounts invested by the Company therein. At December 31, 1993 and 1992 and for the years then ended, A-R Cable's total assets, liabilities and net revenues amounted to $288,348 and $294,111; $650,099 and $594,294; $108,711 and $105,629, respectively. (61) The Company continues to guarantee the debt of A-R Cable to GECC under a limited recourse guarantee wherein recourse to the Company is limited solely to the common and Series B Preferred Stock of A-R Cable owned by the Company. The Company continues to manage A-R Cable under a management agreement that provides for cost reimbursement, an allocation of overhead charges and a management fee of 3-1/2% of gross receipts, as defined, with interest on unpaid amounts thereon at a rate of 10% per annum. The 3-1/2% fee and interest thereon is payable by A-R Cable only after repayment in full of its senior debt and certain other obligations. Under certain circumstances, the fee is subject to reduction to 2-1/2% of gross receipts. After May 11, 1997, either Warburg Pincus or the Company may irrevocably cause the sale of A-R Cable, subject to certain conditions. In certain circumstances, Warburg Pincus may cause the sale of A-R Cable prior to that date. Upon the sale of A-R Cable, the net sales proceeds, after repayment of all outstanding indebtedness and other liabilities, will be used as follows: first, to repay Warburg Pincus' original $105,000 investment in the Series A Preferred Stock; second, to repay the Company's original investment of $45,000 in the Series B Preferred Stock; third, to repay the accumulated unpaid dividends on the Series A Preferred Stock (19% annual rate); fourth, to repay the accumulated unpaid dividends on the Series B Preferred Stock (12% annual rate); fifth, to pay the Company for all accrued and unpaid management fees together with accrued but unpaid interest thereon; sixth, pro rata 60% to the Series A Preferred Stockholders, 4% to the Series B Preferred Stockholders and 36% to the common stockholder(s). 1992 ACQUISITION: In July 1992, the Company acquired (the "CNYC Acquisition") substantially all of the remaining interests in Cablevision of New York City - Phase I through Phase V (collectively, "CNYC" or "Phase Partnerships"), the operator of a cable television system which is under development in The Bronx and parts of Brooklyn, New York. Prior to the CNYC Acquisition, the Company had a 15% interest in CNYC and Charles F. Dolan, the chief executive officer and principal shareholder of the Company, owned the remaining interests. Mr. Dolan remains a partner in CNYC with a 1% interest and the right to certain preferential payments. Mr. Dolan's preferential rights entitle him to an annual cash payment (the "Annual Payment") of 14% multiplied by the outstanding balance of his "Minimum Payment". The Minimum Payment is $40,000 and is to be paid to Mr. Dolan prior to any distributions to partners other than Mr. Dolan. In addition, Mr. Dolan has the right, exercisable beginning on December 31, 1997 to require the Company to purchase his (62) interest. Mr. Dolan would be entitled to receive from the Company the Minimum Payment, any accrued but unpaid Annual Payments, a guaranteed return on certain of his investments in CNYC and a Preferred Payment defined as a payment (not exceeding $150,000) equal to 40% of the Appraised Equity Value (as defined) of CNYC after making certain deductions. The Company has accounted for the purchase of CNYC in a manner similar to a pooling of interests whereby the assets and liabilities of CNYC have been recorded at historical values and the excess of the purchase price over the book value of the net assets acquired, amounting to approximately $44,000, has been charged to par value in excess of capital contributed. The total assets and liabilities of CNYC at acquisition date amounted to $109,000 and $92,000, respectively. Based upon estimates for accounting purposes of the Appraised Equity Value of CNYC made by the Company at December 31, 1993 and 1992, approximately $22,700 and $27,000, respectively, was accrued as additional obligations to Mr. Dolan relating to the Company's purchase of CNYC, which have also been charged to par value in excess of capital contributed. The total amount owed to Mr. Dolan at December 31, 1993 of approximately $91,600 in respect of the Preferred Payment reflects a reduction of approximately $3,700 in 1993 representing Mr. Dolan's obligation to reimburse the Company in connection with certain claims paid or owed by CNYC. SALE OF PROGRAMMING INTERESTS: In February 1991, Rainbow Programming Holdings, Inc. ("RPH"), a wholly-owned subsidiary of the Company, and certain majority-owned and wholly-owned subsidiaries of RPH (RPH and such subsidiaries are hereinafter referred to as "Rainbow Programming") transferred to NBC Cable Holding Inc. ("NBC Cable"), a subsidiary of the National Broadcasting Company, Inc. ("NBC") a 25% general partnership interest in the American Movie Classics Company ("AMCC") (reducing Rainbow Programming's interest in AMCC to a 25% general partnership interest). In connection with this transfer, Rainbow Programming received $15,407 and the Company recorded a gain of approximately $9,966. In July 1991, Rainbow Programming consummated transactions with NBC, Tele-Communications, Inc. ("TCI") and Liberty Media Corporation ("Liberty"), relating to sports programming offered in the San Francisco Bay area, Florida and Chicago through SportsChannel regional cable sports networks. Viacom Inc. ("Viacom") is also a party to the San Francisco Bay area transaction. The agreements extend the carriage of Rainbow Programming's SportsChannel services on certain TCI and Viacom owned and operated cable systems in those areas. As part of the (63) transactions, TCI acquired a 25% general partnership interest in SportsChannel Chicago (12.5% from each of Rainbow Programming and NBC Cable) plus an option to purchase an additional 25% interest for a total of $15,000 and Liberty acquired, for a nominal amount, a 50% general partnership interest (25% from each of Rainbow Programming and NBC Cable) in SportsChannel Pacific. In connection with these transactions the Company recorded a net gain of approximately $5,539. In October 1992 and January 1993, TCI exercised its option to purchase from each of NBC Cable and Rainbow Programming an additional 12.5% of SportsChannel Chicago for an aggregate purchase price of approximately $15,000 plus approximately $1,600 in interest. In connection with this transaction, the Company recorded a net gain of approximately $7,100. The partnership agreement relating to one of Rainbow Programming's businesses, American Movie Classics Company ("AMCC"), contains a provision allowing any partner to commence a buy-sell procedure by establishing a stated value for the AMCC partnership interests. On August 2, 1993, Rainbow Programming received a notice from the AMCC partner affiliated with Liberty Media Corporation initiating the buy-sell procedure and setting a stated value of $390 million for all the partnership interests in AMCC. The partnership agreement provides that the non-initiating partner has a period of 45 days from receipt of the buy-sell notice to elect to purchase the initiating partner's interest at the stated value or sell its interest at the stated value. On September 16, 1993, Rainbow Programming notified its partners in AMCC that it had elected to purchase Liberty Media's 50% interest in AMCC at the stated value. The Company anticipates that the transaction will be consummated in the second quarter of 1994. (64) NOTE 3. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following items, which are depreciated or amortized primarily on a straight-line basis over the estimated useful lives shown below: At December 31, 1993 and l992, property, plant and equipment include approximately $7,714 and $7,879, respectively, of net assets recorded under capital leases. NOTE 4. DEBT BANK DEBT RESTRICTED GROUP The Company is party to a credit agreement (the "Credit Agreement") in the amount of $695,625 with a group of banks led by Toronto Dominion (Texas), Inc., as agent. The total amount of bank debt outstanding at December 31, 1993 and 1992 was $292,556 and $524,810, respectively. As of December 31, 1993, approximately $19,384 was restricted for certain letters of credit issued for the Company. Undrawn (65) funds available to the Company under the Credit Agreement amounted to approximately $385,241 at December 31, 1993. The Credit Agreement contains numerous covenants that may limit the Company's usage of and ability to utilize the undrawn amount of funds available thereunder. In addition, the Company has a separate credit agreement with the banks that are parties to the Credit Agreement to finance the Company's New Jersey subsidiary (collectively with the Credit Agreement, the "Credit Agreements"), in the amount of $58,500. The amount outstanding at December 31, 1993 and 1992 amounted to $58,500 and $52,962, respectively. There were no additional funds available to the Company under this separate credit agreement at December 31, 1993. Interest on outstanding amounts may be paid, at the option of the Company, based on various formulas which relate to the prime rate, rates for certificates of deposit or other prescribed rates. In addition, the Company has entered into interest rate swap agreements with several banks on a notional amount of $275,000 as of December 31, 1993 whereby the Company pays a fixed rate of interest and receives a variable rate. Interest rates and terms vary in accordance with each of the agreements. As of December 31, 1993, the interest rate agreements expire at various times through 2000 and have a weighted average life of approximately two years. The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements. However, the Company does not anticipate nonperformance by the counterparties. The weighted average interest rate on all bank indebtedness was 8.9% and 8.2% on December 31, 1993 and 1992, respectively. The Company is also obligated to pay fees of 3/8 of 1% per annum on the unused loan commitment and from 1-3/8% to 1-5/8% per annum on letters of credit issued under the Credit Agreement. Beginning in 1993, total commitments under the Credit Agreements decline on a scheduled quarterly basis with a final maturity in 2000. The Credit Agreements contain various restrictive covenants, among which are limitations on the amount of investments that may be made in affiliated entities and certain other subsidiaries, the maintenance of various financial ratios and tests, and limitations on various payments, including preferred dividends. The Company is restricted from paying any dividends on its common stock. The Company was in compliance with the covenants of its Credit Agreements at December 31, 1993. Substantially all of the assets of the Company, (excluding the assets of V Cable, CNYC, Rainbow Programming, Rainbow Advertising Sales Corporation and certain other subsidiaries), amounting to approximately $1,255,600 at December 31, 1993, have been pledged to secure the borrowings under the Credit Agreements. (66) CNYC CNYC is party to a credit agreement, in the amount of $185,000 with a group of banks led by Chase Manhattan, N.A., as agent (the "CNYC Credit Agreement"). The amounts outstanding at December 31, 1993 and 1992 were $126,500 and $78,500, respectively. In addition CNYC has a $5,000 line of credit provided by the Bank of New York under which $2,523 and $0 was outstanding at December 31, 1993 and 1992, respectively. Available funds are limited by certain covenants of the CNYC Credit Agreement. Interest on outstanding amounts under the CNYC Credit Agreement, may be paid, at the option of the Company, based on various formulas which relate to the prime rate, rates for certificates of deposit or other prescribed rates. In addition, CNYC has entered into three interest rate swap agreements with several banks on a total notional amount of $35,000 whereby CNYC pays a fixed rate and receives a variable rate of interest. These agreements expire at various times through 1997. The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements, however, the Company does not anticipate nonperformance by the counterparties. The weighted average interest rate on CNYC's bank indebtedness was 5.8% and 7.2%, respectively, on December 31, 1993 and 1992, respectively. CNYC is also obligated to pay fees on the unused portion of the loan commitment. On December 31, 1994, borrowings under the CNYC Credit Agreement convert to a six year term facility in a maximum amount of $185,000. The balance thereafter declines on a scheduled quarterly basis with a final maturity at June 30, 2000. Substantially all of the assets of CNYC, amounting to approximately $207,500 at December 31, 1993, have been pledged to secure the borrowings under the CNYC Credit Agreement. The CNYC Credit Agreement contains various restrictive covenants, among which are the maintenance of various financial ratios and tests and limitations on various payments. CNYC was in compliance with all the covenants of the CNYC Credit Agreement at December 31, 1993. SENIOR SUBORDINATED DEBENTURES In February 1993, the Company issued $200,000 face amount of its 9-7/8% Senior Subordinated Debentures due 2013 (the "2013 Debentures"). Interest is payable on the 2013 Debentures semi-annually on February 15 and August 15. The 2013 Debentures (67) are redeemable, at the Company's option, on February 15, 2003, February 15, 2004, February 15, 2005 and February 15, 2006 at the redemption price of 104.80%, 103.60%, 102.40% and 101.20%, respectively, of the principal amount and thereafter at the redemption price of 100% of the principal amount, in each case together with accrued interest to the redemption date. The indenture under which the 2013 Debentures were issued contains various covenants, which are generally less restrictive than those contained in the Company's Credit Agreement, with which the Company was in compliance at December 31, 1993. The 2013 Debentures are not entitled to the benefits of a sinking fund. The net proceeds of approximately $193,150 were used to reduce bank borrowings. In April 1993, the Company, through a private placement offering, issued $150,000 face amount of its 9-7/8% Senior Subordinated Debentures due 2023 (the "2023 Debentures"). Interest is payable on the 2023 Debentures semi-annually on April 1 and October 1. The 2023 Debentures are redeemable, at the Company's option, on and after April 1, 2003 at the redemption price of 104.938% reducing ratably to 100% of the principal amount on and after April 1, 2010, in each case together with accrued interest to the redemption date. The indenture under which the 2023 Debentures were issued contains various covenants, which are generally less restrictive than those contained in the Company's Credit Agreement, with which the Company was in compliance at December 31, 1993. The 2023 Debentures are not entitled to the benefits of a sinking fund. Approximately $105,000 of the net proceeds of $145,896 were used to reduce bank borrowings. In connection with such repayment, the Company wrote off approximately $1,044 of deferred financing costs. In August 1993, the Company consummated an exchange offer pursuant to which it exchanged $1 principal amount of its 9-7/8% Senior Subordinated Debentures due April 1, 2023 (the "New Debentures") which have been registered under the Securities Act of 1933, as amended (the "Securities Act") for each $1 principal amount of the outstanding 2023 Debentures. The form and terms of the New Debentures are identical in all material respects to the form and terms of the 2023 Debentures except that the New Debentures have been registered under the Securities Act. In April 1992, the Company completed a public offering of $275,000 of its 10-3/4% Senior Subordinated Debentures due 2004 (the "2004 Debentures"). Interest is payable on the 2004 Debentures semi-annually on April 1 and October 1. The 2004 Debentures are redeemable, at the Company's option, on April 1, 1997 and April 1, 1998 at the redemption price of 103.071% and 101.536%, respectively, of the principal amount, and on April 1, 1999 and thereafter at the redemption price of 100% of the principal amount, in each case together with accrued interest to the redemption date. The Indenture under which the 2004 Debentures were issued contains various (68) covenants, which are generally less restrictive than those contained in the Company's Credit Agreement, with which the Company was in compliance at December 31, 1993. The Indenture requires a sinking fund providing for the redemption on April 1, 2002 and April 1, 2003 of $68,750 principal amount of the 2004 Debentures, at a redemption price equal to 100% of the principal amount, plus accrued interest to the redemption date. The net proceeds of approximately $267,000 from the offering were used to repay borrowings under the Company's Credit Agreement. In connection with such repayment, the Company wrote off approximately $4,783 of deferred financing costs. In November 1988, the Company issued $200,000 face amount of its 12-1/4% Senior Subordinated Reset Debentures due November 15, 2003 (the "Reset Debentures"). Interest is payable on the Reset Debentures semi-annually on May 15 and November 15. The Indenture under which the Reset Debentures were issued contains various restrictive covenants with which the Company was in compliance at December 31, 1993. The Reset Debentures are redeemable, at the Company's option, beginning on May 15, 1994 at the redemption price of 101.5% of the principal amount, and thereafter with the redemption price gradually lowered at six month intervals to 100% of the principal amount by November 15, 1995. The Company is required to redeem $20,000 principal amount of Reset Debentures on each of November 15, 2000 and 2001 and $40,000 on November 15, 2002. Effective on May 15, 1991, the interest rate on the Reset Debentures was reset to a rate of 14%. At December 31, 1993 and 1992 the balance outstanding was $199,321 and $199,247, respectively. SENIOR DEBT In connection with the V Cable Reorganization, all of V Cable's senior and subordinated debt with GECC outstanding at December 31, 1992 was restructured. V Cable's Senior Subordinated Deferred Interest Notes (the "V Cable Notes") and its Junior Subordinated Note (the "Junior Note") were replaced with new long-term credit facilities provided by GECC to V Cable and VC Holding. Under the credit agreement between V Cable and GECC (the "V Cable Credit Agreement"), GECC has provided a term loan (the "V Cable Term Loan") in the amount of $20,000 to V Cable, which loan will accrete interest at a rate of 10.62% compounded semi-annually until December 31, 1997 (the reset date). In addition, GECC has extended to VC Holding a $505,000 term loan (the "Series A Term Loan), a $25,000 revolving line of credit (the "Revolving Line") and a $202,554 term loan (the "Series B Term Loan"), all of which comprise the VC Holding Credit Agreement. Interest on the Series A Term Loan and on any amounts drawn under the Revolving Line of credit is payable currently. (69) Interest on the Series B Term Loan accretes at a rate of 10.62% compounded semi-annually until December 31, 1997 (the reset date) and is payable in full on December 31, 2001. At December 31, 1993 and 1992, amounts outstanding under the V Cable Term Loan, the Series A Term Loan, the Series B Term Loan and the Revolving Line were $22,187 and $20,000; $505,000 and $505,000; $221,373 and $199,554; and $6,000 and $4,000, respectively. Unrestricted and undrawn funds available to VC Holding at December 31, 1993 amounted to $17,221. Approximately $7,501 of deferred financing costs related to V Cable's debt prior to its restructuring with GECC were written off. Interest rates on $254,000 of the Series A Term Loan are fixed at 10.12% through December 31, 1997. The remaining $251,000 bears interest at rates based on either GECC's Index Rate (as defined) or LIBOR plus applicable percentages. Interest on any borrowings under the Revolving Line is paid based on either GECC's Index Rate (as defined) or LIBOR plus applicable percentages which vary depending upon certain prescribed financial ratios. Scheduled quarterly principal payments on the Series A Term Loan commence June 30, 1997 and continue through December 31, 2001. Also in connection with the V Cable Reorganization, V Cable agreed to assume on December 31, 1997, approximately $121,000 of debt of U.S. Cable, which amount is subject to adjustment, upward or downward, depending on U.S. Cable's ratio of debt to cash flow (as defined) in 1997 and thereafter. Included in Senior Debt at December 31, 1993 is $78,306 which represents the present value of debt of U.S. Cable to be assumed in 1997. The difference of approximately $42,694 will be charged to interest expense during the period from January 1, 1994 to December 31, 1997. The effective interest rate on this debt is approximately 11%. This debt matures on December 31, 2001. Amortization of deferred interest expense in connection with the assumption of U.S. Cable's debt, which is being amortized on a straight line basis through December 31, 1997, amounted to $14,047 for 1993. The debt of V Cable and VC Holding is guaranteed by, and secured by a pledge of all of the assets of, V Cable, VC Holding and each of their subsidiaries, including a pledge of all direct and indirect ownership interests in such subsidiaries. U.S. Cable's debt is also guaranteed and cross-collateralized by each of V Cable, VC Holding and each of their subsidiaries. All of the V Cable, VC Holding and U.S. Cable credit facilities are non-recourse to the Company other than with respect to the common stock of V Cable owned by the Company. Substantially all of the assets of V Cable, amounting to approximately $536,600 at December 31, 1993, have been pledged to secure borrowings under the V Cable and VC Holding Credit Agreements. At (70) December 31, 1993 V Cable's liabilities exceeded its assets by approximately $331,215. The V Cable and VC Holding Credit Agreements contain various restrictive covenants, among which are the maintenance of certain financial ratios, limitations regarding certain transactions, prohibitions against the transfer of funds to the parent company (except for reimbursement of certain expenses), and limitations on levels of permitted capital expenditures. V Cable and VC Holding were in compliance with all of the covenants of their loan agreements at December 31, 1993. Due to anticipated reductions to regulated revenue arising from the latest round of FCC regulation, V Cable believes that it is likely that it will be unable to meet several of its financial covenants during 1994 and 1995. To remedy the anticipated covenant defaults, V Cable may request waivers and/or amendments to its credit agreement and/or seek equity contributions from the Company. There can be no assurance as to V Cable's ability to accomplish any of these alternatives or the terms or timing of such alternatives. SUMMARY OF FIVE YEAR DEBT MATURITIES Total amounts payable by the Company and its subsidiaries (excluding V Cable and CNYC) under its various debt obligations, including capital leases, during the five years subsequent to December 31, 1993 amount to $20,035 in 1994, $36,828 in 1995, $54,838 in 1996, $57,344 in 1997 and $73,378 in 1998. Total amounts payable by V Cable and CNYC respectively, under their various debt obligations, including capital leases, during the five years subsequent to December 31, 1993 amount to $98 and $83 in 1994; $0 and $2,500 in 1995; $0 and $17,700 in 1996; $18,000 and $24,000 in 1997; and $20,000 and $31,600 in 1998. NOTE 5. PREFERRED STOCK The holders of the Company's 8% Series C Cumulative Preferred Stock ("Series C Preferred Stock") may require the Company to redeem for cash at any time commencing December 31, 1997 all or a portion of the outstanding shares of the Series C Preferred Stock. The Company has the right, upon notice to the holders requesting redemption, to convert all or a part of such shares into shares of Class B Common Stock. If, in the future, holders require the Company to redeem their Series C Preferred Stock, it is the Company's intention to convert such shares into Class B Common Stock. (71) NOTE 6. INCOME TAXES The Company and its majority-owned subsidiaries file consolidated federal income tax returns. At December 31, 1993 the Company had consolidated net operating loss carry forwards for tax purposes of approximately $713,934, which expires in 2001 to 2008. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires the liability method of accounting for deferred income taxes and permits the recognition of deferred tax assets, subject to an ongoing assessment of realizability. The tax effects of temporary differences which give rise to significant portions of deferred tax assets or liabilities and the corresponding valuation allowance at December 31, 1993 are as follows: The Company has provided a valuation allowance for the total amount of net deferred tax assets since realization of these assets was not assured due principally to the Company's history of operating losses. The amounts of net deferred tax assets and corresponding valuation allowance increased by $146,151 during the year ended December 31, 1993. Also, in connection with acquisitions made prior to 1993, the Company recorded certain fair value adjustments net of their tax effects. In accordance with SFAS 109, these assets have been adjusted to their remaining pre tax amounts. Accordingly, property, plant and equipment, franchises, and subscriber lists have been increased by $3,658, $38,470 and $20,892, respectively, with a corresponding decrease in excess costs over fair value of net assets acquired. (72) NOTE 7. OPERATING LEASES The Company leases certain office, production and transmission facilities under terms of leases expiring at various dates through 2004. The leases generally provide for fixed annual rentals plus certain real estate taxes and other costs. Rent expense for the years ended December 31, 1993, 1992 and 1991 amounted to $10,849, $10,071 and $10,292, respectively. In addition, the Company rents space on utility poles for its operations. The Company's pole rental agreements are for varying terms, and management anticipates renewals as they expire. Pole rental expense for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $6,177, $5,042 and $5,458, respectively. The minimum future annual rentals for all operating leases during the next five years, including pole rentals from January 1, 1994 through December 31, 1998, and thereafter, at rates now in force are approximately: 1994, $14,748; 1995, $13,514; 1996, $12,316; 1997, $10,377, 1998, $9,535; thereafter, $9,912. NOTE 8. AFFILIATE TRANSACTIONS The Company has affiliation agreements with certain cable television programming companies, varying ownership interests in which were held, directly or indirectly, by RPH during the three years ended December 31, 1993. RPH's investment in these programming companies is accounted for on the equity basis of accounting. Accordingly, the Company recorded income and (losses) of approximately $8,828, $(12,428) and $(20,290) in 1993, 1992 and 1991, respectively, representing its percentage interests in the results of operations of these programming companies. At December 31, 1993 and 1992, the Company's investment in these programming companies amounted to approximately $17,721 and $10,682, respectively, which exceeded the Company's underlying equity in the net assets of these companies by approximately $290 and $652, respectively. This excess has been classified as other intangible assets in the accompanying consolidated balance sheets. Costs incurred by the Company for programming services provided by these affiliates and included in technical expense for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $26,732, $23,388 and $27,400, respectively. At December 31, 1993 and 1992, amounts due from certain of these programming affiliates aggregated $1,367 and $2,352, respectively, and are included in advances to affiliates. Also, at December 31, 1993 and 1992 amounts due to certain of these affiliates, primarily for programming services provided to the Company, aggregated $16,236 and $14,785, respectively, and are included in accounts payable to affiliates. (73) Summarized combined financial information relating to these programming companies at December 31, 1993, 1992 and 1991 and for the years then ended is as follows: NBC and RPH formed a partnership which distributed on a multi-channel, pay-per-view basis certain events of the 1992 Summer Olympics. This distribution was in addition to NBC's conventional broadcast network coverage of those games. Pursuant to the agreement, profits and losses from the broadcast network coverage and the pay-per-view coverage of the 1992 Summer Games were shared equally by NBC and RPH; however, RPH's liability under this agreement was limited to $50,000. The partnership paid its share of the loss ($50,000) in January 1993 with borrowings under the Credit Agreement. Cablevision of Boston Limited Partnership ("Cablevision Boston") is a Massachusetts limited partnership in which Mr. Dolan is the general partner and in which the Company has certain direct and indirect partnership interests. The Company is a limited partner in Cablevision Boston and currently holds a 7% prepayout (prior to repayment of capital contributions to limited partners) interest and a 20.7% postpayout interest in Cablevision Boston. As of December 31, 1993 and 1992, the Company's consolidated financial statements reflect advances ($8,000 of which were converted to Preferred Equity in Cablevision Boston) to Cablevision Boston of approximately $17,540 and $18,345, respectively. Such amounts are fully subordinated to certain of Cablevision Boston's obligations to other lenders aggregating approximately $68,250 and $71,250 plus accrued interest at December 31, 1993 and 1992, respectively. The Company has also advanced funds to Cablevision of Chicago ("Cablevision Chicago"), an Illinois limited partnership and an affiliate whose general partner is Mr. Dolan. At December 31, 1993 and 1992 approximately $12,445 and $12,473, respectively, was owed the Company and is included in advances to affiliates in the accompanying consolidated balance sheets. Of the amount owed, approximately $12,314 principal amount is evidenced by a subordinated note bearing interest at the rate of 14% per annum, payable as to principal and interest, on demand. Repayment (74) of this subordinated note and accrued interest thereon is restricted until repayment of Cablevision Chicago's bank indebtedness. During 1993, 1992 and 1991, the Company made advances to or incurred costs on behalf of other affiliates engaged in providing cable television, cable television programming, and related services. Amounts due from these affiliates amounted to $6,805 and $8,262 at December 31, 1993 and 1992, respectively and are included in advances to affiliates. In April 1992, Cablevision of Newark, a partnership 25% owned and managed by the Company and 75% owned by an affiliate of Warburg Pincus, acquired cable television systems located in Newark and South Orange, New Jersey from Gilbert Media Associates, L.P. ("Gateway Cable") for a purchase price of approximately $76,483. The Company's capital contributions to Cablevision of Newark amounted to approximately $6,000. The Company's share of the net losses of Cablevision of Newark amounted to $4,206 and $3,070 in 1993 and 1992. The Company manages the operations of Cablevision of Newark for a fee equal to 3-1/2% of gross receipts, as defined, plus reimbursement of certain costs and an allocation of certain selling, general and administrative expenses. For 1993 and 1992, such management fees and expenses amounted to $1,632 and $1,526, respectively, of which $800 and $506 for 1993 and 1992, representing management fees, has been fully reserved by the Company. In connection with the V Cable Reorganization (see Note 2), V Cable acquired for $20,000, a 20% interest in U.S. Cable. The Company has managed the properties of U.S. Cable, since June 1992, under management agreements that provide for cost reimbursement, including an allocation of overhead charges. For 1993 and 1992, such cost reimbursement amounted to $4,894 and $2,160, respectively, which included the allocation of overhead charges of $2,604 and $1,200, respectively. The Company also manages A-R Cable under a management agreement that provides for cost reimbursement, an allocation of overhead charges and a management fee of 3-1/2% of gross receipts, as defined, with interest on unpaid annual amounts thereon at a rate of 10% per annum beginning in 1993. Such management fees amounted to $3,801 and $2,383 for 1993 and 1992, respectively; interest thereon amounted to $244 for 1993. Management fees and interest thereon have been fully reserved by the Company. On December 14, 1993, the Company purchased 50,000 shares of Class A Common Stock from John Tatta, a director of the Company and the Chairman of the Executive (75) Committee, for $64.75 per share, the closing price of a share of Class A common stock on such date. These shares are being held as treasury stock. NOTE 9. PENSION PLANS The Company maintains the CSSC Supplemental Benefit Plan (the "Benefit Plan") for the benefit of certain officers and employees of the Company. As part of the Benefit Plan, the Company established a nonqualified defined benefit pension plan, which provides that, upon attaining normal retirement age, a participant will receive a benefit equal to a specified percentage of the participant's average compensation, as defined. Participants vest in all components of the Benefit Plan 40% after four years of service and 10% for each additional year of service. Net periodic pension cost for the years indicated consisted of the following: The following table sets forth the funded status of the Benefit Plan at December 31, 1993 and 1992: The projected benefit obligation for the plan was determined using an assumed discount rate and assumed long range rate of return of 8% in 1993 and 1992. No assumed rate of salary increase was used to compute the projected benefit obligation, since substantially all participants are currently at their maximum benefit level. (76) In addition, the Company accrues a liability in the amount of 7% of certain officers' and employees' compensation, as defined. Each year the Company also accrues for the benefit of these officers and employees interest on such amounts. The officer or employee will receive such amounts upon termination of employment. Such benefits will vest 40% after four years of service and 10% each additional year of service. The cost associated with this plan for the years ended December 31, 1993, 1992 and 1991 was approximately $497, $358 and $328, respectively. Prior to 1993 the Company, with other affiliates, maintained a defined contribution pension plan covering substantially all employees. The Company contributed 3% of eligible employees' annual compensation (as defined), and employees could voluntarily contribute up to 10% of their annual compensation. Employee contributions were fully vested. Employer contributions became vested in years three through seven. Effective January 1, 1993, the Board of Directors of the Company approved the adoption of an amended and restated Pension and 401(K) Savings Plan (the "Plan"), in part to permit employees of the Company and its affiliates to make contributions to the Plan on a pre-tax salary reduction basis in accordance with the provisions of Section 401(K) of the Internal Revenue Code, and to introduce new investment options under the Plan. The Company contributes 1-1/2% of eligible employees' annual compensation, as defined, to the defined contribution portion of the Plan (the "Pension Plan") and an equivalent amount to the Section 401(K) portion of the Plan (the "Savings Plan"). Employees may voluntarily contribute up to 15% of eligible compensation, subject to certain restrictions, to the Savings Plan, with an additional matching contribution by the Company of 1/4 of 1% for each 1% contributed by the employee, up to a maximum contribution by the Company of 1/2 of 1% of eligible base pay. Employee contributions are fully vested as are employer base contributions to the Savings Plan. Employer contributions to the Pension Plan and matching contributions to the Savings Plan become vested in years three through seven. The cost associated with these plans was approximately $2,905, $2,322 and $2,212 for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 10. STOCK BENEFIT PLANS In June 1992, the Stockholders of the Company approved the Amended and Restated Employee Stock Plan (the "Amended Plan") which consolidated the Company's prior Stock Plan, Nonqualified Plan and Bonus Award Plan (the "Prior Plans"). Under the Amended Plan the Company is authorized to issue a maximum of 3,500,000 shares. The Company may grant incentive stock options, nonqualified stock options, restricted stock, conjunctive stock appreciation rights, stock grants and stock bonus awards. The (77) exercise price of stock options may not be less than the fair market value per share of class A common stock on the date the option is granted and expire no longer than ten years from date of grant. Conjunctive stock appreciation rights permit the employee to elect to receive payment in cash, either in lieu of the right to exercise such option, or in addition to the stock received upon the exercise of such option, equal to the difference between the fair market value of the stock as of the date the right is exercised, and the exercise price. Under the Amended Plan, during 1993 the Company issued options to purchase 15,225 shares of class A common stock, stock appreciation rights related to 15,225 shares under option and stock awards of 10,225 common shares. The options and related conjunctive stock appreciation rights are exercisable at various prices ranging from $27.625 to $38.25 per share in 25% and 33% annual increments beginning from the date of grant. The stock awards vest 100% by May of 1996. Under the Amended Plan, during 1992 the Company issued options to purchase 211,350 shares of class A common stock, stock appreciation rights related to 211,350 shares under option and stock awards of 211,350 common shares. The options and related conjunctive stock appreciation rights are exercisable at $27.625 per share in 25% annual increments beginning one year from the date of grant. The stock awards vest 100% four years from date of grant. Also, during 1992 the Company granted to certain employees conjunctive stock appreciation rights with respect to 472,500 shares under options granted in prior years under the Company's 1985 Employee Stock Plan. Those options are exercisable at prices ranging from $16.625 to $36.00 and vest at various times during the period from October 1992 through October 1996. Under the Nonqualified Plan, nonqualified options to purchase 24,000 shares were granted in 1991 at an exercise price of $25.00 per share. These options are exercisable one-third per year beginning July 30, 1992. Pursuant to a Bonus Award Plan ("Bonus Plan"), adopted in 1986, in 1990 the Company granted to fifteen employees the right to receive 118,900 shares of class A common stock or, at the election of the Stock Option Committee, cash equal to the product of such number of shares times the closing price of a share of Class A Common Stock at the time of issuance. In May 1992, in accordance with the provisions of the Bonus Plan, the Company paid in cash the value of 59,450 shares based on a market price of $28-6/8, totalling $1,709. Rights to the remaining 59,450 shares vest on May 17, 1994. In addition, in 1990 the Company granted to seven employees the right to receive 111,180 shares of class A common stock or, at the (78) election of the Stock Option Committee, cash equal to the product of such number of shares times the closing price of a share of class A common stock at the time of issuance. On March 28, 1991, in accordance with the provisions of the Bonus Plan, the Company paid in cash the value of 91,180 shares based on a market price of $24-5/8, totalling $2,245. On December 31, 1992, the Company paid in cash the value of the remaining 20,000 shares based on a market price of $35 totalling $700. Stock transactions under the Amended Plan and Prior Plans are as follows: Of the total shares awarded, 77,700 shares were restricted at December 31, 1993. Also at December 31, 1993, options for approximately 1,467,000 shares were exercisable. As a result of the stock awards, bonus awards and stock appreciation rights, the Company expensed approximately $28,234, $9,656 and $6,668 in 1993, 1992 and 1991, respectively. In June, 1986, the Company adopted an Employee Stock Purchase Plan (the "Purchase Plan"). The Purchase Plan enabled employees of the Company and its subsidiaries to purchase class A common stock of the Company through payroll deductions of up to $1,250 each year per employee. The price to be paid for a share of stock was 85% of the market price on the last business day of each month. The discount increased to 20% after twelve months of continuous participation in the Purchase Plan and to 25% (79) after twenty-four months of continuous participation. Under the Purchase Plan, employees purchased 26,499 and 34,757 shares during 1992 and 1991, respectively, for which, $796 and $842 was paid to the Company. In connection with the adoption of the amended and restated Pension and 401(K) Savings Plan, the Company discontinued the Purchase Plan. (See Note 9.) NOTE 11. COMMITMENTS AND CONTINGENCIES Cablevision Systems Service Corporation ("CSSC"), an affiliate of the Company, purchases a premium programming service from an unaffiliated program supplier. CSSC makes such service available to the Company and its affiliates at CSSC's cost in return for the Company's assumption of its proportionate share, based on subscriber usage, of CSSC's obligations under its agreement with such unaffiliated program supplier. The Company is contingently liable for approximately $13,399 through 1994 in respect of this agreement. The Company, through Rainbow Programming, has entered into several contracts relating to cable television programming in the normal course of its business, including rights agreements with professional and other sports teams. These contracts typically require substantial payments over extended periods of time. Mr. Dolan, the Company's chairman, has an employment agreement with the Company expiring in January 1995, with automatic renewals for successive one-year terms unless terminated by either party at least three months prior to the end of the then existing term. The agreement provides for a base salary of $400 per year payable to Mr. Dolan or, upon his death during the term of such agreement, a death benefit payment to his estate in an amount equal to the greater of one year's salary or one-half of the compensation that would have been payable to Mr. Dolan during the remaining term of such agreement. John Tatta, the Company's former president, has a three-year consulting agreement with the Company expiring in January 1995, which provides for a fee of $485 per year plus reimbursement of certain expenses payable to Mr. Tatta or, upon his death during the term of such agreement, a death benefit payable to his estate in an amount equal to the greater of one year's fee or one-half of the fee that would have been payable to him during the remaining term of such agreement. (80) Income tax returns of the Company's predecessor entities are currently under examination for 1985 and prior years. The Internal Revenue Service has proposed adjustments which the Company intends to vigorously oppose through the IRS appeals process. In the opinion of management, the ultimate resolution of these matters will not have a material adverse effect on the Company's financial position. The Company does not provide postretirement benefits to any of its employees. NOTE 12. LEGAL MATTERS During 1992, the Company recorded expenses of $5,655 in connection with the settlement of certain litigation pending against Mr. Dolan and the Company and other related matters. The litigation was based upon an alleged breach of fiduciary duty by Mr. Dolan, as the general partner of Cablevision Programming Investments and Rainbow Program Enterprises ("RPE"), involving the allocation of partnership profits from 1983 through 1986 and RPH's offer to purchase limited partnership interests in 1986. The amounts provided also include an estimated value of certain untendered interests in RPE based upon the values utilized in connection with the settlements relating to Cablevision Programming Investments. In addition, the Company is party to various other lawsuits, some involving substantial amounts. Management does not believe that the resolution of these lawsuits will have a material adverse impact on the financial position of the Company. NOTE 13. ACQUISITION RELATED COSTS AND DEPOSITS In March 1994, Cablevision of Cleveland, L.P. ("Cablevision Cleveland"), a partnership currently comprised of subsidiaries of the Company, purchased substantially all of the assets and assumed certain liabilities of North Coast Cable Limited Partnership (the "North Coast Cable Acquisition"), which operates a cable television system in Cleveland, Ohio. As of December 31, 1993, the Company made deposits and or incurred expenses in connection with the North Coast Cable Acquisition amounting to approximately $3,213 (see Note 15). On October 26, 1993, Cablevision MFR, Inc. ("Cablevision MFR"), a wholly-owned subsidiary of the Company, entered into agreements to purchase substantially all of the assets of Monmouth Cablevision Associates, L.P. ("Monmouth Cablevision"), Riverview Cablevision Associates, L.P. ("Riverview Cablevision") and Framingham Cablevision Associates, L.P. ("Framingham Cablevision"), each a limited partnership operated by Sutton Capital Associates. Each of Monmouth Cablevision and Riverview (81) Cablevision own and operate cable television systems in New Jersey. Framingham Cablevision owns and operates a cable television system in Massachusetts. On January 12, 1994 Cablevision MFR assigned its rights and obligations under its agreement to purchase the assets of Framingham Cablevision to Cablevision of Framingham Holdings, Inc. ("CFHI"), currently a wholly-owned subsidiary of the Company. The Company has entered into an agreement with Warburg, Pincus Investors, L.P. ("Warburg Pincus"), pursuant to which Warburg Pincus will (i) purchase 60% of the common stock of CFHI for cash and (ii) purchase preferred stock of CFHI, from time to time, for a purchase price sufficient to pay 70% of the interest and principal payments on the Framingham Cablevision promissory note described below. The Company agreed to purchase preferred stock of CFHI, from time to time, for a purchase price sufficient to pay 30% of the interest and principal payments on the Framingham Cablevision promissory note. The aggregate purchase price for the two New Jersey systems is expected to be $422,300. The purchase price for the Framingham assets is expected to be $41,100. Consummation of the transaction is subject to the receipt of necessary regulatory approvals and other customary closing conditions. There can be no assurance that this transaction will be successfully consummated. As of December 31, 1993, the Company made deposits and/or incurred expenses in connection with the acquisition of these three systems amounting to approximately $10,796. On November 5, 1993, A-R Cable Partners, a partnership comprised of subsidiaries of the Company and E. M. Warburg, Pincus & Co., Inc., entered into an agreement to purchase certain assets of Nashoba Communications ("Nashoba"), a group of three limited partnerships which operate three cable television systems in Massachusetts. A-R Cable Partners will be controlled in a manner substantially similar to the way A-R Cable Services, Inc. is controlled. The purchase price is $90,000, subject to certain adjustments, of which up to $55,000 is expected to be provided by separate financing. The remainder will be provided by equity contributions from the partners in A-R Cable Partners. The Company will provide 30% of such equity through drawings under its senior credit facility. The Company will account for its investment in Nashoba using the equity method of accounting. Consummation of the transaction is subject to regulatory approval, as well as other customary conditions. The Company currently anticipates consummation of this acquisition in the second quarter of 1994. As of December 31, 1993, the Company made deposits and/or incurred expenses related to the Nashoba acquisition amounting to approximately $2,728. (82) NOTE 14. DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS CASH AND CASH EQUIVALENTS, TRADE ACCOUNTS RECEIVABLE, NOTES AND OTHER RECEIVABLES, ACCOUNTS PAYABLE, ACCRUED LIABILITIES AND ACCOUNTS PAYABLE TO AFFILIATES The carrying amount approximates fair value due to the short maturity of these instruments. MARKETABLE SECURITIES AND NOTES RECEIVABLE -- AFFILIATES The fair value of the Company's marketable securities are based on quoted market prices. The fair value of notes receivable -- affiliates is based on current rates for notes with similar maturities. OTHER INVESTMENTS The fair values of the Company's Other Investments are generally based on multiples of the investees' cash flow, after adjustment for net assets or liabilities. BANK DEBT, SENIOR TERM LOANS, SENIOR SUBORDINATED DEBENTURES, AND SUBORDINATED NOTES PAYABLE The fair values of each of the Company's long-term debt instruments are based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. INTEREST RATE SWAP AGREEMENTS The fair values of interest rate swap agreements are obtained from dealer quotes. These values represent the estimated amount the Company would receive or pay to terminate agreements, taking into consideration current interest rates and the current creditworthiness of the counterparties. The carrying amount represents accrued or deferred income arising from the unrecognized financial instruments. OBLIGATION TO RELATED PARTY The fair values of Obligation to Related Party is estimated based on current rates for debt with similar maturities. (83) The fair value of the Company's financial instruments are summarized as follows: Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. NOTE 15. SUBSEQUENT EVENTS On February 22, 1994, after reconsideration, the Federal Communications Commission ("FCC") ordered a further reduction in rates for the basic service tier in effect on September 30, 1992. As the formal text of these new regulations has not yet been released, the Company cannot yet determine the impact on its operations. In March 1994, Cablevision Cleveland, a partnership comprised of subsidiaries of the Company, purchased substantially all of the assets and assumed certain liabilities of North Coast Cable Limited Partnership, which operated a cable television system in Cleveland, Ohio. The purchase price aggregated $133,000 which amount includes: (i) approximately $98,800 paid in cash; (ii) $4,000 paid in a short-term promissory note (84) secured by a letter of credit; (iii) approximately $13,200 paid by the surrender of the Company's 19% interest in North Coast and the satisfaction of certain management fees owed to the Company; and (iv) approximately $17,000 to be paid by the assumption of certain capitalized lease obligations and certain other liabilities. The net cash purchase price of the acquisition was financed by borrowings under the Company's Credit Agreement and Cablevision Cleveland is part of the Restricted Group. (85) NOTE 16. INTERIM FINANCIAL INFORMATION (Unaudited) The following is a summary of selected quarterly financial data for the fiscal years ended December 31, 1993 and 1992. The operating data for the quarters ended March 31, and June 30, 1992 have been restated to reflect as of January 1, 1992 the deconsolidation of the Company's A-R Cable subsidiary for reporting purposes. The Company is accounting for its investment in A-R Cable using the equity method of accounting. Amounts previously reported in the Company's Form 10-Q for the quarter ended March 31, 1992 for net revenues, operating expenses and operating profit were $153,585, $138,072 and $15,513, respectively, and for the quarter ended June 30, 1992, $162,153, $140,563 and $21,590, respectively. (86) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III The information called for by Item 10, Directors and Executive Officers of the Registrant, Item 11, Executive Compensation, Item 12, Security Ownership of Certain Beneficial Owners and Management and Item 13, Certain Relationships and Related Transactions, is hereby incorporated by reference to the Company's definitive proxy statement for its Annual Meeting of Shareholders anticipated to be held in June, 1994 or if such definitive proxy statement is not filed with the Commission prior to April 30, 1994, to an amendment to this report on Form 10-K filed under cover of Form 8. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. The financial statements as indicated in the index is set forth on page 50. 2. Financial Statement schedules: Page No. Schedules supporting consolidated financial statements: Schedule V - Property, Plant and Equipment 88 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 90 Schedule VIII - Valuation and Qualifying Accounts 92 Schedule X - Supplementary Income Statement Information 93 Schedules other than those listed above have been omitted, since they are either not applicable, not required or the information is included elsewhere herein. 3. Independent auditors report and accompanying financial statements of A-R Cable Services, Inc. are filed as part of this report on page 94. 4. The Index to Exhibits is on page 116. (b) Reports on Form 8-K: There were no reports on Form 8-K filed during the last quarter of the fiscal period covered by this report. (87) (continued) (88) CABLEVISION SYSTEMS CORPORATION SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (Dollars in thousands) (89) CABLEVISION SYSTEMS CORPORATION SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in thousands) (continued) (90) CABLEVISION SYSTEMS CORPORATION SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in thousands) (91) CABLEVISION SYSTEMS CORPORATION SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (Dollars in thousands) (92) CABLEVISION SYSTEMS CORPORATION SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (Dollars in thousands) (93) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) Consolidated Financial Statements December 31, 1993 and 1992 (With Independent Auditors' Report Thereon) (94) INDEPENDENT AUDITORS' REPORT The Board of Directors A-R Cable Services, Inc. We have audited the accompanying consolidated balance sheets of A-R Cable Services, Inc. (a wholly-owned subsidiary of Cablevision Systems Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's deficiency and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of A-R Cable Services, Inc. and subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As described in Note 7 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", on a prospective basis in 1993. /s/ KPMG PEAT MARWICK ------------------------ KPMG PEAT MARWICK Jericho, New York March 4, 1994 (95) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (in thousands) See accompanying notes to consolidated financial statements. (96) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (in thousands) See accompanying notes to consolidated financial statements. (97) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (in thousands) See accompanying notes to consolidated financial statements. (98) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) CONSOLIDATED STATEMENTS OF STOCKHOLDER'S DEFICIENCY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (in thousands) See accompanying notes to consolidated financial statements. (99) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (in thousands) See accompanying notes to consolidated financial statements. (100) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (in thousands) (continued) See accompanying notes to consolidated financial statements. (101) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) NOTE 1. THE COMPANY A-R Cable Services, Inc. ("A-R Cable" or the "Company") became a wholly-owned subsidiary of Cablevision Systems Corporation ("CSC") on January 4, 1988 in accordance with the terms of a merger agreement dated July 15, 1987. NOTE 2. 1992 RESTRUCTURING On May 11, 1992, the Company and CSC consummated a restructuring and refinancing transaction whereby the Company repurchased approximately $236,841 principal amount of Senior Subordinated Deferred Interest Notes (the "A-R Cable Notes"), representing approximately 86.9% principal amount of the A-R Cable Notes outstanding pursuant to the terms of a tender offer. In connection with the consummation of the tender offer, Warburg, Pincus Investors, L.P. ("Warburg Pincus") purchased a new Series A Preferred Stock of the Company for a cash investment of $105,000, and CSC purchased a new Series B Preferred Stock of the Company for a cash investment of $45,000. In addition, General Electric Capital Corporation ("GECC") provided the Company with an additional $70,000 under a secured revolving credit line. In connection with the investment by Warburg Pincus, the Company incurred costs of approximately $1,725. In connection with Warburg Pincus' investment in the Company, upon the receipt of certain franchise approvals, Warburg Pincus will be permitted to elect three of the six members of the Company's board of directors, will have approval rights over certain major corporate decisions of the Company and will be entitled to 60% of the vote on all matters on which holders of capital stock are entitled to vote (other than the election of directors). CSC (through a wholly- owned subsidiary) continues to own the common stock, as well as the Series B Preferred Stock, and CSC continues to manage the Company under a management agreement that provides for cost reimbursement, an allocation of overhead charges and a management fee of 3-1/2% of gross receipts, as defined, with interest on unpaid annual amounts thereon at a rate of 10% per annum. The 3-1/2% fee is payable by the Company only after repayment in full of its senior debt and certain other obligations. Under certain circumstances, the fee is subject to reduction to 2-1/2% of gross receipts. After May 11, 1997, either Warburg Pincus or CSC may irrevocably cause the sale of the Company, subject to certain conditions. In certain circumstances, Warburg Pincus may cause the sale of the Company prior to that date. If Warburg Pincus initiates the sale, CSC will have the right to purchase the Company through an appraisal procedure. CSC's purchase right may be forfeited in certain circumstances. Upon the sale of the (102) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) Company, the net sales proceeds, after repayment of all outstanding indebtedness and other liabilities, will be used as follows: first, to repay Warburg Pincus' original $105,000 investment in the Series A Preferred Stock; second, to repay CSC's original investment of $45,000 in the Series B Preferred Stock; third, to repay the accumulated unpaid dividends on the Series A Preferred Stock (19% annual rate); fourth, to repay the accumulated unpaid dividends on the Series B Preferred Stock (12% annual rate); fifth, to pay CSC for all accrued and unpaid management fees together with accrued but unpaid interest thereon; sixth, pro rata 60% to the Series A Preferred Stockholders, 4% to the Series B Preferred Stockholders and 36% to the common stockholder(s). Also in connection with the purchase of the A-R Cable Notes, the Company purchased from an affiliate, for nominal consideration, and retired its previously outstanding 1987 Cumulative Preferred Stock ("1987 Preferred Stock"). The affiliate had purchased the 1987 Preferred Stock from GECC. In connection with the purchase of the 1987 Preferred Stock, a transaction fee agreement between the Company and GECC was terminated and the Company's obligations thereunder were extinguished. The Company recognized a gain of $33,509 on its purchase of the 1987 Preferred Stock. In October and November 1992, the Company repurchased approximately $6,900 principal amount of the A-R Cable Notes at an average price of $98.60 per $100 principal amount. The funds for such repurchase were obtained by additional borrowings under A-R Cable's secured revolving credit line. In connection with the purchase of A-R Cable Notes the Company incurred a loss of approximately $211. On February 9, 1993, the Company redeemed all of its remaining outstanding A-R Cable Notes in the aggregate principal amount of $28,793 (plus accrued interest of $522) in accordance with the terms of the Indenture with respect to the A-R Cable Notes. In connection with this redemption the Company incurred a loss of approximately $390. The funds for such redemption were obtained from the proceeds of an additional $30,000 provided by GECC under the Company's secured revolving credit line. NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements of the Company include the accounts of the Company and its subsidiaries, all of which are wholly owned. All significant intercompany balances and transactions have been eliminated in consolidation. (103) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) REVENUE RECOGNITION The Company recognizes revenues as cable television services are provided to subscribers. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment, including construction materials, are recorded at cost, which includes all direct costs and certain indirect costs associated with the construction of cable television transmission and distribution systems, and the costs of new subscriber installations. Plant and equipment are being depreciated over their estimated useful lives using the straight-line method for financial reporting purposes. Leasehold improvements are amortized over the shorter of their useful lives or the term of the related leases. DEFERRED FINANCING COSTS Costs incurred in obtaining debt are deferred and amortized on the straight-line basis over the life of the related debt. SUBSCRIBER LISTS, FRANCHISES, AND EXCESS COSTS OVER FAIR VALUE OF NET ASSETS ACQUIRED Subscriber lists are amortized on the straight-line basis over varying periods during which subscribers are expected to remain connected to the system (averaging approximately 8 years). Franchises are amortized on the straight-line basis over the average remaining term of the franchises (approximately 7 years). Excess costs over fair value of net assets acquired are being amortized over 20 years on the straight-line basis. The Company assesses the recoverability of such excess costs based upon undiscounted anticipated future cash flows of the businesses acquired. INCOME TAXES The Company is not a member of the CSC consolidated group for federal tax purposes and, accordingly, files its federal income tax return on behalf of itself and its consolidated subsidiaries and not as part of a CSC consolidated group. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires the liability method of accounting for deferred income taxes and (104) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) permits the recognition of deferred tax assets, subject to an ongoing assessment of realizability. Prior years' financial statements have not been restated to reflect the provisions of SFAS 109. CASH FLOWS For purposes of the consolidated statements of cash flows, the Company considers short-term investments with a maturity at date of purchase of three months or less to be cash equivalents. The Company paid cash interest expense of approximately $25,030, $43,008 and $36,472 during the years ended December 31, 1993, 1992 and 1991, respectively. During 1993, 1992 and 1991 the Company's noncash investing and financing activities included capital lease obligations of $0, $65 and $259, respectively, incurred when the Company entered into leases for new equipment, and preferred stock dividend requirements of $29,510, $17,985 and $3,579, respectively. NOTE 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following items which are depreciated over the estimated useful lives shown below: At December 31, 1993 and 1992 property, plant and equipment include approximately $310, and $643, respectively, of net assets recorded under capital leases. (105) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) NOTE 5. DEBT SENIOR TERM LOAN The Company's outstanding borrowings under its senior term loan and revolving lines of credit (the "Senior Term Loan") with GECC amounted to $397,500 at December 31, 1993 and 1992, respectively. The facility consists of a $285,000 senior term loan, $95,000 in special funding advances and a $45,000 revolving line of credit; all of the loans are non-amortizing and mature on December 30, 1997. Aggregate undrawn funds available under the revolving line of credit at December 31, 1993 amounted to approximately $27,500 of which $400 was restricted. Interest rates on the $397,500 of the Senior Term Loan, are at floating rates based on either GECC's LIBOR (as defined in the agreement) or Index Rate plus applicable percentages which vary depending upon certain prescribed financial ratios. Such floating rate approximated 6.8% at December 31, 1993. In addition, the Company entered into an interest rate cap agreement with a bank on a notional amount of $155,000 which limits the interest rate the Company will pay to 7.25% on the $155,000. The cap agreement terminates in May 1995. The Company is exposed to credit loss in the event of nonperformance by the other party to the cap agreement. However, the Company does not anticipate nonperformance by the counterparty. Substantially all of the assets of the Company have been pledged to secure the borrowings under the Senior Term Loan agreement. The Senior Term Loan agreement contains various restrictive covenants, among which are the maintenance of certain financial ratios, limitations regarding certain transactions by the Company, prohibitions against the transfer of funds to the parent company (except for reimbursement of certain expenses) and limitations on levels of permitted capital expenditures. The Company was in compliance with all of the covenants of its Senior Term Loan agreement at December 31, 1993. SUBORDINATED NOTES PAYABLE In January 1988, the Company issued $125,000 ($272,533 face amount) of the A-R Cable Notes due December 30, 1997. No interest was payable on the A-R Cable Notes until June 30, 1993 at which time interest at 16-3/4% per annum became payable. The original issue discount of $147,533 was being charged to operations over the period from January 1988 to December 1992. During 1992, the Company repurchased approximately $243,740 principal amount of the A-R Cable Notes (106) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) pursuant to the terms of a tender offer. In connection with the purchase of the A-R Cable Notes, the Company incurred a loss aggregating approximately $2,435. On February 9, 1993, the Company redeemed all of its remaining outstanding A-R Cable Notes in the aggregate principal amount of $28,793 in accordance with the terms of the Indenture with respect to the A-R Cable Notes. The funds for such redemption were obtained from the proceeds of an additional $30,000 provided by GECC under the Company's secured revolving credit line. CAPITAL LEASES The Company's minimum future obligations under capital leases as of December 31, 1993 are approximately as follows: NOTE 6. PREFERRED STOCK In January, 1988, the Company issued and GECC purchased 200,000 shares of the 1987 Preferred Stock for a purchase price of $100 per share. The 1987 Preferred Stock bore cumulative annual dividends of $12 per share payable quarterly. Dividends on or before January 4, 1993 were payable in additional shares of preferred stock at a rate of one share per $100. The 1987 Preferred Stock was mandatorily redeemable, at a redemption price of $100 per share. In connection with the purchase of the A-R Cable Notes, the Company purchased from an affiliate, (which in 1992 had purchased the 1987 Preferred Stock from GECC) for nominal consideration, and retired the 1987 Preferred Stock. The Company recognized a gain of $33,509 on its purchase of the 1987 Preferred Stock. (107) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) In connection with the consummation of the tender offer, Warburg Pincus purchased a new Series A Preferred Stock of the Company for a cash investment of $105,000, and CSC purchased a new Series B Preferred Stock of the Company for a cash investment of $45,000. The Series A Preferred Stock is entitled to a 19% annual dividend. The Series B Preferred Stock is entitled to a 12% annual dividend. Dividends on the Series A and Series B Preferred Stock are not payable until the repayment in full of all outstanding indebtedness to GECC under the A-R Cable credit agreement. NOTE 7. INCOME TAXES As a result of an Internal Revenue Service ("IRS") examination of the Company's predecessor's tax returns for the years 1981 to 1983, the Company accrued approximately $1,757 in 1991 representing amounts due for federal income taxes and interest thereon, in full settlement of that audit. The Company's tax returns for the years 1984 to 1989 have been examined by the IRS and certain issues related to the amortization of intangible assets are being appealed by the Company. Management believes that any settlement arising out of this examination will not have a material adverse effect on the financial position of the Company. At December 31, 1993, the Company had a net operating loss carry forward for income tax purposes of approximately $206,752, which expires in the years 2003 to 2008. Due to the transaction on May 11, 1992, described in Note 2 above, the Company underwent an ownership change within the meaning of Internal Revenue Code Section 382. This would limit the amount of net operating loss carry forward from the period prior to the transaction which could be utilized to offset any taxable income in periods subsequent to the transaction. There is a pro rata allocation in the year that the ownership change occurs. Therefore, of the $206,752 of net operating loss carry forwards for tax purposes, $201,588 is restricted and $5,164 is currently available. Usage of the $201,588 net operating loss carry forward is limited to a fixed annual amount, calculated using the Federal long-term tax-exempt rate times the value of the Company prior to the ownership change. This amount is increased in any year in which the Company recognizes any built in gain from the sale of assets owned prior to the ownership change. Based on this formula, none of the $201,588 restricted net operating loss carry forwards would currently be available to the Company. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires the liability method of accounting for deferred income taxes and (108) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) permits the recognition of deferred tax assets, subject to an ongoing assessment of realizability. Prior years' financial statements have not been restated to reflect the provisions of SFAS 109. The tax effects of temporary differences which give rise to significant portions of deferred tax assets or liabilities and the corresponding valuation allowance at December 31, 1993 are as follows: The Company has provided a valuation allowance of $61,683 for deferred tax assets since realization of these assets was not assured due to the Company's history of operating losses. The amounts of deferred tax assets and corresponding valuation allowance increased by $11,590 during the year ended December 31, 1993, principally due to a provision for potential state tax benefits. Also, in connection with the acquisition of the Company by CSC in January 1988, the Company recorded certain fair value adjustments net of their tax effects. In accordance with SFAS 109, these assets have been adjusted to their remaining pre tax amounts. Accordingly, property, plant and equipment, franchises, and subscriber lists have been increased by $68, $26,611 and $7,616, respectively. Amortization of these amounts in 1993 resulted in the recognition of income tax benefits of $14,168. NOTE 8. AFFILIATE TRANSACTIONS As a result of the restructuring described in Note 2, the Company entered into a management agreement with CSC whereby the Company continues to be managed by CSC in exchange for a management fee of 3-1/2% of gross receipts, as defined, and interest on unpaid annual amounts thereon at a rate of 10% per annum commencing (109) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) January 1, 1993. Such management fees amounted to $3,801 and $2,383 for 1993 and 1992, respectively. Interest on such management fees amounted to $244 for 1993. The Company is also charged for cost reimbursement and an allocation of certain selling, general and administrative expenses by CSC. For the years ended December 31, 1993, 1992 and 1991 these cost reimbursements and expense allocations approximated $3,373, $2,719, and $1,813, respectively. In accordance with certain restrictive covenants contained in its Senior Term Loan agreement, the Company may not pay in excess of the amounts permitted relating to the allocation of selling, general and administrative expenses, subject to certain escalation provisions, of corporate overhead expenses charged by CSC in any fiscal year. At December 31, 1993 and 1992, the total balance due CSC for management fees, cost reimbursement and expenses amounted to $7,191 and $2,899, respectively. CSC has interests in several companies engaged in providing cable television services and programming services to the cable television industry, including the Company. During 1993, 1992 and 1991, the Company was charged approximately $2,787, $2,690 and $3,127, respectively, by these companies for these services. The total amount due these companies at December 31, 1993 and 1992 was $602 and $794, respectively. Cablevision Systems Services Corporation ("CSSC"), a company owned by CSC's chairman, Charles F. Dolan, entered into an agreement with a certain premium program service supplier allowing all cable systems managed by CSSC or CSC to offer that premium program service to their subscribers. The contract requires minimum annual payments escalating to approximately $13,399 in 1994. Each of the related cable systems offering this service, including the Company, pays its proportionate share of the minimum annual payment based on subscriber usage of the service. In 1993, 1992 and 1991, the Company was charged $949, $976 and $907, respectively, for such usage. NOTE 9. PENSION PLANS Prior to 1993 the Company was a participant, with other affiliates, in a defined contribution pension plan (the "Pension Plan") covering substantially all of its employees. The Company contributed three percent of each eligible employee's annual compensation, as defined, and employees could voluntarily contribute up to ten percent of their annual compensation. Effective January 1, 1993, the Board of Directors of CSC approved the adoption of an amended and restated Pension and 401(K) Savings Plan (the "Plan"), in part to permit (110) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) employees of CSC and its affiliates to make contributions to the Plan on a pre-tax salary reduction basis in accordance with the provisions of Section 401(K) of the Internal Revenue Code, and to introduce new investment options under the Plan. The Company contributes 1-1/2% of eligible employees' annual compensation, as defined, to the defined contribution portion of the Plan (the "Pension Plan") and an equivalent amount to the section 401(K) portion of the Plan (the "Savings Plan"). Employees may voluntarily contribute up to 15% of eligible compensation, subject to certain restrictions, to the Savings Plan, with an additional matching contribution by the Company of 1/4 of 1% for each 1% contributed by the employee, up to a maximum contribution by the Company of 1/2 of 1%. Employee contributions are fully vested as are employer base contributions to the Savings Plan. Employer contributions to the Pension Plan and matching contributions to the Savings Plan become vested in years three through seven. Total expense related to these plans for the years ended December 31, 1993, 1992 and 1991 was approximately $339, $234 and $235, respectively. The Company does not provide any postretirement benefits to its employees. NOTE 10. OPERATING LEASES The Company leases certain office, production, satellite transponder, and transmission facilities under terms of operating leases expiring at various dates through the year 2017. The leases generally provide for fixed annual rentals plus certain real estate taxes and other costs. Rent expense for the years ended December 31, 1993, 1992 and 1991, was approximately $842, $910 and $952, respectively. In addition, the Company rents space on utility poles for its operations. The Company's pole rental agreements are for varying terms, and management anticipates renewals as they expire. Pole rental expense for the years ended December 31, 1993, 1992 and 1991 was approximately $1,507, $1,265 and $1,247, respectively. The minimum future annual rentals for all operating leases, including pole rentals from January 1, 1994 through December 31, 1998, and thereafter, at rates now in force are approximately: 1994, $2,198; 1995, $2,188; 1996, $2,113; 1997, $1,785; 1998, $1,555; thereafter, $213. (111) A-R CABLE SERVICES, INC. AND SUBSIDIARIES (a wholly-owned subsidiary of Cablevision Systems Corporation) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (continued) NOTE 11. DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS CASH AND CASH EQUIVALENTS, TRADE ACCOUNTS RECEIVABLE, NOTES AND OTHER RECEIVABLES, ACCOUNTS PAYABLE, ACCRUED LIABILITIES, ACCOUNTS PAYABLE TO AFFILIATES AND DUE TO PARENT The carrying amount approximates fair value because of the short maturity of these instruments. SENIOR TERM LOAN The fair values of the Company's long-term debt instruments are based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. INTEREST RATE CAP AGREEMENT The fair value of the interest rate cap agreement is obtained from dealer quotes. This value represents the estimated amount the Company would receive or pay to terminate agreements, taking into consideration current interest rates and the current creditworthiness of the counterparties. The carrying amount represents a deferred expense arising from the unrecognized financial instrument. The fair value of the Company's financial instruments are summarized as follows: Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. (112) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 29th day of March, 1994. Cablevision Systems Corporation By: /s/ William J. Bell ------------------------- Name: William J. Bell Title: Vice Chairman POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Francis F. Randolph, Jr., Marc A. Lustgarten and Robert S. Lemle, and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him in his name, place and stead, in any and all capacities, to sign this report, and file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, full power and authority to do and perform each and every act and thing requisite and necessary to be done as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons in the capacities and on the dates indicated. (113) (114) INDEX TO EXHIBITS EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ----- 3.1 --Certificate of Incorporation of the Registrant (incorporated herein by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 dated January 17, 1986, File No. 33-1936 (the "S-1")) 3.1A --Amendment to Certificate of Incorporation and complete copy of amended and restated Certificate of Incorporation (incorporated herein by reference to Exhibits 3.1A(i) and 3.1A(ii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 (the "1989 10-K")) 3.1B --Certificate of Designations for the Series E Redeemable Exchangeable Convertible Preferred Stock 3.1C --Certificate of Designations for the Series F Redeemable Preferred Stock 3.2 --By-laws of the Registrant (incorporated herein by reference to Exhibit 3.2 to the S-1) 3.2A --Amendment to By-laws and complete copy of amended and restated By-laws (incorporated herein by reference to Exhibit 3.2 to the 1989 10-K) 3.2B --Amendment to By-laws and complete copy of amended and restated By-laws (incorporated herein by reference to Exhibit 3.2B to the Company's Annual Report on Form 10K for the fiscal year ended December 31, 1992 (the "1992 10-K"). 4.1 --Indenture dated as of November 10, 1988 relating to the Registrant's $200,000,000 Senior Subordinated Debentures due October 15, 2003 (incorporated herein by reference to Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-9046 (the "1988 10-K"). 4.2 --Indenture dated as of April 1, 1992 relating to the Registrant's $275,000,000 10 3/4% Senior Subordinated Debentures due April 1, 2004 (incorporated herein by reference to Exhibit 4.2 to the 1992 10-K). (115) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ---- 4.3 --Indenture dated as of February 15, 1993 relating to the Registrant's $200,000,000 9 7/8% Senior Subordinated Debentures due February 15, 2013 (incorporated herein by reference to Exhibit 4.3 to the 1992 10-K). 10.1 --Registration Rights Agreement between Cablevision Systems Company and the Registrant (incorporated herein by reference to Exhibit 10.1 of the S-1). 10.2 --Registration Rights Agreement between CSC Holdings Company and the Registrant (incorporated herein by reference to Exhibit 10.2 to the S-1) 10.4 --Form of Right of First Refusal Agreement between Dolan and the Registrant (incorporated herein by reference to Exhibit 10.4 to the S-1) 10.5 --Supplemental Benefit Plan of the Registrant (incorporated herein by reference to Exhibit 10.7 to the S-1) 10.6 --Cablevision Money Purchase Pension Plan, and Trust Agreement dated as of December 1, 1983 between Cablevision Systems Development Company and Dolan and Tatta, as Trustees (incorporated herein by reference to Exhibit 10.8 to the S-1) 10.6A --Amendment to the Cablevision Money Purchase Pension Plan adopted November 6, 1992 (incorporated herein by reference to Exhibit 10.6A to the 1992 10-K). 10.7 --Employment Agreement between Charles F. Dolan and the Registrant dated January 27, 1986 (incorporate herein by reference to Exhibit 10.9 to the S-1) 10.8 --Amended and Restated Agreement dated as of June 1, 1983 between SportsChannel Associates and Cablevision Systems Holdings Company (incorporated herein by reference to Exhibit 10.11 to the S-1) (116) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ----- 10.9 --Assignment of Partnership Interest dated as of November 30, 1984 between Cablevision Systems Company, Cablevision Company and Cablevision of Boston Limited Partnership (incorporated herein by reference to Exhibit 10.15 to the S-1) 10.10 --Promissory Note of Cablevision of Chicago dated November 30, 1984 payable to Cablevision Company (incorporated herein by reference to Exhibit 10.16 to the S-1) 10.11 --Promissory Note of Cablevision of Chicago dated August 11, 1989 payable to Cablevision Systems Corporation (incorporated herein by reference to Exhibit 10.16A to the 1989 10-K) 10.12 --Lease Agreement dated as of October 9, 1978 between Cablevision Systems Development Company and Industrial and Research Associates Co. and amendment dated June 21, 1985 between Industrial and Research Associates Co. and Cablevision Company (incorporated herein by reference to Exhibit 10.18 to the S-1) 10.13 --Lease Agreement dated May 1, 1982 between Industrial and Research Associates Co. and Cablevision Systems Development Company (incorporated herein by reference to Exhibit 10.19 to the S-1) 10.14 --Agreement of Sublease dated as of July 9, 1982 between Cablevision Systems Development Company and Ontel Corporation (incorporated herein by reference to Exhibit 10.20 to the S-1) 10.15 --Agreement of Sublease dated as of June 21, 1985 between Grumman Data Systems Corporation and Cablevision Company (incorporated herein by reference to Exhibit 10.21 to the S-1) 10.16 --Agreement dated as of June 21, 1985 between Industrial and Research Associates Co., Grumman Data Systems Corporation and Cablevision Company (incorporated herein by reference to Exhibit 10.22 to the S-1) (117) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------ ----------- ---- 10.17 --Lease Agreement dated as of June 21, 1985 between Industrial and Research Associates Co. and Cablevision Company (incorporated herein by reference to Exhibit 10.23 to the S-1) 10.18 --Lease Agreement dated as of February 1, 1985 between Cablevision Company and County of Nassau (incorporated herein by reference to Exhibit 10.24 to the S-1) 10.19 --Lease Agreement dated as of January 1, 1981 between Cablevision Systems Development Company and Precision Dynamics Corporation and amendment dated January 15, 1985 between Cablevision Company and Nineteen New York Properties Limited Partnership (incorporated herein by reference to Exhibit 10.25 to the S-1) 10.20 --Option Certificate for 840,000 Shares Issued Pursuant to the 1986 Nonqualified Stock Option Plan of the Registrant (incorporated herein by reference to Exhibit 10.29 to the S-1) 10.21 --Stock Purchase Agreement dated as of February 17, 1989 among the Registrant, Viacom, Inc. and Arsenal Holdings II, Inc. (incorporated herein by reference to Exhibit 10.29 to the 1988 10-K) 10.23 --Acquisition Agreement, dated as of April 20, 1989, among Rainbow Programming Holdings, Inc., Rainbow Program Enterprises and SportsChannel America Holding Corporation, and National Broadcasting Company, Inc. and NBC Cable Holding, Inc. (incorporated herein by reference to Exhibit 2.1 to the Registrant's Report on Form 8-K under the Securities Exchange Act of 1934 dated April 20, 1989) (the "April 1989 8-K")) 10.24 --Investment Agreement, dated as of April 20, 1989, among Rainbow Programming Holdings, Inc., CNBC Holding Corporation, National Broadcasting Company, Inc. and CNBC, Inc. (incorporated herein by reference to Exhibit 2.2 to the April 1989 8-K) (118) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ---------- ----------- ---- 10.25 --New Ventures Agreement, dated as of April 20, 1989, among the Registrant and certain of its subsidiaries, and National Broadcasting Company, Inc. and certain of its subsidiaries (incorporated herein by reference to Exhibit 2.3 to the April 1989 8-K) 10.26 --Olympics Agreement, dated as of April 20, 1989, between Rainbow Programming Holdings, Inc., National Broadcasting Company, Inc. and Rainbow NBC Olympics Company (incorporated herein by reference to Exhibit 2.5 to the April 1989 8-K) 10.27 --Agreement for Asset Trade, dated as of August 25, 1989 among CSC Acquisition Corporation, Times Mirror Cable Television of Long Island, Inc. and Time Mirror Cable Television of Haverhill, Inc. (incorporated herein by reference to Exhibit 10.40 to the 1990 10-K) 10.29 --Letter Agreement dated as of December 19, 1991 among U.S. Cable Television Group, L.P., V Cable, Inc. and General Electric Capital Corporation (incorporated herein by reference to Exhibit 2(a) to the January 1992 8-K). 10.30 --Letter Agreement dated as of December 19, 1991 among General Electric Capital Corporation, the Registrant and V Cable, Inc. (incorporated herein by reference to Exhibit 2(b) to the January 1992 8-K). 10.31 --Amendment dated February 12, 1992 to Letter Agreement dated as of December 19, 1991 among General Electric Capital Corporation, the Registrant and V Cable, Inc. (incorporated herein by reference to Exhibit 2(b) to the March 1992 Form 8). 10.32 --Purchase and Reorganization Agreement dated as of December 20, 1991 between the Registrant and Charles F. Dolan (incorporated herein by reference to Exhibit 2(c) to the January 1992 8-K). (119) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ----- 10.33 --Amendment No. 1 dated as of March 28, 1992 to Purchase and Reorganization Agreement dated as of December 20, 1991 between the Registrant and Charles F. Dolan (incorporated herein by reference to Exhibit 2(g) to the March 1992 Form 8). 10.34 --Letter Agreement dated February 12, 1992, among the Registrant, A-R Cable Services, Inc. and Warburg Pincus Investors, L.P. (incorporated herein by reference to Exhibit 28(a) to the Registrant's Current Report on Form 8-K under the Securities Exchange Act of 1934 dated February 21, 1992 (the "February 1992 8-K")). 10.35 --Letter Agreement dated February 12, 1992 among the Registrant, A-R Cable Services, Inc. and General Electric Capital Corporation (incorporated herein by reference to Exhibit 28(b) to the February 1992 8-K). 10.36 --Letter Agreement dated February 12, 1992 among the Registrant and A-R Cable Services, Inc. (incorporated herein by reference to Exhibit 28(b) to the February 1992 8-K). 10.37 --Non-Competition Agreement, dated as of December 31, 1992, among V Cable, Inc., VC Holding, Inc. and the Registrant, for the benefit of V Cable, Inc., VC Holding, Inc. and General Electric Capital Corporation (incorporated herein by reference to Exhibit 10.37 to the 1992 10-K). 10.38 --Non-Competition Agreement, dated as of December 31, 1992, between U.S. Cable Television Group, L.P. and the Registrant, for the benefit of U.S. Cable Television Group, L.P. and General Electric Capital Corporation (incorporated herein by reference to Exhibit 10.38 to the 1992 10-K). 10.39 --CSC Nonrecourse Guaranty and Pledge Agreement, dated as of December 31, 1992, between the Registrant and General Electric Capital Corporation, as Agent for the Lenders (incorporated herein by reference to Exhibit 10.39 to the 1992 10-K). (120) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ----- 10.40 --U.S. Cable Investment Agreement, dated as of June 30, 1992, among V Cable, Inc., V Cable GP, Inc., U.S. Cable Television Group, L.P. and U.S. Cable Partners (incorporated herein by reference to Exhibit 10.40 to the 1992 10-K). 10.41 --Newco Investment Agreement, dated as of December 31, 1992, among VC Holding, Inc., V Cable, Inc. and U.S. Cable Television Group (incorporated herein by reference to Exhibit 10.41 to the 1992 10-K). 10.42 --Senior Loan Agreement, dated as of December 31, 1992, among V Cable, Inc., the Lenders named therein and General Electric Capital Corporation, as Agent for the Lenders and as Lender (incorporated herein by reference to Exhibit 10.42 to the 1992 10-K). 10.43 --Senior Loan Agreement, dated as of December 31, 1992, among U.S. Cable Television Group, L.P., the Lenders named therein and General Electric Capital Corporation, as Agent for the Lenders and as Lender (incorporated herein by reference to Exhibit 10.43 to the 1992 10-K). 10.44 --Third Amended and Restated Credit Agreement dated as of June 24, 1992 (the "Third Amended and Restated Credit Agreement") among the Registrant, the Restricted Subsidiaries (as defined therein), the banks which are parties thereto and Toronto Dominion (Texas), Inc. as Agent and Bank of Montreal, Chicago Branch, The Bank of New York, The Bank of Nova Scotia, and The Canadian Imperial Bank of Commerce, as Co-Agents (incorporated herein by reference to Exhibit 10.44 to the 1992 10-K). 10.44A --Amendment No. 1, dated as of August 4, 1992, to Third Amended and Restated Credit Agreement (incorporated herein by reference to Exhibit 10.44A to the 1992 10-K). 10.44B --Amendment No. 2 and waiver, dated as of November 8, 1993 to the Third Amended and Restated Credit Agreement. (121) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ----- 10.44C --Amendment No. 3 and waivers, dated as of March __, 1994 to the Third Amended and Restated Credit Agreement. 10.46 --Cablevision Systems Corporation Amended and Restated Employee Stock Plan (incorporated herein by reference to Exhibit 10.46 to the 1992 10-K). 10.47 --Cablevision Systems Corporation 401(K) Savings Plan (incorporated herein by reference to Exhibit 10.47 to the 1992 10-K). 10.49 --Fourth Amended and Restated Credit Agreement, dated as of June 18, 1993, among Cablevision of New York City - Phase I L.P., Cablevision Systems New York City Corporation, Cablevision of New York City- Master L.P., each of the Banks signatory thereto, The Chase Manhattan Bank (National Associates) as Agent and The First National Bank of Chicago and CIBC, Inc. each as Co-Agent. 10.50 --Asset Purchase Agreement, dated as of July 23, 1993, by and between Cablevision of Cleveland, L.P. and North Coast Cable Limited Partnership (incorporated herein by reference to Exhibit 10.50 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993). 10.51 --Master Agreement, dated as of October 26, 1993, between Cablevision MFR, Inc., Monmouth Cablevision Associates, Framingham Cablevision Associates and Riverview Cablevision Associates, L.P. (incorporated herein by reference to Exhibit 10.51 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1993 (the "September 1993 10-Q"). 10.52 --Asset Purchase Agreement, dated as of October 26, 1993, between Monmouth Cablevision Associates and Cablevision MFR, Inc. (incorporated herein by reference to Exhibit 10.52 to the September 1993 10-Q). (122) INDEX TO EXHIBITS (continued) EXHIBIT PAGE NO. DESCRIPTION NO. - ------- ----------- ----- 10.53 --Asset Purchase Agreement, dated as of October 26, 1993, between Framingham Cablevision Associates, Limited Partnership and Cablevision MFR, Inc. (incorporated herein by reference to Exhibit 10.53 to the September 1993 10-Q). 10.54 --Asset Purchase Agreement, dated as of October 26, 1993 between Riverview Cablevision Associates, L.P. and Cablevision MFR, Inc. (incorporated herein by reference to Exhibit 10.54 to the September 1993 10-Q). 10.55 --Asset Purchase Agreement among A-R Cable Partners, Nashoba Communications Limited Partnership, Nashoba Communications Limited Partnership No. 7 and Nashoba Communications of Belmont Limited Partnership dated as of November 5, 1993 (incorporated herein by reference to Exhibit 10.55 to the September 1993 10-Q). 10.56 --Preferred Stock Purchase Agreement, dated as of March 30, 1994, by and among the Company and Toronto Dominion Investments, Inc. 10.57 --Registration Rights Agreement, dated as of March 30, 1994, by and among the Company and Toronto Dominion Investments, Inc. 22 --Subsidiaries of the Registrant 23.1 --Consent of Independent Auditors 28.1 --Form of Guarantee and Indemnification Agreement among Dolan, the Registrant and directors and officers of the Registrant (incorporated herein by reference to Exhibit 28 to the S-1) (123)

740156_1993.txt

740156_1993

1993

740156

ITEM 1. BUSINESS. Century Properties Growth Fund XXII (hereinafter referred to either as "Fund", "Partnership" or "Registrant") was organized in January 1984, as a California limited partnership under the Uniform Limited Partnership Act of the California Corporations Code. Fox Partners IV, a California general partnership, is the general partner of the Fund. The general partners of Fox Partners IV are Fox Capital Management Corporation ("Fox"), Fox Realty Investors ("FRI") and Fox Associates 84. The Fund's Registration Statement, filed pursuant to the Securities Act of 1933 (No. 2-89285), was declared effective by the Securities and Exchange Commission ("Commission") on September 25, 1984. The Partnership marketed its securities pursuant to its Prospectus dated September 25, 1984, and thereafter supplemented (hereinafter the "Prospectus"). This Prospectus was filed with the Commission pursuant to Rule 424(b) of the Securities Act of 1933. The principal business of the Fund is and has been to acquire, hold for investment and ultimately sell income-producing real property. The Fund is a "closed" limited partnership real estate syndicate formed to acquire multi-family residential properties. For a further description of the business of Registrant, see the sections entitled "Risk Management" and "Investment Objectives and Policies" of the Prospectus. Beginning in September 1984 through June 1986, the Fund offered $120,000,000 in Limited Partnership Units and sold $82,848,000. The net proceeds of this offering were used to purchase eleven income-producing real properties. The Fund's property portfolio is geographically diversified with properties acquired in eight states. Leaseback agreements which covered ten of the properties, whereby the seller assumed the risks of operating each property in its initial operating phase, have now expired. The Fund's acquisition activities were completed in September 1986 and since then the principal activity of the Fund has been managing its portfolio. One property was acquired by the lender through foreclosure in 1992. See Item 2 ITEM 2. PROPERTIES. A description of the multi-family residential properties in which the Fund has or had an ownership interest is as follows: CENTURY PROPERTIES GROWTH FUND XXII RECONCILIATION OF NET PROJECT OPERATIONS TO NET LOSS FOR THE YEAR ENDED DECEMBER 31, 1993 1992 1991 (AMOUNTS IN THOUSANDS) Net Project Operations $ 1,475 $ 594 $ (658) Less: Depreciation 4,171 4,594 5,348 General and administrative expenses 721 595 551 Other interest expense 425 405 202 Plus: Interest and other income 94 170 441 Principal payments in debt service 605 447 420 Gain on property disposition - 407 - Gain on extinguishment of debt - 3,403 - ------- ------ ------- Net Loss $(3,143) $ (573) $(5,898) ======= ====== ======= ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Fund is a party or to which any of its assets are subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of security holders during the period covered by this Report. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S EQUITY AND RELATED SECURITY HOLDER MATTERS. The Limited Partnership Unit holders are entitled to certain distributions as provided in the Partnership Agreement. Through December 1993 cash distributions from operations have been $15 for each $1,000 of original investment. No market for Limited Partnership Units exists nor is expected to develop. As of December 31, 1993 the approximate number of holders of Limited Partnership Units was as follows: NUMBER OF RECORD TITLE OF CLASS HOLDERS* Limited Partnership Units 7,711 *Number of Investments. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following represents selected financial data for Century Properties Growth Fund XXII for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. The data should be read in conjunction with the consolidated financial statements included elsewhere herein. This data is not covered by the independent auditors' report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Item should be read in conjunction with Consolidated Financial Statements and other Items contained elsewhere in this Report. RESULTS OF OPERATIONS The markets in which the Fund's properties are located are described below: Mesa/ Phoenix The industrial base is highly concentrated in aerospace and high tech electronics which has been significantly affected by defense cutbacks although relocation to Arizona by commercial aircraft companies and catalog centers is having a slight positive effect. However, continued corporate migration from Southern California is expected to be a source of job growth. The apartment market is competitive but occupancy at Wood Creek Apartments remains stable. However, net operating income increased, in part, as a result of an increase in rental revenue due to an increase in rental rates and decreases in utilities and repair and maintenance costs in 1993. Atlanta Atlanta's economy appears to be recovering. Relocating corporations, 1996 Summer Olympic Games, health services and the Fighter contract awarded to Lockheed are expected to be major sources of job growth. In addition, UPS Headquarters is planning to relocate to Atlanta, enhancing its image as a regional and national business center. The apartment market remains competitive due to oversupply of available rental units. Plantation Creek Apartments operates in a competitive submarket although occupancy and revenue increased as the economy strengthened. Dallas The Dallas economy is relatively diversified; however, the recession still lingers where continued defense cutbacks have slowed the growth in employment. These job losses were partially offset by major corporations relocating to the area near the Dallas/FortWorth International Airport causing a recent increase in economic growth in certain submarkets. The apartment market remains competitive due to affordability of new single family homes and recent job losses as described above. Occupancy at Stoney Creek Apartments remained stable while occupancy and rental rates have increased slightly at Hampton Greens Apartments. Overland Park/ Kansas City The economy began to recover in late 1992. Agriculture and manufacturing remain the dominant industries. A major pharmaceutical corporation has started construction of its new headquarters and a laboratory which is expected to increase job growth in the area. The apartment market remains stable and construction remains virtually non- existent although the availability of favorable home financing has placed pressure on the rental tenant base. Occupancy at Four Winds Apartments remains stable. Austin Economic growth continues as several high tech companies are expanding or relocating into the area. The apartment market is competitive; however, apartment construction has been virtually non- existent for several years. As a result, occupancy at Promontory Point Apartments and rental rates have increased. Charleston The economy continues to expand due to employment gains in the services industries. The single family housing market remains very weak, allowing the apartment market to strengthen. Occupancy at Cooper's Pointe Apartments has increased slightly with a slight increase in rental rates. Rancho Cucamonga The Southern California economy including Rancho Cucamonga remains recessionary due to continued cutbacks in the defense industry. However, the Rancho Cucamonga economy has attracted relocating companies from the City of Los Angeles and Orange County due to lower rents and cost of living. In addition, Rancho Cucamonga remains a popular area in which to live and commute to the City of Los Angeles. However, increased competition and a declining tenant base resulted in lower occupancy and rental rates at Monterey Village Apartments. Naperville The Chicago economy encompasses Naperville and began its recovery only in the latter half of 1992. However, the economy remains weak due to continued layoffs by some corporations in the area. The apartment market is oversupplied and competition is strong whereby rental concessions are common. The affordability and trend towards homeownership has also adversely impacted the rental market. Occupancy and operations at Autumn Run Apartments have decreased slightly. Richmond The economy began to recover in the second half of 1992, although employment growth is expected to be slow. Construction in the apartment market has virtually ceased allowing the market to somewhat stabilize. Occupancy at Copper Mill Apartments has increased slightly and rental concessions have declined. 1993 Compared to 1992 In 1993 some of the Fund's properties experienced an improvement in operations as a result of increased occupancy and/or slight increases in the rental rates due, in part, to improvements in the local economies in which the properties operate. However, the operating results of certain of the Fund's properties continue to be affected by highly competitive market conditions combined with the continued sluggish economy. Markets in some areas remained depressed due, in part, to overbuilding which continued to depress rental rates at some of the Fund's properties. In addition, future military base closures may adversely impact the South Carolina market and consequently, Cooper's Pointe Apartments. Loss before extraordinary item decreased $833,000 in 1993 compared to the same period in 1992 primarily due to a decrease in operating, interest and depreciation expenses due to the disposition of Fox Hollow Apartments in July 1992. In addition, interest expense was further reduced by the lower interest rate resulting from the refinancing of Promontory Point in 1992, the reduced interest rate due to the extension on the Four Winds Apartments note payable in September 1992 and the reduced interest rate due to the extension of Cooper's Pointe Apartments note payable in 1993. Rental revenue remained steady. Decreases due to the disposition of Fox Hollow Apartments and decreased occupancy at Monterey Village and Autumn Run Apartments offset the increases in rental revenue at Woodcreek and Promontory Point Apartments, due to increased rental rates, and Plantation Creek Apartments, due to increased occupancy. Operating expenses decreased only slightly as operating expense increases at Four Winds Apartments and Autumn Run Apartments substantially offset the disposition of Fox Hollow Apartments. Interest and other income decreased due to a decrease in interest rates and cash available for investments. General and administrative expenses increased due to an increase in amounts paid for portfolio management services as a result of the new services agreement and bad debt expense related to revenue bonds acquired when Fox Hollow was purchased. The gain on property disposition recognized in 1992 relates to Fox Hollow Apartments. The extraordinary item-gain on extinguishment of debt recognized in 1992 relates to the discounted prepayment on the Stoney Creek, Hampton Greens and Promontory Point Apartments notes payable. 1992 Compared to 1991 Loss before extraordinary item decreased $1,922,000 in 1992 compared to 1991 primarily due to a decrease in interest expense as a result of lower interest rates resulting from the refinancing of Stoney Creek, Hampton Greens and Promontory Point apartments, and a decrease in depreciation expense due to fully depreciated furnishings at certain of the Fund's properties and the disposition of Fox Hollow Apartments. In addition, a gain on property disposition of $407,000 relating to Fox Hollow Apartments was recognized in 1992. These decreases in expenses were offset in part, by a decrease in interest and other income due to a decrease in interest rates and cash available for investment. Rental revenues increased in 1992 compared to 1991 due to increased occupancy and rental rates at certain of the Fund's properties. However, this increase was offset, in part, by a decrease in revenue from the property disposition of Fox Hollow Apartments. General and administrative expenses increased due to an increase in amounts paid for portfolio management services as a result of the new services agreement. The extraordinary item-gain on extinguishment of debt of $3,403,000 recognized in 1992 relates to the discounted prepayment on the Stoney Creek, Hampton Greens and Promontory Point Apartments notes payable discussed in Note 6. FUND LIQUIDITY AND CAPITAL RESOURCES Introduction The results of net project operations are determined by rental revenues less operating expenses (exclusive of capital improvements and noncash items such as depreciation and amortization) and debt service (see Item 2, Properties). During 1993, seven of the Fund's ten properties generated positive net project operations, while Cooper's Pointe, Monterey Village and Autumn Run Apartments experienced negative net project operations. The Fund, after taking into account results of net project operations, interest and other income and general and administrative expenses, experienced positive operations for the year, as defined herein. However, to preserve working capital reserves required for necessary capital improvements to properties and provide resources for potential refinancing of properties, cash distributions from operations were suspended beginning with the November 1988 scheduled distribution and remained suspended in 1993. It is anticipated cash distributions will remain suspended in 1994 and into the foreseeable future. Net project operations should not be considered as an alternative to Net Loss (as presented in the financial statements) as an indicator of the Fund's operating performance or to cash flows as a measure of liquidity. As presented in the Consolidated Statement of Cash Flows, cash was provided by operating activities. Cash was used by investing activities for the purchase of cash investments and additions to rental properties and was provided primarily by proceeds from sale of cash investments. Cash was used by financing activities for notes payable principal payments and financing costs. The Fund obtained a summary judgement against the seller of Promontory Point Apartments for non-payment of property taxes. As a result of the summary judgement, a settlement agreement was reached in the amount of $140,000. This amount represented the initial summary judgement of approximately $100,000 plus legal and other fees incurred by the Partnership in its efforts to collect the amount due. The $140,000 was to be paid by an initial payment of $70,000 and 12 equal monthly payments of approximately $6,000. The Fund received the $70,000 initial payment in the second quarter of 1991 and monthly payments were received as scheduled through 1991 and 1992. The Fund had been pursuing a discounted prepayment on the Stoney Creek and Hampton Greens Apartments notes payable and, in July 1991, received the lender's approval for such discounted prepayment. The discounted prepayments were dependent upon the Fund obtaining replacement financing on the properties which, as discussed in Note 6 to the consolidated financial statements, was obtained in January 1992. The new financing has a variable interest rate, requires monthly interest only payments and matures in January 1995 with an option to extend the maturity date an additional two years. The Fund had approached the lender of Fox Hollow Apartments requesting debt modification, including a discounted prepayment of the loan. The discounted prepayment was contingent upon the Fund receiving replacement financing on the property. In connection with these negotiations, only partial debt service payments had been made beginning with the August 1989 payment. In March 1992 a Notice of Default was received by the Fund, and the Fund ceased making debt service payments. As the Fund was unable to obtain replacement financing, the Fund allowed the lender to foreclose on the property in July 1992. As discussed in Note 7 to the consolidated financial statements, the gain on property disposition was $407,000. The total consideration for the property had been $12,168,000, including mortgage financing of $7,984,000 when acquired in January 1985. In the Fund's opinion, any return which the Fund might have realized, through a reasonable period of continued ownership of this property would not have been adequate to offset its anticipated deficits. The Fund had been pursuing a discounted prepayment on Promontory Point Apartments and, in January 1992, received the lender's approval for such discounted prepayment. The discounted prepayment was dependent upon the Fund obtaining replacement financing on the property which, as discussed in Note 6 to the consolidated financial statements, was obtained in May 1992. The new financing has a variable interest rate, requires monthly interest only payments and matures in April 1997. During 1992, Four Winds Apartments suffered significant damage due to a severe hailstorm that struck the property. Property damage was estimated to be $1 million of which approximately $800,000 related to repairing the roof. The Fund submitted a claim for approximately $1 million under its insurance program and has received reimbursement for the total amount. The repairs were substantially completed in 1992. The note payable on Four Winds Apartments with a balloon payment of $10,956,000 was due in September 1992. The Fund had an option to extend this loan to September 1995 which it exercised when the loan matured, as discussed in Note 5 to the consolidated financial statements. Erosion under one of the buildings and storm drain damage at Plantation Creek Apartments were discovered during 1992. The cost to repair the foundation and storm drain damage was approximately $180,000 and was not covered by the Fund's insurance policy. Repairs were completed in the first quarter of 1993. In addition, the property has sustained significant termite/dry rot damage. The total cost to repair the termite/dry rot damage was $270,000 of which $127,000 was covered by the Fund's insurance program. Repairs were completed in the fourth quarter of 1993. The Fund had a balloon payment on the Cooper's Pointe Apartments' note payable of $5,554,000 due in December 1992. The Fund approached the lender for an extension of the note; however, the initial request was rejected by the lender. The lender issued a notice of default but had agreed not to enforce it until May 14, 1993. The Fund continued to negotiate with the lender for an extension of the due date and, as discussed in Note 5 to the consolidated financial statements, in May 1993 an agreement was reached for an extension of the due date to December 1, 1995. The extension was finalized in July 1993. In addition, a cash management agreement, which was required by the lender in order to complete the modification, provides that the lender will receive any excess cash flow for the property with such payments applied toward the reduction of the outstanding loan balance. Finally, as part of the agreement, the Fund was required to transfer Cooper's Pointe Apartments from a wholly owned subsidiary back to the Fund. The Fund had a balloon payment on the Monterey Village Apartments note payable of $8,200,000 due in August 1994 due date. To meet this obligation, the Fund approached the lender for debt modification, including an extension of the August 1994. As discussed in Note 8 to the consolidated financial statements, the Fund finalized modification of the loan in January 1994. The terms of the modification include a seven year extension with a reduction in the interest rate and a principal paydown. The Fund has a balloon payment of $3,669,000 due in December 1994 on Copper Mill Apartments. The Fund is currently attempting to obtain replacement financing with a new lender and anticipates that replacement financing will be secured during the second quarter of 1994. During 1993, the Fund spent $1,305,000 on additions and improvements to properties, the majority of which was spent at Plantation Creek and Autumn Run Apartments. The Fund expects to spend approximately $1,050,000 on additions and improvements to properties in 1994, the majority of which is to be spent on Woodcreek, Plantation Creek, Hampton Greens and Autumn Run Apartments. The Fund considers these expenditures necessary in order for its properties to remain competitive in their respective markets. Conclusion At this time, it appears that the investment objective of capital growth will not be attained and that investors will not receive a return of all their invested capital. The extent to which invested capital is returned to investors is dependent upon the success of the Fund's strategy as set forth herein as well as upon significant improvement in the performance of the Fund's remaining properties and the markets in which such properties are located and on the sales price of the remaining properties. In this regard, some or all of the properties will be held longer than originally expected. The ability to hold and operate these properties is dependent on the Fund's ability to obtain refinancing or debt modification as required. The Fund anticipates that its resources should be sufficient to meet capital and operating requirements into the foreseeable future assuming that replacement financing can be arranged for Copper Mill Apartments. In the event that additional resources are required, the Fund could attempt to arrange further debt modification or refinancing for that purpose. __________________________ Although inflation impacts the Fund's expenses, the Fund has the ability to attempt to offset expense increases through rent increases. Certain expenses may not be impacted by inflation, such as the debt service related to the mortgage financing encumbering the Fund's properties which was generally obtained at fixed interest rates. It is impossible to predict the future impact of inflation on the operations of the Fund's properties, the Fund's ability to successfully pass increased costs through to tenants, or the impact of inflation on the ultimate sales price of the properties. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. CENTURY PROPERTIES GROWTH FUND XXII (A LIMITED PARTNERSHIP) PAGE Independent Auditors' Report 15 Consolidated Financial Statements: Consolidated Balance Sheets at December 31, 1993 and 1992 16 Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 17 Consolidated Statements of Partners' Equity (Deficiency) for the Years Ended December 31, 1993, 1992 and 1991 18 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 19 Notes to Consolidated Financial Statements 20 Financial Statement Schedules: Schedule X- Consolidated Statements of Operations Information for the Years Ended December 31, 1993, 1992 and 1991 25 Schedule XI -Real Estate and Accumulated Depreciation at December 31, 1993 26 Consolidated financial statements and financial statement schedules not included have been omitted because of the absence of conditions under which they are required or because the information is included elsewhere in the consolidated financial statements. INDEPENDENT AUDITORS' REPORT Century Properties Growth Fund XXII: We have audited the consolidated financial statements of Century Properties Growth Fund XXII (a limited partnership) ("Partnership"), and its wholly-owned subsidiaries listed in the accompanying table of contents. Our audits also included the financial statement schedules of the Partnership and its wholly-owned subsidiaries listed in the accompanying table of contents. These financial statements and financial statement schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Partnership and its wholly-owned subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. The accompanying consolidated financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Partnership has balloon payments totalling $11,868,000 and $26,511,000 due in 1994 and 1995, respectively, which raises substantial doubt about the Partnership's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. DELOITTE & TOUCHE San Francisco, California March 18, 1994 CENTURY PROPERTIES GROWTH FUND XXII (A LIMITED PARTNERSHIP) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization - Century Properties Growth Fund XXII ("Partnership") is a limited partnership organized under the laws of the State of California to acquire, hold for investment, and ultimately sell income-producing real estate. The general partner of the Partnership is Fox Partners IV, a California general partnership. The general partners of Fox Partners IV are Fox Capital Management Corporation ("Fox", formerly known as Fox & Carskadon Financial Corporation), a California corporation, Fox Realty Investors ("FRI", formerly known as Century Partners), a California general partnership, Fox Partners 85, a California general partnership and Fox Associates 84, a California general partnership. The Partnership was organized in January 1984, but did not commence operations until May 1984. The capital contributions of $82,848,000 ($1,000 per unit) were made by the limited partners. On December 6, 1993, NPI Equity Investments II, Inc. ("NPI Equity II") became the managing partner of FRI and acquired voting control and assumed operational control over Fox. As a result, NPI Equity II became responsible for the operation and management of the business and affairs of the Partnership. Consolidation - The consolidated financial statements include the statements of the Partnership and its wholly owned subsidiaries, one of which was formed in 1991 into which the Stoney Creek, Hampton Greens and Promontory Point Apartments were transferred. The other subsidiary was formed in December 1992 into which Cooper's Pointe Apartments was transferred. In 1993, Cooper's Pointe Apartments was transferred back to the Partnership (see Note 5). All significant intercompany transactions and balances have been eliminated. Basis of Presentation and Operating Strategy - The accompanying consolidated financial statements have been prepared on a going concern basis which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. As of December 31, 1993 the Partnership had balloon payments totalling $11,869,000 due on two properties, Monterey Village and Copper Mill in August and December of 1994, respectively. In addition, balloon payments totalling $26,511,000 are due in 1995 on Four Winds, Woodcreek and Cooper's Pointe. To meet these obligations the Partnership is attempting or will attempt to obtain debt modification or refinancing of the properties. As discussed in Note 8, in January 1994 the Partnership modified the note payable on Monterey Village extending the note for seven years from the modification date and reducing the interest rate to 8.25%. Discussions on a multi-property financing arrangement involving Copper Mill are ongoing and the Partnership expects to complete the transaction in the first half of 1994. If the Partnership is unable to obtain debt modification or refinancing, it is likely that dispositions of properties with significant balloon payments will occur through sale, foreclosure or transfer to the lenders. The Partnership believes that its current strategy, combined with cash generated from the Partnership's properties with positive operations will allow the Partnership to meet its capital and operating requirements. The outcome of this uncertainty cannot presently be determined. The consolidated financial statements do not include any adjustments that might result from the ultimate outcome of this uncertainty. Distributions - Cash distributions from operations have been suspended since 1988 and will continue to be suspended in the foreseeable future to allow the Fund to implement repairs and improvements to the properties and to provide resources for potential refinancing of properties. New Accounting Pronouncements - In December 1991, the Financial Accounting Standards Board (FASB) issued Statement No. 107, "Disclosures About Fair Value of Financial Instruments". This Statement will not affect the financial position or results of operations of the Partnership but will require additional disclosure on the fair value of certain financial instruments for which it is practicable to estimate fair value. Disclosures under this statement will be required in the 1995 financial statements. Cash and Cash Equivalents - The Partnership considers cash investments, primarily commercial paper, with an original maturity date of three months or less at the time of purchase to be cash equivalents. Rental Properties - Rental properties are stated at cost. A provision for impairment of value is recorded when a decline in value of property is determined to be other than temporary as a result of one or more of the following: (1) a property is offered for sale at a price below its current carrying value, (2) a property has significant balloon payments due within the foreseeable future for which the Partnership does not have the resources to meet, and anticipates it will be unable to obtain replacement financing or debt modification sufficient to allow a continued hold of the property over a reasonable period of time, (3) a property has been, and is expected to continue, generating significant operating deficits and the Partnership is unable or unwilling to sustain such deficit results of operations, and has been unable to, or anticipates it will be unable to, obtain debt modification, financing or refinancing sufficient to allow a continued hold of the property for a reasonable period of time or, (4) a property's value has declined based on management's expectations with respect to projected future operational cash flows and prevailing economic conditions. An impairment loss is indicated when the undiscounted sum of estimated future cash flows from an asset, including estimated sales proceeds, and assuming a reasonable period of ownership up to 5 years, is less than the carrying amount of the asset. The impairment loss is measured as the difference between the estimated fair value and the carrying amount of the asset. In the absence of the above circumstances, properties and improvements are stated at cost. Acquisition fees are capitalized as a cost of rental property. Construction interest costs were capitalized as a cost of rental property during the development and construction phase and are expensed as incurred after construction is completed. Lease revenues from the lessee and payments made by the seller pursuant to performance guarantee agreements in excess of the rental property's net operating income (rental revenues less operating expenses) were applied as a reduction of the cost of the related rental property during the construction period and for the first two years after completion of construction, or until two years after acquisition if the property was completed at the time of acquisition. Depreciation - Depreciation is computed by the straight-line method over estimated useful lives of 30 years for buildings and improvements and six years for furnishings. Properties for which a provision for impairment of value has been recorded and are expected to be disposed of within the nex year are not depreciated. Deferred Financing Costs - Financing costs are deferred and amortized as interest expense over the lives of the related loans, which range from three to ten years, or expensed, if financing is not obtained. Net Loss Per Limited Partnership Unit - The net loss per limited partnership unit is computed by dividing the net loss allocated to the limited partners by 82,848 units outstanding. Income Taxes - No provision for Federal and state income taxes has been made in the consolidated financial statements because income taxes are the obligation of the general partner and the limited partners. Reclassification - Certain amounts have been reclassified to conform with 1993 presentation. 2. TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES In accordance with the Partnership Agreement, the Partnership may be charged by the general partner and affiliates for services provided to the Partnership. From March 1988 to December 1992 such amounts were assigned pursuant to a services agreement by the general partner and affiliates to Metric Realty Services, L.P., which performed partnership management and other services for the Partnership. On January 1, 1993, Metric Management, Inc., a company which is not affiliated with the general partner, commenced providing certain property and portfolio management services to the Partnership under a new services agreement. As provided in the new services agreement effective January 1, 1993, no reimbursements were made to the general partner in 1993. Subsequent to December 31, 1992, reimbursements were made to Metric Management, Inc. On December 16, 1993, the services agreement with Metric Management, Inc. was modified and, as a result thereof, the Partnership's general partner assumed responsibility for cash management of the Partnership as of December 23, 1993 and assumed responsibility for day-to-day management of the Fund's affairs, including portfolio management, accounting and investor relations services as of April 1, 1994. Related party expenses are as follows: 1993 1992 1991 Property management fees $ - $ 925,000 $ 924,000 Reimbursement of operational expenses: Accounting - 234,000 245,000 Investor services - 32,000 40,000 Professional services - 58,000 35,000 ------- ----------- ---------- Total $ - $1,249,000 $1,244,000 ======= ========== ========== In accordance with the Partnership Agreement, the general partner received a Partnership management incentive allocation equal to ten percent of net and taxable income (losses) and cash distributions. The general partner was also allocated its two percent continuing interest in the Partnership's net and taxable income (losses) and cash distributions after the above allocation of the Partnership management incentive. 3. RESTRICTED CASH Restricted cash of $775,000 at December 31, 1993 consists of $175,000 restricted tenant security deposits and $600,000 required to be maintained in accordance with the financing agreements on the Stoney Creek, Hampton Greens and Promontory Point Apartments in order to meet future capital requirements. 4. CASH INVESTMENTS Cash investments include all cash not considered cash or cash equivalents, as defined in Note 1 or restricted cash, as defined in Note 3. Cash investments at December 31, 1993 mature in January and February 1994 at effective interest rates ranging from 3.25 to 3.28 percent per annum. 5. NOTES PAYABLE Individual rental properties are pledged as collateral for the related notes payable. The notes bear interest at rates from 7.4 to 10.5 percent. The notes are generally payable monthly with balloon payments totalling $11,869,000 in 1994 and $68,633,000 between 1995 and 1997. Two of the notes with balloon payments totalling $14,926,000 which had been due in July 1995 and February 1996, respectively, were prepaid when the Partnership obtained replacement financing in January 1992. The new note of $12,500,000 is due in 1995 with the option to extend the due date an additional two years. In addition, a note which had been due in April 1995, with a balloon payment of $6,703,000 was prepaid when the Partnership obtained replacement financing in May 1992. The new note of $5,200,000 is due in April 1997 (see Note 6). Principal payments at December 31, 1993 are required as follows before giving effect to the refinancing discussed in Note 8: 1994 $12,539,000 1995 40,571,000 1996 23,661,000 1997 5,077,000 ----------- Total $81,848,000 =========== Amortization of deferred financing costs totalled $357,000, $348,000 and $202,000 for the years ended December 31, 1993, 1992 and 1991, respectively. In July 1993 the Partnership finalized an agreement with the lender for a three year extension of the December 1992 due date on the Cooper's Pointe Apartments note payable of $5,554,000. The loan is due December 1, 1995. The interest rate has been reduced from 11.5 percent to 9 percent through May 31, 1993 and to 8.25 percent through the maturity date. The Partnership paid financing costs of $79,000, of which $53,000 was paid in 1992 in connection with the extension. In addition, a cash management agreement, which was required by the lender in order to complete the modification, provides that the lender will receive any excess cash flow for the property with such payments applied toward the reduction of the outstanding loan balance. Finally, as part of the agreement, the Fund was required to transfer Cooper's Pointe Apartments from a wholly owned subsidiary which held title to the property, back to the Fund. The note payable on Four Winds Apartments with a balloon payment of $10,956,000 was due in September 1992. The Partnership had an option to extend the due date to September 1995 which it exercised when the loan matured. The interest rate on the loan has been reduced from 9.5 percent to 7.4 percent. 6. EXTRAORDINARY ITEM - GAIN ON EXTINGUISHMENT OF DEBT In January 1992 the Partnership obtained replacement financing on the Stoney Creek and Hampton Greens Apartments. The initial advance under the replacement financing totalled $12,500,000. Prior to January 7, 1994, an additional $500,000 could have been drawn upon by the Partnership, provided the properties achieve certain operating results as defined by the terms of the replacement financing agreement. The Partnership did not draw upon any of this amount. The existing notes of $8,135,000 and $7,085,000 with an interest rate of 10.5 percent at December 31, 1991, which had been due in 1995 and 1996, respectively, were prepaid at a discounted amount totalling $12,900,000. As of December 31, 1992, $446,000 had been paid in financing costs. The difference of $400,000 between the initial advance and the discounted prepayment amount and related costs incurred in the close of escrow of $344,000 were paid by the Partnership in 1992. The new financing agreement provides for interest only payments at 3.625 percent over a 90 day LIBOR interest rate with the maximum interest rate not to exceed 12 percent per annum. The note will mature in January 1995 with an option to extend the maturity date an additional two years. The agreement also required the Partnership to transfer the properties into a separate wholly owned subsidiary and to cross-collateralize the properties as security for the loan. The discount amount of $2,320,000, was forgiven by the lender upon prepayment of the original financing and was recognized by the Partnership as extraordinary item - gain on extinguishment of debt in 1992, net of prepayment penalties paid of $258,000 and the write-off of unamortized deferred costs on the original financing of $132,000. In May 1992 the Partnership obtained replacement financing of $5,200,000 on Promontory Point Apartments. The existing note of $6,978,000 with an interest rate of 10 percent at March 31, 1992, which had been due in 1995, was prepaid at a discounted amount totalling $5,450,000. In addition, the Partnership paid an extension fee of $55,000 to the existing lender in order to extend the period required to obtain replacement financing. As of December 31, 1992, $283,000 had been paid in financing costs. The difference of $250,000 between the refinancing proceeds and the discounted prepayment was paid by the Partnership in 1992. The new financing agreement provides for interest only payments at 3.75 percent over a 90 day LIBOR interest rate with a 3 year interest rate cap of 11 percent and a pay rate of 8.75 percent. The note will mature in April 1997. The agreement also required the Partnership to transfer the property into the wholly owned subsidiary created for Stoney Creek and Hampton Greens Apartments and to cross- collateralize Promontory Point Apartments with these properties as security for the loan. The discount amount of $1,528,000 was forgiven by the lender upon prepayment of the original financing. The discount amount, net of the extension fee paid of $55,000 was recognized by the Partnership as extraordinary item - gain on extinguishment of debt in 1992. 7. DISPOSITION OF RENTAL PROPERTY In July 1992, the Partnership allowed Fox Hollow Apartments, located in Atlanta, Georgia, to be acquired through foreclosure by the holder of the first loan. Accordingly, the Partnership was relieved of the first note payable of $7,920,000 (which had been due in 1993), $72,000 in accrued property taxes and $934,000 of accrued and unpaid interest. At date of foreclosure, the carrying value of the property was $8,516,000 with closing costs of $3,000. The gain on disposition was $407,000 which was recognized in 1992. 8. SUBSEQUENT EVENT The Partnership had a balloon payment on the Monterey Village Apartments note payable of $8,200,000 due in August 1994. To meet this obligation the Partnership approached the lender for debt modification and, in January 1994, the Partnership finalized a debt modification agreement with the lender. The terms of the agreement include a seven year extension with a reduction in the interest rate from 10.5 percent to 8.25 percent and a 30 year amortization period in exchange for a principal paydown of approximately $805,000. In connection with the modification, the Partnership paid extension fees and costs of approximately $78,000. 9. RECONCILIATION TO INCOME TAX METHOD OF ACCOUNTING The differences between the accrual method of accounting for income tax reporting and the accrual method of accounting used in the consolidated financial statements are as follows: ` =========== =========== =========== 1. COLUMN A - Description 2. COLUMN B - Encumbrances 3. COLUMN C - Initial cost to Partnership - Land 4. COLUMN C - Initial cost to Partnership - Buildings and Improvements 5. COLUMN D - Cost Capitalized Subsequent to Acquisition - Improvements 6. COLUMN D - Cost Capitalized Subsequent to Acquisition - Carrying Costs 7. COLUMN E - Gross Amount at Which Carried at Close of Period - Land 8. COLUMN E - Gross Amount at Which Carried at Close of Period - Buildings and Improvements 9. COLUMN E - Gross Amount at Which Carried at Close of Period - Total 10. COLUMN F - Accumulated Depreciation 11. COLUMN G - Year of Construction 12. COLUMN H - Date of Acquisition SCHEDULE XI CENTURY PROPERTIES GROWTH FUND XXII (A LIMITED PARTNERSHIP) REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 NOTES: The aggregate cost for Federal income tax purposes is $138,048,000. Depreciation is computed on lives ranging from six to 30 years. Balance, January 1, 1991 $147,881,000 Improvements capitalized subsequent to acquisition 883,000 ------------ Balance, December 31, 1991 148,764,000 Improvements capitalized subsequent to acquisition 860,000 Cost of rental property foreclosed on (11,689,000) ------------ Balance, December 31, 1992 137,935,000 Improvements capitalized subsequent to acquisition 1,305,000 ------------ Balance, December 31, 1993 $139,240,000 ============ Balance, January 1, 1991 $28,923,000 Additions charged to expense 5,348,000 ----------- Balance, December 31, 1991 34,271,000 Additions charged to expense 4,594,000 Accumulated depreciation on rental property foreclosed on (3,176,000) ----------- Balance, December 31, 1992 35,689,000 Additions charged to expense 4,171,000 ----------- Balance, December 31, 1993 $39,860,000 =========== ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Fund has no directors or executive officers. The following are the names and additional information relating to the directors and executive officers of NPI Equity Investments II. On December 6, 1993, NPI Equity II became managing partner of FRI and acquired voting control and assumed operational control over Fox, thereby obtaining management and control of the general partner. By virtue of their positions with NPI Equity II, the listed individuals control the business affairs of the Fund. FRI, Fox and their affiliates, including NPI, serve directly or indirectly as general partner of 30 public partnerships. MICHAEL L. ASHNER (age 41) has been President and a Director of NPI since 1984, President and a Director of NPI Equity II since 1993 and President and a Director of Fox since December 6, 1993. Since 1991, Mr. Ashner has also served as a Director and President of NPI Equity Investments, Inc. ("NPI Equity I"), an affiliate of NPI Equity II, which serves as the general partner of the seven publicly-held NPI real estate limited partnerships. In addition, since 1981 Mr. Ashner has been President and sole shareholder of Exeter Capital Corporation, a firm which has organized and administered real estate limited partnerships. He received his A.B. degree cum laude from Cornell University and received a J.D. degree magna cum laude from the University of Miami School of Law, where he was an editor of the law review. Mr. Ashner is a member of the New Jersey, New York and Florida bar associations and is a member of the Executive Council of the Board of Directors of the Multi Housing Council. MARTIN LIFTON (age 61) has been the Chairman and a Director of NPI since 1991 and NPI Equity II since 1993 and the Chairman and a Director of Fox since December 6, 1993. In addition, since 1991, Mr. Lifton has served as the Chairman and a Director of NPI Equity I. Mr. Lifton is also Chairman and President of Lifton Company, a real estate investment firm. Since entering the real estate business 35 years ago, Mr. Lifton has engaged in a wide range of real estate activities, including the purchase and construction of apartment complexes in the New York metropolitan area and in the southeastern and midwestern United States. Mr. Lifton was also one of the founders of the Bank of Great Neck of which he is Chairman and a major stockholder. Mr. Lifton received his B.S. degree from the New York University School of Commerce where he majored in real estate. ARTHUR N. QUELER (age 47) was a co-founder of NPI, of which he has been Executive Vice President and a Director since 1984. Mr. Queler has also been Executive Vice President and a Director of NPI Equity II since 1993 and of Fox since December 6, 1993. Since 1991, Mr. Queler has been Executive Vice President and a Director of NPI Equity I. In addition, since 1983 Mr. Queler has been President of ANQ Securities, Inc., a NASD registered broker-dealer firm which has been responsible for supervision of licensed brokers and coordination with a nationwide broker-dealer network for the marketing of NPI investment programs. Prior to 1983, Mr. Queler was a managing general partner of Berg Harquel Associates, a real estate syndication firm, in which capacity he was involved in the acquisition, syndication and management of 23 properties. Mr. Queler is a certified public accountant. He received B.B.A. and M.B.A. degrees from the City College of New York. Messrs. Ashner, Lifton and Queler currently are the beneficial owners of all of the outstanding stock of NPI. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Fund does not pay or employ any directors or officers. Compensation to the directors and officers of Fox, the managing general partner of the general partner, and to the partners of FRI, a general partner of the general partner, is paid directly by Fox and FRI, as the case may be. The Fund has not established any plans pursuant to which plan or non-plan compensation has been paid or distributed during the last fiscal year or is proposed to be paid or distributed in the future, nor has the Fund issued or established any options or rights relating to the acquisition of its securities or any plans relating to such options or rights. However, the general partner of the Fund has received and is expected to receive certain allocations, distributions and other amounts pursuant to the Fund's limited partnership agreement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. There is no person known to the Fund who owns beneficially or of record more than five percent of the voting securities of the Fund. However, the general partner has discretionary control over most of the decisions made by or for the Fund pursuant to the terms of the Fund's limited partnership agreement. The Fund has no directors or officers. The directors and executive officers of the corporate managing partner of the Fund's general partner and the partners of FRI, as a group, own less than one percent of the Fund's voting securities. There are no arrangements known to the Fund, the operation of which may, at a subsequent date, result in a change in control of the Fund. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1., 2. and 3. See Item 8 of this Form 10-K for the Consolidated Financial Statements of the Fund, Notes thereto, and Financial Statement Schedules. (A table of contents to Consolidated Financial Statements and Financial Statement Schedules is included in Item 8 and incorporated herein by reference.) (b) The following report on Form 8-K was required to be filed during the last quarter covered by this Report: DATE OF ITEM MONTH SUCH NUMBERS FILED REPORT REPORTED DESCRIPTION December 12/6/93 1 Changes in Control of Registrant (c) Financial Statement Schedules, if required by Regulation S-K, are included in Item 8. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. CENTURY PROPERTIES FUND XXII By: FOX PARTNERS IV Its General Partner By: FOX CAPITAL MANAGEMENT CORPORATION A General Partner ("FOX") By: /s/ Michael L. Ashner ------------------------ Michael L. Ashner President Date: March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. By: /s/ Michael L. Ashner By: /s/ Arthur N. Queler ---------------------- ---------------------- Michael L. Ashner Arthur N. Queler President and Director of Executive Vice President (Principal FOX Financial and Accounting Officer) and Director of FOX By: /s/ Martin Lifton -------------------- Martin Lifton Chairman and Director of FOX Date: March 18, 1994

276189_1993.txt

276189_1993

1993

276189

Item 3. LEGAL PROCEEDINGS ----------------- The information required by Item 3 is incorporated herein by reference to Note 9 - Stockholders' Equity and Note 13 - Contingencies of "Notes to Consolidated Financial Statements" included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- No matters were submitted to a vote of stockholders during the fourth quarter of 1993. Executive Officers of the Registrant - ------------------------------------ The following is a listing of the executive officers of Fairfield, none of whom has a family relationship with directors or other executive officers: John W. McConnell, age 52, President and Chief Executive Officer since 1991; President and Chief Operating Officer from 1990 to 1991; Senior Vice-President and Chief Financial Officer from 1986 to 1990. Morris E. Meacham, age 55, Executive Vice President since 1990; Senior Vice President and Chief Operating Officer of Leisure Products Group from 1986 to 1990. Effective January 1, 1994, Mr. Meacham entered into a new Employment Agreement as Vice President of Special Projects. Marcel J. Dumeny, age 43, Senior Vice President and General Counsel since 1989; Senior Vice President/Law and Development from 1987 to 1989. Clay G. Gring, Sr., age 62, Senior Vice President/Leisure Products Group since September 1991. Self-employed from 1984 to September 1991 specializing in the development and management of real estate properties, including resort communities and hospitality related properties. Robert W. Howeth, age 46, Senior Vice President and Treasurer since October 1992; Senior Vice President/Planning and Administration from 1990 to October 1992; Vice President and Treasurer from 1988 to 1990. Joe T. Gunter, age 52, Senior Vice President, General Counsel/Leisure Products Group since 1989; Senior Vice President and Special Counsel from 1984 to 1989. Robert T. Waugh, age 63, President of First Federal Savings and Loan Association of Charlotte, a wholly owned subsidiary of Fairfield, since 1972. William G. Sell, age 40, Vice President/Controller and Chief Accounting Officer since 1988. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED ------------------------------------------------ STOCKHOLDER MATTERS ------------------- Pursuant to the Plans, all of the outstanding Common Stock of Predecessor Fairfield was cancelled effective September 1, 1992. As of March 18, 1994, the outstanding number of shares of Fairfield's Common Stock totaled 9,792,601, of which 160,001 shares were held by wholly owned subsidiaries. In accordance with the Plans, Fairfield will issue additional shares as the remaining unsecured claims are resolved. The ultimate amount of allowed unsecured claims and the timing of the resolution of claims is largely within the control of the Bankruptcy Court. However, based upon available information, Fairfield presently estimates that approximately 10,908,706 shares of Common Stock will be issued and outstanding, including shares held by wholly owned subsidiaries. Additionally, 588,235 shares have been reserved, but not issued, for the benefit of the holders of the FCI Notes. On November 4, 1993, Fairfield's Common Stock commenced "regular way" trading on the NASDAQ National Market System under the trading symbol FFCI. For the period November 4, 1993 through December 31, 1993, the high and low closing bid prices were $4-5/8 and $2-3/4, respectively. As of February 28, 1994, there were approximately 4,100 stockholders of the Common Stock. During the last two fiscal years Fairfield did not pay any dividends and is prohibited from paying any dividends under the terms of its financing arrangements, except for dividends payable in shares of its Common Stock. Item 6. Item 6. SELECTED FINANCIAL DATA ----------------------- Information required by Item 6 is incorporated herein by reference to the table titled Selected Financial Data included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ----------------------------------------------------------- AND RESULTS OF OPERATIONS ------------------------- Information required by Item 7 is incorporated herein by reference to Management's Discussion and Analysis of Financial Condition and Results of Operations included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- Financial statements and supplementary data required by Item 8 are set forth below in Item 14(a), Index to Financial Statements. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND -------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- None PART III -------- Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------------------- (a) Identification of Directors --------------------------- This item is incorporated herein by reference to Registrant's Proxy Statement for its annual meeting of stockholders to be held June 1, 1994. (b) Identification of Executive Officers ------------------------------------ In accordance with Regulation S-K Item 401(b), Instruction 3, the information required by Item 10(b) concerning the Company's executive officers is furnished in a separate item captioned Executive Officers of the Registrant in Part I above. (c) Compliance with Section 16(a) of the Exchange Act ------------------------------------------------- This item is incorporated by reference to Registrant's Proxy Statement for its annual meeting of stockholders to be held June 1, 1994. Item 11. Item 11. EXECUTIVE COMPENSATION ---------------------- This item is incorporated by reference to Registrant's Proxy Statement for its annual meeting of stockholders to be held June 1, 1994. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND --------------------------------------------------- MANAGEMENT ---------- This item is incorporated by reference to Registrant's Proxy Statement for its annual meeting of stockholders to be held June 1, 1994. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- This item is incorporated by reference to Registrant's Proxy Statement for its annual meeting of stockholders to be held June 1, 1994. PART IV ------- Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K --------------------------------------------------------------- (a)(1) Index to Financial Statements: ------------------------------ The following consolidated financial statements and Report of Ernst & Young, Independent Auditors, included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 are incorporated herein by reference: Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Operations - Year Ended December 31, 1993, Six Months Ended December 31, 1992, Six Months Ended June 30, 1992 and Year Ended December 31, Consolidated Statements of Stockholders' Equity (Deficit) - Year Ended December 31, 1993, Six Months Ended December 31, 1992, Six Months Ended June 30, 1992 and Year Ended December 31, 1991 Consolidated Statements of Cash Flows - Year Ended December 31, 1993, Six Months Ended December 31, 1992, Six Months Ended June 30, 1992 and Year Ended December 31, Notes to Consolidated Financial Statements - December 31, 1993 (2) The following financial statements schedules should be read in conjunction with the consolidated financial statements included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993: Financial Statement Schedules ----------------------------- Schedule III - Condensed Financial Information of Registrant Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information Financial statement schedules not included herein have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. (3) Exhibits required by this item are listed on the Exhibit Index attached to this report and hereby incorporated by reference. (b) Reports on Form 8-K Filed in the Fourth Quarter ---------------------------------------------- On December 21, 1993, a Current Report on Form 8-K was filed in which Fairfield announced it had entered into a letter of intent for the sale of First Federal Savings and Loan Association of Charlotte, North Carolina. On November 3, 1993, a Current Report on Form 8-K was filed disclosing the Stock Purchase Agreement for the sale of Fairfield Green Valley, Inc. and Fairfield Sunrise Village, Inc. On October 1, 1993, a Current Report on Form 8-K was filed disclosing the completion of three new financing transactions. (c) Exhibits -------- The Exhibit Index attached to this Report is hereby incorporated by reference. (d) Financial Statements Schedules ------------------------------ Following are the schedules as referenced in the Index to Financial Statements included in Item 14(a) above. SCHEDULE III Registrant's condensed financial statements for periods prior to reorganization are not presented as the Registrant had a different capital structure and, as a result, financial information for these periods is not meaningful. Condensed financial information of Registrant is as follows (In thousands): SCHEDULE III (Continued) Condensed Statements of Cash Flows SCHEDULE VIII Fairfield Communities, Inc. and Subsidiaries Valuation and Qualifying Accounts (In thousands) (a) Uncollectible loans receivable written-off, net of recoveries. SCHEDULE X Fairfield Communities, Inc. and Subsidiaries Supplementary Income Statement Information (In thousands) NOTE: Amounts for depreciation and amortization of intangible assets and royalties are not presented as such amounts were less than 1% of total sales and revenues. SIGNATURE PAGE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned duly authorized. FAIRFIELD COMMUNITIES, INC. Date: March 22, 1994 By /s/ J.W. McConnell ----------------------------------- J.W. McConnell, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities on the dates indicated: Date: March 22, 1994 By /s/ Russell A. Belinsky ----------------------------------- Russell A. Belinsky, Director Date: March 22, 1994 By /s/ Ernest D. Bennett, III ------------------------------------ Ernest D. Bennett, III, Director Date: March 22, 1994 By /s/ Daryl J. Butcher ------------------------------------ Daryl J. Butcher, Director Date: March 22, 1994 By /s/ Philip L. Herrington ------------------------------------ Philip L. Herrington, Director Date: March 22, 1994 By /s/ William C. Scott ---------------------------------- William C. Scott, Director Date: March 22, 1994 By /s/ J. Steven Wilson ---------------------------------- J. Steven Wilson, Director Date: March 22, 1994 By /s/ J. W. McConnell --------------------------------- J. W. McConnell, Director, President and Chief Executive Officer Date: March 22, 1994 By /s/ Robert W. Howeth ---------------------------------- Robert W. Howeth, Senior Vice President, Chief Financial Officer and Treasurer Date: March 22, 1994 By /s/ William G. Sell -------------------------------- William G. Sell, Vice President /Controller and (Chief Accounting Officer) FAIRFIELD COMMUNITIES, INC. EXHIBIT INDEX Exhibit Number 3(a) Second Amended and Restated Certificate of Incorporation of the Registrant, effective September 1, 1992 (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 3(b) Amended and Restated By-laws of the Registrant, effective September 1, 1992 (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 4.1 Supplemented and Restated Indenture between the Registrant, Fairfield River Ridge, Inc., Fairfield St. Croix, Inc. and IBJ Schroder Bank & Trust Company, as Trustee, and Houlihan Lokey Howard & Zukin, as Ombudsman, dated September 1, 1992, related to the Modified Exchange Notes (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 4.2 First Supplemental Indenture to the Supplemented and Restated Indenture referenced in 4.1 above, dated September 1, 1992 (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 4.3 Second Supplemental Indenture to the Supplemented and Restated Indenture referenced in 4.1 above, dated September 1, 1992 (previously filed with the Registrant's Annual Report on Form 10-K dated December 31, 1992 and incorporated herein by reference) 4.4 Third Supplemental Indenture to the Supplemented and Restated Indenture referenced in 4.1 above, dated March 18, 1993 (previously filed with the Registrant's Quarterly Report on Form 10-Q dated March 31, 1993 and incorporated herein by reference) 4.5 Certificate of Designation, Preferences, and Rights of Series A Junior Participating Preferred Stock, dated September 1, 1992 (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 10.1 Amended and Restated Revolving Credit and Term Loan Agreement, dated as of September 28, 1993, by and between the Registrant, Fairfield Myrtle Beach, Inc., Suntree Development Company, FAC and The First National Bank of Boston ("FNBB") (previously filed with the Registrant's Current Report on Form 8-K dated October 1, 1993 and incorporated herein by reference) 10.2 Second Amended and Restated Credit Agreement, between Fairfield Sunrise Village, Inc., Fairfield Green Valley, Inc. and BA Mortgage and International Realty Corporation, dated as of November 6, 1992 (previously filed with the Registrant's Annual Report on Form 10-K dated December 31, 1992 and incorporated herein by reference) 10.3 Limited Partnership Agreement, dated March 3, 1981, between Harbour Ridge, Inc., Fairfield River Ridge, Inc. and Harbour Ridge Investments, Inc. forming the limited partnership of Harbour Ridge, Ltd. (previously filed with the Registrant's Registration Statement on Form S-7 No. 2-75301 effective February 11, 1982 and incorporated herein by reference) Exhibit Number 10.4 Sugar Island Associates, Ltd. Amended Limited Partnership Agreement, dated October 17, 1984 (previously filed with the Registrant's current Report on Form 8-K dated October 25, 1984 and incorporated herein by reference) 10.5 Rights Agreement, dated as of September 1, 1992, between Registrant and Society National Bank, as Rights Agent (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 10.6 Fourth Amended and Restated Title Clearing Agreement (Lawyer's) between the Registrant, Fairfield Acceptance Corporation ("FAC"), Lawyer's Title Insurance Corporation, FNBB individually and in various capacities as agent and trustee, First Bank National Association, First Commercial Trust Company, N.A., First American Trust Company, N.A. and First Federal, dated September 1, 1992 (previously filed with the Registrant's Annual Report on Form 10-K dated December 31, 1992 and incorporated herein by reference) 10.7 Servicing Agreement between the Registrant, First Federal Savings and Loan Association of Charlotte ("First Federal") and First Commercial Bank, N.A., dated September 14, 1992 (previously filed with Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 10.8 Second Amended and Restated Title Clearing Agreement (Colorado) between the Registrant, FAC, Colorado Land Title Company, FNBB, First Bank National Association, First Commercial Trust Company, N.A. and First Federal, dated September 1, 1992 (previously filed with the Registrant's Annual Report on Form 10-K dated December 31, 1992 and incorporated herein by reference) 10.9 Westwinds Third Amended and Restated Title Clearing Agreement (Lawyers) between the Registrant, FAC, Fairfield Myrtle Beach, Inc., Lawyers Title Insurance Corporation, FNBB, and Resort Funding, Inc. dated November 15, 1992 (previously filed with the Registrant's Annual Report on Form 10-K dated December 31, 1992 and incorporated herein by reference) 10.10 Third Amended and Restated Revolving Credit Agreement between FAC and FNBB, dated as of September 28, 1993 (previously filed with Registrant's Current Report on Form 8-K dated October 1, 1993 and incorporated herein by reference) 10.11 Pledge and Servicing Agreement between Fairfield Funding Corporation ("FFC"), FAC, First Commercial Trust Company, N.A. and Texas Commerce Trust Company, N.A., dated September 28, 1993 (previously filed with Registrant's Current Report on Form 8-K filed October 1, 1993 and incorporated herein by reference) 10.12 Voting and Disposition Rights/Dividend Agreement between the Registrant and the Federal Savings and Loan Insurance Corporation, dated May 30, 1989, (previously filed with the Registrant's Current Report on Form 8-K on June 15, 1989 and incorporated herein by reference) Exhibit Number 10.13 First Amendment to Voting and Disposition Rights/Dividend Agreement referenced in 10.12 above (previously filed with Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 and incorporated herein by reference) 10.14 Supervisory Agreement, dated as of August 26, 1992, between First Federal and the Office of Thrift Supervision (previously filed with Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 and incorporated herein by reference) 10.15 Remarketing Agreement between the Registrant and First Federal, dated as of September 14, 1992 (previously filed with Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 10.16 Contract of Sale of Timeshare Receivables with Recourse, dated as of November 15, 1992, between Resort Funding, Inc. and Fairfield Myrtle Beach, Inc. (previously filed with Registrant's Annual Report on Form 10-K dated December 31, 1992 and incorporated herein by reference) 10.17 Receivable Purchase Agreement, dated as of September 28, 1993, between the Registrant, FAC, and FFC (previously filed with the Registrant's Current Report on Form 8-K filed October 1, 1993 and incorporated herein by reference) 10.18 Second Amended and Restated Operating Agreement, dated as of September 28, 1993, between the Registrant and FAC (previously filed with the Registrant's Quarterly Report on Form 10-Q dated September 30, 1993 and incorporated herein by reference) 10.19 Stock Purchase Agreement by and between the Registrant and F.F. Homes of Arizona, Inc. (previously filed with the Registrant's Current Report on Form 8-K filed November 3, 1993 and incorporated herein by reference) 10.20 Appointment and Acceptance Agreement, dated as of March 3, 1994, between the Registrant and FNBB appointing FNBB as successor Rights Agent (attached) 10.21 Letter of Intent for the sale of First Federal, dated as of December 15, 1993, between the Registrant and Security Capital Bancorp (previously filed with the Registrant's Current Report on Form 8-K filed December 21, 1993 and incorporated herein by reference) COMPENSATORY PLANS OR ARRANGEMENTS 10.22 Form of Warrant Agreement between the Registrant and directors of the Registrant (previously filed with the Registrant's Quarterly Report on Form 10-Q dated September 30, 1993 and incorporated herein by reference) 10.23 Registrant's Employee Profit Sharing Plan and amendment thereto, adopted February 10, 1977 (previously filed with the Registrant's Registration Statement on Form S-1 No. 2-62091 effective September 6, 1978 and incorporated herein by reference) Exhibit Number 10.24 Employment Agreement, dated as of September 20, 1991, by and between the Registrant and Mr. John W. McConnell (previously filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.25 Employment Agreement, dated as of September 20, 1991, by and between the Registrant and Mr. Morris E. Meacham (previously filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.26 Employment Contract, effective January 1, 1994, by and between the Registrant and Mr. Morris E. Meacham (attached) 10.27 Employment Agreement, dated as of September 20, 1991, by and between the Registrant and Mr. Marcel J. Dumeny (previously filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.28 Form of Amendment No. One to Employment Agreements between Registrant and certain officers (previously filed with Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 10.29 Form of Warrant Agreement between Registrant and certain officers and executives of the Registrant (previously filed with Registrant's Quarterly Report on Form 10-Q dated September 30, 1993 and incorporated herein by reference) 10.30 Registrant's First Amended and Restated 1992 Warrant Plan (previously filed with Registrant's Quarterly Report on Form 10-Q dated September 30, 1993 and incorporated herein by reference) 10.31 Form of Indemnification Agreement between the Registrant and certain officers and directors of the Registrant (previously filed with the Registrant's Current Report on Form 8-K dated September 1, 1992 and incorporated herein by reference) 10.32 Form of Severance Agreement between the Registrant and certain officers of the Registrant (attached) 10.33 Registrant's Excess Benefit Plan, adopted February 1, 1994 (attached) 11 Computation of earnings per share (attached) 13 Selected Financial Data; Management's Discussion and --------------------------------------------------- Analysis of Financial Condition and Results of Operations; --------------------------------------------------------- Report of Ernst & Young, Independent Auditors; Consolidated Balance Sheets; Consolidated Statements of Operations; Consolidated Statements of Cash Flows and Notes to Consolidated Financial Statements included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 (attached) 21 Subsidiaries of the Registrant (attached) 23 Consent of Independent Auditors (attached) 28 Ombudsman Report for the period ending December 31, 1993 related to the Registrant's Senior Subordinated Secured Notes (attached)

7214_1993.txt

7214_1993

1993

7214

ITEM 1. BUSINESS Aristar, Inc. (the "Company"), incorporated in Delaware in 1986 as a successor to a company incorporated in 1927, is a holding company headquartered in Tampa, Florida whose subsidiaries are engaged in the consumer finance business. All of the Company's equity securities are owned indirectly by Great Western Financial Corporation ("GWFC"). As a result of a corporate realignment consummated on June 30, 1993, the Company is no longer a subsidiary, directly or indirectly, of Great Western Bank, a Federal Savings Bank ("GWB"). This realignment was consummated as a dividend from GWB to GWFC of the stock of an intermediate holding company, which holds all of the stock of the Company. The operations of the Company consist principally of a network of 476 consumer finance offices located in 22 states, which generally operate under the names Blazer Financial Services and City Finance Company. The Company makes direct consumer instalment loans and purchases retail instalment contracts from local retail establishments. These consumer credit transactions are primarily for personal, family or household purposes. Instalment loans written in 1993 had original terms ranging from 12 to 180 months and averaged 49 months. For the year ended December 31, 1993, 84% of the volume of all instalment loans was either unsecured or secured by guarantor, luxury consumer goods, automobiles or other personal property, with the remaining 16% being secured by real estate. While the interest yield on real estate loans is generally lower than for other direct loans, such loans are typically larger and the ratio of cost to amounts loaned is lower. Additionally, credit loss experience on real estate loans has been significantly lower than on other loan types. Retail instalment sales contracts are generally acquired without recourse to the originating merchant and provide a vehicle for developing future loan business. Where these contracts result from the sale of consumer goods, payment is generally secured by such goods, and, in some cases, a portion of the purchase price is withheld from the merchant pending satisfactory payment of the obligation. Contracts are typically written with original terms from 3 to 60 months and for 1993 had an average original term of 23 months. At December 31, 1993, the average portfolio yield by loan type was as follows: PORTFOLIO COMPOSITION The following table provides an analysis by type of the Company's notes and contracts receivable (net of unearned finance charges and deferred loan fees) at the dates shown: Notes and contracts written including balances renewed but, excluding bulk purchases, for the years ended December 31, 1993, 1992 and 1991 totaled $1.60 billion, $1.42 billion and $1.19 billion, respectively. CREDIT LOSS EXPERIENCE The Company closely monitors portfolio delinquency in measuring the quality of the portfolio and the potential for ultimate credit losses. The Company changed its charge-off policy effective June 30, 1991. Under the new policy, non-real estate secured delinquent accounts are charged off based on the number of days contractually delinquent (120 days for closed-end loans and 180 days for open-end loans). At June 30, 1991, approximately $28 million of loans, which had been fully reserved in 1990, were charged off under the new policy. The adoption of this policy did not have a material impact on 1991 net income. Prior to June 30, 1991, accounts were charged off at the end of each month if at least one-half of one contractual instalment had not been received in the aggregate during the previous six months (recency-of-payment method). Collection efforts continue after an account has been charged off until the customer obligation is satisfied or until it is determined that the obligation is not collectible or that the cost of continuing collection efforts will not be offset by the potential recovery. The following table sets forth the credit loss experience for the past three years and the allowance for doubtful accounts at the end of each year: (1) Average of notes and contracts receivable (net of unearned finance charges) at each month end during the period. Accounts past due 60 days and over, based on contract payments were as follows, as of the end of each of the past three years: INTEREST RATE SPREADS AND COST OF BORROWED FUNDS A relatively high ratio of borrowings to invested capital is customary in consumer finance activities due to the liquidity of the assets employed by the business. The spread between the revenues received from loans and interest expense is a significant factor in determining the net income of the Company. The table below sets forth certain percentages relative to the spread between interest the Company received on the loan portfolio and interest expense for each of the last three years: CREDIT INSURANCE OPERATIONS The Company makes available, at the option of its customers, credit life, credit accident and health, and credit casualty insurance products. Credit life insurance provides that the customer's credit obligation, to the extent of the policy limits, is paid in the event of death. Credit accident and health insurance provides for the payment of instalments due on the customer's credit obligation in the event of disability resulting from illness or injury. Credit casualty insurance insures payment, to the extent of the policy limits, of the credit obligation or cost to repair certain property used as collateral for such obligation in the event such property is destroyed or damaged. Purchase of such insurance is not a condition to obtaining a loan, although the Company may require casualty insurance covering collateral to be obtained from unaffiliated sources by the customer. The Company does not sell insurance to non-customers. Credit insurance sold by the Company is written by unaffiliated insurance companies and is substantially all reinsured by the Company, which earns reinsurance premiums thereon. RATIO OF EARNINGS TO FIXED CHARGES The Company's ratio of earnings to fixed charges, which represents the number of times fixed charges were covered by earnings, was 1.89 in 1993, 1.83 in 1992, 1.77 in 1991, 1.40 in 1990 and 1.58 in 1989. For purposes of computing this ratio, earnings consist of income from operations before income taxes and, in 1992, before the cumulative effect of a change in accounting method, plus fixed charges. Fixed charges consist of interest and debt expense and an appropriate portion of rentals. The combination of increased pretax income and lower interest expense in 1993, 1992 and 1991 resulted in the improved ratios for those years, reflected above. The substantial decrease in the fixed charge ratio in 1990 was due primarily to the decrease of $15.8 million in 1990 pretax income as compared to 1989. GOVERNMENTAL REGULATION The Company's operations are, for the most part, regulated by federal and state consumer finance laws or similar legislation. All of the states in which finance subsidiaries of the Company are licensed to do business have laws, which vary from state to state, regulating the consumer finance business. These laws, among other things, typically limit the size of loans, set maximum interest rates and maximum maturities and regulate certain lending and collection activities. Although consumer finance laws have been in effect for many years, amending and new legislation is frequently proposed. The Company is unable to predict whether or when any such proposals might ultimately be enacted into law or to assess the impact any such enactment might have on the Company. COMPETITION The consumer finance business is highly competitive. The Company's principal competitors are other local, regional and national finance companies, banks, credit unions, savings associations, and other similar financial institutions. Based upon information published in the American Banker in December 1993, the Company was ranked as the 25th largest among all finance companies in the United States, as measured by size of capital funds (consisting of stockholder's equity and subordinated debt). EMPLOYEES The Company employs approximately 2,300 full-time employees. None of these employees are represented by a union. Management considers relations with its employees to be satisfactory. ITEM 2. ITEM 2. PROPERTIES The Company began relocating its headquarters from Memphis, Tennessee to Tampa, Florida in the third quarter of 1993 and completed this move in the first quarter of 1994. In connection with this relocation, the Company has constructed a 71,000 square foot headquarters building on 6 acres of land at a total cost of approximately $7 million. In Memphis, Tennessee, the Company had leased approximately 62,000 square feet of office space as its headquarters; this lease, which would have expired on October 31, 1994, was terminated in the first quarter of 1994. The Company's consumer finance offices, located in 22 states, are leased typically for terms of three to five years with options to renew. Typical locations include shopping centers, office buildings and storefronts, generally of relatively small size sufficient to accommodate a staff of four to eight employees. See Note 11 to the Consolidated Financial Statements for additional information on rental expense and lease commitments. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are routinely involved in litigation incidental to their businesses. It is management's opinion that the aggregate liability arising from the disposition of all such pending litigation will not have a material adverse effect on the Company. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company is an indirect wholly-owned subsidiary of GWFC and the Company's common stock is not traded on any national exchange or in any other established market. Payment of dividends is within the discretion of the Company's Board of Directors, and it is expected that dividends will be paid quarterly in 1994, totaling $25 million. Provisions of certain of the Company's debt agreements restrict the payment of dividends to a maximum prescribed proportion of cumulative earnings and contributed capital and otherwise provide for the maintenance of minimum levels of equity and maximum leverage ratios. The Company declared and paid dividends of $12 million each in December 1992, December 1991 and January 1991. In 1993, the Company declared and paid dividends on a quarterly basis, totalling $20.5 million during the year. ITEM 7. ITEM 7. MANAGEMENT'S ANALYSIS OF THE RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1993 During the first nine months of 1993, average finance receivables outstanding were lower than in the comparable 1992 period; however, this trend reversed in the fourth quarter 1993, during which period finance receivables increased approximately $91 million. However, in response to general money market trends, the Company's gross yield on average net receivables decreased to 14.8% in 1993 from 15.0% in 1992. During the same period, the Company reduced its average outstanding debt and paid off maturing long-term debt by issuing commercial paper at substantially lower interest rates. The resulting decrease in interest expense offset the decrease in interest income, so that 1993's net interest income, before provision for credit losses, is comparable to that of 1992. During the fourth quarter of 1991, the Company purchased approximately $132 million in net finance receivables as a liquidating portfolio. The balance of these receivables at December 31, 1993 and December 31, 1992 was approximately $63 million and $84 million, respectively. These receivables generated loan interest and fee income of $11.7 million in the year ended December 31, 1993 as compared to $17.2 million during the same period in 1992. On July 15, 1993, the Company issued $150 million of 5.75% senior notes maturing in 1998. The proceeds were used primarily to reduce short-term debt. The provision for credit losses for the year ended December 31, 1993 was 2.50% as a percentage of average net finance receivables for that period, as compared to 2.79% for the comparable 1992 period. The decrease in provision rate reflects management's assessment of the quality of the Company's receivable portfolio at this time. The Company began relocating its headquarters from Memphis, Tennessee to Tampa, Florida in the third quarter of 1993 and completed this move in the first quarter of 1994. In connection with this relocation, the Company has constructed a 71,000 square foot headquarters building on 6 acres of land at a total cost of approximately $7 million. Personnel costs for the year ended December 31, 1993 increased $1.5 million, or 2.5% over the comparable 1992 period primarily as a result of relocation costs incurred due to this move. Occupancy, advertising and other operating expenses decreased $900,000, or 1.7% for the year ended December 31, 1993, primarily because the comparable 1992 period includes various one-time costs to convert forty-four branches acquired on December 31, 1991 to the Company's systems. Productivity in 1993 improved as compared to 1992, with operating and administrative expenses as a percent of average outstanding finance receivables of 8.3% in 1993 and 8.4% in 1992. The Company's effective tax rate was 35.8% for the year ended December 31, 1993, as compared to 44.8% for the same 1992 period. The decrease is primarily attributable to the effect of an amendment in the fourth quarter of 1993, retroactive to the beginning of that year, to GWFC's income tax allocation policy, which provides that the Company's state income taxes will be determined as if the Company had filed such returns on a separate entity basis. Additionally, 1993's Federal income tax provision decreased due to the expected increased deductibility of current and prior year's amortization of intangible assets resulting from the Omnibus Budget Reconciliation Act of 1993. As of January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions", ("FAS 106"), which requires that the expected cost of such postretirement benefits be charged to expense during the period over which eligible employees render active service. See Note 10 to the accompanying Consolidated Financial Statements for additional information. As of December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("FAS 115"), which requires that debt and equity securities classified as available for sale be reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as a separate component of stockholder's equity. The net effect of this change increased equity by $445,000. See Note 4 to the accompanying Consolidated Financial Statements for additional information. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholder of Aristar, Inc. In our opinion, the accompanying consolidated statements of financial condition and the related consolidated statements of operations and retained earnings and of cash flows present fairly, in all material respects, the financial position of Aristar, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 1 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions. PRICE WATERHOUSE Memphis, Tennessee January 18, 1994 ARISTAR, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION See Notes to Consolidated Financial Statements. ARISTAR, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND RETAINED EARNINGS See Notes to Consolidated Financial Statements. ARISTAR, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See Notes to Consolidated Financial Statements. ARISTAR, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Ownership. As a result of a corporate realignment consummated on June 30, 1993, the Company is no longer a subsidiary, directly or indirectly, of Great Western Bank, a Federal Savings Bank ("GWB"). After giving effect to the realignment which was consummated as a dividend from GWB to Great Western Financial Corporation ("GWFC") of the stock of an intermediate holding company (which holds all of the stock of the Company), the Company continues to be a wholly owned indirect subsidiary of GWFC. The realignment is not expected to have a significant effect on the operations of the Company. Principles of Consolidation. The consolidated financial statements include the accounts of Aristar, Inc. and its wholly-owned subsidiaries (the "Company") after elimination of all material intercompany balances and transactions. Certain amounts in prior years have been reclassified to conform to the current year's presentation. Income Recognition from Finance Operations. Unearned finance charges on all types of consumer notes and contracts receivable are recognized on an accrual basis, using the interest method. Accrual generally is suspended when payments are more than three months contractually overdue. Loan fees and directly related lending costs are deferred and amortized using the interest method over the contractual life of the related loans. Provision and Allowance for Credit Losses. The Company provides, through charges to income, an allowance for losses which, based upon management's evaluation of numerous factors, including current economic trends, loan portfolio agings, historical loss experience and evaluation of collateral, is deemed adequate to cover reasonably expected losses on outstanding loans. Losses on loans are charged to the allowance for credit losses based upon the number of days delinquent or when collectibility becomes questionable and the underlying collateral, if any, is considered insufficient to liquidate the loan balance (see Note 2). Recoveries on previously written-off loans are credited to the allowance. Investment Securities. As of December 31, 1993, investments classified as available for sale are accounted for according to Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("FAS 115"). This statement requires that debt and equity securities classified as available for sale be reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as a separate component of stockholder's equity. The adoption of FAS 115 resulted in the Company recording a net unrealized holding gain of $445,000 as a separate component of stockholder's equity and a deferred tax liability of $324,000. Beginning December 31, 1992 until the adoption of FAS 115, investment securities that may be sold in response to or in anticipation of changes in interest rates and prepayment risk, liquidity considerations, and other factors were carried at the lower of aggregate amortized cost or market value. As of December 31, 1992, all investment securities were deemed to be available for sale. Prior to December 31, 1992, generally all securities were recorded at cost and adjusted for amortization of premium and accretion of discount. Gains and losses on investment securities were recorded when realized on a specific identity basis. Property, Equipment and Leasehold Improvements. Property, equipment and leasehold improvements are stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are provided principally on the straight-line method over the estimated useful life or, if less, the term of the lease. Deferred Charges. Expenditures that are deferred are amortized over the period benefited. Amortization is computed principally using the straight-line method. Excess of Cost Over Equity of Companies Acquired. The excess of cost over the fair value of net assets of companies acquired is amortized on a straight-line basis, generally over periods of up to 25 years. Insurance Premiums and Acquisition Costs. Insurance premiums are deferred and subsequently amortized into revenue over the terms of the related insurance contracts. The methods of amortization used are pro rata, sum-of-the-digits and a combination thereof. Policy acquisition costs (principally ceding commissions and premium taxes) are deferred and charged to expense over the terms of the related policies in proportion to premium recognition. Insurance Claims and Benefits Reserves. Reserves for reported claims on credit life and health insurance are established based upon standard actuarial assumptions used in the insurance business for such purposes. Claims reserves for reported property and casualty insurance claims are based upon estimates of costs and expenses to settle each claim. Additional amounts of reserves, based upon prior experience and insurance in force, are provided for each class of insurance for claims which have been incurred but not reported as of the balance sheet date. Income Taxes. The Company is included in the consolidated Federal income tax return filed by GWFC. Currently payable Federal income taxes will be paid to GWFC. Federal income taxes are allocated between GWFC and its subsidiaries in proportion to the respective contribution to consolidated income or loss. Beginning in 1993, allocations for state income taxes approximate the amount the Company would have paid on a separate entity basis. Prior to 1993, state income taxes were allocated using a combined GWFC effective tax rate. Deferred income taxes are provided on elements of income or expense that are recognized in different periods for financial and tax reporting purposes. Taxes on income are determined by using the liability method as prescribed by Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("FAS 109"). This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, FAS 109 requires the consideration of all expected future events other than enactments of changes in the tax law or rates. Statement of Cash Flows. For purposes of reporting cash flows, the Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Accounting Changes. The Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106") as of January 1, 1992. FAS 106 requires that the expected cost of postretirement benefits other than pensions be charged to expense during the period over which eligible employees render active service. The unfunded benefit obligation as of January 1, 1992 reflected in liabilities on the Consolidated Statements of Financial Condition and shown as an accounting change on the Consolidated Statements of Operations follows: In 1992, the Company also adopted FAS 109, which supersedes Statement No. 96 "Accounting for Income Taxes", which was adopted by the Company in 1987. The adoption of FAS 109 did not have a significant impact on the financial statements for 1992. Market Value Disclosures. The Company adopted Statement of Financial Accounting Standards No. 107 "Disclosures about Fair Value of Financial Instruments" ("FAS 107") in December 1992. FAS 107 requires disclosures about fair value for all financial instruments, whether recognized or not in the body of the financial statements or in the accompanying notes, and the methods and significant assumptions used to estimate their fair value. Quoted market prices are used, where available, to estimate the market value of financial instruments. Because no quoted market prices exist for a significant portion of the Company's financial instruments, market value is estimated using comparable market prices for similar instruments or using management's estimates of appropriate discount rates and cash flows for the underlying asset or liability. A change in management's assumptions could significantly affect these estimates; accordingly, the Company's market value estimates are not necessarily indicative of the value which would be realized upon disposition of the financial instruments. NOTE 2 FINANCE RECEIVABLES Finance receivables at December 31, 1993 and 1992 are summarized as follows: The amount of gross nonaccruing receivables included above was approximately $19 million and $20 million at December 31, 1993 and 1992, respectively. Contractual maturities, net of unearned finance charges and deferred loan fees, at December 31, 1993 are as follows: Consumer finance receivables have maximum terms of 180 months, while retail contracts have maximum terms of 60 months. The weighted average contractual term of all loans and contracts written during each of the years ended December 31, 1993 and 1992 was 41 months and 42 months, respectively. Experience has shown that a substantial portion of the receivables will be renewed or repaid prior to contractual maturity. Therefore, the tabulation of contractual payments should not be regarded as a forecast of future cash collections. During the years ended December 31, 1993 and 1992, the ratio of principal cash collections to average net consumer finance receivables outstanding was 66% and 64%, respectively. Additionally, substantially all loans provide for a fixed rate of interest over the contractual life of the loan. The approximate fair value of the Company's net finance receivables as of December 31, 1993 and 1992 follows: The approximate fair value of finance receivables is estimated by discounting the future cash flows using current rates at which similar loans would be made with similar maturities to borrowers with similar credit ratings. The current rates for finance receivables approximate the weighted average rates of the portfolio at December 31, 1993 and 1992; therefore, there is no significant difference between the estimated fair value of the loan portfolio and its net book value. The fair value is not adjusted for the value of potential loan renewals from existing borrowers. Because the Company primarily lends to consumers, it did not have receivables from any industry group that comprised 10 percent or more of total consumer finance receivables at December 31, 1993. Activity in the Company's allowance for credit losses is as follows: The Company changed its charge-off policy effective June 30, 1991. Under the new policy, non-real estate secured delinquent accounts are charged off based on the number of days contractually delinquent (120 days for closed-end loans and 180 days for open-end loans), as opposed to the previous recency-based method. At June 30, 1991, approximately $28 million of loans, which had been fully reserved in 1990, were charged off under the new policy. The adoption of the policy did not have a material impact on 1991 net income. NOTE 3 ACQUISITIONS Effective October 11, 1991, the Company acquired, as a liquidating portfolio, approximately $132 million of finance receivables from GWB. GWB had acquired the receivables along with certain deposit accounts from the Resolution Trust Corporation, as a receiver of The First, F.A. of Florida, on the same date and in turn sold the finance receivables to the Company at a discount of approximately $17 million. This discount is being accreted into income over the contractual lives of the loans acquired. On December 31, 1991, the Company purchased substantially all the assets and assumed certain liabilities of Capitol Finance Group, Inc. ("Capitol") and its subsidiaries. Capitol was owned by an unrelated financial institution and operated 54 consumer finance branches in 5 states. The Company retained 44 of the branches. The total assets acquired of approximately $149 million were primarily finance receivables. Liabilities assumed were approximately $4 million, and the total purchase price of approximately $164 million (net of cash acquired) resulted in an excess of cost over equity in net assets acquired of approximately $21 million. The excess is being amortized on a straight-line basis over 6 years, the estimated life of the intangible assets acquired. The following unaudited pro forma results have been prepared based on the fair values of the assets acquired and the liabilities assumed of Capitol and are not necessarily representative of the actual results that would have occurred or may occur in the future if the transaction had been in effect on January 1, 1991. NOTE 4 INVESTMENT SECURITIES Investment securities as of December 31, 1993 and 1992 are as follows: There were no significant realized gains or losses during 1993 or 1992. The following table presents the maturity of the investment securities at December 31, 1993: NOTE 5 DEFERRED CHARGES Deferred charges, net of amortization, as of December 31, 1993 and 1992 are as follows: Amortization of these deferred charges for each of the last three years is as follows: NOTE 6 SHORT-TERM DEBT Short-term debt at December 31, 1993 and 1992 consisted of commercial paper notes issued in the minimum amount of $500,000 with original terms to 92 days. The book value of short-term debt at December 31, 1993 approximates its estimated fair value. Additional information concerning total short-term borrowings is as follows: Weighted average interest rates include the effect of commitment fees. Short-term notes totalling $65 million and $69 million were issued in December, 1993 and 1992, respectively. The proceeds of these notes were used to purchase investment securities and were repaid through liquidation of these securities in the January following issuance. This short-term debt has been reflected net of the securities balances in the accompanying Consolidated Statements of Financial Condition. In 1991, the Company entered into a $100 million international revolving credit agreement with several foreign banks, which was increased to $120 million in 1993. The agreement originally had a three-year term with repayment in full of any balance outstanding in December, 1994. In 1993, $110 million of this credit was extended to December, 1996. In 1992, the Company entered into a $200 million domestic revolving credit agreement with various banks. The agreement has a three-year term with repayment in full of any balance outstanding in January, 1995. In 1992, the Company entered into an arrangement with GWB for a $100 million revolving credit line originally set to expire in January, 1995. This arrangement was cancelled during 1993 as a result of the corporate realignment consummated on June 30, 1993. There were no borrowings under the above revolving credit agreements in 1993 or 1992. NOTE 7 LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 was comprised of the following: Aggregate maturities and sinking fund requirements at December 31, 1993 are as follows: The approximate fair value of the Company's long-term debt as of December 31, 1993 and 1992 is as follows: Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the approximate fair value of existing debt. In September, 1990, the Company filed a $400 million shelf registration statement. In May, 1991, under this registration statement, the Company issued, through a public offering, $100 million of 8.55% senior notes maturing June 1, 1995. In August, 1991, also under this registration statement, the Company issued $100 million of 8.875% senior subordinated notes maturing August 15, 1998. In February, 1992, under this registration statement, the Company issued $100 million of 7.375% senior notes maturing February 15, 1997 and $100 million of 7.875% senior notes maturing February 15, 1999. The proceeds of the offerings in 1991 were principally used to reduce other long-term debt obligations and, in 1992, were used principally to reduce short-term debt. In March, 1992, the Company filed a $600 million shelf registration statement. In July, 1992, under this registration statement, the Company issued $100 million of 6.25% senior notes maturing July 15, 1996 and $100 million of 7.5% senior subordinated notes maturing July 1, 1999. In July, 1993, also under this registration statement, the Company issued $150 million of 5.75% senior notes maturing July 15, 1998. The proceeds of each of these issues were used principally to reduce short-term debt. NOTE 8 INCOME TAXES The components of income tax expense are as follows: Deferred taxes result from temporary differences in the recognition of certain items for tax and financial reporting purposes. Deferred tax liabilities (assets) are comprised of the following: The provisions for income taxes differ from the amounts determined by multiplying pretax income by the statutory Federal income tax rate of 35% for 1993 and 34% for 1992 and 1991. A reconciliation between these amounts is as follows: NOTE 9 STOCKHOLDER'S EQUITY Provisions of certain of the Company's debt agreements restrict the payment of dividends to a maximum prescribed proportion of cumulative earnings and contributed capital and provide for the maintenance of minimum levels of equity and maximum leverage ratios. At December 31, 1993, approximately $94 million was available under the debt agreement restriction for future dividends. NOTE 10 RETIREMENT AND SAVINGS PLANS GWFC's non-contributory defined benefit pension plan covers substantially all of the Company's employees. Accumulated plan benefits and annual pension expense are derived from an allocation formula based on the Company's total participants and the Plan's total participants. Pension expense for the Company's participants for the years ended December 31, 1993, 1992 and 1991 was $1,515,000, $1,200,000 and $1,140,000, respectively. Due to the Company's participation in a multiemployer defined benefit plan, information as to separate Company participant assets and vested benefits is not presented. The Company's employees also participate in GWFC's employee savings plan, which allows employees to defer part of their pretax compensation until retirement. Company contributions equal 50% of the contributions made by employees up to 6% plus annual discretionary amounts, if any, as determined by management. The Company's cost is based on the actual contribution related to its participating employees. Total expense was $1,342,000, $1,388,000 and $1,125,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company's employees also participate in GWFC's defined benefit postretirement plans which provide medical and life insurance coverage to eligible employees and dependents based on age and length of service. Medical coverage options are the same as available to active employees. The accumulated postretirement benefit obligation and related expense are derived from an allocation formula based on the Company's total participants and the Plan's total participants. The net postretirement medical and life insurance expense allocated to the Company for the years ended December 31, 1993 and 1992 were $1,300,000 and $1,216,000, respectively. In 1991, the cost of these benefits, funded currently, was not significant to the Company. NOTE 11 LEASES At December 31, 1993, the Company was lessee of office space, principally for loan offices, computer and other office equipment and automobiles, generally for terms of five or fewer years. The lease for the Company's former headquarters expires in 1994 and will not be renewed due to the purchase of its new headquarters in Tampa, Florida. The Company has no material capital leases. Under operating leases that have initial or remaining noncancelable lease terms in excess of one year, approximate aggregate annual minimum rentals are $5,400,000 in 1994; $3,500,000 in 1995; $2,400,000 in 1996; $1,500,000 in 1997; and $800,000 in 1998. Rent expense for the years ended December 31, 1993, 1992 and 1991 was $8,560,000, $8,007,000 and $7,028,000, respectively. NOTE 12 COMMITMENTS AND CONTINGENCIES The Company is routinely involved in litigation incidental to its businesses. It is management's opinion that the aggregate liability arising from the disposition of all such pending litigation will not have a material adverse effect on the Company. NOTE 13 TRANSACTIONS WITH RELATED PARTIES The Company had long-term debt outstanding with GWB of $244,500,000 at December 31, 1990, which was repaid in 1991. During 1991, the Company borrowed $264,130,000 from GWB under a short-term master note, which was repaid in July, 1992. Interest expense related to the above short-term and long-term debt was $2.5 million in 1992 and $12.9 million in 1991. The debt was issued primarily to reduce commercial paper and other nonaffiliated debt. Other transactions with GWFC or its subsidiaries are identified as follows: - - The Company provides supervisory and administrative services to affiliates engaged in industrial banking and other consumer finance activities at no cost to such affiliates. The Company also provides data processing services to such affiliates, and revenue from these services totalled approximately $768,000 in 1993, $699,000 in 1992 and $640,000 in 1991. From time to time, the Company advances funds to these operations. At December 31, 1993 and 1992, there were outstanding advances of $855,000 and $2,548,000, respectively. - - GWB provides the Company with certain administrative services, including human resources and cash management. The Company paid GWB management fees of $1,239,000 in 1993, $1,163,000 in 1992 and $1,071,000 in 1991. - - The Company makes payments to GWFC in accordance with GWFC's tax allocation policy and in connection with the retirement and savings plans. NOTE 14 BUSINESS SEGMENTS The Company is engaged primarily in the consumer finance business. NOTE 15 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the quarterly results of operations for the years ended December 31, 1993 and 1992 is set forth below: (1) Includes approximately $1.2 million associated with the relocation of the Company's headquarters from Memphis, Tennessee to Tampa, Florida. (2) Reflects a decrease in the Company's effective tax rate primarily attributable to the expected increased deductibility of current and prior year's amortization of intangible assets resulting from the recently enacted Omnibus Budget Reconciliation Act of 1993. (3) Reflects a change in GWFC's income tax allocation policy, which provides that the Company's state income taxes will be charged or credited in amounts approximating such taxes as computed on a separate entity basis. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Index of Documents filed as a part of this Report: 1. FINANCIAL STATEMENTS Included in Part II of this Report: 2. FINANCIAL STATEMENT SCHEDULES All schedules are omitted because of the absence of the conditions under which they are required or because the required information is set forth in the financial statements or related notes. 3. EXHIBITS Included in Part IV of this Report: EXHIBIT NUMBER (3) (a) Certificate of Incorporation of Aristar, Inc. as presently in effect. (1) (b) By-Laws of Aristar, Inc. as presently in effect. (1) (4) (a) Indenture dated as of July 15, 1984, between Aristar, Inc. and Bank of Montreal Trust Company, as trustee. (2) (b) First supplemental indenture to Exhibit (4)(a) dated as of June 1, 1987. (2) (c) Indenture dated as of August 15, 1988, between Aristar, Inc. and Bank of Montreal Trust Company, as trustee. (3) (d) Indenture dated as of May 1, 1991 between Aristar, Inc. and Security Pacific National Bank, as trustee. (4) (e) Indenture dated as of May 1, 1991 between Aristar, Inc. and The First National Bank of Boston, as trustee. (4) (f) Indenture dated as of July 1, 1992 between Aristar, Inc. and The Chase Manhattan Bank, N.A., as trustee. (5) (g) Indenture dated as of July 1, 1992 between Aristar, Inc. and Citibank, N.A., as trustee. (5) (h) The registrant hereby agrees to furnish the Securities and Exchange Commission upon request with copies of all instruments defining rights of holders of long-term debt of Aristar and its consolidated subsidiaries. (10) (a) Great Western Financial Corporation Income Tax Allocation Policy. (6) (b) Amendment Number 2 to Great Western Financial Corporation Income Tax Allocation Policy. (c) Purchase Agreement dated as of November 5, 1991 between Great Western Bank and Blazer Financial Services, Inc. of Florida d/b/a Great Western Financial Services, Inc. of Florida. (7) (d) Amended and Restated Acquisition Agreement made as of December 2, 1991 by and between Aristar, Inc. and Capitol Finance Group, Inc., Capitol Credit Plan of North Carolina, Inc., Capitol Credit Plan of South Carolina, Inc., Capitol Credit Plan of Georgia, Inc., Capitol Credit Plan of Tennessee, Inc., Capitol Credit Plan of Virginia, Inc., Capitol Mortgage Plan Corporation, Capitol Mortgage Plan of Virginia, Inc., Capitol Premium Plan, Inc., Advance Insurance Agency, Inc., Capitol Financial Services, Inc., Capitol Lease Plan Corporation and Amity Life Insurance Company, and the exhibits thereto. (8) (12) Statement Re: Computation of Ratios. (23) Consent of Independent Accountants. (24) Power of Attorney included on Page 33 of the Form 10-K. (1) Incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987, Commission File number 1-3521. (2) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993, Commission file number 1-3521. (3) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, Commission file number 1-3521. (4) Incorporated by reference to Registrant's Current Report on Form 8-K dated May 29, 1991, Commission file number 1-3521. (5) Incorporated by reference to Registrant's Current Report on Form 8-K dated June 24, 1992, Commission file number 1-3521. (6) Incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, Commission file number 1-3521. (7) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission file number 1-3521. (8) Incorporated by reference to Registrant's Current Report on Form 8-K dated December 31, 1991, Commission file number 1-3521. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the period covered by this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ARISTAR, INC. By /s/ James A. Bare March 23, 1994 --------------------------------- -------------- James A. Bare, Senior Vice President Date and Chief Financial Officer (and Principal Accounting Officer) POWER OF ATTORNEY Each person whose signature appears below hereby authorizes James A. Bare as attorney-in-fact to sign on his behalf as an individual and in every capacity stated below, and to file all amendments to the registrant's Form 10-K, and the registrant hereby confers like authority to sign and file in its behalf. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 23, 1994. /s/ Michael M. Pappas ------------------------ Michael M. Pappas, President and Director (Principal Executive Officer) /s/ James A. Bare ------------------------ James A. Bare, Director /s/ Carl F. Geuther ------------------------ Carl F. Geuther, Director /s/ J. Lance Erikson ------------------------ J. Lance Erikson, Director

855433_1993.txt

855433_1993

1993

855433

ITEM 1. BUSINESS. General BHC Communications, Inc. ("BHC"), the majority owned (71.8% at February 28, 1994) television broadcasting subsidiary of Chris- Craft Industries, Inc. ("Chris-Craft"), was organized in Delaware in 1977 under the name "BHC, Inc." and changed its name to BHC Communications, Inc. on August 4, 1989. BHC's principal business is television broadcasting, conducted through its wholly owned subsidiaries, Chris-Craft Television, Inc. ("CCTV") and Pinelands, Inc. ("Pinelands"), and its majority owned (54.3% at February 28, 1994) subsidiary, United Television, Inc. ("UTV"). At February 28, 1994, BHC, solely through subsidiaries, had 979 full-time employees and 97 part-time employees. Television Broadcasting BHC operates six very high frequency ("VHF") television stations and two ultra high frequency ("UHF") television stations, together constituting Chris-Craft's Television Division. Commercial television broadcasting in the United States is con- ducted on 68 channels numbered 2 through 69. Channels 2 through 13 are in the VHF band, and channels 14 through 69 are in the UHF band. In general, UHF stations are at a disadvantage relative to VHF stations, because UHF frequencies are more difficult for households to receive. This disadvantage is eliminated when a viewer receives the UHF station through a cable system. Commercial broadcast television stations may be either affiliated with one of the three national networks (ABC, NBC and CBS) or may be independent. In addition, Fox Broadcasting Company ("Fox") has established itself as a national network by entering into affiliation agreements with independent stations in many television markets. Chris-Craft, through BHC, is organizing, in partnership with Paramount Communications, Inc., an additional network, The Paramount Network, which currently plans to commence broadcasting in January 1995. There can be no assurance that the network will be viable. Moreover, BHC knows of one other effort to establish a network, and it is considered unlikely that two additional networks will be viable. The following table sets forth certain information with respect to BHC's stations and their respective markets: Television stations derive their revenues primarily from selling advertising time. The television advertising sales market consists primarily of national network advertising, national spot advertising and local spot advertising. An advertiser wishing to reach a nationwide audience usually purchases advertising time directly from the national networks, from "superstations" (i.e., broadcast stations carried by cable operators in areas outside their broadcast coverage area) or from "unwired" networks (groups of otherwise unrelated stations whose advertising time is combined for national sale). A national advertiser wishing to reach a particular regional or local audience usually buys advertising time from local stations through national advertising sales representative firms having contractual arrangements with local stations to solicit such advertising. Local businesses generally purchase advertising from the stations' local sales staffs. Television stations compete for television advertising revenue primarily with other television stations serving the same DMA. There are 211 DMAs in the United States. DMAs are ranked annually by the estimated number of households owning a television set within the DMA. Advertising rates that a television station can command vary in part with the size, in terms of television households, of the DMA served by the station. Within a DMA, the relative advertising rates charged by competing stations depend primarily on three factors: the stations' program ratings (number of television households or persons within those households tuned to a program as a percentage of total television households or persons within those households in the viewing area); the time of day the advertising will run; and the demographic qualities of a program's viewers (primarily age and sex). Ratings data for television markets are measured by A.C. Nielsen Co. ("Nielsen"). This rating service uses two terms to quantify a station's audience: rating points and share points. A rating point represents one percent of all television households in the entire DMA, and a share point represents one percent of all television households within the DMA actually using at least one television set at the time of measurement. Because the major networks regularly provide first-run programming during prime time viewing hours (in general, 8:00 P.M. to 11:00 P.M. Eastern time), their affiliates generally (but do not always) achieve higher audience shares during those hours than independent stations. However, independent stations generally have substantially more advertising time ("inventory") for sale than network affiliates, because the networks use almost all of their affiliates' inventory during network shows. Independent stations' smaller audiences and greater inventory during prime time hours generally result in lower advertising rates charged and more advertising time sold during those hours, whereas affiliates' larger audiences and limited inventory generally allow affiliates to charge higher advertising rates for prime time programming. By selling more advertising time, an independent station typically achieves a share of advertising revenues in its market greater than its audience ratings. On the other hand, because a nonaffiliated station broadcasts more syndicated programming than a network- affiliated station, total programming costs for an independent station are generally higher than those of a network affiliate in the same market. Programming BHC's independent stations depend heavily on independent third parties for programming, as do BHC's network affiliates for their non-network broadcasts. Recognizing the need to have a more direct influence on the quality of programming available to its stations, and desiring to participate in potential profits through national syndication of programming, BHC has begun to invest directly in the development of original programming. The aggregate amount invested through December 31, 1993 was not significant to BHC's financial position. BHC's independent stations currently expect to broadcast, as affiliates of The Paramount Network, four hours of original prime time programming over two nights per week, beginning in January 1995. BHC's television stations also produce programming directed to meet the needs and interests of the area served, such as local news and events, public affairs programming, children's programming and sports. Programs obtained from independent sources consist principally of syndicated television shows, many of which have been shown previously on a network, and syndicated feature films, which were either made for network television or have been exhibited previously in motion picture theatres (most of which films have been shown previously on network and cable television). Syndicated programs are sold to individual stations to be broadcast one or more times. Independent television stations generally have large numbers of syndication contracts; each contract is a license for a particular series or program that usually prohibits licensing the same programming to other television stations in the same market. A single syndication source may provide a number of different ser- ies or programs. Licenses for syndicated programs are often offered for cash sale (i.e., without any barter element) to stations; however, some are offered on a barter or cash plus barter basis. In the case of a cash sale, the station purchases the right to broadcast the program, or a series of programs, and sells advertising time during the broadcast. The cash price of such programming varies, de- pending on the perceived desirability of the program and whether it comes with commercials that must be broadcast (i.e., on a cash plus barter basis). Bartered programming is offered to stations without charge, but comes with a greater number of commercials that must be broadcast, and therefore with less time available for sale by the station. Recently, the amount of bartered and cash plus barter programming broadcast both industry-wide and by BHC's stations has increased substantially. BHC television stations are frequently required to make substantial financial commitments to obtain syndicated programming while such programming is still being broadcast by a network and before it is available for broadcast by BHC stations or before it has been produced. Generally, syndication contracts require the station to acquire an entire program series, before the number of episodes of original showings that will be produced has been determined. While analyses of network audiences are used in estimating the value and potential profitability of such pro- gramming, there is no assurance that a successful network program will continue to be successful or profitable when broadcast after network airing. For many years, the FCC has restricted the ability of television networks to acquire financial interests in the production of television shows by independent sources, or to participate in the syndication of television programs, either on a first-run or an off-network basis. These rules were based in part on concern that networks engaged in syndication would have economic incentives to discriminate against independent stations (such as those owned by BHC) in making programs available in the syndication market, either by warehousing them or favoring the network's owned or affiliated stations. Late in 1992, the United States Court of Appeals for the Seventh Circuit remanded the rules to the FCC with instructions to revisit the need for them. In 1993, the FCC adopted new rules which allow networks to acquire financial interests and passive syndication rights in off-network programs, but bar them from actively syndicating such programs in the United States or delaying the entry into syndication of any long-running prime time network-owned series beyond the fourth year after its network debut. The new rules also bar networks from acquiring domestic financial interests or syndication rights in first-run programs unless the network is the sole producer of the program and prohibit networks from active domestic syndication of all first-run programs. However, these rules are scheduled to expire in November 1995, unless the FCC issues an order to the contrary. A number of petitions for review of these new regulations have been filed, which have been consolidated and transferred to the Seventh Advertising is generally placed with BHC stations through advertising agencies, which are allowed a commission generally equal to 15% of the price of advertising placed. National advertising time is usually sold through an independent national sales representative, which also receives a commission, while local advertising time is sold by each station's sales staff. Practices with respect to sale of advertising time do not differ markedly between BHC's network and non-network stations, although the net- work-affiliated stations have less inventory to sell. Government Regulation Television broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended (the "Communications Act"). The Communications Act empowers the FCC, among other things, to issue, revoke or modify broadcast licenses, to assign frequencies, to determine the loca- tions of stations, to regulate the broadcasting equipment used by stations, to establish areas to be served, to adopt such regulations as may be necessary to carry out the provisions of the Communications Act and to impose certain penalties for violation of its regulations. BHC television stations are subject to a wide range of technical, reporting and operational requirements imposed by the Communications Act or by FCC rules and policies. The Communications Act provides that a license may be granted to any applicant if the public interest, convenience and necessity will be served thereby, subject to certain limitations, including the requirement that the FCC allocate licenses, frequencies, hours of operation and power in a manner that will provide a fair, efficient and equitable distribution of service throughout the United States. Television licenses generally are issued for five- year terms. Upon application, and in the absence of a conflicting application that would require the FCC to hold a hearing, or adverse questions as to the licensee's qualifications, television licenses have usually been renewed for additional terms without a hearing by the FCC. An existing license automatically continues in effect once a timely renewal application has been filed until a final FCC decision is issued. KMSP's license renewal was granted on April 15, 1993, and is due to expire on April 1, 1998. KTVX's license renewal was granted on September 29, 1993, and is due to expire on October 1, 1998. KMOL's license renewal application is currently pending, subject to two petitions challenging the station's compliance with FCC requirements concerning equal employment opportunity; UTV has vigorously opposed the petitions, and believes that they are without merit. KUTP, KCOP, KBHK, and KPTV have each filed timely renewal applications, which are pending. No petitions to deny any of those applications have been filed, no competing applications have been filed, and the deadlines for filing such petitions and competing applications have all expired. Pursuant to FCC requirements, each station's application has reported instances in which the station has exceeded the commercial limits applicable to children's programs. In the case of KBHK, these instances have been substantial, and the FCC has recently granted renewals, in such cases, subject to forfeitures of as much as $80,000. WWOR's license renewal was granted on January 22, 1992 and expires on June 1, 1994. A renewal application was timely filed on January 31, 1994. The deadline for filing petitions to deny or competing applications against that application has not yet expired. Under existing FCC regulations governing multiple ownership of broadcast stations, a license to operate a television station generally will not be granted to any party (or parties under common control) if such party directly or indirectly owns, operates, controls or has an attributable interest in another television or radio station serving the same market or area. The FCC, however, is favorably disposed to grant waivers of this rule for radio station-television station combinations in the top 25 television markets, in which there will be at least 30 separately owned, operated and controlled broadcast licenses, and in certain other circumstances. FCC regulations further provide that a broadcast license will not be granted if that grant would result in a concentration of control of radio and television broadcasting in a manner inconsis- tent with the public interest, convenience or necessity. FCC rules generally deem such concentration of control to exist if any party, or any of its officers, directors or stockholders, directly or in- directly, owns, operates, controls or has an attributable interest in more than 12 television stations, or in television stations capable of reaching, in the aggregate, a maximum of 25% of the national audience. This percentage is determined by the DMA market rankings of the percentage of the nation's television households considered within each market. Because of certain limitations of the UHF signal, however, the FCC will attribute only 50% of a market's DMA reach to owners of UHF stations for the purpose of calculating the audience reach limits. Applying the 50% reach attribution rule to UHF stations KBHK and KUTP, the eight BHC stations are deemed to reach approximately 18% of the nation's television households. To facilitate minority group participation in radio and television broadcasting, the FCC will allow entities with attributable ownership interests in stations controlled by minority group members to exceed the ownership limits. The FCC's multiple ownership rules require the attribution of the licenses held by a broadcasting company to its officers, directors and certain of its stockholders, so there would ordinarily be a violation of FCC regulations where an officer, director or such a stockholder and a television broadcasting company together hold interests in more than the permitted number of stations or more than one station that serves the same area. In the case of a corporation controlling or operating television stations, such as BHC, there is attribution only to stockholders who own 5% or more of the voting stock, except for institutional investors, including mutual funds, insurance companies and banks acting in a fiduciary capacity, which may own up to 10% of the vot- ing stock without being subject to such attribution, provided that such entities exercise no control over the management or policies of the broadcasting company. The Communications Act and FCC regulations prohibit the holder of an attributable interest in a television station from having an attributable interest in a cable television system located within the predicted coverage area of that station. FCC regulations also prohibit the holder of an attributable interest in a television station from having an attributable interest in a daily newspaper located within the predicted coverage area of that station. The Communications Act limits the amount of capital stock that aliens may own in a television station licensee or any corporation directly or indirectly controlling such licensee. No more than 20% of a licensee's capital stock and, if the FCC so determines, no more than 25% of the capital stock of a company controlling a licensee, may be owned or voted by aliens or their representatives. Should alien ownership exceed this limit, the FCC may revoke or refuse to grant or renew a television station license or approve the assignment or transfer of such license. BHC believes the ownership of its stock by aliens to be below the applicable limit. The Communications Act prohibits the assignment of a broadcast license or the transfer of control of a licensee without the prior approval of the FCC. Legislation was introduced in the past that would impose a transfer fee on sales of broadcast properties. Although that legislation was not adopted, similar proposals, or a general spectrum licensing fee, may be advanced and adopted in the future. Recent legislation has imposed annual regulatory fees applicable to BHC's stations, currently ranging as high as $18,000 per station. The foregoing does not purport to be a complete summary of all the provisions of the Communications Act or regulations and policies of the FCC thereunder. Reference is made to the Communications Act, such regulations and the public notices promulgated by the FCC for further information. Other Federal agencies, including principally the Federal Trade Commission, also impose a variety of requirements that affect the business and operations of broadcast stations. Proposals for additional or revised requirements are considered by the FCC, other Federal agencies or Congress from time to time. BHC cannot predict what new or revised Federal requirements may result from such consideration or what impact, if any, such requirements might have upon the operation of BHC television stations. Competition BHC television stations compete for advertising revenue in their respective markets, primarily with other broadcast television stations and cable television channels, and compete with other advertising media, as well. Such competition is intense. In addition to programming, management ability and experience, technical factors and television network affiliations are important in determining competitive position. Competitive success of a television station depends primarily on public response to the pro- grams broadcast by the station in relation to competing entertainment, and the results of this competition affect the advertising revenues earned by the station from the sale of advertising time. Audience ratings provided by Nielsen have a direct bearing on the competitive position of television stations. In general, network programs achieve higher ratings than independent station programs. There are at least five other commercial television stations in each market served by a BHC station. BHC believes that the three VHF network-affiliated stations and the two other independent VHF stations in New York City generally attract a larger viewing audience than does WWOR, and that WWOR generally attracts a viewing audience larger than the audience attracted by the UHF stations in the New York City market. In Los Angeles, the three VHF network- affiliated stations and two independent VHF stations generally attract a larger viewing audience than does KCOP, and KCOP generally attracts a viewing audience approximately the same size as the audiences attracted by the other independent VHF station but larger than the ten UHF stations in Los Angeles. In Portland, the three VHF network-affiliated stations generally attract a larger audience than does KPTV, which generally attracts a larger audience than the other independent stations, both of which are UHF sta- tions. BHC believes that, in Minneapolis/St. Paul, KMSP generally attracts a smaller viewing audience than the three VHF network- affiliated stations, but a larger viewing audience than the other independent stations, all of which are UHF stations. In Salt Lake City, KTVX generally ranks first of the six television stations in terms of audience share. In San Antonio, KMOL ranks third of the six stations in terms of audience share. KBHK generally ranks fifth in terms of audience share, behind the one independent and three network-affiliated VHF television stations, of the 14 commer- cial television stations in San Francisco. KUTP ranks sixth in terms of audience share, of the eight commercial stations in the Phoenix market. BHC stations may face increased competition in the future from additional television stations that may enter their respective markets. See note (c) to the table under Television Broadcasting. Cable television has become a major competitor of television broadcasting stations. Because cable television systems operate in each market served by a BHC station, the stations are affected by rules governing cable operations. If a station is not widely accessible by cable in those markets having strong cable pene- tration, it may lose effective access to a significant portion of the local audience. Even if a television station is carried on a local cable system, an unfavorable channel position on the cable system may adversely affect the station's audience ratings and, in some circumstances, a television set's ability to receive the station being carried on an unfavorable channel position. Some cable system operators may be inclined to place broadcast stations in unfavorable channel locations. FCC regulations requiring cable television stations to carry or reserve channels for retransmission of local broadcast signals have twice been invalidated in Federal court. In October 1992, Congress enacted legislation designed to provide television broadcast stations the right to be carried on cable television stations (and to be carried on specific cable channel positions), or (at the broadcaster's election) to prohibit cable carriage of the television broadcast station without its consent. This legislation is currently being challenged in the United States Supreme Court, and BHC cannot predict the outcome. While Federal law now generally prohibits local telephone companies from providing video programming to subscribers in their service areas, this restriction has been invalidated by one federal district court and is currently being challenged in other federal courts; legislation eliminating or relaxing the law has been proposed. "Syndicated exclusivity" rules allow television stations to prevent local cable operators from importing distant television programming that duplicates syndicated programming in which local stations have acquired exclusive rights. In conjunction with these rules, network nonduplication rules protect the exclusivity of network broadcast programming within the local video marketplace. The FCC is also reviewing its "territorial exclusivity" rule, which limits the area in which a broadcaster can obtain exclusive rights to video programming. BHC believes that the competitive position of BHC stations would likely be enhanced by an expansion of broadcasters' permitted zones of exclusivity. Alternative technologies could increase competition in the areas served by BHC stations and, consequently, could adversely affect their profitability. Direct broadcast satellite ("DBS") systems and subscription television ("STV"), recognized as potential competitors a few years ago, have thus far failed to materialize as such. However, at least two DBS operators are scheduled to begin service in 1994. An additional challenge is now posed by multichannel multipoint distribution services ("MMDS"). Two four-channel MMDS licenses have been granted in most television markets. MMDS operation can provide commercial programming on a paid basis. A similar service can also be offered using the instructional television fixed service ("ITFS"). The FCC now allows the educational entities that hold ITFS licenses to lease their "excess" capacity for commercial purposes. The multichannel capacity of ITFS could be combined with either an existing single channel MDS or a new MMDS to increase the number of available channels offered by an individual operator. The emergence of home satellite dish antennas has also made it possible for individuals to receive a host of video programming options via satellite trans- mission. Technological developments in television transmission have created the possibility that one or more of the broadcast and nonbroadcast television media will provide enhanced or "high definition" pictures and sound to the public of a quality that is technically superior to that of the pictures and sound currently available. It is not yet clear when and to what extent technology of this kind will be available to the various television media; whether and how television broadcast stations will be able to avail themselves of these improvements; whether all television broadcast stations will be afforded sufficient spectrum to do so; what channels will be assigned to each of them to permit them to do so; whether viewing audiences will make choices among services upon the basis of such differences; or, if they would, whether significant additional expense would be required for television stations to provide such services. Many segments of the television industry are intensively studying enhanced and "high definition" television technology, and both Congress and the FCC have initiated proceedings and studies on its potential and its application to television service in the United States. The broadcasting industry is continuously faced with technological changes, competing entertainment and communications media and governmental restrictions or actions of Federal regulatory bodies, including the FCC. These technological changes may include the introduction of digital compression by cable systems that would significantly increase the number and availability of cable program services with which BHC stations compete for audience and revenue, the establishment of interactive video services, and the offering of multimedia services that include data networks and other computer technologies. Such fac- tors have affected, and will continue to affect, the revenue growth and profitability of BHC. ITEM 2. ITEM 2. PROPERTIES. KCOP owns its studios and offices in two buildings in Los Angeles containing a total of approximately 54,000 square feet located on adjacent sites having a total area of approximately 1.93 acres. KCOP's transmitter is located atop Mt. Wilson on property utilized pursuant to a permit issued by the United States Forest Service. KPTV owns its studios and offices in a building in Portland, Oregon, containing approximately 33,520 square feet located on a site of approximately 1.09 acres. Its transmitter is located on its own property at a separate site containing approximately 16.18 acres. WWOR owns office and studio facilities in Secaucus, New Jersey, containing approximately 110,000 square feet on approximately 3.5 acres and leases additional office space in New York City. Along with almost all of the television stations licensed to the New York market, WWOR's transmitter is located on top of the World Trade Center in New York City pursuant to a lease agreement which expires in 2004, unless terminated by WWOR in 1994 or 1999. Physical facilities consisting of offices and studio facilities are owned by UTV in Minneapolis, San Antonio and Phoenix and are leased in Salt Lake City and San Francisco. The Salt Lake City lease agreement expires in 1999 and is renewable, at an increased rental, for two five-year periods. The San Francisco lease expires in 2007. The Minneapolis facility includes approximately 49,700 square feet of space on a 5.63-acre site. The Salt Lake City facility is approximately 30,400 square feet on a 2.53-acre site. The San Antonio facility is approximately 41,000 square feet on a .92-acre site. The San Francisco facility is approximately 27,700 square feet in downtown San Francisco. The Phoenix facility is approximately 26,400 square feet on a 3.03-acre site. Smaller buildings containing transmission equipment are owned by UTV at sites separate from the studio facilities. UTV owns a 55-acre tract in Shoreview, Minnesota, of which 40 acres are used by KMSP for transmitter facilities and tower. KTVX's transmitter facilities and tower are located at a site on Mt. Nelson, close to Salt Lake City, under a lease that expires in 2004. KTVX also maintains back-up transmitter facilities and tower at a site on nearby Mt. Vision under a lease that expires in 2002 and is renewable, at no increase in rental, for a 50-year period. KMOL's transmitter facilities are located at a site near San Antonio on land and on a tower owned by Texas Tall Tower Corporation, a corporation owned in equal shares by UTV and another television station that also transmits from the same tower. KBHK's transmitter is located on Mt. Sutro, as part of the Sutro Tower complex, which also houses equipment for other San Francisco television stations and many of its FM radio stations. The lease for the Mt. Sutro facilities expires in February 1995. KUTP's transmitter facilities and tower are located on a site within South Mountain Park, a communications park owned by the City of Phoenix, which also contains transmitter facilities and towers for the other television stations in Phoenix as well as facilities for several FM radio stations. The license for this space expires in 2012. BHC believes its properties are adequate for their present uses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Not applicable. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of BHC, as of February 28, 1994, are as follows: Chris-Craft, through its majority ownership of BHC, is principally engaged in television broadcasting. The principal occupation of each of the individuals for the past five years is stated in the foregoing table, except that prior to being elected General Counsel and Secretary of BHC on December 14, 1992, Brian C. Kelly served as President of Finevest Foods, Inc. ("Finevest") from July 1992 through December 13, 1992, served as Executive Vice President, General Counsel and Secretary of Finevest from March 1992 until July 1992 and served as Vice President, General Counsel and Secretary of Finevest from January 1989 through February 1992. Finevest filed a Chapter 11 bankruptcy petition on February 11, 1991, and emerged from bankruptcy on July 9, 1992 pursuant to a confirmed reorganization plan. All officers hold office until the meeting of the Board following the next annual meeting of stockholders or until removed by the Board. Evan C Thompson, age 51, is Executive Vice President of Chris- Craft. Although not an officer of BHC, as President of UTV and Chris-Craft's Television Division for more than the past five years, Mr. Thompson may be considered an executive officer of BHC, within the Securities and Exchange Commission definition of the term. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information appearing in the Annual Report under the caption STOCK PRICE, DIVIDEND AND RELATED INFORMATION is incorporated herein by this reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information appearing in the Annual Report under the caption SELECTED FINANCIAL DATA is incorporated herein by this reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information appearing in the Annual Report under the caption MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS is incorporated herein by this reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements, notes thereto, report of independent public accountants thereon and quarterly financial information (unaudited) appearing in the Annual Report are incor- porated herein by this reference. Except as specifically set forth herein and elsewhere in this Form 10-K, no information appearing in the Annual Report is incorporated by reference into this report nor is the Annual Report deemed to be filed, as part of this report or otherwise, pursuant to the Securities Exchange Act of 1934. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Nominees of the Board of Directors is incorporated herein by this reference. Information relating to BHC's executive officers is set forth in Part I under the caption EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Executive Compensation is incorporated herein by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Voting Securities of Certain Beneficial Owners and Management is incorporated herein by this reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS -- Certain Relationships and Related Transactions is incorporated herein by this reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this report: 1. The financial statements and quarterly financial information incorporated by reference from the Annual Report pursuant to Item 8. 2. The report of predecessor independent public accountants and the schedules and report of independent accountants thereon, listed in the Index to Consolidated Financial Statements and Schedules. 3. Exhibits listed in the Exhibit Index, including the following compensatory plans listed below: Chris-Craft's Benefit Equalization Plan Employment Agreement dated as of January 1, 1994 between and Evan C Thompson and Chris-Craft (b) No reports on Form 8-K were filed by the registrant during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, there- unto duly authorized. Date: March 29, 1994 BHC COMMUNICATIONS, INC. (Registrant) By: WILLIAM D. SIEGEL William D. Siegel Senior Vice President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Date HERBERT J. SIEGEL March 29, 1994 Herbert J. Siegel Chairman, President and Director (principal exe- cutive officer) WILLIAM D. SIEGEL March 29, 1994 William D. Siegel Director (principal financial officer) JOELEN K. MERKEL March 29, 1994 Joelen K. Merkel Vice President, Controller and Director (principal accounting officer) JOHN L. EASTMAN March 29, 1994 John L. Eastman Director BARRY S. GREENE March 29, 1994 Barry S. Greene Director LAURENCE M. KASHDIN March 29, 1994 Laurence M. Kashdin Director MORGAN L. MILLER March 29, 1994 Morgan L. Miller Director JOHN C. SIEGEL March 29, 1994 John C. Siegel Director VIN WEBER March 29, 1994 Vin Weber Director BHC COMMUNICATIONS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES CONSOLIDATED FINANCIAL STATEMENTS: Report of Independent Accountants Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- For the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows -- For the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Investment -- For the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULES: Report of Predecessor Independent Public Accountants Report of Independent Accountants on Financial Statement Schedules I. Marketable Securities - Other Investments II. Amounts Receivable from Related Parties, Underwriters, Promoters and Employees other than Related Parties X. Supplementary Income Statement Information Schedules other than those listed above have been omitted since the information is not applicable, not required or is included in the respective financial statements or notes thereto. REPORT OF PREDECESSOR INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of BHC Communications, Inc.: We have audited the consolidated statements of income, shareholders' investment and cash flows of BHC Communications, Inc. (a Delaware corporation and majority owned subsidiary of Chris- Craft Industries, Inc.) and subsidiaries for the year ended December 31, 1991. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of BHC Communications, Inc. and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to consolidated financial statements and schedules for the year ended December 31, 1991 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, New York, February 10, 1992. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of BHC Communications, Inc. Our audits of the consolidated financial statements referred to in our report dated February 8, 1994 appearing on page 11 of the 1993 Annual Report to Shareholders of BHC Communications, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included audits of the Financial Statement Schedules as of December 31, 1993 and 1992, and the years then ended, listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE New York, New York February 8, 1994 Schedule I BHC COMMUNICATIONS, INC. AND SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 (Columns C, D, and E in Thousands) Schedule X BHC COMMUNICATIONS, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In Thousands) EXHIBIT INDEX

26093_1993.txt

26093_1993

1993

26093

ITEM 1 - BUSINESS Culbro Corporation and its subsidiaries (the "Corporation") comprise a diversified consumer and industrial products company. The Corporation engages in four principal lines of business: (1) Consumer Products, comprised of (a) the manufacturing and marketing of cigars and the growing, processing and selling of cigar wrapper tobacco; and (b) wholesale distribution, which engages in the wholesaling of cigarettes, cigars and other tobacco products, foodservice products, groceries, confectionery, health and beauty aids, sundries and general merchandise; (2) Nursery Products, growing for sale container and field grown nursery products principally to nursery mass merchandisers, and owning and operating wholesale sales and service centers; (3) Industrial Products, which consists of the manufacturing and marketing of packaging and labeling systems which include plastic shrink film labels and tamper-evident seals and the production of packaging and labeling machinery to apply them; and (4) Real Estate, owning, building and managing commercial and industrial properties and developing residential subdivisions on real estate owned by the Corporation in Connecticut and Massachusetts, and owning and managing its headquarters building at 387 Park Avenue South in New York City. IN DECEMBER 1990 THE CORPORATION CHANGED ITS FISCAL YEAR FROM THE SATURDAY NEAREST DECEMBER 31 TO THE SATURDAY NEAREST NOVEMBER 30. The approximate net sales and other revenue, operating profit and identifiable assets attributable to each reportable segment of the Corporation in each of the last three fiscal periods are set forth in Note 11 to the Consolidated Financial Statements on page 18 of the Annual Report. In July 1991 the Corporation sold the assets of its Moll Tool & Plastics Corp. subsidiary, part of the Industrial Products group and a manufacturer of injection molded plastic components, to a limited partnership formed by a combination with a smaller injection molded plastics business. In December 1992, the Corporation relinquished its 25% equity interest in the purchaser and exchanged its Notes for $5,000,000 in cash and a note for $750,000. See Note 2 to the Consolidated Financial Statements on page 12 of the Annual Report. The Corporation owns approximately 25% of the stock of Centaur Communications Limited, a privately-held publisher of business magazines in the United Kingdom. In late 1992 The Eli Witt Company ("Eli Witt"), the Corporation's wholesale distribution subsidiary, executed a Merger Agreement with Certified Grocers of Florida, Inc. (the "Merger"). The Merger became effective February 19, 1993 and the Corporation currently owns approximately 85% of the Common Stock of Eli Witt, which is the surviving company after the Merger. On November 24, 1993 Eli Witt signed a letter of intent for the acquisition of the six southern divisions of NCC, L.P. See "Wholesale Distribution Business" herein and Note 1 to the Consolidated Financial Statements on page 11 of the Annual Report. CONSUMER PRODUCTS The Consumer Products segment is comprised of the Cigar Business and the Wholesale Distribution Business. CIGAR BUSINESS The cigar business is comprised principally of (a) the manufacture and sale, by General Cigar Co., Inc. ("General Cigar"), of domestic and imported cigars in all major price categories under numerous trademarks, including the premium cigar brands of Macanudo, Partagas, Temple Hall, Ramon Allones, Cohiba and Canaria D'Oro and the domestic cigar brands of Garcia y Vega, White Owl, Tiparillo, Robt. Burns, Wm. Penn and Tijuana Smalls and (b) the growing, processing and sale of cigar wrapper tobacco by the Culbro Tobacco Division of General Cigar. Cigars are produced with three tobacco components: filler, binder and wrapper. Filler tobacco is purchased from a large number of growers and suppliers in many areas of the world. The binder is principally natural binder leaf or HTL, a homogenized tobacco binder developed by General Cigar. General Cigar's premium brands and its Garcia y Vega brand are wrapped with natural cigar wrapper tobacco. Its other domestic cigars are primarily wrapped with homogenized tobacco wrappers. Some of the natural leaf wrapper tobacco used for General Cigar's cigars is grown by General Cigar on farms it leases from the Corporation in the Connecticut River Valley. The remainder of General Cigar's requirements for natural leaf wrapper tobacco is purchased from a number of foreign growers and suppliers. A major portion of the wrapper tobacco grown by General Cigar is sold to others, including export sales principally in Europe. General Cigar annually adjusts acreage grown to reflect changing market demands from export customers. In November 1990 the Corporation sold the homogenized wrapper and binder manufacturing facility used by General Cigar in Lancaster, Pennsylvania to Brown & Williamson Tobacco Corporation. As part of the transaction, Brown & Williamson will manufacture at the facility General Cigar's requirements for these products for a term of ten years. In 1992 General Cigar completed the consolidation of its Dothan, Alabama domestic cigar manufacturing operations into one building. Also in late 1992 General Cigar moved its corporate headquarters from the Corporation's New York City headquarters building to the Griffin Center corporate park of Culbro Land Resources in Bloomfield, Connecticut. The move integrated General Cigar's headquarters operations with its Culbro Tobacco operations in Connecticut. 1993 was General Cigar's first full year of benefitting from the cost savings of being at that location. General Cigar maintains inventories of wrapper and filler tobacco for cigars sufficient to meet its estimated requirements for more than one year. Most of its inventories are stored in warehouses in the United States. General Cigar believes that its inventories are adequately insured. The markets for General Cigar's cigars are highly competitive. The industry has experienced a long continuing decline in cigar consumption and substantial consolidation. In order to maintain its position in its markets, General Cigar advertises and employs a variety of promotional activities. General Cigar believes that it is among the industry leaders in the manufacture and sale of cigars in the United States, with particular strength in the higher priced, premium and super premium segments which have evidenced growing consumer acceptance in recent years. General Cigar's products are distributed in the United States through approximately 1,300 wholesale distributors, including the distribution operation of the Corporation, and direct retail and chain store accounts. The cigar business carried on by General Cigar in Jamaica and the Dominican Republic, where the Corporation produces its highest priced, handmade cigars, and warehouses certain of its inventories, and some of the sources of tobacco purchased by General Cigar, are subject to the risks associated with foreign operations. General Cigar's handmade cigars include Macanudo, Macanudo Vintage Cabinet, Partagas, Partagas Limited Reserve, Temple Hall, Cohiba, Ramon Allones and Canaria D'Oro. General Cigar cannot predict the effect on its cigar business of a reopening of trade with Cuba, if that should occur, except that such trade could adversely affect its handmade cigar manufacturing business. In 1993 General Cigar reappointed its independent sales agent in Europe to take advantage of increased opportunities resulting from the eradication of trade barriers among Common Market countries. Cigar export sales, revenues from royalties and other revenues from foreign operations are not material. General Cigar imports for sale in the United States on an exclusive basis the Djeep lighter - a disposable butane gas lighter made in France. One customer comprises approximately 60% of General Cigar's Djeep lighter sales. * * * While the substantial adverse publicity resulting from the 1964 Report of the Surgeon General and subsequent reports with respect to studies linking the use of tobacco with human disease have not been principally directed at cigars, General Cigar believes such publicity and the health concerns it has provoked have contributed to the long decline of sales in the cigar industry. The reported health effects upon non-smokers of so-called "passive" or "environmental tobacco smoke" have caused the U.S. Surgeon General and others to support restrictive legislation. Federal and state regulations designating certain areas as non-smoking areas and the prohibition of smoking cigars in certain areas have adversely affected the sales of cigar products. Various legislative initiatives affecting tobacco, including warnings of carcinogenic chemical contents, advertising bans and nondeductibility of advertising expenses have recently been implemented or proposed. Tobacco products, including cigars, also face increased federal excise taxes to fund various health care legislative initiatives that have been proposed. WHOLESALE DISTRIBUTION BUSINESS The wholesale distribution business of the Corporation is managed by The Eli Witt Company ("Eli Witt"). Giving effect to the merger of Certified Grocers, Inc., the acquisition of Trinity Distributors, Inc. of Ft. Worth, Texas and the consolidation of six branch operations, Eli Witt ended 1993 with 12 distribution centers. The products distributed included cigarettes, foodservice products, health and beauty aids, candy, cigars, paper, other tobacco products and other confectionery and general merchandise. In late 1992 Eli Witt executed a Merger Agreement with Certified Grocers of Florida, Inc. (the "Merger"). The Merger became effective February 19, 1993 and the Corporation currently owns approximately 85% of the Common Stock of Eli Witt. The businesses of Eli Witt and Certified Grocers of Florida, Inc. are described at pages 66-72 and 72-75, respectively, and the Merger is described at pages 36-53, of the Proxy Statement and Prospectus filed with the Securities and Exchange Commission by The Eli Witt Company as Part of a Registration Statement on Form S-4 (Registration No. 33-54934, Amendment No. 2) on January 8, 1993. Such descriptions are incorporated by reference herein pursuant to Rule 12b-23 and General Instruction G to Form 10-K. Eli Witt's 1993 Form 10-K is incorporated herein by reference pursuant to Rule 12b-23 and General Instruction G to Form 10-K. Eli Witt signed a letter of intent on November 24, 1993 for the acquisition of the six southern divisions of NCC, L.P. ("NCC South"). This acquisition would combine the operations of two leading wholesale distributors which together serve the southeast, mid-atlantic, and southwest markets. The combined company would be the second largest wholesale distributor of tobacco, candy, beverages, and grocery products in the United States with annual sales of approximately $2 billion. The acquisition of NCC South by Eli Witt is pending and subject to several conditions. NURSERY PRODUCTS BUSINESS Imperial Nurseries, Inc., which previously operated as a division of the Corporation, became in February 1993 a wholly owned subsidiary of the Corporation. Imperial Nurseries, Inc. ("Imperial") is a grower, distributor and broker of wholesale nursery stock. The nursery industry is extremely fragmented, with the industry leader having less than 1% of total market share. Imperial believes that its volume places it among the ten largest nursery companies in the country. Imperial's growing operations are located on property owned by the Corporation and leased to Imperial in Connecticut (1000 acres) and in northern Florida (350 acres). Such operations mainly serve landscapers, retail chain store garden departments, retail nurseries and garden centers, and wholesale nurseries and distributors. Imperial-grown products are also distributed through the company's own wholesale horticultural sales and service centers. Most of Imperial's customers are located east of the Mississippi River and over 70% of sales are in Connecticut, New York, Michigan, New Jersey and Massachusetts. Nursery sales are seasonal, peaking in spring, and are affected by commercial and residential building activity as well as weather conditions. Imperial operates seven wholesale sales and service centers which sell a wide range of plant material and horticultural tools and products to the trade. These centers, owned by the Corporation and leased to Imperial, are located in Windsor, Connecticut; Aston, Pennsylvania; Pittsburgh, Pennsylvania; Columbus, Ohio; Cincinnati, Ohio; White Marsh, Maryland; and Manassas, Virginia. In 1992 Imperial's customer base grew by 60%, allowing for less dependence on a few large customers, with much of this growth occurring in independent retail garden centers and mass merchandise chain stores where "do- it-yourself" consumer demand has been strong. The brokerage operation is located in Connecticut. Approximately 35% of the nursery stock sold by Imperial is purchased from other growers through its brokerage business. Growing and shipping capacity has been increased to meet the potential volume and quality needs of Imperial's customers and to capitalize on any growth in this market during the predicted economic upturn in the Northeast. As the result of studies undertaken in 1993, Imperial is reorganizing its operations by changing to a regional organizational structure. The new structure is anticipated to remove conflicting objectives between the nursery and distribution operations and improve overall customer satisfaction. 1993 was the first full year for Imperial's Vice President of Total Quality Management. Current initiatives are aimed at reducing costs and improving customer service levels. INDUSTRIAL PRODUCTS BUSINESS Industrial Products consists of CMS Gilbreth Packaging Systems, Inc. ("CMS Gilbreth") which manufactures high quality plastic labels and a variety of application equipment. This market is both highly specialized and fragmented. CMS Gilbreth believes it is a leader in the several markets in which it participates. CMS Gilbreth has manufacturing plants in Bensalem and Bristol, Pennsylvania (labeling materials), Kingston, Pennsylvania and Turlock, California (application machinery), and its headquarters is located in Trevose, Pennsylvania. It also has regional sales offices located in Chicago, Illinois and Brussels, Belgium. In 1991, CMS Gilbreth restructured its business and positioned itself to offer a complete system featuring a full range of shrink film, labeling and tamper-evident seal products as well as application machinery. In 1992 CMS Gilbreth continued its market development process and initiated Total Quality Management focusing on total customer satisfaction. In addition, there were increased new product development activities in both materials and machine operations. CMS Gilbreth operating results in 1993 reflected a significant improvement over 1992. This favorable trend was the consequence of earlier adopted Total Quality Management processes and continuous improvement savings in both the materials and roll-fed machinery applications segments and increased volume in the roll-fed market. In 1993 one customer accounted for approximately 22% of CMS Gilbreth's aggregate sales. Certain of CMS Gilbreth's shrink label printing business is dependent upon its ability to source raw material of print quality film. Such film is available only from a limited number of suppliers, but CMS Gilbreth believes its sources to be adequate. The machine manufacturing operations of Trine Manufacturing Company, Inc. ("Trine"), a subsidiary of the Corporation and a separate legal entity whose operations are integrated with CMS Gilbreth, are dependent on the validity and enforceability of various patents issued to it or others by the United States Patent and Trademark Office and internationally. Sales of its machines may be affected by patents issued to others (See Item 3(iii)) and the commercial exploitation of technological advances in the design and production of labeling machinery may be limited by such patents. CMS Gilbreth has developed environmentally-compatible wraparound and sleeved film for labeling in conjunction with its high-speed application machinery. Management has been advised that certain aspects of these new developments may be patentable and has taken appropriate steps to protect its proprietary rights. Due to the nature of Trine's business, purchases of its machines are generally on a onetime basis. The only continuing business is for parts and service. Trine's sales are principally in the food and beverage industry, including substantial sales to soft drink bottlers. Approximately 35% of its sales are to foreign customers. Trine sales in the domestic market are principally to companies in the food and dairy industry, although other outlets for its machinery are being developed. REAL ESTATE The Corporation's Real Estate segment is comprised of Culbro Land Resources, Inc. and 387 Park Avenue South, the New York City building which the Corporation owns and operates. CULBRO LAND RESOURCES The Corporation is engaged in the real estate development business on portions of its land in Connecticut through Culbro Land Resources, Inc. ("Resources"), headquartered in Windsor, Connecticut. Resources develops portions of the Corporation's properties for office, residential and commercial use. Resources' most substantial development is Griffin Center in Windsor, Connecticut and Griffin Center South in Bloomfield, Connecticut. Together these master planned developments comprise approximately 600 acres, half of which have been developed with nearly 2,000,000 square feet of office and industrial space. Griffin Center currently includes nine Class A corporate office buildings built by Resources. Prior to 1983, Resources sold 70% interests in five of the buildings to a bank-managed real estate investment fund. In 1984, Resources sold one office building and a 70% interest in a second to an insurance company; and, in 1986, Resources sold a 70% interest in a building to the same insurance company. Resources manages these properties for its investor-partners. At year end approximately 73% of the rentable space in Griffin Center was rented. After years of growth, the commercial rental market is flat and excess capacity is prevalent in northern Connecticut. To attract and retain tenants, Resources continues to provide a variety of amenities to maintain Griffin Center as a highly competitive, prime office park offering quality services to tenants. Griffin Center South, a 130-acre tract, comprises fifteen buildings of industrial and research/development space. Nine of these buildings have been retained by Resources for rental and are 88% rented. The other buildings have been built on land sold by Resources to commercial users who occupy the space. Resources has a master plan state traffic certificate which allows for the development of an additional 500,000 square feet of space. Resources owns a 600-acre tract of land near Bradley International Airport and Interstate 91 now known as New England Tradeport. To date, 140,000 square feet of warehouse and light manufacturing space have been developed and are 77% occupied. Resources recently completed a major road extension and utilities installation in order to service the 18-acre Tradeport site sold in early 1992 to Allied Bottlers, Inc., a major distributor for Pepsi-Cola. A state traffic certificate for the future development of 1.3 million square feet has been obtained for the Tradeport. Two additional Resources' parcels available for development include 33 acres in the Day Hill Technology Center in Windsor, and 100 acres in the South Windsor Technology Center. State traffic certificates have been obtained for 500,000 square feet and 750,000 square feet of development, respectively, and in 1993 ground was broken in Day Hill Technology Center to accommodate a 185,000 square foot building. In 1988, Culbro Homes, Inc. ("Culbro Homes"), a subsidiary of Resources, began infrastructure work at Walden Woods, a 153-acre site in Windsor, Connecticut which is planned to contain more than 400 residential units. Prior to 1992 Culbro Homes had built and sold 45 homes before discontinuing the home building part of developing Walden Woods. Since then, Culbro Homes has concluded agreements with two third-party home builders which would ultimately transfer the building rights to a total of 110 units at Walden Woods. A second section of Walden Woods was opened for development in 1993. It is also anticipated that the development of Resources' land in Simsbury, Connecticut will commence in 1994 with the sale of an approved 14 lot residential subdivision to a local builder. Resources has several other tracts in the Greater Hartford area suitable for residential development but cannot predict when, or if, development will begin due to the continuing slowdown in the residential market throughout the region. 387 PARK AVENUE SOUTH In 1983 the Corporation acquired all of the outstanding stock of a corporation whose principal asset was an office building in New York City. The building is 12 stories and contains approximately 210,000 square feet of rental space. The purchase price of approximately $15 million was financed principally by a $12 million mortgage which was prepaid in 1988. The Corporation has advanced substantial amounts for building improvements. Approximately 11% of the space in the building has been leased to the Corporation for use as its offices and the remaining space is being leased or is available for lease as commercial rental property. Currently approximately 24% of rentable space is available for lease in this building. SUBSIDIARIES In 1987 the Corporation established several wholly-owned subsidiaries and transferred to them the assets and liabilities of formerly unincorporated divisions. The Corporation serves as the parent company of separate subsidiaries operating its cigar, distribution, nursery, machine and labeling systems and land development operations. Imperial Nurseries, Inc., formerly a Division of the Corporation, was incorporated as a separate company in February 1993. See Exhibit 22 hereto. In connection with the loan agreements entered into by the Corporation in February 1993 (see Note 4 to the Consolidated Financial Statements on page 12 of the Annual Report), the Corporation pledged the stock of all of its active subsidiaries as collateral for such loans. EMPLOYEES The Corporation employs approximately 4,050 persons (excluding seasonal help employed in wrapper tobacco and nursery operations). NOTE: The brand names mentioned in this Report are trademarks owned by or licensed to the Corporation or its subsidiaries. All rights with respect thereto are reserved. ITEM 2 ITEM 2 - PROPERTIES LAND HOLDINGS The Corporation is a major landholder in the State of Connecticut and owns some land in the State of Massachusetts, with holdings of approximately 5,600 acres, located principally in the Connecticut River Valley. In addition, the Corporation owns approximately 1,100 acres in Florida, a portion of which is used for Imperial Nurseries' growing operations, and the sites for Imperial Nurseries' seven sales and service centers. Each such center typically has a warehouse/office facility and 10-15 acres of nursery stock. The book value of undeveloped land holdings, which includes land currently needed for tobacco and nursery operations, owned by the Corporation and Resources in the Connecticut River Valley is approximately $5,000,000. The Corporation believes the fair market value is very substantially in excess of such book value. The Corporation is developing certain of these holdings. (See the description of Culbro Land Resources, Inc. under "Real Estate"). Such development activities have increased the value of the Corporation's adjoining properties. Of the Corporation's land not currently needed for tobacco or nursery operations, only a portion is currently suitable for development. FACILITIES The table below sets forth the general character and location of certain of the principal facilities of the Corporation and its subsidiaries. It does not include the facilities of Culbro Land Resources, Inc. (See discussion of Real Estate under Item 1 - Business). In addition to the above, the Corporation owns approximately 10 other distribution properties located principally in the Eastern United States having an aggregate of approximately 463,000 square feet of floor space. The Corporation and its General Cigar Co., Inc. subsidiary lease approximately 80 acres of land for growing tobacco in the Dominican Republic. In addition, the Corporation leases approximately 15 other facilities for distribution, storage, sales and related warehousing operations and office locations which have an aggregate of approximately 355,000 square feet of floor space. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS The Corporation is involved in various legal actions including the following: (i) TOWN OF WEST SPRINGFIELD V. CULBRO CORPORATION In 1986 the State of Massachusetts closed certain public and private wells in the West Springfield, Massachusetts area, where the Corporation had farmed tobacco, because of alleged contamination by ethylene dibromide (EDB) and other pesticides. Subsequently the Corporation's farms were identified as a probable source of the EDB contamination. In April 1987 the Town of West Springfield, Massachusetts filed suit in Hampden County Superior Court against the Corporation, another tobacco farmer, nine chemical manufacturers and an unknown number of unnamed manufacturers and distributors of pesticides. The Complaint alleges, among many other things with respect to each defendant, that the Corporation was negligent in that it should have known that its use of farm pesticides would contaminate the Town's public wells. The Complaint demands judgment in the amount of $10,000,000 plus costs and expenses. The Town has recently calculated that its "direct costs incurred or to be incurred" as a result of the alleged contamination are $7,532,000 and it demanded $4,170,000 "in full and complete satisfaction of this matter". The Corporation believes the five chemical companies which remain defendants in this action will play the major role in any defense or other resolution of this litigation. One of the Corporation's general liability insurance carriers is bearing legal expenses for this action while reserving its rights as to coverage. The Corporation believes another carrier is also jointly and severally responsible for coverage. It is impossible to predict the outcome of the litigation at this preliminary stage, although the Corporation believes it has meritorious defenses. In a similar action in Connecticut the chemical manufacturers bore the major part of settlement contributions and the Corporation's insurance did respond. (ii) TOBACCO LIABILITY While the Corporation now has no pending litigation respecting tobacco and health, there is currently substantial litigation respecting cigarette smoking and "environmental tobacco smoke", and other forms of tobacco use may also be challenged in the courts. (iii) TRINE MANUFACTURING COMPANY, INC. Trine Manufacturing Company, Inc., a subsidiary of the Corporation which manufactures labeling machines ("Trine"), has reached a settlement of its patent infringement litigation with B&H Manufacturing, Inc. ("B&H) in the Federal District Court for the Eastern District of California, Fresno Division. This litigation was described in the Corporation's previous Forms 10-K. The settlement provides relief for Trine from several, potentially large, claims for indemnity for patent infringement damages and/or royalties paid by certain of Trine's customers including Foster Forbes, a division of American National Can Corporation, to B&H. The settlement also provides a mechanism under which other Trine customers using Trine machines in an allegedly infringing manner would be offered a special licensing arrangement from B&H. The arrangement offers these customers a release of all liability for past patent infringement if they enter into a license agreement and pay royalties to B&H on all future production of allegedly infringing articles during the life of the B&H patents. There is no assurance these customers will accept the license agreement and thus they may seek indemnity from Trine. Certain other terms and conditions of the settlement are confidential by agreement of the parties. Trine did not admit the validity of B&H's patents, will not make any representations as to whether a customer's use of its Trine machines infringes these patents and agreed to notify its customers that a patent license may be available from B&H. The settlement contains mutual releases by B&H and Trine for all claims and causes of action which were asserted or could have been asserted in the litigation. B&H also agreed never to sue the Corporation, Trine, or CMS Gilbreth Packaging Systems, Inc., an affiliated company, or their successors in interest for future infringement of the B&H patents involved in the litigation and foreign counterparts of these patents. The settlement was also signed on behalf of the seller ("Seller") to the Corporation of the Trine business. In connection with the Corporation's acquisition of Trine in 1988 the Seller indemnified the Corporation respecting the B&H patents and the Corporation has reached a separate agreement with the Seller whereby the Seller would allow the Corporation to reimburse itself for 85% of the legal fees paid to its patent attorneys in the B&H litigation from the escrow account established as part of the acquisition. In addition, funds withheld from payment to the Seller under certain related consulting and non- competition agreements will be used to reimburse the Seller for 85% of its legal fees. Approximately $1,500,000 of withheld funds will remain after such reimbursements and will continue to be held by the Corporation to secure other potential indemnity obligations of the Seller, including those relating to litigation against the Seller and it by Anchor Glass Container Corporation. (iv) IMPERIAL NURSERIES AZALEA CROP In early 1991 at its Quincy, Florida farm the Imperial Nurseries ("Imperial") Division of the Corporation sustained a significant loss of its azalea crop. The loss appears to have been caused by the use of Benlate 50 DF, a product of E.I. DuPont De Nemours & Co. ("DuPont") which was contaminated, possibly by the herbicide atrazine. DuPont reportedly had a similar problem in 1989. The crops involved have been inspected by adjusters for DuPont and for the Corporation's property insurance carrier, Arkwright- Factory Mutual ("Arkwright"). In August 1991 Imperial made a claim for approximately $2,200,000 for lost sales of azaleas and other plants unsaleable because of the damaged azaleas, less $240,000 previously advanced by DuPont. Despite consistent expressions of support and approval by its claims adjuster, DuPont refused payment of the claim. Imperial then filed suit in the United States District Court for the Northern District of Florida seeking compensation for its full losses from DuPont and certain distributors of Benlate. The suit is in the discovery stage and the outcome cannot at this time be predicted. Imperial has also filed a claim with Arkwright which has been denied. Imperial may also initiate an insurance coverage action against Arkwright with respect to this claim. In 1992 DuPont announced that it was terminating its claims settlement program. Such termination is not expected to affect this litigation because DuPont had previously refused to settle Imperial's claim. Discovery continued in 1993 and trial could occur in late 1994. (v) ELI WITT - TENNESSEE In November 1991 and again in May 1992, the State of Tennessee Department of Revenue (the "Department") notified Eli Witt of "several instances against your firm for sales of cigarettes below the minimum fair trade price set by" the Tennessee Unfair Cigarette Sales Law (Tenn. Code Ann. 47-25-Part 3) (the "Law"). The second notice sought to impose a $5000 fine and a revocation of Eli Witt's wholesale tobacco license, both of which actions have been stayed by Eli Witt's timely petition for a formal hearing. Eli Witt believes the Department is misinterpreting the Law by attacking "pass through" payments by Eli Witt to its retailer customers of the discounts and payment programs Eli Witt receives from cigarette manufacturers. The Administrative Law Judge assigned to this matter left the Department and a new Judge was assigned. The new Judge granted Eli Witt's Motion for a More Definitive Statement. Eli Witt has twice tried to have the Tennessee Chancery Court assume jurisdiction for its case without success. The matter is now again in proceedings under Tennessee's Administrative Procedure Act. Another wholesale distributor has been defending a similar charge by the Department since 1989. Such distributor is defending upon grounds that the Law is either unconstitutional or violates federal anti-trust laws. Eli Witt concurs in that position and will argue those same grounds. Eli Witt believes the defenses described above are meritorious but cannot predict the ultimate outcome of these proceedings. In January 1993 a third distributor filed suit in the Chancery Court against the Department to invalidate the Law and/or the Department's interpretation of it. It based its case on the same grounds as Eli Witt and the second distributor. * * * Management does not believe that the above described actions will have a material adverse effect upon the financial condition of the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS On February 18, 1994 the approximate number of record holders of Common Stock of the Corporation was 1,052 which does not include beneficial owners whose shares are held of record in the names of brokers or nominees. The closing market price as quoted on the New York Stock Exchange on such date was $15.75 per share. The information appearing (i) under Quarterly Data on Common Shares on page 3 of the Annual Report, (ii) in Note 4 to the Consolidated Financial Statements on page 12 of the Annual Report and (iii) in Note 11 to the Consolidated Financial Statements on page 18 of the Annual Report are hereby incorporated by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Consolidated Statement of Operations and the Selected Financial Data appearing on pages 7 and 4, respectively, of the Annual Report are hereby incorporated by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management's Discussion and Analysis appearing on pages 4, 5 and 6 of the Annual Report is hereby incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements appearing on pages 7 through 19 of the Annual Report, together with the Report of Independent Accountants, which appears on page 21 of the Annual Report, are hereby incorporated by reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE CORPORATION In accordance with General Instruction G-3 to Form 10-K, the information called for in this Item 10 with respect to directors is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from such proxy statement. The following table sets forth the information called for in this Item 10 with respect to executive officers of the Corporation. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION In accordance with General Instruction G-3 to Form 10-K, the information called for in this Item 11 is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from such proxy statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT In accordance with General Instruction G-3 to Form 10-K, the information called for in this Item 12 is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from such proxy statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In accordance with General Instruction G-3 to Form 10-K, the information called for in this Item 13 is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from such proxy statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements (annexed hereto): There are filed as part of this Report on Form 10-K: the Consent and Report of Independent Accountants; and the Consolidated Financial Statements (including Notes) of the Corporation appearing on pages 7 through 19 of the Annual Report. See Index To Financial Statements and Additional Financial Data. (a)(2) Schedules (annexed hereto): Financial Statement Schedules required by Item 8 of Form 10-K for the fiscal years ended 1993, 1992 and 1991. See Index To Financial Statements and Additional Financial Data. (a)(3) Exhibits. (Enumeration corresponds to the Exhibit Table, Item 601, Regulation S-K. Items not enumerated are not applicable). (3) THE ARTICLES OF INCORPORATION AND BY-LAWS OF THE CORPORATION. (A) The Articles of Incorporation, as amended to date (Incorporated by reference to Exhibits to Form 10-K of the Corporation filed for the fiscal year 1984 - (Exhibit 3(A)) and to the definitive proxy statement of Registrant, dated April 11, 1988, for its Annual Meeting of Shareholders held on May 12, 1988). (B) The By-Laws, as amended to date (Incorporated by reference to Exhibits to Form 10-K of the Corporation filed for the fiscal year 1984 - (Exhibit 3(B)) and to the definitive proxy statement of Registrant, dated April 11, 1988, for its Annual Meeting of Shareholders held on May 12, 1988). (4) INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES. (A) Note Purchase Agreement, dated July 15, 1988, respecting 9.10% Series A Senior Notes due 1991, 9.56% Series B Senior Notes due 1994, 9.87% Series C Senior Notes due 1998 and 9.93% Series D Senior Notes due 1998 (Incorporated by reference to Exhibits to Form 10-Q of the Corporation filed for the thirteen weeks ended July 2, 1988 - (Exhibit (a)(2)). (B) Credit Agreement, dated May 24, 1990 with several banks and Manufacturers Hanover Trust Company, as Agent. (Incorporated by reference to Exhibits to Form 10-Q of the Corporation filed for the thirteen weeks ended June 30, 1990 - (Exhibit (a)). (C) Amended and Restated Note Purchase Agreement among the Corporation and six institutional investors relating to the private placement of $35,000,000 of Senior Notes, dated July 15, 1988 amended and restated as of February 19, 1993, including Exhibits (which have been omitted but will be furnished to the Commission upon request). (Incorporated by reference to Exhibits to Form 10-K of the Corporation filed for the fiscal year 1992). (D) Amended and Restated Credit Agreement, dated February 19, 1993 with several banks and Chemical Bank, as Agent, including Exhibits (which have been omitted but will be furnished to the Commission upon request). (Incorporated by reference to Exhibits to Form 10-K of the Corporation filed for the fiscal year 1992). (E) Pages 36-53 and 66-75 of the Proxy Statement and Prospectus filed with the Securities and Exchange Commission by The Eli Witt Company as Part of a Registration Statement on Form S-4 (Registration No. 33-54934, Amendment No. 2). Such Proxy Statement and Prospectus are incorporated by reference to such filing. (F) Credit Agreement among The Eli Witt Company, The Several Lenders from Time to Time Parties Hereto and Chemical Bank, as Agent, Dated as of February 19, 1993. (Incorporated by reference to Exhibits to Form 10-K of the Corporation filed for the fiscal year 1992). Certain other documents evidencing indebtedness of the Corporation are not filed herewith in reliance upon the exemption provided by Item 601(b)(4)(iii)(A); the Registrant hereby undertakes to furnish a copy of such documents to the Commission upon request. (10) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS. (A) 1992 Stock Plan of Registrant, dated December 10, 1993 (Incorporated by reference to the definitive proxy statement of Registrant, dated March 3, 1993, for its Annual Meeting of Shareholders held on April 8, 1993). (B) Stock Option Plan for Non-employee Directors of Registrant, dated December 10, 1993 (Incorporated by reference to the definitive proxy statement of Registrant, dated March 3, 1993, for its Annual Meeting of Shareholders held on April 8, 1993). (C) 1991 Employees Incentive Stock Option Plan of Registrant (Incorporated by reference to the definitive proxy statement of Registrant, dated April 9, 1991, for its 1991 Annual Meeting of Shareholders held on May 9, 1991). (D) 1983 Employees Incentive Stock Option Plan of Registrant, as amended (Incorporated by reference to the definitive proxy statement of Registrant, dated April 6, 1983, for its Annual Meeting of Shareholders held on May 12, 1983 and to the Appendix filed pursuant to Rule 424(c) under the Securities Act of 1933, as amended, dated March 3, 1987). (13) ANNUAL REPORT TO SECURITY HOLDERS. The Corporation's Annual Report to Shareholders for 1993 (annexed hereto). Such Annual Report, except for those portions which are expressly incorporated by reference, is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" or incorporated by reference as part of this Form 10-K. (22) SUBSIDIARIES. List of Subsidiaries. (28) UNDERTAKING. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference to registrant's Registration Statement on Form S-8 (Incorporated by reference to Exhibits to Form 10-K of the Corporation filed for the fiscal year 1984 - (Exhibit 28)) and subsequent Form S-8's: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. (b) The Corporation filed two reports on Form 8-K in the last quarter of its 1993 fiscal year: (1) October 22, 1993, settlement of patent litigation. (2) November 30, 1993, letter of intent for an acquisition by the Registrant's majority owned subsidiary, The Eli Witt Company. (c) See (a)(3) above. (d) See Index to Financial Statements and Additional Financial Data. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. CULBRO CORPORATION By (JAY M. GREEN) Jay M. Green Executive Vice President-Finance and Administration Dated: March 10, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934 this annual report has been signed by the following persons on behalf of the Corporation and in the capacities indicated on March 10, 1994. Signatures & Title (BRUCE A. BARNET), Director (Bruce A. Barnet) (JOHN L. BERNBACH), Director (John L. Bernbach) (EDGAR M. CULLMAN), Chairman of the Board, Director and (Edgar M. Cullman) Principal Executive Officer (EDGAR M. CULLMAN, JR.), President, Director and (Edgar M. Cullman, Jr.) Principal Operating Officer (FREDERICK M. DANZIGER), Director (Frederick M. Danziger) (JOHN L. ERNST), Director (John L. Ernst) (JAY M. GREEN), Executive Vice President and (Jay M. Green) Principal Financial Officer (THOMAS C. ISRAEL), Director (Thomas C. Israel) (DAN W. LUFKIN), Director (Dan W. Lufkin) (GRAHAM V. SHERREN), Director (Graham V. Sherren) (PETER J. SOLOMON), Director (Peter J. Solomon) (FRANCIS T. VINCENT, JR.), Director (Francis T. Vincent, Jr.) (JOSEPH C. AIRD), Vice President and Controller (Joseph C. Aird) EXHIBIT 22 CULBRO CORPORATION ------------------ State/Jurisdiction Subsidiaries (1) of Incorporation - ------------ ---------------- General Cigar Co., Inc. (2) Delaware Culbro Machine Systems, Inc. Delaware Culbro Land Resources, Inc. (3) Delaware 387 PAS Corporation New York The Eli Witt Company * (4) Delaware CMS Gilbreth Packaging Systems, Inc. (5) Pennsylvania Trine Manufacturing Company Delaware Imperial Nurseries, Inc. Delaware * The Corporation owns approximately 85% of the common stock of this subsidiary. (1) The Corporation also has approximately 7 inactive subsidiaries which considered in the aggregate as a single subsidiary would not constitute a significant subsidiary. The Consolidated Financial Statements of the Corporation include the accounts of all subsidiaries of the Corporation. (2) Includes approximately 8 subsidiaries and 4 operating divisions within which it carries on its cigar manufacturing and distribution business, and approximately 12 assumed names in which it does business. (3) Includes approximately 5 subsidiaries utilized to carry on certain aspects of its real estate development business. (4) Includes approximately 4 subsidiaries utilized to carry on certain aspects of its wholesale distribution business. (5) Includes Gilbreth International Corporation, a wholly-owned subsidiary of the Corporation, which carries on its plastic shrink film and labeling systems business. CONSUMER PRODUCTS GENERAL CIGAR CO., INC. Manufacturing and marketing cigars, growing wrapper tobacco and distributing disposable lighters. THE ELI WITT COMPANY Wholesaling tobacco products, candy, groceries, food, health and beauty aids and general merchandise. NURSERY PRODUCTS IMPERIAL NURSERIES, INC. Growing plants which are sold principally to garden centers and mass merchandisers and operating horticultural distribution centers which sell principally to landscapers. INDUSTRIAL PRODUCTS CMS GILBRETH PACKAGING SYSTEMS, INC. Manufacturing and marketing of packaging and labeling systems, including plastic shrink film labels and tamper-evident seals, and packaging machinery to apply them. REAL ESTATE CULBRO LAND RESOURCES, INC. Building and managing commercial and industrial properties and developing residential subdivisions on real estate owned by the Corporation in Connecticut and Massachusetts. 387 PAS CORP. Owning and managing a commercial office building in New York City. - ------------------------------------------------------------------------------- QUARTERLY DATA ON COMMON SHARES Following are the high and low prices of the common shares of Culbro Corporation in 1993 and 1992 as traded on the New York Stock Exchange. - ------------------------------------------------------------------------------- SELECTED FINANCIAL DATA - ------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS LIQUIDITY AND CAPITAL RESOURCES The net cash provided by operations principally reflects the liquidation of excess cigarette inventories at The Eli Witt Company ("Eli Witt"), Culbro Corporation's (the "Corporation") subsidiary in the wholesale distribution business. At year end 1992, there was a substantial amount of excess cigarette inventory on hand that was purchased in connection with cigarette manufacturers' purchase incentive programs and price increases. That excess cigarette inventory was liquidated during the first half of 1993 and not replaced because cigarette manufacturers significantly reduced purchase incentive programs. Cash generated from the excess cigarette inventory reduction was partially offset by repurchasing previously sold yet uncollected accounts receivable under the Corporation's accounts receivable sales agreement. This agreement was terminated in connection with Eli Witt's separate financing concurrent with its acquisition of Certified Grocers of Florida, Inc. ("Certified Grocers") on February 19, 1993 (see below). Investing activities reflect cash used for capital expenditures and the acquisition of Certified Grocers, partially offset by proceeds received upon completion of the Take-out Agreement with Moll PlastiCrafters. The Corporation's financing activities reflect the repayment of debt, including notes payable, from the cash generated by the sale of the excess cigarette inventory on hand at the beginning of the year. Also included in the repayment of debt is the refinancing of the debt assumed from Certified Grocers, and a $12.5 million prepayment of the Corporation's 9.7% Senior Notes. On February 19, 1993, Eli Witt acquired Certified Grocers and, concurrent with the acquisition, entered into a $125 million Credit Agreement ("Eli Witt Credit Agreement") with a syndicate of banks to separately finance its business. Consequently, the cash flow of Eli Witt is no longer available to the Corporation and its other subsidiaries. The Eli Witt Credit Agreement provides committed financing through February, 1998 and includes a $30 million term loan, a $45 million revolving facility for working capital and general business purposes and a $50 million revolving facility for the periodic purchase of excess cigarette inventories to take advantage of manufacturers' purchase incentive programs. In connection with the acquisition, Eli Witt paid $87.7 million to the Corporation, which included a special cash dividend and the repayment of Eli Witt's intercompany debt. The Corporation used these proceeds to repay its existing debt, including the prepayment on its Senior Notes, and the repurchase of previously sold and uncollected accounts receivable. Concurrent with the separate financing of Eli Witt, the Corporation replaced its $90 million Credit Agreement with an $80 million Credit Agreement ("Culbro Credit Agreement") which provides committed financing through June 1996 to the Corporation and its other subsidiaries. The commitment under the Culbro Credit Agreement will be reduced to $75 million in June 1994 and to $65 million in September 1995. In March 1993, the Corporation and Eli Witt entered into interest rate swap agreements to convert variable rate debt under the Culbro and Eli Witt Credit Agreements into fixed rate debt. The swap agreements converted a total of $50 million of variable rate debt under Culbro's Credit Agreement to fixed rate debt at an average rate of 6.30% for three years. The swap agreements entered into by Eli Witt range from two to - ------------------------------------------------------------------------------- three years and converted a total of $60 million of variable rate debt under the Eli Witt Credit Agreement to fixed rate debt at an average rate of 7.25%. In November 1993, the Corporation and Eli Witt entered into a letter of intent with NCC L.P. ("NCC"), a limited partnership engaged in the wholesale distribution business, whereby Eli Witt would purchase the net assets of NCC's southern divisions in exchange for Eli Witt common stock. Additionally, a partner of NCC will purchase, for $12 million, newly issued preferred stock of the Corporation with a stated value of $15 million, exchangeable into Series B preferred stock of Eli Witt currently held by the Corporation. The NCC partner will also purchase $3 million of subordinated notes from Eli Witt at face value. This proposed transaction is subject to completion of a definitive agreement, financing arrangements, and the delivery of certain amounts of net assets at closing by NCC and Eli Witt. In January 1994, the Corporation obtained a $5 million mortgage on certain equipment. The proceeds were used to reduce the amount outstanding under the Culbro Credit Agreement. The mortgage has a term of 10 years, bears interest at 7.25% per annum and has a balloon payment of $1.2 million at termination. Management believes that the Corporation's cash flow from operations will need to be supplemented by proceeds generated from other transactions to meet operating and capital requirements and scheduled debt repayments. Management is pursuing certain alternatives and expects to conclude agreements that will generate the necessary funds. Over the long-term, management will seek to maintain a level of indebtedness which is commensurate with the Corporation's earnings and cash flow. RESULTS OF OPERATIONS 1993 COMPARED TO 1992 The 1993 net loss was due to the cumulative effect of the Corporation's adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which resulted in a net charge of $9.2 million. Income before the accounting change in 1993 declined from the prior year, principally reflecting higher interest expense and lower operating profit in the consumer products segment (excluding the effect of certain nonrecurring charges recorded in this segment in 1992), partially offset by higher operating profit in the industrial products segment. Operating profit was not materially different in 1993 as compared to 1992 in the nursery products and real estate segments. In the consumer products segment, net sales and other revenue increased primarily due to Eli Witt's acquisition of Certified Grocers near the end of the first quarter. Excluding the effect of the nonrecurring charges recorded in the prior year, which included a restructuring charge of $3.5 million at Eli Witt and a relocation charge of $1.0 million at General Cigar Co., Inc. ("General Cigar"), operating profit in the consumer products segment declined, due to lower operating profit at Eli Witt, while operating profit at General Cigar was substantially unchanged. Eli Witt's operating profit was negatively impacted by competitive pricing pressures, which reduced gross margins, and lower profit from inventory price appreciation on excess cigarettes purchased in anticipation of manufacturers' price increases. Additionally, gross profit was negatively affected when cigarette manufacturers reduced prices on their premium cigarette brands by approximately 25% during the year and curtailed purchase incentive programs. In the fourth quarter, Eli Witt adjusted its pricing to customers to partially compensate for these effects. At General Cigar, the effect of increased net sales of cigars was substantially offset by lower sales of Connecticut shade wrapper tobacco, due to a further reduction in demand by foreign cigar manufacturers. The increased net sales of cigars in 1993 reflected price increases and higher volume of premium cigar sales partially offset by lower volume of nonpremium cigar sales. In the industrial products segment, operating profit at CMS Gilbreth Packaging Systems, Inc. ("CMS Gilbreth") increased in 1993 due to higher net sales and improved gross margins. CMS Gilbreth's higher net sales reflected sales volume increases for both packaging materials and machinery. The improved gross margins resulted mainly from continued manufacturing improvements in the production of packaging materials. Operating profit in the real estate segment was substantially unchanged as higher profit in the Connecticut real estate business, Culbro Land Resources, Inc. ("CLR") was offset by the lower results in the Corporation's New York office building, due to the full year effect of 1992 lease expirations. The higher profit at CLR principally reflected higher gains on sales of both commercial and residential properties. The Corporation's equity loss from investees was lower in 1993 because the prior year's results included the loss on the disposition of the Corporation's 25% equity investment in Moll PlastiCrafters, a transaction that generated cash of approximately $5 million. Results attributed to the Corporation's remaining equity investment, the 25% ownership in Centaur Communications Limited ("Centaur"), a publishing company in the United Kingdom, were lower after excluding a 1992 gain related to a sale of shares by Centaur. The higher interest expense reflected several factors, including the effect of the additional debt assumed in the acquisition of Certified Grocers and the termination of the accounts receivable sales agreement. These were partially offset by lower borrowings in 1993 for the purchase of excess cigarette inventories because of the reduction of these purchases in anticipation of manufacturers' price increases and purchase incentive programs, and the effect of the prepayment of the Corporation's 9.7% Senior Notes. Fees on sales of accounts receivable declined due to the termination of the accounts receivable sales agreement near the end of the first quarter. In 1992, the accounts receivable sales agreement was in effect the entire year. - ------------------------------------------------------------------------------- The higher effective tax rate reflects the effect of certain tax liability adjustments on the 1992 income tax provision and the effect of higher state taxes in the current year as a result of a change in the mix of pretax income. 1992 COMPARED TO 1991 1992 net income decreased as compared to 1991 due principally to the comparatively lower cost of sales in 1991 in the wholesale distribution business. The liquidation of LIFO inventories in that year reduced cost of sales in that business by approximately $17 million. There was no liquidation of LIFO inventories in 1992. In 1992, the Corporation incurred several nonrecurring charges, which, in total, were slightly higher than nonrecurring charges in the previous year. The 1992 results included a $3.5 million pretax restructuring charge for branch closings and the curtailment of benefits under the Eli Witt Pension Plan in connection with Eli Witt's acquisition of Certified Grocers. Other nonrecurring items in 1992 included a loss of approximately $900,000 on the Take-out Agreement with Moll PlastiCrafters and approximately $1 million of expenses related to the relocation of General Cigar Company headquarters from the Corporation's New York office building to its office complex north of Hartford, Connecticut. These charges were partially offset by other income of approximately $900,000 reflecting the proceeds from the favorable outcome of a litigation matter to recover certain expenses from the former owner of Gilbreth International, one of the Corporation's subsidiaries in the packaging and labeling systems business. In 1991, nonrecurring items reflected principally a loss of $3.3 million on the sale of Moll Tool. Operating profit in the consumer products segment declined due principally to the effect of the 1991 liquidation of LIFO inventories in the wholesale distribution business discussed above, and lower operating profit in the cigar business. In the wholesale distribution business, excluding the effect of the liquidation of LIFO inventories on prior year's results, operating profit increased, due principally to increased volume and higher gross margins. The increased volume reflected new business obtained in 1992 and the full year effect of new business obtained in 1991. The increase in gross margins principally reflected lower merchandise costs resulting from manufacturers' purchase incentive programs on cigarettes. Operating profit in the cigar business declined due to lower sales volume of Connecticut shade wrapper tobacco, resulting from increased competition and reduced demand by foreign cigar manufacturers, the principal market for sales of its wrapper tobacco. Revenue from sales of cigars increased, as higher prices more than offset a decline in volume, which has occurred in this industry over the past several years. The operating profit in the industrial products segment reflected the substantially improved results of the packaging and labeling systems business, which incurred an operating loss in 1991. The improved results were due to increased volume, higher margins, and lower operating expenses. The increased volume reflected higher sales of both packaging materials and machinery, including increased machine sales in international markets. Margins increased due principally to lower manufacturing costs of packaging materials resulting from the implementation of a manufacturing cost reduction program in 1992. The reduction in operating expenses reflected a lower headcount and increased efficiencies. The operating profit in the nursery products segment, as compared to an operating loss in the prior year, was due to increased volume and lower operating expenses, partially offset by the effect of lower margins. Margins declined due to pricing pressures caused by the weakened economy and an oversupply of product in the marketplace. Operating profit in the real estate segment declined due principally to lower profit from the Corporation's New York office building, due to the expiration of certain leases and the renewal of other leases at lower rates. Operating profit in the Corporation's Connecticut real estate business, Culbro Land Resources, was slightly lower than the prior year. This business continues to be adversely affected by the weak northeast real estate market which has depressed both commercial lease rates and residential home sales. Operating profit in 1992 included a substantial land sale to a bottler of The Pepsi Cola Company, which was the first major new entrant in the New England Tradeport, the Corporation's planned 600 acre industrial park located north of Hartford. Total revenue in the real estate segment declined, reflecting the transition from home builder to the lot sales program at Culbro Homes in 1992 and lower revenue from the New York office building, partially offset by the land sale in the New England Tradeport. Equity in the net loss of investees in 1992 reflected principally the loss on the disposition of the Corporation's 25% equity investment in Moll PlastiCrafters as a result of the Take-out Agreement previously discussed. Results from the Corporation's equity investment in Centaur improved due principally to the effect of asset write-offs taken by that Company in the prior year. Interest expense, net, decreased due to several factors. The more significant factors include overall lower rates, the full year effect of the $19.5 million prepayment of the 9.7% Senior Notes in August 1991, interest income on a tax refund received in the current year and the accounts receivable sales program being in effect the entire year compared to six months in 1991. The lower effective tax rate in 1992 reflects the effect of tax liability adjustments and foreign subsidiary results. - ------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF OPERATIONS AND RETAINED EARNINGS CONSOLIDATED STATEMENT OF CHANGES IN COMMON STOCK AND CAPITAL IN EXCESS OF PAR VALUE - ------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS - ------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET - ------------------------------------------------------------------------------- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) BASIS OF CONSOLIDATION The consolidated financial statements reflect the accounts of all of Culbro Corporation's (the "Corporation") subsidiaries. The Corporation accounts for its approximately 25% investment in Centaur Communications Limited ("Centaur") on the equity method. Approximately $6,550, representing the excess of the cost of the Corporation's investment over the book value of its equity in Centaur, is being amortized on a straight-line basis over 40 years. The Corporation accounts for its investments in real estate joint ventures on the equity method. FISCAL YEAR The Corporation's fiscal year ends on the Saturday nearest November 30. Fiscal 1993, 1992 and 1991 ended on November 27, 1993, November 28, 1992 and November 30, 1991, respectively, and each year included 52 weeks. INVENTORIES Inventories are stated at the lower of cost or market. The first-in, first- out (FIFO) or average cost method is used to determine the cost of all inventories, except for The Eli Witt Company ("Eli Witt"), the Corporation's subsidiary in the wholesale distribution business, which uses the last-in, first-out (LIFO) method. Eli Witt's inventories consist mainly of cigarettes, tobacco, confectionery, grocery and paper products. The Corporation believes that the LIFO method results in a better matching of the costs and revenues of Eli Witt. Raw materials include tobacco in the process of aging and landscape nursery stock, a substantial amount of which will not be used or sold within one year. It is the practice in these industries to include such inventories in current assets. Raw materials also include tobacco in bond which is subject to customs duties payable upon withdrawal from bond. Following industry practice, the Corporation does not include such duties in inventories until paid. PROPERTY AND EQUIPMENT Property and equipment are carried at cost. Depreciation is determined on a straight-line basis over the estimated useful asset lives for financial reporting purposes and principally on accelerated methods for tax purposes. Upon the sale or retirement of property and equipment, the cost and related accumulated depreciation are removed from the accounts and the difference between the book value and any proceeds realized on the sale is charged or credited to income. Expenditures for maintenance and repairs are charged to income as incurred; renewals and improvements are capitalized. INTANGIBLE ASSETS Intangible assets include principally the excess of the costs of businesses acquired over the fair value of their net tangible assets and are amortized on a straight-line basis principally over 40 years. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Effective at the beginning of the 1993 fiscal year, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires the Corporation to recognize postretirement benefits on the accrual basis. The adoption of SFAS No. 106 resulted in a net charge for the cumulative effect of the accounting change of $9,177, or $2.13 per common share (see Note 8). MINORITY INTEREST IN SUBSIDIARY The minority interest in subsidiary included in the Corporation's balance sheet reflects the Series A preferred stock of Eli Witt issued in connection with the 1993 acquisition of Certified Grocers of Florida, Inc. (see Note 1). The Series A preferred stock was recorded at its estimated fair market value at the time of issuance and is being accreted to its face value under the interest method over approximately six years. INCOME TAXES The Corporation uses the liability method of accounting for income taxes in accordance with SFAS No. 109 "Accounting for Income Taxes." EARNINGS PER SHARE Earnings per share of common stock are based on the weighted average number of shares of common stock outstanding considering the dilutive effect of outstanding stock options. FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosure About Fair Values of Financial Instruments," requires disclosure of the fair value of certain financial instruments. For cash equivalents, accounts receivable, accounts payable and accrued liabilities, the amounts included in the financial statements reflect their fair value because of the short-term maturity of these instruments. The fair value of the Corporation's debt instruments is discussed in Note 4. - ------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 1 -- ACQUISITIONS CERTIFIED GROCERS ACQUISITION On February 19, 1993, pursuant to an Agreement and Plan of Merger (the "Agreement") dated November 3, 1992, Culbro Corporation's (the "Corporation") subsidiary in the wholesale distribution business, The Eli Witt Company ("Eli Witt") acquired Certified Grocers of Florida, Inc. ("Certified Grocers"), an independent full service grocery wholesale distribution company which serviced retail outlets in Florida and Georgia. Originally a cooperative, Certified Grocers was a retailer-owned grocery wholesaler that operated from a 700,000 square foot warehouse facility in Ocala, Florida. The acquisition was accounted for as a purchase and the Corporation's results subsequent to the acquisition date include the results of Certified Grocers. Approximately $1.8 million of goodwill from the acquisition was recorded, representing the excess of the fair value of Eli Witt's Series A preferred stock issued and other costs and expenses of the acquisition over the fair value of the net assets acquired. The goodwill is being amortized over twenty-five years. Under the terms of the Agreement, each share of Certified Grocers' common stock was converted into one share of newly issued nonvoting Eli Witt Series A preferred stock. The Series A preferred stock was recorded at its estimated fair value of $9.3 million when it was issued and is being accreted to its stated value of $15.8 million using the interest method. Dividends on the Series A preferred stock are cumulative, and are payable quarterly beginning in May, 1997. The dividend rate is 4% per annum of the stated value for the first year, 8% per annum of the stated value for the second year and thereafter adjusts quarterly to 2% above the interest rate on seven year U.S. Treasury Notes. The adjustable dividend rate may not be less than 7% per annum nor more than 12% per annum. Payment of dividends on the Series A preferred stock may be offset against certain contingent liabilities if they are actually incurred, or reduced if default conditions under supply agreements (see below) arise. The Series A preferred stock is redeemable at the option of Eli Witt, in whole or in part, at any time at the stated value plus accrued and unpaid dividends. A redemption of not less than $10 million of the Series A preferred stock will be required if the Corporation's ownership in Eli Witt falls below 50% or other prohibited transactions, as defined, occur. Former Certified Grocers shareholders who entered into supply agreements with Eli Witt, in which they agreed to purchase minimum quantities of merchandise from Eli Witt for a three-year period commencing with the acquisition, received 300,000 shares of Class C common stock, which represented 15% of the issued and outstanding common stock of Eli Witt after the acquisition. Accordingly, the Corporation's ownership of Eli Witt's common stock was reduced to 85%. Holders of Class C common stock are entitled, voting as a separate class, to elect two members of the Board of Directors of Eli Witt. As a result of this acquisition, Eli Witt is being financed separately from the Corporation and its other subsidiaries; therefore, Eli Witt's cash flow is no longer available to the Corporation and its other subsidiaries. Eli Witt obtained a $125 million Credit Agreement to finance its business (see Note 4). In connection with the acquisition, Eli Witt repaid its intercompany debt to the Corporation and also paid the Corporation a cash dividend. These payments totaled $87.7 million. The dividend amount was equal to Eli Witt's consolidated book value, as defined, at the acquisition date less $25 million. The Corporation used the proceeds from these payments to reduce existing debt, including a $12.5 million prepayment on its 9.7% Senior Notes, and to repurchase all previously sold yet uncollected receivables under its accounts receivable sales agreement. Eli Witt used the initial proceeds from its new credit facility to make these payments and refinance Certified's debt of approximately $24.3 million that was assumed in the acquisition. The Corporation also holds a $10 million mortgage on a warehouse previously owned by Certified Grocers. The mortgage will be repaid upon receipt of a mortgage from a third-party lender. In connection with the acquisition, Eli Witt also declared a special dividend to the Corporation in the form of its Series B preferred stock, with a stated value of $15 million. Dividends on the Series B preferred stock are cumulative, and accrue from the acquisition date at the rate of 10% per annum of the stated value. There were no dividend payments from Eli Witt to the Corporation in 1993. The Series B preferred stock is subject to mandatory redemption five years and six months after the acquisition date at a price equal to the stated value plus accrued dividends. The holders of Series B preferred stock are entitled to vote, as a class, on all matters on which holders of common stock (other than holders of Class C common stock) have the right to vote. - ------------------------------------------------------------------------------- Unaudited pro forma condensed consolidated results of operations of the Corporation, assuming the acquisition of Certified Grocers by Eli Witt had occurred at the beginning of the 1993 and 1992 fiscal years, are as follows: This unaudited pro forma information has been presented for comparative purposes only and may not necessarily reflect the combined results of operations had the acquisition actually taken place at the beginning of the respective years. PENDING ACQUISITION On November 24, 1993, the Corporation and Eli Witt entered into a letter of intent to purchase the net assets of the southern divisions of NCC L.P. ("NCC"), a limited partnership engaged in the wholesale distribution business. Estimated annual revenue of NCC's southern divisions is approximately $600 million. As proposed, Eli Witt would acquire the net assets of NCC's southern divisions in exchange for 35% of the outstanding common stock of Eli Witt after completion of this transaction. Concurrent with the acquisition, a partner of NCC will purchase, for $12 million, newly issued preferred stock of Culbro with a face value of $15 million, exchangeable into the Series B preferred stock of Eli Witt currently held by the Corporation. In connection with the foregoing, the NCC partner will also purchase, at face value, $3 million of newly issued convertible subordinated notes of Eli Witt. If this transaction is completed as presently structured, the Corporation's ownership in Eli Witt's common equity would be reduced to approximately 53%. This proposed transaction is subject to completion of a definitive agreement, financing arrangements, and the delivery of certain amounts of net assets by Eli Witt and NCC at closing. NOTE 2 -- BUSINESS DISPOSITION In 1991, the Corporation sold its injection molded plastics business, Moll Tool & Plastics Corporation ("Moll Tool"), to a limited partnership ("Moll PlastiCrafters") formed by the consolidation of the Moll Tool business and a smaller injection molded plastics business. A $3.3 million pretax loss on the sale was reflected in the Corporation's 1991 consolidated statement of operations. Proceeds from the sale included cash, notes receivable of $6 million, a 25% interest in Moll PlastiCrafters, and assumption of $6.7 million of capital lease obligations by Moll PlastiCrafters (see Note 13). On December 17, 1992, the Corporation completed a Take-out Agreement with Moll PlastiCrafters, whereby the Corporation received cash of approximately $5 million and a note for $750 for the outstanding notes receivable. As part of the agreement, the Corporation relinquished its 25% equity interest in Moll PlastiCrafters. A loss of $897 on the relinquishment of the Corporation's equity investment was included in the Corporation's 1992 consolidated statement of operations. NOTE 3 -- SALES OF ACCOUNTS RECEIVABLE In 1991, the Corporation entered into a three-year agreement with a major bank to sell, without recourse, up to $35 million of undivided fractional interests in a designated pool of receivables of the Corporation's consumer products businesses. As receivables were collected, new receivables were sold to replace them. The Corporation paid certain fees at the time of each sale. As a result of the acquisition of Certified Grocers and the separate financing obtained by Eli Witt, the agreement to sell accounts receivable was terminated and all previously sold yet uncollected accounts receivable were repurchased by the Corporation. NOTE 4 -- LONG-TERM DEBT AND CREDIT ARRANGEMENTS Long-term debt includes: - ------------------------------------------------------------------------------- The annual payment requirements under the terms of all the above loans, excluding the Culbro Corporation Credit Agreement ("Culbro Credit Agreement"), the revolving loans under The Eli Witt Company Credit Agreement ("Eli Witt Credit Agreement") and capital leases, for the years 1994 through 1998 are $12,852, $11,724, $16,095, $15,796 and $10,730, respectively. During 1992, prior to the separate financing of Eli Witt, the Corporation obtained additional temporary short-term credit facilities to enable Eli Witt to purchase additional cigarette inventories to take advantage of profit opportunities in connection with manufacturers' quarterly purchase incentive programs. These additional facilities included a $65 million facility obtained on June 30, 1992, which was repaid August 27, 1992 and a $40 million facility obtained on September 30, 1992, which was repaid February 1, 1993. The $40 million was included in notes payable on the Corporation's balance sheet at November 28, 1992. On February 19, 1993, in connection with the acquisition of Certified Grocers (see Note 1), Eli Witt entered into a $125 million Credit Agreement with a syndicate of banks. The agreement is secured by inventories and accounts receivable and provides Eli Witt with committed financing through February 1998 at market rates, principally LIBOR plus a margin of 2 3/4%. The Eli Witt Credit Agreement, which is nonrecourse to the Corporation, includes a $30 million term loan, a $45 million revolving credit facility for working capital and general business purposes, and a $50 million revolving credit facility for the purchase of excess cigarette inventories in connection with manufacturers' purchase incentive programs and price increases. In lieu of compensating balance requirements, Eli Witt pays a commitment fee of 1/2 of 1% per annum on the unused available balance of the revolving credit facilities. The Eli Witt Credit Agreement prohibits payment of dividends on its common stock, places limitations on indebtedness, capital expenditures and significant asset sales, as defined, and requires Eli Witt to maintain a minimum fixed charge coverage, net worth and working capital. The Eli Witt Credit Agreement requires proceeds from substantial asset sales not in the ordinary course of business to be used to reduce the commitments under the agreement. Additionally, Eli Witt's cash flow is no longer available to the Corporation and its other subsidiaries. Concurrent with the acquisition of Certified Grocers and the related financing obtained by Eli Witt, the Corporation's $90 million Credit Agreement was replaced with an $80 million Credit Agreement. The new Culbro Credit Agreement terminates in June 1996 (the commitment will be reduced to $75 million in June 1994 and to $65 million in September 1995) and provides committed financing at market rates, principally LIBOR plus a margin of 1 1/2 %. In lieu of compensating balance requirements, the Corporation pays a commitment fee of 1/2 of 1% per annum on the unused available balance. The Culbro Credit Agreement is collateralized by the stock of the Corporation's operating subsidiaries and includes limitations on indebtedness, capital expenditures, investments and other significant transactions, as defined. Proceeds from significant asset sales not in the ordinary course of business are required to be used to reduce commitments under the Culbro Credit Agreement and the Corporation's 9.7% Senior Notes. The Culbro Credit Agreement permits dividends to be paid subsequent to 1994, provided the Corporation's results exceed certain requirements, as defined. In March 1993, the Corporation and Eli Witt entered into interest rate swap agreements with major banks as a hedge against interest rate exposure on variable rate debt. The Corporation entered into an interest rate swap agreement which effectively converted $30 million of variable rate debt under the Culbro Credit Agreement into fixed rate debt at 6.24% for three years. The Corporation also entered into an interest rate swap agreement to convert an additional $20 million of variable rate debt under the Culbro Credit Agreement to fixed rate debt at 6.39% for two years. This agree-ment replaced a $20 million interest rate swap agreement which expired in September 1993. Eli Witt entered into several interest rate swap agreements which range from two to three years, and converted a total of $60 million of variable rate debt under the Eli Witt Credit Agreement to fixed rate debt at an average rate of 7.25%. Management believes that risk of loss due to the nonperformance by the counter parties of the swap agreements is minimal. In January 1994, the Corporation obtained a $5 million mortgage on certain equipment. The proceeds were used to reduce the amount outstanding under the Corporation's Credit Agreement. The mortgage bears interest at 7.25% per annum and has a term of 10 years, with a balloon payment of $1.2 million due at termination. Management believes that the overall value of debt as stated on its November 27, 1993 balance sheet approximates its fair market value. Based on the estimated fair market value of the interest rate swap agreements in effect at November 27, 1993, the Corporation and Eli Witt would be required to pay a total of $1.1 million to terminate such agreements. NOTE 5 -- SHAREHOLDERS' EQUITY EMPLOYEES STOCK OPTION PLANS The 1992 Stock Plan (the "1992 Plan") and the 1991 Employees Incentive Stock Option Plan (the "1991 Plan") for officers and key employees, made available 300,000 and 210,000 shares of common stock, respectively, for purchase at prices equal to the fair market value at date of grant. The options outstanding under these plans may be exercised as Incentive Stock Options, which under current tax laws do not provide any tax deduction to the Corporation. Options may be - ------------------------------------------------------------------------------- exercised over a period ending not later than eight years from the date of grant. The exercise period for each grant is determined by the Corporation's Compensation Committee. The 1983 Employees Incentive Stock Option Plan (the "1983 Plan") expired in 1993. At November 27, 1993, a total of 220,100 shares under the 1992 Plan were available for future grant. There are no shares available for future grant under the 1991 Plan. Of the options outstanding at November 27, 1993, a total of 146,400 may be exercised as stock appreciation rights. The options granted under the 1992 and 1991 Plans are not exercisable until three years from the date of grant. Transactions under the 1992, 1991 and 1983 Plans are summarized as follows: NONEMPLOYEE DIRECTORS STOCK OPTION PLAN The 1992 Stock Option Plan for Nonemployee Directors made available 45,000 shares of common stock for purchase at prices equal to the fair market value at date of grant. Options canceled become available for future grant. In 1993, the total of 14,000 options granted to nonemployee directors at a price of $16.69 per share are not exercisable until three years from the date of grant. Accordingly, 31,000 shares remained available for future grant at November 27, 1993. Options may be exercised over a period ending not later than eight years from the date of grant. The options outstanding will be exercised as Incentive Stock Options. None of the options outstanding at November 27, 1993 may be exercised as stock appreciation rights. PREFERRED STOCK The Corporation has 1,000,000 authorized but unissued shares of preferred stock, par value $1. NOTE 6 -- LEASE COMMITMENTS The Corporation and its subsidiaries have noncancellable leases relating principally to manufacturing facilities and distribution equipment. CAPITAL LEASES Future minimum lease payments under capital leases and the present value of such payments as of November 27, 1993 were: - ------------------------------------------------------------------------------- The present value of future minimum payments under capital leases of Eli Witt was $1,946 at November 27, 1993. At November 27, 1993, property and equipment included capital leases amounting to $7,114 (1992 - $8,070), net of accumulated depreciation of $10,032 (1992 - $9,591). Depreciation expense relating to capital leases was $1,906 in 1993 (1992 - $2,273; 1991 - $2,831). OPERATING LEASES Future minimum rental payments under noncancellable leases as of November 27, 1993 were: - ------------------------------------------------------------------------------- Future minimum rental payments under non-cancellable operating leases of Eli Witt was $15,408 as of November 27, 1993. Total rental expenses for all operating leases in 1993 was $4,042 (1992 - $2,893; 1991 - $2,967). - ------------------------------------------------------------------------------- NOTE 7 -- PENSION PLANS The Corporation and its Eli Witt subsidiary have noncontributory defined benefit pension plans covering certain employees. The plans provide benefits based on employees' years of service and compensation. Contributions to the plans are made in accordance with the provisions of the Employee Retirement Income Security Act. In 1992, in connection with the anticipated acquisition of Certified Grocers, management curtailed benefits under the Eli Witt Pension Plan. Accordingly, a charge of $1,415 was included in the restructuring charge related to Eli Witt in the Corporation's 1992 consolidated statement of operations. Pension expense included in the consolidated results of operations was as follows: At November 27, 1993 and November 28, 1992, the status of the plans was as follows: Discount rates of 7.5% and 8% were used to compute the present value of pension benefits at November 27, 1993, and November 28, 1992, respectively. A 5% rate of increase in future compensation levels was used to estimate the projected pension obligations at both November 27, 1993, and November 28, 1992. The expected rate of return on pension plan assets in 1993, 1992 and 1991 was estimated at 9% representing the average long-term rate expected from investment of the plans' assets. NOTE 8 -- OTHER POSTRETIREMENT BENEFITS The Corporation provides health and life insurance benefits to certain retired employees. Effective at the beginning of the 1993 fiscal year, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement required the Corporation to record a liability for the present value of its unfunded accumulated postretirement benefit obligation and recognize postretirement benefits on the accrual basis. Previously, the Corporation expensed the cost of these benefits when paid. The Corporation elected to immediately recognize the cumulative effect of the change in accounting for postretirement benefits and record its accumulated liability, measured as of the beginning of the current fiscal year. A net charge of $9.2 million ($2.13 per share) reflecting the accrued postretirement benefit obligation of $14.8 million, net of a deferred tax benefit of $5.6 million, was recorded in the Corporation's 1993 statement of operations. The effect of adopting SFAS No. 106 on 1993 operating profit was not material. The components of the 1993 expense for such nonpension postretirement benefits were as follows: Nonpension postretirement benefits expense, recorded on a cash basis, were $1,100 and $1,300 in 1992 and 1991, respectively. At November 27, 1993 the actuarial and recorded liabilities for such postretirement benefits, none of which have been funded, were as follows: ACCUMULATED POSTRETIREMENT BENEFIT OBLIGATION: - ------------------------------------------------------------------------------- The accumulated postretirement benefit obligation was determined using a discount rate of 7.5%. Because the Corporation's obligation for medical benefits is fixed, any increase in the medical cost trend would have no effect on the accumulated postretirement benefit obligation, service cost or interest cost. The adoption of SFAS No. 106 did not have an adverse effect on the Corporation's cash flow because the Corporation continues funding the cost of postretirement benefits as paid. NOTE 9 -- INCOME TAXES The provision for income taxes is summarized as follows: Income before income taxes in 1993, 1992 and 1991 was substantially from domestic U.S. operations. The reasons for the differences between the United States statutory income tax rate and the effective rates are shown in the following table: Net operating loss carryforwards of $5,797 are available to offset future taxable income through 2007. In addition, preacquisition net operating loss carryforwards totaling $11,599, which expire substantially in 2006, are available to offset future taxable income of the related subsidiaries. The significant components of the net deferred tax liabilities are as follows: NOTE 10 -- SUPPLEMENTAL FINANCIAL STATEMENT INFORMATION NET SALES AND OTHER REVENUE Excise taxes paid on cigar and cigarette sales in 1993 amounted to $135,028 (1992 - $104,414; 1991 - $106,363) and are included in net sales and other revenue and cost of goods sold. OTHER EXPENSE, NET Other expense, net, in the 1992 consolidated statement of operations reflected $1,040 to relocate the headquarters of the Corporation's subsidiary, General Cigar Co., Inc. from New York to a building in the Corporation's office complex north of Hartford. Also included in 1992 was other income of $918 that represented the proceeds from the favorable settlement of a litigation matter to recover certain expenses in connection with the 1988 acquisition of Gilbreth International. Other expense in the 1991 consolidated statement of operations reflected the settlement of certain lease obligations of a former subsidiary in the wholesale distribution business. EQUITY IN NET LOSS OF INVESTEES The Corporation's equity in net loss of investees in the 1993 and 1991 consolidated statement of operations related to the Corporation's investment in Centaur Communications Limited ("Centaur"). Equity in net loss of investees in the 1992 consolidated statement of operations reflected an equity loss of $897 on the Corporation's Take-out Agreement with Moll PlastiCrafters (see Note 2) and equity income from a gain recognized on the sale of shares by Centaur which more than offset the Corporation's equity in Centaur's loss. - ------------------------------------------------------------------------------- INVENTORIES Inventories consist of: The cost of Eli Witt's inventories at LIFO was $52,674 and $86,029 at November 27, 1993 and November 28, 1992, respectively. On a FIFO basis, the cost of the inventories would have been $65,975 and $101,420, respectively. Cost of sales on a FIFO basis would have been higher by $2,090 in 1993 and lower by $1,725 in 1992. At November 28, 1993, the current cost of Eli Witt's cigarette inventory was lower than the cost at the previous year end and quantities were less than at the end of the previous year, which resulted in a reduction in costs and the liquidation of LIFO inventory quantities. The effect in 1993 was to increase pretax income by $2,090. At November 30, 1991 cigarette inventory quantities were also lower than the previous year, resulting in the liquidation of LIFO inventory carried at lower cost. The effect was to increase 1991 pretax income by $17,045. The aforementioned supplemental information is presented for comparative purposes. PROPERTY AND EQUIPMENT Property and equipment consist of: ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities include trade payables of $40,785 (1992 - $28,822) and various accrued liabilities totaling $36,119 (1992 - $33,594). SUPPLEMENTAL CASH FLOW INFORMATION Cash paid during the year for: - ------------------------------------------------------------------------------- NOTE 11 -- INDUSTRY SEGMENT INFORMATION - ------------------------------------------------------------------------------- NOTE 12 -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Summarized quarterly financial data are presented below. At November 27, 1993, the effect of manufacturers' price reductions on cigarettes, valued on LIFO, and lower quantities of cigarette inventories on hand than at the end of the previous year, resulted in lower cost of sales of approximately $2.1 million, of which approximately $1.4 million was reflected in the fourth quarter. The net loss and net loss per common share in the 1993 first quarter have been restated to reflect the adoption of SFAS No. 106 "Employees' Accounting for Postretirement Benefits Other Than Pensions" effective at the beginning of fiscal 1993. The 1992 fourth quarter includes the restructuring charge of $3.5 million related to the acquisition of Certified Grocers (see Note 1) and a charge of $897 for the relinquishment of the Corporation's 25% equity investment in Moll PlastiCrafters as a result of the December 17, 1992 Take-out Agreement with Moll PlastiCrafters (see Note 2). NOTE 13 -- COMMITMENTS AND CONTINGENCIES In connection with the sale of Moll Tool in 1991, the Corporation remains liable on certain capital lease obligations of approximately $5.6 million assumed by the purchaser of Moll Tool. The leases are collateralized by certain machinery and a manufacturing facility. Patent litigation involving the Corporation's subsidiary, Trine Manufacturing Company ("Trine"), in the labeling machinery business, was favorably settled in 1993. Trine and the previous owner of the Trine business continue as defendants in an action by a customer of Trine for indemnification resulting from its own settlement of a related patent action. While it is impossible to predict the outcome of this indemnification action and any similar actions which may be filed, management believes that the outcome of this action and any similar such actions will not have a material adverse effect upon the financial condition of the Corporation. - ------------------------------------------------------------------------------- REPORT OF MANAGEMENT Management is responsible for the accompanying consolidated financial statements, which are prepared in accordance with generally accepted accounting principles. In management's opinion, the consolidated financial statements present fairly the Corporation's financial position, results of operations and cash flows. The Corporation maintains a system of internal accounting procedures and controls intended to provide reasonable assurance, at appropriate cost, that transactions are executed in accordance with proper authorization, are properly recorded and reported in the financial statements, and that assets are adequately safeguarded. The Corporation's internal auditors continually evaluate the adequacy and effectiveness of this system of controls. The Audit Committee of the Board of Directors is comprised solely of outside directors and is responsible for overseeing and monitoring the quality of the Corporation's accounting and auditing practices. The Audit Committee meets regularly with management, the internal auditors and the independent accountants to discuss audit activities, internal controls and financial reporting matters. The internal auditors and the independent accountants have full and free access to the Audit Committee. To foster the conduct of its business in accordance with the highest ethical standards, the Corporation annually disseminates ethical guidelines, the compliance with which is monitored by senior management and the Audit Committee. The appointment of Price Waterhouse as the Corporation's independent accountants was recommended and approved by the Audit Committee and the Board of Directors, and was approved by the shareholders. Their Report is based on an examination conducted in accordance with generally accepted auditing standards, including a review of internal accounting controls and tests of accounting procedures and records. /s/ Edgar M. Cullman Edgar M. Cullman CHAIRMAN AND CHIEF EXECUTIVE OFFICER /s/ Jay M. Green Jay M. Green EXECUTIVE VICE PRESIDENT -- CHIEF FINANCIAL OFFICER AND TREASURER - ------------------------------------------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS PRICE WATERHOUSE [Logo] To the Shareholders and Directors of Culbro Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations and retained earnings, of cash flows and of changes in common stock and capital in excess of par value present fairly, in all material respects, the financial position of Culbro Corporation and its subsidiaries at November 27, 1993, and November 28, 1992, and the results of their operations and their cash flows for the fiscal years ended November 27, 1993, November 28, 1992 and November 30, 1991, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the management of Culbro Corporation; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 8 to the consolidated financial statements, the Corporation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1993. /s/ Price Waterhouse New York, New York February 21, 1994 - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ________________________ FORM 10-K ________________________ FOR FISCAL YEAR ENDED NOVEMBER 27, 1993 ITEMS 8 and 14 - INDEX TO FINANCIAL STATEMENTS AND ADDITIONAL FINANCIAL DATA ________________________ CULBRO CORPORATION ________________________________________________ CULBRO CORPORATION AND SUBSIDIARY COMPANIES Index to Financial Statements and Additional Financial Data The financial statements together with the report thereon of Price Waterhouse dated February 21, 1994, appearing on Pages 7 to 19 of the accompanying 1993 Annual Report to Shareholders, are incorporated by reference in this Form 10-K Annual Report. With the exception of the aforementioned information, and such other information specifically incorporated by reference herein, the 1993 Annual Report to Shareholders is not to be deemed filed or incorporated by reference as part of this report. The following additional financial data should be read in conjunction with the financial statements in such 1993 Annual Report to Shareholders. Schedules not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES TO THE BOARD OF DIRECTORS OF CULBRO CORPORATION Our audits of the consolidated financial statements referred to in our report dated February 21, 1994 appearing on page 21 of the 1993 Annual Report to Shareholders of Culbro Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PRICE WATERHOUSE New York, New York February 21, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 2 - 94202) of Culbro Corporation of our report dated February 21, 1994 appearing on page 21 of the 1993 Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules which appears above. /s/ PRICE WATERHOUSE New York, New York March 10, 1994 C - 1 S - 1 S - 2 S - 4 S-5

764622_1993.txt

764622_1993

1993

764622

ITEM 1. BUSINESS THE COMPANY Pinnacle West Capital Corporation (the "Company") was incorporated in 1985 under the laws of the State of Arizona and is engaged in the acquisition and holding of securities of corporations for investment purposes. The principal executive offices of the Company are located at 400 East Van Buren Street, Phoenix, Arizona 85004 (telephone 602-379-2500). The Company and its subsidiaries employ approximately 7,915 persons. Of these employees, approximately 7,050 are employees of the Company's principal subsidiary, Arizona Public Service Company ("APS"), and employees assigned to joint projects of APS where APS serves as a project manager, and approximately 865 are employees of the Company and its other subsidiaries. Other subsidiaries of the Company, in addition to APS, include SunCor Development Company ("SunCor") and El Dorado Investment Company ("El Dorado"). SunCor is engaged primarily in the owning, holding and development of real property. El Dorado is involved in the business of making equity investments in other companies. See "Business of Non-Utility Subsidiaries" in this Item for further information regarding SunCor and El Dorado. Effective December 16, 1986, the Company acquired MeraBank, A Federal Savings Bank ("MeraBank"). On January 31, 1990, MeraBank was placed in receivership, and is therefore considered a discontinued operation of the Company for financial reporting purposes. See Note 2 of the Notes to the Consolidated Financial Statements in Item 8 for information regarding the Company's $450 million cash infusion into MeraBank in settlement of claims made by certain federal agencies with respect to MeraBank. CAPITAL REQUIREMENTS. During the past three years, the Company's primary cash needs were for the repayment of principal and interest on its outstanding debt. Additional cash needs in 1993 were related to the fourth quarter restoration of common stock dividends. As a result of a restructuring of substantially all of its outstanding debt in 1990, and the prepayment of approximately $112 million, $96 million and $152 million of its long-term debt in 1991, 1992 and 1993, respectively, the Company has reduced required principal debt payments for the next three years. The Company's principal and interest payment obligations during 1994, 1995 and 1996 are expected to total approximately $129 million, $129 million and $83 million, respectively (based upon certain anticipated prepayments). See Note 6 of the Notes to the Company's Consolidated Financial Statements in Item 8 for additional information regarding the Company's and APS' outstanding long-term debt. The Company's ability to satisfy its debt service obligations is substantially dependent upon the receipt of common stock dividends from APS. The Company has in place a $40 million liquidity facility to assist the Company in meeting its debt service requirements in the event that cash flow is less than anticipated. The facility is available for principal and interest payments on the Company's outstanding debt, with a maximum of $20 million for principal payments. The terms and provisions of certain of the Company's financing agreements place severe restrictions on the Company's ability to incur additional debt, to make capital infusions into its subsidiaries (excluding APS), to make other new investments and to pay cash dividends to its shareholders unless certain conditions are met. While the debt under these financing agreements remains outstanding, the Company has agreed not to incur new debt, except generally (and with certain restrictions) for (1) borrowings to reduce, refinance or prepay existing debt and (2) borrowings under the liquidity facility discussed in the immediately preceding paragraph. The Company's ability to pay cash dividends or to make other corporate distributions is dependent upon the satisfaction of certain financial covenants. The Company restored a dividend on its common stock in the fourth quarter of 1993. In the event of a sale of all or substantially all of the assets or shares of common stock of El Dorado or SunCor, the net cash proceeds must be applied by the Company to reduce its outstanding debt. Until the Company's lenders are fully repaid, (1) any new investments by the Company in its subsidiaries (excluding APS) are generally restricted to $15 million in the aggregate and (2) any other new investments by the Company are generally restricted to $20 million in the aggregate. As of December 31, 1993, the Company had not made any such investments. As part of the Company's 1990 debt restructuring, the Company granted substantially all of its lenders a security interest in the outstanding common stock of APS pursuant to a Pledge Agreement, dated as of January 31, 1990 (the "Pledge Agreement"). At December 31, 1993, the APS common stock secured approximately $564 million of the Company's outstanding debt. Any borrowings under the Company's liquidity facility (see above) would also be secured by the APS common stock owned by the Company. Until the Company and the collateral agent under the Pledge Agreement (the "Collateral Agent") receive notice of the occurrence and continuation of an Event of Default (as defined in the Pledge Agreement), the Company is entitled to exercise or refrain from exercising any and all voting and other consensual rights pertaining to the APS common stock. As to matters other than the election of directors, the Company agreed not to exercise or refrain from exercising any such rights if, in the Collateral Agent's judgment, such action would have a material adverse effect on the value of the APS common stock. After notice of an Event of Default, the Collateral Agent would have the right to vote the APS common stock. REGULATION PUBLIC UTILITY HOLDING COMPANY The Company currently conducts no significant business activities other than investing in its subsidiaries and owns no significant assets other than the common stock of its subsidiaries. The Company and its subsidiaries are currently exempt from registration under the Public Utility Holding Company Act of 1935 (the "Holding Company Act"); however, there are limits on the extent to which the Company can diversify beyond energy-related fields without affecting its exempt status. In February 1989, the Securities and Exchange Commission (the "SEC") released for public comment a proposed rule under the Holding Company Act relating to holding companies, like the Company, that are exempt under Section 3(a)(1) of the Holding Company Act. The proposed rule, if finally adopted by the SEC in its present form, could require the divestiture of a portion of the Company's interests in non-utility businesses within a three-year period after the rule's adoption in order for the Company to maintain its Section 3(a)(1) exemption. If the Company failed to maintain this exemption, the proposed rule would require the Company to divest itself of all of its interests in non-utility businesses within the same three-year period. At this time, the Company is unable to predict whether the proposed rule will be adopted by the SEC and, if so, in what form it will be adopted. On May 1, 1990, the ACC approved the filing of a petition with the SEC requesting the SEC to revoke or modify the Company's exemption under the Holding Company Act. The SEC has the power to terminate the Company's exemption upon thirty days notice to the Company if it determines that a question exists as to whether the exemption may be detrimental to the public interest or the interests of investors or consumers. In the event of the exercise of such power by the SEC, if the Company were to file an application with the SEC during such thirty-day period requesting an exemption order, the Company's exemption would remain in place until the SEC ruled on such application. If the Company ultimately were to have its exemption modified, conditioned or revoked, APS could be subject to SEC regulation in many aspects of its business, including those relating to securities issuances, diversification and transactions among affiliates. In a series of responses to the ACC's petition and subsequent ACC letters to the SEC, the Company has asked the SEC to refuse to take the action requested by the ACC. The Company cannot predict what action, if any, the SEC may take with respect to the ACC petition. ARIZONA CORPORATION COMMISSION REPORTING REQUIREMENTS On April 29, 1985, the ACC issued an order subjecting the Company and APS to certain reporting requirements in connection with certain of their activities. The order requires the Company to report to the ACC on a monthly basis concerning the Company's diversification activities and plans, financing arrangements and changes in management. The order also requires monthly reports describing transactions between APS and the Company or its affiliates. ARIZONA CORPORATION COMMISSION AFFILIATED INTEREST RULES On March 14, 1990 the ACC issued an order adopting certain rules purportedly applicable only to a certain class of public utilities regulated by the ACC, including APS. The rules define the terms "public utility holding company" and "affiliate" with respect to public service corporations regulated by the ACC in such a manner as to include the Company and all of the Company's non-public service corporation subsidiaries. By their terms, the rules, among other things, require public utilities, such as APS, to receive ACC approval prior to (1) obtaining an interest in, or guaranteeing or assuming the liabilities of, any affiliate not regulated by the ACC; (2) lending to any such affiliate (except for short-term loans in an amount less than $100,000); or (3) using utility funds to form a subsidiary or divest itself of any established subsidiary. The rules also would prevent a utility from transacting business with an affiliate unless the affiliate agrees to provide the ACC "access to the books and records of the affiliate to the degree required to fully audit, examine or otherwise investigate transactions between the public utility and the affiliate." In addition, the rules provide that an "affiliate or holding company may not divest itself of, or otherwise relinquish control of, a public utility without thirty (30) days prior written notification to the [ACC]" and would require all public utilities subject to them and all public utility holding companies to annually "provide the [ACC] with a description of diversification plans for the current calendar year that have been approved by the Boards of Directors." The order became effective as to APS on December 1, 1992. The rules have not had, nor does the Company expect the rules to have, a material adverse impact on the business or operations of the Company. BUSINESS OF ARIZONA PUBLIC SERVICE COMPANY Following is a discussion of the business of APS, the Company's principal subsidiary. GENERAL APS was incorporated in 1920 under the laws of Arizona and is engaged principally in serving electricity in the State of Arizona. The principal executive offices of APS are located at 400 North Fifth Street, Phoenix, Arizona 85004 (telephone 602-250-1000). APS currently employs approximately 7,050 persons, which includes employees assigned to joint projects where APS is project manager. APS serves approximately 654,000 customers in an area that includes all or part of 11 of Arizona's 15 counties. During 1993, no single purchaser or user of energy accounted for more than 3% of total electric revenues. INDUSTRY AND COMPANY ISSUES The utility industry continues to experience a number of challenges. Depending on the circumstances of a particular utility, these may include (i) competition in general from numerous sources; (ii) effects of the National Energy Policy Act of 1992 (the "Energy Act"); (iii) difficulties in meeting government imposed environmental requirements; (iv) the necessity to make substantial capital outlays for transmission and distribution facilities; (v) uncertainty regarding projected electrical demand growth; (vi) controversies over electromagnetic fields; (vii) controversies over the safety and use of nuclear power; (viii) issues related to spent fuel and low level waste (see "Generating Fuel" below); and (ix) increasing costs of wages and materials. The impact on APS of other utility industry problems is discussed in this Item under "Environmental Matters." Also see "Water Supply" in this Item with respect to certain problems specific to APS and other utilities. COMPETITION Certain territory adjacent to or within areas served by APS is served by other investor-owned utilities (notably Tucson Electric Power Company serving electricity in the Tucson area, Southwest Gas Corporation serving gas throughout the state, and Citizens Utilities Company serving electricity and gas in various locations throughout the state) and a number of cooperatives, municipalities, electrical districts, and similar types of governmental organizations (principally the Salt River Project Agricultural Improvement and Power District ("SRP") serving electricity in various areas in and around Phoenix). APS expects increased competition in the future, mostly with respect to large customers, from entities offering alternative sources of energy. In recent years, changing laws and governmental regulations, interest in self- generation, competition from nonregulated energy suppliers, and aggressive marketing from the gas industry, are providing some utility customers with alternative sources to satisfy their energy needs. This may be increased as a result of the Energy Act which, among other things, removes certain previously existing barriers to entry into electric generation. The Energy Act also permits certain other parties to compete for resale customers currently served by a particular utility and to use that utility's transmission facilities in order to do so. The requirements with respect to implementation of the Energy Act have not yet been completely determined, so APS cannot currently predict its impact on APS' business and operations. In order to remain competitive in this changing environment, APS has determined that it must be a cost-effective supplier, provide excellent service and be knowledgeable about its customers' businesses. APS is concentrating on several areas which are key to the success of this strategy, including effectively managing its operating and maintenance expenses; reinforcing the importance of customer needs among APS employees; and working with customers to evaluate, recommend and provide services which will optimize their efficiency. CAPITAL STRUCTURE The capital structure of APS (which, for this purpose, includes short-term borrowings and current maturities of long-term debt) as of December 31, 1993 is tabulated below. Amount Percentage ---------- ---------- (Thousands of Dollars) Long-Term Debt Less Current Maturities: First mortgage bonds................................ $1,729,070 Other............................................... 395,584 ---------- Total long-term debt less current maturities...... 2,124,654 50.7% ---------- Non-Redeemable Preferred Stock........................ 193,561 4.6 ---------- Redeemable Preferred Stock............................ 197,610 4.7 ---------- Common Stock Equity: Common stock, $2.50 par value, 100,000,000 shares authorized; 71,264,947 shares outstanding......... 178,162 Premiums and expenses............................... 1,037,681 Retained earnings................................... 307,098 ---------- Total common stock equity......................... 1,522,941 36.4 ---------- Total capitalization............................ 4,038,766 Current Maturities of Long-Term Debt.................. 3,179 .1 Short-Term Borrowings................................. 148,000 3.5 ---------- -------- Total........................................... $4,189,945 100.0% ========== ======== See Notes 6, 7, and 8 of Notes to the Consolidated Financial Statements in Item 8. On March 1, 1994 APS redeemed all of the outstanding shares of its $8.80 Cumulative Preferred Stock, Series K ($100 par value), in the amount of $14.21 million. On March 2, 1994, APS issued $100 million of its First Mortgage Bonds, 6 5/8% Series due 2004 and applied the net proceeds to the repayment of short-term debt that had been incurred for the redemption of preferred stock and for general corporate purposes. So long as any of APS' first mortgage bonds are outstanding, APS is required for each calendar year to deposit with the trustee under its mortgage cash in a formularized amount related to net additions to APS' mortgaged utility plant; however, APS may satisfy all or any part of this "replacement fund" requirement by utilizing redeemed or retired bonds, net property additions, or property retirements. For 1993, the replacement fund requirement amounted to approximately $122 million. Many, though not all, of the bonds issued by APS under its mortgage are redeemable at their par value plus accrued interest with cash deposited by APS in the replacement fund, subject in many cases to a period of time after the original issuance of the bonds during which they may not be so redeemed and/or to other restrictions on any such redemption. The cash deposited with the trustee by APS in partial satisfaction of its 1993 replacement fund requirements will be used to redeem $60.264 million in aggregate principal amount of APS' First Mortgage Bonds, 10 3/4% Series due 2019, at their principal amount plus accrued interest, on April 4, 1994. RATES STATE. The ACC has regulatory authority over APS in matters relating to retail electric rates and the issuance of securities. See "Rate Case Settlement" in Note 3 of the Notes to the Consolidated Financial Statements in Item 8 for a discussion of the December 1991 settlement of APS' most recent retail rate case before the ACC. FEDERAL. APS' rates for wholesale power sales and transmission services are subject to regulation by the Federal Energy Regulatory Commission ("FERC"). During 1993, approximately 8% of APS' electric operating revenues resulted from such sales and charges. For most wholesale transactions regulated by the FERC, a fuel adjustment clause results in monthly adjustments for changes in the actual cost of fuel for generation and in the fuel component of purchased power expense. CONSTRUCTION PROGRAM Although its plans are subject to change, APS does not presently intend to construct any new major baseload generating units for at least the next ten years. Utility construction expenditures for the years 1994 through 1996 are therefore expected to be primarily for expanding transmission and distribution capabilities to meet customer growth, upgrading existing facilities, and for environmental purposes. Construction expenditures, including expenditures for environmental control facilities, for the years 1994 through 1996 have been estimated as follows: (MILLIONS OF DOLLARS) BY YEAR BY MAJOR FACILITIES - ------------------------------ ------------------------------------------ 1994 $279 Electric generation $271 1995 302 Electric transmission 92 1996 293 Electric distribution 390 ---- General facilities 121 $874 ---- ==== $874 ==== The amounts for 1994 through 1996 include expenditures for nuclear fuel but exclude capitalized interest costs and capitalized property taxes. APS conducts a continuing review of its construction program. This program and the above estimates are subject to periodic revisions based upon changes in assumptions as to system reliability, system load growth, rates of inflation, the availability and timing of environmental and other regulatory approvals, the availability and costs of outside sources of capital, and changes in project construction schedules. During the years 1991 through 1993, APS incurred approximately $641 million in construction expenditures and approximately $31 million in additional capitalized items. ENVIRONMENTAL MATTERS Pursuant to the Clean Air Act, the United States Environmental Protection Agency ("EPA") has adopted regulations, applicable to certain federally- protected areas, that address visibility impairment that can be reasonably attributed to specific sources. In September 1991, the EPA issued a final rule that would limit sulfur dioxide emissions at the Navajo Generating Station ("NGS"). Compliance with the emission limitation becomes applicable to NGS Units 1, 2, and 3 in 1997, 1998, and 1999, respectively. SRP, the NGS operating agent, has estimated a capital cost of $530 million, most of which will be incurred from 1995-1998, and annual operations and maintenance costs of approximately $10 million per unit, for NGS to meet these requirements. APS will be required to fund 14% of these expenditures. The Clean Air Act Amendments of 1990 (the "Amendments") became effective on November 15, 1990. The Amendments address, among other things, "acid rain," visibility in certain specified areas, toxic air pollutants, and the nonattainment of national ambient air quality standards. With respect to "acid rain," the Amendments establish a system of sulfur dioxide emissions "allowances." Each existing utility unit is granted a certain number of "allowances." On March 5, 1993, the EPA promulgated rules listing allowance allocations applicable to Company-owned plants, which allocations will begin in the year 2000. Based on those allocations, APS will have sufficient allowances to permit continued operation of its plants at current levels without installing additional equipment. In addition, the Amendments require the EPA to set nitrogen oxides emissions limitations which would require certain plants to install additional pollution control equipment. On March 22, 1994, the EPA issued rules for nitrogen oxide emissions limitations which will require the Company to install additional pollution control equipment at the Four Corners Power Plant ("Four Corners"). In the year 2000 Four Corners must comply with either these or more stringent requirements which might be promulgated by the EPA. The EPA has until 1997 to set more stringent requirements. However, if Four Corners accelerates to 1997 compliance with these March 22, 1994 requirements, it can delay until 2008 compliance with any more stringent requirements which the EPA may set. APS has not yet determined how it will proceed; however, APS currently estimates the capital cost of complying by 1997 with the specified requirements will be approximately $16 million. With respect to protection of visibility in certain specified areas, the Amendments require the EPA to complete a study by November 1995 concerning visibility impairment in those areas and identification of sources contributing to such impairment. Interim findings of this study have indicated that any beneficial effect on visibility as a result of the Amendments would be offset by expected population and industry growth. EPA has established a "Grand Canyon Visibility Transport Commission" to complete a study by November 1995 on visibility impairment in the "Golden Circle of National Parks" in the Colorado Plateau. NGS, the Cholla Power Plant ("Cholla"), and Four Corners are located near the "Golden Circle of National Parks." Based on the recommendations of the Commission, the EPA may require additional emissions controls at various sources causing visibility impairment in the "Golden Circle of National Parks" and may limit economic development in several western states. APS cannot currently estimate the capital expenditures, if any, which may be required as a result of the EPA studies and the Commission's recommendations. With respect to hazardous air pollutants emitted by electric utility steam generating units, the Amendments require two studies. First, there will be a study to be completed by November 1994 of potential impacts of mercury emissions from such units and various other sources on public health and on the environment, including available control technologies. Second, the EPA will complete a general study by November 1995 concerning the necessity of regulating such units under the Amendments. Due to the lack of historical data, and because APS cannot speculate as to the ultimate requirements by the EPA, APS cannot currently estimate the capital expenditures, if any, which may be required as a result of these studies. Certain aspects of the Amendments may require related expenditures by APS, such as permit fees, none of which APS expects to have a material impact on its financial position. GENERATING FUEL Coal, nuclear, gas, and other contributions to total net generation of electricity by APS in 1993, 1992, and 1991, and the average cost to APS of those fuels (in dollars per MWh), were as follows: Other includes oil and hydro generation. APS believes that Cholla has sufficient reserves of low sulfur coal committed to that plant for the next six years, the term of the existing coal contract, and sufficient reserves of low sulfur coal available for use to continue operating it for its useful life. APS also believes that Four Corners and NGS have sufficient reserves of low sulfur coal available for use by those plants to continue operating them for at least thirty years. The current sulfur content of coal being used at Four Corners, NGS, and Cholla is 0.8%, 0.6%, and 0.4%, respectively. In 1993, average prices paid for coal supplied from reserves dedicated under the existing contracts were relatively stable, although applicable contract clauses permit escalations under certain conditions. In addition, major price adjustments can occur from time to time as a result of contract renegotiation. NGS and Four Corners are located on the Navajo Reservation and held under easements granted by the federal government as well as leases from the Navajo Tribe. See "Properties" in Item 2. ITEM 2. PROPERTIES APS' present generating facilities have an accredited capacity aggregating 4,022,410 kw, comprised as follows: Capacity(kw) ------------ Coal: Units 1, 2, and 3 at Four Corners, aggregating........... 560,000 15% owned Units 4 and 5 at Four Corners, representing.... 222,000 Units 1, 2, and 3 at Cholla Plant, aggregating........... 590,000 14% owned Units 1, 2, and 3 at the Navajo Plant, representing........................................... 315,000 ----------- 1,687,000 =========== Gas or Oil: Two steam units at Ocotillo, two steam units at Saguaro, and one steam unit at Yucca, aggregating............... 468,400(1) Eleven combustion turbine units, aggregating............. 500,600 Three combined cycle units, aggregating.................. 253,500 ----------- 1,222,500 =========== Nuclear: 29.1% owned or leased Units 1, 2, and 3 at Palo Verde, representing........................................... 1,108,710 =========== Other........................................................ 4,200 =========== - ---------- (1) West Phoenix steam units (96,300 kw) are currently mothballed. -------------- APS' peak one-hour demand on its electric system was recorded on August 2, 1993 at 3,802,300 kw, compared to the 1992 peak of 3,796,400 kw recorded on August 17. Taking into account additional capacity then available to it under purchase power contracts as well as its own generating capacity, APS' capability of meeting system demand on August 2, 1993, computed in accordance with accepted industry practices, amounted to 4,505,000 kw, for an installed reserve margin of 16.7%. The power actually available to APS from its resources fluctuates from time to time due in part to planned outages and technical problems. The available capacity from sources actually operable at the time of the 1993 peak amounted to 4,099,500 kw, for a margin of 13.4%. NGS and Four Corners are located on land held under easements from the federal government and also under leases from the Navajo Tribe. The risk with respect to enforcement of these easements and leases is not deemed by APS to be material. APS is dependent, however, in some measure upon the willingness and ability of the Navajo Tribe to honor its commitments. Certain of APS' transmission lines and almost all of its contracted coal sources are also located on Indian reservations. See "Generating Fuel" in Item 1. Operation of each of the three Palo Verde units requires an operating license from the NRC. Full power operating licenses for Units 1, 2, and 3 were issued by the NRC in June 1985, April 1986, and November 1987, respectively. The full power operating licenses, each valid for a period of approximately 40 years, authorize APS, as operating agent for Palo Verde, to operate the three Palo Verde units at full power. On August 18, 1986 and December 19, 1986, APS entered into a total of three sale and leaseback transactions under which it sold and leased back approximately 42% of its 29.1% ownership interest in Palo Verde Unit 2. The leases under each of the sale and leaseback transactions have initial lease terms expiring on December 31, 2015. Each of the leases also allows APS to extend the term of the lease and/or to repurchase the leased Unit 2 interest under certain circumstances at fair market value. The leases in the aggregate require annual payments of approximately $40 million through 1999, approximately $46 million in 2000, and approximately $49 million through 2015 (see Note 11 of the Notes to the Consolidated Financial Statements in Item 8). See "Water Supply" in Item 1 with respect to matters having possible impact on the operation of certain of APS' power plants, including Palo Verde. APS' construction plans are susceptible to changes in forecasts of future demand on its electric system and in its ability to finance its construction program. Although its plans are subject to change, APS does not presently intend to construct any new major baseload generating units for at least the next ten years. Important factors affecting APS' ability to delay the construction of new major generating units are continuing efforts to upgrade and improve the reliability of existing generating stations, system load diversity with other utilities, and continuing efforts in customer demand-side conservation and load management programs. In addition to that available from its own generating capacity, APS purchases electricity from other utilities under various arrangements. One of the most important of these is a long-term contract with SRP which may be canceled by SRP on three years' notice and which requires SRP to make available, and APS to pay for, certain amounts of electricity that are based in large part on customer demand within certain areas now served by APS pursuant to a related territorial agreement. APS believes that the prices payable by it under the contract are fair to both parties. The generating capacity available to APS pursuant to the contract was 302,000 kw until May 1993, at which time the capacity increased to 304,000 kw. In 1993, APS received approximately 840,000 MWh of energy under the contract and paid approximately $40 million for capacity availability and energy received. In September 1990, APS and PacifiCorp, an Oregon-based utility company, entered into certain agreements relating principally to sales and purchases of electric power and electric utility assets, and in July 1991, after regulatory approvals, APS sold Cholla Unit 4 to PacifiCorp for approximately $230 million. As part of the transaction, PacifiCorp agreed to make a firm system sale to APS for thirty years during APS' summer peak season in the amount of 175 megawatts for the first five years, increasing thereafter, at APS' option, up to a maximum amount equal to the rated capacity of Cholla Unit 4. After the first five years, all or part of the sale may be converted to a one-for-one seasonal capacity exchange. PacifiCorp has the right to purchase from APS up to 125 average megawatts of energy per year for thirty years. PacifiCorp and APS also entered into a 100 megawatt one-for-one seasonal capacity exchange to be effective upon the latter of January 1, 1996 or the completion of certain new transmission projects. In addition, PacifiCorp agreed to pay APS (i) $20 million upon commercial operation of 150 megawatts of peaking capacity constructed by APS and (ii) $19 million in connection with the construction of transmission lines and upgrades that will afford PacifiCorp 150 megawatts of northbound transmission rights. In addition, PacifiCorp secured additional firm transmission capacity of 30 megawatts over APS' system. In 1993, APS received 401,475 MWh of energy from PacifiCorp under these transactions and paid approximately $19 million for capacity availability and the energy received, and PacifiCorp paid approximately $2.7 million for 144,171 MWh. See "El Paso Electric Company Bankruptcy" in Note 13 of the Notes to the Consolidated Financial Statements in Item 8 for a discussion of the filing by El Paso Electric Company ("EPEC") of a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code. EPEC has a joint ownership interest with APS and others in Palo Verde and Four Corners Units 4 and 5. See Notes 6 and 12 of the Notes to the Consolidated Financial Statements in Item 8 with respect to property of APS not held in fee or held subject to any major encumbrance. See "SunCor Development Company" and "El Dorado Investment Company" under the heading "Business of Non-Utility Subsidiaries" in Item 1 for a description of properties held by the non-utility subsidiaries of the Company. GRAPHIC - ------- MAP OF THE STATE OF ARIZONA SHOWING APS' SERVICE AREA, THE LOCATION OF ITS MAJOR POWER PLANTS AND PRINCIPAL TRANSMISSION LINES, AND THE LOCATION OF TRANSMISSION LINES OPERATED BY APS FOR OTHERS. SEE APPENDIX FOR DETAILED DESCRIPTION. ITEM 3. ITEM 3. LEGAL PROCEEDINGS APS On June 29, 1990, a new Arizona state tax law was enacted, effective as of December 31, 1989, which adversely impacted APS' earnings in tax years 1990 through 1993 by an aggregate amount of approximately $82 million, before income taxes. On December 20, 1990, the Palo Verde participants, including APS, filed a lawsuit in the Arizona Tax Court, a division of the Maricopa County Superior Court, against the Arizona Department of Revenue, the Treasurer of the State of Arizona, and various Arizona counties, claiming, among other things, that portions of the new tax law are unconstitutional. (Arizona Public Service Company, et al. v. Apache County, et al., No. TX 90-01686 (Consol.), Maricopa County Superior Court). In December 1992, the court granted summary judgment to the taxing authorities, holding that the law is constitutional. APS has appealed this decision to the Arizona Court of Appeals. APS cannot currently predict the ultimate outcome of this matter. See "Water Supply" and "Palo Verde Nuclear Generating Station" in Item 1 and "El Paso Electric Company Bankruptcy" in Note 13 of the Notes to the Company's Consolidated Financial Statements in Item 8 in regard to other pending or threatened litigation involving APS. PINNACLE WEST A lawsuit was filed in the United States District Court for the District of Arizona against the Company, its inside directors and certain of its officers on November 7, 1988 and was amended on December 15, 1988 to add the remaining directors and additional substantive claims. As amended, the complaint alleges violations of federal securities laws and Arizona securities, consumer fraud and other state laws in connection with certain actions of the Company and statements made on its behalf relating to the Company's diversification activities, future business prospects and dividends. The Court certified a class consisting of all purchasers of the Company's common stock between April 1, 1987 and October 7, 1988 (the alleged "Class Period"). The complaint sought unspecified compensatory and punitive damages as well as fees and costs. On December 20, 1988 a lawsuit was filed in the United States District Court for the District of Arizona against the Company and certain officers and directors, alleging violations of federal securities laws and Arizona securities, consumer fraud and other state laws in connection with certain actions of the Company and statements made on its behalf relating to the Company's diversification activities, future business prospects and dividends. The lawsuit is substantially similar to the lawsuit referenced in the preceding paragraph. The plaintiffs, two individuals who claim to have purchased the Company's common stock between April 1, 1987 and October 7, 1988 (the alleged "Class Period"), requested unspecified compensatory and punitive damages as well as fees and costs. On October 2, 1989, the cases described in this and the preceding paragraph were consolidated. On December 15, 1989 a shareholder derivative lawsuit was filed in the United States District Court for the District of Arizona naming the Company's directors as defendants and the Company as nominal defendant. The lawsuit alleges breach of fiduciary duties by the directors in connection with the Company's diversification activities, and further alleges violation of federal securities laws by one director in connection with the sale of MeraBank to the Company in 1986. The plaintiffs requested, on the Company's behalf, unspecified compensatory and punitive damages. On April 22, 1991 a lawsuit was filed in the United States District Court for the District of Arizona by the Resolution Trust Corporation (the "RTC") against certain former officers and directors of MeraBank. The suit sought, among other things, damages in excess of $270 million, and alleged negligence, gross negligence, breach of fiduciary duty, breach of duty of loyalty and breach of contract with respect to the management and operation of MeraBank by the defendants beginning in the early 1980s. Although the Company was not a defendant, the Company agreed to advance reasonable attorneys' fees and expenses, in various amounts, to those defendants who served on the MeraBank Board of Directors at the request of the Company. The Company reserved the right to alter the amount of such advances or to terminate them as the case developed, and received undertakings from the persons receiving such advances to repay such amounts in the event that they are ultimately determined not to be entitled to indemnification. The Company has terminated future such advances as to certain of those defendants. In addition, in June and November of 1989 the Company's Board of Directors adopted resolutions whereby the Company agreed to indemnify the non-officer members of the MeraBank Board of Directors against claims brought against such individuals in their capacity as directors of MeraBank, for acts occurring on or after June and November 1989, the effective dates of the indemnification resolutions. On December 30, 1993, and as the result of a negotiated settlement, the United States District Court for the District of Arizona entered orders and final judgments (1) dismissing the consolidated shareholder class litigation and shareholder derivative litigation initiated in 1988 and 1989, respectively, and described in the first three paragraphs under this heading and (2) partially dismissing the litigation initiated by the RTC and described in the immediately preceding paragraph. Two non-settling individuals who are pursuing independent claims against the RTC were not dismissed from the RTC litigation and have appealed the settlement. These individuals may attempt to look to the Company, its insurance carriers and others for indemnification of certain costs and damages. The Company believes that it has no obligation with respect to any such costs or damages. The settlement provides for for payments totaling $61.625 million, of which the Company's share is $5.75 million. A litigation reserve previously established by the Company is sufficient to cover the Company's share of the settlement. The balance of the settlement payment will be funded by the Company's insurers. On January 18, 1991 a lawsuit was filed in the United States District Court, Southern District of Ohio, Western Division, against, among other parties, the Company and certain of its officers and directors, the Office of Thrift Supervision ("OTS"), the RTC and the Federal Deposit Insurance Corporation ("FDIC"). The amended complaint in this lawsuit alleges that the plaintiff purchased MeraBank subordinated debentures with a face amount of $1 million in 1987 in reliance upon the capital maintenance stipulation executed by the Company as a condition to the Company's acquisition of MeraBank. The plaintiff further alleges that the value of such debentures was impaired because of the Company's release from its purported obligations under the stipulation and the actions of the OTS in placing MeraBank in receivership. See Note 2 of the Notes to the Consolidated Financial Statements in Item 8 for additional information regarding the stipulation. The plaintiff is seeking damages in the approximate amount of $4.8 million. On August 2, 1991 the Ohio court issued an order dismissing the case with prejudice as to the Company and the officer/director defendants for lack of personal jurisdiction. The court also ordered the case dismissed with prejudice as to the OTS, the RTC and the FDIC. On October 1, 1991 the plaintiff appealed the court's order. On February 17, 1993, the United States Court of Appeals for the Sixth Circuit affirmed the entry of summary judgment in favor of the RTC, OTS, and FDIC, but reversed the district court's dismissal in favor of the Company and certain of its officers and directors. The Court of Appeals remanded the case to the district court for a determination of whether plaintiff had adequately pled its claims so that the district court could exercise personal jurisdiction. The district court was further instructed to consider whether the Southern District of Ohio was the proper venue for the suit. On June 8, 1993, the Ohio court ordered this case to be transferred to the District of Arizona. On August 17, 1993, the Company was served with a separate complaint filed by the same plaintiff in the District Court for the District of Arizona alleging claims under the Arizona Racketeering Act and the Arizona Consumer Fraud Act seeking compensatory damages in the amount of $1.2 million plus interest, punitive damages, treble damages, interest, attorneys' fees and costs. The plaintiff has voluntarily dismissed the Arizona Consumer Fraud Act claims; however, the Arizona Racketeering Act claims remain pending. The Company and the individual directors and officers believe that the lawsuit is without merit and will vigorously defend themselves. On May 1, 1991, a lawsuit was filed in the United States District Court for the District of Arizona against the Company by another purchaser of the same issue of MeraBank subordinated debentures referred to in the immediately preceding paragraph. This plaintiff also claims to have purchased the debentures, with a face amount of approximately $12.4 million, in reliance upon the stipulation. The suit further alleges that the Company induced the plaintiff to retain its investment in the debentures by representing to the plaintiff that the Company would keep MeraBank capitalized in accordance with federal regulatory requirements. The suit alleges violations of federal and state securities laws, fraud, negligent representation, racketeering and intentional interference with contractual relations. The plaintiff seeks unspecified compensatory and punitive damages and has requested that the compensatory damages be trebled under Arizona's civil racketeering statute. The Company intends to vigorously defend itself in this action. On December 22, 1993, Pinnacle West was served with a complaint filed by another purchaser of MeraBank subordinated debentures alleging claims substantially similar to the claims described in the preceding paragraph. The complaint, which was filed in the United States District Court for the District of Arizona, seeks compensation and punitive damages in an unspecified amount plus attorneys' fees and costs. The Company intends to vigorously defend itself in this action. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report, through the solicitation of proxies or otherwise. SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT The Company's executive officers are as follows: AGE AT NAME MARCH 1, 1994 POSITION(S) AT MARCH 1, 1994 - ---- ------------- ---------------------------- Michael S. Ash 40 Corporate Counsel Arlyn J. Larson 59 Vice President of Corporate Planning and Development Nancy E. Newquist 42 Vice President and Treasurer Henry B. Sargent 59 Executive Vice President and Chief Financial Officer(1) Richard Snell 63 Chairman of the Board of Directors, President and Chief Executive Officer(1) Faye Widenmann 45 Vice President of Corporate Relations and Administration and Secretary - ---------- (1) Member of the Board of Directors. The executive officers of the Company are elected no less often than annually and may be removed by the Board of Directors at any time. The terms served by the named officers in their current positions and the principal occupations (in addition to those stated in the table) of such officers for the past five years have been as follows: Mr. Ash was elected Corporate Counsel of the Company in February 1991. He previously held the positions of Legal Counsel to the Company (December 1986 to February 1991) and Attorney in the APS Law Department (July 1983 to September 1985). Mr. Larson was elected Vice President, Corporate Planning and Development in July 1986. Ms. Newquist was elected Treasurer in June 1990 and as a Vice President in February 1994. Ms. Newquist also serves as Treasurer of APS, a position she was elected to in June 1993 after serving as Assistant Treasurer of APS since October 1992. From May 1987 to June 1990, Ms. Newquist served as the Company's Director of Finance. Mr. Sargent was elected Executive Vice President and Chief Financial Officer of the Company in April 1985. Mr. Sargent was Executive Vice President and Chief Financial Officer of APS from September 1981 until July 1986. He is also a director of Magma Copper Company, Tucson, Arizona. Mr. Snell was elected Chairman of the Board, President and Chief Executive Officer of the Company effective February 5, 1990. He was also elected Chairman of the Board of APS effective the same date. Previously, he was Chairman of the Board (1989-1992) and Chief Executive Officer (1989-1990) of Aztar Corporation, and Chairman of the Board, President and Chief Executive Officer of Ramada Inc., Phoenix, Arizona (1981-1989). Mr. Snell remains a director of Aztar Corporation and is also a director of Bank One Arizona Corporation, Phoenix, Arizona. Ms. Widenmann was elected Secretary of the Company in 1985 and Vice President of Corporate Relations and Administration in November 1986. She was Secretary of APS from June 1983 until April 1987. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is publicly held and is traded on the New York and Pacific Stock Exchanges. At the close of business on March 14, 1994, the Company's common stock was held of record by approximately 59,795 shareholders. The chart below sets forth the common stock price ranges on the composite tape, as reported in the Wall Street Journal for 1993 and 1992. There were no dividends declared or paid on or in respect of the Company's common stock during 1992 and the first three quarters of 1993. A dividend of $.20 per share was declared and paid on the Company's common stock during the fourth quarter of 1993. COMMON STOCK PRICE RANGES - ------------------------------------------------------------------------------ 1992 HIGH LOW - ------------------------------------------- 1st Quarter 18 1/4 16 3/4 2nd Quarter 18 3/8 16 7/8 3rd Quarter 20 17 7/8 4th Quarter 20 1/2 19 1/8 - ------------------------------------------- - ------------------------------------------- 1st Quarter 21 3/4 19 5/8 2nd Quarter 23 1/2 20 7/8 3rd Quarter 25 1/4 23 1/8 4th Quarter 24 3/8 20 3/8 - ------------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion relates to Pinnacle West Capital Corporation (the "Company" or "Pinnacle West") and its subsidiaries: Arizona Public Service Company ("APS"), SunCor Development Company ("SunCor") and El Dorado Investment Company ("El Dorado"). The discussion also relates to the discontinued operations of MeraBank, A Federal Savings Bank ("MeraBank"). CAPITAL NEEDS AND RESOURCES Parent Company During the past three years, Pinnacle West's primary cash needs were for the payment of interest and prepayment of principal on its long-term debt (see Note 6 of Notes to Consolidated Financial Statements). Additional cash needs in 1993 were related to the fourth quarter restoration of common stock dividends. Dividends from APS have been Pinnacle West's primary source of cash. Tax allocations within the consolidated group and net operating loss carryforwards associated with MeraBank have also been sources of cash. The non-utility subsidiaries (SunCor and El Dorado) are also expected to contribute to Pinnacle West's cash flow. Pinnacle West prepaid substantial amounts of its parent-level debt in each of the last three years. Management expects Pinnacle West to have sufficient cash flow available for mandatory and optional debt repayments to allow parent company debt to be reduced from $564 million at the end of 1993 to approximately $300 million by year-end 1995. At the end of 1993, Pinnacle West had a $40 million liquidity facility as summarized in Note 5 of Notes to Consolidated Financial Statements; no borrowings were outstanding thereunder. APS APS' capital needs consist primarily of construction expenditures and required repayments or redemptions of long-term debt and preferred stock. The capital resources available to meet these requirements include funds provided by operations and external financings. Present construction plans exclude any major baseload generating plants for at least the next ten years. In general, most of the construction expenditures are for expanding transmission and distribution capabilities to meet customer growth, upgrading existing facilities, and environmental purposes. Construction expenditures are anticipated to be $279 million, $302 million and $293 million for 1994, 1995 and 1996, respectively. These amounts include nuclear fuel expenditures, but exclude capitalized property taxes and capitalized interest costs. In the 1991 through 1993 period, APS funded all of its capital expenditures (construction expenditures and capitalized property taxes) with internally generated funds, after the payment of dividends. For the period 1994 through 1996, APS estimates that it will fund substantially all of its capital expenditures with internally generated funds, after the payment of dividends. During 1993, APS redeemed or repurchased approximately $637 million of long-term debt and preferred stock, of which approximately $527 million was optional. Refunding obligations for preferred stock, long-term debt, a capitalized lease obligation, and certain anticipated early redemptions are expected to total approximately $187 million, $135 million and $4 million for the years 1994, 1995 and 1996, respectively. APS currently expects to issue in 1994 a total of approximately $125 million of long-term debt (primarily first mortgage bonds) and approximately $125 million of preferred stock. Of this, APS issued on March 2, 1994, $100 million of its First Mortgage Bonds, 6 5/8% series due 2004, and applied the net proceeds to the repayment of short-term debt that had been incurred for the redemption of preferred stock and for general corporate purposes. APS expects that substantially all of the net proceeds of the balance of the securities to be issued during 1994 will be used for the retirement of outstanding debt and preferred stock. On March 1, 1994, APS redeemed all of the outstanding shares of its $8.80 Cumulative Preferred Stock, Series K ($100 Par Value) in the amount of $14.21 million. As of April 4, 1994, APS will be redeeming all $60.264 million of its outstanding First Mortgage Bonds, 10 3/4% Series due 2019. Provisions in APS' mortgage bond indenture and articles of incorporation require certain coverage ratios to be met before APS can issue additional first mortgage bonds or preferred stock. In addition, the mortgage bond indenture limits the amount of additional bonds which may be issued to a percentage of net property additions, to property previously pledged as security for certain bonds that have been redeemed or retired, and/or to cash deposited with the mortgage bond trustee. After giving effect to the transactions described in the preceding paragraph, as of December 31, 1993, APS estimates that the mortgage bond indenture and the articles of incorporation would have allowed it to issue up to approximately $1.2 billion and $986 million of additional first mortgage bonds and preferred stock, respectively. The Arizona Corporation Commission (the "ACC") has authority over APS with respect to the issuance of long-term debt and equity securities. Existing ACC orders allow APS to have up to approximately $2.6 billion in long-term debt and approximately $501 million of preferred stock outstanding at any one time. Management does not expect any of the foregoing restrictions to limit APS' ability to meet its capital requirements. As of December 31, 1993, APS had credit commitments from various banks totalling approximately $302 million, which were available either to support the issuance of commercial paper or to be used for bank borrowings. Commercial paper borrowings totalling $148 million were outstanding at the end of 1993. Non-Utility Subsidiaries During the past three years, the non-utility subsidiaries generally financed all of their operations through cash flow from operations and financings that did not involve Pinnacle West. SunCor's capital needs consist primarily of construction expenditures, which are expected to approximate $33 million, $18 million and $14 million for 1994, 1995 and 1996, respectively. Capital resources available to meet these requirements include funds provided by operations and external financings. On March 2, 1994, SunCor issued $25 million of Collateralized Mortgage Bonds, due in 2004. The bonds are secured by specified parcels of real property and bear variable interest based on London Interbank Offered Rate (LIBOR). Simultaneously, $6 million of 12% debt due in 1997 was prepaid. Management expects El Dorado's internal cash flows to be sufficient to fund its operations for the foreseeable future. RESULTS OF OPERATIONS 1993 Compared to 1992 Pinnacle West reported income from continuing operations of $170.0 million in 1993 compared to $150.4 million in 1992, for an increase of $19.6 million. The primary factor contributing to this increase was lower interest expense. Interest costs in 1993 were $22.5 million lower than 1992 due to refinancing debt at lower rates, lower average debt balances and lower interest rates on APS' variable-rate debt. Partially offsetting the lower interest expense were increased taxes and higher utility operating expenses. Electric operating revenues were up $16.6 million in 1993 on sales volumes of 20.1 million megawatt-hours (MWh) compared to 20.6 million MWh in 1992. Although revenues increased $45.3 million due to growth in the residential and business customer classes, these increases were largely offset by milder than normal weather and reduced interchange sales to other utilities. Fuel and purchased power costs increased $15.5 million in 1993 due to Palo Verde outages and reduced power operations (see Note 13 of Notes to Consolidated Financial Statements). Partially offsetting the $15.5 million were miscellaneous items resulting in a net increase of $13.3 million over 1992. These increases are reflected currently in earnings because APS does not have a fuel adjustment clause as part of its retail rate structure. The net result of electric operating revenues less fuel and purchased power expense was an increase of $3.3 million comparing 1993 to 1992. In 1993, utility operations expense increased $11.8 million over 1992 levels primarily due to the implementation of new accounting standards for postemployment benefits and postretirement benefits other than pensions, which added $17 million to expense in 1993 (see Note 9 of Notes to Consolidated Financial Statements). Partially offsetting these factors were lower power plant operating costs, lower rent expense and lower costs for an employee gainsharing plan. Real estate operating revenues and operating expenses were up $12.3 million and $10.9 million, respectively, in 1993 due to increased sales of residential lots. 1992 Compared to 1991 Income from continuing operations in 1992 was $150.4 million compared to a loss in 1991 of $340.3 million. This was primarily due to the after-tax write- offs of $407 million in 1991 resulting from a rate case settlement with the ACC (see "Rate Case Settlement" in Note 3 of Notes to Consolidated Financial Statements). Excluding the effects of the write-offs, income from continuing operations increased by $83.7 million in 1992 as a result of several factors, including higher revenues, lower interest costs and lower utility operations expenses. Partially offsetting these factors were higher fuel and purchased power costs and higher utility maintenance expenses. Electric operating revenues were up $154.4 million during 1992 on sales volumes of 20.6 million MWh compared to 20.0 million MWh in 1991. The volume increase of $48.6 million was largely due to growth in residential and business customer classes and increased sales due to more normal weather as compared to 1991. A price-related increase of $85.9 million was largely due to an increase in retail base rates effective December 6, 1991 and a higher average price for interchange sales to other utilities. Also contributing to the increase in 1992 was a $19.9 million reversal of a non-cash refund obligation recorded in December, 1991 (see Note 3 of Notes to Consolidated Financial Statements). Real estate revenues increased in 1992 primarily due to the sale of a golf course. Interest costs were $47.8 million lower in 1992 as compared to 1991 due to lower average debt balances, lower interest rates on APS' variable-rate debt and lower interest rates on refinanced debt. Fuel expenses increased in 1992 over 1991 by $13.4 million as a result of increased generation due to increased retail and interchange sales, and increased gas prices. These increases were partially offset by lower prices for coal and uranium. The increase in the purchased power component of fuel expenses was due to favorable market prices. Utility operations costs were $15.3 million lower in 1992 as compared to 1991 primarily due to lower operating costs at Palo Verde, lower fossil plant overhaul costs and other miscellaneous cost reductions. Partially offsetting these were an obligation recorded for an employee gainsharing plan and higher nuclear refueling outage costs. Non-Cash Income Net income reflects accounting practices required for regulated public utilities and represents a composite of cash and non-cash items, including Allowance for Funds Used During Construction (AFUDC), accretion income on Palo Verde Unit 3 and the reversal of a refund obligation related to the Palo Verde write-off (see "Consolidated Statements of Cash Flows" and Note 3 of Notes to Consolidated Financial Statements). APS recorded after-tax accretion income of $45.3 million, $40.7 million and $3.2 million in 1993, 1992 and 1991, respectively. APS also recorded refund obligation reversals in electric operating revenues of $12.9 million after tax in each of the years 1993 and 1992 and $0.9 million in 1991. APS will record after-tax accretion income and refund obligation reversals of $20.3 million and $5.6 million, respectively, through June 5, 1994. Palo Verde Nuclear Generating Station As APS continues its investigation and analysis of the Palo Verde steam generators, certain corrective actions are being taken. These include chemical cleaning, operating the units at reduced temperatures, and for some periods, operating the units at approximately 86% power. So long as three units are involved in mid-cycle outages and are operated at the 86% level, APS will incur an average of approximately $2 million per month (before income taxes) for additional fuel and purchased power costs. See "Palo Verde Tube Cracks" in Note 13 of Notes to Consolidated Financial Statements for a more detailed discussion. Accounting Issues Note 4 of Notes to Consolidated Financial Statements describes a new accounting standard for income taxes which required the recognition in 1993 of $19.3 million of state tax benefits related to net operating loss carryforwards. Discontinued Operations Income from discontinued operations of $6.0 million and $153.5 million in 1992 and 1991, respectively, resulted from tax benefits recorded in connection with the MeraBank settlement. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page ---------- Report of Management.............................................. 25 Independent Auditors' Report...................................... 26 Statements of Income for each of the three years in the period ended December 31, 1993......................................... 27 Balance Sheets -- December 31, 1993 and 1992...................... 28, 29 Statements of Cash Flows for each of the three years in the period ended December 31, 1993......................................... 30 Statements of Retained Earnings for each of the three years in the period ended December 31, 1993.................................. 31 Notes to Financial Statements..................................... 32 Financial Statement Schedules for each of the three years in the period ended December 31, 1993 Schedule V -- Property, Plant and Equipment.................. 50 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment.............. 53 Schedule VIII -- Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991............... 56 Schedule IX -- Short-Term Borrowings......................... 57 See Note 14 of Notes to Consolidated Financial Statements for the selected quarterly financial data required to be presented in this Item. REPORT OF MANAGEMENT The primary responsibility for the integrity of the Company's financial information rests with management, which has prepared the accompanying financial statements and related information. Such information was prepared in accordance with generally accepted accounting principles appropriate in the circumstances, based on managements best estimates and judgments and giving due consideration to materiality. These financial statements have been audited by independent auditors and their report is included. Management maintains and relies upon systems of internal accounting controls, which are periodically reviewed by both the Company's internal auditors and its independent auditors to test for compliance. Reports issued by the internal auditors are released to management, and such reports, or summaries thereof, are transmitted to the Audit Committee of the Board of Directors and the independent auditors on a timely basis. The Audit Committee, composed solely of outside directors, meets periodically with the internal auditors and independent auditors (as well as management) to review the work of each. The internal auditors and independent auditors have free access to the Audit Committee, without management present, to discuss the results of their audit work. Management believes that the Company's systems, policies and procedures provide reasonable assurance that operations are conducted in conformity with the law and with management's commitment to a high standard of business conduct. Richard Snell Henry B. Sargent Chairman & President Executive Vice President & Chief Financial Officer INDEPENDENT AUDITORS' REPORT We have audited the accompanying consolidated balance sheets of Pinnacle West Capital Corporation and its subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pinnacle West Capital Corporation and its subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth herein. As discussed in Note 4 of Notes to Consolidated Financial Statements, the Company changed its method of accounting for income taxes effective January 1, 1993 to conform with Statement of Financial Accounting Standards No. 109. Deloitte & Touche Phoenix, Arizona February 21, 1994 PINNACLE WEST CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) YEAR ENDED DECEMBER 31, ----------------------------------------- 1993 1992 1991 ------------- ------------ ------------ Operating Revenues Electric......................... $ 1,686,290 $ 1,669,679 $ 1,515,289 Provision for rate refund (Note 3)....................... -- -- (53,436) Real estate...................... 32,248 19,959 12,697 ------------- ------------ ------------ Total........................ 1,718,538 1,689,638 1,474,550 ------------- ------------ ------------ Fuel Expenses Fuel for electric generation..... 231,434 230,194 223,983 Purchased power.................. 69,112 57,007 49,788 ------------- ------------ ------------ Total........................ 300,546 287,201 273,771 ------------- ------------ ------------ Operating Expenses Utility operations and maintenance.................... 401,216 390,512 401,736 Real estate operations........... 38,220 27,309 25,482 Depreciation and amortization.... 223,558 220,076 219,010 Taxes other than income taxes (Note 11)...................... 222,345 217,063 215,541 Palo Verde cost deferral (Notes 1 and 3)................ -- -- (70,886) Disallowed Palo Verde costs (Note 3)....................... -- -- 577,145 ------------- ------------ ------------ Total........................ 885,339 854,960 1,368,028 ------------- ------------ ------------ Operating Income (Loss)............ 532,653 547,477 (167,249) ------------- ------------ ------------ Other Income (Deductions) Allowance for equity funds used during construction (Note 1)... 2,326 3,103 3,902 Palo Verde cost deferral (Notes 1 and 3)................ -- -- 63,068 Palo Verde accretion income (Note 3)....................... 74,880 67,421 5,306 Interest on long-term debt....... (245,961) (272,240) (316,282) Other interest................... (16,505) (12,718) (16,447) Allowance for borrowed funds used during construction (Note 1)... 4,153 4,492 6,636 Preferred stock dividend requirements of APS............ (30,840) (32,452) (33,404) Other -- net..................... (2,282) (13,045) (31,463) ------------- ------------ ------------ Total........................ (214,229) (255,439) (318,684) ------------- ------------ ------------ Income (Loss) From Continuing Operations Before Income Taxes.............. 318,424 292,038 (485,933) Income Tax Expense (Benefit) (Note 4)......................... 148,446 141,598 (145,616) ------------- ------------ ------------ Income (Loss) From Continuing Operations....................... 169,978 150,440 (340,317) Income From Discontinued Operations (Note 2)......................... -- 6,000 153,455 Cumulative Effect of Change in Accounting for Income Taxes...... 19,252 -- -- ------------- ------------ ------------ Net Income (Loss).................. $ 189,230 $ 156,440 $ (186,862) ============= ============ ============ Average Common Shares Outstanding.. 87,241,899 87,044,180 86,937,052 Earnings (Loss) Per Average Common Share Outstanding Continuing operations.......... $ 1.95 $ 1.73 $ (3.91) Discontinued operations........ -- 0.07 1.76 Accounting change.............. 0.22 -- -- ------------- ------------ ------------ Total........................ $ 2.17 $ 1.80 $ (2.15) ============= ============ ============ Dividends Declared Per Share....... $ 0.20 $ -- $ -- ============= ============ ============ See Notes to Consolidated Financial Statements. PINNACLE WEST CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME (THOUSANDS OF DOLLARS) DECEMBER 31, ---------------------- 1993 1992 ---------- ---------- ASSETS Current Assets Cash and cash equivalents........................... $ 52,127 $ 87,926 Customer and other receivables -- net............... 126,343 157,433 Accrued utility revenues (Note 1)................... 60,356 51,517 Materials and supplies (at average cost)............ 96,174 95,978 Fossil fuel (at average cost)....................... 34,220 36,668 Other current assets................................ 13,782 8,000 Deferred income taxes (Note 4)...................... 100,234 105,348 ---------- ---------- Total current assets.............................. 483,236 542,870 ---------- ---------- Investments and Other Assets Real estate investments -- net...................... 402,873 394,527 Other assets........................................ 136,074 142,309 ---------- ---------- Total investments and other assets................ 538,947 536,836 ---------- ---------- Utility Plant (Notes 6, 11 and 12) Electric plant in service, including nuclear fuel... 6,462,589 6,335,327 Construction work in progress....................... 197,556 162,168 ---------- ---------- Total utility plant............................... 6,660,145 6,497,495 Less accumulated depreciation and amortization...... 2,058,895 1,973,698 ---------- ---------- Net utility plant................................. 4,601,250 4,523,797 ---------- ---------- Deferred Debits Regulatory asset for income taxes (Note 4).......... 585,294 -- Palo Verde Unit 3 cost deferral (Notes 1 and 3)..... 301,748 310,908 Palo Verde Unit 2 cost deferral (Note 1)............ 177,998 184,061 Other deferred debits............................... 268,326 172,004 ---------- ---------- Total deferred debits............................. 1,333,366 666,973 ---------- ---------- Total Assets.......................................... $6,956,799 $6,270,476 ========== ========== See Notes to Consolidated Financial Statements. PINNACLE WEST CAPITAL CORPORATION CONSOLIDATED BALANCE SHEETS (THOUSANDS OF DOLLARS) DECEMBER 31, ----------------------- 1993 1992 ---------- ----------- LIABILITIES AND EQUITY Current Liabilities Accounts payable................................... $ 97,489 $ 105,718 Accrued taxes...................................... 96,303 117,694 Accrued interest................................... 57,674 58,579 Short-term borrowings (Note 5)..................... 148,000 195,000 Current maturities of long-term debt (Note 6)...... 78,841 94,217 Other current liabilities.......................... 60,845 78,909 ---------- ----------- Total current liabilities........................ 539,152 650,117 ---------- ----------- Non-Current Liabilities Long-term debt less current maturities (Note 6).... 2,633,620 2,774,305 Other liabilities.................................. 8,246 9,449 ---------- ----------- Total non-current liabilities.................... 2,641,866 2,783,754 ---------- ----------- Deferred Credits and Other Deferred income taxes (Note 4)..................... 1,278,673 578,020 Deferred investment tax credit..................... 127,331 133,359 Unamortized gain -- sale of utility plant.......... 107,344 116,167 Other deferred credits............................. 221,762 133,138 ---------- ----------- Total deferred credits and other................. 1,735,110 960,684 ---------- ----------- Commitments and Contingencies (Note 13) Minority Interests Non-redeemable preferred stock of APS (Note 7)..... 193,561 168,561 ---------- ----------- Redeemable preferred stock of APS (Note 7)......... 197,610 225,635 ---------- ----------- Common Stock Equity (Note 8) Common stock, no par value; authorized 150,000,000 shares; issued and outstanding 87,423,817 in 1993 and 87,161,872 in 1992........................... 1,642,783 1,646,772 Retained earnings (deficit)........................ 6,717 (165,047) ---------- ----------- Total common stock equity........................ 1,649,500 1,481,725 ---------- ----------- Total Liabilities and Equity......................... $6,956,799 $6,270,476 ========== =========== PINNACLE WEST CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (THOUSANDS OF DOLLARS) YEAR ENDED DECEMBER 31, -------------------------------------- 1993 1992 1991 ------------ ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES (Note 1) Income (loss) from continuing operations.......................... $ 169,978 $ 150,440 $ (340,317) Items not requiring cash Depreciation and amortization....... 258,562 259,637 268,153 Deferred income taxes -- net........ 139,725 84,146 (128,863) Palo Verde cost deferral (Notes 1 and 3)............................ -- -- (133,954) Provision for rate refund -- net (Note 3).......................... (21,374) (21,374) 52,057 Disallowed Palo Verde costs (Note 3) -- -- 577,145 Palo Verde accretion income (Note 3) (74,880) (67,421) (5,306) Other -- net........................ (168) (1,829) (4,235) Changes in current assets and liabilities Accounts receivable -- net.......... 31,090 (31,715) 18,006 Accrued utility revenues............ (8,839) (7,055) 1,004 Materials, supplies and fossil fuel. 2,252 5,094 (8,490) Other current assets................ (5,782) 2,042 (478) Accounts payable.................... (27,196) 9,547 18,866 Accrued taxes....................... (21,391) 45,962 (18,902) Accrued interest.................... (905) (16,593) (3,588) Other current liabilities........... (18,408) (16,549) 3,364 Additions to real estate............ (29,290) (12,647) (18,593) Sales of real estate................ 21,396 14,622 7,787 Other -- net........................ 34,292 5,973 4,407 ------------ ----------- ----------- Net Cash Flow Provided By Operating Activities.......................... 449,062 402,280 288,063 ------------ ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures.................. (234,944) (224,419) (182,687) Allowance for equity funds used during construction........................ 2,326 3,103 3,902 Sale of property (Note 3)............. 89 5,480 233,875 Other -- net.......................... 1,609 (6,555) (2,630) ------------ ----------- ----------- Net Cash Flow Provided By (Used For) Investing Activities................ (230,920) (222,391) 52,460 ------------ ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Issuance of long-term debt............ 535,893 649,165 485,844 Issuance of preferred stock........... 72,644 24,781 49,375 Short-term borrowings -- net.......... (47,000) 195,000 (159,000) Dividends paid on common stock........ (17,466) -- -- Repayment of long-term debt........... (711,241) (1,109,181) (593,252) Repayment of preferred stock.......... (78,663) (27,850) (15,175) Other -- net.......................... (8,108) 2,407 6,042 ------------ ----------- ----------- Net Cash Flow Used For Financing Activities.......................... (253,941) (265,678) (226,166) ------------ ----------- ----------- Net Cash Flow......................... (35,799) (85,789) 114,357 Cash and Cash Equivalents at Beginning of Year............................. 87,926 173,715 59,358 ------------ ----------- ----------- Cash and Cash Equivalents at End of Year................................ $ 52,127 $ 87,926 $ 173,715 ============ =========== =========== See Notes to Consolidated Financial Statements. PINNACLE WEST CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (THOUSANDS OF DOLLARS) YEAR ENDED DECEMBER 31, ----------------------------------- 1993 1992 1991 ----------- ---------- ---------- Retained Earnings (Deficit) at Beginning of Year................................ $ (165,047) $ (321,487) $ (134,625) Net Income (Loss)........................ 189,230 156,440 (186,862) Common Stock Dividends................... (17,466) -- -- ----------- ---------- ---------- Retained Earnings (Deficit) at End of Year................................... $ 6,717 $ (165,047) $ (321,487) =========== ========== ========== PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. CONSOLIDATION The consolidated financial statements include the accounts of Pinnacle West Capital Corporation and its subsidiaries: Arizona Public Service Company, an electric utility; SunCor Development Company, a real estate development company; and El Dorado Investment Company, a venture capital firm. Certain prior year balances have been reclassified to conform to the 1993 presentation. B. UTILITY PLANT AND DEPRECIATION Utility plant represents the buildings, equipment and other facilities used to provide electric service. The cost of utility plant includes labor, material, contract services and other related items and an allowance for funds used during construction. The cost of retired depreciable utility plant, plus removal costs less salvage realized, is charged to accumulated depreciation. Depreciation on utility property is provided on a straight-line basis. The applicable rates for 1991 through 1993 ranged from 0.84% to 15.00%, which resulted in annual composite rates of 3.37%. Depreciation and amortization of non-utility property and equipment are provided over the estimated useful lives of the related assets, ranging from 3 to 33.3 years. C. REVENUES Electric operating revenues are recognized on the accrual basis and include estimated amounts for service rendered but unbilled at the end of each accounting period. D. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION AFUDC represents the cost of debt and equity funds used to finance construction of utility plant. Plant construction costs, including AFUDC, are recovered in authorized rates through depreciation when completed projects are placed into commercial operation. AFUDC does not represent current cash earnings. AFUDC has been calculated using composite rates of 7.20% for 1993, 10.00% for 1992 and 10.15% for 1991. APS compounds AFUDC semiannually and ceases to accrue AFUDC when construction work is completed and the property is placed in service. E. INCOME TAXES Pinnacle West and its subsidiaries file a consolidated U.S. income tax return. Provisions for income tax are made by each subsidiary as if separate income tax returns were filed. The difference, if any, between these provisions and consolidated income tax expense is allocated to Pinnacle West. Investment tax credits were deferred and are being amortized to other income over the estimated lives of the related assets as directed by the ACC. In 1993, Pinnacle West adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" (see Note 4). F. REACQUIRED DEBT COSTS APS amortizes gains and losses on reacquired debt over the remaining life of the original debt, consistent with ratemaking. G. NUCLEAR FUEL AND DECOMMISSIONING COSTS Nuclear fuel is charged to fuel expense using the unit-of-production method under which the number of units of thermal energy produced in the current period is related to the total thermal units expected to be produced over the remaining life of the fuel. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In 1993, APS recorded $6.5 million for decommissioning expense. Based on the most recent site-specific study to completely remove all facilities, APS expects to record $11.4 million for decommissioning expense in 1994. APS estimates it will cost approximately $2.1 billion ($407 million in 1993 dollars), over a thirteen-year period beginning in 2023, to decommission its 29.1% interest in Palo Verde. Decommissioning costs are charged to expense over the respective units operating license term and included in the accumulated depreciation balance until Palo Verde is retired from service. As required by the ACC, APS has established external trust accounts into which quarterly deposits are made for decommissioning. As of December 31, 1993, APS has deposited a total of $35.0 million. The trust accounts are included in "Investments and Other Assets" on the Consolidated Balance Sheets and have accumulated a $44.7 million balance at December 31, 1993, including investment earnings. H. STATEMENTS OF CASH FLOWS Temporary cash investments and marketable securities with an initial maturity of three months or less are considered to be cash equivalents for purposes of the Consolidated Statements of Cash Flows. During 1993, 1992 and 1991, Pinnacle West and its subsidiaries paid interest, net of amounts capitalized, of $243.9 million, $286.4 million and $305.4 million, respectively. Income taxes paid were $45.3 million, $33.8 million and $19.7 million, respectively; and dividends paid on preferred stock of APS were $30.9 million, $32.6 million and $33.1 million, respectively. I. PALO VERDE COST DEFERRALS As authorized by the ACC, APS deferred operating costs (excluding fuel) and financing costs of Palo Verde Units 2 and 3 from each units commercial operation date until the date each unit was included in a rate order. The deferrals are being amortized and recovered through rates over thirty-five year periods. 2. DISCONTINUED OPERATIONS In 1989, a settlement was reached which resolved claims made by certain federal agencies with respect to MeraBank, resulting in a $450 million capital infusion by Pinnacle West into MeraBank. The settlement released Pinnacle West from its purported obligations under a capital maintenance stipulation relating to MeraBank. Because of certain unresolved federal income tax issues, Pinnacle West could not at the time record an income tax benefit related to the loss incurred as a result of the settlement. In January 1992, the Internal Revenue Service issued a ruling which allowed Pinnacle West to deduct, for federal income tax purposes, its remaining investment in MeraBank including the capital infusion. As a result, Pinnacle West recorded income from discontinued operations in 1991 of $153.5 million representing the tax benefit of a federal net operating loss (NOL) carryforward. In 1992, Pinnacle West recorded $6 million of income from discontinued operations representing the recognition of a portion of the state NOL carryforward. 3. REGULATORY MATTERS RATE CASE SETTLEMENT In December 1991, APS and the ACC reached a settlement in the retail rate case that had been pending before the ACC since January 1990. The ACC authorized an annual net revenue increase of $66.5 million, or approximately 5.2%. In turn, APS wrote off $577.1 million of costs associated with Palo PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Verde and recorded a refund obligation of $53.4 million. The after-tax impact of these adjustments reduced 1991 net income by $407 million. A discussion of the components of the disallowance follows. Prudence Audit The ACC closed its prudence audit of Palo Verde and APS wrote off $142 million ($101.3 million after tax) of construction costs relating to Palo Verde Units 1, 2 and 3 and $13.3 million ($8.6 million after tax) of deferred costs relating to the prudence audit. Interim or Temporary Revenues The ACC removed the interim and temporary designation on $385 million of revenues collected by APS from 1986 through 1991 that had been previously authorized for Palo Verde Units 1 and 2. APS recorded a refund obligation to customers of $53.4 million ($32.3 million after tax) related to the Palo Verde write-off discussed above. The refund obligation has been used to reduce the amount of annual rate increase granted rather than require specific customer refunds and is being reversed over thirty months beginning December 1991. During 1993, 1992 and 1991 after-tax refund obligation reversals recorded by APS as electric operating revenue were $12.9 million, $12.9 million and $0.9 million, respectively. APS will record $5.6 million after tax in 1994. Excess Capacity Issue The ACC deemed a portion of Palo Verde Unit 3 to be excess capacity and, accordingly, did not recognize the related Unit 3 costs for ratemaking purposes. This action effectively disallows for thirty months a return on approximately $475 million of APS' investment in Unit 3. APS recognized a charge of $181.2 million ($109.5 million after tax), representing the present value of the lost cash flow and to that extent temporarily discounted the carrying value of Unit 3. In accordance with generally accepted accounting principles, APS is recording, over the thirty-month period, accretion income on Unit 3 in the aggregate amount of the discount. During 1993, 1992 and 1991 APS recorded after-tax accretion income of $45.3 million, $40.7 million and $3.2 million, respectively. APS will record $20.3 million after tax in 1994. In December 1991, APS stopped deferring Unit 3 costs and recorded a $240.6 million ($155.3 million after tax) write-off of Unit 3 cost deferrals due to a portion of Unit 3 being deemed excess capacity. At that time, APS began amortizing to expense and recovering in rates the remaining $320 million balance of the deferrals over a thirty-five year period as approved by the ACC. Future Retail Rate Increase APS agreed not to file a new rate application before December 1993 and the ACC agreed to expedite the processing of a future rate application. APS and the ACC also agreed on an average unit sales price ceiling of 9.585 cents per kilowatt-hour in this future rate application, if filed prior to January 1, 1995. APS' 1993 average unit sales price was approximately 9 cents per kilowatt-hour. This ceiling may be adjusted for the effects of significant changes in laws, regulatory requirements or APS' cost of equity capital. Management believes that the unit sales price ceiling will not adversely impact APS' future earnings and has not yet determined when a rate case may be filed. Dividend Payments APS agreed to limit its annual common stock dividends to Pinnacle West to $170 million through December 1993. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SALE OF CHOLLA 4 July 1991, APS sold Unit 4 of the Cholla Power Plant to PacifiCorp for approximately $230 million. The resulting after-tax gain of approximately $20 million was deferred and is being amortized as a reduction to operations expense over a four-year period in accordance with an ACC order. The transaction also provides for transmission access and electrical energy sales and exchanges between APS and PacifiCorp. 4. INCOME TAX EXPENSE Effective January 1, 1993, Pinnacle West adopted the provisions of SFAS No. 109, "Accounting for Income Taxes," which requires the use of the liability method of accounting for income taxes. The cumulative effect on prior years of this change in accounting principle resulted in an increase to net income of $19.3 million, due primarily to the recognition of deferred tax benefits relating to state NOL carryforwards of Pinnacle West. As a result of adopting SFAS No. 109, APS recorded additional deferred income taxes related to the equity comoponent of AFUDC; the debt component of AFUDC net-of-tax; and other temporary differences for which deferred income taxes had not been provided. Deferred tax balances were also adjusted for changes in tax rates. The adoption of SFAS No.109 increased deferred income tax liabilities by $585.3 million at December 31, 1993. Historically, the FERC and the ACC have allowed revenues sufficient to pay for these deferred tax liabilities and, in accordance with SFAS No. 109, a regulatory asset was established in a corresponding amount. The components of income tax expense (benefit) from continuing operations are as follows: PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Income tax expense (benefit) differed from the amount computed by multiplying income from continuing operations before income taxes by the statutory federal income tax rate due to the following: The components of the net deferred income tax liability at December 31, 1993, were as follows: At December 31, 1993, Pinnacle West had federal NOL carryforwards of approximately $304 million which may be used through 2005 and state NOL carryforwards of approximately $218 million which expire in 1994 through 1996. Pinnacle West also had ITC carryforwards of approximately $41 million which expire in 2000 through 2005. See Note 2 for tax benefits recorded in connection with discontinued operations. 5. LINES OF CREDIT PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) APS had committed lines of credit with various banks totalling $302 million at December 31, 1993 and 1992 which were available either to support the issuance of commercial paper or to be used for bank borrowings. The commitment fees on these lines were 0.1875% per annum through April 29, 1992 and 0.25% thereafter through December 31, 1993. APS had commercial paper borrowings outstanding of $148 million at December 31, 1993 and bank borrowings of $130 million at December 31, 1992. In 1992, APS also had a $70 million letter of credit commercial paper program. Under this program, which expired in November 1993, APS had $65 million of borrowings outstanding at December 31, 1992. The commitment fees for this program were 0.30% per year. By Arizona statute, APS' short-term borrowings cannot exceed 7% of its total capitalization without the consent of the ACC. Pinnacle West had a liquidity facility of $40 million at December 31, 1993 and $50 million at December 31, 1992. The facility is available for payments of principal and interest on Pinnacle West's outstanding debt with a maximum of $20 million for principal payments. Any borrowings on this facility would be secured by the APS common stock owned by Pinnacle West and would bear interest, at Pinnacle West's option, at rates based on the prime rate or on LIBOR. Pinnacle West pays a 0.3125% commitment fee on the facility based on existing long-term credit ratings. There were no borrowings outstanding under the liquidity facility at December 31, 1993 or 1992. 6. LONG-TERM DEBT In January 1990, Pinnacle West restructured the majority of its long-term debt. Pinnacle West granted the affected lenders a security interest in the outstanding common stock of APS and agreed not to incur new debt except to reduce, refinance or prepay existing debt. Pinnacle Wests ability to pay dividends is dependent upon the satisfaction of specified interest coverage ratios. Additionally, cumulative dividend payments for the period April 1, 1990 through any dividend declaration date are limited to 50% of cumulative consolidated net income (as defined) for the same period. As of December 31, 1993, Pinnacle West could have declared dividends of approximately $241 million based on this formula. Pinnacle West's aggregate investments in its existing subsidiaries (excluding APS) and new investments are generally limited to $15 million and $20 million, respectively, until the lenders are repaid. Pinnacle West must maintain certain interest coverage ratios and meet certain funded debt tests. Additionally, Pinnacle West would be required to use the net cash proceeds from the sale of SunCor or El Dorado or substantially all of their assets to repay debt. The following table presents long-term debt outstanding as of December 31, 1993 and 1992. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Aggregate annual principal payments due on total long-term debt and for sinking fund requirements through 1998 are as follows: 1994, $78,841,000; 1995, $82,625,000; 1996, $43,858,000; 1997, $231,543,000; and 1998, $110,297,000. See Note 7 for redemption and sinking fund requirements of redeemable preferred stock of APS. Substantially all utility plant other than nuclear fuel, transportation equipment and the combined cycle plant, is subject to the lien of the first mortgage bonds. The first mortgage bond indenture includes provisions which would restrict the payment of dividends on APS common stock under certain conditions which did not exist at December 31, 1993. Pinnacle West and its subsidiaries incurred interest expense of $264,306,000, $286,347,000 and $333,923,000 in 1993, 1992 and 1991, of which $1,840,000, $1,389,000 and $1,194,000 was capitalized in each year, respectively. APS had approximately $370 million of variable-rate long-term debt outstanding at December 31, 1993. Changes in interest rates would affect the costs associated with this debt. 7. PREFERRED STOCK OF APS Non-redeemable preferred stock is not redeemable except at the option of APS. Redeemable preferred stock is redeemable through sinking fund obligations in addition to being callable by APS. The balances at December 31, 1993 and 1992, of preferred stock of APS are shown below: PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) If there were to be any arrearage in dividends on any of its preferred stock or in the sinking fund requirements applicable to any of its redeemable preferred stock, APS could not pay dividends on its common stock or acquire any shares thereof for consideration. The combined aggregate amount of preferred stock redemption requirements for the next five years are: 1994, $65,775,000; 1995, $13,525,000; 1996, $13,525,000; 1997, $13,525,000; and 1998, $13,525,000. Redeemable preferred stock transactions of APS during each of the three years in the period ended December 31, 1993, are as follows: NUMBER OF PAR VALUE SHARES AMOUNT ---------- --------- (THOUSANDS OF DOLLARS) Balance, December 31, 1990............................. 1,924,532 $192,453 Issuance $10.00 Series U...................................... 500,000 50,000 Retirements $10.00 Series H...................................... (16,000) (1,600) $8.80 Series K....................................... (40,275) (4,027) $12.90 Series N...................................... (24,975) (2,498) $11.50 Series R...................................... (70,500) (7,050) ---------- --------- Balance, December 31, 1991............................. 2,272,782 227,278 Issuance $7.875 Series V...................................... 250,000 25,000 Retirements $10.00 Series H...................................... (8,677) (868) $8.80 Series K....................................... (4,725) (472) $12.90 Series N...................................... (213,280) (21,328) $11.50 Series R...................................... (39,750) (3,975) ---------- --------- Balance, December 31, 1992............................. 2,256,350 225,635 Retirements $8.80 Series K....................................... (45,000) (4,500) $11.50 Series R...................................... (35,250) (3,525) $8.48 Series S....................................... (200,000) (20,000) ---------- --------- Balance, December 31, 1993............................. 1,976,100 $ 197,610 ========== ========= 8. COMMON STOCK Pinnacle West's common stock issued during each of the three years in the period ended December 31, 1993, is as follows: NUMBER OF PAR VALUE SHARES AMOUNT ---------- ----------- Balance, December 31, 1990........................... 86,873,174 $1,646,570 Common stock issued................................ 136,800 319 ---------- ----------- Balance, December 31, 1991........................... 87,009,974 1,646,889 Common stock issued................................ 151,898 (117) ---------- ----------- Balance, December 31, 1992........................... 87,161,872 1,646,772 Common stock issued................................ 261,945 (3,989) ---------- ----------- Balance, December 31, 1993........................... 87,423,817 $1,642,783 ========== =========== - ---------- (a) Including premiums and expenses of preferred stock issues of APS. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Pinnacle West Stock Purchase and Dividend Reinvestment Plan provides that any participant may purchase shares of Pinnacle West common stock directly from Pinnacle West. Both Pinnacle West and APS have employee savings plans under which contributions by participating employees and contributions by employers could involve the issuance of new shares of Pinnacle West common stock. Contributions made by Pinnacle West and APS to their respective employee retirement plans may also involve one or more such issuances of common stock. However, Pinnacle West plans to continue making market purchases of its outstanding stock to meet its needs related to the Stock Purchase and Dividend Reinvestment Plan, the employee savings plans and the employee retirement plans. Under the Pinnacle West Stock Option and Incentive Plan, non-qualified stock options (NQSOs), incentive stock options (ISOs) and restricted stock awards may be granted to officers and key employees of Pinnacle West and subsidiaries up to an aggregate of 3 million shares of Pinnacle West common stock. The plan also provides for the granting of stock appreciation rights, performance shares, dividend equivalents or any combination thereof. Another plan provides for the granting of NQSOs to Pinnacle Wests directors up to an aggregate of 500,000 shares of stock. As of December 31, 1993, approximately 333,000 restricted shares, 1,789,000 NQSOs, 10,000 ISOs and 30,000 dividend equivalent shares were outstanding under the plans. 9. PENSION PLANS AND OTHER BENEFITS Pension plans Pinnacle West and its subsidiaries have defined benefit pension plans covering substantially all employees. Benefits are based on years of service and compensation utilizing a final average pay plan benefit formula. The plans are funded on a current basis to the extent deductible under existing tax regulations. Plan assets consist primarily of domestic and international common stocks and bonds and real estate. Pension cost, including administrative cost, for 1993, 1992 and 1991 was approximately $14,267,000, $14,384,000 and $10,913,000, respectively, of which approximately $6,833,000, $4,279,000 and $5,262,000, respectively, was charged to expense; the remainder was either capitalized as a component of construction cost or billed to other owners of facilities for which APS is operating agent. The components of net periodic pension costs are as follows: 1993 1992 1991 --------- -------- -------- (THOUSANDS OF DOLLARS) Service cost -- benefits earned during the period....................................... $17,051 $17,227 $14,831 Interest cost on projected benefit obligation.. 35,046 33,633 31,216 Return on plan assets.......................... (52,026) (23,225) (65,262) Net amortization and deferral.................. 13,547 (15,097) 28,924 --------- -------- -------- Net consolidated periodic pension cost......... $13,618 $12,538 $ 9,709 ========= ======== ======== The discount rate used in determining the actuarial present value of the projected benefit obligation was 7.50% in 1993 and 8.25% in 1992. The rate of increase in future compensation levels used was 5.0% in 1993 and 1992. The expected long-term rate of return on assets was 9.5% in 1993 and 1992; in 1994, the company will assume a 9% rate of return. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A reconciliation of the funded status of the plan to the amounts recognized in the balance sheet is presented below: 1993 1992 --------- --------- (THOUSANDS OF DOLLARS) Plan assets at fair value............................... $ 421,563 $ 391,827 --------- --------- Less actuarial present value of benefit obligation, including vested benefits of $350,812 and $288,456 in 1993 and 1992, respectively........................... 375,800 309,607 Effect of projected future compensation increases....... 128,797 106,218 --------- --------- Total projected benefit obligation...................... 504,597 415,825 --------- --------- Plan assets less than projected benefit obligation...... (83,034) (23,998) Plus: Unrecognized net loss from past experience different from that assumed........................... 51,551 8,097 Unrecognized prior service cost................... 14,866 15,893 Unrecognized net transition asset................. (39,371) (42,597) --------- --------- Accrued pension liability............................... $ (55,988) $ (42,605) ========= ========= In addition to the defined benefit pension plans described above, Pinnacle West and its subsidiaries also sponsor qualified defined contribution plans. Collectively, these plans cover substantially all employees. The plans provide for employee contributions and partial employer matching contributions after certain eligibility requirements are met. The cost of these plans for 1993, 1992 and 1991 was $6,391,000, $5,404,000 and $2,756,000, of which $3,114,000, $2,607,000 and $1,392,000 was charged to expense. Postretirement Plans Pinnacle West and its subsidiaries provide medical and life insurance benefits to their retired employees. Employees may become eligible for these retirement benefits based on years of service and age. The retiree medical insurance plan is contributory; the retiree life insurance plan is noncontributory. In accordance with the governing plan documents, the companies retain the right to change or eliminate these benefits. During 1993, Pinnacle West adopted SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions," which requires that the cost of postretirement benefits be accrued during the years that the employees render service. Prior to 1993, the costs of retiree benefits were recognized as expense when claims were paid. This change had the effect of increasing 1993 retiree benefit costs from approximately $6 million to $35 million; the amount charged to expense increased from approximately $2 million to $17 million for an increase of $15 million including the amortization (over 20 years) of the initial postretirement benefit obligation estimated at January 1, 1993 to be $184 million. Funding is based upon actuarially determined contributions that take tax consequences into account. The components of the estimated postretirement benefit costs for 1993 are: (THOUSANDS OF DOLLARS) Service cost -- benefits earned during the period.... $ 9,710 Interest cost on accumulated benefit obligation...... 15,755 Net amortization and deferral........................ 9,212 ------- Net consolidated periodic postretirement benefit cost $34,677 ======= PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A reconciliation of the funded status of the plan to the amounts recognized in the balance sheet for 1993 is presented below: Plan assets at fair value, funded at December 31, 1993.. $ 28,154 ---------- Less accumulated postretirement benefit obligation: Retirees............................................ 49,493 Fully eligible plan participants.................... 13,671 Other active plan participants...................... 138,364 ---------- Total accumulated postretirement obligation............. 201,528 ---------- Plan assets less than accumulated benefit obligation.... (173,374) Plus: Unrecognized transition obligation................ 175,023 Unrecognized net gain from past experience different from that assumed and from from changes in assumptions...................... (2,089) ---------- Accrued postretirement liability included in other deferred credits...................................... $ (440) ========== Principal actuarial assumptions used were: Discount rate......................................... 7.50% Initial health care cost trend rate under age 65...... 12.00% Initial health care cost trend rate -- age 65 and over 9.00% Ultimate health care cost trend rate (reached in the year 2003).......................... 5.50% Annual salary increases for life insurance obligation. 5.00% Assuming a one percent increase in the health care cost trend rate, the Company's 1993 cost of postretirement benefits other than pensions would increase by $6.9 million and the accumulated benefit obligation as of December 31, 1993 would increase by $40.8 million. In 1993, Pinnacle West adopted SFAS No. 112, "Employers Accounting for Postemployment Benefits." The new standard requires a change from a cash method to an accrual method in accounting for benefits (such as long-term disability) provided to former or inactive employees after employment but before retirement. The adoption of this new standard resulted in an increase in 1993 postemployment benefit costs of approximately $2 million. 10. SUPPLEMENTAL INCOME STATEMENT INFORMATION Other taxes charged to operations during each of the three years in the period ended December 31, 1993 are as follows: 1993 1992 1991 --------- -------- -------- (THOUSANDS OF DOLLARS) Ad valorem..................................... $124,630 $119,173 $121,936 Sales.......................................... 84,901 83,185 80,815 Other.......................................... 12,814 14,705 12,790 --------- -------- -------- Total other taxes.............................. $222,345 $217,063 $215,541 ========= ======== ======== 11. LEASES In 1986, APS entered into sale and leaseback transactions under which it sold approximately 42% of its share of Palo Verde Unit 2. The gain of approximately $140,220,000 has been deferred and is being amortized to expense over the original lease term. The leases are being accounted for as operating leases. The amounts paid each year approximate $40,134,000 through December 1999; $46,285,000 through December 2000; and $48,982,000 through December 2015. Options to renew the leases for two additional years and to purchase the property at fair market value at the end of the lease terms are also included. Lease expense for 1993, 1992 and 1991 was $41,750,000, $45,838,000 and $45,633,000, respectively. APS has a capital lease on a combined cycle plant which it sold and leased back. The lease requires semiannual payments of $2,582,000 through June 2001, and includes renewal and purchase options based on fair market value. This plant is included in electric plant in service at its original cost of $54,405,000; accumulated depreciation at December 31, 1993 was $37,315,000. In addition, Pinnacle West and its subsidiaries lease certain land, buildings, equipment and miscellaneous other items through operating rental agreements with varying terms, provisions and expiration dates. Rent expense for 1993, 1992 and 1991 was approximately $21,535,000, $26,104,000 and $28,185,000, respectively. Annual future minimum rental commitments, excluding the Palo Verde and combined cycle leases, through 1998 are as follows: 1994, $22,879,000; 1995, $17,183,000; 1996, $14,146,000; 1997, $14,120,000; and 1998, $14,126,000. Total rental commitments after 1998 are estimated at $198 million. 12. JOINTLY-OWNED FACILITIES At December 31, 1993, APS owned interests in the following jointly-owned electric generating and transmission facilities. APS' share of related operating and maintenance expenses is included in utility operations and maintenance. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 13. COMMITMENTS AND CONTINGENCIES Litigation Pinnacle West and its subsidiaries are parties to various claims, legal actions and complaints arising out of the normal course of business. Various claims have been asserted against Pinnacle West and against present and former directors of Pinnacle West and MeraBank. A settlement agreement that would resolve the preponderance of these claims has been approved by the court. An appeal of the settlement by two non-settling individuals is pending. In the opinion of management, the ultimate resolution of these claims will not have a material adverse effect on the operations or financial position of Pinnacle West. Palo Verde Tube Cracks Tube cracking in the Palo Verde steam generators adversely affected operations in 1993, and will continue to do so in 1994 and probably into 1995, because of the cost of replacement power and maintenance expense associated with unit outages and corrective actions required to deal with the issue. The operation of Palo Verde Unit 2 has been particularly affected by this issue. APS has encountered axial tube cracking in the upper regions of the two steam generators in Unit 2. This form of tube degradation is uncommon in the industry and, in March 1993, led to a tube rupture and an outage of the unit that extended to September 1993, during which the unit was refueled. Unit 2 is currently completing a mid-cycle inspection outage which revealed further tube degradation. Unit 2 will have another mid-cycle inspection outage later in 1994. The steam generators of Units 1 and 3 were inspected late in 1993, but did not show signs of axial cracking in their upper regions. All three units have, however, experienced cracking in the bottom of the steam generators of the types which are common in the industry. Although its analysis is not yet completed, APS believes that the axial cracking in Unit 2 is due to deposits on the tubes and to the relatively high temperatures at which all three units are now designed to operate. APS also believes that it can retard further tube degradation to acceptable levels by remedial actions which include chemically cleaning the generators and performing analyses and adjustments that will allow the units to be operated at lower temperatures without appreciably reducing their output. The temperature analyses should be concluded within the next several months. In the meantime, the lower temperatures will be achieved by operating the units at less than full power (86%). Chemical cleaning was performed during Unit 2's current mid-cycle outage, and will be performed in the next refueling outage of Unit 3 (which will begin shortly) and of Unit 1 (which is scheduled for March 1995). APS has concluded that Unit 1 can be safely operated until the 1995 outage and has submitted its supporting analysis to the Nuclear Regulatory Commission, but a mid-cycle inspection later in 1994 is possible. As a result of these corrective actions, all three units should be returned to full power by mid-1995, and one or more of the units could be returned to full power during 1994. So long as the three units are involved in mid-cycle outages and are operated at 86%, APS will incur additional fuel and purchased power costs averaging approximately $2 million per month (before income taxes). Because of schedule changes associated with the tube issues and other circumstances, it now appears that all three units will be down for refueling outages at various times during 1995. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) When significant cracks are detected during any outage, the affected tubes are taken out of service by plugging. That has occurred in a number of tubes in Unit 2, which is by far the most affected by cracking and plugging. APS expects that this will slow considerably because of the foregoing remedial actions and that, while it may ultimately reach some limit on plugging, it can operate the present steam generators over a number of years. Construction Program Total construction expenditures in 1994 are estimated at $312 million, excluding capitalized property taxes and capitalized interest. Fuel and Purchased Power Commitments APS is a party to various fuel and purchased power contracts with terms expiring from 1994 through 2020. APS estimates its 1994 contract requirements at approximately $136 million. However, this amount may vary significantly pursuant to certain provisions in such contracts which permit APS to decrease its required purchases under certain circumstances. Nuclear Insurance The Palo Verde participants have insurance for public liability resulting from nuclear energy hazards to the full limit of liability under federal law. This potential liability is covered by primary liability insurance provided by commercial insurance carriers in the amount of $200 million, and the balance by an industry-wide retrospective assessment program. The maximum assessment per reactor under the retrospective rating program for each nuclear incident is approximately $79 million, subject to an annual limit of $10 million per incident. Based upon APS' 29.1% interest in the three Palo Verde units, APS' maximum potential assessment per incident is approximately $69 million, with an annual payment limitation of $8.73 million. The Palo Verde participants maintain "all risk" (including nuclear hazards) insurance for property damage to, and decontamination of, property at Palo Verde in the aggregate amount of $2.75 billion, a substantial portion of which must first be applied to stabilization and decontamination. APS has also secured insurance against portions of any increased cost of generation or purchased power and business interruption resulting from a sudden and unforeseen outage of any of the three units. The insurance coverage discussed in this and the previous paragraph is subject to certain policy conditions and exclusions. El Paso Electric Company Bankruptcy The other joint owners in the Palo Verde and Four Corners facilities (see Note 12) include El Paso Electric Company, which currently is operating under Chapter 11 of the Bankruptcy Code. A plan whereby El Paso would become a wholly-owned subsidiary of Central and South West Corporation would resolve certain issues to which APS could be exposed by the bankruptcy, including El Paso allegations regarding the 1989-1990 Palo Verde outages. The plan has been confirmed by the bankruptcy court, but cannot become fully effective until several additional or related approvals are obtained. If they are not obtained, the plan could be withdrawn or terminate, thereby reintroducing the APS exposures. PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Consolidated quarterly financial information for 1993 and 1992 is as follows: PINNACLE WEST CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 15. FAIR VALUE OF FINANCIAL INSTRUMENTS Pinnacle West estimates that the carrying amounts of its cash equivalents and commercial paper are reasonable estimates of their fair values at December 31, 1993 and 1992 due to their short maturities. The December 31, 1993 and 1992 fair values of debt and equity investments, determined by using quoted market values or by discounting cash flows at rates equal to the Company's costs of capital, approximate their carrying amounts. It was not practicable to estimate the fair values of several investments in joint ventures and untraded equity securities because costs to do so would be excessive. The carrying value of these investments totalled $45.6 million and $63.6 million at year-end 1993 and 1992, respectively. On December 31, 1993, the carrying amount of long-term debt liabilities (excluding $30 million of capital lease obligations) was $2.682 billion and its estimated fair value was approximately $2.911 billion. On December 31, 1992, the carrying amount of long-term debt (excluding $32 million of capital lease obligations was $2.848 billion and its estimated fair value was approximately $3.020 billion. The fair value estimates were determined by independent sources using quoted market rates where available. Where market prices were not available, the fair values were estimated by discounting future cash flows using rates available for debt of similar terms and remaining maturities. The carrying amounts of long-term debt bearing variable interest rates approximate their fair values at December 31, 1993 and 1992. PINNACLE WEST CAPITAL CORPORATION SCHEDULE IX -- SHORT-TERM BORROWINGS Column A Column B Column C (b) Column D Column E (a) Column F (b) Weighted Weighted average Maximum Average average Category of Balance interest amount amount interest aggregate at end rate outstanding outstanding rate short-term of at end of during the during the during the borrowings period period period period period ---------- -------- ------------ ----------- ------------ ------------ (Dollars in Thousands) YEAR ENDED DECEMBER 31, 1993 Bank Borrowings $ -- -- % $130,000 $63,616 3.97% Commercial Paper 148,000 3.48 148,000 23,049 3.36 YEAR ENDED DECEMBER 31, 1992 Bank Borrowings $130,000 4.28% $175,000 $ 9,372 5.25% Commercial Paper 65,000 3.73 70,000 12,682 3.75 YEAR ENDED DECEMBER 31, 1991 Bank Borrowings $ -- -- % $100,000 $26,973 7.44% Commercial Paper -- -- 70,000 24,077 6.74 - ---------- (a) Average daily balance during the period. (b) Total applicable interest in the period divided by average daily balance. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is hereby made to "Election of Directors" in the Company's Proxy Statement relating to the annual meeting of shareholders to be held on May 19, 1994 (the "1994 Proxy Statement") and to the Supplemental Item -- "Executive Officers of the Company" in Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is hereby made to the last two paragraphs under the heading "The Board and its Committees," and to "Summary Compensation Table," "Option Grants 1993," "Option Exercises and Year-End Values," and "Executive Benefit Plans" in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is hereby made to "Certain Securities Ownership" in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES See the Index to Financial Statements and Financial Statement Schedules in Part II, Item 8. EXHIBITS FILED EXHIBIT NO. DESCRIPTION - ----------- ----------- 10.1 -- Summary of the Pinnacle West Capital Corporation 1994 Bonus Plan 22 -- Subsidiaries of the Company 23.1 -- Consent of Deloitte & Touche In addition to those Exhibits shown above, the Company hereby incorporates the following Exhibits pursuant to Exchange Act Rule 12b-32 and Regulation (S) 201.24 by reference to the filings set forth below: REPORTS ON FORM 8-K During the quarter ended December 31, 1993, and the period ended March 30, 1994, the Company filed the following Reports on Form 8-K: Report dated December 15, 1993, regarding (i) inspections of the steam generators of the Palo Verde units and related issues and (ii) APS' settlement agreement with a former contract employee. Report dated January 24, 1994 regarding the settlement and dismissal of certain lawsuits involving the Company, one of the lawsuits being partially dismissed. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PINNACLE WEST CAPITAL CORPORATION (Registrant) Date: March 30, 1994 RICHARD SNELL ---------------------------------------------------- (Richard Snell, Chairman of the Board of Directors, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- RICHARD SNELL Principal Executive March 30, 1994 - ---------------------------------------- Officer and Director (Richard Snell, Chairman of the Board of Directors, President and Chief Executive Officer) H. B. SARGENT Principal Financial March 30, 1994 - ---------------------------------------- Officer, Principal (H. B. Sargent, Executive Vice President Accounting Officer and Chief Financial Officer) and Director O. MARK DE MICHELE Director March 30, 1994 - ---------------------------------------- (O. Mark De Michele) PAMELA GRANT Director March 30, 1994 - ---------------------------------------- (Pamela Grant) ROY A. HERBERGER, JR. Director March 30, 1994 - ---------------------------------------- (Roy A. Herberger, Jr.) MARTHA O. HESSE Director March 30, 1994 - ---------------------------------------- (Martha O. Hesse) WILLIAM S. JAMIESON, JR. Director March 30, 1994 - ---------------------------------------- (William S. Jamieson, Jr.) JOHN R. NORTON, III Director March 30, 1994 - ---------------------------------------- (John R. Norton, III) DONALD N. SOLDWEDEL Director March 30, 1994 - ---------------------------------------- (Donald N. Soldwedel) DOUGLAS J. WALL Director March 30, 1994 - ---------------------------------------- (Douglas J. Wall) APPENDIX In accordance with Item 304 of Regulation S-T of the Securities Exchange Act of 1934, APS' Service Territory map contained in this Form 10-K is a map of the state of Arizona showing APS' service area, the location of its major power plants and principal transmission lines, and the location of transmission lines operated by APS for others. The major power plants shown on such map are the Navajo Generating Station located in Coconino County, Arizona; the Four Corners Power Plant located near Farmington, New Mexico; the Cholla Power Plant, located in Navajo County, Arizona; the Yucca Power Plant, located near Yuma, Arizona; and the Palo Verde Nuclear Generating Station, located about 55 miles west of Phoenix, Arizona (each of which plants is reflected on such map as being jointly owned with other utilities), as well as the Ocotillo Power Plant and West Phoenix Power Plant, each located near Phoenix, Arizona, and the Saguaro Power Plant, located near Tucson, Arizona. APS' major transmission lines shown on such map are reflected as running between the power plants named above and certain major cities in the state of Arizona. The transmission lines operated for others shown on such map are reflected as running from the Four Corners Plant through a portion of northern Arizona to the California border. COMMISSION FILE NUMBER 1-8962 - ------------------------------------------------------------------------------ - ------------------------------------------------------------------------------ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------- EXHIBITS TO FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 -------------- PINNACLE WEST CAPITAL CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER) - ------------------------------------------------------------------------------ - ------------------------------------------------------------------------------ INDEX TO EXHIBITS Exhibit No. Description - ----------- ----------- 10.1 -- Summary of the Pinnacle West Capital Corporation 1994 Bonus Plan 22 -- Subsidiaries of the Company 23.1 -- Consent of Deloitte & Touche

831259_1993.txt

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1993

831259

Item 3. Legal Proceedings. - --------------------------- Although FCX may be from time to time involved in various legal proceedings of a character normally incident to the ordinary course of its business, the management of FCX believes that potential liability in any such pending or threatened proceedings would not have a material adverse effect on the financial condition or results of operations of FCX. FCX, through FTX, maintains liability insurance to cover some, but not all, potential liabilities normally incident to the ordinary course of its business as well as other insurance coverages customary in its business, with such coverage limits as management deems prudent. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------- Not applicable. Executive Officers of the Registrant. - ------------------------------------- In addition to the elected executive officers of FCX (the "Elected FCX Executive Officers"), certain employees of affiliates of FCX are deemed by FCX to be executive officers of FCX (the "Designated FCX Executive Officers") for purposes of the federal securities laws. Listed below are the names and ages, as of March 15, 1994, of each of the Elected FCX Executive Officers and the Designated FCX Executive Officers, together with the principal positions and offices with FCX, FTX, and PT-FI held by each. All officers of FCX, FTX, and PT-FI are elected or appointed for one year terms, subject to death, resignation or removal. Name Age Position or Office ---- --- ------------------ Richard C. Adkerson 47 Senior Vice President of FCX. Senior Vice President of FTX. Commissioner of PT-FI. John G. Amato 50 General Counsel of FCX. General Counsel of FTX. Commissioner of PT-FI. Richard H. Block* 43 Senior Vice President of FTX. Thomas J. Egan* 49 Senior Vice President of FTX. Charles W. Goodyear 36 Senior Vice President of FCX. Senior Vice President of FTX. Commissioner of PT-FI. Hoediatmo Hoed* 54 President Director of PT-FI. W. Russell King* 44 Senior Vice President of FTX. Rene L. Latiolais* 51 Director of FCX. Director, President, and Chief Operating Officer of FTX. Commissioner of PT-FI. George A. Mealey 60 Director, President, and Chief Executive Officer of FCX. Executive Vice President of FTX. Director and Executive Vice President of PT-FI. James R. Moffett 55 Director and Chairman of the Board of FCX. Director, Chairman of the Board, and Chief Executive Officer of FTX. President Commissioner of PT-FI. - -------------------- * This individual is a Designated FCX Executive Officer and not an Elected FCX Executive Officer. He is deemed by FCX to be a Designated FCX Executive Officer solely for purposes of the federal securities laws in view of his position and responsibilities as an officer of FTX or PT- FI, as applicable; he holds no actual position as an officer of FCX. The individuals listed above, with the exceptions of Messrs. Adkerson, Amato, and Goodyear, have served FCX, FTX, or PT-FI in various executive capacities for at least the last five years. Until 1989, Mr. Adkerson was a partner in Arthur Andersen & Co., an independent public accounting firm, and Mr. Goodyear was a Vice President of Kidder, Peabody & Co. Incorporated, an investment banking firm. During the past five years and prior to that period, Mr. Amato has been engaged in the private practice of law and has served as outside counsel to FCX, FTX, and PT-FI. PART II ------- Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder - ----------------------------------------------------------------------------- Matters. -------- The information set forth under the caption "FCX Class A Common Shares" and "Class A Common Share Dividends", on the inside back cover of FCX's 1993 Annual Report to stockholders, is incorporated herein by reference. As of March 15, 1994, there were 2,355 record holders of FCX's Class A common stock. Item 6. Item 6. Selected Financial Data. - --------------------------------- The Information set forth under the caption "Selected Financial and Operating Data", on page 17 of FCX's 1993 Annual Report to stockholders, is incorporated herein by reference. FCX's ratio of earnings to fixed charges for each of the years 1989 through 1993, inclusive, was 27.6x, 9.2x, 4.5x, 6.5x and 3.6x respectively. For this calculation, earnings consist of income from continuing operations before income taxes, minority interest and fixed charges. Fixed charges include interest and that portion of rent deemed representative of interest. Item 7. Item 7. Management's Discussion and Analysis of Financial - ----------------------------------------------------------------- Condition and Results of Operations. ----------------------------------- ORE RESERVE ADDITIONS AND ONGOING EXPLORATION PROGRAM Total estimated proved and probable recoverable reserves at P.T. Freeport Indonesia Company (PT-FI), Freeport-McMoRan Copper & Gold Inc.'s (FCX or the Company) principal operating unit, have increased since December 31, 1992, by 5.9 billion pounds of copper (a 28 percent increase), 7.0 million ounces of gold (a 22 percent increase), and 32.0 million ounces of silver (a 72 percent increase), bringing PT-FI's total year-end 1993 estimated proved and probable recoverable reserves to 26.8 billion pounds of copper, 39.1 million ounces of gold and 76.7 million ounces of silver. The increases, net of production during the year, were added primarily at the Grasberg deposit, but also include additions at the Company's underground mine at the DOZ (Deep Ore Zone) deposit and the recently discovered Big Gossan deposit. In addition to continued delineation of the Grasberg deposit and other deposits including Big Gossan, PT-FI is proceeding with its ongoing exploration program for mineralization within the original mining area. During 1993, PT-FI initiated helicopter-supported surface drilling of the Wanagon gold/silver/copper prospect, located 1.5 miles northwest of Big Gossan and 2 miles southwest of Grasberg, where seven holes were drilled. Significant copper mineralization has been encountered below the 2,900 meter elevation. Preliminary exploration of the new contract of work area (New COW Area) has indicated numerous promising targets. Extensive stream sediment sampling within the new acreage has generated analytical results which are being evaluated. This sampling program, when coupled with regional mapping completed on the ground and from aerial photographs, has led to the outlining of over 50 exploration targets. PT-FI has also completed a fixed-wing air-magnetometer survey of the entire New COW Area. Detailed follow-up exploration of these anomalies by additional mapping and sampling and through the use of both aerial and ground magnetic surveys is now in progress. Systematic drilling of these targets has already commenced with significant mineralization being discovered at several prospects. Additional drilling is required to determine if any of these are commercially viable. Initial surface and stream sampling began on an additional 2.5 million acres, just north and west of our existing COW area, on which an affiliate has an exploration permit and a pending COW. 1993 RESULTS OF OPERATIONS COMPARED WITH 1992 After discussions with the staff of the Securities and Exchange Commission (SEC), FCX is reclassifying certain expenses and accruals previously recorded in 1993 as restructuring and valuation of assets. In response to inquiries, the Company advised the SEC staff that $15.5 million originally reported as restructuring and valuation of assets represented the cumulative effect of changes in accounting principle resulting from the adoption of the new accounting policies that the Company considered preferable, as described in Note 1 to the financial statements. The Company also informed the SEC staff of the components of other charges included in the amount originally reported as restructuring and valuation of assets. The Company concluded that the reclassification and the related supplemental disclosures more accurately reflect the nature of these charges to 1993 net income in accordance with generally accepted accounting principles. These reclassifications had no impact on net income or net income per share. FCX reported 1993 net income applicable to common stock of $21.9 million ($.11 per share) compared with net income of $122.9 million ($.66 per share) for 1992. The results for 1993 reflect (a) a $15.7 million loss for Rio Tinto Minera, S.A. (RTM) since its acquisition (Note 3) and (b) charges totaling $52.6 million ($30.4 million to net income or $.15 per share), of which $28.3 million was noncash, related to (1) restructuring the administrative organization at Freeport-McMoRan Inc. (FTX), the parent company of FCX, (2) adjustments to general and administrative expenses and site production and delivery costs discussed below, and (3) changes in accounting principle, discussed further in Note 1 to the financial statements. Operating income was lower in 1993 due to a lower gross margin resulting primarily from lower copper realizations; higher exploration expenses; administrative restructuring costs (Note 1); and higher general and administrative costs. Also impacting net income were lower interest expense resulting from reduced debt levels, a higher effective tax rate, and an increase in preferred dividends (Notes 4 and 5). Revenues in 1993 increased as a result of the acquisition of RTM, adding sales of copper cathodes and anodes ($204.9 million), gold bullion ($57.4 million), and other products ($26.1 million). Excluding RTM, revenues declined 4 percent when compared to 1992. Copper price realizations, taking into account PT-FI's $.90 per pound price protection program, were 12 percent lower than in 1992, but gold price realizations were up 6 percent. Although ore production averaged 62,300 metric tons of ore milled per day (MTPD) in 1993 (8 percent higher than in 1992), copper sales volumes decreased slightly from 1992 primarily because of sales from inventory in 1992. Gold sales volumes in 1993 benefited from significantly higher fourth-quarter 1993 gold grades (a 46 percent increase over fourth- quarter 1992 and a 38 percent increase over third-quarter 1993), which are not anticipated to continue in 1994, and an increase in gold recovery rates for the year which improve with higher gold grades. See Selected Financial and Operating Data. A reconciliation of revenues from 1992 to 1993 is presented below (in millions): Revenues - 1992 ........................................... $714.3 RTM revenues ........................................... 288.4 Elimination of intercompany sales.......................... (47.7) Concentrate: Price realizations: Copper ............................................... (84.7) Gold ............................................... 14.7 Sales volumes: Copper ............................................... (5.5) Gold ............................................... 30.2 Treatment charges 23.6 Adjustments to prior year concentrate sales ............. (13.0) Other ............................................... 5.6 ------ Revenues - 1993 $925.9 ====== Revenues also benefited from a decline in treatment charges of 3.4 cents per pound from 1992, resulting from a tightening in the concentrate market, as the industry's inventories were reduced for much of 1993. Additionally, lower copper prices led to lower treatment charges since these charges vary with the price of copper. Adjustments to prior year concentrate sales include changes in prices on all metals for prior year open sales as well as the related impact on treatment charges. Open copper sales at the beginning of 1993 were recorded at an average price of $1.04 per pound, but subsequently were adjusted downward as copper prices fell during the year, negatively impacting 1993 revenues. As of December 31, 1993, 213.4 million pounds of copper remained to be contractually priced during future quotational periods. As a result of PT-FI's price protection program, discussed below, these pounds are recorded at $.90 per pound. The copper price on the London Metal Exchange (LME) was $.84 per pound on February 1, 1994. In June 1993, two of PT-FI's four mill level ore passes caved, resulting in a blockage of a portion of the ore pass delivery system. The blockage's primary effect was to limit mill throughput to approximately 40,700 MTPD for approximately eight weeks. The impact of the blockage was minimized by using an ore stockpile adjacent to the mill and installing conveyors to alternative ore pass systems. The ore pass blockage has been rectified through the temporary use of alternative delivery systems and by- passes. A permanent delivery system is expected to be in service by mid- 1994. The copper recovery rate for 1993 was adversely affected because the ore milled from the stockpile contained higher than normal oxidized copper, which yields lower copper recoveries. The Company's insurance policies are expected to cover the property damage and business interruption claims relative to the blockage. PT-FI's unit site production and delivery costs, excluding the $10.0 million charge discussed below, increased slightly from 1992 primarily as a result of costs incurred in connection with the ore pass blockage and an increase in production overhead costs related to expansion activities. Unit cash production costs declined significantly to 31.1 cents per pound in 1993 from 40.7 cents per pound in 1992, benefiting from higher gold and silver credits, lower treatment charges, and reduced royalties primarily due to lower copper prices on which such royalties are based. PT-FI's depreciation rate increased from 7.4 cents per recoverable pound during 1992 to 8.3 cents in 1993, reflecting the increased cost relating to the 66,000 MTPD expansion. As a result of the reserve additions discussed earlier, PT-FI's depreciation rate is expected to decrease to 7.5 cents per recoverable pound for 1994, absent any other significant changes in ore reserves. In addition, FCX is amortizing costs in excess of book value ($2.4 million of amortization in 1993) relating to certain capital stock transactions with PT-FI. Amortization of these excess costs is expected to be $3.6 million per year starting in 1994. Exploration expenditures in Irian Jaya totaled $31.7 million in 1993, compared to $12.2 million in 1992 and are projected to be approximately $35 million in 1994. Exploration expenditures in Spain are expected to be approximately $6 million in 1994. FCX's general and administrative expenses increased from $68.5 million in 1992 to $81.4 million in 1993 primarily because of the additional personnel and facilities needed due to the expansion at PT-FI and the acquisition of RTM. Included in the 1993 expense is $5.0 million for RTM (since its acquisition in March 1993) and charges of $6.3 million primarily consisting of a write-off of deferred charges incurred in 1992 related to a planned securities offering that was withdrawn ($2.0 million) and costs to downsize FCX's computing and management information systems (MIS) structure ($4.0 million). Further increases in general and administrative expenses by FCX are anticipated in conjunction with continuing expansion at PT-FI. General and administrative expenses, including those of RTM, are currently expected to increase by approximately 25 percent in 1994. During the second quarter of 1993, FTX undertook a restructuring of its administrative organization. This restructuring represented a major step by FTX to lower its costs of operating and administering its businesses in response to weak market prices of the commodities produced by its operating units. As part of this restructuring, FTX significantly reduced the number of employees engaged in administrative functions, changed its MIS environment to achieve efficiencies, reduced its needs for office space, outsourced a number of administrative functions, and implemented other actions to lower costs. As a result of this restructuring process, the level of FCX's administrative cost has been reduced substantially over what it would have been otherwise, which benefit will continue in the future. However, the restructuring process entailed incurring certain one-time costs by FTX, portions of which were allocated to FCX pursuant to its management services agreement with FTX. FCX's restructuring costs totaled $20.8 million, including $10.7 million allocated from FTX based on historical allocations, consisting of the following: $8.3 million for personnel related costs; $3.2 million relating to excess office space and furniture and fixtures resulting from the staff reduction; $6.1 million relating to the cost to downsize its computing and MIS structure; and $3.2 million of deferred charges relating to PT-FI's 1989 credit facility which was substantially revised in June 1993. As of December 31, 1993, the remaining accrual for these restructuring costs totaled $1.5 million relating to excess office space. In connection with the restructuring project, FCX changed its accounting systems and undertook a detailed review of its accounting records. As a result of this process, FCX recorded a $10.0 million charge to site production and delivery costs comprised of the following: $5.0 million for materials and supplies inventory obsolescence; $2.5 million for revised estimates of value added taxes and import duties related to prior years; and $2.5 million of adjustments for various items identified in converting its accounting system. Interest expense was $15.3 million during 1993 compared with $18.9 million in 1992, excluding $24.5 million and $24.0 million of capitalized interest, respectively. The New COW provides a 35 percent corporate income tax rate for PT-FI and a 15 percent withholding tax on interest for debt incurred after the signing of the New COW and on dividends paid to FCX by PT-FI. The additional withholding required on interest and on dividends paid to FCX by PT-FI, and a $15.7 million loss by RTM for which no tax benefit is recorded, results in a 1993 effective tax rate of 52 percent (Note 6). TRENDS AND OUTLOOK - MARKETING PT-FI's copper concentrates, which contain significant amounts of recoverable gold and silver, are sold primarily under long-term sales agreements which accounted for virtually all of PT-FI's 1993 sales. PT-FI has commitments from various parties to purchase virtually all of its estimated 1994 production. Concentrate sales agreements provide for provisional billings based on world metals prices, primarily the LME, generally at the time of loading. As is customary within the industry, sales under these long-term contracts usually "final-price" within a few months of shipment. Certain terms of the long-term contracts, including treatment charges, are negotiated annually on a portion of the tonnage to reflect current market conditions. Treatment charges have declined during 1993 as a result of the tightening in the concentrate market and are expected to remain at or below 1993 levels. RTM has commitments from most of its suppliers for 1994 treatment charge rates in excess of current spot market rates. The increased production at PT-FI has required it to market its concentrate globally. Its principal markets include Japan, Asia, Europe and North America. PT-FI's mill throughput is currently forecast to be approximately 67,000 MTPD for 1994 as it continues to integrate new mill equipment for the expansion to 115,000 MTPD. Current estimates for 1994 production are approximately 700 million pounds of copper and 780,000 ounces of gold for PT-FI and 165,000 ounces of gold at RTM. RTM, whose smelter can be expanded, was acquired to provide low-cost smelter capacity for a portion of PT-FI's concentrate and to improve PT-FI's competitive position in marketing concentrate to other parties. During 1993, copper prices dropped to their lowest levels since 1987, reflecting lower demand caused by the continuing global recession, but recovered to a level in excess of $.80 per pound. Prices for copper, gold, and silver are influenced by many factors beyond the Company's control and can fluctuate sharply. PT-FI has a price protection program for virtually all of its estimated copper sales to be priced in 1994 at an average floor price of $.90 per pound of copper, while allowing full benefit from prices above this amount. Based on projected 1994 PT-FI copper sales of approximately 720 million pounds, a 1 cent per pound change in the average annual copper price received over $.90 per pound would have an approximately $6 million effect on pretax operating income and cash flow. Based on projected 1994 gold sales of approximately 800,000 ounces by PT- FI, a $10 per ounce change in the average annual gold price received would have an approximately $8 million effect on 1994 pretax operating income and cash flow. CAPITAL RESOURCES AND LIQUIDITY Cash flow from operations decreased to $158.5 million during 1993 compared with $252.6 million for 1992, due primarily to lower net income and an increase in inventories. Materials and supplies increased over year-end 1992 as additional explosives, reagents and chemicals, fuel, and spare parts are required for the expanding PT-FI operations. For the year ended December 31, 1993, consolidated working capital decreased by $352.0 million from December 31, 1992, primarily as a result of a $358.0 million decrease in cash and short-term investments, which was used to reduce long- term debt and fund capital expenditures, and the negative working capital position of RTM. Cash flow used in investing activities totaled $463.5 million compared with $579.7 million in 1992. Capital expenditures increased 23 percent in 1993 due to increased expansion activities. During 1992, FCX acquired an indirect interest in PT-FI for $211.9 million. Cash flow used in financing activities totaled $53.1 million compared with $618.2 million provided by financing activities in 1992. FCX issued shares of its Step-Up Preferred Stock and its Gold-Denominated Preferred Stock during 1993 for net proceeds totaling $561.1 million. Net proceeds from the two offerings were used in part to reduce borrowings under the PT- FI amended credit agreement by a net $537.0 million, thereby increasing the facility's availability for general corporate purposes and the continued expansion of mining and milling operations. Also in 1993, the Company received net proceeds of $80.0 million from the sale of a portion of PT- FI's infrastructure assets (Note 10). In 1992, $212.5 million was received from the sale of a 10 percent interest in PT-FI to Indonesian investors in December 1991 and $392.0 million was received from the sale of Class A common stock and Special Preference Stock. Dividend payments rose in 1993 due to increased Class A shares outstanding and dividends paid on the Special Preference and Preferred Stock issued in 1992 and 1993. FCX called its Zero Coupon Exchangeable Notes (Note 7) for redemption in January 1994 (substantially all of which were exchanged for Class A common stock) and completed a public offering of its Gold-Denominated Preferred Stock, Series II (Note 4) which yielded net proceeds of $158.5 million to be used primarily for expansion related activities. Cash flow from operations increased to $252.6 million during 1992 compared with $73.9 million for 1991, due primarily to higher net income. Customer accounts receivable rose by $76.1 million to $130.6 million because of increased sales. Partially offsetting the increase in receivables was an increase in accounts payable and accrued liabilities associated with expansion activities. Cash flow used in investing activities increased to $579.7 million during 1992 compared with $240.0 million for 1991, due to increased capital expenditures for the 57,000 MTPD expansion and the purchase of an indirect interest in PT-FI. Cash flow from financing activities increased $415.8 million in 1992 compared with 1991, primarily due to the sale of Class A common stock, Special Preference Stock, and a 10 percent interest in PT-FI to Indonesian investors. The proceeds from these financing activities were used to purchase an indirect interest in PT-FI and to fund ongoing expansion related expenditures. RTM's principal operations currently consist of a copper smelter. The FCX purchase proceeds will be used by RTM for working capital requirements and capital expenditures, including funding a portion of the expansion of its smelter production capacity (expected to cost approximately $50 million) from its current 150,000 metric tons of metal per year to 180,000 metric tons of metal per year by mid-1995. RTM is also studying further expansion of the smelter facilities to as much as 270,000 metric tons of metal production per year and is assessing the opportunity to expand its tankhouse operations from 135,000 metric tons per year to 215,000 metric tons per year. RTM's 1993 cash flow from operations was negative ($5.9 million) primarily due to cash requirements related to shut-down costs for RTM's gold mine. RTM has relied on short-term credit facilities and the FCX purchase proceeds to fund this shortfall. RTM is currently evaluating financing alternatives to fund its short-term needs and to provide long- term funding for expansion. RTM's future cash flow is dependent on a number of variables including fluctuations in the exchange rate between the United States dollar and the Spanish peseta, future prices and sales volumes of gold, the size and timing of the smelter and tankhouse expansions, and the supply/demand for smelter capacity and its impact on related treatment and refining charges. During 1992, the Company established the Enhanced Infrastructure Project (EIP). The full EIP (currently expected to involve aggregate cost of as much as $500 million to $600 million) includes plans for commercial, residential, educational, retail, medical, recreational, environmental and other infrastructure facilities to be constructed during the next 20 years for PT-FI operations. The EIP will develop and promote the growth of local and other third-party activities and enterprises in Irian Jaya through the creation of certain necessary support facilities. The initial phase of the EIP is under construction and is scheduled for completion in 1995. Additional expenditures for EIP assets beyond the initial phase depend on the long-term growth of PT-FI's operations and would be expected to be funded by third-party financing sources, which may include debt, equity or asset sales. As discussed in Note 10, certain portions of the EIP and other existing infrastructure assets are expected to be sold in the near future to provide additional funds for the expansion to 115,000 MTPD. Through 1995, capital expenditures are expected to be greater than cash flow from operations. Upon completion of the previously announced 115,000 MTPD expansion by year-end 1995, annual production is expected to approach 1.1 billion pounds of copper and 1.5 million ounces of gold. Subsequently, capital expenditures will be determined by the results of FCX's exploration activities and ongoing capital maintenance programs. Estimated capital expenditures for 1994 and 1995 for the expansion to 115,000 MTPD, the initial phase of the EIP, ongoing capital maintenance expenditures, and the expansion of RTM's smelter to 180,000 metric tons of metal per year are expected to range from $850 million to $950 million and will be funded by operating cash flow, sales of existing and to-be- constructed infrastructure assets and a wide range of financing sources the Company believes are available as a result of the future cash flow from PT- FI's mineral reserve asset base. These sources include, but are not limited to, PT-FI's credit facility and the public and private issuances of securities (including the January 1994 public offering of Gold-Denominated Preferred Stock, Series II). The New COW contains provisions for PT-FI to conduct or cause to be conducted a feasibility study relating to the construction of a copper smelting facility in Indonesia and for the eventual construction of such a facility, if it is deemed to be economically viable by PT-FI and the Government of Indonesia (the Government). PT-FI has participated in a group assessing the feasibility of constructing a copper smelting facility in Indonesia. PT-FI amended its $550.0 million credit agreement in June 1993. The amended credit agreement, which, among other things eliminated a required debt service reserve and provided a lower interest rate, is guaranteed by FCX and FTX, and is structured as a three year revolving line of credit followed by a 3 1/2 year reducing revolver. As of February 1, 1994, $425.0 million was available to PT-FI under the credit facility. To the extent FTX and its other subsidiaries incur additional debt, the amount available to PT-FI under the credit facility may be reduced (Note 7). Payment of future dividends by FCX will depend on the payment of dividends by PT-FI, which, in turn, depends on PT-FI's economic resources, profitability, cash flow and capital expenditures. It is the policy of PT- FI to maximize its dividend payments to stockholders, taking into account its operational cash needs including debt service requirements. FCX currently pays an annual cash dividend of 60 cents per share to its common shareholders. Management anticipates that this dividend will continue at this level through completion of the expansion in 1995, absent significant changes in the prices of copper and gold. However, FCX's Board of Directors determines its dividend payment on a quarterly basis and in its discretion may change or maintain the dividend payment. In determining dividend policy, the Board of Directors considers many factors, including current and expected future prices and sales volumes, future capital expenditure requirements, and the availability and cost of financing from third parties. PT-FI has had good relations with the Government since it commenced operations in Indonesia in 1967. The New COW provides that the Government will not nationalize the mining operations of PT-FI or expropriate assets of PT-FI. Disputes under the New COW are to be resolved by international arbitration. The 1967 Foreign Capital Investment Law, which expresses Indonesia's foreign investment policy, provides basic guarantees of remittance rights and protection against nationalization, a framework for incentives and some basic rules as to other rights and obligations of foreign investors. ENVIRONMENTAL FTX and affiliates, including FCX, have a history of commitment to environmental responsibility. Since the 1940s, long before public attention focused on the importance of maintaining environmental quality, FTX has conducted preoperational, bioassay, marine ecological, and other environmental surveys to ensure the environmental compatibility of its operations. FTX's Environmental Policy commits FTX's operations to full compliance with local, state, and federal laws and regulations. The Company believes it is in compliance with Indonesian environmental laws, rules, and regulations. The Company had a team of environmental scientists from a leading Indonesian scientific institution conduct a study to update its 1984 Environmental Impact Assessment that covered expansion to 66,000 MTPD. Subsequently, that document was expanded by other independent scientists to cover all environmental aspects of the current expansion to 115,000 MTPD. The latest study document was submitted to the Government in December 1993. Based on preliminary hearings, the Company believes the study document will be accepted substantially as submitted. The Company has made, and will continue to make, expenditures at its operations for protection of the environment. Increasing emphasis on environmental matters can be expected to require the Company to incur additional costs, which will be charged against income from future operations. On the basis of its analysis of its operations in relation to current and presently anticipated environmental requirements, management does not anticipate that these investments will have a significant adverse impact on its future operations, liquidity, capital resources, or financial position. 1992 RESULTS OF OPERATIONS COMPARED WITH 1991 FCX reported 1992 net income of $122.9 million ($.66 per share) compared with 1991 net income of $96.2 million ($.53 per share). A reconciliation of revenues from 1991 to 1992 is presented below (in millions): Revenues - 1991 .............................................. $467.5 Price realizations: Copper ..................................................... 8.8 Gold........................................................ (7.4) Sales volumes: Copper...................................................... 218.5 Gold ....................................................... 95.7 Treatment charges............................................. (73.0) Adjustments to prior year concentrate sales................... 12.5 Other......................................................... (8.3) ------ Revenues - 1992 .............................................. $714.3 ====== Revenues increased 53 percent in 1992, reflecting higher production rates due to the mine/mill expansion, higher gold grades, and the sale of all year-end 1991 inventory. Price realizations were relatively unchanged between years (2 percent increase in copper realizations and 5 percent decrease in gold realizations), but sales volumes benefited significantly from the expansion, higher gold grades, and inventory sales discussed above. Copper sales volumes increased 48 percent and gold sales volumes increased 71 percent. Partially offsetting the benefit from sales volumes increases was a 3.6 cents per pound increase in treatment charges because of tight market conditions in the smelting industry early in 1992 and increased spot market sales attributable to higher than anticipated production due to the early completion of the 57,000 MTPD expansion program. A $5.7 million upward revenue adjustment was made in 1992 compared with a $6.8 million downward revenue adjustment in 1991 for prior year concentrate sales contractually priced during the year. Cost of sales for 1992 were $357.2 million, an increase of 47 percent from 1991 due primarily to the 48 percent increase in copper sales volumes. Unit site production and delivery costs in 1992 approximated 1991 costs. FCX's depreciation rate declined from an average 8.7 cents per recoverable pound in 1991 to 7.4 cents in 1992 because of the significant increase in ore reserves during 1991. Interest expense was $18.9 million during 1992 compared with $21.5 million in 1991, excluding $24.0 million and $18.3 million of capitalized interest, respectively. The 1992 general and administrative expenses rose to $68.5 million from $40.6 million in 1991, because of several financing transactions and operational and environmental studies in 1992 which required additional corporate personnel whose salaries and related overhead, were charged to the Company. General and administrative expenses also increased because of the additional personnel and facilities needed in Indonesia for the expanding operations. Minority interest share of net income reflects FCX's 80 percent ownership interest in PT-FI for 1992, compared with its 90 percent interest during 1991. ___________________________ The results of operations reported and summarized above are not necessarily indicative of future operating results. The information set forth under the caption "FCX Class A Common Shares" and "Class A Common Share Dividends", on the inside back cover of FCX's 1993 Annual Report to stockholders, is incorporated herein by reference. As of March 15, 1994, there were 2,355 record holders of FCX's Class A common stock. Item 8. Item 8. Financial Statements and Supplementary Data. - ----------------------------------------------------- The financial statements of FCX, the notes thereto, the report of management and the report thereon of Arthur Andersen & Co., appearing on pages 25 through 39, inclusive, of FCX's 1993 Annual Report to stockholders, are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting - ---------------------------------------------------------------------------- and Financial Disclosure. ------------------------- Not applicable. PART III -------- Items 10, 11, 12, and 13. Directors and Executive Officers of the Registrant, - ------------------------------------------------------------------------------ Executive Compensation, Security Ownership of Certain Beneficial -------------------------------------------------------------------- Owners and Management, and Certain Relationships and Related ----------------------------------------------------------------- Transactions. ------------- The information set forth under the captions "Voting Procedure" and "Election of Directors", beginning on pages 1 and 5, respectively, of the Proxy Statement dated March 31, 1994, submitted to the stockholders of FCX in connection with its 1994 Annual Meeting to be held on May 5, 1994, is incorporated herein by reference. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - -------------------------------------------------------------------------- (a)(1), (a)(2), and (d). Financial Statements. See Index to Financial Statements appearing on page hereof. (a)(3) and (c). Exhibits. See Exhibit Index beginning on page E-1 hereof. (b). Reports on Form 8-K. No reports on Form 8-K were filed by the registrant during the fourth quarter of 1993. SIGNATURES ---------- Pursuant to the requirements of Section 13 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, on March 29, 1994. FREEPORT-McMoRan COPPER & GOLD INC. BY: /s/ James R. Moffett -------------------------------- James R. Moffett Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 29, 1994. /s/ James R. Moffett Chairman of the Board and - ------------------------------ Director James R. Moffett George A. Mealey* President, Chief Executive Officer and Director (Principal Executive Officer) Stephen M. Jones* Vice President and Chief Financial Officer (Principal Financial Officer) C. Donald Whitmire* Controller (Principal Accounting Officer) Leland 0. Erdahl* Director Ronald Grossman* Director Rene L. Latiolais* Director Wolfgang F. Siegel* Director Elwin E. Smith* Director Eiji Umene* Director *By: /s/ James R. Moffett ------------------------------- James R. Moffett Attorney-in-Fact ------------------------------ The financial statements of FCX, the notes thereto, and the report thereon of Arthur Andersen & Co. appearing on pages 25 through 39, inclusive, of FCX's 1993 Annual Report to stockholders are incorporated by reference. The financial statement schedules listed below should be read in conjunction with such financial statements contained in FCX's 1993 Annual Report to stockholders. Page ---- Report of Independent Public Accountants........................ II-Amounts Receivable from Employees............................ III-Condensed Financial Information of Registrant............... V-Property, Plant and Equipment................................. VI-Accumulated Depreciation and Amortization.................... X-Supplementary Income Statement Information.................... Schedules other than those schedules listed above have been omitted since they are either not required or not applicable or the required information is included in the financial statements or notes thereof. * * * REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- We have audited, in accordance with generally accepted auditing standards, the financial statements as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 included in Freeport-McMoRan Copper & Gold Inc.'s annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index above are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. New Orleans, Louisiana January 25, 1994 FREEPORT-McMoRan COPPER & GOLD INC. SCHEDULE II - AMOUNTS RECEIVABLE FROM EMPLOYEES for the years ended December 31, 1993, 1992 and 1991 FREEPORT-McMoRan COPPER & GOLD INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT Balance Sheets December 31, ---------------------------- 1993 1992 ---------- -------- (In Thousands) ASSETS Cash and short-term investments $ 427 $174,760 Interest receivable 7,582 1,739 Receivable from Government of Indonesia 2,247 8,535 Notes receivable-PT-FI 1,064,888 458,274 Investment in PT-FI 145,959 106,169 Investment in PTII 75,601 74,401 Investment in RTM 43,254 - Other Assets 2,011 115 ---------- -------- Total assets $1,341,969 $823,993 ========== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Accounts payable & accrued liabilities $ 32,468 $ 3,953 Zero coupon exchangeable notes 102,039 173,583 Amount due to FTX 12,270 - RTM stock subscription payable 12,644 - Other liabilities and deferred credits 2,001 - Mandatory Redeemable Gold-Denominated Preferred Stock 232,620 - Stockholders' equity 947,927 646,457 ------- -------- Total liabilities and stockholders' equity $1,341,969 $823,993 ========== ======== Statements of Income Years Ended December 31, ------------------------------------- 1993 1992 1991 -------- --------- -------- (In Thousands) Income from investment in PT-FI and PTII, net of PT-FI tax provision $ 53,861 $128,220 $100,472 Net loss from investment in RTM (15,666) - - Elimination of intercompany profit (6,610) - - General and administrative expenses (5,207) (4,802) (3,280) Depreciation and amortization (2,397) (200) (1,134) Interest expense (8,017) (16,518) (8,767) Interest income on PT-FI notes receivable: Zero coupon exchangeable notes 19,175 18,326 8,767 Promissory notes 9,292 11,097 - 8.235% convertible 14,036 - - Step-up perpetual convertible 12,785 - - Gold production payment loan 4,055 - - Other income (expense), net (406) 5,561 101 Provision for income taxes (24,085) (11,791) - ------- -------- -------- Net income 50,816 129,893 96,159 Preferred dividends (28,954) (7,025) - ------- -------- -------- 21,862 $122,868 $ 96,159 ======= ======== ======== FREEPORT-McMoRan COPPER & GOLD INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) Statements of Cash Flow Years Ended December 31, ----------------------------- 1993 1992 1991 -------- -------- -------- (In Thousands) Cash flow from operating activities: Net income $ 50,816 $129,893 $ 96,159 Adjustments to reconcile net income to net cash provided by operating activities: Income from investment in PT-FI and PTII (53,861) (128,220) (100,472) Net loss from investment in RTM 15,666 - - Elimination of intercompany profit 6,610 - - Dividends received from PT-FI 132,048 78,214 126,330 Accretion of note receivable - PT-FI, net (9,104) (1,808) - Depreciation and amortization 2,397 200 1,134 (Increase) decrease in accounts receivable - 20,000 (20,000) Increase (decrease) in accounts payable (646) 597 (18) Other (5,959) (1,854) - -------- -------- -------- Net cash provided by operating activities 137,967 97,022 103,133 -------- -------- -------- Cash flow from investing activities: Received from Government of Indonesia 6,288 3,911 5,615 Investment in RTM (43,642) - - Investment in PTII - (211,892) - Investment in Freeport Hasa Inc. - (1) - -------- -------- -------- Net cash provided by (used in) investing activities (37,354) (207,982) 5,615 -------- -------- -------- Cash flow from financing activities: Cash dividends paid: Class A common stock (33,298) (26,088) (22,000) Class B common stock (85,277) (85,277) (78,171) Special preference stock (15,708) (4,407) - Step-Up preferred stock (5,590) - - Gold-denominated preferred stock (1,683) - - Net proceeds from issuance of zero coupon notes - - 218,560 Proceeds from Class A common stock offering - 174,142 - Proceeds from Depositary shares offerings 561,090 217,867 - Proceeds from sale of stock to Bakrie - 212,484 - Proceeds from FTX 20,650 - - Repayment to FTX (8,380) - - Loans to PT-FI (706,750) (212,484) (218,560) -------- -------- -------- Net cash provided by (used) in financing activities (274,946) 276,237 (100,171) -------- -------- -------- Net increase (decrease) in cash and short-term investments (174,333) 165,277 8,577 Cash and short-term investments at beginning of year 174,760 9,483 906 -------- -------- -------- Cash and short-term investments at end of year $ 427 $174,760 $ 9,483 ======== ======== ======== Interest paid $ 213 $ - $ - ======== ======== ======== Taxes paid $ 22,723 $ 11,762 $ - ======== ======== ======== a. The footnotes contained in FCX's 1993 Annual Report to stockholders are an integral part of these statements. b. Effective December 31, 1991, PT-FI issued 21,300 of its shares, representing a 10 percent interest in PT-FI, to a publicly traded entity owned by Indonesian investors for $212.5 million, pursuant to an agreement negotiated in early 1991. FCX guaranteed the buyer's financing for this purchase and accordingly, deferred the gain on the sale. In December 1992, FCX purchased approximately 49 percent of the capital stock of P.T. Indocopper Investama Corporation (PTII), a publicly traded Indonesian entity which owned 10 percent of the outstanding common stock of PT-FI. PTII acquired the 10 percent of the outstanding common stock of PT-FI from the Indonesian investors who acquired the shares on December 31, 1991. When FCX recorded its investment in PTII it utilized purchase accounting and thus eliminated the deferred gain of $138.6 million on the original sale to the Indonesian investors against the cost of the 4.9 percent indirect interest in PT-FI. The excess cost resulting from the purchase ($69.5 million) is reflected in FCX's consolidated balance sheet as property, plant and equipment and is being amortized over the remaining life of the Contract of Work (approximately 28 years), at a rate of approximately $2.4 million per year. This property, plant and equipment is included in the condensed balance sheet as part of FCX's investment in PTII. FREEPORT-McMoRan COPPER & GOLD INC. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992, and 1991 Col. A Col. B Col. C Col. D Col. E Col. F - --------------------- ------------ --------- ----------- --------- ---------- Balance at Balance at Beginning of Additions Retirements Other-Add End of Description Period at Cost and Sales (Deduct) Period - --------------------- ------------ --------- ----------- --------- --------- (In Thousands) 1993: - ---- Exploration and development costs $ 137,576 $ 9,365 $ - $ - $ 146,941 Plant and equipment 1,306,363 751,131 (2,882) (29,331) 2,025,281 ---------- -------- ------- --------- ---------- $1,443,939 $760,496 $(2,882) $ (29,331) $2,172,222 ========== ======== ======= ========= ========== 1992: - ---- Exploration and development costs $ 135,548 $ 2,028 $ - $ - $ 137,576 Plant and equipment 876,481 365,820 (5,445) 69,507 (a) 1,306,363 ---------- -------- ------- --------- ---------- $1,012,029 $367,848 $(5,445) $ 69,507 $1,443,939 ========== ======== ======= ========= ========== 1991: - ---- Exploration and development costs $ 129,138 $ 6,410 $ - $ - $ 135,548 Plant and equipment 748,851 233,544 (3,729) (102,185)(a) 876,481 ---------- -------- ------- --------- ---------- $ 877,989 $239,954 $(3,729) $(102,185) $1,012,029 ========== ======== ======= ========= ========== a. See note (b) on Schedule III. FREEPORT-McMoRan COPPER & GOLD INC. SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION for the years ended December 31, 1993, 1992, and 1991 Col. A Col. B Col. C Col. D Col. E Col. F - ------------------------- ----------- ----------- ---------- --------- ------- Balance at Additions Balance Beginning Charged to Retire- at of Costs and ments Other-Add End of Description Period Expenses(a) and Sales (Deduct) Period - ------------------------- ----------- ----------- --------- --------- ------ (In Thousands) 1993: Accumulated - ---- depreciation and amortization $450,527 $67,906 $(2,732) $ 9,918 $525,619 ======== ======= ======= ======= ======== 1992: Accumulated - ---- depreciation and amortization $410,354 $48,272 $(5,438) $(2,661) $450,527 ======== ======= ======= ======= ======== 1991: Accumulated - ---- depreciation and amortization $375,818 $38,397 $(3,729) $ (132) $410,354 ======== ======= ======= ======= ======== a. Mine and mill assets, including estimated future capital costs, are depreciated on the unit-of-production method while the remaining assets are depreciated on a straight-line basis. FREEPORT-McMoRan COPPER & GOLD INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992, and 1991 Col. A Col. B - -------------------------------------- ------------------------------------ Description Charged to Costs and Expenses - -------------------------------------- ------------------------------------ 1993 1992 1991 ------- ------- ------- (In Thousands) Maintenance and repairs $78,335 $68,623 $52,061 ======= ------- ------- Taxes, other than payroll and income taxes: Value added tax $ 4,164 $ 792 $ 1,371 Shippers tax - - (12) Fiscal 259 263 60 P.I.U.D. 3,050 3,148 2,716 ------- ------- ------- $ 7,473 $ 4,203 $ 4,135 ======= ======= ======= Royalties $ 9,539 $15,708 $10,355 ======= ======= ======= Freeport-McMoRan Copper & Gold Inc. Exhibit Index Sequentially Exhibit Numbered Number Page ------ ------------ 3.1 Composite copy of the Certificate of Incorporation of FCX. 3.2 By-Laws of FCX, as amended. Incorporated by reference to Exhibit 3.2 to the Annual Report on Form 10-K of FCX for the fiscal year ended December 31, 1992 (the "FCX 1992 Form 10-K"). 4.1 Certificate of Designations of the 7% Convertible Exchangeable Special Preference Stock (the "Special Preference Stock") of FCX. Incorporated by reference to Exhibit 5 to the Form 8 Amendment No. 1 dated July 16, 1992 (the "Form 8 Amendment") to the Application for Registration on Form 8-A of FCX dated July 2, 1992. 4.2 Deposit Agreement dated as of July 21, 1992 among FCX, Mellon Securities Trust Company, as Depositary, and holders of depositary receipts ("Depositary Receipts") evidencing certain Depositary Shares, each of which, in turn, represents 2-16/17 shares of Special Preference Stock. Incorporated by reference to Exhibit 2 to the Form 8 Amendment. 4.3 Form of Depositary Receipt. Incorporated by reference to Exhibit 1 to the Form 8 Amendment. 4.4 Certificate of Designations of the Step-Up Convertible Preferred Stock (the "Step-Up Convertible Preferred Stock") of FCX. 4.5 Deposit Agreement dated as of July 1, 1993 among FCX, Mellon Securities Trust Company, as Depositary, and holders of depositary receipts ("Step-Up Depositary Receipts") evidencing certain Depositary Shares, each of which, in turn, represents 0.05 shares of Step-Up Convertible Preferred Stock. 4.6 Form of Step-Up Depositary Receipt. 4.7 Certificate of Designations of the Gold-Denominated Preferred Stock (the "Gold-Denominated Preferred Stock") of FCX. 4.8 Deposit Agreement dated as of August 12, 1993 among FCX, Mellon Securities Trust Company, as Depositary, and holders of depositary receipts ("Gold-Denominated Depositary Receipts") evidencing certain Depositary shares, each of which, in turn, represents 0.05 shares of Gold Denominated Preferred Stock. 4.9 Form of Gold-Denominated Depositary Receipt. 4.10 Credit Agreement dated as of June 1, 1993 (the "PT-FI Credit Agreement") among PT-FI, the several banks which are parties thereto (the "PT-FI Banks"), Morgan Guaranty Trust Company of New York, as PT-FI Trustee (the "PT-FI Trustee"), and Chemical Bank, as agent (the "PT-FI Bank Agent"). 4.11 First Amendment dated as of February 2, 1994 to the PT-FI Credit Agreement among PT-FI, the PT-FI Banks, the PT- FI Trustee and the PT-FI Bank Agent. 4.12 Second Amendment dated as of March 1, 1994 to the PT-FI Credit Agreement among PT-FI, the PT-FI Banks, the PT- FI Trustee and the PT-FI Bank Agent. 4.13 Agreement dated as of May 1, 1988 between Freeport Minerals Company and FCX assigning certain stockholder rights and obligations. Incorporated by reference to Exhibit 10.13 to Registration No. 33-20807. 10.1 Design, Engineering and Related Services Contract dated as of September 15, 1992 between PT-FI and Fluor Daniel Engineers & Constructors, Ltd. Incorporated by reference to Exhibit 10.1 to the FCX 1992 Form 10-K. 10.2 Site Services Contract dated as of September 15, 1992 between PT-FI and Fluor Daniel Eastern, Inc. Incorporated by reference to Exhibit 10.2 to the FCX 1992 Form 10-K. 10.3 Contract of Work dated December 30, 1991 between The Government of the Republic of Indonesia and PT-FI. Incorporated by reference to Exhibit 10.20 to the FCX 1991 Form 10-K. 10.4 Management Services Agreement dated as of May 1, 1988 among FCX, FII and FTX. Incorporated by reference to Exhibit 10.01 to Registration No. 33- 20807. 10.5 Concentrate Sales Agreement dated as of December 30, 1990 between FII and Dowa Mining Co., Ltd., Furukawa Co., Ltd., Mitsubishi Materials Corporation, Mitsui Mining & Smelting Co., Ltd., Nittetsu Mining Co., Ltd., Nippon Mining Co., Ltd. and Sumitomo Metal Mining Co., Ltd. (Confidential information omitted and filed separately with the Securities and Exchange Commission.) Incorporated by reference to Exhibit 10.3 to the Annual Report on Form 10-K of FCX for the fiscal year ended December 31, 1990. 12.1 FCX Computation of Ratio of Earnings to Fixed Charges. 13.1 Those portions of the 1993 Annual Report to stockholders of FCX which are incorporated herein by reference. 18.1 Letter from Arthur Andersen & Co. concerning changes in accounting principles. 21.1 Subsidiaries of FCX. 23.1 Consent of Arthur Andersen & Co. dated March 25, 1994. 24.1 Certified resolution of the Board of Directors of FCX authorizing this report to be signed on behalf of any officer or director pursuant to a Power of Attorney. 24.2 Powers of Attorney pursuant to which this report has been signed on behalf of certain officers and directors of FCX.

73902_1993.txt

73902_1993

1993

73902

Item 1. BUSINESS Ogden Corporation (hereafter together with its consolidated subsidiaries referred to as "Ogden" or the "Company") has its offices located at Two Pennsylvania Plaza, New York, New York 10121, pursuant to a lease that expires on April 30, 1998 and which contains an option by Ogden to renew for an additional five years. Ogden is a diversified company primarily engaged in providing services through subsidiaries within each of its Operating Services and Waste-to-Energy Operations as described below: I. OPERATING SERVICES Ogden Services Corporation ("Ogden Services"), a wholly owned subsidiary of Ogden, provides services through each of its operating groups. The principal groups and services provided by each are as follows: (i) Ogden Aviation Services provides ground services, catering and fueling of aircraft at domestic and foreign airports; (ii) Ogden Entertainment Services provides facility management, concert promotions, food, beverage and novelty concession services and maintenance services at amphitheaters, stadiums, arenas and other venues; (iii) Ogden Environmental and Energy Services provides independent power generation, engineering and consulting services in the environmental and energy markets; (iv) Ogden Government Services and Atlantic Design Company provides engineering design, drafting and technical services; building and repairing electronic systems; and a broad range of technical support, logistics, and operation and maintenance services; and (v) Ogden Facility Services provides a broad range of turnkey facility management, housekeeping, mechanical maintenance, energy management, security, warehousing, shipping and receiving services. In addition, Ogden Services provides the removal or encapsulation of asbestos from office buildings and other structures and, through its 50% ownership in Universal Ogden Services, provides food and housekeeping services to offshore drilling rigs and logistical support services to remote industrial campsites in the United States and abroad. II. Waste-to-Energy Operations Ogden Projects, Inc. ("OPI"), an 84.2% owned subsidiary of Ogden, through its wholly owned subsidiaries, provides waste disposal services throughout the United States. Its principal business, conducted largely through its wholly owned subsidiary, Ogden Martin Systems, Inc. ("OMS") provides waste-to-energy services through designing, permitting, constructing, assisting in financing and operating and maintaining waste-to-energy facilities. These waste-to-energy facilities combust municipal solid waste to make saleable energy in the form of electricity or steam. OMS holds the exclusive rights to market a proprietary mass-burn technology, the principal feature of which is the reverse-reciprocating stoker grate upon which the waste is burned. This technology is used by OPI in most of the waste-to-energy facilities it designs and constructs in the United States and abroad. OPI is also pursuing opportunities to develop independent power projects that utilize fuels other than waste, as well as pursuing opportunities to operate and maintain wastes and wastewater processing facilities. - ------------------------------------------------------------------- The amounts of revenue from sales and services to unaffiliated customers, operating profit or loss, and identifiable assets attributable to each of Ogden's two major operating areas and foreign operations, if any, for each of the last three fiscal years are set forth on pages 41 and 42 of Ogden's 1993 Annual Report to Shareholders certain specified portions of which are incorporated herein by reference. OPERATING SERVICES The operations of Ogden's Operating Services are performed by Ogden Services Corporation ("Ogden Services") through its five major operating groups as follows: Ogden Aviation Services; Ogden Entertainment Services; Ogden Environmental and Energy Services; Atlantic Design Company and Ogden Government Services; and Ogden Facility Services. This organizational structure is described in more detail below. Ogden Services, through wholly-owned subsidiaries within each of the foregoing major operating groups, provides a wide range of services to private and public facilities. Its principal customers include airlines, transportation terminals, sports arenas, stadiums, banks, owners and tenants of office buildings, state, local and Federal governments, universities and other institutions and large industrial organizations that are leaders in such fields as plastics, chemicals, drugs, tires, petroleum and electronics. Ogden Services' bills most of its work on a cost-plus or fixed-price and time and material basis. Where services are performed on a cost-plus basis, the customer reimburses the appropriate Ogden Services' group for all reimbursable expenditures made in connection with the job (in some instances with a limit on the reimbursed amount) and also pays a fee, which may be a percentage of the reimbursable expenditures, a specific dollar amount, or a combination of the two. Fixed-price contracts, in most cases, contain escalation clauses increasing the fixed price in the event, and to the extent, that there are increases in payroll and related cost. Many of the contracts in the Ogden Aviation Services and Ogden Facility Services areas are written on a month-to-month basis or provide for a longer or indefinite term but are terminable by either party on notice varying from 30 to 180 days. OGDEN AVIATION SERVICES The Ogden Aviation Services group provides specialized support services to over 200 airlines at 90 cities throughout the United States, Canada, Mexico, Germany, Czech Republic, The Netherlands, Brazil, Peru, Chile, Venezuela, New Zealand, Australia and other locations. The specialized support services provided by this group includes comprehensive ground handling, inflight catering and aviation fueling. These services are performed through contracts with individual airlines, through consolidated agreements with several airlines, and contracts with various airport authorities. Within the area of inflight catering, Ogden Aviation Services operates 14 inflight kitchens for over 85 airline customers. Locations include John F. Kennedy International and LaGuardia Airports in New York; Newark International Airport in New Jersey; Los Angeles and San Francisco International Airports in California; Miami International Airport in Florida; Washington Dulles International near Washington, D.C.; McCarren International in Las Vegas, Nevada; and Honolulu International in Hawaii. During 1993, Ogden Aviation Services signed new inflight catering contracts with Aeromexico, British Airways, EVA Airways, Malev Hungarian Airlines and Mexicana Airlines, among others. The Ogden Aviation inflight kitchen at Honolulu International also received a three year contract from NAVATEK, a Hawaiian cruise line, to provide catering services for its two cruise ships. Ogden Aviation Services also operates fueling facilities, including storage and hydrant fueling systems for the fueling of aircraft. This operation assists airlines in designing, arranging financing for, and installing underground fueling systems. These fueling operation services are principally performed in the North American market. However, Ogden Aviation Services will begin providing these services in Latin America following the award of contracts in Puerto Rico and Panama. Ground handling services include diversified ramp operations such as baggage unloading and loading, aircraft cleaning, aircraft maintenance, flight planning, de-icing, cargo warehouse operations and passenger-related services such as ticketing, check-in, porter ("skycap") service, passenger lounge operations and other miscellaneous services. Global expansion by this service group has resulted in the start-up of operations at several international locations over the past several years. For example, in Germany services are performed at eight different airports throughout the country; service at Schiphol International Airport in Amsterdam began in 1993; comprehensive ground handling services are provided at Auckland International Airport in New Zealand under a ten year licensing agreement; and services are provided in the Czech Republic through a 50% interest in a Prague-based airport handling company. In Canada Ogden Aviation Services provides ground handling and other related services at the Pearson International Airport in Toronto and the Mirabel and Dorval Airports in Montreal. During December 1993 Ogden Aviation Services began providing comprehensive ground handling services in Caracas, Venezuela at Simon Bolivar International Airport. Through an 80% owned company Ogden Aviation also began providing ground handling services at the Arturo Merino Benitez Airport in Santiago, Chile. Ogden Aviation continues to perform Air Aruba's aviation ground service operations at Reina Beatrix International Airport in Aruba through a corporation jointly owned by Ogden and Air Aruba with Ogden Aviation Services controlling and performing all day-to-day ground service operations at the airport. OGDEN ENTERTAINMENT SERVICES The Ogden Entertainment Services group provides total facility management services, concert promotions, food, beverage and novelty concessions, janitorial, security, parking, and other maintenance services to a wide variety of public and private facilities located in the United States, Mexico, Canada and the United Kingdom. Many of the operating contracts and concession leases under which this group operates are individually negotiated and vary widely as to duration. Concession contracts usually provide for payment by an Ogden Entertainment Services subsidiary of commissions or rentals based on a stipulated percentage of gross sales or net profits, sometimes with a minimum rental or payment. Facility management contracts are usually on a cost-plus fee basis. Food and beverage service in the United States is provided at more than 100 stadiums, convention and exposition centers, arenas, parks, amphitheaters, fairgrounds and racetracks, including the following: Anaheim Stadium (Anaheim, California); Rich Stadium (Buffalo, New York); the U.S. Air Arena (Landover, Maryland); the Milwaukee Exposition and Convention Center (Milwaukee, Wisconsin); the Los Angeles Convention Center and The Great Western Forum (Los Angeles, California); the Kingdome (Seattle, Washington); Philadelphia Veterans Stadium (Philadelphia, Pennsylvania); Market Square Arena (Indianapolis, Indiana); Target Center (Minneapolis, Minnesota); McNichols Arena (Denver, Colorado); and Cobo Hall (Detroit, Michigan). During 1993 this service group was awarded a ten year contract to provide concession and novelty services at the Tempe Diablo Stadium in Tempe, Arizona; a five year contract to provide food, beverage and novelty services at the University of Oklahoma Stadium, and the Lloyd Noble Center, located in Norman, Oklahoma; a ten year contract to provide food and beverage services at Fiddler's Green Amphitheatre located in Englewood, Colorado; a ten year contract to provide food, beverage and concession services at the MGM Grand Gardens Arena located in Las Vegas, Nevada at the MGM Grand Hotel; and a ten year contract to provide concession and novelty services at the Sandstone Amphitheatre located in Kansas City, Missouri. During 1993 Ogden Entertainment Services also entered a new market pursuant to a ten year contract to provide food and beverage services at the San Jose Swap Meet, the largest open-air market in California. Ogden Entertainment Services also provides food and beverage services at the 20,000 seat Starlake Amphitheater near Pittsburgh, Pennsylvania and concession and catering services at zoos located in Seattle, Washington and Cleveland, Ohio. Various combinations of security, parking, maintenance and janitorial services at accounts such as The Great Western Forum; U.S. Air Arena; and The Palace (Auburn Hills, Michigan) are also provided by this service group. Ogden Entertainment Services has facility management agreements for various convention centers, arenas and public facilities including the Pensacola Civic Center in Pensacola, Florida; the Sullivan Arena and Egan Convention Center in Anchorage, Alaska; and the Rosemont Horizon, near Chicago, Illinois. In each of these facilities, Entertainment Services provides a comprehensive support service program. Facility management agreements are generally billed on a cost-plus fee basis. Ogden Entertainment Services, through long-term management and concession agreements, provides management services, food, beverage and novelty concessions and maintenance services at the Target Center in Minneapolis and The Great Western Forum in Los Angeles. Ogden Entertainment Services through its agreement with the City of Anaheim provides the exclusive operation of the food, beverage and novelty concessions at Anaheim Stadium, a 70,000 seat stadium located in Anaheim, California adjacent to the City's recently opened Arrowhead Pond (see below for further discussion of Arrowhead Pond). In Mexico, this service group has a 27% equity interest in a company which manages the Sports Palace, a 22,000 seat arena, and the Autodrome, a 45,000 seat open air facility, located in Mexico City, as well as the new amphitheater in Monterey Mexico that will be able to accommodate about 18,000 people. Ogden Entertainment also owns a 51% equity interest in a company that provides food and beverage concessions at the Sports Palace, Autodrome and Monterey Amphitheater. In Canada, Ogden Entertainment provides food, beverage and novelty concessions at the Saint John Regional Exhibition Centre located in New Brunswick, Canada and at Lansdowne Park in Ottawa, Canada. The New London Stadium, a 20,000 seat soccer stadium near London, England, for which Ogden acted as design and marketing consultants during construction, was opened during 1993. The Stadium serves as the home stadium for the Millwall Football Club and Ogden Entertainment Services, through a ten year contract, provides food and beverage services at the Stadium. Ogden Entertainment Services also provides design and consulting services at the 18,000 seat Victoria station Arena in Manchester, England which Ogden Entertainment will manage and operate pursuant to a 20- year lease upon its scheduled completion during 1994. Ogden Entertainment Services also leases and operates a thoroughbred and harness racetrack in Illinois and five off-track betting parlors in Illinois where it telecasts races from Fairmount Park and other racing facilities. Restaurants and other food and beverage services are provided by Ogden Entertainment Services at these facilities. Racing days are usually awarded on an annual basis and a large portion of the track's revenue is derived from its share of the pari-mutual handle, which can be adjusted by state legislation. Other income is derived from admission charges, parking, programs and concessions. Pursuant to the Amended and Restated Arena Management Agreement (the "Management Agreement"), between Ogden Facility Management Corporation of Anaheim ("OFMA"), a wholly owned subsidiary of Ogden Services, and the City of Anaheim, California (the "City"), OFMA manages and operates the recently completed Arrowhead Pond which is owned by the City and located within the City of Anaheim. The Pond is a multi-purpose facility capable of accommodating professional basketball and hockey, concerts and other attractions, and has a maximum seating capacity of approximately 19,400. Construction of the Pond was financed through the sale of municipal securities issued by an instrumentality of the City in January, 1991. OFMA has agreed that the Pond, under OFMA's management, will generate a minimum amount of revenues computed in accordance with the 30-year Management Agreement between the City and OFMA. OFMA's obligations under the Management Agreement are guaranteed by Ogden. Ogden Entertainment Services has an agreement with the Walt Disney Company for a 30- year lease at the Pond where The Walt Disney Company's new National Hockey League team, the Mighty Ducks, began playing during the 1993/1994 hockey season. OGDEN ENVIRONMENTAL AND ENERGY SERVICES (OEES) OEES provides a comprehensive range of environmental, infrastructure and energy consulting, engineering and design services to industrial and commercial companies, electric utilities and governmental agencies. Environmental services include analysis and characterization, remedial investigations, analytical testing, engineering and design, data management, project management, and regulatory assistance to detect, evaluate, solve and monitor environmental problems and health and safety risks. Infrastructure services include environmental, civil, geotechnical, transportation and sanitary engineering, urban and regional planning and storm water management. Energy services include regulatory assistance, nuclear safety and engineering, and consulting services relating to nuclear waste management, security engineering and design services, and independent power production. Services are provided to a variety of clients in the public and private sectors in the United States and abroad. Principal clients include major Federal agencies, particularly the Department of Defense and the Department of Energy as well as major corporations in the chemical, petroleum, transportation, public utility and health care industries and Federal and state regulatory authorities. Approximately 30% of OEES's revenues is derived from contracts or subcontracts with departments or agencies of the United States Government. United States Government contracts may be terminated, in whole or in part, at the convenience of the government or for cause. In the event of a convenience termination, the government is obligated to pay the costs incurred by OEES under the contract plus a fee based upon work completed. As of December 31, 1993, OEES's backlog of orders amounted to approximately $120 million, of which approximately $37 million represented government orders that were not yet funded; as of December 31, 1992, the comparable amounts were $87 million and $14 million, respectively. This service group continues to provide professional environmental engineering services, including program management, to the United States Navy CLEAN Program (Comprehensive Long Term Environmental Action Navy) pursuant to a $100 million contract awarded during 1991. Thus far OEES has provided these services in Hawaii and Guam. Through Catalyst New Martinsville Hydroelectric Corporation, OEES manages and operates the New Martinsville Hydroelectric Plant under a long-term lease with the City of New Martinsville, West Virginia. The plant has been in operation since 1988 and rated at approximately 40 megawatts of power. The plant's electrical output is sold to the Monongahela Power Company under a long-term power sales agreement. An OEES subsidiary, as a 50% partner in the Heber Geothermal Company ("HGC"), a partnership with Centennial Geothermal, Inc. leases and operates a 47-megawatt (net) power plant in Heber, California. The power is sold to Southern California Edison. The working interest in the geothermal field, which is adjacent to and supplies fluid to the power plant, is owned by a partnership composed of an OEES subsidiary and Centennial Field, Inc., an unaffiliated company. Separate subsidiaries of OEES have the contracts to operate and maintain both the Well field, which currently produces approximately eight million pounds per hour of fluid, and the power plant. During 1993 OEES received a four year contract from the State of Tennessee's Department of Transportation to survey road and stream bid profiles and perform underwater inspections and sounding around bridge foundations; Air Force bases in Ohio, Michigan and North Carolina were added to OEES' $25.0 million, three year contract with the U.S. Air Force Center for Environmental Excellence for the removal of storage tanks and contaminated soil from Air Force bases across the United States and in U.S. territories; and, OEES was one of four contractors selected by the U.S. Air Force to competitively bid for work valued at $195 million over five years to identify, investigate and remediate environmental contamination problems at the Kelly Air Force Base, Texas. OEES continued the development of its mixed waste analytical business through the modified portion of its analytical laboratory in Fort Collins, Colorado which opened during 1993 and analyzes mixtures of nuclear and non-nuclear hazardous waste. This mixed waste laboratory provides testing services for the Department of Energy and other Federal government agencies involved in the clean up of government facilities. OEES is continuing to examine the European market for long- term expansion of all of its services. During 1993 it acquired a privately-owned environmental, water resources and geotechnical consulting firm in Spain; was awarded an environmental services contract by the U.S. Army Corps of Engineers, Europe District, to provide environmental site assessments in Frankfurt, Germany; and, pursuant to a one year contract is working with the Chevron Overseas Petroleum, Inc.'s Tengizchevroil Joint Venture Project and the Republic of Kazakhstan, Russia to develop an environmental protection public health and safety plan. OGDEN GOVERNMENT SERVICES AND ATLANTIC DESIGN COMPANY Ogden Government Services The Ogden Government Services group functions through five operating groups: W.J. Schafer Associates, Inc. ("WJSA"), the Systems group, the Engineering group, the Biomedical Services group, and Operations Support Services group. Through these operating groups Ogden Government Services offers to private industry and Federal, state and local government agencies a broad range of engineering and technical support services; biomedical research and biological repository services; software design, integration and related services; systems engineering integration, management and logistics support; consulting, total facility management; property management; management support services and software; and maintenance services of all types required to maintain and operate governmental facilities worldwide. The WJSA group currently provides technology and engineering services and consultation in space-based and free electron laser, high energy systems research to the Ballistic Missile Defense Organization as well as technical research to the other agencies within the Department of Defense. During 1993 major awards included a contract by the Ballistic Missile Defense Organization to provide technical support to the Innovative Science Technology Directorate and by the Coleman Research Corporation to provide system engineering and technical assistance support for the Theater High Altitude Area Defense Project. The Engineering and Systems groups provide systems and software engineering and related services to the U.S. Navy, the General Services Administration, the Office of Personnel Management and many other Federal and state agencies. During 1993 these groups were awarded several large contracts ranging from one to five years in duration, including contracts by: The Department of Defense, to assist Unisys Government Systems with its Defense Enterprise Integration Services program; the Naval Command Control and Ocean Surveillance Center, to provide systems engineering, configuration management and other support services for naval combat systems; the State of Wisconsin to provide software systems transfer support to its Kids Information Data System; and the Internal Revenue Service to modernize its tax collection process. The Operations Support Services group provides custodial operations and maintenance, building management, logistical support, construction and repairs, and vehicle maintenance services to many Federal and state government facilities throughout the country. The group currently provides perimeter security in the United States embassies in Panama and the Bahamas as well as logistic functions at various other bases in the United States pursuant to contracts with the Department of Defense as well as a wide variety of operations and maintenance services for the U.S. Army's European Redistribution facilities located at Nahbollenbach and Hanau, Germany. During 1993 this group was awarded a complete facility management contract by the Department of Defense for the National Information Center, its top-secret facility located in Washington, D.C. The Bioservices group operates repositories and provides services in support of the National Institute of Health, the Walter Reed Army Institute of Research, the Federal Drug Administration, the National Institute of Allergy and Infectious Diseases, the National Cancer Institute and other health agencies. Atlantic Design Company, Inc. ("Atlantic Design") Atlantic Design with principal offices located in Charlotte, North Carolina and engineering facilities located in Livingston, New Jersey and New York, provides engineering design, drafting and technical services, as well as turn-key, integrated services in electronics contract manufacturing and assembly and through its Lenzar operation in Florida develops and markets medical products and custom image capturing products. Atlantic Design provides services to various industries, including such customers as IBM, Seiko, Compaq, Diasonics, AT&T, E.Systems, Decision Data, LXE and Pratt and Whitney. Atlantic Design's services also include the design of mechanical, electro-mechanical and electronic equipment; technical writing; engineering analysis; building, testing and repairing electronic assemblies and equipment; and the development of prototype equipment for a variety of industries. Atlantic Design's customers are primarily in the computer, medical and electronic industries located in the Eastern United States. During 1993 Atlantic Design was awarded a contract by Sequoia Pacific Systems to assemble electronic voting booths for the State of Louisiana as well as contracts from Compaq Computer, Seiko and AT&T. OGDEN FACILITY SERVICES The Ogden Facility Services group (formerly Ogden Building Services and Ogden Industrial Services) provides a comprehensive range of facility management, maintenance and manufacturing support services to industrial, commercial, electric utilities, and education and institutional customers throughout the United States and Canada. The range of services provided include total facility management; facility operations and maintenance; operations, maintenance and repair of production equipment; security and protection; housekeeping; landscaping and grounds care; energy management; warehousing and distribution; project and construction management; and skilled craft support services. Ogden Facility Services' commercial and office building customers include the World Trade Center and the American Express Tower in New York, Phillips Petroleum Headquarters in Bartlesville, Oklahoma, and A.T.& T. at several sites in New Jersey. Facility's industrial and manufacturing customers include IBM, Chrysler, Colgate Palmolive, Bridgestone/Firestone, Exxon, Dow Chemical, American Cyanamid and Martin Marietta. The group continues to expand its support to the institutional and educational marketplace. Customers include the University of Miami; New York University; Clark Atlanta University in Georgia; and Concordia University in Montreal, Canada. During 1993 the group was awarded a five year contract by the Orlando Utility Commission (OUC) to provide support services at OUC's Orlando and Titusville, Florida plants. Additional awards included The Bank of New York (Housekeeping Services); Geon Company, formerly B.F. Goodrich (Warehousing and Distribution Services); Ameritech (Facility Management) and Ford Stamping Plant in Chicago Heights, Illinois (Facility Maintenance). Ogden Facility Services, in conjunction with Ogden Projects, Inc., also provides services to the waste-to-energy plants in operation, or being built, by Ogden Martin Systems, Inc. on a cost- plus basis as negotiated between Ogden Martin and Ogden Facility Services. OTHER SERVICES Ogden Services also provides services relating to the removal and encapsulation of asbestos-containing materials from office buildings and other facilities and arranges for the transport of such material to approved disposal sites. Asbestos-remediation jobs are being performed principally in the greater Manhattan-New York metropolitan area. The market for asbestos removal and encapsulation services by office buildings and large residential complexes, industrial plants, airports and other public facilities has been greatly reduced over the past several years and Ogden Services' continued involvement in this industry is reviewed on an annual basis. Through Universal Ogden Services, a joint venture based in Seattle, Washington, services are provided to a wide range of facilities where people live for extended periods of time, such as remote job sites and oil rigs. Food and housekeeping services are currently provided to offshore oil production platforms and drilling rigs in the Gulf of Mexico, the North Sea, the West Coast of Africa and South America, for oil production and drilling companies. Logistical support services, including catering, housing, security, operations, and maintenance are provided to remote industrial campsites located in the United States and abroad. WASTE-TO-ENERGY OPERATIONS OGDEN PROJECTS, INC. Ogden Projects, Inc. ("OPI"), through its wholly-owned subsidiaries, provides waste disposal services throughout the United States. Its principal business, conducted through wholly- owned subsidiaries, including Ogden Martin Systems, Inc. ("OMS"), is providing waste-to-energy services. Waste-to-energy facilities combust municipal solid waste to make saleable energy in the form of electricity or steam. OPI was organized as a wholly-owned subsidiary of Ogden (together with its subsidiaries, "Ogden") in 1984. Through OMS it holds the exclusive rights to use the proprietary technology (the "Martin Technology") of Martin GmbH fur Umwelt - und Energietechnik of Germany ("Martin") in the United States, other Western Hemisphere locations and Israel. In addition, OPI has exclusive rights to use the Martin Technology on a full service design, construct and operate basis in Germany, the Netherlands, Denmark, Norway, Sweden, Finland, Poland, and Italy. The Martin Technology is used in over 150 waste-to-energy facilities operating worldwide, principally in Europe, the Far East and the United States. OPI completed construction of its first waste-to-energy facility in 1986 and currently operates twenty-five waste-to-energy projects at twenty-four locations. Three facilities are under construction. OPI is the owner or lessee of seventeen of these projects. Additional projects are in various stages of development. During early 1993, OPI acquired all of the United States waste-to-energy business of Asea Brown Boveri, Inc. through the acquisition of the stock of one of its indirect, wholly-owned subsidiaries. By virtue of the acquisition, OPI became the operator of these facilities. These three facilities do not employ the Martin Technology. OPI also owns and operates four additional facilities that do not utilize the Martin technology. OPI has taken preliminary steps toward expanding its waste-to- energy business internationally. It is also pursuing opportunities to develop independent power projects that utilize fuels other than waste. In addition, OPI is pursuing opportunities to operate and maintain water and wastewater processing facilities. WASTE-TO-ENERGY SERVICES In most cases, OPI, through wholly-owned subsidiaries ("Operating Subsidiaries"), provides waste-to-energy services pursuant to long term service contracts ("Service Agreements") with local governmental units sponsoring the waste-to-energy project ("Client Communities"). OPI has projects currently under development for which there is no sponsoring Client Communities and may in the future undertake other such projects. (a) Terms and Conditions of Service Agreements. Waste-to- energy projects are generally awarded by Client Communities pursuant to competitive procurement. OPI has also built and is operating projects that were not competitively bid. Following award, the Client Community and the winning vendor must agree upon the final terms of the Service Agreement. Following execution of a Service Agreement between the Operating Subsidiary and the Client Community, several conditions must be met before construction commences. These usually include, among other things, financing the facility, executing an agreement providing for the sale of the energy produced by the facility, purchase or lease of the facility site, and obtaining of required regulatory approvals, including the issuance of environmental and other permits required for construction. In many respects, satisfaction of these conditions are not wholly within OPI's control and accordingly, implementation of an awarded project is not assured or may occur only after substantial delays. OPI incurs substantial costs in preparing bids and, if it is the successful bidder, implementing the project so it meets all conditions precedent to the commencement of construction. In some instances OPI has made contractual arrangements with communities that provide partial recovery of development costs if the project fails to go into construction for reasons beyond OPI's control. Each Service Agreement is different in order to reflect the specific needs and concerns of the Client Community, applicable regulatory requirements and other factors. The following description sets forth terms that are generally common to these agreements. Pursuant to the Service Agreement, the Operating Subsidiary designs the facility, generally applies for the principal permits required for its construction and operation and helps to arrange for financing. The Operating Subsidiary then constructs and equips the facility on a fixed price and schedule basis. The actual construction and installation of equipment is performed by contractors under the supervision of the Operating Subsidiary. The Operating Subsidiary bears the risk of costs exceeding the fixed price of the facility and may be charged liquidated damages for construction delays, unless caused by the Client Community or unforeseen circumstances beyond OPI's control, such as changes of law ("Unforeseen Circumstances"). After the facility successfully completes acceptance testing, the Operating Subsidiary operates and maintains the facility for an extended term, generally 20 years or more. Under the Service Agreement, the Operating Subsidiary generally guarantees that the facility will meet minimum processing capacity and efficiency standards, energy production levels and environmental standards. The Operating Subsidiary's failure to meet these guarantees or to otherwise observe the material terms of the Service Agreement, (unless caused by the Client Community or Unforeseen Circumstances) may result in liquidated damages to the Operating Subsidiary or, if the breach is substantial, continuing and unremedied, the termination of the Services Agreement, in which case the Operating Subsidiary may be obligated to discharge project indebtedness. The Service Agreement requires the Client Community to deliver minimum quantities of municipal solid waste ("MSW") to the facility and, regardless of whether that quantity of waste is delivered to the facility, to pay a service fee. These fees are further described below. Generally, the Client Community also provides or arranges for debt financing. Additionally, the Client Community bears the cost of disposing ash residue from the facility and, in many cases, of transporting the residue to the disposal site. Generally, expenses resulting from the delivery of unacceptable and hazardous waste to the facility and from the presence of hazardous materials on the site are also borne by the Client Community. In addition, the Client Community is also generally responsible to pay increased expenses and capital costs resulting from Unforeseen Circumstances, subject to limits which may be specified in the Service Agreement. Ogden guarantees the Operating Subsidiaries performance of their respective Service Agreements. (b) Other arrangements for providing Waste-to-Energy Services. OPI owns two facilities which are not operated pursuant to Service Agreements with Client Communities, and is currently developing, and may undertake in the future, additional such projects. In such projects, OPI must obtain sufficient waste under contracts with haulers or communities to ensure sufficient project revenues. OPI is subject to risks usually assumed by the Client Community, such as those associated with Unforeseen Circumstances, and the supply and price of municipal waste to the extent not contractually assumed by other parties. OPI's current contracts with waste suppliers for these two facilities provide limited contractual protection for Unforeseen Circumstances. On the other hand, OPI generally retains all of the energy revenues and disposal fees for waste accepted at these facilities. Accordingly, OPI believes that such projects carry both greater risks and greater potential rewards than projects in which there is a Client Community. As a result of the declining number of municipal procurements in the United States, which is anticipated to continue in the near future, such projects are likely to become more common. (c) Project Financing. Financing for projects is generally accomplished through the issuance of a combination of tax-exempt and taxable revenue bonds issued by a public authority. If the facility is owned by an Operating Subsidiary, the authority lends the bond proceeds to the Operating Subsidiary and the Operating Subsidiary contributes additional equity to pay the total cost of the project. For such facilities, project-related debt is included as a liability in OPI's consolidated financial statements. Generally, such debt is secured only by the assets of the Operating Subsidiary and otherwise provides no recourse to OPI. The Operating Subsidiaries are able to realize value from facilities owned by them either by selling the facilities and leasing them from the purchaser for extended terms or by selling limited partnership interests in the entity owning the facility. OPI has taken advantage of these financing mechanisms by selling the interests in Tulsa I and Tulsa II to a leverage lessor and leasing the facility back under a long term lease. In addition, in 1991, limited partnership interests in, and the related tax benefits of, the partnership that owns the Huntington, New York facility were sold to third party investors. In 1992, OPI sold the subsidiary that held the remaining limited partnership interest in, and certain related tax benefits of, that partnership. Under the limited partnership agreement, an Operating Subsidiary is the general partner and retains responsibility for the operation and maintenance of the facility. The Operating Subsidiary retained 85% of the residual value of the facility after the initial term of the Service Agreement. In 1991, OPI acquired a facility from Blount, Inc. which was sold through a sale-leaseback arrangement. An Operating Subsidiary is the owner of the facility under construction in Onondaga, New York and a sale of equity interests in such facility is under consideration. (d) Revenues and Income. During the construction period, for facilities owned by Client Communities, construction income is recognized on the percentage-of-completion method based on the percentage of costs incurred to total estimated costs. Construction revenues also include amounts relating to sales of limited partnership interests and related tax benefits in facilities not yet in commercial operation as well as other amounts received with respect to activities conducted by OPI prior to the commencement of commercial operation. After construction is completed and the facility is accepted, the Client Community pays the Operating Subsidiary a fixed operating fee which escalates in accordance with specified indices; reimburses the Operating Subsidiary for certain costs specified in the Agreement including taxes and governmental impositions (other than income taxes), ash disposal and utility expenses; and shares with the Operating Subsidiary a portion of the energy revenues (generally 10%) generated by the facility. If the facility is owned by the Operating Subsidiary, the Client Community also pays as part of the Service Fee an amount equal to the debt service on the bonds issued to finance the facility. With respect to such facilities OPI recognizes as revenue principal on such bonds on a level basis over the term of the debt. At most facilities, OPI may earn additional fees from accepting waste from the Client Community or others utilizing the capacity of the facility which exceeds the minimum amount of waste committed by the Client Community. For the projects that are not operated pursuant to a Service Agreement, tipping fees which are generally subject to escalation in accordance with specified indices, and energy revenues are paid to OPI. Electricity generated by these projects is sold to public utilities, and in one instance, steam and a portion of the electricity generated is sold to industrial users. Under certain of the contracts under which waste is provided to these facilities, OPI may be entitled to fee adjustments to reflect certain Unforeseen Circumstances. (e) OPI's Waste-to-Energy Projects. Certain information with respect to OPI's projects as of February 28, 1994 is summarized in the following table: (f) Markets and Competition. OPI markets its services principally to governmental entities, including city, county and state governments as well as public authorities or special purpose districts established by one or more local government units for the purpose of managing the collection and/or disposal of MSW. For certain projects, OPI may market its services directly to private firms in the business of MSW collection and/or disposal. MSW generated in the United States is processed in waste-to- energy facilities; incinerated without energy recovery; recycled and landfilled. OPI believes that no single waste disposal technique can properly manage all MSW and that an effective waste management program must include waste minimization, recycling, and waste-to-energy to utilize as much waste as possible for reuse and energy production. Steps to minimize the quantity of MSW produced are being taken at the manufacturing and consumer levels. Some jurisdictions, for example, have banned the use of certain plastic containers. These efforts have not yet had an appreciable impact on the quantities of MSW being generated. Increased recycling is a goal of many state and local governments, and some have legislated ambitious mandatory targets. OPI believes that increased recycling is an important aspect of waste disposal planning in the United States and will continue to grow. However, the inherent limitation on the types of materials that can successfully be recycled will continue to require municipalities to use other disposal methods such as waste-to- energy or landfilling for much of the waste produced. Most of OPI's facilities have been sized to accommodate the accomplishment of communities recycling goals. Waste-to-energy facilities compete with other disposal methods, such as landfills. Compliance with regulations promulgated by the United States Environmental Protection Agency (the "EPA") in 1991 will to some extent increase the cost of landfilling although landfills may be less expensive, in some cases, in the short term, than waste-to-energy facilities. Landfills generally do not commit their capacity for extended periods. Much of the landfilling done in the United States is done on a spot market or through short term contracts. Accordingly, landfill pricing tends to be more volatile as a result of periodic changes in waste generation and available capacity than OPI's pricing, which is based on long term contracts. Another factor effecting the competitiveness of waste-to-energy fees are the additional charges imposed by Client Communities to support recycling programs, household hazardous waste collections, citizen education and similar initiatives. The cost competitiveness of waste-to-energy facilities also depends on the prices at which the facility can sell the energy it generates. Mass-burn waste-to-energy systems compete with various refuse- derived fuel ("RDF") systems in which MSW is preprocessed to remove various non-combustibles and is shredded for sizing prior to burning. OPI believes that the large-scale facilities being contracted for today are primarily mass-burn systems. Although OPI operates four RDF projects, these were all acquired after construction. OPI does not intend to develop any new RDF facilities. Since 1989, there has been a decline in the number of communities requesting proposals for waste-to-energy facilities. OPI believes that this decline has resulted from a number of factors that adversely affected communities willingness to make long term capital commitments to waste disposal projects, including uncertainties about the impact of recycling on the waste stream; concerns arising from the Clean Air Act Amendments of 1990 and the regulatory actions currently being proposed pursuant to its terms. In addition, there was aggressive opposition to proposed waste disposal projects of all types by many individuals and small groups during this period. OPI believes that legislative developments increased public acceptance of the safety and cost effectiveness of waste-to-energy and economic recovery will resolve many of these uncertainties. In response to the decline in the number of requests for proposals, OPI has sought projects for which there are no sponsoring Client Communities. In 1993, OPI negotiated a waste disposal agreement with Clark County, Ohio, for the disposal of MSW at such a project. OPI also completed negotiation of contracts with Ohio Edison Company pursuant to which Ohio Edison leases a site to OPI and purchases steam generated at the proposed waste-to- energy facility. This project is conditional upon obtaining commitments of additional MSW from other sources. There is substantial competition within the waste-to-energy field. OPI competes with a number of firms, some of which have greater financial resources than OPI. Some competitors have licenses or similar contractual arrangements for competing technologies in the waste-to-energy field, and a limited number of competitors have their own proprietary technology. Other technologies utilized in mass-burn-type facilities in the United States include the Von Roll, W+E Umwelltechnik, A.G., Takuma, Volund, Steinmueller, Deutsche Babcock, O'Connor and Detroit Stoker. The principal factors influencing selection of vendors for governmentally sponsored projects are technology, financial strength, performance guarantees, experience, reputation for environmental compliance, service and price. (g) Technology. The principal feature of the Martin Technology is the reverse-reciprocating stoker grate upon which the waste is burned. The patent for the basic stoker grate technology used in the Martin Technology expired in 1989. OPI has no information that would cause it to believe that any other company uses the basic stoker grate technology that was protected by the expired patent. OPI believes that unexpired patents on other portions of the Martin Technology would limit the ability of other companies to effectively use the basic stoker grate technology in competition with OPI. More importantly, it is Martin's know-how in manufacturing grate components and in designing and operating mass- burn facilities and Martin's worldwide reputation in the waste-to- energy field, rather than the use of potential technology, that is important to OPI's competitive position in the waste-to-energy industry in the United States. OPI does not believe that the expiration of the patent covering the basic stoker grate technology will have a material adverse effect on OPI's financial condition or competitive position. (h) The Cooperation Agreement. Under an agreement between OPI and Martin (the "Cooperation Agreement"), OPI has the exclusive right to use the Martin Technology in waste-to-energy facilities in the United States, Canada, Mexico, Bermuda, certain Caribbean countries most of Central and South America and Israel. In addition, in Germany, Turkey, Saudi Arabia, Kuwait, the Netherlands, Denmark, Norway, Sweden, Finland, Poland and Italy, OPI has exclusive rights to use the Martin Technology only on a full service design, construct and operate basis. OPI may not use any other technology to design and construct waste-to-energy refuse incineration facilities without Martin's permission. OPI may, however, acquire, own, commission and/or operate facilities that use technology other than the Martin technology that have been constructed by entities other than OPI. Martin is obligated to assist OPI in installing, operating and maintaining facilities incorporating the Martin Technology. The fifteen year term of the Cooperation Agreement renews automatically each year unless notice of termination is given, in which case the Cooperation Agreement would terminate 15 years after such notice. Additionally, the Cooperation Agreement may be terminated by either party if the other fails to remedy its material default within 90 days of notice. The Cooperation Agreement is also terminable by Martin if there is a "change in control" (as defined in the Cooperation Agreement) of OMS, or any direct or indirect parent of OMS not approved by its respective board of directors. Although termination would not affect the rights of OPI to design, construct, operate, maintain or repair waste-to-energy facilities for which contracts have been entered into or proposals made prior to the date of termination, the loss of OPI's right to use the Martin Technology could have a material adverse effect on OPI's future business and prospects. For example, Germany has enacted legislation which would prevent the landfilling of untreated raw municipal waste by the end of the decade. OPI therefore believes this is an appropriate time to seek to expand its business in these markets. (i) International Business Developments. In 1993, OPI continued the development of its waste-to-energy business in selected international markets. OPI opened an office in Munich, Germany in 1993 and, as indicated above, extended its right to use the Martin technology to develop full service projects in much of Europe. OPI had no operations outside the United States previously. Furthermore, in Europe, waste-to-energy facilities have been built as turn-key construction projects and then operated by local governmental units or by utilities under cost-plus contracts. OPI emphasizes developing projects which it will build and then operate for a fixed fee. Some European countries are seeking to substantially reduce their dependency on landfilling. (j) Backlog. OPI's backlog as of December 31, 1993 is set forth under (e) above. As of the same date of the prior year, the estimated unrecognized construction revenues for projects under construction was $192,935,000, and the estimated construction revenues for projects awarded but not yet under construction was $513,488,000 (includes $99,620,000 expressed in Canadian Dollars). The changes reflect construction progress on four projects. Generally, the construction period for a waste-to-energy facility is approximately 28 to 34 months. The backlog does not reflect the cancellation of projects owned by OPI or the cancellation of the Quonset Point and Johnston Rhode Island projects. OTHER SERVICES OPI operates transfer stations in connection with its Montgomery County, Maryland project, and will use a railway system to transport MSW and ash residue to and from the facility. OPI leases and operates a landfill located at its Haverhill, Massachusetts facility, and leases, but does not operate, a landfill in connection with its Bristol, Connecticut facility. In 1991, OPI announced that it would discontinue the on-site remediation business utilizing a mobile technology then conducted by Ogden Waste Treatment Service, Inc. ("OWTS"). OWTS was formed by Ogden in 1986 to conduct on-site remediation of hazardous wastes using a proprietary incineration process. In 1991, OWTS operated at sites located in Alaska and California. Certain of these operations continued into 1993; and certain contractual obligations resulting from the disposal of assets are expected to conclude in 1994. In 1993, OPI announced that it would discontinue the fixed- site hazardous waste business it had been conducting through American Envirotech, Inc. ("AEI"), an indirect subsidiary. AEI received a permit in 1993 for the construction and operation of a facility near Houston, Texas (the "RCRA Permit"), which is subject to a pending appeal in the state of Texas. Substantial and adverse changes in the market for hazardous waste incineration services such as those proposed to be provided by AEI, and regulatory uncertainty stemming from EPA pronouncements apparently foreshadowing more pervasive regulation, led OPI to conclude that successful commercial development of the project was unlikely. OPI has ceased all development activities and in 1994 intends to dispose of the assets related to this business, primarily a permit to build and operate a hazardous waste incineration facility. OPI, through Ogden Power Systems, Inc., a wholly owned subsidiary, intends to develop, operate and, in some cases, own power projects which cogenerate electricity and steam or generate electricity alone for sale to utilities. These power systems may use, among other fuels, wood, tires, coal, or natural gas as fuel. OPI does not currently operate any power projects. OPI, through Ogden Water Systems, Inc., a wholly owned subsidiary, intends to develop, operate and, in some cases, own projects that purify water, treat wastewater, and treat and manage biosolids and compost organic wastes. As with OPI's waste-to- energy business, water and wastewater projects involve various contractual arrangements with a variety of private and public entities including municipalities, lenders, joint venture partners (which provide financing or technical support), and contractors and subcontractors which build the facilities. OPI also intends to develop, operate and, in some cases, own projects that process recyclable paper products into linerboard for reuse in the commercial sector. As with OPI's waste-to-energy business, such projects involve various contractual arrangements with a variety of private and public entities, including municipalities, lenders, joint venture partners (which provide financing or technical support) and contractors and subcontractors which build the facilities. In addition, such projects require significant amounts of energy in the form of steam, which may be provided by present or future waste-to-energy projects operated by OPI. REGULATION (a) Environmental Regulations. OPI's business activities are pervasively regulated pursuant to Federal, state and local environmental laws. Federal laws, such as the Clean Air Act and Clean Water Act, and their state counterparts govern discharges of pollutants into the air and water. Other Federal, state and local laws such as the Resource Conservation and Recovery Act ("RCRA") comprehensively govern the generation, transportation, storage, treatment and disposal of solid waste, including hazardous waste (such laws and the regulations thereunder, "Environmental Regulatory Laws"). The Environmental Regulatory Laws and other Federal, state and local laws, such as the Comprehensive Environmental Recovery Response Compensation and Liability Act ("CERCLA"), make OPI potentially liable for any environmental contamination which may be associated with its activities or properties (collectively, Environmental Remediation Laws"). Many states have mandated local and regional solid waste planning, and require that new solid waste facilities may be constructed only in conformity with such plans. State laws may authorize the planning agency to require that waste generated within its jurisdiction be brought to a designated facility which may help that facility become economically viable but preclude the development of other facilities in that jurisdiction. Such ordinances are sometimes referred to as legal flow control. Legal flow control has been challenged in a number of law suits on the basis that it is a state regulation of interstate commerce prohibited by the United States Constitution. The decisions on these cases have not been consistent. However, several recent decisions have invalidated ordinances creating legal flow control. In 1993, the United States Supreme Court granted an appeal from a decision of a New York State Court upholding a New York municipality's ordinance requiring that all waste generated within its jurisdiction be disposed of at a transfer station operating under contract with the municipality. The case was argued in December 1993 and a decision is expected during the Court's spring 1994 term. OPI believes that legal flow control is an important tool used by municipalities in fulfilling their obligations to provide safe and environmentally sound waste disposal services to their constituencies. Although a decision invalidating legal flow control would reduce the number of options local government would have in meeting this obligation, OPI does not believe it would materially impact OPI's existing facilities or its ability to develop new ones. Most of the contracts pursuant to which OPI provides disposal services require the Client Community to deliver stated minimum quantities of waste on a put-or-pay basis. OPI does not believe these obligations would be negated by an adverse Supreme Court decision. Furthermore, only a few of the Client Communities served by OPI rely solely on flow control to provide waste to OPI's facilities, a factor influenced in part by past difficulties in enforcing legal flow control ordinances. Although some municipalities may experience temporary difficulties in meeting delivery commitments as they address required changes in their waste disposal plans, such difficulties should not be long- lived as indicated by the experience of municipalities served by OPI which determined that it could not enforce its flow control ordinance and therefore adopted alternative measures. OPI believes that there are other methods for providing incentives to use integrated waste systems incorporating waste to energy that do not entail legal flow control, which incentives should not be affected by the Court's decision. These include mandating that charges for utilization of the system be maintained at competitive levels and that revenue shortfalls be funded from tax revenues or special assessments on residents. This type of incentive will be utilized at the facility being constructed, which will be operated by OPI in Montgomery County Maryland. Furthermore, in most of the municipalities where OPI provides services, information available to OPI indicates that the cost to the Client Community of waste-to-energy is competitive with alternative disposal facilities, and therefore OPI's facilities should be able to compete for waste economically. As indicated, however, certain additional waste disposal services are financed by the Client Community's increasing the cost for disposal at waste- to-energy facilities, and these services may have to be paid for by other mechanisms. A number of bills are presently pending in Congress to authorize legal flow control. Whether Congress will enact legislation on this subject is uncertain. In addition, state laws have been enacted in some jurisdictions that may also restrict the intrastate and interstate movement of solid waste. Restrictions on importation of waste from other states have generally been voided by Federal Courts as invalid restrictions on interstate commerce. Bills proposed in past sessions of Congress would authorized such designations and restrictions. Bills of this nature are expected to be introduced in the current session of Congress. Similar bills have been introduced in previous sessions of Congress and it remains uncertain whether Congress acts to authorize such laws. The Environmental Regulatory Laws require that many permits be obtained before the commencement of construction or operation of any waste-to-energy facility, including: air quality, construction and operating permits, stormwater discharge permits, solid waste facility permits in most cases, and, in many cases, wastewater discharge permits. There can be no assurance that all required permits will be issued, and the process of obtaining such permits can often cause lengthy delays, including delays caused by third party appeals challenging permit issuance. The Environmental Regulatory Laws and regulations and permits issued pursuant to them also establish operational standards, including specific limitations upon emissions of certain air and water pollutants. Failure to meet these standards subjects an Operating Subsidiary to regulatory enforcement actions by the appropriate governmental unit, which could include fines and orders which could limit or prohibit operations. Certain of the Environmental Regulatory Laws also authorize suits by private parties for damages and injunctive relief. Repeated unexcused failure to comply with environmental standards may also constitute a default by the Operating Subsidiary under its Service Agreement. The Environmental Regulatory Laws and governmental policies governing their enforcement are subject to revision. New technology may be required or stricter standards may be established for the control of discharges of air or water pollutants or for solid waste or ash handling and disposal. Most Federal Environmental Regularly Laws encourage development of new technology to achieve increasingly stringent standards; they also often require use of the best technology available at the time a permit is issued. The Federal Prevention of Significant Deterioration of air quality Program requires that new or substantially modified waste-to-energy facilities of the size constructed by OPI that are located in areas of the country that are in compliance with national ambient air quality standards ("NAAQS") employ the Best Available Control Technology ("BACT"). The selection of control technology and the emission limits that must be achieved are made on a case-by-case basis considering economic impacts, energy and other environmental impacts and costs, and may include requirements that certain components of the mixed waste stream be separated for treatment by means other than combustion in the Operating Subsidiary's facility. For facilities developed in areas where NAAQS are not met, Federal law requires that control technology capable of achieving the Lowest Achievable Emission Rate ("LAER") must be employed. LAER means the most stringent emission limit achievable in practice by emission sources similar to the facility in question, which does not involve any consideration of the economic impact or cost to achieve such a limitation. Existing facilities in areas where LAER is now required for new facilities may be required to retro-fit Reasonably Available Control Technology ("RACT") established by EPA applicable to selected pollutants to enhance progress toward these areas achieving the NAAQS. RACT is that technology which EPA or state agencies determine to be available, proven, reliable, and affordable to reduce targeted emissions from specific types of existing sources of air emissions within geographic areas in which NAAQS for the target emissions is not being met. Thus, as new technology is developed and proven, it must be incorporated into new or modified facilities. This new technology may often be more expensive than that used previously. EPA has promulgated regulations establishing New Source Performance Standards ("NSPS") and Emission Guidelines ("EG") applicable to new and existing municipal waste combustion units with a capacity of greater than 250 tons per day, respectively. The EG and NSPS limit the concentrations of carbon monoxide in combustion gases and establish limitations upon the flue gas pollutant concentrations entering the ambient air for particulate matter (opacity), organics (dioxins and furans), carbon monoxide and acid gases (sulfur dioxide and hydrogen chloride). The NSPS also establish emissions limitations for nitrogen oxides. The NSPS apply to facilities beginning construction after December 20, 1989 and the EG will become effective three years after each individual state adopts them but no later than five years after promulgation. Additional air pollution control equipment is likely to be required at three of OPI's existing waste-to-energy facilities to achieve the EG limitations. The Clean Air Act required EPA to re-evaluate the NSPS and EG for particulate matter (total and fine), opacity (as appropriate), sulfur dioxide, hydrogen chloride, oxides of nitrogen, carbon monoxide, dioxins and dibenzofurans and to establish new NSPS and EG for lead, cadmium, and mercury no later than November 15, 1991 for all waste combustion facilities. Such re-evaluation and regulations were not completed by that date. These standards must reflect maximum achievable control technology ("MACT") for both new and existing waste-to-energy units. MACT means the maximum degree of reduction in emissions, considering the cost, energy requirements, and non air quality related health and environmental impacts. OPI cannot predict what standards will be proposed or promulgated, although EPA is reviewing data from existing facilities. The revised standards for new facilities will become effective six months after the date of promulgation of the revised standards. Standards for lead, cadmium and mercury are expected to be proposed in 1994 under a consent order entered in 1993 in connection with litigation commenced by several parties against the EPA. The Clean Air Act also requires each state to implement a state implementation plan in conformity with Federal law that outlines how areas are out of compliance with NAAQs will be returned to compliance. One aspect of the state implementation plan must be an operating permit program. Most states are now in the process of developing or augmenting their implementation plans to meet these requirements. The state implementation plans and the operating permits issued under them may place new requirements on waste-to-energy facilities. Under federal law, the new operating permits may have a term of up to 12 years after issuance or renewal, subject to review every five years. Changes in standards can affect the manner in which OPI operates existing projects and could require significant additional expenditures to achieve compliance. OPI believes that for a majority of the facilities operated by its Operating Subsidiaries, the cost of capital improvements required to meet Clean Air Act Requirements will not exceed $1 million per facility. Those improvements are expected to increase the cost of disposal at those facilities by less than two dollars per ton of MSW processed. Capital Improvements for four of OPI's earlier Facilities, however, are expected to cost between $20 million and $44 million. As a consequence, related cost of disposal increases are expected to range from six dollars to seventeen dollars per ton of MSW processed. OPI's estimates are preliminary and depend on whether Clean Air Act requirements are implemented as currently proposed. Such expenditures are, in most cases, borne by the Client Communities. For Facilities owned by OPI equity contributions of up to 20 percent of the capital costs described herein may be required. For projects not operated pursuant to a Service Agreement, such capital costs are the responsibility of OPI. OPI expects to recover such expenditures through increases in the tipping fee. In certain cases, there are limitations on the total amount or type of costs for complying with changes in law that can be "passed through" to the Client Communities, and if such limits are exceeded, the Client Community may be able to terminate the Service Agreement relating to the affected project, in which case the Client Community would be responsible for retiring or otherwise providing for the outstanding project debt. OPI does not believe that any of its Service Agreements will be terminated for this reason. The Environmental Remediation Laws, including CERCLA, may subject OPI, like other entities that manage waste, to joint and several liability for the costs of remediating contamination at sites, including landfills, which OPI has owned, operated or leased, or at which there has been disposal of residue or other waste handled or processed by OPI. OPI leases and operates a landfill in Haverhill, Massachusetts and leases a landfill in Bristol, Connecticut in connection with its projects at those locations. Some state and local laws also impose liabilities for injury to persons or property caused by site contamination. Some Service Agreements provide for indemnification of the Operating Subsidiaries from some such liabilities. Environmental Regulatory Laws, such as RCRA and state and local solid waste laws, impose significantly more stringent requirements upon disposal of hazardous waste than upon disposal of MSW and other non-hazardous wastes. These laws prohibit disposal of hazardous waste, other than in small, household-generated quantities, at the Company's municipal solid waste facilities and generally makes disposal of hazardous waste more expensive than management of non-hazardous waste. The Service Agreements recognize the potential for improper deliveries of hazardous wastes and specify procedures for dealing with hazardous waste that is delivered to a facility. Although certain Service Agreements require the Operating Subsidiary to be responsible for some costs related to hazardous waste deliveries, to date, no Operating Subsidiary has incurred material hazardous waste disposal costs. No ash residue from a fully operating facility operated by OPI has been characterized as hazardous under the present or past prescribed EPA test procedures, and such ash residue is currently disposed of in permitted landfills as non-hazardous waste. Some state laws or regulations provide that if prescribed test procedures demonstrate that ash residue has hazardous characteristics, it must be treated as hazardous waste. In certain states, ash residue from certain waste-to-energy facilities of other vendors or communities has been found to have hazardous characteristics under these test procedures. There is a conflict between the two Federal courts which have decided whether municipal solid waste ash residue having hazardous characteristics is subject to RCRA'S provisions for management as a hazardous waste. The Second Circuit Court of Appeals has held that it is not. The Seventh Circuit Court of Appeals reached the opposite result. In September 1992, the Administrator of the United States EPA officially stated that EPA policy was that waste-to-energy ash residue was exempt from treatment as a hazardous waste as a matter of law and could be safely disposed of in MSW landfills that met the EPA's criteria. In reaching its decision, the Seventh Circuit Court of Appeals refused to give deference to the EPA's policy. An appeal of this decision was filed in early 1993 in the United States Supreme Court, and a decision is expected during the Court's Spring 1994 session. OPI does not expect that a decision that requires ash residue having hazardous characteristics to be managed as a hazardous waste would have significant impacts on the OPI's business. Eight of the Company's facilities are located in states or dispose of their ash residue in states which require testing to determine whether such residue must be managed as a hazardous waste under state law. Furthermore, ash processing technology is available which could be used to further ensure that ash does not exhibit characteristics of hazardous waste. From time to time, state and federal moratoria on waste to energy have been proposed in legislation, regulation, and by executive action. Generally, such proposals have not been adopted, and where they have, as in the State of New Jersey, following the moratorium, waste to energy has continued to be included in the options available to local municipalities. In 1992, as previously reported, the State of Rhode Island eliminated waste to energy from its unique legislation in which the state's solid waste management plan was enacted as law. As a consequence of this legislation, OPI brought an action against the state challenging the validity of the change in the plan which has been settled by the State's agreement to pay OPI approximately $5.5 million in 1994, a portion of which must be shared with Blount, Inc., the former developer of the Quonset, Rhode Island project. OWTS' business activities are regulated under Federal, state and local environmental laws governing air and water emissions and the generation, transportation, storage, treatment and disposal of solid wastes, and hazardous and toxic materials. In particular, RCRA, its implementing regulations and parallel state laws create a cradle-to-grave system for regulating hazardous waste; and CERCLA and similar state laws create programs for remediation of contaminated sites and for the imposition of liability upon those who owned or operated such sites or who generated or transported hazardous substances disposed of at such sites. OPI believes that OWTS's units and projects were operated in compliance in all material respects with regulatory requirements that apply to its business. OPI's waste-to-energy business is subject to the provisions of the Federal Public Utility Regulatory Policies Act ("PURPA"). Pursuant to PURPA, the Federal Energy Regulatory Commission ("FERC") has promulgated regulations that exempt qualifying facilities (facilities meeting certain size, fuel and ownership requirements) from compliance with certain provisions of the Federal Power Act, the Public Utility Holding Company Act of 1935, and, except under certain limited circumstances, state laws regulating the rates charged by electric utilities. PURPA was promulgated to encourage the development of cogeneration facilities and small facilities making use of non-fossil fuel power sources, including waste-to-energy facilities. The exemptions afforded by PURPA to qualifying facilities from the Federal Power Act and the Public Utility Holding Company Act of 1935 are of great importance to the Company and its competitors in the waste-to-energy industry. State public utility commissions must approve the rates, and in some instances other contract terms, by which public utilities purchase electric power from the Company's projects. PURPA requires that electric utilities purchase electric energy produced by qualifying facilities at negotiated rates or at a price equal to the incremental or "avoided" cost that would have been incurred by the utility if it were to generate power itself or purchase it from another source. While public utilities are not required by PURPA to enter into long-term contracts, PURPA creates a regulatory environment in which such contracts can typically be negotiated. In October, 1992, Congress enacted, and the President signed into law, comprehensive energy legislation, several provisions of which are intended to foster the development of competitive, efficient bulk power generation markets throughout the country. Although the impact of the legislation will not be fully known until any judicial challenges are resolved and Federal and State regulatory agencies develop policies and promulgate implementing regulations, OPI believes that, over the long term, the legislation will create business opportunities both in the waste-to-energy field as well as in other power generation fields. OTHER INFORMATION (a) Raw Materials. The construction of each of OPI's waste-to- energy facilities is generally carried out by a general contractor selected by OPI. The general contractor is usually responsible for the procurement of bulk commodities used in the construction of the facility, such as steel and concrete. These commodities are generally readily available from many suppliers. OPI generally directs the procurement of all major equipment utilized in the facility, which equipment is also generally readily available from may suppliers. The stoker grates utilized in facilities constructed by OPI are required to be obtained from Martin pursuant to the Cooperation Agreement. In connection with the currently operating waste-to-energy facilities, OPI has entered into long-term waste disposal agreements which obligate the relevant Client Communities (or in the case of the Haverhill projects, the private haulers) to deliver specified amounts of waste on an annual basis. OPI believes that sufficient amounts of waste are being produced in the United States to support current and future waste-to-energy projects. Other commodities used in operation of OPI's facilities are readily available from many suppliers. Item 2. Item 2. PROPERTIES (a) Operating Services The principal physical properties of Ogden Services are the fueling installations at various airports in the United States and Canada and the corporate premises located at Two Pennsylvania Plaza, New York, New York 10121 under lease, which expires on April 30, 1998 and which contains an option by Ogden Services to renew for an additional five years. Atlantic Design Company's corporate offices are located in Charlotte, North Carolina. Atlantic Design owns a 51,000 square foot operating facility on 3.5 acres of land in Vestal, New York. Atlantic Design also leases operating facilities at various locations in Florida, New Jersey and New York. The leases range from a term of one year to as long as ten years. Ogden Services Corporation, through wholly-owned subsidiaries, owns and leases buildings in various areas in the United States which house office, laboratory and warehousing operations. The leases range from a month-to-month term to as long as five years. The Ogden Services Corporation in-flight food service operation facilities, aggregating approximately 600,000 square feet, are leased, except at Newark, New Jersey; Miami, Florida,; and Las Vegas, Nevada which are owned. Ogden Services, through a subsidiary, operates the Fairmount Park racetrack which conducts thoroughbred and harness racing in Collinsville, Illinois, eight miles from downtown St. Louis. The track is on a 150-acre site with a long-term lease expiring in 2017. It also owns a 148-acre site located at East St. Louis, Illinois. Ogden Abatement and Decontamination Services owns a 12,000 square-foot warehouse and office facility located in Long Island City, New York. Ogden Government Services leases most of its facilities, consisting almost entirely of office space. This includes an 11-year lease which began in 1986 for its headquarters facility in Fairfax, Virginia, for approximately 119,000 square feet as well as office space in other locations throughout the United States under lease terms of five years or less. OEES's headquarters is located in Fairfax, Virginia, where OEES currently occupies approximately 27,000 square feet of space in the headquarters building of ERC International, Inc. ("ERCI"), a wholly-owned subsidiary of Ogden. OEES's lease payments include the cost of certain services and allocations which are shared with ERCI. OEES has agreed to continue to occupy and sublease from ERCI not less than 24,000 square feet of space in the building for the remainder of the lease term expiring in 1997. OEES leases an aggregate of approximately 347,000 square feet of office and laboratory space in 40 separate locations in 17 states in the United States. OEES's leases are generally short term in nature, with terms which range from five to ten years or less and include (i) the headquarters office described above, (ii) office and laboratory space in Nashville and Oak Ridge, Tennessee; San Diego, California; Pensacola, Florida; and Phoenix, Arizona, and (iii) laboratory office space owned in Fort Collins, Colorado. In addition to its Fairfax, Virginia headquarters, OEES maintains regional headquarters in San Diego, California and Nashville, Tennessee. Many of the other Ogden Services' facilities operate from leased premises located principally within the United States. (b) Waste-to-Energy Operations OPI's principal executive offices are located in Fairfield, New Jersey in an office building located on a 5.4-acre site owned by OPI. The following table summarizes certain information relating to the locations of the properties owned or leased by OPI or its subsidiaries as of January 31, 1994 (1). OTHER INFORMATION COMPETITION AND GENERAL BUSINESS CONDITIONS Ogden's businesses can be adversely affected by general economic conditions, war, inflation, adverse competitive conditions, governmental restriction and controls, natural disasters, energy shortages, weather, the adverse financial condition of customers and suppliers, various technological changes and other factors over which Ogden has no control. The economic climate can adversely affect several of Ogden's operations, including reduced requests by communities for waste-to- energy facilities at Ogden Projects, Inc., fewer airline flights and flight cancellations in the Ogden Aviation Services group; cost cutting and budget reductions in the Ogden Government Services and Ogden Facility Services groups; and, reduced event attendance in the Ogden Entertainment Services group. EQUAL EMPLOYMENT OPPORTUNITY In recent years, governmental agencies (including the Equal Employment Opportunity Commission) and representatives of minority groups and women have asserted claims against many companies, including some Ogden subsidiaries, alleging that certain persons have been discriminated against in employment, promotions, training, or other matters. Frequently, private actions are brought as class actions, thereby increasing the practical exposure. In some instances, these actions are brought by many plaintiffs against groups of defendants in the same industry, thereby increasing the risk that any defendant may incur liability as a result of activities which are the primary responsibility of other defendants. Although Ogden and its subsidiaries have attempted to provide equal opportunity for all of its employees, the combination of the foregoing factors and others increases the risk of financial exposure. EMPLOYEE AND LABOR RELATIONS As of January 31, 1994, Ogden and its subsidiaries employed approximately 41,800 people. Certain employees at Ogden subsidiaries are covered by collective bargaining agreements with various unions. During 1993, Ogden subsidiaries successfully renegotiated collective bargaining agreements in certain of its business sectors with no strike- related loss of service. Ogden does not anticipate any significant labor disputes in any of its service areas in 1994. INTERNATIONAL TERMINAL OPERATING CO. INC. Since April 1983, Ogden has owned 50% of the outstanding shares of International Terminal Operating Co. Inc. (ITO), which is engaged in providing stevedoring and related terminal services for loading and unloading containerized and breakbulk cargo in the United States. Because of severely depressed industry conditions, as well as the possibility of high pension liabilities under multiemployer plans, it does not appear likely that Ogden will be able to recover its investment in the foreseeable future. Ogden previously recorded a $28.5 million loss to fully reserve its entire investment. Ogden is contingently liable for up to $19.2 million as guarantor under certain of ITO's surety bonds and letters of credit. AVONDALE INDUSTRIES, INC. Pursuant to Ogden's sale of Avondale Industries, Inc., (Avondale) in 1985, Ogden continues as guarantor of tax-exempt Industrial Revenue Bonds (IRBs), amounting to approximately $36,000,000 on behalf of Avondale. The IRBs are secured by a letter of credit which expires June 16, 1994 issued for the account of Ogden. These IRBs are redeemable (unless remarketed) at the option of the bondholders or Avondale on June 1, 1994, and annually thereafter through June 1, 2001. The IRBs are subject to a mandatory call for redemption on June 1, 1994 if the existing letter of credit is not extended or replaced or the IRBs otherwise refinanced. If the IRBs are redeemed, Ogden may be required to purchase Avondale preferred stock. In addition, Ogden may also be required to purchase Avondale preferred stock in connection with certain litigation and income tax matters. Item 3. Item 3. LEGAL PROCEEDINGS AND ENVIRONMENTAL MATTERS (a) Legal Proceedings Ogden and its subsidiaries are parties to various legal proceedings involving matters arising in the ordinary course of business. Ogden does not believe that there are any pending legal proceedings for damages against Ogden and its subsidiaries, the outcome of which would have a material adverse effect on Ogden and its subsidiaries on a consolidated basis. (b) Environmental Matters Ogden conducts regular inquiries of its subsidiaries regarding litigation and environmental violations which include determining the nature, amount and likelihood of liability for any such claims, potential claims or threatened litigation. In the ordinary course of its business, subsidiaries of Ogden may become involved in Federal, state, and local proceedings relating to the laws regulating the discharge of materials into the environment and the protection of the environment. These include proceedings for the issuance, amendment, or renewal of the licenses and permits pursuant to which the subsidiary operates. Such proceedings also include actions brought by individuals or local governmental authorities seeking to overrule governmental decisions on matters relating to the subsidiaries' operations in which the subsidiary may be, but is not necessarily, a party. Most proceedings brought against an Ogden subsidiary by governmental authorities under these laws relate to alleged technical violations of regulations, licenses, or permits pursuant to which the subsidiary operates. At September 30, 1993, an Ogden subsidiary was involved in one such proceeding in which the subsidiary believes sanctions involved may exceed $100,000. Ogden believes that such proceeding will not have a material adverse effect on Ogden and its subsidiaries on a consolidated basis. Ogden's operations are subject to various Federal, state and local environmental laws and regulations, including the Clean Air Act, the Clean Water Act, the Comprehensive Environmental Response Compensation and Liability Act (CERCLA) and Resource Conservation and Recovery Act (RCRA). Although Ogden's operations are occasionally subject to proceedings and orders pertaining to emissions into the environment and other environmental violations, Ogden believes that it is in substantial compliance with existing environmental laws and regulations and to the best of its knowledge neither Ogden nor any of its operations have been named as a potential responsible party at any site. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of Ogden during the fourth quarter of 1993. There is no family relationship by blood, marriage or adoption (not more remote than first cousins) between any of the above individuals and any Ogden director, except that R. Richard Ablon, an Ogden director and President and Chief Executive Officer, is the son of Ralph E. Ablon, an Ogden director and Chairman of the Board. The term of office of all officers shall be until the next election of directors and until their respective successors are chosen and qualified. There are no arrangements or understandings between any of the above officers and any other person pursuant to which any of the above was selected as an officer. Except as set forth below, the foregoing table lists the principal occupation and employment of the named individual and the position or similar position that he/she has held since January 1, 1989: Ralph E. Ablon has been Chairman of the Board of Ogden since 1962 and served as its Chief Executive Officer prior to May 1990. R. Richard Ablon has been President and Chief Executive Officer of Ogden since May 1990. From January, 1987 to May 1990, he was President and Chief Operating Officer, Operating Services, Ogden. Mr. Ablon has served as Chairman of the Board and Chief Executive Officer of Ogden Projects, Inc., an 84.2% owned subsidiary, since November 1990. Constantine G. Caras has been Executive Vice President and Chief Administrative Officer since July 1990. Since September 1986 he has served as Executive Vice President of Ogden Services Corporation. Scott G. Mackin was made an Executive Officer of Ogden during 1992. He has been President and Chief Operating Officer of Ogden Projects, Inc. since January 1991. From November 1990 to January 1991, he was Co-President, Co-Chief Operating Officer, General Counsel and Secretary of Ogden Projects, Inc. Between 1987 and 1990 Mr. Mackin served in various executive capacities of Ogden Projects, Inc. Philip G. Husby has been Senior Vice President and Chief Financial Officer of Ogden since January 1, 1991. From April 1987 to December 31, 1990, he served as Senior Vice President and Chief Administrative Officer of Ogden Financial Services, Inc., an Ogden subsidiary. Lynde H. Coit has been a Senior Vice President and General Counsel of Ogden since January 17, 1991. From April 1989 to January 1991, he was Senior Vice President and General Counsel of Ogden Financial Services, Inc., an Ogden subsidiary. From January 1988 to March 1989, he was a partner of the law firm of Nixon, Hargrave, Devans & Doyle and prior thereto he was employed by that firm. Nancy R. Christal has been Vice President - Investor Relations of Ogden since February 1992 and served as Ogden's Director, Investor Relations from January 1991 to February 1992. From April 1990 to January 1991, she was Director, Investor Relations at Ogden Projects, Inc. From 1985 to March 1990 she served first as Manager and then as Assistant Vice President, Investor Relations at Chemical Bank. Part II Item 5. Item 5. MARKET FOR OGDEN'S COMMON EQUITY & RELATED STOCKHOLDER MATTERS Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Page 47 of Ogden's 1993 Annual Report to Shareholders. As of March 1, 1994, the approximate number of Ogden common stock Shareholders was 12,700. Item 6. Item 6. SELECTED FINANCIAL DATA Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Page 24 of Ogden's 1993 Annual Report to Shareholders. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Pages 22 and 23 of Ogden's 1993 Annual Report to Shareholders. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Pages 24 through 44 and Page 47 of Ogden's 1993 Annual Report to Shareholders. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF OGDEN Pursuant to General Instruction G (3), the information regarding directors called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Item 11. Item 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G (3), the information called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. The information regarding officers called for by this item is included at the end of Part I of this document under the heading "Executive Officers of Ogden." Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G (3), the information called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G (3), the information called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy statement to be filed with the Securities and Exchange Commission. Part IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Listed below are the documents filed as a part of this report: 1). All financial statements contained on pages 25 through 44 and the Independent Auditors' Report on page 45 of Ogden's 1993 Annual Report to Shareholders are incorporated herein by reference. 2). Financial statement schedules as follows: (i) Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than Related Parties for the years ended December 31, 1993, 1992 and 1991. (ii) Schedule V - Property, Plant and Equipment for years ended December 31, 1993, 1992 and 1991. (iii) Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. (iv) Schedule VIII - Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991. (v) Schedule IX - Short-Term Borrowings for the year ended December 31, 1991. (vi) Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991. 3). Those exhibits required to be filed by Item 601 of Regulation S-K: EXHIBITS 3.0 Articles of Incorporation and By-laws. 3.1 Ogden's Restated Certificate of Incorporation as amended.* 3.2 Ogden's By-Laws, as amended through March 17, 1994 transmitted herewith as Exhibit 3.2. 4.0 Instruments Defining Rights of Security Holders. 4.1 Fiscal Agency Agreement between Ogden and Bankers Trust Company, dated as of June 1, 1987, and Offering Memorandum dated June 12, 1987, relating to U.S. $85 million Ogden 6% Convertible Subordinated Debentures, Due 2002.* 4.2 Fiscal Agency Agreement between Ogden and Bankers Trust Company, dated as of October 15, 1987, and Offering Memorandum, dated October 15, 1987, relating to U.S. $75 million Ogden 5-3/4% Convertible Subordinated Debentures, Due 2002.* 4.3 Indenture dated as of March 1, 1992 from Ogden Corporation to The Bank of New York, Trustee, relating to Ogden's $100 million debt offering.* 10.0 Material Contracts 10.1 Agreement and Plan of Merger, dated as of October 31, 1989, among Ogden, ERCI Acquisition Corporation and ERC International, Inc.* 10.2 Credit Agreement by and among Ogden, The Bank of New York, as Agent and the signatory bank Lenders thereto dated as of September 20, 1993. Transmitted herewith as Exhibit 10.2. 10.3 Stock Purchase Agreement, dated May 31, 1988, between Ogden and Ogden Projects, Inc.* 10.4 Tax Sharing Agreement, dated January 1, 1989, between Ogden, Ogden Projects, Inc. and subsidiaries, Ogden Allied Services, Inc. an subsidiaries, and Ogden Financial Services, Inc. and subsidiaries.* 10.5 Stock Purchase Option Agreement, dated June 14, 1989, between Ogden and Ogden Projects, Inc. as amended on November 16, 1989.* 10.6 Preferred Stock Purchase Agreement, dated July 7, 1989, between Ogden Financial Services, Inc. and Image Data Corporation.* 10.7 Rights Agreement between Ogden Corporation and Manufacturers Hanover Trust Company, dated as of September 20, 1990.* 10.8 Executive Compensation Plans and Arrangements (a) Ogden Corporation 1986 Stock Option Plan (Filed as Exhibit (10) (k) to Ogden's Form 10- K for the fiscal year ended December 31, 1985) (b) Ogden Corporation 1990 Stock Option Plan (Filed as Exhibit (10) (j))** (c) Ogden Services Corporation Executive Pension Plan (Filed as Exhibit (10) (k))** (d) Ogden Services Corporation Select Savings Plan (Filed as Exhibit (10) (L))** (e) Ogden Services Corporation Select Savings Plan Trust (Filed as Exhibit (10) (M))** (f) Ogden Services Corporation Executive Pension Plan Trust (Filed as Exhibit (10) (N))** (g) Changes effected to the Ogden Profit Sharing Plan effective January 1, 1990 (Filed as Exhibit (10) (O))** (h) Employment Letter Agreement between Ogden and an Executive officer dated January 30, 1990 (Filed as Exhibit (10) (p))** (i) Employment Agreement between Ogden and R. richard Ablon dated as of May 24, 1990 (Filed as Exhibit (10) (R))** (i) Letter Amendment Employment Agreement between Ogden and R. Richard Ablon dated as of October 11, 1990 (Filed as Exhibit (10) (R) (i))** (j) Employment Agreement between Ogden and C. G. Caras dated as of July 2, 1990 (Filed as Exhibit (10) (S))** (i) Letter Amendment to Employment Agreement between Ogden Corporation and C.G. Caras, dated as of October 11, 1990 (Filed as Exhibit (10) (S) (i).** (k) Employment Agreement between Ogden and Philip G. Husby as of July 2, 1990 (Filed as Exhibit (10) (T))** (l) Termination Letter Agreement between Maria P. Monet and Ogden dated as of October 22, 1990 (Filed as Exhibit (10) (V)** (m) Letter Agreement between Ogden Corporation and Ogden's Chairman of the Board, dated as of January 16, 1992 (Filed as Exhibit (10.2) (P) to Ogden Form 10-K for the fiscal year ended December 31, 1991) (n) Employment Agreement between Ogden and Ogden's Chief Accounting Officer dated as of December 18, 1991 (Filed as Exhibit (10.2) (Q) to Ogden Form 10-K for fiscal year ended December, 1991) (o) Employment Agreement between Scott G. Mackin and Ogden Projects, Inc. dated as of January 1, 1994. Transmitted herewith as Exhibit 10.8 (o). (p) Ogden Corporation Profit Sharing Plan (Filed as Exhibit (10.8) (P))*** (i) Ogden Profit Sharing Plan as amended and restated January 1, 1991 and as in effect through January 1, 1993. Transmitted herewith as Exhibit 10.8 (p) (i). (q) Ogden Corporation Core Executive Benefit Program (Filed as Exhibit 10.8 (Q))*** (r) Ogden Projects Pension Plan (Filed as Exhibit 10.8 (R))*** (s) Ogden Projects Profit Sharing Plan (Filed as Exhibit 10.8 (S))*** (t) Ogden Projects Supplemental Pension and Profit Sharing Plans (Filed as Exhibit 10.8 (T))*** (u) Ogden Projects Employee's Stock Option Plan (Filed as Exhibit 10.8 (U))*** (v) Ogden Projects Core Executive Benefit Program (Filed as Exhibit 10.8 (V))*** (w) Form of amendments to the Ogden Projects, Inc. Pension Plan and Profit Sharing Plans effective as of January 1, 1994. Transmitted herewith as Exhibit 10.8 (w). ** Filed as Exhibits with Ogden's Form 10-K for fiscal year ended December 31, 1990. *** Filed as Exhibits with Ogden's Form 10-K for fiscal year ended December 31, 1992. 10.9 Agreement and Plan of Merger among Ogden Corporation, ERC International, Inc., ERC Acquisition Corporation and ERC Environmental and Energy Services Co., Inc., dated as of January 17, 1991.* 10.10 First Amended and Restated Ogden Corporation Guaranty Agreement made as of January 30, 1992 by Ogden Corporation for the benefit of Mission Funding Zeta and Pitney Bowes Credit Corporation.* 10.11 Ogden Corporation Guaranty Agreement as of January 30, 1992 by Ogden Corporation for the benefit of Allstate Insurance Company and Ogden Martin Systems of Huntington Resource Recovery Nine Corporation.* 11 Ogden Corporation and Subsidiaries Detail of Computation of Earnings Applicable to Common Stock for the years ended December 31, 1993, 1992 and 1991. Transmitted herewith as Exhibit 11. 13 Those portions of the Annual Report to Stockholders for the year ended December 31, 1993, which are incorporated herein by reference. Transmitted herewith as Exhibit 13. 21 Subsidiaries of Ogden. Transmitted herewith as Exhibit 21. 24 Consent of Deloitte & Touche. Transmitted herewith as Exhibit 24. * Incorporated by reference as set forth in the Exhibit Index of this Annual Report on Form 10-K. (b) No Reports on Form 8-K were filed by Ogden during the fourth quarter of 1992. SIGNATURES Pursuant to the requirements of Section 13 and 15(d) 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. OGDEN CORPORATION March 17, 1994 By /S/ R. Richard Ablon R. Richard Ablon President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 17, 1994. SIGNATURE TITLE /S/ Ralph E. Ablon Chairman of the Board & Director RALPH E. ABLON /S/ R. Richard Ablon President & Chief Executive Officer R. RICHARD ABLON and Director /S/ Philip G. Husby Senior Vice President and Chief PHILIP G. HUSBY Financial Officer /S/ Robert M. DiGia Vice President, Controller and Chief ROBERT M. DIGIA Accounting Officer /S/ David M. Abshire Director DAVID M. ABSHIRE /S/ Norman G. Einspruch Director NORMAN G. EINSPRUCH /S/ Constantine G. Caras Director CONSTANTINE G. CARAS /S/ Rita R. Fraad Director RITA R. FRAAD /S/ Attallah Kappas Director ATTALLAH KAPPAS Director TERRY ALLEN KRAMER /S/ Maria P. Monet Director MARIA P. MONET Director JUDITH D. MOYERS /S/ Homer A. Neal Director HOMER A. NEAL /S/ Stanford S. Penner Director STANFORD S. PENNER /S/ Frederick Seitz Director FREDERICK SEITZ /S/ Robert E. Smith Director ROBERT E. SMITH /S/ Abraham Zaleznik Director ABRAHAM ZALEZNIK INDEPENDENT AUDITOR'S REPORT Ogden Corporation: We have audited the consolidated financial statements of Ogden Corporation and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 2, 1994, which report includes an explanatory paragraph relating to the adoption of Statements of Financial Accounting Standards No. 106 and No. 109; such consolidated financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Ogden Corporation and subsidiaries, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Deloitte & Touche February 2, 1994

3449_1993.txt

3449_1993

1993

3449

ITEM 1. BUSINESS GENERAL Alexander & Alexander Services Inc., a holding company incorporated under the laws of Maryland in 1973, together with its subsidiaries (collectively, the "Company"), is a global insurance brokerage, risk management, and human resource management consulting company. It is one of the leading insurance brokerage and risk management companies worldwide. Through predecessor entities the Company has been in business since 1899. The Company has extensive international operations representing 46 percent, 47 percent and 45 percent of the Company's consolidated operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively. It operates from offices located in more than 80 countries and territories through wholly owned subsidiaries, affiliates and other servicing capabilities. The Company believes that it is the second largest insurance broker in the world, based upon 1992 revenues, and that it is one of very few companies capable of providing insurance brokerage, risk management and human resource management consulting services on a global basis to clients with multinational operations. The Company's clients are primarily commercial enterprises, including a broad range of industrial, transportation, service, financial and other businesses. Clients also include government and governmental agencies, not-for-profit organizations and individuals. The Company's core businesses include risk management and insurance services, specialist insurance broking, reinsurance broking and human resource management consulting. INDUSTRY SEGMENTS Insurance Services The Company's principal industry segment is insurance services. For the years ended December 31, 1993, 1992 and 1991, total revenues contributed by the Company's insurance services segment accounted for 84 percent, 82 percent and 84 percent, respectively, of its consolidated operating revenues. The Company's operations in this segment include risk management and insurance services, specialist insurance broking and reinsurance broking. The Company's extensive services permit it to handle diverse lines of coverage. Risk Management and Insurance Services. For the years ended December 31, 1993, 1992 and 1991, the Company's risk management and insurance services operations accounted for approximately 65 percent, 64 percent and 67 percent, respectively, of the Company's consolidated operating revenues. The Company develops risk management programs and places coverage on behalf of its clients directly with insurance companies, or indirectly through specialist insurance brokers. Since January 1991, the Company's worldwide risk management and insurance services have operated under a single coordinated management structure. In 1993, the Company reorganized its retail operations based on a global business segmentation strategy initiated in 1992. In implementing this strategy, the Company formed risk management and insurance services divisions to align its resources more closely with the servicing requirements of its customers. In 1993, the Company introduced the common trading name of "Alexander & Alexander" throughout its global insurance services network in the United States, the United Kingdom, Canada and Japan and in most of its markets in continental Europe, Asia-Pacific and the Middle East. The Company's risk analysis and management capabilities include a broad range of services such as risk surveys and analyses, loss control and cost studies, formulation of safety procedures and insurance programs. Through Anistics, the Company offers financial and actuarial, risk information and strategic risk management consulting to clients worldwide. Alexander Insurance Managers Limited manages captive insurance companies and Alexander Trade Services arranges political risk/export credit risk insurance programs and trade finance packages worldwide. In the United States, Alexsis offers risk management services, including risk analysis, claims administration and claims information reporting. Through Alexander Underwriting Services, the Company offers administration of runoff of insurance and reinsurance companies and intermediaries. Specialist Insurance Broking. For the years ended December 31, 1993, 1992 and 1991, the Company's wholesale operations accounted for approximately 8 percent, 7 percent and 6 percent, respectively, of the Company's consolidated operating revenues. As a specialist insurance broker, the Company acts as an intermediary between the retail broker and insurance companies and Lloyd's of London syndicates. London-based Alexander Howden Limited places large and complex risks that require access to the London and world markets. U.S.-based Alexander Howden North America, Inc. offers excess, surplus and specialty lines placements. From Australia and Singapore, Alexander Howden Asia Pacific specializes in specialist insurance broking and facultative reinsurance. Reinsurance Broking. For each of the years ended December 31, 1993, 1992 and 1991, the Company's reinsurance operations accounted for approximately 11 percent of the Company's consolidated operating revenues. As a reinsurance broker, the Company places coverage on behalf of its insurance or reinsurance company clients to reinsure all or a portion of the risk underwritten by that insurance or reinsurance company. The Company's worldwide reinsurance brokerage services, led by its U.K. subsidiary, Alexander Howden Reinsurance Brokers Limited, arrange reinsurance programs for Lloyd's of London syndicates and other insurance and reinsurance companies worldwide. Alexander Reinsurance Intermediaries, Inc. provides a full range of reinsurance services in the United States. The Company is compensated for its broking services by commissions, usually as a percentage of insurance premiums paid by the client, or by negotiated fees. The Company may also receive contingent commissions which are based on the volume and/or profitability of business placed with an insurance company over a given period of time. The Company is generally compensated on a fee basis when providing consulting and advisory services with respect to its clients' risk and underwriting management programs. Premiums received from insureds but not yet remitted to the carriers and claims payments received from carriers but not yet remitted to the insureds are held as cash or investments in a fiduciary capacity. Human Resource Management Consulting The Company offers global human resource management consulting services and benefits broking through the Alexander Consulting Group Inc. ("ACG"). For the years ended December 31, 1993, 1992 and 1991, total revenues contributed by the Company's human resource management consulting services segment accounted for 16 percent, 18 percent and 16 percent, respectively, of the Company's consolidated operating revenues. ACG provides advisory and support services in human resource management, organizational effectiveness, integrated information technologies, strategic health care and flexible compensation, retirement planning and actuarial services, benefit plan design and implementation, international benefits/compensation, and benefit plan investment consulting through Alexander & Alexander Consulting Group Inc. in the U.S., Alexander Clay & Partners in Europe and Alexander Consulting Group Limited in Canada and the Asia-Pacific region. ACG provides broking services for group health and welfare, special risk, and association/mass marketing insurance coverage through Alexander & Alexander Benefits Services Inc. in the U.S. and as a division of the Alexander Consulting Group Limited in Canada. ACG operates in 18 countries. The Company is compensated for human resource management consulting services on a fee basis, except in instances where it receives commissions from insurance companies for the placement of individual and group insurance contracts. Financial Information about Industry Segments Financial information related to the Company's industry segments and geographical concentrations for each of the three years in the period ended December 31, 1993 is contained in Note 15 of the Notes to Financial Statements to the Company's 1993 Annual Report to Stockholders (the "1993 Annual Report") and is incorporated herein by reference. DISCONTINUED OPERATIONS In March 1985, the Company discontinued the insurance underwriting operations acquired in 1982 as part of the Alexander Howden acquisition. In 1987, the Company sold Sphere Drake Insurance Group (Sphere Drake) and is currently running-off the Atlanta and Bermuda insurance companies. The 1987 Sphere Drake sales agreement provides indemnities by the Company for various potential liabilities including provisions covering future losses on the insurance pooling arrangements from 1953 to 1967 between Sphere Drake and Orion Insurance Company, a U.K.-based insurance company and future losses pursuant to a stop loss reinsurance contract between Sphere Drake and Lloyd's Syndicate 701. As to operations in run-off, reinsurance agreements provide the Atlanta and Bermuda insurance companies with insurance coverage for their reserves as of December 31, 1988, and for up to $50 million of insurance coverage for potential losses in excess of those reserves, subject to a deductible for one of the Atlanta companies of $12.5 million. The agreements also provide for a reinsurance premium adjustment, whereby at any time after January 1, 2001, the reinsurance agreements can be terminated and any excess funds, net of any reinsurance premium paid to a substitute reinsurance company, would be returned to the Company. The Sphere Drake indemnities and other liabilities arising out of the discontinued operations are expected to be settled and paid over many years and could extend over a 20 to 30 year period. Further information concerning discontinued operations is contained in Note 6 of the Notes to Financial Statements to the Company's 1993 Annual Report and is incorporated herein by reference. ACQUISITIONS AND DISPOSITIONS On November 30, 1993, the Company issued 2.3 million shares of its Common Stock for all of the partnership interests of Clay & Partners, a U.K.-based actuarial consulting operation. This acquisition has been accounted for as a pooling of interests and, accordingly, the consolidated financial statements have been restated for all periods prior to the acquisition. Effective July 1, 1993, the Company acquired an 80 percent interest in a Mexican insurance brokerage company which was accounted for as a purchase. The purchase price was $16.9 million, including a $7.4 million cash payment and notes payable of $9.5 million due in three installments from 1994 to 1996. The excess of the purchase price over the fair value of net tangible assets acquired was approximately $16 million. The effect of this acquisition was not significant to the Company's consolidated financial statements. During 1993, the Company sold three small operations for gross proceeds of $9.6 million. Pre-tax gains of $3.9 million have been recognized on the sales with resulting after-tax gains totaling $2.3 million or $0.05 per share. During 1992, the Company sold three non-core businesses, including a U.K.-based pension fund management operation, a Netherlands-based non-broking operation and a U.S.-based administrator of workers compensation funds. Total proceeds on these sales were $77.4 million with resulting pre-tax gains of $43.8 million ($28.5 million after-tax or $0.66 per share). Further information concerning acquisitions and dispositions is contained in Note 3 of the Notes to Financial Statements to the Company's 1993 Annual Report and is incorporated herein by reference. COMPETITION AND CUSTOMERS Insurance broking and human resource management consulting are highly competitive industries. The Company competes with other worldwide and national companies, as well as regional and local firms. The principal methods of competition in these businesses involve the nature, quality and cost of the services the broker or consultant provides. As a service provider, the Company also encounters competition with respect to attracting and retaining qualified employees. In addition, insurance and reinsurance underwriters compete with the Company by marketing and servicing their insurance products without the assistance of insurance brokers. Also, certain insureds and groups of insureds have initiated programs of self-insurance, thereby reducing or eliminating the need for insurance brokers. EMPLOYEES The Company has approximately 14,500 employees. A small number of employees in foreign countries are represented by labor unions. In addition, support personnel in Australia are represented by an industrywide union. The Company considers relations with its employees to be satisfactory. REGULATIONS AND LICENSING The activities of the Company related to insurance broking and human resource management consulting services are subject to licensing requirements and extensive regulation under the laws of the United States and each of its various states, territories and possessions, as well as the laws of numerous other countries in which the Company's subsidiaries conduct business. These laws and regulations vary by jurisdiction. The appropriate regulatory authorities generally have wide discretionary authority in adopting, amending and implementing such regulations. In addition, certain of the Company's insurance activities are governed by the rules of the Lloyd's of London insurance market and other similar organizations. In every state of the United States and most foreign jurisdictions, an insurance broker or agent is required to have a license and such license may be denied or revoked by the appropriate governmental agency for various reasons, including the violation of its regulations and the conviction of crimes. In a few jurisdictions, licenses are issued only to individual residents or locally owned business entities. In certain of those jurisdictions, if the Company itself has no subsidiary that is so licensed, the Company may from time to time make arrangements with residents or business entities licensed to act on its behalf in the jurisdiction. The legality of the Company's operations depends on the continuing retention and validity of the licenses under which it operates and on compliance with a diverse and complex regulatory structure. The Company's licenses may not be readily transferable in many jurisdictions. The Company expends significant amounts of time and money to maintain its licenses and to ensure compliance with applicable laws and regulations. Because of its multistate and international operations, in some instances the Company follows practices which are based upon its interpretation of laws or regulations or upon the interpretation generally followed by the industry. However, such interpretations may be in conflict with those of regulatory authorities. Therefore, the possibility exists that the Company may be precluded or temporarily suspended from continuing its business or otherwise penalized in a given jurisdiction. ITEM 2. ITEM 2. PROPERTIES Substantially all of the Company's worldwide facilities are leased. No difficulty is anticipated in negotiating renewals as leases expire or in finding other satisfactory space if the premises become unavailable. Further information concerning the Company's obligations under capital leases and noncancelable operating leases is contained in Notes 9 and 12 of the Notes to Financial Statements to the 1993 Annual Report incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are subject to various claims and lawsuits from both private and governmental parties, which include claims and lawsuits in the ordinary course of business, consisting principally of alleged errors and omissions in connection with the placement of insurance and in rendering consulting services. In some of these cases, the remedies that may be sought or damages claimed are substantial. Additionally, the Company and its subsidiaries are subject to the risk of losses resulting from the potential uncollectibility of insurance and reinsurance balances and claims advances made on behalf of clients. MUTUAL FIRE AND OTHER SHAND CONTINGENCIES In December 1987, the Company sold Shand, Morahan & Company, Inc. ("Shand"), its domestic underwriting management subsidiary. The sales contract between the Company and Shand's purchasers obligates the Company to certain indemnities with respect to transactions involving Mutual Fire Marine and Inland Insurance Company ("Mutual Fire"). The Company, Alexander & Alexander Inc., a subsidiary of the Company, and Shand are defendants in a lawsuit brought in 1991 by the Pennsylvania Insurance Commissioner as rehabilitator of Mutual Fire. The complaint alleges matters within the terms of such indemnification obligation. The action, in the United States District Court for the Eastern District of Pennsylvania and styled Constance B. Foster v. Alexander & Alexander Services Inc. et al. (Civil Action No. 91-1179), arises out of Shand's relationship as underwriting manager for Mutual Fire, now insolvent. The complaint alleges that Shand, and in certain respects the Company, breached duties to, and agreements with, Mutual Fire. In addition to claiming compensatory damages, the complaint seeks punitive damages and recovery of certain commissions paid to Shand and the Company. The complaint does not specify, to any meaningful degree, the amount of alleged damages incurred or sought. In June 1993, however, the rehabilitator through an expert's report has indicated to Shand and the Company that the alleged damages are in the amount of $238.5 million. The Company and Shand strongly disagree with the alleged damages in the rehabilitator's report and have substantial arguments to sustain their position. The Company and Shand are in the process of finalizing a series of expert reports that rebut the damage number alleged in the rehabilitator's report. The case is likely to be placed on the trial calendar in the summer of 1994. Management of the Company believes that there are valid defenses to the allegations set forth in the complaint and the Company is vigorously defending this action. The sales contract between the Company and Shand's purchasers also obligates the Company to certain other indemnities with respect to transactions involving Mutual Fire. In November 1992, the purchaser, by written notice, asserted indemnification claims related to reinsurance recoverables due from Mutual Fire. In February 1993, the Company agreed to settle certain of these claims. The Company has estimated its exposure under this settlement, net of anticipated recoveries from certain trusteed assets held for Shand's benefit of $10.8 million and net of $4.6 million of set-offs, and established a reserve as part of the 1992 special charge described in Note 4 of the Notes to Financial Statements to the Company's 1993 Annual Report. The Mutual Fire rehabilitator has challenged Shand's right to recover these assets and the utilization of such set-offs. The purchaser of Shand has also notified the Company of claims relating to reinsurance recoverables based on alleged errors and omissions of Shand in placing reinsurance. The allegations have, so far, led to the institution of four arbitration proceedings involving certain of these reinsurers. The amount at issue aggregates $33 million. These claims are potentially subject to indemnification by the Company under the terms of the sales agreement. Shand is actively disputing these allegations. However, pursuant to the terms of the indemnity, the Company may be responsible for the costs of these proceedings and related expenses. Until there is a final determination that a reinsurer has a right to withhold payment of a reinsurance recoverable, based on an actual error or omission of Shand, the Company believes that its exposure under the indemnity is limited to the above-mentioned costs and expenses. The Company intends to vigorously dispute these claims. SPHERE DRAKE In November 1984, Sphere Drake Insurance Company plc ("Sphere Drake") issued a writ against, and served points of claim upon, Mark Edmond Denby, individually and as a representative of the Names on Lloyd's Syndicate 701, pursuant to a stop-loss reinsurance contract between Sphere Drake and Syndicate 701 and for a determination of continuing stop-loss coverage protecting Sphere Drake under the contract. A defense was entered in Sphere Drake Insurance Company plc v. Mark Edmond Denby, 1984 S. No. 6548 (Q.B. Commercial Court). The Company has indemnified the purchasers of Sphere Drake in connection with this litigation. A trial was held in late 1991 and an adverse decision was issued in April 1992. The Company's appeal of the decision was heard in October 1993 with the U.K. Court of Appeals upholding the adverse decision of the lower courts. In the Company's opinion this indemnity is limited in amount pursuant to the terms of the stop-loss reinsurance contract. GLICKMAN On November 4, 1993, a class action suit was filed against the Company and two of its directors and officers, Tinsley H. Irvin and Michael K. White, in the United States District Court for the Southern District of New York under the caption Harry Glickman v. Alexander & Alexander Services Inc., et al. (Civil Action No. 93 Civ. 7594). In response to defendants' motion to dismiss an amended complaint was filed on February 16, 1994 purportedly on behalf of a class of persons who purchased the Company's Common Stock during the period May 1, 1991 to September 28, 1993, alleging that during said period the Company's financial statements contained material misrepresentations as a result of inadequate reserves established by the Company's subsidiary, Alexander Consulting Group Inc., for unbillable work-in-progress. The amended complaint seeks damages in an unspecified amount, as well as attorneys' fees and other costs, for alleged violations of the federal securities laws. Management of the Company believes there are valid defenses to the allegations set forth in the complaint and the Company intends to vigorously dispute this claim. Management presently believes that this claim will not be material to the Company's financial condition. PINE TOP AND RELATED CONTINGENCIES Claims have been or may be asserted against the Company and certain of its subsidiaries alleging, among other things, that certain Alexander Howden subsidiaries accepted, on behalf of certain insurance companies, insurance or reinsurance at premium levels not commensurate with the level of underwriting risks assumed and retroceded or reinsured those risks with financially unsound reinsurance companies. Claims asserting these allegations are pending in suits filed in New York and Ohio. In New York, a suit was brought against the Company in 1985 (Pine Top Insurance Company, Ltd. v. Alexander & Alexander Services Inc., et al., 85 Civ. 9860 (RPP) (S.D.N.Y.)). Plaintiff in this case seeks compensatory and punitive, as well as treble damages under RICO totaling approximately $87 million, arising from alleged RICO violations, common law fraud, breach of contract and negligence. Discovery in this case has been substantially completed and the trial is scheduled to begin in June 1994. In a similar New York action brought in 1988 (Certain Underwriters at Lloyd's of London Subscribing to Insurance Agreement ML8055801, et al. v. Alexander & Alexander Services Inc., et al., formerly captioned Dennis Edward Jennings v. Alexander & Alexander Europe plc, et al., 88 CIV. 7060 (RO) (S.D.N.Y.)), plaintiffs seek compensatory and punitive damages, as well as treble damages under RICO totaling $36 million. Discovery in this case remains to be concluded and no trial date has been set. In the Ohio action brought in 1985 (The Highway Equipment Company, et al. v. Alexander Howden Limited, et al. (Case No. 1-85-01667, U.S. Bankruptcy Court, So. Dist. Ohio, Western Div.)), plaintiffs seek compensatory and punitive damages, as well as treble damages under RICO totaling $24 million. In April 1993, the bankruptcy court ordered a directed verdict in the Company's favor. That verdict was affirmed on March 14, 1994 in a decision by the U.S. District Court for the Southern District of Ohio and plaintiffs have 30 days in which to appeal the decision to the U.S. Court of Appeals for the Sixth Circuit. Management of the Company believes there are valid defenses to the claims asserted and the Company is vigorously defending the pending actions. In a New York action, which was initially commenced in 1984, a subsidiary of the Company asserted claims against two reinsurers and their parent company for breach of certain reinsurance contracts and tortious interference with these contracts (American Special Risk Insurance Co. v. Delta America Re Insurance Co., et al., 84 Civ. 1329 (S.D.N.Y.)). One of the reinsurers counterclaimed, alleging RICO violations, common law fraud and negligence and claiming compensatory and punitive damages, as well as treble damages under RICO. The action was settled in December 1993 by payment to the Company's subsidiaries of $8.1 million and the counterclaim against the Company's subsidiaries was voluntarily dismissed in February 1994. In a Florida action brought in 1986 (The Staff Fund, Inc. f/k/a the North Broward Hospital District Active Medical Staff Self-Insurance Fund, Inc. v. Alexander & Alexander, Inc., a Florida Corporation, et al., Case No. 86-05314 CN (Cir. Ct., Broward Cty., Fl.)), the plaintiff sought compensatory and punitive damages of over $1.7 million. This action was settled to the parties satisfaction on March 16, 1994. IN RE INSURANCE ANTITRUST LITIGATION One of the Company's subsidiaries, Thomas A. Greene & Company Inc., now operating as Alexander Reinsurance Intermediaries, Inc., is one of 31 defendants named in a series of antitrust actions which were filed beginning in March 1988 by the attorneys general of 18 states and by 20 private parties. All actions have been consolidated in the United States District Court for the Northern District of California (In Re Insurance Antitrust Litigation, C-88-1688-WWS (N.D. Cal.)). The defendants, which include various insurance and reinsurance companies, reinsurance brokers and trade associations, are alleged to have manipulated the market for commercial insurance by, among other things, conspiring to restrict the terms of, and hence the availability of, general liability insurance. Plaintiffs seek to enjoin further violations and to order a restructuring of the insurance industry, in addition to recovering damages for injuries to both public entities and the private party plaintiffs. In September 1989, the court granted defendants' Motion for Summary Judgment on various grounds. The plaintiffs appealed the matter to the Ninth Circuit Court of Appeals, which reversed the decision of the District Court. The United States Supreme Court granted certiorari and in June 1993 affirmed in part and reversed in part the decision of the Ninth Circuit Court of Appeals and remanded the case for further proceedings. Management of the Company believes that there are valid defenses to the allegations asserted and the Company is vigorously defending this action. Further information concerning the above-mentioned legal contingencies is contained in Notes 6, 13, and 14 of the Notes to the Financial Statements to the Company's 1993 Annual Report and is incorporated herein by reference. These contingent liabilities involve significant amounts, and while it is not possible to predict with certainty the outcome of such contingent liabilities, the applicability of coverage for such matters under the Company's professional liability insurance programs, or their financial impact on the Company, management presently believes that such impact will not be material to the Company's financial condition. However, it is possible that future developments with respect to these matters could have a material effect on future interim or annual results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year covered by this report, no matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated herein by reference is information concerning the market price and dividends per share of the Company's Common Stock contained in Note 16 of the Notes to Financial Statements and information under the caption "Approximate Number of Equity Security Holders," in the Company's 1993 Annual Report. Also incorporated herein by reference is information concerning restrictions on the payment of dividends on the Company's Common Stock contained in Note 11 of the Notes to the Financial Statements to the Company's 1993 Annual Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information under the caption "Selected Financial Data" in the 1993 Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information under the caption "Management's Discussion and Analysis of Financial Condition & Results of Operations" in the Company's 1993 Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following are incorporated herein by reference to the 1993 Annual Report: Independent Auditors' Report Consolidated Statements of Operations for each of the three years in the period ended December 31, 1993 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1993 Notes to Financial Statements, including unaudited quarterly financial data ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the fiscal years ended December 31, 1993 and 1992 and in the subsequent interim period, there has been no change in, or disagreements on accounting matters with, the Company's independent auditors. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this item as to directors is included under the caption "Nominees for Election" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders (The "1994 Proxy Statement") and is incorporated herein by reference. Information required by this item is included under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the 1994 Proxy Statement and is incorporated herein by reference. The following sets forth information with respect to executive officers of the Company and a former executive officer: LAWRENCE E. BURK, 52, has served as chairman and chief executive officer of Alexander & Alexander Inc. ("A&A Inc."), the Company's U.S. retail broking subsidiary since November 1993. Since joining the Company in 1970, he has held various senior management positions for the Company's retail broking operations, including global business development director, January 1991 to October 1993, and U.S. eastern regional director, May 1989 to January 1991. RONALD W. FORREST, 51, former executive officer of the Company who retired January 1, 1994, and who served as a senior vice president of the Company and as chairman and chief executive officer of A&A Inc., from February 1989 and September 1991, respectively, until his retirement. From 1985 until his retirement, he held various executive, management and operating positions with the Company. RONALD L. HENDRICK, 48, has served as controller and vice president of the Company since May 1993. From February 1988 to March 1993 he was vice president and controller of the Adolph Coors Company and director of treasury management from November 1987 to January 1989. From 1972 to 1987, he held various financial and management positions with subsidiaries of Coors. RONALD A. ILES, 58, has served as a senior vice president of the Company since 1985 and is responsible for general management of the Company's reinsurance operations. Since 1981, he has been chairman of Alexander Howden Reinsurance Brokers Limited, a U.K.-based subsidiary acquired in 1982, which manages the Company's worldwide reinsurance operations. In January 1993, he was appointed chairman of Alexander & Alexander Services UK plc. TINSLEY H. IRVIN, 60, announced his retirement from the Company effective April 1, 1994, having served as chief executive officer of the Company from May 1987 through March 1994, as chairman of the board from May 1988 to January 1994, and as president from March 1982 to May 1993. He has served in various executive management and operating positions for the Company and its predecessor entities since 1953. Mr. Irvin has been a director of the Company and its predecessor entities since 1970. DANIEL E. KESTENBAUM, 60, has served as a senior vice president of the Company and director of quality and professional practice since May 1993. Mr. Kestenbaum joined the Company in 1974 and has held various management positions with the Company's U.S. broking operation, including senior vice president of A&A Inc. from October 1992 to May 1993 and chief executive officer of Alexander Howden North America, Inc., the Company's U.S. wholesale broker, from January 1986 to September 1992. ROBERT H. MOORE, 53, has served as a senior vice president since November 1985 and is responsible for management of the Company's corporate relations, including Alexander & Alexander Government and Industry Affairs Inc. in Washington, D.C. He has served in various management and advisory capacities since joining the Company in 1977. DAN R. OSTERHOUT, 43, has served as a senior vice president of the Company since January 1988, with responsibility for management of the Company's underwriting exposures. In January 1994, he was appointed chairman and chief executive officer of Alexander Underwriting Services, a new business unit offering administration of run-off of insurance and reinsurance companies and intermediaries. From September 1991 to December 1993, he also served in various executive positions with A&A Inc., including president and chief operating officer. He has held various other financial and management positions since joining the Company in 1970. RONALD J. ROESSLER, 54, has served as general counsel and senior vice president of the Company since 1976 and 1988, respectively. He joined the Company in 1972. PAUL E. ROHNER, 57, has served as chief financial officer and senior vice president of the Company since 1987. Prior to joining the Company, he was chief financial officer with Tambrands Inc. and Dekalb Corporation. DONALD L. SEELEY, 50, has served as a senior vice president of the Company since May 1992 and as chief executive officer of the Alexander Consulting Group Inc., the Company's human resource management subsidiary, since October 1993. From September 1988 to September 1993 he was responsible for the management of the Company's treasury, tax, strategic planning and corporate secretary functions, having served as vice president from September 1988 to April 1992. From 1982 until joining the Company, he held various executive financial management positions, including treasurer, with United Airlines and G.D. Searle & Company. THOMAS SOPER III, 44, has served as senior vice president of corporate human resources since May 1991 and as vice president from April 1986 to April 1991. From 1982 until joining the Company, Mr. Soper held various human resource management positions with General Electric Financial Services and International Playtex Inc. MICHAEL K. WHITE, 55, has served as president and chief operating officer of the Company since May 1993. Since January 1993, he has had executive management responsibility for the Company's global operations. From September 1990 to May 1993, he served as a deputy chairman of the Company and from May 1987 to May 1993 as an executive vice president. He has held various executive and operating positions with the Company since 1983 and various managerial positions with the Company and its predecessor entities since 1970. Mr. White has been a director of the Company since 1983, and of RSC since January 1989. ITEM 11. ITEM 11. MANAGEMENT REMUNERATION AND TRANSACTIONS Information included under the caption "Executive Compensation" in the Company's 1994 Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information included under the caption "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Directors and Executive Officers" in the 1994 Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information included under the caption "Certain Transactions" in the 1994 Proxy Statement is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) and (a)(2): The financial statements, supplemental schedules and related information are listed in the accompanying table of contents on page 15 of this report. (a)(3) Exhibits: (b) Reports on Form 8-K: In a report filed on Form 8-K, dated December 15, 1993, the Company reported the acquisition by the Company of all of the partnership interests of Clay & Partners, a U.K.-based actuarial consulting operation in exchange for 2.27 million shares of the Company's Common Stock. In a report filed on Form 8-K, dated January 17, 1994, the Company noticed certain management and corporate governance changes, including the appointment of Robert E. Boni as chairman of the Board of Directors of the Company and the retirement of T.H. Irvin, chairman and chief executive officer. In a report filed on Form 8-K, dated February 25, 1994, the Company reported earnings for the year ended and the quarter ended December 31, 1993. - --------------- * The referenced exhibit is a management contract or compensation plan or arrangement described in Item 601(b)(10)(iii) of Regulation S-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 31st day of March, 1994. ALEXANDER & ALEXANDER SERVICES INC. By: /s/ TINSLEY H. IRVIN March 31, 1994 _____________________________________________ TINSLEY H. IRVIN DATE Chief Executive Office and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated. ALEXANDER & ALEXANDER SERVICES INC. AND SUBSIDIARIES FINANCIAL STATEMENTS AND RELATED INFORMATION The following consolidated financial statements and related information of Alexander & Alexander Services Inc. and subsidiaries, included in the Company's 1993 Annual Report to Stockholders, are incorporated by reference to Item 8 of this report: Independent Auditors' Report Consolidated Statements of Operations for each of the three years in the period ended December 31, 1993 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1993 Notes to Financial Statements, including unaudited quarterly financial data The following supplemental schedules and related information of Alexander & Alexander Services Inc. and its consolidated subsidiaries are included in pages 16 through 20 of this report: Independent Auditors' Report Schedule II-- Amounts Receivable from Officers and Employees of the Company and Its Affiliates Schedule VIII--Valuation and Qualifying Accounts INDEPENDENT AUDITORS' REPORT To ALEXANDER & ALEXANDER SERVICES INC.: We have audited the consolidated financial statements of Alexander & Alexander Services Inc. and Subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 25, 1994; such consolidated financial statements and report are included in your 1993 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Alexander & Alexander Services Inc. and Subsidiaries, listed in the accompanying table of contents referred to under Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Baltimore, Maryland February 25, 1994 SCHEDULE II ALEXANDER & ALEXANDER SERVICES INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES OF THE COMPANY AND ITS AFFILIATES FOR THE YEAR ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - --------------- Notes: (1) Represents housing loan due to employee relocation. SCHEDULE II ALEXANDER & ALEXANDER SERVICES INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES OF THE COMPANY AND ITS AFFILIATES FOR THE YEAR ENDED DECEMBER 31, 1992 (THOUSANDS OF DOLLARS) - --------------- Notes: (1) Represents housing loan due to employee relocation. (2) Represents portion of debt forgiven. SCHEDULE II ALEXANDER & ALEXANDER SERVICES INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES OF THE COMPANY AND ITS AFFILIATES FOR THE YEAR ENDED DECEMBER 31, 1991 (THOUSANDS OF DOLLARS) - --------------- Notes: (1) Represents housing loan due to employee relocation. (2) Represents personal assistance loan. (3) Represents obligation for compensation advanced to employee. SCHEDULE VIII ALEXANDER & ALEXANDER SERVICES INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - --------------- Notes: (1) Recoveries and adjustments for foreign currency translation. (2) Writeoffs of receivables which are not recoverable. (3) Restated to reflect acquisition of Clay & Partners. ALEXANDER & ALEXANDER SERVICES INC. ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993 INDEX TO EXHIBITS Certain exhibits to this Report on Form 10-K have been incorporated by reference. For a list of these Exhibits see Item 14 hereof. The following exhibits are being filed herewith:

758004_1993.txt

758004_1993

1993

758004

ITEM 1. BUSINESS THE COMPANY Novell, Inc. ("Novell" or the "Company") is an information system software company, which develops, markets and services specialized and general purpose operating system products and application programming tools. Novell's NetWare(R), UnixWare(TM) and AppWare(TM) families of products provide matched software components for distributing information resources within local, wide area and internetworked information systems. The Company was incorporated in Delaware on January 25, 1983. Novell's executive offices are located at 122 East 1700 South, Provo, Utah 84606. Its telephone number at that address is (801) 429-7000. The Company sells its products domestically and internationally through 33 U.S. sales offices and 31 foreign offices. The Company sells its products primarily through distributors and national retail chains, who in turn sell the Company's products to retail dealers. The Company also sells its products through OEMs, system integrators, and VARs. The Company conducts product development activities in Cupertino, Monterey, San Jose, Sunnyvale, and Walnut Creek, California; Boulder, Colorado; Natick, Massachusetts; Summit, New Jersey; Austin, Texas; Provo, Salt Lake City, and Sandy, Utah; Toronto, Canada; and Hungerford, U.K. It also contracts out some product development activities to other third-party developers. In December 1990, the Company announced that Canon, Fujitsu, NEC, Sony, and Toshiba, five major Japanese computer companies, joined SOFTBANK Corporation and Novell as investment partners in Novell Japan, Ltd., a Tokyo-based joint venture inaugurated in April 1990. Novell has a 54% ownership interest, and accordingly, the financial statements of Novell Japan, Ltd. are consolidated in the financial statements of the Company, with the minority interest in profit or loss offset within other income and expense. In April 1991, the Company invested $15.0 million in UNIX System Laboratories, Inc. (USL), a subsidiary of AT&T that develops and licenses the UNIX operating system and other standards-based software to customers worldwide. In December 1991, the Company announced the formation of Univel, a joint venture with USL, formed to accelerate the expanded use of the UNIX operating system in the personal computer and network computing marketplace. Novell and USL contributed cash and technology rights to Univel. Then in June 1993, the Company acquired the remaining portion of USL by issuing approximately 11.1 million shares of Novell common stock valued at $321.8 million in exchange for all of the outstanding stock of USL not previously owned by Novell and assumed additional liabilities of $9.4 million. The transaction was accounted for as a purchase and, on this basis, resulted in a one-time write-off of $268.7 million for purchased research and development in the third quarter of fiscal 1993. On October 28, 1991, the Company completed a merger with Digital Research Inc. (DRI), a producer of personal computer operating software, whereby DRI became a wholly owned subsidiary of Novell. There were 6.0 million shares of Novell common stock exchanged for all of the outstanding stock of DRI. This transaction was accounted for as a pooling of interests; however, prior year financial statements have not been restated due to immateriality. In April 1992, the Company purchased all of the outstanding stock of International Business Software, Ltd. (IBS), a developer of distributed computing technology for Apple Macintosh computers, for $5.2 million cash, whereby IBS became a wholly owned subsidiary of Novell. In June 1992, the Company purchased all of the outstanding stock of Annatek Systems, Inc. (Annatek), a developer of software distribution products, for $10.0 million cash, whereby Annatek became a wholly owned subsidiary of Novell. In June 1993, the company purchased all of the outstanding stock not previously owned by Novell of Serius Corporation (Serius), a developer of object-based application tools, for $17.0 million cash and assumed liabilities of $5.0 million, whereby Serius became a wholly owned subsidiary of Novell. Novell previously had invested cash of $1.1 million in Serius. This transaction was accounted for as a purchase and, on this basis, resulted in a one-time write-off of $22.1 million for purchased research and development in the third quarter of fiscal 1993. In June 1993, the Company acquired all of the outstanding stock of Software Transformation, Inc. (STI), a developer of software development tools, by issuing approximately 800,000 shares of Novell common stock in exchange for all of the outstanding stock of STI. The transaction was accounted for as a pooling of interests; however, prior periods were not restated due to immateriality. In July 1993, the Company acquired all of the outstanding stock of Fluent, Inc. (Fluent), a developer of multimedia software for personal computers, for $18.5 million cash and assumed liabilities of $3.0 million, whereby Fluent became a wholly owned subsidiary of Novell. The transaction was accounted for as a purchase and, on this basis, resulted in a one-time write-off of $20.7 million for purchased research and development in the third quarter of fiscal 1993. The Company will continue to look for similar acquisitions, investments, or strategic alliances which it believes complement its overall business strategy. BUSINESS STRATEGY Novell's business strategy is to be a leading supplier of software products for the network computing industry. Over the past several years the Company has issued common stock or paid cash to acquire technology companies, invested cash in other technology companies, and formed strategic alliances with still other technology companies. Novell undertook all of these transactions to promote the growth of the network computing industry, and in many cases to also broaden the Company's business as a system software supplier. Novell believes that companies implement technologies to meet business needs. People use technology to help them to be more productive in their jobs. As a result of these motivations, customers have made the NetWare operating system the most popular network solution in the industry. This is a direct result of Novell's delivery of a networking environment that contributes to the success of individuals and companies. Novell is focused on meeting customer needs. To meet the needs of its customers, over the past year Novell has embarked on a strategy to combine the industry's most proven network operating system with the industry's most proven application platform -- UNIX. This "matched pair" combines the best network services with the best application services to deliver to customers the best computing platform on which to run their businesses. These strong operating systems combine with Novell's innovative client/server application platform to deliver a total system software solution. Novell's mission is to accelerate the growth of the network computing industry through responsible leadership. The Company accomplishes this by delivering an overall networking environment which includes industry leading product technology, programs, and partnerships. The key elements of the Company's overall business strategy are: Technological Leadership. Integration Platform. Novell's NetWare network operating system provides a platform for the integration of multiple technologies. This includes the seamless integration of multiple desktop systems and host environments. Novell believes that the customer environments are inherently heterogeneous and therefore require an information system that integrates dissimilar technologies. The goal of Novell's strategy of integrating various desktop systems is to allow IBM and IBM-compatible, Apple Macintosh, and UNIX-based PCs and workstations to access and share simultaneously a common set of network resources and information. This gives customers the freedom to choose the desktop and application server systems that best fit their application requirements. In addition to the integration of desktops, host environments from vendors such as IBM, DEC, HP and Olivetti are integrated into the NetWare network so that users can access host-based resources and information from their desktops across the network. Novell continues to extend this hardware and infrastructure integration to other communication devices such as PBXs and imbedded systems such as cash registers and process control devices. The overall objective is to seamlessly connect users by shielding them from the underlying network technology used to share resources and information across heterogenous systems. Network Services. Novell delivers advanced network services on top of the integration platform. These services enhance the functionality available to users on the network. In the first release of NetWare eleven years ago, those services were file and print only. While Novell has continued to enhance NetWare file and print services, the services provided by Novell and third parties have expanded significantly to include communications, network and systems management, messaging, directory, software licensing and distribution, imaging and document management, and telephony services. Novell continues to add network services through internal development efforts, partnerships, and acquisitions. Application Framework: AppWare. In addition to the programming interfaces that Novell provides for application developers, Novell has begun delivering AppWare -- a set of development tools that significantly eases the development of true client/server applications. AppWare allows application developers and internal IS development teams to deliver distributed applications that integrate and take advantage of all of the network services available in NetWare and UnixWare. Directory Services. With the introduction of NetWare 4 in March 1993, Novell began to deliver an industry leading distributed naming service -- NetWare Directory Services (NDS). NDS allows administrators and users to view the information and resources on the network in a simple and integrated way. It provides for one common view of the network rather than having to track resources by knowing on which server the resource resides. NDS allows the user to login once into the network and access information and resources independent of physical location. While this simplifies both the administration and use of the network, NDS also improves the security of network information with the use of encryption technology. The NetWare Directory Service will continue to become the centerpiece of network services and client/server applications for the next several years. Programs Technical Support Alliance. In May 1991 Novell announced the formation of the Technical Support Alliance (TSA), with 37 current members including Apple, Compaq, Hewlett-Packard, Intel, IBM, Lotus, Microsoft, Oracle and WordPerfect. The TSA was organized to provide one-stop multivendor support. Certified NetWare Engineer Program. Through the Certified NetWare Engineer (CNE) program, Novell is strengthening the networking industry's Level I support self-sufficiency. CNEs are individuals who receive high-level training, information, and advanced technical telephone support (Level II) from Novell. CNEs may be employed by resellers, independent support organizations, or Novell Support Organizations (NSOs). The NSO program pools the capabilities of the industry's best support providers. NSOs have contractual agreements with Novell that are designed to ensure quality service on a national or global level. National Authorized Education Centers. Novell offers education to end users through more than 1,200 established Novell Authorized Education Centers (NAECs) worldwide, which use Novell-developed courses to instruct more than 30,000 students per month in the use and maintenance of Novell products. Novell also offers self-paced training products. Novell Labs. Through its Independent Manufacturer Support Program (IMSP), Novell works with third-party manufacturers to test and certify hardware components designed to interoperate with the NetWare operating system. Novell distributes these tests results to inform NetWare customers about products that have formally demonstrated NetWare compatibility. In effect, IMSP certification programs help vendors to market their products through Novell's distribution channels. The primary goal of IMSP is to foster working relationships between Novell and strategic third-party hardware manufacturers. Secondary goals include promoting certified hardware to industry resellers, anticipating industry hardware directions through comarketing efforts, and working with vendors to codevelop critical network hardware components. Client-Server NetWare Loadable Module (NLM) Testing Program. Novell is committed to ensuring the highest quality customer solutions by raising the level of importance that quality assurance and testing hold in the software development cycle. The NLM testing program is a result of that commitment; it allows developers to submit client-server NLM applications for testing. Partnerships Development Partners. When customers request a new network service be added to the NetWare operating system, Novell investigates the most effective way to deliver that functionality to the user. Very often the best way is for Novell to partner with a company who has expertise in that specific area. By partnering, the combination of Novell's expertise in networks and the partner's expertise in the given product area combine to deliver a better solution faster than if Novell would have attempted to develop it alone. Systems Partners. Novell partners with companies who have complimentary software and hardware. The resulting solution is a powerful combination of products that deliver enterprise-wide connectivity solutions. These partners include system suppliers like IBM, DEC and HP, as well as system integration experts like Memorex Telex, Arthur Andersen, EDS, etc. Application Partners. Novell works very closely with application developers to provide integrated software support for end users. Because Novell does not market applications, relationships with software developers can be very synergistic. Multiple Channel Distribution Network. The Company markets a broad line of the NetWare operating system and the UnixWare operating system through distributors, dealers, value added resellers, systems integrators, and OEMs as well as to major end users. Worldwide Service and Support. The Company is committed to providing service and support on a worldwide basis to its resellers and to their end-user customers. The Company has established agreements with third party service vendors to expand and complement the service provided directly by the Company's service personnel and the Company's resellers. PRODUCTS The Company's products fall within three operating groups: NetWare Systems Group (NSG), UNIX Systems Group (USG), and AppWare Systems Group (ASG). NETWARE SYSTEMS GROUP. NSG develops operating systems products to meet customer demands and include the following features. Open Architecture. Novell maintains an open architecture in all of its networking products. Application interfaces to all of the NetWare services have been developed and published, allowing developers to take advantage of NetWare functionality. NetWare applications interfaces provide access to all NetWare services, including file and print, database, communications, and messaging services. The NetWare Directory Service will be the foundation for network services and client/server applications for the next several years. Besides enhanced NetWare file and print services, the services provided by Novell and third parties will also include communications, network and systems management, messaging, directory, software licensing and distribution, imaging and document management, and telephony services. Ease of Use. NetWare 4 reduces administrative costs by allowing network supervisors to manage and administer their networks easily. A new graphical utility called the NetWare Administrator consolidates all network administration tools into a single console, giving intuitive control of the entire network. Reliability. NetWare contains a wide variety of features that ensure system reliability and data integrity. These features protect everything from the storage medium to critical application files, allowing Novell to provide the highest levels of network reliability in the industry. Novell pioneered system fault tolerance in PC-based networks and continues to lead the industry in this area. Novell's introduction of mirrored server technology in 1992 provides the highest level of fault tolerance for PC based networks. Manageability. Through NetWare Distributed Management Services (NDMS), Novell delivers industry leading products that provide network and systems management capabilities. NetWare manages all of a customers critical assets -- information, infrastructure, hardware, and software -- through delivery of storage management, device, and software licensing and distribution services. Security. Throughout its history, the NetWare product line has provided the tightest security features in the industry. Novell introduced the concept of usernames, passwords, and user profiles to the network market in NetWare as early as 1983. These user profiles list the resources to which a user has access, and the rights he or she has while using that resource. With version 2.15 of the NetWare operating system, network managers have been able to specify the date, time, and location from which a user can login to the network. Intruder detection and lockout features notify supervisors of any unauthorized access attempt. NetWare 3 incorporates additional security features including encrypted passwords over the wire. NetWare 4 network operating system adds new security auditing capabilities required in many security conscious network environments. Workstation Independence. NetWare currently supports DOS, MS Windows, OS/2, Macintosh, and UNIX workstations. By providing a network operating system that can integrate all the standard workstation operating systems, Novell gives users the freedom to choose their workstation environment while ensuring them full network participation. Hardware Independence. NetWare is hardware-independent and the Company has close working relationships with more than 350 strategic third-party hardware manufacturers. This independence and these relationships provide the Company with a broad market for its networking software and the ability to support new hardware as it is developed. High Performance. When Novell introduced the Advanced NetWare network operating system to the market in 1985, it represented a major improvement in network operating system performance, and NetWare network operating systems still lead the market in performance today. The NetWare 3 network operating system extends Novell's performance leadership by providing end users the potential of up to three times the performance of the NetWare 2 network computing products. The NetWare 4 network operating system allows users and applications to gain access to network-wide information and services transparently through technologies such as NetWare Directory Services, new security capabilities, wide-area networking improvements, and enhanced administration and management tools. NETWARE OPERATING SYSTEMS PRODUCT LINE. The NetWare family of network operating systems provides solutions to a wide variety of needs ranging from small, simple networks to enterprise-wide networks and include the following products. NetWare 4. In March 1993, Novell introduced the NetWare 4 operating system. An elaborate demonstration showed the ability of how one network server can support 1,000 clients or how one client can access 1,000 servers. Novell sees itself and NetWare at the center of the converging market forces reshaping business computing on to downsized, or rightsized information systems. Cohesively managed computer networks are taking on computing responsibilities held by mainframe computers over the last three decades. NetWare has increasingly defined a system services environment that supports this world-wide shift away from mainframe and mid-range computing solutions to computer networks. Novell's NetWare 4 operating system is designed to deliver the power and technology to meet downsizing requirements. All Encompassing Environment. Delivering a manageable, global, directory framework that provides connectivity to other computing platforms enables users to access applications and system services regardless of their physical location on the network. System Fault Tolerance. Providing robust business-critical reliability to a network using the concept of server mirroring allows the workflow of the business to be uninterrupted even in the event of a hardware failure. Large Scale Configurations. NetWare 4 supports single server configurations up to 1,000 concurrent users, or clients, on each server. NetWare 3. NetWare 3 is a proven, sophisticated connectivity tool for businesses, departments, and workgroups of various sizes. NetWare 3 is a full-featured, 32-bit network operating system that supports all key desktop operating systems -- DOS, MS Windows, OS/2, UNIX, and Macintosh -- as well as the IBM SAA environment. NetWare 3 provides a high-performance integration platform for businesses requiring a sophisticated network computing solution in a multivendor environment. NetWare 3 offers centralized network management and is available in 5-,10-, 20-, 50-, 100-and 250-user versions, allowing organizations to standardize on a high-performance networking solution regardless of their size. NetWare Clients. As new desktop operating systems become available Novell has continued its Open Desktop Strategy by offering NetWare clients and redirectors for connection into NetWare through fulfillment and 1-800 numbers. This allows existing users of NetWare to update client network components while maintaining their investment in NetWare servers. In 1992 Novell released Workstation kits for MS DOS, DR DOS, MS Windows 3.1 and OS/2 2.0. These kits provide users and administrators with the ability to get the latest desktop client support available and allows Novell the flexibility to enhance the desktop support independently of NetWare Operating System releases. Messaging Services. Messaging technology provides communications capabilities that allow messages to be sent between people, between processes, or between a person and a process without using real-time links. Novell also provides products with these capabilities. NetWare MHS is a "store-and-forward" message handling service for the Novell distributed computing platform. NetWare MHS platform supports a wide range of services including Electronic mail (E-mail), workflow automation, calendar and scheduling, and fax services. Applications from more than 900 developers (including more than 150 commercial applications) operate on this foundation and support the NetWare MHS platform. For example, Indisy provides connectivity between mainframe, minicomputer, and PC-based network users. Indisy's software provides for the exchange of mail transparently across IBM SNA networks. In addition to electronic mail, Indisy also provides software for the exchange of single mail parcels containing spreadsheets, graphics and text, batch report distribution, remote job submission, document translation, and other functions. NetWare for Macintosh. When used in conjunction with a NetWare environment, NetWare for Macintosh brings the comprehensive networking features of NetWare, such as enhanced security, resource accounting, and fault tolerance, to the Apple Macintosh environment. NetWare for Macintosh allows Macintosh, DOS, and OS/2 workstations to share data and resources in a high-performance, secure network environment. This product is of special interest to large-and medium-sized companies that have heterogeneous computing environments. NetWare for Macintosh comes in two versions: NetWare for Macintosh 4.01 and NetWare for Macintosh 3.12. NetWare for Macintosh 4.01 is the premier solution for integrating Macintosh computers into the NetWare environment. It provides file services, print services, administrative utilities, and AppleTalk routing for Macintosh users on a NetWare 4 network. NetWare for Macintosh 4.01 also allows fast and secure CD-ROM access and DOS-to-Macintosh application mapping. NetWare for Macintosh 3.12 provides NetWare file, print, routing, and administrative utilities to Macintosh users and integrates them into the NetWare 3 environment. Personal NetWare. As the networking industry continues to grow, new users are interested in simple and inexpensive entry level networking solutions to connect small groups of users together in workgroups. In September 1991 Novell introduced a new peer-to-peer desktop networking product aimed at this market called NetWare Lite 1.0. In July 1992 Novell released an updated NetWare Lite 1.1 that improved the performance of NetWare Lite 1.0 by adding a full network caching and also improved the reliability and Windows support. Novell continued to enhance its desktop networking solutions with the release of Personal NetWare in 1993. Personal NetWare is the ideal solution for small businesses and for workgroups in larger businesses and enterprise-wide NetWare networks. Personal NetWare allows users to connect as many as 50 PCs running DOS or MS Windows so they can share hard disks, printers, CD-ROM drives and other resources. In addition to tighter integration with NetWare, Personal NetWare will include support for mobile users and network management at the desktop. Other features of Personal NetWare include a single-network view, single login, full compatibility with other versions of the NetWare network operating system, easy management and administration, security, autoreconnect, and a flexible configuration to maximize memory use. Novell DOS. In September 1991, the Company introduced DR DOS 6.0, a major upgrade of its advanced DR DOS operating system. DR DOS 6.0 represents a significant advance over DR DOS 5.0 and other competing products with respect to features such as memory management, disk caching and task-switching. The latest addition to Novell's desktop operating system products is Novell DOS 7. Novell DOS 7 is the first DOS that fully integrates advanced DOS technology with networking. Novell DOS 7 advances the DOS standard by providing state-of-the-art network and client management utilities, workstation security, disk compression, and NetWare, with all inherent peer-to-peer networking capabilities. Fully integrated networking makes Novell DOS 7 the best DOS client operating system for the Novell NetWare network operating system. It is also fully compatible with the installed base of DOS and MS Windows applications. COMMUNICATIONS AND CONNECTIVITY PRODUCTS. As the leader in local area network technology, the Company has made a significant commitment to implementing communications and connectivity services within the NetWare environment. Remote PC Access to Networks. The company provides two types of dial-in services for remote PCs: NetWare for SAA. NetWare for SAA 1.3B, which runs on both NetWare 3 and NetWare 4 platforms, integrates the NetWare network operating system with traditional IBM SNA mainframe and AS/400 environments. With NetWare for SAA, NetWare clients can access host data and applications while simultaneously accessing files and data on NetWare servers. Built as a set of NetWare Loadable Modules (NLMs), NetWare for SAA capitalizes on the high performance, security, name services, and administration features on the NetWare operating system. NetWare SNA Links. NetWare SNA Links 2.0 is an NLM that works with NetWare for SAA to provide LAN-to-LAN communications over existing SNA networks. With NetWare SNA Links, users in geographically dispersed branch offices can access remote LAN and host resources over SDLC and Token-Ring backbones without requiring specialized software on the host. Network supervisors can administer branch office servers from a central location using standard NetWare utilities and management products. When installed on a NetWare 3 server or a NetWare MultiProtocol Router 2.0, NetWare SNA Links can route IPX, IP, AppleTalk, and OSI over leased lines using the Point-to-Point Protocol or using X.25 private or public data networks. INTERNETWORKING PRODUCTS. Novell's internetworking products connect NetWare services at headquarters with services at branch offices, providing access to information and NetWare resources. NetWare MultiProtocol Router. The NetWare MultiProtocol Router v2.11 and NetWare MultiProtocol Router Plus v2.11 are software-based bridge/routers that run on 80386, 80486, and Pentium PCs. These bridge/routers enable users to connect to remote offices using familiar NetWare and PC technology. NetWare MultiProtocol Router is ideal for connecting local area networks by routing the IPX, IP, AppleTalk, and OSI protocols over a wide range of LAN types, and source-route bridging over Token-Ring. NetWare MultiProtocol Router Plus provides remote routing and source-bridge routing over leased lines, Frame Relay, and x.25. UNIX SYSTEMS GROUP. USG provides a full suite of UNIX operating system and UNIX connectivity products. Key products include: Operating System Products. Novell's UnixWare operating system provides a powerful application server and client for today's distributed computing environments. The current product offerings are the UnixWare Application Server 1.1 and the UnixWare Personal Edition 1.1. UnixWare uses the network services available from NetWare and the cross-platform development tools available from AppWare to make applications available throughout the entire enterprise. UnixWare is easy to use, enabling users to be productive right away. Its fully graphical user interface gives users access to all the enterprise-wide information and services available in the corporate computing environment with simple point-and-click mouse functions. UnixWare also supports a variety of international languages. Optional products for the Application Server systems include: UnixWare Server Merge for Windows, which provides UnixWare users with multiuser DOS access and limited multiuser MS Windows access; UnixWare Online Data Manager 1.1, a UNIX System V, industry-standard, robust file system designed to maximize system and data availability and improve I/O performance; and OracleWare System-UnixWare Edition, a powerful applications data server platform which integrates the UnixWare Application Server 1.1 operating system with Oracle 7 cooperative database server on a single CD-ROM disk. Optional add-on products for UnixWare Personal Edition include UnixWare NFS, which enables resource-sharing with other UNIX systems; UnixWare C2 Auditing, which records security-related events to help detect attempts to breach security; and UnixWare Encryption Utilities, which provide support for DES encryption and decryption. Novell also supplies the UNIX operating system source code to other UNIX system vendors. The latest version, UNIX System V Release 4.2 (SVR4.2), unifies several earlier versions and offers greatly enhanced ease of use and ease of administration features. UNIX Connectivity Products. Novell provides several product families designed to integrate NetWare into the UNIX and TCP/IP environments. NetWare NFS provides UNIX workstations with transparent access to the NetWare 3 and NetWare 4 file systems. Once NetWare NFS is installed, workstations with NFS client services can share files with other NetWare clients-such as DOS, Macintosh and OS/2 workstations. NetWare NFS enables UNIX and NetWare clients to share all network printing devices. It also provides an X Window System application that enables UNIX network supervisors to remotely manage NetWare servers. NetWare FLeX/IP provides all the services delivered in the NetWare NFS product except the transparent access to the NFS distributed file system. The NetWare NFS Gateway enables DOS and MS Windows users on NetWare to transparently access files on NFS servers. It extends the users' reach into the UNIX world yet preserves the familiar NetWare look and feel. The NetWare NFS Gateway provides easy-to-use, server-based installation, administration and management. Novell's popular LAN WorkPlace family of products provides users with fast, direct access to enterprise-wide TCP/IP resources, including the Internet, from a variety of desktop workstations. LAN WorkPlace for DOS offers unsurpassed flexibility by including both DOS and MS Windows TCP/IP applications, as well as new native language versions in French, German, Spanish, Portuguese and Japanese. LAN WorkGroup provides the same versatile connectivity to DOS and MS Windows users of large NetWare networks; its server-based installation, maintenance and management greatly reduce administration time and costs. LAN WorkPlace products are also available for such users of Macintosh and OS/2 systems. Mobile WorkPlace is the newest member of the family, enabling users to access TCP/IP resources when they're on the road just as if they were in the office. NetWare/IP is another way for customers to tightly integrate NetWare services into their TCP/IP environments. By installing NetWare/IP on existing NetWare 3 and NetWare 4 servers, customers can create an environment that supports both the TCP/IP and IPX transport protocols, or one that uses TCP/IP only. Novell also offers a solution for integrating Open Systems Interconnection (OSI) with NetWare. NetWare FTAM from Firefox is a fully FOSIP-compliant FTAM server that enables a variety of FTAM clients to access the NetWare 3 file system. This standard protocol-based product provides a key to enabling multivendor interoperability with NetWare systems. APPWARE SYSTEMS GROUP. ASG provides tools and technologies for the development of network-aware applications. Four key requirements are the focus of ASG's product line: (1) object based tools and systems for use by corporate and consulting developers for rapid network application development, (2) libraries for use by commercial software vendors for writing portable source code, covering dominant desktop and network system services, (3) transaction processing monitor technology for the creation and management of mission- critical corporate transaction applications, and (4) operating systems and network access technologies for office, commercial, and industrial devices to connect into local area networks. AppWare Bus and AppWare Loadable Modules. The AppWare Bus and ALMs provide a model for software components from separate vendors to work together in custom applications. The AppWare Bus is a sophisticated engine for managing the interactions between the ALM components. Novell and many third parties provide high-level, easy to use ALMs covering network, DBMS, communications, multimedia, and other application fields. When accessed by a development tool such as Novell's Visual AppBuilder, the AppWare Bus allows all ALMs to be used rapidly in any combination to create powerful applications. The AppWare Bus and ALMs are usually bundled with other Novell products, and several OEM agreements are in place for building within other vendors' development tools. Visual AppBuilder. Visual AppBuilder is Novell's rapid development tool for corporate and consulting developers. It provides an intuitive, visual interface to application construction, empowering developers who need not necessarily be fluent with traditional languages such as C and C++. Visual AppBuilder accesses the AppWare Bus and ALMs to provide the component engine and component set for developers to visually assemble into custom applications. Visual AppBuilder, when combined with network ALMs, is one of the most effective tools for building network-aware applications. Visual AppBuilder is targeted for sale through a variety of distribution channels, and will be bundled with several other Novell products. ALM SDK. The ALM SDK is a tool for C and C++ programmers to use to create new ALMs. The interface to the AppWare Bus is provided, allowing any third party programmer or vendor to create ALMs that interoperate with Novell's ALMs. The ALM SDK is bundled with Visual AppBuilder. AppWare Foundation. AppWare Foundation is a set of libraries which provide an application programming interface (API) for C and C++ developers to write portable source code. The problem of portability which is addressed by the AppWare Foundation is perhaps one of the most important issues facing software vendors today. Using the AppWare Foundation, a programmer may write code once for a new application or software component, and simply recompile the code to run on any of the dominant desktop computing systems, including MS Windows, MacIntosh, UnixWare and other versions of UNIX, and soon OS/2 and Windows NT. The Foundation offers such portable APIs covering graphical interfaces, operating systems, network systems, and network services. AppWare Foundation is targeted for sale through a variety of distribution channels, and several OEM relationships have been formed to distribute the Foundation libraries as a part of third party development tools. Tuxedo. Derived from Novell's 1993 acquisition of USL, Tuxedo is a sophisticated transaction processing manager for mission critical transaction-oriented applications. Tuxedo provides both client and server software for connecting client applications and server services together with a highly reliable, high-performance, secure, managed transaction connection. In use today in mission critical applications within Fortune 500 companies, Tuxedo is well recognized as a leading offering in its field. Its integration with NetWare, via NLMs, and AppWare, via ALMs, provides those key Novell products with effective transaction processing facilities. Tuxedo is sold largely through OEM agreements with major system software vendors, and directly to large corporate customers. Extended Networks Group products. The Extended Networks Group is developing and providing system software and application technologies for integrating office, commercial, and industrial devices into NetWare networks. While its products are not yet announced, they will include technology components such as: FlexOS. Novell's FlexOS is a 32-bit real time operating system which is most often embedded in business, commercial, and industrial devices to make such devices "intelligent". Widely used today in point-of-sale and industrial hardware systems, Flex OS will play an important role in the extension of NetWare LANs into emerging device markets. Device-centric ALMs. AppWare Loadable Modules which control devices through NetWare networks will offer complete system control to application developers. Given the other ALMs described above, applications will be able to be created quickly integrating control over desktop computer functions, network functions, and device functions. PRODUCT DEVELOPMENT Due to the rapid pace of technological change in its industry, the Company believes that its future success will depend, in part, on its ability to enhance and develop its network and communications software products to satisfactorily meet specific market needs. The Company's current product development activities include the enhancement of existing products and the development of products that will support (1) further integration of NetWare and UNIX environments and the establishment of UnixWare as an industry-leading UNIX platform; (2) network management services; (3) global naming services; (4) international networking standards; (5) integrated peer services in NetWare clients; (6) integration of current and future desktop operating systems into the overall networking environment; (7) host-based versions of NetWare, such as NetWare for UNIX and NetWare for OS/2; (8) processor independent versions of NetWare; (9) additional network services; (10) technologies for distributed applications development and operation; (11) AppWare ALMs for a broad range of Novell and UNIX services; and (12) multiplatform and multivendor APIs for major network services. During fiscal 1993, 1992, and 1991, product development expenses were approximately $164.9 million, $120.8 million, and $77.9 million, respectively. The Company's product development effort consists primarily of work performed by employees; however, the Company also utilizes third-party technology partners to assist with product development. SALES AND MARKETING Novell markets its NetWare family of network products and the UnixWare operating system through distributors, dealers, vertical market resellers, systems integrators, and OEMs who meet the Company's criteria, as well as to major end users. In addition, the Company provides technical support, training, and field service to its customers from its field offices and corporate headquarters. The Company also conducts sales and marketing activities from its offices in Cupertino, Monterey, San Jose, and Sunnyvale, California; Summit, New Jersey; Austin, Texas; Provo and Sandy, Utah; and from its 33 U.S. domestic and 31 foreign field offices. Distributors. Novell has established a network of independent distributors, which resell the Company's products to dealers, smaller VARs, and computer retail outlets. As of December 31, 1993, there were approximately 21 domestic distributors and approximately 113 foreign distributors. Dealers. The Company also markets its products to large-volume dealers and regional and national computer retail chains. VARs and Systems Integrators. Novell also sells directly to value added resellers and systems integrators who market data processing systems to vertical markets, and whose volume of purchases warrants buying directly from the Company. OEMs. The Company licenses its network software to domestic and international OEMs for integration with their products. With the acquisitions of USL and DRI, the number of OEM agreements the Company has increased significantly as USL and DRI have marketed their products quite extensively through OEMs, both domestically and internationally. End Users. Generally, the Company refers prospective end-user customers to its resellers. However, the Company has the internal resources to work directly with major end users and has developed master license agreements with approximately 150 of them to date. Additionally, some upgrade products are sold directly to end users. Export Sales. In fiscal 1993, 1992, and 1991, approximately 48%, 47%, and 44%, respectively, of the Company's net sales were to customers outside the U.S.--primarily distributors. (See Note L of Notes to Consolidated Financial Statements.) To date, substantially all international sales except Japanese sales have been invoiced by the Company in U.S. dollars, and in fiscal 1994 the Company anticipates that substantially all foreign revenues except Japanese sales, will continue to be invoiced in U.S. dollars. Except for Germany, which accounted for 11% of revenue in fiscal 1993, 13% of revenue in fiscal 1992 and 10% of revenue in fiscal 1991, no one foreign country accounted for more than 10% of net sales in any period. Except for one multi-national distributor which accounted for 12% of revenue in fiscal 1993, no customer accounted for more than 10% of revenue in any period. Marketing. The Company's marketing activities include distribution of sales literature and press releases, advertising, periodic product announcements, support of NetWare user groups, publication of technical and other articles in the trade press, and participation in industry seminars, conferences, and trade shows. The marketing departments of the Company employ many technical laboratories of networked computer equipment and individual device testing and evaluation. The knowledge derived from these laboratories is the basis for the technical publications published by the Company. These activities are designed to educate the market about local area networks in general, as well as to promote the Company's products. Through the Professional Developers Program, the Company strongly supports independent software and hardware vendors in developing products that work on NetWare networks. Thousands of multiuser application software packages are now compatible with the NetWare operating system. In March 1993, the ninth annual BrainShare Conference (formerly Developers' Conference) was held to inform and educate developers about NetWare product strategy, NetWare open architecture programming interfaces, and NetWare third-party product certification programs. SERVICE, SUPPORT, AND EDUCATION The purpose of any service program is to help users get the most out of the products they buy. Novell offers a variety of support alternatives and encourages users to select the services that meet their own needs. These include the worldwide service and support organization, the Technical Support Alliance, the CNE program, NAECs, IMSP and the ClientServer NLM Testing Program. MANUFACTURING SUPPLIERS The Company's products, which consist primarily of software diskettes and manuals, are duplicated by outside vendors. This allows the Company to minimize the need for expensive capital equipment in an industry in which multiple high-volume manufacturers are available. BACKLOG Lead times for the Company's products are typically short. Consequently, the Company does not believe that backlog is a reliable indicator of future sales or earnings. The absence of significant backlog may contribute to unpredictability in the Company's net income and to fluctuations in the Company's stock price. See "Factors Affecting Earnings and Stock Price." The Company's backlog of orders at January 21, 1994, was approximately $35.3 million, compared with $35.7 million at January 22, 1993. COMPETITION Novell competes in the highly competitive market for computer software, including in particular, network operating systems, desktop operating systems and related systems software. In the market for network operating systems, Novell believes that the principal competitive factors are hardware independence and compatibility, availability of application software, marketing strength in desktop operating systems, system/performance, customer service and support, reliability, ease of use, price/performance, and connectivity with minicomputer and mainframe hosts. The market for operating systems software, including network operating systems and client operating systems, has become increasingly problematic due to Microsoft's growing dominance in all sectors of the software business. The Company does not have the product breadth and market power of Microsoft. Microsoft's dominant position provides it with enormous competitive advantages, including the ability to unilaterally determine the direction of future operating systems and to leverage its strength in one or more product areas to achieve a dominant position in new markets. This position may enable Microsoft to increase its dominance even if the Company succeeds in continuing to introduce products with superior performance and features to those offered by Microsoft. Microsoft's ability to offer networking functionality in future versions of MS Windows and Windows NT, or to provide incentives to customers to purchase certain products in order to obtain favorable sales terms or necessary compatibility or information with respect to other products, may significantly inhibit the Company's ability to maintain its business. Moreover, Microsoft's ability to offer products on a bundled basis can be expected to impair the Company's competitive position with respect to particular products. Novell may be unable to maintain compatibility with Microsoft's key products, although Novell will continue to seek to do so. The Company has not succeeded in establishing significant sales from DR DOS following its acquisition of Digital Research Inc. in October 1991. The Company believes that it will continue to be at a substantial competitive disadvantage in selling its client operating systems due in part to Microsoft's dominance and certain of Microsoft's pricing and licensing practices. Such competitive position and practices may prevent the Company from successfully offering products to a broad variety of customers or from maintaining demand for these products. There can be no assurance that the Company will be successful in competing against Microsoft in any market or market segment in the future. The application software development tools market in which Novell now operates is also highly competitive. There can be no assurance that Novell will be successful in competing in this market or any other market in the future. LICENSES, PATENTS AND TRADEMARKS The Company currently relies on copyright, patent, trade secret and trademark law, as well as provisions in its license, distribution and other agreements in order to protect its intellectual property rights. The Company currently holds six United States patents and has numerous United States patents pending. Additionally, the Company has a number of patents pending in foreign jurisdictions. No assurance can be given that such patents pending will be issued or, if issued, will provide protection for the Company's competitive position. Although the company intends to protect its patent rights vigorously, there can be no assurance that these measures will be successful. Additionally, no assurance can be given that the claims on any patents held by the Company will be sufficiently broad to protect the Company's technology. In addition, no assurance can be given that any patents issued to the Company will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide competitive advantages to the Company. The loss of patent protection on the Company's technology or the circumvention of its patent protection by competitors could have a material adverse effect on the Company's ability to compete successfully in its products business. The software industry is characterized by frequent litigation regarding copyright, patent and other intellectual property rights. There can be no assurance that third parties will not assert claims against the Company with respect to existing or future products or that licenses will be available on reasonable terms, or at all, with respect to any third party technology. In the event of litigation to determine the validity of any third party claims, such litigation could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation is determined in favor of the Company. In the event of an adverse result in any such litigation, the Company could be required to expend significant resources to develop non-infringing technology or to obtain licenses to the technology which is the subject of the litigation. There can be no assurance that the Company would be successful in such development or that any such licenses would be available. In addition, the laws of certain countries in which the Company's products are or may be developed, manufactured or sold may not protect the Company's products and intellectual property rights to the same extent as the laws of the United States. EMPLOYEES As of December 31, 1993, the Company had 4,335 employees. The functional distribution of its employees was: sales and marketing -- 939; product development and marketing-1,817; general and administrative -- 487; service, support and education -- 807; operations -- 146; and joint ventures -- 139. Of these, 349 employees are located in U.S. field offices, and 755 employees are in offices outside the U.S. All other Company personnel are based at the Company's facilities in Utah, California, Colorado, Massachusetts, New Jersey, or Texas. None of the employees is represented by a labor union, and the Company considers its employee relations to be excellent. Competition for qualified personnel in the computer industry is intense. To make a long-term relationship with the Company rewarding, Novell endeavors to give its employees and consultants challenging work, educational opportunities, competitive wages, and, through sales commission plans, bonuses, and stock option and purchase plans, opportunities to participate financially in the Company. FACTORS AFFECTING EARNINGS AND STOCK PRICE In addition to factors described above under "Competition" which may adversely affect the Company's earnings and stock price, other factors may also adversely affect the Company's earnings and stock price. The successful combination of companies in the high technology industry may be more difficult to accomplish than in other industries. There can be no assurance that Novell will be successful in integrating acquired businesses into its own, that it will retain their key technical and management personnel or that Novell will realize any of the other anticipated benefits of the acquisitions. The computer software industry has experienced delays in its product development and "debugging" efforts, and the Company could experience such delays in the future. Significant delays in developing, completing or shipping new or enhanced products would adversely affect the Company. Furthermore, it can be expected that as products become more complex, development cycles will become longer and more expensive. There can be no assurance that Novell will be able to respond effectively to technological changes or new product announcements by others, or the Novell's research and development efforts will be successful. The Company's industry is characterized by rapid technological change, resulting in continuing pressure for price/performance improvements in response to advances in computer software and hardware technology. The Company believes that its future success will depend on its ability to continue to enhance its current products and to develop and introduce new products that maintain its technological leadership and achieve market acceptance. In particular, the Company has recently introduced the NetWare 4 operating system, a new version of the NetWare operating system which provides increased functionality as compared to prior releases of the NetWare product, including the ability to support a substantial increase in the number of clients connected on a single network. As with the introduction of any major new product or upgrade, the introduction of the product may cause a deferral in orders or reduction in demand for prior versions of the NetWare operating system, as customers and value-added resellers evaluate the functionality of the new product. Moreover, because the new product addresses new market segments and is offered at a higher price than prior NetWare product releases, the Company is unable to predict the level of demand for the NetWare 4 operating system which will actually occur. Should orders and sales for either the NetWare 4 operating system or prior versions of the NetWare product fall short of the Company's objectives, the Company could experience excess inventories and unexpected costs. As a result, the Company's future sales and earnings may be subject to substantial fluctuations, particularly in the near term. The introduction of new products also involves material marketing risks due to the possibility of errors or shortfalls in product performance. Should any new product experience a high rate of bugs or performance difficulties, the Company could experience product returns, unexpected warranty expenses and lower than expected sales. No assurance can be given as to the Company's financial results during such periods. The Company's future earnings and stock price could be subject to significant volatility, particularly on a quarterly basis. The Company's revenues and earnings may be unpredictable due to the Company's shipment patterns. As is typical in the software industry, a high percentage of Novell's revenues are earned in the third month of each fiscal quarter and tend to be concentrated in the latter half of that month. Accordingly, quarterly financial results are difficult to predict and quarterly financial results may fall short of anticipated levels. Because the Company's backlog early in a quarter is not generally large enough to assure that it will meet its revenue targets for any particular quarter, quarterly results may be difficult to predict until the end of the quarter. A shortfall in shipments at the end of any particular quarter may cause the results of that quarter to fall significantly short of anticipated levels. Due to analysts' expectations of continued growth and the high price/earnings ratio at which the Company's common stock trades, any such shortfall in earnings could have an immediate and very significant adverse effect on the trading price of the Company's common stock in any given period. As a result of the foregoing factors and other factors that may arise in the future, the market price of the Company's common stock may be subject to significant fluctuations over a short period of time. These fluctuations may be due to factors specific to the Company, to changes in analysts' earnings estimates, or to factors affecting the computer industry or the securities markets in general. ITEM 1A. ITEM 1A. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below are the names, ages, titles with Novell, and present and past positions of the persons currently serving as executive officers of Novell. Raymond J. Noorda, a founder of the Company, has been President, Chief Executive Officer, and a director of the Company since March 1983, and Chairman of the Board since January 1986. Mary M. Burnside joined the Company in January 1988 as Materials Manager. In November 1988, she was promoted to Vice President, Operations. In January 1989 she became Senior Vice President, Operations and was elected a corporate officer. In November 1991 she became Executive Vice President, Corporate Services Group. In August 1993 she joined the Office of the President as Chief Operating Officer. James R. Tolonen became a Senior Vice President and Chief Financial Officer of Novell in August 1989 and was elected a corporate officer. In August 1993 he joined the Office of the President as Chief Financial Officer. He served as Vice President, Finance, Chief Financial Officer, and Treasurer of Excelan since 1983. A Certified Public Accountant, he also served as Excelan's acting President from April through August 1985. John W. Edwards joined the Company in August 1988 as a Senior Marketing Manager. In November 1989 he became a Product Line Manager and in April 1991 he became a Director of Product Marketing. In November 1991 he was promoted to Director of Marketing and in February 1992 he became Vice President, Marketing. In April 1992 he became Executive Vice President, Desktop Systems Group and was elected a corporate officer. In August 1993 he became Executive Vice President, AppWare Systems Group. Michael J. DeFazio joined the Company as Vice President, UNIX Systems Group, when it acquired USL in June 1993. In January 1994 he became Executive Vice President, UNIX Systems Group and was elected a corporate officer. Previous to the acquisition, he was USL's Executive Vice President, UNIX System V Software. Prior to the formation of USL in 1989 he was with AT&T, responsible for business planning, product management, marketing and licensing for UNIX System V and associated system software. Richard W. King joined the Company in 1985 as Manager of Software Development and was promoted to Vice President, Software Development in April 1986. In September 1987 he became Vice President, NetWare Products Division and in September 1991 he became Vice President, Service and Support. Then in August 1993 he was promoted to Executive Vice President, NetWare Systems Group and was elected a corporate officer. Darrell L. Miller joined the Company in November 1987 as Vice President of Corporate Marketing. In June 1988 he became Vice President and General Manager of the Communications Products Division. In March 1989, he was promoted to Executive Vice President, Software Group and was elected a corporate officer. In March 1990, he became Executive Vice President, Strategic Relations. In November 1993, he resigned from the Company. Kanwal S. Rekhi has been an Executive Vice President from June 1989 to the present, and is currently Executive Vice President, Corporate Technology and a director of the Company. Mr. Rekhi, a founder and executive officer of Excelan, Inc., a company acquired by Novell in June 1989, served as Excelan's President and Chief Executive Officer from 1988 to June 1989 and as Executive Vice President of Business Development from 1986 to 1988. Mr. Rekhi was also Secretary of Excelan from 1982 to 1988 and a member of its Board of Directors from 1986 to June 1989. David R. Bradford joined the Company in October 1985 as Corporate Counsel. He became Corporate Secretary in January 1986, Senior Corporate Counsel in April 1986, and Senior Vice President, General Counsel, and Corporate Secretary in April 1989. Robert W. Davis joined the Company when it acquired Excelan in June 1989 where he had held various marketing positions since 1986. In November 1992 he became Vice President, Connectivity Products and then in August 1993 he became Vice President Marketing, UNIX Systems Group. In January 1994 he became Senior Vice President, Corporate Marketing and was elected a corporate officer. Ernest J. Harris joined the Company when it acquired Excelan in June 1989 as Vice President, Human Resources. He had served in the same capacity at Excelan since 1984. In May 1990 he became Senior Vice President, Human Resources and in January 1994 was elected a corporate officer. Joseph A. Marengi joined the Company when it acquired Excelan in June 1989 where he had been National Sales Manager since January 1989. He served in various sales positions with the Company until October 1992 when he became Senior Vice President, Worldwide Sales. In August 1993 he was elected a corporate officer. Jan E. Newman joined the Company in June 1986 as a Programmer. In July 1988 he became Manager of Documentation and Testing, followed by a promotion to Director of Software Services in November 1988. In March 1991 he became Vice President, Support and Services and was made Vice President, NetWare Products in November 1991. In April 1992 he became Executive Vice President, NetWare Systems Group and was elected as a corporate officer. In August 1993 he became Senior Vice President, Service and Support and Novell Labs. Stephen C. Wise became Vice President, Accounting and Planning in January 1990 and was elected a corporate officer. In January 1991, he became Vice President and Corporate Controller. In December 1993 he became Senior Vice President, Finance. He had served previously as Corporate Controller and Assistant Treasurer of Excelan since July 1984. Darcy G. Mott, a Certified Public Accountant, joined the Company in September 1986 as Manager, Financial Reporting and Taxes. He became Corporate Controller in February 1989, was elected an officer in November 1989, and became Treasurer in January 1991. ITEM 2. ITEM 2. PROPERTIES The Company owns and occupies a 542,000 square-foot office complex in Provo, Utah, which is used as corporate headquarters and a product development center. In March 1993, the Company purchased a 52,000 square foot building in San Jose, California, which it had previously leased. It is used primarily for product development. The Company also owns a 175,000 square-foot office complex in Austin, Texas. Approximately 80,000 square-feet of this complex is used as a product development center and the remainder is leased to tenants. Additionally, the Company owns a 100,000 square-foot office building in Herndon, Virginia. The Company occupies approximately 1/2 of the space in this building and leases the remainder to tenants. Additionally, the Company owns approximately 48 acres of undeveloped land in San Jose, California and an additional 17 acres of undeveloped land in Provo, Utah, for future expansion. The Company has subsidiaries in Australia, Belgium, Brazil, Canada, France, Germany, India, Italy, Japan, Korea, Mexico, South Africa, Spain, Sweden, Switzerland, and the United Kingdom--each of which leases its facilities. The Company leases offices for product development in Cupertino, Monterey, San Jose, Sunnyvale, and Walnut Creek, California; Boulder, Colorado; Natick, Massachusetts; Summit, New Jersey; Salt Lake City and Sandy, Utah; Toronto, Canada; and Hungerford, U.K.; and a distribution facility in San Jose, California. The Company also leases sales and support offices in Arizona, California (6), Colorado, Connecticut, Florida (2), Georgia, Illinois, Massachusetts (2), Michigan, Minnesota, Missouri, New Jersey, New York (2), North Carolina, Ohio (2), Oregon, Pennsylvania (2), Tennessee, Texas (3), Utah, Washington, Hong Kong, Singapore and Taiwan. The terms of such leases vary from month to month to up to ten years. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On November 10, 1993, a suit was filed against Novell and certain of its officers and directors alleging violation of federal securities laws. The lawsuit was brought as a purported class action on behalf of purchasers of Novell common stock from June 23, 1993 through July 26, 1993. Although the case is in its earliest stages, Novell does not believe that the resolution of this legal matter will have a material adverse effect on its financial position or results of operations. In December of 1991, Roger Billings and his International Academy of Science, (the "Academy") filed suit against Novell alleging that the Company infringes on a patent allegedly owned by the Academy. The case is still in its pretrial phase. The Company believes that the ultimate resolution of this legal proceeding will not have a material adverse effect on its financial position or results of operations. The Company is a party to a number of additional legal proceedings arising in the ordinary course of its business. The Company believes the ultimate resolution of these claims will not have a material adverse effect on its financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information required by Item 5 of Form 10-K is incorporated herein by reference to the information contained in the section captioned "Novell, Inc. Common Stock" on page 38 of the Company's Annual Report to Shareholders for the fiscal year ended October 30, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 of Form 10-K is incorporated herein by reference to the information contained in the section captioned "Selected Consolidated Financial Data" on page 20 of the Company's Annual Report to Shareholders for the fiscal year ended October 30, 1993. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by Item 7 of Form 10-K is incorporated herein by reference to the information contained in the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 21 through 24 of the Company's Annual Report to Shareholders for the fiscal year ended October 30, 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 of Form 10-K is incorporated herein by reference to the Company's consolidated financial statements and related notes thereto, together with the report of the independent auditors presented on pages 25 through 36 of the Company's Annual Report to Shareholders for the fiscal year ended October 30, 1993, and to the information contained in the section captioned "Selected Consolidated Quarterly Financial Data" on page 37 of the Company's Annual Report to Shareholders for the fiscal year ended October 30, 1993. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information required with respect to identification of directors is incorporated herein by reference to the information contained in the section captioned "Election of Directors" of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held March 9, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities and Exchange Act of 1934, as amended. Information regarding executive officers of Novell is set forth under the caption "Executive Officers" in Item 1a hereof. Each director and each officer of the Company who is subject to Section 16 of the Securities Exchange Act of 1934 (the "Act") is required by Section 16(a) of the Act to report to the Securities and Exchange Commission by a specified date his or her transactions in the Company's securities. During the period from November 1, 1992 to fiscal 1993 year end, Director Elaine R. Bond filed her Form 3 upon joining the Board of Directors in a timely manner but inadvertently omitted a derivative security that she beneficially owned. She subsequently amended such Form 3 to reflect such ownership, which amendment was filed late. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 of Form 10-K is incorporated by reference to the information contained in the sections captioned "Executive Compensation" of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held March 9, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 of Form 10-K is incorporated by reference to the information contained in the section captioned "Securities Ownership of Certain Beneficial Owners and Management" of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held March 9, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 of Form 10-K is incorporated by reference to the information contained in the section captioned "Compensation Committee Interlocks and Insider Participation" of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held on March 9, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Act of 1934, as amended. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this annual report on Form 10-K for Novell, Inc.: 1. The Consolidated Financial Statements, the Notes to Consolidated Financial Statements and the Report of Ernst & Young, Independent Auditors, listed below are incorporated herein by reference to pages 25 through 36 of the Company's Annual Report to Shareholders for the fiscal year ended October 30, 1993. Consolidated Statements of Operations for the fiscal years ended October 30, 1993, October 31, 1992, and October 26, 1991. Consolidated Balance Sheets at October 30, 1993 and October 31, 1992. Consolidated Statements of Shareholders' Equity for the fiscal years ended October 30, 1993, October 31, 1992, and October 26, 1991. Consolidated Statements of Cash Flows for the fiscal years ended October 30, 1993, October 31, 1992, and October 26, 1991. Notes to Consolidated Financial Statements. Report of Ernst & Young, Independent Auditors. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Registrant during the quarter ended October 30, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. NOVELL, INC. (Registrant) Date: January 24, 1994 By /s/ RAYMOND J. NOORDA (Raymond J. Noorda, Chairman of the Board, President and Chief Executive Officer) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. NOVELL, INC. SCHEDULE I -- MARKETABLE SECURITIES - ------------ (1) The portfolio includes tax exempt municipal bonds with put features and interest rates that are reset periodically as specified with no fluctuation. It also includes tax exempt commercial paper, and tax exempt auction rate instruments. NOVELL, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS - ------------ (1) Write-off of uncollectible accounts NOVELL, INC. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION EXHIBIT INDEX - ---------- (1) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-1, filed November 30, 1984, and amendments thereto (File No. 2-94613). (2) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Annual Report on Form 10-K, filed for the fiscal year ended October 25, 1986 (File No. 0-13351). (3) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Current Report on Form 8-K, dated December 7, 1988 (File No. 0-13351). (4) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Annual Report on Form 10-K, filed for the fiscal year ended October 29, 1988 (File No. 0-13351). (5) Incorporated by reference to the Appendix identified in parentheses, filed as an appendix in the Registrant's Registration Statement on Form S-4, filed May 9, 1989 (File No. 33-28470). (6) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-8, filed on July 27, 1989 (File No. 33-29798). (7) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-8, filed September 28, 1989 (File No. 33-31299). (8) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-8, filed on September 4, 1990 (File No. 33-36673). (9) Incorporated by reference to the Appendix identified in parentheses, filed as an appendix in the Registrant's Registration Statement on Form S-4, filed September 24, 1991 (File No. 33-42254). (10) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-8, filed June 5, 1992 (File No. 33-48395). (11) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement of Form S-4, filed May 13, 1993 (File No. 33-60120). (12) Incorporated by reference to the Exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-8, filed July 2, 1993 (File No. 33-65440). (13) Filed herewith.

65622_1993.txt

65622_1993

1993

65622

Item 1. Business General Michigan Bell Telephone Company (the "Company") is incorporated under the laws of the State of Michigan and has its principal office at 444 Michigan Avenue, Detroit, Michigan 48226 (telephone number 313-223-9900). The Company is a wholly owned subsidiary of Ameritech Corporation ("Ameritech"), a Delaware corporation. Ameritech is the parent of the Company, Illinois Bell Telephone Company, Indiana Bell Telephone Company, Incorporated, The Ohio Bell Telephone Company and Wisconsin Bell, Inc. (the "landline telephone companies"), as well as several other communications businesses, and has its principal executive offices at 30 South Wacker Drive, Chicago, Illinois 60606 (telephone number 312-750-5000). The Company is managed by its sole shareholder rather than a Board of Directors, as permitted by Michigan law. In 1993, Ameritech restructured its landline telephone companies and two other related businesses into a structure of customer-specific business units supported by a single, regionally coordinated network unit. The five Bell companies continue to function as legal entities, owning Bell company assets in each state and continue to be regulated by the individual state public utility commissions. Products and services are now marketed under a single common brand identity, "Ameritech", rather than using the "Bell" name. While the Ameritech logo is now used to identify all the Ameritech companies, the Company is sometimes regionally identified as Ameritech Michigan. The Company is engaged in the business of furnishing a wide variety of advanced telecommunications services in Michigan, including local exchange and toll service and network access services. In accordance with the Consent Decree and resulting Plan of Reorganization ("Plan") described below, the Company provides two basic types of telecommunications services within specified geographical areas termed Local Access and Transport Areas ("LATAs"), which are generally centered on a city or other identifiable community of interest. The first of these services is the transporting of telecommunications traffic between telephones and other equipment on customers' premises located within the same LATA ("intraLATA service"), which can include toll service as well as local service. The second service is providing exchange access service, which links a customer's telephone or other equipment to the network of transmission facilities of interexchange carriers which provide telecommunications service between LATAs ("interLATA service"). About 82% of the population and 42% of the area of Michigan is served by the Company. The remainder of the State is served by other telecommunications companies. The Company does not furnish local service in the areas and localities served by such companies. Muskegon is the only city of over 50,000 population in the State in which local service is furnished by a non-affiliated telephone company. The Company estimates that on December 31, 1993, non-affiliated telephone companies had approximately 794,000 customer lines in service. Other communications services offered by the Company include data transmission, transmission of radio and television programs and private line voice and data services. The following table sets forth for the Company the number of customer lines in service at the end of each year. Thousands 1993 1992 1991 1990 1989 Customer Lines in Service 4,563 4,431 4,314 4,242 4,150 XXX BEGIN PAGE 5 HERE XXX The Company has certain agreements with Ameritech Publishing, Inc. ("Ameritech Publishing"), an Ameritech business unit doing business as "Ameritech Advertising Services", under which Ameritech Publishing publishes and distributes classified directories under a license from the Company and provides services to the Company relating to both classified and alphabetical directories. Ameritech Publishing pays license fees to the Company under the agreements. See the discussion in Part II, Item 7., on page 20 for further information on the status of the agreements. Ameritech Services, Inc. ("ASI") is a company jointly owned by the Company and the other Ameritech landline telephone companies. ASI provides to those companies human resources, technical, marketing, regulatory planning and real estate asset management services, purchasing and material management support, as well as labor contract bargaining oversight and coordination. ASI acts as a shared resource for the Ameritech subsidiaries providing operational support for the landline telephone companies and integrated communications and information systems for all the business units. Ameritech Information Systems, Inc., a subsidiary of Ameritech, sells, installs and maintains business customer premises equipment and sells network and central office-based services provided by the Company and the other four landline telephone companies. It also provides expanded marketing, product support and technical design resources to large business customers in the Ameritech region. In 1993, about 90% of the total operating revenues of the Company were from telecommunications services and the remainder principally from billing and collection services, rents, directory advertising and other miscellaneous nonregulated operations. About 77% of the revenues from telecommunication services were attributable to intrastate operations. Capital Expenditures Capital expenditures represent the single largest use of Company funds. The Company has been making and expects to continue to make large capital expenditures to meet the demand for telecommunications services and to further improve such services. The total investment in telecommunications plant increased from about $6,789,500,000 at December 31, 1988, to about $7,559,000,000 at December 31, 1993, after giving effect to retirements but before deducting accumulated depreciation at either date. Capital expenditures of the Company since January 1, 1989 were approximately as follows: 1989. . . . . . . $502,000,000 1992. . . . . . . $523,000,000 1990. . . . . . . $530,000,000 1993. . . . . . . $452,000,000 1991. . . . . . . $542,000,000 Expanding on the aggressive deployment plan it began it 1992, in January 1994, Ameritech unveiled a multi-billion dollar plan for a digital network to deliver video services. Ameritech is launching a digital video network upgrade that by the end of the decade will enable six million customers in its region to access interactive information and entertainment services, as well as traditional cable TV services, from their homes, schools, offices, libraries and hospitals. The Company, for its part in the network upgrade has made an initial filing with the FCC seeking approval of the program. The filing reflects capital expenditures of approximately $55 million over the next three years. The video network concept, along with other competitive concerns, is discussed on page 20. The Company may also, depending on market demand, make additional capital expenditures under the digital video network upgrade program. In addition to the video network upgrade expenditures, other capital expenditures are expected to be about $348 million in 1994. These are part of a $2 billion, four-year program that Ameritech began in 1992 to incur construction-related costs to expand and improve Michigan's telecommunications infrastructure with technologies such as fiber optics and digital switching. Through December 31, 1993, Ameritech has spent over $1 billion in Michigan toward that program. XXX BEGIN PAGE 5 HERE XXX Consent Decree and Line of Business Restrictions On August 24, 1982, the United States District Court for the District of Columbia ("Court") approved and entered a consent decree entitled "Modification of Final Judgment" ("Consent Decree"), which arose out of antitrust litigation brought by the Department of Justice ("DOJ"), and which required American Telephone and Telegraph Company ("AT&T") to divest itself of ownership of those portions of its wholly owned Bell operating communications company subsidiaries ("Bell Companies") that related to exchange telecommunications, exchange access and printed directory advertising, as well as AT&T's cellular mobile communications business. On August 5, 1983, the Court approved a Plan of Reorganization ("Plan") outlining the method by which AT&T would comply with the Consent Decree. Pursuant to the Consent Decree and the Plan, effective January 1, 1984, AT&T divested itself of, by transferring to Ameritech, one of the seven regional holding companies ("RHCs") resulting from divestiture, its ownership of the exchange telecommunications, exchange access and printed directory advertising portions of the Ameritech landline telephone companies, as well as its regional cellular mobile communications business. The Consent Decree, as originally approved by the Court in 1982, provided that the Company (as well as the other Bell Companies) could not, directly or through an affiliated enterprise, provide interLATA telecommunications services or information services, manufacture or provide telecommunications products or provide any product or service, except exchange telecommunications and exchange access service, that is not a natural monopoly service actually regulated by tariff. The Consent Decree allowed the Company and the other Bell Companies to provide printed directory advertising and to provide, but not manufacture, customer premise equipment. The Consent Decree provided that the Court could grant a waiver to a Bell Company or its affiliates upon a showing to the Court that there is no substantial possibility that the Bell Company could use its monopoly power to impede competition in the market it seeks to enter. The Court has, from time to time, granted waivers to the Company and other Bell Companies to engage in various activities. The Court's order approving the Consent Decree provided for periodic reviews of the restrictions imposed by it. Following the first triennial review, in decisions handed down in September 1987 and March 1988, the Court continued the prohibitions against Bell Company manufacturing of telecommunications products and provision of interLATA services. The rulings allowed limited provision of information services by transmission of information and provision of information gateways, but excluded generation or manipulation of information content. In addition, the rulings eliminated the need for a waiver for entry into non-telephone related businesses. In April 1990, a Federal appeals court decision affirmed the Court's decision continuing the restriction on Bell Company entry into interLATA services and the manufacture of telecommunications equipment, but directed the Court to review its ruling that restricted RHC involvement in the information services business and to determine whether removal of the information services restriction would be in the public interest. In July 1991, the Court lifted the information services ban but stayed the effect of the decision pending outcome of the appeals process. Soon after, the stay was lifted on appeal and in July 1993, the U.S. Court of Appeals unanimously upheld the Court's order allowing the Bell Companies to produce and package information for sale across business and home phone lines. In November 1993, the U.S. Supreme Court declined to review the lower court ruling. Members of Congress and the White House are intensifying efforts to enact legislative reform of telecommunications policy in order to stimulate the development of a modern national information infrastructure to bring the benefits of advanced communications and information services to the American people. XXX BEGIN PAGE 7 HERE XXX Intrastate Rates and Regulation Prior to January 1, 1992, most of the intrastate communications services provided by the Company were subject to regulation by the Michigan Public Service Commission ("MPSC") with respect to intrastate rates and services. The MPSC prescribed a uniform system of accounts that largely parallels the one promulgated by the Federal Communications Commission and prescribed depreciation rates for the intrastate portion of the Company's assets. Effective January 1, 1992, the authority of the MPSC over many of the Company's services and asset depreciation parameters has been removed or narrowed by the new Michigan Telecommunications Act of 1991 ("MTA"), Public Act 179. Under MTA, the MPSC retains administrative responsibility for the Act and has duties such as establishing quality of service standards and investigating complaints. Effective January 1, 1992, for a four-year period, MTA replaced the 1913 Michigan Telephone Act and 1986 Public Act 305 which were scheduled to sunset December 31, 1991. A major goal of MTA was to encourage the development of a modern, high-quality telecommunications infrastructure that would allow the state to be competitive in a national and international information economy. MTA encourages the Company to commit significant investment in advanced technology by allowing new flexibility in developing and pricing telecommunications services. New services may be introduced without MPSC approval; however, the MPSC has the authority to regulate such services in the future if they are found to be adverse to the public interest. Prices of certain services such as intraLATA toll may be reduced without prior MPSC approval. MTA also allows the Company to seek a waiver from federal restrictions to provide two-way interactive video across LATA boundaries for educational services and also allows the Company to offer cable television services if permitted by federal law. The Act established a 400-call allowance for residential flat- rate local service. Calls above the 400 allowance are billed on a per- call basis, which was later approved at 6.2 cents per call. Unlimited residence flat-rate local calling is provided to persons age 60 and older, handicapped individuals and persons volunteering services to certain charitable and veterans organizations. MTA froze residential monthly basic local exchange rates for two years at rates in effect at the end of 1991. It also caps intraLATA long-distance rates for the four-year life of the Act at those in effect at the end of 1991, unless carrier access charges are increased during that period. However, the Act institutes a streamlined system for changes to basic rates, depending on the size of the change. Rate changes which do not exceed 1% less than the change in the consumer price index ("CPI") may be put in place after 90 days' notice unless the MPSC takes further action, but proposed rate changes greater than 1% less than the CPI change require MPSC approval. As a direct response to the new pricing flexibility afforded by MTA, the Company immediately reduced intraLATA message toll rates by $20 million effective January 1, 1992, with an additional reduction of over $20 million implemented on December 15, 1992. In addition, the Company made progress in reducing pricing anomalies that had resulted from the fully regulated pricing structure which had evolved over the decades before competition was introduced. Where prices did increase, primarily in discretionary services such as operator handled call surcharges and certain nonregulated services, they were to recognize increased costs and to price these services more in line with the marketplace. In the more flexible regulatory environment created by MTA, the Company introduced new products and services made possible by new technologies. Caller ID, ScanFone, and Voice Mail were three information services that became available during 1992. Caller ID helps customers identify a calling party before they answer by displaying the telephone number from which the call is made. ScanFone services uses specialized telephone equipment to pay bills and shop electronically, and Voice Mail provides electronic answering service. XXX BEGIN PAGE 8 HERE XXX Two new calling plans were introduced effective February 1, 1992. Circle Calling 20 allows seven hours of calling within a 20- mile radius of a residential customer for a charge of $20 a month. Circle Calling 30 provides a 30 percent discount on long-distance charges within a 30-mile radius and includes 30 minutes of toll calling for a fee of $3 per month. Overall, the reductions and discount plans will amount to a cut of more than 12 percent in prices residence and business customers pay for long-distance calls within LATAs. In addition, the Company introduced other new services such as Information Call Completion in which the Company will complete the call to a number supplied by an information operator for a nominal fee. Halfway through the four year life of MTA, the Company believes the record shows that the Act has been an unqualified success. MTA has been nationally recognized as progressive, forward looking legislation that has served as a model for change in other jurisdictions. MTA is scheduled to sunset on December 31, 1995. On February 16, 1993, the Company filed an application with the MPSC for approval to increase the local message charge for calls from public and semi-public coin telephones from 20 cents to 25 cents per call. The 20-cent rate has been in effect since 1976. The Company estimated the annual revenue impact of the proposal to be an increase of approximately $5.6 million after a 90-day period required to convert all coin phones to the new rate. Also on February 16, 1993, the Company filed a separate application to change the way it charges for directory assistance service. The Company proposed that changes would be implemented in three phases over a twelve-month period. In the first phase, the monthly allowance of free calls would be reduced from twenty to eight and the charge for calls over the allowance will increase from 22 cents to 35 cents per call. In the second phase, six months after MPSC approval, the calling allowance would be reduced to five calls per month, and in the final phase, six months later, the calling allowance would be reduced to three. On May 11, 1993, the MPSC issued orders on both of the applications discussed above. In the 25 cent coin telephone filing, the MPSC declined approval of the Company's proposal, finding that there was unsatisfactory resolution of the issues concerning the size of the local calling area for customer-owned customer operated coin phones and the charges for directory assistance calls made from those phones. The MPSC directed the Company to initiate a contested case proceeding under Section 203 of MTA. On August 6, 1993, the Company complied by resubmitting its February 16, 1993 application. Currently, the contested case is approximately halfway through the scheduled proceedings, with a proposal for decision by the administrative law judge anticipated in April 1994, and an MPSC order expected in June 1994. In the May 11, 1993 MPSC order related to directory assistance service, the MPSC approved portions of the Company's proposal but only under the condition that the effects of the changes be revenue neutral. Specifically, the MPSC approved the first phase of the Company's proposal which called for an increase of the per call charge from 22 cents to 35 cents and a reduction in the free call allowance from twenty to eight. The Company implemented this phase on July 1, 1993, after receiving approval of its revenue neutral plan which reduced rates in other areas, primarily access charges. The MPSC also approved a second phase of a directory assistance increase to begin six months after the first phase which increases the per call charge to 45 cents and reduces the free call allowance from eight to five per month. The Company is still in the process of developing its revenue neutral proposal related to this phase, but it is anticipated that rate reductions will again be made primarily in access charges to be effective in July 1994. The May 11, 1993 MPSC order rejected the Company's proposal for a third phase on directory assistance service which would have reduced the free call allowance from five to three per month. XXX BEGIN PAGE 9 HERE XXX FCC Regulatory Jurisdiction The Company is also subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to intraLATA interstate services, interstate access services and other matters. The FCC prescribes for communications companies a uniform system of accounts apportioning costs between regulated and non-regulated services, depreciation rates (for interstate services) and the principles and standard procedures ("separations procedures") used to separate property costs, revenues, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to services under the jurisdiction of the respective state regulatory authorities. For certain companies, including the Company, interstate services regulated by the FCC are covered by a price cap plan. The plan creates incentives to improve productivity over benchmark levels in order to retain higher earnings. Price cap regulation sets maximum limits on the prices that may be charged for telecommunications services but also provides for a sharing of productivity gains. Earnings in excess of 12.25% will result in prospective reduction to the price ceilings on interstate services. In January 1994, the FCC began a scheduled fourth-year comprehensive review of price cap regulation for local exchange companies. Access Charge Arrangements Interstate Access Charges. The Ameritech landline telephone companies provide access services for the origination and termination of interstate telecommunications. The access charges are of three types: common line, switched access and trunking. The common line portion of interstate revenue requirements are recovered through monthly subscriber line charges and per minute carrier common line charges. The carrier common line rates include recovery of transitional and long-term support payments for distribution to other local exchange carriers. Transitional support payments were made over a four-year period which ended on April 1, 1993. Long-term support payments will continue indefinitely. Effective January 1, 1994, rates for local transport services were restructured and a new "trunking" service category created. Trunking services consist of two types: those associated with the local transport element of switched access and those associated with special access. Trunking services associated with switched access handle the transmission of traffic between a local exchange carrier's serving wire center and a Company end office where local switching occurs. Trunking services associated with special access handle the transmission of telecommunications services between any two customer-designated premises or between a customer-designated premise and a Company end office where multiplexing occurs. High volume customers generally use the flat-rated dedicated facilities associated with special access, while usage sensitive rates apply for lower-volume customers that utilize a common switching center. Local transport rate elements for switched services assess a flat monthly rate and a mileage sensitive rate for the physical facility between the customer's point of termination and the end office, a usage sensitive and mileage sensitive rate assessed for the facilities between the end office through the access tandem to the customer's serving wire center, and a minute of use charge assessed to all local transport. The flat rate transport rates and structure generally mirror special access rate elements. Customers can order direct transport between the serving wire center or end office and the access tandem and tandem switched transport between the access tandem and the end office. Special access charges are monthly charges assessed to customers for access to interstate private line service. Charges are paid for local distribution channels, interoffice mileage and optional features and functions. XXX BEGIN PAGE 10 HERE XXX State Access Charges. Compensation arrangements required in connection with origination and termination of intrastate communications by interexchange carriers are subject to the jurisdiction of the MPSC. The Company currently provides intrastate access services to interexchange carriers pursuant to MPSC tariffs which generally parallel the terms of the interstate access tariffs. The MPSC granted authority to certain interexchange carriers to provide intrastate interLATA service and, effective January 1, 1988, intrastate intraLATA communications services in Michigan. The Company provides intraLATA access service under the same tariffs as are applicable to intrastate interLATA services. On February 24, 1994, the MPSC issued an order on intrastate intraLATA communications service. See discussion under "IntraLATA Long Distance Service Order" in Part II, Item 7., on page 19. Separate arrangements have historically governed compensation between the Company and independent telephone companies for jointly provided communications within the Company's local serving areas and associated independent telephone company exchanges. The FCC ordered, effective January 1, 1988, that Meet Point Billing be implemented. Meet Point Billing requires the local exchange carriers ("LEC's") involved to divide ordering, rating and billing services on a proportional basis, so that each carrier bills under its respective tariff. On December 21, 1989, the MPSC issued an order on access charge arrangements. The MPSC ordered that, effective January 1, 1990, all intrastate toll carriers, including the Company, purchase any necessary access services from other local exchange carriers at their access tariff rates. Competition Regulatory, legislative and judicial decisions and technological advances, as well as heightened customer interest in advanced telecommunications services, have expanded the types of available communications services and products and the number of companies offering such services. Market convergence, already a reality, is expected to intensify. The FCC has taken a series of steps that are expanding opportunities for companies to compete with local exchange carriers in providing services that fall under the FCC's jurisdiction. In September 1992, the FCC mandated that local exchange carriers provide network access for special transmission paths to competitive access providers, interexchange carriers and end users. In February 1993, Ameritech filed a tariff with the FCC, which was effective in May, making possible this type of interconnection. In August 1993, the FCC issued an order that permits competitors to interconnect to local telephone company switches. Under the new rules, certain telephone companies must allow all interested parties to terminate their switched access transmission facilities at phone company central offices, wire centers, tandem switches and certain remote nodes. Ameritech filed a tariff in November 1993 to effect that change in February 1994. Ameritech is seeking opportunities to compete on an equal footing. Although the Company is barred from providing interLATA and nation-wide cable services, its competitors are not. Cellular telephone and other wireless technologies are poised to bypass Ameritech's local access network. Cable providers, who currently serve more than eighty percent of American homes, could provide telephone service and have expressed their desire to do so. Certain interexchange carriers and competitive access providers have demonstrated interest in providing local exchange service. Ameritech's plan is to facilitate competition in the local exchange business in order to compete in the total communications marketplace. Customers First: Ameritech's Advanced Universal Access Plan In 1993, Ameritech embarked on a long-range restructuring with the intent of dramatically changing the way it serves its customers, and in the process altered its corporate framework, expanding the nature and scope of its services and supporting the development of a fully competitive marketplace. In March, Ameritech filed a plan with the FCC to change the way local telecommunications services are provided and regulated and to furnish a policy framework for advanced universal access to modern telecommunications services - voice, data and video information. XXX BEGIN PAGE 11 HERE XXX Ameritech proposes to facilitate competition in the local exchange business by allowing other service providers to purchase components of its network and to repackage them with their own services for resale, in exchange for the freedom to compete in both its existing and currently prohibited businesses. Ameritech has requested regulatory reforms to match the competitive environment as well as support of its efforts to remove restraints, such as the interLATA service restriction, which currently restrict its participation in the full telecommunications marketplace. In addition, Ameritech asks for more flexibility in pricing new and competitive services and replacement of caps on earnings with price regulation. Under the plan, customers would be able to choose from competitive providers for local service as they now can choose a provider for interexchange service. To demonstrate conclusively the substantial customer and economic benefits of full competition, in December 1993, Ameritech proposed a trial of its plan beginning in 1995. Ameritech has petitioned the DOJ to recommend Federal District Court approval of a waiver of the long-distance restriction of the Consent Decree so that Ameritech can offer interexchange service. At the same time, Ameritech would facilitate the development of local communications markets by unbundling the local network and integrating competitors' switches. The trial would begin in Illinois in the first quarter of 1995 and would last indefinitely. Other states could be added over time. If the trial is approved by the DOJ, the request must be acted on by the Court which retains jurisdiction over administering the terms of the Consent Decree. In February 1994, Ameritech filed tariffs with the Illinois Commerce Commission that propose specific rates and procedures to open the local network in that state. Approval could take up to 11 months. Ameritech has received broad support for the plan from Midwest elected officials, national and Midwest business leaders, and education, health industry, economic development and consumer leaders. The national and local offices of the Communications Workers of America ("CWA") and the International Brotherhood of Electrical Workers ("IBEW") also support the plan. Ameritech has alternative regulatory proposals pending with other state regulatory commissions in its region to support implementation of the plan. Ameritech's Video Network Concept In January 1994, Ameritech filed plans with the FCC to construct a digital video network upgrade that will enable it to reach 6 million customers by the end of the decade. Ameritech expects to spend $4.4 billion to upgrade its network to provide video services, part of a total of approximately $29 billion Ameritech estimates it will spend on network improvements over the next fifteen years. Ameritech is pursuing alliances and partnerships that will position it as a key participant in the emerging era of interactive video experiences. Pending FCC approval of Ameritech's plan and clearing of other regulatory hurdles, the construction of the first phase of the network could begin as soon as the fourth quarter of 1994. The new network, which will be separate from Ameritech's core local communications network, will be expanded by approximately 1 million additional Midwest customers in each of the next five years. Ameritech will be only one of many users of the broadband network. A multitude of competing video information providers, businesses, institutions, interexchange carriers and video telephony customers will also have access to the technology. With the new system, customers will have access to a virtually unlimited variety of programming sources. These will include basic broadcast services, similar to today's cable service, and advanced interactive services such as video on demand, home healthcare, interactive educational software, distance learning, interactive games and shopping, and a variety of other entertainment and information services that can be accessed from homes, offices, schools, hospitals, libraries and other public and private institutions. XXX BEGIN PAGE 12 HERE XXX Cable/Telco Cross-ownership Ban In November 1993, Ameritech filed lawsuits in two federal courts seeking freedom from the ban on providing video services in its own service area. Ameritech asked U.S. District Courts in Illinois and Michigan to declare unconstitutional the provisions of the Cable Act of 1984 that bar the RHCs from providing cable TV service in areas where they hold monopolies on local phone service. In August 1993, a U.S. District Court granted a request by Bell Atlantic Corporation for such an order, but that court denied similar requests by Ameritech and the other RHCs. Legislation has been introduced in Congress that would repeal the cross-ownership ban. Employee Relations As of December 31, 1993, the Company employed 14,561 persons, a decrease from 15,142 at December 31, 1992. During 1993, approximately 217 management employees left the payroll as a result of voluntary and involuntary workforce reduction programs, and 214 nonmanagement employees took advantage of a Supplemental Protection Program ("SIPP") established under labor agreements to voluntarily exit the workforce. Additional restructuring was done by normal attrition. On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995, including approximately 1,560 at the Company. Under terms of agreements between Ameritech, the CWA and the IBEW, Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW to selected nonmanagement employees who leave the business before the end of 1995. The reduction of workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. Approximately 12,021 employees are represented by the CWA which is affiliated with the AFL-CIO. In July and August 1993, the Ameritech landline telephone companies and Ameritech Services reached agreement with the CWA and the IBEW on a workforce transition plan for assigning union- represented employees to the newly established business units. The separate agreements with the two unions extend existing union contracts with the landline telephone companies and Ameritech Services to the new units. The pacts address a number of force assignment, employment security and union representation issues. In 1995, when union contracts are due to expire, the parties will negotiate regional contracts. Item 2. Item 2. Properties The properties of the Company do not lend themselves to description by character and location of principal units. At December 31, 1993, central office equipment represented 40% of the Company's investment in telecommunications plant in service; land and buildings (occupied principally by central offices) represented 9%; and connecting lines which constitute outside plant, the majority of which are on or under public roads, highways or streets and the remainder of which are on or under private property, represented 46%. Substantially all of the installations of central office equipment and administrative offices are located in buildings owned by the Company situated on land which it owns in fee. Many garages, business offices and some administrative offices are in leased premises. XXX BEGIN PAGE 13 HERE XXX Item 3. Item 3. Legal Proceedings Pre-divestiture Contingent Liabilities Agreement The Plan provides for the recognition and payment of liabilities that are attributable to pre-divestiture events (including transactions to implement the divestiture) but that do not become certain until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts, equal employment matters, environmental matters and torts (including business torts, such as alleged violations of the antitrust laws). With respect to such liabilities, AT&T and the Bell Companies, including the Company, will share the costs of any judgment or other determination of liability entered by a court or administrative agency, the costs of defending the claim (including attorneys' fees and court costs) and the cost of interest or penalties with respect to any such judgment or determination. Except to the extent that affected parties may otherwise agree, the general rule is that responsibility for such contingent liabilities will be divided among AT&T and the Bell Companies on the basis of their relative net investment (defined as total assets less reserves for depreciation) as of the effective date of divestiture. Different allocation rules apply to liabilities which relate exclusively to pre-divestiture interstate or intrastate operations. Although complete assurance cannot be given as to the outcome of any litigation, in the opinion of the Company's management any monetary liability or financial impact to which the Company would be subject after final adjudication or settlement of all such liabilities would not be material in amount to the financial position of the Company. XXX BEGIN PAGE 14 HERE XXX PART II Item 6. Item 6. Selected Financial and Operating Data MICHIGAN BELL TELEPHONE COMPANY (Dollars in Millions) 1993 1992 1991 1990 1989 Revenues Local service . . . . . $1,092.1 $1,168.6 $1,097.7 $1,093.0 $1,082.8 Interstate network access . . 512.6 479.4 474.0 496.2 453.5 Intrastate network access . . 201.5 199.9 182.0 186.4 173.8 Long distance . . . . . . . . 695.8 591.6 582.7 605.3 570.2 Other . . . . . . . . . . . 244.8 239.4 238.9 237.0 234.9 2,746.8 2,678.9 2,575.3 2,617.9 2,515.2 Operating expenses . . . . . 2,152.3 2,103.1 2,043.7 2,038.2 1,957.0 Operating income . . . . . 594.5 575.8 531.6 579.7 558.2 Interest expense . . . . . . . 106.2 109.6 125.3 116.9 117.2 Other (income) expense, net . . . 4.6 9.4 (5.0) (3.8) (3.5) Income taxes . . . . . . . . . 140.5 130.6 120.8 140.8 126.9 Income before cumulative effect of change in accounting principles . . . . . . . . . . 343.2 326.2 290.5 325.8 317.6 Cumulative effect of change in accounting principles . . . -- (448.4) -- -- -- Net income (loss) . . . . . . $ 343.2 $ (122.2) $ 290.5 $ 325.8 $ 317.6 Total assets . . . . . . . . 5,259.2 5,289.9 5,251.8 5,192.8 5,001.1 Telecommunications plant, net . 4,382.8 4,456.1 4,446.5 4,410.4 4,398.3 Capital expenditures . . . . 452.1 523.3 542.2 530.1 501.6 Long-term debt . . . . . . . $1,132.4 $1,085.1 $1,071.0 $1,202.8 $1,174.4 Debt ratio . . . . . . . . . 46.3% 46.4% 41.9% 41.3% 41.3% Pre-tax interest coverage . . 5.74 4.88 4.12 4.70 4.58 Return to average equity * . . . 19.6% (7.1)% 14.0% 16.0% 16.0% Return on average total capital * 13.2% (0.6)% 11.0% 12.2% 12.2% Customer lines at end of year (in thousands) . . . . . . . 4,563 4,431 4,314 4,242 4,150 % Customer lines served by digital electronic offices . . 68% 53% 49% 44% 39% % Customer lines served by analog electronic offices . . . . . 31% 46% 49% 52% 56% Employees at end of year . . . . 14,561 15,142 15,836 16,234 16,785 Customer lines per employee . . . 313 293 272 261 247 Local calls per year (in millions) # . . . . . 14,198 14,555 14,136 14,072 12,679 Calls per customer line . . . . . . . . . . . . 3,112 3,285 3,277 3,317 3,055 * After cumulative effect of change in accounting principles. # Effective August 1991 (MPSC NO.U9004), certain local calls from private line circuits were reclassified to Access Service. The years 1989-1991 have been restated to be on a comparable basis. XXX BEGIN PAGE 15 HERE XXX Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions) Following is a discussion and analysis of the results of operations of the Company for the year ended December 31, 1993 and for the year ended December 31, 1992, which is based on the Statements of Income and Reinvested Earnings on page 23 Other pertinent data are also given in Selected Financial and Operating Data on page 14. Results of Operations REVENUES Revenues increased $67.9 or 2.5% due to the following: Increase 1993 1992 (Decrease) %Change Local service . . . . . . . . . . $1,092.1 $1,168.6 ($76.5) (6.5%) The decrease of $76.5 was primarily due to a $119.9 reclassification, at the Company's initiative, of certain measured interzone messages from the local service category to the long distance service category. Without the reclassification, local service would have increased $43.4. This was comprised of $37.6 in volume increases attributable to continued growth in central office custom features and public telephone revenues, and a 3.0% increase in access lines to 4,562,740 from 4,431,174 in the prior year. An additional $5.7 increase resulted from rate changes which consisted of an increase in certain operator assisted services, custom calling features, and the expiration of temporary customer credits in effect during 1992. Increase 1993 1992 (Decrease) %Change Access service Interstate access . . . $512.6 $479.4 $ 33.2 6.9% Intrastate access . . . $201.5 $199.9 $ 1.6 0.8% Interstate access increased $33.2 due to a $16.7 reduction in support payments made to the National Exchange Carrier Association, volume of business increases of $11.3, and a $10.6 increase related to anticipated settlements with other telecommunications providers. These increases were partially offset by $6.0 in rate reductions. The intrastate access increase of $1.6 was mainly the result of the effect of higher calling volumes of $11.3 and true-ups and settlements with other local exchange carriers of $5.2. These increases were offset by $10.8 in rate reductions and $3.3 in various claims and settlements with interexchange carriers. Increase 1993 1992 (Decrease) %Change Long distance services . . . . $695.8 $591.6 $104.2 17.6% The increase in long distance revenues of $104.2 is primarily the result of the $119.9 reclassification related to local service revenues discussed above. Without this reclassification, long distance revenues would have decreased $15.7. Volume increases of $46.9 were more than offset by shifts to discount calling plans of $42.6 and rate reductions totaling $19.3. XXX BEGIN PAGE 16 HERE XXX Increase 1993 1992 (Decrease) %Change Other revenues . . . . . . . $244.8 $239.4 $5.4 2.3% An increase of $5.4 was primarily due to growth in nonregulated revenues (primarily inside wiring services) of $8.7 and $2.2 in Ameritech Publishing, Inc. license fees. This was reduced by a $6.3 increase in uncollectibles resulting from increased write- offs. OPERATING EXPENSES The Company has changed the presentation of its operating expenses in the Statements of Income and Reinvested Earnings to facilitate a better understanding of its operating results. Prior year amounts have been reclassified to conform with this presentation. Operating expenses increased $49.2 or 2.3% primarily due to the following: Increase 1993 1992 (Decrease) %Change Depreciation . . . . . . . . . $543.3 $520.7 $22.6 4.3% Depreciation expense increased $22.6 due mainly to a $13.4 increase in intrastate rates resulting from the Company's ongoing review of the lives of its property. In addition, a $15.6 increase resulted from the continued expansion of the plant investment base. These increases were partially offset by a $6.7 reduction caused by the expiration of FCC-authorized inside wire and reserve deficiency amortization schedules. Increase 1993 1992 (Decrease) %Change Employee-related expenses. . . . . . . . . $705.8 $701.8 $4.0 0.6% The $4.0 increase in employee-related expenses was due to increases of $16.3 in basic wage rates, $5.7 in the provision for team awards and bonus payments, and $5.0 in other employee- related costs, mainly tuition aid and technical training fees, relocation costs and travel expenses. Offsetting these increases were reductions of $21.5 due to lower force levels than the previous year. The remaining offset was primarily due to lower overtime payments recorded in 1993. The Company's total employee count was 14,561 as of December 31, 1993, compared to 15,142 at December 31, 1992. Increase 1993 1992 (Decrease) %Change Taxes other than income taxes . . . . . . . . . . . $132.2 $144.1 ($11.9) (8.3%) The decrease in taxes other than income taxes is due to a $13.2 reduction made to the provision for property taxes to recognize the impact of new state legislation enacted in December 1993 which lowers property tax millage rates in Michigan for December 31, 1993 assessments. Partially offsetting this reduction was a $1.9 increase in other taxes, primarily Michigan single business tax expense, resulting from higher 1993 business volumes. XXX BEGIN PAGE 17 HERE XXX Increase 1993 1992 (Decrease) %Change Other operating expenses. . . . . . . $771.0 $736.5 $34.5 4.7% The growth reported in this category was due to increases of $28.7 in payments for services provided by affiliated companies due in part to a transfer of certain work functions to Ameritech Services, Inc. (a subsidiary jointly owned by the Company and the other four Ameritech landline telephone companies)("ASI"), $8.7 in higher advertising costs, a $5.7 increase in expenses paid to other carriers for access, and a $2.5 increase in the provision made for potential claims and settlements with interexchange carriers. Partially offsetting these increases was a $10.8 decrease resulting from the effects of the work force resizing provision reflected in 1992 results. OTHER INCOME AND EXPENSES Increase 1993 1992 (Decrease) %Change Interest Expense . . . . . . $106.2 $109.6 $(3.4) (3.1)% The decrease in interest expense is attributable primarily to $3.8 in tax and other settlements made in 1992. In addition, interest related to debt decreased $.9 due to lower composite interest rates on short-term debt. These decreases were partially offset by $1.7 of interest related to the 1990 incentive regulation plan. Increase 1993 1992 (Decrease) %Change Other expense, net . . . . . . $4.6 $ 9.4 $(4.8) (51.1)% The $4.8 decrease is primarily the result of $4.0 in higher earnings from ASI in which the Company has a 26% ownership interest. In addition, other expenses were $4.1 lower: $2.4 in lower 1993 costs related to the early retirement of debt, and $1.7 from a 1992 write-off of relocation work performed but not collectible. These reductions in expense were partly offset by a $3.1 increase in 1993 contributions, primarily new commitments to education in the form of educational grants. Increase 1993 1992 (Decrease) %Change Income taxes . . . . . . .. . $140.5 $130.6 $9.9 7.6% The income tax increase of $9.9 was the net effect of several items. There were increases of $9.4 due to higher pre-tax income, $9.0 in adjustments to the provision for future settlements, and $6.1 due to the change to the new 35% tax rate. These were somewhat offset by a one-time $6.8 reduction caused by adjusting the SFAS Nos. 106 and 112 deferred tax asset to reflect the change in tax rate, and a $6.5 true-up in the investment-related components of the 1992 tax provision. The remaining offset is due mainly to a $2.0 increase in investment tax credits amortized in 1993. XXX BEGIN PAGE 18 HERE XXX OTHER INFORMATION Changes in Accounting Principles Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The new accounting method is essentially a refinement of the liability method already followed by the companies of Ameritech Corporation ("Ameritech", the Company's parent) and, accordingly, did not have a significant impact on the Company's financial statements upon adoption. As more fully discussed in Note (C) to the financial statements, effective January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 112, "Employers Accounting for Postemployment Benefits". The cumulative effect of these accounting changes was recognized in the first quarter of 1992 as a change in accounting principles of $448.4, net of a deferred income tax benefit of $225.1. Regulatory Environment Customer demand, technology, and the preferences of policy makers are all converging to increase competition in the local exchange business. The effects of increasing competition are apparent in the marketplace the Company serves. For example, certain large telecommunications providers have recently announced their intentions to provide full local exchange service. Additionally, increasing volumes of intraLATA long distance services purchased by large and medium sized business customers are sold by carriers other than the Company. Recognizing this trend, the Company's regulatory/public policy activities are focused on achieving a framework that allows for expanding competition while providing a fair opportunity for all carriers, including the Company, to succeed. The cornerstone of this effort is Ameritech's "Customers First Plan" that was filed with the FCC on March 1, 1993. In a subsequent filing with the U.S. Department of Justice, Ameritech proposed that the Customers First Plan be implemented on a trial basis beginning in January 1995 in Illinois and other states thereafter. The Customers First Plan proposes to open all of the local telephone business in the Company's service area to competition. In exchange, Ameritech has requested three regulatory changes. First, Ameritech has requested relief from the Modification of Final Judgment ("MFJ") interLATA ban. Such relief would mean that the Company would be allowed to offer all long distance services. Second, Ameritech has requested a number of modifications in the FCC's price cap rules. These modifications would apply only to Ameritech, including the Company, and would eliminate any obligation to refund, in the form of its share of future rate reductions, its share of interstate earnings in excess of 12.25%. The modifications would also provide the Company increased ability to price its interstate access services in a manner appropriate to competitive conditions. Third, Ameritech has requested FCC authority to collect in a competitively neutral manner, the social subsidies currently embedded in the rates that the Company charges long distance carriers for access to the local network. The Michigan Public Service Commission ("MPSC") adopted an incentive regulation plan on March 13, 1990. The incentive regulation plan, which became effective April 1, 1990, was terminated as of December 31, 1991, having been found inconsistent with the Michigan Telecommunications Act ("MTA") effective January 1, 1992. Through the end of 1991, after 21 months under the plan, the Company had recognized a liability of $8.2 for potential sharing of profits with customers. In September 1992, the Company increased this provision to $10.5 in accordance with a tentative agreement reached with the MPSC staff. In January 1993, the MPSC issued an order approving the agreement but also providing that interest be accrued on the $10.5 at 9% per annum since January 1, 1992. As of December 31, 1993, the total liability related to ratepayer sharing is $12.2. XXX BEGIN PAGE 19 HERE XXX In response to the January 1993 order, the Company filed its proposed plan in February 1993 for the matching of shareable earnings to benefit education. This plan proposed to match the original $10.5 plus interest with an equal amount if all amounts would be available for and dedicated to educational telecommunications services. In December 1993, the MPSC issued an order approving an agreement reached between the Company, intervenors, and the MPSC staff, establishing two separate funds dedicated to educational telecommunications projects: the ratepayers' portion and the Company's matching fund. As of December 31, 1993, the amount recorded to recognize the matching portion is $11.3. A three-member Michigan Council on Telecommunications Services for Public Education ("Council") was established to review and make recommendations on all projects funded by the ratepayers' portion. The Company retains control over how the matching funds are expended, which may be in the form of capital, expense or in-kind services, but agrees to work with the Council in making those determinations. IntraLATA Long Distance Service Order On July 31, 1992, MCI Telecommunications Corporation ("MCI") filed a complaint with the MPSC seeking "1+" intraLATA dialing parity for all toll competitors of the Company, alleging that current dialing arrangements violated the Michigan Telecommunications Act. Callers in Michigan must currently dial "10" plus a three digit access code to use the services of the Company's intraLATA toll competitors. The MPSC dismissed MCI's complaint finding no statutory violations. However, as a result of subsequent proceedings in the case, on February 24, 1994, the MPSC issued an order requiring the implementation of "1+" intraLATA toll dialing parity in Michigan. The MPSC order requires dialing parity to be implemented concurrently with the termination of prohibitions against the Company's ability to offer interLATA service, but in no event later than January 1, 1996. The order also requires the establishment of an industry task force to consider all issues involved in the implementation of intraLATA dialing parity. The task force will develop a deployment schedule, identify the costs for deployment, and determine the methodology to recover those costs. The task force is required to file a report with the MPSC no later than September 23, 1994, setting forth its findings and recommendations. The Company believes that the MPSC has not considered all relevant factors in rendering its decision on intraLATA parity. Accordingly, the Company has filed a petition for a rehearing with the MPSC as a first step in bringing further clarification to the issues. In 1993 the Company recorded $695.8 of long distance revenue, of which approximately $634.0 resulted from intraLATA message and unidirectional long distance services. Customer response to dialing parity and the effect on the Company's intraLATA long distance revenue is uncertain. However, it is estimated that approximately 50% of any long distance revenue lost, which could be significant, would be offset by additional access revenue. Effects of Regulatory Accounting The Company presently gives accounting recognition to the actions of regulators where appropriate, as prescribed by Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" ("SFAS No. 71"). Under SFAS No. 71, the Company records certain assets and liabilities because of actions of regulators. Further, amounts previously charged to operations for depreciation expense reflect estimated useful lives and methods prescribed by regulators rather than those that might otherwise apply to unregulated enterprises. In the event the Company determines that it no longer meets the criteria for following SFAS No. 71, the accounting impact to the Company would be an extraordinary noncash charge to operations of an amount which could be material. Criteria that give rise to the discontinuance of SFAS No. 71 include (1) increasing competition which restricts the Company's ability to XXX BEGIN PAGE 20 HERE XXX establish prices to recover specific costs, and (2) a significant change in the manner in which rates are set by regulators from cost-based regulation to another form of regulation. The Company periodically reviews these criteria to ensure that continuing application of SFAS No. 71 is appropriate. Status of new business units In February 1993, following a year-long examination of its business called "Breakthrough Leadership," Ameritech announced it would restructure its business into separate units organized around specific customer groups - such as residential customers, small businesses, interexchange companies and large corporations - and a single unit that will run Ameritech's network in Illinois, Indiana, Michigan, Ohio and Wisconsin. The Ameritech Bell Companies will continue to function as legal entities owning current Bell company assets in each state. The network unit will provide network and information technology resources in response to the needs of the other business units. This unit will be the source of network capabilities for products and services offered by the other business units and will be responsible for the development and day-to-day operation of an advanced information infrastructure. All of the market units and the network unit are currently operational. Ameritech has developed a new logo and is marketing all of its products and services under the single brand name "Ameritech." Digital Video Network In January 1994, Ameritech announced a program to launch a digital video network upgrade that is expected, by the end of the decade, to make available interactive information and entertainment services, as well as traditional cable TV services, to approximately six million Ameritech customers. The Company has filed an application with the FCC seeking approval of the program. The application reflects capital expenditures of approximately $55.0 over the next three years. The Company may also, depending on market demand, make additional capital expenditures under this program. The Company anticipates that its capital expenditures for the program will be funded without an increase in its recent historical level of capital expenditures. Termination of publishing services contract On September 9, 1993, Ameritech Publishing exercised its right to terminate its publishing services contract (the "Agreement") with the Company, effective September 8, 1994, or such other mutually acceptable date. Pursuant to the Agreement, which became effective on January 1, 1991, the Company granted a license and provides billing, collection and other services to Ameritech Publishing, and Ameritech Publishing provides directory services for the Company. Ameritech Publishing is a wholly-owned subsidiary of the Company's parent, Ameritech Corporation. The Agreement's initial term was to have been five years, subject, however, to either party's right to terminate on not less than twelve months' prior notice. In 1993, the Company earned fees of approximately $132.7 from Ameritech Publishing and paid Ameritech Publishing approximately $19.8 for services rendered. The Company has begun negotiations with Ameritech Publishing for a new contract. While the Company cannot predict at this time the specific terms and conditions of any new contract it may negotiate with Ameritech Publishing, it anticipates that annual payments from Ameritech Publishing under a new contract could be significantly less than current annual payments under the Agreement. A new contract with Ameritech Publishing could also vary from the Agreement as to duration, services to be provided by the parties, and other provisions. XXX BEGIN PAGE 21 HERE XXX Property Tax Litigation The Company has disputed the manner of assessment of its property taxes in Michigan. In August of 1993, the Michigan Supreme Court agreed to hear certain issues associated with that dispute which involves the 1984-1986 tax years. If the Company is successful in its arguments, it will receive a refund of overpayment of property taxes. If unsuccessful, the Company may be subject to an additional, and possibly substantial, tax liability for those years beyond 1986. An opinion of the court could be issued by the end of 1994. Management of the Company believes that the ultimate resolution of this case will not have a material adverse effect on the Company's financial position or results of operations. Workforce Resizing On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995, including approximately 1,560 at the Company. Under terms of agreements between Ameritech, the Communications Workers of America ("CWA") and the International Brotherhood of Electrical Workers ("IBEW"), Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW, to selected nonmanagement employees who leave the business before the end of 1995. The above actions will result in a charge to first quarter 1994 earnings of approximately $137.8 or $89.2 after tax. A significant portion of the program cost will be funded by Ameritech's pension plan, whereas financial incentives to be paid from Company funds are estimated to be approximately $36.9. Settlement gains, which result from terminated employees accepting lump-sum payments from the pension plan, will be reflected in income as employees leave the payroll. The Company believes this program will reduce its employee-related costs by approximately $78.0 on an annual basis upon completion of this program. The reduction of the workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition XXX BEGIN PAGE 22 HERE XXX Item 8. Item 8. Financial Statements and Supplementary Data Report of Independent Public Accountants To the Shareholder of Michigan Bell Telephone Company: We have audited the accompanying balance sheets of Michigan Bell Telephone Company (a Michigan Corporation), as of December 31, 1993 and 1992, and the related statements of income and reinvested earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Michigan Bell Telephone Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note (C) to the financial statements, the Company changed its method of accounting for certain postretirement and postemployment benefits in 1992. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Detroit, Michigan January 28, 1994 XXX BEGIN PAGE 23 HERE XXX Statements of Income and Reinvested Earnings MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) Year Ended December 31, 1993 1992 1991 Revenues . . . . . . . .. . . . . . $2,746.8 $2,678.9 $2,575.3 Costs and expenses Depreciation. . . . . . . . . . . . . 543.3 520.7 507.9 Employee-related expenses. . . . . 705.8 701.8 708.1 Taxes other than income taxes . . . 132.2 144.1 136.9 Other operating expenses. . . . . . 771.0 736.5 690.8 2,152.3 2,103.1 2,043.7 Operating Income . . . . . . . . . . 594.5 575.8 531.6 Interest expense. . . . . . . . . . . 106.2 109.6 125.3 Other (income) expense - net . . . . 4.6 9.4 (5.0) 110.8 119.0 120.3 Income before income taxes and cumulative effect of change in accounting principles. . . . . . . 483.7 456.8 411.3 Income taxes . . . . . . . . . . . . 140.5 130.6 120.8 Income before cumulative effect of change in accounting principles . . 343.2 326.2 290.5 Cumulative effect of change in accounting principles . . . . . . -- (448.4) -- Net income (loss). . . . . . . . . . 343.2 (122.2) 290.5 Reinvested earnings, beginning of year . 2.8 348.5 323.3 Less: Dividends . . . . . . . . . . . 324.6 223.5 265.3 Reinvested earnings, end of year . . $ 21.4 $ 2.8 $ 348.5 The accompanying notes are an integral part of these financial statements. XXX BEGIN PAGE 24 HERE XXX Balance Sheets MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) December 31, December 31, 1993 1992 ASSETS CURRENT ASSETS Cash and temporary cash investments . . . . $ 17.0 $ -- Receivables, net Customers and agents (less allowance for uncollectibles of $44.9 and $40.6 for 1993 and 1992, respectively) . . . 452.9 458.1 Ameritech and affiliates . . . . . . . . 15.7 16.5 Other . . . . . . . . . . . . . . . . . . 27.8 29.0 Material and supplies . . . . . . . . . . . . . 26.4 28.0 Prepaid and other . . . . . . . . . . . . . 23.0 30.4 562.8 562.0 TELECOMMUNICATIONS PLANT In service . . . . . . . . . . . . . . . 7,452.8 7,315.5 Under construction . . . . . . . . . . . . 106.2 140.2 7,559.0 7,455.7 Less accumulated depreciation . . . . . . . 3,176.2 2,999.6 4,382.8 4,456.1 INVESTMENTS, principally in affiliates. . . . . . 68.5 56.4 OTHER ASSETS AND DEFERRED CHARGES . . . . . . 245.1 215.4 TOTAL ASSETS . . . . . . . . . . . . . . . . . $5,259.2 $5,289.9 LIABILITIES AND SHAREOWNER'S EQUITY CURRENT LIABILITIES Debt maturing within one year Ameritech . . . . . . . . . . . . . . . $ 382.9 $ 264.0 Other . . . . . . . . . . . . . . . . . . 3.2 157.6 Accounts payable Ameritech Services, Inc. . . . . . . . . . 50.6 46.7 Other Ameritech Affiliates . . . . . . . . 47.0 24.5 Other . . . . . . . . . . . . . . . . . . 168.5 183.7 Other current liabilities . . . . . . . . 322.9 326.8 975.1 1,003.3 LONG-TERM DEBT . . . . . . . . . . . . . . 1,132.4 1,085.1 DEFERRED CREDITS AND OTHER LONG-TERM LIABILITIES Accumulated deferred income taxes . . . . . 405.7 440.2 Unamortized investment tax credits. . . . . . 93.7 117.4 Postretirement benefits other than pensions . 636.8 653.1 Long-term payable to affiliate (ASI) for SFAS 106 adoption . . . . . . . . . . 22.9 25.8 Regulatory liability and other . . . . . 230.9 221.9 1,390.0 1,458.4 SHAREOWNER'S EQUITY Common stock ($14 2/7 par value, 120,810,000 shares authorized, 120,526,415 issued and outstanding) . 1,721.8 1,721.8 Proceeds in excess of par value . . . . 18.5 18.5 Reinvested earnings . . . . . . . . . . . 21.4 2.8 1,761.7 1,743.1 TOTAL LIABILITIES AND SHAREOWNER'S EQUITY . $5,259.2 $5,289.9 The accompanying notes are an integral part of these financial statements. XXX BEGIN PAGE 25 HERE XXX Statements of Cash Flows MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) Year Ended December 31, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) . . . . . . . . . . . . . $ 343.2 $(122.2) $ 290.5 Adjustments to net income (loss) Cumulative effect of change in accounting principles. . . . . . . . . . -- 448.4 -- Depreciation. . . . . . . . . . . . . . . . 543.3 520.7 507.9 Deferred income taxes, net. . . . . . . . . (18.3) (15.0) (37.2) Investment tax credits . . . . . . . . . . (23.7) (18.9) (18.3) Interest during construction . . . . . . . ( 1.4) ( 1.2) ( 2.2) Provision for uncollectibles. . . . . . . 42.7 36.4 34.9 Change in accounts receivable. . . . . . . (35.4) (56.2) (71.1) Change in materials and supplies . . . . . ( 2.2) 1.0 ( 4.7) Change in prepaid expense and certain other current assets . . . . . . . . . . ( 7.1) 1.2 3.1 Change in accounts payable . . . . . . . . . . 14.1 (26.7) 1.7 Change in accrued taxes . . . . . . . . . . (6.4) (26.4) 19.5 Change in certain other current liabilities . 1.2 22.7 21.8 Change in certain non-current assets and liabilities . . . . . . . . .. (45.9) 17.9 (2.8) Other . . . . . . . . . . . . . . . . . . . ( 0.7) ( 19.5) 0.2 Net cash from operating activities . . . . 803.4 762.2 743.3 CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net . . . . . . . . (449.5) (515.6) (537.8) Proceeds from (costs of) disposal of telecommunications plant. . . . . . . . . ( 5.2) (11.3) 5.5 Additional equity investments in ASI. . . . . ( 7.8) (10.4) -- Net cash used in investing activities . . . . (462.5) (537.3) (532.3) CASH FLOWS FROM FINANCING ACTIVITIES: Intercompany financing, net . . . . . . . . . 118.9 (37.5) 301.5 Net change in other short-term debt . . . -- -- (210.0) Issuance of long-term debt . . . . . . . 200.0 450.0 50.0 Retirements of long-term debt . . . . . . . . (307.0) (412.2) ( 87.8) Cost of refinancing long-term debt . . . . . ( 11.2) ( 1.7) -- Dividend payments . . . . . . . . . . . . . (324.6) (223.5) (265.3) Net cash from financing activities . . . . . (323.9) (224.9) (211.6) Net increase (decrease) in cash and temporary cash investments. . . . . . . . 17.0 -- (0.6) Cash and temporary cash investments, beginning of year. . . . . . . . . . . . -- -- 0.6 Cash and temporary cash investments, end of year. . . . . . . . . . . . . . . $ 17.0 $ -- $ -- The accompanying notes are an integral part of these financial statements. XXX BEGIN PAGE 26 HERE XXX Notes to Financial Statements MICHIGAN BELL TELEPHONE COMPANY (Dollars in millions) Michigan Bell Telephone Company ("the Company") is a wholly- owned subsidiary of Ameritech Corporation ("Ameritech"). (A) ACCOUNTING POLICIES - The financial statements of the Company reflect the application of the accounting policies described in this note. Basis of Accounting - The financial statements have been prepared in accordance with generally accepted accounting principles. In compliance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS No. 71), the Company, which is still subject to regulation for certain services, recognizes the actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset or impose a liability. Actions of a regulator can also eliminate a liability previously imposed by the regulator. Transactions with Affiliates -The Company has various agreements with affiliated companies. Below is a description of the significant arrangements followed by a table of the amounts involved. 1. Ameritech Services, Inc. (ASI) The Company has a 26% ownership interest in ASI, an Ameritech-controlled affiliate that provides consolidated planning, development, management and support services to all the Ameritech Bell companies. The Company also has an agreement with ASI whereby the Company provides certain services such as loaned employees to ASI. 1993 1992 1991 Purchase of materials and charges for services . . . . $526.5 $489.4 $397.4 Recovery of costs of services provided to ASI . . . . 11.7 9.3 7.9 2. Ameritech (the Company's parent) Ameritech provides various administrative, planning, financial, and other services to the Company. Such services are billed to the Company at cost. 1993 1992 1991 Charges incurred for services . . . . . . . . . . . . $29.4 $29.7 $29.8 3. Ameritech Publishing, Inc. (API) The Company has an agreement whereby payments are made to the Company by API for license fees and billing and collection services provided by the Company. The Company also purchases directory services from API under the same agreement. 1993 1992 1991 Fees paid to the Company by API . . . . . . . . . $132.7 $130.5 $128.6 Purchases by the Company from API. . . . . . . . . . . 19.8 18.9 18.5 4. Ameritech Information Systems, Inc. (AIS) The Company has an agreement whereby the Company reimburses AIS for costs incurred by AIS in connection with the sale of network services on behalf of the Company by AIS employees. 1993 1992 1991 Charges incurred for services . . . . . . . . . . $13.9 $9.9 $11.1 XXX BEGIN PAGE 27 HERE XXX 5. Bell Communications Research, Inc. (Bellcore) Bellcore provides research and technical support to the Company. ASI has a one-seventh interest in Bellcore and bills the Company for the costs. 1993 1992 1991 Charges incurred for services . . . . . . . . . . . $32.2 $40.7 $39.0 Telecommunications Plant - Telecommunications plant is stated at original cost. The original cost of telecommunications plant purchased from ASI includes a return on investment to ASI. The provision for interstate depreciation, as prescribed by the FCC, is based principally on the straight-line remaining life and the straight- line equal life group (ELG) methods of depreciation applied to individual categories of telecommunications plant with similar characteristics. Effective January 1, 1990, the Company began a phase-in of ELG rates for determination of intrastate depreciation. This method was applied to two classes of plant in 1990, with all other classes (except electromechanical switching) completed in 1991. In 1992 the Company began a cyclical review plan under which the depreciation rate parameters of various classes of plant are under examination on a triennial basis. When depreciable plant is retired, the amount at which such plant has been carried in telecommunications plant in service is charged to accumulated depreciation. The cost of maintenance and repairs of plant is charged to expense. Investments - The Company's investments in ASI (26% ownership and $68.5) are reflected in the financial statements using the equity method of accounting. Material and Supplies - Inventories of new and reusable materials and supplies are stated at the lower of cost or market with cost stated principally at average original cost; for certain large individual items, cost is determined on a specific identification basis. Interest During Construction - Regulatory authorities allow the Company to accrue interest as a cost of constructing certain plant and as an item of income, i.e., allowance for debt and equity funds used to finance construction. Such income is not realized in cash currently but will be realized over the service life of the plant as the resulting higher depreciation expense is recovered in the form of increased revenues. Income Taxes - The Company is included in the consolidated federal income tax return filed by Ameritech and its subsidiaries. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). The new accounting method is essentially a refinement of the liability method already followed by the Ameritech companies and, accordingly, did not have a significant impact on the Company's financial statements upon adoption. Consolidated income tax currently payable has been allocated by Ameritech to the Company based on the Company's contribution to consolidated taxable income and tax credits. Deferred tax assets and liabilities are based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities. Under the liability method, deferred tax assets and liabilities at the end of each period are determined using the statutory tax rates in effect when these temporary differences are expected to reverse. Deferred income tax expense is measured by the change in the net deferred income tax asset or liability during the year. In addition, for regulated companies, SFAS No. 109 requires that all deferred regulatory assets and liabilities be recognized at the revenue requirement level. It further requires that a deferred tax liability be recorded to reflect the amount of cumulative tax benefits previously flowed through to ratepayers and that a long-term deferred asset be recorded to reflect the revenues to be recovered in telephone rates when the related taxes become payable in future years. XXX BEGIN PAGE 28 HERE XXX The Company uses the deferral method of accounting for investment tax credits. Therefore, credits earned prior to the repeal of investment tax credits by the Tax Reform Act of 1986 and also certain transitional credits earned after the repeal are being amortized as reductions in tax expense over the life of the plant which gave rise to the credits. Temporary Cash Investments - Temporary cash investments are stated at cost which approximates market. The Company considers all highly liquid, short-term investments with an original maturity of three months or less to be cash equivalents. Short-Term Financing Arrangement - During 1991, Ameritech entered into an arrangement with its subsidiaries, including the Company, for the provision of short-term financing and cash management services. Ameritech issues commercial paper and notes and secures bank loans to fund the working capital requirements of its subsidiaries and invests short-term, excess funds on their behalf (See Notes (D) and (H)). (B) INCOME TAXES - The components of income tax expense (before cumulative effect of change in accounting principles) were as follows: 1993 1992 1991 Federal Current . . . . . . . . . . . $180.7 $162.5 $174.1 Deferred, net . . . . . . . . . . (18.3) (14.8) (36.8) Investment tax credits . . . . . . (23.7) (18.9) (18.3) Total . . . . . . . . . . $138.7 $128.8 $119.0 Local Current . . . . . . . . . . . . . $ 1.9 $ 2.0 $ 2.2 Deferred, net . . . . . . . . . . (0.1) (0.2) (0.4) Total . . . . . . . . . . . 1.8 1.8 1.8 Total income tax expense . . $140.5 $130.6 $120.8 Deferred income tax expense (credits) results principally from temporary differences caused by the change in the book and tax bases of telecommunications plant due to the use of different depreciation methods and lives for financial reporting and income tax purposes. Total income taxes paid were $175.0, $171.7, and $159.1 in 1993, 1992 and 1991, respectively. XXX BEGIN PAGE 29 HERE XXX The following is a reconciliation between the statutory federal income tax rates of 35% in 1993, and 34% in 1992 and 1991, and the Company's effective tax rates: 1993 1992 1991 Statutory tax rate . . . . . . . . . . 35.0% 34.0% 34.0% Reduction in tax expense due to amortization of investment tax credits . . . . . . (4.0)% (3.8)% (4.4)% Effect of adjusting deferred income tax balances due to tax law changes . . . (1.4)% -- -- Benefit of tax rate differential applied to reversing temporary differences . . (3.3)% (3.2)% (4.1)% Depreciation of certain taxes and payroll-related construction costs capitalized for financial statement purposes, but deducted when incurred for income tax purposes . . . . . . . 2.3% 1.8% 1.1% Flow-through of temporary differences related to cost of removal/ salvage credit . . . . . . . . . . . . 0.6% 1.3% 3.0% Other . . . . . . . . . . . . . . . . (0.2)% (1.5)% (0.2)% Effective tax rate . . . . . . . . . 29.0% 28.6% 29.4% The Revenue Reconciliation Act of 1993, enacted in August of that year, increased the statutory federal income tax rate for 1993 to 35 percent. In accordance with the liability method of accounting, the Company adjusted, on the enactment date, its deferred income tax balances not subject to regulatory accounting prescribed by SFAS No. 71 (see Note (A)). The result was a reduction in deferred income tax expense of $6.8, primarily from increasing the deferred tax assets associated with SFAS Nos. 106 and 112 (See Note (C)). As of December 31, 1993 the Company had a regulatory asset of $112.5 (reflected in Other Assets and Deferred Charges) related to the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers. In addition, on that date, the Company had a regulatory liability of $210.4 (reflected primarily in Regulatory Liability and Other) related to the reduction of deferred taxes resulting from the change in the statutory federal income tax rate to 35% and deferred taxes provided on unamortized investment tax credits. These amounts will be amortized over the regulatory lives of the related depreciable assets concurrent with recovery in rates. The accounting for and the impact on future net income of these amounts will depend on the ratemaking treatment authorized in future regulatory proceedings. XXX BEGIN PAGE 30 HERE XXX As of December 31, 1993 and 1992, the components of long-term accumulated deferred income taxes were as follows: 1992 1993 Deferred tax assets Postretirement and postemployment benefits $232.4 $231.7 SFAS No. 71 accounting 97.8 81.9 Other, net 19.0 24.6 Total non-current deferred tax assets $349.2 $338.2 Deferred tax liabilities Accelerated depreciation $733.1 $756.4 Other 21.8 22.0 Total non-current deferred tax liabilities $754.9 $778.4 Net long-term accumulated deferred tax liability $405.7 $440.2 Deferred income taxes in current assets and liabilities are not significant and therefore are not itemized. (C) EMPLOYEE BENEFIT PLANS Pension Plans Ameritech maintains noncontributory defined pension and death benefit plans ("the plans") covering substantially all of the Company's management and non-management employees. The pension benefit formula used in the determination of pension cost is based on the average compensation earned during the five highest consecutive years of the last ten years of employment for the management plan and a flat dollar amount per year of service for the non-management plan. Pension (credit) expense is allocated to subsidiaries based upon the percentage of compensation for the management plan and per employee for the non-management plan. The Company's funding policy is to contribute annually an amount up to the maximum amount that can be deducted for federal income tax purposes. However, due to the funded status of the plans, no contributions have been made for the years reported below. The following data provides information on the Company's credit for the Ameritech plans: 1993 1992 1991 Pension credit $(27.8) $(29.9) $(21.1) Current year credit as a percent of salaries and wages (4.7)% (4.9)% (3.6)% Pension credits were determined using the projected unit credit actuarial method in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The resulting pension credits are primarily attributable to favorable investment performance and the funded status of the plans. Certain disclosures are required to be made of the components of pension cost and the funded status of the plans, including the actuarial present value of accumulated plan benefits, accumulated projected benefit obligation and the fair value of plan assets. Such disclosures are not presented for the Company because the structure of the Ameritech plans does not permit the plans' data to be readily disaggregated. The assets of the Ameritech plans consist principally of debt and equity securities, fixed income securities, and real estate. As of December 31, 1993, the fair value of plan assets available for plan benefits exceeded the projected benefit obligation (calculated using a discount rate of 5.8% as of December 31, 1993 and 1992). The assumed long-term rate of return on plan assets used in determining pension cost was 7.25% for 1993, 1992, and 1991. The assumed XXX BEGIN PAGE 31 HERE XXX increase in future compensation levels, also used in the determination of the projected obligation, was 4.5% in 1993 and 1992. Postretirement Benefits Other Than Pensions Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). SFAS No. 106 requires the cost of postretirement benefits granted to employees to be accrued and recognized as expense over the period in which the employee renders service and becomes eligible to receive benefits. The cost of health care and postretirement life insurance benefits for current and future retirees was recognized as determined under the projected unit credit actuarial method. In adopting SFAS No. 106, the Company elected to immediately recognize effective January 1, 1992 the transition obligation for current and future retirees. The transition obligation was $608.9 less deferred income taxes of $208.6 or $400.3, net. To this amount, $16.0 was added for the Company's 26% share of ASI's transition obligation, for a total charge of $416.3. As defined by SFAS No. 71, a regulatory asset and any corresponding regulatory liability associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery in the rate-making process. Substantially all current and future retirees are covered under postretirement benefit plans sponsored by Ameritech. Such benefits include medical, dental, and group life insurance. Ameritech has been prefunding (including cash received from the Company) certain of these benefits through Voluntary Employee Benefit Associations (VEBAs) and Retirement Funding Accounts (RFAs). The associated plan assets (primarily corporate securities and bonds) were considered in determining the transition obligation under SFAS No. 106. Ameritech intends to continue to fund its obligation appropriately, and is exploring other available funding and cost containment alternatives. Ameritech allocates its retiree health care cost on a per participant basis, whereas group life insurance is allocated based on compensation levels. SFAS No. 106 requires certain disclosures as to the components of postretirement benefit costs and the funded status of the plans. Such disclosures are not presented for the Company, as the structure of the Ameritech plans does not permit the data to be readily disaggregated. However, the Company has been advised by Ameritech as to the following assumptions used in determining its SFAS No. 106 costs. As of December 31, 1993, the accumulated postretirement benefit obligation exceeded the fair value of plan assets available for plan benefits. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.0% as of December 31, 1993, and 7.5% as of December 31, 1992. The assumed rate of future increases in compensation level was 4.5% as of December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 7.25% in 1993 and 1992 on VEBAs and 8.0% in 1993 and 1992 on RFAs. The assumed health care cost trend rate was 9.6% in 1993 and 10.0% in 1992, and is assumed to decrease gradually to 4.0% in 2007 and remain at that level. The assumed increase in health care cost is 9.2% for 1994. The health care cost trend rates have a significant effect on the amounts reported for costs each year. Specifically, increasing the assumed health care cost trend rate by one percentage point in each year would increase the 1993 annual expense by approximately 18%. Postretirement benefit costs determined under SFAS No. 106 for 1993 and 1992 were $55.9 and $57.8, respectively. During 1991, the cost of postretirement health care benefits for retirees was $54.3. As of December 31, 1993, the Company had approximately 13,893 retirees eligible to receive health care and group life insurance benefits. XXX BEGIN PAGE 32 HERE XXX Postemployment Benefits Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to accrue the future cost of certain benefits such as workers compensation, disability benefits, and health care continuation coverage. A one-time charge related to adoption of this statement was recognized as a change in accounting principle, effective as of January 1, 1992. The charge was $48.1, less deferred income taxes of $16.5, for a net of $31.6. To this amount, $.4 is added for the Company's 26% share of ASI's one-time charge, for a total of $32.0. Previously, these costs were accounted for on a cash basis. Current expense levels are dependent upon actual claim experience, but are not materially different than prior charges to income. Workforce Reductions During 1993, 217 management employees left the Company through voluntary and involuntary termination programs. These programs, including termination benefits, settlement and curtailment gains from the pension plan, resulted in a credit to expense of $5.4. The involuntary plan remains in effect until December 31, 1994. During 1992, 210 management employees left the Company through voluntary early retirement programs and involuntary terminations. The net cost of this program, along with other transfers from the pension plan, including termination benefits, and settlement and curtailment gains from the pension plan was $.4. During 1991, the Company also offered most of its management employees an early retirement program. The net cost of that program, including termination benefits and a settlement gain from the pension plan, was $.7. D) DEBT MATURING WITHIN ONE YEAR - Debt maturing within one year consists of the following at December 31: Weighted Average Amounts Interest Rates 1993 1992 1991 1993 1992 1991 Notes payable Parent (Ameritech) $382.9 $264.0 $301.5 3.3% 3.4% 5.1% Long-term debt maturing within one year 3.2 157.6 134.1 -- -- -- Total . . . $386.1 $421.6 $435.6 Average notes payable outstanding during the year . . . . . . $237.8 $223.3 $218.0 3.1%* 3.9%* 6.1%* Maximum notes payable at any month end during the year . . $382.9 $264.5 $301.5 In December 1992, the Company called $150.0 of 8.625% debentures due in 2010. The debentures were retired in February 1993 using funds obtained from long-term borrowings. This debt was classified as Debt Maturing Within One Year as of December 31, 1992. * Computed by dividing the average daily face amount of notes payable into the aggregate related interest expense. During 1991 Ameritech consolidated the short-term financing of its subsidiaries at Ameritech Corporate. See note (A), short-term financing arrangement. XXX BEGIN PAGE 33 HERE (E) LONG-TERM DEBT - Interest rates and maturities on long- term debt, consisting principally of debentures and notes, outstanding at December 31, were as follows: 1993 1992 Thirty-six year 4.625% debentures due August 1, 1996 $ 35.0 $ 35.0 Thirty-seven year 6.375% debentures due February 1, 2005 125.0 125.0 Forty year 7.0% debentures due November 1, 2012 75.0 75.0 Thirty year 7.50% debentures due February 15, 2023 200.0 -- Forty year 7.75% debentures due June 1, 2011 150.0 150.0 Thirty year 7.85% debentures due January 15, 2022 200.0 200.0 Thirty-eight year 8.125% debentures due June 1, 2015 -- 150.0 Seven year 5.875% notes due September 15, 1999 150.0 150.0 Ten year 6.375% notes due September 15, 2002 100.0 100.0 Ten year 9.25% notes due November 15, 1998 100.0 100.0 $1,135.0 $1,085.0 Long-term capital lease obligations . . . . 7.8 10.2 Unamortized discount - net . . . . . . . . . . (10.4) (10.1) Total $1,132.4 $1,085.1 On February 15, 1993, the Company issued $200.0 of 7.5% debentures due February 15, 2023 under a $350.0 shelf registration filed in August 1992. The proceeds from this issuance were used to repay long-term borrowings and for general corporate purposes. On October 29, 1993, the Company called $150.0 of 8.125% debentures due June 1, 2015. The redemption on December 2, 1993, was funded by short-term borrowings from Ameritech. On November 16, 1993, the Company filed a registration statement with the SEC for issuance of up to $450.0 in unsecured debt securities. No issuances have been made under this shelf registration. Early extinguishment of debt costs (including call premiums and write-offs of unamortized deferred costs) were $7.0, $9.4, and $7.2 in 1993, 1992 and 1991, respectively, and were included in other income on the statements of income. (F) LEASE COMMITMENTS - The Company leases certain facilities and equipment used in its operations under both capital and operating leases. Rental expense under operating leases was $40.5, $43.6 and $44.3 for 1993, 1992 and 1991, respectively. At December 31, 1993 the aggregate minimum rental commitments under non- cancelable leases were approximately as follows: Years Operating Capital 1994 . . . . . . . . . . . . . $22.9 $ 4.9 1995 . . . . . . . . . . . . 20.9 4.1 1996 . . . . . . . . . . . . . 14.6 2.4 1997 . . . . . . . . . . . . . 9.7 1.6 1998 . . . . . . . . . . . . 5.2 1.0 Thereafter . . . . . . . . . . 9.0 3.8 Total minimum rental commitments . . . . . . . . $82.3 17.8 Less: amount representing executory costs . . . . . . . . . . . . 3.1 amount representing interest costs . . . . . . . . 3.7 Present value of minimum lease payments $11.0 XXX BEGIN PAGE 34 HERE XXX (G) FINANCIAL INSTRUMENTS - The following table presents the estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992: Carrying Fair Value Value Cash and temporary cash investments . . . . . . . $ 17.0 $ 17.0 Debt . . . . . . . . . . . . . . . . . . . . . . . . . . 1,532.8 1,583.3 Long-term payable to ASI (for postretirement benefits) 22.9 22.9 Other assets . . . . . . . . . . . . . . . . . . . . . . 3.5 3.5 Other liabilities. . . . . . . . . . . . . . . . . . . . . 31.6 31.6 Carrying Fair Value Value Cash and temporary cash investments . . . . . . . $ 0.0 $ 0.0 Debt . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524.5 1,501.8 Long-term payable to ASI (for postretirement benefits ) 25.8 25.8 Other assets . . . . . . . . . . . . . . . . . . . . . . . 7.3 7.3 Other liabilities. . . . . . . . . . . . . . . . . . . . . 17.6 17.6 The following methods and assumptions were used to estimate the fair value of financial instruments: Cash and temporary cash investments: Carrying value approximates fair value because of the short-term maturity of these instruments. Debt: The carrying amount (including accrued interest) of the Company's debt maturing within one year approximates fair value because of the short-term maturities involved. The fair value of the Company's long-term debt was valued based on the year-end quoted market prices for the same or similar issues. Long-term payable to ASI (for postretirement benefits): This item represents the long-term payable to ASI for the Company's proportionate share of ASI's transition benefit obligation related to adoption of SFAS No. 106. Carrying value approximates fair value for this item. Other assets and liabilities: These financial instruments consist primarily of long-term receivables and payables, other investments, and customer deposits. The fair value of these items was based on expected cash flows or, if available, quoted market prices. (H) ADDITIONAL FINANCIAL INFORMATION December 31, 1993 1992 Balance Sheets Other current liabilities: Accrued payroll . . . . . . . . . . . . . $ 23.2 $ 24.4 Compensated absences . . . . . . . . . . . . 50.3 47.4 Accrued taxes . . . . . . . . . . . . . . . 140.1 146.5 Advance billings and customer's deposits . . 58.2 54.6 Accrued interest . . . . . . . . . . . . . . 26.5 26.3 Other . . . . . . . . . . . . . . . . . . . 24.6 27.6 Total . . . . . . . . . . . . . . . . . . $ 322.9 $ 326.8 XXX BEGIN PAGE 35 HERE XXX 1993 1992 1991 Statements of Income Interest expense: Interest on long-term debt . . . . . $ 92.1 $ 91.9 $ 96.0 Interest on notes payable - Ameritech . . 7.5 8.8 9.7 Interest on other notes payable . . . . . -- -- 3.6 Interest on capital leases . . . . . . . . 1.4 1.6 2.0 Other . . . . . . . . . . . . . . . . . 5.2 7.3 14.0 Total . . . . . . . . . . . . . . . $ 106.2 $ 109.6 $ 125.3 Interest paid, net was $102.4, $106.4, and $118.2 in 1993, 1992, and 1991 respectively. 1993 1992 1991 Taxes other than income taxes: Property . . . . . . . . . . . . . . . . $ 99.9 $ 113.7 $ 106.0 Other . . . . . . . . . . . . . . . . . . . 32.3 30.4 30.9 Total . . . . . . . . . . . . . . . . $ 132.2 $ 144.1 $ 136.9 Maintenance and repair expense . . . . . . . $ 463.7 $ 478.8 $ 444.0 Advertising expense . . . . . . . . . . . . $ 30.8 $ 22.1 $ 19.4 Depreciation-Percentage of average depreciable telecommunications plant . . . 7.4% 7.3% 7.0% Revenues from American Telephone and Telegraph Company, consisting principally of interstate network access and billing and collection service revenues, comprised approximately 11%, 12%, and 13%, of total revenues in 1993, 1992 and 1991, respectively. No other customer accounted for more than 10% of total revenues. (I) CONTINGENCIES The Company has disputed the manner of assessment of its property taxes in Michigan. In August of 1993, the Michigan Supreme Court agreed to hear certain issues associated with that dispute which involves the 1984-1986 tax years. If the Company is successful in its arguments, it will receive a refund of overpayment of property taxes. If unsuccessful, the Company may be subject to an additional, and possibly substantial, tax liability for those years beyond 1986. An opinion of the court could be issued by the end of 1994. Management of the Company believes that the ultimate resolution of this case will not have a material adverse effect on the Company's financial position or results of operations. (J) OTHER INFORMATION Michigan Telecommunications Act On January 1, 1992, the Michigan Telecommunications Act of 1991 ("MTA"), Public Act 179, became effective. The new law replaced the former Michigan Telephone Act of 1913 and Public Act 305 and terminated traditional rate-of-return regulation of telecommunication providers within Michigan, including the Company. MTA affords the Company new pricing flexibility in certain areas such as message toll services and encourages the introduction of new services. XXX BEGIN PAGE 36 HERE XXX (K) CALCULATION OF RATIO OF EARNINGS TO FIXED CHARGES The ratio of earnings to fixed charges of the Company for the five years ended December 31, 1993, 1992, 1991, 1990, and 1989 was 5.27, 4.88, 4.12, 4.70, and 4.58 respectively. For the purpose of calculating this ratio: (i) earnings have been calculated by adding to income before interest expense and accounting changes, the amount of related taxes on income, the Single Business Tax, and the portion of rentals representative of the interest factor, (ii) the Company considers one-third of rental expense to be the amount representing return on capital, and (iii) fixed charges comprise total interest expense and such portion of rentals. (L) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Calendar Operating Net Quarter Revenues Income Income(Loss) 1st . . . . . . . . . . . . .. . $ 667.0 $134.5 $ 74.3 2nd . . . . . . . . . . . . . . . . 683.8 147.7 85.6 3rd . . . . . . . . . . . . . . . . . 696.2 142.1 90.6 4th . . . . . . . . . . . . . . . . . 699.8 170.2 92.7 Total . . . . . . . . . . . . . . $2,746.8 $594.5 $ 343.2 Calendar Operating Net Quarter Revenues Income Income(Loss) 1st . . . . . . . . . . . . . . . . . $ 647.3 $137.3 $(366.0) 2nd . . . . . . . . . . . . . . . . . 671.5 144.1 81.9 3rd . . . . . . . . . . . . . . . . . 683.0 147.3 79.6 4th . . . . . . . . . . . . . . . . . 677.1 147.1 82.3 Total . . . . . . . . . . . . . . $2,678.9 $575.8 $(122.2) Operating income represents revenues less costs and expenses excluding interest expense and other income-net. The fourth quarters of 1993 and 1992 were affected by several income and expense items. The fourth quarter of 1993 was affected by gains from a workforce resizing of $5.4, a reduction in the tax provision of $13.2 due to a change in state property tax law, and charges for the early retirement of debt of $7.0. In the fourth quarter of 1992, the Company recognized higher costs and charges resulting from its market realignment efforts, the early retirement of debt, and increased advertising costs. These costs were offset by gains resulting from workforce resizing and higher than expected pension credits. First quarter 1992 results reflect charges related to the adoption of SFAS Nos. 106 and 112 for certain postretirement and postemployment benefits, as discussed previously in Note (C) above. The charges totaled approximately $448.4. All adjustments necessary for a fair statement of results for each period have been included. (M) EVENT SUBSEQUENT TO DATE OF AUDITORS' REPORT (UNAUDITED) On March 25, 1994, Ameritech announced it would reduce its nonmanagement workforce resulting in an after-tax charge to the Company of $89.2. The charge will be recorded in the first quarter of 1994. The details of this plan are discussed on page 21 in Management's Discussion and Analysis of Results of Operations. XXX BEGIN PAGE 37 HERE XXX Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure No changes in nor disagreements with accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure occurred during the period covered by this annual report. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as part of the report: (1) Financial Statements: Page Selected Financial and Operating Data. . . . 14 Report of Independent Public Accountants . . 22 Statements of Income and Reinvested Earnings . . . . . . . . . . . . . 23 Balance Sheets . . . . . . . . . . . . . . . . 24 Statements of Cash Flows. . . . . . . . . . 25 Notes to Financial statements. . . . . . . . 26 (2) Financial Statement Schedules V - Telecommunications Plant. . . . . . . . 41 VI - Accumulated Depreciation. . . . . . . . 43 VIII- Allowance for Uncollectibles. . . . . . 45 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. XXX BEGIN PAGE 38 HERE XXX (3) Exhibits: Exhibits identified below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3 Articles of Incorporation of the registrant, as amended March 26, 1990, and by-laws of the registrant, as amended May 7, 1992. 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Reorganization and Divestiture Agreement among American Telephone and Telegraph Company, American Information Technologies Corporation and affiliates dated November 1, 1983 (Exhibit 10a to Form 10-K for 1983 for American Information Technologies Corporation, File No. 1-8612). 10b Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among American Telephone and Telegraph Company, Bell System Operating Companies, Regional Holding Companies and Affiliates dated November 1, 1983 (Exhibit 10j to Form 10-K for American Information Technologies Corporation, File No. 1-8612). 12 Computation of Ratio of Earnings to Fixed Charges for the five years Ended December 31, 1993. 23 Consent of independent public accountants. (b) Reports on Form 8-K: No report on Form 8-K was filed by the registrant during the last quarter of the year covered by this report. XXX BEGIN PAGE 39 HERE XXX SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MICHIGAN BELL TELEPHONE COMPANY by James W. Trunk James W. Trunk Vice President - Comptroller March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Principal Executive Officer: James E. Wilkes James E. Wilkes, President Principal Accounting and Financial Officer: James W. Trunk James W. Trunk, Vice President - Comptroller March 30, 1994 XXX BEGIN PAGE 40 HERE XXX SIGNATURES - (Continued) Ameritech Corporation By Richard H. Brown Richard H. Brown Vice Chairman the sole shareholder of the registrant, which has elected under the law of its state of incorporation to be managed by the shareholder rather than by a board of directors. March 30, 1994 XXX BEGIN PAGE 41 HERE XXX Schedule V -- Sheet 1 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Additions Retire- Other at end of Classification of period at cost(a) ments(b) changes(c) period Year 1993 Land . . . . . . . . .. $ 29.3 $ -- $ 0.1 $ -- $ 29.2 Buildings . . . . . . . . . . 612.4 21.3 10.0 -- 623.7 Computers and Other Office Equipment 244.3 13.5 39.9 -- 217.9 Vehicles and Other Work Equipment . 57.7 5.8 3.7 -- 59.8 Central Office Equipment . . 2,966.2 264.5 268.9 1.3 2,963.1 Information Orig/ Term Equipment . . 67.6 9.0 5.6 (0.8) 70.2 Cable and Wire Facilities . 3,305.2 178.3 26.1 -- 3,457.4 Capitalized Lease Assets . 24.2 1.1 2.3 -- 23.0 Miscellaneous Other Property 8.6 (0.1) -- -- 8.5 Total telecommunications plant in service . . . . . . 7,315.5 493.4 356.6 0.5 7,452.8 Telecommunications plant under construction. . 140.2 (34.0) -- -- 106.2 Total telecommunications plant. . . . $7,455.7 $459.4 $356.6 $ 0.5 $7,559.0 Year 1992 Land . . . . . . . . . . $ 29.4 $ -- $ 0.1 $ -- $ 29.3 Buildings . . . . . . . . 592.7 26.4 6.7 -- 612.4 Computers and Other Office Equipment 224.0 29.5 9.2 -- 244.3 Vehicles and Other Work Equipment . 58.3 5.8 6.4 -- 57.7 Central Office Equipment . 2,885.9 240.5 160.2 -- 2,966.2 Information Orig/ Term Equipment . . 86.6 6.1 25.1 -- 67.6 Cable and Wire Facilities . 3,145.7 179.6 20.1 -- 3,305.2 Capitalized Lease Assets . 18.4 6.5 0.7 -- 24.2 Miscellaneous Other Property 7.3 1.3 -- -- 8.6 Total telecommunications plant in service . . . . . . 7,048.3 495.7 228.5 -- 7,315.5 Telecommunications plant under construction. . . 112.3 27.9 -- -- 140.2 Total telecommunications plant. . . $7,160.6 $523.6 $228.5 $ -- $7,455.7 The notes on Sheet 2 are an integral part of this schedule. XXX BEGIN PAGE 42 HERE XXX Schedule V -- Sheet 2 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Additions Retire- Other at end of Classification of period at cost(a) ments(b) changes(c) period Year 1991 Land . . . . . $ 28.6 $ 0.8 $ -- $ -- $ 29.4 Buildings . . . . . . . . . 575.3 29.0 11.6 -- 592.7 Computers and Other Office Equipment 207.7 31.2 14.9 -- 224.0 Vehicles and Other Work Equipment . 64.1 5.8 11.6 -- 58.3 Central Office Equipment . . 2,736.9 283.4 165.8 31.4 2,885.9 Information Orig/ Term Equipment . . 553.7 8.0 443.7 (31.4) 86.6 Cable and Wire Facilities . 3,017.6 179.0 50.9 -- 3,145.7 Capitalized Lease Assets . . 21.0 2.2 4.8 -- 18.4 Miscellaneous Other Property 6.5 0.8 -- -- 7.3 Total telecommunications plant in service . . . . . . 7,211.4 540.2 703.3 -- 7,048.3 Telecommunications plant under construction. . . 101.9 10.4 -- -- 112.3 Total telecommunications plant. . . $7,313.3 $550.6 $703.3 $ -- $7,160.6 Notes: (a) Additions, other than to Buildings, include material purchased from Ameritech Services, Inc., a centralized procurement subsidiary in which the Company has a 26 percent ownership interest (see note (A) to Financial Statements). Additions shown also include (1) the original cost (estimated if not known) of reused material, which is concurrently credited to Material and Supplies, and (2) Interest During Construction. Transfers between the classifications listed are included in Column E. (b) Items of telecommunications plant when retired or sold are deducted from the property accounts at the amounts at which they are included therein (estimated if not known). (c) Reflects reclassification of certain subscriber equipment to central office circuit equipment accounts. XXX BEGIN PAGE 43 HERE XXX Schedule VI -- Sheet 1 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Depreciation Retire- Other at end of Classification of period expense(a) ments(b) changes period Year 1993 Buildings . . . . . . . $ 146.9 $ 17.2 $ 12.8 $ 0.1 $ 151.4 Computers and Other Office Equipment 147.6 26.3 39.8 -- 134.1 Vehicles and Other Work Equipment . . 18.3 5.4 5.0 -- 18.7 Central Office Equipment 1,217.5 303.0 264.0 (1.8) 1,254.7 Information Orig/ Term Equipment . . 43.9 4.4 6.1 0.4 42.6 Cable and Wire Facilities 1,411.5 183.8 34.3 (1.8) 1,559.2 Capitalized Lease Assets 12.8 3.1 2.2 0.1 13.8 Miscellaneous Other Property 1.1 -- -- 0.6 1.7 Total Accumulated Depreciation. . . . $2,999.6 $543.2 $364.2 $ (2.4) $3,176.2 Year 1992 Buildings . . . . . $ 138.7 $ 16.4 $ 8.1 $ (0.1) $ 146.9 Computers and Other Office Equipment 129.5 27.6 9.5 -- 147.6 Vehicles and Other Work Equipment . . 18.0 6.8 6.5 -- 18.3 Central Office Equipment 1,088.2 286.9 157.6 -- 1,217.5 Information Orig/ Term Equipment . . 62.9 6.6 25.2 (0.4) 43.9 Cable and Wire Facilities 1,265.7 173.1 27.3 -- 1,411.5 Capitalized Lease Assets 10.1 3.3 0.6 -- 12.8 Miscellaneous Other Property 1.0 -- -- 0.1 1.1 Total Accumulated Depreciation. . . . $2,714.1 $520.7 $234.8 (0.4) $2,999.6 The notes on Sheet 2 are an integral part of this schedule. XXX BEGIN PAGE 44 HERE XXX Schedule VI -- Sheet 2 MICHIGAN BELL TELEPHONE COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION Col. A Col. B Col. C Col. D Col. E Col. F Balance at Balance at beginning Depreciation Retire- Other at end of Classification of period expense(a) ments(b) changes period (Millions of Dollars) Year 1991 Buildings . . . . .. $ 136.1 $ 17.1 $ 14.3 $ (0.2) $138.7 Computers and Other Office Equipment 115.6 27.6 13.7 -- 129.5 Vehicles and Other Work Equipment . . 17.3 10.1 9.4 -- 18.0 Central Office Equipment 934.6 281.6 155.7 27.7 1,088.2 Information Orig/ Term Equipment . . 527.6 6.8 443.8 (27.7) 62.9 Cable and Wire Facilities 1,159.8 161.6 55.7 -- 1,265.7 Capitalized Lease Assets 11.1 3.1 4.1 -- 10.1 Miscellaneous Other Property 0.8 -- -- 0.2 1.0 Total Accumulated Depreciation. . . $2,902.9 $507.9 $696.7 $ -- $2,714.1 Notes: (a) The provision for interstate depreciation as prescribed by the FCC is based on the straight-line remaining life and the straight-line equal life group methods of depreciation applied to individual categories of telephone plant with similar characteristics. Beginning in 1983, the Company has accounted for intrastate depreciation in accordance with MPSC straight-line remaining life depreciation rates and the ten-year amortization of a recognized intrastate reserve deficiency. Beginning in 1990, the Company began a phase-in of equal life group rates for determination of intrastate depreciation. Beginning in 1992, the Company is implementing a cyclical review plan under which the depreciation rate parameters of various classes of plant are under examination on a triennial basis. For the years 1993, 1992, and 1991 depreciation expressed as a percentage of average depreciable plant was 7.4%, 7.3% and 7.0%, respectively. (b) 1991 data includes amortization of the undepreciated balance and retirement of investment in tools and equipment costing less than five hundred dollars but more than two hundred dollars purchased prior to January 1, 1988. 1991 also includes $442.4 in retirements of customer premises wiring assets fully amortized. XXX BEGIN PAGE 45 HERE XXX Schedule VIII MICHIGAN BELL TELEPHONE COMPANY SCHEDULE VIII - ALLOWANCE FOR UNCOLLECTIBLES (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Additions Balance at Charged Charged to Balance at beginning to other Other end of Classification of period expense accounts(a) Deductions(b) period Year 1993 . . . . . . $ 40.6 $ 42.7 $ 57.5 $ 95.9 $ 44.9 Year 1992 . . . . . . . . 38.2 36.4 50.4 84.4 40.6 Year 1991. . . . . . . $ 72.4 $ 34.9 $ 51.2 $120.3 $ 38.2 (a) Includes principally amounts previously written off which were credited directly to this account when recovered and amounts related to interexchange carrier receivables which are being billed by the Company. (b) Amounts written off as uncollectible.

101063_1993.txt

101063_1993

1993

101063

ITEM 1 - BUSINESS GENERAL Chiquita Brands International, Inc. ("Chiquita" or the "Company") is a leading international marketer, processor and producer of quality fresh and processed food products. In recent years, the Company has capitalized on its "Chiquita" and other premium brand names by building on its worldwide leadership position in the marketing, distribution and sourcing of bananas; by expanding its quality fresh fruit and vegetable operations; and by further developing its business in value-added processed foods. Chiquita's products include: - Bananas, citrus, grapes, kiwi, mangos, pears and pineapples sold under the "Chiquita" brand name; - Bananas, citrus and other quality fresh fruit including apples, grapes, papaya, peaches, pears, plums, strawberries and tomatoes sold under the "Consul," "Chico," "Amigo," "Frupac" and other brand names; - A wide variety of fresh vegetables including asparagus, beans, broccoli, carrots, celery, lettuce, onions and potatoes sold under the "Premium" and various other brand names; - Fruit and vegetable juices and other processed fruits and vegetables, including banana puree, marketed under the "Chiquita," "Friday" and other brands; - Wet and dry salads sold under the "Club Chef," "Chef Classic" and "Naked Foods" brands; and - Margarine, shortening and other consumer packaged foods sold under the "Numar," "Clover" and various regional brand names. No individual customer accounted for more than 10% of the Company's consolidated net sales during any of the last three years. See "Management's Analysis of Operations and Financial Condition," which is incorporated by reference in Item 7 herein from the Company's 1993 Annual Report to Shareholders, for a discussion of factors affecting results of the Company's operations for 1993, 1992 and 1991. Factors which may cause fluctuations in the results of operations are also discussed in the description of the Company's operations below. Fresh food products The Company markets an extensive line of fresh fruits and vegetables sold under the "Chiquita" and other brand names. The core of Chiquita's fresh foods operations is the marketing, distribution and sourcing of bananas. Sales of bananas, as a percent of consolidated net sales, were 67% in 1991, 62% in 1992 and 58% in 1993. Chiquita believes that it derives competitive benefits in the marketing, distribution and sourcing of fresh foods through its: - Recognized brand names and reputation for quality; - Strong market position in Europe, North America and Japan, the world's principal markets for fresh fruit; - Modern, cost-efficient fresh fruit transportation system; and - Industry leading position in terms of number and geographic diversity of its sources of bananas, which enhances its ability to provide customers with premium quality products on a consistent basis. Chiquita has benefitted from its multi-year investment spending program and the ongoing effects of its restructuring and cost reduction efforts to adjust its fresh foods volume and cost infrastructure to significantly reduce production, distribution and overhead costs. (See "Distribution and Logistics" and "Sourcing" below and ITEM 2 ITEM 2 - PROPERTIES The Company owns approximately 132,000 acres and leases approximately 46,000 acres of improved land, principally in Costa Rica, Panama and Honduras. Substantially all of this land is used for the cultivation of bananas and oil palm and support activities, including the maintenance of floodways. The Company also owns power plants, packing stations, warehouses, irrigation systems and loading and unloading facilities used in connection with its banana and oil palm operations. The Company owns or controls under long-term bareboat leases 23 ocean-going refrigerated vessels, including 1 delivered in early 1994, and has 21 additional such vessels under time charters, primarily for transporting tropical fruit sold by the Company. From time to time, excess capacity may be chartered or subchartered to others. In addition, the Company enters into spot charters as necessary to supplement its transportation resources. The Company also owns or leases other related equipment, including refrigerated container units, used to transport fresh food. The majority of the ships owned and related container units are pledged as collateral for related financings. Properties used by the Company's processed foods operations include processing facilities in Costa Rica and Honduras, and vegetable canning facilities in Wisconsin. Other operating units of the Company own, lease and operate properties, principally in the United States and Central and South America. The Company leases the space for its executive offices in Cincinnati, Ohio. For further information with respect to the Company's physical properties, see the descriptions under ITEM 1 - BUSINESS - GENERAL and DISCONTINUED OPERATIONS, above, and Notes 6 and 7 to the Consolidated Financial Statements included in the Company's 1993 Annual Report to Shareholders. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS A number of legal actions are pending against the Company, including those described below and in ITEM 1 - BUSINESS - DISCONTINUED OPERATIONS affecting the Meat Division, which is reported as a discontinued operation. Based on evaluations of facts which have been ascertained and opinions of counsel, management does not believe such litigation will, individually or in the aggregate, have a material adverse effect on the consolidated financial condition or results of operations of the Company. The Company and other major banana producing companies have been added as defendants in two purported class actions, filed in state courts in Galveston and Brazoria counties, Texas, and in three other Texas state court cases. These cases were originally filed in early 1993 against the manufacturers of an agricultural chemical called DBCP by an aggregate of approximately 20,000 individuals. Most of the plaintiffs are foreign citizens who claim to have been employees of banana companies, including in some cases subsidiaries of the Company. The plaintiffs allege they were injured as a result of exposure to DBCP, which was used primarily in the 1970's. The damage claims have not been quantified. The suits are Franklin Rodriguez Delgado, et al. v. Shell Oil Company, et al., Cause No. 93-CV-0030 (Galveston County, Texas); Armando Ramos Bermudez, et al. v. Shell Oil Company, et al., Cause No. 93-C-2290 (Brazoria County, Texas); Narcisco Borja, et al. v. Dow Chemical Company, et al., Cause No. 93-320 (Dallas County, Texas); Juan Ramon Valdez, et al. v. Shell Oil Company, et al., Cause No. 17814 (Morris County, Texas); and Ramon Rodriguez Rodriguez, et al. v. Shell Oil Company, et al., Cause No. 3813 (Jim Hogg County, Texas). Similar suits have been filed in Costa Rica and Panama by approximately 800 individuals against subsidiaries of the Company, including Compania Palma Tica and Compania Bananera Atlantica Limitada. Similar suits have been filed in other countries against other defendants as well. The Company has answered all suits, believes it has substantial and meritorious defenses and is vigorously defending the actions. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information concerning the number of shareholders at March 1, 1994, and the market for the Company's capital stock is set forth on the inside back cover of the Company's 1993 Annual Report to Shareholders under "Investor Information." Information concerning the price ranges of the Company's capital stock and dividends declared thereon is set forth in Note 15 to the Consolidated Financial Statements included in the 1993 Annual Report to Shareholders. Information concerning restrictions on the Company's ability to declare and pay dividends is set forth in Note 8 to the Consolidated Financial Statements included in the 1993 Annual Report to Shareholders. All such information is incorporated herein by reference. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA This information is included in the table entitled "Selected Financial Data" on page 6 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This information is included under the caption "Management's Analysis of Operations and Financial Condition" included on pages 8 through 10 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of Chiquita Brands International, Inc. and its subsidiaries included on pages 11 through 23 of the Company's 1993 Annual Report to Shareholders, and "Quarterly Financial Data" which is set forth in Note 15 to such Consolidated Financial Statements, are incorporated herein by reference. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Except for information relating to the Company's executive officers set forth in ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company are: Carl H. Lindner (age 74) - Mr. Lindner has been Chairman of the Board of Directors and Chief Executive Officer of the Company since August 1984 and Chairman of the Board of Directors and Chief Executive Officer of AFC since AFC was founded over 30 years ago. AFC is a holding company which, through subsidiaries, is engaged in several financial businesses, including property and casualty insurance, annuities, and portfolio investing. In nonfinancial areas, AFC has substantial operations in the food products industry, through its ownership in Chiquita, in television and radio station operations, through its ownership of Great American Communications Company ("GACC"), and in industrial manufacturing. Keith E. Lindner (age 34) - Mr. Lindner has been President and Chief Operating Officer of the Company since June 1989 and President of its Chiquita Brands, Inc. subsidiary since December 1986. He was Senior Executive Vice President of the Company from March 1986 to June 1989. Fred J. Runk (age 51) - Mr. Runk has been a Vice President of the Company since September 1984. From September 1984 to March 1994 he served as the Company's Chief Financial Officer. From February 1985 until June 1988, he was also Treasurer of the Company. Mr. Runk has served as Vice President and Treasurer of AFC for more than five years. Steven G. Warshaw (age 40) - Mr. Warshaw was named Chief Financial Officer of the Company in March 1994. He has also served as the Company's Executive Vice President and Chief Administrative Officer since January 1990. Mr. Warshaw has been employed by the Company in various executive capacities since April 1986. Robert F. Kistinger (age 41) - Mr. Kistinger was named Senior Executive Vice President of the Company's Chiquita Banana Group in February 1994. From March 1989 until February 1994, he was Executive Vice President, Operations of the Company's Chiquita Tropical Products Division. Mr. Kistinger has been employed by the Company in various capacities since 1980. Thomas E. Mischell (age 46) - Mr. Mischell has served as a Vice President of the Company since July 1986 and has served as Vice President of AFC for more than five years. Charles R. Morgan (age 47) - Mr. Morgan has been Vice President, General Counsel and Secretary of the Company since January 1990. Mr. Morgan has also served as Vice President, General Counsel and Secretary of Chiquita Brands, Inc. since June 1988 and as Vice President and Secretary of Morrell since February 1989. From February 1989 to July 1993, he was also General Counsel of Morrell. Jos P. Stalenhoef (age 52) - Mr. Stalenhoef was named President, Chiquita Banana-North American Division in February 1994. From March 1989 until February 1994, he was Senior Vice President, North America, Chiquita Tropical Products Division. Prior to that time, Mr. Stalenhoef was Vice President, Marketing, Chiquita Tropical Products Division. William A. Tsacalis (age 50) - Mr. Tsacalis has served as Vice President and Controller of the Company since November 1987. In December 1993, GACC completed a comprehensive financial restructuring which included a prepackaged plan of reorganization filed in November of that year under Chapter 11 of the Bankruptcy Code. Carl H. Lindner and Fred J. Runk were executive officers of GACC within two years before GACC's bankruptcy reorganization. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements of the Company and the Report of Independent Auditors are included in the Company's 1993 Annual Report to Shareholders and are incorporated by reference in Part II, Item 8: Page of Annual Report Report of Independent Auditors 7 Consolidated Statement of Income Years ended December 31, 1993, 1992 and 1991 11 Consolidated Balance Sheet December 31, 1993 and 1992 12 Consolidated Statement of Shareholders' Equity Years ended December 31, 1993, 1992 and 1991 13 Consolidated Statement of Cash Flow Years ended December 31, 1993, 1992 and 1991 14 Notes to Consolidated Financial Statements 15 2. Financial Statement Schedules The following consolidated financial statement schedules of the Company, which exclude amounts relating to its discontinued operations, are included in this Annual Report on Form 10-K: Page of Form 10-K II - Amounts Receivable from Related Parties, and Underwriters, Promoters, and Employees Other Than Related Parties V - Property, Plant and Equipment 18 VI - Accumulated Depreciation of Property, Plant and Equipment VIII - Allowance for Doubtful Accounts Receivable 20 IX - Short-term Borrowings 21 X - Supplementary Income Statement Information 22 All other schedules are not required under the related instructions or are inapplicable and, therefore, have been omitted. 3. Exhibits See Index of Exhibits (page 23) for a listing of all exhibits filed with this Annual Report on Form 10-K. (b) There were no reports on Form 8-K filed by the Company during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 on March 30, 1994. CHIQUITA BRANDS INTERNATIONAL, INC. By /s/ Carl H. Lindner Carl H. Lindner Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated below on March 30, 1994: /s/ Carl H. Lindner Chairman of the Board and Carl H. Lindner Chief Executive Officer /s/ Keith E. Lindner Director; President and Keith E. Lindner Chief Operating Officer /s/ S. Craig Lindner Director S. Craig Lindner Hugh F. Culverhouse* Director Hugh F. Culverhouse /s/ Fred J. Runk Director and Vice President Fred J. Runk Jean H. Sisco* Director Jean H. Sisco /s/ Ronald F. Walker Director Ronald F. Walker /s/ Steven G. Warshaw Executive Vice President, Chief Administrative Steven G. Warshaw Officer and Chief Financial Officer /s/ William A. Tsacalis Vice President and Controller William A. Tsacalis (Chief Accounting Officer) * By /s/ William A. Tsacalis Attorney-in-Fact** ** By authority of powers of attorney filed with this annual report on Form 10-K. (This page left blank intentionally.) CHIQUITA BRANDS INTERNATIONAL, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS (In thousands) Short-term borrowings include borrowings in currencies other than the U.S. dollar carrying interest rates which generally are higher than interest rates on U.S. dollar debt. Average outstanding borrowings during each year were determined based on the amounts outstanding at the end of each month during the year. The weighted average interest rate during each year was computed by dividing actual interest expense on short-term borrowings in each year by average short-term borrowings in such year. CHIQUITA BRANDS INTERNATIONAL, INC. AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) CHIQUITA BRANDS INTERNATIONAL, INC. Index of Exhibits Exhibit Number Description 3-a The Company's Certificate of Incorporation *3-b The Company's By-Laws, filed as Exhibit 3-b to Annual Report on Form 10-K for the year ended December 31, 1992 4 Registrant has no outstanding debt issues exceeding 10% of the assets of Registrant and its consolidated subsidiaries. The Registrant will furnish to the Securities and Exchange Commission, upon request, copies of all agreements and instruments defining the rights of security holders for debt issues not exceeding 10% of the assets of Registrant and its consolidated subsidiaries. 10-a Lease of Lands and Operating Contract between United Brands Company, Chiriqui Land Company, Compania Procesadora de Frutas and the Republic of Panama, dated January 8, 1976, effective January 1, 1976 10-b Agreement dated April 22, 1976 effective January 1, 1976 between Tela Railroad Company and the Government of Honduras Executive Compensation Plans *10-c 1986 Stock Option and Incentive Plan, filed as Exhibit A to the definitive Proxy Statement in connection with the Company's 1992 Annual Meeting of Shareholders *10-d Individual Stock Option Plan and Agreement, filed as Exhibit 4 to Registration Statement on Form S-8 No. 33- 25950 dated December 7, 1988 *10-e Deferred Compensation Plan, filed as Exhibit 10-e to Annual Report on Form 10-K for the year ended December 31, 1992 11 Computation of Earnings Per Common Share 12 Computation of Ratios of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends 13 Chiquita Brands International, Inc. 1993 Annual Report to Shareholders (pages 6 through 23 and inside back cover) 21 Subsidiaries of Registrant 23 Consent of Independent Auditors 24 Powers of Attorney 99 Annual Reports on Form 11-K for the Chiquita Savings and Investment Plan and the John Morrell & Co. Salaried Employees Incentive Savings Plan for 1993 will be filed by amendment on or before June 29, 1994. * Incorporated by reference.

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Item 2 Properties 9 Item 3 Item 3 Legal Proceedings 10 Item 4 Item 4 There has been no submission of matters to a vote of shareholders during the quarter ended December 31, 1993. PART II Item 5 Item 6 Selected Financial Data 11 Item 7 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operation 11-30 Item 8 Item 8 Financial Statements and Supplementary Data: Consolidated Statements of Condition - December 31, 1993 and 1992 31 Consolidated Statements of Earnings - Years Ended December 31, 1993, 1992, and 1991 32 Consolidated Statements of Changes in Stockholders' Equity - Years Ended December 31, 1993, 1992, and 1991 33 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992, and 1991 34 Notes to Consolidated Financial Statements 35-46 Independent Auditors' Report 47 Item 9 Item 9 There has been no disagreement with accountants on accounting and financial matters. CROSS REFERENCE INDEX PART III Item 10 Item 11 Executive Compensation * Item 12 Item 12 Security Ownership of Certain Beneficial Owners and Management * Item 13 Item 13 Certain Relationships and Related Transactions * PART IV Item 14

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Item 1. Business. United Parcel Service of America, Inc., through subsidiaries, provides specialized transportation services, primarily through the delivery of packages. Service is offered throughout the United States and in more than 185 other countries and territories around the world. In terms of revenue, UPS is the largest package delivery company in the world. During 1993 UPS delivered approximately 2.9 billion packages. UPS currently has approximately 1.3 million customer locations in the United States to which it provides daily pickup services. With minor exceptions, UPS Common Stock is owned by or held for the benefit of managers and supervisors actively employed by UPS, or their families; or by former employees, their estates or heirs; or by charitable foundations established by UPS founders and their family members; or by other charitable organizations which have acquired their stock by donations from shareowners. UPS stock is not listed on a national securities exchange or traded in the organized over-the-counter markets. When used herein the term "UPS" refers to United Parcel Service of America, Inc., a Delaware corporation, and its subsidiaries. Delivery Service in the United States Ground Services UPS is engaged primarily in the delivery of packages. During 1993, the packages delivered were up to a maximum of 70 pounds in weight, 108 inches in length and 130 inches in length and girth combined. Effective February 1994, UPS increased the weight limit to 150 pounds. UPS provides interstate and intrastate ground service to every address in the 48 contiguous states and between those states and Hawaii and Alaska. In Hawaii, an intra-island service is provided between addresses on Oahu and an inter-island air service is offered between all islands of the state. In Alaska, an intrastate package delivery service is available throughout the state. In 1993, UPS introduced a new service called UPS 3 Day Select(SM). This service offers a money-back guarantee of third-business-day delivery, along with the ability to verify deliveries on the day of delivery. It meets customers' needs for a faster, more reliable delivery service than long-distance ground options at a lower cost than air services. UPS provides Hundredweight Service(SM) for ground shipments to all 48 contiguous states on an interstate basis. As of December 31, 1993, this service was also available intrastate in 39 states and the District of Columbia. Under this service, contract rates are established for multi-package shipments weighing in the aggregate 200 pounds or more and addressed to one consignee at one location on one day. Customers can realize savings on such shipments compared to regular ground service rates. In 1993, UPS Hundredweight volume grew over 20% from 1992, primarily due to the expansion of intrastate Hundredweight Service and the introduction of Weight Break Pricing. Weight Break Pricing offers rate incentives for shipments of over 500 pounds. UPS also provides UPS GroundSaver(SM) service offering special rates and services for business-to-business shipments to specified ZIP Codes. GroundSaver revenue for 1993 increased over 59% from 1992 due primarily to an expansion of its service territory to all 48 contiguous states and expanded incentive qualifications to include a broader range of customers. UPS's domestic ground volume decreased slightly during 1993. Much of the decline in volume occurred in residential deliveries, which followed rate increases for such deliveries. For a description of the rate increase, see "Item 1 -- Rates." However, due to a general rate increase in February 1993 (discussed below) and continued growth in UPS's higher margin services, such as UPS Hundredweight Service, during 1993, domestic ground revenues increased in 1993 by 6% over 1992. Domestic Air Services UPS provides domestic air delivery services known as "UPS Next Day Air(R)" and "UPS 2nd Day Air(R)," which are available throughout the United States and Puerto Rico. In 1993, UPS introduced UPS Prepaid Letter, which permits customers to purchase UPS Next Day Air and 2nd Day Air Letters in advance at lower prices. For both UPS Next Day Air and UPS 2nd Day Air, packages and documents are either picked up from shippers by UPS or are dropped off by shippers at Air Service Centers or Letter Centers located throughout UPS's service network. UPS offers guaranteed delivery by 10:30 a.m. for UPS Next Day Air Packages and Letters sent to areas covering over 76% of the U.S. population and noon delivery to areas covering over 89% of the U.S. population. In 1993, UPS began offering Next Day Air Saver, which is Next Day Air delivery in the afternoon -- by either 3 p.m. or 4:30 p.m., depending on location, at a slightly lower rate than 10:30 a.m. delivery. UPS also guarantees on-schedule delivery of UPS 2nd Day Air packages. UPS offers Saturday Delivery for UPS Next Day Air shipments to an area covering approximately 90% of all UPS customers. In 1993, UPS also began offering Saturday Pickup service of air shipments in all areas served by UPS Saturday delivery. Further, in 1993, UPS began accepting hazardous materials in its air services, for an additional charge. UPS offers UPS Next Day Air and UPS 2nd Day Air Hundredweight Service for package shipments totaling at least 100 pounds addressed to one consignee at one location on one day. 3 Day Select Hundredweight Service is also available. UPS Air Cargo Service provides two services designed to fill what would otherwise be unfilled capacity on regular UPS flights: the transportation of containerized and palletized cargo in available space on UPS flights; and aircraft charters when UPS planes are not being utilized by UPS. The volume of UPS's higher margin air services, such as UPS Next Day Air service, continued to grow during 1993. In 1993, UPS's air services' volume increased by 20% and revenues increased by 14%. To enable UPS to accommodate future demand for air delivery services, UPS plans to open a new regional air sorting facility in Rockford, Illinois. Regional air sorting facilities are currently located in Ontario, California, Philadelphia, Pennsylvania and Dallas, Texas. In 1993, UPS ordered thirty new Boeing 767 freighter aircraft and ten more 757 freighter aircraft, in addition to the twenty-one 757 freighter aircraft previously ordered, to meet anticipated future growth in air delivery volume. For a further description of UPS's properties, see "Item 2 Item 2. Properties. Operating Facilities During 1991, UPS moved its corporate office to Atlanta, Georgia. UPS is currently leasing portions of several office buildings and is occupying a portion of an owned office building. Completion of its new headquarters, which has an anticipated cost of $103 million, is scheduled to occur in 1994. Among UPS's principal operating facilities are those located in New York City, Uniondale (New York), Houston, Denver, Los Angeles, Chicago, Addison (Illinois), San Francisco, Minneapolis, Chelmsford (Massachusetts) and New Stanton (Pennsylvania). These operating facilities, having floor spaces which range from 300,000 to 1,000,000 square feet, have central sorting facilities, operating hubs and service centers for local operations. UPS is constructing a large hub facility near Chicago, Illinois. This facility, which will have floor space of approximately 1,900,000 square feet, is scheduled to commence operations in 1995. The estimated cost of this facility is $272 million. UPS also owns approximately 700 and leases approximately 1,000 other operating facilities throughout the territories it serves. The smaller of these facilities have vehicles and drivers stationed for the pickup of packages and facilities for sorting and transfer and delivery of packages. The larger of these facilities have additional facilities for servicing UPS vehicles and equipment, and employ specialized mechanical installations for the sorting and handling of packages. UPS's aircraft are operated in a hub and spokes pattern in the United States. UPS's principal air hub in the United States is located in Louisville, Kentucky, with regional air hubs in Philadelphia, Pennsylvania and Ontario, California. These hubs house facilities for sorting, transfer and delivery of packages. The Louisville hub handles the largest volume of packages for air delivery in the United States. The Louisville hub site also contains UPS's administrative offices for its airline operation, and its flight training school. UPS also is constructing a regional air hub in Dallas, Texas, which is scheduled for completion in 1994 at an anticipated cost of $35 million and has plans to construct a regional air hub in Rockford, Illinois. UPS's European air hub is located in Cologne, Germany. UPS's computer operations have been consolidated in a 400,000 square foot facility located on a 39 acre site in Mahwah, New Jersey. The construction of a 20,000-27,000 square foot addition of the facility is planned to commence in 1994. The addition will accommodate further expansions of up to 54,000 square feet. UPS has leased this facility for an initial term ending in 2019 for use as a data processing, telecommunications and opera- tions facility. UPS has also begun construction of a 165,000 square foot facility located on a 25 acre site in the Atlanta, Georgia area, which will serve as a backup to the main facility in New Jersey. The new facility, to be completed in 1995, will provide backup capacity in case a power outage or other disaster incapacitates the main data center, and it will also help meet future communication needs. Aircraft UPS operates a fleet of 458 aircraft. UPS's fleet at December 31, 1993 consisted of the following aircraft: An inventory of spare engines and parts is maintained for each aircraft. UPS is currently carrying out a retrofit program to refurbish more than 90 of its aircraft with state-of-the-art avionics equipment and a common cabin configuration. All of UPS's DC-8-71's, DC-8-73's, 747-100's and 757-200's meet Stage III federal noise standards. UPS is also replacing the three engines on each of the 727-100 aircraft with new, quieter engines to enable them to meet Stage III federal noise standards and to increase its ability to send the 727 aircraft to airports where local noise curfews prevent some aircraft from landing. UPS will perform modifications to existing engines to enable its eight 727-200 aircraft to achieve Stage III compliance. The current noise regulations do not impact the valuation of these aircraft as their depreciable lives all end before the final phase-in date for Stage III compliance in 1999. All other aircraft operated by UPS are not subject to Stage III noise regulations. During 1993, UPS ordered 30 new Boeing 767 freight aircraft with options to buy 30 more. Delivery of the first 767 is scheduled for 1995. UPS exercised its option under an agreement with The Boeing Corporation to purchase 15 757-200PF aircraft. The final airplanes under this agreement were delivered during 1993. UPS also entered into agreements with Boeing for the purchase of 31 additional 757-200PF aircraft, for delivery between 1994 and 1998. UPS has an option for additional aircraft, if required, for delivery between 1998 and 2001. Vehicles UPS owns and operates a fleet of approximately 132,000 vehicles, ranging in size from panel delivery cars to large tractors and trailers, including 1,540 temperature-controlled trailers owned by Martrac and 5,272 vehicles owned by UPS Truck Leasing, Inc. During 1993, approximately 4,000 package cars, tractors and trailers were purchased and approximately 3,000 older vehicles were retired. Item 3. Item 3. Legal Proceedings. While UPS is routinely involved in litigation relating to the conduct of its business, there are no pending legal proceedings which, individually or in the aggregate, are material to the business of UPS. UPS was subject to a tax audit by the United States Internal Revenue Service for the 1984 tax year. Information regarding the tax audit is incorporated herein by reference from Note 4 to the Consolidated Financial Statements filed herewith. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. PART II Item 5. Item 5. Market for the Registrant's Common Equity And Related Stockholder Matters. UPS is authorized to issue 900,000,000 shares of common stock, par value $.10 per share, of which 580,000,000 shares were issued and outstanding (including those shares held by UPS for distribution in connection with its stock plans) as of February 28, 1994. UPS is also authorized to issue 200,000,000 shares of preferred stock, without par value. No shares of preferred stock have been issued or are outstanding. Each share of UPS Common Stock is entitled to one vote in the election of directors and other matters, except that, generally, any shareowner, or shareowners acting as a group, who beneficially own more than 10 percent of the voting stock are entitled to only one one-hundredth of a vote with respect to each vote in excess of 10 percent of the voting power of the then outstanding shares of voting stock. Holders have no preemptive or other right to subscribe to additional shares. In the event of liquidation or dissolution, they are entitled to share ratably in the assets available after payment of all obligations. The shares are not redeemable by UPS except through UPS's exercise of the preferential right of purchase mentioned below and, in the case of stock subject to the UPS Managers Stock Trust, UPS's right of purchase in the circumstances described herein. Shareowners are entitled to such dividends as are declared by the Board of Directors. The policy of the UPS Board is to declare dividends each year out of current earnings. However, the declaration of future dividends is subject to the discretion of the Board of Directors in light of all relevant facts, including UPS's earnings, general business conditions and capital requirements. UPS Common Stock is not listed on a national securities exchange or traded in the organized over-the-counter market. The UPS Certificate of Incorporation provides that no outstanding shares of UPS capital stock entitled to vote generally in the election of directors may be transferred to any other person, except by bona fide gift or inheritance, unless the shares shall have first been offered, by written notice, for sale to UPS at the same price and on the same terms upon which they are to be offered to the proposed transferee. UPS has the right, within 30 days after receipt of the notice, to purchase all or a part of the shares at the price and on the terms offered. If it fails to exercise or waives the right, the shareowner may, within a period of 20 days thereafter, sell to the proposed transferee all, but not part, of the shares which UPS elected not to purchase, for the price and on the terms described in the offer. All transferees of shares hold their shares subject to the same restriction. Shares previously offered but not transferred within the 20 day period remain subject to the initial restrictions. Shares may be pledged or otherwise used for security purposes, but no transfer may be made upon a foreclosure of the pledge until the shares have been offered to UPS at the price and on the terms and conditions bid by the purchaser at the foreclosure. UPS, from time to time, has waived its right of first refusal to purchase its shares in order to permit managers and supervisors to purchase shares at the same price as UPS was willing to pay. The grant of waivers in these cases has been effected after considering the needs of UPS for purposes of the UPS Managers Incentive Plan and UPS's 1986 and 1991 Stock Option Plans ("Plans") and other corporate purposes and has been subject to those needs. Persons who purchase shares in this manner are required to deposit them in the UPS Managers Stock Trust. UPS notifies its shareowners periodically of its willingness to purchase shares at specified prices determined by the Board of Directors, in the event that shareowners wish to sell their shares. During 1993, UPS purchased 28,035,837 shares at an aggregate purchase price of approximately $535 million. In determining the prices, the Board considers a variety of factors, including past and current earnings, earnings estimates, the ratio of UPS Common Stock to debt of UPS, other factors affecting the business and outlook of UPS and general economic conditions, as well as opinions furnished from time to time by a bank and by two firms of investment counselors, each acting independently, as to the value of UPS shares. The Board has not followed any predetermined formula. It has considered a number of formulas commonly used in the evaluation of securities of closely held and of publicly held companies, but its decisions have been based primarily on the judgment of the Board of Directors as to the long-range prospects of UPS rather than what the Board considers to be the short-term trends relating to UPS or the values of securities generally. Thus, for example, the Board has not given substantial weight to short-term variations in average price-earnings ratios of publicly traded securities which at times have been considerably higher, and at other times, considerably lower, than those for UPS's securities. However, the Board's decision as to prices does take into account factors affecting generally the market prices of publicly traded securities, and prolonged changes in those prices could have an effect on the prices offered by UPS. One factor in determining the prices at which securities trade in the organized markets is that of supply and demand. When demand is high in relation to the shares which investors seek to sell, prices tend to increase, while prices tend to decrease when demand is low in relation to the shares being sold. To date, the UPS Board of Directors has not given significant weight to considerations of supply and demand in determining the price to be paid by UPS for its shares. UPS has had a need for many of its shares for purposes of awards under the Plans, and eligible managers and supervisors have purchased many other available shares. When the number of shares acquired by UPS exceeds the number needed for these purposes within a reasonable period, the excess shares are treated as authorized and unissued shares by UPS. During 1993, UPS determined that it had acquired its Common Stock in excess of the amount required to fund its Plan obligations. Accordingly, UPS constructively retired 15 million of those excess shares on June 30, 1993 which reduced "Common Stock Held for Stock Plans" and "Shareowners' Equity" by $276 million. UPS intends to continue its policy of purchasing a limited number of shares when offered by shareowners. However, there can be no assurance of continuation of that policy. The feasibility of purchases by UPS and the prices at which shares may be purchased are both subject to the continued maintenance by UPS of satisfactory earnings and financial condition. Hence, both the salability of UPS shares and the prices at which they may be sold would be adversely affected by a continuous decline of UPS's earnings or by unfavorable changes in its financial position and might be adversely affected by decisions of shareowners to sell substantially more shares than the Board considers necessary for the ultimate purpose of making awards under the Plans. The prices at which UPS has published notices of its willingness to purchase shares of Common Stock since January 1992 have been as follows: On February 17, 1994, UPS expressed its willingness to purchase shares at $21.25 per share, which is still the price at the date of this report. In February 1994, UPS distributed an aggregate of 6,325,902 shares of UPS Common Stock, subject to the UPS Managers Stock Trust, under the UPS Managers Incentive Plan to a total of 28,096 employees at a managerial or supervisory level. In February 1993, it distributed an aggregate of 7,214,509 shares of UPS Common Stock under that Plan to a total of 26,596 managerial or supervisory employees. The UPS Managers Stock Trust and the Managers Incentive Plan have been previously described in the UPS Registration Statement on Form 10 and in the UPS Prospectus, dated February 1, 1994, relating to the UPS Managers Incentive Plan awards. Such distributions do not represent "sales" as defined under the Securities Act of 1933, as amended (the "1933 Act"). However, the shares awarded were registered under the 1933 Act to permit resales of the shares consistent with the interpretations of the Securities and Exchange Commission under Rule 144 adopted under the 1933 Act. During 1993, 1,167,638 shares of UPS Common Stock were distributed to 1,228 employees upon the exercise of stock options granted to them by UPS under the 1986 Stock Option Plan. In addition, a total of 3,642,972 shares of UPS Common Stock were sold, pursuant to a stock offering by UPS, to 15,028 UPS managers and supervisors. The offering has been previously described in the UPS Registration Statement on Form S-3 (No. 33-5582), which became effective in the summer of 1986. The shares issued upon exercise of the options and the shares purchased pursuant to the offering are subject to the UPS Managers Stock Trust. Shares of UPS Common Stock issued to employees under the Plans and most other shares of UPS Common Stock owned by UPS employees are held subject to the UPS Managers Stock Trust (the "Trust"). First Fidelity Bank ("Fidelity") serves as trustee under the Trust. The Trust agreement gives UPS the right to purchase the shares of UPS Common Stock of members deposited in the Trust at their fair market value, as defined, when the member retires, dies or ceases to be an employee of UPS, or when the member requests the withdrawal of shares from the Trust. Fair market value is defined as the fair market value of the shares at the time of the sale, or in the event of differences of opinion as to value, the average price per share of all shares of UPS sold during the 12 months preceding the sale involved. UPS becomes entitled to purchase shares of UPS Common Stock held under the Trust within 60 days of a request from the member to release the shares from the Trust and upon occurrence of the other enumerated events. The time during which UPS may purchase shares of UPS Common Stock following the cessation of employment varies from three years to thirteen years, depending upon the number of shares held by the employee and the date of the applicable trust agreement. In the event UPS fails to exercise its option within the prescribed periods, the employee would become entitled, upon request, to the delivery of the shares of UPS Common Stock free and clear of the Trust, unless the purchase period has been extended by agreement of UPS and the shareowner. UPS has consistently exercised its purchase rights. Members of the Trust are entitled to the dividends on shares of UPS Common Stock held for their accounts (except that stock dividends are added to the shares held by the Trustee for the benefit of the individual members), to direct the Trustee as to how the shares held for their benefit are to be voted and to request proxies from the Trustee to vote shares held for their accounts. In June 1993, UPS paid a cash dividend of $.25 a share, and in January 1994, $.25 a share. In June 1992, UPS paid a cash dividend of $.25 a share, and in December 1992, $.25 a share. UPS intends to continue its policy of paying dividends to its shareowners. However, the declaration of future dividends is subject to the discretion of the Board of Directors in light of all relevant facts, including earnings, general business conditions and working capital requirements. Loan agreements, to which UPS is a party, limit the amount which UPS may declare as dividends and use for the repurchase of its Common Stock. The most restrictive of these agreements limits the declaration of dividends, other than stock dividends, and payments for the purchase of Common Stock to the extent that such declarations and payments, together with all other payments made subsequent to January 1, 1985 would exceed, in the aggregate, (i) $250,000,000, (ii) 66-2/3% of net income, as defined in the agreement, and (iii) the net proceeds from the issuance, sale or disposition of any shares of stock of UPS or any warrants or other rights to purchase such stock subsequent to January 1, 1985. As of December 31, 1993 UPS had approximately $695 million not subject to these restrictions. These limits do not materially restrict the declaration of dividends. Set forth below is the approximate number of record holders of equity securities of UPS as of February 28, 1994. Number of Title of Class Record Holders -------------- -------------- Common Stock of UPS, $.10 par value 2,466 Common Stock of UPS, $.10 par value, 42,162(1) subject to UPS Managers Stock Trust - ------------------------------------------------------------------------------ 1. Refers to beneficial owners. The record holder of the shares of Common Stock subject to the Trust is Saul & Co., as nominee for First Fidelity Bank, N.A., Newark, New Jersey, as Trustee. Item 6. Item 6. Selected Financial Data. - ----------------------------- (1) All per share amounts have been adjusted to reflect a 4-for-1 stock split effective September 6, 1991. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Operations 1993 Compared to 1992 Revenue increased $1.264 billion, or 7.7% during 1993 compared to 1992. For 1993, domestic revenue totaled $15.823 billion, an increase of $1.101 billion, or 7.5% over 1992, and international revenue totalled $1.960 billion, an increase of $163 million, or 9.1% over 1992. Domestic revenue increased as a result of favorable changes in rates and a shift toward higher yielding packages. Increases in published rates during the first quarter of 1993 ranged from 4.9% to 5.9% for domestic air shipments and averaged approximately 4.5% for domestic ground shipments. These increases offset a 0.6% decline in domestic volume during 1993. The increase in international revenue was attributable to higher volume, which was up 11.8%. However, the effect of the international volume increase on revenue was partially offset by a decrease in revenue per piece. This decrease resulted from competitive pressures and poor economic conditions in certain foreign markets along with currency exchange rate fluctuations with respect to the U.S. dollar and discounting in connection with efforts to build volume. Operating expenses increased by $1.084 billion, or 7.1%. The increase was primarily the result of increases in average pay rates and employee benefits. In November 1993, UPS entered into a new, four-year labor agreement with the International Brotherhood of Teamsters ("Teamsters"). The new agreement resulted in hourly increases in wages and employee benefits for senior drivers of $2.25 and $1.80, respectively, over the four-year term. The agreement will result in similar increases in wages and employee benefits for the Company's other Teamsters employees. Terms of the agreement were effective August 1, 1993. Operating profit for 1993 increased by $180 million, or 14.1%. This increase resulted primarily from higher revenue. Income before income taxes and cumulative effect of a change in accounting principle ("pre-tax income") increased by $162 million, or 12.8%. Domestic pre-tax income amounted to $1.698 billion, an increase of $153 million, or 9.9% over 1992 as a result of higher operating profit. The international pre-tax loss decreased by $10 million, or 3.5% bringing the international pre- tax loss to $267 million for 1993. This change resulted from improved export operations and favorable swings in currency exchange rates offset by declines in foreign domestic operations. The international pre-tax loss attributable to the foreign domestic operations increased by $71 million, or 68.2% primarily as a result of weak economic conditions and tough competition. The pre-tax loss associated with export operations decreased by $81 million, or 47.1% as a result of increased volume and the achievement of greater cost efficiencies in the international network. Export volume increased by 36.1% and 35.7% for international and U.S. origin, export shipments, respectively. UPS expects that the cost of operating its international business will continue to exceed revenue in the near future. The provision for income taxes increased by approximately $118 million, or 23.4%. This increase is a result of higher pre-tax income as well as an increase in the U.S. federal income tax rate, as described more fully in Note 7 to the Consolidated Financial Statements. Income before cumulative effect of a change in accounting principle increased by $45 million, or 5.8%. This increase resulted from the increase in pre-tax income, partially offset by the increase in the U.S. federal income tax rate. 1992 Compared to 1991 Revenue increased by $1.5 billion, or 10.0%, with $1.03 billion coming from increased domestic revenue and $472 million coming from increased international revenue. Increased domestic revenue resulted primarily from favorable changes in volume, rates and product mix. Domestic delivery volume increased 1.0%, while increases in published rates during the first quarter of 1992 ranged from 2.6% to 4.9% for domestic air shipments and averaged approximately 5.0% for domestic ground shipments. International revenue increased primarily from higher volume which was up 21.4% as a result of the Company's efforts to expand its international operations. Operating expenses increased by $1.47 billion, or 10.7%. The increase is primarily due to the additional delivery volume along with increases in average pay rates and employee benefits. As discussed in a following section titled "Changes in Accounting Methods" as well as Note 5 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 106 during 1992. In addition to the one-time cumulative effect discussed below, 1992 operating expenses were charged an additional $65 million as a result of adoption. Operating profit for the period increased by $27 million, or 2.1%. This resulted primarily from the increase in domestic revenues, partially offset by increased losses in international operations. Income before income taxes and cumulative effect of a change in accounting principle ("pre-tax income") increased $52 million, or 4.3%. Domestic pre-tax income was up $75 million over the prior year as a result of higher operating profit. This increase was offset by an increase in the international pre-tax loss of $23 million. Although the international loss trend in total is negative, the operating margin (defined here as operating expenses plus other income and expense, net, as a percent of revenue) improved to 115.4% in 1992 from 119.1% in 1991. Income before cumulative effect of a change in accounting principle increased by $65 million, or 9.3%. The increase resulted primarily from higher operating profit and a decrease in the effective income tax rate. The cumulative effect of a change in the method of accounting for postretirement benefits other than pensions is discussed in a following section titled "Changes in Accounting Methods" as well as Note 5 to the Consolidated Financial Statements. Liquidity and Capital Resources UPS believes that its internally generated funds, revolving credit facility and commercial paper program (discussed below) will provide adequate sources of liquidity and capital resources to meet its expected future short-term and long-term needs for the operation of its business, including anticipated capital expenditures of $1.8 billion for land, buildings, equipment and aircraft in 1994, as well as commitments for aircraft purchases through 2002. Additionally, UPS sold a long-term investment property for $45.6 million cash in January 1994. During the fourth quarter of 1993, UPS established a commercial paper program under which it may borrow up to $500 million on a short-term, unsecured basis at favorable rates. No amounts had been borrowed under this program as of December 31, 1993. An agent for the United States Internal Revenue Service ("IRS") has asserted in a report that UPS is liable for additional tax and possible penalties for the 1984 tax year. The assertion is based in large part on the theory that UPS is liable for tax on income of Overseas Partners Ltd. ("OPL"), a Bermuda company, which has reinsured excess value package insurance purchased by UPS's customers from unrelated insurers. The adjustments sought by the agent relating to package insurance are based on a number of inconsistent theories and range from $7.9 million of tax to $45.5 million of tax and estimated penalties. Management believes that the IRS positions are without merit and the eventual resolution of this matter will not have a material impact on the Company. No assessment has been made by the IRS with respect to 1984, and the Company is pursuing a protest before the IRS's Appeals Division against the imposition of any additional tax liability. The matter is awaiting a hearing before the IRS Appeals Division. The IRS has not proposed assessments for years subsequent to 1984, although the IRS may take positions similar to those in the report described above for periods after 1984. Changes in Accounting Methods Effective January 1, 1992, UPS adopted the provisions of Financial Accounting Standards Board Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires accrual of postretirement benefits, which include health care benefits, during the years an employee provides service. Additional information regarding this change in accounting method is included in Note 5 to the Consolidated Financial Statements. Effective January 1, 1993, UPS adopted the provisions of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). This statement prescribes an asset and liability approach for accounting for income taxes. FAS 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. Prior to January 1, 1993, and since 1987, UPS accounted for income taxes in accordance with Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" ("FAS 96"). The adoption of FAS 109 had no effect on net income for the year ended December 31, 1993. The adoption of FAS 109 did, however, affect the classification of deferred tax amounts on the balance sheet. As a result of these classification changes, the deferred tax asset at December 31, 1992 of $45 million has been offset against deferred tax liabilities. Additionally, $75 million of the net deferred tax liability of $1.471 billion has been segregated as a current liability at December 31, 1993. The change had no impact on liquidity or cash flow. Future Accounting Changes In November 1992, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires employers to recognize an obligation for certain postemployment benefits when certain conditions are met. Management does not anticipate that adoption of this standard will have a material effect on net income or shareowners' equity. The statement must be adopted by 1994, with earlier application encouraged. UPS will adopt the statement during 1994. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The standard will be adopted by UPS during the first quarter of 1994. The majority of the Company's investments which are within the purview of this standard are short-term cash equivalents. Because the Company has the intent and ability to hold these investments until maturity, Management does not expect adoption of this standard to have a material effect on net income or shareowners' equity. Item 8. Item 8. Financial Statements and Supplementary Data. Financial Statements The Financial Statements of UPS are filed together with this Report: see Index to Financial Statements, page, which is incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Information regarding the Directors of UPS presented under the captions "Stock Ownership" and "Compliance with Section 16(a) of the Securities Exchange Act" in UPS's definitive Proxy Statement for the Annual Meeting of Shareowners to be held on May 11, 1994, which will be filed with the Securities and Exchange Commission (the "SEC") by April 12, 1994, is incorporated herein by reference. Information concerning UPS's executive officers can be found in Part I, Item 1, of this Form 10-K under the caption "Executive Officers" in accordance with Instruction 3 of Item 401(b) of Regulation S-K and General Instruction G(3) of Form 10-K. Item 11. Item 11. Executive Compensation. Information in answer to this Item 11 is presented under the caption "Compensation of Directors and Executive Officers and Other Information" excluding the information under the captions "Report of the Officer Compensation Committee on Executive Compensation" and "Shareowner Return Performance Graph" in UPS's definitive Proxy Statement for the Annual Meeting of Shareowners to be held on May 11, 1994, which will be filed with the SEC by April 12, 1994, is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Information in answer to this Item 12 is presented under the caption "Stock Ownership" in UPS's definitive Proxy Statement for the Annual Meeting of Shareowners to be held on May 11, 1994, which will be filed with the SEC by April 12, 1994, is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. Information in answer to this Item 13 is presented under the captions "Certain Business Relationships" and "Common Relationships with Overseas Partners Ltd." in UPS's definitive Proxy Statement for the Annual Meeting of Shareowners to be held on May 11, 1994, which will be filed with the SEC by April 12, 1994, is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements. - See Index to Financial Statements and Financial Statement Schedules at page, which is incorporated herein by reference. 2. Financial Statement Schedules. - See Index to Financial Statements and Financial Statement Schedules at page, which is incorporated herein by reference. 3. List of Exhibits. - See Exhibit Index at page E-1, which is incorporated herein by reference. (b) Reports on Form 8-K. - No reports on Form 8-K were filed during the quarter ended December 31, 1993. (c) Exhibits required by Item 601 of Regulation S-K. - See Exhibit Index at page E-1, which is incorporated herein by reference. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, United Parcel Service of America, Inc. has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. UNITED PARCEL SERVICE OF AMERICA, INC. (Registrant) Date: March 23, 1994 By: /s/ Kent C. Nelson ------------------- Kent C. Nelson Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. - ------------------------------------------------------------------------------ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _______________________ EXHIBITS TO FORM 10-K ANNUAL REPORT FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 _______________________ UNITED PARCEL SERVICE OF AMERICA, INC. - ------------------------------------------------------------------------------ EXHIBIT INDEX E-1 E-2 E-3 E-4 E-5 E-6 E-7 E-8 UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES COMPRISING 8 AND 14(a) (2) OF ANNUAL REPORT ON FORM 10-K TO SECURITIES AND EXCHANGE COMMISSION THREE YEARS ENDED DECEMBER 31, 1993 UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the consolidated financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT Board of Directors and Shareowners United Parcel Service of America, Inc. Atlanta, Georgia We have audited the accompanying consolidated balance sheets of United Parcel Service of America, Inc. and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareowners' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index on page. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of United Parcel Service of America, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 7 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109, and in 1992, as discussed in Note 5, changed its method of accounting for postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106. DELOITTE & TOUCHE Atlanta, Georgia February 9, 1994 UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET December 31, 1993 and 1992 (000's omitted except share amounts) See notes to consolidated financial statements. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET December 31, 1993 and 1992 (000's omitted except share amounts) See notes to consolidated financial statements. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED INCOME Years Ended December 31, 1993, 1992 and 1991 (000's omitted except per share amounts) See notes to consolidated financial statements. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED SHAREOWNERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (000's omitted except per share amounts) UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (000's omitted) See notes to consolidated financial statements. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 1. SUMMARY OF ACCOUNTING POLICIES Basis of Financial Statements and Business Activities The accompanying consolidated financial statements include the accounts of United Parcel Service of America, Inc. and all of its subsidiaries (collectively "UPS"). All material intercompany balances and transactions have been eliminated. UPS concentrates its operations in the field of transportation services, primarily domestic and international package delivery. Revenue is recognized upon delivery of a package. Cash Equivalents Cash equivalents (short-term investments) consist of highly liquid investments which are readily convertible into cash. The carrying amount approximates fair value because of the short-term maturity of these instruments. Common Stock Held for Stock Plans UPS accounts for its common stock held for distribution pursuant to awards under the UPS Managers Incentive Plan and the UPS Stock Option Plan as a current asset. The liability for the amount of the annual managers incentive award is included in Accrued Wages and Withholdings. Common stock held in excess of current requirements is accounted for as a reduction in Shareowners' Equity. Property, Plant and Equipment Property, plant and equipment are carried at cost. Depreciation (including amortization) is provided by the straight-line method over the estimated useful lives of the assets, which are as follows: Vehicles - 9 years; Aircraft - 12 to 20 years; Buildings - 10 to 40 years; Leasehold Improvements - lives of leases; Plant Equipment - 8 1/3 years. Costs in Excess of Net Assets Acquired Costs in excess of net assets acquired are amortized over a 10- year period using the straight-line method. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 Income Taxes Deferred income taxes result primarily from the use of accelerated depreciation methods allowable for income tax purposes, certain differences in asset lives adopted for income tax purposes, temporary differences between the accrual and payment of employee compensation and investments in leveraged leases. UPS adopted Statement of Financial Accounting Standards No. ("FAS") 96, "Accounting for Income Taxes," in 1987, and FAS 109, "Accounting for Income Taxes," in 1993. The benefit of investment tax credits is amortized over seven years except investment tax credits from the investment in leveraged leases, which is amortized over the life of the lease. Capitalized Interest Interest incurred during the construction period of certain property, plant and equipment is capitalized until the underlying assets are placed in service, at which time amortization of the capitalized interest begins, straight-line, over the estimated useful lives of the related assets. Capitalized interest was $27,800,000, $26,500,000, and $21,000,000 for 1993, 1992 and 1991, respectively. 2. LONG-TERM DEBT Long-term debt as of December 31, consists of the following (000's omitted): UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 The debentures are not subject to redemption prior to maturity and are not subject to sinking fund requirements. Interest is payable semi-annually on the 1st of April and October. The industrial development bonds bear interest at either a daily, variable, or fixed rate. The average interest rates for 1993 and 1992 were 2.2% and 2.5%, respectively. The installment notes, mortgages and bonds bear interest at rates of 6.0% to 11.5%. The aggregate annual principal payments are summarized as follows (000's omitted): Based on the borrowing rates currently available to the Company for long-term debt with similar terms and maturities, the fair value of long-term debt is approximately $987,000,000 as of December 31, 1993. 3. COMMON STOCK SPLIT AND PER SHARE DATA During 1991, the UPS Board of Directors approved a resolution to split the outstanding common stock of the Company, four for one. The split was effected September 6, 1991 by distributing three additional shares of common stock for each share held as of the close of business on August 21, 1991. All appropriate references to shares and per share amounts have been retroactively restated in these financial statements to reflect this split. Per share amounts related to income are based on 580,000,000 shares in 1993, 595,000,000 shares in 1992 and 616,000,000 shares in 1991, as restated, and include Common Stock Held for Stock Plans. 4. LEGAL PROCEEDINGS AND COMMITMENTS UPS is a defendant in various lawsuits which arose in the normal course of business. In the opinion of management, none of these cases are expected to have a material effect on the financial condition of UPS. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 An agent for the United States Internal Revenue Service ("IRS") has asserted in a report that UPS is liable for additional tax and possible penalties for the 1984 tax year. The assertion is based in large part on the theory that UPS is liable for tax on income of Overseas Partners Ltd. ("OPL"), a Bermuda company, which has reinsured excess value package insurance purchased by UPS's customers from unrelated insurers. The adjustments sought by the agent relating to package insurance are based on a number of inconsistent theories and range from $7.9 million of tax to $45.5 million of tax and estimated penalties. Management believes that the IRS positions are without merit and the eventual resolution of this matter will not have a material impact on the Company. No assessment has been made by the IRS with respect to 1984, and the Company is pursuing a protest before the IRS's Appeals Division against the imposition of any additional tax liability. The matter is awaiting a hearing before the IRS Appeals Division. The IRS has not proposed assessments for years subsequent to 1984, although the IRS may take positions similar to those in the report described above for periods after 1984. UPS leases certain operating facilities and aircraft, the majority of which are from related parties, including various UPS employee benefit plans. These leases expire at various dates through 2018 and two of them require additional amounts based upon usage. Total aggregate minimum lease commitments are as follows (000's omitted): UPS maintains two credit agreements with a consortium of banks which provide revolving credit facilities of $500,000,000 each, with one expiring on June 13, 1994 and the other June 13, 1996. At December 31, 1993, there were no outstanding borrowings under these facilities. As of December 31, 1993, UPS has outstanding letters of credit totaling approximately $753,506,000 issued in connection with routine business requirements. At December 31, 1993, UPS had commitments outstanding for capital expenditures under purchase orders and contracts of approximately $4.1 billion, of which approximately $973 million is expected to be spent in 1994. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 5. EMPLOYEE BENEFIT PLANS UPS maintains the UPS Retirement Plan (the "Plan"). The Plan is a defined benefit plan which provides employees annual defined retirement benefits. The Plan is non-contributory and all employees who meet certain minimum age and years of service are eligible, except those covered by certain multi-employer plans provided for under collective bargaining agreements. The Plan provides for retirement benefits based on average compensation levels earned by employees during certain years of service preceding retirement. The Plan's assets consist primarily of publicly traded stocks and bonds. In addition, the Plan's assets include 8,052,840 and 4,721,840 shares of UPS common stock at December 31, 1993 and 1992, respectively. The actual earnings on the Plan's assets were $224,405,000, $124,661,000, and $168,027,000 in 1993, 1992 and 1991, respectively. UPS's funding policy is consistent with relevant federal tax regulations. Accordingly, UPS contributes amounts deductible for federal income tax purposes. Pension expense, consisting of various component parts, and certain assumptions used during the years ended December 31, is as follows (000's omitted): UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 The following schedule reconciles the funded status of the Plan with certain amounts included in the balance sheet as of December 31 (000's omitted): The Plan was amended during 1992 to reflect certain enhancements to benefits provided to participants under the Plan. The amendment to the Plan resulted in an increase in the projected benefit obligation at December 31, 1992 of $184,674,000 and an increase in pension expense for the year then ended of $42,400,000. UPS also contributes to several multi-employer pension plans for which the above information is not determinable. Amounts charged to operations for contributions to pension plans other than the Plan described above were $504,109,000, $428,282,000, and $402,911,000 during 1993, 1992 and 1991, respectively. UPS sponsors defined benefit postretirement medical plans that provide health care benefits to its retirees who meet certain eligibility requirements and who are not covered by multi-employer retirement plans. Generally, this includes employees with at least 10 years of service who have reached age 55 and will be receiving benefits from one of the Company's retirement plans. The Company has the right to modify or terminate certain of these plans. Historically, these benefits have been provided to retirees on a non-contributory basis, however, effective January 1, 1992, the Company made modifications which will likely result in cost sharing in the future for certain of its retirees. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 Prior to 1992, UPS has generally expensed the costs of these benefits on a current, "pay as you go" basis. During 1992, UPS adopted the provisions of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This Statement requires accrual of postretirement benefits, which include health care benefits, during the years an employee provides service. The effect of adoption resulted in a one-time "catch-up" charge during 1992 of approximately $248.9 million, after tax, representing the cumulative effect of the change as of January 1, 1992. In addition to the cumulative effect, adoption of this Statement resulted in additional charges to income in 1993 and 1992 of approximately $47.5 and $40.3 million, respectively, after tax, ($0.08 and $0.07 per share, respectively). Overall, net income for 1993 and 1992 was reduced $47.5 and $289.2 million, respectively, as a result of adoption ($0.08 and $0.49 per share, respectively). The accumulated postretirement benefit obligation at December 31, is detailed as follows (000's omitted): Net periodic postretirement benefit cost for 1993 and 1992 included the following components (000's omitted): UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 The significant assumptions used in determining postretirement benefit cost and the accumulated postretirement benefit obligation were as follows: Future benefit costs were forecasted assuming an initial annual increase of 11.25% for pre-65 medical costs and an increase of 10.25% for post-65 medical costs, decreasing to 7.25% for pre-65 and 6.25% for post-65 by the year 2001 and with consistent annual increases at those ultimate levels thereafter. A one percentage point increase in the annual trend rate would have increased the total accumulated postretirement benefit obligation at December 31, 1993, by $10.4 million and the aggregate of the service and interest components of the net periodic postretirement benefit costs for 1993 by $9.8 million. Plan assets consist primarily of publicly traded stocks and bonds. The Trust holding the Plan assets is not subject to income taxes. UPS's funding policy is consistent with relevant federal tax regulations. Accordingly, UPS contributes amounts deductible for federal income tax purposes. 6. MANAGEMENT INCENTIVE PLANS UPS maintains the UPS Managers Incentive Plan. Persons earning the right to receive awards are determined annually by either the Officer Compensation or the Salary Committees of the UPS Board of Directors. Awards consist primarily of UPS common stock and cash equivalent to the tax withholdings on such awards. The total of all such awards is limited to 15% of consolidated income before federal income taxes for the 12-month period ending each September 30, exclusive of gains and losses from the sale of real estate and stock of subsidiaries. In addition, the cumulative effect of a change in accounting principle was specifically excluded from the 1992 award calculation in accordance with a vote of shareowners. Amounts charged to operations were $217,784,000, $198,943,000, and $169,606,000, during 1993, 1992 and 1991, respectively. UPS maintains stock option plans. Originally, these plans were established to issue Book Value Shares. Book Value Shares were shares of UPS common stock with a stated value equal to the UPS book value per share as of the year end immediately preceding the date of option grant. Voting, dividends and liquidation rights for the Book Value Shares were the same as for other UPS common stock. UPS repurchased all Book Value Shares immediately after their issuance except that UPS deferred some repurchases from officers and directors for up to six months. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 Except in the case of death, disability, or retirement, options are exercisable only during a limited period after the expiration of five years from the date of grant but are subject to earlier cancellation or exercise under certain conditions. The number of options and option prices for Book Value Shares exercised under the Plans were 4,611,372 and $5.68 in 1992 and 4,896,588 and $5.47 in 1991. There were no Book Value Shares exercised during 1993. Compensation expense charged to operations related to exercise of these options was not material. No further shares may be issued under either the 1981 or 1986 plans. Options granted under the 1981 plan were either exercised or expired as of December 31, 1991. Prior to issuing options for any Book Value Shares, the 1991 Plan was amended during 1992 to change it to a Current Price Plan. Under a Current Price Plan, options are granted to purchase shares of UPS common stock at the current price of UPS shares as determined by the Board of Directors on the date of option grant. Unlike Book Value Shares, the optionee may continue to hold the shares of common stock received on exercise, subject to the terms of the UPS Managers Stock Trust. Persons earning the right to receive stock options under the 1991 plan are determined each year by either the Officer Compensation Committee or Salary Committee of the UPS Board of Directors. Options covering a total of 30,000,000 common shares may be granted during the five-year period ending in 1996. Also during 1992, an amendment was made to the 1986 plan to allow options on Book Value Shares issued during the period 1988 through 1991 to be converted to Current Price options in the ratio of three common shares for five Book Value Shares. Substantially all holders of unexpired options for Book Value Shares elected to convert to options for common stock as of December 31, 1992. Following is an analysis of options for shares of common stock issued and outstanding: Current Price options converted from Book Value options were issued with exercise prices equal to the published price of UPS common stock as of the year end immediately preceding the original date of grant. Options granted during 1993 and 1992 have an exercise price equal to the current price of a share of UPS common stock at the date of grant. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 The conversion of previously issued Book Value options resulted in a change for accounting purposes from a variable plan to a fixed plan. As a fixed plan, the difference between the exercise price and current price at the measurement date will be charged to operations over the remaining vesting periods of the options. Such charges totaled approximately $19,110,000 during 1993, leaving approximately $14,622,000 to be charged during the period 1994 to 1996. Under current accounting literature, no additional compensation will be recorded for appreciation of converted options or for the issue of new options. 7. INCOME TAXES Effective January 1, 1993, UPS adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, FAS 109 generally considers all expected future events other than enactments of changes in the tax law or rates. Previously, the Company used the FAS 96 asset and liability approach that gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. The adoption of FAS 109 had no effect on pre-tax income for the year ended December 31, 1993. Additionally, adoption of FAS 109 had no effect on retained earnings at January 1, 1993. During the third quarter of 1993, the maximum U.S. federal income tax rate for corporations was increased from 34% to 35% effective January 1, 1993. In addition to increasing the Company's income tax accruals for its 1993 current and deferred taxable income, the Company made a $31.8 million adjustment to reflect the effect of the rate change on its net deferred tax liabilities on January 1, 1993. The provision for income taxes for the years ended December 31, consists of the following (000's omitted): UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 Income before income taxes and cumulative effect of a change in accounting principle includes losses of foreign subsidiaries of $163,689,000, $114,941,000 and $92,541,000 for 1993, 1992 and 1991, respectively. A reconciliation of the statutory federal income tax rate to the effective income tax rate for the years ended December 31, consists of the following: Deferred tax liabilities and assets are comprised of the following at December 31, 1993 (000's omitted): The valuation allowance increased $60,000,000 during the year ended December 31, 1993. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 The tax effects of items included in the deferred tax provision for years prior to 1993, consist of the following (000's omitted): UPS has international loss carryforwards of approximately $385,100,000. Of this amount, $260,800,000 expires in varying amounts through 2000. The remaining $124,300,000 may be carried forward indefinitely. 8. OTHER ASSETS Other assets as of December 31, consist of the following (000's omitted): UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 Leveraged Leases The net investment in leveraged leases as of December 31, consists of the following (000's omitted): Unearned income on each leveraged lease is amortized to provide an approximate level rate of return when compared to UPS's unrecovered net investment. 9. DEFERRED TAXES, CREDITS AND OTHER LIABILITIES Deferred taxes, credits and other liabilities as of December 31, consist of the following (000's omitted): UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 10. SEGMENT AND GEOGRAPHIC INFORMATION UPS operates primarily in one industry segment, transportation services, which is comprised principally of domestic and international package delivery. Information about operations in different geographic segments for the years ended December 31, is shown below (000's omitted): Foreign operations include shipments which either originate in or are destined to foreign (non-U.S.) locations. Foreign revenues attributable to shipments which originated in the U.S. totaled $308,800,000, $255,666,000, and $190,568,000 in 1993, 1992 and 1991, respectively. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES (000's omitted) SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (A) Primarily represents foreign currency translation adjustments and transfers from construction in progress to other categories. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES (000's omitted) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES (000's omitted) Year Ended December 31, 1993 SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES (000's omitted) Year Ended December 31, 1993 SCHEDULE IX - SHORT-TERM BORROWINGS (A) (A) Borrowings from banks represent amounts borrowed under the Company's credit agreements with a consortium of banks. The Company may borrow on an unsecured basis under these agreements, with interest payable at a variable rate. (B) Calculated based upon the stated annual interest rate of 3.23% and the 30-day period during which the borrowing was outstanding during 1993. UNITED PARCEL SERVICE OF AMERICA, INC. AND SUBSIDIARIES (000's omitted) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (1) (Charged to operating expenses) Column A Column B (1) Items omitted were less than 1% of revenue

50217_1993.txt

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Item 1. BUSINESS ORGANIZATION Indianapolis Power & Light Company (IPL) is an operating public utility incorporated under the laws of the State of Indiana on October 27, 1926. IPL is a subsidiary of IPALCO Enterprises, Inc. (IPALCO). IPALCO is a holding company incorporated under the laws of the State of Indiana on September 14, 1983. All common stock of IPL is owned by IPALCO. GENERAL IPL is engaged primarily in generating, transmitting, distributing and selling electric energy in the City of Indianapolis and neighboring cities, towns, communities, and adjacent rural areas, all within the State of Indiana, the most distant point being about forty miles from Indianapolis. It also produces, distributes and sells steam within a limited area in such city. There have been no changes in the services rendered, or in the markets or methods of distribution, since the beginning of the fiscal year. IPL intends to do business of the same general character as that in which it is now engaged. No private or municipally-owned electric public utility companies are competing with IPL in the territory it serves. IPL operates under indeterminate permits subject to the jurisdiction of the Indiana Utility Regulatory Commission (IURC). Such permits are subject to revocation by the IURC for cause. The Public Service Commission Act of Indiana (the PSC Act), which provides for the issuance of such permits, also provides that if the PSC Act is repealed, indeterminate permits will cease and a utility will again come into possession of such franchises as were surrendered at the time of the issue of the permit, but in no event shall such reinstated franchise be terminated within less than five years from the date of repeal of the PSC Act. The electric utility business is affected by the various seasonal weather patterns throughout the year and, therefore, the operating revenues and associated operating expenses are not generated evenly by months during the year. IPL's electric system is directly interconnected with the electric systems of Indiana Michigan Power Company, PSI Energy, Inc., Southern Indiana Gas and Electric Company, Wabash Valley Power Association and Hoosier Energy Rural Electric Cooperative, Inc. Also, IPL and 28 other electric utilities, known as the East Central Area Reliability Group (the Group), are cooperating under an agreement which provides for coordinated planning of generating and transmission facilities and the operation of such facilities to provide maximum reliability of bulk power supply in the nine- state region served by the Group. In 1993, approximately 99.7% of the total kilowatthours sold by IPL were generated from coal, .2% from middle distillate fuel oil and .1% from secondary steam purchased from the Indianapolis Resource Recovery Project. In addition to use in oil-fired generating units, fuel oil is used for start up and flame stabilization in coal-fired generating units as well as for coal thawing and coal handling. IPL's long-term coal contracts provide for the supply of the major portion of its burn requirements through the year 1999, assuming environmental regulations can be met. The long-term coal agreements are with six suppliers and the coal is produced entirely in the State of Indiana (these six suppliers are located in the following counties: Clay, Daviess, Greene, Knox, Pike, Sullivan and Warrick, and are not affiliates of IPL). See Exhibits listed under Part IV Item 14(a)3(10). It is presently believed that all coal used by IPL will be mined by others. IPL normally carries a 70-day supply of coal and fuel oil to offset unforeseen occurrences such as labor disputes, equipment breakdowns, power sales to other utilities, etc. When strikes are anticipated in the coal industry, IPL increases its stockpile to an approximate 103-day supply. The combined cost of coal and fuel oil used in the generation of electric energy for 1993 averaged 1.151 cents per kilowatthour or $24.49 per equivalent ton of coal, compared with the 1992 average fuel cost for electric generation of 1.146 cents per kilowatthour or $24.55 per equivalent ton of coal. Fuel costs are expected to experience only moderate changes in the near future due to increased supplier productivity, the stabilizing of coal prices and a low dependency on oil. However, an acceleration of inflation and/or changes in laws, regulations or ordinances which impact the mining industry or place more restrictive environmental controls on utilities could have a detrimental effect on such prices. IPL has a long-term contract to purchase steam for use in its steam distribution system with Ogden Martin Systems of Indianapolis, Inc. (Ogden Martin). Ogden Martin owns and operates the Indianapolis Resource Recovery Project which is a waste-to- energy facility located in Marion County, Indiana. During 1993, IPL's steam system purchased 49.4% of its total therm requirement from Ogden Martin. Additionally, 33.3% of its 1993 one-hour peak load was met with steam purchased from Ogden Martin. IPL also purchased 3.2 million secondary therms which represent Ogden Martin send-out in excess of the IPL steam system requirements. Such secondary steam is used to produce electricity at the IPL Perry K and Perry W facilities. CONSTRUCTION The cost of IPL's construction program during 1993, 1992 and 1991 was $149.3 million, $115.3 million and $96.3 million, respectively, including Allowances for Funds Used During Construction (AFUDC) of $3.6 million, $3.2 million and $1.6 million, respectively. IPL's construction program is reviewed periodically and is updated to reflect among other things the changes in economic conditions, revised load forecasts and cost escalations under construction contracts. The most recent projections indicate that IPL will need about 800 megawatts (MW) of additional energy resources by the year 2000. IPL plans to meet this need through the combination of the use of Demand Side Management, power purchases, peaking turbines and base-load generation. During 1992, IPL entered into a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP), which will supply additional capacity for the near-term requirements. IPL receives 200 MW of capacity. IPL can also elect to extend the agreement through November 1999. See Item 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" under "Capital Requirements" for additional information regarding the IMP agreement. IPL's construction program for the five-year period 1994- 1998, is estimated to cost $1.0 billion including AFUDC. The estimated cost of the program by year (in millions) is $234.4 in 1994; $191.9 in 1995; $116.6 in 1996; $221.4 in 1997; and $251.8 in 1998. It includes $113.7 million for four 80 MW combustion turbines with in-service dates of 1994, 1995, 1998 and 1999, respectively, and $217.2 million for base-load capacity with in- service dates of 2000 and 2002, or beyond. The forecast also includes $284.4 million for additions, improvements and extensions to transmission and distribution lines, substations, power factor and voltage regulating equipment, distribution transformers and street lighting distribution. With respect to the expenditures for pollution control facilities to comply with the Clean Air Act and with respect to the regulatory authority of the IURC as it relates to the integrated resource plan, see "REGULATORY MATTERS" and Item 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS". FINANCING IPL's 1994-1998 long-term financing program anticipates sales of debt and equity securities totaling $447.7 million. The timing and amounts of such activities are contingent upon the timing and cost of any new capacity, as well as market conditions and other factors near the dates of the required financings. In addition to the sale of new securities, IPL has authority from the IURC to redeem and replace certain of its existing securities should favorable market conditions arise. Such action, if considered, may result in additional financing in the form of long-term debt. (With respect to restrictions on the issuance of certain securities, see Item 7, "LIQUIDITY AND CAPITAL RESOURCES".) EMPLOYEE RELATIONS As of December 31, 1993, IPL had 2,276 employees of whom 1,155 were represented by the International Brotherhood of Electrical Workers, AFL-CIO (IBEW) and 411 were represented by the Electric Utility Workers Union (EUWU), an unaffiliated labor organization. In December 1993, the membership of the IBEW ratified a new labor agreement which remains in effect until December 16, 1996. The agreement provides for general pay adjustments of 4% in 1993, 3.5% in both 1994 and 1995, and changes in pension and health care coverage. In March, 1992, the membership of the EUWU ratified a new labor agreement which remains in effect until February 27, 1995. The agreement provides for general pay adjustments of 4.5% in both 1992 and 1993, and 3% in 1994, as well as changes in health care coverage. REGULATORY MATTERS IPL is subject to regulation by the IURC as to its services and facilities, valuation of property, the construction, purchase or lease of electric generating facilities, classification of accounts, rates of depreciation, rates and charges, issuance of securities (other than evidences of indebtedness payable less than twelve months after the date of issue), the acquisition and sale of public utility properties or securities, and certain other matters. In addition, IPL is subject to the jurisdiction of the Federal Energy Regulatory Commission, in respect of short-term borrowings not regulated by the IURC, the transmission of electric energy in interstate commerce, the classification of its accounts and the acquisition and sale of utility property in certain circumstances as provided by the Federal Power Act. IPL is also subject to federal, state, and local environmental laws and regulations, particularly as to generating station discharges affecting air and water quality. The impact of such regulations on the capital and operating costs of IPL has been and will continue to be substantial. IPL's 1994-1998 construction program includes $335 million in environmental costs, including AFUDC, of which approximately $207 million pertains to the Clean Air Act. Accordingly, IPL has developed a plan to reduce sulfur dioxide and nitrogen oxide emissions from several generating units. This plan has been approved by the IURC. Annual costs for all air, solid waste, and water environmental compliance measures are $106 million and $112 million in 1994 and 1995, respectively. Item 2. Item 2. PROPERTIES IPL owns and operates five primarily coal-fired generating plants, three of which are used for total electric generation and two of which are used for a combination of electric and steam generation. In relation to electric generation, there exists a total gross nameplate rating of 2,885 MW, a winter capability of 2,862 MW and a summer capability of 2,829 MW. All figures are net of station use. In relation to steam generation, there exists a gross capacity of 2,290 Mlbs. per hour. Total Electric Stations: H. T. Pritchard plant (Pritchard), 25 miles southwest of Indianapolis (six units in service - one in 1949, 1950, 1951, two in 1953 and one in 1956) with 367 MW nameplate rating and net winter and summer capabilities of 344 MW and 341 MW, respectively. E. W. Stout plant (Stout) located in southwest part of Marion County (five units in service - one each in 1941, 1947, 1958, 1961 and 1973) with 771 MW nameplate rating and net winter and summer capabilities of 798 MW and 767 MW, respectively. Petersburg plant (Petersburg), located in Pike County, Indiana (four units in service - one each in 1967, 1969, 1977 and 1986) with 1,716 MW nameplate rating and net winter and summer capabilities of 1,690 MW and 1,690 MW, respectively. Combination Electric and Steam Stations: C.C. Perry Section K plant (Perry K), in the city of Indianapolis with 20 MW nameplate rating (net winter capability 20 MW, summer 19 MW) for electric and a gross capacity of 1,990 Mlbs. per hour for steam. C.C. Perry Section W plant (Perry W), in the city of Indianapolis with 11 MW nameplate rating (net winter capability 10 MW, summer 12 MW) for electric and a gross capacity of 300 Mlbs. per hour for steam. Net electrical generation during 1993, at the Petersburg, Stout and Pritchard stations accounted for about 74.9%, 19.6% and 5.5%, respectively, of IPL's total net generation. All steam generation by IPL for the steam system was produced by the Perry K and Perry W stations. Included in the above totals are three gas turbine units at the Stout station added in 1973 with a combined nameplate rating of 64 MW, one diesel unit each at Pritchard and Stout stations, and three diesel units at Petersburg station, all added in 1967. Each diesel unit has a nameplate rating of 3 MW. IPL's transmission system includes 454 circuit miles of 345,000 volt lines, 353 circuit miles of 138,000 volt lines and 275 miles of 34,500 volt lines. Distribution facilities include 4,686 pole miles and 19,785 wire miles of overhead lines. Underground distribution and service facilities include 436 miles of conduit and 4,900 wire miles of conductor. Underground street lighting facilities include 110 miles of conduit and 668 wire miles of conductor. Also included in the system are 74 bulk power substations and 85 distribution substations. Steam distribution properties include 22 miles of mains with 286 services. Other properties include coal and other minerals, underlying 798 acres in Sullivan County and coal underlying about 6,215 acres in Pike and Gibson Counties, Indiana. Additional land, approximately 4,722 acres in Morgan County, and approximately 884 acres in Switzerland County has been purchased for future plant sites. Item 3. Item 3. LEGAL PROCEEDINGS On March 16, 1993, Smith Cogeneration of Indiana, Inc., and its affiliates (Smith) filed a petition with the Indiana Utility Regulatory Commission (IURC) requesting that IPL be ordered to enter into a power sales agreement to purchase power from Smith's proposed 240 megawatt plant. On September 24, 1993, IPL filed a motion for summary adjudication of Smith's petition. This motion is currently pending, has been fully briefed and no further proceedings have been scheduled in this matter. In June 1993, IPL received a Notice of Violation from the Indianapolis Air Pollution Control Section (IAPCS) regarding fugitive dust emissions at its Perry K Generating Station. IPL met with IAPCS to discuss four alleged violations over a span of 15 months. Each violation was subject to a fine of up to $2,500. IPL agreed to a settlement in the amount of $3,500 for all violations, but settlement has not yet been finalized. On August 18, 1993, the IURC entered an order in Cause No. 39437, approving IPL's Environmental Compliance Plan to comply with the Clean Air Act Amendments of 1990. The estimated cost of IPL's Environmental Compliance Plan is approximately $250 million before including allowance for funds used during construction. A primary part of IPL's Plan, scrubbing IPL's Petersburg 1 and 2 coal-fired units by 1996 to enable IPL to continue to burn high sulfur coal, was opposed by the Office of Utility Consumer Counselor (OUCC), the Citizens Action Coalition, and the Industrial Intervenors Group (IIG). OUCC and IIG are in the process of appealing the Commission's order to the Indiana Court of Appeals. In October 1993, IPL received a Findings of Violation from EPA, Region V, regarding IPL's compliance with the thermal limitations of the NPDES (water discharge) permit under which IPL operates its Petersburg Generating Station. On February 20, 1992, IPL filed an application for renewal of that permit but the application has not been acted upon by the Indiana Department of Environmental Management. Although unclear to IPL, EPA's action seems to have resulted from its misinterpretation of data IPL supplied to EPA in response to the latter's Clean Water Act information request that preceded issuance of the Findings of Violation. IPL believes it continues to be in compliance with the requirements of the permit and has made continuing efforts to meet with EPA to discuss the matter. If IPL is found to be in violation of its permit, it could be subject to maximum fines of $25,000 per day per violation. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT AT FEBRUARY 22, 1994 Name, age (at December 31, 1993), and positions and offices held for the past five years: From To John R. Hodowal (48) Chairman of the Board February, 1990 Chief Executive Officer May, 1989 Executive Vice President April, 1987 May, 1989 Ramon L. Humke (61) President and Chief Operating Officer February, 1990 President and Chief Executive Officer of Ameritech Services and Senior Vice President of Ameritech Bell Group September, 1989 February, 1990 President and Chief Executive Officer of Indiana Bell Telephone Company October, 1983 September, 1989 John R. Brehm (40) Senior Vice President - Finance and Information Services May, 1991 Senior Vice President - Financial Services May, 1989 May, 1991 Treasurer August, 1987 May, 1989 Robert W. Rawlings (52) Senior Vice President - Electric Production May, 1991 Vice President - Electric Production May, 1989 May, 1991 Vice President - Engineering and Construction April, 1986 May, 1989 From To Gerald D. Waltz (54) Senior Vice President - Business Development May, 1991 Senior Vice President - Engineering and Operations April, 1986 May, 1991 Max Califar (40) Vice President - Human Resources December, 1992 Treasurer May, 1989 December, 1992 Assistant Controller July, 1987 May, 1989 Stephen J. Plunkett (45) Controller May, 1991 Assistant Controller May, 1989 May, 1991 PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS All common stock of IPL is owned by Enterprises and is not publicly traded on any stock exchange. Aggregate quarterly dividends paid on the common stock during 1993 and 1992 were as follows (in thousands): 1993 1992 First Quarter $18,445 $17,648 Second Quarter 19,209 18,399 Third Quarter 19,209 18,400 Fourth Quarter 19,209 18,443 The IPL Board of Directors at its meeting on February 22, 1994, declared a regular quarterly dividend on common stock of $19,979,921.98 in total, payable April 15, 1994. Dividend Restrictions So long as any of the several series of bonds of IPL issued under the Mortgage and Deed of Trust, dated as of May 1, 1940, as supplemented and modified, executed by IPL to American National Bank and Trust Company of Chicago, as Trustee, remain outstanding, IPL is restricted in the declaration and payment of dividends, or other distribution on shares of its capital stock of any class, or in the purchase or redemption of such shares, to the aggregate of its net income, as defined in Section 47 of such Mortgage, after December 31, 1939, available for dividends. The amount which these Mortgage provisions would have permitted IPL to declare and pay as dividends at December 31, 1993 exceeded retained earnings at that date. Such restrictions do not apply to the declaration or payment of dividends upon any shares of capital stock of any class to an amount in the aggregate not in excess of $1,107,155, or to the application to purchase or redemption of any shares of capital stock of any class of amounts not to exceed in the aggregate the net proceeds received by IPL from the sale of any shares of its capital stock of any class subsequent to December 31, 1939. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On a national basis, competition for wholesale and retail sales within the electric utility industry has been increasing. In Indiana, competition has been primarily focused on the wholesale power markets. Existing Indiana law provides for public utilities to have an exclusive permit at the retail level. The impact of continuing competitive pressures on IPL's wholesale and retail electric and steam markets cannot be determined at this time. Rate Matters Environmental Compliance Plan IPL is subject to the new air quality provisions specified in the federal Clean Air Act Amendments of 1990 and related regulations (the Act). During 1993, IPL obtained an order from the Indiana Utility Regulatory Commission (IURC) approving its environmental compliance plan, together with the costs and expenses associated therewith, which provides for the installation of sulfur dioxide and nitrogen oxide emissions abatement equipment and the installation of continuous emission monitoring systems to meet the requirements of both Phase I and Phase II of the Act - See "Capital Requirements". Certain intervenors in the hearing before the IURC have requested a transcript preparatory to an appeal of that order which appeal has not yet been perfected. As required by the Act, IPL filed its proposed compliance plan with the Environmental Protection Agency in February 1993. As provided in the Act, effective January 1, 1995, IPL is scheduled to receive annual emission "allowances" for certain of its generating units. Each allowance would permit the emission of one ton of sulfur dioxide. IPL presently expects that annual sulfur dioxide emissions will not exceed annual allowances provided to IPL under the Act. Allowances not required in the operation of IPL facilities may be reserved for future periods or sold. The value of such unused allowances that may be available to IPL for use in future periods or for sale is subject to a developing market and is unknown at this time. The IURC Order provides for the deferral of net gains and losses resulting from any sale of emission allowances for future amortization to cost of service on a basis to be determined in the next general retail electric rate proceeding. Demand Side Management Program On September 8, 1993, IPL obtained an order from the IURC approving a Stipulation of Settlement Agreement between IPL, the Office of Utility Consumer Counsel, Citizens Action Coalition of Indiana, Inc., an industrial group, the Trustees of Indiana University and the Indiana Alliance for Fair Competition relating to IPL's Demand Side Management Program (DSM). The order provides for the deferral and subsequent recovery in rates of certain approved DSM costs. The order also provides for the recording of a return on deferred costs until recognized in rates. Postretirement Benefits On December 30, 1992, the IURC issued an order authorizing Indiana utilities to account for postretirement benefits on the basis required by the Statement of Financial Accounting Standard No. 106 -- Accounting for Postretirement Benefits other than Pensions (SFAS 106). Generally, SFAS 106 requires the use of an accrual basis accounting method for determining annual costs of postretirement benefits. Prior to 1993, IPL used a pay-as-you-go method to account for such costs. IPL was required to adopt SFAS 106 effective January 1, 1993. Additionally, the order authorized the deferral of SFAS 106 costs in excess of such costs determined on a pay-as-you-go and the recording of a resulting regulatory asset. The order further provides for the recovery in rates of such costs in a subsequent general rate proceeding on an individual company basis in an amount to be determined in each such proceeding. IPL is deferring as a regulatory asset the non-construction related SFAS 106 costs associated with its electric business. IPL is expensing its non- construction related SFAS 106 costs associated with its steam business. Regulatory Asset Deferrals Balance sheet deferrals of regulatory assets for DSM, postretirement benefits, income taxes and other such costs amounted to $33.1 million in 1993. Future deferrals for such items are expected to increase due to SFAS 106, and DSM and related carrying charges until IPL's next retail electric rate order. Future Rate Relief IPL presently anticipates that it will petition the IURC to increase its electric rates and charges during 1994. A final IURC order on such a request may not occur until 1995. IPL's last authorized increase in electric rates and charges occurred in August, 1986. Steam Rate Order The IURC authorized IPL to increase its steam system rates and charges over a six-year period beginning January 13, 1993. Accordingly, IPL implemented new steam tariffs effective on that date which were designed to produce estimated additional annual steam operating revenues as follows: Capital Requirements The capital requirements of IPL are primarily driven by the need for facilities to ensure customer service reliability and environmental compliance and by the impact of maturing long-term debt. Forecasted Demand & Energy From 1994 to 1998, annual peak demand is forecasted to experience a compound 1.5% increase, while retail kilowatthour (KWH) sales are anticipated to increase at a 2.0% compound growth rate. Both compound growth rates are computed assuming normal weather conditions and include the effects of DSM. IPL expects a reduction of about 120 megawatts (MW) of annual peak demand by the year 2000 as a result of DSM programs. Integrated Resource Plan Sales growth projections indicate a need for about 800 MW of additional capacity resources by the year 2000. These resource requirements can be met in a variety of ways including, but not limited to, a combination of the use of DSM, power purchases, peaking turbines and base-load generation. IPL continues to review its integrated resource plan to consider the appropriateness of all resource options to meet capacity requirements over the decade of the 1990's and beyond. IPL has a well-defined, near-term integrated resource plan and is considering all reasonable options to meet its long-term capacity requirements. The following discussion makes certain assumptions regarding IPL's plans to meet these requirements. In order to maintain adequate summer capacity reserve margins in the near-term, IPL entered into a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP), which expires March 31, 1997. Under this agreement, IPL is receiving 200 MW of capacity. The agreement provides for monthly capacity payments by IPL of $1.2 million through March 31, 1997. IPL can terminate the agreement, should the ability to recover future demand charges through rates be disallowed. IPL and IMP will also exchange 50 MW of seasonal power over the 1995-1998 period. IPL plans to add two 80 MW combustion turbines with in-service dates in 1994 and 1995. Under Indiana law, IPL must obtain from the IURC a certificate of "public convenience and necessity" (Certificate) prior to purchasing or commencing construction of any new electric generation facility. IPL received Certificates from the IURC for construction of these combustion turbines during 1992. IPL is considering a variety of options to meet its long-term capacity requirements through the year 2000 including DSM, utility and nonutility power purchases, additional peaking turbines and base- load generating units. Presently, IPL plans to add two additional 80 MW combustion turbines with in-service dates in 1998 and 1999. IPL also has options to extend the 200 MW firm power purchase agreement with IMP through December 31, 1997 and subsequently through November 30, 1999, with capacity payments of $1.2 million per month and $1.55 million per month, respectively. Under a recent agreement, IPL has an option to purchase up to 250 MW from PSI Energy over the 1996 to 2000 period. IPL is also evaluating the installation, on a joint ownership basis, of two 426 MW base-load generating units to be placed in service in 2000 and 2002, respectively, or beyond. Of the total 852 MW, IPL proposes to own 400 MW, with other partners owning the remaining 452 MW. There is no assurance that IPL will be able to ultimately reach a joint ownership agreement with any other party. IPL has not applied for Certificates for the additional combustion turbines or the base load unit. Environmental Compliance Construction Requests IPL estimates that the capital cost of complying with the Act through 1997 will be approximately $240 million, including Allowance for Funds Used During Construction (AFUDC), of which $33.0 million has been expended prior to 1994. IPL further estimates that, subsequent to December 31, 1997, no significant capital expenditures will be required to bring generating units into compliance with the Act until the year 2010 or beyond. Cost of Construction Program The cost of IPL's construction program during 1993, 1992 and 1991 was $149.3 million, $115.3 million and $96.3 million, including AFUDC of $3.6 million, $3.2 million and $1.6 million, respectively. IPL estimates the cost of the construction program for the five years, 1994-1998, to be approximately $1.0 billion including AFUDC of $73.1 million. This program is subject to continuing review and is revised from time to time in light of changes in the actual customer demand for electric energy, IPL's financial condition and construction cost escalations. In addition to costs of environmental compliance, the five-year construction program includes $113.7 million for the four 80 MW combustion turbines and $217.2 million for the base-load capacity, mentioned above. Additional expenditures will be incurred beyond 1998 for the capacity with in- service dates subsequent to 1998. Transmission and substation facilities relating to the planned base-load capacity amount to $29.0 million in the five-year construction program. Expenditures for the new capacity are contingent upon the review of other long-term and near-term options previously discussed and subsequent receipt of the necessary Certificates. Retirement of Long-term Debt and Equity Securities During 1993, 1992 and 1991, IPL retired long-term debt, including sinking fund payments, of $96.9 million, $75.0 million and $96.4 million, respectively, which required replacement with other debt securities at a lower cost. IPL will retire $7.5 million, $15.0 million, $11.25 million and $18.75 million of maturing long-term debt during 1994, 1996, 1997 and 1998, respectively, which may require replacement in whole or in part with other debt or equity securities. In addition, other existing higher rate debt may be refinanced depending upon market conditions. Financing Financing Requirements During the three-year period ended December 31, 1993, IPL's permanent financing totaled $275.3 million in long-term debt. The net proceeds of these securities were used, along with internal funds, to retire existing long-term debt. All of IPL's construction expenditures during this three-year period were funded with internally generated cash and short-term debt. IPL's permanent financing requirements for the five-year period, 1994-1998, are forecasted to include additional sales of debt and equity securities totaling $447.7 million. This amount is highly contingent on the timing and cost of any new capacity. The timing, number and dollar amounts of such financings will depend on market conditions and other factors, including required regulatory approvals. In addition to the sale of new securities, IPL has authority from the IURC to redeem and replace certain of its existing securities, should favorable market conditions dictate. Internally generated funds supplemented by temporary short-term borrowings are forecasted to provide the remaining funds required for the five-year construction program. Uncertainties which could affect this forecast include the impact of inflation on operating expenses, the actual degree of growth in KWH sales, the level of interchange sales with other utilities and the receipt of Certificates required for new electric generation facilities. Mortgage Restrictions IPL is limited in its ability to issue certain securities by restrictions under its Mortgage and Deed of Trust (Mortgage) and its Amended Articles of Incorporation (Articles). The restriction under the Articles requires that the net income of IPL, as specified therein, shall be at least one and one-half times the total interest on the funded debt and the pro forma dividend requirements on the outstanding preferred stock and on any preferred stock proposed to be issued, before any additional preferred stock can be issued. The Mortgage restriction requires that net earnings as calculated thereunder be two and one-half times the annual interest requirements before additional bonds can be authenticated on the basis of property additions. Based on IPL's net earnings for the twelve months ended December 31, 1993, the ratios under the Articles and the Mortgage are 3.28 and 7.33, respectively. IPL believes these requirements will not restrict any anticipated future financings. RESULTS OF OPERATIONS 1993 vs. 1992 Income applicable to common stock increased by $9.7 million in 1993 compared to 1992. The following discussion highlights the factors contributing to the increase. Operations Utility operating income increased $8.1 million in 1993 compared to 1992. Contributing to this increase was an increase in electric operating revenues of $30.1 million, due to increases in retail sales of $25.9 million, wholesale sales of $2.8 million and miscellaneous electric revenue of $1.4 million. Retail electric sales were higher due to increased retail KWH sales of $31.1 million and decreased fuel cost recoveries of $5.2 million. The increase in retail KWH sales this year resulted primarily from the return to normal weather conditions in 1993 as compared to the abnormally mild summer weather conditions in 1992. During 1992, cooling degree days were 26.5 percent below normal. Wholesale sales were higher as a result of increased energy requirements of other utilities, who were also affected by the mild summer during 1992. The continuing health of the Indianapolis economy also contributed to the growth in KWH sales, particularly in the large industrial class. Fuel costs increased $3.3 million due to increases in fuel consumption of $9.6 million, partially offset by decreased unit costs of coal and oil of $.5 million and deferred fuel costs of $5.8 million. Power purchased increased $11.6 million due to increased capacity payments of $7.2 million to IMP in accordance with a five-year power purchase agreement, and by increased purchases of energy as a result of the near normal weather conditions in 1993 as compared to 1992. Maintenance expenses increased $4.9 million. This increase reflects higher unit overhaul and outage expenses in 1993, partially offset by decreased distribution maintenance expenses as a result of a severe storm in 1992 that cost $3.9 million. Amortization of the deferred return--rate phase-in plan, decreased due to the completion in August 1992 of the five-year amortization period. Taxes other than income taxes decreased $1.7 million as a result of lower property assessments. Income taxes - net, increased $4.3 million as a result of the increase in pretax utility operating income and a one percentage point increase in the federal income tax rate. Other Income And Deductions Other - net, increased $1.6 million as a result of a $1.5 million contribution to customer energy assistance programs expensed last year. Interest Charges Interest on long-term debt decreased $1.3 million as a result of refinancing six series of IPL's First Mortgage Bonds as follows: the 10 1/4% Series, First Mortgage Bonds in October 1993 (replaced with the 5.50% Series, First Mortgage Bonds); the 5.80% Series, First Mortgage Bonds in October, 1993 (replaced with the 5.40% Series, First Mortgage Bonds); the 6.90% and the 6.60% Series, First Mortgage Bonds (replaced with the 6.10% Series, First Mortgage Bonds); and the 9.30% and 9 1/2% Series, First Mortgage Bonds in September 1992 (replaced with the 7 3/8% Series, First Mortgage Bonds). The allowance for borrowed funds used during construction increased due primarily to an increased construction base. Other interest charges increased $1.1 million due to higher notes payable balances carried during 1993. 1992 vs. 1991 Income applicable to common stock decreased by $10.8 million in 1992 compared to 1991. The following discussion highlights the factors contributing to the decrease. Operations Utility operating income decreased $15.6 million in 1992 compared to 1991. Contributing to this decrease were lower electric operating revenues of $16.7 million, due to lower retail electric sales of $13.9 million, lower wholesale sales of $1.8 million and lower miscellaneous electric revenue of $1.0 million. Retail electric sales were lower due to decreased retail KWH sales of $10.6 million and decreased fuel cost recoveries of $3.3 million. The decrease in retail KWH sales in 1992 resulted primarily from unusual weather conditions in both 1992 and 1991. Abnormally mild summer weather conditions in 1992 resulted in lower KWH sales, while the unusually hot weather during the summer of 1991 significantly increased KWH sales in that year. During 1992, cooling degree days were 48 percent lower than 1991 and 26.5 percent below normal. Wholesale sales were lower as a result of decreased energy requirements of other utilities, who were also affected by the mild summer. Fuel costs decreased $7.4 million due to decreases in fuel consumption of $4.3 million, decreased unit costs of coal and oil of $2.0 million and deferred fuel costs of $1.1 million. Other operating expenses increased $2.9 million due primarily to an increase in administrative and general expenses of $1.4 million (primarily as a result of increased salaries and group insurance costs), and a $2.0 million expense related to the FAC Agreement. Power purchased increased $3.9 million due to capacity payments of $5.4 million to IMP in accordance with a five-year power purchase agreement, partially offset by decreased purchases of energy as a result of the mild summer weather. Maintenance expenses increased $2.0 million, reflecting transmission and distribution system repair expenses as a result of a severe storm in June that cost a total of $3.9 million. These expenses were partially offset by decreased unit overhaul expenses in 1992, compared to 1991. Amortization of the deferred return--rate phase-in plan, decreased due to the completion in August 1992, of the five-year amortization period. Taxes other than income taxes increased $2.7 million as a result of increased property assessments and higher property tax rates. Income taxes-net, decreased $3.0 million primarily due to the decrease in pretax utility operating income. Other Income And Deductions Allowance for equity funds used during construction increased $1.3 million due to an increased construction base in 1992. Other - net, decreased $3.9 million due to decreased interest and dividend income earned by IPL of $2.4 million, and as a result of a $1.5 million contribution to customer energy assistance programs expensed in 1992. IPL received interest and dividend income in 1991 from investments, special deposits and other sources which did not occur this year. Income taxes - net, decreased $1.1 million as a result of decreased pretax operating income of the unregulated subsidiaries, decreased IPL interest and dividend income and the increased contribution expense previously mentioned. Interest Charges Interest and other charges - net, decreased $6.4 million primarily due to decreased interest on long-term debt of $3.8 million. This decrease is the result of refinancing four series of IPL's First Mortgage Bonds as follows: the 12% Series, First Mortgage Bonds in August 1991 (replaced with the long-term note at a floating interest rate that approximates tax-exempt Commercial Paper Rates); the 9 7/8% Series, First Mortgage Bonds in November 1991 (replaced with the 8% Series, First Mortgage Bonds); and the 9.30% and 9 1/2% Series, First Mortgage Bonds in September 1992 (replaced with the 7 3/8% Series, First Mortgage Bonds). The allowance for borrowed funds used during construction increased due primarily to an increased construction base. Other interest charges decreased $1.4 million due to lower interest rates during 1992. Factors having a bearing on 1994 earnings compared to 1993 will include the impact of economic conditions, weather conditions, an increased level of construction expenditures, an increase in monthly capacity payments and the implementation of new steam system tariff rates. Authorized electric operating income for 1994 as determined by the IURC is approximately $144.0 million. (IPL earned $141.2 million during 1993 and $133.4 million during 1992.) Affecting 1994 earnings will be the cost of the IMP purchases mentioned previously. Annual capacity payments will increase by $1.8 million. The overall effect these factors will have on 1994 earnings cannot be accurately determined at this time. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT Indianapolis Power & Light Company: We have audited the accompanying balance sheets and statements of capitalization of Indianapolis Power & Light Company as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Indianapolis Power & Light Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 1 and 9 to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. /s/ Deloitte & Touche Deloitte & Touche Indianapolis, Indiana January 21, 1994 INDIANAPOLIS POWER & LIGHT COMPANY Notes to Financial Statements For the Years Ended December 31, 1993, 1992 and 1991 - --------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: All the outstanding common stock of Indianapolis Power & Light Company (IPL) is owned by IPALCO Enterprises, Inc. At December 31, 1993 and 1992, IPL had a receivable, which is due on demand, for advances made to IPALCO. System of Accounts--The accounts of IPL are maintained in accordance with the system of accounts prescribed by the Indiana Utility Regulatory Commission (IURC), which system substantially conforms to that prescribed by the Federal Energy Regulatory Commission. Revenues--Revenues are recorded as billed to customers on a monthly cycle billing basis. Revenue is not accrued for energy delivered but unbilled at the end of the year. A fuel adjustment charge provision, which is established after public hearing, is applicable to substantially all the rate schedules of IPL, and permits the billing or crediting of fuel costs above or below the levels included in such rate schedules. Under current IURC practice, future fuel adjustment revenues may be temporarily reduced should actual operating expenses be less than or income levels be above amounts authorized by the IURC. Authorized Annual Operating Income--In an IURC order dated May 6, 1992, IPL's maximum authorized annual electric operating income, for purposes of quarterly earnings tests, was established at approximately $147 million through July 31, 1992, declining ratably to approximately $144 million at July 31, 1993. This level will be maintained until IPL's next general electric rate order. Additionally, through the date of IPL's next general electric rate order, IPL is required to file upward and downward adjustments in fuel cost credits and charges on a quarterly basis. As provided in an order dated December 21, 1992, IPL's authorized annual steam net operating income is $6.2 million, plus any cumulative annual underearnings occurring during the five-year period subsequent to the implementation of the new rate tariffs. Deferred Fuel Expense--Fuel costs recoverable in subsequent periods under the fuel adjustment charge provision are deferred. Allowance For Funds Used During Construction (AFUDC)--In accordance with the prescribed uniform system of accounts, IPL capitalizes an allowance for the net cost of funds (interest on borrowed and a reasonable rate on equity funds) used for construction purposes during the period of construction with a corresponding credit to income. IPL capitalized amounts using pre-tax composite rates of 8.0%, 9.5% and 9.6% during 1993, 1992 and 1991, respectively. Utility Plant and Depreciation--Utility plant is stated at original cost as defined for regulatory purposes. The cost of additions to utility plant and replacements of retirement units of property, as distinct from renewals of minor items which are charged to maintenance, are charged to plant accounts. Units of property replaced or abandoned in the ordinary course of business are retired from the plant accounts at cost; such amounts plus removal costs, less salvage, are charged to accumulated depreciation. AFUDC is capitalized and depreciated over the life of the related facility. Depreciation was computed by the straight-line method based on the functional rates and averaged 3.4% during each of the years 1993, 1992 and 1991. Statements of Cash Flows - Cash Equivalents--IPL considers all highly liquid investments purchased with original maturities of 90 days or less to be cash equivalents. Unamortized Deferred Return - Rate Phase-in Plan--IPL deferred the pre- tax debt and equity costs relating to its investment in plant which did not earn a cash return during the first year of a two-year, two-step retail electric rate phase-in plan authorized August 6, 1986. This deferred return and the related income taxes were amortized to cost of service over a five-year period commencing with the August 8, 1987 implementation of the second step of the phase-in plan. The deferred return was fully amortized in August, 1992. Unamortized Petersburg Unit 4 Carrying Charges--IPL has deferred certain post in-service date carrying charges of its investment in Petersburg Unit 4 (Unit 4). These carrying charges include both AFUDC on and depreciation of Unit 4 costs from the April 28, 1986 in-service date through the August 6, 1986 IURC rate order date in which IPL's investment in Unit 4 was included in rate base. Subsequent to April 28, 1986, IPL has capitalized interest on these deferred carrying charges. In addition, IPL has capitalized $7.0 million of additional allowance for earnings on shareholders' investment for rate-making purposes but not for financial reporting purposes. As provided in the rate order, the total amount of deferred carrying charges will be included in IPL's next general electric rate case. Unamortized Redemption Premiums and Expenses on Debt and Preferred Stock--In accordance with regulatory treatment, IPL defers non-sinking fund debt redemption premiums and expenses, and amortizes such costs over the life of the original debt or, in the case of preferred stock redemption premiums, over twenty years. Other Regulatory Assets--At December 31, 1993 and 1992, IPL has deferred certain costs and expenses which are recoverable in future rates as follows: Income Taxes--Deferred taxes are provided for all significant timing differences between book and taxable income. Such differences include the use of accelerated depreciation methods for tax purposes, the use of different book and tax depreciable lives, rates and in-service dates, and the accelerated tax amortization of pollution control facilities. Investment tax credits which reduced Federal income taxes in the years they arose have been deferred and are being amortized to income over the useful lives of the properties in accordance with regulatory treatment. Effective January 1, 1993, IPL adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," on a prospective basis. This statement requires the current recognition of income tax expense for (a) the amount of income taxes payable or refundable for the current year, and (b) for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in IPL's financial statements or income tax returns. The effects of income taxes are measured based on enacted laws and rates. Substantially all of the adjustments required by SFAS 109 were recorded to deferred tax balance sheet accounts, with the offsetting adjustments to regulatory assets and liabilities. The adoption of this standard did not have a material impact on IPL's cash flows or results of operations due to the effect of rate regulation. Employee Benefit Plans--Substantially all employees of IPL are covered by a non-contributory, defined benefit pension plan which is funded through two trusts. Additionally, a select group of management employees of IPL are covered under a funded supplemental retirement plan. Collectively, these two plans are referred to as Plans. Benefits are based on each individual employee's years of service and compensation. IPL's funding policy is to contribute annually not less than the minimum required by applicable law, nor more than the maximum amount which can be deducted for Federal income tax purposes. IPL also sponsors the Employees' Thrift Plan of Indianapolis Power & Light Company (Thrift Plan), a defined contribution plan covering substantially all employees of IPL. Employees elect to make contributions to the plan based on a percentage of their annual base compensation. IPL matches each employee's contributions in amounts up to, but not exceeding four percent of the employee's annual base compensation. Reclassification--Certain amounts from prior years' financial statements have been reclassified to conform to the current year presentation. 2. UTILITY PLANT IN SERVICE: The original cost of utility plant in service at December 31, segregated by functional classifications, follows: Substantially all of IPL's property is subject to the lien of the indentures securing IPL's First Mortgage Bonds. 3. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments". The estimated fair value amounts have been determined by IPL, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that IPL could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have an effect on the estimated fair value amounts. Cash, cash equivalents and notes payable--The carrying amount approximates fair value due to the short maturity of these instruments. Long-term debt, including current maturities and sinking fund requirements--Interest rates that are currently available to IPL for issuance of debt with similar terms and remaining maturities are used to estimate fair value. At December 31, 1993 and 1992 the carrying amount of IPL's long-term debt, including current maturities and sinking fund requirements, and the approximate fair value are as follows: 4. CAPITAL STOCK: Common Stock: There were no changes in IPL common stock during 1993, 1992 and 1991. Restrictions on the payment of cash dividends or other distributions on common stock and on the purchase or redemption of such shares are contained in the indenture securing IPL's First Mortgage Bonds. All of the retained earnings at December 31, 1993, were free of such restrictions. Cumulative Preferred Stock: Preferred stock shareholders are entitled to two votes per share, and if four full quarterly dividends are in default, they are entitled to elect the smallest number of Directors to constitute a majority. 5. LONG-TERM DEBT: The 9 5/8% Series due 2012, 10 5/8% Series due 2014, 6.10% Series due 2016, 5.40% Series due 2017, and 5.50% Series due 2023 were each issued to the City of Petersburg, Indiana (City) by IPL to secure the loan of proceeds received from a like amount of tax-exempt Pollution Control Revenue Bonds issued by the City for the purpose of financing pollution control facilities at IPL's Petersburg Generating Station. On August 6, 1992, IPL issued $80 million of First Mortgage Bonds, 7 3/8% series, due 2007. The net proceeds from this issue were used to redeem on September 1, 1992, IPL's First Mortgage Bonds, 9.3% series, due 2006 and 9 1/2% series, due 2016, at the prices of $104.17 and $107.13, respectively, plus accrued interest. On April 13, 1993, IPL issued a First Mortgage Bond, 6.10% Series, due 2016, in the principal amount of $41.85 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds were used to redeem on June 1, 1993, IPL's $19.65 million First Mortgage Bonds, 6.90% Series, due 2006, and IPL's $22.2 million First Mortgage Bonds, 6.60% Series, due 2008, at the prices of $100 and $101, respectively, plus accrued interest. On October 14, 1993, IPL issued a First Mortgage Bond, 5.40% Series, due 2017, in the principal amount of $24.65 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds, were used to redeem on November 15, 1993, IPL's $24.65 million First Mortgage Bonds, 5.80% Series, due 2007, at the price of $100 plus accrued interest. Also, on October 14, 1993, IPL issued a First Mortgage Bond, 5.50% Series, due 2023, in the principal amount of $30.0 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds, were used to redeem on November 15, 1993, IPL's $30.0 million First Mortgage Bonds, 10 1/4% Series, due 2013, at the price of $103 plus accrued interest. IPL has a 30-year unsecured promissory note which was issued to the City of Petersburg, Indiana, in connection with the issuance of $40 million of Pollution Control Refunding Revenue Bonds, due 2021, by the City of Petersburg. This note and the related bonds provide for a floating interest rate that approximates tax-exempt Commercial Paper Rates. The average interest rate on this note was 2.40% for 1993 and 3.00% for 1992. At the option of IPL, the bonds can be converted to First Mortgage Bonds which would bear interest at a fixed rate. Maturities and sinking fund requirements on long-term debt for the five years subsequent to December 31, 1993, are as follows: 6. LINES OF CREDIT: IPL has lines of credit with banks of $100 million at December 31, 1993, to provide loans for interim financing. These lines of credit, based on separate formal and informal agreements, have expiration dates ranging from January 31, 1994 to November 30, 1994 and require the payment of commitment fees. At December 31, 1993, these credit lines were unused. Lines of credit supporting commercial paper were $90 million at December 31, 1993. 7. INCOME TAXES: Federal and State income taxes charged to income are as follows: The provision for Federal income taxes (including net investment tax credit adjustments) is less than the amount computed by applying the statutory tax rate to pre-tax income. The reasons for the difference, stated as a percentage of pre-tax income, are as follows: The significant items comprising IPL's net deferred tax liability recognized in the balance sheet as of December 31, 1993 are as follows: 8. RATE MATTERS Steam Rate Order By an order dated January 13, 1993, the IURC authorized IPL to increase its steam system rates and charges over a six-year period. Accordingly, IPL implemented new steam tariffs designed to produce estimated additional annual steam operating revenues as follows: Environmental Compliance Plan On August 18, 1993, IPL obtained an Order from the IURC approving its Environmental Compliance Plan, together with the costs and expenses associated therewith, which provides for the installation of sulfur dioxide and nitrogen oxide emissions abatement equipment and the installation of continuous emission monitoring systems to meet the requirements of both Phase I and Phase II of the Federal Clean Air Act Amendments of 1990. The order provides for the deferral of net gains and losses resulting from any sale of emission allowances for future amortization to cost of service on a basis to be determined in the next general electric rate proceeding. Demand Side Management Program IPL obtained an Order from the IURC approving a Stipulation of Settlement Agreement between IPL, the Office of Utility Consumer Counsel, Citizens Action Coalition of Indiana, Inc., an industrial group, the Trustees of Indiana University and the Indiana Alliance for Fair Competition relating to the Company's Demand Side Management Program (DSM). The order provides for the deferral and subsequent recovery in rates of certain approved DSM costs. The order also provides for the recording of a return on deferred costs until recognized in rates. 9. EMPLOYEE BENEFIT PLANS AND OTHER POST-RETIREMENT BENEFITS: IPL's contributions to the Thrift Plan, net of amounts allocated to related parties were $3.1 million, $3.1 million and $2.8 million in 1993, 1992 and 1991, respectively. Net pension cost including amounts charged to construction for 1993, 1992 and 1991 are comprised of the following components: A summary of the Plans' funding status, and the amount recognized in the balance sheets at December 31, 1993 and 1992, follows: As of the October 31, 1993 valuation date, approximately 10.5% of the Plans' assets were in equity securities, with the remainder in fixed income securities. IPL also provides certain postretirement health care and life insurance benefits for employees who retire from active service on or after attaining age 55 and have rendered at least 10 years of service. On January 1, 1993, IPL adopted the provisions of SFAS No. 106 -- Employers' Accounting for Postretirement Benefits Other than Pensions (SFAS 106). Generally, SFAS 106 requires the use of an accrual basis accounting method for determining annual costs of postretirement benefits. The January 1, 1993 transition obligation of $122.4 million is being amortized over a 20 year period. Prior to 1993, the cost of such benefits was recognized when incurred and amounted to $3.5 million and $2.8 million in 1992 and 1991, respectively. Net postretirement benefit cost, including amounts charged to construction for 1993 is comprised of the following components: A summary of the retiree health care and life insurance plan's funding status, and the amount recognized in the consolidated balance sheet at December 31, 1993 follows: IPL is expensing its non-construction related SFAS 106 costs associated with its steam business. The SFAS 106 costs, net of amounts paid and capitalized for construction, associated with IPL's electric business is being deferred as a regulatory asset on the balance sheet, as authorized by an order of the IURC on December 30, 1992, which provided for deferral of SFAS 106 costs in excess of such costs determined on a cash basis. A request for recovery in rates of these costs will be included in IPL's next general electric rate petition. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation is 12.6 % for 1994, gradually declining to 5.0% in 2003. A one-percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $24.3 million and the combined service cost and interest cost for 1993 by approximately $3.4 million. Plan assets consist of the cash surrender value of life insurance policies on certain retired employees. The expected long-term rate of return on plan assets is 8 percent. Assumptions used in determining the accumulated benefit obligation for the pension plans for 1993, 1992 and 1991 and for the accumulated postretirement benefit obligation for 1993 were: 10. COMMITMENTS AND CONTINGENCIES: In 1994, IPL anticipates the cost of its construction program to be approximately $234 million. IPL will comply with the provisions of "The Clean Air Act Amendments of 1990" (the Act) through the installation of SO2 scrubbers and NOx facilities. The cost of complying with the Act from 1994 through 1997, including AFUDC, is estimated to be approximately $207 million, of which $80 million is anticipated in 1994. During 1993, expenditures for compliance with the Act were $13.7 million. IPL has a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP) for 100 megawatts (MW) of capacity effective April 1992, with the purchase of an additional 100 MW (for a total of 200 MW) beginning in April 1993. The agreement provides for monthly capacity payments by IPL of $.6 million from April 1992 through March 1993, increasing to a monthly amount of $1.2 million which began in April 1993 and continue through March 31, 1997. The agreement further provides that IPL can elect to extend purchases through December 31, 1997, and subsequently through November 30, 1999, with capacity payments of $1.2 million per month and $1.55 million per month, respectively. IPL can terminate the agreement, should the ability to recover future demand charges through rates be disallowed. Capacity payments in 1993 and 1992 under this agreement totaled $12.6 million and $5.4 million, respectively. In October 1993, IPL received a Findings of Violation regarding compliance with the thermal limits of the National Pollutant Discharge Elimination System permit for its Petersburg Generating Station. IPL expects to meet with the Environmental Protection Agency in early 1994 to resolve this matter. IPL believes it has met all the requirements of its permit, but if IPL's position is found erroneous, IPL could be subject to fines of up to $25,000 per day of violation. IPL is involved in litigation arising in the normal course of business. While the results of such litigation cannot be predicted with certainty, management, based upon advice of counsel, believes that the final outcome will not have a material adverse effect on the financial position and results of operations. 11. QUARTERLY RESULTS (UNAUDITED): Operating results for the years ended December 31, 1993 and 1992 by quarter, are as follows (in thousands): The quarterly figures reflect seasonal and weather-related fluctuations which are normal to IPL's operations. Weather conditions in 1993 reflected near normal conditions, while weather conditions in 1992 were considerably moderate. The quarter ended June 30, 1992, includes a $3.9 million expense as a result of severe storm damage to IPL's transmission and distribution systems, and a $2.8 million expense in connection with the settlement of disputes regarding fuel adjustment issues. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Items 10, 11, 12 Indianapolis Power & Light Company has filed with the and 13 Securities and Exchange Commission a definitive information statement pursuant to Regulation 14C. This document will incorporate by reference the information required by these items, except for the information regarding executive officers which is set forth in Part I, following Item 4 hereof under the heading "EXECUTIVE OFFICERS OF THE REGISTRANT." PART IV Item 14 Item 14 (a). DOCUMENT LIST The Financial Statements and Supplemental Schedules under this Item 14 (a) 1 and 2 filed in this Form 10-K are those of Indianapolis Power & Light Company. 1. Financial Statements Included in Part II of this report: Independent Auditors' Report Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Balance Sheets, December 31, 1993 and 1992 Statements of Capitalization December 31, 1993 and 1992 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements 2. Supplementary Data and Financial Statement Schedules Included in Part IV of this report: For each of the years ended December 31, 1993, 1992 and 1991 Schedule V - Utility Property, Plant, and Equipment Schedule VI - Accumulated Depreciation of Utility Property, Plant, and Equipment Schedule IX - Short-Term Borrowings Schedule X - Supplemental Income Statement Information The schedules, other than those listed above, are omitted because of the absence of the conditions under which they are required or because the information is furnished in the financial statements or notes thereto. 3. Exhibits Required by Securities and Exchange Commission Regulation S-K Copies of the documents listed below which are identified with an asterisk (*) are incorporated herein by reference and made part hereof and have heretofore been classified as basic documents under Rule 24(b) of the SEC Rules of Practice. (3) Articles of Incorporation and By-Laws * --Copy of Amended Articles of Incorporation of IPL. (Form 8-K dated May 19, 1982.) * --Copy of Amended Articles of Incorporation including Articles of Amendment dated April 17, 1991. (Form 10-Q for quarter ended March 31, 1991.) * --Copy of Amended By-Laws dated August 23, 1993. (Form 10-Q for quarter ended September 30, 1993.) (4) Instruments defining the rights of security holders, including indentures * --Copy of Mortgage and Deed of Trust, dated as of May 1, 1940, between IPL and American National Bank and Trust Company of Chicago, Trustee, as supplemented and modified by 33 Supplemental Indentures. Exhibits D in File No. 2-4396; B-1 in File No. 2-6210; 7-C File No. 2-7944; 7-D in File No. 2-72944; 7-E in File No. 2-8106; 7-F in File No. 2-8749; 7-G in File No. 2-8749; 4-Q in File No. 2-10052; 2-I in File No. 2-12488; 2-J in File No. 2-13903; 2-K in File No. 2-22553; 2-L in File No. 2-24581; 2-M in File No. 2-26156; 4-D in File No. 2-26884; 2-D in File No. 2-38332; Exhibit A to Form 8-K for October 1970; Exhibit 2-F in File No. 2-47162; 2-F in File No. 2-50260; 2-G in File No. 2-50260; 2-F in File No. 2-53541, 2E in File No. 2-55154; 2E in File no. 2-60819; 2F in File No. 2-60819; 2-G in File No. 2-60819; Exhibit A to Form 10-Q for the quarter ended 9-30-78 File No. 1-3132; 13-4 in File No. 2-73213; Exhibit 4 in File No. 2-93092. Twenty-eighth, Twenty-ninth and Thirtieth Supplemental Indentures. (Form 10-K dated for the year ended December 31, 1985.) * --Copy of Thirty-First Supplemental Indenture dated as of October 1, 1986. (Form 10-K for the year ended December 31, 1986.) * --Copy of Thirty-Second Supplemental Indenture dated as of June 1, 1989. (Form 10-K for year ended 12-31-89.) * --Copy of Thirty-Third Supplemental Indenture dated as of August 1, 1989. (Form 10-K for year ended 12-31-89.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Copy of Thirty-Fourth Supplemental Indenture dated as of October 15, 1991. (Form 10-K for year ended 12-31-91.) * --Copy of Thirty-Fifth Supplemental Indenture dated as of August 1, 1992. (Form 10-K for year ended 12-31-92.) * --Copy of Thirty-Sixth Supplemental Indenture dated as of April 1, 1993. (Form 10-Q for quarter ended 9-30-93.) * --Copy of Thirty-Seventh Supplemental Indenture dated as of October 1, 1993. (Form 10-Q for quarter ended 9-30-93.) * --Copy of Thirty-Eighth Supplemental Indenture dated as of October 1, 1993. (Form 10-Q for quarter ended 9-30-93.) * --Copy of Thirty-Ninth Supplemental Indenture dated as of February 1, 1994. (Form 8-K, dated 1-25-94.) * --Copy of Fortieth Supplemental Indenture dated as of February 1, 1994. (Form 8-K, dated 1-25-94.) (10) Material Contracts * --Copy of Amended Coal Supply Agreement between IPL and Peabody Coal Company dated as of January 1, 1982. (Form 10-K for the year ended 12-31-82.) * --Copy of Coal Supply Agreement between IPL and Peabody Coal Company effective as of January 1, 1992 and dated April 7, 1993. (Form 10-Q for quarter ended 3-31-93.) * --Copy of Amendment to Coal Supply Agreement dated July 15. 1985, between IPL and Black Beauty Coal Company, Inc. (Form 10-K for year ended 12-31-86.) * --Copy of Coal Supply Agreement dated December 26,1984, between IPL and AMAX Coal Company. (Form 10-K for year ended 12-31-84.) * --Copy of Amendment to Coal Supply Agreement dated February 27, 1987, between IPL and Black Beauty Coal Company, Inc. (Form 10-K for year ended 12-31-87.) * --Copy of Transportation Contract dated September 28,1987, between IPL and Consolidated Rail Corporation. (Form 10-K for year ended 12-31-87.) * --Copy of Amendment No. 1 to Transportation Contract between IPL and Consolidated Rail Corporation dated November 1, 1988. (Form 10-Q for quarterly period ended June 30, 1989.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Copy of Amendments No. 2 and 3 to Transportation Contract between IPL and Consolidated Rail Corporation dated August 1, 1989 and August 2, 1989, respectively. (Form 10-Q for quarterly period ended September 30, 1989.) * --Copy of Amendment No. 4 to Transportation Contract between IPL and Consolidated Rail Corporation dated July 30, 1990. (Form 10-Q for quarterly period ended September 30, 1990.) * --Copy of Coal Supply Agreement dated September 23, 1988, between IPL and Shand Mining, Inc. (Form 10-K for year ended 12-31-88.) * --Copy of Coal Supply Agreement dated March 29, 1988, between IPL and Coal, Inc. (Form 10-K for year ended 12-31-88.) * --Copy of First Amendment to Coal Supply Agreement between IPL and Coal, Inc. dated July 17, 1989. (Form 10-K for year ended 12-31-89.) * --Copy of Coal Supply Agreement between IPL and Triad Mining of Indiana, Inc. and Marine Coal Sales Company. (Form 10-Q for quarterly period ended March 31, 1991.) --Directors' and Officers' Liability Insurance Policy No. DO392B1A93 effective June 30, 1993, to June 1, 1994. * --Certificate of the Resolution amending the Unfunded Deferred Compensation Plan for IPL Directors dated February 22, 1983. (Form 10-K for year ended 12-31-82.) * --Copy of the Resolution amending the Unfunded Deferred Compensation Plan for IPL Directors effective January 1, 1992. (Form 10-K for year ended 12-31-92.) --Copy of the Resolution amending the Unfunded Deferred Compensation Plan for IPL Directors effective January 1, 1994. --Copy of the resolution adopting the Unfunded Deferred Compensation Plan for IPL Officers effective January 1, 1994. * --Eighth Amendment to and Complete Restatement of the IPL Unfunded Supplemental Retirement Plan for a Select Group of Management Employees effective November 1, 1988. (Form 10-K for year ended 12-31-88.) * --Copy of IPL Supplemental Retirement Plan and Trust Agreement for a Select Group of Management Employees (As Amended and Restated Effective January 1, 1992). (Form 10-K for year ended 12-31-92.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) --Copy of IPL Supplemental Retirement Plan and Trust Agreement For a Select Group of Management Employees (As Amended and Restated Effective May 1, 1993). --Copy of First Amendment to the Indianapolis Power & Light Company Supplemental Retirement Plan and Trust Agreement For A Select Group of Management Employees (As Last Amended and Restated Effective May 1, 1993). --Management Performance Program for 1993. * --Interconnection Agreement, dated December 30, 1960, between IPL and Indiana & Michigan Electric Company as modified. (Exhibits 4-A in File No. 2-24581; 5-F in File No. 2-28756; 5-R in File No. 2-43038; 5-S in File No. 2-47162 and 5-L in File No. 2-53541.) * --Modification 14 to Interconnection Agreement between IPL and Indiana & Michigan Electric Company. (Form 10-K for year ended 12-31-82.) * --Modification 15 to Interconnection Agreement dated September 1, 1985, between IPL and Indiana & Michigan Electric Company. (Form 10-K for year ended 12-31-88.) * --Modification 16 to Interconnection Agreement dated September 1, 1991, between IPL and Indiana Michigan Power Company (formerly Indiana & Michigan Electric Company). (Form 10-K for year ended 12-31-91.) * --Interconnection Agreement, dated May 1, 1962, between IPL and Public Service of Indiana, Inc. as supplemented. (Exhibits 4-B in File No. 2-24581; 5-L in File No. 2-38332; 5-N in File No. 2-41916; 5-P in File No. 2-41916; 5-B in File No. 2-60819 and Forms 10-K for years ended 12-31-82 and 12-31-87.) * --Ninth Supplemental Agreement dated May 1, 1992, to Interconnection Agreement between IPL and PSI Energy, Inc. (Form 10-K for year ended 12-31-92.) * --Facilities Agreement effective in 1968 among Indianapolis Power & Light Company, Public Service Company of Indiana, Inc. and Indiana & Michigan Electric Company. (Exhibit 5-G in File No. 2-28756.) * --Facilities Agreement dated August 16, 1977, between IPL and Public Service Company of Indiana, Inc. (Form 10-K for year ended 12-31-81.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Amendment No. 1 dated June 1, 1981, to Facilities Agreement between IPL and Public Service Company of Indiana, Inc. (Form 10-K for year ended 12-31-81.) * --Amendment No. 2 dated October 1, 1984, to Facilities Agreement between IPL and Public Service of Indiana, Inc. (Form 10-K for year ended 12-31-86.) * --East Central Area Reliability Agreement dated August 1, 1967, between IPL and 23 other electric utility companies as supplemented. (Exhibits 5-I in File No. 2-38332 and 5-J in File No. 2-38332.) * --Interconnection Agreement dated December 2, 1969, between IPL and Southern Indiana Gas and Electric Company as modified. (Exhibits 5-K in File No. 2-38332 and 5-Q in File No. 2-43038.) * --Modification 2, Modification 3, and Modification 4 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-80.) * --Modification 5 and Modification 6 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-81.) * --Modification 7 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-82.) * --Modification 8 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-89.) * --Interconnection Agreement dated December 1, 1981, between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-81.) * --Modification 1 to Interconnection Agreement between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-82.) * --Modification 2 to Interconnection Agreement between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-83.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Modification 3 to Interconnection Agreement between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-89.) * --Interconnection Agreement, dated October 7, 1987, between IPL and Wabash Valley Power Association. (Form 10-K for year ended 12-31-87.) (23) Consents of Experts and Counsel --Independent Auditors' Consent (99) Additional Exhibits * --Agreement, dated as of October 27, 1993, by and among IPALCO Enterprises, Inc., Indianapolis Power & Light Company, PSI Resources, Inc., PSI Energy, Inc. The Cincinnati Gas & Electric Company, CINergy Corp., James E. Rogers, John R. Hodowal and Ramon L. Humke. (Form 10-Q for quarterly period ended 9-30-93.) Item 14 (b). REPORTS ON FORM 8-K A report on Form 8-K, dated January 25, 1994, reporting Item 5, "Other Events", and Item 7, "Exhibits", with respect to financial results for the fiscal year ending 1993, and the 39th and 40th Supplemental Indentures. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. INDIANAPOLIS POWER & LIGHT COMPANY By John R. Hodowal ----------------------------------- (John R. Hodowal, Chairman of the Board and Chief Executive Officer) Date February 22, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- (i) Principal Executive Officer: /s/ John R. Hodowal Chairman of the Board February 22, 1994 ---------------------- and Chief Executive (John R. Hodowal) Officer (ii) Principal Financial Officer: /s/ John R. Brehm Senior Vice President February 22, 1994 ---------------------- Finance and Information (John R. Brehm) Services (iii) Principal Accounting Officer: /s/ Stephen J. Plunkett Controller February 22, 1994 ------------------------ (Stephen J. Plunkett) (iv) A majority of the Board of Directors of Indianapolis Power & Light Company: /s/ Joseph D. Barnette, Jr. Director February 22, 1994 ---------------------------- (Joseph D. Barnette, Jr.) /s/ Robert A. Borns Director February 22, 1994 ---------------------------- (Robert A. Borns) SIGNATURES (Continued) /s/ Mitchell E. Daniels, Jr. Director February 22, 1994 ---------------------------- (Mitchell E. Daniels, Jr.) /s/ Rexford C. Early Director February 22, 1994 ---------------------------- (Rexford C. Early) /s/ Otto N. Frenzel III Director February 22, 1994 ---------------------------- (Otto N. Frenzel III) /s/ Max L. Gibson Director February 22, 1994 ---------------------------- (Max L. Gibson) /s/ Edwin J. Goss Director February 22, 1994 ---------------------------- (Edwin J. Goss) /s/ Dr. Earl B. Herr, Jr. Director February 22, 1994 ---------------------------- (Dr. Earl B. Herr, Jr.) /s/ John R. Hodowal Director February 22, 1994 ---------------------------- (John R. Hodowal) /s/ Ramon L. Humke Director February 22, 1994 ---------------------------- (Ramon L. Humke) /s/ Sam H. Jones Director February 22, 1994 ---------------------------- (Sam H. Jones) /s/ Andre B. Lacy Director February 22, 1994 ---------------------------- (Andre B. Lacy) /s/ L. Ben Lytle Director February 22, 1994 ---------------------------- (L. Ben Lytle) /s/ Michael S. Maurer Director February 22, 1994 ---------------------------- (Michael S. Maurer) SIGNATURES (Continued) /s/ Thomas M. Miller Director February 22, 1994 ---------------------------- (Thomas M. Miller) /s/ Sallie W. Rowland Director February 22, 1994 ---------------------------- (Sallie W. Rowland) /s/ Thomas H. Sams Director February 22, 1994 ---------------------------- (Thomas H. Sams) /s/ Zane G. Todd Director February 22, 1994 ---------------------------- (Zane G. Todd)

310183_1993.txt

310183_1993

1993

310183

Item 1. Business Missouri Pacific Railroad Company (the "Registrant") includes the Registrant, a Class I Railroad incorporated in Delaware and a wholly-owned, indirect subsidiary of Union Pacific Corporation (the "Corporation"), as well as a number of wholly-owned and majority-owned subsidiaries of the Registrant engaged in various railroad and related operations, and various terminal companies in which the Registrant has minority interests. In addition to its railroad operations, the Registrant performs truck freight services through its wholly-owned subsidiary, Union Pacific Motor Freight Company ("UPMF"). The Registrant operates in the midwestern and southwestern states of Arkansas, Colorado, Illinois, Kansas, Louisiana, Missouri, Nebraska, Oklahoma, Tennessee and Texas. The Registrant maintains coordinated schedules with other carriers for the handling of freight to and from the Atlantic seaboard, the Pacific Coast, the Southeast, the Southwest, Canada and Mexico. Export and import traffic is moved through Gulf Coast ports and across the Texas-Mexico border. The Registrant's operations have been coordinated with those of Union Pacific Railroad Company ("UPRR"), another wholly-owned, indirect subsidiary of the Corporation. The two railroads operate as a unified system. See Note 2 to the Registrant's financial statements for information on related party transactions. In 1993, the Registrant had transportation revenues of $2.1 billion, approximately 98.2 percent of which were derived from rail freight operations. Percentages of revenue ton-miles ("RTM") and rail freight revenue for major commodities during 1993, 1992 and 1991 were as follows: The Registrant's trucking subsidiary principally serves rail movements. UPMF has authority from the Interstate Commerce Commission ("ICC") to operate between all points in the continental United States and also has nationwide authority to provide contract services for the Corporation's motor carrier broker, Union Pacific Freight Services Company. Competition - ----------- In its rail transportation business, the Registrant is subject to competition from other railroads, motor carriers and barge operators. Most of its railroad operations are conducted in corridors served by competing railroads and by motor carriers. Motor carrier competition has been strengthened by longer combination vehicles which are now allowed in a number of states in which the Registrant operates. Because of the proximity of the Registrant's routes to major inland and Gulf Coast waterways, seasonal barge competition can be particularly pronounced. Employees - --------- As is true with employees of all the principal railroads in the country, the majority of the Registrant's employees are organized along craft lines and represented by national labor unions. The Registrant continues to adapt agreements from the previous round of national negotiations to meet local requirements throughout its system. The Registrant has negotiated the ability to operate all through-freight trains with two-person crews, and is currently modifying operations to take full advantage of this ability. On December 31, 1994, all outstanding labor contracts will reopen for negotiation. Discussions concerning the Registrant's notices for contract revisions will begin in October. The negotiations will likely continue through 1995 and management is optimistic that they will be completed in an expeditious manner. Governmental Regulation - ----------------------- The Registrant's operations are subject to the regulatory jurisdiction of the ICC, other Federal agencies and various state agencies. The ICC has jurisdiction over rates charged on certain regulated traffic, freight car compensation, issuance or guarantee of railroad and certain railroad holding company securities, extension or abandonment of rail lines, and acquisitions of control of rail common carriers and motor carriers by rail common carriers. Other Federal agencies have jurisdiction over safety, movement of hazardous materials, movement and disposal of hazardous waste, and equipment standards. The state agencies regulate intrastate freight rates to the extent that they have adopted Federal standards and procedures and continue to follow such procedures. However, several states in which railroad operations are conducted have ceded intrastate rail rate regulation to the ICC. Various state and local agencies also have jurisdiction over disposal of hazardous wastes and seek to regulate movement of hazardous materials. Item 2. Item 2. Properties Operating Equipment - ------------------- At December 31, 1993 the Registrant owned or leased from others 1,264 locomotives, 29,953 freight cars and 2,003 units of work equipment. Substantially all of the Registrant's railroad rolling stock is subject to the liens of the Registrant's First Mortgage and General (Income) Mortgage as well as the lien of the First Mortgage of the Texas and Pacific Railway Company, its predecessor in interest (collectively the "Mortgages"). In addition, a portion of this property is subject to various equipment obligations which are superior to the liens of one or more of the Mortgages. In connection with its motor freight operations, the Registrant operated 92 tractors, 42 rampers, and 928 trailers at December 31, 1993. Rail Property - ------------- The Registrant operates approximately 9,700 miles of track, including 8,000 miles of main line and 1,700 miles of branch line. Approximately 10 percent of the main line track consists of trackage rights over track owned by others. The Registrant's right-of-way and tracks are subject to one or more of the Mortgages. Item 3. Item 3. Legal Proceedings Registered Income Certificates - ------------------------------ On June 7, 1991, Timothy O. Stuy, purporting to represent a class of all certificateholders, filed an action in the United States District Court for the District of Delaware (Civil Action No. 91-322) against the Registrant with respect to the Certificates Representing a Charge on Income, dated January 1, 1958 (the "Certificates"), which had been issued by The Missouri-Kansas-Texas Railroad Company (the "Katy"). The Registrant acquired the Katy in 1988 and assumed the Katy's obligations with respect to the Certificates at that time. The lawsuit asserted, among other things, that certain contingent sinking fund payments were not made as a result of allegedly improper modifications to the terms of the Certificates and other actions by the defendant, and sought an unspecified amount of damages and injunctive relief. The Certificate modifications were approved by the ICC in connection with the Katy acquisition. The lawsuit was stayed pending resolution of a lawsuit previously filed in the Delaware District Court that raised similar issues with respect to the Katy's 5 1/2% Subordinated Income Debentures due January 1, 2033 (the "Debentures"). In response to motions filed by the Registrant and other defendants, the Debenture lawsuit was dismissed by the District Court for lack of subject matter jurisdiction. On November 17, 1993, the Registrant filed a motion to dismiss the Certificate lawsuit on similar grounds. On February 16, 1994, a Stipulation and Order of Dismissal was entered by the District Court dismissing the Certificate lawsuit with prejudice to the named plaintiff. Environmental - ------------- In October 1992, the Registrant received a Complaint and Notice of Opportunity for Hearing from Region VIII of the Environmental Protection Agency ("EPA") alleging various violations of the Toxic Substances Control Act at the Clive, Utah and Timpe, Utah transfer facilities owned by USPCI, Inc., an affiliate of the Registrant, including the failure to properly mark railcars containing polychlorinated biphenyls ("PCB"), failure to properly dispose of PCB waste, failure to properly contain or store PCB waste, and failure to properly manifest PCB waste. The Complaint includes a proposed penalty totalling $295,000. The Registrant has met with the EPA and expects to settle these alleged violations for substantially less than the initial penalty demand. In December 1992, the Texas Natural Resources Conservation Commission ("TNRCC") served the Registrant with a Notice of Violation for alleged discharges and fuel spills at the Registrant's San Antonio, Texas railyard. The TNRCC proposed penalties totalling $500,000. The Registrant and the TNRCC have tentatively settled this matter for a penalty payment of $300,000 plus the implementation of certain environmental projects in Texas costing $275,000. In addition to the foregoing, the Registrant has received notices from the EPA and state environmental agencies alleging that it is or may be liable under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 and/or other Federal or state environmental legislation for the remediation costs associated with alleged contamination or for violations of environmental requirements at various sites throughout the United States. There are approximately 12 sites for which such notices have been received which are on the Superfund National Priorities List or state superfund lists. Although specific claims have been made by the EPA and state regulators with respect to some of these sites, the ultimate impact of these proceedings and suits by third parties cannot be predicted at this time because of the number of potentially responsible parties involved, the degree of contamination by various wastes, the scarcity and quality of volumetric data related to many of the sites and/or the speculative nature of remediation costs. Nevertheless, at some of the superfund sites, the Registrant believes it will have little or no exposure because no liability should be imposed under applicable law, one or more other financially able parties generated all or most of the contamination, or a settlement of the Registrant's exposure has been reached although regulatory proceedings at the sites involved have not been formally terminated. While the ultimate cost of resolution of the foregoing issues cannot be fully determined, the Registrant does not believe that the resolution of such issues will materially affect the Registrant's financial condition or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Omitted in accordance with General Instruction J of Form 10-K. Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters All of the Common Stock and Class A Stock of the Registrant is owned by a wholly-owned indirect subsidiary of the Corporation. Accordingly, there is no market for the Registrant's capital stock. Dividends on the Registrant's Common Stock, which are paid on a quarterly basis, totalled $90 million in 1993 and $70 million in 1992. Through 1993, no dividends had been declared or paid on the Registrant's Class A Stock; however, a $3.4 million special cash dividend will be paid on the Class A Stock in 1994. See Notes 6 and 8 to the Registrant's financial statements for a discussion of dividend restrictions on the Common Stock and Class A Stock. Item 6. Item 6. Selected Financial Data Omitted in accordance with General Instruction J of Form 10-K. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Omitted in accordance with General Instruction J of Form 10-K. In lieu thereof, a narrative analysis is presented on Pages and. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements and supplementary information related thereto, listed on the Index to Financial Statements, are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Omitted in accordance with General Instruction J of Form 10-K. Item 11. Item 11. Executive Compensation Omitted in accordance with General Instruction J of Form 10-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Omitted in accordance with General Instruction J of Form 10-K. Item 13. Item 13. Certain Relationships and Related Transactions Omitted in accordance with General Instruction J of Form 10-K. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) (1) and (2) Financial Statements and Schedules See Index to Financial Statements. (a) (3) Exhibits (3)(a) - Registrant's Certificate of Incorporation, amended effective as of August 12, 1988, is incorporated herein by reference to Exhibit 3(i) to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1988. (3)(b) - Registrant's By-laws, amended effective as of September 1, 1992, are incorporated herein by reference to Exhibit 3 to the Registrant's Report on Form 10-Q for the quarter ended September 30, 1992. (4) - Pursuant to various indentures and other agreements, the Registrant has issued long-term debt, but no such agreement has securities or obligations covered thereby which exceed 10% of consolidated assets. The Registrant agrees to furnish a copy of any such indenture or agreement to the Securities and Exchange Commission upon request. (24) - Powers of attorney executed by the directors of the Registrant. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Registrant during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on this 29th day of March, 1994. MISSOURI PACIFIC RAILROAD COMPANY By /s/ Richard K. Davidson ------------------------------------- (Richard K. Davidson, Chairman and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below, on this 29th day of March, 1994, by the following persons on behalf of the Registrant and in the capacities indicated. By /s/ Richard K. Davidson ------------------------------------ (Richard K. Davidson, Chairman and Chief Executive Officer and a Director) /s/ L. White Matthews, III ------------------------------------ (L. White Matthews, III, Chief Financial Officer) /s/ James R. Young ------------------------------------ (James R. Young, Vice President-Finance) /s/ Charles E. Billingsley ------------------------------------ (Charles E. Billingsley, Chief Accounting Officer) SIGNATURES - (Continued) Robert P. Bauman* Drew Lewis* Richard B. Cheney* Richard J. Mahoney* E. Virgil Conway* Claudine B. Malone* Spencer F. Eccles* John R. Meyer* Elbridge T. Gerry, Jr.* Thomas A. Reynolds, Jr.* William H. Gray III* James D. Robinson III* Judith R. Hope* Robert W. Roth* Lawrence M. Jones* Richard D. Simmons* * By /s/ Judy L. Swantak ----------------------------------- (Judy L. Swantak, Attorney-in-fact) MISSOURI PACIFIC RAILROAD COMPANY AND CONSOLIDATED SUBSIDIARY COMPANIES Page ------ Independent Auditors' Report Financial Statements: Statement of Consolidated Financial Position - December 31, 1993 and 1992 - Statement of Consolidated Income and Retained Earnings - For the Years Ended December 31, 1993, 1992 and 1991 Statement of Consolidated Cash Flows - For the Years Ended December 31, 1993, 1992 and 1991 Accounting Policies Notes to Consolidated Financial Statements - Financial Statement Schedules - For the Years Ended December 31, 1993, 1992 and 1991: V Property, Plant and Equipment VI Accumulated Depreciation and Amortization of Properties X Supplementary Income Statement Information Management's Narrative Analysis of the Results of Operations - Schedules other than those listed above are omitted because they are not applicable or the required information is set forth in the financial statements referred to above. INDEPENDENT AUDITORS' REPORT To the Board of Directors Missouri Pacific Railroad Company Omaha, Nebraska We have audited the accompanying statements of consolidated financial position of Missouri Pacific Railroad Company (a wholly-owned indirect subsidiary of Union Pacific Corporation) and subsidiary companies (the "Registrant") as of December 31, 1993 and 1992, and the related statements of consolidated income and retained earnings and of consolidated cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the foregoing index to financial statements. These financial statements and financial statement schedules are the responsibility of the Registrant's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Registrant at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Registrant changed its method of accounting for postretirement benefits other than pensions, income taxes and transportation revenue and expense recognition in January 1993. /s/ DELOITTE & TOUCHE Omaha, Nebraska January 20, 1994 MISSOURI PACIFIC RAILROAD COMPANY AND CONSOLIDATED SUBSIDIARY COMPANIES ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Missouri Pacific Railroad Company and all subsidiaries (the "Registrant"). The Registrant is a wholly-owned, indirect subsidiary of Union Pacific Corporation (the "Corporation"). Investments in affiliated companies (20% to 50% owned) are accounted for on the equity method. All material intercompany transactions are eliminated. MATERIALS AND SUPPLIES Materials and supplies are carried at the lower of average cost or market. REVENUE RECOGNITION Transportation revenues are recognized on a percentage-of-completion basis, while delivery costs are recognized as incurred (See Note 1). PROPERTIES Properties are stated at cost. Upon sale or retirement of units of depreciable operating property, gains and losses are charged to accumulated depreciation. With respect to all other property sold or retired (principally land sold for industrial development or as surplus property), cost and any related accumulated depreciation are removed from the accounts and gain or loss is recognized upon disposition. DEPRECIATION Provisions for depreciation are computed principally on the straight-line method based on estimated service lives of depreciable properties. INTANGIBLE ASSETS Intangible and other assets include the cost in excess of fair value of net assets of acquired businesses associated with the Registrant's 1988 purchase of The Missouri-Kansas-Texas Railroad Company (the "Katy"). Amortization is recorded over 40 years on a straight-line basis. The Registrant regularly assesses the recoverability of costs in excess of net assets of acquired businesses through a review of cash flows and fair values of such businesses. HEDGING TRANSACTIONS The Registrant periodically hedges hydrocarbon purchases. Gains and losses from these transactions are recognized upon receipt of the commodity. CHANGE IN PRESENTATION Certain prior year amounts have been reclassified to conform with the 1993 financial presentation. MISSOURI PACIFIC RAILROAD COMPANY AND CONSOLIDATED SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Accounting Changes In January 1993, the Registrant adopted the following accounting changes with a cumulative after-tax charge to earnings of $125.2 million. Other Postretirement Benefits ("OPEB") Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", requires that the cost of non-pension benefits for retirees be accrued during their period of employment. The adoption of this Statement will not affect future cash funding requirements for these benefits. The OPEB component of the cumulative effect adjustment is a $73.5 million charge. See Note 9. Income Taxes SFAS No. 109, "Accounting For Income Taxes", requires the balance sheet approach of accounting for income taxes, whereby assets and liabilities are recorded at the tax rates currently enacted. The Registrant's results were not significantly affected by the adoption of this Statement; however, future results may be affected by changes in the corporate income tax rate. 1993's income tax expense (before accounting changes) rose $26.5 million as a result of the Omnibus Budget Reconciliation Act of 1993 (the "1993 Tax Act") (See Note 5). The income tax component of the cumulative effect adjustment is a $42.2 million charge. Revenue Recognition The Registrant changed its method of transportation revenue and expense recognition from accruing both revenues and expenses at the inception of service to the industry practice of allocating revenues between reporting periods based on relative transit time, while recognizing expenses as incurred. The Registrant's results were not, and are not expected to be, significantly affected by this accounting change. The revenue recognition component of the cumulative effect adjustment is a $9.5 million charge. 2. Related Party Transactions The Registrant is an affiliate of Union Pacific Railroad Company ("UPRR") and has significant interline rail shipments, equipment rents, and fuel and diesel power exchanges with that railroad. These transactions are settled in a manner similar to that used for comparable transactions with nonaffiliated railroads. Balances representing interline receivables and payables with UPRR are classified as due to affiliated companies. Certain management and staff functions of the Registrant have been combined with those of UPRR. In addition, the affiliated railroads have centralized purchasing and disbursing functions which are handled by UPRR. Also, repairs to locomotives and freight cars are made on a system-wide basis without regard to ownership or usage. Marketing, administrative and other expenses (including, but not limited to, those discussed above) are allocated to the Registrant based on revenue contribution, gross ton-miles or time in service. A summary of directly-incurred and allocated costs included in operating expenses (excluding the 1991 special charge - see Note 3) is as follows: Amounts due to and from affiliates, including the Corporation, bear interest at an annually determined rate which considers the Corporation's cost of debt. Net intercompany interest expense on such amounts was $65.5 million, $71.1 million, and $65.9 million in 1993, 1992 and 1991, respectively. 3. Special Charge In 1991, the Corporation announced a major restructuring program, including a $366 million pretax ($241 million after-tax) charge relating to the Registrant. Of the pretax amount, $221 million represented a provision for severance payments and other costs associated with the reduction in the size of train crews and administrative personnel. The remaining $145 million was for costs related to the disposition of light density rail lines. The Registrant spent $88.8 million and $47.3 million in 1993 and 1992, respectively, relating to the restructuring program. 4. Accounts Receivable The Registrant has sold, on a revolving basis, an undivided ownership interest in a designated pool of the Registrant's accounts receivable to UPRR. The undivided ownership interest has been sold by UPRR to third parties. Collection risk on the pool of receivables is minimal. Under the terms of the agreement, UPRR acts as a collection agent for the Registrant. At both December 31, 1993 and 1992, accounts receivable are presented net of $137 million in proceeds generated from the receivables sold. 5. Income Taxes The Registrant is included in the consolidated income tax return of the Corporation. The consolidated income tax liability of the Corporation is allocated among the parent and its subsidiaries on the basis of their separate contributions to the consolidated income tax liability, with full benefit of tax losses and credits made available through consolidation being allocated to the individual companies generating such losses and credits. In August 1993, President Clinton signed the 1993 Tax Act into law raising the Federal corporate income tax rate to 35 percent from 34 percent retroactive to January 1. As a result, 1993 income tax expense increased by $26.5 million: $23.1 million for the one-time non-cash recognition of deferred income taxes related to prior periods and $3.4 million of incremental current year Federal income tax expense. Components of income tax expense for the Registrant are as follows: Prior years' components of tax expense (benefit) (in thousands), which have not been restated to reflect the adoption of SFAS No. 109 (see Note 1), were $59,952 in 1992 and $(41,824) in 1991 for current Federal income tax expense and $38,916 in 1992 and $(20,294) in 1991 for deferred Federal income tax expense. The tax effect of differences in the timing of revenues and expenses for tax and financial reporting purposes is as follows: A reconciliation between statutory and effective tax rates is as follows: Payments of income taxes were $101.8 million in 1993. No taxes were paid for the years 1992 or 1991. The Corporation believes it has adequately provided for income taxes. 6. Debt Long-term debt at December 31, 1993 and 1992 is summarized below: Maturities of long-term debt (in thousands of dollars) for each year 1994 through 1998 are $53,253, $41,555, $23,652, $22,526 and $7,625, respectively. Substantially all properties secure the outstanding equipment obligations and mortgage bonds. Certain debt agreements impose dividend restrictions on the Registrant. The amount of retained earnings available for dividends at December 31, 1993 was $822.2 million. See Note 8 for other dividend restrictions. Terms of certain of the Registrant's mortgage bonds, the 5% income debentures and the 5-1/2% subordinated income debentures require that interest be paid only from "available income", as defined in the indenture agreements. The mortgage bonds and 5% income debentures impose sinking fund and other restrictions in the event all interest is not paid. All interest was paid on the mortgage bonds and 5% income debentures for each of 1993, 1992 and 1991. The Registrant assumed the 5-1/2% subordinated income debentures (the "Debentures") in connection with the Katy acquisition. Current interest must be paid only to the extent that there is available income remaining after allocation to a capital fund for the purpose of reimbursing the Registrant for certain capital expenditures. Unpaid interest accumulates to an amount not in excess of 16-1/2% of the principal amount of the Debentures and is paid only to the extent that there is available income remaining after payment of the current interest. The certificates constituting a charge on income (the "Certificates"), which were also assumed as part of the Katy acquisition, do not bear interest and payments to a sinking fund for the Certificates are made only from available income, as defined in such Certificates. Available income must be applied to the capital fund, current and accumulated interest on the Debentures and a sinking fund for the Debentures before any payment is made to the sinking fund for the Certificates. Available income of $15.2 million was generated in 1993 with respect to the Debentures and the Certificates. As a result, an interest payment on the Debentures of $2.6 million will be made in 1994, representing $1.5 million for 1993 interest and $1.1 million for remaining unpaid accumulated interest. In addition, $6.9 million of available income will be applied to the capital fund, $2.3 million will be applied to the sinking funds for the Debentures and the Certificates, and $3.4 million will be applied as dividends on the Registrant's Class A stock (See Note 8). Amounts applied to sinking funds may be covered by the cost of securities previously repurchased by the Registrant or the Katy. After the 1994 interest payment, all unpaid accumulated interest on the Debentures will have been paid to debentureholders. Amounts in the capital fund which are unused or unappropriated for the reimbursement of capital expenditures may not exceed $4.0 million at any time, and after the application of 1993 available income there will be no unused or unappropriated capital fund balance. During 1993, $23.7 million of the outstanding Debentures were reacquired, principally in connection with a lawsuit settlement. In addition, in February 1993, the remaining $25 million of the 7.50% Exchangeable Guaranteed Notes due 2003, which were issued in conjunction with the acquisition of the Katy, were exchanged for approximately 774,000 shares of the Corporation's common stock. The Registrant's total interest payments approximate interest expense net of intercompany interest described in Note 2. At December 31, 1993, the carrying amount of the Registrant's long and short-term debt exceeded its fair value by approximately 21%, estimated using quoted market prices or the Registrant's current borrowing rates. 7. Lease Commitments The Registrant leases a general office building, computer equipment and transportation equipment under long-term and contingent lease agreements. The following amounts relating to capital leases are included in properties: Future minimum lease payments for capital and operating leases with initial or remaining noncancellable lease terms in excess of one year as of December 31, 1993 are as follows: A summary of rental expense charged to operations is as follows: 8. Capital Stock Concurrently with the acquisition of the Katy, 80 shares of the Registrant's $1.00 par value common stock were exchanged for 80 shares of $1.00 par value Class A stock. The remaining 920 shares of common stock outstanding and the 80 shares of Class A stock have identical voting rights and other privileges except with respect to dividends. The Class A stock is entitled to a cash dividend whenever a dividend is declared on the common stock, in an amount which equals 8% of the sum of the dividends on both the Class A stock and the common stock. However, dividends may be declared and paid on the Class A stock only when there is unappropriated available income in respect of prior calendar years which is sufficient to make a sinking fund payment equal to 25% of such dividend for the benefit of the Debentures or the Certificates. To the extent that dividends are paid on the common stock but not the Class A stock because the amount of unappropriated available income is insufficient to make such a sinking fund payment, a special cash dividend on the Class A stock shall be paid when sufficient unappropriated available income exists to make the sinking fund payment. Such insufficiency does not affect the Registrant's right to declare dividends on the common stock. Available income for 1993 will be sufficient to provide for a $3.4 million special cash dividend on the Class A stock (see Note 6), to be paid in 1994. After such payment, dividends in arrears on the Class A stock will total $25.1 million. There are no other dividend restrictions on the Registrant's capital stock other than those described in Note 6. 9. Retirement Plans The Registrant participates in the Corporation's defined benefit pension plans covering substantially all salaried employees. Pension plan benefits are based on years of service and compensation during the last years of employment. Company contributions to the plans are calculated based on the Projected Unit Credit actuarial funding method and are not less than the minimum funding standards set forth in the Employee Retirement Income Security Act of 1974, as amended. Pension expense allocated to the Registrant under the Corporation's plans amounted to $17.7 million in 1993, $14.8 million in 1992, and $11.6 million in 1991. The Registrant provides postretirement health care and life insurance benefits to substantially all salaried and certain hourly employees through participation in the Corporation's postretirement benefit plans. The Corporation adopted the provisions of SFAS No. 106 (See Note 1) in January 1993. Railroad agreement employees' health care benefits are covered by a separate multiemployer plan and therefore are not subject to the provisions of this Statement. The Registrant's cash payments for these benefits (which were not affected by the adoption of SFAS No. 106) were $5 million in 1993. The Registrant's Accumulated Postretirement Benefit Obligation at December 31, 1993 and its 1993 postretirement benefit expense were $119 million and $9 million, respectively. In late 1993, the Corporation amended its postretirement health care plans to provide greater employee cost sharing. As a result, the Registrant's future plan expense will be reduced. The Corporation does not currently pre-fund health care and life insurance benefit costs. 10. Contingent Liabilities There are various lawsuits pending against the Registrant. The Registrant is also subject to Federal, state and local environmental laws and regulations, and is currently participating in the investigation and remediation of numerous sites. Where the remediation costs can be reasonably determined, and where such remediation is probable, the Registrant has recorded a liability. The Registrant does not expect that the lawsuits or environmental costs will have a material adverse effect on its consolidated financial position or its results of operations. 11. Supplemental Quarterly Financial Information (Unaudited) Selected unaudited quarterly financial information for 1993 and 1992 are as follows: MISSOURI PACIFIC RAILROAD COMPANY AND CONSOLIDATED SUBSIDIARY COMPANIES MANAGEMENT'S NARRATIVE ANALYSIS OF THE RESULTS OF OPERATIONS 1993 COMPARED TO 1992 In the first quarter of 1993, the Registrant recorded a $125.2 million after-tax charge to reflect the adoption of new Financial Accounting Standards Board ("FASB") pronouncements as described in Note 1 to the Financial Statements. In the third quarter, the Registrant recorded a $23.1 million charge reflecting a deferred tax adjustment that resulted from the 1993 Tax Act (see Note 5 to the Financial Statements). As a result of these accounting adjustments and the effects of weather-related traffic interruptions, the Registrant's net income declined to $73.8 million compared to $191.2 million in 1992. Excluding the accounting adjustments, the Registrant would have earned $222.1 million in 1993. OPERATING REVENUES Operating revenues increased $19 million to $2.1 billion (despite being adversely affected by the severe winter and the record 1993 flooding in the Midwest), reflecting a 2% increase in carloadings offset by a 2% decline in average revenue per car. Carloadings increased in intermodal (11%), automotive (5%) and chemicals (2%), while decreases occurred in grain and grain products (2%), food/ consumer/government (1%) and metals/minerals/forest (1%). Energy traffic remained flat compared to the prior year. OPERATING EXPENSES Operating expenses totaled $1.7 billion, $33 million (2%) lower than a year ago, as weather-related cost increases were more than offset by increased charges to other carriers and efficiency-driven expense containment. Other costs declined $26 million due to flood-related increases in repair work on joint facility lines billed to other roads, additional third-party billings, higher overhead credits for work performed on capital projects, and trackage rights settlements. Salary and wages decreased $5 million as productivity improvements and train crew reductions offset both volume and weather-related increases and wage and benefit inflation. Material and supplies expense declined $3 million as improved materials management offset weather-related usage increases. Fuel and utility expense also decreased $3 million as lower fuel prices and an improved fuel consumption rate offset volUme growth. These lower costs were partially offset by higher depreciation charges, which resulted from the implementation of SFAS No. 109 and continuing capital spending, and a $1 million increase in rent expense caused by higher volumes. OPERATING INCOME Operating income rose $52 million to $410 million as a result of continued cost containment and volume growth. OTHER CHANGES Interest expense decreased $16 million, mainly the result of lower interest rates, the repayment of maturing equipment trust obligations, the exchange of the 7.5% Exchangeable Guaranteed Notes and the repurchase of certain Missouri- Kansas-Texas Railroad Company 5-1/2% Subordinated Income Debentures (the "Debentures") (see Notes 2 and 6 to the Financial Statements). Other income decreased $14 million, primarily the result of lower real estate sales, partially offset by a $3.5 million pretax gain on repurchases of Debentures. Income taxes increased $46 million as a result of the 1% increase in the Federal income tax rate, higher pretax earnings and the adoption of SFAS No. 109. OTHER MATTERS The FASB has issued Statements No. 112, "Employers' Accounting for Postemployment Benefits", and No. 115, "Accounting for Certain Investments in Debt and Equity Securities", both effective by January 1994. Statement No. 112 requires employers to recognize the obligation to provide benefits to former or inactive employees after employment but prior to retirement. Statement No. 115 creates new reporting classifications for investments in debt and certain equity securities. Management has evaluated these Statements and has determined that they will not have a significant effect on the Registrant. EXHIBIT INDEX Exhibit Number - ------- (3)(a) Registrant's Certificate of Incorporation, amended effective as of August 12, 1988, is incorporated herein by reference to Exhibit 3(i) to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1988. (3)(b) Registrant's By-laws, amended effective as of September 1, 1992, are incorporated herein by reference to Exhibit 3 to the Registrant's Report on Form 10-Q for the quarter ended September 30, 1992. (4) Pursuant to various indentures and other agreements, the Registrant has issued long-term debt, but no such agreement has securities or obligations covered thereby which exceed 10% of consolidated assets. The Registrant agrees to furnish a copy of any such indenture or agreement to the Securities and Exchange Commission upon request. (24) Powers of attorney executed by the directors of the Registrant.

81061_1993.txt

81061_1993

1993

81061

Item 1. Business Publix Super Markets, Inc. (the "Company") is based in Lakeland, Florida and was incorporated in Florida on December 27, 1921. The Company is in the business of operating retail food supermarkets in Florida, Georgia and South Carolina. The Company's supermarkets sell groceries, produce, deli, bakery, meat, seafood, housewares and health and beauty care items. In addition, some stores have pharmacy and floral departments. The Company's lines of merchandise include a variety of nationally advertised and private label brands, as well as unbranded merchandise such as produce, meat and seafood. Private label items are produced in the Company's manufacturing facilities or are manufactured for the Company by outside vendors. The Company manufactures dairy, bakery and deli products. The Company's dairy plants are located in Lakeland and Deerfield Beach, Florida. The bakery and deli plants are located in Lakeland, Florida. The Company receives the food and non-food items it distributes from many sources throughout the United States. These products are generally available in sufficient quantities to enable the Company to adequately satisfy its customers. The Company believes that its sources of supply of these products and raw materials used in manufacturing are adequate for its needs and that it is not dependent upon a single or relatively few suppliers. The Company operated 425 supermarkets at the end of 1993, compared with 400 at the beginning of the year. In 1993, 29 stores were opened, 4 stores were closed, and 13 stores were expanded or remodeled. The net increase in square footage was 1.50 million or 9.0% since 1992. All of the Company's stores are located in Florida, with the exception of 15 stores located in Georgia and one located in South Carolina. The Company entered the Georgia market in 1991 and the South Carolina market in 1993. As of year end, the Company had 5 stores under construction in South Carolina, 21 in Georgia and 14 in Florida. In 1994, the Company will continue construction of additional distribution centers in Lakeland, Florida and Lawrenceville, Georgia. The Company is engaged in a highly competitive industry. Competition, based primarily on price, quality of goods and service, convenience and product mix, is with several national and regional chains, independent stores and mass merchandisers throughout its market areas. The Company anticipates continued competitor format innovation and location additions in 1994. The influx of winter residents to Florida and increased purchases of food during the traditional Christmas and Thanksgiving holidays typically results in seasonal sales increases between November and April of each year. The Company has experienced no significant changes in the kinds of products sold or in its methods of distribution since the beginning of the fiscal year. The Company had approximately 82,000 employees at the end of 1993, compared with 73,000 at the beginning of the year. Of this total, approximately 53,000 at the end of 1993 and 47,000 at the end of 1992 were not full-time employees. The Company's research and development expenses are insignificant. Compliance by the Company with Federal, state and local environmental protection laws during 1993 had no material effect upon capital expenditures, earnings or the competitive position of the Company. Item 2. Item 2. Properties At year end, the Company operated approximately 18.1 million square feet of retail space. The Company's stores vary in size. Current store prototypes range from 27,000 to 65,000 square feet. Stores are often located in strip shopping centers where Publix is the anchor tenant. The majority of the Company's retail stores are leased. Substantially all of these leases will expire during the next 20 years. However, in the normal course of business, it is expected that the leases will be renewed or replaced by leases on other properties. At 35 locations both the building and land are owned and at 20 other locations the buildings are owned while the land is leased. The Company supplies its retail stores from seven distribution centers located in Lakeland, Miami, Jacksonville, Sarasota, Orlando, Deerfield Beach and Boynton Beach, Florida. A new distribution center is currently under construction in Lawrenceville, Georgia. With the exception of a portion of the Miami distribution facility, the Company's corporate offices, distribution facilities and manufacturing plants are owned with no outstanding debt. All of the Company's properties are well maintained and in good operating condition, and suitable and adequate for operating its business. Item 3. Item 3. Legal Proceedings On January 19, 1993, the Equal Employment Opportunity Commission ("EEOC") applied to the United States District Court, Southern District of Florida in Miami, for an order to show cause why an administrative subpoena previously issued by the EEOC to the Company should not be enforced (EEOC v. Publix Super Markets, Inc., Case No. 93-0091). The application, among other things, alleged that information previously supplied by the Company to the EEOC did not fully comply with the subpoena and that the EEOC was entitled to require the Company to compile additional information and produce additional documents. The matter was resolved by a Consent Order, with which the Company complied, resulting in an order on June 17, 1993 dismissing the action. This application arose out of a notice of charge issued by the EEOC on March 25, 1992, In the Matter of: Kemp v. Publix Super Markets, Inc., Charge No. ###-##-####, alleging that the Company had engaged in past violations and was engaged in continuing violations of Title VII of the Civil Rights Act, as amended, by discriminating against women with respect to job assignments and promotions because of their sex. As currently amended, the charge covers employment practices by the Company in the State of Florida as a whole. On December 6, 1993, the EEOC sought to expand the scope of its investigation to include allegations of race discrimination. The EEOC has requested the Company to compile information and produce documents relating to these allegations. The Company has objected to the expansion and the EEOC has agreed to substantial reductions in the information requested and further discussions as to additional reductions in the information requested are pending. The Company denies the allegations of the charge and the subsequent attempted expansion of the charge. The EEOC has advised that the charge does not in any respect constitute a final finding of a violation, but that the EEOC has a statutory duty to conduct a full and impartial investigation for the purpose of determining whether the facts and circumstances afford the EEOC reasonable cause to believe that the Company's employment patterns and practices constitute discrimination on the basis of sex and race. The EEOC's investigation of the charge remains at the stage of considering whether there is reasonable cause to believe the allegations of the charge. At this early stage, the likelihood of an adverse finding of the Company's liability and an estimate of the amount of any exposure for any such liability cannot be determined. The Company is also a party in various other legal claims and actions considered in the normal course of business. Management believes that the ultimate disposition of these matters will not have a material effect on the Company's financial condition. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None EXECUTIVE OFFICERS OF THE COMPANY The terms of all officers expire at the annual meeting of the Company in May 1994. PART II Item 5. Item 5. Market for the Company's Common Stock and Related Stockholder Matters (a) Market Information* Substantially all transactions of the Company's common stock have been among the Company, its employees, former employees and various benefit plans established for the Company's employees. The market price of the Company's common stock is determined by the Board of Directors based upon appraisals prepared by an independent appraiser. The market price for 1993 was $11.50 per share until March 17, 1993, when the price decreased to $11.25 per share. In the second quarter, the price increased to $11.50 per share. In the third quarter, the price was unchanged at $11.50 per share and in the fourth quarter, the price decreased to $11.00 per share. The market price for 1992 was $9.30 per share until the second quarter when the price increased to $10.60 per share. In the third quarter, the price increased to $10.80 per share and in the fourth quarter the price increased to $11.50 per share. (b) Approximate Number of Equity Security Holders As of March 4, 1994, the approximate number of holders of record of the Company's common stock was 57,500. (c) Dividends* The Company paid cash dividends of $.08 per share of common stock in 1993 and $.08 per share in 1992. Payment of dividends is within the discretion of the Company's Board of Directors and depends on, among other factors, earnings, capital requirements and the operating and financial condition of the Company. It is expected that comparable cash dividends will be paid in the future. *Restated to give retroactive effect for 5-for-1 stock split in July 1992. Item 6. Item 6. Five Year Summary of Selected Financial Data NOTE: Dollars are in thousands except per share amounts. All years include 52 weeks. * Restated to give retroactive effect for 5-for-1 stock split in July 1992. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Business Environment As of December 25, 1993, the Company operated 425 retail grocery stores representing approximately 18.1 million square feet of retail space. Historically, the Company's primary competition has been from national and regional chains and smaller independents located throughout its market areas. The Company has continued to experience increased competition from mass merchandisers. The products offered by these retailers include many of the same items sold by the Company. All of the Company's stores are located in Florida with the exception of 15 stores located in Georgia and one store located in South Carolina. The Company opened its first store in Georgia during the fourth quarter of 1991, four stores during 1992 and 10 additional stores during 1993. The Company opened its first store in South Carolina during the fourth quarter of 1993. The Company intends to continue to pursue vigorously new locations in Florida and other states. Liquidity and Capital Resources Operating activities continue to be the Company's primary source of liquidity. Net cash provided by operating activities was approximately $370.4 million in 1993 compared with $296.8 million in 1992 and $313.7 million in 1991. Working capital was approximately $137.2 million as of December 25, 1993 as compared with $241.2 million and $271.4 million as of December 26, 1992 and December 28, 1991, respectively. Cash and cash equivalents aggregated $199.0 million as of December 25, 1993, as compared with $293.5 million and $332.8 million as of December 26, 1992 and December 28, 1991, respectively. Capital expenditures totaled $320.2 million in 1993. These expenditures were primarily incurred in connection with the opening of 29 new stores and remodeling or expanding 13 stores which added 1.63 million square feet. Significant expenditures were incurred in the continued expansion of the Deerfield Beach, Florida facility, acquisition of a grocery warehouse in Orlando, Florida and construction of a new general merchandise warehouse in Lakeland, Florida and a new distribution center in Lawrenceville, Georgia. In addition, the Company closed four stores. Capital expenditures totaled $202.6 million in 1992. These expenditures were primarily incurred in connection with the opening of 20 new stores and remodeling or expanding 12 stores which added 1.14 million square feet. Significant expenditures were incurred in expanding the Deerfield Beach facility. In addition, the Company closed 12 stores. Capital expenditures totaled $159.0 million in 1991. These expenditures were primarily incurred in connection with the opening of 20 new stores and remodeling or expanding 11 stores which added 1.10 million square feet. In addition, the Company closed six stores. The Company hopes to open as many as 60 stores in 1994. Although real estate development is unpredictable, the Company's 1994 new store growth represents a reasonable estimate of anticipated future growth. Capital expenditures for 1994, primarily made up of new store construction, the remodeling or expanding of several existing stores and the expansion and construction of distribution facilities, are expected to be approximately $400 million. This capital program is subject to continuing change and review. The 1994 capital expenditures are expected to be financed by internally generated funds and current liquid assets. In the normal course of operations, the Company replaces stores and closes unprofitable stores. The impact of future store closings is not expected to be material. The Company is self-insured, up to certain limits, for health care, fleet liability, general liability and workers' compensation claims. Reserves are established to cover estimated liabilities for existing and anticipated claims based on actual experience including, where necessary, actuarial studies. The Company has insurance coverage for losses in excess of varying amounts. The provision for self-insured reserves was $90.1 million, $78.7 million and $56.2 million in fiscal 1993, 1992 and 1991, respectively. The Company does not believe its self-insurance program will have a material adverse impact on its future liquidity, financial condition or results of operations. The Company has committed lines of credit for $75.0 million. These lines are reviewed annually by the banks. The interest rate for these lines is at or below the prime rate. No amounts were outstanding on the lines of credit as of December 25, 1993 or December 26, 1992. Cash generated in excess of the amount needed for current operations and capital expenditures is invested in short-term and long-term investments. Short-term investments were approximately $59.8 million in 1993 compared with $50.4 million in 1992. Long- term investments, primarily comprised of tax exempt bonds and preferred stocks, were approximately $199.4 million in 1993 compared with $126.8 million in 1992. Management believes the Company's liquidity will continue to be strong. The Company currently repurchases common stock at the stockholders' request in accordance with the terms of the Company's Employee Stock Purchase Plan. The Company expects to continue to repurchase its common stock, as offered by its stockholders from time to time, at its then currently appraised value. However, such purchases are not required and the Company retains the right to discontinue them at any time. Results of Operations The Company's fiscal year ends on the last Saturday in December. Fiscal years 1993, 1992 and 1991 included 52 weeks. Sales for fiscal 1993 were $7,472.7 million as compared with $6,664.3 million in fiscal 1992, a 12.1% increase. This reflects an increase of $426.5 million or 6.4% in sales from stores that were open for all of both years (comparable stores) and sales of $381.9 million or 5.7% from the net impact of 29 new stores and four closed stores. This activity contributed a net increase of 9.0% or approximately 1.50 million square feet in retail space. Sales for fiscal 1992 were $6,664.3 million as compared with $6,139.7 million in fiscal 1991, an 8.5% increase. This reflects an increase of $283.9 million or 4.6% in sales from stores that were open for all of both years (comparable stores) and sales of $240.7 million or 3.9% from the net impact of 23 new stores and 12 closed stores. This activity contributed a net increase of 5.9% or approximately .88 million square feet in retail space. This includes the acquisition of three stores from affiliated companies and the three stores closed as a result of extensive damage caused by Hurricane Andrew. In 1992, the Company identified potential environmental problems relating to properties that are owned or leased. Other income, net includes $8.0 million which was accrued for estimated clean-up costs. On August 24, 1992, Hurricane Andrew destroyed three of the Company's stores in south Florida. Several other stores sustained varying degrees of damage but were operational within four weeks. In management's opinion, the resulting property damage and business interruption losses are substantially covered by insurance and are immaterial to the Company's financial position and operations. Cost of merchandise sold including store occupancy, warehousing and delivery expenses was approximately 78.1% of sales in 1993 as compared with 77.8% and 77.3% in 1992 and 1991, respectively. In 1993 and 1992, cost of merchandise sold increased as a percent of sales due to competitive pressures. Operating and administrative expenses, as a percent of sales, were 19.1%, 19.3% and 19.9% in 1993, 1992 and 1991, respectively. In 1993, the Company's workers' compensation expense increased approximately $17.5 million or 89% as compared to 1992 due to increases in claim payments and estimated reserves for claim payments. The significant components of operating and administrative expenses are payroll costs, employee benefits and depreciation. In August 1993, the "Omnibus Budget Reconciliation Act of 1993" became effective. The major provision of the new tax law affecting the Company is the increase in the maximum corporate income tax rate from 34% to 35%. This 1% increase in the tax rate was retroactive to January 1, 1993. Therefore, in accordance with Financial Accounting Standard No. 109, "Accounting for Income Taxes," the Company recognized an additional $3.5 million income tax expense during fiscal year 1993. In recent years, the impact of inflation on the Company's food prices continues to be lower than the overall increase in the Consumer Price Index. New Accounting Standards The Company adopted Statement 109, without restating prior years' financial statements, in the first quarter of 1993. This Standard requires a change from the deferred method to the asset and liability method of accounting for income taxes. The cumulative effect of the change in method resulted in a reduction of deferred Federal and state income taxes and an increase in net earnings of approximately $11.8 million. The Company adopted Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in the first quarter of 1993. This Standard requires that an employer's obligation for postretirement benefits be fully accrued by the date the employees attain full eligibility to receive these benefits. The Company provides certain life insurance benefits for retired employees. Employees become eligible for these benefits when they reach normal retirement age while working for the Company. The cumulative effect of the change in method resulted in a decrease in net earnings of approximately $15.3 million. At the beginning of 1993, the accumulated postretirement obligation accrued was $24.6 million. During 1993, the Company's accrual increased approximately $1.9 million in additional annual costs under the new Standard. In May 1993, the Financial Accounting Standards Board issued Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. This Standard expands the use of fair value accounting for certain debt securities that are classified as available-for-sale or trading but retains the use of the amortized cost method for investments in debt securities that the Company has the positive intent and ability to hold to maturity. The Company will prospectively adopt Statement 115 in the first quarter of 1994. This Standard is not expected to materially affect the Company's financial statements. In November 1992, the Financial Accounting Standards Board issued Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits," effective for fiscal years beginning after December 15, 1993. This Standard requires the accrual of a liability for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. The Company has historically accrued postemployment benefits; therefore, the adoption of Statement 112 will not materially affect the Company's financial statements. Item 8. Item 8. Financial Statements and Supplemental Data The Company's financial statements, together with the independent auditors' report thereon, are included in the section following Part IV of this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors, Executive Officers, Promoters and Control Persons of the Registrant Certain information concerning the directors of the Company is incorporated by reference to pages 2 through 5 of the Proxy Statement of the Company (1994 Proxy Statement) which the Company intends to file no later than 120 days after its fiscal year end. Certain information concerning the executive officers of the Company is set forth in Part I under the caption "Executive Officers of the Company." Item 11. Item 11. Executive Compensation Information regarding executive compensation is incorporated by reference to pages 6 through 9 of the 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth, as of March 4, 1994, the information with respect to common stock ownership of all Directors, including some who are 5% or more beneficial owners, and all Officers and Directors as a group. Also, listed are others known by the Company to own beneficially 5% or more of the shares of the Company's common stock. Note references are explained on the next two pages. *Shares represent less than 1% of class (1) As used in the table on the preceding page, "beneficial ownership" means the sole or shared voting or investment power with respect to the Company's common stock. Holdings of officers include shares allocated to their individual accounts in the Company's Employee Stock Ownership Plan, over which each officer exercises sole voting power and shared investment power. In accordance with the beneficial ownership regulations, the same shares of common stock may be included as beneficially owned by more than one individual or entity. The address for all beneficial owners is 1936 George Jenkins Boulevard, Lakeland, Florida 33801. (2) Excludes shares of common stock beneficially owned by Carol Jenkins Barnett's husband, as to which Carol Jenkins Barnett disclaims beneficial ownership. (3) Hoyt R. Barnett is Trustee of the Profit Sharing Plan which is the record owner of 23,278,750 shares of common stock over which he exercises sole voting and investment power. Total shares beneficially owned excludes shares of common stock owned by Hoyt R. Barnett's wife, as to which Hoyt R. Barnett disclaims beneficial ownership. (4) Mark C. Hollis is Co-Trustee with Peoples Bank of Lakeland for 1,577,699 shares of common stock in three family trusts. The remaining shares are owned in a separate family trust over which Mark C. Hollis is Co-Trustee with his wife. As Co-Trustee, Mark C. Hollis has shared voting and investment power for these shares. (5) Howard M. Jenkins is Voting Trustee of a Voting Trust Agreement (Agreement), effective May 30, 1987, established by him, his brother and two of his sisters. The Agreement, as amended, has a ten year term and covers 45,733,983 shares of common stock, of which 13,887,305 shares are beneficially owned by Howard M. Jenkins and 14,185,405 shares are beneficially owned by Nancy E. Jenkins. The remaining shares held under the Agreement are owned by various individuals who are not beneficial owners of 5% or more of the Company's common stock. As Trustee, Howard M. Jenkins has voting power for the shares represented by the Agreement unless the stockholders of a majority of the shares direct him to vote all shares in a specified manner. In addition, Howard M. Jenkins beneficially owns 571,940 shares of common stock which are either individually owned or owned as Trustee for three trusts over which he exercises sole voting and investment power. (6) William H. Vass is Trustee of the Employee Stock Ownership Plan (ESOT) which is the record owner of 27,610,780 shares of common stock over which he has shared investment power. As Trustee, William H. Vass exercises sole voting power over 545,249 shares in the ESOT because such shares have not been allocated to participants' accounts. The ESOT participants, not William H. Vass, exercise sole voting power over all remaining shares in the ESOT. (7) Includes 50,889,530 shares of common stock owned by the Profit Sharing Plan and ESOT. (8) Includes 14,185,405 shares of common stock which are held in and subject to the Voting Trust Agreement, effective May 30, 1987, for which Howard M. Jenkins is Voting Trustee. Item 13. Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is incorporated by reference to pages 2 through 5 and 9 of the 1994 Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements and Schedules The financial statements and schedules listed in the accompanying Index to Financial Statements and Schedules are filed as part of this Annual Report on Form 10-K. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the fourth quarter of the year ended December 25, 1993. (c) Exhibits 3(a). Articles of Incorporation of the Company, together with all amendments thereto are incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K, as amended, for the year ended December 26, 1987. Articles of Amendment of the Restated Articles of Incorporation of the Company filed with the Secretary of the State of Florida, effective June 9, 1993 is incorporated herein. 3(b). By-laws of the Company are incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K, as amended, for the year ended December 26, 1987. 9. Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 31, 1988. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective March 8, 1990, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 30, 1989. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective June 14, 1991, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 28, 1991. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective November 3, 1992, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 26, 1992. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective February 26, 1993, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 26, 1992. 18. Letter regarding change in accounting principle is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 26, 1992. 27. Financial Data Schedule for the year ended December 25, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PUBLIX SUPER MARKETS, INC. March 15, 1994 By: ------------------------------ Keith Billups Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. PUBLIX SUPER MARKETS, INC. Index to Financial Statements and Schedules Independent Auditors' Report Financial Statements: Balance Sheets - December 25, 1993 and December 26, 1992 Statements of Earnings - Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Statements of Stockholders' Equity - Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Statements of Cash Flows - Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Notes to Financial Statements The following supporting schedules of Publix Super Markets, Inc. for the years ended December 25, 1993, December 26, 1992 and December 28, 1991 are submitted herewith: Schedules: V - Property, Plant and Equipment VI - Accumulated Depreciation of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. INDEPENDENT AUDITORS' REPORT To The Stockholders Publix Super Markets, Inc.: We have audited the financial statements of Publix Super Markets, Inc. as listed in the accompanying index. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Publix Super Markets, Inc. as of December 25, 1993, and December 26, 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 25, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 1 of the notes to financial statements, the Company changed its methods of accounting for postretirement benefits and income taxes during 1993 and, during 1992 changed its method of depreciation for all newly acquired fixed assets. KPMG PEAT MARWICK Tampa, Florida March 9, 1994 PUBLIX SUPER MARKETS, INC. Balance Sheets December 25, 1993 and December 26, 1992 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Balance Sheets December 25, 1993 and December 26, 1992 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Statements of Earnings Years ended December 25, 1993, December 26, 1992 and December 28, 1991 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Statements of Stockholders' Equity Years ended December 25, 1993, December 26, 1992 and December 28, 1991 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Statements of Cash Flows Years ended December 25, 1993, December 26, 1992 and December 28, 1991 See accompanying notes to financial statements. (Continued) PUBLIX SUPER MARKETS, INC. Statements of Cash Flows (Continued) See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Notes to Financial Statements December 25, 1993, December 26, 1992 and December 28, 1991 (1) Summary of Significant Accounting Policies (a) Definition of Fiscal Year The fiscal year ends on the last Saturday in December. Fiscal years 1993, 1992 and 1991 comprised 52 weeks. (b) Cash Equivalents The Company considers all liquid investments with maturities of three months or less to be cash equivalents. (c) Investments Short and long-term investments are recorded at the lower of cost or market. The Company will adopt Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," in the first quarter of 1994. This Standard is not expected to materially affect the Company's financial statements. (d) Investment in Joint Ventures The Company has invested in joint ventures to develop shopping centers. The investment in these joint ventures is accounted for using the equity method. (e) Inventories Inventories are valued at cost (principally the dollar value last-in, first-out method) including store inventories which are calculated by the retail method. (f) Property, Plant and Equipment and Depreciation Maintenance and repairs are charged to expense as incurred. Expenditures for renewals and betterments are capitalized. The gain or loss on traded items is applied to the asset accounts or reflected in income for disposed items. Prior to fiscal year 1992, depreciation was computed for financial statement purposes by the declining balance and straight-line methods. During 1992, the Company adopted the straight-line method of depreciation for all newly acquired fixed assets. Assets acquired before 1992 continue to be depreciated using prior years' depreciation methods. The change to the straight-line method of depreciation was made to conform to predominant industry practice. Use of the straight-line method of depreciation on assets placed in service in 1993 and 1992, as compared with accelerated methods, resulted in an increase in earnings before income taxes of approximately $20,800,000 and $4,743,000 and in net earnings of approximately $10,848,000 or $.05 per share and $2,514,000 or $.01 per share in 1993 and 1992, respectively. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (g) Postretirement Benefits At the beginning of fiscal year 1993, the Company adopted Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," without restating prior years' financial statements. This Standard requires that an employer's obligation for postretirement benefits be fully accrued by the date the employees attain full eligibility to receive these benefits. The cumulative effect of the change in method of accounting for postretirement benefits has been reported in the 1993 statement of earnings (note 3). (h) Self-insurance Self-insurance reserves are established for heath care, fleet liability, general liability and workers' compensation claims. These reserves are determined based on actual experience including, where necessary, actuarial studies. The Company has insurance coverage for losses in excess of varying amounts. (i) Income Taxes At the beginning of fiscal year 1993, the Company adopted Financial Accounting Standard No. 109, "Accounting for Income Taxes," without restating prior years' financial statements. This Standard requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The cumulative effect of the change in method of accounting for income taxes has been reported in the 1993 statement of earnings (note 7). In prior years, the deferred method under APB Opinion 11 was applied. Under the deferred method, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Deferred taxes are not adjusted for subsequent changes in tax rates. (j) Related Parties Historically, the Company sold merchandise, performed various services and leased equipment and fixtures from two affiliated companies. In November 1992, the Company acquired these companies (note 6). (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (2) Merchandise Inventories If the first-in, first-out method of valuing inventories had been used by the Company, inventories and current assets would have been higher than reported by approximately $83,741,000, $87,012,000 and $89,930,000 as of December 25, 1993, December 26, 1992 and December 28, 1991, respectively. Also, net earnings would have decreased by approximately $1,706,000 or less than $.01 per share in 1993 and $1,547,000 or less than $.01 per share in 1992 and $712,000 or less than $.01 per share in 1991. (3) Postretirement Benefits The Company provides life insurance benefits for salaried and hourly full-time employees. Such employees retiring from the Company on or after attaining age 55 and having ten years of credited service are entitled to postretirement life insurance benefits. The Company funds the life insurance benefits on a pay-as-you-go basis. During 1993, the Company made benefit payments of approximately $1,233,000. As discussed in Note 1, the Company adopted Statement 106 at the beginning of fiscal year 1993. The accumulated postretirement obligation accrued was $24,607,000. The cumulative effect of this accounting change decreased net earnings by approximately $15,347,000. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements The accumulated postretirement benefit obligation calculated at the beginning of fiscal year 1993 was determined using an assumed discount rate of 8% and a salary increase rate of 4%. The accumulated postretirement benefit obligation as of December 25, 1993 was determined using an assumed discount rate of 7.25% and a salary increase rate of 4%. The change in the discount rate from 8% to 7.25% increased the accumulated postretirement benefit obligation by $3,892,000 and is expected to increase annual postretirement benefit costs by $455,000, beginning in 1994. (4) Common Stock Split On May 12, 1992, the Company's stockholders approved an increase in the number of authorized shares of common stock from 60,000,000 shares to 300,000,000 shares to effect a 5-for-1 stock split. All data in the accompanying financial statements has been restated to give retroactive effect for the stock split. (5) Profit Sharing Plan and Employee Stock Ownership Trust The Company has a trusteed, noncontributory profit sharing plan for the benefit of eligible employees. The amount of the Company's contribution to the plan is determined by the Board of Directors. The contribution cannot exceed 15% of compensation paid to participants. Contributions to the plan amounted to $33,976,000 in 1993, $29,867,000 in 1992 and $28,310,000 in 1991. The Company has an Employee Stock Ownership Trust (ESOT). Annual contributions to the ESOT are determined by the Board of Directors and can be made in Company stock or cash. In 1993, the Company contributed 2,000,000 shares of its common stock to the ESOT at an appraised value resulting in an expense to the Company of $22,000,000. In 1992, the Company contributed $21,200,000 in cash to the ESOT. In 1991, the Company contributed 2,000,000 shares of its common stock to the ESOT at an appraised value resulting in an expense to the Company of $18,600,000. During 1993, 1992 and 1991, the Board of Directors approved additional contributions to the ESOT of $16,983,000, $14,923,000 and $14,126,000, respectively. The additional contributions are made to the ESOT during the subsequent year. The Company intends to continue the profit sharing plan and ESOT indefinitely; however, the right to modify, amend or terminate these plans has been reserved. In the event of termination, all amounts contributed under the plans must be paid to the participants or their beneficiaries. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (6) Acquisition In November 1992, the Company issued 611,144 shares of its common stock valued at approximately $7,028,000 for all of the outstanding common stock of two affiliated companies, Publix Food Stores, Inc. and Publix Market, Inc. The merger was accounted for as a combination of companies under common control and therefore treated in a manner similar to the pooling-of-interests method. Acquired assets of approximately $6,022,000 and liabilities of approximately $3,916,000 were recorded at historical amounts. The acquisition was considered immaterial and thus the fiscal year 1992 financial statements include the assets, liabilities, results of operations and cash flows from the acquisition date to year end. (7) Income Taxes As discussed in Note 1, the Company adopted Statement 109 at the beginning of fiscal year 1993. The cumulative effect of this accounting change resulted in a reduction of deferred Federal and state income taxes and an increase in net earnings of approximately $11,853,000. The provision for income taxes consists of the following: (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements Income tax expense amounted to $104,898,000 for 1993 (an effective rate of 36.3%), $87,222,000 for 1992 (an effective rate of 34.4%) and $82,019,000 for 1991 (an effective rate of 34.2%). The actual expense for 1993, 1992 and 1991 differs from the "expected" tax expense for those years (computed by applying the U.S. Federal corporate tax rate of 35% for 1993 and 34% for 1992 and 1991 to earnings before income taxes) as follows: The significant components of deferred income taxes and their tax effects for 1993, 1992 and 1991 are as follows: The "Omnibus Budget Reconciliation Act of 1993" included various rule changes and increased the maximum corporate income tax rate from 34% to 35%, effective January 1, 1993. The impact of the new tax law increased the Company's 1993 income tax expense by $3,484,000. This included $2,514,000 attributable to the new tax rate on current income and $970,000 resulting from an adjustment of deferred tax balances. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities as of December 25, 1993 are as follows: As of December 25, 1993, the Company had net noncurrent deferred tax liabilities of $63,409,000 and current deferred tax assets of $25,299,000. The Company expects the results of future operations to generate sufficient taxable income to allow utilization of deferred tax assets. (8) Fair Value of Financial Instruments The following methods and assumptions were used by the Company in estimating the fair value for its financial instruments: Cash and cash equivalents: The carrying amount for cash and cash equivalents approximates fair value. Investment securities: The fair value for marketable debt and equity securities are based on quoted market prices. Long-term debt, including current installments: The carrying amount for long-term debt approximates fair value based on current interest rates. The carrying amount and fair value of the Company's financial instruments as of December 25, 1993 and December 26, 1992 are as follows: (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (9) Commitments and Contingencies (a) Operating Leases The Company conducts a major portion of its retail operations from leased store and shopping center premises generally under 20 year leases. Contingent rentals paid to lessors of certain store facilities are determined on the basis of a percentage of sales in excess of stipulated minimums plus, in certain cases, reimbursement of taxes and insurance. Total rental expense, net of sublease rental income, for the years ended December 25, 1993, December 26, 1992 and December 28, 1991 is as follows: As of December 25, 1993, future minimum lease payments for all noncancelable operating leases and related subleases are as follows: The Company also owns shopping centers which are leased to tenants for fixed monthly rentals. Contingent rentals received from certain tenants are determined on the basis of a percentage of sales in excess of stipulated minimums plus, in certain cases, taxes. Contingent rentals were estimated at December 25, 1993 and are included in trade receivables. Rental income was approximately $7,624,000 in 1993, $7,034,000 in 1992 and $6,454,000 in 1991. The approximate amounts of minimum future rental payments to be received under operating leases are $5,927,000, $4,845,000, $3,985,000, $2,874,000 and $2,212,000 for the years 1994 through 1998, respectively, and $9,061,000 thereafter. (b) Lines of Credit The Company has committed lines of credit for $75,000,000 available for short-term borrowings, with interest rates at or below the prime rate. There were no amounts outstanding as of December 25, 1993 or December 26, 1992. The Company pays no fees related to these lines. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (c) Litigation On January 19, 1993, the Equal Employment Opportunity Commission ("EEOC") applied to the United States District Court, Southern District of Florida in Miami, for an order to show cause why an administrative subpoena previously issued by the EEOC to the Company should not be enforced (EEOC v. Publix Super Markets, Inc., Case No. 93-0091). The application, among other things, alleged that information previously supplied by the Company to the EEOC did not fully comply with the subpoena and that the EEOC was entitled to require the Company to compile additional information and produce additional documents. The matter was resolved by a Consent Order, with which the Company complied, resulting in an order on June 17, 1993 dismissing the action. This application arose out of a notice of charge issued by the EEOC on March 25, 1992, In the Matter of: Kemp v. Publix Super Markets, Inc., Charge No. ###-##-####, alleging that the Company had engaged in past violations and was engaged in continuing violations of Title VII of the Civil Rights Act, as amended, by discriminating against women with respect to job assignments and promotions because of their sex. As currently amended, the charge covers employment practices by the Company in the State of Florida as a whole. On December 6, 1993, the EEOC sought to expand the scope of its investigation to include allegations of race discrimination. The EEOC has requested the Company to compile information and produce documents relating to these allegations. The Company has objected to the expansion and the EEOC has agreed to substantial reductions in the information requested and further discussions as to additional reductions in the information requested are pending. The Company denies the allegations of the charge and the subsequent attempted expansion of the charge. The EEOC has advised that the charge does not in any respect constitute a final finding of a violation, but that the EEOC has a statutory duty to conduct a full and impartial investigation for the purpose of determining whether the facts and circumstances afford the EEOC reasonable cause to believe that the Company's employment patterns and practices constitute discrimination on the basis of sex and race. The EEOC's investigation of the charge remains at the stage of considering whether there is reasonable cause to believe the allegations of the charge. At this early stage, the likelihood of an adverse finding of the Company's liability and an estimate of the amount of any exposure for any such liability cannot be determined. The Company is also a party in various legal claims and actions considered in the normal course of business. Management believes that the ultimate disposition of these matters will not have a material effect on the Company's financial condition. Schedule V PUBLIX SUPER MARKETS, INC. Property, Plant and Equipment Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) (Continued) Schedule V PUBLIX SUPER MARKETS, INC. Property, Plant and Equipment Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) Notes: (1) Fully depreciated assets written off. (2) Transfer from construction in progress. (3) Accumulated depreciation on fixed assets of acquired companies. Schedule VI PUBLIX SUPER MARKETS, INC. Accumulated Depreciation of Property, Plant and Equipment Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) Note: (1) Accumulated depreciation on fully depreciated assets written off. (2) Accumulated depreciation on fixed assets of acquired companies. Schedule VIII PUBLIX SUPER MARKETS, INC. Valuation and Qualifying Accounts Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) Schedule IX PUBLIX SUPER MARKETS, INC. Short-term Borrowings Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 Notes: (1) Computed based on the daily balance outstanding during the year. (2) Computed by dividing interest expense for the year by the average amount outstanding for the year. PUBLIX SUPER MARKETS, INC. Index to Exhibits EXHIBIT 3A Restated Articles of Incorporation of the Company as incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K, as amended, for the year ended December 26, 1987 (restated in electronic format). Articles of Amendment of the Restated Articles of Incorporation of the Company filed with the Secretary of the State of Florida, effective June 9, 1993. EXHIBIT 27 Financial Data Schedule for the year ended December 25, 1993.

726513_1993.txt

726513_1993

1993

726513

ITEM 1. BUSINESS. Tribune Company (the "Company") is an information and entertainment company. Through its subsidiaries, the Company is engaged in the publishing of newspapers, books and information in print and digital formats and the broadcasting, production and syndication of information and entertainment in metropolitan areas in the United States. The Company also has an ownership interest in a Canadian newsprint manufacturer. The Company was founded in 1847 and incorporated in Illinois in 1861. As a result of a corporate restructuring in 1968, the Company became a holding company incorporated in Delaware. References in this report to "Tribune Company" or "the Company" include Tribune Company and its subsidiaries, unless the context otherwise indicates. The information in this Item 1 should be read in conjunction with the information contained under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference. BUSINESS SEGMENTS Through 1992, the Company's operations were divided for reporting purposes into three industry segments: Publishing, Broadcasting and Entertainment, and Newsprint Operations. The newsprint operations segment consisted entirely of QUNO Corporation ("QUNO"), which operates in Canada while the other segments operate in the United States. As a result of an initial public offering completed by QUNO in February 1993, the Company's ownership interest in the newsprint operations segment was reduced from 100% to 59%, and its voting interest was reduced to 49%. As the Company's voting interest is now less than 50%, the Company is using the equity method of accounting for its investment in QUNO beginning in 1993 and newsprint operations is no longer reported as a business segment. On March 20, 1991, the Company sold its New York newspaper, the Daily News. The following table sets forth operating revenue and profit information regarding each segment of the Company and presents publishing results both including and excluding the New York Daily News (in millions). - ---------- (1) 1992 amounts have been restated to conform to the 1993 presentation. (2) 1992 includes $12.3 million of Major League Baseball expansion fees. (3) Operating profit for each segment excludes interest income and expense, non- operating gains and losses, equity in QUNO net loss and income taxes. (4) 1992 includes a $15.3 million charge for the disposition of The Peninsula Times Tribune. The following table sets forth asset information for each industry segment (in millions). - ---------- (1) 1993 Corporate assets include a $250.9 million investment in and advances to QUNO Corporation. The Company's results of operations, when examined on a quarter-by-quarter basis, reflect the seasonality of advertising that affects both publishing and broadcasting operations. Second and fourth quarter advertising revenues are typically higher than first and third quarter revenues. Results for the second quarter usually reflect spring advertising, while the fourth quarter includes advertising related to the holiday season. PUBLISHING The publishing segment represented 63% of the Company's consolidated operating revenues for 1993. The combined average circulation of the Company's newspapers was approximately 1.4 million daily and 2.0 million Sunday, according to Audit Bureau of Circulation ("ABC") averages for the six-month period ended September 1993. The Company's primary newspapers are the Chicago Tribune, the Fort Lauderdale-based Sun-Sentinel and The Orlando Sentinel. In Virginia, the Company owns the Newport News Daily Press. In California, the Company owns two daily newspapers and a weekly newspaper located in suburban areas in the San Diego market. The Company also operated one daily newspaper and several weekly newspapers in Palo Alto, California, which ceased their publication in March 1993. The Company recorded a $15.3 million pre-tax charge in 1992 for the closure of these Palo Alto-based papers. For 1993, the portion of total publishing operating revenues represented by each of the Company's principal newspapers was as follows: Chicago Tribune--53%; Sun-Sentinel--19%; The Orlando Sentinel--16%; and California and Virginia Newspapers--5%. On July 28, 1993, the Company acquired Contemporary Books, Inc., a publisher of non-fiction trade titles and educational books and materials, for $22.0 million in cash and $18.5 million in common stock. On September 13, 1993, the Company acquired Compton's Multimedia Publishing Group for $57 million in cash. Compton's develops and distributes interactive multimedia software for the consumer and education markets. Both of these acquisitions were accounted for as purchases and the results of their operations are included in the consolidated statements of income from the respective dates of their acquisition. In February 1994, the Company acquired substantially all of the assets of The Wright Group, a leading publisher of "whole language" educational materials for the elementary school market, for approximately $100 million in cash. The acquisition will be accounted for as a purchase in 1994. In addition, the Company owns a newspaper syndication and media marketing company, direct mail operations and other publishing-related businesses. Each of the Company's newspapers operates independently to meet most effectively the needs of the area it serves. Editorial policies are established by local management. The Company coordinates certain aspects of operations and resources in order to provide greater efficiency and economies of scale. The Company's newspapers compete for readership and advertising in varying degrees with other metropolitan, suburban and national newspapers as well as with television, radio and other media. Competition for newspaper advertising is based upon circulation levels, readership demographics, price, service and advertiser results, while competition for circulation is based upon the content of the newspaper, service and price. The Company's newspapers are printed in Company-owned production facilities. The principal raw material is newsprint. In 1993, the Company's newspapers utilized approximately 376,000 metric tons of newsprint. Approximately 70% of the newspapers' supply was purchased from QUNO, with the remainder purchased from outside sources. The Company is party to a contract with QUNO expiring in 2007 to supply newsprint based on market prices. Under the contract, the Company has agreed to purchase specified minimum amounts of newsprint each year subject to certain limitations. The specified minimum annual volume is 250,000 metric tons in years 1994 to 1999, 225,000, 200,000 and 175,000 metric tons in years 2000 to 2002, respectively, and 150,000 metric tons in each of years 2003 to 2007. See "QUNO Corporation" for a discussion of the Company's investment in the newsprint manufacturing business. The following table provides a breakdown of revenues for the publishing segment for the last five years, excluding revenues at the Daily News. - ----------- (1) 1992 amounts have been restated to conform to the 1993 presentation. (2) Primarily includes revenues from advertising placement services, the syndication of columns, features, information and comics to newspapers, publishing books and information in print and digital formats, commercial printing operations, direct mail operations and other publishing-related activities. 1993 includes revenues from Contemporary Books and Compton's, from their respective dates of acquisition, totaling $24 million. Total advertising revenues improved in 1993 due to increases in full run linage and preprint volume and higher advertising rates. The increase in retail advertising reflects increases in the electronics and department store categories in Chicago and Fort Lauderdale. General advertising revenues decreased in 1993 due to lower advertising in the transportation and resorts categories at nearly all the newspapers. Classified advertising also increased in 1993 as help wanted and automobile advertising improved at most newspapers. Chicago Tribune Founded in 1847, the Chicago Tribune is published daily, including Sunday, and primarily serves an eight-county market in northern Illinois and Indiana. This market ranks third in the United States in number of households. For the six months ended September 1993, the Chicago Tribune ranked 8th in average daily circulation and 5th in average Sunday circulation in the nation, based on ABC averages. Approximately 69% and 50% of the Tribune's daily and Sunday circulation, respectively, is sold through home delivery, with the remainder primarily sold at newsstands and vending boxes. The daily edition's newsstand price increased by $.15 to $.50 and its home delivery price increased $.05 to $.40 effective September 27, 1992. The Sunday edition's newsstand price increased by $.25 to $1.50 effective April 8, 1990. The following tables set forth selected information for the Chicago Tribune. The 1993 improvement in advertising volume is due to increases in part run and preprinted inserts as more targeted zoning options were offered to advertisers. The daily edition price increase on September 27, 1992 contributed to the decrease in circulation volume between 1993 and 1992. Based on ABC averages for the six months ended September 1993, the Chicago Tribune had a 29% lead in total daily circulation and a 110% lead in Sunday circulation over its principal competitor, the Chicago Sun-Times. The Chicago Tribune's total advertising volume and operating revenues are estimated to be substantially greater than those of the Sun-Times. The Chicago Tribune also competes with other city, suburban and national daily newspapers, direct mail operations and other media. In September 1993, the Chicago Tribune began publishing Exito!, targeted to Spanish-speaking households. The Chicago Tribune also operates Chicago Online, a local interactive computer service that offers news and entertainment information through a joint venture with America Online and audiotex services and publications targeted to specific consumer market segments. Sun-Sentinel The Sun-Sentinel is published daily, including Sunday, and leads the Fort Lauderdale market in circulation. Approximately 66% and 64% of the Sun- Sentinel's daily and Sunday circulation, respectively, is sold through home delivery, with the remainder sold at newsstands and vending boxes. The paper's principal competition comes from the Miami Herald and national and local publications, as well as other media. The Miami/Fort Lauderdale market ranks 16th in the nation in terms of households. The newsstand price of all Sunday editions was increased by $.25 to $1.00 on November 20, 1989. In January 1992, the newsstand price of the Palm Beach Sunday edition increased by $.25 to $1.25. Prior to March 27, 1992, the News and the Sun-Sentinel, based in Fort Lauderdale, Florida, were published in the afternoon and morning, respectively. The paper was combined for Saturday and Sunday editions as the Fort Lauderdale Sun-Sentinel. The News, which accounted for approximately three percent of 1991 circulation, discontinued publication after the March 27, 1992 edition. The following tables set forth selected information for the Sun-Sentinel. The 1993 improvement in advertising volume is primarily due to increased help wanted and automotive advertising. The 1991 and 1990 reductions in advertising volume are attributable primarily to the slowdown in the south Florida economy during those years. In 1989, the Sun-Sentinel began a commercial printing operation. In 1991, two weekly publications, XS and Exito!, targeted to young adults and Spanish- speaking households, respectively, were launched and continued to expand readership in 1992 and 1993. Like the Chicago Tribune, the Sun-Sentinel also operates audiotex services and publications targeted to specific consumer market segments. The Orlando Sentinel The Orlando Sentinel is published daily including Sunday and serves primarily a five-county area in central Florida. It is the only major daily newspaper in the Orlando market, although it competes with other Florida and national newspapers as well as other media. Approximately 74% of the paper's daily and 66% of its Sunday circulation is sold on a home delivery basis, with the remainder sold at newsstands and vending boxes. On October 12, 1992, the weekly home delivery price was increased by $.50 to $3.75. On March 30, 1992, the newsstand price of the daily edition increased $.15 to $.50, except for most Thursday editions, which had been priced at $.50 since February 1991. The newsstand price of the Sunday edition was increased to $1.50 from $1.25 at the end of 1990. The Orlando/Daytona Beach/Melbourne market ranks 23rd among U.S. markets in terms of households. The following tables set forth selected information for The Orlando Sentinel. The economy in central Florida began to strengthen in 1993. Advertising volume was up overall due to improved help wanted and automotive advertising and increased preprint volume from increased zoning. The 1991 and 1990 reductions in advertising volume are attributable primarily to the slowdown in the central Florida economy during those years. In 1990, The Orlando Sentinel launched US Express, a free weekly entertainment publication that is used to distribute advertising to non-subscribers. US Express is syndicated nationally, beginning in 1993. California and Virginia Newspapers The Times Advocate, located in Escondido, California, serves the northern portion of San Diego County. The Times Advocate was published weekday afternoons and Saturday and Sunday mornings until April 1992, when the weekday afternoon edition was converted to a morning edition. In 1988, the Times Advocate acquired several weekly newspaper publications, which complement the paper's daily coverage with more local news and advertising. In June 1990, one of these weekly publications, The Californian, began publishing six days a week. The Palo Alto-based Times Tribune ceased publication in March 1993. A $15.3 million pre-tax charge was recorded at December 27, 1992, for the closure of the Times Tribune. In 1986, the Company purchased the Daily Press/The Times-Herald in Newport News, Virginia. The Daily Press is published every morning including Sunday. The Times-Herald was published each weekday afternoon until September 1, 1991, when this edition was discontinued. The Daily Press constitutes the only major daily newspaper in the market, although it competes with other regional and national newspapers as well as other media. In addition to Newport News, the Daily Press market includes Hampton, Williamsburg and eight other cities and counties in Virginia. This market area is commonly called the Virginia Peninsula and, together with Norfolk, Portsmouth and Virginia Beach, is the 39th largest U.S. market in terms of households. The weekly home delivery price was increased by $.30 to $2.75 in September 1992. The newsstand price of the daily edition increased by $.10 to $.35, and the Sunday edition newsstand price was increased to $1.25 from $1.00, both effective October 1, 1990. Approximately 78% of the paper's daily and 75% of its Sunday circulation is sold on a home delivery basis, with the remainder sold at newsstands and vending boxes. The following tables set forth selected combined information for the California and Virginia daily newspapers. - ----------- (1) The Peninsula Times Tribune was closed on March 12, 1993. Circulation and inches relating to the Times Tribune have been excluded from all years presented. (2) The Times-Herald (afternoon edition) was discontinued on September 1, 1991. Inches relating to this edition have been excluded from all years presented. (3) Includes related weekly publications. The increased inches in 1993 reflect the improving economies of both Virginia & California. Related Businesses The Company is engaged in publishing books and information in print and digital formats through Contemporary Books Inc. and Compton's Multimedia Publishing Group, both acquired in 1993. The Company is also involved in syndication activities, primarily through Tribune Media Services, Inc. ("TMS"), involving the marketing of columns, features, information and comic strips to newspapers, direct mail operations through AmeriComm/Illinois, acquired in 1991, and other publishing-related activities. TMS is also engaged in advertising placement services for television listings in newspapers and the development of news products and services for electronic and print media. Tribune Properties is responsible for oversight of the Company's real estate assets and property leasing transactions. The Company also owns Gold Coast, a shopper publication located in Fort Lauderdale. During 1990, 13 other shoppers and weekly publications located on Florida's Gulf Coast were sold and during 1989 Penny Saver, an Illinois shopper publication, was sold. Total operating revenues for these related businesses are shown below, net of intercompany revenues. The amount for 1992 has been restated to conform to the 1993 presentation. RELATED BUSINESS REVENUES --------------------------- (IN THOUSANDS) 1993.......... $81,648 1992.......... 56,080 1991.......... 48,686 1990.......... 51,315 1989.......... 50,672 Sale of the New York Daily News On March 20, 1991 the Company sold the New York Daily News to Maxwell Newspapers, Inc. ("Maxwell"). Daily News operating losses for 1991 through the date of sale were recorded as part of the Company's 1990 financial statements. Founded in 1919 by Tribune Company as America's first tabloid newspaper, the Daily News serves the New York metropolitan area, the largest market in the United States. The following tables set forth selected historical information for the New York Daily News included as part of total Publishing through 1990. BROADCASTING AND ENTERTAINMENT The broadcasting and entertainment segment represented 37% of the Company's consolidated operating revenues for 1993. The segment currently includes independent VHF television stations located in New York, Los Angeles, Chicago and Denver, independent UHF television stations located in Philadelphia, Atlanta and New Orleans, and six radio stations in New York, Chicago, Denver (2) and Sacramento (2). In November 1993, the Company announced that it had reached an agreement to acquire independent television station WLVI-Boston for approximately $25 million in cash plus the amount of working capital at closing. The acquisition is expected to be completed in the second quarter of 1994, subject to FCC approval. In January 1993, the Company acquired its two Denver radio stations, KOSI-FM and KEZW-AM, for $19.9 million. The acquisition was accounted for as a purchase in 1993. In June 1992, the Company exercised its warrant to acquire a controlling common equity interest in WPHL- TV, Inc., in Philadelphia. This warrant was acquired by the Company in 1991 for $19 million. The exercise of the warrant was accounted for as a purchase and the results of WPHL are included in the Company's consolidated statements of income since June 1992. In entertainment, the Company owns the Chicago Cubs baseball team, produces and syndicates television programming and, beginning in 1993, operates a Chicago area cable programming service. The following table shows sources of revenue for the broadcasting and entertainment segment for the last five years. - ----------- (1) Includes WPHL-Philadelphia since its acquisition on June 5, 1992. (2) Includes KOSI/KEZW-Denver since their acquisition on January 6, 1993. (3) 1992 includes $12.3 million of Major League Baseball expansion fees. Television In 1993, television broadcasting contributed 74% of broadcasting and entertainment operating revenues. The Company's television stations compete for audience and advertising with other television and radio stations, cable television and other media serving the same markets. Competition for audience and advertising is based upon various interrelated factors including programming content, audience acceptance and price. Selected data for the Company's television stations is shown in the following table. - ----------- (1) Source: Nielsen Station Index, September 1993. Ranking of markets is based on number of television households in DMA (Designated Market Area). (2) Source: 1993 Television & Cable Fact Book. (3) See "Governmental Regulation." (4) Expires on June 1, 1994. Renewal application filed on February 1, 1994 is pending. (5) Expired on December 1, 1993. Renewal application filed on August 2, 1993 is pending. (6) Expires on August 1, 1994. Renewal application will be filed. (7) Expired on April 1, 1993. Renewal application filed on December 1, 1992 is pending. Independent television stations, in contrast to network affiliates, are required to produce or acquire all of their programming and to sell all advertising time. Programming emphasis at the Company's stations is placed on syndicated series, feature motion pictures, local and regional sports coverage, news and children's programs. The stations acquire most of their programming from outside sources, although a significant amount is produced locally or supplied by Tribune Entertainment (see "Entertainment"). Contracts for purchased programming generally cover a period of one to seven years, with payment also typically made over several years. The expense for amortization of television broadcast rights in 1993 was approximately $221 million, which represents approximately 41% of total television operating revenues. Average audience share information for the Company's television stations for the past five years is shown in the following table. - ------------ (1) Represents the estimated number of television households tuned to a specific station as a percent of total viewing households in a defined area. The percentages shown reflect the average Nielsen ratings shares for the February, May, July and November measurement periods for 7 a.m. to 1 a.m. daily, except for WGNO's 1992 and 1991 figures, which are based on Arbitron ratings shares calculated in the same manner. (2) Acquired June 5, 1992. Radio In 1993, the Company's radio stations contributed 8% of broadcasting and entertainment operating revenues. The largest radio station owned by the Company, measured in terms of operating revenues, is WGN. Radio operations include Tribune Radio Networks, which produces and distributes farm and sports programming to radio stations, primarily in the Midwest. Selected information for the Company's radio stations is shown in the following table. - ----------- (1) Source: Radio markets ranked by Arbitron Metro Survey Area, Arbitron Company 1993. (2) Source: Arbitron Company 1993. (3) Source: Average of Winter, Spring, Summer and Fall 1993 Arbitron shares for persons 12 years old and over, 6 a.m. to midnight daily during the period measured. (4) Acquired January 1993. Entertainment In 1993, entertainment contributed 18% of the segment's operating revenues. The entertainment portion of the broadcasting and entertainment segment includes Tribune Entertainment Company, the Chicago Cubs baseball team, two minor league baseball teams, ChicagoLand Television News and Tribune Regional Programming. Starting in 1993, the Company has a 31% equity share in Television Food Network, a 24-hour basic cable channel of nutrition and fitness. The Chicago Cubs baseball team received $12.3 million in Major League Baseball expansion fees in December 1992. Tribune Entertainment Company was formed in 1982 to acquire and develop programming for Company television stations and for syndication. Tribune Entertainment participates in the production or distribution of first-run programming, including a daily talk show, a combination home shopping and talk show, music and variety shows, television movies and specials. Tribune Entertainment's most popular program is "Geraldo," a one-hour, daily talk show which is aired on 142 stations that cover 95% of U. S. television households and is sold internationally to many cities in Canada, as well as to several countries in Latin America and Europe. During the 1993-1994 television season, Tribune Entertainment will originate approximately 13 hours of first-run programs per week. On average, the Company's seven television stations will utilize over 9 hours per week of programming furnished by Tribune Entertainment. The Company owns the Chicago Cubs baseball team. In addition to providing local sports entertainment, the Cubs represent an important source of live programming for the Company's Chicago-based broadcasting operations and regional cable programming service. In 1992, the Company acquired a Class AA Southern League franchise in Orlando and a Class A Midwest League franchise in Rockford, Illinois. ChicagoLand Television News, a regional 24-hour cable news programming service, was launched in January 1993 and currently is available to more than 1.1 million cable households in the Chicago-area market. Tribune Regional Programming, Inc. was formed to develop and produce cable television services dedicated to specific local markets. QUNO CORPORATION In February 1993, QUNO completed an initial public offering of 9 million shares of common stock. At the conclusion of the offering, the Company holds 8.8 million, or 49%, of the voting common shares and 4.2 million non-voting common shares of QUNO for a combined total of 59% of QUNO's total 22 million outstanding common shares. The Company also holds a $138.8 million subordinated debenture, convertible into 11.7 million voting common shares of QUNO. As the Company's voting interest is now less than 50%, the Company is accounting for its investment in QUNO using the equity method of accounting beginning in 1993. QUNO is no longer a business segment for reporting purposes. Based in Canada, QUNO's principal operation is the manufacturing and marketing of newsprint. QUNO's related operations presently include a sawmill, a materials recycling company and 60% ownership of a hydro-electric power company in Baie-Comeau, Quebec. QUNO operates two newsprint mills, in Thorold, Ontario and Baie-Comeau, Quebec. The mills were started in 1913 and 1937, respectively, to assure a dependable supply of newsprint at competitive prices for the Company's newspapers. QUNO ranks seventh in production capacity among newsprint-producing groups in North America. The following table shows sources of revenue for QUNO Corporation from 1989 through 1992, the last year QUNO's balance sheet and income statement were consolidated in the Company's financial statements. OPERATING REVENUES (IN THOUSANDS OF U.S. DOLLARS) Diminished newsprint revenues for 1992 reflect lower transaction prices. Production and Sales The Company's paper mills in Baie-Comeau and Thorold currently have annual newsprint production capacities of approximately 469,000 and 346,000 metric tons, respectively. Competition for newsprint sales is based upon price, product quality and customer service. Sales of newsprint through 1993 are shown in the following table. QUNO reported an operating loss of $31 million in 1993, $23 million less than the $54 million operating loss incurred in 1992. This was partially the result of higher average newsprint selling prices. The North American newsprint industry has endured significant economic difficulties over the past several years mainly caused by a capacity/demand imbalance. New mills and improvements to existing paper machines have increased overall production capacity, while demand has diminished or remained stagnant. As a result, QUNO's transaction prices over the 1989-1993 period have declined by approximately 20%. On August 1, 1992, and again on March 1, 1993, QUNO began implementing, along with the rest of the industry, a reduction in discounts offered on newsprint sales. Though prices began to soften in the second half of 1993, newsprint prices averaged 5% higher in 1993 than in 1992. QUNO supplies newsprint to most of the Company's newspapers. The newspapers also purchase newsprint from other suppliers to maintain diversified sources of supply. Approximately 35% of QUNO's 1993 sales (in metric tons) were to the Company's newspapers. See "Publishing" for a discussion of the supply contract between the Company and QUNO. QUNO sells newsprint to approximately 100 unaffiliated customers located primarily in North America. The majority of such sales are to medium and small newspapers and commercial printers, with no single unaffiliated customer accounting for more than 10% of total newsprint revenue. Generally, QUNO sells newsprint under renewable contracts varying in length from one to five years. These contracts base the selling price on the list price for comparable newsprint at the date of shipment, with negotiated discounts from the list price. Manufacturing Facilities QUNO's Baie-Comeau mill is the largest newsprint mill in eastern Canada, with an annual production capacity of approximately 469,000 metric tons. The mill is on the St. Lawrence tidewater with year-round navigable access to the Atlantic seaboard, overseas ports and a rail ferry service with connections to the railway systems of North America. The Thorold mill, with annual production capacity of about 346,000 metric tons, currently uses a blend of two types of pulp in making newsprint. One type is thermo-mechanically produced and the other is produced from de-inked recycled waste newspapers and magazines. Scierie des Outardes ("SDO"), the QUNO sawmill located near the Baie-Comeau newsprint mill, produces finished lumber that is sold in North America and overseas. SDO is a source of fiber to the Baie-Comeau mill, providing wood chips for conversion into pulp. SDO can produce approximately 225,000 cubic meters of construction grade lumber per year. The papermaking process generally requires substantial quantities of power and steam. The Baie-Comeau mill purchases approximately 45% of its total electric power needs from the Manicouagan Power Company, a 60%-owned QUNO subsidiary, and the remainder from Hydro-Quebec, a governmental agency. The Thorold mill purchases all of its power directly from Ontario Hydro, a governmental agency. Power supplies at both mills are believed to be adequate to meet QUNO's needs for the foreseeable future. Fiber Supply The primary ingredient in the manufacture of newsprint is fiber, which is derived from roundwood logs, wood chips and recycled newspapers and magazines. The Baie-Comeau mill processes both roundwood logs and wood chips obtained primarily from QUNO's timber limits and its sawmill in Quebec. At Thorold, the mill's newsprint is produced approximately 70% from recycled paper pulp and 30% from virgin wood pulp. The wood chips are obtained from outside contractors who harvest QUNO's Ontario timber limits and process the cuttings into chips. Recycled papers for the Thorold mill are obtained primarily in the southern Ontario area from newspaper publishers, magazine printers and community recyclers. Timber limits in Canada are generally made available by provincial governments to forest products companies by means of long-term licenses or forest supply and management agreements. Under such agreements, QUNO holds exclusive cutting rights in Quebec and Ontario on a total of approximately 8,270 square kilometers of timberlands. QUNO's agreements with the Province of Quebec are for a term of 25 years and are subject to a review of QUNO's performance every five years. In Ontario, QUNO has 20-year forest management agreements that call for a review every five years of QUNO's performance under the reforestation provisions thereof. QUNO also owns 700 square kilometers of timberlands. QUNO believes its combined fiber sources continue to be adequate to meet its needs for the foreseeable future. GOVERNMENTAL REGULATION Various aspects of the Company's operations are subject to regulation by governmental authorities in the United States and Canada. The Company's television and radio broadcasting operations are subject to Federal Communications Commission ("FCC") jurisdiction under the Communications Act of 1934, as amended. FCC rules, among other things, govern the term, renewal and transfer of radio and television broadcasting licenses, prohibit concentrations of broadcasting control inconsistent with the public interest, strictly limit common ownership of most communications media in the same market and regulate network programming and syndication of programs. The FCC also regulates certain commercial practices of local broadcast stations, including the rates charged for political advertising and the quantity of advertising within children's programs. The Company is permitted to own both newspaper and broadcast operations in the Chicago market by virtue of "grandfather" provisions in the FCC regulations. Licensees are currently permitted to own up to 12 television stations, 18 AM radio stations and 18 FM radio stations. These numerical limits are subject to other FCC regulations which impose geographic market restrictions and limit the percentage of the national television audience that may be reached by a licensee's television stations in the aggregate. Television and radio broadcasting licenses are subject to renewal by the FCC at five-year and seven-year intervals, respectively, and at such times may be subject to competing applications for the licensed frequencies. The Company presently has FCC authorization to operate seven television stations and three AM and three FM radio stations. From time to time, the FCC revises existing regulations and policies in ways that could affect the Company's broadcasting operations. In addition, Congress from time to time considers and adopts substantive amendments to the Communications Act of 1934 and related legislation. The Company cannot predict what regulations or legislation may be proposed or finally enacted or what effect, if any, such regulations or legislation could have on the Company's broadcasting operations. EMPLOYEES The average number of full-time equivalent employees of the Company in 1993 was 9,900, approximately 2,500 less than the average for 1992. This decrease was due to QUNO employees being included in the Company's 1992 total, but omitted in 1993 due to the deconsolidation of QUNO in 1993. Pension and other employee benefit plans are provided for substantially all employees of the Company. Eligible employees also participate in the Company's Employee Stock Ownership Plan. During 1993, the Company's publishing segment employed approximately 7,700 full-time equivalent employees, about 9% of whom were represented by a total of 7 unions. Contracts with unionized employees of the publishing segment expire at various times through October 1996. Broadcasting and entertainment had an average of 2,100 full-time equivalent employees in 1993. Approximately 26% of these employees are represented by a total of 21 unions. EXECUTIVE OFFICERS OF THE COMPANY Information with respect to the executive officers of the Company is set forth below. The descriptions of the business experience of these individuals include the principal positions held by them since March 1989. Charles T. Brumback (65) Chairman since January 1993, President since January 1989 and Chief Executive Officer since August 1990 (Chief Operating Officer until July 1990) of the Company; formerly President and Chief Executive Officer of Chicago Tribune Company*; Director of the Company since 1981. James E. Cushing, Jr. (38) Vice President and General Counsel of the Company since November 1993; Vice President/Business Affairs of ChicagoLand Television News* from March 1993 to November 1993 (Director/Business Affairs from March 1992 to March 1993); Senior Counsel from October 1990 to March 1992 and Counsel of the Company until October 1990. James C. Dowdle (60) Executive Vice President of the Company since August 1991; President and Chief Executive Officer of Tribune Broadcasting Company* since 1981; Director of the Company since 1985. Stanley J. Gradowski (55) Vice President and Secretary of the Company since 1982. David J. Granat (47) Vice President (since May 1991) and Treasurer (since 1985) of the Company. Donald C. Grenesko (45) Senior Vice President and Chief Financial Officer (since March 1993) and Vice President and Chief Financial Officer (from October 1991 to March 1993) of the Company; President and Chief Executive Officer (until September 1991), Chicago National League Ball Club, Inc.* Joseph A. Hays (63) Vice President/Corporate Relations of the Company since 1983. David D. Hiller (40) Senior Vice President/Development since November 1993; Senior Vice President and General Counsel (from March to November 1993) and Vice President and General Counsel (until March 1993) of the Company; Partner, Sidley & Austin until November 1993. John E. Houghton (62) Retired since January 1993. Chairman since January 1989 (Chief Executive Officer until January 1991) of QUNO Corporation. Director of the Company since 1980. M. Catherine Jaros (44) Vice President/Marketing of the Company since November 1992; formerly Director of Marketing, Strategy and External Development, May-October 1992; Director of Corporate Strategies and Acquisitions, September 1991 to May 1992; Director of Marketing and Specialty Products, May-August 1991; Director of Strategy, December 1990 to May 1991, all at Kraft USA; Vice President Business Development until 1990 at Tappan Capital Partners. - ----------- *A subsidiary of the Company. John S. Kazik (51) Senior Vice President/Information Systems since March 1993; Vice President/Information Systems from December 1989 to March 1993 of the Company and Vice President of Chicago Tribune Company* since 1982. James N. Longson (47) Vice President/Technology of the Company since August 1992; Director of Corporate Development of the Company from April 1991 to August 1992; Vice President/Director of Marketing and Strategic Planning of the New York Daily News from July 1990 to April 1991; formerly Vice President, Facilities and Systems Development of the New York Daily News. John W. Madigan (56) Executive Vice President of the Company and President and Chief Executive Officer of Tribune Publishing Company* since August 1991; Publisher of the Chicago Tribune since August 1990 and President and Chief Executive Officer of Chicago Tribune Company* until September 1993. Director of the Company since 1975. R. Mark Mallory (43) Vice President and Controller since May 1991 (Controller and Director of Planning until May 1991) of the Company. William B. Nelson (43) Vice President/Financial Operations of the Company since February 1994 and Vice President/Chief Financial Officer of Chicago Tribune Company* since January 1983. Andrew J. Oleszczuk (37) Vice President/Development of the Company since December 1993; Director of Planning from August 1990 to December 1993 and Manager of Planning of Tribune Broadcasting Company* until August 1990. Shaun M. Sheehan (49) Vice President/Washington of the Company since July 1992 and Vice President/Washington of Tribune Broadcasting Company* since February 1986. John T. Sloan (42) Senior Vice President/Administration since March 1993 and Vice President/Human Resources of the Company from August 1991 to February 1993; Vice President and Director of Human Resources of the New York Daily News from September 1989 to July 1991; formerly Vice President and Director of Employee Relations of Chicago Tribune Company*. Scott C. Smith (43) President and Chief Executive Officer of Sun-Sentinel Company* (since September 1993); Senior Vice President/Development (August 1991 to September 1993), Senior Vice President and Chief Financial Officer (October 1989 to July 1991) and Vice President/Finance until October 1989 of the Company. - ------------ *A subsidiary of the Company. ITEM 2. ITEM 2. PROPERTIES. The corporate headquarters of the Company are located at 435 North Michigan Avenue, Chicago, Illinois. The general character, location and approximate size of the principal physical properties used by the Company at December 26, 1993 are listed below. In addition to those listed, the Company owns or leases transmitter sites, parking lots and other properties aggregating approximately 338 acres in 29 separate U.S. locations, and owns or leases an aggregate of approximately 1,927,000 square feet of space in 187 locations. Included in these figures are 82,000 square feet of space owned by The Peninsula Times Tribune. On March 12, 1993, the Times Tribune ceased publication. Also included in these figures are 62 acres and 233,000 square feet of space owned by the Company which had previously been owned by the New York Daily News. On March 20, 1991, the Company sold the Daily News. The Times Tribune and Daily News properties are being offered for sale. The Company also owns the 39,000- seat stadium used by the Chicago Cubs baseball team. The Company considers its various properties to be in good condition and suitable for the purposes for which they are used. (1) Includes Tribune Tower, an approximately 630,000 square foot office building in downtown Chicago, and Freedom Center, the approximately 697,000 square foot production center of the Chicago Tribune. Tribune Tower houses the Company's corporate headquarters, the Chicago Tribune's business and editorial offices, offices of various subsidiary companies and approximately 77,800 square feet of space leased to unaffiliated tenants. Freedom Center houses the Chicago Tribune's printing, packaging and distribution operations. (2) Consists of space leased in New River Center, which is owned by a real estate joint venture in which the Company had a 50% interest at December 26, 1993. No portion of this building is listed as "owned" property in the table. (3) Includes space leased by subsidiary companies in the New York Daily News building, which is owned by a limited partnership in which the Company has a minority interest. No portion of this building is listed as "owned" property in the table. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries are defendants from time to time in actions for libel and other matters arising out of their business operations. In addition, the Company and its subsidiaries are involved from time to time as parties in various regulatory, environmental and other proceedings with governmental authorities and administrative agencies. The Company does not believe that any such proceedings presently pending will have a material adverse effect on its consolidated financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is presently listed on the New York, Chicago and Pacific stock exchanges. The high and low sales prices of the Common Stock by fiscal quarter for the two most recent fiscal years, as reported on the New York Stock Exchange Composite Transactions list, were as follows: At March 3, 1994 there were 4,180 record holders of the Company's Common Stock. Quarterly cash dividends declared on Common Stock for both 1993 and 1992 were $.24 per share. Total cash dividends declared on Common Stock by the Company were $63,799,000 for 1993 and $62,450,000 for 1992. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information for the years 1989 through 1993 contained under the heading "Eleven Year Financial Summary" in the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information contained under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's Consolidated Financial Statements and Notes thereto and the information contained under the heading "Business Segments" appearing on pages 35 through 51 of the Company's 1993 Annual Report to Stockholders, together with the report thereon of Price Waterhouse dated January 28, 1994, appearing on page 52 of such Annual Report and the information contained under the heading "Quarterly Results" on pages 54 and 55, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information contained under the heading "Executive Officers of the Company" in Item 1 hereof, and the information under the heading "Election of Directors" in the definitive Proxy Statement for the Company's April 19, 1994 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information contained under the heading "Executive Compensation" (except those portions relating to Item 13, below) in the definitive Proxy Statement for the Company's April 19, 1994 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information contained under the subheadings "Principal Stockholders" and "Management Ownership" under the heading "Ownership Information" in the definitive Proxy Statement for the Company's April 19, 1994 Annual Meeting of Stockholders, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information contained under the heading "Executive Compensation" (except those portions relating to Item 11, above) and the subheadings "Compensation of Directors" and "Other Transactions" in the definitive Proxy Statement for the Company's April 19, 1994 Annual Meeting of Stockholders, is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1)&(2) Financial Statements and Financial Statement Schedules filed as part of this report As listed in the Index to Financial Statements and Financial Statement Schedules on page 23 hereof. (a)(3) Index to Exhibits filed as part of this report As listed in the Exhibit Index beginning on page 32 hereof. (b) Reports on Form 8-K The Company filed a Form 8-K Current Report dated October 29, 1993, which reported under Item 5 the filing of a Prospectus Supplement on October 25, 1993 relating to the offer and sale from time to time of up to $300,000,000 principal amount of the Company's Medium-Term Notes, Series C. This Supplement was to a Registration Statement on Form S-3 (File No. 33-45793), effective July 13, 1992. No financial statements were filed with the report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 21, 1994. TRIBUNE COMPANY By: Charles T. Brumback Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 21, 1994. Signature Title --------- ----- Charles T. Brumback Chairman, President and Chief Executive Officer and Director (principal executive officer) James C. Dowdle Executive Vice President and Director John W. Madigan Executive Vice President and Director Donald C. Grenesko Senior Vice President and Chief Financial Officer (principal financial officer) Signature Title --------- ----- R. Mark Mallory Vice President and Controller (principal accounting officer) Stanton R. Cook Director Diego E. Hernandez Director Robert E. La Blanc Director Newton N. Minow Director Donald H. Rumsfeld Director TRIBUNE COMPANY AND FINANCIAL STATEMENT SCHEDULES PAGE ---- Consolidated Statements of Income for each of the three fiscal years in the period ended December 26, 1993 ..................................... * Consolidated Statements of Financial Position at December 26, 1993 and December 27, 1992 ...................................................... * Consolidated Statements of Cash Flows for each of the three fiscal years in the period ended December 26, 1993 .................................. * Consolidated Statements of Stockholders' Investment for each of the three fiscal years in the period ended December 26, 1993 ..................... * Notes to Consolidated Financial Statements ............................... * Report of Independent Accountants on Consolidated Financial Statements ... * Report of Independent Accountants on Financial Statement Schedules ....... 24 Financial Statement Schedules for each of the three fiscal years in the period ended December 26, 1993 (as applicable) ......................... 25-31 Schedule II Amounts receivable from related parties and underwriters, promoters and employees other than related parties. Schedule IV Indebtedness of and to related parties - noncurrent. Schedule V Property, plant and equipment. Schedule VI Accumulated depreciation, depletion and amortization of property, plant and equipment. Schedule VII Guarantees of securities of other issuers. Schedule VIII Valuation and qualifying accounts and reserves. Schedule X Supplementary income statement information. - ----------- * Incorporated by reference to the Company's 1993 Annual Report to Stockholders. See Item 8 of this Annual Report on Form 10-K. ------------ All other schedules required under Regulation S-X are omitted because they are not applicable, not required or the required information is shown in the consolidated financial statements or notes thereto. Columns omitted from certain schedules included herein have been omitted because the information is not applicable. Financial statements of entities accounted for by the equity method have been omitted because they do not constitute significant subsidiaries. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES TO THE BOARD OF DIRECTORS OF TRIBUNE COMPANY Our audits of the consolidated financial statements referred to in our report dated January 28, 1994 appearing on page 52 of the 1993 Annual Report to Stockholders of Tribune Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules appearing on pages 25 through 31 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Price Waterhouse Chicago, Illinois January 28, 1994 SCHEDULE II TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES (IN THOUSANDS OF DOLLARS) ================================================================================ All of the above loans were made to assist in financing the purchase of residences upon the employee's transfer at the request of the Company. - ------------ (1) Promissory note secured by personal residence at a rate contingent upon the net appreciation of the residence acquired. (2) Non-interest bearing demand note secured by personal residence. (3) Non-interest bearing demand note secured by shares of a cooperative association and by common stock owned by Mr. Brumback. ================================================================================ SCHEDULE IV TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE IV--INDEBTEDNESS OF AND TO RELATED PARTIES--NONCURRENT (IN THOUSANDS OF U.S. DOLLARS) ================================================================================ (1) The QUNO convertible debenture matures in 2002, is convertible at the option of the Company into 11.7 million voting common shares of QUNO, and is callable by QUNO after December 27, 1997. (2) The mortgage note, purchased by the Company in 1993, is on a building owned by a partnership in which the Company held a 50% interest at December 26, 1993. ================================================================================ SCHEDULE V TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS OF DOLLARS) ================================================================================ - ----------- (1) Includes spending on construction projects less amounts transferred during the year to other categories as the projects become operational. (2) Property, plant and equipment of acquired companies. (3) Represents (i) for 1992 and 1991, the effect of translating Canadian dollar denominated accounts to U.S. dollars, as well as certain reclassifications of items between categories, (ii) for 1992, deductions of $15.2 million related to the disposition of The Peninsula Times Tribune and (iii) for 1993, deductions related to the assets of QUNO Corporation. As a result of the initial public offering by QUNO in February 1993, QUNO's balance sheet is no longer included in the consolidated financial statements. For 1993, the deduction for QUNO's assets is as follows: ================================================================================ SCHEDULE VI TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS OF DOLLARS) ================================================================================ Estimated useful lives and methods used for depreciation, amortization and depletion are as follows: Buildings--7 to 55 years--straight line. Leasehold improvements--5 to 40 years--straight line. Machinery, equipment and furniture--3 to 25 years--straight line. Land improvements--10 to 30 years--straight line. Timber limits and leases--5 years--straight line and unit-of-production method. - ------------ (1) Represents (i) for 1992 and 1991, the effect of translating Canadian dollar denominated accounts to U.S. dollars, as well as certain reclassifications of items between categories, (ii) for 1992, deductions of $9.2 million related to the disposition of The Peninsula Times Tribune and (iii) for 1993, deductions related to assets of QUNO Corporation, whose balance sheet is no longer consolidated in the Company's financial statements, beginning in 1993. For 1993, the deduction for QUNO's assets is as follows: Building and leasehold improvements $ 67,543 Machinery, equipment and furniture 289,294 Timber limits and leases, land improvements 24,733 -------- Total $381,570 ======== ================================================================================ SCHEDULE VII TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS (IN THOUSANDS OF DOLLARS) ================================================================================ ================================================================================ SCHEDULE VIII TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS OF DOLLARS) ============================================================================== - -------------- (1) For 1993, $4,612 represents deductions pertaining to QUNO Corporation. As a result of an initial public offering by QUNO in February 1993, QUNO's balance sheet is no longer consolidated in the Company's financial statements. ================================================================================ SCHEDULE X TRIBUNE COMPANY AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS OF DOLLARS) ================================================================================ - ---------- (1) 1993 excludes supplementary income statement information for QUNO Corporation as QUNO's income statement is no longer included in the Company's consolidated financial statements. Amounts in 1992 and 1991 relating to QUNO were as follows: (2) Includes all costs related to advertising, public relations and promotion of the Company's products. Amortization of preoperating costs and other deferrals and royalties are omitted as none of these items exceed one percent of the Company's consolidated operating revenues in any of the years. ================================================================================ TRIBUNE COMPANY EXHIBIT INDEX Exhibits marked with an asterisk (*) are incorporated by reference to documents previously filed by Tribune Company with the Securities and Exchange Commission, as indicated. Exhibits marked with a circle (o) are management contracts or compensatory plan contracts or arrangements filed pursuant to Item 601(b)(10)(iii)(A) of Regulation S-K. All other documents listed are filed with this Report.

15511_1993.txt

15511_1993

1993

15511

ITEM 1. BUSINESS AND ITEM 2. ITEM 2. PROPERTIES Burlington Northern Railroad Company's (Railroad) principal business activity is railroad transportation. Railroad is the principal subsidiary of Burlington Northern Inc. (BNI). RAILROAD TRANSPORTATION Railroad operates the largest railroad system in the United States based on miles of road and second main track, with approximately 24,500 total miles at December 31, 1993. The principal cities served include Chicago, Minneapolis-St. Paul, Fargo-Moorhead, Billings, Spokane, Seattle, Portland, St. Louis, Kansas City, Des Moines, Omaha, Lincoln, Cheyenne, Denver, Fort Worth, Dallas, Houston, Galveston, Tulsa, Wichita, Springfield (Missouri), Memphis, Birmingham, Mobile and Pensacola. During 1993, Railroad refined its customer oriented business units by creating smaller, more focused business units. The following table presents Railroad's revenue information by business unit, and includes reclassification of prior-year information to conform to current year presentation. Percent of revenues was calculated before consideration of shortline payments and other miscellaneous revenues. The principal contributors to rail transportation revenues were as follows (revenues and revenue ton miles in millions, carloadings in thousands): COAL The transportation of coal is Railroad's largest source of revenues, accounting for approximately one-third of the total. Based on carloadings and tons hauled, Railroad is the largest transporter of Western low-sulfur coal in the United States. Over 90 percent of Railroad's coal traffic originated in the Powder River Basin of Montana and Wyoming during the three years ended December 31, 1993. These coal shipments were destined for coal-fired electric generating stations primarily in the North Central, South Central and Mountain regions of the United States with smaller quantities exported. Railroad also handles increasing amounts of low-sulfur coal from the Powder River Basin for delivery to markets in the eastern and southeastern portion of the United States. The low-sulfur coal from the Powder River Basin is abundant, inexpensive to mine and clean-burning. Since the Clean Air Act of 1990 requires power plants to reduce harmful emissions either by burning coal with a lower sulfur content or by installing expensive scrubbing units, opportunities for increased shipments of this low-sulfur coal still exist. AGRICULTURAL COMMODITIES Based on carloadings and tons hauled, Railroad is the largest rail transporter of grain in North America. Railroad's system is strategically located to serve the Midwest and Great Plains grain producing regions where Railroad serves most major terminal, storage, feeding and food-processing locations. Additionally, Railroad has access to major export markets in the Pacific Northwest, western Great Lakes and Texas Gulf regions as well as direct entry to consuming markets in southern Mexico through its Protexa Burlington International affiliate. INTERMODAL Intermodal transportation moves traffic on specially designed flatcars or doublestack equipment which competes with motor carriers. Railroad's intermodal transportation system integrates the movement of approximately 46 daily trains operating between 30 rail hubs and 28 satellite rail hubs (Railroad-operated marshalling points for trailer/container movements). These operations are strategically located across Railroad's rail network and also serve major distribution centers outside Railroad's system. Strategic alliances have been formed to enhance Railroad's market access both with other railroads and with major truck transportation providers. FOREST PRODUCTS The Forest Products business unit is primarily comprised of lumber, plywood, pulpmill feedstock, wood pulp and paper products. These products primarily come from the Pacific Northwest, upper Midwest and Southeast areas of the United States. CHEMICALS The Chemicals business unit is comprised of fertilizer, petroleum and chemical commodities as well as Railroad's environmental logistics business. Primary origin markets for Railroad include the Gulf Coast, the Pacific Northwest, and various Canadian ports of entry. Environmental logistics is an area of significant opportunity as municipalities exhaust their traditional disposal sources and must increasingly transport their waste longer distances. CONSUMER PRODUCTS Products included in Railroad's Consumer Products business unit represent a wide variety of commodities. Some of the major products in this group are food products, beverages, frozen foods, canned foods, appliances and electronics. Because this business unit handles a wide variety of consumer goods, the business unit performance typically mirrors the country's economy. MINERALS PROCESSORS Commodities in this group include clays, cements, sands and other minerals and aggregates. This group services both the oil and construction industries. IRON & STEEL The Iron & Steel business unit handles virtually all of the commodities included in or resulting from the production of steel. Taconite, an iron ore derivative produced in northern Minnesota, scrap steel and coal coke are the business unit's primary input products, while finished steel products range from structural beams and coil to wire and nails. VEHICLES & MACHINERY The Vehicles & Machinery business unit is responsible for both domestic and international vehicle manufacturers as well as an assortment of primary and secondary markets for heavy machinery. Through the development and implementation of Autostack technology (using containers to move motor vehicles), Railroad is redefining transit time and ride quality. Heavy machinery includes primary markets for aircraft, construction, farm and railroad equipment and secondary markets for used equipment. The business unit is also responsible for military and other miscellaneous traffic for the United States government. ALUMINUM, NON-FERROUS METALS & ORES The Aluminum, Non-Ferrous Metals & Ores business unit handles alumina and aluminum products, petroleum coke and a variety of other metals and ores such as zinc, copper and lead. OPERATING FACTORS Certain significant operating statistics were as follows: PROPERTIES In 1993, approximately 96 percent of the total ton miles, both revenue and non-revenue generating, carried by Railroad were handled on its main lines. At December 31, 1993, approximately 18,828 miles of Railroad's track consisted of 112-lb. per yard or heavier rail, including approximately 10,461 track miles of 132-lb. per yard or heavier rail. Additions and replacements to properties were as follows: Equipment Railroad owned or leased, under both capital and operating leases, with an initial lease term in excess of one year, the following units of railroad rolling stock at December 31, 1993: Number of Units ------------------------- Owned Leased Total Locomotives: ----- ------ ----- Freight...................................... 581 1,334 1,915 Passenger.................................... - 2 2 Multi-purpose................................ 151 58 209 Switching.................................... 176 18 194 ------ ------ ------ Total locomotives.......................... 908 1,412 2,320 ====== ====== ====== Freight Cars: Box-general purpose.......................... 776 2,813 3,589 Box-specially equipped....................... 4,587 689 5,276 Gondola...................................... 4,811 2,013 6,824 Hopper-open top.............................. 7,744 1,210 8,954 Hopper-covered............................... 16,528 12,640 29,168 Refrigerator................................. 3,347 9 3,356 Flat......................................... 3,280 494 3,774 Caboose...................................... 498 - 498 Other........................................ 552 7 559 ------ ------ ------ Total freight cars......................... 42,123 19,875 61,998 ====== ====== ====== Commuter passenger cars........................ - 141 141 ====== ====== ====== In addition to the owned and leased locomotives identified above, Railroad operates 199 freight locomotives under power purchase agreements. The average age of locomotives and freight cars was 14.5 years and 18.6 years, respectively, at December 31, 1993, compared with 13.5 years and 18.4 years, respectively, at December 31, 1992. The average percentage of Railroad's locomotives and freight cars awaiting repairs during 1993 was 7.4 and 3.3, respectively, compared with 7.4 and 4.1, respectively, in 1992. The average time between locomotive failures was 67.9 days in 1993 compared with 71 days in 1992. During 1993, Railroad entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. Railroad anticipates reduced locomotive operating costs as well as an increase in both horsepower and traction, meaning fewer locomotives will be needed for many freight operations. Railroad accepted delivery of one locomotive during 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. EMPLOYEES Railroad employed an average of 30,502 employees in 1993 compared with 31,204 in 1992 and 31,760 in 1991. Railroad's payroll and employee benefits costs, including capitalized labor costs, were approximately $1.9 billion for each of the years ended December 31, 1993, 1992 and 1991. Almost 90 percent of Railroad's employees are covered by collective bargaining agreements with 14 different labor organizations. In October 1991, Railroad entered into an agreement (Crew Consist Agreement No. 1) with the United Transportation Union (UTU) covering the southern portion of Railroad's system. Crew Consist Agreement No. 1 provided for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. Under the terms of Crew Consist Agreement No. 1, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $60,000 per employee. Remaining conductors or brakemen who, as a result of Crew Consist Agreement No. 1, were unable to hold a position in active service, due to relative seniority, were placed on a reserve board. Employees in reserve status received compensation at a rate equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. Each UTU member on the southern portion of Railroad's system received a lump-sum payment of $1,000 upon ratification of Crew Consist Agreement No. 1. In May 1993, Railroad entered into an agreement (Crew Consist Agreement No. 2) with the UTU covering approximately 3,400 UTU members in the northern portion of Railroad's system. Crew Consist Agreement No. 2 provides for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. It is similar to Crew Consist Agreement No. 1, covering the southern portion of Railroad's system. Each UTU member on the northern portion of Railroad's system received a one-time lump-sum payment of $5,000, pursuant to Crew Consist Agreement No. 2. Under the terms of Crew Consist Agreement No. 2, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $80,000 per employee. Conductors and brakemen who choose not to accept the voluntary separation offer can elect volunteer surplus status pursuant to which they will receive $60,000 to be paid out over a period of 18 to 48 months, as each selects. If such employee has not been recalled to active service by the time such payments cease upon expiration of the selected period, such employee will remain in volunteer surplus status, without further compensation or benefits, until recalled to active service. Employees in volunteer surplus status may be called back to service only after the individuals in reserve status, within their own subdivided seniority district, have been recalled. Remaining conductors and brakemen who, as a result of Crew Consist Agreement No. 2, are not needed in train service, and who do not elect one of the above severance options, will be placed on a reserve board. Employees in reserve status will receive compensation equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. In October 1993, the UTU elected to adopt Crew Consist Agreement No. 2 for those southern portion UTU members who were previously covered by Crew Consist Agreement No. 1. Crew Consist Agreement No. 2 was implemented on the southern portion of the Railroad's system during the fourth quarter of 1993. Upon implementation, each of the approximately 3,300 UTU members on the southern portion of Railroad's system received a one-time lump-sum payment of $4,000, which was the incremental difference between the $1,000 lump-sum payment received following ratification of Crew Consist Agreement No. 1 and the amount received by UTU members following adoption of Crew Consist Agreement No. 2. Railroad will continue to remove excess positions from train service through the implementation of Crew Consist Agreement No. 2. Approximately 1,350 excess positions have been removed as a result of employees accepting severance or voluntary surplus payments. Other excess positions have been eliminated and personnel formerly in those positions have been assigned to reserve boards, absorbed through additional train starts and/or utilized in quality and safety initiatives. Based upon its experience under Crew Consist Agreement No. 1, Railroad anticipates that the number of employees on reserve status will decline over time. In July 1993, the American Train Dispatchers Association ratified an April agreement which will facilitate the consolidation of all dispatching functions into a centralized train dispatching office in Fort Worth, Texas by the end of 1995. COMPETITION The general environment in which Railroad operates remains highly competitive. Depending on the specific market, deregulated motor carriers, other railroads and river barges exert pressure on various price and service combinations. The presence of advanced, high service truck lines with expedited delivery, subsidized infrastructure and minimal empty mileage continues to impact the market for non-bulk, time sensitive freight. The potential expansion of long combination vehicles could further encroach upon markets traditionally served by railroads. In order to remain competitive, Railroad and other railroads continue to develop and implement technologically supported operating efficiencies to improve productivity. As railroads streamline, rationalize and otherwise enhance their franchises, competition among rail carriers intensifies. Railroad's primary rail competitors in the western region of the United States consist of Atchison, Topeka & Santa Fe Railway Company; Chicago & Northwestern Transportation Company (C&NW); Southern Pacific Transportation Company; and Union Pacific Railroad Company (UP). Coal, one of Railroad's primary commodities, has experienced significant pressure on rates due to competition from the joint effort of C&NW/UP and Railroad's efforts to penetrate into new markets. In addition to the railroads discussed above, numerous regional railroads and motor carriers operate in parts of the same territory served by Railroad. ENVIRONMENTAL Railroad's operations, as well as those of its competitors, are subject to extensive federal, state and local environmental regulation. In order to comply with such regulation and to be consistent with Railroad's corporate environmental policy, Railroad's operating procedures include practices to protect the environment. Amounts expended relating to such practices are inextricably contained in the normal day-to-day costs of Railroad's business operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS WHEAT AND BARLEY TRANSPORTATION RATES In September 1980 a class action lawsuit was filed against Railroad in United States District Court for the District of Montana (District Court) challenging the reasonableness of Railroad's export wheat and barley rates. The class consists of Montana grain producers and elevators. The plaintiffs sought a finding that Railroad's single car export wheat and barley rates for shipments moving from Montana to the Pacific Northwest were unreasonably high and requested damages in the amount of $64 million. In March 1981 the District Court referred the rate reasonableness issue to the Interstate Commerce Commission (ICC). Subsequently, the State of Montana filed a complaint at the ICC challenging Railroad's multiple car rates for Montana wheat and barley movements occurring after October 1, 1980. The ICC issued a series of decisions in this case from 1988 to 1991. Under these decisions, the ICC applied a revenue to variable cost test to the rates and determined that Railroad owed $9,685,918 in reparations plus interest. In its last decision, dated November 26, 1991, the ICC found Railroad's total reparations exposure to be $16,559,012 through July 1, 1991. The ICC also found that Railroad's current rates were below a reasonable maximum and vacated its earlier rate prescription order. Railroad appealed to the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit) those portions of the ICC's decisions concerning the post-October 1, 1980 rate levels. Railroad's primary contention on appeal was that the ICC erred in using the revenue to variable cost rate standard to judge the rates instead of Constrained Market Pricing/Stand Alone Cost principles. The limited portions of decisions that cover pre-October 1, 1980 rates were appealed to the Montana District Court. On March 24, 1992, the Montana District Court dismissed plaintiffs' case as to all aspects other than those relating to pre-October 1, 1980 rates. On February 9, 1993, the D.C. Circuit served its decision regarding the appeal of the several ICC decisions in this case. The Court held that the ICC did not adequately justify its use of the revenue to variable cost standard as Railroad had argued and remanded the case to the ICC for further administrative proceedings. On July 22, 1993, the ICC served an order in response to the D.C. Circuits' February 9, 1993 decision. In its order, the ICC stated it would use the Constrained Market Pricing/Stand Alone Cost standards in assessing the reasonableness of Railroad wheat and barley rates moving from Montana to Pacific Coast ports from 1978 forward. The ICC assigned the case to the Office of Hearings to develop a procedural schedule. The parties are now engaged in discovery. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable-see Table of Contents note. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the outstanding Common Stock of Railroad is owned of record by BNI and therefore not traded on any market. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Not applicable-see Table of Contents note. ITEM 7. ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 COMPARED WITH YEAR ENDED DECEMBER 31, 1992 Railroad had net income of $332 million for 1993 compared with net income of $334 million for 1992. Results for 1993 included the effects of severe flooding in the Midwest, most notably in the third quarter. The floods slowed and often halted operations, forced extensive detours, increased car, locomotive and crew costs and resulted in extensive rebuilding of damaged track and bridges. Railroad estimated that the third quarter flooding reduced revenues during 1993 by $44 million and increased operating expenses by $35 million, for a combined reduction of $79 million. Net income for 1993 included the retroactive effects of the Omnibus Budget Reconciliation Act of 1993 (the Act), which was passed into law during August 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $28 million through the date of enactment. Railroad recognized a one-time, non-cash charge of $27 million to income tax expense to adjust deferred taxes as of the enactment date and a charge of $1 million to current income tax expense. Net income for 1992 included settlement payments received for the reimbursement of attorneys' fees and costs incurred by Railroad in connection with litigation filed by Energy Transportation Systems, Inc., and others, and reimbursement of a portion of the amount paid by Railroad in settlement of that action. The pre-tax amount recorded in other income (expense), net was approximately $47 million. Also during 1992, Railroad's net income included a $21 million cumulative effect of changes in accounting methods and a $17 million favorable tax settlement with the Internal Revenue Service (IRS). REVENUES During 1993, Railroad refined its customer oriented business units by creating smaller, more focused business units. The following table presents Railroad's revenue information by business unit, and includes reclassification of prior-year information to conform to current year presentation: Coal revenues improved $12 million compared with 1992, primarily as a result of increased traffic caused by a rise in the demand for electricity. Higher revenues resulting from volume increases were partially offset by lower yields arising from competitive pricing pressures in contract renegotiations, traffic mix and other factors. Additionally, Railroad estimated lost coal revenues of approximately $35 million for the third quarter of 1993 as a result of flood-related problems in July and August which interrupted service to several utilities. Agricultural Commodities revenues were $7 million higher than 1992 as stronger yields were partially offset by lower volumes. Improved yields resulted from a traffic mix with a greater portion of wheat traffic in 1993. Stronger export demand, for high-quality wheat grown in regions served by Railroad, contributed to a $74 million improvement in wheat revenues. Reduced crop quality and production problems, stemming from poor planting and growing conditions, resulted in lower corn volumes and produced a year-over-year decline in corn revenues of $45 million. Intermodal revenues were $19 million higher in 1993 compared with 1992. BN AMERICA revenues in 1993 surpassed revenues in 1992 as a result of continued escalating demand for containerized transportation and an increased demand for intermodal service due generally to a shortage in truck capacity. As import traffic expanded and shifted from ports in California to ports served by Railroad in the Pacific Northwest, intermodal-international revenues increased. Domestic trailer revenues declined as trailer traffic continued to convert to containers, partially offsetting other Intermodal increases. Chemicals revenues for 1993 were $17 million greater than in 1992. Increased plastics shipments for existing customers led improvements in overall Chemicals revenues. Environmental logistics and fertilizer traffic in 1993 surpassed 1992 levels, also contributing to the higher revenues for Chemicals. Revenues for Minerals Processors increased $15 million when compared with 1992. As drilling activity increased, export traffic for clays and aggregates expanded, contributing to greater revenues in 1993 than in 1992. Glass minerals and cement revenues exceeded 1992 levels. This increase was due to expanded sand traffic, which also benefited from increased drilling activity, and increased cement traffic, related to certain highway and airport construction projects. Vehicles & Machinery revenues were $21 million greater than in 1992. This improvement was due in part to growth in production and sales of light vehicles which increased domestic traffic volumes. A rise in demand for heavy machinery also contributed to greater revenues. Yields increased in 1993 primarily as a result of a decline in the average length of haul. Forest Products, Iron & Steel and Aluminum, Non-Ferrous Metals & Ores had lower revenues in 1993 compared with 1992. Current year Forest Products revenues were $6 million less than in 1992 because of reduced lumber traffic, resulting from a weak timber industry market, which was partially offset by increased particle and construction board traffic. Iron & Steel revenues declined $6 million compared with 1992, primarily due to lower taconite traffic caused by labor strikes at two large customers. Aluminum, Non-Ferrous Metals & Ores revenues decreased by $5 million as aluminum production declined. Revenues for Consumer Products were relatively flat compared with 1992. EXPENSES Total operating expenses for 1993 were $4,049 million compared with $4,043 million for 1992. Despite the adverse effects of the Midwest flooding on operating expenses during the third quarter of 1993, Railroad's year-to-date operating ratio improved one percentage point, to 86 percent, compared with 87 percent for 1992. Compensation and benefits expenses for 1993 decreased $3 million compared with 1992. Cost of living allowances for union employees were $24 million lower during 1993 compared with 1992 due to timing differences of vesting periods. Work force reductions and a decrease in railroad unemployment taxes also lowered expenses in 1993. The majority of these savings were offset by increases in incentive compensation, wages and salaries, and higher costs for union health, welfare and life insurance benefits. Increased wages were partially caused by a scheduled three percent basic wage increase effective July 1993 and inefficiencies associated with the Midwest flooding during 1993. Fuel expenses were $14 million higher during 1993 compared with 1992, primarily due to weather-related reductions in fuel efficiency. Increased fuel consumption due to higher traffic volume was substantially offset by the decrease in the average price paid for diesel fuel, 61.5 cents per gallon in 1993 compared with 62.2 cents per gallon in 1992. Included in the 1993 average price per gallon is a 4.3 cents per gallon increase in the federal fuel tax effective October 1, 1993, as part of the Omnibus Budget Reconciliation Act of 1993. This increase added approximately $7 million to expense in the fourth quarter. Materials expenses for 1993 increased $5 million compared with 1992. The combination of flood-related problems and a larger fleet size increased materials costs for locomotive repairs. Also, safety and protective equipment expenditures were higher due to continued emphasis of Railroad's safety programs. Offsetting these increases were lower car materials expenses. Equipment rents expenses were $15 million higher in 1993 compared with 1992 due to increases in both car-hire expenses and locomotive rentals. Increased equipment rentals from an affiliate also contributed to this increase. A reduction in car-hire expenses during the first half of 1993, due to improved utilization of equipment, was more than offset by flood-related inefficiencies which increased car-hire expenses during the second half of 1993. Purchased services expenses for 1993 were $7 million higher than in 1992. Contributing to this increase were cost increases for intermodal logistics, training, moving and derailments. Lower trackage rights credits, which reduces purchased services expenses, were received from the Southern Pacific Transportation Company (SPTC) as the floods reduced SPTC volumes over Railroad track. These increases were partially offset by decreases in contracted locomotive repairs and consultant fees. Depreciation expense for 1993 was $10 million higher compared with 1992 primarily due to an increase in the asset base. The $42 million decrease in other operating expenses compared with 1992 was primarily due to a $35 million decline in costs associated with personal injury claims. Railroad has introduced a number of programs to improve worker safety and counter increasing personal injury costs. Reductions in bad debt expense and various other costs were partially offset by losses on property retired due to flood damages and increased moving expenses. Interest expense declined $17 million in 1993 compared with 1992. This decline was mainly due to a lower average long-term debt balance outstanding during 1993. Other income (expense), net was $45 million lower in 1993 than in 1992. The higher 1992 income was due to a first quarter net gain of $47 million for payments and reimbursements received for the settlement of prior litigation. This decline was partially offset by an increase in the net gain on property dispositions in 1993 compared with 1992. The effective tax rate was 42.4 percent for 1993 compared with 34.4 percent for 1992. This increase resulted primarily from the retroactive increase, effective January 1, 1993, in tax rates as part of the Omnibus Budget Reconciliation Act of 1993. Excluding the retroactive effect of the tax rate change on deferred tax balances at January 1, 1993, Railroad's effective tax rate was 37.9 percent for 1993. Additionally, a favorable tax settlement with the IRS reduced the 1992 effective tax rate by 3.1 percent. Other matters In October 1991, Railroad entered into an agreement (Crew Consist Agreement No. 1) with the United Transportation Union (UTU) covering the southern portion of Railroad's system. Crew Consist Agreement No. 1 provided for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. Under the terms of Crew Consist Agreement No. 1, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $60,000 per employee. Remaining conductors or brakemen who, as a result of Crew Consist Agreement No. 1, were unable to hold a position in active service, due to relative seniority, were placed on a reserve board. Employees in reserve status received compensation at a rate equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. Each UTU member on the southern portion of Railroad's system received a lump-sum payment of $1,000 upon ratification of Crew Consist Agreement No. 1. In May 1993, Railroad entered into an agreement (Crew Consist Agreement No. 2) with the UTU covering approximately 3,400 UTU members in the northern portion of Railroad's system. Crew Consist Agreement No. 2 provides for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. It is similar to Crew Consist Agreement No. 1, covering the southern portion of Railroad's system. Each UTU member on the northern portion of Railroad's system received a one-time lump-sum payment of $5,000, pursuant to Crew Consist Agreement No. 2. Under the terms of Crew Consist Agreement No. 2, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $80,000 per employee. Conductors and brakemen who choose not to accept the voluntary separation offer can elect volunteer surplus status pursuant to which they will receive $60,000 to be paid out over a period of 18 to 48 months, as each selects. If such employee has not been recalled to active service by the time such payments cease upon expiration of the selected period, such employee will remain in volunteer surplus status, without further compensation or benefits, until recalled to active service. Employees in volunteer surplus status may be called back to service only after the individuals in reserve status, within their own subdivided seniority district, have been recalled. Remaining conductors and brakemen who, as a result of Crew Consist Agreement No. 2, are not needed in train service, and who do not elect one of the above severance options, will be placed on a reserve board. Employees in reserve status will receive compensation equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. In October 1993, the UTU elected to adopt Crew Consist Agreement No. 2 for those southern portion UTU members who were previously covered by Crew Consist Agreement No. 1. Crew Consist Agreement No. 2 was implemented on the southern portion of the Railroad's system during the fourth quarter of 1993. Upon implementation, each of the approximately 3,300 UTU members on the southern portion of Railroad's system received a one-time lump-sum payment of $4,000, which was the incremental difference between the $1,000 lump-sum payment received following ratification of Crew Consist Agreement No. 1 and the amount received by UTU members following adoption of Crew Consist Agreement No. 2. Railroad will continue to remove excess positions from train service through the implementation of Crew Consist Agreement No. 2. Approximately 1,350 excess positions have been removed as a result of employees accepting severance or voluntary surplus payments. Other excess positions have been eliminated and personnel formerly in those positions have been assigned to reserve boards, absorbed through additional train starts and/or utilized in quality and safety initiatives. Based upon its experience under Crew Consist Agreement No. 1, Railroad anticipates that the number of employees on reserve status will decline over time. In July 1993, the American Train Dispatchers Association ratified an April agreement which will facilitate the consolidation of all dispatching functions into a centralized train dispatching office in Fort Worth, Texas by the end of 1995. Since 1935, Railroad has participated in the national railroad retirement system which is separate from the national social security system. Under this system, an independent Railroad Retirement Board administers the determination and payment of benefits to all railroad workers. Both Railroad and its employees are subject to a tax on employee earnings which is above the normal social security rate assessed to those who are employed outside the railroad industry. Personal injury claims, including work-related injuries to employees, are a significant expense for the railroad industry. Employees of Railroad are compensated for work-related injuries according to the provisions of the Federal Employers' Liability Act (FELA). FELA's system of requiring finding of fault, coupled with unscheduled awards and reliance on the jury system, has resulted in significant increases in expense. The result has been a trend during the last several years of significant increases in Railroad's personal injury expense which reflects the combined effects of increasing medical expenses, legal judgments and settlements. To improve worker safety and counter increasing costs, Railroad has introduced a number of programs to reduce the number of personal injury claims and the dollar amount of claims settlements which helped reduce cost in 1993. If these efforts continue to be successful, future expenses could be further reduced. The total amount of personal injury expenses (including wage continuation payments) were $216 million, $253 million and $224 million in 1993, 1992 and 1991, respectively. Railroad is also working with others through the Association of American Railroads to seek changes in legislation to provide a more equitable program for injury compensation in the railroad industry. Railroad's operations, as well as those of its competitors, are subject to extensive federal, state and local environmental regulation. In order to comply with such regulation and to be consistent with Railroad's corporate environmental policy, Railroad's operating procedures include practices to protect the environment. Amounts expended relating to such practices are inextricably contained in the normal day-to-day costs of Railroad's business operations. Under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and certain other laws, Railroad is potentially liable for the cost of clean-up of various contaminated sites identified by the U.S. Environmental Protection Agency and other agencies. Railroad has been notified that it is a potentially responsible party (PRP) for study and clean-up costs at a number of sites and, in many instances, is one of several PRPs. Railroad generally participates in the clean-up of these sites through cost-sharing agreements with terms that vary from site to site. Costs are typically allocated based on relative volumetric contribution of material, the amount of time the site was owned or operated, and/or the portion of the total site owned or operated by each PRP. However, under Superfund and certain other laws, as a PRP, Railroad can be held jointly and severally liable for all environmental costs associated with a site. Environmental costs include initial site surveys and environmental studies of potentially contaminated sites as well as costs for remediation and restoration of sites determined to be contaminated. Liabilities for environmental clean-up costs are initially recorded when Railroad's liability for environmental clean-up is both probable and a reasonable estimate of associated costs can be made. Adjustments to initial estimates are recorded as necessary based upon additional information developed in subsequent periods. Railroad conducts an ongoing environmental contingency analysis, which considers a combination of factors, including independent consulting reports, site visits, legal reviews, analysis of the likelihood of participation in and ability to pay for clean-up by other PRPs, and historical trend analysis. Railroad is involved in a number of administrative and judicial proceedings in which it is being asked to participate in the clean-up of sites contaminated by material discharged into the environment. Railroad paid $27 million, $20 million and $21 million during 1993, 1992 and 1991, respectively, relating to mandatory clean-up efforts, including amounts expended under federal and state voluntary clean-up programs. At this time, Railroad expects to spend approximately $120 million in future years to remediate and restore these sites. Liabilities for environmental costs represent Railroad's best estimates for remediation and restoration of these sites and include asserted and unasserted claims. Railroad's best estimate of unasserted claims was approximately $5 million as of the end of 1993. Although recorded liabilities include Railroad's best estimates of all costs, without reduction for anticipated recovery from insurance, Railroad's total clean-up costs at these sites cannot be predicted with certainty due to various factors such as the extent of corrective actions that may be required, evolving environmental laws and regulations, advances in environmental technology, the extent of other PRPs participation in clean-up efforts, developments in ongoing environmental analyses related to sites determined to be contaminated, and developments in environmental surveys and studies of potentially contaminated sites. As a result, charges to income for environmental liabilities could possibly have a significant effect on results of operations in a particular quarter or fiscal year as individual site studies and remediation and restoration efforts proceed or as new sites arise. However, expenditures associated with such liabilities are typically paid out over a long period, in some cases up to 40 years, and are therefore not expected to have a material adverse effect on Railroad's consolidated financial position, cash flow or liquidity. In November 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires employers to recognize benefits provided to former or inactive employees after employment but before retirement, if certain conditions are met. In the first quarter of 1994, Railroad will adopt SFAS No. 112. The principal effect of adopting this standard will be to establish liabilities for long-term and short-term disability plans. The effect upon earnings to adopt this standard is expected to be approximately $15 to $20 million. The initial effect of applying this standard will be reported as the effect of a change in accounting method and previously issued financial statements will not be restated. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 addresses the accounting and reporting requirements for investments in equity securities that have readily determinable fair values and for all investments in debt securities, and is effective for fiscal years beginning after December 15, 1993. The initial effect of applying this standard is to be reported as the effect of a change in accounting method and previously issued financial statements may not be restated. No material effect on Railroad's financial condition or results of operations is anticipated from the adoption of SFAS No. 115. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED STATEMENTS OF OPERATIONS Burlington Northern Railroad Company and Subsidiaries (Dollars in millions) Year ended December 31, 1993 1992 1991 - ----------------------- ------ ------ ------ Revenues............................................ $4,699 $4,630 $4,559 Costs and expenses: Compensation and benefits......................... 1,701 1,704 1,753 Fuel.............................................. 362 348 368 Materials......................................... 300 295 283 Equipment rents................................... 425 410 413 Purchased services................................ 464 457 444 Depreciation...................................... 334 324 340 Other............................................. 463 505 489 Special charge.................................... - - 708 ------ ------ ------ Total costs and expenses........................ 4,049 4,043 4,798 ------ ------ ------ Operating income (loss)............................. 650 587 (239) Interest expense.................................... 86 103 136 Other income (expense), net......................... 12 57 (10) ------ ------ ------ Income (loss) before income taxes and cumulative effect of changes in accounting methods........... 576 541 (385) Income tax expense (benefit)........................ 244 186 (140) ------ ------ ------ Income (loss) before cumulative effect of changes in accounting methods............................. 332 355 (245) Cumulative effect of change in accounting methods, net of tax........................................ - (21) - ------ ------ ------ Net income (loss)............................. $ 332 $ 334 $ (245) ====== ====== ====== See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS Burlington Northern Railroad Company and Subsidiaries (Dollars in millions) December 31, 1993 1992 - ------------ ------ ------ ASSETS Current assets: Cash and cash equivalents....................... $ 17 $ 57 Accounts receivable, net........................ 591 474 Materials and supplies.......................... 91 106 Current portion of deferred income taxes........ 167 144 Other current assets............................ 23 22 ------ ------ Total current assets.......................... 889 803 Property and equipment, net....................... 5,488 5,285 Investments in and advances to affiliates......... 104 133 Other assets...................................... 130 116 ------ ------ Total assets.............................. $6,611 $6,337 ====== ====== LIABILITIES AND STOCKHOLDER'S EQUITY Current liabilities: Accounts payable................................ $ 498 $ 479 Casualty and environmental reserves............. 286 249 Compensation and benefits payable............... 269 319 Taxes payable................................... 131 124 Accrued interest................................ 22 24 Other current liabilities....................... 69 71 Current portion of long-term debt............... 177 37 Commercial paper................................ 26 - ------ ------ Total current liabilities..................... 1,478 1,303 Long-term debt.................................... 702 921 Deferred income taxes............................. 1,329 1,178 Casualty and environmental reserves............... 426 482 Other liabilities................................. 182 217 ------ ------ Total liabilities............................. 4,117 4,101 ------ ------ Common stockholder's equity: Common stock, without par value (1,000 shares authorized, issued and outstanding)........... 1,191 1,190 Retained earnings............................... 1,303 1,046 ------ ------ Total common stockholder's equity............. 2,494 2,236 ------ ------ Total liabilities and stockholder's equity $6,611 $6,337 ====== ====== See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Burlington Northern Railroad Company and Subsidiaries (Dollars in millions) Year ended December 31, 1993 1992 1991 - ----------------------- ------ ------ ------ Cash flows from operating activities: Net income (loss)............................... $ 332 $ 334 $(245) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Cumulative effect of changes in accounting methods..................................... - 21 - Depreciation.................................. 334 324 340 Deferred income taxes......................... 128 25 (259) Special charge................................ - - 708 Changes in current assets and liabilities: Accounts receivable, net.................... (117) (30) (104) Materials and supplies...................... 6 2 9 Other current assets........................ (1) 1 (9) Accounts payable............................ 19 19 (14) Casualty and environmental reserves......... 37 2 10 Compensation and benefits payable........... (50) 16 (58) Taxes payable............................... 7 4 7 Accrued interest............................ (2) (9) (2) Other current liabilities................... (2) 3 24 Changes in long-term casualty and environmental reserves...................... (56) 16 (13) Other, net.................................... (60) (22) (1) ----- ----- ----- Net cash provided by operating activities... 575 706 393 ----- ----- ----- Cash flows from investing activities: Additions to property and equipment............. (530) (469) (355) Collections from (advances to) affiliates, net.. 29 266 (48) Proceeds from property and equipment dispositions.................................. 35 33 57 Other, net...................................... (16) (19) (10) ----- ----- ----- Net cash used in investing activities....... (482) (189) (356) ----- ----- ----- Cash flows from financing activities: Net increase (decrease) in commercial paper..... 26 (353) 118 Payments on long-term debt...................... (83) (71) (70) Dividends paid.................................. (75) (50) (125) Other, net...................................... (1) (2) - ----- ----- ----- Net cash used in financing activities....... (133) (476) (77) ----- ----- ----- Increase (decrease) in cash and cash equivalents............................... (40) 41 (40) Cash and cash equivalents: Beginning of year............................... 57 16 56 ----- ----- ----- End of year..................................... $ 17 $ 57 $ 16 ===== ===== ===== Supplemental cash flow information: Interest paid, net of amounts capitalized....... $ 92 $ 110 $ 131 Income taxes paid, net of refunds............... 109 163 102 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCKHOLDER'S EQUITY Burlington Northern Railroad Company and Subsidiaries (Dollars in millions) See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Burlington Northern Railroad Company and Subsidiaries 1. ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION Burlington Northern Railroad Company (Railroad) is a wholly owned subsidiary of Burlington Northern Inc. (BNI). The consolidated financial statements include the accounts of Railroad and its majority-owned subsidiaries. All significant intercompany accounts and transactions between Railroad and its affiliates have been eliminated. PROPERTY AND EQUIPMENT Main line track is depreciated on a group basis using a units-of-production method. All other property and equipment are depreciated on a straight-line basis over estimated useful lives. Interstate Commerce Commission (ICC) regulations require periodic formal studies of ultimate service lives for all railroad assets. Resulting service life estimates are subject to review and approval by the ICC. An annual review of rates and accumulated depreciation is performed and appropriate adjustments are recorded. Significant premature retirements are recorded as gains or losses at the time of their occurrence, which would include major casualty losses, abandonments, sales and obsolescence of assets. Expenditures which significantly increase asset values or extend useful lives are capitalized. Repair and maintenance expenditures are charged to operating expense when the work is performed. All properties are stated at cost. MATERIALS AND SUPPLIES Materials and supplies consist mainly of diesel fuel, repair parts for equipment and other railroad property and are valued at average cost. REVENUE RECOGNITION Transportation revenues are recognized proportionately as a shipment moves from origin to destination. INCOME TAXES Income taxes are provided based on earnings reported for tax return purposes in addition to a provision for deferred income taxes. The provision for income taxes includes deferred taxes determined by the change in the deferred tax liability, which is computed based on the differences between the financial statement and tax basis of assets and liabilities as measured by applying enacted tax laws and rates. Deferred tax expense is the result of changes in the net liability for deferred taxes. Investment tax credits were accounted for under the "flow-through" method. CASH AND CASH EQUIVALENTS All short-term investments which mature in less than 90 days when purchased are considered cash equivalents for purposes of disclosure in the consolidated balance sheets and consolidated statements of cash flows. Cash equivalents are stated at cost, which approximates market value. RECLASSIFICATIONS Certain prior year data has been reclassified to conform to the current year presentation. These reclassifications had no effect on previously reported net income, stockholder's equity or cash flows. 2. ACCOUNTS RECEIVABLE, NET Railroad has an agreement to sell, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable with limited recourse. As of December 31, 1993, the agreement allowed for the sale of accounts receivable up to a maximum of $175 million. The agreement expires not later than December 1994. Average monthly proceeds from the sale of accounts receivable were $182 million, $190 million and $269 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, accounts receivable were net of $100 million and $189 million, respectively, representing receivables sold. Included in other income (expense), net were expenses of $9 million, $11 million and $20 million in 1993, 1992 and 1991, respectively, relating to the sale. Railroad maintains an allowance for doubtful accounts based upon the expected collectibility of all trade accounts receivable, including receivables sold with recourse. Allowances for doubtful accounts and recourse on receivables sold of $17 million and $16 million have been recorded at December 31, 1993 and 1992. 3. PROPERTY AND EQUIPMENT, NET Property and equipment, net was as follows (in millions): December 31, 1993 1992 - ------------ ------ ------ Road, roadway structures and real estate.......... $7,342 $7,024 Equipment......................................... 1,784 1,744 ------ ------ Total cost..................................... 9,126 8,768 Less accumulated depreciation..................... 3,638 3,483 ------ ------ Property and equipment, net.................. $5,488 $5,285 ====== ====== Certain noncancellable leases were classified as capital leases and were included in property and equipment. The consolidated balance sheets at December 31, 1993 and 1992 included $36 million and $35 million, respectively, of property and equipment under capital leases. The related depreciation was included in depreciation expense. Accumulated depreciation for property and equipment under capital leases was $31 million and $29 million at December 31, 1993 and 1992, respectively. Main line track is depreciated on a group basis using a units-of-production method. The accumulated depreciation and annual depreciation accrual rates for railroad assets other than main line track are calculated using a straight-line method and statistical group measurement techniques, which closely approximate unit depreciation. The group techniques project depreciation expense and estimated accumulated depreciation utilizing historical experience and expected future conditions relating to the timing of asset retirements, cost of removal, salvage proceeds, maintenance practices and technological changes. In this manner, the net book value of reported assets reflects estimated remaining asset utility on a historical cost basis. Due to the imprecision of annual reviews using statistical group measurement techniques for long-term asset retirement, replacement and deterioration patterns, Railroad adjusts accumulated depreciation for significant differences between recorded accumulated depreciation and computed requirements. Differences between recorded accumulated depreciation and computed requirements are recognized prospectively on a straight-line basis. Under ICC regulations, Railroad conducts service life studies on an annual basis. Results of service life studies are recorded over the remaining life of the asset group studied. During 1993, Railroad completed service life studies of equipment and road property. During 1992, the service life studies consisted of rail. The effect of implementing the results of new service life studies and similar rate adjustments were to decrease depreciation expense in 1993 by $2 million compared with 1992 and to decrease depreciation expense in 1992 by $28 million compared with 1991. In future periods, service life studies will be conducted on other asset groups as well as these same assets under ICC requirements. However, the impact of such studies is not determinable at this time. In 1993, capitalization of certain software development costs increased as a result of new strategic initiatives. Capitalization of software development costs begins upon establishment of technological feasibility. The establishment of technological feasibility is based upon completion of planning, design and other technical performance requirements. Capitalized software development costs are amortized over a seven-year estimated useful life using the straight-line method. No amortization was recorded for the year ended December 31, 1993. Unamortized capitalized software costs were $6 million as of December 31, 1993. 4. DEBT Debt outstanding was as follows (in millions): December 31, 1993 1992 - ------------ ---- ---- LONG-TERM DEBT Consolidated mortgage bonds, 3 1/5% to 10%, due serially to 2045............................... $622 $673 Equipment and other obligations, weighted average rate of 7.33% and 7.72%, respectively, due serially to 2009................................... 113 139 General mortgage bonds, 3 1/8% and 2 5/8%, due 2000 and 2010, respectively............................. 62 62 Prior lien railway and land grant bonds, 4%, due 1997 57 57 General lien railway and land grant bonds, 3%, due 2047........................................... 35 35 First mortgage bonds, series A, 4%, due 1997......... 24 26 Capitalized lease obligations, weighted average rate of 8.20% and 7.92%, respectively, expiring 1996 and 2003...................................... 10 13 Income debentures, series A, 5%, due 2006............ 8 8 Commercial paper..................................... 26 - Unamortized discount.................................... (52) (55) ---- ---- Total.............................................. 905 958 Less: Current portion of long-term debt.................... 177 37 Commercial paper..................................... 26 - ---- ---- Long-term debt................................... $702 $921 ==== ==== Railroad maintains an effective program for the issuance, from time to time, of commercial paper. These borrowings are supported by Railroad's bank credit agreement, thus outstanding commercial paper balances reduce available borrowings under this agreement. The bank credit agreement allows borrowings of up to $500 million on a short-term basis. The agreement is currently scheduled to expire in November 1994. At Railroad's option, borrowing rates are based on prime, certificate of deposit or London Interbank Offered rates. Annual facility fees are 0.25 percent. The maturity value of commercial paper outstanding at December 31, 1993 was $27 million, leaving a total of $473 million of the credit agreement available, while no commercial paper was outstanding at December 31, 1992. The financial covenants of the bank credit agreement require that Railroad's consolidated tangible net worth, as defined in the agreement, be at least $1.4 billion, and its debt, as defined in the agreement, cannot exceed the lesser of 140 percent of its consolidated tangible net worth or $2.5 billion. The agreement contains an event of default arising out of the occurrence and continuance of a "Change in Control." A "Change in Control" is generally defined as the acquisition of more than 50 percent of the voting securities of BNI, which has not been approved by the BNI Board of Directors, a change in the control relationship between BNI and Railroad, and finally, a "Change in Control" is deemed to occur when a majority of the seats on the BNI Board of Directors is occupied by persons who are neither nominated by BNI management nor appointed by directors so nominated. The commercial paper program is further summarized as follows (dollars in millions): December 31, 1993 1992 - ------------ ---- ---- Balance at year end................................. $ 26 $ - Weighted average interest rate...................... 3.55% - Maximum outstanding during the year................. $ 179 $ 427 Average daily amount outstanding during the year.... $ 41 $ 129 Weighted daily average interest rate during the year 3.27% 4.07% Maturities of commercial paper averaged 4 and 14 days in 1993 and 1992, respectively. Aggregate long-term debt scheduled maturities for 1994 through 1998 and thereafter are $177 million, $24 million, $18 million, $235 million, $11 million and $466 million, respectively. Substantially all Railroad properties and certain other assets are pledged as collateral to or are otherwise restricted under the various Railroad long-term debt agreements. 5. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of Railroad's financial instruments at December 31, 1993 and 1992 and the methods and assumptions used to estimate the fair value of each class of financial instruments held by Railroad, were as follows: CASH AND SHORT-TERM INVESTMENTS The carrying amount approximated fair value because of the short maturity of these instruments. NOTES RECEIVABLE The fair value of notes receivable was estimated by discounting the anticipated cash flows. Discount rates of 8.7 percent and 10 percent at December 31, 1993 and 1992, were determined to be appropriate when considering current U.S. Treasury rates and the credit risk associated with these notes. ACCRUED INTEREST PAYABLE The carrying amount approximated fair value as the majority of interest payments are made semiannually. LONG-TERM DEBT AND COMMERCIAL PAPER The fair value of Railroad's long-term debt, excluding unamortized discount, was primarily based on secondary market indicators. For those issues not actively quoted, estimates were based on each obligation's characteristics. Among the factors considered were the maturity, interest rate, credit rating, collateral, amortization schedule, liquidity and option features such as optional redemption or optional sinking funds. These features were compared to other similar outstanding obligations to determine an appropriate increment or spread, above U.S. Treasury rates, at which the cash flows were discounted to determine the fair value. The carrying amount of commercial paper approximated fair value because of the short maturity of these instruments. RECOURSE LIABILITY FROM SALE OF RECEIVABLES It is unlikely that Railroad would be able to pay a second entity to assume its recourse obligation. Therefore, the carrying value of the allowance for doubtful accounts on receivables sold approximated the fair value of the recourse liability related to those receivables. The carrying amount and estimated fair values of Railroad's financial instruments were as follows (in millions): December 31, 1993 1992 - ------------ ---------------- ---------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- ------ -------- ------ Cash and short-term investments...... $ 17 $ 17 $ 57 $ 57 Notes receivable..................... 9 11 9 9 Accrued interest payable............. 22 22 24 24 Long-term debt and commercial paper.. 957 978 1,013 1,007 Recourse liability from sale of receivables....................... 4 4 5 5 Railroad also holds investments in, and has advances to, several unconsolidated transportation affiliates. It was not practicable to estimate the fair value of these financial instruments, which were carried at their original cost of $17 million and $16 million in the December 31, 1993 and 1992 consolidated balance sheets. There were no quoted market prices available for the shares held in the affiliated entities, and the cost of obtaining an independent valuation would have been excessive considering the materiality of these investments to Railroad. In addition, Railroad has a note receivable, from a shortline railroad, that has principal payments which are based on traffic volume over a segment of line. The carrying value of the note was $5 million at December 31, 1993 and 1992. As it is not practicable to forecast the traffic volume over the remaining life of the note, it was not included in the notes receivable amount shown above. In May 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 addresses the accounting and reporting requirements for investments in equity securities that have readily determinable fair values and for all investments in debt securities, and is effective for fiscal years beginning after December 15, 1993. The initial effect of applying this standard is to be reported as the effect of a change in accounting method and previously issued financial statements may not be restated. No material effect on Railroad's financial condition or results of operations is anticipated from the adoption of SFAS No. 115. 6. INCOME TAXES Effective January 1, 1993, Railroad adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 modifies SFAS No. 96, which established the liability method of accounting for income taxes, and had been adopted by Railroad effective January 1, 1986. Railroad adopted SFAS No. 109 consistent with the transitional guidelines of SFAS No. 109. The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. There was no effect on net income, stockholder's equity or cash flows. Income tax expense (benefit), excluding the cumulative effect of changes in accounting methods, was as follows (in millions): Year ended December 31, 1993 1992 1991 - ----------------------- ----- ---- ----- Current: Federal ................................... $ 102 $138 $ 107 State ..................................... 14 23 12 ----- ---- ----- 116 161 119 ----- ---- ----- Deferred: Federal ................................... 111 24 (227) State ..................................... 18 1 (32) ----- ---- ----- 129 25 (259) ----- ---- ----- Total.................................... $ 244 $186 $(140) ===== ==== ===== Reconciliation of the federal statutory income tax rate to the effective tax rate, excluding the cumulative effect of changes in accounting methods, was as follows: Year ended December 31, 1993 1992 1991 - ----------------------- ----- ---- ----- Federal statutory income tax rate................. 35.0% 34.0% 34.0% State income taxes, net of federal tax benefit.... 3.5 3.3 3.4 Effect of one percent federal tax rate increase on deferred tax balances at January 1, 1993....... 4.5 - - Internal Revenue Service settlement............... - (3.1) - Other, net........................................ (.6) .2 (1.0) ----- ---- ----- Effective tax rate............................. 42.4% 34.4% 36.4% ===== ==== ===== The components of deferred tax assets and liabilities were as follows (in millions): December 31, 1993 1992 - ------------ ------- ------- Deferred tax liabilities: Accelerated depreciation and amortization...... $(1,616) $(1,510) Other.......................................... (89) (81) ------- ------- Total deferred tax liabilities............... (1,705) (1,591) ------- ------- Deferred tax assets: Casualty and environmental reserves............ 267 270 Pensions....................................... 29 28 Other.......................................... 247 259 ------- ------- Total deferred tax assets.................... 543 557 ------- ------- Valuation allowance............................ - - ------- ------- Net deferred tax liability................. $(1,162) $(1,034) ======= ======= Noncurrent deferred income tax liability........ $(1,329) $(1,178) Current deferred income tax asset............... 167 144 ------- ------- Net deferred tax liability................. $(1,162) $(1,034) ======= ======= On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $28 million through the date of enactment. A one-time, non-cash charge of $27 million to income tax expense was recorded as an adjustment to deferred taxes as of the enactment date and a charge of $1 million to income tax expense was recorded as an adjustment to current income taxes. In December 1992, Railroad received notification that an Appeals Division settlement of the Internal Revenue Service audits for the years 1981 through 1985 had been approved by the Joint Committee on Taxation. This action settled all unagreed issues for those years. The tax effect of the settlement was included in the 1992 tax provision as shown below (in millions): Current tax expense.............................. $ 2 Deferred tax benefit............................. (19) ---- Total tax benefit.............................. $(17) ==== 7. RETIREMENT PLANS Railroad participates in BNI's pension plans, which are non-contributory defined benefit plans covering substantially all non-union employees. The benefits are based on years of credited service and the highest five-year average compensation levels. Contributions to the plans are determined by BNI and are limited to amounts that are currently deductible for tax purposes. Railroad's pension expense was $26 million, $31 million and $23 million in 1993, 1992 and 1991, respectively. Net pension cost for 1993 was lower than 1992 primarily due to a decrease in the rate of future compensation growth from 6 percent to 5.5 percent. The changes in pension cost for the two years ended December 31, 1992 were primarily attributable to the expected year-to-year changes in the discount rates. Railroad participates in a 401(k) thrift and profit sharing plan, sponsored by BNI, which covers substantially all non-union employees. BNI matches 35 percent of the first 6 percent of the employees' contributions, which is subject to certain percentage limits of the employees' earnings, at the end of each quarter. Depending on BNI's consolidated performance, an additional matching contribution of 20 or 40 percent can be made at the end of the year. Railroad's expense was $6 million, $4 million and $6 million in 1993, 1992 and 1991, respectively. Effective January 1, 1994, Railroad also participates in a 401(k) retirement savings plan, sponsored by BNI, which covers substantially all union employees which is non-contributory on the part of Railroad. 8. OTHER BENEFIT PLANS POSTRETIREMENT BENEFITS Effective January 1, 1992, Railroad adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." BNI provides certain postretirement health care benefits, payable until age 65, for a small number of retirees who retired on or before March 1986. BNI provides life insurance benefits for eligible non-union employees. Railroad participates in these plans and adopted accrual accounting for the expense of these plans in 1992 by taking a $16 million cumulative effect charge to income in order to establish a liability for those benefits. Railroad pays benefits as claims are processed. In addition, Railroad's expense for these plans was approximately $1 million in both 1993 and 1992. Under collective bargaining agreements, Railroad participates in multi-employer benefit plans which provide certain postretirement health care and life insurance benefits for eligible union employees. Insurance premiums attributable to retirees, which are expensed as incurred, were $10 million in 1993 and $11 million in both 1992 and 1991. POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires employers to recognize benefits provided to former or inactive employees after employment but before retirement, if certain conditions are met. In the first quarter of 1994, Railroad will adopt SFAS No. 112. The principal effect of adopting this standard will be to establish liabilities for long-term and short-term disability plans. The effect upon earnings to adopt this standard is expected to be approximately $15 to $20 million. The initial effect of applying this standard will be reported as the effect of a change in accounting method and previously issued financial statements will not be restated. 9. CASUALTY AND ENVIRONMENTAL RESERVES Casualty reserves consist primarily of personal injury claims, including work-related injuries to employees. Employees of Railroad are compensated for work-related injuries according to the provisions of the Federal Employers' Liability Act. Liabilities for personal injury claims are estimated through an actuarial model that considers historical data and trends and is designed to record those costs in the period of occurrence. Railroad conducts an ongoing review and analysis of claims and other information to ensure the continued adequacy of casualty reserves. To the extent costs exceed recorded accruals they will not materially affect Railroad's financial condition, results of operations or liquidity. Under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and certain other laws, Railroad is potentially liable for the cost of clean-up of various contaminated sites identified by the U.S. Environmental Protection Agency and other agencies. Railroad has been notified that it is a potentially responsible party (PRP) for study and clean-up costs at a number of sites and, in many instances, is one of several PRPs. Railroad generally participates in the clean-up of these sites through cost-sharing agreements with terms that vary from site to site. Costs are typically allocated based on relative volumetric contribution of material, the amount of time the site was owned or operated, and/or the portion of the total site owned or operated by each PRP. However, under Superfund and certain other laws, as a PRP, Railroad can be held jointly and severally liable for all environmental costs associated with a site. Environmental costs include initial site surveys and environmental studies of potentially contaminated sites as well as costs for remediation and restoration of sites determined to be contaminated. Liabilities for environmental clean-up costs are initially recorded when Railroad's liability for environmental clean-up is both probable and a reasonable estimate of associated costs can be made. Adjustments to initial estimates are recorded as necessary based upon additional information developed in subsequent periods. Railroad conducts an ongoing environmental contingency analysis, which considers a combination of factors, including independent consulting reports, site visits, legal reviews, analysis of the likelihood of participation in and ability to pay for clean-up by other PRPs, and historical trend analysis. Liabilities for environmental costs represent Railroad's best estimates for remediation and restoration of these sites and include asserted and unasserted claims. Railroad's best estimate of unasserted claims was approximately $5 million as of the end of 1993. Although recorded liabilities include Railroad's best estimates of all costs, without reduction for anticipated recovery from insurance, Railroad's total clean-up cost at these sites cannot be predicted with certainty due to various factors such as the extent of corrective actions that may be required, evolving environmental laws and regulations, advances in environmental technology, the extent of other PRPs participation in clean-up efforts, developments in ongoing environmental analyses related to sites determined to be contaminated, and developments in environmental surveys and studies of potentially contaminated sites. As a result, charges to income for environmental liabilities could possibly have a significant effect on results of operations in a particular quarter or fiscal year as individual site studies and remediation and restoration efforts proceed or as new sites arise. However, expenditures associated with such liabilities are typically paid out over a long period, in some cases up to 40 years, and are therefore not expected to have a material adverse effect on Railroad's consolidated financial position, cash flow or liquidity. 10. COMMITMENTS AND CONTINGENCIES LEASE COMMITMENTS Railroad has substantial lease commitments for railroad, highway and data processing equipment, office buildings and a taconite dock facility. Most of these leases provide the option to purchase the equipment at fair market value at the end of the lease. However, some provide fixed purchase price options. Lease rental expense for operating leases was $205 million, $222 million and $211 million for the years ended December 31, 1993, 1992 and 1991, respectively. Minimum annual rental commitments were as follows (in millions): Capital Operating Year ended December 31, Leases Leases - ----------------------- ------- --------- 1994......................................... $ 5 $ 209 1995......................................... 4 185 1996......................................... 2 162 1997......................................... - 146 1998......................................... - 145 Thereafter................................... 1 911 --- ------ Total.................................... 12 $1,758 Less amount representing interest............ 2 ====== --- Present value of minimum lease payments.. $10 === In addition to the above, Railroad also receives and pays rents for railroad equipment on a per diem basis, which is included in equipment rents. OTHER COMMITMENTS AND CONTINGENCIES During 1993, Railroad entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. Railroad accepted delivery of one locomotive in 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. Railroad has two locomotive electrical power purchase agreements, expiring in 1998 and 2001, that currently involve 199 locomotives. Payments required by the agreements are based upon the number of megawatt hours of energy consumed, subject to specified take-or-pay minimums. The rates specified in the two agreements are renegotiable every two years. Railroad's 1994 minimum commitment obligation is $48 million. Based on projected locomotive power requirements, Railroad's payments in 1994 are expected to be in excess of the minimum. Payments under the agreements totaled $53 million, $56 million and $55 million in 1993, 1992 and 1991, respectively, which exceeded the applicable minimums in each year. In 1990, Railroad entered into a letter of credit for the benefit of a vendor. This letter of credit is a performance guarantee for up to $15 million in major overhauls to be performed on the power purchase equipment. In connection with its program to transfer certain rail lines to independent operators, Railroad has agreed to make certain payments for services performed by the operators in connection with traffic that involves the shortlines and Railroad as carriers. These payments are not fixed in amount, will vary with such factors as traffic volumes and shortline costs and are not expected to exceed normal business requirements for services received. These payments are reflected as reductions to revenue to conform with reporting to the ICC. Revenues for these joint moves, including amounts applicable to the independent operator portion of the line haul, are reflected by Railroad as revenue from operations. There are no other commitments or contingent liabilities which Railroad believes would have a material adverse effect on the consolidated financial position, results of operations or liquidity. 11. OTHER INCOME (EXPENSE), NET Other income (expense), net includes the following (in millions): Year ended December 31, 1993 1992 1991 - ----------------------- ---- ---- ---- Gain on property dispositions..................... $19 $ 9 $ 4 Interest income................................... 9 11 5 Loss on sale of receivables....................... (9) (11) (20) Litigation settlement agreement................... - 47 - Miscellaneous, net................................ (7) 1 1 --- ---- ---- Total......................................... $12 $ 57 $(10) === ==== ==== In the first quarter of 1992, both Railroad and BNI were parties to a settlement agreement relating to the reimbursement of attorneys' fees and costs incurred by Railroad in connection with litigation filed by Energy Transportation Systems, Inc., and others, and reimbursement of a portion of the amount paid in prior years by Railroad in settlement of that action. Under the terms of the settlement, Railroad received approximately $50 million before legal fees. 12. ACCOUNTING CHANGES Effective January 1, 1993, Railroad adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 modifies SFAS No. 96, which established the liability method of accounting for income taxes, and had been adopted by Railroad effective January 1, 1986. Railroad adopted SFAS No. 109 consistent with the transitional guidelines of SFAS No. 109. The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. There was no effect on net income, stockholder's equity or cash flows. In January 1992, the Emerging Issues Task Force of the FASB reached a consensus that origination of service revenue recognition was not an acceptable method beginning in 1992 for the freight services industry. Accordingly, effective January 1, 1992, Railroad changed its method of revenue recognition from one which recognized transportation revenue at the origination point, to a method whereby transportation revenue is recognized proportionately as a shipment moves from origin to destination. The cumulative effect, net of a $7 million income tax benefit, of the change on the prior year's revenue, at the time of adoption, decreased 1992 net income by $11 million. In the fourth quarter of 1992, effective January 1, 1992, Railroad adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and elected immediate recognition of the $16 million transition obligation. The cumulative effect, net of a $6 million income tax benefit, of the change on prior years', at the time of adoption, decreased 1992 net income by $10 million. Financial results for the first quarter of 1992 have previously been restated for the cumulative effect of the change in accounting method for revenue recognition, which had previously been reported in other income (expense), net and for the cumulative effect of the implementation of the accounting standard for postretirement benefits. There was no material effect on the second and third quarter, and those quarters were not restated for the adoption of SFAS No. 106. 13. 1991 SPECIAL CHARGE Included in 1991 results was a pre-tax special charge of $708 million related to railroad restructuring costs and increases in liabilities for casualty claims and environmental clean-up costs. The 1991 special charge included the following components: RESTRUCTURING This program provided for work force reduction of employees. The restructuring program and related charge had two components: . $185 million to provide for employee related costs for the elimination of surplus crew positions. . $40 million to provide for employee related costs for a separation program. OTHER . $350 million to increase casualty reserves based on an actuarial valuation and escalations in both the cost and number of projected hearing loss claims. . $133 million to increase environmental reserves based on studies and analyses of potential environmental clean-up and restoration costs. The special charge reduced 1991 net income by $442 million. 14. RELATED PARTY TRANSACTIONS In addition to various corporate-related transactions with its parent, BNI, Railroad also rents under operating leases rolling stock and other property from BN Leasing Corporation (BNLC), a wholly owned subsidiary of BNI. The following is a summary of balances representing the result of transactions with related parties (in millions): December 31, 1993 1992 - ------------ ---- ---- Short-term: Payable to BNLC for rent associated with property and equipment....................... $ 8 $ 6 ==== ==== Receivable from BNLC for accrued interest associated with the notes receivable for hub centers and rail facilities........................................ $ 2 $ 2 ==== ==== Long-term: Receivable from BNI, representing net settlement account for dividends, taxes and other............ $ 9 $ 43 Notes receivable from BNLC for hub centers.......... 28 28 Note receivable from BNLC for rail facilities....... 41 41 Investments in affiliates........................... 7 7 Receivable from other affiliates.................... 19 14 ---- ---- Total investments in and advances to affiliates... $104 $133 ==== ==== Railroad recorded the following amounts for transactions with related parties (in millions): Year ended December 31, 1993 1992 1991 - ----------------------- ---- ---- ---- Rental expense.......................... $ 39 $ 32 $ 18 Interest income......................... 7 8 3 In prior years, Railroad transferred the Denver and Houston hub centers to Burlington Northern Railroad Holdings, Inc. (BNRRHI), a wholly owned subsidiary of Railroad. BNRRHI subsequently sold the hub centers to BNLC. The hub centers, with a combined book value of $22 million, were sold for the fair market value of $28 million. BNRRHI received two promissory notes due October 31, 2000, with interest at 10.05 percent from BNLC for the total sale price. The notes will be paid off using proceeds generated from rental payments from Railroad to BNLC for use of the facilities at the rate of $3 million per year. No gain was recorded on the sale of the property. In prior years, Railroad purchased certain rail facilities at and between Ortonville, Minnesota and Terry, Montana from the South Dakota Rail Authority. These properties were subsequently sold to BNLC for the recorded net book value of the property. Railroad received a promissory note from BNLC for the purchase price of $41 million. Interest at a rate of 10.0 percent is due annually. Principal is due at maturity on August 31, 2001. Railroad will make rental payments of $5 million per year until 2001 for use of these facilities. No gain or loss was recorded on the sale of the property. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholder and Directors of Burlington Northern Railroad Company and Subsidiaries We have audited the consolidated financial statements and financial statement schedules of Burlington Northern Railroad Company and Subsidiaries listed in Item 14 of this Form 10-K. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits according to generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Burlington Northern Railroad Company and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 12 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 and for revenue recognition and postretirement benefits other than pensions in 1992. COOPERS & LYBRAND Fort Worth, Texas January 17, 1994 QUARTERLY FINANCIAL DATA-UNAUDITED ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS TEN, ELEVEN, TWELVE AND THIRTEEN DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT; AND CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable - see Table of Contents note. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Page ---- Financial Statements: Consolidated Statements of Operations for the three years ended December 31, 1993................................ 17 Consolidated Balance Sheets at December 31, 1993 and 1992 18 Consolidated Statements of Cash Flows for the three years ended December 31, 1993................................ 19 Consolidated Statements of Changes in Common Stockholder's Equity for the three years ended December 31, 1993.................................... 20 Notes to Consolidated Financial Statements............... 21 Report of Independent Accountants.......................... 34 Quarterly financial data-unaudited......................... 35 Consolidated Financial Statement Schedules for the three years ended December 31, 1993: Schedule V-Property, Plant And Equipment................. 40 Schedule VI-Accumulated Depreciation, Depletion, And Amortization of Property, Plant And Equipment...... 41 Schedule VIII-Valuation And Qualifying Accounts.......... 42 Schedule X-Supplementary Income Statement Information.... 43 Schedules other than those listed above are omitted for the reason that they are not required or not applicable, or the required information is included in the consolidated financial statements or related notes. Exhibit Index The following exhibits are filed as part of this report. Exhibit Page Number Description Number - ------- ----------- ------ 3.1 Certificate of Incorporation of Burlington Northern ** Railroad Company as amended through July 20, 1987. 3.2 By-Laws of Burlington Northern Railroad Company ** as amended through July 17, 1991. 4.1 The Company has either previously filed with the * Securities and Exchange Commission or upon request will furnish a copy of any instrument with respect to the long-term debt of the Company (1989 Form 10-K, filed March 1990). 10.1 Trade Receivables Purchase and Sale Agreement, dated as * of December 15, 1989, as amended by Amendment dated as of December 15, 1989, by and among Burlington Northern Railroad Company, Corporate Asset Funding Company, Inc. and Citicorp North America, Inc. (1989 Form 10-K Amendment No. 1, filed March 1990). 10.2 Trade Receivables Purchase and Sale Agreement, dated as * of December 15, 1989, as amended by Amendment dated as of December 15, 1989, by and among Burlington Northern Railroad Company, the banks parties thereto and Citicorp North America, Inc. (1989 Form 10-K Amendment No. 1, filed March 1990). 10.3 $500,000,000 Competitive Advance Facility and Revolving * Credit Facility Agreement, dated October 18, 1991, between Burlington Northern Railroad Company and a consortium of lenders (Form 10-Q for the quarter ended September 30, 1991, filed October 1991). 10.4 Employment Agreement, dated as of September 4, 1990, by * and between Burlington Northern Railroad Company and Mr. John T. Chain (1990 Form 10-K, filed March 1991). 10.5 Employment Agreement, dated as of September 18, 1991, by * and between Burlington Northern Railroad Company and Mr. Richard A. Russack (1991 Form 10-K, filed February 1992). * Exhibit is incorporated by reference as indicated. ** Exhibit is filed with Form 10-K for the year ended December 31, 1993. REPORTS ON FORM 8-K During the fourth quarter of 1993, there were no reports filed on Form 8-K. SIGNATURES Pursuant to the requirements of 13 or 15(d) of the Securities Exchange Act of 1934, Burlington Northern Railroad Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BURLINGTON NORTHERN RAILROAD COMPANY By /s/ GERALD GRINSTEIN ------------------------------------ Gerald Grinstein, Chairman and Chief Executive Officer Date February 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Burlington Northern Railroad Company and in the capacities and on the dates indicated. /s/ GERALD GRINSTEIN Chairman and - ------------------------- Chief Executive Officer February 14, 1994 Gerald Grinstein /s/ DAVID C. ANDERSON Executive Vice President and - ------------------------- Chief Financial Officer February 14, 1994 David C. Anderson /s/ DON S. SNYDER Vice President, Controller and - ------------------------- Chief Accounting Officer February 14, 1994 Don S. Snyder /s/ EDMUND W. BURKE Director - ------------------------- February 14, 1994 Edmund W. Burke /s/ WILLIAM E. GREENWOOD Director - ------------------------- February 14, 1994 William E. Greenwood SCHEDULE V BURLINGTON NORTHERN RAILROAD COMPANY AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) See accompanying notes to consolidated financial statements for information regarding depreciation methods and other matters. SCHEDULE VI BURLINGTON NORTHERN RAILROAD COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) See accompanying notes to consolidated financial statements for information regarding depreciation methods and other matters. SCHEDULE VIII BURLINGTON NORTHERN RAILROAD COMPANY AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) SCHEDULE X BURLINGTON NORTHERN RAILROAD COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) Exhibit Index

29924_1993.txt

29924_1993

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ITEM 1. Business. Dow Jones & Company, Inc. (the company) is a communications and publishing company. Its operations are currently divided into three industry segments: information services, business publications and general interest community newspapers. Financial information about industry segments and geographic areas are incorporated by reference to Note 15 to Financial Statements on pages 42 and 43 of this report. The company currently has approximately 10,000 full-time employees. The company's principal executive offices are located at 200 Liberty Street, New York, New York. Information Services - - - -------------------- The information services segment of Dow Jones reflects the operations of the company's Dow Jones/Telerate group and the Business Information Services group. The Dow Jones/Telerate group primarily serves the financial services market world-wide and includes Dow Jones Telerate, Dow Jones News Service, Professional Investor Report, AP-Dow Jones News Service, Federal Filings and the Dow Jones Asian Equities Report. The Business Information Services group serves corporate, small business and individual investor needs largely through Dow Jones News/Retrieval. This group also includes DowVision, Voice Information Services, SportsTicker, Telco Alliance, and two radio networks. Dow Jones Telerate is one of the largest suppliers of real-time market information and related services to financial professionals with offices or distributors in more than 80 countries world-wide. Almost two-thirds of Dow Jones Telerate's revenues are generated by its foreign operations. Telerate, Inc., which became a wholly-owned subsidiary of Dow Jones in 1990, started in 1969 as a provider of commercial paper quotations. The breadth and depth of Dow Jones Telerate are reflected in the mix of services presently offered. The foundation of the service rests on providing prices of U.S. Government securities, foreign exchange, international government bonds, global equities, energy, mortgage-backed securities and a variety of money market instruments. In addition, Dow Jones Telerate provides global news coverage of the world's financial markets and an array of services from outside information providers, ranging from informed commentary on Federal Reserve actions to analysis of the commodities markets. Dow Jones Telerate also provides products and software to help users analyze its live market data. Its Matrix terminal employs the power of a personal computer to allow customers to build personalized, full-color, market-specific pages using Dow Jones Telerate data. In 1993 Matrix added expanded graphing and charting capabilities, as well as access to more historical and analytical information. Matrix has modules to analyze the fixed income and foreign exchange markets and sophisticated analytical tools, including a spreadsheet from Lotus Development Corporation that uses live Telerate data and contains built-in formulas customized to help traders analyze financial markets. Telerate Trading Room Systems (TTRS) provide even more advanced decision-support tools. Designed to serve the needs of large trading rooms, TTRS have networking capabilities which enable customers to link trading rooms world-wide. Running on powerful desktop workstations, TTRS consolidates several information, transaction and analytic services into a single terminal at a trader's desk. In 1993 new terminal software, based on Microsoft's Windows, was added to this product line. The Treasury 500 product offers the widest coverage available of U.S. Government securities and provides value-added analytics in addition to the price information distributed through Dow Jones Telerate's long-standing exclusive agreement with Cantor Fitzgerald Securities Corp. One of Treasury 500's most important features is that it provides live bids and offers from an identified source that customers can actually trade on. It also has live two-sided market displays of best-bid and best-offer prices. In 1993 prices for U.S. Treasury odd-lot securities from Cantor Fitzgerald were added as was exclusive distribution of odd-lot prices from Fuji Securities. In 1993 Dow Jones Telerate began exclusive distribution of real-time foreign exchange and money market prices from M. W. Marshall & Company and Exco International, two of the world's foremost foreign exchange brokers. Dow Jones holds an equity stake in the Japanese consortium Minex Corp. and serves as exclusive world-wide sales and distribution agent outside of Japan for Minex's foreign exchange trading service. Minex's service, which provides for automated matching of trades, was launched in April 1993. TeleTrac and Tactician products are continually enhanced to make them more powerful for customers. TeleTrac is a technical analysis tool favored by dealers in the foreign exchange and fixed income markets and is a leading technical analysis program in Europe and Asia. Tactician is a fundamental analysis product targeted at institutional traders in the Treasury markets and is particularly popular with traders of Japanese government bonds. The Digital Page Feed product fills the needs of larger customers who prefer to receive Dow Jones Telerate's thousands of pages of data in the form of an electronic feed that can be incorporated into their own information systems. Telerate International Quotations (TIQ) product line offers quotes and news on thousands of securities traded on stock, futures and options exchanges around the world. TIQ, when combined with Dow Jones Telerate's fixed income and foreign exchange information, gives customers comprehensive coverage of the world's major markets and reflects the markets' growing interaction. Two of TIQ's products, Access Plus and QuotElite, combine in one service all Dow Jones Telerate data, including information on equities, foreign exchange and U.S. Government issues. In early 1993, Dow Jones Telerate introduced a new service, Dow Jones Emerging Markets Report, which provides information on the emerging capital markets of developing countries, with particular emphasis on Latin America, by combining Dow Jones Telerate's live market prices with news from Dow Jones and the Associated Press, plus market commentary from Thomson Financial Services. Other Dow Jones Telerate products and services currently in the marketplace include: the Telerate Access Service, a personal-computer software package that provides a link to Telerate's core information base through the public telephone network and includes access to Dow Jones News/ Retrieval; hand-held quotation devices that deliver current prices, rates and other data at the touch of a button; and data for mortgage markets. Dow Jones News Service is the nation's preeminent supplier of business and financial news to subscribers at brokerage firms, banks, investment companies and other businesses. The News Service significantly increased its transmission speed in 1992, enabling it to carry more news and distribute it faster. Professional Investor Report (PIR), a companion to the News Service, focuses on daily trading activity and news of interest to traders, arbitragers, hedge fund operators and other equity market professionals. In 1993, PIR began following Nasdaq small capitalization market issues thereby increasing by 25% the number of issues tracked by PIR computers. Capital Markets Report, which is incorporated into Dow Jones Telerate's basic information package, is the company's newswire that covers fixed income and financial futures markets around the world. AP-Dow Jones, a news service joint venture with Associated Press, provides international economic, business and financial news to subscribers in 63 countries. In addition to two broad international newswires, AP-Dow Jones offers specialized wires dedicated to the coverage of European equities, banking and the markets in foreign exchange and petroleum. AP-Dow Jones also produces the European Corporate Report, a news service focusing on European companies and stock markets, and the World Equities Report newswire which serves domestic institutions investing in international markets. Washington-based Federal Filings publishes newswires, newsletters and investment research based on its coverage of federal regulatory agencies, Capitol Hill and bankruptcy courts nationwide. Federal Filings' products include Corporate BondWatch, a fixed income bond ownership database, and 13F Advance, which analyzes the equity portfolio changes of prominent money managers. In early 1994 Dow Jones Telerate launched the Dow Jones Asian Equities Report, which covers 12 Asian-Pacific stock markets and the companies traded on them. Headquartered in Singapore, the service draws on the staffs of AP- Dow Jones, The Asian Wall Street Journal and Far Eastern Economic Review, as well as its own editors and reporters. Dow Jones News/Retrieval is widely recognized as one of the nation's leading suppliers of online business and financial news and information to financial professionals, private investors, corporate executives and managers, as well as to information specialists in corporate libraries. In 1993, it introduced TextSearch Plus, available for personal computers running Microsoft Windows, to simplify searching and retrieving articles from its library of more than 1,400 full-text publications. In 1993, the Business Information Services group began development of Personal Journal, an electronic publication designed to deliver customized business and market news, stock quotes, world and national news, weather and sports 24 hours a day. It will be introduced in 1994 when it will be included with Microsoft Corp.'s Microsoft At Work operating system for portable computing devices. Also in development is The Wall Street Journal Interactive Edition, which will be a real-time, electronic extension of the printed Journal and the company's newswire services. DowVision, a comprehensive service that delivers all the Dow Jones newswires, three press release services and the complete text of The Wall Street Journal directly to desktops through corporate computer systems, enables individual users in the corporate and financial marketplaces to tailor information to their own needs. Other electronic services offered by the company include SportsTicker, the nation's leading electronic sports news service, and Voice Information Services, which provides pay-per-call stock quotes, market updates, company news and investment analysis. The Dow Jones Market Report, another pay-per- call service, provides a one minute summary, which is updated hourly, of the stock market. The Business Information Services group established the Telco Alliance Development unit to explore emerging business opportunities with Regional Bell and other telephone companies. Its primary offering, the Dow Jones PersonalInfo Network, provides news and information for delivery through voicemail and electronic mail systems, pagers, personal digital assistants and screenphones. Dow Jones' radio products include two radio networks -- "The Wall Street Journal Report" on AM stations and "The Dow Jones Report" on FM stations. Together these programs were carried on over 160 stations and reach nearly 90% of the country, including all of the top 50 markets. Business Publications - - - --------------------- Dow Jones' best-known publication, The Wall Street Journal, is the country's largest daily newspaper with average circulation for 1993 of 1,839,900. The Wall Street Journal is edited in New York City at the company's executive offices. The Journal's four regional editions are printed at eighteen plants located across the United States. Advertisers can also focus their messages on readers served by sixteen localized editions. In September 1993, Texas Journal was started to provide Journal- quality reporting on regional business trends and issues. Texas Journal, a four-page weekly section of regional news produced by a separate staff, appears in the copies of The Wall Street Journal that are distributed in Texas. Production of the paper employs satellite transmission of page images to the outlying plants and other technologies designed to speed the delivery of editorial material to the presses and to reduce the steps taken in the printing process. The Wall Street Journal is delivered in two ways: by second class postal service and through the company's own National Delivery Service, Inc., a subsidiary. At the end of 1993, National Delivery Service delivered nearly one million of the Journal's subscription copies. The system provides delivery earlier and more reliably than the postal service. Approximately 230,000 copies of the Journal are sold each day on newsstands. Barron's National Business and Financial Weekly, a magazine specializing in reporting and commentary on financial markets, had average circulation of 265,200 in 1993. The magazine uses the same facilities employed in the production of The Wall Street Journal. Barron's is edited in New York City, and is delivered by second class postal service and through National Delivery Service. About 123,400 copies are sold on newsstands. The Wall Street Journal Europe is headquartered in Brussels and printed in the Netherlands, Switzerland and England. It is available on day-of- publication in continental Europe and the United Kingdom. The newspaper, which began publication in 1983, had average circulation in 1993 of 58,300. The Asian Wall Street Journal began publication in 1976. It is headquartered and printed in Hong Kong and is transmitted by satellite to additional printing sites in Singapore and Japan. The Asian Wall Street Journal had average circulation of 43,400 in 1993. The Wall Street Journal Europe and the Asian Journal draw on the resources of The Wall Street Journal's world-wide staff. The Asian Journal provides the foundation for the company's Asian Wall Street Journal Weekly, which is published in New York for North American readers with interests in Asia. Other business publications include Far Eastern Economic Review, Asia's leading English-language newsweekly; the National Business Employment Weekly, which contains career-related news features, job-related ads from the Journal's regional editions and self-generated advertising; The Wall Street Journal Classroom Edition, which is published nine times during the school year and is used by more than 2,700 teachers in high school classrooms nationwide; and American Demographics magazine, which contains feature stories analyzing statistics from the United States Census Bureau and private data collectors. SmartMoney, The Wall Street Journal Magazine of Personal Business, is published jointly with Hearst Corp. SmartMoney, introduced in 1992, became a monthly publication with its November 1993 issue. Dow Jones and American City Business Journals, Inc. launched BIZ, a monthly magazine targeted to the heads of America's fastest-growing small businesses, in March 1994. Also included in this segment is The Wall Street Journal's television group which produces "The Wall Street Journal Report" a half-hour weekly program with about one million viewers in the U.S. In October 1993, the television group launched "The Asian Wall Street Journal Report", a half- hour weekly television news magazine program distributed throughout Asia. The television group also produces daily news feeds to stations in the U.S. and abroad. Dow Jones Investor Network is a video business-news service delivered to customers' computer terminals, that includes exclusive video interviews with business leaders and coverage of major corporate announcements and events. Community Newspapers - - - -------------------- Community newspapers published by Ottaway Newspapers, Inc., a wholly- owned subsidiary, include 21 general-interest dailies in Arizona, California, Connecticut, Kentucky, Massachusetts, Michigan, Minnesota, Missouri, New York, Oregon and Pennsylvania. Average circulation of the dailies during 1993 was approximately 556,300; Sunday circulation for 13 newspapers was approximately 523,200. The principal administrative office of Ottaway Newspapers is in Campbell Hall, New York. The primary delivery method for the newspapers is private delivery. Other - - - ----- Dow Jones also has investments in Handelsblatt-Dow Jones GmbH, a joint venture with the von Holtzbrinck Group, publisher of Germany's leading business daily, Handelsblatt; Press-Enterprise Co., a daily newspaper in Riverside, Calif.; Groupe Expansion S.A., a French business publishing company; Mediatex Communications Corp., publisher of Texas Monthly magazine; Nation Publishing Group, a Bangkok, Thailand publisher of English and Thai- language magazines and newspapers; AmericaEconomia, a Spanish-language business magazine in South America; Asia Business News, a business and financial television news channel broadcasting in Asia; and newsprint mills in the United States and Canada. In early 1994, the company invested in Hubbard Broadcasting Inc.'s new U.S. Satellite Broadcasting venture which will direct broadcast television programming to viewers in the U.S. having 18-inch dish antennas linked to special home receivers. Dow Jones will be the exclusive provider of business and financial news to U.S. Satellite Broadcasting. Raw Materials - - - ------------- The primary raw material used by the company is newsprint. In 1993, approximately 218,000 metric tons were consumed. Newsprint was purchased from sixteen suppliers. F.F. Soucy, Inc. & Partners and Company, Limited, Riviere du Loup, Quebec, Canada, and Bear Island Paper Company, Richmond, Virginia, furnished 16.3% and 20.9%, respectively, of total newsprint requirements. The company is a limited partner in both ventures and has signed long-term contracts with both for a substantial portion of its annual newsprint requirements. For many years the available sources of newsprint have been adequate to supply the company's needs. Competition - - - ----------- The company believes that Reuters Holdings PLC ("Reuters"), a company headquartered in London whose shares are publicly traded in the United States and the UK, is the only significant company which currently provides, on a world-wide basis, financial information display services closely comparable to those furnished by Dow Jones Telerate, although other companies, primarily Automated Data Processing Corporation, Knight- Ridder, Inc., Bloomberg L.P., Telekurs A.G., ILX Systems, Inc. and Quick Corporation of Japan are also in the business of providing financial information displayed on video screens to customers. The company believes that Reuters has more subscribers and video screens than the company outside North America, but that Dow Jones Telerate has more subscribers and video screens than Reuters in North America. The company believes that it is the largest provider of fixed income and foreign exchange data in the United States. Many business enterprises, including banks, brokerage houses and other financial firms, operate data or voice telecommunications systems which are able to move information rapidly from one location to another, competing with the company's other information services products. The business publications of the company remain highly competitive. In its various news publishing activities, Dow Jones competes with a wide spectrum of other information media, and this competition may well become more intense as telecommunications systems are improved and new techniques are developed. All metropolitan general newspapers and many small city or suburban papers carry business and financial pages or sections, including securities quotations. In addition, specialized magazines in the economics field, as well as general news magazines, publish substantial amounts of business material. Nearly all these publications seek to sell advertising space and much of this effort is directly or indirectly competitive with Dow Jones' publications. The company also competes with television and radio for advertisers. All of the community newspapers operating under Ottaway Newspapers, Inc. compete with metropolitan general newspapers and most compete with other newspapers available in their respective sales areas. ITEM 2. ITEM 2. Properties. Dow Jones operates eighteen plants with an aggregate of approximately 1.1 million square feet for the printing of its domestic publications. Printing plants are located in Palo Alto and Riverside, California; Denver, Colorado; Orlando, Florida; LaGrange, Georgia; Naperville and Highland, Illinois; Des Moines, Iowa; White Oak, Maryland; Chicopee Falls, Massachusetts; South Brunswick, New Jersey; Charlotte, North Carolina; Bowling Green, Ohio; Oklahoma City, Oklahoma; Sharon, Pennsylvania; Dallas and Beaumont, Texas; and Federal Way, Washington. All plants include office space. All are owned in fee except the Palo Alto, California plant, which is located on 8.5 acres under a lease to Dow Jones for 50 years, expiring in 2015. Other facilities owned in fee with a total of approximately 870,000 square feet house news, sales, administrative, research, computer and operations staff. These facilities are located in Chicopee Falls, Massachusetts and South Brunswick, New Jersey. Dow Jones occupies two major leased facilities in New York City: editorial and executive staff occupy 340,000 square feet, while advertising sales staff occupy 90,000 square feet at a separate location. The company also leases other business and editorial offices in numerous separate locations around the world, including 50,000 square feet in two locations in Hong Kong. Dow Jones Telerate leases approximately 23,000 square feet in New York City, 325,000 in Jersey City, New Jersey, 115,000 at three locations in London, England, 70,000 at three locations in Toronto, Ontario and 30,000 at two locations in Hong Kong. In addition, Dow Jones Telerate leases space around the world for its operations. Ottaway Newspapers operates in 27 locations, including a 24,000 square foot administrative headquarters in Campbell Hall, New York. These facilities are located in Sun City, Arizona; Santa Cruz, California; Danbury, Connecticut; Ashland, Kentucky; Beverly, Hyannis, New Bedford, Gloucester, Nantucket, Peabody, Fall River and Newburyport, Massachusetts; Traverse City, Michigan; Mankato, Minnesota; Joplin, Missouri; Exeter and Hampton, New Hampshire; Middletown, Oneonta, Plattsburgh and Port Jervis, New York; Medford, Oregon; and Grove City, Sharon, Stroudsburg and Sunbury, Pennsylvania. Local printing facilities, which include office space, total approximately 1,062,000 square feet. All facilities are owned in fee. The company believes that its current facilities are suitable and adequate, well maintained and in good condition. Older facilities have been modernized and expanded to meet present and anticipated needs. It is estimated that between 65% and 75% of the capacity of the company's existing production facilities is being utilized. ITEM 3. ITEM 3. Legal Proceedings. Not applicable. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders. Not applicable. Executive Officers of the Registrant - - - ------------------------------------ Each executive officer is elected annually to serve at the pleasure of the Board of Directors. All executive officers named below have been employed by the company for more than five years. Peter R. Kann, age 51, Chairman of the Board since July 1991, Chief Executive Officer since January 1991 and Publisher of The Wall Street Journal since January 1989, served as President from July 1989 to July 1991 and Chief Operating Officer from July 1989 to December 1990, Executive Vice President from 1985 to 1989 and Associate Publisher of The Wall Street Journal from 1979 to 1988. Kenneth L. Burenga, age 49, President since July 1991 and Chief Operating Officer since January 1991, served as Executive Vice President from January 1991 to July 1991 and Senior Vice President from 1986 thru 1990, and General Manager from January 1989 thru December 1990, as Chief Financial and Administrative Officer from 1986 to 1988 and Vice President/ Circulation of The Wall Street Journal from 1980 to 1986. James H. Ottaway, Jr., age 56, Senior Vice President since 1986, President of International Group and Magazine Group since February 1988, President of Affiliated Companies Group since 1986, and Chairman of Ottaway Newspapers, Inc. since 1979, served as Vice President/Community Newspapers from 1980 to 1985 and as President of Ottaway Newspapers, Inc. from 1970 to 1985 and Chief Executive from 1976 to January 1989. Peter G. Skinner, age 49, Senior Vice President since November 1989 and General Counsel and Secretary since 1985, served as Vice President from 1985 to November 1989. Carl M. Valenti, age 55, Senior Vice President and Publisher and President of the Information Services Group since July 1989 and President of Dow Jones Telerate, Inc. since May 1990, served as Vice President of the company and President/Information Services Group from 1987 to 1989 and as Vice President/Information Services Group from 1980 to 1987. Kevin J. Roche, age 59, Vice President/Finance since 1986 and Chief Financial Officer since January 1989, served as Comptroller from 1977 to March 1987. Thomas G. Hetzel, age 38, Comptroller since October 1993, served as Associate Comptroller from 1992 to 1993 and Assistant Comptroller from 1988 to 1992. PART II. ITEM 5. ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The company's common stock is listed on the New York Stock Exchange. The class B common stock is not traded. The approximate number of stockholders of record as of January 31, 1994, was 10,400 for common stock and 4,700 for class B common stock. The company paid $.80 per share in dividends in 1993 and $.76 per share in 1992, which represented an earnings payout of 54.1% in 1993 and 60.9% in 1992, excluding the nonrecurring net charge for accounting changes and asset write-downs in 1992. ITEM 6. ITEM 6. Selected Financial Data. See Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of factors that affect the comparability of the information reflected in this table. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Net income in 1993 of $147.5 million, or $1.48 per share, increased $40 million, or 37.1%, from 1992 net income of $107.6 million, or $1.06 per share. Earnings in 1992 were up $35.4 million, or 49%, from 1991 net income of $72.2 million, or $.71 per share. Net income in 1992 excluding accounting changes and asset write-downs was $126.4 million, or $1.25 per share. Net income in 1993 increased $21.1 million, or 16.7%, from 1992 earnings, adjusted to exclude the nonrecurring items described below. The improvement was largely the result of advertising linage growth at The Wall Street Journal, reduced interest expense and improved operating results for the information services segment. Earnings in 1992 included the cumulative effect of the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which reduced net income by $32.4 million, or $.32 per share, and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which increased earnings by $21.6 million, or $.21 per share. Also included in 1992 net income were after-tax charges totaling $8 million, or eight cents per share, for the write-down of the company's minority investments in Groupe Expansion, S.A., a French publisher of business magazines, and other Groupe Expansion-related companies, and for the write-down of Ottaway Newspapers, Inc.'s investment in the Chapel Hill News. Results in 1991 included an after-tax charge of $31.8 million, or $.32 per share, from the write-down of goodwill, capitalized development costs and equipment associated with The Trading Service (TTS), the company's foreign exchange trading service. If the cumulative effect of the 1992 accounting changes and asset write-downs and the 1991 write-down of TTS were excluded from each year's respective net income, 1992's net income would have increased $22.4 million, or 21.5%, from 1991 income of $104 million, or $1.03 per share. A summary of the results of operations for each of the company's principal business segments as well as financial data by geographic area can be found in Note 15 to the financial statements. OPERATING INCOME Operating income in 1993 advanced $35.8 million, or 12.7%, to $316.5 million. Operating income was $280.7 million in 1992, an increase of $40 million, or 16.6%, from 1991's income of $240.7 million. In 1991 operating income grew $11.5 million, or 5%. The operating margin improved to 16.4% in 1993 from 15.4% in 1992 and 14% in 1991. Approximately $126.2 million, or roughly 40%, of 1993 operating income was due to foreign operations, primarily at Dow Jones Telerate. Foreign operations in total were up 21% from $104.3 million in 1992. Operating income from U.S. operations increased 7.4% in 1993. Operating income at the information services segment, which includes the Dow Jones/Telerate and Business Information Services groups, grew $6.7 million, or 4.5%, to $157.4 million in 1993. Revenues in 1993 for the segment rose $52.6 million, or 6.5%, while operating expenses increased $45.9 million, or 7%. Operating income in 1993 benefited from fluctuations in foreign currency exchange rates, chiefly in the Europe/Gulf region. Excluding this benefit, 1993 operating income would have been down 1%. Dow Jones/Telerate group operating income grew 4.5% in 1993, and operating income at the Business Information Services group was up 4.3%. The operating margin for the information services segment was 18.3% in 1993, 18.6% in 1992 and 19.4% in 1991. In 1992 operating income for the segment grew $3 million, or 2.1%, as revenues advanced $47.4 million, or 6.2%, and operating expenses increased $44.3 million, or 7.2%. Expenses in 1993 and 1992 included substantial investments in technical and product development and in the acquisition of enhanced information. Operating income at this segment rose 14.3% in 1991. Business publications operating income in 1993 increased $28.6 million, or 24.8%, to $143.7 million. Revenues were up $51.5 million, or 6.7%, as Wall Street Journal advertising linage grew 3.3%, following a 4% increase in 1992. Operating expenses rose $22.9 million, or 3.5%. Operating income in 1992 climbed $33.6 million, or 41.3%, to $115.1 million. In 1991 operating income fell 2.7%. The operating margin for the business publications segment increased to 17.4% in 1993 from 14.9% in 1992 and 11.1% in 1991. Community newspapers segment operating income of $32.6 million grew $0.9 million, or 2.9%. The increase was primarily due to higher advertising rates and continuing cost controls. Operating income was up $4.7 million, or 17.6%, in 1992 and down $4.5 million, or 14.2%, in 1991. The operating margin in 1993 for the community newspapers segment was 13.3% compared with 13.5% in 1992 and 11.9% in 1991. REVENUES Revenues of $1.9 billion increased $113.9 million, or 6.3%, in 1993 and $92.8 million, or 5.4%, in 1992, compared with the respective prior years. Revenues from domestic operations increased 6.3% to $1.4 billion in 1993 and accounted for slightly less than three-quarters of total revenues. Revenues from foreign components grew 6.2% to $527.3 million in 1993. Advertising revenue advanced $44.4 million, or 6.8%, to $699 million. Advertising revenue in 1992 was up $30 million, or 4.8%, from 1991. Circulation revenue improved $14.3 million, or 4.3%, in 1993 climbing to $347.8 million. In 1992 circulation revenue rose 5.5% to $333.5 million. Information services 1993 revenue, which accounted for about 45% of the company's revenue, increased $52.6 million, or 6.5%, reaching $862 million. In 1992 revenue from this segment grew $47.4 million, or 6.2%, to $809.4 million from $762 million in 1991. Dow Jones/Telerate, which primarily serves the financial services market and includes Dow Jones Telerate, Dow Jones News Services, AP-Dow Jones News Service, Federal Filings and Professional Investor Report, produced 90% of information services revenue in 1993. Despite an economic slowdown in Japan and parts of Europe, revenue in the Europe/Gulf region was up 6.5% in 1993, while revenue from the Asia/Pacific region was up 5%. As economic conditions in the U.S. improved, revenue in 1993 from U.S. operations increased 6% after being essentially flat in 1992. In 1992 revenues from the Europe/Gulf and Asia/Pacific regions rose 12.6% and 12.2%, respectively. The remaining 10% of information services revenue was earned by Business Information Services, which serves corporate and individual business consumer needs through Dow Jones News/Retrieval and related services. Business Information Services revenue was up 13.1% in 1993 after increasing 1.8% in 1992. Business publications 1993 revenues of $825.2 million advanced 6.7% from 1992 revenues of $773.8 million. Revenues in 1992 were up 5.1% from 1991 revenues of $735.9 million. Advertising revenue increased 7.7% in 1993, with the Journal, its overseas editions and Barron's all posting gains. Advertising linage in 1993 at The Wall Street Journal, the largest component of business publications, increased 3.3% after rising 4% in 1992. Ad linage, hurt by the effects of the Persian Gulf war, was down 10.3% in 1991. Financial advertising at The Wall Street Journal increased 13.4% in 1993 on top of 17.4% growth in 1992. This category comprised 34.2% of total Journal advertising in 1993, compared with 31.2% in 1992, 27.6% in 1991 and 39% at its peak in 1987. General linage was off 0.9% in 1993, following declines of 1.2% in 1992 and 9.8% in 1991. Journal advertising rates were increased an average of about 5% in 1993, 4.5% in 1992 and 6% in 1991. Advertising linage at Barron's increased 6.9% in 1993. Barron's advertising linage in 1992 was flat, following an 11.6% drop in 1991. Circulation revenue at business publications grew 4.4%, as The Wall Street Journal benefited from roughly a 1% gain in average circulation and a $10, or 7.2%, midyear increase in its annual subscription price to $149. This price was last raised in January 1991. The newsstand price of the Journal remained 75 cents a copy, unchanged since December 1990. Including the Journal's European and Asian editions, world-wide average circulation increased to 1,941,600 in 1993 compared with 1,920,300 in 1992 and 1,922,800 in 1991. Barron's average circulation for 1993 was up 5.3% from 1992 to 265,200. Revenues at Ottaway Newspapers, Inc., the company's community newspapers subsidiary, were up $9.9 million, or 4.2%, in 1993 compared with the prior year. Revenues were up 3.4% in 1992 after being down in 1991. Ottaway's advertising revenue in 1993 increased $6.7 million, or 4.1%, chiefly as a result of rate increases and sales gains in preprinted inserts. Advertising revenue rose 2.1% in 1992, after falling 7% in 1991. Advertising linage edged up 0.6% in 1993. Linage had declined 3.9% in 1992 and 11.9% in 1991, the result of industrywide weakness in retail and classified advertising. Circulation revenue improved $2.5 million, or 3.8%, in 1993, following increases of 6.2% and 7.2% in 1992 and 1991, respectively. Average circulation for Ottaway's 21 daily newspapers was essentially flat over the 1991-1993 period, at about 556,000. OPERATING EXPENSES Operating expenses in 1993 rose $78.2 million, or 5.1%, to $1.6 billion, in part due to increases in payments to outside information providers, newsprint costs and depreciation. In 1992 operating expenses increased $52.8 million, or 3.6%, with higher information services costs partially offset by lower newsprint. In 1991 operating expenses declined $6.5 million, or 0.4%. Information services expenses were up $45.9 million, or 7%, to $704.6 million in 1993, mainly due to increases in contributed data costs, depreciation and continuing investments in research and product development. At December 31, 1993, the number of full-time employees for information services was up 1.5% from year-end 1992. Business publications expenses rose 3.5% to $681.6 million in 1993, partially due to additional newsprint expense reflecting increased consumption and a higher average price. In 1992 operating expenses of $658.7 million were essentially flat compared with 1991, largely due to deeply discounted newsprint prices. At December 31, 1993, business publications full-time employee count was up about 3% from year-end 1992. Community newspapers expenses were up $9 million, or 4.4%, in 1993, largely due to newsprint and salaries. Operating expenses increased 1.4% in 1992, after decreasing 1.5% in 1991. The number of full-time employees at year-end 1993 fell 0.6% from the end of 1992. In 1993 Dow Jones' purchases of newsprint containing recycled fiber reached 54% of total purchases, up from 39% in 1992 and 11.5% in 1991. The company expects purchases of newsprint containing recycled material to continue to increase in 1994. Salaries and wages were 31% of operating expenses in 1993, 30% in 1992 and 29% in 1991. Salaries and wages increased 6.4% in 1993, following increases of 8.4% in 1992 and 1.4% in 1991. In 1993 the company signed a new three-year contract with a union representing about 20% of its work force. The contract, which expires January 31, 1996, calls for compensatory increases of 4% each year for 1993, 1994 and 1995. At December 31, 1993, Dow Jones employed 10,006 full-time employees, compared with 9,860 at year- end 1992 and 9,459 at year-end 1991. Dow Jones and the Dow Jones Foundation made public-interest and charitable contributions in 1993 totaling $2.8 million, which was approximately 1% of earnings before income taxes and 1.9% of net income. Contributions in 1993 included those given to the United Negro College Fund to support entrepreneurial studies at Spelman College, Clark Atlanta University and the Atlanta University Center. OTHER INCOME / DEDUCTIONS Interest expense of $22.6 million decreased $7.8 million, or 25.7%, from 1992, the result of a lower average debt level and reduced interest rates on commercial paper. Long-term debt outstanding averaged $339.9 million during 1993 compared with $385.4 million in 1992 and $531.4 million in 1991. The company broke even in 1993 in its equity earnings from associated companies, compared with losses of $4.2 million in 1992 and earnings of $3.9 million in 1991. The company's share of earnings from its newsprint affiliates was $2.2 million, a $6.9 million improvement from losses of $4.7 million in 1992. Gains on land sales coupled with increased sales of newsprint, reflecting the recovering U.S. economy, caused the better 1993 results from newsprint affiliates. Equity losses from newsprint mill affiliates in 1992 were $8.8 million worse than earnings of $4.1 million in 1991. The fourth quarters of 1993 and 1992 included write-downs of assets totaling $8.2 million ($5.4 million after taxes) and $13.4 million ($8 million after taxes), respectively. In 1991's fourth quarter the company wrote down certain assets of TTS, its foreign exchange direct dealing service. This write-down resulted in a nonrecurring charge of $45 million ($31.8 million after taxes). Included in this charge was an $11.3 million write-down of goodwill and $33.7 million ($20.5 million after taxes) related to capitalized development costs and equipment. INCOME TAXES The effective income tax rate was 48.5% in 1993 versus 49.5% in 1992 and 54.7% in 1991. The lower 1993 rate was chiefly caused by the lesser impact of stable nondeductible goodwill amortization on higher 1993 pretax earnings. Excluding goodwill amortization, the effective income tax rate would have increased to 42.4% in 1993 from 42.1% in 1992, the result of an increase as of January 1, 1993, to 35% from 34% in the corporate federal income tax rate, which diluted net income about $3.3 million, or three cents per share. The effective tax rate in 1991 excluding goodwill amortization and the write-down of assets was 40.9%. In 1992 the company adopted SFAS No. 109, "Accounting for Income Taxes," which mandates a change in accounting for income taxes from an income statement-based deferred method to a balance sheet-based asset/ liability method. The cumulative effect of the accounting change was a benefit of $21.6 million, or $.21 per share, to 1992 earnings. The Omnibus Budget Reconciliation Act of 1993 raised the federal corporate income tax rate to 35%. The revaluation of deferred taxes, as required by SFAS No. 109, at the 35% rate was immaterial. FINANCIAL POSITION Cash provided by operations in 1993 was $337.6 million, up $32 million, or 10.5%, from $305.6 million in 1992. The increase, which mainly resulted from higher earnings, was tempered by a $28.7 million rise in accounts receivable in 1993 relative to a $0.8 million decline in 1992. The increase in accounts receivable was attributable both to revenue growth and a slowdown in advertising receipts resulting from the elimination in early 1993 of a cash discount. In 1993 cash generated through operations was used to pay dividends of $79.8 million, fund capital expenditures of $159.9 million and repay debt of $73.9 million. In 1993 Dow Jones purchased 1,668,000 shares of its stock totaling $48.3 million. The year-end cash balance was reduced to $5.7 million in 1993 from $16.4 million at year-end 1992. At December 31, 1993, outstanding long-term debt, excluding current maturities, was $261.1 million. The debt-to-equity ratio at December 31, 1993, was 17.5%, compared with 23.1% at 1992's year end. Long-term debt peaked at $719 million on December 31, 1989, when the debt-to-equity ratio was 51.2%. The company used commercial paper to retire long-term notes of $100 million which matured on February 1, 1994, and will likely use commercial paper again to retire long-term notes of approximately $92 million which will mature on December 1, 1994. The company expects in 1994 to be able to meet its normal recurring operating commitments, to fund estimated capital expenditures of roughly $210 million, to pay dividends of about $84 million and to repay a portion of its commercial paper borrowings, all with cash provided by operations. Capital spending in 1994 will include press equipment, which will enable the company's business publications to offer advertisers limited four-color capability several years hence, as well as continued investments in the technical infrastructure of print and electronic services. Working capital, excluding unearned revenue, was 1 to 1 at December 31, 1993, compared with 0.9 to 1 at December 31, 1992. Return on equity rose to 9.9% in 1993 from 7.4% in 1992 and 5% in 1991. On January 19, 1994, Dow Jones announced that it would raise its quarterly dividend to 21 cents per share from 20 cents per share, an increase of 5%. In January 1994, the company acquired a minority interest in a subsidiary of Hubbard Broadcasting, Inc., United States Satellite Broadcasting Company, Inc., for $20 million plus services valued at $5 million. U.S. Satellite plans to broadcast television programming directly to viewers who will receive the signals on 18-inch dish antennas linked to special home receivers. Dow Jones will be the exclusive provider of business and financial news to U.S. Satellite Broadcasting. Also, in early 1994 Dow Jones agreed to lease a transponder to increase its flexibility in distributing television programming in Asia. The transponder will be on the APSTAR-2 satellite, which is scheduled to be launched in late 1994 or early 1995. Both investments reflect Dow Jones' intention to become more active in television programming on a global basis. OUTLOOK In 1994 business publications revenues are expected to continue showing improvement from both rate and volume increases. Advertising rates at The Wall Street Journal were raised an average of almost four percent effective January 3, 1994. Improvement in domestic Journal advertising linage is largely dependent on the continuing recovery of the national economy. Advertising rates at the Journal's overseas editions were raised an average of about eight percent, effective January 3, 1994. Information services revenues in 1994 are expected to continue to increase at a rate similar to the annual rates of growth achieved over the past several years. It is expected that a significant portion of the growth will continue to come from Dow Jones Telerate's overseas operations. Information services will continue to make substantial investments in expanded information and product enhancements. Dow Jones Telerate is expected to expand the capacity of its networks and will continue to integrate all its information into more flexible systems. In addition, information services will continue to concentrate in 1994 on developing advanced platforms for the storage and retrieval of text, user-friendly, front-end software for customer terminals and an interactive, real-time edition of The Wall Street Journal. Following revenue increases at the community newspapers segment of 4.2% in 1993 and 3.4% in 1992, revenues are expected to grow modestly in 1994 largely due to price increases. Dow Jones continues to maintain and monitor its budgetary cost controls despite the continuing signs of U. S. economic recovery. In 1993 the company benefited from substantial discounts from its newsprint suppliers. No increase in stated newsprint prices is anticipated in 1994, and discounts on average are not expected to vary substantially. Second class postage rates were last raised in February 1991. No postal rate increases are anticipated in 1994. In the absence of a major acquisition, it is expected that interest expense will continue to fall in 1994 as notes due in 1994 will most likely be refinanced with lower rate commercial paper. In November 1992 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which provides for a change in current accounting practice by requiring accrual, during the years that the employee renders service, of the costs of providing certain postemployment benefits. Currently, most of these expenses are accrued by the company at termination. The company will adopt SFAS No. 112 in the first quarter of 1994 and will record an after-tax cumulative adjustment of approximately $3 million. The annual expense of postemployment benefits is not expected to be materially different from the current expense. NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES THE CONSOLIDATED FINANCIAL STATEMENTS include the accounts of the company and its majority-owned subsidiaries. The equity method of accounting is used for companies and other investments in which the company's common stock ownership and partnership equity is at least 20% and not more than 50% (see Note 3). All significant intercompany transactions are eliminated in consolidation. UNEARNED REVENUE is recorded as earned, pro rata on a monthly basis, over the life of subscriptions. Costs in connection with the procurement of subscriptions are charged to expense as incurred. DEPRECIATION is computed using straight-line or declining-balance methods over the estimated useful lives of the respective assets or terms of the related leases. Upon retirement or sale, the cost of disposed assets and the related accumulated depreciation are deducted from the respective accounts and the resulting gain or loss is included in income. MAINTENANCE AND REPAIRS are charged to expense as incurred. Major renewals, betterments and additions are capitalized. CASH EQUIVALENTS are highly liquid investments with a maturity of three months or less when purchased. NEWSPRINT INVENTORY is stated at the lower of last-in, first-out (LIFO) cost or market (see Note 4). DEFERRED INCOME TAXES are provided for temporary differences in bases between financial statement and income tax assets and liabilities. In 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Accordingly, deferred tax assets and liabilities are recalculated annually at tax rates then in effect (see Note 7). THE EXCESS OF COST OVER NET ASSETS OF BUSINESSES ACQUIRED (GOODWILL) is amortized using the straight-line method over various periods, principally forty years. The company evaluates annually whether there has been a permanent impairment in the value of goodwill. Factors considered in the valuation include cash flows from operations of businesses acquired and the market value of comparable companies. FORWARD EXCHANGE CONTRACTS are entered into to insulate contracted revenue streams from foreign currency exchange rate fluctuations. As such, these nonspeculative forward exchange contracts are not recorded on the company's consolidated balance sheet. Also, unrealized gains and losses on these forward exchange contracts are deferred and realized upon settlement. Accordingly, cash flows resulting from forward exchange contract settlements are classified as cash provided by operations as are the corresponding cash flows from the revenue streams being insulated (see Note 16). ACCOUNTING CHANGES required by two recent accounting standards, Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," were adopted by the company effective January 1, 1992. The impact, as of January 1, 1992, of these changes on the consolidated statement of income was recorded as the cumulative effect of accounting changes as follows: NOTE 2. OTHER, NET Other, net includes write-downs of assets and gains/losses from foreign currency exchange rate fluctuations, as well as other miscellaneous non- operating income and expenses. In 1993's fourth quarter, the company recorded a charge of $8.2 million ($5.4 million after taxes) to write down certain of its assets. In the fourth quarter of 1992, a charge of $13.4 million ($8 million after taxes) was recorded to write down certain of the company's assets. The assets written down included the company's minority position in Groupe Expansion, S.A., a French publisher of business magazines, as well as Groupe Expansion-related companies, and the Chapel Hill News, a community newspaper held by the company's Ottaway Newspapers, Inc. subsidiary. In 1991's fourth quarter, the company wrote down certain assets of its foreign exchange direct dealing service. This write-down of goodwill, capitalized development costs and equipment resulted in a charge of approximately $45 million ($31.8 million after taxes). NOTE 3. INVESTMENTS IN ASSOCIATED COMPANIES, AT EQUITY The operating results of the principal associated companies accounted for by the equity method have been included in the accompanying consolidated financial statements on the following bases: Bear Island Paper Company, L.P. (Bear Island Paper), 33% owned; Bear Island Timberlands Company, L.P., 33% owned; and F.F. Soucy, Inc. & Partners and Company, Limited (Soucy), 40% owned. The company, as a limited partner in Bear Island Paper and Soucy, has signed long-term contracts with both covering a substantial portion of its annual newsprint requirements. Operating expenses of the company include the cost of newsprint supplied by Bear Island Paper and Soucy of $39,558,000 in 1993, $42,918,000 in 1992 and $45,750,000 in 1991. In January 1994, the company increased its ownership in Bear Island Paper Company, L.P. and Bear Island Timberlands Company, L.P. to 35%. NOTE 4. NEWSPRINT INVENTORY Newsprint inventory was determined by the last-in, first-out (LIFO) method. If inventory had been valued by the average cost method, it would have been approximately $4,976,000 and $5,085,000 higher in 1993 and 1992, respectively. NOTE 5. LONG-TERM DEBT Payments on long-term debt are due as follows: $197,200,000 in 1994, $5,318,000 in 1995, $37,282,000 in 1996, $5,318,000 in 1997, $5,318,000 in 1998 and $15,955,000 thereafter. Interest payments were $22,459,000 in 1993, $31,825,000 in 1992 and $36,637,000 in 1991. The company can borrow up to $400 million through August 12, 1996, under a revolving credit agreement with several banks. Borrowings may be made either in Eurodollars with interest that approximates the applicable Eurodollar rate or in domestic dollars with interest that approximates either the bank's prime rate or its C/D rate. A fee of 1/8% is payable on the unused portion of the commitment which the company may terminate or reduce at any time. Prepayment of borrowings may be made without penalty. Although there were no borrowings under the agreement as of December 31, 1993, the company intends to maintain the commitment at least through December 31, 1994. Accordingly, commercial paper was classified as long- term. The bank loan agreement contains various restrictive covenants principally relating to net worth, liabilities and cash flows. At December 31, 1993, consolidated net worth exceeded the minimum by $742 million and total consolidated liabilities were $1.7 billion less than the maximum. In December 1989 the company sold $100 million of 8.4% notes due December 1, 1994 and in February 1991 the company sold $100 million of 7.7% notes due February 1, 1994. Based on the company's ability and intent to refinance these notes on a long-term basis, through either long-term debt issuances or the issuance of commercial paper supported by the company's revolving credit agreement, these notes have been classified as long-term. The notes are general unsecured obligations of the company and may not be called prior to maturity. In 1992, at the request of a noteholder, the company redeemed $8 million of its 8.4% notes due December 1, 1994. The notes payable to the Associated Press are owed by the company in equal annual principal payments of $5,318,000 which commenced in 1991. The company purchased a guaranteed investment contract from an insurance company which is supported by an irrevocable stand-by letter of credit. The contract, which is included in Other Investments, provides for payments to the company of interest and principal that match the payments owed the Associated Press. The floating rate demand industrial development revenue bonds were repaid during 1993. NOTE 6. CAPITAL STOCK Common stock and class B common stock have the same dividend and liquidation rights. Class B common stock has ten votes per share, free convertibility into common stock on a one-for-one basis and can be transferred in class B form only to members of the stockholder's family and certain others affiliated with the stockholder. NOTE 7. INCOME TAXES Effective January 1, 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Under Statement No. 109, deferred taxes are determined upon the cumulative differences in bases between financial statement and income tax assets and liabilities. The measurement of deferred taxes resulting from these differences is based on currently enacted tax rates. It was principally the recalculation of deferred taxes at the lower 34% federal income tax rate enacted in the Tax Reform Act of 1986 that resulted in the 1992 earnings benefit of $21.6 million, or $.21 per share, which has been included in the cumulative effect of accounting changes (see Note 1). During 1993 the Omnibus Budget Reconciliation Act was enacted, which increased the federal corporate income tax rate to 35%. The impact of remeasuring deferred tax assets and liabilities at this higher rate was immaterial. The company's combined current and noncurrent deferred taxes at December 31, 1993 and 1992, consisted of the following deferred tax assets and liabilities: The company has not established a deferred tax asset with respect to certain foreign operating loss carryforwards which are not expected to be realized. The components of income before income taxes and accounting changes were as follows: The following is a reconciliation of income tax expense to the amount derived by multiplying income before income taxes and the cumulative effect of accounting changes by the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991. In the table shown above, amortization of excess of cost over net assets of businesses acquired for 1991 includes the write-down of The Trading Service. Income tax payments were $142,988,000 in 1993, $135,180,000 in 1992 and $83,681,000 in 1991. NOTE 8. STOCK PURCHASE, STOCK OPTION AND EXECUTIVE INCENTIVE PLANS STOCK PURCHASE PLAN: Under the terms of the Dow Jones 1990 Employee Stock Purchase Plan, eligible employees may purchase shares of the company's common stock based on compensation through payroll deductions or lump-sum payment. The purchase price for payroll deductions is the lower of 85% of the fair market value of the stock on the first or last day of the purchase period. Lump-sum purchases are made during the offering period at the lower of 85% of the fair market value of the stock on the first day of the purchase period or the payment date. At December 31, 1993, there were 1,014,350 shares available for future offerings. STOCK OPTION PLAN: Under the Dow Jones 1991 Stock Option Plan, options for shares of common stock may be granted to key employees at not less than the fair market value of the common stock on the date of grant. Options expire ten years from the date of grant. EXECUTIVE INCENTIVE PLANS: The executive incentive plans provide for the grant to key executives of stock options, performance awards, which were suspended in 1992, and contingent stock rights. The incentive plans are administered by the compensation committee of the Board of Directors, the members of which may not participate in the plans. The Dow Jones 1992 Long Term Incentive Plan provides for the grant to key executives of stock options and contingent stock rights (collectively, "plan awards"). Options for shares of common stock may be granted at not less than the fair market value of the common stock on the date of grant. An optionee may purchase shares upon exercise of an option or may surrender exercisable options in return for an amount equal to any excess of the market value over the option price on the day the option is surrendered. Payment to the optionee for such stock appreciation rights may be made in common stock, cash or a combination of both. Options expire ten years after date of grant. Contingent stock rights entitle the participant to receive future payments in the form of common stock. The number of shares of common stock ultimately received will depend upon the extent to which specified performance criteria are achieved over the performance period, the participant's individual performance and other factors, all as determined by the compensation committee. Accordingly, the number of shares received could be less than or equal to the number specified in the right, but not greater than 125% of that amount. Under the stock option plan, options granted in 1993 become exercisable in 1994 and all other options granted were exercisable at December 31, 1993. Under the executive incentive plans, options granted prior to 1991 become exercisable and performance awards and contingent stock rights become payable four years after they are granted. Fifty percent of the options granted in 1991 and thereafter become exercisable in the year following the year of grant; the balance of the options granted become exercisable in the second year following the year of grant. Compensation expense was $2,826,000 in 1993, $1,850,000 in 1992 and $1,633,000 in 1991, with respect to both the stock option and executive incentive plans. NOTE 9. PROFIT SHARING AND PENSION PLANS The company and certain subsidiaries have profit sharing retirement plans for a majority of employees who meet specified length of service requirements. The annual cost of the plans, which are funded currently, is based upon a percentage of consolidated net income, as defined, or compensation but is limited to the amount deductible for income tax purposes. Substantially all employees of subsidiaries who are not covered by the above plans are covered by noncontributory defined benefit pension plans. These plans are not material in respect to charges to operations. Total profit sharing and pension plan expenses amounted to $44,805,000, $42,157,000 and $38,420,000 in 1993, 1992 and 1991, respectively. NOTE 10. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS, AND POSTEMPLOYMENT BENEFITS For a majority of its employees, the company sponsors a defined benefit postretirement medical plan which provides lifetime health care benefits to retirees, who meet specified length of service and age requirements, and their eligible dependents. The plan is unfunded. The company sponsors no other postretirement benefit plans other than its profit sharing and pension plans (see Note 9). As of January 1, 1992, the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," were adopted. The company elected immediate recognition of its liability attributable to service prior to 1992. Accordingly, after-tax earnings for 1992 were lowered $32.4 million, or $.32 per share, which was included in the cumulative effect of accounting changes (see Note 1). A 12.5% annual rate of increase in the per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 5.5% by the year 2008. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $15.4 million and increase the aggregate of the service cost and interest cost components of net periodic postretirement benefit cost for 1993 by $2.3 million. A discount rate of 7% was used to determine the accumulated postretirement benefit obligation as of December 31, 1993. At December 31, 1992, the company's accumulated postretirement benefit obligation was calculated using a discount rate of 8.5% and a health care cost trend rate of 13.7% for 1993 decreasing to 6.6% by the year 2017. See Management's Discussion and Analysis regarding Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." NOTE 11. COMMITMENTS Commitments for capital expenditures amounted to $24,160,000 at December 31, 1993. Also, the company has a commitment to invest a total of $8,750,000 in certain of its newsprint affiliates in January 1994 (see Note 3). These leases are principally for office space and equipment and contain renewal and escalation clauses. Total rental expense amounted to $83,853,000 in 1993, $82,382,000 in 1992 and $80,610,000 in 1991. At December 31, 1993, the company had foreign currency forward exchange contracts settling on various dates through January 1995 to sell 6.6 billion Japanese yen (against $59,501,000). Risk arises from movements in foreign currency exchange rates and from the possible inability of counterparties to meet the terms of their commitments, which the company views as unlikely. The company has the obligation to furnish financial support in the form of capital contributions, loans and loan guarantees up to a total of $16.6 million to certain of its investees. At December 31, 1993, loan guarantees of $7,344,000 with remaining terms of up to nine and one-half years were in effect. The company views it as unlikely that its investees will fail to meet the terms of their loan obligations. NOTE 12. PER SHARE AMOUNTS Net income per share has been computed on the basis of the weighted average number of shares outstanding (99,773,000 shares in 1993, 101,150,000 shares in 1992 and 101,011,000 in 1991). The assumed exercise of outstanding options under the stock purchase, stock option and executive incentive plans does not have a material dilutive effect on earnings per share. NOTE 13. RECLASSIFICATIONS Certain amounts for prior years have been reclassified for comparative purposes. NOTE 14. SUMMARY OF QUARTERLY FINANCIAL DATA (UNAUDITED) The summary of unaudited 1993 and 1992 quarterly financial data shown on pages 47 and 48 of this report is incorporated herein by reference. NOTE 16. FAIR VALUE OF FINANCIAL INSTRUMENTS The following information presents the fair value of the company's financial instruments which are not carried as such on the company's consolidated balance sheets. The fair value of these financial instruments as of December 31, 1993 and 1992, was determined primarily by reference to dealer markets. Nonspeculative forward exchange contracts, which insulate contracted revenue streams from foreign currency exchange rate fluctuations, are not recorded on the company's consolidated balance sheets (see Note 1). The fair value of the forward exchange contracts at December 31, 1993, was $59,030,000 against a contracted value of $59,501,000. The fair value as of December 31, 1992, of forward exchange contracts then in effect was $59,344,000 against a contracted value of $59,854,000. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Dow Jones & Company, Inc.: We have audited the accompanying consolidated balance sheets of Dow Jones & Company, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and the significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Dow Jones & Company, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 7 and 10 to the consolidated financial statements, effective January 1, 1992, the company changed its method of accounting for income taxes and postretirement benefits other than pensions. COOPERS & LYBRAND New York, New York January 25, 1994 STATEMENT OF MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS To the Stockholders of Dow Jones & Company, Inc.: Management has prepared and is responsible for the consolidated financial statements and related information in the Annual Report. The financial statements, which include amounts based on judgment, have been prepared in conformity with generally accepted accounting principles consistently applied. Management has developed, and in 1993 continued to strengthen, a system of internal accounting and other controls for the company and its wholly owned subsidiaries. Management believes these controls provide reasonable assurance that assets are safeguarded from loss or unauthorized use and that the company's financial records are a reliable basis for preparing the financial statements. Underlying the concept of reasonable assurance is the premise that the cost of control should not exceed the benefit derived. The company's system of internal controls is supported by written policies, a program of internal audits, including a periodic review of the Internal Audit Department, and by a program of selecting and training qualified staff. Coopers & Lybrand, independent accountants, have audited the company's consolidated financial statements, as described in their report. The report expresses an independent opinion of the fairness of presentation of the financial statements and, in so doing, provides an independent objective assessment of the manner in which management meets its responsibility for fairness and accuracy in financial reporting. The Board of Directors, through its audit committee consisting solely of outside directors, is responsible for reviewing and monitoring the company's financial reporting and accounting practices. The audit committee meets regularly with management, internal auditors and independent accountants - both separately and together. The internal auditors and the independent accountants have free access to the audit committee to review the results of their audits, the adequacy of internal accounting controls and the quality of financial reporting. Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," were adopted effective January 1, 1992. Excluding the net cumulative effect of these accounting changes, net income was $26,948,000, or $.27 per share, in the first quarter of 1992 and $118,391,000, or $1.17 per share, for the year (see Note 1). ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III. ITEM 10. Directors and Executive Officers of the Registrant. The information required by this item with respect to directors of the company and with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the tables, including the footnotes thereto, appearing on pages 8 to 10 of the 1994 Proxy Statement and to the material on pages 19 to 20 of the 1994 Proxy Statement under the caption "Compliance with Section 16(a) of the Exchange Act". For information relating to executive officers, see Part I, page 11. ITEM 11. Executive Compensation. The information required by this item is incorporated by reference to pages 11 to 13 of the 1994 Proxy Statement. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this item is incorporated by reference to the tables, including the footnotes thereto, appearing on pages 2 to 6 of the 1994 Proxy Statement under the captions "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Directors and Management". ITEM 13. Certain Relationships and Related Transactions. The information required by this item is incorporated by reference to footnotes (3) and (4) on page 10 of the 1994 Proxy Statement and to the material on page 17 of the 1994 Proxy Statement under the caption "Compensation Committee Interlocks and Insider Participation". PART IV. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. 14 (a) (1) Financial Statements: Page Reference --------- Included in Part II, Item 8

763739_1993.txt

763739_1993

1993

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ITEM 1. BUSINESS (All dollar amounts in thousands) GENERAL Morrison-Knudsen Company, Inc., the predecessor to Morrison Knudsen Corporation (the "Corporation") was incorporated in Delaware in 1932 to carry on a business founded eighty two years ago at Boise, Idaho. The Corporation's principal executive offices are located at Morrison Knudsen Plaza, Boise, Idaho 83729. The Corporation operates in two industry segments, engineering and construction, and rail systems. ENGINEERING AND CONSTRUCTION SEGMENT: The Corporation's engineering and construction segment engages in all types of general construction work including industrial, heavy civil and marine, mechanical, pipeline, building, and underground, for a wide range of public and private clients. In addition, the Corporation renders design services in practically all engineering disciplines. Other markets for its services include nuclear and fossil- fueled power plants, environmental and hazardous waste abatement and operations and maintenance for military and commercial facilities. The Corporation also operates, through a number of domestic subsidiaries, coal and lignite mines under long-term contracts. As a general contractor, the Corporation provides construction services in accordance with the terms and specifications of each contract, including planning and scheduling, marshalling of manpower, procurement of equipment and materials, awarding of subcontracts and direction and overall management of the project. The Corporation is also responsible for any failure to perform on the part of a subcontractor. In order to minimize the potential for losses caused by such defaults, the Corporation normally requires performance and payment bonds or other adequate assurances of operational and financial capacity from subcontractors. RAIL SYSTEMS SEGMENT: The locomotive division of the Corporation's rail systems segment remanufactures locomotives, manufactures new high technology locomotives, designs, manufactures and distributes locomotive component parts, and provides locomotive fleet maintenance services to the railroad industry. The Corporation provides its products and services to freight and passenger railroads, including every Class I Railroad in North America, many metropolitan transit and commuter rail authorities and Amtrak. The transit division of the rail systems segment is the leading U.S. based manufacturer of transit cars. Since 1982, the Corporation has remanufactured and/or overhauled over 3,000 rail passenger vehicles and manufactured approximately 300 new transit cars. The transit division has manufacturing facilities in Hornell, New York and Chicago, Illinois, and in early 1994 the Corporation opened a manufacturing facility in Pittsburg, California. Current new car backlog includes contracts for the Metro North, Chicago Metra, Caltrans and Bay Area Rapid Transit authorities as well as Amtrak. The Corporation offers a full range of locomotive and transit services and currently serves customers in 37 countries around the world. UNCONSOLIDATED AFFILIATES: In addition, the Corporation has investments in a number of unconsolidated affiliated companies at December 31, 1993 accounted for by the equity method including the following principal unconsolidated affiliates: MK Gold Company ("MK Gold") (46.5%); Strait Crossing Development, Inc. (45%); Texas TGV Corporation (38.2%); AmerBank (31.1%); and Westmoreland Resources, Inc. (24%). MK Gold holds interests in two producing gold mining projects in California and provides contract mining services. Strait Crossing Development, Inc. has a contract to design, build and operate for 35 years an 8.4-mile-long toll bridge linking the Canadian provinces of New Brunswick and Prince Edward Island. Texas TGV Corporation is a development-stage company with a 50-year franchise to provide 200 m.p.h. passenger service connecting five major Texas cities. AmerBank is a licensed bank operating in Poland. Westmoreland Resources, Inc. is a mining company that operates a surface coal mine in Montana. See the "Investments in Unconsolidated Affiliates" and "Subsequent Events" Notes to Consolidated Financial Statements in Part II of this Annual Report on Form 10-K for additional information related to unconsolidated affiliates. In connection with its construction business, the Corporation, in order to balance risk with reward, enters into four basic types of contracts: fixed- price contracts providing for a single price for the total amount of work to be performed and unit-price contracts providing for a specified price for each unit of work performed, under which both risk and anticipated income are the highest; cost-plus-fee contracts with guaranteed maximum costs, under which risk is reduced and anticipated income is accordingly lower; and cost- plus-fee contracts, under which risk is minimal and anticipated income is earned solely from the fee received for services provided. In connection with its engineering I-1 contracts, including design and program management, the Corporation's compensation is typically on a cost-plus-fee basis. Regardless of the type of contract, the construction business always has been subject to unusual risks, including unforeseen conditions encountered during construction, the impact of inflation upon costs and financing requirements of clients, and changes in political and legal circumstances in foreign countries, particularly since contracts for major projects are performed over an extended period of time. Although the Corporation constantly seeks to minimize and spread the risks over a large number of contracts, a combination of unusual circumstances could result in a loss on a particular contract or contracts and the Corporation may experience significant changes in operating results on a quarterly or annual basis. The Corporation frequently participates (principally as sponsor and manager of the projects) in construction joint ventures with others to share risks and combine financial, technical and other resources. Each of the joint venture participants is usually committed to supply a predetermined amount of capital, and to share in a predetermined percentage of income or loss of the joint venture. Construction joint ventures frequently have a short life span, since they are designed and created for the sole purpose of bidding on, negotiating for, and completing one specific project. These single-purpose joint ventures last only as long as the construction project undertaken, which can be less than one year, but are frequently longer on major construction projects. Construction joint ventures undertaken to complete a specific project are liquidated when the project is completed. See the "Construction Joint Ventures" Note to Consolidated Financial Statements in Part II of this Annual Report on Form 10-K for additional summary joint venture financial information. There were no significant changes in the business of the Corporation or in the services or products offered during 1993 except for the acquisitions and disposition of certain assets and businesses as described below. ACQUISITIONS: The Corporation's rail systems segment has established its position as a leading supplier in North America of critical locomotive components through a series of business combinations begun in 1991, including the following acquisitions completed in 1993 and early 1994, and accounted for by the purchase method of accounting. See the "Acquisitions" and "Subsequent Events" Notes to Consolidated Financial Statements in Part II of this Annual Report on Form 10-K for additional information. - Arrowsmith Power Systems, Inc., a remanufacturer of locomotive turbo chargers was acquired in August, 1993. - Clark Industries, Inc., a manufacturer of engine power assemblies was acquired in December, 1993 - Touchstone, Inc., a leading manufacturer and refurbisher of locomotive cooling systems was acquired in January, 1994. The Corporation acquired additional voting stock of McConnell Dowell Corporation Limited ("MDC") representing 3% of the total issued and outstanding voting stock bringing the total of its investment to 51.9%. The Corporation consolidated the accounts of MDC effective with the change in control. MDC and its subsidiaries are engaged in civil, mechanical, and commercial construction. DISPOSITION: In December, 1993, MK Gold, then a wholly-owned subsidiary of the Corporation, completed an initial public offering ("IPO") of its common stock. After the exercise of the underwriters' over-allotment option and (ii) the secondary sale of MK Gold's stock by the Corporation, the Corporation's ownership interest in MK Gold decreased to 46.5%. See the "Subsidiary Sale of Stock" and "Subsequent Events" Notes to Consolidated Financial Statements in Part II of this Annual Report on Form 10-K for additional information. In addition, the Corporation announced on February 23, 1994 that MK Rail Corporation ("MK Rail"), a wholly owned subsidiary of the Corporation (formerly the locomotive division of the rail systems segment, and the locomotive related subsidiaries and affiliates of the Corporation) filed a Registration Statement with the Securities and Exchange Commission for an initial public offering of MK Rail common stock. After the Registration Statement becomes effective and upon completion of the offering, the Corporation will own approximately 58% of the common stock of MK Rail (approximately 55% if the underwriters' over-allotment option is exercised in full) and will continue to control MK Rail. INDUSTRY SEGMENT DATA: The Corporation's revenue and operating income for the three years ended December 31, 1993 for each of the industry segments is set forth below, (dollars in thousands). I-2 Operating income consists of revenue less applicable direct and indirect operating costs and expenses, and excludes general and administrative expenses and other non-operating income and expense. See the "Industry Segment and Geographic Information" Note to Consolidated Financial Statements in Part II of this Annual Report on Form 10-K for additional operating and asset data for the three years ended December 31, 1993. ENGINEERING AND CONSTRUCTION The engineering and construction segment is a leading provider of planning, design, engineering, construction, procurement, program management, construction management and project finance services in the infrastructure market (both domestic and foreign), including water resources and hydroelectric power, rail and transit, highways and bridges, airports and other heavy civil projects. The engineering and construction segment accounted for 84 percent of consolidated revenue in 1993, 87 percent in 1992 and 77 percent in 1991. The engineering and construction segment booked new work of $1,873,700 in 1993 compared with $1,633,100 in 1992 and its backlog at December 31, 1993 stood at $3,049,300, a decrease of $443,900 from the previous year end total of $3,493,200. RAIL SYSTEMS The rail systems segment is engaged principally in building new and rebuilding used mass-transit rail cars and in building new and rebuilding used railroad locomotives. In addition, the segment provides aircraft service and maintenance to private and commercial aircraft at its Boise, Idaho facility. The rail systems segment accounted for 16 percent of consolidated revenue in 1993, 13 percent in 1992, and 23 percent in 1991. This segment booked new work of $450,000 in 1993 compared with $1,052,500 in 1992 and its year-end 1993 backlog stood at $1,182,600 an increase of $25,100 from the previous year end. This segment currently depends upon a relatively few large municipal transit agencies and railroads. The Corporation expects that this dependence on key customers will continue. The loss of one or more key customers could have a material adverse effect on the Corporation's results of operations. FOREIGN OPERATIONS The Corporation operates outside the United States through foreign and domestic subsidiaries which are qualified to do business in various foreign countries. The Corporation has intensified efforts to market its wide-ranging engineering, construction and rail systems services abroad. In addition, as part of its efforts to expand its presence I-3 in international markets, the Corporation has entered into several agreements with foreign joint venture partners, acquired interests in rail systems manufacturing operations and construction companies abroad. In 1993, the rail systems segment obtained a controlling interest in a fully integrated manufacturing operation in Buenos Aires, Argentina which includes an approximately 500,000 square foot facility equipped for maintenance, repair and remanufacture of locomotives, freight cars and transit vehicles. In addition, the Corporation acquired a 16.7% equity interest in a company that operates and maintains commuter railways in Buenos Aires, Argentina. In certain instances, international projects entail a higher degree of risk than equivalent domestic projects both from difficulties encountered in performing work in remote locations (i.e. distances, communication and logistics) and from potential actions of foreign governments (i.e., political strife, multiple taxation, currency and foreign exchange limitations). The Corporation recorded revenues from foreign sources of $600,800 in 1993, $195,300 in 1992, and $58,100 in 1991. BACKLOG Backlog consists of uncompleted portions of engineering and construction contracts, including the Corporation's proportionate share of joint venture contracts; the next five-year portion of long-term mining service contracts and uncompleted portions of rail systems contracts. The following table reflects the composition of year-end backlog distinguished on the basis of their pricing arrangements for the three years ended December 31, 1993: Composition of year-end backlog Approximately 43 percent of engineering and construction and 52 percent of rail systems backlog at December 31, 1993 is expected to be completed in 1994. Although backlog reflects only business which is considered to be firm and is an indication of expected future revenues, there can be no assurance that cancellations or scope adjustments will not occur or when revenue from such backlog will be realized. U.S. Government contracts continue to be an important part of the Corporation's business. In 1993, 1992, and 1991, approximately 22, 23, and 23 percent of revenue, respectively, was derived from various U.S. Government agencies. At December 31, 1993, the Corporation's backlog contains approximately $951,300 (22 percent) of both fixed-price and cost-plus-fee contracts and subcontracts with various agencies of the U.S. Government which are subject to termination at the election of the U.S. Government agencies. Additional information concerning the Corporation's backlog of uncompleted contracts is set forth under the caption "New Business and Backlog" of Management's Financial Review and Analysis in Part II of this Annual Report on Form 10-K. COMPETITION The Corporation is engaged in highly competitive businesses, particularly that portion which relates to contracts for construction obtained by competitive bidding. The Corporation competes with other general and specialty contractors both foreign and domestic, including a number of small local contractors. Competition is based primarily on price, reputation and reliability. There can be no assurance that competition in one or more of the Corporation's markets will not adversely affect the Corporation and its results of operations. Success or failure in the construction industry is, in large measure, based upon the ability to compete successfully for contracts and to provide the engineering, planning, procurement, management and project financing skills required to complete them in a timely and cost- efficient manner. Exact statistical data are not available for determining the relative size of construction and engineering companies. The Corporation's rail systems segment operates in a highly competitive environment. In the case of locomotive remanufacturing, it faces competition from AMF Canada, Conrail, numerous smaller remanufacturers, as well as the in-house shops of certain railroads. The new locomotive manufacturing market is dominated by the Electro-Motive I-4 Division, General Motors Corporation ("EMD") and GE Transportation Systems, General Electric Company ("GE"), which collectively accounted for virtually 100% of the new locomotives delivered in the last five years. The locomotive division's component parts operations face competition from EMD and GE, as well as a number of smaller independent component part manufacturers and distributors. The transit division competes for mass transit rail car business primarily in the U.S. market with approximately five major competitors. While the transit division competes with approximately five major foreign manufacturers, it believes, to the best of its knowledge, that it is the only domestic designer and manufacturer of new mass transit rail cars. Contracts for rebuilding locomotives and building new and rebuilding used mass transit rail cars are awarded on the basis of competitive bid and negotiated contracts. AVAILABILITY OF RAW MATERIALS Raw materials and components necessary for the fabrication and manufacturing of products and the rendering of construction and engineering services for the Corporation are generally available from numerous sources. The Corporation does not foresee any unavailability of materials and components which would have a material adverse effect on its overall business or on either of its business segments in the near term. EMPLOYEES Total worldwide Corporation employment varies widely since it depends upon the volume, type and scope of operations under way at any given time, as well as upon weather conditions and other factors. Worldwide employment, including project direct-hire craft employees at December 31, 1993 was approximately 11,910 with 8,720 employed in the engineering and construction segment, 2,920 employed in the rail systems segment and 270 employed at corporate offices in Boise, Idaho. ITEM 2. ITEM 2. PROPERTIES At December 31, 1993, the Corporation and its subsidiaries owned a total of 17 principal plants, warehouses, offices and rental properties located throughout the United States, Canada, Australia, New Zealand, the Hawaiian Islands, Micronesia, Melanesia and Indonesia. The approximate major building space utilized by each segment of the Corporation at December 31, 1993 is as follows: Aggregate annual rental payments on real estate and equipment leased by the Corporation during the year ended December 31, 1993 was $38,800. For further information on rentals and minimum rental commitments, see the "Commitments and Contingencies" Note to Consolidated Financial Statements in Part II of this Annual Report on Form 10-K. The Corporation considers that its construction equipment, rail systems manufacturing facilities and administrative properties are well maintained and suitable for its current operations. Maintenance and repair expenses of $44,200 in 1993, $49,500 in 1992, and $56,600 in 1991 have been charged to operations. I-5 The description, location and expiration dates of major real and personal property leases in effect as of December 31, 1993 are as follows: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Corporation has no material legal actions pending, but is party to litigation incidental to its business. I-6 ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Corporation did not submit any matters to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to the General Instructions to Form 10-K, the following list is included in lieu of being presented in the proxy statement, dated April 4, 1994 for the annual meeting of stockholders to be held on May 12, 1994. Following is a list of the names and ages of the executive officers of the Corporation together with the date of their election to corporate office and person(s) chosen to become executive officers, subject to election by the Board of Directors in May, 1994. There are no family relationships between the following officers of the Corporation nor are there any arrangements or understandings between any officer or any other person pursuant to which he was selected as an officer. Messrs. Agee, Hanks, Gorman, and Grant have served the Corporation and its subsidiaries in various executive capacities for the past five years. The principal occupations and employment of Messrs. Howland, Brandon, Cleary, Brigham and Carmichael for the past five years is set forth below. Mr. Howland served the Corporaton as Assistant Director and Director of Internal Audit. Prior to his employment with the Corporation in August, 1992, Mr. Howland was employed as a Senior Audit Manager by Price Waterhouse. Mr. Brandon served the Corporation as Executive Assistant to the Chairman, and President of Western Aircraft, Inc., a subsidiary of the Corporation. Prior to his employment with the Corporation in January 1992, Mr. Brandon served in the armed forces of the United States. Mr. Cleary served the Corporation as Director of Strategic Planning, Executive Assistant to the Chairman, and Project Controls Engineer. Prior to his employment with the Corporation in June 1990, Mr. Cleary was a student at Harvard Business School in Boston, Massachusetts. Mr. Brigham served the Corporation as Manager of Investor Relations and Assistant Manager and Manager of Corporate Finance. Mr. Carmichael served the Corporation as Senior Vice President, International Group. Prior to his employment with the Corporation in February, 1993, Mr. Carmichael served from January, 1989 to December, 1993 as United States Federal Railroad Administrator. I-7 PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Traded on the New York and Pacific Stock Exchanges under the Symbol MRN. At the close of business on March 18, 1994 the Corporation had 33,022,099 shares issued and outstanding (including 516,363 unallocated shares held by the trustee for registrant's Employee Stock Ownership Plan Trust). The approximate number of record holders of the Corporation's voting common stock at March 18, 1993 is 5,149 and does not include beneficial owners of the Corporation's common stock held in the name of a broker, dealer, bank, voting trustee or other nominee. The cash dividends declared and the New York Stock Exchange composite high and low sales prices of the Corporation's common stock traded on the New York and Pacific Stock Exchanges for each quarterly period within the two most recent fiscal years required by this item are set forth under the caption "Quarterly Financial Data" on page II-6 of this Annual Report on Form 10-K. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is set forth under the caption "Selected Five-Year Financial Data" on page II-2 of this Annual Report on Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is set forth under the caption "Management's Financial Review and Analysis" beginning on page II-2 of this Annual Report on Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is set forth beginning on page II-6 of this Annual Report on Form 10-K. II-1 MANAGEMENT'S FINANCIAL REVIEW AND ANALYSIS BUSINESS Morrison Knudsen Corporation operates in two industry segments: engineering and construction, and rail systems. The engineering and construction segment provides design, engineering, construction, procurement, project-management and construction-management services in the infrastructure market, including transportation, water resources, heavy civil and energy developments, as well as industrial, institutional and commercial buildings. The segment also provides skills for the nuclear and fossil-fueled power markets and in cogeneration, waste-to-energy, environmental and hazardous waste, and wastewater treatment fields; and in addition serves the hydroelectric, toxic waste, oil and gas, and mine engineering markets. A number of domestic subsidiaries are engaged in long-term contract mining of coal and lignite at mines in the United States. Other markets include operations and maintenance services for military and commercial facilities. The rail systems segment is engaged principally in building new and rebuilding used mass transit rail cars in New York, California, Illinois and Buenos Aires, Argentina and rebuilding railroad locomotives at Boise, Idaho, Pennsylvania and South Australia and, in addition, provides aircraft service and maintenance to private and commercial aircraft at Boise, Idaho. In addition, the Corporation has equity interests in a U.S. development-stage, high-speed commuter rail company, a gold mining company, Indonesian prestress concrete manufacturing and construction companies, a mining company that operates a surface coal mine in Montana, a company to design, build and operate a toll bridge in Canada and a company that operates and maintains commuter railways in Buenos Aires, Argentina. II-2 Financial information about each segment's operations by industry and geographic area is provided in a note to the financial statements. The following table sets forth the revenue by industry segment and geographic area for the years ended December 31, 1993, 1992 and 1991. NEW BUSINESS AND BACKLOG Backlog of all uncompleted contracts at December 31, 1993, totaled $4,232 million, compared with $4,651 million at year end 1992. The 1993 year-end backlog is composed of 59% fixed priced and 41% fee-type contracts, compared with 54% and 46%, respectively, at December 31, 1992. The Corporation booked new business of $2,304 million in 1993 compared to $2,686 million in 1992. New business in 1993 consisted of $1,854 million for engineering and construction and $450 million for rail systems compared with $1,633 million and $1,053 million in 1992, respectively. New business consists of new contracts and changes to existing contracts. Backlog consists of uncompleted portions of engineering and construction contracts, including the proportionate share of joint-venture contracts, the next five-year portion of long-term mining contracts, and uncompleted portions of rail systems contracts. The following table sets forth the revenue backlog at December 31, 1993 and 1992 and the new business booked in each of the two years ended December 31, 1993. Approximately 46% of total 1993 year-end backlog (43% of engineering and construction and 52% of rail systems) is expected to be recognized as revenue in 1994. Although backlog reflects only business which is considered to be firm and is an indication of expected future revenues, there can be no assurance that cancellations or scope adjustments will not occur or when revenue and earnings from such backlog will be realized. RESULTS OF OPERATIONS 1993 COMPARED TO 1992 Operating income of the engineering and construction segment in the fourth quarter of 1993 was $10.9 million compared with $14.1 million (restated) for the comparable 1992 quarter. The 1993 fourth quarter's results were adversely affected by (i) the sluggishness of the private sector market for engineering and construction services and (ii) an increase in operating loss provisions of $1.2 million. In addition, the 1992 fourth quarter was favorably effected by the recognition of additional claim revenue of $1.5 million. Operating income of the engineering and construction segment increased in 1993 to $55.1 million from $40.3 million II-3 (restated) in 1992 due primarily to an improvement in operating results from heavy civil construction, which sustained significant losses on a number of contracts in 1992, but which returned to profitability in 1993. Operating income of the rail systems segment in the fourth quarter of 1993 was $8.4 million compared with $9.0 million for the comparable quarter of 1992. This decrease results primarily from a decrease in the number of transit cars shipped in 1993 compared to 1992, partially offset by an increase in operating income from the segment's Australian operations and an increase in shipments of rebuilt locomotives and traction motors. Operating income of this segment increased to $21.3 million for the year 1993 compared to $11.0 million for 1992. This increase is primarily the result of shipments of new transit cars to a midwest transit authority begun in the last quarter of 1992 and continuing through 1993 and increased operating income from the Australian operations. Research and development expenditures of $3.7 million by the rail systems segment, relating to the design of new locomotives intended for sale or lease, were charged to net income in 1993. The Corporation did not incur significant research and development expenses in 1992. In December 1993 MK Gold Company, previously a wholly-owned subsidiary of the Corporation, completed an initial public offering of 8 million unissued shares of its common stock at an offering price of six dollars a share. The Corporation recognized a $10.6 million pretax gain because the selling price per share exceeded the Corporation's carrying cost per share. Concurrent with the initial public offering, the Corporation sold 1 million shares of MK Gold's common stock to the public and recognized a $2.1 million pretax gain. See the "Subsidiary Sale of Stock" Note to Consolidated Financial Statements. Interest expense in 1993 increased to $3.3 million compared to $1.7 million of interest expense in 1992 (excluding $10.6 million of original issue discount recognized in 1992 prior to the redemption for cash of the outstanding LYONs in 1992). The increase reflects the rise in the average short-term borrowings outstanding from $1.4 million in 1992 to $41.1 million in 1993, partially offset by a decline in the weighted average interest rate in 1993 compared to 1992. See the discussions related to the LYONs redemption in "Results of Operations 1992 Compared to 1991" below. The increase in the Corporation's share of investee net losses from $.1 million (restated) in 1992 to $5.8 million in 1993 reflect increases in the Corporation's share of losses including (i) $.7 million from Texas TGV Corporation, (ii) $2.9 million from a new venture investment, (iii) $1.2 million from McConnell Dowell Corporation Limited ("MDC") (for the period prior to consolidation in July 1993), and a reduction in interest income from MDC in 1993. Other income, net increased from $23.7 million in 1992 to $25.8 million in 1993. See the "Other Income (Expense) Net" Note to Consolidated Financial Statements. The effective tax rates for the past three years have been: 39.3% in 1991; 44.3% in 1992; and 42.1% in 1993. These rates are higher than the U.S. statutory rates of 34% in 1991 and 1992 and 35% in 1993, because they include both foreign income, which generally continues to be taxed at rates higher than the U.S. statutory rate, and state income taxes. The Corporation changed its method of accounting for income taxes effective January 1, 1993. The impact of this change was not significant. 1992 COMPARED TO 1991 Operating income of the engineering and construction segment in the fourth quarter of 1992 was $14.1 million (restated) compared with $13.0 million for the comparable 1991 quarter. The increase was primarily due to the recognition of $1.5 million additional claim revenue. Operating income of the engineering and construction segment declined from $59.0 million in 1991 to $40.3 million (restated) in 1992 due in large part to an increase of $2.8 million (restated) in provisions for estimated losses on a number of heavy-civil construction contracts, $16.9 million less claims for additional contract revenue and a $3.0 million charge resulting from the suspension of a rapid transit construction contract. Operating income of the rail systems segment increased to $9.0 million in the 1992 fourth quarter from $2.9 million in the 1991 fourth quarter, but declined for the year 1992 overall due to the absence of new transit car shipments until late in the third quarter of 1992. The decrease in the Corporation's share of investee's earnings and interest income was due to the acquisition by the Corporation of MD Investments, Inc. ("MDI"), a wholly owned subsidiary of MDC because pursuant to the terms of the purchase agreement, the management fee of approximately $1.9 million from MDC ceased in December 1991. The Corporation also recognized $2.0 million in losses from two corporate joint-venture investments. The loss of $3.0 million annual interest income from MDC, due to the acquisition of MDI, together with the completion of a major MDC joint venture project (for which the corporation rec- ognized $1.1 million income in 1992) reduced the income recognized from MDC in 1993. The decrease in other income, net stems in part from recognition of a number of unusual and infrequent charges including: $3.5 million provision for unrealized losses for marketable equity securities, $1.7 million loss from settlement of a foreign currency transaction, and $1.5 million loss from terminating a non-construction joint venture. See the "Other Income (Expense) Net" Note to Consolidated Financial Statements. In addition, the Corporation realized $39.7 million of income from investments in 1992. However, the redemption of the 7.25 percent convertible LYONs on September 30, 1992 for $204.0 million in cash reduced investment income in future periods. II-4 Interest expense declined from $4.2 million in the fourth quarter of 1991 to $.3 million in the comparable 1992 period and from $16.2 million in the year 1991 to $12.3 million in 1992. The LYONs redemption on September 30, 1992 eliminated the impact of accrued original issue discount (interest expense) on the results of operations. The effective income tax rate for 1992 (before extraordinary charge and cumulative effect of accounting change) was 44.3% compared to 39.3% for 1991. The increase in the effective rate was the result of operating losses incurred which were not deductible for state tax purposes and an increase in foreign tax expense. A tax benefit of 36% was provided on the extraordinary charge and cumulative effect of accounting change using the incremental tax rate applicable to the items. General and administrative expense decreased $2.8 million in the fourth quarter of 1992 compared to the fourth quarter of 1991 and $7.3 million in 1992 compared to 1991. These decreases are the result of downsizing corporate staff functions in the third quarter of 1991, reductions in pension expense, group medical costs, and compensation expense in connection with executive incentive and stock award plans. The extraordinary charge of $3.1 million represents the write-off of unamortized issue cost (net of $1.7 million tax) of the LYONs which were redeemed for cash on September 30, 1992. The Corporation changed to the accrual method of accounting for postretirement health care costs effective January 1, 1992. The cumulative effect of the change of $17.4 million (net of $9.8 million tax), representing unfunded prior service cost at December 31, 1991, was recognized in the consolidated statement of operations as a restatement of the first quarter's results of operations. FINANCIAL CONDITION Total capitalization at December 31, 1993 was $454.0 million composed of $47.0 million debt and $407.0 million equity. The Corporation's primary sources of short-term financing during the past few years were customer advances, particularly for the rail systems segment, sale of short-term investments and operations. However, in 1993, net cash generated by operations decreased compared to the previous two years, primarily as a result of increased accounts receivable and inventory levels and a decrease in customer advances, particularly for the rail system segment. The increase in accounts receivable, including customer's retentions, which increased $17.9 million at December 31, 1993 compared with December 31, 1992 was due principally to increased revenues. The increased inventory levels at year-end 1993 primarily reflected higher inventory levels necessary to support the rail systems' expanding role as a fully-integrated manufacturer of transit cars and locomotives and supplier of aftermarket railway products. The decrease in customer advances in 1993 of $75.7 million were used primarily to fund rail systems inventories. Excluding $47.9 million of cash provided from the sale of short-term investments, net cash used for investments declined in 1993. In 1993 net cash used for investing activities included $52.2 million that was invested in property, plant and equipment, primarily for rail systems leasehold improvements, manufacturing machinery, and equipment. Aside from certain owned facilities, the Corporation leases the majority of its facilities and certain construction equipment under noncancellable operating leases. In 1993, rent expense under all operating leases was $38.8 million. The Corporation's future lease commitments are discussed in the "Commitments and Contingencies" Note to Consolidated Financial Statements. In addition to investments in fixed assets, the Corporation funded $15.5 million for initial design and engineering relating to new transit car models. Net cash provided by financing activities increased in 1993 compared to 1992. In 1992, the Corporation redeemed the LYONs for cash and paid down loan balances assumed in business combinations. In 1993, the Corporation borrowed short-term to finance working capital needs. The Corporation expects that it will continue to incur short-term borrowings from time to time to finance rail systems and engineering and construction working capital needs. The Corporation believes that its balance of cash, together with funds generated from operations and existing short-term and potential long-term borrowing capabilities, will be sufficient to meet its operating cash requirements in the foreseeable future. The Corporation had available from banks $135.0 million under committed revolving credit agreements. The Corporation is currently negotiating with banks to replace its two unsecured revolving credit agreements with a $150.0 million revolving credit facility by March 31, 1994. II-5 - -------------------------------------------------------------------------------- QUARTERLY FINANCIAL DATA (THOUSANDS OF DOLLARS EXCEPT SHARE DATA) - -------------------------------------------------------------------------------- II-6 INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors Morrison Knudsen Corporation We have audited the accompanying consolidated balance sheets of Morrison Knudsen Corporation and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flow for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedule listed in the Table of Contents at Item 14. These financial statements and the financial statement schedule are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly in all material respects the financial position of Morrison Knudsen Corporation and Subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed on page II-23 of the "Notes to Consolidated Financial Statements," the Corporation changed its method of accounting for postretirement health care costs in 1992 to conform with Statement of Financial Accounting Standards No. 106. /s/ Deloitte & Touche DELOITTE & TOUCHE Boise, Idaho February 8, 1994 II-7 CONSOLIDATED STATEMENTS OF OPERATIONS (THOUSANDS OF DOLLARS EXCEPT SHARES DATA) THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. II-8 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. II-9 II-10 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. II-11 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (THOUSANDS OF DOLLARS EXCEPT SHARE DATA) THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. II-12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (THOUSANDS OF DOLLARS EXCEPT SHARE DATA) - -------------------------------------------------------------------------------- The term "Corporation" as used in this Annual Report includes Morrison Knudsen Corporation and its consolidated subsidiaries unless otherwise indicated. SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of the Corporation and all of its majority-owned subsidiaries. Investments in 20 percent to 50 percent owned companies and joint ventures are accounted for by the equity method. The Corporation's proportionate share of joint venture revenue, cost of revenue and operating income is included in the consolidated statement of operations. Intercompany accounts and transactions have been eliminated. RECOGNITION OF REVENUE: The Corporation recognizes revenue on construction contracts, including substantially all of its construction joint-venture contracts, on the percentage-of-completion method, based on the proportion of costs incurred on the contract to total estimated contract costs. Construction-management and engineering contract revenue is recognized on the accrual method. Revenue is recognized on long-term rail systems contracts when products are shipped. Revisions in contract revenue and cost estimates are reflected in the accounting period when known. Provision is made currently for estimated losses on uncompleted contracts. Claims for additional contract revenue in excess of original contract price are recognized when an offer to settle has been received from the customer. Costs and earnings in excess of billings represent revenue accrued under the percentage of completion method but not yet billable under the terms of the con- tract and are recoverable from customers upon various measures of performance such as quantities excavated or delivered, costs incurred, time schedules or completion of the contract. Substantially all the unbilled amounts at December 31, 1993, net of progress payments, are expected to be collected during 1994. CLASSIFICATION OF CURRENT ASSETS AND LIABILITIES: The Corporation includes in current assets and liabilities amounts realizable and payable under engineering, construction and rail systems contracts that extend beyond one year. Accounts receivable at December 31, 1993 include $26,920 of retentions, generally payable by customers on final acceptance, which are expected to be collected after 1994. Advances received from customers as payments on account of work in progress are regarded as partial payment and reflected as deductions from the related asset. Advances by customers to provide a revolving fund from which to pay contract-related costs are reflected as liabilities until the contract is substantially or fully completed. The Corporation does not pay interest on advances from customers. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS: Cash equivalents consist of investments in highly liquid securities having an original maturity of three months or less. Short-term investments consist of marketable equity securities and other investment-grade securities and are stated at the lower of their aggregate cost or market. For purposes of the consolidated statement of cash flow, the Corporation does not consider short-term investments to be cash equivalents. INVENTORIES: Inventories are stated at the lower of cost or market. Most inventories are valued at actual purchase or standard production costs of units to be produced under a long-term contract. The remainder are valued at the lower of last-in, first-out (LIFO) cost or market. TRANSIT CAR DESIGN COSTS: Certain initial design and engineering costs on new transit car models are capitalized and amortized over their estimated economic useful lives of 5 years. The unamortized balance of transit car design and engineering costs at December 31, 1993 was $15,519. Similar costs were not material in prior years. Such capitalized costs are included in the accompanying balance sheet under the caption "Other Investments and Assets". The capitalized costs are written off if it becomes probable that they cannot be recovered from future transit car contract revenue. CREDIT RISKS: Financial instruments which potentially subject the Corporation to concentrations of credit risks consist of cash equivalents, short-term investments and billed and unbilled accounts receivable. The Corporation by policy, limits the amount of credit exposure to any one financial institution and places the investments with financial institutions evaluated as highly creditworthy. Concentrations of credit with respect to billed and unbilled accounts receivable are limited due to the Corporation's credit evaluation process. Historically, the Corporation has not incurred any significant credit-related losses. DEPRECIATION AND AMORTIZATION: The cost of buildings and office furniture and equipment is depreciated on the straight-line method over periods from 3 to 30 years. The cost of construction equipment (less salvage values of 10 to 20%) is depreciated on the straight-line method over periods from 5 to 10 years. Certain specialty equipment is depreciated using the units-of-production method and may have salvage values which exceed 20% of original cost. The cost and accumulated depreciation of property and equipment disposals are removed from the accounts, and gains or losses are reflected in operations. II-13 GOODWILL AND OTHER INTANGIBLES: Goodwill, costs in excess of the net assets of businesses acquired, is amortized on a straight-line basis over periods ranging from 5 to 30 years. Costs of noncompete agreements are being amortized over their contract periods of 5 and 10 years. Accumulated amortization at December 31, 1993 and 1992, was $2,741 and $1,300, respectively. PROJECT DEVELOPMENT COSTS: The Corporation defers certain costs related to the design, engineering, construction, and ongoing operation and maintenance of certain major projects in which the Corporation for the first time intends to retain an ownership interest. Project development costs of $5,922 and $3,031 were deferred at December 31, 1993 and 1992, respectively and are included in the accompanying balance sheet under the caption "Other Investments and Assets". FOREIGN CURRENCY TRANSLATION: The functional currency for the majority of the Corporation's foreign operations is the applicable local currency. The translation from the applicable foreign currencies to U.S. dollars is performed for asset and liability accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. The gains or losses, net of applicable deferred income taxes, resulting from such translation are deferred as a separate component of stockholders' equity until disposition or substantial disposition of the investment. Gains or losses resulting from foreign currency transactions are included in the net income of the period in which the transaction is completed. The Corporation enters into foreign exchange forward contracts to minimize the impact of foreign currency fluctuations on operating results. The contracts hedge firm purchase commitments and any gains or losses are deferred and included as a component of the related transaction. INCOME TAXES: Effective January 1, 1993, the Corporation adopted the provisions of Statement of Financial Accounting Standards No. 109 ACCOUNTING FOR INCOME TAXES ("SFAS 109") which requires a company to recognize deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in the company's financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Adoption of FAS 109 did not have a material effect on the financial statements of the Corporation. RESEARCH AND DEVELOPMENT: Company sponsored research and development expenditures related to rail systems segment products are expensed as incurred. EARNINGS (LOSS) PER SHARE: Earnings (loss) per share are computed based on the weighted average number of shares outstanding plus shares issuable upon assumed exercise of stock options, reduced by the shares which could be purchased with the assumed proceeds from such shares, if dilutive. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS The Financial Accounting Standards Board has issued Statement No. 112 EMPLOYER'S ACCOUNTING FOR POSTEMPLOYMENT BENEFITS ("FAS 112"). Adoption is required by January 1, 1994. The statement establishes standards of financial accounting and reporting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. The Corporation believes that FAS 112, when adopted, will not have a material effect on its financial position or results of operations. SUBSIDIARY SALE OF STOCK On December 21, 1993, MK Gold Company, ("MK Gold") then a wholly-owned subsidiary of the Corporation, completed an initial public offering ("IPO") of 8,000,000 shares of its common stock at an offering price of six dollars a share. MK Gold is in the business of mining gold, developing gold mining projects and providing contract mining services. The net proceeds to MK Gold from the IPO, after deducting underwriters'commissions and offering expenses, were $43,077. The Corporation recorded a $10,602 pretax gain on the IPO in recognition of the net increase in value of the Corporation's investment in MK Gold. Concurrent with MK Gold's IPO, the Corporation sold 1,000,000 shares of MK Gold's common stock to the public, at a price of six dollars a share. These sales reduced the Corporation's investment to 50%. The Corporation received net cash proceeds of $5,385 and recognized a $2,056 pretax gain. In January 1994, MK Gold sold additional common stock to the public which reduced the Corporation's ownership in MK Gold to 46.5%. The Corporation's accompanying financial state- ments at December 31, 1993 reflect the investment in MK Gold under the equity method of accounting. MK Gold's revenue and net income for 1993 prior to the IPO was $40,963 and $2,475, respectively. MARKETABLE SECURITIES Non-current marketable securities are carried at the lower of aggregate cost or market value. The portfolio consists primarily of foreign government bonds (maintained in support of the Corporation's self-insurance programs). At December 31, 1993, the excess of market value over cost consisted of unrealized gains of $2,472 and unrealized losses of $435. II-14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED ACQUISITIONS In April 1993, the Corporation reached an agreement with Joy Technologies Inc. ("JTI") whereby JTI exchanged cash and other assets, (including its 50% common stock interest in Joy MK Projects Company ("J/MK"), an unconsolidated affiliate), for a release by the Corporation of JTI's obligation to complete a contract for installation of pollution control devices and other consideration. Effective May 1, 1993, the accounts of J/MK have been fully consolidated with those of the Corporation. The consolidation of the accounts had no material effect on the Corporation's accompanying financial statements as of December 31, 1993 and for the year then ended. Effective July 1, 1993, the Corporation acquired for $527 cash additional voting stock of McConnell Dowell Corporation Limited ("MDC") representing 3% of the total issued and outstanding voting stock of MDC bringing the Corporation's aggregate share of MDC's voting stock to 51.9%. Prior to July 1, 1993, the Corporation had accounted for its investment in MDC on the equity method. The Corporation consolidated the accounts of MDC effective with the change in control. On August 20, 1993, the Corporation acquired all of the voting stock of Arrowsmith Power Systems, Inc. ("Arrowsmith") for $11,425 which consisted of 424,752 shares of the Corporation's common stock and $700 cash. In addition, the Corporation entered into noncompete agreements with certain former stockholders of Arrowsmith in exchange for $2,000 cash which cost is being amortized over 10 years. Arrowsmith manufactures turbochargers for locomotives. The acquisition has been accounted for by the purchase method of accounting. The $3,551 excess of the purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill, and is being amortized over 15 years. The operating results of Arrowsmith are included in the Corporation's consolidated results of operations from the date of acquisition. ACCOUNTS RECEIVABLE The Corporation has a three year agreement with banks (expiring in December 1994) to sell, with limited recourse, up to $60,000 of undivided interests in a designated pool of accounts receivables. As collections reduce previously sold undivided interests, new receivables can be sold up to the $60,000 level. In addition, accounts receivable were sold to a bank under an agreement which ends in February 1994. Accounts receivable totaling $713,804 and $651,030 have been sold under the agreements in 1993 and 1992, respectively. At December 31, 1993 and 1992, accounts receivable in the accompanying balance sheet are net of receivables sold under the agreements of $75,937 and $87,264, respectively. INVENTORIES Rail systems inventories are summarized as follows: Approximately $34,540 and $25,299 of total inventories at December 31, 1993 and 1992, respectively, were valued on the LIFO cost method, and the excess current replacement cost of these inventories over the stated LIFO value was $2,924 and $2,930, respectively. CONSTRUCTION JOINT VENTURES The Corporation has entered into a number of partnership arrangements commonly referred to as "joint ventures". Generally, each construction joint venture is formed to accomplish a specific project and is dissolved upon completion of the project. The number of joint ventures in which the Corporation participates and the size, scope and duration of the projects vary between periods. Specific joint ventures change from period to period, and the comparability of the following group financial information between periods may not be meaningful. Summary joint venture financial information follows: II-15 INVESTMENTS IN UNCONSOLIDATED AFFILIATES The following table presents summarized financial information on a combined 100 percent basis of the unconsolidated affiliated companies accounted for by the equity method. Amounts presented include the accounts of the following principal unconsolidated affiliates: MK Gold (50%); Strait Crossing Development, Inc. (45%); Texas TGV Corporation ("Texas TGV") (38.2%); AmerBank (31.1%); and Westmoreland Resources, Inc. (24%). MK Gold holds interests in two producing gold mining projects in California and provides contract mining services. MK Gold's results of operations are included on the equity basis of accounting for the period subsequent to the IPO. Strait Crossing Development, Inc. is a joint venture with a contract to design, build and operate for 35 years an 8.4-mile-long toll bridge linking the Canadian provinces of New Brunswick and Prince Edward Island. Texas TGV Corporation is a development-stage company with a 50-year franchise to provide 200 m.p.h. passenger service connecting five major Texas cities. AmerBank is a licensed bank operating in Poland. The investment in AmerBank has been classified as current to reflect the Corporation's intent to sell its interest therein. West moreland Resources, Inc. is a mining company that operates a surface coal mine in Montana. The Corporation's investment in MK Gold at December 31, 1993 was $29,954. The aggregate market value of MK Gold's voting stock held by the Corporation was $54,000 at December 31, 1993. The Corporation received dividends from unconsolidated affiliates of $216 and $1,380 in 1993 and 1992, respectively. The Corporation's consolidated retained earnings at December 31, 1993 include $8,665 of undistributed earnings of the unconsolidated affiliates accounted for by the equity method. SHORT-TERM DEBT The Corporation has two unsecured committed revolving credit agreements ("credit agreements") with U.S. banks under which it may borrow, at varying interest rates up to $135,000. One facility allows the Corporation to borrow up to $100,000 until September 30, 1995, subject to annual extension by the banks. The second facility for $35,000 expires on March 31, 1994. The Corporation pays a facility fee of .25 of 1% per year. A balance of $15,900 was outstanding under these credit agreements at December 31, 1993. In addition, a subsidiary of the Corporation has an unsecured credit facility ("credit facility") with a Canadian bank with an aggregate commitment at December 31, 1993, of $26,628 (Canadian $35,000). The credit facility is the primary source of financing for the construction of a project in Ontario, Canada. The credit facility terminates January 31, 1995 when the project is expected to be completed. The subsidiary pays a commitment fee of .75 of 1% per year. A balance of $14,470 was outstanding under the credit facility at December 31, 1993. Both the credit agreements and credit facility contain restrictive financial covenants that require minimum levels of working capital and net worth and maintenance of specific financial ratios. The Corporation was in compliance with such covenants at December 31, 1993. Certain information with respect to short-term debt at December 31, 1993, 1992 and 1991 and for the years then ended follows: II-16 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED TAXES ON INCOME The components of the U.S. federal, state and foreign income tax expense are shown below: The income tax expense (benefit) applicable to continuing operations, extraordinary charge and cumulative effect of accounting change are as follows: Deferred income taxes arise from temporary differences in the recognition of certain items of revenue and expense for income tax and consolidated financial statement purposes. The source of each difference and the related tax effect are as follows: The Corporation may be entitled to recovery of certain material foreign tax credits not taken or recorded in prior years. The amount of such credits has not been determined and is subject to challenge by the Internal Revenue Service. Deferred tax benefits and liabilities as of December 31, 1993 and 1992 consist of the following: Deferred U.S. federal income taxes of $2,325 have not been provided on $5,691 of cumulative undistributed earnings of foreign subsidiaries at December 31, 1993 as such earnings have been or are intended to be indefinitely reinvested in foreign operations. Income tax expense on continuing operations differed from income taxes at the U.S. federal statutory tax rate of 34% (35% for 1993) for the following reasons: The domestic and foreign components of income before taxes are as follows: II-17 OTHER INCOME (EXPENSE) NET COMMITMENTS AND CONTINGENCIES The Corporation has commitments and performance guarantees arising from engineering, construction and rail systems contracts including those of its construction joint ventures. The Corporation is self insured for workers' compensation, automobile, general liability and third party errors and omissions. The Corporation has insurance agreements with insurers for losses in excess of self insurance limits. LONG-TERM LEASES Total rentals charged to operations in 1993, 1992 and 1991 were $38,800, $39,800 and $33,300, respectively. Future minimum rental payments under operating leases with remaining noncancelable terms in excess of one year at December 31, 1993 are as follows: In addition, the Corporation has leased mining equipment under an operating lease through 2008 with a basic annual rent of $6,686, which is reimbursable and funded under the operating contract with the mine owner. VERTAC SITE CONTRACTORS Design, engineering, construction and pre-production start-up costs to develop a facility for incineration of certain hazardous wastes have been capitalized. The incineration facility was engaged in hazardous waste processing under a contract with the State of Arkansas which has expired. The Corporation concluded negotiations with a prime contractor, who is under contract with the Federal Environmental Protection Agency ("EPA"), and reached agreement on a subcontract under which the Corporation will continue processing the measured hazardous waste at the Arkansas site. The Corporation's investment representing the net assets of the business was $21,950 and $23,768 at December 31, 1993 and 1992, respectively. The Corporation will not recover its investment under this subcon- tract but anticipates that it will receive additional contracts to incinerate hazardous waste at the site to fully recover its investment. CF SYSTEMS The Corporation acquired a solvent extraction processing technology in 1990 and subsequently deferred additional design and engineering costs in modifying the processing facility for commercial application. The Corporation is currently negotiating a "sole source" contract with a state agency for remediation of contaminated soil. The contract, if awarded, should begin about mid-1994, be of approximately 36 months duration and be principally funded by the EPA. The Corporation's investment in the business was $13,896 and $14,120 at December 31, 1993 and 1992, respectively. TEXAS TGV CORPORATION Texas TGV was awarded a franchise in May 1991 to finance, construct and operate a high speed rail system in Texas. Through December 31, 1993, the project has been funded by its shareholders, including the Corporation, which has a 38.2% equity investment of $13,996 at December 31, 1993. The Texas High Speed Rail Authority ("Authority") has asserted that Texas TGV is in technical default because it failed to provide the equity financing commitment by December 31, 1993 as required under the franchise agreement. The Authority has requested that Texas TGV provide reasons why it is not in default. Texas TGV has informed the Authority that it believes it is not in default because certain delays have extended the deadline for providing the equity financing commitment. According to the franchise agreement, such event of default could result in the ter- mination of the franchise. No provision for loss, if any, of the Corporation's investment has been made in the financial statements because the ultimate outcome of this matter is not predictable at this time. II-18 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED DISCONTINUED OPERATIONS In 1989, the Corporation sold its interest in National Steel and Shipbuilding Company ("NASSCO") to a NASSCO management group and a NASSCO Employee Stock Ownership Plan. NASSCO has the right prior to July 31, 1994 to require the Corporation to provide NASSCO a $21,000 credit facility, $13,000 of which expires on July 31, 1994 while the remaining $8,000 continues until completion of a U.S. Navy contract, expected in 1998. At December 31, 1993, NASSCO had no balance outstanding under the Corporation's credit facility. The Corporation is contingently liable up to a maximum of $21,000 on a bank credit facility obtained by NASSCO. The Corporation's credit facility is reduced by the amount of funds NASSCO borrows under its bank credit facility. The balance outstanding under NASSCO's bank credit facility at December 31, 1993 was $12,000. If NASSCO's borrowings under the bank credit facility exceed $8,000 at July 31, 1994, NASSCO has the right to require the Corporation to purchase NASSCO preferred stock equal to the amount of borrowings in excess of $8,000. The Corporation has also guaranteed $21,000 of NASSCO's port facility bonds until not later than December 1, 2002, and guaranteed $1,833 of NASSCO's state and federal workers' compensation bonds. NASSCO's floating dry dock is pledged as collateral for the $21,000 port facility bonds. Net assets of the real estate operations discontinued in 1987 are included in the accompanying balance sheet under the caption "Other Investments and Assets" and consist of: The notes receivable are due at various dates through 1995 at interest rates ranging from 4.6% to 12%. Most of the notes are collateralized by deeds of trust. LETTERS OF CREDIT The Corporation is contingently liable, in the normal course of business, for $414,203 in standby letters of credit not reflected in the accompanying financial statements at December 31, 1993. Of this aggregate amount, $374,097 are for contract performance guarantees on a number of construction and rail systems contracts. In addition, the Corporation provides a guarantee for a $40,106 letter of credit issued by third parties to meet the reinsurance requirements of the Corporation's captive insurance subsidiary. The credit risk is mitigated by the insurance subsidiary's portfolio of high quality investments used to collaterize the letter of credit. II-19 INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION The Corporation operates in two industry segments: engineering and construction, and rail systems. All intercompany revenues and expenses are eliminated in computing revenues and operating income. A summary of the Corporation's operations by geographic area is presented below: Ten percent or more of the Corporation's revenue was derived from contracts with U.S. Government agencies of $603,900 in 1993, $535,100 in 1992, and $468,800 in 1991, and $242,000 from a major metropolitan transit authority in 1991. II-20 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consisted of the following: STOCK PLANS STOCK OPTION Under the amended 1991 Stock Incentive Plan ("Plan") the Corporation may grant incentive stock options ("ISOs") and nonqualified stock options ("NQSOs"), stock appreciation rights, limited stock appreciation rights and shares of restricted stock to officers and other key employees. The exercise price of an ISO may not be less than 100% of the fair market value on the date of grant. For NQSOs, the plan provides for granting fixed- and variable-price options at exercise prices equal to the fair market value on the date of grant ("grant price"), except variable-price options may be exercised at (1) the fair market value on the date of exercise if less than the grant price or (2) the grant price less any market appreciation from date of grant to date of exercise, but not less than par value of $1.67 per share. Options granted become exercisable cumulatively over periods of three, four, five, and six years from the date of grant. At December 31, 1993, options were exercisable to purchase 526,313 shares. Unexercised options expire 10 years after the date of grant. At December 31, 1993, 380,652 shares of treasury stock were held for variable-price option distributions. The following table summarizes the changes in shares under option: The number of shares of common stock reserved for granting future options and restricted stock awards was 405,874, 883,924, and 483,324, at December 31, 1993, 1992, and 1991, respectively. The Corporation has a stock option plan, adopted in 1990, under which 192,000 shares of common stock have been reserved for issuance to non-employee directors and 132,000 shares have been granted as of December 31, 1993. The plan entitles the non-employee directors to purchase shares of common stock at a 50 percent discount from fair market value at the date of grant. The options granted become exercisable in one-third increments over a three-year period beginning one year after the date of grant. Options for 80,000 shares were exercisable at December 31, 1993. RESTRICTED STOCK The restricted stock awards are partially conditioned on continued employment during restriction periods of from one to five years. In certain instances a portion of the award immediately vests at the date of the award. Recipients of awards have all the rights of stockholders except the right to receive the stock until the condition of continued employment has been met. During 1993, there were 116,000 shares awarded as restricted stock. At December 31, 1993, there were 99,000 restricted shares outstanding under the current plan and 18,400 shares outstanding under the predecessor plan, with restriction periods ranging from one to four years. In addition, the Corporation has issued 190,117 shares of restricted stock, with restriction periods of three, five and ten years, to former stockholders of acquired businesses as consideration for noncompete agreements and II-21 in return for an agreement to provide services to the Corporation during specific future periods. During 1993, the recipients acquired full rights to 18,412 shares. At December 31, 1993, 171,705 shares remained outstanding with restriction periods ranging from two to ten years. Compensation expense for the employee and non-employee restricted stock award plans and the non-employee directors stock option plan was $852 in 1993, $804 in 1992 and $1,291 in 1990. EMPLOYEE STOCK OWNERSHIP PLAN The Corporation has an Employee Stock Ownership Plan ("ESOP") for salaried employees. The Corporation prefunded 2,441,936 shares of common stock to an ESOP Trust in 1988. Employee salary deferrals to the Corporation's 401(k) savings plan, not to exceed 3% of annual compensation, are matched with an allocation of shares in the ESOP. Unallocated shares are reflected as treasury stock in the accompanying balance sheet. Cash dividends paid by the Corporation on allocated and unallocated shares held by the ESOP Trust are subsequently paid in cash to plan participants. Compensation expense for the fair market value of the allocated shares and the redistribution of Corporation dividends on unallocated shares paid in cash to plan participants in 1993, 1992 and 1991 was $8,555, $7,777 and $7,529, respectively. BENEFIT PLANS PENSION PLANS The Corporation sponsors a non-contributory defined benefit pension plan, adopted effective January 1, 1988, covering substantially all of its non-union, salaried employees. The Corporation funds amounts deductible for federal income tax purposes. Effective December 31, 1991 the Corporation curtailed its defined benefit plan so that employees do not earn additional defined benefits for future services. The Plan remains in existence and continues to pay benefits, to invest assets and to receive contributions, if necessary. Pension cost (income) included the following components: The funded status of the plan at December 31, 1993 and 1992 follows: The prepaid pension cost is included in the accompanying balance sheet under the caption "Other Investments and Assets". At December 31, 1993, approximately 44% of plan assets of $44,332 are invested in common stocks, 15% in corporate bonds, 22% in U.S. government securities and 19% in cash equivalents. The discount rates used in determining the actuarial present value of the accumulated benefit obligation were 7% and 8.5% for 1993 and 1992, respectively. The expected long-term rate of return on plan assets was 8.5% for 1993 and 1992. The Corporation sponsors several defined contribution pension plans for certain hourly contract mining and construction service employees. Pension cost recognized, based on hours worked, amounted to $2,320 in 1993, $1,596 in 1992 and $1,667 in 1991. The Corporation participates in numerous construction-industry multiemployer pension plans. Generally, the plans provide defined benefits to substantially all direct-hire craft employees covered by collective bargaining agreements. Pension cost under the plans amounted to $10,302 in 1993, $12,693 in 1992 and $9,728 in 1991. Under ERISA, as amended by the Multiemployer Pension Plan Amendment Act of 1980, a contributor to a multiemployer plan is liable, upon termination of the plan or its withdrawal from the plan, for its share of the multiemployer Plan's unfunded vested liabilities. The Corporation has long maintained policies and procedures to attempt to preclude it from being subject to withdrawal liability for any portion of an unfunded vested liability under a construction industry multi employer pension plan. Based on information provided by the multiemployer plan's administrators to the U.S. Department of Labor, the Corporation's share of such plans unfunded vested liabilities as of the most recent disclosures available is approximately $11,200. II-22 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INCENTIVE PLANS The Corporation has an executive incentive plan and two long-term incentive and benefit plans for officers and key executives, the costs of which amounted to $5,536 in 1993, $3,528 in 1992 and $4,336 in 1991. SUPPLEMENTAL RETIREMENT INCOME ARRANGEMENTS The Corporation has unfunded supplemental retirement income arrangements for officers and key employees and an unfunded defined benefit pension plan for non-employee directors. Periodic cost of the plans included the following components: The unfunded status of the plans at December 31, 1993 and 1992 follows: The discount rates and rates of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7% and 6%, and 8.5% and 6%, respectively, for 1993 and 1992. POSTRETIREMENT HEALTH CARE PLAN In addition to providing pension and other supplemental retirement income arrangements, certain health care benefits are provided for retired employees. Benefit design changes in 1992 limited postretirement health care benefits to employees who retired by July 1, 1993. Employees who retire thereafter are not eligible for postretirement health care benefits. Retirees who retired before July 1, 1990 pay no contributions for coverage while those who retired after July 1, 1990 and before July 1, 1993 pay contributions. Effective January 1, 1992, the Corporation changed its accounting for postretirement health care costs to the accrual method. In prior years, cost was recognized when retirees' claims were paid. The unfunded present value of the accumulated postretirement benefit obligation for retirees of $27,192 ($17,403 after tax) at December 31, 1991 was recognized as a cumulative effect of an accounting change as of the beginning of 1992. Postretirement health care costs for 1993 and 1992 were $2,494 and $2,470, respectively, consisting of interest cost of $2,494 and $2,311 respectively, on the unfunded accumulated postretirement benefit obligation. Cash payments for retiree's claims were $2,181 in 1991. The following table sets forth the plan's activity and unfunded balance at December 31, 1993 and 1992. The accumulated postretirement benefit obligation was determined using the projected unit credit method and an assumed discount rate of 7% and 8.5% for 1993 and 1992, respectively. In addition, an annual rate increase of 11.6% and 12.3% in the per capita cost of health care benefits was assumed for 1993 and 1992, respectively, gradually declining to 5% in the year 2008 and thereafter over the projected payout period of the benefits. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, a 1% increase in the health care cost trend rate would increase the accumulated postretirement benefit obligation at December 31, 1993 by $3,014 and the 1993 cost by $211. FINANCIAL INSTRUMENTS The estimated fair values of financial instruments at December 31, 1993 and 1992 have been determined by the Corporation, using available market information and appropriate valuation methodologies. However, considerable judgment is necessary in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Corporation could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The contract or notional amounts reflect the extent of involvement the Corporation has in particular classes of financial instruments. II-23 The carrying amounts and estimated fair values of financial instruments at December 31, 1993 and 1992 are as follows: CASH AND CASH EQUIVALENTS, SHORT-TERM INVESTMENTS, ACCOUNTS RECEIVABLE (LESS RETENTIONS), UNBILLED COSTS, ACCOUNTS PAYABLE, BILLINGS IN EXCESS, SHORT-TERM AND LONG-TERM DEBT.The carrying amounts of these items are reasonable estimates of their fair values. RETENTIONS. Rates currently available to the Corporation for the sale of trade receivables at a discount are used to estimate fair value. MARKETABLE SECURITIES. Fair values are based on quoted market prices. DISCONTINUED OPERATIONS. Fair value of notes and interest receivable are determined by discounting the projected cash flows using rates which would be made to borrowers with similar credit ratings for the same maturities. Notes payable are valued at rates currently available to the Corporation for debt with similar terms. OTHER FINANCIAL ASSETS. The projected cash flows of notes receivable are discounted at current market rates to estimate fair value. The fair values of investments at cost in small untraded companies are estimated using conservative potential earnings ratios or at the Corporation's proportionate share of the market value of the investee's underlying net assets. ADVANCES. Net present value of future expected cash flows discounted at rates currently available for short term debt are used to estimate fair value. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS. The fair value of committed revolving credit agreements, standby letters of credit, and lending commitments are estimated using fees currently charged to the Corporation taking into account remaining terms and the creditworthiness of the counterparty. Forward exchange contracts and hedges are valued based on quoted prices for financial instruments with identical or similar terms. NON-FINANCIAL INSTRUMENTS.The estimated fair value of financial guarantees is based upon rates charged for similar agreements or estimated cost to terminate them determined from the amount of exposure under the guarantee and the likelihood of performance being required. SUBSEQUENT EVENTS SUBSIDIARY SALE OF STOCK Under an option granted by MK Gold to the underwriters of the IPO to purchase additional shares of common stock to cover over-allotments, 1,350,000 shares of MK Gold's common stock at six dollars a share were sold on January 14, 1994 which decreased the Corporation's ownership to 46.5%. The net proceeds to MK Gold from the January 1994 sale, after deducting commissions and offering expenses, were $7,533. In January 1994, the Corporation recorded a $1,182 pretax gain in recognition of the net increase in value of the Corporation's investment in MK Gold. ACQUISITION On January 31, 1994, the Corporation acquired all of the voting stock of Touchstone, Inc. ("Touchstone") for $22,665 which consisted of 720,000 shares of the Corporation's common stock and $3,900 cash. Touchstone is a supplier of new and remanufactured locomotive cooling systems. The acquisition has been accounted for by the purchase method of accounting. The excess of the purchase price over the estimated fair values of the net assets acquired was approximately $17,965 and has been recorded as goodwill, which will be amortized over fifteen years. Touchstone had total assets at December 31, 1993 of $12,341 and net assets of $5,466. Touchstone's revenue and net income for the year ended December 31, 1993 was $20,032 and $265, respectively. II-24 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. II-25 PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information with respect to the executive officers of the Corporation, see the unnumbered caption "Executive Officers of the Registrant" at the end of Part I of this Annual Report of Form 10-K. For information with respect to the directors of the Corporation, see the caption "Election of Directors" on pages 2 and 3 of the proxy statement, which is incorporated herein by this reference. For information with respect to delinquent Section 16(a) filings by reporting persons of the Corporation, see the caption "Filing Disclosure" on page 19 of the proxy statement, which is incorporated herein by this reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION For information with respect to compensation of the executive officers and directors of the Corporation, see the disclosures set forth under the captions "Director Compensation", "Stock Option Plan for Non-Employee Directors", "Retirement Plan for Non-Employee Directors", "Non-Employee Directors Deferred Compensation Plan", "Compensation Committee Report on Executive Compensation- (I. General Compensation Policies Applicable to Officers and Key Employees, II. Corporate Performance and Executive Compensation, III. CEO Compensation, IV. Company Performance Graph and V. Section 162(m) of the Internal Revenue Code"), "Executive Compensation", "Aggregate Option Exercises and Fiscal Year-End Option Values", "Long-Term Incentive Plans", "Pension", and "Employment Contracts and Change in Control Arrangements" on pages 4 through 19, and the information set forth under the Corporation's proposal on "Approval of the Morrison Knudsen Corporation Chief Executive Officer Incentive Plan" and "Proposal to Approve the Morrison Knudsen Corporation Stock Compensation Plan" on pages 21 through 27 of the proxy statement, which is incorporated herein by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Merrill Lynch & Co., Inc., New York, New York and Mellon Bank Corporation, Pittsburgh, Pennsylvania, trustee for the Corporation's Employee Stock Ownership Plan Trust are each known by the Corporation to beneficially own more than 5 percent of the Corporation's voting common stock. The information set forth under the caption "Voting Securities and Principal Holders Thereof" on pages 20 and 21 of the proxy statement is incorporated herein by this reference. (b) Security ownership by management as outlined on pages 20 and 21 of the proxy statement under the caption "Voting Securities and Principal Holders Thereof," is incorporated herein by this reference. (c) There are no arrangements known to the Corporation the operation of which may at a subsequent date result in a change in control of the registrant. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information with respect to certain relationships and related transactions see the disclosure set forth under the caption "Indebtedness Information" on page 19 of the proxy statement, which is incorporated herein by this reference. III-1 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K PAGE (a) Financial Statements, Schedules and Exhibits. 1. Financial Statements included in Part II of this Annual Report on Form 10-K: Independent Auditors' Report II-7 Consolidated Statements of Operations for years ended December 31, 1993, 1992, and 1991 II-8 Consolidated Balance Sheets at December 31, 1993 and 1992 II-9, II-10 Consolidated Statements of Cash Flow for years ended December 31, 1993, 1992 and 1991 II-11 Consolidated Statements of Stockholders' Equity for years ended December 31, 1993, 1992 and 1991 II-12 Notes to Consolidated Financial Statements II-13 - II-24 2. Financial Statement Schedule as of December 31, 1993 included in Part IV of this Annual Report on Form 10-K: VII. Guarantee of Securities of Other Issuers IV-3 Financial statement schedules not listed above are omitted because they are not required or are not applicable, or the required information is given in the financial statements including the notes thereto. Captions and column headings have been omitted where not applicable. 3. Exhibits: The exhibits to this Annual Report on Form 10-K are listed in the Exhibit Index contained elsewhere in this Annual Report. (b) Reports on Form 8-K: During the quarter ended December 31, 1993 the Corporation reported (a) the completion of an initial public offering by MK Gold Company, then a wholly-owned subsidiary of the Corporation and (b) the acquisition of a one-third ownership interest in a German state-owned mining and reclamation company. IV-1 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized on March 30, 1994. Morrison Knudsen Corporation By /s/ W. J. Agee * ------------------------------------------------- W. J. Agee, Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below on March 30, 1994 by the following persons on behalf of the Corporation in the capacities indicated. Chairman of the Board, President and Chief Executive Officer /s/ W. J. Agee * (Principal Executive Officer) - ----------------------- W. J. Agee Executive Vice President - Finance and Administration, /s/ S.G. Hanks and Secretary - ----------------------- (Principal Financial Officer) S.G. Hanks Vice President and Controller /s/ M. E. Howland * (Principal Accounting Officer) - ----------------------- M.E. Howland /s/ G. E. Sarsten * Director - ----------------------- G. E. Sarsten /s/ J. Arrillaga * Director - ----------------------- J. Arrillaga Director - ----------------------- Z. Brzezinski /s/ L. E. Fox * Director - ----------------------- L. E. Fox /s/ C. B. Hemmeter * Director - ----------------------- C. B. Hemmeter /s/ P. S. Lynch * Director - ----------------------- P. S. Lynch /s/ R. A. McCabe * Director - ----------------------- R. A. McCabe /s/ I. C. Peden * Director - ----------------------- I. C. Peden /s/ J. W. Rogers, Jr. * Director - ----------------------- J. W. Rogers, Jr. /s/ G. R. Roche * Director - ----------------------- G. R. Roche /s/ P. V. Ueberroth * Director - ----------------------- P. V. Ueberroth * Stephen G. Hanks, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of each of the above-named officers and directors of Morrison Knudsen Corporation, pursuant to powers of attorney executed on behalf of each such officer and director. *By /s/ S.G. Hanks - ------------------------------------------- S.G. Hanks, Attorney-in-fact IV-2 MORRISON KNUDSEN CORPORATION SCHEDULE VII. GUARANTEE OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) IV-3 MORRISON KNUDSEN CORPORATION EXHIBIT INDEX EXHIBITS MARKED WITH AN ASTERISK ARE FILED HEREWITH, THE REMAINDER OF THE EXHIBITS HAVE HERETOFORE BEEN FILED WITH THE COMMISSION AND ARE INCORPORATED BY REFERENCE. Exhibit Number Exhibits - ------- -------- 3.1 The registrant's Restated Certificate of Incorporation, including all amendments thereto (filed as Exhibit 4.1 to the registrant's Form S-3 Registration Statement No. 33-55402 filed on December 4, 1992 and incorporated herein by reference.) 3.2 The registrant's Restated By-Laws, including all amendments thereto (filed as Exhibit 3.2 to the registrant's Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 4.1 Rights Agreement dated as of June 12, 1986 (the "Rights Agreement") between the registrant and Chemical Trust Company of California, as Rights Agent (filed as Exhibit 2.1 to the registrant's Registration Statement on Form 8- A filed on June 25, 1986 and incorporated herein by reference) and Amendment to Rights Agreement dated July 7, 1988 (filed as Exhibit 28 to the registrant's Current Report on Form 8-K dated July 7, 1988 and incorporated herein by reference.) 4.2 The registrant's credit agreement totalling $150 million with the following financial institutions: Morgan Guaranty Trust Company of New York, Bank of America National Trust and Savings Association, Continental Bank N.A., Deutsche Bank AG, Society National Bank, National Westminster Bank PLC. (The registrant undertakes to furnish a copy of such credit agreement to the Commission upon request.) 4.3 The registrant's unsecured credit facility with a Canadian bank of $26,628,000 (The registrant undertakes to furnish a copy of the credit agreement to the Commission upon request.) 10.1 Agreement to Vary Shareholders Agreement and Plan of Restructuring and for the Sale and Purchase of Shares in McConnell Dowell Investments, Inc. among the registrant, McConnell Dowell Holdings Pty Limited and McConnell Dowell Corporation Limited dated April 29, 1992 (filed as Exhibit 10.4 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.2 Deed of Variation of Class C Notes dated August 14, 1992, and Deed of Indemnity dated August 14, 1992, each entered into pursuant to the Agreement to Vary Shareholders Agreement and Plan of Restructuring and for the Sale and Purchase of Shares in McConnell Dowell Investments, Inc. dated April 29, 1992 (filed as Exhibit 10.6 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.3 Form of Guaranty by the registrant, as Guarantor, in favor of Morgan Guaranty Trust Company of New York, as Trustee (filed as Exhibit 4.2 to Amendment No. 1 to Form S-3 Registration Statement No. 33-50046 filed on October 30, 1992 and incorporated herein by reference.) 10.4 Form of Indenture of Trust between the City of San Diego and Morgan Guaranty Trust Company of New York, as Trustee (filed as Exhibit 4.3 to Amendment No. 1 to Form S-3 Registration Statement No. 33-50046 filed on October 30, 1992 and incorporated herein by reference.) 10.5 Form of Loan Agreement between the City of San Diego and National Steel and Shipbuilding Company (filed as Exhibit 4.4 to Amendment No. 1 to Form S-3 Registration Statement No. 33-50046 filed on October 30, 1992 and incorporated herein by reference.) MANAGEMENT CONTRACT OR COMPENSATORY PLAN OR ARRANGEMENT WHICH IS SEPARATELY IDENTIFIED IN ACCORDANCE WITH ITEM 14(A) (3) OF FORM 10-K. 10.6 The registrant's Executive Incentive Plans for the years 1972 through 1981, inclusive (filed as Exhibit 10.2 to Form 10-K Annual Report for year ended December 31, 1990 and incorporated herein by reference.) 10.7* The registrant's 1982 Executive Incentive Plan, as amended. 10.8 A description of the registrant's Key Executive Disability Insurance Plan (filed as Exhibit 10.12 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.9 The registrant's Key Executive Life Insurance Plan (filed as Exhibit 10.13 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.10 The registrant's Key Executive Long-Term Incentive Plan (filed as Exhibit 10.2 to Form 10-Q Quarterly Report for quarter ended March 31, 1991 and incorporated herein by reference.) 10.11 The registrant's Long-Term Performance Compensation Benefit Plan (filed as Exhibit 10.8 to Form 10-K Annual Report for year ended December 31, 1991 and incorporated herein by reference.) 10.12 The registrant's Stock Incentive Plan, as amended (filed as Exhibit 10.16 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.13 * The registrant's Supplemental Savings Plan, as amended. 10.14 * The registrant's Deferred Compensation Plan. 10.15 Form of registrant's Indemnification Agreement (filed as Exhibit B to Proxy Statement dated March 23, 1987, and incorporated herein by reference.) A schedule listing the individuals with whom the registrant has entered into such agreements is filed herewith. 10.16 Form of registrant's Supplemental Retirement Benefit Agreement (filed as Exhibit 10.6 to Form 10-K Annual Report for year ended December 31, 1988 and incorporated herein by reference.) A schedule listing the individuals with whom the registrant has entered into such agreements is filed herewith. 10.17 Form of registrant's Employment Agreement (filed as Exhibit 10.2 to Form 10-Q Quarterly Report for quarter ended June 30, 1993 and incorporated herein by reference.) A schedule listing the individuals with whom the registrant has entered into such agreements is filed herewith. 10.18 The registrant's Non-Employee Directors' Deferred Compensation Plan, as amended (filed as Exhibit 10.4 to Form 10-K Annual Report for year ended December 31, 1989 and incorporated herein by reference.) 10.19 The registrant's Retirement Plan for Non- Employee Directors, as amended (filed as Exhibit 10.22 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.20 The registrant's Stock Option Plan for Non-Employee Directors, as amended (filed as Exhibit 10.23 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.) 10.21 The registrant's employment agreement with William J. Agee dated April 2, 1991 (filed as Exhibit 10.1 to Form 10-Q Quarterly Report for quarter ended March 31, 1991 and incorporated herein by reference.) 10.22 The registrant's Key Executive Long-Term Incentive Plan Participation Agreement with William J. Agee dated November 1, 1991, amending the registrant's employment agreement with William J. Agee dated April 2, 1991 (filed as Exhibit 10.16 to Form 10-K Annual Report for year ended December 31, 1991 and incorporated herein by reference.) 10.23 The registrant's Supplemental Retirement Benefit Agreement with William J. Agee dated April 2, 1991 (filed as Exhibit 10.26 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.). 10.24 The registrant's Deferred Compensation Agreement with Stephen Grant dated January 1, 1989 (filed as Exhibit 10.27 to Form 10-K Annual Report for year ended December 31, 1992 and incorporated herein by reference.). 10.25 The registrant's Amendment to Deferred Compensation Agreement with Stephen R. Grant dated July 15, 1993 (filed as Exhibit 10.3 to Form 10-Q Quarterly Report for quarter ended June 30, 1993 and incorporated herein by reference.) 10.26 * The registrant's employment agreement with Gunnar E. Sarsten dated as of March 1, 1994. 13. * The registrant's Annual Report to Stockholders for the year ended December 31, 1993, furnished for the information of the SEC and not deemed to be "filed" as part of the Form 10-K filing. 21. * Subsidiaries of the registrant. 23. * Consent of Deloitte & Touche, independent auditors. 24. * Powers of Attorney.

852772_1993.txt

852772_1993

1993

852772

ITEM 1. BUSINESS INTRODUCTION Flagstar Companies, Inc. ("FCI"), through its wholly-owned subsidiary Flagstar Corporation ("Flagstar"), is one of the largest food service enterprises in the United States, operating (directly and through franchisees) 2,500 moderately priced restaurants and providing contract food services to more than 1,600 business, industrial and institutional clients and vending services at approximately 11,400 locations. The Company's restaurant operations are conducted through three principal chains. Denny's is the nation's largest chain of family-oriented full service restaurants, with over 1,500 units in 49 states and eight foreign countries, including 490 in California and Florida. According to an independent survey conducted in 1993, Denny's has the leading share of the national market in the family segment. Hardee's is a chain of fast-food restaurants of which the Company, with 564 units located primarily in the southeast, is the largest franchisee. Although specializing in sandwiches, the Company's Hardee's restaurants have introduced fresh fried chicken and also offer a breakfast menu that accounts for approximately 38% of total sales and features the chain's famous "made-from-scratch" biscuits. Quincy's, with more than 200 locations, is one of the largest chains of steakhouse restaurants in the southeastern United States, offering steak, chicken and seafood entrees as well as a buffet food bar, called the "Country Sideboard," that features as many as 87 different items. A weekend breakfast buffet is available at most Quincy's locations. The Company also operates El Pollo Loco, a chain of fast-food restaurants featuring flame-broiled chicken and steak products and related Mexican food items, with a strong regional presence in California. Although operating in three distinct segments of the restaurant industry -- family-style, fast-food and steakhouse -- the Company's restaurants benefit from a single management strategy that emphasizes superior value and quality, friendly and attentive service and appealing facilities. During the past year, the Company has remodeled 59 of its existing restaurants and added a net of 86 new restaurants to its principal chains. The Company's contract food and vending services are conducted through Canteen, one of the three largest contract food and vending companies in the nation. Canteen also operates food, beverage and lodging facilities and gift shops and provides ancillary services at various national and state parks, sports stadiums, amphitheaters and arenas throughout the United States. FCI is a holding company that was organized in Delaware in 1988 in order to effect the acquisition of Flagstar in 1989. On November 16, 1992, FCI and Flagstar consummated the principal elements of a recapitalization (the "Recapitalization"), which included, among other things, an equity investment by TW Associates, L.P. ("TW Associates") and KKR Partners II, L.P. ("KKR Partners II") (collectively, "Associates"), partnerships affiliated with Kohlberg Kravis Roberts & Co. ("KKR"), and a restructuring of Flagstar's bank credit facility and public debt securities. As a result of such transactions, Associates acquired control of FCI and Flagstar. Prior to June 16, 1993, FCI and Flagstar had been known, respectively, as TW Holdings, Inc. and TW Services, Inc. As used herein, the term "Company" includes, in addition to FCI, Flagstar and its subsidiaries, except as the context otherwise requires. GENERAL The Company's operating revenues and operating income by business segment for the periods shown were as follows: (1) Operating income by business segment reflects the write-off of goodwill and other intangible assets and the provision for restructuring charges (see Notes 2 and 3 to the Consolidated Financial Statements) as follows: restaurants $1,265.6 million, contract food service $359.8 million, and corporate, net $41.4 million. For additional financial information about the Company's business segments, see Note 14 of the Notes to Consolidated Financial Statements appearing elsewhere herein. On July 1, 1993, culminating a dialogue which began in early 1992, the Company signed a Fair Share Agreement with the NAACP "as a commitment to continue and expand opportunities at Flagstar for African-American and other minorities." Pursuant to that agreement, the Company agreed to place special emphasis on management and employment advancement, advertising and marketing, franchising opportunities, purchasing and professional service opportunities, philanthropic and charitable contributions and policy development, to enhance policies and programs by which African-Americans and other minorities realize greater participation in business opportunities at Flagstar. The Company and the NAACP have agreed to meet quarterly during the first year of the agreement and semiannually thereafter to review progress toward the stated goals of the agreement. RESTAURANTS The Company believes its restaurant operations benefit from the diversity of the restaurant concepts represented by its three principal chains, the strong market positions and consumer recognition enjoyed by each of these chains, the benefits of a centralized support system for purchasing, menu development, human resources, management information systems, site selection, restaurant design and construction, and an aggressive new management team. The Company owns or has rights in all trademarks it believes are material to its restaurant operations. Denny's and Quincy's are expected to benefit from the demographic trend of aging baby boomers and the growing population of elderly persons. The largest percentage of "family style" customers comes from the 35 and up age group. The Company also expects its chain of Hardee's restaurants to maintain its strong market position in the southeast. During the fourth quarter of 1993, the Company approved a restructuring plan which includes the identification of units that have produced inadequate returns on investment, have been difficult to supervise or lack market penetration so that such units can be sold, closed or converted to another restaurant concept. These actions should result in a redeployment of capital to activities which produce a higher rate of return. Accordingly, such units were written down to their net realizable value. The plan includes changes to the field management structure which will eliminate a layer of management, increasing the regional manager's "span of control" and expanding the restaurant general manager's decision making role. Also, the Company will consolidate certain Company operations and eliminate overhead positions in the field and in its corporate marketing, accounting, and administrative functions. The Company's restructuring charge reflected in the accompanying Consolidated Financial Statements includes the severance and relocation costs related to these changes. The plan includes specific action plans to fundamentally change the competitive positions of Denny's, El Pollo Loco, and Quincy's, as discussed below. DENNY'S (1) Includes distribution and processing operations. (2) Operating income reflects the write-off of goodwill and other intangible assets and the provision for restructuring charges for the year ended December 31, 1993 of $716 million. Denny's is the largest full-service family restaurant chain in the United States in terms of both number of units and total revenues and, according to an independent survey conducted in 1993 by Consumer Reports on Eating Share Trends (CREST), an industry market research firm, Denny's has the leading share of the national market in the family segment. Denny's restaurants currently operate in 49 states and eight foreign countries, with principal concentrations in California, Florida, Texas, Washington, Arizona, Illinois, Pennsylvania and Ohio. Denny's restaurants are designed to provide a casual dining atmosphere with moderately priced food and quick, efficient service to a broad spectrum of customers. The restaurants generally are open 24 hours a day, seven days a week. All Denny's restaurants have uniform menus (with some regional and seasonal variations) offering traditional family fare (including breakfast, steaks, seafood, hamburgers, chicken and sandwiches) and provide both counter and table service for breakfast, lunch and dinner as well as a "late night" menu. The Company acquired the Denny's chain in September 1987. Since the acquisition, the Company has reduced corporate level overhead (including through the relocation of key operating personnel to the Company's Spartanburg, South Carolina headquarters), accelerated Denny's remodeling program, added point-of-sale ("POS") systems to the chain's restaurants, simplified the menu and created new advertising and marketing programs. The Company remodeled 125 Denny's restaurants in 1992 and another 41 in 1993, raising the total number of restaurants remodeled since the Company's aquisition of Denny's to over one-half of all Denny's restaurants. The Company expects to remodel approximately 90 units this year so that, by the end of 1994, Company-owned Denny's restaurants will be remodeled on an eight year cycle. A typical Denny's remodeling requires approximately ten days to complete (with the temporary closing of the restaurant), is managed by the Company's in-house design and construction staff, and currently costs approximately $265,000 per unit. The 90 units to be remodeled in 1994 will represent the first phase in a "reimaging" strategy. This reimaging strategy includes an updated exterior look, new signage, an improved interior layout with more comfortable seating and enhanced lighting. Reimaging also includes a new menu, new menu offerings, new uniforms, and enhanced dessert offerings, including a current market test of Baskin-Robbins ice cream. The Company believes this reimaging program, currently being tested at its units in Houston, will increase customer satisfaction and customer traffic. The Company completed the rollout of its Denny's restaurants with POS systems in January 1993. This system provides hourly sales reports, cash control and marketing data and information regarding product volumes. POS systems improve labor scheduling, provide information to evaluate more effectively the impact of menu changes on sales, and reduce the paperwork of managers. Additional efficiency improvements are being designed in 1994. Marketing initiatives in 1994 will emphasize positioning Denny's as the price value leader within its segment, initially concentrating on breakfast. The Company intends to support these initiatives by expanding the number of media markets and using co-op advertising with franchisees in other markets. These promotions are designed to capitalize on the strong public recognition of the Denny's name. The Company intends to open relatively few Company-owned Denny's restaurants and to expand its franchising efforts in 1994 in order to increase its market share, establish a presence in new areas and further penetrate existing markets. To accelerate the franchise expansion, the Company will identify units to sell to franchisees which are not part of its growth strategy for Company-owned Denny's units. These units are in addition to 105 units that are to be sold to franchisees or closed under the Company's restructuring plan. The restructured field management infrastructures established to serve the existing Denny's system are expected to provide sufficient support for additional units with moderate incremental expense. Expanded franchising also will permit the Company to exploit smaller markets where a franchisee's ties to the local community are advantageous. During 1993, the Company added a net of 49 new Denny's franchises, bringing total franchised units to 427, or 28% of all Denny's restaurants. The initial fee for a single Denny's franchise is $35,000, and the current royalty payment is 4% of gross sales. In 1993, Denny's realized $33.5 million of revenues from franchising. Franchisees also purchase food and supplies from a Company subsidiary. During 1993, the Company also made certain changes in the management of Denny's, including the appointment of C. Ronald Petty as chief operating officer. Mr. Petty, 49, has twenty years of experience in the food service industry, including senior leadership positions with other national restaurant chains. Mr. Petty has assumed overall responsibility for the operation of the Denny's chain. HARDEE'S (1) Operating income reflects the write-off of goodwill and other intangible assets and the provision for restructuring charges for the year ended December 31, 1993 of $260 million. The Company's Hardee's restaurants are operated under licenses from Hardee's Food Systems, Inc. ("HFS"). The Company is HFS' largest franchisee, operating 17% of Hardee's restaurants nationwide. HFS is the third largest sandwich chain in the United States. Of the 564 Hardee's restaurants operated by the Company at December 31, 1993, 544 were located in ten southeastern states. The Company's Hardee's restaurants provide uniform menus in a fast-food format targeted to a broad spectrum of customers. The restaurants offer hamburgers, chicken, roast beef and fish sandwiches, hot dogs, salads and low-fat yogurt, as well as a breakfast menu featuring Hardee's popular "made-from-scratch" biscuits. To add variety to its menu, further differentiate its restaurants from those of its major competitors and increase customer traffic during the traditionally slower late afternoon and evening periods, HFS added fresh fried chicken as a menu item in a number of its restaurants beginning in 1991. The Company first tested fresh fried chicken in one of its market areas in October 1991. Based on the success experienced in this market area and the early success experienced by HFS, the Company accelerated the introduction of fresh fried chicken as a regular menu item during 1992 and completed the planned rollout in 1993. Substantially all of the Company's Hardee's restaurants have drive-thru facilities, which provided 51% of the chain's revenues in 1993. Most of the restaurants are open 18 hours a day, seven days a week. Operating hours of selected units have been extended to 24 hours a day, primarily on weekends. Hardee's breakfast menu, featuring the chain's signature "made-from-scratch" biscuits, accounts for approximately 38% of total sales at the Company's Hardee's restaurants. The Company plans to remodel its Hardee's restaurants every ten years at a current average cost of $175,000 per unit for major remodels. Each Hardee's restaurant is operated under a separate license from HFS. Each license grants the exclusive right, in exchange for a franchise fee, royalty payments and certain covenants, to operate a Hardee's restaurant in a described territory, generally a town or an area measured by a radius from the restaurant site. Each license has a term of 20 years from the date the restaurant is first opened for business and is non-cancellable by HFS, except for the Company's failure to abide by its covenants. Earlier issued license agreements are renewable under HFS' renewal policy; more recent license agreements provide for successive five-year renewals upon expiration, generally at rates then in effect for new licenses. A number of the Company's licenses are scheduled for renewal. The Company has historically experienced no difficulty in obtaining such renewals and does not anticipate any problems in the future. The Company has a territorial development agreement with HFS which calls for the Company to open an additional 69 new Hardee's restaurants in its existing development territory in the southeast (and certain adjacent areas) by the end of 1996. The Company presently plans to open new restaurants in an amount not less than that required by the territorial development agreement. It is anticipated that construction of 69 additional units will require approximately $69 million in capital expenditures. If the Company determines not to open the total number of specified units in the territory within the time provided, its development rights may become non-exclusive. The Company may seek to expand its Hardee's operations by purchasing existing Hardee's units from HFS and other franchisees, subject to HFS' right of first refusal, but any such purchases will not be counted toward the number of new unit openings called for under the agreement. QUINCY'S (1) Operating income reflects the write-off of goodwill and other intangible assets and the provision for restructuring charges for the year ended December 31, 1993 of $164 million. Ranked by 1993 sales, Quincy's is the sixth largest steakhouse chain in the country and one of the largest such chains in the southeastern United States. The Quincy's chain consists of 213 Company-owned restaurants at December 31, 1993 which are designed to provide families with limited-service dining at moderate prices. All Quincy's are open seven days a week for lunch and dinner. The restaurants serve steak, chicken and seafood entrees along with a buffet-style food bar, called the "Country Sideboard," offering hot foods, soups, salads and desserts and featuring as many as 87 items at a time. In addition, weekend breakfast service, which is available at most locations, allows Quincy's to utilize its asset base more efficiently. Since 1986 Quincy's has remodeled approximately 85 restaurants to expand seating capacity from approximately 225 to approximately 280 seats. During 1993, seven units were remodeled to introduce the new scatter bar format. The Company also began testing a unit concept conversion in 1993 by remodeling and converting three steakhouses in Columbia, S.C., to a buffet only concept. Under the Company's restructuring plan, 90 units have been identified that currently are not producing adequate returns and, therefore, are to be converted, sold, or closed. Upon successful completion of its concept conversion tests, the Company plans to convert most of these units to the buffet only concept or other concepts under consideration. The concept remodels are expected to have an average cost of approximately $250,000 per unit. EL POLLO LOCO El Pollo Loco, which accounted for only 4.2% of the Company's total restaurant revenues (2.7% of consolidated revenues) in the year ended December 31, 1993, is the leading chain in the quick service chain segment of the restaurant industry to specialize in flame-broiled chicken. As of December 31, 1993, there were 209 El Pollo Loco units (of which 139 were operated by the Company, 64 were operated by franchisees and 6 were operated under foreign licensing agreements). Approximately 92% of these restaurants are located in southern California. El Pollo Loco directs its marketing at customers desiring an alternative to other fast food products. The Company's El Pollo Loco restaurants are designed to facilitate customer viewing of the preparation of the flame-broiled chicken. El Pollo Loco restaurants generally are open 12 hours a day, seven days per week. El Pollo Loco restaurants feature a limited, but expanding menu highlighted by marinated flame-broiled chicken and steak products and related Mexican food items. As a part of the restructuring plan, the Company has identified 45 units which do not generate an adequate return on investment, and thus will be sold to franchisees or closed. The Company's restructuring plan includes reimaging the existing units through a limited remodeling program, expanded menu items (including fried foods) and an all-you-can-eat salsa bar. These changes are intended to increase customer satisfaction and expand the customer market resulting in higher customer traffic. OPERATIONS The Company believes that successful execution of basic restaurant operations in each of its restaurant chains is critical to its success. Accordingly, significant effort is devoted to ensuring that all restaurants offer quality food and service. Through a network of division leaders, region leaders, district leaders and restaurant managers, the Company standardizes specifications for the preparation and efficient service of quality food, the maintenance and repair of its premises and the appearance and conduct of its employees. Major emphasis is placed on the proper preparation and delivery of the product to the consumer and on the cost-effective procurement and distribution of quality products. A principal feature of the Company's restaurant operations is the constant focus on improving operations at the unit level. Unit managers are especially hands-on and versatile in their supervisory activities. Region and district leaders have no offices and spend substantially all of their time in the restaurants. A significant majority of restaurant management personnel began as hourly employees in the restaurants and therefore perform restaurant functions and train by example. The Company benefits from an experienced management team. Each of the Company's restaurant chains maintains training programs for employees and restaurant managers. Restaurant managers and assistant managers receive training at specially designated training units. Areas of training for managers include customer interaction, kitchen management and food preparation, data processing and cost control techniques, equipment and building maintenance and leadership skills. Video training tapes demonstrating various restaurant job functions are located at each restaurant location and are viewed by employees prior to a change in job function or utilizing new equipment or procedures. Each of the Company's restaurant chains continuously evaluates its menu. New products are developed in Company test kitchens and then introduced in selected restaurants to determine customer response and to ensure that consistency, quality standards and profitability are maintained. If a new item proves successful at the research and development level, it is usually tested in selected markets, both with and without market support. A successful menu item is then incorporated into the restaurant system. In the case of the Hardee's restaurants, menu development is coordinated through HFS. Financial and management control of the Company's restaurants is facilitated by the use of POS systems. Detailed sales reports, payroll data and periodic inventory information are transmitted to the Company for management review. These systems economically collect accounting data and enhance the Company's ability to control and manage these restaurant operations. Such systems are in use in all of the Company's Hardee's and Quincy's restaurants, and installation of such systems in the Denny's chain was completed in January 1993. Denny's size allows it to operate its own distribution and supply facilities, thereby controlling costs and improving efficiency of food delivery while enhancing quality and availability of products. Denny's operates seven regional centers for distribution of substantially all of the ingredients and supplies used by the Denny's restaurants. As opportunities arise, the Company is extending these operations to its other restaurant chains. The Company also operates a food-processing facility in Texas which supplies beef, pork sausage, soup and many other food products currently used by the Company's restaurants. Food and packaging products for the Company's Hardee's restaurants are purchased from HFS and independent suppliers approved by HFS. A substantial portion of the products for the Company's Hardee's and Quincy's restaurants is obtained from MBM Corporation, an independent supplier/distributor. Adequate alternative sources of supply for required items are believed to be available. ADVERTISING Denny's primarily relies upon regional television and radio advertising. Advertising expenses for Denny's restaurants were $41.1 million for 1993, or about 3.1% of Denny's system-wide restaurant revenues. Individual restaurants are also given the discretion to conduct local advertising campaigns. In accordance with HFS licensing agreements, the Company spends approximately 5.6% of Hardee's total gross sales on marketing and advertising. Of this amount, approximately 2.4% of total gross sales is contributed to media cooperatives and HFS' national advertising fund. The balance is directed by the Company on local levels. HFS engages in substantial advertising and promotional activities to maintain and enhance the Hardee's system and image. The Company participates with HFS in planning promotions and television support for the Company's primary markets and engages in local radio, outdoor and print advertising for its Hardee's operations. The Company, together with a regional advertising agency, advertises its Quincy's restaurants primarily through print, radio and billboards. Quincy's has focused on in-store promotions as well as regional marketing. The Company spent approximately 4.1% of Quincy's gross sales on Quincy's marketing in 1993. During 1993, El Pollo Loco's advertising focused on promoting large meals and menu variety. SITE SELECTION The success of any restaurant depends, to a large extent, on its location. The site selection process for Company-owned restaurants consists of three main phases: strategic planning, site identification and detailed site review. The planning phase ensures that restaurants are located in strategic markets. In the site identification phase, the major trade areas within a market area are analyzed and a potential site identified. The final and most time consuming phase is the detailed site review. In this phase, the site's demographics, traffic and pedestrian counts, visibility, building constraints and competition are studied in detail. A detailed budget and return on investment analysis are also completed. The Company considers its site selection standards and procedures to be rigorous and will not compromise those standards or procedures in order to achieve accelerated growth. CONTRACT FOOD, VENDING AND RECREATION SERVICES (1) Operating income reflects the write-off of goodwill and other intangible assets and the provision for restructuring charges for the year ended December 31, 1993 of $360 million. Through Canteen, the Company conducts its contract food and vending services on a national basis. According to NATION'S RESTAURANT NEWS (published August 9, 1993), Canteen is the third largest provider of contract food and vending services in the United States (on the basis of U.S. system-wide sales). It had approximately 1,600 food service clients and served approximately 11,400 vending locations at December 31, 1993. Canteen provides its clients with on-site food preparation, cooking and service as well as vending machines that dispense a variety of food and beverage products. These services are offered both independently and in conjunction with each other. Canteen also grants franchises to distributors to operate contract food service facilities and vending businesses. In addition, Canteen licenses its trademark internationally and currently has licensees in Japan and Sweden. Canteen provides both its franchised distributors and international licensees with marketing assistance, training, purchasing services and financial and accounting systems. Canteen's concession and recreation services operations provide food, beverage, novelty, and ancillary services in sports stadiums, amphitheaters, arenas and other locations, including five major league baseball parks (Hubert H. Humphrey Metrodome, Oakland-Alameda County Coliseum, Royals Stadium, Yankee Stadium and Candlestick Park), five minor league baseball parks and five professional football stadiums (Arrowhead Stadium, Hubert H. Humphrey Metrodome, Los Angeles Coliseum, Tampa Stadium and Candlestick Park). It operates food, beverage and lodging facilities and gift shops and provides other ancillary services at a number of national parks (including Yellowstone, Mount Rushmore, Everglades, Bryce Canyon, Zion and the North Rim of the Grand Canyon) and at state parks in Ohio and New York. In addition, Canteen operates food and beverage services, gift shops, bus tours and the IMAX Theatre at Spaceport USA at the Kennedy Space Center. Contracts to provide these services usually are obtained on the basis of competitive bids. In most instances, Canteen receives the exclusive right to provide the services in a particular location for a period of several years, with the duration of the term often a function of the required investment in facilities or other financial considerations. Canteen's contract food service and vending operations are conducted throughout the United States. Approximately 30% of the Company's revenues from these operations are derived from industrial plants in the automotive, defense and other manufacturing industries. These industries have experienced a general reduction in employment over the past several years, which has been accelerated by the nation's recent recession. To ameliorate the effects of this trend, Canteen has increased its penetration of the educational, lifecare and correctional facility markets and has targeted these (along with concession and recreation services) as areas of potential growth. These target markets, which accounted for 39% of Canteen's revenues in 1993, are recession-resistant and, at present, are not widely served by contract food service companies. Management believes that growing budgetary pressures on institutions in these target markets should favor their increasing reliance on private sector contractors who can provide required food service at lower costs. As part of the restructuring plan, the Company will de-emphasize vending operations in certain markets resulting in the sale of certain vending branches, with the related severance and lease buy-out costs included in the restructuring charges. Canteen operates through four primary divisions: the Eastern, Central, and California divisions within the food and vending divisions, and the concession and recreation services division. These operations are managed on a regional basis, each of which is led by a regional vice president with responsibility for operations, sales and marketing in the assigned area. Field operations are supported by centralized legal, human resources, finance, purchasing, data processing and other services. Formal training programs on a variety of subjects are regularly provided to field personnel at 28 learning centers maintained on clients' premises and at other on-site locations. In addition, management training is provided at the Company's central training facility in Spartanburg, South Carolina. Canteen has improved its performance and responsiveness to clients by transferring more responsibility to field operations, while at the same time ensuring that innovative ideas for servicing the customer are shared across operations. Redundant accounting functions were reduced when Canteen closed 12 field accounting centers in 1993. The restructuring plan includes severance and other costs related to further consolidation of accounting and administrative functions. These steps have created a more focused and responsive operational structure and reduced administrative costs. Canteen normally contracts with customers for food and vending services on a local basis, but, in the case of national customers, it may serve many geographically dispersed facilities. Approximately 47% of Canteen's food service accounts are conducted under management fee arrangements, whereby Canteen typically receives a fixed dollar amount or a fixed percentage of revenues in return for providing food services at price and service levels determined by its clients. Management fee arrangements are prevalent where companies subsidize food services as part of the benefits provided to employees. In other food service accounts, Canteen contracts to provide food service on a profit/loss basis. In the case of vending operations, service is predominantly provided on a profit/loss basis, and a commission is usually payable by Canteen to the owner of the premises on which the vending machines are located. The ability of Canteen to increase its prices in order to cover its cost increases is an important factor in maintaining satisfactory profit levels from operations not conducted pursuant to management fee arrangements. Canteen's ability to increase prices is materially affected by competitive factors and resistance from consumers and from firms and institutions on whose premises Canteen's operations are conducted and whose prior approval is usually required. Food and vending service contracts generally may be terminated on short notice given by either side. The equipment, other than vending equipment (which can be moved to another location), used by Canteen at an on-site operation is usually owned by its customer. New business is obtained primarily through solicitation of new customers and responding to requests for bids. In competitive bid situations, financial terms as well as other factors, such as reputation and ability to perform, influence customers' decisions in awarding contracts, particularly in the private sector. Canteen capitalizes on its name recognition and owns or has rights in all trademarks it believes are material to its operations. Canteen's sales force is decentralized in order to tailor sales efforts to customers in various regions. As opportunities arise, Canteen also seeks to expand its operations through the acquisition of small regional food service companies that can be integrated into its existing operations. COMPETITION The restaurant industry can be divided into three main categories: quick service (fast-food), midscale (family) and upscale (dinner house). The quick service segment (which includes Hardee's and El Pollo Loco) is overwhelmingly dominated by the large sandwich, pizza and chicken chains. The midscale segment (which includes Denny's and Quincy's) includes a much smaller number of national chains and many local and regional chains, as well as thousands of independent operators. The upscale segment consists primarily of small independents in addition to several regional chains. The restaurant industry is highly competitive and affected by many factors, including changes in economic conditions affecting consumer spending, changes in socio-demographic characteristics of areas in which restaurants are located, changes in customer tastes and preferences and increases in the number of restaurants generally and in particular areas. Competition among a few major companies that own or operate fast-food restaurant chains is especially intense. Restaurants, particularly those in the fast-food segment, compete on the basis of name recognition and advertising, the quality and perceived value of their food offerings, the quality and speed of their service, the attractiveness of their facilities and, to a large degree in a recessionary environment, price and perceived value. Denny's, which has a strong national presence, competes primarily with regional family chains such as IHOP, Big Boy, Shoney's, Friendly's and Perkins -- all of which are ranked among the top six midscale restaurant chains. According to an independent survey conducted during 1993, Denny's had a 14.4% share of the national market in the family segment. Hardee's restaurants compete principally with four other national fast food chains: McDonald's, Burger King, Wendy's and Taco Bell. In addition, Hardee's restaurants compete with fast-food restaurants serving other kinds of foods, such as chicken outlets (e.g., Kentucky Fried and Bojangles), family restaurants (e.g., Shoney's and Friendly's) and dinner houses. Management believes that Hardee's has the highest breakfast sales per unit of any major fast-food restaurant chain. Quincy's primary competitors include Ryan's and Western Sizzlin', both of which are based in the southeast. Quincy's also competes with other family restaurants and with dinner houses and fast-food outlets. Nationwide, the top five chains are Sizzler, Ponderosa, Golden Corral, Ryan's, and Western Sizzlin'. According to NATION'S RESTAURANT NEWS (published August 9, 1993), Quincy's ranked sixth nationwide in system-wide sales and third in sales per unit among the steak chains. All aspects of Canteen's operations are highly competitive. Competition takes a number of different forms, including pricing, capital investment, maintaining food and service standards and securing and maintaining accounts with firms and institutions. Canteen competes with several national and a large number of local and regional companies, some of which, including Marriott and ARA, are substantial in size and scope. In addition, firms and institutions may, as an alternative to using a food service company such as Canteen, operate vending and food service businesses themselves. Many Canteen facilities must also compete with local alternatives such as restaurants, sandwich shops, convenience stores, delicatessans and other public arenas, convention centers, and entertainment venues. EMPLOYEES At December 31, 1993, the Company had approximately 123,000 employees, of whom 88,000 were employed in restaurant operations and 34,000 were engaged in contract food, vending and recreation services. Less than 1% of the restaurant employees are union members. Many of the Company's restaurant employees work part time, and many are paid at or slightly above minimum wage levels. Approximately 20% of Canteen's employees are unionized. The Company has experienced no significant work stoppages and considers its relations with its employees to be satisfactory. ITEM 2. ITEM 2. PROPERTIES Most of the Company's restaurants are free-standing facilities. An average Denny's restaurant ranges from 3,900 to 5,800 square feet and seats 100 to 175 customers. Denny's restaurants generally occupy 35,000 to 45,000 square feet of land. An average Hardee's restaurant operated by the Company has approximately 3,300 square feet and provides seating for 94 persons, and most have drive-thru facilities. Each of the Company's Hardee's restaurants occupies approximately 50,000 square feet of land. The average Quincy's restaurant has approximately 7,100 square feet and provides seating for 250 persons. Each Quincy's restaurant occupies approximately 63,000 square feet of land. A typical El Pollo Loco restaurant has 2,250 square feet and seats 66 customers. The following table sets forth certain information regarding the Company's restaurant properties as of December 31, 1993: The number and location of the Company's restaurants in each chain as of December 31, 1993 are presented below: At December 31, 1993, the Company owned seven warehouses in California, Illinois, Florida, Pennsylvania, Texas and Washington, and one manufacturing facility in Texas. At that date, Canteen owned approximately 94,600 vending machines in its food and vending service operations, of which approximately 6,700 were leased to distributors. In addition, Canteen owned approximately 42 buildings with approximately 704,000 square feet and leased approximately 934,000 square feet for warehousing and office space throughout the United States for use in its food and vending services and recreation services operations. The Company also owns a 19-story, 187,000 square foot office tower, which serves as its corporate headquarters, located in Spartanburg, South Carolina. The Company's corporate offices currently occupy approximately 14 floors of the tower, with the balance leased to others. See Item 13. Certain Relationships and Related Transactions -- Description of Indebtedness and Note 4 to the accompanying Consolidated Financial Statements for information concerning encumbrances on certain properties of the Company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Trans World Airlines, Inc. ("TWA") commenced a lawsuit on October 8, 1986 against Transworld Corporation ("Transworld"), certain contingent liabilities of which were assumed by Flagstar, and against certain of its past and present directors and certain former TWA directors, in the Supreme Court of the State of New York, New York County, alleging fraud and breach of fiduciary obligations in the execution and subsequent termination of a tax allocation agreement between Transworld and its former subsidiary, TWA. TWA's complaint seeks the following remedies: (i) damages equal to $52 million for investment tax credits ("ITC") claimed by Transworld on its 1984 federal income tax return, (ii) damages equal to the "present value" of Transworld's potential liability to TWA as of December 31, 1983 for net operating losses and ITC claimed by Transworld, including the $52 million in ITC, (iii) the voiding of a tax allocation agreement and damages to be determined at trial, or (iv) the voiding of certain sections of the tax allocation agreement and the payment to TWA of certain amounts as provided in such tax allocation agreement. There has been no activity relating to this lawsuit since 1988. FCI, Flagstar, El Pollo Loco and Denny's, along with several officers and directors of those companies, have been named as defendants in an action filed on August 28, 1991 in the Superior Court of Orange County, California. The plaintiffs are several current and former El Pollo Loco franchisees. They allege that the defendants, among other things, failed or caused a failure to promote, develop and expand the El Pollo Loco franchise system in breach of contractual obligations to the plaintiff franchisees and made certain misrepresentations to the plaintiffs concerning the El Pollo Loco system. Asserting various legal theories, the plaintiffs seek actual and punitive damages in excess of $90 million, together with declaratory and certain other equitable relief. FCI, Flagstar and the other defendants have filed answers in this action. FCI and Flagstar have also filed cross-complaints against various plaintiffs in the action for breach of contract and other claims. Discovery has not yet been completed. Accordingly, it is premature for the Company to express a judgment herein as to the likely outcome of the action. The defendants, through counsel, intend to defend the action vigorously. The Company has received proposed deficiencies from the Internal Revenue Service (the "IRS") for federal income taxes and penalties totalling approximately $46.6 million. Proposed deficiencies of $34.3 million relate to examinations of certain income tax returns filed by Denny's for periods ending prior to Flagstar's purchase of Denny's on September 11, 1987. The deficiencies primarily involve the proposed disallowance of certain expenses associated with borrowings and other costs incurred at the time of the leveraged buy-out of Denny's in 1985 and the purchase of Denny's by Flagstar in 1987. The Company has filed protests of the proposed deficiencies with the Appeals Division of the IRS, stating that, with minor exceptions, it believes the proposed deficiencies are erroneous. The Company and the IRS have reached a preliminary agreement on substantially all of the issues included in the original proposed deficiency. Based on this preliminary agreement, the IRS has agreed to waive all penalties, and the Company estimates that its ultimate federal income tax deficiency will be less than $5 million. The remaining $12.3 million of proposed deficiencies relates to examinations of certain income tax returns filed by the Company for the four fiscal years ended December 31, 1989. The deficiencies primarily involve the proposed disallowance of deductions associated with borrowings and other costs incurred prior to, at and just following the time of the acquisition of Flagstar in 1989. The Company intends to vigorously contest the proposed deficiencies because it believes the proposed deficiencies are substantially incorrect. On March 26, 1993, a consent decree was signed by Flagstar and its subsidiary Denny's, Inc. and by the U.S. Department of Justice with respect to a complaint filed by the Department of Justice on that same date in the U.S. District Court for the Northern District of California. Such complaint alleged that the Company, through Denny's, had engaged in a pattern or practice of discrimination against African-American customers. The Company denied any wrongdoing. The consent decree, which was approved by the court on April 1, 1993, enjoins the Company from racial discrimination and requires the Company to implement certain employee training and testing programs and provide public notice of Denny's non-discrimination policies. It carries no direct monetary penalties. In a related matter, on March 24, 1993, a public accommodations lawsuit was filed against the Company by certain private plaintiffs in the U.S. District Court for the Northern District of California alleging that certain Denny's restaurants in California have engaged in racially discriminatory practices and seeking certification as a class action in California, unspecified actual, compensatory and punitive damages, and injunctive relief. The Company is also a defendant in various other public accommodations actions brought in various jurisdictions. The principal additional action was filed on May 24, 1993 in Maryland. This action was filed in the U.S. District for the District of Maryland, alleging that a Denny's restaurant in Annapolis, Maryland engaged in racially discriminatory practices, and seeks certification as a class action covering all states except California, unspecified actual compensatory and punitive damages, and injunctive relief. Other individual public accommodations cases have also been filed, including some cases which allege substantial compensatory and punitive damages for each plaintiff, statutory damages and injunctive relief. Discovery in these actions has not yet been completed. Class certification hearings in the two purported class actions are scheduled to occur in 1994. The Company believes that these actions lack merit and, unless there is an early resolution thereof, intends to defend them vigorously. The Company is also the subject of pending and threatened employment discrimination claims principally in California and Alabama. In certain of these claims, the plaintiffs have threatened to seek to represent a class alleging racial discrimination in employment practices at Company restaurants and to seek actual, compensatory and punitive damages, and injunctive relief. The Company believes that these claims also lack merit and, unless there is an early resolution thereof, intends to defend them vigorously. The parties in the foregoing actions have explored and continue to explore the possibility of reaching an early resolution of these matters in an effort to avoid the costs and risks of litigation. No assurances can be given, however, that these matters can be resolved on mutually acceptable terms. Other proceedings are pending against the Company, in many cases involving ordinary and routine claims incidental to the business of the Company, and in others presenting allegations that are nonroutine and include compensatory or punitive damage claims. The ultimate legal and financial liability of the Company with respect to the matters mentioned above and these other proceedings cannot be estimated with certainty. However, the Company believes, based on its examination of these matters and its experience to date, that sufficient accruals have been established by the Company to provide for known contingencies. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of FCI, $.50 par value per share (the "Common Stock"), is currently traded on the NASDAQ National Market System using the symbol "FLST." As of March 31, 1994, 42,369,319 shares of Common Stock were outstanding, and there were approximately 13,000 record and beneficial stockholders. FCI has not paid and does not expect to pay dividends on its outstanding Common Stock. Restrictions contained in the instruments governing the outstanding indebtedness of Flagstar restrict its ability to provide funds that might otherwise be used by FCI for the payment of dividends on its Common Stock. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources and Note 4 to the accompanying Consolidated Financial Statements of the Company. The closing sales prices indicated below for the Common Stock were obtained from the National Association of Securities Dealers, Inc. and have been adjusted on a retroactive basis to reflect FCI's 5-for-1 reverse stock split with respect to the Common Stock effected as of June 16, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Set forth below are certain selected financial data concerning the Company for each of the five years ended December 31, 1993. Such data have been derived from the Consolidated Financial Statements of the Company for such periods which have been audited. The following information should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto presented elsewhere herein and Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with Item 6. Selected Financial Data and the Consolidated Financial Statements and other more detailed financial information appearing elsewhere herein. 1993 COMPARED TO 1992 Operating revenues for 1993 increased by approximately $249.9 million (6.7%) as compared with 1992. This increase was the result of a $155.9 million (6.4%) increase in revenues from restaurant operations and a $94.0 million (7.4%) increase in revenues from Canteen's contract food service operations. Canteen's concession and recreation revenues increased by $35.0 million (12.2%) and its food and vending revenues increased by $59.0 million (6.0%) as compared with 1992, primarily as a result of regional acquisitions. Food and vending revenues from Canteen's existing customer base continue to be adversely impacted by reduced employment levels at Canteen's business and industrial accounts. Denny's revenues increased $80.8 million (5.6%) principally as a result of the following: an 11-unit increase in the number of Company-owned restaurants, the addition of 49 net new franchised units, and favorable outside sales at the Company's distribution and food processing operations. Revenues at Denny's, however, were adversely affected by severe weather conditions in the first quarter, which forced the temporary closing of many of its restaurants, by the delay in implementation of certain promotional programs, and, management believes, by the negative publicity relating to the litigation described above in Item 3. Legal Proceedings. As a result of these factors, Denny's increase in average unit sales of 0.1% included a decrease in customer traffic of 4.1% while the average check increased 4.4%. Hardee's accounted for a significant portion of the increase in restaurant operating revenues for the year with a $75.0 million (12.4%) increase in 1993 as compared with 1992, due to a 6.0% increase in average unit sales and a 36-unit increase in the number of restaurants. The increase in average unit sales resulted from an 7.2% increase in the average check offset, in part, by a decrease of 1.1% in customer traffic. The increases in average unit sales and average check at Hardee's are primarily attributable to the fresh fried chicken product and the continued development of Hardee's "Frisco" product line. Quincy's revenues decreased by $11.1 million (3.8%) in 1993 as compared with 1992, primarily due to a 2.5% decrease in average unit sales combined with a 4-unit decline in the number of units. The decrease in average unit sales resulted from a decrease in customer traffic of 7.5% which was offset, in part, by a 5.3% increase in average check. The significant decrease in traffic at Quincy's as compared with 1992 reflects the impact of a number of programs that were in place in early 1992 which increased customer traffic in 1992, but which proved to be more costly than anticipated and were subsequently refined or discontinued, resulting in the comparative decline in 1993 traffic. Revenues of El Pollo Loco, which account for only 4.2% of total restaurant operating revenues, increased by $11.2 million (11.5%) in 1993 as compared to 1992 as a result of a full year's impact in 1993 of 11 franchised units which were acquired by the Company in the fourth quarter of 1992 and a 1.8% increase in average unit sales. The Company's operating expenses before considering the effects of the write-off of goodwill and certain other intangible assets and the provision for restructuring charges, discussed below, increased by $290.3 million (8.4%) in 1993 as compared with 1992. This increase was primarily attributable to an increase of $190.3 million (8.5%) in operating expenses before the effects of the write-off of goodwill and certain other intangible assets and the provision for restructuring charges relating to the Company's restaurant operations, and a $98.5 million (8.0%) increase in the operating expenses before the effects of the write-off of goodwill and certain other intangible assets and the provision for restructuring charges relating to Canteen's contract food service operations. Canteen's increased expenses were primarily a result of the corresponding increase in operating revenues described above. Of the total increase in operating expenses relating to restaurant operations, a significant portion ($118.7 million) is attributable to Denny's. The significant increase in operating expenses before the effects of the write-off of goodwill and certain other intangible assets and the provision for restructuring charges at Denny's is due primarily to an increase in product costs of $84.8 million and an increase in payroll and benefit expense of $30.0 million. These increases resulted from higher commodity costs, additional labor associated with a Denny's breakfast promotion (which was discontinued in the second quarter) and an initiative to improve Denny's service capabilities, one time charges of $8.3 million related to efforts to address claims of discrimination, $1.1 million for the write-off of an international joint venture, and an increase in the number of Denny's units. Management expects the discrimination claims at Denny's to have an ongoing cost impact on the Company at least until resolution of the matters described above in Item 3. Legal Proceedings. The increase in operating expenses before the effects of the write-off of goodwill and certain other intangible assets and the provision for restructuring charges at Hardee's of $66.4 million is mainly attributable to increased revenues and is comprised principally of an increase in payroll and benefits expenses of $21.0 million and an increase in product costs of $29.9 million. Conversely, the decrease in operating expenses before the effects of the write-off of goodwill and certain intangible assets and the provision for restructuring charges at Quincy's of $8.9 million is attributable to the decrease in revenues. Quincy's experienced decreases in payroll and benefits expense of $3.9 million and in product costs of $3.8 million. Corporate and other expenses before the effects of the write-off of goodwill and certain intangible assets and the provision for restructuring charges increased by $1.5 million in 1993 as compared with 1992, primarily due to an increase in payroll and benefits expense of $1.9 million. The write-off of goodwill and certain other intangible assets, primarily tradenames and franchise agreements, represent noncash charges of $1,267.7 million and $207.1 million, respectively. Since the acquisition of Flagstar in 1989, the Company has not achieved the revenue and earnings projections that were prepared and utilized at the time of the acquisition. In assessing the recoverability of goodwill and other intangible assets in prior years, the Company developed projections of future operations which indicated the Company would become profitable within several years and fully recover the carrying value of its goodwill and other intangible assets. Actual results, however, have fallen short of these projections, primarily due to increased competition, intensive pressure on pricing due to discounting, declining customer traffic, adverse economic conditions, and relatively limited capital resources to respond to these changes. During the fourth quarter of 1993, management determined that projections of future operating results, based on the assumption that historical operating trends derived from the last four years would continue (rather than projections derived from those utilized in 1989 or projections based on assumptions that the restructuring plan described below will be successful), did not support the future amortization of the remaining goodwill balance and certain other intangible assets at December 31, 1993. See Notes 1 and 2 to the Consolidated Financial Statements for a description of the methodology employed to assess the recoverability of the Company's goodwill and other intangible assets. Effective in the fourth quarter of 1993, the Company approved a restructuring plan that includes the sale or closure of restaurants, a reduction in personnel, and a reorganization of certain management structures. The provision for restructuring charges is the result of disappointing operating results and a comprehensive financial and operational review initiated in 1993 due to a re-engineering study that evaluated the Company's major business processes. The restructuring charge of $192 million includes primarily a non-cash charge of $156 million to write-down certain assets and incremental cash charges of $36 million for severance, relocation and other costs. See Note 3 to the Consolidated Financial Statements for further details. The write-down of assets under the restructuring plan represents predominantly non-cash adjustments made to reduce the carrying value of approximately 240 of the Company's 1,376 Denny's, Quincy's, and El Pollo Loco restaurants. Approximately 105 Denny's and 45 El Pollo Loco restaurants will be sold to franchisees or closed over a twelve month period and have been written down to net realizable value. The Quincy's concept is over-penetrated in a number of its markets; thus, most of the 90 Quincy's units identified in the restructuring plan will be converted to another concept with some units closed. As a result of the conversion to another concept, the estimated amount of the units' carrying value with no future benefit has been written off. The write-down of assets also includes a charge of $22 million to establish a reserve for operating leases primarily related to restaurant units which will be sold to franchisees or closed. The 240 restaurant units identified in the restructuring plan had aggregate operating revenues during 1993 of approximately $227 million and a negative operating cash flow of approximately $2.4 million. Such units had a net remaining carrying value after the write-down of approximately $43 million. The restructuring plan will consolidate certain Company operations and eliminate overhead positions in the field and in its corporate marketing, accounting, and administrative functions. Also, the Company's field management structure will be reorganized to eliminate a layer of management. The restructuring charge includes a provision of approximately $25 million for the related severance, relocation, and office closure costs. The Company's restructuring plan also includes the decision to fundamentally change the competitive positioning of Denny's, El Pollo Loco, and Quincy's. The Company anticipates that the restructuring plan will result in reduced general and administrative costs of approximately $10 million annually. Interest and debt expense decreased by $37.7 million in 1993 as compared with 1992, primarily due to a reduction in the Company's weighted average borrowing rate following the Recapitalization, the principal elements of which were consummated in the fourth quarter of 1992. The decrease in interest and debt expense includes a net decrease of $68.3 million in non-cash charges related to the accretion of original issue discount on the Company's 17% Senior Subordinated Discount Debentures Due 2001 which were retired in the fourth quarter of 1992 as part of the Recapitalization. Non-cash interest expense related to the accretion of insurance liabilities also decreased by approximately $7.0 million in 1993 as a result of a change in the method of determining the discount rate applied to insurance liabilities retroactive to January 1, 1993, as discussed below. These decreases in non-cash interest expense were offset, in part, by an increase in cash interest of $38.8 million from the refinance debt which was issued as part of the Recapitalization. The Company's accounting change pursuant to Staff Accounting Bulletin No. 92 resulted in a charge of $12.0 million, net of income tax benefits, for the cumulative effect of the change in accounting principle as of January 1, 1993. The impact of this change on the Company's 1993 operating results was to increase operating expenses and decrease interest expense by approximately $7.0 million, respectively. For the year ended December 31, 1993, the Company recognized extraordinary losses totalling $26.4 million, net of income tax benefits of $0.2 million. The extraordinary losses resulted from the write-off of $26.5 million of unamortized deferred financing costs associated with the prepayment in September 1993 of $387.5 million of term facility indebtedness and a charge of $0.1 million in March 1993 related to the repurchase of $741,000 in principal amount of the 10% Debentures. During the year ended December 31, 1992, the Company recognized extraordinary losses totalling $155.4 million, net of income tax benefits of $85.1 million from (i) premiums paid to retire certain indebtedness in connection with the Recapitalization and the write-off of related unamortized deferred financing costs, resulting in a charge of $144.8 million, net of income tax benefits of $83.6 million, (ii) the write-off of unamortized deferred financing costs associated with the prepayment of a portion of the Company's indebtedness under its prior credit agreement from the proceeds of the offer and sale (the "Preferred Stock Offering") in July 1992 of FCI's $2.25 Series A Cumulative Convertible Exchangeable Preferred Stock, $.10 par value per share (the "Preferred Stock"), resulting in a charge of $8.8 million, net of income tax benefits of $1.3 million, and (iii) the defeasance of $7.6 million of mortgage notes payable resulting in a charge of $1.8 million, net of income tax benefits of $0.2 million. 1992 COMPARED TO 1991 Operating revenues for 1992 increased by approximately $102.3 million (2.8%) as compared with 1991. This increase was the result of a $104.3 million (4.5%) increase in revenues from restaurant operations that was partially offset by a $2.0 million (0.2%) decrease in revenues from Canteen's contract food service operations. Canteen's concession and recreation revenues increased by $22.4 million or 8.5% over 1991. However, Canteen's food and vending revenues decreased by $24.4 million or 2.4% as compared with 1991 as the food and vending segment continued to be adversely impacted by reduced employment levels, particularly in the western and northeastern sections of the United States. Denny's accounted for $20.0 million of the $104.3 million increase in revenues from restaurant operations. The increase in revenues of Denny's was primarily attributable to a 17-unit increase in the number of Company-owned restaurants. Average unit sales decreased 0.1% as a result of a 4.2% decrease in customer traffic, offset by a 4.3% increase in the average check. The decrease in traffic during 1992 resulted from intense competition and discounting in the midscale market segment, limited television exposure during the second half of 1992, and the continuing weakness of the west coast economy. The increase in the average check at Denny's primarily reflects a shift in consumer preferences to higher-priced menu items. Denny's also added 52 new franchise units during the year. Hardee's accounted for $81.2 million of the increase in restaurant operating revenues, primarily due to an 11.5% increase in average unit sales and a 28-unit increase in the number of restaurants. The increase in average unit sales resulted from a 5.9% increase in the average check at the Company's Hardee's restaurants combined with an increase of 5.3% in customer traffic. These increases are believed to be attributable, in part, to the introduction in the Company's Hardee's restaurants of fresh fried chicken as a new menu item in 300 units and the introduction in July 1992 of the "Frisco Burger" sandwich in all units. Quincy's contributed $6.6 million to the increase in restaurant operating revenues. The increase at Quincy's reflects a 1.1% increase in average unit sales, primarily due to a 2.6% increase in customer traffic (principally for breakfast service), which was offset in part by a 1.5% decrease in the average check. Quincy's results also reflect a number of programs which were introduced in the first quarter and were designed to increase customer traffic. Such programs, which proved to be more costly than originally anticipated, were refined or eliminated in the second quarter. Revenues of El Pollo Loco, which accounted for only 4.0% of total restaurant operating revenues, decreased by $3.5 million as a result of a decrease in the number of Company-owned restaurants for the first three quarters of 1992 as compared to the same period in 1991. The Company's overall operating expenses increased by $79.9 million in 1992 as compared with 1991. This increase was primarily attributable to an increase of $82.3 million (3.8%) in operating expenses of the restaurant operations, partially offset by a $7.0 million (0.6%) decrease in operating expenses of Canteen's contract food service operations. The increases in the operating expenses of the restaurant operations reflected the increased revenues and consisted primarily of increased payroll and benefit expenses at Denny's ($7.3 million), Hardee's ($22.6 million) and Quincy's ($0.8 million). Aggressive product cost management and favorable commodity prices reduced the effects of product costs which increased at Hardee's ($22.4 million) and Quincy's ($7.9 million), and decreased at Denny's ($10.6 million). The product cost increases at Quincy's were due in part to the programs discussed in the preceding paragraph. The decrease in Canteen's operating expenses was due principally to a $8.5 million decline in product costs. Canteen's operating expenses were also reduced in the first quarter by approximately $2.6 million of unusual credits resulting from settlements of various insurance matters. Corporate and other expenses increased by $4.6 million, primarily due to a full year's impact in 1992 of certain support function expenses that, in 1991, were reflected in the restaurants' and Canteen's operating expenses. Interest and debt expense decreased by $4.9 million in 1992 as compared with 1991, due primarily to a net decrease in cash interest of $13.5 million in 1992 due to lower interest rates on outstanding variable rate indebtedness, principal payments made during the year (including prepayment of a portion of the Company's term loan under its prior credit agreement with proceeds of the Preferred Stock Offering) and the issuance of the Preferred Stock. This decrease was offset, in part, by an increase of $8.5 million in non-cash charges principally related to the accretion of discounts recorded on certain self-insurance liabilities. For the year, the Company recognized extraordinary losses totalling $155.4 million, net of income tax benefits of $85.1 million. The extraordinary losses resulted primarily from premiums paid to retire certain indebtedness in connection with the Recapitalization and the write-off of related unamortized deferred financing costs, resulting in a charge of $144.8 million, net of income tax benefits of $83.6 million, and from the write-off of unamortized deferred financing costs associated with the prepayment of a portion of the Company's term loan under its prior credit agreement from the proceeds of the Preferred Stock Offering, resulting in a charge of $8.8 million, net of income tax benefits of $1.3 million. In addition, in May 1992 the Company defeased $7.6 million of mortgage notes payable resulting in a charge of $1.8 million, net of income tax benefits of $0.2 million. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has met its liquidity needs and capital requirements with internally generated funds and external borrowings. The Company expects to continue to rely on internally generated funds, supplemented by available working capital advances under its Amended and Restated Credit Agreement, dated as of October 26, 1992, among Flagstar and TWS Funding, Inc., as borrowers, certain lenders and co-agents named therein, and Citibank, N.A., as managing agent (as amended, from time to time, the "Restated Credit Agreement"), and other external borrowings, as its primary sources of liquidity and believes that funds from these sources will be sufficient for the next twelve months to meet the Company's working capital, debt service and capital expenditure requirements. Although the Company reported net losses in 1992 and 1993, those losses have been attributable in major part to non-cash charges, consisting principally of the write-off of goodwill and certain intangible assets, depreciation of tangible assets, amortization of intangible assets and goodwill, accretion of original issue discount, non-cash charges for extraordinary items related to refinancings and defeasance of indebtedness, and non-cash charges related to the cumulative effect of changes in accounting principles. The following table sets forth, for each of the years indicated, a calculation of the Company's cash from operations available for debt repayment and capital expenditures: The provision for restructuring charges of $192.0 million recorded during 1993 includes approximately $36.0 million in incremental cash charges. Such cash charges, less approximately $6.5 million expended in 1993, are expected to require funding predominantly over a period of approximately twelve months. Included in the $156 million of primarily non-cash charges is a reserve of $22 million for the present value of operating leases, net of estimated sublease rentals, related to restaurant units that will be sold to franchisees or closed and offices to be closed. This liability will be liquidated over the remaining terms of the operating leases. The Company plans to fund the cash portion of the restructuring through the sale of certain Denny's and El Pollo Loco restaurant units to franchisees, increased cash flows from operations as a result of reduced general and administrative expenses and increased royalties on newly franchised restaurants, and borrowings under the Restated Credit Agreement. During 1993, the Company sold in a public offering (the "1993 Offering") $275 million aggregate principal amount of 10 3/4% Senior Notes Due 2001 (the "10 3/4% Notes") and $125 million aggregate principal amount of 11 3/8% Senior Subordinated Debentures Due 2003 (the "11 3/8% Debentures"). Proceeds of the 1993 Offering were used to reduce the term facility under the Restated Credit Agreement. Although the interest rates payable on the 10 3/4% Notes and 11 3/8% Debentures are higher than the rate paid by the Company under the term facility partially refinanced thereby, the 1993 Offering and the related amendment to the Restated Credit Agreement served to extend the scheduled maturities of the Company's long-term indebtedness and thereby provide the Company with additional financial flexibility. The Restated Credit Agreement includes a working capital and letter of credit facility of up to $350.0 million with a working capital sublimit of $200 million and a letter of credit sublimit of $245 million. The amendment to the Restated Credit Agreement consummated in conjunction with the 1993 Offering included, among other things, a modification to the former requirement that working capital advances under the credit facility be repaid in full and not reborrowed for at least 30 consecutive days during any 13-month period but at least once during each year to provide that working capital advances under the credit facility be paid down to a maximum borrowing thereunder of $100 million in 1993, reducing to $50 million in 1998, for such 30 day period in each year. Such amendment also made less restrictive certain financial covenants under the Restated Credit Agreement. An additional amendment to the Restated Credit Agreement was consummated in 1993 for the Company to use up to $50 million of net cash proceeds from the disposition of Denny's and El Pollo Loco restaurant units to acquire new Denny's restaurant units and refurbish other existing units and to exclude from limitations on capital expenditures (as defined) and investments (as defined) up to $25.6 million of cash or debt assumed in the purchase of certain franchisee units. For additional information see Item 13. Certain Relationships and Related Transactions -- Description of Indebtedness. The Restated Credit Agreement and the indentures governing the Company's outstanding public debt contain negative covenants that restrict, among other things, the Company's ability to pay dividends, incur additional indebtedness, further encumber its assets and purchase or sell assets. In addition, the Restated Credit Agreement includes provisions for the maintenance of a minimum level of interest coverage, limitations on ratios of indebtedness to earnings before interest, taxes, depreciation and amortization (EBITDA) and limitations on annual capital expenditures. At December 31, 1993 scheduled debt maturities of long-term debt for the years 1994 through 1998 are as follows: In addition to scheduled maturities of principal, approximately $265.0 million of cash will be required in 1994 to meet interest payments on long-term debt (including interest on variable rate term indebtedness under the Restated Credit Agreement of approximately $11.0 million, assuming an annual interest rate of 6.3%) and dividends on the Preferred Stock. The Company's principal capital requirements are those associated with opening new restaurants and expanding its contract food service business, as well as those associated with remodeling and maintaining its existing restaurants and facilities. During 1993, total capital expenditures were approximately $225.5 million, of which approximately $83.0 million was used to open new restaurants, $22.0 million was used for new products equipment, $61.2 million was applied to expand and maintain the Company's contract food service business, and $59.3 million was expended to upgrade and maintain existing facilities. Of these expenditures, approximately $77.1 million were financed through capital leases and secured borrowings. Capital expenditures during 1994 are expected to total approximately $185 million, of which approximately $60 million is expected to be financed externally. The Company is able to operate with a substantial working capital deficiency because (i) restaurant operations and most other food service operations are conducted primarily on a cash (and cash equivalent) basis with a low level of accounts receivable, (ii) rapid turnover allows a limited investment in inventories, and (iii) accounts payable for food, beverages and supplies usually become due after the receipt of cash from the related sales. At December 31, 1993 the Company's working capital deficiency was $304.6 million as compared with $284.1 million at the end of 1992. Such increase is attributable primarily to an increase in restructuring and other liabilities which was partially offset by an increase in receivables and inventories from the acquisition of contract food service operations during 1993. During November 1992, the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits" which requires that benefits provided to former or inactive employees prior to retirement be recognized as an obligation when earned, subject to certain conditions, rather than when paid. The Company does not expect Statement No. 112 to have a material impact on the Company's operations and will implement this statement during the first quarter of 1994. On April 11, 1994, Standard & Poor's Corporation downgraded the long-term credit ratings on Flagstar's outstanding senior debt securities from B+ to B and on its subordinated debt securities and FCI's Preferred Stock from B- to CCC+. Moody's Investors' Service, Inc. has also indicated that it is reviewing the ratings of Flagstar's debt securities for a possible downgrade. As a result of this action, certain payments by the Company relating to a subsidiary's mortgage financing will become due and payable on a monthly, rather than semi-annual, basis. See Item 13. Certain Relationships and Related Transactions - Description of Indebtedness - Mortgage Financings. Although the Company has not yet had an opportunity to evaluate the effect of such downgrade, management does not currently anticipate a significant impact on the Company's liquidity or ongoing operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index to Financial Statements and Financial Statement Schedules which appears on page herein. FORM 11-K INFORMATION FCI, pursuant to Rule 15d-21 promulgated under the Securities Exchange Act of 1934, as applicable, will file as an amendment to this Annual Report on Form 10-K the information, financial statements and exhibits required by Form 11-K with respect to the Flagstar Thrift Plan and the Denny's, Inc. Profit Sharing Retirement Plan. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth information with respect to the directors and executive officers of FCI. Each director of FCI is also a director of Flagstar. (a) Messrs. Kravis and Roberts are first cousins. In connection with the Recapitalization, FCI and Flagstar agreed that their respective Boards of Directors would be expanded to eleven members and that a majority of each such board will consist of persons designated by affiliates of KKR. For additional information concerning agreements regarding the composition of the Board of Directors, see Item 12. Security Ownership of Certain Beneficial Owners and Management -- The Stockholder's Agreement. EXECUTIVE OFFICERS OF FLAGSTAR The following table sets forth information with respect to the executive officers of Flagstar (other than as identified above). (a) Messrs. Maw and McManus are brothers-in-law. See Item 12. Security Ownership of Certain Beneficial Owners and Management for certain additional information concerning directors, executive officers and certain beneficial owners of the Company. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION COMPENSATION OF OFFICERS No executive officer of FCI is compensated directly by FCI in connection with services provided to the Company. All such executive compensation is paid by Flagstar. Set forth below is information for 1993, 1992 and 1991 with respect to compensation for services to the Company of Jerome J. Richardson, the Chief Executive Officer of the Company, and each of the five most highly compensated executive officers (other than the Chief Executive Officer) of the Company during 1993. SUMMARY COMPENSATION TABLE (1) The amounts shown for each named executive officer exclude perquisites and other personal benefits that did not exceed, in the aggregate, the lesser of either $50,000 or 10% of the total of annual salary and bonus reported for the named executive officer for any year included in this table. (2) The amounts shown for 1993 include accruals of $62,082, $26,823 and $9,027 for Messrs. Richardson, Maw and McManus, respectively, under a supplemental executive retirement plan. The amounts shown for 1992 include accruals of $58,053, $30,119 and $11,920 for Messrs. Richardson, Maw and McManus, respectively, under the same plan, while the amounts shown for 1991 include accruals of $34,421, $25,220 and $5,966 for Messrs. Richardson, Maw and McManus, respectively. (3) For additional information concerning the grant of options in 1993, see Item 11. Executive Compensation -- Stock Options below. Options to purchase Common Stock were granted to Mr. Richardson on December 15, 1992 pursuant to the 1989 Non-Qualified Stock Option Plan of FCI, as adopted December 1, 1989 and thereafter amended (the "1989 Option Plan"), and his employment agreement dated as of August 11, 1992, upon the termination of his prior option to purchase 160,000 shares of Common Stock. Such options become exercisable at the rate of 20% per year beginning on November 16, 1993, conditioned upon his continued employment with the Company. Pursuant to Mr. Richardson's employment agreement, all shares of Common Stock that Mr. Richardson acquires upon any exercise of such options shall be subject to the Richardson Shareholder Agreement (as defined herein). See Item 11. Executive Compensation -- Employment Agreements -- Richardson Employment Agreement and Item 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of March 31, 1994, the beneficial ownership of the Common Stock by each stockholder known by the Company to own more than 5% of the outstanding shares, by each director of FCI, by each officer of the Company included in the Summary Compensation Table in Item 11. Executive Compensation above, and by all directors and executive officers of FCI and Flagstar as a group. Except as otherwise noted, the persons named in the table below have sole voting and investment power with respect to all shares shown as beneficially owned by them. The number of shares and options indicated herein (including shares issuable upon the exercise of stock options), as well as corresponding option exercise and market prices, have been adjusted to give effect to the five-for-one reverse stock split of the Common Stock effected by FCI as of June 16, 1993. * Less than one percent. (1) Shares shown as owned by KKR Associates are owned of record by TW Associates (19,913,333 shares) and KKR Partners II (86,666 shares). KKR Associates is the sole general partner and possesses sole voting and investment power as to each of TW Associates and KKR Partners II. Messrs. Kravis, Raether, Roberts and Tokarz (directors of FCI and Flagstar) and Messrs. Robert J. MacDonnell, Michael W. Michelson and Saul A. Fox, as the general partners of KKR Associates, may be deemed to share beneficial ownership of the shares shown as beneficially owned by KKR Associates. Such persons disclaim beneficial ownership of such shares. (2) Excludes 15,000,000 shares of Common Stock underlying warrants (the "Warrants"), which become exercisable in 1995, acquired by TW Associates (14,935,000 shares) and KKR Partners II (65,000 shares) under the Purchase Agreement. The Warrants were issued pursuant to the Warrant Agreement dated November 16, 1992 by and between FCI and Associates (the "Warrant Agreement"). Each Warrant entitles the holder thereof to purchase one fully paid and nonassessable share of Common Stock at an initial exercise price (the "Exercise Price") of $17.50, subject to adjustment from time to time upon the occurrence of certain events. Any or all of the Warrants may be exercised at any time after December 31, 1994 (or the date to which such date may be extended in accordance with certain provisions of the Stockholders' Agreement (as defined herein) or March 31, 1995 if GTO has complied with its obligations thereunder to sell specified amounts of its Common Stock) (the "Warrant Effectiveness Date") and until November 16, 2000. Notwithstanding the foregoing, in the event (a) a sale of or acceptance of an offer to purchase 90% or more of the outstanding shares of Common Stock, or (b) a merger or other similar extraordinary corporate transaction involving an entity which immediately prior thereto is not an affiliate of Associates or any partner thereof or of FCI which modifies the outstanding Common Stock and which results in a change of control of FCI occurs on or prior to the Warrant Effectiveness Date, each Warrant will become exercisable immediately prior to such sale or acceptance or consummation of such transaction. (3) The Saurer Group Investments Ltd., North Atlantic Continental Capital Ltd. and The Common Fund (who are parties to certain investment management arrangements with GTO) own, respectively, 403,014, 301,358 and 1,872,540 of the shares listed. GTO disclaims beneficial ownership of such shares. GTO and related entities own the balance of the shares listed. Mr. Oliver is a general partner of GTO and as such may be deemed to share beneficial ownership of the shares owned by GTO. Mr. Oliver disclaims beneficial ownership of such shares. (4) Excludes shares underlying options that are not currently exercisable, but includes 7,500 shares that each of Messrs. James and Smart has a right to acquire upon the exercise of currently exercisable options granted by the Company in 1990. Mr. James also has a limited investment in GTO or related entities, or both. Shares listed for Mr. James exclude shares held by DLJ Capital. (5) Includes shares held by the trustee of the Thrift Plan as of January 31, 1994 for the individual accounts of employee participants. Under the Thrift Plan, shares attributable to participating employees' contributions and Company contributions are voted by the trustee in accordance with the employees' instructions, while shares as to which no instructions are received are voted by the trustee in its discretion. Of shares held in the Thrift Plan for the accounts of directors and executive officers of FCI and Flagstar, approximately 3,364, 222 and 1,596 are credited to the accounts of Messrs. Richardson, Maw and McManus, respectively, and 6,808 are credited to the accounts of all directors and executive officers as a group. (6) Includes 120,000 shares that Mr. Richardson has the right to acquire upon the exercise of currently exercisable options under the 1989 Option Plan. (7) Includes 4,166 shares that Mr. Smart has the right to acquire upon conversion of the 10% Debentures. (8) Excludes shares owned by KKR Associates through TW Associates and KKR Partners II, as set forth above. Messrs. Kravis, Raether, Roberts and Tokarz are general partners of KKR Associates, the sole general partner of TW Associates and KKR Partners II. They also are directors of FCI and Flagstar. Each of Messrs. Kravis, Raether, Roberts and Tokarz disclaims beneficial ownership of those shares listed above as owned by KKR Associates. Also excludes shares held by GTO and related entities, as set forth above. Mr. Oliver is a general partner of GTO and also is a director of FCI and Flagstar. Mr. Oliver disclaims beneficial ownership of those shares listed above as owned by GTO and related entities. THE STOCKHOLDERS' AGREEMENT. Concurrently with the execution of the Purchase Agreement, GTO and certain of its affiliates (collectively, the "GTO Group"), DLJ Capital, Mr. Richardson, TW Associates (the "Stockholder Parties") and FCI entered into an agreement (the "Stockholders' Agreement") pursuant to which the Stockholder Parties have agreed not to transfer or sell shares of Common Stock held by them prior to December 31, 1994 (or, in certain circumstances, March 31, 1995), except in connection with the sale of 90% or more of the outstanding Common Stock and except for transfers in connection with extraordinary corporate transactions, transfers in certain cases to certain affiliates of GTO or Associates and sales to the public by GTO commencing on or after June 30, 1993. The GTO Group has agreed not to purchase any additional Common Stock. Pursuant to the Stockholders' Agreement, each of the Stockholder Parties has agreed to nominate and vote all shares of Common Stock owned by it to elect as directors (a) six persons designated by Associates, (b) Mr. Richardson (for so long as Mr. Richardson remains Chief Executive Officer of FCI), (c) one representative designated by each of the GTO Group and DLJ Capital (for so long as the GTO Group and DLJ Capital, respectively, continue to own at least 2% of the outstanding shares of Common Stock on a fully-diluted basis) and (d) two independent directors. The Stockholder Parties have further agreed to increase by two the number of directors constituting the entire Board of Directors of FCI and to nominate (if requested) and vote to elect as directors two additional persons to be designated by Associates if at any time the holders of the Preferred Stock, voting together as a class with all other classes or series of preferred stock ranking junior to or on a parity with the Preferred Stock, are entitled to elect two additional directors; PROVIDED that the two Associates' designees so elected shall resign and the size of the FCI Board of Directors shall be reduced accordingly at such time as the directors elected by preferred stockholders shall resign or their term shall end. Under the Stockholders' Agreement, the GTO Group is granted the right to make two written requests to FCI for registration of shares of Common Stock owned by the GTO Group under the Securities Act of 1933, as amended (the "Securities Act"), exercisable on or after June 30, 1993, and is obligated, if the trading price of the Common Stock exceeds $20.00 per share for fifteen consecutive trading days and a registration statement of FCI under the Securities Act is effective for specified periods, to dispose of up to 50% of its shares of Common Stock prior to September 30, 1994. FCI may, but is not obligated to, file and maintain an effective shelf registration (the "Shelf Registration") with respect to the shares of Common Stock to be disposed of by the GTO Group. At any time after December 31, 1994 (or, in certain circumstances, March 31, 1995), (i) DLJ Capital may make two written requests to FCI for registration under the Securities Act of all or any part of the shares of Common Stock owned by DLJ Capital, and (ii) the holders of a majority of all shares of Common Stock and Warrants issued to Associates and all shares of Common Stock issued or issuable to Associates upon exercise of any Warrant (the "Associates Registrable Securities") may make five written requests to FCI for registration of all or part of such securities under the Securities Act. In addition, the GTO Group, DLJ Capital and Associates have customary "piggyback" registration rights to include their securities, subject to certain limitations, in any other registration statement filed by FCI (other than the Shelf Registration and certain demand registrations by the GTO Group), pursuant to any of the foregoing requests or otherwise under the Securities Act. If Associates exercises its demand or "piggyback" registration rights and Mr. Richardson is then employed by the Company, then Mr. Richardson has the right to have included in any registration statement relating to the exercise of such rights by Associates the same percentage of his Common Stock as the fully-diluted percentage of Associates Registrable Securities registered thereunder. If at any time Mr. Richardson shall have the right to participate in a "piggyback" registration and Mr. Richardson elects not to exercise such "piggyback" registration right, he may make one written request to FCI for registration under the Securities Act of up to the number of shares of Common Stock that he had the right to include, but did not so include, in such one or more registrations pursuant to his "piggyback" registration rights. The Company has agreed to pay all expenses in connection with the performance of its obligations to effect demand or "piggyback" registrations under the Securities Act of securities covered by the registration rights of the Stockholder Parties, and to indemnify and hold harmless, to the full extent permitted by law, each holder of such securities against liability under the securities laws. The Stockholders' Agreement will terminate upon the sale of all shares of Common Stock now owned or hereafter acquired by the GTO Group, DLJ Capital, Mr. Richardson or Associates; PROVIDED that, (i) at such time as the GTO Group or DLJ Capital shall own less than 2% of the outstanding Common Stock on a fully-diluted basis, the GTO Group or DLJ Capital, as the case may be, shall be released from its respective obligations and forfeit its respective rights under the Stockholders' Agreement, and (ii) at such time after December 31, 1994, or the date to which such date may be extended in accordance with the provisions of the Stockholders' Agreement, as GTO or a related entity shall cease to have investment advisory authority over the shares of Common Stock now owned or hereafter acquired by certain affiliates of GTO, and the GTO Group shall have complied with the provisions of the Stockholders' Agreement requiring it to dispose of certain of its shares of Common Stock under certain circumstances, each such affiliate will be released from its respective obligations and forfeit its respective rights under the Stockholders' Agreement. In any event, the provisions of the Stockholders' Agreement with respect to voting arrangements and restrictions will terminate no later than ten years from the date of the Stockholders' Agreement, subject to extension in accordance with applicable law by the agreement of the remaining parties to the Stockholders' Agreement. RICHARDSON SHAREHOLDER AGREEMENT. Shares of Common Stock currently owned by Mr. Richardson ("Owned Stock") and shares that he would acquire upon exercise of any stock options granted to him by the Company under the 1989 Option Plan ("Option Stock") are subject to various rights and restrictions contained in a shareholder agreement (the "Richardson Shareholder Agreement") executed by Mr. Richardson and FCI concurrently with the execution of the Purchase Agreement. In general, the Richardson Shareholder Agreement provides that, (i) subject to Mr. Richardson's registration rights under the Stockholders' Agreement, Mr. Richardson may not sell or transfer the Owned Stock or Option Stock until after November 16, 1997, unless Mr. Richardson's employment terminates by reason of death or permanent disability, or is terminated by Flagstar without "cause" and FCI elects to require payment of the balance of the principal and accrued interest on the Richardson Loan (as defined herein) (in which case he may transfer the Owned Stock), (ii) before November 16, 1997, with respect to any Owned Stock permitted to be transferred pursuant to clause (i) above, and after November 16, 1997 with respect to the Option Stock, Mr. Richardson may not transfer any such Owned Stock or Option Stock without first offering to sell it to FCI at the price offered by a third party, (iii) upon Mr. Richardson's death or permanent disability while he is employed by Flagstar or following his retirement after November 16, 1997, Mr. Richardson and his estate each have a one-time right, exercisable within six months after death or permanent disability, to elect to require FCI, except under certain circumstances, to purchase all or part of Mr. Richardson's Option Stock at its market value and to cash out the value of his exercisable options based on the excess of such value over the exercise price, and FCI may elect to require Mr. Richardson and his estate to sell such stock and cash out such options at such prices, (iv) if Mr. Richardson's employment is terminated by him voluntarily or by Flagstar with "cause," then FCI may repurchase 20% (if he voluntarily terminates his employment between July 26, 1993 and July 26, 1994) or all (if his employment is terminated for "cause" prior to July 26, 1994), as the case may be, of the Owned Stock at $20.00 per share and (v) if Mr. Richardson's employment is terminated for any reason other than his death or permanent disability or his retirement on or after November 16, 1997, FCI may repurchase all but not less than all of Mr. Richardson's Option Stock at the lesser of (i) its market value or (ii) the sum of the exercise price of the options pursuant to which such stock was acquired, plus a multiple of 20% of any excess of such market value over such exercise price for each year of his employment after November 16, 1992, and, in the event of an exercise by FCI of any option to repurchase (described above), FCI shall cash out his exercisable options at a price equal to the excess of the applicable repurchase price over the option exercise price; PROVIDED that, if Mr. Richardson's employment is terminated as a result of a termination without cause pursuant to the Employment Agreement (as defined herein), the exercisability of Mr. Richardson's option with respect to 160,000 shares of Common Stock will be determined on the basis of the vesting schedule applicable to options granted to Mr. Richardson and in effect prior to December 15, 1992, and the market value of the shares for the purpose of cashing out the value of his exercisable options is to be reduced on a per share basis by the difference between $20.00 and the exercise price of his current options. The Richardson Shareholder Agreement provides that all shares of Owned Stock and Option Stock shall be deemed to be "Registrable Securities" under the Stockholders' Agreement and shall be entitled to registration rights as set forth herein. For additional information, see Item 11. Executive Compensation -- Employment Agreements -- Richardson Employment Agreement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS CERTAIN TRANSACTIONS Pursuant to the Employment Agreement, the Company advanced funds to Mr. Richardson during 1992 to refinance approximately $13.9 million of his outstanding bank indebtedness. Interest and principal on the Richardson Loan is payable, subject to acceleration upon Mr. Richardson's earlier termination of employment for any reason, on November 16, 1997, and interest thereon accrues at the rate prescribed for five-year term loans under Section 7872 of the Code (5.6% per annum) as of the date the loan by the Company was made. The Richardson Loan is secured by 812,000 shares of Common Stock and certain other collateral as is required to comply with margin regulations. See Item 11. Executive Compensation -- Employment Agreements -- Richardson Employment Agreement. GTO received fees of $250,000 in 1993 for certain financial advisory services. Under an existing agreement, GTO will be entitled to an additional $250,000 for such services in 1994. DLJ served as an underwriter in connection with the Company's issuance of certain indebtedness in 1993 in consideration for an underwriting discount of $4,059,000. In connection with his employment with the Company, Mr. Buckley, the Chief Operating Officer of Quincy's, received a non-interest bearing home equity advance from the Company in the amount of $113,000. Such advance was repaid in full by Mr. Buckley in 1994. For information concerning certain transactions in which KKR (and their affiliates) have an interest, see Item 11. Executive Compensation -- Compensation and Stock Option Committee Interlocks and Insider Participation. DESCRIPTION OF INDEBTEDNESS The following summary of the principal terms of the indebtedness of the Company does not purport to be complete and is qualified in its entirety by reference to the documents governing such indebtedness, including the definitions of certain terms therein, copies of which have been filed as exhibits to this Annual Report. Whenever particular provisions of such documents are referred to herein, such provisions are incorporated herein by reference, and the statements are qualified in their entirety by such reference. THE RESTATED CREDIT AGREEMENT In connection with the Recapitalization, Flagstar entered into the Restated Credit Agreement, pursuant to which senior debt facilities were established consisting (after certain adjustments and prepayments subsequent to the closing of the Recapitalization) of (i) a $171.3 million senior term loan (the "Term Facility"), and (ii) a $350 million senior revolving credit facility (the "Revolving Credit Facility" and, together with the Term Facility, the "Bank Facilities"), with sublimits for working capital advances and standby letters of credit, and a swing line facility of up to $30 million. The proceeds of the Term Facility were used principally to refinance comparable facilities under a prior credit agreement and the balance was used to finance the redemption of certain debt securities pursuant to the Recapitalization and to pay certain transaction costs. Proceeds of the Revolving Credit Facility may be used solely to provide working capital to the Company. The Restated Credit Agreement provides generally that Flagstar must repay the Term Facility over six years in increasing quarterly installments (subject to the effects of a reallocation of a portion of a 1993 prepayment that would otherwise have been applied to scheduled principal installments that mature after December 31, 1996 to installments due on or prior to such date) and that the working capital advances under the Revolving Credit Facility must be paid down to a maximum amount (ranging from $100 million in 1993 to $50 million in 1998) and not reborrowed for at least 30 consecutive days during any thirteen-month period but at least once during each fiscal year. Under the Restated Credit Agreement, Flagstar is required to prepay advances outstanding under the Term Facility (or, if no advances are outstanding thereunder, to permanently reduce the Revolving Credit Facility) with the aggregate amount of Net Cash Proceeds (as defined therein) received from (i) the sale, lease, transfer or other disposition of assets of the Company (other than dispositions of assets permitted by the terms of the Restated Credit Agreement and other dispositions of assets not exceeding $5,000,000 in any fiscal year or $1,000,000 in any transaction or series of related transactions) and (ii) the sale or issuance by FCI or any of its subsidiaries of any Debt (as defined therein) (other than Debt permitted by the terms of the Restated Credit Agreement and to the extent the Net Cash Proceeds are applied to refinance certain existing Subordinated Debt). The Restated Credit Agreement contains covenants customarily found in credit agreements for leveraged financings that restrict, among other things, (i) liens and security interests other than liens securing the obligations under the Restated Credit Agreement, certain liens existing as of the date of effectiveness of the Restated Credit Agreement, certain liens in connection with the financing of capital expenditures, certain liens arising in the ordinary course of business, including certain liens in connection with intercompany transactions and certain other exceptions; (ii) the incurrence of Debt, other than Debt in respect of the Recapitalization, Debt under the Loan Documents (as defined therein), the 10 3/4% Notes, the 11 3/8% Debentures, certain capital lease obligations, certain Debt in existence on the date of the Restated Credit Agreement, certain Debt in connection with the financing of capital expenditures, certain Debt in connection with Investments (as defined therein) in new operations, properties and franchises, certain trade letters of credit, certain unsecured borrowings in the ordinary course of business, certain intercompany indebtedness and certain other exceptions; (iii) lease obligations, other than obligations in existence as of the effectiveness of the Restated Credit Agreement, certain leases entered into in the ordinary course of business, certain capital leases, certain intercompany leases and certain other exceptions; (iv) mergers or consolidations, except for certain intercompany mergers or consolidations and certain mergers to effect certain transactions otherwise permitted under the Restated Credit Agreement; (v) sales of assets, other than certain dispositions of inventory and obsolete or surplus equipment in the ordinary course of business, certain dispositions in the ordinary course of business of properties no longer used or useful to the business of the Company, certain intercompany transactions, certain dispositions in connection with sale and leaseback transactions and certain exchanges of real property, fixtures and improvements for other real property, fixtures and improvements; (vi) investments, other than certain intercompany indebtedness, certain investments made in connection with joint venture or franchise arrangements, certain loans to employees, investments in new operations, properties or franchises subject to certain limitations and certain other exceptions; (vii) payment of dividends or other distributions with respect to capital stock of Flagstar, other than dividends from Flagstar to FCI to enable FCI to repurchase Common Stock and FCI stock options from employees in certain circumstances, payments to FCI with respect to fees and expenses incurred in the ordinary course of business by FCI in its capacity as a holding company for Flagstar, payments under a tax sharing agreement among FCI, Flagstar and its subsidiaries and certain other exceptions; (viii) sales or dispositions of the capital stock of subsidiaries other than sales by certain subsidiaries of Flagstar to Flagstar or certain other subsidiaries and certain other exceptions; (ix) the conduct by Flagstar or certain of its subsidiaries of business inconsistent with its status as a holding company or single purpose subsidiary, as the case may be, or entering into transactions inconsistent with such status; and (x) the prepayment of Debt, other than certain payments of Debt in existence on the date of the Restated Credit Agreement, certain payments to retire Debt in connection with permitted dispositions of assets, certain prepayments of advances under the Restated Credit Agreement and certain other exceptions. The Restated Credit Agreement also contains covenants that require Flagstar and its subsidiaries on a consolidated basis to meet certain financial ratios and tests described below: TOTAL DEBT TO EBITDA RATIO. Flagstar and its subsidiaries on a consolidated basis are required not to permit the ratio of (a) Adjusted Total Debt (as defined below) outstanding on the last day of any fiscal quarter to (b) EBITDA (as defined below) for the Rolling Period (as defined below) ending on such day to be more than a specified ratio, ranging from a ratio of 5.70:1.00 applicable upon the effectiveness of the Restated Credit Agreement to a ratio of 4.30:1.00 applicable on or after December 31, 1997. SENIOR DEBT TO EBITDA RATIO. Flagstar and its subsidiaries on a consolidated basis are required not to permit the ratio of (a) Adjusted Senior Debt (as defined below) outstanding on the last day of any fiscal quarter to (b) EBITDA for the Rolling Period ending on such day to be more than a specified ratio, ranging from a ratio of 3.50:1.00 applicable upon the effectiveness of the Restated Credit Agreement to a ratio of 2.75:1.00 on or after December 31, 1996. INTEREST COVERAGE RATIO. Flagstar and its subsidiaries on a consolidated basis are required not to permit the ratio, determined on the last day of each fiscal quarter for the Rolling Period then ended, of (a) EBITDA less Cash Capital Expenditures (as defined below) to (b) Adjusted Cash Interest Expense to be less than a specified ratio, ranging from a ratio of 1.20:1.00 applicable upon the effectiveness of the Restated Credit Agreement to a ratio of 1.60:1.00 on or after December 31, 1997. CAPITAL EXPENDITURES TEST. Flagstar and its subsidiaries are prohibited from making capital expenditures in excess of $195,000,000, $210,000,000 and $250,000,000 in the aggregate for the fiscal years ending in December 1992 through 1994, respectively, and $275,000,000 in the aggregate for each of the fiscal years 1995 through 1998. "Adjusted Cash Interest Expense" is defined in the Restated Credit Agreement to mean, for any Rolling Period (as defined below), Cash Interest Expense (as defined below) for such Rolling Period. "Adjusted Senior Debt" is defined in the Restated Credit Agreement to mean Senior Debt (as defined therein) outstanding on the last day of any fiscal quarter. "Adjusted Total Debt" is defined in the Restated Credit Agreement to mean Total Debt (as defined below) outstanding on the last day of any fiscal quarter. "Capex Financing" is defined in the Restated Credit Agreement to mean, with respect to any capital expenditure, the incurrence by certain subsidiaries of Flagstar of any Debt (including capitalized leases) secured by a mortgage or other lien on the asset that is the subject of such capital expenditure, to the extent that the Net Cash Proceeds of such Debt do not exceed the amount of such capital expenditure. "Cash Capital Expenditures" is defined in the Restated Credit Agreement to mean, for any period, without duplication, capital expenditures of the Company for such period, LESS (without duplication) (i) the Net Cash Proceeds of all Capex Financings during such period and (ii) the aggregate amount of the principal component of all obligations of the Company in respect of capitalized leases entered into during such period. "Cash Interest Expense" is defined in the Restated Credit Agreement to mean, for any Rolling Period, without duplication, interest expense net of interest income, whether paid or accrued during such Rolling Period (including the interest component of capitalized lease obligations) on all Debt, INCLUDING, without limitation, (a) interest expense in respect of advances under the Restated Credit Agreement, the 10 7/8% Notes and the Subordinated Debt (as defined therein), (b) commissions and other fees and charges payable in connection with letters of credit, (c) the net payment, if any, payable in connection with all interest rate protection contracts and (d) interest capitalized during construction, but EXCLUDING, in each case, interest not payable in cash (including amortization of discount and deferred debt expenses), all as determined in accordance with generally accepted accounting principles as in effect on December 31, 1991. "EBITDA" of any person is defined in the Restated Credit Agreement to mean, for any period, on a consolidated basis, net income (or net loss) PLUS the sum of (a) interest expense net of interest income, (b) income tax expense, (c) depreciation expense, (d) amortization expense, (e) extraordinary or unusual losses included in net income (net of taxes to the extent not already deducted in determining such losses) and (f) in the case of the fiscal quarter ending in December 1992 only, an amount (not to exceed $18,500,000) equal to the aggregate amount of fees paid in connection with the Recapitalization that are not otherwise excluded in determining net income (or net loss), LESS extraordinary or unusual gains included in net income (net of taxes to the extent not already deducted in determining such gains), in each case determined in accordance with generally accepted accounting principles as in effect on December 31, 1991. "Funded Debt" is defined in the Restated Credit Agreement to mean the principal amount of Debt in respect of advances under the Bank Facilities and the principal amount of all Debt that should, in accordance with generally accepted accounting principles as in effect on December 31, 1991, be recorded as a liability on a balance sheet and matures more than one year from the date of creation or matures within one year from such date but is renewable or extendible, at the option of the debtor, to a date more than one year from such date or arises under a revolving credit or similar agreement that obligates the lender or lenders to extend credit during a period of more than one year from such date, including, without limitation, all amounts of Funded Debt required to be paid or prepaid within one year from the date of determination. "Rolling Period" is defined in the Restated Credit Agreement to mean, for any fiscal quarter, such quarter and the three preceding fiscal quarters. "Total Debt" outstanding on any date is defined in the Restated Credit Agreement to mean the sum, without duplication, of (a) the aggregate principal amount of all Debt of Flagstar and its subsidiaries, on a consolidated basis, outstanding on such date to the extent such Debt constitutes indebtedness for borrowed money, obligations evidenced by notes, bonds, debentures or other similar instruments, obligations created or arising under any conditional sale or other title retention agreement with respect to property acquired or obligations as lessee under leases that have been or should be, in accordance with generally accepted accounting principles, recorded as capital leases, (b) the aggregate principal amount of all Debt of Flagstar and its subsidiaries, on a consolidated basis, outstanding on such date constituting direct or indirect guarantees of certain Debt of others and (c) the aggregate principal amount of all Funded Debt of Flagstar and its subsidiaries on a consolidated basis consisting of obligations, contingent or otherwise, under acceptance, letter of credit or similar facilities; PROVIDED that advances under the Revolving Credit Facility shall be included in Total Debt only to the extent of the average outstanding principal amount thereof outstanding during the 12-month period ending on the date of determination. Under the Restated Credit Agreement, an event of default will occur if, among other things, (i) any person or group of two or more persons acting in concert (other than KKR, GTO and their respective affiliates) acquires, directly or indirectly, beneficial ownership of securities of FCI representing, in the aggregate, more of the votes entitled to be cast by all voting stock of FCI than the votes entitled to be cast by all voting stock of FCI beneficially owned, directly or indirectly, by KKR and its affiliates, (ii) any person or group of two or more persons acting in concert (other than KKR and its affiliates) acquires by contract or otherwise, or enters into a contract or arrangement that results in its or their acquisition of the power to exercise, directly or indirectly, a controlling influence over the management or policies of Flagstar or FCI or (iii) Flagstar shall cease at any time to be a wholly-owned subsidiary of FCI. If such an event of default were to occur, the lenders under the Related Credit Agreement would be entitled to exercise a number of remedies, including acceleration of all amounts owed under the Restated Credit Agreement. PUBLIC DEBT As part of the Recapitalization, Flagstar consummated on November 16, 1992 the sale of $300 million aggregate principal amount of 10 7/8% Senior Notes Due 2002 (the "10 7/8% Notes") and issued pursuant to an exchange offer for previously outstanding debt issues $722.4 million principal amount of 11.25% Senior Subordinated Debentures Due 2004 (the "11.25% Debentures"). On September 23, 1993, Flagstar consummated the sale of $275 million aggregate principal amount of the 10 3/4% Notes and $125 million aggregate principal amount of the 11 3/8% Debentures. The 10 7/8% Notes and the 10 3/4% Notes are general unsecured obligations of Flagstar and rank PARI PASSU in right of payment with Flagstar's obligations under the Restated Credit Agreement. The 11.25% Debentures are general unsecured obligations of Flagstar and are subordinate in right of payment to the obligations of Flagstar under the Restated Credit Agreement, the 10 7/8% Notes and the 10 3/4% Notes. The 11.25% Debentures rank PARI PASSU in right of payment with the 11 3/8% Debentures. All such debt is senior in right of payment to the 10% Debentures. THE SENIOR NOTES. Interest on the 10 7/8% Notes is payable semi-annually in arrears on each June 1 and December 1. They will mature on December 1, 2002. The 10 7/8% Notes will be redeemable, in whole or in part, at the option of Flagstar, at any time on or after December 1, 1997, initially at a redemption price equal to 105.4375% of the principal amount thereof to and including November 30, 1998, at a decreased price thereafter to and including November 30, 1999 and thereafter at 100% of the principal amount thereof, together in each case with accrued interest. Interest on the 10 3/4% Notes is payable semi-annually in arrears on each March 15 and September 15. They will mature on September 15, 2001. The 10 3/4% Notes may not be redeemed prior to maturity, except that prior to September 15, 1996, the Company may redeem up to 35% of the original aggregate principal amount of the 10 3/4% Notes, at 110% of their principal amount, plus accrued interest, with that portion, if any, of the net proceeds of any public offering for cash of the Common Stock that is used by FCI to acquire from the Company shares of common stock of the Company. THE SENIOR SUBORDINATED DEBENTURES. Interest on the 11.25% Debentures is payable semi-annually in arrears on each May 1 and November 1. They will mature on November 1, 2004. The 11.25% Debentures will be redeemable, in whole or in part, at the option of Flagstar, at any time on or after November 1, 1997, initially at a redemption price equal to 105.625% of the principal amount thereof to and including October 31, 1998, at decreasing prices thereafter to and including October 31, 2002 and thereafter at 100% of the principal amount thereof, together in each case with accrued interest. Interest on the 11 3/8% Debentures is payable semi-annually in arrears on each March 15 and September 15. They will mature on September 15, 2003. The 11 3/8% Debentures will be redeemable, in whole or in part, at the option of the Flagstar, at any time on or after September 15, 1998, initially at a redemption price equal to 105.688% of the principal amount thereof to and including September 14, 1999, at 102.844% of the principal amount thereof to and including September 14, 2000 and thereafter at 100% of the principal amount thereof, together in each case with accrued interest. THE 10% DEBENTURES. Interest on the 10% Debentures is payable semi-annually in arrears on each May 1 and November 1. The 10% Debentures mature on November 1, 2014. Unless previously redeemed, the 10% Debentures are convertible at any time at the option of the holders thereof by exchange into shares of Common Stock at a conversion price of $24.00 per share, subject to adjustment. The 10% Debentures are redeemable, in whole or in part, at the option of the Company upon payment of a premium. The Company is required to call for redemption on November 1, 2002 and on November 1 of each year thereafter, through and including November 1, 2013, $7,000,000 principal amount of the 10% Debentures. A "Change of Control" having occurred on November 16, 1992, holders of the 10% Debentures had the right, under the indenture relating thereto, to require the Company, subject to certain conditions, to repurchase such securities at 101% of their principal amount together with interest accrued to the date of purchase. On February 19, 1993, FCI made such an offer to repurchase the $100 million of 10% Debentures then outstanding. As of March 24, 1993 the Company repurchased $741,000 principal amount of the 10% Debentures validly tendered and accepted pursuant to such offer. MORTGAGE FINANCINGS A subsidiary of Flagstar had issued and outstanding, at December 31, 1993, $208.5 million in aggregate principal amount of 10 1/4% Guaranteed Secured Bonds due 2000. Interest is payable semi-annually in arrears on each November 15 and May 15. As a result of the recent downgrade of Flagstar's outstanding debt securities, certain payments by the Company which fund such interest payments are now due and payable on a monthly basis. Principal payments total $2.9 million annually through 1995; $12.5 million annually through 1999; and $152.7 million in 2000. The bonds are secured by a financial guaranty insurance policy issued by Financial Security Assurance, Inc. and by collateral assignment of mortgage loans on 237 Hardee's and 148 Quincy's restaurants. Another subsidiary of Flagstar has outstanding $160 million aggregate principal amount of 11.03% Notes due 2000. Interest is payable quarterly in arrears, with the principal maturing in a single installment payable in July 2000. These notes are redeemable, in whole, at the subsidiary's option, upon payment of a premium. They are secured by a pool of cross-collateralized mortgages on approximately 240 Denny's restaurant properties. PART IV ITEM 14. ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) -- Financial Statements: See the Index to Financial Statements and Financial Statement Schedules which appears on page hereof. (2) -- Financial Statement Schedules: See the Index to Financial Statement Schedules which appears on page hereof. (3) -- Exhibits: Certain of the exhibits to this Report, indicated by an asterisk, are hereby incorporated by reference to other documents on file with the Commission with which they are physically filed, to be a part hereof as of their respective dates. * Certain of the exhibits to this Annual Report on Form 10-K, indicated by an asterisk, are hereby incorporated by reference to other documents on file with the Commission with which they are physically filed, to be part hereof as of their respective dates. (b) FCI filed no reports on Form 8-K during the fourth quarter of 1993. FLAGSTAR COMPANIES, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES INDEPENDENT AUDITORS' REPORT FLAGSTAR COMPANIES, INC. We have audited the accompanying consolidated balance sheets of Flagstar Companies, Inc. and subsidiaries (the Company), as of December 31, 1992 and 1993, and the related statements of consolidated operations and consolidated cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at page. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1992 and 1993 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 8 and 1 to the consolidated financial statements, the Company changed its method of accounting for other postretirement benefits, effective January 1, 1992, to conform with Statement of Financial Accounting Standards No. 106 and also changed its method of accounting for self-insurance liabilities, effective January 1, 1993. DELOITTE & TOUCHE Greenville, South Carolina March 25, 1994 FLAGSTAR COMPANIES, INC. STATEMENTS OF CONSOLIDATED OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) See notes to consolidated financial statements. FLAGSTAR COMPANIES, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) See notes to consolidated financial statements. FLAGSTAR COMPANIES, INC. STATEMENTS OF CONSOLIDATED CASH FLOWS (IN THOUSANDS) See notes to consolidated financial statements. FLAGSTAR COMPANIES, INC. STATEMENTS OF CONSOLIDATED CASH FLOWS (CONTINUED) (IN THOUSANDS) See notes to consolidated financial statements. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INTRODUCTION Flagstar Companies, Inc. (Company) was incorporated under the laws of the State of Delaware on September 24, 1988 to effect the acquisition of Flagstar Corporation (Flagstar). Prior to June 16, 1993 the Company and Flagstar had been known, respectively, as TW Holdings, Inc. and TW Services, Inc. The acquisition was accounted for under the purchase method of accounting as of July 20, 1989. Accordingly, the Company has allocated its total purchase cost of approximately $1.7 billion to the assets and liabilities of Flagstar based upon their respective fair values, which were determined by valuations and other studies. As discussed in Note 2, during 1993 the Company determined that goodwill and certain intangible assets arising principally from the acquisition were impaired resulting in a $1.5 billion write-off. On November 16, 1992, a recapitalization of the Company and Flagstar was substantially completed which included the issuance of 20 million shares of common stock and warrants to acquire an additional 15 million shares of common stock at $17.50 per share to TW Associates, L.P., an affiliate of Kohlberg Kravis Roberts & Co. (KKR) in exchange for $300 million, the consummation of a Restated Bank Credit Agreement, the consummation of the offers to exchange the 17% Senior Subordinated Discount Debentures Due 2001 (the 17% Debentures) and the 15% Subordinated Debentures Due 2001 (the 15% Debentures) for 11.25% Senior Subordinated Debentures Due 2004, the consummation of the sale of $300 million aggregate principal amount of Senior Notes, the call for redemption of all 17% Debentures and all 15% Debentures not acquired pursuant to the Exchange Offers, and the call for redemption of all of the outstanding 14.75% Senior Notes Due 1998 (the 14.75% Senior Notes). On December 16, 1992 the 17% Debentures and 15% Debentures that were not exchanged were called for redemption on November 16, 1992, were redeemed at 110% of accreted value or principal amount. In addition, the 14.75% Senior Notes were redeemed including a make-whole premium. On March 24, 1993 the Company repurchased, pursuant to the change in control provision of the indenture, $741,000 in principal amount from the holders of its 10% Convertible Debentures such securities at 101% of their principal amount plus unpaid accrued interest. NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting policies and methods of their application that significantly affect the determination of financial position, cash flows and results of operations are as follows: (a) CONSOLIDATED FINANCIAL STATEMENTS. The Consolidated Financial Statements include the accounts of the Company, Flagstar, and all its subsidiaries. Certain 1992 amounts have been reclassified to conform to the 1993 presentation. (b) CASH AND CASH EQUIVALENTS. For purposes of the Statements of Consolidated Cash Flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. (c) INVENTORIES. Merchandise and supply inventories are valued primarily at the lower of average cost or market. (d) PROPERTY AND DEPRECIATION. Property and equipment owned are depreciated principally on the straight-line method over its estimated useful life. Property held under capital leases (at capitalized value) is amortized over its estimated useful life, limited generally by the lease period. The following estimated useful service lives were in effect during all periods presented in the financial statements: Merchandising equipment -- Principally five to ten years Buildings -- Fifteen to forty years Other equipment -- Two to ten years Leasehold improvements -- Estimated useful life limited by the lease period. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- Continued (e) GOODWILL AND OTHER INTANGIBLE ASSETS. The excess of cost over the fair value of net assets of companies acquired had been amortized over a 40-year period on the straight-line method prior to being written-off at December 31, 1993. Other intangible assets consist primarily of costs allocated in the acquisition to tradenames, franchise and other operating agreements. Such assets are being amortized on the straight-line basis over the useful lives of the franchise or the contract period of the operating agreements. Certain tradenames, franchise and other operating agreements were amortized over periods up to 40 years on the straight-line basis prior to being written-off at December 31, 1993. The Company assesses the recoverability of goodwill and other intangible assets by projecting future net income, before the effect of amortization of goodwill and other intangible assets, over the remaining amortization period of such assets. The Company's large debt burden requires approximately 60% of the Company's annual cash flow for current interest cost, as a result, it is appropriate to reduce operating income by interest expense to evaluate the recoverability of goodwill and other intangibles. The results of this evaluation allow the Company to assess whether the amortization of the goodwill or other intangible assets balance over its remaining life can be recovered through expected non-discounted future results. The projected future results used in the evaluation performed in 1993 are based on the four year historical trends since the 1989 leveraged buy out. Management believes that the projected future results are the most likely scenario assuming historical trends continue. See Note 2 for further discussion of the write-off of goodwill and other intangible assets. (f) DEFERRED FINANCING COSTS. Costs related to the issuance of debt are deferred and amortized as a component of interest and debt expense over the terms of the respective debt issues using the interest method. (g) PREOPENING COSTS. The Company capitalizes certain costs incurred in conjunction with the opening of restaurants and food services locations and amortizes such costs over a twelve month period from the date of opening. (h) INCOME TAXES. Income taxes are accounted for under the provisions of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes." (i) INSURANCE. The Company is primarily self insured for workers compensation, general liability, and automobile risks which are supplemented by stop loss type insurance policies. The liabilities for estimated incurred losses are discounted to their present value based on expected loss payment patterns determined by independent actuaries or experience. During 1993, the Company changed its method of determining the discount rate applied to insurance liabilities retroactive to January 1, 1993 pursuant to Staff Accounting Bulletin (SAB) No. 92 issued by the staff of the Securities and Exchange Commission in June 1993 concerning the accounting for environmental and other contingent liabilities. The SAB requires, among other things, that a risk free rate (approximately 4% at December 31, 1993) be used to discount such liabilities rather than a rate based on average cost of borrowing which had been the Company's practice. As a result of this change, the Company recognized an additional liability, measured as of January 1, 1993 through a one-time charge of $12,100,000 (net of income tax benefits of $90,000). The effect of this accounting change on 1993 operating results, in addition to recording the cumulative effect for years prior to 1993, was to increase insurance expense and decrease interest expense by approximately $7,000,000 (see Note 15). The total discounted self-insurance liabilities recorded at December 31, 1992 and 1993 were $120.7 million and $139.5 million, respectively. The related undiscounted amounts at such dates were $142.8 million and $151.9 million, respectively. (j) POSTRETIREMENT BENEFITS. In 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions." This new standard requires that the Company's expected cost of retiree health benefits be charged to expense during the years of employee service. Previously, such costs were expensed as paid. See Note 8 for a further description of the accounting for postretirement benefits other than pensions. (k) POSTEMPLOYMENT BENEFITS. During November 1992, the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits" which requires that benefits provided to former FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- Continued or inactive employees prior to retirement be recognized as an obligation when earned, subject to certain conditions, rather than when paid. The Company does not expect Statement No. 112 to have a material impact on its operations and will implement this statement during the first quarter of 1994. NOTE 2 WRITE-OFF OF GOODWILL AND OTHER INTANGIBLE ASSETS For the year ended December 31, 1993, the Company's consolidated statement of operations reflects non-cash charges totaling $1,474.8 million, including $1,267.7 million and $207.1 million for the write-off of goodwill and other intangible assets, primarily tradenames and franchise agreements, respectively. Since the acquisition of Flagstar in 1989, the Company has not achieved the revenue and earnings projections prepared at the time of the acquisition. In assessing the recoverability of goodwill and other intangible assets in prior years, the Company developed projections of future operations which indicated the Company would become profitable within several years and fully recover the carrying value of the goodwill and other intangible assets. However, actual results have fallen short of these projections primarily due to increased competition, intensive pressure on pricing due to discounting, declining customer traffic, adverse economic conditions, and relatively limited capital resources to respond to these changes. During the fourth quarter of 1993, management determined that the most likely projections of future operating results would be based on the assumption that historical operating trends derived from the last four years would continue rather than projections based on assumptions that the restructuring plan (described in Note 3) will be successful. Thus, the Company has determined that the projected financial results would not support the future amortization of the remaining goodwill balance and certain other intangible assets at December 31, 1993. The methodology employed to assess the recoverability of the Company's goodwill and other intangible assets involved a detail six year projection of operating results extrapolated forward 30 years, which approximates the maximum remaining amortization period for such assets as of December 31, 1993. The Company then evaluated the recoverability of goodwill on the basis of this projection of future operations. Based on this projection over the next six years, the Company would have a net loss each year before income taxes and amortization of goodwill and other intangibles. Extension of these trends to include the entire 36 year amortization period indicates that there would be losses each year, unless the restructuring plan or other activities are successful in reversing the present operating trends; thus, the analysis indicates that there is insufficient net income to recover the goodwill and other intangible asset balances at December 31, 1993. Accordingly, the Company wrote off the goodwill balance and certain other intangible asset balances including tradename and franchise agreements for its Denny's, Quincy's, and El Pollo Loco restaurant operations and tradename and location contracts for its contract food and vending services operations. See Note 14 for a description of the Company's operations. The projections generally assumed that historical trends experienced by the Company over the past four years would continue. The current mix between company-owned and franchised restaurants was assumed to continue, customer traffic for Denny's, Quincy's, and El Pollo Loco was assumed to decline at historical rates, average check amounts for Denny's, Hardee's, Quincy's, and El Pollo Loco were assumed to increase indefinitely at historical rates due to inflation and changes in product mix, volume for Canteen was assumed to decline at historical rates, and pricing for Canteen was assumed to increase at historical rates, as a result of inflation. Capital expenditures are assumed to continue at a level necessary to repair and maintain current facilities and systems. No new unit growth was assumed. Variable costs for food and labor are assumed to remain at their historical percentage of revenues. Other costs are assumed to increase at the historical inflation rate consistent with revenue pricing increases. Through the year 1999, the Company's projections indicate that interest expense will exceed operating income, which is determined after deducting annual depreciation expense; however, operating income before depreciation is adequate to cover interest expense. A continuation of this trend for the next 30 years does not generate cash to repay the current debt and management assumes it will be refinanced at constant interest rates. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3 PROVISION FOR RESTRUCTURING CHARGES Effective the fourth quarter of 1993, as a result of a comprehensive financial and operational review initiated in 1993, the Company approved a restructuring plan. The plan involves the sale or closure of restaurants, reduction in personnel, a reorganization of certain management structures, and a decision to fundamentally change the competitive positioning of Denny's, El Pollo Loco, and Quincy's. The plan resulted in a restructuring charge, which is comprised of the following: The write-down of assets represents predominantly non-cash adjustments made to reduce to net realizable value approximately 240 of the Company's 1,376 Denny's, Quincy's, and El Pollo Loco restaurants. These 240 restaurants have been identified for sale to franchisees, conversion to another concept, or closure. The write-down of assets also includes a charge of $22 million to establish a reserve for operating leases related to restaurant units which will be sold to franchisees or closed and offices which will be closed. Approximately $36 million of the restructuring charges represent incremental cash charges of which approximately $6.5 million had been incurred and paid in 1993. The reorganization of the field management structure of the restaurant group and the contract food services group will result in elimination of a layer of supervisory management and consolidation of field offices resulting in related severance and relocation costs. In addition, the Company will eliminate a number of positions in the corporate marketing, accounting, and administrative functions. NOTE 4 DEBT Short-term borrowings of $39.0 million at December 31, 1992 represent advances under the working capital facility of the Company's credit agreement (Restated Credit Agreement). Interest on the advances under the working capital facility at December 31, 1992 accrued at a weighted average rate of 7.1% per annum and was based on prime or LIBOR. During 1993, an amendment to the Restated Credit Agreement was consummated and included a modification to the requirement that working capital advances under the credit facility be repaid in full and not reborrowed for at least 30 consecutive days during any 13-month period to provide that working capital advances under the credit facility be paid down to a maximum borrowing thereunder of $100 million in 1993 reducing to $50 million in 1998 for such 30 day period in each year. Accordingly, the $93.0 million outstanding under the working capital portion of the revolving credit facility at December 31, 1993, is classified as long-term debt. The Restated Credit Agreement includes a working capital and letter of credit facility up to a total of $350.0 million with a working capital sublimit of $200.0 million and a letter of credit sublimit of $245.0 million. All amounts outstanding under the facility must be repaid by November 16, 1998. See also discussion below. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 DEBT -- Continued Long-term debt consists of the following: (a) Collateralized by restaurant and other properties with a net book value of $41.7 million at December 31, 1993. (b) Collateralized by equipment with a net book value of $23.5 million at December 31, 1993. (c) Aggregate annual maturities during the next five years of long-term debt are as follows (in thousands): 1994 -- $41,668; 1995 -- $42,450; 1996 -- $55,293; 1997 -- $96,732, and 1998 -- $119,609. The Restated Credit Agreement provides for a senior term loan and a senior revolving credit facility. The Company had drawings under the senior term loan of $572.5 million during 1992 and $778,000 during 1993. The borrowings under the Restated Credit Agreement are secured by the stock of certain operating subsidiaries and the Company's trade and service marks and are guaranteed by certain operating subsidiaries. Such guarantees are further secured by certain operating subsidiary assets. The Restated Credit Agreement and indentures under which the debt securities have been issued contain a number of restrictive covenants. Such covenants restrict, among other things, the ability of Flagstar and its subsidiaries to incur indebtedness, create liens, engage in business activities which are not in the same field as that in which the Company currently operates, mergers and acquisitions, sales of assets, transactions with affiliates and the payment of dividends. In addition, the Restated Credit Agreement contains affirmative and negative financial covenants including provisions for the maintenance of a minimum level of interest coverage (as defined), limitations on ratios of indebtedness (as defined) to earnings before interest, taxes, depreciation and amortization (EBITDA), and limitations on annual capital expenditures. During September 1993, net proceeds of $387.5 million from the issuance of $275 million of 10.75% Senior Notes and $125 million of 11.375% Senior Subordinated Debentures were used to reduce the Company's senior term loan. In FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 DEBT -- Continued connection with the reduction of the senior term loan, the Restated Credit Agreement was amended to include, among other things, the following: an increase in the amount of annual capital expenditures permitted for remodeling and expansion of operations, modification of financial ratios of debt to EBITDA and of interest coverage, a rescheduling of the remaining principal installments under the senior term loan, and modification of the requirement that working capital advances under the credit facility be repaid in full and not reborrowed for at least 30 consecutive days during any 13-month period but at least once during each year to provide that working capital advances under the credit facility be paid down to a maximum borrowing thereunder of $100 million in 1993 reducing to $50 million in 1998 for such 30 day period in each year. The Company was in compliance with the terms of the Restated Credit Agreement at December 31, 1993. Under the most restrictive provision of the Restated Credit Agreement (ratio of total debt to EBITDA, as defined), at December 31, 1993, the Company could incur approximately $44.0 million of additional indebtedness. At December 31, 1993, the 10.25% guaranteed bonds were secured by, among other things, mortgage loans on 385 restaurants, a lien on the related restaurant equipment, assignment of intercompany lease agreements, and the stock of the issuing subsidiaries. At December 31, 1993, the restaurant properties and equipment had a net book value of $347.8 million. In addition, the bonds are insured with a financial guaranty insurance policy written by a company that engages exclusively in such coverage. Principal and interest on the bonds is payable semiannually. Principal payments total $2.9 million annually through 1995; $12.5 million annually through 1999; and $152.7 million in 2000. The Company through its operating subsidiaries covenants that it will maintain the properties in good repair and expend annually to maintain the properties at least $15.8 million in 1994 and increasing each year to $23.7 million in 2000. The 11.03% mortgage notes are secured by a pool of cross collateralized mortgages on 240 restaurants with a net book value at December 31, 1993 of $228.1 million. In addition, the notes are collateralized by, among other things, a security interest in the restaurant equipment, the assignment of intercompany lease agreements and the stock of the issuing subsidiary. Interest on the notes is payable quarterly with the entire principal due at maturity in 2000. The notes are redeemable, in whole, at the issuer's option beginning in July 1993. The Company through its operating subsidiary covenants that it will use each property as a food service facility, maintain the properties in good repair and expend at least $5.3 million per annum and not less than $33 million, in the aggregate, in any five year period to maintain the properties. At December 31, 1993, the Company has $400 million aggregate notional amount in effect of reverse interest rate exchange agreements with maturities ranging from thirty-six to seventy-two months. The Company receives interest on such notional amount at fixed rates (average rate of 5.64% at December 31, 1993) and pays interest at six months LIBOR in arrears based floating rates on like notional amount. Subsequent to December 31, 1993, an additional $400 million aggregate notional amount of reverse interest rate exchange agreements with maturities of thirty-six months became effective. The Company will receive interest on the notional amount at average fixed rates of 5.29% and pay interest at six months LIBOR in arrears based floating rates on like notional amount. Also at December 31, 1993 the Company has a $50 million aggregate notional amount interest rate exchange agreement which matures within twelve months. The Company pays interest on such notional amount (9.76% at December 31, 1993) and is paid interest at LIBOR based floating rates (3.30% at December 31, 1993) on like notional amount. The net payments on all such agreements are reflected in interest and debt expense. The estimated fair value of the Company's long-term debt (excluding capital lease obligations) approximates the principal amount of such debt outstanding at December 31, 1993. Such computations are based on market quotations for the same or similar debt issues or the estimated borrowing rates available to the Company. The estimated fair value of the $50 million notional amount interest rate exchange agreement at December 31, 1993 is $2.8 million which represents an unrealized loss and is the amount at which such exchange agreement could be settled based on estimates obtained from dealers. At December 31, 1993, the estimated fair value of the $400 million notional amount of reverse interest rate exchange agreements was zero. The fair value of accounts receivable, short-term borrowings, and accounts payable approximate their carrying value. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5 LEASES AND RELATED GUARANTEES The Company's operations utilize property, facilities, equipment and vehicles leased from others. In addition, certain owned and leased property, facilities and equipment are leased to others. Buildings and facilities leased from others primarily are for restaurants and support facilities. At December 31, 1993, 974 restaurants were operated under lease arrangements which generally provide for a fixed basic rent, and, in some instances, contingent rental based on a percentage of gross operating profit or gross revenues. Initial terms of land and restaurant building leases generally are not less than twenty years exclusive of options to renew. Leases of other equipment primarily consist of merchandising equipment, computer systems and vehicles, etc. As lessor, leasing operations principally consist of merchandising equipment under noncancelable leases for a term of eight years to franchised distributors of a subsidiary. Numerous miscellaneous sublease agreements also exist. Information regarding the Company's leasing activities at December 31, 1993 is as follows: The total rental expense included in the determination of operating income for the three years ended December 31, 1991, 1992 and 1993 is as follows: Total rental expense does not include sublease rental income of $10,068,000, $9,437,000 and $8,998,000 for the three years ended December 31, 1991, 1992, and 1993, respectively. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 6 INCOME TAXES A summary of the provision (benefit) from income taxes attributable to loss before extraordinary items and cumulative effect of change in accounting principle is as follows: The deferred federal tax benefit for the year ended December 31, 1993 includes a reduction for the utilization of regular tax net operating loss carryforwards of approximately $9.5 million. In addition, the deferred federal tax benefit for the year ended December 31, 1993, has been offset by approximately $2.7 million due to the 1% corporate tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 6 INCOME TAXES -- Continued The following represents the approximate tax effect of each significant type of temporary difference and carryforward giving rise to the deferred income tax liability or asset: The Company has provided a valuation allowance for the portion of the deferred tax asset for which it is more likely than not that a tax benefit will not be realized. The difference between the statutory federal income tax rate and the effective tax rate on loss before extraordinary items and cumulative effect of accounting changes is as follows: At December 31, 1993, the Company has available, to reduce income taxes that become payable in the future, general business credit carryforwards of approximately $4.7 million which expire in approximately 2000, and alternative minimum tax (AMT) credits of $13.3 million. The AMT credits may be carried forward indefinitely. In addition, the Company has available regular income tax net operating loss carryforwards of $207.2 million, of which approximately $14.4 million expires in 2006 and $192.8 million expires in 2007. Due to the Recapitalization of the Company which occurred during 1992, the Company's ability to utilize general business credits, AMT credits and net operating loss carryforwards which arose prior to 1992 will be limited to a specified annual amount. The annual limitation for the utilization of the tax credit FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 6 INCOME TAXES -- Continued carryforwards is approximately $8 million and the annual limitation for the utilization of the net operating loss carryforwards is approximately $24 million. The usage of the net operating loss carryforward which arose in 1992 of $192.8 million is not expected to be subject to any annual limitation. NOTE 7 EMPLOYEE BENEFIT PLANS The Company maintains several defined benefit plans which cover a substantial number of employees. Benefits are based upon each employee's years of service and average salary. The Company's funding policy is based on the minimum amount required under the Employee Retirement Income Security Act of 1974. The Company also maintains defined contribution plans. Total net pension cost of defined benefit plans for the years ended December 31, 1991, 1992, and 1993 amounted to $4,576,000, $4,311,000 and $6,103,000, respectively, of which $3,172,000, $2,231,000 and $3,906,000 related to funded defined benefit plans and $1,404,000, $2,080,000 and $2,197,000 related to nonqualified unfunded supplemental defined benefit plans for executives. The components of net pension cost of the funded and unfunded defined benefit plans for the three years ended December 31, 1991, 1992, and 1993 determined under SFAS 87 follow: The following table sets forth the funded status of the plans and amounts recognized in the Company's balance sheet for its defined benefit plans: As of December 31, 1992 and 1993, the accrued pension liability related to unfunded plans was $9,940,000 and $10,817,000, respectively, the accumulated benefit obligation was $6,310,000 and $7,711,000, respectively, and the projected benefit obligation was $12,118,000 and $13,758,000, respectively. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 7 EMPLOYEE BENEFIT PLANS -- Continued Significant assumptions used in determining net pension cost and funded status information for all the periods shown above are as follows: In addition, the Company has defined contribution plans whereby eligible employees can elect to contribute from 1%-15% of their compensation to the plans. These plans include profit sharing and savings plans under which the Company makes matching contributions, with certain limitations. Amounts charged to income under these plans were $6,706,000, $7,406,000 and $5,327,000 for the years ended December 31, 1991, 1992, and 1993, respectively. Incentive compensation plans provide for awards to management employees based on meeting or exceeding certain levels of income as defined by such plans The amounts charged to income under the plans for the years ended December 31, 1991, 1992, and 1993 were as follows: $2,605,000, $5,344,000 and zero. In addition to these incentive compensation plans, certain operations have incentive plans in place under which regional, divisional and local management participate. The 1989 Stock Option Plan permits a Committee of the Board of Directors to grant options to key employees of the Company and its subsidiaries to purchase shares of common stock of the Company at a stated price established by the Committee. Such options are exercisable at such time or times either in whole or part, as determined by the Committee. During 1992, the 1989 Stock Option Plan was amended to authorize grants of up to 3,000,000 shares and 651,400 shares were granted. Options of 866,180 and 612,480, respectively, were outstanding as of December 31, 1992 and 1993 of which 136,764 and 131,870, respectively, were exercisable. Such options have exercise prices of $15.00 to $20.00 per share and twenty percent of the shares under option to become exercisable beginning one year from the date of grant and an additional twenty percent each year thereafter until all options are exercisable. During 1993 certain participants of the 1989 Stock Option Plan received replacement grant options of 1,092,990 at an exercise price of $11.25 per share which provide for fifty percent of the shares under option to become exercisable beginning two years after the date of grant and an additional twenty-five percent each year thereafter, until all the options are exercisable. The replacement grant options issued during 1993 were part of a grant to approximately 6,400 of the Company's field managers and administrative employees each of whom received options to purchase two hundred shares of the Company's common stock under the same terms as the recipients of the replacement grant options. At December 31, 1993, options for 1,273,800 shares with an exercise price of $11.25 per share were outstanding of which none were exercisable. If not exercised, the options expire ten years from the date of grant. In 1990, the Board of Directors adopted a 1990 Non-qualified Stock Option Plan (the 1990 Option Plan) for its directors who do not participate in management and are not affiliated with GTO (see Note 13). Such plan authorizes the issuance of up to 30,000 shares of common stock. The plan is substantially similar in all respects to the 1989 Option Plan described above. The Committee of the Board administering the 1990 Option Plan granted options for 30,000 shares as of July 31, 1990 at $29.05 per share, the market price per share on the date of grant. At December 31, 1992 and 1993, respectively, options outstanding under the 1990 Option Plan totalled 20,000 shares. NOTE 8 OTHER POSTRETIREMENT BENEFITS The Company adopted, in the fourth quarter of 1992, Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" retroactive to January 1, 1992. This statement requires the accrual of the cost of providing postretirement benefits, including medical and life insurance benefits, during the active service period of covered employees. The Company has recognized the accumulated liability, measured as of January 1, 1992 through a one-time charge of $17,834,000 (net of income tax benefit of $8,785,000). This charge excludes amounts accrued in prior years related to the acquisition of the Company. The effect of this accounting change on 1992 FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8 OTHER POSTRETIREMENT BENEFITS -- Continued operating results, in addition to recording the cumulative effect for years prior to 1992, was to recognize additional benefits expense of $3,983,000. Accordingly, the operating results for the first three quarters of 1992 have been restated to reflect this change (see Note 15). Prior to 1992, the Company recognized the cost of postretirement benefits in the year the benefits were paid. The Plan, which provides certain medical and life insurance benefits for eligible retired employees, is unfunded. The Company's contract food service employees become eligible for such benefits upon at least 15 years of credited service (as defined in the Plan) and retirement at age 55 or later. The Plan also requires monthly medical contributions by retired participants based upon age, credited service, and salary at retirement. Dependent benefits cease after the death of the retiree. Life insurance benefits provided are non-contributory. The Company amended the Plan in 1993. The amendment decreased the Company's accumulated benefit obligation at January 1, 1993 by approximately $17,535,000 which is being accounted for by amortization to income over future periods. The amendment curtails life and medical benefits for certain eligible employee groups and phases out the Company's subsidy of the cost of coverage for certain eligible employee groups over a five year period beginning in 1993. The components of net periodic postretirement benefit cost determined under SFAS 106 follow: The amount charged to expense for years prior to adoption of SFAS 106 was $1,035,000 for the year ended December 31, 1991. For this period, the cost of providing benefits for the Company's retired participants is not separable from the cost of benefits for the Company's active participants. The following table sets forth the amounts recognized in the Company's consolidated balance sheet: For measuring the expected postretirement benefit obligation, a 20% annual rate of increase in the cost of covered health care and death benefits was assumed for 1994. This rate was assumed to decrease to 6.5% in 1997 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rate by 1% each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $3,385,000 and would increase the aggregate of the service and interest components of net periodic postretirement benefit cost for the year then ended by $131,000. The weighted average discount rate used in determining the accumulated postretirement obligation was 8.5% at December 31, 1992 and 7.5% at December 31, 1993. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9 COMMITMENTS AND CONTINGENCIES There are various claims and pending legal actions against or indirectly involving the Company, including actions concerned with financing matters, civil rights of employees and customers, taxes, sales of franchise rights, and other matters. Certain of these are seeking damages in substantial amounts. The amounts of liability, if any, on these direct or indirect claims and actions at December 31, 1993, over and above any insurance coverage in respect to certain of them, are not specifically determinable at this time. Flagstar has received proposed deficiencies from the Internal Revenue Service (IRS) for federal income taxes and penalties totalling approximately $46.6 million. Proposed deficiencies of $34.3 million relate to examinations of certain income tax returns filed by Denny's for periods ending prior to Flagstar's purchase of Denny's on September 11, 1987. These deficiencies primarily involve the proposed disallowance of certain expenses associated with borrowings and other costs incurred at the time of the leveraged buyout of Denny's in 1985 and the purchase of Denny's by Flagstar in 1987. Flagstar filed protests of the proposed deficiencies with the Appeals Division of the IRS stating that it believed the proposed deficiencies were erroneous. Flagstar and the IRS have reached a preliminary agreement on substantially all of the issues included in the original proposed deficiency. Based on this preliminary agreement, the IRS has agreed to waive all penalties and Flagstar estimates that its ultimate federal income tax deficiency will be less than $5 million. The remaining $12.3 million of proposed deficiencies relate to examinations of certain income tax returns filed by the Company and Flagstar for the four fiscal periods ended December 31, 1989. The deficiencies primarily involve the proposed disallowance of deductions associated with borrowings and other costs incurred prior to, at and just following the time of the acquisition of Flagstar in 1989. The Company intends to vigorously contest the proposed deficiencies because it believes the proposed deficiencies are substantially incorrect. On March 26, 1993, a consent decree was signed by the Company and the U.S. Department of Justice resolving a complaint filed by the Department of Justice that alleged that the Company, through Denny's had engaged in a pattern or practice of discrimination against African-American customers. The Company denied any allegation of wrongdoing. The consent decree, which carries no direct monetary penalties, enjoins the Company from racial discrimination and requires the Company to implement certain employee training and testing programs and provide public notice of Denny's nondiscrimination policies. In a related matter, on March 24, 1993, a public accommodations lawsuit was filed against the Company in California. The lawsuit alleges that certain Denny's restaurants in California have engaged in racially discriminatory practices, and seeks certification as a class action, unspecified actual, compensatory and punitive damages, and injunctive relief. On May 24, 1993 and July 8, 1993 two additional public accommodations lawsuits were filed against the Company. The May 24, 1993 action alleges that a Denny's restaurant in Annapolis, Maryland engaged in racially discriminatory practices, and seeks certification as a class action covering all states except California, unspecified actual compensatory and punitive damages, and injunctive relief. Other individual public accommodations cases have also been filed, including some cases which allege substantial compensatory and punitive damages for each plaintiff, statutory damages, and injunctive relief. The Company is also the subject of pending and threatened employment discrimination claims principally in California and Alabama. In certain of these claims, the plaintiffs have threatened to seek to represent a class alleging racial discrimination in employment practices at Company restaurants and to seek actual, compensatory and punitive damages, and injunctive relief. It is the opinion of Management (including General Counsel), after considering a number of factors, including but not limited to the current status of the litigation (including any settlement discussions), the views of retained counsel, the nature of the litigation or proposed tax deficiencies, the prior experience of the consolidated companies, and the amounts which the Company has accrued for known contingencies that the ultimate disposition of these matters will not materially affect the consolidated financial position or results of operations of the Company. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10 SHAREHOLDERS' EQUITY (DEFICIT) On June 16, 1993, the Company's shareholders approved an amendment to the Restated Certificate of Incorporation authorizing the issuance of 200,000,000 shares of $0.50 par value common stock and 25,000,000 shares of $2.25 Series A Cumulative Convertible Exchangeable Preferred Stock (Preferred Stock) and authorizing a five-for-one reverse stock split. Such amendment increases the par value of the common stock to $0.50 per share from $0.10 per share. All references in the financial statements with respect to the number of shares of common stock and related per share amounts have been restated to reflect the reverse stock split. Each share of the $2.25 Series A Cumulative Convertible Exchangeable Preferred Stock (Preferred Stock) is convertible at the option of the holder, unless previously redeemed, into 1.359 shares of common stock. The Preferred Stock may be exchanged at the option of the Company, in up to two parts, at the earlier of any dividend payment date after November 16, 1992 or July 15, 1994 for the Company's 9% Convertible Subordinated Debentures (Exchange Debentures) due July 15, 2017 in a principal amount equal to $25.00 per share of Preferred Stock. Each Exchange Debenture, if issued, would be convertible at the option of the holder into 1.359 shares of common stock of the Company. The Preferred Stock may be redeemed at the option of the Company, in whole or in part, on or after July 15, 1994 at $26.80 per share if redeemed during the twelve month-period beginning July 15, 1994, and thereafter at prices declining annually to $25.00 per share on or after July 15, 2002. The warrants outstanding at December 31, 1993 entitle the holder to purchase 15 million shares of Company common stock at $17.50 per share, subject to adjustment for certain events, and may be exercised at any time after December 31, 1994 through November 16, 2000. NOTE 11 LOSS PER SHARE APPLICABLE TO COMMON SHAREHOLDERS The $2.25 Preferred Stock and 10% Convertible Debentures, which are convertible into the common stock of the Company (see Note 4), are considered "other potentially dilutive securities" which may become dilutive in the future and be included in the calculation of fully diluted loss per share. The outstanding warrants as well as the stock options issued to management and directors are common stock equivalents. Loss per common share during the periods presented have been based on the weighted average number of Company shares outstanding and give consideration to the issuance of common shares during the periods presented. In addition, the FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 LOSS PER SHARE APPLICABLE TO COMMON SHAREHOLDERS -- Continued loss per share amounts have been adjusted on a retroactive basis to reflect the reverse stock split effected during 1993. The warrants, options, preferred stock, and debentures have been omitted from the calculation because they have an antidilutive effect on loss per share data. The loss per share applicable to common shareholders before extraordinary items and the cumulative effect of change in accounting principle would have been $0.85 for the year ended December 31, 1992 if the issuance of common stock and warrants and the related recapitalization (see Introduction to Notes to Consolidated Financial Statements) had occurred at the beginning of the year. NOTE 12 EXTRAORDINARY ITEMS The Company recorded losses from extraordinary items as follows: Losses during the fourth quarter of 1992 were attributable to the recapitalization and related transactions for premiums paid to retire the 14.75% Senior Notes, 17% Debentures, and 15% Debentures. In addition, the remaining unamortized deferred financing costs related to such indebtedness and the Term A loan under the Prior Bank Credit Agreement, were charged-off simultaneously. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12 EXTRAORDINARY ITEMS -- Continued During the third quarter of 1992, the prepayment of the Term B loan under the Prior Bank Credit Agreement resulted in a charge-off of the remaining unamortized deferred financing costs on the Term B loan. Proceeds received from the sale of 6,300,000 shares of $2.25 Series A Cumulative Convertible Exchangeable Preferred Stock were used to prepay the Term B loan. During the second quarter of 1992, $7,648,000 of the Company's 10.25% Guaranteed Secured Bonds were defeased in accordance with the provisions of the bond indenture. Accordingly, premiums were paid on the defeased debt and the related unamortized deferred financing costs were charged-off. During the third quarter of 1993, the prepayment of $387.5 million of the Company's term loan under the Restated Credit Agreement resulted in a charge-off of $26.5 million of unamortized deferred financing costs. During the first quarter of 1993, the Company purchased $741,000 in principal amount of 10% Convertible Debentures at 101% of their principal amount plus unpaid accrued interest, pursuant to change in control provisions of the indenture. The repurchase of the 10% Convertible Debentures resulted in a charge of $132,000. NOTE 13 RELATED PARTY TRANSACTIONS The Company expensed annual advisory fees of $1,000,000 during 1991 and 1992, respectively, and $250,000 during 1993 for Gollust, Tierney & Oliver, Incorporated (GTO). Annual advisory fees of $250,000 will be received by GTO through 1994. GTO earned interest of $3,574,000 in 1991 and $1,344,000 in 1992 from senior indebtedness which was previously outstanding. In addition, GTO and related entities received premiums of $2,689,000 related to the redemption of such indebtedness during 1992. The Company expensed annual advisory fees to Donaldson, Lufkin & Jenrette Securities Corporation (DLJ) of $200,000 for 1991 and 1992, respectively. DLJ earned interest of $5,298,000 in 1991 from senior indebtedness which was previously outstanding. During 1991, DLJ received $897,000 related to the disposition of certain non-core businesses of the Company. In 1992 DLJ received fees of $1,380,000 related to investment banking services for the sale of the Company's preferred stock, $7,000,000 as financial advisor to the Company, and $3,738,000 related to the exchange of and issuance of certain indebtedness in the recapitalization. DLJ received $4,059,000 during 1993 for investment banking services related to the issuance of indebtedness by the Company. In 1992, the Company paid a fee to KKR of $15,000,000 for financial advisory services in connection with the recapitalization. In 1993, KKR received financial advisory fees of $1,250,000. In November 1992 in connection with the recapitalization, the Company loaned $13,922,000 to its chairman and chief executive officer, the proceeds of which were used to repay a 1989 loan obtained by the officer for the purchase of Company common stock. The loan is due in November 1997 and is secured by 812,000 shares of common stock and certain other collateral. During 1993, the Company earned $789,000 on the loan which accrues interest at 5.6% per annum and is payable at maturity. NOTE 14 BUSINESS SEGMENTS The Company's restaurant operations are concentrated in the western and southeastern United States and consist of Denny's, Hardee's, Quincy's and El Pollo Loco restaurants. The Company's restaurants include basic food concepts found in various segments of the food industry: family restaurants, fast-food hamburger restaurants, steak houses, and char-broiled chicken restaurants. The Company's contract food service business is conducted by Canteen Corporation, which directly and through subsidiaries and independent franchised distributors, engages in vending and contract food and recreation service operations throughout the United States. FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14 BUSINESS SEGMENTS -- Continued Revenues and operating income by business segment for each of the last three years are as follows: Operating income by business segment for the year ended December 31, 1993 reflects nonrecurring charges for the write-off of goodwill and other intangible assets and the provision for restructuring as follows: restaurants -- $1,265.6 million, contract food service -- $359.8 million, and corporate and other, net -- $41.4 million. Depreciation/amortization expense and capital expenditures for each of the last three years are as follows: Identifiable assets as of the specified dates are as follows: FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 15 QUARTERLY DATA (UNAUDITED) The results for each quarter include all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for interim periods. The consolidated financial results on an interim basis are not necessarily indicative of future financial results on either an interim or an annual basis. Selected consolidated financial data for each quarter within 1992 and 1993 are as follows: FLAGSTAR COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 15 QUARTERLY DATA (UNAUDITED) -- Continued In the fourth quarter of 1992, the Company retroactively adopted to January 1, 1992 SFAS No. 106. Accordingly, operating expenses for the first, second and third quarters of 1992 have been restated by $1,067,000, $1,071,000, and $806,000, respectively, to reflect charges related to the implementation of this statement. During the third quarter of 1993, the Company changed its method of determining the discount rate applied to insurance liabilities retroactive to January 1, 1993 pursuant to Staff Accounting Bulletin (SAB) No. 92 issued by the staff of the Securities and Exchange Commission in June 1993 concerning the accounting for environmental and other contingent liabilities. Accordingly, operating expenses for the first and second quarters of 1993 have been restated by $1,869,000 and $1,869,000, respectively, to reflect charges related to the implementation of this pronouncement. FLAGSTAR COMPANIES, INC. INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules not filed herewith are omitted because of the absence of conditions under which they are required or because the information called for is shown in the Consolidated Financial Statements or Notes thereto. SCHEDULE V FLAGSTAR COMPANIES, INC. PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (AMOUNTS IN THOUSANDS) CONSOLIDATED SCHEDULE V FLAGSTAR COMPANIES, INC. PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (AMOUNTS IN THOUSANDS) CONSOLIDATED SCHEDULE V FLAGSTAR COMPANIES, INC. PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) CONSOLIDATED (1) Substantially all of the amount represents the write-down of property relating to the Company's restructuring. SCHEDULE VI FLAGSTAR COMPANIES, INC. ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (AMOUNTS IN THOUSANDS) CONSOLIDATED SCHEDULE VI FLAGSTAR COMPANIES, INC. ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (AMOUNTS IN THOUSANDS) CONSOLIDATED SCHEDULE VI FLAGSTAR COMPANIES, INC. ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) CONSOLIDATED (1) Substantially all of the amount represents the write-down of property relating to the Company's restructuring. SCHEDULE IX FLAGSTAR COMPANIES, INC. SHORT-TERM BORROWINGS (AMOUNTS IN THOUSANDS) (1) Amount computed by dividing the total of daily outstanding principal balances by the number of days in the year. (2) Amount computed by dividing total interest expense by the average amount outstanding. (3) Working capital advances outstanding at December 31, 1993 under the Restated Credit Agreement totalled $93,000 and accrued interest at a weighted average interest rate of 6.51%. For the year ended December 31, 1993 the maximum amount outstanding was $103,000, the average amount outstanding during the period was $49,397 and the weighted average interest rate during the period was 6.26%. The Restated Credit Agreement, as amended, provides for the advances outstanding at December 31, 1993 to be classified as long-term. SCHEDULE X FLAGSTAR COMPANIES, INC. SUPPLEMENTAL INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (AMOUNTS IN THOUSANDS) CONSOLIDATED SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. FLAGSTAR COMPANIES, INC. By: /s/ ROBERT L. WYNN, III Robert L. Wynn, III (General Counsel) Date: April 12, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. INDEX TO EXHIBITS * Certain of the exhibits to this Annual Report on Form 10-K, indicated by an asterisk, are hereby incorporated by reference to other documents on file with the Commission with which they are physically filed, to be part hereof as of their respective dates.

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ITEM 2. PROPERTIES. The Company's headquarters are located in one of two adjacent office buildings owned by Genuine Parts Company in Atlanta, Georgia. The Company's Automotive Parts Group operates 65 NAPA Distribution Centers in the United States distributed among nine geographic divisions. More than 90% of these distribution centers are owned by the Company. At December 31, 1993, the Company owned 683 jobbing stores located in 40 states, and Genuine Parts Company owned a 51% interest in 59 jobbing stores located in 26 states. Other than jobbing stores located within Company owned distribution centers, most of the jobbing stores were operated in leased facilities. In addition, UAP/NAPA, in which Genuine Parts Company owns a minority interest, operated 81 jobbing stores in Western Canada. The Company's Automotive Parts Group also operates three Balkamp distribution centers, six Rayloc rebuilding plants, two transfer and shipping facilities and a Rayloc warehouse. The Company's Industrial Parts Group, operating through Motion and the Berry Companies, operates five distribution centers, two re-distribution centers, 10 service centers and approximately 300 branches. Approximately 80% of these branches are operated in leased facilities. In addition, the Industrial Parts Group operates an industrial parts and agricultural supply distribution center in Western Canada for its seven branches of which approximately 85% are operated in leased facilities. The Company's Office Products Group operates 41 distribution centers in the United States distributed among the Group's five geographic divisions. Approximately 75% of these distribution centers are operated in leased facilities. For additional information regarding rental expense on leased properties, see "Note 5 of Notes to Consolidated Financial Statements" on Page 24 of Annual Report to Shareholders for 1993. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Not Applicable. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCK- HOLDER MATTERS. Information required by this item is set forth under the heading "Market and Dividend Information" on Page 18 of Annual Report to Shareholders for the year ended December 31, 1993, and is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Information required by this item is set forth under the heading "Selected Financial Data" on Page 18 of Annual Report to Shareholders for the year ended December 31, 1993, and is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information required by this item is set forth under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on Page 26 of Annual Report to Shareholders for the year ended December 31, 1993, and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Information required by this item is set forth in the consolidated financial statements on Pages 20 through 25 and Page 27, in "Report of Independent Auditors" on Page 19, and under the heading "Quarterly Results of Operations" on Page 27, of the Annual Report to Shareholders for the year ended December 31, 1993, and is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information required by this item is set forth on Pages 1 through 6, and Page 16 of the definitive proxy statement for the Company's Annual Meeting to be held on April 18, 1994, and is incorporated herein by reference. Certain information about Executive Officers of the Company is included in Item 1 of Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information required by this item is set forth on Page 5, and on Pages 7 through 16 of the definitive proxy statement for the Company's Annual Meeting to be held on April 18, 1994, and is incorporated herein by reference. In no event shall the information contained in the definitive proxy statement for the Company's 1994 Annual Meeting on Pages 9 through 11 under the heading "Compensation and Stock Option Committee Report on Executive Compensation" or on Pages 15 and 16 under the heading "Performance Graph" be incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this item is set forth on Pages 5 and 6 of the definitive proxy statement for the Company's Annual Meeting to be held on April 18, 1994, and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this item is set forth on Page 16 of the definitive proxy statement for the Company's Annual Meeting to be held on April 18, 1994, and is incorporated herein by reference. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K. (a) (1) and (2) The response to this portion of Item 14 is submitted as a separate section of this report. (3) The following Exhibits are filed as part of this report in Item 14(c): Exhibit 3.1.1 Restated Articles of Incorporation of the Company, dated as of April 18, 1988, and as amended April 17, 1989. (Incorporated herein by reference from the Company's Quarterly Report on Form 10-Q, dated May 8, 1989). Exhibit 3.1.2 Amendment to the Restated Articles of Incorporation of the Company, dated as of November 20, 1989. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 12, 1990). Exhibit 3.2 By-laws of the Company, as amended. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 5, 1993). Exhibit 4.1 Shareholder Protection Rights Agreement, dated as of November 20, 1989, between the Company and Trust Company Bank, as Rights Agent. (Incorporated herein by reference from the Company's Report on Form 8-K, dated November 20, 1989). Exhibit 10.1 * Incentive Stock Option Plan. (Incorporated herein by reference from the Company's Annual Meeting Proxy Statement, dated March 12, 1982). Exhibit 10.2 * 1988 Stock Option Plan. (Incorporated herein by reference from the Company's Annual Meeting Proxy Statement, dated March 9, 1988). Exhibit 10.3 * Form of Amendment to Executive Supplemental Retirement Income Agreement adopted February 13, 1989, between the Company and William C. Hatcher. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 15, 1989). Exhibit 10.4 * Form of Amendment to Deferred Compensation Agreement, adopted February 13, 1989, between the Company and certain executive officers of the Company. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 15, 1989). Exhibit 10.5 * Form of Agreement adopted February 13, 1989, between the Company and certain executive officers of the Company providing for a supplemental employee benefit upon a change in control of the Company. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 15, 1989). Exhibit 10.6 * Genuine Parts Company Partnership Plan, effective July 1, 1988. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 15, 1989). Exhibit 10.7 * Genuine Parts Company Supplemental Retirement Plan, effective January 1, 1991. (Incorporated herein by reference from the Company's Annual Report on Form 10-K, dated March 8, 1991). Exhibit 10.8 * 1992 Stock Option and Incentive Plan, effective April 20, 1992. (Incorporated herein by reference from the Company's Annual Meeting Proxy Statement, dated March 6, 1992). Exhibit 10.9 * The Genuine Parts Company Tax-Deferred Savings Plan, effective January 1, 1993. * Indicates executive compensation plans and arrangements Exhibit 13 The following sections and pages of the 1993 Annual Report to Shareholders: - Selected Financial Data on Page 18 - Market and Dividend Information on Page 18 - Report of Independent Auditors of Page 19 - Consolidated Financial Statements and Notes to Consolidated Financial Statements on Pages 20 - 25 - Management's Discussion and Analysis of Financial Condition and Results of Operations on - Industry Data Information on Page 27 - Quarterly Results of Operations on Page 27 Exhibit 22 Subsidiaries of the Company Exhibit 24 Consent of Independent Auditors (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Registrant during the last quarter of the fiscal year. (c) Exhibits. The response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedules. The response to this portion of Item 14 is submitted as a separate section of this report. SIGNATURES. Pursuant to the requirements of Section 13 or 15(d) 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. GENUINE PARTS COMPANY /s/Larry L. Prince 3/4/94 /s/George W. Kalafut 3/4/94 - ------------------------------------- ------------------------------------ Larry L. Prince (Date) George W. Kalafut (Date) Chairman of the Board Executive Vice President - and Chief Executive Officer Finance and Administration and Principal Financial Officer Pursuant to the requirements of the Securities and Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/James R. Courim 2/21/94 /s/William A. Parker 2/21/94 - ------------------------------------- ------------------------------------ James R. Courim (Date) William A. Parker (Date) Director Director /s/Bradley Currey, Jr. 2/21/94 /s/Larry L. Prince 2/21/94 - ------------------------------------- ------------------------------------ Bradley Currey, Jr. (Date) Larry L. Prince (Date) Director Director Chairman of the Board and Chief Executive Officer /s/Jean Douville 2/21/94 /s/John J. Scalley 2/21/94 - ------------------------------------- ------------------------------------ Jean Douville (Date) John J. Scalley (Date) Director Director Chairman of the Board and Executive Vice President Chief Executive Officer UAP INC. /s/John B. Ellis 2/21/94 /s/Alana S. Shepherd 2/21/94 - ------------------------------------- ------------------------------------ John B. Ellis (Date) Alana S. Shepherd (Date) Director Director /s/Thomas C. Gallagher 2/21/94 /s/Lawrence G. Steiner 2/21/94 - ------------------------------------- ------------------------------------ Thomas C. Gallagher (Date) Lawrence G. Steiner (Date) Director Director President and Chief Operating Officer /s/E. Reginald Hancock 2/21/94 /s/James B. Williams 2/21/94 - ------------------------------------- ------------------------------------ E. Reginald Hancock (Date) James B. Williams (Date) Director Director /s/Gardner E. Larned 2/21/94 - ------------------------------------- Gardner E. Larned (Date) Chairman of the Board and Chief Executive Officer of Berry Bearing Company and Its Affiliates ANNUAL REPORT ON FORM-10-K ITEM 14(a)(1) AND (2), (c) AND (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULE YEAR ENDED DECEMBER 31, 1993 GENUINE PARTS COMPANY ATLANTA, GEORGIA FORM 10-K - ITEM 14(A)(1) AND (2) GENUINE PARTS COMPANY AND SUBSIDIARIES INDEX OF FINANCIAL STATEMENTS The following consolidated financial statements of Genuine Parts Company and subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated balance sheets -- December 31, 1993 and 1992 Consolidated statements of income -- Years ended December 31, 1993, 1992 and 1991 Consolidated statements of shareholders' equity -- Years ended December 31, 1993, 1992 and 1991 Consolidated statements of cash flows -- Years ended December 31, 1993, 1992 and 1991 Notes to consolidated financial statements -- December 31, 1993 The following consolidated financial statement schedule of Genuine Parts Company and subsidiaries is included in Item 14(d): Schedule IX - Short-term borrowings All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. ANNUAL REPORT ON FORM 10-K ITEM 14(a)(3) LIST OF EXHIBITS The following Exhibits are filed as a part of this Report: 10.9* The Genuine Parts Company Tax-Deferred Savings Plan, effective January 1, 1993 13 The following Sections and Pages of Annual Report to Shareholders for 1993: - Selected Financial Data on Page 18 - Market and Dividend Information on Page 18 - Report of Independent Auditors on Page 19 - Consolidated Financial Statements and Notes to Consolidated Financial Statements on Pages 20-25 - Management's Discussion and Analysis of Financial Condition and Results of Operations on Page 26 - Industry Data Information on Page 27 - Quarterly Results of Operations on Page 27 22 Subsidiaries of the Company 24 Consent of Independent Accountants The following Exhibits are incorporated by reference as set forth in Item 14 on pages 9 and 10 of this Form 10-K: - 3.1.1 Restated Articles of Incorporation of the Company, dated as of April 18, 1988, and as amended April 17, 1989. - 3.1.2 Amendment to the Articles of Incorporation of the Company, dated as of November 20, 1989. - 3.2 By-laws of the Company, as amended. - 4.1 Shareholder Protection Rights Agreement, dated as of November 20, 1989, between the Company and Trust Company Bank, as Rights Agent. - 10.1* Incentive Stock Option Plan. - 10.2* 1988 Stock Option Plan. - 10.3* Form of Amendment to Executive Supplemental Retirement Income Agreement adopted February 13, 1989, between the Company and William C. Hatcher and Earl Dolive. - 10.4* Form of Amendment to Deferred Compensation Agreement adopted February 13, 1989, between the Company and certain executive officers of the Company. - 10.5* Form of Agreement adopted February 13, 1989, between the Company and certain executive officers of the Company providing for a supplemental employee benefit upon a change in control of the Company. - 10.6* Genuine Parts Company Partnership Plan, effective July 1, 1988. - 10.7* Genuine Parts Company Supplemental Retirement Plan, effective January 1, 1991. - 10.8* 1992 Stock Option and Incentive Plan, effective April 20, 1992. * Indicates executive compensation plans and arrangements

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ITEM 1. BUSINESS CVB Financial Corp. CVB Financial Corp. (referred to herein on an unconsolidated basis as "CVB" and on a consolidated basis as the "Company") is a bank holding company incorporated in California on April 27, 1981 and registered under the Bank Holding Company Act of 1956, as amended. The Company commenced business on December 30, 1981 when, pursuant to a reorganization, it acquired all of the voting stock of Chino Valley Bank (the "Bank"), which is the Company's principal asset. The Company has two other subsidiaries, Community Trust Deed Services ("Community") and Premier Results, Inc. ("Premier"). The Company's principal business is to serve as a holding company for the Bank and Community and for other banking or banking related subsidiaries which the Company may establish or acquire. Although Premier offered item and other processing services, all of its assets were sold to Electronic Data Systems Corporation on December 31, 1992. See "Item 1. BUSINESS - - Premier Results, Inc." The Company has not engaged in any other activities to date. As a legal entity separate and distinct from its subsidiaries, CVB's principal source of funds is and will continue to be dividends paid by and other funds advanced from primarily the Bank. Legal limitations are imposed on the amount of dividends that may be paid and loans that may be made by the Bank to CVB. See "Item 1. BUSINESS - Supervision and Regulation - Restrictions on Transfers of Funds to CVB by the Bank." At December 31, 1993, the Company had $687.4 million in total consolidated assets, $442.1 million in total consolidated net loans and $596.0 million in total consolidated deposits. The principal executive offices of the Company and the Bank are located at 701 North Haven Avenue, Suite 350, Ontario, California. Chino Valley Bank The Bank was incorporated under the laws of the State of California on December 26, 1973, was licensed by the California State Banking Department and commenced operations as a California state chartered bank on August 9, 1974. The Bank's deposit accounts are insured under the Federal Deposit Insurance Act up to applicable limits. Like many other state chartered banks in California, the Bank is not a member of the Federal Reserve System. At December 31, 1993, the Bank had $686.7 million in assets, $442.1 million in net loans and $596.5 million in deposits. The Bank currently has 16 banking offices located in San Bernardino County, Riverside County and the eastern portion of Los Angeles County in Southern California. Of the 16 offices, the Bank opened seven as de novo branches and acquired the other nine in acquisition transactions. Since 1990, the Bank has added four offices, two in 1990 and two in 1993. On March 5, 1993, the Company completed its acquisition of Fontana First National Bank, a one-branch bank located in Fontana, California ("Fontana"), for an aggregate cash purchase price of $5.0 million. As of December 31, 1992, Fontana had total assets of $26.3 million, net loans of $18.5 million, deposits of $22.8 million and shareholders' equity of $3.4 million. For the year ended December 31, 1992, Fontana reported net income of $74,000. On October 21, 1993, the Bank entered into an agreement with the Federal Deposit Insurance Corporation for the purchase of certain assets and the assumption of deposits and other liabilities of the failed Mid City Bank. The agreement provided the Bank with the ability to re-price the deposits assumed within specific time frames, regardless of the original terms of the deposit. Net of the deposits that were re-priced and allowed to withdraw, the Bank assumed approximately $20.0 million in deposits, $2.0 million in investments, and $18.0 million in loans. Through its network of banking offices, the Bank emphasizes personalized service combined with offering a full range of banking services to businesses, professionals and individuals located in the service areas of its offices. Although the Bank focuses the marketing of its services to small- and medium-sized businesses, a full range of retail banking services are made available to the local consumer market. The Bank offers a wide range of deposit instruments. These include checking, savings, money market and time certificates of deposit for both business and personal accounts. The Bank also serves as a federal tax depository for its business customers. The Bank also provides a full complement of lending products, including commercial, installment and real estate loans. Commercial products include lines of credit and other working capital financing, accounts receivable lending and letters of credit. Financing products for individuals include automobile financing, lines of credit and home improvement and home equity lines of credit. Real estate loans include mortgage and construction loans. The Bank also offers a wide range of specialized services designed for the needs of its commercial accounts. These services include cash management systems for monitoring cash flow, a credit card program for merchants, courier pick-up and delivery, payroll services and electronic funds transfers by way of domestic and international wires and automated clearing house. The Bank also makes available investment products to customers, including a full array of fixed income vehicles and a program pursuant to which it places its customers' funds in federally insured time certificates of deposit of other institutions. The Bank does not operate a trust department; however, it makes arrangements with a correspondent institution to offer trust services to its customers on request. Community Trust Deed Services The Company owns 100% of the voting stock of Community, which has one office. Community's services, which are provided to the Bank and non-affiliated persons, include preparing and filing notices of default, reconveyances and related documents and acting as a trustee under deeds of trust. At present, the assets, revenues and earnings of Community are not material in amount as compared to the Bank. Premier Results, Inc. The Company owns 100% of the voting stock of Premier. Through Premier, the Company offered item processing services to the Bank and other financial institutions, in addition to statement reconcilement, bookkeeping, check filing, lock box, microfilm development and on-site printing. On December 31, 1992, the Company sold all of the assets of Premier to Electronic Data Systems Corporation. The assets, revenues and earnings of Premier were not material in amount as compared to the Bank. Economic Environment in the Bank's Market Area The Bank concentrates on marketing to, and serving the needs of, businesses, professionals and individuals in San Bernardino, Riverside, northern Orange and eastern Los Angeles counties. The general economy in Southern California, including the Bank's market area, and particularly the real estate market, is suffering from the effects of a prolonged recession that has negatively impacted upon the ability of certain borrowers to perform their obligations to their lending institutions, including the Bank. According to The UCLA Business Forecast For California, December 1993 Report (the "UCLA Report"), the current recession in California is expected to continue until at least the second half of 1994, despite the presence of a moderate national economic recovery. The UCLA Report attributes the length and depth of the California recession, which began in 1990, to a number of negative economic factors, including permanent cutbacks in the California defense industries and military base closings, a cyclical downturn in California residential real estate construction, lower rates on international trade growth as a result of the worldwide recession and the effects on employment of an increased global emphasis on cost controls and downsizing. The statewide unemployment rate in November 1993 was 8.6%, compared with the national average of 6.4%. The UCLA Report notes that while statewide unemployment figures have improved recently, this was due to a decline in the size of the labor force and that total CalifoRnia employment has declined. Nevertheless, the UCLA Report expects a weak job recovery to begin in California during the second half of 1994, approaching a normal growth rate over the next four years. Based on its assessment of recent economic reports and the current economic environment in the Company's market areas, management believes that the California recession may continue beyond 1994. The overall general economic conditions and the real estate market in Southern California have had and may continue to have an adverse impact on certain of the Bank's borrowing customers and their debt service capacities. The Bank's nonperforming assets increased from $19.0 million at year end 1992 to $23.0 million at year end 1993. While management believes that the allowance for credit losses at December 31, 1993 was adequate to absorb the then known or inherent losses in the loan portfolio, declining real estate values in Southern California have reduced the value of the real estate collateral that secures certain of the Bank's loans and increased the loan-to-value ratio of those credits. As of December 31, 1993, the Bank had approximately $322.9 million in loans secured by real estate located in Southern California. For a further discussion of the Bank's nonperforming assets and allowance for possible credit losses, see "Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." Competition The Bank faces substantial competition for deposits and loans throughout its market areas. The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. Competition for deposits comes primarily from other commercial banks, savings institutions, credit unions, money market and mutual funds and other investment alternatives. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services. Competition for loans comes primarily from other commercial banks, savings institutions, mortgage banking firms and other financial intermediaries. The Bank faces competition for deposits and loans throughout its market areas not only from local institutions but also from out-of-state financial intermediaries which have opened loan production offices or which solicit deposits in the Bank's market areas. Many of the financial intermediaries operating in the Bank's market areas offer certain services, such as trust, investment and international banking services, which the Bank does not offer directly. Additionally, banks with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers. The Bank has 16 offices located in San Bernardino, Riverside, northern Orange and eastern Los Angeles counties. Neither the deposits nor loans of any office of the Bank exceed 1% of the aggregate loans or deposits of all financial intermediaries located in the counties in which such offices are located. Employees At December 31, 1993, CVB, the Bank, Community and Premier employed 311 persons, 200 on a full-time and 111 on a part-time basis. The Company believes that its employee relations are satisfactory. Effect of Governmental Policies and Recent Legislation Banking is a business that depends on rate differentials. In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank's portfolio comprise the major portion of the Company's earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and growth of the Company are subject to the influence of local, domestic and foreign economic conditions, including recession, unemployment and inflation. The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. The likelihood of any major changes and the impact such changes might have on the Company are impossible to predict. Certain of the potentially significant changes which have been enacted and proposals which have been made recently are discussed below. Federal Deposit Insurance Corporation Improvement Act of 1991 On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") was enacted into law. Set forth below is a brief discussion of certain portions of this law and implementing regulations that have been adopted or proposed by the Federal Reserve Board, the Comptroller of the Currency, the Office of Thrift Supervision and the FDIC (collectively, the "federal banking agencies"). BIF Recapitalization. The FDIC Improvement Act provides the FDIC with three additional sources of funds to protect deposits insured by the Bank Insurance Fund (the "BIF") administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the U.S. Treasury; borrow from the Federal Financing Bank up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver; and borrow from financial intermediaries that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. Improved Examinations. All insured depository institutions, except certain small, well managed and, well capitalized institutions, must undergo a full-scope, on-site examination by their appropriate federal banking agency at least once every 12 months. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Standards for Safety and Soundness. Pursuant to the FDIC Improvement Act, the federal banking agencies have issued proposed safety and soundness standards on matters such as loan underwriting and documentation, asset quality, earnings, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. The proposals establish, among other things, the maximum ratio of classified assets to total capital plus ineligible allowance at 1.0 and the minimum level of earnings sufficient to absorb losses without impairing capital. The proposals provide that a bank's earnings are sufficient to absorb losses without impairing capital if the bank is in compliance with minimum capital requirements and the bank would, if its net income or loss over the last four quarters continued over the next four quarters, remain in compliance with minimum capital requirements. Any institution which fails to comply with these standards must submit a compliance plan. Failure to submit an acceptable plan or to comply with an approved plan will subject the institution to further enforcement action. No assurance can be given as to the final form of the proposed regulations or, if adopted, the impact of such regulations on the Company and the Bank. In December 1992, the federal banking agencies issued final regulations prescribing uniform guidelines for real estate lending. The regulations, which became effective on March 19, 1993, require insured depository institutions to adopt written policies establishing standards, consistent with such guidelines, for extensions of credit secured by real estate. The policies must address loan portfolio management, underwriting standards and loan-to-value limits that do not exceed the supervisory limits prescribed by the regulations. Prompt Corrective Regulatory Action. The FDIC Improvement Act requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions that fall below one or more prescribed minimum capital ratios. The purpose of this law is to resolve the problems of insured depository institutions at the least possible long-term cost to the appropriate deposit insurance fund. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized (significantly exceeding the required minimum capital requirements), adequately capitalized (meeting the required capital requirements), undercapitalized (failing to meet any one of the capital requirements), significantly undercapitalized (significantly below any one capital requirement) and critically undercapitalized (failing to meet all capital requirements). In September 1992, the federal banking agencies issued uniform final regulations implementing the prompt corrective action provisions of the FDIC Improvement Act. Under the regulations, an insured depository institution will be deemed to be: o "well capitalized" if it (i) has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater and (ii) is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure; o "adequately capitalized" if it has a total risk- based capital ratio of 8% or greater, a Tier 1 risk- based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or a leverage ratio of 3% or greater if the institution is rated composite 1 under the applicable regulatory rating system in its most recent report of examination); o "undercapitalized" if it has a total risk-based capital ratio that is less than 8%, a Tier 1 risk- based capital ratio that is less than 4% or a leverage ratio that is less than 4% (or a leverage ratio that is less than 3% if the institution is rated composite 1 under the applicable regulatory rating system in its most recent report of examination); o "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3% or a leverage ratio that is less than 3%; and o "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2%. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized or undercapitalized may be reclassified to the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, (i) determines that the institution is in an unsafe or unsound condition or (ii) deems the institution to be engaging in an unsafe or unsound practice and not to have corrected the deficiency. At each successive lower capital category, an insured depository institution is subject to more restrictions and federal banking agencies are given less flexibility in deciding how to deal with it. The law prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions if after such transaction the institution would be undercapitalized. If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency, subject to asset growth restrictions and required to obtain prior regulatory approval for acquisitions, branching and engaging in new lines of business. Any undercapitalized depository institution must submit an acceptable capital restoration plan to the appropriate federal banking agency 45 days after becoming undercapitalized. The appropriate federal banking agency cannot accept a capital plan unless, among other things, it determines that the plan (i) specifies the steps the institution will take to become adequately capitalized, (ii) is based on realistic assumptions and (iii) is likely to succeed in restoring the depository institution's capital. In addition, each company controlling an undercapitalized depository institution must guarantee that the institution will comply with the capital plan until the depository institution has been adequately capitalized on an average basis during each of four consecutive calendar quarters and must otherwise provide adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (a) an amount equal to 5% of the depository institution's total assets at the time the institution became undercapitalized or (b) the amount which is necessary to bring the institution into compliance with all capital standards applicable to such institution as of the time the institution fails to comply with its capital restoration plan. Finally, the appropriate federal banking agency may impose any of the additional restrictions or sanctions that it may impose on significantly undercapitalized institutions if it determines that such action will further the purpose of the prompt corrective action provisions. An insured depository institution that is significantly undercapitalized, or is undercapitalized and fails to submit, or in a material respect to implement, an acceptable capital restoration plan, is subject to additional restrictions and sanctions. These include, among other things: (i) a forced sale of voting shares to raise capital or, if grounds exist for appointment of a receiver or conservator, a forced merger; (ii) restrictions on transactions with affiliates; (iii) further limitations on interest rates paid on deposits; (iv) further restrictions on growth or required shrinkage of assets; (v) modification or termination of specified activities; (vi) replacement of directors or senior executive officers, subject to certain grandfather provisions for those elected prior to enactment of the FDIC Improvement Act; (vii) prohibitions on the receipt of deposits from correspondent institutions; (viii) restrictions on capital distributions by the holding companies of such institutions; (ix) required divestiture of subsidiaries by the institution; or (x) other restrictions as determined by the appropriate federal banking agency. Although the appropriate federal banking agency has discretion to determine which of the foregoing restrictions or sanctions it will seek to impose, it is required to force a sale of voting shares or merger, impose restrictions on affiliate transactions and impose restrictions on rates paid on deposits unless it determines that such actions would not further the purpose of the prompt corrective action provisions. In addition, without the prior written approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to its senior executive officers or provide compensation to any of them at a rate that exceeds such officers' average rate of base compensation during the 12 calendar months preceding the month in which the institution became undercapitalized. Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. For example, a critically undercapitalized institution generally would be prohibited from engaging in any material transaction other than in the ordinary course of business without prior regulatory approval and could not, with certain exceptions, make any payment of principal or interest on its subordinated debt beginning 60 days after becoming critically undercapitalized. Most importantly, however, except under limited circumstances, the appropriate federal banking agency, not later than 90 days after an insured depository institution becomes critically undercapitalized, is required to appoint a conservator or receiver for the institution. The board of directors of an insured depository institution would not be liable to the institution's shareholders or creditors for consenting in good faith to the appointment of a receiver or conservator or to an acquisition or merger as required by the regulator. As of December 31, 1993, the Bank had a total risk-based capital ratio of 13.0%, a Tier 1 risk-based ratio of 11.7% and a leverage ratio of 8.3%. Other Items. The FDIC Improvement Act also, among other things, (i) limits the percentage of interest paid on brokered deposits and limits the unrestricted use of such deposits to only those institutions that are well capitalized; (ii) requires the FDIC to charge insurance premiums based on the risk profile of each institution; (iii) eliminates "pass through" deposit insurance for certain employee benefit accounts unless the depository institution is well capitalized or, under certain circumstances, adequately capitalized; (iv) prohibits insured state chartered banks from engaging as principal in any type of activity that is not permissible for a national bank unless the FDIC permits such activity and the bank meets all of its regulatory capital requirements; (v) directs the appropriate federal banking agency to determine the amount of readily marketable purchased mortgage servicing rights that may be included in calculating such institution's tangible, core and risk-based capital; and (vi) provides that, subject to certain limitations, any federal savings association may acquire or be acquired by any insured depository institution. The FDIC has adopted final regulations implementing the risk-based premium system mandated by the FDIC Improvement Act. Under the transitional regulations, which cover the assessment periods commencing on and after January 1, 1994, insured depository institutions are required to pay insurance premiums within a range of 23 cents per $100 of deposits to 31 cents per $100 of deposits depending on their risk classification. To determine the risk-based assessment for each institution, the FDIC will categorize an institution as well capitalized, adequately capitalized or undercapitalized based on its capital ratios. A well capitalized institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio and a 5% Tier 1 leverage capital ratio. An adequately capitalized institution will have at least an 8% total risk-based capital ratio, a 4% Tier 1 risk-based capital ratio and a 4% Tier 1 leverage capital ratio. An undercapitalized institution will be one that does not meet either of the above definitions. The FDIC will also assign each institution to one of three supervisory subgroups based upon reviews by the institution's primary federal or state regulator, statistical analyses of financial statements and other information relevant to evaluating the risk posed by the institution. As a result, the assessment rates within each of three capital categories will be as follows (expressed as cents per $100 of deposits): Supervisory Subgroup A B C Well capitalized 23 26 29 Adequately capitalized 26 29 30 Undercapitalized 29 30 31 In addition, the FDIC has issued final regulations implementing provisions of the FDIC Improvement Act relating to powers of insured state banks. The regulations prohibit, subject to certain specified exceptions, insured state banks from making equity investments of a type, or in an amount, that are not permissible for national banks. In general, equity investments include equity securities, partnership interests and equity interests in real estate. Under the final regulations, non-permissible investments must be divested by no later than December 19, 1996. The FDIC has also issued final regulations which prohibit insured state banks from engaging as principal in any activity not permissible for a national bank, without FDIC approval. The regulations also provide that, subject to certain specified exceptions, subsidiaries of insured state banks may not engage as principal in any activity that is not permissible for a subsidiary of a national bank, without FDIC approval. The impact of the FDIC Improvement Act on the Company and the Bank is uncertain, especially since many of the regulations promulgated thereunder have been only recently adopted and certain of the law's provisions still need to be defined through future regulatory action. Certain provisions, such as the recently adopted real estate lending standards and the limitations on investments and powers of state banks and the rules to be adopted governing compensation, fees and other operating policies, may affect the way in which the Bank conducts its business, and other provisions, such as those relating to the establishment of the risk-based premium system, may adversely affect the Bank's results of operations. Capital Adequacy Guidelines The Federal Reserve Board and the FDIC have issued guidelines to implement risk-based capital requirements. The guidelines are intended to establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance-sheet financial instruments into account in assessing capital adequacy and minimizes disincentives to holding liquid, low-risk assets. Under these guidelines, assets and credit equivalent amounts of off-balance-sheet financial instruments, such as letters of credit and long-term outstanding loan commitments, are assigned to one of several risk categories, which range from 0% for credit risk-free assets, such as cash and certain U.S. government securities, to 100% for relatively high-risk assets, such as loans and investments in fixed assets, premises and other real estate owned. The aggregated dollar amount of each category is then multiplied by the risk-weight associated with that category. The resulting weighted values from each of the risk categories are then added together to determine the total risk-weighted assets. Beginning on December 31, 1992, the guidelines require a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must consist of Tier 1 capital. Higher risk-based ratios are required to be considered well capitalized under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Federal Deposit Insurance Improvement Act of 1991 - Prompt Corrective Regulatory Action." A banking organization's qualifying total capital consists of two components: Tier 1 capital (core capital) and Tier 2 capital (supplementary capital). Tier 1 capital consists primarily of common stock, related surplus and retained earnings, qualifying noncumulative perpetual preferred stock (plus, for bank holding companies, qualifying cumulative perpetual preferred stock in an amount up to 25% of Tier 1 capital) and minority interests in the equity accounts of consolidated subsidiaries. Intangibles, such as goodwill, are generally deducted from Tier 1 capital; however, purchased mortgage servicing rights and purchase credit card relationships may be included, subject to certain limitations. At least 50% of the banking organization's total regulatory capital must consist of Tier 1 capital. Tier 2 capital may consist of (i) the allowance for possible loan and lease losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stock and long-term preferred stock (which for bank holding companies must have an original maturity of 20 years or more) and related surplus; (iii) hybrid capital instruments (instruments with characteristics of both debt and equity), perpetual debt and mandatory convertible debt securities; and (iv) eligible term subordinated debt and intermediate-term preferred stock with an original maturity of five years or more, including related surplus, in an amount up to 50% of Tier 1 capital. The inclusion of the foregoing elements of Tier 2 capital are subject to certain requirements and limitations of the federal banking agencies. The Federal Reserve Board and the FDIC have also adopted a minimum leverage ratio of Tier 1 capital to average total assets of 3% for the highest rated banks. This leverage ratio is only a minimum. Institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain capital well above the minimum level. Furthermore, higher leverage ratios are required to be considered well capitalized or adequately capitalized under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Federal Deposit Insurance Corporation Improvement Act of 1991 -Prompt Corrective Regulatory Action." As of December 31, 1993, the Company and the Bank had total risk-based capital ratios of 13.1% and 13.0%, Tier 1 risk-based capital ratios of 11.8% and 11.7% and leverage ratios of 8.4% and 8.3%, respectively. In addition, the federal banking agencies have issued proposed rules, in accordance with the FDIC Improvement Act, seeking public comment on methods for measuring interest rate risk, and two alternative methods for determining what amount of additional capital, if any, a bank may be required to have for interest rate risk. The Company cannot yet determine whether such proposals will be adopted or the impact of such regulations, if adopted, on the Company and the Bank. The federal banking agencies issued a statement advising that, for regulatory purposes, federally supervised banks and savings associations should report deferred tax assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," beginning in 1993. See "Item 1. BUSINESS -Effect of Governmental Policies and Recent Legislation - Accounting Changes." However, the federal banking agencies have advised that they will place a limit on the amount of deferred tax assets that is allowable in computing an institution's regulatory capital. Deferred tax assets that can be realized from taxes paid in prior carryback years and from the future reversal of temporary differences would generally not be limited. Deferred tax assets that can only be realized through future taxable earnings, including the implementation of a tax planning strategy, would be limited for regulatory capital purposes to the lesser of (i) the amount that can be realized within one year of the quarter-end report date or (ii) 10% of Tier 1 capital. The amount of deferred taxes in excess of this limit, if any, would be deducted from Tier 1 capital and total assets in regulatory capital calculations. The federal banking agencies have notified institutions that their capital rules will be amended to reflect this change. Management does not expect implementation of this proposal to have a material impact on the Bank's regulatory capital levels. The federal banking agencies issued a proposal in January 1994 seeking public comment on whether to amend their capital definitions of leverage and risk based capital to conform such definitions to the recently issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires an institution to recognize as a separate component of stockholders' equity the amount of unrealized gains and losses on securities that are deemed to be "available for sale." See "Business -- Effect of Government Policies and Recent Legislation -- Accounting Changes." Accounting Changes In February 1992, the Financial Accounting Standards Board ("FASB") issued SFAS No. 109, which supersedes SFAS No. 96. SFAS No. 109 is effective for fiscal years beginning after December 31, 1992, or earlier at the Company's option. SFAS No. 109 employs an asset and liability approach in accounting for income taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and as measured by the provisions of enacted tax laws. The Company adopted SFAS No. 109 in 1992, elected not to restate prior years and has determined that the cumulative effect of the implementation was immaterial. In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114"). Under the provisions of SFAS No. 114, a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. SFAS No. 114 requires creditors to measure impairment of a loan based on the present value of expected future cash flows discounted at the loan's effective interest rate, market prices (when available) or the fair market value of collateral for a collateral-dependent loan. If the measure of the impaired loan is less than the recorded investment in the loan, a creditor shall recognize an impairment by recreating a valuation allowance with a corresponding charge to bad debt expense. This statement also applies to restructured loans and changes the definition of in-substance foreclosures to apply only to the loans where the creditor has taken physical possession of the borrower's assets. SFAS No. 114 applies to financial statements for fiscal years beginning after December 15, 1994. Earlier implementation is permitted. The Company is currently evaluating the impact of the statement on its results of operations and financial position but is unlikely to implement the statement early. In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions" ("SFAS No. 106"), effective for fiscal years beginning after December 15, 1992. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Post- Employment Benefits" ("SFAS No. 112") effective for fiscal years beginning after December 15, 1993. SFAS No. 106 and SFAS No. 112 focus primarily on post-retirement health care benefits. The Company does not provide post- retirement benefits and SFAS No. 106 and SFAS No. 112 will have no impact on net income in 1994. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," addressing the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments would be classified in three categories and accounted for as follows: (i) debt and equity securities that the entity has the positive intent and ability to hold to maturity would be classified as "held to maturity" and reported at amortized cost; (ii) debt and equity securities that are held for current resale would be classified as trading securities and reported at fair value, with unrealized gains and losses included in operations; and (iii) debt and equity securities not classified as either securities held to maturity or trading securities would be classified as securities available for sale, and reported at fair value, with unrealized gains and losses excluded from operations and reported as a separate component of shareholders' equity. The Compnay adopted SFAS No. 115 effective as of January 1, 1994, and as of that date the Bank had both investment securities classified at "held to maturity" and investment securities classified as "available for sale." Securities classified as available for sale will be reported at their fair value at the end of each fiscal quarter. The value of such securities fluctuates based on changes in interest rates. Generally, an increase in interest rates would result in a decline in the value of investment securities held for sale, while a decline in interest rates would result in an increase in the value of such securities. Therefore, the value of investment securities available for sale and the Bank's shareholders' equity could be subject to fluctuation, based on changes in interest rates. As a consequence, the Bank's capital levels for regulatory purposes could change based solely on fluctuations in interest rates and fluctuations in the value of investment securities available for sale. Such change could result in additional regulatory restrictions under the prompt corrective actions provisions of the FDIC Improvement Act of 1991 and various other laws and regulations that are based, in part, on a institution's capital levels, including those dealing with the risk related insurance premium system and brokered deposit restrictions. See "Item 1, Business -- Effect of Governmental Policies and Recent Legislation -- Federal Deposit Insurance Corporation Improvement Act of 1991." Omnibus Budget Reconciliation Act of 1993 On August 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "Reconciliation Act"). Some of the provisions in the Reconciliation Act that may have an effect on the Company include the following: (i) the corporate income tax rate was increased from 34.04% to 35.0% for taxable income in excess of $10.0 million; (ii) mark-to-market rules for tax purposes with regard to securities held for sale by the Company; (iii) beginning in 1994 the amount of business meals and entertainment expenses that will be disallowed will be increased from the current 20.0% disallowance to 50.0% disallowance; (iv) club dues and lobbying expenses will no longer be deductible; and (v) certain intangible assets, including goodwill, will be amortized over a period of 15 years. Considering the Company's current tax situation, the Company does not expect the provisions of the Reconciliation Act to have a material effect on the Company. Supervision and Regulation Bank holding companies and banks are extensively regulated under both federal and state law. The Company The Company, as a registered bank holding company, is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Act"). The Company is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Act. The Federal Reserve Board may conduct examinations of the Company and its subsidiaries. The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest certain subsidiaries or affiliates when the Federal Reserve Board believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities. Under the Act and regulations adopted by the Federal Reserve Board, a bank holding company and its nonbanking subsidiaries are prohibited from requiring certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Further, the Company is required by the Federal Reserve Board to maintain certain levels of capital. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Capital Adequacy Guidelines." The Company is required to obtain the prior approval of the Federal Reserve Board for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company. The Company is prohibited by the Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in , or acquire shares of companies engaged in, any activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making any such determination, the Federal Reserve Board is required to consider whether the performance of such activities by the Company or an affiliate can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board is also empowered to differentiate between activities commenced de novo and activities commenced by acquisition, in whole or in part, of a going concern and is generally prohibited from approving an application by a bank holding company to acquire voting shares of any commercial bank in another state unless such acquisition is specifically authorized by the laws of such other state. Under Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve Board's policy that, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both. This doctrine has become known as the "source of strength" doctrine. Although the United States Court of Appeals for the Fifth Circuit found the Federal Reserve Board's source of strength doctrine invalid in 1990, stating that the Federal Reserve Board had no authority to assert the doctrine under the Act, the decision, which is not binding on federal courts outside the Fifth Circuit, was recently reversed by the United States Supreme Court on procedural grounds. The validity of the source of strength doctrine is likely to continue to be the subject of litigation until definitively resolved by the courts or by Congress. The Company is also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the California State Banking Department. Finally, the Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, including, but not limited to, filing annual, quarterly and other current reports with the Securities and Exchange Commission. The Bank The Bank, as a California state chartered bank, is subject to primary supervision, periodic examination and regulation by the California Superintendent of Banks ("Superintendent") and the FDIC. The Bank is insured by the FDIC, which currently insures deposits of each member bank to a maximum of $100,000 per depositor. For this protection, the Bank, as is the case with all insured banks, pays a semiannual statutory assessment and is subject to the rules and regulations of the FDIC. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation." Although the Bank is not a member of the Federal Reserve System, it is nevertheless subject to certain regulations of the Federal Reserve Board. Various requirements and restrictions under the laws of the State of California and the United States affect the operations of the Bank. State and federal statutes and regulations relate to many aspects of the Bank's operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Capital Adequacy Guidelines." Restrictions on Transfers of Funds to CVB by the Bank CVB is a legal entity separate and distinct from the Bank and its subsidiaries. There are statutory and regulatory limitations on the amount of dividends which may be paid to CVB by the Bank. California law restricts the amount available for cash dividends by state chartered banks to the lesser of retained earnings or the bank's net income for its last three fiscal years (less any distributions to shareholders made during such period). In the event a bank has no retained earnings or net income for its last three fiscal years, cash dividends may be paid in an amount not exceeding the greater of the retained earnings of the bank, the net income for such bank's last preceding fiscal year, or the net income of the bank for its current fiscal year only after obtaining the prior approval of the Superintendent. The FDIC also has authority to prohibit the Bank from engaging in what, in the FDIC's opinion, constitutes an unsafe or unsound practice in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the FDIC could assert that the payment of dividends or other payments might, under some circumstances, be such an unsafe or unsound practice. Further, the FDIC and the Federal Reserve Board have established guidelines with respect to the maintenance of appropriate levels of capital by banks or bank holding companies under their jurisdiction. Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions of the FDIC Improvement Act could limit the amount of dividends which the Bank or the Company may pay. See "Item 1. BUSINESS - Federal Deposit Insurance Corporation Improvement Act of 1991 - Prompt Corrective Regulatory Action and - Capital Adequacy Guidelines" for a discussion of these additional restrictions on capital distributions. At present, substantially all of CVB's revenues, including funds available for the payment of dividends and other operating expenses, are, and will continue to be, primarily dividends paid by the Bank. At December 31, 1993, the Bank had approximately $18.0 million available for the payment of cash dividends. The Bank is subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, CVB or other affiliates, the purchase of or investments in stock or other securities thereof, the taking of such securities as collateral for loans and the purchase of assets of CVB or other affiliates. Such restrictions prevent CVB and such other affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by the Bank to or in CVB or to or in any other affiliate are limited to 10% of the Bank's capital and surplus (as defined by federal regulations) and such secured loans and investments are limited, in the aggregate, to 20% of the Bank's capital and surplus (as defined by federal regulations). California law also imposes certain restrictions with respect to transactions involving CVB and other controlling persons of the Bank. Additional restrictions on transactions with affiliates may be imposed on the Bank under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - - Federal Deposit Insurance Corporation Improvement Act of 1991 - Prompt Corrective Regulatory Action." Potential Enforcement Actions Commercial banking organizations, such as the Bank, and their institution-affiliated parties, which include the Company, may be subject to potential enforcement actions by the Federal Reserve Board, the FDIC and the Superintendent for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of the Bank), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDIC Improvement Act. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company. Neither the Company nor the Bank have been subject to any such enforcement actions. ITEM 2. ITEM 2. Properties The principal executive offices of the Company and the Bank are located at 701 N. Haven Avenue, Suite 350, Ontario, California. The office of Community is located at 125 East "H" Street, Colton, California. The Bank occupies the premises for ten of its offices under leases expiring at various dates from 1994 through 2014. The Bank owns the premises for its six other offices. The Company's total occupancy expense, exclusive of furniture and equipment expense, for the year ended December 31, 1993, was $2.2 million. Management believes that its existing facilities are adequate for its present purposes. However, management currently intends to increase the Bank's assets over the next several years and anticipates that a substantial portion of this growth will be accomplished through acquisition or de novo opening of additional banking offices. For additional information concerning properties, see Notes 6 and 9 to the Company's financial statements included in this report. See "Item 8, FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA." ITEM 3. ITEM 3. Legal Proceedings From time to time the Company and the Bank are party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company and the Bank management believes that the ultimate aggregate liability represented thereby, if any, will not have a material adverse effect on the Company's consolidated financial position or results of operations. ITEM 4. ITEM 4.Submission of Matters to a Vote of Security Holders No matters were submitted to shareholders during the fourth quarter of 1993. ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT As of March 15, 1994, the principal executive officers of the Company and Chino are: Name Position Age George A. Borba Chairman of the Board of 61 the Company and the Bank D. Linn Wiley President and Chief Executive 55 Officer of the Company and the Bank Daniel L. Thomas Executive Vice President/Manager 53 of the Chino office Vincent T. Breitenberger Executive Vice President/Senior 60 Loan Officer of the Bank Jay W. Coleman Executive Vice President of the Bank 51 Robert J. Schurheck Chief Financial Officer of 61 the Company and Executive Vice President and Chief Financial Officer of the Bank Other than George A. Borba, who is the brother of John A. Borba, a director of the Company and the Bank, there is no family relationship among any of the above-named officers or any of the Company's directors. Mr. Borba has served as Chairman of the Board of the Company since its organization in April 1981 and Chairman of the Board of the Bank since its organization in December 1973. In addition, Mr. Borba is the owner of George Borba Dairy. Mr. Wiley has served as President and Chief Executive Officer of the Company since October 4, 1991. Mr. Wiley joined the Company and Bank as a director and as President and Chief Executive Officer designate on August 21, 1991. Prior to that, Mr. Wiley served as an Executive Vice President of Wells Fargo Bank from April 1, 1990 to August 20, 1991. From 1988 to April 1, 1990 Mr. Wiley served as the President and Chief Administrative Officer of Central Pacific Corporation, and from 1983 to 1990 he was the President and Chief Executive Officer of American National Bank. Mr. Thomas assumed the position of Executive Vice President/Manager of the Chino office effective November 1, 1988. Prior to that time he was Executive Vice President from February 25, 1985 to October 31, 1988. Prior to that, he served as Senior Vice President of Loan Administration at Bank of Newport. Mr. Breitenberger has served as Executive Vice President of the Bank since April 1982, and prior to that time was Senior Vice President of the Bank from November 1980 to March 1982. He has been the Senior Loan Officer of the Bank since November 1980. Mr. Coleman assumed the position of Executive Vice President of the Bank on December 5, 1988. Prior to that he served as President and Chief Executive Officer of Southland Bank, N.A. from March 1983 to April 1988. Mr. Schurheck assumed the position of Chief Financial Officer of the Company and Executive Vice President/Chief Financial Officer of the Bank on March 1, 1990. He served as Senior Vice President of the Bank from September 11, 1989 to February 28, 1990. Prior to that he served as Senior Vice President of General Bank from June 1988 to September 1989. From July 1987 to June 1988 Mr. Schurheck was a self-employed consultant; from December 1973 to June 1987 he was Senior Vice President of Operations and Finance of State Bank in Lake Havasu City, Arizona. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Shares of CVB Financial Corp. common stock price increased from an average price of $10.129 for the first quarter of 1993, to an average price of $12.538 for the fourth quarter of 1993. Fears regarding the recession, weak California real estate prices, and bank capital levels continued to dominate investors' perceptions of bank stocks, regardless of the performance of CVB Financial Corp. The average price of CVB common stock for the fourth quarter of 1993 was $12.538, and this represented a multiple of book value of approximately 1.52. The following table presents the high and low sales prices for the Company's common stock during each quarter for the past three years. The share prices and cash dividend per share amounts presented for all periods in the table below have been restated to give retroactive effect to the ten percent stock dividends declared on December 15, 1993. There were approximately 1,039 shareholders as of December 31, 1993. Three Year Summary of Common Stock Prices Quarter Ended High Low Dividends 3/31/91 11.57 8.58 $.058 Cash Dividend 6/30/91 10.85 9.61 $.058 Cash Dividend 9/30/91 10.13 8.26 $.058 Cash Dividend 12/31/91 9.50 6.82 $.066 Cash Dividend 3/31/92 10.02 7.34 $.066 Cash Dividend 6/30/92 8.88 8.16 $.066 Cash Dividend 9/30/92 8.36 7.65 $.066 Cash Dividend 12/31/92 8.47 6.82 $.066 Cash Dividend 10% Stock Dividend 3/31/93 12.27 8.52 $.073 Cash Dividend 6/30/93 11.42 10.00 $.073 Cash Dividend 9/30/93 13.41 10.91 $.073 Cash Dividend 12/31/93 13.52 11.70 $.073 Cash Dividend 10% Stock Dividend The Company lists its common stock on the American Stock Exchange under the symbol "CVB." ITEM. 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis is written to provide greater insight into the results of operations and the financial condition of CVB Financial Corp. and its subsidiaries. This analysis should be read in conjunction with the audited financial statements contained within this report including the notes thereto. CVB Financial Corp., (CVB) is a bank holding company. Its primary subsidiary, Chino Valley Bank, (the Bank) is a state chartered bank with 16 branch offices located in San Bernardino, Riverside, east Los Angeles, and north Orange Counties. Community Trust Deed Services (CTD) is a nonbank subsidiary providing services to the Bank as well as nonaffiliated persons. For purposes of this analysis, the consolidated entities are referred to as the "Company". The results of operations, and the financial condition of the Company were affected in 1993 by two separate bank acquisitions. On March 8, 1993, the Company acquired Fontana First National Bank through merger with the "Capital B Bank" as the continuing entity. On the date of acquisition Fontana First National Bank had approximately $23.7 million in deposits and acquiring approximately $18.5 million in loans. Fontana First National Bank was purchased for $5.04 million, which resulted in $2.0 million in goodwill. On October 21, 1993, the Bank assumed the deposits and purchased certain assets of the failed Mid City Bank, N.A. from the Federal Deposit Insurance Corporation (the FDIC). The acquisition was structured under a written agreement between the FDIC and the Bank that allowed the Bank certain rights in regard to repricing deposits and purchasing additional assets as well as providing the Bank with indemnification from prior activities of the failed bank. After exercising its right to re-price specific deposits, the Bank assumed approximately $20.0 million in deposits, and purchased $2.0 million in investments and $18.0 million in loans. ANALYSIS OF THE RESULTS OF OPERATIONS The Company reported net earnings of $9.5 million for the year ended December 31, 1993. This represented an increase of $507,000 or 5.60%, over net earnings of $9.0 million for the year ended December 31, 1992. For the year ended December 31, 1991, net earnings totaled $7.9 million. Earnings per share have increased from $1.10, to $1.23, to $1.27, for the years ended December 31, 1991, 1992, and 1993, respectively. The return on average assets increased from 1.54% for the year ended December 31, 1991, to 1.62% for the year ended December 31, 1992, then decreased to 1.52% for the year ended December 31, 1993. Return on average shareholders' equity decreased from 19.45%, to 18.72%, to 17.46%, for the years ended December 31, 1991, 1992, and 1993, respectively. The capital to asset ratio (the leverage ratio) increased from 8.28% at December 31, 1991, to 8.37% at December 31, 1993. The increase in net earnings for 1993 and 1992 was primarily the result of increases in net interest income. Contributing to the increase in net interest income was a significant increase in assets and a lower cost of total deposits resulting from increased noninterest bearing demand deposits as a percent of total deposits. Significant growth in other operating income for 1993 also contributed to increased net earnings. This was the result of gains realized on securities sold during the year. Increases in the provision for loan losses for 1992 and 1993, and a $2.8 million provision for potential losses on other real estate owned for 1993, offset a portion of the increase in net interest income for 1992 and 1993. Growth in assets exceeded increases in earnings for 1993, resulting in a decrease in return on assets. NET INTEREST INCOME AND THE NET INTEREST MARGIN Table 1 provides average balances of assets, liabilities, and shareholders' equity, for the years ended December 31, 1993, 1992, and 1991. Interest income and interest expense and the corresponding yields and costs are included for applicable interest earning assets and interest bearing liabilities for each year ended. Rates for tax preferenced investments are provided on a taxable equivalent basis using a marginal tax rate of 34.25%. Net interest income is equal to the difference between the interest the Company receives on interest earning assets and the interest it pays for interest bearing liabilities. Net interest income totaled $35.9 million for the year ended December 31, 1993, representing an increase of $3.9 million, or 12.1%, over net interest income of $32.0 million for the year ended December 31, 1992. For the year ended December 31, 1991, the Company generated net interest income of $29.5 million. The net interest margin is the net return on average interest earning assets, or net interest income measured as a percent of average interest earning assets. The net interest margin totaled 6.56%, 6.49%, and 6.36%, for the years ended December 31, 1993, 1992, and 1991, respectively. The increases in net interest income and net interest margin for both 1993 and 1992 were the result of continued improvement in the net interest spread. A general decline in the rate paid for interest bearing liabilities, coupled with increases in noninterest bearing demand deposits as a percent of total deposits, resulted in a decrease in the cost of funds. The net interest spread is the difference between the yield on interest earning assets and the cost of interest bearing liabilities. The yield on interest earning assets decreased from 10.51%, to 8.95%, to 8.37%, for the years ended December 31, 1991, 1992, and 1993, respectively. During the same period, the cost of interest bearing liabilities decreased from 5.44% for 1991, to 3.34% for 1992, to 2.55% for 1993. The decreases in the yields on interest earning assets as well as the cost of interest bearing liabilities both reflect decreases in interest rates in general during the three year period. As the decreases in the cost of interest bearing liabilities was greater than the decreases in the yield on interest earning assets, the net interest spread increased from 5.07% for 1991, to 5.61% for 1992, to 5.82% for 1993. Increases in net interest income and the net interest margin for 1992 and 1993 were also affected by a less costly deposit mix. The Company's assets are primarily funded by deposits, including non-interest bearing demand deposits. Noninterest bearing demand deposits have increased from $131.5 million, to $157.4 million, to $221.6 million at December 31, 1991, 1992 and 1993, respectively. This represented increases of $64.1 million, or 40.70% for 1993, and $25.9 million, or 19.75% for 1992. As a percent of average total deposits, average noninterest bearing demand deposits have increased from 24.70%, to 27.96%, to 31.99%, for the years ended December 31, 1991, 1992, and 1993, respectively. As average noninterest bearing deposits have increased as a percent of average total deposits, the cost of average total deposits has decreased from 4.09%, to 2.40%, to 1.73%, for the years ended December 31, 1991, 1992 and 1993, respectively. Table 2 provides a summary of the changes in interest income and interest expense resulting from changes in the volume of interest earning assets and interest bearing liabilities, and the changes resulting from changes in interest rates for the years ended December 31, 1993, 1992, and 1991. The changes in interest income or expense attributable to volume changes are calculated by multiplying the change in volume by the initial average rate. The changes in interest income attributable to changes in interest rates are calculated by multiplying the change in rate by the initial volume. The changes attributable to rate and volume changes are calculated by multiplying the change in rate times the change in volume. The Company's primary source of revenue is the interest income it receives on loans. In general, the Company stops accruing interest on a nonperforming loan after its principal or interest becomes 90 days or more past due. Interest that has already accrued on a nonperforming loan is reversed from income when the loan is placed in a nonperforming status. Interest income for the year ended December 31, 1992, and 1991, respectively, included interest of $115,900, and $89,500 that was accrued and not reversed on nonperforming loans. There was no interest income that was accrued and not reversed on any nonperforming loan at December 31, 1993. For 1991 and 1992, the amount of interest accrued on nonperforming loans was deemed collectable primarily based on the value of collateral in which the Bank held a security interest. Had nonperforming loans for which interest was no longer accruing complied with the original terms and conditions of the notes, interest income would have increased by $1,186,000, $698,600, and $1,037,200 for the years ended December 31, 1993, 1992, and 1991 respectively. Accordingly, yields on loans would have increased by 0.28%, 0.19%, and 0.29%, respectively. Included in Other Real Estate Owned at December 31, 1993 is a loan totaling $977,000 which, although performing according to its original terms, is accounted for as real estate held for sale as required under SFAS 66. As principal and interest payments on this loan were current at December 31, 1993, for analysis purposes, the average balance of the loan was included in total loans, and the yield on loans was adjusted accordingly. Loan fees and the direct costs associated with the origination of loans are deferred and netted against the outstanding loan balance. The deferred net loan fees and costs are recognized as interest income net of cost over the term of the loan in a manner that approximates the level-yield method. (See Note 1 of the Financial Statements). Fees collected on loans are an integral part of the loan pricing decision. For the year ended December 31, 1993, the Company recognized $2.7 million in loan origination fees, representing an increase of $373,000, or 16.1%, from fee income of $2.3 million recognized in 1992. Fee income recognized for 1991 totaled $2.4 million. Table 3 summarizes loan fee activity for the Bank for the three year period. During periods of changing interest rates, the ability to reprice interest earning assets and interest bearing liabilities can influence net interest income, the net interest margin, and consequently, the Company's earnings. The Bank's Management actively monitors interest rate "sensitivity" to potential changes in interest rates using a maturity/repricing gap analysis. This analysis measures, for specific time intervals, the differences between interest earning assets and interest bearing liabilities for which re-pricing opportunities will occur. A positive difference, or gap, indicates that interest earning assets will reprice faster than interest bearing liabilities. This will generally produce a greater net interest margin during periods of rising interest rates, and a lower net interest margin during periods of decreasing interest rates. Conversely, a negative gap will generally produce lower net interest margin during periods of rising interest rates and a greater net interest margin during periods of decreasing interest rates. Table 4 provides the Bank's maturity/repricing gap analysis at December 31, 1993 and 1992. The Bank had a positive one year cumulative gap of $22.1 million at December 31, 1993, compared to a negative one year cumulative gap of $33.5 million at December 31, 1992. The change from a negative gap position to a positive gap position is primarily the result of an increase in loans that reprice within one year. The interest rates paid on deposit accounts do not always move in unison with the rates charged on loans. Specifically, changes in the prime lending rate do not always result in an immediate change in the rate paid on money market and savings accounts. In addition, the magnitude of changes in the rate charged for loans is not necessarily proportionate to the magnitude of changes in the rate paid for deposits. Consequently, changes in interest rates do not necessarily result in increases or decreases in the net interest margin solely as a result of the differences between re-pricing opportunities of interest earning assets or interest bearing liabilities. The fact that the Bank reported a nominal positive gap at December 31, 1993 does not necessarily indicate that the Bank's net interest margin will increase if rates increase in 1994, or decrease if interest rates decrease. The analysis does provide a measure for the Bank's Management to determine the relative level of interest rate risk at any point in time. SUMMARY OF CREDIT LOSS EXPOSURE Implicit in lending activities is the risk that losses will be experienced and the amount of such losses will vary over time. Consequently, the Company maintains an allowance for credit losses by charging to earnings a provision for potential credit losses. Loans determined to be a loss are charged to the allowance. The Company's allowance for credit losses is maintained at a level considered by the Bank's Management to be adequate to provide for estimated losses inherent in the existing portfolio, including commitments under commercial and standby letters of credit. In evaluating the adequacy of the allowance for credit losses, the Bank's Management estimates the amount of potential loss for each loan that has been identified as having greater than standard credit risk, including loans identified as nonperforming. Loss estimates also consider the borrowers' financial data and the current valuation of collateral when appropriate. In addition to the allowance for specific potential problem credits, an allowance is further allocated for all loans in the portfolio based on the risk characteristics of particular categories of loans including historical loss experience in the portfolio. Additional allowance is allocated on the basis of credit risk concentrations in the portfolio and contingent obligations under off-balance sheet commercial and standby letters of credit. At December 31, 1993, the allowance for credit losses was $8.8 million, representing an increase of $2.4 million or 36.96%, over the allowance for credit losses of $6.5 million at December 31, 1992. As a percent of gross loans, the allowance for credit losses increased from 1.70% at December 31, 1992, to 1.96% at December 31, 1993. The increase in the allowance for credit losses at December 31, 1993 resulted as the provision for credit losses of $1.7 million, plus acquired reserves of $1.6 million, exceeded the net amount of loans charged to the reserve of $919,000 for the year. Acquired reserves represent the allowance for credit losses acquired from Fontana First National Bank, and the discount from face value of specific loans purchased from the FDIC relating to the Mid City Bank acquisition. Net loans charged to the allowance for credit losses totaled $433,000, $574,000, and $919,000 for the years ended December 31, 1991, 1992, and 1993, respectively. The increase in the amount charged to reserves each year reflects the increases in loans outstanding and the continued economic downturn in the Southern California economy. The provision for credit losses totaled $604,000, $1,772,000, and $3,307,000, for the years ended December 31, 1991, 1992 and 1993. The increased provision primarily reflects the increase in loans charged to the allowance for credit losses for each period. Net loans charged to the reserve, as a percent of average loans totaled 0.12%, 0.16%, and 0.22% for the years ended December 31, 1991, 1992, and 1993. The increase in the allowance for credit losses reflects the prolonged regional economic downturn and the Bank's recognition of the possibility that the downturn may continue and the uncertain impact it may have on the Company's loan portfolio. The increase in the allowance for credit losses has been made to support the growth in the loan portfolio and to provide an additional measure of protection in a recessionary economic environment. The Bank recognizes that the current recessionary conditions may continue, and the potential impact this may have on the loan portfolio is uncertain. Nonperforming loans increased from $10.2 million, or 2.68% of gross loans, at December 31, 1992, to $12.5 million, or 2.77% of gross loans, at December 31, 1993. While the Bank's Management believes that the allowance was adequate to provide for both recognized potential losses and estimated inherent losses in the portfolio, no assurance can be given that economic conditions that may adversely affect the Company's service area or other circumstances will not result in increased provisions for credit losses in the future. Table 5 provides the comparative statistics on net credit losses, the provisions for credit losses, and the allowance for credit losses. Loan losses are fully, or partially charged against the allowance for credit losses when, in the Bank's Management's judgment, the full collectability of the loan's principal is in doubt. However, there is not a precise method of predicting specific losses which ultimately may be charged against the allowance for credit losses, and as such, Management is unable to reasonably estimate the full amount of loans to be charged to the reserve in future periods. Table 6 provides a summary of the allocation of the allowance for credit losses for specific loan categories for the five year period ended December 31, 1993. The allocations presented should not be interpreted as an indication that loans charged to the allowance for credit losses will occur in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amount available for future losses that may occur within such categories, since there is a large unallocated portion of the allowance for credit losses and the total allowance is applicable to the entire loan portfolio. OTHER OPERATING INCOME Other operating income for the Company includes service charges on deposit accounts, gain on sale of securities, gross revenue from CTD, and other revenues not derived from interest on earning assets. Other operating income increased from $7.9 million for the year ended December 31, 1992, to $10.7 million for the year ended December 31, 1993. This represented an increase of $2.8 million, or 36.05%. For 1992, other operating income increased $858,899, or 12.2%, from $7.0 million for the year ended December 31, 1991. The increase in other operating income for 1993 was the result of gains on securities sold. Gains on sales of securities totaled $3.7 million for the year ended December 31, 1993, compared to gains of $261,531 for 1992, and $716,608 for 1991. The gains in 1993 were a result of restructuring the portfolio in anticipation of adopting SFAS 115. (See discussion of Investment Securities for explanation of SFAS 115). Service charges on deposit accounts increased from $5.0 million to $5.2 million for the years ended December 31, 1992 and 1993, respectively. Service charges totaled $4.5 million for the year ended December 31, 1991. Other operating income for 1991 and 1992 included gross revenue from a subsidiary called Premier Results (Premier). Premier began operation in 1990 and provided item processing services for other financial institutions. Premier had total revenues of $870,000 in 1992, and $638,000 for 1991. In December of 1992, Premier was sold to Electronic Data Systems, Inc. as it was determined that the nature of the business was not compatible with the Company's long term strategic plans. Net earnings from Premier for 1992 totaled $125,000. Consequently, the divestiture did not have a significant impact on 1993's earnings. Other income also includes total revenue from CTD, a subsidiary of the Company. Total revenue from CTD was approximately $238,000, $337,000, and $271,000 for the years ended December 31, 1991, 1992, and 1993, respectively. NONINTEREST EXPENSES Noninterest expenses totaled $29.4 million for the year ended December 31, 1993. This represented an increase of $5.9 million, or 25.34%, from total noninterest expenses of $23.4 million for the year ended December 31, 1992. Total noninterest expenses for the year ended December 31, 1991 were $22.7 million. As a percent of average assets, total noninterest expenses decreased from 4.39% for 1991, to 4.20% for 1992, then increased to 4.68% for 1993. This increase was entirely related to expenses associated with collection and foreclosure costs on troubled credits. A $2.8 million provision for potential losses on the sale of other real estate owned contributed substantially to the increase in noninterest expense for 1993. Other real estate owned is property acquired by the Bank through foreclosure (See Loans). Primarily as a result of the current economic climate in Southern California, real estate values have decreased significantly over the last two years. In anticipation of a continuation of this trend in both commercial and residential real estate values, the Bank's Management has provided an allowance for potential losses on specific properties currently held by the Bank. The allowance primarily protects against further decreases in real estate values. Without the provision for potential losses on other real estate owned for 1993, and the cost of carrying that real estate, total noninterest expense, as a percent of average assets, would have decreased for 1993 compared to 1992. Salaries and related expenses totaled $14.4 million for the year ended December 31, 1993. This represented an increase of $962,073, or 7.14%, over total salaries and related expenses of $13.5 million for the year ended December 31, 1992. Total salaries and related expenses were $13.7 million for the year ended December 31, 1991. As a percent of average assets, total salaries and related expenses have decreased from 2.64%, to 2.42%, to 2.30%, for the years ended December 31, 1991, 1992, and 1993, respectively. Full time equivalent employees decreased from 296 for 1991, to 243 for 1992, then increased to 302 for 1993. This increase in salaries for 1993 was primarily related to the acquisitions of Fontana First National Bank and Mid City Bank. As both acquisitions resulted in increased assets, the additional salaries did not impact salary expense as a percent of average assets. INCOME TAXES The Company's effective tax rate for 1993 was 39.2%, compared to a rate of 38.8% for 1992, and a rate of 39.5% for 1991. These rates are below the nominal combined Federal and State tax rates as a result of tax preferenced income for each period. The increase in the effective tax rate for 1993 reflects the retroactive Federal tax increase for revenues in excess of $10.0 million, and the increase in the State tax rate for 1993. ANALYSIS OF FINANCIAL CONDITION Total assets increased from $592.1 million at December 31, 1992, to $687.4 million at December 31, 1993. This represented an increase of $95.3 million, or 16.10%. Net loans increased $67.4 million, or 18.00%, from $374.7 million for the year ended December 31, 1992, to $442.1 million for the year ended December 31, 1993. As in previous years, asset growth was primarily funded by increased deposit growth. Total deposits increased from $526.9 million at December 31, 1992, to $596.0 million at December 31, 1993, an increase of $69.0 million, or 13.10%. The acquisitions of Fontana First National Bank and Mid City Bank accounted for approximately $43.0 million, or 45.0% of the $95.3 million increase in the Company's assets for 1993. INVESTMENT SECURITIES The Company maintains a portfolio of investment securities to provide income and serve as a source of liquidity for its ongoing operations. Note 2 of the financial statements sets forth the distribution of the investment portfolio at December 31, 1993 and 1992. In 1993, the Financial Accounting Standards Board introduced new mark to market accounting rules for investment securities (SFAS 115). Under the new accounting method, when adopted, securities held as "available for sale" will be reported at current market value for financial reporting purposes. Increases or decreases in market value when compared to cost will be adjusted directly to the Company's capital accounts. While the Company has demonstrated the ability and the intent to hold investment securities until maturity, changes in liquidity needs as well as changes in interest rates have resulted in the sale of investment securities in the past. The introduction of SFAS 115 has changed the methodology used in determining the type of securities purchased for the portfolio and the timing of sales of securities within the portfolio. The Bank's Management now reviews the portfolio from a total return perspective. Current yields, in addition to current and projected changes in market values, are now considered for both purchases and sales of investment securities. Primarily as a result of the adoption of this methodology in 1993, significant changes were made to both the structure and maturities of the investment portfolio. This restructure resulted in significant gains from the sales of securities in 1993. (See Other Operating Income) The Bank's Management has elected to adopt SFAS 115 effective for 1994. At December 31, 1993, the market value of the investment portfolio was approximately $150.9 million, representing an unrealized gain of approximately $1.4 million over "book value" of $149.5 million. Had SFAS 115 been adopted, stockholders' equity would have been increased by the amount of the unrealized gain at December 31, 1993, net of the tax effect. The variance between market value and the cost value reported at December 31, 1993, is not material in relation to the Company's total capital. In preparing for the implementation of SFAS 115 in 1994, the Bank's investment portfolio is divided into two primary categories. These included the "held for sale" portfolio and the "held to maturity" portfolio. At December 31, 1993, the held for sale portion of the portfolio comprised approximately 93.9% of the investment portfolio. The balance was allocated to securities to be held to maturity. If securities are sold prior to maturity to provide for liquidity needs or to take advantage of changes in interest rates, securities from the held for sale portion of the portfolio will be sold. LOANS Table 7 sets forth the distribution of the Company's loan portfolio for each of the last five years. Net loans increased $67.4 million, or 18.00%, from $374.7 million at December 31, 1992, to $442.1 million at December 31, 1993. Approximately $32.9 million, or 48.8% of the $67.4 million increase in net loans for 1993 resulted from the acquisitions of Fontana First National Bank and Mid City Bank. Net of acquired loans, loans increased approximately $34.5 million, or 9.2%, for 1993. The increase in loans, net of acquired loans, represents a significant increase over the increase for 1992 when net loans increased only $9.1 million, or 2.49%. The relatively slow real growth in loans (net of loans acquired) for both 1992 and 1993, reflects the prolonged economic downturn in the Southern California economy, and the resulting decrease in loan demand. Approximately $192.1 million, or 42.5% of the loan portfolio matures within one year. Of this total, approximately $169.3 million, or 88.1%, have variable rates that are tied to the Bank's prime lending rate. Loans that mature within one year assist with the liquidity needs of the Bank as well as providing greater repricing opportunities. Variable rate loans tied to the Bank's prime lending rate provide immediate re-pricing opportunities when interest rates change. Table 8 provides the maturity distribution for commercial and industrial loans as well as real estate construction loans as of December 31, 1993. Amounts are also classified according to repricing opportunities or rate sensitivity. As a normal practice in extending credit for commercial and industrial purposes, the Bank may accept trust deeds on real property as collateral. In some cases, when the primary source of repayment for the loan is anticipated to come from cash flow from normal operations of the borrower, the requirement of real property as collateral is an abundance of caution. In these cases, the real property is considered a secondary source of repayment for the loan. Since the Bank lends primarily in Southern California, its real estate loan collateral is concentrated in this region. At December 31, 1993, approximately 97.0% of the Bank's loans secured by real estate were collateralized by properties located in Southern California. This concentration is considered when determining the adequacy of the Company's allowance for credit losses. In January of 1994, the greater Los Angeles area was affected by a major earthquake and a series of aftershocks that were centered in the San Fernando Valley. The Company is not located in the San Fernando Valley nor is the San Fernando Valley part of the Company's service area. It is not yet possible to assess the effect of the earthquake on the Company's borrowers' primary or secondary repayment sources, or its overall effect on the local economy in general. The Company's facilities and other real estate owned suffered no damage, and management is not aware of any effects from the earthquake that would materially impact its financial condition. At December 31, 1993, nonperforming assets totaled $22.1 million. This represented an increase of $4.1 million, or 21.6%, from total nonperforming assets of $19.0 million at December 31, 1992. Nonperforming assets include loans for which interest is no longer accruing, loans 90 or more days past due, restructured loans, other real estate owned, and in substance foreclosures. Although the Bank's Management believes that nonperforming loans are generally well secured and that potential losses are provided for in the Company's allowance for credit losses, there can be no assurance that continued deterioration in economic conditions or collateral values will not result in future credit losses. Table 9 provides information on nonperforming loans and other real estate owned for the periods indicated. At December 31, 1993, loans for which interest was no longer accruing totaled $12.5 million. All loans on a nonaccrual status were secured by real property which has a current appraisal that is less than one year old. The estimated ratio of the outstanding loan balances to the fair values of the related collateral for nonaccrual loans at December 31, 1993, ranged between approximately 21% to 92% of the loan value. The Bank has allocated specific reserves included in the allowance for credit losses for potential losses on these loans. Except for nonperforming loans as set forth in Table 9, the Bank's Management is not aware of any loans as of December 31, 1993 for which known credit problems of the borrower would cause the Company to have serious doubts as to the ability of such borrowers to comply with their present loan repayment terms or any known events that would result in the loan being designated as nonperforming at some future date. The Bank's Management cannot, however, predict the extent to which the current economic environment may persist or worsen or the full impact this environment may have on the Company's loan portfolio. At December 31, 1993, the book value of other real estate owned totaled $9.8 million. This included 9 separate parcels of property acquired through foreclosure, and one loan secured by real estate that is performing but is classified as real estate held for sale. The Bank is actively marketing these properties. The Bank's Management cannot predict when these properties will be sold or the terms of those sales when they occur. While Management recognizes that the Southern California real estate market continues to remain weak, the Bank has recent appraisals on each property that support the carrying costs of those properties at December 31, 1993. No assurance can be given that if Southern California real estate values continue to decrease, and the Bank cannot dispose of the properties held promptly, further charges to earnings may not occur. DEPOSITS Total deposits increased $69.0 million, or 13.10%, from $526.9 million at December 31, 1992, to $596.0 million at December 31, 1993. The acquisitions of Fontana First National Bank and Mid City Bank accounted for approximately $43.0 million, or 62.0%, of the $69.0 million increase in the Company's deposits for 1993. Non-interest bearing demand deposits represented the largest growth, increasing $64.1 million, or 40.73%, from $157.4 million at December 31, 1992, to $221.6 million at December 31, 1993. As a result of the increase, average non-interest bearing demand deposits represented 32.0% of average deposits for the year ended December 31, 1993. This compared with 27.96% of average deposits for 1992. Table 1 provides the average balances for each general deposit category, including the associated costs for the years ended December 31, 1991, 1992, and 1993. As average non-interest bearing demand deposits have increased as a percent of total average deposits for 1992 and 1993, average savings and time deposits have decreased as a percent of total average deposits. Average savings deposits, as a percent of average total deposits, have decreased from 58.30% in 1991, to 55.56% for 1992, to 51.44% for 1993. Average time deposits, as a percent of average total deposits, have decreased from 17.00% in 1991, to 16.48% in 1992, to 16.57%, for 1993. The change in the deposit mix has resulted in a lower cost of average total deposits in 1992 and 1993. Despite the changes in the deposit mix, the majority of funds provided from customer deposits are derived from savings deposits. Savings deposits include money market accounts as well as traditional savings accounts. Table 10 provides the remaining maturities of large denomination ($100,000 or more) time deposits, including public funds as of December 31, 1993. TABLE 10 - Maturity Distribution of Large Denomination Time Deposits (amounts in thousands) December 31, 1993 3 months or less $27,242 Over 3 months through 6 months 7,732 Over 6 months through 12 months 6,716 Over 12 months 4,172 Total $45,862 LIQUIDITY Liquidity is actively managed to ensure sufficient funds are available to meet the ongoing needs of both the Bank and CVB. This includes projections of future sources and uses of funds, in addition to the maintenance of sufficient liquid reserves to provide for unanticipated events. For the Bank, sources of funds normally include interest and principal payments on loans and investments, proceeds from maturing or sold investments, and growth in deposits. Uses of funds include withdrawal of deposits, interest paid on deposits, advances or funding of new loans, purchases and operating expenses. The Bank maintains funds as overnight federal funds sold and other short term investment securities to provide for short term liquidity needs. In addition, the Bank maintains short term unsecured lines of credit of $50.0 million with correspondent banks to provide for contingent liquidity needs. At December 31, 1993, the Bank reported liquid assets, including cash, federal funds sold, and unpledged investment securities of $156.0 million. Liquid assets represented 22.7% of total assets at December 31, 1993. Since the primary sources and uses of funds for the Bank are loans and deposits, the relationship between gross loans and total deposits provides a useful measure of the Bank's liquidity. Typically, the closer the ratio of loans to deposits is to 100%, the more reliant the Bank is on its loan portfolio to provide for short term liquidity needs. Since repayment of loans tends to be less predictable than investments and other liquid resources, the higher the loan to deposit ratio the less liquid the Bank. For the year ended December 31, 1993, the Bank's loan to deposit ratio averaged 74.7%, compared to an average ratio of 73.9% for 1992. The liquidity ratio provides another measure of the Bank's liquidity. This ratio is calculated by dividing the difference between short term liquid assets from short term volatile liabilities by the sum of loans and long term investments. This ratio measures the percent of illiquid long term assets that are being funded by short term volatile liabilities. As of December 31, 1993, this ratio was 2.72%, compared to a negative 1.7%, at December 31, 1992. CVB is a company separate and apart from the Bank that must provide for its own liquidity. Substantially all of CVB's revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to CVB. At December 31, 1993, approximately $20.0 million of the Bank's equity was unrestricted and available to be paid as dividends to CVB. Management of CVB believes that such restrictions will not have a significant impact on the ability of CVB to meet its ongoing cash obligations. As of December 31, 1993, neither the Bank nor CVB had any material commitments for capital expenditures. On November 16, 1993, the Company entered into a definitive agreement and plan of reorganization (the Agreement) for the Company to acquire, through merger, Western Industrial National Bank (WIN). Chino Valley Bank will be the continuing operation. The Company will provide to the shareholders of WIN $13.5 million, plus accrued earnings from December 31, 1993. WIN currently has two branch offices located in South El Monte. WIN reported total assets of $45.3 million, total deposits of $36.3 million, and gross loans of $37.5 million at December 31, 1993. It is not anticipated that the acquisition will have a significant effect on the Company's liquidity or its capital ratios. CAPITAL RESOURCES Historically, the primary source of capital for the Company has been the retention of operating earnings. The Company conducts an ongoing assessment of projected sources and uses of capital in conjunction with projected increases and anticipated mixes of assets in order to maintain adequate levels of capital. Total adjusted capital, shareholder equity plus allowance for credit losses, was $68.8 million at December 31, 1993, representing an increase of $10.3 million, or 17.6%, over total adjusted capital of $58.5 million at December 31, 1992. Bank regulators have established minimum capital adequacy guidelines requiring that qualifying capital be at least 8.0% of risk-based assets, of which at least 4.0% must be Tier 1 capital (primarily stockholders' equity). These ratios represent minimum capital standards. Under Prompt Corrective Action rules, certain levels of capital adequacy have been established for financial institutions. Depending on an institution's capital ratios, the established levels can result in restrictions or limits on permissible activities. The highest level for capital adequacy under Prompt Corrective Action is "Well Capitalized". To qualify for this level of capital adequacy an institution must maintain a total risk-based capital ratio of at least 10.0%, a Tier 1 risk-based capital ratio of at least 6.0%, and a leverage ratio of at least 5.0%. At December 31, 1993, the Company exceeded all of the minimum capital ratios required to be considered well capitalized. At December 31, 1993, the Company's total risk-based capital ratio was 13.1% compared to 13.7% on December 31, 1992. The ratio of Tier I capital to risk weighted assets was 11.8% at December 31, 1993, compared to a ratio of 13.3% for December 31, 1992. The decrease in the risk-based capital ratios during 1993 reflects increases in risk weighted assets greater than increases in both Tier I and total adjusted capital. The Company's risk- based capital ratio was also affected by $2.0 million in goodwill that resulted from the acquisition of Fontana First National Bank. In addition to the aforementioned requirement, the Company and Bank must also meet minimum leverage ratio standards. The leverage ratio is calculated as Tier 1 capital divided by the most recent quarterly period's average total assets. As of December 31, 1993, the Company's leverage ratio was 8.4%, down from a ratio of 9.2% at December 31, 1992. The Bank's leverage ratio was 8.3% at the 1993 year end, down from 8.9% at December 31, 1992. Banking regulators have established 3.0% as the minimum leverage ratio. However, institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain a leverage ratio in excess of the minimum. During 1992, the Board of Directors of the Company declared quarterly cash dividends that totaled 32 cents per share for the full year (29 cents per share after retroactive adjustment for the ten percent stock dividend declared on December 15, 1993). After retroactive adjustment, cash dividends declared during 1993 was equal to dividends paid for 1992. Management does not believe that the continued payment of cash dividends will impact the ability of the Company to exceed the current minimum capital standards. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CVB Financial Corp. Index to consolidated Financial Statements and Financial Statement Schedules Consolidated Financial Statements Page Consolidated Balance Sheets -- 51 December 31, 1993 and 1992 Consolidated Statements of Earnings Year Ended December 31, 1993, 1992 and 1991 52 Consolidated Statements of Stockholders' Equity Year Ended December 31, 1993, 1992 and 1991 53 Consolidated Statements of Cash Flows for the Year Ended December 31, 1993, 1992 and 1991 54 Notes to Consolidated Financial Statements 57 Independent Auditors' Report 79 All schedules are omitted because they are not applicable, not material or because the information is included in the financial statements or the notes thereto. CONSOLIDATED BALANCE SHEETS - DECEMBER 31, 1993 AND 1992 CONSOLIDATED STATEMENTS OF EARNINGS THREE YEARS ENDED DECEMBER 31, 1993 See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE-YEAR PERIOD ENDED DECEMBER 31, 1993 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of CVB Financial Corp. and subsidiaries are in accordance with generally accepted accounting principles and conform to practices within the banking industry. A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows: Principles of Consolidation - The consolidated financial statements include the accounts of CVB Financial Corp. (the "Company") and its wholly owned subsidiaries, Chino Valley Bank (the "Bank"), Community Trust Deed Services and Premier Results, Inc., after elimination of all material intercompany transactions and balances. Investment Securities Held for Sale - The Bank has identified those investment securities which may be sold prior to maturity. These assets have been classified as held for sale on the accompanying consolidated balance sheet and are recorded at the lower of amortized cost or market value on an aggregate basis by type of asset. Investment Securities Held for Investment - Investment securities, excluding those held for sale, are carried at amortized cost, adjusted for amortization of premiums and accretion of discounts over the estimated terms of the assets using the interest method. Such amortization and accretion are included in interest income. Sales of certain of these assets could occur if unforeseen circumstances arise, and any gain or loss on sale would be calculated based on the specific identification method. The carrying value of these assets is not adjusted for temporary declines in market value because the Bank intends and has the ability to hold them to maturity. Equity securities are accounted for at the lower of aggregate cost or market. Loans and Lease Finance Receivables - Loans and lease finance receivables are reported at the principal amount outstanding, less deferred net loan origination fees and the allowance for credit losses. Interest on loans and lease finance receivables is credited to income based on the principal amount outstanding. Interest income is not recognized on loans and lease finance receivables when collection of interest is deemed by management to be doubtful. The Bank receives collateral to support loans, lease finance receivables and commitments to extend credit for which collateral is deemed necessary. The most significant category of collateral is real estate, principally commercial and industrial income-producing properties. Nonrefundable fees and direct costs associated with the origination or purchase of loans are deferred and netted against outstanding loan balances. The deferred net loan fees and costs are recognized in interest income over the loan term in a manner that approximates the level-yield method. Provision and Allowance for Credit Losses - The determination of the balance in the allowance for credit losses is based on an analysis of the loan and lease finance receivables portfolio and reflects an amount that, in management's judgment, is adequate to provide for potential credit losses after giving consideration to the character of the loan portfolio, current economic conditions, past credit loss experience and such other factors as deserve current recognition in estimating credit losses. The provision for credit losses is charged to expense. Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on the straight-line method over the estimated useful lives of the assets. Property under capital lease and leasehold improvements are amortized over the shorter of their economic lives or the initial term of the lease. Other Real Estate Owned - Other real estate owned, shown net of an allowance for losses of $1,650,903 and $100,000 at December 31, 1993 and 1992, respectively, represents real estate acquired through foreclosure in satisfaction of commercial and real estate loans and is stated at the lower of the fair value minus estimated costs to sell or cost (fair value at time of foreclosure). Loan balances in excess of fair value of the real estate acquired at the date of acquisition are charged against the allowance for credit losses. Any subsequent operating expenses or income, reduction in estimated values, and gains or losses on disposition of such properties are charged to current operations. Goodwill - Goodwill of $2.1 million, net of amortization of $116,000 resulting from the acquisition of Fontana First National Bank during March 1993, and the excess purchase premium of $50,000 paid on assuming the deposits of Mid City Bank, N.A. in October 1993, are included in other assets. Goodwill is amortized on a straight-line basis over 15 years. Income Taxes - In the fourth quarter of 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Under SFAS No. 109, deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each year-end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Prior years' financial statements have not been restated for the accounting change. Earnings per Common Share - Earnings per common share are computed on the basis of the weighted average number of common shares outstanding during the year plus shares issuable upon the assumed exercise of outstanding common stock options (common stock equivalents). The weighted average number of common shares outstanding and common stock equivalents was 7,511,884 (1993), 7,357,187 (1992) and 7,220,967 (1991). Earnings per common share and stock option amounts have been retroactively restated to give effect to all stock splits and dividends. Statement of Cash Flows- Cash and cash equivalents as reported in the statement of cash flows include cash and due from banks and federal funds sold. Recent Accounting Pronouncements - In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This statement prescribes that a loan is impaired when it is probable that a creditor will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. Measurement of the impairment can be based on the expected future cash flows of an impaired loan, which are to be discounted at the loan's effective interest rate, or impairment can be measured by reference to an observable market price, if one exists, or the fair value of the collateral. Collateral-dependent loans for which foreclosure is probable must be measured at the fair value of the collateral. Additionally, the statement prescribes measuring impairment of a restructured loan by discounting the total expected future cash flows at the loan's effective rate of interest in the original loan agreement. Finally, the impact of initially applying the statement is reported as a part of the provision for credit losses. The Company must adopt this standard by 1995. The Company has not yet determined the impact of the adoption of this statement or when the Company will adopt this statement. In May 1993, the FASB also issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values, and all investments in debt securities. Under this statement, securities will be classified into three categories as follows: Held-to-Maturity Securities - Debt securities that the Company has the positive intent and ability to hold to maturity. These securities are to be reported at amortized cost. Trading Securities - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term. These securities are to be reported at fair value with unrealized gains and losses included in earnings. Available-for-Sale Securities - Debt and equity securities not classified as either held-to-maturity or trading securities. These securities are to be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity (net of tax effects). The Company has elected to adopt SFAS No. 115 as of January 1, 1994. If the Company had adopted SFAS No. 115 as of December 31, 1993, stockholders' equity would have been increased by approximately $620,000, net of $394,000 of applicable income taxes. Reclassifications - Certain reclassifications were made to prior years' presentations to conform them to the current-year presentation. These reclassifications are of a normal recurring nature. 2.INVESTMENT SECURITIES The amortized cost and estimated market value of investment securities held for investment and investment securities held for sale are shown below. All securities held are publicly traded, and estimated market value was obtained from an independent pricing service. The CMO/REMIC securities noted above represent collateralized mortgage obligations and real estate mortgage investment conduits. All are issues of U.S. government agencies that guarantee payment of principal and interest of the underlying mortgages. All CMO/REMIC securities in the Bank's investment portfolio have met or surpassed the Federal Financial Institutions Examination Council's three-part test. At December 31, 1993 and 1992, investment securities having an amortized cost of approximately $38,780,000 and $42,553,000, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law. The amortized cost and market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Although mortgage-backed securities/CMO/REMIC have contractual maturities through 2019, expected maturities will differ from contractual maturities because borrowers may have the right to prepay such obligations without penalty. 3.LOANS AND LEASE FINANCE RECEIVABLES The Bank grants loans to its customers throughout its primary market in the San Gabriel Valley and Inland Empire areas of Southern California, which has recently experienced adverse economic conditions, including declining real estate values. These factors have adversely affected certain borrowers' ability to repay loans. Although management believes the level of allowances for loan losses is adequate to absorb losses inherent in the loan portfolio, additional declines in the local economy may result in increasing loan losses that cannot be reasonably predicted at December 31, 1993. The Bank makes loans to borrowers in a number of different industries. No industry had aggregate loan balances exceeding 10% of the December 31, 1993 or 1992 loan and lease finance receivables balance. At December 31, 1993 the Bank's loan portfolio included approximately $322.9 million of loans secured by commercial and residential real estate properties. The following is a summary of the components of loan and lease finance receivables: The following is a summary of nonperforming loans at December 31, 1993 and 1992: Interest foregone on nonperforming loans outstanding during the years ended December 31, 1993, 1992 and 1991 amounted to approximately $1,186,000, $698,600, and $1,037,200, respectively. 4.TRANSACTIONS INVOLVING DIRECTORS AND SHAREHOLDERS In the ordinary course of business, the Bank has granted loans to certain directors, executive officers and the businesses with which they are associated. All such loans and commitments to lend were made under terms that are consistent with the Bank's normal lending policies. The following is an analysis of the activity of all such loans: 5.ALLOWANCE FOR CREDIT AND OTHER REAL ESTATE OWNED LOSSES Activity in the allowance for credit losses was as follows: Activity in the allowance for other real estate owned losses was as follows: The Company incurred expenses of $1,004,015 (1993), $205,768 (1992) and $103,651 (1991) related to the holding and disposition of other real estate owned. 6.PREMISES AND EQUIPMENT Premises and equipment consist of: 7.INCOME TAXES In 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Under the provisions of SFAS No. 109, the Company elected not to restate prior year financial statements, and has determined that the cumulative effect of implementation was immaterial. Income tax expense (benefit) comprised the following: Income tax liability (asset) comprised the following: The components of the net deferred tax asset are as follows: No valuation allowance under SFAS No. 109 was required. Deferred tax assets would be fully realized as an offset against reversing temporary differences, which create net future tax liabilities, or through loss carrybacks. Therefore, even if no future income was expected, deferred tax assets would still be fully realized. A reconciliation of the statutory income tax rate to the consolidated effective income tax rate follows: 8.DEPOSITS Time certificates of deposit with balances of $100,000 or more amounted to approximately $45,862,000 and $43,887,000 at December 31, 1993 and 1992, respectively. Interest expense on such deposits amounted to approximately $1,804,000 (1993), $2,044,000 (1992) and $2,856,000 (1991). 9.COMMITMENTS AND CONTINGENCIES The Bank leases land and buildings under operating leases for varying periods extending to 2014, at which time the Bank can exercise options that could extend the leases to 2027. The future minimum annual rental payments required, which have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993, excluding property taxes and insurance, are approximately as follows: 1994 $ 1,548,000 1995 1,498,000 1996 1,458,000 1997 1,444,000 1998 1,461,000 Succeeding years 6,475,000 Total minimum payments required $13,884,000 Total rental expense was approximately $1,449,000 (1993), $1,460,000 (1992) and $1,223,000 (1991). At December 31, 1993, the Bank had commitments to extend credit of approximately $61,543,000 and obligations under letters of credit of $7,182,000. Commitments to extend credit are agreements to lend to customers provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments are generally variable rate, and many of these commitments are expected to expire without being drawn upon. As such, the total commitment amounts do not necessarily represent future cash requirements. The Company uses the same credit underwriting policies in granting or accepting such commitments or contingent obligations as it does for on-balance-sheet instruments, evaluating customers' creditworthiness individually. Standby letters of credit written are conditional commitments issued by the Company to guarantee the financial performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. When deemed necessary, the Company holds appropriate collateral supporting those commitments. Management does not anticipate any material losses as a result of these transactions. In the ordinary course of business, the Company becomes involved in litigation. In the opinion of management and based upon discussions with legal counsel, the disposition of such litigation will not have a material effect on the Company's consolidated financial position. During 1993 the Company executed a definitive agreement that provides for its acquisition of Western Industrial National Bank ("WIN") through a merger of WIN and the Bank. At December 31, 1993, WIN had deposits, loans and shareholders' equity of $36.3 million, $36.6 million and $8.4 million, respectively. Management currently expects the acquisition to be consummated during the second quarter of 1994. 10.EMPLOYEE PROFIT SHARING PLAN The Bank sponsors a noncontributory profit-sharing plan for the benefit of its employees. Employees are eligible to participate in the plan after 12 months of consecutive service provided they have completed 1,000 service hours in the plan year. Contributions to the plan are determined by the Board of Directors. Contributions are limited to 15% of the compensation of eligible participants. The Bank contributed approximately $680,000 (1993), $639,000 (1992) and $760,000 (1991). 11.STOCK OPTION PLANS The Company has a plan under which options to purchase shares of the Company's common stock have been and may be granted to certain officers and directors. The plan authorizes the issuance of up to 1,028,500 shares. Option prices under the plan are to be at the fair market value of such shares on the date of grant, and options are exercisable in such installments as determined by the Board of Directors. Each option shall expire no later than ten years from the grant date. Additional options have been granted to certain officers and directors under a plan that expired during 1991. Although no more options can be granted under the expired plan, the options granted thereunder will remain outstanding until they are exercised or canceled pursuant to their terms. At December 31, 1993, options for the purchase of 482,555 shares of the Company's common stock were outstanding, of which options to purchase 119,143 shares were exercisable at prices ranging from $2.66 to $14.50; 573,271 shares of common stock were available for the granting of future options. Status of all optioned shares is as follows: Shares Price Range Outstanding at January 1, 1991 641,570 $ 2.66 - $16.14 Granted 348,810 $ 11.71 - $12.62 Exercised (88,312) $ 2.66 - $ 3.97 Canceled (285,718) $ 3.99 - $16.14 Outstanding at December 31, 1991 616,350 $ 2.66 - $12.62 Granted 348,398 $ 7.50 - $10.45 Exercised (159,645) $ 2.66 - $ 7.50 Canceled (350,460) $ 2.66 - $10.68 Outstanding at December 31, 1992 454,643 $ 2.66 - $12.62 Granted 55,745 $ 10.88 - $14.50 Exercised (13,753) $ 7.50 - $11.70 Canceled (14,080) $ 7.50 - $11.71 Outstanding at December 31, 1993 482,555 $ 2.66 - $14.50 In 1993 and 1992, the Company granted to a key executive 22,000 and 10,000 shares, respectively, of the Company's common stock in accordance with his compensation agreement. The agreement also provides for the granting of an additional 60,500 shares through 1996 for which the executive is entitled to receive stock and cash dividends. 12.REGULATORY MATTERS Section 23A of the Federal Reserve Act restricts the Bank from making loans or advances to the Company and other affiliates in excess of 20% of the Bank's capital stock and surplus. In addition, California Banking Law limits the amount of dividends that a bank can pay without obtaining prior approval from bank regulators. Under this law, the Bank could, as of December 31, 1993, declare and pay dividends of approximately $18,025,000 to the Company. The remaining amount of Bank equity of approximately $41,265,000 is restricted with respect to dividends and represents 70% of consolidated stockholders' equity. As of December 31, 1993, the Company and the Bank were required to meet the risk-based capital standard set by the respective regulatory authorities. The risk-based capital standards require the achievement of a minimum ratio of total capital to risk-weighted assets of 8.0% (of which at least 4.0% must be Tier 1 capital, which consists primarily of common stock and retained earnings, less goodwill). Additionally, the regulatory authorities require the highest rated institutions to maintain a minimum leverage ratio of 3% as of December 31, 1993. The leverage ratio basically consists of Tier 1 capital divided by average total assets. Institutions experiencing or anticipating significant growth or those with high or inordinate levels of risk are expected to maintain a leverage ratio well above the minimum level, e.g., 4% or 5%. The leverage ratio will operate in conjunction with the risk-based capital guidelines. The capital ratios of the Company and Bank at December 31, 1993 and 1992 are as follows: Company Bank Minimum Risk-Based Capital Ratio: Tier 1 11.8% 11.7% 4.00% Total 13.1% 13.0% 8.00% Leverage Ratio 8.4% 8.3% 3.00% Risk-Based Capital Ratio: Tier 1 12.4% 12.1% 4.00% Total 13.7% 13.3% 8.00% Leverage Ratio 9.2% 8.9% 3.00% Banking regulations require that all banks maintain a percentage of their deposits as reserves at the Federal Reserve Bank. During the year ended December 31, 1993, required reserve balances averaged approximately $11,099,000. 13.CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY BALANCE SHEETS (In thousands) December 31, 1993 1992 Assets: Investment in Chino Valley Bank $59,290 $50,410 Other assets, net 782 1,628 Total assets $60,072 $52,038 Liabilities $ 114 Stockholders' equity 59,958 $52,038 Total liabilities and stockholders' equity $60,072 $52,038 STATEMENTS OF EARNINGS (In thousands, except per-share amounts) Year Ended December 31, 1993 1992 1991 Equity in earnings of Chino Valley Bank $9,935 $8,941 $8,075 Other (expense) income, net (413) 74 (106) Net earnings $9,522 $9,015 $7,969 Dividends received from Chino Valley Bank $6,098 $ 956 $1,872 14.QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data follows: 15.FAIR VALUE INFORMATION The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to develop the estimates of fair value. Accordingly, the estimates presented below are not necessarily indicative of the amounts the Company could have realized in a current market exchange as of December 31, 1993 and 1992. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The methods and assumptions used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value are explained below: For federal funds sold and cash and due from banks, the carrying amount is considered to be a reasonable estimate of fair value. For investment securities, fair values are based on quoted market prices, dealer quotes and prices obtained from an independent pricing service (see also Notes 1 and 2). The carrying amount of loans and lease financing receivables is their contractual amounts outstanding reduced by deferred net loan origination fees and the allocable portion of the allowance for credit losses (see also Notes 1 and 3). Variable rate loans are composed primarily of loans whose interest rates float with changes in the prime interest rate. The carrying amount of variable rate loans (other than such loans in nonaccrual status) is considered to be their estimated fair value. The fair value of fixed rate loans (other than such loans in nonaccrual status) was estimated by discounting the remaining contractual cash flows using the estimated current rate at which similar loans would be made to borrowers with similar credit risk characteristics and for the same remaining maturities, reduced by deferred net loan origination fees and the allocable portion of the allowance for credit losses. Accordingly, in determining the estimated current rate for discounting purposes, no adjustment has been made for any change in borrowers' credit risks since the origination of such loans. Rather, the allocable portion of the allowance for credit losses is considered to provide for such changes in estimating fair value. The fair value of loans on nonaccrual status (see Note 3) has not been specifically estimated because it is not practicable to reasonably assess the credit risk adjustment that would be applied in the market place for such loans. As such, the estimated fair value of total loans at December 31, 1993 and 1992 includes the carrying amount of nonaccrual loans at each respective date. The amounts payable to depositors for demand, savings, and money market accounts are considered to be stated at fair value. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates presented herein are based on pertinent information available to management as of December 31, 1993 and 1992. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and, therefore, current estimates of fair value may differ significantly from the amounts presented above. 16.ACQUISITION OF BRANCH AND PURCHASE OF ASSETS AND LIABILITIES On March 8, 1993, the Company purchased Fontana First National Bank, assuming approximately $23.7 million in deposits and acquiring approximately $18.3 million in loans. Fontana First National Bank was purchased by the Company for $5.0 million, which resulted in the recording of $1.9 million in goodwill. The assets and liabilities were contributed to the Bank by the Company. On October 21, 1993, the Bank assumed the deposits and purchased certain assets of the failed Mid City Bank, N.A. from the Federal Deposit Insurance Corporation (the "FDIC"). The acquisition was structured under a written agreement between the FDIC and the Bank that allowed the Bank certain rights in regard to repricing deposits and purchasing additional assets, as well as providing the Bank with indemnification from prior activities of the failed bank. The Bank assumed approximately $79.3 million in deposits and purchased $4.6 million in investments and $20.8 million in loans. 17.SUBSEQUENT EVENT In January 1994, the greater Los Angeles area was affected by a major earthquake and series of aftershocks which were centered in the San Fernando Valley. The Company is not located in the San Fernando Valley, nor is the San Fernando Valley part of the Company's service area. However, it is not yet possible to assess the effect of the earthquake on the Company's borrowers' primary or secondary repayment sources, or its overall effect on the local economy in general. The Company's facilities and other real estate owned suffered no significant damage, and management is not aware of any effects from the earthquake which would materially impact its financial condition. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of CVB Financial Corp. Ontario, California We have audited the accompanying consolidated balance sheets of CVB Financial Corp. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of CVB Financial Corp.'s management. Our responsibility is to express an opinion on these financial statements based on our audits. We have conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CVB Financial Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/ Deloitte & Touche Delloite & Touche Los Angeles, California January 27, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Except as hereinafter noted, the information concerning directors and executive officers of the Company is incorporated by reference from the section entitled "DIRECTORS AND EXECUTIVE OFFICERS - Election of Directors" and "COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. For information concerning executive officers of the Company, see "Item 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT" above. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information concerning management remuneration and transactions is incorporated by reference from the section entitled "DIRECTORS AND EXECUTIVE OFFICERS -Compensation of Executive Officers and Directors - Executive Compensation, - Employment Agreements and Termination of Employment Arrangements, - Stock Options, - Option Exercises and Holdings and - Compensation Committee Interlocks and Insider Participation" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning security ownership of certain beneficial owners and management is incorporated by reference from the sections entitled "INTRODUCTION -Principal Shareholders" and "DIRECTORS AND EXECUTIVE OFFICERS - Election of Directors" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions with management and others is incorporated by reference from the section entitled "DIRECTORS AND EXECUTIVE OFFICERS--Certain Transactions" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements Reference is made to the index to Financial Statements at page 50 for a list of financial statements filed as part of this Report. Exhibits See Index to Exhibits at Page 85 of this Form 10-K. Executive Compensation Plans and Arrangements The following compensation plans and arrangements are filed as exhibits to this Form 10-K: 1981 Stock Option Plan, Exhibit 10.1; Agreement by and among D. Linn Wiley, CVB Financial Corp. and Chino Valley Bank dated August 8, 1991, Exhibit 10.2; Chino Valley Bank Profit Sharing Plan, Exhibit 10.3; 1991 Stock Option Plan, Exhibit 10.17; Severance Agreement between John Cavallucci, Chino Valley Bank and CVB Financial Corp. dated March 26, 1991 and Waiver Agreement dated October 4, 1991, Exhibit 10.18; Key Employee Stock Grant Plan, Exhibit 10.19. See Index to Exhibits at Page 85 to this Form 10-K. Reports on Form 8-K The Company filed a Report on Form 8-K, on November 4, 1993 reporting under Item 5. Undertaking for Registration Statement on Form S-8 For the purpose of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statement on Form S-8 No. 2-76121 (filed February 18, 1982): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 16th day of March, 1994. CVB FINANCIAL CORP. (Registrant) By /s/ D. Linn Wiley D. LINN WILEY President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. Signature Title Date /s/ George A. Borba Chairman of the Board March 28, 1994 George A. Borba /s/ John A. Borba Director March 28, 1994 John A. Borba /s/ Ronald O. Kruse Director March 28, 1994 Ronald O. Kruse /s/ John J. LoPorto Director March 28, 1994 John J. LoPorto /s/ Charles M. Magistro Director March 28, 1994 Charles M. Magistro /s/ John Vander Schaaf Director March 28, 1994 John Vander Schaaf /s/ Robert J. Schurheck Chief Financial Officer March 28, 1994 Robert J. Schurheck (Principal Financial and Accounting Officer) /s/ D. Linn Wiley Director, President and March 28, 1994 D. Linn Wiley Chief Executive Officer (Principal Executive Officer) INDEX TO EXHIBITS Exhibit No. Page 3.1 Articles of Company, as amended.(1) * 3.2 Bylaws of Company, as amended.(2) * 10.1 1981 Stock Option Plan, as amended.(1) * 10.2 Agreement by and among D. Linn Wiley, CVB Financial Corp. and Chino Valley Bank dated August 8, 1991.(2) * 10.3 Chino Valley Bank Profit Sharing Plan, as amended.(3) * 10.4 Definitive Agreement by and between CVB Financial Corp. and Huntington Bank dated January 6, 1987.(4) * 10.5 Transam One Shopping Center Lease dated May 20, 1986, by and between Transam One and Chino Valley Bank for the East Chino Office.(4) * 10.6 Sublease dated November 1, 1986, by and between Eldorado Bank and Chino Valley Bank for the East Highland Office.(4) * 10.7 Lease Assignment, Acceptance and Assumption and Consent dated December 23, 1986, executed by the FDIC, Receiver of Independent National Bank, Covina, California, as Assignor, Chino Valley Bank, as Assignee, and INB Bancorp, as Landlord under that certain Ground Lease dated September 30, 1983 by and between INB Bancorp and Independent National Bank for the Covina Office.(4) * 10.8 Lease Assignment dated May 15, 1987 and Consent of Lessor dated April 21, 1987 executed by Huntington Bank, as Assignor, Chino Valley Bank as Assignee and Gerald G. Myers and Lynn H. Myers as Lessors under that certain lease dated March 1, 1979 between Lessors and Huntington Bank for the Arcadia Office.(5) * 10.9 Lease Assignment dated May 15, 1987 and Consent of Lessor dated March 18, 1987 executed by Huntington Bank, as Assignor, Chino Valley Bank as Assignee and George R. Meeker as Lessor under that certain Memorandum of Lease dated May 1, 1982 between Lessor and Huntington Bank for the South Arcadia Office.(5) * 10.10 Lease Assignment dated May 15, 1987 and Consent of Lessor dated March 17, 1987 executed by Huntington Bank, as Assignor, Chino Valley Bank as Assignee and William R. Hayden and Marie Virginia Hayden as Lessor under that Certain Lease and Sublease, dated March 1, 1983, as amended, between Lessors and Huntington Bank for the San Gabriel Office.(5) * 10.11 Lease Assignment dated May 15, 1987 executed by Huntington Bank as Assignor and Chino Valley Bank as Assignee under that certain Shopping Center Lease dated June 1, 1982, between Anita Associates, a limited partnership and Huntington Bank for the Santa Anita ATM Branch.(5) * 10.12 Office Building Lease between Havenpointe Partners Ltd. and CVB Financial Corp. dated April 14, 1987 for the Ontario Airport Office.(6) * 10.13 Form of Indemnification Agreement.(7) * 10.14 Office Building Lease between Chicago Financial Association I, a California Limited Partnership and CVB Financial Corp. dated October 17, 1989, as amended, for the Riverside Branch.(1) * 10.15 Office Building Lease between Lobel Financial Corporation and Chino Valley Bank dated June 12, 1990, for the Premier Results data processing center.(3) * 10.16 Office Space Lease between Rancon Realty Fund IV and Chino Valley Bank dated September 6, 1990, for the Tri-City Business Center Branch.(3) * 10.17 1991 Stock Option Plan.(6) * 10.18 Severance Agreement between John Cavallucci, Chino Valley Bank and CVB Financial Corp. dated March 26, 1991 and Waiver Agreement dated October 4, 1991.(2) * 10.19 Key Employee Stock Grant Plan.(8) * 10.20 Lease by and between Allan G. Millew and William F. Kragness and Chino Valley Bank dated March 5, 1993 for the Fontana Office. (9) * 10.21 Office Lease by and between Mulberry Properties and Chino Valley Bank dated October 12, 1992. (9) * 10.22 First Amended and Restated Agreement and Plan of Reorganization by and between CVB Financial Corp., Chino Valley Bank and Fontana First National Bank, dated October 8, 1992 88 10.23 Purchase and Assumption Agreement among FDIC receiver of Mid City Bank, National Association, FDIC and Chino Valley Bank, dated October 21, 1993 (10) * 10.24 Agreement and Plan of Reorganization by and between CVB Financial Corp., Chino Valley Bank and Western Industrial National Bank, dated November 16, 1993 181 10.25 Lease by and between Bank of America and Chino Valley Bank dated October 15, 1993, for the West Arcadia Office 230 10.26 Lease be and between RCI Loring and CVB Financial Corp dated March 11, 1993, for the Riverside Office. 250 22 Subsidiaries of Company. (9) * 23 Consent of Independent Certified Public Accountants. 283 __________________________ *Not applicable. (1) Filed as Exhibits 3.1, 10.1 and 10.14 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission file number 0-10140, which are incorporated herein by this reference. (2) Filed as Exhibits 3.2, 10.2 and 10.18 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission file number 0-10140, which are incorporated herein by this reference. (3) Filed as Exhibits 10.3, 10.15 and 10.16 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission file number 0-10140, which are incorporated herein by this reference. (4) Filed as Exhibits 10.4, 10.5, 10.6 and 10.7 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, Commission file number 0-10140, which are incorporated herein by this reference. (5) Filed as Exhibits 10.8, 10.9, 10.10, 10.11 and 10.12 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission file number 0- 10140, which are incorporated herein by this reference. (6) Filed as Exhibit 4.1 to Registrant's Registration Statement on Form S-8 (33-41318) filed with the Commission on June 21, 1991, which is incorporated herein by this reference. (7) Filed as Exhibit 10.13 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission file number 0-10140, which is incorporated herein by this reference. (8) Filed as Exhibit 4.1 to Registrant's Registration Statement on Form S-8 (33-50442) filed with the Commission on August 1, 1992, which is incorporated herein by this reference. (9) Filed as Exhibit 10.20, 10.21 and 22 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission file number 0-10140, which are incorporated herein by this reference. (10) Filed as Exhibit 99 to the Registrant's Current Report on Form 8-K filed with the Commission on November 4, 1993, which is incorporated herein by this reference.

84792_1993.txt

84792_1993

1993

84792

ITEM 1. BUSINESS The information indicated below appears in the 1993 Annual Report to Stockholders (Stockholders' Report) and is incorporated by reference: PAGE OF STOCKHOLDERS' REPORT ------------- Business operations: Polymers, Resins and Monomers .......................... 12 Plastics ............................................... 14 Performance Chemicals .................................. 15 Agricultural Chemicals ................................. 17 Industry segment information for years 1991-93 ............. 42 Foreign operations for years 1991-93 ....................... 42 Employees .................................................. 54 Raw Materials The company uses a variety of commodity chemicals as raw materials in its operations. In most cases, these raw materials are purchased from multiple sources under long-term contracts. Most of these materials are hydrocarbon derivatives such as propylene, acetone and styrene. Competition The principal market segments in which the company competes are described in the company's Annual Report to Stockholders on pages 12 through 18. The company experiences vigorous competition in each of these segments. The company's competitors include many large multinational chemical firms based in Europe, Japan and the United States. In some cases, the company competes against firms which are producers of commodity chemicals which the company must purchase as the raw materials to make its products. The company, however, does not believe this places it at any significant competitive disadvantage. The company's products compete with products offered by other manufacturers on the basis of price, product quality and specifications, and customer service. Most of the company's products are specialty chemicals which are sold to customers who demand a high level of customer service and technical expertise from the company and its sales force. Research and Development The company maintains its principal research and development laboratories at Spring House, Pennsylvania. Research and development expenses, substantially all company sponsored, totaled $204,990,000, $199,520,000, and $182,963,000 in 1993, 1992 and 1991, respectively. Approximately 16% of the company's employees have been engaged in research and development activities in each of the past three years. Environmental Matters A discussion of environmental matters is incorporated herein by reference to pages 28 and 29 of the Stockholders' Report. ITEM 2. ITEM 2. PROPERTIES The company, its subsidiaries and affiliates presently operate 47 manufacturing facilities in 21 countries. A list identifying those facilities is found on page 60 of the company's Annual Report to Stockholders which is hereby incorporated by reference. Additional information addressing the suitability, adequacy and productive capacity of the company's facilities is found on page 30 of the company's Stockholders' Report and throughout the various business discussions of the company's industry segments found on pages 12 through 18 of the Stockholders' Report. ITEM 3. ITEM 3. LEGAL PROCEEDINGS A discussion of legal proceedings is incorporated herein by reference to page 52 of the Stockholders' Report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The company's common stock of $2.50 par value is traded on the New York Stock Exchange (Symbol: ROH). There were 4,973 registered common stockholders as of March 4, 1994. The 1993 and 1992 quarterly summaries of the high and low prices of the company's common stock and the amounts of dividends paid on common stock are presented on pages 32 and 33 of the Stockholders' Report and are incorporated in this Form 10-K by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The company's summary of selected financial data and related notes for the years 1989 through 1993 are incorporated in this Form 10-K by reference to pages 54 through 56 of the Stockholders' Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of 1991 to 1993 results is incorporated herein by reference to pages 22 through 31 of the Stockholders' Report. These items should be read in conjunction with the consolidated financial statements presented on pages 34 through 53 of the Stockholders' Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated balance sheets as of December 31, 1993, and 1992, and the related statements of consolidated earnings and retained earnings and cash flows for the years ended December 31, 1993, 1992, and 1991, together with the report of KPMG Peat Marwick dated February 21, 1994, are incorporated in this Form 10-K by reference to pages 34 through 53 of the Stockholders' Report. Supplementary selected quarterly financial data is incorporated in this Form 10-K by reference to pages 32 and 33 of the Stockholders' Report. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No reports on Form 8-K were filed during 1993 or 1992 relating to any disagreements with accountants on accounting and financial disclosure. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AND ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information called for by Items 10 and 11 of this Form 10-K report for the fiscal year ended December 31, 1993, has been omitted, except for the information presented below, because the company on or about March 28, 1994, will file with the Securities and Exchange Commission a definitive Proxy Statement pursuant to regulation 14(a) under the Securities Exchange Act of 1934. Executive Officers The company's executive officers along with their present position, offices held and activities during the past five years are presented below. All officers normally are elected annually and serve at the pleasure of the Board of Directors. The company's non-employee directors and their business experience during the past five years are listed in the company's definitive Proxy Statement. Paul J. Baduini, 46, vice president since 1993; business unit director for ion exchange resins since 1992; previously manager of the Southern Cone countries from 1990 to 1991 and general manager of Rohm and Haas Brazil form 1988 to 1991. Albert H. Caesar, 56, vice president since 1993: business unit director and president of AtoHaas North America Inc. since 1992; previously business unit director for performance plastics from 1989 to 1992. Nance K. Dicciani, 46, vice president since 1993; business unit director for petroleum chemicals since 1991; previously general manager for business development and technology, chemicals group for Air Products and Chemicals, Inc. from 1990 to 1991 and director commercial development and technology, specialty chemicals division for Air Products and Chemicals, Inc. from 1988 to 1990. Robert M. Downing, 51, vice president since 1993; operations director for the North American region since 1986. David T. Espenshade, 55, vice president since 1993; director of materials management since 1990; previously business unit director for formulation chemicals from 1989 to 1990. J. Michael Fitzpatrick, 47, vice president since 1993; director of research since 1993; previously general manager of Rohm and Haas (UK) Limited and business director for polymers and resins from 1990 to 1993 and general manager of Rohm and Haas Mexico from 1988 to 1990. Donald C. Garaventi, 57, vice president since 1982; business group executive for polymers, resins and monomers and business unit director for polymers and resins since 1989; previously corporate business director for industrial chemicals and polymers, resins and monomers from 1986 to 1989. Rajiv L. Gupta, 48, vice president since 1993; regional director of Pacific since 1993; previously business unit director for plastics additives from 1989 to 1993. Howard C. Levy, 50, vice president since 1993; business unit director for biocides since 1989. Phillip G. Lewis, 43, vice president since 1993; director of safety, health and environmental affairs and product integrity since 1993; previously director of safety, health and environmental affairs from 1989 to 1993 and corporate medical director from 1987 to 1993. Enrique F. Martinez, 56, vice president and regional director of Latin America since 1989. John P. Mulroney, 58, director since 1982; president and chief operating officer since 1986; director of Teradyne Inc. and Aluminum Company of America. Robert E. Naylor, Jr., 61, director since 1986; group vice president and regional director of North America since 1989; previously group vice president for research and corporate development from 1985 to 1989; director of Airgas, Inc. Richard G. Peterson, 55, vice president since 1987; business group executive for performance chemicals and business unit director for separations since 1989; previously corporate business director for agricultural chemicals from 1987 to 1989. Frank R. Robertson, 53, vice president since 1991; business director for polymers and resins, North America, since 1989; previously business director for polymers, resins and monomers, European region, from 1985 to 1989. Fred W. Shaffer, 61, vice president since 1977; chief financial officer since 1978; previously controller from 1972 to 1990. William H. Staas, 50, vice president since 1993; business unit director for monomers since 1990; previously president of TosoHaas from 1988 to 1990. John F. Talucci, 54, vice president and business group executive for agricultural chemicals since 1989; previously director of polymers, resins and monomers business group for the North America region from 1983 to 1989. Charles M. Tatum, 46, vice president since 1990; business unit director of plastics additives since 1993; previously director of research from 1989 to 1993 and business director of agricultural chemicals business group, North America, from 1988 to 1989. Basil A. Vassiliou, 59, vice president since 1986; regional director of Europe since 1985; business group executive for plastics since 1991. Robert P. Vogel, 49, vice president since 1993; general counsel responsible for legal, insurance, tax and regulatory matters since 1994; previously associate general counsel, regulatory counsel and director of safety, health and environment and product integrity from 1991 to 1993 and associate general counsel and regulatory counsel from 1983 to 1990. J. Lawrence Wilson, 58, director since 1977; chairman of the board and chief executive officer since 1988; director of The Vanguard Group of Investment Companies and Cummins Engine Company, Inc. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The security ownership of certain beneficial owners and management is incorporated in this Form 10-K by reference to pages 18 and 19 of the definitive Proxy Statement to be filed with the Securities and Exchange Commission on or about March 28, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is incorporated in this Form 10-K by reference to pages 18 and 19 of the definitive Proxy Statement to be filed with the Securities and Exchange Commission on or about March 28, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. Financial Statements The consolidated financial statements of Rohm and Haas Company and the accompanying report of KPMG Peat Marwick dated February 21, 1994, are incorporated in this Form 10-K by reference to pages 34 through 53 of the Stockholders' Report, a complete copy of which follows page 6 of this report: 2. Financial Statement Schedules The following supplementary financial information is filed in this Form 10-K and should be read in conjunction with the financial statements in the Stockholders' Report: PAGE ---- Independent Auditors' Report on Financial Statement Schedules ... 6 Schedules submitted: V -- Land, buildings and equipment for the years 1993, 1992 and 1991 ............................................ 7 VI -- Accumulated depreciation of buildings and equipment for the years 1993, 1992 and 1991 ........................ 8 VIII -- Valuation and qualifying accounts for the years 1993, 1992 and 1991 ............................................ 9 The schedules not included herein are omitted because they are not applicable or the required information is presented in the financial statements or related notes. 3. Exhibits Exhibit (10), Material Contracts. The following management compensatory plans, which are subject to stockholders' approval at the annual meeting on May 2, 1994, are incorporated in this Form 10-K by reference to Exhibits A, B and C of the definitive Proxy Statement to be filed with the Securities and Exchange Commission on or about March 28, 1993: (a) Rohm and Haas Top Executive Annual Performance Award (b) Rohm and Haas Top Executive Long-Term Award Plan (c) Amended Rohm and Haas Stock Option Plan of 1992 Exhibit (12), Computation of Ratio of Earnings to Fixed Charges for the company and subsidiaries, is attached as page 10 of this Form 10-K. Exhibit (22), Subsidiaries of the registrant, is attached as page 11 of this Form 10-K. Exhibit (24), Consent of independent certified public accountants, is attached as page 13 of this Form 10-K. (b) On October 18, 1993, the company filed Form 8-K for reporting and filing a copy of the company's press release dated October 15, 1993, disclosing that the company expected to report a loss for the quarter ended September 30, 1993, due to charges not related to ongoing operations totaling $50 million, after tax, or 74 cents per share. These charges included an accrual for a landfill in New Jersey and a writedown of a plastics manufacturing facility in Kentucky. The company also restated first quarter earnings to reflect an after-tax charge of $20 million related to the adoption of a new accounting standard. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, Rohm and Haas Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. /s/ Fred W. Shaffer --------------------------------- Fred W. Shaffer Vice President and Chief Financial Officer March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 25, 1994 by the following persons on behalf of the registrant and in the capacities indicated. - ------------------------------------------------------------------------------ SIGNATURE AND TITLE SIGNATURE AND TITLE - ------------------------------------------------------------------------------ /s/ J. Lawrence Wilson /s/ Sandra O. Moose - ----------------------------------- ----------------------------------- J. Lawrence Wilson Sandra O. Moose Director, Chairman of the Board and Director Chief Executive Officer /s/ Fred W. Shaffer /s/ John P. Mulroney - ----------------------------------- ----------------------------------- Fred W. Shaffer John P. Mulroney Vice President and Director Chief Financial Officer /s/ George B. Beitzel /s/ Robert E. Naylor, Jr. - ----------------------------------- ----------------------------------- George B. Beitzel Robert E. Naylor, Jr. Director Director /s/ Daniel B. Burke /s/ Gilbert S. Omenn - ----------------------------------- ----------------------------------- Daniel B. Burke Gilbert S. Omenn Director Director /s/ Earl G. Graves /s/ Ronaldo H. Schmitz - ----------------------------------- ----------------------------------- Earl G. Graves Ronaldo H. Schmitz Director Director /s/ James A. Henderson /s/ Alan Schriesheim - ----------------------------------- ----------------------------------- James A. Henderson Alan Schriesheim Director Director /s/ John H. McArthur /s/ Marna C. Whittington - ----------------------------------- ----------------------------------- John H. McArthur Marna C. Whittington Director Director /s/ Paul F. Miller, Jr. - ----------------------------------- Paul F. Miller, Jr. Director INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Rohm and Haas Company: Under date of February 21, 1994, we reported on the consolidated balance sheets of Rohm and Haas Company and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated earnings and retained earnings, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed under the heading "Financial Statement Schedules" on page 4. These financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 5 and 16 to the consolidated financial statements, the company adopted the provisions of Financial Accounting Standards Board Statement No. 112, "Accounting for Postemployment Benefits" in 1993, and the provisions of Financial Accounting Standards Board Statements No. 106, "Accounting for Postretirement Benefits Other Than Pensions" and No. 109, "Accounting for Income Taxes," in 1992. /s/ KPMG PEAT MARWICK --------------------------------- KPMG PEAT MARWICK Philadelphia, PA February 21, 1994

51720_1993.txt

51720_1993

1993

51720

ITEM 1. BUSINESS (General) Interstate Power Company, (the company), is an operating public utility incorporated in 1925 under the laws of the State of Delaware. The company is engaged in the generation, purchase, transmission, distribution and sale of electricity. It owns property in portions of twenty-five counties in the northern and northeastern parts of Iowa, in portions of twenty-two counties in the southern part of Minnesota, and in portions of four counties in northwestern Illinois. The company also engages in the distribution and sale of natural gas in Albert Lea, Minnesota; Clinton, Mason City and Clear Lake, Iowa; Fulton and Savanna, Illinois and in a number of smaller Minnesota, Iowa and Illinois communities, and in the transportation of natural gas within Iowa, Minnesota and in interstate commerce. For information pertaining to industry segments and lines of business please refer to page 27 of Exhibit EX-13 (the Annual Report to Stockholders). (Construction Program) The table below shows actual construction expenditures for 1993 and estimated expenditures for the period 1994 through 1998: (Thousands of Dollars) 1993 Actual $33,904 1994 Est. $46,510 1995 Est. $39,012 1996 Est. $31,818 1997 Est. $40,494 1998 Est. $67,166 Refer to (Environmental Regulations) on page 11 for additional information on construction expenditures related to compliance with the regulations of the Clean Air Act of 1990. (Electric Operations) Of the 234 communities served with electricity, Dubuque, Iowa, is the largest with a population of approximately 58,000. Other major cities served are Albert Lea, Minnesota and Clinton and Mason City, Iowa. The remainder of the communities served are under 15,000 population, of which 193 or 84% are less than 1,000 population. The company sells electricity at wholesale to 19 small communities which have municipal distribution systems, 13 of which are total requirements customers, and 6 of which are partial requirements customers. The territory served with electricity at retail by the company is a residential, agricultural and widely diversified industrial area with an estimated population of 338,000. There have been no significant changes since the beginning of the fiscal year in the kind of products produced, services rendered, markets or method of distribution. The facilities owned or operated by the company include facilities for the transmission of electric energy in interstate commerce or the sale of electric energy at wholesale in interstate commerce. (Sources and Availability of Raw Materials) Electricity generated by the company in 1993 was 93.5% from coal as a fuel, 0.1% from oil and 6.4% from natural gas. In 1994, the sources of such generation are estimated to be: 98.2% from coal, 0.2% from middle distillate oils, and 1.6% from natural gas. In 1993, 80.9% of the company's coal requirements came from long-term contracts. In 1994, the company anticipates that 83.8% of its coal requirements will be from long-term contracts. These contracts have expiration dates ranging from December 31, 1994 through December 31, 1998. The company in 1990 negotiated the buyout of a 300,000 ton per year contract for Montana coal. See Note 9 to the Financial Statements of the Annual Report to Stockholders (EX-13) regarding recovery of contract cancellation costs. The company has two 5 year contracts effective January 1, 1990 through December 31, 1994, for a total of 500,000 tons per year of 2% sulfur Midwestern coal for its Kapp #2, a 217 MW unit at Clinton, Iowa because of sulfur dioxide restrictions mandated by the State of Iowa. The company has a contract for 150,000 tons of coal, 50,000 tons for Lansing Units #1, #2 and #3 and 100,000 tons for Dubuque, which expires at December 31, 1994. The company has a contract for 500,000 tons per year for its 260 MW Lansing #4 unit. Lansing Unit #4 requires low sulfur coal, which is being purchased in the Powder River Basin of Wyoming. The company has this coal shipped by rail and then transloaded to barge, using facilities near Keokuk, Iowa. A contract with Orba-Johnson Transshipment Company, Inc., covers rail to barge coal transloading. Coal required for the company's generation by Neal #4 unit, located near Sioux City, Iowa is contracted for by the operator, Midwest Power Systems, under terms of the Unit Participation Agreement. Similar arrangements prevail with respect to the company's participation in Louisa #1 located near Muscatine, Iowa and operated by Iowa-Illinois Gas and Electric Company. The company owns 120 coal cars, has an undivided ownership (21.528%) in 372 coal cars in connection with Neal #4. During February 1993, 21 coal cars were damaged or destroyed beyond repair. Nine of these cars have been repaired and 12 have been replaced. The company was reimbursed by the railroad carrier for all costs of repair or replacement. The company has an undivided ownership (4%) in 136 cars in connection with Louisa #1. Coal requirements in 1994 will require using leased cars for the Louisa #1 coal supply. The company burned 665,952 gallons of No. 2 and No. 6 oil in 1993 and has 6,477,000 gallons of oil storage capacity in which to store adequate reserves during periods of high demand on refineries. The company relies on spot purchases of oil. The company presently has interruptible natural gas available for its electric generation station at Clinton, Iowa through Natural Gas Pipeline Company of America. At the Fox Lake and Dubuque plants, interruptible gas is available through Peoples Natural Gas Company. There is no assurance that interruptible gas will continue to be available as fuel for electric generating plants. (Duration and Effect of Electric Patents and Franchises) The company owns no patents. The company has, in the opinion of its legal counsel, all necessary franchises or other rights from the incorporated communities and other governmental subdivisions now served, required for the operation of its properties. With 196 electric franchises in effect in cities and villages, and with the majority of such franchises being for a term of 25 years, the renewal of such franchises is a continuing process. Thirty-two percent (62) of the franchises have been secured since January 1, 1984. (Electric Seasonal Business) The effects of air conditioning in summer and heating in winter have a seasonal impact on the business of the registrant. The air conditioning sales in the summer months are primarily related to the residential and commercial customer classes, however, the company does not meter air conditioning sales separately. During the past five years, the highest and lowest average residential consumption in the peak summer month has been 891 Kwh (July 1991) and 560 Kwh (June 1989), respectively, compared to 811 Kwh (January 1991) and 635 Kwh (February 1990) during the peak winter month. Refer to the section (Electric Governmental Regulations) for discussion of Iowa seasonal rates. (Working Capital Items) Three of the company's generating stations are located on the Mississippi River at Clinton, Dubuque and Lansing, Iowa, with their coal supply being delivered by barge during the barging season (approximately April 1st to December 1st). Coal in the stockpile at December 1st of each year has been sufficient to supply the normal requirements of these generating stations until the reopening of the Mississippi River for barge traffic. Coal shipments to the company's Neal #4 and Louisa #1 generating stations are able to continue year-round because river transportation is not involved. (Electric Governmental Regulations) The company filed an application with the IUB in September 1991 which requested an electric rate increase of $22.4 million. Interim rates of $16.2 million were placed in effect in May 1992 subject to refund. In July 1992, the IUB granted an annual revenue increase of $9.0 million (with an additional $1.4 million over the 12 months beginning November 1992 to recover costs related to a coal contract buyout). Revenue collected in excess of the IUB ordered level in the amount of $3,835,000 plus $236,000 of interest was reserved in 1992 and refunded in February 1993. On May 26, 1993, the IUB approved electric tariffs which more closely track costs incurred by the company. Individual customers experienced an increase or decrease in their electric bill, but the adoption of the new tariffs did not change the company's overall revenue. The new tariffs, which were implemented in August 1993, give greater weight to the demand component of electric usage, and include a provision for a higher rate during the summer cooling season (June - September), and a lower rate during the remainder of the year. Due to implementation of the seasonal rates, revenue for the third and fourth quarters of 1993 is not comparable to the corresponding quarters of prior years. The company filed an Iowa electric rate increase application on May 14, 1993. The IUB ruled on June 4, 1993 that the company's rate design docket approved by the IUB on May 26, 1993 constituted a change in rates. Thus, pursuant to a section of the Iowa Code which limits a utility to one rate application at a time, the rate filing was rejected. The company refiled in August 1993. The revised application requested an annual increase of $11.5 million, including a return on common equity of 12.35%. Interim rates in an annual amount of $11.0 million, which include a provision to recover SFAS 106 costs, were placed in effect on October 28, 1993, subject to refund. A decision on the rate increase is expected by the end of the second quarter of 1994. The company filed an application with the MPUC in August 1991. The application requested an electric rate increase of $8.0 million. The MPUC allowed an interim increase of $4.2 million effective October 1991. In June 1992, the MPUC issued an order granting an annual revenue increase of $4.9 million, and a return on common equity of 10.9%. The MPUC order stated that the company has 100 MW of excess capacity and disallowed recovery of $1.9 million per year applicable to the excess capacity. In instances where final rates are higher than interim rates, Minnesota law allows the utility to recover the difference. Settlement rates, including a temporary increase to recover the difference between the interim and final rates over a six month period ending May 1993, were placed into effect in December 1992. In May 1993, the Minnesota Court of Appeals affirmed the MPUC order. In June 1992, sixteen municipal wholesale customers filed a Complaint and Request for Investigation and Hearing with FERC. The complaint alleges that the company had been imprudent by entering into certain long-term coal contracts, an associated transloading agreement, and a rail transportation agreement and seeks recovery in the range of approximately $3 million to $7 million. The issue will be presented before an administrative law judge, with hearings currently scheduled to commence in August 1994. The decision by the administrative law judge is expected to be presented to the full Commission in 1995. Under this process an appeal of the FERC decision most likely would not occur until 1996 or later. The company's electric rate tariffs provide for recovery of the cost of fuel through energy adjustment clauses, which clauses are subject to revision from time to time by the regulatory authority having jurisdiction. These clauses are designed to pass on to the consumer the increases or decreases in the cost of fuel without formal rate proceedings. Purchased capacity costs are not recovered from customers through energy adjustment clauses, but rather must be addressed in base rates in a formal rate proceeding. In the company's 1991 Iowa electric rate case, the IUB required that any jurisdictional revenue from capacity sales to other utilities be returned to Iowa customers through the fuel adjustment clause. (Electric Competitive Conditions) In 1993 the Illinois Commerce Commission entered an order determining that Interstate, and not Jo-Carroll Electric Cooperative, had the right to provide electric service to a large new freezer service plant near East Dubuque, IL. The company is providing service to that plant pursuant to Commission order. Jo-Carroll filed for judicial review of the Commission's action in a proceeding now pending in the Illinois 15th Judicial Circuit. The Energy Policy Act of 1992 (Act) allows FERC to order utilities to grant access to transmission systems by third-party power producers. The Act specifically prohibits federally-mandated wheeling of power for retail customers. The company's industrial rates generally compare favorably with those of neighboring utilities. For the company's six largest industrial customers, the aggregate 1993 rate was approximately 3.4 cents per KWH. This rate also compares favorably with that of potential independent power producers and electric wholesale generators. The company's favorable rates reduce any incentive that these customers might otherwise have to relocate, self-generate or purchase electricity from other suppliers. The company has no competition from the same type of public utility service in the sale of electricity in any of the incorporated communities served by it. Interstate may be subject to competition in unincorporated areas. In the States of Iowa, Illinois and Minnesota, territorial laws govern the question of possible service to customers in such unincorporated areas, and such laws regulate competition in such areas. Laws and statutory regulations in the different states in which service is rendered provide, under varying terms and conditions, for municipal ownership of electric generating plants and distribution systems. Certain franchises under which utility service is rendered give the municipality the right to purchase the system of the company within said municipality upon certain terms and conditions. However, no such purchase option and no right of condemnation of the company's properties has been exercised and no municipal generating plant or municipal distribution system has been established in the territory now served by the company during the past twenty-five years. The Iowa Utilities Board, the Illinois Commerce Commission and the Minnesota Public Utilities Commission have each approved tariffs that allow the company to offer interruptible electric service for qualifying customers. The availability of this service provides price incentives to those customers having the ability to interrupt their connected load. The primary objective of the incentives is to reduce the system peak. The incentives also serve to retain existing customers and attract new customers. (Other Sources of Power) The company has been a participant in the Mid-Continent Area Power Pool (MAPP) Agreement since March 31, 1972. MAPP had a total coincident 1993 summer peak of 23,290 MW at which time the net capacity of the pool was 30,345 MW. Membership in the pool permits sharing of reserve capacities of the members which affects reductions in plant facilities investment for MAPP members. The minimum reserve margin for participants in MAPP has been established at 15%. Parties to the MAPP Agreement include, as participants, 29 electric power suppliers consisting of 10 investor-owned utilities, the United States Department of Interior (Western Area Power Administration), a Canadian system, public power districts and rural electric generating and transmission cooperative associations, municipal electric supply agencies and, as associate participants, 14 other electric power suppliers operating in Canada and in the North Central region of the United States. The pool coordinates planning and operation of power suppliers in Minnesota, Wisconsin, Montana, Iowa, Nebraska, North Dakota and South Dakota and provides reliability and economy for the company's bulk power supply. The MAPP Agreement was filed with the FERC and accepted as an initial rate filing effective December 1, 1972 and has been in operation since that time. In addition to MAPP, the company has interchange connections with certain Missouri and Illinois utilities through 345 KV transmission systems. Future interconnections are planned to meet transmission requirements for the next ten years. The company's total capacity includes three long-term power purchase contracts with area electric utilities. The contracts provide for the purchase of 230 to 255 megawatts of capacity over the period from May 1992 through April 2001. The company is obligated to pay the capacity charges regardless of the actual electric demand by the company's customers. Energy is available at the company's option at approximately 100% to 110% of monthly production costs for the designated units. The three power purchase contracts required capacity payments of approximately $24.1 million in 1993. Over the remaining period of the contracts, total capacity payments will be approximately $180 million. Capacity costs are not recovered from customers through energy adjustment clauses, but rather must be addressed in base rates in a formal rate proceeding. The IUB order in the company's 1991 rate case indicated that the capacity purchases were prudent and allowed recovery of the costs in rates. A 1992 rate order by the MPUC stated that the company has 100 MW of excess capacity and disallowed recovery of $1.9 million per year applicable to the excess capacity. The Minnesota Court of Appeals affirmed the MPUC disallowance in May 1993. The company has not yet filed for rate recovery in the Illinois and FERC jurisdictions. The company has contracts with several governmental power agencies whereby the company provides transmission service to their customer/members. During 1993, the company received $1,183,588 for transmission service to customers of the Western Area Power Administration (WAPA), and $1,233,863 from Cooperative Power Association (CPA) for wheeling power to nine of its member distribution cooperatives. The company's contract with CPA also provides for payment by the company for needed mutually utilized facilities constructed and owned by CPA. During 1993, these payments amounted to $330,319. The company and Southern Minnesota Municipal Power Agency (SMMPA) have agreed by contract to compensate each other if over/underinvestment in the shared transmission system occurs. During 1993, SMMPA made payments to the company in the amount of $535,342. The company's contract with Central Iowa Power Cooperative (CIPCO) provides for compensation to each other if over/underinvestment in the shared transmission system occurs. During 1993, the company owed CIPCO $63,259 for underinvestment in the Liberty Substation property. Also during 1993, CIPCO owed to the company $46,730 for underinvestment in the Dubuque-Clinton project. The net payment by the company to CIPCO totalled $16,529. (Other Electric Operations) The 1993 peak of 927,366 KW occurred on August 26, 1993 between 3:00 and 4:00 in the afternoon. At the time of its 1993 peak the company had a net effective electric capability of 1,295,600 KW. Of this net effective capability at the time of peak, 898,300 KW was in steam generation, 113,500 KW was in combustion turbine and the balance was in internal combustion units and purchases. The previous historical system net peak load for a sixty-minute period, of 919,100 KW, was reached on August 16, 1988. (Gas Operations) The company supplies retail gas service in 39 communities and serves approximately 48,000 gas customers. There have been no significant changes since the beginning of the fiscal year in the kind of products produced, markets or methods of distribution. (Gas Sources and Availability of Raw Materials) The natural gas industry was recently restructured as a result of Order 636, issued by the Federal Energy Regulatory Commission (FERC) on April 8, 1992. This Order requires the interstate pipelines to provide transportation capacity unbundled (separated) from the sales of gas supply, as well as to provide open access to their storage facilities. The company no longer purchases a bundled gas supply from Northern Natural Gas Company (NNG) and Natural Gas Pipeline Company of America (NGPL). The company purchases pipeline capacity (space) from these companies to deliver a gas supply purchased from others. As of November 1, 1993 the company purchased gas from six non-traditional suppliers, such as producers, brokers, marketers, etc., at market responsive rates. The FERC continues to approve the tariffs of NNG and NGPL, but only with regard to capacity and storage rates, subject to change as rate cases are filed. A section of the Order permits the interstate pipelines to pass on industry transition costs to their customers. Transition costs are comprised of gas supply realignment costs, unrecovered gas cost, stranded costs and new facilities costs. As a customer of NGPL and NNG, Interstate will be subject to a share of those costs. The FERC has approved the Order 636 Settlement between NNG and its customers; NGPL's Settlement is still being negotiated with its customers. Gas for the company's Mason City, Albert Lea and Savanna service areas is transported by NNG under capacity contracts for 36,533 Mcf daily, and for an additional 15,657 Mcf in the November to March time frame. The majority, 27,194 Mcf, of the above capacities is from the producing areas of New Mexico, Oklahoma and Texas, etc. These contracts expire in October, 1997. Gas is supplied by other producers, marketers and brokers as well as from storage services to meet the peak heating season requirements. The company had 20,363 Mcf/d of storage, with the necessary pipeline capacity, available for the 1993-1994 heating season. Gas for its Clinton service area is transported by NGPL under capacity contracts for 19,781 Mcf annually, with expiration dates of December 1, 1995 (6,949), February 28, 1996 (5,000), and November 30, 1996 (7,832). This gas is supplied by other producers, marketers and brokers. The company supplements this capacity with storage gas, which has the pipeline capacity embedded in its FERC approved rate. The company had 18,613 Mcf of storage available for the 1993-1994 heating season. During 1993 the company utilized approximately 42.2% of its annualized daily contract gas available from its firm suppliers. The Company's total throughput level of 34,008,768 Mcf represents a 5.6% increase for 1993 as compared to 1992. The total throughput was composed of sales gas (20.1%), spot gas (9.4%) and customer transportation gas (70.5%). During 1993 nineteen of Interstate's customers transported a total of 23,994,891 Mcf of their own gas over the company's pipeline and distribution systems. This reflects an increase over 1991 and 1992 in the number of customers exercising the transportation option. In 1991, fourteen of Interstate's customers transported a total of 16,055,921 Mcf, and in 1992 sixteen customers transported a total of 23,547,107 Mcf. The customer owned gas was delivered by interstate pipeline companies for those customers' accounts at Interstate's town border stations, under terms and conditions in tariffs approved by respective state commissions. Company policy is to assist any customer in exploring its options relative to purchasing gas directly from the producing sector. The company owns propane-air gas plants at Albert Lea, Minnesota and Clinton and Mason City, Iowa. The daily output capacities are: 5,500 Mcf, 4,000 Mcf and 9,600 Mcf of propane-air mix gas, respectively. The requirement for gas on the peak winter day of the 1992-1993 season was 139,877 Mcf, including both firm and interruptible customers. This peak consisted of 29.0% jurisdictional sales gas, 1.4% spot gas, 51.6% customer purchased gas, 6.4% firm transportation service and 11.6% storage gas. Propane-air from the company's peak- shaving plants was not needed to meet demands due to the adequate gas supply. The maximum daily firm gas sales during the 1992-1993 season were as follows: Albert Lea 10,611 Mcf; Savanna 2,338 Mcf; Clinton 20,970 Mcf; Mason City 26,494 Mcf, or 43.2% of the peak winter day throughput. The direct purchase of approximately 3,408,561 Mcf of natural gas in the spot market has resulted in a savings of $1,495,860 in the cost of natural gas during 1993. These savings have been passed on to the customers through the company's purchased gas adjustment clause. (Duration and Effect of Gas Patents and Franchises) The company owns no patents. The company has, in the opinion of its legal counsel, all necessary franchises or other rights from the incorporated communities and other governmental subdivisions now served, required for the opera- tion of its properties. With 34 gas franchises in effect in cities and villages, and with the larger majority of such franchises being for a term of 25 years, the renewal of such franchises is a continu- ing process. fifty percent (17) of the franchises have been secured since January 1, 1984. (Gas Seasonal Business) The effects of heating sales to the residential and commercial classes of customers have a significant seasonal impact on the business of the registrant. The heating sales in the winter months account for 98% of the total annual sales to these classes of custom- ers. The average consumption for a residential customer during the peak winter months is 18.5 Mcf compared to the average of 2.6 Mcf during the summer. The average consumption for a commercial customer during the peak winter months is 90.7 Mcf compared to the average of 13.4 Mcf during the summer. (Gas Governmental Regulations) In November 1992 the company filed an application with the IUB for an increase in gas rates in an annual amount of approximately $4.1 million. Interim rates were placed in effect in February 1993. Additional interim rates in an annual amount of $300,000 were placed in effect in May 1993 after the IUB approved the company's trust agreement arrangements for additional postretirement benefits expense to be recognized under SFAS 106. On August 31, 1993, the IUB issued a final order allowing an annual increase of $3.3 million. Due to customers subsequently shifting to alternate tariffs, the company estimates that it will realize an annual increase of $2.8 million. (Gas Competitive Conditions) The company has no competition from the same type of public utility service in the sale of gas in any of the incorporated communities service by it. Certain major industrial customers of the company have taken advantage of Federal and State regulations to purchase their own gas supply from producers and have that gas transported by the company as described in the "Gas Sources and Availability of Raw Materials" section. Laws and statutory regulations in the different states in which service is rendered provide, under varying terms and conditions, for municipal ownership of distribution systems. Certain franchises under which utility service is rendered give the municipality the right to purchase the system of the company within said municipality upon certain terms and conditions. However, no such purchase option and no right of condemnation of the company's properties has been exercised and no municipal distribution system has been established in the territory now serviced by the company during the past twenty-five years. (Dependence of Segment Upon a Single Customer) In 1993, 1992 and 1991, the company had no single customer or indus- try for which electric and/or gas sales accounted for 10% or more of the company's consolidated revenues. In 1993, the company's three largest industrial customers accounted for 1,288,415,514 Kwh of electric sales ($42,000,742) and 21,950,299 Mcf of gas sales and transportation ($2,905,935). (Research and Development) The company has no full-time professional employees engaged in research activities and had no company-sponsored research programs during 1993, 1992 and 1991. In the public utility industry, research is commonly and traditionally done by manufacturers of equipment, trade organizations to which the company belongs, and university research programs. In 1993 approximately $1,089,599 was paid for research activities compared with $1,012,150 in 1992 and $955,862 in 1991. (Electric and Magnetic Fields) The possibility that exposure to electric and magnetic fields emanat- ing from power lines and other electric sources may result in adverse health effects has been a subject of increased public, governmental and media attention. A considerable amount of scientific research has been conducted on this topic with no definitive results. Re- search is continuing. It is not possible to tell what, if any, impact these actions may have on the company's financial condition. (Environmental Regulations) The company is subject to environmental regulations promulgated and enforced by federal and state governments. The company believes that it presently meets existing regulations. The Federal Clean Air Act Amendments of 1990 will require reductions in sulfur dioxide and nitrogen oxide emissions from power plants. The legislation sets two deadlines for compliance, Phase 1 (January 1, 1995) and Phase 2 (January 1, 2000). The most restrictive provisions relate to sulfur dioxide emissions. During Phase 1, only one of the company's units is affected. That unit's net effective capacity is 217 MW. Present plans for the affected unit are to switch to lower sulfur coal and install low nitrogen oxide burners. Phase 2 compliance will require addition- al capital, operating and maintenance costs beyond those required for Phase 1. The Phase 2 regulations will affect approximately 87% of the company's current generating capacity. The company's long-range construction forecast (through the year 2000) contains estimated Phase 1 capital expenditures of approximate- ly $6.5 million and estimated Phase 2 capital expenditures in the range of $35.0 million. Estimated expenditures for 1994 and 1995 include $10.9 million for facilities necessary to comply with the Clean Air Act. The estimated expenditures include provisions for low nox burners, emission monitors, and flue gas conditioning systems. The company anticipates the costs of compliance with the Clean Air Act will be recovered through the ratemaking process. The United States EPA, via the Clean Water Act, and the states have promulgated discharge limits necessary to meet water quality stan- dards. A National Pollutant Discharge Elimination System (NPDES) permit is required for all discharges. The company has current NPDES permits for all discharges and meets or or falls within the required discharge limits. Early this century, various utilities including the company operated plants which used coal, coke and/or oil to produce manufactured gas for cooking and lighting. These facilities were abandoned 40 to 60 years ago when natural gas pipelines were extended into the upper Midwest. Some of the former gasification sites contain waste products which may present an environmental hazard. Waste remediation costs can vary significantly, dependent on the disposal method and type of contaminants. Current estimates range from $75 to $1,200 per ton of waste material. In 1957, the company purchased facilities in Mason City, Iowa from Kansas City Power & Light company (KCPL) which included a parcel of land previously used for coal gasification. In 1986 and again in 1991, the company entered into Consent Orders with the Environmental Protection Agency (EPA) which obligate the company to conduct a Remedial Investigation and Feasibility Study at the Mason City site. A Remedial Investigation has been completed and has been approved by the EPA. The company is continuing to perform investigative testing to determine the limits of potential groundwater contamination at the Mason City site. The remediation process will not begin until the EPA has approved the scope of the project and the appropriate process for cleaning up the site. To-date, a total of 1,200 tons of contaminated soil has been identified. To-date, all costs have been charged to expense. The company spent $300,000 on the Mason City project in 1993; it has spent $1.7 million on the site since the discovery of the tar wastes in 1984. In 1991, the company recorded estimated future expenditures of $1.4 million for groundwater monitoring, construction of an interim groundwater treatment facility and design of site remediation. In addition, the company expensed an additional $200,000 in 1992 to cover the estimated cost to remediate 1,200 tons of waste presently in a storage pile. The company is pursuing recov- ery of response costs from KCPL. The Federal District Court ruled in the third quarter of 1993 that KCPL is liable to the company regard- ing the response costs at the Mason City site. (KCPL is a strong A rated company with total assets in excess of $2 billion.) Additional court proceedings will be held in 1994 or 1995 to determine the extent of that liability. In the opinion of the company, presently accrued liabilities of $800,000 are adequate to cover the company's share of future expenses at this site. The company formerly operated a manufactured gas plant in Rochester, Minnesota. This facility was sold to another utility, which later demolished the plant. The site is currently owned by a utility and the City of Rochester. The limits of contaminated soil have been identified and are estimated to be 50,000 tons. Tentative agreements have been reached between the Minnesota PCA and all three parties noted above regarding the clean-up process. The remediation process will begin in early 1994. The total costs to clean-up this site are estimated to be $7.8 million. A verbal agreement has been reached among the parties regarding cost sharing and a written agreement is expected in the near future. The company has agreed to pay for $4.9 million of the estimated costs ($3.5 million was recorded in 1993, $1.2 million in 1992, $200,000 in 1991). To-date, all costs have been charged to expense. The company owned and operated a manufactured gas facility in Albert Lea, Minnesota and is solely responsible for the site. Testing for contaminated soil and groundwater has taken place and additional testing will take place in 1994. Based on the past testing, contami- nation is at a low level. All costs have been charged to expense. $80,000 was spent in 1993 and $243,000 has been spent to-date. Estimated investigative and remedial expenditures in the amount of $400,000 were expensed in 1991. The company anticipates that a risk assessment will be completed by late 1994. Remediation requirements will not be known until the risk assessment is completed. The company owned and operated a manufactured gas plant at Clinton, Iowa. The company believes that the coal gasification waste was removed subsequent to plant decommissioning, and therefore it is not necessary to accrue for any future liability. If hazardous wastes are found at the site, the EPA may name several potentially responsible parties in addition to the company, as other industrial operations have been conducted on or adjacent to the site. In September 1992, the company prepared a consent order (the agreement to investigate and, if necessary, remediate the site) and forwarded it to the Iowa Department of Natural Resources - Department of Environmental Quali- ty. On November 24, 1993, the company was notified that the site was referred to the Federal EPA. In addition, the company has identified four other sites in the Midwest for which the company is potentially responsible. The company has not conducted an investigation of these sites, nor has the EPA requested that any investigations be initiated. No environmental response costs have been recorded for these sites, as no evidence has been brought forth to indicate that any of these sites contain hazardous materials. In January 1994, the company was notified by an Illinois property owner of a site which contains hazardous materials which may have come from a manufactured gas plant. Investigations are underway to determine if the company has any responsibility for the site. The company has retained an outside law firm to pursue recovery from insurance carriers of environmental remediation costs applicable to the coal gasification sites. While the company's insurance carriers have stated that they are not liable, the company contends that it has coverage. Neither the company nor its legal counsel is able to predict the amount or timing of any insurance recovery, and accord- ingly, no potential recovery has been recorded. Previous actions by Iowa, Minnesota and Illinois regulators have permitted utilities to recover prudently incurred remediation and legal costs. The company anticipates that any unreimbursed costs applicable to the Iowa, Illinois and Albert Lea, Minnesota jurisdic- tions should be recovered from gas customers. It is uncertain whether the company will recover any uninsured costs applicable to the Rochester, Minnesota site, as the company no longer serves that city, and no Minnesota precedent has been established for recovery in a similar situation. Under the Federal Comprehensive Environmental Response, Compensation and Liability Act, a past waste generator can be designated by the EPA as a Potentially Responsible Party (PRP). Certain types of used transformer oil (primarily those containing polychlorinated bipheny- ls, or "PCBs") have been designated as hazardous substances by the EPA. The company has been cited as a PRP by the EPA in 3 instances which involve used transformer oil. The company was identified in 1986 by the EPA as a PRP for the clean-up of the facilities formerly operated by Martha C. Rose Chemicals, Inc. (Rose) in Holden, Missouri. Rose, pursuant to permits issued by the EPA, was engaged in decontamination of PCB fluids and processing of PCB-contaminated electrical equipment for disposal including equipment sent to them by the company. Rose ceased opera- tions in 1986, was declared bankrupt, and did not comply with EPA orders for site clean-up. Final clean-up activities at the site will not begin until 1994. The Martha Rose Chemical Steering Committee has estimated that total clean-up cost may be up to $18 million. The company, along with 14 other steering committee members, has filed suit against non-participating potentially liable entities to recover their ratable share of the costs. The company has paid clean-up costs of $317,000 to-date. The Steering Committee has indicated that it has adequate funds for clean-up, and the company anticipates that addi- tional assessments, if any, will not be material. In 1988, the EPA designated the company a PRP for the clean-up of former salvage facilities operated by B&B Salvage in Warrensburg, Missouri. The EPA pursued recovery of costs from several PRPs, although not from the company. The PRPs sued by the EPA in turn named the company as a Third Party Defendant in an attempt to recover a ratable share of the costs. In April 1993, the company paid $69,000 in full settlement of its liability for the claims asserted in that litigation. In 1988, the EPA designated the company a PRP for the clean-up of former salvage facilities operated by the Missouri Electric Works, Inc. (MEW) in Cape Girardeau, Missouri. A portion of the PCB-contami- nated equipment found at the site was formerly owned by the company. The company notified the EPA that it disclaims responsibility for the site, as the equipment was in proper operating condition when sold by the company to a third party, which subsequently made arrangements to transport this equipment to MEW. The EPA has not responded to the company's disclaimer. The company has not recorded any liability for the MEW site, and management believes that it will be able to suc- cessfully defend itself against any claims applicable to the site. (Employees) The company has 979 regular employees consisting of 941 full-time and 38 part-time employees. (Accounting Matters) The company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" in 1993. The new standard requires a deferred tax asset or liability to be recognized for each temporary book/tax difference, including timing differences flowed through and items not previously considered timing differences (primarily Deferred Investment Tax credits and Equity AFUDC). Corresponding regulatory assets or liabilities, reflecting the expected future rate treatment, have also been recognized. For this reason, the new standard did not have a significant effect on the income statement, but did result in increased regulatory assets and deferred tax liabilities. The balance sheet as of December 31, 1993 includes additional regulatory assets and deferred tax liabilities of $27.0 million as a result of the adoption of SFAS 109. The company adopted SFAS No. 106, "Accounting for Postretirement Benefits Other Than Pensions" in 1993. Under the provisions of SFAS 106, the estimated future cost of providing these postretirement benefits is accrued during the employees' service periods. The postretirement benefit obligation at January 1, 1993 (transition obligation) was $30.9 million and is being amortized over a 20 year perod. The annual SFAS 106 cost for 1993 is $4.9 million, compared to the 1993 pay-as-you-go amount of $1.7 million. The company is deferring the difference between the SFAS 106 costs and the pay-as- you-go amount until rate cases are filed to recover the additional costs. Effective May 1993, the IUB allowed the company to recover $300,000 annually of additional SFAS 106 expense in gas rates. Effective November 1993, the IUB allowed recovery of $1.6 million annually of additional SFAS 106 expense in electric rates, subject to refund upon final determination. On the basis of generic hearings or specific rate orders issued to other utilities by the Minnesota Public Commission (MPUC), FERC and the Illinois Commerce Commission (ICC), the company believes that amounts deferred meet the criteria for deferral established by the Financial Accounting Standards Board. As of December 31, 1993 $2.6 million of SFAS 106 costs in excess of the pay-as-you-go amount have been deferred. ITEM 2. ITEM 2. PROPERTIES The principal power plants and other materially important physical properties of the Company are maintained in accordance with sound operating practices. Their general character and location are described below: (Electric Properties) The Company has been a participant in the Mid-Continent Area Power Pool (MAPP) Agreement since March 31, 1972. As a part of this power network the Company is the owner of a 55.0 mile section of the 345 KV transmission line extending from St. Louis, Missouri to Minneapolis, Minnesota; a 15.5 mile section of the 345 KV transmission line between Minneapolis, Minnesota and Kansas City, Missouri; a 5.0 mile 345 KV transmission line from near Clinton, Iowa to near Cordova, Illinois; a 49.8 mile 345 KV transmission line from near Clinton, Iowa to a substation south of Dubuque, Iowa; and three associated 345/161 KV substations. The Company's electric generating stations at year-end consist of six steam plants, three combustion turbine stations, and five internal combustion facilities. Pertinent information regarding each electric generating station is shown on the following page: INTERSTATE POWER COMPANY GENERATING STATIONS Net Generating Units December 31, 1993 Output Nameplate Capability in KWH Unit Capacity Year KW KW (000's) Location Number KW Installed (Gross) (Net) 1993 STEAM: Dubuque, IA 2 15,000 1929 82,500 78,000 140,551 3 25,000 1952 4 33,000 1959 Clinton, IA 1 15,000 1947 254,900 235,000 1,146,141 (M.L.Kapp Plt.) 2 212,284 1967 Lansing, IA 1 15,000 1948 337,800 320,000 728,926 2 11,500 1949 3 33,000 1957 4 252,649 1977 Sherburn, MN 1 11,500 1950 113,500 108,000 167,927 (Fox Lake Plt.) 2 11,500 1951 3 75,000 1962 Sioux City, IA 4* 125,924 1979 142,000 134,300 922,780 (Neal Unit #4) Louisa County, IA 1** 27,400 1983 27,400 26,000 175,595 (Louisa Unit #1) TOTAL STEAM 958,100 901,300 3,281,920 GAS TURBINE: Montgomery, MN 1 26,535 1974 22,200 22,200 (87) Sherburn, MN 4 26,535 1974 21,300 21,300 40 (Fox Lake Plt.) Mason City, IA 1 37,520 1991 70,400 70,000 597 (Lime Creek Plt.) 2 37,520 1991 TOTAL GAS TURBINE 113,900 113,500 550 INTERNAL COMBUSTION: Dubuque, IA 1 2,000 1966 4,600 4,600 (110) 2 2,000 1966 Hills, MN 2 2,000 1960 2,000 2,000 (62) Lansing, IA 1 1,000 1970 2,000 2,000 4 2 1,000 1971 New Albin, IA 1 685 1970 700 700 (50) Rushford, MN 1 2,000 1961 2,000 2,000 (91) TOTAL INTERNAL COMBUSTION 11,300 11,300 (309) TOTAL COMPANY 1,083,300 1,026,100 3,282,161 * Interstate owns 21.528% of a 584,931 KW unit operated by Midwest Re- sources. ** Interstate owns 4.0% of a 685,000 KW unit operated by Iowa-Illinois Gas and Electric Company. (Gas Properties) The company owns and operates natural gas distributing systems in Albert Lea, Minnesota; Savanna, Illinois; Clinton, Mason City and Clear Lake, Iowa and in a number of smaller Minnesota, Illinois and Iowa communities. At Albert Lea, the company owns 14 tanks with a liquid propane storage capacity of 357,000 gallons; at Clinton there are 12 tanks with 306,000 gallons capacity and at Mason City 22 tanks with 561,000 gallons capacity. The company also owns 110 gas regulating stations and approximately 965 miles of gas distribution mains. (General Properties) The company owns numerous miscellaneous properties in various parts of its territory which are used for office, service and other purpos- es. The most important of these are three General Office buildings in Dubuque and the district office buildings at Clinton, Decorah, Dubuque, Mason City and Oelwein, Iowa and Albert Lea, and Winnebago, Minnesota and the distribution service buildings in each of those locations. The company, as lessee, leases office space at various locations. The company also leases a few small parcels of land for storage of poles and miscellaneous temporary uses. (Titles) In the opinion of legal counsel for the company, the company has satisfactory title to its properties for use in its utility business- es subject only to permitted liens as defined in the Bond Indenture and to minor defects and encumbrances customarily found in cases of like size and character and which do not materially interfere with the use of such properties. Properties such as electric transmission and electric and gas distri- bution lines are constructed principally on rights-of-way which are maintained under franchise or held by easement only. All properties of the company, other than "excepted property" as defined in the Bond Indenture, are subject to the lien of the compan- y's Bond Indenture dated as of January 1, 1948, as supplemented, securing the company's outstanding First Mortgage Bonds. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Reference is made to "Electric Governmental Regulations", "Electric Competitive Conditions" and "Environmental Regulations" under "Item 1. Business" for certain pending legal proceedings and proceedings known to be contemplated by governmental authorities. Reference is also made to Note 9 to Financial Statements of the Annual Report to Stockholders, included herein as EX-13. Other than these items, there are no material pending legal proceedings, or proceedings known to be contemplated by governmental authorities, other than ordinary routine litigation incidental to the business, to which the company is a party or of which any of the company's property is the subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There was no submission of matters to a vote of security holders during the fourth quarter of the 1993 year. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS For information pertaining to common stock market data required by Item 201 of Regulation S-K please refer to page 33 of Exhibit EX-13 (the Annual Report to Stockholders). ITEM 6. ITEM 6. SELECTED FINANCIAL DATA On March 11, 1993, the company filed a shelf registration with the Securities and Exchange Commission for $125 million of first mortgage bonds and 745,000 shares of $50 par value preferred stock. On May 26, 1993 the company issued $94 million of 7 5/8% first mortgage bonds due in 2023. The proceeds from the sale of the bonds were used to retire higher cost bonds due in 1999, 2001, 2002 and 2008. Also, on May 26, 1993 the company issued 545,000 shares of 6.40% preferred stock. The proceeds from the issuance of the stock were used to redeem higher cost series preferred and preference stock. Below is set forth the ratio of earnings to fixed charges for each of the years in the period 1989 through 1993. December 31, 1989................. 3.69 December 31, 1990................. 3.84 December 31, 1991................. 3.77 December 31, 1992................. 2.69 December 31, 1993................. 2.68 Below is set forth the ratio of earnings to fixed charges and pre- ferred stock dividends for each of the years in the period 1989 through 1993. December 31, 1989................. 3.03 December 31, 1990................. 3.11 December 31, 1991................. 3.13 December 31, 1992................. 2.28 December 31, 1993................. 2.21 See Exhibit EX-12 for the computation of the above ratios. For information pertaining to selected financial data required by Item 301 of Regulation S-K please refer to page 32 of Exhibit EX-13 (the Annual Report to Stockholders). ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For information pertaining to management's discussion and analysis required by Item 303 of Regulation S-K please refer to pages 1 through 11 of Exhibit EX-13 (the Annual Report to Stockholders). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements and supplementary data incorporated by reference to Exhibit EX-13 (the Annual Report to Stockholders for 1993): Statements of Income and Retained Earnings Page 12 Balance Sheets Pages 13 & 14 Statements of Cash Flows Page 15 Statements of Capitalization Page 16 Notes to Financial Statements Pages 17 - 29 Independent Auditors' Report Page 30 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Offices Held Past 5 Years W. H. Stoppelmoor 60 1-1-87 - President and Chief Executive Officer 5-1-90 - President, Chief Executive Officer and Chairman of the Board M. R. Chase 55 1-1-91 - Vice President - Production 5-7-91 - Vice President - Power Production A. D. Cordes 62 1-1-86 - Vice President - District Adminis- tration 5-1-90 - Vice President - District Adminis- tration and Public Affairs R. R. Ewers 49 5-1-90 - Vice President - Administrative Services D. E. Hamill 57 9-1-80 - Vice President - Budgets and Regu- latory Affairs G. L. Kopischke 62 9-1-80 - Vice President - Electric Opera- tions J. C. McGowan 56 5-1-86 - Assistant Secretary and Assistant Treasurer 2-1-89 - Secretary and Treasurer R. P. Richards 57 1-1-91 - Vice President - Gas Operations W. C. Troy 55 5-1-86 - Controller All officers are elected and serve as such until the next annual meeting of directors. There are no arrangements or understandings with respect to election of any person as an officer. For information pertaining to directors, and other data required by Items 401 and 405 of Regulation S-K, refer to pages 3 through 6 of the company's Official Proxy Statement filed with the Securities and Exchange Commission on March 18, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Refer to information on pages 8, 9, 10, 11 and 12 of the company's Official Proxy Statement filed with the Securities and Exchange Commission on March 18, 1994 for data required by Item 402 of Regulation S-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Refer to information on pages 6 and 7 of the company's Official Proxy Statement filed with the Securities and Exchange Commission on March 18, 1994 for data required by Item 403 of Regulation S-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Transactions with Management and Others: In 1993 there were no transactions and there are presently proposed no transactions with management, to which the company or its subsid- iary was or is to be a party, of the character as to which answer is called for in response to Item 404(a) of Regulation S-K. Indebtedness of Management: No director or officer, or nominee for election as a director, or any associate of any thereof, was indebted to the company or its subsid- iary during 1993, as to which answer is called for in response to Item 404(b) of Regulation S-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) List of documents filed as part of this report: 1. The financial statements, including supporting schedules, are listed in the Index to Financial Statements, Schedules and Exhibits filed as part of this Annual Report. 2. Exhibits which are filed herewith, including those incor- porated by reference are listed in the Index to Financial Statements, Schedules and Exhibits filed as part of this Annual Report. (b) Reports on Form 8-K: No reports on Form 8-K were filed with the Securities and Exchange Commission during the last quarter of 1993. INDEX TO FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS The 1993, 1992 and 1991 financial statements, together with the Indepen- dent Auditors' Report thereon of Deloitte & Touche dated February 3, 1994, appearing on pages 12 through 30 of Exhibit EX-13 (the 1993 Annual Report to Stockholders), are incorporated in this Form 10-K Annual Report. The following additional data, as attached on EX-23.a, EX-23.b, EX-23.c, S-1, S-2, S-3 and S-4, should be read in conjunction with the financial statements in such Exhibit EX-13. Schedules and other historical financial information not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the financial state- ments or notes thereto. Page or Exhibit Reference Exhibit EX-13 Form (Annual Report to 10-K Stockholders) Report of Independent Auditors EX-23.a Consent of Independent Auditors EX-23.b Consent of Independent Auditors EX-23.c Financial Statements: Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991 12 Balance Sheets, December 31, 1993 and 1992 13 & 14 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 15 Statements of Capitalization, December 31, 1993 and 1992 16 Notes to Financial Statements 27 - 29 Selected Financial Data 32 Common Stock Market Data 33 Management's Discussion and Analysis 1 - 11 Schedules: V. Property, Plant and Equipment S-1 VI. Accumulated Provision for Depreciation of Property, Plant and Equipment S-2 VIII. Valuation and Qualifying Accounts and Provisions S-3 X. Supplementary Profit and Loss Information S-4 INDEX TO FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS (CONT'D.) Exhibits filed as part of this report: EX-3.a Restated Certificate of Incorporation of Interstate Power Company as originally filed April 18, 1925 and as amended effective through October 21, 1993. EX-12 Statement re computation of ratios. EX-13 The Company's 1993 Annual Report to Stockholders. EX-23.a Report of Independent Auditors EX-23.b Consent of Independent Auditors EX-23.c Consent of Independent Auditors EX-99.a Listing of current material contracts, indentures and other exhibits and identified as having been previously filed with the Commission. EX-99.b Form 11-K. Interstate Power Company 401(k) Plan for the year ended December 31, 1993. EX-99.c Summary Plan Description for the Interstate Power Company 401(k) Plan dated November 30, 1993. EX-99.d Interstate Power Company Supplemental Retirement Plan dated October 8, 1990. EX-99.e Interstate Power Company Amended Deferred Compensation Plan as amended through January 30, 1990. EX-99.f Interstate Power Company Irrevocable Trust Agreement dated April 30, 1990. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. INTERSTATE POWER COMPANY Date March 17, 1994 By /s/ W. H. STOPPELMOOR (W. H. Stoppelmoor, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title /s/ W. H. STOPPELMOOR President and Chief Executive (W. H. Stoppelmoor) Officer (Principal Executive Officer and Principal Financial Officer) /s/ W. C. TROY Controller (Principal (W. C. Troy) Accounting Officer) /s/ A. B. ARENDS Director (A. B. Arends) /s/ J. E. BYRNS Director (J. E. Byrns) /s/ A. D. CORDES Director (A. D. Cordes) /s/ J. L. HANES Director (J. L. Hanes) /s/ G. L. KOPISCHKE Director (G. L. Kopischke) /s/ N. J. SCHRUP Director (N. J. Schrup) Date March 17, 1994 SCHEDULE V Page 1 of 3 INTERSTATE POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F OTHER BALANCE CHARGES AT ADD BALANCE BEGINNING ADDITIONS RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR AT COST MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1993 Utility Plant: Electric: Production $363,006 $ 4,313 $1,804 $ 1 $365,516 Transmission 167,423 7,293 1,348 2 173,370 Distribution 191,433 10,895 2,502 (52) 199,774 General 40,834 6,692 3,156 (6) 44,364 Land held for future use 587 0 0 0 587 C.W.I.P. 3,281 (117) 0 (1) 3,163 Total 766,564 29,076 8,810 (56) 786,774 Gas: Production 1,828 0 0 0 1,828 Distribution 50,378 4,896 490 0 54,784 General 2,727 399 216 (2) 2,908 C.W.I.P. 206 (207) 0 1 0 Total 55,139 5,088 706 (1) 59,520 TOTAL $821,703 $34,164 $9,516 $(57) $846,294 Property held by subsidiary $ 450 $ 297 $ 102 $ 0 $ 645 (a) Gross values of property, plant and equipment retired are summarized as follows: Charges to reserves for depreciation $9,465 Property, plant and equipment in retirement work in progress at: End of year 0 Beginning of year 0 Total (see Schedule VI) 9,465 Retirements not charged to reserve 51 TOTAL $9,516 (b) Denotes reclassifications between accounts and reduction of property due to contributions in aid of construction. S-1 SCHEDULE V Page 2 of 3 INTERSTATE POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F OTHER BALANCE CHARGES AT ADD BALANCE BEGINNING ADDITIONS RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR AT COST MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1992 Utility Plant: Electric: Production $358,421 $ 5,916 $1,339 $ 8 $363,006 Transmission 163,858 6,555 2,931 (59) 167,423 Distribution 182,638 11,051 2,338 82 191,433 General 38,098 3,658 927 5 40,834 Land held for future use 610 0 0 (23) 587 C.W.I.P. 4,207 (926) 0 0 3,281 Total 747,832 26,254 7,535 13 766,564 Gas: Production 1,740 197 87 (22) 1,828 Distribution 43,957 6,914 491 (2) 50,378 General 2,567 248 86 (2) 2,727 C.W.I.P. 1,341 (1,135) 0 0 206 Total 49,605 6,224 664 (26) 55,139 TOTAL $797,437 $32,478 $8,199 $(13) $821,703 Property held by subsidiary $ 317 $ 308 $ 175 $ 0 $ 450 (a) Gross values of property, plant and equipment retired are summarized as follows: Charges to reserves for depreciation $8,056 Property, plant and equipment in retirement work in progress at: End of year 0 Beginning of year 0 Total (see Schedule VI) 8,056 Retirements not charged to reserve 143 TOTAL $8,199 (b) Denotes reclassifications between accounts and reduction of property due to contributions in aid of construction. S-1 SCHEDULE V Page 3 of 3 INTERSTATE POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F OTHER BALANCE CHARGES AT ADD BALANCE BEGINNING ADDITIONS RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR AT COST MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1991 Utility Plant: Electric: Production $333,095 $26,226 $ 897 $ (3) $358,421 Transmission 134,357 31,548 2,047 0 163,858 Distribution 176,155 8,923 2,402 (38) 182,638 General 36,651 2,232 784 (1) 38,098 Land held for future use 610 0 0 0 610 C.W.I.P. 41,982 (37,775) 0 0 4,207 Total 722,850 31,154 6,130 (42) 747,832 Gas: Production 1,694 47 1 0 1,740 Distribution 41,575 2,846 461 (3) 43,957 General 2,433 282 148 0 2,567 C.W.I.P. 54 1,287 0 0 1,341 Total 45,756 4,462 610 (3) 49,605 TOTAL $768,606 $35,616 $6,740 $(45) $797,437 Property held by subsidiary $ 379 $ 157 $ 219 $ 0 $ 317 (a) Gross values of property, plant and equipment retired are summarized as follows: Charges to reserves for depreciation $6,672 Property, plant and equipment in retirement work in progress at: End of year 0 Beginning of year 0 Total (see Schedule VI) 6,672 Retirements not charged to reserve 68 TOTAL $6,740 (b) Denotes reclassifications between accounts and reduction of property due to contributions in aid of construction. S-1 SCHEDULE VI INTERSTATE POWER COMPANY ACCUMULATED PROVISION FOR DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F ADDITIONS OTHER CHARGED CHARGES BALANCE AT TO COSTS ADD BALANCE BEGINNING AND RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR EXPENSE MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1993 Utility Plant: Electric $320,183 $24,705 $8,759 $1,214 $337,343 Gas 19,464 2,223 706 6 20,987 TOTAL $339,647 $26,928 $9,465 $1,220 $358,330 YEAR ENDED DEC. 31, 1992 Utility Plant: Electric $301,689 $23,817 $7,392 $2,069 $320,183 Gas 18,005 2,044 664 79 19,464 TOTAL $319,694 $25,861 $8,056 $2,148 $339,647 YEAR ENDED DEC. 31, 1991 Utility Plant: Electric $283,118 $22,509 $6,062 $2,124 $301,689 Gas 16,703 1,951 610 (39) 18,005 TOTAL $299,821 $24,460 $6,672 $2,085 $319,694 (a) See note (a) to Schedule V for reconciliation of retirements with this schedule. (b) Other charges - additions (deductions) are summarized below: 1993 1992 1991 Salvage and amounts realized from sales $1,806 $2,522 $2,535 Depreciation charged to asset accounts 685 713 893 Depreciation charged to other expense accounts 624 571 528 Cost of removal (1,895) (1,658) (1,871) $1,220 $2,148 $2,085 S-2 SCHEDULE VIII INTERSTATE POWER COMPANY VALUATION AND QUALIFYING ACCOUNTS AND PROVISIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E ADDITIONS BALANCE AT CHARGED CHARGED DEDUCTION BALANCE BEGINNING TO TO OTHER FROM AT END DESCRIPTION OF YEAR INCOME ACCOUNTS RESERVES OF YEAR YEAR ENDED DEC. 31, 1993 Valuation account deducted from caption of which it applies - accumulated provision for doubtful accounts $206 $225 $134 (a) $362 (b) $203 Provision for medical benefits, injuries and damages $1,506 $4,302 $3,521 $5,224 (c) $4,105 YEAR ENDED DEC. 31, 1992 Valuation account deducted from caption of which it applies - accumulated provision for doubtful accounts $206 $152 $115 (a) $267 (b) $206 Provision for medical benefits, injuries and damages $1,655 $4,103 $838 $5,090 (c) $1,506 YEAR ENDED DEC. 31, 1991 Valuation account deducted from caption of which it applies - accumulated provision for doubtful accounts $202 $202 $116 (a) $314 (b) $206 Provision for medical benefits, injuries and damages $783 $4,113 $946 $4,187 (c) $1,655 (a) Recoveries on accounts previously written off. (b) Accounts written off. (c) Claims and damages paid and expenses in connection therewith. S-3 SCHEDULE X INTERSTATE POWER COMPANY SUPPLEMENTARY PROFIT AND LOSS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 In addition to the amounts of maintenance and depreciation shown separate- ly in the statement of income, there are insignificant amounts for such items applicable to unit train coal cars charged to the coal inventory account and vehicles charged to construction work in progress. Taxes, other than income taxes, were as follows: Year Ended December 31 1993 1992 1991 (Thousands of Dollars) Real estate and personal property taxes $14,481 $14,054 $12,853 Franchise taxes 160 160 148 Payroll taxes 2,809 2,696 2,613 Miscellaneous 201 169 195 Total $17,651 $17,079 $15,809 The above amounts were charged to accounts: Year Ended December 31 1993 1992 1991 (Thousands of Dollars) Tax expense $17,080 $16,533 $15,315 Clearing accounts 206 187 171 Construction work in progress 296 290 258 Retirement work in progress 69 69 65 Total $17,651 $17,079 $15,809 There were no royalties paid or incurred during 1993, 1992 or 1991. Rent and advertising costs were not material. S-4 INDEX OF EXHIBITS EX-3.a Restated Certificate of Incorporation of Interstate Power Company as originally filed April 18, 1925 and as amended effective through October 21, 1993. EX-12 Statement re computation of ratios. EX-13 The Company's 1993 Annual Report to Stockholders. EX-23.a Report of Independent Auditors EX-23.b Consent of Independent Auditors EX-23.c Consent of Independent Auditors EX-99.a Listing of current material contracts, indentures and other exhibits and identified as having been previously filed with the Commission. EX-99.b Form 11-K. Interstate Power Company 401(k) Plan for the year ended December 31, 1993. EX-99.c Summary Plan Description for the Interstate Power Company 401(k) Plan dated November 30, 1993. EX-99.d Interstate Power Company Supplemental Retirement Plan dated October 8, 1990. EX-99.e Interstate Power Company Amended Deferred Compensation Plan as amended through January 30, 1990. EX-99.f Interstate Power Company Irrevocable Trust Agreement dated April 30, 1990.

872553_1993.txt

872553_1993

1993

872553

ITEM 1. BUSINESS Each of the Grantor Trusts, (the "Trusts"), listed below, was formed by GMAC Auto Receivables Corporation (the "Seller") by selling and assigning the receivables and the security interests in the vehicles financed thereby to The First National Bank of Chicago, as Trustee, in exchange for Class A certificates representing an undivided ownership interest that ranges between approximately 91% and 94.5% in each Trust, which were remarketed to the public, and Class B certificates representing an undivided ownership interest that ranges between approximately 5.5% and 9% in each Trust, which were not offered to the public and initially were held by the Seller. The right of the Class B certificateholders to receive distribution of the receivables is subordinated to the rights of the Class A certificateholders. GRANTOR TRUST ------------- GMAC 1990-A GMAC 1991-A GMAC 1991-B GMAC 1991-C GMAC 1992-A GMAC 1992-C GMAC 1992-D GMAC 1992-E GMAC 1992-F GMAC 1992-G GMAC 1993-A GMAC 1993-B _____________________ PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Grantor Trusts, listed in the table as shown below, was formed by GMAC Auto Receivables Corporation (the "Seller") pursuant to a Pooling and Servicing Agreement between the Seller and The First National Bank of Chicago, as trustee. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for certificates representing undivided ownership interests in each Trust. Each Trust's property includes a pool of retail instalment sale contracts secured by new, and in some Trust's used, automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The certificates for each of the following Trusts consist of two classes, entitled Asset Backed certificates, Class A and Asset Backed certificates, Class B. The Class A certificates represent in the aggregate an undivided ownership interest that ranges between approximately 91% and 94.5% of the Trusts and the Class B certificates represent in the aggregate an undivided ownership interest that ranges between approximately 5.5% and 9% of the Trusts. Only the Class A certificates have been remarketed to the public. The Class B certificates have not been offered to the public and initially are being held by the Seller. The rights of the Class B certificateholder to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. Original Aggregate Amount ----------------------------------- Date of Pooling Retail Asset Backed Certificates Grantor and Servicing Finance ------------------------- Trust Agreement Receivables Class A Class B - ------- ----------------- --------- -------- ------- (In millions of dollars) GMAC 1990-A December 20, 1990 $1,162.6 $1,057.9 $104.7 GMAC 1991-A March 14, 1991 891.7 811.4 80.3 GMAC 1991-B September 17, 1991 1,007.4 916.7 90.7 GMAC 1991-C December 16, 1991 1,326.4 1,207.0 119.4 GMAC 1992-A January 30, 1992 2,001.4 1,851.3 150.1 GMAC 1992-C March 26, 1992 1,100.3 1,012.3 88.0 GMAC 1992-D June 4, 1992 1,647.6 1,499.3 148.3 GMAC 1992-E August 20, 1992 1,578.0 1,436.0 142.0 GMAC 1992-F September 29, 1992 1,644.6 1,496.6 148.0 GMAC 1992-G November 19, 1992 1,379.4 1,303.5 75.9 GMAC 1993-A March 24, 1993 1,403.0 1,297.8 105.2 GMAC 1993-B September 16, 1993 1,450.6 1,341.8 108.8 II-1 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (concluded) General Motors Acceptance Corporation, the originator of the retail receivables, continues to service the receivables for each of the aforementioned Grantor Trusts and receives compensation and fees for such services. Investors receive monthly payments of the pro rata portion of principal and interest for each Trust as the receivables are liquidated. ------------------------ II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CROSS REFERENCE SHEET Caption Page - --------------------------------------------------- ------ GMAC 1990-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-4 Data for the Year Ended December 31, 1993. GMAC 1991-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-9 Data for the Year Ended December 31, 1993. GMAC 1991-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-14 Data for the Year Ended December 31, 1993. GMAC 1991-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-19 Data for the Year Ended December 31, 1993. GMAC 1992-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-24 Data for the Year Ended December 31, 1993. GMAC 1992-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-29 Data for the Year Ended December 31, 1993. GMAC 1992-D Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-34 Data for the Year Ended December 31, 1993. GMAC 1992-E Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-39 Data for the Year Ended December 31, 1993. GMAC 1992-F Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-44 Data for the Year Ended December 31, 1993. GMAC 1992-G Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-49 Data for Year Ended from December 31, 1993. GMAC 1993-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-54 Data for the period from March 24, 1993 to December 31, 1993. GMAC 1993-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-59 Data for period from September 16, 1993 to December 31, 1993. II-3 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1990-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1990-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1990-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for each of the three years in the period ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-4 GMAC 1990-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 207.1 459.8 ------- ------- TOTAL ASSETS ........................... 207.1 459.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 207.1 459.8 ------- ------- TOTAL LIABILITIES ...................... 207.1 459.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-5 GMAC 1990-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- Distributable Income $ $ $ Allocable to Principal ............... 252.7 344.1 358.7 Allocable to Interest ............... 27.7 52.9 82.6 ----- ----- ----- Distributable Income ................... 280.4 397.0 441.3 ===== ===== ===== Income Distributed ..................... 280.4 397.0 441.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-6 GMAC 1990-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1990-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 20, 1990, GMAC 1990-A Grantor Trust acquired retail finance receivables aggregating approximately $1,162.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 8.25% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-7 GMAC 1990-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 70.0 9.0 79.0 Second quarter ..................... 69.0 7.5 76.5 Third quarter ...................... 61.8 6.2 68.0 Fourth quarter ..................... 51.9 5.0 56.9 --------- -------- ----- Total ......................... 252.7 27.7 280.4 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 90.4 16.0 106.4 Second quarter ..................... 90.0 14.1 104.1 Third quarter ...................... 86.1 12.3 98.4 Fourth quarter ..................... 77.6 10.5 88.1 --------- -------- ----- Total ......................... 344.1 52.9 397.0 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 86.6 23.4 110.0 Second quarter ..................... 93.2 21.7 114.9 Third quarter ...................... 90.8 19.7 110.5 Fourth quarter ..................... 88.1 17.8 105.9 --------- -------- ----- Total ......................... 358.7 82.6 441.3 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-A Grantor Trust at December 31, 1993 and 1992 and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 GMAC 1991-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 162.0 370.4 ------- ------- TOTAL ASSETS ........................... 162.0 370.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 162.0 370.4 ------- ------- TOTAL LIABILITIES ...................... 162.0 370.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-10 GMAC 1991-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period March 14, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- $ $ $ Distributable Income Allocable to Principal ................ 208.3 290.7 230.6 Allocable to Interest ................ 21.2 41.2 46.7 ----- ----- ----- Distributable Income .................... 229.5 331.9 277.3 ===== ===== ===== Income Distributed ...................... 229.5 331.9 277.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-11 GMAC 1991-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 14, 1991, GMAC 1991-A Grantor Trust acquired retail finance receivables aggregating approximately $891.7 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 7.90% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-12 GMAC 1991-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 58.0 6.9 64.9 Second quarter ..................... 55.5 5.8 61.3 Third quarter ...................... 50.6 4.7 55.3 Fourth quarter ..................... 44.2 3.8 48.0 --------- -------- ----- Total ......................... 208.3 21.2 229.5 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 78.5 12.5 91.0 Second quarter ..................... 75.1 11.0 86.1 Third quarter ...................... 71.9 9.5 81.4 Fourth quarter ..................... 65.2 8.2 73.4 --------- -------- ----- Total ......................... 290.7 41.2 331.9 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 78.6 17.1 95.7 Third quarter ...................... 76.7 15.6 92.3 Fourth quarter ..................... 75.3 14.0 89.3 --------- -------- ----- Total ......................... 230.6 46.7 277.3 ========= ======== ===== II-13 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-B Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-B Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-14 GMAC 1991-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 306.4 582.8 ------- ------- TOTAL ASSETS ........................... 306.4 582.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 306.4 582.8 ------- ------- TOTAL LIABILITIES ...................... 306.4 582.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-15 GMAC 1991-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period September 17, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ------ ------ ------ $ $ $ Distributable Income Allocable to Principal ............... 276.3 340.7 83.9 Allocable to Interest ............... 30.4 51.5 16.5 ------ ------ ------ Distributable Income ................... 306.7 392.2 100.4 ====== ====== ====== Income Distributed ..................... 306.7 392.2 100.4 ====== ====== ====== Reference should be made to the Notes to Financial Statements. II-16 GMAC 1991-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 17, 1991, GMAC 1991-B Grantor Trust acquired retail finance receivables aggregating approximately $1,007.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 6.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-17 GMAC 1991-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 72.7 9.4 82.1 Second quarter ..................... 74.8 8.2 83.0 Third quarter ...................... 68.3 7.0 75.3 Fourth quarter ..................... 60.5 5.8 66.3 --------- -------- ----- Total ......................... 276.3 30.4 306.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 87.1 15.1 102.2 Second quarter ..................... 89.5 13.6 103.1 Third quarter ...................... 84.9 12.1 97.0 Fourth quarter ..................... 79.2 10.7 89.9 --------- -------- ----- Total ......................... 340.7 51.5 392.2 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 83.9 16.5 100.4 ========= ======== ===== II-18 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the years then ended. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the years then ended, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-19 GMAC 1991-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 496.0 874.6 ------- ------- TOTAL ASSETS ........................... 496.0 874.6 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 496.0 874.6 ------- ------- TOTAL LIABILITIES ...................... 496.0 874.6 ======= ======= Reference should be made to the Notes to Financial Statements. II-20 GMAC 1991-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993 and 1992 (in millions of dollars) 1993 1992 -------- -------- $ $ Distributable Income Allocable to Principal ...................... 378.5 451.8 Allocable to Interest ...................... 39.7 63.3 -------- -------- Distributable Income .......................... 418.2 515.1 ======== ======== Income Distributed ............................ 418.2 515.1 ======== ======== Reference should be made to the Notes to Financial Statements. II-21 GMAC 1991-C GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 16, 1991, GMAC 1991-C Grantor Trust acquired retail finance receivables aggregating approximately $1,326.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.70% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-22 GMAC 1991-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 96.7 12.0 108.7 Second quarter ..................... 101.1 10.6 111.7 Third quarter ...................... 95.2 9.2 104.4 Fourth quarter ..................... 85.5 7.9 93.4 --------- -------- ----- Total ......................... 378.5 39.7 418.2 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 120.6 18.3 138.9 Second quarter ..................... 115.3 16.6 131.9 Third quarter ...................... 109.9 15.0 124.9 Fourth quarter ..................... 106.0 13.4 119.4 --------- -------- ----- Total ......................... 451.8 63.3 515.1 ========= ======== ===== II-23 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-24 GMAC 1992-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 370.7 1,052.5 ------- ------- TOTAL ASSETS ...................................... 370.7 1,052.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 370.7 1,052.5 ------- ------- TOTAL LIABILITIES ................................. 370.7 1,052.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-25 GMAC 1992-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 681.7 948.9 Allocable to Interest ...................... 35.4 72.0 ------- ------- Distributable Income .......................... 717.1 1,020.9 ======= ======= Income Distributed ............................ 717.1 1,020.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-26 GMAC 1992-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On January 30, 1992, GMAC 1992-A Grantor Trust acquired retail finance receivables aggregating approximately $2,001.4 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing February 18, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.05% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-27 GMAC 1992-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 206.9 12.4 219.3 Second quarter ..................... 192.5 9.8 202.3 Third quarter ...................... 157.7 7.5 165.2 Fourth quarter ..................... 124.6 5.7 130.3 --------- -------- ----- Total ......................... 681.7 35.4 717.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 171.8 16.5 188.3 Second quarter ..................... 278.3 21.9 300.2 Third quarter ...................... 263.6 18.4 282.0 Fourth quarter ..................... 235.2 15.2 250.4 --------- -------- ------- Total ......................... 948.9 72.0 1,020.9 ========= ======== ======= II-28 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-29 GMAC 1992-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 311.3 716.3 ------- ------- TOTAL ASSETS ...................................... 311.3 716.3 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) .................................. 311.3 716.3 ------- ------- TOTAL LIABILITIES ................................. 311.3 716.3 ======= ======= Reference should be made to the Notes to Financial Statements. II-30 GMAC 1992-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 405.0 384.0 Allocable to Interest ...................... 31.0 41.2 ------- ------- Distributable Income .......................... 436.0 425.2 ======= ======= Income Distributed ............................ 436.0 425.2 ======= ======= Reference should be made to the Notes to Financial Statements. II-31 GMAC 1992-C GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 26, 1992, GMAC 1992-C Grantor Trust acquired retail finance receivables aggregating approximately $1,100.3 million from the Seller in exchange for certificates representing undivided ownership interests of 92% for the Class A certificates and 8% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.95% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-32 GMAC 1992-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 109.2 10.1 119.3 Second quarter ..................... 109.3 8.5 117.8 Third quarter ...................... 99.7 6.9 106.6 Fourth quarter ..................... 86.8 5.5 92.3 --------- -------- ----- Total ......................... 405.0 31.0 436.0 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 133.1 15.7 148.8 Third quarter ...................... 129.8 13.7 143.5 Fourth quarter ..................... 121.1 11.8 132.9 --------- -------- ----- Total ......................... 384.0 41.2 425.2 ========= ======== ===== II-33 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-D Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-D Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-D Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-34 GMAC 1992-D GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 702.0 1,270.4 ------- ------- TOTAL ASSETS ...................................... 702.0 1,270.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 702.0 1,270.4 ------- ------- TOTAL LIABILITIES ................................. 702.0 1,270.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-35 GMAC 1992-D GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period June 4,1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 568.4 377.2 Allocable to Interest ...................... 55.4 48.0 ------ ------ Distributable Income .......................... 623.8 425.2 ====== ====== Income Distributed ............................ 623.8 425.2 ====== ====== Reference should be made to the Notes to Financial Statements. II-36 GMAC 1992-D GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-D Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On June 4, 1992, GMAC 1992-D Grantor Trust acquired retail finance receivables aggregating approximately $1,647.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing June 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.55% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-37 GMAC 1992-D GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 148.6 16.9 165.5 Second quarter ..................... 153.3 14.8 168.1 Third quarter ...................... 140.7 12.8 153.5 Fourth quarter ..................... 125.8 10.9 136.7 --------- -------- ----- Total ......................... 568.4 55.4 623.8 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 50.7 7.6 58.3 Third quarter ...................... 166.9 21.4 188.3 Fourth quarter ..................... 159.6 19.0 178.6 --------- -------- ----- Total ......................... 377.2 48.0 425.2 ========= ======== ===== II-38 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-E Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-E Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-E Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-39 GMAC 1992-E GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 885.4 1,398.0 ------- ------- TOTAL ASSETS ...................................... 885.4 1,398.0 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 885.4 1,398.0 ------- ------- TOTAL LIABILITIES ................................. 885.4 1,398.0 ======= ======= Reference should be made to the Notes to Financial Statements. II-40 GMAC 1992-E GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 512.6 180.0 Allocable to Interest ...................... 55.1 23.9 ------- ------- Distributable Income .......................... 567.7 203.9 ======= ======= Income Distributed ............................ 567.7 203.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-41 GMAC 1992-E GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-E Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On August 20, 1992, GMAC 1992-E Grantor Trust acquired retail finance receivables aggregating approximately $1,578.0 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing September 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-42 GMAC 1992-E GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 128.3 16.1 144.4 Second quarter ..................... 134.8 14.5 149.3 Third quarter ...................... 129.0 13.0 142.0 Fourth quarter ..................... 120.5 11.5 132.0 --------- -------- ----- Total ......................... 512.6 55.1 567.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Third quarter ...................... 46.1 6.2 52.3 Fourth quarter ..................... 133.9 17.7 151.6 --------- -------- ----- Total ......................... 180.0 23.9 203.9 ========= ======== ===== II-43 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-F Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-F Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-F Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-44 GMAC 1992-F GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 908.7 1,492.8 ------- ------- TOTAL ASSETS ...................................... 908.7 1,492.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 908.7 1,492.8 ------- ------- TOTAL LIABILITIES ................................. 908.7 1,492.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-45 GMAC 1992-F GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 584.1 151.8 Allocable to Interest ...................... 55.0 17.9 ------ ------ Distributable Income .......................... 639.1 169.7 ====== ====== Income Distributed ............................ 639.1 169.7 ====== ====== Reference should be made to the Notes to Financial Statements. II-46 GMAC 1992-F GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-F Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 29, 1992, GMAC 1992-F Grantor Trust acquired retail finance receivables aggregating approximately $1,644.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.50% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-47 GMAC 1992-F GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 146.9 16.2 163.1 Second quarter ..................... 151.2 14.6 165.8 Third quarter ...................... 147.3 12.9 160.2 Fourth quarter ..................... 138.7 11.3 150.0 --------- -------- ----- Total ......................... 584.1 55.0 639.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 151.8 17.9 169.7 ========= ======== ===== II-48 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-G Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-G Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-G Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-49 GMAC 1992-G GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 335.3 1,288.5 ------- ------- TOTAL ASSETS ...................................... 335.3 1,288.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 335.3 1,288.5 ------- ------- TOTAL LIABILITIES ................................. 335.3 1,288.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-50 GMAC 1992-G GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 953.1 91.0 Allocable to Interest ...................... 35.2 4.9 ------ ------ Distributable Income .......................... 988.3 95.9 ====== ====== Income Distributed ............................ 988.3 95.9 ====== ====== Reference should be made to the Notes to Financial Statements. II-51 GMAC 1992-G GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-G Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On November 19, 1992, GMAC 1992-G Grantor Trust acquired retail finance receivables aggregating approximately $1,379.4 million from the Seller in exchange for certificates representing undivided ownership interests of 94.5% for the Class A certificates and 5.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing December 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.30% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-52 GMAC 1992-G GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 268.1 12.9 281.0 Second quarter ..................... 258.3 10.0 268.3 Third quarter ...................... 230.4 7.3 237.7 Fourth quarter ..................... 196.3 5.0 201.3 --------- -------- ----- Total ......................... 953.1 35.2 988.3 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 91.0 4.9 95.9 ========= ======== ===== II-53 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-A Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period March 24, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-A Grantor Trust at December 31, 1993 and its distributable income and distributions for the period March 24, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-54 GMAC 1993-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 845.9 ------- TOTAL ASSETS ...................................... 845.9 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 845.9 ------- TOTAL LIABILITIES ................................. 845.9 ======= Reference should be made to the Notes to Financial Statements. II-55 GMAC 1993-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period March 24, 1992 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 557.0 Allocable to Interest .................... 35.6 ----- Distributable Income ......................... 592.6 ===== Income Distributed ........................... 592.6 ===== Reference should be made to the Notes to Financial Statements. II-56 GMAC 1993-A GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 24, 1993, GMAC 1993-A Grantor Trust acquired retail finance receivables aggregating approximately $1,403.0 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.15% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-57 GMAC 1993-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 196.7 13.9 210.6 Third quarter ...................... 194.4 11.8 206.2 Fourth quarter ..................... 165.9 9.9 175.8 --------- -------- ----- Total ......................... 557.0 35.6 592.6 ========= ======== ===== II-58 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-B Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period September 16, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-B Grantor Trust at December 31, 1993 and its distributable income and distributions for the period September 16, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-59 GMAC 1993-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 1,269.0 ------- TOTAL ASSETS ...................................... 1,269.0 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 1,269.0 ------- TOTAL LIABILITIES ................................. 1,269.0 ======= Reference should be made to the Notes to Financial Statements. II-60 GMAC 1993-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period September 16, 1993 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 181.6 Allocable to Interest .................... 13.9 ----- Distributable Income ......................... 195.5 ===== Income Distributed ........................... 195.5 ===== Reference should be made to the Notes to Financial Statements. II-61 GMAC 1993-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 16, 1993, GMAC 1993-B Grantor Trust acquired retail finance receivables aggregating approximately $1,450.6 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.00% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-62 GMAC 1993-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 181.6 13.9 195.5 ========= ======== ===== II-63 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) (1) FINANCIAL STATEMENTS. Included in Part II, Item 8, of Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- GMAC 1990-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-A Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1991-B Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-C Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-C Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1992-D Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-E Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-F Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-G Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1993-A Grantor Trust Financial Statements for the period March 24, 1993 through December 31, 1993. -- GMAC 1993-B Grantor Trust Financial Statements for the period September 16, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by any of the above-mentioned Grantor Trusts during the fourth quarter ended December 31, 1993 ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustee has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GMAC 1990-A GRANTOR TRUST GMAC 1991-A GRANTOR TRUST GMAC 1991-B GRANTOR TRUST GMAC 1991-C GRANTOR TRUST GMAC 1992-A GRANTOR TRUST GMAC 1992-C GRANTOR TRUST GMAC 1992-D GRANTOR TRUST GMAC 1992-E GRANTOR TRUST GMAC 1992-F GRANTOR TRUST GMAC 1992-G GRANTOR TRUST GMAC 1993-A GRANTOR TRUST GMAC 1993-B GRANTOR TRUST The First National Bank of Chicago (Trustee) s\ Steven M. Wagner ---------------------------------- (Steven M. Wagner, Vice President) Date: March 30, 1994 -------------- IV-2

741341_1993.txt

741341_1993

1993

741341

Item 1.BUSINESS. General Metropolitan Financial Corporation (the "Company") is a regional financial services holding company. The Company's mission is to be the premier provider of community financial and home ownership services throughout its markets by offering exceptional value to its customers, resulting in profitable growth, fulfilling careers and community enhancement. The primary operations of the Company are in North Dakota, Minnesota, Nebraska, Iowa, Kansas, South Dakota, Wisconsin and Arizona. The Company operates an FDIC insured consumer savings bank, Metropolitan Federal Bank, fsb (the "Bank"), which concentrates on the traditional thrift business of soliciting deposits and making residential mortgage and other secured consumer loans. The Bank solicits deposits and makes residential mortgage and other secured consumer loans through more than 190 full service branches. Through its mortgage loan production offices in Minnesota and Arizona, as well as its branch offices, the Bank originates and services first mortgage loans for the purchase of one to four family residential properties. The Company's residential real estate brokerage subsidiary, Edina Realty, Inc. ("Edina Realty"), and title company subsidiary, Equity Title Services ("Equity Title") are among Minnesota's largest providers of their respective services. Edina Realty and Equity Title conduct their business in Minnesota and western Wisconsin. Certain financial services products like annuities, uninsured investments, such as mutual funds, and insurance are provided to customers through a subsidiary operating as Metropolitan Financial Services ("MFS"). The Company's primary objective is to maximize shareholder value through the traditional thrift mission of promoting savings and home ownership. To achieve its objective, the Company has identified the goals of continuing to expand the geographic area, presence and market share of its subsidiaries, thereby further strengthening the Company's financial condition and enhancing its financial performance. The Company was organized under the laws of the State of Delaware in February 1984. All references to the Company or the Bank include its respective consolidated subsidiaries, unless the context otherwise requires. The principal executive office of the Company is located at 1000 Metropolitan Centre, 333 South Seventh Street, Minneapolis, Minnesota 55402. The Company's telephone number is (612) 399-6000. Additional discussion of the Company's business can be found in Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes to Consolidated Financial Statements of the 1993 Annual Report, which is incorporated herein by reference. Competition The Bank actively competes for savings deposits with thrift institutions and banks located in its primary market areas. The deposit programs of thrift institutions such as the Bank also compete with government securities, money market mutual funds, and other investment alternatives. The Bank competes for residential mortgage loans, with thrift institutions, banks, mortgage banking companies, life insurance companies and other types of lenders. Interest rate, loan origination fees and range of services offered are the primary factors in competing for these loans. Access to prospective mortgage customers is facilitated by the ownership of Edina Realty. Edina Realty actively competes for real estate brokerage business in the Minneapolis-St. Paul metropolitan area and other areas of Minnesota and western Wisconsin. The primary sources of competition are other large regional and national real estate brokerage firms. Attracting and retaining a large and effective group of sales associates is the main factor in competing within the real estate brokerage business. The Company seeks to accomplish these goals through compensation and service. Equity Title competes for mortgage title and closing business in the Minneapolis-St. Paul metropolitan area and other areas of Minnesota and western Wisconsin. Equity Title competes principally with local and regional title closing companies. The main factors for competing in the industry are price and service quality. MFS, a registered broker-dealer, offers bank customers financial advice and an array of investment products, including fixed and variable annuities, mutual funds, unit investment trusts and life insurance. MFS' competition is principally other financial institutions, brokerage houses and other financial intermediaries. Access to prospective customers is facilitated by the Bank. Employees At December 31, 1993, the Company had approximately 2,600 full time equivalent employees. Edina Realty works with approximately 2,000 sales associates who function as independent contractors. The Company maintains a comprehensive employee benefit program providing, among other benefits, a qualified pension plan, 401-K savings plan, stock purchase plan, paid sick leave, hospitalization, dental and major medical insurance, life insurance, short and long term disability insurance and education assistance. Regulation The following discussion is a summary of some of the important statutes and regulations applicable to the Company and the Bank. It is not an exhaustive description of applicable statutes and regulations, but rather an outline of those which are most significant, and it is qualified in its entirety by reference to the provisions described. Regulatory Structure. The Company is a savings and loan holding company, and the Bank is a federal savings association. As such, both the Company and the Bank are subject to regulatory examination and supervision by the Office of Thrift Supervision (the "OTS"), and in certain circumstances by the Federal Deposit Insurance Corporation (the "FDIC") because the Bank's deposits are insured by the FDIC. The Bank is also subject to some regulation by the Federal Reserve Board. The Bank is a member of the Federal Home Loan Bank ("FHLB") of Des Moines, which is one of 12 regional FHLB's governed by the Federal Housing Finance Board. As a member of a FHLB, the Bank is required to purchase and maintain stock in its FHLB. The Bank meets the applicable requirement. Regulatory Capital. Under regulatory capital regulations issued by the OTS, thrift institutions are required to maintain the three following capital standards. First, thrift institutions must maintain a ratio of tangible capital to adjusted total assets of at least 1.5%. Tangible capital is defined as common shareholders' equity, noncumulative preferred stock, nonwithdrawable accounts and pledged deposits, minority interests in fully consolidated subsidiaries, and purchased mortgage servicing rights ("PMSRs"), (which may constitute up to 50% of tangible capital), less total intangible assets (except for includable PMSRs) and certain investments in subsidiaries that conduct activities not permissible for a national bank. Second, thrift institutions must maintain a ratio of core capital to adjusted total assets of at least 3%. Core capital generally includes common shareholders' equity, noncumulative preferred stock and related surplus, and minority interests in fully consolidated subsidiaries, PMSRs and purchased credit card relationships ("PCCRs") (which PMSRs may collectively constitute up to 50% of core capital), less intangible assets (except for includable PMSRs and PCCRs). Until 1995, thrift institutions which are in substantial compliance with all applicable laws and regulations and are generally judged to be safe and sound will also be permitted to include a percentage (.375% at January 1, 1994, decreasing to 0% on January 1, 1995) of qualifying supervisory goodwill (in existence on April 12, 1989) in core capital. Third, thrift institutions must maintain a ratio of total capital to total risk weighted assets equal to 8.0%. Total capital consists of core capital, plus supplementary capital in an amount up to 100% of core capital. Supplementary capital includes certain permanent capital instruments such as cumulative perpetual preferred stock, certain subordinated debt securities and a limited percentage of loan loss reserves. Total risk weighted assets are determined by assigning a risk weight to each of the institution's assets depending on the risk inherent in the type of asset. Certain off balance sheet items must be included in the calculation of risk weighted assets by being converted into balance sheet equivalent amounts and multiplied by the assigned risk weights. The applicable risk weights, as defined by regulation, range from 0% for cash and certain government obligations to 100%. The OTS amended its risk-based capital requirements, generally effective January 1, 1994, to require thrift institutions with more than a "normal" level of interest rate risk to maintain additional total capital. A savings institution's interest rate risk will be measured in terms of the sensitivity of its "net portfolio value" to changes in interest rates. The interest rate risk amendments have not had a material impact on the Company's regulatory capital ratios. As of December 31, 1993, the Bank met all three fully phased in capital requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Capital Adequacy" in the 1993 Annual Report on page 32. Thrift institutions are subject to additional minimum regulatory capital regulations that require thrift supervisory agencies to take certain prescribed prompt corrective action in the event an institution fails to meet minimum capital levels of its ratios of total capital to total risk-weighted assets ("risk-based"), core capital to total risk-weighted assets ("Tier 1 risk- based"), and core capital to adjusted total assets ("leverage"). These three ratios are used to classify thrift institutions into five separate capital categories: well capitalized (10%, 6%, and 5%), adequately capitalized (8%, 4%, and 4% (or 3% if the institution is rated composite 1 under the OTS MACRO rating system and is experiencing no significant growth)), and three undercapitalized categories. Lower classification results in increasingly severe supervisory restrictions on thrift activities, although the activities of well and adequately capitalized thrifts are relatively unencumbered. Under the prompt corrective action regulations, however, all institutions are restricted from making any capital distributions or paying any management fees that would cause the institution to fail to satisfy the minimum levels for any of its capital requirements. Undercapitalized thrifts are required to timely submit and adhere to a plan to restore capital to adequate levels. As of December 31, 1993, the Bank was classified as well capitalized. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Capital Adequacy" in the 1993 Annual Report on page 32. Qualified Thrift Lender Status. In order to qualify as a qualified thrift lender ("QTL"), an institution currently must maintain a minimum of 65% of certain tangible assets in certain qualifying housing and consumer related activities. At December 31, 1993, based on its asset composition, the Bank was a "qualified thrift lender." An insured institution that does not maintain its status as a QTL is subject to the dividend, branching, and new activity restrictions applicable to banks, and will be ineligible for new FHLB advances. An institution failing to regain QTL status after three years will be required to divest investments in or discontinue activities that are not permissible for banks. In addition, a unitary savings and loan holding company, such as the Company, that owns a thrift failing the QTL test becomes subject to activity restrictions applicable to multiple savings and loan holding companies, unless the thrift regains its QTL status within a one-year period. Restrictions on Dividends. Savings associations are limited in the amount of "capital distributions" that they are permitted to make, including cash dividends, payments by a savings association to repurchase or otherwise acquire its shares, payments to shareholders of another entity in a cash out merger and other distributions charged against capital. The regulation also applies to capital distributions that the Bank may make to the Company, thereby affecting the dividends that the Company may pay to its shareholders. The regulation requires that the Bank provide the OTS with 30 days prior written notice of any capital distribution (which period begins to run from the date of OTS receipt of notice). A dividend declared within the notice period, or without giving the prescribed notice, is invalid. The regulation establishes a three tiered system of regulation, with the greatest flexibility being afforded to well capitalized institutions such as the Bank. An institution that has regulatory capital that is at least equal to its fully phased in capital requirements, and has not been notified that it "is in need of more than normal supervision," is a Tier 1 institution. Any institution that has regulatory capital at least equal to it minimum capital requirement, but less than its fully phased in capital requirements, is a Tier 2 institution. An institution having regulatory capital that is less than its minimum capital requirements is a Tier 3 institution. At December 31, 1993, the Bank qualified as a Tier 1 institution. A Tier 1 institution is permitted, after prior notice to the OTS, to make capital distributions up to the higher of 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its "surplus capital ratio" (the percentage by which the ratio of its regulatory capital to assets exceeds its fully phased in capital ratio) at the beginning of the calendar year or 75% of its net income over the most recent four-quarter period. Any additional amount of capital distributions would require prior regulatory approval. A Tier 2 institution is permitted, after prior notice to the OTS, to make capital distributions in amounts up to 75% of its net income for the most recent four quarters, if it maintains total regulatory capital equal to at least 8% of its risk weighted assets, which the amount of capital distributions permitted is reduced by the amount of capital distributions that the institution previously has made during the four quarter period. A Tier 3 institution is not authorized to make any capital distributions except with prior OTS approval or pursuant OTS approved capital plan. Liquidity. Applicable regulations require member institutions to maintain an average daily balance of liquid assets equal to 5% of the sum of their average daily balance of net withdrawable deposit accounts and current borrowings (borrowings payable in one year or less). At December 31, 1993, the Bank was in compliance with this requirement, with a liquidity ratio of 6.7%. Loans to One Borrower Restrictions. Permissible lending limits for loans to one borrower are the greater of $500,000 or 15% of unimpaired capital and surplus (except for loans fully secured by certain readily marketable securities, in which case this limit is increased to 25% of unimpaired capital and surplus). At December 31, 1993, the Bank did not have any borrowers above the lending limits. Insurance of Accounts and Regulation by the FDIC. The Bank is a member of the Savings Association Insurance Fund ("SAIF"), which is administered by the FDIC. The FDIC has certain regulatory and oversight authority over federal savings associations, such as the Bank. The deposits of the Bank are insured up to $100,000 per insured depositor (as defined by law and regulations) by the SAIF and are backed by the full faith and credit of the United States Government. Pursuant to FDIC regulations, well capitalized thrifts may accept brokered deposits, adequately capitalized institutions may do so only with FDIC approval, while under capitalized thrift institutions may not accept such deposits. As insurer, the FDIC is authorized to conduct examinations of and to require reporting by FDIC insured institutions. It also may prohibit any FDIC insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the SAIF. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action. The FDIC has adopted a risk-based assessment system that assesses insurance premiums significantly higher than the premiums formerly charged and that places higher assessments on those thrifts that pose a greater threat to the SAIF. The system classifies SAIF insured institutions into one of three capital categories, well capitalized, adequately capitalized or undercapitalized, based on measurements of their risk-based, Tier 1 risk-based and leverage ratios. These categories are very similar to those used for purposes of prompt corrective action regulations. Within each of these three capital groups, institutions are further classified into one of three subgroups principally on the basis of supervisory evaluations by the institution's primary supervisory authority. The assessment rate will vary from 0.23% of deposits for well capitalized institutions in the highest subgroup to 0.31% of deposits for undercapitalized institutions in the lowest subgroup. As of January 1, 1994, the Bank was classified as well capitalized. In addition, the FDIC has authority to increase SAIF assessment rates. Transactions with Affiliates. All transactions involving a savings association and its affiliates are subject to sections 23A and 23B of the Federal Reserve Act ("FRA"). Generally, these sections restrict certain of these transactions to a percentage of a savings association's capital and require such transactions to be on terms consistent with safe and sound banking practice and as favorable to the savings association as transactions with nonaffiliates. The affiliates of a savings association include any company (i) that controls the savings association, (ii) with which the savings association is under common control, (iii) controlled by controlling shareholders of the savings association or the company controlling the savings association, (iv) with a majority of interlocking directors with the savings association or the company controlling the savings association and (v) sponsored and advised on a contractual basis by the savings association or any of its subsidiaries or affiliates. The Bank's subsidiaries are not deemed affiliates; however, transactions between the Bank or any of its subsidiaries and any affiliates are subject to the requirements and limits of sections 23A and 23B. Affiliated persons include insiders, i.e. officers, directors and controlling (10%) shareholders. Regulations of the OTS also circumscribe the activities between the bank and its subsidiaries and insiders. Loans to insiders are subject to Sections 22(g) and 22(h) of the FRA and the regulations promulgated thereunder. Among other things, such loans must be made on terms substantially the same as for loans to non-insiders and are subject to the loans to one borrower restrictions. See "Loans to One Borrower Restrictions." Total loans to insiders may not, in the aggregate, exceed the Bank's unimpaired capital and unimpaired surplus. Change in Control Regulations. Savings and loan holding companies, such as the Company, are prohibited from directly or indirectly acquiring (i) control of another thrift institution or thrift holding company without prior OTS approval, (ii) another thrift institution or thrift holding company or all or substantially all of the assets of any thrift institution or thrift holding company without prior OTS approval, (iii) more than 5% of the voting shares of another thrift institution or thrift holding company which is not a subsidiary, or (iv) control of an institution not insured by the FDIC. Savings and loan holding companies are also subject to the Federal Change in Bank Control Act, which imposes additional notification requirements on the Company when it acquires control of an FDIC insured institution. Additionally, savings associations may not acquire control of banks without the prior approval of the OTS. Safety and Soundness. On November 18, 1993, the OTS issued proposed regulations that establish (for savings associations but not holding companies) general operational and managerial standards for internal controls and information systems, an internal audit system, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation matters. Savings associations will be required to maintain a ratio of classified assets (generally, substandard or doubtful assets) to total capital (including any general valuation allowance not eligible for inclusion in total capital for risk-based capital purposes) of no more than 1.0, or such lesser ratio required by the OTS. Additionally, a savings association must have minimum earnings sufficient to absorb losses without impairing capital. The proposed regulations generally require a savings association holding company to not pose a serious risk to its savings association subsidiary. The failure of a savings association or holding company to comply with safety and soundness standards will result in the required filing of a compliance plan with the OTS and, potentially, the issuance of an OTS order or other enforcement action. Possible Restrictions on the Activities of the Corporation and its Subsidiaries. If the OTS determines there is reasonable cause to believe that any of the Company's activities present a risk to the soundness or stability of the Bank, the OTS may restrict the payment of dividends by the Bank, transactions between the Bank and any affiliate or any Bank activity. In addition, if the Bank loses its status as a Qualified Thrift Lender, it could become ineligible to receive FHLB advances and the Company could be subject to significant restrictions on its activities and additional regulation. See "Qualified Thrift Lender Status." Enforcement Powers. The OTS and the FDIC have substantial enforcement remedies, including civil and criminal penalties, that may be assessed against an institution or an institution's directors, officers, employees, agents or independent contractors for failure to comply with OTS or FDIC regulations, policies and directives. For known violations and under certain other aggravated circumstances, civil or criminal penalties up to $1,000,000 per day may be assessed, as well as jail sentences of up to five years. For lesser violations, penalties of up to $25,000 or $5,000 per day, or lesser jail sentences, may be imposed. Item 2. Item 2.PROPERTIES. The Company's executive offices are located at 1000 Metropolitan Centre, 333 South Seventh Street, Minneapolis, Minnesota. The Bank's executive offices are located at 1600 Radisson Tower, Fargo, North Dakota. At December 31, 1993, the Bank had branch offices located in North Dakota (32), Minnesota (58), Nebraska (26), Iowa (31), Kansas (31), South Dakota (10), Wisconsin (6) and Arizona (2). The Bank has two mortgage loan production offices in Minnesota and one in Arizona. In addition to its production offices, the Bank has loan officers located in Edina Realty locations. Edina Realty which has 49 real estate sales offices in the states of Minnesota and Wisconsin, has its headquarters located in Edina, Minnesota. Equity Title, which has 9 closing offices in the states of Minnesota and Wisconsin, is also headquartered in Edina, Minnesota. The Company owns and operates 129 of the facilities listed. The remaining 125 facilities are leased. All of these properties are well maintained and are adequate to meet the Company's immediate needs. The Company uses computer service bureaus to perform the primary data processing functions on a fee for service basis. The Company owns and leases computers, peripheral equipment and terminals which are used to interface with the service bureau's equipment. Additional information regarding premises and equipment is presented in Note I of Notes to Consolidated Financial Statement on page 43 of the 1993 Annual Report, which is incorporated herein by reference. Item 3. Item 3.LEGAL PROCEEDINGS. The Company is not involved in any pending legal proceedings other than nonmaterial proceedings which arise in the ordinary course of business. Item 4. Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 1993. Item 4A. EXECUTIVE OFFICERS OF THE REGISTRANT [FN] Executive officers of the Company are elected annually by the Board of Directors and hold office until their successors are duly elected and qualify or until they resign or are replaced by the Board of Directors. *All officers and positions described are with the Company except as noted. ** J. Michael Nilles and William O. Nilles, Vice Chairman of the Company, are siblings. PART II Item 5. Item 5.MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS. Information under the caption "Dividends per Common Share" on page 55 and "Common Stock Prices" on page 56 of the 1993 Annual Report are incorporated herein by reference. As of March 9, 1994, there were approximately 3,568 common stock record holders. MFC has paid quarterly cash dividends on its common stock since the 1985 holding company reorganization and has periodically issued stock dividends on the common stock. The Board of Directors considers the advisability and amount of each proposed dividend. Future cash dividends on the Company's common stock will be determined on the basis of the Company's income, financial condition, capital needs, regulatory requirements and other factors deemed relevant by the Board. There can be no assurance that cash or stock dividends on the common stock will continue to be declared by the Company. As a holding company without significant assets other than its equity interest in the Bank and Edina Realty, the Company's ability to pay cash dividends on its common stock primarily depends upon the cash dividends it receives from these subsidiaries. Dividend payments from the Bank are subject to regulation by the OTS. See "Item 1 - Business - Regulation - Restrictions on Dividends" for a discussion of regulatory restrictions on the ability of the Bank to pay dividends. The amount available for payment of dividends by the Bank to the Company for 1994 is $89 million plus the total of current year earnings. Edina Realty's ability to pay dividends is limited by Minnesota's corporate law. Dividends payable by the Bank may also be limited by tax law considerations. In addition, the Company's ability to pay dividends is limited by the Delaware General Corporation Law. Item 6. Item 6. SELECTED FINANCIAL DATA. Selected Financial Data on pages 16 and 17 of the 1993 Annual Report is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 16 through 32 of the 1993 Annual Report is incorporated herein by reference. Item 8. Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Report of Independent Auditors and the Consolidated Financial Statements included on pages 33 through 54 of the 1993 Annual Report are incorporated herein by reference. Quarterly Results of Operations on page 55 of the 1993 Annual Report are incorporated herein by reference. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. (a) Directors of the Registrant. The information under the captions "Election of Directors-Information about Directors and Nominees" in the Company's 1994 Proxy Statement is incorporated herein by reference. (b) Executive Officers of the Registrant. Information concerning Executive Officers of the Company is included in this Report under Item 4A. "Executive Officers of the Registrant." Item 11. Item 11. EXECUTIVE COMPENSATION. The information under the caption "Election of Directors-Director Compensation" and "Compensation and Other Benefits" in the Company's 1994 Proxy Statement is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information under the caption "Security Ownership of Management" in the Company's 1994 Proxy Statement is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information under the caption "Certain Transactions" in the Company's 1994 Proxy Statement is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) Financial Statements. The following information appearing in the Company's 1993 Annual Report is incorporated by reference in this Form 10-K Annual Report. (a)(2) Financial Statement Schedules. All financial statement schedules have been omitted as the required information is inapplicable or has been included in the Consolidated Financial Statements. (a)(3) Exhibits. The exhibits to this Report are listed in the Exhibit Index on pages 13, 14, 15 and 16 herein. A copy of any of these exhibits will be furnished at a reasonable cost to any person who is a shareholder of the Company as of March 23, 1994, upon receipt from any such person of a written request for any such exhibit. Such requests should be sent to Metropolitan Financial Corporation, 1000 Metropolitan Centre, 333 South Seventh Street, Minneapolis, Minnesota, 55402, Attention: Patricia Henning, Vice President, Corporate Communications and Investor Relations. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an Exhibit to this Annual Report on Form 10-K pursuant to Item 14 (c): (b) Reports on Form 8-K. During the quarter ended December 31, 1993, the Company filed no Reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. METROPOLITAN FINANCIAL CORPORATION /S/ Norman M. Jones NORMAN M. JONES (Duly Authorized Representative) March 23 ,1994 (Date) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. METROPOLITAN FINANCIAL CORPORATION Exhibit Index to Annual Report on Form 10-K For Fiscal Year Ended December 31, 1993

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ITEM 1. BUSINESS GENERAL Handy & Harman (hereinafter "H&H" or the "Company"), was incorporated in the State of New York in 1905 as the successor to a partnership which commenced business in 1867. Unless the context indicates otherwise, the terms, "H&H" and the "Com- pany", refer to Handy & Harman and its consolidated subsidiaries. Historically, until commencing a diversification program in 1966, the Company was engaged primarily in the manufacture of silver and gold alloys in mill forms and the refining of precious metals from jewelry and industrial scrap. The Company's markets were largely among silversmiths and manufacturing jewelers, users of silver brazing alloys, and manufacturers who required silver and gold primarily for the properties of those metals. As part of these precious metals operations, the Company still publishes a daily New York price for its purchases of silver and gold and now also publishes a daily price for its fabricated silver and gold. The silver price is recognized, relied on and used by others throughout the world. Further, the review entitled "The Silver Market", published annually by the Company since 1916, is widely distributed in trade and financial centers in this country and abroad. The diversification program has added lines of precious metals products and various specialty manufacturing operations, including stainless steel and specialty metal alloy products, for industrial users in a wide range of applications which include the electrical, electronic, automotive original equipment, office equipment, oil and other energy-related, refrigeration, utility, telecommunications and medical industries. The Company's business segments are (a) manufacturing and selling precious metals products and providing refining services; (b) manufacturing and selling products for the original equipment automotive industry; (c) manufacturing and selling of non-precious metal wire and tubing products; and (d) manufacturing and selling other specialty products. Three-year financial data for the Company's business segments appear under the caption "The Company's Business" on pages 18 and 19 of the Handy & Harman 1993 Annual Report to Shareholders (hereinafter referred to as the "Annual Report") and are incorporated by reference herein. One customer of the Automotive Original Equipment Group represented 10.7%, 11.3%, and 10.5% of consolidated sales and service revenues for 1993, 1992 and 1991, respectively. Export sales and revenues are not significant in the total sales and revenues of any of the Company's business segments. In June 1991 the Company announced a major restructur- ing program designed to strengthen the Company's balance sheet by reducing debt and interest expense, to provide a sound basis for improved profitability and to allow management to concentrate on those businesses which have demonstrated potential for above average growth. The program called for divestiture of six businesses deemed to be non-core operations that no longer fit within the Company's long-term strategies. The six discontinued businesses were those involved in the manufacture of automotive replacement parts, proprietary chemicals, metal powders, pressur- ized vessels, coldheaded parts and specialized platinum group metals refinings and products. See Notes 1 and 10 to the Consol- idated Financial Statements included in the Annual Report and Management's Discussion and Analysis on page 21 of the Annual Report. PRECIOUS METALS PRODUCTS AND REFINING SERVICES The operational structure of the parent company's precious metals activities consists of two distinct profit centers: Products Operations and Refining Operations. Both of these profit centers and the activities of other precious metals subsidiaries are included in the following discussion of the precious metals segment of the Company's business. Within the precious metals segment of the Company's business, two principal classes of products are manufactured: wire products and rolled products. The table on page 19 of the Annual Report, showing percentages of gross shipments of these classes of precious metals products which contributed 10% or more to total sales and revenues, is incorporated herein by reference. In the following discussion of the Company's precious metals products, the term "karat" refers to the amount of gold in a gold alloy. Pure gold is 24-karat, and karat golds generally range between 10-karat (41.6%) and 18-karat (75%). The usual alloy metals are silver, copper, nickel and zinc. By varying the other elements in the alloy, karat golds may be fabricated in a number of colors including white, green, yellow and red. Sterling silver is an alloy of silver, which contains a minimum of 92.5% pure silver. The Company's profits from the products manufactured in this segment are derived from the "value added" of processing and fabricating, not from the purchase and resale, of precious metals. In accordance with general practice in the industry, prices to customers are a composite of two factors, namely, (1) the value of the precious metal content of the product plus (2) an amount referred to as "fabrication values" to cover the cost of base metals, labor, overhead, financing and profit. Wire Products - In the manufacture of the Company's wire products, precious metal alloys are cast, extruded and then drawn into wire. The Company's precious metal wire products con- sist of karat golds, sterling and other alloys of silver, and other precious metal alloys in drawn and coiled wire and rod forms of differing diameters, ranging from .007 of an inch to .25 of an inch. The Company also manufactures Easy Flo(R), Sil- Fos(R) and other silver brazing alloys in wire form for making permanent, strong, leak-tight joints of the metals joined. Brazing alloy wire is also sold in preformed rings and special shapes. The Company's precious metal alloy wire products are marketed for electrical conductive and contact applications in a wide variety of industries, including the aerospace, electronics and appliance industries. Manufacturing jewelers use the Com- pany's precious metal wire in a wide range of production applica- tions, including, for example, necklaces, bracelets, earring parts and pins and clips. Rolled Products - The Company's rolled products are manufactured from karat golds, sterling and lesser alloys of silver, and alloys of other precious metals in sheets, strips and bars of varying thicknesses, widths and lengths. These precious metal rolled products range in standard thickness from foils .0005 of an inch thick to strips or bars .375 of an inch thick, and in standard widths from strips .125 of an inch wide to fifteen inches wide. Rolled products are shipped in lengths up to many hundred feet. The Company's rolled products include precious metals bonded with other metals in bimetallic and tri- metallic strips which provide more versatile industrial applica- tions at a lower cost than would be possible if a solid precious metal or a precious metal alloy were used. Because of the physical properties of precious metals and precious metal alloys, the Company's rolled products have a wide variety of applications by the Company's industrial cus- tomers. The Company's rolled products are sold to silversmiths for use as anodes in plating operations and for flatware and hollowware, to manufacturing jewelers for a variety of jewelry, to mints and others for coins, commemorative medals and ingots, to manufacturers of electrical and electronic devices for elec- trical contacts and circuitry, to the nuclear power industry for control assemblies, to the defense industry as foil for batter- ies, and to the aerospace industry for use in guidance systems. Powder Products - The Company produced a variety of precious metal powders and flakes which it sold under various names, including Silpowder(R) and Silflake(R), for use in the production of electronic parts and in powder metal contacts, batteries, conductive coatings and other electrical applications. It produced a line of silver oxide powders for use in chemical silver alumina catalysts and in button batteries. The Company sold this business in 1992 and effectively exited the business in December 1992. However, it continues to produce silver/tin alloy powders for use in dental applications and silver/copper alloy powders, sold under the names Easy-Flo(R) and Sil-Fos(R), for use in industrial brazing applications. Other Precious Metals Products - The Company produces grain beads of various precious metal alloys by melting the metal and then pouring it through water. Grain beads are distinguished from the Company's precious metal powders, which are not as coarse and are produced by atomization spraying. The major grain product is karat gold grain produced in a number of colors, including white, green, yellow and red. The Company also produces grain in various silver and other gold alloys. Electronic parts are selectively electroplated in order to deposit gold, silver, palladium, and various base metals on such parts for applications in computer connectors, semi-conductor devices and telecommunication equipment. Refining Services - The Company recovers precious metals from waste and scrap generated by users of the Company's precious metals products and other industrial users of precious metals, from metal-bearing objects delivered for that purpose by non-manufacturing refining customers, and from high grade mining concentrates and bullion. The Company receives a fee for this service. After controlled sampling, assaying, weighing, deter- mination of values and settlement with the customer, the Company purchases for its own use the precious metal resulting from such refining, or, upon request by the customer, returns an equivalent amount of metal to the customer. Raw Materials - The raw materials for the Company's precious metals products consist principally of silver, gold, copper, cadmium, zinc, nickel, tin, and the platinum group metals in various forms. Gold and silver constitute the major portion of the value of the raw materials involved. In addition, the Company buys waste and scrap containing precious metals for recycling and refining, as described above. The Company purchases all of its precious metals at free market prices from either refining customers, primary producers or bullion dealers. Over the past several years, the prices of gold and silver have been subject to fluctuations, and are expected to continue to be affected by world market conditions; however, the Company has not experienced any problem in obtaining the necessary quantities of raw materials required for this segment. In the normal course of business, the Company receives precious metals from suppliers and customers. These metals are returnable in fabricated or commercial bar form under agreed upon terms. Since precious metals are fungible, the Company does not physically segregate supplier and customer metals from its own inventories. Therefore, to the extent that supplier or customer metals are used by the Company, the amount of inventory which the Company must own is reduced. All raw materials used in this segment are readily available from several sources. For a discussion of the Company's inventory purchasing and pricing, and of the Company's practices to eliminate the economic risk of precious metal price fluctuations, see "The Company's Business" on page 18 of the Annual Report. Working Capital Items - The Company maintains a con- stant level of inventory of fine and fabricated precious metals in various stages of processing and/or refining for customer delivery requirements and for a continuous supply of raw mate- rials. Such inventories are carried under the Last-In, First- Out (LIFO) method of accounting. The LIFO carrying values are substantially less than the market values of the inventories. In the Notes to Consolidated Financial Statements, commencing on page 28 of the Annual Report, see Note 7 for a comparison of the cost and market values of the Company's precious metals invento- ries at December 31, 1992 and December 31, 1993 and see Note 2 for a discussion of the effects of fluctuations in precious metals prices on the Company's credit requirements. Both Notes are incorporated by reference herein. Product Development, Patents and Trademarks - While the Company holds a number of patents and trademarks related to its precious metals products and processes, and is licensed under others, the precious metals business, as a whole, is not depen- dent upon such patents. The Company's trademarks are registered in the United States and in several foreign countries. The Com- pany maintains a technical laboratory and staff in connection with its precious metals operations and a portion of the work of that staff is devoted to metallurgical products and development. Distribution Facilities - The Company distributes precious metals products directly to customers from its plants and service branches, except that certain products, primarily brazing alloys, are distributed through independent distributors throughout the United States and Canada. The Company has a marketing organization trained to service its customers and dealers, to solicit orders for its precious metal and related products, and to obtain refining business. This organization markets all of the Company's refining services and precious metals products and provides special technical assistance with respect to precious metals through product engineers and other technical personnel. The Company maintains customer service and sales offices at its various manufacturing and processing plants and in Los Angeles and Chicago. It also has warehouse facilities to support sales and distribution at each of its manufacturing and processing plants and in Chicago and Los Angeles. Competition - The Company is one of the leading fab- ricators and refiners of precious metals. The Company currently sells its precious metal fabricated products to approximately 5,000 customers throughout the United States and Canada. Al- though there are no companies in the precious metals field whose operations exactly parallel those of H&H in every area, there are a number of competitors in each of the classes of the Company's precious metals products. Many of these competitors also carry on activities in other product lines in which the Company is not involved. Competition is based on quality, service and price, each of which is of equal importance. MANUFACTURING OF AUTOMOTIVE ORIGINAL EQUIPMENT Through Handy & Harman Automotive Group, Inc. (the "Automotive Group"), a subsidiary, the Company manufactures a wide variety of parts, components and assemblies for the North American domestic automobile original equipment manufacturers (the OEM market). The Automotive Group produces a wide variety of tubular parts for the OEM market from steel, stainless steel and other metals. Formed and brazed tubing parts made from stainless and carbon steel and various other metals are produced as air pipes, brake and fuel lines, components of fuel delivery systems, and other tubing parts. The Automotive Group also produces small diameter cables and a variety of control assemblies for automotive applications, including parking brake cables, speedometer cables, various transmission cables and other mechanical assemblies, made from steel and other materials. In addition, the Automotive Group produces plastic parts, tubing, fuel lines, plastic component manifolds and assemblies for the OEM market. Raw Materials - The raw materials used in this segment include stainless and carbon steels, tin, zinc, nickel and various plastic compositions. Raw materials are purchased at open market prices principally from domestic suppliers. The Automotive Group has not experienced any problem in obtaining sufficient quantities of raw materials. Competition - There are many companies, domestic and foreign, which manufacture products of the type manufactured by the Automotive Group. Some are larger than the Company and many are larger than the Automotive Group's operation with which they compete. Competition is based to a great extent on price, quality, service and new product introduction. The domestic automobile industry has traditionally engineered and manufactured in its own plants a high percentage of the parts used in assem- bling its automobiles. In recent years the industry has begun to purchase more parts and assemblies from outside suppliers such as the Automotive Group. Although this trend continued during 1993 there can be no assurance that it will do so in the future. Equally as important is the industry trend to use outside suppliers to participate in the engineering and designing of some parts and assemblies. Research and Development Center - The Automotive Group operates a Research and Development Center in Auburn Hills, Michigan. The Center contains approximately 40,000 square feet of floor space and "state-of-the-art" equipment, including chassis rolls, dynamometers, vibration equipment and flow testing equipment. A number of highly-qualified personnel currently are employed at the Center which also houses automotive administrative and sales personnel. They offer the capability to design, fabricate and test complete fuel and cable control systems; to support the Automotive Group and other units of the Company in the design, fabrication and testing of automotive components; and to assist in the design and development of new components and systems for automotive purposes. Distribution - Essentially all of the Automotive Group's original equipment products is sold directly to the major domestic automobile companies through its sales and marketing employees. MANUFACTURING OF WIRE AND TUBING PRODUCTS The Company, through several subsidiaries, manufactures a wide variety of non-precious metal wire and tubing products. Small diameter precision drawn tubing fabricated from stainless steel, nickel alloy and carbon and alloy steel is produced in many sizes and shapes to critical specifications for use in the semi-conductor, aircraft, petrochemical, automotive, appliance, refrigeration and instrumentation industries. Additionally, tubular product is manufactured for the medical industry for use as implants, surgical supplies and instrumentation. Stainless steel wire products are redrawn from rods for such diverse applications as bearings, brushes, cable lashing, hose reinforcement, nails, knitted mesh, wire cloth, air bags and antennas in the aerospace, automotive, chemical, communications, marine, medical, petrochemical and other industries. Raw Materials - The raw materials used in this segment include stainless and carbon steels, nickel alloys and a variety of high performance alloys. The Company purchases all such raw materials at open market prices from domestic and foreign suppli- ers. The Company has not experienced any problem in obtaining the necessary quantities of raw materials. Prices and availabil- ity, particularly of raw materials purchased from foreign suppli- ers, will be affected by world market conditions and governmental policies. Competition - There are many companies, domestic and foreign which manufacture wire and tubing products of the types manufactured by this segment. Competition is based on quality, service, price and new product introduction, each of which is of equal importance. Distribution - Most of the products manufactured by this segment are sold directly to customers through Company salesmen; however, some are sold through manufacturer's represen- tatives and through distributors. MANUFACTURING OF OTHER SPECIALTY PRODUCTS Other Company subsidiaries manufacture a large number of other specialty products for industrial use. Plastic and steel fittings and connections, plastic pipe and non-ferrous thermite welding powders are produced for the natural gas, electrical and water distribution industries. In 1993 the Company sold its business which used powdered metals to make custom-molded structural parts and assemblies from ferrous and non-ferrous powdered metals for components and assemblies for office products, business machines, hand-held power tools, hydraulic motors and pumps and lawn and garden equipment. Also in 1993, the Company sold the large industrial heat exchanger business which made packaged power units for oil and gas, construction, agricultural and the skiing industries. Distribution - Most of the Company's specialty prod- ucts comprising this segment are sold directly to customers through Company salesmen, although some are sold by agents and manufacturer's representatives. In particular, gas distribution supplies and fittings, thermite welding powders and certain other products are sold primarily through manufacturer's representa- tives to the ultimate users, although some sales also are made by manufacturer's representatives to distributors. Raw Materials - The raw materials used in this segment include various steel alloys, copper, tin, zinc, nickel and various plastic compositions. The Company purchases all such raw materials at open market prices primarily from domestic suppliers. The Company has not experienced any problem in obtaining the necessary quantities of raw materials. Prices and availability, particularly as to raw materials purchased from foreign suppliers, will continue to be affected by world market conditions and governmental policies. Competition - There are many companies, domestic and foreign, which manufacture products of the type manufactured by this segment. Some are larger than the Company, and many are larger than the Company's operations with which they compete. Competition in portions of this segment's business is based primarily on price, and significant competition has come from lower-priced foreign imports. Competition is otherwise generally based on quality, service and price, each of which is of equal importance. GOVERNMENT REGULATION During the last fiscal year, the Company spent or committed approximately $2,700,000 in complying with federal, state and local occupational safety and health, environmental control and equal employment opportunity laws and regulations. These expenditures included monies spent by the Company in the clean-up of hazardous wastes and toxic substances under Federal, State and local laws and regulations relating to protection of the environment. Like many other large domestic manufacturing concerns, the Company's operations may affect the environment. These operations may produce, process, and dispose of materials and waste products which, under certain conditions, are toxic or hazardous under such environmental laws and regulations. The Company expects to make comparable expenditures and commitments during the current fiscal year, provided that no further changes are made in such laws and regulations or in their application. Such expenditures are not material to the competitive position or financial condition of the Company; however, such laws and regulations may require capital expenditures not now contemplated and may result in increased operating costs. See Item 3 Legal Proceedings. ENERGY The Company requires significant amounts of electrici- ty, natural gas, fuel oil and propane to operate its facilities. The Company has few contracts covering natural gas or electrici- ty, but has some one-year contracts for the delivery of fuel oil and/or propane at some facilities. These contracts are the result of competitive bidding. In an attempt to minimize the effects of any fuel shortages, the Company has made a number of process and equipment changes to allow use of alternate fuels in key processes, and the Company has equipped certain plants with alternate fuel reserves intended to reduce any curtailment upon a local shortage. A general and continuing shortage of such fuels, however, or a government allocation of supplies resulting in a general reduc- tion in fuel supplies, could cause some curtailment of produc- tion. EMPLOYEES The Company had 4,246 employees on December 31, 1993. Of these, approximately 35% are covered by collective bargaining agreements which expire at various times during the next three years. ITEM 2. ITEM 2. PROPERTIES The Company has 32 operating plants in the United States, Canada, Mexico, England, Brazil (50% owned) and Singapore (50% owned) with a total area of approximately 2,500,000 square feet, including warehouse, office and laboratory space, but not including the plants used by the Brazil or Singapore operations and by the discontinued operations described in Notes 1 and 10 to the Consolidated Financial Statements included in the Annual Report. The Company owns or leases sales, service and warehouse facilities at 4 other locations in the United States and Canada, which, with the Company's executive and general offices, have a total area of approximately 115,000 square feet. The Company considers its manufacturing plants and service facilities to be well maintained and efficiently equipped, and therefore suitable for the work being done. Theproductive capacity and extent of utilization of the Company'sfacilities is dependent in some cases on general business condi-tions and in other cases on the seasonality of the utilization ofits products. Productivity can be expanded readily to meet additional demands. A description of the Company's principal plants by industry segment is as follows: Precious Metals The Company's principal precious metal products and refining services operations are conducted in Fairfield and South Windsor, Connecticut; Attleboro, Massachusetts; and East Providence, Rhode Island. Other precious metal operations are conducted in Phoenix, Arizona; North Attleboro, Massachusetts; Cudahy, Wisconsin; Indianapolis, Indiana; Toronto, Canada and Singapore (50% owned). The Company owns all these operating plants in fee. Automotive Original Equipment The headquarters of Handy & Harman Automotive Group, Inc. is located in Auburn Hills, Michigan in the same building as the sales offices and the Engineering Research and Development Center. Manufacturing facilities are in Dover and Archbold, Ohio; Kendallville and Angola, Indiana; and Martinsburg, West Virginia. All of this segment's operating plants are owned in fee. The Auburn Hills building is leased. The Automotive Group also has operated in Mexico through a "maquiladora" arrangement and now has "National Supplier Status." Wire and Tubing The headquarters of the wire portion of this segment is in Cockeysville, Maryland and the headquarters of the tubing portion of this segment is in Norristown, Pennsylvania. Manufacturing facilities are located in Cockeysville, Maryland; Norristown, Pennsylvania; Willingboro and Middlesex, New Jersey; Oriskany, New York; Camden, Delaware; Evansville, Indiana; Salto, Sao Paulo, Brazil; Retford, Notts. and Liversedge, Yorkshire, England. All these plants are owned in fee except the Retford and Salto plants which are leased. Other Specialty Products The principal facilities currently engaged in the Company's other specialty products businesses are located in Tulsa and Broken Arrow, Oklahoma; and Bolton, England. The Oklahoma plants are owned in fee while the Bolton plant is leased. Company's Offices The Company's executive offices are in New York, New York and occupy 17,000 square feet under a lease. The Company has leased approximately 30,000 square feet in Rye, New York, for its general offices and approximately 8,500 square feet in New York, New York for its Corporate MIS Center. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no pending legal proceedings to which the Company or any of its subsidiaries is a party or which any of their property is the subject, other than ordinary, routine litigation incidental to the business, none of which individually or in the aggregate is material to the business or financial condition of the Company, except as follows: Palmer Well Fields On February 25, 1991 the Massachusetts Department of Environmental Protection ("MDEP") filed a lien against the property owned by Pal-Rath Realty, Inc. (a subsidiary of the Company formerly named Rathbone Corporation) which is located in Palmer, Massachusetts and is leased to Rathbone Realty, Inc. whose affiliated corporation purchased the business and assets of Pal-Rath Realty (other than the real estate) in May 1988. The lien is for a claim in the amount of $1,131,105.31 for expenses allegedly incurred in connection with the Palmer Well Fields known as the Galaxy Well Field and Gravel Pack Well No. 2. A claim has also been made against a neighboring industry and a lien similarly filed against that industry's property. The MDEP has not allocated the alleged liability between Pal-Rath and the other industry. In June 1987, the Massachusetts Department of Environmental Quality Engineering (now called the Massachusetts Department of Environmental Protection) had issued a Notice of Responsibility to Rathbone (now Pal-Rath) relating to alleged contami- nation of the Palmer Well Fields by Rathbone. Rathbone responded to that letter and has from time to time assisted the MDEP and also conducted an extensive investigation of the Rathbone proper- ty. In November 1990 the MDEP had issued a letter requesting submittal of good faith offers by Pal-Rath and its neighbor to pay past costs and to conduct further work. In January 1991 Pal-Rath responded that the MDEP's request for money was not supported by the law or the facts and that it would not pay past costs but would conduct or assist in further work. Discussions were continuing when the MDEP filed its liens. Agreement has been reached to submit the matter to non-binding mediation before the Massachusetts Office of Dispute Resolutions. The mediation proceedings are continuing. Although the final outcome of this matter cannot be assured, the Company believes that it will not have a materially adverse affect on the financial position of the Company. Montvale, New Jersey Facility On April 13, 1993, the Borough of Park Ridge, New Jersey sued Handy & Harman Electronic Materials Corporation, a subsidiary ("HHEM"), and Handy & Harman, in the Superior Court of New Jersey, Law Division, Bergen County, asserting that a chemical used at a formerly owned facility in Montvale, New Jersey, an adjoining municipality, had migrated and entered a drinking water supply of Park Ridge. Park Ridge seeks reimbursement of $2,190,437 expended in the construction and operation of water treatment equipment for wells alleged to have been contaminated from the Montvale facility, and of $1,255,582 for future expenditures over a 20-year period. The lawsuit includes as additional defendants the prior owner and operator of the Montvale facility, and a vendor of the chemical involved. Evidence exists that contamination existed at Park Ridge prior to HHEM's ownership of the site and that there are other sources of the contamination of the Park Ridge wells. HHEM has worked with the New Jersey Department of Environmental Protection and Energy to investigate and implement a remedy for conditions at the site; and Park Ridge has requested the assistance of the New Jersey DEPE to investigate whether there is a connection between the contamination at the site and at the Park Ridge wells. HHEM is negotiating with Park Ridge and the other defendants to agree on a settlement of all outstanding issues. Although the final outcome of this matter cannot be assured, the Company believes that it will not have a materially adverse affect on the financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None during the fourth quarter of the year ended December 31, 1993. EXECUTIVE OFFICERS OF THE COMPANY As of March 30, 1994, the executive officers of the Company, their ages, their present positions and offices, and their recent business experience and employment, are as follows: Richard N. Daniel - Age 58; Chairman (since 1988) and Chief Executive Officer of the Company (since 1983); a Director (since 1974). Frank E. Grzelecki - Age 56; President and Chief Operating Officer of the Company (since 1992); prior thereto Vice Chairman of the Board (since 1989); a Director (since 1988); prior thereto a Management Consultant (since 1986); Paul E. Dixon - Age 49; Vice President, General Counsel and Secretary (since 1993); prior thereto Vice President and General Counsel (since 1992); prior thereto Senior Vice President and General Counsel of Warnaco Group (since prior to 1989). Richard P. Schneider - Age 47; Vice President-Corporate Development (since 1993); prior thereto Vice President-Corporate Development of Sequa Corporation (a diversified manufacturing company) (since prior to 1989). Dennis C. Kelly - Age 42; Controller (since 1993) of the Company; prior thereto Assistant Controller (since 1989); and prior thereto Director of Internal Audit (since 1985). James S. McElya - Age 46; Group Vice President (since 1992); prior thereto President of Handy & Harman Automotive Group, Inc. (since 1987), a subsidiary. John M. McLoone - Age 51; Vice President - Financial Services (since 1992); prior thereto Group Vice President, Information Technologies for W. R. Grace & Co. (a multinational company) (since prior to 1989). Stephen B. Mudd - Age 62; Vice President (since 1983) and Treasurer (since 1977). Robert M. Thompson - Age 61; Group Vice President (since 1984); prior thereto President of Handy & Harman Tube Company, Inc. (1976 to 1984), a subsidiary. There are no family relationships between any of the executive officers. The regular term of office for all executive officers is one year, beginning on May 1. There are no arrangements or understandings between any of the executive officers and any other person pursuant to which such officer was elected to be an officer. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information for this Item is incorporated by reference to the section entitled "Stock Trading and Dividends" on page 19 of the Annual Report and to Note 5 of the Notes to Consolidated Financial Statements included in the Annual Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information for this Item is incorporated by reference to the section entitled "Five Year Selected Financial Data" on page 20 of the Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information for this Item is incorporated by reference to the section entitled "Management's Discussion and Analysis" on pages 21 and 22 of the Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information for this Item is incorporated by reference to the Consolidated Financial Statements contained on pages 23 through 26 of the Annual Report and by reference to the Summary of Significant Accounting Policies contained on page 27 of the Annual Report and the Notes to Consolidated Financial Statements commencing on page 28 of the Annual Report and by reference to the Independent Auditors' Report set forth on page 34 of the Annual Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information for this Item is incorporated by reference to the section entitled "Election of Directors," on pages 2 and 3 of the Company's Proxy Statement, dated March 30, 1994 (the "Proxy Statement"), for the 1994 Annual Meeting of Shareholders, and by reference to the item captioned "Executive Officers of the Company" at the end of Part I of this Annual Report on Form 10-K. No person who was during the 1993 fiscal year a director, officer or beneficial owner of more than ten percent of any class of equity securities of the registrant failed to file on a timely basis reports required by Section 16(a) of the Exchange Act of 1934, as amended. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information for this Item is incorporated by reference to the sections entitled "Executive Compensation," "Base Salaries," "Annual Incentive Awards for 1993," "Stock Options," "Long-Term Incentive Plan," "Compensation Committee Report on Executive Compensation," "Pensions," "Compensation of Directors," "Employment Contracts and Termination of Employment and Change-in- Control Agreements" on pages 4 to 10 of the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information for this Item is incorporated by reference to the sections entitled "Voting Rights and Principal Holders Thereof" and "Election of Directors" on page 1 and pages 2 and 3, respectively, of the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information for this Item is incorporated by reference to the section entitled "Election of Directors" on pages 2 and 3 of the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents Filed as a Part of This Report 1. Financial Statements The Consolidated Financial Statements, the Summary of Significant Accounting Policies and Notes to Consolidated Finan- cial Statements, the Independent Auditors' Report thereon and the items of Supplementary Information incorporated by reference in Part II, Item 8 of this Report are set forth at the respective pages of the Annual Report indicated in the list contained on page 17 of the Annual Report, which list is incorporated herein by reference to the Annual Report. 2. Financial Statement Schedules The following Financial Statement Schedules are filed as a part of this Report, beginning herein at the respective pages indicated: (i) Report and Consent of Independent Auditors (page ). (ii) Schedule V - Property, Plant and Equipment (page S-1). (iii) Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (page S-2). (iv) Schedule VIII - Valuation and Qualifying Accounts and Reserves (page S-3). (v) Schedule X - Supplementary Income Statement Information (page S-4). All other Schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or Notes thereto. 3. Exhibits Required To Be Filed The following exhibits required to be filed as part of this Report have been included: (3) Certificate of Incorporation and By-Laws. (a) The Restated Certificate of Incorporation of Handy & Harman (Filed as Exhibit 3(a) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (b) The By-Laws as amended (Filed as Exhibit 3(b) to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference). (4) Instruments defining the rights of security holders, including indentures. (a) Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent (Filed as Exhibit 4(a) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (b) Short Term Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemi- cal Bank, as Co-Agents and The Bank of Nova Scotia, as the Administrative Agent (Filed as Ex- hibit 4(b) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (c) Amendment to Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent (filed as Exhibit 4(e) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference). (d) Amendment to Short Term Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia, as the Administrative Agent (filed as Exhibit 4(d) to the Company's Annual Report on Form 10- K and incorporated herein by reference). (e) Amendment to Revolving Credit Agreement dated February 4, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent. (f) Amendment to Short Term Revolving Credit Agreement dated February 4, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and the Bank of Nova Scotia, as the Administrative Agent. (g) Amendment to Revolving Credit Agreement dated July 1, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent. (h) Amendment to Short Term Revolving Credit Agreement dated July 1, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and the Bank of Nova Scotia, as the Administrative Agent. No other required to be filed. The Company agrees to furnish to the Securities and Exchange Commission upon its request therefor a copy of each instrument omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. (10) Material contracts. (a) 1982 Stock Option Plan (Filed as Exhibit 1 to the Company's Registration Statement on Form S-8 (Registration No. 2-78264) under the Securities Act of 1933 and incorporated herein by reference). (b) Amendment to 1982 Stock Option Plan approved in December 1988 (Filed as Exhibit 10(a) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (c) Management Incentive Plan, as amended February 26, 1981 (Filed as Exhibit 10(b) to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference thereto). (d) Amendment to Management Incentive Plan approved in December 1988 (Filed as Exhibit 10(d) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (e) Amendment to Management Incentive Plan approved in October 1991 (Filed as Exhibit 10(e) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (f) Deferred Fee Plan For Directors, as amended February 26, 1981 (Filed as Exhibit 10(c) to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference thereto). (g) Form of Executive Agreement entered into with the Company's executive officers in September 1986 (Filed as Exhibit 10(d) to the Company's 1986 Annual Report on Form 10-K and incorporated herein by reference thereto). (h) Amendment to Executive Agreement approved in December 1988 (Filed as Exhibit 10(b) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (i) 1988 Long-Term Incentive Plan (Filed as Exhibit 10(h) to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference). (j) Amendment to 1988 Long-Term Incentive Plan approved in December 1988 (Filed as Exhibit 10(c) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (k) Amendment to 1988 Long-Term Incentive Plan approved in June 1989 (Filed as Exhibit 10(j) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (l) Agreement dated as of May 1, 1989 between the Company and R. N. Daniel (Filed as Exhibit 10(k) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (m) Amendment to Agreement between the Company and R. N. Daniel approved by the Company on May 11, 1993. (n) Supplemental Executive Retirement Plan approved by the Company in September, 1989 (Filed as Exhibit 10(l) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (o) Outside Directors Stock Option Plan (Filed as Exhibit 10(m) to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference. (p) Amended and Restated Joint Venture Agreement dated as of June 1, 1990 by and between Allen Heat Transfer Products Inc. and Handy & Harman Radiator Corporation (Filed as Exhibit (2) to the Company's Report on Form 8-K for June 1990 and incorporated herein by reference). (q) Handy & Harman Long-Term Incentive Stock Option Plan (Filed as Exhibit 10(p) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (r) Handy & Harman Supplemental Executive Plan (Filed as Exhibit 10(q) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference). (11) Statement re computation of per share earnings. Incorporated by reference to item (g) of Summary of Significant Accounting Policies on page 27 of the Annual Report. (13) Pages 17 through 34 of the Company's Annual Report to Shareholders for 1993. Except for those portions which are expressly incorporated by reference in this Annual Report on Form 10-K, this exhibit is furnished for the information of the Commission and is not deemed to be filed as part of this Annual Report on Form 10-K. (22) List of Subsidiaries of the Company is filed as Exhibit 22 to this Annual Report on Form 10-K. (24) Report and Consent of Independent Auditors. Included as part of the Report and Consent of Independent Auditors on page filed with the Financial Statement Schedules as part of this Annual Report on Form 10-K pursuant to Part IV hereof and incorporated herein by reference thereto. (b) Reports on Form 8-K The Company did not file a Report on Form 8-K during the fourth quarter of the fiscal year ended December 31, 1993. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby under- takes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 2-78264 (filed July 1, 1982), 33-37919 (filed November 21, 1990) 33-43709 (filed October 31, 1991): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the regis- trant in the successful defense of any action, suit or proceed- ing) is asserted by such director, officer or controlling person in connection with the securities being registered, the regis- trant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnifica- tion by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Handy & Harman has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HANDY & HARMAN Dated: March 24, 1994 By /s/ R. N. Daniel ---------------------- R.N. Daniel Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company, in the capacities and on the respective dates indicated. REPORT AND CONSENT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Handy & Harman: Under the date of February 18, 1994 we reported on the consolidated balance sheet of Handy & Harman and Subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audit of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules on pages S-1, S-2, S-3 and S-4. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statements on Form S-8 (Registration Nos. 2-78264, 33-37919 and 33-43709) of Handy & Harman of our report dated February 18, 1994. KPMG PEAT MARWICK New York, New York March 24, 1994 HANDY & HARMAN AND SUBSIDIARIES S-1 SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (Thousands of Dollars) (a) Amounts represent transfers to depreciable assets in excess of new construction in progress. (b) The translation adjustment results from restating the property, plant and equipment of the Company's Canadian and British subsidiaries in U.S. dollars. (c) Amounts represent reclass of discontinued operations property, plant and equipment. (d) Amounts represent reclass of discontinued operations property, plant and equipment and contribution of machinery and equipment to Joint Venture. (e) Amounts include reclass of machinery and equipment to assets held for resale. Note: The depreciation and amortization policy is to provide for retirement of property at the end of its estimated useful life, determined as follows: HANDY & HARMAN AND SUBSIDIARIES S-2 SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Thousands of Dollars) (a) The translation adjustment results from restating the accumulated depreciation of the Company's Canadian and British subsidiaries in U.S. dollars. (b) Amounts represent reclass for discontinued operations property, plant and equipment. (c) Amounts represent reclass for discontinued operations property, plant and equipment and contribution of machinery and equipment to Joint Venture. (d) Amounts include reclass of machinery and equipment to assets held for resale. HANDY & HARMAN AND SUBSIDIARIES S-3 SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (Thousands of Dollars) (1) 1,530 of the provision for doubtful accounts was part of continuing operations' reserve for restructuring, nonrecurring and unusual charges. (b) Items determined to be uncollectible, less recovery of amounts reviously written off. (c) $1,165 of allowance for doubtful accounts receivable reclassed to current assets of discontinued operations. HANDY & HARMAN AND SUBSIDIARIES S-4 SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION Three Years Ended December 31, 1993 (Thousands of Dollars) EXHIBIT INDEX Exhibit Number Description ------- ----------- (3) Certificate of Incorporation and By-Laws. (a) The Restated Certificate of Incorporation of Handy & Harman (Filed as Exhibit 3(a) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (b) The By-Laws as amended (Filed as Exhibit 3(b) to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference). (4) Instruments defining the rights of security holders, including indentures. (a) Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent (Filed as Exhibit 4(a) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (b) Short Term Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemi- cal Bank, as Co-Agents and The Bank of Nova Scotia, as the Administrative Agent (Filed as Ex- hibit 4(b) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (c) Amendment to Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent (filed as Exhibit 4(e) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference). (d) Amendment to Short Term Revolving Credit Agreement dated as of March 16, 1992 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia, as the Administrative Agent (filed as Exhibit 4(d) to the Company's Annual Report on Form 10- K and incorporated herein by reference). (e) Amendment to Revolving Credit Agreement dated February 4, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent. (f) Amendment to Short Term Revolving Credit Agreement dated February 4, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and the Bank of Nova Scotia, as the Administrative Agent. (g) Amendment to Revolving Credit Agreement dated July 1, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and The Bank of Nova Scotia as the Administrative Agent. (h) Amendment to Short Term Revolving Credit Agreement dated July 1, 1993 among the Company, certain financial institutions as lenders, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A. and Chemical Bank, as Co-Agents and the Bank of Nova Scotia, as the Administrative Agent. No other required to be filed. The Company agrees to furnish to the Securities and Exchange Commission upon its request therefor a copy of each instrument omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. (10) Material contracts. (a) 1982 Stock Option Plan (Filed as Exhibit 1 to the Company's Registration Statement on Form S-8 (Registration No. 2-78264) under the Securities Act of 1933 and incorporated herein by reference). (b) Amendment to 1982 Stock Option Plan approved in December 1988 (Filed as Exhibit 10(a) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (c) Management Incentive Plan, as amended February 26, 1981 (Filed as Exhibit 10(b) to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference thereto). (d) Amendment to Management Incentive Plan approved in December 1988 (Filed as Exhibit 10(d) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (e) Amendment to Management Incentive Plan approved in October 1991 (Filed as Exhibit 10(e) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (f) Deferred Fee Plan For Directors, as amended February 26, 1981 (Filed as Exhibit 10(c) to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference thereto). (g) Form of Executive Agreement entered into with the Company's executive officers in September 1986 (Filed as Exhibit 10(d) to the Company's 1986 Annual Report on Form 10-K and incorporated herein by reference thereto). (h) Amendment to Executive Agreement approved in December 1988 (Filed as Exhibit 10(b) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (i) 1988 Long-Term Incentive Plan (Filed as Exhibit 10(h) to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference). (j) Amendment to 1988 Long-Term Incentive Plan approved in December 1988 (Filed as Exhibit 10(c) to the Company's Report on Form 8-K for December 1988 and incorporated herein by reference). (k) Amendment to 1988 Long-Term Incentive Plan approved in June 1989 (Filed as Exhibit 10(j) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (l) Agreement dated as of May 1, 1989 between the Company and R. N. Daniel (Filed as Exhibit 10(k) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (m) Amendment to Agreement between the Company and R. N. Daniel approved by the Company on May 11, 1993. (n) Supplemental Executive Retirement Plan approved by the Company in September, 1989 (Filed as Exhibit 10(l) to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference). (o) Outside Directors Stock Option Plan (Filed as Exhibit 10(m) to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference. (p) Amended and Restated Joint Venture Agreement dated as of June 1, 1990 by and between Allen Heat Transfer Products Inc. and Handy & Harman Radiator Corporation (Filed as Exhibit (2) to the Company's Report on Form 8-K for June 1990 and incorporated herein by reference). (q) Handy & Harman Long-Term Incentive Stock Option Plan (Filed as Exhibit 10(p) to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference). (r) Handy & Harman Supplemental Executive Plan (Filed as Exhibit 10(q) to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference). (11) Statement re computation of per share earnings. Incorporated by reference to item (g) of Summary of Significant Accounting Policies on page 27 of the Annual Report. (13) Pages 17 through 34 of the Company's Annual Report to Shareholders for 1993. Except for those portions which are expressly incorporated by reference in this Annual Report on Form 10-K, this exhibit is furnished for the information of the Commission and is not deemed to be filed as part of this Annual Report on Form 10-K. (22) List of Subsidiaries of the Company is filed as Exhibit 22 to this Annual Report on Form 10-K. (24) Report and Consent of Independent Auditors. Included as part of the Report and Consent of Independent Auditors on page filed with the Financial Statement Schedules as part of this Annual Report on Form 10-K pursuant to Part IV hereof and incorporated herein by reference thereto.

778977_1993.txt

778977_1993

1993

778977

ITEM 1. BUSINESS OVERVIEW Levi Strauss Associates Inc. (the Company) acquired Levi Strauss & Co. (LS&CO.) in 1985 and is the world's largest brand-name apparel manufacturer. It designs, manufactures and markets apparel for men, women and children, including jeans, slacks, shirts, jackets, skirts and fleece. Most of its products are marketed under the Levi's(R) and Dockers(R) trademarks and are sold in the United States and in many other locations throughout North and South America, Europe, Asia and Oceania. These products are produced by the Company worldwide at owned and operated facilities or by independent contractors. The Company's revenues are derived mostly from the sale of jeans and jeans- related products. Jeans include pants that usually have five pockets and are made of denim, corduroy, twill and other fabrics. These and other jeans-related products generated approximately 71 percent of the Company's total sales in 1993 ($4.2 billion of $5.9 billion) and are the mainstays of the Company's profitability. Casual products (mostly pants and tops marketed under the Dockers(R) brand that are not jeans or jeans-related products) are increasingly becoming an important source of revenues in the U.S. The non-U.S. businesses generate higher gross profit as a percent of sales than U.S. businesses and are an important source of cash flows. The worldwide apparel market is characterized by constant change and diversity. It is affected by demographic fluctuations in the consumer population, frequent shifts in prevailing fashions and styles, international trade and economic developments, and retailer practices. The Company has historically enjoyed its largest brand share and customer base for jeans among men, especially those aged 15-24 years old, and, to a lesser extent, those aged 25 and over. The demographics of the U.S. and other industrialized countries outside the U.S. reflect aging populations and declining target markets. The demographics of less industrialized countries indicate growing younger populations and increasing target markets for the Company's jeans and jeans-related products. The Company's market success is dependent on the Company's ability to quickly and effectively respond to changes in market trends and other consumer preferences, especially now that U.S. and Canada consumers are more price and value conscious and many competitors are offering lower priced and innovative products. This increasing price consciousness is putting pressure on brand and product loyalty. The ongoing competitive nature of the apparel industry and market trends present a continuous risk that new products or market segments may emerge and compete with the Company's existing products and/or markets. The Company's business is also dependent on the quality of service the Company provides to its customers. Retailers are striving to maintain lower inventory positions and place orders closer in time to requested delivery dates. As a result, the Company has faced increasing pressure from U.S. retailers to improve its product support and delivery performance. Additionally, the U.S. retail market has changed in recent years, resulting in more centralized buying practices and potentially greater credit exposures from customers. Outside the U.S., customer service and product support demands from large retailers are also increasing. ORGANIZATION STRUCTURE The Company's current operating structure consists of two principal organizations: Levi Strauss North America (LSNA) and Levi Strauss International (LSI). LSNA encompasses the Company's businesses in the U.S., Canada and Mexico. The LSNA operating structure currently consists of seven principal marketing and/or operating divisions: Men's Jeans, Youthwear, Menswear, Womenswear, Canada, Mexico and Brittania Sportswear Ltd. Jeans and jeans-related products marketed by Men's Jeans and Dockers(R) products marketed by Menswear are the Company's most important source of U.S. sales and earnings. The Womenswear, Youthwear and Canada divisions also market jeans, jeans-related products and casual products, including Dockers(R) products. The Mexico division markets mostly jeans, jeans- related products and Dockers(R) products. Brittania Sportswear Ltd. markets the Brittania(R) line of men's and women's jeans, tops and casual sportswear in the U.S. As part of a strategic initiative, the Company is aligning its U.S. marketing divisions according to the Company's Levi's(R), Dockers(R) and Brittania(R) brands (SEE STRATEGIC INITIATIVES SECTION). LSI markets jeans and related apparel outside North America and is a major source of operating income for the Company. Its sourcing methods include owned and operated facilities in certain countries and independent contractors. LSI is organized along geographic lines consisting of the Europe, Latin America and Asia Pacific divisions. Europe is the largest LSI division in terms of sales and profits. Asia Pacific is the second largest LSI division, principally due to the performance of its Japanese operations in recent years. The Company continually evaluates the profitability and cash flow of its global operations. The following table presents U.S. and non-U.S. sales for 1993, 1992 and 1991. For additional financial information concerning the U.S. and non-U.S. operations of the Company, SEE NOTE 2 TO THE CONSOLIDATED FINANCIAL STATEMENTS. STRATEGIC INITIATIVES The Company is in the process of examining and re-engineering various aspects of its brand marketing, customer service and operations/distribution strategies in response to current market and economic trends and in accordance with its Business Vision (SEE BUSINESS VISION SECTION). The Company believes its initiatives are essential to staying competitive and meeting the changing competitive needs of its customers. Summaries of these initiatives are as follows: GLOBAL BRAND ALIGNMENT The Company's strategy, as outlined in its Business Vision, is to position its brands to ensure consistency of image and values to consumers around the world. The Company is taking the following actions to implement this strategy: The Company is aligning its U.S. marketing divisions according to the Company's Levi's(R), Dockers(R) and Brittania(R) brands. The Company is analyzing its customer base and product distribution in all markets to ensure that its retail distribution is consistent with its brand image. The Company is entering into a joint venture to build and operate, in the U.S., stores selling only Levi's(R) jeans and jeans-related products (SEE RETAIL JOINT VENTURE CAPTION). The Company's trademarks and brands differentiate its products from those of competitors. Due to the increasingly global nature of the marketplace, brands that are marketed in divergent distribution channels in different countries may confuse retailers and customers and dilute the Company's brand image. To align its brand image, the Company may alter its distribution and marketing procedures. Retailers may react adversely to changes in product distribution, service levels or other aspects of their customer relationship with the Company. However, the Company believes that consistent brand image, on a global basis, is essential to long-term success and attainment of overall objectives. CUSTOMER SERVICE The Company believes that retailer expectations for service from manufacturers are increasing in both the North American and European markets. These expectations and requirements relate to all aspects of the relationship between the manufacturer and retailer. Retailers want manufacturers to develop, deliver and replenish products faster, deliver retail floor-ready merchandise, participate in retail floor product presentation and provide ongoing support for the products on the retail floor. Additionally, manufacturers are expected to establish information systems that would be compatible with retailer systems and to adjust invoicing and payment methods, accordingly. The Company believes that superior customer service, as well as its product development and marketing ability, will be an essential element of competitive strength in the coming years. The Company is engaged in various customer service initiatives in the U.S. and in certain non-U.S. businesses. It is reorganizing and re-engineering its entire U.S. operations to improve customer service, forge stronger relationships with its retail customers and reduce the time it takes to develop products and fill customer orders. The reorganization will affect the Company's entire U.S. supply chain, including product development, production and sourcing, sales and distribution processes, and its information resource systems. The Company expects to upgrade its national distribution network and regionally link manufacturing, finishing and distribution facilities. This will entail the modernization, reconfiguration and expansion of facilities, including purchases of new facilities and equipment. The Company plans to utilize several regional customer service centers to carry core products and replenishable seasonal products of each brand for each consumer segment. The Company intends to use a national center to store one-time seasonal products. Additionally, the Company's initiatives will require information system changes to support the changes in its business processes and distribution network. Common data and on-line access for all parts of the supply chain are critical to reducing leadtimes and building alliances with customers and suppliers. Although key elements of the organizational realignment and distribution system changes are not yet determined, the Company expects to complete this reorganization within the next few years. The Company expects to make capital expenditures of over $300 million during the next few years to support the new distribution network, expanded systems plans, and organization and manufacturing changes. Additionally, the Company expects to spend approximately $200 million for transitional expenses, including software costs, possible write-offs of existing facilities and equipment, training costs and other related expenses. All of these costs may be recognized throughout the implementation period and/or as expenditures occur, depending on the nature of the cost and the decisions made related to this initiative. The LSI initiative to improve customer service will be consistent with the U.S. initiative framework, but modified based on local analysis of customer service requirements in each market. ALTERNATIVE MANUFACTURING SYSTEMS Alternative Manufacturing Systems (AMS) have been implemented in most of the Company's U.S. sewing plants. Similar programs have been implemented in the Company's Canada and Brazil facilities. AMS is a team-based approach to manufacturing, replacing the traditional assembly line. Team-based manufacturing is intended to improve quality, increase flexibility and shorten leadtimes, thus enabling the Company to respond more quickly to its retail accounts. However, the continuing conversion to and success of team-based manufacturing will require major education and training support for the next several years. Additionally, the Company is implementing a new program ("F.A.S.T.") in the U.S. to link specific sewing plants to certain finishing centers and customer service centers to cut leadtimes and decrease the response time in filling customer orders. Traditionally, the U.S. sewing plants shipped products to a variety of finishing centers. The new processing program and the AMS are consistent with the Company's desire to reduce production leadtime and become more responsive to product changes and customer demands. RETAIL JOINT VENTURE As part of its efforts to create consistent brand image, the Company continues to explore and consider dedicated distribution channels, such as joint-venture stores in the U.S. that sell only Levi's(R) brand products. The Company currently has numerous franchised retail operations outside the U.S. that sell only Levi's(R) products. Unlike the non-U.S. franchise operations, the Company will have an equity interest in the U.S. joint ventures (SEE OPERATIONS OUTSIDE THE U.S. SECTION). During 1993, the Company entered into an agreement in principle with Designs, Inc., to form a joint venture that will own and operate stores, in the northeastern U.S., selling only Levi's(R) jeans and jeans-related products. The agreement is subject to negotiation of definitive agreements and final terms and regulatory approvals. The Company will hold a 30 percent interest in this joint venture and will participate in decisions about product presentation and similar image-related matters. The joint ventures will also provide a vehicle for the Company to communicate the benefits of its products to retail customers and consumers, especially since consumers are more price conscious and value-oriented. The Company has very limited experience in operating retail stores in the U.S., therefore it is the Company's intent that its retail partners will have the primary responsibility for day-to-day operations. RISKS OF STRATEGIC INITIATIVES The Company is assuming substantial risks in undertaking these initiatives. For example, it faces disruption of its ongoing business operations during implementation. Management, other personnel and job definition changes may distract employees and adversely affect employee morale. The Company may incur unplanned additional implementation costs, with a resulting impact on cash flow and earnings. The Company may face difficulties in developing the information systems necessary to support new business processes and customer service requirements. If the initiatives are adopted, the Company also may rely on new materials handling technologies in the new customer service centers, and must successfully integrate the software that operates the equipment with its business systems. The Company must also successfully manage the transition of employees to new positions and train them to meet the requirements of those positions, including operating effectively in a more team-based and technology-oriented environment. It will be doing so at the same time it is rolling-out a new compensation-based program that is intended to align employee efforts with overall Company strategies. More broadly, these initiatives involve fundamental changes in the way the Company operates its business. There are numerous commercial, operating, financial, legal and other risks and uncertainties presented by the design and implementation of such programs. Furthermore, the Company is not aware of undertakings of comparable magnitude in the apparel industry, and cannot predict with certainty the outcome of these initiatives. Although there can be no assurance that the Company will successfully design and implement these new business processes, or that the costs of these initiatives will not exceed estimates, the Company believes that the re-engineering initiative is essential to maintain its competitive position. Additionally, the Company believes it is important to implement these initiatives at a time when the Company's market and financial performance is strong. U.S. OPERATIONS The Company's U.S. operations are currently composed of the Men's Jeans, Youthwear, Menswear, Womenswear and Brittania Sportswear Ltd. marketing divisions that, along with Canada and Mexico, constitute the LSNA organization. Each U.S. division maintains its own merchandising, sales and advertising staff. MARKETS The Company's current U.S. apparel market is directly affected by consumer spending, the retail environment and competition. The U.S. economic environment is experiencing moderate inflation growth, low consumer confidence and a stagnant labor market. Consumer spending is low and consumers remain price sensitive. Retailers are responsive to consumer spending patterns and are offering more private label products and demanding higher levels of service and support from their vendors. Additionally, competitors are also becoming more aggressive by offering lower priced and innovative products. The Company's strategy in responding to current market conditions focuses on sensitivity to fashion changes and consumer preferences, brand enhancement, timely product development, innovative marketing activities and enhanced relations with retailers and suppliers. As previously described, superior customer service and efficient product manufacturing is an integral element of the Company's business strategy. The U.S. jeans market in 1993 declined from 1992 levels, with no growth expected in 1994. However, the Company continues to hold a significant market share in the young men's market. Demand for finished jeans products (garments that have been laundered or otherwise treated after assembly), including stonewashed and other wet-processed garments, continues to increase. Over the years, jeans demand by the male consumer has shifted toward substitute products such as casual slacks, shorts and fleecewear. The Company believes that these trends are in part a function of the broad demographic changes described earlier. The women's jeans market tends to be more fragmented among major competitors than jeans for men. In recognition of the ongoing changes in the jeans market, the Company continues to add new designs, finishes, fabrications and colors to its traditional product lines. Ongoing efforts are placed on coordinating with laundry contractors, textile producers and other companies throughout the world to develop concepts and processes to promote finishing development leadership and finished product shade consistency. The growth in new product lines is reflected by the fact that in 1993 traditional "rigid denim" products sold by the Men's Jeans and Youthwear divisions provided 6 percent of total unit sales of those divisions, compared to 68 percent in 1985. The casual sportswear market is dynamic, characterized by continuous product innovation and lower margins than those prevailing in the young men's jeans market due to higher labor content. The sportswear market, like the jeans market, is affected by demographic changes and changes in consumer lifestyles and buying habits. Market research indicates that the maturing male consumer is less brand conscious and brand loyal, and more price conscious and value- oriented, than the female consumer or the younger male consumer. PRODUCTS AND STRATEGY The Company manufactures and markets basic jeans, branded casual products and jeans-related products in a wide range of moderately-priced apparel categories. The 501(R) family of jeans, other basic denim jeans and related jeans products have traditionally been the Company's key products. In addition to the 501(R) products, the Men's Jeans division also markets the Red Tab(TM), Orange Tab(TM) and silverTab(TM) product lines. The Menswear division manufactures and markets men's casual and dress slacks and branded men's knit and woven shirts, including Dockers(R) and Levi's(R) Action product lines. The Womenswear division markets jeans and casual sportswear products for the 501(R), Red Tab(TM), silverTab(TM), 900(R) series and Dockers(R) product lines. The Youthwear division markets jeans and casual youthwear products for the 501(R), Dockers(R) and Little Levi's(TM) product lines. Brittania Sportswear Ltd. manufactures and markets men's and women's jeans, tops and casual sportswear under the Brittania(R) and Brittgear(TM) labels. U.S. sales of the 501(R) family of jeans amounted to 26 million units, 33 million units and 37 million units in 1993, 1992 and 1991, respectively. The decrease in unit sales for the 501(R) family of jeans is related to price increases, various counter-diversion tactics (SEE RISKS OF NON-U.S. OPERATIONS CAPTION) and the success of other Company jeans products, such as Orange Tab(TM) and other Red Tab(TM) products. The Company's 1993 market share of the challenging U.S. jeans market remained relatively stable with the previous year. The Company's unit sales for total U.S. jeans offerings totaled approximately 151 million units. The Company launched an advertising campaign late in 1993 that will extend to 1994, to revitalize consumer interest in the 501(R) family of jeans. However, the Company still expects 1994 sales of the 501(R) family of products to decrease slightly. Additionally, the Company expects 1994 unit sales of silverTab(TM) products to decline due to the repositioning of this product line. Lower unit sales for the 501(R) family of jeans and silverTab(TM) products is expected to be partially offset by increased unit sales of lower margin Orange Tab(TM) products. The Dockers(R) product line has been one of the most rapidly growing and successful lines in the U.S. apparel industry. Sales of Dockers(R) products totaled 64 million units, 67 million units and 57 million units in 1993, 1992 and 1991, respectively. The decline in unit sales is mainly attributable to increased competition and market saturation. The Company expects that sales of Dockers(R) products will be flat for the 1994 fiscal year. The Company's 1993 market share of the U.S. casual market was relatively flat with the previous year. The Company's Dockers(R) men's product line and loose-fitting men's jeans represents a response to demographic and fashion changes. The Company continues to expand the Dockers(R) product line and is constantly adding new colors, fabrications and designs to the line. In 1993, the Company introduced a premium line of Dockers(R) casual pants and shirts products, Dockers(R) Authentics, which are intended to meet the demand for casual office-dress apparel. Additionally, the Company plans to introduce a complete line of wrinkle- resistant Dockers(R) products in fiscal 1994. An initial limited release of these products for the 1993 Holiday season indicated positive retail results, however the lack of availability of certain processing equipment utilized in the finishing cycle could have a temporary effect of delaying the availability of these products. Also, there is no assurance that this product will be successful considering the intensity of competition (SEE COMPETITION CAPTION). Levi's(R) jeans for women will continue to be updated with new colors and cuts in 1994. However, the women's Dockers(R) product line has not been received as well as the men's Dockers(R) product line and is gradually being repositioned as an upgraded casual sportswear line. Unit sales for women's Dockers(R) products are expected to decrease in 1994 due to the repositioning. Once repositioned, these Dockers(R) products will feature better quality construction and fabrics. Both the Levi's(R) jeans for women and the women's Dockers(R) product lines will be supported by new advertising campaigns. The Company's Youthwear division primarily markets products to the boy's and girl's markets. Colored denim and loose silhouettes were prominent products sold by the Youthwear division during 1993. Dollar sales of Men's Jeans products accounted for 33 percent, 31 percent and 29 percent of the worldwide sales of the Company in 1993, 1992 and 1991, respectively. U.S. sales of non-jeans-related casual apparel products represented 19 percent, 21 percent and 24 percent of worldwide dollar sales in those years. For additional financial information on U.S. operations, SEE NOTE 2 TO THE CONSOLIDATED FINANCIAL STATEMENTS. The Brittania(R) brand represents the Company's presence in the growing mass merchant channel, which currently comprises nearly half of the jeans market. Brittania Sportswear Ltd. offers low-priced, high quality products to major mass merchant accounts and is a component of the overall U.S. marketing strategy. During 1993, the Company decided to operate the Brittania business as an independent business unit within LSNA and to move its headquarters to Seattle, Washington. This decision is intended to lower costs and strengthen the brand's competitive position in its marketplace. COMPETITION The Company and its largest competitor in the U.S. jeans market, VF Corporation, account for approximately one-half of the units sold in the U.S. jeans market. The Company believes that the combined brand share of its Levi's(R) and Brittania(R) products in the U.S. jeans market is second only to the combined share of VF Corporation's three principal brands, Wrangler(R), Lee(R) and Rustler(R). The casual apparel market for men and women is characterized by intense competition, among manufacturers and retailers, and ease of entry for new producers. Import competition is more prevalent in the casual apparel market than in the jeans market. Apparel imports have generally lower labor costs and may exert downward pressure on prices of casual wear products. This situation is limited by U.S. trade policies that restrict apparel imports through quotas and tariffs (SEE GLOBAL SOURCING SECTION). Cotton wrinkle-resistant slacks were introduced by competitors in 1993 and are gaining in popularity. Competitors are now applying the wrinkle-resistant process to other apparel items including shirts and sleepwear. These wrinkle- resistant slacks are in direct competition with the Company's existing Dockers(R) products. The Company plans to introduce a complete line of wrinkle- resistant Dockers(R) products in 1994 (SEE PRODUCTS AND STRATEGY CAPTION). Based on the current U.S. economy, the retail environment, increased competition and increases in prices of the Company's jeans products over the last few years, the Company is expecting its U.S. unit sales in 1994 to be slightly lower than 1993. DISTRIBUTION The Company distributes its products through retail stores that satisfy its account selection criteria and sell directly to the retail consumer. The Company does not sell its first quality "in season" products to wholesalers, jobbers or distributors, and maintains a compliance program to enforce its distribution policy and to control unauthorized diversionary sales of its products (SEE RISKS OF NON-U.S. OPERATIONS CAPTION). The principal channels of distribution of the Company's products are department stores, specialty stores and national chains, including J.C. Penney Company, Inc., Sears Roebuck & Co. and Mervyn's Inc. The Company believes that industry leadership and brand strength of the Company's core products are maintained through the use of traditional distribution channels. U.S. sales to the Company's top 5 accounts represented 38 percent of total 1993 U.S. dollar sales. The Company's top 25 customers accounted for approximately 64 percent of the Company's total U.S. dollar sales. The Company has no long-term contracts or commitments with any of its customers. The loss of any of these customers could have an adverse effect on the Company's results and operations. Retail accounts are currently serviced by approximately 395 sales representatives for the U.S. divisions. The Company continues to explore and consider dedicated U.S. distribution channels, such as stores that sell only Levi's(R) brand products (SEE STRATEGIC INITIATIVES SECTION) and in-store shops at retailer locations, consistent with its Business Vision (SEE BUSINESS VISION SECTION). The Company distributes Brittania(R) products principally through mass merchant channels, including Kmart Corporation, Target Stores and Wal-Mart Stores, Inc. These three customers represent approximately 79 percent of Brittania Sportswear Ltd. total sales. The loss of any of these customers could have an adverse effect on Brittania Sportswear Ltd.'s results and operations, but not a material effect on the Company's total results. Brittania Sportswear Ltd. has no long- term contracts or commitments with any of its customers. Mass merchandisers comprise approximately 5 percent of the Company's U.S. unit sales for jeans. ADVERTISING/MARKETING The Company devotes substantial resources to advertising and marketing programs. In the United States, the Company advertises extensively on radio and television and in national publications as well as on billboards and other outdoor displays. It also participates in local co-operative advertising and visual merchandising programs under which the Company shares advertising costs with retailers. In 1993, the Company continued several advertising campaigns that were launched in 1992, including a Men's Jeans and Youthwear campaign for loose-fitting jeans. The Company also initiated new advertising campaigns for women's, men's and boys' products. Additionally, the Company was named "Advertiser of the Year" at the 40th Annual Cannes International Advertising Festival in recognition of three decades of advertising excellence. In 1993, U.S. advertising expense was $246 million, a 7 percent increase from 1992. The Company is increasing its use of sell-through presentation in which the Company influences the way its products are presented at the retail level. The Company assists retailers in displaying products in a manner intended to enhance the product's image and promote its quality. OPERATIONS OUTSIDE THE U.S. ORGANIZATION AND PRODUCTS Operations outside the U.S. were the Company's most profitable businesses on a per unit basis in 1993. Generally, businesses outside the U.S. record higher gross profit as a percent of sales than businesses in the U.S., mostly due to higher overall average unit selling prices. These operations are generally organized by country, and manufacture and market jeans and related products outside the U.S. Each country's operations within the European division are generally responsible for certain marketing activities, sales, distribution, finance and information systems. The European headquarters coordinates production, advertising and merchandising activities for core jeans products and also manages certain information systems development activities. Merchandising activities for tops are decentralized and located in various individual countries. With few exceptions, Canada, Mexico (both included in the LSNA organization), and the Latin America and Asia Pacific divisions are staffed with their own merchandising, sourcing, sales and finance personnel. Sales for operations outside the U.S. are derived primarily from basic lines of jeans (particularly the 501(R) product line and other Red Tab(TM) products), tops and other denim apparel. These operations mainly sell directly to retailers in established markets. Retail accounts are currently serviced by approximately 360 sales representatives and 50 independent sales agents. Also, in 1993, the Company successfully tested the Dockers(R) line of products in Sweden. Manufacturing and distribution activities for non-U.S. marketing divisions are independent of the Company's U.S. operations. However, in 1993 non-U.S. operations purchased $164 million of products from the Company's U.S. divisions. This amount is expected to remain stable in 1994. The Company explores and evaluates new markets on an ongoing basis. In addition to its involvement in eastern Europe (including Hungary and Poland), in 1993, the Company commenced operations in Korea and Taiwan and plans to establish operations in India. In 1993, net sales from non-U.S. operations were $2.2 billion compared to $2.1 billion in 1992. The Company believes its success in these markets reflects the Company's brand image and reputation, the continuing focus on core jeans products and the quality of its retail distribution, including stores that sell only Levi's(R) products. Considering the continuous changing needs of customers and consumers, and economic and trade developments (SEE GLOBAL SOURCING SECTION), among other things, there can be no long-term assurances that the Company will maintain such profitability in these markets. For additional financial information about non-U.S. operations SEE NOTE 2 TO THE CONSOLIDATED FINANCIAL STATEMENTS. THE MARKETS, COMPETITION AND STRATEGY The Company markets products in over 40 countries. As in the U.S., demand for jeans outside the U.S. is affected by a variety of factors that vary in importance in different countries, including socio-economic and political conditions such as consumer spending rates, unemployment, fiscal policies and inflation. In many countries, jeans are generally perceived as a fashion item rather than a basic, functional product and, like most apparel items, are higher- priced relative to the U.S. The non-U.S. jeans markets are more sensitive to fashion trends than the U.S. market. Additionally, the retail industry differs from country to country. Some of the Company's retail customers in certain countries are large "chain" retailers with centralized buying power. In other countries, the retail industry is comprised of numerous smaller, less centralized shops. Some non-U.S. customers are stores that sell only the Company's products and are independent of the Company. The Company distributes to 900 stores outside the U.S. that sell only Levi's(R) brand products. These stores are strategically positioned in prime locations around the world and offer a broad selection of premium Levi's(R) products using state-of-the-art retail fixtures and visual merchandising. Considering the increasingly competitive retail environment, the Company believes these stores are of strategic importance in enhancing the brand image of Levi's(R) products. Other general factors, including the relative strength or weakness of the U.S. dollar and competition from local manufacturers, also affect the Company's financial results in markets outside the U.S. The Company has the largest brand share and strongest brand image in virtually all of its established non-U.S. markets. There are numerous local competitors of varying strengths in most of the Company's principal markets outside the U.S., but there is no single competitor with a comparable global market presence. However, VF Corporation is increasing its activity in markets outside the U.S. and is becoming a more important competitor, particularly in Europe. In Europe, consumer demand has been less affected by demographic changes compared to the U.S. Core denim jeans, especially the 501(R) family of products, continue as key products in Europe and Canada. However, to meet the service commitments the Company makes to its customers around the world, and consistent with the customer service initiative in the U.S., the Company is launching a customer service initiative for the non-U.S. divisions. Sales growth in the Asia Pacific division, particularly in Japan, has slowed during the current year. The Levi's(R) brand continues to be the market share leader in Mexico. The Company's Latin America division activities are mainly in Brazil. Outside the U.S., advertising themes and strategies vary by country depending on the culture in each country, while maintaining consistency with the global positioning of the Levi's(R) brand. Advertising expenditures for non-U.S. operations were $130 million in 1993, a 12 percent increase from 1992. RISKS OF NON-U.S. OPERATIONS The Company's non-U.S. operations, including its use of non-U.S. manufacturing sources (SEE GLOBAL SOURCING SECTION), are subject to the usual risks of doing business outside the U.S. These risks include adverse fluctuations in currency exchange rates, changes in import duties or quotas, disruptions or delays in shipments and transportation, labor disputes, socio-economic and political instability. The occurrence of any of these events or circumstances could adversely affect the Company's operations and results. The Company evaluates the risk of non-U.S. operations when considering capital and reinvestment alternatives. The Company also uses various currency hedging strategies to mitigate the effects of currency fluctuations. In addition, it is not possible to accurately predict the effect that changing political and economic conditions in Russia and Eastern Europe will have on the Company's ability to develop operations there. In many non-U.S. countries, the appeal of Levi's(R) products, particularly the 501(R) family of products, has propelled prices and profit margins far above those in the U.S., which encourages diversion of Levi's(R) products. Accumulators usually buy products in the U.S. at retail prices, or less, and ship them to non-U.S. countries for sale at a higher price, but lower than the retail prices charged by authorized retailers in those countries. Diverters usually procure products in the U.S. at wholesale costs and ship them to other countries for sale at a profit. These diversion tactics reduce the availability of products for U.S. consumers and negatively affect the Company's and retailers' results outside the U.S. Higher average unit selling prices in the U.S. for certain products have narrowed the pricing gap between certain U.S. and non-U.S. jeans products, thus discouraging diversion. However, the risks of increasing prices in the U.S. for certain products include retailer and consumer resistance to pricing that exceeds their perception of the value of the Company's products. This is of particular concern in an environment characterized by difficult economic conditions and, in the U.S., increasing acceptance of lower priced or private label products. Also, the Company's distribution policy requires retailers to limit the number of certain jean products a customer can purchase in U.S. metropolitan-area stores. The Company ceases business relations with retailers known to cooperate with diverters. Additionally, sales of counterfeit Levi's(R) products, mostly made in the People's Republic of China, occur in key markets on a regular basis. The Company is concerned about the loss of its reputation with consumers, who may unknowingly buy counterfeit products, and damage to its business in those markets. The Company actively searches for and investigates counterfeit products. It aggressively seeks to protect its trademarks and has filed numerous legal actions against counterfeiters. GLOBAL SOURCING Apparel manufacturing in less-developed countries continues to affect global apparel markets, including the U.S. market. These less-developed countries have lower labor costs and, in some cases, such as in the production of shirts, access to less expensive fabrics. Despite a growth in workers' health and safety and other costs in the U.S., the Company's U.S. owned and operated manufacturing base is trying to stay competitive in jeans production by achieving shorter leadtimes and meeting production requirements through AMS (SEE ALTERNATIVE MANUFACTURING SYSTEMS CAPTION). The Company's imports into the U.S. have significantly increased in the past six years in response to overall sales growth in casual wear apparel. These casual wear products require more sewing and construction time and are, therefore, not as cost competitive when sourced from the Company's U.S. owned and operated facilities. The Company has increased its use of, and has become more reliant upon, independent contractors for product sewing and finishing functions because of the continued growth in recent years in demand for more casual wear products. However, due to excess capacity at its U.S. owned and operated facilities, the Company plans to source more of its 1994 U.S. products through its facilities, as opposed to independent contractors and locations outside the U.S. Therefore, the Company's use of independent contractors is expected to decrease in 1994. The excess capacity is due to lower production requirements that resulted from the build-up of basic jeans products during 1993 (SEE UNSHIPPED ORDERS AND INVENTORIES SECTION). Additionally, the Company has shifted some of its owned and operated production from basic jeans products to other products due to the high basic jeans inventory and order cancellation levels during the year. This shift in sourcing operations could impact gross margin (SEE MANAGEMENT DISCUSSION AND ANALYSIS SECTION, UNDER ITEM 7, FOR ADDITIONAL INFORMATION). In 1993 and 1992, approximately 54 percent of the apparel production units of the Company's U.S. operations were manufactured by independent contractors. Approximately 49 percent of non-U.S. products in 1993 were manufactured by independent contractors, compared to 48 percent in 1992. In 1993 and 1992, independent contractors were used for the finishing process for approximately 72 percent and 69 percent, respectively, of the finished units of U.S. operations. Approximately 55 percent of the finishing process for non-U.S. finished units in 1993 and 1992 was performed by independent contractors. The Company has no long-term contracts with its manufacturing sources and competes with other companies for production facilities and import quota capacity. Although the Company believes that it has established close relationships with its manufacturing sources, the Company's future success will depend in some measure upon its ability to maintain such relationships and, more broadly, to develop and implement a long-term sourcing plan. The Company established its Global Sourcing Guidelines (GSG) to provide direction for selecting contractors and suppliers that provide labor and/or material utilized in the manufacture and finishing of its products. These guidelines address issues that contractors and suppliers can control, for example, sharing the Company's ethical standards and commitment to the environment, providing workers with a safe and healthy work environment, maintaining fair employment practices and complying with legal requirements. The GSG also prohibits operating in countries that would have an adverse effect on global brand image or trademarks, expose employees or representatives to unreasonable risks, violate basic human rights, or threaten the Company's commercial interests due to political or social turmoil. The GSG possibly limits some of the Company's sourcing options as well as its access to certain lower cost production. Textile trade policy of developed countries has increased the cost of importing apparel products produced in countries with lower labor costs through quotas and high tariffs. However, this protection of apparel manufacturers in developed countries, particularly the U.S., Canada, Australia, the European Free Trade Association countries and the European Economic Community (EEC), is gradually being reduced. The North American Free Trade Agreement (NAFTA) was effective January 1, 1994. Quotas and tariffs will be phased out on specific goods of North American origin over a six-to-seven year period. The effect of NAFTA on the sourcing of goods to and from Mexico will have the most immediate impact on the Company. Once NAFTA is fully phased-in, the impact on the Company will be an approximate 5 percent reduction of tariffs on apparel imports from Mexico, and a 5 percent reduction in tariffs on Mexico imports from the U.S. The member-countries of the international trade organization, the General Agreement on Tariffs and Trade (GATT), have negotiated a proposed agreement to complete the Uruguay Round agreement. The agreement must be approved by the U.S. Congress and the governments of all the member-countries. If approved, the pact would be implemented on January 1, 1995 and phased in over 10 years. The major provision of the draft agreement that would effect the Company is the phase out of the quota system. Therefore, the proposed GATT agreement could have an impact on the Company's sourcing strategy, once the multifiber agreement under GATT phases out. The Company cannot accurately assess at this time how the GATT agreement will affect its financial results and operations. RAW MATERIALS The Company's primary raw materials include fabrics made from cotton. Synthetics and blends of synthetics with cotton or wool are used in certain product lines. Fabric is purchased mostly from U.S. textile producers for U.S. operations, and from both U.S. and non-U.S. textile producers for operations outside the U.S. Cone Mills Corp. and Burlington Industries supplied approximately 26 percent and 14 percent, respectively, of the total volume of fabrics purchased by the Company for U.S. operations in 1993. Cone Mills Corp. and Dominion Textiles Incorporated (including Swift Manufacturing Co., its wholly-owned subsidiary) supplied approximately 26 percent and 13 percent, respectively, of the Company's fabric purchases for non-U.S. operations in 1993. Cone Mills Corp. is the sole supplier of 01 denim, the fabric used in manufacturing 501(R) jeans. The Company has not recently experienced and does not expect any substantial difficulty in obtaining raw materials. Its only long-term raw materials contract with a principal supplier is with Cone Mills Corp. The loss of one or more of the Company's principal suppliers could have an adverse effect on the Company's results and operations. As part of its U.S. re-engineering effort, the Company is rationalizing its supplier base to reduce the number of suppliers it uses for certain fabrics. The Company also purchases large quantities of thread and trim (buttons, zippers, snaps, etc.) but is not dependent on any one supplier for such items. UNSHIPPED ORDERS AND INVENTORIES As of November 28, 1993, the Company's unshipped order position for all products was approximately 95 million units, representing a decrease of approximately 13 percent over the comparable date last year. The decrease in unshipped orders was primarily attributable to the U.S. marketing divisions, as a result of retailers' reluctance to commit to orders as far in advance. This reduction was also partially attributable to a timing change in the Men's Jeans division from 3 booking seasons in 1992 to 2 booking seasons in 1993. The unshipped orders position for non-U.S. products was relatively flat compared with the previous year, reflecting the continued demand for the Company's products. The Company's finished goods inventory was approximately 45 million units at year-end 1993, which was flat with the prior year's level. Production downtime late in the year reduced a build-up in the Men's Jeans division. The build-up resulted from consumer resistance to higher average unit selling prices and a general decline in consumer spending. Additionally, retailers are keeping less inventory on hand and have been relying on suppliers to provide products on a more timely basis. This practice resulted in a high number of order cancellations in 1993. The 1993 unit cancellations increased 30 percent from 1992, mostly due to higher unit cancellations in the Men's Jeans division. The Men's Jeans division, whose inventory consists primarily of first quality saleable basic core products, is reducing some of its future production. Some of the excess production capacity is being shifted to other products (SEE GLOBAL SOURCING SECTION). The Company is making an effort to create the optimal balance between the cost of maintaining current inventory levels with excess production capacity costs and customer service. The need to accommodate shorter delivery dates results in higher inventory levels, which increase the costs of warehousing and the risks of markdowns. Working capital requirements for ongoing operations and other needs were not materially affected by the high inventory unit levels during the year. The Company is in the process of re-engineering its North American operations to reduce the time it takes to develop products and fill customer orders (SEE STRATEGIC INITIATIVES SECTION). TRADEMARKS AND LICENSING AGREEMENTS The Company has a general program concerning the protection and enforcement of its trademark rights. The Company has registered the Levi's(R) trademark, one of its most valuable assets, in over 150 countries. The Company owns and has widely registered other trademarks that it uses in marketing jeans and other products, the most important of which in terms of product sales are the 501(R), Dockers(R), Pocket "TAB" Device and ARCUATE Design trademarks. The Company vigorously defends its trademarks against infringement, including initiating litigation to protect such trademarks when necessary. The Company has licensing agreements permitting third parties to manufacture and market Levi's(R) branded products in countries where the Company has elected not to, or is unable to, manufacture or market on a direct basis. Additionally, it has agreements permitting third parties to manufacture and distribute certain other products, such as shoes, socks and belts, under the Levi's(R), Dockers(R) and Brittania(R) trademarks. SEASONALITY The apparel industry in the United States generally has four selling seasons-- Spring, Summer, Fall and Holiday. New styles, fabrics and colors are introduced on a regular basis, based on anticipated consumer preferences, and are timed to coincide with these retail selling seasons. Historically, seasonal selling schedules to retailers have preceded the related retail season by two to eight months. Outside the U.S., the apparel industry typically has two seasons-- Spring and Fall. The Company's business is impacted by the general seasonal trends that are characteristic of the apparel industry. EMPLOYEES The Company employs approximately 36,400 people, a majority of whom are production workers. A substantial number of production workers are employed in plants where the Company has collective bargaining agreements with recognized labor unions. The Company considers its employees to be an important asset of the Company and believes that its relationships with employees are satisfactory. SOCIAL RESPONSIBILITY Social responsibility is a matter of strong conviction on the part of the Company. The Company has a longstanding commitment to equal employment opportunity, affirmative action and minority purchasing programs. The Company seeks to be an active corporate citizen in the communities in which it operates and maintains a Worldwide Code of Business Ethics. The Company has traditionally supported charitable social investment programs and intends to maintain its historical practice of charitable giving. During 1993, the Company's donations included $15.5 million to the Levi Strauss Foundation. The Company also contributed $.3 million to support matching gifts to the Red Tab Foundation, which was established to provide emergency financial assistance to the Company's employees and retirees in the United States. The Red Tab Foundation is currently in the process of expanding to non-U.S. affiliates. The Levi Strauss Foundation made grants and contributions totaling approximately $7.9 million in 1993 and the Company made additional contributions of $3.8 million, primarily for international programs. These include grants in three community partnership giving (or staff-directed) areas: AIDS and Disease Prevention, economic development (projects which seek to enhance the economic options and opportunities of low-income individuals) and race relations (Project Change, a program in three U.S. communities). Also included are grants through the Community Involvement Team program (in which groups of employees or retirees volunteer their time to review local community needs and then develop and implement projects to meet those needs), the Corporate Childcare Fund and the employee matching gift and volunteer service program. Contributions by the Levi Strauss Foundation have averaged over $7.0 million for each of the last three years. BUSINESS VISION The Company developed its Business Vision to identify its goals and provide direction for prioritizing all its initiatives and strategies. The Business Vision is as follows: We will strive to achieve responsible commercial success in the eyes of our constituencies, which include stockholders, employees, consumers, customers, suppliers and communities. Our success will be measured not only by growth in shareholder value, but also by our reputation, the quality of our constituency relationships, and our commitment to social responsibility. As a global company, our businesses in every country will contribute to our overall success. We will leverage our knowledge of local markets to take advantage of the global positioning of our brands, our product and market strengths, our resources and our cultural diversity. We will balance local market requirements with a global perspective. We will make decisions which will benefit the Company as a whole rather than any one component. We will strive to be cost effective in everything we do and will manage our resources to meet our constituencies' needs. The strong heritage and values of the Company as expressed through our Mission and Aspiration Statements will guide all of our efforts. The quality of our products, services and people is critical to the realization of our business vision. We will market value-added, branded casual apparel with Levi's(R) branded jeans continuing to be the cornerstone of our business. Our brands will be positioned to ensure consistency of image and values to our consumers around the world. Our channels of distribution will support this effort and will emphasize the value-added aspect of our products. To preserve and enhance consumers' impressions of our brands, the majority of our products will be sold through dedicated distribution, such as Levi's(R) Only-Stores and in- store shops. We will manage our products for profitability, not volume, generating levels of return that meet our financial goals. We will meet the service commitments that we make to our customers. We will strive to become both the "Supplier of Choice" and "Customer of Choice" by building business relationships that are increasingly interdependent. These relationships will be based upon a commitment to mutual success and collaboration in fulfilling our customers' and suppliers' requirements. All business processes in our supply chain--from product design through sourcing and distribution--will be aligned to meet these commitments. Our sourcing strategies will support and add value to our marketing and service objectives. Our worldwide owned and operated manufacturing resources will provide significant competitive advantage in meeting our service and quality commitments. Every decision within our supply chain will balance cost, customer requirements, and protection of our brands, while reflecting our corporate values. The Company will be the "Employer of Choice" by providing a workplace that is safe, challenging, productive, rewarding and fun. Our global work force will embrace a culture that promotes innovation and continuous improvement in all areas, including job skills, products and services, business processes, and Aspirational behaviors. The Company will support each employee's responsibility to acquire new skills and knowledge in order to meet the changing needs of our business. All employees will share in the Company's success and commitment to its overall business goals, values and operating principles. Our organization will be flexible and adaptive, anticipating and leading change. Teamwork and collaboration will characterize how we address issues to improve business results. STATEMENT OF COMPANY MISSION AND ASPIRATIONS The Company believes that shared goals are as critical to the Company's success as providing quality products and service and being a leader in the apparel industry. In order to identify and focus these shared goals, the Company adopted the following "Statement of Mission and Aspirations": MISSION STATEMENT The mission of the Company is to sustain responsible commercial success as a global marketing company of branded casual apparel. We must balance goals of superior profitability and return on investment, leadership market positions, and superior products and service. We will conduct our business ethically and demonstrate leadership in satisfying our responsibilities to our communities and to society. Our work environment will be safe and productive and characterized by fair treatment, teamwork, open communications, personal accountability and opportunities for growth and development. ASPIRATIONS FOR THE COMPANY We want a Company that our people are proud of and committed to, where all employees have an opportunity to contribute, learn, grow and advance based on merit, not politics or background. We want our people to feel respected, treated fairly, listened to and involved. Above all, we want satisfaction from accomplishments and friendships, balanced personal and professional lives, and to have fun in our endeavors. When we describe the kind of company we want in the future what we are talking about is building on the foundation we have inherited: affirming the best of our Company's traditions, closing gaps that may exist between principles and practices and updating some of our values to reflect contemporary circumstances. In order to make our aspirations a reality, we need: NEW BEHAVIORS: Leadership that exemplifies directness, openness to influence, commitment to the success of others, willingness to acknowledge our own contributions to problems, personal accountability, teamwork and trust. Not only must we model these behaviors but we must coach others to adopt them. DIVERSITY: Leadership that values a diverse workforce (age, sex, ethnic group, etc.) at all levels of the organization, diversity in experience and a diversity in perspectives. We are committed to taking full advantage of the rich backgrounds and abilities of all our people and to promote a greater diversity in positions of influence. Differing points of view will be sought; diversity will be valued and honesty rewarded, not suppressed. RECOGNITION: Leadership that provides greater recognition--both financial and psychic--for individuals and teams that contribute to our success. Recognition must be given to all who contribute: those who create and innovate and also those who continually support the day-to- day business requirements. ETHICAL MANAGEMENT PRACTICES: Leadership that epitomizes the stated standards of ethical behavior. We must provide clarity about our expectations and must enforce these standards throughout the corporation. COMMUNICATION: Leadership that is clear about Company, unit, and individual goals and performance. People must know what is expected of them and receive timely, honest feedback on their performance and career aspirations. EMPOWERMENT: Leadership that increases the authority and responsibility of those closest to our products and customers. By actively pushing responsibility, trust and recognition into the organization we can harness and release the capabilities of all our people. The Company is providing Aspirations training to employees and holds managers and employees accountable for behaviors that are in accordance with these objectives through its employee performance review process. Consistent with the Company's Mission and Aspirations, the Company sets high goals for responsible environmental stewardship and encourages business partners to do the same. ITEM 2. ITEM 2. PROPERTIES The Company's headquarters are located at Levi's Plaza in San Francisco, California. It currently leases approximately 681,000 square feet, of which 127,000 square feet is subleased to others. The Company owns approximately 204,000 square feet of office space adjacent to Levi's Plaza, commonly known as the Icehouse Building. Currently 195,000 square feet of this office space is used by the Company and approximately 9,000 square feet is being leased to others. The Company also leases 137,000 square feet in other locations in San Francisco and surrounding areas and 15,000 square feet in Florida. The Company owns or leases 93 manufacturing, warehousing and distribution facilities, aggregating to approximately 11,031,400 square feet, as shown in the following table: - ----------------- (1) Includes properties under capital lease. The Company believes that its existing facilities are in good operating condition. The amounts shown in the table include approximately 406,200 square feet of manufacturing capacity and 1,651,200 square feet of distribution capacity currently subleased to others or not in use. SEE NOTE 9 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION ABOUT MATERIAL LEASES. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company does not consider any pending legal proceeding to be material. In the ordinary course of its business the Company has pending, various cases involving contractual matters, employee-related matters, distribution questions, product liability claims, trademark infringement and other matters. The Company believes that these cases are not material in the aggregate in light of the strength of its legal positions in such matters, its accrued reserves and insurance. The Company evaluates environmental liabilities on an ongoing basis and, based on currently available information, does not consider any environmental exposure to be material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None, during the 1993 fourth quarter. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's outstanding Class L common stock is held primarily by members of the families of certain descendants of the Company's founder and certain members of the Company's management. Class E common stock is currently held by the trustee for the Employee Investment Plan of Levi Strauss Associates Inc. ("EIP"), the Levi Strauss Associates Inc. Employee Long Term Investment and Savings Plan ("ELTIS") and employees who purchased stock through the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc. (ESAP) (SEE NOTE 12 TO THE CONSOLIDATED FINANCIAL STATEMENTS). There is no established public trading market for either class of common stock and no shares of common stock are convertible into shares of any other classes of stock or other securities. All holders of Class L common stock are parties to, and bound by, an agreement restricting transfer of the Class L common stock. The outstanding shares of Class E common stock are subject to restrictions on transfer imposed by the EIP, ELTIS and ESAP. On January 10, 1994, there were approximately 191 Class L stockholders and 1,107 Class E stockholders. SEE NOTE 19 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR STOCK VALUATION AND DIVIDEND INFORMATION. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table presents historical income statement data and balance sheet data of the Company for the past five fiscal years. This data has been derived from the consolidated financial statements of the Company, which have been audited by Arthur Andersen & Co., independent public accountants. Unless otherwise indicated, references to years in this Form 10-K refer to the fiscal years of the Company. Unless otherwise stated, the Company's common share amounts, per share data and other financial information appearing in this Form 10-K have been adjusted to reflect the exchange of Class F common stock for Class L common stock during 1991 as part of the recapitalization (SEE NOTE 20 TO THE CONSOLIDATED FINANCIAL STATEMENTS) as well as the two-for-one stock split of Class F common stock, which was effective on November 30, 1989. (1) Fiscal year 1993 contained 52 weeks and ended on November 28, 1993. Fiscal year 1992 contained 53 weeks and ended on November 29, 1992. Fiscal years 1991, 1990 and 1989 each contained 52 weeks and ended on November 24, 1991, November 25, 1990 and November 26, 1989, respectively. (2) Fiscal years before 1993 were restated to reflect certain amendments and reclassifications of amounts related to the 1992 stock option charge, amortization of goodwill and intangibles, losses related to property, plant and equipment and certain operations-related items to operating income. SEE NOTE 1 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following summary of results of operations, financial condition and liquidity discusses data contained in the Consolidated Financial Statements of the Company. The discussion focuses on 1993, 1992, and 1991 comparisons and includes analyses of major components of net income, specific balance sheet items, liquidity and capital resources. (Fiscal years 1993 and 1991 each contained 52 weeks, while fiscal year 1992 contained 53 weeks.) During 1993, the Company filed with the Securities and Exchange Commission an amendment to its 1992 Form 10-K under the cover of Form 10-K/A. The Form 10-K amendments were to reclassify the 1992 stock option charge as an operating expense and to reclassify amounts related to the amortization of goodwill and intangibles and certain losses related to property, plant and equipment from other income, net to marketing, general and administrative expenses on the Consolidated Statements of Income. These reclassifications did not affect net income (SEE NOTE 1 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION). Additionally in 1993, a new line item, other operating (income) expense, net was created for the Consolidated Statements of Income. This new line includes certain operations related items that were previously classified as other income, net or marketing, general and administrative expenses. Certain 1992 and 1991 items have been reclassified to conform to the 1993 presentation format. (SEE NOTE 1 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION.) RESULTS OF OPERATIONS SUMMARY The Company achieved a net income record of $492.4 million in 1993. Net income for 1993 increased $131.6 million from the previous 1992 record mostly due to a stock option charge that negatively affected 1992 net income (SEE STOCK OPTION CHARGE CAPTION). Excluding the 1992 stock option charge effect, current year net income would have increased $16.6 million from 1992, due to higher 1993 sales volume, a lower effective tax rate and lower interest expense. This net income increase was partially offset by lower other operating (income) expense, net. Cost of goods sold and marketing, general and administrative expenses for 1993 were flat with 1992, as a percent of sales. Net income in 1992 of $360.8 million was slightly higher than 1991 net income of $356.7 million. Excluding the effects of the stock option charge, 1992 net income would have been $475.8 million (33 percent above 1991 net income) due to increased 1992 sales volume, a lower effective tax rate and lower interest expense. In connection with a major initiative to align its U.S. marketing divisions by its Levi's(R), Dockers(R) and Brittania(R) brands and greatly improve customer service, the Company is reorganizing and re-engineering its U.S. operations. This will result in significant capital investments, costs and risks (SEE ADDITIONAL INFORMATION SECTION). Net income for full year 1994 is expected to be significantly lower than 1993 mostly due to the effects of adopting Statement of Financial Accounting Standards (SFAS) No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions", slightly offset by the effects of adopting SFAS No. 109 "Accounting for Income Taxes," in 1994 (SEE BENEFIT PLANS SECTION AND PROVISION FOR TAXES CAPTION). Additionally, the Company expects dollar sales in 1994 to increase only slightly due to weak global economic conditions and cautious consumer spending. The results of the past three years indicate that certain operating expenses have been growing at a faster rate than sales. The Company has not been able to pass along all of its higher costs through price increases, thus lowering operating income margins. Operating costs associated with the Company's initiative to improve customer service and lower profit margins are also expected to negatively impact 1994 net income. NET SALES Record dollar sales for 1993 of $5.9 billion increased 6 percent over the prior year amount of $5.6 billion due to record unit sales and higher average unit selling prices. Unit sales and average unit selling prices for 1993 increased 3 percent over 1992. Sales in 1992 increased 14 percent over 1991 sales of $4.9 billion for the same reasons. Additionally, although fiscal year 1993 contained 52 weeks compared to 53 weeks in 1992, 1993 average weekly sales were approximately 8 percent higher than 1992 sales. U.S. dollar sales of $3.7 billion for 1993 increased 7 percent over the previous year amount of $3.5 billion mostly due to a 5 percent increase in average unit selling prices. However, higher order cancellations caused by the slow retail environment, increased prices on certain Company offerings and product competition (particularly private label and casual products), resulted in higher inventory levels of certain products during the year (SEE TRADE RECEIVABLES AND INVENTORIES CAPTION). These factors contributed to the decrease in U.S. dollar and unit sales for Dockers(R) products and the 501(R) family of products compared to 1992. In the U.S., the Company's top 25 retail customers currently account for approximately 64 percent of dollar sales, which was unchanged from the previous two years. U.S. dollar sales for 1994 are expected to decrease slightly from the 1993 amount due to anticipated decreases in unit sales of basic high margin products, based on current forecasts of the Company's markets, competition and consumer spending trends. Record dollar sales outside the U.S. of $2.2 billion for 1993 increased 4 percent over the 1992 amount of $2.1 billion due to record unit sales, which increased 8 percent from 1992. The Company's Europe division reported record unit sales, however, dollar sales were negatively impacted by the effects of unfavorable translation rates of certain European currencies to the U.S. Dollar for 1993 versus 1992. The Company's Asia Pacific division experienced record 1993 dollar sales due to record unit sales and favorable currency translation rates, compared to the previous year. The results in Europe and Asia Pacific reflect the continuing demand for the Company's basic denim products (particularly the 501(R) family of products). Overall dollar sales outside the U.S. are expected to grow in 1994. However, dollar sales may be adversely affected if the value of the U.S. Dollar versus European currencies strengthens, and by the weak economic conditions in many of the Company's markets. Total Company dollar sales for 1994 are expected to increase slightly from 1993, mostly due to non-U.S. dollar sales increases. However, overall unit sales are expected to decrease due to the projected lower U.S. unit sales results, which will more than offset increases in non-U.S. unit sales. GROSS PROFIT As a percent of sales, the 1993 gross profit percentage of 38 percent was flat with 1992 and 1991. In dollars, 1993 gross profit increased 5 percent compared to the prior year period, despite the continuing growth of product costs and the negative effects of certain foreign currency translation rates. The gross profit increase was primarily attributable to higher unit selling prices and unit sales. Gross profit for 1992, in dollars, increased 14 percent from 1991 due to higher average unit selling prices and higher unit sales that more than offset higher product costs. Generally, businesses outside the U.S. record higher gross profit as a percent of sales than businesses in the U.S., mostly due to higher overall average unit selling prices. The businesses outside the U.S. contributed 37 percent of total Company dollar sales and represented 54 percent of the Company's 1993 profit contribution before corporate expenses and taxes, compared to 53 percent in 1992 and 55 percent in 1991. Although average unit selling prices in the U.S. increased over the last year, 1993 U.S. gross profit margins were adversely affected by higher product costs for certain products. Overall production requirements in the U.S. were reduced late in the year due to high inventory levels of basic jeans products (SEE TRADE RECEIVABLES AND INVENTORIES CAPTION). To reduce and align inventory levels with projected sales, the Company incurred some excess production capacity costs at certain U.S. owned and operated plants. Consequently, the Company will produce a greater proportion of certain U.S. products at its owned and operated plants, as opposed to contractor production, in 1994 to mitigate the downtime at those plants. This change in production sourcing will negatively impact certain gross profits per unit. Additionally, expenses related to the continuing transition to team-based manufacturing and increases in U.S. sales of lower margin products, as opposed to higher margin products, will also impact gross profit. MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES Marketing, general and administrative expenses, as a percentage of sales, for 1993 were even with 1992 at 24 percent and one percentage point higher than 1991. Marketing, general and administrative expenses, in dollars, for 1993 increased 6 percent over 1992. This increase was mostly due to higher advertising, administrative, marketing and information resource expenses. Marketing, general and administrative expenses in 1992 increased 14 percent over 1991 for the same reasons. Advertising expense for 1993 increased 8 percent over 1992. This increase was substantially due to new U.S. and Europe advertising campaigns and increased point-of-sale and media advertising in Europe. Advertising expense in 1992 increased 22 percent over 1991 mostly due to Men's Jeans, Menswear and Youthwear campaigns. (SEE BUSINESS SECTION, UNDER ITEM 1, FOR ADDITIONAL INFORMATION.) Administrative expense for 1993 increased 8 percent from prior year. This increase was mostly due to expenses for new business development in Europe and Asia Pacific and higher office facility costs. Administrative expenses in 1992 increased 3 percent over 1991 mostly due to higher incentive compensation costs and non-U.S. business development costs that were partially offset by lower leverage buyout amortization expense (related to the 1985 acquisition of Levi Strauss & Co.). Marketing expense increased 7 percent from prior year, primarily due to additional U.S. merchandising personnel and higher costs associated with the use of sample products in the U.S. The Company also incurred costs associated with promoting higher visibility of its products at the retail level. Outside the U.S., particularly in Europe, costs increased proportionately with increases in unit sales. Marketing expense increased 33 percent in 1992 over 1991 mostly due to costs related to the use of more sample products and increases in retail coordinators in the U.S. Information resource expense for 1993 increased 8 percent from 1992 due to higher lease costs related to certain telecommunications equipment and depreciation related to new mainframe computer equipment. Additionally, higher programming and restructuring costs contributed to the 1993 increase. Information resource expense for 1992 increased 32 percent over 1991 due to increases in systems support, equipment acquisitions and rentals and development costs. Systems and software costs related to the Company's strategic initiative to increase customer service are expected to increase information resource expenses in 1994 (SEE ADDITIONAL INFORMATION SECTION). OTHER OPERATING (INCOME) EXPENSE, NET Other operating (income) expense, net for 1993 decreased $14.3 million from 1992 mostly due to anticipated costs related to the Company's initiative to improve customer service (which included potential losses for existing capital assets; SEE ADDITIONAL INFORMATION SECTION), costs related to idle facilities, relocating certain operations and establishing new operations outside the U.S. Other operating (income) expense, net for 1992 decreased $13.0 million from 1991 primarily due to higher licensee expenses and costs associated with idle facilities, which were partially offset by increased royalty income. Total operating expenses are expected to increase in 1994 due to continuing costs related to the Company's initiative on customer service (SEE ADDITIONAL INFORMATION SECTION). (SEE NOTE 1 TO CONSOLIDATED FINANCIAL STATEMENTS REGARDING THE RECLASSIFICATION OF CERTAIN 1992 AND 1991 AMOUNTS TO OTHER OPERATING (INCOME) EXPENSE, NET.) STOCK OPTION CHARGE During 1992, the Company offered a special payment arrangement under the 1985 Stock Option Plan to facilitate the exercise by optionholders of their outstanding options. Holders of 65 percent of all outstanding options participated in this arrangement. As a result of this arrangement, the Company recognized a pre-tax stock option charge of $158.0 million for all outstanding options during 1992. Separately, the Company also recorded compensation expense for related exercise bonuses and the accelerated use of presently non-vested options. Additionally, the Company disbursed $41.9 million to pay related withholding taxes for optionholders and $4.4 million for related exercise bonuses. A total of 532,368 shares of Class L treasury shares were reissued and 392,755 shares of treasury stock were retired. There are 499,749 options still outstanding and exercisable. The net change in Stockholders' Equity in 1992 due to these stock option transactions (including the after-tax effect of the stock option charge) was an increase of $9.2 million. INTEREST EXPENSE Interest expense decreased 30 percent from 1992 primarily due to lower 1993 average debt balances. Interest expense in 1992 was 25 percent lower than 1991 due to lower interest rates and lower average debt balances. Cash flows from operations were used to reduce debt levels over the last two years, resulting in the lower average debt balances. During 1993, the Company repaid debt on its primary and amended credit agreement and repaid and cancelled its outstanding Japanese Yen loan amounts. Additionally, the Company issued four series of notes payable to Class L stockholders in payment of dividends declared during the fourth quarter of 1992. The first series of notes were repaid during 1993. The interest associated with these notes has and is expected to have a minimal impact on interest expense. (SEE LIQUIDITY AND CAPITAL RESOURCES CAPTION.) During 1992, the Company repaid debt on its then primary credit agreement and redeemed and cancelled the remaining balance outstanding of its 14.45% Subordinated Notes due 2000. The average interest rate in 1993 was approximately 9 percent compared to 10 percent in 1992 and 1991. This decrease over the last year reflects the lower market for interest rates. The average interest rate also reflects the Company's use of interest rate swap transactions to hedge interest rate fluctuations. (SEE NOTE 6 TO THE CONSOLIDATED FINANCIAL STATEMENTS.) The Company expects 1994 interest expense related to borrowings to be lower than 1993 due to anticipated lower 1994 average debt levels (SEE LIQUIDITY AND CAPITAL RESOURCES CAPTION). OTHER INCOME, NET Other income, net increased $6.7 million in 1993 from the prior year period primarily due to lower interest rate swap termination costs and fewer terminations of lease agreements with tenants. This increase was partially offset by lower interest income on investments. (SEE NOTE 1 TO THE CONSOLIDATED FINANCIAL STATEMENTS REGARDING THE RECLASSIFICATION OF CERTAIN OTHER INCOME, NET AMOUNTS.) The $2.7 million decrease in other income, net for 1992 compared to 1991 was primarily attributable to losses incurred for the termination of several interest rate swap agreements. These swap agreements were terminated as a result of lower average debt levels. Lower interest income on investments in 1992, partially offset by lower net losses on foreign currency transactions, also contributed to the decrease. PROVISION FOR TAXES The increase in the 1993 provision for taxes compared to 1992 was substantially due to lower 1992 earnings caused by the stock option charge. The 1993 effective tax rate was 41 percent compared to 43 percent in 1992 and 47 percent in 1991. The reduction in the 1993 effective tax rate from 1992 was primarily due to the mix of non-U.S. and U.S. earnings and the negative effects of the one time stock option charge in 1992. The stock option charge produced a tax benefit of only 27 percent because of its negative impact on the utilization of foreign tax credits in 1992. In addition, the 1993 effective tax rate would have been lower, except for the 1993 U.S. tax bill that increased the U.S. statutory tax rate to 35 percent from 34 percent and, therefore, resulted in a 1 percent increase to the Company's 1993 full year effective tax rate. The reduction in the 1992 rate from 1991 reflected positive changes in the mix of non-U.S. and U.S. earnings. Additionally, the 1992 rate was favorably affected by a settlement reached with the Internal Revenue Service concerning transfer pricing issues, partially offset by the lower tax benefit provided by the stock option charge. The Company will comply in fiscal 1994 with the provisions of SFAS No. 109, which requires an asset and liability approach for financial accounting and reporting of income taxes. The Company will recognize a positive adjustment of $11.4 million upon adoption that will be recorded as a cumulative effect of a change in accounting principles on the Consolidated Statements of Income. (SEE NOTE 3 TO CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION.) EXTRAORDINARY ITEM - LOSS FROM EARLY EXTINGUISHMENT OF DEBT In 1992, the Company used cash generated from operations to purchase on the open market and subsequently cancel all remaining, $33.6 million, 14.45% Subordinated Notes due 2000. In 1991, the Company purchased and subsequently cancelled an aggregate of $97.1 million of the same notes either on the open market or in connection with a recapitalization plan (SEE NOTE 20 TO THE CONSOLIDATED FINANCIAL STATEMENTS). These transactions resulted in an extraordinary loss of $1.6 million in 1992 and $9.9 million in 1991, net of applicable income tax benefits. These losses also reflected accelerated amortization of previously capitalized issuance fees. FINANCIAL CONDITION AND LIQUIDITY The following discussion compares the liquidity position and certain balance sheet items of the Company as of year-end 1993 and 1992. TRADE RECEIVABLES AND INVENTORIES Trade receivables increased 18 percent from 1992 reflecting the 1993 dollar and unit sales records. The increase in trade receivables was also attributable to an increase in U.S. product pre-shipments to retailers during the fourth quarter of 1993. Additionally, the 1993 allowance for doubtful accounts, as a percent of receivables, was 13 percent lower than the 1992 percentage due to a higher number of account bankruptcies and credit failures in 1992. Inventories at year-end 1993 were 9 percent above prior year, mostly due to the build-up of U.S. basic core inventories. This build-up of inventory was primarily attributable to production planning that was based on strong sale results during the first quarter of 1993. However, as the year progressed, sales were not consistently strong and did not match the production output. Additionally, inventory levels increased due to slow 1993 Back-to-School and Holiday seasons, for most marketing divisions, and increased order cancellations. The higher order cancellations reflected the effects of the Company's higher selling prices for certain products and existing inventories at retailers due to a slow retail market. Also, retailers have been keeping less inventory on-hand and relying on suppliers to provide products on a more timely basis. In an effort to partially reduce the high inventory levels during the year, the Company incurred production downtime late in the year. At year-end 1993, unshipped orders were 13 percent below the previous year and order cancellations increased 30 percent, both due to the businesses in the U.S. These results reflect the reluctance of retailers to commit to orders far in advance. Additionally, lower consumer spending is expected to continue into 1994. The Company is currently evaluating its sourcing needs and plans to adjust future production accordingly. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment, net for 1993 increased 9 percent from year-end 1992. The increase in property, plant and equipment was due to capital expenditures that more than offset depreciation expense and retirements during the period. U.S. capital expenditures were related to office renovations, purchases of main-frame data processing equipment, and automation and ergonomic upgrades for the Company's U.S. production facilities. Outside the U.S., the Company upgraded and expanded several of its finishing and distribution facilities in Europe. Capital expenditures were $143.2 million in 1993 and $146.2 million in 1992. Approximately $15.0 million of 1993 capital expenditures related to the Company's initiative on customer service. At year-end 1993, the Company had capital expenditure purchase commitments outstanding of approximately $32.6 million. Approximately 67 percent of these commitments were for distribution center and equipment needs in Europe and approximately 13 percent were for equipment needs in North America. The remaining commitments are for general office and information system needs. The Company monitors the efficiencies of its facilities on an ongoing basis in conjunction with production requirements. The Company modernizes facilities and equipment as necessary and anticipates authorizations for capital expenditures of approximately $196.0 million for new 1994 projects, which does not include estimates related to the Company's initiative on customer service. Currently, actual spending on projects during the 1994 year is expected to be $165.0 million, not including spending related to the Company's initiative on customer service. Certain expenditures may be carried over to the following fiscal year based on timing of completion and spending limitations. Additionally, the Company expects to spend over $300.0 million during the next several years in connection with its initiative on customer service (SEE ADDITIONAL INFORMATION SECTION). WORKING CAPITAL Working capital of $1.0 billion at year-end 1993 increased $407.6 million from year-end 1992 and the current ratio increased to 1.9 from 1.5, respectively. The increase in working capital was mostly due to lower dividends payable, short-term borrowings and taxes payable and higher trade receivables and inventories. The increase in working capital was partially offset by increases in salaries, wages and employee benefits, mostly due to higher workers' compensation claims, and current maturities of a portion of dividend notes (SEE LIQUIDITY AND CAPITAL RESOURCES CAPTION). Working capital requirements for operations and other needs were minimally impacted by the higher inventory levels during the year (SEE TRADE RECEIVABLES AND INVENTORIES CAPTION). LIQUIDITY AND CAPITAL RESOURCES The increase of $15.0 million in cash and cash equivalents from year-end 1992 was primarily due to cash provided by operations. Cash provided by operations was mainly used for the net repayment of debt, capital expenditures and the payment of dividends. At year-end 1993, the Company's total outstanding debt balance was $145.8 million, 63 percent lower than year-end 1992. In the first quarter of 1993, the Company renegotiated, amended and restated its primary credit agreement to provide for a $500.0 million unsecured working capital facility. Under the amended credit agreement, the Company no longer pledges as collateral the outstanding shares of common stock of its subsidiaries and its trademarks. This credit agreement will expire in 1997, but is renewable by the Company, with the consent of the lending banks. Commitment fees are paid on the unused portion of the amounts available for borrowing. Under the amended credit agreement the interest rates and commitment fees on the working capital facility are lower and the financial and operating covenants are less stringent compared to the prior credit agreement. At the time the amended agreement was established, the Company had repaid all amounts outstanding ($195.0 million) on its prior credit agreement and subsequently borrowed $125.0 million on the amended credit agreement. Since that time, net repayments on the amended credit agreement have resulted in an outstanding balance of $50.0 million at year-end 1993. Additionally, the Company repaid all its outstanding 4.8 billion Japanese Yen loan amounts (U.S. dollar equivalent of $38.6 million) and cancelled the related credit line agreements during the first quarter of 1993. Partially offsetting the 1993 debt reductions were the issuance in December 1992 of four series of notes payable to Class L stockholders for partial payment of a dividend declared in November 1992. These notes are payable in four semi-annual installments commencing June 15, 1993 and collectively total $77.1 million. These notes bear an interest rate incrementally above the six-month Treasury Bill rate. At year-end 1993 the Company had repaid the first series of dividend notes payable to Class L stockholders for an aggregate amount of $18.0 million, plus accrued interest of $.4 million. Subsequent to year-end, the Company repaid the second series of dividend notes payable to Class L stockholders for an aggregate amount of $18.0 million, plus accrued interest of $.7 million (SEE NOTES 6 AND 22 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION). The Company expects 1994 debt levels to be lower than 1993. The Company plans to use a portion of cash generated from operations during 1994 for costs relating to the Company's initiative to improve customer service and for investments in retail joint ventures (SEE ADDITIONAL INFORMATION SECTION). The Company also has interest rate swap transactions. The net amounts paid or received under interest rate swap contracts is recognized as interest expense. Several interest rate swap transactions were cancelled during 1993 and 1992 due to lower average debt levels. The gains and losses recognized from these cancellations were recorded as other income, net. (SEE NOTE 6 TO THE CONSOLIDATED FINANCIAL STATEMENTS.) The Company uses forward and option currency contracts to reduce the risks of foreign currency fluctuations on its non-U.S. dollar denominated operations. The Company's market risk is directly related to fluctuations in the currency exchange rates. The Company's credit risk is limited to the currency rate differential for each agreement if a counterparty failed to meet the terms of the contract. The Company does not anticipate nonperformance by any counterparties. (SEE NOTES 1 AND 6 TO 8 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION.) For information regarding the sale of Class E common stock to the Company's employee investment plans, SEE NOTE 12 TO THE CONSOLIDATED FINANCIAL STATEMENTS. PAYMENT OF DIVIDENDS ON CLASS E STOCK In June 1993, the Board of Directors declared a dividend of $.55 per share (totaling $.7 million), which was paid on August 27, 1993 to Class E stockholders of record on July 30, 1993. On November 18, 1993, the Board of Directors declared a dividend of $.55 per share (totaling $.7 million), which was paid on December 15, 1993 to Class E stockholders of record on December 1, 1993. There were no dividends declared on Class L common stock during the year. (SEE NOTES 19 AND 22 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION.) OTHER LIABILITIES Other liabilities increased $85.7 million primarily due to increases in workers' compensation projections and certain pension and benefit plan estimates (SEE NOTE 17 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION). BENEFIT PLANS POSTRETIREMENT BENEFIT PLANS The Company will adopt SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" in fiscal 1994. Upon adoption of SFAS No. 106, the Company will recognize an expense to establish a "transition obligation," representing the value at the beginning of the year of the postretirement benefit obligation earned by employees and retirees in prior periods. Based on an actuarial valuation, the transition obligation is estimated to be $402.3 million before taxes and $248.4 million after taxes, when the Company adopts SFAS No. 106 at the beginning of fiscal 1994. The Company will recognize the entire transition obligation in 1994. This transaction will be recorded as a cumulative effect of a change in accounting principles, net of income taxes, on the Consolidated Statements of Income. Additionally, the Company will record an expense for 1994 service and interest costs, which is currently estimated to be $43.0 million. (SEE NOTE 11 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION.) HEALTH PLANS During 1993, a number of major proposals for U.S. health care reform legislation, including the Clinton Administration proposal, were introduced and are being considered by the U.S. Congress. Presently, the Company cannot accurately assess how these or similar legislation might financially impact the Company. The Company currently provides health and welfare benefits to its employees. ADDITIONAL INFORMATION STRATEGIC INITIATIVES The Company is in the process of examining and re-engineering various aspects of its brand marketing, customer service and operations/distribution strategies. These initiatives include: aligning the Company's U.S. marketing divisions according to its Levi's(R), Dockers(R) and Brittania(R) brands, developing a customer base and product distribution system that is consistent with its brand image, reconfiguring the organization from a functional to a process orientation, implementing a team-based approach to manufacturing, and investing in retail joint ventures. More broadly, the initiative involves fundamental changes in the way the Company operates its business. There are numerous commercial, operating, financial, legal and other risks and uncertainties presented by the design and implementation of such a program. Furthermore, the Company is not aware of undertakings of comparable magnitude in the apparel industry, and cannot predict with certainty the outcome of the initiative. Although there can be no assurance that the Company will successfully design and implement these new business processes, or that the costs of the initiative will not exceed estimates, the Company believes that the re-engineering initiative is essential to maintain and expand its business. Although many details and decisions regarding the organizational realignment and distribution system changes are currently being analyzed, the Company expects to complete this reorganization within the next few years. The Company expects to make capital expenditures of over $300.0 million during the next few years to support a new U.S. distribution network, expanded systems plans, organization and manufacturing changes. Additionally, the Company expects to spend approximately $200.0 million for transitional expenses, including software costs, possible impairment costs of existing facilities and equipment, training costs and other related expenses. All of these costs may be recognized ratably throughout the implementation period and/or as expenditures occur, depending on the nature of the cost and the decisions made related to this initiative. (SEE STRATEGIC INITIATIVES CAPTION OF THE BUSINESS SECTION, UNDER ITEM 1, FOR ADDITIONAL INFORMATION.) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information required by this item and not presented on the following pages is contained in the SUPPLEMENTAL FINANCIAL SCHEDULES that are included in this Form 10-K. CONSOLIDATED FINANCIAL STATEMENTS LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES For the Years Ended November 28, 1993, November 29, 1992 and November 24, 1991 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars In Thousands Except Per Share Data) (1) Fiscal years 1993 and 1991 each contained 52 weeks. Fiscal year 1992 contained 53 weeks. (2) Applicable income tax benefits for fiscal years 1992 and 1991 are $947 and $5,799, respectively. The accompanying notes are an integral part of these financial statements. Page 1 of 2 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) November 28, November 29, 1993 1992 ----------- ------------ The accompanying notes are an integral part of these financial statements. Page 2 of 2 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. Page 1 of 3 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. Page 2 of 3 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. Page 3 of 3 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in Thousands) The accompanying notes are an integral part of these financial statement. Page 1 of 2 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) The accompanying notes are an integral part of these financial statements. Page 2 of 2 LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) The accompanying notes are an integral part of these financial statements. LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Levi Strauss Associates Inc. (LSAI or the Company) and all subsidiaries. All significant intercompany items have been eliminated. DEPRECIATION AND AMORTIZATION METHODS Property, plant and equipment is carried at cost, less accumulated depreciation. Depreciation and amortization are computed on a straight-line basis over the estimated useful lives of the related assets. In the case of certain property under capital lease, depreciation is computed over the lesser of the useful life or the lease term. INCOME TAXES Deferred income taxes result from timing differences in the recognition of revenue, expense and credits for income tax and financial statement purposes. U.S. Federal income tax and foreign withholding taxes are provided on the undistributed earnings of non-U.S. subsidiaries to the extent that taxes on the distribution of such earnings would not be offset by tax credits. Effective November 29, 1993, the Company will adopt Statement of Financial Accounting Standards (SFAS) No. 109. This statement requires a change from the deferral method of accounting for income taxes under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. Under SFAS No. 109, deferred tax assets and liabilities are established at the balance sheet date in amounts that are expected to be recoverable or payable when the difference in the tax bases and financial statement carrying amounts of assets and liabilities ("temporary differences") reverse. The 1994 adoption will be recorded as a cumulative effect of a change in accounting principles on the Consolidated Statements of Income. POSTRETIREMENT BENEFIT PLANS The Company will adopt SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" at the beginning of fiscal 1994. Upon adoption of SFAS No. 106, the Company will recognize an expense to establish a "transition obligation", representing the value at the beginning of the year of the postretirement benefit obligation earned by employees and retirees in prior periods. This transaction will be recorded as a cumulative effect of a change in accounting principles, net of income taxes, on the Consolidated Statements of Income. Additionally, the Company will record an expense for 1994 service and interest costs. INCOME PER COMMON SHARE Income per common share is computed by dividing income (after deducting dividends on preferred stock) by the average number of common shares outstanding for the period. CASH EQUIVALENTS All highly liquid investments with an original maturity of three months or less are included as cash equivalents. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1 (CONTINUED) SIGNIFICANT ACCOUNTING POLICIES INVENTORY VALUATION Inventories are valued at the lower of average cost or market and include materials, labor and manufacturing overhead. Market is calculated on the basis of anticipated selling price less allowances to maintain the normal gross margin for each product. TRANSLATION ADJUSTMENT The functional currency for most of the Company's foreign operations is the applicable local currency. For those operations, assets and liabilities are translated into U.S. dollars at period-end exchange rates, and income and expense accounts are translated at average monthly exchange rates. Net exchange gains or losses resulting from such translation are accumulated as a separate component of stockholders' equity. The U.S. dollar is the functional currency for foreign operations in countries with highly inflationary economies, for which both translation adjustments and gains and losses on foreign currency transactions are included in other income, net. FOREIGN EXCHANGE CONTRACTS The Company enters into foreign exchange contracts to hedge against known foreign currency denominated exposures, particularly dividends and intracompany royalties from its foreign affiliates and licensees. Market value gains and losses on hedge instruments are recognized and offset foreign exchange gains or losses on existing exposures. The effects of exchange rate changes on transactions designated as hedges of net investments are included in the separate component of stockholders' equity. At November 28, 1993, the net effect of exchange rate changes due to net investment hedge transactions was a $9.1 million increase to translation adjustment. AMENDMENTS AND RECLASSIFICATIONS During 1993, the Company filed with the Securities and Exchange Commission an amendment to its 1992 Form 10-K, under the cover of Form 10-K/A. The Form 10-K amendments reclassified the 1992 stock option charge as an operating expense and reclassified amounts related to the amortization of goodwill and intangibles and losses related to property, plant and equipment from other income, net to marketing, general and administrative expenses on the Consolidated Statements of Income. These reclassifications did not affect net income. Separately, a new line item, other operating (income) expense, net was created for the 1993 Consolidated Statements of Income. This new line includes certain operations-related items that were classified as other income, net or marketing, general and administrative expenses. The other operating (income) expense, net line represents operating income or expense items that are not related to marketing, general and administrative expenses. Certain 1992 and 1991 items have been reclassified to conform to the 1993 presentation format. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2 OPERATIONS The following table presents information concerning U.S. and non-U.S. operations (all in the apparel industry). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2 (CONTINUED) OPERATIONS Gains or losses resulting from certain foreign currency hedge transactions are included in other income, net, and amounted to losses of $10.0 million, $10.2 million and $19.7 million for 1993, 1992 and 1991, respectively. NOTE 3 INCOME TAXES The U.S. and non-U.S. components of income before taxes and extraordinary loss are as follows: The provision for taxes consists of the following: - ----------------- Components of the prior year income tax provision have been reclassified from current to deferred to conform to the current year's presentation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3 (CONTINUED) INCOME TAXES At November 28, 1993, cumulative non-U.S. operating losses of $9.7 million generated by the Company are available to reduce future taxable income primarily between the years 1995 and 1998. The Company has utilized all of its remaining foreign tax credit carryforwards in 1993. Income tax expense (benefit) included in translation adjustment was $(0.1) million, $(8.1) million and $(2.8) million for 1993, 1992 and 1991, respectively. The approximate tax effects of timing differences giving rise to deferred income tax expense (benefit) result from: The Company's effective income tax rate in 1993, 1992 and 1991 differs from the statutory federal income tax rate as follows: (1) The stock option charge, which occurred during the third quarter of 1992, produced a tax benefit of only 27.2 percent in 1992 because of its negative impact on the current utilization of foreign tax credits. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 3 (CONTINUED) INCOME TAXES In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes," which requires an asset and liability approach for financial accounting and reporting of income taxes. The Company will comply with the provisions of SFAS No. 109 during the first quarter of fiscal 1994. Preliminary review indicates that adoption will result in a $11.4 million credit to net income. The adoption will be recorded as a cumulative effect of a change in accounting principles on the Consolidated Statements of Income. The Company does not expect the tax aspects of the Omnibus Budget Reconciliation Act of 1993 that was signed into law by President Clinton on August 10, 1993 to materially affect the Company's future tax expense. The primary impact of the new tax law is a one percent increase in the statutory tax rate. The U.S. consolidated tax returns of the Company for 1983 through 1985 are under examination by the Internal Revenue Service (IRS). The audit includes the review of certain transactions of the 1985 leveraged buyout. The Company believes it has made adequate provision for income taxes and interest, which may become payable upon settlement. The IRS has not yet concluded its audit and a settlement has not been negotiated. NOTE 4 PROPERTY, PLANT AND EQUIPMENT The components of property, plant and equipment, including both leased and owned assets stated at cost, are as follows: The Company has idle facilities and equipment (all in the U.S.), including closed plants and certain other properties, that are not being depreciated. The book value of these idle facilities and equipment was $30.6 million at November 28, 1993 and November 29, 1992. The carrying values of idle facilities and equipment are not in excess of net realizable value. These facilities are being offered for sale or lease. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 4 (CONTINUED) PROPERTY, PLANT AND EQUIPMENT Depreciation expense for 1993, 1992 and 1991 was $85.5 million, $73.1 million and $59.2 million, respectively. The Company plans to spend over $300.0 million for capital expenditures over the next few years in conjunction with its initiative to improve customer service. (SEE BUSINESS SECTION, UNDER ITEM 1, FOR ADDITIONAL INFORMATION.) NOTE 5 INTANGIBLE ASSETS The components of intangible assets are as follows: Goodwill, resulting from the 1985 acquisition of Levi Strauss & Co. by Levi Strauss Associates Inc., is being amortized through the year 2025. Acquisition intangibles include trained workforce, leasehold interest, research and development, and licenses that were valued as a result of the acquisition. Tradenames were also valued as a result of the acquisition. Intangible pension asset is not amortized, but is adjusted each year to correspond to changes in the amount of minimum pension liability. Amortization expense for 1993, 1992 and 1991 was $24.0 million, $24.0 million and $47.8 million, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6 DEBT AND LINES OF CREDIT Debt and unused lines of credit are summarized below: PRIMARY CREDIT AGREEMENT During 1993, the Company renegotiated, amended and restated its primary credit agreement to provide for a $500.0 million unsecured working capital facility. Under the amended credit agreement, the Company no longer pledges as collateral the outstanding shares of common stock of its subsidiaries and its trademarks. This credit agreement will expire in 1997, but is renewable by the Company with the consent of the lending banks. Commitment fees are paid on the unused portion of the amounts available for borrowing. Under the amended credit agreement, the interest rates and commitment fees are lower than the prior credit agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6 (CONTINUED) DEBT AND LINES OF CREDIT PRIMARY CREDIT AGREEMENT (CONTINUED) The primary credit agreement requires the Company to maintain minimum levels of working capital, net worth, interest coverage and other ratios. Additionally, the net worth ratio takes into account the effects of SFAS No. 106 on the Consolidated Financial Statements (SEE NOTE 11). All borrowings under the primary credit agreement bear interest based on either the lending banks' base rate, the certificate of deposit rate or the LIBOR rate (at the Company's option) plus an incremental percentage. Interest rates on borrowings related to the primary credit agreement ranged from 3.6 percent to 6.0 percent during 1993. The Company's prior primary credit agreement provided a $500.0 million working capital line. The borrowings against the Company's working capital line were secured by the outstanding shares of common stock of its principal subsidiary, Levi Strauss & Co. and a wholly owned subsidiary, Brittania Sportswear Ltd., and by its United States and Canadian trademarks. JAPANESE YEN CREDIT LINE AGREEMENTS In 1993 the Company repaid all its outstanding 4.8 billion Japanese Yen loan amounts (U.S. dollar equivalent of $38.6 million at the time of repayment) and subsequently cancelled its two unsecured line of credit agreements with two Japanese banks for a total of 6.9 billion Japanese Yen. OTHER DEBT During 1993, the Company issued four series of notes payable collectively totaling $77.1 million to Class L stockholders in partial payment of a dividend declared in November 1992. These notes are payable in four semi-annual installments commencing June 15, 1993 and bear an interest rate incrementally above the six-month Treasury Bill rate. On June 15, 1993, the Company repaid the first series of dividend notes to Class L stockholders for an aggregate amount of $18.0 million, plus accrued interest of $.4 million. Subsequent to year-end on December 15, 1993, the Company repaid the second series of dividend notes to Class L stockholders for an aggregate amount of $18.0 million, plus accrued interest of $.7 million. PRINCIPAL DEBT PAYMENTS The required aggregate long-term debt principal payments, excluding capitalized leases, for the next five years are as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6 (CONTINUED) DEBT AND LINES OF CREDIT SHORT-TERM CREDIT LINES AND STAND-BY LETTERS OF CREDIT The Company has unsecured and uncommitted short-term credit lines available at various interest rates from various U.S. and non-U.S. banks. These credit arrangements may be cancelled by the lenders upon notice and generally have no compensating balance requirements or commitment fees. The Company has $98.2 million of funds available through standby letters of credit with various international banks. The majority of these agreements serve as guarantees by the creditor banks to cover workers' compensation claims. The Company pays fees on the standby letters of credit and any borrowings against the letters of credit are subject to interest at various rates. INTEREST RATE SWAPS The Company enters into interest rate swap transactions to hedge existing floating-rate or fixed-rate liabilities for fixed rates or floating rates. The net interest to be received or paid on the transactions is recorded as an adjustment to interest expense. In 1993, due to lower average debt levels, the Company terminated $100.0 million of interest rate swap agreements and assigned to a third party a $50.0 million interest rate swap agreement that hedged fixed-rate liabilities for floating rates. Additionally, the Company terminated $50.0 million and assigned to a third party $50.0 million of interest rate swap agreements that hedge floating- rate liabilities for fixed rates. This assignment became effective during the fourth quarter of 1993. The Company also terminated a $25.0 million one-way floating-rate swap transaction. These 1993 transactions resulted in a net gain of $.4 million that was classified as other income, net. At year-end 1993, the Company had $100.0 million of interest rate swaps that hedge floating-rate liabilities for fixed rates. In 1992, the Company entered into swap transactions to hedge $50.0 million of existing floating-rate liabilities for fixed rates, swap transactions to hedge $200.0 million of fixed-rate liabilities for floating rates and a one-way floating-rate swap transaction to hedge $25.0 million of floating-rate liabilities. The 1992 swap transactions ranged in maturity from two to four years and were entered into to offset previous existing swap transactions and take advantage of lower interest rates. Due to lower average debt levels in the latter part of the 1992 fiscal year, the Company terminated $150.0 million of swap agreements for a net loss of $5.6 million, included in other income, net. The Company is subject to credit risk exposure from nonperformance of the counterparties to the swap agreements. However, these counterparties are credit-worthy financial institutions and the Company does not anticipate nonperformance. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 7 COMMITMENTS AND CONTINGENCIES The Company has forward currency contracts to buy the aggregate equivalent of $192.3 million of the following foreign currencies: Japanese Yen, Spanish Pesetas, Netherlands Guilders, Italian Lire, British Pounds, Finnish Markkaa, German Marks, Swiss Francs and Belgian Francs. The Company has forward currency contracts to sell the aggregate equivalent of $962.1 million of the following foreign currencies: Japanese Yen, Swedish Kroner, Spanish Pesetas, Norwegian Kroner, Netherlands Guilders, Italian Lire, British Pounds, Finnish Markkaa, French Francs, Danish Kroner, German Marks, Swiss Francs and Belgian Francs. These contracts are at various exchange rates and expire at various dates through 1996. The Company's market risk is directly related to fluctuations in the currency exchange rates. In addition, the Company has the right to sell Japanese Yen for $10.0 million. This contract expires in March 1995. The Company's credit risk is limited to the currency rate differential for each agreement, if a counterparty failed to meet the terms of the contract. These instruments are executed with credit worthy financial institutions and the Company does not anticipate nonperformance by the counterparties. SEE NOTE 8 FOR ADDITIONAL INFORMATION. The Company evaluates environmental liabilities on an ongoing basis and, based on currently available information, does not consider any environmental exposure to be material. Additionally, the Company does not consider any pending legal proceedings to be material. NOTE 8 FAIR VALUE OF FINANCIAL INSTRUMENTS In 1993, the Company adopted SFAS No. 107 "Disclosures About Fair Value of Financial Instruments." This statement requires companies to disclose the fair value of certain financial instruments, as well as the methods and assumptions used to estimate the fair value. The estimated fair value amounts have been determined by the Company, using available market information and appropriate valuation methodologies. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The carrying amount and estimated fair value of the Company's financial instruments, on the balance sheet, at November 28, 1993 are as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8 (CONTINUED) FAIR VALUE OF FINANCIAL INSTRUMENTS Quoted market prices or dealer quotes are used to determine the estimated fair value of the majority of interest rate swap agreements, forward exchange contracts and option contracts. Other techniques, such as the discounted value of future cash flows, replacement cost, and termination cost have been used to determine the estimated fair value for long term debt and the remaining financial instruments. The estimated fair value of the ESAP common stock is based on the latest valuation of Class E common stock. The carrying values of cash and cash equivalents, trade receivables, current assets, current maturities of long-term debt, short-term borrowings, taxes and dividends payable are assumed to approximate fair value. All investments mature in 90 days or less, therefore the carrying values are considered to approximate market value. The fair value estimates presented herein are based on pertinent information available to the Company as of November 28, 1993. Although the Company is not aware of any factors that would substantially affect the estimated fair value amounts, such amounts have not been updated since that date and, therefore, the current estimates of fair value at dates subsequent to November 28, 1993 may differ substantially from these amounts. Additionally, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 9 LEASES The Company is obligated under both capital and operating leases for facilities, office space and equipment. At November 28, 1993, obligations under long-term leases are as follows: The total minimum lease payments on capital and operating leases have not been reduced by estimated future income of $19.3 million from noncancelable subleases. In general, leases relating to real estate include renewal options of up to 20 years. Some leases contain escalation clauses relating to increases in executory costs. Certain operating leases provide the Company with an option to purchase the property after the initial lease term at the then-prevailing market value. Rental expense for 1993, 1992 and 1991 was $75.1 million, $67.1 million and $60.4 million, respectively. NOTE 10 RETIREMENT PLANS The Company has numerous non-contributory defined benefit retirement plans covering substantially all employees. It is the Company's policy to fund its retirement plans based on actuarial recommendations consistent with applicable laws and income tax regulations. Plan assets are invested in a diversified portfolio of securities including stocks, bonds, real estate NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10 (CONTINUED) RETIREMENT PLANS investment funds and cash equivalents. The weighted average expected long-term rate of return on assets is 9.0 percent. Benefits payable under the plans are based on either years of service or final average compensation. The funded status of the plans, as of November 28, 1993 and November 29, 1992, reconciles with amounts recognized on the balance sheet as follows: The unrecognized net liability at transition (established 1988) is being amortized primarily on a straight-line basis over 15 years. Past service costs are amortized on a straight line basis over the average remaining service period of employees expected to receive benefits. The weighted average discount rate and the rate of increase in future compensation levels used to determine the actuarial present value of the projected benefit obligations for the plans were 6.6 percent and 6.0 percent, respectively, for 1993, 7.6 percent and 7.0 percent, respectively, NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 10 (Continued) RETIREMENT PLANS for 1992 and 8.1 percent and 7.0 percent, respectively, for 1991. Changes in the discount rate and the rate of increase in future compensation levels used to measure the 1993 pension obligations resulted in increases to those obligations as compared to the prior year. During 1993, the Company recorded minimum liabilities of $21.4 million for three of its pension plans. The Company also recorded a corresponding intangible asset of $4.8 million and, for two of its pension plans where the required intangible asset exceeded its related prior service costs, an adjustment to stockholders' equity of $16.6 million. Net pension expense includes the following components: NOTE 11 POSTRETIREMENT BENEFIT PLANS Currently, the Company provides certain health care and life insurance benefits for substantially all active and retired employees through both insured and self-insured programs. The Company recognizes the cost of providing these benefits by charging to expense the annual self-insured claims and insurance premiums amounting to $80.3 million, $71.7 million and $59.9 million in 1993, 1992 and 1991, respectively. The cost of providing these benefits for retirees (approximately 9.3 percent of the total receiving these benefits) is not readily separable from the cost of providing benefits for active employees. During 1993, a number of major proposals for U.S. health care reform legislation, including the Clinton administration proposal, were introduced and are being considered by the U.S. Congress. Presently, the Company cannot accurately assess how these or similar legislation might financially impact the Company. The Company will adopt SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" effective November 29, 1993. This statement requires the Company to accrue postretirement benefits (other than pensions), including health care and life insurance benefits for retired employees over the period that an employee becomes fully eligible for benefits. Currently, the Company uses a "pay-as-you-go" method whereby expenses are recorded as claims are incurred. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 11 (Continued) POSTRETIREMENT BENEFIT PLANS Upon adoption of SFAS No. 106, the Company will record a one-time, non-cash charge against earnings of $402.3 million before taxes and $248.4 million after taxes. This transition obligation represents the actuarially determined value at November 29, 1993 of the present value of the postretirement benefit obligation earned by employees and retirees in prior periods. The transition obligation will be recorded in 1994 as a cumulative effect of a change in accounting principles, net of income tax effects, on the Consolidated Statements of Income. Also, the change in accounting will result in an additional annual expense for service and interest cost, which is currently estimated to be $43.0 million for 1994. NOTE 12 EMPLOYEE INVESTMENT PLANS The Company maintains three employee investment plans. The Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc. (ESAP) is a non- qualified employee equity program for highly compensated (as defined by the Internal Revenue Code) employees. The Employee Investment Plan of Levi Strauss Associates Inc. (EIP) and the Levi Strauss Associates Inc. Employee Long-Term Investment and Savings Plan (ELTIS) are two qualified plans that cover non- highly compensated Home Office employees and U.S. field employees. ESAP Under the ESAP, eligible employees may invest up to 10 percent of their annual compensation, through payroll deductions, to directly purchase and hold shares of Class E common stock. Employee contributions are made on an after-tax basis. The Company may match 75 percent of the contributions made by employees in stock. Employees are always 100 percent vested in the Company match. Employees may elect to have their withholding taxes deducted from their match shares contributed by the Company. There are various put, call and first refusal rights associated with Class E common stock obtained through the ESAP. The ESAP generally prohibits all transfers of shares other than to the Company. Put rights associated with ESAP entitle participants to sell shares back to the Company in specified circumstances subject to certain restrictions and penalties. It also entitles the Company to buy back shares upon termination of the participant's employment. In all cases, shares are repurchased at the current appraised value of the shares during the semi-annual employee purchase periods. The intent of ESAP is to be a long-term investment plan and therefore the Company does not expect to repurchase large amounts of ESAP shares at any given time. SEE NOTE 19 FOR STOCK VALUATION INFORMATION. Shares held by participants of the ESAP are classified outside stockholders' equity due to the put rights attached to Class E common stock sold through the ESAP. There were no Class E common stock shares offered for purchase to ESAP participants prior to 1992. The redemption value at the time of repurchase would be based on the latest valuation of Class E common stock. In 1991, the Company registered 5,000,000 additional shares of Class E common stock under the Securities Act of 1933 for sale by the Company under the ESAP. This plan was adopted as part of the 1991 recapitalization (SEE NOTE 20). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 12 (Continued) EMPLOYEE INVESTMENT PLANS ESAP (Continued) The following summary presents ESAP activity for the years ended November 28, 1993, November 29, 1992 and November 24, 1991: (1) includes adjustment due to the reissuance of treasury stock purchased in On January 12, 1994, employees under ESAP purchased 31,840 shares of Class E common stock from the Company, also at $114 per share. The Company contributed approximately 19,512 matching shares before taxes to these employees at a cost of approximately $2.2 million, which is mostly included in fiscal 1993 compensation expense. EIP/ELTIS Under the qualified plans, eligible employees may contribute up to 10 percent of their annual compensation to various investment funds, including a fund that invests in Class E common stock. The Company may match 50 percent of the contributions made by employees to the fund that invests in Class E common stock. Effective for fiscal 1994 contributions, the Company may match 50 percent of the contributions made by employees to all funds maintained under the qualified plans. The additional compensation expense associated with this change is expected to be minimal. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 12 (Continued) EMPLOYEE INVESTMENT PLANS EIP/ELTIS (Continued) Employees are always 100 percent vested in the Company match. The ELTIS also includes a company profit sharing provision with payments made at the sole discretion of the Board of Directors. The EIP allows employees a choice of either pre-tax or after-tax contributions. Employee contributions under the ELTIS are on a pre-tax basis only. During 1993, the qualified plans collectively purchased 47,351 shares and 14,436 shares at $116 and $138 per share, respectively, as determined by the valuation of an independent investment banking firm at the time of purchase (the $116 price was based on the independent valuation of $119 per share, less a $3 per share dividend paid after the valuation was issued but before the stock purchase). In addition, the Company contributed 38,263 shares to these plans. During 1992, the qualified plans purchased 35,997 shares and 13,283 shares at $84 and $122 per share, respectively, and the Company contributed 78,867 matching shares; during 1991, the qualified plans purchased 218,563 shares at $74 per share and the Company contributed 193,193 matching shares (which included a special additional match). It is the Company's intent to have semi-annual sales of Class E common stock to the EIP, ELTIS and ESAP. However, the frequency of these sales may be dependent upon business and economic conditions. On January 12, 1994, EIP and ELTIS purchased 10,208 shares of Class E common stock from the Company at $114 per share as determined by the valuation of an independent investment banking firm. In addition, the Company contributed 16,937 shares (which included a portion related to ELTIS profit sharing) to these plans at a cost of $1.9 million, which is mostly included in fiscal 1993 compensation expense. OTHER PLANS The Company has an Interim Cash Performance Sharing Plan for Home Office payroll employees and a Field Profit Sharing Award Plan for U.S. field employees. These cash plans pay out a percentage of covered compensation based on certain Company earnings criteria as approved by the Board of Directors. The aggregate cost of providing all aspects of these plans, along with other savings and compensation plans in 1993, 1992 and 1991 were $45.4 million, $46.0 million and $53.0 million, respectively. NOTE 13 MANAGEMENT INCENTIVE PLAN The Company's Management Incentive Plan ("MIP") provides selected employees with incentive compensation and provides a tool for recruiting and retaining selected employees. Under the MIP, the Personnel Committee of the Board of Directors, as administrator of the MIP, may NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 13 (Continued) MANAGEMENT INCENTIVE PLAN award discretionary cash payments to selected employees. Such awards are made on the basis of various factors, including profit levels, return on investment, salary grade and individual performance. The amounts charged to expense for the MIP in 1993, 1992 and 1991 were $13.8 million, $12.8 million and $11.9 million, respectively. NOTE 14 LONG-TERM PERFORMANCE PLAN The Company has a Long-Term Performance Plan ("LTPP"), to provide incentive and reward performance over time and potential future contributions, for certain directors, officers and key employees. Under this plan, a number of performance units are granted to each participant. The value assigned to each unit is based on the Company achieving a target performance measure over a three-year period, as determined by a committee of the Board of Directors. Awards are paid in one- third increments on the third, fourth and fifth anniversaries of the date of the grant. The amounts charged to expense for the plan in 1993, 1992 and 1991 were $25.7 million, $27.9 million and $22.1 million, respectively. NOTE 15 EXECUTIVE STOCK APPRECIATION RIGHTS PLAN During 1992, the Board of Directors approved the Levi Strauss Associates Inc. Executive Stock Appreciation Rights Plan. A total of 114,000 stock appreciation rights (SARs) were granted in 1992 to certain executives at an initial grant value of $84 per SAR. These SARs vest over several years and become exercisable commencing in 1995. The amounts charged to expense for the plan in 1993 and 1992 were $.9 million and $.5 million, respectively. NOTE 16 STOCK OPTION PLAN The Company has a 1985 Stock Option Plan (the "Plan") for Class L common stock (previously Class F common stock, SEE NOTE 20) under which options are granted at an exercise price determined on the date of grant by a committee of the Board of Directors. Options under the Plan expire ten years from the date of grant and become exercisable as determined by the committee. In 1992, the Board of Directors approved a special payment arrangement under the Plan to facilitate the exercise by optionholders of their outstanding options. This arrangement accelerated vesting on all non-vested options and allowed each optionholder to exercise outstanding options by surrendering a portion of these outstanding options in full payment of the exercise price and related tax obligations. Holders of 65 percent of all outstanding options participated in this arrangement. The special arrangement required the recognition of a fiscal 1992 pre-tax stock option charge of $158.0 million for all outstanding options (the amount equal to the difference between the fair market value of the underlying shares at the exercise date and at the grant date). Separately, the Company also recognized compensation expense for related exercise bonuses and the accelerated use of presently non-vested options. The Company NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16 (CONTINUED) STOCK OPTION PLAN disbursed $41.9 million to pay related withholding taxes for optionholders (in exchange for an equal amount of surrendered options) and $4.4 million for related exercise bonuses. The optionholders participating in this arrangement exercised 925,123 options resulting in 532,368 reissued treasury shares of Class L common stock. The Company also retired 392,755 shares of treasury stock, which was equal to the number of options surrendered. The net change in Stockholders' Equity (including the after-tax effect of the stock option charge) was an increase of $9.2 million. During 1991, non-vested options were accelerated to attain immediate 50 percent vesting. Also, during 1991, cash bonuses totaling $1.6 million were paid on the exercise of options that were granted in 1985 and 1987. The following summary presents stock option activity for the years ended November 24, 1991, November 29, 1992 and November 28, 1993: NOTE 17 OTHER LIABILITIES The components of other liabilities are as follows: NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) NOTE 17 (CONTINUED) OTHER LIABILITIES Accrued workers compensation expense and accrued expenses related to the Company's program that provides for early identification and treatment of employee injuries are included in Workers' Health and Safety. Deferred employee benefits include accrued liabilities for the Company's long-term performance plan, deferred compensation, benefit restoration, pension and other plans. NOTE 18 SERIES A PREFERRED STOCK At November 28, 1993, there were no shares of Series A preferred stock outstanding. During 1992, the Company redeemed for cash and permanently retired all outstanding shares of Series A preferred stock at $170 per share, for an aggregate of $82.3 million, plus accrued and unpaid dividends of $1.1 million. The Company used cash from operations to purchase the shares. Dividend distributions of $4.3 million and $7.5 million were paid in 1992 and 1991, respectively. NOTE 19 COMMON STOCK RESTATED CERTIFICATE OF INCORPORATION During 1993, holders of a majority of outstanding shares (approximately 60 percent) of the Company approved, by written consent, an amendment and restatement of the Company's Certificate of Incorporation (the "Restatement"). The Restatement simplifies and shortens the capital stock provisions of the Certificate of Incorporation. It removes the Company's authority to issue, and eliminates all references to, Class F common stock, Series A preferred stock and Series B preferred stock. It does not affect any provisions relating to Class E common stock or Class L common stock, or make any other changes in the Certificate of Incorporation. Currently, the Company has an authorized capital structure consisting of: 270,000,000 shares of common stock, par value $.10 per share, of which 100,000,000 shares are designated Class E common stock and 170,000,000 shares are designated Class L common stock; plus 10,000,000 shares of preferred stock, par value $1.00 per share. Class L common stock is subject to a stockholders' agreement (expiring in April 2001), which limits transfers of the shares. The outstanding shares of Class E common stock are subject to restrictions on transfer imposed by the EIP, ELTIS and ESAP. DIVIDENDS During 1993, there were no dividends declared on Class L common stock. On November 18, 1993, the Board of Directors declared a dividend of $.55 per share (totaling $.7 million), which was paid on December 15, 1993 to Class E stockholders of record on December 1, 1993. In June 1993, the Board of Directors declared a dividend of $.55 per share, for an aggregate of $.7 million, which was paid on August 27, 1993 to Class E stockholders of record on July 30, 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 19 (CONTINUED) COMMON STOCK DIVIDENDS (CONTINUED) In November 1992, the Board of Directors declared a dividend of $3.00 per share (totaling $2.9 million), which was paid on December 15, 1992, to Class E stockholders of record on December 1, 1992. Also in November 1992, the Board of Directors declared a dividend of $3.00 per share to Class L stockholders of record on December 1, 1992, $1.50 of which (totaling $77.1 million) was paid on December 15, 1992 and $1.50 of which (totaling $77.1 million) is payable in four semi-annual installments commencing June 15, 1993. The notes issued for these dividends bear an interest rate incrementally above the six-month Treasury Bill rate. In June 1992, the Board of Directors declared a common stock dividend of $.40 per share (totaling $21.0 million), which was paid on August 14, 1992, to Class E and Class L stockholders of record on July 31, 1992. In November 1991, the Board of Directors declared a dividend of $.20 per share (totaling $10.3 million) on both Class E and Class L common shares to stockholders of record on December 2, 1991, which was paid on December 16, 1991. In November 1990, a $.525 per share dividend (totaling $31.6 million) was declared on both Class E and Class F common shares to stockholders of record on November 30, 1990, which was paid on December 14, 1990. The declaration of future dividends on Class E and Class L common stock is within the discretion of the Board of Directors of the Company and will depend upon business conditions, earnings, the financial condition of the Company and other factors. It is the Company's intent to not pay another Class L dividend until after the Class L dividend notes have been repaid. TREASURY STOCK REISSUANCE/RETIREMENT As a result of the special payment arrangement under the 1985 Stock Option Plan (SEE NOTE 16), 532,368 shares of Class L treasury stock were reissued and 392,755 shares of Class L treasury stock were retired during 1992. The net change in Stockholders' Equity (including the after-tax effect of the stock option charge) was an increase of $9.2 million. The Company permanently retired 15,595,552 shares of Class L treasury stock during 1991, which resulted in a $553.7 million charge to retained earnings; however, the retirement of treasury stock had no effect on total stockholders' equity. COMMON STOCK - EMPLOYEE INVESTMENT PLANS Class E common stock held by participants of the ESAP (SEE NOTE 12) are classified outside stockholders' equity due to the put rights attached to ESAP Class E common stock sold. There were no Class E common shares offered for purchase to ESAP participants prior to 1992. The redemption amount of common stock sold through the ESAP represents the latest independent valuation of $114 per share. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 19 (CONTINUED) COMMON STOCK COMMON STOCK - EMPLOYEE INVESTMENT PLANS (CONTINUED) Class E common stock is appraised, usually twice a year, by an independent investment banking firm. The latest appraised value of Class E common stock is used as the price for selling or repurchasing Class E common stock from the EIP and ELTIS trustee and ESAP participants. The latest appraised value of Class E common stock is also used as the value for Class L common stock. The investment firm is instructed to value stock as though there had been a public trading market for the stock on the valuation date, and to not give consideration to an acquisition or control premium, or to a private market discount. There is, however, no assurance that the Company's stock would trade at the price determined through the independent investing banking firm valuation had there been a public trading market for the shares on the valuation date. NOTE 20 RECAPITALIZATION In 1991, the Company completed a series of transactions in accordance with a recapitalization plan. These transactions included, among other things, substantial new borrowings and financial arrangements and the exchange and repurchase of certain capital stock. The purpose of this recapitalization plan was to facilitate the Company's ability to remain independent, thereby eliminating the pressures that may be created by public ownership to focus on short-term rather than long-term performance, and to preserve family control and ownership. Summary descriptions of various transactions completed in 1991 as part of the recapitalization are as follows: The Company repurchased $84.8 million in principal amount (or approximately 71 percent of $118.7 million) of the Company's then outstanding 14.45% Subordinated Notes due 2000. Tendering note holders consented to an amendment to the indenture governing the notes, thereby eliminating a covenant restriction on dividend payments, stock repurchases and other distributions to stockholders. The transaction also involved payments totaling $.4 million to non-tendering holders who consented to the indenture amendment, which deletes restrictions on dividends and distributions. In 1991, an additional $12.3 million of these notes were repurchased on the open market. The 1991 premiums paid and a pro rata portion of the associated unamortized costs of $9.9 million, net of applicable income tax benefits, were reported as an extraordinary loss on early extinguishment of debt. During 1992, all remaining amounts, of $33.6 million, of these notes were repurchased or redeemed and cancelled by the Company. The premiums paid and a pro rata portion of the associated unamortized costs of $1.6 million, net of the applicable income tax benefits, were reported as an extraordinary loss on early extinguishment of debt. The Company entered into a new primary credit agreement which provided for a $300.0 million term loan to be repaid over six years and a working capital line of credit of $500.0 million. This primary credit agreement required the Company to pledge certain of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 20 (CONTINUED) RECAPITALIZATION its assets, including its material trademarks, and contains certain financial and operating restrictions. During 1993, the primary credit agreement was replaced with a new reducing revolving line of credit (SEE NOTE 6). The Company repurchased 8,333,330 shares of Class F common stock (or approximately 14 percent of the total outstanding common shares) at $54 per share, for an aggregate purchase price of $450.0 million. The Company issued 1,416,623 shares of Series B preferred stock at $54 per share in exchange for the same number of shares of Class F common stock. Subsequent to the recapitalization, all shares of Series B preferred stock were redeemed and permanently retired during 1992 at $54 per share for an aggregate of $76.5 million, plus accrued and unpaid dividends of $3.2 million. Dividend distributions of $3.2 million and $1.5 million were paid in 1992 and 1991, respectively. The Company issued shares of Class L common stock in exchange for all of the remaining shares of Class F common stock. The Class L common stock is subject to a new stockholders' agreement limiting transfers of the shares. The agreement expires in April 2001. The Company adopted a new non-qualified employee equity program (SEE NOTE 12). The Company amended its Certificate of Incorporation (SEE NOTE 19). NOTE 21 RELATED PARTIES See Item 13, Other Transactions, for related parties information. NOTE 22 SUBSEQUENT EVENTS The Company adopted SFAS No. 106 and recorded a one-time, non-cash charge against earnings of $402.3 million before taxes and $248.4 million after taxes in the first quarter of 1994. (SEE NOTE 11 FOR ADDITIONAL INFORMATION.) The Company adopted SFAS No. 109 and recorded a $11.4 million credit to net income in the first quarter of 1994. (SEE NOTE 3 FOR ADDITIONAL INFORMATION.) On December 15, 1993, the Company repaid its second series of dividend notes to Class L stockholders for an aggregate amount of $18.0 million, plus interest accrued of $.7 million. (SEE NOTE 6 FOR ADDITIONAL INFORMATION.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 22 (CONTINUED) SUBSEQUENT EVENTS On December 15, 1993, the Company paid to Class E stockholders of record dividends of $.55 per share, for an aggregate of $.7 million. (SEE NOTE 19 FOR ADDITIONAL INFORMATION.) During January 1994, the Company's employee investment plans, collectively, purchased 42,048 shares of Class E common stock from the Company and the Company contributed 36,449 matching shares before taxes to these plans. (SEE NOTE 12 FOR ADDITIONAL INFORMATION.) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Levi Strauss Associates Inc.: We have audited the accompanying consolidated balance sheets of Levi Strauss Associates Inc. (a Delaware corporation) and Subsidiaries as of November 28, 1993 and November 29, 1992, and the related consolidated statements of income, stockholders' equity and cash flows for the years ended November 28, 1993, November 29, 1992 and November 24, 1991. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Levi Strauss Associates Inc. and Subsidiaries as of November 28, 1993 and November 29, 1992, and the results of their operations and their cash flows for each of the three years in the period ended November 28, 1993, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN & CO. San Francisco, California, January 20, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The table below identifies the current directors and executive officers of the Company, along with their offices, positions and ages. (1) Robert D. Haas is the son of Walter A. Haas, Jr.; Walter A. Haas, Jr. is the brother of Peter E. Haas, Sr. and Rhoda H. Goldman, and the uncle of Peter E. Haas, Jr. (2) Member, Corporate Ethics and Social Responsibility Committee (3) Member, Audit Committee (4) Member, Personnel Committee Note: John F. Kilmartin retired December 5, 1993 and was replaced by Angela Glover Blackwell. Directors are divided into three classes of equal number. All directors are and will be elected by holders of a majority of the outstanding shares of the Company entitled to vote in the election of directors. Stockholders vote separately for the election of directors in each class. The first class of directors consists of Mr. R. D. Haas, Mrs. Goldman, Ms. Blackwell and Mr. Friedman and the term of office expires at the 1996 annual meeting. The second class consists of Mr. P.E. Haas, Jr., Mr. W. A. Haas, Jr., Mr. Hellman and Ms. Pineda and the term of office expires at the 1994 annual meeting. The third class consists of Mr. Tusher, Mr. P. E. Haas, Sr., Mr. Gaither and Mr. Koshland and the term of office expires at the 1995 annual meeting of stockholders. Directors who are elected at an annual meeting of stockholders to succeed those whose terms then expire will be identified as being directors of the same class as those they succeed. Staggered board provisions result in the election of only one-third of the Board at each annual meeting. This arrangement limits the ability of a person holding enough stock to control the election process from effecting a rapid change in board composition and therefore may have the effect of delaying, deferring or preventing a change in control of the Company. Executive officers serve at the discretion of the Board of Directors. All members of the Haas family and Mrs. Goldman are direct descendants of the founder of LS&CO., Levi Strauss. WALTER A. HAAS, JR. became Honorary Chairman of the Board of LS&CO. and the Company in 1985. He joined LS&CO. in 1939 and held the positions of President from 1958 to 1970 and Chief Executive Officer from 1958 to 1976. He served as Chairman of the Board from 1970 to 1981 and Chairman of the Executive Committee from 1976 until 1985. Mr. W.A. Haas, Jr. is a director of the National Parks Foundation and a trustee of the Business Enterprise Trust. He was formerly a director of UAL, Inc., United Airlines, Inc., BankAmerica Corporation and Bank of America, NT & SA. He was appointed to the National Commission on Public Service, is a former member of the Citizens Commission on Private Philanthropy and Public Need, a former member of the Trilateral Commission, a former trustee of the Ford Foundation and has served on the Presidential Advisory Council for Minority Enterprise. Mr. Haas is also owner and Managing General Partner of the Oakland Athletics. PETER E. HAAS, SR. assumed his present position as Chairman of the Executive Committee of the Board of Directors in March 1989 after serving as Chairman of the Board of LS&CO. since 1981, and of the Company since 1985. He joined LS&CO. in 1945 and became President in 1970 and Chief Executive Officer in 1976. He has served on the Board of LS&CO. since 1948 and has been a director of the Company since its inception in 1985. Mr. P.E. Haas, Sr. is an Associate of the Smithsonian National Board and a trustee and former Chairman of the Board of Trustees of the San Francisco Foundation. He is a former director of the Northern California Grantmakers, Crocker National Corporation and Crocker National Bank, and American Telephone and Telegraph Co. He is a former President of the United Way of the Bay Area, the Jewish Community Federation, Aid to Retarded Citizens and the Rosenberg Foundation and a former member of the Board of Governors of the United Way of America. ROBERT D. HAAS assumed his present position as Chairman of the Board of Directors of the Company and LS&CO. in March 1989. Since 1984, he has served as Chief Executive Officer of the Company and LS&CO., and was President of the Company from its inception in 1985 to March 1989. Since he joined LS&CO. in 1973, Mr. Haas served in a number of positions, including Marketing Director and Group Vice President of LSI, Director of Corporate Marketing Development, Senior Vice President of Corporate Planning and Policy and President of the New Business Group. He became President of the Operating Groups in 1980 and was named Executive Vice President and Chief Operating Officer in 1981. He was elected to the LS&CO. Board of Directors in 1980 and has been a director of the Company since its inception in 1985. Mr. R.D. Haas is an active participant in business and community organizations and is currently Chairman of the Board of Directors of the Levi Strauss Foundation, a trustee of the Ford Foundation, an honorary trustee of the Brookings Institution and an honorary director of the San Francisco AIDS Foundation. He is also a member of the Conference Board, the Council on Foreign Relations, the Trilateral Commission, the Bay Area Council and the California Business Roundtable. THOMAS W. TUSHER, President and Chief Operating Officer, joined LS&CO. in 1969, was elected Executive Vice President and Chief Operating Officer in 1984 and became President and a director of the Company in March 1989. He previously served as President of the Europe Division, Executive Vice President of the International Group and was appointed President of LSI in 1980. He was elected a Vice President of LS&CO. in 1976 and a Senior Vice President in 1977 and was a director of LS&CO. from 1979 until 1985. Mr. Tusher is a director of Cakebread Cellars and a former director of Great Western Financial Corporation and the San Francisco Chamber of Commerce. He is a member and former Chairman of the Walter A. Haas School of Business Advisory Board, University of California, Berkeley, a member of the Bay Area Sports Hall of Fame Committee and a member of the Board of Trustees of the World Affairs Council. ANGELA GLOVER BLACKWELL, elected to the Board in February 1994, is the founder and executive director of Urban Strategies Council, established in 1987. Previously, she served as staff attorney and managing attorney for Public Advocates, Inc. Ms. Blackwell serves on the boards of the James Irvine Foundation, Children Now, the Center on Budget and Policy Priorities, Public/Private Ventures and Common Cause, the Foundation for Child Development and the Urban Institute. She also co-chairs the Commission for Positive Change in the Oakland Public Schools. TULLY M. FRIEDMAN, a director since 1985, has been a managing partner of the private investment firm of Hellman & Friedman since its inception in 1984. From 1979 until 1984, he was a general partner and, later, managing director of Salomon Brothers Inc. Currently, he is a director of Mattel, Inc., McKesson Corporation and General Cellular Corporation. He is a member of the Advisory Committee of Falcon Cable TV, a trustee and member of the Executive Committee of the American Enterprise Institute, a director of Stanford Management Company, and a member of the Presidio Advisory Council. He is a former President of the San Francisco Opera Association and a former Chairman of Mount Zion Hospital and Medical Center. JAMES C. GAITHER, a director since April 1988, is a partner of the law firm of Cooley, Godward, Castro, Huddleson & Tatum, San Francisco, California. Prior to beginning his law practice with the firm in 1969, he served as law clerk to the Honorable Earl Warren, Chief Justice of the United States, Special Assistant to the Assistant Attorney General in the U.S. Department of Justice and Staff Assistant to the President of the United States, Lyndon B. Johnson. Mr. Gaither is the former President of the Board of Trustees at Stanford University and is a member of the Board of Trustees and executive committees for the Carnegie Endowment for International Peace and for The RAND Corporation. He was formerly Chairman of the Board of Trustees for the Center for Biotechnology Research and has served as Chairman of the Board of many educational and philanthropic organizations in the San Francisco Bay Area. Mr. Gaither is currently a director of Basic American Inc., the James Irvine Foundation and has served as a director of several other public and private companies. RHODA H. GOLDMAN, a director since 1985, devotes substantial time to public service. She is a current director of Mount Zion Health Systems and a former trustee of Mount Zion Medical Center of the University of California, San Francisco, a member of the Board of Directors of the San Francisco Symphony, the Goldman Environmental Foundation, the Walter A. Haas School of Business Advisory Board, University of California, Berkeley, the ARCS Foundation and the Levi Strauss Foundation. She is past President of Congregation Emanu-El, San Francisco. Additionally, she is Chairperson of the Stern Grove Festival Association and has served as Chairperson of the Distribution Committee of the San Francisco Foundation and the Mayor's Holocaust Memorial Committee. PETER E. HAAS, JR., a director since 1985, joined LS&CO. in 1972 as Director of the Minority Purchasing Program. He later transferred to LSI, where he held the positions of Manager of Financial Analysis, Inventory Planning Manager and General Merchandising Manager. He became a Vice President and General Manager in the Menswear Division in 1980, Director of Materials Management for Levi Strauss USA in 1982 and was Director of Product Integrity of The Jeans Company from 1984 to February 1989. Mr. P.E. Haas, Jr. is President of the Board of Trustees of Marin Academy and President of the Board of Directors of the Red Tab Foundation. Additionally, he is director of the following Boards: Vassar College, Levi Strauss Foundation, Novato Youth Center (former President) and North Bay Bancorp. F. WARREN HELLMAN, a director since 1985, has been a general partner of the private investment firm of Hellman & Friedman since its inception in 1984. Previously, he was Managing Director of Lehman Brothers Kuhn Loeb, Inc. Mr. Hellman is currently a director of American President Companies, Ltd., Williams- Sonoma, Inc., Franklin Resources, Inc., Il Fornaio America Corporation, DN&E Walter Co., Children Now, Eagle Industries, Inc., Great America Management & Investment, Inc., Basic American Inc., The California Higher Education Policy Center and University of California San Francisco (UCSF) Foundation. He is a trustee of the Brookings Institution, a member of the University of California Berkeley Foundation and Honorary Lifetime Trustee of Mills College. JAMES M. KOSHLAND, a director since 1985, is a partner of the law firm of Gray Cary Ware & Freidenrich, a Professional Corporation, Palo Alto, California, with which he has been associated since 1978. He is also a director of the Giarretto Institute, the Newhouse Foundation and the Senior Coordinating Council of the Palo Alto area. PATRICIA SALAS PINEDA, a director since 1991, is General Counsel and Assistant Corporate Secretary of New United Motor Manufacturing, Inc., with which she has been associated since 1984. She is currently a trustee of Mills College and a former trustee of the San Francisco Ballet Association. She was formerly a member and served as President of the Port of Oakland Commission and was a former member of the KQED, Inc. Board of Directors and Alameda County Hazardous Waste Authority Committee. THOMAS J. BAUCH, Senior Vice President, General Counsel and Secretary, joined LS&CO. in 1977. He was named General Counsel in 1981, elected a Vice President of LS&CO. in 1982 and assumed his current position as Senior Vice President in 1985. Mr. Bauch serves on the Board of Governors of the Commonwealth Club and the Board of Visitors of the University of Wisconsin Law School. He has served on the Board of Directors of the Urban School of San Francisco and as a legal advisor to the City of Belvedere. He is a member of various bar and legal associations. R. WILLIAM EATON, JR., Senior Vice President and Chief Information Officer, joined LS&CO. in 1978. He became Vice President for Information Resources of LSI in 1983, was elected a Vice President of LS&CO. in 1986, was named Chief Information Officer in 1988 and assumed his current position of Senior Vice President in February 1989. Mr. Eaton is a member of the Commonwealth Club and the King's Mountain Community Association. DONNA J. GOYA, Senior Vice President, Human Resources, joined LS&CO. in 1970 and became the Director of Equal Employment Opportunity and Personnel Policy in 1980. She became Director of Employee Relations and Policy in 1983 and Vice President of Corporate Personnel in 1984. She was elected a Senior Vice President in 1986. Ms. Goya is a director of the Federated Employers Association of the Bay Area and of INROADS and is a member of the Human Resources Roundtable. PETER A. JACOBI, President of Levi Strauss International, joined the Company in 1970 and was named President of the Youthwear Division in 1981. In 1984, he became Executive Vice President of the Jeans Company and was subsequently named President of the Men's Jeans Division. Mr. Jacobi became President of the European Division of LSI in 1988. In 1991, he assumed the position of President of Global Sourcing and was elected Senior Vice President. In 1993, he assumed his current position. Mr. Jacobi is past President of the South-West Apparel and Textile Manufacturers Association and also served on the Board of Directors for the Men's Fashion Association. He is a member of the Board of Directors of the Textile/Clothing Technology Corporation. GEORGE B. JAMES, Senior Vice President and Chief Financial Officer, joined the Company and LS&CO. in 1985. From 1984 to 1985, he was Executive Vice President and Group President of Crown Zellerbach Corporation and from 1982 to 1984, he held the position of Executive Vice President and Chief Financial Officer of Crown Zellerbach Corporation. From 1972 to 1982, he was Senior Vice President and Chief Financial Officer of Arcata Corporation. Mr. James is a director of Basic Vegetable Products, Inc., Fiberboard Corp., the Stanford University Hospital and the San Francisco Chamber of Commerce. In addition, he is a trustee of the San Francisco Ballet Association and serves as trustee for the Stern Grove Festival Association and the Zellerbach Family Fund. ROBERT D. ROCKEY, JR., President of Levi Strauss North America, joined LS&CO. in 1979 and became President of the Womenswear Division in 1983. In 1984, he was named President of the Europe Division of LSI and, in 1988, he was appointed President of the Men's Jeans Division. During 1991, Mr. Rockey became President of U.S. Marketing Divisions and later was elected Senior Vice President. In 1992, he assumed the position of President of Levi Strauss North America. Mr. Rockey is a director and former President of the South-West Apparel and Textile Manufacturers Association. INSIDER REPORT FILINGS The Company's executive officers and directors are not obligated, under Section 16(a) of the Securities Exchange Act of 1934, to file initial reports of ownership and reports of changes in ownership with the Securities and Exchange Commission. ITEM 11. ITEM 11. DIRECTOR AND EXECUTIVE COMPENSATION COMPENSATION OF DIRECTORS Directors of the Company who are also stockholders or employees of the Company do not receive any additional compensation for their services as director. Directors who are not stockholders or employees [Messrs. Kilmartin (before his retirement effective December 5, 1993) and Gaither and Mss. Blackwell and Pineda] receive approximately $36,000 in annual compensation during each of their first five years of service and, beginning in their sixth year of service, are expected to receive annual compensation of approximately $42,000. Such payments include an annual cash retainer of $30,000 for each of the first three years, $20,000 for the fourth year, $10,000 for the fifth year, and $6,000 thereafter, fees of $500 per Board and Board committee meeting attended and award payments under the Company's Long-Term Performance Plan ("LTPP"). The amount of each type of payment varies depending on the year of service and the actual value of the LTPP units. Messrs. Gaither and Kilmartin and Ms. Pineda each received grants of 350 performance units under the LTPP in 1993. In 1993, Messrs. Gaither and Kilmartin each received payments under the LTPP of $98,913. Directors who are not employees or stockholders also receive travel accident insurance while on Company business and are eligible to participate in a deferred compensation plan. (SEE LTPP AND DEFERRED COMPENSATION PLAN CAPTIONS.) COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION F. Warren Hellman and Tully M. Friedman, directors of the Company, are general partners of Hellman & Friedman, an investment banking firm. Hellman & Friedman provides financial advisory services to the Company and received $300,205 for such services in 1993. At November 28, 1993 Messrs. Hellman and Friedman and their families and other partners of Hellman & Friedman beneficially owned an aggregate of 1,081,442 shares of Class L common stock. See Item 12, Security Ownership of Certain Beneficial Owners and Management, for additional information concerning Mr. Hellman's and Mr. Friedman's beneficial ownership of Class L common stock. SUMMARY COMPENSATION TABLE FOR EXECUTIVE OFFICERS The following table sets forth summary compensation information for 1993, 1992 and 1991 for each of the five most highly compensated executive officers of the Company: (1) Fiscal 1993 and 1991 each contained 52 weeks. Fiscal year 1992 contained 53 weeks. (2) Bonuses are paid pursuant to the Company's Management Incentive Plan ("MIP") and Interim Cash Performance Sharing Plan. The bonuses include amounts based upon 1993, 1992 and 1991 performance that will be or were paid in 1994, 1993 and 1992, respectively (SEE MANAGEMENT INCENTIVE PLAN AND HOME OFFICE CASH PERFORMANCE SHARING PLAN CAPTIONS). Amounts paid to Mr. Haas relating to MIP bonuses were $1,010,000, $935,000 and $850,000 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Haas relating to Interim Cash bonuses were $152,795, $147,711 and $126,693 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Tusher relating to MIP bonuses were $580,000, $545,000, and $525,000 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Tusher relating to Interim Cash bonuses were $97,063, $97,003 and $84,677 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. James relating to MIP bonuses were $265,000, $240,000 and $225,000 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. James relating to Interim Cash bonuses were $48,231, $47,650 and $43,006 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Rockey, Jr. relating to MIP bonuses were $271,188, $254,651 and $209,241 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Rockey, Jr. relating to Interim Cash bonuses were $46,536, $42,842 and $31,483 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Jacobi relating to MIP bonuses were $240,043, $211,449 and $190,828 for 1993, 1992 and 1991, respectively. Amounts paid to Mr. Jacobi relating to Interim Cash bonuses were $41,370, $40,348 and $34,836 for 1993, 1992 and 1991, respectively. (3) Other annual compensation represents partial tax reimbursement cash bonuses related to certain stock option exercises under the 1985 Stock Option Plan (SEE 1985 STOCK OPTION PLAN CAPTION). (4) See detail table under 1992 Stock Appreciation Rights Plan section. (5) Amounts are paid pursuant to the Company's Long-Term Performance Plan ("LTPP"). The LTPP amounts shown in the table include amounts based on LTPP units granted in 1988, 1989 and 1990 that were paid in 1991, 1992 and 1993 or deferred to later years (SEE LTPP CAPTION). (6) All other compensation consists of amounts contributed under employee investment plans (ESAP in 1993 and 1992 and EIP in 1991 - SEE EMPLOYEE INVESTMENT PLAN CAPTION) and amounts contributed under the Company's Benefit Restoration Plan (BRP). The Internal Revenue Code (the "Code") limits the amount of benefits that may be paid under plans qualified by the Code. The BRP will pay any benefits that exceed such limitations. Amounts contributed to Mr. Haas relating to ESAP/EIP were $155,958, $148,646 and $0 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Haas relating to BRP were $715,102, $476,368 and $272,200 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Tusher relating to ESAP/EIP were $99,054, $108,868 and $0 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Tusher relating to BRP were $525,456, $371,516 and $217,861 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. James relating to ESAP/EIP were $49,140, $54,876 and $0 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. James relating to BRP were $111,493, $52,296 and $30,487 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Rockey, Jr. relating to ESAP/EIP were $47,424, $47,420 and $0 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Rockey, Jr. relating to BRP were $132,146, $87,608 and $44,169 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Jacobi relating to ESAP/EIP were $42,072, $34,746 and $0 for 1993, 1992 and 1991, respectively. Amounts contributed to Mr. Jacobi relating to BRP were $121,640, $104,009 and $52,415 for 1993, 1992 and 1991, respectively. STOCK OPTION AND STOCK APPRECIATION RIGHTS PLAN 1985 STOCK OPTION PLAN In 1985, the Board of Directors of the Company adopted the 1985 Stock Option Plan (the "1985 Plan"). The 1985 Plan is administered by the Personnel Committee of the Board of Directors (the "Administrator"). A total of 5,000,000 shares of Class L common stock (previously Class F common stock, SEE NOTE 20 TO THE CONSOLIDATED FINANCIAL STATEMENTS) may be issued upon exercise of options under the 1985 Plan to eligible employees or non-employee directors of the Company selected by the Board. Options granted under the 1985 Plan are non- qualified stock options and expire ten years from the date of grant. The Board or the Administrator determines the exercise price, exercise schedule, the manner in which payment occurs and any provision for a cash bonus to be paid at or about the time of exercise of the option. In addition the administrator retains discretion, subject to plan limits, to modify the terms (e.g., acceleration or elimination of vesting requirements of outstanding options). There were no option grants during 1993. In 1992, the Board of Directors approved a special payment arrangement under the Plan to facilitate the exercise by optionholders of their outstanding options. This arrangement accelerated vesting on all non-vested options and allowed each optionholder to exercise outstanding options by surrendering a portion of these outstanding options in full payment of the exercise price and related tax obligations. Holders of 65 percent of all outstanding options participated in this arrangement. The special arrangement required the recognition of a fiscal 1992 pre-tax stock option charge of $158.0 million for all outstanding options (the amount equal to the difference between the fair market value of the underlying shares at the exercise date and at the grant date). Separately, the Company also recognized compensation expense for related exercise bonuses and the accelerated use of presently non-vested options. The Company disbursed $41.9 million to pay related withholding taxes for optionholders (in exchange for an equal amount of surrendered options) and $4.4 million for related exercise bonuses. The optionholders participating in this arrangement exercised 925,123 options resulting in 532,368 reissued treasury shares of Class L common stock. The Company also retired 392,755 shares of treasury stock, which was equal to the number of options surrendered. The net change in Stockholders' Equity (including the after-tax effect of the stock option charge) was an increase of $9.2 million. SEE NOTE 16 TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL STOCK OPTION PLAN INFORMATION. 1992 STOCK APPRECIATION RIGHTS PLAN In 1992, the Board of Directors of the Company adopted the 1992 Executive Stock Appreciation Rights Plan of Levi Strauss Associates Inc. The purpose of the 1992 Executive Stock Appreciation Rights Plan is to attract, retain, motivate and reward certain executives by giving them an opportunity to participate in the future success of the Company. The "stock appreciation rights" (SARs), are tied to and based on changes in the value of the Company's Class E common stock (Class E common stock is appraised, usually twice a year, by an independent investment banking firm). Upon exercise, the holder is entitled to receive a cash payment from the Company equal to the difference in the fair market value of stock on grant date and exercise date, less related tax withholding. A total of 500,000 rights may be granted under this plan. SARs awarded under the Company's plan may not be transferred. The plan is administered by a committee of at least two members of the Board of Directors of the Company who are disinterested persons. The administrative committee for SARs determines the initial values of the SARs, the exercise schedule and any other terms or conditions applicable to the SARs that may be appropriate. In addition, the administrative committee retains discretion, subject to plan limits, to modify the terms (e.g., acceleration or elimination of vesting requirements) of SARs. The 1992 grant of SARs vest and become exercisable over several years commencing in 1995. One-third of these SARs will be exercisable in 1995, one-third in 1996 and the remaining third in 1997. There were no SAR grants during 1993. The following table presents information for the year ended November 28, 1993 regarding aggregated options/SARs of executive officers of the Company listed in the Summary Compensation Table. LONG-TERM PERFORMANCE PLAN The Company has a Long-Term Performance Plan ("LTPP") for outside directors, officers and other key employees, under which performance units are granted to each participant. The value assigned to each unit is determined at the discretion of the Personnel Committee of the Board of Directors. The performance unit value guidelines selected by the Personnel Committee with respect to existing grants are based on the Company's three-year cumulative net earnings before tax. Under such guidelines (which are subject to change by the Personnel Committee), the current forecast value of the units granted in 1993, 1992 and 1991 is $128, $144 and $292 per unit, respectively. The units vest and are paid in cash in one-third increments on the third, fourth and fifth anniversaries of the date of grant or the amounts can be deferred at the election of the participant. The following table sets forth information relating to Long-Term Performance Plan units granted in 1993 for the executive officers of the Company listed in the Summary Compensation Table: _________________ (1) The basis for measuring long-term performance is a corporate three-year cumulative earnings performance calculation (e.g., an internal calculation of earnings from operations). (2) The units vest in three years and are paid out in cash in one-third increments payable in June 1996, June 1997 and June 1998. (3) Each LTPP unit is valued at $100.00 if the Company achieves a target level of corporate earnings performance over a three-year period. Performance above target levels will produce increases in award values. There is no cap on the award value; however, the award formula is directly related to the Company's earnings performance. (4) Under the terms of the Company's LTPP, the Personnel Committee retains discretion, subject to plan limits, to modify the terms of outstanding awards to take into account the effect of unforeseen or extraordinary events and accounting changes. MANAGEMENT INCENTIVE PLAN The Company's Management Incentive Plan ("MIP") provides selected employees with incentive compensation and provides a tool for recruiting and retaining selected employees. Under the MIP, the Personnel Committee of the Board of Directors, as administrator of the MIP, may award discretionary cash payments to selected employees. Such awards are made on the basis of various factors, including profit levels, return on investment, salary grade and individual performance. HOME OFFICE INTERIM CASH PERFORMANCE SHARING PLAN The Company has an Interim Cash Performance Sharing Plan for all Home Office payroll employees that pays out based on a percentage of base salary and certain Company earnings criteria. This interim cash plan was a transition program for 1991 and 1992 and has been extended to 1994. Participants in the MIP can receive up to 8 percent, while other Home Office employees can receive up to 12 percent, of their covered compensation (fiscal year salary and non-LTPP bonus) under the plan. DEFERRED COMPENSATION PLAN The Company has an unfunded Deferred Compensation Plan under which a selected group of employees may elect to defer receipt until termination of employment of up to 33 percent of their base salary and 100 percent of their bonus. The amounts deferred under this plan, plus interest, may be paid prior to termination in certain circumstances specified in the plan. When electing to defer a bonus, eligible employees in certain salary grades may also elect to receive in-service payments of the deferred bonus in five annual installments. The Company also maintains a similar deferred compensation plan for outside directors. BENEFIT PLANS HOME OFFICE PENSION PLAN Generally, all Home Office payroll employees, including executive officers, participate in the Company's Home Office Pension Plan (the "Pension Plan") after completing one year of service. The Pension Plan, subject to Internal Revenue Service (IRS) limitations, provides pension benefits based on an individual's years of service and final average covered compensation (generally, base salary plus bonuses awarded, not exceeding one half of salary, for the five consecutive fiscal years out of the individual's last ten years of service that produces the highest average). Contributions by the Company to the Pension Plan cannot be separately calculated for individual executive officers. The following table shows the estimated annual benefits payable upon retirement under the Pension Plan and the Benefit Restoration Plan to persons in various compensation and years-of-service classifications prior to mandatory offset of Social Security benefits: The preceding table assumes retirement at the age of 65, with payment to the employee in the form of a single-life annuity. As of year-end 1993, the credited years of service for Messrs. R.D. Haas, Tusher, James, Rockey, Jr. and Jacobi were 20, 24, 8, 14 and 23, respectively. The 1993 compensation covered by the Pension Plan for Messrs. R.D. Haas, Tusher, James, Rockey, Jr. and Jacobi was $2,081,171, $1,113,938, $535,880, $633,849, and $563,489, respectively. The 1993 compensation covered by the Pension Plan consists of fiscal year 1993 cash salary and bonus (not including LTPP). These amounts do not correspond to the amounts on the Summary Compensation table because the covered compensation amounts are based on actual cash paid during 1993 and do not include deferred salary (SEE SUMMARY COMPENSATION TABLE CAPTION). The Code limits the amount of pension benefits that may be paid under plans qualified under the Code such as the Pension Plan. The Company maintains a separate unfunded Benefit Restoration Plan (SEE THE BENEFIT RESTORATION PLAN CAPTION) that will pay any retirement benefits under the Pension Plan that exceed such limitations. The five individuals named in the Summary Compensation Table are participants in the Benefit Restoration Plan. The Company has unfunded supplemental pension agreements with Messrs. Tusher and James which provide specific benefits upon retirement. The cost to the Company in 1993 of the agreements for Messrs. Tusher and James was $359,200 and $27,600, respectively. BENEFIT RESTORATION PLAN The Company has an unfunded Benefit Restoration Plan (the "BRP") that provides eligible employees with benefits that would have been payable from tax-qualified plans of the Company except for limitations imposed on such benefits under the Internal Revenue Code (the "Code"). The BRP also provides for the deferral of an eligible employee's current compensation to the extent that such compensation cannot be contributed to the Company's investment plans, due to these limitations, and the restoration of Company matching contributions that could not be credited under those plans as a result. All employees who are subject to such limitations are eligible to participate in the BRP. The BRP is administered by the Administrative Committee of the Retirement Plans. EMPLOYEE INVESTMENT PLANS The Company maintains three employee investment plans. Two of these plans, the Employee Investment Plan of Levi Strauss Associates Inc. (EIP) and the Levi Strauss Associates Inc. Employee Long-Term Investment and Savings Plan (ELTIS), are qualified plans that cover Home Office employees and U.S. field employees, respectively. The third plan, the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc. (ESAP) is a non-qualified employee equity program for highly compensated (as defined by the Code) Home Office employees. Effective December 1990, highly compensated employees were no longer eligible to contribute to the EIP due to amendments to the EIP, which were made to comply with certain changes to the Code. The ESAP commenced in 1992 to allow highly compensated employees to participate in equity ownership. The ESAP is administered by the Personnel Committee of the Board of Directors. The Pension Plan and the EIP are administered by the Administrative Committee of the Retirement Plans of the Company. The Personnel Committee has delegated most of its routine administrative functions to the Administrative Committee and to the Employee Benefits Department. The Administrative Committee is appointed by the Board of Directors and has the general responsibility for the administration and operation of the plans, including compliance with reporting and disclosure requirements, establishing and maintaining plan records and determining and authorizing payments of benefits under the plans. The qualified plans also established an Investment Committee appointed by the Board of Directors. The Investment Committee's duties and responsibilities include (i) reviewing the performance of the trustee under the plans; (ii) appointing, removing and reviewing the performance of investment managers who may be delegated the authority to manage plan assets; (iii) establishing investment standards and policies based upon the objectives of the plans as communicated by the Administrative Committee; and (iv) performing such other functions as are specifically assigned to the Investment Committee under the plans. The foregoing descriptions of the Company's benefit plans and agreements are only summaries and are qualified in their entirety by reference to such agreements and plans. ADDITIONAL INFORMATION ABOUT CERTAIN COMPANY EMPLOYEE PLANS IS CONTAINED IN NOTES 12 THROUGH 16 TO THE CONSOLIDATED FINANCIAL STATEMENTS. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of January 10, 1994, certain information with regard to the beneficial ownership of Class L common stock and Class E common stock by each person who beneficially owns more than 5 percent of these outstanding shares, each of the directors, each of the five most highly compensated executive officers and all directors and executive officers of the Company as a group. The business address of all persons listed is 1155 Battery Street, San Francisco, California 94111. Note: Class E common stock represents 2 percent of all outstanding common stock. Employees of the Company may invest in Class E common stock under the Company's employee investment plans. The Boston Safe Deposit and Trust Company, trustee for the Company's qualified stock investment plans, holds approximately 75 percent of all outstanding Class E common stock. The business address for the Boston Safe Deposit and Trust Company is 1 Cabot Road, Mail Zone WTO4G, Medford, Massachusetts, 02155-5158. SEE EMPLOYEE INVESTMENT PLAN CAPTION UNDER ITEM 11. (1) The percentage of shares outstanding is not shown for those amounting to less than one percent. (2) Includes 526,286 shares owned by the spouse and daughter of Mr. Haas and by trusts for the benefit of his daughter. Mr. Haas disclaims beneficial ownership of such shares. (3) Mr. Haas, as trustee, has sole voting and investing power with respect to these shares. These shares are held by a trust for the benefit of Mr. Haas' nieces and nephews. Mr. Haas disclaims beneficial ownership of such shares. (4) Does not include 158,996 shares held by a trust for the benefit of the sons of Mr. Tusher. Mr. Tusher has neither voting nor investing powers with respect to such shares. (5) Represents shares subject to presently exercisable options. (6) Does not include 3,000,200 shares owned by Miriam L. Haas, the spouse of Mr. Haas. Mr. Haas disclaims beneficial ownership of such shares. (7) Includes 2,903,167 shares in which Mrs. Josephine B. Haas has sole investing power and Mr. Haas has sole voting rights; and 58,800 shares held in trusts for the benefit of his grandnieces and grand nephew in which Mr. Haas has sole voting and investing power. Mr. Haas disclaims beneficial ownership of such shares. (8) Represents shares owned by the Evelyn and Walter Haas, Jr. Fund in which Mr. Haas has shared voting and investing powers. (9) Does not include 4,600 shares held by a trust for the benefit of Mr. Friedman's stepson. Mr. Friedman does not have voting or investing powers with respect to such shares and disclaims beneficial ownership of such shares. (10) Represents shares in which Mr. Friedman has sole voting and investing powers. These shares are held by the Friedman Family Partnership for the benefit of Mr. Friedman's daughter and stepson and Cherry Street Partners for the benefit of Mr. Friedman's former spouse. Mr. Friedman disclaims beneficial ownership of such shares. (11) Includes 1,000,000 shares owned by Mrs. Goldman's spouse. Mrs. Goldman disclaims beneficial ownership of such shares. Does not include 2,886,207 shares held by trusts for the benefit of Mrs. Goldman's grandchildren. Mrs. Goldman neither has voting nor investing rights with respect to such shares. (12) Includes 2,368,785 shares held by trusts for the benefit of Mr. Haas' children and 150,000 shares held by Peter E. Haas and Joanne C. Haas Charitable Annuity Lead Trust and 1,086 shares by the spouse of Mr. Haas. Mr. Haas disclaims beneficial ownership of such shares. (13) Represents shares held by a trust for the benefit of Michael S. Haas in which Mr. Haas has sole voting and investing powers. Mr. Haas disclaims beneficial ownership of such shares. (14) Mr. Hellman's shares are held in his family investment partnership. (15) Mr. Hellman has voting and investing powers with respect to these shares which are held by a trust for the benefit of the daughter of Robert D. Haas. Mr. Hellman disclaims beneficial ownership of such shares. (16) Mr. Kilmartin retired from the Board of Directors on December 5, 1993. (17) James M. Koshland is the son of Daniel E. Koshland, Jr. (18) Represents shares held by trusts for the benefit of James M. Koshland's children. Mr. Koshland disclaims beneficial ownership of such shares. (19) Includes 333,000 shares owned by the spouse of Mrs. Geballe. Mrs. Geballe disclaims beneficial ownership of such shares. (20) Includes 2,903,167 shares in which Mrs. Haas has sole investing powers and Mr. Peter E. Haas, Sr. has sole voting rights. (21) Includes 1,447,855 shares in which Mrs. Haas has shared voting and investing powers and 777,679 shares in which Mrs. Haas has sole voting and investing powers. These shares are held by trusts for the benefit of the son and daughter of Mrs. Haas. Mrs. Haas disclaims beneficial ownership of such shares. (22) Does not include 8,754,426 shares owned by Peter E. Haas, Sr., the spouse of Mrs. Haas. Mrs. Haas disclaims beneficial ownership of such shares. (23) Margaret E. Jones is the daughter of Peter E. Haas, Sr. (24) Represents shares owned by The Koshland Foundation in which Mr. Koshland has sole voting rights. (25) Includes 499,749 shares subject to presently exercisable options. As of January 10, 1994, the Company has 191 and 1,107 record owners of Class L and Class E common stock, respectively. HOLDERS OF AND TRANSFER RESTRICTIONS ON COMMON STOCK. There is no trading market for outstanding shares of Class E and Class L common stock. The outstanding shares of Class E common stock are currently held by the trustee of the ELTIS and EIP and by certain employees under the ESAP. Class E common stock is subject to certain restrictions on transfer as provided in the various employee plans. SEE THE EMPLOYEE INVESTMENT PLANS CAPTION UNDER ITEM 11 FOR ADDITIONAL INFORMATION. Class L common stock is primarily held by members of the families of certain descendants of the Company's founder and certain members of the Company's Board of Directors and management. Under a stockholder agreement that expires in April 2001, transfer of Class L common stock is prohibited except to certain transferees, specified members of the stockholder's family, trusts, charities or other Class L stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ESTATE TAX REPURCHASE POLICY The Board of Directors has a policy under which the Company will, subject to certain conditions, offer to repurchase a portion of the shares of Class L common stock held by the estate of a deceased stockholder in order to assist the estate in meeting estate tax liabilities. The purchase price will be based on periodic valuations of Class L common stock conducted by an investment banking or appraisal firm (SEE NOTE 19 TO THE CONSOLIDATED FINANCIAL STATEMENTS). Purchases will be made at a discount price reflecting the non-liquidity of large blocks of stock; the discount will be established by the investment banking or appraisal firm. Estate repurchase transactions will be subject to, among other things, compliance with applicable laws governing stock repurchases, satisfaction of certain financial ratios specified in the resolutions adopting the policy, and compliance with any limitations on stock repurchases contained in the Company's credit agreements. OTHER TRANSACTIONS Rhoda H. Goldman is a director of the Company; her son, John Goldman, is the controlling person of Richard N. Goldman and Company (RNG), which acts as an insurance broker for the Company. In 1993, the Company paid RNG approximately $380,245 in fees and commissions for the placement of insurance programs. RNG's insurance programs represent approximately 80 percent of worldwide annual premiums paid by the Company for 1993 property casualty coverage, not including workers' compensation coverage. The Company believes the premiums paid to RNG are competitive. At November 28, 1993, Rhoda H. Goldman had no equity interest in RNG and beneficially owned 3,765,257 shares of the Company's Class L common stock. SEE COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION UNDER ITEM 11 FOR ADDITIONAL INFORMATION. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS Consolidated Statements of Income, Years Ended November 28, 1993, November 29, 1992 and November 24, 1991. Consolidated Balance Sheets, November 28, 1993 and November 29, 1992 Consolidated Statements of Stockholders' Equity, Years Ended November 28, 1993, November 29, 1992 and November 24, 1991 Consolidated Statements of Cash Flows, Years Ended November 28, 1993, November 29, 1992 and November 24, 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants (2) FINANCIAL STATEMENT SCHEDULES VIII Reserves IX Short-Term Borrowings X Supplementary Income Statement Information All other schedules have been omitted because they are inapplicable, not required or the information is included in the financial statements or notes thereto. (3) MANAGEMENT CONTRACTS AND COMPENSATORY ARRANGEMENTS 1985 Stock Option Plan and forms of related agreements, exhibit 10a. 1985 Stock Option Plan Notice to Optionholders, exhibit 10b. Long Term Performance Plan, exhibit 10c. Management Incentive Plan, exhibit 10d. Levi Strauss Associates Inc. Excess Benefit Restoration Plan, exhibit 10e. Levi Strauss Associates Inc. Supplemental Benefit Restoration Plan, exhibit 10f. Amendment dated February 9, 1993 to the Levi Strauss Associates Inc. Excess Benefit Restoration Plan and Levi Strauss Associates Inc. Supplemental Benefits Restoration Plan, exhibit 10g. Levi Strauss Associates Inc. Deferred Compensation Plan for Executives (as adopted in 1971 and as amended through January 1, 1992), exhibit 10h. Revised Home Office Pension Plan of Levi Strauss Associates Inc., exhibit 10j. Revised Employment Retirement Plan and December 20, 1991 Amendment thereto, exhibit 10k. Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., exhibit 10n. Amendments dated August 5, 1992, March 31, 1992 and January 1, 1992 to the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., exhibit 10o. Amendment dated February 9, 1993 to the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., exhibit 10p. Amendment effective as of March 1, 1993 to the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., exhibit 10q. Supplemental Pension Agreement dated April 16, 1985 between Levi Strauss & Co. and Thomas W. Tusher, exhibit 10v. Supplemental Pension Agreement dated November 12, 1985 between Levi Strauss & Co. and George B. James, exhibit 10w. Letter Agreement dated August 29, 1985 between the Company and Thomas W. Tusher, exhibit 10x. Home Office Interim Cash Performance Sharing Plan of Levi Strauss Associates Inc., exhibit 10z. Levi Strauss Associates Inc. 1992 Executive Stock Appreciation Rights Plan, exhibit 10bb. (4) EXHIBITS 3a Restated Certificate of Incorporation, incorporated by reference from Exhibit 4 of Form 10-Q filed with the Securities and Exchange Commission on April 13, 1993. 3b Amended By-Laws of the Company, incorporated by reference from Exhibit 3b of Form 10-K filed with the Securities and Exchange Commission on February 20, 1992. 4a Form of Series B dividend note, dated as of December 15, 1992, among the Company and note holders, incorporated by reference from Exhibit 4b of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 4b Form of Series C dividend note, dated as of December 15, 1992, among the Company and note holders, incorporated by reference from Exhibit 4c of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 4c Form of Series D dividend note, dated as of December 15, 1992, among the Company and note holders, incorporated by reference from Exhibit 4d of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 4d Form of Class L Stockholders' Agreement, incorporated by reference from Exhibit (c)(5) of the Company's Issuer Tender Offer Statement on Schedule 13E-4, including all amendments thereto, initially filed with the Securities and Exchange Commission on March 4, 1991. 4e Credit Agreement, dated as of January 21, 1993, among the Company, Levi Strauss & Co., Bank of America N.T. & S.A. and other financial institutions named therein, incorporated by reference from Exhibit 4k of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 4f Amended and Restated Agreement of Master Trust effective as of May 1, 1989 between Levi Strauss Associates Inc. and Boston Safe Deposit and Trust Company, incorporated by reference from Exhibit 4.6 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10a 1985 Stock Option Plan and forms of related agreements, incorporated by reference from Exhibit 10.4 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10b 1985 Stock Option Plan Notice to Optionholders, incorporated by reference from Exhibit 10b of Form 10-K filed with the Securities and Exchange Commission on February 20, 1992. 10c Long Term Performance Plan, incorporated by reference from Exhibit 10.7 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10d Management Incentive Plan, incorporated by reference from Exhibit 10.12 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10e Levi Strauss Associates Inc. Excess Benefit Restoration Plan, incorporated by reference from Exhibit 10e of Form 10-K filed with the Securities and Exchange Commission on February 20, 1992. 10f Levi Strauss Associates Inc. Supplemental Benefit Restoration Plan, incorporated by reference from Exhibit 10f of Form 10-K filed with the Securities and Exchange Commission on February 20, 1992. 10g Amendment dated February 9, 1993 to the Levi Strauss Associates Inc. Excess Benefit Restoration Plan and Levi Strauss Associates Inc. Supplemental Benefits Restoration Plan, incorporated by reference from Exhibit 10d of Form 10-Q filed with the Securities and Exchange Commission on July 13, 1993. 10h Levi Strauss Associates Inc. Deferred Compensation Plan for Executives (as adopted in 1971 and as amended through January 1, 1992). 10i Deferred Compensation Plan for Outside Directors, incorporated by reference from Exhibit 10.9 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10j Revised Home Office Pension Plan of Levi Strauss Associates Inc. 10k Revised Employment Retirement Plan. 10l Levi Strauss Associates Inc. Retirement Plan for Over the Road Truck Drivers and Dispatchers. 10m Levi Strauss & Co. Supplemental Unemployment Benefit Plan and related amendments. 10n Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., incorporated by reference from Exhibit 4.2 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on June 24, 1991 (Reg. No. 33-41332). 10o Amendments dated August 5, 1992, March 31, 1992 and January 1, 1992 to the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., incorporated by reference from Exhibit 10q of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 10p Amendment dated February 9, 1993 to the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., incorporated by reference from Exhibit 10a of Form 10-Q filed with the Securities and Exchange Commission on July 13, 1993. 10q Amendment effective as of March 1, 1993 to the Employee Stock Purchase and Stock Award Plan of Levi Strauss Associates Inc., incorporated by reference from Exhibit 10e of Form 10-Q filed with the Securities and Exchange Commission on July 13, 1993. 10r Levi Strauss Associates Inc. Employee Long-Term Investment and Savings Plan, incorporated by reference from Exhibit 4.2 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on February 9, 1990 (Reg. No. 33-33415), with amendments incorporated by reference from Exhibit 4.2 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on May 31, 1991 (Reg. No. 33-40947). 10s Amendments dated July 21, 1992 and March 31, 1992 to the Levi Strauss Associates Inc. Employee Long-Term Investment and Savings Plan, incorporated by reference from Exhibit 10s of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 10t Amendment dated February 9, 1993 to the Levi Strauss Associates Inc. Employee Long-Term Investment and Savings Plan, incorporated by reference from Exhibit 10c of Form 10-Q filed with the Securities and Exchange Commission on July 13, 1993. 10u Employee Investment Plan of Levi Strauss Associates Inc., incorporated by reference from Exhibit 4.3 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on February 9, 1990 (Reg. No. 33-33415) with amendments incorporated by reference from Exhibit 4.3 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on May 31, 1991 (Reg. No. 33-40947). 10v Supplemental Pension Agreement dated April 16, 1985 between Levi Strauss & Co. and Thomas W. Tusher, incorporated by reference from Exhibit 10.13 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10w Supplemental Pension Agreement dated November 12, 1985 between Levi Strauss & Co. and George B. James, incorporated by reference from Exhibit 10.14 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10x Letter Agreement dated August 29, 1985 between the Company and Thomas W. Tusher, incorporated by reference from Exhibit 10.15 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10y Agreement dated as of May 1, 1989 between the Company and Boston Safe Deposit and Trust Company, incorporated by reference from Exhibit 10.17 to the Company's Registration Statement on Form S-1, filed with the Securities and Exchange Commission on March 9, 1989 (Reg. No. 33-27465). 10z Home Office Interim Cash Performance Sharing Plan of Levi Strauss Associates Inc. 10aa Field Profit Sharing Award Plan of Levi Strauss Associates Inc. 10bb Levi Strauss Associates Inc. 1992 Executive Stock Appreciation Rights Plan, incorporated by reference from Exhibit 10aa of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 10cc Supply Agreement dated as of March 30, 1992, between Levi Strauss & Co. and Cone Mills Corporation, incorporated by reference from Exhibit 10bb of Form 10-K filed with the Securities and Exchange Commission on February 25, 1993. 10dd First Amendment to Supply Agreement dated as of March 30, 1992, between Levi Strauss & Co. and Cone Mills Corporation. 21 Subsidiaries of Levi Strauss Associates Inc. 23 Consent of Independent Public Accountants. (b) REPORTS ON FORM 8-K There were no Reports on Form 8-K filed with the Commission during the fourth quarter of 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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, IN THE CITY OF SAN FRANCISCO, STATE OF CALIFORNIA, ON FEBRUARY 10, 1994. LEVI STRAUSS ASSOCIATES INC. By Robert D. Haas ------------------------- Robert D. Haas Chairman of the Board and Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE FOLLOWING CAPACITIES ON FEBRUARY 10, 1994. Signature Title --------- ----- Director, Honorary Chairman of the Board of Walter A. Haas, Jr. Directors ____________________________________ (Walter A. Haas, Jr.) Director, Peter E. Haas, Sr. Chairman of the Executive Committee ____________________________________ (Peter E. Haas, Sr.) Director, Chairman of the Board of Directors and Robert D. Haas Chief Executive Officer ____________________________________ (Robert D. Haas) Signature Title --------- ----- Angela G. Blackwell Director _____________________________________ (Angela G. Blackwell) Tully M. Friedman Director _____________________________________ (Tully M. Friedman) James C. Gaither Director _____________________________________ (James C. Gaither) Rhoda H. Goldman Director _____________________________________ (Rhoda H. Goldman) Peter E. Haas, Jr. Director _____________________________________ (Peter E. Haas, Jr.) F. Warren Hellman Director _____________________________________ (F. Warren Hellman) Signature Title --------- ----- Patricia S. Pineda Director _____________________________________ (Patricia S. Pineda) James M. Koshland Director _____________________________________ (James M. Koshland) Director, Thomas W. Tusher President and Chief Operating Officer _____________________________________ (Thomas W. Tusher) Senior Vice President and George B. James Chief Financial Officer _____________________________________ (George B. James) Vice President, Controller and Richard D. Murphy Chief Accounting Officer _____________________________________ (Richard D. Murphy) SCHEDULE VIII LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES RESERVES (In Thousands) SCHEDULE IX LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (In Thousands) (1) This was relatively high in 1993 as approximately 69 percent of the balance outstanding at the end of 1993 was related to borrowings in Eastern Europe where the average interest rate was substantially higher than other Company borrowings in 1993. In addition, this was relatively high in 1991 as approximately 6 percent of the balance outstanding at the end of 1991 was related to borrowings in Latin America where the average interest rate was substantially higher than other Company borrowings in 1991. (2) The maximum amount outstanding during the period is based on month-end balances. (3) The average amount outstanding during the period is computed based on average daily borrowings. (4) The weighted average interest rate during the period is an annual rate, calculated by dividing the short-term interest expense by the average borrowings. The weighted average interest rate during 1993 would have been 3.7 percent excluding the Eastern European borrowings. The 1992 and 1991 weighted average interest rate would have been 5.4 percent and 7.6 percent, respectively, excluding the Latin American borrowings. SCHEDULE X LEVI STRAUSS ASSOCIATES INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In Thousands) Items required in this schedule but not shown were omitted as they did not exceed one percent of net sales or are shown elsewhere in the consolidated Financial Statements of Levi Strauss Associates Inc. and Subsidiaries. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Levi Strauss Associates Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements of Levi Strauss Associates Inc. included in this Form 10-K and have issued our report thereon dated January 20, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. Schedules VIII, IX and X are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. San Francisco, California, January 20, 1994 SUPPLEMENTAL INFORMATION The 1994 Proxy will be furnished to security holders subsequent to this filing. CORPORATE DIRECTORY EXECUTIVE OFFICE Robert D. Haas, Chairman of the Board of Directors and Chief Executive Officer Thomas W. Tusher, President and Chief Operating Officer HONORARY CHAIRMAN OF THE BOARD OF DIRECTORS Walter A. Haas, Jr. CHAIRMAN OF THE EXECUTIVE COMMITTEE OF THE BOARD OF DIRECTORS Peter E. Haas, Sr. CORPORATE EXECUTIVE OFFICERS Thomas J. Bauch -- Senior Vice President, General Counsel & Secretary R. William Eaton, Jr. -- Senior Vice President, Chief Information Officer Donna J. Goya -- Senior Vice President, Human Resources George B. James -- Senior Vice President, Chief Financial Officer Robert D. Rockey, Jr. -- Senior Vice President, President of Levi Strauss North America Peter A. Jacobi -- Senior Vice President, President of Levi Strauss International DIRECTORS Angela Glover Blackwell -- Executive Director, Urban Strategies Council(1,3) Tully M. Friedman -- General Partner, Hellman & Friedman(1,3) James C. Gaither -- Partner, Cooley, Godward, Castro, Huddleson & Tatum(2,3) Rhoda H. Goldman -- Director, Mount Zion Health Systems(2,3) Peter E. Haas, Sr.(3) Peter E. Haas, Jr.(3) Robert D. Haas(3) Walter A. Haas, Jr.(3) F. Warren Hellman -- General Partner, Hellman & Friedman(1,2) James M. Koshland -- Partner, Ware & Freidenrich(1,3) Patricia Salas Pineda -- General Counsel, New United Motor Manufacturing, Inc.(1,2) Thomas W. Tusher(3) (1) Member, Audit Committee (2) Member, Personnel Committee (3) Member, Corporate Ethics and Social Responsibility Committee EXECUTIVE OFFICES: Levi's Plaza 1155 Battery Street San Francisco, California 94111 (415) 544-6000 Questions and communications regarding employee investments should be sent to the Director of Employee Benefits at the above address. INDEPENDENT PUBLIC ACCOUNTANTS: Arthur Andersen & Co.

33565_1993.txt

33565_1993

1993

33565

Item 1. Business General Essex Group, Inc. (the "Company") develops, manufactures and markets electrical wire and cable and electrical insulation products. Among the Company's products are magnet wire for electromechanical devices such as motors, transformers and electrical controls; building wire for the construction industry; telephone cable for the telecommunications industry; wire for automotive and industrial applications; and insulation products for the electrical industry. The Company's operations at December 31, 1993 included 26 domestic manufacturing facilities and employed approximately 3,755 persons. The Company was founded in Detroit, Michigan in 1930 to manufacture electrical wire harnesses for automobiles exclusively for the Ford Motor Company. United Technologies Corporation ("UTC") acquired the Company in 1974 and operated it as a wholly-owned subsidiary. On February 29, 1988, MS/Essex Holdings Inc. ("Holdings"), acquired the Company from UTC (the "1988 Acquisition"). After the 1988 Acquisition, the outstanding common stock of Holdings was beneficially owned by the Morgan Stanley Leveraged Equity Fund II, L.P., certain directors and members of management of Holdings and the Company, and others. On October 9, 1992, Holdings was acquired (the "Acquisition") by merger (the "Merger") of B E Acquisition Corporation ("BE") with and into Holdings with Holdings surviving under the name BCP/Essex Holdings Inc. BE was a newly organized Delaware corporation formed for the purpose of effecting the Acquisition. The shareholders of BE included Bessemer Capital Partners, L.P. ("BCP"), affiliates of Goldman, Sachs & Co. ("Goldman Sachs"), affiliates of Donaldson, Lufkin & Jenrette, Inc., Chemical Equity Associates, A California Limited Partnership ("CEA"), and members of management and other employees of the Company. As a result of the Merger, the stockholders of BE became stockholders of Holdings. During 1993, BCP transferred its ownership interest in Holdings to Bessemer Holdings, L.P. ("BHLP"), an affiliate of BCP. See note 2 to the table included herein setting forth information regarding beneficial ownership of Holdings common stock under the caption "Item 12. Security Ownership of Certain Beneficial Owners and Management" for information regarding BHLP. Product Lines The Company's wire products include magnet wire for electromechanical devices such as motors, transformers and electrical controls; building wire; telecommunication cable; and various types of automotive and industrial wires for applications in automobiles, trucks, appliances and construction. Insulation products include mica paper and mica-based composites laminated with glass, fabric and synthetic films, in combination with various proprietary or purchased polymers. The following table sets forth for each of the three years in the period ended December 31, 1993 the dollar amounts and percentages of sales of each of the Company's major product lines and identifies the division (defined below) with which each line is associated: (a) Includes $32.6 million in sales of an industrial wire product line transferred to EPD effective January 1992. (b) Includes $32.7 million in sales of an industrial wire product line; sales of that product line were reported as WCD sales in prior years. (c) Less than 1.0%. Division Operations The Company classifies its operations into four major divisions based on the markets served: Wire and Cable Division ("WCD"); Magnet Wire and Insulation Division ("MWI"); Telecommunication Products Division ("TPD") and Engineered Products Division ("EPD"). A summary of the business of each major division is set forth below. Wire and Cable Division Products. WCD develops, manufactures and markets a complete line of building wire and other related wire products. Specific examples include service entrance cable, underground feeder wire and nonmetallic wire and cable for the residential market and a variety of insulated wires for the nonresidential market. The ultimate end users are electrical contractors and "do-it-yourself" consumers. Sales and Marketing. WCD has produced building wire and cable in the United States since 1933. WCD has developed and maintained a large and diverse customer base, selling primarily to electrical distributors, hardware wholesalers and consumer product retailers. WCD's products are marketed nationally through manufacturers representatives and a Company sales force. WCD has distribution facilities throughout the United States and one in Canada. Historically, approximately 65% of the Company's building wire market is attributable to remodeling and repair activity while the remaining 35% is attributable to new residential and nonresidential construction. Magnet Wire and Insulation Division Products. MWI develops and manufactures magnet wire and insulation products for the electrical equipment and electronics industries in the United States. MWI offers a comprehensive line of insulation and magnet wire products, including over 500 types of magnet wire used in a wide variety of motors, coils, relays, generators, solenoids and transformers. Sales and Marketing. Historically, 66% of MWI sales have been made directly to end users and 34% of sales have been to distributors. The Company distributes electrical insulating materials and certain appliance and magnet wire products through its IWI distribution chain ("IWI"). IWI is a national distributor providing the Company access to small original equipment manufacturers and motor repair markets. In response to a growing number of Japanese transplant businesses that supply products to Japanese automobile companies with United States manufacturing operations, the Company established a joint venture with The Furukawa Electric Company, LTD., Tokyo, Japan ("Femco") in 1988. In the second quarter of 1993, the Company completed construction of a new manufacturing facility that is occupied by both the Company and Femco. Femco manufactures and markets magnet wire with special emphasis on products required by Japanese manufacturers for their production facilities in the United States. Telecommunication Products Division Products. TPD develops, manufactures and markets a broad line of plastic insulated conductor and plastic jacketed telephone cables primarily for use in the United States telephone network, although it is expanding its capability to manufacture products for overseas markets. TPD manufactures polyolefin, PVC, and fluoropolymer insulated cable of various types as well as specialized cables adapted to customer requirements. New product design and materials development activities are supported by TPD's Product Development and Materials Engineering Laboratory. Sales and Marketing. TPD sells products to regional Bell operating companies, many smaller domestic telephone companies and to telephone companies and private contractors overseas. Competition is based primarily on price, with service and product quality important, but secondary, considerations. Engineered Products Division Products. EPD develops, manufactures and distributes automotive primary wire, ignition wire, battery cable, flexible cordage, motor lead wire, submersible pump cables and welding cable. Automotive products are sold primarily to suppliers of automotive original equipment, while industrial wire and cable products are sold to appliance and power tool manufacturers. A recent acquisition has expanded EPD's product offering with the addition of specialty wiring assemblies including heavy truck harnesses and automotive ignition wire assemblies. See "Business-- Business Development." Sales and Marketing. EPD has one principal customer. See Significant Customer below. Considerable progress has been made, however, to broaden its automotive customer base. To this end, the Company has retained an independent sales organization, located in the Detroit, MI area that provides EPD with the local presence necessary to attract and service new customers in the automotive wire market. Sales representatives from MWI and WCD also call on and service many of the division's other original equipment manufacturer customers. EPD has been recognized as a technology leader in the automotive wire and cable industry by two major customers. This has led to increased business with these customers and has helped EPD obtain significant new business from other customers. The principal customer of EPD continues to be serviced by a dedicated sales representative who is a Company employee. Significant Customer. UTC's Automotive Group is the principal customer for EPD's automotive wire, generating approximately 40% of EPD's revenues in 1993. This percent has declined from previous years, when the proportion was as high as 60%, principally through developing a broader customer base; a strategy which is expected to continue. In the event this customer were to cease buying the Company's products, the Company believes EPD could be adversely impacted. However, the Company further believes that if this event were to occur it would market to other customers and any underutilized equipment could be altered to produce other wire products at a reasonable cost and in a reasonable period of time. Business Development The Company has established plans to increase sales across many of its product lines by expanding product offerings within compatible markets, targeting new global markets for existing products and expanding penetration in those overseas markets where a presence has already been established. To accomplish this objective, the Company expects to make business acquisitions and capital investments in new plant and equipment as necessary in the United States and intends to pursue select investments in strategic partners and participate in joint ventures off-shore. A senior executive has been appointed to direct new business development and international activities for the Company. In the second quarter of 1993 the Company completed construction of a new magnet wire manufacturing facility, a portion of which is leased to Femco. Femco manufactures and markets magnet wire with special emphasis on products required by Japanese manufacturers for their production facilities in the United States. In addition to an expanded presence in Japanese transplant markets, the Company also expects to benefit from the Femco joint venture through application of new production methods, product improvement and production efficiencies which, in turn, should have application to other Company Magnet Wire and Insulation Division production facilities. See "Division Operations--Magnet Wire and Insulation." In the fourth quarter of 1993 the Company completed the acquisition of a Mississippi based company which provides an entry into specialty wiring assemblies including heavy truck harnesses and automotive ignition wire assemblies. See "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Liquidity, Capital Resources and Financial Condition." Also during 1993, the Company made an equity investment in a major Mexican wire producer to establish an investment presence in the Latin American wire markets. Manufacturing Strategy The Company's manufacturing strategy is primarily focused on maximizing product quality and optimizing production efficiencies. The Company has achieved a high level of vertical integration through internal production of its principal raw materials: copper rod, enamels and resin compounds. The Company believes one of its primary cost advantages in the magnet wire business is its ability to produce most of its enamel requirements internally. Similarly, the Company believes its ability to develop and produce PVC and rubber compounds, which are used as insulation and jacketing materials for many of its building wire, telecommunication, automotive and industrial wire products, provides cost advantages because the process achieves greater control over the cost and quality of essential components used in production. These operations are supported by the Company's metallurgical, chemical and polymer development laboratories. To further optimize production efficiencies, the Company invests in new plants and equipment, pursues plant rationalizations, and participates in joint venture opportunities. In the period 1988 through 1991, the Company spent an average of $13.4 million per year for capital projects. In 1992 and 1993, the Company made capital expenditures of approximately $31.2 million and $26.2 million, respectively. Company management has continued to identify opportunities to improve the efficiency of its manufacturing facilities and has employed rationalization efforts to accomplish those improvements. Manufacturing Process Copper rod is the base component for most of the Company's wire products. The Company buys copper cathode from a variety of producers and dealers and also reclaims and reprocesses scrap copper from its own and other operations. See "Metals Operations." After the rod is manufactured at the Company's rod mills, it is shipped to other manufacturing facilities where it is processed into the wire and cable products produced by the Company. See "Copper Rod Production." The manufacturing processes for all of the Company's wire and cable products require that the copper rod be drawn and insulated. Certain products also require that the wire be "bunched" or "cabled". Wire Drawing. Wire drawing is the process of reducing the metal conductor diameter by pulling it through a converging die until the specified product size is attained. Since the reduction is limited by the breaking strength of the metal conductor, this operation is repeated several times internally within the machine. As the wire becomes smaller, less pulling force is required. Therefore, machines operating in specific size ranges are required. Take-up containers or spools are generally large, allowing one person to operate several machines. Bunching. Bunching is the process of twisting together single wire strands to form a concentric construction ranging from seven to over 200 strands. The major purpose of bunching is to provide improved flexibility while maintaining current carrying capacity. For some applications (for example, automotive uses), the final wire must be concentric, requiring accurate control of the bare wire's mechanical properties, tension, and diameter. In other applications, such as building wire, different diameters are used within the single conductors to produce a round wire. Insulating. The magnet wire insulating materials (enamels) manufactured by the Company's chemical processing facility are polymeric materials produced by one of two methods. One method involves the blending of commercial resins which are dissolved in various solvents and then modified with catalysts, pigments, cross-linking agents and dyes. The other method involves building polymer resins to desired molecular weights in reactor systems. The enamelling process used in the manufacture of some magnet wire involves applying several thin coats of liquid enamel and evaporating the solvent in baking chambers. Some enamels require a specific chemical reaction in the baking chamber to fully cure the film. Enamels are generally applied to the wires in excess, which is then metered off with dies or rollers; however, some applications apply only the required amount of liquid enamel. Most other wire products are insulated with plastic or rubber compounds through an extrusion process. Extrusion involves the feeding, melting and pumping of a compound through a die to shape it into final form as it is applied to the wire. The Company has the capability to manufacture both rubber and PVC jacketing and insulating compounds, which are then extruded onto wire. In order to enhance the insulation properties of certain products, the polymers can be cross-linked chemically or by radiation after the extrusion process. Extensive chemical cross-linking capability exists within certain of the Company's facilities. In addition, an electron beam radiation facility is utilized at the Lafayette, Indiana plant. Once the wire is fabricated, it is packaged and shipped to regional warehouses, distributors or directly to customers. Metals Operations Although the Company classifies its business into four principal divisions (see "Division Operations" above) the metals operations, due to cost efficiencies, are centrally organized. Copper is the critical component of the Company's overall cost structure, comprising approximately 50% of the Company's 1993 total production cost of sales. Through centralization, the Company carefully manages its copper procurement, internal distribution, manufacturing and scrap recycling processes. The Company's operations are vertically integrated in the production of copper rod; the Company believes that only a few of its larger competitors are able to match this capability. The Company manufactures most of its copper rod requirements and purchases the remainder from various suppliers. Copper Procurement The Company centralizes its copper purchases. In 1993 the Company bought approximately 225,000 tons of copper. North American copper producers and metals merchants accounted for approximately 98% of such purchases. Under producer contracts, the Company commits to take a specified tonnage per month. Most producer contracts have a one-year term. Pricing provisions vary, but they are based on the New York Commodity Exchange, Inc. ("COMEX") price plus a premium. Under merchant contracts, prices are also based on the COMEX price plus a premium. Payment terms are negotiated. Historically, the Company has had adequate supplies of raw materials available to it from producers and dealers, both foreign and domestic. Competition from other users of copper has not affected the Company's ability to meet its copper procurement requirements. However, no assurance can be given that the Company will be able to procure adequate supplies of copper to meet its future needs. Copper Rod Production The production of copper rod is an essential part of the Company's manufacturing process. Through vertical integration, the Company's ability to manufacture rod provides greater control over the cost and quality of an essential component used in producing most of the Company's products. Approximately 80% of the Company's rod requirements are provided internally, with the balance purchased from external sources. External rod purchases are used to cover rod requirements beyond the Company's capacity to produce and for rod requirements at manufacturing locations where shipping Company-produced rod is not cost effective. The Company currently has four rod production facilities which are strategically located near its major wire producing plants to minimize freight costs. During the third quarter of 1994, the Company expects to commence production at a fifth continuous casting unit to further supply its rod requirements and reduce costs. Copper rod is manufactured by a continuous casting process where high quality copper cathodes are melted in a shaft furnace. The molten copper is transferred to a holding furnace and siphoned directly onto a casting wheel where it is cooled and subsequently rolled into copper rod. The rod is subjected to quality control tests to determine that it meets the high quality standards of the Company's products. Numerous other quality tests are performed throughout the process to determine rod characteristic and provide proper utilization of rod by plants requiring specific processing requirements. Finally, the rod is packaged for shipment via an automatic in-line coiling packaging device. Copper Scrap Reclamation The Company's Metals Processing Center receives scrap from a majority of the Company's plants. Copper scrap is processed in rotary furnaces, which also have refining capability to remove impurities. A casting process is employed to manufacture copper rod from scrap material. This continuous casting process is unique in the industry in the conversion of scrap directly into rod. Manufacturing cost economies, particularly in the form of energy savings, result from the Company's direct production technique. Additionally, management believes that internal reclamation of scrap copper provides greater control over the cost to recover the Company's principal manufacturing by-product. The Company also obtains scrap from other copper wire producers in exchange for cathodes and processes it along with the internal scrap. Exports Sales of exported goods approximated $70.6 million, $75.5 million, and $40.8 million for the years ended December 31, 1993, 1992, and 1991, respectively. TPD is the Company's primary exporting division. Backlog The Company has no significant order backlog in that it follows the industry practice of producing its products on an ongoing basis to meet customer demand without significant delay. The Company believes the ability to supply orders in a timely fashion is a competitive factor in the markets in which it operates. Competition In each of the Company's operating divisions, the Company experiences competition from at least one major competitor. However, due to the diversity of the Company's product lines as a whole, no single competitor competes with the Company across the entire spectrum of the Company's product lines. Many of the Company's products are made to industry specifications, and are therefore essentially fungible with those of competitors. Accordingly, the Company is subject in many markets to competition on the basis of price, delivery time, customer service and ability to meet specialty needs. The Company believes it enjoys strong customer relations resulting from its long participation in the industry, its emphasis on customer service, its commitment to quality control, reliability, and its substantial production resources. The Company's distribution networks enable it to compete effectively with respect to delivery time. From time to time the Company has experienced reduced margins in certain markets due to price cutting by competitors. Employees As of December 31, 1993, the Company employed approximately 1,280 salaried and 2,475 hourly employees in 33 states. Labor unions represent approximately 50% of the Company's work force. Collective bargaining agreements expire at various times between 1994 and 1999. Contracts covering approximately 26% of the Company's unionized work force will expire at various times during the remainder of 1994. The Company believes that it will be able to renegotiate its contracts covering such unionized employees on terms that will not be materially adverse to it, however, no assurance can be given to that effect. The Company believes its relations with both unionized and nonunionized employees have been good. Item 2. Item 2. Properties At December 31, 1993 the Company operated 26 manufacturing facilities in 12 states. Except as indicated below, all of the facilities are owned by the Company or its subsidiaries. The Company believes its facilities and equipment are reasonably suited to its needs and are properly maintained and adequately insured. The following table sets forth certain information with respect to the manufacturing facilities of the Company at December 31, 1993: (a) Approximately 30,000 square feet of the Kosciusko, MS facility is leased. (b) The total square footage of the Franklin, IN facility is approximately 70,000 of which 35,000 square feet is leased to Femco as described in the third succeeding paragraph below. In addition to the facilities described in the table above, the Company owns or leases 26 warehouses throughout the United States, plus one in Canada to facilitate the sale and distribution of its products. The Company owns and maintains executive and administrative offices in Fort Wayne, Indiana. The Company believes its plants are generally adequate to service the requirements of its customers. Overall, the Company's plants are utilized to a substantial, but not full degree. The extent of current utilization is generally consistent with historical patterns, and, in the view of the Company, is satisfactory. The Company does not view any of its plants as being substantially underutilized. Most plants operate on schedules of no less than three eight hour shifts, five days a week. During 1993, the Company's facilities operated overall at approximately 93% of capacity, with MWI at 93%, EPD at 77%, TPD at 95% and WCD at 95% of capacity. The property in Franklin, Indiana is a magnet wire manufacturing facility occupied by both the Company and Femco. Half of the Franklin, Indiana building is leased to Femco which was established in 1988 as a joint venture between the Company and The Furukawa Electric Company, LTD., Tokyo, Japan. Femco manufactures and markets magnet wire with special emphasis on products required by Japanese manufacturers with production facilities in the United States. See Division Operations--Magnet Wire and Insulation and "Management's Discussion and Analysis of Results of Operations and Financial Condition Liquidity, Capital Resources and Financial Condition." Item 3. Item 3. Legal Proceedings Legal and Environmental Matters The Company is engaged in certain routine litigation arising in the ordinary course of business. The Company does not believe that the adverse determination of any pending litigation, either singly or in the aggregate, would have a material adverse effect upon its business, financial condition or results of operations. Potential environmental liability to the Company arises from both on-site contamination by, and off-site disposal of, hazardous substances. On-site contamination at certain Company facilities is the result of historic disposal activities, including activities attributable to Company operations and those occurring prior to the use of a facility site by the Company. Off-site liability would include cleanup responsibilities at various sites to be remedied under federal or state statutes for which the Company has been identified by the United States Environmental Protection Agency (the "EPA") (or the equivalent state agency) as a Potentially Responsible Party ("PRP"). The Company has been named in government proceedings which involve environmental matters with potential remediation costs and, in certain instances, sanctions. Once the Company has been named as a PRP, it estimates the extent of its potential liability based upon, among other things, the number of other identified PRPs and the relative contribution of Company waste at the site. Nevertheless, the Company believes that, except as described in the next succeeding paragraph and subject to the $4.0 million "basket" described below and one other identified site, it will not bear the cost of investigation and cleanup at any of these sites because, pursuant to the Stock Purchase Agreement dated January 15, 1988 (the "1988 Acquisition Agreement") covering the 1988 Acquisition, UTC agreed to indemnify the Company against all losses, as defined in the 1988 Acquisition Agreement, incurred under any environmental protection and pollution control laws or resulting from or in connection with damage or pollution to the environment, and arising from events, operations or activities of the Company prior to February 29, 1988 or from conditions or circumstances existing at or prior to February 29, 1988. Except for certain matters relating to permit compliance, the Company believes that it is fully indemnified with respect to conditions, events and circumstances known to UTC prior to February 29, 1988, i.e., matters referred to in documents which were in UTC's possession, custody or control prior to the 1988 Acquisition or matters identified to UTC through the due diligence of Holdings. Further, the Company is indemnified, subject to a $4.0 million "basket" (the "Basket"), for losses related to any environmental events, conditions, or circumstances identified prior to February 28, 1993 to the extent such losses are not caused by activities of the Company after February 29, 1988. None of the foregoing was affected by the change in control of Holdings on October 9, 1992. The Company is not aware of any inability or refusal on the part of UTC to pay amounts which are owing under the UTC indemnity. From time to time, however, the Company and UTC have disagreed as to certain matters of fact which would be determinative as to whether a particular environmental matter is covered by the indemnity or is subject to the Basket. The matters involved have arisen seriatim over the past six years and have not been material. Each matter related to particular sites which have been remediated and the Company has expensed all amounts incurred by it in connection with such sites. Recently the Company and UTC agreed in principle to share financial responsibility for all of such matters without necessarily agreeing on all of the factual issues involved. The Company does not believe that, in light of the UTC indemnity, any of the environmental proceedings in which it is involved and for which it may be liable under the Basket or otherwise will, individually or in the aggregate, have a material adverse effect upon its business, financial condition or results of operations and none involves sanctions for amounts of $0.1 million or more. In 1967, following an investigation regarding the alleged violation of United States antitrust laws, the Company agreed that in the future it would refrain from tying the sale of magnet wire to the purchase of other products. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None during the fourth quarter of 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There is no established public trading market for the common stock of the Company or of its parent, Holdings. The common stock of the Company and its parent has not been traded or sold publicly and accordingly no information with respect to sales prices or quotations is available. Item 6. Item 6. Selected Financial Data The following table sets forth (i) selected historical consolidated financial data of the Company prior to the Acquisition ("Predecessor") as of and for the nine month period ended September 30, 1992, and each of the years in the three year period ended December 31, 1991, (ii) selected historical consolidated financial data of the Company after the Acquisition ("Successor") as of and for the year ended December 31, 1993 and the three month period ended December 31, 1992, and, (iii) combined historical consolidated financial data of Successor for the three month period ended December 31, 1992 and Predecessor for the nine month period ended September 30, 1992. This data should be read in conjunction with "Management's Discussion and Analysis of Results of Operations and Financial Condition" and the consolidated financial statements and related notes included elsewhere herein. The selected historical consolidated financial data presented below as of and for each of the years in the two year period ended December 31, 1990, were derived from the audited consolidated financial statements of Predecessor (not presented herein). The selected historical consolidated financial data presented below, as of and for the year ended December 31, 1993, the three month period ended December 31, 1992, the nine month period ended September 30, 1992, and the year ended December 31, 1991, were derived from the consolidated financial statements of Successor and Predecessor, which were audited by Ernst & Young, independent auditors, whose report with respect thereto, together with such financial statements, appears elsewhere herein. (Footnotes on following page) (Footnotes continued from previous page) (a) Represents a combination of Successor's three month period ended December 31, 1992 and Predecessor's nine month period ended September 30, 1992. Such combined results are not directly comparable to the consolidated results of operations of the Predecessor for each of the three years ended December 31, 1991, nor are they necessarily indicative of the results for the full year due to the effects of the Acquisition and Merger and related refinancings and the concurrent adoption of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," ("FAS 109"). See Notes to Consolidated Financial Statements. Financial data of the Company as of October 1, 1992 and thereafter reflect the Acquisition using the purchase method of accounting, and accordingly, the purchase price has been allocated to assets and liabilities based upon their estimated fair values. However, to the extent that Holdings management had a continuing investment interest in Holdings' common stock, such fair values (and contributed stockholder's equity) were reduced proportionately to reflect the continuing interest (approximately 10%) at the prior historical cost basis. (b) In connection with the Acquisition and Merger, debt issuance costs of $1.5 million and $1.8 million associated with debt retired were included in interest expense for the year ended December 31, 1993 and the three month period ended December 31, 1992, respectively. (c) In connection with the Acquisition and Merger, the Predecessor recorded certain merger related expenses of $18.1 million consisting primarily of bonus and option payments to certain employees and certain merger fees and expenses, which have been charged to the Predecessor's operations in the nine month period ended September 30, 1992. In May 1989, the Predecessor paid cash bonuses to certain members of its management from the proceeds of the debentures issued by Holdings. (d) Holdings and the Company file a consolidated U.S. federal income tax return. Through December 31, 1990 the deductible expenses of Holdings (primarily interest) were included in the calculation of the Company's income taxes under a tax sharing agreement with Holdings. The tax sharing agreement was amended, effective January 1, 1991, to provide that the Company's aggregate income tax liability be calculated as if it were to file a separate return with its subsidiaries. The tax benefits recorded in 1990 and 1989 for the deductible expenses of Holdings were $8.7 million and $4.8 million, respectively. The pro forma net income reflecting income taxes on a separate return basis is presented for 1990 and 1989 as if such benefits had not been recorded. (e) During 1993, Successor recognized extraordinary charges of $3.1 million, net of applicable tax benefit, representing the write off of unamortized debt costs associated with the repayment of the outstanding balance of the Company's term loans, and $0.3 million, net of applicable tax benefit, representing the net loss resulting from the redemption of the Company's 12 3/8% Senior Subordinated Debentures ("Debenture Repurchases"). During 1992 and 1991, Predecessor made Debenture Repurchases which had a carrying value of $13.8 million and $42.0 million, respectively. The net loss resulting from these repurchases, which includes the write off of a portion of unamortized debt costs, was reflected as an extraordinary charge of $0.1 million and $1.5 million, net of applicable income tax benefit for Predecessor during 1992 and 1991, respectively. (f) For purposes of this computation, earnings consist of income before income taxes plus fixed charges (excluding capitalized interest). Fixed charges consist of interest on indebtedness (including capitalized interest and amortization of deferred financing fees) plus that portion of lease rental expense representative of the interest factor (deemed to be one-third of lease rental expense). Earnings of the Successor were insufficient to cover fixed charges by the amount of $7.1 million for the three month period ended December 31, 1992. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition Introduction The Company is engaged in one principal line of business, the production of electrical wire and cable. The Company classifies its operations into four major divisions based on the markets served: Wire and Cable Division, Magnet Wire and Insulation Division, Telecommunication Products Division and Engineered Products Division. See "Business" for a description of the principal products offered by each division and the total sales for each major product line for the years ended 1993, 1992 and 1991. For financial statement purposes, the Acquisition and Merger was accounted for by Holdings as a purchase acquisition effective October 1, 1992. Because the Company is a wholly-owned subsidiary of Holdings, the effects of the Acquisition and Merger have been reflected in the Company's financial statements, resulting in a new basis of accounting reflecting estimated fair values for Successor's assets and liabilities at that date. However, to the extent that Holdings' management had a continuing investment interest in Holdings' common stock, such fair values (and contributed stockholder's equity) were reduced proportionately to reflect the continuing interest (approximately 10%) at the prior historical cost basis. As a result, the Company's financial statements for the periods subsequent to September 30, 1992 are presented on the Successor's new basis of accounting, while the financial statements for September 30, 1992 and prior periods are presented on the Predecessor's historical cost basis of accounting. The consolidated results of operations of the Company for the twelve month period ended December 31, 1992 are not directly comparable to the consolidated results of operations of the Predecessor due to the effects of the Acquisition and Merger and related refinancings and the concurrent adoption of FAS 109. See Notes 1 and 7 of Notes to Consolidated Financial Statements. In connection with the Acquisition and Merger and the concurrent adoption of FAS 109, the Successor recognized $142.2 million of excess of cost over net assets acquired that is being amortized over 35 years on the straight line method. Results of Operations The Year Ended December 31, 1993 Compared With The Twelve Months Ended December 31, 1992 Net sales for 1993 were $868.8 million or 4.5% lower than 1992. Record sales volume in 1993 exceeded the previous record-level volume of 1992 by approximately 5.1% but was more than offset by reduced product prices reflecting lower copper costs, the Company's principal raw material, and competitive pricing pressures. Copper costs are generally passed on to customers through product pricing. The average price for copper on the New York Commodity Exchange, Inc. (the "COMEX") declined 17.0% from 1992. The Company believes the improved sales volume resulted from increased demand for wire products within the served markets and was attributable to an improving economy, especially as it affected the markets served by the Magnet Wire and Insulation and Engineered Products Divisions. For a discussion of the Company's practices with respect to the purchase, internal distribution and processing of copper, see "Business-Metals Operations." Also see "General Economic Conditions and Inflation" under this caption. Sales for the Magnet Wire and Insulation Division were up 5.3% compared to 1992. Sales volume increased 12.5% over 1992 resulting from increased demand for magnet wire products in the automotive, electric motor and transformer markets in addition to increased sales to distributors. Product pricing was down approximately 6.9% due primarily to lower copper prices in 1993 compared to 1992. The Engineered Products Division experienced a 5.3% increase in sales over 1992 attributable primarily to increased demand for the division's automotive wire products. Automotive wire volumes increased approximately 21% from 1992 due in part to improved demand from its primary customer and to several new accounts. See "Business-Division Operations-Engineered Products Division". Of the increased automotive sales volume, 27% resulted from new customers. Sales of non-automotive products also experienced volume improvements despite decreased demand for pump and welding cable products resulting from flooding in the midwest during 1993. The Wire and Cable, and Telecommunication Products Divisions experienced sales declines in 1993 compared with 1992. The Wire and Cable Division's sales were off 11.3% from 1992 due principally to lower copper prices and reduced product pricing. Volume was down slightly compared with 1992 due mainly to selective market participation during part of the year. Sales by the Telecommunication Products Division were down approximately 11.8% compared with 1992. In addition to reduced product pricing, unit sales volume to the domestic telephone markets was down 22.0% partially offset by a 19.3% increase in export unit volume. Product demand within the domestic markets was down due primarily to general uncertainty about the economy as well as the ongoing restructuring of the U.S. telephone cable industry. Cost of goods sold decreased 4.4% in 1993 compared with 1992 due primarily to lower copper prices partially offset by higher sales volume and additional depreciation expense resulting from the application of purchase accounting in connection with the Acquisition and Merger and the concurrent adoption of FAS 109 (See Notes 1 and 7 of Notes to Consolidated Financial Statements). The Company's cost of goods sold as a percentage of net sales was 85.8% in each of 1993 and 1992. The cost of goods sold percentage in 1993 was adversely impacted by generally lower selling prices and additional depreciation expense resulting from the application of purchase accounting in connection with the Acquisition and Merger and the concurrent adoption of FAS 109 partially offset by lower manufacturing costs resulting from increased capacity utilization. Cost of goods sold in 1992 includes a charge of $2.6 million relating to planned plant consolidations, primarily costs to move equipment and personnel related expenses. Raw material costs in 1993, excluding copper, were generally unchanged from 1992. Selling and administrative expenses in 1993 were 7.9% lower than 1992 due primarily to the expiration of a non-compete agreement with UTC in the first quarter 1993 resulting in the elimination of the related amortization charge, a $2.1 million reduction in the Company's health insurance expense and a $1.5 million accrual in 1992 for the relocation of a business unit in 1993. In connection with the 1988 Acquisition, UTC agreed that until March 1, 1993, it would not engage in any business directly competing with any business carried on by the Company on February 29, 1988. The $34.0 million purchase price allocated to the covenant not to compete was amortized over five years on the straight line method. The reduction in health insurance expense was attributable to favorable experience in health related expenditures. Partially offsetting these expense reductions was a $4.0 million amortization charge recorded in 1993 for excess of cost over net assets acquired compared to a $1.0 million charge recorded in the last quarter of 1992 and a $2.5 million reduction in the Company's allowance for doubtful accounts recorded in the third quarter of 1992. In connection with the Acquisition and Merger and concurrent adoption of FAS 109, the Successor recognized $142.2 million of excess of cost over net assets acquired that is being amortized over 35 years on the straight line method. The Company's allowance for doubtful accounts was reduced on the basis of the collection of a substantial receivable which had been considered doubtful as well as management's assessment of collection risk in the primary markets served. Interest expense in 1993 was $25.2 million as compared to $22.6 million in 1992. The increase was principally caused by $19.0 million in additional weighted average debt outstanding and an increase in the Company's average interest rate incurred (from 8.9% to 9.7%). The additional debt outstanding was primarily attributable to Acquisition- related borrowings and the May 1993 sale by the Company of its 10% Senior Notes due 2003 (the "Senior Notes"). Average interest rates increased reflecting the higher interest rate on the Senior Notes compared with the rate of interest on the Term Credit which was repaid from the sale of the Senior Notes, partially offset by the redemption of all outstanding 12 3/8% Senior Subordinated Debentures due 2000 (the "Debentures") which were also repaid in connection with the issuance of the Senior Notes. See also "Liquidity, Capital Resources and Financial Condition". In connection with the Acquisition and Merger, the Company incurred certain merger related expenses in the amount of $18.1 million consisting primarily of bonus and option payments to certain employees, and certain merger fees and expenses which were charged to operations of the Predecessor in the quarter ended September 30, 1992. These Acquisition and Merger expenses had the effect of reducing 1992 net income by $12.5 million (after applicable tax benefit of $5.6 million). See Note 1 of Notes to Consolidated Financial Statements. Income tax expense was $13.1 million, or 58.2% of pretax income in 1993 compared with $7.4 million, or 95.2%, of pretax income in 1992. The Company elected not to step up its tax bases in the assets acquired in either the Acquisition or the 1988 Acquisition. Accordingly, the Company's income tax bases in the assets acquired have not been changed from those prior to the 1988 Acquisition. Depreciation and amortization of the higher allocated financial statement bases are not deductible for income tax purposes, thus causing the effective income tax rate of the Predecessor to be generally higher than the combined federal and state statutory rate. Because of the adoption of FAS 109 by the Successor, concurrent with the Acquisition, deferred income taxes have been provided for bases differences in all assets and liabilities other than excess of cost over net assets acquired. In compliance with the Omnibus Budget Reconciliation Act of 1993, the Company's tax balances were adjusted in the third quarter of 1993 to reflect the new federal statutory tax rate of 35%. The adjustment had the effect of increasing income tax expense by $2.3 million for 1993 or 10.0% of pretax income. See Note 7 of Notes to Consolidated Financial Statements. The Company recorded net income of $6.0 million in 1993 as compared to net income of $0.3 million in 1992. The 1993 results include extraordinary charges of $3.4 million ($5.5 million before applicable tax benefits) associated with the repayment of the Term Credit and redemption of the Debentures. See also "Liquidity, Capital Resources and Financial Condition". The 1992 results include $18.1 million of Acquisition and Merger related expenses, $12.5 million net of applicable tax benefit, and a $0.1 million extraordinary charge ($0.2 million before applicable tax benefit) resulting from the partial repurchase of a portion of the outstanding Debentures. Twelve Months Ended December 31, 1992 Compared With The Year Ended December 31, 1991 Net sales for 1992 were $909.4 million or 2.7% greater than 1991 due principally to a record volume year with an 8.0% increase in sales volume over 1991. The Company attributes the increase in sales volume at least in part to the strengthening U.S. economy during the period. The positive effects of an increase in sales volumes were partially offset, however, by lower copper prices, the Company's principal raw material, and competitive product pricing. Copper costs are generally passed on to customers through product pricing and the average price for copper on the COMEX declined 2.1% from 1991. Due to increased competitive pressures, primarily in the building wire and telecommunication cable product lines, overall product pricing was below 1991 levels. For a discussion of the Company's practices with respect to the purchase, internal distribution and processing of copper, see "Business Metals Operations." Also see "General Economic Conditions and Inflation" under this caption. The Wire and Cable Division's sales, after reflecting the transfer to the Engineered Products Division of an industrial wire product line representing $32.7 million in sales in 1992, declined 3.1% from 1991 sales levels. Despite such product line transfer, Wire and Cable Division sales volume was nearly 4.7% ahead of 1991 due to improved demand for building wire products. Sales for the division would have increased 5.8% and sales volume would have increased 10.9% in 1992 over 1991 had the industrial wire product line transfer occurred on January 1, 1991. Increased competitive pressures in the fourth quarter of 1992, however, caused an overall deterioration in product pricing for the year. Sales volume during the fourth quarter was essentially unchanged from the same period in 1991. The Magnet Wire and Insulation Division's sales increased 2.7% over 1991 due primarily to a 7.5% improvement in sales volume. Increased automobile and truck production coupled with an upturn in housing starts contributed to the higher volumes. Magnet Wire and Insulation Division product pricing declined marginally from 1991. Telecommunication Products Division sales were off 5.5% from 1991 levels. During 1992, the Telecommunication Products Division experienced more severe pricing pressures in its domestic markets and therefore, diverted a larger portion of its manufacturing capacity to serve export markets. Consequently, export sales for the division were up 111.4% from 1991. Due to the change in product mix and continued pricing pressures, average Telecommunication Products Division product pricing declined moderately from 1991. Engineered Products Division's sales were up $37.1 million from 1991 although $32.7 million of that increase was attributable to the transfer from the Wire and Cable Division of the industrial wire product line. Without giving effect to that transfer, sales were up 6.2% due to an increase in automotive and industrial wire sales volumes. A generally improved economy coupled with an approximate 8.9% rise in domestic automobile and truck production were the primary contributors to this improvement. Cost of goods sold in 1992 increased 3.6% from 1991 due primarily to higher sales volume partially offset by lower copper costs and generally lower other material costs. The Company's cost of goods sold as a percent of net sales was 85.8% and 85.0% in 1992 and 1991, respectively. The cost of goods sold percentage in 1992 was higher than in 1991 because the Company's major business units experienced greater competitive pricing pressure resulting in generally lower selling prices. The higher sales volume, however, lead to increased capacity utilization resulting in generally lower manufacturing costs. Cost of goods sold in 1992 was also impacted by a charge of approximately $2.6 million to reflect anticipated plant consolidations and approximately $1.6 million in additional depreciation expense resulting from the October 1, 1992 application of purchase accounting in connection with the Acquisition and Merger and the concurrent adoption of FAS 109 on a prospective basis. Selling and administrative expenses for 1992 were up 2.2% from 1991 but remained at approximately 9.0% of sales. Contributing to this increase was a $1.5 million accrual in 1992 for the anticipated relocation of a business unit in 1993 and a $1.0 million amortization charge for the excess cost over net assets acquired associated with the Acquisition and Merger and adoption of FAS 109. A reduction of $2.5 million in the Company's allowance for doubtful accounts and a $1.0 million reduction in its health insurance accrual in 1992 offset the foregoing charges. The Company's allowance for doubtful accounts was reduced by $2.5 million (net $1.8 million after approximately $0.7 million current provision) on the basis of the collection of a substantial receivable which had been considered doubtful as well as management's assessment of risk of collection in the primary markets served. In addition, actual health related expenditures did not increase to the levels previously anticipated. The 1991 results include a charge for a warranty claim settlement of approximately $1.7 million. Interest expense in 1992 was $22.6 million as compared to $25.0 million in 1991. This 9.5% decrease was due principally to a $17.5 million reduction in the Company's weighted average total debt outstanding during 1992 and generally lower interest rates on the Company's bank credit facilities. During 1992, Debenture Repurchases totalled $13.8 million while the Company's weighted average interest rate on debt outstanding declined from 10.4% to 8.7%. Partially offsetting these favorable outcomes was an amortization charge related to the deferred debt costs incurred to place the new credit agreement and amortization of deferred debt costs on debt retired and to be retired in connection with the Acquisition. See "Liquidity, Capital Resources and Financial Condition." In connection with the Acquisition and Merger, the Company incurred certain merger related expenses in the amount of $18.1 million consisting primarily of bonus and option payments to certain employees, and certain merger fees and expenses which were charged to operations of the Predecessor in the quarter ended September 30, 1992. These Acquisition and Merger expenses had the effect of reducing net income by $12.5 million (after applicable tax benefit of $5.6 million). See Note 1 of Notes to Consolidated Financial Statements. Income tax expense was $7.4 million, or 95.2% of pretax income in 1992 compared with $13.2 million, or 47.7%, of pretax income in 1991. The Company elected not to step up its tax bases in the assets acquired in either the Acquisition or the 1988 Acquisition. Accordingly, the Company's income tax bases in the assets acquired have not been changed from those prior to the 1988 Acquisition. Depreciation and amortization of the higher allocated financial statement bases are not deductible for income tax purposes, thus causing the effective income tax rate of the Predecessor Company to be generally higher than the approximate statutory rate of 39%. Because of the adoption of FAS 109 by the Successor Company concurrent with the Acquisition, deferred income taxes have been provided for bases differences in all assets and liabilities other than excess of cost over net assets acquired. See Notes 2 and 7 of Notes to Consolidated Financial Statements. The Company's net income for the twelve month period ended December 31, 1992 (after giving effect to $18.1 million of Acquisition and Merger related expenses, $12.5 million net of applicable tax benefit) was $0.3 million which included a $0.1 million ($0.2 million before applicable tax benefit) extraordinary charge resulting from Debenture Repurchases. Liquidity, Capital Resources and Financial Condition The Company had a ratio of debt (consisting of current and non-current portions of long-term debt) to stockholder's equity of approximately 0.7 to 1 at December 31, 1993 and 1992. In connection with the Acquisition and Merger, the Company entered into a credit agreement in September 1992, among BE, the Company, Holdings, the lenders named therein and Chemical Bank, as agent (the "Credit Agreement"). Under the Credit Agreement, the Company borrowed $130.0 million in term loans (the "Term Credit") of which $94.0 million was used to repay all indebtedness outstanding under the Company's previous credit agreement and the balance was used to pay a portion of the consideration payable to Holdings' shareholders and option holders in the Merger and certain fees and expenses of the Company and Holdings related to the Acquisition and Merger and for other general corporate purposes. The Credit Agreement also provided for $155.0 million in revolving credit expiring April 9, 1998. In May 1993, the Company issued $200.0 million aggregate principal amount of its Senior Notes. The net proceeds to the Company from the sale of the Senior Notes, after underwriting discounts, commissions and other offering expenses, were approximately $193.5 million. The Company applied approximately $111.0 million of such proceeds to the repayment of the Term Credit and in June 1993 applied the balance of such proceeds together with new borrowings of approximately $7.5 million under the revolving credit facility of the amended and restated credit agreement (see immediately following paragraph), to redeem all of its outstanding Debentures. The Company recognized extraordinary charges in the second quarter of 1993 of approximately $3.4 million ($5.5 million before applicable tax benefit) associated with the repayment of the Term Credit and redemption of the Debentures. Upon application of the net proceeds received from the Senior Notes to repay the Term Credit, as discussed above, an amendment and restatement of the Credit Agreement became effective (the "Restated Credit Agreement"). The Restated Credit Agreement provides for $175.0 million in revolving credit, subject to specified percentages of eligible assets, reduced by outstanding letters of credit (the "Revolving Credit"). The Revolving Credit expires in 1998. Revolving Credit loans bear interest at floating rates at bank prime rate plus 1.25% or a reserve adjusted Eurodollar rate (LIBOR) plus 2.25%. The effective interest rate can be reduced by 0.25% to 0.75% if certain specified financial conditions are achieved. The Company has purchased interest rate cap protection through 1994 covering up to $100.0 million of Revolving Credit borrowings. No term facility is available under the Restated Credit Agreement. Through December 31, 1993, the Company fully complied with all of the financial ratios and covenants contained in the Restated Credit Agreement and the indenture under which the Senior Notes were issued (the "Indenture"). The Restated Credit Agreement and the Indenture contain provisions which may restrict the liquidity of the Company. These include restrictions on the incurrence of additional indebtedness and, in the case of the Restated Credit Agreement, mandatory principal repayment requirements for all indebtedness that exceeds the Borrowing Base as defined in the Restated Credit Agreement. Net cash provided by operating activities in 1993 was $60.7 million, an increase of $27.2 million over 1992. Cash flow provided by operating activities in 1993, together with borrowings under the revolving credit facility of the Credit Agreement and the Restated Credit Agreement were sufficient to meet the Company's cash interest requirements, working capital and capital expenditure needs and to pay mandatory principal payments on the Term Credit portion of the Credit Agreement. As previously discussed, the Term Credit was repaid in full in May 1993 out of proceeds from the issuance and sale of the Senior Notes. Capital expenditures in 1993 were $26.2 million or $5.0 million less than in 1992. Such expenditures included $2.6 and $9.2 million for a new magnet wire manufacturing facility in Franklin, Indiana in 1993 and 1992, respectively. This new facility is occupied by both the Company and Femco. Femco was established in 1988 as a joint venture between the Company and The Furukawa Electric Company, Ltd., Tokyo, Japan. At December 31, 1993, approximately $8.6 million was committed to outside vendors for capital projects to expand capacity, complete modernization projects, reduce costs and ensure continued compliance with regulatory provisions. Capital expenditures in 1994 are expected to approximate 1993 spending levels. In November 1993, the Company acquired a majority interest in Interstate Industries, Inc. for cash of $4.3 million, subject to final purchase price adjustments and the minority interest ownership percentage. See "Business--Business Development." The Restated Credit Agreement imposes annual limits on the Company's capital expenditures and business acquisitions. The Company anticipates that its working capital, capital expenditure and cash interest requirements for 1994 will be satisfied through a combination of funds generated from operating activities together with funds available under the Revolving Credit. Management bases such belief on historical experience and the substantial availability of funds under the Revolving Credit. Increased working capital needs occur whenever the Company experiences strong incremental demand in its business as well as a significant rise in copper prices. Average quarterly cash flow generated from operations for the three year period ended December 31, 1993 was $13.7 million; at December 31, 1993 the entire $175.0 million of Revolving Credit was available, subject to specified percentages of eligible assets, (less $13.9 million in outstanding letters of credit). During 1993, average borrowings under the Company's revolving credit facilities were $10.1 million compared to $66.8 million during 1992. In 1993 certain pension actuarial assumptions were revised to reflect changes in their underlying economic fundamentals. The effect of such revisions on the Company's results of operations and cash flows for 1994 is not expected to be material. The Company expects that it may also make certain cash payments to Holdings or other affiliates from time to time to the extent cash is available and to the extent it is permitted to do so under the terms of the Restated Credit Agreement and the Indenture. Such payments may include (i) an amount necessary under the tax sharing agreement between the Company and Holdings to enable Holdings to pay the Company's taxes as if computed on an unconsolidated basis; (ii) a management fee to an affiliate of BHLP of up to $1.0 million; (iii) amounts to repurchase outstanding Senior Discount Debentures due 2004 of Holdings (the "Holdings Debentures") to the extent they may become available for repurchase in the open market at prices which Holdings and the Company find attractive and to the extent such repurchases are permitted under the terms of the instruments governing Holdings and the Company's indebtedness; and (iv) other amounts to meet ongoing expenses of Holdings (such amounts are considered to be immaterial both individually and in the aggregate). To the extent the Company makes any such payments, it will do so out of operating cash flow or borrowings under the Restated Credit Agreement and only to the extent such payments are permitted under the terms of the Restated Credit Agreement and the Indenture. Each of the foregoing payments is either completely discretionary on the part of the Company or may be waived by an affiliate of the Company. Notwithstanding any of the foregoing payments which the Company may make to Holdings, Holdings' actual liquidity requirements are expected to be insubstantial in 1994 on an unconsolidated basis because Holdings has no operations (other than those conducted through the Company) or employees and is not expected to have any tax liability on an unconsolidated basis. Holdings' Series A Cumulative Redeemable Exchangeable Preferred Stock, Liquidation Preference $25 Per Share (the "Series A Preferred Stock"), which was issued in connection with the Acquisition and Merger, provides that dividends may be paid in kind at the option of Holdings until 1998 and is not subject to mandatory redemption until 2004 (except upon the occurrence of certain specified events). The redemption price is $25 per share plus accrued and unpaid dividends to the date of redemption. For the year ended December 31, 1993 Holdings recorded dividends in kind of $5.2 million. The Restated Credit Agreement permits Holdings to pay dividends in cash on the Series A Preferred Stock subject to certain limitations. However, in the near term, Holdings expects to pay dividends on the Series A Preferred Stock in additional shares of such stock. The Holdings Debentures are not expected to have an impact on the Company's liquidity prior to November 15, 1995 (unless they are repurchased or refinanced prior to that date) when cash interest at 16.0% first becomes payable semi-annually. The Holdings Debentures were issued in May 1989. As of December 31, 1993, Holdings had a liability, net of repurchases, of $228.9 million in respect of the Holdings Debentures ($277.8 million aggregate principal amount). Through December 31, 1993 Holdings had repurchased $64.2 million aggregate principal amount of its Holdings Debentures in the open market using cash dividends, management fees and income taxes paid to Holdings by the Company together with available cash. Such payments were made pursuant to the Company's prior credit agreement which was terminated October 9, 1992. There have been no repurchases of Holdings Debentures since 1991 and further repurchases, if any, may be made at the discretion of Holdings and will depend upon market conditions, and, in particular, the prices at which the Holdings Debentures are trading as well as Holdings' available cash. The Holdings Debentures are unsecured debt of Holdings and are effectively subordinated to all outstanding indebtedness of the Company, including the Senior Notes, and will be effectively subordinated to other indebtedness incurred by direct and indirect subsidiaries of Holdings, if issued. Because Holdings is a holding company with no operations and has virtually no assets other than the outstanding capital stock of the Company (all of which is pledged to the lenders under the Restated Credit Agreement), Holdings' ability to meet its cash obligations will be dependent upon the Company's ability to pay dividends, loan or to otherwise advance or transfer funds to Holdings in sufficient amounts. The Company believes that the Restated Credit Agreement and the Indenture permit the Company to dividend or otherwise provide funds to Holdings to enable Holdings to meet its known cash obligations provided that the Company meets certain conditions. Among such conditions, however, are that the Company meet various financial maintenance tests. There can be no assurance that such tests will be met, in which case the Company would not be able to pay dividends to Holdings without the consent of the percentage of the lenders specified in the Restated Credit Agreement and/or the holders of the percentage of the Senior Notes specified in the Indenture. There can be no assurance that the Company would be able to obtain such consents, or meet the terms on which such consents might be granted if they were obtainable. Moreover, a violation of the Restated Credit Agreement and/or the Indenture could lead to an event of default and acceleration of outstanding indebtedness under the Restated Credit Agreement and to acceleration of the indebtedness represented by the Senior Notes and the Holdings Debentures. Because the capital stock of the Company and its subsidiaries, as well as virtually all of the assets of the Company and its subsidiaries, are pledged to the lenders under the Restated Credit Agreement, such lenders would have a claim over such assets prior to holders of the Senior Notes and the Holdings Debentures. In the event Holdings were unable to meet its cash obligations, a sequence of events similar to that described above could ultimately occur. General Economic Conditions and Inflation The Company faces various economic risks ranging from an economic downturn adversely impacting the Company's primary markets to marked fluctuations in copper prices. In the short-term, pronounced changes in the price of copper tend to affect the Wire and Cable Division's gross profits because such changes affect raw material costs more quickly than those changes can be reflected in the pricing of the Wire and Cable Division's products. In the long-term, however, copper price changes have not had a material adverse effect on gross profits because cost changes generally have been passed through to customers over time. In addition, the Company believes that its sensitivity to downturns in its primary markets is less significant than it might otherwise be due to its diverse customer base and its strategy of attempting to match its copper purchases with its needs. During 1993, the Company experienced general improvement in most of its markets served coinciding with general economic conditions. The Company cannot predict either the continuation of current economic conditions or future results of its operations in light thereof. The Company believes that it is not particularly affected by inflation except to the extent that the economy in general is thereby affected. Should inflationary pressures drive costs higher, the Company believes that general industry competitive price increases would sustain operating results, although there can be no assurance that this will be the case. Item 8. Item 8. Financial Statements and Supplementary Data Report of Independent Auditors . . . . . . . . . . . . . . Consolidated Balance Sheets: Successor as of December 31, 1993 and 1992 . . . . . . Consolidated Statements of Operations: Successor for the year ended December 31, 1993, and the three month period ended December 31, 1992 . . . . . . . . . . . . . . . . . . . Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991 . . . . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows: Successor for the year ended December 31, 1993, and the three month period ended December 31, 1992 . . . . . . . . . . . . . . . . . . . Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991 . . . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . INDEX TO FINANCIAL STATEMENT SCHEDULES V. Property, Plant and Equipment . . . . . . . . . . . . . . . S-1 VI. Accumulated Depreciation of Property, Plant and Equipment . S-2 VIII. Valuation and Qualifying Accounts . . . . . . . . . . . . . S-3 X. Supplementary Income Statement Information . . . . . . . . S-4 All other schedules have been omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or notes thereto. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The following table sets forth information concerning the Directors and Executive Officers of the Company. Name Age Position ____ ___ ________ Stanley C. Craft 55 President and Chief Executive Officer; Director Steven R. Abbott 46 President - Wire and Cable Division; Director John L. Cox 50 President - Telecommunication Products Division; Director Robert J. Faucher 49 President - Engineered Products Division; Director Robert D. Lindsay 39 Director Charles W. McGregor 52 President - Magnet Wire and Insulation Division David A. Owen 48 Vice President - Finance, Treasurer, and Chief Financial Officer; Director Thomas A. Twehues 61 Executive Vice President; Director Ward W. Woods 51 Director Frederick M. Zinser 65 Executive Vice President Messrs. Craft, Abbott and Twehues have been directors since 1988. Messrs. Lindsay and Woods became directors of the Company in 1992. Mr. Owen has been a director since March 1993 and Messrs. Cox and Faucher were elected directors in April 1993. Directors of the Company are elected annually to serve until the next annual meeting of stockholders of the Company or until their successors have been elected or appointed and qualified. Executive officers are appointed by, and serve at the discretion of, the Board of Directors of the Company. Mr. Craft has served as President and Chief Executive Officer of the Company since March 1992 and as President since September 1991 . He was Vice President - Finance, Treasurer and Chief Financial Officer of the Company from March 1988 to August 1991. He was Executive Vice President of the European operations of the Company from November 1986 to February 1988. Mr. Craft is also a Director of Holdings. Mr. Abbott was appointed President of the Wire and Cable Division in September 1993. He was President of the Magnet Wire and Insulation Division from 1987 to 1993. Mr. Abbott has been employed by the Company since 1967. Mr. Cox was appointed President of the Telecommunication Products Division in June 1992 when he joined the Company. He had been with American Telephone and Telegraph for twenty five years the last three of which were as Director of Sales for Distributor Networks. Prior to that Mr. Cox was Manager of Product Planning for distributor network exchange cable. Mr. Faucher was appointed President of the Engineered Products Division in January 1992. He was Vice President, Operations in the Industrial Products Division from June 1988 to January 1992. He joined the Company in 1985 as Vice President, Planning. Mr. Lindsay is the sole shareholder of corporations that are the general partners of the partnerships which are the general partners of BHLP and BCP. He is also the sole shareholder of corporations which are the general partners of the two partnerships affiliated with BHLP and BCP to which the Company and Holdings paid the fees described under Item 13 below. Mr. Lindsay was Managing Director of Bessemer Securities Corporation ("BSC"), the principal limited partner of BHLP and BCP, from January 1991 to June 1993. Prior to joining BSC, Mr. Lindsay was a Managing Director in the Merchant Banking Division of Morgan Stanley & Co., Incorporated. He is a Director of Stant Corporation and private companies. Mr. Lindsay is also a Director of Holdings. Mr. McGregor was appointed President of the Magnet Wire and Insulation Division in September 1993. He was Director of Manufacturing for the Division from 1987 to 1993. Mr. McGregor has been employed by the Company in various technical assignments since January 1970. Mr. Owen was appointed Vice President Finance and Chief Financial Officer of the Company in March 1993. He was appointed Treasurer of the Company in April 1992. Prior to that time, Mr. Owen was Director, Treasury and Financial Services for the Company. Mr. Owen has been employed in various capacities by the Company since 1976. Mr. Twehues has been Executive Vice President since September 1993. He had been President of the Wire and Cable Division since 1981. Mr. Twehues started his career in sales with the Wire and Cable Division in 1960. Mr. Woods is the sole shareholder of corporations that are the general partners of the partnerships which are the general partners of BHLP and BCP. He is also the sole shareholder of corporations which are the general partners of the two partnerships affiliated with BHLP and BCP to which the Company and Holdings paid the fees described under Item 13 below. Mr. Woods is President and Chief Executive Officer of BSC, the principal limited partner of BHLP and BCP. Mr. Woods joined BSC in 1989. For ten years prior to joining BSC, Mr. Woods was a senior partner of Lazard Freres & Co., an investment banking firm. He is a director of Boise Cascade Corporation, Freeport-McMoran Inc., Overhead Door Corporation, Stant Corporation and several private companies. Mr. Woods is also a Director of Holdings. Mr. Zinser had been an Executive Vice President since June 1992 and the President of the Telecommunication Products Division from 1979 to June 1992. Mr. Zinser retired from the Company effective January 1, 1994. Item 11. Item 11. Executive Compensation Compensation of Directors and Executive Officers The directors of the Company receive no compensation for their service as directors except for reimbursement of expenses incidental to attendance at meetings of the Board of Directors. The following table sets forth the cash compensation paid by or incurred on behalf of the Company to its Chief Executive Officer and four other most highly compensated executive officers of the Company for each of the three years ended December 31, 1993. SUMMARY COMPENSATION TABLE (1) All awards are for options to purchase the number of shares of common stock of Holdings indicated, provided, however, that the number of shares for which all options are exercisable and the exercise price therefor may be reduced by the Board of Directors of Holdings in accordance with a specified formula. See "Security Ownership of Certain Beneficial Owners and Management." (2) All Other Compensation in 1993 consists of Company contributions to the defined contribution plan on behalf of the executive officer and imputed income on excess Company-paid life insurance premiums. The following table identifies and quantifies these amounts for the named executive officers: (3) All Other Compensation in 1992 includes principally divestiture and retention bonuses paid in connection with the Acquisition and Merger. OPTIONS/SAR GRANTS IN LAST FISCAL YEAR (1) In February 1994 options to purchase 225,000 shares of Holdings common stock were granted in respect of performance for the year ended December 31, 1993. All such options become exercisable on February 1, 1997. (2) The potential realizable value assumes a per-share market price at the time of the grant to be approximately $2.86 with an assumed rate of appreciation of 5% and 10%, respectively, compounded annually for 10 years. The following table details the December 31, 1993 year end estimated value of each named executive officer's unexercised stock options. All unexercised options are to purchase the number of shares of common stock of Holdings indicated, provided, however, that the Board of Directors of Holdings may require that, in lieu of the exercise of any options, such options be surrendered without payment of the exercise price, in which case the number of shares issuable upon exercise of such options shall be reduced by the quotient of (i) the aggregate exercise price that would have been otherwise payable divided by (ii) the amount paid for each share of Holdings common stock in the Merger (approximately $2.86 per share). See "Security Ownership of Certain Beneficial Owners and Management." AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND YEAR-END OPTION/SAR VALUES (E) Exercisable (U) Unexercisable (1) The estimated value of unexercised stock options held at the end of 1993 assumes a per-share fair market value of approximately $2.86 and per-share exercise prices of $1.00 and $1.25 as applicable. (2) The options to purchase Holdings common stock granted in 1994 in respect of performance for the year ended December 31, 1993, were issued with an exercise price of $2.86 per share. Such options are not considered in-the-money since the assumed per-share fair market value at December 31, 1993 approximated $2.86. Pension Plans. The Company provides benefits under a defined benefit pension plan (the "Pension Plan") and a supplemental executive retirement plan (the "SERP"). The following table illustrates the estimated annual normal retirement benefits at age 65 that will be payable under the Pension Plan and SERP. The remuneration utilized in calculating the benefits payable under the plans is the compensation reported in the Summary Compensation Table under the captions Salary and Bonus. The formula utilizes the remuneration for the five consecutive plan years within the ten completed calendar years preceding the participant's retirement date that produces the highest final average earnings. As of December 31, 1993, the years of credited service under the Pension Plan for each of the executive officers named in the Summary Compensation Table were as follows: Mr. Craft, twenty-four years and nine months; Mr. Abbott, twenty-four years and seven months; Mr. Twehues, thirty-three years and four months; Mr. Faucher, twenty-one years and six months; and Mr. Zinser, twenty-eight years and five months. The benefits listed in the Pension Plan Table are based on the formula in the Pension Plan using a straight-life annuity and are subject to an offset of 50% of the participant's annual unreduced Primary Insurance Amount under Social Security. In addition, benefits for credited service for years prior to 1974 are calculated using the formula in effect at that time and would reflect a lesser benefit than outlined in the Pension Plan Table for those years. Benefits under the Pension Plan are also offset by benefits to which the participant is entitled under any defined benefit plan of UTC (other than accrued benefits transferred to the Pension Plan). Compensation Committee Interlocks and Insider Participation Messrs. Stanley C. Craft and Robert Lindsay constitute the Compensation Committee of the Board of Directors of the Company. See footnote (2) under the caption "Security Ownership of Certain Beneficial Owners and Management" for a description of the relationship between Mr. Lindsay and BHLP and the information set forth under the caption "Certain Relationships and Related Transactions" for a description of certain transactions between the Company and BCP or BHLP and between Holdings and BCP or BHLP. Mr. Lindsay is also a member of the Compensation Committee of the Holdings Board of Directors. The other members of such committee are Messrs. Joseph H. Gleberman and Karl R. Wyss. Mr. Gleberman is a Partner of Goldman Sachs and Mr. Wyss is a Managing Director of DLJ. The Holdings Compensation Committee fixes the compensation paid to the Company's executive officers, based in part on the recommendation of Mr. Craft. See the information set forth under the caption "Certain Relationships and Related Transactions" for a description of certain transactions between the Company and DLJ and Goldman Sachs and their respective affiliates. The Holdings Compensation Committee considers compensation of executive officers of the Company to the extent it is paid by or affects Holdings, as is the case when options to purchase Holdings stock are granted to executive officers of Holdings. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management All of the issued and outstanding common stock of the Company is owned beneficially and of record by Holdings. Holdings has pledged such stock to the lenders under the Restated Credit Agreement in support of its guarantee of the Company's obligations thereunder. In the event of a default by Holdings of its obligations under such guarantee, the lenders under the Restated Credit Agreement could exercise their powers under such pledge and thereby obtain control of the Company. The following table sets forth certain information regarding the beneficial ownership of the common stock of Holdings as of February 28, 1994 by (i) each beneficial owner of more than 5% of the outstanding common stock of Holdings, (ii) each director of Holdings, (iii) all directors and officers of Holdings as a group, (iv) all directors and officers of the Company as a group, and (v) all directors, officers and management of the Company as a group. (1) Percentages have been calculated assuming, in the case of each person or group listed, the exercise of all warrants and options owned (which are exercisable within sixty days following February 28, 1994) by each such person or group, respectively, but not the exercise of any warrants or options owned by any other person or group listed. (2) BHLP is a limited partnership the only activity of which is to make private structured investments. The primary limited partner of BHLP is Bessemer Securities Corporation ("BSC"), a corporation owned by trusts whose beneficiaries are descendants of Henry Phipps and charitable trusts established by such descendants. Each of Messrs. Ward W. Woods and Robert D. Lindsay, directors of Holdings, and Mr. Michael B. Rothfeld, is a sole shareholder of a corporation which is a general partner of the limited partnership which is the sole general partner of BHLP. In addition, each of Messrs. Woods, Lindsay and Rothfeld are the sole shareholders of corporations which are the general partners of each of the partnerships affiliated with BHLP and BCP, respectively, to which the Company and Holdings paid the fees described under Item 13 Item 13. Certain Relationships and Related Transactions The Company incurred advisory fees of approximately $1.0 million and $0.2 million payable to affiliates of BHLP and BCP in 1993 and 1992, respectively. Pursuant to an advisory services agreement among Holdings, the Company and an affiliate of BHLP, the Company agreed to pay such affiliate an annual advisory fee of $1.0 million. The Company also incurred advisory fees of $0.2 million and $0.3 million in 1992 and 1991, respectively payable to Morgan Stanley & Co., Incorporated, an affiliate of the former controlling shareholder of Holdings. In addition, the Company incurred management fees to Holdings of $1.9 million and $3.5 million in 1992 and 1991, respectively. No such fee was incurred in 1993. In connection with the Acquisition, the Company paid to an affiliate of BCP a financial advisory fee of approximately $1.9 million and to Morgan Stanley & Co. Incorporated a financial services fee of approximately $3.6 million and Holdings paid to an affiliate of BCP an acquisition advisory fee of approximately $1.9 million. See footnote (2) under Item 12 above for a description of the relationship of Messrs. Woods and Lindsay, directors of the Company, with such BCP affiliate. Pursuant to an engagement letter dated July 22, 1992 among BCP, BE and DLJ, as amended by a letter agreement dated October 9, 1992 among BCP, BE, DLJ and Goldman Sachs (collectively, the "Engagement Letter"), Holdings paid DLJ a financial advisory fee of $1.0 million upon consummation of the Acquisition. In addition, Holdings paid an affiliate of DLJ a $1.0 million commitment fee in connection with its commitment to purchase Series A Preferred Stock of BE. The Engagement Letter also gives DLJ and Goldman Sachs the right, but not the obligation, subject to certain conditions, to act as financial advisor to the Company and Holdings until the fifth anniversary of the Acquisition on a co-exclusive basis in connection with all acquisition, divestiture and other financial advisory assignments relating to Holdings or the Company and to act as co-exclusive managing placement agents or co- exclusive managing underwriters in connection with any debt or equity financing which is either privately placed or publicly offered (excluding commercial bank debt or other senior debt which is privately placed other than any private placement which contemplates a registration of, registered exchange offer for, or similar registration with respect to such securities). In connection with any other senior debt financing which is privately placed (excluding any private placement of senior debt which contemplates a registration, registered exchange offer for, or similar registration with respect to such securities), DLJ has the right, but not the obligation, to act as co-managing placement agent or co- managing underwriter, together only with Chemical Bank. Holdings has retained the right to designate DLJ or Chemical Bank as lead placement agent or lead managing underwriter. Pursuant to such engagement, DLJ and Goldman Sachs acted as underwriters in the offerings of the Senior Notes, and in such capacity received aggregate underwriting discounts and commissions of $5.3 million. For any further services performed by DLJ or Goldman Sachs pursuant to the Engagement Letters, DLJ and Goldman Sachs are entitled to fees competitive with those customarily charged by DLJ, Goldman Sachs and other major investment banks in similar transactions and to customary out of pocket fee and expense reimbursement and indemnification and contribution agreements. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements The financial statements listed under Item 8 are filed as a part of this report. 2. Financial Statement Schedules The financial statement schedules listed under Item 8 are filed as a part of this report. 3. Exhibits The exhibits listed on the accompanying Index to Exhibits are filed as a part of this report. (b) No reports on Form 8-K were filed by the Company during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. ESSEX GROUP, INC. Date (Registrant) March 29, 1994 By /s/ David A. Owen ______________ _____________________________________ David A. Owen Vice President Finance, Treasurer and Chief Financial Officer; Director (Principal Financial Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date March 29, 1994 /s/ Stanley C. Craft ______________ _______________________________________ Stanley C. Craft President and Chief Executive Officer; Director (Principal Executive Officer) March 29, 1994 /s/ David A. Owen ______________ _______________________________________ David A. Owen Vice President Finance, Treasurer and Chief Financial Officer; Director (Principal Financial Officer) March 29, 1994 /s/ Steven R. Abbott ______________ _______________________________________ Steven R. Abbott Director March 29, 1994 /s/ John L. Cox ______________ _______________________________________ John L. Cox Director March 29, 1994 /s/ Robert J. Faucher ______________ _______________________________________ Robert J. Faucher Director March 29, 1994 /s/ Thomas A. Twehues ______________ _______________________________________ Thomas A. Twehues Director March 29, 1994 /s/ Robert D. Lindsay ______________ _______________________________________ Robert D. Lindsay Director March 29, 1994 /s/ Ward W. Woods, Jr. ______________ _______________________________________ Ward W. Woods, Jr. Director March 29, 1994 /s/ James D. Rice ______________ _______________________________________ James D. Rice Vice President and Corporate Controller (Principal Accounting Officer) ESSEX GROUP, INC. INDEX OF EXHIBITS (Item 14(a)(3)) Exhibit No. Description -------------------------------------------------------------------------- 2.01 Agreement and Plan of Merger, dated as of July 24, 1992 (the "Merger Agreement"), between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.1 to BCP/Essex Holdings Inc.'s (then known as MS/Essex Holdings Inc.) Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 1992 (Commission File No. 1-10211). 2.02 Amendment dated as of October 1, 1992, to the Agreement and Plan of Merger between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 3.01 Certificate of Incorporation of the registrant (Incorporated by reference to Exhibit 3.01 to the Company's Registration Statement on Form S-1, File No. 33-20825). 3.02 By-Laws of the registrant, as amended. (Incorporated by reference to Exhibit 3.02 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 4.01 Indenture under which the 10% Senior Notes Due 2003 are outstanding, incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Pre-Effective Amendment No. 1 to Form S-2 (Commission File No. 33-59488). 9.01 Investors Shareholders Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P., certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, a California Limited Partnership, incorporated by reference to Exhibit 28.1 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.02 Management Stockholders and Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P. and certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.3 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.03 Form of Irrevocable Proxy dated as of October 9, 1992, granted to Bessemer Capital Partners, L.P. by certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.4 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 10.01 Amendment and Restatement of Credit Agreement dated May 7, 1993, incorporated by reference to Exhibit 28.7 to the Company's Registration Statement on Pre-Effective Amendment No. 3 to Form S-2 (Commission File No. 33-59488). Exhibit No. Description -------------------------------------------------------------------------- 10.02 Credit Agreement dated as of September 25, 1992, among B E Acquisition Corporation, BCP/Essex Holdings Inc., the registrant, the lenders named therein and Chemical Bank, as agent, incorporated by reference to Exhibit 4.6 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 10.03 Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.10 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418). 10.04 Amendment dated October 9, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, Donaldson, Lufkin & Jenrette, Inc. and Goldman, Sachs and Co., to Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.11 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418). 12.01 Computation of Ratio of Earnings to Fixed Charges. 22.01 Subsidiaries of the registrant. 99.01 Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, A California Limited Partnership, incorporated by reference to Exhibit 28.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 99.02 Amended and Restated Stock Option Plan of BCP/Essex Holdings Inc., incorporated by reference to Exhibit 4.7 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1- 10211). REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder Essex Group, Inc. We have audited the accompanying consolidated balance sheets of Essex Group, Inc. Successor as of December 31, 1993 and 1992 and the related consolidated statements of operations and cash flows of Essex Group, Inc. Successor for the year ended December 31, 1993 and the three month period ended December 31, 1992, and the consolidated statements of operations and cash flows of Essex Group, Inc. Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991. Our audits also included the financial statement schedules listed in the Index at Item 14 (a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Essex Group, Inc. Successor at December 31, 1993 and 1992 and the consolidated results of operations and cash flows of Essex Group, Inc. Successor for the year ended December 31, 1993, and the three month period ended December 31, 1992, and of Essex Group, Inc. Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Indianapolis, Indiana January 28, 1994 ESSEX GROUP, INC. CONSOLIDATED BALANCE SHEETS See Notes to Consolidated Financial Statements ESSEX GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See Notes to Consolidated Financial Statements ESSEX GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See Notes to Consolidated Financial Statements ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In Thousands of Dollars ----------------------- NOTE 1 ORGANIZATION AND ACQUISITION Acquisition of the Company On February 29, 1988, MS/Essex Holdings Inc. ("Holdings"), acquired Essex Group, Inc. (the "Company") from United Technologies Corporation ("UTC") (the "1988 Acquisition") and operated it as a wholly-owned subsidiary ("Predecessor"). The outstanding common stock of Holdings was beneficially owned by the Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"), certain directors and members of management of Holdings and the Company, and others. On October 9, 1992, Holdings was acquired (the "Acquisition") by merger (the "Merger") of B E Acquisition Corporation ("BE") with and into Holdings with Holdings surviving under the name BCP/Essex Holdings Inc. ("Successor"). BE was a newly organized Delaware corporation formed for the purpose of effecting the Acquisition. Shareholders of BE include affiliates of Bessemer Capital Partners, L.P. ("BCP"), Goldman, Sachs & Co. ("Goldman Sachs"), Donaldson, Lufkin & Jenrette, Inc. ("DLJ"), Chemical Equity Associates, A California Limited Partnership and members of management and other employees of the Company. Pursuant to the Acquisition and Merger, (i) stockholders of Holdings, prior to the Acquisition and Merger, became entitled to receive approximately $2.86 for each outstanding share of common stock of Holdings held by them, (ii) holders of options to purchase Holdings common stock, other than those persons entering into an option continuation agreement, became entitled to receive the difference between approximately $2.86 per share and the per share exercise price of such options and (iii) the capital stock of BE was converted into capital stock of Holdings. The Acquisition and Merger resulted in a change in control of Holdings. Further, the Acquisition and Merger occurred at the Holdings level and, therefore, did not directly affect the Company's status as a wholly-owned subsidiary of Holdings. In December 1993, BCP transferred its ownership interest in Holdings to Bessemer Holdings, L.P. ("BHLP") an affiliate of BCP. In connection with the Acquisition and Merger, the Company recorded certain merger related expenses of $18,139 consisting primarily of bonus and option payments to certain employees, and certain merger fees and expenses, which were charged to operations as of September 30, 1992. For financial statement purposes, the Acquisition and Merger was accounted for by Holdings as a purchase acquisition effective October 1, 1992. Because the Company is a wholly-owned subsidiary of Holdings, the effects of the Acquisition and Merger have been reflected in the Company's financial statements, resulting in a new basis of accounting reflecting estimated fair values for the Successor's assets and liabilities at that date. However, to the extent that Holdings' management had a continuing investment interest in Holdings' common stock, such fair values (and contributed stockholder's equity) were reduced proportionately to reflect the continuing interest (approximately 10%) at the prior historical cost basis. As a result, the Company's financial statements for the periods ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- subsequent to September 30, 1992 are presented on the Successor's new basis of accounting, while the financial statements for September 30, 1992 and prior periods are presented on the Predecessor's historical cost basis of accounting. The aggregate purchase price of Holdings and a reconciliation to the initial capitalization of Successor are as follows: Purchase price, including related fees: Purchase price, excluding Seller's expenses . . . . $138,445 Related fees and expenses . . . . . . . . . . . . . 6,168 -------- 144,613 Less reduction to reflect proportionate historical cost basis for management's continuing common stock interest . . . . . . . . . . . . . . . . . . . . . (15,259) -------- 129,354 Holdings debt ($191,645) and deferred debt issuance costs, deferred and refundable income taxes and other minor Holdings amounts not reflected in Successor financial statements (See Note 9) . . . . . . . . . . . . . . . . . . . 173,430 -------- Initial capitalization of Successor . . . . . . . . $302,784 ======== The allocation of the purchase price to historical assets and liabilities of the Company was as follows: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- The following unaudited pro forma consolidated results of operations for the twelve month periods ended December 31, 1992 and 1991 are presented assuming the Acquisition and Merger had occurred on January 1, 1991 (no affect on revenues): The primary pro forma effects are revised depreciation and amortization charges, interest expense and income taxes. The pro forma information does not purport to present what the Company's consolidated results of operations would actually have been if the Acquisition and Merger had occurred on January 1, 1991 and is not intended to project future results of operations. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation and business segment The consolidated financial statements include the accounts of the Company and all majority-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. The Company operates in one industry segment. The Company develops, manufactures and markets electrical wire and cable and insulation products. Among the Company's products are magnet wire for electromechanical devices such as motors, transformers and electrical controls; building wire for the construction industry; telephone cable for the telecommunications industry; wire for automotive and appliance applications; and insulation products for the electrical industry. The Company's customers are principally located throughout the United States, without significant concentration in any one region or any one customer. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. Fair value of financial instruments The Company's financial instruments consist of cash and cash equivalents, investment securities and the Company's long-term debt. The carrying amounts of the Company's financial instruments approximate fair value at December 31, 1993. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Cash and cash equivalents All highly liquid financial instruments with a maturity of three months or less at the date of purchase are considered to be cash equivalents. Inventories Inventories are stated at cost, determined principally on the last-in, first-out ("LIFO") method, which is not in excess of market. Property, plant and equipment Property, plant and equipment are recorded at cost and depreciated over estimated useful lives using the straight-line method. Investment in joint venture An investment in a joint venture is stated at cost adjusted for the Company's share of undistributed earnings or losses. Investment in subsidiary In late 1993, the Company acquired a majority interest in Interstate Industries, Inc. for cash of $4,300, subject to final purchase price adjustments and the minority interest ownership percentage. At December 31, 1993, the acquisition is included in other assets; consolidation of this subsidiary would not have a significant effect on the 1993 consolidated financial statements. Income taxes Effective October 1, 1992, concurrent with the new basis of accounting, the Successor adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("FAS 109"). FAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Using this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities. These deferred taxes are measured by applying current tax laws. Through September 30, 1992, deferred income taxes were provided by Predecessor for significant timing differences in the recognition of revenue and expense for tax and financial statement purposes. Holdings and the Company file a consolidated U.S. federal income tax return. The Company operates under a tax sharing agreement with Holdings whereby the Company's aggregate income tax liability is calculated as if it filed a separate tax return with its subsidiaries. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Excess of cost over net assets acquired Excess of cost over net assets acquired represents the excess of the Holdings contribution to capital, based on its purchase price over the fair value of the net assets acquired in the Acquisition, and is being amortized by the straight-line method over 35 years. Other intangible assets In connection with the 1988 Acquisition, a covenant not to compete agreement was entered into whereby, in general, UTC agreed that until March 1, 1993, it would not engage in or carry on any business directly competing with any business carried on by the Company on February 29, 1988. The $34,000 purchase price allocated by the Predecessor to the covenant not to compete was classified as an intangible asset and was amortized over five years through February 1993. Recognition of revenue Substantially all of the Company's revenue is recognized at the time the product is shipped. Postretirement and postemployment benefits In 1993, the Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" and Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits". The effect of adopting the new rules was not material to the Company's 1993 consolidated results of operations or financial condition. Unusual items Included in Successor's cost of goods sold for the three month period ended December 31, 1992 is a charge of approximately $2,600 to reflect the estimated cost of anticipated plant consolidations, primarily costs to move equipment and personnel related expenses. In the nine month period ended September 30, 1992, Predecessor recorded a charge of approximately $1,500 to selling and administrative expenses for the relocation of a business unit which was completed in 1993. During 1991, Predecessor settled a warranty claim resulting in a charge of approximately $1,700 to selling and administrative expenses. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 3 INVENTORIES The components of inventories are as follows: Principal elements of cost included in the Company's inventories are copper, purchased materials, direct labor and manufacturing overhead. Inventories valued using the LIFO method amounted to $136,980 and $131,481 at December 31, 1993 and 1992, respectively. NOTE 4 PROPERTY, PLANT AND EQUIPMENT The components of property, plant and equipment are as follows: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 5 ACCRUED LIABILITIES Accrued liabilities include the following: NOTE 6 LONG-TERM DEBT Long-term debt consists of the following: Bank Financing In connection with the Acquisition and Merger, the Company entered into a credit agreement dated September 25, 1992, among BE, Holdings, the lenders named therein and Chemical Bank, as agent (the "Credit Agreement"). Under the Credit Agreement, the Company borrowed $130,000 in term loans (the "Term Credit") of which $94,000 was used to repay all indebtedness ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- outstanding under the previous credit agreement and the balance was used to pay a portion of the consideration payable to Holdings' shareholders and option holders in the Merger and certain fees and expenses in connection with the Acquisition and Merger and for other general corporate purposes. In May 1993, the Company applied $111,000 of the proceeds from the sale of its 10% Senior Notes due 2003 (the "Senior Notes") to repay the outstanding balance under the Term Credit. See Senior Notes below. The Company recognized an extraordinary charge of $3,055, net of applicable tax benefit of $1,953, in the second quarter of 1993 representing the write-off of unamortized debt costs associated with the outstanding Term Credit. On May 7, 1993 an amendment and restatement of the Credit Agreement (the "Restated Credit Agreement") became effective. The Restated Credit Agreement provides for $175,000 in revolving credit, subject to specified percentages of eligible assets, reduced by outstanding letters of credit ($13,924 at December 31, 1993) (the "Revolving Credit"). The Revolving Credit expires in 1998. Revolving Credit loans bear interest at floating rates at bank prime rate plus 1.25% or a reserve adjusted Eurodollar rate (LIBOR) plus 2.25%. The effective interest rate can be reduced by 0.25% to 0.75% if certain specified financial conditions are achieved. Commitment fees during the revolving loan period are 0.5% of the average daily unused portion of the available credit. The Company has purchased interest rate cap protection through 1994 with respect to $100,000 of debt. Such interest rate protection was purchased at a cost of $685 and carries a strike rate of 6% (three month LIBOR). At December 31, 1993 and 1992, the Company's incremental borrowing rate, including applicable margins, approximated 7.3% and 7.8%, respectively, relating to borrowings under the Restated Credit Agreement and the Credit Agreement. The Restated Credit Agreement contains various covenants which include, among other things: (a) the maintenance of certain financial ratios and compliance with certain financial tests and limitations; (b) limitations on investments and capital expenditures; (c) limitations on cash dividends paid; and (d) limitations on leases and the sale of assets. Through December 31, 1993, the Company fully complied with all of the financial ratios and covenants contained in the Restated Credit Agreement. The indebtedness under the Restated Credit Agreement is guaranteed by Holdings and all of the Company's subsidiaries, and is secured by a pledge of the capital stock of the Company and its subsidiaries and by a first lien on substantially all assets. Senior Notes On May 7, 1993 the Company issued $200,000 aggregate principal amount of its Senior Notes which bear interest at 10% and are due in May, 2003. The net proceeds to the Company from the sale of the Senior Notes, after underwriting discounts, commissions and other offering expenses, were $193,450. The Company applied $111,000 of such proceeds to the repayment of the Term Credit and on June 2, 1993 applied the balance of such ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- proceeds, together with new borrowings of $7,450 under the Revolving Credit, to redeem all of its outstanding 12 3/8% Senior Subordinated Debentures due 2000 (the "Debentures"). The Senior Notes rank pari passu in right of payment with all other senior indebtedness of the Company. To the extent that any other senior indebtedness of the Company is secured by liens on the assets of the Company, the holders of such secured senior indebtedness will have a claim prior to any claim of the holders of the Senior Notes as to those assets. At the option of the Company, the Senior Notes may be redeemed, commencing in May 1998 in whole, or in part, at redemption prices ranging from 103.75% in 1998 to 100% in 2001, or at 109% for up to $67,000 with the proceeds from any public equity offering prior to June 30, 1996. Upon a Change in Control, as defined in the indenture covering the Senior Notes (the "Indenture"), each holder of Senior Notes will have the right to require the Company to repurchase all or any part of such holder's Senior Notes at a repurchase price equal to 101% of the principal amount thereof. The Indenture contains various covenants which include, among other things, limitations on debt, on the sale of assets, and on cash dividends paid. Through December 31, 1993, the Company fully complied with all of the financial ratios and covenants contained in the Indenture. Debentures The Debentures were due in 2000 and bore interest at 12 3/8% per annum payable semi-annually. However, the Restated Credit Agreement required the Debentures, which were callable at 106% commencing May 15, 1993, to be retired no later than June 30, 1993. Because of the mandatory retirement, the Debentures were valued by the Successor at the expected retirement cost, discounted at 11.5%. On June 2, 1993, the Company redeemed all of the outstanding Debentures at 106% of their principal amount, resulting in a net loss of $312, net of applicable tax benefit of $199, which has been reported as an extraordinary charge. During 1992 the Company repurchased outstanding Debentures which had a carrying value of $13,843. The net loss resulting from this repurchase, which includes the write-off of a portion of unamortized debt costs, totalled $122, net of applicable income tax benefit of $78, for Predecessor, which has been reported as an extraordinary charge. During 1991, the Company repurchased outstanding Debentures which had a carrying value of $41,960. The net loss resulting from this repurchase, including unamortized debt costs, was reflected as an extraordinary charge of $1,471, net of applicable income tax benefit of $941. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Other The Company capitalized interest costs of $1,599, $116, $220 and $0 for Successor in 1993, Successor and Predecessor in 1992, and for Predecessor in 1991, respectively, with respect to qualifying assets. Total interest paid was $20,961, $7,344, $10,076 and $24,308, for Successor in 1993, Successor and Predecessor in 1992, and for Predecessor in 1991, respectively. There are no maturities of long-term debt within the next five years. NOTE 7 INCOME TAXES Effective October 1, 1992, concurrent with the new basis of accounting, the Successor adopted FAS 109. The Predecessor's financial statements for all periods through September 30, 1992 reflect the historical accounting method for income taxes and have not been restated to reflect FAS 109. Under FAS 109 assets and liabilities acquired, and the resulting charges or credits reflected in future statements of operations, are stated at the gross fair value at the date of acquisition, whereas under the previous historical method, assets and liabilities and the resulting charges or credits were recorded at amounts net of the related tax differences between fair value and the tax basis. Deferred income taxes at December 31, 1993 and December 31, 1992 reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Successor's deferred tax liabilities and assets are as follows: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- The components of income tax expense (benefit) are: In compliance with the Omnibus Budget Reconciliation Act of 1993, enacted in August of 1993 retroactive to January 1, 1993, the Company's tax balances were adjusted in the third quarter of 1993 to reflect the increase in the federal statutory tax rate from 34% to 35%. The adjustment had the effect of increasing income tax expense by $2,250 for the year ended December 31, 1993. Total income taxes paid were $1,131, $8,608, $6,604 and $6,411 for Successor in 1993, Successor and Predecessor in 1992, and for Predecessor in 1991, respectively. The Predecessor's deferred tax provision results from timing differences in the recognition of revenue and expense for tax and financial reporting purposes. Sources of these differences were primarily related to depreciation and accruals deductible in different periods for tax purposes. Principal differences between the effective income tax rate and the statutory federal income tax rate are: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- The Company elected not to step up its tax bases in the assets acquired. Accordingly, the income tax bases in the assets acquired have not been changed from pre-1988 Acquisition values. Depreciation and amortization of the higher allocated financial statement bases are not deductible for income tax purposes, thus increasing the effective income tax rate reflected in the Predecessor's consolidated financial statements. Under FAS 109, the Successor has recorded deferred income taxes for such differences. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 8 RETIREMENT BENEFITS The Company participates in two defined benefit retirement plans for substantially all salaried and hourly employees. In 1992, the Company adopted a supplemental executive retirement plan and related agreements, which provides benefits based on the same formula as in effect under the salaried employees' plan, but which only takes into account compensation in excess of amounts that can be recognized under the salaried employees' plan. Salaried plan benefits are generally based on years of service and the employee's compensation during the last several years of employment. Hourly plan benefits are based on hours worked and years of service with a fixed dollar benefit level. The Company's funding policy is based on an actuarially determined cost method allowable under Internal Revenue Service regulations, the projected unit credit method. Pension plan assets consist principally of fixed income and equity securities and cash and cash equivalents. The components of net periodic pension cost for the plans are as follows: The following table summarizes the funded status of these pension plans and the related amounts that are recognized in the consolidated balance sheets: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Certain actuarial assumptions were revised in 1993 resulting in an increase of $3,448 in the projected benefit obligation. Actuarial assumptions were revised at October 1, 1992 concurrent with the new basis of accounting. The revised assumptions resulted in a $7,328 reduction in the projected benefit obligation as of October 1, 1992. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Following is a summary of significant actuarial assumptions used: The Company contributed $194, $48, $136 and $165 to multi-employer pension plans for Successor in 1993, Successor and Predecessor in 1992 and for Predecessor in 1991, respectively. The Company has no further obligation, other than recurring contributions, to these plans as long as the applicable operations continue. The Company has established a defined contribution savings plan which allows both 401(a) and 401(k) contributions covering substantially all of the salaried employees of the Company. The purpose of this savings plan is generally to provide additional financial security during retirement by providing salaried employees with an incentive to make regular savings. The Company's contributions to the plan, which approximates expense, are based on employee contributions and totalled $1,030, $276, $733 and $946 for Successor in 1993, Successor and Predecessor in 1992, and Predecessor in 1991, respectively. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 9 STOCKHOLDER'S EQUITY The following is an analysis of the changes to the Company's stockholder's equity: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars, Except Per Copper Pound Data ----------------------------------------------------- NOTE 10 RELATED PARTY TRANSACTIONS Advisory services fees of $1,000 and $229 were paid to affiliates of BHLP and BCP for 1993 and the three month period ended December 31, 1992, respectively, and to MSLEF II in the amount of $210 and $280 during the nine month period ended September 30, 1992, and for 1991, respectively. It is expected that financial advisory fees to an affiliate of BHLP will continue to be paid for such services in the future. Also, in connection with the Acquisition and Merger, an affiliate of BCP received financial advisory fees of $1,900 associated with the financing plus certain out of pocket expenses. DLJ and Goldman Sachs acted as underwriters in the offerings of the Senior Notes, and in such capacity received aggregate underwriting discounts and commissions of $5,300. In addition, during the nine month period ended September 30, 1992, and for the year 1991, management fees to Holdings of $1,875 and $3,500 respectively, were incurred. In May 1989, Holdings issued $342,000 aggregate principal amount ($135,117 aggregate proceeds amount) of Holdings Debentures, the proceeds of which were used to pay a dividend to Holdings shareholders, cash bonuses to certain members of its management, and related expenses. During 1991, the Company paid cash dividends to Holdings of $5,000, which amounts were used to repurchase Holdings Debentures. Additionally, during 1992, the Company paid cash dividends of $7,500 which were used to finance a portion of the Acquisition. As of December 31, 1993, Holdings had a liability of $228,942 related to the Holdings Debentures. The Holdings Debentures are unsecured debt of Holdings and are effectively subordinated to all outstanding indebtedness of the Company, including the Senior Notes, and will be effectively subordinated to other indebtedness incurred by direct and indirect subsidiaries of Holdings if issued. No periodic cash payment of interest is required to be made by Holdings prior to November 15, 1995 on the Holdings Debentures and interest is payable in cash at 16.0% thereafter. Holdings is a holding company with no operations and has virtually no assets other than its ownership of the outstanding common stock of the Company. All of such stock is pledged, however, to the lenders under the Restated Credit Agreement. Accordingly, Holdings' ability to meet its obligations when due under the terms of its indebtedness will be dependent on the Company's ability to pay dividends, to loan, or otherwise advance or transfer funds to Holdings in amounts sufficient to service Holdings' debt obligations. NOTE 11 CONTINGENT LIABILITIES AND COMMITMENTS There are various claims and pending legal proceedings against the Company including environmental matters and other matters arising out of the ordinary conduct of its business. Pursuant to the 1988 Acquisition, UTC agreed to indemnify the Company against all losses (as defined) resulting from or in connection with damage or pollution to the environment and arising from events, operations, or activities of the ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Company prior to February 29, 1988 or from conditions or circumstances existing at February 29, 1988. Except for certain matters relating to permit compliance, the Company is fully indemnified with respect to conditions, events or circumstances known to UTC prior to February 29, 1988. Further, the Company is indemnified, subject to a $4,000 "basket" for losses related to any environmental events, conditions or circumstances identified in the five year period ended February 1993, to the extent such losses are not caused by activities of the Company after February 29, 1988. After consultation with counsel, in the opinion of management, the ultimate cost to the Company, exceeding amounts provided, will not materially affect the consolidated financial position or results of operations. At December 31, 1993, the Company had purchase commitments of 444.5 million pounds of copper. This is not expected to be either a quantity in excess of needs or at prices in excess of amounts that can be recovered upon sale of the copper products. The commitments are to be priced based on the COMEX price in the contractual month of shipment except for 60.1 million pounds priced at fixed amounts, of which 36.6 million pounds are covered by customer sales agreements at copper prices at least equal to the Company's commitment. The remaining 23.5 million pounds that are not covered by customer sales agreements are priced at an average of $.81 per pound. At December 31, 1993, the Company had committed $8,644 to outside vendors for certain capital projects. The Company occupies space and uses certain equipment under lease arrangements. Rent expense was $6,224, $1,949, $4,138 and $5,684 under such arrangements for the year ended December 31, 1993, the three month period ended December 31, 1992, the nine month period ended September 30, 1992 and the year 1991, respectively. Rental commitments at December 31, 1993 under long-term noncancellable operating leases were as follows: Real Estate Equipment Total ----------- --------- ----- 1994 $ 2,230 $2,284 $ 4,514 1995 1,883 2,067 3,950 1996 1,391 1,185 2,576 1997 1,132 701 1,833 1998 1,015 652 1,667 After 1998 13,988 1,421 15,409 ------- ------ ------- $21,639 $8,310 $29,949 ======= ====== ======= ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 12 QUARTERLY FINANCIAL DATA (UNAUDITED) (a) In the second quarter of 1993, the Company recognized an extraordinary charge of $3,055 net of applicable income tax benefit of $1,953, representing the write-off of unamortized debt costs associated with retirement of the outstanding Term Credit. During 1993 and the nine month period ended September 30, 1992 the Successor and Predecessor repurchased outstanding Debentures resulting in extraordinary charges of $312 and $122 net of applicable income tax benefits of $199 and $78, respectively (See Note 6). (b) In connection with the Acquisition and Merger, the Company incurred certain merger related expenses of $18,139 consisting primarily of bonus and option payments to certain employees and certain merger fees and expenses, which were charged to the Predecessor's operations in the third quarter 1992. SCHEDULE V ESSEX GROUP, INC. PROPERTY, PLANT AND EQUIPMENT In Thousands of Dollars ----------------------- (a) Balances reflect the allocation of the purchase price as described in Note 1 of Notes to Consolidated Financial Statements. S-2 SCHEDULE VI ESSEX GROUP, INC. ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT In Thousands of Dollars ----------------------- The estimated useful lives currently used in the computation of depreciation for the consolidated financial statements are as follows: Buildings and improvements 10 to 40 years Machinery and equipment 3 to 15 years S-4 SCHEDULE VIII ESSEX GROUP, INC. VALUATION AND QUALIFYING ACCOUNTS S-5 SCHEDULE X ESSEX GROUP, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION Royalties, advertising costs and taxes, other than payroll and income taxes, were either less than one percent of total sales and revenues or were disclosed in the consolidated financial statements. S-6 EXHIBIT INDEX Location of Exhibit Exhibit in Sequential Number Description of Document Numbering System -------------------------------------------------------------------------- 2.01 Agreement and Plan of Merger, dated as of July 24, 1992 (the "Merger Agreement"), between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.1 to BCP/Essex Holdings Inc.'s (then known as MS/Essex Holdings Inc.) Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 1992 (Commission File No. 1-10211). 2.02 Amendment dated as of October 1, 1992, to the Agreement and Plan of Merger between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 3.01 Certificate of Incorporation of the registrant (Incorporated by reference to Exhibit 3.01 to the Company's Registration Statement on Form S-1, File No. 33-20825). 3.02 By-Laws of the registrant, as amended. (Incorporated by reference to Exhibit 3.02 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 4.01 Indenture under which the 10% Senior Notes Due 2003 are outstanding, incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Pre-Effective Amendment No. 1 to Form S-2 (Commission File No. 33-59488). 9.01 Investors Shareholders Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P., certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, a California Limited Partnership, incorporated by reference to Exhibit 28.1 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.02 Management Stockholders and Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P. and certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.3 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.03 Form of Irrevocable Proxy dated as of October 9, 1992, granted to Bessemer Capital Partners, L.P. by certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.4 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 10.01 Amendment and Restatement of Credit Agreement dated May 7, 1993, incorporated by reference to Exhibit 28.7 to the Company's Registration Statement on Pre-Effective Amendment No. 3 to Form S- 2 (Commission File No. 33-59488). EXHIBIT INDEX Location of Exhibit Exhibit in Sequential Number Description of Document Numbering System -------------------------------------------------------------------------- 10.02 Credit Agreement dated as of September 25, 1992, among B E Acquisition Corporation, BCP/Essex Holdings Inc., the registrant, the lenders named therein and Chemical Bank, as agent, incorporated by reference to Exhibit 4.6 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1- 10211). 10.03 Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.10 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418). 10.04 Amendment dated October 9, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, Donaldson, Lufkin & Jenrette, Inc. and Goldman, Sachs and Co., to Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.11 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418).Agreement and Plan of Merger, dated as of July 24, 1992 (the "Merger Agreement"), between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.1 to BCP/Essex Holdings Inc.'s (then known as MS/Essex Holdings Inc.) Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 1992 (Commission File No. 1-10211). 12.01 Computation of Ratio of Earnings to Fixed Charges. 22.01 Subsidiaries of the registrant. 99.01 Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, A California Limited Partnership, incorporated by reference to Exhibit 28.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 99.02 Amended and Restated Stock Option Plan of BCP/Essex Holdings Inc., incorporated by reference to Exhibit 4.7 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1- 10211). EXHIBIT 12.01 ESSEX GROUP, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (a) Earnings of the Successor were insufficient to cover fixed charges by the amount of $7,078 for the three month period ended December 31, 1992. EXHIBIT 12.01 ESSEX GROUP, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES - Continued EXHIBIT 22.01 ESSEX GROUP, INC. (MICHIGAN) SUBSIDIARIES OF THE REGISTRANT Essex Group, Inc. . . . . . . . . . . . . . . . . . . Delaware Essex International, Inc. . . . . . . . . . . . . . . Delaware Essex Wire Corporation . . . . . . . . . . . . . . . Michigan Diamond Wire & Cable Co. . . . . . . . . . . . . . . Illinois ExCel Wire and Cable Co. . . . . . . . . . . . . . . Illinois US Samica Corporation . . . . . . . . . . . . . . . . Vermont Bristol Wire Company . . . . . . . . . . . . . . . . Delaware Femco Magnet Wire Corporation . . . . . . . . . . . . Indiana Essex Group Export Inc. . . . . . . . . . . . . . . . U.S. Virgin Islands Interstate Industries Holdings Inc. . . . . . . . . . Delaware Interstate Industries, Inc. . . . . . . . . . . . . . Mississippi Essex Group Mexico Inc. . . . . . . . . . . . . . . . Delaware Essex Group Mexico S.A. de C.V. . . . . . . . . . . . Mexico

102379_1993.txt

102379_1993

1993

102379

ITEM 1. BUSINESS URS Corporation (the "Company") offers a broad range of planning, design and program and construction management services for engineering, architectural and environmental projects. The Company serves public and private sector clients throughout the United States in two principal markets: infrastructure projects involving transportation systems, institutional and commercial facilities and water resources; and environmental projects involving hazardous waste management and pollution control. The Company conducts its business through 24 offices located throughout the United States. The Company has approximately 1,100 full-time employees, many of whom hold advanced or technical degrees and have extensive experience in sophisticated disciplines applicable to the Company's business. The Company believes that its geographic and technical diversity allow it to compete for local, regional and national projects, and enable it to apply to each project a variety of resources from its national network. Services -------- The Company provides professional services in three major areas: planning, design and program and construction management through the Company's 24 offices. Each of these offices is responsible for obtaining local or regional contracts. This approach allows regional government agencies and private clients to view the Company's offices as local businesses with superior service delivery capabilities. Because the Company can draw from its large and diverse network of professional and technical resources, the Company has the capability to market and perform large, multi-state projects. Planning - -------- Planning covers a broad range of assignments, ranging from conceptual design and technical and economic feasibility studies to community involvement programs. Planning services also involve developing alternative concepts for project implementation and analyzing the impacts of each alternative. In addition to traditional engineering and architectural planning services, the Company has extensive expertise in a number of highly specialized areas, including toll facilities, health care facility renovation, environmental site analysis, water quality planning for urban storm water management and site remediation assignments. Page 2 of 90 Design - ------ The Company's professionals provide a broad range of design and design-related services, including computerized mapping, architectural and interior design, civil, sanitary and geotechnical engineering, process design and seismic (earthquake) analysis and design. For each project, the Company identifies the project requirements and then integrates and coordinates the various design elements. The result is a set of contract documents that may include plans, specifications and cost estimates that are used to build a project. These documents detail design characteristics and set forth for the contractor the materials which should be used and the schedule for construction. Other critical tasks in the design process may include value analysis and the assessment of construction and maintenance requirements. Program and Construction Management - ----------------------------------- The Company's program and construction management services include master scheduling of both the design and construction phases, construction and life-cycle cost estimating, cash flow analysis, value engineering, constructability reviews and bid management. Once construction has begun, the Company supervises and coordinates the activities of the construction contractor. This frequently involves acting as the owner's representative for on-site supervision and inspection of the contractor's work. In this role, the Company's objective is to monitor a project's schedule, cost and quality. The Company generally does not take contractual responsibility for the contractor's risks and methods, nor for site safety conditions. Markets ------- The Company's strategy is to focus on two major markets: infrastructure projects involving transportation systems, institutional and commercial facilities and water resources; and environmental projects involving hazardous waste management and pollution control. The Company has developed a nationwide identity based on its successful completion of a number of highly visible rehabilitation and expansion projects in these markets. Although the Company views these markets as being distinct, the Company provides its planning, design and program and construction management services to both markets. Infrastructure - -------------- The Company has significant expertise in three areas relating to the infrastructure market: transportation systems, institutional and commercial facilities and water resources projects. Page 3 of 90 TRANSPORTATION SYSTEMS. The Company's engineers, designers, planners and managers provide services for projects involving all types of transportation networks, such as highways, roadways, streets, bridges, rapid and mass transit systems, airports and marine facilities. These services range from the design of interstate highways to harbor traffic simulation studies and may extend from conceptual planning through preliminary and final design to construction management. Historically, the Company's emphasis in this area has been on the design of new transportation facilities, but in recent years the rehabilitation of existing facilities has become a major focus. INSTITUTIONAL AND COMMERCIAL FACILITIES. The Company provides architectural, engineering design, space planning and construction supervision services to this market. Demand for low-maintenance, energy efficient facilities drive today's market for commercial and industrial buildings. In addition, there is increased pressure to renovate facilities to meet changing needs and current building standards. WATER RESOURCES. The Company's capabilities in this market include the planning, design and program and construction management of water supply, storage, distribution and treatment systems, as well as work in basin plans, groundwater supply, customer rate studies, urban run-off, bond issues, flood control, water quality analysis and beach erosion control. Environmental - ------------- The Company has developed expertise in two principal environmental markets: hazardous waste management and pollution control. HAZARDOUS WASTE MANAGEMENT. The Company conducts initial site investigations, designs remedial actions for site clean-up and provides construction management services during site clean-up. This market involves identifying and developing measures to effectively dispose of hazardous and toxic waste at contaminated sites. The Company also provides air quality monitoring and designs individual facility modifications required to meet local, state and Federal air quality standards. This work requires specialized knowledge of and compliance with complex Federal and state regulations, as well as the permitting and approval processes. Solid waste management services provided by the Company include facility siting, transfer station design and community-wide master planning. The Company has been awarded several significant contracts with government agencies, including a contract with the U.S. Department of Defense for environmental engineering and remediation work in the Northwest and Alaska under the Comprehensive Long-Term Environmental Action-Navy ("Navy CLEAN") program and two contracts with the U.S. Environmental Protection Agency ("EPA") under its Alternative Remedial Contracting Strategy ("EPA ARCS") program. Under the Navy CLEAN contract, the Company provides site inspections, site characterizations, remediation designs and action plans for contaminated Navy facilities. A portion of the Navy CLEAN contract, which is expected to have a ten-year term, is awarded each year over the life of the contract. In fiscal 1993 and 1992, the Company generated revenues associated with the Navy CLEAN contract of $22.1 million and $29.3 million, respectively. The Company's services under the ten year EPA ARCS contracts include investigating the nature and extent of contamination by hazardous materials, performing risk assessments, evaluating the feasibility of various options for remedial action and providing management, technical, quality assurance and health and safety reviews of potentially responsible party submittals. Work under the EPA ARCS contracts is performed on a task order Page 4 of 90 basis. In fiscal 1993 and 1992, the Company recognized revenues of $16.5 million and $12.4 million, respectively, under the EPA ARCS contracts. POLLUTION CONTROL. The Company's principal services in this market include the planning and design of new wastewater facilities, such as sewer systems and wastewater treatment plants, and the analysis and expansion of existing systems. The types of work performed by the Company include infiltration/ inflow studies, combined sewer overflow studies, water quality facilities planning projects and design and construction management services for wastewater treatment plants. Clients ------- General - ------- The Company's clients include local, state and Federal government agencies and private sector businesses. Since 1989, revenues from Federal government projects have increased as a percentage of the Company's total revenues. The Company's revenues from local, state and Federal government agencies and private businesses for the last five fiscal years are as follows: Page 5 of 90 Contract Pricing and Terms of Engagement - ---------------------------------------- Under its cost-plus contracts, the Company charges clients negotiated rates based on the Company's direct and indirect costs. Labor costs and subcontractor services are the principal components of the Company's direct costs. Federal Acquisition Regulations limit the recovery of certain specified indirect costs on contracts subject to such regulations . In negotiating a cost-plus contract, the Company estimates all recoverable direct and indirect costs and then adds a profit component, which is either a percentage of total recoverable costs or a fixed negotiated fee, to arrive at a total dollar estimate for the project. The Company receives payment based on the total actual number of labor hours expended. If the actual total number of labor hours is lower than estimated, the revenues from that project will be lower than estimated. If the actual labor hours expended exceed the initial negotiated amount, the Company must obtain a contract modification in order to receive payment for such overage. The Company's profit margin will increase to the extent the Company is able to reduce actual costs below the estimates used to produce the negotiated fixed prices on contracts not covered by Federal Acquisition Regulations; conversely, the Company's profit margin will decrease and the Company may realize a loss on the project if the Company does not control costs and exceeds the overall estimates used to produce the negotiated price. Cost-plus contracts covered by Federal Acquisition Regulations require an audit of actual costs and provide for upward or downward adjustments if actual recoverable costs differ from billed recoverable costs. The Defense Contract Audit Agency, auditors for the Department of Defense and other Federal agencies, has completed incurred cost audits of the Company's Federal contracts for fiscal years ended through October 31, 1986, resulting in immaterial adjustments. The Company does not anticipate significant contract adjustments or other government action resulting from government audits of the years 1987 through 1993. Under its fixed-price contracts, the Company receives an agreed sum negotiated in advance for the specified scope of work. Under fixed-price contracts, no payment adjustments are made if the Company over-estimates or under-estimates the number of labor hours required to complete the project, unless there is a change of scope in the work to be performed. Accordingly, the Company's profit margin will increase to the extent the number of labor hours and other costs are below the contracted amounts. The profit margin will decrease and the Company may realize a loss on the project if the number of labor hours required and other costs exceed the estimates. Backlog, Project Designations and Indefinite Delivery Contracts - --------------------------------------------------------------- The Company's contract backlog was $142.0 million at October 31, 1993, compared to $123.5 million at October 31, 1992. The Company's contract backlog consists of the amount billable at a particular point in time for future services under executed, funded contracts. Indefinite delivery contracts, which are executed contracts requiring the issuance of task orders, are included in contract backlog only to the extent the task orders are actually issued and funded. Of the contract backlog of $142.0 million at October 31, 1993, approximately 30%, or $43 million, is not reasonably expected to be filled within the next fiscal year ending October 31, 1994. The Company has also been designated by customers as the recipient of certain future contracts. These "designations" are projects that have been awarded to the Company but for which contracts have not yet been executed. Page 6 of 90 Task orders under executed indefinite delivery contracts which are expected to be issued in the immediate future are included in designations. Total contract designations were estimated to be $213.6 million at October 31, 1993, as compared to $154.8 million at October 31, 1992. Typically, a significant portion of designations are converted into signed contracts. However, there is no assurance this will continue to occur in the future. Indefinite delivery contracts are signed contracts where work is performed only when specific task orders are issued by the client. Generally these contracts exceed one year and often indicate a maximum term and potential value. Examples of such contracts are the Navy CLEAN and EPA ARCs contracts. Certain indefinite delivery contracts are for a definite time period with renewal option periods at the client's discretion. While the Company believes that it will continue to get work under these contracts over their entire term, because of renewals and the necessity for issuance of individual task orders, continued work by the Company and the realization of their potential maximum values under these contracts is not assured. However, because of the increasing frequency with which the Company's government and private sector clients use this contracting method, the Company believes their potential value should be disclosed along with backlog and designations as an indicator of the Company's future business. When the client notifies the Company of the scope and pricing of task orders, the estimated value of such task orders are added to designations. When such task orders are signed and funded, their value goes into backlog. At October 31, 1993, the potential value of the Company's five largest indefinite delivery contracts was as follows: Page 7 of 90 Competition ----------- The engineering and architectural services industry is highly fragmented and very competitive. As a result, in each specific market area the Company competes with many engineering and consulting firms, several of which are substantially larger than the Company and which possess greater financial resources. No firm currently dominates any significant portion of the Company's markets. Competition is based on quality of service, expertise, price, reputation and local presence. The Company believes that it competes favorably with respect to each of these factors in the markets it serves. Employees --------- The Company has approximately 1,100 full-time employees, many of whom hold advanced or technical degrees and have extensive experience in a variety of disciplines applicable to the Company's business. The Company also employs, at various times on a temporary basis, up to several hundred additional persons to meet contractual requirements. None of the Company's employees are covered by collective bargaining agreements. The Company has never experienced a strike or work stoppage. The Company believes that employee relations are good. ITEM 2. ITEM 2. PROPERTIES The Company leases office space in 24 locations throughout the United States. Most of the leases are written for a minimum term of three years with options for renewal, sublease rights and allowances for improvements. Significant lease agreements expire at various dates through the year 2002. The Company believes that its current facilities are sufficient for the operation of its business and that suitable additional space in various local markets is available to accommodate any needs that may arise. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Item 8, Financial Statements and Supplementary Data, Note 7 -- Commitments and Contingencies is hereby incorporated by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of the Company's security holders during the fourth quarter of the fiscal year ended October 31, 1993. Page 8 of 90 ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT NAME POSITION HELD AGE - ---- ------------- --- Martin M. Koffel.........Chief Executive Officer, President 54 and Director of the Company from May 1989; Chairman of the Board from June 1989; independent executive management services contractor, 1988 to 1989; President, Optometric Group, The Cooper Companies, Inc. (formerly CooperVision, Inc.), 1987 to 1988; President, CooperVision, Inc., 1987; President, Cooper LaserSonics, Inc., 1986; President, Diasonics, Inc., 1985 to 1986; President, Oral-B Laboratories, Inc., 1981 to 1985; Director, Regent Pacific Corporation since 1993. Michael B. Shane.........Executive Vice President and 52 Director of the Company from February 1989; Acting Chief Operating Officer of the Company from February 1989 until May 1989 when Mr. Koffel became Chief Executive Officer; General Counsel of the Company since April 1987; Secretary and Vice President of the Company from April 1987 to February 1989 and Secretary since January 1990; outside litigation counsel for the Company from 1979 to 1987. Irwin L. Rosenstein......President of URS Consultants, 57 Inc., a wholly-owned subsidiary of the Company, and Director since February 1989; Vice President of the Company since 1987; President of Eastern Region of URS Consultants, Inc. from August 1986 to February 1989. Page 9 of 90 NAME POSITION HELD AGE - ---- ------------- --- Kent P. Ainsworth........Vice President and Chief 48 Financial Officer of the Company from January 1991; financial consultant from March 1990 through December 1990; Vice President and Chief Financial Officer of DiGiorgio Corporation from November 1987 through February 1990; Vice President and Chief Financial Officer of Hale Technology Corporation and various of its subsidiaries from January 1982 through October 1987. Martin S. Tanzer, Ph.D...Executive Vice President of 49 URS Consultants, Inc., a wholly-owned subsidiary of the Company, since February 1989. Vice President of URS Consultants, Inc. from 1984 through February 1989. Marvin J. Bloom..........Sr. Vice President and Regional 52 Manager of URS Consultants, Inc., a wholly-owned subsidiary of the Company, since January 1993; Sr. Vice President and Division Manager of URS Consultants, Inc. from December 1992 through January 1993; Vice President and Division Manager of URS Consultants, Inc. from March 1991 through December 1992; Vice President and Branch Manager of URS Consultants, Inc. from August 1990 through February 1991; Deputy Division Manager of Sverdrup Corporation from June 1987 through August 1990. Page 10 of 90 NAME POSITION HELD AGE - ---- ------------- --- Charles A. Rodenfels.....Sr. Vice President of Architectural 38 Services, URS Consultants, Inc., a wholly-owned subsidiary of the Company, National Director of Architectural Services from July 1993; Sr. Vice President, URS Consultants, Inc., Ohio Division Manager from November 1990 to July 1993; Vice President, URS Consultants, Inc. Ohio Branch Manager from November 1989 to November 1990; Director of Business Development, URS Consultants, Inc., Ohio Columbus office, November 1981 to November 1989. Page 11 of 90 PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Shares are listed on the New York and Pacific Stock Exchanges (under the symbol "URS"). At January 14, 1994, the Company had approximately 2,200 stockholders of record. The following table sets forth the high and low closing sale prices of the URS Common Shares, as reported by The Wall Street Journal for the periods indicated. MARKET PRICE LOW HIGH ----------------------- Fiscal Period: 1992: First Quarter $ 7.88 $10.38 Second Quarter $ 8.00 $10.75 Third Quarter $ 7.13 $ 8.38 Fourth Quarter $ 6.63 $ 8.38 1993: First Quarter $ 7.50 $10.00 Second Quarter $ 7.13 $ 9.63 Third Quarter $ 4.38 $ 7.50 Fourth Quarter $ 4.75 $ 5.50 1994: First Quarter $ 4.75 $ 6.38 (through January 14, 1994) The Company has not paid cash dividends since 1986. The declaration of dividends, except stock dividends, is restricted by the terms of the Company's credit agreement with it's bank and the indenture governing the 8-5/8% Senior Subordinated Debentures due 2004 (see Item 8, Financial Statements and Supplementary Data, Note 6 -- Long-Term Debt). Further, the declaration of dividends could be precluded by existing Delaware law. ITEM 6. ITEM 6. SUMMARY OF SELECTED FINANCIAL INFORMATION The following table sets forth selected financial data of the Company for the years ended October 31, 1989 through 1993. The data presented below should be read in conjunction with the Consolidated Financial Statements of the Company, including the notes thereto. Page 12 of 90 Page 13 of 90 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Fiscal 1993 Compared with Fiscal 1992 - ------------------------------------- Revenues in fiscal 1993 were $145.8 million, or 7% over the amount reported in fiscal 1992. The growth in revenues is primarily attributable to increases in revenues derived from all areas of the Company's business, particularly transportation and other infrastructure projects in the Northeast. Revenues generated from the Company's three largest contracts; Navy CLEAN; EPA ARCS 9&10; and EPA ARCS 6, 7, & 8, decreased slightly in fiscal 1993 to $38.5 million as compared to $41.7 million in fiscal 1992. The decrease in revenues from these contracts is primarily due to a decrease in the number of task orders for hazardous waste services on the Navy CLEAN contract. Revenues generated from private commercial businesses decreased from $18.9 million in fiscal 1992 to $16.7 million in fiscal 1993. Direct operating expenses, which consist of direct labor and direct expenses, including subcontractor costs, increased $6.1 million, or 7%, over the amount reported in fiscal 1992. The increase is due to an overall increase in the Company's business in fiscal 1993 as compared to fiscal 1992. Indirect general and administrative expenses ("IG&A") increased to $51.6 million in fiscal 1993 from $45.5 million in fiscal 1992. Expressed as a percentage of revenues, IG&A expenses increased from 33% in fiscal 1992 to 35% in fiscal 1993. The increase in IG&A expenses is primarily attributable to the overall increase in the Company's business and to the one-time charge of $2.0 million taken in the third quarter of fiscal 1993 in connection with the planned phase-out of certain of the Company's architectural offices and for claims on certain of the Company's architectural projects. To a lesser extent, IG&A expenses increased due to program delays experienced in connection with certain of the Company's contracts. Net interest expense remained relatively constant at $1.2 million in fiscal 1993. Page 14 of 90 The Company earned $1.4 million before income taxes in fiscal 1993 compared to $4.7 million in fiscal 1992. While the Company has available net operating loss carryforwards for Federal income tax purposes, for state income tax purposes such amounts are not necessarily available to offset income subject to tax. Accordingly, the Company's effective tax rate for fiscal 1993 was approximately 10%. Net income decreased to $1.3 million in fiscal 1993 as compared to $4.3 million in fiscal 1992. The Company earned $.18 per share in fiscal 1993 compared to $.55 per share in fiscal 1992. The Company's backlog of signed and funded contracts at October 31, 1993 was $142.0 million, as compared to $123.5 million at October 31, 1992. The value of the Company's designations, which are awarded projects for which contracts have not been signed, was $213.6 million at October 31, 1993, as compared to $154.8 million at October 31, 1992. Fiscal 1992 Compared with Fiscal 1991 - ------------------------------------- Revenues in fiscal 1992 grew to $136.8 million, or 11% over the amount reported in fiscal 1991. The growth in revenues is primarily attributable to increases in revenues generated from the Company's three largest contracts; Navy CLEAN; EPA ARCS 9 & 10; and EPA ARCS 6, 7 & 8. Combined revenues on these contracts were $41.7 million in fiscal 1992 compared to $25.5 million in fiscal 1991. The increase in revenues from these contracts is due to an increase in the number of task orders for hazardous waste clean-up services. Revenues generated from private commercial businesses increased marginally to $18.9 million from $18.5 million in fiscal 1991. Direct operating expenses, which consist of direct labor and direct expenses, including subcontractor costs, increased $12.7 million, or 17% over the amount reported in fiscal 1991. The increase is due to a greater volume of subcontractor and outside laboratory services related to the Navy CLEAN and EPA ARCS contracts in fiscal 1992. Conversely, while revenues increased by 11%, IG&A expenses remained relatively constant at $45 million. Expressed as a percentage of revenues, IG&A expenses decreased from 37% in fiscal 1991 to 33% in fiscal 1992. The Company attributes this decrease to continued emphasis on cost controls. Net interest expense decreased from $2.3 million in fiscal 1991 to $1.2 million in fiscal 1992 due to significantly lower debt levels in fiscal 1992 as the result of the secondary common stock offering completed by the Company in June 1991. The Company earned $4.7 million before income taxes in fiscal 1992 compared to $2.5 million in fiscal 1991. While the Company has available net operating loss carryforwards for Federal income tax purposes, for state income tax purposes such amounts are not necessarily available to offset income subject to tax. Accordingly, the Company's effective tax rate for fiscal 1992 was approximately 10%. Page 15 of 90 Net income increased 86% to $4.3 million, compared to $2.3 million in fiscal 1991. The Company earned $.55 per share in fiscal 1992 compared to $.38 per share in fiscal 1991. The Company's backlog of signed and funded contracts at October 31, 1992 was $123.5 million, as compared to $120.6 million at October 31, 1991. The value of the Company's designations, which are awarded projects for which contracts have not been signed, was $154.8 million at October 31, 1992, as compared to $101.4 million at October 31, 1991. Income Taxes - ------------ Prior to October 10, 1989, the Company had available net operating loss ("NOL") carryforwards for Federal income tax purposes of approximately $51 million. As a result of a change in ownership as defined by Section 382 of the Internal Revenue Code ("IRC") that occurred on October 10, 1989, the Company's NOL carryforwards for financial statement and Federal income tax purposes became limited to approximately $750,000 per year for the succeeding fifteen-year carryforward period, for an aggregate of $11.2 million, plus NOL attributable to recognized built-in gains, limited to $14 million by IRC Section 382, for a total of $25.2 million. The financial statement tax benefits arising from these NOL carryforwards will be recognized as a reduction in financial statement tax expense and an addition to paid-in capital in the years utilized. At October 31, 1993, the Company had utilized $8.0 million of the total $25.2 million for Federal income tax purposes and $8.1 million for financial statement purposes. Liquidity and Capital Resources ------------------------------- The Company's liquidity and capital measurements are set forth below: October 31, 1993 1992 1991 ------------------------------------------------ Working capital $27,684,000 $26,836,000 $21,891,000 Working capital ratio 2.5 to 1 2.6 to 1 2.4 to 1 Average days to convert billed accounts receivable to cash 67 61 68 Percentage of debt to equity 28.2% 31.2% 35.9% In October 1992, the Company amended its existing line of credit agreement with Wells Fargo Bank (the "Bank"). The amended line of credit, which is secured by all the assets of the Company, provides for advances up to $10,000,000 and expires April 29, 1994. Borrowings on the line of credit bear interest at the Bank's prime rate plus one-half percent payable monthly in arrears. At October 31, 1993, the Company had $9,829,000 available to it under the line of credit. At October 31, 1993, the Company had outstanding letters of credit totalling $171,000 which reduced the amount available to the Company under the line of credit. Page 16 of 90 Under the amended Bank line of credit agreement, the Company is required to satisfy certain financial and non-financial covenants. The Company was in compliance with all financial and non-financial covenants related to the line of credit agreement at October 31, 1993 and October 31, 1992. The Company is a professional services organization and as such, is not capital intensive. Capital expenditures during fiscal years 1993, 1992 and 1991 were $1,952,000, $1,158,000 and $1,004,000, respectively. The expenditures were principally for computer aided design and drafting equipment and facilities expansion to accommodate the Company's growth. The Company expects fiscal 1994 capital expenditures to be comparable to the expenditures in fiscal 1993. The Company believes that its existing financial resources, together with its planned cash flow from operations and its unused Bank line of credit, will provide sufficient capital to fund its operations in fiscal 1994. Page 17 of 90 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- The Board of Directors and Shareholders of URS Corporation: We have audited the accompanying consolidated balance sheets of URS Corporation and its subsidiaries as of October 31, 1993 and 1992, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended October 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of URS Corporation and its subsidiaries as of October 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended October 31, 1993, in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND ----------------------- San Francisco, California December 7, 1993 Page 18 of 90 URS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except per share data) October 31, 1993 1992 ---- ---- ASSETS Current assets: Cash $ 6,628 $ 5,729 Accounts receivable, including retainage amounts of $3,087 and $2,650, less allowance for doubtful accounts of $665 and $346 27,157 23,088 Costs and accrued earnings in excess of billings on contracts in process, less allowances for losses of $416 and $422 11,783 13,903 Prepaid expenses 955 1,092 ------- ------- Total current assets 46,523 43,812 Property and equipment at cost, net 4,596 3,955 Goodwill, net 5,260 5,568 Other assets 1,695 1,557 ------- ------- $58,074 $54,892 ====== ====== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 8,078 $ 6,792 Accrued salaries and wages 3,574 3,759 Accrued expenses 7,187 6,425 ------- -------- Total current liabilities 18,839 16,976 Long-term debt 5,790 5,167 Long-term debt to related parties 2,487 3,538 Deferred compensation and other 1,569 1,333 ------- -------- Total liabilities 28,685 27,014 ------- -------- Commitments and contingencies (Note 7) - - Shareholders' equity: Common shares, par value $.01; authorized 20,000 shares; issued 6,989 and 6,959 70 70 Additional paid-in capital 28,365 27,697 Retained earnings since February 21, 1990, date of quasi-reorganization (total deficit eliminated $92,523) 954 111 ------- ------- Total shareholders' equity 29,389 27,878 ------- ------ $58,074 $54,892 ====== ====== See Notes to Consolidated Financial Statements Page 19 of 90 URS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) Years Ended October 31, 1993 1992 1991 ---- ---- ---- Revenues $145,761 $136,793 $122,838 -------- -------- -------- Expenses: Direct operating 91,501 85,384 72,659 Indirect, general and administrative 51,607 45,473 45,311 Interest expense, net 1,220 1,208 2,326 -------- -------- -------- 144,328 132,065 120,296 -------- -------- -------- Income before taxes 1,433 4,728 2,542 Income tax expense 140 460 250 -------- -------- -------- Net income $ 1,293 $ 4,268 $ 2,292 ======= ======= ======= Net income per share: Primary $ .18 $ .55 $ .40 ======= ======= ======= Fully diluted $ .18 $ .55 $ .38 ======= ======= ======= See Notes to Consolidated Financial Statements Page 20 of 90 Page 21 of 90 URS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (In thousands) Years Ended October 31, 1993 1992 1991 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,293 $ 4,268 $ 2,292 ------ ------ ------ Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation and amortization 2,986 2,396 1,971 Unusual gain - (743) - Changes in current assets and liabilities: Increase in accounts receivable and costs and accrued earnings in excess of billings on contracts in process (1,949) (5,000) (872) Decrease (increase) in prepaid expenses and other 137 (459) 142 Increase (decrease) in accounts payable, accrued salaries and wages and accrued expenses 1,455 1,442 (5,840) Other, net 517 (292) (232) ------- ------- ------- Total adjustments 3,146 (2,656) (4,831) ------- ------- ------- Net cash provided (used) by operating activities 4,439 1,612 (2,539) ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (1,952) (1,158) (1,004) Other (400) - (514) ------- ------- ------- Net cash used by investing (2,352) (1,158) (1,518) activities ------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Net repayments under line of - - (11,188) credit agreement Repayment of debt (1,340) - (6,300) Proceeds from sale of common shares 152 94 19,515 ------- ------- ------- Net cash provided (used) by financing activities (1,188) 94 2,027 ------- ------- ------- Net increase (decrease) in cash 899 548 (2,030) Cash at beginning of year 5,729 5,181 7,211 ------- ------- ------- Cash at end of year $ 6,628 $ 5,729 $ 5,181 ====== ====== ====== See Notes to Consolidated Financial Statements Page 22 of 90 URS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES Principles of Consolidation and Basis of Presentation - ----------------------------------------------------- The consolidated financial statements include the accounts of URS Corporation and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Revenue Recognition - ------------------- Revenue from contract services is recognized by the percentage-of- completion method and includes a proportion of the earnings expected to be realized on a contract in the ratio that costs incurred bear to estimated total costs. Revenue on cost reimbursable contracts is recorded as related contract costs are incurred and include estimated earned fees in the proportion that costs incurred to date bear to total estimated costs. The fees under certain government contracts may be increased or decreased in accordance with cost or performance incentive provisions which measure actual performance against established targets or other criteria. Such incentive fee awards or penalties are included in revenue at the time the amounts can be reasonably determined. Revenue for additional contract compensation related to unpriced change orders is recorded when realization is probable. Revenue from claims by the Company for additional contract compensation is recorded when agreed to by the customer. If estimated total costs on any contract indicate a loss, the Company provides currently for the total loss anticipated on the contract. Costs under contracts with the U.S. Government are subject to government audit upon contract completion. Therefore, all contract costs, including direct, indirect, and general and administrative expenses, are potentially subject to adjustment prior to final reimbursement. Management believes that adequate provision for such adjustments, if any, has been made in the accompanying consolidated financial statements. All overhead and general and administrative expense recovery rates for fiscal 1987 through fiscal 1993 are subject to review by the U.S. Government. Income Taxes - ------------ In accordance with Statement of Financial Accounting Standards No. 96, deferred income taxes are recorded to reflect the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Investment tax credits are treated as a reduction of income tax expense in the year in which the related assets are acquired. Page 23 of 90 Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109") will be effective for the Company in fiscal 1994. The Company believes that the implementation of the new standard will not have a material affect on the Company's consolidated financial statements. Depreciation and Amortization - ----------------------------- Depreciation is provided on the straight-line method over the useful service lives of the assets. Goodwill is amortized on the straight-line method ranging from 10 to 20 years. Income Per Share - ---------------- Primary earnings per share calculations are based on the weighted average number of shares outstanding, warrants and on shares issuable under stock options that have a dilutive affect (shares used in such calculations were 6,742,000 in 1991, 8,221,000 in 1992 and 6,971,000 in 1993). Fully diluted earnings per share calculations assume the conversion of the Company's convertible debentures when there is a dilutive effect on income per share and when the ending market price of the Company's common stock exceeds the average price during the year (shares used in such calculations were 6,282,000 in 1991, 8,221,000 in 1992 and 6,971,000 in 1993). Industry Segment Information - ---------------------------- The Company's single business segment, consulting, provides engineering and architectural services to local and state governments, the Federal government and the private sector. The Company's services are primarily utilized for planning, design and program and construction management of infrastructure and environmental projects. The Company's revenues from local, state and Federal government agencies and private businesses for the last three fiscal years are as follows: Years Ended October 31, 1993 1992 1991 --------------- --------------- --------------- (In thousands) Local and state agencies $ 80,350 55% $ 65,314 48% $ 68,720 56% Federal agencies 48,713 33 52,530 38 35,614 29 Private business 16,698 12 18,948 14 18,504 15 ------ --- ------- --- ------ --- Total $145,761 100% $136,793 100% $122,838 100% ======= === ======= === ======= === Page 24 of 90 Reclassifications - ----------------- Reclassifications of certain balances for the years ended October 31, 1992 and 1991 have been made to conform to the October 31, 1993 financial statement presentation and have not affected previously reported net income or shareholders' equity. NOTE 2. QUASI-REORGANIZATION In conjunction with a restructuring completed in fiscal year 1990, the Company, with the approval of its Board of Directors, implemented a quasi- reorganization effective February 21, 1990 and revalued certain assets and liabilities to fair value as of that date. The fair values of the Company's assets and liabilities at the date of the quasi-reorganization were determined by management to approximate their carrying value and no further adjustment of historical bases was required. No assets were written-up in conjunction with the revaluation. As part of the quasi-reorganization, the deficit in retained earnings of $92,523,000 was eliminated against additional paid-in capital. The balance in retained earnings at October 31, 1993 represents the accumulated net earnings arising subsequent to the date of the quasi-reorganization. NOTE 3. PROPERTY AND EQUIPMENT Property and equipment consists of the following: October 31, 1993 1992 ---- ---- (In thousands) Furniture and fixtures $ 2,894 $ 2,368 Equipment 6,406 4,789 Leasehold improvements 1,011 564 ------ ----- 10,311 7,721 Less: Accumulated depreciation and amortization (5,715) (3,766) ------ ----- Net property and equipment $ 4,596 $3,955 ====== ===== NOTE 4. GOODWILL Goodwill represents the excess of the purchase price over the fair value of the net tangible assets of various operations acquired by the Company. Accumulated amortization at October 31, 1993 and 1992 was $2,035,000 and $1,467,000, respectively. Page 25 of 90 NOTE 5. INCOME TAXES The provision for income taxes consists of the following: Years Ended October 31, 1993 1992 1991 ---- ---- ---- (In thousands) Current: Federal $ 70 $ 110 $ - State and local 85 110 161 ---- ---- ---- 155 220 161 Deferred: Federal - - - State and local (15) 240 89 ---- ---- ---- (15) 240 89 ---- ---- ---- Total tax provision $ 140 $ 460 $ 250 ==== ==== ==== Prior to October 10, 1989, the Company had available net operating loss ("NOL") carryforwards for Federal income tax purposes of approximately $51,000,000. As a result of a change in ownership, as defined by Section 382 of the Internal Revenue Code ("IRC") that occurred on October 10, 1989, the Company's NOL carryforwards for financial statement and Federal income tax purposes became limited to approximately $750,000 per year for the succeeding fifteen-year carryforward period for an aggregate of $11,250,000, plus NOL attributable to recognized built-in gains limited to $14,000,000 by IRC Section 382, for a total of $25,250,000. The financial statement tax benefits arising from these NOL carryforwards will be recognized as a reduction in financial statement tax expense and an addition to paid-in capital in the years utilized. At October 31, 1993, the Company had utilized $8,000,000 of the total $25,250,000 for Federal income tax purposes and $8,100,000 for financial statement purposes. Subsequent to October 10, 1989, the date of the change in ownership, the Company incurred and has available additional NOL carryforwards of approximately $3,000,000 for Federal income tax and financial statement purposes. Generally, these NOL carryforwards will offset future income without limitation over the following fifteen-year period and will be recognized as a reduction in financial statement tax expense in the year utilized. While the Company has available NOL carryforwards for Federal income tax purposes, for state tax purposes such amounts are not necessarily available to offset income subject to tax. Accordingly, state income taxes have been provided. Page 26 of 90 The difference between total tax expense and the amount computed by applying the statutory Federal income tax rate to income before taxes are as follows: Years Ended October 31, 1993 1992 1991 ---- ---- ---- (In thousands) Federal income tax expense based upon Federal statutory tax rate of 34% $ 490 $1,600 $ 860 Nondeductible goodwill amortization 185 185 185 Nondeductible expenses 60 50 40 Financial statement NOL carryforward utilized (640) (1,605) (1,000) State taxes, net of Federal benefit 45 230 165 ------ ------ ------ Total taxes provided $ 140 $ 460 $ 250 ===== ===== ===== NOTE 6. LONG-TERM DEBT Long-term debt consists of the following: October 31, 1993 1992 ---- ---- (In thousands) THIRD PARTY: 6 % Convertible Subordinated Debentures due 2012 (net of bond issue costs of $46 and $49) $2,099 $2,096 8-5/8% Senior Subordinated Debentures due 2004 (net of discount and bond issue costs of $4,081 and $4,171) (effective yield on date of issue was 2,374 2,284 25%) Obligations under capital leases 1,916 1,297 ------ ------ 6,389 5,677 Less: Current maturities of capital leases 599 510 ------ ------ $5,790 $5,167 ===== ===== October 31, 1993 1992 ---- ---- (In thousands) RELATED PARTIES: January Notes (net of discount of $1,513 and $2,462) (effective interest rate on date of restructuring was 12%) $2,487 $3,538 ===== ===== Page 27 of 90 Credit Agreement - ---------------- At October 1993, the Company's line of credit agreement with Wells Fargo Bank (the "Bank") provides for advances up to $10,000,000 and expires April 29, 1994. The line of credit is collateralized by all the assets of the Company, including the stock of its subsidiaries. Borrowings on the line of credit bear interest at the Bank's prime rate plus one-half percent. At October 31, 1993, the Company had $9,829,000 available to it under the line of credit agreement. At October 31, 1993, the Company had outstanding letters of credit totalling $171,000 which reduced the amount available to the Company under its Bank line of credit. Under the Bank line of credit agreement the Company is required to satisfy certain financial and non-financial covenants. The Company was in compliance with all financial and non-financial covenants related to the line of credit agreement at October 31, 1993 and October 31, 1992. Related Parties - --------------- At October 31, 1992, the Company had a $6,000,000 line of credit represented by the January Notes, of which $4,000,000 is with Richard C. Blum & Associates Incorporated, ("RCBA, Inc.") and $2,000,000 with Altus Finance ("Altus"). RCBA, Inc., through various partnerships, beneficially owns approximately 25% of the Company's common shares (approximately 37% assuming exercise of additional warrants) outstanding at October 31, 1993. Richard C. Blum, a director of the Company, is also Chairman of RCBA, Inc. The January Notes were fully drawn at October 31, 1992 and are due November 1, 2000. In December 1992, the Company repurchased the $2,000,000 in January Notes held by Altus for $1,340,000 in cash. On the date of the transaction, the $2,000,000 in January Notes had a net book value of $1,190,000. The remaining $4,000,000 line of credit with RCBA, Inc. was fully drawn at October 31, 1993, bears interest at 6 % per annum and is subordinate only to the Bank line of credit. Debentures - ---------- The Company's 6 % Convertible Subordinated Debentures due 2012 are convertible into the Company's common shares at the rate of $206.30 per share. Sinking fund payments are calculated to retire 70% of the debentures prior to maturity beginning in February 1998. Interest is payable semi- annually in February and August. Interest is payable semi-annually in January and July on the Company's 8-5/8% Subordinated Debentures due 2004. Both the 6 % Convertible Subordinated Debentures and the 8-5/8% Senior Subordinated Debentures are subordinate to all debt to RCBA, Inc. and the Bank. Page 28 of 90 The amounts of long-term debt outstanding at October 31, 1993 maturing in the next five years are as follows: (In thousands) 1994 $ - 1995 - 1996 - 1997 - 1998 - Thereafter $12,600 Amounts payable under capitalized lease agreements are excluded from the above table. Obligations under Leases - ------------------------ Total rental expense included in operations for operating leases for the fiscal years ended October 31, 1993, 1992 and 1991 amounted to $4,938,000, $5,306,000 and $4,994,000, respectively. Certain of the lease rentals are subject to renewal options and escalation based upon property taxes and operating expenses. These operating lease agreements expire at varying dates through 2002. In fiscal 1992, the Company terminated its lease at its Cleveland, Ohio facility. As a result of this transaction, the Company recorded a net gain of $743,000. Obligations under non-cancelable lease agreements are as follows: Capital Operating Leases Leases ------- --------- (In thousands) 1994 $ 828 $ 4,265 1995 568 3,814 1996 472 3,255 1997 324 2,557 1998 90 1,723 Thereafter - 3,601 ------ ------- Total minimum lease payments 2,282 $19,215 ====== Less amounts representing interest 366 ------ Present value of net minimum lease payments $1,916 ===== Page 29 of 90 NOTE 7. COMMITMENTS AND CONTINGENCIES Currently, the Company has $21,000,000 "per occurrence" comprehensive general liability insurance coverage with an aggregate limit of $22,000,000. The Company has also deposited $1,000,000 with an insurer to cover errors and omissions ("E&O") and environmental impairment liability ("EIL") claims and maintains with different insurers' policies for excess E&O coverage with an aggregate limit of $14,000,000. The first $1,000,000 policy of E&O and EIL coverage is essentially self-insurance. Also, the E&O and EIL coverage is on a "claims made" basis, covering only claims actually made to the insurer during the one-year policy period currently in effect. Thus, if the Company does not continue to maintain this policy, it will have no coverage under the policy for claims made after its termination date even if the occurrence was during the term of coverage. It is the Company's intent to maintain this type of coverage, but there can be no assurance that the Company can maintain its existing coverage, that claims will not exceed the amount of insurance coverage or that there will not be claims relating to prior periods that were subject only to claims made coverage. Various legal proceedings are pending against the Company or its subsidiaries alleging breaches of contract or negligence in connection with the performance of professional services. In some actions punitive or treble damages are sought which substantially exceed the Company's insurance coverage. The Company's management does not believe that any of such proceedings will have a material adverse effect on the consolidated financial position and operations of the Company. NOTE 8. CAPITAL STOCK Declaration of dividends, except Common Stock dividends, is restricted by the Bank line of credit agreement. Further, declaration of dividends may be precluded by existing Delaware law. In fiscal 1991, the Company in a secondary public offering sold 2,875,000 shares of Common Stock at $7.50 per share. The 1987 Restricted Stock Plan provides for grants of up to 16,537 shares of Common Stock to key employees of the Company and its subsidiaries. An employee selected to receive shares under the Plan will not be required to pay any consideration for the shares. Shares issued to an employee are subject to forfeiture in the event that the employment of the employee terminates for any reason other than death. The forfeiture restrictions lapse with respect to portions of the grant over a five-year period subsequent to the grant date. As of October 31, 1993, 6,872 restricted shares have been granted. Page 30 of 90 The 1979 Stock Option Plan (the "1979 Option Plan") provided for grants of options to purchase shares of Common Stock to directors, officers and key employees of the Company and its subsidiaries at prices and for periods (not to exceed ten years) as determined by the Board of Directors. The 1979 Option Plan also provided for the granting of Stock Appreciation Rights and incentive stock options. The 1979 Option Plan expired in February 1989, and no further options or rights may be granted under the Plan. On October 20, 1988, the stockholders approved a replacement option program pursuant to which non-management members of the Board of Directors granted replacement stock options to selected employees, exercisable at then current market prices. The selected employees then exchanged their outstanding options for new options covering two shares for each three shares covered by the options being replaced. Options to purchase 16,561 shares were exchanged for pre-existing options. On April 27, 1989, the stockholders approved the 1989 Stock Option and Rights Plan (the "1989 Plan"). The 1989 Plan provides for the grant of 50,000 options to purchase shares of Common Stock to directors, officers and key employees of the Company and its subsidiaries at prices and for periods (not to exceed ten years) as determined by the Board of Directors. The 1989 Option Plan also provides for the granting of Stock Appreciation Rights. No options have been granted under this plan. On March 26, 1991, the stockholders approved the 1991 Stock Incentive Plan (the "1991 Plan"). The 1991 Plan provides for the grant not to exceed 1,500,000 Restricted Shares, Stock Units and Options, plus the number of shares of Common Stock remaining available for awards under the 1987 Restricted Stock Plan (9,655) and the 1989 Plan (50,000) to key employees of the Company and its subsidiaries at prices and for periods as determined by the Board of Directors. The 1991 Plan prohibits granting new options under the 1987 Restricted Stock Plan and the 1989 Plan. Under the Employee Stock Purchase Plan (the "ESP Plan") implemented in September 1985, employees may purchase shares of common stock through payroll deductions of up to 10% of the employee's base pay. Contributions are credited to each participant's account on the last day of each six-month participation period of the ESP Plan (which commences on January 1, and July 1 of each year). The purchase price for each share of Common Stock shall be the lower of 85 percent of the fair market value of such share on the last trading day before the participation period commences or 85 percent of the fair market value of such share on the last trading day in the participation period. The ESP Plan was suspended effective September 19, 1988. On March 24, 1992, the stockholders approved reinstating the ESP Plan. Employees purchased 26,246 shares under the ESP Plan in fiscal 1993 and 16,492 shares in fiscal 1992. On February 21, 1990, the Company issued warrants to purchase 1,819,148 shares of Common Stock at a purchase price of $4.34 per share and expires February 14, 1997. Page 31 of 90 A summary of the Stock Options under the 1979, 1989 and 1991 Plans follows: October 31, 1993 Shares Per Share ------ --------- Number of options: Outstanding at year end 856,445 $3.12 - 31.25 Exercisable at year end 689,275 $3.12 - 31.25 Exercised during the year - - Available for grant at year end 705,565 - October 31, 1992 Shares Per Share ------ --------- Number of options: Outstanding at year end 854,452 $3.12 - 31.25 Exercisable at year end 421,915 $3.12 - 31.25 Exercised during the year - - Available for grant at year end 205,565 - October 31, 1991 Shares Per Share ------ --------- Number of options: Outstanding at year end 739,207 $3.12 - 31.25 Exercisable at year end 171,354 $3.12 - 31.25 Exercised during the year - - Available for grant at year end 334,065 - [FN] Reflects lowest and highest exercise price. NOTE 9. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for: Years Ended October 31, 1993 1992 1991 ---- ---- ---- (In thousands) Interest $1,170 $888 $2,123 Income taxes $ 518 $405 $ 490 There were no significant non-cash investing or financing activities in fiscal 1993 and 1991. In fiscal 1992, the Company terminated its lease at its Cleveland, Ohio facility. As a result of the transaction, the Company recorded a $743,000 gain. Page 32 of 90 NOTE 10. DEFINED CONTRIBUTION PLAN The Company has a defined contribution retirement plan under Internal Revenue Code Section 401(k). The plan covers all full-time employees who are at least 18 years of age. Contributions by the Company are made at the discretion of the Board of Directors. Contributions in the amount of $486,100, $439,000 and $347,000 were made to the plan in fiscal 1993, 1992 and 1991, respectively. NOTE 11. VALUATION AND ALLOWANCE ACCOUNTS Additions Charged to Deductions Beginning Costs and from Ending Balance Expenses Reserves Balance ------- -------- -------- ------- (In thousands) October 31, 1993 Allowances for losses and doubtful collections $ 768 $603 $ 290 $1,081 October 31, 1992 Allowances for losses and doubtful collections $ 699 $310 $ 241 $ 768 October 31, 1991 Allowances for losses and doubtful collections $1,528 $234 $1,063 $ 699 NOTE 12. RELATED PARTY TRANSACTIONS Interest paid to related parties in connection with the January Notes was $254,000, $240,000 and $240,000 in fiscal 1993, 1992 and 1991, respectively. (See Note 6 - Long Term Debt). The Company has agreements for business consulting services to be provided by RCBA Inc., and Richard C. Blum, a Director of the Company. Under these agreements, the Company paid $90,000 and $60,000 to RCBA Inc. and Richard C. Blum, respectively, for fiscal 1993, 1992 and 1991. Richard C. Blum also received an additional $19,000, $12,500 and $15,750 for his services as a Director of the Company in fiscal 1993, 1992 and 1991, respectively. In addition, during fiscal 1993, URS Consultants, Inc., a wholly-owned subsidiary of the Company ("URSC"), performed an underground storage tank remediation investigation on behalf of RCBA, Inc. Such investigation was completed by October 28, 1993, and on November 19, 1993, RCBA, Inc. paid URSC $70,000 in gross revenues. Page 33 of 90 NOTE 13. CONCENTRATION OF CREDIT RISK The Company provides services primarily to local, state and Federal government agencies. The Company believes the credit risk associated with these types of revenues is minimal. However, the Company does perform ongoing credit evaluations of its customers and, generally, requires no collateral. The Company maintains reserves for potential credit losses and such losses have been within management's expectations. NOTE 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for fiscal 1993 and 1992 are summarized as follows: Fiscal 1993 Quarters Ended Jan. 31 Apr. 30 July 31 Oct. 31 ------- ------- ------- ------- (In thousands, except per share data) Revenues $32,957 $36,585 $35,627 $40,592 Gross profit 12,944 13,894 13,111 14,311 Operating income 1,008 1,476 (1,545) 1,714 (loss) $ 632 $ 1,076 $(1,681) $ 1,266 Net income (loss) Income (loss) per share: Primary and fully diluted $ .08 $ .14 $ (.24) $ .18 Weighted average ====== ====== ====== ====== number of shares 8,254 8,255 6,974 8,270 ====== ====== ====== ====== Fiscal 1992 Quarters Ended Jan. 31 Apr. 30 July 31 Oct. 31 ------- ------- ------- ------- (In thousands, except per share data) Revenues $29,619 $35,328 $33,801 $38,045 Gross profit 11,659 13,104 13,108 13,538 Operating income 1,003 1,513 1,613 1,807 Net income $ 624 $ 1,118 $ 1,166 $ 1,360 Income per share: Primary and fully diluted $ .08 $ .14 $ .15 $ .18 Weighted average ====== ====== ====== ====== number of shares 8,099 8,219 8,224 8,239 ====== ====== ====== ====== Operating income represents continuing operations before interest income and interest expense. ITEM 9. ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. Page 34 of 90 PART III ITEM 10. ITEM 10. EXECUTIVE OFFICERS AND DIRECTORS Incorporated by reference from the information under the captions "Election of Directors" and "Compliance with Section 16(a) of Securities Exchange Act" in the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on March 22, 1994, and from Item 4a -- "Executive Officers of the Registrant" in Part I. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the information under the caption "Executive Compensation" in the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on March 22, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the information under the caption "Stock Ownership" in the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on March 22, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from Item 8, Financial Statement and Supplementary Data, Note 6 -- Long-Term Debt and Note 12 -- Related Party Transactions. Page 35 of 90 PART IV ITEM 14. ITEM 14. EXHIBITS. FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1)Item 8. Consolidated Financial Statements and Supplementary Data Report of Independent Accountants Consolidated Balance Sheets October 31, 1993 and October 31, 1992 Consolidated Statements of Operations For the years ended October 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity For the years ended October 31, 1993, 1993 and 1991 Consolidated Statements of Cash Flows For the years ended October 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (a)(2) Financial Statement Schedules Schedules are omitted because they are not applicable, not required or because the required information is included in the Consolidated Financial Statements or Notes thereto. (a)(3) Exhibits 3.1 Certificate of Incorporation of the Company, filed as Exhibit 3.1 to the Annual Report on Form 10-K for the fiscal year ended October 31, 1991 ("1991 Form 10-K"), and incorporated herein by reference. 3.2 By-laws of the Company as amended, filed as Exhibit 3.2 to the Annual Report on Form 10-K for the fiscal year ended October 31, 1992 ("1992 Form 10-K"), and incorporated herein by reference. Page 36 of 90 4.1 Indenture, dated as of February 15, 1987, between the Company and First Interstate Bank of California, Trustees, relating to $57.5 million of the Company's 6 % Convertible Subordinated Debentures Due 2012, filed as Exhibit 4.10 to the Company's Registration Statement on Form S-2 (Commission File No. 33-11668) and incorporated herein by reference. 4.2 Amendment Number 1 to Indenture governing 6 % Convertible Subordinated Debentures due 2012, dated February 21, 1990, between the Company and First Interstate Bank of California, Trustee, filed as Exhibit 4.9 to the Company's Registration Statement on Form S-1 (Commission File No. 33-56296) ("1990 Form S-1") and incorporated herein by reference. 4.3 Indenture, dated as of March 16, 1989, between the Company and MTrust Corp., National Association, Trustee relating to the Company's 8-5/8% Senior Subordinated Debentures due 2004, filed as Exhibit 13C to the Company's Form T-3 under the Trust Indenture Act of 1939 (Commission File No. 22-19189) and incorporated herein by reference. 4.4 Amendment Number 1 to Indenture governing 8-5/8% Senior Subordinated Debentures due 2004, dated as of April 7, 1989, filed as Exhibit 4.11 to the 1990 Form S-1 and incorporated herein by reference. 4.5 Amendment Number 2 to Indenture governing 8-5/8% Senior Subordinated Debentures due 2004, dated February 21, 1990, between the Company and MTrust Corp. National Association, Trustee, filed as Exhibit 4.12 to the 1990 Form S-1 and incorporated herein by reference. 10.1 1979 Stock Option Plan of the Company, filed as Exhibit 10.01 to the Company's Registration Statement on Form S-14 (Commission File No. 2-73909) and incorporated herein by reference. 10.2 1987 Restricted Stock Plan of the Company, filed as Appendix I to the Company's definitive proxy statement filed with the Commission on March 2, 1987 and incorporated herein by reference. 10.3 1985 Employee Stock Purchase Plan as amended and restated, filed as Exhibit 10.3 to the 1991 Form 10-K and incorporated herein by reference. 10.4 1991 Stock Incentive Plan of the Company as amended, filed as Exhibit 10.4 to the 1992 Form 10-K and incorporated herein by reference. 10.5 Selected Executive Deferred Compensation Plan of the Company, filed as Exhibit 10.3 to the 1990 Form S-1 and incorporated herein by reference. 10.6 1993 Incentive Compensation Plan of the Company. FILED HEREWITH. 10.7 1993 Incentive Compensation Plan of URS Consultants, Inc. FILED HEREWITH. Page 37 of 90 10.8 Stock Appreciation Rights Agreement, dated July 18, 1989, between the Company and Irwin L. Rosenstein, filed as Exhibit 10.13 to the 1990 Form S-1 and incorporated herein by reference. 10.9 Stock Appreciation Rights Agreement, dated September 19, 1989, between the Company and Michael B. Shane, filed as Exhibit 10.14 to the 1990 Form S-1 and incorporated herein by reference. 10.10 Stock Appreciation Rights Agreement, dated October 9, 1989, between the Company and Martin M. Koffel, filed as Exhibit 10.15 to the 1990 Form S-1 and incorporated herein by reference. 10.11 Stock Appreciation Rights Agreement, dated August 23, 1989, between the Company and Martin S. Tanzer, filed as Exhibit 10.11 to the 1991 Form 10-K and incorporated herein by reference. 10.12 Employment Agreement, dated August 1, 1991, between URS Consultants, Inc. and Irwin L. Rosenstein, filed as Exhibit 10.12 to the 1991 Form 10-K and incorporated herein by reference. 10.13 Employment Agreement, dated December 16, 1991, between the Company and Martin Koffel, filed as Exhibit 10.13 to the 1991 Form 10-K and incorporated herein by reference. 10.14 Employment Agreement, dated January 24, 1992 between the Company and Michael B. Shane, filed as Exhibit 10.14 to the 1991 Form 10-K and incorporated herein by reference. 10.15 Employment Agreement, dated August 1, 1991, between URS Consultants, Inc. and Martin S. Tanzer, filed as Exhibit 10.15 to the 1991 Form 10-K and incorporated herein by reference. 10.16 Employment Agreement, dated May 7, 1991, between the Company and Kent P. Ainsworth, filed as Exhibit 10.16 to the 1991 Form 10-K and incorporated herein by reference. 10.17 Second Restated Credit Agreement, dated as of October 19, 1992, between Wells Fargo Bank, N.A., the Company, URS Consultants, Inc., Thortec Environmental Systems, Inc. and Mitchell Management Systems, Inc., filed as Exhibit 10.17 to the 1992 Form 10-K and incorporated herein by reference. 10.18 Letter Agreement, dated May 31, 1990, among the Company and certain subsidiaries and certain affiliates of Richard C. Blum & Associates, Inc., amending the Thortec Entities Credit and Security Agreement, filed as Exhibit 10.21 to the 1990 Form S-1 and incorporated herein by reference. Page 38 of 90 10.19 Thortec Entities Credit and Security Agreement, dated January 30, 1989, between the Company and certain subsidiaries and certain affiliates of Richard C. Blum & Associates, Inc., filed as Exhibit 10.54 to the 1988 Form 10-K, and incorporated herein by reference. 10.20 First, Second, Third and Fourth Amendments to the Thortec Entities Credit and Security Agreement, dated January 30, 1989, between the Company and certain entities managed or advised by Richard C. Blum & Associates, Inc., filed as Exhibit 10.23 to the 1990 Form S-1 and incorporated herein by reference. 10.21 Fifth, Sixth and Seventh Amendments to the Thortec Entities Credit and Security Agreement, dated January 30, 1989, between the Company and certain entities managed or advised by Richard C. Blum & Associates, Inc., filed as Exhibit 10.21 to the 1992 Form 10-K and incorporated herein by reference. 10.22 Letter Agreement, dated February 14, 1990, between the Company and Richard C. Blum, filed as Exhibit 10.31 to the 1990 Form S-1 and incorporated herein by reference. 10.23 Letter Agreement, dated February 14, 1990, between the Company and Richard C. Blum & Associates, Inc., filed as Exhibit 10.32 to the 1990 Form S-1 and incorporated herein by reference. 10.24 Registration Rights Agreement, dated February 21, 1990, among the Company, Wells Fargo Bank, N.A. and the Purchaser Holders named therein, filed as Exhibit 10.33 to the 1990 Form S-1 and incorporated herein by reference. 10.25 Warrant Agreement, dated February 21, 1990, between the Company, Wells Fargo Bank, N.A. and the Purchasers named therein, filed as Exhibit 10.24 to the 1990 Form S-1 and incorporated herein by reference. 10.26 URS Corporation Warrant Agreement, dated February 21, 1990, issued to BK Capital Partners I, filed as Exhibit 10.25 to the 1990 Form S-1 and incorporated herein by reference. 10.27 URS Corporation Warrant Agreement, dated February 21, 1990, issued to BK Capital Partners II, filed as Exhibit 10.26 to the 1990 Form S-1 and incorporated herein by reference. 10.28 URS Corporation Warrant Agreement, dated February 21, 1990, issued to BK Capital Partners III, filed as Exhibit 10.27 to the 1990 Form S-1 and incorporated herein by reference. 10.29 URS Corporation Warrant Agreement, dated February 21, 1990, issued to Executive Life Insurance Company, filed as Exhibit 10.28 to the 1990 Form S-1 and incorporated herein by reference. Page 39 of 90 10.30 URS Corporation Warrant Agreement, dated February 21, 1990, issued to Wells Fargo Bank, N.A., filed as Exhibit 10.29 to the 1990 Form S-1 and incorporated herein by reference. 10.31 URS Corporation Warrant Agreement, dated February 21, 1990, issued to Wells Fargo Bank, N.A., filed as Exhibit 10.30 to the 1990 Form S-1 and incorporated herein by reference. 10.32 Post-Affiliation Agreement, dated July 19, 1989, between the Company and URS International, Inc., filed as Exhibit 10.42 to the 1989 Form 10-K and incorporated herein by reference. 10.33 Contract between URS Consultants, Inc. and the U.S. Department of the Navy (No. N62474-89-R-9295) dated June 6, 1989, filed as Exhibit 10.34 to the 1991 Form 10-K and incorporated herein by reference.* 10.34 Form of Indemnification Agreement dated as of May 1, 1992 between the Company and each of Messrs. Ainsworth, Blum, Cashin, Koffel, Madden, Praeger, Rosenstein, Shane and Walsh, and Dr. Tanzer, filed as Exhibit 10.34 to the 1992 Form 10-K and incorporated herein by reference. 22.1 Subsidiaries of the Company, filed as Exhibit 22.1 to the 1992 Form 10-K and incorporated herein by reference. 24.1 Consent of Coopers & Lybrand. FILED HEREWITH. 25.1 Powers of Attorney of certain Directors and Officers. FILED HEREWITH. (b)(1) Reports on Form 8-K No reports were filed on Form 8-K during the fourth quarter of the fiscal year ended October 31, 1993. * Note: Certain material contained in this exhibit and indicated by an asterisk has been omitted and filed separately with the Commission pursuant to an application for confidential treatment under Rule 24b-2 promulgated under the Securities Exchange Act of 1934, as amended, which was granted by the Commission effective April 30, 1992. Page 40 of 90 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, URS Corporation, the Registrant, has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. URS Corporation (Registrant) By /s/ Kent P. Ainsworth ----------------------- Kent P. Ainsworth Vice President and Chief Financial Officer Dated: January 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the date indicated. Signature Title Date - --------- ----- ---- /s/ Martin M. Koffel Chairman of the Board January 28, 1994 - -------------------------- of Directors and Chief (Martin M. Koffel) Executive Officer /s/ Michael B. Shane Executive Vice President, January 28, 1994 - -------------------------- General Counsel, (Michael B. Shane) Secretary and Director /s/ Kent P. Ainsworth Vice President, Chief January 28, 1994 - -------------------------- Financial Officer and (Kent P. Ainsworth) Principal Accounting Officer Irwin L. Rosenstein* Director January 28, 1994 - -------------------------- (Irwin L. Rosenstein) Page 41 of 90 Richard C. Blum* Director January 28, 1994 - -------------------------- (Richard C. Blum) Emmet J. Cashin, Jr.* Director January 28, 1994 - -------------------------- (Emmet J. Cashin, Jr.) Richard Q. Praeger* Director January 28, 1994 - -------------------------- (Richard Q. Praeger) William D. Walsh* Director January 28, 1994 - -------------------------- (William D. Walsh) Richard B. Madden* Director January 28, 1994 - -------------------------- (Richard B. Madden) *By /s/ Kent P. Ainsworth January 28, 1994 - -------------------------- (Attorney-in-fact) Page 42 of 90 EXHIBIT INDEX Exhibit Page No. Description No. - ---------------------------------------------------------------------------- 3.1 Certificate of Incorporation of the Company, filed as Exhibit 3.1 to the Annual Report on Form 10-K for the fiscal year ended October 31, 1991 ("1991 Form 10-K"), and incorporated herein by reference. 3.2 By-laws of the Company as amended, filed as Exhibit 3.2 to the Annual Report on Form 10-K for the fiscal year ended October 31, 1992 ("1992 Form 10-K"), and incorporated herein by reference. 4.1 Indenture, dated as of February 15, 1987, between the Company and First Interstate Bank of California, Trustees, relating to $57.5 million of the Company's 6 % Convertible Subordinated Debentures Due 2012, filed as Exhibit 4.10 to the Company's Registration Statement on Form S-2 (Commission File No. 33-11668) and incorporated herein by reference. 4.2 Amendment Number 1 to Indenture governing 6 % Convertible Subordinated Debentures due 2012, dated February 21, 1990, between the Company and First Interstate Bank of California, Trustee, filed as Exhibit 4.9 to the Company's Registration Statement on Form S-1 (Commission File No. 33-56296) ("1990 Form S-1") and incorporated herein by reference. 4.3 Indenture, dated as of March 16, 1989, between the Company and MTrust Corp., National Association, Trustee relating to the Company's 8-5/8% Senior Subordinated Debentures due 2004, filed as Exhibit 13C to the Company's Form T-3 under the Trust Indenture Act of 1939 (Commission File No. 22-19189) and incorporated herein by reference. 4.4 Amendment Number 1 to Indenture governing 8-5/8% Senior Subordinated Debentures due 2004, dated as of April 7, 1989, filed as Exhibit 4.11 to the 1990 Form S-1 and incorporated herein by reference. 4.5 Amendment Number 2 to Indenture governing 8-5/8% Senior Subordinated Debentures due 2004, dated February 21, 1990, between the Company and MTrust Corp. National Association, Trustee, filed as Exhibit 4.12 to the 1990 Form S-1 and incorporated herein by reference. 10.1 1979 Stock Option Plan of the Company, filed as Exhibit 10.01 to the Company's Registration Statement on Form S-14 (Commission File No. 2-73909) and incorporated herein by reference. 10.2 1987 Restricted Stock Plan of the Company, filed as Appendix I to the Company's definitive proxy statement filed with the Commission on March 2, 1987 and incorporated herein by reference. Page 43 of 90 Exhibit Page No. Description No. - ---------------------------------------------------------------------------- 10.3 1985 Employee Stock Purchase Plan as amended and restated, filed as Exhibit 10.3 to the 1991 Form 10-K and incorporated herein by reference. 10.4 1991 Stock Incentive Plan of the Company as amended, filed as Exhibit 10.4 to the 1992 Form 10-K and incorporated herein by reference. 10.5 Selected Executive Deferred Compensation Plan of the Company, filed as Exhibit 10.3 to the 1990 Form S-1 and incorporated herein by reference. 10.6 1993 Incentive Compensation Plan of the Company. FILED HEREWITH. 48 10.7 1993 Incentive Compensation Plan of URS Consultants, Inc. FILED HEREWITH. 66 10.8 Stock Appreciation Rights Agreement, dated July 18, 1989, between the Company and Irwin L. Rosenstein, filed as Exhibit 10.13 to the 1990 Form S-1 and incorporated herein by reference. 10.9 Stock Appreciation Rights Agreement, dated September 19, 1989, between the Company and Michael B. Shane, filed as Exhibit 10.14 to the 1990 Form S-1 and incorporated herein by reference. 10.10 Stock Appreciation Rights Agreement, dated October 9, 1989, between the Company and Martin M. Koffel, filed as Exhibit 10.15 to the 1990 Form S-1 and incorporated herein by reference. 10.11 Stock Appreciation Rights Agreement, dated August 23, 1989, between the Company and Martin S. Tanzer, filed as Exhibit 10.11 to the 1991 Form 10-K and incorporated herein by reference. 10.12 Employment Agreement, dated August 1, 1991, between URS Consultants, Inc. and Irwin L. Rosenstein, filed as Exhibit 10.12 to the 1991 Form 10-K and incorporated herein by reference. 10.13 Employment Agreement, dated December 16, 1991, between the Company and Martin Koffel, filed as Exhibit 10.13 to the 1991 Form 10-K and incorporated herein by reference. 10.14 Employment Agreement, dated January 24, 1992 between the Company and Michael B. Shane, filed as Exhibit 10.14 to the 1991 Form 10-K and incorporated herein by reference. Page 44 of 90 Exhibit Page No. Description No. - ---------------------------------------------------------------------------- 10.15 Employment Agreement, dated August 1, 1991, between URS Consultants, Inc. and Martin S. Tanzer, filed as Exhibit 10.15 to the 1991 Form 10-K and incorporated herein by reference. 10.16 Employment Agreement, dated May 7, 1991, between the Company and Kent P. Ainsworth, filed as Exhibit 10.16 to the 1991 Form 10-K and incorporated herein by reference. 10.17 Second Restated Credit Agreement, dated as of October 19, 1992, between Wells Fargo Bank, N.A., the Company, URS Consultants, Inc., Thortec Environmental Systems, Inc. and Mitchell Management Systems, Inc., filed as Exhibit 10.17 to the 1992 Form 10-K and incorporated herein by reference. 10.18 Letter Agreement, dated May 31, 1990, among the Company and certain subsidiaries and certain affiliates of Richard C. Blum & Associates, Inc., amending the Thortec Entities Credit and Security Agreement, filed as Exhibit 10.21 to the 1990 Form S-1 and incorporated herein by reference. 10.19 Thortec Entities Credit and Security Agreement, dated January 30, 1989, between the Company and certain subsidiaries and certain affiliates of Richard C. Blum & Associates, Inc., filed as Exhibit 10.54 to the 1988 Form 10-K, and incorporated herein by reference. 10.20 First, Second, Third and Fourth Amendments to the Thortec Entities Credit and Security Agreement, dated January 30, 1989, between the Company and certain entities managed or advised by Richard C. Blum & Associates, Inc., filed as Exhibit 10.23 to the 1990 Form S-1 and incorporated herein by reference. 10.21 Fifth, Sixth and Seventh Amendments to the Thortec Entities Credit and Security Agreement, dated January 30, 1989, between the Company and certain entities managed or advised by Richard C. Blum & Associates, Inc., filed as Exhibit 10.21 to the 1992 Form 10-K and incorporated herein by reference. 10.22 Letter Agreement, dated February 14, 1990, between the Company and Richard C. Blum, filed as Exhibit 10.31 to the 1990 Form S-1 and incorporated herein by reference. 10.23 Letter Agreement, dated February 14, 1990, between the Company and Richard C. Blum & Associates, Inc., filed as Exhibit 10.32 to the 1990 Form S-1 and incorporated herein by reference. 10.24 Registration Rights Agreement, dated February 21, 1990, among the Company, Wells Fargo Bank, N.A. and the Purchaser Holders named therein, filed as Exhibit 10.33 to the 1990 Form S-1 and incorporated herein by reference. Page 45 of 90 Exhibit Page No. Description No. - ---------------------------------------------------------------------------- 10.25 Warrant Agreement, dated February 21, 1990, between the Company, Wells Fargo Bank, N.A. and the Purchasers named therein, filed as Exhibit 10.24 to the 1990 Form S-1 and incorporated herein by reference. 10.26 URS Corporation Warrant Agreement, dated February 21, 1990, issued to BK Capital Partners I, filed as Exhibit 10.25 to the 1990 Form S-1 and incorporated herein by reference. 10.27 URS Corporation Warrant Agreement, dated February 21, 1990, issued to BK Capital Partners II, filed as Exhibit 10.26 to the 1990 Form S-1 and incorporated herein by reference. 10.28 URS Corporation Warrant Agreement, dated February 21, 1990, issued to BK Capital Partners III, filed as Exhibit 10.27 to the 1990 Form S-1 and incorporated herein by reference. 10.29 URS Corporation Warrant Agreement, dated February 21, 1990, issued to Executive Life Insurance Company, filed as Exhibit 10.28 to the 1990 Form S-1 and incorporated herein by reference. 10.30 URS Corporation Warrant Agreement, dated February 21, 1990, issued to Wells Fargo Bank, N.A., filed as Exhibit 10.29 to the 1990 Form S-1 and incorporated herein by reference. 10.31 URS Corporation Warrant Agreement, dated February 21, 1990, issued to Wells Fargo Bank, N.A., filed as Exhibit 10.30 to the 1990 Form S-1 and incorporated herein by reference. 10.32 Post-Affiliation Agreement, dated July 19, 1989, between the Company and URS International, Inc., filed as Exhibit 10.42 to the 1989 Form 10-K and incorporated herein by reference. 10.33 Contract between URS Consultants, Inc. and the U.S. Department of the Navy (No. N62474-89-R-9295) dated June 6, 1989, filed as Exhibit 10.34 to the 1991 Form 10-K and incorporated herein by reference.* 10.34 Form of Indemnification Agreement dated as of May 1, 1992 between the Company and each of Messrs. Ainsworth, Blum, Cashin, Koffel, Madden, Praeger, Rosenstein, Shane and Walsh, and Dr. Tanzer, filed as Exhibit 10.34 to the 1992 Form 10-K and incorporated herein by reference. 22.1 Subsidiaries of the Company, filed as Exhibit 22.1 to the 1992 Form 10-K and incorporated herein by reference. 24.1 Consent of Coopers & Lybrand. FILED HEREWITH. 89 25.1 Powers of Attorney of certain Directors and Officers. FILED HEREWITH. 90 Page 46 of 90 * Note:Certain material contained in this exhibit and indicated by an asterisk has been omitted and filed separately with the Commission pursuant to an application for confidential treatment under Rule 24b-2 promulgated under the Securities Exchange Act of 1934, as amended, which was granted by the Commission effective April 30, 1992. Page 47 of 90 EXHIBIT 10.6 1993 Incentive Compensation Plan of URS Corporation URS CORPORATION 1993 INCENTIVE COMPENSATION PLAN Page 48 of 90 ----------------- I. PURPOSE OF THE PLAN II. HOW AWARDS ARE EARNED UNDER THE PLAN III. OTHER PLAN PROVISIONS IV. DEFINITIONS V. EXAMPLES OF PLAN OPERATION Page 49 of 90 I. PURPOSE OF THE PLAN Page 50 of 90 I.1 PURPOSE The URS Corporation ("URS") 1993 Incentive Compensation Plan (the "Plan") is intended to provide incentive compensation to individuals who make an important contribution to URS' financial performance. Specific Plan objectives are to: - Focus key Employees on achieving specific financial targets; - Reinforce a team orientation; - Provide significant award potential for achieving outstanding performance; and - Enhance the ability of URS Corporation to attract and retain highly talented and competent individuals. I-1 Page 51 of 90 II. HOW AWARDS ARE EARNED UNDER THE PLAN Page 52 of 90 II.1 GENERAL PLAN DESCRIPTION The 1993 Incentive Compensation Plan provides the opportunity for key Employees of URS Corporation (the "Company") to receive cash Awards based on a combination of Company and individual performance. An overview of how the Plan works is shown schematically on the facing page. In general, certain Employees will be selected to participate in the Plan at the beginning of or during the Plan Year. These individuals are referred to in the Plan as "Designated Participants." Upon selection to participate in the Plan, each Designated Participant will be assigned a Target Award Percentage. This Target Award Percentage, multiplied by the Participant's Base Salary earned during the Plan Year, will equal the Participant's Target Award. This Target Award represents the amount that is expected to be paid to a Designated Participant if certain financial Performance Objectives for URS have been fully met. In addition, funds will be set aside for discretionary Awards to selected other Employees (referred to in the Plan as "Nondesignated Participants"), who have demonstrated outstanding individual performance during the Plan Year. It is expected that the amount available to Non-designated Participants for the 1993 Plan Year will be $25,000, assuming that URS meets its financial objectives. The sum of all Target Awards for Designated Participants and expected payouts to Non-designated Participants will equal the Target Bonus Pool. The Actual Bonus Pool will vary from the Target Pool upward or downward based on URS' actual performance in relationship to its Performance Objectives. Actual Awards to Designated Participants and actual funds available for distribution to Non-designated Participants will vary from target amounts based on the relationship between the Actual Bonus Pool and the Target Bonus Pool. A detailed description of how the Plan works is presented in the following sections of this document. II.2 DESIGNATED AND NON-DESIGNATED PARTICIPANTS Plan participation is extended to selected Employees who, in the opinion of the Chief Executive Officer ("CEO") of URS, have the opportunity to significantly impact the annual operating success of the Company. These Employees, referred to as "Designated Participants," will be notified in writing of their selection to participate in the Plan. This notification letter, for all Participants except the CEO of URS, will be signed by the CEO II-1 Page 53 of 90 of URS. The letter of participation for the CEO will be signed by the chairman of the Compensation Committee. In addition to the Designated Participants, there may be a group of other Employees who are selected to receive Awards based on their outstanding individual performance during the Plan Year. These other Employees, referred to as "Nondesignated Participants," will not be selected until the completion of the Plan Year. The selection of Non-designated Participants will be determined by the CEO of URS, subject to the approval of the Compensation Committee. II.3 TARGET AWARD PERCENTAGES FOR DESIGNATED PARTICIPANTS Each Designated Participant will be assigned a Target Award Percentage. This Target Award Percentage, when multiplied by the individual's Base Salary earned during the Plan Year, represents the anticipated payout to a Designated Participant if URS' Performance Objectives are met. Each Designated Participant's Target Award Percentage will be included in the letter of notification mentioned in Section II.2. II.4 TARGET BONUS POOL The Target Bonus Pool (Target Pool) will equal the sum of all Target Awards for Designated Participants PLUS an amount set aside for distribution to Non-designated Participants. For 1993, the Target Bonus Pool equals $442,000. II.5 URS PERFORMANCE OBJECTIVES For 1993, URS' Performance Objectives are focused on the need to improve profitability and generate cash. The Performance Objectives and weightings for the 1993 Plan Year are as follows: II-2 Page 54 of 90 URS CORPORATION PERFORMANCE OBJECTIVES AND WEIGHTINGS Performance Measure Weighting Performance Objective ------------------- --------- --------------------- Net Income ($000s) 50% $5,600 Return on Total Capital (ROTC) 50% 15% For the purposes of the Plan, ROTC is defined as: [(A+B) ((C+D) 2)] where: A = Net Income B = After-Tax Interest C = Interest-bearing debt plus equity at the beginning of the Plan Year D = Interest-bearing debt plus equity at the end of the Plan Year Net Income will be calculated AFTER all URS Corporation (corporate) AND URS Consultants (URSC) bonuses are assumed to have been paid. It is possible that in the course of the Plan Year, unforeseen events could have a material effect upon URS Corporation's performance relative to the Performance Measures. Such events might include, but are not limited to, acquisitions and public offerings. The effect of such events will be treated on a case by case basis. In general, acquisitions and public offerings will be treated as follows: Acquisitions - ------------ In the event that the Company completes an acquisition during the Plan Year, the Performance Objectives will be adjusted for the projected financial impact of the acquisition for the balance of the Year and potential Awards under the Plan will be calculated accordingly. Equity Transactions - ------------------- In the event that URS issues or buys back Company stock during the Plan Year, the financial impact of such a transaction will not be included in calculating potential Awards under the Plan. II.6 RELATIONSHIP BETWEEN PERFORMANCE AND THE ACTUAL BONUS POOL The Actual Bonus Pool (Actual Pool) will vary from the Target Pool based on the relationship between the actual performance of URS and the Performance Objectives. The Actual Pool will vary in relationship to the Target Pool based on the following table: II-3 Page 55 of 90 RELATIONSHIP BETWEEN URS PERFORMANCE AND THE ACTUAL BONUS POOL AS A % OF THE TARGET BONUS POOL Net Income (weighted 50%) ROTC (weighted 50%) -------------------------- -------------------------- Actual Actual Pool Actual Actual Pool Performance as a % of Performance as a % of ($000s) Target Pool (%) Target Pool ----------- ----------- ----------- ----------- $11,200 200% 30% 200% 5,600 100% 15% 100% =< 4,200 0% =< 12% 0% [FN] The calculation of the Actual Award as a % of Target will be interpolated for performance between discrete points. Awards have no upper limit and will be extrapolated for performance beyond discrete points. Based on the table above, the Actual Award will vary depending upon actual performance in relation to Performance Objectives and the weighting of the Performance Objectives. The example on the opposite page illustrates the application of the table and the interpolation and weighting calculations. II.7 ACTUAL AWARDS TO DESIGNATED AND NON-DESIGNATED PARTICIPANTS Actual Awards to Designated Participants will vary from Target levels based on the relationship between the Actual Bonus Pool and the Target Pool. After allocating Actual Awards to Designated Participants, the remaining funds in the Actual Pool will be available for allocation to Non-designated Participants. Actual Awards distributed to Non-designated Participants will be determined on a discretionary basis by the CEO, subject to the approval of the Compensation Committee. The Company is under no obligation to distribute the entire Actual Pool. The sum of all Awards to Non-designated Participants may not exceed the amount available in the Actual Pool. II-4 Page 56 of 90 III. OTHER PLAN PROVISIONS Page 57 of 90 III.1 AWARD PAYMENT Assessment of actual performance and payout of Awards will be subject to the completion of the 1993 Year-end independent audit. The Actual Award earned, up to the Target Award level, will be paid to the Participant (or the Participant's heirs in the case of death) in cash within 30 days of the completion of the independent audit. Any Actual Award earned in excess of the Target Award will be automatically deferred until the end of fiscal 1994. This deferred portion of the Award will be paid to the Participant within 30 days of the end of fiscal 1994, provided that the Participant is still an Employee of URS or one of its Affiliates at Year-end 1994 except for death, permanent disability, or retirement. A Participant whose employment with the Company or an Affiliate is terminated prior to the end of fiscal 1994 for any other reason forfeits the deferred portion of the Award. The Company is under no obligation to pay interest on the deferred portion of the Award and will not do so. III.2 EMPLOYMENT In order to receive an Award under the Plan, a Participant must be employed by URS or an Affiliate at the end of the Plan Year, except as otherwise noted below. A Participant must also have performed his/her duties satisfactorily during the Year, as determined by the CEO of URS. The Compensation Committee will assess the performance of the CEO. III.3 TERMINATION If Termination of a Designated Participant's employment occurs during the Plan Year by reason of death, permanent disability, or retirement, the Designated Participant (or the Participant's heirs in the case of death) will be eligible to receive a prorata Award based on the time employed as a Participant and the Objectives achieved for the Plan Year. Participants who have earned an Award on this basis will receive payment on the same schedule as other Plan Participants, except that there will be no deferral of Awards in excess of Target. In the event that a Participant terminates for reasons above during Fiscal Year 1993, any deferred Award will be paid within 30 days of Termination. A Participant whose employment with the Company or its Affiliates is terminated prior to the end of the Plan Year for any other reason (whether voluntarily or involuntarily) will forfeit the opportunity to earn an Award under the Plan. III-1 Page 58 of 90 III.4 OTHER PRO-RATA AWARDS Individuals who have been selected during the Year for Plan participation and who have a minimum of three months as a Designated Participant will be eligible to receive a pro-rata Award based on the time employed as a Participant and the Objectives achieved for the Plan Year, provided that the Participant is employed by URS or an Affiliate at Year-end. III.5 PLAN FUNDING Estimated payouts for the Plan will be accrued monthly and charged as an expense against the income statement of URS. At the end of each fiscal quarter, the estimated Actual Awards under the Plan will be evaluated based on actual performance to date. The monthly accrual rate will then be adjusted so that the cost of the Plan is fully accrued at Year-end. Accrual of Awards will not imply vesting of any individual Awards to Participants. III.6 PLAN ADMINISTRATION Responsibility for decisions and/or recommendations regarding Plan administration are divided among the URS CEO and the Compensation Committee of the URS Board of Directors. The exhibit on the facing page outlines the levels of responsibility and authority assigned to each. Notwithstanding the above, the Committee retains final authority regarding all aspects of Plan administration, and the resolution of any disputes. The Committee may, without notice, amend, suspend or revoke the Plan. III.7 ASSIGNMENT OF EMPLOYEE RIGHTS No employee has a claim or right to be a Participant in the Plan, to continue as a Participant, or to be granted an Award under the Plan. URS is not obligated to give uniform treatment (e.g., Target Award Percentages, discretionary Awards, etc.) to Employees or Participants under the Plan. Participation in the Plan does not give an Employee the right to be retained in the employment of URS, nor does it imply or confer any other employment rights. Nothing contained in the Plan will be construed to create a contract of employment with any Participant. URS reserves the right to elect any person to its offices and to remove Employees in any manner and upon any basis permitted by law. III-2 Page 59 of 90 Nothing contained in the Plan will be deemed to require URS to deposit, invest or set aside amounts for the payment of any Awards. Participation in the Plan does not give a Participant any ownership, security, or other rights in any assets of URS or any of its Affiliates. III.8 WITHHOLDING TAX URS will deduct from all Awards paid under the Plan any taxes required by law to be withheld. III.9 EFFECTIVE DATE The Plan is effective as of November 1, 1992, and will remain in effect for the Fiscal Year ending October 31, 1993 unless otherwise terminated or extended by the Committee. III.10 VALIDITY In the event any provision of the Plan is held invalid, void, or unenforceable, the same will not affect, in any respect whatsoever, the validity of any other provision of the Plan. III.11 APPLICABLE LAW The Plan will be governed by and construed in accordance with the laws of the State of California. III-3 Page 60 of 90 IV. DEFINITIONS Page 61 of 90 IV.1 DEFINITIONS "Affiliate" refers to any entity owned partially or totally by URS Corporation including URS Corporation. "Actual Award" or "Award" refers to the incentive amount earned under the Plan by a Designated or Non-designated Participant. "Actual Bonus Pool" or "Actual Pool" refers to the calculated amount available for distribution to all Designated and Nondesignated Participants under the terms and provisions of the Plan. "Base Salary" refers to the actual base earnings of a Designated Participant for the Plan Year exclusive of any bonus payments under this Plan or any other prior or present commitment, including contractual arrangements, any salary advance, any allowance or reimbursement, and the value of any basic or supplemental Employee benefits or perquisites. Base Salary refers only to amounts earned while a Designated Participant during the Plan Year. "Company" refers to URS Corporation. "Compensation Committee" or "Committee" refers to the Compensation Committee of the Board of Directors of URS Corporation. "Designated Participant" refers to an Employee of URS Corporation designated by the CEO of URS to participate in the Plan. Designation will be established only in writing. "Employee" refers to an Employee of URS Corporation. "Fiscal Year" refers to the twelve months beginning November 1, and ending October 31. "Net Income" refers to the consolidated revenue less all expenses (including tax and interest charges) of the Company. "Non-designated Participant" refers to an Employee of URS Corporation selected to receive an Award under the Plan on the basis of outstanding individual performance. Employee selection will be made at the end of the Plan Year, at the recommendation of the CEO of URS, within the guidelines agreed with and subject to the approval of the Compensation Committee. Unlike Designated Participants, Non-designated Participants will not be assigned Target Award Percentages or individual Performance Objectives. "Performance Objectives" or "Objectives" refers to the preestablished financial goals upon which URS Corporation performance will be assessed. IV-1 Page 62 of 90 "Plan" refers to the URS Corporation 1993 Incentive Compensation Plan, as described in this document. Any incentives for future years will be covered by subsequent plan documents. "Plan Year" or "Year" refers to the twelve months beginning November 1, 1992, and ending October 31, 1993, over which performance is measured under this Plan. "Target Award" refers to a Designated Participant's Target Award Percentage, multiplied by the Participant's Base Salary earned during the Plan Year. This amount represents the anticipated payout to the Designated Participant if all URS Performance Objectives are met. "Target Award Percentage" refers to a percentage of Base Salary assigned to a Designated Participant in accordance with the terms and provisions of the Plan. "Target Bonus Pool" or "Target Pool" refers to the amount anticipated to be distributed to all Designated and Nondesignated Participants if all URS Performance Objectives are met. "Termination" means the Participant's ceasing his service with the Company or any of its Affiliates for any reason whatsoever, whether voluntarily or involuntarily, including by reason of death or permanent disability. "URS" refers to URS Corporation. "Year-end" refers to the end of a Fiscal Year, October 31. IV-2 Page 63 of 90 V. EXAMPLES OF PLAN OPERATION Page 64 of 90 URS CORPORATION PERFORMANCE TABLE Actual Actual Net Income Actual vs. Return on Total Capital Actual vs. (50% weighting) Target Pool (50% weighting) Target Pool --------------- ----------- ----------------------- ----------- >= $11.200MM 200% >= 30% 200% $5.600MM 100% 15% 100% <= $4.200MM 0% <= 12% 0% Scenario 1 - URS net income and return on total capital performance - ---------- exceeds objectives Net Income Objective ($MMs) $5.6 ($5.8 - $5.6)/($11.2 - $5.6) URS Actual Net Income ($MMs) $5.8 = 3.6% + 100% = 103.6% Return on Total Capital Objective (%) 15.0% (17% - 15%)/(30% - 15%) = 13.3% URS Actual Return on + 100% = 113.3% Total Capital (%) 17.0% TARGET BONUS POOL ($000s) $442.0 (($442 * 50%) * 103.6%) + (($442 ACTUAL BONUS POOL ($000s) $479.4 * 50%) * 113.3%) = $229.0 + $250.4 Scenario 2 - URS net income minimum met; return on total capital not met - ---------- Net Income Objective ($MMs) $5.6 ($4.5 - $5.6)/($4.2 - $5.6) * (-1) URS Actual Net Income ($MMs) $4.5 = -78.6% + 100% = 21.4% Return on Total Capital Objective (%) 15.0% Since the minimum of 12% ROTC is URS Actual Return on not met, there is no bonus for this Total Capital(%) 11.0% Performance Objective TARGET BONUS POOL ($000s) $442.0 (($442 * 50%) * 21.4%) + (($442 * ACTUAL BONUS POOL ($000s) $47.3 50%) * 0.0%) = $47.3 + $0.0 Scenario 3 - URS net income exceeds maximum; return on total capital exceeds - ---------- objective Since the maximum net income equal Net Income Objective ($MMs) $5.6 to $11.2 MM has been met, the bonus URS Actual Net Income ($MMs) $12.3 percentage for this objective is 200% of Target Return on Total Capital Objective (%) 15.0% (18% - 15%)/(30% - 15%) = 20% + URS Actual Return on 100% = 120% Total Capital (%) 18.0% TARGET BONUS POOL ($000s) $442.0 (($442 * 50%) * 200%) + (($442 * ACTUAL BONUS POOL ($000s) $707.2 50%) * 120%) = $442.0 + $265.2 Actual awards to Designated Participants and funds available for distribution to Non-designated Participants will vary from Target levels in relationship to the Actual Bonus Pool versus the Target Pool. V-1 Page 65 of 90 EXHIBIT 10.7 1993 Incentive Compensation Plan of URS Consultants Inc. URS CONSULTANTS INC. 1993 INCENTIVE COMPENSATION PLAN Page 66 of 90 ----------------- I. PURPOSE OF THE PLAN II. HOW AWARDS ARE EARNED UNDER THE PLAN III. OTHER PLAN PROVISIONS IV. DEFINITIONS V. EXAMPLES OF PLAN OPERATION Page 67 of 90 I. PURPOSE OF THE PLAN Page 68 of 90 I.1 PURPOSE The URS Consultants Inc. 1993 Incentive Compensation Plan (the "Plan") is intended to provide incentive compensation to individuals who make an important contribution to URS Consultants financial performance. Specific Plan objectives are to: - Focus key Employees on achieving specific financial targets; - Reinforce a team orientation; - Provide significant award potential for achieving outstanding performance; and - Enhance the ability of URS Consultants to attract and retain highly talented and competent individuals. I-1 Page 69 of 90 II. HOW AWARDS ARE EARNED UNDER THE PLAN Page 70 of 90 II.1 GENERAL PLAN DESCRIPTION (see facing exhibit) The 1993 Incentive Compensation Plan provides the opportunity for key Employees of URS Consultants Inc. ("the Company") to receive cash Awards based on a combination of Company and individual performance. An overview of how the Plan works is shown schematically on the facing page. In general, a Target Bonus Pool is established. This amount represents the total Awards that are expected to be paid to selected URS Consultants Employees if certain financial Performance Objectives for URS Consultants have been fully met. The Actual Bonus Pool will vary from the Target Bonus Pool upward or downward based on URS Consultants' actual performance in relationship to its Performance Objectives. This adjusted bonus pool is the Actual Bonus Pool, from which Actual Award payouts will be made. At the beginning of or during the Plan Year, certain Employees will be selected to participate in the Plan. These individuals are referred to in the Plan as "Designated Participants." Upon selection to participate in the Plan, each Designated Participant will be assigned a Target Award Percentage. This Target Award Percentage, multiplied by the Participant's Base Salary earned during the Plan Year, will equal the Participant's Target Award. This Target Award will be earned for meeting both pre-determined URS Consultants and individual Performance Objectives. Individual Performance Objectives will vary based on the Participant's role within the organization. Each Designated Participant's Actual Award could vary from the Target Award, based on the individual's actual performance measured against his/her Performance Objectives, subject to the amount available for distribution from the Actual Bonus Pool. Another key feature of the Plan is that a portion of the Actual Bonus Pool will be set aside for discretionary Awards to selected other Employees (referred to in the Plan as "NonDesignated Participants"), who have demonstrated outstanding individual performance during the Plan Year. A detailed description of how the Plan works is presented in the following sections of this document. II.2 DESIGNATED AND NON-DESIGNATED PARTICIPANTS Plan participation is extended to selected Employees who, in the opinion of the President of URS Consultants and the Chief Executive Officer ("CEO") of URS Corporation (the "Parent Company"), have the opportunity to significantly impact the annual operating success of URS Consultants. These Employees, referred to as "Designated Participants," will be notified in writing of their selection to participate in the Plan. This notification letter will be signed by both the President of URS Consultants and the CEO of the Parent Company. II-1 Page 71 of 90 In addition to the Designated Participants, there may be a group of other Employees who are selected to receive Awards based on their outstanding individual performance during the Plan Year. These other Employees, referred to as "Nondesignated Participants," will not be selected until the completion of the Plan Year. The selection of Non-designated Participants will be determined by the President of URS Consultants, subject to the approval of the CEO of the Parent Company. II.3 TARGET BONUS POOL A Target Bonus Pool is established, representing an amount which is expected to be sufficient to pay each Designated Participant 100% of his/her Target Award, with a remaining amount available for distribution to Non-designated Participants. (The Awards to Non-designated Participants are estimated at approximately 25% of the total Non-Designated Participants' Bonus Pool.) This Target Bonus Pool is determined based on the current group of Designated Participants and the anticipated group of Nondesignated Participants. The Target Pool is subject to change if the group of Designated Participants, the group of NonDesignated Participants, or the Base Salaries of Designated Participants change. Subject to these potential changes, the Target Bonus Pool for the 1993 Plan Year is established at $1,380,244. II.4 URS CONSULTANTS PERFORMANCE OBJECTIVES URS Consultants Performance Objectives are focused on the need to achieve strong operating results (i.e., contribution) and generate cash through the management of DSOs throughout the Year. Performance will be evaluated based on a combination of URS Consultants Contribution, Average Receivables Days Sales Outstanding (DSO), New Sales and Other Growth measures. The URS Consultants Performance objectives for the 1993 Plan Year are as follows: II-2 Page 72 of 90 URS CONSULTANTS PERFORMANCE OBJECTIVES Performance Measures Performance Objectives -------------------- ---------------------- Contribution ($000s) $12,600 Average DSO (Days) 92 New Sales ($000s) $161,000 Other Growth ($000s) Varies by Participant URS Consultants Contribution is defined as total 1993 Fiscal Year URS Consultants revenues less: - Direct cost of sales; - Indirect expenses; and - ACCRUAL OF EXPECTED AWARDS FOR BOTH DESIGNATED AND NON-DESIGNATED PARTICIPANTS UNDER THE PLAN (I.E., THE PLAN MUST PAY FOR ITSELF) The subtraction of expected Awards from revenues in calculating contribution under the Plan means that the Contribution Objective, for purposes of the Plan, is calculated after all bonuses have been accrued, or assumed to have been paid. URS Consultants Days Sales Outstanding (DSO) is defined by the following formula: BAR + UAR - BEC --------------- x 90 REVENUES where BAR is billed accounts receivable, UAR is unbilled accounts receivable, BEC is billings in excess of cost, and REVENUES is the sum of the last three months revenues. DSOs will be calculated monthly, and the average of the twelve months DSOs will equal Average DSOs. URS Consultants New Sales is defined as gross additions to backlog. URS Consultants Other Growth is defined as growth in New Sales, designations, indefinite delivery contracts, inter-office cooperation, and/or other measures as defined in the Participant's notification letter. II.5 WEIGHTING OF URS CONSULTANTS PERFORMANCE OBJECTIVES The Target Bonus Pool will be weighted based on the aggregate weightings of the individual Participants' Performance Objectives in the Plan. Contribution will be the most heavily weighted component followed by DSO performance, New Sales, and Other Growth Measures. An example of the weighting calculation is shown on the facing page. II-3 Page 73 of 90 II.6 RELATIONSHIP BETWEEN PERFORMANCE AND THE ACTUAL BONUS POOL The Actual Bonus Pool will vary from the Target Bonus Pool based on the relationship between the actual performance of URs Consultants and the Performance Objectives. The Actual Bonus Pool will vary in relationship to the Target Bonus Pool based on the following table: RELATIONSHIP BETWEEN URS CONSULTANTS PERFORMANCE AND THE ACTUAL BONUS POOL AS A % OF THE TARGET BONUS POOL URS Consultants Contribution URS Consultants DSO ---------------------------- ------------------- Actual Performance Actual As A % Of Bonus Pool Bonus Pool Performance Actual As A % Of Actual As A % Of Objective Performance Target Pool Performance Target Pool ----------- ----------- ----------- ----------- ----------- (%) ($000s) (%) (Days) (%) => 115% => $14,490 200% =< 87 200% 100% $12,600 100% 92 100% 85% $10,710 25% 97 25% < 85% < $10,710 0% > 97 0% URS Consultants New Sales - --------------------------------------- Actual Performance Actual As A % Of Pool Bonus Performance Actual As A % Of Objective Performance Target Pool ----------- ----------- ----------- (%) ($000s) (%) => 115% => $185,150 200% 100% $161,000 100% 85% $136,850 25% < 85% < $136,850 0% [FN] Awards for the Other Growth performance measure will be made at the discretion of the President of the Company and the Chief Executive Officer of the Parent Company. Maximum upside opportunity of 200% of the Target Bonus Pool may be raised at the discretion of the Compensation Committee. The calculation of the Actual Bonus Pool As A % Of Target will be interpolated for performance between discrete points shown in the table above. Based on the table above, the Actual Bonus Pool could vary between 0% and 200% of the Target Bonus Pool, depending upon actual performance in relation to II-4 Page 74 of 90 Performance Objectives and the weighting of the Performance Objectives. The example on the opposite page illustrates the application of the table and the interpolation and weighting calculations. Accrual of any Actual Pool tied to DSO, New Sales, and Other Growth performance is contingent upon Contribution performance being at or above 85% of the Performance Objective. II.7 DISCRETIONARY BONUS POOL It is the intent of the Plan that if the Actual Bonus Pool, as calculated in Section II.6, should fall below 25% of the Target Bonus Pool, then a Discretionary Bonus Pool will be created instead. Awards from the Discretionary Pool may be made to selected Employees (both Designated and Non-designated Participants) on a totally discretionary basis by the President of URS Consultants, subject to the approval of the CEO of the Parent Company. The formation of the Discretionary Pool will not guarantee any Award payments. Rather, the Discretionary Pool will be used to recognize selected outstanding Employees in the event that URS Consultants does not meet or exceed 85% of its Contribution Performance Objective. The total sum of Awards made from the Discretionary Pool may not exceed 25% of the Target Bonus Pool. II.8 ACTUAL BONUS POOL ALLOCATION Awards will be paid from the funds available in the Actual Bonus Pool. The portion of the pool actually allocated to NonDesignated Participants will be determined after the end of the Plan Year at the discretion of the CEO of the Parent Company, subject to the approval of the Compensation Committee, and may vary from the estimated 20% of the total Actual Bonus Pool. The sum of the Actual Awards paid, including Awards made to Non-designated Participants, may not exceed the available Actual Bonus Pool. II.9 TARGET AWARD PERCENTAGES Each Designated Participant will be assigned a Target Award Percentage. This Target Award Percentage, when multiplied by the individual's Base Salary earned during the Plan Year, represents the anticipated payout to a Designated Participant if all URS Consultants and the individual's Performance Objectives are met. II-5 Page 75 of 90 Each Designated Participant's Target Award Percentage and individual Performance Objectives will be included in the letter of notification mentioned in Section II.2. II.10 ACTUAL AWARDS FOR DESIGNATED PARTICIPANTS Individual Performance Objectives will be assigned based on the economic unit (i.e., URS Consultants, a region of URS Consultants, or an office of URS Consultants) on which the Participant's performance has the greatest financial impact. Each Designated Participant will be notified of his/her economic unit, the individual Performance Objectives associated with that unit, the weighting of those Performance Objectives, and the relationship between individual unit performance and Award levels in the letter of notification mentioned in Section II.2. II.11 ADJUSTMENT TO ACTUAL AWARDS It is possible that the sum of the Actual Awards for Designated Participants could exceed the Actual Bonus Pool available for Designated Participants. This result could happen for either one of two reasons. First, the CEO of URS Corporation could allocate more for Awards to Non-designated Participants than was accrued. Second, larger economic units could perform worse relative to the smaller economic units, creating an insufficient Actual Bonus Pool. In these cases, all Actual Awards will be reduced pro-rata by a factor determined by dividing the Actual Bonus Pool for Designated Participants by the sum of the individual Actual Awards for Designated Participants. An example of this calculation is shown on the opposite page. If the sum of Actual Awards is less than the Actual Bonus Pool available for Designated Participants, there will be no upward pro-ration of Awards paid. II-6 Page 76 of 90 III. OTHER PLAN PROVISIONS Page 77 of 90 III.1 AWARD PAYMENT Assessment of actual performance and payout of Awards will be subject to the completion of the 1993 Year-end independent audit. The Actual Award earned, up to the Target Award level, will be paid to the Participant (or the Participant's heirs in the case of death) in cash within 30 days of the completion of the independent audit. Any Actual Award earned in excess of the Target Award will be automatically deferred until the end of fiscal 1994. This deferred portion of the Award will be paid to the Participant within 30 days of the end of fiscal 1994, provided that the Participant is still an Employee of URS Consultants or one of its Affiliates at Year-end 1994, except for death, permanent disability, or retirement. A Participant whose employment with the Company or an Affiliate is terminated prior to the end of fiscal 1994 for any other reason forfeits the deferred portion of the Award. The Company is under no obligation to pay interest on the deferred portion of the Award and will not do so. III.2 EMPLOYMENT In order to receive an Award under the Plan, a Participant must be employed by URS Consultants or an Affiliate at the end of the Plan Year, except as otherwise noted below. A Participant must also have performed his/her duties satisfactorily during the Year, as determined by the URS Consultants President. The Parent Company CEO will assess the performance of the President and Executive Vice President. III.3 TERMINATION If Termination of a Designated Participant's employment occurs during the Plan Year by reason of death, permanent disability, or retirement, the Designated Participant (or the Participant's heirs in the case of death) will be eligible to receive a prorata Award based on the time employed as a Participant and the Objectives achieved for the Plan Year. Participants who have earned an Award on this basis will receive payment on the same schedule as other Plan Participants, except that there will be no deferral of Awards in excess of Target. In the event that a Participant terminates for reasons above during Fiscal Year 1993, any deferred Award will be paid within 30 days of Termination. A Participant whose employment with the Company or its Affiliates is terminated prior to the end of the Plan Year for any other reason (whether voluntarily or involuntarily) will forfeit the opportunity to earn an Award under the Plan. III-1 Page 78 of 90 III.4 OTHER PRO-RATA AWARDS Individuals who have been selected during the Year for Plan participation and who have a minimum of three months as a Designated Participant will be eligible to receive a pro-rata Award based on the time employed as a Participant and the Objectives achieved for the Plan Year, provided that the Participant is employed by URS Consultants or an Affiliate at Year-end. III.5 PLAN FUNDING Estimated payouts for the Plan will be accrued monthly and charged as an expense against the income statement of URS Consultants and its economic units. At the end of each fiscal quarter, the estimated Actual Bonus Pool under the Plan will be evaluated based on actual performance to date. The monthly accrual rate will then be adjusted so that the cost of the Plan is fully accrued at Year-end. Accrual of Awards will not imply vesting of any individual Awards to Participants. III.6 PLAN ADMINISTRATION Responsibility for decisions and/or recommendations regarding Plan administration are divided among the URS Consultants President, the URS Corporation CEO, and the Compensation Committee of the URS Corporation Board of Directors. The exhibit on the facing page outlines the levels of responsibility and authority assigned to each. Notwithstanding the above, the Committee retains final authority regarding all aspects of Plan administration, and the resolution of any disputes. The Committee may, without notice, amend, suspend or revoke the Plan. III.7 ASSIGNMENT OF EMPLOYEE RIGHTS No employee has a claim or right to be a Participant in the Plan, to continue as a Participant, or to be granted an Award under the Plan. URS Consultants is not obligated to give uniform treatment (e.g., Target Award Percentages, discretionary Awards, etc.) to Employees or Participants under the Plan. Participation in the Plan does not give an Employee the right to be retained in the employment of URS Consultants, nor does it imply or confer any other employment rights. III-2 Page 79 of 90 Nothing contained in the Plan will be construed to create a contract of employment with any Participant. URS Consultants reserves the right to elect any person to its offices and to remove Employees in any manner and upon any basis permitted by law. Nothing contained in the Plan will be deemed to require URS Consultants to deposit, invest or set aside amounts for the payment of any Awards. Participation in the Plan does not give a Participant any ownership, security, or other rights in any assets of URS Consultants or any of its Affiliates. III.8 WITHHOLDING TAX URS Consultants will deduct from all Awards paid under the Plan any taxes required by law to be withheld. III.9 EFFECTIVE DATE The Plan is effective as of November 1, 1992, and shall remain in effect for the Fiscal Year ending October 31, 1993 unless otherwise terminated or extended by the Committee. III.10 VALIDITY In the event any provision of the Plan is held invalid, void, or unenforceable, the same shall not affect, in any respect whatsoever, the validity of any other provision of the Plan. III.11 APPLICABLE LAW The Plan shall be governed by and construed in accordance with the laws of the State of California. III-3 Page 80 of 90 IV. DEFINITIONS Page 81 of 90 IV.1 DEFINITIONS "Actual Bonus Pool" or "Actual Pool" refers to the calculated amount available to be distributed to all Participants under the terms and provisions of the Plan. "Affiliate" refers to any entity owned partially or totally by URS Corporation including URS Corporation. "Award" refers to any incentive amount earned under the Plan by a Designated or Non-designated Participant. "Actual Award" refers to the calculated incentive amount earned by a Participant under the terms and provisions of the Plan, before any adjustments caused by the size of the Actual Bonus Pool. "Base Salary" refers to the actual base earnings of a Designated Participant for the Plan Year exclusive of any bonus payments under this Plan or any other prior or present commitment, including contractual arrangements, any salary advance, any allowance or reimbursement, and the value of any basic or supplemental Employee benefits or perquisites. Base Salary refers only to amounts earned while a Designated Participant during the Plan Year. "Company" refers to URS Consultants, Inc. "Compensation Committee" or "Committee" refers to the compensation Committee of the Board of Directors of the Parent Company. "Designated Participant" refers to an Employee of URS Consultants designated by the CEO of URS Corporation to participate in the Plan. Designation will be established only in writing. "Discretionary Bonus Pool" or "Discretionary Pool" is the total amount available to be distributed if URS Consultants contribution does not reach or exceed $10,710,000 (85% of the Performance Objective). ----------- "Employee" refers to an Employee of URS Consultants, Inc. "Fiscal Year" refers to the twelve months beginning November 1, and ending October 31. "Non-designated Participant" refers to an Employee of URS Consultants selected to receive an Award under the Plan on the basis of outstanding individual performance. Employee selection will be made at the end of the Plan Year, at the recommendation of the President of URS Consultants, within guidelines agreed with and subject to the approval of the CEO of URS Corporation. Unlike Designated Participants, Nondesignated Participants will not be assigned Target Award Percentages or individual Performance Objectives. IV-1 Page 82 of 90 "Parent Company" refers to URS Corporation. "Performance Objectives" or "Objectives" refers to the preestablished financial goals upon which overall URS Consultants and economic unit (i.e., URS Consultants, a region of URS Consultants, or an office of URS Consultants) performance will be assessed. "Plan" refers to the URS Consultants Inc. 1993 Incentive Compensation Plan, as described in this document. Any incentives for future years will be covered by subsequent plan documents. "Plan Year" or "Year" refers to the twelve months beginning November 1, 1992, and ending October 31, 1993, over which performance is measured under this Plan. "Target Award" refers to a Designated Participant's Target Award Percentage, multiplied by the Participant's Base Salary earned during the Plan Year. This amount represents the anticipated payout to the Designated Participant if all URS Consultants and the individual's Performance Objectives are met. "Target Award Percentage" refers to a percentage of Base Salary assigned to a Designated Participant in accordance with the terms and provisions of the Plan. Non-designated Participants are not assigned Target Award Percentages. "Target Bonus Pool" or "Target Pool" refers to the sum of the Target Awards for Designated Participants plus an estimated amount for Awards to Non-designated Participants. "Termination" means the Participant's ceasing his service with the Company or any of its Affiliates for any reason whatsoever, whether voluntarily or involuntarily, including by reason of death or permanent disability. "Year-end" refers to the end of a Fiscal Year, October 31. IV-2 Page 83 of 90 V. EXAMPLES OF PLAN OPERATION Page 84 of 90 URS CONSULTANTS PERFORMANCE TABLE Actual Actual Actual Contribution Actual DSO New Sales Other Growth (70% weighting) (18% weighting) (8% weighting) (4% weighting) --------------- --------------- -------------- -------------- >= $14,490 <= 87 > $185,150 $12,600 92 $161,000 To be $10,710 97 $136,850 Determined Scenario 1 - URSC Contribution, DSO performance, and New Sales exceed - ---------- objectives; Other Growth target objective met Contribution Objective ($000s) $12,600 ($13,000 - $12,600)/($14,490 - Actual Contribution ($000s) $13,000 $12,600) = 21.2% + 100% = 121.2% DSO Objective (days) 92 (90 - 92)/(87 - 92) = 40% + 100% = Actual DSO (days) 90 140% New Sales Objective ($000s) $161,000 ($170,000 - $161,000)/($185,150 - Actual New Sales ($000s) $170,000 $161,000) = 37.3% + 100% = 137.3% Other Growth Objective ($000s) $xx,xxx = 100% Actual Growth ($000s) $xx,xxx TARGET BONUS POOL ($000s) $1,380 (($1,380 * 70%) * 121.2%) + (($1,380 ACTUAL BONUS POOL ($000s) $1,725 * 18%) * 140%) + (($1,380 * 8%) * 137.3%) + ($1,380 * 4%) * 100%) = $1,725 Scenario 2 - URSC Contribution minimum met; DSO minimum not met; New Sales - ---------- exceeds objectives; Other Growth target objective met Contribution Objective ($000s) $12,600 ($11,000 - $12,600)/($10,710 - Actual Contribution ($000s) $11,000 $12,600) * (-75%) = -63.5% + 100% = 36.5% DSO Objective (days) 92 Since the minimum DSO performance Actual DSO (days) 98 allowable under plan is not met, there is no bonus payout for this Performance Objective New Sales Objective ($000s) $161,000 ($170,000 - $161,000)/($185,150 - Actual New Sales ($000s) $170,000 $161,000) = 37.3% + 100% = 137.3% Other Growth Objective ($000s) $xx,xxx = 100% Actual Growth ($000s) $xx,xxx TARGET BONUS POOL ($000s) $1,380 (($1,380 * 70%) * 36.5%) + (($1,380 ACTUAL BONUS POOL ($000s) $559 * 18%) * 0%) +(($1,380 * 8%) * 137.3%) + ($1,380 * 4%) * 100%) = $559 V-1 Page 85 of 90 Scenario 3 - URSC Contribution minimum not met; DSO and New Sales minimum - ---------- objectives met; Other Growth target objective met Contribution Objective ($000s) $12,600 Contribution < 85% of Target; Actual Contribution ($000s) $10,000 Contribution Pool = 0% DSO Objective (days) 92 DSO portion is contingent upon Actual DSO (days) 94 Contribution of 85% of Target. DSO portion is therefore 0% New Sales Objective ($000s) $161,000 New Sales portion is contingent upon Actual New Sales ($000s) $140,000 Contribution of 85% of Target. New Sales portion is therefore 0% Other Growth Objective ($000s) $xx,xxx Other Growth portion is contingent Actual Growth ($000s) $xx,xxx upon Contribution of 85% of Target. Other Growth portion is therefore 0% TARGET BONUS POOL ($000s) $1,380 Since the pool generated is less ACTUAL BONUS POOL ($000s) $0 than 25% of the Target Pool, a Discretionary Pool not to exceed 25% of Target ($345) is generated Actual awards to Designated Participants and funds available for distribution to Non-designated Participants will vary from Target levels in relationship to the Actual Bonus Pool versus the Target Pool. V-2 Page 86 of 90 DESIGNATED PARTICIPANT PERFORMANCE Contribution DSO New Sales Other Growth vs. Objective vs. Objective vs. Objective vs. Objective Actual vs. (70% weighting) (18% weighting) (8% weighting) (4% weighting) Target Award - --------------- --------------- -------------- -------------- ------------ >= 115% >= - 5 days >= 115% >= 115% 200% 100% 0 days 100% 100% 100% <= 85% <= + 5 days <= 85% <= 85% 0% INDIVIDUAL PERFORMANCE (Assume the percentage weightings in the table above apply to managers a, b, and c) Manager a - exceeds Contribution, DSO, New Sales, and Other Growth minimums, but does not meet target Salary ($000s) $100 Target Bonus % 25% Target Bonus ($000s) $25 Contribution Objective ($000s) $1,325 ($1,250 - $1,325)/($1,126 - $1,325) Actual Contribution ($000s) $1,250 * (-100%) = -38% + 62% = 62% DSO Objective (days) 90 (92 - 90)/(95 - 90) * (-100%) Actual DSO (days) 92 = -40% + 100% = 60% New Sales Objective ($000s) $250 ($230 - $250)/($212.5 - $250) Actual New Sales ($000s) $230 * (- 100%) = -53% + 100% = 47% Other Growth Objective ($000s) $150 ($135 - $150)/($128 - $150) Actual Growth ($000s) $135 * (-100%) = -68% + 100% = 32% ACTUAL BONUS ($000s) $14.8 (($25 * 70%) * 62%) + (($25 * 18%) * 60%) + (($25 * 8%) * 47%) + (($25 * 4%) * 32%) = $14.8 Manager b - URSC Contribution minimum met; DSO minimum not met; New Sales exceeds objective; Other Growth exceeds objective Salary ($000s) $100 Target Bonus % 15% Target Bonus ($000s) $15 Contribution Objective ($000s) $1,325 ($1,300 - $1,325)/($1,126 - $1,325) Actual Contribution ($000s) $1,300 * (-100%) = -13% + 100% = 87% DSO Objective (days) 90 Since the minimum DSO performance Actual DSO (days) 97 allowable under plan is not met, there is no bonus payout for this objective V-3 Page 87 of 90 New Sales Objective ($000s) $300 ($320 - $300)/($345 - $320) * (100%) Actual New Sales ($000s) $320 = 80% + 100% = 180% Other Growth Objective ($000s) $200 ($220 - $200)/($230 - $200) * (100%) Actual Growth ($000s) $220 = 67% + 100% = 167% ACTUAL BONUS ($000s) $12.3 (($15 * 70%) * 87%) + (($15 * 18%) * 0%) + (($15 * 8%) * 180%) + (($15 * 4%) * 167%) = $12.3 Manager c - URSC Contribution minimum met; DSO and New Sales minimums met; Other Growth meets objective Salary ($000s) $120 Target Bonus % 25% Target Bonus ($000s) $30 Contribution Objective ($000s) $1,500 $1,250/$1,500 = 83% Actual Contribution ($000s) $1,250 DSO Objective (days) 92 Actual DSO (days) 94 New Sales Objective ($000s) $200 Actual New Sales ($000s) $180 Other Growth Objective ($000s) $180 Actual Growth ($000s) $180 ACTUAL BONUS ($000s) $0.0 CONTRIBUTION MINIMUM NOT MET = NO BONUS Actual awards to Designated Participants and funds available for distribution to Non-designated Participants will vary from Target levels in relationship to the Actual Bonus Pool versus the Target Pool. V-4 Page 88 of 90 CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We consent to the incorporation by reference in the following registration statements of URS Corporation on: Form S-8 (File No. 2-63576) for 41,825 common shares related to the 1979 Stock Option Plan filed February 8, 1980 Form S-8 (File No. 2-99410) for 50,000 common shares related to the 1985 Employee Stock Purchase Plan filed August 1, 1985 Form S-8 (File No. 33-42192) for 261,177 common shares related to the 1985 Employee Stock Purchase Plan filed August 31, 1991 Form S-8 (File No. 33-41047) for 1,000,000 common shares related to the 1979 Stock Incentive Plan filed June 7, 1991 Form S-8 (File No. 33-61230) for 500,000 common shares related to the 1991 Stock Incentive Plan filed April 1, 1993 of our report dated December 7, 1993, on our audits of the consolidated financial statements of URS Corporation and its subsidiaries as of October 31, 1993 and 1992, and for the years ended October 31, 1993, 1992 and 1991, which report is included in this Annual Report on Form 10-K. /s/ COOPERS & LYBRAND --------------------- San Francisco, California January 21, 1994 Page 89 of 90 POWER OF ATTORNEY ----------------- Each person whose signature appears below hereby constitutes and appoints any one of MARTIN M. KOFFEL, MICHAEL B. SHANE and KENT P. AINSWORTH, each with full power to act without the other, as his true and lawful attorney- in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on SEC Form 10-K for fiscal year 1993 of URS Corporation, and any or all amendments thereto, and to file the same with all the exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all extents and purposes as he might or could do in person, thereby ratifying and confirming all that such attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof. This Power of Attorney may be executed in separate counterparts. Dated: December 21, 1993. /s/Richard C. Blum /s/William D. Walsh - ------------------------------ -------------------------- Richard C. Blum, Director William D. Walsh, Director /s/Emmet J. Cashin, Jr. /s/Irwin L. Rosenstein - ------------------------------ -------------------------- Emmet J. Cashin, Jr., Director Irwin L. Rosenstein, Director /s/Richard Q. Praeger /s/Michael B. Shane - ------------------------------ -------------------------- Richard Q. Praeger, Director Michael B. Shane, Director /s/Martin M. Koffel /s/Richard B. Madden - ------------------------------ -------------------------- Martin M. Koffel, Director Richard B. Madden, Director Page 90 of 90

4962_1993.txt

4962_1993

1993

4962

ITEM 1. BUSINESS American Express Company (the "registrant") was founded in 1850 as a joint stock association and was incorporated under the laws of the State of New York in 1965. The registrant and its subsidiaries are principally in the business of providing travel related services, investors diversified financial services and international banking services throughout the world. In January 1994, the registrant's Board of Directors approved a plan to complete a tax-free spin-off of the common stock of the registrant's subsidiary, Lehman Brothers Holdings Inc. ("Lehman"), through a special dividend to the registrant's common shareholders. Lehman is in the business of providing investment services. The final transaction, which is subject to a number of conditions, is expected to close in the second quarter of 1994. In anticipation of this transaction, Lehman's results are reported as a discontinued operation in the registrant's Consolidated Financial Statements. During 1993, Lehman sold the Shearson Lehman Brothers retail brokerage and asset management businesses, The Boston Company, Inc. and Shearson Lehman Hutton Mortgage Corporation. In March 1993, the registrant reduced its ownership interest in First Data Corporation ("FDC") to approximately 22 percent through a public offering. As a result, effective January 1, 1993, FDC is reported under the equity method of accounting. These transactions are described in more detail on pages 23 and 35-37 of the registrant's Annual Report to Shareholders, which descriptions are incorporated herein by reference. TRAVEL RELATED SERVICES American Express Travel Related Services Company, Inc. (including its subsidiaries, where appropriate, "TRS") provides a variety of products and services, including the American Express(R) Card (the "Card"), consumer lending, the American Express(R) Travelers Cheque (the "Travelers Cheque" or the "Cheque"), corporate and consumer travel products and services, magazine publishing, database marketing and management and insurance. TRS offers products and services in over 160 countries. TRS's business as a whole has not experienced significant seasonal fluctuation, although Travelers Cheque sales and Travelers Cheques outstanding tend to be greatest each year in the summer months, peaking in the third quarter, and Card billed business tends to be moderately higher in the fourth quarter than in other calendar quarters. TRS places significant importance on its trademarks and service marks. TRS diligently protects its intellectual property rights around the world. CARD AND CONSUMER LENDING TRS issues the American Express Card, including the American Express(R) Gold Card, the Platinum Card(R), the Corporate Card, the Optima(SM) Card and, commencing in January 1994, the Purchasing Card. Cards are currently issued in 32 currencies. The Card, which is issued to individuals for their personal account or through a corporate account established by their employer, permits Cardmembers to charge purchases of goods and services in the United States and in most countries around the world at establishments that have agreed to accept the Card. The Card issuer accepts from each participating establishment the charges arising from Cardmember purchases at a discount that varies with the type of participating establishment, the volume of charges, the timing and method of payment to the establishment and the method of submission. Except in the case of the Optima Card, the Card is primarily designed for use as a method of payment and not as a means of financing purchases of goods and services and carries no pre-set spending limit. Charges are approved based on a Cardmember's past spending and payment patterns, credit history and personal resources. Except in the case of the Optima Card and extended payment plans, payment of the full amount billed each month is due from the Cardmember upon receipt of the bill, and no finance charges are assessed. Card accounts that are past due by a given number of days are subject, in most cases, to a delinquency assessment. The Card issuer charges Cardmembers an annual fee, which varies based on the type of Card, the number of Cards for each account, the currency in which the Card is denominated and the country of residence of the Cardmember. The Optima Card is generally offered to pre-approved prospects on a first-year- free basis. Cardmembers generally have access to a variety of special services, including: the Membership Miles(R) Program, Global Assist(R) Hotline, Buyer's Assurance(SM) Protection Plan, Car Rental Loss and Damage Insurance Plan, Travel Accident Insurance Plan and Purchase Protection(SM) Plan. A Cardmember participating in the Gold Card program in the United States has access to certain additional services, including a Year End Summary of Charges Report and, in many instances, the ability to draw on a line of credit. The Platinum Card, offered to certain Cardmembers in the United States and certain other countries, provides access to additional and enhanced travel, financial, insurance, personal assistance and other services. Under the Express Cash program, enrolled Cardmembers can obtain cash or American Express Travelers Cheques 24 hours a day from automated teller machines of participating financial institutions worldwide. TRS also offers merchandise directly to Cardmembers, who may elect to pay for the products they purchase in installments with no finance charges. TRS is planning to offer additional rewards programs in conjunction with other businesses, possibly on a co- branded basis. The Corporate Card program offers travel and expense management systems and services for all business entities and such services as the Business Travel Accident Insurance Plan for large businesses and the Accident Disability Plan and the FleetPlan(SM) auto leasing program for small businesses. TRS is continuing to enhance its business travel and expense management systems through various on-line access technologies and business travel management information reports, as described below under "Travel Services", which are integrated with the Corporate Card. Effective on November 30, 1993, the U.S. General Services Administration awarded TRS a contract to provide American Express(R) Government Card charge card services to federal employees who travel on official government business. The contract is for one year with four one-year renewal options. TRS launched the Corporate Purchasing Card in January 1994. The Corporate Purchasing Card is intended to provide an efficient, low-cost system for managing purchases of supplies, equipment and services by companies. Employees of the company to whom Corporate Purchasing Cards are issued can use the Cards to order directly from suppliers, rather than using the traditional system of requisitions, purchase orders and invoices. TRS pays the suppliers and submits a single monthly billing statement to the company. The Optima Card is a revolving credit card marketed to individuals in the United States and several other countries. In the United States, interest is computed according to one of three tiers, all tied to the prime rate, depending on the spending and payment patterns and tenure of the Cardmember. American Express Centurion Bank ("Centurion Bank") issues the Optima Card in the United States and owns substantially all receivables arising from the use of Optima Cards issued in the United States. In addition, Centurion Bank issues lines of credit in association with many American Express Cards and offers unsecured loans to Cardmembers in connection with their Sign & Travel(R) accounts and other unsecured lines of credit and installment loans. The Sign & Travel account allows qualified U.S. Cardmembers the option of extended payments for airline, cruise and certain prepaid travel charges that are purchased with the Card. Centurion Bank combined its line of credit products with the Optima portfolio, effective in the fourth quarter of 1993. Outside the United States, consumer lending activities are engaged in by other subsidiaries of the registrant where local regulations permit. The Optima Card is currently offered primarily to individuals who already have an American Express Card. TRS is also planning to offer revolving credit cards to individuals who are not Cardmembers. American Express Credit Corporation ("Credco") purchases most Cardmember receivables arising from the use of Cards (other than Optima Cards) issued in the United States and Cardmember receivables in designated currencies arising from the use of Cards outside the United States. Credco finances the purchase of receivables principally through the issuance of commercial paper and the sale of medium- and long-term notes. (In addition, TRS also funds Cardmember receivables through an asset securitization program.) The cost of funding Cardmember receivables is a major expense of Card operations. The American Express Card and consumer lending businesses are subject to extensive regulation in the United States under a number of federal laws and regulations, including the Equal Credit Opportunity Act, which generally prohibits discrimination in the granting and handling of credit; the Fair Credit Reporting Act, which, among other things, regulates credit prescreening practices and requires certain disclosures when an application for credit is rejected; the Truth in Lending Act, which, among other things, requires extensive disclosure of the terms upon which credit is granted; the Fair Credit Billing Act, which, among other things, regulates the manner in which billing inquiries are handled and specifies certain billing requirements; and the Fair Credit and Charge Card Disclosure Act, which mandates certain disclosures on credit and charge card applications. Federal legislation also regulates abusive debt collection practices. In addition, a number of states and foreign countries have similar consumer credit protection and disclosure laws. These laws and regulations have not had, and are not expected to have, a material adverse effect on the Card and consumer lending businesses, either in the United States or on a worldwide basis. Centurion Bank is subject to restrictions on its activities under the Competitive Equality Banking Act of 1987 ("CEBA"). See page 18 for a description of these restrictions. Centurion Bank is a member of the Federal Deposit Insurance Corporation ("FDIC") and is regulated, supervised and regularly examined by the Delaware State Banking Commissioner and the FDIC. TRS encounters substantial and increasingly intense competition worldwide with respect to the Card and consumer lending businesses from general purpose cards issued under revolving credit plans, particularly VISA cards issued by members of VISA International Service Association, Inc. or VISA USA, Inc. (collectively, "VISA"), and MasterCard cards issued by members of MasterCard International, Incorporated ("MasterCard"), including cards sponsored by AT&T, General Electric Company, General Motors Corporation and Ford Motor Company; the Discover Card, a revolving credit card; and, to a lesser extent, charge cards such as Diners Club and JCB. TRS also encounters competition from businesses that issue their own cards or otherwise extend credit to their customers. Most U.S. banks issuing credit cards under revolving credit plans charge annual fees in addition to interest charges where permitted by state law. The issuer of the Discover Card, as well as some issuers of VISA cards and MasterCard cards, charge no annual fees. Certain issuers offer mileage credit to card holders under airline frequent flyer programs or other types of reward programs or rebates. Certain competing issuers offer premium cards with enhanced services or lines of credit. TRS generally charges higher discount rates to service establishments than its competitors. As a result, TRS has encountered complaints from some establishments, as well as suppression of the Card's use. TRS has adjusted its discount structure in certain industries and locations. In addition, TRS has undertaken a reengineering program designed to reduce costs and enhance TRS's ability to address competitive pricing pressures. (For a discussion of this program, see page 26 of the registrant's Annual Report to Shareholders, which is incorporated herein by reference.) TRS has also increased its joint marketing and other services offered to service establishments and has expanded its efforts in handling and resolving suppression problems. TRS's strategy is to focus on achieving Card acceptance at merchants where Cardmembers want to use the Card. The principal competitive factors that affect the Card business are (i) the quality of the service and services, including rewards programs, provided to Cardmembers and participating establishments; (ii) the number and characteristics of Cardmembers; (iii) the quantity and quality of the establishments that will accept a Card; (iv) the cost of Cards to Cardmembers and of Card acceptance to participating establishments; (v) the terms of payment available to Cardmembers and participating establishments; (vi) the number and quality of other payment instruments available to Cardmembers and participating establishments; and (vii) the success of marketing and promotion campaigns. TRAVEL SERVICES A wide variety of travel services is offered to customers for business and personal purposes by a network of offices in more than 120 countries. Travel services include trip planning, reservations, ticketing, management information systems and other incidental services. TRS receives commissions and fees for travel bookings and arrangements from airlines, hotels, car rental companies and other travel suppliers. To meet the competition for the business traveler and to provide client companies with a customized approach to managing their travel and entertainment needs, the Travel Management Services unit ("TMS") integrates the Corporate Card and business travel services in the United States and certain foreign countries. TMS offers to its client companies services to manage their travel and entertainment budgets. American Express Business Travel Centers handle reservations, provide necessary ticketing and deliver ticket/itinerary information in the United States. In addition, this service provides clients with an information package to plan, account for and control travel and entertainment expenses. TMS provides a state-of-the-art Expense Management System, which captures and reconciles expense report data with Corporate Card charge data. TMS also developed On-Line Access, a user-friendly information service that can help organizations obtain necessary travel management information through their office computers. Vigorous competition is encountered in the travel business from more than 30,000 travel agents in the United States and abroad. This competition is mainly based on service, convenience and proximity to the customer and has increased due to several factors in recent years. The number of travel agencies in the United States has increased, and a number of independent agencies have been acquired by larger travel companies. Travel agency groups also have increased in size, enabling independent agencies to be more competitive in providing travel services to regional and national business travel clients and in other activities. In addition, many companies have established in-house business travel departments. TRAVELERS CHEQUES American Express Travelers Cheques are sold as a safe and convenient alternative to currency. The Cheque, a negotiable instrument, has no expiration date and is payable by the issuer in the currency of issuance when presented for the purchase of goods and services or for redemption. The success of the Travelers Cheque operation is in large part related to the worldwide acceptability of the Cheque as a means of payment for goods and services and the worldwide refundability of Cheques that are lost or stolen. American Express Travelers Cheques are issued directly by TRS in United States dollars, Canadian dollars, Swiss francs, German marks and Japanese yen. French franc and British pound Cheques are primarily issued by joint venture companies in which TRS holds an equity interest and for which TRS provides sales, operations, marketing and refund servicing arrangements. American Express Travelers Cheques are sold through a broad network of outlets worldwide, including offices of TRS, its affiliates and representatives, travel agents, commercial banks, savings banks, savings and loan associations, credit unions and other financial, travel and commercial businesses. TRS generally pays compensation to selling agents for their sale of Travelers Cheques. The proceeds from sales of Cheques issued by TRS are remitted to TRS and are invested predominantly in highly-rated debt securities consisting primarily of intermediate- and long-term state and municipal obligations. The investment of these proceeds is regulated by various state laws. TRS also issues the Corporate Travelers Cheque, a cash access product for business travelers, Cheques for Two(SM), a Cheque product with two signature lines designed for people who are traveling together, and the American Express(R) Gift Cheque. All of these Cheque products operate with the same signature-countersignature negotiation procedure as Travelers Cheques and are refundable to the purchaser in the event of loss or theft. Although the registrant believes that TRS is the leading issuer of travelers checks, TRS encounters significant competition from many other forms of payment instruments, from other brands of travelers checks and from national and international automated teller machine networks. The principal competitive factors affecting the travelers check industry are (i) the acceptability of the checks throughout the world as an alternative to currency; (ii) the ability to service satisfactorily the check purchaser if the checks are lost or stolen; (iii) the compensation paid to, and frequency of settlement by, selling agents; (iv) the availability to the consumer of other forms of payment; (v) the accessibility of travelers check sales and refunds; (vi) the success of marketing and promotion campaigns; and (vii) the amount of the fee charged to the consumer. PUBLISHING AND DIRECT MARKETING TRS publishes Travel & Leisure(R), Food & Wine(R), Departures(TM) and Your Company(TM) magazines. Under a March 1993 agreement between TRS and a subsidiary of Time Inc. ("Time"), Time provides management services in connection with these magazines. The magazine publishing business operates in a highly competitive market. The editorial quality of the magazines and the size and quality of their readerships are the most critical competitive factors. TRS also provides direct mail merchandise services and, through its subsidiary Epsilon Data Management, Inc., proprietary database marketing and management. INSURANCE AMEX Life Assurance Company ("AMEX Life"), its subsidiaries and its affiliated property-casualty insurer, AMEX Assurance Company (collectively, the "Life Group"), provide a variety of insurance products to individuals, employers and associations. The Life Group's primary products are individual long-term care insurance and products for American Express Cardmembers such as Automatic Air Flight insurance and a deferred annuity marketed under the name Privileged Assets(R). The Life Group's long-term care products are marketed through a network of 20,000 independent agents and brokers and American Express affiliates. Other products are marketed through direct response methods to Cardmembers. The Life Group competes with companies in the financial services industry that respond to consumer needs for money management, risk management and investments. The principal factors that affect the Life Group's competitive position are (i) premium rates; (ii) providing coverage to meet customers' needs; (iii) the quality of service given its customers; (iv) establishing and maintaining distribution networks to sell policies and administrative capabilities to service policyholders; (v) marketing; and (vi) investment performance. In the first quarter of 1993, the Life Group sold by reinsurance certain closed blocks of business including policies of life, accident and health insurance held by American Express Cardmembers, representing earned premiums in 1992 of approximately $155 million. The Life Group is qualified to transact business in all states of the United States and in Puerto Rico and Canada, and is subject to comprehensive state and federal regulations. (See page 8 for a general discussion of the extent of state insurance regulations.) IDS FINANCIAL SERVICES IDS Financial Corporation (including its subsidiaries, where appropriate, "IDS") is engaged in providing a variety of financial products and services to help individuals, businesses and institutions establish and achieve their financial goals. IDS's products and services include financial planning, insurance and annuities, a variety of investment products, including investment certificates, mutual funds and limited partnerships, investment advisory services, trust services, tax preparation and bookkeeping services, personal auto and homeowner's insurance and retail securities brokerage services. At December 31, 1993, IDS maintained a nationwide financial planning field force of 7,655 persons. IDS's marketing system consists primarily of its field force operating in 50 states and the District of Columbia, organized in 13 regions and 177 divisional offices. FINANCIAL PLANNING IDS Financial Services Inc., IDS's principal marketing subsidiary, offers financial planning and investment advisory services to individuals for which it charges a fee. IDS financial planning services provide financial analyses addressing six basic areas of financial planning: financial position, protection, investment, income tax, retirement and estate planning. To complete their financial plans, IDS planners provide clients with recommendations of products from the more than 100 products distributed by subsidiaries and affiliates of IDS, as well as products of approved third parties. IDS Financial Services Inc. has entered into a marketing arrangement with a subsidiary of TRS, American Express Service Corporation ("AESC"), in which financial planners representing both AESC and IDS offer Cardmembers and others financial analyses through AESC and other financial products and services through IDS in select locations. IDS is planning to rebrand its financial planning business to identify itself more closely with the American Express brand name, and to enable IDS to expand services to Cardmembers. IDS Financial Services Inc. is marketing its financial products and services to customers of banks and credit unions, by establishing offices with dedicated financial planners within the bank's or credit union's retail locations. Such arrangements enable these financial institutions to retain and enhance their relationships with customers who would have gone elsewhere to buy non-insured, non-deposit financial products. First-year financial planners are compensated primarily by salary, while veteran financial planners receive compensation based on sales. The IDS field force compensation is structured to encourage planner retention and product persistency, while adding stability to the financial planner's income. In attracting and retaining members of the field force, IDS competes with financial planning firms, insurance companies, securities broker-dealers and other financial institutions. IDS has undertaken a major initiative called "IDS 1994" to make changes in its business processes and field organization to improve planner retention and client satisfaction. IDS has two pilot division offices implementing the IDS 1994 recommendations and plans additional pilots this year. Although the use of an exclusive field force may entail higher initial costs than other forms of marketing, such as direct-response marketing or independent agency distribution, IDS believes that its ability to provide broad-based integrated services on a relationship basis is a competitive advantage. IDS Financial Services Inc. does business as a broker-dealer and investment adviser in 51 jurisdictions. IDS Financial Corporation, IDS Financial Services Inc. and AESC are registered as broker-dealers and investment advisers regulated by the Securities and Exchange Commission ("SEC"), and are members of the National Association of Securities Dealers, Inc. ("NASD"). IDS financial planners must obtain state and NASD licenses required for the businesses. IDS anticipates regulation of the securities and commodities industries to increase at all levels. Monetary penalties and restrictions on business activities by regulators resulting from compliance deficiencies are also expected to increase. The SEC, self-regulatory organizations and state securities commissions may conduct administrative proceedings, which may result in censure, fine, the issuance of cease-and-desist orders or suspension or expulsion of a broker-dealer or an investment adviser, its officers or employees. The financial services industry responds to consumer needs for money management, risk management and investments. Industry competition focuses primarily on cost, investment performance, yield, convenience, service, reliability, safety and distribution system. Competition in the financial services market is very intense and IDS competes with a variety of financial institutions such as banks, securities brokers, mutual funds and insurance companies, whose products and services increasingly cross over the traditional lines that previously differentiated one type of institution from another. IDS's business does not as a whole experience significant seasonal fluctuations. INSURANCE AND ANNUITIES IDS's insurance business is carried on primarily by IDS Life Insurance Company ("IDS Life"), a stock life insurance company organized under the laws of the State of Minnesota. IDS Life is a wholly-owned subsidiary of IDS Financial Corporation and serves all states except New York. IDS Life Insurance Company of New York is a wholly-owned subsidiary of IDS Life and serves New York State residents. IDS Life also owns American Enterprise Life Insurance Company ("American Enterprise Life"), whose business is currently limited to issuing fixed dollar annuity contracts to banks, thrift institutions and stock brokerages. In Fortune magazine's May 1993 listing of the 50 largest life insurance companies as ranked by assets, IDS Life ranked fourteenth. IDS Life's products include whole life, universal life (fixed and variable), single premium life and term products (including waiver of premium and accidental death benefits). IDS Life also markets disability income and long-term care insurance. In addition, it offers single premium and flexible premium deferred annuities on both a fixed and variable dollar basis. Immediate annuities are offered as well. IDS Life markets variable annuity contracts designed for retirement plans. IDS Life's principal annuity products are fixed deferred annuities. These annuities guarantee a relatively low annual interest rate during the accumulation period (the time before annuity payments begin) although the company may pay a higher rate reflective of current market rates. IDS Life also offers a fixed/variable annuity, or "Flexible Annuity," in which the purchaser may choose between mutual funds, with portfolios of common stocks, bonds, managed assets and/or short-term securities, and IDS Life's "general account" as the underlying investment vehicle. Additionally, IDS Life offers a variable annuity contract that invests in real estate, real estate mortgages and sale-leaseback transactions. IDS Life, IDS Life Insurance Company of New York and American Enterprise Life are subject to comprehensive regulation by the Minnesota Department of Commerce (Insurance Division), the New York Department of Insurance and the Indiana Department of Insurance, respectively, although the laws of the other states in which these companies do business also regulate such matters as the licensing of sales personnel and, in some cases, the contents of insurance policies. The purpose of such regulation and supervision is primarily to protect the interests of policyholders. Virtually all states also mandate participation in insurance guaranty associations, which assess insurance companies in order to fund claims of policyholders of insolvent insurance companies. On the federal level, there is periodic interest in enacting new regulations with respect to various aspects of the insurance industry including taxation and accounting procedures, as well as the treatment of persons differently because of sex, with respect to terms, conditions, rates or benefits of an insurance contract. New federal regulation in any of these areas could potentially have an adverse effect upon IDS's insurance subsidiaries. As a distributor of variable contracts, IDS Life is registered as a broker-dealer and is a member of the NASD. As investment manager of various investment companies, IDS Life is registered as an investment advisor under applicable federal requirements. In addition to selling its products through IDS financial planners, IDS Life also distributes its products through financial consultants of Smith Barney Shearson Inc., an independent firm. The insurance and annuity business is highly competitive, and IDS Life's competitors consist of both stock and mutual insurance companies. Competitive factors applicable to the insurance business include the interest rates credited to its products, the charges deducted from the cash values of such products, the financial strength of the organization and the services provided to policyholders. INVESTMENT CERTIFICATES IDS issues face-amount investment certificates through its wholly-owned subsidiary, IDS Certificate Company ("IDSC"), which is registered as an investment company under the Investment Company Act of 1940. Owners of IDSC certificates are entitled to receive, at maturity, a stated amount of money equal to the aggregate investments in the certificate plus interest at rates declared from time to time by IDSC. In addition, persons holding one type of certificate may have their interest calculated in whole or in part based on any upward movement in a broad-based stock market index. The certificates issued by IDSC are not insured by any government agency. IDS acts as investment manager for IDSC. IDSC's certificates are sold primarily by IDS Financial Services Inc.'s field force. IDSC currently offers eight types of face-amount certificates. The specified maturities of the certificates range from four to twenty years. Within their specified maturity, most certificates have interest rate periods ranging from one to thirty-six months. Certificate holders can surrender their certificates at the end of an interest rate period. Some certificates are marketed by American Express Bank Ltd. to its foreign customers. American Express Bank International has also sold a significant amount of certificates. IDSC is the largest issuer of face-amount certificates in the United States. Such certificates compete, however, with many other investments offered by banks, savings and loan associations, credit unions, mutual funds, insurance companies and similar financial institutions, which may be viewed by potential customers as offering a comparable or superior combination of safety and return on investment. MUTUAL FUNDS IDS Financial Services Inc. offers a variety of mutual funds, for which it acts as principal underwriter (distributor of shares). IDS acts as investment manager and performs various administrative services. These 36 publicly-offered mutual funds, the "IDS MUTUAL FUND GROUP", have varied investment objectives, and include, for example, money market, tax-exempt, bond and stock funds. IDS believes that the IDS MUTUAL FUND GROUP, with combined net assets at December 31, 1993 of $36.5 billion, was the thirteenth largest mutual fund organization and, excluding money market funds, was the eighth largest. IDS Financial Services Inc., as principal underwriter, maintains a continuous public offering of shares of each fund at net asset value plus any applicable sales charge. The maximum sales charge is five percent of the offering price with reduced sales charges for larger purchases. The competitive factors affecting the sale of mutual funds include sales charges ("loads") paid, services received and investment performance. The funds compete with other investment products, including funds that have no sales charge (known as "no load" funds), and with funds distributed through independent brokerage firms as well as with those distributed by other "exclusive" sales forces. OTHER SERVICES IDS provides investment management services for pension, profit-sharing, employee savings and endowment funds of large- and medium-sized businesses and other institutions through the IDS Advisory Group. IDS also offers investment services for wealthy individuals and small institutions. These services are marketed through IDS financial planners and marketing employees and third- party referrals. International or global investment management is offered by IDS International, Inc., a U.S. company with offices in London, England, and IDS Fund Management Ltd., an English company. At December 31, 1993, the IDS Advisory Group managed securities portfolios totaling $12.3 billion for 236 accounts, up from $8.6 billion at December 31, 1992 for 172 accounts. The market for the IDS Advisory Group's services is highly competitive, with investment performance the most critical competitive factor. IDS Trust Company, formerly IDS Bank & Trust, provides trustee, custodial, record-keeping and investment management services for pension, profit sharing, employee savings and endowment funds. Through its personal trust division, IDS Trust Company offers trust services to individuals. IDS Trust Company is regulated by the Minnesota Department of Commerce (Banking Division). On March 1, 1994, IDS Trust Company and IDS Deposit Corp., a Utah industrial loan corporation, assigned their deposits and sold their loans to a subsidiary of TRS. Prior to that date, IDS Trust Company and IDS Deposit Corp. made consumer loans and accepted certain kinds of deposits. IDS Financial Services Inc. distributes a variety of real estate, cable TV, equipment leasing, and venture capital limited partnership investments issued by other companies. IDS Financial Services Inc. also distributes limited partnerships in which various IDS subsidiaries are co-general partners or are involved in providing services to such partnerships. These partnerships include real estate, cable TV and managed futures partnerships. IDS Property Casualty Insurance Company provides personal auto and homeowner's coverage to clients in nineteen states. This insurance is underwritten to some extent by AMEX Assurance Company in fourteen of these states and reinsured by IDS Property Casualty. IDS Property Casualty is regulated by the Commissioner of Insurance for Wisconsin. Tax and Business Services, a division of IDS Financial Services Inc., offers tax planning, tax preparation and small business consulting services to clients in 50 locations in 26 states. In 1993, IDS continued to expand its securities services activities, which offer portfolio analysis and securities brokerage services. American Enterprise Investment Services Inc. provides securities execution and clearance services for IDS. American Enterprise Investment Services Inc. is registered as a broker-dealer with the SEC, is a member of the NASD and the Chicago Stock Exchange and is registered with appropriate states. AMERICAN EXPRESS BANK The registrant's wholly-owned subsidiary, American Express Bank Ltd. (together with its subsidiaries, where appropriate, "AEB"), seeks to meet the financial service needs of wealthy entrepreneurs and local financial service institutions through four core businesses: private banking, correspondent banking, commercial services and treasury. AEB does not directly or indirectly do business in the United States except as an incident to its activities outside the United States. Accordingly, the following discussion relating to AEB generally does not distinguish between U.S. and non-U.S. based activities. AEB's private banking business focuses on wealthy entrepreneurs by providing such customers deposit products, investment and fiduciary services, asset management, mutual funds, trust and estate planning and secured loans. Correspondent banking services are offered primarily to medium-sized and small financial institutions and include processing services (such as check clearing, money transfers, collections and remittances), electronic banking and trade finance, in addition to deposit and investment services. Commercial services are provided to businesses, most of which are owned by wealthy entrepreneurs, and include trade finance products such as letters of credit, payment guaranties, working capital loans and equipment finance. Treasury services are provided to all segments of AEB's customer base, and primarily include trading foreign exchange, interest rate products and other derivative instruments. In certain countries outside the United States and Canada, in some cases by arrangement with TRS, AEB provides travel related services consisting of Card, travel and Travelers Cheque products and offers consumer lending and certain other services. In the future, AEB expects to serve a greater role as an international platform to support TRS's business globally. AEB has a global network of 81 locations in 37 countries. Its international headquarters is located in New York City. It maintains international banking agencies in New York City and Miami, Florida. Its wholly-owned Edge Act subsidiary, American Express Bank International ("AEBI"), is also headquartered in New York City and has branches in New York City, Miami, Beverly Hills, Los Angeles and San Diego. The three offices in California are expected to be sold or closed in 1994. In connection with AEB's sale in 1990 of TDB American Express Bank, its former Swiss-based private banking subsidiary, the registrant and certain of its affiliates, including AEB, have agreed not to engage in Switzerland in the money or asset management businesses prior to March 2, 1995. AEB continues to maintain a banking presence in Switzerland through a wholly-owned subsidiary, American Express Bank (Switzerland) S.A. As part of AEB's strategy to focus its business on wealthy entrepreneurs and local financial service institutions, and to manage its assets and operations more prudently, AEB continued to exit certain off-strategy activities in 1993, including a joint venture commercial bank in the Philippines and leasing joint ventures in Indonesia, Taiwan and Germany. SELECTED FINANCIAL INFORMATION The travel-related and consumer lending services referred to above were included in AEB's legal entity, but not AEB's reporting segment, in 1993 and in certain prior years. The financial information set forth below is generally presented on a segment basis and thus excludes such services, which were presented in TRS' reporting segment, except where otherwise indicated. Commencing in the first quarter of 1994, certain of such services are being operated within, and reported as part of, the AEB segment. AEB provides banking services to the registrant and its subsidiaries. AEB is only one of many international and local banks used by the registrant and its other subsidiaries, which constitute only a few of AEB's many customers. AEB's total assets were $13.6 billion at December 31, 1993, compared with $13.7 billion at December 31, 1992. Liquid assets, consisting of cash and deposits with banks, trading account assets and investments, were $5.9 billion at December 31, 1993, compared with $5.0 billion at December 31, 1992. The following table sets forth a summary of financial data for AEB at and for each of the three years in the period ended December 31, 1993 (dollars in millions): The following tables set forth the composition of AEB's loan portfolio at year end for each of the five years in the period ended December 31, 1993 (millions): By Geographical Region (a) 1993 1992 1991 1990 1989 - - ------------------------------------------------------------------------------- Asia/Pacific $1,924 $1,558 $1,653 $1,472 $1,229 Europe 882 844 910 1,526 1,519 Indian Subcontinent 849 907 623 632 485 Latin America 749 675 546 653 979 North America 283 382 468 537 533 Middle East 368 357 365 340 413 Africa 87 65 61 38 147 Other - - - - 11 - - ------------------------------------------------------------------------------- Total $5,142 $4,788 $4,626 $5,198 $5,316 =============================================================================== (a) Based primarily on the domicile of the borrower. (b) Loans due after 1 year at fixed (predetermined) interest rates totaled $199 million, while those at floating (adjustable) interest rates totaled $519 million. (c) Business loans, which accounted for approximately 51 percent of the portfolio as of December 31, 1993, were distributed over 26 commercial and industrial categories. (d) The decrease from December 31, 1992 to December 31, 1993 reflects $163 million of equipment finance (aircraft) loans transferred to other performing assets upon foreclosure, resulting in a total value of aircraft assets leased to others of $424 million at December 31, 1993. The following tables set forth AEB's nonperforming loans at year end for each of the five years in the period ended December 31, 1993 (millions): 1993 1992 1991 1990 1989 ------------------------------------------------------------------------- Credit $ 43 $102 $ 38 $189 $ 16 Lesser Developed Countries - - - 238 311 ------------------------------------------------------------------------- Total (a) $ 43 $102 $ 38 $427 $327 ========================================================================= 1993 1992 1991 1990 1989 ------------------------------------------------------------------------ Loans to businesses $ 24 $ 22 $ 21 $174 $ 16 Real estate loans 19 69 5 15 - Equipment financing - 6 5 - - Loans to banks and other financial institutions - 4 4 - 12 Loans to governments and official institutions - 1 3 238 299 ------------------------------------------------------------------------ Total (a) (b) $ 43 $102 $ 38 $427 $327 ======================================================================== (a) AEB's other nonperforming assets totaled $89 million at December 31, 1993, $83 million at December 31, 1992 and $43 million at December 31, 1991, and represent balances transferred from nonperforming loans as a result of foreclosures and in-substance foreclosures. The increases were primarily related to real estate exposures. (b) Reduced rate loans were immaterial in amount. The following table sets forth a summary of the credit loss experience of AEB at and for each of the five years in the period ended December 31, 1993 (dollars in millions): 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Total loans at year end $5,142 $4,788 $4,626 $5,198 $5,316 ====== ====== ====== ====== ====== Reserve for credit losses- January 1, $ 134 $ 88 $ 318 $ 452 $ 509 Provision for credit losses 34 94 25 54 127 Transfer to TRS (a) - - - (12) - Translation and other (b) (21) - (1) 2 - ------- ------- ------- ------- ------ Subtotal 147 182 342 496 636 ------- ------- ------- ------- ------ Write-offs: Real estate loans 16 30 7 - - Loans to businesses 19 21 88 24 17 Loans to banks and other financial institutions - 4 18 3 52 Loans to governments and official institutions - 2 149 163 128 All other loans 6 1 - 1 1 Recoveries: Loans to businesses (4) (8) (6) (9) (8) Loans to banks and other financial institutions (1) (1) (1) (1) (3) Real estate loans - - (1) - - Equipment financing - - - - (2) Loans to governments and official institutions - - - (2) - All other loans - (1) - (1) (1) ------ ------ ------- ------ ------ Net write-offs 36 48 254 178 184 ------ ------ ------ ------ ------ Reserve for credit losses- December 31, $ 111 $ 134 $ 88 $ 318 $ 452 ====== ======= ====== ====== ====== Reserve for credit losses/ total loans 2.16% 2.80% 1.90% 6.12% 8.50% ====== ====== ====== ====== ====== (a) During 1990, AEB transferred loans totaling $236 million and related reserves of $12 million to TRS on a segment reporting basis. (b) The decline in 1993 was primarily due to the transfer of reserves relating to loans reclassified to other performing assets upon foreclosure. - - -------------------------- Interest income is recognized on the accrual basis. Loans are placed on nonperforming status when payments of principal or interest are 90 days past due, or if in the opinion of management the borrower is unlikely to meet its contractual commitments. When loans are placed on nonperforming status, all previously accrued interest not yet received is reversed against current interest income. Cash receipts of interest on nonperforming loans are recognized either as income or as a reduction of principal, based upon management's judgment as to the collectibility of principal. A reserve for credit losses is established by charging a provision for credit losses against income. The amount charged to income is based upon several factors, which include the historical credit loss experience in relation to outstanding credits, a continuous determination as to the collectibility of each credit, and management's evaluation of exposures in each applicable country as related to current and anticipated economic and political conditions. RISKS The global nature of AEB's business activities are such that concentrations of credit to particular industries and geographic regions are not unusual. At December 31, 1993, AEB had significant investments in certain on- and off-balance sheet financial instruments, which were primarily represented by deposits with banks, investments, loans, commitments to purchase and sell foreign currencies and U.S. dollars, interest rate swaps and forward rate agreements. The counterparties to these financial instruments were primarily unrelated to AEB, and principally consisted of banks and other financial institutions and various commercial and industrial enterprises operating geographically within the Asia/Pacific region, Europe and North America. AEB continuously monitors its credit concentrations and actively manages to reduce the associated risk. AEB does not anticipate any material losses as a result of these concentrations. In 1991, AEB completed the liquidation of its long-term lesser developed country ("LDC") cross border loan portfolio. At December 31, 1993, AEB had $64 million of equity investments in LDC based enterprises (net of reserves) resulting from certain debt for equity conversions. These remaining conversions included 7 equity investments, the value of which were primarily represented by a minority interest in a Brazilian petrochemical holding company and two Mexican hotel projects. AEB's earnings are sensitive to fluctuations in interest rates, as it is not always possible to match precisely the maturities of interest-related assets and liabilities. Strict limits have been established, however, for both country and total bank mismatching. On occasion, AEB may decide to mismatch in anticipation of a change in future interest rates in accordance with these guidelines. Term loans extended by AEB include both floating interest rate and fixed interest rate loans. Fixed interest rate loans with maturities in excess of one year totaled $199 million at December 31, 1993. COMPETITION The banking services of AEB are subject to vigorous competition in all markets in which AEB operates. Competitors include local and international banks whose assets often exceed those of AEB, other financial institutions (including certain other subsidiaries of the registrant) and, in certain cases, governmental agencies. In some countries, AEB may be one of the more substantial financial institutions offering banking services; in no country, however, has AEB been a major factor. REGULATION AEB's branches, representative offices and subsidiaries are licensed and regulated in the jurisdictions in which they do business and are subject to the same local requirements as other competitors. AEB's New York Agency is supervised and regularly examined by the Superintendent of Banks of the State of New York. At the request of management, the New York State Banking Department has extended its supervision and examination of the New York Agency to cover AEB's global network of branches and subsidiaries. The Florida Department of Banking and Finance supervises and examines the Miami Agency. In addition, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") regulates, supervises and examines AEBI. Following a recent examination of AEBI's California branches, in September 1993 AEBI agreed to pay a fine of $950,000 to, and entered into an agreement (a Consent Cease and Desist Order) with, the Federal Reserve Board. Under the agreement, AEBI agreed to correct two alleged violations of regulations of the Federal Reserve Board and amend certain internal policies and procedures. The fine was not material to, and did not involve a significant part of the business of, AEB. Since AEB does not do business in the United States except as an incident to its activities outside the United States, the registrant's affiliation with AEB neither causes the registrant to be subject to the provisions of the Bank Holding Company Act of 1956, nor requires it to register as a bank holding company under the Federal Reserve Board's Regulation Y. AEB is not a member of the Federal Reserve System, is not subject to supervision by the FDIC, and is not subject to any of the restrictions imposed on grandfathered nonbank banks by CEBA, other than anti-tie-in rules with respect to transactions involving products and services of certain of its affiliates and restrictions on loans to certain executive officers and directors. As a matter of policy, AEB actively monitors compliance with regulatory capital requirements. These requirements are essentially represented by the Federal Reserve Board's risk-based capital guidelines and complementary leverage constraint. Pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991, the relevant provisions of which became effective for year-end 1992, the Federal Reserve Board, among other federal banking agencies, adopted regulations defining levels of capital adequacy. Under these regulations, a bank is deemed to be adequately capitalized if it maintains a Tier 1 risk-based capital ratio of at least 4.0 percent, a total risk-based capital ratio of at least 8.0 percent and a leverage ratio of at least 4.0 percent. Based on AEB's total risk-based capital and leverage ratios, which are set forth on page 12, AEB is considered to be adequately capitalized at December 31, 1993. The Federal Reserve Board has proposed revisions to its regulations which would establish a limitation on the amount of deferred tax assets that may be considered regulatory capital for risk- based and leverage capital purposes. In anticipation that these proposed revisions will be adopted, deferred tax assets are being excluded from AEB's regulatory capital ratably over a two year period commencing in January 1993, which could reduce AEB's capital ratios in 1994. DISCONTINUED OPERATIONS Lehman, through its wholly-owned subsidiary Lehman Brothers ("Lehman Brothers") and other subsidiaries, is a global investment bank serving institutional, corporate, government and high net-worth individual clients in major financial centers worldwide. Lehman's businesses include capital raising for clients through securities underwriting and direct placements; corporate finance and strategic advisory services; merchant banking; securities sales and trading; institutional asset management; research; and the trading of foreign exchange, derivative products and certain commodities. Lehman acts as a market marker in all major fixed income and equity products in both the domestic and international markets. Lehman Brothers, which is a member of all principal securities and commodities exchanges in the United States, as well as the NASD, also holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt and Milan exchanges. During 1993, Lehman sold the Shearson Lehman Brothers retail brokerage and asset management businesses, The Boston Company private banking, trust and mutual fund administration businesses and Shearson Lehman Hutton Mortgage Corporation, which engaged in mortgage banking. In January 1994, the registrant's Board of Directors approved a plan to complete a tax-free spin-off of the common stock of Lehman through a special dividend to the registrant's common shareholders. The final transaction is subject to a number of conditions, including receipt of a favorable tax opinion, regulatory clearances, market conditions and final approval by the registrant's Board. In addition, certain related matters are subject to approval by the Lehman Board. The transaction is expected to close in the second quarter of 1994. In anticipation of this transaction, Lehman's results are reported as a discontinued operation in the registrant's Consolidated Financial Statements. This transaction is described in more detail on pages 23 and 35-37 of the registrant's Annual Report to Shareholders, which descriptions are incorporated herein by reference. CORPORATE AND OTHER BALCOR The Balcor Company, formerly operating as a diversified real estate investment and management company, discontinued new commercial real estate activities in 1990 and began to liquidate its portfolio of real estate loans and properties. The liquidation is expected to be completed in 1996. The Balcor Company Holdings, Inc. was formed in 1992 as a holding company for The Balcor Company and its former subsidiaries (collectively, "Balcor"). At December 31, 1993, Balcor's assets, excluding cash and cash equivalents, totaled $1.1 billion with related reserves of $333 million. Balcor's assets at December 31, 1993 included real estate loans amounting to $225 million, advances to limited partnerships originated by Balcor of $90 million, interests in non-syndicated partnerships of $191 million and investments in real estate of $526 million, inclusive of real estate transferred from borrowers as a result of foreclosure of $402 million. CEBA AND FDICIA The Competitive Equality Banking Act of 1987 ("CEBA"), among other things, prevents the formation of new nonbank banks after March 5, 1987 and restricts the activities of such banks that existed on that date. The registrant owns two nonbank banks -- Centurion Bank and IDS Trust Company -- which are subject to these "grandfather" restrictions. The restrictions include a prohibition on new activities and affiliate overdrafts, and limitations on asset growth and the ability to market the products and services of the bank by an affiliate and vice versa. CEBA has had an impact on the manner in which the registrant's nonbank banks conduct business to assure their continued grandfathered status, but has not had a material adverse effect on the registrant. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") applies generally to the registrant's insured depository institutions, including Centurion Bank. Among other things, FDICIA has enabled the FDIC to raise the amount of assessments for federal deposit insurance paid by the registrant's insured depository institutions and authorizes further increases. In addition, FDICIA significantly restricts the ability of broker-dealers such as IDS Financial Services to broker deposits for insured depository institutions, including affiliates. FDICIA has not had and is not expected to have a material adverse effect on the registrant. FOREIGN OPERATIONS TRS derives a significant portion of its revenues from the use of the Card, Travelers Cheques and travel services in countries outside the United States and is in the process of broadening use of these products and services outside the United States. Political and economic conditions in these countries, including the availability of foreign exchange for the payment by the local Card issuer of obligations arising out of local Cardmembers' spending outside such country, for the payment of Card bills by Cardmembers who are billed in other than their local currency and for the remittance of the proceeds of Travelers Cheque sales, can have an effect on TRS's revenues. Substantial and sudden devaluation of local Cardmembers' currency can also affect their ability to make payments to the local issuer of the Card on account of spending outside the local country. IDS does not have substantial business outside the United States. The major portion of AEB's banking revenues is from business conducted in countries outside the United States. Some of the risks attendant to those operations include currency fluctuations and changes in political, economic and legal environments in each such country. In 1993, the registrant sold its Acuma subsidiary, which distributed life insurance, pension products and mutual funds in the United Kingdom through a sales force of financial planners. As a result of its foreign operations, the registrant is exposed to the possibility that, because of foreign exchange rate fluctuations, assets and liabilities denominated in currencies other than the U.S. dollar may be realized in amounts greater or lesser than the U.S. dollar amounts at which they are currently recorded in the registrant's Consolidated Financial Statements. Examples of transactions in which this may occur include the purchase by Cardmembers of goods and services in a currency other than the currency in which they are billed; the sale in one currency of a Travelers Cheque denominated in a second currency; foreign exchange positions held by AEB as a consequence of its client-related foreign exchange trading operations; and, in most instances, investments in foreign operations. These risks, unless properly monitored and managed, could have an adverse effect on the registrant's operations. The registrant's policy in this area is generally to monitor closely all foreign exchange positions and to minimize foreign exchange gains and losses, for example, by offsetting foreign currency assets with foreign currency liabilities, as in the case of foreign currency loans and receivables, which are financed in the same currency. An additional technique used to manage exposures is the spot and forward purchase or sale of foreign currencies as a hedge of net exposures in those currencies as, for example, in the case of the Cardmember and Travelers Cheque transactions described above. Additionally, Cardmembers may be charged in U.S. dollars for their spending outside their local country. The registrant's investments in foreign operations are hedged by forward exchange contracts or by identifiable transactions, where appropriate. INDUSTRY SEGMENT INFORMATION AND CLASSES OF SIMILAR SERVICES Information with respect to the registrant's industry segments, geographical operations and classes of similar services is set forth in Note 15 to the Consolidated Financial Statements of the registrant, which appears on pages 48 and 49 of the registrant's 1993 Annual Report to Shareholders, which note is incorporated herein by reference. EXECUTIVE OFFICERS OF THE REGISTRANT All of the executive officers of the registrant as of March 29, 1994, none of whom has any family relationship with any other and none of whom became an officer pursuant to any arrangement or understanding with any other person, are listed below. Each of such officers was elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer's age is indicated by the number in parentheses next to his or her name. HARVEY GOLUB - Chairman and Chief Executive Officer; Chairman and Chief Executive Officer, TRS Mr. Golub (55) has been Chief Executive Officer of the registrant since February 1993, Chairman of the registrant since August 1993 and Chairman and Chief Executive Officer of TRS since November 1991. Prior to August 1993, he had been President of the registrant since July 1991. Prior to January 1992, he was also Chairman of IDS Financial Corporation. Prior to July 1991, he had been Vice Chairman of the registrant and Chairman and Chief Executive Officer of IDS since September 1990. Prior thereto, he had been President and Chief Executive Officer of IDS since January 1984. JEFFREY E. STIEFLER - President Mr. Stiefler (47) has been President of the registrant since August 1993. Prior thereto, he had been President and Chief Executive Officer of IDS Financial Corporation since July 1991, and President of IDS since September 1990. Prior thereto, he had been Executive Vice President for Sales and Marketing of IDS since 1987. JONATHAN S. LINEN - Vice Chairman Mr. Linen (50) has been Vice Chairman of the registrant since August 1993. Prior thereto, he had been President and Chief Operating Officer of TRS since March 1992. Prior thereto, he had been President and Chief Executive Officer of the Shearson Lehman Brothers Division of Shearson Lehman Brothers Inc. since June 1990. Before June 1990, he had been President and Chief Executive Officer of TRS's Direct Marketing and Travelers Cheque Group since May 1989. Before May 1989, he had been President of TRS's Direct Marketing Group since 1986. ROGER H. BALLOU - President, Travel Services Group, TRS Mr. Ballou (42) has been President of TRS's Travel Services Group since May 1989. Prior thereto, he was Executive Vice President-Strategic Business Systems since May 1987. KENNETH I. CHENAULT - President, U.S.A, TRS Mr. Chenault (42) has been President, U.S.A. of TRS since August 1993. Prior thereto, he had been President, Consumer Card Group, TRS since 1989. STEVEN D. GOLDSTEIN - President and Chief Executive Officer, American Express Bank Ltd. Mr. Goldstein (42) has been President and Chief Executive Officer of AEB since March 1991. Prior thereto, he had been President of Consumer Financial Services, American Express International, since September 1989 and President of TRS International-United Kingdom and Ireland since December 1987. R. CRAIG HOENSHELL - President, International, TRS Mr. Hoenshell (49) has been President, International of TRS since August 1993. Prior thereto, he had been President of TRS's Travelers Cheque Group since 1990. Prior thereto, he was President of American Express Centurion Bank. DAVID R. HUBERS - President and Chief Executive Officer, IDS Financial Corporation Mr. Hubers (51) has been President and Chief Executive Officer of IDS since August 1993. Prior thereto, he had been a Senior Vice President of IDS since 1982. JOSEPH W. KEILTY - Executive Vice President Mr. Keilty (56) has been Executive Vice President since November 1991. Prior thereto, he had been Managing Director of Keilty, Goldsmith & Company, a consulting company, since 1981. MICHAEL P. MONACO - Executive Vice President, Chief Financial Officer and Treasurer Mr. Monaco (46) has been Executive Vice President and Chief Financial Officer since September 1990 and Treasurer since April 1992. Prior thereto, he had been Senior Vice President since September 1989 and Comptroller since 1985. LOUISE M. PARENT - Executive Vice President and General Counsel Ms. Parent (43) has been Executive Vice President and General Counsel of the registrant since May 1993. Prior thereto, she had been Deputy General Counsel of the registrant since January 1992. Prior thereto, she had been General Counsel of First Data Corporation since April 1989. Prior thereto, she had been Assistant General Counsel of the registrant since April 1988. THOMAS SCHICK - Executive Vice President Mr. Schick (47) has been Executive Vice President since March 1993. Prior thereto, he had been Executive Vice President of TRS since October 1992 and Senior Executive Vice President of Shearson Lehman Brothers Inc. since 1986. EMPLOYEES The registrant, excluding Lehman and its subsidiaries, had 64,493 employees on December 31, 1993. ITEM 2. ITEM 2. PROPERTIES The registrant's headquarters are in a 51-story, 2.2 million square foot building located in lower Manhattan, known as American Express Tower, which also serves as the headquarters for TRS and AEB. This building, which is on land leased from the Battery Park City Authority for a term expiring in 2069, is one of four office buildings in a complex known as the World Financial Center. Lehman is also headquartered at the building and is a co-owner. Other principal locations of TRS include: the Southern Regional Operations Center, Fort Lauderdale, Florida; the Western Regional Operations Center and the Travel Group Service Center, Phoenix, Arizona; the Northern Regional Operations Center, Greensboro, North Carolina; the Optima Regional Operating Center, Jacksonville, Florida; the Travelers Cheque Group Operating Center, Salt Lake City, Utah; and American Express Canada, Inc. headquarters, Markham, Ontario, Canada, all of which are owned by the registrant or its subsidiaries. IDS's principal locations are its headquarters, which IDS leases until 2002, and its Operations Center, which IDS owns; both are in Minneapolis, Minnesota. Generally, the registrant and its subsidiaries lease the premises they occupy in other locations. Facilities owned or occupied by the registrant and its subsidiaries are believed to be adequate for the purposes for which they are used and are well maintained. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The registrant and its subsidiaries are involved in a number of legal and arbitration proceedings concerning matters arising in connection with the conduct of their respective business activities. The registrant believes it has meritorious defenses to each of these actions and intends to defend them vigorously. The registrant believes that it is not a party to, nor are any of its properties the subject of, any pending legal proceedings which would have a material adverse effect on the registrant's consolidated financial condition. SAFRA-RELATED ACTIONS Two purported shareholder derivative actions, now consolidated, were brought in October 1990 in New York State Supreme Court and three purported derivative actions, also now consolidated, were brought in early 1991 in United States District Court for the Southern District of New York against all of the then current directors, certain former directors and certain former officers and employees of the registrant. The consolidated state court complaint alleges that defendants breached their duty of care in managing the registrant, purportedly resulting in losses and in the registrant's payment of $8 million in July 1989 to certain charities agreed to by the registrant and Edmond J. Safra. The federal complaints also allege breach of duty in connection with a severance arrangement of a former executive officer of the registrant and that certain proxy statements of the registrant were misleading in failing to disclose such alleged breaches. Plaintiffs seek a declaratory judgment, unspecified money damages and an accounting. The federal actions also seek to declare void certain charter and by-law amendments relating to exculpation and indemnification of directors and officers. The federal actions were dismissed in December 1993. The plaintiffs have appealed the dismissal. COMPUTERVISION LITIGATION Federal Court Actions. In connection with public offerings of notes and common stock of Computervision Corporation ("Computervision"), actions were commenced in the federal District Court for the District of Massachusetts against Computervision, its directors, certain of its executive officers, Lehman, Lehman Brothers, Donaldson, Lufkin & Jenrette Securities Corporation, The First Boston Corporation, Hambrecht & Quist Incorporated and J. H. Whitney & Co. (collectively, the "Massachusetts Case"). These actions have been consolidated in a consolidated amended class action complaint, which alleges in substance that the registration statement and prospectus used in connection with the offerings contained materially false and misleading statements and material omissions related to Computervision's anticipated operating results for 1992 and 1993. The plaintiffs purport to represent a class of individuals who purchased in the public offering or in the aftermarket. The complaint seeks damages for negligent misrepresentation and under Sections 11, 12 and 15 of the Securities Act of 1933. In addition, three suits were filed in the United States District Court for the Southern District of New York. The suits raise claims similar to those in the Massachusetts Case against the same defendants. The Judicial Panel on Multidistrict Litigation has ordered these cases consolidated with the Massachusetts Case. State Court Action. Lehman Brothers is named as the sole defendant in a putative class action, Greenwald v. Lehman Brothers Inc., brought in New York State Supreme Court. The complaint, which alleges in substance that Lehman Brothers breached a fiduciary duty owed to its customers in selling them the common stock, senior notes and senior subordinated notes of Computervision during the class period, as defined in the complaint, was dismissed. FCH-RELATED ACTIONS FCH Derivative Actions. On or about March 29, 1991, two identical purported shareholder derivative actions were filed, entitled Mentch v. Weingarten, et al. and Isaacs v. Weingarten, et al. The complaints in these two actions, pending in the Superior Court of the State of California, County of Los Angeles, were filed allegedly on behalf of and naming as a nominal defendant First Capital Holdings Corp. ("FCH"). Other defendants include Lehman, two former officers and directors of FCH, Robert Weingarten and Gerry Ginsberg, the four outside directors of FCH, Peter Cohen, Richard DeScherer, William L. Mack and Jerome H. Miller (collectively, the "Outside Directors"), and Michael Milken. The complaints allege generally breaches of fiduciary duty, gross corporate mismanagement and waste of assets in connection with FCH's purchase of non-rated bonds underwritten by Drexel Burnham Lambert Inc. and seek damages for losses suffered by FCH, punitive damages and attorneys' fees. The actions have been stayed pursuant to the bankruptcy of FCH. Concurrent with the bankruptcy filing of FCH and the conservatorship and receivership of its two life insurance subsidiaries, First Capital Life Insurance Company ("FCL") and Fidelity Bankers Life Insurance Company ("FBL") (collectively, the "Insurance Subsidiaries"), a number of additional actions were instituted naming one or more of the registrant, Lehman and Lehman Brothers as defendants. FCH Shareholder and Agent Actions. Three actions were commenced in the United States District Courts for the Southern District of New York and the Central District of California allegedly as class actions on behalf of the purchasers of FCH securities during certain specified periods, commencing no earlier than May 4, 1988 and ending no later than May 31, 1991 (the "Shareholder Class"). The complaints are captioned Larkin, et al. v. First Capital Holdings Corp., et al., amended on May 15, 1991 to add the registrant as a defendant, Zachary v. American Express Company, et al., filed on May 20, 1991, and Morse v. Weingarten, et al., filed on June 13, 1991 (the "Shareholder Class Actions"). The complaints raise claims under the federal securities laws and allege that the defendants concealed adverse material information regarding the finances, financial condition and future prospects of FCH and made material misstatements regarding these matters. On July 1, 1991, an action was filed in the United States District Court for the Southern District of Ohio entitled Benndorf v. American Express Company, et al. The action is brought purportedly on behalf of three classes. The first class is similar to the Shareholder Class; the second consists of managing general agents and general agents who marketed various FCL products from April 2, 1990 to the filing of the suit and to whom it is alleged misrepresentations were made concerning FCH (the "Agent Class"); and the third class consists of Agents who purchased common stock of FCH through the First Capital Life Non Qualified Stock Purchase Plan ("FSPP") and who have an interest in the stock purchase account under the FSPP (the "FSPP Class"). The complaint raises claims similar to those asserted in the other Shareholder Class Actions, along with additional claims relating to the FSPP Class and the Agent Class alleging damages in marketing the products. In addition, on August 15, 1991, Kruthoffer v. American Express Company, et al. was filed in the United States District Court for the Eastern District of Kentucky, which complaint is nearly identical to the Benndorf complaint (collectively, the "Agent Class Actions"). On November 14, 1991, the Judicial Panel on Multidistrict Litigation issued an order transferring and coordinating for all pretrial purposes all related actions concerning the sale of FCH securities, including the Shareholder Class Action and Agent Class Actions, and any future filed "tag-along" actions, to Judge John G. Davies of the United States District Court for the Central District of California (the "California District Court"). The cases are captioned In Re: First Capital Holdings Corp. Financial Products Securities Litigation, MDL Docket No. 901 (the "MDL Action"). On January 18, 1993, an amended consolidated complaint (the "Third Complaint") was filed on behalf of the Shareholder Class and the Agent Class. The Third Complaint names as defendants the registrant, Lehman, Lehman Brothers, Weingarten and his wife Palomba Weingarten, Ginsberg, Philip A. Fitzpatrick (Chief Financial Officer of FCH), the Outside Directors, former outside FCH directors, Jeffrey B. Lane and Robert Druskin (the "Former Outside Directors"), Fred Buck (President of FCL) and Peat Marwick. The Third Complaint raises claims under the federal securities laws and the common law of fraud and negligence. On March 10, 1993, the defendants answered the Third Complaint, denying its material allegations. On March 11, 1993, the California District Court entered an order granting class certification to the Shareholder Class. The class consists of all persons, except defendants, who purchased FCH common stock, preferred stock or debentures during the period May 4, 1988 to and including May 10, 1991. It also issued an order denying class certification to the Agent Class. The FSPP Class action had been previously dropped by the plaintiffs. American Express Shareholder Action. On or about May 20, 1991, a purported class action was filed on behalf of all shareholders of the registrant who purchased the registrant's common shares during the period beginning August 16, 1990 to and including May 10, 1991. The case is captioned Steiner v. American Express Company, et al. and was commenced in the United States District Court for the Eastern District of New York. The defendants are the registrant, Lehman, James D. Robinson III, Howard L. Clark Jr., Harvey Golub and Aldo Papone. The complaint alleges generally that the defendants failed to disclose material information in their possession with respect to FCH which artificially inflated the price of the common shares of the registrant from August 16, 1990 to and including May 10, 1991 and that such non-disclosure allegedly caused damages to the purported shareholder class. The action has been transferred to California and is now part of the MDL Action. The defendants have answered the complaint, denying its material allegations. The Bankruptcy Court Action. In the FCH bankruptcy, pending in the United States Bankruptcy Court for the Central District of California (the "Bankruptcy Court"), on February 11, 1992, the Official Committee of Creditors Holding Unsecured Claims (the "Creditors' Committee") obtained permission from the Bankruptcy Court to file an action for and on behalf of FCH and the parent companies of the Insurance Subsidiaries. On March 3, 1992, the Creditors' Committee initiated an adversary proceeding in the Bankruptcy Court, in which they assert claims for breach of fiduciary duty and waste of corporate assets against Lehman; fraudulent transfer against both Lehman and Lehman Brothers; and breach of contract against Lehman Brothers. Also named as defendants are the Outside Directors, the Former Outside Directors, Weingarten and Ginsberg. Lehman and Lehman Brothers have answered the complaint, denying its material allegations. Fact discovery has been completed, and the contract claim has been dropped by plaintiffs. No trial date has been set. American Express Derivative Action. On June 6, 1991, a purported shareholder derivative action was filed in the United States District Court for the Eastern District of New York, entitled Rosenberg v. Robinson, et al., against all of the then-current directors of the registrant. In January 1992, this action was transferred by stipulation to the United States District Court for the Central District of California for coordinated or consolidated proceedings with all other federal actions related to FCH. The complaint alleges that the Board of Directors of the registrant should have required Lehman to divest its investment in FCH and to write down such investment sooner. In addition, the complaint alleges that the failure to act constituted a waste of corporate assets and caused damage to the registrant's reputation. The complaint seeks a judgment declaring that the directors named as defendants breached their fiduciary duties and duties of loyalty and requiring the defendants to pay money damages to the registrant and remit their compensation for the periods in which the duties were breached, attorneys' fees and costs and other relief. The defendants have answered the complaint, denying its material allegations. The Virginia Commissioner of Insurance Action. On December 9, 1992, a complaint was filed in federal court in the Eastern District of Virginia by Steven Foster, the Virginia Commissioner of Insurance as Deputy Receiver of FBL. The Complaint names Lehman and Weingarten, Ginsberg and Leonard Gubar (a former director of FCH and FBL) as defendants. The action was subsequently transferred to California to be part of the MDL Action. The complaint alleges that Lehman acquiesced in and approved the continued mismanagement of FBL and that it participated in directing the investment of FBL assets. The complaint asserts claims under the federal securities laws and asserts common law claims including fraud, negligence and breach of fiduciary duty and alleges violations of the Virginia Securities laws by Lehman. It seeks no less than $220 million in damages to FBL and its present and former policyholders and creditors and punitive damages. Lehman has answered the complaint, denying its material allegations. MAXWELL-RELATED LITIGATION Certain of Lehman's subsidiaries are defendants in several lawsuits arising out of transactions entered into with the late Robert Maxwell or entities controlled by Maxwell interests. These actions are described below. Berlitz International Inc. v. Macmillan Inc. et al. This interpleader action was commenced in Supreme Court, New York County on or about January 2, 1992, by Berlitz International Inc. ("Berlitz") against Macmillan Inc. ("Macmillan"), Lehman Brothers Holdings PLC ("PLC"), Lehman Brothers International Ltd. (now known as Lehman Brothers International (Europe), "LBIE") and seven other named defendants. The interpleader complaint seeks a declaration of the rightful ownership of approximately 10.6 million shares of Berlitz common stock, including 1.9 million shares then registered in PLC's name, alleging that Macmillan claimed to be the beneficial owner of all 10.6 million shares, while the defendants did or might claim ownership to some or all of the shares. As a result of its bankruptcy filing, Macmillan sought to remove this case to the U.S. Bankruptcy Court for the Southern District of New York. LBIE has moved to remand the case back to the State Supreme Court. Macmillan, Inc. v. Bishopsgate Investment Trust, Shearson Lehman Brothers Holdings PLC et al. This action was commenced by issuance of a writ in the High Court of Justice in London, England on or about December 9, 1991. In this action, Macmillan sought a declaration that it is the legal and beneficial owner of the disputed 10.6 million shares of Berlitz common stock, including 1.9 million shares registered in the name of PLC. After a trial on December 10, 1993, the High Court of Justice handed down a judgment finding for Lehman on all aspect of its defense and dismissing Macmillan's claims. MGN Pension Trustees Limited v. Invesco MIM Management Limited, Capel-Cure Myers Capital Management Limited and Lehman Brothers International Limited. This action was commenced by issuance of a writ in the High Court of Justice, London, England on or about June 5, 1992. The writ alleges that LBIE knew or should have known that certain securities received by it as collateral on a stock loan account held by Bishopsgate Investment Management were in fact beneficially owned by the Mirror Group Pension Scheme ("MGPS") or by MGN Pension Trustees Limited (the trustee of MGPS). On this basis, the plaintiff sought a declaration that LBIE holds or held a portfolio of securities in constructive trust for plaintiff. According to the writ, LBIE sold certain of these securities for 32,024,918 pounds sterling, and that LBIE still holds certain of these securities, allegedly worth approximately 1,604,240 pounds sterling. The plaintiff sought return of the securities still held and the value of the securities liquidated in connection with the stock loan account. On January 31, 1994, Lehman, along with the other defendants, settled the case. Bishopsgate Investment Management Limited (in liquidation) v. Lehman Brothers International (Europe) and Lehman Brothers Holdings PLC. In August 1993, Bishopsgate Investment Management Limited ("BIM") served a Writ and Statement of Claim against LBIE and PLC. The Statement of Claim alleges that LBIE and PLC knew or should have known that certain securities received by them, either for sale or as collateral in connection with BIM's stock loan activities, were in fact beneficially owned by various pension funds associated with the Maxwell Group entities. BIM seeks recovery of any securities still held by LBIE and PLC or recovery of any proceeds from securities sold by them. The total value of the securities is alleged to be 100 million pounds sterling. BIM also commenced certain proceedings for summary disposition of its claims relating to certain of the securities with a value of approximately 30 million pounds sterling. On January 11, 1994, the parties agreed to a settlement of that portion of the claim relating to BIM's request for summary disposition with respect to certain securities. Under this agreement, two securities holdings were delivered to BIM. Lehman continues to defend the balance of BIM's claim for recovery of other assets alleged to be worth approximately 70 million pounds sterling. The case is scheduled for trial in April 1995. MELLON BANK LITIGATION In September 1993, Mellon Bank filed a complaint in the U.S. District Court for the Western District of Pennsylvania against Lehman Brothers and the registrant. The complaint alleges that Lehman Brothers, through the conduct of Smith Barney Shearson Inc. ("Smith Barney") and The Travelers Inc. (formerly Primerica Corporation) ("Travelers"), breached certain covenants contained in the agreement with Mellon Bank relating to the sale of The Boston Company. The covenants, which relate to the provision of custodial and administrative services to certain mutual funds, were assumed by Smith Barney in connection with the sale by Lehman to Smith Barney of certain Shearson Lehman Brothers Inc. retail and asset management businesses. In a separate action, Smith Barney and Travelers were also sued by Mellon Bank in connection therewith. By order dated January 26, 1994, the action against Lehman and the registrant was dismissed. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the registrant's security holders during the last quarter of its fiscal year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market for the registrant's Common Shares is The New York Stock Exchange. Its Common Shares are also listed on the Boston, Chicago, Pacific, London, Zurich, Geneva, Basle, Dusseldorf, Frankfurt, Paris, Amsterdam, Tokyo, and Brussels Stock Exchanges. The registrant had 58,179 common shareholders of record at December 31, 1993. For price and dividend information with respect to such Common Shares, see Note 18 to the Consolidated Financial Statements on page 50 of the registrant's 1993 Annual Report to Shareholders, which note is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The "Consolidated Five-Year Summary of Selected Financial Data" appearing on page 52 of the registrant's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the heading "Financial Review" appearing on pages 22 through 29 of the registrant's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The "Consolidated Financial Statements", the "Notes to Consolidated Financial Statements" and the "Report of Ernst & Young Independent Auditors" appearing on pages 30 through 51 of the registrant's 1993 Annual Report to Shareholders are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEMS 10, 11, 12 and 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The registrant filed with the SEC, within 120 days after the close of its last fiscal year, a definitive proxy statement dated March 14, 1994 pursuant to Regulation 14A, which involves the election of directors. The following portions of such proxy statement are incorporated herein by reference: pages 2 and 3 under the heading "The Shares Voting," pages 3 through 6 under the headings "Security Ownership of Directors and Executive Officers," and "Security Ownership of Named Executives," pages 9 through 11 under the heading "Directors' Fees and Other Compensation," pages 11, beginning at "Election of Directors" through 36, ending at "Selection of Auditors" (excluding the portions under the headings, "Board Compensation Committee Report on Executive Compensation" appearing on pages 14 through 20 and "Performance Graph" appearing on page 28), and page 42 under the heading "Certain Filings." In addition, the registrant has provided, under the caption "Executive Officers of the Registrant" at pages 20 and 21 above, the information regarding executive officers called for by Item 401(b) of Regulation S-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: See Index to Financial Statements on page hereof. 2. Financial Statement Schedules: See Index to Financial Statements on page hereof. 3. Exhibits: See Exhibit Index on pages E-1 through E-3 hereof. (b) Reports on Form 8-K: 1. Form 8-K, dated October 7, 1993, Item 5, reporting the declaration of effectiveness of the registration statement covering the sale of debt exchangeable for shares of First Data Corporation common stock. 2. Form 8-K, dated October 25, 1993, Item 5, reporting earnings for the quarter ended September 30, 1993. 3. Form 8-K, dated January 24, 1994, Item 5, announcing a plan to issue a special dividend and reporting earnings for the quarter and year ended December 31, 1993. 4. Form 8-K, dated January 24, 1994, Item 5, revising certain pro forma financial information previously filed. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN EXPRESS COMPANY March 28, 1994 By /s/ Michael P. Monaco --------------------------- Michael P. Monaco Executive Vice President, Chief Financial Officer and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By /s/ Harvey Golub By /s/ Richard M. Furlaud --------------------------- ------------------------- Harvey Golub Richard M. Furlaud Chairman, Chief Executive Director Officer and Director By /s/ Jeffrey E. Stiefler By /s/ Beverly Sills Greenough --------------------------- --------------------------- Jeffrey E. Stiefler Beverly Sills Greenough President and Director Director By /s/ Michael P. Monaco By /s/ F. Ross Johnson --------------------------- ------------------------- Michael P. Monaco F. Ross Johnson Executive Vice President, Director Chief Financial Officer and Treasurer By /s/ Daniel T. Henry By /s/ Vernon E. Jordan Jr. --------------------------- ------------------------- Daniel T. Henry Vernon E. Jordan Jr. Senior Vice President Director and Comptroller By /s/ Anne L. Armstrong By /s/ Henry A. Kissinger --------------------------- ------------------------- Anne L. Armstrong Henry A. Kissinger Director Director By /s/ William G. Bowen By /s/ Drew Lewis --------------------------- ------------------------- William G. Bowen Drew Lewis Director Director By /s/ David M. Culver By /s/ Aldo Papone --------------------------- ------------------------- David M. Culver Aldo Papone Director Director By /s/ Charles W. Duncan Jr. By /s/ Roger S. Penske --------------------------- ------------------------- Charles W. Duncan Jr. Roger S. Penske Director Director By By /s/ Frank P. Popoff --------------------------- ------------------------- George M.C. Fisher Frank P. Popoff Director Director March 28, 1994 PAGE AMERICAN EXPRESS COMPANY COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14(a)) Annual Report to Shareholders Form 10-K (Page) --------- ------------ American Express Company and Subsidiaries: Data incorporated by reference from attached 1993 Annual Report to Shareholders: Report of independent auditors ........... 51 Consolidated statement of income for the three years ended December 31, 1993 ...... 30 Consolidated balance sheet at December 31, 1993 and 1992 ............................ 31 Consolidated statement of cash flows for the three years ended December 31, 1993 .. 32 Consolidated statement of shareholders' equity for the three years ended December 31, 1993 33 Notes to consolidated financial statements . 34-50 Consent of independent auditors .............. Schedules: I-- Summary of investment securities at December 31, 1993 -7 II-- Amounts receivable from related parties and underwriters, promoters, and employees other than related parties -9 III-- Condensed financial information of registrant-13 VIII-- Valuation and qualifying accounts for the three years ended December 31, 1993 IX-- Short-term borrowings at and for the years ended December 31, 1993, 1992 and 1991 X-- Supplementary income statement information All other schedules for American Express Company and subsidiaries have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the respective financial statements or notes thereto. The consolidated financial statements of American Express Company (including the report of independent auditors) listed in the above index, which are included in the Annual Report for the year ended December 31, 1993, are hereby incorporated by reference. With the exception of the pages listed in the above index, unless otherwise incorporated by reference elsewhere in this Annual Report on Form 10-K, the 1993 Annual Report is not to be deemed filed as part of this report. EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report on Form 10-K of American Express Company of our report dated February 3, 1994 (hereinafter referred to as our Report), included in the 1993 Annual Report to Shareholders of American Express Company. Our audits included the financial statement schedules of American Express Company listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in Registration Statements (Form S-8 No. 2-46918, No. 2-59230, No. 2-64285, No. 2-73954, No. 2-74368, No. 2-89115, No. 2-89680, No. 2-93654, No. 2-97617, No. 33-01771, No. 33-02980, No. 33-05875, No. 33-06350, No. 33-17133, No. 33-19724, No. 33-24675, No. 33-28721, No. 33-32876, No. 33-33552, No. 33-34005, No. 33-34625, No. 33-36422, No. 33-37882, No. 33-38777, No. 33-43671, No. 33-43695, No. 33-45584, No. 33-48629, No. 33-55344, No. 33-62124 and 33-65008; Form S-3 No. 2-89469, No. 2-95771, No. 33-06038, No. 33-07435, No. 33-17706, No. 33-40636, No. 33- 43268, No. 33-66654 and No. 33-50997) and in the related Prospecti of our Report with respect to the consolidated financial statements and schedules of American Express Company included and incorporated by reference in this Annual Report on Form 10-K for the year ended December 31, 1993. ERNST & YOUNG /s/ Ernst & Young New York, New York March 30, 1994 AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE I--SUMMARY OF INVESTMENT SECURITIES DECEMBER 31, 1993 (millions) Principal Amounts at Market amounts of which carried value at bonds and cost in balance December of stocks sheet (a) 31, 1993 ------------- ------------- --------- U.S. Government and Agencies Obligations $ 3,684 $ 3,640 $ 3,641 ------ ------ ------ State and Municipal Obligations: General Obligation bonds (b) $ 1,178 1,179 1,285 Revenue bonds (c) 3,768 3,764 4,082 ------ ------ ------ Total State and Municipal Obligations $ 4,946 4,943 5,367 ------ ------ ------ Corporate Bonds and Obligations (d) $ 12,669 12,935 13,773 ------ ------ ------ Foreign Government Obligations (e) $ 1,498 1,508 1,538 ------ ------ ------ Preferred Stocks: Non-Convertible $ 965 1,265 1,318 Convertible 150 153 193 ------ ------ ------ Total Preferred stocks $ 1,115 1,418 1,511 ------ ------ ------ Common Stocks: Held by domestic offices $ 356 377 409 Held by overseas offices (e) 1 1 4 ------ ------ ------ Total Common Stocks $ 357 378 413 ------ ------ ------ Mortgage-Backed Securities $ 11,657 11,413 11,724 ------ ------ ------ Investment Mortgage Loans (f) $ 2,269 2,231 2,302 ------ ------ ------ Other $ 842 842 818 ------ ------ ------ Total $ 39,308 $ 41,087 ======= ======= (a) See summary of significant accounting policies in the notes to the consolidated financial statements. (b) See for detail listing of General Obligation bonds by state. (c) See for detail listing of Revenue bonds by state. (d) See for detail listing of Corporate Bonds and Obligations by type. (e) Stated at U.S. dollar equivalents based on rates of exchange generally prevailing at December 31, 1993. (f) See for detail listing of Investment Mortgage Loans by type. AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES DETAIL LISTING OF GENERAL OBLIGATION BONDS BY STATE December 31, 1993 (millions) State Par Value Book Value Market Value ----- --------- ---------- ------------- Arizona $ 83 $ 83 $ 88 California 62 63 71 Connecticut 28 28 32 District of Columbia 65 65 69 Florida 58 57 63 Hawaii 39 40 45 Illinois 110 110 120 Louisiana 78 78 83 Massachusetts 72 72 78 Minnesota 30 30 33 New Jersey 40 40 44 New York 58 58 65 Pennsylvania 68 67 74 Texas 170 170 183 Wisconsin 54 54 59 All other states 163 164 178 ------ ------ ------ Totals $1,178 $1,179 $1,285 ====== ====== ====== AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES DETAIL LISTING OF REVENUE BONDS BY STATE December 31, 1993 (millions) State Par Value Book Value Market Value ----- --------- ---------- ------------ Alabama $ 38 $ 38 $ 40 Alaska 29 29 31 Arizona 150 150 161 Arkansas 36 36 38 California 309 311 332 Colorado 64 64 70 Connecticut 59 59 65 Florida 289 289 316 Georgia 55 55 59 Hawaii 30 30 34 Illinois 271 271 290 Indiana 61 61 65 Iowa 31 31 33 Kentucky 42 42 45 Louisiana 91 91 96 Maryland 75 75 84 Massachusetts 83 81 86 Michigan 72 72 80 Minnesota 67 68 73 Missouri 32 32 34 Nebraska 33 33 36 Nevada 33 33 34 New Jersey 90 90 99 New York 226 222 250 North Carolina 102 103 109 Ohio 145 145 159 Oklahoma 40 40 45 Pennsylvania 142 142 154 South Carolina 59 60 64 South Dakota 31 31 34 Tennessee 52 44 47 Texas 497 500 548 Utah 110 110 118 Virginia 46 46 49 Washington 69 69 74 Wisconsin 73 73 80 All other states 136 138 150 ------ ------ ------ Totals $3,768 $3,764 $4,082 ====== ====== ====== AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES DETAIL LISTING OF CORPORATE BONDS AND OBLIGATIONS BY TYPE December 31, 1993 (millions) Par Value Book Value Market Value --------- ---------- ------------ Air Transport $ 313 $ 313 $ 336 Astronautics 193 193 211 Automotive 351 356 388 Banks: Commercial Paper 1,120 1,122 1,132 Interest Rate Caps - 52 21 Other 1,060 1,260 1,334 Building Materials 468 468 501 Business Equipment 51 51 50 Chemicals 455 456 476 Electric Equipment and Appliance 119 119 124 Electronics 98 98 102 Finance Companies 1,222 1,223 1,315 Foods and Beverages 199 199 207 Industrial Machinery 249 244 265 Natural Gas 518 530 575 Oil and Gas 855 852 928 Paper 426 428 451 Power and Light 932 928 987 Publishing 401 404 450 Railroads 650 647 703 Retail Trade 550 552 601 Steel 459 459 495 Telephone 350 352 388 Tobacco 227 227 237 Other 1,403 1,402 1,496 ------- ------- ------- Totals $12,669 $12,935 $13,773 ======= ======= ======= AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES DETAIL LISTING OF INVESTMENT MORTGAGE LOANS BY PROPERTY TYPE December 31, 1993 (millions) Property Type Par Value Book Value Market Value ------------- --------- ---------- ------------ Apartments $ 858 $ 822 Shopping Centers/Retail 707 705 Office Buildings 263 262 Industrial Buildings 254 254 Retirement Homes 85 85 Hotels/Motels 37 37 Medical Buildings 30 30 Other 35 36 ------ ------ Totals $2,269 $2,231 $2,302 ====== ====== ====== AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE II-AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (See accompanying note) Note to Schedule II: The Stock Purchase Plans information relates to loans made to members of senior management pursuant to the American Express Company 1983 Stock Purchase Assistance Plan (the "Plan") and the Lehman Brothers Holdings Inc. ("Lehman") Executive Stock Loan Program (the "Program") established in 1988. Pursuant to the Plan, full recourse loans are provided to certain key employees for the purpose of exercising stock options and/or for paying any taxes in respect thereof or for buying the Company's common shares at fair market value from the Company or on the open market. Eligible key employees may borrow a maximum of 300% of their respective annual base salaries, provided that such persons provide sufficient collateral, presently 100% of the amount of the loan at the date of grant. Such loans currently have five to seven year maturities and bear interest, payable quarterly, at a variable rate of two percentage points below the prime rate of a major New York City bank; at December 31, 1993, this rate was 3.5% per annum. Such loans are payable in full upon the occurrence of certain events, including termination of employment. The Program, terminated in August 1990 as to future loans, provided low interest demand loans, on an unsecured basis, to assist key employees in acquiring Lehman common stock through open market purchases. Eligible employees could borrow up to 150% of their average total compensation for the last two years, subject to credit approval and continuing credit review. These loans are payable on demand, may not extend beyond five years and bear interest at the lower of the prime lending rate minus 2% or 11%; at December 31, 1993, this rate was 3.5% per annum. Such loans are payable in full upon the occurrence of certain events, including termination of employment. Other Loans Receivable relate to loans extended to Mr. Golub in 1984 for the purchase of a new residence in connection with relocation upon assumption of duties as President and Chief Executive Officer of IDS Financial Corporation and Mr. Thoman in 1989 for the purchase of a residence in France used in connection with his duties as President and Chief Executive Officer of American Express International. The loan to Mr. Golub bore interest at an annual rate of 5%, payable quarterly, and was secured by a mortgage on the residence. The loan was fully repaid during 1992. The loan to Mr. Thoman bore interest at an annual rate of 9.5%, payable quarterly, and was secured by a second mortgage on the property. The loan was fully repaid during 1993. AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF INCOME (A) (Parent Company Only) (dollars in millions) Years Ended December 31, ------------------------- 1993 1992 1991 ---- ---- ---- Revenues $ 123 $ 146 $ 113 ---- ---- ---- Expenses: Interest 181 174 160 Human resources 82 84 63 Other (B) (659) (592) 149 ---- ---- ---- Total (396) (334) 372 ---- ---- ---- Pretax income (loss) from continuing operations before accounting changes 519 480 (259) Income tax provision (benefit) 271 237 (75) ---- ---- ---- Net income (loss) before equity in net income of subsidiaries and affiliates 248 243 (184) Equity in net income of subsidiaries(C) 1,357 228 791 and affiliates ----- ---- ---- Income from continuing operations before accounting changes 1,605 471 607 Equity in income (loss) of discontinued (127) (149) 182 operations Cumulative effect of changes in accounting principles, net of income taxes - 139 - ----- ---- ---- Net income $1,478 $ 461 $ 789 ===== ===== ===== (A)Prior year amounts have been restated to reflect Lehman Brothers as a discontinued operation. (B)Includes pretax gains on the sale of First Data Corporation of $779 ($433 million after-tax) million and $706 ($425 million after-tax) million in 1993 and 1992, respectively. (C)Equity in net income of subsidiaries for 1992 includes a $106 million charge related to the adoption of SFAS 106. See Notes to Condensed Financial Information of Registrant AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (Parent Company Only) (millions, except share amounts) ASSETS ------ December 31, ----------------- 1993 1992 ---- ---- Cash and cash equivalents $ 8 $ 27 Investment securities 1,304 625 Securities purchased under agreement to resell 746 317 Equity in net assets of subsidiaries and affiliates - continuing operations 6,875 6,840 Investment in discontinued operations 1,540 1,849 Accounts receivable and accrued interest, less reserves 14 15 Land, buildings and equipment--at cost, less accumulated depreciation: 1993, $65; 1992, $79 95 127 Due from subsidiaries (net) 1,363 899 Other assets 804 430 ------ ------ Total assets $12,749 $11,129 ====== ====== LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ Accounts payable and other liabilities $ 762 $ 874 Long-term debt 3,153 2,409 Short-term debt 100 347 Total liabilities 4,015 3,630 Shareholders' equity: Preferred shares, $1.66 2/3 par value, authorized 20,000,000 shares Convertible Exchangeable Preferred shares, issued and outstanding 4,000,000 shares in 1993 and 1992, stated at liquidation value 200 200 $216.75 CAP Preferred Shares, issued and outstanding 122,448.98 shares in 1993 and 1992, stated at par value (liquidation value of $300) 1 1 Common shares, $.60 par value, authorized 1,200,000,000 shares; issued and outstanding 489,827,852 shares in 1993 and 479,976,358 shares in 1992 294 288 Capital surplus 3,784 3,534 Net unrealized securities gains (losses) 7 (1) Foreign currency translation adjustment (73) (83) Deferred compensation (128) (137) Retained earnings 4,649 3,697 ------ ------ Total shareholders' equity 8,734 7,499 ------ ------ Total liabilities and shareholders' equity $12,749 $11,129 ====== ====== See Notes to Condensed Financial Information of Registrant AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (Parent Company Only) (millions) Years Ended December 31, ---------------------------- 1993 1992 1991 ---- ---- ---- Cash flows from operating activities: Net income $1,478 $ 461 $ 789 Adjustments to reconcile net income to cash provided by operating activities: Equity in net income of subsidiaries and affiliates (1,357) (228) (791) Equity in (income) loss of discontinued operations 127 149 (182) Dividends received from subsidiaries and affiliates 868 492 620 Gain on sale of First Data Corporation (779) (706) - Changes in accounting - (139) - Other (net) 42 (12) (185) ---- ---- ---- Net cash provided by operating activities 379 17 251 ---- ---- ---- Net cash provided (used) by investing activities (655) 309 (226) ---- ---- ---- Cash flows from financing activities: Issuance of American Express common shares 259 159 162 Issuance of American Express preferred shares - - 300 Redemption of American Express Money Market Preferred shares - (150) (150) Dividends paid (526) (518) (477) Other 524 128 101 ---- ---- ---- Net cash provided (used) by financing activities 257 (381) (64) ---- ---- ---- Net decrease in cash and cash equivalents (19) (55) (39) ---- ---- ---- Cash and cash equivalents at beginning of year 27 82 121 ---- ---- ---- Cash and cash equivalents at end of year $ 8 $ 27 $ 82 ===== ===== ===== Note: The Other financing activities in 1993 reflects the issuance of DECs, the proceeds of which were primarily used to fund the increase in investments. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid for interest (net of amounts capitalized) in 1993, 1992, and 1991 was $105 million, $129 million and $127 million, respectively. Net cash paid for income taxes was $256 for 1993 and $113 for 1992. Net cash received for income taxes was $23 for 1991. PAGE NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT 1. Principles of Consolidation The accompanying financial statements include the accounts of American Express Company and on an equity basis its subsidiaries and affiliates. Shearson Lehman Brothers is reported as a discontinued operation and, accordingly, prior years' amounts have been restated. These financial statements should be read in conjunction with the consolidated financial statements of the Company. Certain prior year's amounts have been reclassified to conform to the current year's presentation. 2. Long-term debt consists of (millions): December 31, ------------- 1993 1992 ----- ----- Floating Medium-Term Note Due June 28, 1996 $ 945 $ 945 6 1/4% DECs Due October 15, 1996 868 - 8 5/8% Notes Payable due July 15, 1994 300 299 8 1/2% Notes due August 15, 2001 298 297 8 3/4% Notes Payable due June 15, 1996 199 199 8 5/8% 30 year Senior Note Due 2022 197 197 Employee Stock Ownership Plan 83 86 9% Convertible Notes due April 1, 1994 58 66 11.95% Private Placement Notes due 1995 102 102 WFC Series C 12 1/5% Guaranteed Notes due December 12, 1997 19 23 WFC Series D 11 5/8% Guaranteed Notes due December 12, 2020 22 22 WFC Series Z Zero Coupon Notes due December 12, 2000 30 27 WFC $60 million 8.15% Japanese Yen PPN due July 1996 9 9 WFC $80 million 7.86% Japanese Yen PPN due August 1996 11 11 7 1/2% Debentures due February 27, 1999 7 7 12 3/4% Industrial Revenue Bonds due October 31, 2001 5 5 Samurai Bonds due November 16, 1993 - 75 8% $40 million Promissory Notes due 1994 - 39 ------ ------ $3,153 $2,409 ====== ====== Aggregate annual maturities of long-term debt for the five years ending December 31, 1998 are as follows (millions): 1994, $445; 1995, $106; 1996, $2,038; 1997, $6, 1998, $6. Other assets includes a $215 million receivable from Lehman Brothers consisting of $71 million related to long-term financing for the Company's Headquarters building, and $144 million related to certain notes issued for the 1984 acquisition of Lehman Brothers Kuhn Loeb Holding Co., Inc. AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (millions) Reserve for credit losses, Reserve for doubtful loans and discounts accounts receivable ------------------- ------------------- 1993 1992 1991 1993 1992 1991 ---- ---- ---- ---- ---- ---- Balance at beginning of period $ 911 $ 847 $ 815 $1,124 $1,306 $1,334 Additions: Charges to income 535 1,044 1,135 1,020(a) 1,143(a) 1,329(a) Recoveries of amounts previously written-off 26 14 9 - - - Other credits (debits) (85) 3 (11) - - - Deductions: Charges for which reserves were provided (732) (997) (1,101) (1,348) (1,325) (1,357) --- --- ----- ----- ----- ----- Balance at end of period $ 655 $ 911 $ 847 $ 796 $1,124 $1,306 === === ===== ===== ===== ===== (a) Before recoveries on accounts previously written-off, which are credited to income: 1993--$333, 1992--$243, 1991--$200. AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS AT AND FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (millions) AMERICAN EXPRESS COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993 1992 1991 ---- ---- ---- Taxes, other than payroll and income taxes $168,408 $178,022 $156,899 EXHIBIT INDEX The following exhibits are filed as part of this Annual Report or, where indicated, were heretofore filed and are hereby incorporated by reference (* indicates exhibits electronically filed herewith.) Exhibits numbered 10.1 through 10.25, 10.27, and 10.30 through 10.35 are management contracts or compensatory plans or arrangements. 3.1 Registrant's Restated Certificate of Incorporation (incorporated by reference to Exhibit 4.1 of the registrant's Registration Statement on Form S-8, dated October 31, 1991 (File No. 33-43671)). 3.2 Registrant's By-Laws, as amended (incorporated by reference to Exhibit 1(b) of the registrant's registration statement on Form S-3, dated December 3, 1993 (File No. 33-50997)). 4 The instruments defining the rights of holders of long-term debt securities of the registrant and its subsidiaries are omitted pursuant to Section (b)(4)(iii)(A) of Item 601 of Regulation S-K. The registrant hereby agrees to furnish copies of these instruments to the SEC upon request. 10.1 American Express Company 1979 Long-Term Incentive Plan, as amended (incorporated by reference to Exhibit 10.2 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.2 American Express Company 1989 Long-Term Incentive Plan, as amended (incorporated by reference to Exhibit 28.1 of the registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 10.3 American Express Company Deferred Compensation Plan for Directors, as amended (incorporated by reference to Exhibit 10.3 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.4 American Express Company Executives' Incentive Compensation Plan (incorporated by reference to Exhibit 10.4 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.5 American Express Company Supplementary Incentive Savings Plan (incorporated by reference to Exhibit 10.7 of the registrant's Registration Statement on Form S-14, dated November 17, 1983 (File No. 2-87925)). 10.6 American Express Company Supplementary Pension Plan, as amended (incorporated by reference to Exhibit 10.6 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.7 American Express Company 1983 Stock Purchase Assistance Plan, as amended (incorporated by reference to Exhibit 10.6 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.8* Consulting Agreements dated May 25, 1993 and March 3, 1994 between the registrant and Aldo Papone Consulting. 10.9 Written description of consulting agreement between American Express Company and Kissinger Associates, Inc. (incorporated by reference to Exhibit 10.20 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1984). 10.10 American Express Company Retirement Plan for Non-Employee Directors, as amended (incorporated by reference to Exhibit 10.12 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). E-1 10.11 American Express Company Directors' Stock Option Plan (incorporated by reference to Exhibit 10.16 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.12 American Express Key Executive Life Insurance Plan, as amended (incorporated by reference to Exhibit 10.12 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 10.13 American Express Key Employee Charitable Award Program for Education (incorporated by reference to Exhibit 10.13 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.14 American Express Directors' Charitable Award Program (incorporated by reference to Exhibit 10.14 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.15 Description of separate pension arrangement and loan agreement between the registrant and Harvey Golub (incorporated by reference to Exhibit 10.17 of registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.16 Shearson Lehman Brothers Capital Partners I Amended and Restated Agreement of Limited Partnership (incorporated by reference to Exhibit 10.18 of registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.17 Shearson Lehman Hutton Capital Partners II, L.P. Amended and Restated Agreement of Limited Partnership (incorporated by reference to Exhibit 10.19 of registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.18 American Express Company Salary Deferral Plan (incorporated by reference to Exhibit 10.20 of registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.19 Shearson Lehman Brothers Inc. Voluntary Deferred Compensation Plan (incorporated by reference to Exhibit 10.9 of Shearson Lehman Brothers Holdings Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.20 Shearson Lehman Brothers Holdings Inc. Retirement Plan for Outside Directors (incorporated by reference to Exhibit 10.9 of Shearson Lehman Brothers Holdings Inc.'s Registration Statement on Form S-1, dated March 30, 1987 (File No. 33-12976)). 10.21 Shearson Lehman Brothers Holdings Inc. Deferred Compensation Plan for Outside Directors (incorporated by reference to Exhibit 10.11 of Shearson Lehman Brothers Holdings Inc.'s Registration Statement on Form S-1, dated March 30, 1987 (File No. 33-12976)). 10.22 Written description of certain pension arrangements with Howard L. Clark Jr. and Jonathan S. Linen (incorporated by reference to Exhibit 10.14 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 10.23* Consulting Agreements dated May 25, 1993 and March 3, 1994 between American Express Travel Related Services Company, Inc. and Aldo Papone Consulting. 10.24 1992 Incentive Compensation Agreement between Shearson Lehman Brothers Inc. and Howard L. Clark, Jr. (incorporated by reference to Exhibit 10.24 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992.) 10.25 Written description of Shearson Lehman Brothers Inc. 1991/92 Special Compensation Program (incorporated by reference to Exhibit 10.28 of E-2 the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.26 1990 Agreement, dated as of June 12, 1990, by and between American Express Company and Nippon Life Insurance Company (incorporated by reference to Exhibit 10.25 of Shearson Lehman Brothers Holdings Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.27 Consulting Agreement dated February 25, 1991 between Shearson Lehman Brothers Inc. and Kissinger Associates, Inc., as amended (incorporated by reference to Exhibit 10.27 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.28 Stock Purchase Agreement dated as of September 14, 1992 between Mellon Bank Corporation and Shearson Lehman Brothers Inc. (incorporated by reference to Exhibit 10.15 of Shearson Lehman Brothers Holdings Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.29 Asset Purchase Agreement dated as of March 12, 1993 between Smith Barney, Harris Upham & Co. Incorporated, Primerica Corporation and Shearson Lehman Brothers Inc. (incorporated by reference to Exhibit 10.16 of Shearson Lehman Brothers Holdings Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.30 Termination Agreement dated March 24, 1993 between the registrant and James D. Robinson III (incorporated by reference to Exhibit 10.30 of the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.31* Employment Agreement dated May 27, 1993 between Shearson Lehman Brothers Inc. and Howard L. Clark Jr. 10.32 American Express Company 1993 Directors' Stock Option Plan (incorporated by reference to Exhibit 28.2 of the registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 10.33* Agreement dated July 15, 1993 between the registrant and Richard M. Furlaud. 10.34* Lehman Brothers Inc. Employee Ownership Plan. 10.35* Lehman Brothers Inc. Participating Preferred Plan. 11* Computation of Earnings Per Share. 12.1* Computation in Support of Ratio of Earnings to Fixed Charges. 12.2* Computation in Support of Ratio of Earnings to Fixed Charges and Preferred Share Dividends. 13* Portions of the registrant's 1993 Annual Report to Shareholders that are incorporated herein by reference. 21* Subsidiaries of the registrant. 23* Consent of Ernst & Young (contained on page hereof). E-3

717217_1993.txt

717217_1993

1993

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ITEM 1 - BUSINESS The Corporation is a bank holding company organized in 1983 and registered with the Board of Governors of the Federal Reserve System (the "FRB") under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the bank holding company laws of North Carolina. The Corporation's executive offices are located at 507 West Innes Street, Salisbury, North Carolina, and substantially all of the operations of the Corporation are carried on through its subsidiaries: (a) Security Bank and Trust Company, a North Carolina commercial bank headquartered in Salisbury, North Carolina ("Security Bank"); (b) OMNIBANK, Inc., A State Savings Bank, a North Carolina savings bank headquartered in Salisbury, North Carolina ("OMNIBANK"); (c) Citizens Savings, Inc., SSB, a North Carolina savings bank headquartered in Concord, North Carolina ("Citizens"); (d) Home Savings Bank, Inc., SSB, a North Carolina savings bank headquartered in Kings Mountain, North Carolina ("Home Savings"); (e) First Cabarrus Corporation, a North Carolina corporation that provides management information, electronic data processing and other management services to the financial institution subsidiaries of the Corporation ("FCC"); and, (f) Estates Development Corporation, a North Carolina corporation which formerly engaged in real estate activities and is now in the process of winding down and terminating those operations ("EDC"). Security Bank has one subsidiary, First Security Credit Corporation ("FSCC"), a North Carolina corporation which operates as a consumer finance company. Security Bank, OMNIBANK, Citizens, Home Savings, FCC, EDC and FSCC are hereinafter collectively referred to as the "Subsidiaries." Security Bank, OMNIBANK, Citizens and Home Savings are hereinafter collectively referred to as the "Banking Subsidiaries," and OMNIBANK, Citizens and Home Savings are hereinafter collectively referred to as the "Savings Banks." The Corporation owns 100% of the outstanding common stock of the Subsidiaries other than FSCC, and Security Bank owns 100% of the outstanding common stock of FSCC. The Corporation's principal sources of income are cash dividends from the Banking Subsidiaries. The major sources of operating income of the Subsidiaries are set forth in the Consolidated Financial Statements of the Corporation incorporated elsewhere herein. The Merger On June 30 1992, Omni Capital Group, Inc. ("Omni") was merged with and into the Corporation (the "Merger"). In connection with the Merger, the Corporation's Restated Articles of Incorporation were amended and restated to change the Corporation's name from "First Security Financial Corporation" to "Security Capital Bancorp," to increase the Corporation's authorized shares of common stock (the "Common Stock") from 10,000,000 to 25,000,000, to establish that its shares of Common Stock would have no par value, to authorize 5,000,000 shares of preferred stock with no par value per share, to establish the minimum number of directors as 9 and the maximum number as 30, to stagger the terms of the Board of Directors, and to make certain revisions to the Corporation's Restated Articles of Incorporation to reflect the characteristics of the combined company resulting from the Merger. Prior to the Merger, Omni was a multiple savings and loan holding company registered under the Home Owners' Loan Act, as amended, and it and its subsidiaries (OMNIBANK, Citizens, Home Savings, FCC and EDC) were subject to regulation by the Office of Thrift Supervision (the "OTS"). As a consequence of the Merger, the Corporation continued as a bank holding company regulated by the FRB and became a multiple savings and loan company regulated by the OTS. In December of 1992, the Savings Banks were converted from federally chartered savings banks to North Carolina chartered savings banks. Accordingly, the Corporation is no longer subject to regulation by the OTS. The Merger was effected as a nontaxable reorganization under Section 368(a)(1)(A) of the Internal Revenue Code of 1986, as amended. It was accounted for as a pooling-of-interests, with the result that, on the Corporation's consolidated balance sheet: (a) the historical basis of the assets and liabilities of the Corporation and Omni were combined as of the Merger and carried forward at their previously recorded amounts; (b) the shareholders' equity accounts of the Corporation and Omni were combined as of the Merger and carried forward at their previously recorded amounts; and (c) the income and other financial statements of the Corporation issued after the Merger have been restated retroactively to reflect the consolidated operations of the Corporation and Omni as if the Merger had taken place prior to the periods covered by such financial statements. The Subsidiaries Security Bank was originally chartered in 1915 as the "Morris Plan Company." In 1945, it became a North Carolina commercial bank and changed its name to "Security Bank and Trust Company." At December 31, 1993, it operated 33 branches in 21 communities located in 10 counties in the south central Piedmont region of North Carolina, and had total assets of approximately $385 million, insured deposit liabilities of approximately $332 million, leverage capital of approximately $50 million, and total risk-based capital of approximately $52 million (or 35.23% of risk-weighted assets). OMNIBANK was originally chartered in 1919 as a North Carolina mutual savings and loan association under the name "Home Savings and Loan Association." In 1980 it became a federal mutual savings and loan, and in March of 1988, it converted to a federal capital stock savings bank. In December of 1988, it effected a corporate reorganization and became a subsidiary of Omni (subsequently changing its name to "OMNIBANK, A Federal Savings Bank"). On December 1, 1992, it converted from a federally-chartered to a North Carolina chartered savings bank. At December 31, 1993, OMNIBANK operated 3 branches in Salisbury, North Carolina, and had total assets of approximately $230 million, insured deposit liabilities of approximately $184 million, leverage capital of approximately $30 million, and total risk-based capital of approximately $31 million (or 24.33% of risk-weighted assets). Citizens was originally chartered in 1906 as a North Carolina mutual savings and loan association. In December of 1988, it converted to a federal capital stock savings bank through a merger conversion transaction with Omni. On December 1, 1992, it converted from a federally-chartered to a North Carolina chartered savings bank. At December 31, 1993, Citizens operated 5 branches in Concord, North Carolina and surrounding areas, and had total assets of approximately $212 million, insured deposit liabilities of approximately $189 million, leverage capital of approximately $21 million, and total risk-based capital of approximately $22 million (or 19.47% of risk- weighted assets). Home Savings was originally chartered in 1923 as a North Carolina mutual savings and loan association, and, in 1981, it became a federal mutual savings and loan association. In 1989, it converted into a federal capital stock savings bank through a merger conversion transaction with Omni. On December 1, 1992, it converted from a federally-chartered to a North Carolina chartered savings bank. At December 31, 1993, Home Savings operated 3 branches in Kings Mountain, North Carolina and surrounding areas, and had total assets of approximately $104 million, insured deposit liabilities of approximately $94 million, leverage capital of approximately $8 million, and total risk-based capital of approximately $9 million (or 17.76% of risk-weighted assets). In May 1993, the Corporation consolidated eight branch locations into four banking offices. These "superbranches" are a new concept in North Carolina since the 4 remaining facilities actually provide retail operations for two separately chartered financial institution subsidiaries in each location. FCC is a North Carolina corporation. It provides management, electronic data processing, and other services to the Corporation and the other Subsidiaries. FSCC is a North Carolina corporation. As a consumer finance company, it provides small consumer loans through its two offices in Kannapolis and Concord, North Carolina. EDC is a North Carolina corporation and was formerly in the business of providing real estate appraisal services and engaging in real estate development, building and sales. It is in the process of winding down and terminating these activities in compliance with FRB regulations. Business Activities Through one or more of the Banking Subsidiaries and the 40 banking offices they operate in 28 communities located in eleven counties in the south central and western Piedmont regions of North Carolina, the Corporation offers numerous banking services, including accepting time and demand deposits, making secured and unsecured business and personal loans, making mortgage loans (secured primarily by one-to-four family residential properties), renting safe deposit boxes, sending and receiving wire transfers, and performing trust functions for corporations, pension and other employee benefit plans, and individuals. Additionally, consumer finance, insurance and securities brokerage services, and other services relating to financial management, are offered through one or more of the Subsidiaries. Ranked by total assets, the Corporation is the 10th largest bank holding company headquartered in North Carolina. The economy in the geographic areas served by the Corporation has been influenced positively by the growth of Charlotte, North Carolina, one of the fastest growing cities in the Southeast and North Carolina's largest city. Charlotte is located in Mecklenburg County. A substantial portion of the Banking Subsidiaries' banking offices are located in Mecklenburg County, in other counties included in the Charlotte Standard Metropolitan Statistical Area (the "Charlotte SMSA"), or in counties adjacent to, or within a radius of 30 miles of, the Charlotte SMSA. At December 31, 1993, the economic conditions in this primary market area were considered to be moderate to good, with more favorable unemployment rates and other key economic indicators than national averages. Vigorous competition exists in all major market areas served by the Banking Subsidiaries. The Banking Subsidiaries face direct competition for deposits not only from commercial banks, thrift institutions and credit unions, but from other businesses such as securities brokerage firms and mutual funds. Particularly in times of high interest rates, the Banking Subsidiaries encounter additional significant competition for depositors' funds from short-term money market securities and other corporate and government securities. The Banking Subsidiaries' competition for loans and similar services come from commercial banks, thrift institutions, credit unions, leasing companies, finance companies, insurance companies, other institutional lenders, and a variety of financial services and advisory companies. The Banking Subsidiaries seek to meet the competition of these other companies, many of which are larger and have greater resources than the Corporation, through offering competitive interest rates, focusing upon the efficiency and quality of their services in meeting the banking needs of their customers, and, where appropriate, expanding their presence in attractive markets through branching or acquisitions. Lending Activities General. The principal lending activities of Security Bank have been the making of installment and other consumer loans, real estate mortgage loans, and commercial, financial and agricultural loans. The Savings Banks' principal activity has been the origination of conventional mortgage loans for the purpose of constructing, financing or refinancing one-to-four family residential properties. To a lesser extent, the Savings Banks also make commercial real estate loans (which include loans secured by multi-family and other commercial real properties), other commercial loans and consumer loans. As of December 31, 1993, approximately $320 million, or 67.59%, of the Banking Subsidiaries' total loans consisted of loans secured principally by first mortgages on one-to-four family residential properties. As of that same date, approximately $17.5 million, or 3.69%, of the Banking Subsidiaries' total loans were secured by multi-family properties and approximately $47.3 million, or 10.00%, were secured by other commercial real property. Approximately $62 million, or 13.17%, of the Banking Subsidiaries' loans were installment and other consumer loans, and approximately $65 million, or 13.68%, were commercial, financial and agricultural loans, as of December 31, 1993. Federal regulations limit the aggregate amount of loans a financial institution may make to a single borrower. At December 31, 1993, none of the Banking Subsidiaries had loans to a single borrower that exceeded these limits. See "Regulation." Loan Portfolio Analysis. Set forth below is selected data relating to the composition of the Banking Subsidiaries' loan portfolio, excluding loans held for sale, by type of loan on the dates indicated: Residential Mortgage Loans. The primary lending activity of the Savings Banks has been the granting of conventional loans to enable borrowers to purchase existing homes or refinance existing mortgages. To a lesser extent, Security Bank also makes residential mortgage loans. Mortgage loans made by the Banking Subsidiaries are generally long-term loans, amortized on a monthly basis, with principal and interest due each month. The Banking Subsidiaries' lending policies limit the maximum loan-to-value ratio on residential mortgage loans to 95% of the lesser of the appraised value or purchase price, with the condition that private mortgage insurance generally be required on any home loans with loan-to-value ratios in excess of 80%. The Banking Subsidiaries require mortgage title insurance on most mortgage loans and hazard insurance generally in the amount of the loan. The contractual loan payment period for residential loans typically ranges from 15 to 30 years. Borrowers may refinance or prepay loans at their option, typically without penalty. The Banking Subsidiaries' experience indicates that real estate loans remain outstanding for significantly shorter periods than their contractual terms. The thrift and mortgage banking industries have generally used a 7 to 10 year average loan life as an approximation in calculations calling for prepayment assumptions. Management believes that the Banking Subsidiaries' loan prepayment experience has been somewhat shorter than the industry approximated 12-year average loan life assumption, due to the high rate of refinancing and turnover in the housing markets they serve. The Banking Subsidiaries currently offer adjustable rate mortgage loans generally tied to the one year U.S. Treasury security yield or a published prime lending rate. The interest rates on most of these mortgages are adjustable once a year with limitations on adjustments of one or two percent per adjustment period and five to six percent over the life of the loan. Although adjustable rate mortgage loans allow the Banking Subsidiaries to increase the sensitivity of their asset bases to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate ceilings contained in adjustable rate mortgage loans. The terms of such loans may also increase the likelihood of delinquencies during periods of high interest rates. Adjustable rate residential mortgage loans amounted to 51.79% of the total loan portfolio of the Banking Subsidiaries at December 31, 1993. Commercial Real Estate Loans. The Savings Banks provide commercial real estate loans, including loans secured by multi-family dwellings with more than four units and other commercial real property. From time to time, Security Bank also makes these types of loans. These loans constituted approximately $64.8 million, or 13.69%, of the Banking Subsidiaries' loan portfolio at December 31, 1993. These loans typically are secured by improved real estate located in North Carolina. Commercial real estate loans customarily are made in amounts up to 80% of the appraised value of the property and generally have terms of up to 15 years. Interest rates are tied generally to the one, two, three and five-year U.S. Treasury security yield or a published prime lending rate. Because of their generally shorter terms and higher interest rates, commercial real estate loans, such as those made by the Banking Subsidiaries, are helpful in maintaining a profitable spread between the Banking Subsidiaries' average loan yields and their cost of funds. Traditionally, such loans have been regarded as posing significantly greater risk of default than residential mortgage loans. Such loans generally are substantially larger than single-family residential mortgage loans, and repayment of the loan generally depends on cash flow generated by the property. Because the payment experience on loans secured by such property is often dependent upon successful operation or management of the property, repayment of the loan may be subject to a greater extent to adverse conditions in the real estate market or the economy than generally is the case with one-to-four family residential mortgage loans. The commercial real estate business is cyclical and subject to downturns, overbuilding and local economic conditions. The Banking Subsidiaries seek to limit these risks in a variety of ways, including, among others, limiting the size of their commercial and multi-family real estate loans, generally limiting such loans to a maximum loan-to-value ratio of 80% based on the lesser of the purchase price or the appraised value of the property and generally lending on property located within their market areas. Commercial, Financial, and Agricultural Loans. Security Bank and, to a lesser extent, the Savings Banks also make commercial, financial and agricultural loans primarily to small and medium-sized companies for expansion and renovation, working capital needs, equipment purchases and farming operations. Generally, loans are made at adjustable interest rates with terms of one to five years. These loans constituted approximately $18.7 million, or 3.95%, of the Banking Subsidiaries' loan portfolio at December 31, 1993. Interest rates are tied generally to the one, two, three or five-year U.S. Treasury securities yield or a published prime lending rate. Generally, these commercial, financial and agricultural loans are made to borrowers located in North Carolina. As with commercial real estate loans, commercial, financial and agricultural loans are helpful in maintaining a profitable spread between the Banking Subsidiaries' average loan yields and their cost of funds because of their shorter term and higher interest rates. These loans have a higher degree of risk than residential mortgage loans because they are typically made on the basis of the borrower's ability to make repayment from the cash flow of its business and are either unsecured or secured by business assets, such as accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial, financial and agricultural loans may be substantially dependent on the success of the business itself. The Banking Subsidiaries seek to limit these risks by maintaining close contact with the borrower, obtaining financial statements on a regular basis and determining that the borrower is in compliance with the terms of the loan agreement. Installment and Other Consumer Loans. At December 31, 1993, the Corporation's installment and other consumer loans portfolio aggregated approximately $62.3 million, or 13.17%, of the Corporation's total loan portfolio. The consumer loans made by the Banking Subsidiaries include line of credit loans to individuals, loans on automobiles, boats, recreational vehicles and other consumer goods and unsecured loans. Generally, consumer loans have up to five-year terms and may have either adjustable or fixed interest rates or may be in the form of credit lines with adjustable interest rates. The Banking Subsidiaries normally limit the loan-to-value ratios on secured consumer loans to 85%, depending on the type of collateral securing the loan. Consumer loans typically are either secured by collateral that is rapidly depreciating or has greater recovery risks, such as automobiles, or are unsecured. Therefore, these loans generally carry a greater degree of credit risk than residential mortgage loans. Approximately $13 million, or 20.93%, of the Banking Subsidiaries' consumer loans as of December 31, 1993 were unsecured. Loan Maturity Schedule. The following table sets forth certain information at December 31, 1993 regarding the dollar amount of real estate construction loans and commercial, financial and agricultural loans maturing in the Banking Subsidiaries' loan portfolio. Demand and line of credit loans having no stated schedule of repayments and no stated maturity, and overdrafts, are reported as due in one year or less. Predetermined and Adjustable Interest Rates Schedule. The following table sets forth the dollar amount of all real estate construction loans and commercial, financial and agricultural loans of the Banking Subsidiaries due after one year from December 31, 1993 that have predetermined interest rates or have floating or adjustable interest rates: Predetermined Floating Rates Adjustable Rates (Dollars in Thousands) Real estate construction $ --- $ 1,281 Commercial, financial and agricultural 5,915 30,977 Total $5,915 $32,258 Loan Solicitation and Processing. The Banking Subsidiaries derive their loan originations from a number of sources. Residential loan originations can be attributed to real estate broker referrals, mortgage banking relationships, direct solicitation by the loan officers of the Banking Subsidiaries, current depositors and borrowers, builders, attorneys, walk-in customers, correspondent loan originators and, in some instances, other lenders. Commercial real estate loans, consumer loans, and commercial, financial and agricultural originations result from many of the same sources. Upon receipt of a loan application from a prospective borrower, a credit report and verifications are ordered to verify specific information relating to the loan applicant's employment, income and credit standing. An appraisal of any real estate intended to secure a proposed loan is undertaken by in-house or independent appraisers approved by the applicable Banking Subsidiary. The Corporation and the Banking Subsidiaries have established certain general policies for loan authorization procedures. Loans up to limits established by each Banking Subsidiary's Board of Directors may be made by the applicable loan officers. Such loans are reviewed by the Banking Subsidiary's management and/or Loan Committee. Loans in excess of these limits must be approved by Loan Administration and reviewed by the Loan Committee of the relevant Banking Subsidiary. Loans in excess of a pre-established level are reviewed or approved by the Loan Committee of the relevant Banking Subsidiary and/or the General Loan Committee of the Corporation. Loan applicants promptly are notified of the decision by a letter or, in some instances, orally. If a loan, other than consumer loans or certain loans of lesser amounts, is approved, a commitment letter will specify the terms and conditions of the proposed loan, including the amount of the loan, interest rate, amortization term, a brief description of the required collateral (if a secured loan is to be made) and required insurance coverage. The borrower must provide proof of fire and casualty insurance on any real property serving as collateral, which insurance must be maintained during the full term of the loan. In addition, the Banking Subsidiaries generally require title insurance on all loans secured by real property. Loan rates are normally locked in for a 60-day period. Loan Commitments. In the normal course of business, the Banking Subsidiaries have various commitments to extend credit which are not reflected in the Corporation's consolidated financial statements. At December 31, 1993, outstanding loan commitments approximated $9 million (of which approximately $6 million were fixed rate and $3 million were variable rate), preapproved but unused lines of credit for loans totaled $91 million and standby letters of credit aggregated $268,000. These amounts represent the Corporation's exposure to credit risk for these off-balance sheet financial instruments, and, in the opinion of management, represent no more than the normal lending risk that the Banking Subsidiaries commit to their borrowers. If these commitments are drawn, the Banking Subsidiaries will obtain collateral if it is deemed necessary based on management's credit evaluation of the borrower. Collateral obtained varies but may include accounts receivable, inventory, and commercial or residential real estate. Management expects that these commitments can be funded through normal operations. Loan Activity. Loan originations of the Banking Subsidiaries are primarily generated by their own lending functions, as opposed to purchasing loans from other financial institutions. In this manner, the Banking Subsidiaries collect for themselves the loan origination fees paid by the borrowers. The Savings Banks from time to time have purchased adjustable rate mortgage loans and fixed rate mortgage-backed securities in the secondary market. The Banking Subsidiaries typically underwrite fixed rate mortgage loans according to Federal Home Loan Mortgage Corporation ("FHLMC") or Federal National Mortgage Association ("FNMA") guidelines, so that the loans qualify for sale in the secondary mortgage market or exchange for participation certificates. Such loans may be considered by management to be held for sale at origination based on their interest rates and terms to maturity, and thus such loans are carried at the lower of cost or market as determined by outstanding commitments from investors or current investor yield requirements calculated on the aggregate loan basis. Gains and losses on loan sales are recognized if at the time of sale the average interest rate on the loans sold, adjusted for servicing costs, differs from the agreed yield to the buyer. Any excess servicing fee is deferred and is amortized using a level yield method over the contractual life of such loans. Sales of loans in 1993 and 1992 resulted in no such excess servicing fees. During 1993 and 1992, the Banking Subsidiaries sold, through OMNIBANK, approximately $86 million and $85 million, respectively, of fixed rate residential mortgage loans to generate liquidity and to meet loan demand. In connection with such sales, OMNIBANK generally retains the servicing of the loans (i.e., collection of principal and interest payments), for which it generally receives an average fee payable monthly of .25% to .375% per annum of the unpaid balance of each loan. As of December 31, 1993, the Banking Subsidiaries were servicing loans for others aggregating approximately $203 million. The sale and subsequent servicing of residential mortgage loans have been, and will continue to be, a significant source of other income for the Corporation. The Corporation's gains on sales of loans, however, are largely dependent upon prevailing interest rates, which influence residential loan borrowers to refinance their loans at more favorable interest rates. As a result, this source of other income could be significantly affected by such interest rates in future periods. Gains on sales of loans totaled $1,384,000, $738,000 and $927,000 for 1993, 1992, and 1991, respectively, and loan servicing fees totaled $604,000, $563,000 and $548,000 for 1993, 1992, and 1991, respectively. Loan Origination and Other Fees. In addition to interest earned on loans and fees for making loan commitments, the Banking Subsidiaries receive loan origination fees for originating mortgage loans. These origination fees generally are calculated as a percentage of the principal amount of the mortgage loan and are charged to the borrower for creation of the loan. Non- refundable fees and certain related costs associated with originating or acquiring loans generally are recognized over the life of the related loans as an adjustment to interest income. Deferred net fees and discounts associated with the mortgage loans held by the Banking Subsidiaries are included as components of the carrying value of the loan and are being amortized into interest income over the lives of the related loans by a method that approximates level yield. The Banking Subsidiaries also receive other fees and charges relating to existing loans, including late charges, fees collected in connection with a change in borrower, and insurance commissions. These fees and charges for the years ended December 31, 1993, 1992, and 1991 totaled approximately $792,000, $788,000 and $739,000, respectively. Non-Performing Assets. The Banking Subsidiaries' collection procedures provide that when a loan is 30 days delinquent, the borrower will be contacted by mail and payment requested. If the delinquency continues, subsequent efforts will be made to contact the delinquent borrower. In certain limited instances, the Banking Subsidiary may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his financial affairs. If the loan continues in a delinquent status for at least 90 days, the Banking Subsidiary generally will initiate foreclosure or other collection proceedings. If the loan is unsecured, it is generally charged-off after it is 120 days delinquent. If a loan is secured, upon a foreclosure or other action seizing the collateral, or the determination by management that the collateral has been in substance foreclosed, the collateral property is appraised, and is then classified as real estate owned and is recorded at the lower of cost or fair value, less the estimated costs to sell the property. Generally, such properties are appraised annually to update the fair value estimates made by management. The following table presents information on nonperforming assets, including non-accrual loans, accruing loans that are 90 or more days past due, real estate owned and restructured loans. Management of the Banking Subsidiaries periodically evaluates the collectibility of the principal and interest on these loans. When a loan becomes delinquent by at least 90 days, management determines whether interest should continue to accrue by considering various factors, including the current financial position of the borrower, the value of the underlying collateral, the existence and amount of coverage of any private mortgage insurance, and the date that the last payment or partial payment was received. If collectibility of the outstanding principal balance and the accrued interest appears certain based on a review of the aforementioned factors, and the loan is considered by management to be in the process of collection, management will continue to accrue interest on these loans. Loans are placed on nonaccrual status when management determines uncertainty of interest collection exists but payment of principal is not impaired. When uncertainty of collection of principal exists, the asset is written down to its net realizable value. Interest income foregone on nonaccrual loans and restructured loans for each of the years in the three-year period ended December 31, 1993, was not significant. Asset Classification. Regulations governing insured financial institutions require those institutions to classify their assets on a regular basis. In addition, in connection with examinations of insured institutions, federal and state examiners have authority to identify problem assets and, if appropriate, classify them. If an institution does not agree with an examiner's classification of an asset, it may appeal this determination to the appropriate regulator. Problem assets may be classified as "substandard," "doubtful" or "loss." An asset will be classified as "substandard" if it is determined to involve a distinct possibility that the insured institution may sustain some loss if deficiencies associated with the loan, such as inadequate documentation or credit weakness, are not corrected. An asset will be classified as "doubtful" if full collection is highly questionable or improbable. An asset will be classified as "loss" if it is considered as uncollectible, even if a partial recovery may be expected in the future. There is also a "special mention" category which includes assets that currently do not expose an insured institution to a sufficient degree of risk to warrant classification but that do possess credit deficiencies or potential weaknesses deserving management's close attention. An institution must establish general allowances for loan losses for assets classified as substandard or doubtful. If an asset or portion thereof is classified as loss, the insured institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge off such amount. The aggregate amounts of classified assets (which included non- performing assets) of the Banking Subsidiaries at December 31, 1993 were as follows: Loans classified for regulatory purposes as loss, doubtful, substandard or special mention that have not been disclosed in the nonperforming asset table under the section "Nonperforming Assets" do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms. Allowances for Loan Losses. The Corporation recognizes that the Banking Subsidiaries will experience credit losses in making loans and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a secured loan, the quality of the security for the loan. Management's policy to maintain adequate reserves is based on, among other things, estimates of historical loan loss experience, loan growth, the composition and quality of each Banking Subsidiary's overall loan portfolio and off-balance sheet commitments, evaluations of current and anticipated economic conditions, and collateral values. Management evaluates the carrying value of loans periodically and specific allowances are made for individual loans when the ultimate collection is considered questionable by management after reviewing the current status of loans that are contractually past due and taking into account the fair value of the collateral of the loan. In addition, management of the Banking Subsidiaries utilizes the aforementioned regulatory classification system to evaluate the adequacy of the allowance for loan losses for the remaining portfolio. A percentage allocation is made to the allowance for loan losses based on the various loan classifications, so that loans with higher risk are assigned a larger allocation of allowance for loan losses. Also taken into consideration are the nature and extent of off- balance sheet financial instruments, including loan commitments and preapproved but unused lines of credit. During each of the years in the three-year period ended December 31, 1993 the Corporation had no realized credit losses from such off-balance sheet financial instruments. The Banking Subsidiaries grant primarily commercial, real estate, and installment loans throughout their market areas, which consists primarily of the south central and western Piedmont regions of North Carolina. The Banking Subsidiaries real estate loan portfolios can be affected by the condition of the local real estate markets and their commercial and installment loan portfolios can be affected by local economic conditions. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from assumptions used in making such evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banking Subsidiaries' allowances for loan losses and losses on real estate owned. Such agencies may require the Banking Subsidiaries to adjust the allowance based on their judgments about information available to them at the time of their examinations. The following is a reconciliation of the allowance for loan losses for the years shown: The following table presents an allocation of the allowance for loan losses by the categories indicated and the percentage that loans in each category bear to the Banking Subsidiaries' total loans. This allocation is used by management to assist in its evaluation of the Banking Subsidiaries' loan portfolio. These allocations are merely estimates and are subject to revisions as conditions change. Based upon historical loss experience and the Banking Subsidiaries' assessment of their loan portfolios, the Banking Subsidiaries' allowances for loan losses have been allocated to the categories of loans indicated. Specific allocations for these loans are based primarily on the creditworthiness of each borrower. In addition, general allocations are also made to each category based upon, among other things, the impact of current and future economic conditions on the loan portfolio taken as a whole. Losses on loans made to consumers are reasonably predictable based on prior loss experience and a review of current economic conditions. Non-Banking Subsidiaries The Corporation has two direct Subsidiaries, and one indirect Subsidiary, which are not financial institutions. FCC provides management, electronic data processing and other services to the Corporation and the other Subsidiaries. At December 31, 1993, FCC had assets of approximately $4.3 million and liabilities of approximately $3.8 million. Prior to the Merger, EDC engaged in real estate acquisition, development and construction and provided real estate appraisal services to Omni and its subsidiaries. At December 31, 1993, EDC had assets of approximately $929,000 and liabilities of approximately $21,000. FSCC is a subsidiary of Security Bank and operates as a consumer finance company. At December 31, 1993, FSCC had assets of approximately $2.2 million, including a consumer loan portfolio of approximately $2 million, and total liabilities of approximately $2 million. See "Regulation" below. Investment Activities Interest and dividends on investments historically have provided the Corporation and its Subsidiaries an additional substantial source of income. At December 31, 1993, the Corporation's investment securities portfolio aggregated approximately $368.4 million and consisted primarily of United States Government obligations, with lesser amounts of mortgage-backed securities, state and municipal obligations and federal agency obligations. Purchases of securities are funded either through the sale or maturity of other securities or from the cash flow arising in the ordinary course of business. The Banking Subsidiaries have authority to invest in various types of liquid assets, which include certain time deposits, bank acceptances, specified U.S. Government securities, government agency securities, and state and municipal obligations. Subject to various regulatory restrictions, the Banking Subsidiaries may also invest a portion of their assets in commercial paper, corporate debt securities and in mutual funds whose assets conform to the investments that they are otherwise authorized to make directly. The Banking Subsidiaries are required to maintain liquid assets at minimum levels, which are adjusted by financial institution regulators from time to time. See "Regulation." The Banking Subsidiaries traditionally have maintained levels of liquidity above that required by federal regulations. In addition to providing for regulatory liquidity, the Banking Subsidiaries maintain investments to employ funds not currently required for their various lending activities. Subject to the investment policy of the Corporation's Board of Directors, members of senior management normally make investment decisions. Management determines the maturities and mix of investments in the Banking Subsidiaries' investment portfolios based on liquidity needs and legal liquidity restrictions. Maturities are also determined based on general and anticipated market trends. The Corporation's investment strategy has been, and remains, to invest principally in U.S. Government securities, government agency obligations, and certain types of state and municipal obligations with maturities of seven years or less. These high grade investments generally pose little or no credit risks and are easily liquidated if necessary. Investments in these types of securities and obligations amounted to 97% of the Corporation's investment portfolio at December 31, 1993. Management generally considers government and agency obligations that carry lower yields to be preferable to higher yielding corporate and other securities that carry greater credit risks. Furthermore, management recognizes the Corporation's limitations in being able to evaluate and monitor many corporate and other securities on a timely basis. Management believes that this investment strategy will provide stable earnings and maintain asset quality, although rates of return will be more moderate than those that could be obtained with riskier securities. The Corporation does not engage in hedging or other high risk investment strategies. At December 31, 1993, the Corporation's investment securities portfolio had gross unrealized gains of $7.2 million and gross unrealized losses of $528,000, compared to gross unrealized gains of $9.3 million and gross unrealized losses of $549,000 at December 31, 1992. The net unrealized gain of $6.7 million at December 31, 1993 reflects the fact that the weighted average yield of the Corporation's investment securities portfolio exceeds the current yields being offered in the bond market for securities with similar features. Such amounts generally do not reflect possible future realized gains for the investment securities portfolio. At December 31, 1993, the Corporation had the intent to hold all investment securities in the investment portfolio as long-term investments and had the ability to hold them to maturity. The level of unrealized gains will change in future periods as yields being offered in the bond market for securities with similar features fluctuate. During the year ended December 31, 1993, sales or issuer calls of investment securities totalled $5.86 million. During the year ended December 31, 1992, sales of investment securities were insignificant. During the year ended December 31, 1991, sales of investment securities totaled $56.15 million. These sales occurred in response to an unforeseen decline in interest rates during 1991. The following table presents the book value and the estimated fair value of the various components of the investment securities portfolio, excluding investment securities available for sale, at December 31, 1993, 1992, and 1991: The following table sets forth the maturities of the components of the aggregate investment securities portfolio of the Corporation at December 31, 1993, and the weighted average yields of such securities: Sources of Funds General Sources of Funds. Core deposits are the largest and most important source of the Banking Subsidiaries' funds for lending and other investment purposes. In addition to deposits, the Banking Subsidiaries receive funds from interest payments, loan principal repayments, advances (loans) from the FHLB ("FHLB Advances"), other borrowings and operations. Loan repayments and interest payments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. The Savings Banks generally use borrowings on a short-term basis to compensate for reductions in the availability of funds from other sources. Borrowings may also be used on a longer-term basis for general business purposes. Historically, the Banking Subsidiaries have not relied upon significant amounts of borrowings to fund loan and asset growth. Deposits. The Banking Subsidiaries attract consumer and commercial deposits principally from within their respective primary market areas through the offering of a broad selection of deposit instruments, including (depending upon the Banking Subsidiary), demand deposits, NOW accounts, money market accounts, regular and bonus savings accounts, money market certificates, other time deposits (including negotiated "jumbo" and "mini jumbo" certificates in denominations of at least $100,000 and $50,000, respectively), and individual retirement plans. Deposit account terms vary, with the principal differences being the minimum balance required, the time period that the funds must remain on deposit and the interest rate. The Banking Subsidiaries generally do not obtain funds through brokers, and they do not solicit funds outside of North Carolina. The Banking Subsidiaries' aggregate deposits increased approximately $10.82 million in 1993, decreased approximately $1.51 million in 1992, and increased approximately $7.21 million in 1991. The following table contains information pertaining to the average amount of and the average rate paid on each of the following deposit categories for the periods indicated: The following table sets forth the amount and maturities of jumbo certificates of deposit (certificates of deposit of $100,000 or more) in the Banking Subsidiaries at December 31, 1993: (Dollars in Thousands) Maturing in 3 months or less $17,616 Maturing after 3 but less than 6 months 12,734 Maturing after 6 but less than 12 months 13,222 Maturing after 12 months 19,440 Total $63,012 Borrowings. In addition to the deposits described above, the Savings Banks rely upon FHLB Advances as their principal borrowing source, to supplement their supply of lendable funds and to secure funds for other operational purposes, such as meeting deposit withdrawals and other short-term liquidity requirements. The FHLB of Atlanta functions in a central reserve capacity providing credit for thrift and other financial institutions. FHLB Advances may be on a secured or unsecured basis depending upon a number of factors, including the purpose for which the funds are being borrowed and existing advances outstanding. At December 31, 1993, OMNIBANK had FHLB Advances totaling $8 million, at rates varying from 8.15% to 9.65%, secured by certain of its real estate loans and all of its FHLB of Atlanta stock. The Savings Banks have also entered into blanket collateral agreements with the FHLB of Atlanta whereby they maintain, free of other encumbrances, "qualifying mortgages" with unpaid principal balances at least equal to, when discounted at 65% of the unpaid principal balance, 100% of the total FHLB Advances. The Savings Banks also have unused lines of credit with the FHLB of Atlanta totaling approximately $60 million at December 31, 1993. If drawn, the advanced funds would be at market rates of interest and would be collateralized by the aforementioned blanket collateral agreements, all stock of the borrowing subsidiary in the FHLB, and any other collateral deemed necessary by the FHLB. See Note 7 of Notes To Consolidated Financial Statements for information as to interest rates and maturities for these FHLB Advances. The other Banking Subsidiaries had no FHLB Advances at December 31, 1993. The Savings Banks also enter into retail repurchase agreements on a short-term basis, primarily as a service to their customers. These borrowings are generally secured by investment securities of the Corporation, and are classified as other borrowings in the table below. The following tables set forth the borrowings of the Banking Subsidiaries at the dates and for the periods indicated: Net Interest Income Analysis. The following tables set forth for the periods and at the dates indicated the average interest-earning assets, the average interest-bearing liabilities, interest income from interest-earning assets and interest expense related to interest-bearing liabilities, average yields on interest-earning assets and average rates on interest-bearing liabilities, the spread between the combined average rates earned on interest- earning assets and average rates paid on interest-bearing liabilities, and the net yield on interest-earning assets (net interest margin). Average balances are determined on a daily basis. For the purposes of this table, the loan averages include nonaccrual loans and are stated net of unearned income. The amount of loan fees included in interest income for each of the periods presented is not material. 1 Refer to the table on page 19 for information concerning other borrowings. Asset/Liability Management The Banking Subsidiaries' exposure to interest-rate risk results from the differences in maturities and pricing of their interest-earning assets (loans and other investments) and interest-bearing liabilities (deposits and other borrowings). Historically, financial institutions with substantial mortgage loan portfolios have operated in a mismatched position, with interest-sensitive liabilities greatly exceeding interest-sensitive assets. Because interest rates paid on deposits can adjust more quickly to interest rate movements than do yields earned on loans, sharp increases in interest rates can adversely affect the earnings of such financial institutions. The rapid escalation of interest rates in the early 1980's is directly responsible for many of the problems of banks and thrift institutions as their cost of funds exceeded their yield on assets. Such interest-rate risk can be reduced if the maturities of deposits and loans are reasonably well matched. The senior management personnel of the Corporation and each Banking Subsidiary currently maintain responsibility for and discuss and monitor on a continuing basis the asset/liability management for the Banking Subsidiaries. In addition, the Board of Directors of the Corporation has adopted an interest-rate risk management policy providing for a formal asset/liability committee that meets no less frequently than quarterly to monitor exposure to interest-rate risk and report findings and accomplishments to the Boards of Directors of the Corporation and the Banking Subsidiaries. The Corporation currently measures its exposure to interest rate risks through the utilization of a computer model that outlines a gap position for various maturities and market value of portfolio equity, by Banking Subsidiary. Various interest rate scenarios are used to determine whether the goals established by the Boards of Directors of the Corporation and each Banking Subsidiary are being met. All such data is reviewed with the respective Boards of Directors of the Corporation and the Banking Subsidiaries on a quarterly basis. Realizing that various hedging activities are inherently volatile and that such activities require specific expertise, neither the Corporation nor any Subsidiary engages in the following investment activities: financial options transactions, interest rate futures transactions, mortgage or interest rate swap transactions, transferring securities, trading in mortgage derivative instruments or products such as collateralized mortgage obligations, investing in junk bonds, or otherwise engaging in synthetic or artificial hedging of risk-controlled arbitrage. In an effort to make the yields on their loan and investment portfolios more interest-rate sensitive, the Savings Banks have implemented a number of measures, including: (i) increasing their emphasis on originating adjustable rate mortgage loans on residential and commercial properties, subject to market conditions; (ii) originating higher levels of construction, small commercial real estate and consumer loans, which typically bear higher interest rates than residential loans and offer greater interest rate flexibility through shorter maturities; and (iii) using FHLB Advances and longer- term savings certificates to lengthen maturities of liabilities. Security Bank historically has had, and continues to have, a large percentage of commercial, financial and agricultural loans and installment and other consumer loans in its portfolio and an even higher percentage of its total assets in its investment portfolio. Consequently, its loan and investment portfolios tend to be more interest-rate sensitive than those of the Savings Banks. The risks involved in commercial real estate, consumer and commercial, financial and agricultural loans are evaluated by management carefully as part of the underwriting of such loans. Management is continuing to attempt to direct the Savings Banks' loan portfolios into types of loans other than residential mortgage loans. The effort, together with the emphasis in Security Bank's portfolio upon commercial, financial and agricultural loans and installment and other consumer loans, has resulted in the diversification of the Corporation's aggregate loan portfolio. The Banking Subsidiaries also emphasize longer-term deposits when prudent to do so. It is difficult, however, to attract longer term deposits in periods of rising interest rates or during extended periods of low interest rates. Conversely, in a declining rate environment, longer-term deposits are easier to attract, but could leave the Banking Subsidiaries holding more costly deposits if interest rates declined significantly or for any extended period of time. The following table sets forth the dollar amount of maturing assets and liabilities of the Banking Subsidiaries as of December 31, 1993 and the difference between them for the repricing periods indicated: 1. Gap analysis includes fixed rate loan repayments (contractual and prepayment) and decay rates of deposit accounts based upon historical industry experience. 2. Includes loans held for sale. In evaluating the Corporation's exposure to interest-rate risk, shortcomings inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or repricing periods, they may react in different degrees to changes in market interest rates. The interest rates in certain types of assets and liabilities may fluctuate in advance of changes of market interest rates, while interest rates on other types may lag behind changes in market rates. Certain assets, such as adjustable rate mortgage loans, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. The ability of borrowers to service a debt may decrease in the event of an interest rate increase. The Banking Subsidiaries consider the anticipated effects of these various factors in implementing their interest rate risk management objectives. Management believes that it must continue its efforts to manage the rates, liquidity and interest-rate sensitivity of the assets and liabilities of the Banking Subsidiaries to generate an acceptable return. Rate/Volume Analysis The following table shows, for the periods indicated, the change in interest income and interest expense for each major component of interest- earning assets and interest-bearing liabilities attributable to (1) changes in volume (changes in volume multiplied by old rate) and (2) changes in rates (changes in rate multiplied by old volume). The change in interest income or expense attributable to the combination of rate variance and volume variance is included in the table, but such amount has been allocated equally between, and included in the amounts shown as, changes due to rate and changes due to volume. Liquidity The following discussion supplements the discussion in the Annual Report under the section "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." As discussed in the section "Sources of Funds" and in other sections included or incorporated by reference herein, the Banking Subsidiaries' principal sources of funds, other than cash provided from the net income of the Banking Subsidiaries, are deposit accounts, FHLB Advances, principal and interest payments on loans, interest received on investment securities, and fees. As noted in the consolidated statements of cash flows included in the Annual Report and incorporated by reference herein, the largest source of cash during 1993, 1992 and 1991 was the approximately $3 million, $20 million and $13 million, respectively, in net cash provided by operations. These funds resulted from net income adjusted primarily for the following noncash items: the provision for loan losses, depreciation and amortization, net securities gains, and changes in other assets and liabilities. The most significant investing activity during 1993 and 1992 was purchases of investment securities of approximately $122 million and $126 million, respectively, which was partially funded in 1993 and 1992 by maturities of investment securities totaling approximately $90 million and $72 million, respectively. As discussed elsewhere herein, the net decrease in loans in 1993, 1992 and 1991 of approximately $35 million, $40 million and $26 million, respectively, was largely due to management's policy of selling current production of fixed rate mortgage loans during these years. In total, net cash provided by investing activities in 1993 totalled approximately $433,000, while net cash of approximately $16 million and $16 million was used in investing activities during 1992 and 1991, respectively. Net cash used in financing activities amounted to approximately $168,000, $12 million and $577,000 during 1993, 1992 and 1991, respectively. For additional information regarding liquidity and capital resources, see "Regulation." Key Operating Ratios The table below sets forth certain performance ratios of the Corporation for the periods indicated: Personnel As of December 31, 1993, the Corporation and the Subsidiaries employed 392 employees on a full-time basis and approximately 28 employees on a part- time basis. The Corporation and/or the Subsidiaries currently maintain such employee benefits as pension and retirement plans, hospitalization and major medical insurance coverage, long-term disability and group life insurance, and an employee stock ownership plan. Employee benefits are considered by management to be competitive with those provided by other major employers in the Corporation's primary market areas. The employees are not represented by a collective bargaining unit, and the Corporation believes its relationship with its employees to be good. Regulation Federal and state legislation and regulation have significantly affected the operations of financial institutions in the past several years and have increased competition among commercial banks, savings institutions and other providers of financial services. In addition, federal legislation has imposed new limitations on the investment authority of, and higher insurance and examination assessments on, financial institutions and has made other changes that may adversely affect the future operations and competitiveness of regulated financial institutions with other financial intermediaries. The operations of regulated depository institutions and their holding companies, including the Corporation and its Banking Subsidiaries, will continue to be subject to changes in applicable statutes and regulations from time to time. The Corporation. As a bank holding company registered under the BHCA, the Corporation is subject to the regulations of the FRB. Under the BHCA, the Corporation's activities and those of the Subsidiaries are limited to banking, managing or controlling banks, furnishing services to or performing services for its Subsidiaries or engaging in any other activity which the FRB determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The BHCA prohibits the Corporation from acquiring direct or indirect control of more than 5% of the outstanding voting stock or substantially all of the assets of any bank or savings bank or merging or consolidating with another bank holding company or savings bank holding company without prior approval of the FRB. The BHCA also prohibits the Corporation from acquiring control of any bank or savings bank operating outside the State of North Carolina unless such action is specifically authorized by the statutes of the state where the bank or savings bank to be acquired is located. Additionally, the BHCA prohibits the Corporation from engaging in, or acquiring ownership or control of more than 5% of the outstanding voting stock of any company engaged in a non-banking business, including thrifts, unless such business is determined by the FRB to be so closely related to banking as to be properly incident thereto. The BHCA generally does not place territorial restrictions on the activities of such non-banking related activities. Similarly, FRB approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of the Corporation or a Banking Subsidiary. Control is conclusively presumed to exist if, among other things, a person acquires more than 25% of any class of voting stock of the institution or holding company or controls in any manner the election of a majority of the directors of the institution or the holding company. Control is presumed to exist if a person acquires more than 10% of any class of voting stock and the institution or the holding company has registered securities under Section 12 of the Securities Exchange Act of 1934, as amended, or the acquiror will be the largest shareholder after the acquisition. There are a number of obligations and restrictions imposed on bank holding companies and their insured depository institution subsidiaries by law and regulatory policies that are designed to minimize potential loss to depositors of such depository institutions and the Federal Deposit Insurance Corporation ("FDIC") insurance funds in the event the depository institution becomes in danger of default or in default. For example, under the recently enacted Federal Deposit Insurance Corporation Improvement Act of 1991 (the "1991 Banking Law"), to reduce the likelihood of receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become "undercapitalized" with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institution's total assets at the time the institution became undercapitalized or (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all acceptable capital standards as of the time the institution fails to comply with such capital restoration plan. Under a policy of the FRB with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. Under the BHCA, the FRB also has the authority to require a bank holding company to terminate any activity or to relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the FRB's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company. In addition, the "cross-guarantee" provisions of the Federal Deposit Insurance Act ("FDIA") require insured depository institutions under common control to reimburse the FDIC for any loss suffered by either the Savings Association Insurance Fund (the "SAIF") or the Bank Insurance Fund ("BIF") of the FDIC as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the SAIF or the BIF or both. The FDIC's claim is superior to claims of shareholders of the insured depository institution or its holding company but subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions. The Corporation is subject to the obligations and restrictions described above, and the Banking Subsidiaries are subject to the cross-guarantee provisions of the FDIA. However, management of the Corporation currently does not expect that any of these provisions will have an impact on the operations of the Corporation or its Subsidiaries. Bank holding companies are required to comply with the FRB's risk-based capital guidelines. At the end of 1992, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) increased to 8%. Until such time, the required ratio was 7.25%. At least half of the total capital is required to be "Tier I capital," principally consisting of common shareholders' equity, noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less certain goodwill items. The remainder ("Tier II capital") may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock, and a limited amount of the general loan loss allowance. Until December 31, 1992, a limited portion of Tier II capital could be counted as Tier I capital. In addition to the risk-based capital guidelines, the FRB has adopted a minimum Tier I (leverage) capital ratio, under which a bank holding company must maintain a minimum level of Tier I capital (as determined under the risk-based capital rules in effect at year-end 1992) to average total consolidated assets of at least 3% in the case of a bank holding company which has the highest regulatory examination rating and is not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a Tier I (leverage) capital ratio of at least 1% to 2% above the stated minimum. The following table sets forth the Corporation's regulatory capital position at December 31, 1993 (for the regulatory capital positions of the Banking Subsidiaries as of December 31, 1993, see the discussions below). The 1991 Banking Law requires each federal banking agency, including the FRB, to revise its risk-based capital standards within 18 months of enactment of the statute to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risks of non- traditional activities, as well as reflect the actual performance and expected risk of loss on multi-family mortgages. In August 1992, the FRB, the FDIC and the Office of the Comptroller of the Currency issued a joint advance notice of proposed rulemaking, soliciting comments on a proposed framework for implementing these revisions. Under the proposal, an institution's assets, liabilities, and off-balance sheet positions would be weighed by risk factors that approximate the instruments' price sensitivity to a 100 basis point change in interest rates. Institutions with interest rate risk exposure in excess of a threshold level would be required to hold additional capital proportional to that risk. The notice also asked for comments on how the risk-based capital guidelines of each agency may be revised to take account of concentration and credit risk and the risk of nontraditional activities. The Corporation is studying the notice. It cannot assess at this point the impact, if any, the proposal would have on the capital requirements of the Corporation or its Banking Subsidiaries. Under current federal law, transactions between depository institutions and any affiliate are governed by Section 23A and 23B of the Federal Reserve Act. An affiliate of a depository institution is any company or entity that controls, is controlled by or is under common control with the institution. In a holding company context, the parent holding company of a depository institution and any companies which are controlled by such parent holding company are affiliates of the depository institution. Generally, Sections 23A and 23B (i) limit the extent to which the depository institution or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the savings institution or the subsidiary as those provided to a nonaffiliate. The term "covered transaction" includes the making of loans or other extensions of credit to an affiliate, the purchase of assets from an affiliate, the purchase of, or an investment in, the securities of an affiliate, the acceptance of securities of an affiliate as collateral for a loan or extension of credit to any person, or issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. In addition to the restrictions imposed by Sections 23A and 23B, no depository institution may (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities that are permissible for bank holding companies, or (ii) purchase or invest in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates that are subsidiaries of the institution. Additionally, the FDIC has provided advance notice of a proposed rule- making which would affect contracts between a bank holding company, such as the Corporation, or its non-depository subsidiaries or related interests under common control, and its insured depository institution affiliates, such as the Banking Subsidiaries. The FDIC proposed establishing a rebuttable regulatory presumption that certain types of contracts between an insured depository institution and any company which directly or indirectly controls it (or which is under common control with it) are unsafe and unsound. The types of contracts to be covered by such a presumption would include those relating to: (1) making or purchasing loans, (2) servicing loans, (3) performing trust functions, (4) providing bookkeeping or data processing services, (5) furnishing management services, (6) selling or transferring any department or subsidiary, (7) payments for intangible assets, (8) transferring any asset for less than fair market value as evidenced by an independent written appraisal, or (9) prepaying any liability more than 30 days prior to its due date. The FDIC also has proposed regulations which would prohibit any insured depository institution from entering into any contract with any person to provide goods, products or services if such contract is determined to adversely affect the safety or soundness of the insured institution. The Corporation cannot determine at this point the impact these proposed rules would have upon it and the Banking Subsidiaries if they are adopted in their currently proposed form. Section 4(i) of the BHCA authorizes the FRB to approve the application of a bank holding company to acquire any savings institution under Section 4(c)(8) of the BHCA. In approving such an application, the FRB is precluded from imposing any restrictions on transactions between the bank holding company and the acquired savings institution, except as required by Section 23A or 23B of the Federal Reserve Act or any other applicable law. Further, the FDIA, as amended by the 1991 Banking Law, authorizes the merger or consolidation of any BIF member with any SAIF member, the assumption of any liability by any BIF member to pay any deposits of any SAIF member or vice versa, or the transfer of any assets of any BIF member to any SAIF member in consideration for the assumption of liabilities of such BIF member or vice versa, provided that certain conditions are met and, in the case of any acquiring, assuming or resulting depository institution which is a BIF member, such institution continues to make payment of SAIF assessments on the portion of liabilities attributable to any acquired, assumed or merged SAIF-insured institution. As a result of the Corporation's ownership of Security Bank, in 1983 the Corporation was registered under the bank holding company laws of North Carolina. Accordingly, the Corporation and the Subsidiaries are also subject to regulation by the North Carolina Commissioner of Banks (the "N.C. Commissioner"). The N.C. Commissioner has asserted authority to examine North Carolina bank holding companies and their affiliates and is in the process of formulating regulations in this area. Further, as a result of its ownership of the Savings Banks, the Corporation is also registered under the savings bank holding company laws of North Carolina. Thus, it is also subject to regulation and supervision by the North Carolina Administrator of Savings Institutions (the "N.C. Administrator"). Security Bank. Security Bank is organized as a North Carolina chartered commercial bank and is subject to various statutory requirements and to rules and regulations promulgated and enforced by the N.C. Commissioner and the FDIC. Its deposits are insured by the BIF. North Carolina commercial banks, such as Security Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. Prior approval of the N.C. Commissioner is required if the total of all dividends declared by Security Bank in any calendar year exceeds its net profits (as defined by statute) for that year combined with its retained net profits (as defined by statute) for the preceding two calendar years, less any required transfers to surplus. Also, under the 1991 Banking Law an insured depository institution, such as Security Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become "undercapitalized" (as such term is defined in the statute). Based on its current financial condition, the Corporation does not expect that this provision will have any impact on Security Bank's ability to pay dividends. As a North Carolina chartered, FDIC-insured commercial bank which is not a member of the Federal Reserve System, Security Bank is subject to capital requirements imposed by the FDIC. Under the FDIC's regulations, state nonmember banks that (a) receive the highest rating during the examination process and (b) are not anticipating or experiencing any significant growth, are required to maintain a minimum leverage ratio of 3% of Tier I capital to average total consolidated assets; all other banks are required to maintain a minimum ratio of 1% or 2% above the stated minimum, with a minimum leverage ratio of not less than 4%. As of December 31, 1993, the leverage ratio of Security Bank was 13.17%. The following table sets forth Security Bank's regulatory capital position at December 31, 1993: Leverage Capital Risk-Based Capital Amount % of Assets Amount % of Assets (Dollars in Thousands) Actual $ 49,901 13.17% $ 51,749 35.23% Minimum capital standard 11,366 3.00 11,752 8.00 Excess of actual regulatory capital over minimum regulatory capital standard $ 38,535 10.17% $ 39,997 27.23% As a BIF-insured institution, Security Bank is also subject to insurance assessments imposed by the FDIC. Under current law, as amended by the 1991 Banking Law, the insurance assessment to be paid by BIF-insured institutions shall be as specified in a schedule required to be issued by the FDIC that would specify, at semiannual intervals, target reserve ratios designed to increase the reserve ratio to 1.25% of estimated insured deposits (or such higher ratio as the FDIC may determine in accordance with the statute) in 15 years. Further, the FDIC is authorized, under the 1991 Banking Law, to impose one or more special assessments in any amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the Treasury Department. Effective January 1, 1993, the FDIC replaced the uniform assessment rate with a transitional risk-based assessment schedule which became fully effective in January 1994, having assessments ranging from 0.23% to 0.31% of an institution's average assessment base. The actual assessment to be paid by each BIF member is based on an institution's assessment risk classification, which is determined based on whether the institution is considered "well capitalized," "adequately capitalized" or "under capitalized," as such terms have been defined in applicable federal regulations adopted to implement the prompt corrective action provisions of the 1991 Banking Law, and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. See "Impact of the 1991 Banking Law." As a result of the provisions of the 1991 Banking Law, the assessment rate on deposits could increase significantly over the next 15 years. Based on the current financial condition and capital levels of Security Bank, the Corporation does not expect that the transitional risk-based assessment schedule will have a material impact on Security Bank's future earnings. Further, under current federal law, depository institutions are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act with respect to loans to directors, executive officers and principal stockholders. Under Section 22(h), loans to directors, executive officers and stockholders who own more than 10% of a depository institution (18% in the case of institutions located in an area with less than 30,000 in population), and certain affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the institution's loan-to-one-borrower limit as established by federal law (as discussed below). Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and shareholders who own more than 10% of an institution, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the institution. Any "interested" director may not participate in the voting. The FRB has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, pursuant to Section 22(h), the FRB requires that loans to directors, executive officers, and principal shareholders be made on terms substantially the same as offered in comparable transactions to other persons. Security Bank is subject to FDIC-imposed loan-to-one-borrower limits which are substantially the same as those applicable to national banks. Under these limits, no loans and extensions of credit to any borrower outstanding at one time and not fully secured by readily marketable collateral shall exceed 15% of the unimpaired capital and unimpaired surplus of the bank. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of unimpaired capital and unimpaired surplus. These limits also authorize banks to make loans to one borrower, for any purpose, in an amount not to exceed $500,000. As of December 31, 1993, the largest aggregate amount of loans which Security Bank had to one borrower was $1.9 million. Management does not believe that any of Security Bank's outstanding loans violate the applicable loans-to-one-borrower limits or that these limits will have a significant impact on Security Bank's business, operations or earnings. Regulations promulgated by the FDIC pursuant to the 1991 Banking Law place limitations on the ability of insured depository institutions to accept, renew or roll over deposits by offering rates of interest which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution's normal market area. Under these regulations, "well capitalized" depository institutions may accept, renew or roll such deposits over without restriction, "adequately capitalized" depository institutions may accept, renew or roll such deposits over with a waiver from the FDIC (subject to certain restrictions on payments of rates) and "undercapitalized" depository institutions may not accept, renew or roll such deposits over. The regulations contemplate that the definitions of "well capitalized," "adequately capitalized" and "undercapitalized" will be the same as the definition adopted by the agencies to implement the corrective action provisions of the 1991 Banking Law. See "Impact of the 1991 Banking Law." Management does not believe that these regulations will have a materially adverse effect on the current operations of Security Bank. Security Bank is subject to examination by the FDIC and the N.C. Commissioner. FSCC, the consumer finance company subsidiary of Security Bank, is also subject to such examination. In addition, Security Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking. Security Bank, as an insured North Carolina commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) Security Bank is, and continues to be, in compliance with all applicable capital standards. Under Chapter 53 of the North Carolina General Statutes, if the capital stock of a North Carolina commercial bank is impaired by losses or otherwise, the N.C. Commissioner is authorized to require payment of the deficiency by assessment upon the bank's shareholders, pro rata, and to the extent necessary, if any such assessment is not paid by any shareholder, upon 30 days notice, to sell as much as is necessary of the stock of such shareholder to make good the deficiency. The Corporation is the sole shareholder of Security Bank. The Savings Banks. The Savings Banks are North Carolina-chartered savings banks and members of the FHLB system (the "FHLB System"). Their deposits are insured by the FDIC through the SAIF. They are subject to examination and regulation by the FDIC and the N.C. Administrator and to regulations governing such matters as capital standards, mergers, establishment of branch offices, subsidiary investments and activities, and general investment authority. North Carolina enacted the Savings Bank Act, Ch. 54C of the North Carolina General Statutes ("Chapter 54C"), effective October 1, 1991. Chapter 54C created a state savings bank ("SSB") charter. An SSB is a North Carolina chartered financial institution regulated by the FDIC and the N.C. Administrator, but not by the OTS, with its deposit accounts insured by either the SAIF or the BIF of the FDIC. Each of the Savings Banks converted to an SSB charter on December 1, 1992 (the "Conversions") in order to reduce the regulatory cost and burden imposed by the overlapping regulatory jurisdiction of the three agencies under whose regulation they operated as federal savings banks. The Conversions are expected to reduce substantially the amounts that the Savings Banks would otherwise pay to OTS in assessments, application and securities filing fees. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") effected a major restructuring of the federal regulatory scheme applicable to financial institutions. Among other things, FIRREA abolished the Federal Home Loan Bank Board and Federal Savings and Loan Insurance Corporation, many of the previous regulatory functions of which are now under the control of the OTS and the FDIC. Regulatory functions relating to deposit insurance and to conservatorships and receiverships of federally insured financial institutions, including savings banks, are now exercised by the FDIC. FIRREA contains provisions affecting numerous aspects of the operations and regulation of federally insured savings banks and empowers the FDIC to promulgate regulations implementing the provisions of FIRREA, including regulations defining certain terms used in the statute as well as regulations exercising or defining the limits of regulatory discretion conferred by the statute. Prior to their Conversions, the Savings Banks were regulated by the OTS in addition to the FDIC and the N.C. Administrator. Consequently, they were subject to various operating requirements and restrictions imposed by the OTS. Additionally, they were regulated by the N.C. Administrator under North Carolina law as savings and loan associations rather than as savings banks. The following discussion sets forth the regulatory requirements and restrictions to which the Savings Banks became subject upon their Conversions. As SAIF-insured institutions, the Savings Banks are also subject to insurance assessments imposed by the FDIC. Under current law, as amended by the 1991 Banking Law, the insurance assessment paid by SAIF-insured institutions must be the greater of 0.15% of the institution's average assessment base (as defined) or such rate as the FDIC, in its sole discretion, determines to be appropriate to be able to increase (or maintain) the reserve ratio to 1.25% of estimated insured deposits (or such higher ratio as the FDIC may determine in accordance with the statute) within a reasonable period of time. Through December 31, 1993, the assessment rate could not be less than 0.23% of the institution's average assessment base, and from January 1, 1994 through December 31, 1997, the assessment rate must not be less than 0.18% of the institution's average assessment base. In each case the assessment rate may be higher if the FDIC, in its sole discretion, determines such higher rate to be appropriate. Effective January 1, 1993, the annual assessment rate is determined pursuant to the transitional risk-based assessment schedule issued by the FDIC pursuant to the 1991 Banking Law, which imposes assessments ranging from 0.23% to 0.31% of an institution's average assessment base. The actual assessment to be paid by each SAIF member will be based on the institution's assessment risk classification, which will be determined based on whether the institution is considered "well capitalized," "adequately capitalized" or "undercapitalized" (as such terms have been defined in federal regulations adopted to implement the prompt corrective action provisions of the 1991 Banking Law), and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. See "Impact of the 1991 Banking Law." The Savings Banks do not anticipate any material increase in their insurance assessments. Upon their Conversions, the Savings Banks ceased to be subject to the capital requirements of the OTS and became subject to the capital requirements of the FDIC and the N.C. Administrator. The FDIC requires each of the Savings Banks to have a minimum leverage ratio of Tier I capital to average total assets of at least 3%; provided, however, that all institutions, other than those (i) receiving the highest rating during the examination process and (ii) not anticipating or experiencing any significant growth, are required to maintain a ratio of 1% or 2% above the stated minimum, with a minimum leverage ratio of not less than 4%. The FDIC also requires each of the Savings Banks to have a ratio of total capital to risk-weighted assets of at least 8%. The FDIC leverage and risk-based capital ratio calculations and components are very similar to the OTS core capital and risk-based capital requirements, respectively. The FDIC, however, does not impose a tangible capital requirement. The N.C. Administrator requires a net worth equal to at least 5% of total assets. At December 31, 1993, each of the Savings Banks complied with the net worth requirements of the N.C. Administrator: OMNIBANK, 12.97%; Citizens, 9.92%; and, Home Savings, 8.05%. The following table sets forth the consolidated FDIC regulatory capital positions of OMNIBANK, Citizens and Home Savings as of December 31, 1993: Leverage Capital Risk-Based Capital Amount % of Assets Amount % of Assets (Dollars in Thousands) Actual $ 59,140 10.93% $ 62,837 21.30% Minimum capital standard 16,239 3.00 23,599 8.00 Excess of actual regulatory capital over minimum regulatory capital standard $ 42,901 7.93% $ 39,238 13.30% The FHLB System provides a central credit facility for member institutions. As members of the FHLB of Atlanta, each of the Savings Banks are required to own capital stock in the FHLB of Atlanta in an amount at least equal to the greater of 1% of the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations at the end of each calendar year, or 5% of its outstanding advances (borrowings) from the FHLB of Atlanta. As of December 31, 1993, each of the Savings Banks was in compliance with this requirement. FIRREA has had the effect of significantly reducing the dividends that Savings Banks receive on their stock in the FHLB of Atlanta. FIRREA requires each FHLB to transfer a certain amount of its reserves and undivided profits to the Resolution Funding Corporation ("RECORP"), the government entity established to raise funds to resolve troubled savings association cases, in order to fund the principal and a portion of the interest on RECORP bonds and certain other obligations. In addition, FIRREA requires each FHLB to transfer a percentage of its annual net earnings to the Affordable Housing Program. That amount will increase from 5% of the annual net income of the FHLB in 1990 to at least 10% of its annual net income in 1995 and subsequent years. As a result of these FIRREA requirements, it is anticipated that the FHLB of Atlanta's earnings will be reduced and that each of the Savings Banks will continue to receive reduced dividends on its FHLB of Atlanta stock in future periods. FRB regulations adopted pursuant to the Depository Institutions Deregulation and Monetary Control Act of 1980 require savings associations and savings banks to maintain reserves against their transaction accounts (primarily negotiable order of withdrawal accounts) and certain nonpersonal time deposits. The reserve requirements are subject to adjustment by the FRB. As of December 31, 1993, each of the Savings Banks was in compliance with the applicable reserve requirements of the FRB. Upon their Conversions, the Savings Banks ceased to be subject to OTS liquidity requirements and became subject to the N.C. Administrator's requirement that the ratio of liquid assets to total assets equal at least 10%. The computation of liquidity under North Carolina regulation allows the inclusion of mortgage-backed securities and investments which, in the judgment of the N.C. Administrator, have a readily marketable value, including investments with maturities in excess of five years. On December 31, 1993, the liquidity ratios of the Savings Banks exceeded the requirements of the N.C. Administrator and were as follows: OMNIBANK, 20.39%; Citizens, 34.94%; and, Home Savings, 31.75%. The Savings Banks also are subject to loan-to-one-borrower limits which are substantially the same as those applicable to Security Bank. Additionally, under these limits, a savings bank is authorized to make loans to one borrower to develop domestic residential housing units, not to exceed the lesser of $30 million or 30% of the savings bank's unimpaired capital and unimpaired surplus, provided that (i) the purchase price of each single-family dwelling in the development does not exceed $500,000; (ii) the savings bank is in compliance with its fully phased-in capital requirements; (iii) the loans comply with the applicable loan-to-value requirements; (iv) the aggregate amount of loans made under this authority does not exceed 150% of unimpaired capital and surplus and (v) either the savings bank's regulator issues an order permitting the savings bank to use the higher limit or the savings bank meets the requirements for "expedited treatment." A savings bank meets the requirements of "expedited treatment" if, among other things, it has a composite MACRO rating of 1 or 2, a Community Reinvestment Act rating of satisfactory or better, and has not been notified by supervisory personnel that it is a problem institution or an institution in troubled condition. These limits also authorize a savings institution to make loans to one borrower to finance the sale of real property acquired in satisfaction of debts in an amount up to 50% of unimpaired capital and surplus. As North Carolina chartered savings banks, the Savings Banks are subject under North Carolina law to the same loans-to-one-borrower restrictions as are described above. However, if North Carolina loans-to-one-borrower limitations were to be made less stringent than the restrictions set forth above, the Savings Banks would still be subject to the above described restrictions pursuant to FDIC regulations. As of December 31, 1993, the largest aggregate amount of loans which the Savings Banks had to any one borrower was as follows: OMNIBANK, $3.13 million; Citizens, $2.21 million; and, Home Savings, $1.05 million. None of the Savings Banks had loans outstanding which management believes violate the applicable loans-to-one-borrower limits. The Corporation does not believe that the loans-to-one-borrower limits will have a significant impact on the Savings Banks' business, operations or earnings. The Savings Banks are subject to the same FDIC regulations as Security Bank regarding the ability of insured depository institutions to accept, renew, or roll over deposits offering rates of interest significantly higher than generally prevailing market rates. Management does not believe these regulations will have a materially adverse effect on the current operations of the Savings Banks. As North Carolina-chartered savings banks, the Savings Banks are subject to North Carolina law which requires that at least 60% of their respective assets be investments that qualify under certain Internal Revenue Service guidelines. As of December 31, 1993, each Savings Bank was in compliance with the North Carolina law. Recent FDIC law and regulations generally provide that state-chartered savings banks may not engage as principal in any type of activity, or in any activity in an amount, not permitted for national banks, or directly acquire or retain any equity investment of a type or in an amount not permitted for national banks. The FDIC has authority to grant exceptions from these prohibitions (other than with respect to non-service corporation equity investments) if it determines no significant risk to the SAIF is posed by the amount of the investment or the activity to be engaged in and if the savings bank is and continues to be in compliance with fully phased-in capital standards. National banks are generally not permitted to hold equity investments other than shares of service corporations and certain federal agency securities. Moreover, the activities in which service corporations are permitted to engage are limited to those of service corporations for national banks. FIRREA generally prohibits any savings institution (state or federal) from directly or indirectly acquiring or retaining any corporate debt security that is not of investment grade (generally referred to as "junk bonds'). Any savings institution that held corporate debt securities not of investment grade prior to August 9, 1989 is required to divest those securities as quickly as can be prudently done, but in no event later than July 1, 1994, and must file an application setting forth its plans for divestiture with the FDIC. At December 31, 1993, none of the Savings Banks owned any corporate debt securities not of investment grade for which such divestiture would be required. Additionally, FDIC regulations impose restrictions on the lending limits of state-chartered savings banks, including percentage limitations on the total investment in various types of loans, including limitations which (i) limit total non-residential real estate loans to 400% of capital, (ii) limit total commercial, corporate, business or agricultural loans to 10% of assets, and (iii) limit total consumer loans, commercial paper and corporate debt securities to 35% of assets. Each Savings Bank was in compliance with such requirements as of December 31, 1993. FIRREA also generally requires any savings institution that proposes to establish or acquire a new subsidiary, or to conduct new activities through an existing subsidiary, to notify the FDIC at least 30 days prior to the establishment or acquisition of any subsidiary, or at least 30 days prior to conducting any such new activity. Any such activities must be conducted in accordance with the regulations and orders of the FDIC and the N.C. Administrator. As North Carolina chartered savings banks, the Savings Banks derive their authority from, and are regulated by, the N.C. Administrator. The N.C. Administrator has the right to promulgate rules and regulations necessary for the supervision and regulation of state savings banks under his jurisdiction and for the protection of the public investing in such institutions. The regulatory authority of the N.C. Administrator includes, but is not limited to, the establishment of reserve requirements; the regulation of the payment of dividends; the regulation of incorporators, shareholders, directors, officers and employees; the establishment of permitted types of withdrawable accounts and types of contracts for savings programs, loan and investments; and, the regulation of the conduct and management of savings banks, chartering and branching of institutions, mergers, conversions and conflicts of interest. North Carolina law requires that the Savings Bank maintain federal deposit insurance as a condition of doing business. The N.C. Administrator conducts regular annual examinations of the Savings Banks as well as other state-chartered savings institutions in North Carolina. The purpose of such examinations is to assure that institutions are being operated in compliance with applicable North Carolina law and regulations and in a safe and sound manner. These examinations are usually conducted on a joint basis with the FDIC. In addition, the N.C. Administrator is required to conduct an examination of any institution when he has good reason to believe the standing and responsibility of the institution is of doubtful character or when he otherwise deems it prudent. The N.C. Administrator is empowered to order the revocation of the license of an institution if he finds that it has violated or is in violation of any North Carolina law or regulation and that revocation is necessary in order to preserve the assets of the institution and protect the interest of its depositors. The N.C. Administrator has the power to issue cease and desist orders if any person or institution is engaging in, or has engaged in , any unsafe or unsound practice or unfair and discriminatory practice in the conduct of its business or in violation of any other law, rule or regulation. A North Carolina chartered savings bank must maintain net worth of 5% of total assets and liquidity of 10% of total assets, as discussed above. Additionally, a North Carolina chartered savings bank is required to maintain general valuation allowances and specific loss reserves in the same amounts as required by the federal regulators. A North Carolina chartered stock savings bank may not declare or pay a cash dividend on, or repurchase any of, its capital stock if the effect of such transaction would be to reduce the net worth of the institution to an amount which is less than the minimum amount required by applicable federal and state regulations. Accordingly, each of the Savings Banks is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, it would become "undercapitalized" (as such term is defined in the 1991 Banking Law). In addition, each of the Savings Banks is also subject to the restriction that it is not permitted to declare or pay a cash dividend on or repurchase any of its capital stock if the effect thereof would be to cause its net worth to be reduced below the amount for the liquidation account established in connection with its conversion from mutual to stock form. Subject to limitations established by the N.C. Administrator, North Carolina-chartered savings banks may make any loan or investment or engage in any activity which is permitted to federally chartered savings institutions. In addition to such lending authority, North Carolina-chartered savings banks are authorized to invest funds, in excess of loan demand, in certain statutorily permitted investments, including but not limited to (i) obligations of the United States, or those guaranteed by it; (ii) obligations of the State of North Carolina; (iii) bank demand or time deposits; (iv) stock or obligations of the federal deposit insurance fund or FHLB; (v) savings accounts of any savings and loan association as approved by the board of directors; and (vi) stock or obligations of any agency of the State of North Carolina or of the United States or of any corporation doing business in North Carolina whose principal business is to make education loans. North Carolina law provides a procedure by which savings institutions may consolidate or merge, subject to the approval of the N.C. Administrator. The approval is conditioned upon findings by the N.C. Administrator that, among other things, such merger or consolidation will promote the best interests of the members or shareholders of the merging institutions. North Carolina law also provides for simultaneous mergers and conversions and for supervisory mergers conducted by the N.C. Administrator. Impact of the 1991 Banking Law. The 1991 Banking Law was signed into law on December 19, 1991. Among other things, the 1991 Banking Law provides increased funding for the BIF and the SAIF, and provides for expanded regulation of depository institutions and their affiliates, including parent holding companies. The 1991 Banking Law provides authority for special assessments against insured deposits and for the development of a general risk-based deposit insurance assessment system which the FDIC implemented on a transitional basis effective January 1, 1993. The BIF and SAIF funding provisions could result in a significant increase in the assessment rate on deposits of BIF and SAIF institutions over the next 15 years. No assurance can be given at this time as to what level of assessments against insured deposits will be during this 15-year period. Effective one year after its enactment, the 1991 Banking Law provides the federal banking agencies with broad powers to take corrective action to resolve the problems of insured depository institutions. The extent of these powers will depend upon whether the institutions in question are "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." In September 1992, each of the federal banking agencies issued final uniform regulations to be effective December 19, 1992, which define such capital levels. Under the final regulations, an institution is considered "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier I risk- based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An "adequately capitalized" institution is defined as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier I risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of an institution with the highest examination rating). An institution is considered (A) "undercapitalized" if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating; (B) "significantly undercapitalized" if the institution has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3% and (C) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets equal to or less than 2%. The 1991 Banking Law also amended the prior law with respect to the acceptance of brokered deposits by insured depository institutions to permit only a "well capitalized" (as defined in the statute as significantly exceeding each relevant minimum capital level) depository institution to accept brokered deposits without prior regulatory approval. In June 1992, the FDIC issued final regulations implementing these provisions regulating brokered deposits. Under the regulations, "well-capitalized" banks may accept brokered deposits without restrictions, "adequately capitalized" banks may accept brokered deposits with a waiver from the FDIC (subject to certain restrictions on payment of rates), while "under-capitalized" banks may not accept brokered deposits. The regulations contemplate that the definitions of "well capitalized," "adequately capitalized" and "under capitalized" are the same as the definitions adopted by the agencies to implement the prompt corrective action provisions of the 1991 Banking Law (as described in the previous paragraph). The Corporation does not believe that these regulations have had or will have a material adverse effect on the current operations of its Banking Subsidiaries. To facilitate the early identification of problems, the 1991 Banking Law requires the federal banking agencies to review and, under certain circumstances, prescribe more stringent accounting and reporting requirements than those required by generally accepted accounting principles. In September 1992, the FDIC issued a notice of proposed rulemaking implementing those provisions. The proposed rule, among other things, would require that management report on the institution's responsibility for preparing financial statements and establishing and maintaining an internal control structure and procedures for financial reporting and compliance with laws and regulations concerning safety and soundness, and that independent auditors attest to and report separately on assertions in management's reports concerning compliance with such laws and regulations, using FDIC-approved audit procedures. The 1991 Banking Law further requires the federal banking agencies to develop regulations requiring disclosure of contingent assets and liabilities and, to the extent feasible and practicable, supplemental disclosure of the estimated fair market value of assets and liabilities. The 1991 Banking Law also requires annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well- capitalized institutions and state chartered institutions examined by state regulators. Moreover, the federal banking agencies are required to set operational and managerial, asset quality, earnings and stock valuation standards for insured depository institutions and depository institution holding companies, as well as compensation standards for insured depository institutions that prohibit excessive compensation, fees or benefits to officers, directors, employees, and principal shareholders. In July 1992, the federal banking agencies issued a joint advance notice of proposed rulemaking soliciting comments on all aspects of the implementation of these standards in accordance with the 1991 Banking Law, including whether the compensation standards should apply to depository institution holding companies. The foregoing necessarily is a general description of certain provisions of the 1991 Banking Law and does not purport to be complete. Several of the provisions of the 1991 Banking Law will be implemented through regulations issued by the various federal banking agencies, only a portion of which have been adopted in final form. Several of the significant provisions of the legislation will not become effective until one year or more after enactment. The effect of the 1991 Banking Law on the Corporation and its Subsidiaries will not be full ascertainable until after all of the provisions are effective and after all of the regulations are adopted. Taxation Federal Income Taxation. The Corporation files a consolidated federal income tax return with its Subsidiaries. The Banking Subsidiaries are subject to the taxing provisions of the Internal Revenue Code of 1986, as amended ("Code"), for corporations, as modified by certain provisions of accounting. Thrift institutions, which qualify under certain definitional tests and other conditions of the Code, are permitted certain favorable provisions regarding their deductions from taxable income for annual additions to their bad debt reserve. A reserve may be established for bad debts on qualifying real property loans (generally loans secured by interests in real property improved or to be improved) under (i) a method based on a percentage of the institution's taxable income, as adjusted (the "percentage of taxable income method") or (ii) a method based on actual loss experience (the "experience method"). Nonqualifying loans are computed on the experience method. The Savings Banks generally compute their additions to their reserves using the percentage of taxable income method. The percentage of taxable income method is limited to 8% of taxable income. This method may not raise the reserve to exceed 6% of qualifying real property loans at the end of the year. Moreover, the additions for qualifying real property loans, when added to nonqualifying loans, cannot exceed 12% of the amount by which total deposits or withdrawable accounts exceed the sum of surplus, undivided profits and reserves at the beginning of the year. The experience method is the amount necessary to increase the balance of the reserve at the close of the year to the greater of (i) the amount which bears the same ratio to loans outstanding at the close of the year as the total net bad debts sustained during the current and five preceding years bear to the sum of the loans outstanding at the close of such six years or (ii) the balance in the reserve account at the close of the last taxable year beginning before 1988 (assuming that the loans outstanding have not declined since such date). In order to qualify for the percentage of income method, an institution must have at least 60% of its assets as "qualifying assets" which generally include cash, obligations of the U.S. government or an agency or instrumentality thereof or a state or political subdivision, residential real estate-related loans, or loans secured by savings accounts and property used in the conduct of its business. In addition, it must meet certain other supervisory tests and operate principally for the purpose of acquiring savings and investing in loans. Institutions which become ineligible to use the percentage of income method must change to either the reserve method or the specific charge-off method that apply to banks. Proposed regulations require ratable inclusion in income of excess reserves over a six-year period in the event of ineligibility. Large banks, those generally exceeding $500 million in assets, must convert to the specific charge-off method. Bad debt reserve balances in excess of the balance computed under the experience method or amounts maintained in a supplemental reserve built up prior to 1962 ("excess bad debt reserve") require inclusion in taxable income upon certain distributions to its shareholders. Distributions in redemption or liquidation or stock or distributions with respect to its stock in excess of earnings and profits accumulated in years beginning after December 31, 1951, are treated as a distribution from the excess bad debt reserve. When such a distribution takes place and it is treated as from the excess bad debt reserve, the thrift is required to reduce its reserve by such amount and simultaneously recognize the amount as an item of taxable income increased by the amount of income tax imposed on the inclusion. Dividends not in excess of earnings and profits accumulated since December 31, 1951 will not require inclusion of part or all of the bad debt reserve in taxable income. Each of the Savings Banks has accumulated earnings and profits since December 31, 1951 and has an excess in its bad debt reserve. Distributions in excess of current and accumulated earnings and profits will increase taxable income. Security Bank traditionally has maintained its reserve using the experience method described above. As a commercial bank, Security Bank's use of the experience method is subject to the limitation based upon $500 million in total assets. The Corporation's and Omni's income tax returns for tax years subsequent to 1989 are subject to examination. The Corporation's federal income tax return for the year ended December 31, 1991 was examined during 1993 and its federal income tax return for the year ended December 31, 1992 is currently under examination. State and Local Taxation. Under North Carolina law, the corporate income tax is 7.75% of federal taxable income as computed under the Code, subject to certain prescribed adjustments. In addition, for tax years beginning in 1992, 1993 and 1994, a corporate taxpayer must pay a surtax equal to 3%, 2% and 1%, respectively, of the state income tax otherwise payable by it. An annual state franchise tax is imposed at a rate of 0.15% applied to the greatest of the institutions' (i) capital stock, surplus and undivided profits, (ii) investment in tangible property in North Carolina, or (iii) appraised valuation of property in North Carolina. Accounting Matters Postemployment Benefits. In November 1992 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("Statement 112"), which is effective for fiscal years beginning after December 15, 1993. Statement 112 establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement (referred to in this statement as postemployment benefits). Those benefits include, but are not limited to, salary continuation, supplemental unemployment benefits, severance benefits, continuation of benefits such as health care benefits and life insurance coverage, etc. The Corporation has not determined the effect, if any, of Statement 112 on its consolidated financial statements. Accounting by Creditors for Impairment of a Loan. The FASB has issued Standard No. 114, "Accounting by Creditors for Impairment of a Loan," which requires that all creditors value all specifically reviewed loans for which it is probable that the creditor will be unable to collect all amounts due according to the terms of the loan agreement at either the present value of expected cash flows discounted at the loan's effective interest rate, or if more practical, the market price or value of collateral. This Standard is required for fiscal years beginning after December 15, 1994. The Corporation has not determined the impact, if any, of this Standard on its consolidated financial statements. Accounting for Certain Investments in Debt and Equity Securities. The FASB has issued Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," that requires debt and equity securities held: (i) to maturity be classified as such and reported at amortized cost; (ii) for current resale be classified as trading securities and reported at fair value, with unrealized gains and losses included in current earnings; and (iii) for any other purpose be classified as securities available for sale and reported at fair value, with unrealized gains and losses excluded from current earnings and reported as a separate component of stockholders' equity. It is required for fiscal years beginning after December 15, 1993. The Corporation will adopt Standard No. 115 as of January 1, 1994. In connection with this adoption, the Corporation anticipates that approximately $324,500 of investment securities will be classified as securities available for sale. As of December 31, 1993, these securities had unrealized securities gains of approximately $6,100, which would result in an unrealized securities gain, net of income tax effects, of approximately $4,100 being recorded as an increase to stockholders' equity on the date of adoption. Stock-based Compensation. The FASB has issued an Exposure Draft for a proposed SFAS entitled "Accounting for Stock-based Compensation" which addresses the recognition and measurement of stock-based compensation paid to employees, including employee stock options, restricted stock, and stock appreciation rights. Employers would be required to recognize a charge to earnings for such awards, whereas generally no charge is recognized under current accounting practices. Compensation expense would be measured as the fair value of the award at the grant date with subsequent adjustments made to reflect the outcome of certain service or performance assumptions made at the date of grant but not for effects of subsequent changes in the price of the entity's stock. Disclosure provisions of the proposed statement would be effective for fiscal years beginning after December 31, 1993 with recognition provisions being effective for awards granted after December 31, 1996. ITEM 2 ITEM 2 - PROPERTIES The Corporation's principal office is located at 507 West Innes Street, Salisbury, North Carolina 28144. The main administrative and executive office of OMNIBANK are also located at the same address. The executive office of Security Bank is located at 215 South Main Street, Salisbury, North Carolina 28144; the executive office of Citizens is located at 31 Union Street (North), Concord, North Carolina 28082; and, the executive office of Home Savings is located at 700 West Kings Street, Kings Mountain, North Carolina 28086. Of the Corporation's 47 banking, insurance, and consumer finance locations, 42 are located on real property owned by the related Subsidiary, 5 of the facilities are located on leased land and 5 of the facilities occupy leased quarters. FCC also owns and maintains a facility for operations, data processing and related activities. During 1993, the Corporation paid aggregate rents of approximately $39,000 for utilization of leased premises. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS In the opinion of management, neither the Corporation nor any Subsidiary is involved in any pending legal proceedings other than routine, non-material proceedings occurring in the ordinary course of business. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the Corporation's shareholders during the quarter ended December 31, 1993. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Corporation's outstanding common stock is qualified for quotation on the National Market System of the National Association of Securities Dealers Automated Quotation system under the symbol "SCBC." As of March 7, 1994, the approximate number of shareholders of record of the Corporation was 3,200. Common stock market prices and cash dividends are set forth on page 4 of the Annual Report to Shareholders for the year ended December 31, 1993 (the "Annual Report") and are incorporated herein by reference. See Item 1 above for potential regulatory restrictions upon the Banking Subsidiaries' payments of dividends to the Corporation. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA The information contained under the heading "Selected Financial Data" on page 1 of the Annual Report is incorporated herein by reference. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information contained on pages 5 through 27 and pages 41 and 42 of Item 1 above and the information contained under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 5 through 7 of the Annual Report are incorporated herein by reference. ITEM 8 ITEM 8 - CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Corporation included in the Annual Report are incorporated herein by reference: Annual Report Page Number Independent Auditors' Report 27 Consolidated Balance Sheets - 8 December 31, 1993 and 1992 Consolidated Statements of Income - Years ended 9 December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity - 10 Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years ended 11 December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 12-26 ITEM 9 ITEM 9 - CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth on pages 2 through 6 of the Proxy Statement regarding the Corporation's Annual Meeting of Shareholders on April 28, 1994 (the "Proxy Statement") is incorporated herein by reference. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION The information set forth on pages 9 through 15 of the Proxy Statement is incorporated herein by reference. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth on pages 7-8 and 10 of the Proxy Statement is incorporated herein by reference. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth on page 16 of the Proxy Statement is incorporated herein by reference. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements The following consolidated financial statements of the Corporation are included in the Annual Report and are incorporated herein by reference: Independent Auditors' Report Exhibit 13, page 27 Consolidated Balance Sheets - December 31, 1993 and 1992 Exhibit 13, page 8 Consolidated Statements of Income - Years ended December 31, 1993, 1992 and 1991 Exhibit 13, page 9 Consolidated Statements of Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 Exhibit 13, page 10 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 Exhibit 13, page 11 Notes to Consolidated Financial Statements - Exhibit 13, pages 12-26 (2) Financial Statement Schedules All financial statement schedules are omitted because the required information is either not applicable, is immaterial, or is included in the consolidated financial statements of the Corporation and notes thereto. (b) Reports on Form 8-K The Corporation filed reports on Form 8-K on December 17, 1993 and February 1, 1994 regarding the status of its negotiations with Fairfield Communities, Inc. to purchase all of the outstanding stock of First Federal Savings and Loan Association of Charlotte, North Carolina, a Fairfield subsidiary. (c) Exhibits A listing of the exhibits to this Report on Form 10-K is set forth on the Exhibit Index which immediately precedes such exhibits and is incorporated herein by reference. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. SECURITY CAPITAL BANCORP By: David B. Jordan Vice-Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Exhibit Index **************************************************************************** APPENDIX On the Front Cover of Exhibit 13 the Security Capital Bancorp logo appears where noted. On Page 3 of Exhibit 13 a photo of Lloyd G. Gurley, David B. Jordan, Ralph A. Barnhardt and Miles J. Smith, Jr. appears in the upper left hand corner of the page where indicated. Also on Page 3 the signatures of David B. Jordan and Lloyd G. Gurley appear where indicated. On the Back Cover of Exhibit 13 the Security Capital Bancorp logo appears where noted. On the Notice of 1994 Annual Meeting of Shareholders page on Exhibit 23 the Security Capital Bancorp logo appears where noted. Also the signature of Miles J. Smith, Jr. appears where indicated. On Page 1 of Exhibit 23 the Security Capital Bancorp logo appears where noted. On Page 14 of Exhibit 23 the Comparison of Five Year-Cumulative Total Returns graph appears where noted. The plot points are as listed below: On Page 22 of Exhibit 23 the signature of Miles J. Smith, Jr. appears where noted.

97561_1993.txt

97561_1993

1993

97561

ITEM 1. BUSINESS (CONTINUED). REGULATION AND RATES -- (CONTINUED) difference between bonded rates and rates approved in the final order. (See Docket 11735 below, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation and Note 10 to Consolidated Financial Statements.) The fuel cost recovery rule also contains a procedure for an expedited change in the fixed fuel factor in the event of an emergency. Final reconciliation of fuel costs must be made either in a reconciliation proceeding, which may cover no more than three years and no less than one year, or in a general rate case. In a final reconciliation, a utility has the burden of proving that fuel costs under review were reasonable and necessary to provide reliable electric service, that it has properly accounted for its fuel-related revenues, and that fuel prices charged to the utility by an affiliate were reasonable and necessary and not higher than prices charged for similar items by such affiliate to other affiliates or nonaffiliates. In addition, the rule provides for recovery of purchased power capacity costs with respect to purchases from qualifying facilities, to the extent such costs are not otherwise included in base rates. Recovery is made on a monthly basis through a Power Cost Recovery Factor (PCRF). The energy-related costs of such purchases are included in the fixed fuel factor. Penalties of up to 10% will be imposed in the event an emergency increase has been granted when there was no emergency or when collections under the PCRF exceed PCRF costs by 10% in any month or 5% in the most recent twelve months. DOCKET 11735 In January 1993, TU Electric made applications to the PUC (Docket 11735) and to its municipal regulatory authorities for upward adjustments in rates for electric service throughout its service area, which would have increased annual operating revenues by approximately $760 million, or 15.3%, based upon the test year ended June 30, 1992. Such request reflected, among other things, costs associated with Comanche Peak Unit 2, costs associated with Comanche Peak Unit 1 after the end of the Docket 9300 (see below) test year, additional ad valorem taxes and certain postretirement benefit costs. In August 1993, pursuant to rules of the PUC, TU Electric placed its requested rate increase into effect, under bond and subject to refund with interest, applicable to energy sales on and after such date. Revenues were recorded net of an estimated reserve for possible refunds. In October 1993, the PUC issued an order (Order) approving the terms of an agreement (Settlement Agreement) among TU Electric, the General Counsel's office of the PUC and applicable intervenors which, among other things, settled all remaining issues relating to the design, construction and cost of Comanche Peak through commencement of commercial operation of Unit 2. The Settlement Agreement provided for the disallowance in Docket 11735 of $250 million of costs relating to the completion of Comanche Peak. Pursuant to the Order, TU Electric refunded $5 million in fuel charges previously incurred in order to resolve the fuel phase of Docket 11735 under which TU Electric was seeking reconciliation of approximately $4.6 billion of fuel costs incurred during the three year period ended June 30, 1992, under the fuel rule in effect prior to May 1993. Further, in order to resolve the primary issue in another proceeding which resulted from a complaint filed against TU Electric in October 1992 by the General Counsel's office of the PUC, as a result of the Order, TU Electric agreed to write off $83 million of allowance for funds used during construction (AFUDC), which consisted of the amount subject to dispute in such proceeding and similar charges subsequently accrued. Also, under the Settlement Agreement and confirmed in the Docket 11735 final order (see below), TU Electric will recover, ratably over an eight year period, $197 million of operation and ITEM 1. BUSINESS (CONTINUED). REGULATION AND RATES -- (CONTINUED) maintenance expenditures incurred by TU Electric in connection with its recent cost reduction program. However, an additional $25 million of such expenditures will not be subject to recovery and was written off by TU Electric. As a result of the Settlement Agreement, TU Electric recorded a charge against earnings in September 1993 of approximately $363 million ($265 million after tax). On January 28, 1994, the PUC issued a final order in Docket 11735 which provided for a total annual revenue increase of approximately $435 million, or 8.7%. TU Electric strongly disagrees with the final order and has filed a motion for rehearing with the PUC, and will appeal the outcome, if necessary. As a result of this final order, unless the order is changed on rehearing, TU Electric will refund the difference between the bonded rates and the rates approved in the final order, including interest, all of which is being fully reserved by TU Electric. The total amount to be refunded will be determined once approved rates have been implemented, which is expected to be during the second quarter of 1994. The amount to be refunded at December 31, 1993 was approximately $141.2 million. Such refund will be mitigated by a fuel cost surcharge approved by the PUC of approximately $144.5 million, including interest, in under-collected fuel costs through June 30, 1993. (See Fuel Cost Recovery Rule.) In November 1993, an intermediate appellate court in Texas, considering an appeal of another utility's rate case, ruled that utilizing tax benefits generated by costs not allowed in rates to reduce rates charged to customers was required by prior court rulings for all disallowed costs, including capital costs. TU Electric believes that such rulings are erroneous and not consistent with the Texas Public Utility Regulatory Act. According to a Private Letter Ruling issued to TU Electric by the Internal Revenue Service (IRS) with respect to investment tax credits, such ratemaking treatment, to the extent related to property classified for tax purposes as public utility property, would result in a violation of the normalization rules contained in the Internal Revenue Code of 1986, as amended (Code). Violation of the normalization rules would result in a significant adverse effect on TU Electric's results of operation and liquidity. The tax benefits associated with the Comanche Peak costs disallowed in Docket 9300 (see below) could be affected as a result of the court's method. In addition, in its final order in Docket 11735, the PUC reduced rates for the tax benefits generated by certain costs which were not allowed in rates. However, the PUC recognized the potential for a normalization violation if investment tax credits and tax depreciation generated by disallowed plant costs are used to reduce rates. Therefore, the PUC ordered TU Electric to obtain a Private Letter Ruling from the IRS with respect to tax depreciation on disallowed plant. Thus, TU Electric's rates would not reflect the tax depreciation benefit of disallowed plant unless the IRS rules such benefits can be utilized to reduce rates without violating the normalization rules contained in the Code. Such a finding by the IRS would require TU Electric to refund the tax depreciation benefits to its customers. TU Electric does not believe it is likely that such refund will occur if the IRS maintains a position similar to that stated in its previous Private Letter Ruling to TU Electric. DOCKET 9300 In September 1991, the PUC issued a final order in TU Electric's prior rate case (Docket 9300), which provided for a total revenue increase of approximately $442 million and included $695 million of CWIP in rate base to support the revenue increase. It also included a prudence disallowance of $472 million with respect to certain Comanche Peak costs relating to 87.8% of TU Electric's ownership interest in both units of Comanche Peak. With respect to TU Electric's reacquisition of the remaining 12.2% minority owner interests in Comanche Peak, the order included an additional disallowance of $909 million. ITEM 1. BUSINESS (CONTINUED). REGULATION AND RATES -- (CONCLUDED) In November 1991, TU Electric filed a petition in the 250th Judicial District Court of Travis County, Texas, requesting a reversal and remand of the Docket 9300 final order. Other parties to the PUC proceeding also filed appeals with respect to various portions of the order. In September 1992, after a hearing, the Court entered a judgment in the appeals which affirmed the prudence disallowance of $472 million but reversed and remanded to the PUC for reconsideration those portions of the PUC's final order providing for additional disallowances aggregating $884 million with respect to TU Electric's reacquisition of minority owner interests in Comanche Peak. The Court recognized that on remand the PUC may adjust the amount of CWIP included in TU Electric's rate base to be consistent with the PUC's redeterminations regarding the minority owner reacquisitions and the amount of cash working capital. Therefore, TU Electric does not expect this judgment to affect the rates approved in the Docket 9300 final order. Other parties to this suit have appealed this judgment. TU Electric disagrees with certain portions of this judgment and also has appealed. It is unable to predict the outcome of such appeals and any reconsiderations by the PUC. COMPETITION The electric utility industry in general has become, and is expected to be, increasingly competitive due to a variety of regulatory and economic developments. The level of competition is affected by, among other things, price, reliability of service, the cost of energy alternatives, new technologies and governmental regulations. TU Electric and SESCO's electric businesses are exposed to certain competitive forces in varying degrees. TU Electric and SESCO, like the electric industry generally, face increasing competition in the supply of bulk power at wholesale. Electric utilities have historically sought to sell surplus capacity and energy outside their traditional service territories. The Energy Act was designed, among other things, to foster competition in the wholesale market by (a) facilitating, through amendments to the Public Holding Company Act of 1935, the ownership and operation of generating facilities by "exempt wholesale generators" (which may include independent power producers as well as affiliates of electric utilities) and (b) authorizing, through amendments to the Federal Power Act, the FERC under certain conditions to order utilities which own transmission facilities to provide wholesale transmission services to or for other utilities and other entities selling electric energy. While TU Electric and SESCO have experienced competitive pressures in the wholesale market, resulting in a minor loss of load, wholesale sales constitute a relatively low percentage of total sales. See Item 6. Selected Financial Data - - Consolidated Operating Statistics. The legislatures and/or the regulatory commissions in several states have considered or are considering "retail wheeling" which, in general terms, means the transmission by an electric utility of energy produced by another entity over its transmission and distribution system to a retail customer in such utility's service territory. A requirement to transmit directly to retail customers would have the result of permitting retail customers to purchase electric capacity and energy from, at the election of such customers, the electric utility in whose service area they are located or from any other electric utilities or independent power producers. This issue has not been actively pursued in the Texas legislature or by the PUC. ITEM 1. BUSINESS (CONTINUED). COMPETITION -- (CONCLUDED) TU Electric and SESCO generally have the right, through PUC certification, to provide electric service to the public within their service areas. However, some energy consumers in their service areas have the ability to produce their own electricity or use alternative forms of energy. Additionally, TU Electric and SESCO operate in some dually certified areas with other utilities. Neither TU Electric nor SESCO are able to predict the extent of future competitive developments or what impact, if any, such developments may have on their operations. ENVIRONMENTAL MATTERS The System Companies are subject to various federal, state and local regulations dealing with air and water quality and related environmental matters (see Item 2. ITEM 2. PROPERTIES. The Company owns no utility plant or real property. At December 31, 1993, TU Electric owned or leased and operated the following units: The principal generating facilities and load centers of TU Electric are connected by 3,861 circuit miles of 345,000 volt transmission lines and 9,098 circuit miles of 138,000 and 69,000 volt transmission lines. TU Electric is connected by six 345,000 volt lines to Houston Lighting & Power Company; by three 345,000 volt, eight 138,000 volt and nine 69,000 volt lines to West Texas Utilities Company; by two 345,000 volt, seven 138,000 volt and one 69,000 volt lines to the Lower Colorado River Authority; by four 345,000 volt and eight 138,000 volt lines to the Texas Municipal Power Agency; and at several points with smaller systems operating wholly within Texas. SESCO is connected to TU Electric by three 138,000 volt lines, eight 69,000 volt lines and two lines at distribution voltage. TU Electric and SESCO are members of the Electric Reliability Council of Texas (ERCOT), an intrastate network of investor-owned entities, cooperatives and public entities. ERCOT is the regional reliability coordinating organization for member electric power systems in Texas. The generating stations and other important units of property of TU Electric and SESCO are located on lands owned primarily in fee simple. The greater portion of the transmission and distribution lines of TU Electric and SESCO, and of the gas gathering and transmission lines of Fuel Company, has been constructed over lands of others pursuant to easements or along public highways and streets as permitted by law. The rights of the System Companies in the realty on which their properties are located are considered by them to be adequate for their use in the conduct of their business. Minor defects and irregularities customarily found in titles to properties of like size and character may exist, but any such defects and irregularities do not materially impair the use of the properties affected thereby. TU Electric, SESCO and Fuel Company have the right of eminent domain whereby they may, if necessary, perfect or secure titles to privately held land used or to be used in their operations. Utility plant of TU Electric and SESCO is generally subject to the liens of their respective mortgages. ITEM 2. PROPERTIES (CONTINUED). CONSTRUCTION PROGRAM The Company has taken steps to substantially reduce construction expenditures from amounts previously estimated. Such expenditures, excluding AFUDC (see Note 1 to Consolidated Financial Statements), are presently estimated at $400 million for each of the years 1994, 1995 and 1996. The System Companies are subject to federal, state and local regulations dealing with environmental protection (see Item 1. Business--Environmental Matters). Expenditures for construction to meet the requirements of such regulations at existing generating units are estimated to be $55 million for 1994 and were approximately $34 million in 1993, $25.4 million for 1992 and $10.4 million for 1991. TU Electric's Resource Plan includes two lignite-fueled 750 MW units at Twin Oak currently scheduled for service for the peak seasons of 2000 and 2001, respectively. However, estimated construction expenditures, excluding AFUDC, for the 1994-1996 period do not include any significant amounts for the resumption of construction of these units. Active construction and the accrual of AFUDC on Twin Oak, suspended in 1987 due to forecast changes in load growth, would need to resume in 1996 in order to meet the current schedule. Assuming the units are financed by TU Electric using traditional methods, approximately $210 million would be added to construction expenditures in 1996. TU Electric's Resource Plan also includes 1,502 MW of gas/oil-fueled combustion turbine units (including 272 MW of simple cycle combustion turbines planned for completion during the peak season of 1999), none of which requires significant construction expenditures in the 1994-1996 period reflected above. The reevaluation of growth expectations, the effects of inflation, additional regulatory requirements and the availability of fuel, labor, materials and capital may result in changes in estimated construction costs and dates of completion. Commitments in connection with the construction program are generally revocable subject to reimbursement to manufacturers for expenditures incurred or other cancellation penalties. (See Item 1. Business - -- Peak Load and Capability.) For information regarding financing of the construction program, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation. THE TU ELECTRIC AND SESCO SYSTEMS DECEMBER 31, 1993 ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In May 1990, Nancy F. King and Rodney B. Shields, allegedly as shareholders of the Company, filed suit in the United States District Court for the Northern District of Texas derivatively on behalf of the Company against the Company as a nominal defendant and James K. Dobey, Jack W. Evans, J. S. Farrington, William M. Griffin, Margaret N. Maxey, Erle Nye, Charles R. Perry and William H. Seay, directors of the Company, and Burl B. Hulsey, Jr. and Charles N. Prothro, former directors of the Company. The plaintiffs allege mismanagement involving gross negligence, willful misconduct, breaches of fiduciary duty and waste of corporate assets on the part of the defendants in connection with activities relating to Comanche Peak. In September 1991, the Court entered an order which stayed this suit until thirty days after entry of a final judgment by the District Court in TU Electric's appeal of the final order of the PUC in Docket 9300. In September 1992, a final judgment in this appeal was entered by the District Court. (See Item 1. Business -- Regulation and Rates.) The plaintiff refused to extend the stay pending the appeals of this judgment, filed an amended complaint which claimed damages in excess of $1.247 billion, added as defendants two former directors of the Company, Perry G. Brittain and James H. Zumberge, and one current director of the Company, James A. Middleton, and removed Rodney B. Shields as a plaintiff. In response, the Company moved to extend the stay through resolution of the appeals or alternatively to dismiss the suit. In December 1992, this suit was consolidated with a similar suit described below. In January 1993, the Court entered an order which stays the consolidated suit until thirty days after the disposition of all appeals from the final order of the PUC in Docket 9300. (See Item 1. Business -- Regulation and Rates.) In November 1991, Sheree Anne Meyer, as custodian for Adam Joseph Davenport, allegedly as a shareholder of the Company, filed suit in the United States District Court for the Northern District of Texas derivatively on behalf of the Company and TU Electric against the Company and TU Electric as nominal defendants and J. S. Farrington, Erle Nye, James K. Dobey, Jack W. Evans, William M. Griffin, Margaret N. Maxey, James A. Middleton, Charles R. Perry and William H. Seay, directors of the Company, and James H. Zumberge, a former director of the Company, S. S. Swiger, a former officer of the Company, and T. L. Baker, an officer of TU Electric. The plaintiff alleges breaches of fiduciary duty and negligence primarily relating to Comanche Peak, which the plaintiff claims have resulted in damages in an amount not less than $1.381 billion. In December 1991, the Court entered an order which stayed this suit until thirty days after entry of a final judgment by the District Court in TU Electric's appeal of the final order of the PUC in Docket 9300. In September 1992, a final judgment in this appeal was entered by the District Court. (See Item 1. Business -- Regulation and Rates.) The plaintiff refused to extend the stay pending the appeals of this judgment and the Company moved to extend the stay through resolution of the appeals or alternatively to dismiss the suit. In December 1992, this suit was consolidated into the suit described above. In January 1993, the Court entered an order which stays the consolidated suit until thirty days after the disposition of all appeals from the final order of the PUC in Docket 9300. (See Item 1. Business - Regulation and Rates.) ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. - ------------------ EXECUTIVE OFFICERS OF THE REGISTRANT PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is listed on the New York, Chicago and Pacific stock exchanges (symbol: TXU). The price range of the common stock of the Company on the composite tape, as reported by The Wall Street Journal, and the dividends paid, for each of the calendar quarters of 1993 and 1992 were as follows: The Company has declared common stock dividends payable in cash in each year since its incorporation in 1945. The Board of Directors of the Company, at its February 1994 meeting, declared a regular quarterly dividend of $0.77 a share. Future dividends, however, may vary depending upon the Company's profit levels and capital requirements as well as financial and other conditions existing at the time. Reference is made to Note 4 to Consolidated Financial Statements regarding limitations upon payment of dividends on common stock of TU Electric and SESCO. The approximate number of record holders of the common stock of the Company as of February 28, 1994, was 113,078. Item 6. Item 6. SELECTED FINANCIAL DATA. CONSOLIDATED FINANCIAL STATISTICS * Certain financial statistics for the years 1993 and 1991 were affected by TU Electric recording regulatory disallowances in the rate orders issued by the Public Utility Commission of Texas in Dockets 11735 and 9300, respectively. (See Note 10 to Consolidated Financial Statements.) Item 6. SELECTED FINANCIAL DATA (Concluded). CONSOLIDATED OPERATING STATISTICS * In 1992, other operating revenues do not include $122,586,000 of unbilled base rate revenues which were reclassified as a cumulative effect of a change in accounting principle effective January 1, 1992. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. LIQUIDITY AND CAPITAL RESOURCES The primary capital requirements of Texas Utilities Company (Company) in 1993 and as estimated for 1994 through 1996 are as follows: For information concerning construction work contemplated by the Texas Utilities Company System (System Companies) and the commitments with respect thereto, see Item 2. Properties -- Construction Program and Note 11 to Consolidated Financial Statements. The System Companies have generated cash from operations sufficient to meet operating needs, pay dividends on capital stock and finance a portion of capital requirements. Factors affecting the ability of Texas Utilities Electric Company (TU Electric) to continue to fund a portion of its capital requirements from operations include adequate rate relief in the future reflecting regulatory practices allowing recovery of capital investment through adequate depreciation rates, normalization of federal income taxes, recovery of the cost of fuel and purchased power and the opportunity to earn competitive rates of return required in the capital markets. In order to remain competitive and in response to the recent disappointing rate order in Docket 11735, the Company has taken steps to reduce operating costs and capital expenditures and is reviewing various alternatives and strategies to improve future earnings potential and its basic financial position. This review may result in further initiatives which may include, but not necessarily be limited to, alternative uses or disposition of existing assets, somewhat greater utilization of short-term and variable rate securities, new marketing and rate initiatives and application for additional rate increases from regulatory authorities. It is not possible at this time to predict the effect any of these possible initiatives will have on the Company's financial position or its results of operation. For 1993, approximately 68% of the cash needed for construction expenditures was generated from operations by the System Companies. The Company believes internal cash generation will increase as a result of the Docket 11735 rate order and through the implementation of the initiatives discussed above. In August 1993, TU Electric placed Comanche Peak Unit 2 in commercial operation and implemented, under bond, its 15.3% rate increase requested in Docket 11735. In September 1993, TU Electric recorded a charge against earnings of approximately $363 million ($265 million after tax) related to an agreement (Settlement Agreement) among the parties involved in TU Electric's Docket 11735. The Settlement Agreement resolved all issues in the prudence and fuel phases of Docket 11735 and also permits TU Electric to recover, ratably over an eight year period, $197 million of expenditures incurred in connection with the Company's recent cost reduction program. The Settlement Agreement also resolved the difference between TU Electric and the Public Utility Commission of Texas (PUC) staff that was the primary issue in another proceeding related to the accrual of an allowance for funds used during Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (CONTINUED). LIQUIDITY AND CAPITAL RESOURCES -- (CONTINUED) construction (AFUDC), during the bonded rate period of Docket 9300, on construction work in progress (CWIP) that was subsequently included in rate base pursuant to the final order in Docket 9300. On January 28, 1994, the PUC issued a final order in Docket 11735 which provided for a total annual revenue increase of approximately $435 million, or 8.7%. TU Electric strongly disagrees with the final order and has filed a motion for rehearing with the PUC, and will appeal the outcome, if necessary. As a result of this final order, unless the order is changed on rehearing, TU Electric will refund the difference between the bonded rates and the rates approved in the final order, including interest, all of which is being fully reserved by TU Electric. The total amount to be refunded will be determined once approved rates have been implemented, which is expected to be during the second quarter of 1994. The amount to be refunded at December 31, 1993 was approximately $141.2 million. Such refund will be mitigated by a fuel cost surcharge approved by the PUC of approximately $144.5 million, including interest, in under-collected fuel costs through June 30, 1993. For additional information regarding the rate decision, see Item 1. Business -- Regulation and Rates and Note 10 to Consolidated Financial Statements. As a result of the final order and its effects on earnings, TU Electric could be restricted from issuing additional shares of preferred stock. TU Electric does not believe this restriction would materially affect its ability to fund its continuing operations or capital requirements. Although TU Electric cannot predict the outcome of its appeal of the Docket 9300 rate decision or its expected appeal of the Docket 11735 rate decision, future regulatory actions or any changes in economic and securities market conditions, no changes are expected in trends or commitments, other than those discussed above, which might significantly alter its basic financial position. On November 14, 1993, the emissions chimney for Unit 3 of the Monticello Steam Electric Station collapsed. The cause of the collapse has not been determined but such unit and the associated lignite mining operation will be inoperative until completion of repairs. TU Electric is formulating the engineering, procurement and construction plans that will return the unit to service in 1995. The cost of repairs is covered by TU Electric's insurance which includes a $2,000,000 deductible. Therefore, the Company does not expect the accident to materially effect its results of operation or financial position. On July 1, 1993, Southwestern Electric Service Company (SESCO) became a wholly-owned subsidiary of the Company pursuant to approval by shareholders of SESCO and the Securities and Exchange Commission. The acquisition was accounted for as a purchase business combination with the resulting goodwill being amortized evenly over forty years. The operations of SESCO after the date of acquisition have been reflected in the consolidated financial statements. The acquisition of SESCO did not have a material effect on the Company's results of operation or financial position. External funds of a permanent or long-term nature are obtained through the sales of common stock, preferred stock and long-term debt by the System Companies. The capitalization ratios of the Company and its subsidiaries at December 31, 1993 consisted of approximately 51% long-term debt, 9% preferred stock and 40% common stock equity. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (CONTINUED). LIQUIDITY AND CAPITAL RESOURCES -- (CONTINUED) The System Companies had financings totaling $3,805,754,370 in 1993. Proceeds from such financings were used primarily for the early redemption of higher coupon debt and higher dividend preferred stock. The System Companies redeemed or made principal payments of $2,944,339,000 on long-term debt and preferred stock. Financings in 1993 by the System Companies included the following: LONG-TERM DEBT: ______________________________ * The taxable pollution control series bonds are in a flexible mode and while in such mode will be remarketed for periods of less than 270 days and are secured by an irrevocable letter of credit. TU Electric has sufficient unused existing lines of credit that would allow refinancing of the bonds on a long-term basis should remarketing prove unsuccessful. COMMON STOCK (COMPANY): ______________________________ * Four depositary shares have been issued with respect to each of 5,000,000 of such underlying shares of preferred stock. The replacement of higher coupon debt and higher dividend preferred stock during 1993 reduced interest and dividend requirements by approximately $45,000,000 on an annualized basis. TU Electric redeemed $15,000,000 of 10.45% First Mortgage and Collateral Trust Bonds, Secured Medium-Term Notes on March 16, 1994 and intends to redeem $335,000,000 of First Mortgage Bonds with interest rates ranging from 7-3/8% to 9-1/2% on April 1, 1994 with each redemption subject to the deposit of the necessary redemption monies by TU Electric. Additional early redemptions of long-term debt and preferred stock may occur from time to time in amounts presently undetermined. (See Notes 5 and 6 to Consolidated Financial Statements.) On February 2, 1994, the Company amended its Automatic Dividend Reinvestment and Common Stock Purchase Plan. The amendments include the option for the purchase of common stock on the open market through an independent broker to meet share requirements under the plan. The System Companies expect to sell additional debt and equity securities as needed (subject to the possible restriction on the issuance of additional shares of preferred stock as discussed above) including the possible future sale by TU Electric of up to $450,000,000 of First Mortgage and Collateral Trust Bonds currently registered with the Securities and Exchange Commission for offering pursuant to Rule 415 under the Securities Act of 1933. TU Electric also has 250,000 shares of Cumulative Preferred Stock ($100 liquidation value) similarly registered. It is the intent of the Company and TU Electric to negotiate a new credit facility prior to the scheduled reduction in June 1994 in the joint lines of credit of the Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (CONTINUED). LIQUIDITY AND CAPITAL RESOURCES -- (CONCLUDED) Company and TU Electric. The new facility would be used for working capital, as back-up for commercial paper and for other corporate purposes. For information regarding short-term financings of the Company, see Note 2 to Consolidated Financial Statements. The Company's capital requirements have not been significantly affected by the requirements of the federal Clean Air Act, as amended (Clean Air Act). Although TU Electric is unable to fully determine the cost of compliance with the Clean Air Act, it is not expected to have a significant impact on the Company. Any additional capital costs, as well as any increased operating costs associated with these new requirements, are expected to be recoverable through rates, as similar costs have been recovered in the past. The National Energy Policy Act of 1992 addresses a wide range of energy issues and is intended to increase competition in electric generation and broaden access to electric transmission systems. TU Electric and SESCO are unable to predict the impact of regulations implementing this legislation on their operations until such regulations are promulgated and approved. However, TU Electric and SESCO believe that such legislation reflects the trend toward increased competition in the energy industry. While TU Electric and SESCO have experienced competitive pressures in the wholesale market resulting in a minor loss of load, wholesale sales constitute a relatively low percentage of total sales. TU Electric and SESCO are unable to predict the extent of future competitive developments or what impact, if any, such developments may have on operations. (See Item 1. Business -- Competition.) See Item 6. Selected Financial Data -- Consolidated Financial Statistics for additional information. RESULTS OF OPERATION Operating revenues increased 10.7% and 0.3% for the years ended December 31, 1993 and 1992, respectively. The following table details the factors contributing to these changes: Base rate revenue increased in 1993 due to higher energy sales and higher rate levels implemented in August 1993 as compared to a decrease in base rate revenues in 1992 as a result of lower energy sales. Energy sales increased 6.4% for 1993 and decreased 2.5% for 1992. The increase in energy sales in 1993 was due primarily to increased customer usage resulting from more normal weather conditions and an increase in customers, while the decrease in 1992 resulted from milder than normal weather and unfavorable economic conditions, partially offset by an increase in customers. The rate increase placed in effect in August 1993 increased base rate revenues, net of amounts to be refunded, by approximately $177 million in 1993. The increase in fuel revenue for 1993 resulted from increased energy sales and increased fuel costs. The increase in fuel revenue in 1992 was primarily due to fuel refunds in 1991, partially offset by decreased energy sales in 1992. The increase in unbilled revenue and other resulted from a larger accrual of unbilled revenue in both periods. (See Note 12 to Consolidated Financial Statements.) Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (CONTINUED). RESULTS OF OPERATION -- (CONTINUED) Fuel and purchased power expense increased 10.7% and 0.9% for 1993 and 1992, respectively. Fuel and purchased power expense increased for 1993 primarily due to increased energy sales and the increase in the price of gas partially offset by an increased utilization of nuclear fuel. The 1992 increase in fuel and purchased power was primarily the result of an increased price of gas which more than offset the decrease in generation. (See Item 1. Business -- Fuel Supply and Purchased Power and Item 6. Selected Financial Data - -- Consolidated Operating Statistics.) Total operating expenses, excluding fuel and purchased power, increased 15.7% for 1993 and decreased 1.3% for 1992. Operation, maintenance and depreciation expenses increased in 1993 as a result of the commencement of commercial operation of Unit 2 of Comanche Peak in August 1993. Operation expense in 1993 also increased due to higher pension costs and other postretirement benefits costs associated with Financial Accounting Standards Board (FASB) Statement 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", partially offset by lower employee labor costs. Maintenance expense was also affected by inventory adjustments during the third and fourth quarters of 1993. Operation and maintenance expenses decreased in 1992 primarily due to decreased employee related costs and management's efforts to further reduce other costs through a cost reduction program. Depreciation expense decreased in 1992 as a result of recording the disallowances associated with Comanche Peak Unit 1 in TU Electric's Docket 9300 rate order. Taxes other than income increased in 1993 due primarily to increased local gross receipts taxes resulting from higher tax rates on increased revenues and an increase in ad valorem taxes. The increase in 1993 was partially offset by a refund of prior years franchise taxes of approximately $23,875,000. AFUDC decreased 13.5% and 16.4% in 1993 and 1992, respectively. The decrease in 1993 was primarily due to the discontinuation of the accrual of AFUDC on Unit 2 of Comanche Peak when such unit achieved commercial operation in August 1993. This decrease was partially offset by the change to a gross rate in 1993 related to the adoption of FASB Statement 109, "Accounting for Income Taxes", for projects commenced before March 1986 (see Notes 1 and 7 to Consolidated Financial Statements). The decrease in 1992 was caused by the implementation of the Docket 9300 rate order placing $695 million of CWIP in rate base and the exclusion of $485 million of CWIP disallowed on Unit 2 of Comanche Peak. (See Note 10 to Consolidated Financial Statements.) The regulatory disallowances reflect charges resulting from the Settlement Agreement among the parties in Docket 11735. (See Note 10 to Consolidated Financial Statements.) Other income and deductions -- net decreased for both periods due to reduced interest income on temporary cash investments partially offset by an increase in interest income on under-recovered fuel revenue in 1993. Federal income taxes -- other income decreased in 1993 due to the effect of recording the taxes associated with the regulatory disallowances and increased in 1992 because 1991 was affected by the recording of taxes associated with the provision for regulatory disallowances. (See Notes 7 and 10 to Consolidated Financial Statements.) Total interest charges, excluding AFUDC, decreased 0.2% and 7.4% for 1993 and 1992, respectively. Interest on mortgage bonds increased in 1993 as a result of new issues sold and the annualization of interest on bond issues sold in the prior period, partially offset by reduced interest requirements as a Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (CONCLUDED). RESULTS OF OPERATION -- (CONCLUDED) result of the Company's refinancing efforts. The decrease in 1992 resulted from retirements and redemptions of certain higher rate issues. Interest on other long-term debt decreased in both periods due to the continuing retirement of debt incurred on the purchases of the minority ownership interests in Comanche Peak and refunding of higher interest rate debt. Other interest expense decreased in all periods due primarily to decreased interest on short-term borrowings and decreased interest on over-recovered fuel revenues partially offset by increased amortization of debt issuance expenses and redemption premiums. Preferred stock dividends decreased 2.7% and 2.6% for 1993 and 1992, respectively, primarily due to the redemption of series with higher dividend rates partially offset by dividends on new issues. The cumulative effect of recording unbilled revenue reflects the accounting change made on January 1, 1992, by TU Electric to begin recording base rate revenue for energy sales sold but not billed. The major factors affecting earnings in 1993 were the implementation of the rate increase, the recording of the regulatory disallowances, the discontinuation of AFUDC on Unit 2 of Comanche Peak and the commencement of depreciation on approximately $668 million of investment in Comanche Peak Unit 2 incurred after the end of the Docket 11735 test year which was not included in rates. The factors mentioned above resulted in a decrease in consolidated net income of 47.3% for 1993. The change in accounting for unbilled revenue in 1992 and the recording of the provision for regulatory disallowances in 1991 (see Note 10 to Consolidated Financial Statements) resulted in an increase to consolidated net income in 1992 over 1991. The change in accounting for unbilled revenue increased consolidated net income $0.48 per share, of which $0.38 per share represents the cumulative effect of the change in accounting principle at January 1, 1992. The consolidated net loss in 1991 was due to the recognition of the provision for regulatory disallowances and the provision for refunds and related interest. Another major factor affecting earnings in 1992 and 1991 was the discontinuation of the accrual of AFUDC on approximately $1.3 billion of investment in Comanche Peak Unit 1, incurred after the end of the test year, which was not reflected in rates until Docket 11735 bonded rates were implemented. ACCOUNTING CHANGES In November 1993, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement 112) was issued. Statement 112 is effective for fiscal years beginning after December 15, 1993. Statement 112 applies to certain types of postemployment benefits provided to former or inactive employees after employment but before retirement. The Company does not expect Statement 112 to have a material effect on the Company's financial position or results of operation. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. TEXAS UTILITIES COMPANY AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED INCOME STATEMENTS OF CONSOLIDATED RETAINED EARNINGS See accompanying Notes to Consolidated Financial Statements. TEXAS UTILITIES COMPANY AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS See accompanying Notes to Consolidated Financial Statements. TEXAS UTILITIES COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS See accompanying Notes to Consolidated Financial Statements. TEXAS UTILITIES COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS CAPITALIZATION AND LIABILITIES See accompanying Notes to Consolidated Financial Statements. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES System of Accounts -- The accounting records of Texas Utilities Electric Company (TU Electric), the principal subsidiary of Texas Utilities Company (Company), and Southwestern Electric Service Company (SESCO) are maintained in accordance with the Federal Energy Regulatory Commission's Uniform System of Accounts as adopted by the Public Utility Commission of Texas (PUC). Consolidation -- The consolidated financial statements include the Company and its subsidiaries (System Companies). All significant intercompany items and transactions have been eliminated in consolidation. Certain financial statement items for 1992 and 1991 have been reclassified to conform to the 1993 presentation. On July 1, 1993, SESCO became a wholly-owned subsidiary of the Company pursuant to approval by shareholders of SESCO and the Securities and Exchange Commission. The acquisition was accounted for as a purchase business combination with the resulting goodwill being amortized evenly over forty years. The acquisition of SESCO did not have a material effect on the Company's results of operation or financial condition. Utility Plant -- Utility plant is stated at original cost. The cost of property additions to utility plant includes labor and materials, applicable overhead and payroll-related costs and an allowance for funds used during construction. Allowance For Funds Used During Construction -- Allowance for funds used during construction (AFUDC) is a cost accounting procedure whereby amounts based upon interest charges on borrowed funds and a return on equity capital used to finance construction are added to utility plant. The accrual of AFUDC is in accordance with generally accepted accounting principles for the industry, but does not represent current cash income. TU Electric is capitalizing AFUDC, compounded semi-annually, on expenditures for ongoing construction work in progress (CWIP) and nuclear fuel in process not otherwise allowed in rate base by regulatory authorities. Effective January 1, 1993, TU Electric began using a gross rate of 10.4% for AFUDC for all construction to comply with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement 109). In 1992 and 1991, TU Electric used a net-of-tax rate of 8.8% and 10.4%, respectively, on projects commenced before March 1, 1986, and a gross rate of 10.4% and 12.0%, respectively, on projects commenced thereafter. Rates were determined on the basis of, but are less than, the cost of capital used to finance the construction program. Depreciation of Utility Plant -- Depreciation is generally based upon an amortization of the original cost of depreciable properties (net of regulatory disallowances) on a straight-line basis over the estimated service lives of the properties. Depreciation as a percent of average depreciable property approximated 2.5%, 2.8% and 2.9% for 1993, 1992 and 1991, respectively. Depreciation also includes an amount for Comanche Peak nuclear generating station (Comanche Peak) decommissioning costs which is being accrued over the lives of the units and deposited to external trust funds. (See Note 11.) Amortization of Nuclear Fuel and Refueling Outage Costs -- The amortization of nuclear fuel in the reactors (net of regulatory disallowances) is calculated on the units of production method and, subsequent to commercial operation, is included in nuclear fuel expense. TU Electric accrues a provision for costs anticipated to be incurred during the next scheduled Comanche Peak refueling outage. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1. SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Other Investments -- The difference of $46,153,000 between the amount at which the investments in subsidiaries is carried by the Company and the underlying book equity of such subsidiaries at the respective dates of acquisition is included in other investments. Revenues -- Revenues include billings under approved rates (including a fixed fuel factor) applied to meter readings each month on a cycle basis and, beginning January 1, 1992, an accrual of base rate revenue for energy provided after cycle billing but not billed through the end of each month (see Note 12). Revenues also include an amount for under- or over-recovery of fuel revenue representing the difference between actual fuel cost and billings on the approved fixed fuel factor and a provision that generally allows recovery through a Power Cost Recovery Factor, on a monthly basis, of the capacity portion of purchased power cost from qualifying facilities not included in base rates. The fuel portion of purchased power cost is included in the fixed fuel factor. A utility's fuel factor can be revised upward or downward every six months, according to a specified schedule. Each six months, a utility is required to petition to make either surcharges or refunds to ratepayers, together with interest based on a twelve month average of prime commercial rates, for any material cumulative under- or over-recovery of fuel costs. If the cumulative difference between the under- or over-recovery, plus interest, is in excess of 4% of the annual estimated fuel costs most recently approved by the PUC, it will be deemed to be material. A procedure exists for an expedited change in fuel factors in the event of an emergency. Final reconciliation of fuel costs must be made either in a reconciliation proceeding, which may cover no more than three years and no less than one year, or in a general rate case. Federal Income Taxes -- The System Companies file a consolidated federal income tax return and federal income taxes are allocated to all System Companies based upon their taxable income or loss. Deferred federal income taxes are currently provided for temporary differences between book and the tax basis of assets and liabilities (including the provision for regulatory disallowances). Generally, such differences result primarily from the use of liberalized depreciation and cost recovery deductions allowable under the Internal Revenue Code, the under- or over-recovery of fuel revenue and unbilled revenues accrued for tax purposes. Temporary differences in earlier years for which deferred federal income taxes were not provided approximated $184,000,000 at December 31, 1993. Investment tax credits are normally amortized to income over the estimated service lives of the properties. For 1992 and 1991, the System Companies' taxes were provided for under the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes". (See Note 7 for change in accounting for income taxes.) Consolidated Cash Flows -- For purposes of reporting cash flows, temporary cash investments purchased with a remaining maturity of three months or less are considered to be cash equivalents. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1. SIGNIFICANT ACCOUNTING POLICIES -- (CONCLUDED) The supplemental schedule below details cash payments and noncash investing and financing activities: 2. SHORT-TERM FINANCING At December 31, 1993, the Company and TU Electric had joint lines of credit aggregating $700,000,000 under a credit facility agreement with a group of commercial banks. The facility, for which the Company pays a fee, is scheduled by such agreement to be reduced by $350,000,000 in June 1994 and June 1995. It is the intent of the Company and TU Electric to negotiate a new credit facility prior to the scheduled reduction in June 1994. The new facility would be used for working capital, as backup for commercial paper and for other corporate purposes. At December 31, 1993, the total of short-term borrowings authorized by the Board of Directors of the Company from banks or other lenders was $1,075,000,000. At December 31, 1993, SESCO had lines of credit aggregating $5,500,000 under agreements with commercial banks. These agreements will expire in 1994. 3. COMMON STOCK The Company issued shares of its authorized but unissued common stock as follows: ______________________________ * Shares issued for public offering in 1993 were used in connection with the acquisition of SESCO. At December 31, 1993, 3,492,620 shares of the authorized but unissued common stock of the Company were reserved for issuance and sale pursuant to the above plans. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 3. COMMON STOCK -- (CONCLUDED) On February 2, 1994, the Company amended its Automatic Dividend Reinvestment and Common Stock Purchase Plan. The amendments include the option for purchase of common stock on the open market through an independent broker to meet share requirements under the plan. The trustee of the Employees' Thrift Plan of the Texas Utilities Company System (Thrift Plan) borrowed $250,000,000 in the form of a note payable from an outside lender and purchased 7,142,857 shares of common stock from the Company in connection with the leveraged employee stock ownership provision of the Thrift Plan. Such shares are held by the trustee until allocated to Thrift Plan participants when required to meet the System Companies' obligations under terms of the Thrift Plan. The Company has purchased the note from the outside lender, which has been recorded as a reduction to common stock equity. The Thrift Plan uses dividends on the shares purchased and contributions from the System Companies, if required, to repay the note. Common stock equity increases as shares are allocated to participants. Such allocations in 1993, 1992 and 1991 increased common stock equity by $8,115,000, $8,072,000 and $7,976,000, respectively. The Company has 50,000,000 authorized shares of serial preference stock having a par value of $25 a share, none of which has been issued. 4. RETAINED EARNINGS TU Electric's and SESCO's articles of incorporation, mortgages, as supplemented, and debenture agreements contain provisions which, under certain conditions, restrict distributions on or acquisitions of their common stock. At December 31, 1993, $181,228,000 of retained earnings were thus restricted as a result of the provisions of such articles of incorporation. Retained earnings at such date also includes $431,243,000 representing the Company's equity in undistributed earnings since acquisition included in transfers by TU Electric from its retained earnings to stated value of common stock. The total of such restricted retained earnings at December 31, 1993 is $612,471,000. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. PREFERRED STOCK OF TU ELECTRIC (CUMULATIVE, WITHOUT PAR VALUE, ENTITLED UPON LIQUIDATION TO $100 A SHARE; AUTHORIZED 17,000,000 SHARES) ______________________________ (a) Adjustable rate series A bears a dividend rate for the period ended January 31, 1994, of 6.50% per annum and adjustable rate series B bears a dividend rate for the period ended December 31, 1993, of 7.00% per annum, both of which are based on a fixed liquidation price of $100 per share. (b) TU Electric is required to redeem at a price of $100 per share plus accumulated dividends a specified minimum number of shares annually or semi-annually on the initial/next dates shown below. These redeemable shares may be called, purchased or otherwise acquired. Certain issues may not be redeemed at the option of TU Electric prior to 1995. TU Electric may annually call for redemption, at its option, an aggregate of up to twice the number of shares shown below for each series at a price of $100 per share plus accumulated dividends, except for the $9.64 series which may be redeemed in a minimum amount of 10,000 shares at any time at a price of $100 per share plus accumulated dividends plus a component at a variable price per share which is designed to maintain the expected yield at issuance: Preferred stock mandatory redemption requirements for the next five years are $25 million in 1995 and $45 million annually in 1996, 1997 and 1998. The carrying value of preferred stock subject to mandatory redemption is being increased periodically to equal the redemption amounts at the mandatory redemption dates with a corresponding increase in preferred stock dividends. (c) Under certain circumstances relating to a change in federal tax law governing the dividends received deduction applicable to eligible corporations, the dividend rate of the $9.64 series may increase to a maximum of $10.74. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. PREFERRED STOCK OF TU ELECTRIC (CUMULATIVE, WITHOUT PAR VALUE, ENTITLED UPON LIQUIDATION TO $100 A SHARE; AUTHORIZED 17,000,000 SHARES) -- (CONCLUDED) The table below details changes in preferred stock of TU Electric: TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. LONG-TERM DEBT, LESS AMOUNTS DUE CURRENTLY ____________________ (a) Taxable pollution control series consist of four series: $18,000,000 at 3.35% and $10,340,000 at 3.40% of flexible rate Series 1991A at December 31, 1993; $50,000,000 of Series 1991C at 8.49% through June 1, 1994; $100,000,000 of Series 1991D at 8.85% through June 1, 1995; and $100,000,000 at 3.425% of flexible rate Series 1993 at December 31, 1993. Series 1991A and Series 1993 bonds are in a flexible mode and while in such mode will be remarketed for periods of less than 270 days, and are secured by an irrevocable letter of credit with maturities in excess of one year. The interest rates on Series 1991C and Series 1991D bonds will be repriced on the mandatory tender dates of June 1, 1994 and 1995, respectively. TU Electric has existing lines of credit that would allow refinancing of bonds not supported by the letter of credit on a long-term basis should remarketing prove unsuccessful. (b) In 1988, TU Electric purchased the ownership interest in Comanche Peak of Brazos Electric Power Cooperative and issued a promissory note payable over 33 years. The note is secured by a mortgage on the acquired interest. In 1990, TU Electric purchased the ownership interest in Comanche Peak of Tex-La Electric Cooperative of Texas, Inc. (Tex-La) and assumed debt of Tex-La payable over approximately 32 years. The assumption is secured by a mortgage on the acquired interest. The Company has guaranteed these various payments. (c) The interest rate is reset at the beginning of each period, with the duration of each period being selected by Texas Utilities Fuel Company. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. LONG-TERM DEBT, LESS AMOUNTS DUE CURRENTLY -- (CONCLUDED) Sinking fund and maturity requirements for the years 1994 through 1998 under long-term debt instruments in effect at December 31, 1993, were as follows: ____________________ (a) The maturity requirements do not include the mandatory tenders of TU Electric's taxable pollution control series, equal to $50,000,000 in 1994 and $100,000,000 in 1995, which are expected to be remarketed. (b) The minimum cash requirement does not include the sinking fund requirements that may be satisfied by certification of property additions at the rate of 167% of such requirements, except for twelve issues at 100%. From time to time, various principal amounts of first mortgage bonds have been redeemed by TU Electric prior to maturity. In 1993, the System Companies refunded $1,810,000,000 of higher coupon debt. The debt reacquisition costs have been deferred and are being amortized over the remaining lives of the bonds retired pursuant to current regulatory treatment. Electric plant of TU Electric and SESCO is generally subject to the liens of their respective mortgages. 7. FEDERAL INCOME TAXES In January 1993, the Company adopted Statement 109, which among other things, requires the liability method of recognition for all temporary differences, requires that deferred tax liabilities and assets be adjusted for an enacted change in tax laws or rates and prohibits net-of-tax accounting and reporting. Certain provisions of Statement 109 provide that regulated enterprises are permitted to recognize such adjustments as regulatory assets or liabilities if it is probable that such amounts will be recovered from or returned to customers in future rates. Accordingly, at December 31, 1993, the Company's consolidated balance sheet reflects a regulatory asset of approximately $1.2 billion net of an approximate $0.6 billion regulatory liability. The cumulative effect on consolidated net income of adopting Statement 109 is not considered material to the annual results of operation. In August 1993, Congress passed the Revenue Reconciliation Act of 1993 which increased the top corporate income tax rate from 34% to 35% retroactive to January 1, 1993. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 7. FEDERAL INCOME TAXES -- (CONTINUED) The details of federal income taxes are as follows: TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 7. FEDERAL INCOME TAXES -- (CONTINUED) The significant components of the Company's deferred tax assets and liabilities reflected net in the consolidated balance sheet at December 31, 1993 are: TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 7. FEDERAL INCOME TAXES -- (CONCLUDED) Federal income taxes were less than the amount computed by applying the federal statutory rate to pre-tax book income (loss) as follows: The System Companies have net operating loss carryforwards of approximately $379 million that are available to offset future ordinary taxable income. Approximately $122 million of these loss carryforwards expire in 2006 and the remaining $257 million expire in 2007. In addition, the System Companies have approximately $12 million of general business credit carryforwards which expire in 2006 and $418 million of minimum tax credit carryforwards which are available to offset future taxes. As a part of its ongoing large case audit program, the Internal Revenue Service (IRS) is currently auditing the consolidated Federal income tax returns of the System Companies for the years 1987 through 1990. During the course of the audit, the IRS has proposed a number of adjustments to the returns as filed, the most significant of which relates to a proposed reclassification of certain costs incurred in connection with the construction of Comanche Peak Unit 1 as costs incurred to procure a nuclear operating license. The Company is unable to predict the ultimate resolution of the issues raised in the audit and therefore is unable to predict at this time the amount of any additional tax payment which may be required. While the making of additional tax payments would have an impact on the Company's cash position, the Company does not expect the outcome of the audit to have a material effect on its results of operation. 8. RETIREMENT PLANS AND OTHER POSTRETIREMENT BENEFITS The System Companies have uniform retirement plans covering substantially all employees. An employee's benefits are based on years of accredited service and average annual earnings received during the three years of highest earnings. The costs of the plans were determined by independent actuaries. Contributions to the plans were determined using the frozen attained age method which is one of the several actuarial methods allowed by the Employee Retirement Income Security Act of 1974. For financial reporting purposes, pension cost has been determined using the projected unit credit actuarial method. The cumulative difference between pension cost as determined for financial reporting purposes and contributions to the plans is recorded either as prepaid pension cost or as accrued pension liability. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 8. RETIREMENT PLANS AND OTHER POSTRETIREMENT BENEFITS -- (CONTINUED) The table below details the plans' funded status and amount recognized in the Company's consolidated balance sheets: Assumptions used in determination of the projected benefit obligation include the following: Total pension costs, including amounts charged to fuel cost, deferred and capitalized, were comprised of the following components: The assumed long-term rate of return on plan assets was 8.75% for 1993, 1992 and 1991. In addition to the retirement plans, the System Companies offer certain health care and life insurance benefits to substantially all its employees and their eligible dependents at retirement which normally is age 65 but may be as early as age 55 with 15 years of service. Retirees currently pay a portion of the cost of providing such benefits and are expected to continue to do so in the future. In January 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (Statement 106), which requires a change in the accounting for a company's obligation to provide health care and certain other benefits to its retirees from the "pay-as-you-go" method to an accrual method and requires the cost of the obligation to be recognized in the period from employment date until full eligibility for benefits. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 8. RETIREMENT PLANS AND OTHER POSTRETIREMENT BENEFITS -- (CONCLUDED) The System Companies' net periodic postretirement benefits cost other than pensions for the year ended December 31, 1993, including amounts charged to fuel cost and capitalized, were comprised of the following components: The table below details the funded status for other postretirement benefits and amount recognized by the System Companies at December 31, 1993: The expected increase in costs of future benefits covered by the plan is projected using a health care cost trend rate of 7.5% in 1994, 6.5% in 1995, 5.5% in 1996 and 5.0% in 1997 and thereafter. A one percentage point increase in the assumed health care cost trend rate in each future year would increase the APBO at December 31, 1993 by approximately $68.6 million and other postretirement benefits cost for 1993 by approximately $8.8 million. The assumed discount rate used to measure the APBO is 7.875%. The Company's cost of providing other postretirement benefits in 1992 and 1991, which was recognized on a "pay-as-you-go" basis, was approximately $13,766,000 and $14,499,000, respectively. The Company was granted recovery of its Statement 106 cost in Docket 11735 (see Note 10). Funding of the other postretirement benefits obligation will begin by the third quarter of 1994. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. SALES OF ACCOUNTS RECEIVABLE In November 1993, TU Electric terminated its then existing receivables facility to sell receivables to certain financial institutions and entered into a new facility with other financial institutions. Under such new facility, TU Electric is entitled to sell and such financial institutions may purchase, on an ongoing basis, undivided interests in customer accounts receivable representing up to an aggregate of $350,000,000. Additional receivables are continually sold to replace those collected. At December 31, 1993 and 1992, accounts receivable was reduced by $300,000,000 to reflect the sales of such receivables to financial institutions under such agreements. 10. RATE PROCEEDINGS DOCKET 11735 In January 1993, TU Electric made applications to the PUC in Docket 11735 and to its municipal regulatory authorities for upward adjustments in rates for electric service throughout its service area, which would have increased annual operating revenues by approximately $760 million, or 15.3%, based upon the test year ended June 30, 1992. Such request reflects, among other things, costs associated with Comanche Peak Unit 2, costs associated with Comanche Peak Unit 1 after the end of the Docket 9300 (see below) test year, additional ad valorem taxes and certain postretirement benefit costs. In August 1993, pursuant to rules of the PUC, TU Electric placed its requested rate increase into effect, under bond and subject to refund with interest, applicable to energy sales on and after such date. Revenues were recorded net of an estimated reserve for possible refunds. In October 1993, the PUC issued an order (Order) approving the terms of an agreement (Settlement Agreement) among TU Electric, the General Counsel's office of the PUC and applicable intervenors which, among other things, settled all remaining issues relating to the design, construction and cost of Comanche Peak through commencement of commercial operation of Unit 2. The Settlement Agreement provides for the disallowance in Docket 11735 of $250 million of costs relating to the completion of Comanche Peak. Pursuant to the Order, TU Electric refunded $5 million in fuel charges previously incurred in order to resolve the fuel phase of Docket 11735 under which TU Electric was seeking reconciliation of approximately $4.6 billion of fuel costs incurred during the three year period ended June 30, 1992, under the fuel rule in effect prior to May 1993. Further, in order to resolve the primary issue in another proceeding which resulted from a complaint filed against TU Electric in October 1992 by the General Counsel's office of the PUC, as a result of the Order, TU Electric agreed to write off $83 million of AFUDC, which consists of the amount subject to dispute in such proceeding and similar charges subsequently accrued. Also, under the Settlement Agreement and confirmed in the Docket 11735 final order (see below), TU Electric will recover, ratably over an eight year period, $197 million of operation and maintenance expenditures incurred by TU Electric in connection with its recent cost reduction program. However, an additional $25 million of such expenditures will not be subject to recovery and was written off by TU Electric. As a result of the Settlement Agreement, TU Electric recorded a charge against earnings in September 1993 of approximately $363 million ($265 million after tax). TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10. RATE PROCEEDINGS -- (CONTINUED) On January 28, 1994, the PUC issued a final order in Docket 11735 which provided for a total annual revenue increase of approximately $435 million, or 8.7%. TU Electric strongly disagrees with the final order and has filed a motion for rehearing with the PUC, and will appeal the outcome, if necessary. As a result of this final order, unless the order is changed on rehearing, TU Electric will refund the difference between the bonded rates and the rates approved in the final order, including interest, all of which is being fully reserved by TU Electric. The total amount to be refunded will be determined once approved rates have been implemented, which is expected to be during the second quarter of 1994. The amount to be refunded at December 31, 1993 was approximately $141.2 million. Such refund will be mitigated by a fuel cost surcharge approved by the PUC of approximately $144.5 million, including interest, in under-collected fuel costs through June 30, 1993. The following details the effect on 1993 consolidated net income of the Settlement Agreement and the Docket 11735 final order charges: In November 1993, an intermediate appellate court in Texas, considering an appeal of another utility's rate case, ruled that utilizing tax benefits generated by costs not allowed in rates to reduce rates charged to customers was required by prior court rulings for all disallowed costs, including capital costs. TU Electric believes that such rulings are erroneous and not consistent with the Texas Public Utility Regulatory Act. According to a Private Letter Ruling issued to TU Electric by the IRS with respect to investment tax credits, such ratemaking treatment, to the extent related to property classified for tax purposes as public utility property, would result in a violation of the normalization rules contained in the Internal Revenue Code of 1986, as amended (Code). Violation of the normalization rules would result in a significant adverse effect on TU Electric's results of operation and liquidity. The tax benefits associated with the Comanche Peak costs disallowed in Docket 9300 (see below) could be affected as a result of the court's method. In addition, in its final order in Docket 11735, the PUC reduced rates for the tax benefits generated by certain costs which were not allowed in rates. However, the PUC recognized the potential for a normalization violation if investment tax credits and tax depreciation generated by disallowed plant costs are used to reduce rates. Therefore, the PUC ordered TU Electric to obtain a Private Letter Ruling from the IRS with respect to tax depreciation on disallowed plant. Thus, TU Electric's rates would not reflect the tax depreciation benefit of disallowed plant unless TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10. RATE PROCEEDINGS -- (CONCLUDED) the IRS rules such benefits can be utilized to reduce rates without violating the normalization rules contained in the Code. Such a finding by the IRS would require TU Electric to refund the tax depreciation benefits to its customers. TU Electric does not believe it is likely that such refund will occur if the IRS maintains a position similar to that stated in its previous Private Letter Ruling to TU Electric. DOCKET 9300 In September 1991, the PUC issued a final order in Docket 9300 which provided for a total revenue increase of approximately $442 million and included $695 million of CWIP in rate base to support the revenue increase. It also included a prudence disallowance of $472 million with respect to certain Comanche Peak costs relating to 87.8% of TU Electric's ownership interest in both units of Comanche Peak. With respect to TU Electric's reacquisition of the remaining 12.2% minority owner interests in Comanche Peak, the order included an additional disallowance of $909 million. In September 1991, TU Electric recorded a charge against earnings, as a provision for regulatory disallowances, of $1.381 billion ($1.011 billion after tax) as a result of the Docket 9300 final order. In November 1991, TU Electric filed a petition in the 250th Judicial District Court of Travis County, Texas, requesting a reversal and remand of the Docket 9300 final order. Other parties to the PUC proceeding also filed appeals with respect to various portions of the order. In September 1992, after a hearing, the Court entered a judgment in the appeals which affirmed the prudence disallowance of $472 million but reversed and remanded to the PUC for reconsideration those portions of the PUC's final order providing for additional disallowances aggregating $884 million with respect to TU Electric's reacquisition of minority owner interests in Comanche Peak. The Court recognized that on remand the PUC may adjust the amount of CWIP included in TU Electric's rate base to be consistent with the PUC's redeterminations regarding the minority owner reacquisitions and the amount of cash working capital. Therefore, TU Electric does not expect this judgment to affect the rates approved in the Docket 9300 final order. Other parties to this suit have appealed this judgment. TU Electric disagrees with certain portions of the judgment and also has appealed. TU Electric is unable to predict the outcome of such appeals and any reconsideration by the PUC. 11. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company has taken steps to substantially reduce construction expenditures from amounts previously estimated. Construction expenditures, excluding AFUDC, are presently estimated at $400 million for each of the years 1994, 1995 and 1996. Estimated construction expenditures for 1994 through 1996 do not include $210 million in 1996 to resume active construction of two lignite-fueled units at Twin Oak which would be necessary to meet the current scheduled in service dates of the units. The reevaluation of growth expectations, the effects of inflation, additional regulatory requirements, and the availability of fuel, labor, materials and capital may result in changes in estimated construction costs and dates of completion. Commitments in connection with the construction program are generally revocable subject to reimbursement to manufacturers for expenditures incurred or other cancellation penalties. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. COMMITMENTS AND CONTINGENCIES -- (CONTINUED) CLEAN AIR ACT The federal Clean Air Act, as amended (Clean Air Act) includes provisions which, among other things, place limits on the sulfur dioxide emissions produced by generating units. To meet these sulfur dioxide requirements, the Clean Air Act provides for the annual allocation of sulfur dioxide emission allowances to utilities. Under the Clean Air Act, utilities are permitted to transfer allowances within their own systems and to buy or sell allowances. The EPA grants a maximum number of allowances annually to TU Electric based on the amount of emissions from units in operation during the period 1985 through 1987. The Clean Air Act also provides that TU Electric be granted additional annual allowances for certain TU Electric units under construction based on part of their anticipated emissions. The Company's capital requirements have not been significantly affected by the requirements of the Clean Air Act. Although TU Electric is unable to fully determine the cost of compliance with the Clean Air Act, it is not expected to have a significant impact on the Company. Any additional capital costs, as well as any increased operating costs associated with these new requirements, are expected to be recoverable through rates, as similar costs have been recovered in the past. PURCHASED POWER CONTRACTS TU Electric and SESCO have entered into purchased power contracts to purchase portions of the generating output of certain qualifying cogenerators and qualifying small power producers through the year 2005. These contracts provide for capacity payments subject to a facility meeting certain operating standards and energy payments based on the actual power taken under the contracts. The cost of these and other purchased power contracts is recovered currently through base rates, power cost and fuel recovery factors applied to customer billings. Capacity payments under these contracts for the years ended December 31, 1993, 1992 and 1991 were $251,610,000, $240,341,000 and $229,953,000, respectively. Assuming operating standards are achieved, future capacity payments under the agreements are estimated as follows: LEASES The System Companies have entered into operating leases covering various facilities and properties including combustion turbines, transportation, mining and data processing equipment, and office space. Lease costs charged to operation expense for the years ended December 31, 1993, 1992 and 1991 were $138,184,000, $127,446,000 and $126,690,000, respectively. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. COMMITMENTS AND CONTINGENCIES -- (CONTINUED) The Company's future minimum lease commitments under such operating leases that have initial or remaining noncancellable lease terms in excess of one year as of December 31, 1993, were as follows: ______________________________ * Minimum lease commitments have not been reduced by $3,833,000 due to the Company under noncancellable subleases. COOLING WATER CONTRACTS TU Electric has entered into contracts with public agencies to purchase cooling water for use in the generation of electric energy. In connection with certain contracts, TU Electric has agreed, in effect, to guarantee the principal, $38,590,000 at December 31, 1993, and interest on bonds issued to finance the reservoirs from which the water is supplied. The bonds mature at various dates through 2011 and have interest rates ranging from 5-1/2 to 7%. TU Electric is required to make periodic payments equal to such principal and interest for the years 1994 through 1998 which includes amounts assumed by a third party as follows: $4,423,000 for 1994; $4,431,000 for 1995; $4,430,000 for 1996; $4,435,000 for 1997 and $4,435,000 for 1998. Payments made by TU Electric, net of amounts assumed by a third party under such contracts, for 1993, 1992 and 1991 were $2,954,000, $2,849,000 and $2,596,000, respectively. In addition, TU Electric is obligated to pay certain variable costs of operating and maintaining the reservoirs. TU Electric has assigned to a municipality all contract rights and obligations of TU Electric in connection with $86,450,000 remaining principal amount of bonds at December 31, 1993, issued for similar purposes which had previously been guaranteed by TU Electric. TU Electric is, however, contingently liable in the unlikely event of default by the municipality. CHACO COAL PROPERTIES Chaco Energy Company (Chaco) has a coal lease agreement for the rights to certain surface mineable coal reserves located in New Mexico. The agreement provides for minimum advance royalty payments of approximately $16 million per year through 2017, covering approximately 228 million tons of coal. The Company has entered into a surety agreement to assure the performance by Chaco with respect to this agreement. At December 31, 1993 and 1992, $483,855,000 and $467,819,000, respectively, of minimum advance royalties paid by Chaco are included in non-utility property. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. COMMITMENTS AND CONTINGENCIES -- (CONTINUED) NUCLEAR INSURANCE With regard to liability coverage, the Price-Anderson Act (Act) provides financial protection for the public in the event of a significant nuclear power plant incident. The Act sets the statutory limit of public liability for a single nuclear incident currently at $9.4 billion and requires nuclear power plant operators to provide financial protection for this amount. As required, TU Electric provides this financial protection for a nuclear incident at Comanche Peak resulting in public bodily injury and property damage through a combination of private insurance and industry-wide retrospective payment plans. As the first layer of financial protection, TU Electric has purchased $200 million of liability insurance from American Nuclear Insurers (ANI), which provides such insurance on behalf of two major stock and mutual insurance pools, Nuclear Energy Liability Insurance Association and Mutual Atomic Energy Liability Underwriters. The second layer of financial protection is provided under an industry retrospective payment program called Secondary Financial Protection (SFP). Under the SFP, each operating licensed reactor in the United States is subject to an assessment of up to $79.275 million, subject to increases for inflation every five years, in the event of a nuclear incident at any nuclear plant in the United States. Assessments are limited to $10 million per operating licensed reactor per year per incident. All assessments under the SFP are subject to a 3% insurance premium tax which is not included in the amounts above. With respect to nuclear decontamination and property damage insurance, NRC regulations require that nuclear plant license-holders maintain not less than $1.06 billion of such insurance and require the proceeds thereof to be used to place a plant in a safe and stable condition, to decontaminate it pursuant to a plan submitted to and approved by the NRC before the proceeds can be used for plant repair or restoration or to provide for premature decommissioning. TU Electric maintains nuclear decontamination and property damage insurance for Comanche Peak in the amount of $2.75 billion, above which TU Electric is self-insured. The primary layer of coverage of $500 million is provided by ANI. The remaining coverage includes premature decommissioning coverage and is provided by ANI in the amount of $850 million and Nuclear Electric Insurance Limited (NEIL), a nuclear electric utility industry mutual insurance company, in the amount of $1.4 billion. TU Electric is subject to a maximum annual assessment from NEIL of $17 million in the event NEIL's losses under this type of insurance for major incidents at nuclear plants participating in this program exceed its accumulated funds and reinsurance. TU Electric maintains Extra Expense Insurance through NEIL to cover the additional costs of obtaining replacement power from another source if one or both of the units at Comanche Peak are out of service for more than twenty-one weeks as a result of covered direct physical damage. The coverage provides for weekly payments of up to $3.5 million for the first and $2.345 million for the second and third fifty-two week periods of each outage, respectively, after the initial twenty-one week period. The total maximum coverage is $426 million per unit. The coverage amounts applicable to each unit will be reduced to 80% if both units are out of service at the same time as a result of the same accident. Under this coverage, TU Electric is subject to a maximum assessment of $10 million per year. TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. COMMITMENTS AND CONTINGENCIES -- (CONCLUDED) NUCLEAR DECOMMISSIONING AND DISPOSAL OF SPENT FUEL TU Electric has established a reserve (included in accumulated depreciation) for the decommissioning of Comanche Peak, whereby decommissioning costs are being recovered from customers over the life of the plant and deposited in external trust funds (included in other investments). At December 31, 1993, such reserve totaled $35,978,000 which includes an accrual of $12,612,000 for the year ended December 31, 1993. At December 31, 1993, $35,720,000 has been deposited in the external trust funds for decommissioning of Unit 1 and Unit 2. Realized earnings on funds deposited in the external trust are recognized in the reserve. Based on a site-specific study during 1992 using the prompt dismantlement method and then-current dollars, decommissioning costs for Comanche Peak Unit 1, and Unit 2 and common facilities were estimated to be $255,000,000 and $344,000,000, respectively. Decommissioning activities are projected to begin in 2030 and 2032 for Comanche Peak Unit 1, and Unit 2 and common facilities, respectively. TU Electric is recovering such costs based upon the 1992 study through the rates placed in effect under Docket 11735 (see Note 10). TU Electric has a contract with the United States Department of Energy for the future disposal of spent nuclear fuel at a cost of one mill per kilowatt-hour of Comanche Peak net generation. The disposal fee is included in nuclear fuel expense. GENERAL In addition to the above, the Company and its subsidiaries are involved in various legal and administrative proceedings which, in the opinion of the Company, should not have a material effect upon its financial position or results of operation. 12. CHANGE IN ACCOUNTING FOR UNBILLED REVENUE Effective January 1, 1992, TU Electric began recording base rate revenue for energy sold but not billed through the end of each month to achieve a better matching of revenues and expenses. Prior to the change in accounting method, revenues were recognized based on customer billings on a cycle basis. The change in accounting increased consolidated net income in 1992 by $102,044,000 ($0.48 per share), of which $80,907,000 ($0.38 per share) represents the cumulative effect of the change in accounting principle at January 1, 1992. Pro forma effects, assuming retroactive application of recording unbilled revenues, are presented below: TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 13. FAIR VALUE OF FINANCIAL INSTRUMENTS In December 1991, the FASB issued Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (Statement 107) to provide readers of the financial statements another method of valuing financial instruments on a current basis. The following information represents the Company's estimate of the amount at which the instruments could be exchanged in a current transaction between willing parties, other than in a forced sale. The amounts reflected in the consolidated balance sheet for cash, temporary cash investments and special deposits approximate fair value due to the short maturity of such instruments. The fair values of financial instruments for which estimated fair values have not been specifically presented is not materially different than their related book value. Other investments includes amounts principally for nuclear decommissioning fund assets and funds invested pursuant to certain incentive and compensation agreements. The fair values of the nuclear decommissioning assets and incentive and compensation assets are estimated based on quoted market prices at year-end for the instruments in which such funds are invested. Common stock -- net has been reduced by the note receivable from the trustee of the leveraged employee stock ownership provision of the Thrift Plan. The fair values of such note, long-term debt and preferred stock subject to mandatory redemption are estimated at the lesser of the Company's call price or the present value of future cash flows discounted at rates consistent with comparable maturities adjusted for credit risk. The carrying amount of other financial liabilities classified as current on the consolidated balance sheet, such as notes payable and long- term debt due currently, approximates fair value due to the short maturity of such instruments. Customer deposits have no defined maturities and, therefore, are reflected at the amount payable on demand at the balance sheet date. TU Electric has agreed, in effect, to guarantee the principal and interest on bonds used to finance the reservoirs from which TU Electric uses cooling water for certain generating units. TU Electric is also the guarantor for the principal amount of certain bonds issued for similar purposes which were assigned to a municipality. The outstanding principal at December 31, 1993 and 1992 of the bonds for which TU Electric is contingently liable is $125,000,000 and $131,000,000, respectively. The fair value of the bonds, approximately $136,000,000 and $131,000,000 for December 31, 1993 and 1992, respectively, is based on the present value of the instruments' approximate cash flows discounted at the year-end risk free rate for issues of comparable maturities adjusted for credit risk. The estimated fair value of the System Companies' significant financial instruments are as follows: TEXAS UTILITIES COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONCLUDED) 14. SUPPLEMENTARY FINANCIAL INFORMATION (UNAUDITED) In the opinion of the Company, the information below includes all adjustments (constituting only normal recurring accruals and the change in accounting, see Note 12) necessary to a fair statement of such amounts. Quarterly results are not necessarily indicative of expectations for a full year's operations because of seasonal and other factors, including rate changes, variations in maintenance and other operating expense patterns, the impact of the change in AFUDC accruals (see Note 1) and the charges for regulatory disallowances. For additional information regarding the charges for regulatory disallowances, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation and Note 10. - --------------- * Quarterly earnings per share of common stock are based on the weighted average number of shares outstanding during the quarter and, as a result, the sum of the quarters may not equal annual earnings per share. INDEPENDENT AUDITORS' REPORT Texas Utilities Company: We have audited the accompanying consolidated balance sheets of Texas Utilities Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in Item 14.(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Texas Utilities Company and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 7 and 8 to the consolidated financial statements, in 1993, the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions to conform with Statements of Financial Accounting Standards No. 109 and No. 106, respectively. Also discussed in Note 12 to the consolidated financial statements, in 1992, the Company changed its method of accounting for base rate revenue sold but not billed. /s/ DELOITTE & TOUCHE Dallas, Texas March 11, 1994 TEXAS UTILITIES COMPANY AND SUBSIDIARIES STATEMENT OF RESPONSIBILITY The management of Texas Utilities Company is responsible for the preparation, integrity and objectivity of the consolidated financial statements of the Company and its subsidiaries and other information included in this report. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles. As appropriate, the statements include amounts based on informed estimates and judgments of management. The management of the Company has established and maintains a system of internal control designed to provide reasonable assurance, on a cost-effective basis, that assets are safeguarded, transactions are executed in accordance with management's authorization and financial records are reliable for preparing consolidated financial statements. Management believes that the system of control provides reasonable assurance that errors or irregularities that could be material to the consolidated financial statements are prevented or would be detected within a timely period. Key elements in this system include the effective communication of established written policies and procedures, selection and training of qualified personnel and organizational arrangements that provide an appropriate division of responsibility. This system of control is augmented by an ongoing internal audit program designed to evaluate its adequacy and effectiveness. Management considers the recommendations of the internal auditors and independent certified public accountants concerning the Company's system of internal control and takes appropriate actions which are cost-effective in the circumstances. Management believes that, as of December 31, 1993, the Company's system of internal control was adequate to accomplish the objectives discussed herein. The Board of Directors of the Company addresses its oversight responsibility for the consolidated financial statements through its Audit Committee, which is composed of directors who are not employees of the Company. The Audit Committee meets regularly with the Company's management, internal auditors and independent certified public accountants to review matters relating to financial reporting, auditing and internal control. To ensure auditor independence, both the internal auditors and independent certified public accountants have full and free access to the Audit Committee. The independent certified public accounting firm of Deloitte & Touche is engaged to audit, in accordance with generally accepted auditing standards, the consolidated financial statements of the Company and its subsidiaries and to issue their report thereon. /s/ J. S. FARRINGTON J. S. Farrington, Chairman of the Board and Chief Executive /s/ ERLE NYE Erle Nye, President /s/ H. JARRELL GIBBS H. Jarrell Gibbs, Vice President and Principal Financial Officer /s/ H. DAN FARELL H. Dan Farell, Controller and Principal Accounting Officer ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information with respect to these items is found under the headings Election of Directors, Executive Compensation, and Beneficial Ownership of Common Stock of the Company in the definitive proxy statement to be mailed by the registrant to the Commission for filing on or about April 1, 1994. Additional information with respect to Executive Officers of the Registrant is found at the end of Part I. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. The following financial statement schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the Financial Statements or notes thereto: I, II, III, IV, VII, XI, XII and XIII. (b) Reports on Form 8-K: Reports on Form 8-K filed since September 30, 1993, are as follows: DATE OF REPORT ITEMS REPORTED -------------- -------------- October 26, 1993 Item 5. OTHER EVENTS November 24, 1993 Item 5. OTHER EVENTS January 14, 1994 Item 5. OTHER EVENTS January 31, 1994 Item 5. OTHER EVENTS Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONTINUED). (C) EXHIBITS: Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONTINUED). Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONTINUED). Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONTINUED). Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONTINUED). Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONTINUED). Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (CONCLUDED) TEXAS UTILITIES COMPANY AND SUBSIDIARIES SCHEDULE V -- UTILITY PLANT FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 _______________ (a) Other changes to utility plant and CWIP represents acquisition of SESCO. (See Note 1 to Consolidated Financial Statements.) (b) Other changes to nuclear fuel includes $65,259,000, $24,214,000 and $25,393,000 deducted for amortization in 1993, 1992 and 1991, respectively. (c) Disallowed Comanche Peak related costs. (See Note 10 to Consolidated Financial Statements.) TEXAS UTILITIES COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 __________________ (a) Includes depreciation on lignite fuel production facilities charged to fuel and decommissioning expense for Comanche Peak. (b) Depreciation and depletion charged to various accounts, including depreciation of transportation and work equipment, based on estimated lives thereof, are charged to clearing accounts and allocated on the basis of the use of such equipment. TEXAS UTILITIES COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 ____________________ (a) Deductions represents uncollectible accounts written off net of recoveries of amounts previously written off. TEXAS UTILITIES COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 ______________________ (a) Weighted averages are based upon daily amounts outstanding and equivalent annual interest thereon. TEXAS UTILITIES COMPANY AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INFORMATION FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 ______________________________ Maintenance and repairs, depletion, amortization, royalties, research and development, and advertising, other than amounts set out separately in the financial statements, are not material. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. TEXAS UTILITIES COMPANY Date: By: /s/ J. S. FARRINGTON __________________________________ (J. S. FARRINGTON, CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. APPENDIX TO ELECTRONIC FORMAT DOCUMENT A map outlining the service systems is displayed on page 17 of this report on Form 10-K. This map appears in the paper format version of the document and not in this electronic filing.

21344_1993.txt

21344_1993

1993

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ITEM 1. BUSINESS The Coca-Cola Company (the "Company" or the "Registrant") was incorporated in September 1919 under the laws of the State of Delaware and succeeded to the business of a Georgia corporation with the same name that had been organized in 1892. The Company is the largest manufacturer, marketer and distributor of carbonated soft drink concentrates and syrups in the world. Its soft drink products, sold in the United States since 1886, are now sold in more than 195 countries around the world and are the leading carbonated soft drink products in most of these countries. Within the last two years, the Company has gained entry into several countries such as Romania and India. The Company also manufactures, produces, markets and distributes juice and juice drink products. SOFT DRINKS General Business Description The Company manufactures soft drink concentrates and syrups, which it sells to bottling and canning operations, and manufactures fountain/post-mix soft drink syrups, which it sells to authorized fountain/post-mix wholesalers and some fountain/post-mix retailers. Syrups are composed of sweetener, water and flavoring concentrate. Bottling and canning operations, whether independent or Company-owned, combine the syrup with carbonated water or combine the concentrate with sweetener and carbonated water, and package the final soft drink product in authorized cans, refillable and non-refillable glass bottles and plastic containers for sale to retailers. Fountain/post-mix wholesalers sell soft drink syrups to fountain/post-mix retailers, who sell soft drinks to consumers in cups and glasses. The Company's soft drink products, including bottled and canned beverages produced by independent and Company-owned bottling and canning operations, as well as concentrates and syrups, include Coca-Cola, Coca-Cola classic, caffeine free Coca-Cola, caffeine free Coca-Cola classic, diet Coke (sold under the trademark Coke light in many territories outside the United States), caffeine free diet Coke, cherry Coke, diet cherry Coke, Sprite, diet Sprite, Mr. PiBB, Mello Yello, Fanta brand soft drinks, Hi-C brand fruit drinks, TAB, caffeine free TAB, TAB Clear, Fresca, PowerAde, Minute Maid soft drinks and other products developed for specific markets, including Georgia brand coffee, a non-carbonated drink. Coca-Cola Nestle Refreshments ("CCNR"), the Company's 50% joint venture with Nestle S.A., produces ready-to-drink teas and coffees. The Company's soft drink products accounted for 87% of the Company's net operating revenues in 1993 and 1992 and 86% in 1991. Soft drink products accounted for 96% of the Company's operating income in 1993, 1992 and 1991. In 1993, products bearing the trademark "Coca-Cola" accounted for approximately 73% of the soft drink operations' gallon shipments worldwide. In 1993, sales of the Company's soft drink products in the United States accounted for approximately 31% of the Company's soft drink gallon shipments. In 1993, the Company's principal markets outside the United States, in terms of gallon shipments, were Mexico, Germany, Japan and Brazil, which together accounted for approximately 40% of the remaining 69% of soft drink gallon shipments. Net operating revenues outside the United States, including an immaterial amount from Coca-Cola Foods, were 67% of net operating revenues in 1993 and 1992 and 64% in 1991. Operating income attributable to soft drink products outside the United States amounted to 79% of total operating income from all geographic areas in 1993, 80% in 1992 and 79% in 1991. In 1993, the Company made approximately 64% of its gallon shipments of soft drink concentrates and syrups in the United States to bottlers in approximately 397 licensed territories. Those bottlers prepare and sell the products for the food store and vending machine distribution channels and for other distribution channels supplying home and on-premise consumption. The remaining 36% was sold to fountain/post-mix retailers and to approximately 1,000 authorized fountain/post-mix wholesalers, some of whom are bottlers, who in turn sold the syrup to restaurants and other fountain/post-mix retailers, including fast food restaurants. Coca-Cola Enterprises Inc. ("Coca-Cola Enterprises") and its bottling subsidiaries and divisions account for approximately 36% of the Company's total gallon shipments of soft drink concentrates and syrups sold in the United States. The Company holds an approximate 43.5% ownership interest in Coca-Cola Enterprises, which is the world's largest bottler of Company soft drink products. Outside the United States, soft drink concentrate was sold to independently owned bottling and canning operations and to Company-owned operations. In the United States, approximately 75% of the Company's fountain/post-mix syrups are sold through national or regional retail chains. The remaining 25% of the Company's fountain/post-mix syrups are sold through local outlets, which account for approximately 50% of the total number of retail fountain/post-mix outlets that sell the Company's fountain/post-mix products. In addition to conducting its own independent advertising and marketing activities, the Company may provide promotional and marketing services and consultation to its bottlers and fountain/post-mix customers. It may also develop and introduce new products, packages and equipment in order to assist its bottlers, fountain/post-mix wholesalers and fountain/post-mix retailers. The profitability of the Company's business outside the United States is subject to many factors, including governmental trade regulations, monetary policies, economic conditions in the countries in which such business is conducted and the risk of changes in currency exchange rates and regulations. Agreements with Bottlers and Fountain Wholesalers of Soft Drink Products The bottling subsidiaries and divisions of Coca-Cola Enterprises and bottlers for 71 other territories in the United States have entered into substantially similar bottling contracts (the form of these contracts being referred to herein individually as the "1987 Contract") with the Company which differ from some other bottling contracts in force between the Company and its bottlers in the United States. The 1987 Contract grants exclusive territorial rights to manufacture, market and distribute beverages bearing the trademarks "Coca-Cola" or "Coke" ("Coca-Cola Trademark Beverages") and provides that bottlers purchase all concentrates and syrups for Coca-Cola Trademark Beverages from the Company at prices and with terms of payment and other terms and conditions of supply as determined from time to time by the Company. The 1987 Contract is perpetual, subject to termination by the Company in the event of default. Events of default include: (1) bottlers' insolvency, dissolution, receivership or the like; (2) any disposition by bottlers or any of their bottler subsidiaries of any voting securities of any bottler subsidiary without the consent of the Company; and (3) any material breach of any obligation under the 1987 Contract. The Company has the right to terminate the 1987 Contract of any bottler if a person or affiliated group acquires or obtains any right to acquire beneficial ownership of more than 10% of any class or series of voting securities of the bottler unless authorized by the Company. The Company has agreed with Coca-Cola Enterprises, Coca-Cola Bottling Co. Consolidated ("Consolidated") and Swire Pacific Limited ("Swire") that this provision will not apply with respect to the ownership of any class or series of voting securities of Coca-Cola Enterprises, Consolidated or Swire, or any corporation, not a direct or indirect subsidiary of Swire, owning stock in Swire. The Company has no obligation under the 1987 Contract to participate with bottlers in expenditures for advertising and marketing, but it may, at its discretion, contribute such expenditures and undertake independent advertising and marketing activities, as well as cooperative advertising and sales promotion programs. Under the 1987 Contract, each bottler is obligated to cause any United States bottler of which it acquires control, to amend that bottler's contract for Coca-Cola Trademark Beverages to conform to the terms of the 1987 Contract. The 1987 Contract is not assignable without the prior consent of the Company. The 1987 Contract has been signed by bottlers representing approximately 74% of domestic gallon shipments for bottled and canned beverages, including Coca-Cola Enterprises which represents approximately 54% of domestic gallon shipments for bottled and canned beverages. Prior to 1978, contracts with bottlers in the United States provided for a fixed price for the sale of Coca-Cola syrup used in bottles and cans, subject to quarterly adjustments to reflect changes in the quoted price of sugar. By December 31, 1993, bottlers representing approximately 98% of the Company's Coca-Cola bottler gallon shipments in the United States were parties to contracts with the Company, including the 1987 Contract, which provide certain additional pricing flexibility. This percentage includes bottlers which had entered into amendments to their contracts relating to brand Coca-Cola (the "1978 Amendment") that provide certain additional pricing flexibility to, and impose additional marketing obligations on, the Company with respect to Coca-Cola concentrate and syrup. Under the 1978 Amendment, concentrate or syrup is sold to the bottler by the Company at a price established in 1978 and adjusted annually by the Company up to a maximum ceiling price indexed to reflect increases in the Consumer Price Index from 1978 and, in the case of syrup, adjusted quarterly based upon changes in the average price per pound of fine granulated cane and beet sugar in the United States. In the event the Company modifies the syrup formula to substitute another sweetening ingredient in whole or in part for sugar, the 1978 Amendment requires the Company to adjust the pricing formula so as to give the bottler the benefit of any cost savings realized as a result of such modification. By December 31, 1993, bottlers in the United States representing approximately 98% of the Company's one-calorie cola-flavored gallon shipments in the United States either had entered into the 1987 Contract or had executed an amendment to their contracts to include under those contracts bottling rights for all of the Company's one-calorie and caffeine free cola-flavored products in bottles and cans and to provide formula pricing (based on an initial price for beverage base or syrup established in 1983, adjusted annually by the Company to a maximum ceiling price indexed to reflect increases in the Consumer Price Index and the volume of one-calorie beverage base or syrup sold by the Company and adjusted quarterly to reflect changes in the price of sweetener) and minimum marketing obligations on the Company with respect to these products. In 1979, the Company authorized its bottlers who had agreed to the 1978 Amendment to produce syrup for Coca-Cola from concentrate. This authorization allows such bottlers to purchase concentrate from the Company and sweetener on the open market. Bottlers responsible for most of the volume in the United States purchase sweeteners through the Company under a pass-through arrangement and, accordingly, related collections from bottlers and payments to suppliers are not included in the Company's consolidated statements of income. Approximately 123 bottlers in the United States, representing approximately 95% of the Company's sugar cola-flavored gallon shipments in the United States, produce syrup from concentrate (or have the syrup manufactured from concentrate by an authorized agent) or have notified the Company of their intentions to do so. Standard contracts with bottlers in the United States for the sale of concentrate and syrup for non-cola-flavored products in bottles and cans permit flexible pricing by the Company. In the United States, the Company sells syrup to about 1,000 fountain wholesalers pursuant to a non-exclusive annual letter of appointment, which does not restrict the pricing of fountain/post-mix syrups by the Company and does not restrict the territory in which the wholesaler may resell in the United States. In addition, the Company has contracted in about 259 territories with bottlers of Coca-Cola for the local bottler to provide certain marketing and operational services to local retail accounts and to other wholesalers in those territories that otherwise would be performed by Company employees. Such contracts typically extend for more than one year's duration. Standard contracts with bottlers outside the United States for the sale of concentrate and syrup for Company soft drink products generally do not contain restrictions on the Company for the pricing of syrup and concentrate and have stated durations. Outside the United States, with some exceptions, distribution of the Company's products for sale in cups and glasses is handled through bottlers, on a non-exclusive basis, under the terms of the bottlers' agreements with the Company. The Bottler System The Company is committed to continuing to strengthen its existing strong bottler system, as evidenced by the following examples. In April 1993, the Company purchased majority ownership interests in two bottling companies in Tennessee along with the rights to purchase the remaining minority interests. Such ownership interests and a bottling operation in the Netherlands were sold to Coca-Cola Enterprises in June 1993. The Company received approximately $260 million in cash plus assumption of indebtedness plus carrying costs. Also in June 1993, the Company acquired a 30% equity interest in Coca-Cola FEMSA, S.A. de C.V. ("Coca-Cola FEMSA"), a holding company with bottling subsidiaries in the Valley of Mexico and Mexico's southeastern region, for approximately $195 million. In the third quarter, the Company entered into a joint venture with Consolidated, establishing Piedmont Coca-Cola Bottling Partnership ("Piedmont"), which will operate certain bottling territories in the Carolinas acquired from each company. The Company has made a cash contribution of $70 million to the partnership for a 50% ownership interest. Consolidated has contributed bottling assets valued at approximately $48 million and approximately $22 million in cash to the partnership for the remaining 50% interest. Piedmont has purchased assets and stock of certain bottling operations from the Company for approximately $163 million, which approximated the Company's carrying costs, and certain bottling assets from Consolidated for approximately $130 million. The Company beneficially owns a 30% economic interest and a 23% voting interest in Consolidated. In August 1993, the Company purchased shares which now constitute a 10% voting interest and an 8.6% equity interest in Panamerican Beverages, Inc., a holding company with bottling subsidiaries in Colombia, Brazil and Mexico, for approximately $32 million. See "Significant Equity Investments and Company Bottling Operations." Significant Equity Investments and Company Bottling Operations Over the last decade, bottling investments have represented a significant portion of the Company's capital investments. The principal objective of these investments is to ensure strong and efficient production, distribution and marketing systems in order to maximize long-term growth in volume, cash flows and share-owner value of the bottler and the Company. When considered appropriate, the Company makes equity investments in bottling companies (typically between 20% and 50%). Through these investments, the Company is able to help focus and improve sales and marketing programs, assist in the development of effective business and information systems and help establish capital structures appropriate for these respective operations. In certain situations, management believes it is advantageous to own a controlling interest in bottling operations. For example, in 1990 in eastern Germany, the Company's objective was to establish a modern soft drink business quickly, which was accomplished through a wholly-owned bottling subsidiary. The Company's consolidated bottling and fountain/post-mix operations produced and distributed approximately 16% of worldwide unit case volume and, together with consolidated canning operations, generated approximately $4.6 billion in revenues in 1993. The Company also has substantial equity positions in bottlers that represent approximately 40% of domestic bottling, canning and fountain/post-mix unit case volume. Equity investee bottlers, including entities in which the Company holds, or during 1993 held, a temporary majority interest, produced and distributed approximately 38% of worldwide bottling, canning and fountain/post-mix unit case volume in 1993. In restructuring the bottling system, the Company periodically participates in bottler ownership changes or takes temporary ownership positions in bottlers. The length of ownership is influenced by various factors, including operational changes, management changes and the process of identifying appropriate new investors. Coca-Cola Enterprises. The Company's ownership interest in Coca-Cola Enterprises is approximately 43.5%. On June 30, 1993, Coca-Cola Enterprises purchased from the Company majority ownership interests in two bottling companies in Tennessee, along with the rights to purchase the remaining minority interests, and a bottling operation in the Netherlands. See "The Bottler System." Coca-Cola Enterprises is the world's largest bottler of the Company's soft drink products. Net sales of concentrates and syrups by the Company to Coca-Cola Enterprises were $961 million in 1993. Coca-Cola Enterprises purchases high fructose corn syrup (HFCS-55 & HFCS-42) through the Company under a pass-through arrangement and, accordingly, related collections from Coca-Cola Enterprises and payments to suppliers are not included in the Company's consolidated statements of income. Sweetener transactions with Coca-Cola Enterprises amounted to $211 million in 1993. Coca-Cola Enterprises estimates that the territories in which it markets such soft drink products to retailers (which include portions of 38 states, the District of Columbia, the U.S. Virgin Islands and the Netherlands) contain approximately 52% of the United States population and 100% of the population of the Netherlands. Coca-Cola Enterprises is the principal bottler of products of the Company in the five states in the United States (California, Florida, Texas, Washington and Virginia) with the largest gains in population from 1989 to 1993. As used herein, the term "equivalent unit case volume" refers to 192 U.S. ounces of finished beverage product (24 eight-ounce servings). In 1993, approximately 72% of the equivalent unit case volume of Coca-Cola Enterprises (excluding products in post-mix form) were Coca-Cola Trademark Beverages, approximately 17% of its equivalent unit case volume were other soft drink products of the Company, and approximately 11% of its equivalent unit case volume were soft drink products of other companies. Coca-Cola Enterprises' net sales of beverage products were approximately $5.5 billion in 1993. Coca-Cola Beverages Ltd. ("Coca-Cola Beverages"). The Company owns approximately 49% of the outstanding common stock of Coca-Cola Beverages. Coca-Cola Beverages is the largest bottler of the Company's soft drink products in Canada. Coca-Cola Beverages estimates that the territories in which it markets soft drink products (which include all or significant portions of each of Canada's ten provinces) contained approximately 27 million people in 1993, or approximately 94% of the Canadian population. In 1993, Coca-Cola Beverages' net sales of beverage products were approximately U.S. $687 million. In 1993, approximately 68% of the equivalent unit case volume of Coca-Cola Beverages were Coca-Cola Trademark Beverages, approximately 17% of its equivalent unit case volume were other soft drink products of the Company and approximately 15% of its equivalent unit case volume were soft drink products of other companies. Coca-Cola Amatil Limited ("Coca-Cola Amatil"). The Company owns approximately 51% of Coca-Cola Amatil, an Australian-based bottler of Company products. The Company intends to reduce its ownership interest in Coca-Cola Amatil to below 50% within the next year. Accordingly, the investment has been accounted for by the equity method of accounting. Coca-Cola Amatil is the largest overall bottler, as well as the largest bottler of the Company's soft drink products, in Australia and also has bottling and distribution territories, through direct ownership or joint ventures, in New Zealand, Fiji, Austria, Hungary, Papua New Guinea, the Czech Republic, Slovakia, Indonesia and Belarus. Coca-Cola Amatil estimates that the territories in which it markets soft drink products contain approximately 99% of the Australian population, 100% of the New Zealand and Fiji populations, 80% of the Austrian population, 100% of the Hungarian population, 84% of the Papua New Guinean population, 100% of the Czech Republic and Slovakian populations, 92% of the Indonesian population and 100% of the Belarussian population. In 1993, Coca-Cola Amatil's net sales of beverage products were approximately U.S. $1,315 million. In January 1993, Coca-Cola Amatil sold its snack food operation for approximately U.S. $299 million, and recognized a gain of U.S. $169 million. The Company's ownership interest in the sale proceeds received by Coca-Cola Amatil approximated the carrying value of the Company's investment in the snack food segment. In 1993, approximately 61% of the equivalent unit case volume of Coca-Cola Amatil were Coca-Cola Trademark Beverages, approximately 25% of its equivalent unit case volume were other soft drink products of the Company, approximately 11% of its equivalent unit case volume were soft drink products of Coca-Cola Amatil and approximately 3% of its equivalent unit case volume were soft drink products of other companies. Coca-Cola & Schweppes Beverages Ltd. ("CC&SB"). The Company owns an approximate 49% interest in CC&SB, the leading marketer of soft drink products in Great Britain. CC&SB handles bottling and distribution of products of the Company and Cadbury Schweppes PLC throughout Great Britain. In 1993, CC&SB's net sales of beverage products were approximately $1.1 billion. In 1993, approximately 54% of the equivalent unit case volume of CC&SB were Coca-Cola Trademark Beverages, approximately 10% of its equivalent unit case volume were other soft drink products of the Company, approximately 35% of its equivalent unit case volume were soft drink products of Cadbury Schweppes PLC and approximately 1% of its equivalent unit case volume were soft drink products of other companies. CCNR. In 1991, the Company and Nestle S.A. formed CCNR, which is equally owned by the Company and Nestle S.A. CCNR was created in order to manufacture and sell concentrates and beverage bases to third parties, including some bottlers of the Company's soft drink products, for the production and distribution of ready-to-drink coffee, tea and chocolate beverages on a worldwide basis, except for Japan. The Company and Nestle S.A. have contributed approximately $35 million each. It is expected that capitalization will eventually total approximately $50 million each. CCNR launched its first product, a ready-to-drink canned coffee marketed under the NESCAFE brand, in Korea in September 1991. In January 1992, CCNR launched its first products in the United States, NESTEA sweetened iced tea with lemon flavor and diet NESTEA iced tea with lemon flavor, sold through Company bottlers in all fifty states. Subsequently, additional flavors of NESTEA iced tea have been added in the United States, as well as post-mix NESTEA syrups which are sold through authorized Coca-Cola fountain/post-mix wholesalers. As of early 1994, CCNR had also launched NESTEA iced tea flavors in Taiwan, Italy, Korea, Belgium, Spain, Germany, Canada and Switzerland. NESCAFE ready-to-drink coffee is also available in Taiwan, Hong Kong and Macau. Coca-Cola FEMSA. On June 21, 1993, the Company, through its indirect subsidiary, The Inmex Corporation, entered into a joint venture with Fomento Economico Mexicano, S.A. de C.V. ("FEMSA"), the largest "food, beverage and tobacco" company listed on the Mexican Stock Exchange (Bolsa Mexicana de Valores). The Company invested approximately $195 million in exchange for a 30% equity interest in Coca-Cola FEMSA, a Mexican holding company with bottling subsidiaries in the Valley of Mexico and in Mexico's southeastern region. In September 1993, a wholly owned subsidiary of FEMSA sold shares of Series L common stock of Coca-Cola FEMSA in a registered public offering in Mexico while simultaneously offering in the United States and elsewhere American Depository Shares ("ADSs"). As a result, Coca-Cola FEMSA's Series L shares are now listed and traded on the Mexican Stock Exchange and the ADSs are listed and traded on the New York Stock Exchange. The sale represented a 19% equity interest in Coca-Cola FEMSA; the remaining 51% is held by FEMSA. The Company continues to hold its 30% interest. Other Bottling Interests. The Company holds an indirect 32% equity interest in The Philadelphia Coca-Cola Bottling Company. In January 1994, the Company sold common stock representing a 9% voting interest and a 4% economic interest in The Coca-Cola Bottling Company of New York, Inc. ("CCNY") to Coca-Cola Enterprises for approximately $6 million thereby reducing its voting and economic ownership interest in CCNY to 49%, consistent with its stated intention of ending temporary control after completing certain organizational changes. In total, including the bottling operations discussed herein, the Company holds ownership positions in approximately 35 unconsolidated bottling, canning and distribution operations for its products worldwide. Seasonality Soft drink sales are somewhat seasonal, with the second and third calendar quarters accounting for the highest sales volumes in the Northern Hemisphere. The volume of sales in the soft drink business may be affected by weather conditions. Competition The commercial beverages industry, of which the soft drink business is a part, is competitive. The soft drink business itself is highly competitive. In many parts of the world in which the Company does business, demand for soft drinks is growing at the expense of other commercial beverages. Advertising and sales promotional programs, product innovation, increased efficiency in production techniques, the introduction of new packaging, new vending and dispensing equipment and brand and trademark development and protection are important competitive factors. Raw Materials The principal raw material used by the soft drink industry in the United States is high fructose corn syrup (HFCS-55), a form of sugar, which is available from numerous domestic sources and is historically subject to fluctuations in its market price. The principal raw material used by the soft drink industry outside the United States is sucrose. The Company has a specialized sweetener procurement staff and has not experienced any difficulties in obtaining its requirements. In the United States and certain other countries, the Company has authorized the use of HFCS-55 in syrup for Coca-Cola and allied products for use in both fountain/post-mix syrup and product in bottles and cans. Another raw material used by the soft drink industry is aspartame, a sweetening agent used in low-calorie soft drink products. Generally, raw materials utilized by the Company in its soft drink business are readily available from numerous sources. However, aspartame, which is usually used alone or in combination with saccharin in the Company's one-calorie soft drink products, is currently purchased by the Company for use in the United States from The NutraSweet Company, a subsidiary of Monsanto Company. While The NutraSweet Company is also a major worldwide supplier of aspartame to the Company, other suppliers of aspartame are utilized in certain countries outside of the United States. FOODS General Business Description The Company's Foods Business Sector is an operating unit which includes Coca-Cola Foods, with operations in the United States, Canada and Puerto Rico. Coca-Cola Foods, a division of the Company, is the world's largest marketer and distributor of juice and juice drink products. In North America, Coca-Cola Foods manufactures and markets the following products: Minute Maid chilled ready-to-serve and frozen concentrated citrus and variety juices, lemonades and fruit punches; Minute Maid shelf-stable ready-to-serve juice and juice drink products in single and multi-serve containers; Five Alive refreshment beverages; Bright & Early breakfast beverages; Bacardi tropical fruit mixers, which are manufactured and marketed under a license from Bacardi & Company Limited; and Hi-C brand ready-to-serve fruit drinks in single and multi-serve containers. Both directly and through a network of brokers, Coca-Cola Foods products are sold to retailers and wholesalers in North America and to military commissaries and exchanges in the United States and abroad. Outside North America, Coca-Cola Foods provides both technical and marketing assistance to other units of the Company relating to the production and marketing of branded juice and juice drink products. Minute Maid Foodservice, a division of Coca-Cola Foods, provides airlines, restaurants, hotels, colleges, hospitals and other institutions with a full line of juice and juice drink products and specialty dairy products. Minute Maid Foodservice manufactures and distributes foodservice juice products under the Minute Maid, Hi-C and other trademarks. In 1993, Coca-Cola Foods achieved record results for both volume and operating income and widened its leadership in the juice and juice drink category. Operating income grew 13% to $127 million. Volume increased 16% as aggressive pricing and marketing drove strong gains across all lines of business. Minute Maid orange juice volume was up 18% while volume of other juices and juice drink products was up 14%. Product Line Development During 1993, Coca-Cola Foods began the national rollout of Minute Maid Naturals, a line of shelf-stable juice and juice drink products packaged in multi-serve PET bottles. The rollout followed a successful test market of these products, which were developed to increase the presence of the Minute Maid trademark in the shelf-stable category. Coca-Cola Foods also successfully introduced in 1993 frozen and chilled versions of Minute Maid cranberry lemonade and raspberry lemonade. In conjunction with increased marketing efforts, these products helped to generate a 9% increase in the division's lemonade and fruit punch volume. The division also introduced a 128 ounce plastic bottle for Hi-C fruit drinks, which capitalized on the strength of larger sizes in this line of business. Hi-C multi-serve volume during the year increased 11% as this package generated incremental volume growth to the business. Minute Maid In-The-Box volume grew 20% as a result of lower prices, significant distribution increases and the successful launch of Minute Maid Berry Punch in this package. In conjunction with Coca-Cola Enterprises and other Coca-Cola bottlers, Coca-Cola Foods continued to generate significant volume increases for Minute Maid Juices To Go, which are juice and juice drink products packaged in single-serve bottles and cans and sold through a variety of distribution channels, including vending machines. Volume for Minute Maid Juices To Go grew 160% due to increased availability and strong marketing support. The products are currently available nationwide. Seasonality Demand for juice and juice drink products does not fluctuate in any significant manner throughout the calendar year. Competition The juice and juice drink products manufactured, marketed and distributed by Coca-Cola Foods face strong competition from other producers of regionally and nationally advertised brands of juice and juice drink products. Significant competitive factors include advertising and trade promotion programs, new product introductions, new and more efficient production and distribution methods, new packaging and dispensing equipment, and brand and trademark development and protection. Raw Materials The citrus industry is subject to the variability of weather conditions, in particular the possibility of freezes in central Florida, which may result in higher prices and lower consumer demand for orange juice throughout the industry. Due to the Company's long-standing relationship with a supplier of high-quality Brazilian orange juice concentrate, the supply of juice available that meets the Company's standards is normally adequate to meet demand. PATENTS, TRADE SECRETS, TRADEMARKS AND COPYRIGHTS The Company is the owner of numerous patents, copyrights and trade secrets, as well as substantial know-how and technology (hereinafter referred to as "technology"), which relate to its products and the processes for their production, the packages used for its products, the design and operation of various processes and equipment used in its business and certain quality assurance and financial software. Some of the technology is licensed to suppliers and other parties. The Company's soft drink and other beverage formulae are among the important trade secrets of the Company. Trademarks are very important to the Company's business. Depending upon the jurisdiction, trademarks are valid as long as they are in use and/or their registrations are properly maintained and they have not been found to have become generic. Registrations of trademarks in the United States can generally be renewed indefinitely as long as the trademarks are in use. The majority of the Company's trademark license agreements are included in the Company's bottler agreements. The Company has registered and licenses the right to use its trademarks in conjunction with certain merchandise other than soft drinks. GOVERNMENTAL REGULATION The production, distribution and sale in the United States of many of the Company's products are subject to the Federal Food, Drug and Cosmetic Act; the Occupational Safety and Health Act; the Lanham Act; various environmental statutes; and various other Federal, state and local statutes regulating the production, sale, safety, advertising, labeling and ingredients of such products. On January 6, 1993, the United States Food and Drug Administration (the "FDA") published new labeling requirements for all food products, with a compliance deadline set for May 8, 1994. The Company does not expect the rules to have any significant impact on its products nor does the Company expect compliance to have any material adverse effect upon the Company's capital expenditures, net income or competitive position. A California law, enacted in 1986 by ballot initiative, requires that any person who exposes another to a carcinogen or a reproductive toxicant must provide a warning to that effect. Because the law does not define quantitative thresholds below which a warning is not required, virtually all food manufacturers are confronted with the possibility of having to provide warnings on their food products due to the presence of trace amounts of defined substances. Regulations implementing the law exempt manufacturers from providing the required warning if it can be demonstrated that the defined substances occur naturally in the product or are present in municipal water used to manufacture the product. The Company has assessed the impact of the law and its implementing regulations on its soft drink products and other products and has concluded that none of its products currently requires a warning under the law. The Company cannot predict whether, or to what extent, food industry efforts to minimize the law's impact on foods will succeed; nor can the Company predict what impact, either in terms of direct costs or diminished sales, imposition of the law will have. Bottlers of the Company's soft drink products presently offer non-refillable containers in almost all areas of the United States and Canada. Many such bottlers also offer refillable containers. Measures have been enacted in certain localities and are currently in effect in nine states prohibiting the sale of certain beverages unless a deposit is charged for the container. Similar proposals have been introduced in other states and localities and in past sessions of Congress, and it is anticipated that similar legislation will be introduced in the current session of Congress. All of the Company's facilities in the United States are subject to federal, state and local environmental laws and regulations. Compliance with these provisions has not had, and the Company does not expect such compliance to have, any material adverse effect upon the Company's capital expenditures, net income or competitive position. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries employed nearly 34,000 persons, of whom nearly 10,500 are located in the United States. The Company, through its divisions and subsidiaries, has entered into numerous collective bargaining agreements, and the Company has no reason to believe it will not be able to renegotiate any such agreements on satisfactory terms. The Company believes that its relations with its employees are generally satisfactory. FINANCIAL INFORMATION ON INDUSTRY SEGMENTS AND GEOGRAPHIC AREAS For financial information on industry segments and operations in geographic areas, see pages 69 and 70 of the Annual Report to Share Owners for the year ended December 31, 1993, which are incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES The Company's international headquarters is located on a 35-acre office complex in Atlanta, Georgia. The complex includes the approximately 480,000 square feet headquarters building, the approximately 721,000 square feet Coca-Cola USA building and an additional 232,000 square feet office building of which Coca-Cola Enterprises currently occupies a significant portion of the space. Also located on the complex are several other buildings including the technical and engineering facilities, training center and the Company's Reception Center. The Company and its subsidiaries and divisions have facilities for administrative operations, manufacturing, processing, packaging, packing, storage and warehousing throughout the United States. Coca-Cola Enterprises is presently renting approximately 104,000 square feet of office space, located in the Atlanta office complex, from the Company pursuant to a lease agreement. In 1993, Coca-Cola Enterprises paid approximately $1.7 million under the lease arrangements. It is expected that Coca-Cola Enterprises will materially reduce the amount of space leased in 1994. The Company owns 42 principal soft drink concentrate and/or syrup manufacturing plants throughout the world. The Company currently owns or holds a majority interest in 29 operations with 42 principal soft drink bottling and canning plants located in foreign countries, excluding entities in which the Company's majority interest is temporary. Coca-Cola Foods, whose primary business headquarters is located in Houston, Texas, occupies its own office building, which contains approximately 330,000 square feet. Coca-Cola Foods operates 10 production facilities throughout the United States, Canada and Puerto Rico and utilizes a system of co-packers which produce and distribute products in areas where Coca-Cola Foods does not have its own manufacturing centers or when it experiences manufacturing overflow. In 1993, the Company sold its citrus groves and related assets located in central and southern Florida. The Company directly or through wholly-owned subsidiaries owns or leases additional real estate throughout the world, including an office building at 711 Fifth Avenue in New York, New York. This real estate is used as office space by the Company or, in the case of some owned property, leased to others. Management believes that the facilities for the production of its soft drink and food products are suitable and adequate for the business conducted therein, that they are being appropriately utilized in line with past experience and that they have sufficient production capacity for their present intended purposes. The extent of utilization of such facilities varies based upon the seasonal demand for product. While it is not possible to measure with any degree of certainty or uniformity the productive capacity and extent of utilization of these facilities, management believes that additional production can be obtained at the existing facilities by the addition of personnel and capital equipment and, in some facilities, the addition of shifts of personnel or expansion of such facilities. The Company continuously reviews its anticipated requirements for facilities and, on the basis of that review, may from time to time acquire additional facilities and/or dispose of existing facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In May 1993, the Company discovered that its Carolina, Puerto Rico plant was unintentionally discharging, without a permit, process wastewater to a stormwater sewer which ultimately discharged to a surface waterbody. The Company immediately remedied the unintentional discharge and reported it to appropriate environmental agencies. The statutory maximum penalty which could be sought against the Company is in excess of $100,000. Joseph Siegman, as custodian for Gregory and Michelle Siegman, filed suit in Delaware Chancery Court on December 15, 1987 against the Company, Tri-Star Pictures, Inc. ("Tri-Star"), CPI Film Holdings, Inc., Home Box Office, Inc. and the directors of Tri-Star at that time. Plaintiff, a Tri-Star stockholder acting on behalf of a class of Tri-Star stockholders other than defendants and their affiliates and derivatively on behalf of Tri-Star, challenges a transfer agreement, dated October 1, 1987, among the Company, certain of its subsidiaries and Tri-Star as the product of an alleged self-dealing breach of fiduciary duty by the Company and the Tri-Star Board of Directors. Plaintiff also alleges that the proxy statement issued by Tri-Star in connection with the transaction inadequately disclosed material facts about the transaction. Pursuant to the transfer agreement, the Company transferred its Entertainment Business Sector (other than certain retained assets) to Tri-Star in exchange for approximately 75 million shares of Tri-Star common stock. The complaint seeks judgment imposing a constructive trust upon the Tri-Star shares received by the Company pursuant to the transfer agreement, rescinding the transfer agreement and awarding compensatory damages in an unspecified amount. During 1991 and 1992, the Chancery Court granted defendants' motion to dismiss the case, and plaintiff appealed. On November 24, 1993, the Delaware Supreme Court issued an opinion reversing in part the judgment entered by the Chancery Court and remanding the case for trial on the merits. The Supreme Court's opinion treated all of the factual allegations in plaintiff's complaint as true for purposes of the appeal and determined that the complaint was legally adequate to permit plaintiff an opportunity to prove the complaint allegations. No date has yet been established for trial on remand. The Company believes it has meritorious legal and factual defenses and intends to defend the case vigorously. On February 26, 1992, suit was brought against the Company in Texas state court by The Seven-Up Company, a competitor of the Company. An amended complaint was filed by The Seven-Up Company on February 8, 1994. The suit alleges that the Company is attempting to dominate the lemon-lime segment of the soft drink industry by tortious acts designed to induce certain independent bottlers of the Company's products to terminate existing contractual relationships with the plaintiff pursuant to which such bottlers bottle and distribute the plaintiff's lemon-lime soft drink products. As amended, the complaint alleges that Coca-Cola/Seven-Up bottlers in several different territories, including Nacagdoches, Texas; Oklahoma City, Oklahoma; Fargo, North Dakota; Shreveport, Louisiana; Elkins, West Virginia; Salem, New Hampshire; Fayetteville, Arkansas; Pine Bluff, Arkansas and Vicksburg, Mississippi, were illegally induced into initiating Sprite distribution and discontinuing Seven-Up distribution. The Company is accused of using several different purportedly improper tactics to bring about those bottler decisions, including false and misleading statements by the Company about the plaintiff's past, present and future business operations, improper financial advancements and various forms of alleged coercion. The complaint seeks unspecified money damages for (1) alleged tortious interference with the plaintiff's contractual relations, (2) alleged intentional tortious conduct to injure plaintiff, (3) alleged disparagement of the plaintiff and its business, and (4) alleged false and injurious statements harmful to plaintiff's interests. The complaint also seeks an injunction prohibiting future allegedly tortious conduct by the Company and seeks an award of punitive damages in the amount of at least $500 million. In 1993, the Company filed a counterclaim against The Seven-Up Company in the matter alleging that The Seven-Up Company has tortiously interfered with the Company's efforts to obtain distribution of its lemon-lime soft drink, Sprite, through bottlers of Coca-Cola. Since the inception of the suit, the parties have been engaged in discovery. Trial is presently scheduled to commence in late June 1994. The Company believes it has meritorious legal and factual defenses and intends to defend the suit vigorously. On July 22, 1992, The Seven-Up Company filed a related suit in federal court in Texas alleging that the facts and circumstances giving rise to the state court suit (described above) also constitute a violation of the federal Lanham Act which, inter alia, proscribes false advertisement and disparagement of a competitor's goods and services. The suit seeks injunctive relief, treble damages and attorneys' fees. Discovery in this case has been consolidated with discovery in the state court case, and trial is presently scheduled for June 1994. The Company believes it has meritorious legal and factual defenses and intends to defend the suit vigorously. The Company is involved in various other legal proceedings. The Company believes that any liability to the Company which may arise as a result of these proceedings, including the proceedings specifically discussed above, will not have a material adverse effect on the financial condition of the Company and its subsidiaries taken as a whole. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM X. EXECUTIVE OFFICERS OF THE COMPANY The following are the executive officers of the Company: Roberto C. Goizueta, 62, is Chief Executive Officer and Chairman of the Board of Directors of the Company. In August 1980, Mr. Goizueta was elected Chief Executive Officer and Chairman of the Board effective March 1981, at which time he assumed these positions. M. Douglas Ivester, 46, is Executive Vice President of the Company, Principal Operating Officer/North America and President of Coca-Cola USA. In January 1985, Mr. Ivester was elected Senior Vice President and Chief Financial Officer of the Company and served in that capacity until June 1989, when he was elected President of the European Community Group of the International Business Sector. He was appointed President of Coca-Cola USA in August 1990, and was appointed President of the North America Business Sector in September 1991. He served in the latter capacity until he was elected to his current positions, effective April 15, 1993. John Hunter, 56, is Executive Vice President of the Company and Principal Operating Officer/International. Mr. Hunter served as managing director of the South Pacific Division in 1984, and in 1987 was named President of both Coca-Cola (Japan) Company, Limited and the North Pacific Division. He was elected Senior Vice President of the Company and appointed President of the Pacific Group of the International Business Sector in January 1989. He served as deputy to the President of the International Business Sector from August 1990 until September 1991 and as President of the International Business Sector from September 1991 until April 1993. He was elected to his current positions, effective April 15, 1993. Jack L. Stahl, 40, is Senior Vice President and Chief Financial Officer of the Company. In March 1985, Mr. Stahl was named Manager, Planning and Business Development and was appointed Assistant Vice President in April 1985. He was elected Vice President and Controller in February 1988 and served in that capacity until he was elected to his current position in June 1989. Weldon H. Johnson, 56, is Senior Vice President of the Company and President of the Latin America Group of the International Business Sector. In January 1983, Mr. Johnson was named President of Coca-Cola (Japan) Company, Limited. In April 1987, he was elected Executive Vice President of the Latin America Group of the International Business Sector. He was elected Senior Vice President in December 1987 and was appointed President of the Latin America Group of the International Business Sector in January 1988. E. Neville Isdell, 50, is Senior Vice President of the Company and President of the Northeast Europe/Middle East Group of the International Business Sector. Mr. Isdell became President of the Company's Central European Division in July 1985 and was elected Senior Vice President of the Company and appointed President of the Northeast Europe/Africa Group in January 1988. He was appointed to his current position, effective January 1993. Ralph H. Cooper, 54, is Senior Vice President of the Company and President of the European Community Group of the International Business Sector. Mr. Cooper was appointed Senior Vice President of the Europe and Africa Group in July 1984 and was named Senior Vice President of Coca-Cola International and President of the Northwest European Division in January 1989. He served in those capacities until August 1990 when he was elected to his current position. Douglas N. Daft, 50, is Senior Vice President of the Company and President of the Pacific Group of the International Business Sector. In November 1984, Mr. Daft was appointed President of Coca-Cola Central Pacific Ltd. In October 1987, he was appointed Senior Vice President of the Pacific Group of the International Business Sector. In January 1989, he was named President of Coca-Cola (Japan) Company, Limited and President of the North Pacific Division of the International Business Sector. He served in those capacities until he was elected to his current position, effective September 1991. Carl Ware, 50, is Senior Vice President of the Company and President of the Africa Group of the International Business Sector. In 1979, Mr. Ware was appointed Vice President, Special Markets, Coca-Cola USA. In March 1982, he was appointed Vice President, Urban Affairs, of the Company. He was elected Senior Vice President and Manager, Corporate External Affairs in 1986 and became Deputy Group President of the Northeast Europe/Africa Group of the International Business Sector in July 1991, a position which he held until he was named to his current position, effective January 1993. Joseph R. Gladden, Jr., 51, is Senior Vice President and General Counsel of the Company. In October 1985, Mr. Gladden was elected Vice President. He was named Deputy General Counsel in October 1987 and served in that capacity until he was elected Vice President and General Counsel in April 1990. He was elected Senior Vice President in April 1991. Sergio Zyman, 48, is Senior Vice President of the Company and Chief Marketing Officer. Mr. Zyman first joined the Company in 1979 and eventually served as Senior Vice President of Marketing for Coca-Cola USA. After a seven year absence from the Company, during which he acted as consultant to different companies through Sergio Zyman & Co. and Core Strategy Group, he returned to assume his current position in August 1993. Earl T. Leonard, Jr., 57, is Senior Vice President of Corporate Affairs of the Company. Mr. Leonard was elected to his current position in April 1983. Anton Amon, 50, is Senior Vice President of the Company and manager of the Company's Product Integrity Division. Dr. Amon was named Senior Vice President of Coca-Cola USA in 1983. In 1988, he joined Coca-Cola Enterprises as Vice President, Operations. In September 1989, Dr. Amon returned to the Company as director, Corporate Quality Assurance. He was elected Vice President in 1989. He became manager, Product Integrity Division, in January 1992 and was elected to his current position in July 1992. George Gourlay, 52, is Senior Vice President of the Company and manager of the Technical Operations Division. Mr. Gourlay was named manager, Corporate Concentrate Operations in 1986, named Assistant Vice President in 1988, and was elected Vice President in 1989. Mr. Gourlay became head of the Technical Operations Division in January 1992 and was elected to his current position in July 1992. Timothy J. Haas, 47, is Vice President of the Company and President and Chief Executive Officer of Coca-Cola Foods. In January 1985, Mr. Haas was named Senior Vice President of Sales of Coca-Cola Foods and served in that capacity until he was appointed President and Chief Executive Officer of Coca-Cola Foods in March 1991. He was elected Vice President of the Company in April 1991. All executive officers serve at the pleasure of the Board of Directors. There is no family relationship between any of the executive officers of the Company. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS "Financial Review Incorporating Management's Discussion and Analysis" on pages 44 through 51, "Stock Prices" on page 73 and "Share-Owner Information" on page 77 of the Company's Annual Report to Share Owners for the year ended December 31, 1993, are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA "Selected Financial Data" for the years 1989 through 1993, on pages 52 and 53 of the Company's Annual Report to Share Owners for the year ended December 31, 1993, is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Financial Review Incorporating Management's Discussion and Analysis" on pages 44 through 51 of the Company's Annual Report to Share Owners for the year ended December 31, 1993, is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Registrant and its subsidiaries, included in the Company's Annual Report to Share Owners for the year ended December 31, 1993, are incorporated herein by reference: Consolidated Balance Sheets -- December 31, 1993 and 1992. Consolidated Statements of Income -- Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows -- Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Share-Owners' Equity -- Years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Report of Independent Auditors. "Quarterly Data", on page 73 of the Company's Annual Report to Share Owners for the year ended December 31, 1993, is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The section under the heading "Election of Directors" entitled "Board of Directors" on pages 2 through 6 of the Company's Proxy Statement for the Annual Meeting of Share Owners to be held April 20, 1994, is incorporated herein by reference for information on Directors of the Registrant. See Item X in Part I hereof for information regarding executive officers of the Registrant. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The section under the heading "Election of Directors" entitled "Committees of the Board of Directors; Meetings and Compensation of Directors" on pages 9 and 10 and the section entitled "Executive Compensation" on pages 11 through 17 of the Company's Proxy Statement for the Annual Meeting of Share Owners to be held April 20, 1994, are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section under the heading "Election of Directors" entitled "Ownership of Equity Securities in the Company" on pages 7 through 9, and the section under the heading "The Major Investee Companies" entitled "Ownership of Securities in Coca-Cola Enterprises, Coca-Cola Consolidated, Coca-Cola Amatil, Coca-Cola Beverages and Coca-Cola FEMSA" on page 24 of the Company's Proxy Statement for the Annual Meeting of Share Owners to be held April 20, 1994, are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The sections under the heading "Election of Directors" entitled "Committees of the Board of Directors; Meetings and Compensation of Directors" on pages 9 and 10 and "Certain Transactions" on page 10, the section under the heading "Executive Compensation" entitled "Compensation Committee Interlocks and Insider Participation" on page 23 and the section under the heading "The Major Investee Companies" entitled "Certain Transactions with Coca-Cola Enterprises and Coca-Cola Beverages" on pages 23 and 24 of the Company's Proxy Statement for the Annual Meeting of Share Owners to be held April 20, 1994, are incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements of The Coca-Cola Company and subsidiaries, included in the Registrant's Annual Report to Share Owners for the year ended December 31, 1993, are incorporated by reference in Part II, Item 8: Consolidated Balance Sheets -- December 31, 1993 and 1992. Consolidated Statements of Income -- Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows -- Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Share-Owners' Equity -- Years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Report of Independent Auditors. 2. (a) Financial Statement Schedules of The Coca-Cola Company and subsidiaries: Report of Independent Auditors. Schedule II -- Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties. Schedule V -- Property, Plant and Equipment. Schedule VI -- Accumulated Depreciation and Amortization of Property, Plant and Equipment. Schedule VIII -- Valuation and Qualifying Accounts. Schedule IX -- Short-Term Borrowings. Schedule X -- Supplementary Income Statement Information. (b) The following consolidated financial statements and financial statement schedules of Coca-Cola Enterprises are incorporated herein by reference from the Annual Report on Form 10-K of Coca-Cola Enterprises for the year ended December 31, 1993: Consolidated Statements of Operations for each of the three fiscal years in the period ended December 31, 1993. Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992. Consolidated Statements of Share-Owners' Equity for each of the three fiscal years in the period ended December 31, 1993. Consolidated Statements of Cash Flows for each of the three fiscal years in the period ended December 31, 1993. Notes to Consolidated Financial Statements. Report of Independent Auditors. Financial Statement Schedules -- Coca-Cola Enterprises. Schedule V -- Property, Plant and Equipment. Schedule VI -- Accumulated Depreciation and Amortization of Property, Plant and Equipment. Schedule VIII -- Valuation and Qualifying Accounts. Schedule IX -- Short-Term Borrowings. Schedule X -- Supplementary Income Statement Information. All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. 3. Exhibits - --------------- * Management contracts and compensatory plans and arrangements required to be filed as exhibits to this form pursuant to Item 14(c) of this report. (b) Reports on Form 8-K The Registrant filed a report on Form 8-K on January 27, 1994 in connection with the January 1, 1993 adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." (c) See Item 14(a)3 above. (d) See Item 14(a)2 above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. THE COCA-COLA COMPANY (Registrant) By: /s/ ROBERTO C. GOIZUETA ------------------------------------ ROBERTO C. GOIZUETA Chairman, Board of Directors, Chief Executive Officer and a Director Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ ROBERTO C. GOIZUETA - ------------------------------------------------------ ROBERTO C. GOIZUETA Chairman, Board of Directors, Chief Executive Officer and a Director (Principal Executive Officer) March 14, 1994 /s/ JACK L. STAHL - ------------------------------------------------------ JACK L. STAHL Senior Vice President and Chief Financial Officer (Principal Financial Officer) March 14, 1994 /s/ JAMES E. CHESTNUT - ------------------------------------------------------ JAMES E. CHESTNUT Vice President and Controller (Principal Accounting Officer) March 14, 1994 * - ------------------------------------------------------ HERBERT A. ALLEN Director March 14, 1994 * - ------------------------------------------------------ RONALD W. ALLEN Director March 14, 1994 * - ------------------------------------------------------ CATHLEEN P. BLACK Director March 14, 1994 * - ------------------------------------------------------ WARREN E. BUFFETT Director March 14, 1994 * - ------------------------------------------------------ CHARLES W. DUNCAN, JR. Director March 14, 1994 * - ------------------------------------------------------ SUSAN B. KING Director March 14, 1994 * - ------------------------------------------------------ DONALD F. MCHENRY Director March 14, 1994 * - ------------------------------------------------------ PAUL F. OREFFICE Director March 14, 1994 * - ------------------------------------------------------ JAMES D. ROBINSON, III Director March 14, 1994 * - ------------------------------------------------------ WILLIAM B. TURNER Director March 14, 1994 * - ------------------------------------------------------ PETER V. UEBERROTH Director March 14, 1994 * - ------------------------------------------------------ JAMES B. WILLIAMS Director March 14, 1994 *By /s/ CAROL C. HAYES - ------------------------------------------------------ CAROL C. HAYES Attorney-in-fact March 14, 1994 ANNUAL REPORT ON FORM 10-K ITEM 14(A)2(A) FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 THE COCA-COLA COMPANY AND SUBSIDIARIES REPORT OF INDEPENDENT AUDITORS Board of Directors and Share Owners The Coca-Cola Company We have audited the consolidated financial statements and schedules of The Coca-Cola Company and subsidiaries listed in the accompanying index to financial statements and schedules (Item 14(a)(1) and (a)(2)(a)). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Coca-Cola Company and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, in 1993 the Company changed its method of accounting for postemployment benefits. As discussed in Note 14 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions. /s/ Ernst & Young Atlanta, Georgia January 25, 1994 SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS) - --------------- (a) Twenty-five year mortgage loan at 4 percent interest. (b) Term of less than one year (non-interest bearing). (c) Three year unsecured notes receivable (non-interest bearing). (d) Two year unsecured note receivable (non-interest bearing). (e) Four year unsecured note receivable (non-interest bearing). (f) Represents exchange variances. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS) - --------------- (a) Twenty-five year mortgage loans at 4 percent interest. (b) Term of less than one year at 8.5 percent interest. (c) Term of less than one year (non-interest bearing). (d) Three year unsecured notes receivable (non-interest bearing). (e) Two year unsecured note (non-interest bearing). (f) Four year unsecured note (non-interest bearing). (g) Represents exchange variances. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS) - --------------- (a) Twenty-five year mortgage loans at 4 percent interest. (b) Term of less than one year at 8.5 percent interest. (c) Represents exchange variances. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column E consist of the following: SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1992 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column E consist of the following: SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1991 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column E consist of the following: SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column E consist of the following: SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1992 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column E consist of the following: SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1991 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column E consist of the following: SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column D consist of the following: SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1992 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column D consist of the following: SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THE COCA-COLA COMPANY AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1991 (IN MILLIONS) - --------------- Note 1 -- The amounts shown in Column D consist of the following: SCHEDULE IX -- SHORT-TERM BORROWINGS THE COCA-COLA COMPANY AND SUBSIDIARIES (IN MILLIONS) - --------------- Note 1 -- The average amount outstanding during the period was computed by dividing the sum of the month-end outstanding principal balances by 12 for notes payable and other short-term borrowings and by dividing the sum of the daily weighted average outstanding principal balances by 365 for 1993, 366 for 1992 and 365 for 1991 for commercial paper. Note 2 -- The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. The Company's weighted average interest rates for United States and international borrowings were approximately 5 and 15 percent, respectively, for 1993, 4 and 18 percent, respectively for 1992 and 7 and 18 percent, respectively, for 1991 on average amounts outstanding during these years. Interest rates for international operations are generally higher due primarily to borrowings in certain high inflation countries. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THE COCA-COLA COMPANY AND SUBSIDIARIES (IN MILLIONS) - --------------- Note 1 -- Royalties, taxes other than payroll and income taxes, and amortization of intangible assets do not exceed one percent of net revenues and, accordingly, are not included. Note 2 -- Advertising costs as shown above do not include administrative expenses, as it is not practical to determine these expenses. EXHIBIT INDEX

774197_1993.txt

774197_1993

1993

774197

Item 1. Business THE CENTERIOR SYSTEM Centerior Energy is a public utility holding company and the parent company of the Operating Companies and the Service Company. Centerior was incorporated under the laws of the State of Ohio in 1985 for the purpose of enabling Cleveland Electric and Toledo Edison to affiliate by becoming wholly owned subsidiaries of Centerior. The affiliation of the Operating Companies became effective in April 1986. Nearly all of the consolidated operating revenues of the Centerior System are derived from the sale of electric energy by Cleveland Electric and Toledo Edison. The Operating Companies' combined service areas encompass approximately 4,200 square miles in northeastern and northwestern Ohio with an estimated popula- tion of about 2,600,000. At December 31, 1993, the Centerior System had 6,748 employees. Centerior Energy has no employees. Cleveland Electric, which was incorporated under the laws of the State of Ohio in 1892, is a public utility engaged in the generation, purchase, transmis- sion, distribution and sale of electric energy in an area of approximately 1,700 square miles in northeastern Ohio, including the City of Cleveland. Cleveland Electric also provides electric energy at wholesale to other elec- tric utility companies and to two municipal electric systems (directly and through AMP-Ohio) in its service area. Cleveland Electric serves approxi- mately 748,000 customers and derives approximately 75% of its total electric revenue from customers outside the City of Cleveland. Principal industries served by Cleveland Electric include those producing steel and other primary metals; automotive and other transportation equipment; chemicals; electrical and nonelectrical machinery; fabricated metal products; and rubber and plastic products. Nearly all of Cleveland Electric's operating revenues are derived from the sale of electric energy. At December 31, 1993, Cleveland Electric had 3,606 employees of which about 51% were represented by one union having a collective bargaining agreement with Cleveland Electric. Toledo Edison, which was incorporated under the laws of the State of Ohio in 1901, is a public utility engaged in the generation, purchase, transmission, distribution and sale of electric energy in an area of approximately 2,500 square miles in northwestern Ohio, including the City of Toledo. Toledo Edison also provides electric energy at wholesale to other electric utility companies and to 13 municipally owned distribution systems (through AMP-Ohio) and one rural electric cooperative distribution system in its service area. Toledo Edison serves approximately 285,000 customers and derives approximately 55% of its total electric revenue from customers outside the City of Toledo. Among the principal industries served by Toledo Edison are metal casting, forming and fabricating; petroleum refining; automotive equipment and assembly; food processing; and glass. Nearly all of Toledo Edison's operating revenues are derived from the sale of electric energy. At December 31, 1993, Toledo Edison had 1,909 employees of which about 55% were represented by three unions having collective bargaining agreements with Toledo Edison. The Service Company, which was incorporated in 1986 under the laws of the State of Ohio, is also a wholly owned subsidiary of Centerior Energy. It pro- vides management, financial, administrative, engineering, legal, governmental and public relations and other services to Centerior Energy and the Operating Companies. At December 31, 1993, the Service Company had 1,233 employees. On March 25, 1994, Centerior Energy announced plans to merge Toledo Edison into Cleveland Electric. Since Cleveland Electric and Toledo Edison affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO, the PaPUC and other regulatory authorities. The merger must be approved by Toledo Edison preferred stock share owners. Preferred stock share owners of Cleveland Electric must approve the authori- zation of additional shares of preferred stock. Upon the merger becoming effective, the outstanding shares of Toledo Edison preferred stock will be exchanged for shares of Cleveland Electric preferred stock having sub- stantially the same terms. Cleveland Electric and Toledo Edison plan to seek preferred share owner approval in the summer of 1994. The merger is expected to be effective late in 1994. See Note 15 to the Operating Companies' Financial Statements for further discussion of this matter and "3. Combined Pro Forma Condensed Financial Statements (Unaudited)" contained under Item 14. of this Report for selected historical and combined pro forma financial information of Cleveland Electric and Toledo Edison. CAPCO GROUP Cleveland Electric and Toledo Edison are members of the CAPCO Group, a power pool created in 1967 with Duquesne, Ohio Edison and Pennsylvania Power. This pool affords greater reliability and lower cost of providing electric service through coordinated generating unit operations and maintenance and generating reserve back-up among the five companies. In addition, the CAPCO Group has completed programs to construct larger, more efficient electric generating units and to strengthen interconnections within the pool. The CAPCO Group companies have placed in service nine major generating units, of which the Operating Companies have ownership or leasehold interests in seven (three nuclear and four coal-fired). Each CAPCO Group company owns, as a tenant-in-common, or leases a portion of certain of these generating units. Each company has the right to the net capability and associated energy of its respective ownership and leasehold portions of the units and is, severally and not jointly, obligated for the capital and operating costs equivalent to its respective ownership and leasehold portions of the units and the required fuel, except that the obligations of Pennsylvania Power are the joint and several obligations of that company and Ohio Edison and except that the leasehold obligations of Cleveland Electric and Toledo Edison are joint and several. (See "Operations--Fuel Supply".) For all plants but one, the company in whose service area a generating unit is located is responsible for the operation of that unit for all the owners, except for the procurement of nuclear fuel for a nuclear generating unit. The Mansfield Plant, which is located in Duquesne's service area, is operated by Pennsylvania Power. Each company owns the necessary interconnecting transmission facilities within its service area, and the other CAPCO Group companies contribute toward fixed charges and operating costs of those transmission facilities. All of the CAPCO Group companies are members of ECAR, which is comprised of 28 electric companies located in nine contiguous states. ECAR's purpose is to improve reliability of bulk power supply through coordination of planning and operation of member companies' generation and transmission facilities. CONSTRUCTION AND FINANCING PROGRAMS Construction Program The Centerior System carries on a continuous program of constructing trans- mission, distribution and general facilities and modifying existing generating facilities to meet anticipated demand for electric service, to comply with governmental regulations and to protect the environment. The Operating Companies' 1993 long-term (20-year) forecast, as filed with the PUCO (see "General Regulation--State Utility Commissions"), projects long-term annual growth rates in peak demand and kilowatt-hour sales for the Operating Companies of 1.1% and 1.4%, respectively, after demand-side management con- siderations. The Centerior System's integrated resource plan for the 1990s (which is included in the long-term forecast) combines demand-side management programs with maximum utilization of existing generating capacity to postpone the need for new generating units until the next decade. Demand-side manage- ment programs, such as energy-efficient lighting and motors, curtailable load and energy management, are expected to assist customers in achieving greater energy efficiency. Centerior plans to invest up to $35,000,000 in demand-side programs in 1994 and 1995. Operable capacity margins over the next ten years are expected to be adequate without adding generating capacity. According to the current long-term integrated resource plan, the next increment of generating capacity that the Centerior System plans to put into service will be two 136,000-kilowatt units in 2003, with additional small, short-lead-time capacity in subsequent years. The following tables show, categorized by major components, the construction expenditures by Cleveland Electric and Toledo Edison and, by aggregating them, for the Centerior System during 1991, 1992 and 1993 and the estimated cost of their construction programs for 1994 through 1998, in each case including AFUDC and excluding nuclear fuel: *Construction of Perry Unit 2 was suspended in 1985. In 1992, Cleveland Electric purchased Duquesne's ownership share of Perry Unit 2 for $3,324,000. At December 31, 1993, Centerior Energy, Cleveland Electric and Toledo Edison wrote off their investment in Perry Unit 2 (see Note 4(b)). Each company in the CAPCO Group is responsible for financing the portion of the capital costs of nuclear fuel equivalent to its ownership and leased interest in the unit in which the fuel will be utilized. See "Operations-- Fuel Supply--Nuclear" for information regarding nuclear fuel supplies and Note 6 regarding leasing arrangements to finance nuclear fuel capital costs. Nuclear fuel capital costs incurred by Cleveland Electric, Toledo Edison and the Centerior System during 1991, 1992 and 1993 and their estimated nuclear fuel capital costs for 1994 through 1998 are as follows: Financing Program Reference is made to Centerior Energy's, Cleveland Electric's and Toledo Edison's Management's Financial Analysis contained under Item 7 of this Report and to Notes 11 and 12 for discussions of the Centerior System's financing activity in 1993; debt and preferred stock redemption requirements during the 1994-1998 period; expected external financing needs during such period; re- strictions on the issuance of additional debt securities and preferred stock; short-term and long-term financing capability; and securities ratings for the Operating Companies. In the second quarter of 1994, Cleveland Electric and Toledo Edison expect to issue $46,100,000 and $30,500,000, respectively, of first mortgage bonds as collateral security for the sale by a public authority of equal principal amounts of tax-exempt bonds. The proceeds from the sales of the public authority's bonds will be used to refund $46,100,000 and $30,500,000, respec- tively, of tax-exempt bonds that were issued in 1988 and have been continu- ously remarketed on a floating rate basis. The new series of bonds will each be issued at a fixed rate of interest for the remaining term to July 1, 2023. Centerior expects to raise about $35,000,000 in 1994 from the sale of authorized but unissued common stock under certain of its employee and share owner stock purchase plans. GENERAL REGULATION Holding Company Regulation Centerior Energy is currently exempt from regulation under the Holding Company Act. The Energy Act contains, among other provisions, amendments to the Holding Company Act and the Federal Power Act. The Energy Act also adopted nuclear power licensing and related regulations, energy efficiency standards and incentives for the use of alternative transportation fuels. Amendments to the Holding Company Act create a new class of independent power producers known as "Exempt Wholesale Generators", which are exempt from the Holding Company Act corporate structure regulations and operate without SEC approval or regulation. Exempt Wholesale Generators may be owned by holding companies, electric utility companies or any other person. State Utility Commissions - ------------------------- The Operating Companies are subject to the jurisdiction of the PUCO with re- spect to rates, service, accounting, issuance of securities and other matters. Under Ohio law, municipalities may regulate rates, subject to appeal to the PUCO if not acceptable to the utility. See "Electric Rates" for a description of certain aspects of Ohio rate-making law. The Operating Companies are also subject to the jurisdiction of the PaPUC in certain respects relating to their ownership interests in generating facilities located in Pennsylvania. The PUCO is composed of five commissioners appointed by the Governor of Ohio from nominees recommended by a Public Utility Commission Nominating Council. Nominees must have at least three years' experience in one of several disci- plines. Not more than three commissioners may belong to the same political party. Under Ohio law, a public utility must file annually with the PUCO a long-term forecast of customer loads, facilities needed to serve those loads and prospective sites for those facilities. This forecast must include the following: (1) Demand Forecast--the utility's 20-year forecast of sales and peak demand, before and after the effects of demand-side management programs. (2) Integrated Resource Plan (required biennially)--the utility's projected mix of resource options to meet the projected demand. (3) Short-Term Implementation Plan and Status Report (required biennially)-- the utility's discussion of how it plans to implement its integrated resource plan over the next four years. Estimates of annual expenditures and security issuances associated with the integrated resource plan over the four-year period must also be provided. The PUCO must hold a public hearing on the long-term forecast at least once every five years to determine the reasonableness of such forecast. The PUCO and the OPSB are required to consider the record of such hearings in proceed- ings for approving facility sites, changing rates, approving security issues and initiating energy conservation programs. Ohio law also permits electric utilities under PUCO jurisdiction to submit environmental compliance plans for PUCO review and approval. Ohio law requires that the PUCO make certain statutory findings prior to approving the environmental compliance plan, which includes that the plan is a reasonable least cost strategy for compliance with air quality requirements. In 1992, the PUCO held hearings on the Operating Companies' 1992 long-term forecast and environmental compliance plan. Centerior and the parties intervening in the proceeding reached agreement on the forecast and environmental compliance plan, and the agreement was sub- sequently approved by the PUCO in February 1993. The PUCO has jurisdiction over certain transactions by companies in an elec- tric utility holding company system if it includes at least one Ohio electric utility and is exempt from regulation under Section 3(a)(1) or (2) of the Holding Company Act. An Ohio electric utility in such a holding company system, such as Centerior, must obtain PUCO approval to invest in, lend funds to, guarantee the obligations of or otherwise finance or transfer assets to any nonutility company in that holding company system, unless the transaction is in the ordinary course of business operations in which one company acts for or with respect to another company. Also, the holding company in such a hold- ing company system must obtain PUCO approval to make any investment in any nonutility subsidiaries, affiliates or associates of the holding company if such investment would cause all such capital investments to exceed 15% of the consolidated capitalization of the holding company unless such funds were provided by nonutility subsidiaries, affiliates or associates. The PUCO has a reserve capacity policy for electric utilities in Ohio stating that (i) 20% of service area peak load excluding interruptible load is an appropriate generic benchmark for an electric utility's reserve margin; (ii) a reserve margin exceeding 20% gives rise to a presumption of excess capacity, but may be appropriate if it confers a positive net present benefit to cus- tomers or is justified by unique system characteristics; and (iii) appropriate remedies for excess capacity (possibly including disallowance of costs in rates) will be determined by the PUCO on a case-by-case basis. Ohio Power Siting Board The OPSB has state-wide jurisdiction, except to the extent pre-empted by Federal law, over the location, need for and certain environmental aspects of electric generating units with a capacity of 50,000 kilowatts or more and transmission lines with a rating of at least 125 kV. Federal Energy Regulatory Commission The Operating Companies are each subject to the jurisdiction of the FERC with respect to the transmission and sale of power at wholesale in interstate com- merce, interconnections with other utilities, accounting and certain other matters. Cleveland Electric is also subject to FERC jurisdiction with respect to its ownership and operation of the Seneca Plant. Nuclear Regulatory Commission The nuclear generating units in which the Operating Companies have an interest are subject to regulation by the NRC. The NRC's jurisdiction encompasses broad supervisory and regulatory powers over the construction and operation of nuclear reactors, including matters of health and safety, antitrust considera- tions and environmental impacts. Owners of nuclear units are required to purchase the full amount of nuclear liability insurance available. See Note 5(b) for a description of nuclear in- surance coverages. Other Regulation The Operating Companies are subject to regulation by Federal, state and local authorities with regard to the location, construction and operation of certain facilities. The Operating Companies are also subject to regulation by local authorities with respect to certain zoning and planning matters. ENVIRONMENTAL REGULATION General The Operating Companies are subject to regulation with respect to air quality, water quality and waste disposal matters. Federal environmental legislation affecting the operations and properties of the Operating Companies includes the Clean Air Act, the Clean Air Act Amendments, the Clean Water Act, Superfund, and the Resource Conservation and Recovery Act. The requirements of these statutes and related state and local laws are continually changing due to the promulgation of new or revised laws and regulations and the results of judicial and agency proceedings. Compliance with such laws and regulations may require the Operating Companies to modify, supplement, abandon or replace facilities and may delay or impede construction and operation of facilities, all at costs which could be substantial. The Operating Companies expect that the impact of such costs would eventually be reflected in their respective rate schedules. Cleveland Electric and Toledo Edison plan to spend, during the period 1994-1996, $70,000,000 and $20,000,000, respectively, for pollution control facilities, including Clean Air Act Amendments compliance costs. The Operating Companies believe that they are currently in compliance in all material respects with all applicable environmental laws and regulations, or to the extent that one or both of the Operating Companies may dispute the applicability or interpretation of a particular environmental law or regula- tion, the affected company has filed an appeal or has applied for permits, revisions in requirements, variances or extensions of deadlines. Concerns have been raised regarding the possible health effects associated with electric and magnetic fields. Although scientific research as to such effects has yielded inconclusive results, additional studies are being con- ducted. If electric and magnetic fields are ultimately found to pose a health risk, the Operating Companies may be required to modify transmission and distribution lines or other facilities. Air Quality Control Under the Clean Air Act, the Ohio EPA has adopted Ohio emission limitations for particulate matter and sulfur dioxide for each of the Operating Companies' plants. The Clean Air Act provides for civil penalties of up to $25,000 per day for each violation of an emission limitation. The U.S. EPA has approved the Ohio EPA's emission limitations and the related implementation plans ex- cept for some particulate matter emissions and certain sulfur dioxide emis- sions. The U.S. EPA has adopted separate sulfur dioxide emission limitations for each of the Operating Companies' plants. In November 1990, the Clean Air Act Amendments were signed into law imposing restrictions on nitrogen oxides emissions and making sulfur dioxide emission limitations significantly more severe beginning in 1995. See Note 4(a) for a description of the Operating Companies' compliance strategy, which was in- cluded in the agreement approved by the PUCO in February 1993 in connection with the Operating Companies' 1992 long-term forecast. The Clean Air Act Amendments also require studies to be conducted on the emission of certain potentially hazardous air pollutants which could lead to additional restrictions. In 1985, the U.S. EPA issued revised regulations specifying the extent to which power plant stack height may be incorporated into the establishment of an emission limitation. Pursuant to the revised regulations, the Operating Companies submitted to the Ohio EPA information intended to support continua- tion of the stack height credit received under the previous regulations for stacks at Cleveland Electric's Avon Lake and Eastlake Plants and Toledo Edison's Bay Shore Station. The Ohio EPA has accepted the submissions and forwarded them to the U.S. EPA for approval. In January 1988, the District of Columbia Circuit Appeals Court remanded portions of the 1985 regulations to the U.S. EPA for further consideration; however, the U.S. EPA has not taken action specifically on this issue. Congress is considering legislation to reduce emissions of gases such as those resulting from the burning of coal that are thought to cause global warming. If such legislation is adopted, the cost of operating coal-fired plants could increase significantly and coal-fired generating capacity could decrease significantly. Water Quality Control The Clean Water Act requires that power plants obtain permits that contain certain effluent limitations (that is, limits on discharges of pollutants into bodies of water). It also requires the states to establish water quality standards (which could result in more stringent effluent limitations than those required under the Clean Water Act) and a permit system to be approved by the U.S. EPA. Violators of effluent limitations and water quality standards are subject to a civil penalty of up to $25,000 per day for each such violation. The Clean Water Act permits thermal effluent limitations to be established for a facility which are less stringent than those which otherwise would apply if the owner can demonstrate that such less stringent limitations are sufficient to assure the protection and propagation of aquatic and other wildlife in the affected body of water. By 1978, the Operating Companies had submitted to the Ohio EPA such demonstrations for review with respect to their Ashtabula, Avon Lake, Lake Shore, Eastlake, Acme and Bay Shore plants. The Ohio EPA has taken no action on the submittals. The Operating Companies have received NPDES permit renewals from the Ohio EPA or have applied for such renewals for all of their power plants. In those situations where a permit application is pending, the affected plant may con- tinue to operate under the expired permit while such application is pending. Any violation of an NPDES permit is considered to be a violation of the Clean Water Act subject to the penalty discussed above. In 1990, the Ohio EPA issued revised water quality standards applicable to Lake Erie and waters of the State of Ohio. Based upon these revised water quality standards, the Ohio EPA placed additional effluent limitations in their most recent NPDES permits. The revised standards also may serve as the basis for more stringent effluent limitations in future NPDES permits. Such limitations could result in the installation of additional pollution control equipment and increased operating expenses. The Operating Companies are monitoring discharges at their plants to support their position that addi- tional effluent limitations are not justified. On April 16, 1993, the U.S. EPA issued proposed rules for water quality standards applicable to all states abutting the Great Lakes, including Ohio. These states would be required to adopt state water quality standards and procedures consistent with the rules within two years of final publication. Preliminary reviews indicate that the cost of complying with these rules could be significant. However, Centerior cannot determine what impact these rules will have on its operations until such rules are issued in final form and are incorporated into Ohio regulations. Waste Disposal See "Hazardous Waste Disposal Sites" in Management's Financial Analysis contained under Item 7 of this Report and Note 4(c) for a discussion of the Operating Companies' potential involvement in certain hazardous waste disposal sites, including those subject to Superfund. See "Nuclear Units" and "Fuel Supply--Nuclear" under "Operations", below, for discussions concerning the disposal of nuclear waste. The Resource Conservation and Recovery Act exempts certain fossil fuel com- bustion waste products, such as fly ash, from hazardous waste disposal re- quirements. The Operating Companies are unable to predict whether Congress will choose to amend this exemption in the future or, if so, the costs relat- ing to any required changes in the operations of the Operating Companies. ELECTRIC RATES Under Ohio law, rate base is the original cost less depreciation of a utility's total plant adjusted for certain items. The law permits the PUCO, in its discretion, to include CWIP in rate base when a construction project is at least 75% complete, but limits the amount included to 10% of rate base ex- cluding CWIP or, in the case of a project to construct pollution control fa- cilities which would remove sulfur and nitrous oxides from flue gas emissions, 20% of rate base excluding CWIP. When a project is completed, the portion of its cost which had been included in rate base as CWIP is excluded from rate base until the revenue received due to the CWIP inclusion is offset by the revenue lost due to its exclusion. During this period of time, an AFUDC-type credit is allowed on the portion of the project cost excluded from rate base. Also, the law permits inclusion of CWIP for a particular project for a period not longer than 48 consecutive months, plus any time needed to comply with changed governmental regulations, standards or approvals. The PUCO is em- powered to permit inclusion for up to another 12 months for good cause shown. If a project is canceled or not completed within the allowable period of time after inclusion of its CWIP has started, then CWIP is excluded from rate base and any revenues which resulted from such prior inclusion are offset against future revenues over the same period of time as the CWIP was included. Current Ohio law further provides that requested rates can be collected by a public utility, subject to refund, if the PUCO does not make a decision within 275 days after the rate request application is filed. If the PUCO does not make its final decision within 545 days, revenues collected thereafter are not subject to refund. A notice of intent to file an application for a rate in- crease cannot be filed before the issuance of a final order in any prior pend- ing application for a rate increase or until 275 days after the filing of the prior application, whichever is earlier. The minimum period by which the notice of intent to file must precede the actual filing is 30 days. The test year for determining rates may not end more than nine months after the date the application for a rate increase is filed. Under Ohio law, electric rates are adjusted every six months to reflect changes in fuel costs. The PUCO reviews such adjustments annually. Any difference between actual fuel costs during a six-month period and the fuel revenues recovered in that period is deferred and is taken into account in setting the fuel recovery factor for a subsequent six-month period. The PUCO has authorized the Operating Companies to adjust their rates on a seasonal basis such that electric rates are higher in the summer. Also, under Ohio law, municipalities may regulate rates charged by a utility, subject to appeal to the PUCO if not acceptable to the utility. If municipally fixed rates are accepted by the utility, such rates are binding on both parties for the specified term and cannot be changed by the PUCO. See Note 7 and Management's Financial Analysis contained under Item 7 of this Report for information relating to the PUCO's January 1989 rate orders and the Rate Stabilization Program that was approved by the PUCO for the Operating Companies in October 1992. OPERATIONS Sales of Electricity Kilowatt-hour sales by the Operating Companies follow a seasonal pattern marked by increased customer usage in the summer for air conditioning and in the winter for heating. Historically, Cleveland Electric has experienced its heaviest demand for electric service during the summer months because of a significant air conditioning load on its system and a relatively low amount of electric heating load in the winter. Toledo Edison, although having a significant electric heating load, has experienced in recent years its heaviest demand for electric service during the summer months because of heavy air conditioning usage. The Centerior System's largest customer is a steel manufacturer which has two major steel producing facilities served by Cleveland Electric. Sales to these facilities accounted for 2.5% and 3.5% of the 1993 total electric operating revenues of Centerior Energy and Cleveland Electric, respectively. The loss of these facilities (and the resultant loss of another large customer whose primary product is purchased by the two steel producing facilities) would reduce Centerior Energy's and Cleveland Electric's net income by about $34,000,000 based on 1993 sales levels. The largest customer served by Toledo Edison is a major automobile manufac- turer. Sales to this customer accounted for 1.4% and 3.9% of the 1993 total electric operating revenues of Centerior Energy and Toledo Edison, re- spectively. The loss of this customer would reduce Centerior Energy's and Toledo Edison's net income by about $10,000,000 based on 1993 sales levels. Operating Statistics For data on operating revenues by service category, electric sales by service category, customers by service category and electric energy generation for 1983 and 1989 through 1993, see the attached Pages and for Centerior Energy, and for Cleveland Electric and and for Toledo Edison. Nuclear Units The Operating Companies' generating facilities include, among others, three nuclear units owned or leased by the CAPCO Group--Perry Unit 1, Beaver Valley Unit 2 and Davis-Besse. These three units are in commercial operation. Cleveland Electric has responsibility for operating Perry Unit 1, Duquesne has responsibility for operating Beaver Valley Unit 2 and Toledo Edison has re- sponsibility for operating Davis-Besse. Cleveland Electric and Toledo Edison own, respectively, 31.11% and 19.91% of Perry Unit 1, 24.47% and 1.65% of Beaver Valley Unit 2 and 51.38% and 48.62% of Davis-Besse. Cleveland Electric and Toledo Edison also lease, as joint lessees, another 18.26% of Beaver Valley Unit 2 as a result of a September 1987 sale and leaseback transaction (see Note 2). Davis-Besse was placed in commercial operation in 1977, and its operating license expires in 2017. Perry Unit 1 and Beaver Valley Unit 2 were placed in commercial operation in 1987, and their operating licenses expire in 2026 and 2027, respectively. As part of its January 1989 rate orders, the PUCO approved nuclear plant performance standards for the Operating Companies based on rolling three-year industry averages of operating availability for pressurized water reactors and for boiling water reactors over the 1988-1998 period. Operating availability is the ratio of the number of hours a unit is available to generate elec- tricity (whether or not the unit is operated) to the number of hours in the period, expressed as a percentage. The three-year operating availability averages of the Operating Companies' nuclear units are compared against the industry averages for the same three-year period with a resultant penalty or banked benefit. If the industry performance standards are not met, a penalty would be incurred which would require the Operating Companies to refund in- cremental replacement power costs to customers through the semiannual fuel cost rate adjustment. However, if the performance of the Operating Companies' nuclear units exceeds the industry standards, a banked benefit results which can be used to offset disallowances of incremental replacement power costs should future performance be below industry standards. The relevant industry standards for the 1991-1993 period are 78.0% for pressurized water reactors such as Davis-Besse and Beaver Valley Unit 2 and 72.8% for boiling water reactors such as Perry Unit 1. The 1991-1993 availability average for Davis-Besse and Beaver Valley Unit 2 was 87.1% and for Perry Unit 1 was 69.2%. At December 31, 1993, the total banked benefit for the Operating Companies is estimated to be between $18,000,000 and $20,000,000. All three nuclear units have received generally favorable evaluations from the NRC in their most recent SALP reviews. Each of the functional areas evaluated is rated according to three performance categories, with category 1 indicating performance substantially exceeding regulatory requirements and that reduced NRC attention may be appropriate; category 2 indicating performance above that needed to meet regulatory requirements and that NRC attention may be main- tained at normal levels; and category 3 indicating performance does not significantly exceed that needed to meet minimal regulatory requirements and that NRC attention should be increased above normal levels. The most recent review periods and SALP review scores for Perry Unit 1 and Davis-Besse are: The NRC increased its attention to Perry Unit 1 in 1993 and placed the unit on a newly created list for units identified as showing "safety performance trending downward." Centerior made specific organizational changes and developed a comprehensive course of action to improve the operating performance of Perry Unit 1. In response to this course of action, on January 27, 1994, the NRC removed Perry Unit 1 from the performance trending downward list. In 1993, the NRC revised the functional areas which comprise the SALP grading process. Plant Support is a new category which covers the areas previously covered by Security, Emergency Preparedness and Radiological Controls. The Safety Assessment/Quality Verification category is now an integral part of each category and is no longer being singled out. Beaver Valley Unit 2 is the only Centerior System unit to have been graded under the new system. Perry Unit 1 and Davis-Besse will be graded under the new system when their next SALP scores are issued. The most recent review period and SALP review scores for Beaver Valley Unit 2 are: The Operating Companies ship low-level radioactive waste produced at their nuclear plants to an offsite disposal facility which may not accept such shipments after mid-1994. The Operating Companies' ability to continue offsite disposal depends on whether the State of Ohio develops a low-level radioactive waste disposal facility within the next several years. If offsite disposal becomes unavailable, the Operating Companies have facilities to temporarily store such waste on site at each of the nuclear plants. However, the Operating Companies do not intend to store such waste on site until all available off-site options have been exhausted. See Note 4(b) for a discussion of the write-off of Perry Unit 2, and see Note 5(a) and "Outlook--Nuclear Operations" in Management's Financial Analysis contained under Item 7 of this Report for a discussion of potential risks facing Centerior and the Operating Companies as owners of nuclear generating units. Competitive Conditions General. The Operating Companies compete in their respective service areas with suppliers of natural gas to satisfy customers' energy needs with regard to heating and appliance usage. The Operating Companies also are engaged in competition to a lesser extent with suppliers of oil and liquefied natural gas for heating purposes and with suppliers of cogeneration equipment. One competitor provides steam for heating purposes and provides chilled water for cooling purposes in certain areas of downtown Cleveland. The Operating Companies also compete with municipally owned electric systems within their respective service areas. As discussed below, two of the munici- palities served by the Operating Companies, the City of Toledo and the City of Garfield Heights, are investigating the economic feasibility of establishing and operating municipally owned electric systems. A few other communities have evaluated municipalization of electric service and decided to continue service from Cleveland Electric and Toledo Edison. Officials in still other communities have indicated an interest in evaluating the municipalization issue. The Operating Companies face continuing competition from locations outside their service areas which are promoted by governmental and private agencies in attempts to influence potential and existing commercial and industrial cus- tomers to locate in their respective areas. Cleveland Electric and Toledo Edison also periodically compete with other producers of electricity for sales to electric utilities which are in the market for bulk power purchases. The Operating Companies have inter- connections with other electric utilities (see "Item 2. Item 2. Properties GENERAL The Centerior System The wholly owned, jointly owned and leased electric generating facilities of the Operating Companies in commercial operation as of February 28, 1994 pro- vide the Centerior System with a net demonstrated capability of 5,980,000 kilowatts during the winter. These facilities include 20 generating units (3,634,000 kilowatts) at seven fossil-fired steam electric generation sta- tions; three nuclear generating units (1,856,000 kilowatts); a 351,000 kilo- watt share of the Seneca Plant; seven combustion turbine generating units (135,000 kilowatts) and one diesel generator (4,000 kilowatts). Operations at two fossil-fired generating units (320,000 kilowatts) ceased in 1993 and the units are being preserved for future use. All of the Centerior System's generating facilities are located in Ohio and Pennsylvania. The Centerior System's net 60-minute peak load of its service area for 1993 was 5,397,000 kilowatts and occurred on August 27. At the time of the 1993 peak load, the operable capacity available to serve the load was 5,998,000 kilowatts. The Centerior System's 1994 service area peak load is forecasted to be 5,250,000 kilowatts, after demand-side management considerations. The operable capacity expected to be available to serve the Centerior System's 1994 peak is 5,670,000 kilowatts. Over the 1994-1996 period, Centerior Energy forecasts its operable capacity margins at the time of the projected Centerior System peak loads to range from 7% to 9.5%. Each Operating Company owns the electric transmission and distribution facili- ties located in its respective service area. Cleveland Electric and Toledo Edison are interconnected by 345 kV transmission facilities, some portions of which are owned and used by Ohio Edison. The Operating Companies have a long- term contract with the CAPCO Group companies, including Ohio Edison, relating to the use of these facilities. These interconnection facilities provide for the interchange of power between the two Operating Companies. The Centerior System is interconnected with Ohio Edison, Ohio Power, Penelec and Detroit Edison. Cleveland Electric The wholly owned, jointly owned and leased electric generating facilities of Cleveland Electric in commercial operation as of February 28, 1994 provide a net demonstrated capability of 4,148,000 kilowatts during the winter. These facilities include 16 generating units (2,709,000 kilowatts) at five fossil- fired steam electric generation stations; its share of three nuclear generat- ing units (1,026,000 kilowatts); a 351,000 kilowatt share of the Seneca Plant; two combustion turbine generating units (58,000 kilowatts) and one diesel gen- erator (4,000 kilowatts). Operations at one fossil-fired generating unit (245,000 kilowatts) ceased in October 1993 and the unit is being preserved for future use. All of Cleveland Electric's generating facilities are located in Ohio and Pennsylvania. The net 60-minute peak load of Cleveland Electric's service area for 1993 was 3,862,000 kilowatts and occurred on July 28. The operable capacity at the time of the 1993 peak was 4,122,000 kilowatts. Cleveland Electric's 1994 service area peak load is forecasted to be 3,790,000 kilowatts, after demand- side management considerations. The operable capacity, which includes firm purchases, expected to be available to serve Cleveland Electric's 1994 peak is 4,018,000 kilowatts. Over the 1994-1996 period, Cleveland Electric forecasts its operable capacity margins at the time of its projected peak loads to range from 6% to 9%. Cleveland Electric owns the facilities located in the area it serves for transmitting and distributing power to all its customers. Cleveland Electric has interconnections with Ohio Edison, Ohio Power and Penelec. The intercon- nections with Ohio Edison provide for the interchange of electric power with the other CAPCO Group companies and for transmission of power from the tenant- in-common owned or leased CAPCO Group generating units as well as for the interchange of power with Toledo Edison. The interconnection with Penelec provides for transmission of power from Cleveland Electric's share of the Seneca Plant. In addition, these interconnections provide the means for the interchange of electric power with other utilities. Cleveland Electric has interconnections with each of the municipal systems operating within its service area. Toledo Edison The wholly owned, jointly owned and leased electric generating facilities of Toledo Edison in commercial operation as of February 28, 1994 provide a net demonstrated capability of 1,832,000 kilowatts during the winter. These facilities include six generating units (925,000 kilowatts) at three fossil- fired steam electric generation stations; its share of three nuclear generating units (830,000 kilowatts) and five combustion turbine generating units (77,000 kilowatts). Operations at one fossil-fired generating unit (75,000 kilowatts) ceased in July 1993 and the unit is being preserved for future use. All of Toledo Edison's generating facilities are located in Ohio and Pennsylvania. The net 60-minute peak load of Toledo Edison's service area for 1993 was 1,568,000 kilowatts and occurred on August 27. The operable capacity at the time of the 1993 peak was 1,874,000 kilowatts. Toledo Edison's 1994 service area peak load is forecasted to be 1,490,000 kilowatts, after demand-side management considerations. The operable capacity, which includes the effect of firm sales, expected to be available to serve Toledo Edison's 1994 peak is 1,652,000 kilowatts. Over the 1994-1996 period, Toledo Edison forecasts its operable capacity margins at the time of its projected peak loads to range from 0% to 10%. Toledo Edison owns the facilities located in the area it serves for trans- mitting and distributing power to all its customers. Toledo Edison has interconnections with Ohio Edison, Ohio Power and Detroit Edison. The in- terconnection with Ohio Edison provides for the interchange of electric power with the other CAPCO Group companies and for transmission of power from the tenant-in-common owned or leased CAPCO Group generating units as well as for the interchange of power with Cleveland Electric. In addition, these inter- connections provide the means for the interchange of electric power with other utilities. Toledo Edison has interconnections with each of the municipal systems operating within its service area. TITLE TO PROPERTY The generating plants and other principal facilities of the Operating Companies are located on land owned in fee by them, except as follows: (1) Cleveland Electric and Toledo Edison lease from others for a term of about 29-1/2 years starting on October 1, 1987 undivided 6.5%, 45.9% and 44.38% tenant-in-common interests in Units 1, 2 and 3, respectively, of the Mansfield Plant located in Shippingport, Pennsylvania. Cleveland Electric and Toledo Edison lease from others for a term of about 29-1/2 years starting on October 1, 1987 an 18.26% undivided tenant-in-common interest in Beaver Valley Unit 2 located in Shippingport, Pennsylvania. Cleveland Electric and Toledo Edison own another 24.47% interest and 1.65% interest, respectively, in Beaver Valley Unit 2 as a tenant-in- common. Cleveland Electric and Toledo Edison continue to own as a tenant-in-common the land upon which the Mansfield Plant and Beaver Valley Unit 2 are located, but have leased to others certain portions of that land relating to the above-mentioned generating unit leases. (2) Most of the facilities of Cleveland Electric's Lake Shore Plant are situated on artificially filled land, extending beyond the natural shore- line of Lake Erie as it existed in 1910. As of December 31, 1993, the cost of Cleveland Electric's facilities, other than water intake and discharge facilities, located on such artificially filled land aggregated approximately $112,026,000. Title to land under the water of Lake Erie within the territorial limits of Ohio (including artificially filled land) is in the State of Ohio in trust for the people of the State for the public uses to which it may be adapted, subject to the powers of the United States, the public rights of navigation, water commerce and fishery and the rights of upland owners to wharf out or fill to make use of the water. The State is required by statute, after appropriate pro- ceedings, to grant a lease to an upland owner, such as Cleveland Elec- tric, which erected and maintained facilities on such filled land prior to October 13, 1955. Cleveland Electric does not have such a lease from the State with respect to the artificially filled land on which its Lake Shore Plant facilities are located, but Cleveland Electric's position, on advice of counsel for Cleveland Electric, is that its facilities and occupancy may not be disturbed because they do not interfere with the free flow of commerce in navigable channels and constitute (at least in part) and are on land filled pursuant to the exercise by it of its property rights as owner of the land above the shoreline adjacent to the filled land. Cleveland Electric holds permits, under Federal statutes relating to navigation, to occupy such artificially filled land. (3) The facilities of Cleveland Electric's Seneca Plant in Warren County, Pennsylvania, are located on land owned by the United States and occupied by Cleveland Electric and Penelec pursuant to a license issued by the FERC for a 50-year period starting December 1, 1965 for the construction, operation and maintenance of a pumped-storage hydroelectric plant. (4) The water intake and discharge facilities at the electric generating plants of Cleveland Electric and Toledo Edison located along Lake Erie, the Maumee River and the Ohio River are extended into the lake and rivers under their property rights as owners of the land above the water line and pursuant to permits under Federal statutes relating to navigation. (5) The transmission systems of the Operating Companies are located on land, easements or rights-of-way owned by them. Their distribution systems also are located, in part, on interests in land owned by them, but, for the most part, their distribution systems are located on lands owned by others and on streets and highways. In most cases, permission has been obtained from the apparent owner of the property or, if the distribution system is located on streets and highways, from the apparent owner of the abutting property. Their electric underground transmission and distri- bution systems are located, for the most part, in public streets. The Pennsylvania portions of the main transmission lines from the Seneca Plant, the Mansfield Plant and Beaver Valley Unit 2 are not owned by Cleveland Electric or Toledo Edison. All Cleveland Electric and Toledo Edison properties, with certain exceptions, are subject to the lien of their respective mortgages. The fee titles which Cleveland Electric and Toledo Edison acquire as tenant- in-common owners, and the leasehold interests they have as joint lessees, of certain generating units do not include the right to require a partition or sale for division of proceeds of the units without the concurrence of all the other owners and their respective mortgage trustees and the trustees under Cleveland Electric's and Toledo Edison's mortgages. Item 3. Item 3. Legal Proceedings Regulatory Proceedings and Suits Contesting Sulfur Dioxide Emission Limitations and Related Regulations Applicable to the Operating Companies. See "Item 1. Business--Environmental Regulation--Air Quality Control". Westinghouse Lawsuit. In April 1991, the CAPCO Group companies filed a lawsuit against Westinghouse in the United States District Court for the Western District of Pennsylvania. The suit alleges that six steam generators supplied by Westinghouse for Beaver Valley Power Station Units 1 and 2 contain serious defects, particularly defects causing tube corrosion and cracking. Steam generator maintenance costs have increased due to these defects and will likely continue to increase. The condition of the steam generators is being monitored closely. If the corrosion and cracking continue, replacement of the steam generators could be required earlier than their 40-year design life. The suit seeks monetary and corrective relief. General Electric Lawsuit. On February 2, 1994, the CAPCO Group companies announced that a settlement had been reached with General Electric regarding the lawsuit filed by the CAPCO Group companies against General Electric in August 1991. In that suit which was filed in the United States District Court in Cleveland, the CAPCO Group companies as joint owners of the Perry Plant alleged that General Electric had provided defective design information relating to the containment vessels for Perry Units 1 and 2. The CAPCO Group companies also alleged that the required corrective actions caused extensive delays and cost increases in the construction of the Perry Plant. Under the settlement agreement, General Electric will provide the CAPCO Group companies with discounts on future purchases and cash payments. The value of the settlement depends on the volume of future purchases. Because the payments will be made over a period of years and the discounts will be offered over the life of the plant, they will not have a material impact on the financial results of Centerior, Cleveland Electric and Toledo Edison in any particular year or on their financial conditions. The terms of the settlement agreement are the subject of a confidentiality agreement. Item 4. Item 4. Submission of Matters to a Vote of Security Holders CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART II Item 5. Item 5. Market for Registrants' Common Equity and Related Stockholder Matters The information regarding common stock prices and number of share owners required by this Item is not applicable to Cleveland Electric or Toledo Edison because all of their common stock is held solely by Centerior Energy. Market Information Centerior Energy's common stock is traded on the New York, Chicago and Pacific Stock Exchanges. The quarterly high and low prices of Centerior common stock (as reported on the composite tape) in 1992 and 1993 were as follows: Share Owners As of March 15, 1994, Centerior Energy had 159,506 common stock share owners of record. Dividends See Note 14 to Centerior's Financial Statements for quarterly dividend pay- ments in the last two years. See "Outlook--Common Stock Dividends" in Management's Financial Analysis contained under Item 7 of this Report for a discussion of the payment of future dividends by Centerior and the Operating Companies. At December 31, 1993, Centerior Energy had a retained earnings deficit of $523 million and capital surplus of $2 billion, resulting in an overall surplus of $1.477 billion that was available to pay dividends under Ohio law. Any current period earnings in 1994 will increase surplus under Ohio law. See Note 11(c) to Centerior's Financial Statements and Note 11(b) to the Operating Companies' Financial Statements for discussions of dividend restrictions affecting Cleveland Electric and Toledo Edison. Dividends paid in 1993 on each of the Operating Companies' outstanding series of preferred stock were fully taxable. The Operating Companies believe that all or a portion of their preferred stock dividends paid in 1994 will be a return of capital because they intend to take a deduction for the abandonment of Perry Unit 2. Item 6. Item 6. Selected Financial Data CENTERIOR ENERGY The information required by this Item is contained on Pages and attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages and attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages and attached hereto. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CENTERIOR ENERGY The information required by this Item is contained on Pages through attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages through attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages through attached hereto. Item 8. Item 8. Financial Statements and Supplementary Data CENTERIOR ENERGY The information required by this Item is contained on Pages and through attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages and through attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages and through attached hereto. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrants CENTERIOR ENERGY The information required by this Item for Centerior regarding directors is incorporated herein by reference to Pages 4 through 8 of Centerior's definitive proxy statement dated March 23, 1994. Reference is also made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the executive officers of Centerior Energy. CLEVELAND ELECTRIC Set forth below are the name and other directorships held, if any, of each director of Cleveland Electric. The year in which the director was first elected to Cleveland Electric's Board of Directors is set forth in paren- thesis. Reference is made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the directors and executive officers of Cleveland Electric. The directors received no remuneration in their capacity as directors. Robert J. Farling* Mr. Farling is a director of National City Bank. (1986) Murray R. Edelman Mr. Edelman is a director of Society Bank & Trust. (1993) Fred J. Lange, Jr. (1993) *Also a director of Centerior Energy and the Service Company. TOLEDO EDISON Set forth below are the name and other directorships held, if any, of each director of Toledo Edison. The year in which the director was first elected to Toledo Edison's Board of Directors is set forth in parenthesis. Reference is made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the directors and the executive officers of Toledo Edison. The directors received no remuneration in their capacity as directors. Robert J. Farling* Mr. Farling is a director of National City Bank. (1988) Murray R. Edelman Mr. Edelman is a director of Society Bank & Trust. (1993) Fred J. Lange, Jr. (1993) *Also a director of Centerior Energy and the Service Company. Item 11. Item 11. Executive Compensation CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON The information required by this Item for Centerior is incorporated herein by reference to the information concerning compensation of directors on Page 9 and the information concerning compensation of executive officers, stock option transactions, long-term incentive awards and pension benefits on Pages 17 through 25 of Centerior's definitive proxy statement dated March 23, 1994. The named executive officers for Centerior are included for Cleveland Electric and Toledo Edison regardless of whether they were officers of Cleveland Electric or Toledo Edison because they were key policymakers for the Centerior System in 1993. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management CENTERIOR ENERGY The following table sets forth the beneficial ownership of Centerior common stock by individual directors of Centerior, the named executive officers and all directors and executive officers of Centerior Energy and the Service Company as a group as of February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Centerior Energy and the Service Company as a group were considered to own bene- ficially 0.1% of Centerior's common stock and none of the preferred stock of Cleveland Electric and Toledo Edison. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all directors and executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Owned by the Sisters of Notre Dame. (4) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. CLEVELAND ELECTRIC Individual directors of Cleveland Electric, the named executive officers and all directors and executive officers of Cleveland Electric as a group as of March 15, 1994 beneficially owned the following number of shares of Centerior common stock on February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Cleveland Electric as a group were considered to own beneficially 0.03% of Centerior's common stock and none of Cleveland Electric's serial preferred stock. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all directors and executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. TOLEDO EDISON Individual directors of Toledo Edison, the named executive officers and all directors and executive officers of Toledo Edison as a group as of March 15, 1994 beneficially owned the following number of shares of Centerior common stock on February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Toledo Edison as a group were considered to own beneficially 0.03% of Centerior's common stock. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all other executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. Item 13. Item 13. Certain Relationships and Related Transactions CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents Filed as a Part of the Report 1. Financial Statements: Financial Statements for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Index to Selected Financial Data; Management's Discussion and Analysis of Financial Condition and Re- sults of Operations; and Financial Statements. See Page. 2. Financial Statement Schedules: Financial Statement Schedules for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Index to Schedules. See Page S-1. 3. Combined Pro Forma Condensed Financial Statements (Unaudited): Combined Pro Forma Condensed Financial Statements (unaudited) for Cleveland Electric and Toledo Edison related to their pending merger. See Pages P-1 to P-4. 4. Exhibits: Exhibits for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Exhibit Index. See Page E-1. (b) Reports on Form 8-K During the quarter ended December 31, 1993, Centerior Energy, Cleveland Electric and Toledo Edison did not file any Current Reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. CENTERIOR ENERGY CORPORATION Registrant March 30, 1994 By *ROBERT J FARLING, Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. THE CLEVELAND ELECTRIC ILLUMINATING COMPANY Registrant March 30, 1994 By *ROBERT J. FARLING, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. THE TOLEDO EDISON COMPANY Registrant March 30, 1994 By *ROBERT J. FARLING, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - -------------------------------------------------------------------------------- To the Share Owners and Board of Directors of [Logo] Centerior Energy Corporation: We have audited the accompanying consolidated balance sheet and consolidated statement of preferred stock of Centerior Energy Corporation (an Ohio corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Centerior Energy Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules of Centerior Energy Corporation and subsidiaries listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio February 14, 1994 (Centerior Energy) (Centerior Energy) MANAGEMENT'S FINANCIAL ANALYSIS - -------------------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 1.5% increase in 1993 operating revenues are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $53 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential, commercial and wholesale kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. As a result, total sales increased 3.1% in 1993. Residential and commercial sales increased 4.6% and 3.1%, respectively. Industrial sales increased 1.2%. Increased sales to large automotive manufacturers, petroleum refiners and the broad-based, smaller industrial group were partially offset by lower sales to large steel industry customers. Other sales increased 5.9% because of increased sales to wholesale customers. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. The net decrease in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors increased slightly for The Toledo Edison Company (Toledo Edison) but decreased 5% for The Cleveland Electric Illuminating Company (Cleveland Electric). Operating expenses increased 13.7% in 1993. The increase in total operation and maintenance expenses resulted from the $218 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $54 million and an increase in other operation and maintenance expenses. Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. The increase in other operation and maintenance expenses resulted from higher environmental expenses, power restoration and repair expenses following a July 1993 storm in the Cleveland area, and an increase in other postretirement benefit expenses. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $583 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.8% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $77 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. As a result, total kilowatt-hour sales decreased 1.1% in 1992. Residential and commercial sales decreased 4.5% and 1.3%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales were virtually the same as in 1991 as sales increases to steel producers and auto manufacturers of 10.9% and 2.7%, respectively, offset a decline in sales to other industrial customers. Other sales increased 2.3% because of increased sales to wholesale customers. Operating revenues in 1991 included the recognition by Toledo Edison of $24 million of deferred revenues over the period of a refund to customers under a provision of its January 1989 rate order. No such revenues were reflected in 1992 as the refund period ended in December 1991. The decrease in 1992 fuel cost recovery revenues resulted from the good performance of our generating units, which in turn decreased our fuel cost factors. The weighted averages of these factors decreased approximately 3% for Cleveland Electric and Toledo Edison (Operating Companies). Operating expenses decreased 4% in 1992. Lower fuel and purchased power expense resulted from less amortization of previously deferred fuel costs than the amount amortized in 1991 and lower generation requirements stemming from less electric sales. A reduction of $17 million in other operation and maintenance expenses resulted primarily from cost-cutting measures. Federal income (Centerior Energy) (Centerior Energy) taxes decreased because of the amortization of certain tax benefits under the Rate Stabilization Program discussed in Note 7 and the effects of adopting the new accounting standard for income taxes (SFAS 109) in 1992. These decreases were partially offset by higher depreciation and amortization, caused primarily by the adoption of SFAS 109, and by higher taxes, other than federal income taxes, caused by increased Ohio property and gross receipts taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program. The federal income tax provision for nonoperating income decreased because of lower carrying charge credits and a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income decreased primarily because of lower phase-in carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, we announced a comprehensive strategic action plan to strengthen our financial and competitive position. The plan established specific objectives and was designed to guide us through the year 2001. While the plan has a long-term focus, it also required us to take some very difficult, but necessary, financial actions at that time. We reduced the quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. We also wrote off our investment in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs was $1.023 billion which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. We also recognized other one-time charges totaling $39 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $87 million after taxes representing a portion of the VTP costs. We will realize approximately $50 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of our strategic plan are to maximize share owner return from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, we will continue controlling our operation and maintenance expenses and capital expenditures, reduce our outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of our plants and take other appropriate actions. COMMON STOCK DIVIDENDS The indicated quarterly common stock dividend is $.20 per share. We believe that the new level is sustainable barring unforeseen circumstances and that the new strategic plan will provide the opportunity to grow the dividend as the objectives are achieved. Nevertheless, future dividend action by our Board of Directors will continue to be decided on a quarter-to-quarter basis after the evaluation of financial results, potential earning capacity and cash flow. The lower dividend reduces our cash outflow by about $120 million annually, which we intend to use to repay debt more quickly than would otherwise be the case. This will help improve our capitalization structure and interest coverage ratios, both of which are key measures considered by securities rating agencies in determining credit ratings. Improved credit ratings and less outstanding debt, in turn, will lower our interest costs. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are a number of rural and municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems and the expansion of an existing system. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. Cleveland Public Power continues to expand its operations into areas we have served exclusively. We have been successful in retaining most of the large industrial and commercial customers in those areas by providing economic incentive packages in exchange for sole-supplier contracts. We also have similar contracts with customers in other areas. Most of these contracts have remaining terms of one to five years. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. (Centerior Energy) (Centerior Energy) The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. Our analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS Our three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(e). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Operating Companies have been named as "potentially responsible parties" (PRPs) for three sites listed on the Superfund National Priorities List (Superfund List) and are aware of their potential involvement in the cleanup of several other sites not on such list. The allegations that the Operating Companies disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all PRPs to a particular site can be held liable on a joint and several basis. Consequently, if the Operating Companies were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $400 million. However, we believe that the actual cleanup costs will be substantially lower than $400 million, that the Operating Companies' share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Operating Companies have accrued a liability totaling $19 million at December 31, 1993 based on estimates of the costs of cleanup and their proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing pro- (Centerior Energy) (Centerior Energy) gram of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $1.4 billion. In addition, we exercised various options to redeem and purchase approximately $900 million of our securities. We raised $2.2 billion through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Operating Companies also utilized their short-term borrowing arrangements to help meet their cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for Cleveland Electric and Toledo Edison, respectively, are $791 million and $249 million for their construction programs and $715 million and $324 million for the mandatory redemption of debt and preferred stock. Cleveland Electric and Toledo Edison expect to finance internally all of their 1994 cash requirements of approximately $239 million and $109 million, respectively. About 15-20% of the Operating Companies' 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $128 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Operating Companies under their respective mortgages on the basis of property additions, cash or refundable first mortgage bonds. Under their respective mortgages, each Operating Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, Cleveland Electric and Toledo Edison would have been permitted to issue approximately $78 million and $323 million of additional first mortgage bonds, respectively. After the fourth quarter of 1994, Cleveland Electric's ability to issue first mortgage bonds is expected to increase substantially when its interest coverage ratio will no longer be affected by the write-offs recorded at December 31, 1993. As discussed in Note 11(e), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused Centerior Energy Corporation (Centerior Energy) and the Operating Companies to violate certain of those covenants. The affected creditors have waived those violations in exchange for our commitment to provide them with a second mortgage security interest on our property and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $219 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. For the next five years, the Operating Companies do not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, the Operating Companies believe that they could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Operating Companies also are able to raise funds through the sale of preference stock and, in the case of Cleveland Electric, preferred stock. Toledo Edison will be unable to issue preferred stock until it can meet the interest and preferred dividend coverage test in its articles of incorporation. Centerior Energy will continue to raise funds through the sale of common stock. The Operating Companies currently cannot sell commercial paper because of their low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. We have a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused us to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Operating Companies' needs over the next several years. The availability and cost of capital to meet our external financing needs, however, also depend upon such factors as financial market conditions and our credit ratings. Current credit ratings for both Operating Companies are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Operating Companies. (Centerior Energy) (Centerior Energy) INCOME STATEMENT CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ------------------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Centerior Energy) (Centerior Energy) CASH FLOWS CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ---------------------------------------------------------------------- (1) Interest paid (net of amounts capitalized) was $295 million, $299 million and $339 million in 1993, 1992 and 1991, respectively. Income taxes paid were $50 million, $32 million and $57 million in 1993, 1992 and 1991, respectively. (2) Increases in Nuclear Fuel and Nuclear Fuel Lease Obligations in the Balance Sheet resulting from the noncash capitalizations under nuclear fuel agreements are excluded from this statement. The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES (Centerior Energy) (Centerior Energy) STATEMENT OF PREFERRED STOCK CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) NOTES TO THE FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL Centerior Energy is a holding company with two electric utility subsidiaries, Cleveland Electric and Toledo Edison. The consolidated financial statements also include the accounts of Centerior Energy's other wholly owned subsidiary, Centerior Service Company (Service Company), and Cleveland Electric's wholly owned subsidiaries. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to Centerior Energy and the Operating Companies. The Operating Companies operate as separate companies, each serving the customers in its service area. The preferred stock, first mortgage bonds and other debt obligations of the Operating Companies are outstanding securities of the issuing utility. All significant intercompany items have been eliminated in consolidation. Centerior Energy and the Operating Companies follow the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission and adopted by The Public Utilities Commission of Ohio (PUCO). As rate-regulated utilities, the Operating Companies are subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The Service Company follows the Uniform System of Accounts for Mutual Service Companies prescribed by the Securities and Exchange Commission under the Public Utility Holding Company Act of 1935. The Operating Companies are members of the Central Area Power Coordination Group (CAPCO). Other members are Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO or on ordinances of individual municipalities. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (C) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Operating Companies defer the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Operating Companies have accrued the liability for their share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Operating Companies to recover the assessments through their fuel cost factors. (D) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Operating Companies to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $17 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Operating Companies deferred certain operating expenses and both interest and equity carrying charges pursuant to PUCO-approved rate phase-in plans for their investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Operating Companies also defer certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (Centerior Energy) (Centerior Energy) (E) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depreciable utility plant in service was 3.5% in 1993 and 3.4% in both 1992 and 1991. Effective January 1, 1991, the Operating Companies, after obtaining PUCO approval, changed their method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $36 million and increased 1991 net income $28 million (net of $8 million of income taxes) and earnings per share $.20 from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Operating Companies currently use external funding for the future decommissioning of their nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $8 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Operating Companies' share of the future decommissioning costs are $92 million in 1992 dollars for Beaver Valley Unit 2 and $223 million and $300 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Operating Companies used these estimates to increase their decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $74 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (F) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rates averaged 9.9% in 1993, 10.8% in 1992 and 10.7% in 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (G) DEFERRED GAIN AND LOSS FROM SALES OF UTILITY PLANT The sale and leaseback transactions discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant) and a net loss for the sale of Beaver Valley Unit 2. The net gain and net loss were deferred and are being amortized over the terms of leases. These amortizations and the lease expense amounts are recorded as other operation and maintenance expenses. (H) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (Centerior Energy) (Centerior Energy) (I) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (2) Utility Plant Sale and Leaseback Transactions The Operating Companies are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Operating Companies are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Operating Companies have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(e). In April 1992, nearly all of the outstanding Secured Lease Obligation Bonds (SLOBs) issued by a special purpose corporation in connection with financing the sale and leaseback of Beaver Valley Unit 2 were refinanced through a tender offer and the sale of new bonds having a lower interest rate. As part of the refinancing transaction, Toledo Edison paid $43 million as supplemental rent to fund transaction expenses and part of the tender premium. This amount has been deferred and is being amortized over the remaining lease term. The refinancing transaction reduced the annual rental expense for the Beaver Valley Unit 2 lease by $9 million. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $115 million. The amounts recorded in 1993, 1992 and 1991 as annual rental expense for the Beaver Valley Unit 2 lease were $63 million, $66 million and $72 million, respectively. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. Toledo Edison is selling 150 megawatts of its Beaver Valley Unit 2 leased capacity entitlement to Cleveland Electric. We anticipate that this sale will continue indefinitely. (Centerior Energy) (Centerior Energy) (3) Property Owned with Other Utilities and Investors The Operating Companies own, as tenants in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Operating Companies' share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Operating Companies as tenants in common with other utilities and Lessors: Depreciation for Eastlake Unit 5 has been accumulated with all other nonnuclear depreciable property rather than by specific units of depreciable property. (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of our construction program for the 1994-1998 period is $1.088 billion, including AFUDC of $48 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $222 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses will be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be about 1-2% in the late 1990s. Cleveland Electric may need to install sulfur emission control technology at one of its generating plants after 2005 which could require additional expenditures at that time. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $583 million ($425 million after taxes) for our 64.76% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Operating Companies are aware of their potential involvement in the cleanup of three sites listed on the Superfund List and several other waste sites not on such list. The Operating Companies have accrued a liability totaling $19 million at December 31, 1993 based on estimates of the costs of cleanup and their proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (Centerior Energy) (Centerior Energy) (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS Our three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), our maximum potential assessment under that plan would be $155 million (plus any inflation adjustment) per incident. The assessment is limited to $20 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, our share of such excess amount could have a material adverse effect on our financial condition and results of operations. Under these policies, we can be assessed a maximum of $25 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. We also have extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (6) Nuclear Fuel Nuclear fuel is financed for the Operating Companies through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $370 million of nuclear fuel was financed. The Operating Companies severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments of $110 million, $78 million and $46 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $14 million in 1993, $15 million in 1992 and $21 million in 1991. The estimated future lease amortization payments based on projected consumption are $111 million in 1994, $97 million in 1995, $87 million in 1996, $77 million in 1997 and $69 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plans approved by the PUCO in January 1989 rate orders for the Operating Companies. The phase-in plans were designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plans required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Operating Companies' deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plans. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 were $172 million and $705 million, respectively (totaling $598 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current (Centerior Energy) (Centerior Energy) assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in our service area by freezing base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $216 million for Cleveland Electric and $89 million for Toledo Edison over the 1996-1998 period. As part of the Rate Stabilization Program, the Operating Companies are allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988 and the deferral of Toledo Edison operating expenses equivalent to an accumulated excess rent reserve for Beaver Valley Unit 2 (which resulted from the April 1992 refinancing of SLOBs as discussed in Note 2). The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $95 million and $84 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets and the remaining lease period, or approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $46 million and $12 million, respectively. The Rate Stabilization Program also authorized the Operating Companies to defer and subsequently recover the incremental expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $96 million pursuant to this provision. Amortization and recovery of this deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying the income before taxes and preferred dividend requirements of subsidiaries by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: (Centerior Energy) (Centerior Energy) In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $90 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $90 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $619 million and deferred tax liabilities of $2.198 billion at December 31, 1993 and deferred tax assets of $563 million and deferred tax liabilities of $2.598 billion at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $309 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $108 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $171 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN We sponsor a noncontributing pension plan which covers all employee groups. Two existing plans were merged into a single plan on December 31, 1993. The amount of retirement benefits generally depends upon the length of service. Under certain circumstances, benefits can begin as early as age 55. Our funding policy is to comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, we offered the VTP, an early retirement program. Operating expenses for 1993 included $205 million of pension plan accruals to cover enhanced VTP benefits and an additional $10 million of pension costs for VTP benefits paid to retirees from corporate funds. The $10 million is not included in the pension data reported below. A credit of $81 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs (credits) for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the plan(s) at December 31, 1993 and 1992. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (Centerior Energy) (Centerior Energy) (B) OTHER POSTRETIREMENT BENEFITS We sponsor a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. We adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs totaled $9 million in 1992 and $10 million in 1991, which included medical benefits of $8 million in 1992 and $9 million in 1991. The total amount accrued for SFAS 106 costs for 1993 was $111 million, of which $5 million was capitalized and $106 million was expensed as other operation and maintenance expenses. In 1993, we deferred incremental SFAS 106 expenses totaling $96 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 are summarized as follows: At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $11 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $1 million. (C) POSTEMPLOYMENT BENEFITS In 1993, we adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect our 1993 results of operations or financial position. (10) Guarantees Cleveland Electric has guaranteed certain loan and lease obligations of two mining companies under two long-term coal purchase arrangements. Toledo Edison is also a party to one of these guarantee arrangements. This arrangement requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining companies' loan and lease obligations guaranteed by the Operating Companies was $80 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Shares sold, retired and purchased for treasury during the three years ended December 31, 1993 are listed in the following tables. (Centerior Energy) (Centerior Energy) Shares of common stock required for our stock plans in 1993 were either acquired in the open market, issued as new shares or issued from treasury stock. The Board of Directors has authorized the purchase in the open market of up to 1,500,000 shares of our common stock until June 30, 1994. As of December 31, 1993, 225,500 shares had been purchased at a total cost of $4 million. Such shares are being held as treasury stock. (B) COMMON SHARES RESERVED FOR ISSUE Common shares reserved for issue under the Employee Savings Plan and the Employee Purchase Plan were 1,962,174 and 469,457 shares, respectively, at December 31, 1993. Stock options to purchase unissued shares of common stock under the 1978 Key Employee Stock Option Plan were granted at an exercise price of 100% of the fair market value at the date of the grant. No additional options may be granted. The exercise prices of option shares purchased during the three years ended December 31, 1993 ranged from $14.09 to $17.41 per share. Shares and price ranges of outstanding options held by employees were as follows: (C) EQUITY DISTRIBUTION RESTRICTIONS The Operating Companies make cash available for the funding of Centerior Energy's common stock dividends by paying dividends on their respective common stock, which are held solely by Centerior Energy. Federal law prohibits the Operating Companies from paying dividends out of capital accounts. However, the Operating Companies may pay preferred and common stock dividends out of appropriated retained earnings and current earnings. At December 31, 1993, Cleveland Electric and Toledo Edison had $125 million and $42 million, respectively, of appropriated retained earnings for the payment of dividends. However, Toledo Edison is prohibited from paying a common stock dividend by a provision in its mortgage. (D) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $40 million in 1994, $51 million in 1995, $41 million in 1996, $31 million in 1997 and $16 million in 1998. The annual mandatory redemption provisions are as follows: * All outstanding shares to be redeemed on December 1, 2001. In June 1993, Cleveland Electric issued $100 million principal amount of Serial Preferred Stock, $42.40 Series T. The Series T stock was deposited with an agent which issued Depositary Receipts, each representing 1/20 of a share of the Series T stock. The annualized preferred dividend requirement for the Operating Companies at December 31, 1993 was $68 million. The preferred dividend rates on Cleveland Electric's Series L and M and Toledo Edison's Series A and B fluctuate based on prevailing interest rates and market conditions. The dividend rates for these issues averaged 7%, 7%, 7.41% and 8.22%, respectively, in 1993. Cleveland Electric's Series P had a 6.5% dividend rate in 1993 until it was redeemed in August 1993. (Centerior Energy) (Centerior Energy) Preference stock authorized for the Operating Companies are 3,000,000 shares without par value for Cleveland Electric and 5,000,000 shares with a $25 par value for Toledo Edison. No preference shares are currently outstanding for either company. With respect to dividend and liquidation rights, each Operating Company's preferred stock is prior to its preference stock and common stock, and each Operating Company's preference stock is prior to its common stock. (E) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, for the Operating Companies was as follows: Long-term debt matures during the next five years as follows: $87 million in 1994, $317 million in 1995, $242 million in 1996, $94 million in 1997 and $117 million in 1998. The Operating Companies issued $550 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The mortgages of the Operating Companies constitute direct first liens on substantially all property owned and franchises held by them. Excluded from the liens, among other things, are cash, securities, accounts receivable, fuel, supplies and, in the case of Toledo Edison, automotive equipment. Certain unsecured loan agreements of the Operating Companies contain covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting Centerior Energy and the Operating Companies. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused Centerior Energy and the Operating Companies to violate certain covenants contained in a Cleveland Electric loan agreement and the two reimbursement agreements. The affected creditors have waived those violations in exchange for our commitment to provide them with a second mortgage security interest on our property and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $219 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Operating Companies. Centerior Energy plans to transfer any of its borrowed funds to the Operating Companies, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The (Centerior Energy) (Centerior Energy) revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $300 million for Cleveland Electric and $150 million for Toledo Edison. The Operating Companies are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Operating Companies had no commercial paper outstanding. The Operating Companies are unable to rely on the sale of commercial paper to provide short-term funds because of their below investment grade commercial paper credit ratings. (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Operating Companies' preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $81 million, or $.56 per share, as a result of the recording of $125 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $583 million write-off of Perry Unit 2 (see Note 4(b)), the $877 million write-off of the phase-in deferrals (see Note 7) and $58 million of other charges. These adjustments decreased quarterly earnings by $1.06 billion, or $7.24 per share. Earnings for the quarter ended September 30, 1992 were increased by $41 million, or $.29 per share, as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $61 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (Centerior Energy) (Centerior Energy) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) Operating Expenses (millions of dollars) Income (Loss) (millions of dollars) NOTE: 1983 data is the result of combining and restating data for the Operating Companies. (a) Includes early retirement program expenses and other charges of $272 million in 1993. (b) Includes write-off of phase-in deferrals of $877 million in 1993, consisting of $172 million of deferred operating expenses and $705 million of deferred carrying charges. (c) In 1991, the Operating Companies adopted a change in accounting for nuclear plant depreciation, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Centerior Energy) (Centerior Energy) Investment (millions of dollars) Capitalization (millions of dollars & %) (d) Includes write-off of Perry Unit 2 of $583 million in 1993. (e) Average shares outstanding and related per share computations reflect the Cleveland Electric 1.11-for-one exchange ratio and the Toledo Edison one-for-one exchange ratio for Centerior Energy shares at the date of affiliation, April 29, 1986. (f) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Centerior Energy) (Centerior Energy) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - ---------------------------------------------------------------------- To the Share Owners of The Cleveland Electric [Logo] Illuminating Company: We have audited the accompanying consolidated balance sheet and consolidated statement of preferred stock of The Cleveland Electric Illuminating Company (a wholly owned subsidiary of Centerior Energy Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Cleveland Electric Illuminating Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purposef of forming an opinion on the basic financial statements taken as a whole. The schedules of The Cleveland Electric Illuminating Company and subsidiaries listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio February 14, 1994 (except with respect to the matter discussed in Note 15, as to which the date is March 25, 1994) (Cleveland Electric) (Cleveland Electric) MANAGEMENT'S FINANCIAL ANALYSIS - ---------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 0.5% increase in 1993 operating revenues for The Cleveland Electric Illuminating Company (Company) are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $36 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential, commercial and wholesale kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northeastern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. As a result, total sales increased 2.9% in 1993. Residential and commercial sales increased 4.4% and 3.1%, respectively. Industrial sales decreased 1%. Lower sales to large steel industry customers were partially offset by increased sales to large automotive manufacturers and the broad-based, smaller industrial customer group. Other sales increased 11.9% because of increased sales to wholesale customers. The net decrease in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors decreased approximately 5%. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. Operating expenses increased 12.4% in 1993. The increase in total operation and maintenance expenses resulted from the $130 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $35 million and an increase in other operation and maintenance expenses. The VTP benefit expenses consisted of $102 million of costs for the Company plus $28 million for the Company's pro rata share of the costs for its affiliate, Centerior Service Company (Service Company). Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. The increase in other operation and maintenance expenses resulted from higher environmental expenses, power restoration and repair expenses following a July 1993 storm, and an increase in other postretirement benefit expenses. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $351 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.5% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $55 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. As a result, total kilowatt-hour sales decreased 3.5% in 1992. Residential and commercial sales decreased 4.4% and 0.5%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales declined 0.4% as an 8.1% decrease in sales to the broad-based, smaller industrial customer group completely offset an 8.8% increase in sales to the larger industrial customer group. Sales to steel producers and auto manufacturers within the large industrial customer group rose 10.9% and 7%, respectively. Other sales decreased 16.1% because of decreased sales to wholesale customers and public authorities. The decrease in 1992 fuel cost recovery revenues resulted primarily because of the good performance of our generating units, which in turn decreased our fuel cost factors. The weighted averages of these factors decreased approximately 3%. Operating expenses decreased 3.6% in 1992. Lower fuel and purchased power expense resulted from lower generation requirements stemming from less electric sales and less amortization of previously deferred fuel costs than the amount amortized in 1991. Federal income taxes decreased because of the amortization of certain tax benefits under the Rate Stabilization Program discussed (Cleveland Electric) (Cleveland Electric) in Note 7 and the effects of adopting the new accounting standard for income taxes (SFAS 109) in 1992. These decreases were partially offset by higher depreciation and amortization, caused primarily by the adoption of SFAS 109, and by higher taxes, other than federal income taxes, caused by increased Ohio property and gross receipts taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program. The federal income tax provision for nonoperating income decreased because of lower carrying charge credits and a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income decreased primarily because of lower phase-in-carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, Centerior Energy Corporation (Centerior Energy), along with the Company and The Toledo Edison Company (Toledo Edison), announced a comprehensive strategic action plan to strengthen their financial and competitive positions. The Company and Toledo Edison are the two wholly owned electric utility subsidiaries of Centerior Energy. The plan established specific objectives and was designed to guide Centerior Energy and its subsidiaries through the year 2001. Several actions were taken at that time. Centerior Energy reduced its quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. The Company and Toledo Edison also wrote off their investments in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs for the Company was $691 million which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. The Company also recognized other one-time charges totaling $25 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $51 million after taxes representing a portion of the VTP costs. The Company will realize approximately $30 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of the strategic plan are to maximize share owner return on Centerior Energy common stock from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, the Company will continue controlling its operation and maintenance expenses and capital expenditures, reduce its outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of its plants and take other appropriate actions. COMMON STOCK DIVIDENDS Centerior Energy's common stock dividend has been funded in recent years primarily by common stock dividends paid by the Company. We expect this practice to continue for the foreseeable future. Centerior Energy's lower common stock dividend reduces its cash outflow by about $120 million annually which, in turn, reduces the common stock dividend demands placed on the Company. The Company intends to use the increased retained cash to repay debt more quickly than would otherwise be the case. This will help improve the Company's capitalization structure and interest coverage ratios. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are two municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems and the expansion of an existing system. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. Cleveland Public Power continues to expand its operations into areas we have served exclusively. We have been successful in retaining most of the large industrial and commercial customers in those areas by providing economic incentive packages in exchange for sole-supplier contracts. We also have similar contracts with customers in other areas. Most of these contracts have remaining terms of one to five years. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses (Cleveland Electric) (Cleveland Electric) for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. As mentioned above, we have contracts with many of our large industrial and commercial customers. We will attempt to renew those contracts as they expire which will help us compete if retail wheeling is permitted in the future. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS The Company's three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(f). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Company has been named as a "potentially responsible party" (PRP) for three sites listed on the Superfund National Priorities List (Superfund List) and is aware of its potential involvement in the cleanup of several other sites not on such list. The allegations that the Company disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all PRPs to a particular site can be held liable on a joint and several basis. Consequently, if the Company were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $250 million. However, we believe that the actual cleanup costs will be substantially lower than $250 million, that the Company's share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Company has accrued a liability totaling $13 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. (Cleveland Electric) (Cleveland Electric) Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing program of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $970 million. In addition, we exercised various options to redeem and purchase approximately $430 million of our securities. We raised $1.2 billion through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Company also utilized its short-term borrowing arrangements to help meet its cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for the Company are $791 million for its construction program and $715 million for the mandatory redemption of debt and preferred stock. The Company expects to finance internally all of its 1994 cash requirements of approximately $239 million. About 20% of the Company's 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $87 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Company under its mortgage on the basis of property additions, cash or refundable first mortgage bonds. Under its mortgage, the Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, the Company would have been permitted to issue approximately $78 million of additional first mortgage bonds. After the fourth quarter of 1994, the Company's ability to issue first mortgage bonds is expected to increase substantially when its interest coverage ratio will no longer be affected by the write-offs recorded at December 31, 1993. As discussed in Note 11(d), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused the Company, Toledo Edison and Centerior Energy to violate certain of those covenants. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Toledo Edison and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $47 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Toledo Edison. For the next five years, the Company does not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, we believe that the Company could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Company also is able to raise funds through the sale of preference and preferred stock. The Company currently cannot sell commercial paper because of its low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. The Company is a party to a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused the Company, Toledo Edison and Centerior Energy to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Company's needs over the next several years. The availability and cost of capital to meet the Company's external financing needs, however, also depend upon such factors as financial market conditions and its credit ratings. Current credit ratings for the Company are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Company. (Cleveland Electric) (Cleveland Electric) INCOME STATEMENT THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - -------------------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Cleveland Electric) (Cleveland Electric) CASH FLOWS THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - -------------------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES (Cleveland Electric) (Cleveland Electric) STATEMENT OF PREFERRED STOCK THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) NOTES TO THE FINANCIAL STATEMENTS - ---------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL The Company is an electric utility and a wholly owned subsidiary of Centerior Energy. Centerior Energy has two other wholly owned subsidiaries, Toledo Edison and the Service Company. The Company follows the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by The Public Utilities Commission of Ohio (PUCO). As a rate-regulated utility, the Company is subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The financial statements include the accounts of the Company's wholly owned subsidiaries, which in the aggregate are not material. The Company is a member of the Central Area Power Coordination Group (CAPCO). Other members are Toledo Edison, Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) RELATED PARTY TRANSACTIONS Operating revenues, operating expenses and interest charges include those amounts for transactions with affiliated companies in the ordinary course of business operations. The Company's transactions with Toledo Edison are primarily for firm power, interchange power, transmission line rentals and jointly owned power plant operations and construction. See Notes 2 and 3. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to the Company and other affiliated companies. The Service Company billed the Company $180 million, $150 million and $138 million in 1993, 1992 and 1991, respectively, for such services. (C) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (D) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Company defers the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Company has accrued a liability for its share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Company to recover the assessments through its fuel cost factors. (E) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Company to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $10 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Company deferred certain operating expenses and both interest and equity carrying charges pursuant to a PUCO-approved rate phase-in plan for its investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Company also defers certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (F) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depre- (Cleveland Electric) (Cleveland Electric) ciable utility plant in service was 3.4% in 1993, 1992 and 1991. Effective January 1, 1991, the Company, after obtaining PUCO approval, changed its method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $22 million and increased 1991 net income $17 million (net of $5 million of income taxes) from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Company currently uses external funding for the future decommissioning of its nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $4 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Company's share of the future decommissioning costs are $51 million in 1992 dollars for Beaver Valley Unit 2 and $136 million and $154 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Company used these estimates to increase its decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $41 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (G) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rate was 9.63% in 1993, 10.56% in 1992 and 10.47% in 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (H) DEFERRED GAIN FROM SALE OF UTILITY PLANT The sale and leaseback transaction discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant). The net gain was deferred and is being amortized over the term of leases. The amortization and the lease expense amounts are recorded as other operation and maintenance expenses. (I) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (J) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. (Cleveland Electric) (Cleveland Electric) Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (2) Utility Plant Sale and Leaseback Transactions The Company and Toledo Edison are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Company and Toledo Edison are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Company and Toledo Edison have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(d). As co-lessee with Toledo Edison, the Company is also obligated for Toledo Edison's lease payments. If Toledo Edison is unable to make its payments under the Beaver Valley Unit 2 and Mansfield Plant leases, the Company would be obligated to make such payments. No payments have been made on behalf of Toledo Edison to date. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $70 million. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. The Company is buying 150 megawatts of Toledo Edison's Beaver Valley Unit 2 leased capacity entitlement. We anticipate that this purchase will continue indefinitely. Purchased power expense for this transaction was $103 million, $108 million and $107 million in 1993, 1992 and 1991, respectively. The future minimum lease payments through the year 2017 associated with Beaver Valley Unit 2 aggregate $1.47 billion. (3) Property Owned with Other Utilities and Investors The Company owns, as a tenant in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Company's share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Operating Company as a tenant in common with other utilities and Lessors: Depreciation for Eastlake Unit 5 has been accumulated with all other nonnuclear depreciable property rather than by specific units of depreciable property. (Cleveland Electric) (Cleveland Electric) (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of the Company's construction program for the 1994-1998 period is $829 million, including AFUDC of $38 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $165 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses will be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be about 1-2% in the late 1990s. The Company may need to install sulfur emission control technology at one of its generating plants after 2005 which could require additional expenditures at that time. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $351 million ($258 million after taxes) for the Company's 44.85% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Company is aware of its potential involvement in the cleanup of three sites listed on the Superfund List and several other waste sites not on such list. The Company has accrued a liability totaling $13 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS The Company's three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), the Company's maximum potential assessment under that plan would be $85 million (plus any inflation adjustment) per incident. The assessment is limited to $11 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, the Company's share of such excess amount could have a material adverse effect on its financial condition and results of operations. Under these policies, the Company can be assessed a maximum of $14 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. The Company also has extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been (Cleveland Electric) (Cleveland Electric) incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (6) Nuclear Fuel Nuclear fuel is financed for the Company and Toledo Edison through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $216 million of nuclear fuel was financed for the Company. The Company and Toledo Edison severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments for the Company of $57 million, $48 million and $26 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $9 million in both 1993 and 1992 and $12 million in 1991. The estimated future lease amortization payments based on projected consumption are $63 million in 1994, $56 million in 1995, $50 million in 1996, $44 million in 1997 and $39 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plan approved by the PUCO in a January 1989 rate order for the Company. The phase-in plan was designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plan required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Company's deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plan. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 by the Company were $117 million and $519 million, respectively (totaling $433 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in the Company's service area by freezing the Company's base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $216 million over the 1996-1998 period. As part of the Rate Stabilization Program, the Company is allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988. The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $56 million and $52 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets, approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $28 million and $7 million, respectively. The Rate Stabilization Program also authorized the Company to defer and subsequently recover the incremental (Cleveland Electric) (Cleveland Electric) expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $60 million pursuant to this provision. Amortization and recovery of this deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying income before taxes by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: The Company joins in the filing of a consolidated federal income tax return with its affiliated companies. The method of tax allocation reflects the benefits and burdens realized by each company's participation in the consolidated tax return, approximating a separate return result for each company. In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $61 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $61 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $426 million and deferred tax liabilities of $1.531 billion at December 31, 1993 and deferred tax assets of $415 million and deferred tax liabilities of $1.807 billion at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $197 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $69 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $94 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN Prior to December 31, 1993, the Company and Service Company jointly sponsored a noncontributing pension plan which covered all employee groups. The plan was merged with another plan which covered the employees of Toledo Edison into a single plan on December 31, 1993. The amount of retirement benefits generally depends (Cleveland Electric) (Cleveland Electric) upon the length of service. Under certain circumstances, benefits can begin as early as age 55. The funding policy is to comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, the Company and Service Company offered the VTP, an early retirement program. Operating expenses for both companies for 1993 included $146 million of pension plan accruals to cover enhanced VTP benefits and an additional $7 million of pension costs for VTP benefits paid to retirees from corporate funds. The $7 million is not included in the pension data reported below. A credit of $66 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs (credits) for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the former plan of the Company and Service Company at December 31, 1992 with comparable information for a portion of the merged plan at December 31, 1993. The December 31, 1993 benefit obligation estimates were derived from information for the former plans. Plan assets of the merged plan were allocated based on a pro rata share of the projected benefit obligation. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (B) OTHER POSTRETIREMENT BENEFITS Centerior Energy sponsors jointly with its subsidiaries a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. The Company adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs for the Company totaled $5 million in 1992 and $6 million in 1991, which included medical benefits of $4 million in 1992 and $5 million in 1991. The total amount accrued by the Company for SFAS 106 costs for 1993 was $69 million, of which $4 million was capitalized and $65 million was expensed as other operation and maintenance expenses. In 1993, the Company deferred incremental SFAS 106 expenses totaling $60 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: These amounts included costs for the Company and a pro rata share of the Service Company's costs. The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 (Cleveland Electric) (Cleveland Electric) for the Company and its share of the Service Company's obligation are summarized as follows: The Balance Sheet classification of Other Noncurrent Liabilities at December 31, 1993 includes only the Company's accrued postretirement benefit cost of $52 million and excludes the Service Company's portion since the Service Company's total accrued cost is carried on its books. At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $7 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $0.5 million. (C) POSTEMPLOYMENT BENEFITS In 1993, the Company adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect the Company's 1993 results of operations or financial position. (10) Guarantees The Company has guaranteed certain loan and lease obligations of two mining companies under two long-term coal purchase arrangements. One of these arrangements requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining companies' loan and lease obligations guaranteed by the Company was $60 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Preferred stock shares sold and retired during the three years ended December 31, 1993 are listed in the following table. (B) EQUITY DISTRIBUTION RESTRICTIONS Federal law prohibits the Company from paying dividends out of capital accounts. However, the Company may pay preferred and common stock dividends out of appropriated retained earnings and current earnings. At December 31, 1993, the Company had $125 million of appropriated retained earnings for the payment of preferred and common stock dividends. (C) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $29 million in 1994, $40 million in 1995, $30 million in both 1996 and 1997 and $15 million in 1998. The annual preferred stock mandatory redemption provisions are as follows: * All outstanding shares to be redeemed on December 1, 2001. In June 1993, the Company issued $100 million principal amount of Serial Preferred Stock, $42.40 Series T. The Series T stock was deposited with an agent which issued (Cleveland Electric) (Cleveland Electric) Depositary Receipts, each representing 1/20 of a share of the Series T stock. The annualized preferred dividend requirement at December 31, 1993 was $47 million. The preferred dividend rates on the Company's Series L and M fluctuate based on prevailing interest rates and market conditions. The dividend rates for both issues averaged 7% in 1993. The Company's Series P had a 6.5% dividend rate in 1993 until it was redeemed in August 1993. Preference stock authorized for the Company is 3,000,000 shares without par value. No preference shares are currently outstanding. With respect to dividend and liquidation rights, the Company's preferred stock is prior to its preference stock and common stock, and its preference stock is prior to its common stock. (D) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, was as follows: Long-term debt matures during the next five years as follows: $42 million in 1994, $246 million in 1995, $151 million in 1996, $55 million in 1997 and $78 million in 1998. The Company issued $275 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The Company's mortgage constitutes a direct first lien on substantially all property owned and franchises held by the Company. Excluded from the lien, among other things, are cash, securities, accounts receivable, fuel and supplies. An unsecured loan agreement of the Company contains covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting the Company, Toledo Edison and Centerior Energy. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused the Company, Toledo Edison and Centerior Energy to violate certain covenants contained in the loan agreement and the two reimbursement agreements. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Toledo Edison and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $47 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Toledo Edison. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Company and Toledo Edison. Centerior Energy plans to transfer any of its borrowed funds to the Company and Toledo Edison, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed (Cleveland Electric) (Cleveland Electric) below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios for the Company, Toledo Edison and Centerior Energy. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $300 million for the Company. The Company and Toledo Edison are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Company had no commercial paper outstanding. The Company is unable to rely on the sale of commercial paper to provide short-term funds because of its below investment grade commercial paper credit ratings. (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Company's preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $46 million as a result of the recording of $71 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $351 million write-off of Perry Unit 2 (see Note 4(b)), the $636 million write-off of the phase-in deferrals (see Note 7) and $38 million of other charges. These adjustments decreased quarterly earnings by $716 million. Earnings for the quarter ended September 30, 1992 were increased by $26 million as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $39 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (15) Pending Merger of the Company with Toledo Edison On March 25, 1994, Centerior Energy announced that its operating utility subsidiaries, the Company and Toledo Edison, plan to merge into a single operating entity. Since the Company and Toledo Edison affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO and other regulatory authorities. The merger must be approved by share owners of Toledo Edison's preferred stock. Share owners of the Company's preferred stock must approve the authorization of additional shares of preferred stock. Share owners of Toledo Edison's preferred stock will exchange their shares for preferred stock shares of the successor corporation having substantially the same terms, while the (Cleveland Electric) (Cleveland Electric) Company's preferred stock will automatically become shares of the successor corporation. Debt holders of the merging companies will become debt holders of the successor corporation. The merging companies plan to seek preferred stock share owner approval in the summer of 1994. The merger is expected to be effective in late 1994. For the merging companies, the combined pro forma operating revenues were $2.475 billion, $2.439 billion and $2.561 billion and the combined pro forma net income (loss) was $(876) million, $276 million and $296 million for the years ended December 31, 1993, 1992 and 1991, respectively. The pro forma data is based on accounting for the merger on a method similar to a pooling of interests. The pro forma data is not necessarily indicative of the results of operations which would have been reported had the merger been in effect during those years or which may be reported in the future. The pro forma data should be read in conjunction with the audited financial statements of both the Company and Toledo Edison. (Cleveland Electric) (Cleveland Electric) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) Operating Expenses (millions of dollars) Income (Loss) (millions of dollars) Income (Loss) (millions of dollars) (a) Includes early retirement program expenses and other charges of $165 million in 1993. (b) Includes write-off of phase-in deferrals of $636 million in 1993, consisting of $117 million of deferred operating expenses and $519 million of deferred carrying charges. (c) In 1991, a change in accounting for nuclear plant depreciation was adopted, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Cleveland Electric) (Cleveland Electric) THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES (d) Includes write-off of Perry Unit 2 of $351 million in 1993. (e) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Cleveland Electric) (Cleveland Electric) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - ---------------------------------------------------------------------- To the Share Owners of The Toledo [Logo] Edison Company: We have audited the accompanying balance sheet and statement of preferred stock of The Toledo Edison Company (a wholly owned subsidiary of Centerior Energy Corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Toledo Edison Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules of The Toledo Edison Company listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio February 14, 1994 (except with respect to the matter discussed in Note 15, as to which the date is March 25, 1994) (Toledo Edison) (Toledo Edison) MANAGEMENT'S FINANCIAL ANALYSIS - -------------------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 3.1% increase in 1993 operating revenues for The Toledo Edison Company (Company) are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $17 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential and commercial kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northwestern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. Residential and commercial sales increased 5.1% and 3.2%, respectively, in 1993. Industrial sales increased 6% as a result of increased sales to large automotive manufacturers, petroleum refiners and the broad-based, smaller industrial customer group. Other sales decreased 18.4% because of fewer sales to wholesale customers. Generating plant outages and retail customer demand limited power availability for bulk power transactions. As a result, total sales decreased 2.2% in 1993. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. The net increase in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors increased about 2%. Operating expenses increased 12.6% in 1993. The increase in total operation and maintenance expenses resulted from the $88 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $19 million and a slight increase in other operation and maintenance expenses. The VTP benefit expenses consisted of $75 million of costs for the Company plus $13 million for the Company's pro rata share of the costs for its affiliate, Centerior Service Company (Service Company). Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $232 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.8% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $22 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. Total kilowatt-hour sales increased 0.2% in 1992. Residential and commercial sales decreased 4.9% and 3.8%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales increased 0.6% as increased sales to glass and metal manufacturers and to the broad-based, smaller industrial customer group offset lower sales to petroleum refining and auto manufacturing customers. Other sales increased 5.2% because of increased sales to wholesale customers. Operating revenues in 1991 included the recognition of $24 million of deferred revenues over the period of a refund to customers under a provision of a January 1989 rate order. No such revenues were reflected in 1992 as the refund period ended in December 1991. Operating expenses decreased 4.4% in 1992. A reduction of $14 million in other operation and maintenance expenses resulted primarily from cost-cutting measures. Lower fuel and purchased power expense resulted from less amortization of previously deferred fuel costs than the amount amortized in 1991. These decreases were par- tially offset by higher depreciation and amortization, caused primarily by the adoption of the new accounting (Toledo Edison) (Toledo Edison) standard for income taxes (SFAS 109) in 1992, and by higher taxes, other than federal income taxes, caused by increased Ohio property taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program discussed in Note 7. The federal income tax provision for nonoperating income decreased because of a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income increased primarily because of Rate Stabilization Program carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, Centerior Energy Corporation (Centerior Energy), along with the Company and The Cleveland Electric Illuminating Company (Cleveland Electric), announced a comprehensive strategic action plan to strengthen their financial and competitive positions. The Company and Cleveland Electric are the two wholly owned electric utility subsidiaries of Centerior Energy. The plan established specific objectives and was designed to guide Centerior Energy and its subsidiaries through the year 2001. Several actions were taken at that time. Centerior Energy reduced its quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. The Company and Cleveland Electric also wrote off their investments in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs for the Company was $332 million which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. The Company also recognized other one-time charges totaling $15 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $36 million after taxes representing a portion of the VTP costs. The Company will realize approximately $20 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of the strategic plan are to maximize share owner return on Centerior Energy common stock from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, the Company will continue controlling its operation and maintenance expenses and capital expenditures, reduce its outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of its plants and take other appropriate actions. COMMON STOCK DIVIDENDS In recent years, the Company has retained all of its earnings available for common stock. The Company has not paid a common stock dividend to Centerior Energy since February 1991. Because the Company is currently prohibited from paying a common stock dividend by a provision in its mortgage (see Note 11(b)), the Company does not expect to pay any common stock dividends in the foreseeable future. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are a number of rural and municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. We have entered into contracts with many of our (Toledo Edison) (Toledo Edison) large industrial and commercial customers which have remaining terms of one to five years. We will attempt to renew those contracts as they expire which will help us compete if retail wheeling is permitted in the future. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS The Company's three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(f). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Company is aware of its potential involvement in the cleanup of several sites. Although these sites are not on the Superfund National Priorities List, they are generally being administered by various governmental entities in the same manner as they would be administered if they were on such list. The allegations that the Company disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all "potentially responsible parties" (PRPs) to a particular site can be held liable on a joint and several basis. Consequently, if the Company were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $150 million. However, we believe that the actual cleanup costs will be substantially lower than $150 million, that the Company's share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Company has accrued a liability totaling $6 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing pro- (Toledo Edison) (Toledo Edison) gram of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $440 million. In addition, we exercised various options to redeem approximately $490 million of our securities. We raised $815 million through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Company also utilized its short-term borrowing arrangements to help meet its cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for the Company are $249 million for its construction program and $324 million for the mandatory redemption of debt and preferred stock. The Company expects to finance internally all of its 1994 cash requirements of approximately $109 million. About 15% of the Company's 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions, which will help improve the Company's capitalization structure and interest coverage ratios. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $41 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Company under its mortgage on the basis of property additions, cash or refundable first mortgage bonds. Under its mortgage, the Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, the Company would have been permitted to issue approximately $323 million of additional first mortgage bonds. As discussed in Note 11(d), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused the Company, Cleveland Electric and Centerior Energy to violate certain of those covenants. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Cleveland Electric and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $172 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Cleveland Electric. For the next five years, the Company does not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, we believe that the Company could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Company also is able to raise funds through the sale of preference stock. The Company will be unable to issue preferred stock until it can meet the interest and preferred dividend coverage test in its articles of incorporation. The Company currently cannot sell commercial paper because of its low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. The Company is a party to a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused the Company, Cleveland Electric and Centerior Energy to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Company's needs over the next several years. The availability and cost of capital to meet the Company's external financing needs, however, also depend upon such factors as financial market conditions and its credit ratings. Current credit ratings for the Company are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Company. (Toledo Edison) (Toledo Edison) INCOME STATEMENT THE TOLEDO EDISON COMPANY - ---------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Toledo Edison) (Toledo Edison) CASH FLOWS THE TOLEDO EDISON COMPANY - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) [THIS PAGE INTENTIONALLY LEFT BLANK] BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) The Toledo Edison Company (Toledo Edison) (Toledo Edison) STATEMENT OF PREFERRED STOCK THE TOLEDO EDISON COMPANY - -------------------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) NOTES TO THE FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL The Company is an electric utility and a wholly owned subsidiary of Centerior Energy. Centerior Energy has two other wholly owned subsidiaries, Cleveland Electric and the Service Company. The Company follows the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by The Public Utilities Commission of Ohio (PUCO). As a rate-regulated utility, the Company is subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The Company is a member of the Central Area Power Coordination Group (CAPCO). Other members are Cleveland Electric, Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) RELATED PARTY TRANSACTIONS Operating revenues, operating expenses and interest charges include those amounts for transactions with affiliated companies in the ordinary course of business operations. The Company's transactions with Cleveland Electric are primarily for firm power, interchange power, transmission line rentals and jointly owned power plant operations and construction. See Notes 2 and 3. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to the Company and other affiliated companies. The Service Company billed the Company $76 million, $60 million and $61 million in 1993, 1992 and 1991, respectively, for such services. (C) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO or on ordinances of individual municipalities. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (D) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Company defers the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Company has accrued a liability for its share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Company to recover the assessments through its fuel cost factors. (E) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Company to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $7 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Company deferred certain operating expenses and both interest and equity carrying charges pursuant to a PUCO-approved rate phase-in plan for its investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Company also defers certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (F) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depreciable utility plant in service was 3.6% in both 1993 and 1992 and 3.4% in 1991. Effective January 1, 1991, the Company, after obtaining PUCO approval, changed its method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $14 million and increased 1991 net (Toledo Edison) (Toledo Edison) income $11 million (net of $3 million of income taxes) from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Company currently uses external funding for the future decommissioning of its nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $4 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Company's share of the future decommissioning costs are $41 million in 1992 dollars for Beaver Valley Unit 2 and $87 million and $146 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Company used these estimates to increase its decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $34 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (G) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rate was 10.22% in 1993 and 10.96% in both 1992 and 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (H) DEFERRED GAIN AND LOSS FROM SALES OF UTILITY PLANT The sale and leaseback transactions discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant) and a net loss for the sale of Beaver Valley Unit 2. The net gain and net loss were deferred and are being amortized over the terms of leases. These amortizations and the lease expense amounts are recorded as other operation and maintenance expenses. (I) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (J) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (Toledo Edison) (Toledo Edison) (2) Utility Plant Sale and Leaseback Transactions The Company and Cleveland Electric are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Company and Cleveland Electric are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Company and Cleveland Electric have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(d). As co-lessee with Cleveland Electric, the Company is also obligated for Cleveland Electric's lease payments. If Cleveland Electric is unable to make its payments under the Mansfield Plant leases, the Company would be obligated to make such payments. No payments have been made on behalf of Cleveland Electric to date. In April 1992, nearly all of the outstanding Secured Lease Obligation Bonds (SLOBs) issued by a special purpose corporation in connection with financing the sale and leaseback of Beaver Valley Unit 2 were refinanced through a tender offer and the sale of new bonds having a lower interest rate. As part of the refinancing transaction, the Company paid $43 million as supplemental rent to fund transaction expenses and part of the tender premium. This amount has been deferred and is being amortized over the remaining lease term. The refinancing transaction reduced the annual rental expense for the Beaver Valley Unit 2 lease by $9 million. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $45 million. The amounts recorded in 1993, 1992 and 1991 as annual rental expense for the Beaver Valley Unit 2 lease were $63 million, $66 million and $72 million, respectively. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. The Company is selling 150 megawatts of its Beaver Valley Unit 2 leased capacity entitlement to Cleveland Electric. We anticipate that this sale will continue indefinitely. Revenues recorded for this transaction were $103 million, $108 million and $107 million in 1993, 1992 and 1991, respectively. The future minimum lease payments through the year 2017 associated with Beaver Valley Unit 2 aggregate $1.47 billion. (3) Property Owned with Other Utilities and Investors The Company owns, as a tenant in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Company's share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Company as a tenant in common with other utilities and Lessors: (Toledo Edison) (Toledo Edison) (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of the Company's construction program for the 1994-1998 period is $259 million, including AFUDC of $10 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $57 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses may be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be less than 2% over the ten-year period. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $232 million ($167 million after taxes) for the Company's 19.91% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Company is aware of its potential involvement in the cleanup of several hazardous waste disposal sites. The Company has accrued a liability totaling $6 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS The Company's three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), the Company's maximum potential assessment under that plan would be $70 million (plus any inflation adjustment) per incident. The assessment is limited to $9 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, the Company's share of such excess amount could have a material adverse effect on its financial condition and results of operations. Under these policies, the Company can be assessed a maximum of $11 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. The Company also has extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (Toledo Edison) (Toledo Edison) (6) Nuclear Fuel Nuclear fuel is financed for the Company and Cleveland Electric through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $154 million of nuclear fuel was financed for the Company. The Company and Cleveland Electric severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments for the Company of $52 million, $29 million and $20 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $6 million in both 1993 and 1992 and $9 million in 1991. The estimated future lease amortization payments based on projected consumption are $49 million in 1994, $42 million in 1995, $37 million in 1996, $33 million in 1997 and $30 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plan approved by the PUCO in a January 1989 rate order for the Company. The phase-in plan was designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plan required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Company's deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plan. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 by the Company were $55 million and $186 million, respectively (totaling $165 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in the Company's service area by freezing the Company's base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $89 million over the 1996-1998 period. As part of the Rate Stabilization Program, the Company is allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988 and the deferral of operating expenses equivalent to an accumulated excess rent reserve for Beaver Valley Unit 2 (which resulted from the April 1992 refinancing of SLOBs as discussed in Note 2). The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $39 million and $32 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets and the remaining lease period, or approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $18 million and $5 million, respectively. The Rate Stabilization Program also authorized the Company to defer and subsequently recover the incremental expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $37 million pursuant to this provision. Amortization and recovery of this (Toledo Edison) (Toledo Edison) deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying income before taxes by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: The Company joins in the filing of a consolidated federal income tax return with its affiliated companies. The method of tax allocation reflects the benefits and burdens realized by each company's participation in the consolidated tax return, approximating a separate return result for each company. In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $29 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $29 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $178 million and deferred tax liabilities of $649 million at December 31, 1993 and deferred tax assets of $154 million and deferred tax liabilities of $794 million at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $111 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $39 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $77 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN Prior to December 31, 1993, the Company sponsored a noncontributory pension plan which covered all employee groups. The plan was merged with another plan which covered employees of Cleveland Electric and the Service Company into a single plan on December 31, 1993. The amount of retirement benefits generally depends upon the length of service. Under certain circumstances, benefits can begin as early as age 55. The funding policy is to (Toledo Edison) (Toledo Edison) comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, the Company offered the VTP, an early retirement program. Operating expenses for 1993 included $59 million of pension plan accruals to cover enhanced VTP benefits and an additional $3 million of pension costs for VTP benefits paid to retirees from corporate funds. The $3 million is not included in the pension data reported below. A credit of $15 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the Company's former plan at December 31, 1992 with comparable information for a portion of the merged plan at December 31, 1993. The December 31, 1993 benefit obligation estimates were derived from information for the former plans. Plan assets of the merged plan were allocated based on a pro rata share of the projected benefit obligation. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (B) OTHER POSTRETIREMENT BENEFITS Centerior Energy sponsors jointly with its subsidiaries a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. The Company adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs for the Company totaled $4 million in both 1992 and 1991, which included medical benefits of $3 million in both years. The total amount accrued by the Company for SFAS 106 costs for 1993 was $42 million, of which $1 million was capitalized and $41 million was expensed as other operation and maintenance expenses. In 1993, the Company deferred incremental SFAS 106 expenses totaling $37 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: These amounts included costs for the Company and a pro rata share of the Service Company's costs. The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 (Toledo Edison) (Toledo Edison) for the Company and its share of the Service Company's obligation are summarized as follows: The Balance Sheet classification of Other Noncurrent Liabilities at December 31, 1993 includes only the Company's accrued postretirement benefit cost of $33 million and excludes the Service Company's portion since the Service Company's total accrued cost is carried on its books. At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $4 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $0.3 million. (C) POSTEMPLOYMENT BENEFITS In 1993, the Company adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect the Company's 1993 results of operations or financial position. (10) Guarantees The Company has guaranteed certain loan and lease obligations of a mining company under a long-term coal purchase arrangement. This arrangement requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining company's loan and lease obligations guaranteed by the Company was $20 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Preferred stock shares retired during the three years ended December 31, 1993 are listed in the following table. (B) EQUITY DISTRIBUTION RESTRICTIONS Federal law prohibits the Company from paying dividends out of capital accounts. However, the Company may pay dividends out of appropriated retained earnings and current earnings. At December 31, 1993, the Company had $42 million of appropriated retained earnings for the payment of preferred stock dividends. The Company is currently prohibited from paying a common stock dividend by a provision in its mortgage. (C) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $12 million in each year 1994 through 1996 and $2 million in both 1997 and 1998. The annual preferred stock mandatory redemption provisions are as follows: The annualized preferred dividend requirement at December 31, 1993 was $21 million. The preferred dividend rates on the Company's Series A and B fluctuate based on prevailing interest rates and market conditions. The dividend rates for these issues averaged 7.41% and 8.22%, respectively, in 1993. Preference stock authorized for the Company is 5,000,000 shares with a $25 par value. No preference shares are currently outstanding. With respect to dividend and liquidation rights, the Company's preferred stock is prior to its preference stock and common stock, and its preference stock is prior to its common stock. (Toledo Edison) (Toledo Edison) (D) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, was as follows: Long-term debt matures during the next five years as follows: $45 million in 1994, $71 million in 1995, $91 million in 1996 and $39 million in both 1997 and 1998. The Company issued $275 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The Company's mortgage constitutes a direct first lien on substantially all property owned and franchises held by the Company. Excluded from the lien, among other things, are cash, securities, accounts receivable, fuel, supplies and automotive equipment. Certain unsecured loan agreements of the Company contain covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting the Company, Cleveland Electric and Centerior Energy. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused the Company, Cleveland Electric and Centerior Energy to violate certain covenants contained in the two reimbursement agreements. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Cleveland Electric and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $172 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Cleveland Electric. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Company and Cleveland Electric. Centerior Energy plans to transfer any of its borrowed funds to the Company and Cleveland Electric, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios for the Company, Cleveland Electric and Centerior Energy. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $150 million for the Company. The Company and Cleveland Electric are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Company had no commercial paper outstanding. The Company is unable to rely on the sale of commercial paper to provide short-term funds because of its below investment grade commercial paper credit ratings. (Toledo Edison) (Toledo Edison) (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Company's preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $35 million as a result of the recording of $54 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $232 million write-off of Perry Unit 2 (see Note 4(b)), the $241 million write-off of the phase-in deferrals (see Note 7) and $19 million of other charges. These adjustments decreased quarterly earnings by $345 million. Earnings for the quarter ended September 30, 1992 were increased by $15 million as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $22 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (15) Pending Merger of the Company with Cleveland Electric On March 25, 1994, Centerior Energy announced that its operating utility subsidiaries, the Company and Cleveland Electric, plan to merge into a single operating entity. Since the Company and Cleveland Electric affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO and other regulatory authorities. The merger must be approved by share owners of the Company's preferred stock. Share owners of Cleveland Electric's preferred stock must approve the authorization of additional shares of preferred stock. Share owners of the Company's preferred stock will exchange their shares for preferred stock shares of the successor corporation having substantially the same terms, while Cleveland Electric's preferred stock will automatically become shares of the successor corporation. Debt holders of the merging companies will become debt holders of the successor corporation. The merging companies plan to seek preferred stock share owner approval in the summer of 1994. The merger is expected to be effective in late 1994. For the merging companies, the combined pro forma operating revenues were $2.475 billion, $2.439 billion and $2.561 billion and the combined pro forma net income (loss) was $(876) million, $276 million and $296 million for the years ended December 31, 1993, 1992 and 1991, respectively. The pro forma data is based on accounting for the merger on a method similar to a pooling of interests. The pro forma data is not necessarily indicative of the results of operations which would have been reported had the merger been in effect during those years or which may be reported in the future. The pro forma data should be read in conjunction with the audited financial statements of both the Company and Cleveland Electric. (Toledo Edison) (Toledo Edison) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) - -------------------------------------------------------------------------------- Operating Expenses (millions of dollars) - -------------------------------------------------------------------------------- Income (Loss) (millions of dollars) - -------------------------------------------------------------------------------- Income (Loss) (millions of dollars) - -------------------------------------------------------------------------------- (a) Includes early retirement program expenses and other charges of $107 million in 1993. (b) Includes write-off of phase-in deferrals of $241 million in 1993, consisting of $55 million of deferred operating expenses and $186 million of deferred carrying charges. (c) In 1991, a change in accounting for nuclear plant depreciation was adopted, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Toledo Edison) (Toledo Edison) The Toledo Edison Company - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Investment (millions of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (d) Includes write-off of Perry Unit 2 of $232 million in 1993. (e) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Toledo Edison) (Toledo Edison) S-1 S-2 S-3 S-4 S-5 S-6 S-7 S-8 S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES AND THE TOLEDO EDISON COMPANY COMBINED PRO FORMA CONDENSED FINANCIAL STATEMENTS The following pro forma condensed balance sheets and income statements give effect to the agreement between Cleveland Electric and Toledo Edison to merge Toledo Edison into Cleveland Electric. These statements are unaudited and based on accounting for the merger on a method similar to a pooling of interests. These statements combine the two companies' historical balance sheets at December 31, 1993 and December 31, 1992 and their historical income statements for each of the three years ended December 31, 1993. The following pro forma data is not necessarily indicative of the results of operations or the financial condition which would have been reported had the merger been in effect during those periods or which may be reported in the future. The statements should be read in conjunction with the accompanying notes and with the audited financial statements of both Cleveland Electric and Toledo Edison. P-1 P-2 COMBINED PRO FORMA CONDENSED INCOME STATEMENTS OF CLEVELAND ELECTRIC AND TOLEDO EDISON (Unaudited) (Millions of Dollars) P-3 NOTES TO COMBINED PRO FORMA CONDENSED BALANCE SHEETS AND INCOME STATEMENTS (Unaudited) The Pro Forma Financial Statements include the following adjustments: (A) Elimination of intercompany accounts and notes receivable and accounts and notes payable. (B) Reclassification of prepaid pension costs or pension liabilities. (C) Elimination of intercompany operating revenues and operating expenses. (D) Elimination of intercompany working capital transactions. (E) Elimination of intercompany interest income and interest expense. (R) Rounding adjustments. P-4 EXHIBIT INDEX The exhibits designated with an asterisk (*) are filed herewith. The exhibits not so designated have previously been filed with the SEC in the file indi- cated in parenthesis following the description of such exhibits and are in- corporated herein by reference. An exhibit designated with a pound sign (#) is a management contract or compensatory plan or arrangement. COMMON EXHIBITS (The following documents are exhibits to the reports of Centerior Energy, Cleveland Electric and Toledo Edison.) E-1 E-2 E-3 E-4 E-5 E-6 E-7 E-8 E-9 E-10 Pursuant to Paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Regis- trants have not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt if the total amount of securities authorized there- under does not exceed 10% of the total assets of the applicable Registrant and its subsidiaries on a consolidated basis, but each hereby agrees to furnish to the Securities and Exchange Commission on request any such instruments. Pursuant to Rule 14a-3(b)(10) under the Securities Exchange Act of 1934, copies of exhibits filed by the Registrants with this Form 10-K will be fur- nished by the Registrants to share owners upon written request and upon re- ceipt in advance of the aggregate fee for preparation of such exhibits at a rate of $.25 per page, plus any postage or shipping expenses which would be incurred by the Registrants. E-11

716783_1993.txt

716783_1993

1993

716783

Item 1. BUSINESS Lafarge Corporation (the "Registrant"), a Maryland corporation, is engaged in the production and sale of cement and ready-mixed concrete, aggregates, asphalt, concrete blocks and pipes and precast and prestressed concrete components in the United States and Canada. The Registrant believes that it is one of the largest producers of cement and construction materials in North America. The Registrant is also engaged in road building and other construction using many of its own products. Its wholly-owned subsidiary, Systech Environmental Corporation ("Systech"), provides waste-derived fuels and alternative raw materials to cement plants for use in kilns across North America. The Registrant's Canadian operations are carried out by Lafarge Canada Inc. ("LCI"), a major operating subsidiary of the Registrant. Lafarge Coppee S.A. ("Lafarge Coppee"), a French corporation, and certain of its affiliates own a majority of the Registrant's outstanding voting securities. The terms "Registrant", "LCI" and "Systech", as used in this Annual Report, include not only Lafarge Corporation, LCI, Inc. and Systech Environmental Corporation, respectively, but also their respective subsidiaries and predecessors, unless the context indicates otherwise. The Registrant manufactures and sells various types of portland cement, which is widely used in most types of residential, institutional, commercial and industrial construction. The Registrant also manufactures and sells a variety of special purpose cements. At December 31, 1993 the Registrant operated 15 full-production cement manufacturing plants with a combined rated annual clinker production capacity of approximately 12.3 million tons and two cement grinding facilities. The Registrant sells cement primarily to manufacturers of ready-mixed concrete and other concrete products and to contractors throughout Canada and in many areas of the United States. During 1993 the Registrant's cement operations accounted for 47 percent of consolidated net sales, after the elimination of intracompany sales, and 76 percent of consolidated income from operations. Management believes that LCI is the largest producer of concrete-related building materials in Canada, where approximately 73 percent of the Registrant's construction materials facilities were located at December 31, 1993. The U.S. construction materials operations are located primarily in Texas, Louisiana, Ohio, Pennsylvania, Illinois, New York, Missouri, Kansas and Washington. The Registrant's significant construction materials activities include the manufacture and sale of ready-mixed concrete, construction aggregates, other concrete products and asphalt and road construction. The Registrant has operations at approximately 420 locations including ready-mixed concrete plants, crushed stone and sand and gravel sites, concrete product and asphalt plants. During 1993 the Registrant's construction materials operations accounted for 53 percent of consolidated net sales, after the elimination of intracompany sales, and 24 percent of consolidated income from operations. I-1 At December 31, 1993 Systech operated eight facilities at cement plants in the U.S. and Canada, including five plants that are owned by the Registrant. Systech processed approximately 66 million gallons of supplemental fuel in 1993. Systech's results of operations are included in the results of the Registrant's construction materials operations. The executive offices of the Registrant are located at 11130 Sunrise Valley Drive, Suite 300, Reston, Virginia 22091, and its telephone number is (703) 264-3600. (A) GENERAL DEVELOPMENT OF BUSINESS In 1970, Lafarge Coppee acquired control of Canada Cement Lafarge Ltd. (now LCI) which was Canada's largest cement producer. In 1974, LCI extended its cement manufacturing operations into the United States through a joint venture which operated three cement plants in the United States. Following the termination of the joint venture in 1977, the Registrant (which was incorporated in Maryland in 1977 under the name Citadel Cement Corporation of Maryland) operated two of these U.S. cement plants. In 1981, a subsidiary of the Registrant acquired the stock of General Portland Inc. ("General Portland"), the second largest cement producer in the U.S. In 1983, a corporate reorganization was effected which established the Registrant as the parent company of LCI and General Portland (General Portland was merged into the Registrant in 1988), and the Registrant's name was changed to Lafarge Corporation. In 1986, the Registrant purchased substantially all the assets of National Gypsum Company's Huron Cement Division, consisting of one cement plant, 13 cement terminals and related distribution facilities around the Great Lakes. Also in 1986, the Registrant acquired Systech. During 1989, 1990 and 1991, the Registrant significantly expanded its U.S. construction materials operations through acquisitions, the largest of which included 32 plant facilities in five states and substantial mineral reserves acquired from Standard Slag Holding Company headquartered in Ohio. The Registrant acquired Missouri Portland Cement Company, Davenport Cement Company and certain related companies and assets in 1991. This acquisition included three cement plants and 15 cement distribution terminals located in the Mississippi River Basin, more than 30 ready-mixed concrete and aggregate operations and the assets of a chemical admixtures business. Restructuring In December 1993 the Registrant announced the restructuring of its North American business units to be more efficient and cost competitive. The Registrant will consolidate 11 regional operating units into six in its two main business lines, cement and construction materials. To increase organizational efficiency, the Registrant is reducing management layers, eliminating duplicative administrative functions, and standardizing procedures and information systems. Manufacturing and distribution facilities will not be materially affected by the reorganization. I-2 As of January 1, 1994, the Registrant's new North American organization included three regions for construction materials: Western, based in Calgary, Alberta; Eastern, based in Toronto, Ontario; and U.S., based in Canfield, Ohio. Similarly, the cement group was divided into Western, Eastern and U.S. regions, with office locations in Calgary; Montreal, Quebec; and Southfield, Michigan, respectively. A technical services group will be maintained at the Registrant's research center in Montreal and Corporate headquarters will remain in Reston, Virginia. See page II-7 of Item 7 and page II-35 of Item 8 of this Annual Report for further discussion regarding the restructuring. Sale of Demopolis Cement Operations Effective February 1, 1993 the Registrant sold its cement plant in Demopolis, Alabama. The sale included the Registrant's 810,000 ton single- kiln plant and related assets, seven cement distribution terminals and two terminal leases in the southeastern United States, a cement grinding plant and several barges. The purchase price was approximately $50 million in cash. The Registrant used the proceeds from the sale to repay debt. The gain from the sale was immaterial. Systech continues to supply the Demopolis plant with waste-derived fuels. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Registrant's operations are closely integrated. For reporting purposes, the Registrant currently has only one industry segment, which includes the manufacture and sale of cement, ready-mixed concrete, precast and prestressed concrete components, concrete blocks and pipes, aggregates, asphalt and reinforcing steel. In addition, the Registrant is engaged in road building and other construction utilizing many of its own products. Its subsidiary, Systech, provides waste-derived fuels and alternative raw materials for use in cement kilns. Financial information with respect to the Registrant's product lines and geographic segments is set forth under Item 7 Management's Discussion of Income on pages II-3 through II-19, Management's Discussion of Cash Flows on pages II-20 and II-21 and Item 8 - Consolidated Financial Statements and Supplementary Data on pages II-45 and II-46 of this Annual Report. The Registrant's business is affected significantly by seasonal variations in weather conditions, primarily in Canada and the northern United States. Information with respect to quarterly financial results is set forth in Item 8 page II-54 of this Annual Report. I-3 (C) NARRATIVE DESCRIPTION OF BUSINESS Cement Product Line The Registrant manufactures and sells in Canada (through its subsidiary LCI) and in the United States various types of portland cement, a basic construction material manufactured principally from limestone and clay or shale. Portland cement is the essential binding ingredient in concrete, which is widely used in most types of residential, institutional, commercial and industrial construction. In addition to normal portland cement, the Registrant manufactures and sells a variety of special purpose cements, such as high early strength, low and moderate heat of hydration, sulphate resistant, silica fume, masonry and oilwell cement. At December 31, 1993 the rated annual clinker production capacity of the Registrant's operating cement manufacturing plants was approximately 12.3 million tons with about 5.2 million tons in Canada and approximately 7.1 million tons in the United States. The Canadian Portland Cement Association's "Plant Information Summary Report" dated December 31, 1992 shows that the Canadian capacity is the largest of the cement companies in Canada and represented approximately 31 percent of the total active industry clinker production capacity in that country. This same report for the U.S. at December 31, 1992 shows that the Registrant's operating cement manufacturing plants in the United States accounted for an estimated nine percent of total U.S. active industry clinker production capacity. Cement Plants The following table indicates the location, types of process and rated annual clinker production capacity (based on management's estimates) of each of the Registrant's operating cement manufacturing plants at December 31, 1993. The total clinker production of a cement plant might be less than its rated capacity due principally to product demand and seasonal factors. Generally, a plant's cement production capacity is greater than its clinker production capacity. I-4 Rated Annual Clinker Production Capacity of Cement Manufacturing Plants (In short tons) * * One short ton equals 2,000 pounds. ** Preheater, pre-calciner plants. The capacity of Exshaw's preheater, pre-calciner kiln is 53 percent of the plant's clinker production capacity. *** Preheater plants. All of the Registrant's cement plants are fully equipped with raw grinding mills, kilns, finish grinding mills, environmental protective dust collection systems and storage facilities. Each plant has facilities for shipping by rail and by truck. The Richmond, Alpena, Bath, Davenport, Sugar Creek and Joppa plants have facilities for transportation by water. The Exshaw and Brookfield plants and the Kamloops limestone and cinerite quarries are located on sites leased on a long-term basis. The Registrant owns all other plant sites. The Registrant believes that each of its producing plants is in satisfactory operating condition. At December 31, 1993, the Registrant owned cement grinding plants for the processing of clinker into cement at Fort Whyte, Manitoba; Edmonton, Alberta; Saskatoon, Saskatchewan; Montreal East, Quebec and Superior, Wisconsin. The Edmonton, Montreal East, Saskatoon and Superior grinding plants have been shutdown for several years as cement grinding has not been cost effective at these locations. These plants were used during 1993 for the storage of cement. The Registrant also owns a cement regrind plant and terminal facilities at Tampa, Florida which include facilities for receiving cement by water. The Registrant owns clinker producing plants which have been shut down in Havelock, New Brunswick, Ft. Whyte, Manitoba and Metaline Falls, Washington. I-5 During 1987 the Registrant re-opened the two million ton clinker capacity Alpena plant with restructured low-cost operations utilizing waste- derived fuels supplied by Systech. The Alpena plant was acquired by the Registrant in December 1986. In January 1989 the Registrant announced a multi-year, two-phase modernization and expansion program for the Alpena plant. The first phase of this project, substantially completed in 1990, included approximately $55 million for equipment and related support systems and between $10 and $15 million in facility upgrades. The second phase of the modernization program totalling approximately $26 million is currently underway and will involve additional improvements to the plant's raw materials handling and storage facilities. The facility upgrade and modernization program is expected to reduce operating costs and increase the plant's rated annual cement production capacity to 2.5 million tons. In January 1991, as part of the Missouri Portland/Davenport acquisition, the Registrant acquired three cement plants located in the Mississippi River Basin: a 1,150,000-ton clinker capacity cement plant located in Joppa, Illinois, a 858,000-ton clinker capacity cement plant located in Davenport, Iowa and a 482,000-ton clinker capacity cement plant located near Kansas City, Missouri (Sugar Creek). Total 1993 clinker production from these three dry-process cement plants was 2,225,000 short tons, or 89 percent of capacity. The three cement plants acquired in the Missouri Portland/Davenport acquisition increased the Registrant's annual clinker production capacity by 25 percent. The Manufacturing Process The Registrant manufactures cement by a closely controlled chemical process which begins with the crushing and mixing of calcium carbonates, argillaceous material (clay, shale or kaolin) and silicates (sand). Once mixed, the crushed raw materials undergo a grinding process, which mixes the various materials more thoroughly and increases fineness in preparation for the kiln. This mixing and grinding process may be done by either the wet or the dry method. In the wet process, the materials are mixed with water to form "slurry", which is heated in kilns, forming a hard substance called "clinker". In the more fuel-efficient dry process, the addition of water and the formation of slurry are eliminated, and clinker is formed by heating the dry raw materials. In the preheater process, which provides further fuel efficiencies, the dry raw materials are preheated by air exiting the kiln, and part of the chemical reaction takes place prior to entry of the materials into the kiln. In the pre-calciner process, an extension of the preheater process, heat is applied to the raw materials, increasing the proportion of the chemical reaction taking place prior to the kiln and, as a result, increasing clinker production capacity. After the addition of gypsum, the clinker is ground into an extremely fine powder called cement. In this form, cement is the binding agent which, when mixed with sand, stone or other aggregates and water, produces either concrete or mortar. I-6 The raw materials required to manufacture cement are obtained principally from operations which are owned by the Registrant or in which it has long-term quarrying rights. These sources are located close to the manufacturing plants except for the Joppa and Richmond quarries which are located approximately 70 and 80 miles, respectively, from the plant site. Each cement manufacturing plant except New Braunfels is equipped with rock crushing equipment. At New Braunfels and Richmond, the Registrant owns the reserves, but does not currently quarry them. The Registrant purchases limestone for Richmond from a local source and for New Braunfels from Parker Lafarge, Inc. an affiliate of the Registrant. At Whitehall, Joppa and Kamloops the Registrant sub-contracts the quarry operations. Fuel represents a significant portion of the cost of manufacturing cement. The Registrant has placed special emphasis on becoming, and has become, more efficient in its sourcing and use of fuel. Dry process plants generally consume significantly less fuel per ton of output than do wet process plants. At year-end approximately 79 percent and 89 percent of the Registrant's clinker production capacity in Canada and the United States, respectively, used the dry process. As an additional means of reducing energy costs, most plants are now equipped to convert from one form of fuel to another with very little interruption in production, thus avoiding dependence on a single fuel and permitting the Registrant to take advantage of price variations between fuels. The use of waste-derived fuels supplied by Systech has also resulted in substantial fuel cost savings to the Registrant. At December 31, 1993, the Registrant used industrial waste materials obtained and processed by Systech as fuel at three of the Registrant's United States cement plants. Waste-derived fuels supplied by Systech constituted approximately 10 percent of the fuel used by the Registrant in all of its cement operations during 1993. In August 1991, the Registrant's U.S. cement plants which utilize hazardous waste-derived fuels became subject to a substantial new federal permit program known as the Resource Conservation and Recovery Act ("RCRA") boiler and industrial furnaces (BIF) regulations. In August 1992, these plants submitted certifications of compliance for the emission limits established under these regulations. In Canada, the St. Constant and Brookfield plants have submitted permit applications to use hazardous waste as supplemental fuel. These applications are in the public review phase. The following table shows the possible alternative fuel sources of the Registrant's cement manufacturing plants in the United States and Canada at December 31, 1993. I-7 Marketing Cement is sold by the Registrant primarily to manufacturers of ready-mixed concrete and other concrete products and to contractors throughout Canada and in many areas of the United States. The states in which the Registrant had the most significant U.S. sales in 1993 were Texas and Wisconsin. Other states in which the Registrant had significant sales include Florida, Illinois, Indiana, Iowa, Kansas, Louisiana, Massachusetts, Michigan, Minnesota, Missouri, New Jersey, New York, North Dakota, Ohio, Pennsylvania, Tennessee and Washington. The provinces in Canada in which the Registrant had the most significant sales of cement products were Ontario and Quebec, which together accounted for approximately 44 percent of the Registrant's total Canadian cement shipments in 1993. Approximately 35 percent of the Registrant's cement shipments in Canada were made to affiliates. The Registrant sells cement to several thousand unaffiliated customers. No single unaffiliated customer accounted for more than 10 percent of the Registrant's cement sales during 1993, 1992 or 1991. Sales are made on the basis of competitive prices in each market area, generally pursuant to telephone orders from customers who purchase quantities sufficient for their immediate requirements. The amount of backlog orders, as measured by written contracts, is normally not significant. At December 31, 1993 sales offices in the United States were located in or near New Orleans, Louisiana; Buffalo, New York; Dallas, Texas; Tampa, Florida; Fort Wayne, Indiana; Whitehall, Pittsburgh and Hamburg, I-8 Pennsylvania; East Cambridge, Massachusetts; Chicago, Illinois; Cleveland, Ohio; Lansing, Michigan; Milwaukee, Wisconsin; Seattle and Spokane, Washington; Minneapolis, Minnesota; Kansas City , Missouri; Davenport, Iowa; Valley City and Grand Forks, North Dakota and Nashville, Tennessee. At December 31, 1993 sales offices in Canada were located in Dartmouth, Nova Scotia; Moncton, New Brunswick; Quebec City and Montreal, Quebec; Toronto, Ontario; Winnipeg, Manitoba; Regina and Saskatoon, Saskatchewan; Calgary and Edmonton, Alberta; and Kamloops and Vancouver, British Columbia. Distribution and storage facilities are maintained at all cement manufacturing and finishing plants and at approximately 100 other locations including five deep water ocean terminals. These facilities are strategically located to extend the marketing areas of each plant. Because of freight costs, most cement is sold within a radius of 250 miles from the producing plant, except for waterborne shipments which can be shipped economically considerably greater distances. Cement is distributed primarily in bulk but also in paper bags. The Registrant utilizes trucks, rail cars and waterborne vessels to transport cement from its plants to distribution points or directly to customers. Transportation equipment is owned, leased or contracted for as required. In addition, some customers in the United States make their own transportation arrangements and take delivery of cement at the manufacturing plant or distribution point. Construction Materials Product Line The Registrant is engaged in the production and sale of ready-mixed concrete, aggregates, asphalt, precast and prestressed concrete, concrete block, concrete pipe and other related products. The Registrant is also engaged in highway and municipal paving and road building work. During 1993, 1992 and 1991 no single customer accounted for more than 10 percent of the Registrant's construction materials sales. LCI is the only producer of ready-mixed concrete and construction aggregates in Canada that has operations extending from coast to coast. Ready-mixed concrete plants mix controlled portions of cement, water and aggregates to form concrete which is sold primarily to building contractors and delivered to construction sites by mixer trucks. In addition, management believes that LCI is one of the largest manufacturers of precast concrete products and concrete pipe in Canada. These products are sold primarily to contractors engaged in all phases of construction activity. The Registrant owns substantially all of its ready-mixed concrete, concrete products and aggregates plants and believes that all such plants are in satisfactory operating condition. I-9 The Registrant owned or had a majority interest in 311 construction materials facilities in Canada at December 31, 1993. Of these, 118 are ready-mixed concrete plants concentrated in the Provinces of Ontario (where approximately one-half of the plants are located), Alberta, Quebec and British Columbia. The Registrant also owns ready-mixed concrete plants in New Brunswick, Nova Scotia, Saskatchewan and Manitoba. The Registrant owns 112 construction aggregates facilities in Canada, more than half of which are located in Ontario. The other aggregates facilities are located in Alberta, Saskatchewan, British Columbia, Quebec, Manitoba, New Brunswick and Nova Scotia. The Registrant's 29 Canadian asphalt facilities are also concentrated primarily in Ontario with the remaining plants in Alberta, Nova Scotia, New Brunswick and Quebec. The Registrant owns a total of 52 precast and prestressed concrete, concrete block and concrete pipe plants and miscellaneous other construction materials operations in Ontario (where approximately one-half of the plants are located), Alberta, British Columbia, Manitoba, Quebec and New Brunswick. In the U.S., the Registrant owned or had a majority interest in 117 construction materials facilities at year end. Of these, 54 are ready- mixed concrete plants concentrated in Texas, Missouri, and to a lesser extent, Louisiana, Ohio and Kansas. Of the Registrant's 44 U.S. construction aggregates facilities, 12 were in Ohio, 14 in Texas, five in Pennsylvania, with the remainder located in West Virginia, New York, Louisiana, Michigan, Missouri, and Washington. Two of the Registrant's six U.S. asphalt plants were located in New York and four in Texas. The Registrant owned a total of 13 concrete paving stone, road paving, soil cement, concrete paving and miscellaneous other construction materials operations located in Ohio, Michigan, Texas, Pennsylvania, Missouri and New York. In addition, the Registrant has minority interests in a number of smaller companies primarily engaged in the manufacture and sale of ready- mixed concrete, other concrete products and aggregates in Canada and the U.S. Systech Environmental Corporation provides waste-derived fuels and alternative raw materials for use in cement kilns. Using a technology called co-processing, Systech is able to use high BTU value waste as a fuel substitute for coal, natural gas and petroleum coke in heating the cement kiln. Co-processing preserves natural resources and serves as a safe and efficient method to manage selected waste. In addition, co- processing makes the product more competitive by reducing fuel cost, which represents about 15 percent of the expense of cement manufacturing. Research, Development and Engineering The Registrant is involved in research and development work through its own technical services and laboratories and through its participation in the Portland Cement Association. In addition, Lafarge Coppee, LCI I-10 and the Registrant are parties to agreements relating to the exchange of technical and management expertise under which the Registrant has access to the research and development resources of Lafarge Coppee. Research is directed toward improvement of existing technology in the manufacturing of cement, concrete and related products as well as the development of new manufacturing techniques and products. Systech is also engaged in research and development in an effort to further develop the technology to handle additional waste materials. Research and development costs, which are charged to expense as incurred, were $7.3 million, $8.1 million and $7.5 million for 1993, 1992 and 1991, respectively. This includes amounts accrued for technical services rendered by Lafarge Coppee to the Registrant, under the terms of the agreements discussed above of $4.8 million during 1993, $5.3 million during 1992 and $5.4 million during 1991. Capital Expenditures and Asset Dispositions The Registrant's business is relatively capital-intensive. During the three-year period ended December 31, 1993 the Registrant invested approximately $209 million in capital expenditures, principally for the modernization or replacement of existing equipment. Of this amount, approximately 42 percent related to cement operations and 58 percent to construction materials operations. During the same period, the Registrant also invested approximately $31 million in various acquisitions that expanded its market and product lines which primarily related to the Registrant's construction materials operations. For a discussion on the sale of the Demopolis cement operations see "General Development of Business - Sale of Demopolis Cement Operations". Cement terminal facilities in St. Louis, Missouri and Houston, Texas were shutdown in February 1993. The Registrant intends to sell the land on which these terminals and related assets are located. In September 1992, the Registrant sold the assets of Conchem, a chemical admixtures business located in the United States and Canada. The divestiture included seven facilities engaged in the production and sale of admixture and specialty products for the concrete and construction industry throughout North America. The U.S. assets had been acquired as part of the Missouri Portland/Davenport acquisition in January 1991 (see "General Development of Business"). During 1993, 1992 and 1991 the Registrant disposed of various surplus properties; however, there were no other material divestments of property, plant and equipment during these three years. In December 1993 the Registrant's Construction Materials operations purchased a plant from Koch Industries, Inc. for grinding iron blast furnace slag into slag cement at Spragge, Ontario. In April 1993 the Registrant entered into a joint venture, Richvale-York Block Inc. with another block producer to carry on its concrete block business in the Greater Metropolitan Toronto area. The Registrant is the majority I-11 shareholder in this joint venture which owns two modern block plants that are strategically located in this market. Environmental Matters The Registrant's operations, like those of other companies engaged in similar businesses, involve the use, release/discharge, disposal and clean-up of substances regulated under increasingly stringent federal, state, provincial and/or local environmental protection laws. The major environmental statutes and regulations affecting the Registrant's business and the status of certain environmental enforcement matters involving the Registrant are discussed in Item 7 of this Annual Report in the "Environmental Matters" section of Management's Discussion and Analysis beginning on page II-15. Additionally, certain enforcement matters are described in Item 3 (Legal Proceedings) of this Annual Report. Employees As of December 31, 1993, the Registrant and its subsidiaries employed approximately 7,400 individuals of which 4,640 were hourly rated wage workers. Approximately 1,530 of these hourly employees were engaged in the production of portland cement products and approximately 3,110 were employed in the Registrant's construction materials operations. Salaried employees totalled approximately 2,750. These employees generally perform work in administrative, managerial, marketing, professional and technical endeavors. Overall, the Registrant considers its relations with employees to be satisfactory. - - - U.S. CEMENT OPERATIONS The majority of the Registrant's approximately 2,200 U.S. hourly employees are represented by labor unions. During 1993, labor agreements were renegotiated at the Buffalo, Iowa and Fredonia, Kansas cement plants (including distribution terminals in Fort Worth, Texas and Westlake, Louisiana). Five other terminal labor agreements expired and new agreements were reached during 1993: Waukegan, Illinois; Duluth, Minnesota; Superior, Wisconsin; Toledo; Ohio and Oswego, New York. Four cement plant labor agreements will expire in 1994: Whitehall, Pennsylvania; Sugar Creek, Kansas; Paulding, Ohio; and Balcones, Texas. The labor agreement for Whitehall was renewed for a period of 46 months in early 1994. Effective February 1, 1993, the Registrant completed the sale of its Demopolis, Alabama cement plant and surrounding sales and distribution operations (see "General Development of Business - Sale of Demopolis Cement Operations" above). In addition, terminal facilities in St. Louis, Missouri and Houston, Texas were shut down in February. The Registrant intends to sell the land on which these terminals and related assets are located. In late 1993, it was announced that in connection with the restructuring of the Registrant's North American business units (see "General Development of Business - Restructuring" above), the administrative operations of the Southern Region office in I-12 Dallas would be consolidated into one U.S. region based in Southfield, Michigan. This transition is expected to be completed by June 1994. - - - U.S. CONSTRUCTION MATERIALS OPERATIONS The Registrant's approximately 1,715 U.S. construction materials employees consist of approximately 1,200 hourly employees and 515 salaried employees. In 1993, divestiture of aggregate and construction operations in southern Ohio, northern Kentucky and central Illinois resulted in a reduction of 119 employees (96 hourly and 23 salaried). In the Registrant's Sullivan Lafarge operations in New York, the closure of six plants resulted in the severance of 110 hourly employees. In the Registrant's Standard Lafarge division, a labor agreement covering six plants was negotiated in 1993, and four single site labor agreements covering a total of approximately 105 employees will expire in 1994. Although a work stoppage is possible at one of these sites, it is expected that operations will continue without interruption. At the Registrant's Kurtz Lafarge division, the labor agreement for ready-mixed concrete truck drivers expired in May 1993 for the plants located west of the Missouri River. Negotiations were unsuccessful and 35 drivers went on strike July 15, 1993 and remain on strike. Replacement drivers have been hired and the affected plants are now operating. The labor agreement for the drivers on the east side of the Missouri River expired on March 15, 1994 and negotiations for a new contract have begun. A work stoppage could occur but is not expected. The Kurtz Lafarge operations which are based in Sedalia, Missouri negotiated a new labor agreement in 1993. Labor agreements relating to operations based in Waynesville and Kansas City, Missouri will expire in 1994. - - - CANADIAN CEMENT OPERATIONS Substantially all of the approximately 540 Canadian cement hourly employees are covered by labor agreements. The Kamloops, British Columbia plant's labor agreement was renewed in 1993 for a period of two years. On January 7, 1994 a lock-out was initiated by the Registrant for its 112 hourly employees at the Exshaw, Alberta plant and it remains in effect as of the date of this Report. The plant has continued to operate without interruption, and this situation will not have a material effect on the Registrant's financial condition or results of operations in 1994. The Bath, Ontario plant's labor agreement expired at the end of 1993 and was renewed for 23 months. Labor agreements for the Woodstock, Ontario plant and the St. Constant, Quebec plant will expire in 1994 and are expected to be renegotiated without any work stoppage. Also, several terminal labor agreements will expire in 1994. I-13 - - - CANADIAN CONSTRUCTION MATERIALS OPERATIONS Employees working in the Canadian construction materials operations totalled approximately 2,825 at the end of 1993 with approximately 1,915 hourly employees and 910 salaried employees. In western Canada, twelve labor agreements were renegotiated in 1993, and it is anticipated that 24 labor agreements will be renegotiated during 1994. In eastern Canada, sixteen labor agreements were renegotiated. Competition The competitive marketing radius of a typical cement plant for common types of cement is approximately 250 miles except for waterborne shipments which can be economically transported considerably greater distances. Cement, concrete products and aggregates and construction services are sold in competitive markets. These products and services are obtainable from alternate suppliers. Vigorous price, service and quality competition is encountered in each of the Registrant's primary marketing areas. The Registrant's operating cement plants located in Canada represented an estimated 31 percent of the rated annual active clinker production capacity of all Canadian cement plants at December 31, 1992. The Registrant is the only cement producer serving all regions of Canada. The Registrant's largest competitor in Canada accounted for approximately 23 percent of rated annual active clinker production capacity. The Registrant's operating cement plants located in the United States at December 31, 1992 represented an estimated nine percent of the rated annual active clinker production capacity of all U.S. cement plants. The Registrant's three largest competitors in the United States accounted for 14, seven and five percent, respectively, of the rated annual active clinker production capacity. The preceding statements regarding the Registrant's ranking and competitive position in the cement industry are based on the U.S. and Canadian Portland Cement Industry: "Plant Information Summary Report" dated December 31, 1992. The Registrant also encounters competition from foreign cement producers, especially in its markets in the southern coastal portion of the United States. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES The information with respect to foreign and domestic operations and export sales is set forth on pages II-45 and II-46 of Item 8 - Financial Statements and Supplementary Data of this annual report and is incorporated herein by reference. I-14 EXECUTIVE OFFICERS OF THE REGISTRANT The following tabulation sets forth as of March 25, 1994 the name and age of each of the executive officers of the Registrant and indicates all positions and offices with the Registrant held by them at said date. I-15 Bertrand P. Collomb was appointed to his current position in January 1989. He has also served as Chairman of the Board and Chief Executive Officer of Lafarge Coppee since August 1, 1989. From January 1, 1989 to August 1, 1989 he was Vice Chairman of the Board and Chief Operating Officer of Lafarge Coppee, and from 1987 until January 1, 1989 he was Senior Executive Vice President of Lafarge Coppee. He served as Vice Chairman of the Board and Chief Executive Officer of the Registrant from February 1987 to January 1989. Michel Rose was appointed to his current position in September 1992. He previously served as President and Chief Executive Officer of Orsan, a Lafarge Coppee subsidiary, from 1987 until September 1992. Since 1989 he has served as Senior Executive Vice President of the Lafarge Coppee Group. John M. Piecuch was appointed to his current position in July 1992. Prior to that, he served as Executive Vice President and President of the Registrant's Cement Group. He served as Senior Vice President and President of the Registrant's Great Lakes Region from January 1987 to January 1989. R. Gary Gentles was appointed to his current position in November 1992. He served as President of Lafarge Coppee's European plaster operations from 1990 to 1992 and was President of the Registrant's Northeast Cement Region from 1987 to 1990. Jean-Pierre Cloiseau was appointed to his current position in January 1994. He previously served as Senior Vice President and Chief Financial Officer of the Registrant from September 1990 to December 1993. Prior to that, he served as Vice President and Controller of the Registrant from January 1989 to September 1990. He had served as Vice President and Treasurer of the Registrant from May 1985 to January 1989. Peter H. Cooke was appointed to his current position in July 1990. Prior to that, he served as Vice President of Operations of the Registrant's Great Lakes Region from April 1987 to June 1990. H. L. Youngblood was appointed to his current position in January 1989. He served as Vice President - Distribution of the Registrant's Great Lakes Region from May 1987 to January 1989. Duncan Gage was appointed to his current position in January 1994. He previously served as Senior Vice President and President of the Registrant's Southern Region from May 1992 to December 1993. He served as President of Parker Lafarge, a construction materials affiliate of the Registrant, from 1990 to 1992 and President of Francon Lafarge, another construction materials affiliate of the Registrant, from 1987 to 1990. I-16 Edward T. Balfe was appointed to his current position in January 1994. Prior to that he served as President of the Registrant's Construction Materials Eastern Group and President and General Manager of Permanent Lafarge, a construction materials affiliate of the Registrant, from 1990 to 1993. He had served as President and General Manager of Permanent Lafarge from 1986 - 1990. Patrick Demars was appointed to his current position effective February 1991. He previously served as Vice President - Products and Process of the Registrant's Corporate Technical Services operations from July 1990 to January 1991. He was a Regional Vice President at CNCP, a Brazilian subsidiary of Lafarge Coppee, from July 1986 to June 1990. Thomas W. Tatum was appointed to his current position in April 1987. John C. Porter was appointed to his current position in September 1990. He served as Vice President and Controller of the Registrant's Great Lakes Region from April 1989 until September 1990 and was Assistant Controller of that Region from August 1987 until March 1989. Philip A. Millington was appointed to his current position in January 1989. He served as Assistant Treasurer of the Registrant from October 1987 to January 1989 and as Controller of the Registrant from 1983 to 1987. David C. Jones was appointed to his current position in February 1990. He served as Corporate Secretary of the Registrant from November 1987 to February 1990. David W. Carroll was appointed to his current position in February 1992. He served as Director Environmental Affairs of the Registrant from February 1990 to February 1992. Prior to that he was Director Environmental Programs for the Chemical Manufacturers Association from 1978 to 1990. There is no family relationship between any of the executive officers of the Registrant or its subsidiaries. None was selected as an officer pursuant to any arrangement or understanding between him and any other person. The term of office for each executive officer of the Registrant expires on the date of the next annual meeting of the Board of Directors, scheduled to be held on May 3, 1994. I-17 Item 2. Item 2. PROPERTIES Information set forth in Item 1 of this Annual Report, insofar as it relates to the location and general character of the principal plants, mineral reserves and other significant physical properties owned in fee or leased by the Registrant, is incorporated herein by reference in answer to this Item 2. All of the Registrant's cement plant sites (active and closed) and quarries (active and closed), as well as terminals, grinding plants and miscellaneous properties, are owned by the Registrant free of major encumbrances, except the Exshaw and Brookfield plants and the Kamloops limestone and cinerite quarries. Title to the Brookfield plant site is held by Industrial Estates Limited, a Crown corporation of the Province of Nova Scotia, in connection with assistance provided by the Province in financing the cost of construction of the plant. The site is leased by LCI at rentals sufficient to repay principal and interest on the loan. The lease, which expires in 1998, grants LCI an option to acquire title to the plant site during the term of the lease upon payment of the unpaid principal amount. During 1993, LCI exercised its option to acquire title to the Brookfield plant by paying the unpaid principal. Title to the property is in the process of being transferred to the Registrant. The Exshaw plant is built on land leased from the Province of Alberta. The original lease has been renewed for a 42-year term commencing in 1992. Annual payments under the lease are presently based on a fixed fee per acre. The Kamloops plant, as well as the gypsum quarry which serves this plant, is on land owned by the Registrant. The limestone and cinerite quarries are on land leased from the province of British Columbia until March 2022. Limestone quarry sites for the cement manufacturing plants in the United States are owned and are conveniently located near each plant except for the Joppa plant quarry which is located approximately 70 miles from the plant site. At December 31, 1993, the Registrant also owned substantial reserves which previously supplied raw materials to former cement production facilities which are located at Miami, Tampa, Fort Worth and Dallas. The Fort Worth plant facility is now a cement terminal. The Tampa plant is now operated as a cement grinding and distribution facility. LCI's quarrying rights for limestone in the Canadian provinces of Manitoba, New Brunswick, Quebec, Nova Scotia, Ontario, Alberta and British Columbia, are held under quarry leases, some of which require annual royalty payments to the provincial authorities. Management of the Registrant estimates that its limestone reserves for the cement plants currently producing clinker will be adequate to permit production at present capacities for at least 20 years. Other raw materials, such as clay, shale, sandstone and gypsum, are either obtained from reserves I-18 owned by the Registrant or are purchased from suppliers and are readily available. Deposits of raw materials for the Registrant's aggregate producing plants are located on or near the plant sites. These deposits, due to their varying nature, are either owned by the Registrant or leased upon terms which permit orderly mining of reserves. I-19 Item 3. Item 3. LEGAL PROCEEDINGS During 1989 and 1990, CSX Transportation, Inc., Metro-North Commuter Railroad Company, National Railroad Passenger Corp., Peerless Insurance Company and Massachusetts Bay Transit Authority (the "Railroads") filed actions against Lone Star Industries Inc. and affiliates ("Lone Star") for damages resulting from its fabrication and sale of allegedly defective concrete railroad ties to the Railroads. The Registrant and LCI have been named in third party actions in which Lone Star is claiming indemnity for liability to the Railroads, for damages to its business and for costs and losses suffered as a result of the Registrant and LCI supplying allegedly defective cement used by Lone Star in the fabrication of the railroad ties. The damages claimed total approximately $226.5 million. The Registrant denied the allegations and vigorously defended against the lawsuits (the "Lone Star Case"). During September and October 1992, Lone Star entered into agreements with all five plaintiff Railroads settling their claims regarding the Lone Star Case for an amount totalling approximately $66.7 million. These settlements have been submitted to and approved by the United States Bankruptcy Court for the Southern District of New York which is handling the Lone Star bankruptcy. Lone Star commenced trial in November 1992 in its third party complaint against the Registrant and LCI seeking indemnity for the Railroads' claims in addition to its own claim for business destruction. A jury verdict in this case reached in December 1992 awarded Lone Star $1.2 million as damages. Both Lone Star and the Registrant and LCI have appealed the trial court verdict to the United States Court of Appeals for Fourth Circuit. A decision is expected in the near future. In late 1990 Nationwide Mutual Insurance Company ("Nationwide"), one of the Registrant's primary insurers during the period when allegedly defective cement was supplied to Lone Star by the Registrant, filed a complaint for declaratory judgement against the Registrant, several of its affiliates and eleven other liability insurers of the Registrant (the "Coverage Suit"). The complaint seeks a determination of all insurance coverage issues impacting the Registrant in the Lone Star Case. The Registrant has answered the complaint, counterclaimed against Nationwide, cross-claimed against the co-defendant insurers and filed a third party complaint against 36 additional insurers. In December 1991, the Registrant and Nationwide entered into a settlement agreement pursuant to which Nationwide settled its claim in the Coverage Suit and, among other things, paid the Registrant a portion of past due defense expenses in the Lone Star Case, promised to pay its proportion of continuing defense expenses therein and to post the entire remaining aggregate limits of its policies as reserves to be used in the Lone Star Case, if necessary. Virtually all of LCI's Canadian insurers involved in the Coverage Suit filed motions for summary judgment. In January 1993, the court denied all of the insurers' summary judgment motions. In January 1994 the Registrant filed motions for partial summary judgment regarding the insurers' defense obligations and regarding the reasonableness of fees and expenses included in the defense of the Lone Star Case. In addition, the Registrant filed a motion to strike the designation of several expert witnesses of the insurers. The Registrant I-20 believes that it has substantial insurance coverage that will respond to a large portion of defense expenses and liability, if any, in the Lone Star Case. During 1992, a number of owners of buildings located in Eastern Ontario, Canada most of whom are residential homeowners, filed actions in the Ontario Court (General Division) against Bertrand & Frere Construction Company Limited and a number of other defendants seeking damages as a result of allegedly defective footings, foundations and floors made with ready-mixed concrete supplied by Bertrand. The largest of these cases involves claims by approximately 99 plaintiffs owning 53 homes, a 20-unit condominium building and a municipal building. Together, these plaintiffs are claiming approximately Cdn. $40 million against Bertrand, each plaintiff seeking Cdn. $200,000 for costs of repairs and loss of capital value of their respective home or building, Cdn. $200,000 for punitive and exemplary damages and Cdn. $20,000 for hardship, inconvenience and mental distress, together with interest and costs. Other owners, owning a total of 13 buildings (of which 11 are residential homes), have instituted similar suits against Bertrand and, based on the information available at this time, these claims total approximately Cdn. $9 million. As of the end of December 1993, LCI has been served with third- or fourth-party claims by Bertrand in all but one of the referenced lawsuits. Bertrand is seeking indemnity for its liability to the owners as a result of the supply by LCI of allegedly defective flyash. LCI also supplied cement to Bertrand. It is expected that Bertrand will file a third-party claim against LCI in the other case as well. LCI has delivered its statements of defense. The discoveries are to begin in February 1994. LCI has denied liability and will defend the lawsuits vigorously. The Registrant believes it has substantial insurance coverage that will respond to defense expenses and liability, if any, in the said lawsuits. The Registrant has received a notice of violation and/or a complaint with respect to each of its three cement plants that use hazardous waste derived fuel alleging violations of the Boiler and Industrial Furnaces ("BIF") regulations of the federal Resources Conservation and Recovery Act ("RCRA"). These notices of violation and complaints were issued by the U.S. Environmental Protection Agency ("EPA") with respect to the plants, located in Fredonia, Kansas and Paulding, Ohio and by the State of Michigan, which has been delegated BIF enforcement authority by the EPA, with respect to the plant located in Alpena, Michigan. Although the details of each notice of violation or complaint are specific to the particular plant, the major recurring issue has been the existence or adequacy of the plant's waste analysis plan to ensure compliance with the established allowable emission limits and feed rates. The State of Michigan has proposed a penalty of $979,750 for the Alpena plant and the EPA has proposed penalties of $619,800 for the Paulding plant and $1,200,474 for the Fredonia plant. The Registrant has submitted a response to each notice of violation and complaint setting forth certain defenses and factual information and has had meetings with the EPA and Michigan state officials to discuss the alleged violations and possibilities of settlement. At this time, it is unknown whether the Registrant will be able to settle any or all of these matters or whether I-21 one or more adjudicatory proceedings will result. With respect to a similar EPA complaint regarding the Registrant's Demopolis, Alabama plant (which was sold by the Registrant in early 1993), the Registrant settled the matter in September 1993 by paying a civil penalty of $594,000, approximately one-third of the penalty originally proposed by the EPA. In 1993, the State of Michigan alleged that the Registrant's Alpena plant was managing CKD in violation of applicable state solid waste management requirements. The Registrant has formally responded to the State setting forth defenses and factual information and has had numerous meetings with State officials to discuss the matters raised, the possible technical solutions and the possibilities of settlement. Although significant progress has been made towards potential settlement, it is unknown at this time whether the Registrant will be able to settle this matter by agreeing to make certain operational changes at the plant and/or by paying a penalty amount, or whether an adjudicatory proceeding will result. In another matter relating to the Alpena plant and CKD, the State of Michigan has contacted the Registrant and the former owner of the plant seeking remediation of an old CKD pile from which there is runoff of hazardous substances into Lake Huron. The Registrant has advised the State that it is not responsible for remediating this property because the property was expressly excluded in the purchase agreement pursuant to which the Registrant acquired the plant. The Registrant has advised the former plant owner of the Registrant's position on this matter. In July 1993, the Registrant received a complaint from the EPA alleging certain RCRA violations at its cement plant in Buffalo, Iowa. The alleged violations related to the storage of leaded grease hazardous waste at the plant, and the EPA proposed a penalty of $284,020. The Registrant has reached an agreement in principle with the EPA to settle this matter by paying a penalty of approximately $40,000. On or about March 2, 1994 the Registrant was served with a civil investigative demand by the U.S. Department of Justice, Antitrust Division, requesting the production of documents and responses to interrogatories in connection with an investigation of potential price fixing and market allocation by cement producers. The Registrant is presently engaged in preparing its responses to the inquiry. The Registrant is involved in certain other legal actions and claims. It is the opinion of management that all such legal matters will be resolved without material effect on the Registrant's Consolidated Financial Statements. I-22 Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None during the fourth quarter ended December 31, 1993. I-23 PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information required in response to Item 5 is reported in Item 7, pages II-24 and II-25 of this Annual Report and is incorporated herein by reference. On March 9, 1994, 58,406,650 Common Shares were outstanding and held by approximately 2,970 record holders. In addition, on March 9, 1994, 9,104,150 exchangeable preference shares of LCI, which are exchangeable at the option of the holder into Common Shares on a one-for-one basis and have rights and privileges that parallel those of the Common Shares, were outstanding and held by 7,040 record holders. The Registrant may obtain funds required for dividend payments, expenses and interest payments on its debt from its operations in the U.S., dividends from its subsidiaries or from external sources, including bank or other borrowings. LCI's loan and credit agreements do not contain restrictions on the payment of dividends but do contain maximum borrowing restrictions. II - 1 Item 6. Item 6. SELECTED FINANCIAL DATA The table below summarizes selected financial information for the Registrant. For further information, refer to the Registrant's consolidated financial statements and notes thereto presented under Item 8 of this Annual Report. (a) Before cumulative effect of change in accounting principles. II - 2 Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto: MANAGEMENT'S DISCUSSION OF INCOME The Consolidated Statements of Income (Item 8, page II-28) summarize the Registrant's operating performance for the past three years. To facilitate analysis, sales and operating profit will be discussed by product line and are summarized in the table on page II-4 (in millions). The Registrant's two product lines are: 1. Cement-the production and distribution of portland and specialty cements and cementitious materials. 2. Construction materials-the production and distribution of ready-mixed concrete, construction aggregates, other concrete products, asphalt, road construction and the conversion of industrial waste into fuels for use in cement kilns. II - 3 II - 4 YEAR ENDED DECEMBER 31, 1993 Net Sales The Registrant's net sales were $1,494.5 million, down slightly from $1,511.2 million in 1992. The decrease was due to a drop in the value of the Canadian dollar relative to the U.S. dollar and sales lost from divested operations including the Registrant's cement plant in Demopolis, Alabama. Partially offsetting these declines were a four percent increase in average cement net sales prices and higher sales volumes from both cement and construction materials operations. Canadian net sales were $640.5 million, a decline of four percent from last year while U.S. net sales increased one and one-half percent to $854.0 million. The Registrant's net sales from cement operations increased one percent in 1993. Cement average net sales prices improved four percent over 1992 due to a six percent increase in the U.S. Canadian net sales decreased four percent due to the impact of exchange rates. In the U.S., net sales increased three percent. Prices increased an average of six percent in the Great Lakes U.S. market and seven percent in the southern U.S. The Canadian average net sales price remained stable with lower prices in Ontario offset by higher prices in the west. Cement shipments (after adjusting for sales from the Demopolis, Alabama plant, which was divested in February 1993) increased four percent in 1993 to 12.3 million tons from 11.8 million tons in 1992. Demand was strongest in U.S. markets and in western Canada. U.S. and Canadian shipments increased four percent and two percent, respectively. Spot shortages occurred during 1993 in the southern Great Lakes and Mississippi River markets as the continued improvement in the U.S. construction market increased the demand for cement. Additionally, construction activity in the Midwest increased after the flood waters receded. Shipments in the Pennsylvania and New England markets increased over 1992 and prices improved three percent from 1992's depressed levels. The Florida market performed well in 1993, with sales volumes up 14 percent from the previous year. Oilwell cement sales in the western provinces of Canada nearly doubled in 1993 as an increase in natural gas prices and changes to the royalty system resulted in an increase in drilling activity. Additionally, cement shipments in British Columbia increased nine percent over 1992. In 1993, market conditions in eastern Canada were adversely impacted by excess cement capacity. However, the Registrant used surplus capacity in Ontario to supplement U.S. facilities that were facing inventory shortages. The Registrant's two cement plants in Ontario increased production and lowered unit costs although cement demand dropped two percent in the province. Shipments in the Quebec and Atlantic provinces of Canada were flat in 1993. II - 5 Net sales from the Registrant's construction materials and waste management operations were $802.2 million, down three percent from 1992. The drop in the value of the Canadian dollar, sales lost from divested operations in 1992, the sluggish economy in Canada and flooding in the midwest U.S. were the major causes of this decline. In Canada, net sales dropped five percent primarily due to the decline in the value of the Canadian dollar and the divestment of the Registrant's chemical admixtures operations in 1992. Net sales in the U.S. declined slightly as a result of the weak performance in the Registrant's northern markets, flooding in the midwest and the divestment of several construction materials businesses. These declines were nearly offset by strong performance in the Registrant's southern U.S. markets. Registrant-wide, ready-mixed concrete shipments of 6.1 million cubic yards were one percent higher than a year ago. Aggregate sales of 48.1 million tons were four percent higher than the previous year. In Canada, ready-mixed concrete shipments increased two percent due to an increase in construction activity in British Columbia and Quebec while infrastructure work in eastern Canada boosted aggregate volumes by eight percent. In the U.S., ready-mixed concrete and aggregate volumes declined slightly due to the floods and a drivers strike in St. Louis coupled with the 1992 sale of several construction materials businesses. Gross Profit and Cost of Goods Sold The Registrant's gross profit as a percentage of net sales improved from 15 percent in 1992 to 17 percent in 1993. Cement gross profit was 20 percent compared to 17 percent in 1992 as a result of improved prices. Over the two year period, construction materials gross profit was approximately 11 percent. The Registrant's cement cost per ton is heavily influenced by plant capacity utilization. The following table summarizes the Registrant's cement production (in millions of tons) and the utilization rate of clinker production capacity. The 1993 figures exclude the Demopolis, Alabama plant which was divested in February 1993. Cement production and clinker capacity utilization in 1993 were down somewhat from a year ago. In the U.S., cement production totalled 7.2 million tons, an 11 percent decrease from 1992. Capacity utilization at U.S. plants was 90 percent in 1993 compared to 95 percent in 1992. The decrease in production and utilization was due to operating problems at three of the Registrant's cement plants. Canadian cement production II - 6 was 4.1 million tons in 1993, an increase of 11 percent from 3.7 million tons in 1992. Capacity utilization was 72 percent and 66 percent in 1993 and 1992. The increase in production and utilization was primarily due to higher sales volumes and the use of surplus capacity in the Registrant's Ontario plants to supplement U.S. markets that were experiencing cement shortages. Selling and Administrative Selling and administrative expenses were $161.4 million in 1993, $23.3 million (13 percent) lower than 1992. This reduction resulted primarily from divestments and actions taken to streamline operations and reduce costs in the Registrant's cement and construction materials operations over the last two years. Selling and administrative expenses as a percentage of net sales declined to 10.8 percent in 1993 from 12.2 percent in 1992. Other (Income) Expense, Net Other income and expense consists of items such as net retirement costs, equity income, amortization of intangibles and nonrecurring gains and losses from divestitures. Other income, net was $1.0 million in 1993 compared to expense of $9.1 million in 1992. The change was the result of higher divestment gains from the sale of non-strategic assets and lower amortization coupled with the absence of strike related costs at the Richmond plant. Restructuring In the fourth quarter of 1993, the Registrant recorded a one-time pre-tax restructuring charge of $21.6 million ($16.4 million net of tax benefits) to cover the direct expenses of restructuring the Registrant's North American business units to increase organizational efficiency. The primary components of the restructuring charge are separation benefits for approximately 350 employees ($15.2 million), and employee relocation ($3.3 million). The charge also includes expenses such as office relocation and lease termination. No amounts were paid relative to these items in 1993. The restructuring plan entails the consolidation of 11 regional operating units into six units in the Registrant's two main business lines. This consolidation reduces management layers, eliminates duplicative administrative functions and standardizes procedures and information systems. Manufacturing and distribution facilities will not be materially affected by the restructuring. The Registrant expects the annual expense reductions from the restructuring to be approximately $8 million after-tax in 1994 and increasing to approximately $19 million after-tax once the restructuring is fully implemented. II - 7 Performance by Line of Business In 1993, the Registrant's operating profit from cement operations (before corporate and unallocated expenses) was $96.4 million, $29.8 million better than 1992. All regions reported better results than the prior year. Cement results were much better due to higher prices and stronger shipments, particularly in the second half of 1993. The most notable progress was in the U.S. markets. Prices were up six percent in the U.S. but unchanged in Canada. The Registrant's Canadian operations reported an operating profit of $46.2 million, $5.5 million better than last year. Earnings increased in western Canada due to higher shipments and the absence of costs related to the strike at the Richmond plant that was settled in March 1992. Earnings declined in central Canada due to the continued sluggish market but improved in eastern Canada primarily due to higher intraregional sales to the U.S. New England markets. Earnings from U.S. cement operations were $50.2 million, or $24.3 million better than 1992. Results improved in all U.S. regions, mainly due to the six percent increase in average net selling prices combined with a four percent increase in shipments. The operating profit from the Registrant's construction materials and waste management operations in 1993 (before corporate and unallocated expenses) was $30.6 million, $20.9 million better than 1992. Earnings were boosted by cost reductions and higher ready-mixed concrete and block prices in central Canada, improved ready-mixed concrete and aggregate volumes in eastern Canada, partially offset by lower ready-mixed concrete prices in the western provinces due to competitive pressures in a number of markets. The Canadian operations contributed $20.3 million, $14.7 million higher than the prior year. Most of the increase was attributable to the Registrant's Ontario-based concrete products operations. The U.S. operating profit totalled $10.3 million, $6.2 million better than 1992. This improvement was primarily attributable to the Registrant's construction materials operations in the southern U.S. resulting from higher ready-mixed concrete volumes, lower stone costs and a $3.1 million write-down of a quarry last year. Partially offsetting these gains were an earnings decline in the Registrant's northern U.S. markets due to the continued poor economic climate and high operating costs in the midwest markets as a result of the summer floods and a drivers strike. Total Income From Operations Total income from operations was $70.2 million in 1993, an increase of $42.2 million from 1992. The improved performance was due largely to a six percent increase in the U.S. average cement net sales price. Also contributing to the results were an $18.2 million turnaround in profitability of the Registrant's construction materials operations in central and eastern Canada, higher shipments in the western cement region, higher divestment gains from the sale of non-strategic assets and a 13 percent reduction in selling and administrative expenses. These improvements were partially offset by a one-time restructuring II - 8 charge of $21.6 million. The Registrant's operating profit from its Canadian operations was $36.7 million, $3.2 million better than 1992. Operating profit from U.S. operations was $33.5 million, $39.0 million better than 1992. Interest Expense, Net Net interest expense decreased by $6.7 million in 1993 due to lower average debt levels. Income Taxes Income tax expense increased $5.9 million in 1993. U.S. taxes increased $3.0 million primarily due to a $2.6 million increase in deferred income taxes. The Canadian income taxes increased $2.9 million due to higher earnings in Canada. The Canadian effective income tax rates were 46.1 percent in 1993 and 42.7 percent in 1992. Certain elements of the Canadian income tax provision are fixed in amount. The increase in the Canadian effective tax rate in 1993 was caused by the relatively higher percentage of these fixed amounts to the higher earnings experienced in 1993, partially offset by a tax rate reduction enacted during 1993. Net Income In 1993, the Registrant reported net income of $5.9 million. This was $106.5 million better than 1992's net loss of $100.6 million. The 1992 loss included $12.1 million after-tax of employee severance and other nonrecurring charges, while 1993 results included an after-tax charge of $16.4 million related to corporate restructuring recorded in the fourth quarter. The 1992 loss also included $63.5 million in after-tax charges related to the adoption of new accounting rules for postretirement benefits and income taxes. Excluding this one-time charge, net income in 1993 was $43.0 million better than 1992. Excluding one-time charges resulting from the adoption of these new accounting rules, the Registrant's Canadian operations reported net income of $20.5 million, $0.8 million higher than 1992. The increase was due to better results in the Registrant's ready-mixed concrete and aggregate operations in central and eastern Canada, higher shipments in the western cement region and the absence of strike related costs at the Richmond plant. These increases were offset by a four percent decline in net sales and lower divestment gains. After excluding one-time charges resulting from the adoption of new accounting rules, the Registrant's U.S. operations incurred a net loss of $14.6 million. This was $42.2 million better than 1992. The improved U.S. performance was the result of a $4.9 million gain realized from the expropriation of property at one of the Registrant's construction materials operations and an increase in cement volumes and II - 9 prices. In addition, interest expense in the U.S. was $6.2 million lower than the previous year. U.S. results were negatively impacted by infrequently occurring maintenance projects (those required every three years or more) and an earnings decline in the Registrant's northern and midwest construction materials markets. Recent Acquisitions On January 16, 1991, the Registrant acquired Missouri Portland/ Davenport which was engaged in the production and distribution of cement and construction materials. The three cement plants acquired increased the Registrant's annual clinker production capacity by 25 percent and created significant production and distribution synergies with the Registrant's existing operations, especially along the Mississippi River. The acquisition included 30 ready-mix operations, two aggregate quarries as well as the assets of a chemical admixtures business which was divested in 1992. General Outlook The Registrant's general outlook for 1994 in the Cement Group is favorable, particularly in the United States. According to the Dodge/Sweet's Outlook '94, total new construction in the U.S. is projected to increase six percent in real terms in 1994. This would be the third consecutive year of improvement. Cement consumption generally correlates with trends in construction expenditures. In Canada, cement consumption is expected to be boosted by the housing sector and Ottawa's Cdn. $6 billion public works program. Additionally, in early 1994, the Registrant was chosen to supply 160,000 metric tons of silica fume cement over three years starting in 1994 for the construction of the Prince Edward Island eight-mile bridge in Canada's Atlantic provinces. The Portland Cement Association ("PCA") forecasts higher cement consumption in all provinces. The upward trend in prices during 1993 and the higher cement consumption forecasted by the PCA provides some optimism about the 1994 climate for cement prices. Price increases were phased in at various times during 1993; therefore, their full impact will not be realized until 1994. Also, the Registrant has announced increases for the first part of 1994 in most North American markets. The Registrant's expectations for the construction materials group hold promise for 1994. In Canada, the gradual recovery of construction activity should allow room for a modest increase in construction materials volumes, although performance will once again vary by region. In the Maritimes, the Registrant has a contract to furnish approximately 370,000 cubic meters of concrete over a three year period for the bridge to Prince Edward Island. In the U.S., the group's major business line, II - 10 aggregates, is likely to experience a decline in volumes due to recent divestments; however, average margins are expected to improve. The Registrant's U.S. ready-mixed concrete deliveries should improve as the economic recovery continues to gain momentum. II - 11 YEAR ENDED DECEMBER 31, 1992 Net Sales Net sales in 1992 decreased four percent to $1,511.2 million from $1,568.8 million in 1991 due to sluggish construction activity in central and eastern Canada and a drop in the value of the Canadian dollar relative to the U.S. dollar. The Registrant's net sales from cement operations declined two percent in 1992 due mainly to a five percent decline in the average value of the Canadian dollar. The average net sales price declined slightly from 1991 due to lower prices in the U.S. In the Great Lakes and Northeastern Regions, competitive pressures caused prices to fall, offsetting price gains in the west. Cement shipments were up two percent from 1991 due to improvements in the U.S. Great Lakes. In Canada, higher shipments in the west were offset by decreases in eastern and central Canada due to sluggish construction activity. Net sales from the Registrant's construction materials and waste management operations were 12 percent less than 1991 in Canada but nine percent more in the U.S., resulting in an overall decline of five percent. Compared to 1991, ready-mixed concrete and aggregate volumes in Canada were nine and six percent lower due to the continued weakness in the Toronto and Montreal markets. Ready-mixed concrete and aggregate volumes in the U.S. were six percent and 11 percent higher. The U.S. improvement was primarily the result of a greater market penetration in the northern U.S. and an improving market in Texas. Gross Profit and Cost of Goods Sold The Registrant's gross profit as a percentage of net sales was 14.7 percent in 1992, slightly better than 14.3 percent in 1991. Cement gross profit as a percentage of net sales was 17.4 percent in 1992 and 16.6 percent in 1991. Over the two-year period, construction materials gross profit as a percentage of net sales was approximately 10 percent. The Registrant's cement unit cost is heavily influenced by plant capacity utilization. The following table summarizes the Registrant's cement production (in millions of tons) and the utilization rate of clinker production capacity. II - 12 Cement production increased one and one-half percent in 1992 while clinker capacity utilization was 83 percent, down from 85 percent in 1991. In the U.S., cement production totalled 8.1 million tons, an increase of four percent over 1991. Capacity utilization at U.S. plants was 95 percent in 1992 compared to 94 percent in 1991. The increase in production and utilization was primarily due to higher sales volumes. Canadian cement production fell to 3.7 million tons in 1992, a decline of three percent from 1991. Capacity utilization was 66 percent and 71 percent in 1992 and 1991, respectively. The decline resulted from the temporary shutdown of certain kilns at three of the Registrant's plants in Canada due to a decrease in cement demand. Selling and Administrative Selling and administrative expenses decreased seven percent in 1992 primarily due to the 1991 restructuring of the Registrant's cement operations following the Missouri Portland/Davenport acquisition in January 1991 and other restructuring in the Registrant's construction materials operations, particularly in Ontario. These savings were partially offset by 1992 provisions for additional restructuring. Selling and administrative expenses as a percentage of net sales were 12.2 percent in 1992, down from 12.7 percent in 1991. Other (Income) Expense, Net Other income and expense consists of items such as net retirement costs, equity income, amortization of intangibles and nonrecurring gains and losses from divestitures. Other expense, net was $9.1 million in 1992 compared to $8.1 million in 1991. The change was the result of recurring expenses from adopting the new accounting rule for postretirement benefits as well as nonrecurring provisions for contingencies and restructuring. These charges were partially offset by lower retirement costs, higher equity income and divestment gains from the sale of non- strategic assets and lower costs related to the strike at the Richmond plant. Performance by Line of Business The Registrant's operating profit from cement operations in 1992 was $66.6 million, $14.7 million better than 1991. Earnings improved in three of the Registrant's four cement regions. Depreciation expense increased by $3.4 million as a result of the new accounting rule for income taxes. The Canadian operating profit was $40.8 million, $7.5 million better than 1991. Profits in western Canada improved due to the end of a strike at the Richmond plant plus higher shipments and prices. Profits declined in central and eastern Canada due to sluggish construction activity. In the U.S., operating profit was $25.8 million, up $7.2 million from 1991. Earnings improved in all markets except the Northeast. II - 13 In 1992, operating profit from the Registrant's construction materials and waste management operations was $9.7 million, $4.6 million lower than 1991. Earnings declined because of lower shipments in central and eastern Canada. Canadian operating profit was $5.6 million, $11.6 million less than 1991. Weak construction activity in central and eastern Canada was primarily responsible for the decline. Profit was higher in western Canada as a result of higher shipments. In the U.S., operating profit in 1992 was $4.1 million, or $7.0 million better than the previous year. The improvement resulted from better market conditions and higher prices in the South coupled with a reduction of overhead expenses in the Midwest. Total Income From Operations Total income from operations improved in 1992 to $28.0 million from $17.7 million in 1991, after recording as an additional expense the $9.4 million recurring impact of accounting changes. A majority of the improvement came from restructuring and cost-reduction programs as well as divestment gains. Earnings were boosted by $9.6 million of gains from the sale of non-strategic assets. Operating profit from the Registrant's Canadian operations before the impact of accounting changes was $34.4 million, $7.6 million better than 1991. The U.S. operating profit before accounting changes was $3.0 million, $12.1 million better than 1991. Interest Expense, Net In 1992, net interest expense decreased five percent due to lower interest rates and lower average debt levels in both the U.S. and Canada. Income Taxes Income tax expense decreased $0.4 million in 1992. The Canadian effective income tax rates were 42.7 percent in 1992 and 56.0 percent in 1991. Certain elements of the Canadian income tax provision which are fixed in amount were higher in 1991 but lower in 1992. The decrease in the Canadian effective tax rate in 1992 was caused by a lower percentage of these fixed amounts relative to the higher earnings experienced in 1992. Net Loss The Registrant's net loss in 1992, excluding charges resulting from the adoption of the new accounting rules, was $28.1 million. This was a 44 percent improvement over the 1991 net loss of $50.3 million. The Registrant's Canadian operations reported net income of $20.3 million, an $8.1 million increase over 1991. Canadian earnings benefitted from II - 14 $4.1 million of gains (net of tax), realized primarily from the sale of surplus land and a chemical admixtures business. In addition, expenses were reduced from actions taken in 1991 and during 1992 to streamline operations and reduce cost, and a reallocation of corporate overhead from the U.S. to Canada. Offsetting these gains were a nine percent decline in Canadian net sales due to weak shipments in eastern and central Canada, nonrecurring provisions for contingencies and restructuring, and a decrease in the value of the Canadian dollar. In the U.S., the net loss before accounting changes was $48.4 million, which was $14.1 million better than 1991. The U.S. improvement was primarily due to restructuring and cost reduction programs as well as better market conditions and higher prices in the Registrant's southern construction materials operations offset by reallocation of corporate overhead from Canada. ENVIRONMENTAL MATTERS The Registrant's operations, like those of other companies engaged in similar businesses, involve the use, release/discharge, disposal and clean-up of substances regulated under increasingly stringent federal, state, provincial and/or local environmental protection laws. Many of the regulations are technically and legally complex, posing significant compliance challenges. The Registrant's environmental compliance program includes an environmental policy designed to provide corporate direction for all operations and employees, routine compliance oversight of the Registrant's facilities, routine training and exchange of information by its environmental professionals, and routine and emergency reporting systems. The Registrant has been, or is presently involved in certain environmental enforcement matters, in both the U.S. and Canada. Management's philosophy is to attempt to actively resolve such matters with the appropriate governmental authorities. In certain circumstances, notwithstanding management's belief that a particular alleged violation poses no significant threat to the environment, the Registrant may decide to resolve such matter by entering into a consent agreement and/or paying a penalty. In 1992, the Registrant's four cement plants using hazardous waste derived fuels submitted certifications of compliance for the emission limits established under the federal Resource Conservation and Recovery Act ("RCRA"), Boiler and Industrial Furnaces ("BIF") regulations. The BIF regulations also require extensive record keeping of operational parameters and of fuels and raw materials used. The BIF regulations are extremely complex and certain provisions have been subject to different interpretations. The Registrant has received a notice of violation and/or a complaint alleging violations of the BIF regulations at each of four cement plants. These notices of violation and complaints were issued by the U.S. Environmental Protection Agency ("EPA") with respect to three plants and by the State of Michigan, which has been delegated BIF enforcement authority by the EPA, with respect to a fourth plant. II - 15 Although the details of each notice of violation or complaint are specific to the particular plant, a recurring issue has been the existence or adequacy of the plant's waste analysis plan to ensure compliance with the established allowable emission limits and feed rates. All of the Registrant's plants which are subject to the BIF regulations have revised their waste analysis plans and submitted them for approval. Furthermore, to reduce the potential recurrence of BIF violations, the Registrant has designated an employee who is responsible for managing the Registrant's BIF compliance, including routine auditing of plant operations and plant records which are required to document compliance with the BIF regulations. The current status of these BIF-related matters is as follows: With respect to the Demopolis, Alabama plant (which was sold by the Registrant in early 1993), the Registrant settled the matter by paying a penalty of $594,000, approximately one-third of the penalty originally proposed by the EPA. The State of Michigan has proposed a penalty of $979,750 with respect to the Alpena, Michigan plant and the EPA has proposed penalties of $619,800 with respect to the Paulding, Ohio plant and $1,200,474 with respect to the Fredonia, Kansas plant. The Registrant has submitted a response to each notice of violation and complaint setting forth certain defenses and factual information and has had meetings with the EPA and Michigan State officials to discuss the alleged violations and the possibilities of settlement. At this time, it is unknown whether the Registrant will be able to settle any or all of these matters or whether one or more adjudicatory proceedings will result. In late February 1994, a decision was issued in a lawsuit challenging certain aspects of the BIF regulations. The court's decision, among other things, vacated the tier III standard for hydrocarbon emission levels and instructed the EPA to reconsider the tier III standard. Two of the Registrant's plants have been complying with the tier III standard and are currently not able to meet either the tier I standard or the tier II standard, which are the two remaining standards. The Registrant is evaluating potential raw material alternatives and technological modifications at these two plants to determine whether one or both of the plants could meet the tier I standard or the tier II standard. The Registrant is also working with the EPA to have an interim replacement standard put in place pending the EPA's reconsideration of the tier III standard. In the absence of the tier III standard or a substantially similar replacement standard, the Registrant might have to stop using supplemental fuels at one or both of these plants. A by-product of many of the Registrant's cement manufacturing plants is cement kiln dust ("CKD"). CKD has been excluded from regulation as a hazardous waste under the so-called "Bevill Amendment" to RCRA until the EPA completes a study of CKD, determines if it is hazardous waste, and issues appropriate rules. On December 30, 1993, the EPA issued its Report to Congress and proposed five regulatory options for CKD. The EPA has solicited public comments on the Report to Congress and the regulatory options, following which it will make a final regulatory II - 16 determination of how, if at all, CKD should be regulated in the future. The Registrant is actively participating in this opportunity to submit comments and offer constructive regulatory alternatives. One of the regulatory alternatives being considered by the EPA would classify as a hazardous waste the CKD which is produced by facilities burning hazardous waste as a supplemental fuel. The Registrant's management does not believe that the data included in the Report to Congress support such an approach. If, however, this option is selected by the EPA, the Registrant could incur significant capital costs to meet these new standards, might have to stop using supplemental fuels at its plants, and/or might close one or more plants. In 1993, the State of Michigan alleged that the Registrant's Alpena plant was managing CKD in violation of applicable state solid waste management requirements. The Registrant has formally responded to the State setting forth defenses and factual information and has had numerous meetings with State officials to discuss the matters raised, the possible technical solutions and the possibilities of settlement. Although significant progress has been made towards potential settlement, it is unknown at this time whether the Registrant will be able to settle this matter by agreeing to make certain operational changes at the plant and/or by paying a penalty, or whether an adjudicatory proceeding will result. In another matter relating to the Alpena plant and CKD, the State of Michigan has contacted the Registrant and the former owner of the plant seeking remediation of an old CKD pile from which there is runoff of hazardous substances into Lake Huron. The Registrant has advised the State that it is not responsible for remediating this property because the property was expressly excluded in the purchase agreement pursuant to which the Registrant acquired the plant. The Registrant has advised the former plant owner of the Registrant's position on this matter. In view of the current uncertainty regarding the future regulatory treatment of CKD and with the goal of minimizing long-term liability exposure, the Registrant has been assessing its management practices for CKD in the U.S. and Canada and is voluntarily taking remedial steps and instituting new management practices as well as assessing and modifying process operations, evaluating and using alternative raw materials and implementing new technologies for reducing the generation of CKD. As with most industrial companies in the U.S., the Registrant is involved in certain remedial actions to clean up historical problem waste disposal sites as required by federal and state laws, which provide that responsible parties must fund remedial actions regardless of fault or legality at the time of the original disposal. In this regard, the Registrant is presently involved in approximately 15 federal and state administrative proceedings. At all but four of these sites, the Registrant is either a de minimis party or the Registrant has information to support its position that it did not contribute/dispose, or is not legally responsible for the disposal of materials at the site. With respect to two of the four sites, the Registrant has entered into II - 17 consent agreements with the applicable governmental authorities and received approval in late 1993 to proceed with its proposed remediation plans. In these two cases, the Registrant has recorded provisions for exposure, but has sought to obtain contributions from other non-settling parties and/or believes that its liability insurance covers these costs and is pursuing recovery from its insurers. At a third site, the Registrant has undertaken remediation under a state order of property which the Registrant had leased to an automobile workshop that had a leaking underground storage tank. The lessee vacated the property and did not have the financial resources to clean up the site. The Registrant has completed remediation of the site and is awaiting state approval. The fourth site is the old CKD pile at the Alpena plant discussed above. The 1990 Clean Air Act Amendments have the potential to result in significant capital expenditures and operational expenses for the Registrant. The Clean Air Act Amendments established a new federal operating permit and fee program for virtually all manufacturing operations. By 1995, the Registrant's U.S. operations that are deemed to be "major sources" of air pollution will have to submit detailed permit applications and pay recurring permit fees. To ensure the timely submittal and completeness of permit applications for the Registrant's "major sources", the Registrant has designated an employee to manage the identification of "major sources", prepare permit applications, and negotiate permit terms with the appropriate state agencies. The EPA is also developing air toxics regulations for a broad spectrum of industrial sectors including portland cement manufacturing. The EPA has indicated that the new maximum available control technology ("MACT") standards could force a significant reduction of air pollutants below existing levels. The Registrant is actively participating with other cement manufacturers in working with the EPA to define test protocols, better define the scope of MACT standards and develop realistic emission limitations for the portland cement industry. Until the EPA better defines the applicability and scope, and the proposed emission standards, management cannot determine whether technology in fact exists today to meet such standards and, if it does, the facilities which will be required to install additional controls and the associated costs for such controls. The Registrant's ready-mixed concrete operations generate a cement sludge from concrete recycling. Governmental authorities, especially in Canada, are beginning to focus on regulating management of this residual waste. The Registrant has been voluntarily assessing its cement sludge management practices in the U.S. and Canada. The Registrant hopes to identify new technologies, process modifications and alternative raw materials/additives with the goal of reducing the generation of cement sludge and/or establishing alternative management practices. Because of differences between requirements in the U.S. and Canada, and the complexity and uncertainty of existing and future environmental requirements, permit conditions, costs of new and existing technology, potential remedial costs and insurance coverage, and/or enforcement II - 18 related activities and costs, it is difficult for management to estimate the ultimate level of the Registrant's expenditures related to environmental matters. The Registrant's capital expenditures and operational expenses for environmental matters have increased, and are likely to increase in the future. The Registrant, however, cannot determine at this time if capital expenditures and other remedial actions that the Registrant has taken, or may in the future be required to undertake, in order to comply with the laws governing environmental protection will have a material effect upon its capital expenditures or earnings. II - 19 MANAGEMENT'S DISCUSSION OF CASH FLOWS The Consolidated Statements of Cash Flows summarize the Registrant's main sources and uses of cash. These statements show the relationship between operations which are presented in the Consolidated Statements of Income and liquidity and financial resources which are depicted in the Consolidated Balance Sheets. The Registrant's liquidity requirements arise primarily from the funding of its capital expenditures, working capital needs, debt service obligations and dividends. The Registrant has met its operating liquidity needs primarily through internal generation of cash and expects to continue to do so for both the short-term and long-term. However, because of the seasonality of the Registrant's business, it must borrow to fund operating activities during the spring and summer. The net cash provided by operations for each of the three years presented reflects the Registrant's net income (loss) adjusted primarily for depreciation, depletion and amortization, changes in working capital, restructuring charges in 1993, and the cumulative effect of accounting changes in 1992. Depreciation and depletion increased in 1992 from 1991 because of capital expenditures and acquisitions but declined in 1993 due to lower capital spending and divestments. In addition, net income (loss) was adjusted by the provision for bad debts. This provision has declined over the three year period due to tighter credit policies and a healthier construction market in 1993. During all three years presented, net income (loss) was also adjusted for the turnaround of deferred income taxes, primarily from reversing depreciation differences in Canada, and changes in working capital, which is discussed in Management's Discussion of Financial Position. Finally, net income (loss) from operations was adjusted for gains on sales of assets and other noncash charges and credits. These charges and credits consist principally of equity income net of dividends received, other postretirement benefit accruals, increases in prepaid pension assets and minority interests. Cash flows invested consist primarily of capital expenditures and acquisitions partially offset by proceeds on property, plant and equipment dispositions. Sales of property, plant and equipment during 1993 and 1992 included significant divestments of non-strategic assets. During 1993 the Registrant's proceeds from the sale of non-strategic assets and surplus land totalled approximately $68.9 million. In 1992 the proceeds from divestment of several construction materials businesses and surplus land totalled $25.1 million. Capital investments, including acquisitions, by product line were as follows (in millions): II - 20 Capital investments related to existing operations are not expected to exceed $130 million in 1994. This capital spending is anticipated to be funded by cash flows from operations, after dividends, and proceeds from divestments. During 1993, the Registrant continued its program to regain financial flexibility by reducing its debt position. Debt was reduced by cash flows from operations, divestments and proceeds from the sale of Common Shares. Net cash outflows from financing activities were $124.4 million in 1993 and $14.9 million in 1992. In 1991, cash flows from financing activities were $26.3 million, reflecting borrowings required to finance a portion of the Registrant's capital investments. In February 1993, the Registrant sold its Demopolis, Alabama cement facility and other related assets for approximately $50 million cash. In early 1992, the Registrant sold 1.7 million Exchangeable Shares of LCI, a wholly owned subsidiary, that it had accumulated through exchange transactions for net proceeds of $25.8 million. In October 1993 the Registrant completed an offering of 6.75 million Common Shares priced at $18.25 per share. The net proceeds from the offering, which were used initially to reduce long-term debt, totalled $117.6 million. The Registrant intends to apply the proceeds to internal capital improvement projects and investment or acquisition opportunities to enhance or expand the Registrant's competitive position in the U.S. and Canada. The Registrant has access to a wide variety of short-term and long-term financing alternatives in both the U.S. and Canada. Effective December 15, 1993, the Registrant extended the maturity of its $200 million committed credit facility to December 31, 1996. Although none of the credit facility had been drawn down at December 31, 1993, approximately $11 million was utilized to back outstanding short-term bank loans. Most of the Registrant's cash and cash equivalents are in Canada. If the cash were transferred to the U.S., a 10 percent withholding tax would be levied in Canada which, because of the Registrant's U.S. net operating loss position, would not provide an offsetting tax credit in the U.S. II - 21 MANAGEMENT'S DISCUSSION OF FINANCIAL POSITION The Consolidated Balance Sheets summarize the Registrant's financial position at December 31, 1993 and 1992. The value reported for Canadian dollar denominated net assets decreased from December 31, 1992 as a result of a drop in the value of the Canadian dollar relative to the U.S. dollar. At December 31, 1993 the U.S. dollar equivalent of a Canadian dollar was $ .76 versus $ .79 at December 31, 1992. Working capital, excluding cash and current portion of long-term debt, decreased $6.5 million as a result of the drop in the value of the Canadian dollar relative to the U.S. dollar. The impact of these exchange rate changes was to reduce accounts receivable by $5.8 million, inventories by $4.0 million, and accounts payable by $2.7 million. Working capital, excluding cash, current portion of long-term debt and the impact of exchange rate changes, decreased $49.2 million from December 31, 1992 to December 31, 1993. Accounts receivable increased $14.3 million during the year primarily due to a five percent increase in net sales in the fourth quarter of 1993 compared to 1992. (Net sales are detailed in Management's Discussion of Income). Inventories decreased $36.1 million mainly due to a seven percent increase in cement shipments in the fourth quarter resulting from the continued improvement in the construction market coupled with milder weather conditions in most of the Registrant's major markets. Also contributing to the decline in inventories was the impact of divestments. The increase in other current assets was due to higher deferred income tax assets. Accounts payable and accrued liabilities increased $38.8 million, mainly due to the $21.6 million restructuring accrual and the timing of purchases and payments. Net property, plant and equipment decreased $101.6 million during 1993. The impact of exchange rates resulted in $16.0 million of this decrease. Depreciation and divestments were $108.5 million and $51.9 million. Capital expenditures and acquisitions totalled $67.2 million. The excess of cost over net assets of businesses acquired related primarily to a 1981 U.S. acquisition. During 1993, this balance decreased primarily due to current year amortization. Other long-term liabilities increased $13.9 million during 1992. The increase was due to higher minority interests of $12.4 million primarily resulting from a construction materials joint venture in Canada ($7.2 million) and proceeds from the expropriation of property in a U.S. construction materials joint venture ($4.7 million). The adoption of SFAS No. 106, "Employers Accounting for Postretirement Benefits Other than Pensions", was recorded effective January 1, 1992 and resulted in the establishment of a $111.0 million liability. The related 1993 and 1992 accruals, net of actual payments, were $4.5 million and $6.0 million, respectively. The new accounting standard requires that the expected cost of retiree health care and life insurance benefits be charged to expense during the II - 22 years that the employees render service rather than the Registrant's past practice of recognizing these costs on a cash basis. The Registrant's capitalization is summarized in the following table: The increase in shareholders' equity is discussed in Management's Discussion of Shareholders' Equity. The decline in long-term debt is discussed in Management's Discussion of Cash Flows. II - 23 MANAGEMENT'S DISCUSSION OF SHAREHOLDERS' EQUITY The Consolidated Statements of Shareholders' Equity summarize the activity in each of the components of shareholders' equity for the three years presented. Shareholder's equity increased $91.7 million in 1993. The increase was mainly due to the October 1993 sale of 6.75 million shares of Common Shares for net proceeds of $117.6 million. Also positively impacting 1993 shareholders' equity was net income of $5.9 million. Partially offsetting these increases were dividend payments, net of reinvestments of $14.3 million, and a change in the foreign currency translation adjustments of $24.6 million resulting from a decline in the value of the Canadian dollar relative to the U.S. dollar. Shareholders' equity decreased $142.0 million in 1992 due to the net loss of $100.6 million, a change in the foreign currency translation adjustments of $62.8 million resulting from a significant decline in the value of the Canadian dollar relative to the U.S. dollar and dividend payments, net of reinvestments, totalling $7.7 million. Offsetting these declines were the sale of 1.7 million Exchangeable Shares of LCI in February 1992 for net proceeds of $25.8 million. Common equity interests include Common Shares and the LCI Exchangeable Shares, which have comparable voting, dividend and liquidation rights. Common Shares are traded on the New York Stock Exchange under the ticker symbol "LAF" and on The Toronto Stock Exchange and the Montreal Exchange. The Exchangeable Shares are traded on the Montreal Exchange and The Toronto Stock Exchange. The following table reflects the range of high and low closing prices of Common Shares by quarter for 1993 and 1992 as quoted on the New York Stock Exchange: II - 24 Dividends are summarized in the following table (in thousands, except per share amounts): Net dividend payments during 1993 were higher than 1992 because of an increase in the number of shares outstanding during the year and a decrease in the reinvestment of dividends. II - 25 MANAGEMENT'S DISCUSSION OF SELECTED FINANCIAL DATA The Selected Consolidated Financial Data provides both a handy reference for some data frequently requested about the Registrant and a useful record in reviewing trends. The Selected Consolidated Financial Data for 1990 and 1989 has been restated from January 1, 1989 to reflect the Missouri Portland/Davenport acquisition. The Registrant's net sales increased six percent from 1989 to 1990 because of acquisitions and, to a lesser extent, increased business activity in the Registrant's markets. The 11 percent decline in the Registrant's net sales from 1990 to 1991 reflects the lower sales volumes during the recession, whereas the four percent decline from 1991 to 1992 was caused by sluggish construction activity in central and eastern Canada coupled with a decline in the average value of the Canadian dollar. The one percent decline from 1992 to 1993 was due to the drop in the value of the Canadian dollar and lost sales from divested operations, partially offset by a four percent increase in average cement net sales prices and higher cement and construction materials sales volumes as discussed in Management's Discussion of Income. Inflation has not been a significant factor in the Registrant's sales or earnings growth due to lower inflation rates in recent years, and because the Registrant continually attempts to offset the effect of inflation by improving operating efficiencies, especially in the areas of selling and administrative expenses, productivity and energy costs. The ability to recover increasing costs by obtaining higher prices for the Registrant's products varies with the level of activity in the construction industry and the availability of products to supply a local market. During 1989 and 1990, the Registrant's cement selling price increases in the U.S. and in Canada were generally less than the rate of inflation. In 1991, that pattern continued in the U.S.; however, Canadian selling prices were relatively stable in 1991. In 1992, selling prices in the U.S. decreased 1.4 percent while Canadian selling prices increased one percent. In 1993 selling prices in the U.S. increased six percent while average Canadian prices were unchanged despite depressed volumes and competitive pressures in Ontario. Net cash provided by operations consists primarily of net income (loss), adjusted primarily for depreciation, restructuring charges in 1993 and, in 1992, the cumulative effect of changes in accounting principles. The Registrant is in a capital intensive industry and as a result recognizes large amounts of depreciation. The Registrant has used the cash provided by operations primarily to expand its markets and to improve the performance of its plants and other operating equipment. II - 26 Capital expenditures and acquisitions totalled $771.1 million over the five years and included the acquisition of The Standard Slag Company (Part of the U.S. Region) which has a network of aggregates and construction materials businesses located in the U.S. Great Lakes area. Other significant investments during the period included a variety of cement plant projects to increase production capacity and reduce costs, the installation of waste fuel receiving and handling facilities, the building of additional distribution terminals to extend markets and improve existing supply networks, acquisitions of ready-mixed concrete plants and aggregate operations, and modernization of the construction materials mobile equipment fleet. II - 27 Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share amounts) See Notes to Consolidated Financial Statements II - 28 CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See Notes to Consolidated Financial Statements II - 29 CONSOLIDATED BALANCE SHEETS (in thousands) See Notes to Consolidated Financial Statements II - 30 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) See Notes to Consolidated Financial Statements II - 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Together with its subsidiaries, Lafarge Corporation (the "Registrant"), a Maryland corporation, is engaged in the production and sale of cement, ready-mix concrete, aggregates and other concrete products. The Registrant operates in the U.S. and its major operating subsidiary, LCI, operates in Canada. The Registrant's wholly-owned subsidiary, Systech Environmental Corporation, and its Canadian affiliate (together "Systech"), are involved in the conversion of waste into fuels for use in cement kilns. Lafarge Coppee S.A., a French corporation, and certain of its affiliates ("Lafarge Coppee") own a majority of the voting securities of the Registrant. ACCOUNTING AND FINANCIAL REPORTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Registrant and all of its majority-owned subsidiaries (the "Registrant"), after the elimination of intercompany transactions and balances. Investments in affiliates in which the Registrant has less than a majority ownership are accounted for by the equity method. Foreign Currency Translation Assets and liabilities of LCI are translated at the exchange rate prevailing at the balance sheet date. Revenue and expense accounts for this subsidiary are translated using the average exchange rate during the period. Foreign currency translation adjustments are disclosed as a separate item in shareholders' equity. Revenue Recognition Revenue from the sale of cement, concrete products and aggregates is recorded at the time the products are shipped. Revenue from waste recovery and disposal is recorded at the time the material is received, tested and accepted. Revenue from road construction contracts is recognized on the basis of units of work completed, while revenue from other indivisible lump sum contracts is recognized using the percentage-of-completion method. Change in Accounting Principles Effective January 1, 1992 the Registrant adopted Statements of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and No. 109, "Accounting for Income Taxes." The cumulative effect of these changes in accounting principles of $63.5 million (after-tax) was recorded as a charge to expense in 1992. II - 32 Other Postretirement Benefits SFAS No. 106 requires that the expected cost of retiree health care and life insurance benefits be charged to expense during the years that the employees render service rather than the Registrant's practice, prior to 1992, of recognizing these costs on a cash basis. The January 1, 1992 noncash cumulative charge for the adoption of this standard was $86.1 million, or $1.47 per share, after income taxes of $24.9 million. This charge represents the discounted present value of expected future benefits attributed to employees' service rendered prior to January 1, 1992. The adoption of this accounting principle also reduced 1992 pre-tax income by approximately $6.0 million. The amount of claims paid for these benefits was approximately $7.2 million, $5.5 million and $3.9 million during 1993, 1992 and 1991, respectively. Income Taxes SFAS No. 109 requires a change from the deferred method to the liability method of accounting for income taxes. Under the liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax laws and rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Under this standard, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, deferred taxes were recognized using the tax rate applicable to the year of the calculation and were not adjusted for subsequent changes in tax rates. The January 1, 1992 noncash cumulative credit recognized as income for the adoption of this standard was $22.6 million, or $.39 per share. The adoption of SFAS No. 109 reduced 1992 pre-tax income from continuing operations by $3.4 million. Cash Equivalents For purposes of the Consolidated Statements of Cash Flows, "cash" includes cash and cash equivalents. The Registrant considers liquid investments purchased with a maturity of three months or less to be cash equivalents. Because of the short maturity of those investments, their carrying amount approximates fair value. Inventories Inventories are valued at lower of cost or market. The majority of the Registrant's U.S. inventories, other than maintenance and operating supplies, are stated at last-in, first-out ("LIFO") cost and all other inventories are valued at average cost. Property, Plant and Equipment Depreciation of property, plant and equipment is computed for financial reporting purposes using the straight-line method over the estimated useful lives of the assets. These lives range from three years on light mobile equipment to forty years on certain buildings. Land and mineral II - 33 deposits include depletable raw material reserves on which depletion is recorded using a units-of-production method. Excess of Cost Over Net Assets of Businesses Acquired The excess of cost over fair value of net assets of businesses acquired is amortized on a straight-line basis over periods not exceeding forty years. The amortization recorded for 1993, 1992 and 1991 was $4.3 million, $5.4 million and $6.4 million, respectively. Accumulated amortization at December 31, 1993 and 1992 was $38.2 million and $33.9 million, respectively. Research and Development The Registrant is committed to improving its manufacturing process, maintaining product quality and meeting existing and future customer needs. These objectives are pursued through various programs. Research and development costs, which are charged to expense as incurred, were $7.3 million, $8.1 million and $7.5 million for 1993, 1992 and 1991, respectively. Interest No interest was capitalized during 1993, 1992 or 1991. Interest income of $5.3 million, $4.5 million and $3.3 million, has been applied against interest expense for 1993, 1992 and 1991, respectively. The interest differential to be paid or received as a result of interest rate swaps is accrued as interest rates change and recognized over the life of the agreements as an adjustment to interest expense. Net Income Per Common Equity Share The calculation of net income per common equity share is based on the weighted average number of the Registrant's Common Shares and the Exchangeable Preference Shares of LCI ("Exchangeable Shares") outstanding in each period and the assumed exercise of stock options. The weighted average number of shares and share equivalents outstanding was (in thousands) 61,636, 58,652 and 55,925 in 1993, 1992 and 1991, respectively. The computation of fully diluted earnings per share was antidilutive in 1993, 1992 and 1991. Other Postemployment Benefits In December 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Accounting for Other Postemployment Benefits." SFAS No. 112 requires the accrual of the estimated cost of benefits provided to former or inactive employees after employment but before retirement. These benefits include long-term disability, temporary disability income, medical coverage continuation and COBRA medical coverage continuation. This new standard, which the Registrant must adopt by 1994, requires that the expected cost of these benefits be charged to expense during the years that the employees render service. The Registrant will adopt this new II - 34 standard on January 1, 1994. The impact of adopting this standard will not be material to the Registrant's financial position and operating results. RESTRUCTURING In the fourth quarter of 1993, the Registrant recorded a one-time pre-tax restructuring charge of $21.6 million ($16.4 million net of tax benefits, or $.27 per share) to cover the direct expenses of restructuring the Registrant's North American business units to increase organizational efficiency. The primary components of the restructuring charge are separation benefits for approximately 350 employees, employee relocation costs and early retirement benefits for eligible employees electing early retirement. The charge also includes expenses such as office relocation and lease termination. The restructuring plan entails the consolidation of eleven regional operating units into six units in the Registrant's two main business lines. This consolidation reduces management layers, eliminates duplicative administrative functions and standardizes procedures and information systems. Manufacturing and distribution facilities will not be materially affected by the restructuring. RECEIVABLES Receivables consist of the following (in thousands): II - 35 INVENTORIES Inventories consist of the following (in thousands): Included in the finished products, work in process and raw materials and fuel categories are inventories valued using the LIFO method of $54.8 million and $74.4 million at December 31, 1993 and 1992, respectively. If these inventories were valued using the average cost method, such inventories would have decreased by $7.5 million and $9.7 million, respectively. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following (in thousands): II - 36 OTHER ASSETS Other assets consist of the following (in thousands): Property held for sale represents certain permanently closed cement plants and land which are carried at the lower of cost or estimated net realizable value. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities consist of the following (in thousands): II - 37 LONG-TERM DEBT Long-term debt consists of the following (in thousands): The fair value of long-term debt at December 31, 1993 was approximately $428.0 million. This fair value was estimated based upon quoted market prices or current interest rates offered to the Registrant for debt of the same maturity. The Registrant, does not generally anticipate the refinancing of these obligations prior to maturity. II - 38 The Registrant is a party to $98 million net notional amount of interest rate swap agreements which have effectively fixed the interest rates on its floating rate debt. The fixed rates payable under these agreements have a weighted average of 9.3 percent with terms expiring at various dates from 1996 through 2000. The Registrant is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements, but does not anticipate nonperformance by such parties. Based on current market interest rates, the net termination cost at December 31, 1993 for the Registrant to unwind its various hedging positions was approximately $17.0 million. Annual principal payment requirements on long-term debt for each of the five years in the period ending December 31, 1998, after the exclusion of short-term bank loans for which anticipated refinancing is available, are as follows (in millions): Effective December 15, 1993, the Registrant extended the maturity of its $200 million revolving credit facility to December 1996. At the end of 1993, no amounts were outstanding under the revolving credit facility. The Registrant is required to pay annual commitment fees of up to one-quarter of one percent of the unused portion of the funds available for borrowing under these credit agreements. There was approximately $11.1 million of short-term debt backed by the revolving credit facility outstanding at December 31, 1993. The revolving credit facility and several other off-balance sheet arrangements are generally at market conditions. The Registrant's debt agreements require the maintenance of certain financial ratios relating to cash flow, leverage, working capital and net worth. At December 31, 1993, the Registrant was in compliance with these requirements. II - 39 OTHER LONG-TERM LIABILITIES Other long-term liabilities consist of the following (in thousands): PREFERRED STOCK At December 31, 1990, there were 9.0 million shares of the Registrant's Third Preferred Stock authorized, of which 1 million were outstanding. These shares were issued at a par value of $1.00 per share and were held by Lafarge Coppee. The holders were entitled to one vote per share. The shares were not entitled to any equity participation or dividends and had a cash redemption and liquidation value of $.25 per share. The Third Preferred Stock had certain mandatory redemption provisions and all outstanding shares were redeemed under these provisions on December 31, 1991. The Registrant's charter provides that redeemed shares of Third Preferred Stock automatically become authorized but unissued shares of Common stock. COMMON EQUITY INTERESTS Holders of Exchangeable Shares have voting, dividend and liquidation rights which parallel those of holders of the Registrant's Common Shares. The Exchangeable Shares are exchangeable into the Registrant's Common Shares on a one-for-one basis. Dividends on the Exchangeable Shares are cumulative and payable at the same time as any dividends declared on the Registrant's Common Shares. The Registrant has agreed not to pay dividends on its Common Shares without causing LCI to declare an equivalent dividend in Canadian dollars on the Exchangeable Shares. Dividend payments and the exchange rate on the Exchangeable Shares are subject to adjustment from time to time to take into account certain dilutive events. At December 31, 1993 the Registrant had reserved for issuance approximately 13.4 million Common Shares to allow for the exchange of outstanding Exchangeable Shares. Additional common equity shares are reserved to cover grants under the Registrant's stock option program (3.3 million), employee stock purchase plan (.8 million), conversion of the Convertible Debentures (4.5 million) and issuances pursuant to the Registrant's optional stock dividend plan (.5 million). II - 40 In February 1992, the Registrant sold 1.7 million Exchangeable Shares that it had accumulated through exchange transactions for net proceeds of $25.8 million. On October 13, 1993, the Registrant sold 6.75 million Common Shares for $18.25 per share with net proceeds of $117.6 million. Lafarge Coppee, the Registrant's majority shareholder, purchased 1.0 million of these shares. OPTIONAL STOCK DIVIDEND PLAN The Registrant has an optional stock dividend plan which permits holders of record of common equity shares to elect to receive new common equity shares issued as stock dividends in lieu of cash dividends on such shares. The common equity shares are issued under the plan at 95 percent of the average market price, as defined in the plan. STOCK OPTION AND PURCHASE PLANS Options to purchase the Registrant's Common Shares and Exchangeable Shares have been granted to key employees of the Registrant at option prices based on the market price of the securities at the date of grant. One-fourth of the options granted are exercisable at the end of each year following the date of grant, and all the options granted are exercisable in four years. The options expire ten years from the date of grant. II - 41 The following table summarizes activity for options related to the Registrant's common equity interests: The Registrant has an Employee Stock Purchase Plan which permits substantially all employees to purchase the Registrant's common equity interests through payroll deductions at 90 percent of the lower of the beginning or end of plan year market prices. In 1993, 83,517 shares were issued to employees under the plan at a share price of $15.08 and in 1992, 101,866 shares were issued at a share price of $12.94. At December 31, 1993 and 1992, $.7 million and $.8 million were subscribed for future share purchases, respectively. INCOME TAXES Pre-tax income (loss) is summarized by country in the following table (in thousands): II - 42 The provision for income taxes includes the following components (in thousands): A reconciliation of taxes at the U.S. federal income tax rate to the Registrant's actual income taxes is as follows (in millions): Effective January 1, 1992 the Registrant adopted SFAS No. 109 "Accounting for Income Taxes." The cumulative effect of this accounting change is reported in the Consolidated Statements of Income. Deferred income taxes for 1993 and 1992 reflect the tax consequences of "temporary differences" between the financial statement carrying amounts and the tax bases of existing assets and liabilities. These temporary differences are determined in accordance with SFAS No. 109 and are more II - 43 inclusive in nature than "timing differences" as determined under previously applicable accounting principles. Temporary differences and carryforwards which give rise to deferred tax assets and liabilities are as follows (in thousands): Upon adoption of SFAS No. 109, effective January 1, 1992, the Registrant determined a valuation allowance requirement in the amount of $46.5 million. During 1993 and 1992, the valuation allowance increased to $68.1 million and $66.2 million, respectively, due primarily to the increase in unutilized net operating losses in 1992. In 1991 and prior years, deferred income taxes resulted from timing differences in the recognition of revenues and expenses for tax return and financial reporting purposes. The primary timing difference was caused by tax depreciation less than book depreciation. II - 44 At December 31, 1993 the Registrant had tax net operating loss and investment and other tax credit carryforwards of $110.3 million and $4.4 million, respectively, which expire as follows (in thousands): At December 31, 1993, cumulative undistributed earnings of LCI were $546.9 million. No provision for U.S. income taxes or Canadian withholding taxes has been made since the Registrant considers the undistributed earnings to be permanently invested in Canada. The Registrant believes that such earnings, if repatriated, would not result in significant U.S. income taxes because of tax planning alternatives but would incur a Canadian withholding tax of ten percent of the amount remitted. The Registrant's U.S. federal tax liability has not been finalized by the Internal Revenue Service for any year subsequent to 1983 due to the existence of tax net operating loss and credit carryforwards. The Registrant's Canadian federal tax liability for all taxation years through 1989 has been reviewed and finalized by Revenue Canada Taxation except for certain transactions for the tax years 1984 through 1989 which are currently being reviewed. SEGMENT INFORMATION The Registrant's single business segment includes the manufacture and sale of cement and ready-mixed concrete, precast and prestressed concrete components, concrete block and pipe, aggregates, asphalt and reinforcing steel. In addition, the Registrant is engaged in road building and other construction utilizing many of its own products, and in waste recovery and disposal utilizing industrial waste as supplemental fuels in cement kilns. II - 45 Sales between the United States and Canada are accounted for at fair market value. Income from operations equals net sales plus other income less cost of goods sold, selling and administrative expenses and, in 1993, restructuring charges. It also excludes interest expense and income taxes. Financial information by country is as follows (in millions): SUPPLEMENTAL CASH FLOW INFORMATION Non-cash investing and financing activities included (in thousands) the issuance of 232, 730, and 792 common equity shares upon the reinvestment of dividends totalling $4.1 million, $9.9 million, and $10.2 million in 1993, 1992 and 1991, respectively. II - 46 Cash paid during the year for interest and income taxes is as follows (in thousands): PENSION PLANS The Registrant has several defined benefit and defined contribution retirement plans covering substantially all employees. Benefits paid under the defined benefit plans are based generally either on years of service and the employee's compensation over the last few years of employment or years of service multiplied by a contractual amount. The Registrant's funding policy is to contribute amounts that are deductible for income tax purposes. The following table summarizes the consolidated funded status of the Registrant's defined benefit retirement plans and provides a reconciliation to the consolidated prepaid pension asset recorded on the Registrant's Consolidated Balance Sheets at December 31, 1993 and 1992(in millions). For 1993 the assumed settlement interest rate was 7.5 percent for the Registrant's U.S. plans and 8.0 percent for the Canadian plans. For 1992, the assumed settlement rate was 8.0 percent for the Registrant's U.S. plans and 8.5 percent for the Canadian plans. For 1993, the assumed rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations was 4.5 percent. The 1992 rate was 5.0 percent. The expected long-term rate of investment return on pension assets, which include listed stocks, fixed income securities and real estate, was 9.0 percent for each year presented. II - 47 The preceding table includes information for certain pension plans with an excess of accumulated benefit obligations over plan assets. These particular plans are generally unfunded in nature and result in net deferred pension liabilities in 1993 and 1992 of $14.0 million and $12.1 million, respectively. Net retirement cost for the years indicated includes the following components (in millions): II - 48 Certain employees are also covered under multi-employer pension plans administered by unions. Amounts included in the preceding table as defined benefit plans retirement cost and contributions to such plans were $3.5 million, $3.5 million and $3.4 million for 1993, 1992 and 1991, respectively. The data available from administrators of the multi-employer plans are not sufficient to determine the accumulated benefit obligation, nor the net assets attributable to the multi-employer plans in which Registrant employees participate. The defined contribution plans costs in the preceding table relate to thrift savings plans for eligible U.S. employees in 1991 and for all eligible U.S. and Canadian employees in 1992 and 1993. Under the provisions of the plans, the Registrant contributes an amount proportionate to each participant's salary and will also match a portion of each participant's contribution. OTHER POSTRETIREMENT BENEFITS Effective January 1, 1992 the Registrant adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The cumulative effect of this accounting change is reported in the Consolidated Statements of Income. The Registrant provides certain retiree health and life insurance benefits to eligible employees who retire in the U.S. or Canada. Salaried participants generally become eligible for retiree health care benefits when they retire from active service at age 55 or later, although there are some variances by plan or unit in Canada and the U.S. Benefits, eligibility and cost-sharing provisions for hourly employees vary by location and/or bargaining unit. Generally, the health plans pay a stated percentage of most medical/dental expenses reduced for any deductible, co-payment and payments made by government programs and other group coverage. These plans are unfunded. An eligible retiree's health care benefit coverage is coordinated in Canada with Provincial Health and Insurance Plans and in the U.S., after attaining age 65, with Medicare. Certain retired employees of businesses acquired by the Registrant are covered under other care plans that differ from current plans in coverage, deductibles and retiree contributions. In the U.S., salaried retirees and dependents under age 65 have a $1,000,000 health care lifetime maximum benefit. At age 65 or over, the maximum is $50,000. Lifetime maximums for hourly retirees are governed by the location and/or bargaining agreement in effect at the time of retirement. In Canada, some units have maximums, but in most cases there are no lifetime maximums. In some units in Canada, spouses of retirees have lifetime medical coverage. In Canada, both salaried and nonsalaried employees are generally eligible for life insurance benefits. In the U.S., life insurance is provided for a number of hourly retirees as stipulated in their hourly bargained agreements, but not for salaried retirees except those of certain acquired companies. II - 49 The following table sets forth the plans' combined status reconciled with the accrued postretirement benefit cost included in the Registrant's Consolidated Balance Sheets (in thousands): Net periodic postretirement benefit cost includes the following components (in thousands): The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation differs between U.S. and Canadian plans. For plans in both the U.S. and Canada, the pre-65 assumed rate was 13.4 percent decreasing to 5.5 percent over 14 years. For post-65 retirees in the U.S., the assumed rate was 8.8 percent decreasing to 5.5 percent over 14 years with a Medicare assumed rate for the same group of 7.9 percent decreasing to 5.5 percent over 14 years. For post-65 retirees in Canada, the assumed rate was 11.6 percent decreasing to 5.5 percent over 14 years. If the health care cost trend rate assumptions were increased by 1 percent, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by 11.7 percent. The effect of this change on the net periodic postretirement benefit cost for 1993 would be an increase of 13.3 percent. II - 50 The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5 percent for U.S. plans and 8.0 percent for Canadian plans. COMMITMENTS AND CONTINGENCIES The Registrant leases office space and certain equipment. Total rental expense for 1993, 1992 and 1991 was $16.7 million, $19.3 million and $16.2 million, respectively. Future minimum annual rental commitments for all non-cancelable leases are as follows (in thousands): During 1989 and 1990, CSX Transportation, Inc., Metro-North Commuter Railroad Company, National Railroad Passenger Corp., Peerless Insurance Company and Massachusetts Bay Transit Authority (the "Railroads") filed actions against Lone Star Industries Inc. and affiliates ("Lone Star") for damages resulting from its fabrication and sale of allegedly defective concrete railroad ties to the Railroads. The Registrant and LCI have been named in third party actions in which Lone Star is claiming indemnity for liability to the Railroads, for damages to its business and for costs and losses suffered as a result of the Registrant and LCI supplying allegedly defective cement used by Lone Star in the fabrication of the railroad ties. The damages claimed total approximately $226.5 million. The Registrant denied the allegations and vigorously defended against the lawsuits (the "Lone Star Case"). During September and October 1992, Lone Star entered into agreements with all five plaintiff Railroads settling their claims regarding the Lone Star Case for an amount totalling approximately $66.7 million. These settlements have been submitted to and approved by the United States Bankruptcy Court for the Southern District of New York which is handling the Lone Star bankruptcy. Lone Star commenced trial in November 1992 in its third party complaint against the Registrant and LCI seeking indemnity for the Railroads' claims in addition to its own claim for business destruction. A jury verdict in this case reached in December 1992 awarded Lone Star $1.2 million as damages. Both Lone Star and the Registrant and LCI have appealed the trial court verdict to the United States Court of Appeals for Fourth Circuit. A decision is expected in the near future. In late 1990 Nationwide Mutual Insurance Company ("Nationwide"), one of the Registrant's primary insurers during the period when allegedly defective cement was supplied to Lone Star by the Registrant, filed a II - 51 complaint for declaratory judgement against the Registrant, several of its affiliates and eleven other liability insurers of the Registrant (the "Coverage Suit"). The complaint seeks a determination of all insurance coverage issues impacting the Registrant in the Lone Star Case. The Registrant has answered the complaint, counterclaimed against Nationwide, cross-claimed against the co-defendant insurers and filed a third party complaint against 36 additional insurers. In December 1991, the Registrant and Nationwide entered into a settlement agreement pursuant to which Nationwide settled its claim in the Coverage Suit and, among other things, paid the Registrant a portion of past due defense expenses in the Lone Star Case, promised to pay its proportion of continuing defense expenses therein and to post the entire remaining aggregate limits of its policies as reserves to be used in the Lone Star Case, if necessary. Virtually all of LCI's Canadian insurers involved in the Coverage Suit filed motions for summary judgment. In January 1993, the court denied all of the insurers' summary judgment motions. In January 1994 the Registrant filed motions for partial summary judgment regarding the insurers' defense obligations and regarding the reasonableness of fees and expenses included in the defense of the Lone Star Case. In addition, the Registrant filed a motion to strike the designation of several expert witnesses of the insurers. The Registrant believes that it has substantial insurance coverage that will respond to a large portion of defense expenses and liability, if any, in the Lone Star Case. During 1992, a number of owners of buildings located in Eastern Ontario, Canada most of whom are residential homeowners, filed actions in the Ontario Court (General Division) against Bertrand & Frere Construction Company Limited ("Bertrand") and a number of other defendants seeking damages as a result of allegedly defective footings, foundations and floors made with ready-mixed concrete supplied by Bertrand. The largest of these cases involves claims by approximately 99 plaintiffs owning 53 homes, a 20-unit condominium building and a municipal building. Together, these plaintiffs are claiming approximately Cdn. $40 million against Bertrand, each plaintiff seeking Cdn. $200,000 for costs of repairs and loss of capital value of their respective home or building, Cdn. $200,000 for punitive and exemplary damages and Cdn. $20,000 for hardship, inconvenience and mental distress, together with interest and costs. Other owners, owning a total of 13 buildings (of which 11 are residential homes), have instituted similar suits against Bertrand and, based on the information available at this time, these claims total approximately Cdn. $9 million. As of the end of December 1993, LCI has been served with third- or fourth-party claims by Bertrand in all but one of the referenced lawsuits. Bertrand is seeking indemnity for its liability to the owners as a result of the supply by LCI of allegedly defective flyash. LCI also supplied cement to Bertrand. It is expected that Bertrand will file a third-party claim against LCI in the other case as well. LCI has delivered its statements of defense. The discoveries are to begin in February 1994. LCI has denied liability and will defend the lawsuits vigorously. The Registrant believes it has substantial insurance coverage that will respond to defense expenses and liability, if any, in the said lawsuits. II - 52 The Registrant is involved in certain environmental enforcement matters including being notified by the EPA that it is one of several potentially responsible parties for clean-up costs at waste disposal sites. The Registrant accrues for fines, penalties and/or costs of remedial actions when it believes it has a responsibility for the enforcement matter. The ultimate costs related to all such matters and the Registrant's degree of responsibility, in some of these matters, is not presently determinable. In addition, the Registrant is involved in certain other legal actions and claims. It is the opinion of management that such legal and environmental matters will be resolved without material effect on the Registrant's Consolidated Financial Statements. RELATED PARTY TRANSACTIONS The Registrant is a participant in agreements with Lafarge Coppee for the sharing of certain costs incurred for technical, research and managerial assistance and for the use of certain trademarks. The net expenses accrued for these services were $4.8 million, $5.3 million and $5.4 million during 1993, 1992 and 1991, respectively. In addition, the Registrant purchases various products from Lafarge Coppee. Such purchases totaled $6.3 million, $17.1 million and $27.5 million in 1993, 1992 and 1991, respectively. All transactions with Lafarge Coppee were conducted on an arms-length basis. Lafarge Coppee reinvested a portion of dividends it was entitled to receive on the Registrant's Common Shares during 1993, 1992 and 1991. These reinvestments totaled $3.0 million, $8.9 million and $9.2 million, respectively. At year-end, $15 million of the Registrant's 7% Convertible Debentures were held by Lafarge Coppee. In 1993, Lafarge Coppee purchased 1.0 million Common Shares as part of the Registrant's equity offering of 6.75 million Common Shares. The price paid for these shares was the price to the public. (See Common Equity Interests). II - 53 QUARTERLY DATA (UNAUDITED) The following table summarizes financial data by quarter for 1993 and 1992 (in millions, except per share information): (a) The sum of these amounts does not equal the annual amount because of changes in the average number of common equity shares outstanding during the year. (b) Loss for the fourth quarter of 1992 includes nonrecurring charges of $12.1 million, after tax. Excluding these charges, losses per share for the fourth quarter and year were $(.10) and $(.42), before the cumulative effect of accounting changes. (c) Income for the fourth quarter of 1993 includes nonrecurring restructuring charges of $16.4 million, after tax. Excluding these charges, earnings per share for the fourth quarter and year were $0.28 and $0.36. See Restructuring. II - 54 MANAGEMENT'S REPORT ON FINANCIAL REPORTING RESPONSIBILITY Management is responsible for the preparation, integrity and objectivity of the consolidated financial statements of Lafarge Corporation and subsidiaries and other information contained in this Annual Report. This responsibility includes the selection of accounting procedures and practices, which are in accordance with generally accepted accounting principles. The consolidated financial statements have been prepared in conformity with these procedures and practices applied on a consistent basis. These consolidated financial statements reflect informed judgments and estimates, which management believes to be reasonable, in the determination of certain data used in the accounting and reporting process. The Registrant maintains an effective system of internal accounting controls which is periodically modified and improved to correspond with changes in the Registrant's operations. An important element of the system is an ongoing internal audit function, which has direct access to the Audit Committee of the Board of Directors. The internal audit staff coordinates its audit activities with the Registrant's independent public accountants, Arthur Andersen & Co., to maximize audit effectiveness. The Board of Directors, acting through its Audit Committee, monitors the accounting affairs of the Registrant and has approved the consolidated financial statements. The Audit Committee, consisting of five outside directors, reviews audit plans and results as well as the actions taken by management in discharging its responsibilities for accounting, financial reporting and internal control systems and recommends to the Board of Directors the appointment of the independent public accountants. The Audit Committee meets periodically and privately with management, internal auditors and the independent public accountants to assure that each is carrying out its responsibilities. II - 55 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Lafarge Corporation: We have audited the accompanying consolidated balance sheets of Lafarge Corporation (a Maryland corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, and shareholders' equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above (appearing on pages II-28 through II-53) present fairly, in all material respects, the financial position of Lafarge Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in the notes to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions and for income taxes. Arthur Andersen & Co. Washington, D.C., January 27, 1994 II - 56 Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None II - 57 PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The section entitled "Election of Directors" appearing on pages four through seven of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 sets forth certain information with respect to the directors and nominees for election as directors of the Registrant and is incorporated herein by reference. Certain information with respect to persons who are or may be deemed to be executive officers of the Registrant is set forth under the caption "Executive Officers of the Registrant" in Part I of this Annual Report. Information with respect to directors' and officers' compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth in the section entitled "Executive Compensation - Compliance with Section 16(a) of the Exchange Act" on page 16 of the Registrant's proxy statement referred to above. III - 1 Item 11. Item 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation" appearing on pages seven through 16 of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 sets forth certain information with respect to the compensation of management of the Registrant, and is incorporated herein by reference. III - 2 Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The sections entitled "Voting Securities", "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" appearing on pages one through four and "Election of Directors" appearing on pages four through seven of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 set forth certain information with respect to the ownership of the Registrant's voting securities, and are incorporated herein by reference. III - 3 Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The sections entitled "Executive Compensation - Indebtedness of Management" and "Executive Compensation - Transactions with Management and Others" appearing on pages 15 and 16 of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 set forth certain information with respect to relations of and transactions by management of the Registrant, and are incorporated herein by reference. III - 4 PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this Annual Report: 1. Financial Statements Consolidated Financial Statements filed as part of this Form 10-K are listed under Part II, Item 8 of this Form 10-K. 2. Financial Statement Schedules and Report of Independent Public Accountants IV - 1 Schedules I, III, IV, VII, XI, XII and XIII have been omitted because they are not applicable or the information is included in the consolidated financial statements. Column and line items not included in certain schedules have been omitted because the information is not applicable. IV - 2 IV - 3 IV - 4 IV - 5 IV - 6 CONSOLIDATED SUPPORTING SCHEDULES IV - 7 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Lafarge Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Lafarge Corporation included in this Form 10-K and have issued our report thereon dated January 27, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The consolidated schedules (Schedules II, V, VI, VIII and X) are the responsibility of the company's management and are presented for the purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These consolidated schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Washington, D.C., January 27, 1994. IV - 8 SCHEDULE II LAFARGE CORPORATION AND SUBSIDIARIES CONSOLIDATED AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Years Ended December 31, 1993, 1992 and 1991 IV - 9 (1) Represents a non-interest bearing house loan to an officer or employee of the Registrant. Principal is to be repaid monthly at a rate of 5 percent per year. Term of the loan is for twenty years and the loan is secured by a second mortgage on the individual's house. (2) Represents a non-interest bearing house loan to an officer of the Registrant. Principal is to be repaid at a minimum of $3,750 per year, with balance due at maturity. Term of this loan is for twenty years and the loan is secured by a second mortgage on this individual's house. Effective 1-1-93, this employee retired and the house loan was paid in full in 1993. (3) Represents an non-interest bearing long-term house loan of Cdn $152,000 and a non-interest bearing short-term house loan of $38,488 to an officer of the Registrant. The long-term loan, which is secured by a second mortgage on the individual's house, carries a term of twenty years with annual principal repayments of 5 percent per year. The short-term loan was repaid in 1990. (4) Represents an interest-free, short-term house loan to an employee of the Registrant. (5) Represents an interest-free long-term house loan to an employee of the Registrant. Principal is to be repaid at the rate of Canadian $4,000 for the first three years, Canadian $6,349 for the next two years and Canadian $9,013 for the following fifteen years. The loan is secured by a second mortgage on the individual's house. (6) Represents a long-term, non-interest bearing house loan of Canadian $62,300 and an interest bearing long-term loan to an employee of the Registrant. The house loan, which is secured by a second mortgage on the individual's house, carries a term of twenty years, with principal repayments of 5 percent per year. The interest bearing long-term loan carries a term of fifteen years with monthly repayments of Canadian $672. (7) Represents a 1991 non-interest bearing, short-term loan of $319,633, which was repaid in 1991. 1992 includes an interest bearing, short-term loan of $329,842 and a non-interest bearing, long-term house loan of $65,000. The long-term house loan of $65,000 was repaid in 1993. The interest-bearing, short-term loan of $329,842 was replaced in 1993 with another short-term loan of $194,176 and two non-interest bearing, long-term house loans of $60,666 and $75,000. The loan of $194,176 was interest-bearing from November 1992 until July 1993. The $60,666 loan, which is secured by a second mortgage on the individual's house, carries a term of twenty years with annual principal repayments of 5 percent per year. The $75,000 loan, which is secured by a third mortgage on the individual's house, is payable when the individual's house is sold. (8) Canadian to U.S. foreign currency translation. IV - 10 LAFARGE CORPORATION AND SUBSIDIARIES SCHEDULE V CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In Thousands) - -------------------------------- (1) Primarily represents transfers from construction in progress to the other components of fixed assets. (2) Includes adjustment for adoption of SFAS 109. IV - 11 LAFARGE CORPORATION AND SUBSIDIARIES SCHEDULE VI CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In Thousands) - -------------------------------- (1) Includes adjustment for adoption of SFAS 109. IV - 12 SCHEDULE VIII LAFARGE CORPORATION AND SUBSIDIARIES CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In Thousands) - -------------------------------- (1) Primarily foreign currency translation adjustments. IV - 13 LAFARGE CORPORATION AND SUBSIDIARIES SCHEDULE X CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In Thousands) IV - 14 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. LAFARGE CORPORATION By: /s/ JEAN-PIERRE CLOISEAU ---------------------------- Jean-Pierre Cloiseau, Senior Vice President and Chief Financial Officer Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: IV - 15 IV - 16 INDEX OF EXHIBITS IV-17 INDEX OF EXHIBITS IV-18 INDEX OF EXHIBITS IV-19 INDEX OF EXHIBITS IV-20 INDEX OF EXHIBITS - ------------------------------------------------ * Filed herewith. IV-21

36995_1993.txt

36995_1993

1993

36995

ITEM 1. BUSINESS. GENERAL First Union Corporation (the Corporation or FUNC) was incorporated under the laws of North Carolina in 1967 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the BHCA). In 1968, the Corporation became the sole stockholder of First Union National Bank of North Carolina (FUNB-NC ) and First Union Mortgage Corporation, a mortgage banking firm acquired by FUNB-NC in 1964. In addition to FUNB-NC, the Corporation also operates banking subsidiaries in Florida (since November 1985), South Carolina (since March 1986), Georgia (since March 1986), Tennessee (since December 1987), Maryland (since December 1992), Virginia (since December 1992) and Washington, D.C. (since December 1992). In addition to providing a wide range of commercial and retail banking and trust services through its banking subsidiaries, the Corporation also provides various other financial services, including mortgage banking, home equity lending, consumer lending, asset-based financing, insurance and securities brokerage services, through other subsidiaries. The Corporation's principal executive offices are located at One First Union Center, Charlotte, North Carolina 28288-0013 (telephone number (704)374-6565). Since the 1985 Supreme Court decision upholding regional interstate banking legislation, the Corporation has concentrated its efforts on building a large regional banking organization in the southeastern United States. Since November 1985, the Corporation has completed 38 banking related acquisitions, including the more significant acquisitions set forth in the following table, in addition to the currently pending acquisitions set forth in such table. (1) Additional information relating to certain of the foregoing acquisitions is set forth in the Annual Report in Note 2 on pages 59 through 60. (2) The dollar amounts indicated represent assets of the related organization as of the last reporting period prior to acquisition, except for (i) the dollar amount relating to RTC acquisitions, which represents deposits acquired from the Resolution Trust Corporation, (ii) the dollar amount relating to Southeast banks, which represents assets of the two banking subsidiaries of Southeast Banking Corporation acquired from the Federal Deposit Insurance Corporation (the FDIC), and (iii) the dollar amount relating to the pending acquisition of Lieber, which represents assets under management by Lieber as of December 31, 1993. Since such assets are not owned by Lieber, they will not be reflected on the Corporation's balance sheet upon consummation of the acquisition. Lieber serves as investment adviser to the Evergreen family of mutual funds. The acquisition agreement provides for issuance of approximately 3.1 million shares of Common Stock to acquire Lieber. (3) On January 17, 1994, FUNC entered into an agreement to acquire BancFlorida, which provides for the exchange of FUNC Common Stock for each share of BancFlorida common stock and BancFlorida convertible preferred stock. The exchange ratio will be used upon the average closing price of FUNC Common Stock prior to consummation of the acquisition. Based on the closing price of FUNC Common Stock on March 1, 1994 ($40.50), approximately 4.2 million shares of FUNC Common Stock would be issued in connection with the acquisition. FUNC currently expects to account for the acquisition as a purchase and to purchase in the open market up to one-half of the shares of FUNC Common Stock issued in the acquisition, depending on market conditions and other factors. Interstate banking legislation has greatly impacted the Corporation and the banking industry in general. North Carolina's regional interstate banking bill includes the states of Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, Maryland, Mississippi, South Carolina, Tennessee, Texas, Virginia and West Virginia and Washington, D.C., each of which has passed interstate banking legislation, either on a regional or national basis. In addition, various other states not named in the North Carolina legislation have also adopted interstate banking legislation, which, subject to certain conditions and limitations, would permit the Corporation to acquire banks in such states. The Corporation is continually evaluating acquisition opportunities and frequently conducts due diligence activities in connection with possible acquisitions. As a result, acquisition discussions and, in some cases, negotiations frequently take place and future acquisitions involving cash, debt or equity securities can be expected. Acquisitions typically involve the payment of a premium over book and market values, and therefore some dilution of the Corporation's book value and net income per common share may occur in connection with any future transactions. Additional information relating to the business of the Corporation and its subsidiaries is set forth on pages 6 through 8 in the Annual Report and incorporated herein by reference. Information relating to the Corporation only is set forth in Note 16 on pages 77 through 80 in the Annual Report and incorporated herein by reference. COMPETITION The Corporation's subsidiaries face substantial competition in their operations from banking and nonbanking institutions, including savings and loan associations, credit unions, money market funds and other investment vehicles, brokerage firms, insurance companies, leasing companies, credit card issuers, mortgage banking companies, finance companies and other types of financial institutions. Based on the volume of permanent mortgages serviced on September 30, 1993, the Corporation's mortgage banking subsidiary, First Union Mortgage Corporation, was the 11th largest mortgage banking company in the United States. SUPERVISION AND REGULATION GENERAL As a bank holding company, the Corporation is subject to regulation under the BHCA and its examination and reporting requirements. Under the BHCA, bank holding companies may not directly or indirectly acquire the ownership or control of more than five percent of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Board of Governors of the Federal Reserve System (the Federal Reserve Board). In addition, bank holding companies are generally prohibited under the BHCA from engaging in nonbanking activities, subject to certain exceptions. The earnings of the Corporation's subsidiaries, and therefore the earnings of the Corporation, are affected by general economic conditions, management policies and the legislative and governmental actions of various regulatory authorities, including the Federal Reserve Board and the Comptroller of the Currency (the Comptroller). In addition, there are numerous governmental requirements and regulations which affect the activities of the Corporation and its subsidiaries. PAYMENT OF DIVIDENDS The Corporation is a legal entity separate and distinct from its banking and other subsidiaries. A major portion of the revenues of the Corporation result from amounts paid as dividends to the Corporation by its national bank subsidiaries. The Corporation's banking subsidiaries are subject to legal limitations on the amount of dividends they can pay. The prior approval of the Comptroller is required if the total of all dividends declared by a national bank in any calendar year will exceed the sum of such bank's net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits national banks from paying dividends which would be greater than the bank's undivided profits after deducting statutory bad debt in excess of the bank's allowance for loan losses. Under the foregoing dividend restrictions and certain restrictions applicable to certain of the Corporation's nonbanking subsidiaries, as of December 31, 1993, the Corporation's subsidiaries, without obtaining affirmative governmental approvals, could pay aggregate dividends of $510 million to FUNC during 1994. During 1993, the Corporation's subsidiaries paid $407 million in cash dividends to FUNC. In addition, both the Corporation and its national bank subsidiaries are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a national bank or bank holding company that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The Comptroller has indicated that paying dividends that deplete a national bank's capital base to an inadequate level would be an unsound and unsafe banking practice. The Comptroller and the Federal Reserve Board have each indicated that banking organizations should generally pay dividends only out of current operating earnings. BORROWINGS BY THE CORPORATION There are also various legal restrictions on the extent to which the Corporation and its nonbank subsidiaries can borrow or otherwise obtain credit from its bank subsidiaries. In general, these restrictions require that any such extensions of credit must be secured by designated amounts of specified collateral and are limited, as to any one of the Corporation or such nonbank subsidiaries, to ten percent of the lending bank's capital stock and surplus, and as to the Corporation and all such nonbank subsidiaries in the aggregate, to 20 percent of such lending bank's capital stock and surplus. CAPITAL Under the risk-based capital requirements for bank holding companies, the minimum requirement for the ratio of capital to risk-weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) is eight percent. At least half of the total capital is to be composed of common equity, retained earnings and qualifying perpetual preferred stock, less goodwill (tier 1 capital and together with tier 2 capital total capital). The remainder may consist of subordinated debt, non-qualifying preferred stock and a limited amount of the loan loss allowance (tier 2 capital). At December 31, 1993, the Corporation's tier 1 capital and total capital ratios were 9.14 percent and 14.64 percent, respectively. In addition, the Federal Reserve Board has established minimum leverage ratio requirements for bank holding companies. These requirements provide for a minimum leverage ratio of tier 1 capital to adjusted average quarterly assets (leverage ratio) equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a leverage ratio of from at least four to five percent. The Corporation's leverage ratio at December 31, 1993, was 6.13 percent. The requirements also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the requirements indicate that the Federal Reserve Board will continue to consider a tangible tier 1 leverage ratio (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve Board has not advised the Corporation of any specific minimum tier 1 leverage ratio applicable to it. Each of the Corporation's subsidiary national banks is subject to similar capital requirements adopted by the Comptroller. As of December 31, 1993, the capital ratios of the bank subsidiaries of the Corporation, FUNB-NC, First Union National Bank of South Carolina (FUNB-SC), First Union National Bank of Georgia (FUNB-GA), First Union National Bank of Florida (FUNB-FL), First Union National Bank of Tennessee (FUNB-TN ), First Union National Bank of Maryland (FUNB-MD), First Union National Bank of Virginia (FUNB-VA) and First Union National Bank of Washington, D.C. (FUNB-DC), were as follows: Banking regulators continue to indicate their desire to raise capital requirements applicable to banking organizations, including a proposal to add an interest rate risk component to risk-based capital requirements. FIRREA; SUPPORT OF SUBSIDIARY BANKS The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), among other things, imposes liability on an institution the deposits of which are insured by the FDIC, such as the Corporation's subsidiary national banks, for certain potential obligations to the FDIC incurred in connection with other FDIC-insured institutions under common control with such institution. Under the National Bank Act, if the capital stock of a national bank is impaired by losses or otherwise, the Comptroller is authorized to require payment of the deficiency by assessment upon the bank's stockholders, pro rata, and to the extent necessary, if any such assessment is not paid by any stockholder after three months notice, to sell the stock of such stockholder to make good the deficiency. Under Federal Reserve Board policy, the Corporation is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each of such subsidiaries. This support may be required at times when, absent such Federal Reserve Board policy, the Corporation may not find itself able to provide it. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. FDICIA In December 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was enacted, which substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking agencies to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. A depository institution's capital tier will depend upon where its capital levels compare to various relevant capital measures and certain other factors, as established by regulation. The federal regulatory authorities have adopted regulations establishing relevant capital measures and relevant capital levels. The relevant capital measures are the total capital ratio, tier 1 capital ratio and the leverage ratio. Under the regulations, a bank will be: (i) well capitalized if it has a total capital ratio of ten percent or greater, a tier 1 capital ratio of six percent or greater and a leverage ratio of five percent or greater and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) adequately capitalized if it has a total capital ratio of eight percent or greater, a tier 1 capital ratio of four percent or greater and a leverage ratio of four percent or greater (three percent in certain circumstances) and is not well capitalized; (iii) undercapitalized if it has a total capital ratio of less than eight percent, a tier 1 capital ratio of less than four percent or a leverage ratio of less than four percent (three percent in certain circumstances); (iv) significantly undercapitalized if it has a total capital ratio of less than six percent, a tier 1 capital ratio of less than three percent or a leverage ratio of less than three percent; and (v) critically undercapitalized if its tangible equity is equal to or less than two percent of average quarterly tangible assets. As of December 31, 1993, all of the Corporation's subsidiary banks had capital levels that qualify them as being well capitalized under such regulations. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to five percent of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator. FDICIA directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares and such other standards as the agency deems appropriate. The ultimate effect of these standards cannot be ascertained until final regulations are adopted. FDICIA also contains a variety of other provisions that may affect the operations of the Corporation, including new reporting requirements, regulatory standards for real estate lending, truth in savings provisions, the requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch, and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC. Under regulations relating to the brokered deposit prohibition, all of the Corporation's subsidiary banks are well capitalized and not subject to the prohibition. FDIC INSURANCE ASSESSMENTS FUNC's subsidiary banks are subject to FDIC deposit insurance assessments. The FDIC assessment rates for the Bank Insurance Fund (BIF) range from $.23 to $.31 for every $100 of deposits. Each financial institution is assigned to one of three capital groups -- well capitalized, adequately capitalized or undercapitalized -- and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state supervisors and other information relevant to the institution's financial condition and the risk posed to the applicable insurance fund. The actual assessment rate applicable to a particular institution, therefore, depends in part upon the risk assessment classification so assigned to the institution by the FDIC. For the assessment due on January 31, 1994, the rate for each of the Corporation's subsidiary banks was $.23, except for FUNB-VA, FUNB-MD and FUNB-DC, each whose rate was $.26. ADDITIONAL INFORMATION Additional information related to certain regulatory and accounting matters is set forth on pages 19 and 20 in the Annual Report and incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES. As of December 31, 1993, the Corporation and its subsidiaries owned or leased 1,525 locations in 39 states and one foreign country from which their business is conducted, including a multi-story office complex in Charlotte, North Carolina, which serves as the administrative headquarters of the Corporation, FUNB-NC and most of the Corporation's nonbanking subsidiaries. Listed below are the number of banking and nonbanking locations of the Corporation that are leased or owned, as of December 31, 1993: The principal offices of each of the Corporation's subsidiary banks in Jacksonville, Florida; Atlanta, Georgia; Greenville, South Carolina; Nashville, Tennessee; Roanoke, Virginia; Rockville, Maryland; and Washington, D.C., are all leased. Additional information relating to the Corporation's lease commitments is set forth in Note 17 on page 83 in the Annual Report and incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Corporation and certain of its subsidiaries have been named as defendants in various legal actions arising from their normal business activities in which varying amounts are claimed. Although the amount of any ultimate liability with respect to such matters cannot be determined, in the opinion of management, based upon the opinions of counsel, any such liability will not have a material effect on the consolidated financial position of the Corporation and its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Corporation's Common Stock, $3.33 1/3 par value per share (the Common Stock), is listed on the New York Stock Exchange. Table 6 on page 28 in the Annual Report sets forth information relating to the quarterly prices of, and quarterly dividends paid on, the Common Stock for the two-year period ended December 31, 1993, and is incorporated herein by reference. Prices shown represent the high and low last sale prices of the Common Stock as reported on the New York Stock Exchange, Inc. Composite Transactions Tape. As of December 31, 1993, there were 58,670 holders of record of the Common Stock. In December 1990, the Board of Directors of the Corporation adopted a Shareholder Protection Rights Plan (the Plan) designed to enhance the ability of the Board to protect stockholders against attempts to acquire control of the Corporation by means of unfair or abusive tactics. The Plan provides, among other things, that the rights granted under the Plan to the holders of shares of Common Stock (one right for each share of Common Stock) will become exercisable (after a specified period) if any person or group announces a tender or exchange offer for, or acquires, 15 percent or more of the Common Stock. At that time each right will enable the holders of the rights (other than such person or group, whose rights become void) to purchase additional shares of Common Stock (or at the option of the Board of Directors, shares of junior participating Class A Preferred Stock) having a market value of twice the $110 exercise price of the right, subject to adjustment in certain events. If any person or group acquires beneficial ownership of between 15 percent and 50 percent of the Corporation's Common Stock, the Corporation's Board of Directors may, at its option, exchange for each outstanding and not voided right either two shares of Common Stock or junior participating Class A Preferred Stock having economic and voting terms similar to two shares of Common Stock, subject to adjustment in certain events. The rights are redeemable by the Corporation at $0.01 per right (subject to adjustment in certain events) prior to becoming exercisable and, in certain events, may be cancelled and terminated without any payment to holders. The rights have no voting rights and are not entitled to dividends. The rights will expire on December 28, 2000, unless sooner redeemed or terminated. Each share of Common Stock has attached to it one right, and the rights will not trade separately from the Common Stock unless they become exercisable. Subject to the prior rights of the holders of the Series 1990 Cumulative Perpetual Adjustable Rate Preferred Stock (Series 1990 Preferred Stock) issued in connection with the acquisition of Florida National in January 1990, holders of the Common Stock are entitled to receive such dividends as may be legally declared by the Board of Directors and, in the event of dissolution and liquidation, to receive the net assets of the Corporation remaining after payment of all liabilities, in proportion to their respective holdings. Additional information concerning certain limitations on the payment of dividends by the Corporation and its subsidiaries is set forth above under Business -- Supervision and Regulation; Payment of Dividends and in Note 16 on page 77 in the Annual Report and incorporated herein by reference. Additional information relating to the Series 1990 Preferred Stock and Common Stock is set forth in Note 12 on page 71 in the Annual Report and incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. In response to this Item the information set forth in Table 2 on page 24 in the Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. In response to this Item the information set forth on pages 10 through 51 in the Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. In response to this Item the information set forth on page 28 and on pages 53 through 85 in the Annual Report is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The executive officers of the Corporation are elected to their offices for one year terms at the meeting of the Board of Directors in April of each year. The terms of any executive officers elected after such date expire at the same time as the terms of the executive officers elected on such date. The names of each of the current executive officers of the Corporation, their ages, their current positions with the Corporation and certain subsidiaries and, if different, their business experience during the past five years, are as follows: Edward E. Crutchfield, Jr. (52). Chairman and Chief Executive Officer, the Corporation. Also, President, the Corporation, October 1988 to June 1990. John R. Georgius (49). President, the Corporation, since June 1990. Chairman and Chief Executive Officer, FUNB-NC, from October 1988 to February 1993. Vice Chairman, the Corporation, August 1987 to June 1990. President, FUNB-NC, prior to October 1988. B. J. Walker (63). Vice Chairman, the Corporation. Also, Chairman and Chief Executive Officer, FUNB-FL, prior to March 1991. Robert T. Atwood (53). Executive Vice President and Chief Financial Officer, the Corporation, since March 1991. Prior to that time, Mr. Atwood was a partner with the accounting firm of Deloitte & Touche. Marion A. Cowell, Jr. (59). Executive Vice President, Secretary, and General Counsel, the Corporation. Mr. Cowell served as Senior Vice President, Secretary and General Counsel of the Corporation prior to December 1991. In addition to the foregoing, the information set forth in the Proxy Statement under the heading General Information and Nominees, and in the last paragraph under the heading Other Matters Relating to Executive Officers and Directors is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. In response to this Item the information set forth in the Proxy Statement under the heading Executive Compensation, excluding the information under the subheadings HR Committee Report on Executive Compensation and Performance Graph, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. In response to this Item the information set forth in the Proxy Statement relating to the ownership of Common Stock and Series 1990 Preferred Stock by the directors and executive officers of the Corporation under the heading General Information and Nominees is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. In response to this Item the information set forth in the Proxy Statement in the first two paragraphs under the heading Other Matters Relating to Executive Officers and Directors is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The consolidated financial statements of the Corporation, including the notes thereto and independent auditors' report thereon, are set forth on pages 53 through 85 of the Annual Report. All financial statement schedules are omitted since the required information is either not applicable, is immaterial or is included in the consolidated financial statements of the Corporation and notes thereto. A list of the exhibits to this Form 10-K is set forth on the Exhibit Index immediately preceding such exhibits and is incorporated herein by reference. (b) During the quarter ended December 31, 1993, no current reports on Form 8-K were filed by the Corporation with the Securities and Exchange Commission. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. FIRST UNION CORPORATION Date: March 8, 1994 By: MARION A. COWELL, JR. MARION A. COWELL, JR. EXECUTIVE VICE PRESIDENT, SECRETARY AND GENERAL COUNSEL Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on the date indicated. Date: March 8, 1994 EXHIBIT INDEX * The Corporation agrees to furnish to the Securities and Exchange Commission upon request, copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its subsidiaries. * Except for those portions of the Annual Report which are expressly incorporated by reference in this Form 10-K, the Annual Report is furnished for the information of the Securities and Exchange Commission only and is not to be deemed filed as part of such Form 10-K.

38195_1993.txt

38195_1993

1993

38195

ITEM 1. BUSINESS GENERAL Fort Howard Corporation (the "Company"), founded in 1919, is a major manufacturer, converter and marketer of a diversified line of single-use sanitary tissue paper products for the home and away-from-home markets. The Company's principal products include paper towels, bath tissue, table napkins, wipers and boxed facial tissue. The Company produces and ships its products from manufacturing facilities located in Wisconsin, Oklahoma, Georgia and the United Kingdom. For an analysis of net sales, operating income (loss) and identifiable operating assets by geographic area, refer to Note 16 of the Company's audited consolidated financial statements. The Company believes that it is the largest producer of tissue products sold into the domestic commercial (away-from-home) market. The Company sells a majority of its tissue products through paper and institutional food wholesalers into commercial markets. The Company continues to expand its domestic consumer tissue business for the home market. Tissue products for household use are sold principally through brokers to accounts that include major food store chains, mass merchandisers and wholesale grocers. The Company's domestic tissue products for home use are sold under the brand names Soft 'N Gentle, Mardi Gras, Green Forest, Page and So-Dri. THE ACQUISITION In 1988, FH Acquisition Corp. ("FH Acquisition") was organized on behalf of The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II") to effect the acquisition of the Company. Pursuant to an Agreement and Plan of Merger dated as of June 25, 1988, FH Acquisition commenced a tender offer (the "Offer") on July 1, 1988 for all outstanding shares at $53 per share in cash, and subsequently purchased approximately 53.5 million shares in the Offer. Thereafter, FH Acquisition was merged with and into the Company (the "Merger"). The Offer and the Merger are referred to herein collectively as the "Acquisition." Unless the context otherwise requires, all references in this report to "Common Stock" refer to the common stock of the Company subsequent to the Merger. MSLEF II, an affiliate of Morgan Stanley & Co. Incorporated ("MS&Co."), is a limited partnership formed to finance investments in industrial and other companies. Its principal investors include major U.S. and foreign banks, insurance companies, pension funds and corporations. As a result of the Acquisition, the Company became privately held by MSLEF II and other investors. DOMESTIC TISSUE OPERATIONS The Company's principal markets are in the United States where the Company believes, based on an analysis of publicly available information, that its operating income margins are higher than those of its publicly reporting competition. A key factor contributing to these high operating income margins has been the Company's proprietary de-inking technology, which enables it to use a broad range of wastepaper grades and process wastepaper efficiently to recover the fibers which are the principal raw material in papermaking. However, the Company's operating income margins have been adversely affected by the adverse tissue industry operating conditions experienced since 1991, - 2 - and continue to be affected by low pricing resulting in part from relatively low industry operating rates. Announced industry capacity additions through 1995 and the weak economic recovery indicate that these industry conditions may continue to affect the Company's selling prices and operating income margins in the near term. Commercial Tissue The Company believes it is the leading manufacturer of tissue products for the commercial segment of the U.S. tissue market. The Company believes, based upon industry data, including data collected by the American Forest and Paper Association, that the commercial market represents approximately 40% of the total United States tissue market. The Company's primary thrust in the tissue business has been in the commercial segment which, though smaller in total size than the consumer segment, grew significantly faster than the consumer segment from 1987 to 1990. From 1991 through 1993, the commercial segment grew at a slower rate than the consumer segment due in part to the effects of the recession and weak recovery. The commercial segment of the Company's tissue business includes folded and roll towels, bath and facial tissue, bulk and dispenser napkins, disposable wipers and specialty printed merchandise. The Company also offers a line of tissue products under the Envision brand name which meets U.S. Environmental Protection Agency ("U.S. EPA") guidelines for tissue products containing postconsumer recovered wastepaper. Based primarily on the Company's analysis of publicly available information, the Company estimates that in 1993 its market share in the United States for sales of commercial tissue products was approximately 28%. Consumer Tissue The Company's consumer tissue business has experienced significant growth over the past fifteen years. Based primarily on the Company's analysis of publicly available information, the Company estimates that its market share in the United States for sales of consumer tissue products has grown from 1% in the late 1970's to approximately 9% in the most recent years. The Company's retail line includes bath and facial tissue, household roll towels and table napkins. The Company's brands include Soft 'N Gentle, Mardi Gras, Green Forest, Page and So-Dri. Green Forest bath tissue, napkins and towels, which are made with 100% recycled fibers, are marketed to the environmentally conscious consumer. In addition, the Company has become a major supplier of private label tissue products to the retail grocery trade. The market share information presented herein reflects the Company's best estimates based on publicly available information, and no assurance can be given regarding the accuracy of such estimates. INTERNATIONAL TISSUE OPERATIONS The Company's international operations consist of tissue facilities in the United Kingdom which manufacture and sell a broad line of tissue products. The Company's principal brand in the United Kingdom is Nouvelle. CAPITAL EXPENDITURES The Company has invested heavily in its manufacturing operations. Capital expenditures in the Company's tissue business were approximately $741 million for the five-year period ended December 31, 1993. Given the Company's high leverage and adverse tissue industry operating conditions, the - 3 - Company intends to continue to maintain and modernize existing tissue mills but does not currently intend to make capital expenditures to add material new capacity. Total capital expenditures after 1993 are projected to approximate $55-$80 million annually over the next ten years, plus $32 million in 1994 to complete the Muskogee mill expansion and an additional $32 million over 1994 and 1995 for a new coal-fired boiler under construction at the Company's Savannah River mill. A significant portion of the Company's capital budget in recent years has been invested in the Savannah River mill located in Effingham County, near Savannah, Georgia, which was completed in 1991. Total expenditures for the Savannah River mill were $570 million. In 1993, the Company completed an expansion of its Green Bay, Wisconsin tissue mill. The expansion includes a new paper machine and related environmental protection, pulp processing, converting, and steam generation equipment. The new paper machine commenced production on August 31, 1992. Total expenditures for the expansion were $180 million. In 1992, the Company began the installation of a fifth paper machine, environmental protection equipment and associated facilities at its Muskogee, Oklahoma tissue mill. The expansion is planned for completion in 1994 at an estimated cost of $140 million. Total expenditures for the expansion through December 31, 1993 were $109 million. In 1993, the Company completed an expansion of its United Kingdom tissue mill. The expansion included a new paper machine and related environmental protection, pulp processing and converting equipment. The new paper machine commenced production on February 7, 1993. Total expenditures for the expansion were $96 million. See "Item 2. ITEM 2. PROPERTIES The Company's Green Bay, Wisconsin tissue mill includes a coal-fired cogenerating power plant; a de-inking and pulp processing plant; a chemical plant; papermaking machines and related drying equipment; nonwoven and dry form manufacturing machines; and converting equipment for cutting, folding, printing and packaging paper and nonwovens into the Company's finished products. The Company's Green Bay mill is well maintained and considered suitable for its intended purpose. A second domestic tissue mill is located in Muskogee, Oklahoma. This mill includes a coal-fired cogenerating power plant; a de-inking and pulp processing plant; a chemical plant; papermaking machines and related drying equipment; and converting equipment for cutting, folding, printing and packaging paper into the Company's finished products. The Muskogee mill was specifically designed for its purpose. A third domestic tissue mill, the Savannah River mill, is located in Effingham County, near Savannah, Georgia. This mill includes a de-inking and pulp processing plant; a chemical plant; papermaking machines and related drying equipment; and converting equipment for the cutting, folding, printing and packaging of paper into the Company's finished products. The Savannah River mill also contains coal-fired cogenerating power equipment and combustion turbines for the production of electrical power and steam. The Savannah River mill was specifically designed for its purpose. The Company's tissue manufacturing facilities in the United Kingdom include a de-inking and pulp processing plant; papermaking machines and related drying equipment; and converting equipment for the cutting, folding, printing and packaging of paper into the Company's finished products. The Company's United Kingdom operations are well maintained and considered suitable for their intended purpose. Except for certain facilities and equipment constructed or acquired in connection with sale and leaseback transactions pursuant to which the Company continues to possess and operate such facilities and equipment, substantially all the Company's manufacturing facilities and equipment are owned in fee. The Company's domestic and United Kingdom tissue manufacturing facilities are pledged as collateral under the terms of the Company's debt agreements. See Note 8 to the audited consolidated financial statements. The Green Bay, Muskogee, Savannah River and United Kingdom facilities generally operate paper machines at full capacity seven days per week. Converting facilities are generally operated on a 3-shift, 5-day per week basis or a 7-day per week schedule. Converting capacity could be expanded by working additional hours and/or adding converting equipment. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties to lawsuits and state and federal administrative proceedings in connection with their businesses. Although the final results in such suits and proceedings cannot be predicted with certainty, the Company believes that they will not have a material adverse effect on the Company's financial condition. The Internal Revenue Service ("IRS") issued a statutory notice of deficiency ("Notice") to the Company in March 1992 for additional income tax for the 1988 tax year. The Notice resulted from an audit of the Company's - 8 - 1988 tax year wherein the IRS adjusted income and disallowed deductions, including deductions for fees and expenses related to the Acquisition. The IRS also disallowed deductions for fees and expenses related to 1988 debt financing and refinancing transactions. In March 1992, the Company filed a petition in the U.S. Tax Court opposing substantially all of the claimed deficiency and the case was tried in September 1993. After the trial, the Company and the IRS executed an agreed Supplemental Stipulation of Facts by which the IRS and the Company partially settled the case by agreeing that certain fees and expenses (previously disallowed by the IRS and potentially representing approximately $26 million of tax liability) were properly deductible by the Company over the term of the 1988 debt financing and refinancing. In addition, the Company agreed to capitalize certain amounts identified by the IRS and paid additional federal income tax of approximately $5 million representing its liability with respect to the agreed adjustments. The U.S. Tax Court has not yet decided the points that remain in dispute in the case after the partial settlement. The Company estimates that if the IRS were to prevail in disallowing deductions for the fees and expenses remaining in dispute before the trial judge, the potential amount of additional taxes due the IRS on account of such disallowance for the period 1988 through 1993 would be approximately $31 million and for the periods after 1993 (assuming current statutory tax rates) would be approximately $11 million, in each case exclusive of IRS interest charges. Since the Company's 1988 tax case involves disputed issues of law and fact, the Company is unable to predict its final result with certainty. The Company believes, however, that its ultimate resolution will not have a material adverse effect on the Company's financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS There is no public market for the stock of the Company. The number of holders of record of the Company's Common Stock as of December 31, 1993 was 61. - 9 - ITEM 6. ITEM 6. SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA - 10 - (a) Effective January 1, 1992, the Company prospectively changed its estimates of the depreciable lives of certain machinery and equipment. The change had the effect of reducing depreciation expense by approximately $38 million and net loss by $24 million in 1992. (b) During the third quarter of 1993, the Company wrote off the unamortized balance of its goodwill of $1.98 billion. See Note 4 of the Company's audited consolidated financial statements. (c) In 1989, the Company transferred all the capital stock of Fort Howard Cup Corporation to Sweetheart Holdings Inc. ("Sweetheart") for a 49.9% equity interest in Sweetheart and other assets for a total consideration of $620 million (the "Cup Transfer"). The Company also undertook a plan to divest all its remaining international cup operations. As a result, the Company recorded a $120 million charge in 1989. As of December 31, 1991, the Company had sold all its international cup operations and had discontinued recording equity in net losses of Sweetheart because the carrying value of the the Company's investment in Sweetheart was reduced to zero. During the third quarter of 1993, the Company sold its remaining equity interest in Sweetheart for $5.1 million recognizing a gain of the same amount. (d) Reflects the cumulative effect on years prior to 1992 of adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This change in accounting principle, excluding the cumulative effect, decreased operating income for 1992 by $1.2 million. (e) Represents operating income plus depreciation of property, plant and equipment, amortization of goodwill, the goodwill write-off and the effects of employee stock compensation (credits). EBDIAT is presented here, not as a measure of operating results, but rather as a measure of the Company's debt service ability. Certain financial and other restrictive covenants in the Company's Bank Credit Agreement, the 1993 Term Loan Agreement, the Senior Secured Note Agreement and other instruments governing the Company's indebtedness are based on the Company's EBDIAT, subject to certain adjustments. (f) For purposes of these computations, earnings consist of consolidated income (loss) before taxes plus fixed charges (excluding capitalized interest) of both consolidated and unconsolidated subsidiaries. Amounts applicable to unconsolidated subsidiaries are excluded from such computations commencing on November 14, 1989, due to the Cup Transfer. Fixed charges consist of interest on indebtedness (including capitalized interest and amortization of deferred loan costs) plus that portion (deemed to be one-fourth) of operating lease rental expense representative of the interest factor. - 11 - ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Acquisition was accounted for using the purchase method of accounting. The aggregate purchase price of approximately $3.7 billion, including related acquisition costs, was allocated first to the assets and liabilities of the Company based upon their respective fair values, with the remainder of approximately $2.3 billion allocated to goodwill. In the third quarter of 1993, the Company wrote-off its remaining goodwill balance of $1.98 billion. RESULTS OF OPERATIONS Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- (In millions, except percentages) Net sales: Domestic tissue................ $ 1,004 $ 978 $ 994 International operations....... 143 143 110 Eliminations and other......... 40 30 34 ------- ------ ------ Consolidated................... $ 1,187 $1,151 $1,138 ======= ====== ====== Operating income (loss): Domestic tissue(a)(b).......... $(1,715) $ 252 $ 251 International operations(a).... (1) 17 16 Eliminations and other(a)...... (1) 2 3 ------- ------ ------ Consolidated(b)................ (1,717) 271 270 Amortization of purchase accounting..................... 57 75 85 Goodwill write-off(a)............ 1,980 -- -- Employee stock compensation...... (8) 1 1 ------- ------ ------ Adjusted operating income...... 312 347 356 Other depreciation............... 75 63 88 ------- ------ ------ EBDIAT......................... $ 387 $ 410 $ 444 ======= ====== ====== Consolidated net loss............ $(2,052) $ (80) $ (111) ======= ====== ====== EBDIAT as a percent of net sales...................... 32.6% 35.6% 39.0% (a) See Note 4 to the audited consolidated financial statements. (b) Effective January 1, 1992, the Company prospectively changed its estimates of the depreciable lives of certain machinery and equipment. The change had the effect of reducing depreciation expense and increasing operating income by approximately $38 million in 1992. - 12 - A progressive decline in domestic commercial and consumer market selling prices occurred during 1991. Low industry operating rates and aggressive competitive pricing among tissue producers resulting from the recession, additions to capacity in the industry and other factors adversely affected tissue industry operating conditions in 1991. These conditions persisted through 1992 and 1993 causing further price declines. Although the Company introduced domestic net selling price increases in each of the first three quarters of 1993, industry operating rates were relatively low during this period and are expected to be relatively low in the first quarter of 1994, a period of seasonally lower volume. Accordingly, in the first quarter of 1994, the Company's results may be adversely affected as a result of weak industry demand. In addition, announced industry capacity additions through 1995 and the weak economic recovery indicate that these industry conditions may continue to affect the Company's net selling prices and operating income margins in the near term. Fiscal Year 1993 Compared to Fiscal Year 1992 Net Sales. Consolidated net sales for 1993 increased 3.1% compared to 1992. Domestic tissue net sales for 1993 increased 2.7% compared to 1992 due to volume increases that were largely offset by lower net selling prices. In mid-1992, average net selling prices rose principally as a result of an attempted price increase in the commercial market but then fell to pre-price increase levels in the fourth quarter of 1992 and fell again in the first quarter of 1993, periods of seasonally lower volume shipments. Average net selling prices held flat from the first quarter of 1993 to the second quarter of 1993 and increased in each of the third and fourth quarters of 1993 from the previous quarter levels. However, in spite of introductions of net selling price increases in each of the first three quarters of 1993, average net selling prices for 1993 were below average net selling prices for 1992. Net sales of the Company's international operations were flat in 1993 compared to 1992 primarily due to significantly lower net selling prices and lower exchange rates offset by volume increases resulting from the acquisition of Stuart Edgar and the start-up of a new paper machine. United Kingdom retailers engaged in increasingly competitive pricing activity in 1993 across a broad range of consumer products including disposable paper products. Such competitive pricing activity is expected to continue into 1994. Gross Income. Consolidated gross margins decreased to 34.0% in 1993 compared to 36.9% in 1992. Domestic tissue gross margins decreased to 37.4% in 1993 from 40.0% in 1992 primarily due to lower net selling prices and an increase in wastepaper costs. Gross margins of international operations also declined in 1993 principally due to the lower net selling prices. Unit manufacturing costs of international operations declined in 1993 compared to 1992 as a result of the start-up of a new paper machine and related facilities in the first quarter of 1993 at the Company's United Kingdom tissue operations. Selling, General and Administrative Expenses. Due to the effects of adverse tissue industry operating conditions on its long-term earnings forecast, the Company decreased the estimated fair market valuation of its Common Stock. Accordingly, in 1993 the Company reversed all previously accrued employee stock compensation expense of $8 million, resulting in a decrease in selling, general and administrative expenses, as a percent of net sales, to 8.2% in 1993 from 8.5% in 1992. Excluding the effects of employee stock compensation from both years, selling, general and administrative expenses, as a percent of net sales, would have increased slightly in 1993 to 8.8% from 8.4% for 1992. - 13 - Goodwill Write-Off. As previously reported by the Company (and as further described below), low industry operating rates and aggressive competitive pricing among tissue producers resulting from the recession, additions to industry capacity and other factors have been adversely affecting tissue industry operating conditions and the Company's operating results since 1991. Declining Selling Prices. Although sales volumes have increased, industry pricing has been very competitive due to the factors discussed below. The Company's average domestic net selling prices have declined by approximately 5% in each of 1991 and 1992. Commercial market price increases attempted in mid-1992 were not achieved as commercial market pricing fell to pre-price increase levels in the fourth quarter of 1992 and fell again in the first quarter of 1993, periods of seasonally lower volume shipments. Average net selling prices held flat from the first quarter of 1993 to the second quarter of 1993 and increased from the second to the third quarter of 1993. However, in spite of introductions of net selling price increases in each of the first three quarters of 1993, average net selling prices for the first nine months of 1993 were below average net selling prices for the same period in 1992. Pricing in the Company's international markets declined significantly over this time period as well. Industry Operating Rates. Based on publicly available information, including data collected by the American Forest and Paper Association ("AFPA"), industry capacity additions in 1990 through 1992 significantly exceeded historic capacity addition rates. Such additions and weak demand caused industry operating rates to fall to very low levels in 1991 and 1992 in comparison to historic rates. Tissue industry operating rates increased only slightly during the first nine months of 1993 from the low levels experienced in 1991 and 1992. Announced tissue industry capacity additions through 1995, as reported by the AFPA through the first three quarters of 1993, approximated average industry shipment growth rates after 1990. For the first nine months of 1993, the industry shipment growth rate fell sharply from the already low rates in 1991 and 1992. Consequently, without an improved economic recovery and improved industry demand, tissue industry operating rates may remain at relatively low levels for the near term, adversely affecting industry pricing. Economic Conditions. The recession and weak recovery have continued to adversely affect tissue market growth. Job formation is an important stimulus for growth in the commercial tissue market where approximately two-thirds of the Company's domestic tissue sales are targeted. Since 1990, job formation has been weak and was projected to improve only slightly in 1994. Accordingly, demand growth was weak in 1991, 1992 and in the first nine months of 1993, and does not appear to offer any substantial relief to the outlook for industry operating rates and pricing for the near term. Gross Margins. The Company's gross margins steadily declined in 1991, 1992 and 1993 as a result of the factors noted above. In 1993, the Company's gross margins were also affected by increased wastepaper costs. As a result of these conditions, the Company expected that the significant pricing deterioration experienced in 1991 through mid-1993 would be followed by average annual price increases that approximated the Company's annual historical price increase trend for the years 1984 through 1993 of approximately 1% per year. Accordingly, during the second quarter of 1993, the Company commenced an evaluation of the carrying value of its goodwill for possible impairment. The Company revised its projections and concluded its evaluation in the third quarter of 1993 determining that its forecasted - 14 - cumulative net income before goodwill amortization was inadequate to recover the future amortization of the Company's goodwill balance over the remaining amortization period of the goodwill. For a more detailed discussion of the methodology and assumptions employed to assess the recoverability of the Company's goodwill, refer to Note 4 of the Company's audited consolidated financial statements. Operating Income (Loss). As a result of the goodwill write-off, the Company's operating loss was $1,717 million for 1993 compared to operating income of $271 million for 1992. The depreciation of asset write-ups to fair market value in purchase accounting is charged against the Company's cost of sales and selling, general and administrative expenses. Excluding this purchase accounting depreciation, amortization of goodwill, the goodwill write-off and the reversal of employee stock compensation, adjusted operating income (as reported in the preceding table) declined to $312 million for 1993 from $347 million for 1992. Adjusted operating income declined in 1993 compared to 1992 principally due to the effects of lower domestic and foreign net selling prices, higher wastepaper costs in the U.S. and lower exchange rates. EBDIAT. Earnings before depreciation, interest, amortization and taxes ("EBDIAT") declined to $387 million for 1993 from $410 million for 1992. EBDIAT is reported by the Company, not as a measure of operating results, but rather as a measure of the Company's debt service ability. Certain financial and other restrictive covenants in the Company's Bank Credit Agreement, the Senior Secured Note Agreement, the 1993 Term Loan Agreement and other instruments governing the Company's indebtedness are based on the Company's EBDIAT, subject to certain adjustments. Other Income, Net. In 1993, the Company sold its remaining equity interest in Sweetheart for $5.1 million recognizing a gain of the same amount. The Company had previously reduced the carrying value of its investment in Sweetheart to zero in 1991. Income Taxes. The income tax credit for 1993 principally reflects the reversal of previously provided deferred income taxes. The income tax credit for 1992 reflects the reversal of previously provided deferred income taxes related to domestic tissue operations offset almost entirely by foreign income taxes. Extraordinary Loss and Accounting Change. The Company's net loss in 1993 was increased by an extraordinary loss of $12 million (net of income taxes of $7 million) representing the write-off of unamortized deferred loan costs associated with the repayment of $250 million of term loan indebtedness under the Company's Bank Credit Agreement (the "Term Loan"), the repurchase of all the Company's 14 5/8% Junior Subordinated Debentures due 2004 (the "14 5/8% Debentures") and the repurchase of $50 million of the Company's 12 3/8% Senior Subordinated Notes due 2000 (the "12 3/8% Notes"). The net loss for 1992 was increased by the Company's adoption of Statement of Financial Accounting Standards ("SFAS") No. 106. The cumulative effect on years prior to 1992 of adopting SFAS No. 106 is stated separately in the Company's unaudited condensed consolidated statement of income for 1992 as a one-time, after-tax charge of $11 million. Net Loss. For 1993, the Company's net loss increased, principally due to the goodwill write-off, to $2,052 million compared to $80 million for 1992. - 15 - Fiscal Year 1992 Compared to Fiscal Year 1991 Net Sales. Domestic tissue sales decreased 1.6% in 1992 compared to 1991. The decrease was attributable to lower net selling prices which were partially offset by volume increases. Net sales of the Company's United Kingdom tissue operations increased 30.0% in 1992 compared to 1991. The increase primarily was due to volume increases in both the consumer and commercial markets, and to a lesser extent, due to the acquisition of Stuart Edgar in September 1992, partially offset by lower net selling prices and lower exchange rates. Gross Income. Effective January 1, 1992, the Company prospectively changed its estimates of the depreciable lives of certain machinery and equipment. These changes were made to better reflect the estimated periods during which such assets will remain in service. As a result, the Company believes, based primarily on an analysis of publicly available information, that the lives over which the Company depreciates the cost of its operating equipment and other capital assets more closely approximates industry norms. For 1992, the change had the effect of reducing depreciation expense by $38 million and reducing net loss by $24 million. Domestic tissue gross margins increased slightly in 1992 to 40.0% compared to 39.4% in 1991 due to lower depreciation expense and lower raw material costs, which were largely offset by the decline in net selling prices. Excluding the effects of the changes in depreciable lives, domestic tissue gross margins would have declined to 36.1% in 1992. Gross margins for international operations declined in 1992 due to purchases of parent rolls to support volume increases in anticipation of the start-up of a new paper machine in 1993 and the effects of the acquisition of Stuart Edgar. Selling, General and Administrative Expenses. Selling, general and administrative expenses, as a percent of net sales, decreased to 8.5% in 1992 compared to 8.6% in 1991. These results occurred principally due to an overall cost containment effort on the part of the Company, partially offset by the effects of the lower net selling prices and higher volume. Operating Income. Operating income of $271 million in 1992 was flat with operating income in 1991. The depreciation of asset write-ups to fair market value in purchase accounting is charged against the Company's cost of sales and selling, general and administrative expenses. Excluding this purchase accounting depreciation, amortization of goodwill and employee stock compensation, adjusted operating income would have been $347 million and $356 million or 30.1% and 31.3% as a percent of net sales in 1992 and 1991, respectively. Adjusted operating income as a percent of net sales declined in 1992 from 1991 due to the effects in 1992 of lower net selling prices, the higher volume growth rate of the lower margin international operations compared to domestic operations and the acquisition of Stuart Edgar, partially offset by the effects of the changes in depreciable lives. EBDIAT. EBDIAT declined $34 million in 1992 to $410 million from $444 million in 1991 and declined as a percent of net sales to 35.6% in 1992 from 39.0% in 1991. Interest Expense. Interest expense declined approximately $33 million in 1992 as compared to 1991. Debt repurchased with the proceeds of a private placement of Common Stock in 1991 reduced the Company's average outstanding indebtedness in 1992 compared to 1991. Lower average interest rates, in part - 16 - due to borrowings under the Company's Revolving Credit Facility to repurchase high yield subordinated debt, also contributed to lower interest expense in 1992 as compared to 1991. Equity Earnings. The Company's results for 1992 exclude any equity in the net loss of Sweetheart for the year compared to equity in net losses totaling $32 million in 1991. The Company discontinued the recording of equity in the net losses of Sweetheart, an unconsolidated subsidiary, when the carrying value of its investment in Sweetheart was reduced to zero in the fourth quarter of 1991. Income Taxes. The lower income tax credit for 1992 reflects the Company's lower domestic net loss for the year, offset by foreign income taxes. The income tax credit for 1991 principally reflects the reversal of previously provided deferred income taxes. Extraordinary Loss and Accounting Change. Results for 1991 were impacted by an extraordinary loss of $5 million (net of income taxes) related to debt repurchases. As of January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The standard requires that the expected cost of postretirement health care benefits be charged to expense during the years that employees render service. The cumulative effect on years prior to 1992 of adopting SFAS No. 106 is stated separately in the Company's consolidated statement of income for 1992 as a one-time after-tax charge of $11 million. This change in accounting principle, excluding the cumulative effect, decreased operating income for 1992 by $1 million. Net Loss. For 1992, the Company's net loss decreased 27.7% to $80 million from $111 million in 1991. Excluding the effects of the changes in depreciable lives and the change in accounting principle for postretirement benefits in 1992, and excluding the extraordinary item attributable to debt repurchases and equity in net losses incurred by unconsolidated subsidiaries in 1991, the net loss for 1992 would have increased 7.3% compared to 1991. LIQUIDITY AND CAPITAL RESOURCES During 1993, cash increased $39,000. Capital additions of $166 million and debt repayments of $841 million, including the repayment of $250 million of the Term Loan, the repurchase of all the 14 5/8% Debentures, and the repurchase of $50 million of the 12 3/8% Notes, were funded principally by cash provided from operations of $151 million, net proceeds from the sale of 9 1/4% Senior Unsecured Notes due 2001 (the "9 1/4% Notes") and 10% Subordinated Notes due 2003 (the "10% Notes") of $729 million, net proceeds of a new bank term loan in 1993 (the "1993 Term Loan") of $95 million, borrowings of $28 million under the revolving credit facility under the Bank Credit Agreement (the "Revolving Credit Facility") and Fort Sterling borrowings of $9 million. During 1992, cash decreased $9 million. Capital additions of $233 million, the acquisition of Stuart Edgar for $8 million (net of debt assumed of $17 million) and debt repayments of $168 million, principally for the retirement of the Company's 7% Notes due 1992 (the "7% Notes"), were funded principally by cash provided from operations of $210 million, borrowings under the Revolving Credit Facility of $141 million and borrowings of $49 million by Fort Sterling. - 17 - Although the obligations under the Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement bear interest at floating rates, the Company is required to enter into interest rate agreements which effectively fix or limit the interest cost to the Company. Pursuant to the Bank Credit Agreement, the Company is a party to interest rate cap agreements which limit the interest cost to the Company to 8.25% (including the Company's borrowing margin on Eurodollar rate loans) until June 1, 1996, with respect to $500 million. Pursuant to the 1993 Term Loan Agreement, the Company is party to an interest rate swap agreement which limits the interest cost to the Company to 6.53% (including the Company's borrowing margin on Eurodollar rate loans) until April 21, 1994 with respect to $100 million. The Company is also a party to an interest rate cap agreement which limits the interest cost to the Company to rates between 11.25% and 12.00% until September 11, 1994, with respect to $300 million received through the issuance of the Senior Secured Notes. See Note 8 to the Company's audited consolidated financial statements for additional information concerning the agreements. On March 22, 1993, the Company sold $450 million principal amount of 9 1/4% Notes due 2001 and $300 million principal amount of 10% Notes due 2003 in a registered public offering (collectively, the "1993 Notes"). On April 21, 1993, the Company borrowed $100 million pursuant to the 1993 Term Loan. Proceeds from the sale of the 1993 Notes and from the 1993 Term Loan were applied to the prepayment of $250 million of the Term Loan, to the repayment of a portion of the Company's indebtedness under the Revolving Credit Facility, to the repurchase of all the Company's outstanding 14 5/8% Debentures and to the payment of fees and expenses. The 9 1/4% Notes are senior unsecured obligations of the Company, rank equally in right of payment with the other senior indebtedness of the Company and are senior to all existing and future subordinated indebtedness of the Company. The 10% Notes are subordinated in right of payment to all existing and future senior indebtedness of the Company, including the 12 3/8% Notes (to be repurchased in 1994 as described below), rank equally with the 12 5/8% Subordinated Debentures due 2000 (the "12 5/8% Debentures") and constitute senior indebtedness with respect to the 14 1/8% Junior Subordinated Discount Debentures due 2004 (the "14 1/8% Debentures"). The 1993 Term Loan bears interest, at the Company's option, at Bankers Trust's prime rate, plus 1.75% or, subject to certain limitations, at a reserve adjusted Eurodollar rate, plus 3.00%, and matures May 1, 1997. The 1993 Term Loan constitutes senior secured indebtedness of the Company. In connection with the sale of the 1993 Notes and the borrowing under the 1993 Term Loan, the Company amended the Bank Credit Agreement and the Senior Secured Note Agreement. Among other changes, the amendments reduced domestic capital spending limits for 1993 and future years. In addition, the Company's required ratios of earnings before non-cash charges, interest and taxes to cash interest for 1993 and subsequent years were lowered to give effect to the greater amount of the Company's cash interest payments as a result of the issuance of the 9 1/4% Notes and the 10% Notes and subsequent repurchases of 14 5/8% Debentures. The Company redeemed $50 million of its 12 3/8% Notes at the redemption price of 105% of the principal amount thereof on November 1, 1993, the first date that such notes were redeemable. The redemption was funded principally from excess funds from the sale of the 1993 Notes. In connection with the redemption, the Company incurred an extraordinary loss in the fourth quarter of 1993 of $2 million (net of income taxes), representing the redemption premium and unamortized deferred loan costs. - 18 - On February 9, 1994, the Company sold $100 million principal amount of 8 1/4% Senior Unsecured Notes due 2002 (the "8 1/4% Notes") and $650 million principal amount of 9% Senior Subordinated Notes due 2006 (the "9% Notes") in a registered public offering (collectively, the "1994 Notes"). Proceeds from the sale of the 1994 Notes have been or will be applied to the repurchase of all the remaining 12 3/8% Notes at the redemption price of 105% of the principal thereof, to the repurchase of $238 million of 12 5/8% Debentures at the redemption price of 105% of the principal thereof, to the prepayment of $100 million of the Term Loan, to the repayment of a portion of the Company's indebtedness under the Revolving Credit Facility and to the payment of fees and expenses. The 8 1/4% Notes are senior unsecured obligations of the Company, rank equally in right of payment with the other senior indebtedness of the Company and are senior to all existing and future subordinated indebtedness of the Company. The 9% Notes are subordinated in right of payment to all existing and future senior indebtedness of the Company, and constitute senior indebtedness with respect to the 10% Notes, the 12 5/8% Debentures and the 14 1/8% Debentures. In connection with the sale of the 1994 Notes, the Company amended the Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement. Among other changes, the amendments reduced the required ratio of earnings before non-cash charges, interest and taxes to cash interest for the four fiscal quarters ending March 31, 1994, from 1.50 to 1.00 to 1.40 to 1.00. The Company will incur an extraordinary loss of $27 million (net of income taxes of $16 million) in the first quarter of 1994 representing the redemption premiums on the repurchases of the 12 3/8% Notes and the 12 5/8% Debentures, and the write-off of deferred loan costs associated with the repayment of the $100 million of the Term Loan and the repurchases of the 12 3/8% Notes and the 12 5/8% Debentures. In 1991, Fort Sterling entered into a credit agreement to provide financing for the addition of a third paper machine and related equipment at its tissue mill. The facility consists of a 20 million pound sterling (approximately $30 million) term loan due March 2001, and a 5 million pound sterling (approximately $7 million) revolving credit facility due March 1996. In 1992, Fort Sterling entered into a second credit agreement to finance the acquisition of Stuart Edgar. This facility consists of a term loan due December 1997 with 3.4 million pounds sterling (approximately $5 million) outstanding at December 31, 1993, and a second term loan due December 1997 with 6.8 million pounds sterling (approximately $10 million) outstanding at December 31, 1993. Both credit agreements bear interest at floating rates and are secured by certain assets of Fort Sterling and Stuart Edgar but are nonrecourse to the Company. At December 31, 1993, $47 million was outstanding under these credit agreements. The Company's principal use of funds for the next several years will be for the repayment of indebtedness under the Bank Credit Agreement, the repurchase of the 12 5/8% Debentures and the 14 1/8% Debentures, capital expenditures, including capital expenditures to comply with environmental regulations, the repurchase of its subordinated debt securities generally as described below, and support of the Company's working capital requirements. The Term Loan matures and the Revolving Credit Facility expires in 1996. In connection with the sale of the 1994 Notes, the Company prepaid $100 million of the $107 million mandatory payment due under the Term Loan in 1994, will - 19 - repurchase all the 12 3/8% Notes that were due in 1997 and will repurchase $238 million principal amount of the 12 5/8% Debentures due in 2000. The Company is required to make repayments of the Term Loan of $107 million in 1995 and $118 million in 1996. The 1993 Term Loan matures in 1997. The Company intends to use funds generated from operations and borrowings under the Bank Credit Agreement or from other sources to meet its principal needs for funds. Given the Company's high leverage and adverse tissue industry operating conditions, the Company intends to continue to maintain and modernize existing tissue mills but does not currently intend to make capital expenditures to add material new capacity. Capital expenditures were $166 million, $233 million and $144 million in 1993, 1992 and 1991, respectively. Capital expenditures are projected to approximate $55-$80 million annually over the next ten years, plus $32 million in 1994 to complete the Muskogee mill expansion and another $32 million over 1994 and 1995 for a new coal-fired boiler under construction at the Company's Savannah River mill. The Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement impose limits for domestic capital expenditures, subject to certain exceptions, of $175 million for 1994, $100 million for 1995 and $100 million for 1996 (with lower sublimits for foreign subsidiaries). In addition, the Company may carryover to one or more years (thereby increasing the scheduled permitted limit for capital expenditures in respect of such year) the sum of all previously unutilized amounts in 1993 and subsequent years (up to $400 million per year) by which the scheduled permitted limit for each prior year exceeded the capital expenditures actually made in respect of such prior year. The Company does not believe such limitations impair its plans for capital expenditures. For a discussion of the Company's capital expenditures in connection with environmental control matters, see "Item 1 - Business - Environmental Matters." Market conditions with respect to high yield debt securities may from time to time be such that it is to the Company's advantage to repurchase some or all of its subordinated debt securities in privately negotiated transactions or in the open market. However, the repurchase of subordinated debt securities is limited by certain provisions contained in the Company's senior debt agreements and the indentures under which such subordinated debt securities were issued. As of December 31, 1993, the Company may borrow up to $39 million to repurchase 14 1/8% Debentures. Subsequent to the issuance of the 1994 Notes, the Company may borrow up to $75 million to repurchase 12 5/8% Debentures, until June 30, 1995. Subject to and in compliance with the limitations contained in the Company's debt agreements, and depending upon market conditions, prevailing prices and cash available, the Company may from time to time repurchase subordinated debt. The Company has a $350 million Revolving Credit Facility (including letters of credit) under the Bank Credit Agreement with a final maturity of December 31, 1996, which may be used for general corporate purposes. At December 31, 1993, the Company had $106 million in available capacity under the Revolving Credit Facility. The Company believes that, notwithstanding the adverse tissue industry operating conditions and the non-cash charge to write-off the remaining balance of the Company's goodwill discussed above, cash provided by operations and access to debt financing in the public and private markets will be sufficient to enable it to fund maintenance and modernization capital expenditures and meet its debt service requirements for the foreseeable future. However, in the absence of improved financial results, it is likely - 20 - that in 1995 the Company would be required to seek a waiver of the cash interest coverage covenant under the Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement because the Company's 14 1/8% Debentures will accrue interest in cash commencing on November 1, 1994 and will require payments of interest in cash on May 1, 1995. Although the Company believes that it will be able to obtain appropriate waivers from its lenders, there can be no assurance that this will be the case. During 1993, 1992, and 1991, a slightly higher amount of the Company's revenues and operating income have been recognized during the second and third quarters. The Company expects to fund seasonal working capital needs from the Revolving Credit Facility. The Bank Credit Agreement, the 1993 Term Loan Agreement, the Senior Secured Note Agreement, and the Fort Sterling credit agreements impose certain limitations on the liquidity of the Company that include restrictions on the Company's ability to incur additional indebtedness and mandatory principal repayment requirements, including scheduled principal repayments and repayments out of excess cash flow and from proceeds of asset sales. Refer to Note 8 to the audited consolidated financial statements for a description of other covenants under the terms of the Company's debt agreements. The limitations contained in the Bank Credit Agreement, the 1993 Term Loan Agreement, the Senior Secured Note Agreement, and in the Company's indentures on the ability of the Company and its subsidiaries to incur indebtedness, together with the highly leveraged position of the Company, could limit the Company's ability to effect future financings and may otherwise restrict corporate activities, including the Company's ability to take advantage of business opportunities which may arise or to take actions that require funds in excess of those available to the Company. In addition, as a result of the Company's highly leveraged position and related debt service obligations, the Company will be less able to meet its obligations during a further downturn in its business. Refer to Note 7 to the audited consolidated financial statements for a description of certain matters related to income taxes. - 21 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of FORT HOWARD CORPORATION: We have audited the accompanying consolidated balance sheets of Fort Howard Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for the years ended December 31, 1993, 1992 and 1991. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Fort Howard Corporation and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for the years ended December 31, 1993, 1992 and 1991, in conformity with generally accepted accounting principles. As discussed in Notes 1, 7 and 10 to the consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for postretirement benefits other than pensions and income taxes. ARTHUR ANDERSEN & CO. Milwaukee, Wisconsin, February 1, 1994 - 22 - FORT HOWARD CORPORATION CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) Year Ended December 31, ------------------------------ 1993 1992 1991 ---- ---- ---- Net sales............................... $ 1,187,387 $1,151,351 $1,138,210 Cost of sales........................... 784,054 726,356 713,135 ----------- ---------- ---------- Gross income............................ 403,333 424,995 425,075 Selling, general and administrative..... 96,966 97,620 97,885 Amortization of goodwill................ 42,576 56,700 56,658 Goodwill write-off...................... 1,980,427 -- -- ----------- ---------- ---------- Operating income (loss)................. (1,716,636) 270,675 270,532 Interest expense........................ 342,792 338,374 371,186 Other (income) expense, net............. (2,996) 2,101 (2,655) ----------- ---------- ---------- Loss before taxes....................... (2,056,432) (69,800) (97,999) Income taxes (credit)................... (16,314) (398) (23,963) ----------- ---------- ---------- Loss before equity earnings, extraordinary items and adjustment for accounting change................. (2,040,118) (69,402) (74,036) Equity in net loss of unconsolidated subsidiaries.......................... -- -- (31,504) ----------- ---------- ---------- Net loss before extraordinary items and adjustment for accounting change..................... (2,040,118) (69,402) (105,540) Extraordinary items - losses on debt repurchases (net of income taxes of $7,333 in 1993 and $3,090 in 1991)....................... (11,964) -- (5,044) Adjustment for adoption of SFAS No. 106.......................... -- (10,587) -- ----------- ---------- ---------- Net loss................................ $(2,052,082) $ (79,989) $ (110,584) =========== ========== ========== Loss per share: Net loss before extraordinary items and adjustment for accounting change .................. $ (347.99) $ (11.83) $ (19.67) Extraordinary items................... (2.04) -- (0.94) Adjustment for adoption of SFAS No. 106 ....................... -- (1.81) -- ----------- ---------- ---------- Net loss ............................... $ (350.03) $ (13.64) $ (20.61) =========== ========== ========== The accompanying notes are an integral part of these consolidated financial statements. - 23 - FORT HOWARD CORPORATION CONSOLIDATED BALANCE SHEETS (In thousands) December 31, ------------------ 1993 1992 ---- ---- Assets Current assets: Cash and cash equivalents................... $ 227 $ 188 Receivables, less allowances of $2,366 and $1,376......................... 105,834 103,491 Inventories................................. 118,269 100,975 Deferred income taxes....................... 14,000 10,000 Income taxes receivable..................... 9,500 2,500 ----------- ---------- Total current assets...................... 247,830 217,154 Property, plant and equipment................. 1,845,052 1,694,946 Less: Accumulated depreciation............. 516,938 437,518 ----------- ---------- Net property, plant and equipment......... 1,328,114 1,257,428 Goodwill, net of accumulated amortization of $247,495 in 1992......................... -- 2,023,416 Other assets.................................. 73,843 76,569 ----------- ---------- Total assets............................ $1,649,787 $3,574,567 ========== ========== Liabilities and Shareholders' Equity (Deficit) Current liabilities: Accounts payable............................ $ 101,665 $ 104,405 Interest payable............................ 54,854 33,057 Income taxes payable........................ 122 1,792 Other current liabilities................... 70,138 64,282 Current portion of long-term debt........... 112,750 137,747 ----------- ---------- Total current liabilities................. 339,529 341,283 Long-term debt................................ 3,109,838 2,953,027 Deferred and other long-term income taxes. ... 243,437 259,625 Other liabilities............................. 26,088 36,473 Voting Common Stock with put right............ 11,820 13,219 Shareholders' equity (deficit): Voting Common Stock......................... 600,459 600,465 Cumulative translation adjustment........... (5,091) (3,915) Retained earnings (deficit)................. (2,676,293) (625,610) ----------- ---------- Total shareholders' equity (deficit)...... (2,080,925) (29,060) ----------- ---------- Total liabilities and shareholders' equity (deficit)...................... $1,649,787 $3,574,567 ========== ========== The accompanying notes are an integral part of these consolidated financial statements. - 24 - FORT HOWARD CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Year Ended December 31, ---------------------------- 1993 1992 1991 ---- ---- ---- Cash provided from (used for) operations: Net loss................................ $(2,052,082) $(79,989) $(110,584) Depreciation and amortization........... 130,671 137,977 172,671 Goodwill write-off...................... 1,980,427 -- -- Non-cash interest expense............... 100,844 139,700 141,362 Deferred income tax (credit)............ (17,874) (17,799) (34,881) Employee stock compensation............. (7,832) 1,120 1,256 Equity in net loss of unconsolidated subsidiaries........... -- -- 31,504 Pre-tax loss on debt repurchases........ 19,297 -- 8,134 Pre-tax adjustment for adoption of SFAS No. 106....................... -- 17,076 -- (Increase) decrease in receivables .... (2,343) (5,284) 4,087 Increase in inventories................. (17,294) (1,215) (6,001) (Increase) decrease in income taxes receivable............................ (7,000) (2,500) 26,300 Increase (decrease) in accounts payable .............................. (2,740) 13,572 3,429 Increase (decrease) in interest payable. 21,797 (298) (1,468) Decrease in income taxes payable........ (1,670) (5,094) (394) All other, net.......................... 6,854 12,684 5,466 ----------- -------- --------- Net cash provided from operations..... 151,055 209,950 240,881 Cash provided from (used for) investment activities: Additions to property, plant and equipment............................. (165,539) (232,844) (144,055) Acquisition of Stuart Edgar Limited, net of acquired cash of $749.......... -- (8,302) -- Net proceeds from dispositions of investments in and advances to unconsolidated subsidiaries........... -- -- 38,568 ----------- -------- --------- Net cash used for investment activities.......................... (165,539) (241,146) (105,487) Cash provided from (used for) financing activities: Proceeds from long-term borrowings...... 887,088 189,518 462,995 Repayment of long-term borrowings....... (841,399) (167,731) (759,487) Debt issuance costs..................... (31,160) -- (11,058) Issuance (purchase) of Common Stock..... (6) -- 163,357 ----------- -------- --------- Net cash provided from (used for) financing activities................ 14,523 21,787 (144,193) ----------- -------- --------- Increase (decrease) in cash................ 39 (9,409) (8,799) Cash, beginning of year.................... 188 9,597 18,396 ----------- -------- --------- Cash, end of year....................... $ 227 $ 188 $ 9,597 =========== ======== ========= Supplemental Cash Flow Disclosures: Interest paid........................... $ 228,360 $208,051 $ 236,140 Income taxes paid (refunded), net....... 4,432 9,997 (11,090) The accompanying notes are an integral part of these consolidated financial statements. - 25 - FORT HOWARD CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. SIGNIFICANT ACCOUNTING POLICIES (A) PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements include the accounts of Fort Howard Corporation and all domestic and foreign subsidiaries other than the Company's former cup subsidiaries. Assets and liabilities of foreign subsidiaries are translated at the rates of exchange in effect at the balance sheet date. Income amounts are translated at the average of the monthly exchange rates. The cumulative effect of translation adjustments is deferred and classified as a cumulative translation adjustment in the consolidated balance sheet. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications have been made to conform prior years' data to the current format. On September 4, 1992, Fort Sterling Limited ("Fort Sterling"), the Company's United Kingdom tissue operations, acquired for $25 million, including debt assumed of $17 million, Stuart Edgar Limited ("Stuart Edgar"), a converter of consumer tissue products with annual net sales approximating $43 million. The operating results of Stuart Edgar are included in the consolidated financial statements since September 4, 1992. The Company's investments in unconsolidated subsidiaries were reduced to zero at December 31, 1991 as a result of sales of all foreign cup subsidiaries and recognition of equity in the net losses of its remaining cup subsidiary, Sweetheart Holdings Inc. ("Sweetheart"). During 1993, the Company sold its remaining equity interest in Sweetheart for $5.1 million recognizing a gain of the same amount. (B) CASH AND CASH EQUIVALENTS -- The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying amount of cash equivalents approximates fair value due to the short maturity of the investments. (C) INVENTORIES -- Inventories are carried at the lower of cost or market, with cost principally determined on a first-in, first-out basis (see Note 2). (D) PROPERTY, PLANT AND EQUIPMENT -- Prior to August 9, 1988, property, plant and equipment were stated at original cost and depreciated using the straight-line method. Effective with the Acquisition (as defined below), properties were adjusted to their estimated fair values and are being depreciated on a straight-line basis. Effective January 1, 1992, the Company prospectively changed its estimates of the depreciable lives of certain machinery and equipment. These changes were made to better reflect the estimated periods during which such assets will remain in service. For the year ended December 31, 1992, the change had the effect of reducing depreciation expense by $38 million and net loss by $24 million. Subsequent to the change, depreciation is provided over useful lives of 30 to 50 years for buildings and 2 to 25 years for equipment. Assets under capital leases principally arose in connection with sale and leaseback transactions as described in Note 9 and are stated at the present value of future minimum lease payments. These assets are amortized over the respective periods of the leases which range from 15 to 25 years. - 26 - Amortization of assets under capital leases is included in depreciation expense. The Company follows the policy of capitalizing interest incurred in conjunction with major capital expenditure projects. The amounts capitalized in 1993, 1992 and 1991 were $8,369,000, $11,047,000 and $5,331,000, respectively. (E) REVENUE RECOGNITION -- Sales of the Company's paper products are recorded upon shipment of products. (F) ENVIRONMENTAL EXPENDITURES -- Environmental expenditures that relate to current operations are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities are recorded when material environmental assessments and/or remedial efforts are probable, and the cost can be reasonably estimated. (G) GOODWILL -- In 1988, FH Acquisition Corp., a company organized on behalf of The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"), acquired the Company in a leveraged buyout and was subsequently merged with and into the Company (the "Acquisition"). Goodwill (the acquisition costs in excess of the fair value of net assets of acquired businesses) acquired in connection with the Acquisition and the purchases of other businesses was amortized on a straight-line basis over 40 years through the third quarter of 1993 when the Company wrote off its remaining goodwill balance (see Note 4). The Company evaluates the carrying value of goodwill for possible impairment using a methodology which assesses whether forecasted cumulative net income before goodwill amortization is adequate to recover the future amortization of the Company's goodwill balance over the remaining amortization period of the goodwill. (H) EMPLOYEE BENEFIT PLANS -- A substantial majority of the Company's employees are covered under defined contribution plans. The Company's annual contributions to defined contribution plans are based on pre-tax income, subject to percentage limitations on participants' earnings and a minimum return on shareholders' equity. In recent years, the Company made discretionary contributions as permitted under the plans. Participants may also contribute a certain percent of their wages to the plans. Costs charged to operations for defined contribution plans were approximately $12,725,000, $11,716,000 and $12,231,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Employees retiring prior to February 1, 1990 from the Company's U.S. tissue operations who have met certain eligibility requirements are entitled to postretirement health care benefit coverage. These benefits are subject to deductibles, copayment provisions, a lifetime maximum benefit and other limitations. In addition, employees who retire after January 31, 1990 at age 55 or older with ten years of service may purchase health care benefit coverage from the Company up to age 65. The Company has reserved the right to change or terminate this benefit at any time. As of January 1, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The standard requires that the expected cost of postretirement health care benefits be charged to expense during the years that employees render service (see Note 10). Prior to 1992, the annual cost of these benefits had been expensed as claims and premiums were paid. Employees of the Company's U.K. - 27 - tissue operations are not entitled to Company-provided postretirement benefit coverage. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This new standard requires that the expected cost of benefits to be provided to former or inactive employees after employment but before retirement be charged to expense during the years that the employees render service. In the fourth quarter of 1992, the Company retroactively adopted the new standard effective January 1, 1992. Adoption of the new accounting standard had no effect on the Company's 1992 consolidated statement of income. (I) INTEREST RATE CAP AND SWAP AGREEMENTS -- The cost of interest rate cap agreements is amortized over the respective lives of the agreements. The differential to be paid or received in connection with interest rate swap agreements is accrued as interest rates change and is recognized over the lives of the agreements. (J) INCOME TAXES -- Effective January 1, 1992, the Company has adopted SFAS No. 109, "Accounting for Income Taxes." The Company had previously adopted SFAS No. 96, "Accounting for Income Taxes" in 1988. As a result of the accounting change, the Company reclassified certain deferred tax benefits from long-term deferred income taxes payable to current assets in the accompanying 1992 consolidated balance sheet. The adoption of SFAS No. 109 had no effect on the Company's provision for income taxes for the year ended December 31, 1992. Deferred income taxes are provided to recognize temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The principal difference relates to depreciation expense. Deferred income tax expense represents the change in the deferred income tax asset and liability balances, excluding the deferred tax benefit related to extraordinary losses. (K) EARNINGS (LOSS) PER SHARE -- Earnings (loss) per share has been computed on the basis of the average number of common shares outstanding during the years. The average number of shares used in the computation was 5,862,639, 5,862,685 and 5,364,357 for the years ended December 31, 1993, 1992 and 1991, respectively. (L) SEGMENT INFORMATION -- The Company operates in one industry segment as a manufacturer, converter and marketer of a diversified line of single-use paper products for the home and away-from-home markets. - 28 - 2. INVENTORIES Inventories are summarized as follows: December 31, -------------------- 1993 1992 ---- ---- (In thousands) Components Raw materials and supplies.................. $ 61,285 $ 53,872 Finished and partly-finished products.................................. 56,984 47,103 -------- -------- $118,269 $100,975 ======== ======== Valued at lower of cost or market: First-in, first-out (FIFO).................. $ 94,436 $ 82,805 Average cost by specific lot................ 23,833 18,170 -------- -------- $118,269 $100,975 ======== ======== 3. PROPERTY, PLANT AND EQUIPMENT The Company's major classes of property, plant and equipment are: December 31, -------------------- 1993 1992 ---- ---- (In thousands) Land.......................................... $ 44,429 $ 44,631 Buildings..................................... 318,955 294,768 Machinery and equipment....................... 1,367,839 1,212,136 Construction in progress...................... 113,829 143,411 ---------- ---------- $1,845,052 $1,694,946 ========== ========== Included in the property, plant and equipment totals above are assets under capital leases, as follows: December 31, -------------------- 1993 1992 ---- ---- (In thousands) Buildings..................................... $ 3,989 $ 3,998 Machinery and equipment....................... 185,624 179,487 ---------- ---------- Total assets under capital leases........... $ 189,613 $ 183,485 ========== ========== - 29 - 4. GOODWILL Changes in the Company's goodwill are summarized as follows: Year Ended December 31, ------------------------------ 1993 1992 1991 ---- ---- ---- Balance, beginning of year......... $2,023,416 $2,075,525 $2,132,183 Acquisition of Stuart Edgar........ -- 6,043 -- Amortization of goodwill........... (42,576) (56,700) (56,658) Effects of foreign currency translation............. (413) (1,452) -- Goodwill write-off................. (1,980,427) -- -- ---------- ---------- ---------- Balance, end of year............... $ -- $2,023,416 $2,075,525 ========== ========== ========== Low industry operating rates and aggressive competitive activity among tissue producers resulting from the recession, additions to capacity and other factors have been adversely affecting tissue industry operating conditions and the Company's operating results since 1991. Accordingly, the Company revised its projections and determined that its projected results would not support the future amortization of the Company's remaining goodwill balance of approximately $1.98 billion at September 30, 1993. The methodology employed to assess the recoverability of the Company's goodwill first involved the projection of operating results forward 35 years, which approximated the remaining amortization period of the goodwill as of October 1, 1993. The Company then evaluated the recoverability of goodwill on the basis of this forecast of future operations. Based on such forecast, the cumulative net income before goodwill amortization of approximately $100 million over the remaining 35-year amortization period was insufficient to recover the goodwill balance. Accordingly, the Company wrote off its remaining goodwill balance of $1.98 billion in the third quarter of 1993. The Company's forecast assumed that sales volume increases would be limited to production from a new paper machine under construction at the Company's Muskogee mill which is scheduled to start-up in 1994 and that further capacity expansion was not justifiable given the Company's high leverage and adverse tissue industry operating conditions. Net selling price and cost increases were assumed to approximate 1% per year, based on the Company's annual historical price increase trend for the years 1984 through 1993 and managements estimates of future performance. Through the year 2001, the Company's projections indicated that interest expense would exceed operating income, which is determined after deducting annual depreciation expense. However, projected operating income before depreciation was adequate to cover projected interest expense. Inflation and interest rates were assumed to remain low at 1993 levels during the projected period. Each of the Company's highest yielding debt securities, the 12 3/8% Senior Subordinated Notes due 1997 (the "12 3/8% Notes"), the 12 5/8% Subordinated Debentures due 2000 (the "12 5/8% Debentures") and the 14 1/8% Junior Subordinated Discount Debentures due 2004 (the "14 1/8% Debentures"), were further assumed to be refinanced at lower interest rates. Total capital expenditures were projected to approximate $55-$80 million annually over the next ten years, plus $32 million in 1994 to complete the Muskogee mill expansion and another $32 million over 1994 and 1995 for a new coal-fired boiler under construction at the Company's Savannah River mill. Management believed that the projected - 30 - future results based on these assumptions were the most likely scenario given the Company's high leverage and adverse tissue industry operating conditions. 5. OTHER ASSETS The components of other assets are as follows: December 31, -------------- 1993 1992 ---- ---- (In thousands) Deferred loan costs, net of accumulated amortization................... $71,459 $70,983 Prepayments and other........................ 2,384 5,586 ------- ------- $73,843 $76,569 ======= ======= Amortization of deferred loan costs for the years ended December 31, 1993, 1992 and 1991, totaled $ 13,488,000, $14,910,000 and $14,883,000, respectively. During 1993, $19,297,000 of deferred loan costs were written off in conjunction with the retirement of long-term debt and $31,160,000 of deferred loan costs were incurred for the issuance of a new bank term loan (the "1993 Term Loan), the 9 1/4% Senior Unsecured Notes due 2001 (the "9 1/4% Notes") and the 10% Subordinated Notes due 2003 (the "10% Notes") and for the purchase of interest rate caps. During 1991, $11,250,000 of deferred loan costs were written off in conjunction with the retirement of long-term debt and $11,058,000 of deferred loan costs were incurred for the issuance of Senior Secured Notes (see Note 8). 6. OTHER CURRENT LIABILITIES The components of other current liabilities are as follows: December 31, -------------- 1993 1992 ---- ---- (In thousands) Salaries and wages ........................... $38,152 $35,939 Contributions to employee benefit plans ...... 12,805 11,858 Taxes other than income taxes ................ 5,492 2,536 Other accrued expenses ....................... 13,689 13,949 ------- ------- $70,138 $64,282 ======= ======= - 31 - 7. INCOME TAXES The income tax provision (credit) includes the following components: Year Ending December 31, ---------------------------------- 1993 1992 1991 ---- ---- ---- (In thousands) Current Federal.......................... $ (6,012) $ 10,501 $ 2,040 State............................ 465 411 551 Foreign.......................... (225) -- 5,237 -------- -------- -------- Total current.................. (5,772) 10,912 7,828 Deferred Federal.......................... (7,731) (13,678) (27,120) State............................ (2,956) (2,380) (4,231) Foreign.......................... 145 4,748 (440) -------- -------- -------- Total deferred................. (10,542) (11,310) (31,791) -------- -------- -------- $(16,314) $ (398) $(23,963) ======== ======== ======== The effective tax rate varied from the U.S. federal tax rate as a result of the following: Year Ended December 31, --------------------------------- 1993 1992 1991 ---- ---- ---- U.S. federal tax rate.............. (34.0)% (34.0)% (34.0)% Amortization of intangibles........ 33.4 27.6 19.6 Interest on long-term income taxes..................... -- 5.7 4.1 State income taxes net of U.S. tax benefit.............. (0.1) (3.0) (3.9) Equity in net loss of Sweetheart.................... -- -- (10.9) Other, net......................... (0.1) 3.1 0.6 ----- ----- ----- Effective tax rate................. (0.8)% (0.6)% (24.5)% ===== ===== ===== The net deferred income tax liability at December 31, 1993, includes $229 million related to property, plant and equipment. All other components of the gross deferred income tax assets and gross deferred income tax liabilities are individually not significant. The Company has not recorded a valuation allowance with respect to any deferred income tax asset. - 32 - The Internal Revenue Service ("IRS") issued a statutory notice of deficiency ("Notice") to the Company in March 1992 for additional income tax for the 1988 tax year. The Notice resulted from an audit of the Company's 1988 tax year wherein the IRS adjusted income and disallowed deductions, including deductions for fees and expenses related to the Acquisition. The IRS also disallowed deductions for fees and expenses related to 1988 debt financing and refinancing transactions. In March 1992, the Company filed a petition in the U.S. Tax Court opposing substantially all of the claimed deficiency and the case was tried in September 1993. After the trial, the Company and the IRS executed an agreed Supplemental Stipulation of Facts by which the IRS and the Company partially settled the case by agreeing that certain fees and expenses (previously disallowed by the IRS and potentially representing approximately $26 million of tax liability) were properly deductible by the Company over the term of the 1988 debt financing and refinancing. In addition, the Company agreed to capitalize certain amounts identified by the IRS and paid additional federal income tax of approximately $5 million representing its liability with respect to the agreed adjustments. The U.S. Tax Court has not yet decided the points that remain in dispute in the case following the partial settlement. The Company estimates that if the IRS were to prevail in disallowing deductions for the fees and expenses remaining in dispute before the trial judge, the potential amount of additional taxes due the IRS on account of such disallowance for the period 1988 through 1993 would be approximately $31 million and for the periods after 1993 (assuming current statutory tax rates) would be approximately $11 million, in each case exclusive of IRS interest charges. Since the Company's 1988 tax case involves disputed issues of law and fact, the Company is unable to predict its final result with certainty. The Company believes, however, that its ultimate resolution will not have a material adverse effect on the Company's financial condition. - 33 - 8. LONG-TERM DEBT Long-term debt and capital lease obligations, including amounts payable within one year, are summarized as follows (in thousands): - 34 - The aggregate fair values of the Company's long-term debt and capital lease obligations approximated $3,276 million and $3,116 million compared to aggregate carrying values of $3,223 million and $3,091 million at December 31, 1993 and 1992, respectively. The fair values of the Term Loan, Revolving Credit Facility and 1993 Term Loan are estimated based on secondary market transactions in such securities. Fair values for the Senior Secured Notes, the 9 1/4% Notes, the 12 3/8% Notes, the 12 5/8% Debentures, the 10% Notes, the 14 1/8% Debentures and the Pollution Control Revenue Refunding Bonds were estimated based on trading activity in such securities. Of the capital lease obligations, the fair values of the 1991 Series Pass Through Certificates were estimated based on trading activity in such securities. The fair values of other capital lease obligations were estimated based on interest rates implicit in the valuation of the 1991 Series Pass Through Certificates. The fair value of debt of foreign subsidiaries is deemed to approximate its carrying amount. The 14 1/8% Debentures do not accrue interest in cash until November 1, 1994, and were issued at a discount to yield a 14 1/8% effective annual rate. The 14 1/8% Debentures will require payments of interest in cash commencing on May 1, 1995. For the years ended December 31, 1993, 1992, and 1991, interest related to these debentures was added to the balance due. On March 22, 1993, the Company sold $450 million principal amount of 9 1/4% Notes and $300 million principal amount of 10% Notes in a registered public offering. On April 21, 1993, the Company borrowed $100 million pursuant to the 1993 Term Loan. Proceeds from the sale of the 9 1/4% Notes and the 10% Notes and from the 1993 Term Loan were applied to the prepayment of $250 million of the Term Loan, to the repayment of a portion of the Company's indebtedness under the Revolving Credit Facility, to the repurchase of all the Company's outstanding Junior Subordinated Debentures due 2004 (the "14 5/8% Debentures") and to the payment of fees and expenses. As a result of the repayment of $250 million of the Term Loan and the repurchases of the 14 5/8% Debentures, the Company incurred an extraordinary loss of $10 million (net of income taxes of $6 million) representing the write-off of unamortized deferred loan costs. The 9 1/4% Notes are senior unsecured obligations of the Company, rank equally in right of payment with the other senior indebtedness of the Company and are senior to all existing and future subordinated indebtedness of the Company. The 10% Notes are subordinated in right of payment to all existing and future senior indebtedness of the Company, including the 12 3/8% Notes, rank equally with the 12 5/8% Debentures and constitute senior indebtedness with respect to the 14 1/8% Debentures. The 1993 Term Loan bears interest, at the Company's option, at Bankers Trust's prime rate, plus 1.75% or, subject to certain limitations, at a reserve adjusted Eurodollar rate, plus 3.00%, and matures May 1, 1997. The 1993 Term Loan constitutes senior secured indebtedness of the Company. In connection with the sale of the 9 1/4% Notes and the 10% Notes and the borrowing under the 1993 Term Loan, the Company amended its Bank Credit Agreement and the Senior Secured Note Agreement. Among other changes, the amendments reduced domestic capital spending limits. In addition, the Company's required ratios of earnings before non-cash charges, interest and taxes to cash interest were lowered to give effect to the greater amount of the Company's cash interest payments as a result of the issuance of the 9 1/4% Notes and 10% Notes and subsequent repurchases of 14 5/8% Debentures. - 35 - The Company redeemed $50 million of its 12 3/8% Notes at the redemption price of 105% of the principal amount thereof on November 1, 1993, the first date that such notes were redeemable. The redemption was funded principally from excess funds from the sale of the 9 1/4% Notes and the 10% Notes. In connection with the redemption, the Company incurred an extraordinary loss of $2 million (net of income taxes of $1 million), representing the redemption premium and unamortized deferred loan costs. In 1991, Fort Sterling entered into a credit agreement to provide financing for the addition of a third paper machine and related equipment at its tissue mill. The facility consists of a 20 million pound sterling (approximately $30 million) term loan due March 2001 and a 5 million pound sterling (approximately $7 million) revolving credit facility due March 1996. In 1992, Fort Sterling entered into a second credit agreement to finance the acquisition of Stuart Edgar. This facility consists of a term loan due December 1997 with 3.4 million pounds sterling (approximately $5 million) outstanding at December 31, 1993, and a second term loan due December 1997 with 6.8 million pounds sterling (approximately $10 million) outstanding at December 31, 1993. These credit agreements bear interest at floating rates and are secured by certain assets of Fort Sterling and Stuart Edgar but are nonrecourse to the Company. Although the obligations under the Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement bear interest at floating rates, the Company is required to enter into interest rate agreements which effectively fix or limit the interest cost to the Company. Pursuant to the Bank Credit Agreement, the Company is a party to interest rate cap agreements which limit the interest cost to the Company to 8.25% (including the Company's borrowing margin on Eurodollar rate loans) until June 1, 1996 with respect to $500 million. Pursuant to the 1993 Term Loan Agreement, the Company is party to an interest rate swap agreement which limits the interest cost to the Company to 6.53% (including the Company's borrowing margin on Eurodollar rate loans) until April 21, 1994 with respect to $100 million. The Company is also a party to an interest rate cap agreement which limits the interest cost to the Company to rates between 11.25% and 12.00% until September 11, 1994 with respect to $300 million received through the issuance of the Senior Secured Notes. At current market rates at December 31, 1993, the fair value of the Company's interest rate cap agreements is $1.6 million. The fair value of the interest rate swap agreement at December 31, 1993 is zero. The Company monitors the risk of default by the counterparties to the interest rate cap and swap agreements and does not anticipate nonperformance. In addition to the scheduled mandatory annual repayments, the Bank Credit Agreement provides for mandatory repayments from proceeds of any significant asset sales (except for proceeds from certain foreign asset sales which are redeployed outside the U.S.), from proceeds of sale and leaseback transactions, and annually an amount equal to 50% of excess cash flow for the prior calendar year, as defined. Among other restrictions, the Bank Credit Agreement, the 1993 Term Loan Agreement, the Senior Secured Note Agreement, the foreign credit agreements and the Company's indentures: (1) restrict payments of dividends, repayments of subordinated debt, purchases of the Company's stock, additional borrowings and acquisition of property, plant and equipment; (2) require that the ratios of current assets to current liabilities, senior debt to adjusted net worth plus subordinated debt and earnings before non-cash charges, interest and taxes to cash interest be maintained at prescribed levels; (3) restrict the ability of the Company to make fundamental changes and to enter into new lines - 36 - of business, the pledging of the Company's assets and guarantees of indebtedness of others; and (4) limit dispositions of assets, the ability of the Company to enter lease and sale and leaseback transactions, and investments which might be made by the Company. The Company believes that such limitations should not impair its plans for continued maintenance and modernization of facilities or other operating activities. Pursuant to amendments to the Bank Credit Agreement and the Senior Secured Note Agreement and the completion of various transactions, at December 31, 1993, the Company may borrow up to $39 million to repurchase 14 1/8% Debentures. The Company believes that, notwithstanding the adverse tissue industry operating conditions and the non-cash charge to write-off the remaining balance of the Company's goodwill (see Note 4), cash provided by operations and access to debt financing in the public and private markets will be sufficient to enable it to fund maintenance and modernization capital expenditures and meet its debt service requirements for the foreseeable future. However, in the absence of improved financial results, it is likely that in 1995 the Company would be required to seek a waiver of the cash interest coverage covenant under the Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement because the Company's 14 1/8% Debentures will accrue interest in cash commencing on November 1, 1994 and will require payments of interest in cash on May 1, 1995. Although the Company believes that it will be able to obtain appropriate waivers from its lenders, there can be no assurance that this will be the case. Pursuant to 1993 amendments to the Bank Credit Agreement, the 1993 Term Loan Agreement and the Senior Secured Note Agreement, the required ratio of earnings before non-cash charges, interest and taxes to cash interest for the four fiscal quarters ending March 31, 1994 was reduced from 1.50 to 1.00 to 1.40 to 1.00. At December 31, 1993, receivables totaling $100 million, inventories totaling $118 million and property, plant and equipment with a net book value of $1,177 million were pledged as collateral under the terms of the Bank Credit Agreement, the 1993 Term Loan Agreement, the Senior Secured Note Agreement, the foreign credit agreements and under the indentures for sale and leaseback transactions. The Company is charged a 0.5% fee with respect to any unused balance available under its $350 million Revolving Credit Facility, and a 2% fee with respect to any letters of credit issued under the Revolving Credit Facility. At December 31, 1993, $244 million of borrowings reduced available capacity under the Revolving Credit Facility to $106 million. The aggregate annual maturities of long-term debt and capital lease obligations at December 31, 1993, are as follows (in thousands): 1994........................... $ 112,750 1995........................... 115,906 1996........................... 376,192 1997........................... 541,214 1998........................... 87,498 1999 and thereafter............ 1,989,028 ---------- $3,222,588 ========== - 37 - 9. SALE AND LEASEBACK TRANSACTIONS Buildings and machinery and equipment related to various capital additions at the Company's tissue mills were sold and leased back from various financial institutions (the "sale and leaseback transactions") for periods from 15 to 25 years. The terms of the sale and leaseback transactions contain restrictions which are less restrictive than the covenants of the Bank Credit Agreement described in Note 8. These leases are treated as capital leases in the accompanying consolidated financial statements. Future minimum lease payments at December 31, 1993, are as follows (in thousands): Year Ending December 31, Amount ------ 1994........................... $ 21,205 1995........................... 23,397 1996........................... 24,492 1997........................... 24,492 1998........................... 24,280 1999 and thereafter............ 386,412 -------- Total payments................. 504,278 Less imputed interest at rates approximating 10.9%.... 320,255 -------- Present value of capital lease obligations............ $184,023 ======== 10. EMPLOYEE POSTRETIREMENT BENEFIT PLANS As of January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The cumulative effect on years prior to 1992 of adopting SFAS No. 106 is stated separately in the Company's consolidated statement of income for 1992 as a one-time after- tax charge of $10.6 million. This change in accounting principle, excluding the cumulative effect, decreased operating income by $2.1 million and $1.2 million in 1993 and 1992, respectively. Net periodic postretirement benefit cost included the following components (in thousands): Year Ended December 31, ------------------- 1993 1992 ---- ---- Service cost........................ $1,140 $ 902 Interest cost....................... 1,800 1,366 Other............................... 99 -- ------ ------ Net periodic postretirement benefit cost.................... $3,039 $2,268 ====== ====== - 38 - The following table sets forth the components of the plan's unfunded accumulated postretirement benefit obligation (in thousands): December 31, ------------------- 1993 1992 ---- ---- Accumulated postretirement benefit obligation: Retirees.................................. $ 7,504 $ 6,632 Fully eligible active plan participants....................... 4,401 2,890 Other active plan participants............ 12,037 13,558 ------- ------- 23,942 23,080 Unrecognized actuarial losses................. (3,517) (4,800) ------- ------- Accrued postretirement benefit cost................................ $20,425 $18,280 ======= ======= The medical trend rate assumed in the determination of the accumulated postretirement benefit obligation at December 31, 1993 begins at 12% in 1994, decreases 1% per year to 6% for 2000 and remains at that level thereafter. Increasing the assumed medical trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $2.9 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost by $0.5 million. The medical trend rate assumed in the determination of the accumulated postretirement benefit obligation at December 31, 1992 began at 14% in 1993, decreasing 1% per year to 7% for 2000 and remained at that level thereafter. The discount rate used in determining the accumulated postretirement benefit obligation was 7% and 8% compounded annually with respect to the 1993 and 1992 valuations, respectively. 11. SHAREHOLDERS' EQUITY (DEFICIT) The Company is authorized to issue up to 8,400,000 shares of $.01 par value Voting Common Stock. At December 31, 1993, 5,862,735 shares were issued and 5,862,635 shares were outstanding. At December 31, 1992, 5,862,735 shares were issued and 5,862,685 shares were outstanding. In addition, 600,000 shares of $.01 par value Non-Voting Common Stock have been authorized, of which none were issued and outstanding at both December 31, 1993 and 1992. During 1991, the Company sold 1,361,469 shares of Voting Common Stock and 6,200 shares of Voting Common Stock with put right pursuant to a private placement of Common Stock. The net proceeds of the sales totaled $163.4 million. Also during 1991, 26,918 shares of Non-Voting Common Stock were exchanged on a one-for-one basis for Voting Common Stock. - 39 - Changes in the Company's shareholders' equity (deficit) accounts for the years ended December 31, 1993, 1992 and 1991, are as follows: The aggregate par value of the Voting Common Stock reported in the amounts above at December 31, 1993 was $58,626. 12. VOTING COMMON STOCK WITH PUT RIGHT Pursuant to an Amended and Restated Management Equity Participation Agreement, as amended (the "Management Equity Participation Agreement"), members of the Company's senior management have acquired shares of the Company's $.01 par value Voting Common Stock. In addition, the Fort Howard Corporation Management Equity Plan (the "Management Equity Plan") provides for the offer of Voting Common Stock and the grant of options to purchase Voting Common Stock to officers and certain other key employees of the Company. - 40 - Officers or other key employees of the Company who purchase shares of Voting Common Stock or are granted options pursuant to the Management Equity Plan are required to enter into a Management Equity Plan Agreement with the Company and to become bound by the terms of the Company's stockholders agreement. All Voting Common Stock acquired by management investors, including shares acquired by the Company's former chairman and chief executive officer, are collectively referred to as the "Putable Shares." Beginning with the fifth anniversary of the respective dates of purchase of certain of the Putable Shares to the date on which 15% or more of the Company's Voting Common Stock has been sold in one or more public offerings, specified percentages of the shares may be put to the Company at the option of the holders thereof, with certain limitations, at their fair market value. Subject to certain exceptions, the Management Equity Participation Agreement and Management Equity Plan also provide that management investors who terminate their employment with the Company shall sell their shares of Voting Common Stock and vested options to the Company or its designee. Subject to certain exceptions, options which have not vested at the time a management investor's employment is terminated are forfeited to the Company. At the time of his resignation, all the Putable Shares then owned by the Company's former chairman and chief executive officer became putable to the Company. During 1993, the Company decreased the estimated fair market valuation of its Common Stock as a result of the effects of adverse tissue industry operating conditions on its long-term earnings forecast and, as a result, reduced the carrying amount of its Voting Common Stock with put right to its original cost. The effect of the adjustment was to reduce both the Voting Common Stock with put right and the deficit in retained earnings by approximately $1.4 million. Changes in the Company's Voting Common Stock with put right, are as follows (in thousands, except number of shares): Year Ended December 31, ---------------------------- 1993 1992 1991 ---- ---- ---- Balance, beginning of year.......... $13,219 $12,963 $ 9,574 Issuance of 6,200 shares including 4,934 shares from treasury........ -- -- 744 Amortization of the increase (decrease) in fair market value and increased vested portion of Putable Shares......... (1,399) 256 2,645 ------- ------- ------- Balance, end of year................. $11,820 $13,219 $12,963 ======= ======= ======= 13. STOCK OPTIONS Pursuant to the Management Equity Participation Agreement and the Management Equity Plan, 808,225 shares of Voting Common Stock are reserved for sale to officers and key employees as stock options. The exercisability of such options is subject to certain conditions. Options must be exercised within ten years of the date of grant. All options and shares to be issued under the terms of these plans are restricted as to transferability. Under certain conditions, the Company has the right or obligation to redeem shares issued under terms of the options at a price equal to their fair market value. - 41 - All options outstanding at December 31, 1993, except for fully vested options held by the Company's former chairman and chief executive officer, have a vesting schedule of twenty percent per year, measured from the date of initial grant. Any such options will be subject to partial acceleration of vesting in the event of death or disability and must be exercised within 10 years of the date of grant. Changes in stock options outstanding are summarized as follows: Number of Exercise Price Options Per Option --------- -------------- Balance, December 31, 1990............... 482,662 $100 to 135 Options Granted........................ 136,960 120 Options Cancelled...................... (55,960) 100 to 135 ------- ----------- Balance, December 31, 1991............... 563,662 100 to 120 Options Granted........................ 12,400 120 Options Cancelled...................... (1,060) 100 to 120 ------- ----------- Balance, December 31, 1992............... 575,002 $100 to 120 Options Granted........................ 15,200 120 Options Cancelled...................... (1,640) 100 to 120 ------- ----------- Balance 31, 1993......................... 588,562 $100 to 120 ======= =========== Exercisable at December 31, 1993......... 497,498 $100 to 120 ======= =========== Shares available for future grant at December 31, 1993................... 219,663 ======= The Company amortizes the excess of the fair market value of its Common Stock over the strike price of options granted to employees over the periods the options vest. Due to the effects of adverse tissue industry operating conditions on its long-term earnings forecast, the Company decreased the estimated fair market valuation of its Common Stock and, as a result, reversed all previously accrued employee stock compensation expense in 1993. The reversal of the accrued employee stock compensation resulted in a credit to operations of $7,832,000 for 1993. Employee stock compensation expense was $1,120,000 and $1,256,000 for 1992 and 1991, respectively. 14. RELATED PARTY TRANSACTIONS Morgan Stanley Group Inc. ("Morgan Stanley Group") and an affiliate acquired a substantial majority equity interest in the Company to effect the Acquisition. At December 31, 1993, Morgan Stanley Group and its affiliates controlled 57% (on a fully diluted basis) of the Company's Voting Common Stock. The Company has entered into an agreement with Morgan Stanley & Co. Incorporated ("MS&Co.") for financial advisory services in consideration for which the Company will pay MS&Co. an annual fee of $1 million. MS&Co. will also be entitled to reimbursement for all reasonable expenses incurred in the performance of the foregoing services. The Company paid MS&Co. $1,046,000, $1,096,000 and $1,064,000 for these and other miscellaneous services in 1993, 1992 and 1991, respectively. In 1993, MS&Co. received approximately $19.5 million related to the underwriting of the issuance of the 1993 Notes. In - 42 - 1992, MS&Co. received approximately $0.7 million related to the underwriting of the reissuance of the Company's Development Authority of Effingham County Pollution Control Revenue Refunding Bonds, Series 1988. In connection with a 1991 sale and leaseback transaction, MS&Co. received approximately $2.9 million of advisory and underwriting fees. Also in 1991, in connection with the offering of Senior Secured Notes, MS&Co. received approximately $6.8 million of advisory fees. MS&Co. served as lead underwriter for the initial offering of the Company's subordinated debt securities and since the Acquisition has been a market maker with respect to those securities. In connection with the 1991 repurchases of the Company's subordinated debt securities, $52.8 million aggregate principal amount at maturity of the 14 5/8% Debentures and $132.7 million aggregate principal amount at maturity of the 14 1/8% Debentures were purchased through MS&Co. In addition, $46.5 million and $77.5 million aggregate principal amount at maturity of the 14 1/8% Debentures were purchased from Leeway & Co. and First Plaza Group Trust, respectively, shareholders of the Company. The purchases were made in negotiated transactions at market prices. 15. COMMITMENTS AND CONTINGENCIES In 1992, the Company commenced the installation of a fifth paper machine, environmental protection equipment and associated facilities at its Muskogee, Oklahoma tissue mill. The expansion is planned for completion in 1994 at an estimated cost of $140 million. Total expenditures for the expansion through December 31, 1993 were $109 million. The Company's domestic manufacturing operations are subject to regulation by various federal, state and local authorities concerned with the limitation and control of emissions and discharges to the air and waters and the handling, use and disposal of specified chemicals and solid waste. The Company's United Kingdom operations are subject to similar regulation. The Company has made significant capital expenditures in the past to comply with environmental regulations. Future environmental legislation and developing regulations are expected to further limit emission and discharge levels and to expand the scope of regulation, all of which will require continuing capital expenditures. There can be no assurance that such costs would not be material to the Company. The Company operates a licensed solid waste landfill at each of its tissue mills in the United States to dispose residue from recycling wastepaper and ash from coal-fired boilers. In March 1990, the Company began a remedial investigation of its Green Bay, Wisconsin landfill. The investigation is being overseen by the United States Environmental Protection Agency under authority granted to the agency by the Comprehensive Environmental Response, Compensation and Liability Act, commonly known as the "Superfund Act." A Preliminary Health Assessment released by the United States Department of Health and Human Services in January 1992 reported that the Company's Green Bay landfill does not pose any apparent public health hazard. Based upon the results of the remedial investigation through December 31, 1993, the Company believes that costs or expenditures associated with any future remedial action, were it to be required, would not have a material adverse effect on the Company's financial condition. Except for the Green Bay landfill site, the Company is not presently named as a potentially responsible party at any other Superfund related sites; - 43 - however, there can be no certainty that the Company will not be named as a potentially responsible party at any other sites in the future or that the costs associated with those sites would not be material. The Company and its subsidiaries are parties to lawsuits and state and federal administrative proceedings in connection with their businesses. Although the final results in such suits and proceedings cannot be predicted with certainty, the Company believes that they will not have a material adverse effect on the Company's financial condition. 16. GEOGRAPHIC INFORMATION A summary of the Company's operations by geographic area as of December 31, 1993, 1992 and 1991, and for the years then ended is presented below (in thousands): United United States Kingdom Consolidated ------ ------- ------------ Net sales.......................... $1,044,174 $143,213 $1,187,387 Operating income (loss)............ (1,715,777) (859) (1,716,636) Identifiable operating assets...... 1,482,166 163,621 1,645,787 Net sales.......................... $1,008,129 $143,222 $1,151,351 Operating income................... 253,437 17,238 270,675 Identifiable operating assets...... 3,411,833 162,734 3,574,567 Net sales.......................... $1,027,969 $110,241 $1,138,210 Operating income................... 254,603 15,929 270,532 Identifiable operating assets...... 3,373,199 96,603 3,469,802 Intercompany sales and charges between geographic areas and export sales are not material. In 1993, the Company determined that its projected results would not support the future amortization of the Company's remaining goodwill balance. Accordingly, the Company wrote off its remaining goodwill balance of $1,980 million in the third quarter of 1993, resulting in charges of $1,968 million and $12 million to the operating income of the United States and United Kingdom operations, respectively. In 1992, the Company changed its estimates of the depreciable lives of certain machinery and equipment resulting in a reduction of depreciation expense and an increase in operating income of $38 million in the United States. - 44 - 17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) A summary of the quarterly results of operations for 1993 and 1992 follows (in millions, except per share data): - 45 - ITEM 9. ITEM 9. DISAGREEMENT ON ACCOUNTING AND FINANCIAL DISCLOSURES None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT DIRECTORS The following table provides certain information about each of the current directors of the Company. All directors hold office until the next annual meeting of shareholders of the Company and until their successors are duly elected and qualified. Present Principal Occupation or Employment; Name and Position Five-Year Employment History with the Company Age and other Directorships ----------------- --- ------------------------------------------- Donald H. DeMeuse 58 Chairman of the Board of Directors and Chairman of the Board Chief Executive Officer since March 1992; President and Chief Executive Officer from July 1990 to March 1992. Prior to March 1992, President for more than five years. Director of Associated Bank Green Bay. Kathleen J. Hempel 43 Vice Chairman and Chief Financial Officer Vice Chairman since March 1992; Senior Executive Vice President and Chief Financial Officer prior to that time. Michael T. Riordan 43 President and Chief Operating Officer since Director March 1992; Vice President prior to that time. Donald P. Brennan 53 Managing Director of MS&Co. since prior to Director 1988 and head of MS&Co.'s Merchant Banking Division. Chairman and President of Morgan Stanley Leveraged Equity Fund II, Inc. ("MSLEF II, Inc.") and Chairman of Morgan Stanley Capital Partners III, Inc. ("MSCP III"). Director of Agricultural Minerals and Chemicals Inc., Agricultural Minerals Corporation, A/S Bulkhandling, Beaumont Methanol Corporation, BMC Holdings Inc., Coltec Industries Inc., Container Corporation of America, Hamilton Services Limited, Jefferson Smurfit Corporation, PSF Finance Holdings, Inc., Shuttleway, SIBV/MS Holdings, Inc., Stanklav Holdings, Inc., Waterford Wedgwood plc (Deputy Chairman) and Waterford Wedgwood U.K. plc. - 46 - Present Principal Occupation or Employment; Name and Position Five-Year Employment History with the Company Age and other Directorships ----------------- --- ------------------------------------------- Frank V. Sica 42 Managing Director of MS&Co. since 1988. Vice Director President and Director of MSLEF II, Inc. since 1989 and Vice Chairman of MSCP III. Director of ARM Financial Group, Inc., Consolidated Hydro, Inc., Emmis Broadcasting Corporation, Integrity Life Insurance Company, Interstate Natural Gas Company, Kohl's Corporation, Kohl's Department Stores, Inc., National Integrity Life Insurance Company, PageMart, Inc., Southern Pacific Rail Corporation, Sullivan Communications, Inc., Sullivan Graphics, Inc. and Sullivan Plastics, Inc. Robert H. Niehaus 38 Managing Director of MS&Co. since 1990 Director Principal of MS&Co. prior to that time. Vice President and Director of MSLEF II, Inc. and Vice Chairman of MSCP III. Director of American Italian Pasta Company, MS Distribution Inc., MS/WW Holdings Inc., NCC L.P., Randall's Food Markets, Inc., Randall's Management Corp., Randall's Management of Nevada, Randall's Properties, Inc., Randall's Warehouse, Inc., Shuttleway, Silgan Containers Corporation, Silgan Corporation, Silgan Holdings Inc., Silgan Plastics Inc., Tennessee Valley Steel Corp., Waterford Wedgwood U.K. plc and Waterford Crystal Ltd. James S. Hoch 33 Principal of MS&Co. since February 1993; Director Vice President of MS&Co. from January 1991 to February 1993; Associate of MS&Co. prior to that time. Director of Silgan Containers Corporation, Silgan Corporation, Silgan Holdings Inc., Silgan Plastics Inc., Sullivan Communications, Inc. and Sullivan Marketing Inc. EXECUTIVE OFFICERS The following table provides certain information about each of the current executive officers of the Company. All executive officers are elected by, and serve at the discretion of, the Board of Directors. None of the executive officers of the Company is related by blood, marriage or adoption to any other executive officer or director of the Company. - 47 - Present Principal Occupation or Employment; Name and Position Five-Year Employment History with the Company Age and other Directorships ----------------- --- ------------------------------------------- Donald H. DeMeuse 58 See description under "Directors and Chairman of the Board and Executive Officers of Registrant -- Chief Executive Officer Directors." Kathleen J. Hempel 43 See description under "Directors and Vice Chairman and Chief Executive Officers of Registrant -- Financial Officer Directors." Michael T. Riordan 43 See description under "Directors and President and Chief Executive Officers of Registrant -- Operating Officer Directors." Andrew W. Donnelly 51 Executive Vice President for more than Executive Vice President five years. John F. Rowley 53 Executive Vice President for more than Executive Vice President five years. Jeffrey P. Eves 47 Vice President for more than five years. Vice President George F. Hartmann, Jr. 51 Vice President for more than five years. Vice President James W. Nellen II 46 Vice President and Secretary for more Vice President and than five years. Secretary Daniel J. Platkowski 43 Vice President for more than five years. Vice President Timothy G. Reilly 43 Vice President for more than five years. Vice President Donald J. Schneider 57 Vice President since July 1989. Director Vice President of Research and Development prior to that time. David K. Wong 44 Vice President since June 1993; Director of Vice President Personnel from September 1990 until June 1993. Director of Recruiting and Training prior to that time. R. Michael Lempke 41 Treasurer since November 1989; Assistant Treasurer Treasurer prior to that time. Charles L. Szews 37 Controller since November 1989; Director Controller of Financial Reporting prior to that time. David A. Stevens 45 Assistant Vice President for more than Assistant Vice President five years. - 48 - ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table presents information concerning compensation paid for services to the Company during the last three fiscal years to the Chief Executive Officer and the four other most highly compensated executive officers (the "Named Executive Officers") of the Company. SUMMARY COMPENSATION TABLE (a) Includes amounts reimbursed for the payment of taxes. (b) Company contributions to the Company's profit sharing plan and supplemental retirement plan, including Company contributions to the Company's supplemental retirement plan which were paid to the participant. - 49 - The following table presents information concerning individual grants of stock options made during the last completed fiscal year to each of the Named Executive Officers. (a) The stock options granted in 1993 to Equity Investors (as defined below under "Item 13. Certain Relationships and Related Transactions--Management Equity Plan"), including the options granted to Mr. Riordan, were granted pursuant to the Management Equity Plan as defined below under "Item 13. Certain Relationships and Related Transactions--Management Equity Plan." The options vest and become exercisable at a rate of 20% per year, subject to partial acceleration of vesting in the event of death or disability. Subject to certain exceptions, Equity Investors who terminate their employment with the Company before the later of (i) the fifth anniversary of the date on which the options were granted, and (ii) the date on which 15% or more of the Common Stock has been sold in one or more public offerings, must sell their vested options to the Company or its designee. In addition, Equity Investors may put specified percentages of their vested options to the Company annually during the period from the fifth anniversary of the date the options were granted to the date on which 15% or more of the Common Stock has been sold in one or more public offerings. See "Item 13. Certain Relationships and Related Transactions -- Management Equity Plan." The following table presents information concerning unexercised stock options for the Named Executive Officers. No stock options were exercised by the Named Executive Officers during 1993. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES Value of Unexercised Number of Unexercised Options In-the-money Options Held Held at December 31, 1993 at December 31, 1993 (a) ----------------------------- -------------------------- Exercisable Unexercisable Exercisable Unexercisable ----------- -------------- ----------- ------------- Donald H. DeMeuse 74,375 9,200 -- -- Kathleen J. Hempel 85,515 3,000 -- -- Michael T. Riordan 15,409 11,300 -- -- Andrew W. Donnelly 20,235 4,200 -- -- John F. Rowley 14,342 3,800 -- -- - 50 - a) The Common Stock of the Company is not registered or publicly traded and, therefore, a public market price for the stock is not available. The Company believes that none of the exercisable or unexercisable stock options held at December 31, 1993 were in-the-money as of such date. See Notes 12 and 13 of the Company's audited consolidated financial statements. DIRECTOR'S COMPENSATION Directors of the Company do not receive any compensation for services on the Board of Directors. EMPLOYMENT AGREEMENTS The Named Executive Officers have three-year employment agreements with the Company (the "Employment Agreements") which took effect in 1993. The Employment Agreements contain customary employment terms, have an initial duration of three years beginning October 15, 1993 for Mr. DeMeuse, Ms. Hempel and Mr. Riordan and December 10, 1993 for Mr. Donnelly and Mr. Rowley, provide for automatic one-year extensions (unless notice not to extend is given by either party at least six months prior to the end of the effective term), and provide for base annual salaries and annual incentive bonuses. In addition, the Employment Agreements for Mr. DeMeuse, Ms. Hempel and Mr. Riordan provide for participation in additional bonus arrangements which may be agreed upon in good faith from time to time with the Company. The Employment Agreements provide that certain payments in lieu of salary and bonus are to be made and certain benefits are to be continued for a stated period following termination of employment. The time periods for such payments vary depending on the cause of termination. The amount of the payments to be made to each individual would vary depending upon such individual's level of compensation and benefits at the time of termination and whether such employment is terminated prior to the end of the term by the Company for "cause" or by the employee for "good reason" (as such terms are defined in the Employment Agreements) or otherwise during the term of the agreements. In addition, the Employment Agreements for Mr. DeMeuse, Ms. Hempel and Mr. Riordan include noncompetition and confidentiality provisions. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Executive Committee of the Board of Directors of the Company (the "Executive Committee") acts as a compensation committee for determining certain aspects of the compensation of the executive officers of the Company. The members of the Executive Committee are Donald H. DeMeuse, the Company's Chairman and Chief Executive Officer, and Donald P. Brennan. The Executive Committee administers the Management Equity Plan which provides for the offer of Common Stock and the grant of options to purchase Common Stock to executive officers and certain other key employees of the Company. See "Item 13. Certain Relationships and Related Transactions -- Management Equity Plan." The Executive Committee selects the officers and key employees to whom Common Stock will be offered or options will be granted. The Executive Committee also administers the Company's Management Incentive Plan under which annual cash awards are paid to employees serving in key executive, administrative, professional and technical capacities. Awards are based upon the extent to which the Company's financial performance during the year has met or exceeded certain performance goals specified by the Executive Committee. - 51 - Salaries and employment contract terms are determined by the entire Board of Directors for the Chief Executive Officer, by the Executive Committee for other executive officers who also serve as directors of the Company and by the Company's Chief Executive Officer for other executive officers of the Company. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth certain information regarding the beneficial ownership of the Company's Common Stock as of March 1, 1994 by holders having beneficial ownership of more than 5% of the Company's Common Stock, by certain other principal holders, by each of the Company's directors, by the Named Executive Officers, and by all directors and all executive officers of the Company as a group. Shares Beneficially Owned ----------------------------- Number of Percentage Name Shares of Class ---- --------- ---------- THE MORGAN STANLEY LEVERAGED 2,850,000 (a) 48.6 EQUITY FUND II, L.P. 1251 Avenue of the Americas New York, New York 10020 FIRST PLAZA GROUP TRUST 1,033,155 17.6 c/o Mellon Bank, N.A., as Trustee 1 Mellon Bank Center Pittsburgh, Pennsylvania 15258 LEEWAY & CO. 516,577 8.8 1 Monarch Drive North Quincy, Massachusetts 02177 MORGAN STANLEY GROUP INC. 427,213 (b) 7.3 1251 Avenue of the Americas New York, New York 10020 FORT HOWARD EQUITY INVESTORS II, L.P. 261,737 (c) 4.5 1251 Avenue of the Americas New York, New York 10020 FORT HOWARD EQUITY INVESTORS, L.P. 102,000 (d) 1.7 1251 Avenue of the Americas New York, New York 10020 Donald H. DeMeuse 100,100 (e) 1.7 Kathleen J. Hempel 90,491 (f) 1.5 Michael T. Riordan 17,934 (g) less than 1 Donald P. Brennan 0 -- Frank V. Sica 0 -- - 52 - Shares Beneficially Owned ----------------------------- Number of Percentage Name Shares of Class ---- --------- ---------- Robert H. Niehaus 0 -- James S. Hoch 0 -- Andrew W. Donnelly 22,735 (h) less than 1 John F. Rowley 16,042 (i) less than 1 Directors and Executive Officers 347,414 (j) 5.7 as a Group (a) MSLEF II, Inc. is the sole general partner of MSLEF II and is a wholly owned subsidiary of Morgan Stanley Group Inc. ("Morgan Stanley Group"). (b) Excludes 40,000 shares for which Morgan Stanley Group exercises exclusive voting rights on shares not beneficially owned. (c) Morgan Stanley Equity Investors Inc. is the sole general partner of Fort Howard Equity Investors II, L.P. and is a wholly owned subsidiary of Morgan Stanley Group. (d) Morgan Stanley Equity Investors Inc. is the sole general partner of Fort Howard Equity Investors, L.P. and is a wholly owned subsidiary of Morgan Stanley Group. (e) Includes 74,375 shares subject to acquisition within 60 days by exercise of employee stock options. (f) Includes 85,515 shares subject to acquisition within 60 days by exercise of employee stock options. (g) Includes 15,409 shares subject to acquisition within 60 days by exercise of employee stock options. (h) Includes 20,235 shares subject to acquisition within 60 days by exercise of employee stock options. (i) Includes 14,342 shares subject to acquisition within 60 days by exercise of employee stock options. (j) Includes 284,453 shares subject to acquisition within 60 days by exercise of employee stock options. Certain affiliates of Morgan Stanley Group are entitled, subject to the satisfaction of certain conditions, to receive up to 20% of certain gains realized by MSLEF II on its investment in Common Stock, up to 10% of certain gains realized by Fort Howard Equity Investors, L.P. and up to 10% of certain gains realized by Fort Howard Equity Investors II, L.P. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS MANAGEMENT EQUITY PLAN Effective as of April 29, 1991, the Board of Directors adopted the Fort Howard Corporation Management Equity Plan (the "Management Equity Plan"). The Management Equity Plan provides for the offer of Common Stock and the grant of options to purchase Common Stock to executive officers and certain other key employees of the Company. Executive officers or other key employees of the Company who purchase shares of Common Stock or are granted options pursuant to the Management - 53 - Equity Plan ("Equity Investors") are required to enter into a Management Equity Plan Agreement with the Company, and to become bound by the terms of the Company's stockholders agreement. See "Stockholders Agreement." Options granted pursuant to the Management Equity Plan vest in accordance with a schedule determined at the time of grant and set forth in the applicable Management Equity Plan Agreement. Any such options will be subject to partial acceleration of vesting in the event of death or disability. Shares of Common Stock purchased pursuant to the Management Equity Plan, as well as options that have become vested, may not be transferred for an extended period of time, except in certain limited circumstances. Options which have not vested are not transferable. Subject to certain exceptions, under the Management Equity Plan, Equity Investors who terminate their employment with the Company before the later of (i) the fifth anniversary of the date on which shares of Common Stock were purchased or options were granted, as the case may be, and (ii) the date on which 15% or more of the Common Stock has been sold in one or more public offerings, must sell their shares of Common Stock and vested options to the Company or its designee. The terms and conditions of such repurchases by the Company (including the determination of the applicable repurchase price) are substantially similar to those prescribed for the repurchase by the Company of shares of Common Stock and vested options acquired by certain executive officers and other key employees of the Company pursuant to the Management Equity Participation Agreement (as defined below). See "Management Equity Participation." Subject to certain exceptions, options which have not vested at the time an Equity Investor's employment is terminated are forfeited to the Company. The Management Equity Plan also provides that Equity Investors may put specified percentages of their shares of Common Stock and vested options to the Company annually during the period from the fifth anniversary of the date on which such shares were purchased or options were granted, as the case may be, to the date on which 15% or more of the Common Stock has been sold in one or more public offerings. The terms and conditions governing such put option are substantially similar to those prescribed for the exercise of the put option set forth in the Management Equity Participation Agreement. In April 1991, certain executive officers and other key employees of the Company purchased an aggregate of 6,200 shares of Common Stock at $120 per share pursuant to the Management Equity Plan. In addition, options to purchase a total of 111,100 shares of Common Stock at an exercise price of $120 per share were granted in 1991, 1992 and 1993 pursuant to the Management Equity Plan to certain executive officers and other key employees of the Company. Such options vest at the rate of 20% per year. Further, the terms and conditions of options to purchase 15,500 shares of Common Stock granted in December 1988 at an exercise price of $100 per share pursuant to a predecessor plan are now governed by the Management Equity Plan. MANAGEMENT EQUITY PARTICIPATION Mr. DeMeuse, Ms. Hempel, Mr. Riordan and other current executive officers and members of the Company's senior management (the "Management Investors") are parties to an Amended and Restated Management Equity Participation Agreement, as amended, with the Company, Morgan Stanley Group and MSLEF II (the "Management Equity Participation Agreement"), pursuant to which the Management Investors purchased 63,107 shares of Common Stock in 1988 and 4,896 - 54 - shares of Common Stock in 1990 at $100 and $135 per share, respectively. Management Investors who purchased shares of Common Stock pursuant to the Management Equity Participation Agreement were also granted stock options to acquire 278,052 and 42,460 shares of Common Stock pursuant to the Management Equity Participation Agreement at exercises prices of $100 and $120 per share, respectively. Such options vest at the rate of 20% per year and are subject to partial acceleration of vesting in the event of death or disability. Certain of the Management Investors have also purchased shares of Common Stock and have been granted options to acquire additional shares of Common Stock pursuant to the terms of the Management Equity Plan. See "Management Equity Plan." The Management Equity Participation Agreement prohibits for an extended period of time, except in certain limited circumstances, the transfer of Common Stock and rights to acquire Common Stock, including options that have become vested ("Vested Options"), held by the Management Investors. Options which have not vested are not transferable. Subject to certain exceptions relating to death and disability, the Management Equity Participation Agreement also provides that Management Investors who terminate their employment with the Company within five years of the date (the "Effective Date") on which shares of Common Stock were purchased and options were granted shall sell their shares of Common Stock and Vested Options to the Company or its designee. In the case of termination by the Company without "cause" (as defined), termination as a result of death or disability or retirement at an age of at least 55 years, or, only in the case of Mr. DeMeuse or Ms. Hempel, the voluntary termination of employment by a Management Investor for "good reason" (as defined), the purchase price to be paid by the Company for shares of Common Stock is equal to the greater of the consideration paid for each share or the fair market value of such shares (except that the purchase price is equal to fair market value with respect to shares acquired in 1990 by Management Investors other than Mr. DeMeuse). (Under the Management Equity Plan, the purchase price upon such a termination of employment is in all cases equal to fair market value.) In all other cases, the purchase price to be paid by the Company for shares of Common Stock is equal to the lesser of the consideration paid for each share or the fair market value of such shares. Without regard to the reason for termination, the purchase price to be paid by the Company for Vested Options is equal to the fair market value of the shares subject to the options, minus the aggregate exercise price. The Management Equity Participation Agreement also provides that Management Investors shall sell to the Company or its designee the shares of Common Stock and Vested Options held by them if they terminate their employment with the Company after the date which is five years from the Effective Date unless as of such date 15% or more of the Common Stock has been sold in one or more public offerings. In such event, the purchase price to be paid by the Company for shares of Common Stock and Vested Options is equal to their fair market value. Subject to certain exceptions, any options which have not vested at the time a Management Investor's employment is terminated are forfeited to the Company. The Management Equity Participation Agreement also provides that the Management Investors may put to the Company annually during the period from the fifth anniversary of the Effective Date to the date on which 15% or more of the Common Stock has been sold in one or more public offerings, specified percentages of their shares of Common Stock and Vested Options at a price equal to their fair market value. In certain circumstances and subject to certain limitations, Mr. DeMeuse and Ms. Hempel may require MSLEF II or Morgan Stanley Group to fulfill the Company's purchase obligations upon any termination of employment or exercise of the put option. - 55 - The Management Equity Participation Agreement also provides that the Company will indemnify Management Investors for taxes on income which may be recognized upon the vesting of shares of Common Stock under certain circumstances. The indemnity is limited to the tax benefit to the Company, and if the tax benefit has not yet been received by the Company in cash at the time when the taxes must be paid by a Management Investor, the Company will make a nonrecourse loan to the Management Investor (secured by Common Stock and Vested Options) until the time the tax benefit is actually received. The Management Equity Participation Agreement contains noncompetition provisions applicable to each Management Investor except Mr. DeMeuse, Ms. Hempel and Mr. Riordan, whose noncompetition agreements are contained in their respective Employment Agreements. (Similar noncompetition provisions are applicable to the Equity Investors under the Management Equity Plan.) The Company's obligation to make nonrecourse loans under the Management Equity Participation Agreement or purchase shares of Common Stock for cash pursuant to the Management Equity Participation Agreement or the Management Equity Plan is subject to restrictions contained in any debt or lease agreements to which it is a party. In 1988 and 1990, the Company's former chairman of the board and chief executive officer acquired shares of Common Stock and was granted options to acquire additional shares of Common Stock pursuant to the Management Equity Participation Agreement. Under the terms of an agreement entered into with the Company at the time of his resignation in July 1990, he retained his entire interest in the Company's Common Stock and all options to acquire additional shares thereof granted to him pursuant to the Management Equity Participation Agreement were vested. In addition, all the shares of the Company's Common Stock then owned by him became putable to the Company, and he retained certain other put rights previously granted to him with respect to such options and the shares issuable upon the exercise thereof. Except as set forth above, the former chairman and chief executive officer's interest in the Company's Common Stock remains subject to terms substantially equivalent to the relevant terms of the Management Equity Participation Agreement. STOCKHOLDERS AGREEMENT The Company, Morgan Stanley Group, MSLEF II, certain other investors and the Management Investors have entered into a stockholders agreement (the "Stockholders Agreement"), which contains certain restrictions with respect to the transferability of Common Stock by the parties thereunder, certain registration rights granted by the Company with respect to such shares and certain voting arrangements. The Stockholders Agreement will terminate as of such time as more than 50% of the shares of Common Stock then outstanding have been sold pursuant to one or more public offerings. Pursuant to the terms of the Stockholders Agreement, no holder of Common Stock who is a party or becomes a party to the Stockholders Agreement (a "Holder") may sell or otherwise encumber Common Stock beneficially owned by such Holder unless such transfer is to (i) certain permitted transferees (related persons or affiliated entities) of such Holder, (ii) the Company, or in certain cases its designees, (iii) subject to certain rights of first refusal by the other Holders and the Company, any person if immediately after such sale the transferee and its affiliates do not in the aggregate beneficially own more than 15% of the Common Stock then outstanding, subject to receipt of a legal opinion that such sale does not require the Common Stock to be registered under the Securities Act of 1933, and such transferee is not determined by the Board of Directors of the Company to be an "Adverse Person" - 56 - (as defined in the Stockholders Agreement), (iv) any person pursuant to a public offering, or (v) any person pursuant to Rule 144 under the Securities Act of 1933 after 15% or more of the Common Stock has been sold pursuant to one or more underwritten public offerings. Notwithstanding the above, however, Morgan Stanley Group and MSLEF II, have the right to transfer all or any portion of the Common Stock beneficially owned by them (i) at any time in connection with the refinancing of the Company's outstanding indebtedness, or (ii) at any time in connection with one transaction or a series of transactions in which Morgan Stanley Group and/or MSLEF II intends to sell such number of shares of Common Stock then constituting a majority of the outstanding shares of Common Stock subject to the Stockholders Agreement. In the event that one or more Holders (each a "Controlling Stockholder") sell a majority of the shares of Common Stock subject to the Stockholders Agreement to a third party, each other Holder has the right to elect to sell on the same terms the same percentage of such other Holder's shares to the third party as the Controlling Stockholder is selling of its shares of Common Stock. In addition, if a Controlling Stockholder sells all of its shares of Common Stock to a third party, the Controlling Stockholder has the right to require that the remaining Holders sell all of their shares to the third party on the same terms. Pursuant to the terms of the Stockholders Agreement, Holders of specified percentages of Common Stock will be entitled to certain demand registration rights ("Demand Rights") with respect to shares of Common Stock held by them; provided, however, that the Company (or purchasers designated by the Company) shall have the right to purchase at fair market value the shares which are the subject of Demand Rights in lieu of registering such shares of Common Stock. In addition to the Demand Rights, Holders are, subject to certain limitations, entitled to register shares of Common Stock in connection with a registration statement prepared by the Company to register its equity securities. The Stockholders Agreement contains customary terms and provisions with respect to, among other things, registration procedures and certain rights to indemnification granted by parties thereunder in connection with the registration of Common Stock subject to such agreement. The Stockholders Agreement also requires the Holders to vote for director designees of Morgan Stanley Group and its affiliates (including one director designated by MSLEF II) ensuring Morgan Stanley Group and its affiliates majority board representation for so long as they own a majority of the outstanding Common Stock. Pursuant to the Stockholders Agreement, Holders have certain preemptive rights, subject to certain exceptions, with respect to future issuances of shares or share equivalents of Common Stock so that such Holders may maintain their proportional equity ownership interest in the Company. OTHER TRANSACTIONS The Company has entered into an agreement with MS&Co. for financial advisory services in consideration for which the Company pays MS&Co. an annual fee of $1 million. MS&Co. is also entitled to reimbursement for all reasonable expenses incurred in performance of the foregoing services. The Company paid MS&Co. $1,046,000 for these and other miscellaneous services in 1993. In 1993, MS&Co. also received approximately $19,500,000 related to the underwriting of the issuance of the 1993 Notes. Based on transactions of similar size and nature, the Company believes the foregoing fees received by - 57 - MS&Co. are no less favorable to the Company than would be available from unaffiliated third parties. In 1993, the Company sold its remaining equity interest in Sweetheart for $5.1 million. Terms of the sale were negotiated by Morgan Stanley Group pursuant to a 1992 agreement among the Company and the other holders of Sweetheart common stock granting Morgan Stanley Group the authority, among other things, to contract to sell all or some of the shares of Sweetheart common stock owned by the Company on the Company's behalf, or to restructure Sweetheart's debt and equity capitalization. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a. 1. Financial Statements of Fort Howard Corporation Included in Part II, Item 8: Report of Independent Public Accountants. Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheets as of December 31, 1993 and 1992. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Separate financial statements and supplemental schedules of the Company and its consolidated subsidiaries are omitted since the Company is primarily an operating corporation and its consolidated subsidiaries included in the consolidated financial statements being filed do not have a minority equity interest or indebtedness to any other person or to the Company in an amount which exceeds five percent of the total assets as shown by the consolidated financial statements as filed herein. a. 2. Financial Statement Schedules Report of Independent Public Accountants Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts Schedule X -- Supplementary Income Statement Information All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the audited consolidated financial statements or notes thereto. - 58 - a. 3. Exhibits Exhibit No. Description ----------- ----------- 3.1 Restated Certificate of Incorporation of the Company dated December 7, 1990. (Incorporated by reference to Exhibit 3.A as filed with the Company's Form 10-K for the year ended December 31, 1990.) 3.2 Amended and Restated By-Laws of the Company dated April 2, 1992. (Incorporated by reference to Exhibit 3.B as filed with the Company's Form 10-K for the year ended December 31, 1992.) 4.1 Form of 12 3/8% Senior Subordinated Note Indenture dated as of November 1, 1988 between the Company and State Street Bank and Trust Company, Trustee. (Incorporated by reference to Exhibit 4.1 as filed with Amendment No. 2 to the Company's Form S-1 on October 25, 1988.) 4.2 Form of 12 5/8% Subordinated Debenture Indenture dated as of November 1, 1988 between the Company and United States Trust Company, Trustee. (Incorporated by reference to Exhibit 4.2 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 4.3 Form of 14 1/8% Junior Discount Debenture Indenture dated as of November 1, 1988 between the Company and Ameritrust Company National Association, Trustee. (Incorporated by reference to Exhibit 4.3 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 4.4 Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.5 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 4.4(A) Amendment No. 1 dated as of February 21, 1989 to the Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.E 1 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989.) 4.4(B) Amendment No. 2 dated as of October 20, 1989 to the Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.E 2 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989.) 4.4(C) Amendment No. 3 dated as of November 14, 1989 to the Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.E 3 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989.) - 59 - 4.4(D) Instrument of Designation, Appointment and Acceptance dated as of June 22, 1988 among the Company, Bankers Trust Company and Security Pacific National Bank. (Incorporated by reference to Exhibit 4.7 as filed with the Company's Post-Effective Amendment No. 2 to Form S-1 on February 8, 1990.) 4.4(E) Amendment No. 4 dated as of November 9, 1990 to Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.J as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990.) 4.4(F) Amendment No. 5 dated as of December 19, 1990 to Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.K as filed with the Company's Form 10-K for the year ended December 31, 1990.) 4.4(G) Amendment No. 6 dated as of September 11, 1991 to Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.A as filed with the Company's report on Form 8-K on September 13, 1991.) 4.4(H) Amendment No. 7 dated as of December 2, 1991 to Amended and Restated Credit Agreement dated as of October 14, 1988, and Amendment No. 1 dated as of December 2, 1991, to the Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.N as filed with the Company's Form 10-K for the year ended December 31, 1991.) 4.4(I) Amendment No. 8 dated as of October 7, 1992 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Amendment No. 2 dated as of October 7, 1992 to the Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.O as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992.) 4.4(J) Amended and Restated Amendment No. 8 dated as of November 12, 1992 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Amended and Restated Amendment No. 2 dated as of November 12, 1992 to the Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.P as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992.) 4.4(K) Form of Second Amended and Restated Amendment No. 8 dated as of March 4, 1993 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Second Amended and Restated Amendment No. 2 dated as of March 4, 1993 to Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.3(J) as filed with the Company's Amendment No. 2 to Form S-2 on March 4, 1993.) 4.4(L) Amendment No. 9 dated as of December 31, 1993 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Amendment No. 3 dated as of December 31, 1993 to Note Purchase Agreement dated as of September 22, 1991. - 60 - 4.5 Form of Senior Secured Floating Rate Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.B as filed with the Company's report on Form 8-K on September 13, 1991.) 4.6 Form of 9 1/4% Senior Note Indenture dated as of March 15, 1993 between the Company and Norwest Bank Wisconsin, N.A., Trustee. (Incorporated by reference to Exhibit 4.1 as filed with the Company's Amendment No. 2 to Form S-2 on March 4, 1993.) 4.7 Form of 10% Subordinated Note Indenture dated as of March 15, 1993 between the Company and the United States Trust Company of New York, Trustee. (Incorporated by reference to Exhibit 4.2 as filed with the Company's Amendment No. 2 to Form S-2 on March 4, 1993.) 4.8 Form of 9% Senior Subordinated Note Indenture dated as of February 1, 1994 between the Company and The Bank of New York, Trustee. (Incorporated by reference to Exhibit 4.2 as filed with the Company's Form S-2 on December 17, 1993.) Registrant agrees to provide copies of instruments defining the rights of security holders, including indentures, upon request of the Commission. 10.1 Employment Agreements dated October 15, 1993 with the Company's Chief Executive Officer, Chief Operating Officer and Chief Financial Officer. (Incorporated by reference to Exhibit No. 10 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993.) 10.2 Employment Agreements dated December 10, 1993 with certain executive officers of the Company. (Incorporated by reference to Exhibit 10.13 as filed with the Company's Form S-2 on December 17, 1993.) 10.3 Stockholders Agreement dated as of December 7, 1990. (Incorporated by reference to Exhibit 10.C as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.4 Management Incentive Plan as amended and restated December 10, 1992. (Incorporated by reference to Exhibit 10.C as filed with the Company's Form 10-K for the year ended December 31, 1992.) 10.5 Supplemental Retirement Plan. (Incorporated by reference to Exhibit No. 10.7 as filed with Amendment No. 2 to the Company's Form S-1 on October 25, 1988.) 10.5(1) Amendment No. 1 to the Supplemental Retirement Plan. (Incorporated by reference to Exhibit 10.P as filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1988.) 10.6 Form of Supplemental Retirement Agreement for the Company's Chief Executive Officer as Amended. (Incorporated by reference to Exhibit 10.M as filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1988.) - 61 - 10.7 Supplemental Retirement Agreements for certain directors and officers. (Incorporated by reference to Exhibit 10.T as filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) 10.7(A) Form of Amendment No. 1 to Supplemental Retirement Agreements for certain directors and officers. (Incorporated by reference to Exhibit 10.U as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8 Amended and Restated Management Equity Participation Agreement dated as of August 1, 1988. (Incorporated by reference to Exhibit No. 10.9 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 10.8(A) Letter Agreement dated June 27, 1990, which modifies Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.V as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(B) Letter Agreement dated July 31, 1990, among the Company and the Principal Management Investors which amends Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.W as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(C) Letter Agreement dated July 31, 1990, between the Company and the Management Investor Committee which amends Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.X as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(D) Letter Agreement dated February 7, 1991, between the Company and the Management Investors Committee which amends the Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.GG as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(E) Form of Letter Agreement dated February 7, 1991, among the Company, the Management Investors Committee and Management Investors which cancels certain stock options, grants new stock options and amends the Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.HH as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.9 Management Equity Plan. (Incorporated by reference to Exhibit 10.H as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.9(A) Amendment dated December 28, 1993 to Management Equity Plan. 10.10 Form of Management Equity Plan Agreement. (Incorporated by reference to Exhibit 10.I as filed with the Company's Form 10-K for the year ended December 31, 1991.) - 62 - 10.11 Agreement dated as of July 31, 1990, between the Company and its former Chief Executive Officer. (Incorporated by reference to Exhibit 10.Y as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.11(A) Modification to Agreement dated as of July 31, 1990, between the Company and its former Chief Executive Officer. (Incorporated by reference to Exhibit 10.Z as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.11(B) Letter Agreement dated February 7, 1991, between the Company and its former Chief Executive Officer which cancels stock options, grants new stock options and amends the Agreement dated as of July 31, 1990 among the Company and its former Chief Executive Officer. (Incorporated by reference to Exhibit 10.II as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.12 Financial Advisory Agreement dated as of October 25, 1988, between MS&Co. and the Company. (Incorporated by reference to Exhibit 10.13 as filed with the Company's Post-Effective Amendment No. 1 to Form S-1 on April 6, 1989.) 10.13 Participation Agreement dated as of October 26, 1989, among the Company, Philip Morris Credit Corporation, the Loan Participants listed therein, the Connecticut National Bank, Owner Trustee, and Wilmington Trust Company, Indenture Trustee. (Incorporated by reference to Exhibit 10.15 as filed with the Company's Post-Effective Amendment No. 2 to Form S-1 on February 8, 1990.) 10.14 Facility Lease Agreement dated as of October 26, 1989, between the Connecticut National Bank in its capacity as Owner Trustee, the Lessor and the Company as Lessee. (Incorporated by reference to Exhibit 10.16 as filed with the Company's Post-Effective Amendment No. 2 to Form S-1 on February 8, 1990.) 10.15 Power Installation Lease Agreement dated as of October 20, 1989, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.HH as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.16 Equipment Lease Agreement dated as of October 20, 1989, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.II as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.17 Participation Agreement dated as of December 23, 1990, among the Company, Bell Atlantic Tricon Leasing Corporation, Bankers Trust Company, The Connecticut National Bank, Owner Trustee, and Wilmington Trust Company, Indenture Trustee. (Incorporated by reference to Exhibit 10.BB as filed with the Company's Form 10-K for the year ended December 31, 1990.) - 63 - 10.18 Amended and Restated Equipment Lease Agreement [1990] dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee under the Trust Agreement, as Lessor, and the Company, as Lessee. (Incorporated by reference to Exhibit 10.W as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.19 Facility Lease Agreement dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.EE as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.20 Equipment Lease Agreement [1991] dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.FF as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.21 Power Plant Lease Agreement dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.GG as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.22 Amended and Restated Participation Agreement dated as of October 21, 1991, among the Company, Bell Atlantic Tricon Leasing Corporation, Bankers Trust Company, The Connecticut National Bank, Owner Trustee, and Wilmington Trust Company, Indenture Trustee and the Form of the First Amendment thereto dated as of December 13, 1991. (Incorporated by reference to Exhibit 4.3 as filed with the Company's Amendment No. 3 to Form S-3 on December 13, 1991). 12 Statement of Deficiency of Earnings Available to Cover Fixed Charges. 21 Subsidiaries of Fort Howard Corporation. 25 Powers of Attorney (included as part of signature page). b. Reports on Form 8-K No reports on Form 8-K were filed for the Company during the last quarter of 1993. - 64 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. FORT HOWARD CORPORATION Green Bay, Wisconsin March 7, 1994 By /s/ Donald H. DeMeuse ---------------------------------- Donald H. DeMeuse, Chairman of the Board and Chief Executive Officer POWER OF ATTORNEY The undersigned directors and officer of Fort Howard Corporation hereby constitute and appoint Donald H. DeMeuse, Kathleen J. Hempel and James W. Nellen II and each of them, with full power to act without the other and with full power of substitution and resubstitution, our true and lawful attorneys- in-fact with full power to execute in our name and behalf in the capacities indicated below any and all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission and hereby ratify and confirm all that such attorneys-in-fact, or any of them, or their substitutes shall lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on behalf of the registrant and in the capacities on the dates indicated: /s/ Donald H. DeMeuse Chairman of the Board, March 7, 1994 Donald H. DeMeuse Chief Executive Officer and Director /s/ Kathleen J. Hempel Vice Chairman, Chief March 7, 1994 Kathleen J. Hempel Financial Officer and Director /s/ Michael T. Riordan President, Chief March 7, 1994 Michael T. Riordan Operating Officer and Director /s/ Donald P. Brennan Director March 7, 1994 Donald P. Brennan /s/ Frank V. Sica Director March 7, 1994 Frank V. Sica /s/ Robert H. Niehaus Director March 7, 1994 Robert H. Niehaus /s/ James S. Hoch Director March 7, 1994 James S. Hoch /s/ Charles L. Szews Controller and Principal March 7, 1994 Charles L. Szews Accounting Officer - 65 - REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Fort Howard Corporation included in this Form 10-K and have issued our report thereon dated February 1, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Milwaukee, Wisconsin February 1, 1994 - 66 - Schedule V FORT HOWARD CORPORATION PROPERTY, PLANT AND EQUIPMENT (In thousands) NOTE: *Other includes the effects of foreign currency translation, transfers from construction in progress, the effects of the acquisition of Stuart Edgar in 1992, and the effects of the sale and leaseback transactions in 1991. - 67 - Schedule VI FORT HOWARD CORPORATION ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In thousands) NOTES: *The provision is based on the straight-line depreciation method with rates varying from 2% to 50% per year. **Other includes the effects of foreign currency translation and reclassifications. - 68 - Schedule VIII FORT HOWARD CORPORATION VALUATION AND QUALIFYING ACCOUNTS (In thousands) For the Years Ended December 31, --------------------------------- ALLOWANCE FOR DOUBTFUL ACCOUNTS: 1993 1992 1991 ---- ---- ---- Balance at beginning of year.......... $1,376 $1,379 $1,502 Additions charged to earnings......... 1,633 792 698 Charges for purpose for which reserve was created............... (643) (795) (821) ------ ------ ------ Balance at end of year................ $2,366 $1,376 $1,379 ====== ====== ====== - 69 - Schedule X FORT HOWARD CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) Charged to Costs and Expenses ----------------------------- For the Years Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- Maintenance and repairs.............. $49,626 $46,671 $45,324 ======= ======= ======= - 70 - INDEX TO EXHIBITS Exhibit No. - ----------- 3.1 Restated Certificate of Incorporation of the Company dated December 7, 1990. (Incorporated by reference to Exhibit 3.A as filed with the Company's Form 10-K for the year ended December 31, 1990.) 3.2 Amended and Restated By-Laws of the Company dated April 2, 1992. (Incorporated by reference to Exhibit 3.B as filed with the Company's Form 10-K for the year ended December 31, 1992.) 4.1 Form of 12 3/8% Senior Subordinated Note Indenture dated as of November 1, 1988 between the Company and State Street Bank and Trust Company, Trustee. (Incorporated by reference to Exhibit 4.1 as filed with Amendment No. 2 to the Company's Form S-1 on October 25, 1988.) 4.2 Form of 12 5/8% Subordinated Debenture Indenture dated as of November 1, 1988 between the Company and United States Trust Company, Trustee. (Incorporated by reference to Exhibit 4.2 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 4.3 Form of 14 1/8% Junior Discount Debenture Indenture dated as of November 1, 1988 between the Company and Ameritrust Company National Association, Trustee. (Incorporated by reference to Exhibit 4.3 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 4.4 Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.5 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 4.4(A) Amendment No. 1 dated as of February 21, 1989 to the Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.E 1 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989.) 4.4(B) Amendment No. 2 dated as of October 20, 1989 to the Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.E 2 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989.) 4.4(C) Amendment No. 3 dated as of November 14, 1989 to the Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.E 3 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989.) - 71 - 4.4(D) Instrument of Designation, Appointment and Acceptance dated as of June 22, 1988 among the Company, Bankers Trust Company and Security Pacific National Bank. (Incorporated by reference to Exhibit 4.7 as filed with the Company's Post-Effective Amendment No. 2 to Form S-1 on February 8, 1990.) 4.4(E) Amendment No. 4 dated as of November 9, 1990 to Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.J as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990.) 4.4(F) Amendment No. 5 dated as of December 19, 1990 to Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.K as filed with the Company's Form 10-K for the year ended December 31, 1990.) 4.4(G) Amendment No. 6 dated as of September 11, 1991 to Amended and Restated Credit Agreement dated as of October 24, 1988. (Incorporated by reference to Exhibit 4.A as filed with the Company's report on Form 8-K on September 13, 1991.) 4.4(H) Amendment No. 7 dated as of December 2, 1991 to Amended and Restated Credit Agreement dated as of October 14, 1988, and Amendment No. 1 dated as of December 2, 1991, to the Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.N as filed with the Company's Form 10-K for the year ended December 31, 1991.) 4.4(I) Amendment No. 8 dated as of October 7, 1992 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Amendment No. 2 dated as of October 7, 1992 to the Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.O as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992.) 4.4(J) Amended and Restated Amendment No. 8 dated as of November 12, 1992 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Amended and Restated Amendment No. 2 dated as of November 12, 1992 to the Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.P as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992.) 4.4(K) Form of Second Amended and Restated Amendment No. 8 dated as of March 4, 1993 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Second Amended and Restated Amendment No. 2 dated as of March 4, 1993 to Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.3(J) as filed with the Company's Amendment No. 2 to Form S-2 on March 4, 1993.) *4.4(L) Amendment No. 9 dated as of December 31, 1993 to Amended and Restated Credit Agreement dated as of October 24, 1988, and Amendment No. 3 dated as of December 31, 1993 to Note Purchase Agreement dated as of September 22, 1991. - 72 - 4.5 Form of Senior Secured Floating Rate Note Purchase Agreement dated as of September 11, 1991. (Incorporated by reference to Exhibit 4.B as filed with the Company's report on Form 8-K on September 13, 1991.) 4.6 Form of 9 1/4% Senior Note Indenture dated as of March 15, 1993 between the Company and Norwest Bank Wisconsin, N.A., Trustee. (Incorporated by reference to Exhibit 4.1 as filed with the Company's Amendment No. 2 to Form S-2 on March 4, 1993.) 4.7 Form of 10% Subordinated Note Indenture dated as of March 15, 1993 between the Company and the United States Trust Company of New York, Trustee. (Incorporated by reference to Exhibit 4.2 as filed with the Company's Amendment No. 2 to Form S-2 on March 4, 1993.) 4.8 Form of 9% Senior Subordinated Note Indenture dated as of February 1, 1994 between the Company and The Bank of New York, Trustee. (Incorporated by reference to Exhibit 4.2 as filed with the Company's Form S-2 on December 17, 1993.) Registrant agrees to provide copies of instruments defining the rights of security holders, including indentures, upon request of the Commission. 10.1 Employment Agreements dated October 15, 1993 with the Company's Chief Executive Officer, Chief Operating Officer and Chief Financial Officer. (Incorporated by reference to Exhibit No. 10 as filed with the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993.) 10.2 Employment Agreements dated December 10, 1993 with certain executive officers of the Company. (Incorporated by reference to Exhibit 10.13 as filed with the Company's Form S-2 on December 17, 1993.) 10.3 Stockholders Agreement dated as of December 7, 1990. (Incorporated by reference to Exhibit 10.C as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.4 Management Incentive Plan as amended and restated December 10, 1992. (Incorporated by reference to Exhibit 10.C as filed with the Company's Form 10-K for the year ended December 31, 1992.) 10.5 Supplemental Retirement Plan. (Incorporated by reference to Exhibit No. 10.7 as filed with Amendment No. 2 to the Company's Form S-1 on October 25, 1988.) 10.5(1) Amendment No. 1 to the Supplemental Retirement Plan. (Incorporated by reference to Exhibit 10.P as filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1988.) 10.6 Form of Supplemental Retirement Agreement for the Company's Chief Executive Officer as Amended. (Incorporated by reference to Exhibit 10.M as filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1988.) - 73 - 10.7 Supplemental Retirement Agreements for certain directors and officers. (Incorporated by reference to Exhibit 10.T as filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) 10.7(A) Form of Amendment No. 1 to Supplemental Retirement Agreements for certain directors and officers. (Incorporated by reference to Exhibit 10.U as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8 Amended and Restated Management Equity Participation Agreement dated as of August 1, 1988. (Incorporated by reference to Exhibit No. 10.9 as filed with the Company's Amendment No. 2 to Form S-1 on October 25, 1988.) 10.8(A) Letter Agreement dated June 27, 1990, which modifies Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.V as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(B) Letter Agreement dated July 31, 1990, among the Company and the Principal Management Investors which amends Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.W as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(C) Letter Agreement dated July 31, 1990, between the Company and the Management Investor Committee which amends Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.X as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(D) Letter Agreement dated February 7, 1991, between the Company and the Management Investors Committee which amends the Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.GG as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.8(E) Form of Letter Agreement dated February 7, 1991, among the Company, the Management Investors Committee and Management Investors which cancels certain stock options, grants new stock options and amends the Amended and Restated Management Equity Participation Agreement. (Incorporated by reference to Exhibit 10.HH as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.9 Management Equity Plan. (Incorporated by reference to Exhibit 10.H as filed with the Company's Form 10-K for the year ended December 31, 1991.) *10.9(A) Amendment dated December 28, 1993 to Management Equity Plan. 10.10 Form of Management Equity Plan Agreement. (Incorporated by reference to Exhibit 10.I as filed with the Company's Form 10-K for the year ended December 31, 1991.) - 74 - 10.11 Agreement dated as of July 31, 1990, between the Company and its former Chief Executive Officer. (Incorporated by reference to Exhibit 10.Y as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.11(A) Modification to Agreement dated as of July 31, 1990, between the Company and its former Chief Executive Officer. (Incorporated by reference to Exhibit 10.Z as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.11(B) Letter Agreement dated February 7, 1991, between the Company and its former Chief Executive Officer which cancels stock options, grants new stock options and amends the Agreement dated as of July 31, 1990 among the Company and its former Chief Executive Officer. (Incorporated by reference to Exhibit 10.II as filed with the Company's Form 10-K for the year ended December 31, 1990.) 10.12 Financial Advisory Agreement dated as of October 25, 1988, between MS&Co. and the Company. (Incorporated by reference to Exhibit 10.13 as filed with the Company's Post-Effective Amendment No. 1 to Form S-1 on April 6, 1989.) 10.13 Participation Agreement dated as of October 26, 1989, among the Company, Philip Morris Credit Corporation, the Loan Participants listed therein, the Connecticut National Bank, Owner Trustee, and Wilmington Trust Company, Indenture Trustee. (Incorporated by reference to Exhibit 10.15 as filed with the Company's Post-Effective Amendment No. 2 to Form S-1 on February 8, 1990.) 10.14 Facility Lease Agreement dated as of October 26, 1989, between the Connecticut National Bank in its capacity as Owner Trustee, the Lessor and the Company as Lessee. (Incorporated by reference to Exhibit 10.16 as filed with the Company's Post-Effective Amendment No. 2 to Form S-1 on February 8, 1990.) 10.15 Power Installation Lease Agreement dated as of October 20, 1989, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.HH as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.16 Equipment Lease Agreement dated as of October 20, 1989, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.II as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.17 Participation Agreement dated as of December 23, 1990, among the Company, Bell Atlantic Tricon Leasing Corporation, Bankers Trust Company, The Connecticut National Bank, Owner Trustee, and Wilmington Trust Company, Indenture Trustee. (Incorporated by reference to Exhibit 10.BB as filed with the Company's Form 10-K for the year ended December 31, 1990.) - 75 - 10.18 Amended and Restated Equipment Lease Agreement [1990] dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee under the Trust Agreement, as Lessor, and the Company, as Lessee. (Incorporated by reference to Exhibit 10.W as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.19 Facility Lease Agreement dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.EE as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.20 Equipment Lease Agreement [1991] dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.FF as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.21 Power Plant Lease Agreement dated as of December 19, 1991, between The Connecticut National Bank, not in its individual capacity but solely as Owner Trustee, and the Company. (Incorporated by reference to Exhibit 10.GG as filed with the Company's Form 10-K for the year ended December 31, 1991.) 10.22 Amended and Restated Participation Agreement dated as of October 21, 1991, among the Company, Bell Atlantic Tricon Leasing Corporation, Bankers Trust Company, The Connecticut National Bank, Owner Trustee, and Wilmington Trust Company, Indenture Trustee and the Form of the First Amendment thereto dated as of December 13, 1991. (Incorporated by reference to Exhibit 4.3 as filed with the Company's Amendment No. 3 to Form S-3 on December 13, 1991). *12 Statement of Deficiency of Earnings Available to Cover Fixed Charges. *21 Subsidiaries of Fort Howard Corporation. *25 Powers of Attorney (included as part of signature page). *Filed herewith. - 76 -

110471_1993.txt

110471_1993

1993

110471

Item 1. Business Wolverine World Wide, Inc. (the "Company"), designs, manufactures, distributes and markets various brands and styles of footwear. The wide variety of footwear sold by the Company includes casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes and work boots and shoes. The Company is also the largest domestic tanner of pigskin. The Company, a Delaware corporation, is the successor of a 1969 reorganization of a Michigan corporation of the same name, originally organized in 1906, which in turn was the successor of a business established in Grand Rapids, Michigan, in 1883. The Company is a leading provider of branded, comfort footwear for the entire family, supplying more than 17 million pairs annually to consumers in 80 countries. Footwear has accounted for 90% or more of the consolidated revenues of the Company for each of the last three years. For further financial information regarding the Company, see the consolidated financial statements of the Company, which are attached as Appendix A to this Form 10-K. Footwear manufactured by the Company is sold under many recognizable brand names. The Company's HUSH PUPPIES (Registered) brand is a world leader in affordable, comfortable, casual and functional footwear for men, women and children. The Company's WOLVERINE (Registered) brand of work and sport boots ranks as the number two brand of work and sport boots. The Company's BATES (Registered) brand is the number one brand of uniform footwear in the United States. The Tru-Stitch Footwear Division is the foremost supplier of constructed slippers in the United States. The Company has also introduced a line of rugged outdoor and sport footwear under the WOLVERINE WILDERNESS (Registered) brand. Through these, and several other footwear brands, the Company expects to continue to manufacture quality footwear for its customers. The Company also manufactures and sources shoes for sale through world wide licensing arrangements under the COLEMAN (Registered), CATERPILLAR (Registered) and CAT (Registered) trademarks. The Wolverine Leathers Division is one of the premier tanners of quality pigskin leather for the shoe, automotive and leather goods industries. The pigskin leather tanned by the Company is used in a significant portion of the footwear manufactured and sold by the Company, and is also sold to other domestic and foreign manufacturers of shoes. The Company's products are sold by Company salespersons and agents and through Company-owned stores. Sales are made directly to various retail sellers, including independent shoe stores, footwear chains and department stores. Most customers also sell shoes bought from competing manufacturers. Company products are sold directly to more than 10,000 accounts, operating more than 20,000 retail locations. Sales are also made to large footwear chains, including those owned or operated by other companies in the shoe industry, catalog houses, and to the retail operations referenced below. In addition to its wholesale activities, the Company operated 124 domestic retail shoe stores, leased shoe departments and Company-owned HUSH PUPPIES (Registered) Specialty Stores as of March 25, 1994. A fiscal 1990 decision to downsize the factory outlet business will result in closing approximately 9 outlet retail locations during 1994. Eleven outlet retail locations were closed in fiscal 1993. Of the 124 retail locations, approximately 66 are factory outlet stores located in strip centers or in free-standing buildings. Approximately 36 of these stores operate under the LITTLE RED SHOE HOUSE (Service Mark) format. These stores primarily handle closeouts and factory rejects from the Company's own factories and those of other manufacturers. Of the approximately 66 factory outlet stores, 30 are currently operating under the HUSH PUPPIES (Registered) FACTORY DIRECT (Service Mark) name in major manufacturer outlet malls. These stores carry a large selection of first quality company branded footwear. The Company has and may continue to selectively convert LITTLE RED SHOE HOUSE (Service Mark) locations to this retail and merchandising format. The 124 retail locations include 20 regional mall full service, full price HUSH PUPPIES (Registered) Specialty Stores which feature exclusively a broad selection of men's and women's HUSH PUPPIES (Registered) brand footwear. The Company also licenses independent retailers who operate HUSH PUPPIES (Registered) Specialty Stores at another 81 locations. In addition to retail shoe stores and HUSH PUPPIES (Registered) Specialty Stores, the Company operates 38 full price, full service family leased shoe departments in the Pacific Northwest and Alaska, which feature the Company's wholesale brands. The Company derives royalty income from licensing the HUSH PUPPIES (Registered), WOLVERINE (Registered), WILDERNESS (Registered) and other trademarks to domestic and foreign licensees for use on footwear and related products. In addition, the Company sells its own pigskin leather to certain of its licensees. In fiscal 1993, the Company's foreign licensees and distributors sold an estimated 8.3 million pairs of footwear, an increase from approximately 7.4 million pairs sold in fiscal 1992. The Company continues to develop a global network of licensees to market its footwear brands. The licensees purchase goods from the Company and third-party manufacturers and these purchases are generally supported by letters of credit. Each licensee is responsible for the marketing and distribution of the Company's products, and generally purchases substantially all marketing, advertising materials and products from the Company. The Company operates a pigskin tannery as a part of its Wolverine Leathers Division, from which the Company receives virtually all of its pigskin requirements. The tannery is one of the most modern pigskin tanneries in the world. The quality pigskin leather utilized in the Company's products which incorporate this material is a significant element of product cost, and is generally only available at comparable cost and delivery terms from the Company's tannery. Therefore, the continued operation of this tannery is important to the Company's competitive position in the footwear industry. In addition, the Company owns a minority interest in Wan Hau Enterprise Co., Ltd. ("Wan Hau"), a principal tanner of pigskin in Taiwan. The Company provides semi-finished pigskin leather to Wan Hau for finishing in Taiwan. The Company's principal required raw material is quality leather, which it purchases primarily from a select group of domestic suppliers, including the Company's tannery. The Company has traditionally purchased the vast majority of the shearling used extensively in the manufacture of constructed slippers and related products by its Tru-Stitch Footwear Division from a single source, which has been a reliable and consistent supplier. The Company purchases all of its other raw materials, including man-made materials and fabrics for uppers, and leather, rubber and plastics for soles and heels, from a variety of sources, none of which is believed by the Company to be a dominant supplier. The Company is the holder of many trademarks which identify its products. The trademarks which are most widely used by the Company include HUSH PUPPIES (Registered), WOLVERINE (Registered), WILDERNESS (Registered), WOLVERINE WILDERNESS (Registered), BATES (Registered), FLOATERS (Trademark), BATES FLOATAWAYS (Registered), HARBOR TOWN (Trademark), TOWN & COUNTRY (Trademark), TRU-STITCH (Registered), WIMZEES (Registered), and SIOUX MOX (Registered). The Company is also licensed to market footwear in the United States under the COLEMAN (Registered) trademark and throughout the world under the CATERPILLAR (Registered) and CAT (Registered) trademarks. Pigskin leather produced by the Company is sold under the trademarks BREATHIN' BRUSHED PIGSKIN (Registered), SILKEE (Registered) and WEATHER TIGHT (Registered). The Company believes that its products are identified by its trademarks and thus its trademarks are a valuable asset. It is the policy of the Company to vigorously defend its trademarks against infringement to the greatest extent practicable under the laws of the United States and other countries. The Company is also the holder of several patents, copyrights and various other proprietary rights. The Company protects all of its proprietary rights to the greatest extent practicable under applicable law. The Company does not have a significant backlog of non-cancelable orders. On March 1, 1994, the Company had a backlog of orders believed to be firm of approximately $69 million compared with a backlog of approximately $66 million on March 20, 1993. Historically, the Company has not experienced significant cancellation of orders. While orders in backlog are subject to cancellation by customers, the Company expects that substantially all of these orders will be shipped in fiscal 1994. Retail footwear sales are seasonal with significant increases in sales experienced during the Christmas, Easter and back-to-school periods. Due to this seasonal nature of footwear sales, the Company experiences some fluctuation in the levels of working capital. The Company provides working capital for such fluctuation through internal financing and a revolving credit agreement which the Company has in place. The Company expects the seasonal sales pattern to continue in future years. A broad distribution base insulates the Company from dependence on any one customer. No customer of the Company accounted for more than 10% of the Company's consolidated revenues in fiscal year 1993. The Company's footwear lines are manufactured and marketed in a highly competitive environment. The Company competes with numerous other manufacturers (domestic and foreign) and importers, many of which are larger and have greater resources than the Company. The Company's major competitors for its brands of footwear are generally located in the United States. The Company has at least six major competitors in connection with the sale of its work shoes and boots, at least eight major competitors in connection with the sale of its sport boots, and at least fifteen major competitors in connection with the sale of its casual and dress shoes. Virtually all domestic and foreign manufacturers of footwear compete, or plan to compete, with the Company in the rugged casual and outdoor footwear market. Many of these competitors are established in the footwear industry, and have strong market identities. Product performance and quality, including technological improvements, product identity, competitive pricing, and the ability to adapt to style changes are all important elements of competition in the footwear markets served by the Company. The Company attempts to meet competition and maintain its competitive position through promotion of brand awareness, manufacturing efficiencies, its tannery operations and the style, comfort and value of its products. Future sales of the Company will be affected by its continued ability to sell its products at competitive prices and to meet shifts in customer preference. Because of the lack of reliable published statistics, the Company is unable to state with certainty its position in the shoe industry, however, the Company believes it is one of the ten largest domestic manufacturers of footwear. Foreign footwear manufacturers and importers also provide a source of competition for the Company. In order to remain competitive with these foreign entities, the Company continues to improve and expand its manufacturing facilities in Michigan, the Caribbean basin and Mexico. In addition, the Company is continuing to pursue lower cost manufacturing alternatives in the Far East and Latin America. Although a significant portion of the Company's product line is purchased or sourced overseas, the majority of its products are produced in the United States. The Company's footwear is manufactured in several domestic facilities and certain related foreign facilities, including facilities located in Michigan, Arkansas, New York, Mexico, Puerto Rico, Costa Rica, the Dominican Republic and Canada. The Company includes, as an integral part of its domestic manufacturing operations, five factories located in the Caribbean basin and Mexico that produce footwear uppers for final assembly in the Company's domestic factories. The Company sources certain footwear from a variety of foreign manufacturing facilities in the Far East, Latin America and the Caribbean. The Company also maintains a small office in Taiwan to facilitate the sourcing and import of footwear from the Far East. The Company is subject to the normal risks of doing business abroad due to its international operations, including the risks of expropriation, acts of war, political disturbances and similar events, and loss of most favored nations trading status. With respect to its international sourcing activities, management believes that over a period of time, it could arrange adequate alternative sources of supply for the products obtained from its foreign suppliers. A sustained disruption of such sources of supply could, particularly on a short-term basis, have an adverse impact on the Company's operations. At the end of the third quarter of fiscal 1992, the Company announced its intent to dispose of its Brooks athletic footwear and sports apparel business. The Brooks business consisted of sales and distribution operations in the United States, France, Germany and the United Kingdom, sourcing activities, primarily in the Far East, and worldwide licensing of the rights to the brand name. The Brooks distributors in Europe were 33%-owned equity investees from April 3, 1990 until July 1, 1991 when the remaining equity interests were acquired. During 1993, the Company sold the Brooks businesses in separate transactions in exchange for cash and notes totaling approximately $24 million. Notes receivable of $7,700,000 were outstanding as of January 1, 1994, and are collateralized by substantially all of the assets sold. Payments of $2,300,000, $4,324,000, and $361,000, representing the noncurrent portion of the notes receivable, are due in 1995, 1996 and 1997, respectively. In addition to normal and recurring product development, design and styling activities, the Company engages in research and development related to new and improved materials for use in its footwear and other products and in the development and adaptation of new production techniques. The Company's continuing relationship with the Biomechanics Evaluation Laboratory at Michigan State University, which is funded in part by a grant from the Company, has led to specific biomechanical design concepts which have been incorporated in the Company's footwear. The Company also maintains a footwear design center in Italy to develop contemporary styling for the Company and its international licensees. While the Company continues to be a leading developer of footwear innovations, research and development costs do not represent a material portion of operating expenses. Compliance with federal, state and local regulations with respect to the environment has not had, nor is it expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. The Company uses and generates, and in the past has used and generated, certain substances and wastes that are regulated or may be deemed hazardous under certain federal, state and local regulations with respect to the environment. The Company from time to time works with federal, state and local agencies to resolve cleanup issues at various waste sites. The Company recently received notice from the Michigan Department of Natural Resources ("MDNR") that it is one of the 14 currently named potentially responsible parties for cleanup of the Sunrise Landfill Site in Allegan County, Michigan. The Sunrise Landfill Site is related to another cleanup site in Allegan County, Michigan for which the MDNR has identified 556 potentially responsible parties, including the Company. The MDNR currently estimates that the total cost of cleanup of the Sunrise Landfill Site is approximately $17 million, but actual costs could exceed this amount. The Company is currently conducting an investigation into its responsibility with respect to the Sunrise Landfill Site. The Company currently anticipates that a substantial number of the 556 potentially responsible parties for the related cleanup site in Allegan County, Michigan, will eventually be identified as potentially responsible parties for the cleanup of the Sunrise Landfill Site. As of December 31, 1993, the Company had approximately 5,088 domestic and foreign production, office and sales employees. Approximately 1,218 employees are covered by seven union contracts expiring at various dates through 1996. The Company has experienced four isolated work stoppages since 1975, none of which materially affected operations. The Company presently considers its employee relations to be good. Item 2. Item 2. Properties. The principal executive, sales and administration offices of the Company are located in Rockford, Michigan and consist of administration and office buildings of approximately 123,300 square feet. The Company also has additional administrative and sales offices in Arkansas, New York, Italy, the United Kingdom, Canada and Taiwan totaling approximately 32,400 square feet, the majority of which is leased. The Company owns and operates one pigskin tannery from which it receives virtually all of its pigskin requirements. The tannery is located in Rockford, Michigan and encompasses approximately 160,000 square feet. The Company's footwear manufacturing operations are carried out at 15 separate facilities, totaling approximately 713,500 square feet of manufacturing space. These facilities are located primarily in smaller towns in Arkansas, Michigan, and New York and in Mexico, Puerto Rico, the Dominican Republic and Canada. Approximately 370,400 square feet of manufacturing space is under lease at seven locations and the remaining eight facilities are Company-owned. The Company's current aggregate footwear manufacturing capacity is in excess of 12.0 million pairs of shoes per year. The Company believes its footwear manufacturing facilities are generally among the most modern in the industry. The Company maintains twelve warehouses, located in four states and Canada, containing approximately 804,100 square feet. The vast majority of these warehouses are Company-owned, with approximately 63,500 square feet at three locations under lease. In addition, the Company's retail operations are conducted throughout the United States and as of March 25, 1994, consisted of approximately 124 locations, including 38 leased shoe departments. All retail locations, except three factory outlet stores in Company-owned facilities, are subject to operating leases. The Company believes that all properties and facilities of the Company are suitable, adequate and fit for their intended purposes. Item 3. Item 3. Legal Proceedings. The Company is involved in litigation and various legal matters arising in the normal course of business. The Company is also involved in several proceedings involving cleanup issues associated with various waste disposal sites, as more fully described in Item 1 of this Annual Report on Form 10-K. Having considered facts that have been ascertained and opinions of counsel handling these matters, the Company does not believe the ultimate resolution of such litigation will have a material adverse effect on the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. Supplemental Item. Executive Officers of the Registrant. The following table lists the names and ages of the Executive Officers of the Company as of the date of this Annual Report on Form 10-K, and the positions presently held with the Company. The information provided below the table lists the business experience of each such Executive Officer during the past five years. All Executive Officers serve at the pleasure of the Board of Directors of the Company, or if not appointed by the Board of Directors, they serve at the pleasure of management. Geoffrey B. Bloom has served the Company as President and Chief Executive Officer since April 1993. From 1987 to 1993 he served the Company as President and Chief Operating Officer. Steven M. Duffy has served the Company as a Vice President since April 1993. From 1989 to April 1993 he served the Company in various senior manufacturing positions. Prior to 1989, he served as the Head of Manufacturing for Florsheim Shoes. Stephen L. Gulis, Jr., has served the Company as Vice President and Chief Financial Officer since February 1994. From April 1993 to February 1994 he served the Company as Vice President of Finance and Corporate Controller, and from 1986 to 1993 he was the Vice President of Administration and Control for the Hush Puppies Company. Blake W. Krueger has served the Company as General Counsel and Secretary since April 1993. He has been a partner of the law firm of Warner, Norcross & Judd since 1985. L. James Lovejoy has served the Company as Vice President of Corporate Communications since 1991. From 1984 to 1991 he was the Director of Corporate Communications for Gerber Products Company, a manufacturer of baby food and related products. Charles F. Morgo has served the Company as Senior Executive Vice President since 1984. Thomas P. Mundt has served the Company as Vice President of Strategic Planning and Treasurer since December 1993. From 1988 to 1993 he served in various financial and planning positions at Sears Roebuck & Co. including Vice President Planning, Coldwell Banker's Real Estate Group and Director of Corporate Planning for Sears Roebuck & Co. Timothy J. O'Donovan has served the Company as Executive Vice President since 1982. Robert J. Sedrowski has served the Company as Vice President of Human Resources since October 1993. From 1990 to 1993 he served as Director of Human Resources for the Company, and from 1989 to 1990 he served as Director of Human Resources of Rospatch Corporation (now Ameriwood International, Inc.), a manufacturer. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Wolverine World Wide, Inc. common stock is traded on the New York and Pacific Stock Exchanges. The following table shows the high and low transaction prices by calendar quarter for 1993 and 1992. The number of holders of record of common stock on March 1, 1994 was 2,144. Dividends Per Share Declared: Dividends of $.04 per share were declared for the first quarter of fiscal 1994. Future dividends are restricted as more fully described in Note E of the consolidated financial statements, which are attached as Appendix A to this Form 10-K. Item 6. Item 6. Selected Financial Data. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Operations Results of Operations - 1993 Compared to 1992 Net sales for fiscal 1993 were $333.1 million compared to $293.1 million for fiscal 1992. This 13.6% increase was driven by record sales in the Wolverine Work & Outdoor Footwear Group, the Bates Uniform Footwear Division and the Tru-Stitch Footwear Division. The Hush Puppies Company also recorded a healthy sales increase during the year. These increases were partially offset by a decrease in the Wolverine Leathers Division sales. The Wolverine Work & Outdoor Footwear Group posted a sales increase of 33.8% which was the second year in which the sales gain exceeded 30%. The continued success of Wolverine DURASHOCK (Registered) boots and the introduction of WOLVERINE WILDERNESS (Registered) products to the market place were the primary factors contributing to the sales gain. Increased marketing efforts to promote the Wolverine Work Boot products also contributed to the sales gains. A 16.2% increase in sales was realized by the Bates Uniform Footwear Division. While the U.S. military continues to contract, the comfort characteristics of BATES (Registered) footwear continues to gain acceptance and the durability of the product makes Bates number one in this category. The Tru-Stitch Footwear Division reached record sales with a 20.7% increase for the year. Their prominent position in the market through all distribution channels and the addition of B & B Shoe Company which produces generally lower priced products continues to allow the Tru-Stitch Division to grow its business. While the Hush Puppies Company did not reach record sales volumes, it did post an increase of 5.3%. The repositioning and revitalization of the brand which began in 1992 is beginning to have a positive impact. Retail and consumer acceptance for the product is apparent as the division's reorder business for the year was strong. The Wolverine Leathers Division began resizing during the third quarter of 1993. The primary focus is to retract the business into high margin areas where the business can perform profitability. The volume was reduced and this, combined with other actions, is expected to allow the division to regain its profitability as it focuses on the higher value added product in its offerings. Gross margins as a percentage of net sales decreased to 30.0% from 30.2% in 1992. The emphasis of value priced product in the market place continues to place pressures on wholesale and retail price points. The Company is maximizing its pricing positions when superior products are available, such as WOLVERINE (Registered) DURASHOCKS (Registered) and TRU-STITCH (Registered) slippers, but is very cautious in raising prices in order to increase gross margin levels. A significant benefit, which improved the Company's gross margin levels, is the manufacturing efficiencies being produced in the domestic facilities. This, combined with the Company's low cost import operations, should continue to provide the Company with product which can be priced attractively. Selling and administrative expenses for 1993 were 24.1% of net sales compared to 26.0% of net sales in 1992. While the expenses were reduced as a percentage of net sales, the expenses increased $4.2 million. The increase was primarily a result of increased commissions due to higher volume, the impact of intensified marketing and promotional campaigns, and employee profit sharing programs. The overhead reduction plan which was announced in the fourth quarter of 1992 was successful and the initial target of $3.0 million of savings was exceeded by over $1.0 million. Interest expense of $5.1 million for 1993 reflects a $1.4 million increase over 1992. However, 1992 interest expense did not include interest expense of $2.3 million associated with discontinued operations. Overall, interest expense was reduced by $0.9 million as a result of the reduction in debt levels. Other expenses in 1992 included a restructuring charge of $2.7 million associated with the reduction in corporate staff and the write-down of certain intangible assets. The 1993 effective tax rate of 27.9% compared to 28.7% in 1992. The decrease from the statutory federal rate of 35% was principally a result of non-taxable earnings of Puerto Rican and foreign subsidiaries. Earnings from continuing operations of $11.5 million for fiscal 1993 reflect a 149% increase over fiscal 1992 earnings of $4.6 million. During 1992 the corporation incurred costs associated with the operating losses of the Brooks Athletic Footwear Division and the loss associated with the disposal of this operation, which totaled $14.8 million. Additionally, the corporation elected to adopt SFAS No. 109 ("Accounting for Income Taxes") and SFAS No. 106 ("Employers Accounting for Post-retirement Benefits Other Than Pensions") which resulted in a net charge to earnings of $0.8 million. There were no additional charges associated with either the discontinued operations or accounting changes for 1993. Net earnings of $11.5 million ($1.65 per share) for 1993 compares to a loss of $10.9 million ($1.65 per share) for fiscal year end 1992. The change reflects the significant progress made in the core business units of the Company and the improvements resulting from the divestiture of the Brooks athletic business. Results of Operations - 1992 Compared to 1991 Net sales of continuing operations totaling $293.1 million for fiscal 1992 were $10.4 million, or 3.7% higher than 1991. Sales gains were realized in the Wolverine Work and Outdoor Footwear Group, the Bates Uniform Footwear Division, the Tru-Stitch Footwear Division, and the Wolverine Leather Division. Partially offsetting these gains was a sales decline in the Hush Puppies Company. The Wolverine Work and Outdoor Footwear Group posted sales gains of 38.0% over 1991, resulting primarily from the success of the WOLVERINE (Registered) DURASHOCKS (Registered) boots which feature a rugged adaptation of the patented BOUNCE (Registered) comfort sole. Improved styling coupled with an aggressive advertising campaign also contributed to the product's success. A sales increase of 10.0% was realized by the Bates Uniform Footwear Division despite a shrinking military market place. The majority of the growth in 1992 was attributable to the penetration of the newly introduced HUSH PUPPIES (Registered) PROFESSIONALS (Trademark) line into the civilian uniform market. The Tru-Stitch Footwear Division, the market leader of constructed slippers, generated a 10.0% sales increase compared to 1991 as a result of expanding its product offering to meet a broader range of retail price points. During 1992, the Hush Puppies Company experienced a sales decline of 8.0% from 1991 primarily due to the continued weakness in the retail sector caused by the worldwide recession. The narrowing of the TOWN & COUNTRY (Trademark) brand product offerings also contributed to the sales decrease. Gross margin as a percentage of net sales for 1992 was 30.2%, a decrease from 31.7% for 1991. Margin declines were realized in the Hush Puppies Company, due primarily to manufacturing volume reductions, and the Tru-Stitch Footwear Division, resulting from an increase in sales of lower margin merchandise. Partially offsetting these declines were increases in gross margins for the Wolverine Work and Outdoor Footwear Group and Bates Uniform Division resulting from favorable manufacturing efficiencies and improved pricing margins. The liquidation of lower cost LIFO inventories contributed .4% to the gross margin in 1991 and was not repeated in 1992. Selling and administrative expenses for 1992 of $76.2 million increased by $1.3 million or 1.7% over 1991. Increases in variable selling costs were partially offset by expense reductions related to a corporate overhead cost reduction program initiated in the fourth quarter of 1992. Interest expense of $3.6 million decreased by $0.1 million from 1991 as a result of a decline in interest rates partially offset by increased borrowings. Reported interest expense for 1992 does not include $2.3 million of interest which was classified as discontinued operations. Other expenses include restructuring costs in 1992 amounting to $2.7 million related to corporate staff reductions and asset write-offs compared to a charge in 1991 of $7.5 million for litigation settlement and related costs as described in Notes J and K to the Consolidated Financial Statements. The effective income tax rate for 1992 of 28.7% of earnings from continuing operations is below the statutory rate of 34.0% primarily due to nontaxable earnings of foreign subsidiaries and affiliates. Earnings from continuing operations of $4.6 million or $0.70 per share in 1992 compared favorably to $4.4 million or $0.68 per share in 1991. The loss from discontinued operations in 1992 of $14.8 million is the result of operating losses and the Company's disposition of its Brooks athletic footwear and sports apparel businesses. The disposition includes the sales and distribution operations in the United States, France, Germany and the United Kingdom and the worldwide distribution and licensing rights to the brand name as described in Note C to the Consolidated Financial Statements. During 1992, the Company adopted SFAS No. 109 "Accounting for Income Taxes." The cumulative effect of adopting this change in accounting for income taxes decreased the 1992 net loss by $0.8 million. The Company also adopted the provisions of SFAS No. 106 "Employers' Accounting for Post-retirement Benefits Other than Pensions" in 1992. The cumulative effect of adopting this accounting change increased the 1992 net loss by $1.6 million. The net loss of $10.9 million or $1.65 per share compared unfavorably to fiscal 1991 net earnings of $3.3 million or $0.50 per share due to the cumulative effect of accounting changes and the loss from discontinued operations recognized in fiscal 1992. Liquidity and Capital Resources Earnings from continuing operations after adjusting for non-cash items increased cash by $18.9 million in 1993 compared to $10.9 million in 1992. Of these amounts $12.9 million and $11.8 million were used to fund increases in working capital. The most significant changes in working capital were increases in accounts receivables and inventories during 1993 which were required in order to fund the growth of the business. In fiscal 1992, a significant reduction in other current liabilities was reported as the litigation settlement was paid. Additions to property, plant and equipment of $6.6 million in 1993 was higher than the $4.1 million reported in 1992, but relatively flat with the $6.3 million in 1991. The majority of this expenditure was related to purchases of manufacturing equipment in order to continue to upgrade our manufacturing facilities. In 1993, cash of $12.2 million was provided from the divestiture of the Brooks athletic business. Payments on short-term debt of $15.2 million were made during 1993 which was principally a reduction of debt related to the discontinued operations of Brooks. Long-term debt of $49.6 million in 1993 remains relatively flat compared to $48.4 million in 1992. While the senior notes were reduced by $4.3 million, the Company recognized an increase in the revolving credit obligations of $7.0 million. The Company paid dividends of $1.1 million, or $.16 per share, which was consistent with 1992 and 1991. Additionally, shares issued under employee stock plans provided cash of $2.2 million compared to $1.2 million during 1992. The Company expects to increase its dividend payout beginning the second quarter of 1994 by 50%. The Company continues to strengthen its financial position as the current ratio improved to 3.9 : 1 in 1993 versus 2.8 : 1 in 1992. Additionally, total interest bearing debt to equity was .46 : 1 in 1993 compared to .65 : 1 at year end 1992. The Company's credit facilities and banking relationships combined with cash flow from future operations are expected to be sufficient to meet the cash requirements of the Company. The revolving credit facility which expires in 1995 will be renegotiated during 1994 to assure that proper financing remains in place for the Company. The Company is also evaluating the refinancing of its senior notes to determine the benefits of lower interest rates. Additionally, the Company maintains short-term credit facilities of $41.0 million of which $13.4 million were used at year end 1993. Inflation Inflation has not had a significant impact on the Company over the past three years nor is it expected to have a significant impact in the foreseeable future. The Company continuously attempts to minimize the effect of inflation through cost reductions and improved productivity. Recent Development The number of shares and the amount per share data included in this Form 10-K have not been adjusted to reflect the three-for-two stock split which was approved by the Board of Directors of the Company on March 10, 1994, and which will be payable on April 14, 1994, to stockholders of record of the Company as of March 21, 1994. Item 8. Item 8. Financial Statements and Supplementary Data. The response to this Item is set forth in Appendix A of this Annual Report on Form 10-K and is here incorporated by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The information regarding directors of the Company contained under the captions "Board of Directors" and "Compliance with Section 16(a) of the Exchange Act" in the definitive Proxy Statement of the Company dated March 22, 1994, is incorporated herein by reference. The information regarding Executive Officers is provided in the Supplemental Item following Item 4 of Part I above. Item 11. Item 11. Executive Compensation. The information contained under the captions "Compensation of Directors", "Executive Compensation," "Employment Agreements, Termination of Employment and Change of Control Arrangements" and "Compensation Committee Interlocks and Insider Participation" in the definitive Proxy Statement of the Company dated March 22, 1994, is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information contained under the captions "Ownership of Common Stock" and "Securities Ownership of Management" contained in the definitive Proxy Statement of the Company dated March 22, 1994, is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. The information regarding certain employee loans following the caption "Executive Compensation," under the subheading "Stock Options," and the information contained under the caption "Compensation Committee Interlocks and Insider Participation" contained in the definitive Proxy Statement of the Company dated March 22, 1994, are incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8- K. Item 14(a)(1). List of Financial Statements. Attached as Appendix A. The following consolidated financial statements of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: - Consolidated Balance Sheets as of January 1, 1994, and January 2, 1993. - Consolidated Statements of Stockholders' Equity for the Fiscal Years Ended January 1, 1994, January 2, 1993 and December 28, 1991. - Consolidated Statements of Operations for the Fiscal Years Ended January 1, 1994, January 2, 1993 and December 28, 1991. - Consolidated Statements of Cash Flows for Fiscal Years Ended January 1, 1994, January 2, 1993 and December 28, 1991. - Notes to Consolidated Financial Statements for January 1, 1994. Item 14(a)(2). Financial Statement Schedules. Attached as Appendix B. The following consolidated financial statement schedules of Wolverine World Wide, Inc. and subsidiaries are filed as a part of this report: - Schedule II--Amounts receivable from related parties and underwriters, promoters and employees other than related parties. - Schedule VIII--Valuation and qualifying accounts of continuing operations. - Schedule IX--Short-term borrowings of continuing operations. - Schedule X--Supplementary income statement information of continuing operations. All other schedules (I, III, IV, V, VI, VII, XI, XII, XIII, XIV) for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. Item 14(a)(3). List of Exhibits. Item 14(b). Reports on Form 8-K. No reports on Form 8-K were filed in the fourth quarter of the fiscal year ended January 1, 1994. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. WOLVERINE WORLD WIDE,INC. Dated: March 31, 1994 By:/s/Geoffrey B. Bloom Geoffrey B. Bloom President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date */s/Phillip D. Matthews Chairman of the Board of March 31, 1994 Phillip D. Matthews Directors /s/Geoffrey B. Bloom President, Chief Executive March 31, 1994 Geoffrey B. Bloom Officer and Director */s/Thomas D. Gleason Vice Chairman of the Board March 31, 1994 Thomas D. Gleason of Directors */s/Timothy J. O'Donovan Executive Vice President March 31, 1994 Timothy J. O'Donovan and Director */s/Stephen L. Gulis, Jr. Vice President and Chief March 31, 1994 Stephen L. Gulis, Jr. Financial Officer (Principal Financial and Accounting Officer) */s/Daniel T. Carroll Director March 31, 1994 Daniel T. Carroll */s/David T. Kollat Director March 31, 1994 David T. Kollat */s/David P. Mehney Director March 31, 1994 David P. Mehney */s/Stuart J. Northrop Director March 31, 1994 Stuart J. Northrop */s/Joseph A. Parini Director March 31, 1994 Joseph A. Parini */s/Joan Parker Director March 31, 1994 Joan Parker */s/Elmer L. Ward, Jr. Director March 31, 1994 Elmer L. Ward, Jr. *by/s/Geoffrey B. Bloom Geoffrey B. Bloom Attorney-in-Fact APPENDIX A Wolverine World Wide, Inc. and Subsidiaries Consolidated Balance Sheets Wolverine World Wide, Inc. and Subsidiaries Consolidated Balance Sheets (Continued) See accompanying notes to consolidated financial statements. Wolverine World Wide, Inc. and Subsidiaries Consolidated Statements of Operations See accompanying notes to consolidated financial statements. Wolverine World Wide, Inc. and Subsidiaries Consolidated Statements of Cash Flows Wolverine World Wide, Inc. and Subsidiaries Consolidated Statements of Cash Flows (continued) Wolverine World Wide, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements January 1, 1994 Note A - Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. Upon consolidation, all intercompany accounts, transactions and profits have been eliminated. The investment in a 35%-owned foreign affiliate is carried on the equity basis. Fiscal Year End The Company's fiscal year is the 52- or 53-week period that ends on the Saturday nearest the end of December. Fiscal years presented herein include the 52-week years ended January 1, 1994 and December 28, 1991, and the 53-week year ended January 2, 1993. Revenue Recognition Revenue is recognized on the sale of Company products when the related goods have been shipped and legal title has passed to the customer. Cash Equivalents All short-term investments with a maturity of less than three months when purchased are considered cash equivalents for purposes of the consolidated statement of cash flows. The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value. Inventories Inventories are valued at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for substantially all manufacturing inventories (see Note B). Inventories of the Company's retail operations are valued using the retail method. Property, Plant and Equipment Property, plant and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals and betterments. Normal repairs and maintenance are expensed as incurred. Depreciation of plant and equipment is computed using the straight-line method over the estimated useful lives of the respective assets. Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note A - Summary of Significant Accounting Policies (continued) Income Taxes The provision for income taxes is based on the earnings or loss reported in the financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the cumulative temporary differences between the carrying value of assets and liabilities for financial statement and income tax purposes. Deferred income tax expense (credit) is measured by the change in the deferred income tax asset or liability during the year. Earnings Per Share Primary earnings per share are computed based on the weighted average shares of common stock outstanding during each year and, for fiscal 1993, the assumed exercise of dilutive stock options. Stock options are not included in the computation of earnings per share in prior years since they were not materially dilutive. Fully diluted earnings per share for fiscal 1993 also includes the effect of converting subordinated notes into common stock. Fully diluted earnings per share are not presented for prior years since the effect of exercising stock options and converting subordinated notes was not material. Financial Instruments The Company's financial instruments, as defined by Statement of Financial Accounting Standard No. 107, consist of cash and cash equivalents, notes receivable and long-term debt. The Company's estimate of the fair value of these financial instruments approximates the carrying amounts at January 1, 1994, except for certain long-term debt arrangements as discussed in Note E. Reclassifications Certain amounts in 1992 and 1991 have been reclassified to conform with the presentation used in 1993. Note B - Inventories Inventories in the amount of $47,686,000 at January 1, 1994 and $38,950,000 at January 2, 1993 have been valued using the LIFO method. If the FIFO method had been used, the amounts would have been $19,903,000 and $20,082,000 higher than reported at January 1, 1994 and January 2, 1993, respectively. Reductions in certain inventory quantities during 1991 resulted in the liquidation of LIFO inventory layers carried at costs prevailing in prior Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) years that were lower than current costs. The effect of these reductions was to increase 1991 earnings from continuing operations before income taxes by $1,080,000 and net earnings by $702,000 ($.11 per share). There were no similar liquidations of LIFO inventories in 1993 or 1992. Note C - Discontinued Operations At the end of the third quarter of fiscal 1992, the Company announced its intent to dispose of its Brooks athletic footwear and sports apparel business. The Brooks business consisted of sales and distribution operations in the United States, France, Germany and the United Kingdom, sourcing activities, primarily in the Far East, and worldwide licensing of the rights to the brand name. The Brooks distributors in Europe were 33%- owned equity investees from April 3, 1990 until July 1, 1991 when the remaining equity interests were acquired. During 1993, the Company sold the Brooks businesses in separate transactions in exchange for cash and notes totaling approximately $24 million. Notes receivable of $7,700,000 were outstanding at January 1, 1994 and are collateralized by substantially all of the assets sold. The noncurrent portion of the notes receivable representing payments of $2,300,000, $4,324,000, and $361,000, due in 1995, 1996 and 1997, respectively, are included in other assets. The results of these businesses, which are classified separately as discontinued operations in the accompanying consolidated statements of operations, are summarized as follows: The above results for 1992 are through the third quarter when the decision was made to dispose of the Brooks business. Operating results of discontinued operations for 1992 and 1991 include allocations of overhead and interest expense. Overhead expense of $370,000 and $556,000, respectively, was allocated based upon a determination of those costs which were not expected to be incurred by continuing operations. Interest Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) expense of $2,268,000 and $1,442,000, respectively, was allocated based on debt incurred to finance the discontinued operations since acquisition. The Company also made charges of $16,300,000 ($9,335,000 after income taxes) during fiscal 1992 to provide for estimated losses on the disposal of the Brooks businesses including anticipated operating losses from the end of the third quarter to the expected dates of sale. Note D - Notes Payable to Banks Notes payable to banks at January 1, 1994 consist primarily of unsecured short-term borrowings of the Company's Canadian subsidiary. The notes bear interest at Canadian prime (5.5% at January 1, 1994) plus 2%. Notes payable to banks in 1992 also included unsecured short-term borrowings of the Company's Brooks Europe subsidiaries which were substantially repaid in 1993 in connection with the disposal of the Brooks business. The Company also has $41,000,000 of short-term borrowing and commercial letter-of-credit facilities. There were no outstanding borrowings at the end of fiscal 1993; however, outstanding letters-of-credit amounted to approximately $13,400,000. Note E - Long-Term Debt Long-term debt consists of the following obligations at the end of fiscal 1993 and 1992: The 10.4% senior notes to insurance companies were issued on September 1, 1988. The note agreement requires equal annual principal payments of $4,286,000 on August 15, 1994 through 1998. Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note E - Long-Term Debt (continued) The revolving credit agreement allows for borrowings of up to the lesser of $50,000,000 or amounts determined in accordance with certain asset-based debt limitation formulas. The agreement also requires the outstanding balance to be no more than $30,000,000 during the period December 1 through May 31 each year. Interest is payable at variable rates based on both LIBOR and prime (6% at January 1, 1994). The agreement expires on June 30, 1995, but can be renewed with the mutual consent of the Company and the participating lenders. As of January 1, 1994, the available unused credit under the agreement was $5,000,000. Maximum borrowings under the agreement during 1993 and 1992 were $46,000,000 and $45,000,000, respectively. The subordinated convertible notes are payable in two installments of $1,250,000 each in 1995 and 1996 with interest payable semiannually at 6.5%. The notes are subordinated to all insurance company and bank debt and are convertible into common stock at a price of $12.50 per share at any time prior to maturity. The revolving credit and insurance company loan agreements contain restrictive covenants which, among other things, require the Company to maintain certain financial ratios and minimum levels of working capital and tangible net worth. The agreements also impose restrictions on the occurrence of additional debt, sale and merger transactions, acquisition by the Company of its common stock and the payment of dividends. At January 1, 1994, retained earnings of $2,873,000 are available for dividends or other restricted payments under the most restrictive of these provisions. Principal maturities of long-term debt during the four years subsequent to 1994 are as follows: 1995--$30,705,000; 1996--$5,586,000; 1997--$4,336,000; 1998--$4,286,000. The carrying value of the Company's long-term debt approximates fair market value except for the 10.4% senior notes and the convertible notes. The fair market value of the senior notes is estimated to be $24,300,000. This was determined using discounted cash flow analysis and the Company's incremental borrowing rate for similar financing arrangements. The fair market value of the subordinated convertible notes is $6,000,000 based on the quoted market price of the Company's common stock at January 1, 1994. Note F - Leases The Company leases machinery, transportation equipment and certain warehouse and retail store space under agreements which expire at various dates through 2002. At January 1, 1994, minimum rental payments due under all noncancelable leases are as follows (thousands of dollars): Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note F - Leases (continued) Rental expense under all operating leases is summarized as follows: Contingent rentals are based on retail store sales volume or usage of equipment. Note G - Capital Stock The Company's authorized capital includes 2,000,000 shares of preferred stock with a par value of $1 per share. No preferred stock has been issued; however, the Company has designated 880,000 shares of preferred stock as Series A junior participating preferred stock for possible future issuance under the Company's stock rights plan described below. Each share of Series A junior preferred stock will have 100 votes upon issuance and a preferential quarterly dividend equal to the greater of $6.00 per share or 100 times the dividend declared on the Company's common stock. The Company's stock rights plan is designed to protect stockholder interests in the event the Company is confronted with coercive or unfair takeover tactics. Under its terms, each stockholder received one right for each share of common stock owned. The rights will trade separately from common stock and will become exercisable only upon the occurrence of certain triggering events, including a person, group or company acquiring 15% or more of the Company's outstanding common stock, tendering for a 15% or greater interest in the Company, or acquiring 10% or more of the outstanding common stock and being determined by the Company's Board of Directors to be an adverse person, as defined. Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note G - Capital Stock (continued) Each right, when exercisable, will entitle the holder to purchase one one- hundredth of a share of Series A junior participating preferred stock for $40. Alternatively, in the event the Company is a party to a merger or other business combination, regardless of whether the Company is the surviving corporation, rights holders, other than the party to the merger, will be entitled to receive common stock of the surviving corporation worth twice the exercise price of the rights. The plan also provides for protection against self-dealing transactions by a 15% stockholder or the activities of an adverse person. The Company may redeem the rights for $.01 each at any time prior to fifteen days after a triggering event. Unless redeemed earlier, all rights will expire on May 8, 1997. The Company has stock incentive plans under which options to purchase shares of common stock may be granted to officers, other key employees and nonemployee directors. Under the plans, which were adopted in 1979, 1988 and 1993, options are exercisable in equal annual installments of 25% over three years beginning on the date the options are granted. All unexercised options under the 1988 and 1993 plans are available for future grants upon their cancellation. The 1979 plan expired during 1989 and no additional options are available for future grants under this plan. A summary of the transactions under the plans follows: Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note G - Capital Stock (continued) A provision in the 1993 stock incentive plan allows the Company to make stock awards to officers and key employees as consideration for future services. The intent of this provision is to provide a continuation of the provisions of the executive incentive stock purchase plan adopted in 1984 and expiring on December 31, 1994, which awarded rights to purchase shares of the Company's common stock at a nominal price of $1.00 per share. Common stock acquired under the provisions of either plan is subject to certain restrictions, including prohibition against any sale, transfer or other disposition by the officer or employee, and a requirement to forfeit the award upon termination of employment. These restrictions lapse over a three- to five-year period from the date of the award. During 1993, 15,484 shares were issued under provisions of the current plan and 4,716 shares were issued under the predecessor plan. Rights to purchase 19,700 and 26,500 shares of common stock under the 1984 plan for $1.00 per share were granted in 1992 and 1991, respectively, and rights to 2,913 and 3,375 shares were canceled in 1992 and 1991. The maximum of 150,000 shares have been granted under the 1984 plan. Additional shares may be awarded under the 1993 stock incentive plan. Such awards will reduce the number of shares effected above as available for grant under the stock option provisions of the plan. Note H - Retirement Plans The Company has noncontributory, defined benefit pension plans covering a majority of domestic employees. The Company's principal defined benefit pension plan provides benefits based on the employee's years of service and final average earnings (as defined), while the other plans provide benefits at a fixed rate per year of service. The Company intends to annually contribute amounts deemed necessary, if any, to maintain the plans on a sound actuarial basis. The Company also has individual deferred compensation agreements with certain key employees which entitles them to receive payments from the Company for a period of fifteen to eighteen years following retirement. Under the terms of the individual contracts, the employees are eligible for reduced benefits upon early retirement generally at age 58. Prior to 1992, the Company's policy was to recognize the deferred compensation cost over the expected employment period of the individual employees. In addition, the Company sponsors a noncontributory defined benefit plan that provides postretirement life insurance benefits to full-time employees who have worked ten or more consecutive years and attained age 60 while employed by the Company. Prior to 1992, the Company's policy was to recognize expense when claims were paid. The Company does not provide postretirement medical benefits. Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note H - Retirement Plans (continued) The Company also has a defined contribution plan covering substantially all employees which provides for Company contributions based on the Company's earnings. Contributions to the plan were $760,000 in 1993, $69,000 in 1992 and $267,000 in 1991. The Company adopted the provisions of Statement of Financial Accounting Standard (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1992. SFAS No. 106 requires the estimated cost of life insurance benefits and deferred compensation contracts to be recognized over the period of employment to the date that employees are fully eligible to receive future benefits. The cumulative prior year effect of adopting SFAS No. 106 was recorded in fiscal 1992 and amounted to $2,400,000 ($1,550,000 after related deferred income taxes). If the revised accounting principle had been applied retroactively, net earnings for fiscal 1991 would not have changed significantly. The following summarizes the status of the Company's pension assets and related obligations: Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note H - Retirement Plans (continued) The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.5% and 4% in 1993 and 8.5% and 5% in 1992. These assumption changes increased the projected benefit obligation at September 30, 1993 by approximately $3,300,000. At September 30, 1993, plan assets were invested in listed equity securities (69%), fixed income funds (20%), guaranteed investment contracts (6%) and short-term investments (5%). Equity securities at September 30, 1993 include 200,200 shares of the Company's common stock with a fair value of $5,756,000. The following is a summary of the pension income recognized by the Company: The expected long-term return on plan assets was 9.0% in 1993 and 1992, and 9.5% in 1991. The Company's accumulated postretirement life insurance benefit obligation is as follows: Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note H - Retirement Plans (continued) The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% in 1993 and 8.5% in 1992. The Company's expense for postretirement life insurance benefits was $70,000 in 1993 and $50,000 in 1992 and 1991. Note I - Income Taxes Effective the beginning of fiscal 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes". The new standard requires that an asset and liability approach be applied in accounting for income taxes and provides revised criteria for the recognition of deferred tax assets. As permitted under the new rules, prior years financial statements were not restated. The cumulative prior year effect of adopting SFAS No. 109 was recorded in fiscal 1992 and decreased the net loss by $800,000. The provisions (credit) for income taxes consists of the following: A reconciliation of the Company's total income tax expense (benefit) and the amount computed by applying the statutory federal tax rate of 35% (34% for fiscal 1992 and 1991) to earnings from continuing operations before income taxes is as follows: Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note I - Income Taxes (continued) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of the end of fiscal 1993 and 1992 are as follows: The valuation allowance has been provided to recognize the uncertainty of realizing a portion of the deferred tax assets which are dependent upon future taxable income. The Company has provided for substantially all taxes that would be payable if accumulated earnings of its Puerto Rico subsidiary were distributed. Similar taxes on the unremitted earnings of the Company's foreign affiliates have not been provided because such earnings are considered permanently invested. The additional taxes that would be payable if unremitted earnings of its foreign affiliates were distributed are not significant. Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note J - Restructuring A restructuring charge of $2,700,000 in fiscal 1992 is included in other expense - net. The charge consisted principally of costs associated with a reduction in the corporate staff and the write-off of certain intangible and other assets. After related income taxes, the charge reduced 1992 earnings from continuing operations and net earnings by $1,730,000 ($.26 per share). Note K - Litigation On March 2, 1992, the Company settled lawsuits which were filed in 1989 and 1990 by Southwest Hide Company and First Security Bank of Utah under an agreement requiring the payment of cash and notes. To provide for the settlement, the Company recognized a charge of $7,500,000 in its 1991 financial statements which is included in other expenses - net. After related income taxes, the provision reduced 1991 earnings from continuing operations and net earnings by $6,100,000 ($.93 per share). The Company is involved in various other legal actions arising in the normal course of business. After taking into consideration legal counsel's evaluation of such actions, management is of the opinion that their outcome will not have a significant effect on the Company's consolidated financial position or results of operations. Note L - Industry Information The Company is principally engaged in the manufacture and sale of footwear, primarily casual shoes, slippers, moccasins, dress shoes, boots, uniform shoes and work shoes. The Company is also the largest domestic tanner of pigskin which is used in a significant portion of shoes manufactured and sold by the Company, and is also sold to other domestic and foreign manufacturers of shoes and other products and to the Company's foreign trademark licensees. Royalty income is derived from licensing its trademarks to domestic and foreign licensees for use on non-footwear and footwear products. As part of its footwear business, the Company operates a number of domestic retail shoe stores that sell Company-manufactured products as well as footwear manufactured by unaffiliated companies. Foreign operations consist of factories in the Dominican Republic and Mexico which produce shoe uppers for Company operations in the United States and a 75%-owned subsidiary which manufactures and markets branded footwear in Canada. Export sales, foreign operations and related assets, excluding the discontinued Brooks European operations (see Note C), are not significant. The Company markets its products primarily to customers in the retail sector. Although the Company closely monitors the credit worthiness of its customers and adjusts its credit policies and limits as needed, a substantial portion of its debtors' ability to discharge amounts owed is Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) dependent upon the retail economic environment. The Company does not believe that it is dependent upon any single customer, since none account for more than 10% of consolidated net sales. Note M - Quarterly Results of Operations (Unaudited) The Company reports its quarterly results of operations on the basis of 12-week periods for each of the first three quarters and a 16-week period for the fourth quarter. The fourth quarter of fiscal 1992 included 17 weeks. The following tabulation presents the Company's unaudited quarterly results of operations for fiscal 1993 and 1992. Certain reclassifications have been made to the amounts originally reported in the Company's quarterly reports on Form 10-Q to conform with the presentation used in the annual financial statements. Wolverine World Wide, Inc. and Subsidiaries Notes to Consolidated Financial Statements (continued) Note M - Quarterly Results of Operations (Unaudited) (continued) Adjustments recorded in the fourth quarter of fiscal 1993 and 1992 relating principally to inventories increased net earnings by $1,910,000 ($0.27 per share) in 1993 and earnings from continuing operations in 1992 by $1,030,000 ($0.16 per share). In addition, an after tax provision of $6,900,000 ($1.04 per share) related to discontinued operations was recorded in the fourth quarter of 1992 (see Note C). Report of Independent Auditors The Board of Directors Wolverine World Wide, Inc. We have audited the accompanying consolidated balance sheets of Wolverine World Wide, Inc. and subsidiaries as of January 1, 1994 and January 2, 1993, and the related consolidated statements of stockholders' equity, operations and cash flows for each of the three fiscal years in the period ended January 1, 1994. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wolverine World Wide, Inc. and subsidiaries at January 1, 1994 and January 2, 1993, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended January 1, 1994, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Ernst & Young Grand Rapids, Michigan February 14, 1994 APPENDIX B Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters and Other Employees Other than Related Parties Wolverine World Wide, Inc. and Subsidiaries Fiscal year ended January 1, 1994 Schedule VIII--Valuation and Qualifying Accounts from Continuing Operations Wolverine World Wide, Inc. and Subsidiaries Schedule IX--Short-Term Borrowings of Continuing Operations Wolverine World Wide, Inc. and Subsidiaries Schedule X--Supplementary Income Statement Information of Continuing Operations Wolverine World Wide, Inc. and Subsidiaries Amounts for amortization of intangible assets, taxes other than payroll and income taxes and royalties are not presented, as such amounts are less than one percent of total net sales and other operating income in each of the three fiscal years. Commission File No. 1-6024 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 EXHIBITS TO FORM 10-K For the Fiscal Year January 1, 1994 Wolverine World Wide, Inc. 9341 Courtland Drive Rockford, Michigan 49351 EXHIBIT INDEX

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1993

60860

ITEM 1. BUSINESS. General Lukens Inc. is a holding company incorporated in Delaware. In 1992, Lukens expanded into stainless steel product lines with the acquisition of Washington Steel Corporation for $273.7 million. Subsidiaries of Lukens are involved primarily in the manufacture of carbon, alloy and clad steel plate, and stainless steel plate, sheet, strip, hot band and slabs. As part of a program adopted in 1993 to focus Lukens' resources on its steel businesses, the subsidiaries previously reported in the Corrosion Protection Group, Safety Products Group and most subsidiaries in the Diversified Group are for sale. These subsidiaries are now reported as discontinued operations, with their results reported separately from continuing operations. Production facilities and markets are located primarily in the United States. Business Groups Lukens has two business groups--Lukens Steel and Washington Stainless. Financial information for these business groups is incorporated herein by reference to Note 3 of the 1993 Annual Report to stockholders. The chart below outlines the business group composition of consolidated net sales for each of the last three years. The Washington Stainless Group percent represents sales from the acquisition date on April 24, 1992. Business Group Sales- Percent of Consolidated Net Sales 1993 1992 1991 Lukens Steel % 51.6 60.0 100.0 Washington Stainless 48.4 40.0 - ----- ----- ----- Total % 100.0 100.0 100.0 ===== ===== ===== Lukens Steel Group Lukens Steel Company specializes in the production of carbon, alloy and clad steel plate. It ranks as one of the three largest domestic plate steel producers and is the largest domestic producer in the alloy plate market. There are several domestic and foreign competitors. Major competitors are United States Steel, a subsidiary of the USX Corporation, and Bethlehem Steel Corporation. During 1993, trade rulings by the U.S. International Trade Commission upheld most of the steel-plate cases on unfair trading practices. Lukens Steel's competitive position is enhanced by a concentration on plate with a product line that includes a wide range of plate sizes and grades. In addition to price and quality, customer satisfaction, measured by shipped-on-time performance and production lead times, has become increasingly important in the competitive environment. Given the overcapacity in the steel industry, price competition has been and is expected to remain intense. Products are sold primarily by an in-house sales force. Steel service centers are the largest market for the group with annual shipments ranging between 38 and 42 percent of total shipments in the last three years. The Lukens Steel Group and service center industry supply a wide range of markets in the capital-goods sector of the economy, including markets for: - Machinery and Industrial Equipment - Infrastructure - Environmental and Energy - Transportation - Military and Defense. Some sales involve government contracts which, under certain circumstances, are subject to termination or renegotiation. Terminations for convenience of the government generally provide for payments to a contractor for its costs and a portion of its profit. Lukens does not expect any material portion of its business to be terminated or renegotiated. Raw materials used in the production of steel plate include carbon scrap, alloy scrap and alloy additives. Generally, these materials are purchased in the open market and are available from several sources. Prices and availability are affected by the operating level of the domestic steel industry, the quantity of scrap exported and world political and economic conditions. Scrap costs increased significantly in 1993. These costs historically have moved with changes in selling prices. In 1993, this trend did not continue and it remains to be seen if there has been a fundamental change in the scrap market. Principal energy sources used in production include electricity and natural gas. Propane gas back-up systems are available at the group's primary manufacturing facility in the event of natural gas supply restrictions. Washington Stainless Group Washington Steel Corporation is the largest subsidiary in the group, representing 68 percent of the group sales in 1993. This subsidiary specializes in the manufacture and marketing of stainless steel plate, sheet, strip, hot band and slabs. Primary competitors include Allegheny Ludlum Corporation, J&L Specialty Products Corporation and Armco Inc. Although these competitors have larger market shares, Washington Steel's competitive position is built on the ability to serve niche markets by providing a wide range of quality products. Similar to the competitive environment in the Lukens Steel Group, customer satisfaction, measured by shipped-on-time performance and production lead times, has become increasingly important. During 1993, increased foreign competition put pressure on selling prices. Washington Specialty Metals Corporation is a service and distribution center that specializes in stainless steel. The competitive environment is characterized by numerous competitors on both a national and a regional scale. Washington Specialty Metals is a leading distributor of flat-rolled stainless steel. Products are sold primarily by the group's own sales organizations. The primary market of the group is service centers, which represented over 56 percent of shipments in 1993. The Washington Stainless Group and the service center industry supply diverse markets, including: - Food Service Equipment - Architecture and Construction - Process Industries - Transportation - Consumer Durables. Raw materials used in production include stainless scrap, chrome and nickel. Generally, these materials are purchased in the open market and are available from several sources. Prices and availability are affected by the operating level of the domestic steel industry, the quantity of scrap exported and world political and economic conditions. Principal energy sources used in production include electricity and natural gas. Discontinued Operations Safety Products The Flex-O-Lite subsidiary is a leading supplier in the United States of glass beads used to make highway paint striping, sheeting and signs reflective. Glass beads are also used in industrial cleaning applications. Other product lines include reflective tape, traffic cones and barrels, flashing lights, safety vests and warning flags. Glass beads are primarily marketed by an inside sales force. Highway construction-zone safety products are marketed by an inside sales force and by agents, distributors and representatives. Competitors are primarily domestic producers marketing on a national or regional basis. Approximately one-third of the group's sales are made to state and local governments under a competitive bidding process. Raw materials used by the group include crushed glass, silicates and polyethylene. They are readily available from several sources of supply. Principal energy sources used in production are natural gas and electricity. Corrosion Protection ENCOAT is one of the leading suppliers of protective and insulative coatings for steel pipe in the United States. Cathodic Protection Services provides services to protect steel and other metal structures from corrosion. The primary market of this group is the oil and gas industry. There are a number of domestic competitors, many of which are small with sales generally limited to areas near their production facilities. Products and services are marketed by the group's own sales organizations. Raw materials, all of which are readily available from several suppliers, include polyethylene, epoxy powders, cement, coal tar enamel, magnesium, graphite and aluminum alloy. Diversified Subsidiaries include two relatively small subsidiaries that manufacture materials-handling and screening equipment and a short-line railroad. The major market of the materials-handling subsidiaries is the aggregate industry. Principal raw materials include plate steels, steel rods and wire, and polyurethane resins. The short-line railroad serves agricultural customers. Sales Order Backlog (Dollars in thousands) Listed below is the backlog from continuing operations at the end of 1993 and 1992. The backlog at year-end 1993 is anticipated to be shipped in 1994. December December 25, 1993 26, 1992 Lukens Steel $ 58,712 68,084 Washington Stainless 42,883 46,229 ------- ------- Total $ 101,595 114,313 ======= ======= Environment In 1993, capital expenditures for environmental compliance projects were $2.7 million. Capital expenditures are anticipated to be approximately $4.7 million in 1994 and $4.5 million in 1995. The trend for tighter environmental standards is expected to continue and result in higher waste disposal costs and additional capital expenditures in the long term. Lukens has an environmental committee that meets quarterly to review environmental and remediation issues. Outside consultants are also used on various technical issues. Although it is difficult to project long-term requirements in this area, we are not aware of any environmental problems that would jeopardize our competitive position. Employees The average number of employees during 1993 was 4,769. ITEM 2. ITEM 2. PROPERTIES. Capital Expenditure Program Capital expenditures in 1993 of $67.4 million were part of a five- year program of approximately $400 million. The program is aimed at promoting synergies between the Lukens Steel Group and Washington Stainless Group, and expanding our product lines to take advantage of the anticipated long-term growth in stainless markets. The centerpiece of the program is the installation of a plate and sheet processing system at our Conshohocken, Pennsylvania facility. The new system, scheduled to start up late in 1994, will utilize Steckel rolling technology and is designed to lower production costs and expand the product range of both the Lukens Steel Group and Washington Stainless group. Other expenditures in the program include the expansion of stainless steel melting capacity. Lukens Steel Group Raw steel is produced by electric arc furnaces at the Coatesville, Pennsylvania, plant. Approximately 70 percent of 1993 production was continuously cast into slabs at this facility. Rolling and fabrication facilities are located in Coatesville and Conshohocken, Pennsylvania. Other relatively small properties include a fabrication facility located in Newton, North Carolina and a real estate development and management company in New Castle, Delaware. The group operated near capacity in 1993. Capacity of facilities is considered adequate to support projected sales. Washington Stainless Group Washington Steel Corporation has melting, continuous casting and rolling facilities in Houston, Pennsylvania. Both the Washington, Pennsylvania, and Massillon, Ohio, facilities have rolling and finishing facilities. Utilization of these facilities ranged between 70 and 100 percent in 1993 and is considered adequate to support projected sales. Washington Specialty Metals Corporation has fabrication and distribution facilities in Wheeling, Illinois, and Lawrenceville, Georgia. Additional distribution centers are located in: - Carrollton, Texas - Youngsville, North Carolina - Tampa, Florida - Brampton, Ontario, Canada - Vaudreuil, Quebec, Canada. Discontinued Operations Safety Products Manufacturing facilities include three glass bead plants and four plants for highway construction-zone safety products. These plants operated between 80 and 100 percent of capacity in 1993. Corrosion Protection Manufacturing facilities include nine plants for pipe coating and one plant for anodes that are used in cathodic protection services. Capacity utilization continued to be low in 1993. Diversified Materials-handling manufacturing facilities include four plants. A short-line railroad is located in South Central Florida. Plant and Equipment Pledged as Collateral Plant and equipment with a net depreciated cost of $50.4 million are pledged as collateral for various loans. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. As of year-end 1993, approximately 350 workers' compensation claims alleging hearing loss have been asserted against Lukens Steel Co., a wholly-owned subsidiary, by current and former employees before the Pennsylvania Workers' Compensation Board. Claimants are seeking compensation under state laws governing workers' compensation. A $5.6 million reserve has been established to cover potential awards and defense costs resulting from these claims. The company is party to various claims, disputes, legal actions and other proceedings involving product liability, contracts, equal employment opportunity, occupational safety, environmental issues and various other matters. In the opinion of management, the outcome of these matters should not have a material adverse effect on the consolidated financial condition of the company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were voted upon during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following executive officers were elected by the Board of Directors for the ensuing year and until their respective successors are elected: Executive Officer Executive Officer/Title Age Since R. W. Van Sant 55 October 1991 Chairman and Chief Executive Officer Robert E. Heaton 64 April 1992 Senior Vice President- Vice Chairman-Stainless Group Dennis M. Oates 41 February 1987 Senior Vice President- President and Chief Operating Officer-Carbon and Alloy Group T. Grant John 55 February 1993 Vice President- President and Chief Operating Officer-Washington Steel John H. Bucher 54 April 1993 Vice President-Technology Richard D. Luzzi 42 February 1993 Vice President-Human Resources John N. Maier 42 January 1992 Vice President and Controller James J. Norton 37 April 1992 Vice President- President and Chief Operating Officer-Washington Specialty Metals Frederick J. Smith 50 April 1993 Vice President-Manufacturing Services William D. Sprague 52 October 1988 Vice President, General Counsel and Secretary John C. van Roden, Jr. 45 February 1987 Vice President and Treasurer Listed below are executive officers that have not been employed by Lukens in an executive or managerial capacity during the last five years. R. W. Van Sant was previously the president and chief executive officer and a director of Blount, Inc. Prior to his association with Blount in 1987, he served as president and chief operating officer and a director of the Cessna Aircraft Company. He had earlier served as vice president of manufacturing and engineering at Deere and Company where he was employed for 26 years. Robert E. Heaton, prior to the acquisition of Washington Steel Corporation by Lukens in 1992, was president and chief operating officer of Washington Steel since 1989 and served as president and chief executive officer from 1978. T. Grant John was previously with the Axel Johnson Group, a privately-owned Swedish company with extensive holdings of stainless steel businesses. During his 14 years with Axel Johnson, Mr. John held operating and management positions in the corporation's United States operations. Since 1985, Mr. John was a corporate vice president of Axel Johnson, Inc. Richard D. Luzzi joined Rockwell International Corporation in 1980 and became vice president-human resources at Rockwell Graphic Systems, Inc. in 1988. In 1991, he assumed the additional responsibility of vice president-international human resources for Rockwell International. John N. Maier spent 14 years with various divisions of the Continental Group, including director of capital plans and special projects, Continental Forest Industries; vice president of finance, Continental Woodlands, Inc.; and vice president and controller, Kiewit Continental. James J. Norton, prior to the acquisition of Washington Steel Corporation by Lukens in 1992, was president of the service center group. Previously, he was the chief financial officer of Mercury Stainless Corporation, including Washington Steel, from 1986 to 1991. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required by this item is incorporated herein by reference to the sections entitled "Dividends" and "Quarterly Financial Data" included in Item 7 of this form 10-K. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Dollars in thousands except per share amounts The Year In Review The following discussion focuses on the results of operations, both from a consolidated and a business group perspective, and on the financial condition of Lukens. As part of a program adopted in 1993 to focus Lukens' resources on its steel business, the subsidiaries previously reported in the Corrosion Protection Group, Safety Products Group and most subsidiaries in the Diversified Group are for sale. These subsidiaries are now reported as discontinued operations, with their results reported separately from continuing operations results in 1993 and prior years. At the end of April 1992, Lukens acquired Washington Steel Corporation, reported as the Washington Stainless Group, which had a significant effect on our results and financial condition. This section should be read in conjunction with the consolidated financial statements and notes. Summary of Results Consolidated Results From Continuing Operations Net Sales. Sales from continuing operations were up 24 percent in 1993. The increase primarily reflected the comparison of Washington Stainless Group 1993 sales to 1992, which was for a partial year from the acquisition to year end. The Lukens Steel Group benefited from strong shipment levels and also recorded higher sales. Sales in 1992 were 64 percent higher compared to 1991 with the increase coming from the Washington Stainless Group. Sales were slightly down in the Lukens Steel Group, primarily from lower selling prices. Bar Graph of Net Sales for 1991, 1992 and 1993 included here. Operating Earnings. Operating earnings for 1993 were down 29 percent from 1992. The decrease was attributable to the Lukens Steel Group, which experienced a less profitable shipment mix combined with higher scrap prices. The group also recorded a $14,921 fourth quarter charge, primarily for a work force reduction program. Selling and administrative expenses increased 43 percent in 1993. The increase reflected the comparison of Washington Stainless Group 1993 expenses to a partial year in 1992. Additionally, higher retiree benefit costs associated with the adoption of a new accounting standard discussed in Note 1, and increased pension expense and consulting fees contributed to higher expenses. Operating earnings in 1992 were more than double 1991 earnings. The increase was attributable to Washington Stainless Group results and the comparative effect of a 1991 fourth quarter labor strike in the Lukens Steel Group that resulted in a quarterly loss. Earnings in 1992 were reduced by lower selling prices in the Lukens Steel Group. Interest Income. To help finance the April 1992 acquisition of Washington Steel, the balance of cash equivalents and short-term investments was used. Since the acquisition, excess cash flows have been used to reduce short-term debt. The drop in 1993 interest income reflected this lower investment level. Similarly, interest income in 1992 was lower than 1991 primarily because of lower investment levels. Interest Expense. Acquisition-related interest for a full year in 1993 compared to 1992 expense from the April 1992 acquisition resulted in a 21 percent increase in interest expense. The increase also reflected interest on the $150,000 of long-term notes, 7.625 percent coupon rate, issued in the third quarter of 1992 compared to lower short-term interest rates incurred prior to the issuance of the notes. Income Tax Expense. The effective tax rate was 35.3 percent in 1993 and 39.1 percent in 1992. Included in the 1993 rate was a favorable adjustment of $727, or 3.6 percent, that resulted from the revaluation of the net deferred tax asset position of Lukens. The revaluation reflected a 1 percent increase in the Federal corporate tax rate to 35 percent. The 1993 effective tax rate was based on the new accounting statement for income taxes, discussed in Note 1. The deferred tax assets recognized in the adoption of the statement were based on the combination of future reversals of existing taxable temporary differences, carryback availability, tax planning strategies and future taxable income. The effective tax rate in 1992 of 39.1 percent compared to 37.9 percent in 1991. Higher state taxes and the impact of non-deductible expenses associated with the Washington Steel acquisition contributed to the increase. Earnings From Continuing Operations. Lower operating earnings and higher interest expense translated into a 45 percent drop in 1993 earnings from continuing operations before the cumulative effect of accounting changes. Higher operating earnings partially offset by increased interest expense resulted in a 72 percent increase in 1992 earnings compared to 1991. Earnings From Discontinued Operations. During the fourth quarter of 1993, a $4,500 provision, $2,772 after tax, was recorded to recognize a change in realizable value of the subsidiaries. Earnings, net of taxes, in 1993 were down 40 percent. Lower activity for large pipe-coating orders at our ENCOAT subsidiary and weaker market conditions experienced by the other subsidiaries resulted in the decline. Earnings from discontinued operations in 1992 were up slightly compared to 1991. Earnings Before Cumulative Effect of Accounting Changes. As a result of the factors discussed above, 1993 earnings before the cumulative effect of accounting changes were down 52 percent. 1992 earnings were up 44 percent from 1991. Bar graph on net earnings before cumulative effect of accounting changes for 1991, 1992 and 1993 included here. Net Earnings (Loss). During 1993, Lukens adopted two new accounting statements for retiree medical and life insurance benefits and for income taxes, discussed in Note 1. The cumulative effect, or catch-up net expense was $65,901. As a result, a net loss of $49,999 was recorded for 1993. Business Groups Summary of Business Group Results Lukens Steel. Strong shipment levels partially offset by a lower-value shipment mix resulted in a 7 percent increase in 1993 sales. Shipments for the year were 711,800 tons, up 10 percent from 1992 shipped tons of 646,100. Operating earnings in 1993 were down 59 percent with a $14,921 fourth quarter charge contributing to the decline. The fourth quarter charge included a $9,660 work force reduction provision and other charges for environmental remediation and workers' compensation claims. Additionally, the impact of a less profitable shipment mix and higher scrap costs squeezed profit margins. Increased employee benefit costs also were incurred from the recognition of accrual expense for retiree medical and life insurance benefits resulting from the adoption of SFAS No. 106 and from higher pension expense. 1992 sales were slightly below 1991 sales because of lower selling prices partially offset by a higher sales volume. Shipments in 1992 were up 2 percent from 1991 shipments of 633,100 tons. Higher sales volume was not attributable to improved business conditions, however, but to the comparative effect of the 1991 fourth quarter labor strike that resulted in low shipment levels for the quarter. As the recession continued into 1992, selling price competition intensified and the group experienced historically low selling prices. Operating earnings in 1992 were up 16 percent compared to 1991, primarily due to the comparative effect of the losses incurred during the 1991 fourth quarter labor strike. Through three quarters of 1992, earnings were running behind 1991 levels because of lower selling prices and a less profitable shipment mix. Earnings in 1992 were reduced by a $3,500 provision for workers' compensation claims alleging hearing loss. Washington Stainless. Sales for 1993 were up 50 percent and operating earnings were up 64 percent compared to 1992 results. The increases partially reflected the comparison of 1993 to 1992 results that were from the acquisition of the group in late April. 1993 results benefited from production efficiencies, lower nickel costs and better results from the service center operations. On the negative side, increased imports put pressure on 1993 selling prices. Shipped tons for 1993 were 208,800 and 147,500 tons in 1992. Business Outlook In the Lukens Steel Group, strong shipment levels are expected to continue. We are beginning to see improvements in selling prices and are cautiously optimistic for continued improvement in 1994. Scrap costs that increased dramatically in 1993 remain a concern. These costs historically have moved with changes in selling prices. In 1993, this trend did not continue and it remains to be seen if there has been a fundamental change in the scrap market. Efforts to reduce production costs that were initiated in 1993 will be important to improve margins in 1994. The backlog of orders at the end of 1993 was $58,712, down 14 percent from the beginning of the year. The Washington Stainless Group enters 1994 with increased foreign competition that is contributing to selling price pressure. Efforts to improve production efficiencies will continue in 1994. Margins in the service center operations are expected to remain tight. The backlog of orders at the end of 1993 was $42,883, down 7 percent from the beginning of the year. By 1995, we anticipate that the benefits from our five-year capital expenditure program, discussed in the following Liquidity -Long Term section, will improve earnings from 1993 levels and those expected in 1994. Additionally, the expansion into stainless steel markets from the 1992 acquisition of Washington Steel provides us with access to markets with long-term growth potential. Financial Condition Capital Structure. To finance the 1992 acquisition of Washington Steel, the capital structure of Lukens changed significantly. In 1992, $150,000 of long-term notes were issued along with 1,132,300 shares of common stock. At the end of 1993, cash and cash equivalents totaled $11,483, a decrease of $3,487 from the end of 1992. Working capital of $146,034 was up $3,568 with deferred income tax assets recognized from the adoption of SFAS No. 109 contributing to the increase. Bar graph of Current Assets and Working Capital for 1991, 1992 and 1993 included here Debt at the end of 1993 was $226,589, a $3,314 increase from year-end 1992. The long-term notes at year end were rated Baa2 by Moody's and BBB+ by Standard and Poor's. Included in year-end debt was $26,209 of ESOP debt, which is guaranteed by Lukens. The ratio of long-term debt to total capital (long-term debt plus stockholders' investment) was 45.3 percent at the end of 1993, which compared to 39.9 percent at year-end 1992. The increase in the ratio reflected the net reduction in stockholders' investment following the adoption of the new accounting statements discussed in Note 1. The reduction in stockholders' investment did not trigger any debt covenant violations, nor did it change the borrowing availability of Lukens. In the first quarter of 1993, Lukens entered into a two-year, $75,000 interest rate swap agreement. The swap was structured to convert a fixed interest rate of 4.317 percent to a variable rate based on the six-month LIBOR. During the third quarter, the swap was terminated which resulted in cash proceeds of $317. At the Annual Meeting of Stockholders on April 28, 1993, stockholders approved a 20,000,000 increase in the number of authorized common shares and also approved stock option plan changes. These capital structure changes are discussed in Notes 7 and 10. Liquidity - Short Term. Cash flow from operating activity was $72,290 in 1993 compared to $59,184 in 1992. The increase was partially attributable to a full year of Washington Stainless Group cash flows compared to a partial year in 1992. The cumulative effect of the accounting changes, although resulting in a net loss in 1993, did not impact cash flows and the accounting changes are not anticipated to impact future cash flow. Financing activity required $9,681 with dividend payments of $17,115 partially offset by a net increase in debt and proceeds from stock options exercised. Primarily due to capital expenditures of $67,424, investing activity required $66,096. Based on our business outlook, we do not anticipate any significant increases to our cash flow from operating activity in the short term. In the Lukens Steel Group, liquidity continues to be impacted by a less profitable shipment mix and higher raw material costs. Partially offsetting these negative factors have been recent rulings by the U. S. International Trade Commission that upheld most of the steel plate cases on unfair trading practices. Additionally, the decline in selling prices over the past few years appears to have ended and we anticipate higher selling prices in 1994. No significant changes in operating cash flows from the Washington Stainless Group are anticipated in 1994. The total of Lukens Steel Group and Washington Stainless Group backlog of orders at year-end 1993 was $101,595, down 11 percent from the beginning of the year. The divestiture of the discontinued operations is not anticipated to significantly affect cash flow from operating activity. Capital expenditure projections for 1994 are historically high at $144,000. We anticipate funding these expenditures primarily through the combination of cash flow from operations, debt under an existing committed line of credit and proceeds from the sale of discontinued operations. Additional short-term borrowings may be needed during 1994. Bar graph on Capital Expenditures for 1991, 1992 and 1993 included here. Liquidity - Long Term. In the long term, Lukens relies on the ability to generate sufficient cash flows from operating activity to fund investing and financing requirements and to maintain a target long-term debt to capital ratio of 35 percent. As the chart below indicates, Lukens has consistently generated cash from operations totaling $197,818 from the past three years. Bar Graph on Cash Flow from Operations for 1991, 1992 and 1993 included here. Capital expenditures in 1993 were part of a five-year program of approximately $400,000. The program is primarily aimed at promoting synergies between the Lukens Steel Group and Washington Stainless Group, and expanding our product lines to take advantage of the anticipated long-term growth in stainless steel markets. The centerpiece of the program is the installation of a plate and sheet processing system at our Conshohocken, Pennsylvania facility. The new system, scheduled to start up late in 1994, will utilize Steckel rolling technology and is designed to lower production costs and expand the product range of both the Lukens Steel Group and Washington Stainless Group. Other expenditures in the program include the expansion of stainless steel melting capacity. Because of this capital expenditure program, we anticipate exceeding our target long-term debt to capital ratio of 35 percent until the projected benefits of the program improve cash flow from operations. We anticipate funding these expenditures primarily through the combination of cash flow from operations, debt under an existing committed line of credit and proceeds from the sale of discontinued operations. Additional short-term borrowings may be needed during this period. Other long-term commitments include a contract for the supply of oxygen and related products to a Lukens Steel Group manufacturing facility. The contract runs until 2007 and includes take-or-pay provisions totaling $32,989 at the end of 1993. The $150,000 of long-term notes issued in 1992 to finance the acquisition are due in 2004. Regarding environmental compliance requirements, we are projecting capital expenditures of approximately $4,700 in 1994 and $4,500 in 1995. The trend for tighter environmental standards is expected to continue and result in higher waste disposal costs and additional capital expenditures in the long term. Although it is difficult to project these amounts, we are not aware of any environmental problems that would jeopardize our competitive position. Supporting both our short- and long-term liquidity positions is an agreement for a committed line of credit. At the end of 1993, Lukens could borrow an additional $93,000 under this agreement that expires in 1996. On average, inflation rates for the domestic economy have not been severe over the past few years. With the exception of 1993 scrap cost increases in the Lukens Steel Group, Lukens generally has not incurred significant increases in production costs. One problem area, however, is the cost of employee medical benefit packages. Inflation rates for these employee benefits have consistently run much higher than average inflation rates. Because Lukens structures benefit packages to be competitive in the labor market, these increased costs are incurred, and they are expected to remain relatively high in the near term. Although long-term inflation rates are difficult to predict, Lukens believes it has the flexibility in operations and capital structure to maintain a competitive position. Dividends. Lukens paid $1.00 per share in common stock dividends in 1993. A quarterly common dividend of $.25 per share was paid on February 18, 1994. It is our objective to pay common dividends approximating 35 percent of net earnings over a number of years. The Series B Convertible Preferred Stock held by the ESOP carries a cumulative annual dividend of $4.80 per share. Bar graph with Net Earnings Per Common Share/Dividends Per Common Share for 1991, 1992 and 1993 included here. As of February 7, 1994, there were approximately 5,600 common stockholders of record. Lukens' common stock is listed and traded on the New York Stock Exchange, ticker symbol "LUC." Dividends and stock market price ranges for the last two years are included Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Report of Independent Public Accountants To the Stockholders and Board of Directors, Lukens Inc.: We have audited the accompanying consolidated balance sheets of Lukens Inc. (a Delaware Corporation) and subsidiaries as of December 25, 1993 and December 26, 1992 and the related consolidated statements of earnings, cash flows and stockholders' investment for each of the three fiscal years in the period ended December 25, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lukens Inc. and subsidiaries as of December 25, 1993 and December 26, 1992, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended December 25, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 1 the consolidated financial statements, effective December 27, 1992, the Company changed its methods of accounting for post retirement benefits other than pensions and income taxes. Arthur Andersen & Co. Philadelphia, Pennsylvania February 1, 1994 Consolidated Financial Statements Notes to Consolidated Financial Statements Dollars in thousands except per share amounts 1. Accounting Policies Consolidation and Fiscal Year. The consolidated financial statements include the accounts of Lukens Inc. and all majority-owned subsidiaries. Our fiscal year is the 52- or 53-week period that ends on the last Saturday of December. Certain subsidiaries are consolidated on a calendar year basis. Cash and Cash Equivalents. Highly liquid investments with maturities of three months or less when purchased are recognized as cash equivalents. Inventories. Inventories are recorded at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for most product and raw material inventories. Supplies are valued at the lower of average cost or market. Additional inventory disclosures are included in Note 8. Plant and Equipment. Plant and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful life. The useful life ranges from 20 to 40 years for buildings and from 7 to 18 years for most production machinery and equipment. The cost of plant and equipment retired in the normal course of business is generally charged against accumulated depreciation. Gains and losses on other retirements are reflected in earnings. Earnings Per Share. Primary earnings per common share are calculated by dividing net earnings applicable to common stock by the average of common stock outstanding and common stock equivalents. On a fully-diluted basis, both net earnings and shares outstanding are adjusted to assume the conversion of convertible preferred stock. During 1992, Lukens issued long-term notes and common stock (Notes 9 and 10) to refinance the Washington Steel acquisition (Note 2). If the long-term notes and common stock had been issued on the acquisition date, primary earnings per common share reported for 1992 would not have been significantly different. Accounting Changes - Income Taxes. In the first quarter of 1993, Lukens adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The new statement requires an asset and liability approach to determine the tax provision and related deferred tax assets and liabilities. We elected to record the cumulative effect of this accounting change by the recognition of a $1,321 gain, or $.09 per common share. As a result of adopting SFAS No. 109, the tax benefit on the Lukens' preferred stock dividends for the shares allocated to employee stock ownership plan (ESOP) participants is recognized as a reduction to the income tax provision. In prior years, this amount was recognized as a direct increase to retained earnings. Recognition of income taxes in prior years has not been restated. The provision for income taxes under the previous deferral method was based on financial accounting earnings. Deferred taxes were recognized because some financial accounting income and expense items were recognized in different years in determining taxable income. Note 6 covers our income tax disclosures. Accounting Changes - Retiree Medical & Life Insurance Benefits. In the first quarter of 1993, Lukens adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The new statement requires the liability and expense be actuarially determined in a framework similar to the one used to measure defined benefit pension plans. We elected to record the cumulative effect of this accounting change by the recognition of a $108,000 expense, which represented the accumulated postretirement benefit obligation for current and future retirees at the beginning of 1993. On an after-tax basis, the expense was $67,222, or $4.55 per common share. The adoption of the new statement also changed the accounting for our 1992 acquisition of Washington Steel, discussed in Note 2. The recognition of retiree medical and life insurance benefits in prior years was on a cash basis, and results for prior years have not been restated. Note 5 covers our retiree benefit disclosures. 2. Acquisitions and Discontinued Operations Acquisitions. On April 24, 1992, Washington Steel Corporation was acquired for $273,718 in cash. Washington Steel is a stainless steel producer with two production facilities in Pennsylvania and one in Ohio. Also included in the acquisition were seven stainless service centers in the United States and Canada. The acquisition was accounted for as a purchase with the results of Washington Steel included from the acquisition date. As a result of the adoption of SFAS No. 106, discussed in Note 1, purchase accounting was adjusted in 1993 to reflect the accumulated postretirement benefit obligation assumed of $19,300. Recognition of this liability was offset by $12,200 of goodwill and $7,100 of net long-term deferred tax assets. The fair value of assets acquired as adjusted for the adoption of SFAS No. 106, was $385,876 and liabilities assumed totaled $112,158. Included in assets was $41,150 of goodwill, which is being amortized over 25 years on a straight-line basis. The pro forma consolidated results listed below are unaudited and reflect purchase accounting adjustments assuming the acquisition occurred at the beginning of each year presented. Discontinued Operations. As part of a program adopted in 1993 to focus Lukens resources on its steel businesses, the subsidiaries previously reported in the Corrosion Protection Group, Safety Products Group and most subsidiaries in the Diversified Group are for sale. These subsidiaries are reported as discontinued operations, and prior period results are restated. Net sales and income tax expense of the discontinued operations and an earnings per common share reconciliation (before the cumulative effect of accounting changes) are listed below. During the fourth quarter of 1993, a $4,500 provision was recognized to revise estimates of the realizable value of discontinued operations. On an after-tax basis, the provision was $2,772, or $.19 per common share. Net assets of the discontinued operations at the end of 1993 were $87,857. 3. Business Groups As a result of the discontinued operations presentation discussed in Note 2, the previously reported Safety Products, Corrosion Protection, and Diversified business groups have been eliminated from our business group presentation. Two subsidiaries in the Diversified Group were not classified as discontinued operations, and they are now reported in the Lukens Steel Group. The Washington Stainless Group resulted from the acquisition discussed in Note 2. Listed below is a description of our business groups, which operate primarily in the United States. Sales to foreign countries and sales between business groups are not significant. - - Lukens Steel Group - specializes in the production of carbon, alloy and clad plate steels. - - Washington Stainless Group - specializes in stainless steel plate, sheet, strip, hot band and slabs. The group also operates stainless service centers. Summary business group information is included in the following chart. a. Lukens Steel Operating Earnings: 1993 - In the fourth quarter, charges of $14,921 were recognized that included $9,660 of expense for a work force reduction program (Note 4). The remaining charges included provisions for environmental remediation and workers' compensation claims. The adoption of a new accounting standard for retiree medical and life insurance benefits (Note 1) resulted in additional accrual expense of $4,610 over the cash claims. Results from prior years only include the cash claims. 1992 -In the fourth quarter, a provision for workers' compensation claims alleging hearing loss reduced results by $3,500. Also in the fourth quarter of 1992, a favorable LIFO inventory accounting adjustment increased earnings by $2,719. 1991 - A labor strike resulted in an $8,597 loss for the fourth quarter. b. Washington Stainless Group Results 1992 results are for a partial year, from the acquisition date on April 24, 1992 to year end. c. Corporate Expenses: 1993 - The increase in 1993 expenses included higher consulting fees and expenses from a work force reduction program. 1991 expenses included $2,665 of severance packages for executives. Gains from the sale of corporate assets partially offset these expenses. d. Corporate Assets Corporate assets consist primarily of cash and cash equivalents, refundable income taxes, and office facilities. Assets in 1993 included deferred income taxes. Short-term investments and marketable equity securities were included in 1991 assets. 4. Unusual Item During the fourth quarter of 1993, $10,626 of expenses for a work force reduction program were recognized. The expenses were primarily for pension and medical benefits associated with an early retirement program. On an after-tax basis, the provision reduced net earnings before the cumulative effect of accounting changes by $6,247, or $.43 per common share. 5. Retiree Benefits Pensions. Lukens has several defined benefit plans that provide pension and survivor benefits for most employees. Benefits are primarily based on the combination of years of service and compensation. Plans are funded in accordance with applicable regulations. The components of pension expense are listed below. a. The increase in 1993 pension expense resulted primarily from plan improvements for Lukens Steel Group salary employees. The increase was also attributable to a full year of Washington Stainless Group expense compared to 1992, which was from the acquisition on April 24. Higher pension expense in 1992 compared to 1991 primarily reflected costs from a new labor contract in the Lukens Steel Group. Pension expense from the plans assumed in the Washington Steel acquisition also contributed to the increase. The following table reconciles the net funded status of our plans to amounts recognized in the Consolidated Balance Sheets. a. The increase in the 1993 benefit obligations primarily reflected a lower discount rate. Additionally, incentives offered in an early retirement program (Note 4) increased benefit obligations by $7,716. b. Plan assets primarily consist of stocks, bonds and short-term investments. Included in plan assets is Lukens' common stock totaling $10,585 in 1993 and $12,637 in 1992. The net pension liability was comprised of: Significant assumptions used in the calculation of pension expense and obligations were: Retiree Health & Life Insurance Benefits. Lukens provides retiree health and life insurance benefits for most employees if they continue to work for the company until they reach retirement age. These benefits are funded as the claims are submitted. During 1993, Lukens adopted a new accounting standard, SFAS No. 106, for these retiree benefits. As discussed in Note 1, we elected to recognize the cumulative effect of adopting the standard in 1993. The adoption also resulted in a change in the Washington Steel acquisition accounting for the obligations assumed, discussed in Note 2. The combination of the cumulative effect and acquisition obligations totaled $127,300 at the beginning of 1993. Accrual expense under the new standard is significantly higher than the expense recognized under the previous cash-basis method. Cash payments in 1992 were $6,514 and $5,818 in 1991. The 1993 expense components are listed below. The table below reconciles the actuarial present value of year-end 1993 obligations to the liability recognized in the Consolidated Balance Sheets. a. Obligations include $14,430 for life insurance benefits. Significant assumptions used in the calculation of expense and obligations are listed below. a. Recognition of the cumulative effect at adoption was based on a discount rate of 8.3 percent. b. Health-care cost increase assumptions are reduced to a rate of 5 percent over 10 years. A one-percentage point increase in the medical cost trend rate for each year would increase the accumulated postretirement benefit obligation by approximately $26,000 and would increase expense by approximately $2,800. 6. Income Taxes During 1993, Lukens adopted a new income tax accounting standard, discussed in Note 1. Because we elected to recognize the cumulative effect of adopting the standard in 1993, prior years accounted for under the deferral method have not been restated. The reconciliation between the federal statutory rate applicable to Lukens' earnings from continuing operations and our effective rate is listed below. Essentially all earnings are from United States sources. The components of the deferred income tax assets and liabilities at the end of 1993 are listed below. The current and deferred components of the income tax provision are listed below. Deferred income taxes recognized under the deferral method were the result of the timing differences between financial reporting and taxable earnings listed below. On a cash basis, Lukens paid the following amounts of income taxes, including payments for discontinued operations. 1993 1992 1991 $18,938 $10,960 $19,031 7. Compensation Plans Stock Options. The 1985 Stock Option and Appreciation Plan provides for the issuance of non-qualified stock options and incentive stock options (ISOs) to officers and other executives. At the Annual Meeting of Stockholders on April 28, 1993, stockholders approved an amendment to the plan that increased the number of shares that can be granted by 600,000, and extended the expiration date of the plan until February 26, 1998. A maximum of 1,837,500 options to purchase Lukens' common stock can be granted at an exercise price not less than the fair market value on the grant date. Once granted, options can be exercised after one year, and they will expire in ten years. Also at the 1993 Annual Meeting of Stockholders, stockholders approved a stock option plan for non-employee directors. This plan provides for the issuance of 75,000 non-qualified options to purchase Lukens Inc. common stock at an exercise price based on the fair market value on the grant date. During 1991, 330,000 non-qualified stock options were granted to Mr. Van Sant as part of his employment agreement. These options become exercisable ratably over 11 years. The options carry an exercise price of $23.38 per share, which was 85 percent of the fair market value on the grant date. Compensation expense from this discount from fair market value is being recognized on a straight-line basis over the expected service period. A summary of stock option activity is presented below. Incentive Compensation. Most Lukens' employees participate in incentive compensation plans that are based on the consolidated results of Lukens Inc. and on the results of various subsidiaries. Compensation expense under these plans is listed below. 1993 1992 1991 $19,419 $13,016 $9,312 Employee Stock Ownership Plan (ESOP). In 1989, an ESOP within an existing 401(k) employee savings plan for most salaried employees was established. The ESOP was designed to provide 401(k) employer matching benefits in the form of convertible preferred stock that was acquired with the proceeds from a $33,075 term loan (Note 9). The stock is released for allocation to participants' accounts based on the relationship of debt and interest repayments to the total of all scheduled debt and interest payments. Dividends on allocated stock are paid, in-kind, with preferred stock. The projected maturities of the ESOP loan over the next five years are listed below. 1994 1995 1996 1997 1998 $4,354 $4,971 $6,232 $7,630 $3,022 The loan is guaranteed by Lukens, and the outstanding balance is recognized as debt in the Consolidated Balance Sheets. An offsetting amount, representing deferred compensation measured by the stated value of convertible preferred stock, is recognized in the stockholders' investment section. Debt service requirements of the ESOP are met by the combination of Lukens' cash contributions to the ESOP and dividends on the preferred stock. Regarding expense recognition, cash contributions to the ESOP are recorded as compensation expense, and preferred stock dividends reduce retained earnings. This recognition results in interest expense incurred on the ESOP debt not being recognized as interest expense on Lukens' financial statements. Cash contributions are listed below. 1993 1992 1991 $2,222 $1,597 $1,177 8. Inventories The components of inventory are listed below. The estimated cost to replace inventories at year end is listed below. 1993 1992 1991 $197,000 $180,000 $108,000 Reductions in inventory quantities resulted in a liquidation of LIFO inventory carried at lower costs from prior years. The effect of these liquidations reduced cost of products sold as listed below. 1993 1992 1991 $213 $3,234 $929 9. Long-Term Debt and Interest Listed below is a summary of long-term debt outstanding. a. The weighted-average interest rate at year-end 1993 was 3.7% and 4.2% at year-end 1992. Short-term notes were classified as long-term because they are supported by the revolving credit agreements discussed below. b. The weighted-average interest rate was 4.9% at year-end 1993 and 1992. c. The ESOP debt guaranteed by Lukens carries an 8.26% interest rate on $21,744 as of December 25, 1993. The remaining ESOP debt carries a variable rate of 80.5% of prime. For a discussion on ESOP accounting, see Note 7. d. Annual maturities of long-term debt, excluding the ESOP debt guarantee, over the next five years are listed below. 1994 1995 1996 1997 1998 $1,467 $3,159 $37,789 $691 $693 e. Plant and equipment with a net depreciated cost of $50,400 are pledged as collateral for secured loans. Long-term Notes. On August 4, 1992, Lukens issued $150,000 of notes due in 2004 at a discount of 99.487% of the face amount. The notes carry an interest rate of 7.625%, payable semi-annually. Proceeds, net of issuance expenses, were $148,218 and were used to reduce the debt incurred to finance the acquisition discussed in Note 2. The notes are currently rated Baa2 by Moody's and BBB+ by Standard and Poor's. Revolving Credit Agreements. To finance the acquisition discussed in Note 2, Lukens initially borrowed $262,000 under a new debt agreement. The revolving credit and term loan agreement was structured with a three-year revolving credit line of $125,000 and a five-year term loan of $200,000. With the proceeds from common stock issued (Note 10) and long-term notes issued, the term loan was repaid. Subsequently, the revolving credit and term loan agreement was amended. The amended agreement provides for a $125,000 committed line of credit until September 30, 1996. Interest is based on one of the following rates: * The higher of the Prime Rate or the Federal Funds Rate plus 1/2 of 1% * London Inter-Bank Offered Rate (LIBOR) adjusted for applicable reserves; plus 3/8 of 1%, 1/2 of 1%, or 7/8 of 1% depending on the Standard and Poor's or Moody's rating of the long-term notes of Lukens * Competitively bid rates from lenders. A fee is required on the unused portion (defined in the agreement) of the loan commitment. The commitment fee structure listed below is based on the lower of Standard and Poor's Moody's rating of the long-term notes. A-/A3 or higher 3/16 of 1% BBB-/Baa3 to BBB+/Baa1 1/4 of 1% Below BBB-/Baa3 3/8 of 1% The amended agreement includes covenants that require a maximum leverage ratio (defined in the agreement) of 55 percent and restrictions on additional debt and asset dispositions. At year end, we are in compliance with these covenants, and additional borrowings of $93,000 were available. Interest Rate Swaps. During the first quarter of 1993, Lukens entered into a two-year, $75,000, interest rate swap agreement. The swap was structured to convert a fixed rate of 4.317% to a variable interest rate that was measured by the six-month LIBOR. During the third quarter, Lukens realized $317 from the termination of the swap. The gain on termination is being recognized over the original term of the agreement. At December 25, 1993, Lukens is party to interest rate exchange agreements with a notional principal of $81,250 decreasing through the expiration date in 1994. These agreements, which fix the interest rate at 6.2%, are accounted for as hedges. Lukens is exposed to credit risk from nonperformance by the other parties to the swap agreements. Interest Expense. Capitalized interest was not significant in the last three years. For a discussion on ESOP debt accounting, see Note 7. Listed below are the amounts of interest, debt set-up costs and interest rate swap fees that were paid in cash. 1993 1992 1991 $15,702 $10,449 $1,990 Fair Value of Debt and Interest Rate Swaps. Approximately $160,000 represented the fair value of the long-term notes (face amount $150,000) at year-end 1993. The fair value of the other instruments at year-end 1993 and 1992 were not significantly different from the amount recognized in the Consolidated Balance Sheets. Regarding the interest rate swap agreements, the fair value of the obligations at year-end 1993 totaled $1,500 and $2,500 at the end of 1992. Fair value was calculated by using year-end interest rates and market conditions. 10. Stockholders' Investment Common Stock. At the Annual Meeting of Stockholders on April 28, 1993, a 20,000,000 increase in the number of authorized common shares was approved. The increase, which was designed to provide greater flexibility in future capital structure requirements, brought the total number of shares authorized to 40,000,000. The par value remained at $.01 per share. On July 28, 1992, Lukens issued 1,132,300 shares of common stock. The net proceeds of $58,529 were used to reduce the debt incurred to finance the Washington Steel acquisition. On September 28, 1992, a three-for-two common stock split was completed in the form of a 50 percent stock dividend. As a result of the split, $53, representing the par value of the additional shares, was transferred from capital in excess of par value to common stock. Common shares and equivalents outstanding and per share amounts in this Annual Report have been restated to reflect the stock split. Under the stock option plans discussed in Note 7, 2,242,500 shares of common stock have been reserved. Preferred Stock. There are 1,000,000 shares of series preferred stock, par value $.01 per share, authorized. An ESOP was established in 1989 with the issuance of 551,250 shares of Series B Convertible Preferred Stock. The preferred stock is stated at its liquidation preference of $60 per share and carries an annual cumulative dividend of $4.80 per share. Each share may be converted into three shares of common stock within the guidelines of an employee 401(k) savings plan. The stock is redeemable in common stock, cash, or a combination at the option of Lukens at a price of $64.80 per share. The redemption price declines gradually each year to $60 per share on or after July 2, 2000. Holders of the Series B preferred stock are entitled to vote upon all matters submitted to the holders of common stock for a vote. The number of votes is equal to the number of common shares into which the preferred shares are convertible. Shareholder Rights Plan. Lukens has a Shareholder Rights Plan designed to deter coercive or unfair takeover tactics and to prevent a buyer from gaining control of Lukens without offering a fair price to stockholders. The plan entitles each outstanding share of common stock to four-ninths (reflects adjustment for 1988 and 1992 common stock splits) of a right. Each right entitles stockholders to buy one one-hundredth of a share of Series A Junior Participating Preferred Stock at an exercise price of $110. The rights become exercisable if a person or group acquires or makes a tender or exchange offer for 20 percent or more of common stock outstanding. The rights can also become exercisable if the Board of Directors determines, with the concurrence of outside directors, that a person has certain interests adverse to Lukens and has acquired at least 10 percent of common stock outstanding. If the company is then acquired in a merger or other business combination transaction, each right will entitle the holder to receive, upon exercise, common stock of either Lukens or the acquiring company having a value equal to two times the exercise price of a right. Lukens will generally be entitled to redeem the rights at $.05 per right at any time until the tenth day following public announcement that a 20 percent position has been acquired. The purchase rights will expire on August 10, 1997. Of the 1,000,000 shares of series preferred stock authorized, 75,000 have been reserved for the Series A preferred stock discussed above. As of December 25, 1993, there were 6,457,327 rights outstanding. 11. Commitments and Contingencies Leases. Lukens has various operating leases primarily for real estate and production equipment. At year-end 1993, minimum rental payments under noncancelable leases totaled $27,294. Listed below are the scheduled payments over the next five years for these leases. 1994 1995 1996 1997 1998 $5,474 $4,696 $4,159 $3,413 $2,300 Rent expense for all operating leases is listed below. 1993 1992 1991 $12,245 $10,100 $5,758 Litigation. During 1992, approximately 300 workers' compensation claims alleging hearing loss were filed against Lukens Steel Co., a wholly-owned subsidiary. A $3,500 reserve was established in the fourth quarter of 1992 to cover potential awards and defense costs resulting from these claims. In 1993, additional claims were filed bringing the total number of claims to approximately 350. An additional $2,100 reserve was established in the fourth quarter of 1993. The company is party to various claims, disputes, legal actions and other proceedings involving product liability, contracts, equal employment opportunity, occupational safety, environmental issues and various other matters. In the opinion of management, the outcome of these matters should not have a material adverse effect on the consolidated financial condition or results of operations of the company. Commitments. At year-end 1993, purchase commitments for capital expenditures were $75,500. Capital expenditures projected for 1994 are historically high at $144,000. These expenditures are part of a five-year, $400,000 program that began in 1993. Lukens Steel Company has a long-term contract for the supply of oxygen and related products to its facility in Coatesville, Pennsylvania. The contract runs until 2007 and has take-or-pay provisions totaling $32,989 for the remaining term. Annual minimum commitments are $2,490, which can be adjusted for inflation. Subsequent to year-end 1993, Washington Steel Corporation entered into a three-year, $36,000 purchase contract for nickel. Quarterly Financial Data (Unaudited) a. Earnings per share calculations were based on the weighted-average shares and equivalents outstanding during the period reported. No adjustments were made that would be anti-dilutive or reduce the loss per share. Consequently, the sum of the quarterly earnings per share amounts may not equal the annual per share amounts. b. During the fourth quarter of 1993, $10,626 of expenses from a work force reduction program were recognized. On an after-tax basis, the provision was $6,247, or $.43 per common share. Also during the fourth quarter, a $4,500 provision was recognized to revise estimates of the realizable value of discontinued operations. On an after-tax basis, the provision was $2,772, or $.19 per common share. c. Consolidated results since April 24, 1992 include the results from the Washington Steel acquisition. d. A $3,500 provision for workers' compensation claims alleging hearing loss, reduced net earnings by $2,027, or $.14 per share. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. a. Directors The information contained in the section entitled "Election of Directors" of the Lukens Inc. 1994 Proxy Statement is incorporated herein by reference in response to this item. b. Executive Officers of the Registrant Information required by this item is contained in Part I of this Form 10-K in the section entitled "Executive Officers of the Registrant." c. Compliance With Section 16(a) Information contained in the section entitled "Section 16 Compliance" of the Lukens Inc. 1994 Proxy Statement is incorporated herein by reference in response to this item. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information contained in the sections entitled "Management" and "Report of Executive Development & Compensation Committee" of the Lukens Inc. 1994 Proxy Statement is incorporated herein by reference in response to this item. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information contained in the sections entitled "Principal Holders of Stock" and "Management" of the Lukens Inc. 1994 Proxy Statement is incorporated herein by reference in response to this item. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. a. Documents filed as a part of this report. 1. Financial Statements No financial statements have been filed with this Form 10-K other than those incorporated by reference in Item 8. 2. Financial Statement Schedules Schedules other than those listed above have been omitted because they are not applicable or because the required information is reported in the financial statements or notes. 3. Exhibits See Index to Exhibits. b. Reports on Form 8-K. No reports on Form 8-K were filed during the fourth quarter of 1993 that ended on December 25, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. LUKENS INC. (Registrant) Date: March 2, 1994 By R. W. Van Sant -------------- R. W. Van Sant Chairman and Chief Executive Officer SIGNATURES (continued) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below, as of March 2, 1994, by the following persons on behalf of the registrant and in the capacities indicated. Signature and Title Michael O. Alexander Robert L. Seaman - -------------------- -------------------- Michael O. Alexander Robert L. Seaman Director Director Frederick R. Dusto - -------------------- -------------------- Frederick R. Dusto Harry C. Stonecipher Director Director Ronald M. Gross Joab L. Thomas - -------------------- -------------------- Ronald M. Gross Joab L. Thomas Director Director Nancy Huston Hansen W. Paul Tippett - -------------------- -------------------- Nancy Huston Hansen W. Paul Tippett Director Director William H. Nelson, III R. W. Van Sant - -------------------- -------------------- William H. Nelson, III R. W. Van Sant Director Chairman and Chief Executive Officer Stuart J. Northrop John N. Maier - -------------------- -------------------- Stuart J. Northrop John N. Maier Director Vice President and Controller REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in the Lukens Inc. 1993 Annual Report to stockholders, included or incorporated by reference in this Form 10-K, and have issued our report thereon dated February 1, 1994. Our report on the financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes in 1993 as discussed in Note 1 to the financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The financial statement schedules referred to in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The financial statement schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. Philadelphia, Pennsylvania February 1, 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 1, 1994 included or incorporated by reference in this annual report on Form 10-K, into the Company's previously filed: Form S-8 Registration Statements File No. 33-6673, 33-23405, 33-29105, and 33-69780, and Form S-3 Registration Statement File No. 33-6792. Arthur Andersen & Co. Philadelphia, Pennsylvania March 23, 1994 INDEX TO EXHIBITS (Note 1) ( 3) Certificate of incorporation and by-laws (Note 2) (10) Material Contracts (10.1) Lukens Inc. Supplemental Retirement Plan for Target Incentive Plan Participants, as amended, effective January 1, 1988 (Note 4) (10.2) Lukens Inc. Supplemental Retirement Plan as amended and restated, effective January 1, 1990 (Note 6) (10.3) Lukens Inc. Supplemental Retirement Plan for Designated Executives, effective January 1, 1990 (Note 5) (10.4) Lukens Inc. 1985 Stock Option and Appreciation Plan As Amended (10.5) Lukens Inc. Stock Option Plan for Non-employee Directors (10.6) Employment Agreement dated October 12, 1991, between R. William Van Sant and the company (Note 4) (10.7) Severance Agreement dated October 12, 1991, between R. William Van Sant and the company (Note 4) (10.8) Lukens Inc. Severance Plan for Participants in the Lukens Inc. 1983 Target Incentive Plan and the Lukens Inc. 1985 Division Incentive Compensation Plan (Note 4) (10.9) Severance Agreement dated October 31, 1990, between Dennis M. Oates and the company (Note 5) (10.10) Severance Agreement dated October 31, 1990, between John C. van Roden, Jr. and the company (Note 5) (10.11) Severance Agreement dated October 31, 1990, between William D. Sprague and the company (Note 5) (10.12) Severance Agreement dated January 9, 1992, between John N. Maier and the company (Note 3) (10.13) Lukens Inc. 1983 Target Incentive Compensation Plan as amended through January 1, 1993 (Note 3) (10.14) Lukens Inc. Directors' Deferred Payment Plan (Note 8) (10.15) Guaranty Agreement dated as of June 28, 1989, between Lukens Inc., and The Toronto-Dominion Bank & Trust Company as Agent for the Guaranteed Parties (Note 6) (10.16) Retirement Plan, as amended, for Non-Employee Directors of Lukens Inc. (Note 5) (10.17) Indemnification Agreement dated February 24, 1988, between Frederick R. Dusto and the company (Note 6) (10.18) Indemnification Agreement dated October 17, 1988, between William D. Sprague and the company (Note 6) (10.19) Indemnification Agreement dated September 27, 1989, between W. Paul Tippett and the company (Note 6) (10.20) Indemnification Agreement dated November 30, 1988, between R. William Van Sant and the company (Note 6) (10.21) Indemnification Agreement dated January 27, 1988, between William H. Nelson, III and the company (Note 6) (10.22) Indemnification Agreement dated January 27, 1988, between Nancy Huston Hansen and the company (Note 6) (10.23) Indemnification Agreement dated January 27, 1988, between Stuart J. Northrop and the company (Note 6) (10.24) Indemnification Agreement dated January 27, 1988, between Robert L. Seaman and the company (Note 6) (10.25) Indemnification Agreement dated January 27, 1988, between Dennis M. Oates and the company (Note 6) (10.26) Indemnification Agreement dated January 28, 1988, between John C. van Roden, Jr. and the company (Note 6) (10.27) Indemnification Agreement dated September 25, 1991, between Ronald M. Gross and the company (Note 4) (10.28) Indemnification Agreement dated September 25, 1991, between Harry C. Stonecipher and the company (Note 4) (10.29) Indemnification Agreement dated December 2, 1992, between Joab Thomas and the company (Note 3) (10.30) Indemnification Agreement dated January 27, 1993, between Michael O. Alexander and the company (10.31) Indemnification Agreement dated January 9, 1992, between John N. Maier and the company (Note 3) (10.32) Indemnification Agreement dated February 1, 1993, between T. Grant John and the company (10.33) Indemnification Agreement dated February 1, 1993, between Richard D. Luzzi and the company (10.34) Indemnification Agreement dated April 15, 1993, between Frederick J. Smith and the company (10.35) Indemnification Agreement dated April 15, 1993, between John H. Bucher and the company (10.36) Revolving Credit and Term Loan Agreement, dated April 22, 1992, among Lukens Inc. and Lukens Steel Company, as the Borrowers, Certain Commercial Lending Institutions, the Toronto-Dominion Bank, and NBD Bank, N.A., as the Co-Agents, and Provident National Bank, as the Administrative Agent (Note 9) (10.37) Amended and Restated Credit Agreement, dated as of April 22, 1992, and Amended and Restated as of September 30, 1992 (Note 3) (10.38) Lease Agreement among Washington Steel Corporation, Blount, Inc. and C.I.T. Financial Services, Inc., dated as of December 15, 1980 (Note 3) (10.39) Allied Corporation - Washington Steel Corporation Equipment Lease and Maintenance Agreement, dated September 22, 1986 (Note 3) (10.40) Lease among PNC Leasing Corp., Blount, Inc., and Washington Steel Corporation, dated as of October 1, 1986 (Note 3) (10.41) Lease Amendment No. 1, dated July 22, 1987, among PNC Leasing Corp., Blount, Inc. and Washington Steel Corporation (Note 3) (10.42) Lease Amendment No. 2, Assumption and Consent among PNC Leasing Corp., Blount, Inc. and Washington Steel Corporation, dated as of October 18, 19888 (Note 3) (10.43) Lease Amendment No. 3, Assumption and Consent among PNC Leasing Corp., Lukens Inc. and Washington Steel Corporation, dated as of July 21, 1992 (Note 3) (10.44) Lease Agreement among Wells Fargo Leasing Corporation, Blount, Inc. and Washington Steel Corporation, dated as of April 2, 1981 (Note 3) (10.45) Agreement, dated May 27, 1988, between Robert E. Heaton and Blount, Inc. (Note 3) (10.46) Executive Employment Contract, dated March 13, 1989, between Robert E. Heaton and Washington Steel Corporation (Note 3) (10.47) Amendment No. 1 to Employment Agreement between Robert E. Heaton, Washington Steel Corp. and Mercury Stainless Corp., dated as of February 17, 1989 (Note 3) (10.48) Agreement, dated October 31, 1989, between Robert E. Heaton and Washington Steel Corp. (Note 3) (10.49) Memorandum, dated April 30, 1990, regarding Incentive Compensation Amendment to the Executive Employment Contract (Note 3) (10.50) First Amendment to Executive Employment Contract between Robert E. Heaton and Washington Steel Corp., dated November 26, 1990 (Note 3) (10.51) Second Amendment to Executive Employment Agreement between Robert E. Heaton and Washington Steel Corp., dated November 28, 1990 (Note 3) (10.52) Washington Steel Division Annual Bonus Plan for Elected Officers (Note 3) (10.53) Agreement between James J. Norton and Mercury Stainless Corp., Mercury Stainless, Inc., Mercury Stainless Canada Inc., Washington Steel Corp. and Kramo Corp., dated October 31, 1989 (Note 3) (10.54) Memorandum, dated April 30, 1990, regarding Incentive Compensation Amendment to the Norton Employment Contract (Note 3) (10.55) Amended and Restated Employment Contract between James J. Norton and Mercury Stainless Corp., Mercury Stainless, Inc, Kramo Corp. and Washington Steel Corp., dated as of October 9, 1990 (Note 3) (10.56) First Amendment to Amended and Restated Employment Contract between James J. Norton and Mercury Stainless Corp., Mercury Stainless, Inc, Kramo Corp. and Washington Steel Corp., dated as of January 3, 1991 (Note 3) (10.57) Second Amendment to Amended and Restated Employment Contract between James J. Norton and Mercury Stainless Corp., Mercury Stainless, Inc, Kramo Corp. and Washington Steel Corp., dated as of July 3, 1991 (Note 3) (10.58) Agreement dated July 16, 1993, between Robert Schaal and the company (11) Statement regarding Computation of Per Share Earnings (13) Annual Report to Security Holders Except for the portions of that report expressly incorporated into this Form 10-K by reference, the Lukens' 1993 Annual Report to stockholders is not deemed filed as part of this filing. (21) Subsidiaries of the Registrant (23) Consent of Arthur Andersen & Co. (Note 10) Notes to Exhibits 1. Copies of exhibits will be supplied upon request. There is no charge for a copy of Lukens' 1993 Annual Report to stockholders (Exhibit 13). Other exhibits will be provided at $.25 per page requested. 2. Certificate of incorporation is incorporated by reference to exhibits included in the Lukens Inc. Post-Effective Amendment No. 1 to the Registration Statement on Form S-8, File No. 33-23405. By-laws as amended and restated June 26, 1991, are incorporated by reference to exhibits included in the company's report on Form 10-Q for the quarter ended June 29, 1991. 3. Incorporated by reference to exhibits included in the company's report on Form 10-K for the fiscal year ended December 26, 1992. 4. Incorporated by reference to exhibits included in the company's report on Form 10-K for the fiscal year ended December 28, 1991. 5. Incorporated by reference to exhibits included in the company's report on Form 10-K for the fiscal year ended December 29, 1990. 6. Incorporated by reference to exhibits included in the company's report on Form 10-K for the fiscal year ended December 30, 1989. 7. Incorporated by reference to exhibits included in the company's report on Form 10-K for the fiscal year ended December 31, 1988. 8. Incorporated by reference to exhibits included in the Lukens Inc. Registration Statement on Form S-4, File No. 33-10935. 9. Incorporated by reference to exhibits included in the Lukens Inc. Form 10-Q for the quarter ended March 28, 1992. 10. Incorporated by reference to page 15 of this Form 10-K. EXHIBIT 10.4 LUKENS INC. 1985 STOCK OPTION AND APPRECIATION PLAN As Amended December 17, 1986, February 25, 1987 April 27, 1988, August 15, 1988, January 31, 1990 and April 28, 1993 The Lukens, Inc. 1985 Stock Option and Appreciation Plan is hereby amended and renamed the Lukens Inc. 1985 Stock Option and Appreciation Plan (the "Plan). This Plan has been amended to conform to the changes in the law under the Tax Reform Act of 1986, to reflect a deletion of the requirement of tender of Shares by the Participant to the Company, to increase the number of Shares issuable under the Plan, to reflect a three for two stock split effected August 15, 1988, and to provide for acceleration of Options upon a Change in Control. The purpose of the Plan is to furnish an incentive to those officers and other key employees who have demonstrated a capacity to contribute to the success of the Company and its present or future subsidiaries by making available to them a larger common stock ownership in the Company, to induce the continued service of such employees, and to stimulate their efforts for the continued success of the Company. Options granted under the Plan may be either incentive stock options, as defined in Section 422A(b) of the Internal Revenue Code of 1986, as amended (the "Code"), or options which do not meet the requirements of said Section 422A(b) of the Code, herein referred to as non-qualified stock options. ARTICLE I. Definitions 1.1 As used in this Plan, the following definitions apply to the terms indicated below: (a) "Board" means the Board of Directors of Lukens Inc. (b) "Change in Control" means any of the following events: (i) Any "person" or "group" (as such terms are used in Sections 3(a)(9), 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended), considered together with its or their "affiliates" and "associates" (as such terms are defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), is or becomes the beneficial owner (as defined in Rule 13d-3 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), or acquires or holds voting control, directly or indirectly, of securities of the Company which, when considered together with any other securities which by their terms are convertible, even if not then convertible, represent twenty percent (20%) or more of the voting power of the then outstanding securities of the Company; or (ii) A change in the composition of a majority of the Board within 24 months after any "person" or "group" (as such terms are used in Sections 3(a)(9), 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended), considered together with its or their "affiliates" or "associates" (as such terms are defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), is or becomes the beneficial owner (as defined in Rule 13d-3 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended) or acquires or holds voting control, directly or indirectly, of securities of the Company which, when considered together with any other securities held by such person or group or their affiliates or associates which by their terms are convertible, even if not then convertible, represent twenty percent (20%) of the voting power of the then outstanding securities of the Company; or (iii) Any "person" or "group" (as such terms are used in Section 3(a)(9), 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended) commences a tender offer or exchange offer for securities of the Company if, upon consummation thereof, the offeror, considered together with its "affiliates" and "associates" (as such terms are defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), would own or control, directly or indirectly, securities of the Company which, when considered together with any other securities held by such person or group or their affiliates or associates which by their terms are convertible, even if not then convertible, represent thirty percent (30%) or more of the voting power of the then outstanding securities of the Company. The terms "person and "group", as used in this Section (b), shall not include (i) the Company; (ii) any corporation in which the Company owns, directly or indirectly, voting securities sufficient to elect at least a majority of the directors of such corporation; (iii) any employee benefit plan of the Company or of any corporation described in clause (ii) above; (iv) any individual or entity organized, appointed or established by the Company for, or pursuant to the terms of any employee benefit plan described in clause (iii) above; and (v) a Participant. (as amended January 31, 1990) (c) "Committee" means the Committee appointed pursuant to Section 9.1 of the Plan. (d) "Company" means Lukens Inc. (e) "Eligible Employee" means any employee, who on the date of the granting of an Option hereunder, is an officer or other key employee of the Company or of any Subsidiary Corporation and who, in the opinion of the Committee, has demonstrated a capacity for contributing to the success of the Company and its subsidiaries. (f) "Option" means a right to purchase Shares granted pursuant to the Plan and evidenced by an option certificate in such form as the Committee may adopt for general use from time to time. (g) "Participant" means an Eligible Employee to whom an Option is granted pursuant to this Plan. (h) "Plan" means the Lukens Inc. 1985 Stock Option and Appreciation Plan. (i) "Shares" mean shares of the Company's common stock, par value $.01. (j) "Subsidiary Corporation" means any corporation, as defined in Section 425(f) of the Code, now or hereafter existing in which the Company owns, directly or indirectly, in an unbroken chain of corporations, stock possessing 50% or more of the total combined voting power of all classes of stock of such corporation. 1.2 An Option shall be deemed "granted" under this Plan on the date on which the Committee, by appropriate action, awards the Option to an Eligible Employee, or on such subsequent date as the Committee may designate. 1.3 As used herein, the masculine includes the feminine and the plural includes the singular. 1.4 For purposes of the Plan, the fair market value of the Shares on a valuation date shall be the mean between the highest and lowest prices at which the Company's stock was sold on the New York Stock Exchange on such date (or if such date shall not be a business day, then the next preceding day which shall be a business day), or if no sale takes place, then the mean between the bid and asked prices on such date; if no bid and asked prices are quoted for such date then such value as shall be determined by such method as the Committee shall deem to reflect fair market value as of such date. ARTICLE II. Shares Subject to the Plan 2.1 The aggregate number of Shares which may be delivered upon exercise of Options granted under the Plan (including Shares delivered under Section 4.7 hereof) shall not exceed 1,837,500, subject to appropriate adjustment in the event the number of issued Shares shall be increased or reduced by a change in par value, combination, split-up, merger, reclassification, distribution of a dividend payable in stock, or the like. Shares covered by Options which have lapsed or expired may again be optioned pursuant to the Plan. (as amended April 27, 1988, August 15, 1988 and April 28, 1993) ARTICLE III. Grants of Options 3.1 The Committee may, at any time during the term of the Plan, grant to any Eligible Employee an Option to purchase any number of Shares, subject to the limitation in Section 3.2 hereof. 3.2 With respect to incentive stock options granted prior to January 1, 1987, the aggregate fair market value (determined as of the date the Option is granted) of the Shares for which any Participant may be granted Options intended to be incentive stock options in any calendar year (under all plans of the Company and its subsidiaries) shall not exceed $100,000 plus any unused limit carry-over (as described in Section 422A(c)(4) of the Code prior to amendment by the Tax Reform Act of 1986) to such year. With respect to all incentive stock options granted after December 31, 1986, the aggregate fair market value (determined as of the date the Option is granted) of the Shares for which any Participant may first exercise Options intended to be incentive stock options in any calendar year (under all plans of the Company and its subsidiaries) shall not exceed $100,000. (as amended December 17, 1986) 3.3 No Option intended to be an incentive stock option shall be granted to an employee who, at the time the Option is granted, owns (within the meaning of Section 422A(b)(6) of the Code) stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing such employee or of its parent corporation or subsidiary corporation (as defined in Sections 425(e) and 425(f), respectively, of the Code). 3.4 The Committee may in its discretion grant Options that are not intended to constitute incentive stock options. Such Options may be granted in excess of the limitations provided in this Section or on terms differing from those provided in Section 4.4 hereof. 3.5 Each Option shall be evidenced by a written instrument, in such form as the Committee shall from time to time approve, which shall state the terms and conditions of the Option in accordance with the Plan and also shall contain such additional provisions as may be necessary or appropriate under applicable laws, regulations and rules. ARTICLE IV. Terms of Options 4.1 At the time of granting the Option the Committee shall establish an Option exercise price per Share not less than 100 percent of the fair market value of a Share on the date the Option is granted. 4.2 Options shall not be transferable otherwise than by will or the laws of descent and distribution. No Option shall be subject, in whole or in part, to attachment, execution or levy of any kind. 4.3 A Participant may exercise an Option, subject to the terms of this Plan and applicable rules and regulations of the Committee, only after such Participant has completed one year of full time employment immediately following the date of the grant of such Option. 4.4 Any Option granted before January 1, 1987, intended to be an incentive stock option may not be exercised in whole or in part while there is outstanding any incentive stock option which was granted before the granting of such Option to such Participant to purchase stock in his or her employer corporation or in a corporation which at the time of grant of such Option is a parent corporation or subsidiary corporation (as defined in Section 425(e) and 425(f) respectively, of the Code prior to amendment by the Tax Reform Act of 1986) of the employer corporation or in a predecessor of any such corporations. For this purpose, an incentive stock option shall be treated as outstanding until it is exercised in full or expires by reason of lapse of time. (as amended December 17, 1986) 4.5 The expiration date of each Option shall be no more than ten years after the date of grant. 4.6 All Options shall be exercisable during a Participant's lifetime only by such Participant. 4.7 An Option may, in the discretion of the Committee, provide that upon the exercise of the Option the Participant shall receive, in addition to the Shares purchased upon exercise of the Option, an amount equal to the excess of the then fair market value of the Shares purchasable on exercise of the Option over the exercise price of the Option provided that such amount receivable shall not exceed the exercise price of the Option. Such additional amount shall be delivered to the Participant in cash, in Shares (valued at their then fair market value) or in a combination of cash and Shares as the Committee in its sole discretion shall determine. 4.8 No Participant shall have any rights to dividends or other rights of a stockholder with respect to Shares subject to an Option prior to the purchase of such Shares upon the exercise of the Option. 4.9 An Option may, in the discretion of the Committee, provide that in the event of a Change in Control, such Option shall automatically become fully exercisable, notwithstanding any other provisions of the Plan to the contrary. (as amended January 31, 1990) ARTICLE V. Exercise Rights Upon Termination of Employment 5.1 If a Participant retires, the Participant's Option shall terminate three years after the date of such retirement, but in no event later than the date on which it would have expired if the Participant had not retired; provided, however, that if the Option is exercised later than three months after the date of retirement, it shall not constitute an incentive stock option. After the date of retirement, the Participant may exercise the Option, in whole or in part, notwithstanding the limitations of Section 4.3 hereof. 5.2 If a Participant becomes disabled, the Participant may exercise the Option (i) within one year after the date of disability, but in no event later than the date on which it would have expired if the Participant had not become disabled, or (ii) within such other period, not exceeding three years after the date of disability as shall be prescribed in the Option instrument; provided, however, that if the Option is exercised later than one year after the date of disability it shall not constitute an incentive stock option. During any such period the Participant may exercise the Option in whole or in part, notwithstanding the limitations of Section 4.3 hereof. For this purpose, a Participant shall be deemed to be disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for continuous period of not less than 12 months. 5.3 If a Participant dies during a period in which he or she is entitled to exercise an Option (including the periods referred to in Sections 5.1, 5.2 and 5.4 hereof), the Participant's Option shall terminate three years after the date of death, but in no event later than the date on which it would have expired if the Participant had lived. During such period, the Option may be exercised by the Participant's executor or administrator or by any person or persons who shall have acquired the Option directly from the Participant by bequest or inheritance. The Option may be exercised in whole or in part notwithstanding the limitations of Section 4.3 hereof. 5.4 If a Participant ceases to be employed by the Company or a Subsidiary Corporation for any reason other than retirement, disability or death, the Participant's Option shall terminate three months after the date of such cessation of employment, but in no event later than the date on which it would have expired if such cessation of employment had not occurred. During such period the Option may be exercised only to the extent that the Participant was entitled to do so under Section 4.3 hereof at the date of cessation of employment unless the Committee, in its sole discretion, permits exercise of the Option to a greater extent. The employment of a Participant shall not be deemed to have ceased upon his or her absence from the Company or a Subsidiary Corporation on a leave of absence granted in accordance with the usual procedures of the Company or such Subsidiary Corporation. ARTICLE VI. Delivery of Shares 6.1 No Shares will be delivered upon exercise of an Option until the exercise price of the Option is paid (i) in full in cash, (ii) by the delivery to the Company of Shares with fair market value equal to the exercise price of the Option, or (iii) partly in cash and partly in Shares valued at their fair market value provided, however, that Shares received upon exercise of an Option under this Plan may be delivered in payment of the exercise price only after they have been held by the Participant for one year subsequent to such prior exercise. The Committee will establish procedures implementing the holding period requirement. Fair market value shall be determined as of the close of the business day immediately preceding the date on which the Option is exercised, in the manner described in Section 1.4 hereof. If required by the Committee, no Shares will be delivered upon the exercise of the Option unless a Participant has given the Company a satisfactory written statement that the Shares are being acquired for the Participant's account and not with a view to the distribution of the Shares. 6.2 Share certificates issued to Participants upon exercise of Options may, at the sole discretion of the Committee, bear language limiting their transfer otherwise than in accordance with the Plan and applicable state and federal law. ARTICLE VII. Continuation of Employment 7.1 Neither this Plan nor the grant of any Option hereunder shall confer upon any Participant the right to continue in the employ of the Company or any Subsidiary Corporation or limit in any respect the right of the Company or any Subsidiary Corporation to terminate his employment at any time. ARTICLE VIII. Reorganization of the Company 8.1 In the event the Company is succeeded by another corporation in a reorganization, which term includes a merger, consolidation, acquisition of all or substantially all of the assets or common stock of the Company, separation or liquidation, the Participant shall, at the same cost, be entitled upon the exercise of an Option, to receive (subject to any required action by stockholders) such securities of the surviving or resulting corporation and such additional amount as provided in Section 4.7 hereof as the board of directors of such corporation shall determine to be equivalent, as nearly as practicable, to the nearest whole number and class of shares of stock or other securities and related additional amount determined under Section 4.7 to which the Participant would have been entitled under the terms of the agreement of reorganization, (without adjustment for any fractional interest thereby eliminated), as if, immediately prior to such event, the Participant had been the holder of record of the number of Shares which were then subject to such Option. Such shares of stock or other securities shall, after such reorganization be deemed to be Shares for all purposes of the Plan including the right to an additional amount as provided in Section 4.7 of the Plan. ARTICLE IX. Administration 9.1 The Plan shall be administered by a Committee, consisting of not less than three directors, appointed by the Board to serve at the pleasure of the Board. No member of the Committee shall be eligible to receive Options hereunder while serving thereon. 9.2 The Committee shall be empowered, subject to the provisions of the Plan and to any other directives issued by the Board, to prescribe, amend and rescind rules and regulations of general application relating to the operation of the Plan and to make all other determinations necessary or desirable for its proper administration. Decisions of the Committee shall be final, conclusive and binding upon all parties, including the Company, the stockholders and the Eligible Employees. 9.3 Neither the Company, any Subsidiary Corporation, nor any director or officer thereof, nor the Committee nor any member of the Committee shall be liable for any act, omission, interpretation, construction or determination made in connection with the Plan in good faith. The Committee and each of its members shall be entitled to indemnification and reimbursement by the Company in respect of any claim, loss, damage or expense (including counsel fees) arising therefrom to the full extent permitted by law and under any directors and officers liability insurance coverage which may be in effect from time to time. ARTICLE X. Disposition of Shares 10.1 Each Participant, by accepting an incentive stock option hereunder prior to February 28, 1987, agrees that, before disposing of any Shares acquired pursuant to such Option, he will tender such Shares to the Company. The Company shall have the right, within five (5) days following the receipt of tender of such Shares, to purchase such Shares at a price equal to the fair market value of such Shares, on the date of such tender. If the Company does not accept the offer to purchase the Shares so tendered within the five (5) day period such Shares shall thereafter be free of all restrictions affecting their disposition under this Article X. (as amended February 28, 1987) 10.2 The instruments evidencing Options intended to be incentive stock options shall provide that if, within two years from the date of grant of the Option or within one year after the transfer of Shares of Common Stock to the Participant on exercise of the Option, the Participant makes a disposition (as defined in Section 425(c) of the Code) of any such Shares, the Participant shall notify the Secretary of the Company within 10 days after such disposition. The Committee may direct that a legend restricting transfer in the absence of appropriate notification be affixed to any stock certificates representing Shares transferred under the Plan. ARTICLE XI. Amendment and Discontinuance 11.1 The Board is authorized to make such changes in the Plan as shall be necessary to bring it into conformity with any regulations of any governmental body having jurisdiction; and may otherwise alter the Plan subject, however, to the prior approval of the stockholders of the Company if such alteration would: (a) materially increase benefits to Participants, (b) materially increase the number of Shares issuable under the Plan, or (c) materially modify the requirements as to eligibility for participation in the Plan. The Board may at any time suspend or discontinue the Plan. No action of the Board or of the stockholders, however, shall alter or impair any Option theretofore granted under the Plan except as herein provided. ARTICLE XII. Miscellaneous 12.1 It is expressly understood that this Plan grants powers to the Committee but does not require their exercise; nor shall any person, by reason of the adoption of this Plan, be deemed to be entitled to the grant of any Option; nor shall any rights be deemed to accrue under the Plan except as Options may actually be granted hereunder. 12.2 The adoption of this Plan shall not preclude the Board from granting options to purchase Shares to any person in connection with his employment by the Company or by a Subsidiary Corporation without reference to, and outside of, this Plan. 12.3 All expenses of the Plan, including the cost of maintaining records, shall be borne by the Company. 12.4 The Company and any Subsidiary Corporation shall have the right to deduct from all cash payments any federal, state, or local taxes required by law to be withheld with respect to such cash payments. 12.5 The Plan shall be construed in accordance with and be governed by the laws of the Commonwealth of Pennsylvania. ARTICLE XIII. Plan Adoption and Term 13.1 This Plan shall become effective upon its adoption by the Board, and Options may thereafter be granted, provided, however, that the Plan shall be submitted to the Company's stockholders for their approval at the next following Annual Meeting of Stockholders. If the Plan is not approved by the affirmative vote of the holders of at least a majority of the Shares entitled to vote at the meeting, then the Plan and all Options then outstanding shall immediately automatically terminate and be of no force or effect. 13.2 Subject to the provisions of the Plan relating to amendment or discontinuance, this Plan shall continue in effect until February 26, 1998. No Option may be granted hereunder after such date, but Options granted before such date may extend beyond the termination date of the Plan. (as amended April 28, 1993) Executed this _____ day of _______________, 1993. ______________________________ Secretary to the Board of Lukens Inc. Section 2.1 of the Lukens Inc. 1985 Stock Option and Appreciation Plan is amended to read as follows: "The aggregate number of Shares which may be delivered upon exercise of Options granted under the Plan (including Shares delivered under Section 4.7 hereof) shall not exceed 1,837,500, subject to appropriate adjustment in the event the number of issued Shares shall be increased or reduced by a change in par value, combination, split-up, merger, reclassification, distribution of a dividend payable in stock, or the like. Shares covered by Options which have lapsed or expired may again be optioned pursuant to the Plan." Section 13.2 of the Lukens Inc. 1985 Stock Option and Appreciation Plan is amended to read as follows: "Subject to the provisions of the Plan relating to amendment or discontinuance, this Plan shall continue in effect until February 26, 1998. No Option may be granted hereunder after such date, but Options granted before such date may extend beyond the termination date of the Plan." EXHIBIT 10.5 LUKENS INC. STOCK OPTION PLAN FOR NON-EMPLOYEE DIRECTORS The purpose of the Lukens Inc. Stock Option Plan for Non-Employee Directors (the "Plan") is to furnish an incentive to non-employee directors of the Company by making available to them a larger common stock ownership in the Company, to induce the continued service of such directors, and to stimulate their efforts for the continued success of the Company. Options granted under the Plan are non-qualified stock options (i.e., options that do not qualify as "incentive stock options" under Section 422 of the Internal Revenue Code of 1986, as amended (the "Code")). ARTICLE I. Definitions 1.1 As used in this Plan, the following definitions apply to the terms indicated below: (a) "Board" means the Board of Directors of Lukens Inc. (b) "Change in Control" means any of the following events: (i) Any "person" or "group" (as such terms are used in Sections 3(a)(9), 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended), considered together with its or their "affiliates" and "associates" (as such terms are defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), is or becomes the beneficial owner (as defined in Rule 13d-3 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), or acquires or holds voting control, directly or indirectly, of securities of the Company which, when considered together with any other securities which by their terms are convertible, even if not then convertible, represent twenty percent (20%) or more of the voting power of the then outstanding securities of the Company; or (ii) A change in the composition of a majority of the Board within 24 months after any "person" or "group" (as such terms are used in Sections 3(a)(9), 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended), considered together with its or their "affiliates" or "associates" (as such terms are defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), is or becomes the beneficial owner (as defined in Rule 13d-3 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended) or acquires or holds voting control, directly or indirectly, of securities of the Company which, when considered together with any other securities held by such person or group or their affiliates or associates which by their terms are convertible, even if not then convertible, represent twenty percent (20%) of the voting power of the then outstanding securities of the Company; or (iii) Any "person" or "group" (as such terms are used in Section 3(a)(9), 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended) commences a tender offer or exchange offer for securities of the Company if, upon consummation thereof, the offeror, considered together with its "affiliates" and "associates" (as such terms are defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended), would own or control, directly or indirectly, securities of the Company which, when considered together with any other securities held by such person or group or their affiliates or associates which by their terms are convertible, even if not then convertible, represent thirty percent (30%) or more of the voting power of the then outstanding securities of the Company. The terms "person and "group", as used in this Section (b), shall not include (i) the Company; (ii) any corporation in which the Company owns, directly or indirectly, voting securities sufficient to elect at least a majority of the directors of such corporation; (iii) any employee benefit plan of the Company or of any corporation described in clause (ii) above; (iv) any individual or entity organized, appointed or established by the Company for, or pursuant to the terms of any employee benefit plan described in clause (iii) above; and (v) a Participant. (c) "Committee" means the Committee on the Board. (d) "Company" means Lukens Inc. (e) "Eligible Director" means any member of the Board who, on the date of the granting of an Option hereunder, is not an officer or an employee of the Company or of any Subsidiary Corporation. (f) "Option" means a right to purchase Shares granted pursuant to the Plan and evidenced by an option certificate in such form as the Committee may adopt for general use from time to time. (g) "Participant" means an Eligible Director to whom an Option is granted pursuant to this Plan. (h) "Plan" means the Lukens Inc. Stock Option Plan for Non-Employee Directors. (i) "Shares" mean shares of the Company's common stock, par value $.01. (j) "Subsidiary Corporation" means any corporation, as defined in Section 424(f) of the Code, now or hereafter existing in which the Company owns, directly or indirectly, in an unbroken chain of corporations, stock possessing 50% or more of the total combined voting power of all classes of stock of such corporation. 1.2 An Option shall be deemed "granted" under this Plan on the date of the Company's annual meeting of stockholders. 1.3 As used herein, the masculine includes the feminine and the plural includes the singular. 1.4 For purposes of the Plan, the fair market value of the Shares on a valuation date shall be the mean between the highest and lowest prices at which the Company's stock was sold on the New York Stock Exchange on such date, or if no sale takes place, then the mean between the bid and asked prices on such date; if no bid and asked prices are quoted for such date then such value as shall be determined by such method as the Committee shall deem to reflect fair market value as of such date. ARTICLE II. Shares Subject to the Plan 2.1 The aggregate number of Shares which may be delivered upon exercise of Options granted under the Plan shall not exceed __________, subject to appropriate adjustment in the event the number of issued Shares shall be increased or reduced by a change in par value, combination, split-up, merger, reclassification, distribution of a dividend payable in stock, or the like. Shares covered by Options which have lapsed or expired may again be optioned pursuant to the Plan. ARTICLE III. Grants of Options 3.1 Immediately following the Company's annual meeting of stockholders in each year during the term of this Plan, each Eligible Director who was elected a director at such annual meeting of stockholders, or who continued as a director, shall automatically be granted an Option to purchase 1,000 Shares (subject to appropriate adjustment in the event the number of issued Shares shall be increased or reduced by a change in par value, combination, split-up, merger, reclassification, distribution of a dividend payable in stock, or the like). An individual who ceases to be a director of the Company at the annual meeting of stockholders shall not be entitled to receive an Option. 3.2 Each Option shall be evidenced by a written instrument, in such form as the Committee shall from time to time approve, which shall state the terms and conditions of the Option in accordance with the Plan and also shall contain such additional provisions as may be necessary or appropriate under applicable laws, regulations and rules. ARTICLE IV. Terms of Options 4.1 The Option exercise price per Share shall be 100 percent of the fair market value of a Share on the date the Option is granted. 4.2 Options shall not be transferable otherwise than by will or the laws of descent and distribution. No Option shall be subject, in whole or in part, to attachment, execution or levy of any kind. 4.3 A Participant may exercise an Option, subject to the terms of this Plan and applicable rules and regulations of the Committee, beginning one year after the date of the grant of such Option. 4.4 Options shall expire ten years after the date of grant. 4.5 All Options shall be exercisable during a Participant's lifetime only by such Participant. 4.6 No Participant shall have any rights to dividends or other rights of a stockholder with respect to Shares subject to an Option prior to the purchase of such Shares upon the exercise of the Option. 4.7 Options shall, in the event of a Change in Control, automatically become fully exercisable, notwithstanding any other provisions of the Plan to the contrary. ARTICLE V. Exercise Rights Upon Termination of Service 5.1 If a Participant ceases to be a director of the Company for any reason, the Participant's Option shall terminate three years after the date on which he or she ceased to be a director, but in no event later than the date on which it would have expired if the Participant had continued to be a director. During such period, the Participant may exercise the Option, in whole or in part, notwithstanding the limitations of Section 4.3 hereof. 5.2 If a Participant dies during a period in which he or she is entitled to exercise an Option (including the period referred to in Section 5.1 hereof), the Participant's Option shall terminate three years after the date of death, but in no event later than the date on which it would have expired if the Participant had lived, by the Participant's executor or administrator or by any person or persons who shall have acquired the Option directly from the Participant by bequest or inheritance. The Option may be exercised, in whole or in part, notwithstanding the limitations of Section 4.3 hereof. ARTICLE VI. Delivery of Shares 6.1 No Shares will be delivered upon exercise of an Option until the exercise price of the Option is paid (i) in full in cash, (ii) by the delivery to the Company of Shares with fair market value equal to the exercise price of the Option, or (iii) partly in cash and partly in Shares valued at their fair market value, provided, however, that Shares received upon exercise of an Option under this Plan may be delivered in payment of the exercise price only after they have been held by the Participant for one year subsequent to such prior exercise. The Committee will establish procedures implementing the holding period requirement. Fair market value of any Shares so delivered shall be determined as of the close of the business day immediately preceding the date on which the Option is exercised, in the manner described in Section 1.4 hereof. If required by the Committee, no Shares will be delivered upon the exercise of the Option unless a Participant has given the Company a satisfactory written statement that the Shares are being acquired for the Participant's account and not with a view to the distribution of the Shares. The Company will not be obligated to issue and sell Shares upon exercise of an Option if, in the opinion of its counsel, such issuance and sale would violate any applicable federal or state securities laws. 6.2 Share certificates issued to Participants upon exercise of Options may, at the sole discretion of the Committee, bear language limiting their transfer otherwise than in accordance with the Plan and applicable state and federal law. ARTICLE VII. Continuation of Service 7.1 Neither this Plan nor the grant of any Option hereunder shall confer upon any Participant the right to continue as a director of the Company or obligate the Company to nominate any Participant for election as a director at any time. ARTICLE VIII. Reorganization of the Company 8.1 In the event the Company is succeeded by another corporation in a reorganization, which term includes a merger, consolidation, acquisition of all or substantially all of the assets or common stock of the Company, separation or liquidation, the Participant shall, at the same cost, be entitled upon the exercise of an Option, to receive (subject to any required action by stockholders) such securities of the surviving or resulting corporation as the board of directors of such corporation shall determine to be equivalent, as nearly as practicable, to the nearest whole number and class of shares of stock or other securities to which the Participant would have been entitled under the terms of the agreement of reorganization (without adjustment for any fractional interest thereby eliminated) as if, immediately prior to such event, the Participant had been the holder of record of the number of Shares which were then subject to such Option. Such shares of stock or other securities shall, after such reorganization, be deemed to be Shares for all purposes of the Plan. ARTICLE IX. Administration 9.1 The Plan shall be administered by the Committee. The Committee shall be empowered, subject to the provisions of the Plan and to any other directives issued by the Board, to prescribe, amend and rescind rules and regulations of general application relating to the operation of the Plan and to make all other determinations necessary or desirable for its proper administration. Decisions of the Committee shall be final, conclusive and binding upon all parties, including the Company, the stockholders and the Eligible Directors. 9.2 Neither the Company, any Subsidiary Corporation, nor any director or officer thereof, nor the Committee nor any member of the Committee shall be liable for any act, omission, interpretation, construction or determination made in connection with the Plan in good faith. The Committee and each of its members shall be entitled to indemnification and reimbursement by the Company in respect of any claim, loss, damage or expense (including counsel fees) arising therefrom to the full extent permitted by law and under any directors and officers liability insurance coverage which may be in effect from time to time. ARTICLE X. Amendment and Discontinuance 10.1 The Board is authorized to make such changes in the Plan as shall be necessary to bring it into conformity with any regulations of any governmental body having jurisdiction; and may otherwise alter the Plan, subject, however, to the prior approval of the stockholders of the Company if such alteration would: (a) materially increase benefits to Participants, (b) materially increase the number of Shares issuable under the Plan, or (c) materially modify the requirements as to eligibility for participation in the Plan. Notwithstanding the foregoing, the Plan shall not be amended more than once every six months, other than to comport with changes in the Code, the Employee Retirement Income Security Act, or the rules thereunder. The Board may at any time suspend or discontinue the Plan. No action of the Board or of the stockholders, however, shall alter or impair any Option theretofore granted under the Plan except as herein provided. ARTICLE XI. Miscellaneous 11.1 It is expressly understood that this Plan grants powers to the Committee but does not require their exercise; nor shall any person, by reason of the adoption of this Plan, be deemed to be entitled to the grant of any Option; nor shall any rights be deemed to accrue under the Plan except as Options may actually be granted hereunder. 11.2 The adoption of this Plan shall not preclude the Board from granting options to purchase Shares to any person in connection with his or her service on the Board without reference to, and outside of, this Plan. 11.3 All expenses of the Plan, including the cost of maintaining records, shall be borne by the Company. 11.4 The Plan shall be construed in accordance with and be governed by the laws of the State of Delaware. ARTICLE XII. Plan Adoption and Term 12.1 This Plan shall become effective upon the later to occur of (i) its adoption by the Board and (ii) its approval by the Company's stockholders at an Annual Meeting of Stockholders. 12.2 Subject to the provisions of the Plan relating to amendment or discontinuance, this Plan shall continue in effect for ten years from the date of its approval by the Company's stockholders. No Option may be granted hereunder after such ten- year period, but Options granted within such ten-year period may extend beyond the termination date of the Plan. Executed this ____ day of __________, 1993. ______________________________ Secretary to the Board of Lukens Inc. EXHIBIT 10.30 Michael O. Alexander Director INDEMNIFICATION AGREEMENT AGREEMENT, effective as of January 27, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and Michael O. Alexander (the "Indemnitee"). WHEREAS, it is essential to the Company to retain and attract as directors and executive officers the most capable persons available; WHEREAS, Indemnitee is a director or executive officer of the Company; WHEREAS, both the Company and Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and executive officers of public companies in today's environment; WHEREAS, the Amended and Restated Certificate of Incorporation of the Company (the "Charter") requires the Company to indemnify and advance expenses to its directors and officers to the full extent permitted by law and the Indemnitee has been serving and continues to serve as a director or executive officer of the Company in part in reliance on the Charter; WHEREAS, in recognition of Indemnitee's need for substantial protection against personal liability in order to enhance Indemnitee's continue service to the Company in an effective manner, and Indemnitee's reliance on the Charter, and in part to provide Indemnitee with specific contractual assurance that the protection promised by the Charter will be available to Indemnitee (regardless of, among other things, any amendment to or revocation of the Charter or any change in the composition of the Company's Board of Directors or acquisition transaction relating to the Company), the Company wishes to provide in this Agreement for the indemnification of and the advancing of expenses to Indemnitee to the fullest extent (whether partial or complete) permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained, for the continue coverage of Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises and of Indemnitee continuing to serve the Company directly or, at its request, another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions: (a) Change in Control: Shall be deemed to have occurred if (i) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under said Act), directly or indirectly, of securities of the Company representing 20% or more of the total voting power represented by the Company's then outstanding Voting Securities, or (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of the Company and any new director whose election by the Board of Directors or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof, or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of (in one transaction or a series of transactions) all or substantially all of the Company's assets. (b) Claim: Any threatened, pending or completed action, suit or proceeding, or any inquiry or investigation, whether instituted by the Company or any other party, that Indemnitee in good faith believes might lead to the institution of any such action, suit or proceeding, whether civil, criminal, administrative, investigative or other. (c) Expenses: Include attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing to defend, be a witness in or participate in any Claim relating to any Indemnifiable Event. (d) Indemnifiable Event: Any event or occurrence related to the fact that Indemnitee is or was a director, officer, employee, agent or fiduciary of the Company, or is or was serving at the request of the Company as a director, officer, employee, trustee, agent or fiduciary of another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise, or by reason of anything done or not done by Indemnitee in any such capacity. (3) Independent Legal Counsel: An attorney or firm of attorneys, selected in accordance with the provisions of Section 3, who shall not have otherwise performed services for the Company or Indemnitee within the last five years (other than with respect to matters concerning the rights of Indemnitee under this Agreement, or of other indemnitees under similar indemnity agreements). (f) Potential Change in Control: Shall be deemed to have occurred if (i) the Company enters into an agreement, the consummation of which would result in the occurrence of a Change in Control: (ii) any person (including the Company) publicly announces an intention to take or to consider taking actions which if consummated would constitute a Change in Control; (iii) any person, other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, who is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 9.5% or more of the combined voting power of the Company's then outstanding Voting Securities, increase his beneficial ownership of such securities by five percentage points (5%) or moreover the percentage so owned by such person; or (iv) the Board adopts a resolution to the effect that, for purposes of this Agreement, a Potential Change in Control has occurred. (g) Reviewing Party: Any appropriate person or body consisting of a member or members of the Company's Board of Directors or any other person or body appointed by the Board who is not a party to the particular Claim for which Indemnitee is seeking indemnification, or Independent Legal Counsel. (h) Voting Securities: Any securities of the Company which vote generally in the election of directors. 2. Basic Indemnification Arrangement. (a) In the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Claim by reason of (or arising in part out of) an Indemnifiable Event, the Company shall indemnify Indemnitee to the fullest extent permitted by law as soon as practicable but in any event no later than thirty days after written demand is presented to the Company, against any and all Expenses, judgments, fines, penalties and amounts paid in settlement (including all interest, assessments and other charges paid or payable in connection with or in respect of such Expenses, judgments, fines, penalties or amounts paid in settlement) of such Claim. If so requested by Indemnitee, the Company shall advance (within two business days of such request) any and all Expenses to Indemnitee (an "Expense Advance"). Notwithstanding anything in this Agreement to the contrary, prior to a Change in Control, Indemnitee shall not be entitled to indemnification pursuant to this Agreement in connection with any Claim initiated by Indemnitee unless the Board of Directors has authorized or consented to the initiation of such Claim. (b) Notwithstanding the foregoing, (i) the obligations of the Company under Section 2(a) shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the Independent Legal Counsel referred to in Section 3 hereof is involved) that Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 2(a) shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if Indemnitee has commenced or thereafter commences legal proceedings in a court of competent jurisdiction to secure a determination that determination made by the Reviewing Party that Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or lapsed). If there has not been a Change in Control, the Reviewing Party shall be selected by the Board of Directors, and if there has been such a Change in Control (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control), the Reviewing Party shall be the Independent Legal Counsel referred to in Section 3 hereof. If there has been no determination by the Reviewing Party or if the Reviewing Party determines that Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, Indemnitee shall have the right to commence litigation in any court in the Commonwealth of Pennsylvania or the State of Delaware having subject matter jurisdiction thereof and in which venue is proper seeking an initial determination by the court or challenging any such determination by the Reviewing Party or any aspect thereof, including the legal or factual bases therefor, and the Company hereby consents to service of process and to appear in any such proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the company and Indemnitee. 3. Change in Control. The Company agrees that if there is a Change in Control of the Company (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control) then with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and Expense Advances under the Charter, this Agreement or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events, the Company shall seek legal advice only from Independent Legal Counsel selected by Indemnitee and approved by the Company (which approval shall not be unreasonably withheld). Such counsel, among other things, shall render its written opinion to the Company and Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the Independent Counsel referred to above and to fully indemnify such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or its engagement pursuant hereto. 4. Establishment of Trust. In the event of a Potential Change in Control, the Company shall, upon written request by Indemnitee, create a trust for the benefit of Indemnitee and from time to time upon written request of Indemnitee shall fund such trust in an amount sufficient to satisfy any and all Expenses reasonable anticipated at the time of each such request to be incurred in connection with investigating, preparing for and defending any Claim relating to an Indemnifiable Event, and any and all judgments, fines, penalties and settlement amounts of any and all Claims relating to an Indemnifiable Event from time to time actually paid or claimed, reasonably anticipated or proposed to be paid. The amount or amounts to be deposited in the trust pursuant to the foregoing funding obligation shall be determined by the Reviewing Party, in any case in which the Independent Legal Counsel referred to above is involved. The terms of the trust shall provide that upon a Change in Control (i) the trust shall not be revoked or the principal thereof invaded, without the written consent of the Indemnitee, (ii) the trustee shall advance, within two business days of a request by the Indemnitee, any and all Expenses to the Indemnitee (and the Indemnitee hereby agrees to reimburse the trust under the circumstances under which the Indemnitee would be required to reimburse the Company under Section 2(b) of this Agreement), (iii) the trust shall continue to be funded by the Company in accordance with the funding obligation set forth above, (iv) the trustee shall promptly pay to Indemnitee all amounts for which Indemnitee shall be entitled to indemnification pursuant to this Agreement or otherwise, and (v) all unexpended funds in such trust shall revert to the Company upon a final determination by the Reviewing Party or a court of competent jurisdiction, as the case may be, that Indemnitee has been fully indemnified under the terms of this Agreement. The Trustee shall be chosen by Indemnitee. Nothing in this Section 4 shall relieve the Company of any of its obligations under this Agreement. 5. Indemnification for Additional Expenses. The Company shall indemnify Indemnitee against any and all expenses (including attorneys' fees) and, if requested by Indemnitee, shall (within two business days of such request) advance such expenses to Indemnitee, which are incurred by Indemnitee in connection with any action brought by Indemnitee for (i) indemnification or advance payment of Expenses by the Company under this Agreement, the Charter or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events and/or (ii) recovery under any directors' and officers' liability insurance policies maintained by the Company, regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification, advance expense payment or insurance recovery, as the case may be. 6. Partial Indemnity, Etc. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses, judgments, fines, penalties and amounts paid in settlement of a Claim but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion thereof to which Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that Indemnitee has been successful on the merits or otherwise in defense of any or all Claims relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, Indemnitee shall be indemnified against all Expenses incurred in connection therewith. 7. Burden of Proof. In connection with any determination by the Reviewing Party or otherwise as to whether Indemnitee is entitled to be indemnified hereunder the burden of proof shall be on the Company to establish that Indemnitee is not so entitled. 8. No Presumptions. For purposes of this Agreement, the termination of any claim, action, suit or proceeding, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. In addition, neither the failure of the Reviewing Party to have made a determination as to whether Indemnitee has met any particular standard of conduct or had any particular belief, nor an actual determination by the Reviewing Party that Indemnitee has not met such standard of conduct or did not have such belief, prior to the commencement of legal proceedings by Indemnitee to secure a judicial determination that Indemnitee should b indemnified under applicable law shall be a defense to Indemnitee's claim or create a presumption that Indemnitee has not met any particular standard of conduct or did not have any particular belief. 9. Nonexclusivity, Etc. The rights of the Indemnitee hereunder shall be in addition to any other rights Indemnitee may have under the Charter of the Delaware General Corporation Law or otherwise. To the extent that a change in the Delaware General Corporation Law (whether by statute or judicial decision) permits greater indemnification by agreement than would be afforded currently under the Charter and this Agreement, it is the intent of the parties hereto that Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 10. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any Company director or officer. 11. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or in the right of the Company against Indemnitee, Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, and any claim or cause of action of the Company shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such two-year period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action such shorter period shall govern. 12. Amendments, Etc. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar) nor shall such waiver constitute a continuing waiver. 13. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of Indemnitee, who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 14. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any Claim made against Indemnitee to the extent Indemnitee has otherwise actually received payment (under any insurance policy, the Charter, Company By- law or otherwise) of the amounts otherwise indemnifiable hereunder. 15. Binding Effect, Etc. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, executors and personal and legal representatives. This Agreement shall continue in effect regardless of whether Indemnitee continues to serve as an executive officer or director of the Company or of any other enterprise at the Company's request. 16. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable in any respect, and the validity and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired and shall remain enforceable to the fullest extent permitted by law. 17. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such state without giving effect to the principles of conflicts of laws. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date above written. ATTEST: LUKENS INC. _______________________ By:___________________________ Secretary R. W. Van Sant Chairman & CEO IDEMNITEE: ___________________________ Michael O. Alexander EXHIBIT 10.32 T. Grant John Vice President - Planning/Stainless INDEMNIFICATION AGREEMENT AGREEMENT, effective as of February 1, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and T. Grant John (the "Indemnitee"). WHEREAS, it is essential to the Company to retain and attract as directors and executive officers the most capable persons available; WHEREAS, Indemnitee is a director or executive officer of the Company; WHEREAS, both the Company and Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and executive officers of public companies in today's environment; WHEREAS, the Amended and Restated Certificate of Incorporation of the Company (the "Charter") requires the Company to indemnify and advance expenses to its directors and officers to the full extent permitted by law and the Indemnitee has been serving and continues to serve as a director or executive officer of the Company in part in reliance on the Charter; WHEREAS, in recognition of Indemnitee's need for substantial protection against personal liability in order to enhance Indemnitee's continue service to the Company in an effective manner, and Indemnitee's reliance on the Charter, and in part to provide Indemnitee with specific contractual assurance that the protection promised by the Charter will be available to Indemnitee (regardless of, among other things, any amendment to or revocation of the Charter or any change in the composition of the Company's Board of Directors or acquisition transaction relating to the Company), the Company wishes to provide in this Agreement for the indemnification of and the advancing of expenses to Indemnitee to the fullest extent (whether partial or complete) permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained, for the continue coverage of Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises and of Indemnitee continuing to serve the Company directly or, at its request, another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions: (a) Change in Control: Shall be deemed to have occurred if (i) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under said Act), directly or indirectly, of securities of the Company representing 20% or more of the total voting power represented by the Company's then outstanding Voting Securities, or (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of the Company and any new director whose election by the Board of Directors or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof, or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of (in one transaction or a series of transactions) all or substantially all of the Company's assets. (b) Claim: Any threatened, pending or completed action, suit or proceeding, or any inquiry or investigation, whether instituted by the Company or any other party, that Indemnitee in good faith believes might lead to the institution of any such action, suit or proceeding, whether civil, criminal, administrative, investigative or other. (c) Expenses: Include attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing to defend, be a witness in or participate in any Claim relating to any Indemnifiable Event. (d) Indemnifiable Event: Any event or occurrence related to the fact that Indemnitee is or was a director, officer, employee, agent or fiduciary of the Company, or is or was serving at the request of the Company as a director, officer, employee, trustee, agent or fiduciary of another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise, or by reason of anything done or not done by Indemnitee in any such capacity. (3) Independent Legal Counsel: An attorney or firm of attorneys, selected in accordance with the provisions of Section 3, who shall not have otherwise performed services for the Company or Indemnitee within the last five years (other than with respect to matters concerning the rights of Indemnitee under this Agreement, or of other indemnitees under similar indemnity agreements). (f) Potential Change in Control: Shall be deemed to have occurred if (i) the Company enters into an agreement, the consummation of which would result in the occurrence of a Change in Control: (ii) any person (including the Company) publicly announces an intention to take or to consider taking actions which if consummated would constitute a Change in Control; (iii) any person, other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, who is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 9.5% or more of the combined voting power of the Company's then outstanding Voting Securities, increase his beneficial ownership of such securities by five percentage points (5%) or moreover the percentage so owned by such person; or (iv) the Board adopts a resolution to the effect that, for purposes of this Agreement, a Potential Change in Control has occurred. (g) Reviewing Party: Any appropriate person or body consisting of a member or members of the Company's Board of Directors or any other person or body appointed by the Board who is not a party to the particular Claim for which Indemnitee is seeking indemnification, or Independent Legal Counsel. (h) Voting Securities: Any securities of the Company which vote generally in the election of directors. 2. Basic Indemnification Arrangement. (a) In the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Claim by reason of (or arising in part out of) an Indemnifiable Event, the Company shall indemnify Indemnitee to the fullest extent permitted by law as soon as practicable but in any event no later than thirty days after written demand is presented to the Company, against any and all Expenses, judgments, fines, penalties and amounts paid in settlement (including all interest, assessments and other charges paid or payable in connection with or in respect of such Expenses, judgments, fines, penalties or amounts paid in settlement) of such Claim. If so requested by Indemnitee, the Company shall advance (within two business days of such request) any and all Expenses to Indemnitee (an "Expense Advance"). Notwithstanding anything in this Agreement to the contrary, prior to a Change in Control, Indemnitee shall not be entitled to indemnification pursuant to this Agreement in connection with any Claim initiated by Indemnitee unless the Board of Directors has authorized or consented to the initiation of such Claim. (b) Notwithstanding the foregoing, (i) the obligations of the Company under Section 2(a) shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the Independent Legal Counsel referred to in Section 3 hereof is involved) that Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 2(a) shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if Indemnitee has commenced or thereafter commences legal proceedings in a court of competent jurisdiction to secure a determination that determination made by the Reviewing Party that Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or lapsed). If there has not been a Change in Control, the Reviewing Party shall be selected by the Board of Directors, and if there has been such a Change in Control (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control), the Reviewing Party shall be the Independent Legal Counsel referred to in Section 3 hereof. If there has been no determination by the Reviewing Party or if the Reviewing Party determines that Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, Indemnitee shall have the right to commence litigation in any court in the Commonwealth of Pennsylvania or the State of Delaware having subject matter jurisdiction thereof and in which venue is proper seeking an initial determination by the court or challenging any such determination by the Reviewing Party or any aspect thereof, including the legal or factual bases therefor, and the Company hereby consents to service of process and to appear in any such proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the company and Indemnitee. 3. Change in Control. The Company agrees that if there is a Change in Control of the Company (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control) then with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and Expense Advances under the Charter, this Agreement or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events, the Company shall seek legal advice only from Independent Legal Counsel selected by Indemnitee and approved by the Company (which approval shall not be unreasonably withheld). Such counsel, among other things, shall render its written opinion to the Company and Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the Independent Counsel referred to above and to fully indemnify such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or its engagement pursuant hereto. 4. Establishment of Trust. In the event of a Potential Change in Control, the Company shall, upon written request by Indemnitee, create a trust for the benefit of Indemnitee and from time to time upon written request of Indemnitee shall fund such trust in an amount sufficient to satisfy any and all Expenses reasonable anticipated at the time of each such request to be incurred in connection with investigating, preparing for and defending any Claim relating to an Indemnifiable Event, and any and all judgments, fines, penalties and settlement amounts of any and all Claims relating to an Indemnifiable Event from time to time actually paid or claimed, reasonably anticipated or proposed to be paid. The amount or amounts to be deposited in the trust pursuant to the foregoing funding obligation shall be determined by the Reviewing Party, in any case in which the Independent Legal Counsel referred to above is involved. The terms of the trust shall provide that upon a Change in Control (i) the trust shall not be revoked or the principal thereof invaded, without the written consent of the Indemnitee, (ii) the trustee shall advance, within two business days of a request by the Indemnitee, any and all Expenses to the Indemnitee (and the Indemnitee hereby agrees to reimburse the trust under the circumstances under which the Indemnitee would be required to reimburse the Company under Section 2(b) of this Agreement), (iii) the trust shall continue to be funded by the Company in accordance with the funding obligation set forth above, (iv) the trustee shall promptly pay to Indemnitee all amounts for which Indemnitee shall be entitled to indemnification pursuant to this Agreement or otherwise, and (v) all unexpended funds in such trust shall revert to the Company upon a final determination by the Reviewing Party or a court of competent jurisdiction, as the case may be, that Indemnitee has been fully indemnified under the terms of this Agreement. The Trustee shall be chosen by Indemnitee. Nothing in this Section 4 shall relieve the Company of any of its obligations under this Agreement. 5. Indemnification for Additional Expenses. The Company shall indemnify Indemnitee against any and all expenses (including attorneys' fees) and, if requested by Indemnitee, shall (within two business days of such request) advance such expenses to Indemnitee, which are incurred by Indemnitee in connection with any action brought by Indemnitee for (i) indemnification or advance payment of Expenses by the Company under this Agreement, the Charter or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events and/or (ii) recovery under any directors' and officers' liability insurance policies maintained by the Company, regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification, advance expense payment or insurance recovery, as the case may be. 6. Partial Indemnity, Etc. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses, judgments, fines, penalties and amounts paid in settlement of a Claim but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion thereof to which Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that Indemnitee has been successful on the merits or otherwise in defense of any or all Claims relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, Indemnitee shall be indemnified against all Expenses incurred in connection therewith. 7. Burden of Proof. In connection with any determination by the Reviewing Party or otherwise as to whether Indemnitee is entitled to be indemnified hereunder the burden of proof shall be on the Company to establish that Indemnitee is not so entitled. 8. No Presumptions. For purposes of this Agreement, the termination of any claim, action, suit or proceeding, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. In addition, neither the failure of the Reviewing Party to have made a determination as to whether Indemnitee has met any particular standard of conduct or had any particular belief, nor an actual determination by the Reviewing Party that Indemnitee has not met such standard of conduct or did not have such belief, prior to the commencement of legal proceedings by Indemnitee to secure a judicial determination that Indemnitee should b indemnified under applicable law shall be a defense to Indemnitee's claim or create a presumption that Indemnitee has not met any particular standard of conduct or did not have any particular belief. 9. Nonexclusivity, Etc. The rights of the Indemnitee hereunder shall be in addition to any other rights Indemnitee may have under the Charter of the Delaware General Corporation Law or otherwise. To the extent that a change in the Delaware General Corporation Law (whether by statute or judicial decision) permits greater indemnification by agreement than would be afforded currently under the Charter and this Agreement, it is the intent of the parties hereto that Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 10. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any Company director or officer. 11. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or in the right of the Company against Indemnitee, Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, and any claim or cause of action of the Company shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such two-year period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action such shorter period shall govern. 12. Amendments, Etc. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar) nor shall such waiver constitute a continuing waiver. 13. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of Indemnitee, who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 14. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any Claim made against Indemnitee to the extent Indemnitee has otherwise actually received payment (under any insurance policy, the Charter, Company By- law or otherwise) of the amounts otherwise indemnifiable hereunder. 15. Binding Effect, Etc. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, executors and personal and legal representatives. This Agreement shall continue in effect regardless of whether Indemnitee continues to serve as an executive officer or director of the Company or of any other enterprise at the Company's request. 16. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable in any respect, and the validity and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired and shall remain enforceable to the fullest extent permitted by law. 17. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such state without giving effect to the principles of conflicts of laws. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date above written. ATTEST: LUKENS INC. _______________________ By:___________________________ Secretary R. W. Van Sant Chairman & CEO IDEMNITEE: ___________________________ T. Grant John EXHIBIT 10.33 T. Grant John Vice President - Planning/Stainless INDEMNIFICATION AGREEMENT AGREEMENT, effective as of February 1, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and T. Grant John (the "Indemnitee"). WHEREAS, it is essential to the Company to retain and attract as directors and executive officers the most capable persons available; WHEREAS, Indemnitee is a director or executive officer of the Company; WHEREAS, both the Company and Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and executive officers of public companies in today's environment; WHEREAS, the Amended and Restated Certificate of Incorporation of the Company (the "Charter") requires the Company to indemnify and advance expenses to its directors and officers to the full extent permitted by law and the Indemnitee has been serving and continues to serve as a director or executive officer of the Company in part in reliance on the Charter; WHEREAS, in recognition of Indemnitee's need for substantial protection against personal liability in order to enhance Indemnitee's continue service to the Company in an effective manner, and Indemnitee's reliance on the Charter, and in part to provide Indemnitee with specific contractual assurance that the protection promised by the Charter will be available to Indemnitee (regardless of, among other things, any amendment to or revocation of the Charter or any change in the composition of the Company's Board of Directors or acquisition transaction relating to the Company), the Company wishes to provide in this Agreement for the indemnification of and the advancing of expenses to Indemnitee to the fullest extent (whether partial or complete) permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained, for the continue coverage of Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises and of Indemnitee continuing to serve the Company directly or, at its request, another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions: (a) Change in Control: Shall be deemed to have occurred if (i) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under said Act), directly or indirectly, of securities of the Company representing 20% or more of the total voting power represented by the Company's then outstanding Voting Securities, or (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of the Company and any new director whose election by the Board of Directors or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof, or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of (in one transaction or a series of transactions) all or substantially all of the Company's assets. (b) Claim: Any threatened, pending or completed action, suit or proceeding, or any inquiry or investigation, whether instituted by the Company or any other party, that Indemnitee in good faith believes might lead to the institution of any such action, suit or proceeding, whether civil, criminal, administrative, investigative or other. (c) Expenses: Include attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing to defend, be a witness in or participate in any Claim relating to any Indemnifiable Event. (d) Indemnifiable Event: Any event or occurrence related to the fact that Indemnitee is or was a director, officer, employee, agent or fiduciary of the Company, or is or was serving at the request of the Company as a director, officer, employee, trustee, agent or fiduciary of another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise, or by reason of anything done or not done by Indemnitee in any such capacity. (3) Independent Legal Counsel: An attorney or firm of attorneys, selected in accordance with the provisions of Section 3, who shall not have otherwise performed services for the Company or Indemnitee within the last five years (other than with respect to matters concerning the rights of Indemnitee under this Agreement, or of other indemnitees under similar indemnity agreements). (f) Potential Change in Control: Shall be deemed to have occurred if (i) the Company enters into an agreement, the consummation of which would result in the occurrence of a Change in Control: (ii) any person (including the Company) publicly announces an intention to take or to consider taking actions which if consummated would constitute a Change in Control; (iii) any person, other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, who is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 9.5% or more of the combined voting power of the Company's then outstanding Voting Securities, increase his beneficial ownership of such securities by five percentage points (5%) or moreover the percentage so owned by such person; or (iv) the Board adopts a resolution to the effect that, for purposes of this Agreement, a Potential Change in Control has occurred. (g) Reviewing Party: Any appropriate person or body consisting of a member or members of the Company's Board of Directors or any other person or body appointed by the Board who is not a party to the particular Claim for which Indemnitee is seeking indemnification, or Independent Legal Counsel. (h) Voting Securities: Any securities of the Company which vote generally in the election of directors. 2. Basic Indemnification Arrangement. (a) In the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Claim by reason of (or arising in part out of) an Indemnifiable Event, the Company shall indemnify Indemnitee to the fullest extent permitted by law as soon as practicable but in any event no later than thirty days after written demand is presented to the Company, against any and all Expenses, judgments, fines, penalties and amounts paid in settlement (including all interest, assessments and other charges paid or payable in connection with or in respect of such Expenses, judgments, fines, penalties or amounts paid in settlement) of such Claim. If so requested by Indemnitee, the Company shall advance (within two business days of such request) any and all Expenses to Indemnitee (an "Expense Advance"). Notwithstanding anything in this Agreement to the contrary, prior to a Change in Control, Indemnitee shall not be entitled to indemnification pursuant to this Agreement in connection with any Claim initiated by Indemnitee unless the Board of Directors has authorized or consented to the initiation of such Claim. (b) Notwithstanding the foregoing, (i) the obligations of the Company under Section 2(a) shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the Independent Legal Counsel referred to in Section 3 hereof is involved) that Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 2(a) shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if Indemnitee has commenced or thereafter commences legal proceedings in a court of competent jurisdiction to secure a determination that determination made by the Reviewing Party that Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or lapsed). If there has not been a Change in Control, the Reviewing Party shall be selected by the Board of Directors, and if there has been such a Change in Control (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control), the Reviewing Party shall be the Independent Legal Counsel referred to in Section 3 hereof. If there has been no determination by the Reviewing Party or if the Reviewing Party determines that Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, Indemnitee shall have the right to commence litigation in any court in the Commonwealth of Pennsylvania or the State of Delaware having subject matter jurisdiction thereof and in which venue is proper seeking an initial determination by the court or challenging any such determination by the Reviewing Party or any aspect thereof, including the legal or factual bases therefor, and the Company hereby consents to service of process and to appear in any such proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the company and Indemnitee. 3. Change in Control. The Company agrees that if there is a Change in Control of the Company (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control) then with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and Expense Advances under the Charter, this Agreement or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events, the Company shall seek legal advice only from Independent Legal Counsel selected by Indemnitee and approved by the Company (which approval shall not be unreasonably withheld). Such counsel, among other things, shall render its written opinion to the Company and Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the Independent Counsel referred to above and to fully indemnify such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or its engagement pursuant hereto. 4. Establishment of Trust. In the event of a Potential Change in Control, the Company shall, upon written request by Indemnitee, create a trust for the benefit of Indemnitee and from time to time upon written request of Indemnitee shall fund such trust in an amount sufficient to satisfy any and all Expenses reasonable anticipated at the time of each such request to be incurred in connection with investigating, preparing for and defending any Claim relating to an Indemnifiable Event, and any and all judgments, fines, penalties and settlement amounts of any and all Claims relating to an Indemnifiable Event from time to time actually paid or claimed, reasonably anticipated or proposed to be paid. The amount or amounts to be deposited in the trust pursuant to the foregoing funding obligation shall be determined by the Reviewing Party, in any case in which the Independent Legal Counsel referred to above is involved. The terms of the trust shall provide that upon a Change in Control (i) the trust shall not be revoked or the principal thereof invaded, without the written consent of the Indemnitee, (ii) the trustee shall advance, within two business days of a request by the Indemnitee, any and all Expenses to the Indemnitee (and the Indemnitee hereby agrees to reimburse the trust under the circumstances under which the Indemnitee would be required to reimburse the Company under Section 2(b) of this Agreement), (iii) the trust shall continue to be funded by the Company in accordance with the funding obligation set forth above, (iv) the trustee shall promptly pay to Indemnitee all amounts for which Indemnitee shall be entitled to indemnification pursuant to this Agreement or otherwise, and (v) all unexpended funds in such trust shall revert to the Company upon a final determination by the Reviewing Party or a court of competent jurisdiction, as the case may be, that Indemnitee has been fully indemnified under the terms of this Agreement. The Trustee shall be chosen by Indemnitee. Nothing in this Section 4 shall relieve the Company of any of its obligations under this Agreement. 5. Indemnification for Additional Expenses. The Company shall indemnify Indemnitee against any and all expenses (including attorneys' fees) and, if requested by Indemnitee, shall (within two business days of such request) advance such expenses to Indemnitee, which are incurred by Indemnitee in connection with any action brought by Indemnitee for (i) indemnification or advance payment of Expenses by the Company under this Agreement, the Charter or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events and/or (ii) recovery under any directors' and officers' liability insurance policies maintained by the Company, regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification, advance expense payment or insurance recovery, as the case may be. 6. Partial Indemnity, Etc. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses, judgments, fines, penalties and amounts paid in settlement of a Claim but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion thereof to which Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that Indemnitee has been successful on the merits or otherwise in defense of any or all Claims relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, Indemnitee shall be indemnified against all Expenses incurred in connection therewith. 7. Burden of Proof. In connection with any determination by the Reviewing Party or otherwise as to whether Indemnitee is entitled to be indemnified hereunder the burden of proof shall be on the Company to establish that Indemnitee is not so entitled. 8. No Presumptions. For purposes of this Agreement, the termination of any claim, action, suit or proceeding, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. In addition, neither the failure of the Reviewing Party to have made a determination as to whether Indemnitee has met any particular standard of conduct or had any particular belief, nor an actual determination by the Reviewing Party that Indemnitee has not met such standard of conduct or did not have such belief, prior to the commencement of legal proceedings by Indemnitee to secure a judicial determination that Indemnitee should b indemnified under applicable law shall be a defense to Indemnitee's claim or create a presumption that Indemnitee has not met any particular standard of conduct or did not have any particular belief. 9. Nonexclusivity, Etc. The rights of the Indemnitee hereunder shall be in addition to any other rights Indemnitee may have under the Charter of the Delaware General Corporation Law or otherwise. To the extent that a change in the Delaware General Corporation Law (whether by statute or judicial decision) permits greater indemnification by agreement than would be afforded currently under the Charter and this Agreement, it is the intent of the parties hereto that Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 10. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any Company director or officer. 11. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or in the right of the Company against Indemnitee, Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, and any claim or cause of action of the Company shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such two-year period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action such shorter period shall govern. 12. Amendments, Etc. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar) nor shall such waiver constitute a continuing waiver. 13. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of Indemnitee, who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 14. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any Claim made against Indemnitee to the extent Indemnitee has otherwise actually received payment (under any insurance policy, the Charter, Company By- law or otherwise) of the amounts otherwise indemnifiable hereunder. 15. Binding Effect, Etc. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, executors and personal and legal representatives. This Agreement shall continue in effect regardless of whether Indemnitee continues to serve as an executive officer or director of the Company or of any other enterprise at the Company's request. 16. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable in any respect, and the validity and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired and shall remain enforceable to the fullest extent permitted by law. 17. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such state without giving effect to the principles of conflicts of laws. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date above written. ATTEST: LUKENS INC. _______________________ By:___________________________ Secretary R. W. Van Sant Chairman & CEO IDEMNITEE: ___________________________ T. Grant John EXHIBIT 10.33 Richard D. Luzzi Vice President - Human Resources INDEMNIFICATION AGREEMENT AGREEMENT, effective as of February 1, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and Richard D. Luzzi (the "Indemnitee"). WHEREAS, it is essential to the Company to retain and attract as directors and executive officers the most capable persons available; WHEREAS, Indemnitee is a director or executive officer of the Company; WHEREAS, both the Company and Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and executive officers of public companies in today's environment; WHEREAS, the Amended and Restated Certificate of Incorporation of the Company (the "Charter") requires the Company to indemnify and advance expenses to its directors and officers to the full extent permitted by law and the Indemnitee has been serving and continues to serve as a director or executive officer of the Company in part in reliance on the Charter; WHEREAS, in recognition of Indemnitee's need for substantial protection against personal liability in order to enhance Indemnitee's continue service to the Company in an effective manner, and Indemnitee's reliance on the Charter, and in part to provide Indemnitee with specific contractual assurance that the protection promised by the Charter will be available to Indemnitee (regardless of, among other things, any amendment to or revocation of the Charter or any change in the composition of the Company's Board of Directors or acquisition transaction relating to the Company), the Company wishes to provide in this Agreement for the indemnification of and the advancing of expenses to Indemnitee to the fullest extent (whether partial or complete) permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained, for the continue coverage of Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises and of Indemnitee continuing to serve the Company directly or, at its request, another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions: (a) Change in Control: Shall be deemed to have occurred if (i) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under said Act), directly or indirectly, of securities of the Company representing 20% or more of the total voting power represented by the Company's then outstanding Voting Securities, or (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of the Company and any new director whose election by the Board of Directors or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof, or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of (in one transaction or a series of transactions) all or substantially all of the Company's assets. (b) Claim: Any threatened, pending or completed action, suit or proceeding, or any inquiry or investigation, whether instituted by the Company or any other party, that Indemnitee in good faith believes might lead to the institution of any such action, suit or proceeding, whether civil, criminal, administrative, investigative or other. (c) Expenses: Include attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing to defend, be a witness in or participate in any Claim relating to any Indemnifiable Event. (d) Indemnifiable Event: Any event or occurrence related to the fact that Indemnitee is or was a director, officer, employee, agent or fiduciary of the Company, or is or was serving at the request of the Company as a director, officer, employee, trustee, agent or fiduciary of another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise, or by reason of anything done or not done by Indemnitee in any such capacity. (3) Independent Legal Counsel: An attorney or firm of attorneys, selected in accordance with the provisions of Section 3, who shall not have otherwise performed services for the Company or Indemnitee within the last five years (other than with respect to matters concerning the rights of Indemnitee under this Agreement, or of other indemnitees under similar indemnity agreements). (f) Potential Change in Control: Shall be deemed to have occurred if (i) the Company enters into an agreement, the consummation of which would result in the occurrence of a Change in Control: (ii) any person (including the Company) publicly announces an intention to take or to consider taking actions which if consummated would constitute a Change in Control; (iii) any person, other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, who is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 9.5% or more of the combined voting power of the Company's then outstanding Voting Securities, increase his beneficial ownership of such securities by five percentage points (5%) or moreover the percentage so owned by such person; or (iv) the Board adopts a resolution to the effect that, for purposes of this Agreement, a Potential Change in Control has occurred. (g) Reviewing Party: Any appropriate person or body consisting of a member or members of the Company's Board of Directors or any other person or body appointed by the Board who is not a party to the particular Claim for which Indemnitee is seeking indemnification, or Independent Legal Counsel. (h) Voting Securities: Any securities of the Company which vote generally in the election of directors. 2. Basic Indemnification Arrangement. (a) In the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Claim by reason of (or arising in part out of) an Indemnifiable Event, the Company shall indemnify Indemnitee to the fullest extent permitted by law as soon as practicable but in any event no later than thirty days after written demand is presented to the Company, against any and all Expenses, judgments, fines, penalties and amounts paid in settlement (including all interest, assessments and other charges paid or payable in connection with or in respect of such Expenses, judgments, fines, penalties or amounts paid in settlement) of such Claim. If so requested by Indemnitee, the Company shall advance (within two business days of such request) any and all Expenses to Indemnitee (an "Expense Advance"). Notwithstanding anything in this Agreement to the contrary, prior to a Change in Control, Indemnitee shall not be entitled to indemnification pursuant to this Agreement in connection with any Claim initiated by Indemnitee unless the Board of Directors has authorized or consented to the initiation of such Claim. (b) Notwithstanding the foregoing, (i) the obligations of the Company under Section 2(a) shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the Independent Legal Counsel referred to in Section 3 hereof is involved) that Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 2(a) shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if Indemnitee has commenced or thereafter commences legal proceedings in a court of competent jurisdiction to secure a determination that determination made by the Reviewing Party that Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or lapsed). If there has not been a Change in Control, the Reviewing Party shall be selected by the Board of Directors, and if there has been such a Change in Control (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control), the Reviewing Party shall be the Independent Legal Counsel referred to in Section 3 hereof. If there has been no determination by the Reviewing Party or if the Reviewing Party determines that Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, Indemnitee shall have the right to commence litigation in any court in the Commonwealth of Pennsylvania or the State of Delaware having subject matter jurisdiction thereof and in which venue is proper seeking an initial determination by the court or challenging any such determination by the Reviewing Party or any aspect thereof, including the legal or factual bases therefor, and the Company hereby consents to service of process and to appear in any such proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the company and Indemnitee. 3. Change in Control. The Company agrees that if there is a Change in Control of the Company (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control) then with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and Expense Advances under the Charter, this Agreement or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events, the Company shall seek legal advice only from Independent Legal Counsel selected by Indemnitee and approved by the Company (which approval shall not be unreasonably withheld). Such counsel, among other things, shall render its written opinion to the Company and Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the Independent Counsel referred to above and to fully indemnify such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or its engagement pursuant hereto. 4. Establishment of Trust. In the event of a Potential Change in Control, the Company shall, upon written request by Indemnitee, create a trust for the benefit of Indemnitee and from time to time upon written request of Indemnitee shall fund such trust in an amount sufficient to satisfy any and all Expenses reasonable anticipated at the time of each such request to be incurred in connection with investigating, preparing for and defending any Claim relating to an Indemnifiable Event, and any and all judgments, fines, penalties and settlement amounts of any and all Claims relating to an Indemnifiable Event from time to time actually paid or claimed, reasonably anticipated or proposed to be paid. The amount or amounts to be deposited in the trust pursuant to the foregoing funding obligation shall be determined by the Reviewing Party, in any case in which the Independent Legal Counsel referred to above is involved. The terms of the trust shall provide that upon a Change in Control (i) the trust shall not be revoked or the principal thereof invaded, without the written consent of the Indemnitee, (ii) the trustee shall advance, within two business days of a request by the Indemnitee, any and all Expenses to the Indemnitee (and the Indemnitee hereby agrees to reimburse the trust under the circumstances under which the Indemnitee would be required to reimburse the Company under Section 2(b) of this Agreement), (iii) the trust shall continue to be funded by the Company in accordance with the funding obligation set forth above, (iv) the trustee shall promptly pay to Indemnitee all amounts for which Indemnitee shall be entitled to indemnification pursuant to this Agreement or otherwise, and (v) all unexpended funds in such trust shall revert to the Company upon a final determination by the Reviewing Party or a court of competent jurisdiction, as the case may be, that Indemnitee has been fully indemnified under the terms of this Agreement. The Trustee shall be chosen by Indemnitee. Nothing in this Section 4 shall relieve the Company of any of its obligations under this Agreement. 5. Indemnification for Additional Expenses. The Company shall indemnify Indemnitee against any and all expenses (including attorneys' fees) and, if requested by Indemnitee, shall (within two business days of such request) advance such expenses to Indemnitee, which are incurred by Indemnitee in connection with any action brought by Indemnitee for (i) indemnification or advance payment of Expenses by the Company under this Agreement, the Charter or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events and/or (ii) recovery under any directors' and officers' liability insurance policies maintained by the Company, regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification, advance expense payment or insurance recovery, as the case may be. 6. Partial Indemnity, Etc. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses, judgments, fines, penalties and amounts paid in settlement of a Claim but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion thereof to which Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that Indemnitee has been successful on the merits or otherwise in defense of any or all Claims relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, Indemnitee shall be indemnified against all Expenses incurred in connection therewith. 7. Burden of Proof. In connection with any determination by the Reviewing Party or otherwise as to whether Indemnitee is entitled to be indemnified hereunder the burden of proof shall be on the Company to establish that Indemnitee is not so entitled. 8. No Presumptions. For purposes of this Agreement, the termination of any claim, action, suit or proceeding, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. In addition, neither the failure of the Reviewing Party to have made a determination as to whether Indemnitee has met any particular standard of conduct or had any particular belief, nor an actual determination by the Reviewing Party that Indemnitee has not met such standard of conduct or did not have such belief, prior to the commencement of legal proceedings by Indemnitee to secure a judicial determination that Indemnitee should b indemnified under applicable law shall be a defense to Indemnitee's claim or create a presumption that Indemnitee has not met any particular standard of conduct or did not have any particular belief. 9. Nonexclusivity, Etc. The rights of the Indemnitee hereunder shall be in addition to any other rights Indemnitee may have under the Charter of the Delaware General Corporation Law or otherwise. To the extent that a change in the Delaware General Corporation Law (whether by statute or judicial decision) permits greater indemnification by agreement than would be afforded currently under the Charter and this Agreement, it is the intent of the parties hereto that Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 10. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any Company director or officer. 11. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or in the right of the Company against Indemnitee, Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, and any claim or cause of action of the Company shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such two-year period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action such shorter period shall govern. 12. Amendments, Etc. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar) nor shall such waiver constitute a continuing waiver. 13. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of Indemnitee, who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 14. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any Claim made against Indemnitee to the extent Indemnitee has otherwise actually received payment (under any insurance policy, the Charter, Company By- law or otherwise) of the amounts otherwise indemnifiable hereunder. 15. Binding Effect, Etc. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, executors and personal and legal representatives. This Agreement shall continue in effect regardless of whether Indemnitee continues to serve as an executive officer or director of the Company or of any other enterprise at the Company's request. 16. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable in any respect, and the validity and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired and shall remain enforceable to the fullest extent permitted by law. 17. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such state without giving effect to the principles of conflicts of laws. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date above written. ATTEST: LUKENS INC. _______________________ By:___________________________ Secretary R. W. Van Sant Chairman & CEO IDEMNITEE: ___________________________ Richard D. Luzzi EXHIBIT 10.34 Frederick J. Smith Vice President - Manufacturing Services INDEMNIFICATION AGREEMENT AGREEMENT, effective as of April 15, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and Frederick J. Smith (the "Indemnitee"). WHEREAS, it is essential to the Company to retain and attract as directors and executive officers the most capable persons available; WHEREAS, Indemnitee is a director or executive officer of the Company; WHEREAS, both the Company and Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and executive officers of public companies in today's environment; WHEREAS, the Amended and Restated Certificate of Incorporation of the Company (the "Charter") requires the Company to indemnify and advance expenses to its directors and officers to the full extent permitted by law and the Indemnitee has been serving and continues to serve as a director or executive officer of the Company in part in reliance on the Charter; WHEREAS, in recognition of Indemnitee's need for substantial protection against personal liability in order to enhance Indemnitee's continue service to the Company in an effective manner, and Indemnitee's reliance on the Charter, and in part to provide Indemnitee with specific contractual assurance that the protection promised by the Charter will be available to Indemnitee (regardless of, among other things, any amendment to or revocation of the Charter or any change in the composition of the Company's Board of Directors or acquisition transaction relating to the Company), the Company wishes to provide in this Agreement for the indemnification of and the advancing of expenses to Indemnitee to the fullest extent (whether partial or complete) permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained, for the continue coverage of Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises and of Indemnitee continuing to serve the Company directly or, at its request, another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions: (a) Change in Control: Shall be deemed to have occurred if (i) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under said Act), directly or indirectly, of securities of the Company representing 20% or more of the total voting power represented by the Company's then outstanding Voting Securities, or (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of the Company and any new director whose election by the Board of Directors or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof, or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of (in one transaction or a series of transactions) all or substantially all of the Company's assets. (b) Claim: Any threatened, pending or completed action, suit or proceeding, or any inquiry or investigation, whether instituted by the Company or any other party, that Indemnitee in good faith believes might lead to the institution of any such action, suit or proceeding, whether civil, criminal, administrative, investigative or other. (c) Expenses: Include attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing to defend, be a witness in or participate in any Claim relating to any Indemnifiable Event. (d) Indemnifiable Event: Any event or occurrence related to the fact that Indemnitee is or was a director, officer, employee, agent or fiduciary of the Company, or is or was serving at the request of the Company as a director, officer, employee, trustee, agent or fiduciary of another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise, or by reason of anything done or not done by Indemnitee in any such capacity. (3) Independent Legal Counsel: An attorney or firm of attorneys, selected in accordance with the provisions of Section 3, who shall not have otherwise performed services for the Company or Indemnitee within the last five years (other than with respect to matters concerning the rights of Indemnitee under this Agreement, or of other indemnitees under similar indemnity agreements). (f) Potential Change in Control: Shall be deemed to have occurred if (i) the Company enters into an agreement, the consummation of which would result in the occurrence of a Change in Control: (ii) any person (including the Company) publicly announces an intention to take or to consider taking actions which if consummated would constitute a Change in Control; (iii) any person, other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, who is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 9.5% or more of the combined voting power of the Company's then outstanding Voting Securities, increase his beneficial ownership of such securities by five percentage points (5%) or moreover the percentage so owned by such person; or (iv) the Board adopts a resolution to the effect that, for purposes of this Agreement, a Potential Change in Control has occurred. (g) Reviewing Party: Any appropriate person or body consisting of a member or members of the Company's Board of Directors or any other person or body appointed by the Board who is not a party to the particular Claim for which Indemnitee is seeking indemnification, or Independent Legal Counsel. (h) Voting Securities: Any securities of the Company which vote generally in the election of directors. 2. Basic Indemnification Arrangement. (a) In the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Claim by reason of (or arising in part out of) an Indemnifiable Event, the Company shall indemnify Indemnitee to the fullest extent permitted by law as soon as practicable but in any event no later than thirty days after written demand is presented to the Company, against any and all Expenses, judgments, fines, penalties and amounts paid in settlement (including all interest, assessments and other charges paid or payable in connection with or in respect of such Expenses, judgments, fines, penalties or amounts paid in settlement) of such Claim. If so requested by Indemnitee, the Company shall advance (within two business days of such request) any and all Expenses to Indemnitee (an "Expense Advance"). Notwithstanding anything in this Agreement to the contrary, prior to a Change in Control, Indemnitee shall not be entitled to indemnification pursuant to this Agreement in connection with any Claim initiated by Indemnitee unless the Board of Directors has authorized or consented to the initiation of such Claim. (b) Notwithstanding the foregoing, (i) the obligations of the Company under Section 2(a) shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the Independent Legal Counsel referred to in Section 3 hereof is involved) that Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 2(a) shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if Indemnitee has commenced or thereafter commences legal proceedings in a court of competent jurisdiction to secure a determination that determination made by the Reviewing Party that Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or lapsed). If there has not been a Change in Control, the Reviewing Party shall be selected by the Board of Directors, and if there has been such a Change in Control (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control), the Reviewing Party shall be the Independent Legal Counsel referred to in Section 3 hereof. If there has been no determination by the Reviewing Party or if the Reviewing Party determines that Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, Indemnitee shall have the right to commence litigation in any court in the Commonwealth of Pennsylvania or the State of Delaware having subject matter jurisdiction thereof and in which venue is proper seeking an initial determination by the court or challenging any such determination by the Reviewing Party or any aspect thereof, including the legal or factual bases therefor, and the Company hereby consents to service of process and to appear in any such proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the company and Indemnitee. 3. Change in Control. The Company agrees that if there is a Change in Control of the Company (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control) then with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and Expense Advances under the Charter, this Agreement or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events, the Company shall seek legal advice only from Independent Legal Counsel selected by Indemnitee and approved by the Company (which approval shall not be unreasonably withheld). Such counsel, among other things, shall render its written opinion to the Company and Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the Independent Counsel referred to above and to fully indemnify such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or its engagement pursuant hereto. 4. Establishment of Trust. In the event of a Potential Change in Control, the Company shall, upon written request by Indemnitee, create a trust for the benefit of Indemnitee and from time to time upon written request of Indemnitee shall fund such trust in an amount sufficient to satisfy any and all Expenses reasonable anticipated at the time of each such request to be incurred in connection with investigating, preparing for and defending any Claim relating to an Indemnifiable Event, and any and all judgments, fines, penalties and settlement amounts of any and all Claims relating to an Indemnifiable Event from time to time actually paid or claimed, reasonably anticipated or proposed to be paid. The amount or amounts to be deposited in the trust pursuant to the foregoing funding obligation shall be determined by the Reviewing Party, in any case in which the Independent Legal Counsel referred to above is involved. The terms of the trust shall provide that upon a Change in Control (i) the trust shall not be revoked or the principal thereof invaded, without the written consent of the Indemnitee, (ii) the trustee shall advance, within two business days of a request by the Indemnitee, any and all Expenses to the Indemnitee (and the Indemnitee hereby agrees to reimburse the trust under the circumstances under which the Indemnitee would be required to reimburse the Company under Section 2(b) of this Agreement), (iii) the trust shall continue to be funded by the Company in accordance with the funding obligation set forth above, (iv) the trustee shall promptly pay to Indemnitee all amounts for which Indemnitee shall be entitled to indemnification pursuant to this Agreement or otherwise, and (v) all unexpended funds in such trust shall revert to the Company upon a final determination by the Reviewing Party or a court of competent jurisdiction, as the case may be, that Indemnitee has been fully indemnified under the terms of this Agreement. The Trustee shall be chosen by Indemnitee. Nothing in this Section 4 shall relieve the Company of any of its obligations under this Agreement. 5. Indemnification for Additional Expenses. The Company shall indemnify Indemnitee against any and all expenses (including attorneys' fees) and, if requested by Indemnitee, shall (within two business days of such request) advance such expenses to Indemnitee, which are incurred by Indemnitee in connection with any action brought by Indemnitee for (i) indemnification or advance payment of Expenses by the Company under this Agreement, the Charter or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events and/or (ii) recovery under any directors' and officers' liability insurance policies maintained by the Company, regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification, advance expense payment or insurance recovery, as the case may be. 6. Partial Indemnity, Etc. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses, judgments, fines, penalties and amounts paid in settlement of a Claim but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion thereof to which Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that Indemnitee has been successful on the merits or otherwise in defense of any or all Claims relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, Indemnitee shall be indemnified against all Expenses incurred in connection therewith. 7. Burden of Proof. In connection with any determination by the Reviewing Party or otherwise as to whether Indemnitee is entitled to be indemnified hereunder the burden of proof shall be on the Company to establish that Indemnitee is not so entitled. 8. No Presumptions. For purposes of this Agreement, the termination of any claim, action, suit or proceeding, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. In addition, neither the failure of the Reviewing Party to have made a determination as to whether Indemnitee has met any particular standard of conduct or had any particular belief, nor an actual determination by the Reviewing Party that Indemnitee has not met such standard of conduct or did not have such belief, prior to the commencement of legal proceedings by Indemnitee to secure a judicial determination that Indemnitee should b indemnified under applicable law shall be a defense to Indemnitee's claim or create a presumption that Indemnitee has not met any particular standard of conduct or did not have any particular belief. 9. Nonexclusivity, Etc. The rights of the Indemnitee hereunder shall be in addition to any other rights Indemnitee may have under the Charter of the Delaware General Corporation Law or otherwise. To the extent that a change in the Delaware General Corporation Law (whether by statute or judicial decision) permits greater indemnification by agreement than would be afforded currently under the Charter and this Agreement, it is the intent of the parties hereto that Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 10. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any Company director or officer. 11. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or in the right of the Company against Indemnitee, Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, and any claim or cause of action of the Company shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such two-year period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action such shorter period shall govern. 12. Amendments, Etc. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar) nor shall such waiver constitute a continuing waiver. 13. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of Indemnitee, who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 14. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any Claim made against Indemnitee to the extent Indemnitee has otherwise actually received payment (under any insurance policy, the Charter, Company By- law or otherwise) of the amounts otherwise indemnifiable hereunder. 15. Binding Effect, Etc. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, executors and personal and legal representatives. This Agreement shall continue in effect regardless of whether Indemnitee continues to serve as an executive officer or director of the Company or of any other enterprise at the Company's request. 16. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable in any respect, and the validity and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired and shall remain enforceable to the fullest extent permitted by law. 17. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such state without giving effect to the principles of conflicts of laws. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date above written. ATTEST: LUKENS INC. _______________________ By:___________________________ Secretary R. W. Van Sant Chairman & CEO IDEMNITEE: ___________________________ Frederick J. Smith EXHIBIT 10.35 John H. Bucher Vice President - Technology INDEMNIFICATION AGREEMENT AGREEMENT, effective as of April 15, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and John H. Bucher (the "Indemnitee"). WHEREAS, it is essential to the Company to retain and attract as directors and executive officers the most capable persons available; WHEREAS, Indemnitee is a director or executive officer of the Company; WHEREAS, both the Company and Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and executive officers of public companies in today's environment; WHEREAS, the Amended and Restated Certificate of Incorporation of the Company (the "Charter") requires the Company to indemnify and advance expenses to its directors and officers to the full extent permitted by law and the Indemnitee has been serving and continues to serve as a director or executive officer of the Company in part in reliance on the Charter; WHEREAS, in recognition of Indemnitee's need for substantial protection against personal liability in order to enhance Indemnitee's continue service to the Company in an effective manner, and Indemnitee's reliance on the Charter, and in part to provide Indemnitee with specific contractual assurance that the protection promised by the Charter will be available to Indemnitee (regardless of, among other things, any amendment to or revocation of the Charter or any change in the composition of the Company's Board of Directors or acquisition transaction relating to the Company), the Company wishes to provide in this Agreement for the indemnification of and the advancing of expenses to Indemnitee to the fullest extent (whether partial or complete) permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained, for the continue coverage of Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises and of Indemnitee continuing to serve the Company directly or, at its request, another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions: (a) Change in Control: Shall be deemed to have occurred if (i) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under said Act), directly or indirectly, of securities of the Company representing 20% or more of the total voting power represented by the Company's then outstanding Voting Securities, or (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of the Company and any new director whose election by the Board of Directors or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof, or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of (in one transaction or a series of transactions) all or substantially all of the Company's assets. (b) Claim: Any threatened, pending or completed action, suit or proceeding, or any inquiry or investigation, whether instituted by the Company or any other party, that Indemnitee in good faith believes might lead to the institution of any such action, suit or proceeding, whether civil, criminal, administrative, investigative or other. (c) Expenses: Include attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing to defend, be a witness in or participate in any Claim relating to any Indemnifiable Event. (d) Indemnifiable Event: Any event or occurrence related to the fact that Indemnitee is or was a director, officer, employee, agent or fiduciary of the Company, or is or was serving at the request of the Company as a director, officer, employee, trustee, agent or fiduciary of another corporation, partnership, joint venture, employee benefit plan, trust or other enterprise, or by reason of anything done or not done by Indemnitee in any such capacity. (3) Independent Legal Counsel: An attorney or firm of attorneys, selected in accordance with the provisions of Section 3, who shall not have otherwise performed services for the Company or Indemnitee within the last five years (other than with respect to matters concerning the rights of Indemnitee under this Agreement, or of other indemnitees under similar indemnity agreements). (f) Potential Change in Control: Shall be deemed to have occurred if (i) the Company enters into an agreement, the consummation of which would result in the occurrence of a Change in Control: (ii) any person (including the Company) publicly announces an intention to take or to consider taking actions which if consummated would constitute a Change in Control; (iii) any person, other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company or a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company, who is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 9.5% or more of the combined voting power of the Company's then outstanding Voting Securities, increase his beneficial ownership of such securities by five percentage points (5%) or moreover the percentage so owned by such person; or (iv) the Board adopts a resolution to the effect that, for purposes of this Agreement, a Potential Change in Control has occurred. (g) Reviewing Party: Any appropriate person or body consisting of a member or members of the Company's Board of Directors or any other person or body appointed by the Board who is not a party to the particular Claim for which Indemnitee is seeking indemnification, or Independent Legal Counsel. (h) Voting Securities: Any securities of the Company which vote generally in the election of directors. 2. Basic Indemnification Arrangement. (a) In the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Claim by reason of (or arising in part out of) an Indemnifiable Event, the Company shall indemnify Indemnitee to the fullest extent permitted by law as soon as practicable but in any event no later than thirty days after written demand is presented to the Company, against any and all Expenses, judgments, fines, penalties and amounts paid in settlement (including all interest, assessments and other charges paid or payable in connection with or in respect of such Expenses, judgments, fines, penalties or amounts paid in settlement) of such Claim. If so requested by Indemnitee, the Company shall advance (within two business days of such request) any and all Expenses to Indemnitee (an "Expense Advance"). Notwithstanding anything in this Agreement to the contrary, prior to a Change in Control, Indemnitee shall not be entitled to indemnification pursuant to this Agreement in connection with any Claim initiated by Indemnitee unless the Board of Directors has authorized or consented to the initiation of such Claim. (b) Notwithstanding the foregoing, (i) the obligations of the Company under Section 2(a) shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the Independent Legal Counsel referred to in Section 3 hereof is involved) that Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 2(a) shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if Indemnitee has commenced or thereafter commences legal proceedings in a court of competent jurisdiction to secure a determination that determination made by the Reviewing Party that Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or lapsed). If there has not been a Change in Control, the Reviewing Party shall be selected by the Board of Directors, and if there has been such a Change in Control (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control), the Reviewing Party shall be the Independent Legal Counsel referred to in Section 3 hereof. If there has been no determination by the Reviewing Party or if the Reviewing Party determines that Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, Indemnitee shall have the right to commence litigation in any court in the Commonwealth of Pennsylvania or the State of Delaware having subject matter jurisdiction thereof and in which venue is proper seeking an initial determination by the court or challenging any such determination by the Reviewing Party or any aspect thereof, including the legal or factual bases therefor, and the Company hereby consents to service of process and to appear in any such proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the company and Indemnitee. 3. Change in Control. The Company agrees that if there is a Change in Control of the Company (other than a Change in Control which has been approved by a majority of the Company's Board of Directors who were directors immediately prior to such Change in Control) then with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and Expense Advances under the Charter, this Agreement or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events, the Company shall seek legal advice only from Independent Legal Counsel selected by Indemnitee and approved by the Company (which approval shall not be unreasonably withheld). Such counsel, among other things, shall render its written opinion to the Company and Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the Independent Counsel referred to above and to fully indemnify such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or its engagement pursuant hereto. 4. Establishment of Trust. In the event of a Potential Change in Control, the Company shall, upon written request by Indemnitee, create a trust for the benefit of Indemnitee and from time to time upon written request of Indemnitee shall fund such trust in an amount sufficient to satisfy any and all Expenses reasonable anticipated at the time of each such request to be incurred in connection with investigating, preparing for and defending any Claim relating to an Indemnifiable Event, and any and all judgments, fines, penalties and settlement amounts of any and all Claims relating to an Indemnifiable Event from time to time actually paid or claimed, reasonably anticipated or proposed to be paid. The amount or amounts to be deposited in the trust pursuant to the foregoing funding obligation shall be determined by the Reviewing Party, in any case in which the Independent Legal Counsel referred to above is involved. The terms of the trust shall provide that upon a Change in Control (i) the trust shall not be revoked or the principal thereof invaded, without the written consent of the Indemnitee, (ii) the trustee shall advance, within two business days of a request by the Indemnitee, any and all Expenses to the Indemnitee (and the Indemnitee hereby agrees to reimburse the trust under the circumstances under which the Indemnitee would be required to reimburse the Company under Section 2(b) of this Agreement), (iii) the trust shall continue to be funded by the Company in accordance with the funding obligation set forth above, (iv) the trustee shall promptly pay to Indemnitee all amounts for which Indemnitee shall be entitled to indemnification pursuant to this Agreement or otherwise, and (v) all unexpended funds in such trust shall revert to the Company upon a final determination by the Reviewing Party or a court of competent jurisdiction, as the case may be, that Indemnitee has been fully indemnified under the terms of this Agreement. The Trustee shall be chosen by Indemnitee. Nothing in this Section 4 shall relieve the Company of any of its obligations under this Agreement. 5. Indemnification for Additional Expenses. The Company shall indemnify Indemnitee against any and all expenses (including attorneys' fees) and, if requested by Indemnitee, shall (within two business days of such request) advance such expenses to Indemnitee, which are incurred by Indemnitee in connection with any action brought by Indemnitee for (i) indemnification or advance payment of Expenses by the Company under this Agreement, the Charter or any other agreement or Company By-law now or hereafter in effect relating to Claims for Indemnifiable Events and/or (ii) recovery under any directors' and officers' liability insurance policies maintained by the Company, regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification, advance expense payment or insurance recovery, as the case may be. 6. Partial Indemnity, Etc. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses, judgments, fines, penalties and amounts paid in settlement of a Claim but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion thereof to which Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that Indemnitee has been successful on the merits or otherwise in defense of any or all Claims relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, Indemnitee shall be indemnified against all Expenses incurred in connection therewith. 7. Burden of Proof. In connection with any determination by the Reviewing Party or otherwise as to whether Indemnitee is entitled to be indemnified hereunder the burden of proof shall be on the Company to establish that Indemnitee is not so entitled. 8. No Presumptions. For purposes of this Agreement, the termination of any claim, action, suit or proceeding, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. In addition, neither the failure of the Reviewing Party to have made a determination as to whether Indemnitee has met any particular standard of conduct or had any particular belief, nor an actual determination by the Reviewing Party that Indemnitee has not met such standard of conduct or did not have such belief, prior to the commencement of legal proceedings by Indemnitee to secure a judicial determination that Indemnitee should b indemnified under applicable law shall be a defense to Indemnitee's claim or create a presumption that Indemnitee has not met any particular standard of conduct or did not have any particular belief. 9. Nonexclusivity, Etc. The rights of the Indemnitee hereunder shall be in addition to any other rights Indemnitee may have under the Charter of the Delaware General Corporation Law or otherwise. To the extent that a change in the Delaware General Corporation Law (whether by statute or judicial decision) permits greater indemnification by agreement than would be afforded currently under the Charter and this Agreement, it is the intent of the parties hereto that Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 10. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any Company director or officer. 11. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or in the right of the Company against Indemnitee, Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, and any claim or cause of action of the Company shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such two-year period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action such shorter period shall govern. 12. Amendments, Etc. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar) nor shall such waiver constitute a continuing waiver. 13. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of Indemnitee, who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 14. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any Claim made against Indemnitee to the extent Indemnitee has otherwise actually received payment (under any insurance policy, the Charter, Company By- law or otherwise) of the amounts otherwise indemnifiable hereunder. 15. Binding Effect, Etc. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, executors and personal and legal representatives. This Agreement shall continue in effect regardless of whether Indemnitee continues to serve as an executive officer or director of the Company or of any other enterprise at the Company's request. 16. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable in any respect, and the validity and enforceability of any such provision in every other respect and of the remaining provisions hereof shall not be in any way impaired and shall remain enforceable to the fullest extent permitted by law. 17. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such state without giving effect to the principles of conflicts of laws. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date above written. ATTEST: LUKENS INC. _______________________ By:___________________________ Secretary R. W. Van Sant Chairman & CEO IDEMNITEE: ___________________________ John H. Bucher EXHIBIT 10.58 AGREEMENT THIS AGREEMENT made as of the 16th day of July, 1993, between Lukens Inc., a Delaware corporation (the "Company"), and Robert Schaal, an individual residing at 7 Tullamore Drive, West Chester, Pennsylvania (the "Executive"). WITNESSETH THAT WHEREAS, the Company currently employs the Executive as a Senior Vice President - Consultant; and WHEREAS, the Company and the Executive have mutually agreed that the Executive will relinquish his duties as an officer with the Company but that the Executive will remain employed by the Company pursuant hereto. NOW, THEREFORE, in consideration of the premises and the mutual covenants and agreements herein set forth, the parties hereto agree as follows: 1. Change in Duties. The Executive shall resign as an officer (and director, where applicable) of the Company and all of its subsidiaries effective July 24, 1993 (the "Resignation Date"), but the Executive shall continue in the employ of the Company through December 31, 1994 (the "Termination Date"). In his capacity as an employee, the Executive shall perform such services as the Company may from time to time reasonably request. In providing such services, the Executive shall be entitled to all out-of-pocket expenses normally reimbursed to employees of the Company. The Executive acknowledges that after the Resignation Date, except as expressly provided for herein, he will not be provided with an office or a secretary or any perquisites normally accorded officers of the Company. Nothing herein shall preclude the Executive from accepting other employment and/or consulting opportunities, and accepting such opportunities shall not result in the elimination or reduction of any benefits described herein, except as set forth in paragraphs 3 and 6. 2. Salary. Subject to the terms of this Agreement, the Executive will continue to receive his base salary (which is $220,000 annually) from the Resignation Date through the Termination Date. 3. Additional Benefits. Subject to the terms of this Agreement, between the Resignation Date and the Termination Date the Executive shall be entitled to continued participation in all employee benefit plans (except that the Company shall not provide coverage for short and long-term disability) to the extent to which he is now so participating under the following terms: (a) For purposes of the 1985 Stock Option and Appreciation Plan (the "Stock Option Plan"), under which the Executive currently has granted but unexercised options, the date of termination for purposes of exercising options under the Stock Option Plan shall be the Termination Date. However, if the Executive accepts any employment with a person or entity engaged in "Competitive Activity" (as hereinafter defined) between the Resignation Date and the Termination Date, the date of termination for purposes of the Stock Option Plan shall be the date on which the Executive accepts such employment. The Executive shall not "pyramid" by paying for stock purchases under the Stock Option Plan with so-called "immature" stock. The Executive acknowledges that he shall not be granted any options after the Resignation Date. (b) The Executive may participate in the Lukens Inc. Employees Capital Accumulation Plan until the Termination Date. (c) The Executive and his covered dependents (as long as the Executive pays the proper premiums for dependent coverage) shall continue to be covered under the welfare plans, health care and life insurance programs of the Company in which he is participating on the Resignation Date through the Termination Date or such earlier time, if any, as the Executive accepts employment with another employer from which he receives coverage under its welfare plans, health care and insurance programs. (d) The Executive will continue to accrue benefits through the Termination Date under all Company sponsored retirement benefit programs in which the Executive is participating on the Resignation Date, unless the Executive at any time shall accept employment with a person or entity engaged in "Competitive Activity", in which event benefit accrual shall be deemed to have ceased on the date on which the Executive accepts such employment. "Competitive Activity" means, without the prior written consent of the Board of Directors of the Company, the Executive's employment with, participation in consulting activity for, or management of, any company or business operation if such company or operation engages in substantial and direct competition with Lukens Steel Company or Washington Steel Corporation. The Executive shall be entitled to only such retirement benefits as are set forth from time to time in such retirement benefit programs. The Executive's estimated pension benefits are set forth in Exhibit A attached hereto and made a part hereof. Such benefits will not be reduced other than as a result of changes to reflect different benefit forms or to correct manifest computational errors, all such corrections to be reasonably determined in good faith. (e) If the Executive dies prior to the Termination Date, the compensation and benefits set forth in this Agreement shall terminate, except that benefits will be payable to his spouse or other beneficiaries in accordance with the provisions of the various employee benefit plans sponsored by the Company which provide for payment of benefits upon the death of an active employee. (f) The Executive shall participate in the 1983 Target Incentive Plan ("TIP") for fiscal year 1993 and his individual performance rating shall be 100%. Such award shall be payable on or about February 1, 1994. (g) The Executive will be reimbursed for all unused vacation accrued through the Resignation Date. (h) The Executive will be provided with employment references substantially in the form set forth in Exhibit B attached hereto and made a part hereof. 4. Company Car. The Company will transfer title to the Executive's company car to him, and the Company will pay for any sales or transfer taxes in connection with such transfer, it being understood that such transfer is subject to and conditioned upon the understanding that all Federal and state income taxes in connection therewith will be paid by the Executive and that all insurance, gasoline, maintenance and other charges with respect to such car after the Resignation Date are for the account of the Executive. 5. Outplacement Counseling. The Company shall provide the Executive with outplacement counseling services at Gateway Management Group Inc. until such time as the Executive accepts employment with another employer. Such services shall include office space, telephone usage, secretarial support, postage and other amenities normally provided pursuant to Gateway's program of career transition for executives. 6. Competitive Activity. If the Executive receives compensation from other employment with a person or entity that is engaged in "Competitive Activity" prior to Termination Date, the compensation to be provided by the Company under the provisions of paragraphs 2 and 3(f) of this Agreement shall be reduced by an amount equal to the compensation received from such other employment. 7. Release of Liability; Confidentiality. (a) The Executive acknowledges and agrees that the Company has fully performed any obligations it may have to the Executive and, except with respect to future performance of this Agreement, the Executive releases the Company from any and all further liability or obligation to the Executive. In addition, the Executive hereby releases the Company, its directors, officers, subsidiaries, agents, employees, attorneys, representatives, affiliates, successors and assigns (and those of it subsidiaries and affiliates) (collectively, "Releasees") from any and all claims, causes of action, damages, attorneys' fees and costs and all other liabilities of any kind whatsoever arising from, relating to or based upon the Executive's employment with or resignation from the Company, its subsidiaries or any of its predecessors, including, but not limited to, any claim of unlawful age discrimination under the Age Discrimination in Employment Act of 1967 or the Pennsylvania Human Relations Act; provided, however, that such release by the Executive does not apply to indemnity obligations, if any, which the Company may have to the Executive based on his status as an officer or director of the Company or any subsidiary thereof. In consideration of the benefits provided hereunder, the Executive further agrees that, as long as the Company complies with its obligations under this Agreement, the Executive shall not, directly or indirectly, (i) bring or become voluntarily involved in any lawsuit or other claim against the Company or any other Releasees based on any event occurring on or before the date of this Agreement, (ii) disclose to the media or any persons whatsoever the circumstances resulting in the execution of this Agreement (other than to confirm his resignation to pursue other interests) or (iii) make any comments which disparage or are adverse to the best interests of the Company or any other Releasees. As long as the Executive complies with this Agreement, the Company shall not make any negative public comments regarding the Executive, the circumstances resulting in this Agreement or the performance of the Executive through the date of this Agreement. The Executive also acknowledges that he has consulted with an attorney. The Executive acknowledges that he has been given twenty-one days within which to consider the waiver set forth above and the other terms of this Agreement and that he may revoke this Agreement for a period of seven days following the execution hereof. The Company releases the Executive from any and all claims, causes of action, damages, attorneys' fees and costs and all other liabilities of any kind whatsoever arising from, relating to or based upon the Executive's employment with the Company, it subsidiaries or any of its predecessors. (b) The Executive represents and warrants that he has not disclosed to any third party any Confidential Information (as hereinafter defined), which disclosure was materially prejudicial to the interests of the Company. The Executive further represents and warrants that he has not removed from the Company's premises any document, letter, memorandum, notes or other writing (or copy thereof) that contained Confidential Information, except in the ordinary course of the performance of his duties. The Executive further represents and warrants that he has returned to the Company all documents in his possession that contain Confidential Information. The Executive covenants and agrees that, until expiration of a period of three (3) years after the Termination Date, he shall not disclose to any third party without the written consent of the Company any confidential, proprietary or competitive information belonging to the Company and its subsidiaries, including without limitation, confidential manufacturing processes, inventions, cost data, sales data, marketing information, capital spending or other business plans or strategies, pricing information, customer lists, forecasts, personnel records or any other information not previously disclosed to the public or otherwise generally available to the public or known by the Company's competitors (collectively, "Confidential Information"). The Executive covenants and agrees that he shall not remove from the Company's premises any document, letter, memorandum, notes or other writing (or copy thereof) that contains any Confidential Information. 8. Arbitration. Any dispute between the parties hereto relating to the subject matter hereof shall, at the election of either party by giving notice thereof to the other party hereto, be subject to arbitration in accordance with the rules of the American Arbitration Association then in effect. Unless otherwise agreed by the parties, the arbitration shall take place in Wilmington, Delaware, before three arbitrators, one to be selected by the Company, one to be selected by the Executive and the third to be selected by the first two arbitrators. The decision of the arbitrators shall be conclusive and binding on the parties hereto and may be enforced in any court having jurisdiction. The expenses of arbitration shall be borne equally by the Company and the Executive. 9. Severability. If any part of this Agreement shall be determined to be invalid or unenforceable for any reason, the remaining provisions of this Agreement shall remain in full force and effect to the fullest extent permitted by law. 10. Amendment; Waiver. This Agreement may not be amended, modified, waived or cancelled, except by a writing signed by each party hereto. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of any similar or dissimilar condition or provision at the same or any prior or subsequent time. 11. Entire Agreement/Parties in Interest. This Agreement constitutes the entire Agreement between the parties relative to the subject matter hereof. This Agreement is intended solely for the benefit of the parties hereto and shall not create any rights in any third party. 12. Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Delaware. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year first above written. LUKENS INC. By: ___________________________ R. W. Van Sant Chairman and Chief Executive Officer EXECUTIVE ________________________________ Robert Schaal EXHIBIT 11 EXHIBIT 21 LUKENS INC. SUBSIDIARIES December 25, 1993 Lukens Inc. has twenty-two direct or indirect wholly-owned subsidiaries: State or Other Jurisdiction of Incorporation Allegheny Ore and Iron Company Virginia Brandywine Valley Railroad Company Delaware Cathodic Protection Services Company Delaware Encoat North Arlington, Inc. Delaware Energy Coatings Company Delaware Flex-O-Lite, Inc. Delaware Flex-O-Lite, Ltd. Canada LI Acquisition Corporation Delaware LI Service Company Pennsylvania Ludlow-Saylor, Inc. Delaware Lukens Development Corporation Delaware Lukens Management Corporation Pennsylvania Lukens Steel Company Pennsylvania Pennock Corporation Delaware Simplicity Engineering, Inc. Delaware Simplicity Materials Handling Ltd. Canada South Track Railroad Contracting Co. Florida Sponsor's Plan Asset Management, Inc. Delaware Starlite Safety Supply, Inc. Delaware Washington Specialty Metals Corporation Illinois Washington Specialty Metals Inc. Canada Washington Steel Corporation Delaware

24491_1993.txt

24491_1993

1993

24491

Item 1. BUSINESS. Products and Sales The primary business of Cooper Tire & Rubber Company ("Cooper" or "Company") is the conversion of natural and synthetic rubbers into a variety of carbon black reinforced rubber products. The Company manufactures and markets the following products for the transportation industry: automobile and truck tires, inner tubes, vibration control products, hose and hose assemblies, automotive sealing systems and specialty seating components. Its non-transportation products accounted for less than one percent of sales in 1993, 1992 and 1991. Additional information on the Company's products appears on pages 49, 50 and 54 through 56 of this Annual Report on Form 10-K. The Company's tire products are sold nationally and internationally in the replacement tire market, primarily through independent dealers and distributors. In the United States, this channel of marketing has accounted for 66 percent of all replacement passenger tires sold in 1993 and 1992 and 67 percent during the year 1991. Cooper has an efficient distribution system to serve its markets for replacement passenger and truck tires. Cooper engineers and manufactures rubber parts for automotive vehicle manufacturers. The Company's engineering and marketing personnel work closely with these customers to assist in the design and development of rubber products to meet their changing requirements. Additional information on the Company's marketing and distribution appears on pages 52, 53, 55 and 56 of this Annual Report on Form 10-K. North American vehicle manufacturers experienced an 11.6% increase in total production of light vehicles in 1993. The Company's sales of engineered rubber products are generally linked to light vehicle production. Cooper's improved sales in this market reflected the increased vehicle production as well as the Company's success in the procurement of larger contracts and development of new products. The Company is an authorized supplier to all domestically owned automotive vehicle manufacturers and the foreign-owned and joint-venture vehicle manufacturers in the United States. Current market data indicates an increasing demand for replacement tires and engineered rubber products. Essentially, there are no economical or practical substitutes for tires or certain rubber automotive parts. Based on current data, the Company expects moderate growth in the market for replacement tires and in the use of rubber components by automobile manufacturers. Additional information on the Company's outlook for the industry appears on pages 49 and 53 of this Annual Report on Form 10-K. During recent years Cooper has exported to Canada and countries in Latin America, Western Europe, the Middle East, Asia, Africa and Oceania. The international market for rubber products is expanding as the standard of living in other countries increases and motor vehicle usage grows. Net sales from international operations accounted for approximately five percent of Cooper's sales in 1993, 1992 and 1991. (continued) During 1993 Cooper's ten largest customers accounted for approximately 55 percent of total sales. Sales to one major customer approximated 14, 15 and 14 percent of net sales in 1993, 1992 and 1991. The amount of backlog of orders for the Company's products at any given time is usually small in relation to annual sales and is, therefore, of little value in forecasting sales or earnings for the current or succeeding years. The Company successfully operates in a competitive industry. A number of its competitors are larger than the Company. The four largest tire-producing companies are believed to account for approximately 67 percent of all domestic original equipment and replacement tire sales. The Company's shipments of automobile and truck tires in 1993 represented approximately 10 percent of all such industry shipments. On the basis of domestic tire manufacturing capacity the Company believes it ranks fourth among twelve generally recognized producers of new tires. According to a recognized trade source the Company ranked ninth in worldwide tire sales based on 1992 estimated sales volumes. Sales of the Company's tire products are affected by factors which include price, quality, availability, technology, warranty, credit terms and overall customer service. Raw Materials The primary raw materials used by the Company include synthetic and natural rubbers, polyester and nylon fabrics, steel tire cord and carbon black, which the Company acquires from multiple sources to provide greater assurance of continuing supplies for its manufacturing operations. The Company did not experience any significant raw material shortages in 1993, nor have any shortages been experienced in the opening months of 1994. During 1993 the Company opened a purchasing office in Singapore to acquire various grades of natural rubber direct from producers in Indonesia, Malaysia and Thailand. This purchasing operation enables the Company to work directly with processors to improve the consistency of quality and to reduce the costs of materials, delivery and transactions. In addition, control over packaging methods will enhance the Company's goal to use recyclable materials in the packaging of these raw materials. The Company's contractual relationships with its raw material suppliers are generally based on purchase order arrangements. Certain materials are purchased pursuant to supply contracts which incorporate normal purchase order terms and establish minimum purchase amounts. Cooper has not experienced serious fuel shortages and none are foreseen in the near future. The Findlay, Ohio plant uses coal and natural gas with fuel oil as a standby energy source. All other Company plants use natural gas with fuel oil as a standby energy source. Research, Development and Product Improvement Cooper generally directs its research activities toward product development, improvements in quality, and operating efficiency. A significant portion of basic research for the rubber industry is performed by raw material suppliers. The Company participates in such research with its suppliers. Cooper has approximately 187 full-time employees engaged in research and development programs. Research and development expenditures amounted to approximately $15,100,000 in 1993, $13,700,000 in 1992, and $14,000,000 in 1991. (continued) 3 The Company is a leader in the application of computer technology to the development of new tire products and engineered automotive products. The use of computer-aided design (CAD) and sophisticated modeling programs reduce Cooper's product development costs and the time necessary to bring new products to market. The Company also forms strategic alliances with universities, research firms and high-tech manufacturers to collaborate on new product development, particularly in engineered automotive products. The ability to offer complete component design services and full vehicle analysis to automotive customers increases the Company's value as a partner in product design and development. The Company continues to actively develop new passenger and truck tires. Cooper conducts extensive testing of current tire lines, as well as new concepts in tire design and construction. During 1993 approximately 117 million miles of tests were performed on indoor test wheels and in monitored road tests. Uniformity equipment is used to physically check every radial passenger tire produced for high standards of quality. The Company continues to design and develop specialized equipment to fit the precise needs of its manufacturing and quality control requirements. Additional information on the Company's research, development and product improvement programs appears on pages 51, 52 and 55 of this Annual Report on Form 10-K. Environmental Matters Cooper recognizes the importance of compliance in environmental matters and has an organization structure to supervise environmental activities, planning and programs. The Company also participates in activities concerning general industry environmental matters. Cooper's manufacturing facilities, in common with those of industry generally, are subject to numerous laws and regulations designed to protect the environment. In general, the Company has not experienced difficulty in complying with these requirements and believes they have not had a material adverse effect on its financial condition or the results of its operations. The Company expects that additional requirements with respect to environmental control facilities and waste disposal will be imposed in the future. The Company has been named in environmental matters asserting potential joint and several liability for past and future cleanup, state and Federal claims, site remediation, and attorney fees. The Company has determined that it has no material liability for these matters. The Company's 1993 expense and capital expenditures for environmental control at its facilities were not material, nor is it estimated that expenditures in 1994 for such uses will be material. Seasonal Trends There is a year-round demand for passenger and truck replacement tires, but passenger replacement tire sales are generally strongest during the second and third quarters of the year. Winter tires are sold principally during the months of August through October. Engineered rubber product sales to automotive customers are lowest during the months prior to model changeover. (continued) Employee Relations As of December 31, 1993, the Company employed 7,607 persons, of whom 3,622 were salaried employees. Union contracts covering 3,985 employees include, among other things: wages, hours, grievance procedures, checkoff, seniority and working conditions. Union contracts with the United Rubber, Cork, Linoleum and Plastic Workers of America (AFL-CIO-CLC) for all production and maintenance employees at each of the following Company plants continue in effect until the indicated contract expiration date: Auburn, Indiana - December 5, 1994 Bowling Green, Ohio (Sealing products) - October 31, 1994 Bowling Green, Ohio (Hose products) - April 30, 1995 Clarksdale, Mississippi - July 31, 1996 El Dorado, Arkansas - April 27, 1997 Findlay, Ohio - October 31, 1994 Texarkana, Arkansas, - March 5, 1996 Over-the-road truck drivers are affiliated with the International Brotherhood of Teamsters with their contract in effect until February 13, 1994. This contract has been mutually extended to allow additional time to schedule and hold negotiation meetings. No difficulties are anticipated in the pending negotiations. Employees at the Piedras Negras, Mexico plant are affiliated with Sindicato Autonomo de Trabajadores Rio Grande SerVaas with their contract in effect until January 31, 1996. All labor agreements will be extended for yearly periods unless notice of termination or change is given by either party at least 60 days prior to the expiration of any yearly period. During the last three years there has been only one plant work stoppage, which lasted for 23 days. Cooper considers its labor relations to be favorable. Substantially all employees are covered by hospital and surgical, group life, and accident and sickness benefit plans. The Company has various trusteed non-contributory retirement income plans which cover most employees and retirees. Substantially all retirees are covered by hospital and surgical and group life benefit plans. See "Notes to Consolidated Financial Statements" on pages 28 through 32 of this Annual Report on Form 10-K for additional information as to pension costs and funding and postretirement benefits. Item 2. Item 2. PROPERTIES. The Company owns its headquarters facility which is adjacent to its Findlay, Ohio tire manufacturing plant. Properties are located in various sections of the United States for use in the ordinary course of business. Such properties consist of the following: (continued) 6 The Company also owns a manufacturing facility located in Mexico which produces inner tubes and engineered rubber parts. Cooper's tire plants are operating at rated capacity levels with the exception of the plant in Albany, Georgia. This plant was acquired in 1990, began limited production during 1991, and continues to be equipped to manufacture a full range of radial passenger, light truck and medium truck tires using the most advanced technology. The former regional distribution center in Atlanta, Georgia was sold during 1993. It was closed during 1991 with its operations relocated to Albany, Georgia. The Tupelo, Mississippi and Albany, Georgia plants operate on a 24-hour day, seven-day production schedule. The other plants are operating 24 hours per day, five days per week. The Company believes its properties have been adequately maintained and generally are in good condition. Additional information concerning the Company's facilities appears on pages 51, 53, and 54 of this Annual Report on Form 10-K. Information related to leased properties appears on pages 33 and 34. Item 3. Item 3. LEGAL PROCEEDINGS. Cooper is a defendant in many unrelated actions in Federal and state courts throughout the United States. In a number of such cases the plaintiffs allege violations of state and Federal laws, breach of contract and product liability and assert damages of many thousands of dollars. The Company self-insures product liability losses up to $2,250,000 per occurrence with an annual aggregate of $6,000,000. In addition, Cooper carries Excess Liability Insurance which provides protection with respect to product liability costs in excess of the self-insured amounts. While the outcome of litigation cannot be predicted with any certainty, in the opinion of counsel for the Company, the pending claims and lawsuits against the Company should not have a material adverse effect on the financial condition of the Company or the results of its operations. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of security holders during the last quarter of the fiscal year ended December 31, 1993. Part II. Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Cooper Tire & Rubber Company common stock is traded on the New York Stock Exchange under the symbol CTB. Information concerning the Company's common stock and related security holder matters (including dividends) is presented on pages 9, 21, 25 through 28 and 36 of this Annual Report on Form 10-K. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Financial Condition The financial position of the Company continues to be excellent. Strong operating cash flows provided funds for modernization and expansion and contributed to continued financial strength. Working capital amounted to $205 million at year-end 1993 compared to $175 million one year earlier. A current ratio of 2.6 indicates an excellent liquidity position and is improved from the year-end 1992 current ratio of 2.3. Accounts receivable increased slightly to $182 million versus $181 million at year-end 1992, reflecting fourth quarter sales levels. Adequate allowances have been made for possible collection losses. Generally, collection experience has been excellent and customer payment terms are comparable to the prior year. Total inventories at $111 million were up significantly from $75 million at year-end 1992. Finished goods inventories were $29 million, or 55 percent, higher than one year ago. This increase is a result of rebuilding inventories to provide desirable customer service levels. Raw material and supplies inventories were $5 million higher than one year ago due to increased levels of raw material purchases. Work-in-process inventories were $2 million higher compared to the prior year reflecting current production levels. Prepaid expenses and deferred taxes include $10 million in deferred tax assets at December 31, 1993 which are considered fully realizable within one year. In 1993 additions to property, plant and equipment were $117 million. This was an increase of $7 million from the previous record of $110 million in 1992. The Company's capital expenditure commitments at December 31, 1993 were not material. The Company has invested significant amounts for property, plant and equipment in recent years primarily for continuing expansions and plant modernization. A continuation of high levels of capital expenditures is anticipated. Funding for these projects will be available from operating cash flows with additional funding available, if needed, under a credit agreement and a shelf registration. Depreciation and amortization was $46 million in 1993, a 22 percent increase from $38 million in 1992, and results from the significant capital expenditures in recent years. Other assets of $30 million are up $8 million from year-end 1992 and primarily reflect the increase in the amount of cumulative pension funding in excess of amounts expensed under Statement of Financial Accounting Standards (SFAS) #87, "Employers' Accounting for Pensions". Current liabilities of $127 million were $13 million lower than the $140 million at year-end 1992 reflecting decreases in trade payables. Long-term debt decreased $9 million from year-end 1992 to $39 million due to the payment of the $4 million Industrial Development Revenue Bonds and scheduled debt payments. Long-term debt, as a percent of total capitalization, decreased to 6.6 percent at December 31, 1993 from 9.3 percent one year earlier. The Company has a shelf registration statement with the Securities and Exchange Commission covering the proposed sale of its debt securities in an aggregate amount of up to $200 million. The net proceeds received by the Company from any sale of the debt securities would be available for general corporate purposes. In December 1992, the Company adopted changes in accounting for postretirement benefits other than pensions and income taxes retroactive to January 1, 1992. The net impact of these accounting changes had no effect on cash flows of the Company. The discount rate used to derive the liability for postretirement benefits other than pensions was reduced from 8.5 percent at December 31, 1992 to 7.5 percent at December 31, 1993. (continued) 10 Other long-term liabilities increased $16 million reaching $36 million at December 31, 1993 from $20 million one year earlier. This increase reflects a $14 million increase in the additional minimum pension liability and results primarily from the change in the assumptions used to value pension liabilities. The discount rate for pensions was reduced from 8 percent to 7 percent and the assumed rate of increase in compensation was reduced from 6 percent to 5 percent. Noncurrent deferred income taxes increased to $12 million at December 31, 1993, from $7 million one year earlier, primarily reflecting the excess of tax over book depreciation. The Company has been named in environmental matters asserting potential joint and several liability for past and future cleanup, state and Federal claims, site remediation, and attorney fees. The Company has determined that it has no material liability for these matters. In addition, the Company is a defendant in unrelated product liability actions in Federal and state courts throughout the United States in which plaintiffs assert damages of many thousands of dollars. While the outcome of litigation cannot be predicted with any certainty, in the opinion of counsel for the Company, the pending claims and lawsuits against the Company have not had and should not have a material adverse effect on its financial condition or results of operations. Stockholders' equity increased $79 million during the year reaching $550 million at year end. Earnings retentions for 1993 (net income less dividends paid) added $85 million to stockholders' equity but was offset by a $7 million reduction for minimum pension liability, net of taxes. Stockholders' equity per share was $6.58 at year-end 1993, an increase of 16 percent over $5.65 per share at year-end 1992. Results of Operations High levels of capacity utilization and good customer demand continued for the Company's tires and engineered rubber products. Sales increased 2 percent in 1993 to a record of nearly $1.2 billion. This followed a 17 percent increase in sales in 1992 which resulted primarily from growth in customer demand. Sales margins were lower in 1993 than in 1992 and were higher in 1992 than in 1991. In 1993 intense pricing pressure in the replacement tire industry contributed to the reduction. Changes in product mix and production efficiencies were the primary contributing factors to the 1992 improvement. The effects of inflation on sales and operations were not material during 1993, 1992 and 1991. Other income was lower in 1993 compared with 1992 and higher in 1992 compared to 1991. These changes were related to the investments of cash reserves and rates earned thereon. Increases in 1993 and 1992 selling, general and administrative expenses were normal considering sales activity levels and general inflation. Effective income tax rates were higher in 1993 reflecting the Omnibus Budget Reconciliation Act of 1993 which, among other things, increased the effective federal tax rate and reinstated the research and development credit. The increased rate in 1992 over 1991 was due primarily to differences in tax credits. (continued) The Company currently provides certain health care and life insurance benefits for its active and retired employees. If the Company does not terminate such benefits, or modify coverage or eligibility requirements, substantially all of the Company's United States employees may become eligible for these benefits at their retirement. During 1992 the Company began using the accrual method of accounting for the cost of providing such benefits. The Company continues to fund these benefit costs as claims are incurred. The cumulative effect of adopting this accounting standard was a one-time charge to net income of $67 million, net of a deferred income tax benefit of $41 million, or 81 cents per share. The Company also adopted the liability method of accounting for income taxes in 1992. The cumulative effect of this change in accounting was a credit to net income of $2 million, or 3 cents per share. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Statements of financial position at December 31, 1993 and 1992 and statements of income, cash flows, and stockholders' equity for each of the three years in the period ended December 31, 1993, the independent auditor's report thereon, and the Company's unaudited quarterly financial data for the two-year period ended December 31, 1993 are presented on pages 19 through 36 of this Annual Report on Form 10-K. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. Part III. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning the Company's directors appears on pages 2 through 6 and 17 of the Company's Proxy Statement dated March 22, 1994 and is incorporated herein by reference. The names, ages, and all positions and offices held by all executive officers of the Company, as of the same date are as follows: Each such officer shall hold such office until his successor is elected and qualified in his stead. Item 11. Item 11. EXECUTIVE COMPENSATION. Information regarding executive compensation appears on pages 6 through 14 of the Company's Proxy Statement dated March 22, 1994 and is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information concerning the security ownership of certain beneficial owners and management of the Company's voting securities and equity securities appears on pages 15 through 17 of the Company's Proxy Statement dated March 22, 1994 and is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. Part IV. Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements The financial statements listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. 2. Financial Statement Schedules The financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this Annual Report on Form 10-K. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the fiscal year ended December 31, 1993. INDEX TO FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS Page(s) FINANCIAL STATEMENTS: Reference --------- Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 19 Consolidated Balance Sheets at December 31, 1993 and 1992 20-21 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 22 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 23 Notes to Consolidated Financial Statements 24-34 Report of Independent Auditors 35 SUPPLEMENTARY INFORMATION: Quarterly Financial Data (Unaudited) 36 FINANCIAL STATEMENTS SCHEDULES: I Marketable Securities 37 V Property, plant and equipment 38 VI Accumulated depreciation and amortization of property, plant and equipment 39 VIII Valuation and qualifying accounts 40 IX Short-term borrowings 40 X Supplementary Income Statement Information 41 EXHIBITS: (3) Certificate of Incorporation and Bylaws (i) Certificate of Incorporation, as restated and filed with the Secretary of State of Delaware on May 17, 1993, is incorporated herein by reference from Exhibit 3(i) of the Company's Form 10-Q for the quarter ended June 30, 1993 (ii) Bylaws, as amended May 5, 1987, are incorporated herein by reference from Exhibit 19 of the Company's Form 10-Q for the quarter ended June 30, 1987 (4) Description of the Common Stock of the Company 42 (10) Description of management contracts, compensatory plans, contracts, or arrangements is incorporated herein by reference from pages 6 through 14 of the Company's Proxy Statement dated March 22, 1994. The following related documents are also incorporated by reference: a) 1981 Incentive Stock Option Plan - Form S-8 Registration Statement No. 2-77400, Exhibit 15(a) b) 1986 Incentive Stock Option Plan - Form S-8 Registration Statement No. 33-5483, Exhibit 4(a) c) Thrift and Profit Sharing Plan - Form S-8 Registration Statement No. 2-58577, Post-Effective Amendment No. 6, Exhibit 4 d) Employment Agreements - Form 10-K for fiscal year ended December 31, 1987, Exhibit 10 e) 1991 Stock Option Plan for Non-Employee Directors - Form S-8 Registration Statement No. 33-47980 and Appendix to the Company's Proxy Statement dated March 26, 1991 (continued) 16 (11) Statement regarding computation of earnings per share is presented on page 28 of this Annual Report on Form 10-K (23) Consent of Ernst & Young 43 (24) Powers of Attorney 44-48 (99) Operations Review and Product Overview as published in the Company's Annual Report to Stockholders for its fiscal year ended December 31, 1993 49-56 Undertakings of the Company 57-59 All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedules, or because the information required is included in the financial statements or the notes thereto. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. COOPER TIRE & RUBBER COMPANY /s/ Stan C. Kaiman -------------------------------- STAN C. KAIMAN, Attorney-in-fact Date: March 22, 1994 -------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- IVAN W. GORR* Chairman of the Board, Chief March 22, 1994 Executive Officer and Director (Principal Executive Officer) PATRICK W. ROONEY* President, Chief Operating March 22, 1994 Officer and Director (Principal Operating Officer) J. ALEC REINHARDT* Executive Vice President and March 22, 1994 Director (Principal Financial Officer) JOHN FAHL* Vice President and Director March 22, 1994 JULIEN A. FAISANT* Vice President and Corporate March 22, 1994 Controller (Principal Accounting Officer) DELMONT A. DAVIS* Director March 22, 1994 DENNIS J. GORMLEY* Director March 22, 1994 JOSEPH M. MAGLIOCHETTI* Director March 22, 1994 WILLIAM D. MAROHN* Director March 22, 1994 ALLAN H. MELTZER* Director March 22, 1994 LEON F. WINBIGLER* Director March 22, 1994 *By/s/ Stan C. Kaiman -------------------------------- STAN C. KAIMAN, Attorney-in-fact NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SIGNIFICANT ACCOUNTING POLICIES Accounting policies employed by the Company are based on generally accepted accounting principles. The following summary of significant accounting policies is presented for assistance in the evaluation and interpretation of the financial statements and supplementary data. Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. All material intercompany accounts and transactions have been eliminated. Cash and short-term investments - The Company considers all highly liquid investments with an original maturity of three months or less to be short-term investments (cash equivalents). The carrying amount reported in the balance sheets for cash and short-term investments approximates its fair value. The effect of changes in foreign exchange rates on cash balances was not significant. Inventories - Substantially all inventories are valued at cost, using the last-in, first-out (LIFO) cost method, which is not in excess of market. Property, plant and equipment - Assets are recorded at cost and depreciated or amortized using the straight-line method over their expected useful lives. For income tax purposes accelerated depreciation methods and shorter lives are used. Revenue recognition - Revenues are recognized after goods are shipped to customers in accordance with their purchase orders. Warranties - Estimated costs for product warranties are charged to income at the time of sale. Research and development - These costs are charged to expense as incurred and amounted to approximately $15,100,000, $13,700,000 and $14,000,000 in 1993, 1992 and 1991, respectively. BUSINESS The Company, a specialist in the rubber industry, manufactures and markets automobile and truck tires, inner tubes, vibration control products, hose and hose assemblies, automotive sealing systems, and specialty seating components. The Company manufactures products primarily for the transportation industry. Its non-transportation products accounted for less than one percent of sales in 1993, 1992 and 1991. Sales to one major customer approximated 14, 15 and 14 percent of net sales in 1993, 1992 and 1991, respectively. INVENTORIES Under the LIFO method, inventories have been reduced by approximately $52,850,000 and $52,746,000 at December 31, 1993 and 1992, respectively, from current cost which would be reported under the first-in, first-out method. (continued) LONG-TERM DEBT The Company has a credit agreement with four banks authorizing borrowings up to $120,000,000 with interest at varying rates. The proceeds may be used for general corporate purposes. The agreement provides that on June 30, 1996 the Company may convert any outstanding borrowings into a four-year term loan. A commitment fee of 3/16 percent per year on the daily unused portion of the $120,000,000 is payable quarterly. The credit facility supports the issuance of commercial paper. There were no borrowings under the agreement at December 31, 1993 and 1992. The 9% Senior Notes, due October 1, 2001, provide for semiannual interest payments on April 1 and October 1 and annual principal prepayments of $4,545,000 on October 1 through the year 2000. The Company paid the $4,000,000 Industrial Development Revenue Bonds during 1993 as a result of the sale of a regional distribution facility. The mortgage note is secured by real and personal property with a carrying value of $7,637,000 at December 31, 1993. The most restrictive covenants under the loan agreements require the maintenance of $65,000,000 in working capital and restrict the payment of dividends; the amount of retained earnings not restricted was $342,886,000 at December 31, 1993. Interest paid on debt during 1993, 1992 and 1991 was $4,723,000, $5,111,000 and $8,321,000, respectively. The amount of interest capitalized was $2,297,000, $2,907,000 and $3,733,000 during 1993, 1992 and 1991, respectively. The required principal payments for long-term debt during the next five years are as follows: 1994-$5,345,000; 1995-$5,112,000; 1996-$5,036,000; 1997 - $5,081,000; 1998 - $4,723,000. See the note on lease commitments for information on capitalized lease obligations. The Company has a Registration Statement with the Securities and Exchange Commission covering the proposed sale of its debt securities in an aggregate amount of up to $200,000,000. The Company may sell the securities to or through underwriters, and may also sell the securities directly to other purchasers or through agents or dealers. The net proceeds received by the Company from any sale of the debt securities would be available for general corporate purposes. (continued) ACCRUED LIABILITIES PREFERRED STOCK At December 31, 1993, 5,000,000 shares of preferred stock were authorized but unissued. The rights of the preferred stock will be determined upon issuance by the board of directors. PREFERRED STOCK PURCHASE RIGHT Each stockholder is entitled to the right to purchase 1/100th of a newly-issued share of Series A preferred stock of the Company at an exercise price of $16.88. The rights will be exercisable only if a person or group acquires beneficial ownership of 20 percent or more of the Company's outstanding common stock, or commences a tender or exchange offer which upon consummation would result in such person or group beneficially owning 30 percent or more of the Company's outstanding common stock. If any person becomes the beneficial owner of 25 percent or more of the Company's outstanding common stock, or if a holder of 20 percent or more of the Company's common stock engages in certain self-dealing transactions or a merger transaction in which the Company is the surviving corporation and its common stock remains outstanding, then each right not owned by such person or certain related parties will entitle its holder to purchase a number of shares of the Company's Series A preferred stock having a market value equal to twice the then current exercise price of the right. In addition, if the Company is involved in a merger or other business combination transaction with another person after which the Company's common stock does not remain outstanding, or if the Company sells 50 percent or more of its assets or earning power to another person, each right will entitle its holder to purchase a number of shares of common stock of such other person having a market value equal to twice the then current exercise price of the right. The Company will generally be entitled to redeem the rights at one cent per right, or as adjusted to reflect stock splits or similar transactions, at any time until the tenth day following public announcement that a person or group has acquired 20 percent or more of the Company's common stock. COMMON STOCK There were 7,617,672 common shares reserved for the exercise of stock options and contributions to the Company's Thrift and Profit Sharing Plan at December 31, 1993. (continued) STOCK OPTIONS The Company's 1981 and 1986 incentive stock option plans provide for granting options to key employees to purchase common shares at prices not less than market at the date of grant. These plans were amended in 1988 to allow the granting of nonqualified stock options. Nonqualified stock options are not intended to qualify for the tax treatment applicable to incentive stock options under provisions of the Internal Revenue Code. Options under these plans may have terms of up to ten years becoming exercisable in whole or in consecutive installments, cumulative or otherwise. The plans also permit the granting of stock appreciation rights with the options. Stock appreciation rights enable an optionee to surrender exercisable options and receive common stock and/or cash measured by the difference between the option price and the market value of the common stock on the date of surrender. The options granted under these plans which were outstanding at December 31, 1993 have a term of 10 years and become exercisable 50 percent after the first year and 100 percent after the second year. The Company's 1991 nonqualified stock option plan provides for granting options to directors, who are not employees of the Company, to purchase common shares at prices not less than market at the date of grant. Options granted under this plan have a term of ten years and are exercisable in full beginning one year after the date of grant. At December 31, 1993, under the 1981 plan, options were exercisable on 37,200 shares and no shares were available for future grants. At December 31, 1992, options were exercisable on 53,400 shares and no shares were available for future grants. (continued) Under the 1986 plan, at December 31, 1993, options were exercisable on 285,850 shares and 1,308,640 shares were available for future grants. At December 31, 1992, options were exercisable on 234,700 shares and 1,388,640 shares were available for future grants. At December 31, 1993, under the 1991 plan, 5,074 options were exercisable and 92,495 shares were available for future grants. At December 31, 1992, 3,106 options were exercisable and 94,690 shares were available for future grants. EARNINGS PER SHARE Net income per share is based upon the weighted average number of shares outstanding which were 83,549,566 in 1993, 83,357,141 in 1992 and 82,737,762 in 1991. The effect of common stock equivalents is not significant for any period presented. PENSIONS The Company has defined benefit plans covering substantially all employees. The salary plan provides pension benefits based on an employee's years of service and average earnings for the five highest calendar years during the ten years immediately preceding retirement. The hourly plans provide benefits of stated amounts for each year of service. The Company's general funding policy is to contribute amounts deductible for Federal income tax purposes. (continued) The increase in the actuarial present value of benefit obligations in 1993 is due primarily to the reduction of the assumptions for the discount rate and the rate of increase in future compensation levels. The expected long-term rate of return on the plans' assets was 10 percent in 1993, 1992 and 1991. The assumptions used to determine the status of the Company's plans were as follows: The information presented above includes an unfunded, nonqualified supplemental executive retirement plan covering certain employees whose participation in the qualified plan is limited by provisions of the Internal Revenue Code. The Company sponsors several defined contribution plans for its employees who are eligible to participate. Participation is voluntary and participants' contributions are based on their compensation. A thrift and profit sharing plan is available for any salaried employee (continued) 30 after completion of one year of continuous service. Company contributions are based on the lesser of (a) participants' contributions up to six percent of each participant's compensation, less any forfeitures, or (b) an amount equal to fifteen percent of the Company's pre-tax earnings in excess of ten percent of stockholders' equity at the beginning of the year. Thrift and profit sharing expense for 1993, 1992 and 1991 was $6,027,000, $5,503,000 and $4,759,000, respectively. Pre-tax savings plans are available for certain hourly employees after completion of 30 days of continuous credited service. The Company has not contributed to these plans. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company currently provides certain health care and life insurance benefits for its active and retired employees. If the Company does not terminate such benefits, or modify coverage or eligibility requirements, substantially all of the Company's United States employees may become eligible for these benefits during their retirement if they meet certain age and service requirements. The Company has reserved the right to modify or terminate such benefits at any time. In recent years benefit changes have been implemented throughout the Company. During the fourth quarter of 1992 the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," retroactive to January 1, 1992. The Standard requires, among other things, that employers use the accrual method of accounting for the cost of providing such benefits in the future. The Company continues to fund these benefit costs as claims are incurred. The cumulative effect of adopting this Standard at January 1, 1992 was a one-time charge to net income of $67,393,000, net of a deferred income tax benefit of $40,797,000, or 81 cents per share. Postretirement benefit costs for years prior to 1992 were recorded on a cash basis and have not been restated. (continued) 31 The discount rate used in determining the APBO was 7.5 percent and 8.5 percent for 1993 and 1992, respectively. The increase in the actuarial present value of the accumulated benefit obligation is due primarily to the reduction of the assumption for the discount rate. At December 31, 1993, the assumed average annual rate of increase in the cost of health care benefits (health care cost trend rate) was 11.75 percent for 1994 declining by .75 percent per year through 1997, by .5 percent per year through 2003, and by .25 percent per year through 2007 when the ultimate rate of 5.5 percent is attained. This trend rate assumption has a significant effect on the amounts reported above. A 1 percent increase in the health care cost trend rate would increase the APBO by $7,900,000 and the net periodic expense by $600,000 for the year. The Company has a Voluntary Employees' Beneficiary Trust and Welfare Benefits Plan (VEBA) to pre-fund future health benefits for eligible active and retired employees. The pre-funded amount was $9,200,000 in 1993 and $8,600,000 in 1992. INCOME TAXES Payments for income taxes in 1993, 1992 and 1991 were $54,712,000, $53,123,000 and $35,782,000, respectively. (continued) During the fourth quarter of 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", retroactive to January 1, 1992. The Company's financial statements for years prior to adoption have not been restated. The cumulative effect of adopting this Standard at January 1, 1992 was a one-time credit to income of $2,433,000, or 3 cents per share. LEASE COMMITMENTS The Company leases certain facilities and equipment under long-term leases expiring at various dates. The leases generally contain renewal or purchase options and provide that the Company shall pay for insurance, property taxes and maintenance. (continued) 33 Rental expense for operating leases was $5,362,000 for 1993, $5,756,000 for 1992 and $6,152,000 for 1991. REPORT OF INDEPENDENT AUDITORS The Board of Directors Cooper Tire & Rubber Company We have audited the accompanying consolidated balance sheets of Cooper Tire & Rubber Company as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cooper Tire & Rubber Company at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the notes to the financial statements, in 1992 the Company changed its methods of accounting for postretirement benefits other than pensions and income taxes. /s/ Ernst & Young ----------------- ERNST & YOUNG Toledo, Ohio February 14, 1994 Exhibit (4) DESCRIPTION OF COMMON STOCK The Company is authorized to issue 300,000,000 shares of Common Stock, par value $1.00 per share. As of March 7, 1994, 83,616,872 shares were issued and outstanding. Each share of Common Stock has equal dividend, liquidation and voting rights. The shares of Common Stock are not redeemable and have no conversion rights. The only rights to subscribe for additional shares of the Company's capital stock are those involved in a Stockholder Rights Plan adopted May 27, 1988 and described in a Rights Agreement between the Company and Society National Bank as Rights Agent. All shares of Common Stock presently outstanding are fully paid and nonassessable. The most restrictive covenants under the Company's loan agreements require the maintenance of $65,000,000 in working capital and limit the payment of cash dividends, purchase or redemption of capital stock and any other cash distributions to stockholders. The amount of retained earnings not restricted under the agreements was $342,886,000 at December 31, 1993. Subject to the foregoing, holders of the Common Stock are entitled to receive such dividends as the Board of Directors may from time to time declare out of funds lawfully available therefor. The Company has paid cash dividends on its Common Stock in each year since 1950. See "Quarterly Financial Data (Unaudited)" presented on page 36 of this Annual Report on Form 10-K for a description of the Company's recent dividend practices. The payment of future dividends will depend on the earnings and financial position of the Company, its capital requirements and other relevant factors. The Company's Board of Directors consists of three classes of directors as nearly equal in number as the total number of directors constituting the entire board permits. By a vote of a majority, the Board of Directors has the authority to fix the number of directors constituting the entire board at not less than six (6) nor more than twelve (12) individuals, and the number is currently set at eleven (11). The term of each class of directors is three years and each class of directors is elected in successive years. The shares of Common Stock have non-cumulative voting rights. The Transfer Agent and Registrar for the shares of Common Stock of the Company is Society National Bank, Cleveland, Ohio. Exhibit (23) CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements of Cooper Tire & Rubber Company listed below, and in the Prospectus related to the Form S-3, of our report dated February 14, 1994, with respect to the consolidated financial statements and schedules of Cooper Tire & Rubber Company included in the Annual Report (Form 10-K) for the year ended December 31, 1993: Form S-3 No. 33-44159 $200,000,000 aggregate principal amount of the Company's Debt Securities Form S-8 No. 2-58577 Thrift and Profit Sharing Plan No. 2-77400 1981 Incentive Stock Option Plan No. 33-5483 1986 Incentive Stock Option Plan No. 33-35071 Texarkana Pre-Tax Savings Plan No. 33-47979 Pre-Tax Savings Plan at the Auburn Plant No. 33-47980 1991 Stock Option Plan for Non-Employee Directors No. 33-47981 Pre-Tax Savings Plan at the Findlay Plant No. 33-47982 Pre-Tax Savings Plan at the El Dorado Plant No. 33-52499 Pre-Tax Savings Plan (Bowling Green - Hose) No. 33-52505 Pre-Tax Savings Plan (Bowling Green - Sealing) /s/ Ernst & Young ----------------- ERNST & YOUNG Toledo, Ohio March 22, 1994 Exhibit (24) POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, in the capacities indicated, do hereby constitute and appoint Ivan W. Gorr, or Stan C. Kaiman, or J. Alec Reinhardt, or Patrick W. Rooney as their attorney with full power of substitution and resubstitution for and in their name, place and stead, to sign and file with the Securities and Exchange Commission an Annual Report on Form 10-K, as amended, together with any and all amendments and exhibits thereto and any and all applications, instruments or documents to be filed with the Securities and Exchange Commission pertaining to such report, with full power and authority to do and perform any and all acts and things whatsoever requisite and necessary to be done in the premises, hereby ratifying and approving the acts of said attorney or any such substitute. Executed at Findlay, Ohio this 14th day of February, 1994. /s/ Delmont A. Davis /s/ John Fahl --------------------------- ----------------------------- Delmont A. Davis, Director John Fahl, Director /s/ Julien A. Faisant /s/ Dennis J. Gormley --------------------------- ----------------------------- Julien A. Faisant, Vice Dennis J. Gormley, Director President and Controller, Principal Accounting Officer /s/ Ivan W. Gorr /s/ Stan C. Kaiman --------------------------- ----------------------------- Ivan W. Gorr, Chairman of the Stan C. Kaiman, Secretary Board, Principal Executive Officer, and Director /s/ William D. Marohn --------------------------- ----------------------------- Joseph M. Magliochetti, William D. Marohn, Director Director /s/ J. Alec Reinhardt --------------------------- ----------------------------- Allan H. Meltzer, Director J. Alec Reinhardt, Executive Vice President, Principal Financial Officer, and Director /s/ Patrick W. Rooney /s/ Leon F. Winbigler --------------------------- ------------------------------ Patrick W. Rooney, President, Leon F. Winbigler, Director Principal Operating Officer, and Director (continued) STATE OF OHIO ) ) ss. COUNTY OF HANCOCK) On this 14th day of February, 1994, before me a Notary Public in and for the State and County aforesaid, personally appeared Delmont A. Davis, John Fahl, Julien A. Faisant, Dennis J. Gormley, Ivan W. Gorr, Stan C. Kaiman, William D. Marohn, J. Alec Reinhardt, Patrick W. Rooney, and Leon F. Winbigler, known to me to be the persons whose names are subscribed in the within instrument and acknowledged to me that they executed the same. IN WITNESS WHEREOF, I have hereunto set my hand and affixed my official seal the day and year in this certificate first above written. /s/ Julie A. Grismore -------------------------------------- Julie A. Grismore Notary Public, State of Ohio My commission expires January 15, 1996 (SEAL) Exhibit (24) POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, in the capacity indicated, does hereby constitute and appoint Ivan W. Gorr, or Stan C. Kaiman, or J. Alec Reinhardt, or Patrick W. Rooney as his attorney with full power of substitution and resubstitution for and in his name, place and stead, to sign and file with the Securities and Exchange Commission an Annual Report on Form 10-K, as amended, together with any and all amendments and exhibits thereto and any and all applications, instruments or documents to be filed with the Securities and Exchange Commission pertaining to the filing of such report, with full power and authority to do and perform any and all acts and things whatsoever requisite and necessary to be done in the premises, hereby ratifying and approving the acts of said attorney or any such substitute. Executed at Toledo, Ohio this 21st day of February, 1994. /s/ Joseph M. Magliochetti -------------------------------- Joseph M. Magliochetti, Director STATE OF OHIO ) ) ss. COUNTY OF LUCAS) On this 21st day of February, 1994, before me a Notary Public, in and for the State and County aforesaid, personally appeared Joseph M. Magliochetti, known to me to be the person whose name is subscribed in the within instrument and acknowledged to me that he executed the same. IN WITNESS WHEREOF, I have hereunto set my hand and affixed my official seal the day and year in this certificate first above written. /s/ Marcia L. Coy-Bauman --------------------------------- Marcia L. Coy-Bauman Notary Public, State of Ohio My commission expires March 27, 1997 (SEAL) Exhibit (24) POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, in the capacity indicated, does hereby constitute and appoint Ivan W. Gorr, or Stan C. Kaiman, or J. Alec Reinhardt, or Patrick W. Rooney as his attorney with full power of substitution and resubstitution for and in his name, place and stead, to sign and file with the Securities and Exchange Commission an Annual Report on Form 10-K, as amended, together with any and all amendments and exhibits thereto and any and all applications, instruments or documents to be filed with the Securities and Exchange Commission pertaining to the filing of such report, with full power and authority to do and perform any and all acts and things whatsoever requisite and necessary to be done in the premises, hereby ratifying and approving the acts of said attorney or any such substitute. Executed at Pittsburgh, Pennsylvania this 24th day of February, 1994. /s/ Allan H. Meltzer -------------------------------- Allan H. Meltzer, Director STATE OF PENNSYLVANIA) ) ss. COUNTY OF ALLEGHENY ) On this 24th day of February, 1994, before me a Notary Public, in and for the State and County aforesaid, personally appeared Allan H. Meltzer, known to me to be the person whose name is subscribed in the within instrument and acknowledged to me that he executed the same. IN WITNESS WHEREOF, I have hereunto set my hand and affixed my official seal the day and year in this certificate first above written. /s/ Richard C. Schaeffer --------------------------------- Richard C. Schaeffer Pittsburgh, Allegheny County My commission expires February 29, 1996 (SEAL) Exhibit (24) POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned does hereby, for and on behalf of Cooper Tire & Rubber Company in accordance with the certain resolution of the Board of Directors adopted February 14, 1994, constitute and appoint Ivan W. Gorr, or Stan C. Kaiman, or J. Alec Reinhardt, or Patrick W. Rooney as its attorney with full power of substitution and resubstitution for and in its name, place and stead, to sign and file with the Securities and Exchange Commission an Annual Report on Form 10-K pursuant to the Securities Act of 1934, as amended, together with any and all amendments and exhibits thereto, and all applications, instruments or documents to be filed with the Securities and Exchange Commission pertaining to the filing of such report, with full power and authority to do and perform any and all acts and things whatsoever requisite and necessary to be done in the premises, hereby ratifying and approving the acts of said attorney or any such substitute. Executed at Findlay, Ohio this 23rd day of February, 1994. ATTEST: COOPER TIRE & RUBBER COMPANY /s/ Stan C. Kaiman /s/ Ivan W. Gorr ------------------------- ----------------------------- Stan C. Kaiman Ivan W. Gorr Secretary Chairman of the Board and Chief Executive Officer STATE OF OHIO ) ) ss. COUNTY OF HANCOCK) On this 23rd day of February, 1994, before me a Notary Public, in and for the State and County aforesaid, personally appeared Ivan W. Gorr and Stan C. Kaiman, known to me to be the persons whose names are subscribed in the within instrument and acknowledged to me that they executed the same. IN WITNESS WHEREOF, I have hereunto set my hand and affixed my official seal the day and year in this certificate first above written. /s/ Julie A. Grismore ---------------------------------- Julie A. Grismore Notary Public, State of Ohio My commission expires January 15, 1996 (SEAL) Exhibit (99) OPERATIONS REVIEW AND PRODUCT OVERVIEW OPERATIONS REVIEW Tire Products INDUSTRY OVERVIEW Following an exceptional year in 1992, industry demand returned to rather normal levels in 1993. Total replacement tire shipments for the year were approximately 199.2 million units, virtually equal to the 1992 total of 199 million units. Industry sales of replacement passenger tires were slightly lower than the prior year, while the light truck and medium truck tire segments showed slight gains. The most popular replacement passenger tires continue to be performance-type, all-season radials. Of the total industry replacement passenger tires shipped during the year, eight out of ten were all-season designs, while half carried speed ratings of S or higher and had aspect ratios in the performance range below 75 series. Light truck tires in the replacement market are following a comparable direction. Four out of five replacement light truck tires shipped are radial construction and three out of five have all-season treads. Speed ratings are also finding application in this market, however, the trend is not significant at this time. Five out of six medium truck tires in the replacement market are of radial construction. Industry shipments of radial medium truck tires to the replacement market increased during the year, while bias tire sales declined. The total inner tube market is declining gradually each year. Within the total units shipped, smaller sized tubes, such as for passenger and light truck tires, are decreasing, while larger tubes for trucks, farm implements and construction vehicles are experiencing increased demand. Factors which indicate consumer buying potential in the replacement industry continue to show favorable trends. The number of passenger car registrations in the U.S. increased by more than a half million vehicles during the year over the 1992 figure. Passenger cars in the U.S. traveled almost 2.3 trillion miles during the year, about 50 billion miles more than in 1992. For the second consecutive year, the average age of a passenger car in the U.S. exceeded 8 years. Combined, these factors show that more vehicles are being driven more miles over a longer period of time which will, consequently, require the purchase of additional replacement tires. The Company distributes its Cooper, Falls Mastercraft and Starfire house brand tires primarily through independent tire dealers, who make up the largest distribution channel in the replacement industry. According to consumer surveys, independent dealers are the most preferred source for retail tire purchases. The expertise and customer service provided by independent dealers prevails as a major consumer benefit. PRODUCTS Cooper manufactures and markets full lines of passenger, light truck and medium truck tires in sizes, tread designs and sidewall styles to meet the application and price demands of the replacement market. (continued) 49 Five new lines of tire products were introduced during the year and received excellent dealer and consumer acceptance. The Cooper Lifeliner Grand Classic STE is a premium radial passenger tire with a treadwear protection warranty of 80,000 miles. The Cooper Cobra GTV replaced the Company's initial V speed-rated high performance passenger tire. Market advantages of this new tire include an all-season tread design for excellent overall traction, increased treadwear, and a non-directional tread pattern, which eliminates special inventory handling. Another passenger tire updated during the year was the Cooper Monogram 2000, an original equipment-style all-season radial. The new Monogram 2000 offers longer treadwear and improved wet traction over the previous design. In the light truck category, the Company introduced the Cooper Discoverer STE, a touring design for all-season use on sport utility vehicles, vans, and small and large pickup trucks. For the first time on a light truck tire line, the Company is offering a free, limited replacement warranty on workmanship and materials for the useful life of the tread. Also introduced in the light truck category, the Cooper Discoverer CTD is a radial traction tire designed for heavy-duty commercial applications, such as in farm and construction work. The Company began previewing its lines of radial medium truck tires to customers during the year, while production continues to increase at the Albany plant. The Cooper CXMT 340 all-wheel position tire and the Cooper CT 240 free-rolling position tire feature all-steel, tubeless radial construction. To the end user, these tires will contribute to lower vehicle operating costs through excellent original treadwear and subsequent recapping for extended life. The Company will add a drive wheel version of the tire to the line in 1994. Other tire products are in development for introduction in 1994. The Company will introduce the Cooper Rainmaster, a non-directional passenger tire which channels water and reduces the potential for hydroplaning in wet weather conditions. Also to be introduced is a new premium touring radial, the Cooper Lifeliner Classic II, with a 60,000-mile treadwear warranty, all-season performance and excellent wet traction. Over forty percent of all new vehicles sold in 1993 were sport utility vehicles, vans and pick-up trucks. Cooper has a strong presence in this market with its large Discoverer line of recreational and commercial LT tires. Additional sizes across the line will be provided in 1994 to meet new vehicle specifications. To verify the quality of new products and existing lines, the Company ran more than 117 million tire miles of tests in controlled laboratory conditions and actual on-the-road trials. Through testing, tire characteristics such as carcass durability, treadwear, handling, traction and noise are evaluated to ensure ultimate quality and consumer satisfaction. The Company's products are of the highest quality and value to compete with leading brands on the market today. (continued) FACILITIES A new tire warehouse was constructed at the Findlay plant to add capacity and improve distribution services to customers. The new 163,000-sq. ft. warehouse enhanced the plant's shipping and receiving operations and allowed the previous warehouse to be converted to manufacturing use. The largest of the Findlay plant's rubber compound mixers was replaced with a new state-of-the-art model, which operates at greater efficiency and provides for needed additional mixing capacity. The Albany plant reached planned production goals for radial passenger, light truck and medium truck tires. More tire building and support equipment was installed during the second half of the year to increase production capacity. The Albany plant provides incremental production expansion opportunity at minimum cost to meet growing demand for Cooper tire products. In January 1993 the Tupelo plant reached a milestone with the production of its 50 millionth radial passenger tire. Equipment upgrades and manufacturing process improvements were installed and implemented during the year, including the application of robotics in the tread extrusion operation to enhance quality and efficiency. Major modernization and improvement projects were completed at the Texarkana facility during the year. All curing presses are now fitted with computer controls and a pre-cure process is being applied to all calendered ply material, reducing production cost and yielding high quality products. During 1994 Texarkana employees will observe the plant's 30th anniversary. Additional capacity for producing large size inner tubes for farm and construction vehicles was installed at the Clarksdale plant. The plant reorganized its technical support group and began a program to reduce production costs by increasing process controls and other manufacturing efficiencies. The Piedras Negras plant began production of engineered rubber products in response to market opportunities in Mexico. Inner tube production continues and is dedicated to high-volume lines of passenger, light truck and medium truck sizes, maximizing the plant's efficiency. Expanded production of engineered rubber parts is planned for the future. The Company follows a strategic and systematic schedule of building and equipment maintenance to protect and preserve its capital investments. Programmed systems provide effective scheduling and controls over vital routine maintenance. TECHNOLOGY Virtually all areas of Cooper tire and tube production have been affected by the application of advanced technologies. The Company and its customers have benefited with improved productivity, lower costs and higher quality. Computers, lasers and robotics are used in many production operations. New materials and rubber compounding chemistry improve product performance and overall quality. Cooper has a competitive advantage in being able to design and build much of its proprietary production equipment. Cost savings and increased quality are usually derived from custom-designed equipment. (continued) The Company uses unique, sophisticated tire assembly equipment for passenger, light truck and medium truck tires and is currently implementing new and efficient methods of supplying components in the tire assembly operation. Projects include equipment development to measure aspects of finished products with greater precision for more advanced data collection and analysis. A new system for computer-aided analysis and computer-aided design was installed for mold design operations. The system is expected to reduce mold design time by half, contributing significantly to the Company's ability to respond to customer needs and reduce product launch time. Over the years, Cooper has been an industry leader in obtaining higher tire production rates from its equipment. For example, employee teams have fitted curing presses with specialized computer controls and optical scanners to monitor and adjust curing cycles. Shaving even seconds off a curing cycle can result in significant production increases. Improved production efficiencies have been achieved in many operations resulting in increased competitiveness. MARKETING AND DISTRIBUTION The Company markets its Cooper, Falls Mastercraft and Starfire house brand products primarily through independent dealers and distributors. A 1993 study of the replacement tire industry by J. D. Power and Associates confirmed that independent tire dealers and service stations are viewed by consumers as providing the most expertise for tire purchases, installation and service. Company marketing programs are designed to help position Cooper dealers prominently in their local markets. Two other industry surveys conducted during the year by Tire Review magazine confirmed the Company's excellent service to customers. In the annual Tire Brands Survey, independent dealers rated their suppliers on a number of criteria. Another survey, the annual Tire Dealer Profile, asked independent dealers to rank their most critical needs and concerns. A cross comparison of the two studies shows Cooper scores very high in meeting critical dealer needs, particularly dealer profitability, product availability, total service and ease of doing business. The Company introduced an advertising theme during the year which continued to differentiate Cooper's independence and 100 percent American-made tires from competitors. The theme, "Put Your Trust in American Hands," was used throughout Cooper's national consumer advertising in USA TODAY and on Paul Harvey's syndicated radio broadcasts. Trade advertising also carried the theme, as well as retail materials for dealer use in the Company's cooperative advertising program. Cooper will continue an American-made, American-owned message in its 1994 campaign and expand its media coverage to include national television and consumer automotive magazines. Cooper's network of distribution centers, located strategically around the country, efficiently serve its customers. A computerized information system has streamlined inventory, shipping and receiving operations to fill orders and provide timely shipments to customers. (continued) Limited treadwear protection warranties, ranging from 40,000 miles to 80,000 miles, are offered on five tire lines. Consumers consider mileage warranties an important factor in the tire purchase decision. Highly promoted by dealers, the Cooper warranty program is very competitive with other industry brands. New packaging and labeling processes instituted for inner tube operations are designed to improve product handling. Pallet quantities have been optimized for ease of shipping and storage for customers. In its national advertising and on product information materials, the Company provides a toll-free number for consumers to call to locate their nearest Cooper dealer. The number, 1-800-854-6288, is staffed weekdays during normal business hours. Telephone calls are answered by members of the Cooper team who provide assistance to customers and consumers. Engineered Products INDUSTRY OVERVIEW The Company expects continuing strong demand for its engineered rubber products. The number of new passenger and light truck vehicles produced in the U.S. and Canada during the year was approximately 13 million vehicles, up about 12 percent over the 11.7 million vehicles produced in 1992. About a 10 percent growth rate for North American vehicle production is anticipated by industry economists in 1994. According to industry experts, automobile manufacturers use approximately 134 pounds of rubber components per vehicle, excluding tires. This would indicate the automotive market for engineered rubber products for safety, sealing, convenience and comfort was in excess of 1.7 billion pounds in 1993. There is excellent opportunity for Cooper to expand in this area as a result of its expertise in design, technical and production capabilities. Automotive manufacturers continue to reduce their supplier base in order to simplify administration of the supply process and to realize cost savings from higher volume orders. They require suppliers to provide consistent product quality, on-time deliveries, advanced technical support, and competitive costs and value in order to remain a preferred supplier. As a result of this trend, Cooper is in an excellent position to strengthen its partnerships with automakers. The Company has established a reputation for excellent quality levels, and demonstrated its technical expertise in specific product development. About 99 percent of the Company's vibration control, hose, body sealing and seating products are sold directly to vehicle manufacturers or their primary (tier 1) suppliers. Almost 200 customers are served by the engineered products operation. FACILITIES A second manufacturing plant in Bowling Green, Ohio, was built to accommodate increased demand for both hose and body sealing products. All hose production was moved to the new facility, allowing body seal production to expand at the original plant. Completed on time and under budget, the new hose plant is in full production. (continued) No major plant construction projects are currently planned for engineered products in 1994. New production lines and equipment will be installed at all facilities to increase production capacity and meet customer commitments. The third phase of the Auburn expansion -- the rubber mixing facility -- was completed during 1993. Currently supplying rubber compounds to the Company's engineered products plants in Ohio and Indiana, the new mixer offers greater automation for improved quality controls and operating cost efficiencies. Further expansion phases are scheduled for 1995. Many manufacturing operations have been converted to a cellular configuration. Improved production scheduling and significant inventory and work-in-process reductions have been realized. The reorganization has also resulted in improved product quality and customer service. A reconfiguration of the El Dorado plant in 1994 will optimize process flow, modernize mixing operations, and result in improved manufacturing capabilities and overall efficiency. Production of molded products at the Piedras Negras plant was begun during 1993 and certified for quality on an interim basis. Direct shipments to automotive customers in Mexico will continue to be made from the plant and full certification will be granted in 1994. Tooling is under way for new business which will start production at the plant in mid-1994 and represent a significant volume increase in engineered products sales to Mexican manufacturers. In 1994 additional equipment will be installed in all plants to begin fulfilling orders for 1995 model year products, as well as initial 1996 requirements. PRODUCTS Cooper is one of the most complete engineered rubber component suppliers in the industry. Its extensive manufacturing capabilities include the basic processes of molding and extrusion, including high-technology dual-durometer extrusion, flocking and rubber-to-metal bonding. Cooper has the engineering, technology and research facilities to serve as a development partner with its automotive customers for vehicle design and performance applications. Vibration control products, such as body, cradle and engine mounts, vary in complexity and are used to absorb vibrations throughout the vehicle. Products currently in production for 1994 vehicle models are the result of development projects ranging over several years. Slight alterations in vehicle engine configurations from model year to model year significantly modify hoses and hose assembly requirements. Cooper has proven its ability to respond quickly to design changes. The Company supplies hoses for virtually all categories of passenger vehicles and light trucks made in North America, and branched hose components using the Diradia (Reg. USPTO by Caoutchouc Manufacture et Plastiques) process for the three largest automakers. Body seals around vehicle doors, trunks, hoods and windows prevent water, wind and dust from entering the inside of the vehicle. Done properly, seals also serve as noise barriers. The products often contain both hard and soft rubber compounds, plus metal carriers for attachment and decoration. (continued) The Company's line of seating components is produced for a specialized market. Inflatable comfort bladders are specified primarily for upscale vehicles or as optional equipment on other models. Made from urethane, the inflatable bladders can be positioned anywhere in the seat. Vehicle design and development is a complex process requiring the cooperation of many different suppliers. Due to the long lead time from concept to production, original equipment manufacturers and their suppliers are working with vehicle designs intended for 1998 introductions. Through its design and manufacturing capability, the Company is well-represented in these on-going projects. TECHNOLOGY The auto industry has been challenged to develop a high-mileage "supercar" within the next decade. Along with an 80-miles-per-gallon capability, automotive designers are specifying active control systems and lightweight, high-temperature resistant materials among other innovative ideas. Cooper has product development and service capabilities which are very compatible with these automotive design requirements of the future. Active noise and vibration control systems with electronic sensors have a high priority in future vehicle designs. In 1992 Cooper launched an intensive program to produce a working prototype of an actively controlled engine mount. The prototype will be demonstrated to customers on a test vehicle in 1994. Cooper is also developing 'active' vibration control systems technology for applications on other vehicle components. Engine materials that withstand very high temperatures are targeted components for future development projects. For several years, Cooper has been testing and developing formulas using various polymers with high temperature resistance for use in its lines of engine hose products. Cooper has long established its ability to support customers with product design capability. Using the latest computer-aided design equipment and advanced computer modeling programs, Company engineers provide component design service throughout the vehicle design process, including "black box" (total design) and "gray box" (partial design) assignments. Cooper's partnerships with customers employ direct electronic communication for complete documentation of work, support services, and efficient, just-in-time deliveries. MARKETING AND DISTRIBUTION Cooper has been providing product design and development services to automotive manufacturers for many years. The development and introduction of new products into the manufacturing process is accomplished by close teamwork and cooperation from many individuals representing many disciplines. At the onset of a design project, members of the Company's engineering, manufacturing and quality control staffs join with customer representatives to form a product development team. This early involvement permits the Company's project team members to help optimize the component design for efficient, high quality and cost effective manufacturing. (continued) 55 The Company uses advanced inventory handling and storage methods in its distribution operations to provide excellent service to customers around the world. Warehoused products are inventoried using an on-line, real-time electronic information system. Optical scanning devices aid in ensuring correct shipments and in generating electronic documentation. Approximately 20 percent of the Company's engineered products sales are exported to customers primarily in Canada, Mexico, Europe, Australia and South America. Cooper is a proven and established member of the world automotive supplier base. The Company continues to improve its operations, expand its capabilities and strengthen its service levels for greater business opportunities in the future. PRODUCT OVERVIEW Tire Products PASSENGER TIRES: The 15 lines of passenger tires include touring, high performance and conventional designs. Speed ratings of S, T, H and V are also offered as well as standard and low profiles, all-season, rib and high traction treads, and white, white lettered and black sidewalls. LIGHT TRUCK: Light truck tires in 13 lines fit pickup trucks, vans and sport utility vehicles for either recreational or commercial use. Lines include all-steel radial, steel-belted radial and conventional bias constructions, all-season, rib and high traction treads, and white and black lettered sidewalls. MEDIUM TRUCK: Ten lines of medium truck tires include all-steel radial and conventional bias ply constructions, all-wheel, drive wheel and trailer applications, and rib and traction treads for on-road and off-road service. Medium truck tires fit vehicles such as tractor-semitrailer rigs. INNER TUBES: Inner tubes are offered in radial and bias constructions for passenger, light truck and medium truck applications. The size range covers specialty tires such as farm tractors and implements, road graders and industrial vehicles. Engineered Products VIBRATION CONTROL: These products are used throughout vehicle engines, bodies and powertrains to minimize the amount of vibrations reaching the passenger compartment. Product lines include mounts, bushings, isolators and torsional springs. BODY & WINDOW SEALING SYSTEMS: Rubber seals around doors, trunks and hoods protect vehicle interiors from outside elements. Flocked window channels allow glass panels to slide open and closed easily while still providing a tight weather seal. HOSES: Hoses are used primarily in the engine to transport fluids and gases. Different shapes, sizes, diameters, lengths, rubber compounds and constructions are produced to meet vehicle engine configurations. SPECIALTY SEATING COMPONENTS: Inflatable bladders are placed in various sections of a passenger seat for adjustable comfort. Production includes single- and multi-cell bladders from rubber or polyurethane and provides both manual and electronic inflation systems. A thin-line seat suspension system is also offered under a licensing agreement. Exhibit (99) COOPER TIRE & RUBBER COMPANY UNDERTAKINGS OF THE COMPANY FOR FISCAL YEAR ENDED DECEMBER 31, 1993 1. Undertakings. ------------ a. The undersigned registrant hereby undertakes: 1. To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: i. To include any prospectus required by section 10(a)(3) of the Securities Act of 1933; ii. To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represents a fundamental change in the information set forth in the registration statement; iii. To include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement; Provided, however, that paragraphs (a)(1)(i) and (a)(1)(ii) do not apply if the registration statement is on Form S-3 or Form S-8 and the information required to be included in a post-effective amendment by those paragraphs is contained in periodic reports filed by the registrant pursuant to section 13 or section 15(d) of the Securities Exchange Act of 1934 that are incorporated by reference in the registration statement. 2. That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. 3. To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering. b. The undersigned registrant hereby undertakes that, for purposes of determining any liability under the Securities Act of 1933, each filing of the registrant's annual report pursuant to section 13(a) or section 15(d) of the Securities Exchange Act of 1934 (and, where applicable, each filing of an employee benefit plan's annual report pursuant to section 15(d) of the Securities Exchange Act of 1934) that is incorporated by reference in the registration statement shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. f. Employee plans on Form S-8. 1. The undersigned registrant hereby undertakes to deliver or cause to be delivered with the prospectus to each employee to whom the prospectus is sent or given a copy of the registrant's annual report to stockholders for its last fiscal year, unless such employee otherwise has received a copy of such report, in which case the registrant shall state in the prospectus that it will promptly furnish, without charge, a copy of such report on written request of the employee. If the last fiscal year of the registrant has (continued) 57 ended within 120 days prior to the use of the prospectus, the annual report of the registrant for the preceding fiscal year may be so delivered, but within such 120 day period the annual report for the last fiscal year will be furnished to each such employee. 2. The undersigned registrant hereby undertakes to transmit or cause to be transmitted to all employees participating in the plan who do not otherwise receive such material as stockholders of the registrant, at the time and in the manner such material is sent to its stockholders, copies of all reports, proxy statements and other communications distributed to its stockholders generally. 3. Where interests in a plan are registered herewith, the undersigned registrant and plan hereby undertake to transmit or cause to be transmitted promptly, without charge, to any participant in the plan who makes a written request, a copy of the then latest annual report of the plan filed pursuant to section 15(d) of the Securities Exchange Act of 1934 (Form 11-K). If such report is filed separately on Form 11- K, such form shall be delivered upon written request. If such report is filed as a part of the registrant's annual report on Form 10-K, that entire report (excluding exhibits) shall be delivered upon written request. If such report is filed as a part of the registrant's annual report to stockholders delivered pursuant to paragraph (1) or (2) of this undertaking, additional delivery shall not be required. i. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 2. Indemnification of Directors and Officers. ----------------------------------------- Article VII of the Bylaws of the registrant and Section 145 of the Delaware Code provide for indemnification. Article VII, in which registrant is referred to as "Corporation", provides as follows: Section 1. Right to Indemnification. --------- ------------------------ Each person who was or is made a party or is threatened to be made a party to or is involved in any action, suit or proceeding, whether civil, criminal, administrative or investigative (a "proceeding"), by reason of the fact that he, or a person of whom he is the legal representative, is or was a director or officer of the Corporation or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation or a partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans maintained or sponsored by the (continued) 58 Corporation, whether the basis of such proceeding is alleged action in an official capacity as a director, officer, employee or agent or in any other capacity while serving as a director, officer, employee or agent, shall be indemnified and held harmless by the Corporation to the fullest extent authorized by the Delaware General Corporation Law, as the same exists or may hereafter be amended (but, in the case of any such amendment, only to the extent that such amendment permits the Corporation to provide broader indemnification rights than said Law permitted the Corporation to provide prior to such amendment), against all expense, liability and loss (including attorneys' fees, judgments, fines, excise taxes pursuant to the Employee Retirement Income Security Act of 1974 or penalties and amounts paid or to be paid in settlement) reasonably incurred or suffered by such person in connection therewith and such indemnification shall continue as to a person who has ceased to be a director, officer, employee or agent and shall inure to the benefit of his or her heirs, executors and administrators; provided, however, that the Corporation shall indemnify any such person seeking indemnification in connection with a proceeding (or part thereof) initiated by such person only if such proceeding (or part thereof) was authorized by the Board of Directors. The right to indemnification conferred in this Article shall be a contract right and shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition; provided, however, that if the Delaware General Corporation Law requires, the payment of such expenses incurred by a director or officer in his or her capacity as a director or officer in advance of the final disposition of a proceeding, shall be made only upon delivery to the Corporation of an undertaking, by or on behalf of such director or officer, to repay all amounts so advanced if it shall ultimately be determined that such director or officer is not entitled to be indemnified under this Article or otherwise. The Corporation may, by action of its Board of Directors, provide indemnification to employees and agents of the Corporation with the same scope and effect as the foregoing indemnification of directors and officers. Section 2. Non-Exclusivity of Rights. --------- ------------------------- The right to indemnification and the payment of expenses incurred in defending a proceeding in advance of its final disposition conferred in this Article shall not be exclusive of any other right which any person may have or hereafter acquire under any statute, the Restated Certificate of Incorporation, these Bylaws, agreement, vote of stockholders or disinterested directors or otherwise. Section 3. Insurance. --------- --------- The Corporation may maintain insurance, at its expense, to protect itself and any director, officer, employee or agent of the Corporation or another corporation, partnership, joint venture, trust or other enterprise against any such expense, liability or loss, whether or not the Corporation would have the power to indemnify such person against such expense, liability or loss under the Delaware General Corporation Law. The registrant also maintains policies insuring the liability of the registrant to its directors and officers under the terms and provisions of the Bylaws of the registrant and insuring its directors and officers against liability incurred in their capacities as such directors and officers.

96977_1993.txt

96977_1993

1993

96977

Item 1. BUSINESS ________ Introduction ____________ PTI was organized in 1955 to provide telephone service to suburban and rural communities principally in the Pacific Northwest. Since that time, the Company has grown significantly through acquisitions and expanded its service offerings in several areas within the telecommunications industry. This expansion included the provision of long distance services in the State of Alaska, investments in cellular telephone operations and international communications, including the construction of a trans-Pacific fiber optic cable. Over the past few years, the Company's strategy has been to focus on its core business of providing local exchange service to suburban and rural markets and to divest its diversified portfolio of noncore businesses. This strategy is being implemented through the acquisition of LECs, the sale of certain international operations, the consolidation and sale of cellular holdings, and ongoing efforts to achieve a satisfactory restructuring of the Alaska long distance marketplace. With the completed sale of TRT and upon closing of the pending sale of two additional noncore operations, the Company will have exited from all of its material noncore businesses. PTI has been a majority-owned subsidiary of PacifiCorp since 1973. At December 31, 1993, PacifiCorp beneficially owned approximately 87 percent of PTI's common stock. Telecommunications Operations _____________________________ Local Exchange Companies ________________________ The Company's LECs operate under a common business name and logo, PTI Communications. This marketing concept was established in 1991 to create a unified identity for the local operations, improve communication with customers and assist in the marketing of new products and services. As one of the major independent telephone companies in the U.S., the Company's LECs provide both local telephone service and access to the long distance network for customers in their respective service areas. The Company presently operates 20 LECs within eleven states comprised of 398,700 access lines in 253 exchanges. The average number of access lines per exchange is approximately 1,576, reflecting the lower population density generally found in the Company's service areas which are rural in nature. The Company's largest exchange in terms of access lines is in Kalispell, Montana, which had 21,976 access lines at December 31, 1993. Service areas are located primarily in the states of Alaska, Montana, Oregon, Washington and Wisconsin. States also served, but to a lesser extent, include Colorado, Idaho, Iowa, Minnesota, Nevada and Wyoming. (See "Regulation - General.") The Company provides service to its suburban and rural customer base through centralized administrative services. During the five years ended December 31, 1993, the number of access lines served by the Company increased from 239,600 to 398,700. Approximately 69,000, 3,200 and 1,100 access lines were added in 1990, 1992 and 1993, respectively, as a result of the acquisitions of several LECs located in the Midwest. The LECs have also experienced strong internal access line growth in certain service areas, as evidenced by a five percent increase in access lines served during 1993. The Company anticipates that access line growth in the future will come from population growth in current service areas and acquisitions. - 4 - The Company's LECs have replaced virtually all of their electromechanical switches with digital switches that provide significant space savings, higher reliability and expanded business and residential service capabilities. High volume traffic routes continue to be upgraded with fiber optic or digital microwave systems to meet customer needs for special services. The fiber optic systems provide increased transmission capabilities at a lower cost. Basic exchange telecommunications radio systems have been installed to provide local service to new and existing customers in more remote areas. The Company has nearly completed the conversion of all multi-party lines to single-party lines. Approximately one percent of the Company's access lines were multi-party at the end of 1993. The LECs have contracts with interexchange carriers under which the Company provides billing and collection services. During 1992, the Company signed an agreement to provide these services for AT&T through 2001, and an agreement with Independent NECA Services, a clearinghouse service bureau, to provide these services for other carriers for a minimum of two years. In Alaska, the Company's LECs have similar agreements with Alascom. In addition to its basic telephone service, the Company offered enhanced services, such as caller identification, name display, automatic call back, auto recall and call trace, to certain areas of Washington on a trial basis under the Custom Local Area Signaling Service (CLASS). The Company began providing these services in Washington on a permanent basis in January 1994 and plans to make enhanced services available on a trial basis to other service areas during 1994. The Company's existing switching equipment provides these services with minimal software and hardware enhancements. Some of the Company's switching equipment also has other enhanced service capabilities, such as voice messaging and call forwarding, that are being offered to certain of its customers in Washington. The LECs also sell and lease, on a nonregulated basis, customer premise (i.e., telephone) equipment primarily for use by residential customers. As part of this program, residential and business customers are offered maintenance services on a monthly fee basis. The Company continues to seek expansion of its local exchange operations through acquisition. In July 1993, the Company acquired Casco Telephone Company (Casco), an LEC in Wisconsin, for cash and shares of the Company's common stock aggregating approximately $4.7 million. The Company acquired shares in the market in an amount approximating those used in the acquisition. Casco has approximately 1,100 access lines, 1,100 cable television subscribers and 18,900 pro-rata cellular POPs in Wisconsin. In August 1993, the Company signed a definitive agreement with USWC under which the Company would acquire certain rural telephone exchange properties in Colorado. The properties represent 45 exchanges that serve approximately 50,000 access lines. The Company will pay approximately $207 million for these properties at closing, subject to a purchase price adjustment mechanism, based principally on the estimated book value of the assets to be acquired. Current estimates of book value indicate that the purchase price may be less than $207 million. The Company intends to fund the Colorado acquisition through external debt and internally generated funds. In an attempt to satisfy certain regulatory concerns in Colorado, the Company also entered into a construction contract with USWC in July 1993 that requires the Company to construct and upgrade plant in the properties subject to the agreement. Under the contract, the Company acts as general contractor for USWC. The construction and upgrade program will accelerate single-party - 5 - service and digital switching required by the CPUC. During 1993, the Company spent $5.7 million under this contract. Expenditures of $28 million are projected to be made under the contract in 1994. If the transaction does not close, USWC is required to reimburse the Company for all of the Company's expenditures under the construction contract including interest. The Company filed an application for approval of the transaction with the CPUC in August 1993 and approval, with conditions, was received in early March 1994. The parties to the transaction are reviewing the conditions of the CPUC approval. The Company has also submitted filings with the FCC in which the Company has requested waivers from the FCC to reclassify the exchanges from USWC's study area in Colorado to the Company's study area in Colorado and to permit rate of return regulation on the exchanges being acquired. Approval of the study area waiver would qualify these exchanges for receipt of support from the USF, as the cost to provide service in these exchanges exceeds the national average. Approval of rate of return regulation would allow the Company to replace the incentive regulation adopted for these exchanges by USWC. (See "Regulation - Local Exchange Companies.") Certain local government approvals may also be needed. Transition planning efforts have commenced and the Company expects to close the transaction in late 1994. On March 15, 1994, the Company signed letters of intent with USWC to acquire certain rural exchange properties located in Oregon and Washington from USWC for $183 million in cash, subject to certain purchase price adjustments at closing. These properties represent 49 exchanges that serve approximately 34,100 access lines. Many of these exchanges are contiguous to or located near exchanges that the Company owns and operates in these states. The transaction is subject to negotiation of a definitive purchase agreement with USWC, which is expected to be completed in early April. Completion of the transaction will also be dependent on corporate, regulatory and governmental approvals, all of which should be received by late 1994 or early 1995. The Company expects to fund the acquisition of these properties through the issuance of external debt and the use of internally generated funds. Long Lines __________ Through Alascom, the Company provides intrastate and interstate MTS, WATS, private line, leased channel and other communications services within Alaska and between Alaska and the rest of the world. Alascom's facilities interconnect with 22 LECs and the military bases within Alaska and with the interstate and international long distance network. Virtually all services are provided in accordance with tariffs filed with the appropriate regulatory agencies. (See "Regulation - Long Lines - Interstate Revenues" for information concerning Alascom's settlements arrangement with AT&T for interstate services.) Alascom uses both satellite and terrestrial facilities in providing service. In August 1991, Alascom transferred all interstate MTS and certain interstate private line services from satellite facilities to the Alaska Spur. (See "Telecommunications Operations - Pacific Telecom Cable.") Satellite facilities continue to provide intrastate MTS, WATS and private line services, link remote areas of Alaska to the long distance network (both interstate and intrastate) and serve as alternate routing for vital customer services. - 6 - Alascom operates 17 satellite transponders on Aurora II, a communication satellite that replaced Alascom's original satellite in 1991. Alascom purchased one transponder in July 1993 and leases 16 transponders under an operating lease that expires in mid-1998. Telemetry, tracking, control and in-orbit protection services are provided under contract by GE American Communications, Inc. for the projected service life of the satellite. Alascom owns 168 satellite transmit and receive earth stations (including nine transportable earth stations), a 50 percent interest in 46 earth stations used generally for service throughout Alaska and 10 additional earth stations located in the lower 48 states, Hawaii, Panama, Russia and Saudi Arabia. Alascom routinely upgrades earth stations with digital technology to provide enhanced communication services. Approximately 70 percent of the earth station circuits are digital. Alascom has digital switching equipment located at its toll centers in Anchorage, Fairbanks and Juneau. It also owns and operates major terrestrial microwave systems (primarily digital) that provide communications between Anchorage and Fairbanks and Anchorage and the cities on the Kenai Peninsula. The microwave system also interconnects Anchorage with leased Canadian facilities at the Canadian border and with Haines, Juneau and Ketchikan in the rugged terrain of southeastern Alaska. Alascom owns and operates the communications system along the Trans-Alaska Pipeline that is used to monitor and control the flow of oil through the pipeline. Alaska's geographic location makes the state strategically important for the military. Alascom has numerous private line facilities serving the government, including several transportable earth stations used to support military communication needs. In 1993, the Company sold four transportable earth stations to the U.S. Department of Defense. Alascom continues to operate one transportable earth station in Saudi Arabia, which provides telecommunication services under an agreement with the U.S. Department of Defense. Alascom is participating in a joint venture providing international MTS and private line service to several locations in the eastern part of Russia. Alaska Market Restructuring ___________________________ In 1985, the FCC established a Federal-State Joint Board (FCC CC Docket No. 83-1376) to review the interstate market structure of Alaska and to reconcile various existing and emerging federal policies affecting universal service, rate integration and competition. On October 29, 1993, the Federal-State Joint Board released a Final Recommended Decision (FRD), which proposed modifications to the existing structure for interstate service in and to Alaska. Among other matters, the FRD proposed termination of the JSA between Alascom and AT&T, effective September 1, 1995; the payment by AT&T to Alascom of $150 million for accelerated cost recovery in two equal installments of $75 million each on March 1, 1994 and September 1, 1995; a requirement that AT&T continue to utilize Alascom's facilities for the origination and termination of interstate traffic on a declining scale for a period of two and one-half years following termination of the JSA; and the creation by Alascom of an interstate tariff for carrier services based upon an as yet to be developed allocation of costs between rural and nonrural locations. On November 29, 1993, Alascom filed an Application for Review (Application) of the FRD with the FCC. In the Application, Alascom cited multiple substantive and procedural errors contained in the FRD, which it believes render the FRD legally defective and contrary to the public interest. - 7 - AT&T and GCI subsequently made filings in opposition to Alascom's Application. To date, the FCC has taken no action on either the FRD or Alascom's Application. By statute, the FCC has the sole and final authority with respect to issues in this proceeding, and may adopt, modify and adopt, or reject the FRD. As a practical matter, since a majority of the FCC Commissioners sit on the Joint Board, final actions taken by the FCC often reflect the recommendations of the Joint Board. On October 12, 1993, the Company and AT&T entered into an agreement, under which the parties may exchange proprietary information relating to Alascom's structure and operations. The purpose of the agreement was to promote the possibility of a negotiated resolution of some or all of the outstanding issues relating to the JSA and the restructuring of the Alaska interstate market. Under the terms of the agreement, the substance and progress of any negotiations between the parties are generally not disclosable. Alascom continues its efforts to correct perceived errors in the FRD and to achieve a satisfactory alternative resolution to the Alaska interstate market issues, but is unable to predict the outcome of this matter. Cellular Operations ___________________ The Company's wholly-owned subsidiary, PT Cellular, is a holding company with subsidiaries in Alaska, Michigan, Minnesota, Oregon, South Dakota, Washington and Wisconsin. The Company has ownership interests with respect to 29 MSAs and RSAs and manages 11 of these interests in Alaska, Michigan, South Dakota and Wisconsin. The Company also manages five other RSA interests in Minnesota. Revenues from cellular operations represented approximately two percent of total Company revenues in 1993. Cellular mobile telephone service is being provided or developed in areas designated as RSAs or MSAs within boundaries defined by the FCC. Cellular systems provide local and long distance telephone services through mobile radio telephones (cellular phones) that are generally either hand-held or mounted in vehicles. These cellular phones transmit and receive radio signals to and from transmitter, receiver and signaling equipment (cell sites). Cell sites in an RSA or MSA are located in a manner that will allow for the most complete coverage of an area. Each cell site is connected to a switching facility that controls the cellular system of the specific RSA or MSA and connects the cellular customer to the conventional wireline local and long distance telephone networks or to other cellular phone users in the area. The following table sets forth the Company's POP ownership by state as of December 31, 1993. (1) Represents interests with respect to RSAs and MSAs where the Company has an ownership position and manages the operations. - 8 - The Company plans to increase its ownership interests in certain cellular properties in order to achieve ownership control and to consolidate the Company's cellular service areas into larger contiguous units for operating efficiencies. This plan may be accomplished through the exchange of existing cellular interests and/or future acquisitions. In 1993, the Company sold its interests in an RSA where it had a noncontrolling position and exchanged an RSA where it had a controlling position. In 1993, the Company also increased its ownership interests in an RSA and gained a controlling interest in an MSA, both of which are in Wisconsin. The Company recognized after-tax gains on these transactions totaling $.8 million. The Company has budgeted $17.9 million for the development of cellular operations over the next three years. In 1993, the Company obtained 18,900 pro-rata POPs through an LEC acquisition in Wisconsin and another 75,150 POPs in Wisconsin through the purchase of certain cellular ownership interests. All of the cellular properties in which the Company has an ownership interest are operational. Customers served by the cellular operations controlled by the Company increased 65 percent in 1993, 70 percent in 1992 and 100 percent in 1991. Pacific Telecom Cable _____________________ PTC, which is owned 80 percent by PTI and 20 percent by Cable & Wireless plc (C&W), a United Kingdom corporation, is involved in the operation, maintenance and sale of capacity of a submarine fiber optic cable between the U.S. and Japan, known as the North Pacific Cable. The eastern end of the cable is operated by PTC. The western end is operated by International Digital Communications, Inc. (IDC), a Japanese corporation. Major IDC shareholders include C. Itoh & Co., Ltd, Toyota Motor Corporation, Pacific Telesis International and C&W. The North Pacific Cable is the first submarine fiber optic cable to provide direct service between the U.S. and Japan. In addition, through the Alaska Spur, it provides the first digital fiber optic link between Alaska and the lower 48 states. Service between the U.S. and Japan is carried on three, 420 Mbit/s digital fiber optic pairs, providing a total capacity of 1,260 Mbit/s. Service between Alaska and the lower 48 states is carried on one, 420 Mbit/s digital fiber optic pair. On the eastern end, the cable lands at Pacific City, Oregon and Seward, Alaska. From the landing stations, traffic is transmitted to carrier access centers near Portland, Oregon and Anchorage, Alaska for interconnection with digital communications facilities serving the lower 48 states and Alaska and with facilities transmitting traffic to foreign countries. In 1991, PTC sold capacity on the Alaska Spur and capacity in the landing station facilities at Pacific City, Oregon and Seward, Alaska to Alascom for approximately $56 million. In December 1992, Alascom sold 11 percent of the Alaska Spur's capacity to GCI. On the western end, the cable lands at Miura, Japan, and traffic is transmitted to IDC's carrier access centers in Tokyo, Yokohama and Osaka for interconnection with Japanese domestic service providers. For service to points beyond Japan, IDC has constructed a 75-mile submarine cable from Miura to Chikura where it interconnects with other international cables. IDC also participates in the Asia Pacific Cable system that links Miura with Hong Kong, Singapore, Taiwan and Malaysia. Construction and laying of the North Pacific Cable were completed in December 1990, the system was made available for commercial traffic in May 1991 and final system acceptance occurred in November 1991. - 9 - Forty-one private and government-owned telecommunications firms representing 25 countries have purchased approximately 51 percent of the cable's 17,010 circuit capacity. PTC recognized revenues of $4.9 million in 1993, $10.8 million in 1992 and $30.9 million in 1991 related to cable and backhaul capacity sales, excluding the Alaska Spur revenues. The cable system is operating under a warranty of one to eight years depending on the component of the system. The cable contractor has agreed to certain remedies, including providing industry support programs and enhanced repair arrangements. The Company reduced the cable inventory carrying value by $19.2 million in 1993 as a result of the agreement with the cable contractor and increased cash and accounts receivable by a corresponding aggregate amount. PTC continues to market the remaining 49 percent of unsold capacity. Marketing efforts have included the completion of tests demonstrating the feasibility of transmitting international high-quality television signals via fiber optics using the North Pacific Cable. Based on the Company's estimates of growth in trans-Pacific demand for communications capacity and the availability of other sources of capacity over the next five years, PTC believes that a majority of the remaining capacity can be sold in that time frame. PTC, IDC and C&W (Founders) are responsible for procuring maintenance for the North Pacific Cable and have renewed the existing maintenance arrangements with Cable & Wireless (Marine) Limited for an additional five- year period beginning in April 1994. Thereafter, the contract has annual renewal options for up to five years. The Founders continue to seek arrangements for a maintenance vessel to be available for service on the western end of the cable. The majority of maintenance service costs are passed on to owners of capacity on the cable. PT Transmission provides restoration services for the eastern end of the North Pacific Cable under the terms of its tariff. In the event of a cable failure, restoration services are provided via a PT Transmission satellite earth station located at Moores Valley, Oregon. International Communications ____________________________ Since 1990, the Company had reported ICH as a discontinued operation for financial statement reporting purposes. In October 1993, the Company purchased the remaining minority interest in ICH, which held investments in international telecommunications subsidiaries, including TRT. TRT provides international record messaging, message telephone and private line service between the U.S. and foreign countries, as well as special domestic communications services. The 14.9 percent minority interest in ICH was purchased from a subsidiary of France Cables et Radio. On September 23, 1993, the Company completed the sale of TRT, the major operating subsidiary of ICH, and a smaller subsidiary, to IDB for 4.5 million shares of IDB common stock and $1 million in cash. The agreement provided for the transfer of certain tangible assets and lease obligations from TRT to ICH. Based on the market value of IDB stock at closing, the Company recognized an after-tax gain from discontinued operations of $60.4 million on the sale of TRT and the smaller subsidiary. The IDB common stock was registered and sold in a secondary public offering in November 1993 and the Company received $45 per share before commissions and expenses. The $190.9 million in proceeds received by ICH from the sale of IDB - 10 - stock was paid to PTI in the form of intercompany note repayments and dividends. PTI used these funds to reduce its long-term and short-term debt. (See Notes 3, 4 and 12 to the Consolidated Financial Statements incorporated herein by reference.) Other Communications Subsidiaries and Partnerships __________________________________________________ In May 1984, the Company entered into a 50 percent partnership, Bay Area Teleport, involved in designing, constructing, operating and marketing a regional microwave system and satellite earth station complex near San Francisco, California. During 1991, the partnership was restructured. Under the restructure agreement, the Company received 100 percent of Bay Area Teleport, which is currently held by PTI Harbor Bay, Inc., a wholly-owned subsidiary. After the restructure, Bay Area Teleport was reorganized into two corporations, Niles Canyon Earth Station, Inc. (Niles Canyon), which provides satellite uplink and downlink services, and Bay Area Teleport, Inc., which provides transmission services principally in the greater San Francisco Bay Area. In the transaction involving the sale of TRT, the Company also sold Niles Canyon to IDB. Proceeds related to the sale of the IDB stock received in exchange for the stock of Niles Canyon amounted to $4.3 million. (See "Telecommunications Operations - International Communications" concerning this transaction.) The Company also owns Upsouth Corporation (Upsouth), which owns an earth station complex near Atlanta, Georgia and another near Carteret, New Jersey. In October 1993, the Company agreed to sell PTI Harbor Bay and Upsouth to IntelCom Group, Inc. (IntelCom:ITR) for 853,147 shares of IntelCom stock and $.2 million in cash. The Company will also receive at least 250,000 more shares of IntelCom common stock in lieu of debt that will not be assumed by the purchaser. The Company will be granted certain demand and piggyback registration rights for the IntelCom stock it receives and expects the transaction to close in the first half of 1994. Based on recent prices for IntelCom stock, the Company could record a pre-tax gain ranging from $7 million to $10 million on this transaction, excluding selling commissions and other expenses. The actual gain or loss realized will be dependent on IntelCom's stock price when the shares are sold. The transaction is subject to necessary regulatory approvals. IntelCom provides alternative local network access, local area networks and systems integration, as well as operating a full-service domestic and international satellite uplink teleport. In 1989, the Company acquired three AM/FM combination radio stations in Oregon, Nevada and Idaho in an effort to protect an investment made when the Company was investing in non-telecommunications businesses. In 1992, the AM radio station in Idaho was contributed to an institution of higher education. The Company also has signed a letter of intent to sell the FM station in Idaho and is waiting for regulatory approval of the sale, which is expected to close in the first half of 1994. - 11 - Regulation __________ General _______ Alascom and the Company's LECs operate in an industry that is subject to extensive regulation by the FCC and state regulatory agencies. Virtually all services, both local and long distance, are provided in accordance with tariffs filed with the appropriate regulatory agencies. The telecommunications industry continues to undergo change as a result of a series of regulatory and judicial proceedings regarding the deregulation of certain aspects of the industry. The FCC and some state regulatory agencies are exploring alternative forms of regulation that depart from traditional rate of return regulation for telecommunications companies. These alternatives include possibilities of opening local exchange franchises to encourage greater competition. The effects of any such alternative form of regulation on the Company's LECs is uncertain. Interstate and certain international services provided by Alascom are governed by tariffs filed with the FCC. The Company's LECs are governed by tariffs filed with the FCC for interstate access services provided to interexchange carriers. The FCC also licenses other aspects of the Company's telecommunications operations, including the construction and operation of its microwave, cable and radio facilities and its satellite and earth stations. As part of its regulation, the FCC prescribes a Uniform System of Accounts (USOA) that dictates the account structure and accounting policies used by both Alascom and the LECs. The FCC also establishes the principles and procedures (separations procedures) that allocate telephone investment, operating expenses and taxes between interstate and intrastate jurisdictions for the Company's LEC operations and Alascom. Generally, the state regulatory agencies have adopted the USOA and the principles and procedures prescribed by the FCC. To discourage carriers from subsidizing the cost of nonregulated business activities and to protect customers from unjust and unreasonable rates, the FCC and certain state regulatory commissions have adopted accounting and cost allocation rules for segregating the costs of regulated services and nonregulated services. The rules are based on fully distributed costing principles. In addition to segregating costs, the accounting policies prescribe guidelines for recording transactions between affiliates, require monitoring of jurisdictional earnings of various services and set forth a process for auditing the allocation procedures. The Company's cellular interests are regulated by the FCC with respect to the construction, operation and technical standards of cellular systems and the licensing and designation of geographic boundaries of service areas. Certain states also require operators of cellular systems to satisfy a state certification process to serve as cellular operators. Local Exchange Companies ________________________ The facilities of the Company's LECs are used principally to provide local telephone service and customer access to the long distance network. The costs of providing services are allocated between the interstate and intrastate jurisdictions. Interstate service costs (both traffic sensitive and nontraffic sensitive) are recovered through an access charge plan under which LEC and NECA tariffs filed with the FCC allow for charges to interexchange carriers for access to customers. The traffic sensitive costs are recovered - 12- either directly through access charges or through settlements with NECA. The nontraffic sensitive portion (subscriber loop) of these interstate-related costs is recovered through a settlement process with NECA. The nontraffic sensitive revenue pool administered by NECA is funded by a subscriber line charge to individual customers, interexchange carrier access charges and long-term support payments by nonpooling LECs. Since January 1, 1991, the interstate rate-of-return authorized by the FCC for LECs' interstate access services, has been 11.25 percent. The USF administered by NECA compensates companies whose nontraffic sensitive costs per subscriber are greater than an established threshold over the national average. Due to the suburban and rural nature of its operations, most of the Company's LECs receive this compensation, as the cost of providing local service in rural areas generally exceeds the national average. In November 1993, based on a concern over recent growth in the size of the USF, a Federal-State Joint Board issued a recommended decision to the FCC proposing the adoption of interim USF rules. These interim rules recommend that an indexed cap be placed on USF growth to allow the USF to grow at a rate no greater than the rate of growth in the U.S.'s total working local loops. The interim rules are intended to allow moderate growth in the total level of the USF while the FCC and the Federal-State Joint Board undertake a re-evaluation of the USF assistance mechanism. The Federal-State Joint Board proposed that the interim rules remain in effect for two years. The FCC adopted the Joint Board recommendation at the end of 1993. As most of the Company's LEC operations receive USF compensation, significant changes to the USF assistance mechanism could affect the Company's future results. The Company believes that placing the indexed cap on USF growth may have a negative impact on the Company's revenues, but the impact is not expected to be material. In addition, the Company may request a revenue increase at the state level to offset some or all of the lost assistance where USF proceeds are used to maintain lower rates. As an alternative for rate-of-return regulation, the FCC adopted optional incentive regulation for LECs beginning in 1991. Due to specific constraints, including the requirement that all LECs under common ownership must adopt incentive regulation when it is adopted by any LEC in the group, it is unlikely that the Company will adopt this form of regulation in the near future. NECA has recently filed with the FCC its own recommendation for an incentive regulation plan. The Company intends to monitor the progress of NECA's efforts and evaluate its options if an alternative regulation plan is implemented. In September 1993, the Company filed, in compliance with FCC Docket No. 91-213, to restructure its interstate switched access transport prices consistent with the related proposal of the Telephone Utilities Exchange Carrier Association, which was ultimately approved by the FCC in December 1993 and made effective January 1, 1994. The local transport restructure proceeding accomplished a further unbundling of exchange carrier switched access services. The new structure is expected to promote network efficiency by moving access prices for local transport closer to cost. In 1993, the Wisconsin Public Service Commission (WPSC) mandated a new service, effective December 1, 1993, called Extended Community Calling (ECC). This service extends local calling areas to allow customers to reach their local areas of interest without incurring long distance charges, even if exchange boundaries are crossed. These areas of interest generally extend 15-miles from the customer's home exchange. The Company believes that ECC - 13 - will cause immaterial reductions in the Company's billing and collection revenues and access revenues, which reductions are expected to be offset in part by ECC revenues. In Washington, a process was started in 1990 to restructure rates to allow the conversion of all multi-party to single-party lines, to eliminate touchtone charges and to offer certain customers Extended Area Service (EAS). In August 1993, the Company proposed additional revisions to rates for further extension of EAS to substantially all of its Washington customers. By the end of 1994, all lines in Washington are expected to be single-party, with approximately 98 percent having EAS capabilities. In May 1993, toll free calling was implemented for the entire Flathead Valley in Montana. Evolution to single-party service in Montana was completed during 1993. These changes are not expected to have a significant effect on the financial results of the Company. The Company received authorization from the Oregon Public Utilities Commission to implement revised depreciation rates retroactive to January 1, 1993. This adjustment increased the depreciation rate and increased operating expenses by $2.2 million. In addition, the Company has a depreciation study on file with the WUTC for its LEC operations in the state of Washington. The Company is in negotiation with the WUTC to resolve issues relating to the proposed depreciation rate increase. The Company has also agreed to provide a depreciation study to the APUC. Long Lines - Interstate Revenues ________________________________ Alascom's interstate MTS and WATS revenues are presently derived through the JSA with AT&T providing for cost-based settlements determined in accordance with historical practices and regulatory procedures. The entire Alaska interstate long distance market, including these procedures and the settlement arrangement, have been under review by a Joint Board for several years. Prior to 1991, AT&T, GCI and Alascom submitted proposals to the Joint Board recommending alternative market structures in Alaska. None of these proposals were acted upon by the Joint Board or the FCC. In December 1991, the Company and AT&T signed an agreement to transfer to AT&T the provision of interstate and international MTS and WATS services then currently provided in Alaska by Alascom. This agreement terminated in January 1993 without implementation. In October 1993, the Joint Board issued a final recommendation concerning the restructuring of the interstate telecommunications market for Alaska. That recommendation is awaiting FCC action. (See "Telecommunications Operations - Alaska Market Restructuring.") Long Lines - Access Charges ___________________________ While Alascom's interstate MTS and WATS revenues continue to be determined under the JSA with AT&T, Alascom purchases access to the local network under an access tariff and billing and collection services under a separate contract. These charges for interstate access services are determined using access charge procedures used by LECs in the contiguous 48 states. (See "Regulation - Local Exchange Companies.") Interstate access charges and billing and collection charges are included under the JSA with AT&T. Alascom makes payments for intrastate access charges through a state access tariff. The access charge system was implemented in 1991 to accommodate intrastate competitive entry. (See "Competition - Long Lines - - - -Intrastate.") - 14 - The Alaska Exchange Carriers Association coordinates the filing of access tariffs and the pooling of costs. The adoption of intrastate access charges has had no material adverse effect on the Company's results of operations. Alascom purchases intrastate billing and collection services under a separate contract. Long Lines - Alaska Spur ________________________ In November 1989, Alascom filed an application with the FCC seeking authorization to acquire the Alaska Spur. (See "Telecommunications Operations-Pacific Telecom Cable.") On May 13, 1991, the FCC granted Alascom authorization to acquire and operate the Alaska Spur, subject to certain conditions. Alascom requested the FCC to issue a revised order without the conditions and did not accept the authorization. Subsequently, the FCC issued temporary authorization for Alascom to acquire and operate the Alaska Spur, subject to periodic renewal. The Alaska Spur was placed into service in August 1991. The request for reconsideration of the order is still pending before the FCC. The FCC has granted Alascom a renewal of the temporary authorization through August 8, 1994. In December 1992, Alascom sold 11 percent of the Alaska Spur's capacity to GCI. Competition ___________ Local Exchange Companies ________________________ The Company's LECs have experienced little competition in providing basic services, primarily due to the suburban and rural nature of their service territories. Competition from the development of alternative networks by other carriers and of private networks (bypass) by government agencies and large corporate customers has resulted in minor diversions of traffic from the Company's LECs. To date, the Company has also experienced little competition from cable TV providers and wireless technologies. Competition from these sources may increase if regulators open basic telephone service to cable TV operators and as wireless technologies advance. However, investment by others in facilities will be required to provide competitive service and these investments will be based on appropriate economic opportunities and demand for such services. The Company believes it is well positioned to meet this type of competition and that price and service are the significant competitive factors in dealing with alternative networks, bypass and other forms of competition. With respect to access service, the Company's LECs may face competition from several sources in the future. Alternative or competitive access carriers (CAPs) have, in various parts of the country, constructed facilities which bypass those of the local exchange carrier to provide access between customers and interexchange carriers. The location and extent of such activity is determined by a number of factors, including applicable state and federal regulatory policies, and economic and market conditions in the area. A number of interexchange carriers have also announced or implemented programs to construct facilities which bypass those of local exchange companies. AT&T has entered into an acquisition agreement with a major cellular company, McCaw Cellular Communication, in part for the apparent purpose of reducing its dependence upon local exchange companies for access services. MCI has announced a program for construction of facilities in twenty major metropolitan areas, also for the purpose, in part, of reducing its dependence upon local exchange companies for access services. - 15 - The Company believes that the activities of CAPs and the major interexchange carriers, at present, do not pose a direct, material threat to the Company's revenues due to the rural nature of its operations. The Company anticipates that competition in services and facilities will evolve over time in its LEC service areas. The Company is reviewing the potential effect such competitive activity may have on its operations and is analyzing ways to benefit from changes which may occur as competition increases. Long Lines - Interstate _______________________ In 1982, the FCC authorized a variety of carriers to provide interstate services in Alaska in competition with Alascom. GCI, a carrier providing private line, MTS and WATS equivalent services to and from Alaska, attracted a significant number of customers as LECs converted to equal access in Anchorage, Fairbanks, Juneau and other areas. Although rates were a significant competitive issue during the introduction of equal access, the rate advantage enjoyed by GCI prior to rate integration was reduced with the integration of toll rates in January 1987 and subsequent nationwide annual rate reductions through 1990. As a result of these rate reductions and other factors, Alascom has experienced growth in interstate billed minutes of 6.2 percent in 1993, 11.9 percent in 1992 and 10.4 percent in 1991. The Company believes that with minimal rate differences, service is currently the predominant competitive factor in the Alaska interstate market. In January 1990, GCI filed a petition for rulemaking with the FCC seeking to abolish the present prohibition against construction of duplicate earth station facilities in rural Alaska. GCI stated that it desired to extend its services to rural Alaska over a five-year period. Alascom opposed GCI's petition, as being contrary to the public interest. The FCC has taken no action with regard to the GCI petition. Long Lines - Intrastate _______________________ In 1990, the Alaska Legislature enacted legislation that authorized intrastate competition and the APUC established specific regulations for competition that allowed facilities-based competition in some areas, but prohibited construction of duplicative facilities in most remote locations. The APUC also designed a competitive framework under which high costs of providing service in rural locations are shared by Alascom and its competitors through the LEC access charge pooling mechanism. Intrastate competition in Alaska commenced in May 1991. Competition has been introduced in approximately 90 percent of the Company's intrastate market. The Company's intrastate long distance service revenues, net of related access charges, accounted for approximately five percent of the Company's total revenues for 1993 and six percent in 1992 and 1991. As a result of competition, intrastate minute volumes increased 1.7 percent in 1993 and decreased 7.3 percent in 1992 and 4.9 percent in 1991. The Company has mounted a marketing campaign in response to this competition and believes that price and service are the significant competitive factors in this market. - 16 - Cellular Operations ___________________ Under FCC guidelines, two licenses were granted in each MSA and RSA to provide cellular service. All of the MSAs and RSAs in which the Company has an ownership interest are operational. The Company believes that price and service are significant competitive factors in the cellular market. A competitive threat to cellular operations from other wireless communications technologies also exists. This threat may increase as these technologies are developed in the future. In September 1993, the FCC allocated 160 megahertz (MHz) of spectrum for Personal Communications Services (PCS). The FCC created seven licensed frequency blocks representing 120 MHz of spectrum and identified 40 MHz of spectrum for unlicensed PCS. The licensed spectrum was channelized into two 30 MHz blocks, one 20 MHz block and four 10 MHz blocks. The FCC defined the PCS license areas based on 51 Major and 492 Basic Trading Areas (MTA and BTA, respectively), as defined by Rand McNally. PCS licenses will be awarded through an auction process starting not earlier than May 1994. The Company's cellular operations are eligible to participate in the PCS auction subject to certain limitations established by the FCC. The PCS license term is set at 10 years with requirements to cover 33 percent of the POPs within five years, 67 percent within seven years and 90 percent of the POPs within ten years. The Company is monitoring PCS developments and evaluating its alternatives under the proposed PCS licensing rules. Cable Operations ________________ The North Pacific Cable is currently the only operating cable between the U.S. and the western Pacific that has available capacity for sale. AT&T placed a cable into service between the U.S. and Japan in late 1992. This cable competed directly with the North Pacific Cable for subscribers. AT&T has stated that all capacity on its cable has been subscribed. AT&T has announced plans for an additional cable system between the eastern and western Pacific for completion in the period from 1995 to 1997. The North Pacific Cable also competes with available capacity on international satellites. Environment ___________ Compliance with federal, state and local provisions relating to protection of the environment has had no significant effect on the capital expenditures or earnings of the Company. Future effects of compliance with environmental laws are not expected to be material, but environmental laws could become more stringent over time. Employees _________ At December 31, 1993, the Company had 2,834 employees, approximately 41 percent of whom were members of seven different bargaining units. These units are represented by one of the International Brotherhood of Teamsters, the International Brotherhood of Electrical Workers, Communication Workers of America or the NTS Employee Committee. During 1993, negotiations were completed on two collective bargaining agreements governing 144 employees. Negotiations on six contracts covering 1,180 employees are planned in 1994. Relations with represented and non-represented employees continue to be generally good. - 17 - Construction Program ____________________ The Company financed its 1993 construction program primarily through internally generated funds. Construction expenditures for 1993 and estimated expenditures for 1994 through 1996, excluding expenditures for the construction contract with USWC amounting to $5.7 million in 1993 and estimated at $28 million for 1994, are as follows (in millions): The estimates of construction costs set forth above are subject to continuing review and adjustment. The Company anticipates that it will be able to finance substantially all of its construction programs for 1994 from internally generated funds. Estimated increases in LEC construction expenditures in 1995 and 1996 relates mainly to the acquisition of USWC properties in Colorado anticipated at the end of 1994. Acquisition Program ___________________ The Company expects to complete additional acquisitions as attractive opportunities become available. The Company's strategy is to acquire rural or suburban local exchange properties with operating characteristics similar to existing properties of the Company. These opportunities will allow the Company to leverage LEC investments by providing data processing and administration through its centralized systems. The Company seeks to realize economies of scale through these acquisitions, particularly where the properties are near the Company's current operations or are of sufficient size to support moving into a new geographic area. (See "Item 1. Business - Telecommunications Operations - Local Exchange Companies" for information regarding pending acquisitions of USWC properties in Colorado, Oregon and Washington.) Item 2. Item 2. PROPERTIES _______ The telephone properties of the Company's LECs include central office equipment, microwave and radio equipment, poles, cables, rights of way, land and buildings, customer premise equipment, vehicles and other work equipment. Most of the Company's division headquarters buildings, telephone exchange buildings, business offices, warehouses and storage areas are owned by the Company's LECs and are pledged to secure long-term debt. In addition, certain of the LECs' microwave facilities, central office equipment and warehouses are located on leased land. Such leases are not considered material, and their termination would not substantially interfere with the operation of the Company's business. (See "Item 1. Business - Telecommunications Operations - Local Exchange Companies" for information regarding the states in which the Company has LEC operations.) The properties of Alascom include toll centers with toll switching facilities, microwave and radio equipment, satellite transmit and receive - 18 - earth stations, submarine cables (including the Alaska Spur), land, warehouse and administrative buildings, as well as transportation and other work equipment. Although Alascom owns most of its buildings, much of its telecommunications equipment is located on leased property. In addition, Alascom leases certain microwave and satellite circuits to carry both interstate and intrastate communications. The Company owned 16 transponders on Aurora II until October 1992 when the transponders were sold and leased back on an operating lease basis for a 69-month period. Aurora II was launched in May 1991 to replace the Company's original satellite and was placed in service in July 1991. The Company purchased and placed in service one additional transponder on Aurora II in 1993. (See "Item 1. Business - Telecommunications Operations - Long Lines" for information concerning other properties of Alascom.) PT Cellular's subsidiaries are partners in partnerships that own or lease switching facilities, cell site towers, cell site radio equipment and other equipment required to furnish cellular service to the areas they serve. (See "Item 1. Business - Telecommunications Operations - Cellular Operations" for information regarding the states in which the Company has cellular operations.) The properties of PTC and PT Transmission include a satellite transmit and receive earth station, located at Moores Valley, Oregon, fiber optic cables, land, buildings, operating facilities and business offices, all of which are owned. In addition, PTC leases a duplicate cable for backup between Pacific City, Oregon and Portland, Oregon and business office space. PTC also holds in inventory its portion of the unsold capacity in the North Pacific Cable and backhaul facilities. Almost all the properties of ICH were sold in 1993 to IDB. However, ICH owns land, buildings and office equipment in Florida. ICH is obligated under a lease for office space in Washington D.C., which housed TRT's administrative offices. ICH is actively pursuing the lease or sublease of these properties. ICH has leased the Florida building and equipment to IDB for three years with renewal options for an additional four years. (See Item 1. "Business - Telecommunications Operations - International Communications" for information concerning the sale of ICH's major operating subsidiary to IDB.) The Company's executive, administrative, purchasing and certain engineering functions are headquartered in Vancouver, Washington. The Company has a 50 percent ownership interest in its headquarters building and, through a long-term lease, occupies approximately 72 percent of the 225,000 square-foot building. The Company leases most of the equipment used in conjunction with providing data processing services. Item 3. Item 3. LEGAL PROCEEDINGS _________________ The Company is a party to various legal claims, actions and complaints, one of which is described below. Although the ultimate resolution of legal proceedings cannot be predicted with certainty, management believes that disposition of these matters will not have a material adverse effect on the Company's consolidated results of operations. - 19 - Loewen, et al. v. Galligan, et al. (Circuit Court for the State of Oregon, __________________________________________________________________________ County of Multnomah) ____________________ In November 1991, former shareholders of American Network, Inc. (AmNet) filed a third amended complaint against PTI and others, suing individually and also derivatively on behalf of AmNet for damages allegedly arising out of the acquisition of AmNet by United States Transamerica Systems, Inc. (USTS), a subsidiary of ITT Corporation, in 1988 and various alleged wrongs in connection with certain transactions that occurred in 1984 and 1986 between AmNet or its subsidiaries and PTI or between AmNet and other parties. At the time of the acquisition by USTS, PTI owned 36.4 percent of the common shares of AmNet. The third amended complaint revised the plaintiffs' 1984 and 1986 fraud claims and changed the plaintiffs under all claims. As a result, differing plaintiff groups are now suing PTI and other defendants for state securities and common law fraud allegedly committed in 1984, 1986 and 1988 and four plaintiffs are suing PTI alone for breach of an alleged promise to provide financial support to AmNet in 1984. Plaintiffs seek to recover damages from PTI in the amount of plaintiffs' lost investments, plaintiffs' costs, disbursements and reasonable attorney fees, and punitive damages of $100 million. On August 19, 1992, the court granted defendants' motions for summary judgment against all claims in the third amended complaint. Judgment in favor of defendants was entered on November 23, 1992 and plaintiffs' appeal to the Oregon Court of Appeals is pending. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ___________________________________________________ No information is required to be reported pursuant to this item. Item 4A. EXECUTIVE OFFICERS OF THE REGISTRANT ____________________________________ The executive officers of PTI are as set forth below: Name Age Position ____ ___ ________ Charles E. Robinson 60 Chairman, President, Chief Executive Officer and Director James H. Huesgen 44 Executive Vice President and Chief Financial Officer Donn T. Wonnell 47 Vice President, Regulatory Affairs and Corporate Secretary Wesley E. Carson 43 Vice President, Human Resources Brian M. Wirkkala 53 Vice President, Treasurer Donald A. Bloodworth 37 Vice President, Revenue Requirements and Controller - 20 - The executive officers of PTI are elected annually for one year and hold office until their successors are elected and qualified. There are no family relationships among them. Mr. Robinson was elected Chairman of the Board in February 1989. In April 1982, he was elected Director, President and Chief Operating Officer. He became Chief Executive Officer in April 1985. Mr. Robinson is also President and Chairman of the Board of Alascom and a member of PacifiCorp's Corporate Policy Group. Mr. Huesgen, a CPA, was elected Executive Vice President and Chief Financial Officer in October 1990. He had served as Vice President, Accounting and Financial Planning since February 1989 and as Controller since July 1986. Mr. Wonnell, an attorney, was elected Vice President, Regulatory Affairs and Corporate Secretary in February 1991. Prior to joining the Company, he was engaged in the private practice of law and in corporate development activities. Mr. Carson, an attorney, was elected Vice President, Human Resources in November 1991. He had served as Manager, Employee Relations since February 1990 and as Manager, Labor Relations since February 1989. Prior to joining PTI in 1989, he had served as Manager, Industrial Relations at TRT Telecommunications Corporation since May 1984. Mr. Wirkkala was elected Vice President, Treasurer in February 198l. Mr. Bloodworth, a CPA, was elected Vice President, Revenue Requirements and Controller in April 1993. From October 1987 to April 1993, he was employed by PacifiCorp Financial Services, Inc., most recently as Vice President and Treasurer. Additionally, from January 1992 to April 1993, he served as Vice President and Treasurer of PacifiCorp Holdings, Inc. and Assistant Treasurer of PacifiCorp. Mr. Bloodworth served in various management and supervisory accounting positions at the Company from March 1983 to October 1987. - 21 - PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS _________________________________________________ The information required by this item is included under "Common Stock Prices/Dividends" on page 41 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. See page 62 attached hereto. Item 6. Item 6. SELECTED FINANCIAL DATA _______________________ The information required by this item is included under "Selected Financial Data" on page 16 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. See page 37 attached hereto. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS _________________________________________________ The information required by this item is included under "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 17 through 24 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. See pages 38 through 45 attached hereto. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ___________________________________________ The information required by this item is incorporated by reference from the Company's 1993 Annual Report to Shareholders or filed with this Report as listed in Item 14 hereof. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ________________________________________________ No information is required to be reported pursuant to this item. - 22 - PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT _______________________________________ The information required by this item is incorporated by reference to "Election of Directors" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than 120 days after the end of the fiscal year covered by this Report. Information about the executive officers of the Company is included in Part I of this Report under Item 4A. Item 11. Item 11. EXECUTIVE COMPENSATION ______________________ The information required by this item is incorporated by reference to "Executive Compensation" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than l20 days after the end of the fiscal year covered by this Report. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ________________________________________ The information required by this item is incorporated by reference to "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than 120 days after the end of the fiscal year covered by this Report. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ______________________________________________ The information required by this item is incorporated by reference to "Certain Transactions" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than 120 days after the end of the fiscal year covered by this Report. - 23 - PART IV * Page references are to the incorporated portion of the Annual Report to Shareholders of the Registrant for the year ended December 31, 1993, which portion is appended hereto. ** All other schedules have been omitted because of the absence of the conditions under which they are required or because the required information is included elsewhere in the financial statements incorporated by reference in this Report. - 24 - (3) Exhibits: 2 Agreement for Purchase and Sale of Exchanges between US WEST Communications, Inc. and the Registrant dated August 30, 1993. 3A Restated Articles of Incorporation of the Registrant, as amended June 13, 1990. (Incorporated by reference to Exhibit 3A of the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, File No. 0-873.) 3B Bylaws of the Registrant, as amended and restated effective April 30, 1993. 4 Indenture dated as of September 20, 1991, between the Company and The First National Bank of Chicago, as Trustee for the Series B Medium- Term Notes. (Incorporated by reference to Exhibit 4 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, File No. 0-873.) In reliance upon Item 601(4)(iii) of Regulation S-K, various instruments defining the rights of holders of long-term debt of the Registrant and its subsidiaries are not being filed because the total amount authorized under each such instrument does not exceed 10 percent of the total assets of the Registrant and its subsidiaries on a consolidated basis. The Registrant hereby agrees to furnish a copy of any such instrument to the Commission upon request. *10A Executive Bonus Plan, dated October 26, 1990. (Incorporated by reference to Exhibit 10B of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 0-873.) 10B Intercompany Borrowing Agreement between the Registrant, Inner PacifiCorp, Inc. (now PacifiCorp Holdings, Inc.) and certain other affiliated companies dated as of April 1, 1991. (Incorporated by reference to Exhibit 10A of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, File No. 0-873.) 10C Management Services Agreement between the Registrant and Pacific Power & Light Company. (Incorporated by reference to Exhibit 10D of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1980, File No. 0-873.) 10D Lease Agreement between Northwestel, Inc. and Alascom, Inc., dated January 3, 1990. (Incorporated by reference to Exhibit 10D of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 0-873.) *10E PacifiCorp Supplemental Executive Retirement Plan 1988 Restatement. (Incorporated by reference to Exhibit 10(q) of PacifiCorp's Form 10-K for the year ended December 31, 1987, File No. 1-5152.) *10F Pacific Telecom, Inc. Long-Term Incentive Plan 1994 Restatement dated as of January 1, 1994. - 25 - *10G PacifiCorp Long-Term Incentive Plan 1993 Restatement. *10H Form of Restricted Stock Agreement under the PacifiCorp Long-Term Incentive Plan 1993 Restatement. 10I Credit Agreement dated as of November 13, 1991. (Incorporated by reference to Exhibit 10M of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, File No. 0-873.) 10J Lease Intended for Security dated March 12, 1993, among Alascom, Inc., as lessee, Norwest Bank Minnesota, as Agent, and certain institutions as lessors. (Incorporated by reference to Exhibit 10K of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 0-873.) *10K Non-employee Directors' Stock Compensation Plan dated April 5, 1993. (Incorporated by reference to Exhibit 10L of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 0- 873.) *10L Executive Deferred Compensation Plan dated as of January 1, 1994. 12 Statements re Computation of Ratios. 13 Registrant's Annual Report to Shareholders for the year ended December 31, 1993. Except as specifically incorporated by reference herein, the Annual Report shall not be deemed filed as part of this Report on Form 10-K. 21 Subsidiaries 23 Independent Auditors' Consent and Report on Schedules - Included on page 29 of this Annual Report on Form 10-K. _________________ * This exhibit constitutes a management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. On Form 8-K dated November 19, 1993, under Item 5. "Other Events," the Company reported the sale of IDB Communications Group, Inc. common stock. - 26 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PACIFIC TELECOM, INC. March 25, 1994 By JAMES H. HUESGEN (Date) _____________________________ James H. Huesgen Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE AND CAPACITY DATE ______________________ ____ CHARLES E. ROBINSON ____________________________________ (Charles E. Robinson) March 25, 1994 Chairman, President, Chief Executive Officer and Director JAMES H. HUESGEN ____________________________________ (James H. Huesgen) March 25, 1994 Executive Vice President and Chief Financial Officer (Principal Financial Officer) DONALD A. BLOODWORTH ____________________________________ (Donald A. Bloodworth) March 25, 1994 Vice President Revenue Requirements/Controller - 27 - SIGNATURE AND CAPACITY DATE ______________________ ____ JOYCE E. GALLEHER ____________________________________ (Joyce E. Galleher) March 25, 1994 Director ROY M. HUHNDORF ____________________________________ (Roy M. Huhndorf) March 25, 1994 Director DONALD L. MELLISH ____________________________________ (Donald L. Mellish) March 25, 1994 Director SIDNEY R. SNYDER ____________________________________ (Sidney R. Snyder) March 25, 1994 Director NANCY WILGENBUSCH ____________________________________ (Nancy Wilgenbusch) March 25, 1994 Director - 28 - EXHIBIT 23 DELOITTE & TOUCHE _____________________________________________________ _________________ 3900 US Bancorp Tower Telephone: (503)222-1341 [LOGO] 111 SW Fifth Avenue Facsimile: (503)224-2172 Portland, Oregon 97204-3698 INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULES Pacific Telecom, Inc.: We consent to the incorporation by reference in Registration Statement No. 33- 42577 on Form S-3 and Registration Statement No. 33-52600 on Form S-8 of our report dated January 26, 1994 (which expresses an unqualified opinion and includes an explanatory paragraph relating to a change in method of accounting for other postretirement benefits and income taxes in the year ended December 31, 1993), incorporated by reference in this Annual Report on Form 10-K of Pacific Telecom, Inc. Our audits of the financial statements referred to in our aforementioned report also included the financial statement schedules of Pacific Telecom, Inc., listed in Item 14.

840889_1993.txt

840889_1993

1993

840889

ITEM 1. BUSINESS GENERAL. First Financial Caribbean Corporation ("FFCC" or the "Company"), together with its wholly-owned subsidiaries, including Doral Mortgage Corporation ("Doral"), its principal subsidiary, is primarily engaged in a wide range of mortgage banking activities, including the origination, servicing, purchase and sale of mortgages on single-family residences, the issuance and sale of various mortgage-backed securities, the holding and financing of mortgage loans and mortgage-backed securities for sale or investment and, from time to time, the purchase and sale of servicing rights associated with such mortgage loans (the "Mortgage Banking Business"). Substantially all of FFCC's income is from its Mortgage Banking Business which, until the opening of a branch in Florida in March 1992, was exclusively conducted in Puerto Rico. On September 10, 1993, the Company acquired Doral Federal Savings Bank ("Doral Federal"), a federal savings and loan association which operates through two branches in Puerto Rico. A subsidiary of the Company also acts as agent to residents of Puerto Rico in the sale of houses located in the State of Florida. References herein to the "Company" or "FFCC" shall be deemed to refer to the Company and its consolidated subsidiaries, unless the context requires otherwise. The Company, a mortgagee approved by the United States Department of Housing and Urban Development ("HUD"), has been engaged in the Mortgage Banking Business since its incorporation in Puerto Rico in 1972. The Company's Mortgage Banking Business is principally conducted through two operating units: Doral and HF Mortgage Bankers Division ("HF"), a division of the Company. During the first quarter of 1994, the Company activated another mortgage banking subsidiary, Centro Hipotecario de Puerto Rico, Inc., to serve primarily real estate brokers and corporate employees. The Company acquired Doral and RSC Corp. ("RSC") from Culbro Corporation ("Culbro") in September 1988 for $6 million in cash. FFCC was a wholly-owned subsidiary of Culbro from December 1976 until December 1988 when all then outstanding shares of FFCC's common stock held by Culbro were distributed to Culbro shareholders. Prior to 1976, FFCC was owned by Salomon Levis and David Levis. FFCC's principal executive office is located at 1159 Franklin D. Roosevelt Avenue, San Juan, Puerto Rico 00920, and its telephone number is (809) 749-7100. The business and profitability of FFCC depend, to a large degree, on its ability to sell mortgage loans to investors in the secondary mortgage market at prices that are higher than the prices at which FFCC originates or purchases such loans. The growth of the secondary mortgage market is attributable in large part to programs maintained by the Federal National Mortgage Association ("FNMA"), the Federal Home Loan Mortgage Corporation ("FHLMC") and the Government National Mortgage Association ("GNMA"). In addition, part of the Company's business is dependent upon the continuation of various programs administered by the Federal Housing Administration ("FHA") for HUD, which insures mortgage loans, and the Veterans Administration ("VA"), which partially guarantees mortgage loans. Although the Company is not aware of any proposed discontinuation of, or significant reduction in, the various programs administered by FNMA, FHLMC, GNMA, FHA or VA, any such discontinuation or reduction in the operation of such programs could have a material adverse effect on the Company's operations. See "Mortgage Banking Business - Sale of Loans; Issuance of Mortgage Backed Securities." The Company is subject to the rules and regulations of, and supervision by, several Federal and Puerto Rico entities, including, FNMA, FHLMC, GNMA, FHA, VA, HUD, the Commissioner of Financial Institutions of Puerto Rico (the "Commissioner") and the Department of the Treasury of Puerto Rico ("Puerto Rico Treasury"), with respect to, among other things, licensing requirements, establishment of maximum interest rates, required disclosure to customers and the originating, processing, underwriting, selling and securitizing of mortgage loans. See "Regulation" herein. The Company's operations are significantly affected by Federal and Puerto Rico laws and regulations designed to promote economic development in Puerto Rico, particularly the various Puerto Rico Industrial Incentives Acts (the "Industrial Incentives Acts") and Section 936 ("Section 936") of the United States Internal Revenue Code of 1986, as amended (the "Code"). For a discussion of these matters, see "Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment." The Company's principal revenues from mortgage banking business are loan servicing fees, loan origination fees, interest on mortgage loans and various mortgage-backed securities held prior to sale, gains from the sale of mortgage loans and various mortgage-backed securities, sales of servicing rights and other income (primarily sales of real estate owned). The Company is an approved seller/servicer for FHLMC and FNMA, an approved issuer for GNMA and an approved servicer under the GNMA, FNMA and FHLMC mortgage-backed securities programs. In addition, FFCC is qualified to originate FHA insured and VA guaranteed mortgage loans. The Company is the largest mortgage banking institution in Puerto Rico in terms of the volume of origination of first mortgage loans on single-family residences. To enter a new market and thereby expand its source of mortgage loan originations and its servicing portfolio, Doral opened a branch in Royal Oak Village Mall in the Orlando, Florida, metropolitan area in March 1992. This office represents the first branch office opened by the Company outside of Puerto Rico. The office is staffed by five employees and originates residential mortgage loans. The Orlando office originated approximately $24 million in mortgage loans during the year ended December 31, 1993. In February 1994, Doral opened its second office in the State of Florida in the City of Miami. FFCC's operations in the state of Florida are subject to supervision by the Florida Department of Banking and Finance. The following table sets forth the components of FFCC's revenues and the percentage contribution of each component for the periods indicated: (1)Represents less than one percent of revenues. (2)Sums of the columns may not add up to the totals due to rounding. MORTGAGE BANKING BUSINESS ORIGINATION AND PURCHASE OF MORTGAGES. FFCC has the most extensive system of branch offices for originating mortgages loans of any mortgage banking institution in Puerto Rico. HF operates two branches in the San Juan Metropolitan area. Doral operates 15 branches in Puerto Rico located in Arecibo, Bayamon (2 branches), Caguas, Carolina, Cayey, Fajardo, Guayama, Hato Rey (2 branches), Humacao, Mayaguez, Ponce, Rio Piedras and Vega Baja. Centro Hipotecario operates an additional branch in the San Juan metropolitan area. FFCC originates both (a) conventional mortgages on single-family residences, which generally (i) are insured by private mortgage insurers or (ii) do not exceed 80% of the appraised value of the mortgaged property, and (b) mortgages on single-family residences, guaranteed by the VA ("VA loans") or insured by HUD ("FHA loans"). VA loans and FHA loans qualify for inclusion in the mortgage-backed securities program sponsored by GNMA. A majority of the conventional loans are conforming loans which qualify for inclusion in guarantee programs sponsored by FNMA or FHLMC. The Company also originates construction loans for owner-occupied single family residences and other real estate developments and mortgage loans on commercial properties. Construction loans and mortgage loans on commercial properties constituted less than 1% of the total dollar volume of loans originated by the Company during the year ended December 31, 1993. While the Company makes available a wide variety of mortgage products designed to respond to consumer needs and competitive conditions, it currently emphasizes 15-year and 30-year conventional first mortgages and 15-year and 30-year FHA loans and VA loans. Substantially all the loans are fixed rate mortgages. The average loan size for FHA/VA mortgage loans and conventional mortgage loans was approximately $64,000 and $71,000, respectively, for the year ended December 31, 1993. Although the Company continues to offer second mortgages, this product has been deemphasized recently due to decreased demand for the product. The decreased demand is due in part to the tendency of consumers to refinance their first mortgages during periods of prevailing low interest rates. During 1993, second mortgages constituted less than 2% of the total loans originated by the Company. The maximum loan-to-appraised value ratio on second mortgages permitted by the Company is 80% (including the amount of any first mortgage). Loan origination activities performed by FFCC include soliciting, completing and processing mortgage loan applications and preparing and organizing the necessary loan documentation. Loan applications are examined for compliance with underwriting criteria and, if all requirements are met, FFCC issues a commitment to the prospective borrower specifying the amount of the loan and the loan origination fees, points and closing costs to be paid by the borrower or seller and the date on which the commitment expires. FFCC purchases FHA loans and VA loans from Doral and other mortgage banks for resale to institutional investors in the form of GNMA securities. The Company's strategy is to increase its servicing portfolio through internal originations through its branch network rather than purchasing loans from third parties. The Company purchased only $1.0 million in loans from third parties during the year ended December 31, 1993 as compared to $29 million, $48 million, $117 million and $185 million for the years ended December 31, 1992, 1991, 1990 and 1989, respectively. In recent years, the Company has placed greater emphasis on the origination of conventional conforming first mortgage loans which have a larger loan size than loans qualifying under the FHA and VA programs. The maximum loan size for FHA loans and VA loans has not increased proportionally with the increase in real estate values in Puerto Rico. The Company's continued emphasis on origination of conventional conforming first mortgage loans is dependent on market conditions, the relative return available on the origination and sale of different types of mortgage loans and maximum loan amounts for the various types of loans. The following table sets forth the number and dollar amount of the Company's mortgage loan production for the periods indicated: ________________ (1) Includes second mortgage loans and non-conforming loans (conventional loans that do not qualify for inclusion in the guarantee programs sponsored by FNMA or FHLMC) which generally have lower average initial loan sizes than conforming first mortgage loans. (2) As a percentage of the total dollar volume of loans originated. Unlike many mortgage banking institutions in the United States, a high proportion of the Company's total mortgage loans has consistently been comprised of refinancing loans. For the years ended December 31, 1993, 1992 and 1991, refinancing activity represented approximately 78%, 67% and 67%, respectively, of the Company's total dollar volume of mortgage loans originated. The increase from 1992 to 1993 was principally due to the Company's greater market share in refinancings coupled with a decline in average mortgage interest rates which has stimulated demand for refinancing of existing mortgage loans. A significant future increase in mortgage interest rates in Puerto Rico could adversely affect the Company's business if it resulted in a significant decrease in refinancing of first mortgage loans. For the years ended December 31, 1993, 1992 and 1991, non-conforming conventional loans represented approximately 15%, 19% and 24%, respectively, of the Company's total volume of mortgage loans originated. SERVICING. When FFCC sells the mortgage loans it has originated or purchased, it generally retains the rights to service such loans and receives the related servicing fees. Loan servicing includes collecting principal and interest and remitting the same to the holders of the mortgage loans or mortgage-backed securities to which such mortgage loan relates, holding escrow funds for the payment of real estate taxes and insurance premiums, contacting delinquent borrowers, supervising foreclosures in the event of unremedied defaults and generally administering the loans. FFCC receives annual loan servicing fees ranging from 0.25% to 0.50% of the declining principal amount of the loans serviced plus any late charges. In general, FFCC's servicing agreements are terminable by the investor for cause. Substantially all of FFCC's mortgage servicing portfolio is composed of mortgages secured by real estate in Puerto Rico. At December 31, 1993, approximately $30 million of the Company's mortgage servicing portfolio related to mortgages originated outside Puerto Rico (all of which were originated in Florida). The following table sets forth certain information regarding the total loan servicing portfolio of FFCC for the periods indicated: ____________________ (1) Loans funded and purchased represent that portion of loans originated or purchased with respect to which the servicing rights were retained by the Company. In 1991, there is also included $49.2 million of servicing rights acquired from a financial institution. (2) Run-off refers to regular amortization of loans, prepayments and foreclosures. (3) Expressed as a percentage of the total number of loans serviced. The amount of principal prepayments on mortgage loans serviced by the Company was $537 million, $242 million and $66 million for the years ended December 31, 1993, 1992 and 1991, respectively. This represented approximately 26%, 15.4% and 5.3% of the aggregate principal amount of mortgage loans serviced during such periods and the average size of the loans prepaid were $54,600, $44,500 and $37,801, respectively. The primary means used by the Company to reduce the sensitivity of its servicing fee income to changes in interest and prepayment rates is the development of a strong internal origination capability that has allowed the Company to continue to increase the size of its servicing portfolio even in times of high prepayments. Servicing agreements relating to the mortgage-backed securities programs of FNMA, FHLMC and GNMA, and certain other investors, require FFCC to advance funds to make scheduled payments of principal, interest, taxes and insurance, if such payments have not been received from the borrowers. During 1993, the monthly average amount of funds advanced by FFCC under such servicing agreements was $2.2 million. Funds advanced by FFCC pursuant to these arrangements are generally recovered by FFCC within two weeks. FFCC sells certain mortgage loans to FNMA and FHLMC with recourse, which means that FFCC, as servicer, is responsible for the outstanding amount of the loan, for advancing defaulted payments on the loan and repurchasing the properties on all foreclosed mortgages. For the years ended December 31, 1993 and 1992, only $23.1 million and $28.5 million, or approximately 2.7% and 5.5%, respectively, of all FHMLC and FNMA conforming loans serviced by FFCC were represented by mortgages sold with recourse. In November of 1993, the Company entered into a commitment to deliver by May 15, 1994 approximately $100 million of mortgage loans to FHLMC on a recourse basis. "See" Sale of Loans; Issuance of Mortgage Backed Securities" herein. The Company has also traditionally sold most of its non-conforming loans to local financial institutions with recourse to the Company. The amount of such recourse obligations as of December 31, 1993 and 1992, was $141 million and $215 million, respectively. In 1993, the Company continued to reduce sales of its non-conforming loans with recourse by pooling such loans into private label mortgage-backed securities for sale in the Puerto Rican market through broker-dealers. See "Sale of Loans; Issuance of Mortgage-Backed Securities" below. In connection with the sale of such mortgage-backed securities the Company has entered into servicing arrangements that require the Company to advance funds under conditions similar to those that apply to servicers under the FNMA and FHLMC programs. FFCC's servicing rights, although not reflected as an asset on FFCC's financial statements (except for purchased servicing rights), provide a significant continuing source of income for FFCC. There is a market in Puerto Rico for servicing rights, which are generally valued in relation to the present value of the expected income stream generated by the servicing rights. Among the factors which influence the value of a servicing portfolio are servicing fee rates, loan balances, loan types, loan interest rates, expected average life of underlying loans (which may be reduced through foreclosure or prepayment), the value of escrow balances, delinquency and foreclosure experience, servicing costs, servicing termination rights of permanent investors, and any recourse provisions. In the years ended December 31, 1993, 1992 and 1991, FFCC sold servicing rights on $198.7 million, $53.4 million and $51.5 million, respectively, of mortgages. FFCC may from time to time sell additional portions of its servicing portfolio. The mortgage loan delinquency rate in Puerto Rico is generally higher than in the mainland United States. At December 31, 1993 and 1992, 3.11% and 2.94%, respectively, of the number of loans in FFCC's servicing portfolio were 60 or more days past due and, in addition, 1.21% and 1.44%, respectively, were in foreclosure. During the years ended December 31, 1993 and 1992, the percentage of loans in FFCC's servicing portfolio which were over 60 days past due but not in foreclosure at month end varied from 3.11% to 3.71%, and 2.12% to 4.28%, respectively. For the year ended December 31, 1993, the percentage of the number of serviced loans in foreclosure ranged from 1.19% to 3.37%. The percentage of the number of serviced loans in foreclosure during 1992 ranged from 1.06% to 1.77%. During 1991, the percentage of loans in FFCC's portfolio which were 60 days or more past due at month end varied from 4.27% to 5.43% and the percentage of the number of such loans in foreclosure varied from 1.13% to 1.83%. HRU, Inc. provides mailing and electronic data processing services for FFCC's mortgage servicing and earns fees from FFCC based on the volume of mortgage loans serviced. Such fees are determined at fair market value and amounted to approximately $617,000, $410,000 and $348,000 for the years ended December 31, 1993, 1992 and 1991, respectively. FFCC owns a 25% interest in HRU, Inc. FORECLOSURE EXPERIENCE AND REAL ESTATE OWNED. While delinquency rates in Puerto Rico are generally higher than in the mainland United States, these rates are not necessarily indicative of future foreclosure rates or losses on foreclosures. As of December 31, 1993 and 1992, FFCC held real estate owned as a result of foreclosures ("REO") with a book value of approximately $2.9 million and $3.6 million, respectively. As of December 31, 1993 and 1992, an additional amount of REO consisting of approximately $74,000 and $108,000 was rented under a United States government subsidy program. Sales of REO resulted in net losses to FFCC of approximately $1.05 million for the year ended December 31, 1993 and $439,150 for the year ended December 31, 1992. There is no liquid secondary market for the sale of the Company's REO. With respect to mortgage loans securitized through GNMA programs, the Company is fully insured as to principal by the FHA against foreclosure loss while the VA guarantee is subject to a limitation of the lesser of 25% of the loan or $46,000. As a result of these programs, foreclosure on these loans had generated no loss of principal as of December 31, 1993, FFCC, however, incurs about $2,200 per loan foreclosed in interest and legal charges during the time between payment by FFCC and FHA or VA reimbursement. Although FNMA and FHLMC are obligated to reimburse the Company for principal and interest payments advanced by the Company as a servicer, the funding of delinquent payments or the exercise of foreclosure rights involves costs to the Company which may not be recouped. Of the total number of loans serviced by the Company at December 31, 1993 and 1992, 3.11% and 2.94%, respectively, were delinquent and 1.21% and 1.44%, respectively were in foreclosure. (See the delinquency of mortgage loans serviced in the table above.) Any significant adverse economic developments in Puerto Rico, FFCC's primary service area, could result in an increase in defaults or delinquencies on mortgage loans that are serviced by FFCC or held by FFCC pending sale in the secondary mortgage market, thereby reducing the resale value of such mortgage loans. See "Amendments to Section 936." In December 1990, the Company sold REO consisting of 89 residential properties containing 104 housing units with a cost of approximately $4.7 million including previously incurred rehabilitation costs and construction interest to a Puerto Rico partnership (the "Partnership") formed under a private syndication. The general partner of the Partnership was a corporation that was unrelated to the Company or its officers or directors. Several members of senior management of the Company, invested as limited partners. The Company also invested approximately $135,000 in the Partnership, and owns a 15% interest in the Partnership which is included at cost in "Other Assets" in the Company's Balance Sheet. The REO was sold to the Partnership for $4.7 million which was based on an estimate of the market value of the REO as reflected in an independent appraisal report. The appraisal took into consideration the cost of the improvements to be made which were reflected in the sales price to the Partnership. The Company believes that the sales price of the REO was comparable to that which the Company could have obtained in arm's length transactions with unaffiliated parties. Approximately $600,000 of the purchase price was paid in cash at the closing of the sale of the REO and the remainder was evidenced by promissory notes (the "Notes") of the Partnership issued to the Company in the amount of approximately $4.1 million. The Notes bear interest payable on the first day of each month at the prime rate of Citibank, N.A. (with a maximum and minimum rate of 13.5% and 9%, respectively) and mature on April 1, 2006. During December 1990, February 1991 and March 1992, the Company sold a total of $2.8 million principal amount of the Notes to a local financial institution with recourse. On July 31, 1992, pursuant to a mutual agreement between the Company and the general partner, due to what the Company believed was unsatisfactory performance, the general partner withdrew from the Partnership and a new non-profit corporation became the general partner. The Board of Directors of the new non-profit corporation is composed of three members of FFCC's senior management. In connection with such withdrawal, the Company agreed to indemnify the original general partner from certain liabilities incurred during the period it acted as general partner. The Partnership intends to sell or lease the REO and the Company believes that the change in the general partner together with existing market conditions should facilitate such process and that the matters set forth above will not result in any material adverse affect on the financial condition of the Company. As of December 31, 1993, the principal balance of the Notes held by the Company was approximately $400,000. At December 31, 1993, the Partnership owed the Company $483,000 in past due interest. In addition, the Company holds $54,685 of the Partnership's funds as security. As of December 31, 1993, the Company also had accounts receivable due from the Partnership of approximately $550,000, corresponding primarily to repairs and improvements made to the rental properties that were funded by the Company. SALE OF LOANS; ISSUANCE OF MORTGAGE-BACKED SECURITIES. FFCC, as do most mortgage bankers, customarily sells most of the loans that it originates. FFCC issues GNMA-guaranteed mortgage-backed securities, which involve the packaging of FHA loans or VA loans into pools of $1 million or more ($2.5 million to $5 million for serial notes) for sale primarily to broker-dealers in Puerto Rico. During the year ended December 31, 1993, FFCC issued approximately $485 million in GNMA-guaranteed mortgage-backed securities. Most GNMA-guaranteed mortgage-backed securities sold by FFCC are in the form of GNMA serial notes which permit the investor to receive interest monthly and to select among several maturity dates of the notes included in an issue, each maturity having a specific yield. GNMA serial notes are sold in pools of $2.5 million to $5 million. Such pools are composed solely of FHA loans or VA loans originated in Puerto Rico. GNMA serial notes are sold to investment banks in packages consisting of notes of different yields and maturities, which range from 1 to 30 years and have an average maturity of 12 years, taking into account historical experience with prepayments of the underlying mortgages. The rates on the serial notes or GNMA pools must be 1/2 of 1% less than the rates on the mortgages comprising the pool. Upon completion of the necessary processing, the GNMA-guaranteed mortgage-backed securities are offered to the public through securities broker-dealers. During the year ended December 31, 1993, FFCC issued GNMA serial notes totalling approximately $200 million. With respect to loans securitized through GNMA programs, the Company is insured against foreclosure loss by HUD with respect to FHA loans or partially guaranteed against foreclosure loss by the VA (at present, generally 25% of the loan, up to a maximum amount of $46,000, depending upon the amount of the loan with respect to VA loans). According to the applicable VA guidelines, the maximum amount of a VA loan originated in Puerto Rico is presently $184,000. According to applicable FHA guidelines, the maximum amount of a FHA loan ranges from $67,500 to $121,600 depending on the municipality where the mortgaged property is located. Conventional conforming mortgage loans originated or purchased by FFCC are generally grouped into pools of $1 million or more in aggregate principal balance and sold to FNMA or FHLMC in exchange for FNMA- or FHLMC-issued mortgage-backed securities which FFCC sells to securities broker-dealers. The issuance of mortgage-backed securities provides FFCC with flexibility in selling the mortgages which it originates or purchases and also provides income by increasing the value and marketability of the loans. In addition to the issuance and sale of GNMA, FNMA and FHLMC certificates, the Company also sells to institutional investors conventional loans that do not conform to FNMA or FHLMC requirements. In the past, the Company often sold such non-conforming loans to financial institutions with recourse to the Company. In 1993, the Company continued to implement the strategic decision made during 1992 to reduce the sale of such non-conforming loans with recourse and instead pool such loans into so-called "private label" mortgage-backed securities that can be sold in the local market through broker-dealers without recourse to the Company. Each issue of mortgage-backed securities normally consists of several classes of senior, subordinate and residual certificates. The residual certificates evidence a right to receive payments on the mortgage loans after payment of all required amounts on the senior and subordinate certificates then due. Some form of credit enhancement such as an insurance policy or letter of credit will generally be used to increase the credit rating of the senior certificates and thereby improve their marketability. During the year ended December 31, 1993, the Company completed sales of approximately $115 million aggregate principal amount of mortgage-backed securities in similar transactions, of which $106 million consisted of senior certificates insured by Financial Security Assurance, Inc. ("FSA"). Subject to market conditions, the Company contemplates entering into similar transactions in the future. As part of its arrangement with FSA, the Company has agreed to retain and pledge to FSA the residual certificates issued by the respective trusts. While the Company normally sells mortgage loans on a non-recourse basis, it also engages in the sale of mortgage loans on a recourse basis. At December 31, 1993, the Company had loans in its servicing portfolio with provisions for recourse in the principal amount of approximately $164 million, as compared to $244 million as of December 31, 1992. Of these recourse loans, approximately $23 million in principal amount consisted of loans sold to FNMA and FHLMC, and approximately $141 million principal amount consisted of non-conforming loans sold to other private investors. In November 1993, the Company entered into a commitment to sell $100 million of mortgage loans on a recourse basis to FHLMC by May 15, 1994. The Company will attempt to obtain future FHLMC commitments on a non-recourse basis. The Company estimates the fair value of the retained recourse obligation at the time mortgage loans are sold. Normally, the fair value of any retained recourse is immaterial because the Company is able to resell repurchased loans for at least their carrying costs. Accordingly, to date, the Company has not deemed it necessary to establish reserves for possible losses related to recourse obligations. In addition to the sale of the "private label" mortgage-backed securities referred to above, the Company has, from time to time, sold mortgage-backed securities in bulk to local broker-dealers or financial institutions. These mortgage-backed securities are normally converted into collateralized mortgage obligations by the purchasers and sold in the local market. INTEREST RATE MANAGEMENT. The sale of mortgage loans and mortgage-backed securities can generate a gain or a loss. Cash losses on sales of loans occur when FFCC sells loans at a discount from their book value. A loss from the sale of loans may occur if interest rates rise between the time FFCC fixes the interest rates charged to the borrowers on the loans and the time the loans are sold to investors. FFCC manages this interest rate risk through the use of forward commitments and other hedging techniques. In the case of FNMA and FHLMC conforming loans and FNMA and FHLMC mortgage-backed securities and GNMA certificates, the Company often seeks to obtain commitments from third parties for the purchase of loans or mortgage-backed securities at the time it fixes the interest rates for the loans. At December 31, 1993, the amount of such forward commitments was $175 million or approximately 43% of the total mortgage loans and mortgage-backed securities held for sale as of such date. The Company normally holds GNMA certificates for longer periods prior to sale to investors in order to maximize its net interest income and to take advantage of the tax exempt status of the interest on such securities under Puerto Rico law. The Company has in place long-term reverse repurchase agreements secured by GNMA certificates with a principal amount of approximately $42 million. The Company does not obtain forward commitments for such GNMA certificates because they are financed pursuant to long-term repurchase agreements. The Company has the right to substitute GNMA certificates subject to the repurchase agreements with similar GNMA certificates at any time. Prices for GNMA certificates in Puerto Rico tend to be more stable than on the mainland U.S. because of the tax exempt status of interest paid on these securities under Puerto Rico law. In the case of FNMA and FHLMC conforming loans and mortgage-backed securities the Company also seeks to protect itself from interest rate risk by purchasing options on eurodollar certificates of deposit, futures contracts and, to a lesser extent, options on treasury bond futures contracts. Contracts designated as trading hedges are marked-to-market on a monthly basis with the resulting gains and losses charged to operations. Changes in the market value of futures contracts that qualify as hedges of existing assets and liabilities are recognized as an adjustment to the book value of the asset or liability being hedged. The level of investment in such options is increased or decreased as interest rates change and may reach significant levels relative to the Company's current liabilities. As of December 31, 1993, FFCC had hedged a portion of its short-term liabilities through this strategy. In the future, FFCC may utilize alternative hedging techniques including futures, options or other synthetically created hedge vehicles to help mitigate interest rate and market risk. However, there can be no assurance that any of the above hedging techniques will be successful. For the years ended December 31, 1993, 1992 and 1991, FFCC experienced losses of approximately $1,367,000, $1,376,000 and $999,000, respectively, from its hedging activities. Losses on hedging activities are generally indicative of higher profits realized on the sale of mortgage loans and mortgage-backed securities. MARKET INTEREST RATES AND NET INTEREST INCOME. A greater proportion of the Company's net income has generally been composed of net interest income than is typical of mortgage banking institutions in the mainland United States. This is primarily due to the fact that the Company traditionally has held mortgage loans and mortgage-backed securities, particularly GNMA certificates, for longer periods prior to sale than is typical for mortgage banking institutions in the mainland United States. For the years ended December 31, 1993 and 1992, the Company held mortgage loans for an average period of 98 and 118 days, respectively, as compared to 185 days for 1991. The decrease in the average period mortgage loans were held prior to sale during the year ended December 31, 1993 as compared to the prior year was primarily due to favorable market conditions that allowed the Company to increase its sale of mortgage-backed securities, the continued pooling and selling of non-conforming loans as mortgage backed securities and a shift in emphasis from origination of FHA and VA loans to FHLMC and FNMA conforming loans which the Company normally sells within 60 days of origination. The continued emphasis on the origination of FHLMC and FNMA conforming loans versus FHA and VA loans is dependent on market conditions, the relative pricing and return on origination of the different types of mortgage loans and the maximum loans amounts for the various types of loans. Mortgage loans and mortgage-backed securities have been held for longer periods by the Company primarily for two reasons. The first relates to Puerto Rico regulatory requirements and the operation of the GNMA serial note program in Puerto Rico. In order to be able to fund the origination of mortgage loans with tax-advantaged 936 Funds (see "Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment" below), mortgages qualifying for favorable tax treatment must be segregated and separately funded from non-qualifying mortgages. This requirement, together with the fact that the GNMA serial note pools consist of a minimum of $2.5 million principal amount of mortgage loans as compared to $1 million for other GNMA programs, obligates the Company to hold mortgage loans and mortgage-backed securities for longer periods prior to sale in order to assemble such pools. In addition to the foregoing regulatory constraints, the Company has made a strategic decision to hold GNMA certificates for longer periods to take advantage of attractive interest rate spreads and thereby maximize the Company's net interest income and tax exempt income. The fact that interest rate spreads on certain mortgage loans and mortgage-backed securities in Puerto Rico have traditionally been high due to the ability of mortgage banking institutions to finance their inventory of mortgage loans and mortgage-backed securities with lower-cost tax advantaged funds has also helped the Company maximize its net interest income. See "Interest Rate Management." While holding mortgage loans and mortgage-backed securities for longer periods has allowed FFCC to maximize its net interest income, changes in prevailing market interest rates between the time FFCC commits to an interest rate on a mortgage loan and the time the mortgage loan is sold to permanent investors could reduce FFCC's net interest income on mortgage loans held prior to sale and gains from the sale of loans and thereby reduce FFCC's net income. FFCC attempts to manage these risks by securing commitments for future delivery or engaging in managed hedging transactions such as those described under "Interest Rate Management." PUERTO RICO SECONDARY MORTGAGE MARKET AND FAVORABLE TAX TREATMENT. In general, the Puerto Rico market for mortgage-backed securities is an extension of the United States market with respect to pricing, rating of the investment instruments, and other matters. However, United States and Puerto Rico tax laws provide an economic incentive for Puerto Rico residents and Section 936 Corporations (defined below) to invest in certain mortgage loans and mortgage-backed securities originated in Puerto Rico, including FHA and VA loans and GNMA certificates, thereby increasing the secondary market demand for, and resale value of, such mortgage loans and mortgage-backed securities. These tax advantages also significantly affect FFCC's net interest income by helping create a pool of lower-cost funds that FFCC can access through financial intermediaries such as banks and broker-dealers and use to fund mortgage loans and mortgage-backed securities pending sale. The Company's operations are significantly affected by Federal and Puerto Rico laws and regulations designed to promote economic development in Puerto Rico, particularly the Industrial Incentives Acts and Section 936. Under the Industrial Incentives Acts, certain investment income earned by qualified manufacturing entities or service enterprises ("Exempt Companies") is exempt from Puerto Rico income tax. The various Puerto Rico Industrial Incentive Acts (the "Incentives Acts") also encourage investment in Puerto Rico by allowing Exempt Companies to reduce the otherwise applicable 10% tax (the "Tollgate Tax") on distributions to shareholders by investing their exempt industrial development income ("IDI") in Puerto Rico for fixed periods of time, generally from five years to ten years. Investment income that qualifies for this exemption includes interest on certain mortgage loans and interest on funds of Exempt Companies ("936 Funds") placed with eligible institutions in Puerto Rico (primarily savings and loan associations, commercial banks and registered broker-dealers) provided such funds are invested in certain "eligible activities" in accordance with regulations promulgated by the Commissioner, including certain mortgage loans and mortgage-backed securities. On October 25, 1993 the Legislature of Puerto Rico enacted two bills amending certain provisions of the Incentives Acts and the Puerto Rico Income Tax Act of 1954, as amended (the "TIA"). In general, one of the bills has the effect of increasing the minimum Tollgate Tax paid by an Exempt Company under the Incentives Acts upon distribution of its IDI. Under that bill, any Exempt Company under the TIA may reduce the 10% tollgate tax imposed on distributions of IDI accumulated during taxable years beginning after December 31, 1992 to 6% or 5% (compared to 5% and 2% under current law) if at least 50% of the net IDI is invested in investments described in Section 2(j) for more than five years or more than eight years, respectively. The law also eliminates the provisions of the Incentives Acts and those of the Tax Act that provide special Tollgate Tax reduction benefits to investments of IDI in obligations of the Commonwealth government and its instrumentalities and for investments for a period of more than five years. Under the other bill, Exempt Companies will generally be allowed to pay an up-front 14% income tax (the "Alternative Tax") on the IDI derived including investment income other than interest on government obligations during taxable years beginning after December 31, 1992 payable in the taxable year earned, in lieu of payment of the otherwise applicable income tax on non-exempt income and of the Tollgate Tax on future distributions of such IDI. The Alternative Tax can be reduced to 11% or 9% if the Exempt Company invests 25% or 50%, respectively, of its net IDI in certain Puerto Rico investments for a period of five years. An Exempt Company may satisfy up to one half of the 50% investment requirement by investing in property, plant and equipment with a depreciable life of at least ten years. The amendments, while maintaining important incentives for investing in Puerto Rico could have the effect of reducing the amount of funds invested in Puerto Rico by Exempt Companies as a result of the changes in the relative costs to an Exempt Company of distributing IDI to its shareholders and, therefore, could result in an increase in the costs of funds for Puerto Rico borrowers, including the Company, and a reduction in the demand for Puerto Rico investments, including mortgage loans and mortgage-backed securities sold by the Company. While the final impact on the Company of the adoption of the amendments cannot be determined at this time, to date the adoption of the amendments to date has not had a material adverse effect on the Company's business or financial condition nor does the Company expect such an effect in the future. Most Exempt Companies are United States corporations which operate in Puerto Rico under Section 936 of the Code ("Section 936"). Corporations that meet certain requirements and elect the benefits of Section 936 ("Section 936 Corporations") are entitled to credit against their United States corporate income tax a portion of such tax attributable to (i) income derived from the active conduct of a trade or business within Puerto Rico ("active business income") or from the sale or exchange of substantially all assets used in the active conduct of such trade or business and (ii) qualified possession source investment income ("QPSII"). Interest derived from Puerto Rico mortgage loans and mortgage-backed securities consisting of Puerto Rico mortgage loans generally qualifies as QPSII. To qualify under Section 936 in any given taxable year a corporation must derive (i) for the three-year period immediately preceding the end of such taxable year, 80% or more of it gross income from sources within Puerto Rico and (ii) for taxable years beginning after December 31, 1986, 75% or more of its gross income from the active conduct of a trade or business in Puerto Rico. A Section 936 Corporation may elect to compute its active business income eligible for the Section 936 credit under one of three formulas: (i) a cost sharing formula, whereby it is allowed to claim all profits attributable to manufacturing intangibles and other functions carried out in Puerto Rico, provided it contributes to the research and development expenses of its affiliated group or pays certain royalties; (ii) a profit split formula, whereby it is allowed to claim approximately 50% of the net income of its affiliated group from the sale of products manufactured in Puerto Rico; or (iii) a cost plus formula, whereby it is allowed to claim a reasonable profit on the manufacturing costs incurred in Puerto Rico. To be eligible for the first two formulas, a Section 936 Corporation must have a significant business presence in Puerto Rico for purposes of a Section 936 rules. Section 936 was amended on August 10, 1993, and the benefits thereunder were modified in certain important respect. See "Recent Amendments to Section 936 and Industrial Incentives Acts" below. In addition to the foregoing incentives, interest derived from FHA loans or VA loans secured by real property in Puerto Rico originated after June 30, 1983, and, under certain circumstances, on or before February 15, 1973, and from GNMA certificates consisting of such mortgages, is exempt from Puerto Rico income tax. FHA and VA mortgage loans are also exempt from Puerto Rico gift and estate taxes. Individuals who are bona fide residents of Puerto Rico are also not subject to United States federal income tax on income from Puerto Rico sources, including interest income derived from mortgage loans originated in Puerto Rico whose mortgagors are residents of Puerto Rico. The tax benefits available to investors of mortgage loans decrease the yield Puerto Rico investors, including, Exempt Companies, require; therefore, certain loans, specifically FHA, VA and FHLMC and FNMA conforming conventional loans, are generated at interest rates which are lower than the prevailing interest rates in the mainland United States. FFCC is also able to sell them to local investors at prices higher than those at which comparable instruments would be sold in the mainland United States. In addition, the tax incentives available to Exempt Companies, particularly Section 936 Corporations, on investments in Puerto Rico have created a large pool of tax-advantaged funds in Puerto Rico that make it possible for FFCC to finance its loan originations and inventory of mortgage loans at interest rates that generally are lower than would be available otherwise and thereby generate a higher level of net interest income than would otherwise be possible. FFCC borrows 936 Funds through short-term repurchase agreements and warehousing lines of credit with banks and broker-dealers. See "Borrowing Arrangements." Any change in the United States or Puerto Rico tax laws that would reduce or eliminate the tax benefits available to Section 936 Corporations, financial institutions or individuals on investments in Puerto Rico mortgage loans and mortgage-backed securities, could have a material adverse effect on the liquidity of the secondary mortgage market and the profitability of FFCC. See "Amendment to Section 936" below. In addition, a change in Puerto Rico's political status could result in the elimination or modification of these tax benefits. See "Relationship of Puerto Rico with the United States." AMENDMENT TO SECTION 936. The Omnibus Budget Reconciliation Act of 1993, which was signed into law by President Clinton on August 10, 1993, contains certain amendments (the 936 "Amendments") to Section 936. In general, the 936 Amendments, which are generally effective for taxable years beginning after December 31, 1993, will permit a taxpayer to compute the tax credit available under Section 936 as under prior law but would limit the amount of credit allowed as determined under one of two alternatives to be selected at the option of the taxpayer. Under the first alternative, the limit would be equal to a fixed percentage of the amount of tax credit allowable under current law. This fixed percentage would commence at 60% for taxable years beginning in 1994 and would be reduced by 5% per year until 1998. For taxable years beginning in 1998 such percentage would be 40%. Under the second alternative, which is based on the amount of economic activity conducted by the taxpayer in Puerto Rico, the credit may not exceed the sum of the following three components: (i) 60% of the qualified possession wages and 15% allocable fringe benefits paid by the taxpayer, (ii) applicable percentages of certain depreciation deductions claimed for regular tax purposes by the taxpayer with respect to qualified tangible property and (iii) a portion of the possession income taxes paid by the taxpayer except where the taxpayer uses the profit-split method for determining its income. Unlike certain earlier proposals, the 936 Amendments would not limit the 100% credit currently available under Section 936 for qualified possession source investment income, including income received from investment in certain Puerto Rico mortgage loans and mortgage-backed securities. It is not possible at this time to predict what effect the 936 Amendments will have on the economy of Puerto Rico. The 936 Amendments could have an adverse effect on the general economic condition of Puerto Rico by reducing incentives for investment in Puerto Rico. Any such adverse effect on the general economy of Puerto Rico could lead to an increase in mortgage delinquencies and a reduction in the level of residential construction and demand for mortgage loans. The adoption of the 936 Amendments could also indirectly lead to a decrease in the amount of funds invested in Puerto Rico financial assets by 936 Corporations to the extent that the level of operations and production in Puerto Rico by such 936 Corporations is decreased over time. While the impact on the Company cannot be determined at this time, the Company does not believe that the adoption of the 936 Amendments will have a material adverse effect on its business or financial condition. BORROWING ARRANGEMENTS. Historically, a period of two to four months has normally elapsed between the origination of a mortgage loan by FFCC and its sale to permanent investors. The Company may hold GNMA certificates for longer periods to take advantage of tax exempt interest income on such certificates while FNMA and FHLMC conforming loans are normally sold within 60 days of origination. During this period, FFCC generally completes the loan process, obtains a VA guarantee or HUD/FHA insurance certificate or private mortgage insurance on the loan, and pools the loans for resale in the secondary mortgage market. Prior to issuance of GNMA or other mortgage-backed certificates, FFCC's mortgage loans are funded almost entirely by borrowings under warehousing lines of credit or other financing agreements with financial institutions. FFCC has existing lines of credit with three commercial banks and a line of credit for commercial loans in the amount of $3 million with the Economic Development Bank for Puerto Rico. During 1993, the Company also entered into a presale or gestation facility with a financial institution with an aggregate borrowing capacity of $150 million which permits the Company to obtain more favorable financing rates once mortgage loans have been assigned to a pool but prior to securitization and to the actual issuance of the mortgage-backed security. Typically, FFCC finances on a monthly weighted average basis between 90% and 95% of the principal amount of its mortgage loans and secures advances under these lines of credit by pledging such loans and the servicing agreements relating thereto to such banks or financial institutions, a practice commonly referred to as "warehousing." On an absolute basis, the percentage of principal amount will range from 90% for conventional mortgages (one bank will only lend up to 80% of the principal amount of conventional mortgages) to 95% for FHA and VA loans. The rates of interest FFCC pays under its warehousing lines of credit fluctuate depending upon changes in the lending bank's cost of funds. During 1993, FFCC's cost of funds under its warehousing lines of credit ranged from 3.93% to 4.57%. The monthly weighted average cost of funds borrowed under its warehousing lines of credit during the years ended December 31, 1992 and 1991 was 5.3% and 7.45%, respectively, compared to 4.2% for the year ended on December 31, 1993. FFCC warehousing lines of credit are generally terminable at the discretion of the lender. FFCC pays interest on its lines of credit at floating rates which vary with market conditions. The interest rates on these lines of credit have been lower than the interest rates which FFCC earns on the mortgage loans pledged to secure such financing. Amounts borrowed under lines of credit are payable upon demand and are usually repaid after FFCC packages such mortgage loans into GNMA, FNMA or FHLMC certificates and receives the proceeds from the sale of such certificates or the financing of such securities under repurchase agreements. During 1993 the Company made a strategic to diversify its sources of funding and to obtain funding from sources outside of Puerto Rico. Obtaining credit from financial institutions located outside Puerto Rico generally permits the Company to obtain larger lines of credit and reduces its dependence on tax advantaged funding available in the local market. FFCC also obtains short-term financing through repurchase agreements with financial institutions and investment banking firms. Under these agreements, FFCC sells GNMA, FNMA or FHLMC-guaranteed mortgage-backed securities and simultaneously agrees to repurchase them at a future date at a fixed price. FFCC uses the proceeds of such sales to repay borrowings under its bank warehousing lines of credit. The effective cost of funds under repurchase agreements is typically lower than the costs of funds borrowed under FFCC's warehousing lines of credit. FFCC's continued use of repurchase agreements will depend upon the cost of repurchase agreements relative to the cost of borrowing under lines of credit from banks. The monthly weighted average cost of funds borrowed through repurchase agreements for the years ended December 31, 1992 and 1991 was 4.03% and 5.44%, respectively, compared to 3.34% for the year ended on December 31, 1993. DORAL FEDERAL SAVINGS BANK On September 10, 1993, the Company acquired all the outstanding common stock of Doral Federal, Doral Federal is a federal savings association whose deposit accounts are insured by the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation. As of December 31, 1993, Doral Federal had total assets of approximately $34 million and a net worth of $6.2 million. During the year ended December 31, 1993, Doral Federal did not have a significant impact on the financial results of the Company experiencing a loss of approximately $50,000 from the date of acquisition through December 31, 1993. During 1993, Doral Federal did experience substantial growth in assets growing from $12 million in assets as of September 10, 1993 to $34 million in assets as of December 31, 1993. This growth was financed largely through a $5.0 million capital contribution from the Company, retail deposits, escrow accounts associated with the Company's servicing portfolio and advances from the Federal Home Loan Bank of New York. This rate of growth is not necessarily indicative of future growth. Doral Federal operates through two branches located in the San Juan metropolitan area. These branch locations serve primarily as deposit-taking operations, since to date most loans have been originated pursuant to the Master Loan Production Agreement referred to below. As of December 31, 1993, Doral Federal had deposits of approximately $26.4 million. Escrow accounts associated with the Company's servicing portfolio, commercial accounts of the Company and retail deposits, constituted approximately 32%, 11% and 57%, respectively, of Doral Federal's total deposit accounts. Doral Federal has entered into a Master Loan Production Agreement with the Company whereby the Company has agreed to meet its stated production goals by, among other things, (1) advertising, promotion and marketing to the general public, (2) interviewing prospective borrowers and initial processing of loan applications, consistent with Doral Federal's underwriting guidelines, and (3) providing personnel and facilities with respect to the execution of loan agreements. The terms of the Master Loan Production Agreement are believed to be at least as favorable to Doral Federal as those prevailing for comparable transactions with or involving other non-affiliated companies. In the future, Doral Federal may determine to engage in direct mortgage loan originations through its branch network. Doral Federal has also entered into a Master Purchase, Servicing and Collection Agreement (the "Master Purchase Agreement") with the Company providing for the sale by Doral Federal to the Company of the servicing rights to all first and second mortgage loans secured by residential properties, all loans secured by commercial real estate, all commercial business loans, all consumer and any other loans which presently are, or will become, part of Doral Federal's loan portfolio (the "Loans"). The Master Purchase Agreement further provides that the Company, exclusively, will service the Loans, and that Doral Federal will continue to process collections of payments of the Loans, all according to a fee schedule contained in the Master Purchase Agreement. The fee schedule provides that the purchase price of the servicing rights with respect to the Loans is a percentage of the outstanding principal amount of such Loans, and depends on the term to maturity of the Loans. The terms of the Master Purchase Agreement are believed to be at least as favorable to Doral Federal as those prevailing for comparable transactions with or involving other non-affiliated companies. As of December 31, 1993, Doral Federal met all its fully phased-in capital requirements (i.e. tangible capital and core capital of at least 1.5% and 3.0%, respectively, of adjusted assets and risk based capital of at least 8% of risk adjusted assets). As of December 31, 1993, Doral Federal had tangible capital and core capital equal to $5.6 million, or 17% of adjusted assets. As of such date, it had risk based capital of $5.8 million or 41% of risk adjusted assets. MARKET AREA AND COMPETITION. Prior to March 1992, Puerto Rico was FFCC's exclusive service area. Within Puerto Rico, FFCC's primary market area is the metropolitan San Juan area, which accounted for approximately 79% of FFCC loan originations in 1993. The competition in Puerto Rico for the origination of mortgages is substantial. Competition comes not only from other mortgage bankers, but also from major banks and savings and loan associations. There are approximately 36 mortgage banks, seven savings institutions and 16 commercial banks operating in Puerto Rico, including affiliates of banks headquartered in the United States, Canada and Spain. The Company competes principally by offering loans with competitive features, by emphasizing the quality of its service and pricing its range of products at competitive rates. In March 1992, Doral opened a branch office in the Orlando, Florida metropolitan area. In February 1994, Doral opened an additional office in Miami, Florida. The Company is considering the possibility of opening additional offices in the State of Florida. Puerto Rico, the fourth largest of the Caribbean islands, is located approximately 1,600 miles southeast of New York, New York and 1,000 miles east-southeast of Miami, Florida. It is approximately 100 miles long and 35 miles wide. The population of Puerto Rico for 1990, as determined by the United States Census Bureau, was approximately 3.6 million as compared to 3.2 million in 1980. The Puerto Rico Planning Board estimates that the San Juan metropolitan area has a population in excess of 1.0 million. RELATIONSHIP OF PUERTO RICO WITH THE UNITED STATES. The Constitution of Puerto Rico was drafted by a popularly elected constitutional convention, overwhelmingly approved in a special referendum and approved "as a compact" by the United States Congress and the President, becoming effective upon proclamation of the Governor of Puerto Rico on July 25, 1952. Puerto Rico's relationship to the United States under the compact is referred to herein as "commonwealth status." The United States and Puerto Rico share a common defense, market and currency. Puerto Rico exercises virtually the same control over its internal affairs as a state government does. The people of Puerto Rico are citizens of the United States, but do not vote in national elections and they are represented in Congress by a Resident Commissioner who has a voice in the House of Representatives but only limited voting rights. Most federal taxes, except those such as social security taxes which are imposed by mutual consent, are not levied in Puerto Rico. No federal income tax is collected from Puerto Rico residents on ordinary income earned from sources within Puerto Rico, except for Federal employees who are subject to taxes on their salaries. Corporations organized under the laws of Puerto Rico are treated as foreign corporations for federal income tax purposes. For many years there have been two major views in Puerto Rico with respect to the island's relationship to the United States, one essentially favoring the existing commonwealth status and the other favoring statehood. On November 14, 1993, a plebiscite was held in Puerto Rico to allow eligible voters an opportunity to express their preference between statehood, Commonwealth (with certain changes) and independence for Puerto Rico. The Commonwealth status obtained the most votes receiving 48.6% of the votes cast, statehood and independence received 46.3% and 4.4% of the votes casts, respectively. A change in the political status of Puerto Rico could result in modifications to or elimination of Section 936 and of the Puerto Rico laws providing favorable tax treatment for investment in Puerto Rico mortgages and, therefore, could have a material adverse effect on the Company's cost of borrowing, the liquidity of the secondary mortgage market and the financial performance of FFCC. See "Puerto Rico Secondary Mortgage and Favorable Tax Treatment" herein. PUERTO RICO INCOME TAXES. FFCC is subject to Puerto Rico income taxes. The income tax rates range from 22%, on taxable income of $25,000 or less, to 42% on taxable income in excess of $300,000. The net interest income derived by FFCC from FHA loans or VA loans secured by residential properties located in Puerto Rico originated after June 30, 1983 is excluded from FFCC's gross income in computing its regular income tax. Therefore, such income is tax-exempt to FFCC. However, under the Puerto Rico Income Tax Act of 1954, as amended ("PRITA"), to the extent that FFCC holds obligations on which the interest is not subject to Puerto Rico income tax, including FHA loans or VA loans acquired after December 31, 1987 ("Exempt Obligations"), FFCC's interest expense deduction in computing its regular corporate income tax will be reduced in the same proportion that said Exempt Obligations bear to its total assets. Income tax savings of FFCC attributable to this exemption amounted to $2.7 million, $2.2 million and $1.0 million in 1993, 1992 and 1991, respectively. The Company is also subject to an alternative minimum tax of 22% on its alternative minimum tax net income. In computing the Company's alternative minimum tax net income its interest expense deduction will be reduced in the same proportion that its Exempt Obligations (irrespective of the date on which the same were acquired by the Company) bear to its total assets. Therefore, to the extent that the Company holds FHA loans or VA loans and other Exempt Obligations, it may be subject to the payment of the 22% alternative minimum tax. Under PRITA, corporations are not permitted to file consolidated returns with their subsidiaries and affiliates. FFCC is entitled to an 85% dividend received deduction on dividends received from Doral or any other Puerto Rico corporation subject to tax under PRITA, which, assuming a maximum corporate tax rate of 42%, results in an effective income tax rate on such dividends of 6.3%. UNITED STATES INCOME TAXES. FFCC and Doral are corporations organized under the laws of Puerto Rico. Accordingly, FFCC and Doral are subject generally to United States income tax only on their income, if any, from sources within the United States. Prior to 1992, the Company did not earn any income that was subject to United States income tax. However, in March 1992, Doral opened a branch in Florida. This will make Doral subject to both Florida income and franchise and federal income tax on income effectively connected with the conduct of the trade or business of this branch. The maximum United States corporate income tax rate is presently 34% and the Florida income and franchise tax rate is currently 5.5%. In addition, the United States may impose a branch profits tax of 30% in the event that profits from the Florida branch are repatriated to Puerto Rico. Both the federal tax as well as the branch profit tax may be claimed as a credit in Puerto Rico, subject to certain limitations. Doral Federal, as a federal savings association, is also subject to U.S. income taxes. It will be entitled to a foreign tax credit for a portion of income taxes paid to the Puerto Rico Treasury Department. Doral Federal has also elected to qualify for the benefits provided under Section 936 which allows an income tax credit for a portion of the U.S. income taxes attributable to the earnings derived from sources within Puerto Rico. See "Amendment to Section 936" for a description of these benefits. The election of the benefits available under Section 936 together with the fact that Doral Federal has substantial tax loss carryforwards will result in Doral Federal not having a significant U.S. income tax liability for several years. EMPLOYEES. At December 31, 1993, FFCC employed 927 persons, of whom 252 were administrative personnel, 143 were loan originators, 283 were involved in processing of loan applications (including quality control auditors), 13 were loan underwriters, and 236 were involved in loan servicing activities. None of FFCC's employees is represented by a labor union and FFCC considers its employee relations to be excellent. REGULATION. The Company's Mortgage Banking Business is subject to the rules and regulations of FHA, VA, FNMA, FHLMC and GNMA with respect to originating, processing, selling and servicing mortgage loans and the issuance and sale of mortgage-backed securities. Those rules and regulations, among other things, prohibit discrimination and establish underwriting guidelines which include provisions for inspections and appraisals, require credit reports on prospective borrowers and fix maximum loan amounts, and with respect to VA loans, fix maximum interest rates. Moreover, lenders such as the Company are required annually to submit to FNMA, FHA, FHLMC, GNMA and VA audited financial statements, and each regulatory entity has its own financial requirements. The Company's affairs are also subject to supervision and examination by FNMA, FHA, FHLMC, GNMA, HUD and VA at all times to assure compliance with the applicable regulations, policies and procedures. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act and the Real Estate Settlement Procedures Act and the regulations promulgated thereunder which, among other things, prohibit discrimination and require the disclosure of certain basic information to mortgagors concerning credit terms and settlement costs. The Company is also subject to regulation by the Commissioner, with respect to, among other things, licensing requirements and establishment of maximum interest rates. Although the Company believes that it is in compliance in all material respects with applicable Federal and Puerto Rico laws, rules and regulations, there can be no assurance that more restrictive laws or rules will not be adopted in the future, which could make compliance more difficult or expensive, restrict the Company's ability to originate or sell mortgage loans or sell mortgage-backed securities, further limit or restrict the amount of interest and other fees earned from the origination of loans, or otherwise adversely affect the business or prospects of the Company. See "General." HF's rights to sell mortgage loans to FHLMC were suspended on November 3, 1993 because of deficiencies in its origination procedures. FHLMC's action did not affect HF's ability to continue to service FHLMC loans. HF has worked closely with FHLMC to address the shortcomings. In the meantime, HF has increased substantially the sale of conventional loans to FNMA and other investors. While no assurances can be given, the Company believes that HF will be reinstated as a FHLMC seller. The Company believes that the FHLMC action has not had nor will it have a material adverse effect on HF or the Company. Doral, the Company's principal mortgage banking unit, has continued to sell conforming conventional loans to FHLMC. Such sales are currently being made on a recourse basis. See "Business-Mortgage Banking Business Sale of Loans; Issuance of Mortgage-Backed Securities". FFCC is licensed by the Commissioner as a mortgage banking institution in Puerto Rico. Such authorization to act a mortgage banking institution must be renewed as of January 1 of each year. In the past, FFCC has not had any difficulty in renewing its authorization to act as a mortgage banking institution, and management is unaware of any existing practices, conditions or violations which would result in FFCC being unable to receive such authorization in the future. FFCC operations in the State of Florida are subject to supervision by the Florida Department of Banking and Finance. Section 5 of the Puerto Rico Mortgage Banking Institutions Law (the "Mortgage Banking Law") requires the prior approval of the Commissioner for the acquisition of control of any mortgage banking institution licensed under the Mortgage Banking Law. For purposes of the Mortgage Banking Law, the term "control" means the power to direct or influence decisively, directly or indirectly, the management or policies of a mortgage banking institution. The Mortgage Banking Law provides that a transaction that results in the holding of less than 10% of the outstanding voting securities of a mortgage banking institution shall not be considered a change of control. Pursuant to Section 5 of the Mortgage Banking Law, upon receipt of notice of a proposed transaction that may result in change of control, the Commissioner is obligated to make such inquiries as he deems necessary to review the transaction. Under the Mortgage Banking Law, the determination of the Commissioner whether or not to authorize a proposed change of control is final and non-appealable. As a result of the acquisition of Doral Federal, FFCC became a savings and loan holding company ("SLHC") subject to the restrictions and requirements of the Home Owners' Loan Act of 1933, as amended (the "HOLA"). As an SLHC, FFCC was required to register with the Director (the "Director") of the OTS and is be subject to the various requirements of Sections 10 and 11 of the HOLA and the regulations thereunder, including examination, supervision and reporting requirements. Of particular importance, is the requirement that a subsidiary savings association give the Director at least 30 days advance notice of the proposed declaration by its directors of dividends on its stock. Any such dividend declared within the 30 day notice period, or declared without giving such notice, is invalid. Payment of cash dividends by a savings association on shares of its capital stock is also subject to the limitations on capital distributions imposed by the OTS. Under this regulation, the amount available for the payment of dividends during any calendar year depends on whether such association meets or exceeds certain specified tiers or levels of capital requirements (i.e., the "fully phased-in capital requirement," the "minimum capital requirement," or less than the "minimum capital requirement," for which latter tier specific written approval is required for the payment of any cash dividend). Even though an association may meet one of the specified levels of capital requirements, the OTS may prohibit such payment if it determines that the making of such payment would constitute an unsafe or unsound practice. The OTS may object to or authorize capital distributions in excess of the safe harbor amount specified in such Sections. Federal law and OTS regulations place certain limits on the types of activities in which a SLHC and its subsidiaries may engage. However, in general, these activity restrictions do not apply to a holding company that controls only one savings and loan association, provided such association meets the "qualified thrift lender" test which generally requires an association to have 65% of its portfolio assets in "qualified thrift investments" for nine months out of the immediately preceding 12 months. For Puerto Rico based institutions, these investments include, among other things, home mortgages, mortgage-backed securities, and personal loans. Under some circumstances (principally not holding sufficient "qualified thrift assets" to meet the "qualified thrift lender test") an SLHC may be deemed for regulatory purposes to become a bank holding company. In such event, it would become subject to additional regulatory restrictions including the application of the statutes and regulations governing the payment of dividends by a national bank in the same manner and to the same extent as though it were a national bank. Under the National Bank Act, national banks are only permitted to pay dividends out of "net profits" (as defined therein) subject to the requirement that a certain portion of net profits must be carried periodically to the bank's surplus fund until the surplus fund shall equal its common capital. Capital may not be used to pay dividends. Doral Federal currently is in compliance with the "qualified thrift lender" test and expects to continue to comply with this requirement. With certain specific exceptions, a SLHC is prohibited from acquiring more than 5% of the "voting shares" of a savings association that is not a subsidiary, or of another SLHC that is not a subsidiary. An association which is a subsidiary of a SLHC is prohibited from or subject to restrictions upon engaging in certain transactions involving its affiliates under the provisions of Sections 23A and 23B of the Federal Reserve Act,which are made applicable, with certain exceptions, to savings associations by Section 11(a) of the HOLA. In general, the term "affiliate" with respect to such subsidiary savings association would include the SLHC, its subsidiaries and companies controlled by it, and would also include a bank subsidiary of a savings association, but not a non-bank subsidiary thereof (unless a contrary determination were made pursuant to Section 23A as to such non-bank subsidiary). As a general rule, a savings association may borrow up to the amount authorized by the laws under which the savings association operates. However, if the savings association fails to meet its regulatory capital requirement, it must notify the Director of its intent to issue securities evidencing such borrowings. Such securities may not be issued if the OTS disapproves. Because of the Company's statutes as an SLHC, owners of the Company's Common Stock are subject to certain restrictions and disclosure obligations under various federal laws, including the Change in Bank Control Act (the "Control Act") and the Savings and Loan Holding Company Act (the "Holding Company Act"). Regulations pursuant to the Control Act and the Holding Company Act generally require prior OTS approval for an acquisition of control of an insured institution (as defined) or holding company thereof by any person (or persons acting in concert). Control is deemed to exist if, among other things, a person (or persons acting in concert) acquires more than 25% of any class of voting stock of an insured institution or holding company thereof. Control is presumed subject to rebuttal if a person (or persons acting in concert) acquires more than 10% of any class of voting stock or 25% of any class of nonvoting stock and is subject to any of the "control factors" set forth in such regulations. The control factors relate, among other matters, to the percentage of such company's debt or equity owned by the person (or persons acting in concert), agreements giving the person (or persons acting in concert) influence over a material aspect of the company's management or policies, and the number of seats on the board of directors of the company held by the person (or persons acting in concert). One of the "control factors" is a holder's status as one of the two largest holders of any class of voting stock. The concept of acting in concert is very broad and also is subject to certain rebuttable presumptions, including among others, that relatives, business partners, management officials, affiliates and others are presumed to be acting in concert with each other and their businesses. FFCC has also considered from time to time engaging in the business of acting as an intermediary between Exempt Companies and depository institutions for certain money market deposits in Puerto Rico. ITEM 2. ITEM 2. PROPERTIES The executive and administrative offices of the Company are located at 1159 Franklin D. Roosevelt Avenue, Puerto Nuevo, San Juan, Puerto Rico and consist of approximately 11,136 square feet of office space. Doral's executive and administrative offices are located at 650 Munoz Rivera Avenue, San Juan, Puerto Rico and consist of approximately 33,000 square feet of office space. The Company also leases additional office space of approximately 31,000 square feet throughout Puerto Rico. These offices are leased for various terms expiring through 2005. Annual aggregate rental payments made in the years 1993, 1992 and 1991 were $1,445,000, $817,000 and $586,000, respectively. The Company does not own any real estate except for its interest in real estate held in the ordinary course of business (including real estate owned as a result of foreclosures). ITEM 3. ITEM 3. LEGAL PROCEEDINGS Other than legal proceedings in the normal course of its business, the Company is not a party to any material legal proceedings and, to the knowledge of management of the Company, there are no material legal proceedings threatened. In the opinion of the Company's management, the pending and threatened legal proceedings of which management is aware will not have a material adverse effect on the financial condition or results of operation of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS FFCC's Common Stock, $1.00 par value (the "Common Stock"), is traded on the over-the-counter market and is quoted on the National Association of Securities Dealers Automated Quotation National Market System ("NASDAQ NMS") under the symbol "FRCC." The Company's Common Stock began trading on the NASDAQ NMS on December 19, 1988. FFCC's 10-1/2% Cumulative Convertible Preferred Stock, Series A, $1.00 par value (the "Series A Preferred Stock") is traded on the over-the-counter market and is quoted on the NASDAQ system under the symbol FRCCP. The Company's Series A Preferred Stock began trading on the NASDAQ system on July 1, 1991. The table below sets forth, for the calendar quarters indicated, the high and low sales prices on the NASDAQ NMS and the high and low bid quotes on the NASDAQ system, for the Common Stock and Series A Preferred Stock, respectively, and the dividends declared on the Common Stock and Series A Preferred Stock during such periods. The quotations for the Series A Preferred Stock represent inter-dealer prices, without retail mark-up, mark-down or commissions and do not necessarily represent actual transactions. --------------- * All share prices and dividend information with respect to the Common Stock have been adjusted to reflect a two for one start split effective December 10, 1993. As of March 14, 1994, the approximate number of record holders of the Company's Common Stock and Series A Preferred Stock was 885 and 88, respectively, which does not include beneficial owners whose shares are held in record names of brokers and nominees. The last sales price for the Common Stock and Series A Preferred Stock as quoted on the NASDAQ NMS and the NASDAQ System, respectively, on such date was $16 3/8 and $35 1/2 per share, respectively. After becoming a public corporation in December 1988, FFCC did not declare any dividends until the third quarter of 1989 when the Board of Directors authorized the payment of a regular quarterly cash dividend of $0.050 per share. The quarterly cash dividend was increased by the Board of Directors to $0.0625 per share during the second quarter of 1990, to $0.075 per share during the fourth quarter of 1991 and increased again to $0.10 per share during the first quarter of 1993. The cash dividend was further increased to $0.13 effective for the first quarter of 1994. The payment of cash dividends in the future is dependent upon the earnings, cash position and capital needs of the Company, general business conditions and other matters deemed relevant by the Company's Board of Directors. The terms of the Series A Preferred Stock do not permit the payment of cash dividends on the Company's Common Stock if dividends on the Company's Series A Preferred Stock are in arrears. The holders of shares of Series A Preferred Stock are entitled to receive cumulative cash dividends when, as and if declared by the Board of Directors, out of assets of the Company legally available therefor at a rate of $1.05 per share of Series A Preferred Stock. The Company's existing warehousing credit facilities and repurchase agreements do not impose restrictions on the ability of the Company to pay dividends. PRITA, generally imposes a withholding tax on the amount of any dividends paid by FFCC to individuals, whether residents of Puerto Rico or not, trusts, estates and special partnerships at a special 20% withholding tax rate. The rate of withholding is 25% if the recipient is a foreign corporation or partnership not engaged in trade or business within Puerto Rico. Prior to the first dividend distribution for the taxable year, individuals who are residents of Puerto Rico may elect to be taxed on the dividends at the regular graduated rates, in which case the special 20% tax will be withheld from such year's distributions. United States citizens who are non-residents of Puerto Rico may also make such an election, and will not be subject to Puerto Rico tax on dividends if said individual's gross income from sources within Puerto Rico during the taxable year does not exceed $1,300 if single, or $3,000 if married. United States income tax law permits a credit against United States income tax liability, subject to certain limitations, for certain foreign income taxes paid or deemed paid with respect to such dividends. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain selected consolidated financial data for the Company on a historical basis for each of the five years ended December 31, 1993. This information should be read in conjunction with the Company's Consolidated Financial Statements and related notes thereto and "Management's Discussion and Analysis" contained herein. (1) Adjusted to reflect two-for-one stock split effective December 10, 1993. (2) The Series A Preferred Stock was issued in July 1991. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL FFCC has experienced a significant growth in its business over the last several years, which accelerated in 1992 and climbed to a record level in 1993. The volume of loans originated by FFCC was approximately $1.43 billion, $694 million, $360 million, $321 million and $278 million for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The increased volume from 1988 to 1989 was primarily the result of improvements in the Puerto Rico economy, a successful advertising and promotional campaign by FFCC, and an increase in the number of builders and developers who used FFCC to finance their projects. The increases in 1990 and 1991 were primarily due to an increased volume of loan originations in the HF Mortgage Bankers division following an internal reorganization, expansion of Dorah's branch network and a decline in prevailing interest rates. The increases in 1992 and 1993 were principally due to declines in average mortgage interest rates which plunged to their lowest levels in decades during 1993 and strongly stimulated demand for both refinancing loans and loans to finance the acquisition of new and existing residential units. The Company's strategy is to increase its servicing portfolio through internal originations. As a result of increased originations in recent years, the Company has reduced its purchases of mortgage loans from third parties. The amount of loans purchased from third parties was approximately $1 million, $29 million, $48 million, $117 million and $185 million for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. As long as the volume of mortgage loans originated by the Company remains at satisfactory levels, the Company anticipates that its purchases of mortgage loans from third parties will not increase significantly. On September 10, 1993, the Company acquired all the outstanding stock of Doral Federal Saving Bank ("Doral Federal"), thereby entering the savings and loan industry. Doral Federal operates through two branches in Puerto Rico. During the year ended December 31, 1993, Doral Federal did not have a significant impact on the financial results of the Company, experiencing a small loss for 1993. During 1993, Doral Federal did experience substantial growth in assets growing from $12 million in assets as of September 10, 1993 to $34 in assets as of December 31, 1993. This growth was financed largely through a $5.0 million capital contribution from the Company, retail deposits, escrow accounts held by the Company and advances from the Federal Home Loan Bank of New York. The rate of growth is not necessarily indicative of the growth through retail deposits or of future growth. FFCC's results of operations are primarily influenced by: (i) the level of demand for mortgage credit, which is affected by such external factors as the level of interest rates and the strength of the economy in Puerto Rico; (ii) the direction of interest rates; and (iii) the relationship between mortgage interest rates and the costs of funds. The principal components of FFCC's revenues are: (i) loan origination fees and net gains on sales of mortgage loans and mortgage-backed securities in the secondary mortgage market; (ii) interest income received on mortgage loans and mortgage-backed securities during the period FFCC holds them pending sale, net of interest paid on borrowed funds to finance such mortgage loans and mortgage-backed securities; (iii) loan servicing fees; (iv) gains on sales of mortgage servicing rights; and (v) other income. RESULTS OF OPERATIONS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 REVENUES FROM ORIGINATION FEES AND SALE OF MORTGAGE LOANS AND MORTGAGE-BACKED SECURITIES. FFCC sells substantially all of the loans that it originates as part of its mortgage banking business. When FFCC sells mortgage loans and mortgage-backed securities, it realizes a net gain or loss which is equal to the difference between FFCC's carrying cost and the selling price of the loans sold, net of commitment fees paid. Net gain or loss on sale of loans is affected by interest rate fluctuations on fixed-rate loans and securities, as well as by the status of interest on mortgage loans under Puerto Rico income tax statutes. Revenues from mortgage loan sales and origination fees increased by 43% during 1993 and by 57% and 22.5% during 1992 and 1991, respectively. The increases for years 1993 and 1992 are the result of increased volume of loan originations as a result of a sharp decline in interest rates and increased gains on sale of mortgage loans, as a result of favorable market conditions which permitted the Company to obtain better prices on sales of mortgage loans and mortgage-backed securities. The total volume of loans originated increased to approximately $1.432 billion for the year ended December 31, 1993 from $694 million for the prior year. The percentage of mortgage loans that were refinancing loans was 78% for the year ended December 31, 1993, 67% for the year ended December 31, 1992 and 67% for the year ended December 31, 1991. The Company believes that the increase in loan originations was the result of increased demand for mortgage loans stimulated by a decline in mortgage interest rates together with increased market share. From time to time and depending on market conditions, the Company sells mortgages and mortgage-backed securities in bulk to investors. During 1993, the Company continued its program of pooling nonconforming conventional loans into collateralized mortgage obligations (CMOs) to be issued by grantor trusts for sale to investors. Mortgage loan sales and fees reflect a pre-tax profit of approximately $3.5 million and $4.7 million for the years ended December 31, 1993 and 1992, respectively, in connection with the pooling and sale of approximately $115 million and $99 million in conventional nonconforming mortgage loans to various independent trusts. While the Company anticipates that it will enter into similar transactions in the future, especially with non-conforming loans, future gains on such transactions, if any, will be dependent on then existing market conditions. Other bulk sales of mortgages loans were made during 1993 resulting in the recording of approximately $3 million of excess servicing, while in 1992 only $378,000 of excess servicing on mortgage loans sold was recorded. The increase in revenues from mortgage loan sales and origination fees in 1993 and 1992 was also due to increased volume as a result of decreasing interest rates. For the year ended December 31, 1993, 1992 and 1991 increases in mortgage loan sales and origination fees were partially offset by net losses on the trading of options on futures contracts used for hedging purposes. NET INTEREST INCOME. Net interest income is the difference between the interest income earned on mortgage loans and mortgage-backed securities held for sale, and the interest paid by FFCC on the short-term warehousing lines of credit with commercial banks, repurchase agreements and gestation lines of credit that finance such loans and mortgage-backed securities and advances and deposits in the case of Doral Federal. The conditions that affect net interest income from period to period include the relationship between prevailing mortgage rates and the prime rate, the London Interbank Offered Rate (LIBOR), cost of tax advantaged funds deposited in Puerto Rico financial institutions ("936 Funds"), interest rates on fixed-rate loans and the Company's average holding period before mortgage loans are sold. In each year since FFCC's inception, interest income earned by FFCC on its mortgage loans and mortgage-backed securities has exceeded interest expense on FFCC's short-term bank borrowing. The Company's weighted average interest rate spread was approximately 411 basis points during 1993 as compared with approximately 335 basis points and 256 basis points during 1992 and 1991, respectively. The increase in the interest rate spread in the last three years was due to lower short-term borrowing costs which descended to historically record levels during 1993. Net interest income increased by approximately 82% from 1992 to 1993, and by approximately 53% from 1991 to 1992. Such increases in net interest income are primarily the result of lower interest rates on borrowing, increased inventory of mortgage loans and mortgage-backed securities, and innovative financing arrangements made during the year. Net interest income also reflected the Company's strategic decision to hold mortgage loans and mortgage-backed securities, especially tax exempt GNMA certificates for a longer period of time prior to sale to maximize net interest income. Net interest income has generally represented a greater proportion of the Company's total net income than that of typical mortgage banking institutions. This results primarily from the fact that the Company is able to finance a substantial portion of the mortgage loans that it originates with lower cost funds and holds mortgage-backed securities, mainly GNMA certificates, for longer periods of time prior to sale than is customary for mortgage bankers in the United States, in order to maximize the interest produced by these securities which is tax-exempt to FFCC under the Puerto Rico law. During the year ended December 31, 1993, the Company held mortgage loans and mortgage-backed securities for an average period of 98 days as compared to 118 days for the year ended December 31, 1992. This decrease was due principally to favorable market conditions which allowed the Company to increase its sales of mortgage-backed securities, to continue pooling and selling of nonconforming loans as CMOs, and to its continued shift in emphasis in the origination of mortgage loans from FHA and VA loans to FHLMC and FNMA conforming loans. The Company normally sells the latter within 60 days of origination. The continued emphasis on the origination of FHLMC and FNMA conforming loans is dependent on market conditions, the relative return of originating the different types of loans, and the maximum loan amounts permitted for the same. LOAN SERVICING FEES. Loan servicing fees represent revenue earned by FFCC for administering loans. FFCC's typical annual loan servicing fee depends on the type of mortgage loan being serviced and ranges from 0.25% to 0.50% of the declining outstanding principal amount of such. The size of FFCC's loan servicing portfolio and the amount of its servicing fees have increased substantially since FFCC's inception as a result of the increases in loan originations. Loan servicing fees increased 20% from 1992 to 1993 and 30% from 1991 to 1992, primarily due to increases in the principal amount of loans serviced as compared to prior years. The mortgage servicing portfolio was approximately $2.4 billion at December 31, 1993, an increase of approximately 41% over the December 31, 1992 level. At December 31, 1993, less than $30 million of the Company's servicing portfolio related to mortgages originated outside Puerto Rico (all of which were originated in Florida). The increase in refinance activity caused by the decline in mortgage interest rates, which has affected loan originations favorably, also caused an increase in loan prepayment from the servicing portfolio. During 1993, the prepayment rate of the Company's servicing portfolio was 26% compared to 15.4% for 1992. The primary means used by the Company to reduce the sensitivity of its servicing fees to changes in interest rates is through a strong internal origination capability that has allowed the Company to continuously increase the size of its servicing portfolio even in times of high prepayments. During 1993, total amortization of acquired servicing rights ("ASRs") amounted to $492,000 versus $506,000 for 1992. The Company's strategy is to increase the size of its servicing portfolio through internal originations rather than through the purchase of servicing rights form third parties. As of December 31, 1993, the Company only had $4 million in ASR's. During the years ended December 31, 1993 and 1992 the Company capitalized $14,943 and $251,091, respectively, of servicing rights. As a result, changes in prevailing interest rates will not have a significant impact on the revenues of the Company because of an increase in amortization of ASR's. GAIN ON SALE OF SERVICING RIGHTS. During the years ended December 31, 1993, 1992 and 1991 the Company sold servicing rights of $198.7 million, $53.4 million and $51.5 million, respectively, realizing pre-tax gains of approximately $2.4 million, $935,000 and $764,000, respectively. While the Company's strategy is to retain the servicing rights of the mortgage loans it originates, the Company may sell servicing rights from time to time in the future when market conditions are favorable. OTHER INCOME. Other income increased 34% in 1993 as compared to 1992, and 13% from 1991 to 1992. The increase during 1993 was due primarily to increased fees received for voluntary mortgage life insurance, an increased servicing portfolio and other commissions and fees earned by Doral Federal. EXPENSES (OTHER THAN INTEREST EXPENSE). Aggregate expenses (other than interest expense) in 1993 increased by approximately 57%, before considering the reclassification of deferrable direct costs related to FAS 91 (see Note 21 to the Company's Consolidated Financial Statements. This reflected increases in employee costs of approximately 61% as compared to 1992. These expenses were as a result of additional personnel hired during 1993 due to increased loan production, normal salary increases and increased income-based incentive compensation to senior management. Advertising, professional services and rent expenses increased by 71%, 57% and 77%, respectively as compared to 1992. The increase in advertising expense was necessary to ensure the Company maintains and/or increases its share of the Puerto Rico market for mortgage loans. Professional services and rent expense increases are attributed to the growth experienced by the Company in both human resources and asset size. For 1992 compared to 1991 aggregate expenses (other than interest expense) increased by approximately 47.1%, reflecting increases in employee costs of approximately 51%, as a result of additional personnel hired, increased loan production, normal salary increases and increased income-based incentive compensation to senior management. PUERTO RICO INCOME TAXES. The Puerto Rico maximum statutory corporate income tax rate is 42%. For 1993, the effective income tax rate of FFCC was 31.0% as compared to 20.5% for 1992, and 30.7% for 1991. The increase in 1993 from 1992 in the effective income tax rate was due principally to the fact that during the year ended December 31, 1992, the Company received favorable tax treatment on certain rights with a fair value approximately $3.5 million received as a dividend from a subsidiary, resulting in the exclusion of 85% of said amount from gross income. The decrease in 1992 from 1991 in the effective income tax rate was due to the same reason. In addition, in 1992 $935,000 of income was taxed at the capital gains rate of 25%. The lower effective tax rates (as compared to the maximum statutory rate) experienced by FFCC also reflect the fact that a large portion of the income derived from certain FHA and VA mortgage loans secured by mortgaged properties located in Puerto Rico is tax exempt under Puerto Rico law. Income tax savings to FFCC attributable to this exemption amounted to approximately $2.7 million, $2.2 million and $1.0 million for the years ended December 31, 1993, 1992 and 1991, respectively. Note 15 to the Company's Consolidated Financial Statements includes a reconciliation of the provision for income taxes to the amount computed by applying the applicable Puerto Rico statutory tax rates to income before taxes. ASSETS AND LIABILITIES Total assets were approximately $486 million as of December 31, 1993, reflecting an increase of approximately $165 million from December 31, 1992. This increase was primarily due to an increase of $150 million in mortgage loans and mortgage-backed securities held for sale as a result of the higher volume of mortgage originations. Total liabilities were approximately $409 million at December 31, 1993 compared to $263 million at December 31, 1992. The increase reflects increased borrowings related to the record volume of mortgage originations experienced during 1993, which resulted in carrying a much larger base of mortgage loans and mortgage-backed securities available for sale than in 1992. As of December 31, 1993, FFCC held approximately $2.9 million of real estate owned, excluding approximately $74,000 converted to rental property, compared to $3.6 million of real estate owned, excluding $108,000 converted to rental property as of December 31, 1992. These rental properties are leased to individuals under the HUD Section 8 Housing Assistance Payments Program. LIQUIDITY AND CAPITAL RESOURCES Operating activities provided $3,653,888 of net cash in 1993 versus net cash of $5,274,301 in 1992. The major changes were an increase in loans payable of $98,215,950, an increase in mortgage loans and mortgage-backed securities held for sale of $139,843,925 and an increase in securities sold under agreements to repurchase of $14,444,412, all as a result of the higher volume of mortgage closings experienced during 1993. Net cash provided by operating activities was $5,274,301 for 1992 whereas net cash used by operating activities was $26,962,652 for 1991. The strategic decision to hold loans and mortgage-backed securities for longer periods prior to sale in order to maximize net interest income resulted in an increase in loans held for sale of $45,525,650 and an increase in loans payable of $31,534,057 for the year ended December 31, 1992. Investing activities provided a net of $4,815,853 of cash flow in 1993, whereas in 1992 such activities provided a net cash flow of $6,990,368. The major changes were a decrease in mortgage notes receivable of $6,763,184, and an increase in accounts receivable of $3,900,941. Redemption of certificates of deposit contributed cash of $2,500,000. Acquisitions of real estate held for sale in 1993 used cash of $3,699,118 while disposals of real estate owned contributed cash of $4,363,585. Acquisitions of servicing rights during 1993 were minimal compared to the $251,091 acquired in 1992. This decrease is due to a reduction in purchases of loans from third parties. When the Company purchases loans from third parties a portion of the purchase price is allocated to the related servicing right. Net cash provided by investment activities was $6,990,368 in 1992 versus $72,372,632 in 1991. The major changes were a decrease in mortgage notes receivable of $16,635,365 and an increase in accounts receivable of $7,203,614, net of cash used to acquire certificates of deposit in the amount of $2,500,000. Acquisitions of real estate held for sale in 1992 used cash of $4,955,184 while disposals of real estate owned contributed cash of $6,219,250. The major sources of cash in 1991 came from a decrease of $38,178,316 and $28,799,553 in mortgage loans held for investment and mortgage notes receivable, respectively. In 1993, there was a net increase of $10,150,037 in cash resulting from financing activities. This was due primarily to an increase in deposits following the acquisition of Doral Federal in the amount of $18,141,846, reduced by $3,142,289 in payments of dividends, $3,845,899 in decreases in loans payable related to mortgage notes receivable and repayment of advances from Federal Home Loan Bank of New York in the amount of $1,003,621. Net cash used by financing activities was $1,562,901 in 1992 versus $61,136,229 in 1991. This decrease was due primarily to the repayment of securities sold under agreements to repurchase related to mortgage loans held for investment and to a decrease in loans payable related to mortgage notes receivable. Total liabilities were approximately 5.3 and 4.5 times stockholders' equity at December 31, 1993 and 1992, respectively. The increased leverage at December 31, 1993 from December 31, 1992 resulted from a net increase of $108,814,463 in loans payable and securities sold under agreements to repurchase as compared to 1992. Such additional borrowings were necessary to finance increased volume and higher inventories of mortgage loans and mortgage-backed securities held for sale. The decreased leverage at December 31, 1992, resulted from a net increase in capital of $22.4 million as a result of earnings during 1992, net of dividends paid, and the issuance and sale of 690,000 shares of Common Stock during 1992 that contributed $11.3 million of capital to the Company. FFCC borrows money under warehousing lines of credit to fund its mortgage loan commitments and repays the borrowing as the mortgages are sold. The warehousing lines of credit then become available for additional borrowing. FFCC held mortgage loans prior to sale for an average period of approximately 98 days during the year ended December 31, 1993 and 118 days during the year ended December 31, 1992. The decrease in 1993 was due to sales of approximately $115 million of conventional nonconforming mortgage loans to various grantor trusts in 1993, a shift in emphasis in the origination of mortgage loans from FHA and VA loans to FHLMC and FNMA conforming loans which the Company normally sells within 60 days of origination, several other sales of mortgage loans and mortgage-backed securities in bulk. As stated above, The continued emphasis on the origination of FHLMC and FNMA conforming loans is dependent on market conditions, relative pricing of the different loan products and maximum loan amounts for the various types of loans. FFCC increased its available warehousing lines of credit from $96.5 million at December 31, 1992 to $257.5 million at 1993. Among the additional warehousing and repurchase agreements lines of credits added to the Company's existing credit facilities were so-called gestation or pre-sale facilities which permit the Company to obtain favorable rates once the mortgage loans have been pooled for securitization but prior to the actual issuance of the mortgage-backed securities. At December 31, 1993 and 1992, FFCC had used approximately $90.9 million and $54.3 million, respectively, of credit available under its warehousing lines of credit. FFCC's warehousing lines of credit are generally terminable at the discretion of the lender. Interest rate spreads on certain mortgage loans and mortgage-backed securities in Puerto Rico have traditionally been high due to the ability of the Company to finance its mortgage loans and mortgage-backed securities with lower-cost tax advantaged funds. FFCC also obtains short-term financing through repurchase agreement lines of credit with financial institutions and investment banking firms. Under these agreements, FFCC sells GNMA, FNMA or FHLMC guaranteed mortgage-backed securities and simultaneously agrees to repurchase them at a future date at a fixed price. FFCC uses the proceeds of such sales to repay borrowing under its warehousing lines of credit. The effective cost of funds under repurchase agreements is typically lower than the cost of funds borrowed under FFCC's warehousing lines of credit. FFCC available repurchase agreement lines of credit at December 31, 1993 and December 31, 1992 amounted to $215 million and $180 million, respectively. At December 31, 1993 and 1992, FFCC had outstanding repurchase obligations in the aggregate principal amount of approximately $143 million and $129 million, respectively. FFCC's continued use of repurchase agreements will depend upon the cost of repurchase agreements relative to the cost of borrowing under its warehousing lines of credit with banks and other financial institutions. The weighted monthly average interest rate of FFCC's borrowings for warehousing lines of credit and for repurchase agreement lines of credit was 4.2% and 3.34%, respectively, for the year ended December 31, 1993 compared to 5.3% and 4.03%, respectively, for the year ended December 31, 1992. During the year ended December 31, 1993, the Company collected an average of approximately $719,000 per month as net servicing fees, including late charges. At December 31, 1993 and December 31, 1992, the servicing portfolio amounted to approximately $2.4 billion and $1.7 billion, respectively. The Company might in the future determine to sell part of the servicing portfolio to raise additional funds. FFCC generally has been able to provide for its growth and expansion and for continued liquidity with funds from short-term borrowing. Additional increases in FFCC's lines of credit may be required to support the volume of loan originations anticipated in the future. FFCC expects that it will have adequate resources to finance its operations. During the fourth quarter of 1992, the Company raised additional capital through the issuance and sale of 690,000 shares of its Common Stock. The Company will continue to explore alternative and supplementary methods of financing its operations, including both debt and equity financing. There can be no assurance, however, that the Company will be successful in consummating any such transactions. INFLATION FFCC is affected by fluctuations in real estate values and interest rates. Although general and administrative expenses have increased due to inflation, the increase in real estate values in Puerto Rico in recent years has been a positive factor for the Company's Mortgage Banking Business. The average size of loans originated tends to increase as home values appreciate, which serves to increase loan origination fees and servicing income faster than the cost of providing such services. Significant increases in interest rates, however, make it more difficult for potential borrowers to purchase desirable residential properties and to qualify for mortgage loans and refinance activity. As a result, higher interest rates may adversely affect the volume of loan originations and income related to mortgage production. A high interest rate environment, however, would tend to enhance the value and earnings of the Company's mortgage loan servicing portfolio. PROSPECTIVE TRENDS MARKET TRENDS. The Company has in recent periods increased its market share and its volume of production benefitting from a decline in average mortgage interest rates in recent periods. Such decline has led to: (i) new loan production (particularly from refinancing) resulting in an increase in related income; (ii) growth in the Company's servicing portfolio resulting in greater servicing income and (iii) lower interest rate mortgage loans in the servicing portfolio reducing exposure to future prepayments. An environment of rising interest rates may adversely affect the Company's volume of loan originations and loan origination-related income but should increase earnings from the Company's loan servicing portfolio. If average mortgage interest rates increase, the Company may have to compensate, in part, for the loss of volume by concentrating its origination efforts on those mortgage loans for which it can obtain the most favorable pricing. This may lead to a relative deemphasis on conforming conventional loans and a greater emphasis on the origination of FHA/VA loans and non-conforming conventional loans for which the Company can obtain more favorable sales prices. AMENDMENT TO SECTION 936. The omnibus Budget Reconciliation Act of 1993, which was signed into law by President Clinton on August 10, 1993, contains certain amendments (the "Amendments") to Section 936 of the United States Internal Revenue Code of 1986. Section 936 provides incentives for eligible U.S. corporations that elect the benefits thereunder ("936 Corporations") to invest in Puerto Rico by providing a tax credit for income derived form certain Puerto Rico operations and investments. In general, the Amendments, which are generally effective for taxable years beginning after December 31, 1993, will permit a taxpayer to compute the tax credit available under Section 936 as under present law but would limit the amount of credit allowed as determined under one of two alternatives to be selected at the option of the taxpayer. Under the first alternative, the limit would be equal to a fixed percentage of the amount of tax credit allowable under current law. This fixed percentage would commence at 60% for taxable years beginning in 1994 and would be reduced by 5% per year until 1998. For taxable years beginning in 1998 such percentage would be 40%. Under the second alternative, which is based on the amount of economic activity conducted by the taxpayer in Puerto Rico, the credit may not exceed the sum of the following three components: (i) 60% of the qualified possession wages and 15% of allocable fringe benefits paid by the taxpayer, (ii) applicable percentages of certain depreciation deductions claimed for regular tax purposes by the taxpayer with respect to qualified tangible property and (iii) a portion of the possession income taxes paid by the taxpayer except where the taxpayer uses the profit-split method for determining its income. Unlike certain earlier proposals, the Amendments would not limit the 100% credit currently available under section 936 for qualified possession source investment income, including income received from investment in certain Puerto Rico mortgage loans and mortgage-backed securities. It is not possible at this time to predict what effect the Amendments will have on the economy of Puerto Rico. The Amendments could have an adverse effect on the general economic condition of Puerto Rico by reducing incentives for investment in Puerto Rico. Any such adverse effect on the general economy of Puerto Rico could lead to an increase in mortgage delinquencies and a reduction in the level of residential construction and demand for mortgage loans. The adoption of the Amendments could also indirectly lead to a decrease in the amount of funds invested in Puerto Rico financial assets by 936 Corporations to the extent that the level of operations and production in Puerto Rico by such 936 Corporations is decreased over time. While the impact on the Company cannot be determined at this time, the Company does not believe that the adoption of the Amendments will have a material adverse effect on its business or financial condition or on the Puerto Rico mortgage market in general. NEW ACCOUNTING STANDARDS. In November 1992, the Financial Accounting Standard Board ("FASB") issued the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits". This statement, which the Company must adopt for fiscal years beginning after December 15, 1993, establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement (known as "postemployment benefits"). The Statement requires recognition of the cost of postemployment benefits on an accrual basis. In May 1993, the FASB issued the Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." This statement, which the Company must adopt for fiscal years beginning after December 15, 1994, requires that impaired loans that are within the scope of the statement be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company does not expect the adoption of these statements to have a material effect on the results of its operations or its financial condition. In may 1993, the FASB also issued the Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement, which the Company must adopt in the first quarter of 1994, addresses the accounting and reporting for investments on equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows: - Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Mortgage-backed securities held for sale in conjunction with mortgage banking activities must be classified as trading securities. - Debt and equity securities not classified as either held-to maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholder's equity. Management is currently evaluating the effect of adopting this statement and believes that had the Company adopted the provisions of this standard at December 31, 1993, approximately $132,000,000 of mortgage-backed securities would have been classified as trading securities and the net income for the year ended December 31,1993 would have increased by approximately $1,500,000. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information call for by this Item 8 is hereby incorporated by reference from the Company's Consolidated Financial Statements and Auditor's Report beginning on page of this Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information in response to this Item is incorporated herein by reference to the section entitled "Election of Directors and Related Matters" contained in Company's definitive Proxy Statement for its 1994 Annual Meeting of stockholders (the "Proxy Statement") to be filed with the Securities and Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information in response to this Item is incorporated herein by reference to the section entitled "Executive Compensation" of the Company's Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in response to this Item is incorporated herein by reference to the section entitled "Security Ownership of Management and Principal Holders" of the Company's Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to this Item is incorporated herein by reference to the section entitled "Election of Directors and Related Matters" of the Company's Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) List of documents filed as part of this report. (1) Financial Statements.* The information called for by this subsection of Item 14 is set forth in the Financial Statements and Auditors' Report beginning on page of this Form 10-K. The index to Financial Statements is set forth on page of this Form 10-K. (2) Financial Statement Schedules. All financial schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) Exhibits. Exhibit Number Description ------ ----------- 3.1 Certificate of Incorporation of FFCC, as currently in effect.(1) 3.2 By-laws of FFCC, as amended as of January 31, 1992.(1) 3.3 Amendment to Certificate of Incorporation of FFCC filed with the Department of State of the Commonwealth of Puerto Rico on May 23, 1991.(1) 3.4 Certificate of Designation creating the Series A Preferred Stock.(1) 3.5 Amendment to Certificate of Incorporation of FFCC filed with the Department of State of the Commonwealth of Puerto Rico on April 28, 1993(2) ____________________ (1) Incorporated herein by reference to the same exhibit number of the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 (File No. 0-17224). (2) Incorporated herein by reference to the same exhibit number of the Company's Quarterly Report on From 10-Q for the quarter ended March 31, 1993 (File No. 0-17224) (3) Incorporated herein by reference to the same exhibit number as filed pursuant to Item 15(b) of the Company's Form 10 filed with the Commission on October 7, 1988, as amended by Form 8 amendments thereto. (4) Incorporated herein by reference to the same exhibit number of the Company's Registration Statement on Form S-1 (No. 33-39651) filed with the Commission on March 29, 1991. (5) Incorporated herein by reference to the same exhibit number of the Company's Registration Statement on Form S-2 (No. 33-52292) filed with the Commission on September 23, 1992. (6) Incorporated by reference to exhibit number 19.1 of the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 1993 (File No. 0-17224). (7) Incorporated by reference to exhibit number 19.2 of the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 1993 (File No. 0-17224). (8) Incorporated by reference to exhibit number 19.3 of the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1993 (File No. 0-17224). (9) Incorporated by reference to exhibit number 19.4 of the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1993 (File No. 0-17224). (10) Incorporated herein by reference to exhibit number 1 of the Company's Current Report on Form 8-K filed with the Commission on December 16, 1992. (b) Reports on Form 8-K. Not applicable SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, First Financial Caribbean Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST FINANCIAL CARIBBEAN CORPORATION By: /s/ Salomon Levis --------------------------------- Salomon Levis Chairman of the Board and Chief Executive Officer Date: March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: FIRST FINANCIAL CARIBBEAN CORPORATION CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS FOR INCLUSION IN FORM 10-K ANNUAL REPORT FILED WITH SECURITIES AND EXCHANGE COMMISSION FIRST FINANCIAL CARIBBEAN CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES FEBRUARY 3, 1994 All schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements or notes thereto. Price Waterhouse REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of First Financial Caribbean Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income and retained earnings, of changes in capital stock and of cash flows present fairly, in all material respects, the financial position of First Financial Caribbean Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 2 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1993. /s/ Price Waterhouse - ---------------------- PRICE WATERHOUSE San Juan, Puerto Rico February 3, 1994 Stamp 1196931 of the P.R. Society of Certified Public Accountants has been affixed to the file copy of this report FIRST FINANCIAL CARIBBEAN CORPORATION REPORT AND CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 FIRST FINANCIAL CARIBBEAN CORPORATION CONSOLIDATED BALANCE SHEET ASSETS The accompanying notes are an integral part of this statement. FIRST FINANCIAL CARIBBEAN CORPORATION CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS The accompanying notes are an integral part of this statement. FIRST FINANCIAL CARIBBEAN CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (Continued) The accompanying notes are an integral part of this statement. FIRST FINANCIAL CARIBBEAN CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (CONT.) The accompanying notes are an integral part of this statement. FIRST FINANCIAL CARIBBEAN CORPORATION CONSOLIDATED STATEMENT OF CHANGES IN CAPITAL STOCK The accompanying notes are an integral part of this statement. FIRST FINANCIAL CARIBBEAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - REPORTING ENTITY: The consolidated financial statements include the accounts of First Financial Caribbean Corporation and its wholly-owned subsidiaries ("FFCC" or the "Company"), Doral Mortgage Corporation ("Doral"), RSC Corp. ("RSC") and Doral Federal Savings Bank ("Doral Federal"). All significant intercompany accounts and transactions have been eliminated in consolidation. On September 10, 1993, the Company acquired all of the outstanding common stock of Doral Federal Savings Bank (formerly Catano Federal Savings Bank) at a price of approximately $1,200,000, including transaction expenses. This acquisition was accounted for using the purchase method of accounting. The acquisition cost plus direct costs of the merger were allocated to the individual assets acquired and liabilities assumed based on their fair values. The excess of acquisition cost over the fair values of assets acquired and liabilities assumed amounting to approximately $271,000 was recorded as goodwill and will be amortized over a ten-year period. The consolidated statements of income and retained earnings for the year ended December 31, 1993 includes the results of operations of Doral Federal since the date of the acquisition. The following is a summary of the assets acquired and liabilities assumed as of September 10, 1993: Proforma results of operations for the current and the preceding period as though the acquisition had been made at the beginning of such periods are substantially similar to actual results of operations for the periods and therefore are not presented. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company is engaged in the origination, purchase and sale of FHA, VA and conventional first and second mortgage loans and in providing and/or arranging for interim financing for the construction of residences and other types of real estate developments in Puerto Rico and Florida. The Company, in combination with its subsidiaries, services FHA insured, VA guaranteed and conventional mortgage loans pooled for issuance of Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) backed securities and collaterized mortgage obligations certificates issued by grantor trusts established by the Company (CMO Certificates). Doral Federal is a federal savings bank that operates through a single branch located in Catano, Puerto Rico. The following summarizes the more significant accounting policies used by the Company. Mortgage-backed securities held for sale Mortgage-backed securities held for sale consist of GNMA, FNMA, FHLMC mortgage-backed securities and CMO certificates. These securities are recorded at the lower of cost or market computed on an aggregate portfolio basis. Mortgage loans held for sale Mortgage loans held for sale consist of FHA, VA and conventional loans. These loans are recorded at the lower of cost or market computed on an aggregate portfolio basis. Mortgage notes receivable Mortgage notes receivable are held principally for investment purposes. These consist of residential first and second mortgages with maturity dates ranging from three to ten years. Allowances for losses Allowances for losses are provided for estimated losses on mortgage notes receivable, accounts receivable and real estate held for sale based upon a review of the loan portfolio, loss experience, economic conditions and other pertinent factors. Cost in excess of fair value of net assets acquired The cost in excess of fair value of net assets acquired is amortized on the straight-line basis over their estimated useful lives (30 year period for the acquisition of Doral and RSC, and a 10 year period for the acquisition of Doral Federal). Income and expense recognition Loan origination fees and related direct loan origination costs are deferred and amortized to income as an adjustment of yield throughout the life of the related mortgage loan. Such fees and costs related to loans held for sale are deferred and recognized in income as a component of gain on sale of loans when the related loans are sold. Gains on sales of mortgages are recognized at the time of sale of pools, or individual loans, to investors. Interest rate risk management The Company has various mechanisms to reduce its exposure to interest rate fluctuations, as they affect the values of the portfolio holdings and the prices of newly created loans and loans to be originated. The Company enters into options on futures contracts designated as trading hedges which are marked to market on a monthly basis with the resulting gains and losses charged to operations. Losses on future contracts are generally indicative of higher profits on sale of mortgage loans. During the years ended December 31, 1993, 1992 and 1991 net losses from futures transactions, designated as trading hedges, amounted to approximately $1,367,000, $1,376,000 and $999,000, respectively. Changes in the market value of future contracts that qualify as hedges of existing assets or liabilities are recognized as an adjustment of the carrying amount of the hedged items. Loan servicing The Company pools FHA insured and VA guaranteed mortgages for issuance of GNMA mortgage-backed securities. Also, conventional loans are pooled and issued as FNMA or FHLMC mortgage-backed securities and CMO certificates. Mortgages included in the resulting GNMA, FNMA and FHLMC pools, CMO certificates and certain pools of conventional loans sold to investors are serviced by the Company. The Company is required to advance funds to make scheduled payments to investors, if payments due have not been received from the mortgagors. At December 31, 1993, accounts receivable include advances to investors of approximately $2,800,000 (1992 - $1,400,000). The Company is also required to foreclose on loans in the event of default by the mortgagor, and to make full payment on foreclosed loans. No asset or liability is recorded on the books of account of the Company for mortgages serviced, except for servicing rights acquired. Mortgage loan servicing fees, which are based on a percentage of the principal balances of the mortgages serviced, are credited to income as mortgage payments are collected. When the stated servicing fee rate is materially different from the current servicing fee rate on loans sold with servicing retained, an excess servicing receivable is recognized at the time of the sale. Amortization of excess servicing is provided based on the amount and timing of future cash flows. Amortization of excess servicing for each of the years ended December 31, 1993, 1992, and 1991 was approximately $161,000, $28,000 and $16,000, respectively. Excess servicing receivable at December 31, 1993 amounted to approximately $3,464,000 (1992 -$500,000). Servicing rights acquired The cost of acquiring the rights to service mortgage loans is capitalized. The amount capitalized is amortized in proportion to, and over the period of, estimated net servicing income. Any unamortized balance related to rights sold is charged to income at time of sale. Capitalized servicing rights are analyzed quarterly by stratifying the mortgage servicing portfolio and reviewing the payment history on a pool-by-pool basis. Whenever it is determined that there is a prepayment pattern indicative that the fair value of the purchased mortgage servicing rights (determined based on estimated future net cash flows discounted at current rates) will be less than their carrying amounts, an impairment is recognized by charging such excess to income. Real estate held for sale The Company acquires real estate through foreclosures. These properties are held for sale and are stated at the lower of fair value, minus estimated costs to sell, or cost. Property, leasehold improvements and equipment Property, leasehold improvements and equipment are carried at cost. Depreciation and amortization are provided on the straight-line method over the estimated useful lives of the assets or the terms of the leases, if shorter, for leasehold improvements, ranging from five to ten years. Income taxes In January 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The adoption of FAS 109 changes the Company's method of accounting for income taxes from the deferred method (APB11) to an asset and liability approach. Previously, the Company deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of other assets and liabilities. A valuation allowance is recognized for any deferred tax asset for which, based on management's evaluation, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax asset will not be realized. The initial application of this standard has no effect because there was no significant temporary differences at January 1, 1993. Employers' Accounting for Postemployment Benefits and Accounting for Impairment of a Loan In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." This statement, which the Company must adopt for fiscal years beginning after December 15, 1993, establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement (known as "postemployment benefits"). The Statement requires recognition of the cost of postemployment benefits on an accrual basis. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." This statement, which the Company must adopt for fiscal years beginning after December 15, 1994, requires that impaired loans that are within the scope of the statement be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company does not expect the adoption of these statements to have a material effect on the results of its operations or its financial condition. Accounting for Certain Investments In Debt and Equity Securities In May 1993, the FASB also issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement, which the Company must adopt in the first quarter of 1994, addresses the accounting and reporting for investments on equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows: o Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. o Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and reported at fair value, with unrealized gains and losses included in earnings. Mortgage-backed securities held for sale in conjunction with mortgage banking activities must be classified as trading securities. o Debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. Management is currently evaluating the effect of adopting this statement and believes that had the Company adopted the provisions of this standard at December 31, 1993, approximately $132,000,000 of mortgage-backed securities would have been classified as trading securities and the net income for the year ended December 31, 1993 would have been increased by approximately $1,500,000. Statement of cash flows Cash and cash equivalents include cash in banks and certificates of deposit (1993 - $1,800,000 and 1992 - $700,000) and other highly liquid securities with an original maturity of three months or less. At December 31, 1993, other highly liquid securities include $22,026,203 of securities purchased under agreements to resell as follows: Earnings per share Primary net income per share is determined by dividing net income, after deducting preferred stock dividends, by the weighted average number of common stock outstanding considering the dilutive effect of restricted stock awards. Fully diluted net income per share has been computed based on the assumption that all of the convertible preferred stock are converted into common stock as of July 1, 1991. On October 25, 1993 the Company declared a two for one stock split on its shares of common stock outstanding. The stock split was effected in the form of a stock dividend of one additional share of common stock for each share of common stock held on record date of November 22,1993. As a result, a total of 3,381,069 shares of common stock were issued on December 10, 1993. Also as a result of the stock split referred to above, each outstanding share of the Company's Series A Preferred Stock is now convertible into two shares of common stock at a conversion price of $5 per share. For purposes of the computation of earnings per share and common stock dividends per share, the stock split including the effect of the preferred stock's change in the computation of common stock equivalents, was retroactively recognized in all periods presented in the financial statements. The number of shares of common stock used for computing the primary and fully diluted net income per share was as follows: Primary earnings per share for 1992 would have been $2.33 if the 19,050 shares issued under the Company's Restricted Stock Plan on December 31, 1992 had been issued on January 1, 1992. Fair value of financial instruments The reported fair values of financial instruments are based on a variety of factors. For a substantial portion of financial instruments, fair values represent quoted market prices for identical or comparable instruments. In a few other cases, fair values have been estimated based on assumptions concerning the amount and timing of estimated future cash flows and assumed discount rates reflecting varying degrees of risk. Accordingly, the fair values may not represent actual values of the financial instruments that could have been realized as of year end or that will be realized in the future. Other Certain reclassifications of prior years' data have been made to conform to 1993 classifications. NOTE 3 - COST IN EXCESS OF FAIR VALUE OF NET ASSETS ACQUIRED: Doral and RSC were acquired in December 1986 for approximately $3,700,000 in cash plus a ten-year deferred minimum pay-out of $875,000. These transactions were accounted for by the purchase method of accounting resulting in $1,620,000 of cost in excess of the fair value of net assets acquired. Subsequent contingent payments under the purchase agreements are accounted for as additional cost over the fair value of assets acquired. The amount of such pay-outs are determined based on a percentage ranging from 1/16% to 1/4% of the aggregate principal amount of mortgage loans closed. The deferred pay-out portion has been discounted using an imputed interest rate of 8%. Contingent payments under the Doral purchase agreement amounted to $985,900, $450,497 and $605,331 for the years ended December 31, 1993, 1992 and 1991, respectively. Total amortization expense charged to operations for each of the years ended December 31, 1993, 1992, and 1991 was $255,476, $247,077 and $246,579, respectively. Total accumulated amortization relating to cost in excess of fair value of net assets acquired amounted to $2,617,405, $2,361,929 and $2,114,852 at December 31, 1993, 1992 and 1991, respectively. At December 31, 1993, cost in excess of fair value of net assets acquired includes approximately $271,000 resulting from the acquisition of Doral Federal. NOTE 4 - REGULATORY REQUIREMENTS: The Company is a U.S. Department of Housing and Urban Development (HUD) approved, non-supervised mortgagee and must maintain an excess of current assets over current liabilities and a minimum net worth, as defined by HUD, GNMA, FNMA and FHLMC. The Company is also required to maintain fidelity bond and errors and omissions insurance coverages based on the balance of its servicing portfolio. As a result of the acquisition of Doral Federal, legally the Company became a savings and loan holding company ("SLHC") subject to the restrictions and requirements of the Home Owners' Loan Act of 1933, as amended (the "HOLA"). As a SLHC, the Company was required to register with the Director of the Office of Thrift Supervision (the "OTS") and is subject to various requirements of the HOLA, including examination, supervision and reporting requirements. Federal law and OTS regulations place certain limits on the types of activities in which a SLHC and its subsidiaries may engage. However, in general, these activity restrictions do not apply to a holding company that controls only one savings and loan association, provided such association meets the "qualified thrift lender" test which generally requires the association to have 65% of its portfolio assets in "qualified thrift investments." For Puerto Rico based institutions, these investments include, among other things, home mortgages, mortgage-backed securities, and personal loans. Doral Federal is also subject to certain regulatory capital requirements. The Company has complied with these regulatory requirements. NOTE 5 - MORTGAGE LOANS AND MORTGAGE-BACKED SECURITIES HELD FOR SALE: Mortgage loans and mortgage-backed securities held for sale consist of: At December 31, 1993, the aggregate amortized cost and approximate market value of are as follows: Proceeds from sales of mortgage loans held for sale during 1993 were approximately $1,656,000,000 (1992 - $772,000,000). Gross gains of $49,882,000 (1992 - $27,431,000) and gross losses of $14,652,000 (1992 - $2,872,000) were realized on those sales. As of December 31, 1993, Doral Federal has commercial and consumer loans amounting to approximately $500,000 on which the accrual of interest income had been discontinued If these loans had been accruing interest, the additional interest income realized would have been approximately $51,000. Doral Federal originates adjustable and fixed interest rate loans. The adjustable rate loans have interest rate adjustment limitations and are generally tied to various market indexes. Future market factors may affect the correlation of the interest rate adjustment with the rate Doral Federal pays on the short-term deposits that have primarily funded these loans. NOTE 6 - MORTGAGE NOTES RECEIVABLE: Mortgage notes receivable consist of: NOTE 7 - ALLOWANCES FOR LOSSES: The changes in the allowances for losses were as follows: At December 31, 1993, the reserve for bank loan losses amounted to approximately $234,000. Losses charged to the allowance, net of recoveries, and the provision for losses amounted to approximately $305,000 and $23,000, respectively. NOTE 8 - PROPERTY, LEASEHOLD IMPROVEMENTS AND EQUIPMENT: Property, leasehold improvements and equipment consist of: NOTE 9 - OTHER ASSETS: Amounts capitalized during the years ended December 31, 1993, 1992 and 1991 in connection with the acquisition of rights to service mortgage loans amounted to $14,943, $251,091 and $1,215,034, respectively. Amortization of servicing rights was $492,000, $506,000 and $560,489, for the years ended December 31, 1993, 1992 and 1991, respectively. During the year ended December 31, 1991, $136,707 of unamortized servicing rights acquired related to the portfolios sold was charged to income. The Company's servicing portfolio amounted to approximately $2,375,000,000 and $1,700,000,000 at December 31, 1993 and 1992, respectively, including $164,000,000 and $244,000,000 respectively, of loans sold with recourse which are not government guaranteed or insured. The Company estimates the fair value of the retained recourse obligation at the time the loans are sold. Ordinarily the amounts involved are minimal insofar as the recourse obligations are met by substituting loans which the Company has generally been able to rehabilitate and resell for at least their carrying amount. Accordingly, a reserve for possible losses arising from recourse obligations has not been deemed necessary. During the years ended December 31, 1993, 1992 and 1991, the Company sold rights to service loans amounting to approximately $198,700,000, $53,400,000 and $51,500,000, respectively. During the year ended December 31, 1991, the Company purchased servicing portfolios amounting to approximately $49,400,000. No servicing portfolio was purchased in 1993 and 1992. NOTE 10 - PAYABLES AND ACCRUED LIABILITIES: Payables and accrued liabilities consist of the following: NOTE 11 - LOANS PAYABLE: At December 31, 1993 and 1992, the Company had several mortgage warehousing lines of credit totalling $257,500,000 and $96,500,000, respectively. Advances under the mortgage warehousing lines of credit are secured by loans held for inclusion in GNMA, FNMA and FHLMC pools or for sale to financial investors. Loans payable consist of the following: Maximum borrowings outstanding at any month-end during 1993 and 1992 under the mortgage warehousing lines of credit were $98,000,000 and $77,000,000, respectively. The approximate average outstanding borrowings during the periods were $81,000,000 and 66,000,000, respectively. The weighted average interest rate of such borrowings, computed on a monthly basis, was 4.2% in 1993 and 5.3% in 1992. The existing warehousing credit facilities require the Company to maintain certain capital ratios and to comply with other requirements. At December 31, 1993, the Company was in compliance with these requirements. NOTE 12 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE: The Company sells mortgage-backed securities and mortgage loans under agreements to repurchase. At December 31, 1993 and 1992, the Company had several repurchase agreement lines of credit, totalling $215,000,000 and $180,000,000, respectively. At December 31, 1993 and 1992, the Company had a liability of $143,199,642 and $128,755,230, respectively, relating to such agreements at interest rates ranging from 2.9% to 9.0% in 1993 and 3.0% to 6.0% in 1992. These agreements mature at various dates as follows: December 31, 1993: December 31, 1992: (1) Term up to 30 days (2) Term over 30 days to 90 days (3) Term over 90 days to 1 year (4) Term between 1 to 3 years (5) Term between 3 to 5 years (6) Term between 5 to 8 years Maximum borrowings outstanding at any month-end during 1993 and 1992 under the agreements to repurchase were $152,000,000 and $132,000,000, respectively. The approximate average borrowings outstanding during the periods were $125,000,000 and $102,000,000, respectively. The weighted average interest rate of such borrowings, computed on a monthly basis was 3.34% in 1993 and 4.03% in 1992. At December 31, 1993, securities sold under agreements to repurchase are classified by dealer as follows: NOTE 13 - DEPOSITS: At December 31, 1993, deposits and their weighted average interest rates are summarized as follows: Certificates of deposit over $100,000 in the aggregate amounted to $2,825,000. A summary of certificates of deposit by maturity follows: At December 31, 1993, Doral Federal has deposits from officers, directors, employees and major stockholders of the Company amounting to approximately $1,300,000. At December 31, 1993, escrow funds include approximately $7,754,000 deposited with Doral Federal. These funds are included in the Company's financial statements. Escrow funds also include approximately $54,896,000 (1992-$34,500,000) deposited with other banks and which are excluded from the Company's assets and liabilities. NOTE 14 - ADVANCES FROM THE FEDERAL HOME LOAN BANK: Advances from the Federal Home Loan Bank ("FHLB") consist of the following: The aggregate maturities of the FHLB advances are as follows: At December 31, 1993, the Company's FHLB stock and other qualified collateral (in the form of first mortgage notes) amounting to $3,439,620 were pledged to secure advances from the FHLB. NOTE 15 - INCOME TAXES: Under the provisions of Law No. 38 of May 20, 1983, the Company is exempt from the payment of Puerto Rico income taxes on the interest earned on mortgages on residential properties located in Puerto Rico which were executed after June 30, 1983, and are insured or guaranteed pursuant to the provisions of the National Housing Act of June 27, 1934, as amended, and pursuant to the Provisions of the Servicemen's Readjustment Act of 1944, as amended. The 1987 Puerto Rico Tax Reform Act ("the Reform Act") imposed an alternative minimum tax (AMT) of 22% on regular income after adjustment for certain items provided for by the Reform Act. The income tax liability will be the greater of the tax computed under the regular tax system or the AMT system. Doral Federal as a federally chartered financial institution operating in Puerto Rico, is subject to U.S. Federal income taxes. Doral Federal has filed an election under Section 936 of the U.S. Internal Revenue Code, whereby a possession tax credit is allowed for federal income taxes attributable to income from operations in Puerto Rico. The Omnibus Budget Reconciliation Act of 1993 limits the 936 credit effective for tax years beginning after December 31, 1993. Substantially all income of the Company was from its mortgage banking business in Puerto Rico and, therefore, the amount of the 936 credit as well as the United States income tax was not significant. Consolidated tax returns are not permitted under the Puerto Rico Income Tax Law, therefore, taxable income tax returns are filed individually by each Company. The provision for income taxes differs from amounts computed by applying the applicable Puerto Rico statutory tax rate to income before taxes. A reconciliation of the difference follows: NOTE 16 - RELATED PARTY TRANSACTIONS: Mortgage loans held for sale include approximately $521,000 of loans to various officers of the Company at prevailing interest rates. The Company paid a computer service bureau, in which it holds a 25% interest, $617,000, $410,000 and $348,000 for services rendered during the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992 company's equity on this service bureau was not significant. In December 1990, the Company sold real estate properties acquired through foreclosure valued at approximately $4,000,000 to a special partnership (the "Partnership") formed under a private syndication. The properties were sold at a value determined by an independent appraiser. The Company and several members of senior management invested as limited partners. The Company investment, amounting to approximately $135,000, is carried at cost and is included in other assets. At December 31, 1993 and 1992, mortgage notes receivable include approximately $400,000 and $3,142,000, respectively due from the Partnership. In addition, at December 31, 1993 accounts receivable includes approximately $550,000 due from the Partnership, mostly corresponding to several repairs and improvement made to the rental properties and funded by the Company. NOTE 17 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK: The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and sell mortgage-backed securities and loans, securities sold under agreements to repurchase and securities purchased under agreements to resell, and options on futures contracts. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit losses in the event of non-performance by the other party to the financial instrument for commitments to extend credit and securities purchased under agreements to resell is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments. The Company does not require collateral or other security to support commitments to extend credit. At December 31, 1993, commitments to extend credit to individuals for residential mortgages amounted to approximately $23,900,000 and commitments to sell mortgage-backed securities and loans amounted to approximately $175,000,000. Commitments to extend credit are agreements to lend a customer as long as the conditions established in the contract are met. Commitments generally have fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral if deemed necessary by the company upon extension of credit is based on management's credit evaluation of the counterparty. A geographic concentration exist within the Company's mortgage loans portfolio since most of the Company's business activity is with customers located in Puerto Rico. The Company controls the credit risk of its future contracts through credit approvals, limits and monitoring procedures. Options on future contracts confer the right from sellers to buyer to take a future position at a stated price. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities values and interest rates. Collateral for securities purchased under agreements to resell is kept by the seller under custody agreements. Collateral for securities sold under agreements to repurchase is kept by the purchaser. NOTE 18 - PENSION AND COMPENSATION PLANS: The Company has a noncontributory target benefit pension plan ("the Plan"). The Plan covers all full time Company employees that have completed one year of service and have attained age 21. Under the Plan, the Company contributes annually the funding amount which is projected to be necessary to fund the target benefit. The target benefit is based on years of service and the employees' compensation, as defined in the Plan. The Company has the right to terminate the Plan at any time. Upon termination, all amounts credited to the participants' accounts will become 100% vested. Contributions to the Plan during the years ended December 31, 1993, 1992 and 1991 amounted to approximately $503,000, $120,000 and $127,000, respectively. Plan assets consist principally of mortgage loans. The Company has unfunded deferred incentive compensation arrangements (the "Deferred Compensation") with certain employees. The Deferred Compensation is determined as a percentage of net income arising from the mortgage banking activities, as defined, and is payable to participants after a five year vesting period. The expense for the years ended December 31, 1993, 1992 and 1991, amounted to approximately $885,000, $568,000 and $275,000, respectively. The Company also has incentive compensation arrangements with certain employees payable currently. The incentive payments are based on the amount of mortgage loans closed and consolidated net income in excess of established return on stockholders' equity, as defined in the agreements. The expense under these arrangements for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $7,866,000, $3,370,000 and $1,050,000, respectively. NOTE 19 - COMMITMENTS AND CONTINGENCIES: The Insurance and Indemnity Agreements (the "Agreements") with an insurance company that has issued financial guaranty insurance policies, insuring payment of senior certificates issued by CMO grantors trusts established by the Company, provide, among other things, for the following: - - The Company's consolidated debt shall not exceed 1000% (10 times) of consolidated stockholders' equity. - - The Company can not sell, transfer or pledge the residual certificates issued by the trusts (amounting to approximately $9,500,000) without the insurance company approval. At December 31, 1993 the Company was in compliance with these requirements. At December 31, 1993, the servicing portfolio includes approximately $173,000,000 of loans sold to various grantor trusts in connection with the issuance of CMO's. Approximately $6,000,000 of residual certificates were pledged as collateral to the insurance company. The Company has several noncancellable operating leases for its office facilities expiring through 2005. Total minimum rental commitments for leases in effect at December 31, 1993 are as follows: Total rental expense for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $1,445,000, $817,000 and $586,000, respectively. The Company is subject to legal proceedings and claims which have arisen in the ordinary course of its business and have not been finally adjudicated. These actions, when finally concluded and determined, will not, in the opinion of management, have a material adverse effect upon the financial position or results of operations of the Company. NOTE 20 - CAPITAL STOCK AND PAID-IN CAPITAL: The Company has a Restricted Stock Plan (the "Restricted Stock Plan") and a Stock Option Plan. The Restricted Stock Plan provides for the granting of up to 150,000 shares of common stock to selected officers at no cost. At December 31, 1993, the number of shares awarded and issued under the Restricted Stock Plan is 177,806 shares, including 88,903 shares issued on December 10, 1993 as result of the stock split (1992 and 1991 - 88,903 and 69,853 shares, respectively.) The terms of the Restricted Stock Plan permit the imposition of restrictions ranging from one to five years on the sale or disposition of the shares issued. At December 31, 1993, 38,100 of the shares issued under the Restricted Stock Plan were subject to such restrictions. The Stock Option Plan provides for selected officers and key employees to purchase up to 150,000 shares of common stock at prices equal to the fair market value on date of grant. No options have been awarded. The Company's 10.5% Cumulative Convertible Preferred Stock Series A, has a liquidation preference of $10 per share plus accrued dividends and is convertible at the option of the holder into two shares of common stock at a conversion price of $5 per share. It is redeemable in whole or part at the option of the Company on or after January 1, 1995 and on or prior to December 31, 1996 at $11 per share, and thereafter, at redemption prices declining to a price of $10.30 per share on January 1, 2002. Dividends are cumulative from the date of issue and are payable quarterly. During the year ended December 31, 1993, the number of common stock shares authorized was increased from 5,000,000 to 10,000,000 shares. Present regulations limits the amount of dividends that Doral Federal may pay. Payment of such dividends is prohibited if, among other things, the effect of such payment would be to cause the capital of Doral Federal to be reduced below the regulatory capital requirements. NOTE 21 - SUPPLEMENTAL INCOME STATEMENT INFORMATION: The following expenses are included in loan origination costs and general and administrative expenses in the accompanying statement for the following periods: NOTE 22 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS: At December 31, the estimated fair values of the Company's financial instruments are as follows: As part of the interest rate risk management at December 31, 1993, the Company, as a purchaser, had unexpired options where it had the right to sell and the right to buy securities amounting to approximately $22,200,000 and $52,650,000, respectively. As a seller, the Company had unexpired options where it had the obligation to sell securities amounting to approximately $25,000,000. Generally these options expire without being exercised. NOTE 23 - SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION: Income tax payments made by the Company during the year ended December 31, 1993, 1992 and 1991 were $3,780,000, $5,370,000 and $910,000, respectively. Interest paid for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $9,561,000, $9,191,000 and $12,300,000, respectively. In conjunction with the acquisition of Doral Federal, liabilities were assumed as follows: NOTE 24 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): Financial data showing results of the 1993 and 1992 quarters is presented below. These results are unaudited. Net income per share was retroactively adjusted to reflect the two-for-one split effected on December 10, 1993. In the opinion of management all adjustments necessary for a fair presentation have been included: ____________________ (1) Incorporated herein by reference to the same exhibit number of the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 (File No. 0-17224). (2) Incorporated herein by reference to the same exhibit number of the Company's Quarterly Report on From 10-Q for the quarter ended March 31, 1993 (File No. 0-17224) (3) Incorporated herein by reference to the same exhibit number as filed pursuant to Item 15(b) of the Company's Form 10 filed with the Commission on October 7, 1988, as amended by Form 8 amendments thereto. (4) Incorporated herein by reference to the same exhibit number of the Company's Registration Statement on Form S-1 (No. 33-39651) filed with the Commission on March 29, 1991. (5) Incorporated herein by reference to the same exhibit number of the Company's Registration Statement on Form S-2 (No. 33-52292) filed with the Commission on September 23, 1992. (6) Incorporated by reference to exhibit number 19.1 of the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 1993 (File No. 0-17224). (7) Incorporated by reference to exhibit number 19.2 of the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 1993 (File No. 0-17224). (8) Incorporated by reference to exhibit number 19.3 of the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1993 (File No. 0-17224). (9) Incorporated by reference to exhibit number 19.4 of the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1993 (File No. 0-17224). (10) Incorporated herein by reference to exhibit number 1 of the Company's Current Report on Form 8-K filed with the Commission on December 16, 1992. (b) Reports on Form 8-K. Not applicable

96277_1993.txt

96277_1993

1993

96277

Item 1. Business - ------ -------- General - ------- Tambrands Inc. (the "Company") has been manufacturing and marketing menstrual tampons, which are sold under the trademark TAMPAX(R), since 1936. It is the leading manufacturer and marketer of tampons in the world. The Company operates in one business segment, personal care products. In recent years, the Company has focused on its core TAMPAX tampon business worldwide and has been expanding its international operations. The Company has manufacturing operations in eight countries. In 1993, TAMPAX tampons were sold in over 150 countries. The Company has subsidiaries operating in Brazil, Canada, the Czech Republic, France, Ireland, Mexico, Poland, Russia, South Africa, Switzerland, Ukraine, the United Kingdom and Venezuela. The Company also has an 80% interest in a joint venture in the People's Republic of China. The Company was incorporated under the laws of the State of Delaware in 1936. The Company's principal executive offices are located at 777 Westchester Avenue, White Plains, New York 10604 (telephone number 914-696-6000). Recent Developments - ------------------- In June 1989, the Company adopted a new corporate strategy of concentrating on the Company's core TAMPAX tampon business. As part of this strategy, the Company announced in December 1989 a major restructuring program designed to reduce costs and improve performance. The restructuring program has included sales of the Company's businesses that were not supportive of the Company's core activities, reductions in workforce and consolidation of certain administrative, manufacturing and research and development facilities in the United States, Canada and Europe. This program has been virtually completed. In December 1991, the Company announced a program to restructure its worldwide manufacturing operations to improve efficiency and reduce costs. The program includes workforce reductions and consolidation of facilities. The program has been virtually completed, and has included the sale of non-core businesses in Brazil and Mexico and the closing of manufacturing plants in Canada and the United States. In June 1993, the Company announced that it would provide a $30 million charge ($20 million after-tax) to provide for restructuring of manufacturing and administrative operations and the cost of management changes, including the adoption of a consolidated international management strategy. The program includes workforce reductions and consolidation of facilities. In order to implement these restructuring programs, the number of manufacturing plants has been reduced by approximately 50% and the Company has sold (i) its cosmetics, diagnostics and MAXITHINS(R) pad and panty shield businesses; (ii) its headquarters in Lake Success, New York; (iii) its non- tampon businesses in Spain, which included sanitary pads, disposable diapers and other baby products; (iv) its interest in a joint venture in Turkey, which primarily produced sanitary pads and diapers; (v) its disposable diaper and external pad businesses in Brazil; and (vi) its alcohol, cotton, baby wipes and external pad businesses in Mexico. The Company currently is engaged in an ongoing program of substantially upgrading production equipment at its remaining manufacturing facilities through further automation and computerization. The Company's 1993 capital spending programs were related to investments in equipment to improve product quality and productivity, modernize facilities and reduce costs. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" contained in item 7 of Part II hereof. In June 1989, the Company initiated a stock repurchase program. As of December 31, 1993, the Company had spent approximately $365 million to purchase approximately 5.9 million shares of its Common Stock under four repurchase programs. The Company was authorized as of December 31, 1993 to purchase 2.02 million additional shares. The Company is continuing its repurchases as conditions warrant. In 1992, the Company established a commercial paper program under which it may borrow up to $150 million for general corporate purposes. At December 31, 1993, $48 million was outstanding under this program. In addition, in 1993, the Company established a $150 million Medium-Term Note program. At December 31, 1993, $30 million was outstanding under this program. On June 1, 1993, Martin F. C. Emmett resigned from his position as Chairman and Chief Executive Officer. Howard B. Wentz, Jr. replaced Mr. Emmett as the Chairman of the Board of Directors and, pending the appointment of a Chief Executive Officer, is performing the duties of Chief Executive Officer. Certain other changes in senior management also occurred in mid-1993. The Company is currently in the process of evaluating candidates for the position of Chief Executive Officer. Products - -------- Menstrual tampons represent virtually all of the Company's sales. The Company's largest selling tampon is the TAMPAX flushable applicator tampon, which first became commercially available in 1936. The Company also manufactures and sells (i) TAMPAX tampons with plastic applicators in the United States; (ii) TAMPAX COMPAK(R) tampons, with a compact all-plastic applicator, in the United States, Canada, France, the United Kingdom and other countries in Europe; and (iii) TAMPAX comfort shaped flushable applicator tampons, with an all-paper rounded-end applicator and a slimmer design than the Company's standard product, in the United States, Canada, Australia, parts of Europe and several other countries. In 1993, the Company introduced nationally in Canada the new TAMPAX SATIN TOUCH/TM/ tampon. This tampon offers the ease and comfort of a plastic applicator but has an all-paper applicator that is flushable and biodegradable. In 1993, the Company introduced nationally its new TAMPAX TAMPETS(R) non- applicator tampon in Ireland. The Company also introduced this tampon in test market in the United Kingdom in 1993 and plans to introduce this tampon nationally in the United Kingdom in 1994. The Company continues to evaluate the possible introduction of these and other products in additional markets. Marketing and Sales - ------------------- Marketing operations are conducted either directly by the Company and its subsidiaries and joint venture, or by independent brokers or sales agents and distributors. Sales are made directly to drug, grocery, variety and discount stores and other comparable outlets, as well as to wholesalers and distributors in those trades. No single customer (including distributors) of the Company and its subsidiaries and joint venture accounted for 10% or more of total net sales in 1993. A small number of significant customers have highly leveraged capital structures, making them particularly sensitive to adverse market interest rate changes and other economic variables. This situation has not significantly affected the Company in prior years. Substantially all sales involve extensions of credit. Credit terms generally are consistent with terms typically extended under local industry practices. Default rates by the Company's customers in the United States have been at or below industry averages, based on information from the Credit Research Foundation. In the United States, the Company's internal sales management group directly handles sales to certain large customer accounts. These sales have been increasing as a percentage of total sales. Other sales in the United States and sales in Belgium, Canada, France and the Netherlands are handled through independent sales brokers, who also may sell other branded consumer products but generally do not carry products that compete with the products of the Company and its subsidiaries. Sales are conducted in the Czech Republic, Poland, Russia, Ukraine and the United Kingdom by the Company's subsidiaries and in the People's Republic of China by its joint venture. Sales are conducted in other countries through independent distributors and agents. During 1993, retailers in the United States and Europe and distributors in Europe continued to reduce their inventories of TAMPAX tampons, as part of an industry-wide trend to reduce consumer goods inventory levels. This inventory reduction adversely affected the Company's 1993 financial results. This inventory reduction trend has continued in the first quarter of 1994 and the Company believes that the trend will continue. However, the rate of inventory reduction in future periods is expected to be significantly less than the rate of reduction experienced in 1993. Media advertising is important to the overall success of the TAMPAX tampon brand. In the United States, Canada and Europe, the Company focuses its advertising on women aged 12-34, using a variety of media, including television and print advertisements. The Company increased its advertising and promotional spending substantially in the second half of 1993, in the face of a significant decline in the Company's market share of the tampon category in the United States in the first half of 1993 and a decline in the tampon share of the sanitary protection category in Europe in 1992 and 1993. The advertising and promotional spending is being concentrated in the Company's five largest markets (the United States, the United Kingdom, Canada, France and Spain) and in the four international markets believed to have the greatest development potential (CIS, principally Russia and Ukraine, Mexico, China and Brazil). The Company also seeks to attract and retain customers through its teen education program, which is designed to help female teenagers understand the various forms of sanitary protection and promotes trial usage of TAMPAX tampons. Competition - ----------- Highly competitive conditions prevail in the feminine protec-tion industry for external pads and menstrual tampons, which are directly competitive in both performance and price, the principal methods of competition. In the United States, there are four other manufacturers whose sales, directly or through subsidiaries, are significant in the total sanitary protection market: Johnson & Johnson, Kimberly-Clark Corporation, Playtex Family Products Corporation and The Procter & Gamble Company. Each of these corporations manufactures and sells external pads or menstrual tampons or both. Each makes and sells products other than external pads and tampons, and the total sales of all products by and the capitalization of each of Johnson & Johnson, Kimberly-Clark and Procter & Gamble are substantially greater than the total sales and capitalization of the Company. These factors may be helpful to the respective competitive positions of these companies in the feminine protection industry. Substantially all of the tampons manufactured by the above-mentioned four companies are sold under these companies' brand names. In addition, there is a small but growing private label segment of the industry. Management believes that the TAMPAX tampon's leading market share position in the U.S. tampon category (approximately 50.3% in dollars and 53.7% in units for the year 1993, according to Information Resources, Inc.) and strong brand loyalty among consumers (as verified by household panel data obtained by Nielsen Marketing Research), are positive factors in the Company's ability to compete in the feminine protection industry. During 1993, the level of competitive activity increased in the United States, particularly in the area of price discounting. Highly competitive conditions prevail in virtually all foreign markets. Competition tends to be fragmented and regional in nature in most of those markets, but tampons produced by, or under license from, Johnson & Johnson, and external pads produced by Procter & Gamble, are sold in many of the foreign markets where the Company does business. Competitive activity intensified in Europe in 1993. This activity included the introduction and aggressive marketing of several new external pad products. Management expects that highly competitive conditions will continue in 1994, including price discounting, new product introductions and continued growth in private label tampons. Raw Materials - ------------- The principal raw materials used in the Company's business are cotton and rayon for tampons, paper and plastic for tampon applicators, and paperboard for cartons and containers. Most of these raw materials are readily available in the market from many sources. Trademarks and Patents - ---------------------- The Company, directly or through its subsidiaries, owns a number of trademarks, trademark registrations and trademark applications in the United States and other countries, which, in the opinion of management, are significant. The Company's trademark registrations vary in duration and are typically renewable by the Company. Certain features of TAMPAX tampons are the subject of U.S. and foreign patents or patent applications owned by the Company. In management's opinion, certain of these patents are significant. The duration of the Company's patents ranges from 5 to 19 years (i.e., the patents have ---- expiration dates ranging from the year 1999 to the year 2013). Research and Development - ------------------------ The Company maintains a research and development laboratory at its facilities in each of Palmer, Massachusetts and Havant, England. The Company's research and development expenditures have approximated 2% of net sales in each of the past three years. Management believes that developing better protecting and more comfortable and convenient products, and products which are environmentally sound, is important to maintaining the Company's competitive position. Research is directed toward these goals. Employees - --------- As part of the restructuring program announced in 1989, the staff of the Company's headquarters and North American Division has been reduced substantially. The sale of non-core businesses also has reduced the number of employees. Additional headcount reductions have occurred and will occur as a result of the restructuring programs announced in 1991 and 1993. At December 31, 1993, the Company and its consolidated subsidiaries employed approximately 3,600 persons, including 900 employees in the People's Republic of China, Russia and Ukraine. Foreign and Domestic Operations; Export Sales - --------------------------------------------- The information regarding foreign and domestic operations of the Company and its subsidiaries set forth on page 38 under the caption "Segment and Geographic Information" in the Notes to Consolidated Financial Statements is incorporated herein by reference. Over the past three years, sales by the Company's foreign operations accounted for approximately one-half of total unit sales. In 1993, sales between geographic areas and export sales of the Company were not significant. Item 2. Item 2. Properties - ------ ---------- Domestic Properties - ------------------- As part of its worldwide manufacturing restructuring program, during 1993, the Company's Palmer, Massachusetts manufacturing plant was converted to a facility for testing new equipment and developing new products. The Company has consolidated its U.S. manufacturing operations in its three other U.S. plants, located in Auburn, Maine; Claremont, New Hampshire; and Rutland, Vermont. Technical and research and development operations are conducted at the Company's Technical Center, also located in Palmer, Massachusetts. This facility is a testing center for the application of advanced manufacturing technology to the Company's products. The Company owns each of these plants and the Technical Center. The Company leases headquarters office space in White Plains, New York. The Company's production machinery and equipment and the properties owned by it described above are held free and clear of encumbrances. During the last fiscal year, the Company's domestic plants were suitable and adequate for the Company's requirements. The Company's domestic plants operate principally on a three-shift basis, and have sufficient additional capacity to satisfy the foreseeable requirements of the Company. Foreign Properties - ------------------ The Company's foreign subsidiaries own and operate manufacturing plants in France, Ireland, Russia, South Africa, Ukraine and the United Kingdom. The Company's joint venture in the People's Republic of China has contractual rights to use a manufacturing plant there. The Company's foreign subsidiaries lease office space in Brazil, Canada, France, Mexico, Switzerland, Venezuela and in several other countries. The Company's subsidiary in the United Kingdom leases office space there for the Company's international headquarters. In 1993, as part of the Company's worldwide manufacturing restructuring program, the Company determined to effect a restructuring of the manufacturing operations conducted at the plant owned by its subsidiary in France. All European production of COMPAK tampons now will be concentrated at the French plant, and production of other tampons will be consolidated in the Company's other European plants. As part of the restructuring program, the Company also decided in 1993 to close the tampon manufacturing plant in Mexico leased by a subsidiary. The Mexican manufacturing operations are being consolidated in the Company's U.S. plants. The production machinery and equipment and properties owned by the Company's foreign subsidiaries described above are held free and clear of encumbrances. During the last fiscal year, the Company's foreign facilities were suitable and adequate for the Company's requirements. In general, the Company's foreign manufacturing facilities operate on a two- or three-shift basis, and have sufficient additional capacity to satisfy the foreseeable requirements of the Company. Item 3. Item 3. Legal Proceedings - ------ ----------------- The Company or a subsidiary is a defendant in a small number of pending product liability lawsuits based on allegations that toxic shock syndrome ("TSS") was contracted through the use of tampons. A small number of pre-suit claims involving similar allegations have also been asserted. The damages alleged vary from case to case and often include claims for punitive damages. The Company and certain of its present and former officers have been named as defendants in certain shareholder lawsuits that have been filed in the United States District Court for the Southern District of New York and that have been consolidated under the caption In Re Tambrands Inc. Securities Litigation. The ------------------------------------------ consolidated lawsuit purports to be a federal securities fraud class action on behalf of all purchasers of the Company's common stock during the period December 14, 1992 through June 2, 1993. The complaint alleges that the Company's disclosures during the alleged class period contained material misstatements and omissions concerning its anticipated future earnings. The complaint seeks an unspecified amount of damages on behalf of the purported class. The Company is a nominal defendant in three purported shareholder derivative lawsuits that have been filed in the Supreme Court of the State of New York for Westchester County and that have been consolidated into a single action. Named collectively in the consolidated complaint as individual defendants are the Company's directors (and certain of its former directors) and two of its former officers. The complaint alleges that the officer-defendants exposed the Company to liability in the purported shareholder class action described in the preceding paragraph and misappropriated corporate opportunities by trading in the Company's stock on the basis of nonpublic information. One of the former officers is also alleged to have received improper reimbursements from the Company for alleged personal expenses. The director-defendants are alleged to have acquiesced in the aforesaid alleged violations. The complaint seeks to recover on behalf of the Company an unspecified amount of damages from the individual defendants. No relief is sought against the Company. The Company is involved in certain other legal proceedings incidental to the normal conduct of its business. While it is not feasible to predict the outcome of these legal proceedings and claims with certainty, management is of the belief that any ultimate liabilities for damages either are covered by insurance, are provided for in the Company's financial statements or, to the extent not so covered or provided for, should not individually or in the aggregate have a material adverse effect on the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------ --------------------------------------------------- No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. Executive Officers of the Registrant - ------------------------------------ The names and ages of all executive officers of the Company, the current office held by each, and the period during which each has served as such are set forth in the following table: Each executive officer is appointed by the Board of Directors to serve until the first meeting of directors following the annual meeting of shareholders of the Company. Except as indicated in the footnotes below, the principal occupation and employment during the past five years of each of the above-named executive officers have been as an officer or other member of management of the Company or one or more of its subsidiaries. (1) Mr. Chapman has served as an officer of the Company since August 1989. From prior to March 1989 until August 1989, he was employed by The Spectrum Group, Inc. (an investment company) as Vice President. (2) Mr. Wainick has served as an officer of the Company since June 1990. From prior to March 1989 until June 1990, he was employed by Binney & Smith, Inc. (a manufacturer of arts and crafts supplies), a subsidiary of Hallmark Cards, Inc., as Director of Technical Development. (3) Mr. Wentz is a non-employee director of the Corporation and has been Chairman of the Board and has performed the duties of the Chief Executive Officer of the Corporation since June 2, 1993. Mr. Wentz has served as Chairman of the Board of ESSTAR Incorporated (a manufacturer of portable electric tools and architectural hardware) since July 1989. From prior to March 1989 until June 1989, he served as Chairman, President and Chief Executive Officer of Amstar Corporation (a diversified manufacturer). (4) Mr. Wright has served as an officer of the Company since August 1989. From prior to March 1989 until August 1989, he was employed by International Nabisco Brands as Senior Vice President-Finance. PART II ------- Item 5. Item 5. Market for Registrant's Common Equity and Related - ------ ------------------------------------------------- Shareholder Matters ------------------- The Company's Common Stock is traded on the New York and Pacific Stock Exchanges. The following table provides quarterly dividend and Common Stock price range information for the years 1992 and 1993: (a) Reflects trading on the New York Stock Exchange. (b) Dividends of $0.42 per share declared in the third quarter were paid in December 1993. As of March 15, 1994, there were 7,001 holders of record of the Company's Common Stock. Item 6. Item 6. Selected Financial Data - ------ ----------------------- The information required by this item is set forth in a separate section of this Annual Report on Form 10-K under the caption "Selected Financial Data" appearing on page 25 and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Results of - ------ -------------------------------------------------- Operations and Financial Condition ---------------------------------- The information required by this item is set forth in a separate section of this Annual Report on Form 10-K under the caption "Management's Discussion and Analysis" beginning on page 26 and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data - ------ ------------------------------------------- The information required by this item is set forth in a separate section of this Annual Report on Form 10-K as indicated in the "Index to Financial Information" appearing on page 24 and is incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on - ------ ------------------------------------------------ Accounting and Financial Disclosure ----------------------------------- None. PART III -------- Item 10. Item 10. Directors and Executive Officers of the Registrant - ------- -------------------------------------------------- The information relating to nominees for election as directors of the Company set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on April 26, 1994 is incorporated herein by reference. Mr. Brian Healey is currently a director of the Company, but he is retiring from the Board of Directors, and he is not a nominee for election as a director at the annual meeting of shareholders to be held on April 26, 1994. Mr. Healey has been a Principal of Brian Healey & Associates, Victoria, Australia (a business consulting firm), since before March 1989. He has been a director of the Company since 1992 and is 60 years old. The information on executive officers set forth under the caption "Executive Officers of the Registrant" beginning on page 9 is incorporated herein by reference. The information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, set forth under the caption "Executive Compensation and Other Information - Other Information" in the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on April 26, 1994 is incorporated herein by reference. Item 11. Item 11. Executive Compensation - ------- ---------------------- The information regarding executive compensation set forth under the captions "Information Regarding the Board of Directors - Compensation of Directors," "Executive Compensation and Other Information" and "Proposal to Approve Amendment to the 1992 Directors Stock Incentive Plan" in the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on April 26, 1994 is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and - ------- ---------------------------------------------------- Management ---------- The information regarding the security ownership of certain beneficial owners and management set forth under the caption "Security Ownership by Management and Others" in the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on April 26, 1994 is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions - ------- ---------------------------------------------- The information pertaining to certain relationships and related transactions set forth under the captions "Information Regarding the Board of Directors - Compensation of Directors" and "Executive Compensation and Other Information - Other Information" in the Company's definitive Proxy Statement for the annual meeting of shareholders to be held on April 26, 1994 is incorporated herein by reference. The services performed for the Company by Doherty, Wallace, Pillsbury & Murphy, P.C. were on terms no less favorable to the Company than if such services had been provided by unaffiliated parties. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules, - ------- ---------------------------------------- and Reports on Form 8-K ----------------------- (a) Documents filed as part of this report 1. Financial Statements The list of financial statements set forth under the caption "Index to Financial Information" on page 24 is incorporated herein by reference. 2. Financial Statement Schedules The list of financial statement schedules set forth under the caption "Index to Financial Information" on page 24 is incorporated herein by reference. All other schedules have been omitted, as the required information is inapplicable or the information is presented in the financial statements or related notes. 3. Exhibits Exhibit Number Description ------- ----------- 3(1) Certificate of Incorporation of the Company, as amended through April 28, 1987, filed April 30, 1987 as Exhibit 4(a) to the Company's Form S-8 Registration Statement (Reg. No. 33-13902), incorporated herein by reference. 3(2) Certificate of Amendment of Certificate of Incorporation of the Company, dated April 24, 1990, filed May 15, 1990 as Exhibit 4(2) to the Company's Report on Form 10-Q for the quarter ended March 31, 1990, incorporated herein by reference. 3(3) Certificate of Amendment of Certificate of Incorporation of the Company, dated April 28, 1992, filed May 15, 1992 as Exhibit 4(2) to the Company's Report on Form 10-Q for the quarter ended March 31, 1992, incorporated herein by reference. 3(4) By-Laws of the Company, as amended, filed herewith. 4(1) Description of the rights of security holders set forth in the Certificate of Incorporation of the Company, as amended through April 28, 1987, filed April 30, 1987 as Exhibit 4(a) to the Company's Form S-8 Registration Statement (Reg. No. 33-13902), incorporated herein by reference. 4(2) Description of the rights of security holders set forth in the Certificate of Amendment of Certificate of Incorporation of the Company, dated April 28, 1992, filed May 15, 1992 as Exhibit 4(2) to the Company's Report on Form 10-Q for the quarter ended March 31, 1992, incorporated herein by reference. 4(3) Rights Agreement, dated as of October 24, 1989, between the Company and First Chicago Trust Company of New York, which includes the Form of Right Certificate as Exhibit A and the Summary of Rights to Purchase Common Shares as Exhibit B, filed October 27, 1989 as Exhibit 1 to the Company's Form 8-A Registration Statement, incorporated herein by reference. 4(4)(a) Indenture dated as of December 1, 1993 between the Company and Citibank, N.A., as trustee, relating to the Company's Medium- Term Note Program, filed herewith. 4(4)(b) Form of Floating Rate Debt Security, filed December 16, 1993 as Exhibit 4-a to the Company's Report on Form 8-K, incorporated herein by reference. 4(4)(c) Form of Fixed Rate Debt Security, filed December 16, 1993 as Exhibit 4-b to the Company's Report on Form 8-K, incorporated herein by reference. Management Contracts and Compensatory Plans and Arrangements (Exhibits 10(1) - 10(21)) ----------------------- 10(1)(a) 1981 Long Term Incentive Plan, as amended through November 4, 1988, filed as Exhibit 10(1)(a) to the Company's Report on Form 10-K for the year 1988, incorporated herein by reference. 10(1)(b) Amendment to 1981 Long Term Incentive Plan, dated as of February 27, 1990, filed as Exhibit 10(1)(b) to the Company's Report on Form 10-K for the year 1989, incorporated herein by reference. 10(1)(c) Amendment to 1981 Long Term Incentive Plan, effective as of June 25, 1991, filed as Exhibit 10(1)(c) to the Company's Report on Form 10-K for the year 1991, incorporated herein by reference. 10(1)(d) Amendment to 1981 Long Term Incentive Plan, effective as of June 23, 1992, filed as Exhibit 10(1)(d) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(1)(e) Amendment to 1981 Long Term Incentive Plan, effective as of February 23, 1993, filed as Exhibit 10(1)(e) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(1)(f) Addendum to 1981 Long Term Incentive Plan, filed April 30, 1987 as Exhibit 28(a) to the Company's Form S-8 Registration Statement (Reg. No. 33-13902), incorporated herein by reference. 10(2)(a) 1981 Incentive Stock Option Plan, as amended through April 30, 1987, filed April 30, 1987 as Exhibit 28(a) to the Company's Form S-8 Registration Statement (Reg. No. 33- 13902), incorporated herein by reference. 10(2)(b) Amendment to 1981 Incentive Stock Option Plan, dated as of February 27, 1990, filed as Exhibit 10(2)(b) to the Company's Report on Form 10-K for the year 1989, incorporated herein by reference. 10(2)(c) Amendment to 1981 Incentive Stock Option Plan, effective as of June 23, 1992, filed as Exhibit 10(2)(c) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(2)(d) Amendment to 1981 Incentive Stock Option Plan, effective as of February 23, 1993, filed as Exhibit 10(2)(d) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(3)(a) 1991 Stock Option Plan, filed as Exhibit 10(3) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference. 10(3)(b) First Amendment to 1991 Stock Option Plan, effective as of July 1, 1991, filed as Exhibit 10(3)(b) to the Company's Report on Form 10-K for the year 1991, incorporated herein by reference. 10(3)(c) Second Amendment to 1991 Stock Option Plan, effective as of July 1, 1991, filed as Exhibit 10(3)(c) to the Company's Report on Form 10-K for the year 1991, incorporated herein by reference. 10(3)(d) Third Amendment to 1991 Stock Option Plan, effective as of June 23, 1992, filed as Exhibit 10(3)(d) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(3)(e) Fourth Amendment to 1991 Stock Option Plan, effective as of February 23, 1993, filed as Exhibit 10(3)(e) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(3)(f) Fifth Amendment to 1991 Stock Option Plan, effective as of February 23, 1993, filed as Exhibit 10(3)(f) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(3)(g) Addendum to 1991 Stock Option Plan, filed as Exhibit 10(3)(g) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(3)(h) Sixth Amendment to 1991 Stock Option Plan, effective as of February 1, 1994, filed herewith. 10(4)(a) 1989 Restricted Stock Plan, as amended through December 31, 1990, filed as Exhibit 10(4) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference. 10(4)(b) Amendment to 1989 Restricted Stock Plan, effective as of February 23, 1993, filed as Exhibit 10(4)(b) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(5)(a) Supplemental Executive Retirement Plan, effective July 1, 1986, as amended and restated effective July 1, 1994, filed herewith. 10(5)(b) Resolutions of the Compensation Committee of the Board of Directors of the Company with respect to certain benefits under the Supplemental Executive Retirement Plan, adopted on February 11, 1993, filed as Exhibit 10(5)(b) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(6) Trust Agreement between the Company and The Northern Trust Company, dated as of October 31, 1988, filed as Exhibit 10(6) to the Company's Report on Form 10-K for the year 1988, incorporated herein by reference. 10(7) Pension Plan for Non-Employee Directors, filed as Exhibit 10(10) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference. 10(8)(a) 1992 Directors Stock Incentive Plan, filed as Exhibit 10(11) to the Company's Report on Form 10-K for the year 1991, incorporated herein by reference. 10(8)(b) First Amendment to 1992 Directors Stock Incentive Plan, effective as of August 18, 1992, filed as Exhibit 10(8)(b) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(8)(c) Second Amendment to 1992 Directors Stock Incentive Plan, effective as of February 23, 1993, filed as Exhibit 10(8)(c) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(8)(d) Third Amendment to the 1992 Directors Stock Incentive Plan, effective as of August 24, 1993, filed as Exhibit 10(3) to the Company's Report on Form 10-Q/A for the quarterly period ended September 30, 1993, incorporated herein by reference. 10(8)(e) Fourth Amendment to 1992 Directors Stock Incentive Plan, effective as of March 1, 1994 (subject to shareholder approval at the annual meeting of shareholders to be held on April 26, 1994), filed herewith. 10(9)(a) Amended and Restated Employment Protection Agreement between the Company and Mr. Martin F.C. Emmett, dated as of October 16, 1990, filed as Exhibit 10(11)(a) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference. 10(9)(b) Employment Protection Agreement between the Company and Mr. Charles J. Chapman, dated as of August 23, 1989, and First Amendment to Employment Protection Agreement between the Company and Mr. Charles J. Chapman, dated as of October 16, 1990, filed as Exhibit 10(11)(b) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference; 10(9)(c) Employment Protection Agreement between the Company and Mr. Alain Strasser, dated as of November 15, 1989, and First Amendment to Employment Protection Agreement between the Company and Mr. Alain Strasser, dated as of October 16, 1990, filed as Exhibit 10(11)(e) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference; 10(9)(d) Employment Protection Agreement between the Company and Mr. Raymond F. Wright, dated as of August 23, 1989, and First Amendment to Employment Protection Agreement between the Company and Mr. Raymond F. Wright, dated as of October 16, 1990, filed as Exhibit 10(11)(c) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference; 10(9)(e) Employment Protection Agreement between the Company and Ms. Helen G. Goodman, dated as of December 1, 1989, and First Amendment to Employment Protection Agreement between the Company and Ms. Helen G. Goodman, dated as of October 16, 1990, filed herewith; The Company has agreements similar to the agreements listed as Exhibits 10(9)(b), 10(9)(c), 10(9)(d) and 10(9)(e) with its other executive officers. 10(10) Letter Agreement between the Company and Mr. Martin F.C. Emmett, dated October 16, 1990, filed as Exhibit 10(12) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference. 10(11) Amended and Restated Stock Option Agreement between the Company and Mr. Martin F.C. Emmett, dated October 16, 1990, filed as Exhibit 10(13) to the Company's Report on Form 10-K for the year 1990, incorporated herein by reference. 10(12) Consulting Agreements between the Company and Mr. Brian Healey, dated July 1, 1989, filed as Exhibit 10(12) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(13) Executive Severance Program of the Company, filed as Exhibit 10(15) to the Company's Report on Form 10-K for the year 1989, incorporated herein by reference. 10(14) Annual Incentive Plan of the Company, filed as Exhibit 10(6) to the Company's Report on Form 10-K for the year 1984, incorporated herein by reference. 10(15) Summary of supplemental pension plan of Tambrands France S.A., filed as Exhibit 10(16) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(16) Summary of Revision to Non-Employee Director Cash Compensation, approved August 24, 1993, filed as Exhibit 10(1) to the Company's Report on Form 10-Q/A for the quarterly period ended September 30, 1993, incorporated herein by reference. 10(17) Amended and Restated Letter Agreement between the Company and Mr. Howard B. Wentz, Jr., dated August 24, 1993, filed as Exhibit 10(2) to the Company's Report on Form 10-Q/A for the quarterly period ended September 30, 1993, incorporated herein by reference. 10(18) Letter Agreement between the Company and Mr. James G. Mitchell, dated June 30, 1993, and amendment thereto, dated October 13, 1993, filed as Exhibit 10(5) to the Company's Report on Form 10-Q/A for the quarterly period ended September 30, 1993, incorporated herein by reference. 10(19) Letter Agreement between the Company and Mr. Constantin B. Ohanian, dated August 18, 1993, filed as Exhibit 10(6) to the Company's Report on Form 10-Q/A for the quarterly period ended September 30, 1993, incorporated herein by reference. 10(20) Severance Agreement between the Company and Mr. Martin F. C. Emmett, dated July 21, 1993, filed as Exhibit 10(4) to the Company's Report on Form 10-Q/A for the quarterly period ended September 30, 1993, incorporated herein by reference. 10(21) Retirement Agreement between the Company and Mr. Charles J. Chapman, dated as of February 28, 1994, filed herewith. 10(22)(a) Commercial Paper Dealer Agreement between the Company and Merrill Lynch Money Markets, Inc., dated November 18, 1992, filed as Exhibit 10(15)(a) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(22)(b) Letter Agreement between the Company and The First National Bank of Chicago, dated as of November 18, 1992, filed as Exhibit 10(15)(b) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 10(22)(c) Credit Agreement by and among the Company, the signatory banks thereto and The Bank of New York, as agent, dated as of October 16, 1992, filed as Exhibit 10(15)(c) to the Company's Report on Form 10-K for the year 1992, incorporated herein by reference. 12 Computation of Ratio of Earnings to Fixed Charges, filed herewith. 21 Subsidiaries of the Company, filed herewith. 23 Independent Auditors' Consent, filed herewith. 24 Powers of attorney, filed herewith. 99 Trust Agreement, dated as of November 1, 1991, between the Company and Manufacturers Hanover Trust Company, as trustee under the Tambrands Inc. Savings Plan, filed as Exhibit 28 to the Company's Report on Form 10-K for the year 1991, incorporated herein by reference. (b) Reports on Form 8-K The Company filed a Report under Item 5 of Form 8-K on December 16, 1993 in order to file the forms of Floating Rate Debt Security and Fixed Rate Debt Security to be used in connection with the Company's Medium- Term Note Program. TAMPAX, COMPAK, SATIN TOUCH and TAMPETS are trademarks of Tambrands Inc. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) 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. TAMBRANDS INC. Date: March 28, 1994 By /s/ HOWARD B. WENTZ, JR. ----------------------------- Howard B. Wentz, Jr. Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ HOWARD B. WENTZ, JR. Chairman and March 28, 1994 - ---------------------------- Director (Principal HOWARD B. WENTZ, JR. Executive Officer) /s/ RAYMOND F. WRIGHT Senior Vice President- March 28, 1994 - ---------------------------- Chief Financial RAYMOND F. WRIGHT Officer (Principal Financial Officer and Principal Accounting Officer) * Director March 28, 1994 - ---------------------------- LILYAN H. AFFINITO /s/ CHARLES J. CHAPMAN Executive Vice March 28, 1994 - ---------------------------- President and CHARLES J. CHAPMAN President, North America and Director * Director March 28, 1994 - ---------------------------- PAUL S. DOHERTY * Director March 28, 1994 - ---------------------------- FLOYD HALL * Director March 28, 1994 - ---------------------------- BRIAN HEALEY Signature Title Date --------- ----- ---- * Director March 28, 1994 - --------------------------- ROBERT P. KILEY * Director March 28, 1994 - --------------------------- JOHN LOUDON * Director March 28, 1994 - --------------------------- RUTH M. MANTON * Director March 28, 1994 - --------------------------- JOHN A. MEYERS * Director March 28, 1994 - --------------------------- H.L. TOWER * Director March 28, 1994 - --------------------------- ROBERT M. WILLIAMS * By /s/ HOWARD B. WENTZ, JR. --------------------------- Howard B. Wentz, Jr. Attorney-in-Fact INDEX TO FINANCIAL INFORMATION ------------------------------ Page Reference --------- Selected Financial Data................................. 25 Management's Discussion and Analysis of Results of Operations and Financial Condition........... 26 Financial Statements: Consolidated Statements of Earnings for the years ended December 31, 1993, 1992 and 1991................. 28 Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991................. 28 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991................. 29 Consolidated Balance Sheets as of December 31, 1993 and 1992....................... 30 Notes to Consolidated Financial Statements....................................... 31 Independent Auditors' Report on Consolidated Financial Statements................ 39 Financial Statement Schedules: V Property, Plant and Equipment.............. 40 VI Accumulated Depreciation of Property, Plant and Equipment.............. 43 VIII Reserves................................... 46 IX Short-Term Borrowings...................... 47 X Supplementary Income Statement Information................................ 50 Independent Auditors' Report on Financial Statement Schedules.................... 51 Supplementary Financial Information and Quarterly Data for the years ended December 31, 1993 and 1992................. 52 Per share amounts have been restated to reflect a two-for-one stock split effected in the form of a 100% stock dividend in December 1990. (a) Net of Restructuring and other charges which reduced Net earnings by $20,273, $23,477 and $65,692 in 1993, 1991 and 1989, respectively. MANAGEMENT'S DISCUSSION AND ANALYSIS Results of Operations 1993 VS. 1992 Consolidated Net sales for 1993 were $611.5 million, a decrease of 10.6% from 1992. The decrease is the result of lower unit sales in the USA and Europe, unfavorable foreign exchange rates in Europe and the elimination of non-core products. Volume shortfalls in 1993 were principally caused by a continuing trend by US retailers and European distributors to reduce consumer goods inventory levels. The decline was partially offset by favorable pricing adjustments associated with the European restaging in 1992. Gross profit as a percent of Net sales was 67% for 1993, up from 66.7% in 1992. This increase is attributable to elimination of lower-margin sales of divested products and worldwide manufacturing efficiencies, partially offset by the impact of lower sales volume. In 1993, the Company provided $30.0 million for restructuring of manufacturing and administrative operations and the cost of management changes including the adoption of a consolidated international management strategy. The anticipated annual savings of approximately $20.0 million resulting from work force reductions and worldwide manufacturing restructuring are expected to be fully realized by 1995. Operating income was $116.3 million in 1993, down $78.4 million from 1992. In addition to the restructuring charge of $30.0 million, the decline in Operating income is primarily due to lower Net sales. Marketing, selling and distribution expenses increased 4.4% over 1992. The Company raised its level of advertising and promotional spending to support the Tampax brand in the face of increased competition and to regain market share in the second half of 1993. The increase in brand support was partially offset by reductions in the other components of Marketing, selling and distribution as well as lower administrative spending in 1993. These reductions were the result of the continuing program to reduce overhead expenses. Interest, net and other improved by $5.2 million primarily due to net gains on foreign exchange contracts in the current year, somewhat mitigated by interest expense on increased borrowings. The effective tax rate for 1993, exclusive of the restructuring charge, was 36.8%, compared to 36.2% in 1992. OUTLOOK The Company believes that the recent trend by retailers and distributors to reduce inventories and the related adverse impact on shipments will continue in future periods. However, the rate of inventory reduction in future periods is expected to be significantly less than the rate of reduction experienced in 1993. The Company intends to continue in 1994 the increased advertising and promotional activities in the USA and Europe to provide support for the Tampax brand. 1992 VS. 1991 Consolidated Net sales for 1992 were $684.1 million, an increase of 4% over 1991. The increase was due primarily to pricing adjustments associated with the restaging programs in North America and Europe, partially offset by elimination of non-core sanitary pad and disposable diaper products and lower restaged volume in Europe, but aided somewhat by favorable foreign exchange rates in Europe. Gross profit as a percent of sales in 1992 improved by 3.4 percentage points over 1991, to 66.7%, reflecting the successful North American restaging implemented in the third quarter of 1991, the European restaging of 1992, elimination of non-core products and worldwide manufacturing efficiencies. Operating income rose 21% in 1992 compared to 1991 exclusive of the restructuring charge. Marketing, selling and distribution expenses in the USA decreased in 1992 compared to the prior year's unusually high levels incurred to support the 1991 restaging. This reduction was offset by promotional spending to support the European restaging program and heavy planned advertising and education expenditures designed to build the Tampax franchise worldwide. Operating margins continued to rise in 1992 as marketing and promotional spending normalized and the benefit of the worldwide restaging program was felt. Interest, net and other declined significantly in 1992 compared to 1991 due to reductions in cash and marketable securities balances combined with interest expense on increased Short-term borrowings as a result of the Company's share buyback program. The effective tax rate for 1992 was 36.2%, compared to 36.8% in 1991, exclusive of the restructuring charge. Financial Condition CASH FLOWS FROM OPERATING ACTIVITIES 1993 Cash flows from operating activities amounted to $128.7 million versus $95.8 million in 1992. The reduction in Net earnings was more than offset by the 1993 restructuring charge, the cumulative effect of accounting change, and an improvement in working capital. Over the past three years, Cash flows from operating activities totaled $331.9 million. These funds were used for the repurchase of Common Stock for treasury purposes, payment of dividends and capital expenditures. CAPITAL EXPENDITURES The 1993 capital spending programs relate to investments in equipment to improve product quality and productivity, modernize production facilities and reduce costs. Over the past three years, the Company has spent $145.4 million on capital improvements. Capital expenditures in 1994 are expected to be somewhat below 1993 levels. LIQUIDITY AND CAPITAL RESOURCES During 1993, the Company continued to utilize its strong debt rating and a favorable financial climate to take advantage of low US interest rates through short-term bank credit lines and a commercial paper program. Additionally, to provide financial flexibility, the Company established a $150 million Medium-Term Note facility and accessed the debt market in December 1993 by issuing $30 million of these notes. Cash flows from operations and the ability to borrow from a variety of sources will provide the Company with the liquidity to continue the investments necessary to meet the Company's long-term strategic goals. The Company also utilizes cash resources to enhance shareholder value through the payment of dividends and its stock repurchase program. In 1993, the Company paid record cash dividends of $60.1 million. This is the 42nd consecutive year of higher annual dividend payments. During the year, Tambrands spent $57.9 million in its Common Stock repurchase program. Since 1989, a total of 5,901,900 shares have been purchased. The Company will continue the share repurchase program as conditions warrant. CONSOLIDATED STATEMENTS OF EARNINGS Tambrands Inc. and subsidiaries CONSOLIDATED STATEMENTS OF RETAINED EARNINGS See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Tambrands Inc. and subsidiaries See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS Tambrands Inc. and subsidiaries See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Tambrands Inc. and subsidiaries (dollar amounts in thousands, except per share amounts) Accounting Policies The consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. Where alternatives exist, the choices selected are described below. CONSOLIDATION The 1993 consolidated financial statements include the accounts of Tambrands Inc. and all majority owned subsidiaries (the "Company"). Prior to 1993, businesses in China, Russia and Ukraine were accounted for under the cost method and carried as Investments in Affiliates. The financial results and positions of these businesses were consolidated in 1993. The effect of consolidation of these subsidiaries is not material to the financial statements as a whole; therefore, prior years have not been restated. FOREIGN CURRENCY TRANSLATION For subsidiaries not located in highly inflationary economies, gains or losses resulting from the translation of subsidiary companies' assets and liabilities denominated in foreign currencies are shown as a separate component of Shareholders' Equity. For subsidiaries operating in highly inflationary economies, working capital items are translated using current rates of exchange with adjustments included in Operating income. CASH EQUIVALENTS Highly liquid investments with a maturity of three months or less when purchased are considered to be cash equivalents. MARKETABLE SECURITIES Marketable securities, comprised of corporate obligations, are stated at cost, which approximates market. INVENTORIES Inventories are stated at the lower of cost or market. Cost is determined using the LIFO method for all domestic inventories. All other inventories are stated at FIFO. DEPRECIATION Depreciation is computed on the straight-line and accelerated methods over the useful lives of the assets. BRANDS, TRADEMARKS, PATENTS AND OTHER INTANGIBLE ASSETS Intangible assets are amortized on a straight-line basis over periods not exceeding 40 years. INCOME TAXES In 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," which requires a provision for deferred taxes for differences between the financial statement and tax bases of assets and liabilities. Prior to 1992, deferred income taxes were provided on timing differences between financial and income tax reporting methods. Provision has not been made for income taxes on foreign subsidiaries' unremitted earnings to the extent that such earnings have been reinvested in the business; any United States income taxes payable on the distribution of available earnings should generally be offset by credits for foreign taxes paid. RECLASSIFICATIONS Certain reclassifications have been made to prior years' financial statements to conform to the 1993 presentation. Balance Sheet Components The components of certain balance sheet accounts at December 31 are as follows: Statement of Earnings Information Benefit Plans The Company maintains several non-contributory pension plans covering domestic and foreign employees who meet certain minimum service and age requirements and provides supplemental non-qualified retirement benefits to non-employee directors, certain officers and key employees. Pensions are based upon earnings of covered employees during their periods of credited service. The Company's funding policy for its pensions is to make the annual contributions required by applicable regulations. The following table sets forth the funded status of the plans and the amounts recognized in the accompanying financial statements. At December 31, 1993 and 1992, the accumulated benefit obligation of the domestic plans exceeded plan assets by $10,251 and $4,400, respectively. The net cost of pensions included in the Statements of Earnings consists of: In 1993 and 1992, the discount rate used to determine the projected benefit obligation for the domestic plans was 7.5% and the rate of increase in future compensation was 6%. For the international plans, the discount rate used to determine the projected benefit obligation was 8% in 1993 and ranged from 8.5% to 9% in 1992, and the rate of increase in future compensation ranged from 5.5% to 6.5% and 5.5% to 7% in 1993 and 1992, respectively. Expected long-term rates of return on plan assets ranged from 8.5% to 9.25% in 1993 and 8.4% to 9% in 1992. Prior service costs arising from plan amendments are amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits under each plan. As of January 1, 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," recognizing a pre-tax charge to earnings of $16,000, amounting to $10,252 or $.27 per share after tax. In 1992, the Company recognized the full amount of its estimated accumulated postretirement benefit obligation in accordance with the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The pre-tax charge to 1992 earnings was $1,627 with a net earnings effect of $1,009 or $.03 per share. The after-tax amounts of these accounting changes have been reflected in the 1993 and 1992 Statements of Earnings as a cumulative effect of accounting change. The incremental annual cost of accounting for postretirement and postemployment benefits under the new accounting methods is not material. The actuarial assumptions used to measure the cost of postretirement benefits are consistent with those used to measure the cost of the pension plans. The Company also sponsors a defined contribution 401(k) savings plan available to domestic employees who meet certain minimum age and service requirements. The plan, which is funded principally with the Company's Common Stock, includes provision for a discretionary contribution by the Company of up to 2% of each employee's covered earnings based on Company performance. Income Taxes Provision for income taxes for the years ended December 31 has been made as follows: Changes in deferred taxes are due primarily to the restructuring provisions established in 1993, 1991 and 1989 and "safe harbor" leases entered into in 1981 and 1982. The difference between the Company's effective tax rate and the statutory federal rate is principally due to state income taxes and the restructuring and other charges. During 1993 and 1992, Shareholders' Equity was credited for $1,330 and $2,336, respectively, relating to compensation expense for tax purposes in excess of the amounts recognized for financial reporting purposes. In 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." The adoption of the statement did not have a material effect on Net earnings. Deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The components of the net deferred tax asset (liability) for the years ended December 31 are as follows: Restructuring and Other Charges In 1991, the Company announced a program to restructure its worldwide manufacturing operations to improve efficiency and reduce costs and its intention to exit the sanitary pad and diaper businesses in Brazil. As a result, the Company recorded a $30,348 ($23,477 after tax) restructuring charge. In 1993, the Company announced further restructuring as its previous investments in technology will enable it to operate with reduced manufacturing and administrative overhead and number of employees. The Company provided $30,042, or $20,273 after tax, for this restructuring and the cost of management changes including the adoption of a consolidated international management strategy. The provision includes the costs associated with salary and benefit continuation due to work force reductions and the revaluation and consolidation of certain manufacturing and office facilities. Commitments and Contingencies The Company's lease of its headquarters in White Plains, New York and European headquarters in the United Kingdom are non-cancelable operating leases. Certain computers and related equipment are held under capital leases. Future minimum lease payments under operating leases with terms in excess of one year amount to $4,593 in 1994, $4,088 in 1995, $3,560 in 1996, $3,221 in 1997 and $3,021 in 1998. Rent expense in 1993, 1992 and 1991 amounted to $5,027, $4,031 and $4,204, respectively. Future minimum lease payments under capital leases with terms in excess of one year amount to approximately $550 in both 1994 and 1995; no capital leases extend beyond 1995. The Company has been named in product liability litigation and claims arising from the alleged association of tampons with Toxic Shock Syndrome. The cases seek compensatory and punitive damages in various amounts. The Company and certain of its present and former officers have been named as defendants in certain shareholder lawsuits now consolidated into one action. The consolidated lawsuit purports to be a federal securities fraud class action on behalf of all purchasers of the Company's Common Stock during the period December 14, 1992 through June 2, 1993. The complaint alleges that the Company's disclosures during the alleged class period contained material misstatements and omissions concerning its anticipated future earnings. The complaint seeks an unspecified amount of damages on behalf of the purported class. The Company is a nominal defendant in three purported shareholder derivative lawsuits that have been consolidated into a single action. Named in the consolidated complaint as individual defendants are the Company's directors (and certain of its former directors) and two of its former officers. The complaint alleges that, among other things, the officer-defendants exposed the Company to liability in the purported shareholder class action described in the preceding paragraph. The director-defendants are alleged to have acquiesced in the alleged violations. The complaint seeks to recover on behalf of the Company an unspecified amount of damages from the individual defendants. No relief is sought against the Company. While it is not feasible to predict the outcome of these legal proceedings and claims with certainty, management is of the belief that any ultimate liabilities for damages either are covered by insurance or should not have a material adverse effect on the Company's financial position. Borrowings The Company's Short-term borrowings consist of unsecured commercial paper and notes payable bearing interest at prevailing market rates and supported by bank lines of credit amounting to $161,000 at December 31, 1993 and 1992. Commercial paper borrowings at December 31, 1993 and 1992 were $48,425 and $79,135 at average annual interest rates of 3.4% and 4%, respectively, with maturities in the first quarter of the subsequent year. Notes payable at December 31, 1993 and 1992 totaled $15,943 and $1,025 at average annual rates of 4.3% and 7%, respectively. Commitment fees to secure the lines of credit are not material. In 1993, the Company established a $150,000 Medium-Term Note facility and issued $30,000 of these unsecured notes at interest rates ranging from 5.525% to 5.58% maturing in January 1999. The terms of the borrowing facilities include various covenants which provide, among other things, for limitations on liens and the maintenance of a minimum debt service ratio. The Company was in compliance with such covenants at December 31, 1993. Financial Instruments The Company minimizes its exposure to foreign currency fluctuation through the use of forward exchange contracts and options. Realized and unrealized gains and losses on hedging contracts designated as hedges of foreign currency transactions are deferred and recognized in the Statement of Earnings in the same period as the underlying transactions. All other realized and unrealized gains and losses are recognized in the current period. At December 31, 1993 and 1992, the Company had forward exchange contracts outstanding with face values of $50,627 and $24,038, respectively, the carrying value of which approximated market. The contracts mature in less than one year. The estimated fair value of Medium-Term Notes payable at December 31, 1993 approximated their carrying value of $30,000. Shareholders' Equity COMMON STOCK In 1992, the Company increased the number of authorized shares of Common Stock from 150 million to 300 million. Changes in outstanding shares for the years ended December 31 are as follows: The Company has stock option plans which provide for the granting of options to directors, officers and key employees to purchase shares of its Common Stock within ten years at prices equal to the fair market value on the date of grant. Activity for the years 1993, 1992 and 1991 is as follows: At December 31, 1993 and 1992, respectively, there were 1,137,470 and 616,003 shares exercisable at average prices of $51.18 and $42.45 and there were 2,741,522 and 337,887 shares available for granting options. UNAMORTIZED VALUE OF RESTRICTED STOCK AND PENSION COSTS Changes in the unamortized value of restricted stock represent charges for the market value of grants made during the year offset by periodic amortization. Such net charges amounted to ($577), ($442) and $827 for the years ended December 31, 1993, 1992 and 1991, respectively. In 1993, an excess pension liability adjustment amounting to $1,263, net of tax benefits, was charged to Shareholders' Equity. CUMULATIVE FOREIGN CURRENCY TRANSLATION ADJUSTMENT Amounts charged to Shareholders' Equity were $10,073, $19,804 and $1,014 for the years ended December 31, 1993, 1992 and 1991, respectively. Segment and Geographic Information The Company operates in one industry segment, personal care products. The Company markets these products around the world. Sales are made and credit is granted to drug, grocery, variety and discount stores and other comparable outlets as well as to wholesalers and distributors in those trades. A small number of significant customers are financed through highly leveraged capital structures, making them particularly sensitive to market interest rate changes and other economic variables. Information about the Company's operations in different geographic areas follows: Certain overhead costs are allocated to the geographic areas based on the anticipated benefit to be derived by the area. Net current assets of consolidated subsidiaries operating outside of the United States and the total net assets of such subsidiaries were as follows: INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Tambrands Inc.: We have audited the accompanying consolidated balance sheets of Tambrands Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Tambrands Inc. and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in the notes to the consolidated financial statements, the Company changed its method for accounting for postemployment benefits in 1993 and for postretirement benefits in 1992. KPMG PEAT MARWICK Stamford, Connecticut January 25, 1994 Schedule V - Page 1 ------------------- TAMBRANDS INC. AND SUBSIDIARIES Property, Plant and Equipment Year Ended December 31, 1993 (dollars in thousands) (a) Includes assets of previously unconsolidated subsidiaries of $9,780. Schedule V - Page 2 ------------------- TAMBRANDS INC. AND SUBSIDIARIES Property, Plant and Equipment Year Ended December 31, 1992 (dollars in thousands) (a) Includes assets of subsidiary acquired of $1,259. Schedule V - Page 3 ------------------- TAMBRANDS INC. AND SUBSIDIARIES Property, Plant and Equipment Year Ended December 31, 1991 (dollars in thousands) (a) Includes capital leases of $525. Schedule VI - Page 1 -------------------- TAMBRANDS INC. AND SUBSIDIARIES Accumulated Depreciation of Property, Plant and Equipment Year Ended December 31, 1993 (dollars in thousands) (a) Includes accumulated and current year depreciation of previously unconsolidated subsidiaries amounting to $2,916. Schedule VI - Page 2 -------------------- TAMBRANDS INC. AND SUBSIDIARIES Accumulated Depreciation of Property, Plant and Equipment Year Ended December 31, 1992 (dollars in thousands) Schedule VI - Page 3 -------------------- TAMBRANDS INC. AND SUBSIDIARIES Accumulated Depreciation of Property, Plant and Equipment Year Ended December 31, 1991 (dollars in thousands) Schedule VIII ------------- TAMBRANDS INC. AND SUBSIDIARIES Reserves Years Ended December 31, 1993, 1992 and 1991 (dollars in thousands) Schedule IX - Page 1 -------------------- TAMBRANDS INC. AND SUBSIDIARIES Short-Term Borrowings December 31, 1993 (dollars in thousands) Schedule IX - Page 2 -------------------- TAMBRANDS INC. AND SUBSIDIARIES Short-Term Borrowings December 31, 1992 (dollars in thousands) (a) Commercial paper was outstanding only in the month of December. Average outstanding for the month was $50,287. Schedule IX - Page 3 -------------------- TAMBRANDS INC. AND SUBSIDIARIES Short-Term Borrowings December 31, 1991 (dollars in thousands) (a) Loans outstanding in hyperinflationary countries. (b) Nominal rate excluding devaluation. Schedule X ---------- TAMBRANDS INC. AND SUBSIDIARIES Supplementary Income Statement Information Years Ended December 31, 1993, 1992 and 1991 (dollars in thousands) Independent Auditors' Report ---------------------------- The Board of Directors and Shareholders Tambrands Inc.: Under date of January 25, 1994, we reported on the consolidated balance sheets of Tambrands Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the annual report on Form 10-K for the year 1993. Our report refers to a change in accounting for postemployment benefits in 1993 and postretirement benefits in 1992. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Item 14(a)2 of the annual report on Form 10-K for the year 1993. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Stamford, Connecticut January 25, 1994 Supplementary Financial Information and Quarterly Data ----------------------------------- QUARTERLY DATA (unaudited) (a) Results have been adversely affected by the restructuring and other charges as described in the notes to the consolidated financial statements. Index to Exhibits ----------------- The Company will furnish a copy of any exhibit to a shareholder requesting such exhibit in writing upon payment by the shareholder of a fee representing the Company's reasonable expenses in furnishing such exhibit.

106752_1993.txt

106752_1993

1993

106752

Item 1. Business. THE COMPANY EnviroSource, Inc. (the "Company") supplies industrial customers with long-term, specialized services, primarily the recycling, handling, stabilization or landfilling of environmentally sensitive wastes or by-products. The Company's principal business units are International Mill Service, Inc. ("IMS"), a leader in metals reclamation and slag recycling for the steel industry, IMSAMET, an aluminum reclamation and recycling company, Envirosafe Services, Inc. ("Envirosafe"), a hazardous waste treatment and disposal company, and Conversion Systems, Inc. ("CSI"), a waste stabilization company. IMS and IMSAMET constitute the Industrial Environmental Services segment, and Envirosafe and CSI constitute the Treatment and Disposal Services segment. With the exception of its IMSAMET joint ventures, the Company conducts its operations exclusively through its subsidiaries. References herein to the Company include its subsidiaries as well as its Ohio predecessor, NEOAX, Inc., except where the context requires otherwise. "Note" references herein are to Notes to Consolidated Financial Statements appearing elsewhere in this Report. DEVELOPMENT OF THE COMPANY The Company's predecessor was originally incorporated in Ohio in 1915 as White Motor Corporation. Its name was changed to Northeast Ohio Axle, Inc. when it emerged from reorganization proceedings in 1983 and was changed again in May 1986 to NEOAX, Inc. ("NEOAX"). In June 1987, NEOAX reincorporated in Delaware. On November 14, 1989, the Company changed its name to EnviroSource, Inc. EnviroSource's present business units originally represented a portion of the operations of IU International Corporation ("IU"). Early in 1988, the Company acquired IU with the goal of establishing a substantial operating company centered primarily on IMS's stable and growing steel industry business relationships and prospects. Between March 1988 and the end of 1991, the Company disposed of all the businesses it had owned prior to the IU acquisition and virtually all of IU's operations and assets other than IMS, IMSAMET, Envirosafe and CSI, completing its transformation into an environmental services company. See Notes H and M for additional information regarding the development of the Company. The 1993 recapitalization described below completed the refinancing of the Company's remaining IU acquisition indebtedness and, together with the 1993 restructuring described below, will facilitate the achievement of significant growth in the Company's businesses. THE RECAPITALIZATION During 1993 the Company completed a comprehensive recapitalization (the "Recapitalization") designed to increase the Company's liquidity and capital resources, improve operating and financial flexibility, reduce interest expense and preferred dividend requirements, and enhance the Company's ability to pursue the growth opportunities in its businesses. On May 13, 1993, the Company sold 6,433,333 shares of Common Stock and 230,000 shares of Class J Convertible Preferred Stock, par value $.25 per share (the "Class J Preferred"), to an affiliate of Freeman Spogli & Co. ("FS&Co.") and another investor (collectively, the "Investors") as the first step in the Recapitalization. On August 5, 1993, the Class J Preferred was automatically converted into 6,900,000 shares of Common Stock upon the effectiveness of an amendment to the Company's Certificate of Incorporation increasing to 60,000,000 the number of authorized shares of Common Stock. Also on May 13, 1993, the Investors purchased from The Dyson- Kissner-Moran Corporation ("DKM") and WM Financial Corporation ("WM Financial") the following: (i) 5,636,568 shares of Common Stock, (ii) all 107,000 outstanding shares of Class H Preferred Stock, par value $.25 per share, all of which were immediately exchanged for 3,066,667 newly issued shares of Common Stock, (iii) warrants to purchase 1,695,652 shares of Common Stock at exercise prices of $3.50 and $4.00 per share and (iv) an option (subsequently exercised) to purchase 1,000 shares of Common Stock from DKM for $3.75 per share. FS&Co. sold a portion of the aforementioned securities to The IBM Retirement Plan Trust Fund (the "IBM Trust"). The sale of stock and warrants to FS&Co. is hereinafter referred to as the "FSC Transaction." On July 1, 1993, the Company sold $220 million principal amount of 9-3/4% Senior Notes Due 2003 (the "Senior Notes"). A significant portion of the proceeds from the sale of the Senior Notes was used to retire $150 million principal amount of the Company's 14% Extendible Reset Senior Subordinated Notes Due 1998 (the "Subordinated Notes"). The Subordinated Notes were called for redemption on July 1, 1993 and were redeemed on August 2, 1993. See Note B for additional information concerning the Recapitalization. THE RESTRUCTURING During the fourth quarter of 1993 the Company took a number of steps to reduce costs and terminate unprofitable operations. These steps included (i) terminating certain recycling units, (ii) discontinuing efforts to obtain a hazardous waste landfill permit in Pennsylvania and (iii) reorganizing the Envirosafe and CSI businesses into a new Treatment and Disposal Services business unit. The terminated recycling units include two facilities for the thermal treatment of electric arc steel furnace flue dust to recover zinc, a pilot plant for the sale of stabilized electric utility scrubber sludge for use in manufacturing concrete masonry blocks and two smaller sites. None of the terminated units had achieved economic feasibility. In addition, CSI is actively marketing its proprietary process for stabilizing electric arc steel furnace flue dust, which the Company believes is a better environmental solution for such waste. In view of the continued weakness in demand in the hazardous waste disposal industry, the Company decided to discontinue its efforts to obtain a hazardous waste landfill permit in Pennsylvania and to sell the proposed landfill site. Because the Company concluded that waste stabilization and disposal activities will be more closely integrated in the future, the Company also decided to combine its Envirosafe and CSI businesses into a unified Treatment and Disposal Services business unit. This reorganized business unit now also constitutes a new business segment for the Company and replaces the former Hazardous Waste Disposal Services segment. See "Business Segments" below. The combination of Envirosafe and CSI reduced staff headcount and eliminated an office. As a result of the activities described above, the Company recorded a $22 million restructuring charge, which after a partial offset relating to a reduction of other liabilities reduced 1993 operating income by $18.5 million. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note C for additional information regarding the restructuring. TAX LOSS CARRYFORWARDS The Company has substantial federal income tax net operating loss carryforwards. The FSC Transaction produced an "ownership change" (as defined in the Internal Revenue Code) that limits the future use of these carryforwards. However, the Company has estimated that at least $7 million of the tax loss carryforwards will still be available to offset regular taxable income through the year 2006. The final amount of this limitation will be affected by the resolution of various tax issues and the nature and timing of certain amounts of future income. See Note J. BUSINESS SEGMENTS Industrial Environmental Services IMS. IMS has served the steel industry for more than 55 years. The Company believes IMS increases its customers' productivity by providing cost-effective and reliable on-site reclamation of steel and iron and a variety of other specialized services that are essential to the efficient functioning of steel mills. America's steel mills operate in a highly competitive environment. Services that help to reduce their total process costs are therefore of significant value. IMS provides recycling and metal recovery operations under long-term contracts at over 40 steel mill sites in North America, including integrated mills, mini-mills and specialty mills. Using specially designed equipment, IMS provides a total recycling solution by processing slag (a by-product of steel production), recovering valuable metallics and selling the residual aggregate for road base and other uses. These services are economically and environmentally attractive. Moreover, the effective removal of slag on a continuous basis is critical to a steel mill's ability to remain in operation. IMS also processes blast furnace scrap through an IMS- developed iron crushing process, making the scrap metal more suitable for recycling and improving processing speed, thereby reducing customers' raw material costs. This process is currently in place at two locations. In recent years, IMS has successfully pursued a strategy of building on its leadership position by offering an expanded range of services that enhance mill productivity and provide IMS with growth opportunities. These services include: - Specialized Materials Handling - IMS has enhanced the slab hauling process by using rubber-tired carriers that straddle steel slabs to move them more efficiently throughout the mill. This service, currently in place at two integrated steel mills, is significantly more cost- effective than the traditional rail and crane systems. - Surface Conditioning - IMS has introduced a proprietary specialized steel slab surface conditioning process (called scarfing) that helps its customers increase product yields and improve product quality, while gaining measurable cost savings. This service is currently provided at six steel mills. Over the past several years, IMS has invested in a number of significant new capital projects at customer facilities. Such projects completed or to be completed since late 1991 generated incremental revenues of $10 million in 1992 and an additional $20 million in 1993. IMS has a diversified customer base, with approximately 60% of its revenues coming from integrated steel producers and 40% from mini-mills and specialty mills. IMS's largest site is at USX's Gary Works, in Gary, Indiana, the largest integrated steel mill in the U.S. USX accounted for 17%, 13%, and 11% of the Company's consolidated revenues in 1993, 1992, and 1991, respectively. Long- term contracts awarded by USX to IMS in 1991 account for a substantial portion of the incremental revenues described in the preceding paragraph. Such contracts expire between 1997 and 2001. Over the next several years, the maintenance of USX as a customer will be material to the Company's consolidated revenues and operating income. Substantially all of IMS's services are provided on-site at the steel mill, using IMS employees and equipment. IMS's services are integrated with operations of the customer, providing for a strong working partnership. If necessary, most equipment can be relocated, but this has not often been required as contracts are generally long-term and IMS has a history of high renewal rates. Competition in IMS's markets is based primarily on quality of service, reliability, technology and price. In its core steel reclamation business, IMS services customers responsible for approximately one-third of total domestic steel production. IMS has one major competitor, the Heckett Division of Harsco Corporation, which the Company estimates has approximately the same domestic market share, as well as numerous smaller competitors. The Company believes that IMS's leading market position is based on its reliability, responsiveness to customer needs, capital resources and breadth of expertise. IMSAMET. IMSAMET meets the aluminum industry's needs for outsourcing, recycling and waste management in a number of ways. At its Idaho facility, IMSAMET processes a minimum of 80 million pounds of used aluminum beverage cans ("UBCs") and aluminum scrap per year pursuant to a long-term contract with Kaiser Aluminum and Chemical Corporation ("Kaiser") through 1996. In 1993, this modern and efficient facility processed over 170 million pounds of material, including approximately 2.8 billion UBCs. Due to the high cost of primary aluminum production in the U.S., recycled aluminum is frequently an attractive alternative for manufacturers such as Kaiser. Both at its Idaho facility and its 70% owned partnership in Arizona, IMSAMET reclaims aluminum from dross, a by-product of the aluminum production process. The dross is loaded into rotary furnaces where gas heat is applied along with a flux mixture (salt and potash). After the dross is melted, the molten metal is cast into ingots and then delivered to customers. In the fourth quarter of 1993 and in early 1994, IMSAMET purchased certain assets of two western U.S. dross processors and increased its dross customer base. IMSAMET has recently begun construction of a new aluminum dross processing facility in Wendover, Utah, adjacent to the SALTS facility (described below), which is scheduled to commence operations in the fall of 1994. A majority of the equipment recently acquired will be utilized at the new Utah dross processing facility. Finally, IMSAMET has a 50% interest in a Utah partnership, Solar Aluminum Technology Services ("SALTS"), with Reilly Industries, Inc. ("Reilly") to recycle saltcake into marketable aluminum metal concentrate, aluminum oxide and salt brine, using a proprietary wet milling system. Saltcake is a by-product generated in the recovery of aluminum from dross. Improper disposal of saltcake poses risks of groundwater contamination, and the cost of disposal of saltcake in properly designed landfills can be considerable. SALTS offers a significant benefit to the aluminum industry by converting the environmental problem of saltcake disposal into a recycling opportunity. The SALTS facility commenced operations in March 1992. UBC recycling is performed mostly by the aluminum producers themselves, with IMSAMET and one other independent UBC recycler accounting for a substantial portion of the balance. There are approximately seven major aluminum dross processors other than IMSAMET in the U.S., as well as several smaller competitors. IMSAMET believes that its SALTS joint venture is the only enterprise successfully recycling saltcake on a commercial scale in North America. Treatment and Disposal Services Envirosafe. Envirosafe has been dedicated to the safe, economical treatment and disposal of industrial and hazardous wastes since 1980. It owns major commercial hazardous waste landfills in Ohio and Idaho -- two of the 19 such landfills that are currently active in the U.S. Envirosafe's customers include some of the country's largest chemical, automotive and steel companies and utilities, as well as numerous government agencies. Envirosafe has approximately 4.2 million cubic yards of permitted capacity. In 1992 Envirosafe received final approval to expand its Ohio facility and in 1993 completed construction of the first phase of a new 2.3 million cubic yard disposal cell. This state-of-the-art unit commenced accepting waste in July 1993. The next phase of construction of this cell is scheduled for completion in late 1994. In late 1993, Envirosafe received final approval to expand an active disposal cell at its Idaho facility and completed construction of the second phase of such cell. Envirosafe's Idaho and Ohio permits extend through 1998 and 1996, respectively. Envirosafe's hazardous waste landfill business is characterized by high barriers to entry resulting from increasingly stringent environmental legislation and the lengthy and uncertain permitting process for new facilities. Envirosafe has a limited number of competitors in the off-site hazardous waste landfill business, only two of which operate more than two landfills. In general, the markets for Envirosafe's services are regional. As a result, each of Envirosafe's landfills competes mainly with four other landfills in its area. Envirosafe plans to complete a number of capital projects during 1994 in order to maintain and enhance its competitive position. These projects include new debris handling facilities and expanded stabilization capacity at both the Ohio and Idaho landfills. The debris handling facilities will enable Envirosafe to respond to requirements for the processing of contaminated debris recently promulgated under the Resource Conservation and Recovery Act ("RCRA"), as amended. In addition, a new rail off- loading facility was opened in Idaho in May 1993. During 1993, Envirosafe entered into a new service contract to operate and maintain a captive landfill for a domestic steel mill. Envirosafe is exploring additional opportunities for providing captive landfill services. Envirosafe and its competitors and customers are subject to a complex, evolving array of federal, state and local environmental laws and regulations, which not only can affect the demand for Envirosafe's services, but could also require Envirosafe to incur significant costs for such matters as facility upgrading, remediation or other corrective action, facility closure and post- closure maintenance and monitoring. It is possible that the future imposition of such requirements could have a material adverse effect on Envirosafe's results of operations or financial condition, but the Company believes that the Consolidated Financial Statements appropriately reflect all presently known compliance costs in accordance with generally accepted accounting principles. Under normal circumstances, Envirosafe would expect to be able to absorb increased operating compliance costs by increasing prices charged to customers. Competition in this industry is based on service, site and process integrity and the all-in cost of landfill disposal, which includes transportation costs and taxes. Expanded use of rail services and planned additions to stabilization services will further improve Envirosafe's competitive position. CSI. CSI provides electric utilities with turn-key design, engineering and installation of systems for the stabilization of effluent and ash residues produced at coal-fired power plants. These systems convert the sludge resulting from wet scrubber removal of sulfur dioxide from power plant emissions into a concrete-like material suitable for environmentally responsible landfilling. Once a facility is completed, the customer has the option to operate the facility itself or have CSI provide ongoing management. Since 1991, CSI has been awarded three stabilization contracts and is actively pursuing bidding opportunities relating to additional sites expected to install wet scrubbers within the next several years, either as retrofits or in response to the "Acid Rain" provisions of the Clean Air Act Amendments of 1990. Although it is not yet clear how many power plants installing wet scrubbers will elect or be required to include stabilization units, the Company believes that its technology will continue to provide the utility industry with a cost-effective and environmentally desirable waste management solution. CSI also stabilizes electric arc furnace flue dust - a hazardous waste under RCRA generated by steel mills - through the use of a proprietary technology that renders the flue dust suitable for landfilling in non-hazardous landfills and for potential reuse. CSI is the sole licensee of this technology under a license that expires in 2006. CSI currently operates a flue dust stabilization facility on-site at the largest domestic mini-mill. CSI is actively marketing its process to other U.S. mini-mills. During 1993, CSI applied to the U.S. Environmental Protection Agency ("USEPA") for a generic delisting of its stabilized flue dust product, which, if granted, would enable CSI to handle flue dust treated through its proprietary process as a non-hazardous waste. USEPA has published proposed rules granting such delisting and CSI expects that final rules will be forthcoming during 1994. The generic delisting status for the process will save CSI and its customers the time and expense involved in petitioning USEPA on a facility by facility basis for delisting status. USEPA, as well as the Illinois Department of Environmental Regulation, previously has granted site specific delistings for this process. The Company believes that this technology provides an environmentally safer and more cost-effective solution than the off-site thermal process currently employed by most of the mini-mill industry. The market for wet scrubber stabilization units has been dormant until recently and it is difficult to determine the number and nature of CSI's viable competitors. However, CSI expects to encounter increased competition through the decade from wet scrubber manufacturers as well as from wet scrubber technologies and processes that do not, or purport not to, require sludge stabilization units. With the termination of IMS's process for the thermal treatment of flue dust, CSI's principal competition in electric arc furnace flue dust stabilization is a single off-site thermal metal recovery processor, which has accounted for more than 80% of the market nationwide. Competition in these businesses is based primarily on price, quality of service, technical expertise and the environmental integrity of the process. SEGMENT DATA See Note I for information concerning revenues and operating income by segment for the years ended December 31, 1993, 1992 and 1991 and the percentage of total revenues contributed by each class of service of the Company's continuing operations for each such year. EMPLOYEES At March 1, 1994, the Company employed approximately 1,900 persons. A majority of the hourly employees in the Industrial Environmental Services segment are covered by site specific collective bargaining agreements with various unions, including the International Union of Operating Engineers, the United Steelworkers and the International Brotherhood of Teamsters. Several of these contracts will be renegotiated in 1994. All other contracts will be renegotiated in 1995 or thereafter. Approximately 8% of the Treatment and Disposal Services segment employees are also unionized. The Company believes it has a good working relationship with its employees. Item 2. Item 2. Properties. INDUSTRIAL ENVIRONMENTAL SERVICES IMS has operations providing metal recovery and other services at steel mills throughout the continental United States and in Canada. Equipment located at the sites operated by IMS and its subsidiaries includes prefabricated storage, shop and office structures, pot carriers, slab haulers, loaders, railcars, cranes, trucks, metal recovery plants and crushers and other specialized mobile and stationary equipment used in metal-recovery operations and industrial service work, most of which is owned. IMSAMET owns its UBC and dross recycling plant in Idaho and leases land for a new dross processing facility to be constructed in Utah. Through a partnership, IMSAMET leases land for its plant in Arizona that is used to recover metal from aluminum dross. The business units in this segment lease office space in Arizona, Missouri, Pennsylvania and Utah. Management believes that the physical facilities for the Company's Industrial Environmental Services segment are adequate for its operations and provide sufficient capacity to meet their anticipated requirements. The metal recovery and slag processing installations are generally located at specific customer facilities and are adequate to handle current levels of customer operations and anticipated future needs for current customers. TREATMENT AND DISPOSAL SERVICES Envirosafe owns substantially all of the land, buildings and equipment used in its disposal operations, including the following: active landfills in Oregon, Ohio and near Grand View, Idaho; a clay mine in Narvon, Pennsylvania; and additional inactive sites or parcels in Idaho, New Jersey and Pennsylvania that are not planned for use as hazardous waste landfills. Envirosafe leases office space in Pennsylvania, Ohio and Idaho. Assuming the timely completion of subsequent phases under existing permit authority, Envirosafe expects to maintain ample hazardous waste disposal capacity through at least the balance of the decade. CSI owns the building and equipment at one stabilization facility in Illinois and one in Pennsylvania and leases land for both facilities. CSI also leases office space in Pennsylvania. Management believes that the physical facilities for CSI are adequate for its operations and provide sufficient capacity to meet its anticipated requirements. OTHER The Company's corporate headquarters are located in Stamford, Connecticut in leased premises. Item 3. Item 3. Legal Proceedings. On March 11, 1993, the City of Oregon, Ohio requested that the Director of the Ohio Environmental Protection Agency ("OEPA") modify or revoke Envirosafe's Ohio landfill permit, alleging that if the Ohio Hazardous Waste Facility Board ("HWFB") had been aware of certain scientific and technical data developed by Envirosafe, HWFB would not have approved the issuance of the permit in May 1991. On April 12, 1993, the OEPA Director determined not to modify or revoke the permit, concluding that the data in question presented no new or meaningful information in light of other data already in the record and the final design of the disposal cell authorized by the permit. On May 12, 1993, the City of Oregon filed a notice of appeal before the Ohio State Environmental Board of Review seeking review of the OEPA Director's April 12, 1993 decision. Envirosafe is contesting this appeal vigorously. In light of the factual findings by the OEPA Director, management does not believe that the outcome of this matter will have a material adverse effect on the Company's financial condition or results of operations. The Company is a party to litigation and proceedings arising in the normal course of its present or former businesses, and in several instances the Company has been named as a potentially responsible party regarding properties that could be subject to remedial action under RCRA or the Comprehensive Environmental Response and Liability Act of 1980, as amended. As to such matters, the Company is not subject to any administrative or judicial order requiring material expenditures, and the Company has determined that it is not likely to be subject to sanctions or held responsible for material remediation expenditures. In the opinion of management, the outcome of the matters described in this paragraph will not have a material adverse effect on the Company's financial condition or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. * * * EXECUTIVE OFFICERS OF THE COMPANY The Company's executive officers are as follows: Name Age Position Ronald P. Spogli 46 Chairman of the Board; Director Louis A. Guzzetti, Jr. 55 President and Chief Executive Officer; Director George E. Fuehrer 45 Senior Vice President, Planning Aarne Anderson 53 Vice President, Taxes Jerrold I. Dolinger 47 Vice President, Corporate Development James C. Hull 56 Vice President and Chief Financial Officer Gene A. Iannazzo 47 Vice President, Corporate Marketing George T. Milano 45 Vice President and Controller Officers are elected annually and hold office until their successors are elected and qualified. Ronald P. Spogli became a director and Chairman of the Board of the Company in May 1993. Mr. Spogli is one of the FS&Co. (a private investment firm) designees appointed to the Board of Directors on May 13, 1993. He is a founding partner of FS&Co. Mr. Spogli is also a director of Calmar Inc., Mac Frugal's Bargains Close-Outs Inc., Orchard Supply Hardware Stores Corporation, Buttrey Food and Drug Stores Company and Purity Supreme, Inc. and a member of the Board of Representatives of Brylane, L.P. Louis A. Guzzetti, Jr. has been a director and President and Chief Executive Officer of the Company since October 1986. From June 1983 until April 1986, Mr. Guzzetti was employed by United Brands Company ("United Brands"), a diversified international company, serving as its Executive Vice President and Chief Administrative Officer from June 1983 until August 1985 and as President and Chief Executive Officer of its United Fruit Company subsidiary from October 1984 until April 1986. He was also a director of United Brands from August 1984 until June 1986. George E. Fuehrer has been employed by the Company since 1982 and has served as its Senior Vice President, Planning since May 1989. From June 1988 until May 1989 he served as Senior Vice President - Finance of the Company. He was its Treasurer from November 1984 until May 1989. Mr. Fuehrer also served as Vice President - Finance from February 1984 until June 1988. Aarne Anderson has been employed by the Company since May 1980, except for the period from August 1983 through April 1984 during which he served as a consultant to the Disposition Assets Trustee in the Company's reorganization under Chapter 11 of the Bankruptcy Code. Mr. Anderson was elected Vice President, Taxes in August 1985. Jerrold I. Dolinger joined the Company as a Vice President in May 1988 and has served as Vice President, Corporate Development since August 1988. James C. Hull has been the Company's Vice President and Chief Financial Officer since May 1989, when he joined the Company. From 1975 until May 1989, Mr. Hull was employed by General Host Corporation, where he held the position of Vice President and Controller. Gene A. Iannazzo was appointed Vice President, Corporate Marketing in December 1992. Mr. Iannazzo also served as Vice President, Technology and Market Development from October 1989 until June 1990. At all other times since 1972 he has been an employee of IMS, serving in a variety of marketing and business development assignments in North and South America. Mr. Iannazzo first became an officer of IMS in 1985 and was most recently its Vice President, Business Development from July 1990 until November 1992. George T. Milano was elected Vice President in June 1988 and has served as the Company's Controller since May 1987. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The Company's Common Stock trades on The Nasdaq Stock Market under the symbol "ENSO" and on the Pacific Stock Exchange under the symbol "ES". The following table sets forth the high and low sales prices for the Common Stock for each of the calendar quarters of 1993 and 1992, based upon prices supplied by The National Association of Securities Dealers ("NASD") Automated Quotation System ("Nasdaq"). 1993 1992 High Low High Low First Quarter $5.125 $3.250 $3.000 $2.000 Second Quarter 4.625 3.500 4.125 2.250 Third Quarter 4.625 3.000 4.000 2.875 Fourth Quarter 3.500 2.500 5.375 3.500 The Company is not currently in technical compliance with one of the requirements for continued designation of its Common Stock as a Nasdaq National Market System security. The NASD indicated to the Company in March 1992 that it did not intend to commence formal proceedings to remove the Common Stock from the National Market System. It is possible that in the future the NASD could seek to do so, but the NASD has a procedure for seeking exemptions from its requirements, which the Company would seek to utilize if necessary. If the Common Stock were removed from the National Market System, it would continue to be eligible for inclusion in the regular Nasdaq inter-dealer quotation system. The Company has not paid a cash dividend on its Common Stock since the confirmation of its plan of reorganization in November 1983 and has no present plan to pay cash dividends. The Company is currently prohibited from paying cash dividends on its Common Stock by its Certificate of Incorporation and its bank credit agreement. At March 21, 1994 the Company had approximately 3,400 holders of record of its Common Stock. Item 6. Item 6. Selected Financial Data. The information presented below should be read in conjunction with the Consolidated Financial Statements and Notes thereto, including Note B which describes the 1993 Recapitalization. Notes (1) After tax, the net restructuring charge amounts to $17.6 million or $.52 per share (Note C). (2) In 1989, the Company decided to retain, and therefore consolidate, Envirosafe. Prior to that decision, Envirosafe was accounted for as a "business held for sale" and, accordingly, the Company deferred its $.9 million share of Envirosafe's income from continuing operations during the first half of 1989. At the time of such decision, the Company recognized as an expense $3.3 million of cumulative deferred charges. (3) The 1993 working capital deficiency is due to the $11.9 million current portion of IU acquisition obligations (Note H), $10.9 million of estimated restructuring costs (Note C), and the current classification of the $3.4 million paid to retire Class G preferred stock in March of 1994 (Note E). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. RESULTS OF OPERATIONS 1993 Versus 1992 Revenues were $38.4 million (16%) higher in 1993, due to increases of $18.3 million (10%) for Industrial Environmental Services and $20.1 million (37%) for Treatment and Disposal Services. The Industrial Environmental Services increase is attributable primarily to the full year effect of new services started up in 1991 and 1992 and also to the increased production volumes at steel mill customers. These increases were partially offset by the absence of revenue from a maintenance services contract that was sold in 1992. The Treatment and Disposal Services increase was due entirely to the timing of billings for equipment installations under CSI's long-term contracts to design, supply and construct scrubber sludge stabilization systems for electric utilities. Revenues from hazardous waste landfilling were about the same as in 1992, as an increase from higher volume was offset by a reduction in average prices due to weak demand that resulted in extremely competitive industry conditions. Gross profit increased $1.7 million (3%), due to a $7.8 million (19%) increase at Industrial Environmental Services reduced by a $6.1 million (31%) decline at Treatment and Disposal Services. The Industrial Environmental Services increase resulted from higher volume and new services for steel customers, partially offset by lower aluminum recycling profit margins, resulting from a worldwide aluminum glut. The decline at Treatment and Disposal Services resulted primarily from reduced profits on CSI's long-term contracts, because the contracts were in lower-margin equipment installation phases in 1993 compared to higher-margin design phases in 1992. CSI's return to 1992 profitability levels depends on its ability to secure additional long-term contracts. In addition, Treatment and Disposal Services' hazardous waste landfilling profits declined as the adverse effects of the extremely competitive market conditions more than offset a $2.1 million reduction in depreciation expense during the first six months of the year (see Note P). Selling, general and administrative costs increased $.9 million, primarily due to the absence in 1993 of a $1.1 million 1992 gain on the aforementioned sale of a maintenance services contract and the assets used in performing the contract. A $1.6 million reduction in permitting expense for a Pennsylvania landfill site was largely offset by the absence of a $.9 million 1992 net gain from the favorable settlement of a waste disposal tax dispute. During the fourth quarter of 1993, the Company explored a number of business restructuring alternatives, to eliminate loss operations and reduce costs. As a result of these deliberations, the Company decided to (i) terminate unprofitable recycling units, (ii) discontinue efforts to obtain a Pennsylvania hazardous waste landfill permit, and (iii) reorganize the Envirosafe and CSI businesses into the Treatment and Disposal Services business segment. Accordingly, the Company recorded a $22 million restructuring charge, as follows (in millions): Total Cash Non-cash Charge Costs Write-offs Termination of two flue dust recycling units and other unprofitable units $ 15.0 $ 6.3 $ 8.7 Withdrawal of Pennsylvania permit application and sale of landfill site 2.7 1.8 .9 Organization of the Treatment and Disposal Services business segment 3.2 2.8 .4 Other restructuring costs 1.1 1.1 ------- ------- ----- $ 22.0 $ 12.0 $10.0 The terminated recycling units include two facilities for the thermal treatment of electric arc steel furnace flue dust to recover zinc, a pilot plant for the sale of stabilized electric utility scrubber sludge for use in manufacturing concrete masonry blocks and two smaller sites. None of the terminated units had achieved economic feasibility. Also, the Company's CSI business is actively marketing its Super Detox(TM) process for stabilizing electric arc steel furnace flue dust, which the Company believes is a better environmental solution for that type of waste. In view of the continued weakness in demand in the hazardous waste disposal industry, the Company decided to discontinue its efforts to obtain a Pennsylvania hazardous waste landfill permit. Since permit costs for this prospective landfill were expensed as incurred, the restructuring charge primarily includes costs to close down and sell the landfill site, where the Company has been excavating and selling clay. Altogether these activities incurred 1993 operating losses and costs of $3.3 million, in addition to the restructuring charge. Because the Company concluded that waste stabilization and disposal activities will be more closely integrated in the future, the Company also decided to combine its Envirosafe and CSI business units into a unified Treatment and Disposal Services business segment. The combination reduced staff headcount and eliminated an office that together would have cost approximately $2.8 million in 1994. In addition, the Company has taken steps to reduce its annual corporate headquarters costs by approximately $1 million, also through a staff reduction. The non-cash costs listed above primarily represent write- offs of property, plant and equipment of the terminated units. The cash costs are primarily to close down operating sites and terminate employees, most of which will be expended during 1994. At the same time, the annual savings resulting from the actions outlined above will approximate $7 million. The $22 million restructuring charge was partially offset by a $3.5 million credit resulting from a reduction of liabilities, recorded in connection with the 1988 acquisition of IU International Corporation, that the Company expects to settle for less than previously estimated (Note H). Together, the restructuring charge and credit reduced 1993 operating income by $18.5 million ($17.6 million after taxes). Due to the factors described above, operating income decreased $17.7 million. However, absent the $18.5 million net restructuring charge, operating income would have increased $.8 million. This increase includes a $6.4 million improvement for Industrial Environmental Services, a $6 million decline for Treatment and Disposal Services and a $.4 million decrease in corporate headquarters costs. Interest expense decreased $4.8 million, primarily due to the Recapitalization (Note B). Pursuant to Statement of Financial Accounting Standards No. 109, the Company adopted a new method of accounting for income taxes in the first quarter of 1993. Prior periods were not restated. The cumulative effect of adopting the new method was a non-cash charge in the consolidated statement of operations of $2.3 million as of January 1, 1993. This new method of accounting is not expected to significantly affect the Company's reported results in the near future. Due to the factors described above and a $21.9 million extraordinary loss from extinguishment of debt resulting from the Recapitalization (see Note B), the 1993 net loss was $45.8 million. Before the extraordinary loss and the cumulative effect of the accounting change, the 1993 loss was $21.6 million, after tax, including the net restructuring charge of $17.6 million, after tax. These amounts compare to a $7.5 million net loss in 1992. The impact of inflation on revenues and results of operations has not been significant. 1992 Versus 1991 Revenues were $8.8 million (4%) higher in 1992, due to improvements of $5.3 million (11%) for Treatment and Disposal Services and $3.5 million (2%) for Industrial Environmental Services. The Treatment and Disposal Services improvement resulted primarily from a 26% hazardous waste landfilling volume increase, partially offset by a 10% reduction in average prices. The Industrial Environmental Services increase was due primarily to the start-up of new services for steel customers and to a lesser extent a small volume increase in core services for steel customers. These increases were partially offset by the absence of further revenue from a maintenance services contract that was sold in July 1992. Gross profit increased $5.5 million (10%), reflecting a $5.8 million (42%) improvement for Treatment and Disposal Services partially offset by a $.3 million (1%) decline for Industrial Environmental Services. The Treatment and Disposal Services improvement resulted from the increased landfilling revenue, increased profits from CSI's long-term contracts to design, supply and construct scrubber sludge stabilization systems for electric utilities, as well as a $1.9 million reduction in depreciation expense during the last six months of the year (see Note M). The Industrial Environmental Services results were attributable to gross profit from the new steel customer services and higher core services volume, offset by increased costs, including the costs of starting up the new services, and the absence of gross profit from the aforementioned maintenance services contract after its July 1992 sale. Selling, general and administrative expenses declined by $1.9 million, primarily due to a $1.1 million gain on the aforementioned sale of the maintenance services contract and the assets used in performing the contract, as well as a reduction in administrative costs due to the acquisition of the 37.5% minority interest of Envirosafe. A $.7 million increase in landfill permitting expenses to obtain a Pennsylvania landfill permit was offset by decreases in other costs. In addition, 1992 results included a $.9 million net gain, primarily from the favorable settlement of a waste disposal tax dispute, and 1991 results included a $.9 million gain from the sale of a non-strategic asphalt manufacturing plant. Due to the factors described above, operating income increased $7.4 million (39%). The increase included a $7.1 million improvement for Treatment and Disposal Services, a $.6 million increase for Industrial Environmental Services, partially offset by a $.3 million increase in corporate headquarters costs. Interest expense decreased $2.2 million, primarily due to a reduction in interest rates and fees. This reduction was partially offset by the effect of a higher average debt level during the year, including debt incurred in April 1991 in order to redeem $20 million of a subsidiary's preferred stock. Due to the factors described above, the net loss declined from $17.4 million in 1991 to $7.5 million in 1992. The impact of inflation on revenues and results of operations has not been significant. LIQUIDITY AND CAPITAL RESOURCES During 1993 the Company completed a comprehensive Recapitalization that has significantly improved its liquidity and capital resources. The Recapitalization also increased by 70% the shares of common stock outstanding. See Note B for a description of the Recapitalization and Note D for a summary of the terms of the Company's $220 million of 9-3/4% Senior Notes and its new bank credit facility. Cash flow provided by operating activities increased to $35.7 million in 1993 from $29.6 million in 1992. The Company's liquidity requirements arise primarily from the funding of its capital expenditures, trust fund payments for Treatment and Disposal Services, working capital needs and debt service obligations. Historically, the Company has met these requirements through cash flows generated by operations and with additional debt financing. In 1993 Industrial Environmental Services spent $19.8 million for additions to property, plant and equipment, primarily for equipment replacements and expansion of services to steel industry customers. In 1994 the Company expects to spend approximately the same amount for this segment, to replace equipment and expand services to the steel and aluminum industries. As of March 1994, the Company has spent or is committed to spend $6 million for the 1994 planned additions. In January 1994, the Company purchased certain assets of an aluminum dross processor for $5 million, including $2.9 million for intangible assets. During 1993 Treatment and Disposal Services spent $13 million for additions to property, plant and equipment, primarily for landfill development and waste treatment facilities at both the Ohio and Idaho landfills. The Company expects to spend somewhat more for this segment in 1994, primarily for landfill development and the completion of treatment facilities. As of March 1994, the Company has spent or is committed to spend $13 million for the planned additions. Treatment and Disposal Services' landfill permits require it to fund closure and post-closure monitoring and maintenance obligations by making essentially nonrefundable trust fund payments. The Company estimates its future trust fund payments as follows: for the Idaho landfill, approximately $1.1 million annually through 1998; and for the Ohio landfill, approximately $7.6 million in each of 1994 and 1995 and $3.9 million in 1996. Ohio landfill trust fund payments increased significantly in 1993 because a new 2.3 million cubic yard disposal cell was placed in service. The above payments will satisfy substantially all the Company's trust fund payment requirements for the foreseeable future based on current regulations and permitted capacity. The consolidated balance sheet reflects negative working capital of $17.4 million at December 31, 1993, including $10.9 million of estimated restructuring costs (Note C) and $11.9 million of estimated IU acquisition obligations (Note H), which are unrelated to ongoing operations. Negative working capital also includes $3.4 million paid in March 1994 to retire Class G preferred stock (Note E). The Company has not paid dividends on its Class G preferred stock since July 1990 and is prohibited from paying dividends by the bank credit facility. The facility permits the Company to redeem (including accumulated dividends) or retire shares of its Class G preferred stock with up to $5 million in cash (including borrowings thereunder) at any time. Subject to a test that requires improved financial performance, the amount of allowable Class G retirements progressively increases to a total of $35 million by July 1995. The facility also permits the Company to redeem shares of its Class G preferred stock with the net cash proceeds from future issuances of certain capital stock and debt. In March 1994, the Company retired 30,000 shares of Class G preferred stock for $3.4 million. Redemption of the remaining outstanding shares of Class G preferred stock, assuming no dividends are paid earlier, would require $44.3 million in 1996. Cash on hand, funds from operations and borrowing capacity under the bank credit facility are expected to satisfy the Company's operating and debt service requirements through the term of the bank facility, as well as provide funds to retire a portion of the Company's Class G preferred stock. The Company may be required to issue additional capital stock or debt to redeem the balance of the Class G preferred stock. The bank credit facility provides $60 million of revolving credit borrowing and letter of credit capacity, declining by $5 million on each of July 15, 1996 and 1997 and terminating on July 15, 1998. At December 31, 1993, there were no revolving credit borrowings and $12.7 million of standby letters of credit were outstanding. The Company has substantial deferred tax assets arising from federal income tax net operating loss carryforwards. The Recapitalization (described in Note B) produced an "ownership change" (as defined in the Internal Revenue Code) that limits the future use of these carryforwards. However, the Company has estimated that at least $7 million of the tax loss carryforwards will still be available annually to offset regular taxable income through the year 2006. The final amount of this limitation will be affected by the resolution of various tax issues and the nature and timing of certain amounts of future income. The Company also has substantial additional deferred tax assets that will become available to reduce future federal income taxes as they become deductible for tax purposes. Consequently, the Company does not expect to pay any federal income taxes for 1994, and thereafter the Company expects to utilize its deferred tax assets to reduce substantially its federal income tax payments over the next several years. See Note J. See Note O for a discussion of various contingencies, including environmental compliance matters. Item 8. Item 8. Financial Statements and Supplementary Data. See the financial statements and schedules attached hereto and listed in Item 14(a)(1) and (a)(2) hereof. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Company. DIRECTORS OF THE COMPANY Wallace B. Askins (age 63) has been a director of the Company since 1978. Mr. Askins served as Executive Vice President and Chief Financial Officer of Armco Inc. ("Armco") (a manufacturer of steel and other products) from June 1984, and as a director of Armco from December 1985, until his retirement in December 1992. Raymond P. Caldiero (age 59) has served as a director of the Company since February 1992. Mr. Caldiero has served as Chairman of Caldiero International, Inc. (a consultant in the areas of hotel development, lobbying, marketing and sales) since 1989. From 1973 to 1988, Mr. Caldiero served as Vice President and Assistant to the President of the Marriott Corporation (a hotel and restaurant company). He is a director of Capital Bank and served as a director of Envirosafe from 1987 until February 1992. Mr. Caldiero became a director of the Company in February 1992 pursuant to the terms of the merger of Envirosafe into a wholly- owned subsidiary of the Company. The merger agreement required that the Company appoint to its Board of Directors two of Envirosafe's independent directors. Mr. Caldiero is one of those directors. Louis A. Guzzetti, Jr. (age 55) has been a director and President and Chief Executive Officer of the Company since October 1986. From June 1983 until April 1986, Mr. Guzzetti was employed by United Brands, serving as its Executive Vice President and Chief Administrative Officer from June 1983 until August 1985 and as President and Chief Executive Officer of its United Fruit Company subsidiary from October 1984 until April 1986. He was also a director of United Brands from August 1984 until June 1986. Jeffrey G. Miller (age 52) was re-elected as a director of the Company in August 1993. Mr. Miller has been a professor at Pace University School of Law since 1987. He has also been of counsel to the Seattle and Washington, D.C. law firm of Perkins Coie since 1987. Mr. Miller was a director of Envirosafe from 1987 to February 1992. Mr. Miller became a director of the Company in February 1992 pursuant to the terms of a merger agreement between Envirosafe and a wholly-owned subsidiary of the Company. Mr. Miller resigned on May 13, 1993 pursuant to the FSC Transaction. Later, Mr. Miller became one of three additional FS&Co. designees appointed to the Board of Directors in connection with the consummation of the FSC Transaction. Jon D. Ralph (age 29) became a director of the Company in August 1993. Mr. Ralph is one of three additional FS&Co. designees appointed to the Board of Directors in connection with the consummation of the FSC Transaction. Mr. Ralph joined FS&Co. in August 1989. Prior to joining FS&Co., Mr. Ralph worked in the Investment Banking Division of Morgan Stanley & Co. Incorporated. John M. Roth (age 35) became a director of the Company in May 1993. Mr. Roth is one of the FS&Co. designees appointed to the Board of Directors on May 13, 1993. He joined FS&Co. in March 1988 and became a general partner in March 1993. From 1984 to 1988, Mr. Roth was a Vice President in the Merger and Acquisition Group of Kidder, Peabody & Co. Incorporated. From 1983 to 1984, Mr. Roth worked as a management consultant with McKinsey & Company, Inc. Mr. Roth is also a director of Calmar Inc. and Purity Supreme, Inc. and a member of the Board of Representatives of Brylane, L.P. Arthur R. Seder, Jr. (age 73) has served as a director of the Company since June 1988. Mr. Seder is a consultant in matters relating to the natural gas industry. He served as Special Counsel to Columbia Gas Transmission Corporation from June 1988 until 1992. From 1985 to 1988, he was of counsel to the Washington, D.C. office of the law firm of Sidley & Austin. From 1976 until 1985, he was Chairman and Chief Executive Officer of American Natural Resources Company (a diversified energy and transportation company). William H. Sherer (age 40) became a director of the Company in May 1993. Mr. Sherer is one of the FS&Co. designees appointed to the Board of Directors on May 13, 1993. He joined FS&Co. in 1988. Prior to joining FS&Co., Mr. Sherer was a Vice President of the Corporate Finance Department of Kidder, Peabody & Co. Incorporated. Mr. Sherer is also a director of Duff & Phelps Corporation and a member of the Board of Representatives of Brylane, L.P. J. Frederick Simmons (age 39) became a director of the Company in May 1993. Mr. Simmons is one of the FS&Co. designees appointed to the Board of Directors on May 13, 1993. He joined FS&Co. in 1986 and became general partner in January 1991. Prior to 1986, Mr. Simmons was Vice President of Bankers Trust Company's lending group specializing in leveraged buyouts and health care. Mr. Simmons is also a director of Buttrey Food and Drug Stores Company, Purity Supreme, Inc. and Orchard Supply Hardware Stores Corporation. Ronald P. Spogli (age 46) became a director and Chairman of the Board of the Company in May 1993. Mr. Spogli is one of the FS&Co. designees appointed to the Board of Directors on May 13, 1993. He is a founding partner of FS&Co. Mr. Spogli is also a director of Calmar Inc., Mac Frugal's Bargains Close-Outs Inc., Orchard Supply Hardware Stores Corporation, Buttrey Food and Drug Stores Company and Purity Supreme, Inc. and a member of the Board of Representatives of Brylane, L.P. William M. Wardlaw (age 47) became a director of the Company in August 1993. Mr. Wardlaw is one of three additional FS&Co. designees appointed to the Board of Directors in connection with the consummation of the FSC Transaction. Mr. Wardlaw joined FS&Co. in March 1988 and became a general partner in January 1991. From 1984 to 1988, Mr. Wardlaw was a principal of the law firm of Riordan & McKinzie. Mr. Wardlaw is also a member of the Board of Directors of Buttrey Food and Drug Stores Company and Purity Supreme, Inc. EXECUTIVE OFFICERS OF THE COMPANY Reference is made to "Executive Officers of the Company" in Part I of this Report, which information is incorporated herein by reference. COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT Section 16(a) of the Exchange Act requires certain officers and directors of the Company to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission"). To the best of the Company's knowledge, all required reports were timely filed. Item 11. Item 11. Executive Compensation. The following table sets forth all compensation awarded to, earned by or paid to the Chief Executive Officer and each of the other four most highly compensated executive officers of the Company for the last three completed fiscal years. Information in the columns labeled "Annual Compensation" and "Long Term Compensation" is provided for the last three fiscal years and information in the column labeled "All Other Compensation" is provided for the 1993 and 1992 fiscal years only. Summary Compensation Table Long Term Annual Compensation Compensation Number Name and of Stock All Other Principal Position Year Salary Bonus Options Compensation Louis A. Guzzetti, Jr. 1993 $390,750 $ 0 168,000 $20,786 (1) Chief Executive Officer 1992 367,750 0 0 20,171 (2) 1991 351,250 50,000 30,000 -- Jerrold I. Dolinger 1993 155,625 0 56,000 22,291 (1)(3) Vice President, 1992 144,438 0 0 22,542 (2)(3) Corporate Development 1991 137,250 19,000 20,000 -- George E. Fuehrer 1993 172,000 0 76,000 8,615 (1) Senior Vice President, 1992 161,000 0 0 9,074 (2) Planning 1991 153,000 20,000 40,000 -- James C. Hull 1993 187,312 0 16,000 18,360 (1) Vice President and 1992 177,188 0 0 18,737 (2) Chief Financial Officer 1991 169,000 23,000 20,000 -- Gene A. Iannazzo 1993 138,000 0 8,000 18,160 (1)(3) Vice President, 1992 132,000 0 0 17,920 (2)(3) Corporate Marketing 1991 132,000 29,700 5,000 -- (1) Includes Company contributions to accounts in the EnviroSource, Inc. Savings Plan, as follows: Mr. Guzzetti, $8,994; Mr. Dolinger, $4,497; Mr. Hull, $8,994; and Mr. Iannazzo, $8,160 and Company contributions to accounts in the EnviroSource, Inc. Profit Sharing Plan as follows: Mr. Guzzetti, $11,792; Mr. Dolinger, $7,794; Mr. Fuehrer, $8,615; and Mr. Hull, $9,366. (2) Includes Company contributions to accounts in the EnviroSource, Inc. Savings Plan, as follows: Mr. Guzzetti, $8,728; Mr. Dolinger, $4,347; Mr. Hull, $8,728; and Mr. Iannazzo, $7,920 and Company contributions to accounts in the EnviroSource, Inc. Profit Sharing Plan as follows: Mr. Guzzetti, $11,443; Mr. Dolinger, $8,195; Mr. Fuehrer, $9,074; and Mr. Hull, $10,009. (3) Includes $10,000 of loan forgiveness. See Item 13 of this Report "Certain Relationships and Related Transactions - Employee Loans". ------------------------ The following table sets forth the number and value of options granted during the fiscal year ended December 31, 1993 to the Chief Executive Officer and the other four most highly compensated executive officers of the Company, as well as the per share exercise price and the expiration date of options granted. (1) The exercise price is equal to the closing market price of the Company's Common Stock on the date of grant. (2) The grant date present values were determined using the Black-Scholes pricing model and the following assumptions: 50% expected stock price volatility, 6.36% risk-free rate of return, zero dividend yield and option exercise at the end of the 10-year term. (3) These options vest at the annual rate of 33-1/3% beginning on the first anniversary of the date of grant. All other options listed vest at the annual rate of 20% beginning on the first anniversary of the date of grant. ------------------------- The following table sets forth the number and value at December 31, 1993 of all exercisable and unexercisable options held by the Chief Executive Officer and the other four most highly compensated executive officers of the Company under the Company's Incentive Stock Option Plan and the 1993 Stock Option Plan. In 1993 none of the named executive officers exercised any options. Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values Number of Securities Value of Underlying Unexercised Unexercised In-the-Money Options/ Options/ SARs at SARs at FY-End (#) FY-End ($) Exercisable/ Exercisable/ Name Unexercisable Unexercisable(1) Louis A. Guzzetti, Jr. 168,000/195,000 $10,500/$15,750 Jerrold I. Dolinger 24,000/72,000 7,000/10,500 George E. Fuehrer 68,000/93,000 7,000/10,500 James C. Hull 14,000/32,000 7,000/10,500 Gene A. Iannazzo 11,200/13,800 1,750/2,625 (1) The value of unexercised in-the-money options represents the difference between the fair market value of the underlying securities as of December 31, 1993 and the exercise price of such options. ------------------------------- Mr. Iannazzo is a participant in the International Mill Service, Inc. Retirement Plan for Salaried Employees (the "IMS Retirement Plan"), a defined benefit plan. The IMS Retirement Plan allocates annually to each participant five percent of such participant's total annual cash compensation (excluding bonuses in excess of the guideline bonus amount under the EnviroSource, Inc. Management Compensation Incentive Plan for any year) and provides for interest to accrue annually at the Pension Benefit Guaranty Corporation's immediate annuity rate. Mr. Iannazzo is the only named executive officer who participates in the IMS Retirement Plan. The estimated benefits payable to Mr. Iannazzo under the IMS Retirement Plan upon retirement at normal retirement age is $37,046 per year for life for a straight life annuity, with other actuarially equivalent forms of benefit available under such plan. Normal retirement age is defined in the IMS Retirement Plan as age 65. All other named executive officers of the Company participate in the EnviroSource, Inc. Profit Sharing Plan, a defined contribution plan, contributions under which are included in the Summary Compensation Table in this Item 11. DIRECTORS' COMPENSATION The Company pays each director other than Mr. Guzzetti and general partners or employees of FS&Co. an annual fee of $15,000 (payable in four equal quarterly installments). The Company also pays the reasonable expenses of each director in connection with his attendance at each meeting of the Board of Directors or any committee thereof. In connection with their election in February 1992 as directors of the Company, each of Messrs. Caldiero and Miller was granted an option to purchase 20,000 shares of Common Stock of the Company at an exercise price of $2.625 per share, which became exercisable in September 1993 and expires in March 2002. Upon his resignation as a director in May 1993, Mr. Miller's option would have expired within three months. However, Mr. Miller's option was amended to provide for the continuation thereof upon his re-election to the Board of Directors on August 5, 1993. On August 5, 1993, Mr. Askins was granted an option to purchase 20,000 shares of Common Stock of the Company at an exercise price of $4.25 per share, which becomes exercisable in August 1995 and expires in August 2003. On November 1, 1993, the Company granted an option to purchase 20,000 shares of Common Stock of the Company to Mr. Seder at an exercise price of $4.25 per share, which becomes exercisable in November 1995 and expires in November 2003. Mr. Seder's previously issued option to purchase 20,000 shares of Common Stock at an exercise price of $7.75 was terminated at the same time. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The members of the Company's Compensation and Stock Option Committee for 1993 were Messrs. Askins, Caldiero, Roth and Simmons. Mr. Askins was an executive officer of the Company from December 1976 until June 1984. The members of the Company's 1993 Stock Option Plan Committee for 1993 were Messrs. Caldiero, Roth and Simmons. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS The Company's records, and other information obtained by the Company from outside sources, indicate that as of March 1, 1994, unless otherwise stated, the following persons were the beneficial owners of more than 5% of the outstanding shares of the Common Stock of the Company.(1) Number of Shares Percent Name and Address Beneficially of of Beneficial Owner Class Owned Class FS Equity Common 20,574,079(3) 49.5% Partners II, L.P. Stock c/o Freeman Spogli & Co.(2) 11100 Santa Monica Blvd. Suite 1900 Los Angeles, CA 90025 The IBM Retirement Plan Common 2,871,954(4) 7.1% Trust Fund Stock 262 Harbor Drive Stamford, CT 06904 (1) Unless otherwise disclosed, the persons named in the table have sole voting and investment power with respect to all shares of equity securities shown as beneficially owned by them. (2) FS&Co., as general partner of FS Equity Partners II, L.P. ("FSEP"), has the sole power to vote and dispose of such shares. Messrs. Roth, Simmons, Spogli and Wardlaw, each of whom is a director of the Company, and Bradford M. Freeman are general partners of FS&Co., and as such may be deemed to be the beneficial owners of the shares of the Company's Common Stock indicated as owned by FSEP. (3) Includes 1,469,933 shares issuable upon exercise of warrants held by FSEP. (4) Includes 205,200 shares issuable upon exercise of warrants held by the IBM Trust. SECURITY OWNERSHIP OF MANAGEMENT As of March 1, 1994, the following directors, executive officers and all directors and officers as a group, were the beneficial owners of shares of Common Stock of the Company. * Less than 1% (1) Unless otherwise disclosed, the persons named in the table have sole voting and investment power with respect to all shares of equity securities shown as beneficially owned by them. (2) All shares shown as beneficially owned are held of record by FSEP. As general partner of FSEP, FS&Co. has the sole power to vote and dispose of such shares. Messrs. Roth, Simmons, Spogli and Wardlaw, each of whom is a director of the Company, are general partners of FS&Co., and as such may be deemed to be the beneficial owners of the shares of the Company's Common Stock indicated as beneficially owned by each of them. (3) Includes (i) shares for which options under EnviroSource's Incentive Stock Option Plan, EnviroSource's 1993 Stock Option Plan or otherwise are exercisable within 60 days, as follows: Mr. Dolinger, 28,000 shares; Mr. Fuehrer, 73,000 shares; Mr. Guzzetti, 177,000 shares; Mr. Hull, 16,000 shares; Mr. Iannazzo, 13,000 shares; and Messrs. Caldiero and Miller, 20,000 shares each; and (ii) shares held through the EnviroSource, Inc. Savings Plan and the EnviroSource, Inc. Profit Sharing Plan as of December 31, 1993, as follows: Mr. Dolinger, 36,810 shares; Mr. Fuehrer, 25,003 shares; Mr. Guzzetti, 81,255 shares; Mr. Hull, 35,020 shares; and Mr. Iannazzo, 15,593 shares. (4) Includes 1,469,933 shares issuable upon exercise of warrants held by FSEP. (5) Excludes 2,000 shares owned by members of Mr. Dolinger's immediate family as to which Mr. Dolinger disclaims beneficial ownership. (6) Includes (i) 394,600 shares for which options under EnviroSource's Incentive Stock Option Plan, EnviroSource's 1993 Stock Option Plan or otherwise are exercisable within 60 days; (ii) 229,665 shares held through the EnviroSource, Inc. Savings Plan and the EnviroSource, Inc. Profit Sharing Plan as of December 31, 1993; (iii) 19,104,146 shares held of record by FSEP; and (iv) 1,469,933 shares issuable upon exercise of warrants held by FSEP. See footnote (2) for an explanation of the relationship between certain directors and FSEP. ------------------------------ CHANGE OF CONTROL Not applicable. Item 13. Item 13. Certain Relationships and Related Transactions. THE FSC TRANSACTION On May 13, 1993, FS&Co., through an affiliate, purchased certain equity securities of the Company from the Company and DKM and WM Financial. See Item 1, "Business - The Recapitalization." In connection with the equity investment, the Company paid FS&Co. a transaction fee of $3,025,137 and DKM and WM Financial collectively paid FS&Co. a transaction fee of $1,974,863. Certain directors of the Company are general partners or employees of FS&Co. See Item 10, "Directors of the Company." FINANCING TRANSACTIONS In 1984, the Company issued $10 million of debentures and a warrant to purchase 1,000,000 shares of the Company's Common Stock at an exercise price of $5.00 per share (the "1984 Warrant") to WM Financial for $10 million in cash. The debentures bore interest at 10% and were payable in annual installments of $2 million commencing January 1, 1991. Subsequently, WM Financial assigned the warrant to DKM. Under the terms of the 1984 Warrant, DKM could purchase 1,000,000 shares at any time through December 31, 1994. However, the number of shares eligible to be purchased was automatically reduced by 200,000 shares per year commencing January 1, 1991, to the extent not previously purchased. In May 1990, these debentures were exchanged for 1,840,000 shares of the Company's Common Stock, and in connection with such exchange, the warrant expiration date was extended to January 1, 1998 and the 200,000 share annual reductions were modified to commence January 1, 1994. In November 1991, DKM waived certain anti-dilution and pre-emptive right provisions of the 1984 Warrant in connection with the Company's acquisition of the minority interest in Envirosafe. In consideration for such waiver, the Company agreed to reduce the exercise price of the 1984 Warrant from $5.00 to $3.50 per share. In July 1990, the Company issued a warrant to purchase 695,652 shares of the Company's Common Stock at an exercise price of $5.75 per share (the "1990 Warrant") to DKM in consideration for DKM's agreement to guarantee up to $12 million of letter of credit reimbursement obligations of the Company. In connection with DKM's consent to the April 15, 1991 amendment to the Company's credit agreement, the Company agreed to reduce the exercise price of such warrant from $5.75 to $4.00 per share. As part of the Recapitalization, DKM sold the 1984 Warrant and the 1990 Warrant to the Investors. Messrs. Spogli, Roth, Simmons and Wardlaw are each general partners of FS&Co. FS&Co. sold a portion of each of the 1984 Warrant and the 1990 Warrant to the IBM Trust. Concurrent with the closing of the FSC Transaction, the 1984 Warrants were amended to modify the first 200,000 share annual reduction to commence March 31, 1994, provide for the adjustment of the exercise price under certain circumstances and provide for a cashless exercise feature. The 1990 Warrants were amended to provide for the adjustment of the exercise price under certain circumstances and provide for a cashless exercise feature. See Item 1, "Business - The Recapitalization," Item 12, "Security Ownership of Management," and Note F. MANAGEMENT AGREEMENT In 1984, the Company entered into a consulting agreement with WM Financial pursuant to which WM Financial provided advice and assistance in connection with corporate and financial planning and the investigation, development and negotiation of acquisitions and financing arrangements, for an annual fee of $400,000. The consulting agreement was terminated upon consummation of the FSC Transaction. FS&Co. provides advice and assistance to the Company regarding corporate and financial planning and the development of business strategies. The Company does not pay FS&Co. a fee for such services but has agreed to reimburse FS&Co. for all expenses incurred in connection with such advice and assistance. EMPLOYEE LOANS In 1986, the Company granted Mr. Guzzetti a loan of $500,000 (the "1986 Loan") bearing interest at 7.5% per annum and repayable in ten equal annual installments. The first $50,000 installment was repaid on March 31, 1988, the second $50,000 on April 1, 1989 and the third on April 18, 1990. Effective March 31, 1991, the Company agreed to defer the 1991 principal installment payment and extend the maturity of such loan by one year. In addition, the Company loaned Mr. Guzzetti $26,250 to finance the payment of interest on such loan otherwise due on March 31, 1991, represented by a new note bearing interest at 7.5% per annum and repayable on the date the 1986 Loan is due. Effective March 31, 1992, the Company agreed to defer the 1992 principal installment payment and extend the maturity of such loan by an additional year. In addition, the Company loaned Mr. Guzzetti $26,250 to finance the payment of interest on such loan otherwise due on March 31, 1992, represented by a new note bearing interest at 7.5% per annum and repayable on the date the 1986 Loan is due. Effective March 31, 1993, the Company and Mr. Guzzetti agreed to amend the terms of the 1986 Loan to (i) increase the principal amount of such loan by the amount of interest otherwise due on March 31, 1993, (ii) reduce the interest rate commencing April 1, 1993 to 6% per annum, payable annually half in cash and half by adding to the principal amount of the loan on each due date of such interest, (iii) provide for a lump sum payment of principal and accrued and unpaid interest thereon on March 31, 1998, in lieu of annual installment payments, (iv) require payment in full within 30 days of termination of employment and (v) provide for forgiveness of all outstanding amounts due in the event Mr. Guzzetti dies while still employed by the Company. The outstanding principal amount (including financed interest payments) of the 1986 Loan will be $445,669 on March 31, 1994. In connection with Common Stock purchases by certain executive officers of the Company in January 1989, the Company loaned $350,000 to Mr. Guzzetti, $220,000 to Mr. Fuehrer, $90,000 to Mr. Anderson, $150,000 to James H. Cornell, former Vice President, General Counsel and Secretary, and $150,000 to Mr. Dolinger. All of such indebtedness bears interest payable annually at the annual rate of 8%, and its principal amount is payable on the earlier of January 13, 1994 or the date of such borrower's termination of employment with the Company. As of April 1, 1991, the Company agreed to increase the principal amount of such loans by the amount of interest payments otherwise then due. Effective April 1, 1992, the Company agreed to increase the principal amount of such loans by the amount of interest payments otherwise due on April 1, 1992. Effective April 1, 1993, the Company agreed to (i) increase the principal amount of such loans by the amount of interest payments otherwise due on April 1, 1993, (ii) extend the maturity of such loans to March 31, 1998, (iii) reduce the interest rate payable on such loans to 6% per annum, payable annually half in cash and half by adding to the principal amount of such loans on each due date of such interest, (iv) require payment in full of all outstanding amounts due under the loans, including accrued interest, within 30 days of termination of employment and (v) provide for forgiveness of all outstanding amounts due under the loans in the event of the officer's death while still employed by the Company. Mr. Cornell's loan, together with accrued and financed interest, was repaid in full in 1993. The aggregate principal amounts (including financed interest payments) of such loans will be $454,126 for Mr. Guzzetti, $285,451 for Mr. Fuehrer, $116,775 for Mr. Anderson, and $194,626 for Mr. Dolinger on April 1, 1994. In connection with his relocation to Connecticut in 1989, the Company loaned an aggregate of $40,000 to Mr. Dolinger. The Company agreed to forgive one-fourth of such indebtedness in July 1990, 1991, 1992 and 1993. The amount of such forgiveness has been recorded as income to Mr. Dolinger. In connection with Mr. Iannazzo's relocation to Connecticut in 1989, the Company loaned him an aggregate of $40,000. The Company agreed to forgive one-fourth of such indebtedness in November 1990, 1991, 1992 and 1993. The amount of such forgiveness has been recorded as income to Mr. Iannazzo. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents Filed as Part of this Report. (1) Financial Statements. The following Consolidated Financial Statements of the Company and its subsidiaries are included in this Report: Reports of Independent Auditors Consolidated Balance Sheet at December 31, 1993 and Consolidated Statement of Operations for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (2) Financial Statement Schedules. The following schedules to the Consolidated Financial Statements of the Company and its subsidiaries are included in this Report: Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties III - Condensed Financial Information of Registrant IV - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts X - Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required or are inapplicable, and therefore have been omitted, or the required information is disclosed in the Consolidated Financial Statements. (3) Exhibits. 2.1 - Second Modified Plan of Reorganization of the Company (incorporated herein by reference to Exhibits 1, 2 and 3 to the Company's Current Report on Form 8-K dated November 30, 1983 (File No. 1-1363)). 2.2 - Order, dated January 13, 1984, of the United States District Court for the Northern District of Ohio (modifying the Second Modified Plan of Reorganization of the Company) (incorporated herein by reference to Exhibit 2.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1983 (File No. 1- 1363)). 2.3 - Agreement and Plan of Merger, dated as of November 26, 1991, by and among the Company, Envirosafe Services, Inc. and ESI Merger Co. (incorporated herein by reference to Annex A to the Joint Proxy Statement/Prospectus included in the Company's Registration Statement on Form S- 4, filed on January 24, 1992 (File No. 33- 45270)). 3.1 - Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 (File No. 1-1363)). 3.2 - Certificate of Amendment to the Certificate of Incorporation of the Company, dated February 26, 1992 (incorporated herein by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-1363)). 3.3 - Certificate of Amendment to the Certificate of Incorporation of the Company, dated August 5, 1993 (incorporated herein by reference to Exhibit 4.9 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993 (File No. 1-1363)). 3.4 - Certificate of Designation of Shares of Class H Cumulative Preferred Stock of the Company (incorporated herein by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1987 (File No. 1-1363)). 3.5 - Certificate of Designation of Shares of Class I Cumulative Redeemable Preferred Stock, Series A, Increasing Rate of the Company (incorporated herein by reference to Exhibit 3.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1- 1363)). 3.6 - Certificate of Designation of Shares of Class I Cumulative Redeemable Preferred Stock, Series B, Exchangeable of the Company (incorporated herein by reference to Exhibit 3.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1-1363)). 3.7 - Certificate of Designation of Shares of Class I Preferred Stock, Series C of the Company (incorporated herein by reference to Exhibit 3.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-1363)). 3.8 - Certificate of Designation of the Preferences of Class J Convertible Preferred Stock of the Company (incorporated herein by reference to Exhibit 3.7 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 3.9 - Certificate of Correction to the Certificate of Designation of the Preferences of Class J Convertible Preferred Stock of the Company (incorporated herein by reference to Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993 (File No. 1-1363)). 3.10 - By-Laws of the Company (incorporated herein by reference to Exhibit C (pages C-1 to C-9) to the Company's Proxy Statement filed April 24, 1987, in respect of its 1987 Annual Meeting of Stockholders (File No. 1-1363)). 3.11 - Amendment to the By-Laws of the Company (incorporated herein by reference to Exhibit 3.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1-1363)). 4.1 - Term Loan Agreement, dated as of December 28, 1990, between West One Bank, N.A., Imsamet of Idaho, Inc., the Company and International Mill Service, Inc. (The Company agrees to furnish a copy of such agreement to the Commission upon request). 4.2 - Letter Amendment, effective January 28, 1992, to the Term Loan Agreement to which reference is made in Exhibit 4.1 to this Annual Report on Form 10-K. (The Company agrees to furnish a copy of such amendment to the Commission upon request.) 4.3 - Loan and Security Agreement, dated as of April 6, 1993, between IMS Funding Corporation and Greyhound Financial Corporation. (The Company agrees to furnish a copy of such agreement to the Commission upon request.) 4.4 - Indenture, dated as of July 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9- 3/4% Senior Notes due 2003, including the form of such Notes attached as Exhibit A thereto (incorporated herein by reference to Exhibit 4.10 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993 (File No. 1-1363)). 4.5 - Registration Rights Agreement, dated as of May 13, 1993, among the Company, FS Equity Partners II, L.P., The IBM Retirement Plan Trust Fund and Enso Partners, L.P. (incorporated herein by reference to Exhibit 4.29 to Amendment No. 1 to the Company's Registration Statement on Form S- 1, filed June 14, 1993 (File No. 33-62050)). 4.6 - Warrants to purchase shares of Common Stock of the Company issued to FS Equity Partners II, L.P., pursuant to the Stock Purchase Agreement, dated as of April 16, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and FS Equity Partners II, L.P., as amended (incorporated herein by reference to Exhibit 4.30 to Amendment No. 1 to the Company's Registration Statement on Form S- 1, filed June 14, 1993 (File No. 33-62050)). 4.7 - Warrants to purchase shares of Common Stock of the Company issued to The IBM Retirement Plan Trust Fund, pursuant to the Purchase Agreement and Assignment and Assumption Agreement, dated as of May 13, 1993, among the Company, FS Equity Partners II, L.P. and The IBM Retirement Plan Trust Fund (incorporated herein by reference to Exhibit 4.31 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 4.8 - Warrants to purchase shares of Common Stock of the Company issued to Enso Partners, L.P., pursuant to the Stock Purchase Agreement, dated as of May 13, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and Enso Partners, L.P. (incorporated herein by reference to Exhibit 4.32 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 4.9 - Credit Agreement, dated as of June 24, 1993, among the Company, International Mill Service, Inc., the banks parties thereto, Chemical Bank, Banque Paribas and Credit Lyonnais New York Branch, as Co-Agents, and Chemical Bank, as Administrative Agent (incorporated herein by reference to Exhibit 28.3 to the Company's Current Report on Form 8-K, dated July 1, 1993 (File No. 1-1363)). 4.10* - First Amendment to the Credit Agreement, dated as of December 23, 1993, among the Company, International Mill Service, Inc., the banks parties thereto, Chemical Bank, Banque Paribas and Credit Lyonnais New York Branch, as Co- Agents, and Chemical Bank, as Administrative Agent. 4.11 - Warrants to purchase 300,000 shares of Common Stock issued to Chemical Bank, NCNB Texas National Bank, Banque Paribas, National Bank of Canada and Royal Bank of Canada (incorporated herein by reference to Exhibit 10.24 to Amendment No. 2 to the Company's Registration Statement on Form S-1, filed October 31, 1991 (File No. 33-42381)). * Filed herewith. 10.1 - Restated Incentive Stock Option Plan of the Company, as amended (incorporated herein by reference to Exhibit A to the Company's Registration Statement on Form S-8, filed January 17, 1989 (File No. 33-26633)). 10.2 - Stock Purchase Agreement, dated as of April 16, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and FS Equity Partners II, L.P. (incorporated herein by reference to Exhibit 4.21 to the Company's Form 8 Amendment to Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-1363)). 10.3 - First Amendment to the Stock Purchase Agreement, dated as of May 13, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and FS Equity Partners II, L.P. (incorporated herein by reference to Exhibit 28.2 to the Company's Current Report on Form 8- K, dated May 27, 1993 (File No. 1-1363)). 10.4 - Purchase Agreement and Assignment and Assumption Agreement, dated as of May 13, 1993, among the Company, FS Equity Partners II, L.P. and The IBM Retirement Plan Trust Fund (incorporated herein by reference to Exhibit 28.4 to the Company's Current Report on Form 8-K, dated May 27, 1993 (File No. 1-1363)). 10.5 - Stock Purchase Agreement, dated as of May 13, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and Enso Partners, L.P. (incorporated herein by reference to Exhibit 28.3 to the Company's Current Report on Form 8-K, dated May 27, 1993 (File No. 1- 1363)). 10.6 - Promissory Note of Louis A. Guzzetti, Jr., dated March 31, 1993, amending and replacing the Promissory Notes dated October 15, 1987, March 31, 1991 and March 31, 1992 and the Letter Amendments dated April 13, 1991 and May 12, 1992, payable to the Company in the principal amount of $432,678.50 (incorporated herein by reference to Exhibit 10.13 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.7 - Promissory Notes of Aarne Anderson, James H. Cornell, Jerrold I. Dolinger, George E. Fuehrer, George T. Milano and Mr. Guzzetti, dated as of April 1, 1993, amending and replacing the Promissory Notes dated January 13, 1989, April 1, 1991 and April 1, 1992, payable to the Company in the aggregate principal amount of $1,247,123.80 (incorporated herein by reference to Exhibit 10.17 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33- 46930)). 10.8 - Stock Option Agreement, dated March 18, 1992, between the Company and Raymond P. Caldiero (incorporated herein by reference to Exhibit 10.20 to the Company's Annual Report on Form 10- K for the fiscal year ended December 31, 1992 (File No. 1-1363)). 10.9 - Stock Option Agreement, dated March 18, 1992, between the Company and Jeffrey G. Miller (incorporated herein by reference to Exhibit 10.21 to the Company's Annual Report on Form 10- K for the fiscal year ended December 31, 1992 (File No. 1-1363)). 10.10 - Amendment, dated August 5, 1993, to the Stock Option Agreement, dated March 18, 1992, between the Company and Jeffrey G. Miller, to which reference is made in Exhibit 10.9 to this Annual Report on Form 10-K (incorporated herein by reference to Exhibit 10.22 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.11 - Stock Option Agreement, dated August 5, 1993, between the Company and Wallace B. Askins (incorporated herein by reference to Exhibit 10.23 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.12* - Stock Option Agreement, dated November 1, 1993, between the Company and Arthur R. Seder, Jr. * Filed herewith. 10.13 - 1993 Stock Option Plan of the Company (incorporated herein by reference to Exhibit 10.21 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 21.1* - Subsidiaries of the Company. 23.1* - Consent of Ernst & Young. 23.2* - Consent of KPMG Peat Marwick. (b) Reports on Form 8-K. During the last quarter of the fiscal year ended December 31, 1993, the Company filed no Current Reports on Form 8-K. * Filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ENVIROSOURCE, INC. Dated: March 25, 1994 By: /S/ LOUIS A. GUZZETTI, JR. Louis A. Guzzetti, Jr. President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated on March 25, 1994. Signature Title /S/ LOUIS A. GUZZETTI, JR. President and Chief Executive Louis A. Guzzetti, Jr. Officer (Principal Executive Officer) and Director /S/ JAMES C. HULL Vice President and Chief James C. Hull Financial Officer (Principal Financial and Accounting Officer) /S/ RONALD P. SPOGLI Chairman of the Board of Ronald P. Spogli Directors /S/ WALLACE B. ASKINS Director Wallace B. Askins /S/ RAYMOND P. CALDIERO Director Raymond P. Caldiero /S/ JEFFREY G. MILLER Director Jeffrey G. Miller Director Jon D. Ralph /S/ JOHN M. ROTH Director John M. Roth /S/ ARTHUR R. SEDER, JR. Director Arthur R. Seder, Jr. /S/ WILLIAM H. SHERER Director William H. Sherer /S/ J. FREDERICK SIMMONS Director J. Frederick Simmons Director William M. Wardlaw REPORT OF INDEPENDENT AUDITORS Stockholders and Board of Directors EnviroSource, Inc. We have audited the accompanying consolidated balance sheet of EnviroSource, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the 1991 financial statements of Envirosafe Services, Inc., a consolidated subsidiary, which statements reflect total revenues of $37.5 million for the year ended December 31, 1991. The 1991 financial statements of Envirosafe Services, Inc. were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for Envirosafe Services, Inc., is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and, in 1991, the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of EnviroSource, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, based on our audits and in 1991, the report of other auditors, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note J to the financial statements, in 1993 the Company changed its method of accounting for income taxes. ERNST & YOUNG Stamford, Connecticut March 2, 1994 Independent Auditors' Report The Board of Directors Envirosafe Services, Inc.: We have audited the consolidated statements of operations, shareholders' equity, and cash flows of Envirosafe Services, Inc. and subsidiaries for the year ended December 31, 1991 (not presented separately herein). In connection with our audit of the consolidated financial statements, we have audited the financial statement schedules of Property, Plant and Equipment (Schedule V), Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (Schedule VI) and the Valuation and Qualifying Accounts (Schedule VIII) for the year ended December 31, 1991 (not presented separately herein). These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosure in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Envirosafe Services, Inc. and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Philadelphia, Pennsylvania February 28, 1992 EnviroSource, Inc. CONSOLIDATED BALANCE SHEET (Dollars in thousands) December 31, 1993 1992 ASSETS Current assets: Cash and cash equivalents $ 10,582 $ 10,695 Accounts receivable, less allowance for doubtful accounts of $944 and $1,333 36,196 37,394 Other current assets 8,093 7,577 ---------- --------- Total current assets 54,871 55,666 Property, plant and equipment: Land and improvements 6,085 7,422 Landfill development 38,303 32,153 Buildings and improvements 15,505 15,246 Machinery and equipment 188,892 176,798 ---------- --------- 248,785 231,619 Less allowance for depreciation 107,241 86,048 ---------- --------- 141,544 145,571 Goodwill, less amortization 172,166 198,517 Landfill permits, less amortization 24,661 25,967 Closure trust funds and deferred charges, less amortization 14,909 10,600 Debt issuance costs, less amortization 9,061 2,303 Other assets 10,033 5,923 ---------- --------- $ 427,245 $ 444,547 ========== ========= See Notes to Consolidated Financial Statements. EnviroSource, Inc. CONSOLIDATED BALANCE SHEET -- Continued (Dollars in thousands) December 31, 1993 1992 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade payables $ 13,607 $ 11,873 Salaries, wages and related benefits 9,075 7,410 Insurance 7,217 10,932 Interest 1,072 6,105 Estimated restructuring costs 10,900 Other current liabilities 21,904 19,359 Current portion of debt and redeemable preferred stock 8,492 5,125 --------- --------- Total current liabilities 72,267 60,804 Long-term debt 235,842 235,668 Other liabilities 66,208 83,676 Redeemable preferred stock 38,711 43,850 Commitments and contingencies (Notes D and O) Stockholders' equity: Class H Cumulative Preferred Stock 27 Common stock, par value $.05 per share, 60,000,000 shares author- ized, 40,052,259 shares issued and outstanding in 1993 and 25,002,454 shares issued in 1992 2,003 1,250 Capital in excess of par value 162,461 129,394 Accumulated deficit (148,605) (100,209) Treasury stock (8,923) Stock purchase loans receivable from officers (840) (990) Canadian translation adjustment (802) --------- --------- Total stockholders' equity 14,217 20,549 --------- --------- $ 427,245 $ 444,547 ========= ========= See Notes to Consolidated Financial Statements. EnviroSource, Inc. CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in thousands, except for per share amounts) Years Ended December 31, 1993 1992 1991 Revenues $ 271,026 $ 232,652 $ 223,902 Cost of revenues 208,511 171,803 168,563 Selling, general and admin- istrative expenses 35,362 34,504 36,394 Restructuring charge, net 18,500 --------- --------- --------- Operating income 8,653 26,345 18,945 Interest income 1,185 1,069 1,576 Interest expense (28,863) (33,653) (35,856) --------- --------- --------- (19,025) (6,239) (15,335) Income tax expense 2,549 1,299 1,483 Minority interest 566 --------- --------- --------- Loss before extraordinary loss and cumulative effect of accounting change (21,574) (7,538) (17,384) Extraordinary loss from extinguishment of debt (21,930) Cumulative effect of income tax accounting change (2,302) --------- --------- --------- Net loss (45,806) (7,538) (17,384) Preferred stock dividend requirements and accretion (3,182) (4,095) (4,691) --------- --------- --------- Loss applicable to common shares and equivalents $ (48,988) $ (11,633) $ (22,075) ========= ========= ========= Loss per share: Before extraordinary loss and cumulative effect of accounting change $ (.73) $ (.52) $ (1.51) Extraordinary loss (.64) Cumulative effect of accounting change (.07) --------- --------- --------- Net loss $ (1.44) $ (.52) $ (1.51) ========= ========= ========= See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. EnviroSource, Inc. CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in thousands) Years Ended December 31, 1993 1992 1991 OPERATING ACTIVITIES Loss before extraordinary loss and cumu- lative effect of accounting change $(21,574) $(7,538) $(17,384) Adjustments to reconcile loss to cash provided by operations: Restructuring charge, net 18,500 Depreciation 27,241 24,682 25,161 Amortization 10,782 12,583 12,085 Closure cost amortization and accruals 3,219 2,926 2,316 Net changes in working capital (1,505) (3,850) 444 Other (941) 792 (2,442) -------- ------- -------- Cash provided by operating activities 35,722 29,595 20,180 -------- ------- -------- INVESTING ACTIVITIES Property, plant and equipment: Additions (32,768) (39,126) (25,824) Proceeds from dispositions 128 4,467 2,441 Landfill permit additions and closure expenditures (965) (2,657) (3,300) Closure trust fund payments (5,174) (1,797) (2,211) Ongoing net cash flows related to IU acquisition (4,816) 8,372 (2,354) Disposition of an equity investment 12,000 Refunds (deposits) on equipment to be leased 4,005 (4,005) Other 131 (1,066) (2,990) -------- ------- -------- Cash used by investing activities (43,464) (27,802) (26,243) -------- ------- -------- FINANCING ACTIVITIES Sale of common stock 42,716 111 Issuance of debt 238,500 46,915 31,349 Debt issuance costs (9,687) Debt repayments (247,404) (43,362) (32,112) Cash portion of extraordinary loss (11,348) Redemption of preferred stock (5,148) (1,352) Preferred stock exchange costs (218) -------- ------- -------- Cash provided (used) by financing activities 7,629 2,312 (981) -------- ------- -------- CASH AND CASH EQUIVALENTS Increase (decrease) during the year (113) 4,105 (7,044) Beginning of year 10,695 6,590 13,634 -------- -------- -------- End of year $ 10,582 $ 10,695 $ 6,590 ======== ======== ======== See Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A -- ACCOUNTING POLICIES Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated. Certain amounts in prior years' financial statements have been reclassified to conform with the current year presentation. Cash equivalents: Cash equivalents are highly liquid investments with maturities of three months or less when acquired. Property, plant and equipment: Property, plant and equipment is stated at cost. For financial reporting purposes, depreciation is computed by the straight-line method based on the following lives: buildings -- 10 to 30 years and machinery and equipment -- 3 to 25 years. Landfill development costs are depreciated based on the ratio of cubic yards of disposal capacity utilized to total cubic yards of disposal capacity. Landfill permits: Permit costs for prospective landfills are expensed until management determines that permitting efforts will be successful. Costs to acquire or maintain permits for authorized facilities are deferred and amortized based on the ratio of cubic yards of disposal capacity utilized to total cubic yards of disposal capacity. Accumulated amortization was $7.6 million and $5.5 million at December 31, 1993 and 1992. Closure trust funds and deferred charges: An Idaho closure trust fund secures Idaho landfill closure and post-closure obligations, which are being accrued as liabilities in the balance sheet. The trust fund is invested in U.S. government and government agency securities that are carried at cost, which approximates market value. Interest income is recognized and excess funds, if any, will revert to the Company. Ohio landfill trust fund balances represent deferred charges that are being amortized as part of closure costs. These trusts (also invested in U.S. government and government agency securities) will fund the latter stages of closure activity and all post-closure activity in perpetuity. Excess funds, if any, will revert to the State of Ohio; accordingly, no interest income is recognized. Accumulated amortization was $5.8 million and $4.3 million at December 31, 1993 and 1992. Closure costs: The estimated costs of the future closure and post- closure monitoring and maintenance of landfills are amortized or accrued based on the ratio of cubic yards of disposal capacity utilized to total cubic yards of disposal capacity. Closure costs are similar to landfill development costs, but are generally incurred for aboveground construction. Closure cost accruals of $8.7 million and $7.6 million are included in other long-term liabilities at December 31, 1993 and 1992. Goodwill: The excess of purchase price over fair value of identified net assets of acquired businesses is recorded as an asset and amortized using the straight-line method over 40 years. Accumulated amortization was $32.5 million and $26.9 million at December 31, 1993 and 1992. Most of the goodwill is identified with the Company's excellent reputation and long-term relationships with steel industry customers. The goodwill would not be impaired unless the Company were to lose a significant number of these customers. The Company has a history of high customer contract renewal rates. Revenues: Most of the Company's revenues are recognized as services are provided to customers. Revenues of $27.2 million in 1993, $6.7 million in 1992 and $3.5 million in 1991 are from long-term contracts to design, supply and construct "wet scrubber sludge" stabilization systems for electric utilities. Revenues from these contracts are recognized using the percentage-of-completion method, with progress toward completion measured in labor hours. Such contracts are segmented between "design and supply" and "construction", and a separate profit margin is recognized for each segment. Unbilled revenues of $4.1 million included in accounts receivable at December 31, 1992, became billable in 1993 as contract milestones were reached. Other assets includes long-term contract receivables of $4 million at December 31, 1993 that become due in 1995. Postemployment benefits: The requirements of Statement of Financial Accounting Standards No. 112, to be adopted as of January 1, 1994, will not have a material effect on the Company. Per share calculations: Per share amounts are based on the weighted average number of common shares outstanding: 34,009,000 in 1993, 22,251,000 in 1992 and 14,572,000 in 1991. As anticipated, the Class J preferred stock was automatically converted into common stock (Note B); accordingly, all common share and per share amounts reflect it as common stock from its May 13, 1993 issuance. Because there were losses in all years, common stock equivalents and Class G preferred stock had no dilutive effects. On May 13, 1993 the Company issued the equivalent of 13,333,333 shares of common stock, including the Class J preferred stock, and all the outstanding Class H preferred stock was exchanged into 3,066,667 common shares (Note B). Had such transactions taken place at the beginning of 1993, the per share loss before the extraordinary loss and the cumulative effect of an accounting change would have been $.58. NOTE B -- RECAPITALIZATION All of the following transactions were completed on May 13, 1993 except for the August 5, 1993 conversion of Class J preferred stock and replacement of three directors. - - The Company sold the equivalent of 13,333,333 shares of the Company's common stock to an affiliate of Freeman Spogli & Co. ("Freeman Spogli") and another investor for $50 million in cash ($42.7 million after fees and expenses). The securities sold were 6,433,333 shares of common stock and 230,000 shares of a new Class J preferred stock. On August 5, 1993 all the Class J preferred stock was automatically converted into 6,900,000 shares of common stock upon the effectiveness of an amendment to the Company's Certificate of Incorporation increasing the number of authorized common shares to 60,000,000. - - Freeman Spogli and the other investor purchased from The Dyson-Kissner-Moran Corporation and WM Financial Corporation (together "DKM"), for an aggregate purchase price of $32.6 million, the following: (i) 5,636,568 shares of the Company's common stock, (ii) all 107,000 outstanding shares of the Company's Class H preferred stock, (iii) warrants to purchase 1,695,652 shares of the Company's common stock at exercise prices of $3.50 and $4.00 per share, and (iv) an option (subsequently exercised) to purchase 1,000 shares of the Company's common stock from DKM for $3.75 per share. Simultaneous with their purchase, all of the outstanding shares of Class H preferred stock were exchanged for 3,066,667 newly issued shares of the Company's common stock and the warrants were amended to provide for their exercise using a cashless exercise feature. - - Freeman Spogli sold a portion of the aforementioned securities to The IBM Retirement Plan Trust Fund (the "IBM Trust"). As a result of these transactions, Freeman Spogli owns 47.3% and the IBM Trust owns 6.6% of the total outstanding voting power of the Company, and DKM no longer owns any interest in the Company. - - Four of the 11 members of the Board of Directors were replaced by designees of Freeman Spogli. Three additional members were replaced by Freeman Spogli designees at the Company's Annual Meeting on August 5, 1993. - - The net proceeds from the equity sale were applied to (i) redeem for $4.3 million the Class B, D and E preferred stock held by DKM, (ii) repay $10 million of notes due June 30, 1994, and (iii) reduce bank credit agreement borrowings. In addition, on July 1, 1993: - - The Company sold $220 million principal amount of 9-3/4% Senior Notes for $212.4 million of net proceeds, after expenses and underwriting discounts and commissions. See Note D. Most of the proceeds were used to retire the 14% Subordinated Notes and reduce bank credit agreement borrowings to zero. - - The Company entered into a new $60 million bank credit facility to replace its then existing bank credit agreement. See Note D. - - The Company called all of its outstanding 14% Subordinated Notes for redemption, at a price of 106.2% of principal amount plus interest through the redemption date. The redemption was completed on August 2, 1993. Extraordinary Loss - - The above transactions resulted in an extraordinary loss from extinguishment of debt of $21.9 million, consisting of the unamortized debt discount and issuance costs of the retired debt and terminated bank credit agreement together with the redemption premium and other related costs for the 14% Subordinated Notes. NOTE C -- RESTRUCTURING CHARGE, NET In the fourth quarter of 1993, the Company recorded a $22 million restructuring charge, primarily to (i) terminate recycling initiatives that have not achieved profitability, (ii) discontinue efforts to obtain a hazardous waste landfill permit in Pennsylvania, and (iii) reorganize its Envirosafe and Conversion Systems units into the Treatment and Disposal Services business segment. The terminated recycling units (for the thermal treatment of electric arc steel furnace flue dust to recover zinc and for the sale of stabilized electric utility scrubber sludge for use in manufacturing concrete masonry blocks), together with Pennsylvania permitting efforts and other terminated activities, incurred 1993 operating losses and costs that reduced operating income by $3.3 million. Reorganizing into the Treatment and Disposal Services business segment has reduced staff headcount and eliminated an office that together would have cost approximately $2.8 million in 1994. In addition, the Company has taken steps to reduce its annual corporate headquarters costs by approximately $1 million. Approximately $10 million of the total restructuring charge represents anticipated non-cash losses resulting primarily from the write-off of property, plant and equipment. The charge also includes $1 million for estimated operating losses while the discontinued activities are being terminated, mostly during the first half of 1994, and the remainder represents estimated 1994 cash costs to close down operating sites, most of which will be expended in 1994. Based on progress to date, the Company expects to settle certain of the IU acquisition liabilities recorded for insurance and other matters (Note H) for less than originally anticipated. Accordingly, the Company reduced such liabilities by $3.5 million in the fourth quarter of 1993. The resulting credit to income, together with the $22 million restructuring charge, amounted to $17.6 million or $.52 per share, after taxes. NOTE D -- DEBT As part of the recapitalization (see Note B), the Company sold $220 million of 9-3/4% Senior Notes and negotiated a new bank credit facility. Most of the proceeds were used to retire $160 million principal amount of unsecured notes (effective interest rate approximately 16.4%) and reduce bank credit agreement borrowings to zero. Debt is summarized as follows (in thousands): December 31, 1993 1992 9-3/4% Senior Notes $ 220,000 1993 Equipment Loan 8,482 Debt repaid in recapitalization $ 222,800 Other 12,447 17,169 ---------- --------- 240,929 239,969 Less current maturities 5,087 4,301 ---------- --------- Long-term debt $ 235,842 $ 235,668 ========== ========= At December 31, 1993, required principal payments for each of the succeeding five years are: $5.1 million in 1994, $5 million in 1995, $4.2 million in 1996, $2.5 million in 1997 and $3.7 million in 1998. The 9-3/4% Senior Notes (10.3% effective rate including amortization of issuance costs) are due in 2003 and are redeemable, in whole or in part, at the Company's option after June 15, 1998 at 104.9% of principal amount, declining to 100% by June 15, 2001. In addition, the Company may redeem prior to June 15, 1995 up to $55 million principal amount at a price of 109.75% of principal amount with the net proceeds of an offering of capital stock (as defined). Upon a change in control (as defined), the Company must offer to purchase the Senior Notes at 101% of principal amount. The bank credit facility provides $60 million of revolving credit borrowing and letter of credit capacity, declining by $5 million on each of July 15, 1996 and 1997 and terminating on July 15, 1998. Interest on borrowings is at a bank's prime rate (6% at December 31, 1993) plus 1.5%. Outstanding letter of credit fees are at the rate of 2% per annum, and there is a .5% per annum commitment fee on the unutilized portion of the total amount. The facility is secured by accounts receivable and stock and notes of subsidiaries. At December 31, 1993, there were no revolving credit borrowings and $12.7 million of standby letters of credit were outstanding under this facility. The bank credit facility prohibits cash dividends and contains financial covenants that require the Company to meet certain financial ratios and tests. The bank facility also restricts retirements of Class G preferred stock as set forth in the next paragraph and limits 1994 capital expenditures to $42.2 million. Both the Senior Notes indenture and the bank facility contain additional restrictions customarily found in such agreements, such as limits on indebtedness and payments with respect to capital stock. The bank facility prohibits the Company from paying dividends on its Class G preferred stock, but permits the Company to redeem (including accumulated dividends) or retire shares of its Class G preferred stock with up to $5 million in cash (including borrowings thereunder) at any time. Subject to a test that requires improved financial performance, the amount of allowable Class G retirements progressively increases to a total of $35 million by July 1995. The bank facility also permits the Company to redeem shares of its Class G preferred stock with the net cash proceeds from future issuances of certain capital stock and debt. In March 1994, the Company retired 30,000 shares of Class G preferred stock for $3.4 million. Redemption of the remaining outstanding Class G preferred stock, assuming no dividends are paid earlier, would require $44.3 million in 1996. On April 6, 1993, the Company entered into a $9.5 million equipment loan that bears interest at 7.89% (11.7% effective rate) and is repayable monthly at the rate of $1.4 million per year through March 1998, with the balance due April 1, 1998. NOTE E -- REDEEMABLE PREFERRED STOCK Redeemable preferred stock includes the following (in thousands): Recorded Values December 31, Issue 1993 1992 1991 Class G $ 42,116 $ 39,526 $ 36,922 Classes B, D and E 5,148 6,500 ---------- ---------- ---------- $ 42,116 $ 44,674 $ 43,422 ========== ========== ========== At December 31, 1993, 338,580 shares of Class G preferred stock, $.25 par value per share, were outstanding, with a redemption value of $42.4 million. Each share is convertible into 7.7 shares of common stock and 2,607,066 shares are reserved for such conversions; 3,600 shares were converted in 1991. Also in 1991, pursuant to an exchange offer, 211,750 shares of Class G preferred stock were exchanged for 2,011,625 shares of common stock. In March 1994, the Company retired 30,000 shares of Class G preferred stock for $3.4 million. The Company is required to redeem, at $100 per share plus accrued dividends, the remaining 308,580 shares on July 15, 1996. Redemption of the Class G preferred stock is limited by the bank credit facility (Note D). Class G preferred stock holders are entitled to receive cumulative quarterly dividends, when declared, at the annual rate of $7.25 per share. The Company has not declared quarterly dividends that were otherwise payable beginning in October 1990, and the bank credit facility prohibits the Company from paying such dividends until 1998 (Note D). Due to dividend arrearages, the holders of the Class G preferred stock became entitled in 1992 to add two directors to the Company's Board of Directors, but have not exercised this right. The December 31, 1993 recorded value and redemption value of the Class G preferred stock both include approximately $8.6 million of cumulative and undeclared dividends. The terms of the Class G preferred stock prohibit dividends on the Company's common stock. Upon liquidation, dissolution or winding up of the Company, the holders of Class G preferred stock are entitled to receive the redemption value of their shares before any distribution in respect of the common stock. Each share of Class G preferred stock has one vote, generally voting as a single class with the shares of common stock upon all matters presented to the stockholders. NOTE F -- STOCKHOLDERS' EQUITY As part of the recapitalization (Note B), the Company issued the equivalent of 13,333,333 shares of the Company's common stock, including all 1,410,750 shares held in the treasury, and all 107,000 outstanding shares of Class H Cumulative Preferred Stock, par value $.25 per share, were exchanged for 3,066,667 shares of common stock. In 1991, 2,039,345 shares of common stock were issued in exchange for and conversion of Class G preferred stock (Note E), and 800,000 shares were issued to DKM in lieu of $2.8 million of interest payments otherwise due over the following two years on a promissory note. In 1992, 7,205,000 shares were issued to purchase the 37.5% Envirosafe minority interest (Note M). The Company issued 499,993 shares of its common stock to the noteholders in 1992 and 500,000 shares in 1991 pursuant to the terms of the Company's previously outstanding 14% Subordinated Notes, rather than purchase portions of such notes at a premium. This resulted in stockholders' equity increases of $1.8 million in 1992 and $2 million in 1991. At December 31, 1993, warrants were outstanding to purchase (i) 695,652 shares of the Company's common stock at $4 per share, expiring in 1995, and (ii) 1,000,000 shares at $3.50 per share. The number of shares purchasable under the $3.50 warrants declines by 200,000 annually on March 31, 1994 and on each January 1 thereafter. The warrants may be exercised using a cashless exercise feature (by the surrender of shares of common stock subject to the warrants). Freeman Spogli holds warrants for 87% of such shares and the IBM Trust holds 12%. In 1993, a warrant to purchase 55,555 shares of the Company's common stock was exercised at seven cents per share. Warrants to purchase an additional 244,445 shares of common stock at seven cents per share, issued in October 1991 in connection with a credit agreement amendment, remain outstanding. A total of 7,747,613 shares of the Company's common stock have been reserved for the warrants described above, for conversion of Class G preferred stock (Note E) and for stock options (Note G). Under the terms of the Senior Notes indenture and bank credit facility, the Company may not declare or pay dividends or make cash distributions to the common stockholders. The Company is authorized to issue 5.3 million shares of preferred stock, par value $.25 per share, with such terms and conditions as shall be specified by the Company's Board of Directors. NOTE G -- STOCK OPTIONS The Company maintains stock option plans that provide for grants to key employees of options to purchase up to 3,250,000 shares of the Company's common stock. Options under the plans may be incentive stock options or non-qualified stock options. The terms, conditions and numbers of shares are determined by the Compensation and Stock Option Committee of the Board of Directors. Incentive stock options may not be granted at option prices less than the fair market value of the stock at the time of grant. Non-qualified stock options may not be granted at option prices less than 50% of the fair market value at the time of grant. At December 31, 1993, 1,556,850 shares were available for grants under the plans. As a result of the February 1992 acquisition of the Envirosafe minority interest (Note M), Envirosafe's outstanding stock options became options to purchase 700,000 shares of the Company's common stock at prices ranging from $2.73 to $3.36 per share. The Company has granted four directors (who are not affiliated with Freeman Spogli) options outside the option plans to purchase 80,000 shares of the Company's common stock at option prices equal to the fair market value at the time of grant. Option activity is summarized below: Shares 1993 1992 1991 Shares under option at Jan. 1 1,511,600 1,021,100 918,100 Options granted 689,000 144,500 309,600 Envirosafe options that became EnviroSource options 700,000 Options exercised (at average exercise prices of $2.50 in 1993 and $3.05 in 1992) (5,000) (36,250) Options expired or cancelled (552,000) (317,750) (206,600) --------- --------- --------- Shares under option at Dec. 31 1,643,600 1,511,600 1,021,100 ========= ========= ========= Options exercisable at Dec. 31 618,140 957,300 454,700 ========= ========= ========= At December 31, 1993, option prices ranged from $2.13 to $8.38 per share, and averaged $4.40 per share. These options expire on various dates from January 1994 through November 2003. NOTE H - IU ACQUISITION OBLIGATIONS The Company purchased IU International Corporation ("IU") on March 21, 1988. The Company has certain ongoing obligations resulting from the IU acquisition that are unrelated to its current operations. As described further in Note O, the Company continues to make payments resulting from IU's Insurance Guarantees made in connection with its disposition of PIE in 1985. Payments of these and other IU acquisition obligations for insurance, employee benefits and other matters, reduced by proceeds from IU asset dispositions, amounted to $4.8 million in 1993, $8.1 million in 1992 and $2.4 million in 1991. During 1992 the Company obtained refunds of $16.5 million of federal income taxes paid by IU prior to its acquisition by the Company. Recovery of these pre- acquisition IU tax payments and interest thereon was anticipated in the March 21, 1988 allocation of the IU acquisition cost. Current liabilities include $11.9 million at December 31, 1993 and $17.4 million at December 31, 1992 for IU acquisition obligations for insurance and employees benefits as well as for $5 million of additional IU acquisition costs. Non-current other liabilities includes $44.6 million at December 31, 1993 and $66.2 million at December 31, 1992 for IU acquisition obligations for insurance, employee benefits and income tax matters. In 1993 IU liabilities were reduced by $22 million because these liabilities will ultimately be settled for less than the amounts anticipated in the allocation of the March 21, 1988 acquisition cost; goodwill was reduced by $18.5 million related to income taxes and $3.5 million was credited to income (Note C). Estimated future annual payments of IU acquisition obligations amount to approximately $8 million in 1994 and decline annually thereafter to less than $2 million by 1998. NOTE I -- BUSINESS SEGMENTS In 1993, the Company reorganized its business segments consistent with its restructuring (Note C). Prior periods have been restated accordingly. The Company's business segments are: Industrial Environmental Services, which provides recycling and other specialized services for the steel and aluminum industries, and Treatment and Disposal Services, which operates hazardous waste disposal landfills and provides waste stabilization services for the electric utility, steel and other industries. Information by business segment for the three years ended December 31, 1993 follows (in thousands): Industrial Treatment Environ- and Corporate mental Disposal Head- Services Services quarters Total Revenues 1993 $197,268 $ 73,758 $ 271,026 1992 178,932 53,720 232,652 1991 175,495 48,407 223,902 - ----------------------------------------------------------------- Operating income (loss) 1993 - after restructuring charge, net (Note C) $ 17,926 $ (5,269) $ (4,004) $ 8,653 Restructuring charge, net subtracted above 14,000 7,600 (3,100) 18,500 1992 25,521 8,321 (7,497) 26,345 1991 24,978 1,201 (7,234) 18,945 - ----------------------------------------------------------------- Identifiable assets 1993 $300,622 $ 111,424 $ 15,199 $ 427,245 1992 326,009 108,036 10,502 444,547 1991 322,969 101,913 25,970 450,852 - ----------------------------------------------------------------- Depreciation and amortization 1993 $ 25,960 $ 11,485 $ 2,963 $ 40,408 1992 24,139 11,478 3,286 38,903 1991 22,254 12,814 3,749 38,817 - ----------------------------------------------------------------- Capital expenditures 1993 $ 19,752 $ 12,963 $ 53 $ 32,768 1992 28,943 10,153 30 39,126 1991 22,844 2,946 34 25,824 Corporate headquarters expenses and assets support both segments but are not directly associated with either. In 1993, corporate assets consist principally of cash and cash equivalents and unamortized debt issuance costs. Industrial Environmental Services revenues of approximately $47 million in 1993, $30 million in 1992 and $25 million in 1991 were from one major steel customer. Revenues of approximately $9 million in 1993, $16 million in 1992 and $25 million in 1991 were from another major steel customer that is a 50%-owned affiliate of a company of which a member of the Company's Board of Directors was an officer until December 1992. At December 31, 1993, $19.5 million of consolidated accounts receivable result from services performed within the domestic steel industry. Foreign operations are not significant. The following table sets forth the percentage of total revenue contributed by each class of services during the three years ended December 31, 1993: 1993 1992 1991 Industrial recycling 59.4% 64.8% 65.7% Specialized services 12.0 6.8 3.5 Waste stabilization and disposal 17.2 20.2 20.1 Stabilization system design, supply and construction 10.0 2.9 1.6 Discontinued services 1.4 5.3 9.1 NOTE J -- INCOME TAXES Pursuant to Statement of Financial Accounting Standards No. 109, as of January 1, 1993 the Company adopted a new method of accounting for income taxes. Prior periods, accounted for under the provisions of Accounting Principles Board Opinion No. 11, were not restated. The cumulative effect of adopting the new method was a non-cash charge in the consolidated statement of operations of $2.3 million. The resulting $2.3 million liability was eliminated by the recognition of offsetting tax benefits associated with future tax deductible payments of liabilities recorded in connection with the 1988 IU acquisition (Note H). Because these tax benefits are attributable to deductible temporary differences that existed at the IU acquisition date, such benefits were applied to reduce goodwill. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred federal tax liabilities and assets as of December 31, 1993 are as follows (in thousands): Deferred tax liabilities: Tax over book depreciation plus IU acquisition purchase price allocation to property, plant and equipment $ (10,661) Tax over book landfill permit amortization (3,470) --------- Total deferred tax liabilities (14,131) --------- Deferred tax assets: Net operating loss carryforwards 108,291 Capital loss carryforward 1,855 Insurance accruals that will result in capital loss deductions 9,361 Other insurance accruals 4,429 Restructuring charge 7,700 Allowance for an uncollectible receivable 4,235 Pension and other post retirement benefits accruals 5,702 Closure accruals 2,866 Book over tax prospective landfill permits cost 1,733 Other accruals 5,309 --------- Total deferred tax assets 151,481 Valuation allowance for deferred tax assets (137,350) --------- Net deferred tax assets 14,131 --------- Net deferred taxes $ -0- ========= Deferred tax assets represent reductions of future tax payments that would otherwise be required when the Company reports taxable income. The $108.3 million deferred tax asset listed above represents net operating loss carryforwards of $309 million, which expire in various years and are limited by a 1993 "ownership change" as discussed in the next paragraph. The $1.9 million deferred tax asset represents a capital loss carryforward of $5 million that expires in 2008. All the carryforwards are based on the Company's consolidated federal income tax returns through 1992 and estimated return amounts for 1993. All the other deferred tax assets represent items already reflected in the financial statements that will become available to reduce future federal income taxes as they become deductible for tax purposes. The valuation allowance for deferred tax assets increased $17 million in 1993 due to additional net deferred tax assets generated in 1993 and a one percent federal tax rate increase. The $309 million of net operating loss carryforwards expire as follows: $74 million in 1996, $10 million in 1997, $147 million in 1998, $1 million in 2000, $15 million in 2003, $45 million in 2005, $11 million in 2006 and $6 million in 2008. The recapitalization described in Note B resulted in an "ownership change" (as defined in the Internal Revenue Code) that limits the future use of the net operating loss carryforwards expiring through 2006. However, the Company has estimated that at least $7 million of such tax loss carryforwards will still be available annually to offset regular taxable income through 2006. The final amount of this limitation will be affected by the resolution of various tax issues and the nature and timing of certain amounts of future income. The Internal Revenue Service has not examined the Company's tax returns for years after 1979. The effects of such examinations on the Company's tax loss carryforwards, if any, cannot currently be determined. The Internal Revenue Service is, however, precluded from assessing any taxes with respect to any year prior to 1987. A substantial portion of the deferred tax asset arising from net operating loss carryforwards originated prior to the Company's November 19, 1983 voluntary bankruptcy reorganization. In accordance with applicable accounting principles, future tax benefits associated with the pre-reorganization carryforwards will be excluded from net income (loss) and credited directly to capital in excess of par value. The resulting charges in lieu of income taxes will be reflected as income tax expense in the consolidated statements of operations, representing taxes that would be accrued if these pre-reorganization carryforwards were not available. In addition, the Company has deferred tax assets from post- reorganization tax loss carryforwards arising both from payment of IU acquisition obligations and from normal operations. Future tax benefits associated with carryforwards from payment of IU acquisition obligations will result in charges in lieu of income taxes and reductions of goodwill. Future tax benefits associated with carryforwards from normal operations will reduce income tax expense. Subject to the limitations described in the preceding paragraph, upon realization of the net deferred tax assets and liabilities, the $137.4 million valuation allowance would be applied as follows: $83.5 million would be credited to capital in excess of par value, $32.6 million would reduce goodwill and $21.3 million would reduce income tax expense. The components of income tax expense for continuing operations are as follows (in thousands): 1993 1992 1991 Current taxes: Federal $ (137) $ (426) State $ 2,280 1,158 1,371 Canadian 269 278 277 Deferred federal tax 261 --------- --------- --------- $ 2,549 $ 1,299 $ 1,483 ========= ========= ========= Consolidated income tax expense varies from amounts computed by applying the United States federal income tax rates (35% in 1993, 34% in 1992 and 1991) for the following reasons (in thousands): 1993 1992 1991 Benefit of pre-tax losses at statutory rates $ (6,659) $ (2,121) $ (5,214) Goodwill amortization 1,942 1,907 1,906 Acquisition depreciation with no tax benefit 320 332 Effect of losses added to tax loss carryforwards because tax benefit was not assured 75 3,576 Effects of increased valuation allowance for deferred tax assets 5,708 Effects of state and Canadian income taxes 1,558 837 1,087 Other 281 (204) --------- --------- --------- $ 2,549 $ 1,299 $ 1,483 ========= ========= ========= Prior to February 28, 1992, the Company owned less than 80% of Envirosafe. Accordingly, for periods prior to that date the Company did not include Envirosafe's taxable income in its consolidated federal income tax returns. The above tax effects of losses added to tax loss carryforwards are attributable to operations other than Envirosafe through February 28, 1992, and all operations thereafter. For periods prior to February 28, 1992, Envirosafe losses were carried back and used to recover Envirosafe taxes paid in previous years. In addition to Envirosafe losses reflected in the 1991 consolidated statement of operations, in 1991 Envirosafe established the tax deductibility of certain permitting costs that were incurred prior to the Company's acquisition of Envirosafe and the resulting $1 million income tax benefit was applied to reduce goodwill. Canadian income before tax amounted to $.7 million in 1993, $.6 million in 1992 and $.7 million in 1991. NOTE K -- RETIREMENT PLANS The Company has several non-contributory defined benefit pension plans covering certain salaried and hourly employees. The plans provide pension benefits that are based on varying levels of service and compensation. Assets of the plans are principally common stocks, fixed income securities and cash equivalents. Contributions are based on funding standards established by the Employee Retirement Income Security Act of 1974. Net periodic pension cost for defined benefit plans includes the following (in thousands): 1993 1992 1991 Service cost - benefits earned during the period $ 1,036 $ 1,100 $ 1,239 Interest cost on projected benefit obligations 1,458 1,456 1,516 Actual gain on plan assets (2,204) (1,792) (3,381) Net amortization and deferral 643 215 1,493 --------- --------- --------- Net periodic pension cost $ 933 $ 979 $ 867 ========= ========= ========= The funded status, calculated principally using measurement dates of October 31, 1993 and 1992, and the liability accrued in the consolidated balance sheets at December 31, 1993 and 1992 for defined benefit plans are as shown below (in thousands): December 31, 1993 1992 Actuarial present value of benefit obligations: Vested $ 17,007 $ 17,399 --------- --------- Accumulated $ 17,100 $ 17,478 --------- --------- Projected $ 18,055 $ 18,465 Plan assets at fair value 13,799 15,323 --------- --------- Projected benefit obligations in excess of plan assets 4,256 3,142 Unrecognized net loss (2,322) (2,252) Prior service gain not yet recognized in net periodic pension cost 4,629 5,008 Other 306 128 --------- --------- Pension liability, principally noncurrent $ 6,869 $ 6,026 ========= ========= The actuarial present value of projected benefit obligations was determined using discount rates of 7% in 1993 and 8.5% in 1992 and an average annual long-term rate of increase in compensation levels of 4.5% in 1993 and 6% in 1992. The expected annual long-term rate of return on plan assets used in determining net periodic pension cost was 8.5%. The Company also sponsors several defined contribution retirement plans for which contributions and costs are based on percentages of defined earnings of participating employees. Costs for these plans amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.1 million in 1991. In addition, the Company participates in defined benefit multi- employer pension plans, for which reliable information concerning the Company's share of related estimated plan benefits and assets is not available, and defined contribution multi-employer pension plans. Costs for multi-employer pension plans amounted to $1.7 million in 1993, $1.9 million in 1992 and $2.4 million in 1991. In addition to pension plans, the Company has several defined benefit postretirement plans that provide varying amounts of medical and death benefits, primarily to retired employees. Pursuant to Statement of Financial Accounting Standards No. 106 ("SFAS No. 106"), in the first quarter of 1993 the Company adopted a new method of accounting for these postretirement benefits. The cumulative effect of this accounting change is immaterial and will be recognized on a prospective basis. Under the new method, the actuarially computed 1993 cost for these plans is $.4 million, which approximates annual amounts historically recorded on a cash basis in prior years. The Company funds the postretirement benefits on a "pay-as-you-go" basis. At each of December 31, 1993 and 1992, other long-term liabilities includes approximately $5 million of accrued postretirement benefit obligations, based on discount rates of 7% in 1993 and 8.5% in 1992. Such amount, recorded in connection with the 1988 IU acquisition, approximates the accumulated postretirement obligations under SFAS No. 106. Future cost increases in health care benefits covered by the plans are assumed to be 12.5% in 1994, decreasing 1% per year to 4.5% in 2002 and remaining at that level thereafter. Increasing these rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $.3 million and would not have a material impact on the cost for 1993. NOTE L -- SUPPLEMENTAL CASH FLOW INFORMATION Amortization in the consolidated statements of cash flows includes amortization of goodwill and permits together with noncash interest costs. Net changes in working capital include the following (in thousands): 1993 1992 1991 Accounts receivable $ 1,270 $ (3,620) $ (3,942) Other current assets (1,279) 691 2,441 Trade payables and other current liabilities (1,496) (4,308) 1,740 Receivables and liabilities of a discontinued operation 3,387 205 --------- --------- --------- Cash provided (used) $ (1,505) $ (3,850) $ 444 ========= ========= ========= Closure trust fund payments include the following activity (in thousands): 1993 1992 1991 Purchases of investments $ (12,110) $ (6,270) $ (38,507) Sales of investments 6,936 4,473 36,296 --------- --------- --------- Net cash used $ (5,174) $ (1,797) $ (2,211) ========= ========= ========= Ongoing net cash flows related to IU acquisition are principally payments of non-recurring pre-acquisition obligations and in 1992 $16.5 million of income tax refunds (Note H). The Company paid interest of $30.7 million in 1993, $29 million in 1992 and $29.9 million in 1991, excluding amounts capitalized. Interest costs of $.6 million in 1993, $.8 million in 1992 and $.6 million in 1991 were capitalized. The Company paid income taxes, net of refunds, of $1.4 million in 1993 and $.8 million in 1992 and received net refunds of $.1 million in 1991. The 1992 amount excludes the aforementioned $16.5 million refunds of taxes paid by IU prior to its acquisition by the Company. In April 1991 the holder of a minority interest preferred stock exchanged it for a $20 million term loan that was part of the former bank credit agreement. NOTE M -- ENVIROSAFE Purchase of minority interest: Prior to February 28, 1992 the Company owned 62.5% of Envirosafe Services, Inc. ("Envirosafe"). On February 28, 1992, the Company purchased the 37.5% Envirosafe minority interest for a total cost of approximately $22 million, by issuing 7,205,000 shares of the Company's common stock. Pro forma net losses (unaudited), as if the transaction had occurred as of the beginning of each year, would be $7.8 million or $.51 per share in 1992 and $17.9 million or $1.04 per share in 1991. The pro forma amounts reflect the elimination of the minority interest in Envirosafe's earnings and losses, consolidated income taxes as if Envirosafe's results had been included in the Company's consolidated income tax returns and increased landfill permit and goodwill amortization. The pro forma information is not necessarily indicative of the results that would have occurred had the transaction taken place at the beginning of the respective years. Landfill development costs: Prior to July 1, 1992, depreciation of landfill development costs was determined on a cell-by-cell basis because of uncertainty as to whether the entire Ohio landfill could be used for hazardous waste. During June 1992, all opportunities for appeals opposing issuance of Envirosafe's Ohio "Part B" permit expired, enabling the Company to utilize all the remaining Ohio landfill capacity for its intended purpose as a hazardous waste landfill. Accordingly, commencing July 1, 1992, landfill development costs are being depreciated over the total remaining capacity of each landfill, which has the effect of reducing depreciation expense for Ohio cell capacity constructed prior to July 1, 1992. Lower depreciation expense in the last six months of 1992 increased 1992 operating income by $1.9 million and reduced the net loss for 1992 by $1.9 million, or $.09 per share. The impact of depreciation on a total landfill basis rather than a cell-by-cell basis prior to July 1, 1992 would not have been material. NOTE N -- FAIR VALUES OF FINANCIAL INSTRUMENTS The estimated fair values of financial instruments carried in the Company's consolidated balance sheets are as follows (in thousands): December 31, 1993 1992 Consolidated Balance Fair Carrying Fair Carrying Sheet Caption Values Amounts Values Amounts Other current assets $ 2,613 $ 2,613 $ 1,583 $ 1,583 Closure trust fund (Idaho) 8,174 8,117 6,786 6,586 Other non-current assets 4,948 5,367 2,568 2,680 Insurance 7,217 7,217 9,632 9,632 Other current liabilities 8,731 8,731 8,852 8,852 Current portion of debt and redeemable preferred stock 8,492 8,492 5,125 5,125 Other non-current liabilities 13,885 18,677 15,337 19,563 Long-term debt 230,822 235,842 253,650 235,668 Redeemable preferred stock 33,670 38,711 32,124 43,850 The fair values of financial instruments included in current assets and liabilities approximate their carrying amounts. The fair values of fixed-rate long-term debt and Class G redeemable preferred stock, which are thinly traded, are based on management's best knowledge of recent trading prices. The fair values of other non-current assets, liabilities and redeemable preferred stock are estimated using discounted cash flow analysis and borrowing rates in the Company's bank credit facility. As of December 31, 1993 the estimated fair value of the Company's obligations to deposit $24.5 million in closure trust funds over the next five years is $21.9 million, using discounted cash flow analysis and borrowing rates in the Company's bank credit facility. See Note O. NOTE O -- COMMITMENTS AND CONTINGENCIES Future minimum lease payments for non-cancelable operating leases as of December 31, 1993 amount to $4.8 million in 1994, $4 million in 1995, $3.1 million in 1996, $2.5 million in 1997, $1.7 million in 1998 and $2.4 million thereafter. Operating leases are primarily for office space and machinery and equipment. Rental expense was $6.9 million in 1993, $6 million in 1992 and $5.5 million in 1991. In January 1994, the Company purchased certain assets of an aluminum dross processor for $5 million, including $2.9 million for intangible assets. In addition, the Company has made commitments to spend $19 million in 1994 for equipment additions, a new dross processing facility and hazardous waste landfill development and treatment facilities. To secure its obligations to close its Idaho landfill and perform post-closure monitoring and maintenance procedures for 30 years, the Company must deposit into a closure trust fund approximately $1.1 million annually through 1998. The Company is also obligated to make nonrefundable payments into Ohio closure trust funds of approximately $7.6 million in each of 1994 and 1995 and $3.9 million in 1996 to fund the latter stages of Ohio landfill closure and all post-closure procedures in perpetuity. The Company believes these payments together with those previously made will satisfy substantially all of its closure and post-closure obligations, based on current regulations and permitted capacity. At December 31, 1993, the Company was contingently liable for $12.7 million of letters of credit outstanding under its bank credit agreement, approximately $5 million of which were issued to secure liabilities already reflected in the consolidated balance sheet. In connection with IU's disposition of P-I-E Nationwide, Inc. ("PIE") in 1985, IU guaranteed bonds or undertakings made to surety companies and/or states of the United States in connection with PIE's self-insurance programs for workers' compensation and other losses arising through 1987 (the "Insurance Guarantees"). During the fourth quarter of 1990, PIE commenced bankruptcy proceedings, ceased operations and ceased making payments in respect of the claims covered by the Insurance Guarantees. These obligations aggregated an estimated $18.2 million at December 31, 1993, and currently require the Company to make payments averaging $.5 million per quarter. Although the Company has the right to receive proceeds from the liquidation of various classes of PIE assets, the timing and amount of receipt, if any, cannot be predicted. However, because sufficient liabilities are reflected in the consolidated balance sheets and the Company's estimates do not assume any such liquidation proceeds, the Company's financial condition as reported at December 31, 1993 will not be adversely affected if IU receives no proceeds from such liquidation. PIE's bankruptcy has triggered withdrawal liabilities to certain multi-employer pension plans estimated by PIE to aggregate $58 million. Early in 1991 the trustee of the largest plan sought information from the Company for the stated purpose of determining whether the circumstances of IU's 1985 sale of PIE would justify a claim against IU for any deficiencies in PIE's payment of such withdrawal liabilities. However, no such claim has been asserted. The Company believes no such claim would be warranted. Also in 1991, the same pension plan trustee demanded payment of approximately $38 million from a more recent owner of most of PIE's capital stock and such owner in turn demanded an identical amount from IU. Such owner has made no attempt to pursue its demand. The Company believes the ultimate outcome of these matters will not have a material adverse effect on its financial condition or results of operations. The U.S. Environmental Protection Agency ("EPA") and applicable state agencies have issued "Part B" permits under the Resource Conservation and Recovery Act ("RCRA") to the Company's Ohio and Idaho landfills. These permits are subject to regulatory review five years after issuance and may be modified by the applicable government agencies at any time. The Company and its competitors and customers are subject to a complex, evolving array of federal, state and local environmental laws and regulations. In particular, such regulations can affect the demand for Treatment and Disposal Services, and could also require this segment to incur significant costs for such matters as facility upgrading, remediation or other corrective action and landfill closure and post-closure maintenance and monitoring. Under normal circumstances, the segment would expect to be able to absorb increased operating compliance costs by increasing prices charged to customers. On March 11, 1993, the City of Oregon, Ohio requested that the Director of the Ohio Environmental Protection Agency ("OEPA") modify or revoke the Company's Ohio landfill permit, alleging that if the Ohio Hazardous Waste Facility Board ("HWFB") had been aware of certain scientific and technical data developed by the Company, HWFB would not have approved the issuance of the permit in May 1991. On April 12, 1993, the OEPA Director determined not to modify or revoke the permit, concluding that the data in question presented no new or meaningful information in light of other data already in the record and the final design of the disposal cell authorized by the permit. On May 12, 1993, the City of Oregon filed a notice of appeal before the Ohio State Environmental Board of Review seeking review of the OEPA Director's April 12, 1993 decision. The Company is contesting this appeal vigorously. In light of the factual findings by the OEPA Director, management does not believe that the outcome of this matter will have a material adverse effect on the Company's financial condition or results of operations. In several instances the Company has been named as a potentially responsible party regarding properties that could be subject to remedial action under RCRA or the Comprehensive Environmental Response and Liability Act of 1980, as amended. As to such matters, the Company is not subject to any administrative or judicial order requiring material expenditures, and the Company has determined that it is not likely to be subject to sanctions or held responsible for material remediation expenditures. In the opinion of management, the outcome of the matters described in this paragraph will not have a material adverse effect on the Company's financial condition or results of operations. The Company is a party to litigation, proceedings and other contested matters, arising in the normal course of its present or former businesses, for which it is possible that the Company's exposure could exceed by as much as $3 million the amounts currently recorded. In the opinion of management, the amounts recorded adequately reflect the expected outcomes of such matters and the final outcome of all such matters will not have a material adverse effect on the Company's financial condition or results of operations. NOTE P -- SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (In thousands, except per share amounts) Mar. 31 June 30 Sept. 30 Dec. 31 Revenues $ 59,864 $ 77,902 $ 66,475 $ 66,785 Gross profit 14,151 18,008 13,418 16,938 Restructuring charge, net (Note C) (18,500) Operating income (loss) 5,345 8,762 5,102 (10,556) Loss before extraordinary loss and cumu- lative effect adjustment (3,195) (128) (1,136) (17,115) Net loss (5,497) (21,624) (1,570) (17,115) Loss per share before extra- ordinary loss and cumulative effect adjustment (.18) (.03) (.05) (.44) - ----------------------------------------------------------------- Revenues $ 55,312 $ 59,976 $ 60,211 $ 57,153 Gross profit 13,365 17,183 16,460 13,841 Operating income 4,605 8,884 8,900 3,956 Net income (loss) (3,878) 206 (472) (3,394) Loss per share (.26) (.03) (.06) (.19) - ----------------------------------------------------------------- The restructuring charge, net amounted to $.44 per share in the quarter ended December 31, 1993. Lower depreciation increased operating income by $1.2 million in the first quarter of 1993 and $.9 million in the second quarter of 1993 (see Note M), as compared with the corresponding 1992 quarters. Second quarter 1992 results include a $.9 million net pre-tax gain, primarily from the favorable settlement of a dispute. Third quarter 1992 results include a $1.1 million pre-tax gain from the sale of a maintenance services contract and the assets used in performing the contract. (A) As amended effective March 31, 1993, unsecured loan bearing interest at 6% per annum, half in cash and half by increasing the loan balance, and due March 31, 1998. (B) As amended effective April 1, 1993, unsecured loans bearing interest at 6% per annum, half in cash and half by increasing the interest payment loan balances, and due March 31, 1998. Classified as deductions from stockholders' equity in the consolidated balance sheet. (C) As amended effective April 1, 1993, unsecured loans bearing interest at 6% per annum, half in cash and half by increasing the loan balances, and due March 31, 1998. (A) Unsecured loan bearing interest at 7.5% per annum and payable in annual installments of $50 with the balance due March 31, 1999, except that no installment was due in 1992. (B) Unsecured loans bearing interest at 8% per annum and due January 13, 1994, classified as deductions from stockholders' equity in the consolidated balance sheet. (C) Unsecured loans bearing interest at 8% per annum and due January 13, 1994. (D) Secured loan bearing interest at 10% per annum and due upon termination of employment. The loan was forgiven $10 annually. (A) Unsecured loan bearing interest at 7.5% per annum and payable in annual installments of $50 with the balance due March 31, 1999, except that no installment was due in 1991 and 1992. (B) Unsecured loans bearing interest at 8% per annum and due January 13, 1994, classified as deductions from stockholders' equity in the consolidated balance sheet. (C) Unsecured loans bearing interest at 8% per annum and due January 13, 1994. (D) Secured loan bearing interest at 10% per annum and due upon termination of employment. The loan was forgiven $10 annually. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT EnviroSource, Inc. (Parent Company) CONDENSED BALANCE SHEET (In thousands) December 31, ASSETS 1993 1992 Current assets: Cash and cash equivalents $ 4,943 $ 3,931 Other current assets 2,670 2,879 ---------- --------- Total current assets 7,613 6,810 Investments in, net of amounts due to, consolidated subsidiaries 260,513 223,599 Goodwill, less amortization 11,838 13,435 Debt issuance costs, less amortization 7,376 Other assets 6,162 8,848 ---------- --------- $ 293,502 $ 252,692 ========== ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade payables $ 776 $ 913 Other current liabilities 11,796 15,701 Redeemable preferred stock 3,405 824 ---------- --------- Total current liabilities 15,977 17,438 Long-term debt 220,000 169,800 Other long-term obligations 4,597 1,055 Redeemable preferred stock 38,711 43,850 Commitments and contingencies (Note 4) Stockholders' equity 14,217 20,549 ---------- --------- $ 293,502 $ 252,692 ========== ========= See Notes to Condensed Financial Information of Registrant. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- Continued EnviroSource, Inc. (Parent Company) CONDENSED STATEMENT OF OPERATIONS (In thousands) December 31, 1993 1992 1991 Revenues $ 8,678 $ 9,420 $ 11,183 Management fee income from consolidated subsidiaries 102 116 160 Cost of revenues (8,784) (9,899) (10,867) General and administrative expense (8,433) (7,646) (8,392) Restructuring charge (700) Interest expense: Consolidated subsidiaries (54,586) (58,462) (77,285) Other (23,519) (25,710) (27,639) Interest income: Consolidated subsidiaries 320 720 5,258 Other 494 338 392 --------- --------- -------- (86,428) (91,123) (107,190) Income tax benefit 24,616 35,798 38,432 Equity in net income of consolidated subsidiaries 40,238 47,787 51,374 --------- --------- --------- Loss before extraordinary loss and cumulative effect of accounting change (21,574) (7,538) (17,384) Extraordinary loss from extinguishment of debt (21,930) Cumulative effect of income tax accounting change (2,302) --------- --------- --------- Net loss $ (45,806) $ (7,538) $ (17,384) ========= ========= ========= See Notes to Condensed Financial Information of Registrant. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- Continued EnviroSource, Inc. (Parent Company) CONDENSED STATEMENT OF CASH FLOWS (In thousands) Year Ended December 31, 1993 1992 1991 CASH USED BY OPERATING ACTIVITIES $ (58,321) $ (48,378) $ (65,968) --------- --------- --------- INVESTING ACTIVITIES Ongoing net cash flows related to IU acquisition (319) (1,652) (2,182) Additions to property, plant and equipment (894) (887) (429) Other (144) (1,538) (1,312) --------- --------- --------- Cash used by investing activities (1,357) (4,077) (3,923) --------- --------- --------- FINANCING ACTIVITIES Net cash from consolidated subsidiaries 1,340 53,879 68,055 Sale of common stock 42,716 111 Issuance of debt 220,000 Debt issuance costs (7,601) Debt repayments (180,000) Cash portion of extraordinary loss (10,617) Redemption of preferred stock (5,148) (1,352) Other (84) (682) --------- --------- --------- Cash provided by financing activities 60,690 52,554 67,373 --------- --------- --------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,012 99 (2,518) Cash and cash equivalents at beginning of year 3,931 3,832 6,350 --------- --------- --------- Cash and cash equivalents at end of year $ 4,943 $ 3,931 $ 3,832 ========= ========= ========= See Notes to Condensed Financial Information of Registrant. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- Continued EnviroSource, Inc. (Parent Company) NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTE 1 -- PARENT COMPANY FINANCIAL STATEMENTS Parent Company Financial Statements should be read in conjunction with the consolidated financial statements of the Company. NOTE 2 -- RECAPITALIZATION See Note B to the consolidated financial statements for a description of the recapitalization. NOTE 3 -- LONG-TERM BORROWINGS As part of the recapitalization, the Company sold $220 million of 9-3/4% Senior Notes and retired $160 million principal amount of unsecured notes (effective interest rate approximately 16.4%) and a $20 million bank term loan. See Note D to the consolidated financial statements for a description of the 9-3/4% Senior Notes. Borrowings under the bank credit agreement are made by a consolidated subsidiary and are guaranteed by the Company. The agreement permits cash transfers from the subsidiary to the Company. See Note D to the consolidated financial statements for a description of the bank credit agreement. NOTE 4 -- REDEEMABLE PREFERRED STOCK AND COMMITMENTS AND CONTINGENCIES See Notes D, E and O to the consolidated financial statements. (A) Reclassified on the consolidated balance sheet to machinery and equipment. (B) Assets of recycling units and a landfill site that were terminated as part of the 1993 restructuring. (A) Accumulated depreciation of recycling units and a landfill site that were terminated as part of the 1993 restructuring. (A) Amounts written off. EXHIBIT INDEX Number Exhibit Page 2.1 Second Modified Plan of Reorganization of the Company (incorporated herein by reference to Exhibits 1, 2 and 3 to the Company's Current Report on Form 8-K dated November 30, 1983 (File No. 1- 1363)). 2.2 Order, dated January 13, 1984, of the United States District Court for the Northern District of Ohio (modifying the Second Modified Plan of Reorganization of the Company) (incorporated herein by reference to Exhibit 2.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1983 (File No. 1- 1363)). 2.3 Agreement and Plan of Merger, dated as of November 26, 1991, by and among the Company, Envirosafe Services, Inc. and ESI Merger Co. (incorporated herein by reference to Annex A to the Joint Proxy Statement/Prospectus included in the Company's Registration Statement on Form S-4, filed on January 24, 1992 (File No. 33-45270)). 3.1 Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 (File No. 1-1363)). 3.2 Certificate of Amendment to the Certificate of Incorporation of the Company, dated February 26, 1992 (incorporated herein by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 (File No. 1- 1363)). 3.3 Certificate of Amendment to the Certificate of Incorporation of the Company, dated August 5, 1993 (incorporated herein by reference to Exhibit 4.9 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993 (File No. 1-1363)). 3.4 Certificate of Designation of Shares of Class H Cumulative Preferred Stock of the Company (incorporated herein by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1987 (File No. 1-1363)). 3.5 Certificate of Designation of Shares of Class I Cumulative Redeemable Preferred Stock, Series A, Increasing Rate of the Company (incorporated herein by reference to Exhibit 3.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1-1363)). 3.6 Certificate of Designation of Shares of Class I Cumulative Redeemable Preferred Stock, Series B, Exchangeable of the Company (incorporated herein by reference to Exhibit 3.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1-1363)). 3.7 Certificate of Designation of Shares of Class I Preferred Stock, Series C of the Company (incorporated herein by reference to Exhibit 3.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-1363)). 3.8 Certificate of Designation of the Preferences of Class J Convertible Preferred Stock of the Company (incorporated herein by reference to Exhibit 3.7 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 3.9 Certificate of Correction to the Certificate of Designation of the Preferences of Class J Convertible Preferred Stock of the Company (incorporated herein by reference to Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993 (File No. 1-1363)). 3.10 By-Laws of the Company (incorporated herein by reference to Exhibit C (pages C-1 to C-9) to the Company's Proxy Statement filed April 24, 1987, in respect of its 1987 Annual Meeting of Stockholders (File No. 1-1363)). 3.11 Amendment to the By-Laws of the Company (incorporated herein by reference to Exhibit 3.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1- 1363)). 4.1 Term Loan Agreement, dated as of December 28, 1990, between West One Bank, N.A., Imsamet of Idaho, Inc., the Company and International Mill Service, Inc. (The Company agrees to furnish a copy of such agreement to the Commission upon request). 4.2 Letter Amendment, effective January 28, 1992, to the Term Loan Agreement to which reference is made in Exhibit 4.1 to this Annual Report on Form 10-K. (The Company agrees to furnish a copy of such amendment to the Commission upon request.) 4.3 Loan and Security Agreement, dated as of April 6, 1993, between IMS Funding Corporation and Greyhound Financial Corporation. (The Company agrees to furnish a copy of such agreement to the Commission upon request.) 4.4 Indenture, dated as of July 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-3/4% Senior Notes due 2003, including the form of such Notes attached as Exhibit A thereto (incorporated herein by reference to Exhibit 4.10 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993 (File No. 1-1363)). 4.5 Registration Rights Agreement, dated as of May 13, 1993, among the Company, FS Equity Partners II, L.P., The IBM Retirement Plan Trust Fund and Enso Partners, L.P. (incorporated herein by reference to Exhibit 4.29 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 4.6 Warrants to purchase shares of Common Stock of the Company issued to FS Equity Partners II, L.P., pursuant to the Stock Purchase Agreement, dated as of April 16, 1993, among the Company, The Dyson- Kissner-Moran Corporation, WM Financial Corporation and FS Equity Partners II, L.P., as amended (incorporated herein by reference to Exhibit 4.30 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 4.7 Warrants to purchase shares of Common Stock of the Company issued to The IBM Retirement Plan Trust Fund, pursuant to the Purchase Agreement and Assignment and Assumption Agreement, dated as of May 13, 1993, among the Company, FS Equity Partners II, L.P. and The IBM Retirement Plan Trust Fund (incorporated herein by reference to Exhibit 4.31 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 4.8 Warrants to purchase shares of Common Stock of the Company issued to Enso Partners, L.P., pursuant to the Stock Purchase Agreement, dated as of May 13, 1993, among the Company, The Dyson- Kissner-Moran Corporation, WM Financial Corporation and Enso Partners, L.P. (incorporated herein by reference to Exhibit 4.32 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 4.9 Credit Agreement, dated as of June 24, 1993, among the Company, International Mill Service, Inc., the banks parties thereto, Chemical Bank, Banque Paribas and Credit Lyonnais New York Branch, as Co-Agents, and Chemical Bank, as Administrative Agent (incorporated herein by reference to Exhibit 28.3 to the Company's Current Report on Form 8-K, dated July 1, 1993 (File No. 1-1363)). 4.10 First Amendment to the Credit EXHIBIT 1 Agreement, dated as of December 23, 1993, among the Company, International Mill Service, Inc., the banks parties thereto, Chemical Bank, Banque Paribas and Credit Lyonnais New York Branch, as Co-Agents, and Chemical Bank, as Administrative Agent. 4.11 Warrants to purchase 300,000 shares of Common Stock issued to Chemical Bank, NCNB Texas National Bank, Banque Paribas, National Bank of Canada and Royal Bank of Canada (incorporated herein by reference to Exhibit 10.24 to Amendment No. 2 to the Company's Registration Statement on Form S-1, filed October 31, 1991 (File No. 33-42381)). 10.1 Restated Incentive Stock Option Plan of the Company, as amended (incorporated herein by reference to Exhibit A to the Company's Registration Statement on Form S-8, filed January 17, 1989 (File No. 33-26633)). 10.2 Stock Purchase Agreement, dated as of April 16, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and FS Equity Partners II, L.P. (incorporated herein by reference to Exhibit 4.21 to the Company's Form 8 Amendment to Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-1363)). 10.3 First Amendment to the Stock Purchase Agreement, dated as of May 13, 1993, among the Company, The Dyson-Kissner- Moran Corporation, WM Financial Corporation and FS Equity Partners II, L.P. (incorporated herein by reference to Exhibit 28.2 to the Company's Current Report on Form 8-K, dated May 27, 1993 (File No. 1-1363)). 10.4 Purchase Agreement and Assignment and Assumption Agreement, dated as of May 13, 1993, among the Company, FS Equity Partners II, L.P. and The IBM Retirement Plan Trust Fund (incorporated herein by reference to Exhibit 28.4 to the Company's Current Report on Form 8-K, dated May 27, 1993 (File No. 1-1363)). 10.5 Stock Purchase Agreement, dated as of May 13, 1993, among the Company, The Dyson-Kissner-Moran Corporation, WM Financial Corporation and Enso Partners, L.P. (incorporated herein by reference to Exhibit 28.3 to the Company's Current Report on Form 8-K, dated May 27, 1993 (File No. 1-1363)). 10.6 Promissory Note of Louis A. Guzzetti, Jr., dated March 31, 1993, amending and replacing the Promissory Notes dated October 15, 1987, March 31, 1991 and March 31, 1992 and the Letter Amendments dated April 13, 1991 and May 12, 1992, payable to the Company in the principal amount of $432,678.50 (incorporated herein by reference to Exhibit 10.13 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.7 Promissory Notes of Aarne Anderson, James H. Cornell, Jerrold I. Dolinger, George E. Fuehrer, George T. Milano and Mr. Guzzetti, dated as of April 1, 1993, amending and replacing the Promissory Notes dated January 13, 1989, April 1, 1991 and April 1, 1992, payable to the Company in the aggregate principal amount of $1,247,123.80 (incorporated herein by reference to Exhibit 10.17 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.8 Stock Option Agreement, dated March 18, 1992, between the Company and Raymond P. Caldiero (incorporated herein by reference to Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-1363)). 10.9 Stock Option Agreement, dated March 18, 1992, between the Company and Jeffrey G. Miller (incorporated herein by reference to Exhibit 10.21 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-1363)). 10.10 Amendment, dated August 5, 1993, to the Stock Option Agreement, dated March 18, 1992, between the Company and Jeffrey G. Miller, to which reference is made in Exhibit 10.9 to this Annual Report on Form 10-K (incorporated herein by reference to Exhibit 10.22 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.11 Stock Option Agreement, dated August 5, 1993, between the Company and Wallace B. Askins (incorporated herein by reference to Exhibit 10.23 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1, filed September 16, 1993 (File No. 33-46930)). 10.12 Stock Option Agreement, dated November EXHIBIT 2 1, 1993, between the Company and Arthur R. Seder, Jr. 10.13 1993 Stock Option Plan of the Company (incorporated herein by reference to Exhibit 10.21 to Amendment No. 1 to the Company's Registration Statement on Form S-1, filed June 14, 1993 (File No. 33-62050)). 21.1 Subsidiaries of the Company. EXHIBIT 3 23.1 Consent of Ernst & Young. EXHIBIT 4 23.2 Consent of KPMG Peat Marwick. EXHIBIT 5

316004_1993.txt

316004_1993

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ITEM 1. BUSINESS GENERAL DSC Communications Corporation was incorporated under the laws of the State of Delaware in 1976. As used herein, the term "Company" refers to DSC Communications Corporation and, unless the context clearly indicates otherwise, all of its subsidiaries. The Company's executive offices are located at 1000 Coit Road, Plano, Texas 75075. Its telephone number is (214) 519-3000. The Company designs, develops, manufactures, and markets digital switching, transmission, access, and private network system products for the worldwide telecommunications marketplace. These products allow telecommunications service providers to build and upgrade their networks to support a wide range of voice, data, and video services. The Company offers a comprehensive product line including digital switching systems, intelligent network products, cellular switching systems, digital loop carrier products, and digital cross-connect products. The Company develops hardware and software to meet both United States and international standards, and the specific requirements of its customers. The Company supplies products to both local exchange companies and long- distance carriers. Its customers include all seven of the Regional Bell Holding Companies ("RHCs") and most major domestic independent telephone companies, including GTE Communications Systems Corporation ("GTE"), United Telecommunications, Inc. ("United"), and Alltel Supply, Inc. ("Alltel"). The Company's long-distance carrier customers include MCI Communications Corporation ("MCI"), DDI Corporation of Japan ("DDI"), Sprint Communications Company L.P. ("Sprint"), and AAP Communications Pty Ltd. of Australia ("AAP"). The Company is also a manufacturer of high-capacity cellular switches for Motorola, Inc. ("Motorola"), a global supplier of wireless communication systems. PRODUCTS GENERAL. The Company's principal products are sophisticated microprocessor-controlled systems which incorporate advanced hardware and software technology. The Company develops such systems to meet United States and international telecommunications standards, and the specific requirements of the operating companies of the RHCs, independent telephone companies, long-distance carriers, private networks, and companies operating public and private communication networks in other countries. The percentage of consolidated revenue from the Company's product groups, which represented ten percent or more of consolidated revenue, was as follows: SWITCHING AND INTELLIGENT NETWORK PRODUCTS. The Company's switching and intelligent network products include the MegaHub product line, the Bandwidth Allocation System for Integrated Services ("BASiS"), the Integrated Broadband Service Switch ("iBSS"), cellular switching platforms, and the Company's family of digital tandem switches. The MegaHub family of products is based upon the Message Transfer Network ("MTN") architecture. The MTN architecture affords a high degree of flexibility by interconnecting clusters of independent application processors over high-speed links, using fast-packet switching technology and multifunctional software. Because of the MTN's flexible architecture, the MegaHub platform can serve as a tandem switch, a signal transfer point, a service control point, or as a platform for a variety of wideband and broadband services. One of the Company's first applications of the MegaHub technology was the MegaHub Signal Transfer Point ("MegaHub STP"), a high-capacity switching system used to route or switch signaling messages through the Common Channel Signaling System No. 7 network ("SS7"). The MegaHub STP can be used as an access facility to information services such as 700, 800, and 900 numbers and alternate billing arrangements. The Company is delivering the MegaHub STP to a majority of the major local telephone companies in the United States, including the RHCs and several of the RHCs' cellular subsidiaries, and various long-distance carriers in the United States and DDI, a long-distance competitor of Nippon Telegraph and Telephone in Japan. First introduced in 1989, the MegaHub Service Control Point (the "MegaHub SCP") combines the functionalities of the Company's MegaHub STP and standard UNIX-based computing systems. The MegaHub SCP can act as a central storehouse for information about calls and callers, and can answer network requests for such information in an expeditious manner. In 1992, the Company introduced the Programmable Advanced Intelligent Network Computing Environment (the "MegaHub PACE SCP") which builds upon the Company's initial SCP system by creating an open, state-of-the-art computing environment. The capabilities of the MegaHub PACE SCP will provide the user with extremely high transaction rates needed to support applications like credit and calling card validation and cellular fraud detection. The Company has provided the MegaHub PACE SCP to DDI; to a large independent local exchange carrier in the United States; and to Optus Communications Pty Ltd. ("Optus"), a newly-licensed competitive telecommunications service provider in Australia. In March, 1994, the Company entered into an agreement with Cable & Wireless plc, a global telecommunications carrier, who will initially deploy the MegaHub PACE SCP and related equipment in the network of its subsidiary, Mercury Communications Ltd, the first company licensed to compete against British Telecom in the United Kingdom. In 1991, the Company announced the development and testing of the BASiS switching system. BASiS is a circuit switching platform which will allow telecommunications carriers to provide their customers with bandwidth on demand. This capability will serve as the foundation for numerous high-speed applications existing in the market today, including video teleconferencing, medical imaging, high-speed facsimile transmission, local area network interconnection, and certain residential applications such as video-on-demand. The BASiS switching system will allow customer-to-customer connections at data rates ranging from 1.5Mb per second to 45Mb per second. The BASiS switching system is presently being deployed in the network of a major long-distance carrier. In addition, Bell Atlantic chose BASiS as its video switch to provide video-on-demand service for its field trial in northern Virginia. In 1992, the Company announced the development and testing of the iBSS, an Asynchronous Transfer Mode ("ATM") switching platform. The iBSS uses ATM technology to provide a multiservice platform which is designed to provide network-based applications for high-speed data, image, and video. Use of the iBSS will allow network service providers to respond more quickly to customer demands for current and evolving broadband communication services, and to meet the increasing demand for the transfer of information at rates much higher than current data services. The most likely first application of the iBSS will be in those situations, such as the interconnection of local area networks, that demand high-speed transmission rates and easy integration of data, voice, and video applications. The iBSS is currently undergoing laboratory evaluations with both local and long-distance carriers. The Company has developed a group of cellular telephone switches utilizing its tandem switching technology. The Company has supplied cellular switches to Motorola since 1985, and currently has an agreement to license software and sell equipment to Motorola on a nonexclusive basis. In July, 1993, the Company and Motorola expanded their ongoing relationship by agreeing that the Company would provide repackaged, smaller configurations of its existing cellular switching system to Motorola as an alternative to Motorola's line of older and smaller cellular switching systems. Motorola has incorporated the Company's cellular switches into cellular communications systems in the United States and in numerous other countries including, most recently, the People's Republic of China and Russia. The Company is a vendor of tandem switches to those United States and Canadian companies which compete with AT&T and Bell Canada as alternate long-distance carriers. In addition, the Company provides tandem switches to DDI and to AAP, an Australian private network provider of value added and virtual private network services. Tandem switches are generally used to route calls over long-distance networks. The MegaHub version of the tandem switch, the MegaHub 600E, was first placed into service in 1990. ACCESS PRODUCTS. The Company designs, manufactures, and sells equipment for the local loop, that portion of the public telecommunications network which extends from the local telephone company's central office switch to the individual home or business user. Such products include the Litespan-2000, which is the world's first digital loop carrier to meet North American Synchronous Optical Network ("SONET") fiber optic standards and related fiber optic interface requirements set forth by the RHCs. The Litespan-2000 allows telecommunications service providers to introduce the high-capacity technology of fiber optics into the local loop, while supporting basic services, in a cost-effective manner. The Company has entered into multi-year agreements with a majority of the seven RHCs for purchase of the Litespan-2000 system. The Company's Starspan-R- product is an optical fiber distribution system which extends the capabilities of the Litespan-2000 through fiber cables to optical network units at the customer's premises. Starspan is a cost-effective means of extending the capacity of optical fibers from the telephone company central office to cover the entire local loop. The Starspan system is currently being deployed and is carrying traffic with several RHCs. In addition to improving network reliability, fiber optic technology will be key to local service providers such as the RHCs as they expand services for business and residential users to include voice, data, and video. The Litespan- 2000 and Starspan provide high-capacity capability to transmit large amounts of voice, data, and video simultaneously to and from business or residential users. The Company believes that the introduction of multi-media services, such as video-on-demand, will increase the demand for fiber optics-based products such as the Litespan-2000 and Starspan. In 1993, the Company introduced a new product, Metrospan, which extends the capabilities of the Litespan-2000 technology base outside of the local loop. Metrospan will be used as a broadband transport system within a campus-type setting or a metropolitan communication network. Metrospan has already been selected for use by a leading Canadian utility company. During 1993, the Company developed a new product which will be called Airspan. The Airspan product, which was developed initially in cooperation with a major European carrier, will be used to connect end-user customers to central office facilities via cellular or radio connections. In November, 1993, the Company entered into a cooperative agreement with General Instrument Corporation ("GI"), a leading supplier of equipment to the cable television industry. The Company and GI have agreed to combine the Company's expertise in fiber optics and switching systems and GI's expertise in cable television equipment. The Company and GI plan to develop joint proposals for customers who need to capitalize on emerging digital video cable processing technologies for the distribution of enhanced pay-per-view, video-on-demand, interactive multimedia, and other new video services. The Company also announced in 1993 an agreement with Westell, Inc. to jointly develop systems which allow cost-effective deployment of interactive video services over existing copper wire transmission facilities. TRANSMISSION PRODUCTS. The Company's digital cross-connect systems provide switching, multiplexing, and termination of digital transmission services. The Company's various digital cross-connect products are distinguished from one another principally by the capacity which each system handles. Digital cross-connect products are widely deployed in the United States by the RHCs, long-distance carriers, independent local exchange carriers, and a number of large corporations. In 1992, the Company announced the development and testing of a major new transmission platform, the Integrated Multi-Rate Transport Node ("iMTN"). Building on the Company's experience with digital cross-connect systems, the iMTN will provide for the public telecommunications network's evolution to SONET-based transmission and the deployment of automated administration functions. The iMTN will enable network service providers to offer their customers, on an integrated basis, narrowband services such as voice communications, high-speed wideband data services, and broadband services such as video-on-demand. The iMTN has been designed to meet the interconnectivity requirements of SONET in North America, SDH/CCITT in Europe, and the unique standards of Japan. In 1993, the Company entered into an agreement to supply the iMTN to carriers in both the local and long-distance marketplace. MCI, one of the carriers with whom an agreement was signed, is expected to use the iMTN to support SONET-based broadband and wideband network requirements. The Company also develops, manufactures, and markets a variety of digital transmission products such as echo cancellers and transcoders. CUSTOMER PREMISE PRODUCTS. The Company's customer premise products allow service providers and corporate customers with high-capacity networks to transport multiple types of data, voice, and video traffic over public and private network facilities. The Company develops, manufactures, and sells a complete line of T1/E1 multiplexers which have been sold to private and public network service providers throughout the world. In 1993, the Company introduced the iMPAX line of products. The iMPAX product will serve as the Company's next generation multiservice platform. The iMPAX will support voice circuits, frame relay, and cell-based ATM traffic. The iMPAX can be deployed in a telephone company central office, at the site of an independent service provider, or on the premises of an end user. Use of the iMPAX will give service providers access to network elements through which they can offer new wideband and broadband services such as LAN-to-LAN internetworking, video conferencing, and supercomputer connectivity. REGULATION The telecommunications industry is subject to regulation in the United States and other countries. Federal and state regulatory agencies, including the Federal Communications Commission ("FCC") and the various state Public Utility Commissions ("PUCs") and Public Service Commissions ("PSCs"), regulate most of the Company's domestic customers. In addition, the RHCs are restricted by the terms of the Modified Final Judgment which resulted from the court-ordered divestiture of the RHCs by AT&T, and currently prohibits the RHCs from manufacturing telecommunications equipment and providing interexchange or long-distance services. Legislation has been introduced which would lift these restrictions on manufacturing and interexchange services. Should this legislation be enacted, the Company cannot predict the impact on its business, although it is possible that passage of legislation allowing the RHCs to manufacture telecommunications equipment could create additional competition in the markets addressed by the Company's products. In addition, the FCC and a majority of the states have enacted or are considering regulations based upon alternative pricing methods. Under traditional rate of return pricing, telecommunications service providers were limited to a stated percentage profit on their investment. Under the new method of pricing, many PUCs have entered into agreements with the local exchange carriers where the PUCs have relaxed or eliminated the profit cap in return for the carrier's promise to reduce or hold service prices at current levels. In some states, the PUCs and the carriers have further agreed, in order to win relaxation of profit limits, that the carriers would invest large sums to further upgrade the digital and optical capabilities of the network. The Company believes that the new methods of price regulation could increase the demand for its products which enhance the efficiency of the network or allow the expedited introduction of new revenue-producing services. Outside the United States, telecommunications networks are primarily owned by the government or are strictly regulated by the government. Although potential growth rates of some international markets are higher than those of the United States, access to such markets is often difficult due to the established relationship between the government owned or controlled telecommunications operating company and its traditional indigenous suppliers of telecommunications equipment. However, there has been a global trend towards privatization and deregulation of the state-owned telecommunications operations. This trend has found favor in the industrialized world, the emerging markets of the newly-industrialized countries, and various developing market countries which want to both capitalize on the value of the existing network and promote the development of the telecommunications network as an integral part of the economic infrastructure. The Company believes that the current trend of privatization and deregulation will continue, and that such trend could provide the Company with additional international opportunities. MARKETING The Company sells products and services on a domestic and international basis to both the public and private network markets through various sales and distribution channels. The Company's internal sales group is a direct sales force, divided into market business segments. The Company also sells through third-party distributors such as original equipment manufacturers ("OEMs") and sales representatives. In 1993, the Company entered into separate agreements with Nokia Telecommunications Oy of Finland ("Nokia") and a European subsidiary of Northern Telecom Ltd. ("Northern") to distribute the iMTN. The agreement with Nokia, a leading worldwide supplier of wireless communications systems, will allow Nokia to market the iMTN on a nonexclusive basis in Scandinavia and certain other countries. The agreement with Northern grants the European subsidiary of Northern the exclusive right to market the iMTN system in certain European countries and a nonexclusive right to market the iMTN system in certain other countries. INTERNATIONAL OPERATIONS AND MAJOR CUSTOMERS Revenue generated from export sales in 1991 was $48,012,000. Revenue generated from export sales was less than ten percent of consolidated revenue in 1993 and 1992. Revenue and assets of the Company's foreign operations for those same periods were less than ten percent of the Company's consolidated revenue and total assets, respectively. For the year ended December 31, 1993, MCI, Ameritech, Motorola, Bell Atlantic, and NYNEX accounted for 18 percent, 13 percent, 12 percent, 11 percent, and 11 percent, respectively, of the Company's consolidated revenue. The termination or material reduction of the purchases of the Company's products by any of the above-named companies could have a material effect on the Company. BACKLOG The Company's backlog, calculated as the aggregate of the sales price of orders received from customers less revenue recognized, was approximately $320,000,000 and $200,000,000 on December 31, 1993 and December 31, 1992, respectively. Approximately $70,000,000 of orders included in the December 31, 1993 backlog are scheduled for delivery after December 31, 1994. However, all orders are subject to possible rescheduling by customers. While the Company believes that the orders included in the backlog are firm, some orders may be cancelled by the customer without penalty, and the Company may elect to permit cancellation of orders without penalty where management believes that it is in the Company's best interest to do so. RESEARCH AND PRODUCT DEVELOPMENT The industry in which the Company operates is characterized by rapidly- changing technological and market conditions which may shorten product life cycles. The Company's future competitive position will depend not only upon successful production and sales of its existing products, but also upon its ability to develop and produce, on a timely basis, new products to meet existing and anticipated industry demands. The Company is currently engaged in the development of several new products, including the iMTN and the iBSS. During the product development process, the Company invests a substantial amount of resources in products which often require extensive field testing and evaluation prior to actual sales to its customers. The Company's research and product development costs charged to expense were $86,620,000, $68,303,000, and $63,842,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Additionally, approximately $21,947,000, $18,097,000, and $22,793,000 of software development costs were capitalized in the Consolidated Balance Sheets in 1993, 1992, and 1991, respectively. COMPETITION The segments of the telecommunications industry in which the Company competes are intensely competitive and are characterized by continual advances in technology. The Company believes that it enjoys a strong competitive position due to its large installed base, its strong relationship with key customers, and its technological leadership and new product development capabilities. However, many of the Company's foreign and domestic competitors have more extensive engineering, manufacturing, marketing, financial, and personnel resources than those of the Company. The Company's ability to compete is dependent upon several factors, including product features, innovation, quality, reliability, service support, price, and the retention and attraction of qualified design and development personnel. Due to its breadth of product offerings, the Company has different competitors in each of the markets which it serves. The Company's primary competitors in the tandem switching and intelligent network markets are AT&T and Northern. In the ATM switching market, AT&T and Fujitsu, Ltd. ("Fujitsu") are the Company's primary competitors. The Company's primary competitors in the digital cross-connect market are AT&T, Alcatel Network Systems, and Tellabs, Inc. The Company's primary competitors in the access market are AT&T, R-TEC, a wholly-owned subsidiary of Reliance Electric Co., and Fujitsu. MANUFACTURING AND SUPPLIERS The Company generally uses standard parts and components for its products, and believes that, in most cases, there are a number of alternative, qualified vendors for most of those parts and components. The Company purchases certain custom components and products from single suppliers. The Company believes that the manufacturers of the particular custom components and products should be able to meet expected future demands. Although the Company has not experienced any material adverse effects from the inability to obtain timely delivery of needed components, an unanticipated failure of any significant supplier to meet the Company's requirements for an extended period, or an interruption of the Company's ability to secure comparable components could have an adverse effect on the Company's revenues and profitability. In addition, the Company's products contain a number of subsystems or components acquired from other manufacturers on an OEM basis. These OEM products are often available only from a limited number of manufacturers. In the event that an OEM product was no longer available from a current OEM vendor, second sourcing would be required and could delay customer deliveries which could have an adverse effect on the Company's revenues and profitability. PATENTS AND PROTECTION OF OTHER PROPRIETARY INFORMATION The Company has been awarded patents and has patent applications pending in the United States and certain foreign countries. There can be no assurance that any of these applications will result in the award of a patent, or that the Company would be successful in defending its patent rights in any subsequent infringement actions. Because of the existence of a large number of third-party patents in the telecommunications field and the rapid rate of issuance of new patents, some of the Company's products, or the use thereof, could infringe third-party patents. If any such infringement exists, the Company believes that, based upon historical industry practice, it or its customers should be able to obtain any necessary licenses or rights under such patents upon terms which would not be materially adverse to the Company. In addition to the patent protection described above, the Company protects its software through contractual arrangements with its customers and through copyright protection procedures. ENVIRONMENTAL AFFAIRS The Company's manufacturing operations are subject to numerous federal, state, and local laws and regulations designed to protect the environment. Compliance with these laws and regulations has not had, and is not expected to have, a material effect upon the capital expenditures, earnings, or the competitive position of the Company. EMPLOYEES As of December 31, 1993, the Company had a total of 4,041 employees. The Company is not a party to any collective bargaining agreement. ITEM 2. ITEM 2. PROPERTIES The Company owns two buildings and approximately 250 acres of land in Plano, Texas, of which 148 acres were acquired in 1994. One of the buildings is a 282,000 square foot office building. The other building is a 421,000 square foot manufacturing and assembly facility. As of December 31, 1993, the Company had under lease approximately 949,280 square feet of office, manufacturing, and warehouse space in suburban Dallas, Texas; Santa Clara, California; Petaluma, California; and Aguadilla, Puerto Rico under leases expiring between September 30, 1994 and September 30, 2002. Subsequent to December 31, 1993, the Company entered into a lease for approximately 65,000 square feet of office space in Feltham, England expiring on March 25, 2004, which replaced a lease in Weybridge, England for 10,000 square feet expiring March 31, 1994. The Company also has under lease smaller facilities, including sales offices, in the United States, Canada, Japan, Australia, Singapore, and Taiwan, with leases expiring between June 30, 1994 and June 30, 2002. The Company believes that the above-described facilities are suitable and adequate to meet the Company's production requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In July, 1991, three complaints were filed in the United States District Court for the Northern District of Texas by three individuals on behalf of themselves and, purportedly, on behalf of an alleged class of persons who purchased common stock of the Company during the period from February 7, 1991 through July 9, 1991. Named as defendants in these actions are the Company, two of the Company's principal officers, and a former principal officer of the Company. In December, 1991, four plaintiffs, including each of the three original plaintiffs, filed a Consolidated Complaint (the "Consolidated Complaint") in the United States District Court for the Northern District of Texas against the Company and six individuals, each of whom is either a present or former officer of the Company, including two present directors and one former director. The Consolidated Complaint amends and consolidates the three original complaints and purports to be a class action on behalf of an alleged class of persons who purchased common stock of the Company during the period from February 7, 1991 through October 31, 1991. The Consolidated Complaint alleges violations of Sections 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and negligent misrepresentation as a result of alleged misrepresentations and omissions with respect to information contained in press releases, reports to the Company's shareholders, and certain filings and periodic reports filed with the Securities and Exchange Commission by the Company. The plaintiffs allege that the Company made certain misleading statements regarding the quality and reliability of its products and the Company's financial condition and its prospects. The Consolidated Complaint seeks actual and punitive damages in unspecified amounts, prejudgment interest, and attorneys' fees. On February 3, 1992, the Company filed a motion with the Court seeking dismissal of the complaint. In March, 1993, the Court dismissed the Consolidated Complaint without prejudice. On February 25, 1994, the United States Fifth Circuit Court of Appeals affirmed the Court's decision to dismiss the Consolidated Complaint. The plaintiffs filed a petition for a rehearing on March 25, 1994. On January 26, 1994, C. L. Grimes, a shareholder of the Company, filed a suit in Delaware Chancery Court, derivatively purportedly on behalf of the Company as the real party in interest and as a shareholder of the Company, seeking a declaration that the Employment Agreement of James L. Donald, his Executive Income Continuation Plan, and the 1990 Long-Term Incentive Compensation Plan, as it applies to Mr. Donald and all other benefits of Mr. Donald, including previously-granted Company stock options, are null and void. The defendants in the suit are Mr. Donald, all current non-employee directors, and two former directors of the Company. The Company itself is a nominal defendant. The plaintiff contends that Mr. Donald's employment contract contains an improper delegation of the Board of Directors' authority to Mr. Donald and excess payments. The suit also contends that the salary and benefits established for Mr. Donald pursuant to the Donald agreements referred to above and by the Company's Board of Directors are excessive and constitute a diversion and waste of corporate assets. The suit seeks an injunction restraining Mr. Donald from exercising any stock options, taking any action to implement any of the Donald agreements, or declaring a constructive termination of his employment, and also seeks unspecified damages against the defendants and Grimes' legal fees. The individual defendants will file a responsive pleading and intend to vigorously contest Grimes' claims. On July 20, 1993, the Company filed suit against Advanced Fibre Communications ("AFC"), a California corporation; Quadrium Corporation ("Quadrium"), a California corporation; Alan E. Negrin ("Negrin"); and Henri Sulzer ("Sulzer") in the United States District Court for the Eastern District of Texas, Marshall Division, Civil Action No. 2-93CV126. The Company seeks a declaratory judgment that Negrin and Sulzer are not entitled to any stock options or cash payments under the Company's 1990 Stock Option and Cash Payment Plan because of these defendants' alleged breaches of certain employment-related agreements entered into with the Company. The Company further seeks a declaration that AFC's products, including the UMC 1000 digital loop carrier, are the proprietary property of the Company under the terms of certain Proprietary Information Agreements and certain Consulting Agreements with Quadrium. The Company also seeks unspecified damages for breach of contract, civil conspiracy, and tortious interference. The individual defendants have both filed counterclaims whereby they claim entitlement to certain stock options and cash payments under several of the Company's stock option plans. AFC has also filed a counterclaim alleging that the Company has violated the Sherman Antitrust Act and a California statutory antitrust act known as the Cartwright Act. AFC further claims that the Company has (a) tortiously interfered with existing and prospective contractual relationships, (b) committed industrial espionage and misappropriation, (c) trespassed on AFC's business premises, (d) converted certain property of AFC, and (e) committed unfair competition. AFC also seeks a declaratory judgment that it owns all rights to its product, the UMC Digital Loop Carrier. AFC asks the court to award unspecified actual damages, treble damages under the antitrust statutes, punitive damages, injunctive relief, and attorneys' fees. Although the outcome of litigation is inherently uncertain, the Company believes that it has valid and substantial claims against all of the defendants and valid defenses to all of the counterclaims. The case is in the early stages of discovery, and the Company intends to vigorously prosecute its claims and defend all of the defendants' counterclaims. The Company does not believe that the ultimate resolution of any of these suits will have a material adverse effect on its consolidated financial position. The Company is also a party to other legal proceedings which, in the opinion of management, are not expected to have a material adverse effect on the Company's consolidated financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Executive officers are elected annually and serve at the pleasure of the Board of Directors. No family relationships exist among the executive officers of the Company. As of March 1, 1994, the executive officers of the Company are as follows: Allen R. Adams joined the Company in 1979, as Director of Hardware and Systems Development. Since 1979, Mr. Adams has held a variety of project and design engineering positions. In May, 1991, Mr. Adams was elected Vice President. Mr. Adams was elected Senior Vice President in February, 1993. Wylie D. Basham was named to the position of Vice President, Transmission Products Division in 1993. Mr. Basham has held a variety of management positions since joining the Company in 1983. Michael R. Bernique joined the Company in 1989, as Vice President, Sales. Since joining the Company, Mr. Bernique has held a number of management positions. In 1993, Mr. Bernique was named to the position of Senior Vice President, North American Sales. John W. Bischoff joined the Company in 1989, as Vice President, Quality and Reliability Assurance. David T. Boyce joined the Company in 1989, as Managing Director, DSC Communications (Europe) Limited. In March, 1992, Mr. Boyce was named to the position of Vice President, International Sales and Service. Gerald G. Carlton joined the Company in 1988, as Vice President, Administration, responsible for all of the Company's national and international human resource functions and corporate facilities management activities. Robert W. Clark has held a variety of positions since joining the Company in 1982, including Vice President, Program Management. In 1991, Mr. Clark was named to the position of Vice President, Customer Service. James L. Donald became President and a director of the Company in March, 1981. He was elected Chief Executive Officer in August, 1981. Mr. Donald was elected Chairman of the Company's Board of Directors in 1989. Daryl J. Eigen joined the Company in 1993, as Vice President, Corporate Marketing and Planning. Prior to joining the Company, Mr. Eigen was employed by Siemens Stromberg-Carlson since 1984, where his most recent position was that of Vice President, Central Region. John H. Montgomery joined the Company as Vice President, Customer Premises Products in 1990, when the Company acquired Integrated Telecom Corporation ("Integrated"). Since 1988, Mr. Montgomery served as President of Integrated. From 1981 through 1987, Mr. Montgomery was employed by the Company in various senior management capacities. Gerald F. Montry joined the Company in 1986, as Senior Vice President and Chief Financial Officer. In 1989, Mr. Montry was elected to the Company's Board of Directors. William R. Tempest joined the Company in October, 1982, as General Counsel. He was elected Secretary of the Company in December, 1982, and Vice President in 1986. Hensley E. West joined the Company in 1987, as Vice President, Sales. Since joining the Company, Mr. West has held a variety of management positions, including his present position as Senior Vice President, Access Products Division. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock prices are listed daily in THE WALL STREET JOURNAL and other publications under the NASDAQ National Market System of the over-the-counter listing with the abbreviation "DSC Commun" or "DSC". The stock is traded in the NASDAQ National Market System with the ticker symbol "DIGI". The following were the high and low close prices of the Company's stock per the NASDAQ National Market System: The Company has not paid or declared any cash dividends on the common stock since its organization. The closing price of the Company's common stock on March 1, 1994, was $53.125 per share. As of December 31, 1993, there were 3,462 shareholders of record of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) ITEM 6. SELECTED FINANCIAL DATA (Continued) (Dollars in thousands, except per share data) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In 1993, DSC Communications Corporation achieved record revenue levels, a strong operating performance, and ended 1993 with a significantly improved financial position. Revenue grew 36%, while net income increased to $81.7 million, or $1.53 per share, compared to net income of $11.6 million, or $0.25 per share, in 1992. Cash and marketable securities grew to over $313 million at the end of 1993, and debt as a percentage of shareholders' equity declined to 11.4% from 69.3% at the end of 1992. FINANCIAL CONDITION AND LIQUIDITY The Company ended 1993 and 1992 with the following: Two major transactions in 1993 significantly impacted the Company's financial condition and enhanced its long-term liquidity. The Company sold 3.5 million shares of its common stock in a public offering which generated $231.1 million in cash. In addition, the $71.5 million of outstanding 7 3/4% subordinated convertible debentures were converted into 3.8 million shares of common stock. Cash of $79.3 million was also generated from operating activities. Income, before depreciation and amortization, exceeded receivable and inventory growth of $72.0 million, while non-debt current liabilities did not change significantly during 1993. Receivables and inventory grew as business levels increased. Inventory velocity improved to approximately four turns by the end of 1993. Capital expenditures were $71.0 million during 1993. The Company's business expansion during 1993 and expected future domestic and international growth have and will continue to increase capital requirements including facilities, and manufacturing and development equipment and software. As a result of this expected business expansion, it is anticipated that 1994 capital requirements should substantially exceed 1993 capital expenditures. In February 1994, the Company acquired 148 acres of land for approximately $16.4 million. This acreage, along with 42 acres acquired in late 1993, is located near the Company's present campus location and will be used for future building expansion. The timing and extent of building expansion will be dependent on future business growth. The Company's commitment to research and product development continued in 1993 with $86.6 million expensed for research and product development costs and $21.9 million capitalized as software development costs. These costs are primarily related to expenditures for various new products which are expected to contribute to revenue in future periods. In addition to the sale of stock to the public, other financing activities included $20.1 million of proceeds from the issuance of common stock under employee stock plans, additional secured borrowings of $20.1 million, and scheduled payments under existing loan agreements of $18.5 million. Scheduled long-term debt maturities for the three years ending December 31, 1996 are $13.7 million, $11.1 million, and $9.2 million, respectively. The Company periodically finances facilities and equipment requirements under operating leases. At December 31, 1993, operating lease obligations were $62.8 million, of which scheduled lease payments for 1994 - 1996 were $17.7 million, $13.7 million and $8.9 million, respectively. In February 1994, the Company entered into a new unsecured revolving credit agreement providing for borrowings up to $50.0 million, reduced by the amount of outstanding letters of credit not to exceed $25.0 million. The new agreement expires in February 1997. See "Credit Agreements" in Notes to Consolidated Financial Statements. The new agreement replaces a $22.5 million credit agreement which was secured by domestic receivables and inventories and expired on February 28, 1994. The Company had no borrowings under existing credit agreements during 1993. In January 1994, the Company called for redemption of all of its $36.4 million outstanding 8% subordinated convertible debentures. As a result, in February 1994, debenture holders converted approximately $34.7 million of debentures into approximately 637,000 shares of the Company's common stock and redeemed approximately $1.7 million for cash. The Company believes that it has the financial resources required to support its expected business growth, including working capital expansion, necessary capital expenditure requirements, operating lease obligations, and scheduled debt payments. The Company is a party to certain litigation, as discussed in "Commitments and Contingencies" in Notes to Consolidated Financial Statements, the outcome of which the Company believes will not have a material adverse effect on its consolidated financial position. RESULTS OF OPERATIONS 1993 Compared to 1992 Revenue for 1993 increased 36% to $730.8 million compared to $536.3 million in 1992. Net income was $81.7 million, or $1.53 per share, compared to a net income of $11.6 million, or $0.25 per share, for the year ended December 31, 1992. The Company's 1993 revenue growth was due to a higher volume of switching and access product shipments. Switching products revenue increased 13% over 1992 and represented 45% of consolidated revenue compared to 54% in 1992. The increase in switching products revenue was due, in part, to a higher volume of hardware and software deliveries for customer expansion and upgrades of existing switching systems. This more than offset a reduction in signal transfer point (STP) system product deliveries from the volume achieved in 1992 when several domestic customers populated their networks with the Company's STP's. Access products revenue accounted for approximately 28% of consolidated revenue in 1993 compared to 8% in 1992 as the Company began delivery on several major customer orders received in 1992 and 1993. While the access products group achieved profitability in the last half of 1993, a loss was recorded for the full year. Future profitability will be dependent upon product mix, cost reduction activities, and economies and benefits from continued higher levels of customer deliveries. As a result, the Company believes that as deliveries of access products continue to increase, and as further cost reduction activities are successful, the Company's operating performance will be favorably impacted in the future. Revenue of transmission products grew slightly in 1993 over 1992 and represented 19% of 1993 revenue compared to 24% of 1992 revenue. Cost of revenue of $412.8 million in 1993 represented 56.5% of total revenue, compared to 62.2% in 1992. The Company benefited from cost reduction activities, increased operating efficiencies, and production efficiencies due to the higher business volumes, while the higher volume of lower margin access products revenue impacted product cost as a percentage of revenue. Certain of the Company's products typically produce gross margin content greater than other Company products. As a result, shifts in the product mix of the Company's consolidated revenue in the future could impact gross margin as a percentage of revenue. Research and product development expenses increased in 1993 to $86.6 million, or 11.9% of revenue, compared to $68.3 million in 1992, or 12.7% of revenue. This increase reflects the Company's continued commitment to the development of new products which are targeted to high growth markets. Selling, general and administrative expenses were $112.7 million in 1993, or 15.4% of revenue, compared to $87.0 million, or 16.2% of revenue, in 1992. The higher expense level reflects increased domestic and international selling and marketing activities, expansion of the Company's customer base and an increased level of incentive compensation. See "Incentive Compensation" in the Notes to Consolidated Financial Statements for further information. Interest expense declined $15.1 million in 1993 compared to the 1992 period. This reduction was due to the repayment of over $134.0 million of senior unsecured debt during the last half of 1992 and conversion of $71.5 million of 7 3/4% subordinated convertible debentures into approximately 3.8 million shares of the Company's common stock during the 1993 first quarter. Other expense, net in 1993 declined by $8.2 million from $8.3 million in 1992. The 1993 amount includes a $2.2 million gain from the sale of securities acquired several years ago as part of financing provided to a customer. The 1992 amount included provisions for litigation, senior unsecured debt restructuring costs, certain facilities costs and higher cash discounts taken by customers in the first half of 1992 for early payment on receivables. The Company's effective income tax rate was 25% for the year ended December 31, 1993. See "Income Taxes" in Notes to Consolidated Financial Statements for further information. As discussed in Financial Condition and Liquidity above, the Company issued approximately 3.5 million shares of common stock in a public offering in October 1993, which will increase the amount of weighted average shares outstanding used to compute earnings per share in 1994. Until required to support expected future business growth, the proceeds from the public offering are expected to be invested in interest bearing marketable securities which will increase interest income in the future. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions." The implementation of this standard had no financial impact to the Company since post retirement benefits currently provided are reimbursed by the retirees. 1992 Compared to 1991 The Company's 1992 operating results reflect significant improvement in operating performance. Overall, revenue for 1992 increased 16% to $536.3 million compared to $461.5 million in 1991. Net income was $11.6 million, or $0.25 per share, compared to a net loss of $108.3 million, or $2.62 per share, in 1991. The results for the year ended December 31, 1991 included non-cash charges of (i) approximately $48.1 million related primarily to a write-down of assets, provision for doubtful receivables, and restructuring and consolidation costs and (ii) approximately $7.0 million of charges (included in costs of revenue) relating primarily to excess and obsolete inventory. The Company's 1992 revenue growth was due to a higher volume of switching products and an increase in shipments of access products. Switching revenue represents 54% of consolidated revenue in 1992 compared to 49% of consolidated revenue in 1991. The significant increase in switching revenue was in part due to increased shipments of signal transfer points (STP's) including a growth in software revenue, partially offset by a lower volume of certain tandem products. Deliveries of STP's in 1991 were unfavorably impacted by a number of factors, including service outages experienced by certain customers. Revenue of transmission products represented 24% of 1992 revenue compared to 29% of 1991 revenue. Access products revenue accounted for approximately 8% of consolidated revenue in 1992 compared to 3% in 1991 with substantial volume increases during the last half of 1992. While shipments have increased, the access products division did not have the volumes necessary in 1992 to achieve profitability. Cost of revenue of $333.5 million in 1992 represented 62.2% of total revenue, compared to 73.3% in 1991. The 1992 improvement was due to increased deliveries of higher margin switching products, including a larger component of software revenue, higher production levels which lowered fixed costs as a percentage of revenue, cost reductions and increased operating efficiencies. Research and product development expenses increased in 1992 to $68.3 million, or 12.7% of revenue, compared to $63.8 million in 1991, or 13.8% of revenue. Selling, general and administrative expenses were $87.0 million in 1992 or 16.2% of revenue compared to $88.6 million or 19.2% of revenue in 1991. The decrease is primarily due to the impact of the Company's 1991 actions to improve operating efficiency and reduce costs. Other operating costs in 1992 were $5.1 million as compared to $4.4 million in 1991, exclusive of the $48.1 million of special charges recorded in 1991. Interest expense of $21.3 million declined $4.1 million from 1991 due to an overall decline in the average outstanding borrowings and a decline in the average cost of borrowing. Other expense, net, of $8.3 million in 1992 increased by $4.7 million from $3.6 million in 1991 primarily as a result of provisions recorded in 1992 for litigation, senior unsecured debt restructuring costs and certain idled facilities costs. In addition, higher cash discounts taken by customers, primarily in the first half of 1992, for early payments on receivables increased other expense, net, in 1992. See "Other expense, net" in Notes to Consolidated Financial Statements. See "Income Taxes" in Notes to Consolidated Financial Statements for further information relating to income taxes. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries CONSOLIDATED BALANCE SHEETS (In thousands) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Continued) DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (In thousands) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation DSC Communications Corporation (the "Company") is a leading designer, developer, manufacturer and marketer of digital switching, transmission, access and private network system products for the worldwide telecommunications marketplace. The consolidated financial statements of the Company include the accounts of the Company and all its majority-owned subsidiaries. All significant intercompany transactions and balances are eliminated. Certain prior years' financial statement information has been reclassified to conform with the current year financial statement presentation. Revenue Recognition Revenue is generally recognized when the Company has completed substantially all manufacturing and/or software development to customer specifications, factory testing has been completed and the product has been shipped. Additionally, for systems where installation requirements are the responsibility of the Company and payment terms are related to installation completion, revenue is generally recognized when the system has been shipped to the customer's final site for installation. Revenue under contracts with customers for development and customization of software is accounted for using the percentage-of-completion method as certain contracted milestones are completed. Revenue from technical assistance service contracts is recognized ratably over the period the services are performed. The Company establishes an allowance for potential returns pending completion of customer product acceptance and payment. Warranty Costs The Company provides for estimated future warranty costs at the time revenue is recognized. Cash and Cash Equivalents Cash equivalents are primarily short-term, interest bearing, high credit quality investments with major financial institutions and are subject to minimal risk. These investments have maturities at the date of purchase of three months or less (see "Investments in Debt and Equity Securities"). Investments in Debt and Equity Securities The Company has elected to adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115), in 1993. In accordance with FAS 115, prior years' financial statements have not been restated to reflect the change in accounting method. There was no cumulative effect as a result of adopting FAS 115 in 1993. Management determines the appropriate classification of its investments in debt and equity securities at the time of purchase and reevaluates such determination at each balance sheet date. Debt securities for which the Company does not have the intent or ability to hold to maturity are classified as available for sale, along with the Company's investment in equity securities. Securities available for sale are carried at fair value, with the unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. At December 31, 1993, the Company had no investments that qualified as trading or held to maturity. The amortized cost of debt securities classified as available for sale is adjusted for amortization of premiums and accretion of discounts to maturity or, in the case of mortgage-backed securities, over the estimated life of the security. Such amortization and interest are included in interest income. Realized gains and losses are included in other income or expense. The cost of securities sold is based on the specific identification method. At December 31, 1993, the Company's investments in debt and equity securities were classified as cash and cash equivalents and marketable securities. These investments are diversified among high credit quality securities in accordance with the Company's investment policy. Inventories Inventories are valued at the lower of average cost or market. Inventories consisted of the following (in thousands): Contract Development Costs Costs incurred in the development of software and hardware which pertain to specific contracts with customers are capitalized at the lower of cost or net realizable value and charged to cost of revenue when the related revenue is recognized. Property and Equipment Property and equipment are recorded at cost and depreciated on a straight-line basis over their estimated useful lives as follows: Capital leases and equipment leased to customers under operating leases are amortized on a straight-line basis over the term of the lease. Amortization of these leases is included in depreciation expense. Capitalized Interest Interest costs related to certain qualifying assets (primarily capitalized software development costs) are capitalized during their construction or development period and amortized over the economic life of the related assets. For the years ended December 31, 1993, 1992 and 1991, the Company capitalized $895,000, $1,112,000 and $725,000, respectively, of such interest costs. Cost in Excess of Net Assets of Businesses Acquired, Net Cost in excess of net assets of businesses acquired generally is amortized on a straight-line basis over its estimated life. The Company periodically reviews the original assumptions and rationale utilized in the establishment of the carrying value and estimated life. The carrying value would be adjusted if significant facts and circumstances altered the Company's original assumptions and rationale. Cost in excess of net assets of businesses acquired, net, was $50,317,000 and $62,238,000 at December 31, 1993 and 1992, respectively. This represents the cost of acquiring businesses over the fair value of net assets received at the date of acquisition, net of accumulated amortization of $12,430,000 and $8,809,000 at December 31, 1993 and 1992, respectively. Amortization was computed by use of the straight-line method over the estimated life of the benefits received from the acquisitions and was included in "Other operating costs" in the Consolidated Statements of Operations. Additionally, the carrying value was reduced in 1993 by $8,300,000 as a result of utilization of preacquisition net operating loss carryforwards (see "Income Taxes"). Research and Development Expenditures Certain software development costs are capitalized when incurred. Capitalization of software development costs begins upon the establishment of technological feasibility. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenues, estimated economic life and changes in software and hardware technologies. Amortization of capitalized software development costs is provided on a product-by-product basis at the greater of the amount computed using (a) the ratio of current gross revenues for a product to the total of current and anticipated future gross revenues or (b) the straight-line method over the remaining estimated economic life of the product. Generally, an original estimated economic life of two years is assigned to capitalized software development costs. Capitalized software development costs were $33,485,000 and $29,083,000 at December 31, 1993 and 1992, respectively, net of accumulated amortization costs of $18,638,000 and $13,365,000, respectively. During 1991, the Company reduced the carrying value of certain capitalized software development costs by approximately $9,500,000 to their estimated net realizable value (see "Special Charges"). All other research and development expenditures are charged to research and development expense in the period incurred. Debt Issuance Cost Costs associated with the borrowing of funds and placement of debt are deferred and amortized over the term of the related debt as interest expense or included as an additional cost if the debt is paid prior to its scheduled maturity (see "Other Expense, Net"). Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). As permitted by FAS 109, prior year financial statements have not been restated to reflect the change in accounting method. Under FAS 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of FAS 109, income tax expense was determined using the liability method prescribed by Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" (FAS 96), which is superseded by FAS 109. Among other changes, FAS 109 changes the recognition and measurement criteria for deferred tax assets included in FAS 96 and requires that the tax benefit of net operating loss carryforwards, tax credits and future taxable deductions be recorded as deferred tax assets net of an appropriate valuation reserve. Income tax benefits related to stock option exercises are credited to additional capital when recognized. Provision is made for U.S. income taxes, net of available credits, on the earnings of foreign subsidiaries which are in excess of amounts being held for reinvestment in overseas operations. Additionally, Puerto Rican tollgate taxes are not provided on a portion of the undistributed earnings in Puerto Rico, which are considered to be indefinitely invested (see "Income Taxes"). Foreign Currency Translation For the majority of the Company's foreign subsidiaries, the functional currency is the U.S. dollar. Accordingly, most foreign entities translate monetary assets and liabilities at year-end exchange rates while non monetary items are translated at historical rates. Revenue and expense items are translated at the average exchange rates in effect during the year, except for depreciation and cost of sales, which are translated at historical rates. The resulting translation adjustments and transaction gains and losses are included in "Other Expense, Net" in the Consolidated Statements of Operations and were not material in 1993, 1992 or 1991. Income (Loss) Per Share Income (loss) per share is based upon weighted average common shares outstanding and common stock equivalents. Common stock equivalents have been determined assuming the exercise of all dilutive stock options and warrants adjusted for the assumed repurchase of common stock, at the average market price, from the exercise proceeds. The fully diluted per share computation also assumes the conversion of the convertible subordinated debentures, when dilutive, and the assumed repurchase of common stock at the ending market price. Primary and fully diluted income (loss) per share are essentially the same for all periods presented except for 1992 when primary income per share was $0.26 and fully diluted income per share was $0.25. INVESTMENTS IN DEBT AND EQUITY SECURITIES The following is a summary of the estimated fair value of available for sale securities by balance sheet classification at December 31, 1993 (in thousands): The estimated fair value of each investment approximates the amortized cost, and therefore, there are no unrealized gains or losses as of December 31, 1993. The estimated fair value of debt securities available for sale by contractual maturity at December 31, 1993 is as follows (in thousands): Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties. RECEIVABLES Receivables consisted of the following (in thousands): To meet market competition, the Company finances sales of equipment to certain of its customers through sales-type and operating leases. The repayment terms vary from one to five years. The components of the receivables from sales-type leases are as follows (in thousands): Future minimum lease payments to be received on sales-type leases are as follows (in thousands): PROPERTY AND EQUIPMENT The Company's property and equipment consisted of the following (in thousands): In late 1993, the Company acquired 42 acres of land for approximately $1,833,000. In February 1994, the Company acquired an additional 148 acres for approximately $16,400,000 in cash. The land will be used for future building expansion. ACCRUED LIABILITIES AND CUSTOMER ADVANCES Accrued liabilities consisted of the following (in thousands): At December 31, 1992, customer advances included $34,300,000 of cash advanced against future purchases from a customer as part of a settlement of certain litigation. During 1993, the customer purchases exceeded the December 31, 1992 advances, and there is no advance from the customer at December 31, 1993. CREDIT AGREEMENTS In June 1993, the Company entered into a new revolving credit agreement with a bank, which expired on February 28, 1994, providing for borrowings up to $22,500,000 reduced by the value of outstanding letters of credit issued by the bank on behalf of the Company up to $14,000,000. This agreement replaced an earlier agreement which had expired. Letters of credit issued by the bank on behalf of the Company were $8,081,000 at December 31, 1993. The Company paid a fee on the unused portion of the credit facility of 0.125% per annum. The agreement was collateralized by current domestic receivables and inventories. There were no borrowings under the credit agreements during 1993. On February 24, 1994, the Company entered into an uncollateralized revolving credit facility, which expires on February 24, 1997, with two banks providing for borrowings up to $50,000,000. The maximum available borrowings are reduced by the value of outstanding letters of credit issued by the banks on behalf of the Company up to $25,000,000. Borrowings under the facility bear interest at the prime rate or at 0.75% to 1.50% above the LIBOR rate. A commitment fee of 0.35% on the daily average unused portion of the facility will also be assessed. The agreement contains various financial covenants. DEBT Total debt consisted of the following (in thousands): The prime interest rate at December 31, 1993 and 1992 was 6.0%. The aggregate maturities of long-term debt for the next five years are as follows: 1994 - $13,664,000; 1995 - $11,052,000; 1996 - $9,231,000; 1997 - $49,000; 1998 - $0. In June 1993, the Company borrowed $19,975,000 under a loan agreement which is secured by certain long-term lease receivables. This note is due in installments through June 29, 1996, and bears interest at the prime rate plus one-half percent. All of the senior debt contains various financial convenants, including, among other things, minimum working capital levels, maintenance of certain ratios of assets to liabilities, and maximum allowable indebtedness to tangible net worth. Subordinated Convertible Debentures 7.75% Debentures In 1993, the Company issued approximately 3,842,000 shares of the Company's common stock upon conversion of its outstanding 7.75% subordinated convertible debentures. As a result, approximately $68,561,000 was credited to common stock and additional capital, which was net of $2,906,000 of remaining deferred debt costs associated with the original issuance of the subordinated convertible debentures and costs related to the conversion. On a pro forma basis, income per share for the year ended December 31, 1993 would have been $1.51 had the 7.75% subordinated convertible debentures been converted on January 1, 1993. 8.0% Debentures On January 14, 1994, the Company called for the redemption of all of the outstanding 8% subordinated convertible debentures. The debentures were convertible, at the option of the holder, into shares of the Company's common stock at $54.50 per share. In February 1994, approximately $34,720,000 of debentures were converted into approximately 636,900 shares of common stock and approximately $1,696,000 of debentures were redeemed for cash. INCOME TAXES Effective January 1, 1992, the Company began accounting for income taxes under the method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). See "Summary of Significant Accounting Policies" for additional details. As permitted under the new rules, prior years' financial statements have not been restated. Accordingly, amounts shown for 1991 reflect income tax accounting under FAS 96. At December 31, 1993 and 1992, the Company had a net deferred tax asset of $66,423,000 and $68,235,000, respectively, reflecting the tax benefits of U.S. and foreign subsidiary net operating loss carryforwards, tax credit carryforwards and net future tax deductions. FAS 109 requires a valuation reserve be established if it is "more likely than not" that realization of the tax benefits will not occur. In recent years, the Company has cumulative losses within its U.S. consolidated tax group which FAS 109 indicates is significant evidence that could require a valuation reserve. Similarly, certain foreign jurisdictions also have cumulative losses. As a result, a valuation allowance equal to the net deferred tax asset was established at December 31, 1993 and 1992, although the Company believes the tax benefits will ultimately be realized through future operations. Because a valuation reserve was established equal to the net deferred tax asset, there was no cumulative effect on pretax net income or cash flows as a result of the adoption of FAS 109 in 1992. The net deferred tax asset would have decreased an additional $1,397,000 had the Federal tax rate not increased from 34% to 35% retroactively effective to January 1, 1993. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's net deferred tax asset as of December 31, 1993 and 1992, are as follows (in thousands): Included in Noncurrent Income Taxes and Other Liabilities at December 31, 1993 and 1992 are $25,150,000 and $17,928,000, respectively, for noncurrent taxes related to foreign jurisdictions. The Federal and foreign loss carryforwards at December 31, 1993 shown above include approximately $33,000,000 of tax benefits related to the exercise of employee stock options which, when recognized, will increase "Additional capital" on the Consolidated Balance Sheet. Income tax expense (benefit) was composed of the following (in thousands): The current Federal tax expense included $5,800,000 and $1,860,000 for 1993 and 1992, respectively, representing the tax benefits of stock option deductions credited to "Additional capital" and $8,300,000 for 1993 representing all of the tax benefits of preacquisition net operating loss carryforwards utilized to reduce the Company's Cost in Excess of Net Assets of Businesses Acquired. The effective income tax rate on pretax income (loss) differed from the Federal income tax statutory rate for the following reasons (in thousands): At December 31, 1993, the Company had consolidated regular tax net operating loss carryforwards for Federal tax purposes of approximately $99,500,000 available to be carried to future periods. The loss carryforwards expire from 2002 to 2008 if not used. Also, a foreign subsidiary of the Company had approximately $9,000,000 of net operating and capital loss carryforwards available to be carried to future periods which do not expire. The Company has general business and other regular tax credit carryforwards of approximately $13,000,000 which expire from 1994 to 2005. The Company also has alternative minimum tax credits of approximately $1,500,000 which can be utilized against regular taxes in the future. Puerto Rican tollgate taxes (maximum rate of 10%) have not been provided on approximately $13,594,000 of undistributed earnings in Puerto Rico, which are considered to be indefinitely invested. DSC's Puerto Rican subsidiary has been granted a 90% tax exemption from Puerto Rican income taxes. The tax grant expires in 2005. Undistributed earnings of foreign subsidiaries are not material. INCENTIVE COMPENSATION The Company has an Incentive Awards Plan administered by the Compensation Committee of the Board of Directors which provides for payment of cash awards to officers and key employees based upon achievement of specific goals by the Company and the participating executives. For the years ended 1993 and 1992, provisions of approximately $6,100,000 and $2,900,000 were charged against income related to the plan. No incentive awards were granted under the plan for 1991. The Company also has a Long-Term Incentive Compensation Plan (LTIP) which awards performance units to certain key executives. Certain officers were awarded units in 1990 under the Company's LTIP by the Compensation Committee of the Board of Directors. The units vest to the officers over six years, and the value of a unit is determined annually based on the Company's operating performance, as defined in the plan. The value of the units charged to income in 1993 was approximately $2,300,000. Prior to 1993, the units awarded had no value. COMMON AND PREFERRED STOCK Description and Dividends At December 31, 1993 the Company was authorized to issue 100,000,000 shares of common stock, $.01 par value, and 5,000,000 shares of preferred stock, $1.00 par value. Since inception, the Company has not declared or paid a cash dividend. In October 1993, the Company issued 3,450,000 shares of the Company's common stock in a public offering for which the Company received net proceeds of approximately $231,149,000. In May 1986 and subsequently amended in April 1991, the Company declared a dividend distribution of one preferred stock purchase right on each outstanding share and each subsequently issued share of the Company's common stock. The rights will not become exercisable until the close of business ten days after a public announcement that a person or group has acquired 20% or more of the common stock of the Company, or a public announcement or commencement of a tender or exchange offer which would result in the offeror acquiring 30% or more of the common stock of the Company. Once exercisable, each right would entitle a holder to buy 1/100 of a share of the Company's Series A Junior Participating preferred stock at an exercise price of $45.00. The Company may redeem the rights for 5 cents per right prior to the close of business on the tenth day following the announcement that a person or group has acquired 20% or more of the outstanding common stock of the Company. The rights will expire in 1996 unless redeemed or exercised at an earlier date. Stock Purchase Plans Under provisions of the Company's employee stock purchase plans, employees can purchase the Company's common stock at a specified price through payroll deductions during an offering period, currently established on an annual basis. In July 1993, approximately 1,543,000 shares were issued to employees under the employee stock purchase plan. At December 31, 1993, approximately $3,151,000 had been contributed by employees that will be used to purchase shares at the end of the offering period in July 1994. The amount of shares issuable in July 1994 for the current offering is approximately 166,000 shares assuming no future withdrawals from the plan. At December 31, 1993, the Company could issue up to 4,450,000 shares under the employee stock purchase plans of which approximately 3,672,000 shares had been purchased and issued. Warrants and Options The Company has stock option plans providing for the issuance of both incentive stock options and nonqualified stock options exercisable for a period of ten years, as well as restricted stock issuances. The plans cover 13,420,000 shares of common stock. At December 31, 1993, plan options covering 3,382,000 shares had been granted and are outstanding, options granted under the plans covering 7,369,000 shares had been exercised, 658,000 restricted shares had been issued (net of forfeitures), 224,000 shares had expired and options covering 1,787,000 shares are available for grant. The exercise prices of stock options granted and warrants issued were at the market value of the Company's common stock at the date of grant or issuance. In the event of discontinuation of service by the optionees, all or a portion of the shares acquired pursuant to these options can be repurchased by the Company, at its option, based on the vesting terms in the option agreements. Other options at December 31, 1993 include 34,000 options granted to various current or prior members of the Company's Board of Directors and certain nonemployees who have performed services for the Company. Outstanding warrants and options are summarized as follows: Restricted Stock The Company's Board of Directors authorized the issuance of restricted shares of the Company's common stock to certain key employees under its 1993, 1988 and 1984 employee stock option plans. Holders of restricted stock retain all rights of a shareholder, except the shares cannot be sold until they are vested. Upon employee termination, all unvested shares are forfeited to the Company. The shares vest annually through 1996. The Company issued 255,000, 104,000 and 313,000 shares of restricted stock to employees in 1993, 1992, and 1991, respectively, and increased common stock and additional capital by the fair market value of the stock at the date of issuance ($7,348,000, $778,000 and $1,714,000 in 1993, 1992 and 1991, respectively), net of unearned compensation. At December 31, 1993, 1992 and 1991, unearned compensation related to the restricted shares was $3,266,000, $1,507,000 and $1,424,000, respectively. The unearned compensation will be charged to expense ratably over the vesting period. During 1992, 14,000 restricted shares were forfeited. Reserved Stock Common stock has been reserved for the following purposes (in thousands): SPECIAL CHARGES Special charges for 1991 included the following (in thousands): These charges resulted from the Company's reassessment in 1991 of anticipated near-term business levels in light of the current economic environment and the related impact on estimated revenue levels. Also during 1991, the Company realigned its management structure on a product line basis to refocus key management on product line performance. This realignment resulted in the restructuring charge of $4,184,000 related to excess lease and personnel related costs. OTHER OPERATING COSTS The agreement to acquire a company (Optilink) in 1990 requires the Company to pay certain former employees of Optilink up to $7,900,000 if certain revenue targets are achieved through December 31, 1995. At December 31, 1993, approximately $5,514,000 had been earned under the agreement, including $4,052,000 in 1993, $912,000 in 1992 and $288,000 in 1991. Such amounts are included in "Other Operating Costs" on the Consolidated Statements of Operations. OTHER EXPENSE, NET Other expense, net for the year ended December 31, 1993 included a gain of $2,154,000 from the sale of securities acquired several years ago as part of financing provided to a customer. Other expense, net for the year ended December 31, 1992 included provisions of approximately $1,500,000 for legal and related costs associated with litigation activities and approximately $2,000,000 for costs related to the restructuring of the Company's senior unsecured debt. RELATED PARTIES The Company has agreements to pay consulting fees, which amounted to $486,000 in 1993, $424,000 in 1992 and $411,000 in 1991 to members of the Company's Board of Directors. The Company paid legal fees of $175,000 in 1992 and $199,000 in 1991 to a legal firm with a shareholder who became a member of the Company's Board of Directors during 1989 and subsequently resigned during 1992. During 1992, the Company purchased approximately 98,000 shares of its outstanding common stock from various employees and an officer of the Company, who is also a member of the Board of Directors, at the existing market price at the date of the transactions. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the fair value of certain financial instruments. Cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities are reflected in the financial statements at fair value. Marketable securities are recorded in the financial statements at current market values (see "Investments in Debt and Equity Securities"). The following methods and assumptions were used by the Company in estimating its fair value disclosures for the Company's financial instruments: Debt The carrying amounts of the Company's borrowings under its senior unsecured debt agreement and other debt approximate their fair value at December 1993 and 1992 due to renegotiation of the senior unsecured debt in December 1992 combined with similar interest rates at December 1993 and 1992, and the other debt containing market interest rates. The subordinated convertible debentures are based on quoted market values. Forward foreign exchange contracts, letters of credit and guarantees The fair values of the Company's off-balance sheet instruments are based on current settlement values (forward foreign exchange contracts) and fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing (guarantees and letters of credit). The difference between these contract values and the fair value of these instruments is included when it is material. The carrying amounts and fair values of the Company's significant financial instruments at December 31, 1993 and 1992 are as follows (in thousands): COMMITMENTS AND CONTINGENCIES Operating Lease Commitments The Company leases certain facilities and equipment which require future rental payments. These rental arrangements do not impose any financing or dividend restrictions on the Company or contain contingent rental provisions. Certain of these leases have renewal and purchase options generally at the fair value at the renewal or purchase option date. Future minimum rental commitments under operating leases with noncancellable lease terms in excess of one year were as follows at December 31, 1993 (in thousands): Operating lease rental expense was $19,268,000, $17,296,000 and $18,203,000, for the years ended December 31, 1993, 1992 and 1991, respectively. Additionally, for the year ended December 31, 1991, the Company received sublease rental income of $2,530,000. Contingent Liabilities The Company periodically sells customer receivables and operating leases under agreements which contain recourse provisions. The Company could be obligated to repurchase receivables and operating leases which were previously sold on a partial recourse basis, the terms of which allow the Company to limit its risk of loss to approximately $5,328,000 at December 31, 1993. The Company has guarantees of approximately $12,973,000 outstanding at December 31, 1993, supporting Company and third-party performance bonds to customers and others, of which approximately $8,081,000 was collateralized by letters of credit issued under the Company's credit facility. The Company believes it has adequate reserves for any ultimate losses associated with these contingencies. The Company enters into forward foreign exchange contracts to hedge certain receivables and firm contracts for delivery of products and services which are denominated in foreign currencies. At December 31, 1993, the Company had forward foreign exchange contracts of $22,277,000 to hedge future receipts in such currencies. Gains and losses related to the forward contracts are recognized as part of the cost of the underlying transactions being hedged. Forward foreign exchange contracts generally have maturities of one year or less and contain an element of risk that the counterparty may be unable to meet the terms of the agreement. However, the Company minimizes such risk exposure by limiting the counterparty to major financial institutions. Management believes the risk of incurring such losses is remote and any losses therefrom would be immaterial. Litigation In February 1994, the United States Fifth Circuit Court of Appeals (the "Court of Appeals") affirmed dismissal by the United States District Court for the Northern District of Texas of a shareholder suit against the Company and certain of its present and former officers and directors. The suit was purportedly filed as a class action on behalf of an alleged class of persons who purchased common stock of the Company from February 7, 1991, through October 31, 1991. The complaint had alleged violations of Section 10(b) of the Securities and Exchange Act of 1934, Rule 10b-5 promulgated thereunder and negligent misrepresentation. The complaint sought actual and punitive damages in unspecified amounts. The plaintiffs have been granted an extension of time through March 25, 1994, in which to determine whether or not to request a rehearing by the Court of Appeals. In addition, the plaintiffs have the option to seek further review by the United States Supreme Court. The Company does not believe the ultimate resolution of this matter will have a material adverse effect on the Company's consolidated financial position. On July 20, 1993, the Company filed suit against Advanced Fibre Communications ("AFC"), Quadrium Corporation and two former employees in the United States District Court for the Eastern District of Texas. The Company seeks: (i) a declaratory judgment that the two former employees are not entitled to any stock options or cash payments under certain employee plans due to alleged breaches of certain employment related agreements; (ii) a declaration that AFC's products are proprietary property of the Company; and (iii) unspecified damages for breach of contract, civil conspiracy and tortious interference. Counterclaims have been filed by the former employees claiming entitlement to certain stock options and cash payments. Additionally, AFC has filed counterclaims including various tort claims and claims based on alleged violations of various Federal and State antitrust and unfair competition laws. AFC also seeks a declaratory judgment that it owns all rights to its products and seeks unspecified damages, including treble damages under antitrust statutes and punitive damages. The case is in the early stages of discovery, and the Company intends to vigorously prosecute its claims and defend all of the defendants' counterclaims. The Company believes that it has valid and substantial claims against all of the defendants and valid defenses to all of the counterclaims and does not believe the ultimate resolution of this matter will have a material adverse effect on the Company's consolidated financial position. The Company is a party to other legal proceedings which, in the opinion of management, are not expected to have a material adverse effect on the Company's consolidated financial position. INTERNATIONAL OPERATIONS AND MAJOR CUSTOMERS Export Sales Revenue generated from export sales in 1991 was $48,012,000. Revenue generated from export sales was less than 10% of total revenue in 1993 and 1992. Major Customers Customers that accounted for 10% or more of consolidated revenue and their related percentage of consolidated revenue were as follows: REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Shareholders of DSC Communications Corporation: We have audited the accompanying consolidated balance sheets of DSC Communications Corporation and subsidiaries (the "Company") as of December 31, 1993 and 1992 and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Ernst & Young Dallas, Texas January 24, 1994 DSC Communications Corporation and Subsidiaries QUARTERLY RESULTS (Unaudited) (In thousands, except per share data) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item with respect to the directors and nominees for election to the Board of Directors of the Company is incorporated by reference from the information set forth on page 1 of the definitive proxy statement of the Company, previously filed in connection with its 1994 Annual Meeting of Stockholders under the heading "ELECTION OF DIRECTORS", and on pages 11 and 12 of such definitive proxy material under the heading "DIRECTORS CONTINUING IN OFFICE". The information regarding executive officers of the Company is contained in Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference from the information set forth under the heading "EXECUTIVE COMPENSATION" on pages 5 through 11 of the definitive proxy statement of the Company, previously filed in connection with its 1994 Annual Meeting of Stockholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference from the information set forth under the heading "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" on page 14 of the definitive proxy statement of the Company, previously filed in connection with the 1994 Annual Meeting of Stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference from the information set forth under the heading "COMPENSATION OF DIRECTORS" on pages 12 and 13 of the definitive proxy statement of the Company, previously filed in connection with the 1994 Annual Meeting of Stockholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following is a list of the consolidated financial statements and financial statement schedules which are included in this Form 10-K or which are incorporated herein by reference. 1. Financial Statements: As of December 31, 1993 and 1992: Consolidated Balance Sheets For the Years Ended December 31, 1993, 1992, and 1991 -- Consolidated Statements of Operations -- Consolidated Statements of Cash Flows -- Consolidated Statements of Changes in Shareholders' Equity Notes to Consolidated Financial Statements Report of Independent Auditors 2. Financial Statement Schedules: As of December 31, 1993: -- Schedule I -- Marketable Securities - Other Investments For the years Ended December 31, 1993, 1992, and 1991: -- Schedule II -- Amounts Receivable From Related Parties, Underwriters, Promoters, and Employees Other Than Related Parties -- Schedule V -- Property and Equipment -- Schedule VI -- Accumulated Depreciation and Amortization of Property and Equipment -- Schedule VIII -- Valuation and Qualifying Accounts -- Schedule IX -- Short Term Borrowings -- Schedule X -- Supplementary Income Statement Information All other financial statements and financial statement schedules have been omitted because they are not applicable, or the required information is included in the consolidated financial statements or notes thereto. 3. Exhibits: 3.1 Amended and Restated Certificate of Incorporation of the Company (1) 3.2 Amended and Restated By-laws of the Company (8) 4.3 Rights Agreement, Dated as of May 12, 1986, Between the Company and The Chase Manhattan Bank, N.A., as Rights Agent (3) 4.4 Form of Letter to the Company's Stockholders, Dated May 22, 1986, Relating to the Adoption of the Rights Agreement Described in Exhibit 4.3 (3) 10.1 Employment Agreement Between the Company and James L. Donald, Dated January 1, 1990 (9) 10.2 Executive Income Continuation Plan, Dated January 1, 1990, Between the Company and James L. Donald (9) 10.3 Insurance Ownership Agreement, Dated January 1, 1990, Between the Company and James L. Donald (9) 10.4 Management Consulting Agreement Among the Company, Nolan Consulting, Inc., and James M. Nolan, Dated March 15, 1982 (4) 10.5 Amended and Restated Note Agreement, Dated December 31, 1992, Between the Company and an Institutional Lender (10) 10.6 Revolving Credit Agreement, Dated as of February 24, 1994, Between the Company and Certain of its Subsidiaries and Certain Financial Institutions Providing for Secured Revolving Credit (13) 10.7 The Company's Amended and Restated 1979 Employee Stock Option Plan (5) 10.8 The Company's Amended and Restated 1981 Employee Stock Option Plan (5) 10.9 The Company's Amended and Restated 1984 Employee Stock Option Plan (7) 10.10 The Company's Amended and Restated 1988 Employee Stock Option Plan (7) 10.11 The Company's Amended and Restated 1985 Convertible Debenture Plan (2) 10.12 The Company's 1993 Employee Stock Option and Securities Award Plan (11) 10.13 The Company's 1993 Non-Employee Directors Stock Option Plan (11) 10.14 The Company's Employee Thrift Plan as Amended and Restated (2) 10.15 The Company's 1988 Employee Stock Ownership Plan (6) 10.16 Form of Amended and Restated Severance Compensation Agreement Between the Company and Certain of its Executive Officers (8) 10.17 The Company's Restoration Plan, Dated July 1, 1988 (6) 10.18 Form of Indemnification Agreement Between the Company and its Directors and Senior Officers as Approved by the Board of Directors and Entered Into on or After January 22, 1990, and the Related Trust Agreement, Dated March 1, 1990, Between the Company and First City, Texas-Dallas, as Trustee (7) 10.19 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1990 (9) 10.20 The 1990 Optilink Stock Option and Cash Payment Plan, Dated May 15, 1990 (9) 10.21 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1994 (12) 11.1 Statement re: Computation of Per Share Earnings (13) 22.1 Subsidiaries of the Registrant (13) 23.1 Consent of Ernst & Young (13) MANAGEMENT CONTRACTS OR COMPENSATORY PLANS AND ARRANGEMENTS The following above-described exhibits are management contracts or compensatory plans and arrangements: 10.1 Employment Agreement Between the Company and James L. Donald, Dated January 1, 1990; 10.2 Executive Income Continuation Plan, Dated January 1, 1990, Between the Company and James L. Donald; 10.3 Insurance Ownership Agreement, Dated January 1, 1990, Between the Company and James L. Donald; 10.4 Management Consulting Agreement Among the Company, Nolan Consulting, Inc., and James M. Nolan, Dated March 15, 1982; 10.7 the Company's Amended and Restated 1979 Exployee Stock Option Plan; 10.8 The Company's Amended and Restated 1981 Employee Stock Option Plan; 10.9 The Company's Amended and Restated 1984 Employee Stock Option Plan; 10.10 The Company's Amended and Restated 1988 Employee Stock Option Plan; 10.11 The Company's Amended and Restated 1985 Convertible Debenture Plan; 10.12 The Company's 1993 Employee Stock Option and Securities Award Plan; 10.13 The Company's 1993 Non-Employee Directors Stock Option Plan; 10.14 The Company's Employee Thrift Plan as Amended and Restated; 10.15 The Company's 1988 Employee Stock Ownership Plan; 10.16 Form of Amended and Restated Severance Compensation Agreement Between the Company and Certain of its Executive Officers; 10.17 The Company's Restoration Plan, Dated July 1, 1988; 10.18 Form of Indemnification Agreement Between the Company and its Directors and Senior Officers as Approved by the Board of Directors and Entered Into on or After January 22, 1990, and the Related Trust Agreement, Dated March 1, 1990, Between the Company and First City, Texas-Dallas, as Trustee; 10.19 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1990; 10.21 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1994. (b) Reports on Form 8-K: None - ------------------------------------------------------------------------------ (1) Incorporated by reference from the Company's Amendment to Application or Report on Form 8, dated July 28, 1989 (2) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (3) Incorporated by reference from the Company's Registration Statement on Form 8-A, dated May 21, 1986, as amended by Amendment No. 1 on Form 8, dated July 28, 1989, and Amendment No 2. on Form 8, dated May 28, 1991, each as filed with the Securities and Exchange Commission pursuant to Section 12(g) of the Exchange Act (4) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1981 (5) Incorporated by reference from the Company's Registration Statement on Form S-8 (Registration No. 2-83398) (6) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1988 (7) Incorporated by reference from the definitive proxy statement of the Company, filed in connection with the 1990 Annual Meeting of Stockholders (8) Incorporated by reference from the Company's Annual Report for the year ended December 31, 1989 (9) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (10) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (11) Incorporated by reference from the definitive proxy statement of the Company, filed in connection with the 1993 Annual Meeting of Stockholders (12) Incorporated by reference from the definition proxy statement of the Company, filed in connection with the 1994 Annual Meeting of Stockholders (13) Filed herewith SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. DSC COMMUNICATIONS CORPORATION (Registrant) /s/ James L. Donald ------------------------------ James L. Donald, Chairman of the Board, President, Chief Executive Officer, and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature and Title Date ------------------- ---- /s/ James L. Donald March 30, 1994 - ------------------------------ James L. Donald, Chairman of the Board, President, Chief Executive Officer, and Director (Principal Executive Officer) /s/ Clement M. Brown, Jr. March 30, 1994 - ------------------------------ Clement M. Brown, Jr. Director /s/ Frank J. Cummiskey March 30, 1994 - ------------------------------ Frank J. Cummiskey Director /s/ Sir John Fairclough March 30, 1994 - ------------------------------ Sir John Fairclough Director /s/ Raymond J. Dempsey March 30, 1994 - ------------------------------ Raymond J. Dempsey Director /s/ James L. Fischer March 30, 1994 - ------------------------------ James L. Fischer Director /s/ Robert S. Folsom March 30, 1994 - ------------------------------ Robert S. Folsom Director Signature and Title Date ------------------- ---- /s/ Gerald F. Montry March 30, 1994 - ------------------------------ Gerald F. Montry, Senior Vice President, Chief Financial Officer, and Director (Principal Financial Officer) /s/ James M. Nolan March 30, 1994 - ------------------------------ James M. Nolan Director /s/ Kenneth R. Vines March 30, 1994 - ------------------------------ Kenneth R. Vines Vice President and Controller (Principal Accounting Officer) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE I MARKETABLE SECURITIES-OTHER INVESTMENTS FOR THE YEAR ENDED DECEMBER 31, 1993 (In Thousands) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 (CONTINUED) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE II (CONTINUED) AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1991 DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1993 (CONTINUED) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE V (CONTINUED) PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1991 DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1993 (CONTINUED) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VI (CONTINUED) ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1991 DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR DOUBTFUL ACCOUNTS (In Thousands) DSC COMMUNICATIONS CORPORATION SCHEDULE IX SHORT-TERM BORROWINGS (In thousands) DSC COMMUNICATIONS CORPORATION SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) EXHIBIT INDEX 10.6 Revolving Credit Agreement, Dated as of February 24, 1994, Between the Company and Certain of its Subsidiaries and Certain Financial Institutions Providing for Secured Revolving Credit 11.1 Statement re: Computation of Per Share Earnings 22.1 Subsidiaries of the Registrant 23.1 Consent of Ernst & Young

719271_1993.txt

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1993

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Item 1. Business. Anuhco, Inc. ("Anuhco"), through its subsidiary, Crouse Cartage Company ("Crouse Cartage"), operates a diversified motor freight transportation system primarily serving the upper central and midwest portion of the United States. Crouse Cartage, acquired by Anuhco as of September 1, 1991, is a regular-route motor common carrier of general commodities in less-than- truckload ("LTL") quantities with a ten state service area, and also offers irregular-route motor common carrier service for truckload quantities of general and perishable commodities throughout the 48 contiguous United States. Crouse Cartage operates as an autonomous company with the same management and operations as before its acquisition by Anuhco. Anuhco, with two employees, performs those functions required of a public holding company and monitors the operations of Crouse Cartage. Crouse Cartage Company The following table sets forth certain financial and operating data with respect to Crouse Cartage prior to the effects of acquisition related adjustments for the years 1993 through 1991. [FN] Notes: (1) Operating ratio is the percent of operating expenses to operating revenue. (2) Less-than-truckload refers to shipments weighing less than 10,000 pounds. (3) Includes company-owned, company leased, agent and other operating locations. Crouse Cartage, an Iowa Corporation headquartered in Carroll, Iowa, is engaged in the transportation of general commodities which include all types of freight other than personal household goods, commodities of exceptionally high value, explosives and commodities in bulk or requiring special equipment. During 1993, LTL shipments (less than 10,000 pounds) comprised 77% of revenue and truckload shipments (10,000 pounds or greater) comprised 23% of revenue. Crouse Cartage is an LTL regular route common carrier with LTL service in the 10 states of Illinois, Indiana, Iowa, Minnesota, Missouri, Nebraska, South Dakota, Wisconsin, Kansas and Michigan. Crouse Cartage also has a truckload general commodities and special commodities division which operates in all 48 contiguous states. More than 90% of Crouse Cartage's business originates or terminates within 400 miles of its headquarters. Crouse Cartage with over 12,000 customers has a broad customer base, with no one customer comprising 5% of its total revenue. LTL shipments must be handled rapidly and carefully in several coordinated stages. Shipments are first picked up from customers by local drivers operating from the Crouse Cartage network of 48 service locations, each of which services a particular territory. The freight is then transported to a terminal, loaded into intercity trailers, carried by linehaul drivers to the terminal which services the delivery area, transferred to trucks or trailers and then delivered to the consignee by local drivers. Much of Crouse Cartage's LTL freight is handled and/or transferred through one of three centrally located "break bulk" terminals between the origin and destination service areas. Competition for LTL freight is primarily based upon service and freight rates. LTL operations require substantial equipment capabilities and an extensive network of terminal facilities. Accordingly, LTL operations, compared to truckload shipments and operations, command higher rates per weight shipped and have tended historically to be less vulnerable to competition from other forms of transportation such as railroads. Crouse Cartage's concentrated and efficient operations typically allow it to provide overnight service (delivery on the day after pickup) on over 90% of the LTL freight it handles; providing Crouse Cartage with a competitive advantage and the ability to maintain compensatory rates. Seasonality Crouse Cartage's quarterly operating results, as well as those of the motor carrier industry in general, fluctuate with the seasonal changes in tonnage levels and with changes in weather-related operating conditions. Tonnage levels are generally highest from September through November. A smaller peak also generally occurs in April through June. Inclement weather conditions during the winter months adversely affect the number of freight shipments and increase operating costs. Historically, Crouse Cartage has achieved its best operating results in the second and third quarters when adverse weather conditions do not affect its operations and seasonal peaks occur in the freight shipped via public transportation. Insurance and Safety Crouse Cartage is largely self-insured with respect to public liability, property damage, workers' compensation, cargo loss or damage, fire, general liability and other risks. In addition, Crouse Cartage maintains excess liability coverage for risks over and above the self-insured retention limits. All claims pending against Crouse Cartage are fully covered by outside insurance or, in the opinion of management, are adequately reserved under Crouse Cartage's self-insurance program. Because most risks are largely self-insured, Crouse Cartage's insurance costs are primarily a function of the success of its safety programs and less subject to the large increases in insurance premiums experienced in recent years by the motor carrier industry. Crouse Cartage conducts a comprehensive safety program to meet its specific needs. Crouse Cartage's drivers have good driving records and have won the Iowa State Truck Driving Championship 13 times in the past 15 years. Auto liability and workers' compensation claims consistently are below industry average in number of claims and amounts paid for such claims (approximately 2.1% of revenue in 1993). Competition Crouse Cartage's operations are subject to intense competition with other motor common carriers and, to a lesser degree, with contract and private carriage. The enactment of the Motor Carrier Act of 1980 substantially deregulated the trucking industry, eased entry requirements into the transportation industry and increased competition among motor carriers. Intense competition for freight has resulted in a proliferation of discount programs among competing carriers. Crouse Cartage competes in such price discounting on an account by account basis, taking into consideration the cost of services relative to the net revenue to be obtained, the competing carriers and the need for freight in specific traffic lanes. Crouse Cartage's main competition over its shorter routes is with Con-Way Central Express, Ann Arbor, Michigan; Central Transport, Sterling Heights, Michigan; H&W Motor Express, Dubuque, Iowa; Hyman Freightways, St. Paul, Minnesota; and Midland Transportation, Marshalltown, Iowa. For freight moving over greater distances, Crouse Cartage must compete with national and large inter-regional carriers. Crouse Cartage's reliable overnight service on key lanes, very low level of freight loss and damage claims and general shipper satisfaction have allowed it to maintain steady growth with a compensatory level of rates. Regulation The interstate operations of Crouse Cartage are subject to regulation by the Interstate Commerce Commission ("ICC") and the Department of Transportation ("DOT"). Crouse Cartage is also subject to state public utilities commissions and similar state regulatory agencies with respect to its intrastate operations. The ICC regulates entry into motor carrier operations, rates and charges, tariffs, accounting systems and certain mergers and consolidations. The DOT generally regulates driver qualifications and safety and equipment standards. Crouse Cartage is also subject to safety regulations of the states in which it operates, as well as regulations governing the weight and dimensions of equipment. Passage of the Motor Carrier Act of 1980 represented, among other things, an effort to increase competition among motor carriers and substantially reduce industry regulation. Entry into the motor carrier market has been facilitated by making ICC operating authority more readily available. Carriers have been given the opportunity to greatly expand the scope of their operations. (See "Competition".) In addition, the Motor Carrier Act of 1980 limited the immunity from the antitrust laws previously applicable to the trucking industry in setting prices for transportation services. After July 1, 1984, collective discussions by motor carriers may only involve general rate increases or tariff restructuring relating to average costs for the industry as a whole. Such discussions may not relate to individual single-line rates or specific markets. In addition, the Motor Carrier Rate-Making Study Commission, established by the Motor Carrier Act of 1980, has, by majority vote, recommended to the Congress that antitrust immunity for all motor carrier collective ratemaking be eliminated. The DOT also has recommended an end to collective ratemaking. Employees Crouse Cartage employs approximately 806 persons, of whom approximately 664 are drivers, mechanics, dockworkers or terminal office clerks. The remainder are engaged in managerial, sales and administrative functions. Labor costs represent the largest single component of Crouse Cartage's operating expenses, totaling 54.4% of consolidated revenue for 1993. In the opinion of its management, Crouse Cartage has a good working relationship with its employees. Approximately 72% of Crouse Cartage employees, including primarily drivers, dockworkers and mechanics, are represented by the International Brotherhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America ("Teamsters Union"). Crouse Cartage and the Teamsters Union are parties to the National Master Freight Agreement ("NMFA") which expires on March 31, 1994. Negotiations by and between Crouse Cartage and the Teamsters Union for the next contract period are ongoing. Crouse Cartage believes the final impact of such negotiations will not significantly affect the results of operations or financial position of the Company. As an employer signatory to the agreement, Crouse Cartage must contribute to certain pension plans established for the benefit of employees belonging to the Teamsters Union. Under provisions of the NMFA, Crouse Cartage has maintained a profit sharing program for all employees since 1988 ("Profit Sharing"). Profit Sharing was implemented after 76% of the union employees and 84% of its non- union employees voted for approval in 1988. In 1991, Profit Sharing was extended for at least another 3 years after 90% of the union employees and 97% of the non-union employees voted for such extension. Although the outcome is uncertain, Crouse Cartage believes the Profit Sharing will be further extended coincident with the conclusion of the NMFA contract negotiations. Profit Sharing is structured to allow all Crouse Cartage employees to ratably share 50% of Crouse Cartage's income before income taxes (excluding extraordinary items and gains and losses on the sale of assets) in return for a 15% reduction in wages. Profit Sharing distributions, made quarterly, totalled $3.3 million in 1993. American Freight System, Inc. Anuhco was a public holding company with several operating motor carrier subsidiaries from 1983 through 1988, under the name American Carriers, Inc. ("ACI"). Following ACI's 1987 acquisition of a large motor carrier, and the merger of its operations into American Freight System, Inc. ("AFS"), ACI's largest LTL subsidiary, substantial operating losses were incurred in the last half of 1987 and the first half of 1988. As a result of the heavy operating losses and cancellation of ACI's bank credit, following ACI's inability to obtain credit from other sources, AFS and ACI's other LTL subsidiary, USA Western, Inc. ("USAW"), ceased operations and filed petitions for protection under Chapter 11 of the Bankruptcy Code (Title 11 of the United States Code) and later in 1988 other subsidiaries of ACI also filed under Chapter 11 ("Debtor Companies"). By the end of 1988 ACI was also under the protection of Chapter 11 of the Bankruptcy Code; as a result of a petition filed by multiemployer pension plans who were creditors of AFS and who also asserted claims against ACI under the Multiemployer Pension Plan Amendments Act of 1980. On July 11, 1991, ACI and the Debtor Companies were discharged from bankruptcy under a reorganization plan confirmed by the U. S. Bankruptcy Court, District of Kansas ("Joint Plan"). ACI's name was changed to Anuhco, Inc., its authorized common stock was increased to 13 million shares and it may only issue voting capital stock. Shareholders retained their shares of ACI's common stock and no new securities were issued by ACI. The other Debtor Companies were merged into AFS and AFS assumed all liabilities of the bankruptcy estates and gained control of all assets of ACI and its other subsidiaries; except for $3.8 million in cash and the capital stock of AFS retained by ACI. AFS was discharged from bankruptcy with an obligation to administer the provisions of the Joint Plan under the control of a reconstituted AFS Board of Directors, which currently consists of three individuals who formerly served on creditors' committees of ACI and AFS, and two additional persons selected by Anuhco. AFS is to sell its remaining non-cash assets and distribute its assets as provided in the Joint Plan. AFS is to resolve creditor claims against the estates of ACI and the Debtor Companies and make distributions to holders of allowed claims as cash is available. The Joint Plan also provides for certain distributions from AFS to Anuhco as unsecured creditor distributions occur in excess of 50% of allowed claims, as shown in the following table: Anuhco receives the full benefit of any remaining assets through its ownership of the capital stock of AFS if unsecured creditors receive distributions equivalent to 130% of their allowed claims. Anuhco and unsecured creditors have received distributions from AFS during 1993 and 1992 as follows: AFS currently projects that cumulative unsecured creditor distributions will equal or exceed 110% of allowed claims and that additional distributions to Anuhco will approximate $4 million, excluding any effects of the judgment held against Westinghouse Credit Corporation. AFS had 14 remaining employees and $37 million of assets as of December 31, 1993. As the Joint Plan provides that liabilities of AFS will be settled solely with the assets of AFS, the liabilities have been set equal to assets in the accompanying financial statements in which AFS is treated as a discontinued operation in conformity with generally accepted accounting principles. (See Note 12 to the consolidated financial statements - Discontinued Operations for further discussion.) Item 2. Item 2. Properties. Anuhco owns property through Crouse Cartage which operates a modern intercity fleet and maintains a network of terminals to support the intercity movement of freight. Crouse Cartage owns most of its fleet but leases some equipment from owner-operators to supplement the owned equipment and to provide flexibility in meeting seasonal and cyclical business fluctuations. As of December 31, 1993 Crouse Cartage owned 446 tractors and 37 trucks. During 1993 Crouse Cartage leased 173 tractors and 30 flatbed trailers from owner-operators. On December 31, 1993, it also owned 248 temperature controlled trailers, 594 volume vans (including 176 53-foot high-cube van trailers), and 27 flatbed trailers. The table below sets forth the number of operating locations at year end for the last three years: Effective January 1, 1994, Crouse Cartage exercised its purchase options under certain operating leases to purchase eleven (11) of the "Leased Terminals", above (See Note 11 to the consolidated financial statements for further discussion). The depreciated net book value of Crouse Cartage's property and equipment at December 31 was: Item 3. Item 3. Legal Proceedings. On February 5, 1991, ACI and the Debtor Subsidiaries filed a Joint Plan of Reorganization ("Joint Plan") and a related Disclosure Statement with the United States Bankruptcy Court, District of Kansas, Topeka Division ("Bankruptcy Court"). After approval by each class of creditors entitled to vote and the equity security holders, on June 10, 1991, following the confirmation hearing, the Bankruptcy Court confirmed the Joint Plan with an Effective Date of July 11, 1991. The Joint Plan provided for the reorganization of ACI with $3.8 million in cash, no debt and the expressed intent of acquiring one or more operating companies; and the administration of the Joint Plan by AFS. (See Item 1, American Freight System, Inc. for further discussion.) On January 12, 1994 a complaint was filed in the District Court of Johnson County, Kansas, against Anuhco, AFS and certain employees of those companies by a former employee of AFS. Such complaint alleges breach of contract, promissory estoppel, tortious interference, and misrepresentation and fraud, as it relates to an alleged incentive compensation arrangement between the former employee and AFS. The suit claims, from Anuhco and others, actual damages in excess of $2 million and punitive damages of $5 million. Management believes such claims will not likely have a material adverse effect on Anuhco's financial position or business. Anuhco's subsidiaries are parties to routine litigation, other than litigation being conducted pursuant to the Joint Plan, primarily involving claims for personal injury and property damage incurred in the transportation of freight and the collection of receivables. Anuhco and its subsidiaries maintain insurance programs and accrue for expected losses in amounts designed to cover liability resulting from personal injury and property damage claims. In the opinion of management, the outcome of such claims and litigation will not materially affect the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of the security holders during the fourth quarter of 1993. Included herein, pursuant to General Instruction G, is the information regarding executive officers required by Item 401 (b) and (e) of Regulation S-K, as of March 31, 1994. John P. Bigger, a member of the Company's Board from July 19, 1988 to March 22, 1991, has been President and Chief Executive Officer of the Company since September 23, 1988. On July 8, 1991 he was elected to the additional office of Treasurer and designated as Chief Financial Officer. He previously served as Executive Vice President, Senior Vice President-Administration and Corporate Secretary, and Vice President-Administration of ACI at various times from 1982. From 1978 to 1982, he held positions as Vice President- Administration of AFS and Assistant to the Chairman of AFS. From 1972 to 1978 he was Dean of Admissions and Registrar of Georgia State University and from 1960 through 1969 was employed by Arthur Andersen & Co. in their consulting division. Mr. Bigger has sole voting and investment power with respect to 17,863 shares of Anuhco Common Stock. Lawrence D. ("Larry") Crouse has been a member of the Company's Board and Vice President of the Company since September 5, 1991. He has served as Chairman and Chief Executive Officer of CC Investment Corporation (former parent of Crouse Cartage and now a subsidiary of Anuhco) since 1987 and has been Chief Executive Officer of Crouse Cartage since 1987. He has been owner and President of K. P. Enterprises, a personal investment and holding company with a truckload common carrier division doing business as Corrugated Carriers, since 1966. K. P. Enterprises, then named Nebraska Iowa Xpress, Inc., operated as a common motor carrier from 1966 to 1983. Mr. Crouse has sole voting and investment power with respect to 168,036 shares of Anuhco Common Stock. Barbara J. Wackly has been Corporate Secretary of Anuhco since November, 1988. From 1988 to 1992 she served as Vice President of ACI Services, Inc., a wholly-owned subsidiary of the Company. From 1983 to 1988 she was the Executive Assistant to the Chairman of the Board of ACI. Ms. Wackly has sole voting and investment power with respect to 773 shares of Anuhco Common Stock. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters. (a) Market Information. Anuhco's Common Stock is and has been traded on the American Stock Exchange under the symbol ANU since its listing on June 21, 1993. From November 12, 1991 to June 21, 1993 Anuhco's Common Stock was traded over-the- counter under the symbol ANUH on the Nasdaq Small-Cap Market. The following table shows the sales price information for each full quarterly period after June 30, 1992, and the bid prices for each full quarterly period from January 1, 1992 through June 30, 1992. (b) Holders. (c) Dividends. No cash dividends were paid during 1993 or 1992 on Anuhco's Common Stock. Anuhco currently intends to retain earnings to finance expansion and does not anticipate paying cash dividends on its Common Stock in the near future. Anuhco's future policy with respect to the payment of cash dividends will depend on several factors including, among others, any acquisitions, earnings, capital requirements and financial and operating conditions. Item 6. Item 6. Selected Financial Data. [FN] 1 See Note 12 of the Notes to Consolidated Financial Statements. 2 Including current maturities of $0 for 1993, $297,000 for 1992 and $315,000 for 1991 (See Note 5 of the Notes to Consolidated Financial Statements). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation. The following table sets forth the percentage relationship of revenue and expense items to operating revenue for the registrant for the years ended December 31: RESULTS OF OPERATIONS The 1993 and 1992 consolidated financial statements for the registrant include both Anuhco and Crouse Cartage for the full year. The 1991 results include Anuhco from July 11, 1991, the effective date of the Joint Plan and the operations of Crouse Cartage from September 1, 1991, the date it was acquired by Anuhco. The 1991 operations were affected by a recession which continued to have some impact on operations in 1992. Anuhco, through its subsidiary Crouse Cartage, was able to continue its growth in total revenue and number of LTL shipments in 1993. In 1993 total tonnage of shipments increased by 3.8% over 1992; with LTL tonnage increasing 9.7% and truckload tonnage decreasing by 0.3%. The decrease in truckload tonnage resulted in a 0.1% increase in truckload revenue per hundredweight due to the retention of the more profitable traffic. In spite of a January 1993 rate increase, LTL revenue per hundredweight only increased 0.1% due to the continued effects of rate discounting. In 1992 total tonnage of shipments increased by 4.9% over 1991; with LTL tonnage increasing 19.0% and truckload tonnage decreasing by 2.8%. The decrease in truckload tonnage resulted in a 3.7% increase in truckload revenue per hundredweight due to the retention of more profitable traffic. In spite of a 3.0% rate increase, LTL revenue per hundredweight decreased 2.3% largely as a result of industry freight rate discounting; fueled by the continued softness of the economy and excess capacity in the motor carrier industry. Led by a 1.3% increase in salaries and wages in 1992 under the labor contract effective April 1, 1991, and with a 3.9% increase in number of employees, operating expenses increased 12.1% over 1991, while revenue increased by 12.3%; resulting in a 22.3% increase in Anuhco's operating income. Crouse Cartage increased its total revenue and number of LTL shipments in the full year 1991 from the full year 1990, albeit at a lower rate of growth and with a lower level of profitability than in the previous year, while truckload shipments dropped. In 1991 total tonnage of shipments decreased by 8.5% from 1990; with LTL tonnage increasing 10.3% and truckload tonnage decreasing by 16.3%. The reduction in truckload tonnage resulted in a 9.9% increase in truckload revenue per hundredweight due to the retention of the more profitable traffic. In spite of a 5.5% rate increase, LTL revenue per hundredweight decreased 1.3% largely as a result of industry freight rate discounting; fueled by the soft economy, excess capacity in the motor carrier industry and lower fuel prices. Led by a 7.3% increase in salaries and wages in 1991, under the new labor contract effective April 1, 1991 and with a 2% increase in number of employees, operating expenses increased 4.4% over 1990, while revenue only increased by 3.7%; resulting in a 7.4% decrease in Crouse Cartage's operating income, excluding any expenses resulting from its acquisition by Anuhco. As a result of inflationary cost increases and in anticipation of labor and other cost increases in 1994, freight rate increases were made effective January 1, 1994 which could favorably impact revenues, if the economy improves and industry wide discounting does not accelerate. Indications are that expenses will increase generally in line with increases experienced in 1993. FINANCIAL CONDITION Anuhco continued to strengthen its financial position during 1993 and 1992. At the beginning of 1992 assets totaled $18.2 million while shareholders' equity amounted to $6.1 million. By the end of 1993 total assets had increased to $24.5 million and shareholders' equity had increased to $17.1 million. During this period long-term debt was reduced from $6.9 million to $1.9 million, while the Company's cash position increased from $2.8 million to $4.7 million. Major factors contributing to these improvements were successful operations creating $2.7 million and $2.3 million of net income and discontinued operations which generated $3.75 million and $2.25 million of net income for 1993 and 1992, respectively. The increased capital is being utilized to further upgrade the company's equipment and for additions and enhancement of terminal facilities. Capital expenditures totaled $2.7 million and $4.3 million in 1993 and 1992, respectively; including $2.0 million to acquire and improve a Chicago area freight terminal and over $4.8 million in equipment upgrades. Anuhco expects available cash and cash generated from 1994 operations to be sufficient to fund its operations, service its debt and to meet other cash needs for 1994. Should additional cash be required, Crouse Cartage has a $2.5 million secured revolving credit agreement with Bankers Trust Company of Des Moines, Iowa, with no balance outstanding on December 31, 1993, which is available to meet short term operational needs and long-term requirements. In addition to principal payments on long-term debt, the $1.9 million of long term debt bears interest at the prime rate plus 1% per annum. At December 31, 1993, Crouse Cartage owns or leases 28 parcels of real property which are utilized in their operations. Because many of these facilities maintain underground or other fuel storage tanks, some ongoing environmental liability exists; however, management is not aware of any material contamination. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 which will become effective in 1994. This statement requires the recording of certain post employment benefit obligations over the service life of such employees. This statement will not have a material impact on financial position or results of operations. AFS is accounted for as a discontinued operation in the financial statements with a net asset value of zero; due to provisions of the Joint Plan which provide that all assets of AFS are dedicated to payments of obligations under the Joint Plan and that AFS' liabilities, including administrative costs, will be paid out of its net assets. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of Anuhco, Inc.: We have audited the accompanying consolidated balance sheet of Anuhco, Inc. (a Delaware corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Anuhco, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedules IV, V, VI, VIII and X are presented for the purpose of complying with the Securities and Exchange Commission rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, are fairly stated in all material respects in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Kansas City, Missouri February 16, 1994 [FN] The accompanying notes to consolidated financial statements are an integral part of this statement. [FN] The accompanying notes to consolidated financial statements are an integral part of these statements. ANUHCO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (/FN> The accompanying notes to consolidated financial statements are an integral part of these statements. ANUHCO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY [FN] The accompanying notes to consolidated financial statements are an integral part of these statements. ANUHCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 and 1992 1. Acquisition and Plan of Reorganization On August 2, 1991, Anuhco, Inc. ("Anuhco") entered into an agreement for the acquisition of Crouse Cartage Company ("Crouse Cartage"), a regional less-than-truckload motor carrier. The acquisition was consummated effective September 1, 1991 with the final purchase price composed of $5.5 million cash, a $4.0 million convertible note and 1,342,524 shares of common stock in exchange for the outstanding shares of Crouse Cartage. This transaction has been accounted for as a purchase and the operating results of Crouse Cartage have been consolidated with Anuhco beginning September 1, 1991. On June 10, 1991, the Joint Plan of Reorganization ("Joint Plan") was confirmed by the Bankruptcy Court resulting in the formal discharge of American Carriers, Inc. ("ACI"), American Freight System, Inc. ("AFS"), and other subsidiaries from Chapter 11 Bankruptcy proceedings. ACI filed with the Secretary of the State of Delaware an amended and restated certificate of incorporation changing its name to Anuhco, Inc., prohibiting the issuance of non-voting capital stock and increasing the authorized common stock to 13 million shares. 2. Summary of Significant Accounting Policies Principles of Consolidation - The consolidated financial statements include Anuhco and all of its subsidiary companies ("the Company"), all of which are wholly-owned. All significant intercompany accounts and transactions have been eliminated in consolidation. Depreciation and Maintenance - Depreciation is computed using the straight- line method and the following useful lives for new equipment: Upon sale or retirement of operating property, the cost and accumulated depreciation are removed from the accounts and any gain or loss is reflected in non-operating income. The Company expenses costs related to repairs and overhauls of equipment as incurred. Cost of Tires - The cost of tires, including those purchased with new equipment, is expensed when the tires are placed in service. Recognition of Revenues - Operating revenues, and related direct expenses, are recognized when freight is delivered. Other operating expenses are recognized as incurred. Income Taxes - The Company accounts for income taxes in accordance with the liability method as specified in the Financial Accounting Standards Board's Statement No. 109, Accounting for Income Taxes. Deferred income taxes are determined based upon the difference between the book and the tax basis of the Company's assets and liabilities. Deferred taxes are provided at the enacted tax rates expected to be in effect when these differences reverse. Discontinued Operations - American Freight System, Inc. has been accounted for as a "discontinued operation" with only the "net assets" of this operation reflected on the Anuhco financial statements. Anuhco recognizes income from discontinued operations upon receipt of a distribution in accordance with the Joint Plan (See Note 12). Statements of Cash Flows - For purposes of the consolidated statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. 3. Employee Benefits Multiemployer Plans Crouse Cartage contributed $2,780,082, $2,573,270 and $805,164 to the multiemployer pension plans for 1993, 1992 and 1991, respectively. Crouse Cartage contributed $3,600,635, $3,128,312 and $1,005,485 to the multiemployer health and welfare plans for 1993, 1992 and 1991, respectively. Contribution amounts for 1991 relate only to the post-acquisition period of September 1 through December 31. Non-Union Pension Plan Crouse Cartage has a defined contribution profit sharing (as defined by the Internal Revenue Code) plan ("the Non-union Plan") providing for a mandatory Company contribution of 5% of annual earned compensation of the non-union employees. Additional discretionary contributions can be made by Crouse Cartage depending upon profitability of Crouse Cartage. Any discretionary funds contributed to the Non-union Plan will be invested 100% in Anuhco Common Stock. Crouse Cartage had a defined benefit pension plan covering employees not covered under collective bargaining agreements. Crouse Cartage terminated this plan effective December 31, 1992, at which time all benefit accruals ceased. Benefits under the plan were based on years of service and the employees' compensation during the last three years of employment. All par- ticipants who had met this plan's requirements, who had been entered into this plan and who were actively employed by Crouse Cartage as of the termination date, are 100% vested in their accrued plan benefits. Crouse Cartage has purchased an annuity contract to satisfy the individual accrued plan benefits as of the termination date. Crouse Cartage intends to distribute any excess plan assets to plan participants as additional annuities or through rolling them into the Non-union Plan. The Company believes the plan assets will be sufficient to settle all termination obligations and expenses, including the participants' accrued plan benefits. Final settlement of the terminated plan is expected in 1994. Pension expense, exclusive of the multi-employer pension plans, was $80,000, $0 and $184,845 for the years 1993, 1992 and 1991, respectively. The accompanying consolidated balance sheet includes a pension liability of $152,158 and $375,000 as of December 31, 1993 and 1992, respectively. Profit Sharing In September, 1988, the employees of Crouse Cartage approved the establishment of a profit sharing plan ("the Plan"). The Plan is structured to allow all employees (union and non-union) to ratably share 50% of Crouse Cartage's income before income taxes (excluding extraordinary items and gains or losses on the sale of assets) in return for a 15% reduction in their wages. The Plan calls for profit sharing distributions to be made on a quarterly basis. The Plan was recertified in 1991, and shall continue in effect through March 31, 1994, or until a replacement Collective Bargaining Agreement is reached between the parties, whichever is the later. Although the outcome is uncertain, Crouse Cartage believes the Plan will be further extended coincident with the conclusion of the overall union contract negotiations. The accompanying consolidated balance sheet includes profit sharing accruals of $986,583 and $742,408 for 1993 and 1992, respectively. The accompanying consolidated statement of income includes profit sharing expense of $3,307,862, $3,071,057 and $874,268 for 1993, 1992 and 1991, respectively. 401(k) Plan Effective January 1, 1990, Crouse Cartage established a salary deferral program under Section 401(k) of the Internal Revenue Code ("the Code"). To date, participant contributions to the 401(k) plan have not been matched with Company contributions. All employees of the Company are eligible to participate in the 401(k) plan after they attain age 21 and complete one year of qualifying employment. 4. Insurance Coverage Claims and insurance accruals reflect accrued insurance premiums and the estimated cost of incurred claims for cargo loss and damage, bodily injury and property damage and workers' compensation not covered by insurance. Workers' compensation expense is included in "Salaries, wages and fringe benefits" in the accompanying statement of income. The Company's public liability and property damage, cargo and workers' compensation premiums are subject to retrospective adjustments based on actual incurred losses. The actual adjustments normally are not known for at least one year; however, based upon a review of the preliminary compilation of losses incurred through December 31, 1993, management does not believe any material adjustment will be made to the premiums paid or accrued at that date. In connection with its public liability and property damage, cargo and workers' compensation insurance coverage, the Company has an irrevocable standby letter of credit ("LOC"), which at December 31, 1993, was $850,000. The LOC, required by the Company's insurance provider, is deemed to be automatically extended unless notice of termination is given. The fee for the LOC is 1% of the LOC amount. 5. Long-Term Debt Long-term debt was as follows, as of December 31: The Convertible Note is payable to sellers of Crouse Cartage, including certain employees, Crouse Cartage officers, and a director and officer of Anuhco. If such note remains unpaid for 15 days after maturity, October 15, 1995, the holders of the note, may at their option, elect to convert the unpaid principal and interest thereunder into 11% cumulative $100 par value preferred stock. The number of such shares is to be determined by dividing the aggregate dollar amount of the unpaid principal and interest by 100. Under certain conditions and upon 30 days prior written notice to the Company, all but not less than all of the preferred stock may be converted to common stock. There are no required payments of existing long-term debt during 1994 through 1998. However, it is the Company's intent to repay the Convertible Note prior to the option date or otherwise prevent its conversion. At December 31, 1993, substantially all net property, equipment and accounts receivable was subject to liens under various debt instruments. 6. Revolving Credit Agreement In September, 1988, Crouse Cartage entered into a five-year credit agreement with a commercial bank which provided for maximum borrowings equaling the lesser of $2,500,000 or the borrowing base, as defined in such agreement. Based on the value of its revenue equipment, such borrowing base exceeds $2,500,000 at December 31, 1993. This agreement was amended and superseded on September 30, 1991, and Anuhco was added as a guarantor. In May, 1993 the term was extended to July 31, 1995. There was no outstanding balance on this revolving line of credit at December 31, 1993 or 1992. On the last day of each calendar month through the term of the agreement, Crouse Cartage is required to pay to the bank equal payments of principal, each in an amount equal to one forty-eighth (1/48) of the highest unpaid principal balance of the previous 12-month period. The agreement provides for interest on borrowings at the bank's prime rate. The effective rate at December 31, 1993, was 6%. The agreement can be terminated by the bank on six months notice or by Crouse Cartage on 30 days notice after full payment of any debt to the bank. The terms of the agreement require the maintenance of a minimum shareholder's equity and contain restrictions on declaration and payment of dividends, acquisition of Crouse Cartage stock, loans to officers or employees, type of investments and annual capital expenditures. The Company was in compliance with all such restrictions at December 31, 1993. 7. Common Stock In accordance with a resolution to amend Anuhco's Certificate of Incorporation, duly prepared and adopted at the Company's 1993 Annual Shareholders' Meeting, the capital stock of Anuhco was changed from stock without par value to $0.01 par value per share effective June 1, 1993. Such change has no impact on total shareholders' equity but does require a reclassification of a portion of capital stock to paid-in capital. This amendment will provide a cost savings on certain franchise taxes. An Incentive Stock Option Plan was adopted in 1983 which provides that options for shares of Anuhco Common Stock may be granted to officers and key employees at fair market value of the stock at the time such options are granted. This plan terminated under its provisions in May, 1993 and no further options may be granted. At December 31, 1993 options for 30,000 shares were outstanding at an average option price of $2.36 per share and options for 10,000 were exercisable. The remaining outstanding options will become exercisable over a period through 1997. An Incentive Stock Plan was adopted in 1992 which provides that options for shares of Anuhco Common Stock shall be granted to directors, and may be granted to officers and key employees at fair market value of the stock at the time such options are granted. At December 31, 1993 options for 73,000 shares were outstanding at an average option price of $4.00 per share and options for 14,500 shares were exercisable. The remaining outstanding options will become exercisable over a period through 2003. 8. Income Taxes The Company accounts for income taxes in accordance with the liability method as required in the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". The impact of significant temporary differences and carryforwards representing deferred tax assets and liabilities is determined utilizing the enacted tax rates expected to be in effect when such differences reverse. Deferred tax liabilities (assets) are comprised of the following at December 31: At December 31, 1992 the Company had $25 million of net operating loss carryforwards and $1 million of tax credit carryforwards which will be available for Federal income tax purposes. In addition, the Company generated net operating loss carryforwards in 1993. The amount of these additional carryforwards is estimated to be in excess of $10 million. The net operating loss carryforwards will expire over a period from 2005 to 2008. The tax credit carryforwards expire over a period from 1998 to 2001. The following is a reconciliation of the statutory Federal income tax rate to the effective income tax rate. No net provision for income tax has been made for the years ended December 31, 1993, 1992 or 1991 and no asset related to the Company's net operating loss carryforwards has been recognized due to significant tax losses from the discontinued operations during those years and projected future tax losses. 9. Union Contract During 1991, Crouse Cartage negotiated with its unions for a new contract and in June, 1991, the unions approved a three-year National Master Freight Agreement ("the Agreement") with wage rate increases of $0.50 per hour in 1991 and $0.45 per hour in 1992 and 1993. The Agreement included a profit sharing program provided that such program was ratified by at least 75% of the Company's bargaining unit employees (see Note 3). Negotiations by and between Crouse Cartage and the Teamsters Union for the next contract period are ongoing. Crouse Cartage believes the final impact of such negotiations will not significantly affect the results of operations or financial position of the Company. 10. Long-Term Obligation Receivable In connection with the sale of its terminal in Hodgkins, Illinois, Crouse Cartage received a $1,000,000 Subordinated Tax Incremental General Obligation Bond, Series 1991 ("the Bond"), issued by the Village of Hodgkins, Illinois. The Bond has a face value of $1,000,000, accrues interest at a rate of 14% and is due in December, 2009. Interest at 10% is payable semi-annually on June 1 and December 1, and interest at 4% is due on the December 20th immediately following the date that the principal amount is paid in full. Payments of interest and the repayment of the Bond principal will be funded by future tax revenues from the commercial development of the acquired property and no payments have been made, to date. Based upon the Village of Hodgkins' current cash flow projections and the timing of interest and principal payments, the effective interest rate on the Bond is estimated to be approximately 9%. Accrued interest, during 1993 and 1992 of $90,000, has been recorded as an addition to the carrying value of this bond. 11. Contingencies and Commitments The Company is party to certain other claims and litigation arising in the ordinary course of business. In the opinion of management, the outcome of such claims and litigation will not materially affect the Company's financial position. Crouse Cartage leases buildings and office equipment under various leases which expire from 1994 to 2001. The majority of these building leases are with a former owner of Crouse Cartage. Effective January 1, 1994, Crouse Cartage exercised its purchase options under certain operating leases. Such options covered the purchase of twelve (12) facilities (11 terminals and a salvage store operation) from P&R Realty, a sole proprietorship and related party, for approximately $2.6 million. The option prices were based on the market value of each property, as established by an independent real estate appraiser, and were each equal to or less than the appraised values. Crouse Cartage financed these purchases through currently available operating funds, which included borrowing of $0.5 million on its $2.5 million revolving credit agreement. Crouse Cartage has utilized these facilities for its operations for numerous years and currently anticipates their continued use without change. The exercise of these options will, among other things, have the effect of reducing rental expense by approximately $314,000 annually. Rental expense for 1993, 1992 and 1991 was $492,262, $576,066 and $597,822, respectively. At December 31, 1993, there are no future minimum lease payments under noncancellable operating leases having initial or remaining lease terms of more than one year. Payments are made to tractor owner-operators under various short-term lease agreements for the use of revenue equipment. These lease payments, which totaled $9,554,580, $9,416,968 and $9,275,336 for 1993, 1992 and 1991, respectively, are primarily based on miles traveled or on a percent of revenue generated through the use of the equipment. Future commitments for the purchase of operating property totaled approximately $2.6 million at December 31, 1993, including the aforementioned exercise of options on real property. The total amount of this commitment was paid in January, 1994 and was funded by current operations and a $500,000 draw on the revolving credit agreement. 12. Discontinued Operations Under the provisions of the Joint Plan, American Freight System, Inc. ("AFS") is responsible for the continued resolution of pre-July 12, 1991 creditor claims and conversion of assets owned before that date. As claims are allowed and cash is available, distributions to the creditors will occur. The Joint Plan also provides for distributions to Anuhco as unsecured creditor distributions occur in excess of 50% of allowed claims in accordance with the following table. Such distributions are recognized as "Income from Discontinued Operations" by Anuhco at the time they are received. Anuhco also receives the full benefit of any remaining assets through its ownership of AFS stock, if unsecured creditors receive distributions, including interest, equivalent to 130% of their claims. The preceding and the following information does not disclose all the financial impacts of the Joint Plan. For a more in-depth analysis, the complete Joint Plan and related Disclosure Statement, incorporated in this 10-K by reference, should be reviewed. AMERICAN FREIGHT SYSTEM, INC. STATEMENT OF NET ASSETS Assets and Liabilities - Assets, including property and equipment remaining at December 31, 1993 and 1992, are stated at estimated net realizable value. Certain contingent assets have been identified and are described in the Disclosure Statement. Among these contingent assets is a judgment against Westinghouse Credit Corporation ("WCC"). On February 23, 1993, a judgment in favor of Anuhco and AFS was entered in the Circuit Court of Jackson County, Missouri, at Kansas City, Missouri ("the Court"). This judgment was entered in a case filed by Anuhco and AFS against WCC seeking damages as a result of WCC's failure to provide financing pursuant to a loan commitment issued on June 3, 1988. The judgment awarded $70 million in actual damages to be paid to Anuhco and AFS. WCC filed motions with the Court to have this judgment set aside or to have a new trial granted. On April 8, 1993 WCC's motions were overruled. WCC filed a notice of appeal of this judgment with the Western District Court of Appeals of Missouri and posted a $76.35 million surety bond in support of such judgment, accrued interest (9% simple interest) and other costs. Oral arguments before the appellate court were made on November 4, 1993, with an order expected during the first half of 1994. The Appellate Court could (i) reverse the Court's decision, thereby eliminating the judgment; (ii) remand the case to the Court for retrial; or (iii) affirm the Court's decision. Even with the affirmation of the Appellate Court, WCC could request a rehearing before the Appellate Court and/or a transfer to the Missouri Supreme Court. Any damages paid, net of trial expenses, will be remitted to AFS and AFS will distribute such proceeds under the Joint Plan. Under the Joint Plan, if the judgment is affirmed and/or is otherwise substantially collected and the other assets of the discontinued operations are liquidated, Anuhco could receive net proceeds of $29 million to $37 million, including the additional $4 million described under "Distributions" below. This represents $4 to $5 per share based on Anuhco's 7.5 million currently outstanding shares. Anuhco and AFS are unable to predict when or how this matter or other contingent asset issues will ultimately be resolved and, therefore, they have not been included in the above assets. AFS has provided notice to all known creditors and the deadline for filing claims to be resolved under the Joint Plan has expired. Creditors are barred from submitting claims after the deadline. Claims filed by the creditors are significantly in excess of recorded liabilities. In addition, unliquidated and/or contingent claims were filed; the potentially significant claims are described in the Disclosure Statement. Although some of these claims may result in an increase in liabilities, the amount and timing of such liabilities are unknown. AFS is in the process of investigating these claims, however until this process is completed the amount of liabilities to be settled cannot be ascertained. The ultimate resolution of the amounts, validity and priority of recorded liabilities and other claims is uncertain at this time. Accordingly, liabilities are reflected at estimated amounts due or are based on claims filed with the debtor and modified to reflect AFS assets available to distribute on such liabilities. Future Administrative Costs and Investment Income - AFS will continue to incur professional fees and other administrative costs in connection with the sale of its assets, collection of receivables and settlement of its liabilities. In addition, investment income will be realized on funds invested pending disbursements to creditors. The amount of such costs and income will depend on many factors including the length of time the close- down process continues. An accrual of $3.4 million for future administrative costs net of investment income has been reflected in the 1993 consolidated financial statements. The estimated costs and/or income and any deviations therefrom are absorbed by AFS and only impact Anuhco as a result of the aforementioned participation arrangement. Distributions - On February 18, 1992, September 11, 1992, April 15, 1993 and October 13, 1993 AFS made interim distributions under the Joint Plan at the rate of 20%, 20%, 10% and 5%, respectively, of each allowed unsecured claim. Anuhco's participation in these distributions were $1 million, $1.25 million, $2.5 million and $1.25 million, respectively. A portion of these distributions was applied as payment of a note payable to AFS. To date AFS has distributed a total of 95% on allowed claims which is a more favorable result than was assumed in the March 21, 1991 Disclosure Statement relating to the Joint Plan. Such result is due to favorable (i) settlements of certain claims, (ii) court decisions, and (iii) asset realizations. A revised projection, excluding any impact of the WCC judgment, is that total distributions to Anuhco (including the $6 million previously distributed) may exceed $10 million. This revised projection continues to include the assumptions enumerated in the Disclosure Statement regarding conditions and contingencies. Due to the number and value of claims to be resolved and assets to be converted to cash, the timing and amount of additional interim distributions and the timing of the final distribution have not been included in the revised projection. SUPPLEMENTAL FINANCIAL INFORMATION Summary of Quarterly Financial Information (Unaudited) Anuhco's quarterly operating results, as well as those of the motor carrier industry in general, fluctuate with the seasonal changes in tonnage levels and with changes in weather related operating conditions. Inclement weather conditions during the winter months adversely affect freight shipments and increase operating costs. Historically, Anuhco has achieved its best operating results in the second and third quarters when adverse weather conditions have a lessor effect on operating efficiency. Discontinued operations reflects the continuing winddown of the AFS and related estates. The amounts and timing of future distributions/income are not known (see Note 12 to the consolidated financial statements). The following table sets forth selected unaudited financial information for each quarter of 1993 and 1992 (in thousands, except per share amounts). Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures This Item 9 is not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Pursuant to General Instruction G(3), the information required by this Item 10 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. (See Item 4, included elsewhere herein, for a listing of Executive Officers of the Registrant). Item 11. Item 11. Executive Compensation Pursuant to General Instruction G(3), the information required by this Item 11 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to General Instruction G(3), the information required by this Item 12 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. Item 13. Item 13. Certain Relationships and Related Transactions Pursuant to General Instruction G(3), the information required by this Item 13 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports (a)1. Financial Statements Included in Item 8, Part II of this Report - Consolidated Balance Sheet at December 31, 1993 and 1992 Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Supplemental Financial Information (Unaudited) - Summary of Quarterly Financial Information for 1993 and (a)2. Financial Statement Schedules Included in Item 14, Part IV of this Report - Financial Statement Schedules for the three years ended December 31, 1993: Schedule IV - Indebtedness of and to Related Parties Schedule V - Property and Equipment Schedule VI - Accumulated Depreciation of Property and Equipment Section VIII - Valuation and Qualifying Accounts Section X - Supplemental Income Statement Information Other financial statement schedules are omitted either because of the absence of the conditions under which they are required or because the required information is contained in the consolidated financial statements or notes thereto. (a)3. Exhibits 2(a) - Fifth Amended Joint Plan of Reorganization of the Registrant and others and Registrant's Disclosure Statement Relating to the Fifth Amended Joint Plan of Reorganization. Filed as Exhibit 28(a) and 28(b) to the Registrant's Form 8-K dated March 21, 1991. 2(b) - United States Bankruptcy Court order confirming the Fifth Amended Joint Plan of Reorganization of the Registrant and others. Filed as Exhibit 28(c) to Registrant's Form 8-K dated June 11, 1991. 3(a) - 1993 Restated Certificate of Incorporation of the Registrant. Filed as Exhibit 3 to Registrant's Form 10-Q dated August 4, 1993. 3(b) - By-Laws of the Registrant. Filed as Exhibit 3(b) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 4 - Specimen Certificate of the Common Stock, no par value, of the Registrant. Filed as Exhibit 4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(a) - Registrant's 1983 Incentive Stock Option Plan. Filed as Exhibit 10(a) to Registrant's Registration Statement No. 2- 83536, effective May 22, 1986. 10(b) - Form of Indemnification Agreement with Directors and Executive Officers. Filed as Exhibit 10(k) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986. 10(c) - Trust and Security Agreement by and between American Freight System, Inc. (Grantor) and The Merchants Bank (Trustee), dated July 11, 1991. Filed as Exhibit 10(c) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(d) - Agreement by and between Registrant (Buyer) and owners of the outstanding capital stock of CC Investment Corporation (Sellers). Filed as Exhibit 10 to Registrant's Form 8-K dated August 9, 1991. 10(e) - Convertible Note for the principal sum of $3,620,000 issued by Registrant (Maker) to Bankers Trust of Des Moines, Iowa, as agent for the owners of the outstanding capital stock of CC Investment Corporation, dated November 1, 1992. Filed as Exhibit 10(e) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 10(f) - Incentive Compensation Agreement by and between Registrant and Lawrence D. Crouse, and Employment Agreement by and between Crouse Cartage Company and Lawrence D. Crouse. Filed as Appendices F. and G. to Exhibit 28(a) to Registrant's Form 8-K dated September 19, 1991. 10(g) - Promissory Note for the principal sum of $2,800,000 by and between Registrant and American Freight System, Inc., dated October 1, 1991. Filed as Exhibit 10(g) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(h) - Stock Sale Agreement for shares of common stock of Crouse Cartage Company by and between Registrant and American Freight System, Inc., dated October 1, 1991 and supplement thereto dated September 25, 1991. Filed as Exhibit 10(h) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(i) - Secured Revolving Credit Agreement for a revolving credit facility in the amount of $2,500,000 by and between Crouse Cartage Company and Bankers Trust Company of Des Moines, Iowa. Filed as Exhibit 10(i) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(j) - Registrant's 1992 Incentive Stock Plan. Filed as Exhibit 10(j) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 22* - List of all subsidiaries of Anuhco, Inc., the state of incorporation of each such subsidiary, and the names under which such subsidiaries do business. 24* - Consent of Independent Public Accountant. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended December 31, 1993. * Filed herewith. [FN] 1 As mandated by the Joint Plan, AFS loaned $2.8 million to Anuhco which was utilized in the purchase of Crouse Cartage. 2 The indebtedness was incurred as a portion of the purchase price for the acquisition of Crouse Cartage. [FN] 1 Property and equipment acquired in connection with the acquisition of Crouse Cartage Company. [FN] 1 Accumulated depreciation at the date of acquisition of Crouse Cartage Company. [FN] 1 Deduction for purposes for which reserve was created. 2 Reserve balance at the time of the acquisition of Crouse Cartage Company. [FN] NOTE: Depreciation and amortization of intangible assets, royalties and advertising costs were each less than 1% of operating revenue during the years 1993, 1992 and 1991. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Date: March 2, 1994 By /s/ John P. Bigger John P. Bigger, Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ John P. Bigger President and Chief Executive Officer John P. Bigger (Principal Executive Officer) /s/ John P. Bigger Treasurer and Chief Financial Officer John P. Bigger (Principal Financial and Accounting Officer) /s/ Joe J. Brown /s/ Roy R. Laborde Joe J. Brown, Director Roy R. Laborde, Chairman of the Board of Directors /s/ William D. Cox /s/ Eleanor B. Schwartz William D. Cox, Director Eleanor B. Schwartz, Director /s/ Lawrence D. Crouse /s/ Walter P. Walker Lawrence D. Crouse, Director Walter P. Walker, Director /s/ Donald M. Gamet Donald M. Gamet, Director March 2, 1994 Date of all signatures Registrant's Proxy Statement for Annual Meeting of Shareholders to be held in 1994 and Annual Report will be mailed to security holders at a later date. Copies of such material will be furnished to the Securities and Exchange Commission when it is sent to security holders. (All companies do business under same name unless otherwise indicated). Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K into the Company's previously filed Registration Statements for the Anuhco, Inc. 1992 Incentive Stock Plan, File No. 33-51494 and the American Carriers, Inc. 1983 Incentive Stock Option Plan, File No. 2-86915. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Kansas City, Missouri March 2, 1994

806027_1993.txt

806027_1993

1993

806027

Item 1. Business DESCRIPTION OF THE BUSINESS Business Groups ServiceMaster is functionally divided into four operating groups: Management Services, Consumer Services, Diversified Health Services and International and New Business Development. Management Services and Consumer Services are the two principal business groups. Reference is made to the information under the caption "Business Unit Reporting" on page 31 of the ServiceMaster Annual Report to Shareholders for 1993 (the "1993 Annual Report") for detailed financial information on these two groups. The Company's trademarks and service marks are important for all elements of the Company's business, although such marks are particularly important in the advertising and franchising activities conducted by the operating subsidiaries of ServiceMaster Consumer Services L.P. Such marks are registered and are renewed at each registration expiration date. Within ServiceMaster Consumer Services, franchises are important for the ServiceMaster Residential/Commercial business, the Merry Maids business, the Terminix business and the TruGreen- ChemLawn business. Nevertheless, revenues and profits derived from franchise-related activities constitute less than 10% of the revenue and profits of the consolidated ServiceMaster enterprise. Franchise agreements made in the course of these businesses are generally for a term of five years. ServiceMaster's renewal history is that the majority of franchise agreements which expire in any given year are renewed. As discussed in further detail below, the Terminix and TruGreen-ChemLawn businesses are seasonal in nature. Management Services ServiceMaster pioneered the providing of supportive management services to health care facilities by instituting housekeeping management services in 1962. Since then, ServiceMaster has expanded its management services business such that it now provides a variety of supportive management services to health care, education and commercial customers (including the management of housekeeping, plant operations and maintenance, laundry and linen, grounds and landscaping, clinical equipment maintenance, energy management services and food service). ServiceMaster's general programs and systems free the customer to focus on its core business activity with confidence that the support services are being managed and performed in an efficient manner. As of December 31, 1993, ServiceMaster was providing supportive management services to approximately 2,300 health care, educational and commercial facilities. These services were being provided in all 50 states and the District of Columbia and in 15 foreign countries. Outside of the United States, ServiceMaster was providing management services through subsidiaries in the United Kingdom and Japan, through affiliated companies in Canada, Japan and Italy, and through licensees in Mexico, Korea, Australia, New Zealand, Singapore, Taiwan, Hong Kong, Czechoslovakia, Japan and throughout the Middle East. International and New Business Development is responsible for overseeing the services provided in foreign markets. Consumer Services ServiceMaster Consumer Services provides specialty services to homeowners and commercial facilities through five companies: The Terminix International Company L.P. ("Terminix"); TruGreen- ChemLawn L.P. ("TruGreen-ChemLawn"); Merry Maids L.P. ("Merry Maids"); American Home Shield Corporation ("American Home Shield" or "AHS"); and ServiceMaster Residential/Commercial Services L.P. ("Res/Com"). The services provided by these companies include termite and pest control and radon testing services under the "Terminix" service mark; lawn care, tree and shrub services under the "TruGreen" and "ChemLawn" service marks; domestic housekeeping services under the "Merry Maids" service mark; home systems and appliance warranty contracts under the "American Home Shield" service mark; and residential and commercial cleaning and disaster restoration services under the "ServiceMaster" service mark. The services provided by the five Consumer Services companies are part of the ServiceMaster "Quality Service Network" and are accessed by calling a single toll-free telephone number: 1-800-WE SERVE. ServiceMaster focuses on establishing relationships to provide one or more of these services on a repetitive basis to customers. Since 1986, the number of customers served by ServiceMaster Consumer Services has increased from fewer than one million customers to more than 5.9 million customers (including International operations). Terminix. Terminix is a wholly owned subsidiary of ServiceMaster Consumer Services L.P. Terminix, both directly and through franchisees, is the leading provider of termite, pest control and radon testing services to approximately 1.9 million residential and commercial customers in the United States. As of December 1993, Terminix was providing these services through 315 company-owned branches in 39 states and Mexico and through 218 franchised branches in 21 states and Mexico. Terminix also provides termite and pest control services in Japan, Taiwan, Lebanon, Saudi Arabia, Oman and the United Kingdom through licensing arrangements with local partners. TruGreen-ChemLawn. TruGreen-ChemLawn is an 85% owned subsidiary of ServiceMaster Consumer Services Limited Partnership (with senior management of TruGreen-ChemLawn holding the remaining 15% interest) and is the entity through which ServiceMaster provides lawn care services. TruGreen-ChemLawn is the leading provider of lawn care services to over 2.2 million residential and commercial customers in the United States. As of December 31, 1993, TruGreen-ChemLawn had 172 company-owned branches and 71 franchised branches. Merry Maids. Merry Maids is a wholly owned subsidiary of ServiceMaster Consumer Services Limited Partnership. (A minority interest held by senior management of Merry Maids at the end of 1993 will be acquired by Merry Maids in 1994). Merry Maids is the organization through which ServiceMaster provides domestic house cleaning services, of which it is one of the country's leading providers. As of December 31, 1993, these services were provided to about 170,000 customers through one company-owned branch and through 689 licensees operating in 49 states. Merry Maids also provides domestic housecleaning services in Japan, the United Kingdom, Canada, Saudi Arabia and Australia through licensing arrangements with local service providers. American Home Shield. AHS is a wholly owned subsidiary of SVM Holding Corp., a holding company in which ServiceMaster Consumer Services L.P. owns 100% of the equity. (An 8% interest held by senior management of AHS at the end of 1993 will be acquired by SVM Holding Corp. in 1994). AHS is a leading provider of home service warranty contracts in the United States, providing homeowners with contracts covering the repair or replacement of built-in appliances, hot water heaters and the electrical, plumbing, central heating, and central air conditioning systems which malfunction by reason of normal use. Service contracts are presently sold principally through participating real estate brokerage offices in conjunction with resales of single-family residences to homeowners. AHS also sells service warranty contracts directly to non-moving homeowners through various other distribution channels which are currently being expanded. As of December 31, 1993, AHS was providing services to approximately 268,000 homes through approximately 6,000 independent repair maintenance contractors in 48 states and the District of Columbia, with operations in California, Texas and Arizona accounting for 32%, 20% and 9%, respectively, of AHS' gross contracts written. AHS also provides home service warranty contracts in Japan and Saudi Arabia through licensing arrangements with local service providers. Res/Com. Res/Com is a wholly owned subsidiary of ServiceMaster Consumer Services L.P. ServiceMaster, through Res/Com, is one of the leading franchisors in the residential and commercial cleaning field. Res/Com provides, through franchisees, carpet and upholstery cleaning and janitorial services, disaster restoration services and window cleaning services to over 1.2 million residential and commercial customers worldwide through a worldwide network of over 4,260 independent franchisees. Diversified Health Services The Diversified Health Services Group was organized in 1993. It consists of ServiceMaster Home Health Care Services and ServiceMaster Diversified Health Services. The latter company was acquired by ServiceMaster in August 1993, at which time the company was known as VHA Long Term Care. ServiceMaster Diversified Health Services. ServiceMaster Diversified Health Services, Inc., ServiceMaster Diversified Health Services L.P. and their respective subsidiaries (collectively, the "ServiceMaster Diversified Health Services Companies") form a comprehensive health services organization which provides: management services to freestanding, hospital based, and government owned nursing homes and assisted living facilities; design, development, refurbishing and construction consulting services to long-term care facilities; hospice services; and various medical supplies. The companies are the exclusive licensee to promote the provision of long-term care services to the hospitals in the Voluntary Hospitals of America alliance. As of December 31, 1993, the ServiceMaster Diversified Health Services Companies were providing management services to approximately 14,000 beds in 26 states in a total of 93 facilities. Home Health Care Services. ServiceMaster Home Health Care Services Inc. provides management services to hospital-based home health care agencies and operates freestanding home health care agencies. As of December 31, 1993, this organization was serving 46 hospital-affiliated home health care agencies and was serving four freestanding agencies. International and New Business Development. The International and New Business Development Group oversees the performance of supportive management services and consumer services in international markets in each case through the arrangements described above. The International and New Business Development Group also operates employer or developer sponsored child care centers under the "GreenTree" service mark. As of December 31, 1993, GreenTree had 14 child care centers in operation, all of which were in the greater Chicago area and in Milwaukee, Wisconsin. Other Activities Supporting Departments. ServiceMaster has various departments responsible for technical, engineering, management information, planning and market services, and product and process development activities. Various administrative support departments provide personnel, public relations, administrative, education, accounting, financial and legal services. Manufacturing Division. ServiceMaster has a manufacturing division which manufactures and distributes supplies, products and equipment that are used internally in providing management services to customers and which are sold to licensees for use in the operation of their businesses. ServiceMaster has an insignificant share of the market for the manufacture and distribution of cleaning equipment, chemicals and supplies. Industry Position, Competition and Customers The following information is based solely upon estimates made by the management of ServiceMaster and cannot be verified. In considering ServiceMaster's industry and competitive positions, it should be recognized that ServiceMaster competes with many other companies in the sale of its services, franchises and products and that some of these competitors are larger or have greater financial and marketing strength than ServiceMaster. The principal methods of competition employed by ServiceMaster in the Management Services, etc. business are price, quality of service and history of providing management services. The principal methods of competition employed by ServiceMaster in the Consumer Services business are name recognition, assurance of customer satisfaction and history of providing quality services to homeowners. The principal methods of competition employed by ServiceMaster in the Diversified Health Services business are name recognition, price, quality of services and history of providing management services. Management Services: Health Care Market. Within the market consisting of general health care facilities having 50 or more beds, ServiceMaster is the leading supplier of plant operations and maintenance, housekeeping, clinical equipment maintenance, and laundry and linen management services. As of December 31, 1993, ServiceMaster was serving in approximately 1,300 health care facilities. The majority of health care facilities within this market not currently served by ServiceMaster assume direct responsibility for managing their own non-medical support functions. ServiceMaster believes that its management services for health care facilities may expand by the addition of facilities not presently served, by initiating additional services at facilities which use only a portion of the services now offered, by the development of new services and by growth in the size of facilities served. At the same time, changes in use and methods of health care delivery and payment for services continue to affect the health care environment. Management Services: Education Market. ServiceMaster is a leading provider of maintenance, custodial, grounds and food management services to the education market. The facilities which comprise the education market served by ServiceMaster include primary schools, secondary schools and school districts, private specialty schools and colleges and universities. ServiceMaster continues to experience steady growth in this market. As of December 31, 1993, ServiceMaster was serving in approximately 500 educational facilities. ServiceMaster believes there is significant potential for expansion in the education market due to its current relatively low penetration of that market and the trend of educational facilities to consider outsourcing more of their service requirements. However, a majority of the educational facilities continue to assume direct responsibility for managing their support functions. Management Services: Industrial and Commercial Market. ServiceMaster believes it is a leading provider of plant operations and maintenance, custodial and grounds management services to industrial and commercial customers. During the period 1991 - 1993, this market has been adversely affected by generally weak economic conditions and corporate downsizing, but ServiceMaster continues to believe that there is potential for expansion in the industrial and commercial market due to ServiceMaster's low current penetration of that market and the trend of industrial and commercial enterprises to consider outsourcing more of their service requirements. Consumer Services. Consumer Services franchisees provide a variety of residential and commercial services under their respective names on the basis of their and ServiceMaster's reputation, the strength of their service mark, their size and financial capability, training and technical support services. The market for termite, pest control and radon testing services to commercial and residential customers includes several large competitors and many small competitors. Terminix is the leading national termite and pest control company within this market and has a significant share of the market. Competition within the termite and pest control market is strong, coming mainly from regional and local, independently owned firms throughout the United States and from one other company which operates on a national basis. Termite and pest control services are regulated by law in most of the states in which Terminix provides such services. These laws require licensing which is conditional on a showing of technical competence and adequate bonding and insurance. The extermination industry is regulated at the federal level under the Federal Insecticide, Fungicide and Rodenticide Act, and pesticide applicators (such as Terminix) are regulated under the Federal Environmental Pesticide Control Act of 1972. Such laws, together with a variety of state and local laws and regulations, may limit or prohibit the use of certain pesticides, and such restrictions may adversely affect the business of Terminix. TruGreen-ChemLawn, both directly and through ChemLawn franchisees, provides lawn care services to residential and commercial customers. Competition within the lawn care market is strong, coming mainly from regional and local, independently owned firms and from homeowners who elect to care for their lawns through their own personal efforts. TruGreen-ChemLawn is the leading national lawn care company within this market. The market for domestic house cleaning services is highly competitive. In urban areas the market involves numerous local companies and a few national companies. ServiceMaster believes that its share of the total potential market for such services is small and that there is a significant potential for further expansion of its housecleaning business through continued internal expansion and greater penetration of the housecleaning market. Through its franchisees, ServiceMaster has a small share of the market for the cleaning of residential and commercial buildings. The market for home systems and appliance warranty contracts is relatively new. ServiceMaster believes that AHS maintains a favorable position in its industry due to the system developed and used by AHS for accepting, dispatching and fulfilling service calls from homeowners through a nationwide network of approximately 6,000 independent contractors. AHS also has a computerized information system developed and owned by AHS, and an electronic digital voice communication system through which AHS handled more than 5.3 million calls in 1993. Diversified Health Services. The ServiceMaster Diversified Health Services Companies constitute the nation's ninth largest long term care company based on the number of beds served and the largest company that is primarily a management services company (as distinguished from a real estate operator). It is also a major provider of planning and design services for long term care facilities and for acute care hospitals. ServiceMaster Home Health Care Services is a leading provider of management services to hospital-affiliated home health care agencies. The number of free-standing home health care agencies operated by ServiceMaster Home Health Care Services represents a very small proportion of home health care agencies in the United States. New Business Development. ServiceMaster Child Care Services, Inc. is the sixth largest manager of employer-based child care facilities in the United States. ServiceMaster believes that there is a significant potential for expansion of its child care services, including particularly in the market consisting of employer-based child care. Major Customers. ServiceMaster has no single customer which accounts for more than 10% of its total revenues. No part of the Company's business is dependent on a single customer or a few customers the loss of which would have a material adverse effect on that part. Revenues from governmental sources are not material. Employees On December 31, 1993, ServiceMaster had a total of approximately 31,000 employees. ServiceMaster provides its employees with annual vacation, medical, hospital and life insurance benefits and the right to participate in additional benefit plans which are described in the Notes to Financial Statements included in the 1993 Annual Report. [CHART] STRUCTURE OF SERVICEMASTER DESCRIPTION OF THE PARTNERSHIP STRUCTURE Organization and Structure of the Parent Companies Until December 30, 1986, the ServiceMaster business was conducted by ServiceMaster Industries Inc. On December 30, 1986, ServiceMaster was reorganized into a limited partnership with the following results, among others: (i) ServiceMaster Limited Partnership became the new parent unit in the ServiceMaster enterprise with one limited partnership share in ServiceMaster Limited Partnership being issued to replace every then outstanding share of common stock issued by ServiceMaster Industries Inc.; (ii) The ServiceMaster Company Limited Partnership was established as the principal operating subsidiary of ServiceMaster Limited Partnership, with the parent entity receiving the entire limited partnership interest in The ServiceMaster Company (representing not less than 99% of the entire ownership interest); and (iii) substantially all of the assets and liabilities associated with the ServiceMaster business were conveyed to The ServiceMaster Company. Until January 31, 1992, the general partners in ServiceMaster Limited Partnership and The ServiceMaster Company were ServiceMaster Management Corporation, which served as the managing general partner, and three individual general partners. On January 31, 1992, the three individual general partners withdrew and became stockholders of ServiceMaster Management Corporation, leaving ServiceMaster Management Corporation as the sole general partner having management authority in the two principal partnerships and, as further discussed below, the sole general partner having an interest in the 1% carried interest reserved to the general partners of the two partnerships. Since January 1, 1987, the general partners have collectively held a 1% interest in all profits and losses of ServiceMaster Limited Partnership and of The ServiceMaster Company, in each case limited to profits and losses generated since the reorganization. Following the withdrawal of the individual general partners on January 31, 1992, the entire 1% interest in the profits and losses of each of ServiceMaster Limited Partnership and The ServiceMaster Company has been held by ServiceMaster Management Corporation. These separate interests constitute an aggregate interest of approximately 2% of the consolidated income and losses of the ServiceMaster business (determined after allowing for minority interests in subsidiaries, where applicable). The Board of Directors of ServiceMaster Management Corporation has the ultimate power to govern the ServiceMaster business. A majority of the positions on the Board are reserved for independent directors. Although the stock of ServiceMaster Management Corporation is owned by members of ServiceMaster management, the stockholders have entered into voting trust arrangements under which the incumbent members of the Board have the right to determine the persons who will be elected to the Board each year. These arrangements were not altered by the 1992 Reorganization. Although the owners of the outstanding limited partner shares issued by ServiceMaster Limited Partnership do not have the right to vote directly for the directors of ServiceMaster Management Corporation, they do have the right to replace ServiceMaster Management Corporation as the managing general partner by voting the percentages of their shares prescribed in the Partnership Agreement in favor of such replacement (provided, however, that certain opinions of counsel are obtained). The holders of the outstanding shares of ServiceMaster Limited Partnership accordingly retain the ultimate right to select the ServiceMaster management. The 1992 Reorganization (ServiceMaster Corporation) Reference is made to the Preface on page 1 for the background of the 1992 Reorganization. As a result of the approval of the Reorganization Package on January 13, 1992, ServiceMaster Corporation was admitted as a Special General Partner of the Registrant on January 31, 1992. As of March 21, 1994, no shares of stock of ServiceMaster Corporation had been issued and the corporation remained in a formative stage. Organization and Structure of Management Services ServiceMaster Management Services Limited Partnership ("SMMS") provides a separate identity for the Management Services business. This business is primarily carried out through several divisions of SMMS, with a small amount of specialized business conducted through a wholly owned subsidiary. SMMS has two general partners, ServiceMaster Management Services, Inc. and The ServiceMaster Company and 44 limited partners in two classes: Class A and Class B. The general partners together hold a 1% interest in SMMS. The Class A limited partners, all of whom are senior members of SMMS management, collectively own 10% of the equity of SMMS (with equity determined for this purpose after allowing for $505.6 million of intercompany debt to The ServiceMaster Company). The Class B limited partner is The ServiceMaster Company, which holds the remaining equity interest in SMMS. The board of directors of ServiceMaster Management Services, Inc. establishes policy for all elements of the Management Services unit of the ServiceMaster enterprise, subject to the overriding authority of the board of directors of ServiceMaster Management Corporation. Organization and Structure of Consumer Services ServiceMaster Consumer Services Limited Partnership ("SMCS") provides a separate identity for the Consumer Services business. SMCS is a holding company for all of the operating units which comprise such business. SMCS holds all of the Company's interests in the following organizations: ServiceMaster Residential/Commercial Services L.P. and its managing general partner; The Terminix International Company L. P. and its managing general partner; TruGreen L.P. and its managing general partner; Merry Maids L. P. and its managing general partner; and SVM Holding Corp. (the parent company of American Home Shield Corporation). SMCS has two general partners, ServiceMaster Consumer Services, Inc., and The ServiceMaster Company, and two limited partners, The ServiceMaster Company and a subsidiary of WMX Technologies, Inc. (which holds a 27.8% interest). The controlling interest in ServiceMaster Consumer Services, Inc., is held by ServiceMaster Management Corporation. The board of directors of ServiceMaster Consumer Services, Inc. is the governance body for SMCS and establishes policy for all elements of the Consumer Services unit of the ServiceMaster enterprise, subject to the overriding authority of the board of directors of ServiceMaster Management Corporation. Organization and Structure of Diversified Health Services The ServiceMaster Company holds the controlling interests in the following organizations which, together, comprise the ServiceMaster Diversified Health Services Group: the ServiceMaster Diversified Health Services Companies and ServiceMaster Home Health Care Services Inc. The ServiceMaster Diversified Health Services Companies consist of a limited partnership and its general partner and their respective subsidiaries. The ServiceMaster Company owns 89% of the equity of the ServiceMaster Diversified Health Services Companies, with members of senior management owning the remaining 11% of such equity. ServiceMaster Home Health Care Services Inc. is wholly owned by The ServiceMaster Company. Organization and Structure of International and New Business Development International operations of the Company are carried out through licensing or joint venture arrangements all of which are coordinated and supervised by International and New Business Development. This unit of the Company also owns all of the equity in ServiceMaster Child Care Services, Inc. Notes to Organizational Structure Chart The following Notes are intended to be read in conjunction with the organizational structure chart on page 13. Note A--Public Investors The public investors in the Registrant collectively hold a 99% interest in the profits, losses and distributions of the Registrant through their ownership of the limited partner interests in the Registrant ("Partnership Shares"). (If ServiceMaster Corporation were to issue any shares of its common stock, this 99% interest would be divided among the owners of the Partnership Shares and the owners of the corporate shares in accordance with their respective interests). The Partnership Shares are listed on the New York Stock Exchange under the symbol "SVM". For the reasons indicated in Note D below, the public investors' 99% interest in the Registrant entitles the public investors to an approximately 98% interest in the consolidated profits, losses and distributions of ServiceMaster. On June 7, 1993 the Registrant effected a 3-for-2 split of its outstanding Partnership Shares. Note B--ServiceMaster Limited Partnership The Registrant (ServiceMaster Limited Partnership) serves as the holding company for the ServiceMaster business. It does not conduct any significant business operations or own any significant property except for its 99% common equity interest in the profits, losses and distributions of The ServiceMaster Company Limited Partnership. ServiceMaster Corporation became a special general partner of the Registrant following the approval of and in accordance with the 1992 Reorganization. Reference is made to the Proxy Statement/Prospectus of ServiceMaster Limited Partnership dated December 11, 1991 for a complete discussion of the background and arrangements regarding ServiceMaster Corporation. Note C--The ServiceMaster Company Limited Partnership The ServiceMaster Company Limited Partnership conducts all of the operations of the International and New Business Development Group and serves as a holding company for the Management Services, Consumer Services, and Diversified Health Services Groups. All of its common limited partner interests are held by the Registrant. An individual holds a preferred limited partner interest in The ServiceMaster Company which will be redeemed by The ServiceMaster Company on March 31, 1994 with payment to be made on May 31, 1994 - see Note R. On January 1, 1993, the ServiceMaster SGP Trust became a special general partner of The ServiceMaster Company - see Note S. Note D--ServiceMaster Management Corporation (Managing General Partner) ServiceMaster Management Corporation is the managing general partner of ServiceMaster Limited Partnership and The ServiceMaster Company Limited Partnership (collectively referred to in this Note D as the "Partnerships"). ServiceMaster Management Corporation has the ultimate authority to control each entity in the ServiceMaster enterprise. The certificate of incorporation of ServiceMaster Management Corporation requires that a majority of the positions on its board of directors must be comprised of independent directors. The certificate of incorporation further provides that this requirement may not be amended without the consent of the holders of a majority of the outstanding shares of ServiceMaster Limited Partnership. The stock of ServiceMaster Management Corporation is owned by persons who were or are senior members of the ServiceMaster management. The stockholders of this corporation have deposited their stock in a voting trust of which the directors themselves are trustees with discretionary power to vote the stock. These arrangements enable the incumbent members of the Board of Directors to choose the persons elected to the Board each year. On January 31, 1992, as contemplated by the 1992 Reorganization, all individuals who were then serving as general partners of the Partnership withdrew as general partners and became stockholders of ServiceMaster Management Corporation with stock interests therein which indirectly represented their former general partner carried interests. Their general partner carried interests were transferred to ServiceMaster Management Corporation as part of these adjustments. ServiceMaster Management Corporation does not employ any significant number of persons or own any office space or other equipment used to conduct the day-to-day management of ServiceMaster; rather, the employees and assets necessary to manage the ServiceMaster business are based within the operating entities. The applicable partnership agreements as adopted in 1986 and as amended since then provide that the general partners of the Partnerships are entitled to a 1% interest in each of the two Partnerships. As noted above, since January 31, 1992, the sole holder of the 1% interest in each of the two Partnerships has been ServiceMaster Management Corporation. These interests are "carried interests" which means that ServiceMaster Management Corporation is not required to contribute to the capital of the Partnerships except as may be necessary to pay liabilities for which provision cannot otherwise be made. These carried interests will remain at a constant 1% in each of the two Partnerships at all times regardless of the extent to which additional investments in the Partnerships are made by others and regardless of the extent to which the Partnerships redeem other interests. These 1% interests provide ServiceMaster Management Corporation with approximately 1.99% of the profits and losses of the entire ServiceMaster enterprise, that is, ServiceMaster Management Corporation is entitled to 1% of the profits of The ServiceMaster Company Limited Partnership and, because that partnership is 99% owned by ServiceMaster Limited Partnership, it is entitled to an additional 1% of the 99% of The ServiceMaster Company Limited Partnership's profits which are allocated to ServiceMaster Limited Partnership. For the year 1993, each of the Partnerships made cash distributions equal to 1% of its net income to ServiceMaster Management Corporation. The total of the distributions made with respect to 1993 was $2,547,618. From that amount the corporation paid state corporate taxes and, on behalf of its stockholders, the letter of credit fees charged with respect to the promissory notes described in the next paragraph. The balance, $2,339,310, was distributed by ServiceMaster Management Corporation to those past and present officers of ServiceMaster who constituted the stockholders of ServiceMaster Management Corporation. Such persons include Messrs. Pollard, Stair, Cantu, Erickson and Oxley, whose indirect allocations of the total 1.99% carried interest at the end of 1993 were 15.46%, 11.34%, 11.34%, 11.34% and 5.02%, respectively. At December 31, 1993, the stock of ServiceMaster Management Corporation was owned by 33 ServiceMaster executives, each of whom had signed a promissory note payable to the corporation in the amount of the purchase price of his or her stock. Such notes amounted to approximately $15,000,000 in the aggregate and are payable upon demand. The payment of each such note is secured by a letter of credit from the Continental Bank N.A. The fees for such letters of credit are borne entirely by the makers of the notes and not by ServiceMaster. Note E--ServiceMaster Consumer Services Limited Partnership and ServiceMaster Consumer Services,Inc. ServiceMaster Consumer Services Limited Partnership ("SMCS") is the holding company and governance entity for the Consumer Services business. The governance function is carried out through ServiceMaster Consumer Services, Inc., one of the two general partners of SMCS. The second general partner is The ServiceMaster Company. The general partners collectively hold a 1% interest in SMCS. The ServiceMaster Company, one of two limited partners, holds a 72.2% equity interest in SMCS. The other limited partner is WMI Urban Services, Inc. ("WMUS"), a wholly owned subsidiary of WMX Technologies, Inc., which owned 27.8% of the common equity of SMCS at the end of 1993. In June 1992, WMUS and ServiceMaster amended the SMCS limited partnership agreement for the purpose of eliminating the right which WMUS theretofore held to withdraw from SMCS and to receive $160 million in redemption of its equity ownership interest. This withdrawal right was replaced by a right held by WMUS to increase its equity ownership interest in SMCS to 27.8% upon a payment to SMCS of $68 million. On June 8, 1993, WMUS exercised such right, with the result that SMCS received $68 million and WMUS' limited partner interest in SMCS increased from 22% to 27.8%. The board of directors of ServiceMaster Consumer Services, Inc., consists of twelve persons in the following categories: ServiceMaster directors and officers: C. William Pollard, Carlos H. Cantu, Charles W. Stair; persons who are also members of the Board of Directors of ServiceMaster Management Corporation or Senior Management Advisors but who are not ServiceMaster officers: Henry O. Boswell, Herbert P. Hess, Vincent C. Nelson, Kay A. Orr, Phillip B. Rooney and Dallen W. Peterson; persons who are ServiceMaster officers but not directors of ServiceMaster Management Corporation or a Senior Management Adviser: Robert F. Keith; and persons not affiliated with ServiceMaster except as a director of ServiceMaster Consumer Services, Inc.: Donald G. Soderquist (Vice Chairman of the Board and Chief Operating Officer of Wal Mart Stores, Inc.). ServiceMaster Management Corporation has the power to elect and remove the directors of ServiceMaster Consumer Services, Inc. The following persons have been appointed as Senior Management Advisers to the Board of Directors of ServiceMaster Consumer Services, Inc.: Paul A. Bert and Thomas W. Scherer (both of whom are officers of Consumer Services). A Senior Management Adviser, Consumer Services, attends Consumer Services board meetings but does not vote. This position carries no compensation. Note F--ServiceMaster Management Services Limited Partnership and ServiceMaster Management Services, Inc. ServiceMaster Management Services Limited Partnership ("SMMS") is the holding company and governance entity for the Management Services business. The governance function is carried out through ServiceMaster Management Services, Inc., one of the two general partners of SMMS. The second general partner is The ServiceMaster Company. The general partners collectively hold a 1% interest in SMMS, and The ServiceMaster Company, as the Class B limited partner, and members of senior management of Management Services, as Class A limited partners, hold the remaining 99% interest. The board of directors of ServiceMaster Management Services, Inc. consists of nine persons in the following categories: ServiceMaster directors and officers: C. William Pollard, Carlos H. Cantu, Charles W. Stair and Robert D. Erickson; persons who are also members of the Board of Directors of ServiceMaster Management Corporation but who are not ServiceMaster officers: Herbert P. Hess, Gunther H. Knoedler and David K. Wessner; persons who are Senior Management Advisers and officers: Brian D. Oxley; persons who are ServiceMaster officers but not members of the Board of Directors of ServiceMaster Management Corporation or a Senior Management Adviser: Jerry D. Mooney (President, ServiceMaster Diversified Health Services); and persons not affiliated with ServiceMaster except as a director of ServiceMaster Management Services, Inc.: Paul W. Berezny, Jr. (real estate investor). ServiceMaster Management Corporation has the power to elect and remove the directors of ServiceMaster Management Services, Inc. Members of senior SMMS management purchased a 10% interest in SMMS as Class A limited partners. The equity of SMMS is determined, for purposes of such 10% interest, after allowing for intercompany debt to The ServiceMaster Company. Such intercompany debt is offset and eliminated in preparing the consolidated financial statements of the Registrant. SMMS has the right (the "call right") to purchase this minority interest and each Class A limited partner has the right (the "put right") to require SMMS to purchase his or her interest at any time during the period beginning on January 1, 1999 and ending on January 31, 2003. Each Class A limited partner can accelerate his or her put right to the end of 1997 in order to receive shares of the Registrant instead of cash. The purchase price for all transactions involving the purchase of a Class A limited partner interest is the then current fair market value of the interest as confirmed by an independent appraisal. Note G--ServiceMaster Diversified Health Services ServiceMaster Diversified Health Services is comprised of the ServiceMaster Diversified Health Services Companies and ServiceMaster Home Health Care Services. The former is 89% owned by The ServiceMaster Company while the latter is 100% owned by The ServiceMaster Company. The ServiceMaster Diversified Health Services Companies include a parent limited partnership and its general partner, and a number of subsidiary companies. The governance body for the ServiceMaster Diversified Health Services Companies is the board of directors of ServiceMaster Diversified Health Services, Inc. This board consists of eight persons in the following categories: ServiceMaster directors and officers: Carlos H. Cantu, Charles W. Stair, Jerry D. Mooney, Joseph K. Piper, Robert D. Erickson and David K. Wessner; and persons not affiliated with ServiceMaster except as a director of ServiceMaster Diversified Health Services, Inc.: Richard D. Thomas and Curt W. Nomomaque. The following persons have been appointed as Senior Management Advisers, ServiceMaster Diversified Health Services: Bradley T. Barker, James J. Goodrich, Steven R. Martin and Judith A. Ullery. A Senior Management Adviser attends ServiceMaster Diversified Health Services board meetings but does not vote. This position carries no compensation. Note H--The Terminix International Company Limited Partnership The Terminix International Company Limited Partnership ("Terminix") has two general partners: Terminix International, Inc., the managing general partner, and TSSGP Limited Partnership ("TSSGP"). Terminix is a wholly owned subsidiary of SMCS. Note I--TruGreen Limited Partnership TruGreen Limited Partnership ("TruGreen") has two general partners: TruGreen, Inc., which is the managing general partner, and TSSGP. Members of TruGreen management own a 15% minority interest in TruGreen. TruGreen has the right (the "call right") to purchase this 15% minority interest, and each person who holds a part of the minority interest has the right (the "put right") to require TruGreen to purchase his or her minority interest in TruGreen. The call right and the put right may be exercised at any time during the period beginning on January 1, 1997, and ending on January 31, 2002. The purchase price for all transactions involving a minority interest purchase is the then current fair market value as confirmed by an independent appraisal. Note J--Res/Com ServiceMaster Residential/Commercial Services Limited Partnership ("Res/Com") has two general partners: ServiceMaster Residential/Commercial Services Management Corporation, which is the managing general partner, and TSSGP. Res/Com is a wholly owned subsidiary of SMCS. Note K--Merry Maids Merry Maids Limited Partnership ("Merry Maids") has two general partners: Merry Maids, Inc., which is the managing general partner, and TSSGP. Merry Maids is a wholly owned subsidiary of SMCS. (The minority interest in Merry Maids held by members of senior management of Merry Maids at the end of 1993 will be acquired by Merry Maids in 1994). Note L--American Home Shield American Home Shield Corporation ("AHS") is a wholly-owned subsidiary of SVM Holding Corp. ("Holding"). Holding is a wholly owned subsidiary of SMCS. (The 8% interest in Holding held by members of senior management of AHS at the end of 1993 was acquired by Holding in 1994). Note M--ServiceMaster Diversified Health Services Companies The ServiceMaster Diversified Health Services Companies (formerly VHA Long Term Care) are wholly owned subsidiaries of LTCS Investment, L.P. The latter partnership is 89% owned by The ServiceMaster Company and 11% by members of senior management of the ServiceMaster Diversified Health Services Companies. LTCS L.P. has the right (the "call right") to purchase this 11% minority interest, and each person who holds a part of the minority interest has the right (the "put right") to require LTCS L.P. to purchase his or her minority interest in LTCS L.P. The call right and the put right may be exercised at any time during the period beginning on January 1, 1999, and ending on January 31, 2004. The purchase price for all transactions involving a minority interest purchase is the then current fair market value as confirmed by an independent appraisal. Note N--Home Health Care Services ServiceMaster Home Health Care Services Inc. is a wholly owned subsidiary of The ServiceMaster Company and is a part of the ServiceMaster Diversified Health Services Group. Note O--International and New Business Development International and New Business Development is a division of The ServiceMaster Company. Its operations have been described above (page 8). Note P--Child Care Services ServiceMaster Child Care Services, Inc., is a wholly owned subsidiary of The ServiceMaster Company and is a part of the International and New Business Development Group. Its operations have been described above (page 8). Note Q--Other Subsidiaries Other subsidiaries include CMI Group, Inc., a subsidiary of ServiceMaster Management Services L.P.; miscellaneous operating and name protection entities; and ServiceMaster Operations, AG, a Swiss corporation which, in turn, operates through separate subsidiaries organized in the United Kingdom and Germany. Reference is made to Exhibit 22 for a complete list of the subsidiaries of the Registrant. Note R--Norrell Corporation On February 11, 1994, ServiceMaster sold to Norrell Corporation ("Norrell") all of the common equity interest in Norrell held by ServiceMaster for $29.3 million, an amount which exceeded its carrying value. On March 31, 1994, ServiceMaster will redeem the preferred interest in The ServiceMaster Company which was issued in 1991 to, and thereafter held by, Norrell's principal stockholder. Payment of the redemption price will be made on May 31, 1994 in the form of cash in the amount of $14.6 million and 372,950 shares of the Registrant. Note S--ServiceMaster SGP Trust On January 1, 1993, the limited partnership agreement of The ServiceMaster Company was amended to admit a trust as a special general partner of The ServiceMaster Company (the "SGP Trust"). The beneficiaries of the ServiceMaster SGP Trust are the limited partners of the Registrant as constituted from time to time and ServiceMaster Corporation (but the latter is a beneficiary only if shares of its common stock are outstanding, which is not now the case). SGP Trust will receive each year an allocation of taxable income equal to the amount by which the aggregate taxable income of The ServiceMaster Company exceeds the cash distributions made by the Registrant directly to its limited partners and to ServiceMaster Corporation. As a result of this allocation of taxable income, the cash distributions made by the Registrant directly to its limited partners and to ServiceMaster Corporation will be exactly equal to the taxable income of the Registrant which is directly allocated to its limited partners and to ServiceMaster Corporation. The ServiceMaster Company will annually make a cash distribution to SGP Trust in the amount required by the trust for the payment of its federal and state income tax liabilities. This arrangement solves the "crossover problem" described in earlier annual reports and in the Registrant's Proxy Statement dated December 11, 1991. Item 2. Item 2. Properties The headquarters facility of ServiceMaster, which also serves as headquarters for the ServiceMaster Management Services and International and New Business Development Groups, is owned by The ServiceMaster Company and is located on a ten-acre tract at One ServiceMaster Way, Downers Grove, Illinois. The initial structure was built in 1963, and two additions were completed in 1968 and 1976. In early 1988, ServiceMaster completed construction of a two-story 15,000 square foot addition for office space, food service demonstrations and dining facilities. The building contains approximately 118,900 square feet of air conditioned office space and 2,100 square feet of laboratory space. In the Spring of 1992, ServiceMaster completed the conversion of approximately 30,000 square feet of space formerly used as a warehouse to offices for Management Services and for The Kenneth and Norma Wessner Training Center. ServiceMaster owns a seven acre, improved tract at 2500 Warrenville Road, Downers Grove, Illinois, which is adjacent to its headquarters facility. In 1993, ServiceMaster substantially remodeled the building and thereafter leased approximately half the space (50,000 square feet) to a commercial tenant. The balance of the space will continue to be utilized by ServiceMaster personnel. ServiceMaster leases a 50,000 square foot facility near Aurora, Illinois which is used by ServiceMaster as a warehouse/distribution center. ServiceMaster believes that the facilities described in the preceding three paragraphs will satisfy the Company's needs for administrative and warehouse space in the Chicago area for the immediate future. ServiceMaster owns four properties in Cairo, Illinois, consisting of a 36,000 square foot, three-story building used for manufacturing and warehousing equipment, supplies and products used in the business; a warehouse and package facility comprising 30,000 square feet; a three-story warehouse and manufacturing building consisting of 43,000 square feet; and a 2,500 square foot building used for a machine shop. ServiceMaster leases a 44,000 square foot manufacturing facility in Lancaster, Pennsylvania, which is used to provide products and equipment primarily to customers of Management Services in the eastern part of the United States. Management believes that the foregoing manufacturing and warehouse facilities are adequate to support the current needs of ServiceMaster. The headquarters for ServiceMaster Consumer Services L.P. are located in leased premises at 855 Ridge Lake Boulevard, Memphis, Tennessee. This facility also serves as the headquarters for Terminix, Res/Com and TruGreen-ChemLawn. The headquarters facility for Merry Maids is located in leased premises at 11117 Mill Valley Road, Omaha, Nebraska. The headquarters facility for American Home Shield is presently located in leased premises at 90 South E Street, Santa Rosa, California, but later in 1994 this facility will be closed and the American Home Shield headquarters will be relocated to Memphis, Tennessee. American Home Shield's service and data processing departments are located in premises owned by the company in Carroll, Iowa. This facility consists of a 43,000 square foot building on a seven-acre site. American Home Shield owns approximately 98 acres of land in Santa Rosa, California. This land is held for investment purposes and has been and will continue to be offered for sale, with the timing of sales being affected by, among other things, market demand, zoning regulations, and the availability of financing to purchasers. Terminix owns 16 buildings which are used as branch sites. These properties are all one-story buildings that contain both office and storage space. These properties are located in New Jersey (2 properties), California (2 properties), Florida (8 properties), and Texas (4 properties). TruGreen-ChemLawn owns several buildings which are used as branch sites for lawn care services. These facilities are located in various parts of the United States. In July 1992, TruGreen leased the former ChemLawn headquarters facility in Columbus, Ohio. In 1993, this facility was sold by its owner and the lease with TruGreen was terminated. The headquarters for the ServiceMaster Diversified Health Services Companies ("DHS") is located in leased premises at 5050 Poplar Avenue, Memphis, Tennessee. DHS leases other administrative facilities in Plymouth Meeting, Pennsylvania; Dallas, Texas; and Atlanta, Georgia. DHS has an ownership interest in three nursing home facilities through joint venture arrangements in which DHS has a 50% interest. Item 3. Item 3. Legal Proceedings In the ordinary course of conducting its business activities, ServiceMaster becomes involved in judicial and administrative proceedings which involve both private parties and governmental authorities. As of March 21, 1994, these proceedings included a number of general liability actions and a very small number of environmental proceedings. General Liability Matters. Terminix is a party to litigation in Tennessee involving an alleged misapplication of the chemical Aldrin. This matter has been settled as to the compensatory element of the case for an amount within Terminix's insurance coverage. The punitive damages element of the case will be the subject of a new trial. Terminix expects that punitive damages, if any, will not be material in amount. Environmental Matters. Terminix is one of several defendants named in a suit filed by the United States Environmental Protection Agency (the "EPA") on November 3, 1986 in the United States District Court for the Western District of Tennessee, to recover the costs of remediation at two sites in Tennessee which have been designated by the EPA as "Superfund sites" under the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). Terminix has agreed, on an interim basis, to a ten percent cost share with respect to one site and has not entered a cost sharing agreement with respect to the other. Terminix has also been notified by a letter from the EPA, along with many other parties, as a "potentially responsible party" under CERCLA at a site in Wichita, Kansas. Terminix was named in a Superfund site in Michigan but Terminix's connection to this matter is through an acquisition in which the seller retained responsibility for environmental matters; Terminix considers its exposure in this case to be not material. Terminix's actual participation in the total volume of hazardous waste at these sites is less than five percent. The CERCLA law is written to impose joint and several liability for the cleanup costs at any particular site on every contributor to that site, and accordingly every contributor's potential liability at every site is large. Based on practical experience with prior CERCLA situations and the circumstances of the cases in which it is now involved, Terminix expects that its actual liability at these sites will not be material. ServiceMaster believes the outcome of the proceedings referred to above will not be, individually or in the aggregate, material to its business, financial condition or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable PART II Item 5. Item 5. Market for Registrant's Partnership Shares and Related Shareholder Matters Except for the information set forth in the second and third sentences of this Item 5, the portions of the ServiceMaster Annual Report to Shareholders for 1993 under the captions "Shareholders' Equity" (pages 34 - 35) and "Cash Distributions Per Share" and "Price Per Share" in the Quarterly Operating Results table (page 36) supply the information required by this item and such portions are hereby incorporated herein by reference. The Registrant's shares are listed and traded on the New York Stock Exchange. At March 21, 1994, the Registrant's shares were held of record by approximately 65,000 persons. Item 6. Item 6. Selected Financial Data The portion of the ServiceMaster Annual Report to Shareholders for 1993 in the Financial Statements and Management Discussion section ("FSMD Section") under the caption "Eleven Year Financial Summary" (pages 24 - 25) supplies the information required by this item and such portion is hereby incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations for the three years ended December 31, 1993, is contained in the FSMD Section of the ServiceMaster Annual Report to Shareholders for 1993 on pages 19 - 23 and is hereby incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The consolidated statements of financial position of ServiceMaster as of December 31, 1993 and 1992, and the consolidated statements of income, cash flows and shareholders' equity for the years ended December 31, 1993, 1992 and 1991 and notes to the consolidated financial statements are contained in the FSMD Section of the ServiceMaster Annual Report to Shareholders for 1993 on pages 27 - 36 and are incorporated herein by reference. The report of Arthur Andersen & Co. thereon dated January 25, 1994, and the summary of significant accounting policies are contained in the FSMD Section of the ServiceMaster Annual Report to Shareholders for 1993 on page 26 and are hereby incorporated herein by reference. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure Inapplicable. PART III Item 10. Item 10. Directors and Executive Officers of the Corporate General Partner of Registrant and The ServiceMaster Company The following section of this Item 10 shows: (i) the names and ages (as of March 18, 1994) of the present directors of ServiceMaster Management Corporation (the corporate general partner of ServiceMaster Limited Partnership and The ServiceMaster Company); (ii) all positions and offices with ServiceMaster held by each such director; and (iii) the term of each such person as a director and all period(s) during which each director has served. There are no arrangements or understandings between any director and any other person pursuant to which the director was or is to be selected as a director or nominee. 1994 Class Carlos H. Cantu, age 60, has been a director since 1988. On January 1, 1994, Mr. Cantu became the President and Chief Executive Officer of ServiceMaster. He is the President and Chief Executive Officer of ServiceMaster Consumer Services, a director and the Chairman of ServiceMaster Consumer Services, Inc., a director and the Chairman of ServiceMaster Management Services, Inc. and a director of ServiceMaster Diversified Health Services, Inc. He served as Executive Vice President and Chief Operating Officer, Consumer Services, from October 1988 to May 1990 and as President and Chief Operating Officer of ServiceMaster Consumer Services from June 1, 1990 to May 1991. Mr. Cantu also serves as Vice Chairman of American Home Shield Corporation. He served as President and Chief Executive Officer of The Terminix International Company Limited Partnership from December 18, 1986 to December 31, 1992. He is a director of Terminix International, Inc., the corporate general partner of The Terminix International Company Limited Partnership. He has been a director of NationsBank/Memphis in Memphis, Tennessee, since August 1988; of NationsBank/Tennessee in Nashville, Tennessee, since January 1990; and of Midland Financial Group, Inc., an insurance company in Memphis, Tennessee, since September 1992. Lord Brian Griffiths of Fforestfach, age 52, has been a director since August 1992. He is a member of the Executive Committee of the Board of Directors. He is an international advisor to Goldman, Sachs & Co. concerned with strategic issues related to their United Kingdom and European operations and business development activities worldwide. During the period 1985 to 1990, he served at No. 10 Downing Street as Head of the Prime Minister's Policy Unit. He was made a life peer at the conclusion of his service to the Prime Minister. Lord Griffiths is a director of THORN EMI plc, Times Newspapers Holding Ltd., Herman Miller, Inc., Zeeland, Michigan, and HTV (Harlech Television). Gunther H. Knoedler, age 64, has been a director since 1979. He is a member of the Executive Committee, the Chairman of the Audit Committee and a member of the Share Option Committees of the Board of Directors and he is a director of ServiceMaster Management Services, Inc. Mr. Knoedler is Executive Vice President and Director Emeritus of Bell Federal Savings & Loan Association, Chicago, Illinois. He is the Chairman of the Board of Trustees of Wheaton College, Wheaton, Illinois, and a member of the Board of Directors of Tyndale House Publishers, Inc. Vincent C. Nelson, age 52, has been a director since 1978. Mr. Nelson is a member of the Executive Committee and the Audit, Employee Share Purchase Plan, and Share Option Committees of the Board of Directors. He is also a director of ServiceMaster Consumer Services, Inc. Mr. Nelson is a business investor and is a trustee of Westmont College, Santa Barbara, California. Mr. Nelson is the foster son of Kenneth N. Hansen, Director Emeritus and Adviser. C. William Pollard, age 55, has been a director since December 1977. Since May 1990, he has been the Chairman of the Board and Chairman of the Executive Committee. From May 1983 to December 31, 1993, Mr. Pollard served as the Chief Executive Officer of ServiceMaster. He served as President of ServiceMaster from 1981 to May 1990 and has been the Chief Executive Officer of the Company since May 1983. He is a director and the Vice Chairman of ServiceMaster Consumer Services, Inc., a director and the Vice Chairman of ServiceMaster Management Services, Inc. and a director and the Chairman of American Home Shield Corporation. Mr. Pollard joined ServiceMaster as Senior Vice President in December 1977. He served as Executive Vice President and Chief Operating Officer from November 1980 until his election as Chief Executive Officer in May 1983. Mr. Pollard is a director of Herman Miller, Inc., Zeeland, Michigan; a director of Provident Life and Casualty Insurance Company, Chattanooga, Tennessee; and an advisory director of Trammell Crow Company, Dallas, Texas. 1995 Class Henry O. Boswell, age 64, has been a director since 1985. He is a member of the Executive Committee of the Board of Directors and he is a director of ServiceMaster Consumer Services, Inc. From 1983 until his retirement in October 1987, Mr. Boswell was President of Amoco Production Company. During the same time period, he was Chairman of the Board of Amoco Canada and a director of Amoco Corporation. He has served in various positions with affiliates of Amoco Corporation since 1953. Mr. Boswell is a director of Rowan Companies, Inc., Houston, Texas, and Cabot Oil & Gas Corp. in Houston, Texas. James D. McLennan, age 57, has been a director since May 1986. He is a member of the Audit Committee. Mr. McLennan joined McLennan Company, a real estate service company, in 1958. He was named partner in 1968 and became President in 1981. He is a member of the Board of Directors of Lutheran General Medical Health Systems, Park Ridge, Illinois and the Chairman of the Board of the Lutheran General Foundation. Mr. McLennan is also a director of NBD Bank of Park Ridge, Park Ridge, Illinois, a director of Potomac Corporation in Wheeling, Illinois, a laminator of paper products and a director of The Loewen Group Inc., a provider of funeral services, Burnaby, B.C., Canada. Burton E. Sorensen, age 64, has been a director since May 1984. He is a member of the Executive Committee of the Board of Directors. He is the Chairman and Chief Executive Officer of Lord Securities Corporation. He served as President and Chief Executive Officer of the corporation from December 1984 to December 1992. He joined Goldman, Sachs & Co., an investment banking and brokerage firm, in 1972 as Vice President, Investment Banking Division, and became a general partner in 1977. Mr. Sorensen is also a director of Provident Life and Casualty Insurance Company, Chattanooga, Tennessee. Charles W. Stair, age 53, has been a director since December 1986. He previously served as a director from 1976 to 1983. He has been the President and Chief Executive Officer of ServiceMaster Management Services since May 1991, he is a director of ServiceMaster Management Services, Inc. and he is a director and the Chairman of ServiceMaster Diversified Health Services, Inc. Mr. Stair served as President and Chief Operating Officer, Management Services, from June 1990 to April 1991 and as Executive Vice President and Chief Operating Officer, Management Services, from October 1, 1988 to May 1990. He served as Executive Vice President, Management Services from December 31, 1987 to September 30, 1988. Mr. Stair is a member of the Profit Sharing, Savings and Retirement Plan Administrative Committee. He is a director of Tyndale House Publishers, Inc., Wheaton, Illinois. David K. Wessner, age 42, has been a director since March 1987. He is a member of the Executive Committee and is a director of ServiceMaster Management Services, Inc. and ServiceMaster Diversified Health Services, Inc. Mr. Wessner has been Senior Vice President, Programs and Process Improvement, Geisinger Health Systems, since January 1, 1994. He served as Executive Vice President, Programs and Process Improvement, Geisinger Health Systems from November 1992 to December 31, 1993 and as Senior Vice President and Administrative Director from 1982 to November 1992. Mr. Wessner is a director of Commonwealth Bank, a division of Meridian Bank, Reading, Pennsylvania, and a director of Geisinger Health Plan, Danville, Pennsylvania. He is the son of Kenneth T. Wessner, who is a Director Emeritus. 1996 Class Herbert P. Hess, age 57, has been a director since 1981. He is a member of the Executive Committee and a director of ServiceMaster Consumer Services, Inc. Mr. Hess is a Managing Director of Berents & Hess Capital Management, Inc., an investment management firm. He is the past President and Chief Executive Officer of State Street Research & Management Company, an investment management firm. Mr. Hess was Chairman of MetLife-State Street Investment Services, Inc. from 1988 to April 1, 1990. Kay A. Orr, age 55, has been a director since January 1, 1994. She is also a director of ServiceMaster Consumer Services, Inc. Mrs. Orr was Governor of Nebraska from 1987 to 1991 and served as the State Treasurer of Nebraska from 1981 to 1986. From 1979 to 1981, she served as Chief of Staff to the Governor of Nebraska. Mrs. Orr is a director of The Williams Companies, Tulsa, Oklahoma, a trustee of Hastings (Nebraska) College, and a trustee of the Peoples City Mission Foundation. Philip B. Rooney, age 49, has been a director since January 1, 1994. He is a member of the Executive Committee of the Board of Directors. He is also a director of ServiceMaster Consumer Services, Inc. Mr. Rooney is a director and the President and Chief Operating Officer of WMX Technologies, Inc., Oak Brook, Illinois, the Chairman of the Board and Chief Executive Officer of Wheelabrator Technologies, Inc., Hampton, New Hampshire, Chairman of the Board of Rust International, Inc., Oak Brook, Illinois, a director of Chemical Waste Management, Inc., Oak Brook, Illinois, and a director of Waste Management International, Inc., Oak Brook, Illinois. He is also a director of Illinois Tool Works, Inc., Caremark International, Inc. and Urban Shopping Centers, Inc. Directors Emeritus Kenneth N. Hansen, age 75, served as a director from 1947 until 1987. Mr. Hansen has been Director Emeritus and Adviser to ServiceMaster since April 1987. He served as Vice Chairman from 1981 until 1987. He served as Chairman of the Executive Committee from 1975 to 1981, as Chairman of the Board of Directors from 1973 to 1981, as Chief Executive Officer from 1957 through 1975 and as President from 1957 to 1973. He is an ex- officio member of all committees of the Board. Mr. Hansen is the foster parent of Vincent C. Nelson, a director of ServiceMaster Management Corporation. Kenneth T. Wessner, age 71, served as a director from 1965 to December 12, 1992. Since that date he has been Director Emeritus. Mr. Wessner was Chairman of the Board and Chairman of the Executive Committee of ServiceMaster from 1981 to May 1990. He was Chief Executive Officer from 1975 until June 1, 1983 and President from 1973 until June 1, 1981. Mr. Wessner established the Health Care Division in 1962 and served as its President. He is a director of Bell Federal Savings & Loan Association, Chicago, Illinois. Mr. Wessner is a member of the Nominating Committee. He is the father of David K. Wessner who is a ServiceMaster director. Senior Management Advisers The Bylaws of ServiceMaster Management Corporation provide that the Board of Directors may appoint officers of ServiceMaster and other persons having a special relationship to ServiceMaster to serve as Senior Management Advisers. Senior Management Advisers attend the meetings of the Board and advise the Board but do not have the power to vote. The Board has determined that providing a greater number of officers the opportunity to advise and interact with the Board is in the best interest of ServiceMaster as well as the individual officers. The Senior Management Advisers receive no special compensation for their services in this capacity. The Board of Directors has appointed the persons listed below as Senior Management Advisers effective as of the 1993 annual meeting of shareholders to serve in such capacity until the annual meeting of shareholders in 1994 or until otherwise determined by the Board of Directors. Robert D. Erickson, age 50, was a director from May 1987 to May 1993. He previously served as a director from May 1981 through May 1984. He is a director of ServiceMaster Management Services, Inc. He is presently President, International and New Business Development. He served as Executive Vice President and Chief Operating Officer of this division from November 1992 to December 31, 1993. He served as Executive Vice President and Chief Operating Officer, People Services, from January 1990 to October 1992 and as Executive Vice President and Chief Financial Officer of ServiceMaster from January 1986 through December 1989. Mr. Erickson is a director of Moody Bible Institute, Chicago, Illinois; and VanCom Incorporated, South Holland, Illinois, a transportation company. Mr. Erickson is a member of the Profit Sharing, Savings and Retirement Plan Administrative Committee, the Employee Share Purchase Plan Administrative Committee, and the Employee Benefits Plan Committee. Brian D. Oxley, age 43, is Executive Vice President and Chief Operating Officer of ServiceMaster Management Services. He is a director of ServiceMaster Management Services, Inc. From November 1992 to December 31, 1993, he served as the President and Chief Executive Officer of the International and New Business Development Group. He served as Executive Vice President, New Business Development from January 1991 to November 11, 1992 and as President of International Services from January 1, 1988 to November 11, 1992. He served as President of the Residential/Commercial and International divisions of ServiceMaster from 1987 through 1989. Mr. Oxley is a director of Kawakita Hospital, Tokyo, Japan. Dallen W. Peterson, age 57, served as the Chairman of Merry Maids, Inc. until the acquisition of that company's assets by Merry Maids Limited Partnership in July 1988. He is presently the Chairman of Merry Maids Limited Partnership. Donald K. Karnes, age 43, is President of TruGreen- ChemLawn. He has served as President and Chief Operating Officer of TruGreen-ChemLawn since January 1, 1992; from January 1, 1990 to December 31, 1991, he was Senior Vice President, TruGreen Limited Partnership. During the year 1989, Mr. Karnes was a Regional Vice President for Waste Management Urban Services, Inc. Executive Officers of ServiceMaster The following table shows: (i) the names and ages (as of March 18, 1994) of the present executive officers of the Registrant, The ServiceMaster Company and ServiceMaster Management Corporation; (ii) all positions presently held by each officer; and (iii) the year each person became an officer. Each person named has served as an officer of the Registrant continuously since the year shown. There are no arrangements or understandings between any executive officer and any other person pursuant to which the officer was or is to be selected as an officer. Messrs. Pollard, Stair and Cantu are also Directors of ServiceMaster Management Corporation. Messrs. Erickson and Oxley are Senior Management Advisers. See pages 31, 32, and 33 for biographical information with respect to these executive officers. Vernon T. Squires, age 59, was elected Senior Vice President and General Counsel effective January 1, 1988. He served as Vice President and General Counsel from April 1, 1987 until December 31, 1987. He served as an associate and partner with the law firm of Wilson & McIlvaine in Chicago, specializing in corporate and tax law, from 1960 to April 1, 1987. He is presently Of Counsel to that firm. He is a director of the Suburban Bus Division of the Regional Transportation Authority. Ernest J. Mrozek, age 40, was elected Vice President, Treasurer and Chief Financial Officer effective November 1, 1992. He served as Vice President and Chief Accounting Officer, from January 1, 1990 to October 31, 1992 and as Vice President, Accounting, from December 1987 to December 1989. He practiced public accounting as a manager with Arthur Andersen and Co. from 1981 to December 1987. Compliance With Section 16(a) of The Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires ServiceMaster's officers and directors, and persons who own more than ten percent of ServiceMaster's shares, to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission") and the New York Stock Exchange. The Commission's regulations require certain officers, directors and greater-than-ten-percent shareholders to furnish to ServiceMaster copies of all Section 16(a) forms that they file. During 1993, ServiceMaster received Section 16(a) forms from such officers and directors; ServiceMaster has no shareholders with an interest greater than ten percent. Based solely on a review of the copies of Section 16(a) forms received by ServiceMaster or on written representations from certain reporting persons that no Forms 5 were required for those persons, ServiceMaster believes that during 1993, its officers and directors complied with applicable filing requirements except that five reports, covering an aggregate of six transactions, were filed late by Messrs. Karnes, Oxley, Rooney and Mrs. Orr. (Two of such late reports were amendments of earlier reports which were timely filed). Item 11. Item 11. Executive Compensation The following table sets forth all compensation awarded to, earned by, or paid to the Chief Executive Officer of ServiceMaster and ServiceMaster's four most highly compensated executive officers other than the Chief Executive Officer of ServiceMaster during or in respect of the year 1993. Each of the listed persons was holding the office indicated in the table on the last day of December 1993. Notes: (A) President and Chief Executive Officer, ServiceMaster Consumer Services. (B) President and Chief Executive Officer, ServiceMaster Management Services. (C) Executive Vice President and Chief Operating Officer, Management Services. (D) President, International and New Business Development. (E) The table does not include the cash distributions made to ServiceMaster Management Corporation, as the managing general partner of the Registrant and The ServiceMaster Company, and the redistribution of such amounts to the stockholders of ServiceMaster Management Corporation (who include the persons listed in the above table). See "Description of the Partnership Structure" Note D, page 18. The foregoing amounts represent the stockholders' share of profits in return for their equity risk. The table also does not include the value of shares of the Registrant issued to C. William Pollard pursuant to certain agreements made in 1986 and concluded in 1993 (see Item 13: "Miscellaneous Transactions", page 58). (F) With respect to the year 1993, see Note (A) to the Option/SAR Grants Table. The figures shown for earlier years are the number of the underlying shares for grants of options under the ServiceMaster 10 Plus Option Plan. The number of options shown for Mr. Oxley for the year 1991 has been adjusted to reflect the Registrant's 3-for-2 share split in June 1993. The following table summarizes the number and terms of the stock options (if any) granted during the year 1993 to the named executive officers. Notes: (A) ServiceMaster 10 Plus Option grants were approved for C. William Pollard, Brian D. Oxley and Robert D. Erickson in October 1992. In the case of each of the foregoing grantees, acceptance of the option and payment by the grantee of the price for the option itself ($1.00 per option share on a post-split basis) was not required and did not occur until early 1993. These grants were not shown in the Option/SAR Grants Table in ServiceMaster's Form 10-K for 1992 but are reported in the above table. Column (A) reflects the 3-for-2 share split effected by the Registrant in June 1993. (B) ServiceMaster 10 Plus Option grants were approved for C. William Pollard, Carlos H. Cantu, and Robert D. Erickson in October 1993. In the case of each of the foregoing grantees, acceptance of the option and payment by the grantee of the price for the option itself ($1.50 per option share) was not required until early 1994. These grants will be shown in the Option/SAR Grants Table in ServiceMaster's Form 10-K for 1994. (C) The fair market value of the Registrant's shares at the time when the grants of the option were made (October 1992) was $26.00. Each grantee was required to pay $1.50 per option share as a condition to the actual grant of the option (which sum was, in each case, paid in February 1993). Column (d) combines the exercise price and the option price. In June 1993, the Registrant split its shares 3-for-2 and the exercise price for the options shown in the table has therefore been adjusted to $18.33 per share, which includes the option price as adjusted to $1.00 per option share. The following table summarizes the exercises of stock options during the year 1993 by the named executive officers and the number of, and the spread on, unexercised options held by such officers at December 31, 1993. As shown in the following table, no long-term incentive awards were granted to any of the named executive officers during the year 1993. Compensation of Directors Directors of ServiceMaster Management Corporation who are not officers receive $3,000 for each meeting of the Board of Directors and each meeting of the Executive Committee which they attend. In addition, directors who are not officers and who are not members of the Executive Committee receive an annual stipend of $5,000; directors who are not officers and who are members of the Executive Committee receive an annual stipend of $10,000. Directors who are members of the Audit Committee (which committee does not include any officers) receive an annual stipend of $8,000, except that the annual stipend for the Chairman of the Audit Committee is $10,000. A director of a subsidiary company who is not an officer of that company or any ServiceMaster company which is a parent of the subsidiary receives $3,000 for each meeting of the subsidiary board of directors which he or she attends. If such a person is not a director of ServiceMaster Management Corporation, he or she also receives an annual stipend of $5,000. Each director of ServiceMaster Management Corporation or of a subsidiary board of directors may enter into a deferred fee agreement with the company on whose board he or she is serving whereby part or all of the fees payable to him or her as a director are deferred and will either earn interest based on the five-year borrowing rate for ServiceMaster or be used to purchase shares of ServiceMaster Limited Partnership in a number determined by the fair market value of such shares on the date of purchase. Upon termination of a director's services as a director or attainment of age 70, whichever occurs first, a director will receive the amount for his or her deferred fee account in a lump sum or in installments or in shares of ServiceMaster Limited Partnership, depending on which deferral plan the director has elected. Directors of ServiceMaster Corporation do not receive any compensation for their services in that capacity. Employment Contracts and Termination of Employment ServiceMaster enters into employment contracts with each of its executive officers in December of each year to cover the officer's employment during the subsequent calendar year. Each contract provides for the amount of such officer's base salary for the calendar year covered by the contract. Either party may cancel the contract on two week's notice to the other party. If an executive's employment terminates, the executive is prohibited from entering into certain activities which are competitive with any of the ServiceMaster businesses. These contracts do not provide for any bonuses or other form of compensation beyond the base salary stated in the contract. The amounts paid under the employment contracts with each of the persons listed in the Summary Compensation Table are included in Column (c) of the table. Change-in-Control Arrangements The ServiceMaster Plan for Continuity of Employment (the "Plan") was adopted by the Board of Directors of ServiceMaster Industries Inc. on July 19, 1986 and assumed by ServiceMaster Limited Partnership and its subsidiaries at the time the ServiceMaster reorganization became effective on December 30, 1986. The purpose of the Plan is to provide protection to a broad range of ServiceMaster employees from damage to their careers which could result if ServiceMaster were taken over by another organization. The Plan provides that if during the period following a takeover to which the Plan applies any covered employee is fired or leaves after being demoted, then ServiceMaster will be obligated to pay that employee an amount equal to either (i) the amount of the employee's relevant annual compensation (if the employee has between two and five years of credited service with ServiceMaster) or (ii) 2.5 times the employee's relevant annual compensation (if the employee has more than five years of credited service). The amount of an employee's relevant annual compensation will be the amount of the cash compensation received by the employee during the calendar years preceding the year in which the Plan becomes activated with respect to the takeover involved, provided that in no event will an employee be entitled to receive under the Plan more than twice the amount of the compensation (including both cash compensation and benefits with a monetary value received in a form other than cash) received by the employee during the calendar year preceding the termination of his or her employment. The Plan is not limited to management employees but rather covers every ServiceMaster employee who has at least two years of credited service at the time his employment terminates. The Plan provides that a takeover will be deemed to have occurred for purposes of the Plan when (i) any organization or group (other than ServiceMaster employees or plans established for the benefit of ServiceMaster employees) acquires ownership of at least 20% of ServiceMaster outstanding shares, or (ii) a majority of the positions on the ServiceMaster Board come to be occupied by "Takeover Directors" (as defined in the Plan). The Plan provides that it will automatically become activated with respect to any particular takeover ten days after the ServiceMaster Chief Executive Officer becomes aware that the takeover has occurred except that the ServiceMaster Board has the right to accelerate or postpone the date upon which the Plan will become activated with respect to any particular takeover. The Board has the right at any time before the Plan becomes activated to modify the terms of the Plan and to exempt any particular takeover from operation of the Plan or to terminate the Plan, but no such notification exemption or termination can be made after activation. Employees are entitled to compensation under the Plan in connection with any takeover to which the Plan applies only if their employment terminates within the "Shakeout Period" beginning at the time such takeover occurs and ending on the second anniversary of the date on which the Plan is activated with respect to that particular takeover. The Plan is expressly intended to be a severance pay plan for purposes of the Employee Retirement Income Security Act of 1974 ("ERISA") and ServiceMaster employees are expressly entitled to the protection afforded by ERISA to participants in a severance pay plan. The Plan is designed to put any organization which may at any time consider taking over ServiceMaster on notice in advance that it may be required to compensate individuals who have made significant career investments in ServiceMaster if those individuals are disadvantaged by the takeover. At the same time, the Plan is intended to serve the best interests of those who invest in ServiceMaster for the long term by (i) improving the ability of the ServiceMaster enterprise to recruit and retain employees, (ii) increasing the willingness of employees to risk working for long-term rewards rather than seeking to maximize their immediate salary, and (iii) providing insurance to employees against any unfavorable outcome, and thereby encouraging employees to remain with ServiceMaster while the outcome of a takeover attempt is in doubt. Compensation Committee Interlocks and Insider Participation The persons who served as members of the compensation committee of the Registrant's board of directors during 1993 are listed in the next section. The compensation committee consists solely of independent members of the board of directors. There are no interlocking arrangements involving service by any executive officer of the Registrant on the compensation committee of another entity and an executive officer of such other entity serving on the ServiceMaster compensation committee. Board Compensation Committee Report on Executive Compensation The following report of the Compensation Committee of the Board of Directors of ServiceMaster Management Corporation was delivered to the Board of Directors on March 18, 1994. The Compensation Committee consists of the members of the Executive Committee other than the Chairman of the Company. (The Executive Committee consists of independent directors and the Chairman. As used in the report, the term "salary year" means the calendar year. "REPORT OF THE COMPENSATION COMMITTEE To: The Board of Directors: The Executive Committee as constituted in December 1993, in its capacity as the Compensation Committee for the year 1993, hereby submits its report to the Board of Directors for the year 1993. In December of each year, the Compensation Committee reviews the compensation levels of senior members of management, evaluates the performance of management and recommends a base salary for each member of senior management for the next salary year. This review and recommendation process includes a review of additional compensation (if any) payable under the Company's Incentive Reward Compensation Plan. At the end of each salary year, the Compensation Committee determines whether adjustments should be made in the compensation of an executive as established by his base salary and the Incentive Reward Compensation Plan. The Compensation Committee does not constitute the administering committee under any of the Company's stock option plans, but the Compensation Committee does take option grants to senior members of management into account in the reviews and recommendations described above. Summary of Compensation Policies. The compensation policies applicable to all executive officers are as follows: (1) a base level of compensation is established by reference to the standards described below; (2) bonuses are paid in accordance with the Company's Incentive Reward Compensation Plan, under which bonuses are determined by the extent to which the actual performance of the Company (or the relevant division thereof) achieved budget objectives; and (3) such year-end adjustments as the Compensation Committee may consider to be warranted. The standards for determining the base compensation in any given year for the Chief Executive Officer (and for all other officers whose salaries are subject to Compensation Committee approval) are: performance by the officer in the discharge of his or her responsibilities, financial performance of the Company for the immediately preceding year, and the base salary levels of comparable officers in comparable companies. Five Highest Paid Officers. The base compensation of each of the highest paid officers for 1993 (including the Chief Executive Officer) was in the amount recommended by the Compensation Committee in December 1992 and approved by the Board of Directors in the same month. This base compensation was further reviewed at the end of 1993. The Compensation Committee unanimously agrees that these base levels were reasonable at the time established and reasonable in the context of the performance of the Company in 1993 and the contribution of such persons to the Company's performance. Chief Executive Officer. The base compensation of C. William Pollard, Chairman and Chief Executive Officer of ServiceMaster, for the year 1993 was set at $300,000 at the commencement of the year. This amount did not reflect any increase in his base compensation for the year 1992. No increases in his base compensation were made during the year 1993. An increase in the base compensation for the Chief Executive Officer for the year 1993 would have been warranted in the light of both the Company's and his performance in the year 1993. (Reference is made to the Management Discussion and Analysis section of the Company's 1993 Annual Report to Shareholders (the "Annual Report") for a summary of the Company's growth in 1993 relative to 1992). The Committee approved a modification of the formula in the Company's Incentive Reward Compensation Plan so that the Chief Executive Officer was awarded incentive compensation in the amount of 150% of his base compensation. That award included $60,000 beyond what the Incentive Reward Compensation Plan would have called for without modification. (Reference is made to the Annual Report for a discussion of the Company's performance in 1993). The Compensation Committee notes that the Chief Executive Officer was granted an option for 75,000 shares in October 1993, subject to acceptance by him and payment of the price for the option itself of $1.50 per option share. This grant was accepted and the required payment was made in March 1994. No member of the Compensation Committee is a former or current officer or employee of the Company or any of its subsidiaries. However, for a short period of time Mr. Nelson was Vice Chairman of American Home Shield Corporation. Dated: March 18, 1994 Respectfully submitted, H. O. Boswell Lord Brian Griffiths H. P. Hess G. H. Knoedler V. C. Nelson D. K. Wessner (Compensation Committee)" Performance Graph The following graph compares the five-year cumulative total return to shareholders of the Registrant with the five year cumulative return as determined under the Standard & Poor's 500 Index and under the Standard & Poor's Commercial Services Group. [Performance Graph] Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth as of March 18, 1994, the beneficial ownership of the Partnership Shares with respect to the ServiceMaster directors and senior management advisers and directors and officers as a group. ServiceMaster does not know of any person who is the beneficial owner of more than five percent of the Partnership Shares. Notes: (1) The shares owned by each person and by all directors and officers as a group, and the shares included in the total number of shares, have been adjusted, and the percentage ownership figures have been computed, in accordance with Rule 13d-3(d)(1)(i). (2) Shares in column (3) include shares held by spouse and/or other family members. (3) Shares in column (2) include shares which may be acquired within sixty days under the ServiceMaster Executive Debenture Plan, options granted under the ServiceMaster Share Option Plan, and/or options granted under the ServiceMaster 10-Plus Plan. (4) Shares in column (3) include shares held in one or more investment partnerships in which the listed person is a partner with shared voting power and investment power. (5) Shares in column (2) include shares held in trust for the benefit of self and/or family members. (6) Shares in column (3) include shares held in trust for the benefit of self and/or family members. (7) Shares in column (3) include 28,792 shares owned by spouse or held in trust for the benefit of family members as to which beneficial ownership is disclaimed. (8) The 1,378,996 shares in column (3) are in trust for the benefit of family members as to which beneficial ownership is disclaimed. (9) Shares in column (3) include 4,204 shares in trust for the benefit of family members as to which beneficial ownership is disclaimed. (10) Shares in column (2) include 17,445 shares in trust for the benefit of family members as to which beneficial ownership is disclaimed. (11) Shares in column (2) include 450,000 shares held in trust for the benefit of the parents of David K. Wessner and for charitable interests. Mr. Wessner is a trustee of this trust and has sole voting and investment power over such shares but he disclaims beneficial ownership of such shares. (12) Shares in column (3) includes 206,110 shares held by an investment company of which David K. Wessner is a shareholder and one of four directors. (13) Shares in column (2) include 20,815 shares owned by a charitable foundation of which C. William Pollard is a director. Mr. Pollard disclaims beneficial ownership of such shares. (14) Shares in column (2) includes 292,408 shares held in trust for the benefit of spouse as to which beneficial ownership is disclaimed. (15) Includes 2,150,464 shares which certain officers of ServiceMaster, through the exercise of their respective rights, may acquire within 60 days under share purchase agreements, the ServiceMaster Executive Debenture Plan, options granted under the ServiceMaster Share Option Plan and options granted under the ServiceMaster 10-Plus Option Plan. This figure includes shares purchasable by the persons identified in Item 11 as follows: Mr. Pollard - 112,500 shares; Mr. Oxley - 30,000 shares; Mr. Erickson - 30,000 shares; and all executive officers as a group - 292,500 shares. Item 13. Item 13. Certain Relationships and Related Miscellaneous Transactions ServiceMaster Limited Partnership and The ServiceMaster Company distributed an aggregate of $2,547,618 to ServiceMaster Management Corporation with respect to the year 1993, the managing general partner of each of these partnerships, with respect to its aggregate 1.99% carried interest in the profits and losses of these two partnerships. (See Note D, pages 18 -20). On January 17, 1993, ServiceMaster Limited Partnership, as the successor to ServiceMaster Industries Inc., distributed 18,708 partnership shares to C. William Pollard pursuant to the Exchange Agreement between Mr. Pollard and ServiceMaster Industries Inc. dated December 24, 1986. (This agreement related to the acquisition by ServiceMaster of Jubilee Investment Company in December 1986). On March 19, 1993, the Executive Committee of the Board of Directors of ServiceMaster Management Corporation, acting on the basis of a recommendation from a special committee of three independent directors, approved the issuance of 37,806 shares of ServiceMaster Limited Partnership to C. William Pollard as a payment in final settlement of the above-mentioned Exchange Agreement of December 24, 1986. On September 30, 1993, The ServiceMaster Company loaned Carlos H. Cantu the sum of $282,143, with interest at the rate of 3.5% per annum, as a bridge loan in connection with his purchase of a personal residence in Illinois. This purchase was made in connection with Mr. Cantu's assumption of the responsibilities as the Chief Executive Officer of ServiceMaster on January 1, 1994. This loan was paid in full in December, 1993. Indebtedness of Management The following executive officers were indebted to The ServiceMaster Company in excess of $60,000 at some point during the year 1993. Except for the indebtedness referred to in the last sentence of this paragraph, in each case, the indebtedness was incurred by reason of one or more share grants made to the person before 1993 under the ServiceMaster Share Grant Award Plan. As provided in the Share Grant Award Plan, The ServiceMaster Company advances to a share grant recipient the amount of federal and state income taxes incurred by the recipient as a result of the receipt of the share grant. The figure set opposite the person's name below is the largest amount of indebtedness outstanding during the year 1993; the figure in parentheses is the amount of indebtedness outstanding on March 21, 1994: Brian D. Oxley - $142,914 ($118,373); Ernest J. Mrozek - $117,582 ($103,355); and Vernon T. Squires $139,260 ($119,322). Interest on each of the foregoing loans is charged to the borrower at a rate between 7.75% and 9.29% per annum. Interest and principal payments on all of such loans are made quarterly. On September 30, 1993 The ServiceMaster Company made the loan to Carlos H. Cantu which is described under "Miscellaneous Transactions"; such loan was paid in full prior to the end of 1993. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements, Schedules and Exhibits 1. Financial Statements The documents shown below are contained in the Financial Statements and Management Discussion section of the ServiceMaster Annual Report to Shareholders for 1993, on pages 19 - 36 and are incorporated herein by reference: Summary of Significant Accounting Policies Report of Independent Public Accountants Consolidated Statements of Income for the three years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Financial Position as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the three years ended December 31, 1993, 1992 and Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993, 1992 and 1991 Notes to the Consolidated Financial Statements 2. Financial Statements Schedules Schedule IV--Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties. The items required by this Schedule are incorporated into the information relating to Share Grants on page 35. Included in Part IV of this Report: Schedule VIII--Valuation and Qualifying Accounts Schedule X--Supplementary Income Statement Information Report of Independent Public Accountants on Schedules Exhibit 11 -- Exhibit Regarding Detail of Income Per Share Computation Exhibit 24 -- Consent of Independent Public Accountants Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. Separate financial statements and supplemental schedules of ServiceMaster are omitted because prior to 1987 the Registrant was primarily an operating company. Its subsidiaries, included in the consolidated financial statements being filed, did not have a minority equity interest or indebtedness to any person other than the Registrant in an amount in excess of five percent of the total assets as shown by the consolidated financial statements as filed herein. 3. Exhibits The exhibits filed with this report are listed on pages 63-67 herein (the "Exhibits Index"). The following entries in the Exhibits Index are management contracts or compensatory plans in which a director or any of the named executive officers of the Registrant does or may participate. Reference is made to the Exhibits Index for the filing with the Commission which contains such contract or plan. Exhibit Contract or Plan 10.1 1987 ServiceMaster Option Plan. 10.3 Deferred Compensation and Salary Continuation Agreement for Officers. 10.4 Deferred Directors Fee Agreement. 10.5 ServiceMaster Executive Share Subscription Program. 10.6 Incentive Reward Compensation Plan. 10.9 ServiceMaster Profit Sharing, Savings & Retirement Plan as amended and restated effective January 1, 1987. 10.11 Share Grant Award Plan. 10.13 Executive Debenture Equity Program 9% Convertible Subordinated Debenture due April 1, 1995. 10.14 The Terminix International Company L.P. Profit Sharing and Retirement Plan. See note below. 10.15 ServiceMaster 10-Plus Plan. See also Item 10.21. 10.17 Directors Deferred Fees Plan (ServiceMaster Shares Alternative). 10.20 ServiceMaster 10-Plus Plan as amended September 3, 1991. Notes: The Terminix International Company L.P. Profit Sharing and Retirement Plan (Item 10.14) was integrated into the ServiceMaster Consumer Services Limited Partnership Profit Sharing Plan in February 1993. The ServiceMaster Consumer Services Limited Partnership Profit Sharing Plan is available to officers and employees generally. (b) Reports on Form 8-K None in the last quarter of the period covered by this Report on Form 10-K. Certain Undertakings With Respect To Registration Statements on Form S-8 For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the Registrant hereby undertakes as follows which undertaking shall be incorporated by reference into each of the Registrant's Registration Statements on Form S-8, including No. 33-19763 and No. 2-75851: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. FEDERAL INCOME TAX CONSIDERATIONS The following discussion of Federal income tax matters describes the material consequences to the non-corporate U.S. shareholders of ServiceMaster Limited Partnership (the "Public Partnership") and to the Public Partnership as sole common limited partner of The ServiceMaster Company Limited Partnership (the "Principal Subsidiary Partnership"). This discussion does not consider state, local and foreign tax issues, nor does it separately describe (except where noted) the consequences to shareholders who received their shares as a form of compensation (or in exchange for ServiceMaster stock issued in prior years as compensation), or which are corporations, tax-exempt entities, or non-resident alien individuals. THIS DISCUSSION MAY NOT BE DIRECTLY APPLICABLE TO ANY PARTICULAR SHAREHOLDER, DEPENDING ON THAT SHAREHOLDER'S UNIQUE CIRCUMSTANCES. SHAREHOLDERS ARE URGED TO CONSULT THEIR OWN TAX ADVISORS TO DETERMINE THE FEDERAL INCOME TAX TREATMENT IN THEIR SPECIFIC TAX SITUATIONS, INCLUDING THE APPLICATION AND EFFECT OF THE STATE, LOCAL AND FOREIGN LAWS WHICH MIGHT APPLY TO A SPECIFIC SHAREHOLDER. The following discussion is based on provisions of the Internal Revenue Code of 1986 (the "Code"), as amended, existing and proposed regulations promulgated thereunder, judicial deci- sions, legislative history, and current administrative rulings and practices. For a number of Code sections the Internal Revenue Service (the "IRS") has been directed or authorized by statute to issue regulations that may materially affect the tax consequences of holding an interest in ServiceMaster. As of the date hereof, certain of these regulations have not yet been promulgated. Moreover, any of the statutes, regulations, rulings, practices, or judicial precedents upon which this discussion is based could be changed, perhaps retroactively, with adverse tax consequences. The Federal income tax treatment of shareholders, as described below, depends in some instances on interpretation by ServiceMaster Management Corporation (hereinafter referred to as the "Managing General Partner") of complex provisions of the Federal income tax law for which no clear precedent or authority may be available. In determining basis adjustments, allocations, asset valuations and taxable income of the Principal Partnerships, the Managing General Partner must make determinations that will affect a shareholder in various ways depending on such factors as the date a shareholder purchased shares of the Principal Partnerships and subsidiary partnerships. Possible Legislative Changes. Congress is considering the possible enactment of proposals to revise in certain respects the federal income taxation of widely held partnerships (such as the Public Partnership). These proposals would, among other changes, simplify the rules under which the partners report their share of partnership income or loss and change the rules relating to the auditing of, and the collection of deficiencies with respect to, such partnerships. Tax Status of the Partnerships Significance of "Partnership" Status. Except as otherwise provided by Code Section 7704, a partnership incurs no Federal income tax liability unless the partnership is classified as an association taxable as a corporation. Instead, each partner in a partnership is required to take into account in computing his or her Federal income tax liability his or her allocable share of the income, gains, losses, deductions and credits of the partnership. The Federal income tax treatment contemplated for shareholders will be available only if the Principal Partnerships are not classified as associations taxable as corporations. If either of the Principal Partnerships were classified as an association taxable as a corporation in any year, such partnership's income, gains, losses, deductions and credits would be reflected on its own tax return, rather than being passed through to shareholders, and its net income would be taxed at corporate rates (with the maximum rate for regular tax currently equal to 35%, and the rate for alternative minimum tax equal to 20%). In addition, distributions made to shareholders would be treated as (a) taxable dividend income (to the extent of such partnership's current and accumulated earnings and profits) or, to the extent distributions exceed the partnership's earnings and profits, (b) a non-taxable return of capital (to the extent of a shareholder's basis for his or her shares) or (c) taxable capital gain. In sum, classification of either of the Principal Partner- ships as an association taxable as a corporation would result in a material reduction in the anticipated cash flow and after-tax return to shareholders from holding Public Partnership shares. Classification of the Principal Partnerships. The Principal Partnerships received an opinion of counsel that, as of their formation in December, 1986, the Principal Partnerships would be classified as partnerships for Federal income tax purposes. Counsel's opinion regarding the Federal income tax classification of the Principal Partnerships is based upon, among other things, the Managing General Partner's representations that: (a) ServiceMaster Management Corporation has acted as a general partner in each of the Principal Partnerships and will maintain a net worth, on a fair market value basis, of at least $15.0 million (apart from direct or indirect interests in either of the Principal Partnerships or in any subsidiaries of the Principal Partnerships) in the form of (i) cash or cash equivalents; (ii) marketable obligations issued or guaranteed by the United States government or any agency or political subdivision thereof or issued by any state of the United States or any agency or political subdivision thereof; (iii) commercial paper; (iv) certificates of deposit; (v) bankers' acceptances; (vi) securities regularly traded on an established market; and/or (vii) notes receivable secured by bank letters of credit; (b) Each of the Principal Partnerships has operated at all times in accordance with applicable provisions of the Delaware Revised Uniform Limited Partnership Act, the terms and conditions of their respective partnership agreements, and the statements and representations made in ServiceMaster's December 11, 1991, proxy statement/prospectus; (c) Except as required by Section 704(c) of the Code or as the result of a temporary allocation required under Section 704(b) of the Code (for example, a qualified income offset or a minimum gain chargeback), the aggregate interest of the general partners of the Principal Partnerships in each material item of gain, loss, deduction or credit of each of the Principal Partnerships has been equal to at least 1% of each such item; (d) The partnership agreement governing each of the Principal Partnerships has provided, and continues to provide, in accordance with IRS Revenue Procedure 89-12, that upon dissolution of the respective partnership the general partners of that partnership will contribute to the partnership an amount equal to the deficit balance, if any, in their capital accounts; and (e) The general partners of each of the Principal Partnerships have held their interests in each of the Principal Partnerships for their own account and, in managing each of the Principal Partnerships, have not acted under the direction of or as agents for the limited partners of the Public Partnership. If the Managing General Partner were to withdraw as a partner at a time when there is no successor Managing General Partner, or if the successor Managing General Partner could not satisfy the applicable net worth requirement and other restric-tions, then the IRS might attempt to classify one or both of the Principal Partnerships as associations taxable as corporations. The general partners and the Principal Partnerships intend to contest any material adverse determination by the IRS classifying either of the Principal Partnerships as an associ-ation taxable as a corporation. Shareholders should be aware that the Principal Partnerships, and hence indirectly the shareholders, may incur substantial legal expenses in the event of such a contest, and there can be no assurance that such a contest would be successful. Publicly Traded Partnerships Treated as Corporations. Pursuant to Code Section 7704, a publicly traded partnership (i.e., any partnership if interests in the partnership are traded on an established securities market or are readily tradeable on a secondary market or the substantial equivalent thereof) will generally be treated as a corporation for Federal income tax purposes with respect to taxable years beginning after 1987. However, a partnership which was a publicly traded partnership on December 17, 1987 will not be treated as a corporation under Sec- tion 7704 until the partnership's first taxable year beginning after 1997. This "grandfather status" is lost, however, if the partnership adds a substantial new line of business after December 17, 1987; in that event, the partnership may be treated as a corporation as of the day after the date on which such substantial new line of business is added. The Public Partnership is a publicly traded partnership for purposes of Section 7704 but ServiceMaster currently intends to operate its businesses in a manner so as to qualify under this exception to the general rule of Section 7704 and to thereby retain its partnership tax status for Federal income tax purposes for tax years beginning before 1998. If the Public Partnership were treated as a corporation under Code Section 7704, shareholders of the Public Partnership would be deemed to exchange their shares in the Public Partner-ship ("Partnership Shares") for stock in a corporation. Such deemed exchange is currently anticipated to be generally tax-free; however, the exchange could result in tax liability for a shareholder of the Public Partnership (i) if the shareholder's tax basis for his or her partnership Shares is less than his or her share of the Principal Partnerships' liabilities (as determined for purposes of Code Section 752); (ii) if the deemed exchange triggers any tax benefit recapture; or (iii) if ServiceMaster's liabilities exceed the tax basis of its assets. For most shareholders, it is unlikely that Federal income taxes would have to be paid on the deemed exchange. After such deemed exchange, shareholders would not be taxable on their allocable shares of the taxable income of the Public Partnership. Instead, distributions from the Public Part-nership would generally be taxable to the shareholders to the same extent as dividends from a corporation. Thus, distributions would be taxable to the shareholders as ordinary income to the extent of the Public Partnership's earnings and profits, and distributions in excess of the Public Partnership's earnings and profits would first reduce the shareholder's basis in his or her shares and would, to the extent in excess of such basis, be taxed as capital gain. If the Public Partnership were treated as a corporation under Code Section 7704, the Public Partnership's income, gains, losses, deductions and credits would be reflected on its own tax return and its net income would be taxed at corporate rates (with the top average rate for regular tax currently equal to 35% and the rate for alternative minimum tax equal to 20%). The treatment of the Public Partnership as a corporation pursuant to Section 7704 could result in a reduction in the anticipated cash flows and after-tax return to shareholders holding Partnership Shares and could have a negative impact on the value of the Shares. In accordance with shareholder approval granted on January 13, 1992, ServiceMaster currently intends to engage in a reincorporating merger on December 31, 1997, immediately prior to the time when Code Section 7704 would otherwise automatically treat the Public Partnership as a corporation for Federal income tax purposes. The reincorporating merger should provide certain benefits which might not be available if ServiceMaster remained in partnership form subject to the application of Code Section 7704. As discussed more fully in ServiceMaster's December 11, 1991 proxy statement/prospectus, no Federal income tax will be imposed on shareholders in the Public Partnership by reason of the reincorporating merger, assuming that Federal income tax laws remain as now constituted and also based on certain factual assumptions The board of directors of the Managing General Partner may accelerate the effective date of the reincorporating merger to a date earlier than December 31, 1997 if either changes in tax laws or other developments cause more than 51% of ServiceMaster's income to be subject to corporate income tax prior to 1998 or the board of directors, in its sole discretion, determines that the advantages of such acceleration to ServiceMaster and the holders of a majority of its outstanding shares outweigh the disadvantages. It is possible that acceleration of the effective date of the reincorporating merger could adversely impact some shareholders in the Public Partnership. THE DISCUSSION THAT FOLLOWS IS BASED ON THE ASSUMPTION THAT THE PRINCIPAL PARTNERSHIPS ARE NOT CLASSIFIED FOR FEDERAL INCOME TAX PURPOSES AS ASSOCIATIONS TAXABLE AS CORPORATIONS, AND THAT THE PUBLIC PARTNERSHIP IS NOT TREATED AS A CORPORATION PURSUANT TO CODE SECTION 7704. Tax Consequences of Partnership Share Ownership General. The Public Partnership is not subject to Federal income tax as an entity. Rather, subject to the limitations prescribed in Code Section 469, each partner is required to report on his or her Federal and state income tax returns his or her allocable share of the income, gains, losses, deductions and credits (and, for alternative minimum tax purposes, tax preference items) of the Public Partnership for the taxable year of the Public Partnership ending with or within his or her taxable year and will be taxable directly on his or her allocable share of the Public Partnership's taxable income. The Public Partnership's taxable income includes its allocable share of the income, gains, losses, deductions and credits (and, for alternative minimum tax purposes, tax preference items) of the Principal Subsidiary Partnership which, in turn, includes its allocable share of such items of subsidiary partnerships. The beneficial owners of Partnership Shares are treated as partners of the Public Partnership for Federal income tax purposes. Thus, if Partnership Shares are held by a nominee, the beneficial owner of the Partnership Shares will be taxed on income and loss of the Public Partnership. Subject to the discussion set forth in the next five paragraphs, because shareholders are required to include Public Partnership income in their income for tax purposes without regard to whether they receive cash distributions of that income, shareholders may be liable for Federal income taxes with respect to Public Partnership income even though they have not received cash distributions from the Public Partnership sufficient to pay such taxes. However, throughout the period from January 1, 1987 to December 31, 1993, the Public Partnership's cash distributions to its shareholders have been substantially in excess of the taxes payable in respect of the taxable income allocated to such shareholders. The Public Partnership has no reason to expect that this situation will not continue through the end of the year 1997. ServiceMaster SGP Trust. In recognition of the fact that in 1993 (for the first time in the Public Partnership's history) taxable income was likely to exceed cash distributions to many shareholders of the Public Partnership, the Principal Subsidiary Partnership admitted the ServiceMaster T Trust as a special general partner of the Principal Subsidiary Partnership effective January 1, 1993. On September 30, 1993, the ServiceMaster T Trust was replaced by the ServiceMaster A Trust. Each of these trusts is hereinafter referred to as the "SGP Trust". The interest held by the SGP Trust is denominated in the Principal Subsidiary Partnership's partnership agreement as a Class T Partnership Interest. (See Note S, page 16). As stated in such Note, the beneficiaries of the SGP Trust are the limited partners of the Public Partnership as constituted from time to time. On the date on which ServiceMaster converts back to corporate form pursuant to the Reincorporating Merger approved on January 16, 1992, the SGP Trust will be assimilated into ServiceMaster Incorporated of Delaware, the successor corporate holding company for the ServiceMaster enterprise. The beneficial interests held by the beneficiaries of the SGP Trust are not assignable or transferable separately, but only by and in connection with the transfer of shares in the Public Partnership Every assignment, sale or transfer of any interest in shares in the Public Partnership prior to the date on which the SGP Trust terminates will include a proportional undivided beneficial interest in the SGP Trust. The SGP Trust will receive each year, beginning with the year 1993, an allocation of the amount of the taxable income of the Principal Subsidiary Partnership which exceeds the aggregate cash distributions made by the Public Partnership to its limited partners. The effect of this arrangement is that the cash distributions made by the Principal Partnership to its limited partners will be exactly equal to the taxable income of the Principal Partnership which is directly allocated to its limited partners. The Principal Subsidiary Partnership will make cash distributions to the SGP Trust in the amounts required by the SGP Trust to discharge its federal and state income tax liabilities. The SGP Trust will not receive any other allocations of income or cash distributions. The formation of the SGP Trust was not a taxable event to the Principal Partnerships or the shareholders, and the creation of the Class T Partnership Interest was not a taxable event to either the SGP Trust or the Principal Subsidiary Partnership or to the Principal Partnership. The distribution of funds to the SGP Trust by the Principal Subsidiary Partnership will not be a taxable event to either party. The SGP Trust will include in its taxable income its allocable share of the income of the Principal Subsidiary Partnership. If the SGP Trust were to distribute its income to its beneficiaries, such distributions would be taxable to the beneficiaries. However, because it is not anticipated that the SGP Trust will make any distributions to its beneficiaries, the shareholders of the Principal Partnership will not recognize any taxable income on account of the establishment of, and allocations to, the SGP Trust. Accounting Method and Tax Information. The Public Partnership uses the accrual method of accounting in reporting income and computes income on the basis of a taxable year ending on December 31. The Public Partnership will prepare and furnish to each shareholder of record during any taxable year the information necessary for the preparation of the shareholder's Federal, state and other tax returns required as a result of the operations of the Public Partnership for that year. Tax Basis of Partnership Shares. The tax basis of a share- holder in his or her Partnership Shares is significant because (i) basis is used in measuring the gain or loss recognized for tax purposes either upon the receipt of cash distributions from the Public Partnership or upon a partial or complete disposition of Partnership Shares by the shareholder and (ii) a shareholder may deduct his or her allocable share of Public Partnership losses only to the extent of his or her tax basis in his or her shares. See "Tax Consequences of Partnership Share Ownership --Taxation of Partners on Public Partnership Distributions" and "Sale or Other Disposition of Shares." Generally, the initial tax basis of any shareholder in his shares received upon the 1986 reorganization of ServiceMaster (the "1986 Reorganization") was equal to the fair market value of the shares on the date of the 1986 Reorganization and the initial tax basis of any shareholder who purchases Partnership Shares is equal to the amount paid. In either case, a shareholder's tax basis is increased by his or her share (as determined for purposes of Code Section 752) of the Principal Partnerships' liabilities. Any reduction of his or her share of liabilities would reduce a shareholder's basis. Adjustments to a shareholder's tax basis are made to reflect distributions and the shareholder's allocable share of Public Partnership income and loss. Taxation of Partners on Public Partnership Distributions. If the cash distributions to a shareholder by the Public Partner-ship in any year exceed his or her allocable share of the Public Partnership's taxable income for that year, the excess will constitute a return of capital to the shareholder to the extent of the shareholder's basis in his or her Partnership Shares. This situation is expected to occur for shareholders whose taxable income is determined by reference to the Section 754 election (see "Section 754 Election", page 51). A return of capital will not be reportable as taxable income by a shareholder for Federal income tax purposes, but will reduce the tax basis of his or her Partnership Shares. If a shareholder's tax basis were reduced to zero, then any further cash distribution to the shareholder for any year in excess of his or her allocable share of the Public Partnership's taxable income for that year would be taxable to him or her as though it were gain on the sale or exchange of his or her Partnership Shares. All or a portion of such excess cash distribution could be treated as ordinary income as the result of the application of the recapture provisions of the Code. See "Sale or Other Disposition of Shares." A decrease in the shareholder's percentage interest in the Public Partnership due, for example, to a new Public Partnership offering of shares, will give rise to a deemed cash distribution to the extent the shareholder's share of liabilities (as determined for purposes of Code Section 752) decreases. Such deemed distribution would result in ordinary income pursuant to Code 751(b) to a shareholder (whether or not such deemed distribution exceeds the adjusted basis of the shareholder's Partnership Shares) to the extent that such deemed distribution is treated as an exchange of "unrealized receivables" (including recapture amounts) and "substantially appreciated inventory" (as defined in Code Sections 751(b) and 751(d)) for money. However, when additional shares are issued by the Public Partnership, certain items of income, gain, loss or deduction will be reallocated to reflect the fair market value of the Principal Partnerships' property and such reallocation should minimize or eliminate the recognition of such ordinary income pursuant to Code Section 751(b). Nevertheless, the IRS may contend that such ordinary income must be recognized by shareholders whose percentage interests have decreased due to an offering of addi-tional shares by the Public Partnership. Limitation on Losses. No investor should invest in the Public Partnership with the expectation that an investment in the Public Partnership will result in tax losses that may be applied to offset an investor's income from other sources. To the extent that the Principal Partnerships' operations result in losses for tax purposes in any calendar year, a shareholder generally will be entitled to use his or her allocable share of such losses to the extent of his or her tax basis in his or her Partnership Shares at the end of the year, subject to the limitations prescribed in Code Section 469. Code Section 469 limits a taxpayer's ability to use losses or credits generated by limited partnerships and other business activities in which such taxpayer does not materially participate ("passive activities"). In general, losses from passive activities will not offset earned income (salary and bonus) or portfolio income (interest, dividends and royalties). Such losses will generally only offset income from other passive activities. Similarly, tax credits from passive activities will only reduce income tax attributable to income from passive activities. Losses and credits from a passive activity which cannot be used in a given year are generally carried forward. These deferred losses and credits, if not usable sooner, will generally be allowed in full when the taxpayer disposes of his or her entire interest in the activity. Section 469 applies separately to each publicly traded partnership. Thus, passive activity losses and credits attribut- able to a limited partner's interest in a publicly traded partnership (such as the Public Partnership) cannot be applied against the limited partner's other income, even if such income is treated as passive under Section 469. Such losses and credits are suspended and carried forward for applications against income from the publicly traded partnership in future years. Upon a complete disposition of the limited partner's interest in the publicly traded partnership in a fully taxable transaction, any of the limited partner's remaining suspended losses generally may be applied against other income. Income attributable to a limited partner's interest in a publicly traded partnership (such as the Public Partnership) cannot be offset by losses or credits from the limited partner's other passive activities. Substantially all of any losses or credits generated by the Public Partnership will likely be subject to the limitations prescribed in Section 469. The limitations prescribed in Section 469 generally apply to individuals, estates, trusts, personal service corporations and, with certain modifications, closely-held corporations. Under current law, a partner who is subject to the "at-risk" limitations of Code Section 465 may not deduct his or her allocable share of partnership losses for a taxable year to the extent they exceed the aggregate amount for which he or she is considered to be "at-risk" with respect to the partnership activities giving rise to those losses as of the end of its taxable year in which the losses occur. Because it is not anticipated that the Principal Partnerships will incur losses that exceed either the shareholders' aggregate basis in their Partnership Shares or amounts "at-risk" with respect to the Principal Partnerships' activities, the "at- risk" limitations under current law should generally not affect shareholders adversely. Federal Income Tax Allocations General. In general, items of Principal Partnership income, gain, loss, deduction and credit are allocated for both accounting and Federal income tax purposes in accordance with the percentage interests of the general and limited partners. However, as discussed in greater detail below, the Managing General Partner is empowered by the limited partnership agreements for the Principal Partnerships (the "Principal Partnership Agreements") to specially allocate various Principal Partnership tax items other than in accordance with percentage interests when, in the judgment of the Managing General Partner, such special allocations are necessary to comply with applicable provisions of the Code and the regulations or, to the extent permissible under the Code and the regulations, to preserve the uniformity of the shares in the Public Partnership, i.e., to ensure that all Partnership Shares will have identical attributes. These allocation provisions will be recognized for Federal income tax purposes if they are considered to have "substantial economic effect" within the meaning of Code Section 704(b). If any allocation fails to satisfy the "substantial economic effect" requirement, the allocated items will be reallocated among the shareholders based on their respective "interests in the partnership," determined on the basis of all of the relevant facts and circumstances. Pursuant to regulations issued under Section 704(b), a partnership allocation will be considered to have "substantial economic effect" if it is determined that the allocation has "economic effect" and the economic effect is "substantial." An allocation to partners (other than an allocation of loss, deduction or certain other items attributable to nonrecourse liabilities ("nonrecourse deductions")) will be considered to have "economic effect" if (i) the partnership maintains capital accounts in accordance with specific rules set forth in the regulations and the allocation is reflected through an increase or decrease in the partners' capital accounts, (ii) liquidating distributions are required to be made in accordance with the partners' respective positive capital account balances by the end of the taxable year (or, if later, within 90 days after the date of liquidation), and (iii) any partner with a deficit in his or her capital account following the distribution of liquidation proceeds would be unconditionally required to restore the amount of such deficit to the partnership. If the first two of these requirements are met but the partner to whom an allocation is made is not obligated to restore the full amount of any deficit balance in his or her capital account, the allocation still will be considered to have "economic effect" to the extent the allocation does not cause or increase a deficit balance in the partner's capital account (determined after reducing that account for certain "expected" adjustments, allocations, and distributions specified by the regulations) if the partnership agreement contains a "qualified income offset" provision. A qualified income offset requires that in the event of any unex-pected distribution (or specified adjustments or allocations) to a partner that results in a deficit balance in such partner's capital account, there must be an allocation of income or gain to the distributee that eliminates the resulting capital account deficit as quickly as possible. In order for the "economic effect" of an allocation to be considered "substantial," the regulations require that the allocation must have a "reasonable possibility" of "substantially" affecting the dollar amounts to be received by the partners, independent of tax consequences. The regulations provide that the "economic effect" of an allocation will be presumed to be insubstantial if it merely shifts tax consequences within a partnership taxable year or is transitory, i.e., likely to be offset by other allocations in subsequent taxable years. The regulations state, however, that adjustments to the tax basis in property will be presumed to be matched by corresponding changes in the fair market value of the property. Thus, the regulations conclude that there will not be a strong likelihood that an allocation of deductions attributable to depreciation will be transitory due to a provision for a subsequent corresponding allocation of gain attributable to the disposition of that property. In addition to the regulations described above, the Treasury has issued regulations which address the effect of nonrecourse liabilities upon partnership allocations. Under the regulations, if (i) the partnership maintains capital accounts in accordance with specific rules set forth in the regulations and allocations are reflected through an increase or decrease in partners'capital accounts and (ii) liquidating distributions are required to be made in accordance with partners' respective positive capital account balances by the end of the taxable year (or, if later, within 90 days after the date of liquidation), then a partner may be allocated nonrecourse deductions that cause his or her capital account to fall below zero, provided (among other requirements) that the deficit produced by the allocation is not in excess of the minimum gain that would be allocated to the partner in the event the partnership property securing the nonrecourse liability were disposed of in a taxable transaction in full satisfaction of such liability. The regulations further provide that in the event there is a decrease in such partnership's minimum gain for a partnership taxable year, the partners must be allocated items of partnership income and gain for such year (and, if necessary, for subsequent years) in proportion to, and to the extent of, an amount equal to such partner's share of the net decrease in partnership minimum gain during such year. The Principal Partnership Agreements provide that a capital account is to be maintained for each partner, that the capital accounts are to be maintained in accordance with applicable prin- ciples set forth in the regulations, and that all allocations to a partner are to be reflected in the partner's capital account. In addition, distributions upon liquidation of the Principal Partnerships are to be made in accordance with respective capital account balances. The Principal Partnership Agreements do not require the limited partners to restore any deficit balance in their capital accounts upon liquidation of the Principal Partnerships. However, the Principal Partnership Agreements contain a "minimum gain" allocation for nonrecourse deductions and a "qualified income offset" provision. Pursuant to the Principal Partnership Agreements, tax income and gain will be allocated in a manner consistent with the book income and gain allocations associated with the minimum gain and qualified income offset provisions. The manner of allocation of items of income, gain, loss, deduction and credit for both book and Federal income tax purposes is set forth in the Principal Partnership Agreements. In general, the Principal Partnerships' income, gains, losses, deductions and credits are allocated pursuant to the Principal Partnership Agreements among the partners pro rata in accordance with their percentage interests, except that the allocation of taxable income of the Principal Subsidiary Partnership to the ServiceMaster SGP Trust is determined in the manner described above and in Note S, page 25. The Principal Partnership Agreements contain special allocations of book income and gain for the qualified income offset and minimum gain provisions (discussed above) and special allocations of income and deduction to preserve the uniformity of shares. The Principal Partnership Agreements further provide exceptions to the pro rata allocations for Federal income tax purposes of (i) income, gain, loss and deductions attributable to properties contributed to the Principal Partnerships in exchange for shares ("Contributed Property"), (ii) income, gain, loss and deductions attributable to the Principal Partnerships' properties where the Principal Partnerships have adjusted the book value of such properties upon the Public Partnership's issuance of additional shares to reflect unrealized appreciation or depreciation in value from the later of the Principal Partnerships' acquisition date for such properties or the latest date of a prior issuance of shares ("Adjusted Property"), (iii) curative allocations of gross income and deductions to preserve the uniformity of shares issued or sold from time to time, (iv) recapture income resulting from the sale or disposition of Principal Subsidiary Partnership assets ("Recapture Income"), (v) income and gain in a manner consistent with the allocation of book income and gain pursuant to a qualified income offset, and (vi) income and gain attributable to nonrecourse debt in a manner consistent with the allocation of book income and gain under a minimum gain provision. With respect to property contributed by a shareholder to the Principal Partnerships, the Principal Partnership Agreements provide that, for Federal income tax purposes, partnership income, gain, loss and deductions shall first be allocated among the partners in a manner consistent with Code Section 704(c). In addition, the Principal Partnership Agreements provide that partnership income, gain, loss and deductions attributable to Adjusted Property shall be allocated for Federal income tax purposes in accordance with Section 704(c) principles. Pursuant to Section 704(c), items of partnership income, gain, loss and deduction with respect to Contributed Property are to be shared among the partners pursuant to regulations not yet adopted so as to take account of the differences between the Principal Subsidiary Partnership's basis for the property and the fair market value of the property at the time of the contribution (i.e., a Book-Tax Disparity). The IRS has issued proposed regulations under Section 704(c) which provide that these allocations of partnership income, gain, loss and deduction to account for the Book-Tax Disparity can be made by any reasonable method. The proposed regulations set forth three non-exclusive allocation methods which are generally considered to be reasonable. Because regulations have not been issued in final form under Section 704(c), it is not clear whether allocations made pursuant to the Principal Partnership Agreements will be respected for Federal income tax purposes. As discussed below, the Code Section 754 election permits an adjustment in the basis in the assets of the Principal Subsidiary Partnerships and subsidiary partnerships pursuant to Code Section 743(b) to reflect the price at which Partnership Shares are purchased from a shareholder as if such purchaser had acquired a direct interest in such assets. See "Section 754 Election." Such Section 743(b) adjustment is attributed solely to such purchaser of shares and is not added to the bases of the assets of the Principal Subsidiary Partnership and subsidiary partnerships associated with all of the shareholders ("common bases"). With respect to Section 743(b) adjustments, proposed regulations relating to ACRS depreciation appear to require the acquiring partner to use a depreciation method and useful life for the increase in basis which is different from the method and useful life generally used to depreciate the Public Partnership's common bases in the assets of the Principal Subsidiary Partnerships and subsidiary partnerships. The Managing General Partner has the authority under the Principal Partnership Agreements to specially allocate items of income and deductions in a manner that will preserve the uniformity among all shares, so long as such allocations are consistent with and supportable under the principles of Code Section 704. The Managing General Partner may use a "depreciation convention method" or any other convention to preserve the uniformity of shares. If no allowable or workable convention is available to preserve the uniformity of Partnership Shares or the Managing General Partner in its discretion so elects, the Partnership Shares may be separately identified as distinct classes to reflect differences in tax consequences. The Managing General Partner has adopted conventions and allocations to achieve uniformity among all Partnership Shares. The Principal Partnership Agreements also require that gain from the sale of Principal Subsidiary Partnership properties, to the extent characterized as Recapture Income, be allocated (to the extent such allocation does not alter the allocation of gain otherwise provided for in the Principal Partnership Agreements) among the partners (or their successors) in the same manner in which such partners were allocated the deductions giving rise to such Recapture Income. The Section 704(b) regulations and Sections 1.1245-1(e) and 1.1250-1(f) of the regulations tend to support a special allocation of Recapture Income. However, such regulations do not specifically address a special allocation based on the allocation of the deductions giving rise to such Recapture Income as stated in the Principal Partnership Agreements. Therefore, it is not clear that the allocation of Recapture Income will be given effect for Federal income tax purposes. If it is not, such Recapture Income will be allocated to all shareholders and the general partners. Transferor/Transferee Allocations. The Principal Part- nerships will allocate their taxable income and losses among the shareholders of record in proportion to the number of Partnership Shares owned by them based on the number of months during the year for which each shareholder was record owner of the shares. The Principal Partnerships' taxable income and loss allocable to each month will be determined by allocating such income or loss pro rata to each month in the year. With respect to any Partnership Share that is transferred during any calendar month, the Principal Partnerships will treat a shareholder who becomes the record owner of such share on or before the close of business on the fifteenth day of the month as having been the owner of such share for the entire month if he or she holds such share for the remainder of such month. Conversely, a shareholder who becomes the record owner of a Partnership Share during such month but after the fifteenth day of a calendar month will be allocated the taxable income and losses attributable to the second half of such month if he or she holds such share for the remainder of such month. Code Section 706 generally requires that items of partnership income and deduction be allocated among transferors and transferees of partnership interests (as well as among partners whose interests otherwise vary during a taxable period) on a daily basis among the partners who own interests on the end of each such day. The Principal Partnerships' proposed allocation method will not literally comply with this requirement. However, the legislative history indicates that monthly and semi-monthly conventions may be permitted in normal situations. This issue may be clarified by regulations. The floor debates in connection with the enactment of the Deficit Reduction Act of 1984 (the "1984 Act") reflect that Congress intended that any regulations limiting the use of conventions under the 1984 Act provisions would apply only on a prospective basis. If the "mid-month" convention to be used by the Principal Partnerships were not permitted by the regulations ultimately adopted, then the IRS might contend that taxable income (or losses) of the Principal Partnerships must be allocated among the shareholders in a manner different from that presently contemplated (for example, on a daily basis). In that event, the respective tax liabilities of the shareholders might be adjusted, and some shareholders might be allocated additional income. The Principal Partnership Agreements authorize the Managing General Partner to revise the Principal Partnerships' method of allocating income and loss between transferor and transferee, as well as among shareholders whose interests otherwise vary during a taxable period, in order to comply with any regulations or rulings ultimately adopted. Depreciation; Amortization; Recapture General. The Principal Partnerships claim depreciation, cost recovery and amortization deductions with respect to the purchase price (or other tax basis) of the various properties of the Principal Partnerships and subsidiary partnerships and related improvements to the extent permitted by the applicable Code provisions. Land is not subject to depreciation, cost recovery or amortization deductions. As a general rule, if an intangible asset has a determinable useful life, then the cost of the asset may be amortized over that useful life using a straight-line method. If, however, the useful life of an intangible asset is not determinable, then the cost of the intangible asset may not be amortized or deducted. Various components of the Principal Partnerships' properties fall into each of the categories discussed in the preceding paragraphs. A portion of the cost of certain Principal Partnership properties is allocable to (i) nondepreciable, nonamortizable land, (ii) tangible property, some of which is real property (i.e., buildings and structural components) or tangible personal property that may qualify for depreciation deductions, and (iii) intangible property that may or may not qualify for amortization. As part of the Revenue Reconciliation Act of 1993, Congress enacted Code Section 197. This section allows for the amortization of certain intangibles over a 15-year period. This 15-year amortization period must be used even if the intangible asset has a useful life of less than 15 years. The types of intangible assets covered by Code Section 197 include goodwill, going concern value, work force in place, licenses, permits, covenants not to compete, franchises, trademarks, trade names, customer-based intangible assets (e.g., favorable sale contracts ) and supplier-based intangible assets (e.g., favorable supply contracts). Interests in partnerships are specifically excluded from Code Section 197, among other types of intangible assets. Code Section 197 applies to intangible assets acquired after August 10, 1993 unless an election is made to apply Code Section 197 retroactively starting after July 25, 1991. The Principal Partnerships will elect to have the provisions of Code Section 197 apply retroactively to an increase in basis for property acquired by the Principal Partnerships after that date. This election can be expected to increase the amount of intangible amortization of the Principal Partnerships. For shareholders who purchased shares in the Public Partnership after July 25, 1991, the amortization on the intangible assets acquired by the Principal Partnerships before July 26, 1991 allowed by Section 197 will apply only to the increase in basis resulting from the Code Section 754 election. In other words, no amortization under Code Section 197 will be allowed on the Principal Partnerships' original basis in intangible assets, unless those assets were acquired by the Principal Partnerships after July 25, 1991. With respect to bases adjustments for partners resulting from the Section 754 election, in March 1994, the IRS issued proposed and temporary regulations which, among other things, provided a procedure by which a taxpayer who purchased shares of a partnership during the period July 25, 1991 to August 10, 1993 and in respect of which a Section 754 election was in effect (which is true for the Public Partnership's shares) may elect to apply retroactively the provisions of Code Section 197. However, the regulations as initially issued may effectively prevent shareholders of publicly traded partnerships (such as the Parent Partnership) from making the election. Whether such regulations will become final as initially written, and whether such regulations are entirely valid in the form originally issued, were matters which were not clear as of the date of this Form 10-K. Deductions for depreciation, cost recovery and amortization claimed by the Principal Partnerships with respect to assets of the Principal Partnerships and subsidiary partnerships reduce the partnerships' adjusted basis for the properties, thereby increasing the potential gain (or decreasing the potential loss) to the Principal Partnerships upon the ultimate disposition of the properties. These deductions also have the effect of reducing the shareholders' adjusted basis for their Partnership Shares (by reducing taxable income or increasing tax losses), thereby affecting the potential gain or loss to be realized upon a subsequent sale of the shares. See "Sale or Other Disposition of Shares." Sale or Other Disposition of Shares General. In the event of a sale or disposition of Part- nership Shares, a shareholder will recognize gain or loss, as the case may be, on the disposition in an amount equal to the differ- ence between the amount realized by the shareholder on the dispo- sition and his adjusted tax basis for his Partnership Shares. See "Tax Consequences of Partnership Share Ownership" -- "Tax Basis of Partnership Shares." For these purposes, a shareholder's share (as determined for purposes of Code Section 752) of any Principal Partnership indebtedness attributable to the transferred Part- nership Shares will be included in the amount realized on the disposition. Generally, under current law, gain recognized by a share- holder on the sale or exchange of shares that have been held for more than twelve months will be taxable as long-term capital gain, taxable at a maximum rate of 28% in the case of taxpayers other than corporations. However, that portion of the gain attributable to "substantially appreciated inventory items" and "unrealized receivables" of the Principal Partnerships, as those terms are defined in the Code, will be treated as ordinary income. Ordinary income attributable to unrealized receivables and inventory items may exceed the net taxable gain realized upon the sale and may be recognized even if there is a net tax loss realized upon the sale. "Unrealized receivables" include, among other things, the shareholder's proportionate share of the amounts that would be recaptured as ordinary income if the Principal Partnerships were to have sold their assets at fair market value at the time the shareholder transferred his shares. See "Depreciation; ACRS; Amortization; Recapture" -- "Recapture." Any loss recognized upon the sale of shares generally will be treated as a capital loss. A shareholder will not ordinarily recognize any gain or loss upon making a gift of Partnership Shares. However, a shareholder making a gift of Partnership Shares more likely than not will include as an amount realized the share (as determined for purposes of Code Section 752) of any of the Partnerships' indebt- edness allocable to the transferred Partnership Shares. See "Tax Consequences of Partnership Share Ownership" -- "Tax Basis of Partnership Shares," such shareholder would therefore recognize gain (but not loss) on making a gift of Partnership Shares if the shareholder's basis had declined so that it were less than such amount deemed realized. In the case of a deductible gift to a charitable organization the donor's basis is apportioned between the value deemed contributed and the deemed sale price. Any gain recognized more likely than not would be subject to the same rules (described above) which apply to gain recognized on a sale of a Partnership Share, so that some portion could be treated as ordinary income. The IRS has ruled that a partner must maintain an aggregate adjusted tax basis in his entire partnership interest (consisting of all interests in a given partnership acquired in separate transactions). Upon the sale of a portion of such aggregate interest, such partner would be required to allocate his aggregate tax basis between the portion of the interest sold and the portion of the interest retained according to some equitable apportionment method. (The IRS ruling requires that the apportionment be based on the relative fair market values of such interests on the date of sale.) This requirement, if applicable to the Public Partnership, effectively would preclude a shareholder owning shares that were purchased at different prices on different dates from controlling the timing of the recognition of the inherent gain or loss in his shares by selecting the specific shares that he will sell. However, the application of this ruling in the context of a publicly traded limited partnership such as the Public Partnership is not clear. The ruling does not address whether this aggregation requirement, if applicable, results in the tacking of the holding period of older shares onto the holding period of more recently acquired shares. Transferor/Transferee Allocations. The manner in which the Principal Partnerships intend to allocate their taxable income and losses between transferors and transferees of shares is described above under "Federal Income Tax Allocations" -- "Transferor/Transferee Allocations." Shareholders contemplating a transfer of shares should note that cash distributions to which they are entitled may not correspond to the Principal Partnerships' taxable income and loss which shall be allocated between the transferor and transferee of such shares. Information Return Filing Requirements. Any shareholder who sells or exchanges a share at a time when the Principal Part- nerships have unrealized receivables (including certain recapture items) or substantially appreciated inventory generally will be required to notify the Public Partnership of such transaction within 30 days of the transaction (or if earlier by January 5 of the calendar year following the calendar year in which the trans- action occurs). The notification is required to include (i) the name and address of the transferor shareholder and the transferee; (ii) the taxpayer identification number of the transferor shareholder and, if known, of the transferee; and (iii) the date of the sale or exchange. Any transferor of a share who fails so to notify the Public Partnership may be subject to a $50 penalty for each such failure. In addition, the Public Partnership is required to notify the IRS of any sale or exchange (of which the Public Partnership has notice) of a share and to report to the IRS the name, address, and taxpayer identification number of the transferee and the transferor who were parties to such transaction and of the Public Partnership, the date of the transaction and any additional information required by the applicable information return or its instructions. The Public Partnership also must provide this information to the transferor and the transferee. If the Public Partnership fails to furnish the required information to the IRS, the Public Partnership may be subject to a penalty of up to $50 per failure, up to an annual maximum penalty of $250,000, unless the failure is due to an intentional disregard of the requirement, in which ease a penalty of $100 per failure or if greater, 5% of the amount required to be reported, would apply, without limit. Penalties could also be asserted against the Public Partnership if it fails to furnish the required information to the transferor and the transferee. Any person who directly or indirectly holds an interest in the Public Partnership as a nominee on behalf of another person during a Public Partnership taxable year must furnish the Public Partnership with a written statement for such taxable year iden- tifying the name, address and taxpayer identification number of the nominee and such other person and providing information regarding acquisitions and transfers of Partnership Shares (including information regarding acquisition cost and net sale proceeds) made by the nominee on behalf of such other person during such taxable year. Section 754 Election Effect of the Election. The Principal Partnerships have made and expect to continue to make the election permitted by Section 754 of the Code which allows adjustments to the basis of partnership property under Section 743 of the Code upon certain transfers of a partnership interest. Such election, once made, is irrevocable absent the consent of the IRS. The general effect of such an election upon a transfer of shares is to permit the purchaser of such shares to adjust the basis of the Principal Partnerships' properties for purposes of his tax return to reflect the price at which his shares are purchased, as if such purchaser had acquired a direct interest in the Principal Partnerships' assets. Effect of the Interplay Between the Section 754 Election, Section 197 and the SGP Trust. As discussed on pages 69 - 70, the existence of the SGP Trust means that the taxable income of ServiceMaster Limited Partnership as allocated to each of its shareholders will not be greater than the cash distributions made to that shareholder. For many shareholders, however, taxable income will be less than their cash distributions due to the effect of the Section 754 election. The principal effect of the Section 754 election is to cause the calculation of a partner's share of taxable income to reflect amortization and depreciation deductions which are determined by using a higher basis (reflecting the partner's purchase price) in the underlying assets than the partnership's own internal, historical basis for those assets. In this connection, the provision in the Revenue Reconciliation Act of 1993 which permits the amortization of intangible assets over a 15- year period has important consequences to those persons who purchased ServiceMaster shares on July 25, 1991 or thereafter. If their purchase price for such shares is at least $22 per share ($33 per share before the June 7, 1993 3-for-2 share split), their proportionate interest in the assets of ServiceMaster, including goodwill and other intangible assets on which amortization is now being taken over a 15-year period, will cause the calculation of their share of ServiceMaster's taxable income to include deductions which are expected to leave such persons with an allocation of no taxable income on such ServiceMaster shares or with negative taxable income on those shares. (If a limited partner is allocated negative taxable income on his or her ServiceMaster shares, it can be used to offset a like amount of positive taxable income on other ServiceMaster shares or gain upon the sale of ServiceMaster shares; however, it can not be used to offset taxable income from other sources). Under these circumstances, cash distributions on such shares will decrease the tax basis of those shares by the amount of cash distributed and without an offset increase in basis attributable to the allocation of taxable income to those shares. Accordingly, the amount of gain realized upon a taxable disposition of the shares will be greater than would be the case if the Section 754 election had not been made. Tax exempt organization such as pension plans, profit sharing plans, IRAs, Keoghs, private foundations and other charitable organizations will benefit from the interplay among the Section 754 election, the SGP Trust and the amortization of intangibles in another way. Such entities are subject to the unrelated business income tax on their share of the taxable income of a publicly traded partnership (such as ServiceMaster). However, since their ServiceMaster taxable income is expected to be zero or less (for the reasons discussed above), such entities should not be subject to any unrelated business income tax liability. Other Section 754-Related Matters. If a shareholder's adjusted basis in his or her Partnership Shares is less than his or her proportionate share of adjusted basis of the Principal Partnerships' property at the time of acquisition of such Partnership Shares, such shareholder's share of adjusted basis of the Principal Partnerships' property must be reduced to equal his or her basis in the Partnership Shares, resulting in adverse con- sequences to such shareholder. A proper allocation of the adjustment among the various assets deemed purchased for purposes of Section 743(b) requires a determination of the relative value of the Principal Partnerships' assets at such time. The IRS may challenge any such allocations. The Public Partnership calculates the basis adjustments for purchasers of its shares. For basis adjustments relating to new Code section 197 (see Depreciation; Amortization; Recapture) the Public Partnership will not provide amended K-1s to its shareholders but will provide the necessary information to the shareholders upon request. The rules governing basis adjustments under Section 743(b) and 754 of the Code are very complex and are made more complex by the interaction of various tax rules governing the allocation of the Public Partnership's items of income, gain, loss and deduction. Interpretation and application of the rules in some cases is uncertain because of the lack of precedents. Reference is made to the discussion under "Depreciation; Amortization; Recapture" for information on the ability of partners of the Public Partnership to apply Section 157 retroactively to purchases of shares during the period July 25, 1991 to August 10, 1993. Should the IRS require a different basis adjustment to be made, and should, in the Corporate General Partner's opinion, the expense of compliance exceed the benefit of the election, the Corporate General Partner may seek permission from the IRS to revoke the Section 754 elections for the Principal Partnerships. If such permission is granted, a purchaser of Partnership Shares probably will incur increased tax liability. Termination of the Principal Partnerships for Tax Purposes Code Section 708 provides that if 50% or more of the capital and profits interests in a partnership are sold or exchanged within a single 12-month period, the partnership will be considered to have terminated for tax purposes. Because of the structure of the Principal Partnerships, it is likely that a Code Section 708 termination of the Public Partnership would result in a Code Section 708 termination of the Principal Subsidiary Part- nership as well. In view of the fact that Partnership Shares will be publicly traded, it is possible that shares representing 50% or more of the Public Partnership's capital and profits interests might be sold or exchanged within a single 12-month period. However, a share that changes hands several times during a 12-month period would only be counted once for purposes of determining whether a termination has occurred. If the Principal Partnerships should terminate for tax purposes, they would be deemed to have distributed their assets to their partners, who would then be deemed to have contributed the assets to new partnerships. The Principal Partnerships would have a new basis in their non-cash assets equal to the aggregate basis of the shareholders in their Partnership Shares prior to the termination plus any gain recognized by the shareholders in the termination, less any cash deemed distributed to the shareholders in connection with the termination. Accordingly, if the basis of the shareholders in their Partnership Shares is more or less than the Principal Partnerships' aggregate basis in their assets immediately prior to the termination, the Principal Partnerships' basis in their non- cash assets following the termination might have to be reallocated among those assets to reflect the relative fair market values of those assets at the time of termination. Such a reallocation may be favorable or unfavorable, depending on the circumstances. Generally, a shareholder would not recognize any taxable gain or loss as a result of the deemed pro rata distribution of Principal Partnership assets incident to a termination of the Principal Partnerships. A shareholder, however, would recognize gain to the extent, if any, that the shareholder's pro rata share of the Principal Partnerships' cash (and the reduction, if any in the shareholder's share of the Principal Partnerships' indebtedness as determined for purposes of Code Section 752) at the date of termination exceeded the adjusted tax basis of his Partnership Shares. Also, the Principal Partnerships' taxable years would terminate. If the shareholder's taxable year were other than the calendar year, the inclusion of more than one year of the Principal Partnerships' income in a single taxable year of the shareholder could result. Also, new tax elections would be required to be made by the reconstituted partnerships. Finally a termination of the Principal Partnerships may cause the Principal Partnerships or their assets to become subject to unfavorable statutory or regulatory changes enacted prior to the termination but previously not applicable to the Principal Partnerships or their assets because of protective "transitional" rules. However, a constructive termination under Code Section 708 should not cause the Partnership to lose the benefits of the up-to-10-year grace period during which the application of new Code Section 7704 is postponed. See "Tax Status of the Partnerships"- "Publicly Traded Partnerships Treated as Corporations." In order to preserve maximum liquidity for the Partnership Shares, the Public Partnership has not adopted procedures designed to prevent a deemed termination of the Principal Partnerships from occurring. An actual dissolution of the Principal Partnerships will result in the distribution to the shareholders of record of any assets remaining after payment of, or provision for, the Principal Partnerships' debts and liabilities. To the extent that a shareholder is deemed to receive money (including any reduction in his share of Principal Partnership liabilities as determined for purposes of Code Section 752) in excess of the basis of his Partnership Shares, such excess generally will be taxed as a capital gain, except to the extent of any unrealized receivables or substantially appreciated inventory items, as described above. See "Sale or Other Disposition of Shares." A shareholder will recognize a loss upon dissolution only if the liquidating distribution consists solely of cash, or of cash and unrealized receivables and appreciated inventory items, and then only to the extent that the adjusted basis of his Partnership Shares exceeds the amount of money received and his basis in such unrealized receivables and inventory items. Minimum Tax on Tax Preference Items For noncorporate taxpayers, the alternative minimum tax is imposed on the excess of alternative minimum taxable income ("AMTI") over the exemption amount. If this excess is less than or equal to $175,000, the alternative minimum tax is imposed at a rate of 26% if such excess is greater than $175,000. The exemption amount is reduced (though not below zero) by 25% of the amount by which AMTI exceeds $150,000 for married taxpayers filing jointly, $112,500 for single taxpayers, and $75,000 for estates, trusts, and married taxpayers filing separately. For corporate taxpayers, the alternative minimum tax is imposed at the rate of 20% on the excess of the corporation's AMTI over the $40,000 exemption amount. The exemption amount is reduced (but not below zero) by 25% of the amount by which AMTI exceeds $150,000. As in the case of noncorporate taxpayers, corporations are liable for alternative minimum tax only to the extent the tax exceeds regular Federal income tax liability (with certain adjustments) for the taxable year. Both corporate and noncorporate shareholders must take into account in determining AMTI their respective shares of tax preference items generated by the Principal Partnerships' opera- tions including: (i) for most tangible property that the Principal Partnerships place in service after 1986, both corporate and noncorporate shareholders must essentially treat as a preference item their respective shares of the excess of any accelerated depreciation deductions taken by the Principal Partnerships over the deductions that would have been allowed under a new alternative depreciation system; (ii) if the Principal Partnerships sell inventory or similar dealer property, all shareholders will be prohibited from using the installment method in computing their allocable shares of gain on the sale for AMTI purposes; (iii) to the extent the Principal Partnerships receive tax-exempt interest income from certain sources, all shareholders must treat such income as a preference item; and (iv) for a shareholder that is an individual, estate, trust, closely- held C corporation, or personal service corporation, net losses generated by the Principal Partnerships in any taxable year might not be deductible for minimum tax (or regular tax) purposes unless the shareholder materially participates in the activities of the Principal Partnerships. Although these rules are applicable to the shareholders of the Public Partnership, in fact the Public Partnership has had no preference items since inception and does not anticipate generating any preference items in the future. Investment Interest Each individual shareholder's distributive share of the Public Partnership's portfolio income (i.e., income from interest, dividends, annuities and royalties not derived in the ordinary course of a trade or business) will be treated as investment income under Code Section 163(d) and may be offset by the shareholder's investment interest expense. Code section 163(d) has been amended to exclude capital gains on the disposition of investment property from the computation of investment income unless a shareholder elects to include such gains in his or her taxable income at ordinary rates. A portion of the interest incurred by a shareholder to finance the acquisition of Partnership Shares will generally be treated as investment interest expense if the Principal Partnerships hold investment property. The IRS has announced that forthcoming Regulations will also treat an individual shareholder's net passive income from a publicly traded partnership (such as the Public Partnership) as investment income under Code Section 163(d). Accordingly, the amount of an individual shareholder's net passive income if any from the Public Partnership will be treated as investment income for purposes of Code Section 163(d). For this purpose, the computation of the amount of a shareholder's net passive income from the Public Partnership will take into account any passive activity deductions attributable to expenses of the shareholder that are incurred outside the Public Partnership and are properly allocable to the interest in passive activities that the share- holder holds through Partnership Shares. Thus, the amount of a shareholder's net passive income, if any, from the Public Part- nership generally will be reduced on account of a portion of any interest incurred by the shareholder to finance the acquisition of Partnership Shares. Noncorporate shareholders are urged to consult their tax advisors with regard to the specific effect that limitations on the deduction of investment interest would have on their investment in the Public Partnership. Tax-Exempt Entities, Individual Retirement Accounts and Regulated Investment Companies Unrelated Business Taxable Income. Tax-exempt entities (including IRAs and trusts that hold assets of employee benefit or retirement plans) are subject to tax on certain income derived from a business regularly carried on by the entity that is unre-lated to its exempt activities (i.e., "unrelated business taxable income" ("UBTI")). It is anticipated that nearly all of any tax-exempt entity's share (whether or not distributed) of the Principal Partnerships' gross income will be treated as gross income from an unrelated business, and the tax-exempt entity's share of nearly all of the Principal Partnerships' deductions will be allowed in computing the tax-exempt entity's UBTI. Tax-exempt shareholders other than those who benefit from the interplay between the Section 754 Election, Section 197 and the SGP Trust as described on pages 51 and 52 would be subject to tax on any UBTI to the extent that the sum of such UBTI (i.e., gross income net of deductions), if any, from their Partnership Shares and from other sources were to exceed $1,000 in any particular year. Moreover, even if their UBTI does not exceed $1,000 so that tax-exempt shareholders do not incur a Federal income tax liability, they nevertheless will be required to file income tax returns if their gross income included in computing such UBTI is $1,000 or more for any tax year. Investment Company Income. For purposes of determining whether a shareholder is a regulated investment company (within the meaning of Code Section 851), the shareholder's income derived from the Principal Partnerships will be treated as income from dividends, interest and gains from the sale or other disposition of securities only to the extent the shareholder's income is attributable to such dividends, interest and gains realized by the Principal Partnerships. Administrative Matters Information to Shareholders and Assignees. In addition to the required Schedule K1 to be furnished by the Public Part-nership to holders of Partnership Shares during a particular taxable year, the Public Partnership intends to furnish detailed instructions and explanations advising recipients of the Schedule K1 as to how to fill out their own income tax returns. The information will be provided within 90 days after the end of the Public Partnership's taxable year. Partnership Tax Returns and Possible Audit. Although a partnership is not required to pay any Federal income tax, tax audits are conducted, and the tax treatment of partnership income, loss, deduction and credit is determined, at the partnership level in a unified proceeding. In audits of partnerships, the IRS ordinarily will provide notice of the commencement of administrative proceedings and final adjustment only to each partner with an interest in profits of 1% or more. The Corporate General Partner is designated the "tax matters partner" ("TMP") to receive notice on behalf of and to provide notice to those shareholders with interests of less than 1% in the Public Partnership ("non-notice shareholders"). The TMP may extend the statutory period of limitations for assessment of adjustments attributable to "partnership items" for all shareholders and may enter into a binding settlement on behalf of non-notice shareholders, except for any group of such shareholders with an aggregate interest of 5% or more in Public Partnership profits that elects to form a separate notice group or shareholders who otherwise properly notify the IRS that the TMP is not authorized to act on their behalf. If the IRS and the TMP fail to settle an audit proceeding, then the TMP may choose to litigate the matter. In that event, the TMP would select the court in which such litigation would occur (including, perhaps, a court where prepayment of the tax may be required). All shareholders would have the right to participate in such litigation and, regardless of participation, would be bound by the outcome of the litigation. Because shareholders will be affected by the outcome of any administrative or court proceedings with respect to both the Public Partnership and the Principal Subsidiary Partnership, the Corporate General Partner intends to provide shareholders with appropriate notices of Federal income tax proceedings with respect to both Principal Partnerships. Shareholders will be required to treat Public Partnership items on their individual returns in a manner consistent with the treatment of those items on the Public Partnership's return, unless the shareholders file with the IRS a statement identifying the inconsistency. Examination of the Principal Partnerships' tax returns could result in an adjustment to the tax liability of a shareholder without any examination of the shareholder's tax return. In addition, any such audit could result in an audit of a shareholder's entire tax return and in adjustments to non- partnership related items on that return. Tax Shelter Registration. The Code requires a tax shelter organizer to register a "tax shelter" with the IRS by the first date on which interests in the tax shelter are offered for sale. Such registration does not indicate approval by the IRS and could result in an audit. The registration provisions require the tax shelter organizer to maintain a list containing information on each investor, would require the shareholders to report the Public Partnership's tax registration number on their separate Federal income tax returns, and would require the Public Partnership to maintain a list of each person to whom it transfers an interest in a "tax shelter." Penalties may be imposed if registration is required and not made. A "tax shelter" for purposes of the registration requirement is one in which a person could reasonably infer, from the representations made in connection with any offer for sale of any interest in the investment, that the "tax shelter ratio" for any investor may be greater than two to one as of the close of any of the first five years ending after the date on which the investment is offered for sale. The term "tax shelter ratio" is the ratio that the aggregate amount of gross deductions plus 350% of the credits that are potentially allowable to an investor bears to the partner's investment base for the year. The Public Partnership has not been registered as a "tax shelter" because it expects that no shareholder's tax shelter ratio will exceed two to one. Accuracy-Related Penalties. The Code provides for a penalty to be assessed in the event of a tax underpayment attributable to a substantial overstatement of the value or adjusted basis of property claimed on a tax return. This penalty will apply if (i) the claimed value or adjusted basis of the property equals or exceeds 200% of the correct value or adjusted basis, and (ii) the amount of the tax underpayment for the taxable year attributable to substantial valuation overstatements exceeds $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company). The amount of the penalty generally is 20% of the tax underpayment attributable to substantial valuation overstatements where the claimed value or adjusted basis is less than 400% of the correct value of adjusted basis, and 40% of the tax underpayment attributable to substantial valuation overstatements where the claimed value or adjusted basis equals or exceeds 400% of the correct value or adjusted basis. The penalty will likely be potentially applicable to partners in cases where the partnership has made a substantial valuation overstatement. The penalty generally will not apply with respect to any portion of a tax underpayment attributable to a substantial valuation overstatement (with respect to property other than charitable deduction property) if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. The IRS might contend that the portion of the Principal Partnerships' basis allocated to certain customer contracts of the properties exceeds the correct fair market value of those elements and therefore that the adjusted basis used by the Principal Partnerships for calculating deductions with respect to those elements of the properties constitutes substantial valuation overstatement for purposes of this penalty. Although the Corporate General Partner's allocation of the basis among the various properties and elements comprising the properties has been determined by an independent appraisal of the individual assets, there can be no assurance that the IRS will not contend that the allocation resulted in an overvaluation of certain assets. The Code provides for a penalty in the amount of 20% of any underpayment of tax attributable to a "substantial understatement of income tax." A "substantial understatement of income tax" is the amount of the understatement of tax on a taxpayer's return for a particular taxable year that exceeds the greater of $5,000 ($10,000 if the taxpayer is a corporation other than an S corporation or a personal holding company) or 10% of the tax required to be shown on the return for the year. As a general rule, the penalty will not be imposed with respect to underpayments attributable to items for which (i) there is or was substantial authority for the tax treatment afforded such items by the taxpayer, or (ii) the relevant facts affecting the treatment of such items are adequately disclosed in the taxpayer's return or in a statement attached to the return and there was a reasonable basis for the position. The penalty will not apply with respect to any portion of a tax underpayment attributable to a substantial understatement of income tax if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. There can be no assurance that a shareholder will not have a substantial understatement of income tax as a result of the treatment of items of income, gain, loss, deduction and credit resulting from his investment in the Public Partnership or that the IRS will not contend that there is not substantial authority for the treatment on the shareholder's return of certain items of income, gain, loss, deduction and credit. If the IRS should challenge the treatment by the Principal Partner-ships for tax purposes of the various items of income, gain, loss, deduction and credit, and if a shareholder should fail to meet the substantial authority and adequate disclosure tests, a shareholder could incur a penalty for a substantial underpayment of taxes resulting from his investment in the Public Partnership. Interest on Deficiencies. The Code provides that interest accrues on all tax deficiencies at a rate based on the Federal short-term rate plus 3 percentage points (5 percentage points in certain cases involving underpayment by a C corporation of tax amounting to more than $100,000) and compounded daily. This interest applies to penalties as well as tax deficiencies. Backup Withholding. Distributions to shareholders whose Partnership Shares are held on their behalf by a broker may con- stitute reportable payments subject to backup withholding. Backup withholding, however, would apply only if the shareholder (i) failed to furnish his Social Security number or other taxpayer identification number to the person subject to the backup withholding requirement (e.g., the broker) or (ii) furnished an incorrect Social Security number or taxpayer identification number. If backup withholding were applicable to a shareholder, the person subject to the backup withholding requirement would be required to withhold 31% of each distribution to such shareholder and to pay such amount to the IRS on behalf of such shareholder. Amounts withheld under the backup withholding provisions are allowable as a refundable credit against a taxpayer's Federal income tax. Tax Considerations for Foreign Investors General. A nonresident alien or foreign corporation, trust or estate ("foreign person") which is a partner in a partnership which is engaged in a business in the United States will be considered to be engaged in such business, even though the foreign person is only a limited partner. The activities of the Principal Partnerships will constitute a United States business for this purpose, and such activities likely will be deemed to be conducted through a permanent establishment within the meaning of the Code and applicable tax treaties. Therefore, a foreign person who becomes a shareholder in the Public Partnership will be required to file a United States tax return on which he must report his distributive share of the Principal Partnerships' items of income, gain, loss, deduction and credit, and to pay United States taxes at regular United States rates on his share of any of the Principal Partnerships' net income, whether ordinary income or capital gains. Code Section 1446 generally requires partnerships which have taxable income effectively connected with a trade or business in the United States to withhold tax with respect to the portion of such income allocable to foreign partners. This withholding tax generally is imposed at the rate of 39.6% with respect to effectively connected income (as computed for purposes of Section 1446) allocable to foreign individuals, and 35% with respect to effectively connected income (as computed for purposes of Section 1446) allocable to foreign corporations and withholding may be required under Section 1446 even if no actual distribution has been made to partners. However, pursuant to an IRS Revenue Procedure, in the case of a publicly traded partnership (such as the Public Partnership) the Code Section 1446 withholding tax will be imposed in an alternative manner unless the publicly traded partnership elects not to have such alternative treatment apply. Under this alternative approach, the Code Section 1446 withholding tax is imposed on distributions made to individual or corporate foreign partners. The Treasury is authorized to issue such regulations applying Section 1446 to publicly traded partnerships as may be necessary to carry out the purposes of Section 1446, but such regulations have not yet been issued. Although foreign shareholders would be entitled to a United States tax credit for amounts withheld by Principal Partnerships under Section 1446, either Section 1446 or the regulations (not yet issued) applying Section 1446 to publicly traded partnerships could under some circumstances adversely affect the Principal Partnerships and the foreign shareholders, e.g., by destroying the uniformity of Partnership Shares. Branch Profits Tax. Code Section 884 imposes a branch profits tax at the rate of 30 percent (or lower to the extent provided by any applicable income tax treaty) on the earnings and profits (after certain adjustments) of a U.S. branch of a foreign corporation, if such earnings and profits are attributable to income effectively connected with a U.S. trade or business. The legislative history of Code Section 884 indicates that the branch prose tax is intended to apply to foreign corporations that are partners in partnerships which have a U.S. trade or business. Thus, foreign corporations which own shares in the Public Part- nership may be subject to the branch profits tax on earnings and profits attributable to the Principal Partnerships' income as well as federal income tax on their share of Partnership income. The earnings and profits (which are subject to branch profits tax) attributable to Partnership Shares held by a foreign corporation will, of course, reflect a reduction for Federal income taxes paid by the foreign corporate shareholder on its share of Partnership income. FIRPTA. The Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"), as amended by subsequent legislation, provides that gain or loss on the disposition of a United States Real Property Interest ("USRPI") is taxable in the United States as if effectively connected with a U.S. business and imposes withholding requirements on such sales and on distributions of USRPIs by partnerships to foreign persons. USRPIs include (i) United States real estate and (ii) interest in certain entities (including publicly traded partnerships) holding United States real estate. The shares will not be USRPIs unless the value of the Principal Partnerships' United States real estate equals or exceeds 50% of the value of all its business assets. Furthermore, the FIRPTA rules generally do not apply to any foreign person which owns 5% or less of the publicly traded Partnership Shares. FIPPTA also imposes certain withholding obligations with respect to dispositions of USRPIs by a partnership that are includable in a foreign person's share of partnership income. Foreign Taxes. A foreign person may be subject to tax on his share of the Principal Partnerships' income and gain in his country of nationality or residence, or elsewhere. The method of taxation in such jurisdictions, if any, may differ considerably from the United States tax system described previously, and may be affected by the United States characterization of the Principal Partnerships and their income. Prospective investors who are foreign persons should consult their own tax advisors with respect to the potential tax effects of these and other items related to an investment in the Public Partnership. State and Local Income Taxes In addition to the Federal income tax consequences described above, prospective investors should consider state and local tax consequences of an investment in the Public Partnership. A shareholder's share of the taxable income or loss of the Principal Partnerships generally will be required to be included in determining his reportable income for state or local tax purposes. If the Public Partnership is treated as a corporation under Code Section 7704, as described above under "Tax Status of the Partnerships" -- "Publicly Traded Partnerships Treated as Corporations," the Public Partnership may also be treated as a corporation for state tax purposes in those states which base state income taxes on Federal income tax laws. Management has been successful in filing a composite return on behalf of its individual shareholders in all states where the Principal Partnerships do business. The Public Partnership will provide information each year to the shareholders as to the share of income and taxes paid on their behalf in each state. For those entities not included in the composite state return (corpo-rations, partnerships and certain other entities), the Public Partnership will provide the applicable state information. Certain tax benefits which are available to shareholders for Federal income tax purposes may not be available to shareholders for state or local tax purposes and, in this regard, investors are urged to consult their own tax advisors. The Public Partnership intends to supply shareholders with information regarding their income, if any, derived from various jurisdictions in which the Principal Subsidiary Partnership operates. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of ServiceMaster Limited Partnership: We have audited in accordance with generally accepted auditing standards, the financial statements included in ServiceMaster Limited Partnership's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules included in Part IV in the Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These supporting schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. /s/ Arthur Andersen & Co. Chicago, Illinois January 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. SERVICEMASTER LIMITED PARTNERSHIP Registrant By: ServiceMaster Management Corporation (General Partner) Date: March 18, 1994 By: /s/ C. WILLIAM POLLARD C. William Pollard Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in their capacities and on the date indicated. EXHIBIT 22 SUBSIDIARIES OF THE REGISTRANT As of March 21, 1994, ServiceMaster had the following subsidiaries: State or Country of Subsidiary or Organization Incorporation The ServiceMaster Company Limited Partnership Delaware ServiceMaster Consumer Services Limited Partnership Delaware ServiceMaster Consumer Services, Inc Delaware ServiceMasterResidential/Commercial Services Limited Partnership Delaware ServiceMaster Residential/Commercial Services Management Corporation Delaware The Terminix International Company Limited Partnership Delaware Terminix International, Inc. Delaware Merry Maids Limited Partnership Delaware Merry Maids, Inc. Delaware TruGreen Limited Partnership Delaware TruGreen, Inc. Delaware SVM Holding Corp. Delaware American Home Shield Corporation Delaware ServiceMaster Direct Distributor Company Limited Partnership Delaware ServiceMaster DDC, Inc. Delaware ServiceMaster Management Services Limited Partnership Delaware ServiceMaster Management Services, Inc. Delaware CMI Group, Inc. Wisconsin ServiceMaster Home Health Care Services Inc. Delaware ServiceMaster Child Care Services, Inc. Delaware The ServiceMaster Acceptance Company Limited Partnership Delaware ServiceMaster AM Limited Partnership Delaware ServiceMaster Acceptance Corporation Delaware Azimuth Advertising Limited Partnership Delaware Azimuth Management Corporation Delaware AFM Beveraging, Inc. Missouri FCIC Inc. Illinois ServiceMaster Employment Corporation Delaware ServiceMaster International Limited Partnership Delaware ServiceMaster International Management Corporation Delaware ServiceMaster Operations, AG Switzerland ServiceMaster Limited United Kingdom ServiceMaster Operations Germany GmbH Germany ServiceMaster Japan, Inc. Japan LTCS Investment Limited Partnership Delaware ServiceMaster Diversified Health Services, Inc. Delaware ServiceMaster Diversified Health Services, L.P. Tennessee We Serve America, Inc. Delaware TSSGP Limited Partnership Delaware TSSGP, Inc. Delaware EXHIBIT 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of our report dated January 25, 1994, included in the ServiceMaster Limited Partnership Annual Report to Shareholders for the year ended December 31, 1993. ARTHUR ANDERSEN & CO. /s/ Arthur Andersen & Co. Chicago, Illinois March 21, 1994 Graphics Appendix This appendix describes the graphics which could not be put into electronic format and which have been filed with the Securities and Exchange Commission as a paper filing. A diagram captioned "Structure of ServiceMaster" is set forth on page 8. This diagram shows the principal holding and operating units within the ServiceMaster enterprise. The Registrant is shown at the top of the diagram and The ServiceMaster Company appears directly below the Registrant. The four principal segments of ServiceMaster are set forth below. The principal operating units within each segment are then depicted. Reference is made to the "Notes to Organizational Structure Chart" on page 11 for a further explanation of the diagram. A Performance Graph is set forth on page 31 which consists of a line graph which compares the yearly percentage change in ServiceMaster's cumulative total shareholder return on its limited partner shares (computed in accordance with the Item 302(d) of Reg. S-K) with the cumulative return on the stocks of the companies within the S&P 500 Index and with the S&P Commercial Services Index over the five year period from January 1, 1988 to December 31, 1993. The chart shows that ServiceMaster underperformed both indices in 1988; ServiceMaster outperformed the Commercial Services Index in 1989 but slightly underperformed the S&P 500 Index in 1989; and outperformed both indices in 1991, 1992 and 1993 in increasingly wide margins over this three-year period.

81033_1993.txt

81033_1993

1993

81033

ITEM 1. BUSINESS. GENERAL ENTERPRISE Public Service Enterprise Group Incorporated (Enterprise), incorporated under the laws of the State of New Jersey with its principal executive offices located at 80 Park Plaza, Newark, New Jersey 07101, is a public utility holding company that neither owns nor operates any physical properties. Enterprise has two direct wholly-owned subsidiaries, Public Service Electric and Gas Company (PSE&G) and Enterprise Diversified Holdings Incorporated (EDHI). Enterprise's principal subsidiary, PSE&G, is an operating public utility providing electric and gas service in certain areas in the State of New Jersey. Enterprise has claimed an exemption from regulation by the Securities and Exchange Commission (SEC) as a registered holding company under the Public Utility Holding Company Act of 1935 (PUHCA), except for Section 9(a)(2) thereof which relates to the acquisition of voting securities of an electric or gas utility company. PSE&G is subject to direct regulation by the New Jersey Board of Regulatory Commissioners (BRC) and the Federal Energy Regulatory Commission (FERC). PSE&G has a nonutility finance subsidiary, PSE&G Fuel Corporation (Fuelco), providing financing not to exceed $150 million aggregate principal amount at any one time of a 42.49% undivided interest in the nuclear fuel acquired for Peach Bottom Atomic Power Station Units 2 and 3 (Peach Bottom) and guaranteed by PSE&G. PSE&G has also organized a nonutility subsidiary Public Service Conservation Resources Corporation (PSCRC) to offer Demand Side Management (DSM) services to utility customers. EDHI is the parent of Enterprise's other nonutility businesses: Energy Development Corporation (EDC), an oil and gas exploration, development, production and marketing company; Community Energy Alternatives Incorporated (CEA), an investor in and developer of cogeneration and power production facilities; Public Service Resources Corporation (PSRC), which makes diversified passive investments; Enterprise Group Development Corporation (EGDC), a diversified nonresidential real estate development and investment business; PSEG Capital Corporation (Capital), which has provided up to $750 million of privately-placed debt financing on the basis of a support agreement from Enterprise; and Enterprise Capital Funding Corporation (Funding), which provides privately-placed debt financing on the basis of the consolidated financial position of EDHI without direct support from Enterprise. As of December 31, 1993 and December 31, 1992, respectively, PSE&G comprised 86% and 83% of Enterprise's assets. For the years 1993, 1992 and 1991, PSE&G's revenues were 93%, 93% and 94%, respectively, of Enterprise's revenues and PSE&G's earnings available to Enterprise for such years were 96%, 88% and 95%, respectively, of Enterprise's net income. PSE&G will continue as the principal business of Enterprise for the foreseeable future. Financial information with respect to business segments of PSE&G and Enterprise is set forth in Note 15 -- Financial Information by Business Segments of Notes to Consolidated Financial Statements. PSE&G PSE&G, a New Jersey corporation with its principal executive offices at 80 Park Plaza, Newark, New Jersey 07101, is an operating public utility company engaged principally in the generation, transmission, distribution and sale of electric energy service and in the production, transmission, distribution and sale of gas service in New Jersey. PSE&G supplies electric and gas service in areas of New Jersey in which approximately 5,500,000 persons reside, approximately 70% of the State's population. PSE&G is Enterprise's principal operating subsidiary. (See General -- Enterprise.) PSE&G's electric and gas service area is a corridor of approximately 2,600 square miles running diagonally across New Jersey from Bergen County in the northeast to an area below the City of Camden in the southwest. The greater portion of the area is served with both electricity and gas, but some parts are served with electricity only and other parts with gas only. This heavily populated, commercialized and industrialized territory encompasses most of New Jersey's largest municipalities, including its six largest cities -- Newark, Jersey City, Paterson, Elizabeth, Trenton and Camden -- in addition to approximately 300 suburban and rural communities. It contains a diversified mix of commerce and industry, including major facilities of many corporations of national prominence. Under the general laws of New Jersey, PSE&G has the right to use the public highways, streets and alleys in New Jersey for the erection, laying and maintenance of poles, conduits and wires necessary for its electric operations. PSE&G must, however, first obtain the consent in writing of the owners of the soil for the purpose of erecting poles. In incorporated cities and towns, PSE&G must obtain from the municipality a designation of the streets in which the poles are to be placed and the manner of placing them. PSE&G's rights are also subject to regulation by municipal authorities with respect to street openings and the use of streets for erection of poles in incorporated cities and towns. PSE&G, by virtue of a special charter granted by the State of New Jersey to one of its predecessors, has the right to use the roads, streets, highways and public grounds in New Jersey for pipes and conduits for distributing gas. PSE&G believes that it has all the franchises (including consents) necessary for its electric and gas operations in the territory it serves. Such franchises are non-exclusive. For discussion of the significant changes which PSE&G's electric and gas utility businesses have been and are undergoing, see Competition and Regulation. INDUSTRY ISSUES Enterprise and PSE&G are affected by many issues that are common to the electric and gas industries, such as: an increasingly competitive energy marketplace; sales retention and growth potential in a mature service territory and need to contain costs (see Regulation and Competition); deregulation and unbundling of energy supplies and services (see Competition); ability to obtain adequate and timely rate relief and other necessary regulatory approvals (see PSE&G -- Rate Matters and Regulation); costs of construction (see Construction and Capital Requirements and Competition); operating restrictions, increased costs and construction delays attributable to environmental regulations (see Environmental Controls); controversies regarding electric and magnetic fields (EMF); nuclear decommissioning and the availability of reprocessing and storage facilities for spent nuclear fuel (see Electric Fuel Supply); and credit market concerns with these issues. COMPETITION Overview The energy utility industry is an industry in transition. Changes in Federal law and regulation are encouraging new entrants to the traditional markets of electric and gas utilities. New technology is creating opportunity for new energy services. Customers are more aware and sophisticated about their choices and dissatisfied with the often limited range of options available from the local utility and are turning elsewhere. Competition has now arrived and, as a consequence, the traditional utility structure -- consisting of a vertically integrated system and functioning as a natural monopoly -- is being dramatically altered. Current Federal energy laws are designed to decrease oil imports by increasing production of non-conventional sources of domestic energy, making more efficient use of all energy and shifting the use of energy to more abundant domestic sources. Among other things, these laws are designed to (1) increase ceiling prices on newly-discovered natural gas, (2) encourage conservation of energy through certain financial incentives, including incentives by individual utilities to customers to help them to conserve energy, (3) require state regulatory authorities to consider certain standards on rate design and certain other utility practices, (4) require interconnections of power systems and wheeling of power for wholesale transactions and (5) encourage development of alternative energy generation. Federal and State laws designed to reduce air and water pollution and control hazardous substances have had the effect of increasing the costs of operation and replacement of existing utility plant. (See Environmental Controls.) Retention of existing customers and potential sales growth will depend upon the ability of PSE&G to contain costs, meet customer expectations and respond to changing economic conditions. Competition from cogenerators and independent power producers (IPP), as permitted by PURPA, continues to impact upon PSE&G. Further, as a result of changes brought about by NEPA, discussed below, electric customers and suppliers, including PSE&G and its customers, have increased opportunities for purchase and sale of electricity from and to sellers and buyers outside of traditional franchised territories. Electric In the electric utility industry, competitive pressures began with the enactment of the Public Utility Regulatory Policies Act of 1978 ("PURPA"). This law, together with subsequent changes in federal regulation, has increasingly opened the electric utility industry to competition. PURPA created a class of generating facilities exempt from federal and state public utility regulation -- cogeneration and small power producers known as "qualifying facilities" (QFs) -- and created an instant market for them. The Federal Energy Policy Act of 1992 (NEPA), by facilitating the development of the independent power industry, will lead to even stronger competition. NEPA provides FERC with increased authority to order 'wheeling' of wholesale, but not retail, electric power on the transmission systems of electric utilities, provided that certain requirements are met. In order to facilitate the transition to increased competition in wholesale power markets made possible by NEPA, FERC has, in a Notice of Inquiry, requested comments on a wide array of policy and legal questions related to wholesale transmission pricing. NEPA also amends PUHCA to permit a new class of wholesale generators who are exempt from PUCHA regulation (EWG). NEPA permits both independent companies and utility affiliates to participate in the development of EWG projects regardless of the location and ownership of other generating resources. The transmission access provisions apply to wholesale, but not retail, 'wheeling' of power, subject to FERC review. See Construction and Capital Requirements, Financing Activities and Electric Operations -- Other Power Purchases and the discussion below of New Jersey Gross Receipts and Franchise Tax (NJGRT). For information concerning the activities of CEA, which is an owner-developer of QFs under PURPA, see EDHI -- CEA. Another key factor in determining how competition will affect PSE&G's electric business is the extent to which New Jersey public utility regulation may be modified to be reflective of these new competitive realities. To this end, the BRC convened an Advisory Council on Electricity Planning and Procurement (Advisory Council). The Advisory Council issued a report in July 1993 which recommended that the BRC institute a rulemaking proceeding to adopt rules for integrated resource planning. The Advisory Council could not reach agreement on a new process for supply-side procurement but suggested several general principles that the BRC should consider. The Advisory Council acknowledged in its report that, with the adoption of integrated resource planning and a new procurement process, the Electric Facility Need Assessment Act (Need Assessment Act) could be modified. Further, the Advisory Council recommended that the BRC consider the need for legislation to allow alternatives to traditional ratemaking. PSE&G cannot predict what other actions, if any, the BRC may take in response to these recommendations. (See Regulation and Note 2 -- Rate Matters of Notes to Consolidated Financial Statements). Gas The natural gas industry and its regulation have also been dramatically altered. This restructuring, which began in 1978, has occurred in a series of steps. In 1985, FERC issued Order 436 which generally required each interstate gas pipeline company to make its pipeline capacity available on an equal basis to all parties who wish to transport natural gas through the pipeline, if the pipeline company elected to provide transportation of natural gas for any party other than through a full certification procedure at FERC. In response to the United States Court of Appeals order overturning Order 436 in 1987, FERC issued subsequent orders adopting the same basic provisions as Order 436. With the issuance of its Order Nos. 636 and 636-A (636 Orders) the FERC has dramatically accelerated the pace at which the natural gas industry is being transformed from an industry driven by regulation to one driven by competitive market forces. The principal thrust of Orders 636 is to require interstate natural gas pipelines to reconfigure their services such that services provided to third party shippers are fully comparable to the services that pipelines have historically provided in their role as gas merchants. To this end, Orders 636 required the unbundling of interstate pipeline services (i.e., transportation service and sales service bundled together for one price) in order to develop a more competitive interstate natural gas industry. While unbundling of services provides PSE&G with greater access to lower cost gas supplies, it also results in pipeline transition costs being borne by pipeline ratepayers and their customers. The 636 Orders also prohibit buy/sell transactions; essentially mandate the implementation of straight fixed/variable rate design (which allocates all of the pipeline's fixed costs to the demand portion of the rate); abolish capacity brokering programs; establish a right of first refusal mechanism for long-term, firm transportation contracts; and create a formal capacity release program. Currently, each pipeline has completed the restructuring of its services in order to comply with the 636 Orders. Furthermore, numerous parties have appealed the 636 Orders to the U.S. Court of Appeals for the Eleventh Circuit and for the D.C. Circuit. PSE&G has been granted status as an intervenor in these appeals. However, the appeals have not had the effect of staying the 636 Orders. PSE&G's gas business will also be affected by the extent to which New Jersey public utility regulation may be modified to be reflective of these new competitive realities. On November 10, 1993, the BRC adopted a proposal for the unbundling of traditional services provided by the local gas distribution companies within the State of New Jersey. The proposal was developed as a guideline with the intention of encouraging and promoting unrestricted access to natural gas and natural gas related services in New Jersey for all customer classes except, at this time, the residential end user. The guidelines are directed at developing a more competitive environment for the natural gas industry within the state. The action by the BRC requires that local distribution companies within New Jersey file modifications to their tariffs for gas service which comply with the guidelines by April 1, 1994. These regulatory changes, coupled with other economic factors, have made and are expected to make the gas supply business extremely competitive. However, the changes provide PSE&G, as a large pipeline customer, the opportunity to convert its remaining pipeline sales contracts to transportation agreements and purchase the natural gas supplies directly from a producer or other seller. Most of PSE&G's sales contracts have been converted during the past year. Fluctuation in the price of oil results in the loss of gas sales, at certain times, to customers with dual fuel capability. In addition, other companies supply gas service in certain portions of PSE&G's electric territory and others supply electricity in parts of PSE&G's gas service area. Also, as discussed above, as a result of deregulation, pipeline customers, such as PSE&G, have the opportunity to convert a portion of their pipeline sales contracts to transportation agreements and purchase the natural gas supplies directly from a producer or other seller of natural gas, increasing competition in the gas market by encouraging pipelines to act as non-discriminatory transporters of natural gas. Aggressive competition in the gas supply business is expected to continue. Customers As of December 31, 1993, PSE&G provided service to approximately 1,900,000 electric customers and 1,500,000 gas customers. PSE&G is not dependent on a single customer or a few customers for its electric or gas sales. For the year ended December 31, 1993, PSE&G's operating revenues aggregated $5.3 billion, of which 70% was from its electric operations and 30% from its gas operations. These revenues were derived as follows: In July 1993, PSE&G and its largest industrial customer submitted a proposed electric tariff modification to the BRC, providing for a $9 million or 23% rate discount, with PSE&G's shareholders absorbing $2.4 million or 27% of the discount. The proposed tariff modification was designed to dissuade the customer from buying its electricity supply from a third party nonutility generator. In December 1993, following extensive proceedings, the BRC recognized the need for flexible pricing in a competitive market, approved the requested discount but required PSE&G's shareholders to absorb $3.8 million or 42% of such discount. The decision allows PSE&G a special tariff for certain large customers. Customers of PSE&G, as well as those of other New Jersey electric and gas utilities, pay NJGRT which, in effect, adds approximately 13% to their bills. The NJGRT is a unit tax based on electric kilowatt hour and gas therm sales. This tax differential coupled with the increasing ability of large volume electric and gas companies to obtain their energy supplies from nonutility sources not subject to NJGRT could result in a significant decrease in PSE&G's revenues and earnings. PSE&G's business is seasonal in that sales of electricity are higher during the summer months because of air conditioning requirements and sales of gas are greater in the winter months due to the use of gas for space-heating purposes. CONSTRUCTION AND CAPITAL REQUIREMENTS PSE&G PSE&G has substantial commitments as part of its ongoing construction program which includes capital requirements for nuclear fuel. PSE&G's construction program is continuously reviewed and periodically revised as a result of changes in economic conditions, revised load forecasts, changes in the scheduled retirement dates of existing facilities, changes in business plans, site changes, cost escalations under construction contracts, requirements of regulatory authorities and laws, the timing of and amount of electric and gas rate changes and the ability of PSE&G to raise necessary capital. Pursuant to an integrated electric resource plan (IRP), PSE&G periodically reevaluates its forecasts of customer load and peak growth and the sources of electric generating capacity load and DSM to meet such projected growth (see DSM). The IRP takes into account assumptions concerning future customer demand, effectiveness of conservation and load management activities, the long-term condition of and projected additions to PSE&G's plants and capacity available from electric utilities and other non-utility suppliers. Based on PSE&G's current IRP and PSE&G's construction program, construction expenditures are expected to aggregate approximately $4.2 billion during the years 1994 through 1998, including $483 million for nuclear fuel and $133 million of allowance for funds used during construction (AFDC) and capitalized interest. For additional information, see Management's Discussion and Analysis of Financial Position and Results of Operation (MD&A) -- Liquidity and Capital Resources and Note 12 -- Commitments and Contingent Liabilities -- Construction and Fuel Supplies of Notes to Consolidated Financial Statements. PSE&G's estimate of its electric construction expenditures, including AFDC, for the years 1994 through 1998, described above, recognizes the current and planned results of PSE&G's IRP which is designed to reduce the rate of growth in its electric system peak demand and improve system load factor without restricting the continued economic development of PSE&G's service area. PSE&G's DSM Plan includes rebates for high efficiency appliances and heating equipment, audits, loans, seal-ups and for larger customers, an overall standard offer for eligible DSM end-users. PSE&G's 1993 IRP includes a demand forecast of the average compound annual rate of growth through the year 2003 of electric system peak demand of 1.1%. (See PSE&G -- Other Power Purchases and DSM.) Aggressive conservation and load management efforts are expected to reduce the system peak by 860 megawatts (MW) by 1998. By the year 2003, 1,323 MW are expected to be saved through these programs. The second component of PSE&G's consists of expected additions to nonutility generation (NUG) from cogenerators, independent power producers and refuse burning generators. These additions are projected to be 139 MW and are scheduled for service by 1998. NUG projects are expected to grow from approximately 4% of efficient additions at Bergen Generating Station would allow PSE&G to retire approximately 750 MW of older, less efficient generating units by 2000, if economically and environmentally desirable. (See Note 12 -- Commitments and Contingent Liabilities of Notes to Consolidated Financial Statements.) In addition, PSE&G's construction program is also focusing on upgrading electric and gas transmission and distribution systems and constructing new transmission and distribution facilities to serve new load. Gross additions to PSE&G's utility plant during the three-year period ended December 31, 1993 amounted to approximately $2.5 billion, including $83 million of AFDC. Retirements of utility plant for the same period totaled $500 million. In 1993, construction expenditures amounted to $890 million, including $27 million of AFDC. Retirements for 1993 aggregated $102 million. EDHI Following a 1992 focused audit (see Regulation) of Enterprise's nonutility businesses which concluded that such businesses had not harmed PSE&G, in April 1993, the BRC accepted a Focused Audit Implementation Plan in which Enterprise agreed, among other things, that it will not permit its investments in EDHI, as defined in the agreement, to exceed 20% of its consolidated assets without prior notice to the BRC and that debt supported by a support agreement (see Financing Activities) between Enterprise and Capital will be limited to $750 million, with a good faith effort to eliminate such support over the next six to ten years. (See Regulation and MD&A -- Liquidity and Capital Resources.) As of December 31, 1993 and 1992, respectively, EDHI's long-term investments and property, plant and equipment were as follows: Property, Plant and Equipment (net of accumulated depreciation and amortization and valuation allowances): For further discussion of capital requirements, investments and internal generation of cash from operations, see MD&A -- Liquidity and Capital Resources, and Note 7 -- Long-Term Investments, of Notes to Consolidated Financial Statements. For a discussion of sinking fund payments and maturities through 1998 see Note 6 -- Schedule of Consolidated Long-Term Debt. FINANCING ACTIVITIES For a discussion of issuance, book value and market value of Enterprise's Common Stock and external financing activities of Enterprise, PSE&G and EDHI for the year 1993, see MD&A -- Liquidity and Capital Resources. Enterprise's Common Stock is listed on the New York and Philadelphia Stock Exchanges. In 1988, Enterprise entered into a support agreement with Capital which provides, among other things, that Enterprise (i) maintain its ownership, directly or indirectly, of all outstanding common stock of Capital, (ii) cause Capital to have at all times a positive tangible net worth of at least $100,000 and (iii) make sufficient contributions of liquid assets to Capital in order to permit it to pay its debt obligations. Capital borrows on behalf of EDC, CEA, PSRC and EGDC and Funding borrows on behalf of EDC, CEA and PSRC. Capital and Funding enter into financial agreements with banks and other lenders in providing funds to the operating subsidiaries. The operating subsidiaries generate cash from operating activities and short-term investments are made on behalf of the operating subsidiaries only if such funds cannot be employed in intercompany loans. Intercompany borrowing rates are established with reference to market rates of interest at Capital's and Funding's respective cost of funds. As of December 31, 1993, EDHI's consolidated long-term debt and short-term commercial paper and loan debt was $892 million and $151 million, respectively. For further discussion of long-term debt and short-term debt, see Note 11 -- Short-Term Debt (Commercial Paper and Loans) and Note 12 -- Schedule of Long-Term Debt of Notes to Consolidated Financial Statements. FEDERAL INCOME TAXES For information regarding Federal income taxes, see Note 1 -- Organization and Summary of Significant Accounting Policies, Note 2 -- Rate Matters and Note 9 -- Federal Income Taxes of Notes to Consolidated Financial Statements. CREDIT RATINGS The current ratings of securities of Enterprise's subsidiaries set forth below reflect the respective views of the rating agency furnishing the same, from whom an explanation of the significance of such ratings may be obtained. There is no assurance that such ratings will continue for any given period of time or that they will not be revised downward or withdrawn entirely by such rating agencies, if, in their respective judgment, circumstances so warrant. Any such downward revision or withdrawal of such ratings, or any of them, may have an adverse effect on the market price of Enterprise's Common Stock and PSE&G's securities and serve to increase the cost of capital of PSE&G and EDHI. (A) Supported by commercial bank letter of credit (see MD&A and Note 11 -- Short-Term Debt (Commercial Paper and Loans) of Notes to Consolidated Financial Statements.) PSE&G RATE MATTERS For information concerning PSE&G's rate matters, see Note 2 -- PSE&G Rate Matters of Notes to Consolidated Financial Statements. For information concerning PSE&G Energy and Fuel Adjustment Clauses, see MD&A. For information concerning PSE&G's Under (Over) recovered Electric Energy and Gas Fuel Costs, see Note 5 -- Deferred Items of Notes to Consolidated Financial Statements. NUCLEAR PERFORMANCE STANDARD PSE&G is subject to a BRC imposed nuclear performance standard with respect to the five nuclear generating stations in which it has ownership interests: Salem 1 and Salem 2 -- 42.59% each; Hope Creek -- 95% and Peach Bottom 2 and Peach Bottom 3 -- 42.49% each. PSE&G operates Salem and Hope Creek and Peach Bottom is operated by PECO Energy Inc., formerly known as Philadelphia Electric Company, (PECO). The following table sets forth the capacity factor in accordance with the nuclear performance standard of each of PSE&G's nuclear units for the years indicated: For information concerning such standard, see Note 12 -- Commitments and Contingent Liabilities of Notes to Consolidated Financial Statements. ELECTRIC OPERATIONS The following table sets forth certain information as to PSE&G's installed generating capacity as of December 31, 1993: (a) Units with aggregate capacity of 1,406 MW can also burn gas. (b) Can also burn gas. (c) PSE&G share of jointly-owned facilities. (d) Primarily used for peaking purposes. (e) Excludes 583 MW of nonutility generation contracted for purchase by PSE&G. For additional information, see Item 2. ITEM 2. PROPERTIES. PSE&G The statements under this Item as to ownership of properties are made without regard to leases, tax and assessment liens, judgments, easements, rights of way, contracts, reservations, exceptions, conditions, immaterial liens and encumbrances and other outstanding rights affecting such properties, none of which is considered to be significant in the operations of PSE&G, except that PSE&G's First and Refunding Mortgage, (Mortgage), securing the bonds issued thereunder, constitutes a direct first mortgage lien on substantially all of such property. PSE&G maintains insurance coverage against loss or damage to its principal plants and properties, subject to certain exceptions, to the extent such property is usually insured and insurance is available at a reasonable cost. For a discussion of nuclear insurance, see Note 12 -- Commitments and Contingent Liabilities of Notes to Consolidated Financial Statements. The electric lines and gas mains of PSE&G are located over or under public highways, streets, alleys or lands, except where they are located over or under property owned by PSE&G or occupied by it under easements or other rights. These easements and rights are deemed by PSE&G to be adequate for the purposes for which they are being used. Generally, where payments are minor in amount, no examinations of underlying titles as to the rights of way for transmission or distribution lines or mains have been made. ELECTRIC PROPERTIES As of December 31, 1993, PSE&G's share of installed generating capacity was 10,479 MW, as shown in the following table: (a) Net generation divided by the product of weighted average generating capacity times total hours. (b) PSE&G's share of jointly-owned facility. (c) Excludes energy for pumping and synchronous condensers. For information regarding construction see Item 1. Business -- Construction and Capital Expenditures. As of December 31, 1993, PSE&G owned 40 switching stations with an aggregate installed capacity of 31,249,000 kilovolt-amperes, and 224 substations with an aggregate installed capacity of 7,194,000 kilovolt-amperes. In addition, 6 substations having an aggregate installed capacity of 133,000 kilovolt-amperes were operated on leased property. All of these facilities are located in New Jersey. Also at that date, PSE&G owned undivided interests in similar jointly-owned facilities at jointly-owned generating facilities in New Jersey and Pennsylvania as indicated in the table above. As of December 31, 1993, PSE&G's transmission and distribution system included 148,272 circuit miles, of which 33,937 miles were underground, and 776,484 poles, of which 531,952 poles were jointly-owned. Approximately 99% of this property is located in New Jersey. In addition, as of December 31, 1993, PSE&G owned 4 electric distribution headquarters and 5 subheadquarters and leased 2 subheadquarters in 4 operating divisions all located in New Jersey. Also, PSE&G leases electric transmission headquarters and owns subheadquarters. GAS PROPERTIES As of December 31, 1993, the daily gas capacity of PSE&G's 100%-owned peaking facilities (the maximum daily gas delivery available during the three peak winter months) consisted of liquid petroleum air gas (LPG) and liquefied natural gas (LNG) and aggregated 2,973,000 therms (approximately 297,300 Mcf. on an equivalent basis of 1,000 Btu/cubic foot) as shown in the following table: As of December 31, 1993, PSE&G owned and operated approximately 15,172 miles of gas mains, owned 12 gas distribution headquarters and one subheadquarter and leased one other subheadquarter all in two operating regions located in New Jersey and owned one meter shop in New Jersey serving all such areas. In addition, PSE&G operated 61 natural gas metering or regulating stations, all located in New Jersey, of which 26 were located on land owned by customers or natural gas pipeline companies supplying PSE&G with natural gas and were operated under lease, easement or other similar arrangement. In some instances, portions of the metering and regulating facilities were owned by pipeline companies. OFFICE BUILDINGS AND FACILITIES PSE&G leases substantially all of a 26-story office tower for its corporate headquarters at 80 Park Plaza, Newark, N. J., together with an adjoining three-story building. PSE&G also leases other office space at various locations throughout New Jersey for district offices and offices for various corporate groups and services. PSE&G also owns various other sites for training, testing, parking, records storage, research, repair and maintenance, warehouse facilities and for other purposes related to its business. EDHI owns no real property. EDHI leases its corporate headquarters at One Riverfront Plaza, Newark, New Jersey 07102. For a brief general description of the properties of the subsidiaries of EDHI, see Item 1. Business -- EDHI. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. See the following under Business, at the pages indicated: (1) Page 3. Proceedings before FERC relating to competition and electric wholesale power markets. (Inquiry Concerning the Pricing Policy for Transmission Services Provided by Utilities Under the Federal Power Act, Docket No. RM93-19(NOI).) (2) Page 3. Proceedings before FERC relating to restructuring of natural gas industry pursuant to Orders 636. (In Re Pipeline Service Obligations and Revisions to Regulations Governing Self-Implementing Transportation Under Part 284 of the Commission's Regulations, Docket No. RM91-11-000). (3) Page 8. Proceedings before the BRC relating to PSE&G's LGAC, filed November 3, 1993, in Docket No. GR91071226J. (4) Page 18. Appeal by an association of competitors of PSE&G of the NJDEPE's air permit for Phase I of the repowering of PSE&G's Bergen station to the Appellate Division of the New Jersey Superior Court. (5) Page 22. Requests filed in 1974 and later supplemented, to EPA and NJDEPE to establish thermal discharges and intake structures for PSE&G's electric generating stations (Sewaren Generating Station, NJ 0000680; Bergen Generating Station, NJ 0000621; Hudson Generating Station, NJ 0000647; Kearny Generating Station, NJ 0000655; Salem Generating Station, NJ 0005622; Linden Generating Station, NJ 0000663). (6) Page 24. On November 7, 1988, PSE&G filed a lawsuit in the United States District Court for the District of New Jersey against Associated Electric & Gas Insurance Services, Ltd., Certain Underwriters at Lloyd's London, and Certain London Market Companies (PSE&G v. AEGIS, et al., Civ. Action No. 884811.) The suit seeks insurance coverage from these insurers for claims that have been made against PSE&G by the NJDEPE and certain private parties. The claims concern alleged contamination at former gas manufacturing plant sites in New Jersey that are either currently owned by PSE&G or that were previously owned by PSE&G or one of its predecessors. (7) Pages 24 through 29. Various administrative actions, claims, litigation and requests for information by federal and/or state agencies, and/or private parties, under CERCLA, RCRA, and state environmental laws to compel PRPs, which may include PSE&G, to provide information with respect to transportation and disposal of hazardous substances and wastes, and/or to undertake or contribute to the costs of investigative and/or cleanup actions at various locations because of actual or threatened releases of one or more potentially hazardous substances and/or wastes. As part of one of the administrative actions by NJDEPE, PSE&G has signed ACO's with NJDEPE in the matter of its former gas plant sites: South Amboy, Morristown, Bordentown, Gloucester, Bayonne (Hobart Avenue), Woodbury, Riverton and Paterson. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Enterprise and PSE&G, inapplicable. ITEM 10. EXECUTIVE OFFICERS OF THE REGISTRANTS. Enterprise and PSE&G. Information regarding executive officers required by this Item is set forth in Part III, Item 10 hereof. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Enterprise's Common Stock is listed on the New York Stock Exchange, Inc. and the Philadelphia Stock Exchange, Inc. All of PSE&G's common stock is owned by Enterprise, its corporate parent. As of December 31, 1993, there were 192,999 holders of record of Enterprise Common Stock. The following table indicates the high and low sale prices for Enterprise's Common Stock, as reported in The Wall Street Journal as Composite Transactions and dividends paid for the periods indicated: Since 1986, PSE&G has made regular cash payments to Enterprise in the form of dividends on outstanding shares of PSE&G's Common Stock. PSE&G has paid quarterly dividends on its common stock in each year commencing in 1948, the year of the distribution of PSE&G's common stock by Public Service Corporation of New Jersey, the former parent of PSE&G. Beginning in 1992, EDHI has made regular cash payments to Enterprise in the form of dividends on outstanding shares of EDHI's common stock. Enterprise has paid quarterly dividends in each year commencing with the corporate restructuring of PSE&G when Enterprise became the owner of all the outstanding common stock of PSE&G. While the Board of Directors of Enterprise intends to continue the practice of paying dividends quarterly, amounts and dates of such dividends as may be declared will necessarily be dependent upon Enterprise's future earnings, financial requirements and other factors. The ability of Enterprise to declare and to pay dividends is contingent upon its receipt of dividend payments from its subsidiaries. PSE&G has restrictions on the payments of dividends which are contained in its Restated Certificate of Incorporation, as amended, certain of the indentures supplemental to its Mortgage and certain debenture bond indentures. Under these restrictions, dividends on PSE&G's common stock may be paid only out of PSE&G's earned surplus and may not reduce PSE&G's earned surplus to less than $10,000,000. PSE&G dividends on common stock would be limited to 75% of Earnings Available for Public Service Enterprise Group Incorporated if payment thereof would reduce PSE&G's Stock Equity to less than 33 1/3% of PSE&G's Total Capitalization and would be limited to 50% of Earnings Available for Public Service Enterprise Group Incorporated if payment thereof would reduce Stock Equity to less than 25% of PSE&G's Total Capitalization, as each of said terms is defined in PSE&G's said debenture bond indentures. None of these restrictions presently limits the payment of dividends out of current earnings. The amount of Enterprise's and PSE&G's consolidated retained earnings free of these restrictions at December 31, 1993 was $1.351 billion and $1.171 billion, respectively. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ENTERPRISE The information presented below should be read in conjunction with Enterprise Consolidated Financial Statements and Notes thereto. (A) Fixed charges include the preferred stock dividend requirements of PSE&G. PSE&G The information presented below should be read in conjunction with PSE&G Consolidated Financial Statements and Notes thereto. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ENTERPRISE Following are the significant factors affecting the consolidated financial condition and the results of operations of Public Service Enterprise Group Incorporated (Enterprise) and its subsidiaries. This discussion refers to the Consolidated Financial Statements and related Notes of Enterprise and should be read in conjunction with such statements and notes. OVERVIEW Enterprise has two direct wholly-owned subsidiaries, Public Service Electric and Gas Company (PSE&G) and Enterprise Diversified Holdings Incorporated (EDHI). Enterprise's principal subsidiary, PSE&G, is an operating public utility providing electric and gas service in certain areas in the State of New Jersey. PSE&G has a finance subsidiary, PSE&G Fuel Corporation (Fuelco), providing financing, unconditionally guaranteed by PSE&G, of up to $150 million aggregate principal amount at any one time of a 42.49% interest in the nuclear fuel acquired for Peach Bottom Atomic Power Station Units 2 and 3 (Peach Bottom). PSE&G also has a nonutility subsidiary, Public Service Conservation Resources Corporation (PSCRC), which offers demand side management (DSM) services to utility customers. EDHI is the parent of Enterprise's other nonutility businesses: Energy Development Corporation (EDC), an oil and gas exploration, development, production and marketing company; Community Energy Alternatives Incorporated (CEA), an investor in and developer of cogeneration and power production facilities; Public Service Resources Corporation (PSRC), which makes diversified passive investments; and Enterprise Group Development Corporation (EGDC), a diversified nonresidential real estate development and investment business. EDHI also has two finance subsidiaries: PSEG Capital Corporation (Capital), which has provided up to $750 million of privately-placed debt financing on the basis of a support agreement from Enterprise and Enterprise Capital Funding Corporation (Funding), which provides privately-placed debt financing guaranteed by EDHI but without direct support from Enterprise. As of December 31, 1993 and December 31, 1992, PSE&G comprised 86% and 83%, respectively, of Enterprise assets. For the years 1993, 1992 and 1991, PSE&G revenues were 93%, 93% and 94%, respectively, of Enterprise revenues and PSE&G earnings available to Enterprise for such years were 96%, 88% and 95%, respectively, of Enterprise net income. Pursuant to the Focused Audit Implementation Plan approved by the New Jersey Board of Regulatory Commissioners (BRC) regarding operations and intercompany relationships between PSE&G and EDHI, in 1993 Enterprise agreed with the BRC, among other things, that it will not permit its investment in EDHI to exceed 20% of its consolidated assets without prior notice to the BRC, that the PSE&G Board will make an annual certification that the business and financing plans of EDHI will not adversely affect PSE&G, that debt supported by the support agreement between Enterprise and Capital will be limited to $750 million, that a good faith effort will be made to eliminate such support over the next six to ten years and that EDHI will pay PSE&G an affiliation fee of $2 million a year, to be proportionately reduced as the amount of debt under the support agreement is reduced. The major factors which will affect Enterprise's future results include general and regional economic conditions, PSE&G's customer retention and growth, the ability of PSE&G and EDHI to meet competitive pressures and to contain costs, the adequacy and timeliness of required regulatory approvals, including rate relief to PSE&G, continued access to the capital markets and continued favorable regulatory treatment of consolidated tax benefits. (See Note 2 -- Rate Matters and Note 12 -- Commitments and Contingent Liabilities of Notes to Consolidated Financial Statements.) PSE&G ENERGY AND FUEL ADJUSTMENT CLAUSES PSE&G has fuel and energy tariff rate adjustment clauses which are designed to permit adjustments for changes in electric energy and gas supply costs and certain other costs as approved by the BRC, when compared to cost recovery included in base rates. Charges under the clauses are primarily based on energy and gas supply costs which are normally projected over twelve-month periods. The changes in the Levelized Gas Adjustment Clause (LGAC) and the Levelized Energy Adjustment Clause (LEAC) do not directly affect earnings because such costs are adjusted monthly to match amounts recovered through revenues. However, the carrying of underrecovered costs ultimately increases financing costs. PSE&G is also required to pay interest on net overrecovered costs. Under the clauses, if actual costs differ from the costs recovered, the amount of the underrecovery or overrecovery is deferred and is reflected in the average cost used to determine the fuel and energy tariff rate adjustment for the period in which it is recovered or repaid. Actual costs otherwise includable in the LEAC are subject to adjustment by the BRC in accordance with PSE&G's nuclear performance standard. (See Note 2 -- Rate Matters and Note 12 -- Commitments and Contingent Liabilities of Notes to Consolidated Financial Statements.) ENTERPRISE EARNINGS Earnings per share of Enterprise Common Stock were $2.50 in 1993, $2.17 in 1992 and $2.43 in 1991. The changes are summarized as follows: The average shares of Enterprise Common Stock outstanding were 240,663,599 for 1993 and 232,306,492 for 1992. PSE&G In 1993, excluding the $33 million net effect of the 1992 settlement of litigation against Philadelphia Electric Company, now known as PECO Energy Company (PECO) in connection with the 1987 shutdown of Peach Bottom by the Nuclear Regulatory Commission (1992 Settlement), PSE&G's earnings available to Enterprise increased by $166 million. The principal contributing factors to the increase in earnings available to Enterprise were PSE&G's higher electric and gas base rates that became effective January 1, 1993 and a substantial increase in electric kilowatthour sales. (See PSE&G Electric and Gas Revenues, below.) The increase in electric sales was primarily due to the abnormally warm weather. Partially offsetting the increase in earnings were higher other operation expenses (comprised primarily of labor and employee benefits costs and miscellaneous nuclear production costs), higher depreciation and amortization and higher Federal income taxes resulting from increased pre-tax operating income and an increase in the Federal corporate income tax rate, effective January 1993. (See Note 9 -- Federal Income Taxes of Notes to Consolidated Financial Statements.) In 1992, excluding the $33 million net effect of the 1992 Settlement, PSE&G's earnings available to Enterprise declined by $105 million. This decline was principally due to the 1.7% decrease in electric kilowatthour sales resulting from significantly cooler weather during 1992 and higher other operation expenses (comprised primarily of labor and employee benefits costs and miscellaneous nuclear production costs). Also contributing to the decrease in earnings were increased interest charges resulting from timing of refunding operations and higher depreciation and amortization expenses. Partially offsetting the decrease in earnings were lower maintenance expenses at certain of PSE&G's fossil fuel generating stations and at Peach Bottom and lower Federal income taxes resulting from lower pre-tax operating income. EDHI The net income of EDHI was $24 million in 1993, a decrease of $36 million from 1992. As a result of a management review of each of EGDC's property's current value and the potential for increasing such value through operating and other improvements, EGDC recorded an impairment related to certain properties, including properties upon which management revised its intent from a long-term investment strategy to a short-term hold for sale status, reflecting such properties on its books at their net realizable value. This impairment reduced EDHI earnings by $51 million, after tax, or 21 cents per share of Enterprise Common Stock. Partially offsetting this decrease was an increase in the earnings of EDC due to the higher price of natural gas. Exclusive of the recorded impairment, EDHI net income would have been $75 million for 1993. The net income of EDHI was $60 million in 1992, an increase of $33 million from 1991. The increase in EDHI net income was due primarily to an increase in EDC net income of $23 million resulting from higher natural gas prices and volumes and an $8 million increase in CEA net income due to improved performance of certain projects and the sale of its interest in various projects. DIVIDENDS The ability of Enterprise to declare and pay dividends is contingent upon its receipt of dividend payments from its subsidiaries. PSE&G has made regular payments to Enterprise in the form of dividends on outstanding shares of its common stock since Enterprise was formed in 1986. In addition, commencing in 1992, EDHI has also made payments to Enterprise in the form of dividends on its outstanding common stock. Dividends paid to holders of Enterprise Common Stock increased $18 million during 1993 compared to 1992 and increased $27 million during 1992 compared to 1991. The increase in the 1993 dividend payment over 1992 was due to the issuance of additional shares of Enterprise Common Stock. The increase in the 1992 dividend payment over 1991 was due to the issuance of additional shares of Enterprise Common Stock and a one cent per share increase in the quarterly dividend rate for the first three quarters of 1992 compared to the same periods of 1991. Dividends paid to holders of PSE&G Preferred Stock increased $6 million during 1993 compared to 1992 and $3 million during 1992 compared to 1991. The increase in 1993 dividend payments over 1992 dividend payments was due to the issuance and sale of 750,000 shares of 5.97% Preferred Stock on March 17, 1993 and the issuance and sale of 750,000 shares of 7.44% Preferred Stock on June 23, 1992, while the increase in 1992 dividend payments over 1991 dividend payments was due to the issuance and sale of the 7.44% Preferred Stock. REVENUES PSE&G ELECTRIC Revenues increased $285 million, or 8.4%, in 1993 from 1992; 1992 revenues decreased $92 million, or 2.6%, compared to 1991. The significant components of these changes follow: Changes in kilowatthour sales by customer category are described below: 1993 -- The increase in electric revenues over 1992 was primarily due to the base rate increase which became effective January 1, 1993, partially offset by the larger LEAC credit also effective January 1, 1993. Abnormally warm weather resulted in a significant increase in weather sensitive sales during 1993. Increased competition from nonutility generators (NUGs) and an unscheduled maintenance shutdown at PSE&G's largest industrial customer negatively impacted industrial sales. 1992 -- The reduction in electric revenues from 1991 was due to a 1.7% reduction in kilowatthour sales resulting from reduced weather-sensitive load. Industrial and commercial sales also declined reflecting the effect of New Jersey's weak economy. Competition from NUGs continued to negatively impact industrial sales. PSE&G GAS Revenues increased $8 million, or 0.5%, during 1993 over 1992; 1992 revenues increased $278 million or 21.3% over 1991. The significant components of these changes follow: Changes in gas sold or transported by customer category are described below: 1993 -- The increase in gas revenues over 1992 was primarily attributable to the base rate increase which became effective January 1, 1993 and the higher recovery of fuel related costs. Sales to cogenerators was the largest contributor to the increase in industrial sales as cogeneration average customer usage for electric generation continues to increase. Transportation service sales reflect the movement of some interruptible customers to transportation service. 1992 -- Revenues for 1992 increased over 1991 due principally to the recovery of fuel costs resulting from higher levels of weather-sensitive therm sales and an increase in the LGAC authorized by the BRC, effective January 1, 1992. The increase in residential and firm commercial sales, which represent the majority of PSE&G gas revenues, was principally attributable to the colder weather. Higher industrial and transportation service sales over 1991 were due to cogeneration customer growth. EDHI EDHI revenues increased $33 million, or 8% during 1993 over 1992; 1992 revenues increased $72 million, or 22% in 1992 over 1991. The significant components contributing to such results were as follows: 1993 -- EDC was the largest contributor to the EDHI revenue increase due to the higher price of natural gas, partially offset by lower sales to PSE&G. CEA revenues increased as a result of greater income from partnership operating projects. PSRC revenues decreased due to unrealized losses on investments and lower income from leases. 1992 -- The increase in 1992 revenues over 1991 was due to higher revenues of each of EDHI's operating subsidiaries. EDC's higher revenues were principally attributable to increased sales and higher gas prices in 1992. CEA's increased revenues were derived from higher partnership income and gains on the sales of certain partnership interests in 1992. PSRC's greater revenues were attributable to increased gains on investments and higher income from partnerships and leases, net of pre-tax valuation allowances and a write-off totaling $35 million, primarily related to the loss on its investment in the Second National Federal Savings Bank of Salisbury, Maryland. EGDC's increased revenues resulted from higher rental and partnership income. PSE&G ELECTRIC ENERGY COSTS Electric energy costs decreased $59 million or 7.7% in 1993 compared to 1992 and $5 million or .6% in 1992 compared to 1991. The significant components of these changes follow: (A) Reflects the change in the deferred over(under)recovered energy costs, which in the years 1993, 1992 and 1991 amounted to $(93) million, $13 million and $5 million, respectively. (See PSE&G Energy and Fuel Adjustment Clauses and Note 2 -- Rate Matters of Notes to Consolidated Financial Statements.) 1993 -- The decrease in total costs was the result of an adjustment in the recovery of energy costs resulting from the base rate case decision effective January 1, 1993, partially offset by a 17% increase in nuclear kilowatthour generation and an 11% increase in purchased power costs. 1992 -- The decrease in total costs resulted from lower kilowatthour generation due primarily to a reduction in weather-sensitive load. Higher prices paid for fuel and power purchases resulted principally from the need to purchase power due to outages at various times of the Salem Nuclear Generating Station, Units 1 and 2 (Salem 1 and 2), in which PSE&G owns 42.59% of undivided interest. Kilowatthour generation from the Salem units declined 31% in 1992 compared to 1991. (See Note 12 -- Commitments and Contingent Liabilities -- Nuclear Performance Standard of Notes to Consolidated Financial Statements.) GAS SUPPLY COSTS Gas supply costs increased $39 million or 4.6% in 1993 compared to 1992 and $223 million or 35.0% in 1992 compared to 1991. The significant components of these changes follow: (A) Reflects the change in the deferred over(under)recovered gas supply costs, which in the years 1993, 1992 and 1991 amounted to $(100) million, $52 million and $(32) million, respectively. (See PSE&G Energy and Fuel Adjustment Clauses and Note 2 -- Rate Matters of Notes to Consolidated Financial Statements.) 1993 -- The increase in total costs was principally due to greater sales to NUGs and other customers, higher gas costs and higher therm sendout resulting from the colder 1993 winter season compared to the 1992 winter season. The increase in costs was reduced by deferred underrecovered 1993 gas costs resulting from the BRC approved adjustment in PSE&G's LGAC, effective January 1, 1993 of $71 million on an annualized basis through December 31, 1993. The adjustment reflects lower gas costs and the inclusion of $15.1 million of conservation program costs in LGAC. In addition, gas customers received $45 million of credits during the first quarter of 1993. 1992 -- The increase in total costs was principally due to greater therm sendout resulting from the colder 1992 weather compared to 1991 and increased sales to NUGs. LIQUIDITY AND CAPITAL RESOURCES Enterprise's liquidity is affected by maturing debt (see Note 6 -- Schedule of Consolidated Long-Term Debt of Notes to Consolidated Financial Statements), investment and acquisition activities and the capital requirements of PSE&G's construction program. Capital resources available to meet such requirements depend upon the factors noted above under Overview. PSE&G For 1993, PSE&G had utility plant additions, including AFDC, of $890 million, an increase of $63 million versus 1992 additions of $827 million. Additions in 1992 increased $14 million from 1991 additions of $813 million. AFDC for 1993, 1992 and 1991 amounted to $27 million, $26 million and $30 million, respectively. Construction expenditures were related to improvements in PSE&G's existing power plants, transmission and distribution system, gas system and common facilities. Construction expenditures from 1994 through 1998 are expected to aggregate $4.2 billion. (See Construction, Investments and Other Capital Requirements Forecast below.) PSE&G expects that it will be able to generate internally a majority of its capital requirements including construction expenditures over the next five years, assuming adequate and timely rate relief as to which no assurances can be given. (See Note 2 -- Rate Matters and Note 12 -- Commitments and Contingent Liabilities of Notes to Consolidated Financial Statements.) Legislation effective January 1, 1992 phases in an acceleration of payment of the NJGRT during 1992-94, so that for 1994 and for each year thereafter PSE&G will be paying its estimated current year's NJGRT liability in April of each such year. In April 1993, PSE&G paid $899 million (its 1992 NJGRT plus 50% of its estimated 1993 NJGRT). In April 1994, PSE&G will be required to pay approximately $850 million (the remainder of its 1993 NJGRT plus its 1994 estimated NJGRT). Pending collection from customers, PSE&G is required to finance such NJGRT payments. EDHI During the next five years, a majority of EDHI's capital requirements are expected to be provided from operational cash flows. EDHI intends to focus its efforts on CEA and EDC, its energy-related core businesses. CEA is expected to be the primary vehicle for its business growth and EDC is projected to attain and maintain a reserve base at approximately 900 billion cubic feet equivalent, approximately 11% above the year-end 1993 level. PSRC will limit new investments, while EGDC will exit the real estate business in a prudent manner. This strategy places greater emphasis on its investment in the independent energy market. Over the next several years, EDHI and its subsidiaries will also be required to refinance a portion of their maturing debt in order to meet their capital requirements. Any inability to extend or replace maturing debt at current levels and interest rates may affect future earnings and result in an increase in EDHI's cost of capital. PSRC is a limited partner in various partnerships and is committed to make investments from time to time, upon the request of the respective general partners. On December 31, 1993, $139.5 million remained as PSRC's unfunded commitment subject to call. EDHI and each of its subsidiaries are subject to restrictive business and financial covenants contained in existing debt agreements and are required to not exceed various debt to equity ratios which vary from 3:1 to 1.75:1. EDHI is also required to maintain a twelve months earnings before interest and taxes to interest (EBIT) coverage ratio of at least 1.35:1. As of December 31, 1993 and 1992, EDHI had consolidated debt to equity ratios of 1.34:1 and 1.84:1 and, for the years ended December 31, 1993 and 1992, EBIT coverage ratios, which exclude the effect of EGDC, of 2.13:1 and 1.88:1, respectively. Compliance with applicable financial covenants will depend upon future levels of earnings, among other things, as to which no assurance can be given. (See Construction, Investments and Other Capital Requirements Forecast and Note 6 -- Schedule of Consolidated Long-Term Debt of Notes to Consolidated Financial Statements.) CONSTRUCTION, INVESTMENTS AND OTHER CAPITAL REQUIREMENTS FORECAST The estimated construction requirements of PSE&G, including AFDC, investments and other capital requirements of PSE&G and EDHI for 1994 through 1998 are based on expected project completion dates and include anticipated escalation due to inflation of approximately 4% for utility projects and are as follows: While the above forecast includes capital costs to comply with revised Clean Air Act (CAA) requirements through 1998, it does not include additional requirements being developed under the CAA by Federal and State agencies. Such additional costs cannot be reasonably estimated at this time. PSE&G believes that such CAA costs would be recoverable from electric customers. Not included in PSE&G's estimated construction expenses is the capital cost of compliance with the New Jersey Department of Environmental Protection and Energy (NJDEPE) draft permit issued October 3, 1990 pursuant to the Federal Water Pollution Control Act with respect to Salem 1 and 2 which, if adopted as proposed, would require the immediate shutdown of both units pending retrofit with cooling towers. On June 24, 1993, NJDEPE issued a revised draft permit that would permit Salem to continue to operate with once-through cooling and would require PSE&G to make certain plant modifications and to take certain other actions to enhance the ecology of the affected water body. The public comment period with respect to the revised draft permit expired on January 15, 1994. While a final permit is expected to be issued sometime in the second quarter of 1994, no assurances can be given as to the timing of any final agency determination. The capital cost of complying with the revised permit is estimated at approximately $75 million, PSE&G's share of which is included in the above forecast. Nevertheless, if cooling towers are ultimately required, PSE&G estimates that it would take at least four years, and between $720 million and $2.0 billion in capital, operation and maintenance costs and replacement power costs to retrofit Salem with cooling towers. PSE&G's share of any such costs would be 42.59%. In addition, the estimate does not include costs associated with the proposed Phase II of the repowering of PSE&G's Bergen Generating Station. INTERNAL GENERATION OF CASH FROM OPERATIONS Although net income increased $97 million for 1993 (See Enterprise Earnings and Revenues), net cash provided by operating activities decreased by $332 million from 1992 to $1.008 billion. This decrease was primarily due to an underrecovery of electric energy and gas costs through PSE&G's LEAC and LGAC, increased NJGRT payments and a decrease in amortization of property abandonments and write-downs. Partially offsetting these cash outflows were the increase in net income, increases in deferred income taxes and inventory decreases in fuel and materials and supplies. Although net income decreased $39 million for 1992 (See Enterprise Earnings and Revenues), Enterprise's cash provided by operating activities increased by $185 million from 1991 to $1.340 billion. This increase was primarily due to greater recovery of electric energy and gas costs through PSE&G's LEAC and LGAC and increases in accounts payable. Partially offsetting these cash inflows were inventory increases in fuel and materials and supplies and decreases in deferred income taxes. EXTERNAL FINANCINGS CASH FLOWS FROM FINANCING ACTIVITIES (A) During 1993, Enterprise issued and sold 4,400,000 shares of Common Stock through a public offering through underwriters and 3,892,505 shares of Common Stock through its Dividend Reinvestment and Stock Purchase Plan (DRIP) and various employee benefit plans. The net proceeds from such sales, aggregating approximately $273 million, were used by Enterprise to make equity investments of $179 million in PSE&G and $94 million in EDHI. PSE&G utilized such funds for general corporate purposes, including payment of a portion of its construction expenditures. EDHI used the funds for general corporate purposes, including the payment of outstanding debt obligations. Book value per share was $21.07 at December 31, 1993 compared to $20.32 at December 31, 1992. (See Note 4 -- Schedule of Consolidated Capital Stock of Notes to Consolidated Financial Statements.) (B) See DIVIDENDS. (C) Under the terms of PSE&G's First and Refunding Mortgage (Mortgage) and its Restated Certificate of Incorporation, as amended, at December 31, 1993, PSE&G would qualify to issue an additional $4.488 billion of First and Refunding Mortgage Bonds (Bonds) at a rate of 7.375% or $4.101 billion of Preferred Stock at a rate of 7.0%. In addition, as a prerequisite to the issuance of additional Bonds, PSE&G's Mortgage requires a 2:1 ratio of earnings to fixed charges as computed thereunder. For the twelve months ended December 31, 1993 such ratio was 3.30:1. The BRC has authorized PSE&G to issue not more than $800 million of its short-term obligations at any one time outstanding, consisting of commercial paper and other unsecured borrowings from banks and other lenders through December 31, 1994. On December 31, 1993, PSE&G had $424 million of short-term debt outstanding. PSE&G has a $600 million revolving credit agreement with a group of commercial banks which expires on September 17, 1994. On December 31, 1993, there was no short-term debt outstanding under this credit agreement. (D) Includes commercial paper issued and/or redeemed by Fuelco and guaranteed by PSE&G pursuant to a commercial paper program supported by a bank revolving credit facility to finance the acquisition of a 42.49% undivided interest in the nuclear fuel for Peach Bottom. Fuelco has a $150 million commercial paper program through June 1996. On December 31, 1993, Fuelco had $109 million of its commercial paper outstanding. (E) Enterprise's long-term debt aggregated $5.256 billion as of December 31, 1993, of which $4.364 billion was attributable to PSE&G and $892 million to EDHI. During 1993, PSE&G issued $1.973 billion principal amount of its Bonds. The net proceeds of these Bonds were used by PSE&G to refund and redeem certain of its higher-cost and maturing debt obligations including reimbursement of its treasury for funds expended for such purposes and for the payment of a portion of PSE&G's construction expenditures. During 1993, PSE&G redeemed or paid at maturity $1.7 billion aggregate principal amount of its Bonds and Debenture Bonds. In February 1994, PSE&G issued $50 million principal amount of its Bonds to service and secure an equal principal amount of tax-exempt revenue bonds issued by the Pollution Control Financing Authority of Salem County, New Jersey to finance pollution control facilities at the Hope Creek Generating Station. Under authority granted by the BRC, expiring December 31, 1994, PSE&G is authorized to issue an additional $495 million principal amount of Bonds after giving effect to the 1994 issuance of Bonds. For more detail see Note 6 -- Schedule of Consolidated Long-Term Debt of Notes to Consolidated Financial Statements. (F) In March 1993, PSE&G sold 750,000 shares of Preferred Stock ($100 Par). The net proceeds of $75 million were used by PSE&G for general corporate purposes. In February 1994, PSE&G sold 600,000 shares of Preferred Stock -- $25 Par and 600,000 shares of Preferred Stock ($100 Par). The net proceeds of $15 million from the sale of the Preferred Stock -- $25 Par were used by PSE&G to redeem all of the 150,000 outstanding shares of PSE&G's 8.08% Preferred Stock ($100 Par). The net proceeds of $60 million from the sale of the Preferred Stock ($100 Par) were added to the general funds of PSE&G and used to pay a portion of its then outstanding short-term debt obligations, which were principally incurred to fund a portion of its construction expenditures. Under authority granted by the BRC, expiring December 31, 1995, PSE&G is authorized to issue an additional $330 million of Preferred Stock after giving effect to the 1994 issuances of Preferred Stock. (See Note 4 -- Schedule of Consolidated Capital Stock of Notes to Consolidated Financial Statements.) (G) Funding has a commercial paper program, supported by a commercial bank letter of credit and revolving credit facility, through November 18, 1995 in the amount of $225 million. As of December 31, 1993, Funding had $45 million outstanding under its commercial paper program. Funding has a $225 million revolving credit facility which terminates on November 18, 1995. As of December 31, 1993, Funding had no debt outstanding under this facility. In February 1993, Funding repaid $60 million of its 9.43% Series A Notes. In March 1993, Funding privately placed an aggregate of $60 million principal amount of its Senior Notes. In May 1993, Capital amended its Medium-Term Notes (MTNs) program to provide for an aggregate principal amount of up to $750 million of MTNs, provided that its total debt outstanding at any time, including MTNs, shall not exceed such amount. During 1993, $88 million principal amount of Capital's MTNs were repaid, $42.5 million sinking fund payments on Capital's long-term debt obligations were made and $105 million principal amount of MTNs were issued. At December 31, 1993, Capital had $517 million of MTNs outstanding and total debt outstanding of $724.5 million. For additional detail see Note 6 -- Long-Term Debt of Notes to Consolidated Financial Statements. PSE&G Following are the significant factors affecting the consolidated financial condition and the results of operations of PSE&G and its subsidiaries. This discussion refers to the Consolidated Financial Statements and related Notes of PSE&G and should be read in conjunction with such statements and notes. Except as modified below, the information required by this item is incorporated herein by reference to the following portions of Enterprise's Management's Discussion and Analysis of Financial Condition and Results of Operations, insofar as they relate to PSE&G and its subsidiaries: Overview; PSE&G Energy and Fuel Adjustment Clauses; Enterprise Earnings; Dividends; Revenues -- PSE&G Electric, PSE&G Gas; PSE&G Electric Energy Costs; Liquidity and Capital Resources, PSE&G; Construction, Investments and Other Capital Requirements Forecast; and External Financings. GAS SUPPLY COSTS Gas supply costs increased $17 million or 1.8% in 1993 compared to 1992 and $216 million or 31.4% in 1992 compared to 1991. The significant components of these changes follow: (A) Reflects the change in the deferred over(under)recovered gas supply costs, which in the years 1993, 1992 and 1991 amounted to $(100) million, $52 million and $(32) million, respectively. (See PSE&G Energy and Fuel Adjustment Clauses and Note 2 -- Rate Matters of Notes to Consolidated Financial Statements.) 1993 -- The increase in total costs was principally due to greater sales to cogenerators and other customers, higher gas costs and higher therm sendout resulting from the colder 1993 winter season compared to the 1992 winter season. The increase in costs was reduced by deferred underrecovered 1993 gas costs resulting from the BRC approved adjustment in PSE&G's LGAC, effective January 1, 1993, of $71 million on an annualized basis through December 31, 1993. The adjustment reflects lower gas costs and the inclusion of $15.1 million of conservation program costs in LGAC. In addition, gas customers received $45 million of credits during the first quarter of 1993. 1992 -- The increase in total costs was principally due to greater therm sendout resulting from the colder 1992 weather compared to 1991 and increased sales to cogenerators. LIQUIDITY AND CAPITAL RESOURCES INTERNAL GENERATION OF CASH FROM OPERATIONS Although net income increased $139 million for 1993 (See Enterprise Earnings -- PSE&G and Revenues -- PSE&G Electric and PSE&G Gas), PSE&G's net cash provided by operating activities decreased by $376 million from 1992 to $811 million. This decrease was primarily due to an underrecovery of electric energy and gas costs through PSE&G's LEAC and LGAC, increased NJGRT payments, and a decrease in amortization of property abandonments and write-down. Partially offsetting these cash outflows were increases in deferred income taxes and decreases in fuel and materials and supplies inventories. Although net income decreased $70 million for 1992 (See Enterprise Earnings -- PSE&G and Revenues -- PSE&G Electric and PSE&G Gas), PSE&G's net cash provided by operating activities increased by $128 million from 1991 to $1.187 billion. This increase was primarily due to greater recovery of electric energy and gas costs through PSE&G's LEAC and LGAC and increases in accounts payable. Partially offsetting these cash inflows were the decrease in net income, increases in fuel and materials and supplies inventories and decreases in deferred income taxes. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENT RESPONSIBILITY Management of Enterprise is responsible for the preparation, integrity and objectivity of the consolidated financial statements and related notes of Enterprise. The consolidated financial statements and related notes are prepared in accordance with generally accepted accounting principles. The financial statements reflect estimates based upon the judgment of management where appropriate. Management believes that the consolidated financial statements and related notes present fairly Enterprise's financial position and results of operations. Information in other parts of this Annual Report is also the responsibility of management and is consistent with these consolidated financial statements and related notes. The firm of Deloitte & Touche, independent auditors, is engaged to audit Enterprise's consolidated financial statements and related notes and issue a report thereon. Deloitte & Touche's audit is conducted in accordance with generally accepted auditing standards. Management has made available to Deloitte & Touche all the corporation's financial records and related data, as well as the minutes of directors' meetings. Furthermore, management believes that all representations made to Deloitte & Touche during its audit were valid and appropriate. Management has established and maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded, and that transactions are executed in accordance with management's authorization and recorded properly for the prevention and detection of fraudulent financial reporting, so as to maintain the integrity and reliability of the financial statements. The system is designed to permit preparation of consolidated financial statements and related notes in accordance with generally accepted accounting principles. The concept of reasonable assurance recognizes that the costs of a system of internal accounting controls should not exceed the related benefits. Management believes the effectiveness of this system is enhanced by an ongoing program of continuous and selective training of employees. In addition, management has communicated to all employees its policies on business conduct, safeguarding assets and internal controls. The Internal Auditing Department of PSE&G conducts audits and appraisals of accounting and other operations of Enterprise and its subsidiaries and evaluates the effectiveness of cost and other controls and recommends to management, where appropriate, improvements thereto. Management has considered the internal auditors' and Deloitte & Touche's recommendations concerning the corporation's system of internal accounting controls and has taken actions that, in its opinion, are cost-effective in the circumstances to respond appropriately to these recommendations. Management believes that, as of December 31, 1993, the corporation's system of internal accounting controls is adequate to accomplish the objectives discussed herein. The Board of Directors of Enterprise carries out its responsibility of financial overview through its Audit Committee, which presently consists of six directors who are neither employees of Enterprise nor its affiliates. The Audit Committee meets periodically with management as well as with representatives of the internal auditors and Deloitte & Touche. The Audit Committee reviews the work of each to ensure that their respective responsibilities are being carried out and discusses related matters. Both the internal auditors and Deloitte & Touche periodically meet alone with the Audit Committee and have free access to the Audit Committee, and its individual members, at any time. FINANCIAL STATEMENT RESPONSIBILITY Management of PSE&G is responsible for the preparation, integrity and objectivity of the consolidated financial statements and related notes of PSE&G. The consolidated financial statements and related notes are prepared in accordance with generally accepted accounting principles. The financial statements reflect estimates based upon the judgment of management where appropriate. Management believes that the consolidated financial statements and related notes present fairly PSE&G's financial position and results of operations. Information in other parts of this Annual Report is also the responsibility of management and is consistent with these consolidated financial statements and related notes. The firm of Deloitte & Touche, independent auditors, is engaged to audit PSE&G's consolidated financial statements and related notes and issue a report thereon. Deloitte & Touche's audit is conducted in accordance with generally accepted auditing standards. Management has made available to Deloitte & Touche all the corporation's financial records and related data, as well as the minutes of directors' meetings. Furthermore, management believes that all representations made to Deloitte & Touche during its audit were valid and appropriate. Management has established and maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded, and that transactions are executed in accordance with management's authorization and recorded properly for the prevention and detection of fraudulent financial reporting, so as to maintain the integrity and reliability of the financial statements. The system is designed to permit preparation of consolidated financial statements and related notes in accordance with generally accepted accounting principles. The concept of reasonable assurance recognizes that the costs of a system of internal accounting controls should not exceed the related benefits. Management believes the effectiveness of this system is enhanced by an ongoing program of continuous and selective training of employees. In addition, management has communicated to all employees its policies on business conduct, safeguarding assets and internal controls. The Internal Auditing Department conducts audits and appraisals of accounting and other operations and evaluates the effectiveness of cost and other controls and recommends to management, where appropriate, improvements thereto. Management has considered the internal auditors' and Deloitte & Touche's recommendations concerning the corporation's system of internal accounting controls and has taken actions that are cost-effective in the circumstances to respond appropriately to these recommendations. Management believes that, as of December 31, 1993, the corporation's system of internal accounting controls is adequate to accomplish the objectives discussed herein. The Board of Directors carries out its responsibility of financial overview through the Audit Committee of Enterprise, which presently consists of six directors who are neither employees of Enterprise nor its affiliates. The Enterprise Audit Committee meets periodically with management as well as with representatives of the internal auditors and Deloitte & Touche. The Audit Committee reviews the work of each to ensure that their respective responsibilities are being carried out and discusses related matters. Both the internal auditors and Deloitte & Touche periodically meet alone with the Audit Committee and have free access to the Audit Committee, and its individual members, at any time. INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of Public Service Enterprise Group Incorporated: We have audited the accompanying consolidated balance sheets of Public Service Enterprise Group Incorporated and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the consolidated financial statement schedules listed in the Index in Item 14(a)(1). These consolidated financial statements and the consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Public Service Enterprise Group Incorporated and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990, and 1989, and the related consolidated statements of income, retained earnings, and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented herein) and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the Selected Financial Data for each of the five years in the period ended December 31, 1993 for the Company, presented in Item 6, is fairly stated in all material respects, in relation to the consolidated financial statements from which it has been derived. As discussed in Note 1 to the Consolidated Financial Statements, in 1993 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109 and changed its method of accounting for the costs of postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106. DELOITTE & TOUCHE February 18, 1994 Parsippany, New Jersey INDEPENDENT AUDITORS' REPORT To the Board of Directors of Public Service Electric and Gas Company: We have audited the accompanying consolidated balance sheets of Public Service Electric & Gas Company and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the consolidated financial statement schedules listed in the Index in Item 14(a)(2). These consolidated financial statements and the consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Public Service Electric & Gas Company and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990, and 1989, and the related consolidated statements of income, retained earnings, and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented herein) and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the Selected Financial Data for each of the five years in the period ended December 31, 1993 for the Company, presented in Item 6, is fairly stated in all material respects, in relation to the consolidated financial statements from which it has been derived. As discussed in Note 1 to the Consolidated Financial Statements, in 1993 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109 and changed its method of accounting for the costs of postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106. DELOITTE & TOUCHE February 18, 1994 Parsippany, New Jersey PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED CONSOLIDATED STATEMENTS OF INCOME See Notes to Consolidated Financial Statements PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED CONSOLIDATED BALANCE SHEETS ASSETS See Notes to Consolidated Financial Statements PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED CONSOLIDATED BALANCE SHEETS CAPITALIZATION AND LIABILITIES PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS See Notes to Consolidated Financial Statements PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (A) The ability of Enterprise to declare and pay dividends is contingent upon its receipt of dividend payments from its subsidiaries. PSE&G, Enterprise's principal subsidiary, has restrictions on the payment of dividends which are contained in its Restated Certificate of Incorporation, as amended, certain of the indentures supplemental to its Mortgage, and certain debenture bond indentures. However, none of these restrictions presently limits the payment of dividends out of current earnings. The amount of PSE&G's restricted retained earnings at December 31, 1993 was $10 million. See Notes to Consolidated Financial Statements. PUBLIC SERVICE ELECTRIC AND GAS COMPANY CONSOLIDATED STATEMENTS OF INCOME See Notes to Consolidated Financial Statements. PUBLIC SERVICE ELECTRIC AND GAS COMPANY CONSOLIDATED BALANCE SHEETS ASSETS See Notes to Consolidated Financial Statements. PUBLIC SERVICE ELECTRIC AND GAS COMPANY CONSOLIDATED BALANCE SHEETS CAPITALIZATION AND LIABILITIES PUBLIC SERVICE ELECTRIC AND GAS COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS See Notes to Consolidated Financial Statements. PUBLIC SERVICE ELECTRIC AND GAS COMPANY CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (A) The Company has restrictions on the payment of dividends which are contained in its Restated Certificate of Incorporation, as amended, certain of the indentures supplemental to its Mortgage, and certain debenture bond indentures. However, none of these restrictions presently limits the payment of dividends out of current earnings. The amount of the Company's restricted retained earnings at December 31, 1993 was $10 million. See Notes to Consolidated Financial Statements. PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION Enterprise has two direct wholly-owned subsidiaries, Public Service Electric and Gas Company (PSE&G) and Enterprise Diversified Holdings Incorporated (EDHI). Enterprise's principal subsidiary, PSE&G, is an operating public utility providing electric and gas service in certain areas in the State of New Jersey. PSE&G has a finance subsidiary, PSE&G Fuel Corporation (Fuelco), providing financing, unconditionally guaranteed by PSE&G, of up to $150 million aggregate principal amount at any one time of a 42.49% interest in the nuclear fuel acquired for Peach Bottom Atomic Power Station Units 2 and 3 (Peach Bottom). PSE&G also has a nonutility subsidiary, Public Service Conservation Resources Corporation (PSCRC) which offers demand side management (DSM) services to utility customers. EDHI is the parent of Enterprise's other nonutility businesses: Energy Development Corporation (EDC), an oil and gas exploration, development, production and marketing company; Community Energy Alternatives Incorporated (CEA), an investor in and developer of cogeneration and power production facilities; Public Service Resources Corporation (PSRC), which makes diversified passive investments; and Enterprise Group Development Corporation (EGDC), a diversified nonresidential real estate development and investment business. EDHI also has two finance subsidiaries: PSEG Capital Corporation (Capital), and Enterprise Capital Funding Corporation (Funding). Enterprise has claimed an exemption from regulation by the Securities and Exchange Commission (SEC) as a registered holding company under the Public Utility Holding Company Act of 1935, except for Section 9(a)(2) which relates to the acquisition of voting securities of an electric or gas utility company. Also, Enterprise is not subject to direct regulation by the New Jersey Board of Regulatory Commissioners (BRC) or the Federal Energy Regulatory Commission (FERC). CONSOLIDATION POLICY The consolidated financial statements include the accounts of Enterprise and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications of prior years' data have been made to conform with the current presentation. REGULATION -- PSE&G The accounting and rates of PSE&G are subject, in certain respects, to the requirements of the BRC and FERC. As a result, PSE&G maintains its accounts in accordance with their prescribed Uniform Systems of Accounts, which are the same. The applications of generally accepted accounting principles by PSE&G differ in certain respects from applications by non-regulated businesses. UTILITY PLANT AND RELATED DEPRECIATION -- PSE&G Additions to utility plant and replacements of units of property are capitalized at original cost. The cost of maintenance, repairs and replacements of minor items of property is charged to appropriate expense accounts. At the time units of depreciable properties are retired or otherwise disposed of, the original cost less net salvage value is charged to accumulated depreciation. For financial reporting purposes, depreciation is computed under the straight-line method. Depreciation is based on estimated average remaining lives of the several classes of depreciable property. These estimates are reviewed on a periodic basis and necessary adjustments are made as approved by the BRC. Depreciation provisions stated in percentages of original cost of depreciable property were 3.46% in 1993 and 3.48% in 1992 and 1991. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECONTAMINATION AND DECOMMISSIONING -- PSE&G In September 1993, FERC issued Order No. 557 on the accounting and ratemaking treatment of special assessments levied under the National Energy Policy Act (NEPA). Order No. 557 provides that special assessments are a necessary and reasonable current cost of fuel and shall be fully recoverable in rates in the same manner as other fuel costs. While PSE&G expects to recover such special assessments through its Levelized Energy Adjustment Clause (LEAC) no assurances can be given that the BRC will authorize such recovery from customers. PSE&G cannot predict what actions the BRC will take concerning any recovery associated with this matter. AMORTIZATION OF NUCLEAR FUEL -- PSE&G Nuclear energy burnup costs are charged to fuel expense on a units-of-production basis over the estimated life of the fuel. Rates for the recovery of fuel used at all nuclear units include a provision of one mill per kilowatthour (Kwh) of nuclear generation for spent fuel disposal costs. (See Note 3 -- PSE&G Nuclear Decommissioning and Amortization of Nuclear Fuel.) REVENUES AND FUEL COSTS -- PSE&G Revenues are recorded based on services rendered to customers during each accounting period. PSE&G records unbilled revenues representing the estimated amount customers will be billed for services rendered from the time meters were last read to the end of the respective accounting period. Rates include projected fuel costs for electric generation, purchased and interchanged power, gas purchased and materials used for gas production. Any under or overrecoveries, together with interest (in the case of overrecoveries), are deferred and included in operations in the period in which they are reflected in rates. LONG-TERM INVESTMENTS PSRC has invested in marketable securities and limited partnerships investing in securities, which are stated at fair value, and various leases and other limited partnerships. EGDC is a participant in the nonresidential real estate markets. CEA is an investor in and developer of cogeneration and power production facilities. (See Note 7 -- Long-Term Investments.) OIL AND GAS ACCOUNTING -- EDC EDC uses the successful efforts method of accounting under which proved leasehold costs are capitalized and amortized over the proved developed and undeveloped reserves on a units-of-production basis. Drilling and equipping costs, except exploratory dry holes, are capitalized and depreciated over the proved developed reserves on a units-of-production basis. Estimated future abandonment costs of offshore proved properties are depreciated on a units-of-production basis over the proved developed reserves. Unproved leasehold costs are capitalized and not amortized, pending an evaluation of their exploration potential. Unproved leasehold and producing properties costs are assessed periodically to determine if an impairment of the cost of significant individual properties has occurred. The cost of an impairment is charged to expense in the period in which it occurs. Costs incurred for exploratory dry holes, exploratory geological and geophysical work and delay rentals are charged to expense as incurred. INCOME TAXES Enterprise and its subsidiaries file a consolidated Federal income tax return and income taxes are allocated to Enterprise's subsidiaries based on taxable income or loss of each. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Investment tax credits are deferred and amortized over the useful lives of the related property including nuclear fuel. Deferred income taxes are provided for differences between book and taxable income. For periods prior to January 1, 1993, PSE&G provided deferred income taxes to the extent permitted for ratemaking purposes. Effective January 1, 1993, Enterprise and its subsidiaries adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" (SFAS 109). Under SFAS 109, deferred income taxes are provided for all temporary differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities irrespective of the treatment for ratemaking purposes. (See Note 9 -- Federal Income Taxes.) ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFDC) AND CAPITALIZED INTEREST PSE&G -- AFDC represents the cost of debt and equity funds used to finance the construction of new utility facilities. The amount of AFDC capitalized is also reported in the Consolidated Statements of Income as a reduction of interest charges for the borrowed funds component and as other income for the equity funds component. The rates used for calculating AFDC in 1993, 1992 and 1991 were 6.96%, 7.80% and 7.50%, respectively. These rates are within the limits set by the FERC. EDHI -- The operating subsidiaries of EDHI capitalize interest costs allocable to construction expenditures at the average cost of borrowed funds. PENSION PLAN AND OTHER POSTRETIREMENT BENEFITS The employees of PSE&G and participating affiliates, after completing one year of service, are covered by a noncontributory trusteed pension plan (Pension Plan). The policy is to fund pension costs accrued. PSE&G also provides certain health care and life insurance benefits to active and retired employees. The portion of such costs pertaining to retirees amounted to $28 million, $24 million and $24 million in 1993, 1992 and 1991, respectively. The current cost of these benefits is charged to expense when paid and is currently being recovered from ratepayers. On January 1, 1993, Enterprise and PSE&G adopted Statement of Financial Accounting Standards No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), which requires that the expected cost of employees' postretirement health care benefits be charged to expense during the years in which employees render service. PSE&G elected to amortize over 20 years its unfunded obligation at January 1, 1993. The effect of EDHI's adoption of SFAS 106 was not material. Prior to 1993, Enterprise and PSE&G recognized postretirement health care costs in the year in which the benefits were paid. (See Note 13 -- Postretirement Benefits Other Than Pensions and Note 14 -- Pension Plan.) NOTE 2. RATE MATTERS BASE RATES On December 31, 1992, the BRC approved a settlement of PSE&G's base rate case that effectively provides additional annual base revenues of $295 million. At such time, the BRC also approved annual reductions of $66 million and $71 million, respectively, in PSE&G's LEAC and Levelized Gas Adjustment Clause (LGAC). The BRC also approved stipulations resolving all electric and gas cost of service/rate design issues. The new base rates became effective January 1, 1993. The settlement agreement allows PSE&G a 12% return on common equity and a 10.08% return on rate base. In July 1993, PSE&G and its largest industrial customer submitted a proposed electric tariff modification to the BRC, providing for a $9 million or 23% rate discount, with PSE&G's shareholders absorbing $2.4 million or 27% of the discount. The proposed tariff modification was designed to dissuade the customer from buying its electricity supply from a third party nonutility generator. In December 1993, following extensive proceedings, the BRC recognized the need for flexible pricing in a competitive market, approved the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) requested discount but required PSE&G's shareholders to absorb $3.8 million or 42% of such discount. The decision allows PSE&G a special tariff for certain large customers. LEVELIZED GAS ADJUSTMENT CLAUSE On December 8, 1993, the BRC approved an interim LGAC settlement which provides for an increase of $75.3 million for the approximate ten-month period ending September 1994. The LGAC increase principally reflects recent increases in the cost of natural gas. PSE&G GAS PLANT REMEDIATION PROGRAM On September 15, 1993, the BRC issued a written order allowing the continued collection of costs incurred by PSE&G to identify and clean up its former gas plant sites (Remediation Costs). The decision concluded that PSE&G had met its burden of proof for establishing the reasonableness and prudence of Remediation Costs incurred in operating and decommissioning these facilities in the past. The Remediation Costs incurred during the period July 1, 1992 through September 30, 1992 are subject to verification and audit in PSE&G's 1992-1993 LGAC. The audit is currently ongoing. The order also approved a mechanism for costs incurred since October 1, 1992. This mechanism allows the recovery of actual costs plus carrying charges, net of insurance recoveries, over a seven-year period through a rider to PSE&G's LEAC and LGAC. Sixty percent of such costs will be charged to gas customers and forty percent charged to electric customers. On November 1, 1993, the Public Advocate of New Jersey filed a motion requesting the BRC to reconsider its September 15, 1993 order. On January 21, 1994, the BRC denied the motion. (See Note 12 -- Commitments and Contingent Liabilities.) CONSOLIDATED TAX BENEFITS The BRC does not directly regulate Enterprise's nonutility activities. However, in a case affecting another utility in which neither Enterprise nor PSE&G were parties, the BRC considered the extent to which tax savings generated by nonutility affiliates included in the consolidated tax return of that utility's holding company should be considered in setting that utility's rates. On September 30, 1992, the BRC approved an order in such case treating certain consolidated tax savings generated after June 30, 1990 by that utility's nonutility affiliates as a reduction of its rate base. On December 31, 1992 the BRC issued an order approving a stipulation in PSE&G's 1992 base rate proceeding which resolved the case without separate quantification of the consolidated tax issue. The stipulation does not provide final resolution of the consolidated tax issue for any subsequent base rate filing. While Enterprise continues to account for these entities on a stand-alone basis, resulting in a realization of the tax benefits by the entity generating the benefit, an ultimate unfavorable resolution of the consolidated tax issue could reduce PSE&G's future revenue and net income and the future net income of Enterprise. In addition, an unfavorable resolution may adversely impact Enterprise's nonutility investment strategy. Enterprise believes that PSE&G's taxes should be treated on a stand-alone basis for ratemaking purposes, based on the separate nature of the utility and nonutility businesses. However, neither Enterprise nor PSE&G is able to predict what action, if any, the BRC may take concerning consolidation of tax benefits in future rate proceedings. (See Note 9 -- Federal Income Taxes.) NOTE 3. PSE&G NUCLEAR DECOMMISSIONING AND AMORTIZATION OF NUCLEAR FUEL PSE&G's 1992 base rate decision by the BRC utilized studies based on the prompt removal/dismantlement method of decommissioning for all of PSE&G's nuclear generating stations. This method consists of removing all fuel, source material and all other radioactive materials with activity levels above accepted release limits from the nuclear sites. PSE&G has an ownership interest in five nuclear units: Salem 1 and Salem 2 -- 42.59% each, Hope Creek -- 95% and Peach Bottom 2 and 3 -- 42.49% each. In accordance with rate orders received from the BRC, PSE&G has established an external master nuclear decommissioning trust for all of its nuclear units. The Internal Revenue Service (IRS) has ruled that payments to the trust are tax deductible. PSE&G's total estimated cost of decommissioning its share of these NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) nuclear units is estimated at $681 million in year-end 1990 dollars, (the year that the site specific estimate was prepared), excluding contingencies. The 1992 base rate decision provided that $15.6 million of such costs are to be collected through base rates and an additional annual amount of $7.0 million in 1993 and $14.0 million in 1994 and thereafter are to be recovered through PSE&G's LEAC. At December 31, 1993 and 1992, the accumulated provision for depreciation and amortization included reserves for nuclear decommissioning for PSE&G's units of $211 million and $179 million, respectively. As of December 31, 1993 and 1992, PSE&G has contributed $155 million and $109 million, respectively, into external qualified and nonqualified nuclear decommissioning trust funds. URANIUM ENRICHMENT DECONTAMINATION AND DECOMMISSIONING FUND In accordance with the NEPA, domestic utilities that own nuclear generating stations are required to pay a cumulative total of $150 million each year into a decontamination and decommissioning fund, based on their past purchases of enriched nuclear fuel from the United States Department of Energy (DOE) Uranium Enrichment Enterprise (now a federal government corporation known as the United States Enrichment Corporation (USEC)). These amounts are being collected over a period of 15 years or until $2.25 billion has been collected. Under this legislation, the nuclear facilities operated by PSE&G, Salem and Hope Creek, aggregate 2.82% of the total amount of enrichment services sold to the domestic commercial nuclear industry and the nuclear facilities operated by PECO Energy Company, formerly known as Philadelphia Electric Company (PECO), Peach Bottom and other nuclear facilities not co-owned by PSE&G, aggregate 3.89%. In 1993, PSE&G paid approximately $4 million and deferred the balance of $56 million. PSE&G has included these costs in its LEAC. PSE&G cannot predict the outcome, amount or timing of any recovery associated with this matter. SPENT NUCLEAR FUEL DISPOSAL COSTS In accordance with the Nuclear Waste Policy Act, PSE&G has entered into contracts with the USEC for the disposal of spent nuclear fuel. Payments made to the USEC for disposal costs are based on nuclear generation and are included in Fuel for Electric Generation and Net Interchanged Power in the Statements of Income. These costs are recovered through the LEAC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4. SCHEDULE OF CONSOLIDATED CAPITAL STOCK NOTES TO SCHEDULE OF CONSOLIDATED CAPITAL STOCK (A) Total authorized and unissued shares include 7,571,442 shares of Enterprise Common Stock reserved for issuance through Enterprise's Dividend Reinvestment and Stock Purchase Plan (DRIP) and various employee benefit plans. In 1993, 8,292,505 shares of Enterprise Common Stock were issued and sold for $273,479,342, including a public offering of 4,400,000 shares issued and sold for $142,670,000; in 1992, 8,694,899 shares were issued and sold for $237,045,247, including a public offering of 5,000,000 shares issued and sold for $132,025,000; in 1991, 8,228,647 shares were issued and sold for $218,735,528, including a public offering of 5,000,000 shares issued and sold for $129,950,000. (B) Enterprise has authorized a class of 50,000,000 shares of Preferred Stock without par value, none of which is outstanding. (C) As of December 31, 1993, there were 1,700,060 shares of $100 par value and 10,000,000 shares of $25 par value Cumulative Preferred Stock which were authorized and unissued, and which upon issuance may or may not provide for mandatory sinking fund redemption. If dividends upon any shares of Preferred Stock are in arrears in an amount equal to the annual dividend thereon, voting rights for the election of a majority of PSE&G's Board of Directors become operative and continue until all NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) accumulated and unpaid dividends thereon have been paid, whereupon all such voting rights cease, subject to being again revived from time to time. In January 1994, PSE&G called for redemption on March 1, 1994 all of the outstanding shares of two series of securities: 300,000 shares of its 8.16% Cumulative Preferred Stock ($100 Par) and 150,000 shares of its 8.08% Cumulative Preferred Stock ($100 Par). In February 1994, PSE&G issued and sold 600,000 shares of 6.92% Cumulative Preferred Stock ($100 Par) which may not be redeemed before February 1, 2004 and 600,000 shares of 6.75% Cumulative Preferred Stock -- $25 Par which may not be redeemed before February 1, 1999. The net proceeds from the sale of the 6.75% Cumulative Preferred Stock -- $25 Par will be used by PSE&G to redeem the outstanding shares of the 8.08% Cumulative Preferred Stock ($100 Par). (D) At December 31, 1993, the annual dividend requirement and embedded dividend for Preferred Stock without mandatory redemption were $29,012,000 and 6.75%, respectively and for Preferred Stock with mandatory redemption were $10,057,500 and 6.71%, respectively. (E) In March 1993, PSE&G sold 750,000 shares of 5.97% Cumulative Preferred Stock ($100 Par). PSE&G will be required to redeem through the operation of a sinking fund 37,500 shares, plus accumulated dividends, on March 1 of each year commencing March 1, 2003 and shall redeem the remaining shares on March 1, 2008, plus accumulated dividends. (F) In accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), the estimated fair value was determined using the ready market price for the Preferred Stock at the end of 1993. As of December 31, 1993, the estimated fair value of the Preferred Stock was $158 million. As of December 31, 1992, the estimated fair value of the Preferred Stock was $78 million. NOTE 5. DEFERRED ITEMS PROPERTY ABANDONMENTS The BRC has authorized PSE&G to recover after-tax property abandonment costs from its customers. The following table reflects the application of Statement of Financial Accounting Standards No. 90, "Regulated Enterprises -- Accounting for Abandonments and Disallowances of Plant Costs" (SFAS 90), as amended, on property abandonments for which no return is earned. The net-of-tax discount rate used was between 4.443% and 7.801%. As part of its base rate decision of December 31, 1992, the BRC required the elimination of the amortization of the abandonment cost for Hope Creek Unit 2 as of December 31, 1992. The net remaining balance was transferred to the LEAC. (See Note 2 -- Rate Matters.) The following table reflects the property abandonments and related tax effects on which no return is earned. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) UNDER (OVER) RECOVERED ELECTRIC ENERGY AND GAS COSTS -- NET Recoveries of electric energy and gas costs are determined by the BRC under the LEAC and LGAC. PSE&G's deferred fuel balances as of December 31, 1993 and December 31, 1992, reflect an underrecovery of $62.0 million and an overrecovery of $122.7 million, respectively. UNRECOVERED PLANT AND REGULATORY STUDY COSTS Amounts shown in the consolidated balance sheets consist of costs associated with developing, consolidating and documenting the specific design basis of PSE&G's jointly-owned nuclear generating stations, as well as PSE&G's share of costs associated with the cancellation of the Hydrogen Water Chemistry System Project at Peach Bottom. PSE&G has received both BRC and FERC approval to defer and amortize, over the remaining life of the Salem and Hope Creek nuclear units, costs associated with configuration baseline documentation projects. PSE&G has received FERC approval to defer and amortize over the remaining life of the applicable Peach Bottom units, costs associated with the configuration baseline documentation and the cancelled Hydrogen Water Chemistry System Projects. While PSE&G expects the BRC to authorize recovery of such costs from electric customers, no assurances can be given. OIL AND GAS PROPERTY WRITE-DOWN On December 31, 1992, the BRC approved the recovery of the EDC write-down through PSE&G's LGAC over a ten year period beginning January 1, 1993. At December 31, 1993, the remaining balance to be amortized was $46 million. UNAMORTIZED DEBT EXPENSE Gains and losses and the cost of redeeming long-term debt for PSE&G are deferred and amortized over the life of the applicable debt. NOTE 6. SCHEDULE OF CONSOLIDATED LONG-TERM DEBT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTES: (A) PSE&G's Mortgage, securing the Bonds, constitutes a direct first mortgage lien on substantially all PSE&G property and franchises. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In January 1994, PSE&G called for redemption on March 1, 1994 all of its First and Refunding Mortgage Bonds 4 5/8% Series due 1994. In February 1994, PSE&G issued $50 million principal amount of its First and Refunding Mortgage Bonds Pollution Control Series O due 2032. (B) The aggregate principal amounts of mandatory requirements for sinking funds and maturities for each of the five years following December 31, 1993 are as follows: For sinking fund purposes, certain First and Refunding Mortgage Bond issues require annually the retirement of an aggregate $13.3 million principal amount of bonds or the utilization of bondable property additions at 60% of cost. The portion expected to be met by property additions has been excluded from the table above. (C) Capital is providing up to $750 million debt financing for EDHI's businesses on the basis of a support agreement with Enterprise. (D) Funding provides debt financing for EDHI's businesses other than EGDC on the basis of unconditional guarantees from EDHI. (E) At December 31, 1993, the annual interest requirement on long-term debt was $421.2 million of which $327.5 million was the requirement for Bonds. The embedded interest cost on long-term debt on such date was 8.06%. (F) In accordance with the requirements of SFAS 107, the estimated fair value was determined using market quotations or values of debt with similar terms, credit ratings and remaining maturities at the end of 1992. As of December 31, 1993, the estimated fair value of PSE&G's and EDHI's long-term debt was $4.7 billion and $1.2 billion, respectively. As of December 31, 1992, the estimated fair value of PSE&G's and EDHI's long-term debt was $4.4 billion and $1.3 billion, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 7. LONG-TERM INVESTMENTS Long-Term Investments are primarily those of EDHI. A summary of Long-Term Investments is as follows: PSRC's leveraged leases are reported net of principal and interest on nonrecourse loans and unearned income, including deferred tax credits. Income and deferred tax credits are recognized at a level rate of return from each lease during the periods in which the net investment is positive. Partnership investments are those of PSRC, EGDC and CEA and are undertaken with other investors. PSRC is a limited partner in various partnerships and is committed to make investments from time to time, upon the request of the respective general partners. As of December 31, 1993, $139.5 million remained as PSRC's unfunded commitment subject to call. PSRC has invested in marketable securities and limited partnerships investing in securities, which are stated at fair value. Realized investment gains and losses on the sale of investment securities are determined utilizing the specific cost identification method. NOTE 8. CASH AND CASH EQUIVALENTS The December 31, 1993 and 1992 balances consist primarily of working funds and highly liquid marketable securities (commercial paper) with a maturity of three months or less. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. FEDERAL INCOME TAXES A reconciliation of reported Net Income with pretax income and of Federal income tax expense with the amount computed by multiplying pretax income by the statutory Federal income tax rates of 35% in 1993 and 34% in 1992 and 1991 is as follows: Reconciliation between total Federal income tax provisions and tax computed at the statutory tax rate on pretax income: (A) The provision for deferred income taxes represents the tax effects of the following items: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Since 1987, Enterprise's Federal alternative minimum tax (AMT) liability has exceeded its regular Federal income tax liability. This excess can be carried forward indefinitely to offset regular income tax liability in future years. Enterprise expects to utilize these AMT credits in the future as regular tax liability exceeds AMT. As of December 31, 1993, 1992 and 1991, Enterprise had AMT credits of $247 million, $212 million and $185 million, respectively. Since 1986, Enterprise has filed a consolidated Federal income tax return on behalf of itself and its subsidiaries. Prior to 1986, PSE&G filed consolidated tax returns. On March 20, 1992, the Internal Revenue Service (IRS) issued a Revenue Agents Report (RAR) following completion of examination of PSE&G's consolidated tax return for 1985 and Enterprise's consolidated tax returns for 1986 and 1987, proposing various adjustments for such years which would increase Enterprise's consolidated Federal income tax liability by approximately $121 million, exclusive of interest and penalties, of which approximately $118 million is attributable to PSE&G. Interest after taxes on these proposed adjustments is currently estimated to be approximately $82 million as of December 31, 1993 and will continue to accrue at the Federal rate for large corporate underpayments, currently 9% annually. The most significant of these proposed adjustments relates to the IRS contention that PSE&G's Hope Creek nuclear unit is a partnership with a short 1986 taxable year. In addition, the IRS contends that the tax in-service date of that unit is four months later than the date claimed by PSE&G. On June 19, 1992, Enterprise and PSE&G filed a protest with the IRS disagreeing with certain of the proposed adjustments (including those related to Hope Creek) contained in the RAR for taxable years 1985 through 1987 and continues to contest these issues. Any tax adjustments resulting from the RAR would reduce Enterprise's and PSE&G's respective deferred credits for accumulated deferred income taxes. Enterprise expects PSE&G to recover all interest paid with respect to tax adjustments attributable to PSE&G from PSE&G's customers through rates. While PSE&G believes that assessments attributable to it are generally recoverable from its customers in rates, no assurances can be given as to what regulatory treatment may be afforded by the BRC. On January 1, 1993, Enterprise adopted SFAS 109 without restating prior years' financial statements which resulted in Enterprise recording a $5.4 million cumulative effect increase in its net income. Under SFAS 109, deferred taxes are provided at the enacted statutory tax rate for all temporary differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities irrespective of the treatment for ratemaking purposes. Since management believes that it is probable that the effects of SFAS 109 on PSE&G, principally the accumulated tax benefits that previously have been treated as a flow-through item to customers, will be recovered from utility customers in the future, an offsetting regulatory asset was established. As of December 31, 1993, PSE&G had recorded a deferred tax liability and an offsetting regulatory asset of $790 million representing the future revenue expected to be recovered through rates based upon established regulatory practices which permit recovery of current taxes payable. This amount was determined using the 1993 Federal income tax rate of 35%. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SFAS 109 The following is an analysis of accumulated deferred income taxes: The Revenue Reconciliation Act of 1993, enacted in August 1993, increased the Federal corporate income tax rate from 34% to 35% effective January 1, 1993. This resulted in an increase in Federal income tax expense for Enterprise of $18.1 million for the year 1993. NOTE 10. LEASING ACTIVITIES As Lessee The Consolidated Balance Sheets include assets and related obligations applicable to capital leases where PSE&G is a lessee. The total amortization of the leased assets and interest on the lease obligations equals the net minimum lease payments included in rent expense for capital leases. Capital leases of PSE&G relate primarily to its corporate headquarters and other capital equipment. Certain of the leases contain renewal and purchase options and also contain escalation clauses. Enterprise and its other subsidiaries are not lessees in any capitalized leases. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Utility plant includes the following amounts for capital leases at December 31: Future minimum lease payments for noncancelable capital and operating leases at December 31, 1993 were: (A) Reflected in the Consolidated Balance Sheets in Capital Lease Obligations of $52.530 million and in Long-Term Debt and Capital Lease Obligations due within one year of $574 thousand. The following schedule shows the composition of rent expense included in Operating Expenses: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) AS LESSOR PSRC's net investments in leveraged and direct financing leases are composed of the following elements: PSRC's other leases are with various regional, state and city authorities for transportation equipment and aggregated $8 million and $12 million as of December 31, 1993 and 1992, respectively. NOTE 11. SHORT-TERM DEBT (COMMERCIAL PAPER AND LOANS) Commercial paper represents unsecured bearer promissory notes sold through dealers at a discount with a term of nine months or less. PSE&G Certain information regarding commercial paper follows: PSE&G has authorization from the BRC to issue and have outstanding not more than $800 million of its short-term obligations at any one time, consisting of commercial paper and other unsecured borrowings from banks and other lenders. This authorization expires December 31, 1994. PSE&G expects to be able to renew such authority. PSE&G has a $600 million revolving credit agreement with a group of banks which expires in September 1994. As of December 31, 1993, there was no short-term debt outstanding under this agreement. Fuelco has a $150 million commercial paper program to finance a 42.49% share of Peach Bottom nuclear fuel, supported by a $150 million revolving credit facility with a group of banks which expires in June 1996. PSE&G has guaranteed repayment of Fuelco's respective obligations. As of December 31, 1993, 1992 and 1991, Fuelco had commercial paper of $108.7 million, $122.5 million and $135.9 million, respectively, outstanding under such program, which amounts are included in the table above. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) EDHI Certain information regarding commercial paper follows: At December 31, 1993, Funding had a $225 million commercial paper program supported by a direct pay commercial bank letter of credit and revolving credit facility and a $225 million revolving credit facility each of which expires in November 1995. ENTERPRISE At each of December 31, 1993, 1992 and 1991, Enterprise had $25 million of lines of credit supported by compensating balances under informal arrangements with banks. At each of December 31, 1993, 1992 and 1991, Enterprise had no line of credit compensated for by fees. NOTE 12. COMMITMENTS AND CONTINGENT LIABILITIES NUCLEAR PERFORMANCE STANDARD The BRC has established a nuclear performance standard (Standard) for nuclear generating stations owned by New Jersey electric utilities, including the five nuclear units in which PSE&G has an ownership interest: Salem -- 42.59%; Hope Creek -- 95%; and Peach Bottom -- 42.49%. PSE&G operates Salem and Hope Creek, while Peach Bottom is operated by PECO. The penalty/reward under the Standard is a percentage of replacement power costs. (See table below.) The Standard provides that the penalties will be calculated to the edge of each capacity factor range. For example, a 30% penalty applies to replacement power costs incurred in the 55% to 65% range and a 40% penalty applies to replacement power costs in the 45% to 55% range. Under the Standard, the capacity factor is calculated annually using maximum dependable capability of the five nuclear units in which PSE&G owns an interest. This method takes into account actual operating conditions of the units. While the Standard does not specifically have a gross negligence provision, the BRC has indicated that it would consider allegations of gross negligence brought upon a sufficient factual basis. A finding of gross negligence could result in penalties other than those prescribed under the Standard. During 1993, the five nuclear units in which PSE&G has an ownership interest aggregated a 77% combined capacity factor. In accordance with the Standard, PSE&G's combined capacity factor exceeded the 75% reward threshold, entitling PSE&G to a reward of approximately $3.9 million. PSE&G will petition the BRC to recover this reward through the LEAC commencing on June 30, 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NUCLEAR INSURANCE COVERAGES AND ASSESSMENTS PSE&G's insurance coverages and maximum retrospective assessments for its nuclear operations are as follows: (A) Retrospective premium program under the Price-Anderson liability provisions of the Atomic Energy Act of 1954, as amended, (Price-Anderson). Subject to retrospective assessment with respect to loss from an incident at any licensed nuclear reactor in the United States. Assessment adjusted for inflation effective August 20, 1993. (B) Limit of liability for each nuclear incident under Price-Anderson. (C) Industry aggregate limit representing the potential liability from workers claiming exposure to the hazard of nuclear radiation. This policy includes automatic reinstatements up to an aggregate of $200 million, thereby providing total coverage of $400 million. This policy does not increase PSE&G's obligation under Price-Anderson. (D) Includes $100 million sublimit for premature decommissioning costs. (E) New policy effective January 1, 1994. (F) Includes up to $250 million for premature decommissioning costs. (G) In the event of a second industry loss triggering NEIL coverage, the maximum retrospective premium assessment can increase to $23.4 million. (H) Weekly indemnity for 52 weeks which commences after the first 21 weeks of an outage. Beyond the first 52 weeks of coverage indemnity of $2.3 million per week for 104 weeks is afforded. Total coverage amounts to $425.9 million over three years. Price-Anderson sets the "limit of liability" for claims that could arise from an incident involving any licensed nuclear facility in the nation. The "limit of liability" is based on the number of licensed nuclear reactors and is adjusted at least every five years based on the Consumer Price Index. The current "limit of liability" is $9.4 billion. All utilities owning a nuclear reactor, including PSE&G, have provided for this exposure through a combination of private insurance and mandatory participation in a financial protection pool as established by Price-Anderson. Under Price-Anderson, each party with an ownership interest in a nuclear reactor can be assessed its share of $79.3 million per reactor per incident, payable at $10 million per reactor NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) per incident per year. If the damages exceed the "limit of liability", the President is to submit to Congress a plan for providing additional compensation to the injured parties. Congress could impose further revenue raising measures on the nuclear industry to pay claims. PSE&G's maximum aggregate assessment per incident is $210.2 million (based on PSE&G's ownership interests in Hope Creek, Peach Bottom and Salem) and its maximum aggregate annual assessment per incident is $26.5 million. PSE&G purchases all property insurance available, including decontamination expense coverage and premature decommissioning coverage, with respect to loss or damage to its nuclear facilities. PECO has advised PSE&G that it maintains similar insurance coverage with respect to Peach Bottom. Under the terms of the various insurance agreements, PSE&G could be subject to a maximum retrospective assessment for a single incident of up to $28.3 million. Certain of the policies also provide that the insurer may suspend coverage with respect to all nuclear units on a site without notice if the NRC suspends or revokes the operating license for any unit on a site, issues a shutdown order with respect to such unit or issues a confirmatory order keeping such unit shut down. PSE&G is a member of an industry mutual insurance company, NEIL, which provides replacement power cost coverage in the event of a major accidental outage at a nuclear station. The policies provide for a weekly indemnity payment of $3.5 million for 52 weeks, subject to a 21-week waiting period. The policies provide for weekly indemnity payments of $2.3 million for a 104 week period beyond the first year's indemnity. The premium for this coverage is subject to retrospective assessment for adverse loss experience. Under the policies, PSE&G's present maximum share of any retrospective assessment in any year is $11.3 million. NUCLEAR FUEL As a result of the NEPA, all United States nuclear utilities are responsible to co-fund with the United States Government a decontamination and decommissioning fund for DOE nuclear fuel enrichment facilities. PSE&G is responsible for making annual payments into this fund for 15 years beginning in 1993. In September 1993, PSE&G paid its $4 million annual assessment based on its proportionate share of the five nuclear units in which it has an ownership interest. PSE&G deferred such amount and expects to recover it, together with its estimated $56 million future liability, from customers through its LEAC. (See Note 3 -- PSE&G Nuclear Decommissioning and Amortization of Nuclear Fuel -- Uranium Enrichment Decontamination and Decommissioning Fund.) CONSTRUCTION AND FUEL SUPPLIES PSE&G has substantial commitments as part of its ongoing construction program which includes capital requirements for nuclear fuel. PSE&G's construction program is continuously reviewed and periodically revised as a result of changes in economic conditions, revised load forecasts, changes in the scheduled retirement dates of existing facilities, changes in business plans, site changes, cost escalations under construction contracts, requirements of regulatory authorities and laws, the timing of and amount of electric and gas rate changes and the ability of PSE&G to raise necessary capital. Pursuant to an integrated electric resource plan (IRP), PSE&G periodically reevaluates its forecasts of future customers, load and peak growth, sources of electric generating capacity and DSM to meet such projected growth, including the need to construct new electric generating capacity. The IRP takes into account assumptions concerning future demands of customers, effectiveness of conservation and load management activities, the long-term condition of PSE&G's plants, capacity available from electric utilities and other suppliers and the amounts of cogeneration and other nonutility capacity projected to be available. Based on PSE&G's 1994-1998 construction program, construction expenditures are expected to aggregate approximately $4.2 billion, which includes $483 million for nuclear fuel and $133 million of AFDC and capitalized interest during the years 1994 through 1998. The estimate of construction requirements is based on expected project completion dates and includes anticipated escalation due to inflation of approximately 4%, annually. Therefore, construction delays or higher inflation levels could cause significant increases in these NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) amounts. PSE&G expects to generate internally a majority of the funds necessary to satisfy its construction expenditures over the next five years, assuming adequate and timely rate relief, as to which no assurances can be given. In addition, PSE&G does not presently anticipate any difficulties in obtaining sufficient sources of fuel for electric generation or adequate gas supplies during the years 1994 through 1998. BERGEN STATION REPOWERING PSE&G is presently engaged in Phase I of a construction project to renovate (or "repower") the Bergen Station pursuant to an air pollution control permit issued by New Jersey Department of Environmental Protection and Energy (NJDEPE) on May 27, 1993. The current effort would maintain the existing electric supply of the station (with a small increase from 629 MW to 669 MW), improve operational reliability and efficiency and significantly improve the environmental effects of operation of the facility. Phase II of the project, if it is undertaken by PSE&G, would increase the capacity of Bergen by an additional 650 MW. On July 12, 1993, an association of competitors of PSE&G appealed the NJDEPE's issuance of the air permit for Phase I of the project to the Appellate Division of the New Jersey Superior Court, alleging that PSE&G is first required to obtain a Certificate of Need under the New Jersey Need Assessment Act (Need Assessment Act). The NJDEPE determined that the Need Assessment Act was inapplicable to this renovation project. Obtaining a Certificate of Need would be a complex procedure entailing proceedings of at least a two year duration before the NJDEPE, the outcome of which could not be assured. As of December 31, 1993, Phase I of the renovation project was about 20% complete and PSE&G had spent approximately $169 million on this effort. The final cost is estimated to be approximately $400 million. Briefs have been filed in the appeal and PSE&G believes that a Certificate of Need is not required for Phase I of the project. However, if a Certificate of Need were ultimately required by the courts after exhaustion of all appeals, the permits needed to operate the plant could not be issued until after a Certificate of Need was obtained. PSE&G intends to continue this renovation project and to vigorously defend its position through all available means. ENVIRONMENT GENERAL Certain Federal and State laws authorize the United States Environmental Protection Agency (EPA) and the NJDEPE, among other agencies, to issue orders and bring enforcement actions to compel responsible parties to take investigative and remedial actions at any site that is determined to present an imminent and substantial danger to the public or the environment because of an actual or threatened release of one or more hazardous substances. Because of the nature of PSE&G's business, including the production of electricity, the distribution of gas and, formerly, the manufacture of gas, various by-products and substances are or were produced or handled which contain constituents classified as hazardous. PSE&G generally provides for the disposal or processing of such substances through licensed independent contractors. However, these statutory provisions impose joint and several responsibility without regard to fault on all responsible parties, including the generators of the hazardous substances, for certain investigative and remediation costs at sites where these substances were disposed of or processed. PSE&G has been notified with respect to a number of such sites and the remediation of these potentially hazardous sites is receiving greater attention from the government agencies involved. Generally, actions directed at funding such site investigations and remediation include all suspected or known responsible parties. PSE&G does not expect its expenditures for any such site to be material. PSE&G MANUFACTURED GAS PLANT REMEDIATION PROGRAM In March 1988, NJDEPE notified PSE&G that it had identified the need for PSE&G, pursuant to a formal arrangement, to systematically investigate and, if necessary, resolve environmental concerns extant at PSE&G's former manufactured gas plant sites. To date, NJDEPE and PSE&G have identified 38 former gas NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) plant sites. PSE&G is currently working with NJDEPE under a program to assess, investigate and, if necessary, remediate environmental concerns at its former gas plant sites (Remediation Program). The Remediation Program is periodically reviewed and revised by PSE&G based on regulatory requirements, experience with the Remediation Program and available technologies. The cost of the Remediation Program cannot be reasonably estimated, but experience to date indicates that costs of at least $20 million per year could be incurred over a period of more than 30 years and that the overall cost could be material. Costs incurred through December 31, 1993 for the Remediation Program amounted to $44.5 million, net of insurance recoveries. In addition, at December 31, 1993, PSE&G's liability for estimated remediation costs, net of insurance recoveries, through 1996 aggregated $111 million. In accordance with a Stipulation approved by the BRC on January 21, 1992, PSE&G is recovering $32 million of its actual remediation costs to reflect costs incurred through September 30, 1992, net of insurance recoveries, over a six-year period. In its 1992-93 LGAC, PSE&G refunded $0.3 million during the 1993 LGAC year and will recover $5.3 million in each of its next three LGAC periods ending in 1996, net of insurance recoveries. The regulatory treatment of the remediation costs covered by this Stipulation was not changed in the BRC's September 15, 1993 written order, allowing continued collection under the terms of the January 21, 1992 Stipulation. The decision of September 15, 1993 concluded that PSE&G had met its burden of proof for establishing the reasonableness and prudence of remediation costs incurred in operating and decommissioning these facilities in the past. The remediation costs incurred during the period July 1, 1992 through September 30, 1992 are subject to verification and audit in PSE&G's 1992-93 LGAC. The audit is currently ongoing. The order also approved a mechanism for costs incurred since October 1, 1992, allowing the recovery of actual costs plus carrying charges, net of insurance recoveries, over a seven-year period through PSE&G's LEAC and LGAC, with 60% charged to gas customers and 40% charged to electric customers. On November 1, 1993, the Public Advocate of New Jersey filed a motion requesting the BRC to reconsider its September 15, 1993 order. On January 21,1994, the BRC denied the motion. In November 1988, PSE&G filed suit against certain of its insurers to recover the costs associated with addressing and resolving environmental issues of the Remediation Program. PSE&G has settled its claim with one insurer and there is a trial scheduled for September 1994 with the remaining insurers. Pending full recovery of Remediation Program costs through rates or under its insurance policies, neither of which can be assured, PSE&G will be required to finance the unreimbursed costs of its Remediation Program. NOTE 13. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS On January 1, 1993, Enterprise and PSE&G adopted SFAS 106, which requires that the expected cost of employees' postretirement health care and insurance benefits be charged to expense during the years in which employees render service. PSE&G elected to amortize over 20 years its unfunded obligation of $609.3 million at January 1, 1993. Prior to 1993, Enterprise and PSE&G recognized postretirement health care and insurance costs in the year that the benefits were paid. The following table discloses the significant components of the January 1, 1993, accumulated postretirement benefit obligation amortization: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table discloses the significant components of the net periodic postretirement benefit obligation: The discount rate used in determining the PSE&G net periodic postretirement benefit cost was 7.5%. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase the aggregate of the service and interest cost components of net periodic postretirement health care cost by approximately $2.4 million, or 6.0%, and increase the accumulated postretirement benefit obligation as of December 31, 1993 by $29.3 million, or 6.0%. The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation in 1993 were: medical costs for pre-age sixty-five retirees -- 13.5%, medical costs for post-age retirees -- 9.5%, prescription drugs -- 18% and dental costs -- 7.5%, such rates are assumed to gradually decline to 5.5%, 5.0%, 5.5% and 5.0%, respectively, in 2010. In its recent base rate case, PSE&G requested full recovery of the costs associated with postretirement benefits other than pensions (OPEB) on an accrual basis, in accordance with SFAS 106. The BRC's December 31, 1992 base rate order, provided that (1) PSE&G's pay-as-you-go basis OPEB costs will continue to be included in cost of service and will be recoverable in base rates on a pay-as-you-go basis; (2) prudently incurred OPEB costs, that are accounted for on an accrual basis in accordance with SFAS 106, will be recoverable in future rates; (3) PSE&G should account for the differences between its OPEB costs on an accrual basis and the pay-as-you-go basis being recovered in rates as a regulatory asset; (4) the issue of cash versus accrual accounting will be revisited and in the event that the Financial Accounting Standards Board (FASB) or the SEC requires the use of accrual accounting for OPEB costs for ratemaking purposes, the regulatory asset will be recoverable, through rates, over an appropriate amortization period. Accordingly, PSE&G is accounting for the differences between its SFAS 106 accruals cost and the cash cost currently recovered through rates as a regulatory asset. OPEB costs charged to expense during 1993 were $28 million and accrued OPEB costs deferred were $58.6 million, including an increase of $25 million due to the recognition of PSE&G's obligation for life insurance benefits. The amount of the unfunded liability, at December 31, 1993, as shown below, is $657.0 million and funding options are currently being explored. The primary effect of adopting SFAS 106 on Enterprise's and PSE&G's financial reporting is on the presentation of their financial positions with minimal effect on their results of operations. In accordance with SFAS 106 disclosure requirements, a reconciliation of the funded status of the plan as of December 31, 1993, is as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The discount rate used in determining the accumulated postretirement benefit obligation as of December 31, 1993 was 7.25%. During January 1993 and subsequent to the receipt of the Order, the FASB's Emerging Issues Task Force (EITF) concluded that deferral of such costs is acceptable, provided regulators allow SFAS 106 costs in rates within approximately five years of the adoption of SFAS 106 for financial reporting purposes, with any cost deferrals recovered in approximately twenty years. PSE&G intends to request the BRC for full SFAS 106 recovery in accordance with the EITF's view of such standard and believes that it is probable that any deferred costs will be recovered from utility customers within such twenty year time period. NOTE 14. PENSION PLAN The discount rate, expected long-term return on assets and average compensation growth used in determining the Pension Plan's funded status as of December 31, 1993 and 1992, and net pension costs for 1993, 1992 and 1991, were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table shows the Pension Plan's funded status: The net pension cost for the years ending December 31, 1993, 1992 and 1991, include the following components: Supplemental pension costs in 1993, 1992 and 1991, were $168,000, $299,000 and $419,000, respectively. See Note 1 -- Organization and Summary of Significant Accounting Policies. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 15. FINANCIAL INFORMATION BY BUSINESS SEGMENTS Information related to the segments of Enterprise's business is detailed below: (A) The Nonutility Activities include amounts applicable to Enterprise, the parent corporation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 16. PROPERTY IMPAIRMENT OF ENTERPRISE GROUP DEVELOPMENT CORPORATION As a result of a management review of each property's current value and the potential for increasing such value through operating and other improvements, EGDC recorded an impairment related to certain of its properties, including properties upon which EDHI's management revised its intent from a long-term investment strategy to a hold for sale status, reflecting such properties on its books at their net realizable value. This impairment reduced the estimated value of EGDC's properties by $77.6 million and net income by $50.5 million, after tax, or 21 cents per share of Enterprise common stock. EGDC's real estate held for sale of $33.8 million and $6.7 million at December 31, 1993 and 1992 are presented in "Other Investments -- net" and "Current Assets", respectively, in the accompanying consolidated balance sheets. NOTE 17. JOINTLY-OWNED FACILITIES -- UTILITY PLANT PSE&G, has ownership interests and is responsible for providing its share of the necessary financing for the following jointly-owned facilities. All amounts reflect the share of jointly-owned projects and the corresponding direct expenses are included in Consolidated Statements of Income as an operating expense. (See Note 1 -- Organization and Summary of Significant Accounting Policies.) NOTE 18. SELECTED QUARTERLY DATA (UNAUDITED) The information shown below in the opinion of Enterprise includes all adjustments, consisting only of normal recurring accruals, necessary to a fair presentation of such amounts. Due to the seasonal nature of the utility business, quarterly amounts vary significantly during the year. PUBLIC SERVICE ELECTRIC AND GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PSE&G Except as modified below the Notes to Consolidated Financial Statements of Enterprise are incorporated herein by reference insofar as they relate to PSE&G and its subsidiaries: Note 1. Organization and Summary of Significant Accounting Policies, Note 2. Rate Matters, Note 3. PSE&G Nuclear Decommissioning and Amortization of Nuclear Fuel, Note 4. Schedule of Consolidated Capital Stock, Note 5. Deferred Items, Note 6. Schedule of Consolidated Long-Term Debt, Note 7. Long-Term Investments, Note 8. Cash and Cash Equivalents, Note 10. Leasing Activities -- As Lessee, Note 11. Short-Term Debt (Commercial Paper and Loans), Note 12. Commitments and Contingent Liabilities, Note 13. Postretirement Benefits Other Than Pensions, Note 14. Pension Plan and Other Postemployment Benefits, Note 15. Financial Information by Business Segments and Note 17. Jointly-Owned Facilities -- Utility Plant. NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION PSE&G is an operating public utility, providing electric and gas service in certain areas of New Jersey. PSE&G is the principal subsidiary of Enterprise, which owns all of PSE&G's common stock (without nominal or par value). Of the 150,000,000 authorized shares of such common stock at December 31, 1993, 1992 and 1991, there were 132,450,344 shares outstanding, with an aggregate value of $2,563,003,000. Enterprise has claimed an exemption from regulation by the Securities and Exchange Commission as a registered holding company under the Public Utility Holding Company Act of 1935, except for Section 9(a)(2) which relates to the acquisition of voting securities of an electric or gas utility company. PSE&G has a nonutility finance subsidiary, Fuelco, providing financing, unconditionally guaranteed by PSE&G, not to exceed $150 million aggregate principal amount at any one time of a 42.49% undivided interest in the nuclear fuel acquired for Peach Bottom. PSE&G also has organized a nonutility subsidiary, PSCRC, which offers DSM services to utility customers. CONSOLIDATION POLICY The consolidated financial statements include the accounts of PSE&G and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications of prior years' data have been made to conform with the current presentation. NOTE 6. SCHEDULE OF CONSOLIDATED LONG-TERM DEBT At December 31, 1993, the annual interest requirement on long-term debt was $331.5 million, of which $327.5 million was the requirement for Bonds. The embedded interest cost on long-term debt was 7.85%. NOTE 8. CASH AND CASH EQUIVALENTS The December 31, 1993 and 1992 balances consist primarily of working funds. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. FEDERAL INCOME TAXES A reconciliation of reported Net Income with pretax income and of Federal income tax expense with the amount computed by multiplying pretax income by the statutory Federal income tax rates of 35% in 1993 and 34% in 1992 and 1991 is as follows: Reconciliation between total Federal income tax provisions and tax computed at the statutory tax rate on pretax income: (A) The provision for deferred income taxes represents the tax effects of the following items: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SFAS 109 The following is an analysis of accumulated deferred income taxes: The Revenue Reconciliation Act of 1993, enacted in August 1993, increased the Federal corporate income tax rate from 34% to 35% effective January 1, 1993. This resulted in an increase in Federal income tax expense for PSE&G of $9.2 million for the year ended December 31, 1993. The balance of Federal income tax payable by PSE&G to Enterprise was zero and $7 million, as of December 31, 1993 and December 31, 1992, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 18. SELECTED QUARTERLY DATA (UNAUDITED) The information shown below, in the opinion of PSE&G, includes all adjustments, consisting only of normal recurring accruals, necessary to a fair presentation of such amounts. Due to the seasonal nature of the utility business, quarterly amounts vary significantly during the year. NOTE 19. ACCOUNTS PAYABLE TO ASSOCIATED COMPANIES -- NET The balances at December 31, consisted of the following: (A) Liability for gas purchased. PART III ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Enterprise and PSE&G, none. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS. DIRECTORS OF THE REGISTRANTS ENTERPRISE The information required by Item 10 of Form 10-K with respect to present directors who are nominees for election as directors at Enterprise's Annual Meeting of Stockholders to be held on April 19, 1994, and directors whose terms will continue beyond the meeting, is set forth under the heading "Election of Directors" in Enterprise's definitive Proxy Statement for such Annual Meeting of Stockholders, which definitive Proxy Statement is expected to be filed with the Securities and Exchange Commission on or about March 1, 1994 and which information set forth under said heading is incorporated herein by this reference thereto. The information with respect to present directors who have reached the mandatory retirement age for directors and thus will not be standing for election follows. There is shown as to each information as to the period of service as a director of Enterprise (and PSE&G prior to the formation of Enterprise), age as of April 19, 1994, present committee memberships, business experience during the last five years and other present directorships. ROBERT R. FERGUSON, JR. has been a director since 1981. Age 70. Director of Enterprise and PSE&G. Was Chairman of the Board, President and Chief Executive Officer of First Fidelity Bancorporation, Newark, New Jersey, from December 1988 until his retirement in February 1990; Chairman of the Board of First Fidelity, Inc., from March 1988 until February 1990, and Chairman of the Board of First Fidelity Bank, N.A., New Jersey from 1984 until February 1990. Was Chairman of the Board of First Fidelity Bancorporation from March 1988 to December 1988, and President and Chief Executive Officer, First Fidelity Bancorporation, from 1985 to March 1988. WILLIAM E. MARFUGGI has been a director since 1980. Age 70. Director of Enterprise and its subsidiary, EDHI. Was Chairman of Tri-Maintenance & Contractors, Inc. (provides property management and facility maintenance services) from August 1989 until 1993. Was Chairman of the Board of Victory Optical Manufacturing Company and Plaza Sunglasses Inc., both of Newark, New Jersey, from 1973 until 1989. PSE&G Pursuant to the Focused Audit Implementation Plan (see Item 1. Business -- Regulation), effective July 20, 1993, Harold W. Borden, Jr., Thomas M. Crimmins, Jr., Robert J. Dougherty, Jr., Robert C. Murray, R. Edwin Selover and Rudolph D. Stys, each of whom is an officer of PSE&G, resigned as directors of PSE&G and the persons shown below, except for Lawrence R. Codey and E. James Ferland, each of whom remained as a director, were elected as directors of PSE&G to serve until the next Annual Meeting of Stockholders of PSE&G, to be held April 19, 1994, and until each of their successors are duly elected and qualified. There is shown as to each present director information as to the period of service as a director of PSE&G, age as of April 19, 1994, present committee memberships, business experience during the last five years and other present directorships. LAWRENCE R. CODEY has been a director since 1988. Age 49. Member of Executive Committee. Has been President and Chief Operating Officer of PSE&G since September 1991. Was Senior Vice President-Electric of PSE&G from January 1989 to September 1991. Director of Enterprise. Director of Sealed Air Corporation, The Trust Company of New Jersey, United Water Resources Inc., Hackensack Water Company, Rivervale Realty Company Inc. and Blue Cross & Blue Shield of New Jersey. ROBERT R. FERGUSON, JR. has been a director since July 20, 1993. Was previously a director from 1981 to February 1988. For additional information, see Enterprise, above. E. JAMES FERLAND has been a director since 1986, and Chairman of the Board, President and Chief Executive Officer of Enterprise since July 1986, Chairman of the Board and Chief Executive Officer of PSE&G since September 1991, and Chairman of the Board and Chief Executive Officer of EDHI since June 1989. Age 52. Chairman of Executive Committee. President of PSE&G from July 1986 to September 1991. Director of Enterprise and of EDHI and its subsidiaries, CEA, EDC, PSRC, EGDC, Capital and Funding. Director of First Fidelity Bancorporation, First Fidelity Bank, N.A., Foster Wheeler Corporation and The Hartford Steam Boiler Inspection and Insurance Company. RAYMOND V. GILMARTIN has been a director since July 20, 1993. Age 53. Director of Enterprise. Has been Chairman of the Board, President and Chief Executive Officer of Becton Dickinson and Company, Franklin Lakes, New Jersey (manufactures medical devices and diagnostic systems) since November 1992. Was President and Chief Executive Officer of Becton Dickinson and Company from February 1989 to November 1992 and President from September 1987 to February 1989. Director of Becton Dickinson and Company and Capital Holding Corp. SHIRLEY A. JACKSON has been a director since July 20, 1993. Was previously a director from 1987 to February 1988. Age 47. Director of Enterprise. Has been Professor of Physics, Rutgers University, since 1991 and has been a theoretical physics consultant since 1991 and was a theoretical physicist from 1976 to 1991 at AT&T Bell Laboratories (performs research and development in areas related to telecommunications for American Telephone and Telegraph Company). Director of Core States Financial Corporation, Core States/New Jersey National Bank, New Jersey Resources Corporation and Sealed Air Corporation. Trustee of Massachusetts Institute of Technology. IRWIN LERNER has been a director since July 20, 1993. Was previously a director from 1981 to February 1988. Age 63. Director of Enterprise. Was Chairman, Board of Directors and Executive Committee from January 1993 to September 1993 and President and Chief Executive Officer from 1980 to December 1992 of Hoffmann-La Roche Inc., Nutley, New Jersey (manufactures pharmaceuticals, vitamins, fine chemicals and provides home health care and diagnostic products and services). Director of Humana Inc. and Affymax, N.V. JAMES C. PITNEY has been a director since July 20, 1993. Was previously a director from 1979 to February 1988. Age 67. Member of Executive Committee. Director of Enterprise. Has been a partner in the law firm of Pitney, Hardin, Kipp & Szuch, Morristown, New Jersey, since 1958, Director of Seligman Capital Fund, Inc., Seligman Cash Management Fund, Inc., Seligman Common Stock Fund, Inc., Seligman Communications and Information Fund, Inc., Seligman Frontier Fund, Inc., Seligman Growth Fund, Inc., Seligman High Income Fund Series, Inc., Seligman Income Fund, Inc., Seligman Mutual Benefit Portfolios, Inc., Seligman New Jersey Tax-Exempt Fund, Inc., Seligman Pennsylvania Tax-Exempt Fund Series, Seligman Tax-Exempt Fund Series, Inc., Seligman Tax-Exempt Series Trust, Inc., Seligman Quality Fund, Inc., Seligman Select Municipal Fund, Inc. and Tri-Continental Corporation. EXECUTIVE OFFICERS OF THE REGISTRANTS The following table sets forth certain information concerning the executive officers of Enterprise and PSE&G, respectively. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ENTERPRISE The information required by Item 11 of Form 10-K is set forth under the heading "Executive Compensation" in Enterprise's definitive Proxy Statement for the Annual Meeting of Stockholders to be held April 19, 1994, which definitive Proxy Statement is expected to be filed with the Securities and Exchange Commission on or about March 1, 1994 and such information set forth under such heading is incorporated herein by this reference thereto. PSE&G Information regarding the compensation of the Chief Executive Officer and the four most highly compensated executive officers of PSE&G as of December 31, 1993 is set forth below. Amounts shown were paid or awarded for all services rendered to Enterprise and its subsidiaries and affiliates including PSE&G. SUMMARY COMPENSATION TABLE - --------------- (1) Due to pay schedules, 1992 amounts reflect one additional pay period per individual compared to 1993 and 1991. (2) Amount awarded in given year was earned under Management Incentive Compensation Plan (MICP) and determined in following year with respect to the given year based on individual performance and financial and operating performance of Enterprise and PSE&G, including comparison to other companies. Award is accounted for as market-priced phantom stock with dividend reinvestment at 95% of market price, with payment made over three years beginning in second year following grant. (3) Granted under Long-Term Incentive Plan in tandem with equal number of performance units and dividend equivalents which may provide cash payments, dependent upon future financial performance of Enterprise in comparison to other companies and dividend payments by Enterprise, to assist officers in exercising options granted. (4) Employer contribution to Thrift and Tax-Deferred Savings Plan and value of 5% discount on phantom stock dividend reinvestment under MICP: (5) The 1993 MICP award amount has not yet been determined. The target award is 40% of salary for Mr. Ferland, 30% for Mr. Codey, 25% for Messrs. Murray and Dougherty and 20% for Mr. Selover. The target award is adjusted to reflect Enterprise's comparative return on common equity, PSE&G's comparative electric and gas costs and individual performance. (6) Amount paid pursuant to Mr. Murray's employment agreement. (See below). (7) Mr. Murray commenced employment January 6, 1992. OPTION GRANTS IN LAST FISCAL YEAR (1993) - --------------- (1) Granted under Long-Term Incentive Plan in tandem with equal number of performance units and dividend equivalents which may provide cash payments, dependent on future financial performance of Enterprise in comparison to other companies and dividend payments by Enterprise, to assist individuals in exercising options, with exercisability commencing January 1, 1996. (2) All options reported have a ten-year term, as noted. Amounts shown represent hypothetical future values at such term based upon hypothetical price appreciation of Enterprise Common Stock and may not necessarily be realized. Actual values which may be realized, if any, upon any exercise of such options, will be based on the market price of Enterprise Common Stock at the time of any such exercise and thus are dependent upon future performance of Enterprise Common Stock. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR (1993) AND FISCAL YEAR-END OPTION VALUES (12/31/93) - --------------- (1) Does not reflect any options granted and/or exercised after year-end (12/31/93). The net effect of any such grants and exercises is reflected in the table appearing under Security Ownership of Directors and Management. (2) Represents difference between exercise price and market price of Enterprise Common Stock on date of exercise. (3) Represents difference between market price of Enterprise Common Stock and the respective exercise prices of the options at fiscal year-end (12/31/93). Such amounts may not necessarily be realized. Actual values which may be realized, if any, upon any exercise of such options will be based on the market price of Enterprise Common Stock at the time of any such exercise and thus are dependent upon future performance of Enterprise Common Stock. EMPLOYMENT CONTRACTS AND ARRANGEMENTS Employment agreements were entered into with Messrs. Ferland and Murray at the time of their employment. For Mr. Ferland, the remaining applicable provisions of these agreements provide for additional credited service for pension purposes in the amount of 22 years. The principal remaining applicable terms of the agreement with Mr. Murray provide for payment of severance in the amount of one year's salary, if discharged without cause during his first five years of employment, for lump sum cash payments of $75,000 in 1993, $50,000 in 1994 and $25,000 in 1995 to align Mr. Murray with MICP payments for other executive officers, and additional years of credited service for pension purposes for allied work experience of five years after completion of five years of employment, and up to fifteen years after completion of ten years of service. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION PSE&G does not have a compensation committee. Decisions regarding compensation of PSE&G's executive officers are made by the Organization and Compensation Committee of Enterprise. Hence, during 1993 the PSE&G Board of Directors did not have, and no officer, employee or former officer of PSE&G participated in any deliberations of such Board, concerning executive officer compensation. In December 1993, Mr. Codey was elected as a director of Sealed Air Corporation, the President and Chief Executive Officer of which, T.J. Dermot Dunphy, served as a director and member of the Organization and Compensation Committee of Enterprise during 1993. COMPENSATION OF DIRECTORS AND CERTAIN BUSINESS RELATIONSHIPS A director who is not an officer of Enterprise or its subsidiaries and affiliates, including PSE&G, is paid an annual retainer of $20,000 and a fee of $1,000 for attendance at any Board or committee meeting, inspection trip, conference or other similar activity relating to Enterprise, PSE&G or EDHI. Enterprise has a Retirement Plan for outside directors. Each of the outside directors of PSE&G is also an outside director of Enterprise. Under this Plan, directors with five years of service who have not been employees of Enterprise or its subsidiaries, who leave service after age 65, or for disability, receive an annual retirement benefit payable for life equal to the annual Board retainer in effect at the time the director's service terminates. The benefit payment is prorated for directors with less than 10 years of service on the Board. Dr. Shirley A. Jackson, a director of Enterprise and PSE&G, is the liaison member for the Board of Directors on and Chair of PSE&G's Nuclear Oversight Committee (NOC). The NOC met five times during 1993, with each meeting lasting two days. In accordance with the compensation policy for all NOC members, Dr. Jackson receives an annual retainer of $28,000 and $1,000 per day for each NOC meeting attended. COMPENSATION PURSUANT TO PENSION PLANS PENSION PLAN TABLE The above table illustrates annual retirement benefits expressed in terms of single life annuities based on the average final compensation and service shown and retirement at age 65. A person's annual retirement benefit is based upon a percentage that is equal to years of credited service plus 30, but not more than 75%, times average final compensation at the earlier of retirement, attainment of age 65 or death. These amounts are reduced by Social Security benefits and certain retirement benefits from other employers. Pensions in the form of joint and survivor annuities are also available. Average final compensation, for purposes of retirement benefits of executive officers, is generally equivalent to the average of the aggregate of the salary and bonus amounts reported in the Summary Compensation Table above under 'Annual Compensation' for the five years preceeding retirement, not to exceed 120% of the average annual salary for such five year period. Messrs. Ferland, Codey, Murray, Dougherty and Selover will have accrued approximately 48, 41, 39, 48 and 43 years of credited service, respectively, as of age 65. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ENTERPRISE The information required by Item 12 of Form 10-K with respect to directors and executive officers is set forth under the heading 'Security Ownership of Directors and Management' in Enterprise's definitive Proxy Statement for the Annual Meeting of Stockholders to be held April 19, 1994, which definitive Proxy Statement is expected to be filed with the Securities and Exchange Commission on or about March 7, 1994 and such information set forth under such heading is incorporated herein by this reference thereto. PSE&G All of PSE&G's 132,450,344 outstanding shares of Common Stock are owned beneficially and of record by PSE&G's parent, Enterprise, 80 Park Plaza, P.O. Box 1171, Newark, New Jersey. The following table sets forth beneficial ownership of Enterprise Common Stock by the directors and executive officers named below as of February 23, 1994. None of these amounts exceed 1% of the Enterprise Common Stock outstanding at such date. No director or executive officer owns any PSE&G Preferred Stock of any class. - --------------- (1) Disclaims beneficial ownership of 472 shares. Has options to purchase 8,700 additional shares. (2) Includes the equivalent of 588 shares held under Thrift and Tax-Deferred Savings Plan. Has options to purchase 6,500 additional shares. (3) Includes the equivalent of 8,087 shares held under Thrift and Tax-Deferred Savings Plan. Has options to purchase 16,800 additional shares. (4) Includes the equivalent of 377 shares held under Thrift and Tax-Deferred Savings Plan. Has options to purchase 5,400 additional shares. (5) Disclaims beneficial ownership of 273 shares. Has options to purchase 6,200 additional shares. (6) Includes 745 shares owned by relatives as to which beneficial ownership is disclaimed. Also includes the equivalent of 9,711 shares held under Thrift and Tax-Deferred Savings Plan. All directors and executive officers as a group have options to purchase 55,600 additional shares. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. ENTERPRISE The information required by Item 13 of Form 10-K is set forth under the heading "Executive Compensation" in Enterprise's definitive Proxy Statement for the Annual Meeting of Stockholders to be held April 19, 1994, which definitive Proxy Statement is expected to be filed with the Securities and Exchange Commission on or about March 1, 1994. Such information set forth under such heading is incorporated herein by this reference thereto. PSE&G None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Financial Statements: (1) Enterprise Consolidated Statements of Income for the years ended December 31, 1993, 1992, and 1991, on page 55. Enterprise Consolidated Balance Sheets for the years ended December 31, 1993 and 1992, on pages 56 and 57. Enterprise Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 on page 58. Enterprise Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 on page 59. Enterprise Notes to Consolidated Financial Statements on pages 65 through 90. (2) PSE&G Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991, on page 60. PSE&G Consolidated Balance Sheets for the years ended December 31, 1993 and 1992, on pages 61 and 62. PSE&G Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 on page 63. PSE&G Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 on page 64. PSE&G Notes to Consolidated Financial Statements on pages 91 through 94. (b) The following documents are filed as a part of this report: (1) Enterprise Financial Statement Schedules: Schedule V -- Property, Plant and Equipment for each of the three years in the period ended December 31, 1993 (pages 105 through 107). Schedule VI -- Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment for each of the three years in the period ended December 31, 1993 (pages 108 through 110). Schedule VIII -- Valuation and Qualifying Accounts for each of the three years in the period ended December 31, 1993 (page 111). Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the consolidated financial statements or notes thereto. (2) PSE&G Financial Statement Schedules: Schedule V -- Property, Plant and Equipment for each of the three years in the period ended December 31, 1993 (pages 112 through 114). Schedule VI -- Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment for each of the three years in the period ended December 31, 1993 (pages 115 through 117). Schedule VIII -- Valuation and Qualifying Accounts for each of the three years in the period ended December 31, 1993 (page 118). Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the consolidated financial statements or notes thereto. (c) The following exhibits are filed herewith: (1) Enterprise: (See Exhibit Index on pages 121 through 127). (2) PSE&G: (See Exhibit Index on pages 128 through 133). (d) The following reports on Form 8-K were filed by the registrant(s) named below during the last quarter of 1993 and the 1994 period covered by this report under Item 5: - --------------- * Indicates employment agreement. SCHEDULE V PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 NOTES: (A) Interaccount and interdepartment transfers. (B) Includes amortization of discount on the Hope Creek indirect disallowance of $2,113,299. (C) Additions to Construction Work in Progress (CWIP) is net of transfers of completed construction of $249,363,488. (D) Includes $77.6 million EGDC property impairment and reclassifications of $33.8 million to assets held for sale. Descriptions of Utility Plant and Related Depreciation and Amortization -- PSE&G and Oil and Gas Accounting -- EDC are set forth in Note 1 -- Organization and Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements. SCHEDULE V PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1992 NOTES: (A) Interaccount and interdepartment transfers. (B) Includes amortization of discount on the Hope Creek indirect disallowance of $1,676,456, and an increase in the Hope Creek indirect disallowance of 6,191,172 resulting from the rate case settlement. (C) Additions to Construction Work in Progress (CWIP) is net of transfers of completed construction of $358,917,902. (D) Consolidation of partnership interests. Descriptions of Utility Plant and Related Depreciation and Amortization -- PSE&G and Oil and Gas Accounting -- EDC are set forth in Note 1 -- Organization and Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements. SCHEDULE V PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 NOTES: (A) Interaccount and interdepartment transfers. (B) Includes amortization of discount on the Hope Creek indirect disallowance of $1,686,000. (C) Additions to Construction Work in Progress (CWIP) is net of transfers of completed construction of $477,201,000. (D) Consolidation of partnership interests. Descriptions of Utility Plant and Related Depreciation and Amortization -- PSE&G and Oil and Gas Accounting -- EDC are set forth in Note 1 -- Organization and Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements. SCHEDULE VI PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 NOTES: (A) Interaccount and interdepartment transfers. (B) Reclassification of accumulated depreciation for real estate held for sale to other investments -- net. SCHEDULE VI PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1992 NOTES: (A) Interaccount and interdepartment transfers. SCHEDULE VI PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 NOTES: (A) Interaccount and interdepartment transfers. SCHEDULE VIII PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993 -- DECEMBER 31, 1991 NOTES: (A) Accounts Receivable/Investments written off. (B) Amortization of discount to income. SCHEDULE V PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE V -- PROPERTY, PLANT, AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 NOTES: (A) Interaccount and interdepartment transfers. (B) Includes amortization of discount on the Hope Creek indirect disallowance of $2,113,299. (C) Additions to Construction Work in Progress (CWIP) is net of transfers of completed construction of $249,363,488. Description of Utility Plant and Related Depreciation and Amortization is set forth in Note 1 -- Organization and Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements. SCHEDULE V PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE V -- PROPERTY, PLANT, AND EQUIPMENT YEAR ENDED DECEMBER 31, 1992 NOTES: (A) Interaccount and interdepartment transfers. (B) Includes amortization of discount on the Hope Creek indirect disallowance of $1,676,456, and an increase in the Hope Creek indirect disallowance of $6,191,172 resulting from the recent rate case settlement. (C) Additions to Construction Work in Progress (CWIP) is net of transfers of completed construction of $358,917,902. Description of Utility Plant and Related Depreciation and Amortization is set forth in Note 1 -- Organization and Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements. SCHEDULE V PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE V -- PROPERTY, PLANT, AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 NOTES: (A) Interaccount and interdepartment transfers. (B) Includes amortization of discount on the Hope Creek indirect disallowance of $1,686,000. (C) Additions to Construction Work in Progress (CWIP) is net of transfers of completed construction of $447,201,000. Description of Utility Plant and Related Depreciation and Amortization is set forth in Note 1 -- Organization and Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements. SCHEDULE VI PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 NOTE: (A) Interaccount and interdepartment transfers. SCHEDULE VI PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1992 NOTE: (A) Interaccount and interdepartment transfers. SCHEDULE VI PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 NOTE: (A) Interaccount and interdepartment transfers. SCHEDULE VIII PUBLIC SERVICE ELECTRIC AND GAS COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993 -- DECEMBER 31, 1991 Notes: (A) Accounts Receivable written off. (B) Amortization of discount to income. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED By E. JAMES FERLAND ------------------------------- E. James Ferland Chairman of the Board, President and Chief Executive Officer Date: February 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PUBLIC SERVICE ELECTRIC AND GAS COMPANY By E. JAMES FERLAND -------------------------------- E. James Ferland Chairman of the Board and Chief Executive Officer Date: February 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EXHIBIT INDEX Certain Exhibits previously filed with the Commission and the appropriate securities exchanges are indicated as set forth below. Such Exhibits are not being refiled, but are included because inclusion is desirable for convenient reference. (a) Filed by PSE&G with Form 8-A under the Securities Exchange Act of 1934, on the respective dates indicated, File No. 1-973. (b) Filed by PSE&G with Form 8-K under the Securities Exchange Act of 1934, on the respective dates indicated, File No. 1-973. (c) Filed by PSE&G with Form 10-K under the Securities Exchange Act of 1934, on the respective dates indicated, File No. 1-973. (d) Filed by PSE&G with Form 10-Q under the Securities Exchange Act of 1934, on the respective dates indicated, File No. 1-973. (e) Filed by Enterprise with Form 10-K under the Securities Exchange Act of 1934, on the respective dates indicated, File No. 1-9120. (f) Filed with registration statement of PSE&G under the Securities Exchange Act of 1934, File No. 1-973, effective July 1, 1935, relating to the registration of various issues of securities. (g) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-4995, effective May 20, 1942, relating to the issuance of $15,000,000 First and Refunding Mortgage Bonds, 3% Series due 1972. (h) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-7568, effective July 1, 1948, relating to the proposed issuance of 200,000 shares of Cumulative Preferred Stock. (i) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-8381, effective April 18, 1950, relating to the issuance of $26,000,000 First and Refunding Mortgage Bonds, 2 3/4% Series due 1980. (j) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-12906, effective December 4, 1956, relating to the issuance of 1,000,000 shares of Common Stock. (k) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-59675, effective September 1, 1977, relating to the issuance of $60,000,000 First and Refunding Mortgage Bonds, 8 1/8% Series I due 2007. (l) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-60925, effective March 30, 1978, relating to the issuance of 750,000 shares of Common Stock through an Employee Stock Purchase Plan. (m) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-65521, effective October 10, 1979, relating to the issuance of 3,000,000 shares of Common Stock. (n) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 2-74018, filed on June 16, 1982, relating to the Thrift Plan of PSE&G. (o) Filed with registration statement of Public Service Enterprise Group Incorporated under the Securities Act of 1933, No. 33-2935 filed January 28, 1986, relating to PSE&G's plan to form a holding company as part of a corporate restructuring. (p) Filed with registration statement of PSE&G under the Securities Act of 1933, No. 33-13209 filed April 9, 1987, relating to the registration of $575,000,000 First and Refunding Mortgage Bonds pursuant to Rule 415. ENTERPRISE PSE&G

75208_1993.txt

75208_1993

1993

75208

ITEM 1. BUSINESS Overseas Shipholding Group, Inc. (the "registrant") and its subsidiaries (collectively the "Company") constitute a major international shipping enterprise owning and operating a diversified fleet of oceangoing bulk cargo vessels (principally tankers and dry bulk carriers). The Company's operating bulk fleet consists of 58 vessels having an aggregate carrying capacity of approximately 5,434,700 deadweight tons ("DWT"), including ten ships aggregating approximately 1,536,300 DWT which the Company owns jointly with others and in which the Company has at least a 49% interest.* Sixteen vessels in the Company's operating bulk fleet, which total approximately 993,350 DWT and represent about 30% of the Company's investment in bulk cargo vessels at cost, are registered under the U.S. flag; the balance are registered under foreign flags. Thirty-nine tankers account for 73% of the total tonnage, and 18 dry bulk carriers and a pure car carrier account for the remainder. A single company and its subsidiaries, for and under the direction and control of the Company, act as agents in respect of the bulk fleet of the registrant's majority-owned subsidiaries and certain of its bulk shipping joint ventures. - ---------------- * Except as otherwise noted, references herein to the Company's "operating bulk fleet" are as of March 7, 1994 and denote the 58 vessels referred to above, including eight vessels that are leased from financial institutions under bareboat charters having remaining terms of from 8 to 18 years, but do not include a 29,300 DWT petroleum barge, which is owned by a partnership in which the Company has a 50% interest, a 50%-owned 252,350 DWT tanker contracted for sale in February 1994 (scheduled to be delivered to the buyer upon completion of a charter at the end of March 1994), or the six vessels more fully described under "Vessels on Order" below. The Company's passenger cruise business joint venture which the Company entered into in October 1992, Celebrity Cruise Lines Inc. ("CCLI"), owns and operates five cruise ships marketed under the trade names of Celebrity Cruises and Fantasy Cruises. As of March 7, 1994, CCLI had on order two 1,760-passenger cruise ships scheduled for delivery in late 1995 and 1996, respectively, and held an option for a third sistership (which it has since exercised), all for the Celebrity fleet. See "Investment in Cruise Business" below. The Company's operating bulk fleet, aggregating approximately 5,434,700 DWT, represents approximately 1% of the total world tonnage of oceangoing bulk cargo vessels. At January 1, 1994, the average age of the Company's international fleet as well as its international tanker fleet (in each case excluding non-Company interests in jointly-owned ships) was approximately 11.5 years compared with reported worldwide averages of approximately 13 years for each fleet. As of March 7, 1994, the Company had on order six double-hulled tankers, aggregating nearly one million DWT of newbuildings, for delivery to its international bulk fleet. See "Vessels on Order" below. The Company charters its ships to commercial shippers and U.S. and foreign governmental agencies for the carriage of bulk commodities, principally crude oil and petroleum products, coal, iron ore and grain. Generally, each ship is chartered for a specific period of time ("time charter"), or for a specific voyage or voyages ("voyage charter"). Under the terms of time and voyage charters covering the Company's vessels, the ships are equipped and operated by the Company and are manned by personnel in the Company's employ. From time to time, the Company also has some of its vessels on bareboat charter. Under the terms of bareboat charters, the ships are chartered for fixed periods of time (generally medium-or long-term) during which they are operated and manned by the charterer. Generally, the Company's ships engage in carriage of cargo in various parts of the world, principally in carriage of petroleum from Alaska to the lower 48 states and U.S. territories, from Caribbean ports to United States, South American and European ports, from Mediterranean, West African, Arabian Gulf and Far East ports to European, United States, Caribbean, South American and Far East ports, and in the United States coastwise trade, and in carriage of dry cargo between United States ports and the Far East, between United States East Coast and Gulf ports and European, Mediterranean, Black Sea and Baltic ports, between South American and various European, Black Sea and Baltic ports, and from Australia to Japan, Korea and European ports. The Company does not employ any container or similar vessels in its operation. Revenues from carriage of petroleum and its derivatives represented approximately 75% of the voyage revenues of the registrant and its majority-owned subsidiaries for 1993, 78% for 1992 and 75% for 1991. Revenues from carriage of dry cargo accounted for the balance of such voyage revenues for each of those years. The carriage of petroleum and its derivatives also accounted for the majority of the voyage revenues of the Company's bulk shipping joint ventures. The relative contributions to voyage revenues of the various types of cargoes carried may vary from year to year, depending upon demand for particular kinds of carriage and the purposes for which and the terms on which the ships are chartered. As of March 28, 1994, with the exception of three U.S.- flag crude oil carriers and one U.S.-flag dry bulk carrier, all of the vessels in the Company's operating bulk fleet were employed. Fifty of these vessels were chartered to non-governmental commercial shippers. These 50 ships include nine U.S.-flag ships and 41 foreign-flag ships, which together represent approximately 89% of the combined carrying capacity of the Company's operating bulk fleet. Of the remaining ships in the Company's operating bulk fleet, three U.S.-flag ships and two foreign-flag ships were under charter to foreign governmental agencies. U.S.-FLAG AND FOREIGN-FLAG OPERATIONS - ------------------------------------- The Company's U.S.-flag and foreign-flag bulk fleets operate substantially in separate markets. The Company believes that ownership of a diversified fleet, with vessels of different flags, types and sizes and with operating flexibility, enables the Company to take advantage of chartering opportunities for domestic and international shipment of bulk commodities and thereby cushion the effects of weakness in particular markets. Information about the Company's operations under U.S. and foreign flags for the three years ended December 31, 1993 is set forth in the table in Note B to the Company's financial statements incorporated by reference in Item 8 below. For information regarding the revenues and net income of the Company's bulk shipping joint ventures for the three years ended December 31, 1993, see Note E to the Company's financial statements incorporated by reference in Item 8 below. In each of the years 1993, 1992 and 1991 the Company had one charterer (BP Oil Company, USA) from which it had revenues in excess of 10% of revenues from voyages, amounting in 1993 to approximately $73.7 million, in 1992 to approximately $84.3 million, and in 1991 to approximately $65 million. U.S. DOMESTIC AND PREFERENCE TRADES - ----------------------------------- Shipping between United States coastal ports, including the movement of Alaskan oil, is reserved by law primarily to U.S.- flag vessels owned by U.S. citizens, crewed by U.S. seafarers, and built in the United States without construction subsidies and operated without operating differential subsidies. The Company owns the largest independent fleet of unsubsidized ("Jones Act") U.S.-flag tankers and is a major participant in the Alaskan oil trade. Demand for tonnage in the Alaskan oil trade depends on the volume of crude shipped out of Alaska and its distribution to ports at varying distances from the source. In recent years, the amount of crude shipped on the long-haul route to the Gulf of Mexico has fallen sharply, and this development has reduced tonnage requirements. Alaskan crude oil shipments provide the main source of employment for U.S.-flag crude carriers and is shipped mostly on unsubsidized U.S.-flag crude carriers of over 60,000 DWT. Exports of Alaskan crude oil have been restricted by law since 1973. Additional, more stringent limitations were incorporated in the Export Administration Act of 1979, which has been extended to June 30, 1994. A lawsuit brought by the State of Alaska challenging the legality of these export restrictions was recently dismissed by the Federal District Court. By law, vessels built with construction differential subsidies and operated with operating differential subsidies ("ODS") have not been permitted in the Jones Act trade. Under a recent Maritime Administration interpretation, product tankers and crude carriers built with subsidies may be eligible for full coastwise privileges when they reach 20 years of age and their ODS contracts expire. The Company believes that this interpretation is contrary to law and has commenced litigation seeking to overrule it. Should the lawsuit fail, it is possible that several older product and crude carriers may enter the coastwise trade over the next few years. United States military cargo must be transported on U.S.- flag vessels, if available. The Merchant Marine Act, 1936, as amended, requires that preference be given to U.S.-flag vessels, if available at reasonable rates, in the shipment of at least half of all U.S. government-generated cargoes and 75% of food-aid cargoes. Half of the imports into the Strategic Petroleum Reserve ("SPR"), a U.S. government procurement program, must be transported on U.S.- flag vessels. Vessels in the Company's operating bulk fleet have been chartered from time to time to the Military Sealift Command of the United States Navy ("MSC"), and to recipient nations for the carriage of grain under United States foreign aid and agricultural assistance programs. Charters to MSC reflect in large part the requirements of the United States military for waterborne carriage of cargoes, and, accordingly, depend in part on world conditions and United States foreign policy. EMPLOYMENT OF VESSELS - --------------------- The bulk shipping industry is highly fragmented and competitive. The Company competes in its charter operations with other owners of U.S. and foreign-flag tankers and dry cargo ships operating on an unscheduled basis similar to the Company and, to some extent, with owners operating cargo ships on a scheduled basis. About one third of the world's tanker tonnage is owned by oil companies and is primarily engaged in the carriage of proprietary cargoes. In chartering vessels to the United States government, the Company competes primarily with other owners of U.S.-flag vessels. U.S.-flag product carriers, whose trade demands are closely linked to changes in regional energy demands and in refinery activity, also compete with pipelines, oceangoing barges, and, with regard to imports from abroad, foreign-flag product carriers. In the spot and short-term charter market, the Company's vessels compete with all other vessels of a size and type required by a charterer that can be available at the date specified. In the spot market, competition is based primarily on price. Nevertheless, within a narrow price band, factors related to quality of service and safety enter into a potential customer's decision as to which vessel to charter. Prevailing rates for charters of particular types of ships are subject to fluctuations depending on conditions in United States and international bulk shipping markets and other factors. The Company endeavors to minimize the effects of periods of weakness in its markets by pursuing a chartering policy that favors medium- and long-term charters, thereby avoiding, to some extent, the sharp rate fluctuations characteristic of the spot or voyage markets. In recent years, the availability of medium- to long-term business has been relatively limited, and, when available, rates of return have generally been unattractive. While price also dominates the customer's chartering decision in the long-term charter market, quality of service, safety and financial strength play a more important role because of the length of commitment the charterer is making. The Company believes this developing emphasis on safety and financial strength is advantageous for the Company and that many customers, including many of the world's major oil companies, prefer to limit longer term business to well respected owners such as the Company. For additional information as of March 7, 1994 regarding the 58 vessels in the Company's operating bulk fleet, including information as to the employment of such vessels, see the table in the "To Our Shareholders" section (page 2), and the "International Bulk Fleet" and "U.S. Bulk Fleet" tables in the "Review of the Fleet" section (page 22), of the registrant's Annual Report to Shareholders for 1993, which tables are incorporated herein by reference. ENVIRONMENTAL MATTERS RELATING TO BULK SHIPPING - ----------------------------------------------- During the past five years, the tanker business has experienced a more stringent regulatory environment, a greater emphasis on quality, and more inspections by governmental authorities and charterers. It is anticipated that in the coming years these trends will make it increasingly difficult for poorly maintained ships to find employment. The added environmental and quality concerns on the part of governmental authorities and charterers are anticipated to impose greater inspection and safety requirements and to accelerate scrapping of older vessels. OPA 90. The Oil Pollution Act of 1990 ("OPA 90") significantly expands the liability of a vessel owner or operator (including a bareboat charterer), for damage resulting from spills in U.S. waters (up to 200 miles offshore). OPA 90 applies to all U.S. and foreign-flag vessels. Under OPA 90, a vessel owner or operator is liable without fault for removal costs and damages, including economic loss without physical damage to property, up to $1,200 per gross ton of the vessel. The Company's largest vessel measures 144,139 gross tons; therefore, the theoretical liability limit for that vessel would be $173 million. When a spill is proximately caused by gross negligence, willful misconduct or a violation of a Federal safety, construction or operating regulation, liability is unlimited. OPA 90 did not preempt state law, and therefore states remain free to enact legislation imposing additional liability. Virtually all coastal states have enacted pollution prevention, liability and response laws, many with some form of unlimited liability. In addition, OPA 90 imposes a requirement that tankers calling at U.S. ports have double hulls. This requirement applies to newly constructed tankers contracted for after June 30, 1990, or delivered after January 1, 1994. Beginning on January 1, 1995, the double-hull requirement is phased in for existing tankers. The age requirement is reduced in stages so that by the year 2000, tankers of at least 30,000 gross tons over 23 years old (and tankers between 15,000 and 30,000 gross tons over 30 years old) must have double hulls, and by 2010, all tankers must have double hulls, except that tankers with double bottoms or double sides are afforded an additional five years for compliance but must comply no later than January 1, 2015. Tankers discharging at a deepwater port or lightering more than 60 miles offshore will not be required to have double hulls until January 1, 2015. The double-hull requirement will not begin to affect the Company's existing tanker fleet until near the end of the decade, with most of the Company's vessels not affected until the next decade. Each of the 16 vessels in the Company's current fleet to which the double-hull requirements are expected to apply in the next ten years will be at least 23 years old on the applicable double-hull requirement date and consequently near the end of its economic life. OPA 90 also requires owners and operators of vessels calling at U.S. ports to adopt contingency plans for responding to a worst case oil spill under adverse weather conditions. The plans must include contractual commitments with clean-up response contractors in order to ensure an immediate response to an oil spill. Furthermore, training programs and drills for vessel, shore and response personnel are required. The Company has developed and timely filed its vessel response plans with the United States Coast Guard and has received preliminary approval of such plans. OPA 90 requires that an owner demonstrate its ability to meet OPA 90's liability limits in accordance with regulations promulgated by the Coast Guard. While most owners would expect to meet such requirements by supplying evidence of adequate insurance coverage, currently proposed Coast Guard regulations would not deem such coverage sufficient unless the insurer consents to be subject to direct third-party suits in the United States, which the major insurers to date have declined to do. Although it is not possible to predict the outcome of the pending rulemaking, the Company believes that it will be able to establish its financial responsibility under the regulations as finally adopted. Until final regulations are promulgated, owners continue to be able to establish evidence of financial responsibility under existing regulations. OPA 90 and regulations as well as various state laws and regulations have increased the cost of operating, insuring and building ships for operation in U.S. waters. The owners of all vessels that sail in U.S. waters will be subject to these increased costs, and therefore the Company does not expect to be disadvantaged relative to its competition. International Requirements for Double-Hulled Vessels. The International Maritime Organization ("IMO") adopted regulations requiring double hulls on all oil tankers over 20,000 DWT and all product tankers over 30,000 DWT for which building contracts are placed after July 5, 1993 or, in the absence of a building contract, that have keels laid after January 5, 1994, or that are delivered after July 5, 1996. Additionally, the regulations require that any oil tanker over 20,000 DWT and any product tanker over 30,000 DWT existing on July 6, 1995 that is not subject to the requirements for newbuilding set forth in the previous sentence must have a double hull not later than 25 years after the date of its delivery, unless it is fitted with segregated ballast tanks or is designed so that loaded cargo does not exert outward pressure on the vessel's bottom shell plating in excess of the external hydrostatic water pressure (hydrostatically balanced loading), in which case the vessel need not comply with the double-hull requirement until 30 years after the date of its delivery. In addition, more stringent surveys of steel condition have been instituted for existing vessels. These requirements will apply to all vessels trading to ports in countries that are parties to the International Convention for the Prevention of Pollution by Ships, as amended ("MARPOL"), which include the world's major trading countries. The United States has reserved its position on the IMO regulations. Since the schedule for phasing in the double-hull requirements under the IMO regulations is in certain instances faster and in certain instances slower than the requirements under OPA 90, if the United States does not accept the IMO regulations, tankers trading between U.S. ports and ports in countries that are parties to MARPOL will have to meet the requirements of the earlier of the two to apply. The Company believes that as the double-hull requirements imposed by U.S. law and international conventions become applicable, some older vessels will be scrapped. The impact of the double-hull requirements of the IMO regulations on the Company's vessels will not be significantly different from the impact of the double-hull requirements of OPA 90. INSURANCE. Consistent with the currently prevailing practice in the industry, the Company presently carries a minimum of $700 million of pollution coverage per occurrence on every vessel in its fleet. While the Company has historically been able to obtain such insurance at commercially reasonable rates, no assurances can be given that such insurance will continue to be so available in the future. BULK SHIPPING MARKETS - --------------------- Information regarding the international bulk shipping markets and the markets for U.S.-flag vessels, including the Alaskan oil trade, is set forth in the text of the "Global Bulk Shipping Markets" section (pages 14 through 17) of the registrant's Annual Report to Shareholders for 1993, which information is incorporated herein by reference. CHANGES IN THE BULK FLEET - ------------------------- SALES: As part of the Company's ongoing modernization program, the Company in 1993 sold two foreign-flag single-hulled 97,800 DWT tankers, and two older foreign-flag 34,400 DWT dry bulk carriers. In the first quarter of 1994, a foreign-flag 28,950 DWT dry bulk carrier was sold, and a 50%-owned older foreign-flag single-hulled 252,350 DWT tanker was contracted for sale (scheduled to be delivered to the buyer upon completion of a charter at the end of March 1994). VESSELS ON ORDER: In 1993, the Company placed orders for two double-hulled 295,250 DWT tankers, scheduled for delivery in 1995. With the four double-hulled 93,650 DWT tankers ordered in 1991 which are all scheduled for delivery by year-end 1994 (one of which was delivered on March 10, 1994), the Company's newbuilding program aggregated nearly 1 million DWT. All of these six ships are being built by a major South Korean shipbuilder for delivery to the Company's international fleet. The commitments for these six vessels are in U.S. Dollars; for additional information as of March 7, 1994 about the commitments, see Note L(1) to the Company's financial statements incorporated by reference in Item 8 below. The Company's newbuilding program, together with the selective upgrading of the Company's fleet through acquisition and disposition of existing tonnage, reflects changes that the Company makes from time to time in light of its continuing review of changing market conditions. There is no assurance that the Company's fleet will expand, or that the Company will acquire vessels or place orders for the construction of new vessels, to the same extent as in the past. EMPLOYEES - --------- At March 7, 1994, the Company employed approximately 1,955 seagoing personnel to operate its ships. The Company has collective bargaining agreements with three different maritime unions, covering seagoing personnel employed on the Company's U.S.- flag vessels, which agreements are in effect through June 15, 1996 with one of the unions and through June 15, 1994 with two of the unions. Under the collective bargaining agreements, the Company is obligated to make contributions to pension and other welfare programs. The Company believes that its relations with its employees are satisfactory. U.S. SUBSIDIES - -------------- To encourage private investment in U.S.-flag ships, the Merchant Marine Act of 1970 permits deferral of taxes on earnings deposited into capital construction funds and amounts earned thereon, which can be used for the construction or acquisition of, or retirement of debt on, qualified U.S.-flag vessels (primarily those limited to United States foreign and noncontiguous domestic trades). The registrant is a party to an agreement under the Act. Under the agreement, the general objective is (by use of assets accumulated in the fund) for two vessels to be constructed or acquired by the end of 1999. If the agreement is terminated or amounts are withdrawn from the capital construction fund for non- qualified purposes, such amounts will then be subject to Federal income taxes. Provision has been made in the Company's financial statements for deferred taxes on the amounts deposited in the capital construction fund and on the earnings thereon. Monies can remain tax deferred in the fund for a maximum period of twenty-five years (commencing January 1, 1987 for deposits prior thereto). See the second paragraph of Note J to the Company's financial statements incorporated by reference in Item 8 below. The Company does not receive any operating differential subsidies or any construction differential subsidies under the Merchant Marine Act, 1936, as amended. FINANCIAL HIGHLIGHTS - -------------------- In December 1993, the registrant successfully completed a $200 million public offering of 8%, 10-year notes and 8.75%, 20- year debentures. These securities were rated investment grade by Standard & Poor's. In early March 1994, the registrant completed a public offering of 3,450,000 shares of its common stock, all of which were newly issued by the registrant. This represents the registrant's first issuance of equity since 1972. Since early 1992, the Company has raised more than $580 million of long-term debt and equity capital through these recent public offerings and through two private placements. INVESTMENT IN CRUISE BUSINESS - ----------------------------- In October 1992, the Company invested cash of approximately $220 million for 49% of the equity of Celebrity Cruise Lines Inc. ("CCLI"), a joint venture with the Chandris Cruise Division (an established cruise line operator unrelated to the Company) that owns and operates five cruise vessels contributed to it by the co-venturer. Three of the cruise ships are marketed under the trade name of Celebrity Cruises and two are marketed under the trade name of Fantasy Cruises. In May 1993, the Company invested additional cash of approximately $2.7 million upon the final determination by CCLI's shareholders of the value of certain of its assets. Pursuant to the related agreements, CCLI functions as an equal joint venture and the approval of both shareholders is required for all substantive policy matters. All debt of the joint venture is non-recourse to the joint venture partners. It is anticipated that CCLI's earnings will be reinvested in the cruise business, and accordingly the Company has made no provision for U.S. income taxation with respect to its share of CCLI's earnings. During 1993, CCLI's first full year of operation, CCLI contracted to build two 1,760-passenger cruise ships which are scheduled for delivery in late 1995 and the Fall of 1996, respectively, and obtained an option for a third sistership, each at a contract price of approximately $317.5 million. These vessels, designated as CCLI's new "Century" series, are all for the Celebrity Cruises fleet, which serves the premium segment of the cruise market. The contracts are with the same German shipyard which built the two most recently delivered new ships in the Celebrity fleet. The contracts provide for shipyard arranged long- term bank financing to CCLI for a substantial portion of the cost of each vessel. For additional information about CCLI and its fleets and the CCLI commitments as of March 7, 1994, see the text of the "CCLI" section (pages 18 through 20), including the CCLI fleet table (page 18), and the CCLI fleet table in the "Review of the Fleet" section (page 22) of the registrant's Annual Report to Shareholders for 1993, which information is incorporated herein by reference, and Note D to the Company's financial statements incorporated by reference in Item 8 below. In March 1994, CCLI exercised its option mentioned above to build the third 1,760-passenger cruise ship in its "Century" series. Upon delivery of this third sistership, scheduled for the Fall of 1997, CCLI's present passenger-carrying capacity in the premium segment of the cruise market will have more than doubled to over 9,000 berths. COMPETITION. The cruise industry has evolved from a trans- ocean carrier service into a vacation alternative to land-based resorts and sightseeing destinations. The North American passenger cruise industry dominates the worldwide cruise market; it has experienced substantial growth over the past 25 years. The North American cruise market, which is the market in which CCLI's ships primarily operate, is characterized by large and generally well-capitalized companies and is highly competitive. There are four companies in the industry each of which has a fleet with an aggregate number of berths in excess of 10,000, substantially more berths than CCLI's current fleet. Larger capacity affords fleet owners certain economies of scale. According to recently published data, the top six companies, including CCLI, have approximately 68% of total capacity and the top fifteen companies have approximately 94% of total capacity. Cruise lines compete with other vacation alternatives such as land-based resort hotels and sightseeing destinations for consumers' discretionary income. The amount of discretionary income spent on vacations is influenced by general economic conditions. Within the cruise industry, competition is primarily based on product quality, itinerary and price. Product quality is a function of ship design, onboard facilities, amenities, service and cuisine. REGULATORY MATTERS. Each ship is subject to regulations of its country of registry, including regulations issued pursuant to international treaties governing the safety of the ship and its passengers. Each country of registry conducts periodic inspections to verify compliance with these regulations. In addition, ships operating from U.S. ports are subject to inspection by the U.S. Coast Guard for compliance with international treaties and by the U.S. Public Health Service for sanitary conditions. With respect to passengers to and from U.S. ports, CCLI is required to obtain certificates from the U.S. Federal Maritime Commission and the U.S. Coast Guard relating to its ability to satisfy liabilities arising out of nonperformance of obligations to passengers, casualty or personal injury and water pollution. The Company believes CCLI is in compliance with all material regulations applicable to its ships and has all licenses necessary for the conduct of its business. The International Maritime Organization's SOLAS 1974 convention, which became effective in 1980 and was last amended in 1992, established minimum safety, fire prevention and fire fighting standards (the "SOLAS '74 standards"). Under the amended SOLAS requirements, by October 1, 1997 all passenger ships must have upgraded fire detection and fire fighting systems. The schedule for compliance with certain other aspects of the amended requirements for passenger vessels currently meeting SOLAS '74 standards extends until 2005 or 15 years after construction, whichever is later. Since substantial capital expenditures may be needed to bring older vessels into compliance with the SOLAS requirements that become applicable in 1997, it is likely that some ships for which such capital expenditures would not be economical will be removed from the market. Two of CCLI's Celebrity vessels were delivered in 1990 and 1992, respectively, and the third was rebuilt in 1990. Based on present estimates, any work necessary for these vessels to meet SOLAS requirements applicable in 1997 can be done without material capital expenditures. Whether the two Fantasy vessels will be refitted to bring them into compliance with the 1997 SOLAS requirements will be determined at a later date. ITEM 2. ITEM 2. PROPERTIES ---------- See Item 1. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- The Company is a party, as plaintiff or defendant, to various suits for monetary relief arising principally from personal injuries, collision or other casualty and to claims arising under charter parties, in each case in the ordinary course of business. All such personal injury, collision and casualty claims against the Company are fully covered by insurance (subject to deductibles not material in amount). Each of the other claims involves an amount which in the opinion of management is not material in relation to the consolidated current assets of the Company as shown in the Company's Consolidated Balance Sheet as at December 31, 1993, incorporated herein by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- None. EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------ Has Served as Name Age Position Held Such Since - ---- --- ------------- ------------- Morton P. Hyman 58 President October 1971 Michael A. Recanati 36 Executive February 1993 Vice President Robert N. Cowen 45 Senior Vice February 1993 President, Secretary, June 1982 General Counsel November 1989 Gabriel Kahana 35 Senior Vice February 1993 President and Treasurer Alan Carus 55 Controller December 1987 Messrs. Hyman, Recanati and Cowen are directors of the registrant and Messrs. Hyman and Recanati are members of the Finance and Development Committee of its Board of Directors (Mr. Recanati is Vice Chairman of the Committee). The term of office of each executive officer continues until the first meeting of the Board of Directors of the registrant immediately following the next annual meeting of its stockholders, to be held in June 1994, and until the election and qualification of his successor. There is no family relationship between the executive officers; Mr. Michael A. Recanati is a son of Mr. Raphael Recanati and a nephew of Mr. Ran Hettena, directors of the registrant. Mr. Morton P. Hyman has served as a director of the registrant since 1969. Mr. Michael A. Recanati has served as a director, senior vice president and treasurer of the registrant and as an officer and director of certain of its subsidiaries during the past five years; he has also served as a director and senior officer of Maritime Overseas Corporation ("MOC"), the agent for the Company's vessels referred to in the first paragraph of Item 1, during the past five years. Mr. Robert N. Cowen has served as a director of the registrant since June 1993, as an officer and director of certain of the registrant's subsidiaries during the past five years, and as a director of MOC since January 1991; he also serves as executive vice president and a director of Overseas Discount Corporation, which is engaged in the business of finance and investment. Mr. Gabriel Kahana has served as an officer and director of certain of the registrant's subsidiaries during the past five years; he has also served as an officer of MOC during the past five years. Mr. Alan Carus has served as an officer and director of certain of the registrant's subsidiaries during the past five years; he has also served as a senior officer of MOC during the past five years. PART II -------- The information called for by Items 5 through 8 is incorporated herein by this reference from the following respective portions and page numbers of the registrant's Annual Report to Shareholders for 1993: Item Incorporated from: ---- ----------------- ITEM 5. ITEM 5.Market for Registrant's Last three paragraphs under Common Equity and Related "Shareholder Information" on Stockholder Matters inside back cover; "Stock Price and Dividend Data" table on last page (page 29) of "Management's Discussion and Analysis" section of "Financial and Corporate Data". ITEM 6. ITEM 6.Selected Financial Data The information for the years 1989 through 1993 under "Eleven-Year Statistical Review" section (pages 42 and 43) of "Financial and Corporate Data". ITEM 7. ITEM 7.Management's Discussion Information set forth in text and Analysis of Financial of "Management's Discussion Condition and Results of and Analysis" section (pages Operations 26 through 29) of "Financial and Corporate Data". ITEM 8. ITEM 8.Financial Statements and "Consolidated Statements of Supplementary Data Income and Retained Earnings", "Consolidated Balance Sheets", "Consolidated Statements of Cash Flows" and "Notes to Consolidated Financial Statements" sections (pages 31 through 41) of "Financial and Corporate Data". Additional Supplementary Data - Ratio of Fixed Charges ------------------------------ The ratio of earnings to fixed charges for 1993 was 1.27 and has been computed by dividing the sum of income before Federal income taxes and fixed charges by fixed charges. Fixed charges consist of interest expense, including the proportionate share of interest of joint venture companies, capitalized interest and an estimate of the interest component of an operating lease. ITEM 9. ITEM 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III -------- The information called for by Items 10 through 13, except for the information set forth in Part I above regarding the executive officers of the registrant, is incorporated herein by this reference from the following respective portions of the definitive proxy statement to be filed by the registrant in connection with its 1994 Annual Meeting of Shareholders. ITEM INCORPORATED FROM: ---- ----------------- ITEM 10. ITEM 10. Directors and Executive "Election of Directors" Officers of the Registrant ITEM 11. ITEM 11. Executive Compensation "Compensation and Certain Transactions"* ITEM 12. ITEM 12. Security Ownership of "Election of Directors" Certain Beneficial Owners and "Information as to and Management Stock Ownership" ITEM 13. ITEM 13. Certain Relationships and "Election of Directors" and Related Transactions "Compensation and Certain Transactions"* PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON ------------------------------------------------------- FORM 8-K -------- (a) See the accompanying index to financial statements and schedules, and the accompanying Exhibit Index. (b) Reports on Form 8-K: The registrant did not file any report on Form 8-K during the quarter ended December 31, 1993. - ---------------- * Excluding material under "Stockholder Return Performance Presentation" and "Executive Compensation Report of the Executive Compensation Committee and the Stock Option Committee". SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. OVERSEAS SHIPHOLDING GROUP, INC. By: /s/ GABRIEL KAHANA ----------------------------- Gabriel Kahana Senior Vice President & Treasurer Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Each of such persons appoints Morton P. Hyman and Gabriel Kahana, and each of them, as his agents and attorneys- in-fact, in his name, place and stead in all capacities, to sign and file with the SEC any amendments to this report and any exhibits and other documents in connection therewith, hereby ratifying and confirming all that such attorneys-in-fact or either of them may lawfully do or cause to be done by virtue of this power of attorney. By /s/ MORTON P. HYMAN ------------------------------ Morton P. Hyman, Principal Executive Officer and Director By /s/ GABRIEL KAHANA ------------------------------- Gabriel Kahana, Principal Financial Officer By /s/ ALAN CARUS ------------------------------- Alan Carus, Controller By /s/ RAN HETTENA ------------------------------- Ran Hettena, Director By /s/ GEORGE C. BLAKE ------------------------------- George C. Blake, Director By /s/ SOLOMON N. MERKIN ------------------------------- Solomon N. Merkin, Director By /s/ WILLIAM L. FROST ------------------------------- William L. Frost, Director By /s/ JOEL I. PICKET ------------------------------- Joel I. Picket, Director By /s/ THOMAS H. DEAN ------------------------------- Thomas H. Dean, Director By /s/ ROBERT N. COWEN ------------------------------- Robert N. Cowen, Director Date: March 28, 1994 FORM 10-K--ITEM 14(a) (1) and (2) OVERSEAS SHIPHOLDING GROUP, INC. AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Overseas Shipholding Group, Inc. and subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1993 are incorporated by reference in Item 8: Consolidated Balance Sheets--December 31, 1993 and 1992 Consolidated Statements of Income and Retained Earnings-- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows-- Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements--December 31, 1993 The following financial statement schedules of Overseas Shipholding Group, Inc. and subsidiaries are included in Item 14(d): Schedule V--Property, Plant and Equipment Schedule VI--Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule IX--Short-Term Borrowings Schedule X--Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. The following consolidated financial statements of Celebrity Cruise Lines Inc. and subsidiaries are included in Item 14(d): Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Earnings -- Year Ended December 31, 1993 and Period from October 1, 1992 (Commencement of Operations) to December 31, 1992 Consolidated Statements of Stockholders' Equity -- Year Ended December 31, 1993 and Period from October 1, 1992 (Commencement of Operations) to December 31, 1992 Consolidated Statements of Cash Flows -- Year Ended December 31, 1993 and Period from October 1, 1992 (Commencement of Operations) to December 31, 1992 Notes to Financial Statements -- December 31, 1993 The following financial statement schedules of Celebrity Cruise Lines Inc. and subsidiaries are included in Item 14(d): Schedule V --Property, Plant and Equipment Schedule VI --Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule IX --Short-Term Borrowings Schedule X --Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. FSTATE.8 REPORT OF INDEPENDENT AUDITORS To the Shareholders Overseas Shipholding Group, Inc. We have audited the accompanying consolidated balance sheets of Overseas Shipholding Group, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audit also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Overseas Shipholding Group, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A6 to the consolidated financial statements, in 1992, the Company changed its method of accounting for income taxes, in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ERNST & YOUNG March 7, 1994 REPORT OF INDEPENDENT AUDITORS The Board of Directors Celebrity Cruise Lines Inc. We have audited the accompanying consolidated balance sheets of Celebrity Cruise Lines Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for the year ended December 31, 1993 and the period from October 1, 1992 (commencement of operations) through December 31, 1992. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Celebrity Cruise Lines Inc. and subsidiaries at December 31, 1993 and 1992 and the consolidated results of their operations and their cash flows for the year ended December 31, 1993 and the period from October 1, 1992 (commencement of operations) through December 31, 1992 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Athens, Greece March 7, 1994 MOORE STEPHENS ERNST & YOUNG CELEBRITY CRUISE LINES INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 1993 and 1992 1. Organization Celebrity Cruise Lines Inc. ("Company"), a Cayman Islands corporation, was formed pursuant to agreements dated September 23, 1992 which became effective October 1, 1992. The agreements provide that the Company be operated as an equal joint venture and that all substantive policy matters be approved by both stockholders ("Approval Requirement"). In October 1992, the Chandris Group ("Chandris") contributed net assets valued (subject to final determination by the shareholders - see below) pursuant to the terms of the joint venture agreement at $227,888,346 in exchange for all of the Company's Class C shares (51% of the Company's equity) and Overseas Shipholding Group, Inc. ("OSG") contributed cash of $218,951,546 for all of the Company's Class O shares (49% of the Company's equity). The Class C shares and the Class O shares each carry one vote (subject to the Approval Requirement) and rank pari passu in all material respects. Liabilities of Chandris assumed included long-term debt and an obligation to pay for a 50% interest in two of the vessels (which obligation was paid). The aforementioned net assets contributed by Chandris included six vessels, intangibles and certain other assets, the latter valued, for the purpose of determining the capital contributions by the stockholders, by a method specified in the joint venture agreement. In May 1993 a final determination of the value of the net assets contributed by Chandris was made and an additional $2,845,117 was credited to capital as a result thereof; accordingly, OSG contributed to capital an additional $2,733,542 in cash. From October 1, 1992 to December 31, 1992 certain services related to sales, marketing and the operation of the vessels were provided by related entities (see Note 4). Effective January 1, 1993 the Company acquired the net assets (the amount of which was not material) of these entities for consideration which was not material. The net assets acquired included a 40% interest in a corporate joint venture. These services are being performed by subsidiaries of the Company and the joint venture since January 1, 1993. 2. Significant Accounting Policies (a)The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant inter-company transactions and balances have been eliminated in consolidation. The Company's investment in a joint venture (see Note 1) is accounted for by the equity method. The Company's equity in the net income of the joint venture is reflected in other income. CELEBRITY CRUISE LINES INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 1993 and 1992 2. Significant Accounting Policies (cont'd) (b)Interest bearing deposits which are highly liquid investments and have a maturity of three months or less when purchased have been included in cash and cash equivalents. (c)Vessels and equipment as of October 1, 1992 and fixed assets acquired on January 1, 1993 (see Note 1) were recorded at amounts assigned to them by the stockholders (substantially all based on independent appraisal) in connection with the capital contributions. All subsequent additions to vessels and equipment have been recorded at cost. Depreciation is calculated using the straight-line method based on cost, less estimated salvage value, over the assets estimated useful lives which primarily range for vessels from 20 to 30 years and for equipment from 5 to 10 years. (d)Drydock costs are amortized on a straight-line basis over the period to the next drydocking. (e)The countries in which the Company and its subsidiaries are incorporated impose, with regard to shipping companies, taxes based on the tonnage, not the income, of the vessels. Tonnage taxes paid by the companies have been included in operating expenses. The Company and its subsidiaries do not pay United States income taxes under exemptions available pursuant to the Internal Revenue Code. (f)Inventories are recorded at the lower of first-in, first-out cost or market. (g)Monetary assets and liabilities denominated in foreign currencies are translated into U.S. dollars, which is the functional currency, at year end rates and foreign currency income and expense transactions are translated at the average weekly rate. Gains and losses on foreign currency transactions were not material. (h)Customer cruise deposits, which represent unearned income, are recorded as liabilities when received and are recognized as cruise revenue on a completed voyage basis for cruises with durations of 12 days or less and on a pro-rata basis for cruises in excess of 12 days. (i)Intangibles arose from the valuation (based on independent appraisal) of net assets contributed by Chandris (see Note 1) and are being amortized using the straight-line method over 40 years. 3. Restricted Cash and Cash Equivalents At December 31, 1993 and 1992, other assets includes $ 16,143,223 and $14,500,000, respectively, of cash and cash equivalents which is restricted as to withdrawal pursuant to certain loan agreement covenants (see Note 7). CELEBRITY CRUISE LINES INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 1993 and 1992 4. Related Party Transactions During 1993, net amounts paid to a joint venture (see Note 1) for certain operating services totalled $26,951,924 and $1,298,884 is due to this entity at December 31, 1993. During 1992, the Company was a party to management agreements which provided that various services related to sales, marketing and the operation of the vessels be performed by certain companies that were owned by Chandris (see Note 1). Fees charged by these companies and included in operating expenses totalled $4,673,087 in 1992 and $3,230,532 was due from companies owned by Chandris at December 31, 1992 which amount was paid in 1993. 5. Vessels and Equipment At December 31, 1993 and 1992, vessels, including vessels under construction at December 31, 1993, and equipment consist of the following: 1993 1992 Vessels $694,216,771 $640,675,467 Office equipment 3,135,876 ----------- ----------- 697,352,647 640,675,467 Accumulated depreciation 26,892,961 5,272,053 ----------- ----------- $670,459,686 $635,403,414 =========== =========== 6. Short-Term Debt The Company has available approximately $9,800,000 of revolving lines of credit with banks, of which $7,000,000 is available through March 1995 and bears interest at 1.5% below the applicable basic interest rate of Eurodollar overdraft facilities on open account. The balance of the lines remain available provided cash collateral in an amount equal to the lines is on deposit with the bank and they bear interest at the prime rate. 7. Long-Term Debt At December 31, 1993 and 1992, long-term debt consists of the following bank term loans which are secured by the Company's vessels: 1993 1992 Variable rate loans bearing interest at rates ranging from LIBOR plus 1% to 1.25% due through 2006 $102,817,629 $ 92,550,038 Fixed rate loans bearing interest substantially at 8% due through 2000 226,400,184 263,706,536 ----------- ----------- 329,217,813 356,256,574 Less current portion 42,593,169 43,316,409 ----------- ----------- $286,624,644 $312,940,165 =========== =========== CELEBRITY CRUISE LINES INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 1993 and 1992 7. Long-Term Debt (cont'd) Aggregate principal payments to be made on long-term debt for the five years subsequent to December 31, 1993 are: 1994 $42,593,169 1995 41,508,304 1996 41,508,304 1997 46,505,699 1998 44,821,442 Certain subsidiaries are required, pursuant to their debt agreements, to create, based on available cash flow, cash debt reserves totaling approximately $12,700,000. Other of their loan agreements require debt reserves of up to $20,000,000, payable in semi-annual installments. At December 31, 1993 and 1992, the balance of these reserves amounted to $ 16,143,223 and $12,000,000, respectively (see Note 3). The payment of dividends by certain subsidiaries is limited under certain agreements to 50% of their annual earnings (as defined) after the required reserves have been established; under certain circumstances, a dividend of 10% of "net profits" (as defined in the agreements) is permitted. 8. Fair Value of Financial Instruments Cash and Cash Equivalents The carrying amounts reported in the balance sheets approximate fair value. Debt The carrying amounts of short-term debt reported in the balance sheets approximate their fair value. The fair value of the Company's long-term debt (including current portion), which is principally OECD export financing, also approximated its carrying amounts in the balance sheets based on the rates currently available for similar debt with similar terms. Foreign Currency Forward Contracts At December 31, 1993, the Company had contracts maturing on various dates through October 1994 to sell various foreign currencies. The fair value of foreign currency forward contracts is the amount the Company would receive if the contracts were closed at the balance sheet date. At December 31, 1993, this amount approximated $13,568. CELEBRITY CRUISE LINES INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 1993 and 1992 9. Capital Commitments and Contingent Liabilities As of March 7, 1994 the Company has commitments with an aggregate unpaid cost of $570,000,000 for the construction of two cruise ships. Delivery of the first ship is scheduled for late 1995 and delivery of the second ship is scheduled for late 1996. Unpaid costs are net of progress payments of $64,300,000 (including $15,400,000 paid subsequent to December 31, 1993). The Company has an option, which it intends to exercise, for the construction of a third ship at a cost of approximately $317,500,000. Financing has been arranged for substantially all the unpaid cost of these ships. The Company is contingently liable for up to $16,500,000 to reimburse an insurance company for any amounts paid by the insurance company under a bond posted by it with the U.S. Federal Maritime Commission. The Company leases office space under operating lease agreements expiring through November 2000. The future minimum rental payments required under these lease agreements are as follows: Year Ending December 31, Minimum Annual Rental 1994 $ 1,155,188 1995 966,948 1996 710,403 1997 955,558 1998 898,597 After 1998 2,026,475 Rent expense for the year ended December 31, 1993 was $1,268,218. Rent expense includes certain escalation costs that are not reflected in the minimum annual rental commitments. 10. Pension Plan The Company has pension plans, which are principally defined contribution plans, in various countries. The plan maintained in the United States is qualified under section 401(k) of the Internal Revenue Code and covers all eligible employees. The Company matches a percentage of employee contributions to the plan. Pension expense, principally related to the 401 (k) plan, for the year ended December 31, 1993 was $634,031. Exhibit Index 3(i) Certificate of Incorporation of the registrant, as amended to date (filed as Exhibit 3(a) to the registrant's Form 10-K for 1988 and incorporated herein by reference). *3(ii) By-Laws of the registrant, as amended January 28, 1994. 4(a)(1) Credit Agreement dated as of February 9, 1990 among the registrant, two subsidiaries of the registrant and certain banks (filed as Exhibit 4(a) to the registrant's Form 10-K for 1989 and incorporated herein by reference). 4(a)(2) Amendment No. 1 dated as of April 17, 1990 to Credit Agreement referred to above (filed as Exhibit 4 to the registrant's Form 10-Q for the quarter ended June 30, 1990 and incorporated herein by reference). 4(a)(3) Amendment No. 2 dated as of October 19, 1990 to Credit Agreement referred to above (filed as Exhibit 4 to the registrant's Form 10-Q for the quarter ended September 30, 1990 and incorporated herein by reference). 4(a)(4) Amendment No. 3 dated as of November 16, 1990 to Credit Agreement referred to above (filed as Exhibit 4(a)(4) to the registrant's Form 10-K for 1990 and incorporated herein by reference). 4(a)(5) Amendment No. 4 dated as of December 10, 1991 to Credit Agreement referred to above (filed as Exhibit 4(a)(5) to the registrant's Form 10-K for 1991 and incorporated herein by reference). 4(a)(6) Amendment No. 5 dated as of December 29, 1992 to Credit Agreement referred to above (filed as Exhibit 4(a)(6) to the registrant's Form 10-K for 1992 and incorporated herein by reference). 4(b) Form of Note Purchase Agreement dated as of March 1, 1992 between the registrant and each of the purchasers of its senior notes (filed as Exhibit 4(b) to the registrant's Form 10-K for 1991 and incorporated herein by reference). 4(c) Form of Note Purchase Agreement dated as of June 1, 1993 between the registrant and each of the purchasers of its senior notes (filed via EDGAR as Exhibit 4 to the registrant's Form 10-Q for the quarter ended June 30, 1993 and incorporated herein by reference.) *4(d)(1) Form of Indenture dated as of December 1, 1993 between the registrant and The Chase Manhattan Bank (National Association) providing for the issuance of debt securities by the registrant from time and time. *4(d)(2) Resolutions dated December 2, 1993 fixing the terms of two series of debt securities issued by the registrant under the Indenture. *4(d)(3) Form of 8% Notes due December 1, 2003 of the registrant. *4(d)(4) Form of 8-3/4% Debentures due December 1, 2013 of the registrant. NOTE: The Exhibits filed herewith do not include other instruments authorizing long-term debt of the registrant and its subsidiaries, none of which exceeds 10% of total assets of the registrant and its subsidiaries on a consolidated basis. The registrant agrees to furnish a copy of each such instrument to the Commission upon request. 10(a) Form of Agency Agreements between Maritime Overseas Corporation and each of the registrant's majority-owned subsidiaries that owns or operates a U.S.-flag vessel (refiled as Exhibit 10(a) to the registrant's Form 10-K for 1989 and incorporated herein by reference). 10(b) Form of Agency Agreements between Maritime Overseas Corporation and each of the registrant's majority-owned subsidiaries that owns or operates a foreign-flag vessel (refiled as Exhibit 10(b) to the registrant's Form 10-K for 1989 and incorporated herein by reference). 10(c)(1) Form of Management Agreement dated as of January 1, 1985 between Lion Insurance Company Ltd. and Maritime Overseas Corporation (filed as Exhibit 10(c)(2) to the registrant's Form 10-K for 1985 and incorporated herein by reference). 10(c)(2) Form of Amendment No. 1 dated as of April 1, 1986 to the Management Agreement between Lion Insurance Company Ltd. and Maritime Overseas Corporation (filed as Exhibit 10(c)(2) to the registrant's Form 10-K for 1986 and incorporated herein by reference). 10(d)(1) Form of General Services Agreement dated December 31, 1969 between the registrant and Maritime Overseas Corporation (the form of which was filed as Exhibit 13(3) to Registration Statement No. 2-34124 and is incorporated herein by reference). 10(d)(2) Form of Amendment dated as of January 1, 1975 to General Services Agreement between the registrant and Maritime Overseas Corporation (refiled as Exhibit 10(e)(1) to the registrant's Form 10-K for 1984 and incorporated herein by reference). 10(d)(3) Amendment dated January 10, 1980 to General Services Agreement between the registrant and Maritime Overseas Corporation (refiled as Exhibit 10(d)(3) to the registrant's Form 10-K for 1989 and incorporated herein by reference). 10(d)(4) Form of Amendment dated as of January 1, 1981 to General Services Agreement between the registrant and Maritime Overseas Corporation (refiled as Exhibit 10(d)(4) to the registrant's Form 10-K for 1990 and incorporated herein by reference). 10(d)(5) Form of Amendment dated as of October 1, 1987 to General Services Agreement between the registrant and Maritime Overseas Corporation (filed as Exhibit 10(d)(5) to the registrant's Form 10-K for 1987 and incorporated herein by reference). 10(e)(1) Form of Letter Agreement dated as of August 9, 1973 between the registrant and Maritime Overseas Corporation (refiled as Exhibit 10(f)(1) to the registrant's Form 10-K for 1984 and incorporated herein by reference). 10(e)(2) Form of Letter Agreement dated as of August 9, 1973 by Maritime Overseas Corporation (refiled as Exhibit 10(f)(2) to the registrant's Form 10-K for 1984 and incorporated herein by reference). 10(e)(3) Form of Letter Agreement dated as of August 9, 1973 by Maritime Overseas Corporation (refiled as Exhibit 10(f)(3) to the registrant's Form 10-K for 1984 and incorporated herein by reference). 10(e)(4) Form of Letter Agreement dated as of January 1, 1981 between the registrant and Maritime Overseas Corporation (refiled as Exhibit 10(e)(4) to the registrant's Form 10-K for 1991 and incorporated herein by reference). 10(f)(1) Form of Service Agreements between Maritime Overseas Corporation and each of the partnerships First Shipmor Associates, Second Shipmor Associates, Third Shipmor Associates and Fourth Shipmor Associates and related letter agreements between the registrant and each of said partnerships (refiled as Exhibit 10(f)(1) to the registrant's Form 10-K for 1987 and incorporated herein by reference). 10(f)(2) Service Agreement dated January 27, 1983 between Cambridge Tankers, Inc. and Maritime Overseas Corporation relating to the OVERSEAS BOSTON (refiled as Exhibit 10(f)(2) to the registrant's Form 10-K for 1992 and incorporated herein by reference). 10(f)(3) Form of Service Agreement between respective subsidiaries of the registrant and Maritime Overseas Corporation relating to the OVERSEAS NEW ORLEANS and OVERSEAS PHILADELPHIA (not filed--substantially identical in all material respects to the agreement listed as Exhibit 10(f)(2) hereto except as to the parties, the vessels and the dates). 10(g)(1) Form of Management Agreements between Maritime Overseas Corporation and each of First United Shipping Corporation, Interocean Tanker Corporation, Second United Shipping Corporation and Third United Shipping Corporation (refiled as Exhibit (10)(h)(1) to the registrant's Form 10-K for 1984 and incorporated herein by reference). 10(g)(2) Form of Amendment No. 1 and Amendment No. 2 to Management Agreements between Maritime Overseas Corporation and each of First United Shipping Corporation, Interocean Tanker Corporation, Second United Shipping Corporation and Third United Shipping Corporation (filed as Exhibit 10(g)(1)(b) to the registrant's Form 10-K for 1985 and incorporated herein by reference). 10(h)(1) Agreement dated April 1, 1992 between the registrant and Maritime Overseas Corporation (filed as Exhibit 10 to the registrant's Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference). *10(h)(2) Letter Agreement dated November 9, 1993 amending the Agreement dated April 1, 1992 referred to above. 10(i) Indemnification Agreement dated December 21, 1992 among Continental Grain Company, Third Contiship Inc., Fourth Contiship Inc., OSG Bulk Ships, Inc., Third Shipco Inc., Fourth Shipco Inc. and the registrant (filed as Exhibit 10(i) to registrant's Form 10-K for 1992 and incorporated herein by reference). 10(j)(1) Exchange Agreement dated December 9, 1969 (including exhibits thereto) between the registrant and various parties relating to the formation of the registrant (the form of which was filed as Exhibit 2(3) to Registration Statement No. 2-34124 and is incorporated herein by reference). 10(j)(2) Form of Additional Exchange Agreement referred to in Section 2.02 of Exhibit 10(j)(1) hereto (filed as Exhibit 2(4) to Registration Statement No. 2-34124 and incorporated herein by reference). *10(k)(1) Form of Supplementary Retirement Plan adopted by registrant for Messrs. Morton P. Hyman and Michael A. Recanati (previously filed more than 10 years ago and refiled herewith). 10(k)(2) Form of Second Supplementary Retirement Plan adopted by registrant for Messrs. Morton P. Hyman and Michael A. Recanati (filed as Exhibit 10(k)(2) to the registrant's Form 10-K for 1988 and incorporated herein by reference). 10(l)(1) 1989 Stock Option Plan adopted for officers and key employees of the registrant or its subsidiaries (filed as Exhibit 10(l) to the registrant's Form 10-K for 1989 and incorporated herein by reference). 10(l)(2) Amendment adopted October 9, 1990 to the registrant's 1989 Stock Option Plan referred to above (filed as Exhibit 10(l)(2) to the registrant's Form 10-K for 1990 and incorporated herein by reference). 10(m) 1990 Stock Option Plan adopted for officers and employees of the registrant or its subsidiaries, excluding the recipients of options under Exhibits 10(l)(1) and (2) listed above (filed as Exhibit 10(m) to the registrant's Form 10-K for 1990 and incorporated herein by reference). 10(n)(1) Joint Venture Agreement dated September 23, 1992 among Archinav Holdings Ltd. ("Archinav"), Overseas Cruiseship Inc. ("Overseas"), and Celebrity Cruise Lines Inc. ("CCLI") (excluding exhibits and schedules) and the following related agreements: Guarantee of the registrant dated September 23, 1992 and Shareholders Agreement dated October 21, 1992 among Archinav, Overseas and CCLI (excluding exhibits)(filed as Exhibits 2(a), (b) and (c), respectively, to the registrant's Report on Form 8-K dated October 21, 1992 and incorporated herein by reference). 10(n)(2) Supplemental Agreement dated January 29, 1993 to the Shareholders Agreement referred to in Exhibit 10(n)(1) above (filed as Exhibit 10(n)(2) to the registrant's Form 10-K for 1992 and incorporated herein by reference). *12 Computation of Ratio of Earnings to Fixed Charges. *13 Such portions of the Annual Report to security holders for 1993 as are expressly incorporated herein by reference. (The registrant is furnishing the Annual Report in paper format to the Commission solely for the information of the Commission; except for those portions expressly incorporated by reference in this Form 10-K, the Annual Report is not being "filed" with the Commission.) *21 List of subsidiaries of the registrant. *23(a) Consent of Independent Auditors of the registrant. *23(b) Consent of Independent Auditors of Celebrity Cruise Lines Inc. NOTE: The Exhibits which have not previously been filed or listed or are being refiled are marked with an asterisk (*). List of Executive Compensation Plans and Arrangements - See Exhibits 10(k)(1) and (2), 10(l)(1) and (2), and 10(m) above. EXHIBIT 3(ii) As amended 1/28/94 BY-LAWS OF OVERSEAS SHIPHOLDING GROUP, INC. ARTICLE I OFFICES SECTION 1. DELAWARE OFFICE. The registered office of the Corporation in the State of Delaware shall be in the City of Wilmington, County of New Castle, State of Delaware, but the location of said office may be changed from time to time, to any other place within the State of Delaware, in the manner provided by law. SECTION 2. OTHER OFFICES. The Corporation may have an office or offices at such other places in the United States or elsewhere as the Board of Directors may from time to time determine. ARTICLE II MEETINGS OF STOCKHOLDERS SECTION 1. ANNUAL MEETING. The annual meeting of stockholders of the Corporation for the election of directors and for the transaction of such other business as may properly come before said meeting shall be held on the third Tuesday in May or any subsequent date in the months of May or June of each year, the specific date, hour and place, within or without the State of Delaware, to be determined in advance by the Board of Directors and stated in the notice of said meeting. Said meeting by be adjourned from day to day until its business is completed. SECTION 2. SPECIAL MEETINGS. Special meetings of stockholders for any purpose or purposes may be called at any time by the President or any Vice President, or by resolution of the Board of Directors, to be held at such time and place as may be designated in the call of meeting, and the President or any Vice President or the Secretary shall call such a meeting whenever stockholders holding not less than 25% of all of the outstanding stock of the Corporation entitled to vote at such meeting shall make a written request therefor, stating the purpose or purposes of the meeting requested. SECTION 3. NOTICE OF MEETINGS. Written notice of all meetings of stockholders, stating the place, date and hour and, in the case of special meetings, the purpose or purposes thereof, shall be given by mail to each stockholder of record entitled to vote, addressed to him at his address as it appears on the records of the Corporation, at least ten days but not more than fifty days prior to the date of the meeting. SECTION 4. QUORUM. The holders of a majority of the stock issued and outstanding and entitled to vote thereat, present in person or by proxy, shall constitute a quorum at all meetings of the stockholders. If a quorum shall not be present or represented at any meeting of the stockholders, the stockholders entitled to vote thereat, present in person or by proxy, shall have power to adjourn the meeting from time to time, without notice other than announcement at the meeting of the time and place of the adjourned meeting, until a quorum shall be present or represented. At such adjourned meeting any business may be transacted that might have been transacted at the original meeting. If any adjournment, whether a quorum is present or not, is for more than thirty days, or if after the adjournment a new record date is fixed for the adjourned meeting, notice of the adjourned meeting shall be given to each stockholder of record entitled to vote at the meeting. When a quorum is present at any meeting, directors shall be elected by a plurality and other corporate action shall be authorized by a majority of the votes cast by the holders of stock entitled to vote thereon, unless the question is one upon which by express provision of law or of the Certificate of Incorporation or of these By-Laws a larger or different vote is required, in which case such express provision shall govern. The stockholders present or represented at any duly called and held meeting at which a quorum is present or represented may continue to transact business until adjournment, irrespective of the withdrawal of any stockholders from the meeting. SECTION 5. ORGANIZATION. The President, or in his absence, the Executive Vice President, or in the absence of both of said officers, a Vice President designated by the President or by the Board of Directors, shall preside at all meetings of stockholders. The Secretary, or in his absence an Assistant Secretary, or in the absence of both the Secretary and an Assistant Secretary, any person designated by the President or other person presiding at the meeting, shall act as secretary of the meeting. SECTION 6. ORDER OF BUSINESS. The Order of Business at all meetings of stockholders, unless otherwise determined by a vote of the holders of a majority of the number of shares present in person or represented by proxy thereat, shall be determined by the presiding officer. SECTION 7. PROXIES AND VOTING OF SHARES. Except as otherwise provided in the Certificate of Incorporation of the Corporation, and subject to the provisions and limitations herein and therein contained, at all meetings of the stockholders each stockholder of record shall be entitled to cast one vote for each share of stock held by him of record, as shown on the record of stockholders of the Corporation. At any meeting of stockholders, each stockholder entitled to vote any shares on any matter to be voted upon at such meeting may exercise such voting right either in person or by proxy appointed by an instrument in writing, which shall be filed with the secretary of the meeting before being voted. Except as otherwise expressly required by statute, the vote on any question need not be by written ballot. SECTION 8. ACTION BY CONSENT OF STOCKHOLDERS. Except as otherwise provided by law, any action required by law to be taken at any annual or special meeting of stockholders or any action that may be taken at any annual or special meeting of such stockholders, may be taken without a meeting, without prior notice and without a vote, if a consent in writing, setting forth the action so taken, shall be signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares of stock entitled to vote thereon were present and voted. Prompt notice of the taking of the corporate action without a meeting by less than unanimous written consent shall be given to those stockholders who have not consented in writing. ARTICLE III DIRECTORS SECTION 1. POWER AND DUTIES OF THE BOARD OF DIRECTORS. The Board of Directors shall have the general management of the affairs, property and business of the Corporation and may adopt such rules and regulations for that purpose and for the conduct of their meetings as they may deem proper. The Board may exercise and shall be vested with the powers of the Corporation insofar as not inconsistent with law, the Certificate of Incorporation or with these By-Laws. SECTION 2. NUMBER AND QUALIFICATIONS. The number of directors constituting the whole Board shall be not less than three (3) nor more than seventeen (17). The first Board shall consist of six directors. Thereafter the authorized number of directors, within the limits above specified, may be changed by the affirmative vote of a majority of the whole Board at any regular or special meeting of the Board of Directors or by vote of stockholders at any annual meeting or at any special meeting noticed for that purpose, provided that the number of directors shall not be reduced by action of the Board of Directors below the number of directors then in office. Directors need not be stockholders of the Corporation. No more of the directors than a minority of the number necessary to constitute a quorum shall be persons other than citizens of the United States. SECTION 3. ELECTION AND TERM. Except as otherwise provided by law or by these By-Laws, the directors of the Corporation elected after the election of the first Board shall be elected at a annual meeting of stockholders in each year. Each director shall be elected to serve until the next annual meeting of shareholders and until a successor shall have been duly elected and shall qualify. SECTION 4. PLACE OF MEETING. The Board of Directors may hold its meetings at such place or places within or without the State of Delaware as the Board may from time to time determine or, in the absence of such determination, as may be specified in the call of any meeting. SECTION 5. REGULAR MEETINGS. After each annual meeting of stockholders for the election of directors or as soon thereafter as may be convenient, the newly elected Board of Directors shall meet for the purpose of organization and the transaction of such other business as may properly come before the meeting. Such meeting shall be held at the place where the annual meeting of stockholders was held at which the directors were elected, or at such other place as may have been designated by the Board of Directors or as may be fixed by consent of all of the newly elected directors. Notice of such meeting need not be given. Regular meetings of the Board of Directors shall be held at such time and place, either within or outside of the State of Delaware, as may be determined by resolution of the Board. No notice of a regular meeting need be given and any business may be transacted at a regular meeting, except as otherwise provided by law, the Certificate of Incorporation or these By-Laws. SECTION 6. SPECIAL MEETINGS. Special meetings of the Board of Directors may be called from time to time by the President or the Executive Vice President, and shall be called by them at the written request of any three or more directors. Each special meeting of the Board shall be held at such date, time, and place, either within or outside of the State of Delaware, as shall be designated in the call of such meeting. SECTION 7. NOTICE OF SPECIAL MEETING. Notice of a special meeting of the Board of Directors, stating the place, date and hour thereof, shall be given by mail, telegram, or cable addressed to each director at his residence or business address not less than five days before the day of the meeting or by delivering the same to him at his residence or business address not less than two days before the day of the meeting. Except as otherwise required by statute or these By-Laws, no notice or waiver of notice of a special meeting of the Board need state the purpose or purposes of such meeting, and any business may be transacted thereat. SECTION 8. QUORUM. A majority of the directors then in office, but in no event less than one-third of the entire Board, shall constitute a quorum for the transaction of business at any meeting of the Board of Directors. If less than a quorum be present at a meeting, the directors present thereat may adjourn the meeting from time to time without notice other than announcement at the meeting, until a quorum shall be present. Except as otherwise provided by law, by the Certificate of Incorporation or by these By-Laws, when a quorum is present at any meeting of the Board of Directors, a majority of the directors present at such meeting shall decide any question brought before such meeting and the action of such majority shall be deemed to be the action of the Board. SECTION 9. ORGANIZATION. The President or, in his absence, the Executive Vice President, or, in the absence of both of said officers, any director selected by vote of a majority of the directors then present, shall preside over each meeting of the Board of Directors. The Secretary, or in his absence an Assistant Secretary, or in the absence of both the Secretary and an Assistant Secretary, any person designated by the President or other person presiding at the meeting, shall act as secretary of the meeting. SECTION 10. COMPENSATION OF DIRECTORS. The Board of Directors shall have authority to fix the compensation of directors for services in any capacity. SECTION 11. ACTION BY WRITTEN CONSENT. Any action required or permitted to be taken at any meeting of the Board of Directors or by any committee thereof may be taken without a meeting, if all members of the Board or of such committee, as the case may be, consent thereto in writing, and the writing or writings are filed with the minutes of proceedings of the Board or committee. ARTICLE IV COMMITTEES SECTION 1. EXECUTIVE COMMITTEE. The Board of Directors may by resolution or resolutions adopted by a majority of the whole Board, designate three or more of its number to constitute an Executive Committee, which to the extent provided in said resolution or resolutions shall have and may exercise all the powers and authority of the Board except as otherwise provided by law or by the Certificate of Incorporation. Only United States citizens may be members of the Executive Committee. The Board of Directors shall have the power at any time to fill vacancies in, to change the membership of, or to dissolve the Executive Committee. The Executive Committee may hold meetings and makes rules for the conduct of its business. A majority of the members of the Executive Committee shall constitute a quorum for the transaction of business by said Committee, and it may act by affirmative vote of a majority of those present at a meeting at which a quorum is present. All action of the Executive Committee shall be reported to the Board of Directors at its meeting next succeeding such action. SECTION 2. OTHER COMMITTEES. The Board of Directors may, by resolution or resolutions adopted by a majority of the whole Board, designate one or more other committees, each such committee to consist of one or more of the directors of the Corporation, and to have only such powers as may be provided in said resolution or resolutions. ARTICLE V OFFICERS SECTION 1. EXECUTIVE OFFICERS. The executive officers of the Corporation shall be elected by the Board of Directors and shall be a President, an Executive Vice President, a Senior Vice President, one or more Vice Presidents, a Treasurer, a Comptroller and a Secretary. (Reference in these By-Laws to the "Vice Presidents" shall, unless the context indicates otherwise, be deemed to include the Executive Vice President, the Senior Vice President and the Vice Presidents.) Any number of offices may be held by the same person but no officer shall execute, acknowledge or verify any instrument in more than one capacity. The powers and duties of the officers shall be as specified in these By-Laws or as may from time to time be determined by the Board of Directors. SECTION 2. ELECTION AND TERM. The executive officers shall be elected by the Board at the first meeting thereof after each annual meeting of stockholders. Each executive officer shall be elected to serve until the next annual meeting of the Board of Directors and until his successor shall have been duly elected and shall qualify. SECTION 3. OTHER OFFICERS. The Board of Directors may also appoint such other officers and agents as it may deem necessary for the transaction of the business of the Corporation. Such officers and agents shall hold office for such period, have such authority and perform such duties as shall be determined from time to time by the Board. SECTION 4. THE PRESIDENT. The President shall, if present, preside at all meetings of stockholders and of the Board of Directors, and shall keep the Board of Directors fully informed and shall freely consult with them concerning the business of the Corporation. He shall be the chief executive officer of the Corporation, and, subject to the control of the Board of Directors, shall have general direction and supervision over the business and affairs of the Corporation and, in general, perform all duties incident to the office of President and such other duties as from time to time may be assigned to him by the Board of Directors. The President shall at all times be a citizen of the United States. SECTION 5. VICE PRESIDENTS. The Executive Vice President and the Senior Vice President, and the other Vice President or Vice Presidents, in that order, shall in the absence of the President perform all of the duties and exercise all of the powers of the President, to the extent and in the respects authorized by the Board of Directors or these By-Laws, and each of them shall have such duties as from time to time may be assigned to him by the Board of Directors. The Executive Vice President shall at all times be a citizen of the United States. SECTION 6. THE TREASURER. The Treasurer shall be the chief financial officer of the Corporation and shall have charge and custody of and be responsible for all funds and securities of the Corporation, and deposit all such funds in the name of the Corporation in such banks, trust companies or other depositories as shall be selected in accordance with the provisions of these By-Laws; at all reasonable times exhibit his books of account and records to any of the directors of the Corporation upon application during business hours at the place where such books and records are kept; receive, and give receipts for, monies due and payable to the Corporation from any source whatsoever; and in general, perform all the duties incident to the office of Treasurer and such other duties as from time to time may be assigned to him by the Board of Directors or the President. SECTION 7. THE COMPTROLLER. The Comptroller shall be the chief accounting officer of the Corporation and shall keep or cause to be kept at the principal place of business of the Corporation, and shall be responsible for the keeping of, correct records of the business and transactions of the Corporation and shall exhibit such records to any of the directors or the President or Treasurer of the Corporation upon application during business hours at the office of the Corporation where such records are kept. SECTION 8. THE SECRETARY. The Secretary shall record or cause to be recorded in books provided for the purpose all the proceedings of the meetings of the Board of Directors and the stockholders of the Corporation; shall attend to the giving of all notices of such meetings in accordance with the provisions of these By-Laws and as required by law; shall be custodian of the records (other than financial) and of the seal of the Corporation and have authority to affix the seal to all documents the execution of which on behalf of the Corporation is duly authorized in accordance with the provisions of these By-Laws; and in general, shall perform all duties incident to the office of Secretary and such other duties as may, from time to time, be assigned to him by the Board of Directors or the President. SECTION 9. CERTAIN OFFICERS TO GIVE BONDS. Every officer, agent or employee of the Corporation, who may receive, handle, or disburse money for its account or who may have any of the Corporation's property in his custody or be responsible for its safety or preservation, may be required in the discretion of the Board of Directors to give bond, in the sum and with such sureties and in such form as shall be satisfactory to the Board of Directors, for the faithful performance of the duties of his office and for the restoration to the Corporation, in the event of his death, resignation or removal from office, of all books, papers, vouchers, monies and other property of whatsoever kind in his custody belonging to the Corporation. SECTION 10. COMPENSATION. The compensation of the executive officers of the Corporation shall be fixed from time to time by the Board of Directors. No officer shall be prevented from receiving compensation by reason of the fact that he is also a director of the Corporation or a member of any committee. SECTION 11. TAX RETURNS. Unless otherwise provided by the Board of Directors, the President, any of the Vice Presidents, the Treasurer, the Comptroller or the Secretary shall be authorized to sign tax returns on behalf of the Corporation. ARTICLE VI RESIGNATIONS AND REMOVALS SECTION 1. RESIGNATIONS. Any director or officer of the Corporation may resign as such at any time by giving written notice to the Board of Directors or to the President or to the Secretary of the Corporation, and any member of any committee may resign at any time by giving notice either as aforesaid or to the Committee of which he is a member or to the chairman thereof. Any such resignation shall take effect at the time specified therein or, if the time be not specified, upon receipt thereof; and unless otherwise specified therein, acceptance of such resignation shall not be necessary to make it effective. SECTION 2. REMOVALS. The stockholders at any meeting called for the purpose, by vote of the majority of the outstanding stock entitled to vote, may at any time remove any director with or without cause. The Board of Directors by vote of not less than a majority of the whole Board may at any time with or without cause remove from office any officer or committee member elected or appointed by it. ARTICLE VII VACANCIES SECTION 1. AMONG DIRECTORS. If the office of any director becomes vacant at any time by reason of death, resignation, retirement, disqualification, removal from office, increase in the number of directors, or otherwise, a majority of the directors then in office, although less than a quorum, or the sole remaining director, may choose a successor to fill such vacancy and any director so chosen shall hold office, subject to the provisions of these By-Laws, until the next annual election of directors and until his successor shall be duly elected and shall qualify. In the event that a vacancy arising as aforesaid shall not have been filled by the Board of Directors, such vacancy may be filled by the stockholders at any meeting thereof. SECTION 2. AMONG OFFICERS, ETC. If the office of the President, any of the Vice Presidents, the Treasurer, the Comptroller or the Secretary, or of any other officer or member of any committee, becomes vacant at any time by reason of death, resignation, retirement, disqualification, removal from office, or otherwise, such vacancy or vacancies may be filled by the Board of Directors. ARTICLE VIII CITIZENSHIP OF STOCKHOLDERS The outstanding shares of the Corporation shall at all times be owned by citizens of the United States to such extent as will, in the judgment of the Board, reasonably assure the preservation of the Corporation's status as a United States citizen within the provisions of Section 2 of the Shipping Act of 1916, as amended, or any successor statute applicable to the business being conducted by the Corporation (the "Citizenship Provisions"). The Board of Directors may restrict any original issuance of shares of the Corporation to citizens of the United States as defined in the Citizenship Provisions ("United States Citizens"), and, in any event, shall from time to time establish, as a condition to the issuance or transfer of shares of the Corporation to non-United States Citizens, the minimum percentage of the total outstanding shares of the Corporation which shall be owned by United States Citizens (the "Minimum U.S. Ownership"), which minimum percentage may, in the discretion of the Board of Directors, exceed the minimum percentage required by law. Nothing herein shall be deemed to preclude ownership by United States Citizens of shares of the Corporation in excess of the Minimum U.S. Ownership. Certificates evidencing shares of stock of the Corporation may be issued in separate series, denominated respectively "Domestic Share Certificates" and "Foreign Share Certificates". Domestic Share Certificates shall be issued in respect of shares owned of record and beneficially by United States Citizens; Foreign Share Certificates shall be issued in respect of shares owned of record or beneficially by non-United States Citizens. Holders of Domestic Shares Certificates and of Foreign Share Certificates shall have in all respects the same corporate status and corporate rights, share for share, except that transfers of Domestic Share Certificates to non-United States Citizens shall be restricted as herein provided. If any shares evidenced by Domestic Share Certificates or by Foreign Share Certificates shall be transferred to United States Citizens, the share certificates issued to the transferee in respect of the shares transferred shall be Domestic Share Certificates. Any purported transfer to non-United States Citizens of shares evidenced by Domestic Share Certificates which, at the time of presentation to the transfer agent of the Corporation, would result in reducing the ownership of shares by United States Citizens below the Minimum U.S. Ownership shall not be recorded on the books of the Corporation and shall be ineffective to transfer the shares or any voting or other rights in respect thereof, and the Corporation may regard the Certificate, whether or not validly issued, as having been invalidly issued. The Board may establish reasonable procedures with respect to the order in which and terms upon which such transfers may be given effect when the transfer to non-United States Citizens of shares evidenced by Domestic Share Certificates will not result in reducing the ownership of shares by United States Citizens below the Minimum U.S. Ownership. In the case of any permitted transfer to non-United States Citizens of shares evidenced by Domestic Shares Certificates, and in the case of any transfer to non-United States Citizens of shares evidenced by Foreign Share Certificates, the share certificates issued to the transferee in respect of the shares transferred shall be Foreign Share Certificates. The Board may establish from time to time reasonable procedures for establishing the citizenship of shareholders of the Corporation and, without limiting the foregoing, may require that in connection with each issue or transfer of shares of the Corporation the purchaser or transferee shall certify his citizenship status and such matters relevant thereto as the Board may require. The Board may also establish from time to time such other reasonable procedures as it may deem desirable for the purposes of implementing the provisions of Article FIFTH of the Certificate of Incorporation and this Article VIII. ARTICLE IX CAPITAL STOCK SECTION 1. FORM AND ISSUANCE. Subject to Article VIII of these By-Laws, certificates of stock shall be issued in such form as may be approved by the Board of Directors and shall be signed by, or in the name of the Corporation by, the President or any of the Vice Presidents, and by the Treasurer or an Assistant Treasurer or the Secretary or an Assistant Secretary of the Corporation; provided, however, that if any such certificate is countersigned (1) by a transfer agent other than the Corporation or its employee, or, (2) by a registrar other than the Corporation or its employee, the signatures of the officers of the Corporation and the seal of the Corporation on such Certificate may be facsimiles. In case any officer who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer before such certificate is issued, it may be issued by the Corporation with the same effect as if he were such officer at the date of issue. The Corporation shall be entitled to treat the holder of record of any shares or shares of stock as the owner in fact thereof and, accordingly, shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it has actual or other notice thereof, save as provided by the laws of the State of Delaware. SECTION 2. TRANSFER OF SHARES OF STOCK. Except as otherwise provided in the Certificate of Incorporation or in these By-Laws, shares of stock shall be transferable on the books of the Corporation by the holder thereof or by his attorney thereunto duly authorized upon the surrender and cancellation of certificates for a like number of shares. SECTION 3. OLD CERTIFICATES TO BE CANCELLED; LOST, STOLEN, OR DESTROYED CERTIFICATES. Except in cases of lost, stolen or destroyed certificates, and in that case only after conforming to the requirements hereinafter provided, no new certificates shall be issued until the former certificate for the shares represented thereby shall have been surrendered and cancelled. Any person claiming a certificate of stock to be lost or destroyed shall make such affidavit or affirmation of that fact as the Board of Directors may require and at the option of the Board of Directors shall give the Corporation and/or its transfer agent or agents, registrar or registrars, a bond of indemnity, in the form and with one or more sureties satisfactory to the Board of Directors, whereupon a new certificate may be issued of the same tenor and for the same number of shares as the one alleged to have been lost or destroyed, and, if required by such Board, a final order or decree of a court of competent jurisdiction of the right of any such person to receive a new certificate shall be procured. SECTION 4. FIXING OF RECORD DATE. In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or to express consent to corporate action in writing without a meeting, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the Board of Directors may fix, in advance, a record date, which shall not be more than sixty, nor less than ten days before the date of such meeting, nor more than sixty days prior to any other action. Only such stockholders as shall be stockholders of record on the date so fixed shall be entitled to such notice of, and to vote at, such meeting and any adjournment thereof, or to receive payment of such dividend or other distribution, or to receive such allotment of rights, or to exercise such rights in respect of any such change, conversion or exchange of stock, or to participate in such other action or to give such consent, as the case may be, notwithstanding any transfer of any stock on the books of the Corporation after any such record date fixed as aforesaid. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board of Directors may fix a new record date for the adjourned meeting. SECTION 5. REGULATIONS. The Board of Directors may make such regulations as it may deem expedient concerning the issue, transfer and registration of stock and may from time to time appoint such transfer agents or registrars of shares as it may deem advisable and may define their powers and duties. ARTICLE XI NEGOTIABLE INSTRUMENTS, CONTRACTS, ETC. SECTION 1. SIGNATURES ON CHECKS, ETC. All checks, drafts, bills of exchange, notes or other instruments or orders for the payment of money or evidences of indebtedness shall be signed for or in the name of the Corporation by such officer or officers, person or persons, as the Board of Directors may from time to time designate by resolution, and in the absence of such resolution by the President or any of the Vice Presidents. SECTION 2. EXECUTION OF CONTRACTS. The President or any of the Vice Presidents, and any other officer or officers that the Board of Directors may designate shall have full authority in the name of and on behalf of the Corporation to enter into any contract or execute and deliver any instruments or notes, or other evidences of indebtedness unless such authority shall be limited by the Board of Directors to specific instances. SECTION 3. BANK ACCOUNTS. All funds of the Corporation shall be deposited from time to time to the credit of the Corporation in such banks, trust companies or other depositories as the Board of Directors may select or as may be selected by any officer or officers, agent or agents of the Corporation to whom such power may from time to time be delegated by the Board of Directors. ARTICLE XII CORPORATE SEAL The seal of the Corporation shall have inscribed thereon the name of the Corporation, the year of its organization and the words "Corporate Seal -- Delaware." Said seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced in any manner whatsoever. ARTICLE XIII FISCAL YEAR The fiscal year of the Corporation shall end on such date as may be determined by the Board of Directors. ARTICLE XIV VOTING OF STOCK HELD Unless otherwise provided by resolution of the Board of Directors, the President or any of the Vice Presidents may from time to time appoint an attorney or attorneys or agent or agents of the Corporation, in the name and on behalf of the Corporation, to cast the votes that the Corporation may be entitled to cast as a stockholder or otherwise in any other corporation or association, any of whose stock or securities may be held by the Corporation, at meetings of the holders of the stock or other securities of such other corporation or association, or to consent in writing to any action by any such other corporation or association, and may instruct the person or persons so appointed as to the manner of casting such votes or giving such consents, and may execute or cause to be executed on behalf of the Corporation and under its corporate seal, or otherwise, such written proxies, consents, waivers or other instruments as he may deem necessary or proper in the premises; or the President or any of the Vice Presidents may himself attend any meeting of the holders of stock or other securities of any such other corporation or association and thereat vote or exercise any or all other powers of the Corporation as the holder of such stock or other securities of such other corporation or association, or may consent in writing to any action by any such other corporation or association. ARTICLE XV AMENDMENTS The Board of Directors at any regular meeting or special meeting called for the purpose, and the stockholders at any annual meeting or special meeting called for the purpose may make, alter, amend or repeal the By-Laws of the Corporation or any of them. EXHIBIT 4(d)(1) [CONFORMED] ================================================================= OVERSEAS SHIPHOLDING GROUP, INC. TO THE CHASE MANHATTAN BANK (NATIONAL ASSOCIATION) Trustee ---------- INDENTURE Dated as of December 1, 1993 ---------- ================================================================= OVERSEAS SHIPHOLDING GROUP, INC. Certain Sections of this Indenture relating to Sections 310 through 318, inclusive, of the Trust Indenture Act of 1939: Trust Indenture Act Section Indenture Section Section 310(a)(1) 609 (a)(2) 609 (a)(3) Not Applicable (a)(4) Not Applicable (b) 608 Section 311(a) 613 (b) 613 Section 312(a) 701 (b) 702 (c) 702 Section 313(a) 703 (b) 703 (c) 703 (d) 703 Section 314(a) 704 (a)(4) 101 (b) Not Applicable (c)(1) 102 (c)(2) 102 (c)(3) Not Applicable (d) Not Applicable (e) 102 Section 315(a) 601 (b) 602 (c) 601 (d) 601 (e) 514 Section 316(a) 101 (a)(1)(A) 502 (a)(1)(B) 513 (a)(2) Not Applicable (b) 508 (c) 104 Section 317(a)(1) 503 (a)(2) 504 (b) 1003 Section 318(a) 107 ___________________ NOTE: THIS RECONCILIATION AND TIE SHALL NOT, FOR ANY PURPOSE, BE DEEMED TO BE A PART OF THE INDENTURE. INDENTURE, dated as of December 1, 1993, between Overseas Shipholding Group, Inc., a corporation duly organized and existing under the laws of the State of Delaware (herein called the "Company"), having its principal office at 1114 Avenue of the Americas, New York, New York 10036, and The Chase Manhattan Bank (National Association), a national banking association duly organized and existing under the laws of the United States of America, as Trustee (herein called the "Trustee"). RECITALS OF THE COMPANY The Company has duly authorized the execution and delivery of this Indenture to provide for the issuance from time to time of its unsecured debentures, notes or other evidences of indebtedness (herein called the "Securities"), to be issued in one or more series as in this Indenture provided. All things necessary to make this Indenture a valid agreement of the Company, in accordance with its terms, have been done. NOW, THEREFORE, THIS INDENTURE WITNESSETH: For and in consideration of the premises and the purchase of the Securities by the Holders thereof, it is mutually agreed, for the equal and proportionate benefit of all Holders of the Securities or of series thereof, as follows: ARTICLE ONE DEFINITIONS AND OTHER PROVISIONS OF GENERAL APPLICATION SECTION 101. DEFINITIONS. For all purposes of this Indenture, except as otherwise expressly provided or unless the context otherwise requires: (1) the terms defined in this Article have the meanings assigned to them in this Article and include the plural as well as the singular; (2) all other terms used herein which are defined in the Trust Indenture Act, either directly or by reference therein, have the meanings assigned to them therein; (3) all accounting terms not otherwise defined herein have the meanings assigned to them in accordance with generally accepted accounting principles, and, except as otherwise herein expressly provided, the term "generally accepted accounting principles" with respect to any computation required or permitted hereunder shall mean such accounting principles as are generally accepted at the date of such computation; (4) unless the context otherwise requires, any reference to an "Article" or a "Section" refers to an Article or a Section, as the case may be, of this Indenture; and (5) the words "herein", "hereof" and "hereunder" and other words of similar import refer to this Indenture as a whole and not to any particular Article, Section or other subdivision. "Act", when used with respect to any Holder, has the meaning specified in Section 104. "Affiliate" of any specified Person means any other Person directly or indirectly controlling or controlled by or under direct or indirect common control with such specified Person. For the purposes of this definition, "control" when used with respect to any specified Person means the power to direct the management and policies of such Person, directly or indirectly, whether through the ownership of voting securities, by contract or otherwise; and the terms "controlling" and "controlled" have meanings correlative to the foregoing. "Attributable Debt" of a Person means, as to any sale and leaseback transaction relating to any property or assets under which any Person is at the time liable and which is not permitted under Section 1010(2), at any date as of which the amount thereof is to be determined, the lesser of (i) the fair market value of the assets subject to such transaction as determined by any two of the Chairman of the Board of the Company, its President, any Executive or Senior Vice President of the Company, its Chief Financial Officer, its Treasurer and its Controller or (ii) the total net amount of Rentals required to be paid by such Person under such lease during the remaining term thereof, discounted from the respective due dates thereof to such date at a rate per annum equal to the discount rate which would be applicable to a capital lease obligation with like term in accordance with generally accepted accounting principles. "Authenticating Agent" means any Person authorized by the Trustee pursuant to Section 614 to act on behalf of the Trustee to authenticate Securities of one or more series. "Board of Directors" means either the board of directors of the Company or any duly authorized committee of that board. "Board Resolution" means a copy of a resolution certified by the Secretary or an Assistant Secretary of the Company to have been duly adopted by the Board of Directors and to be in full force and effect on the date of such certification, and delivered to the Trustee. "Business Day", when used with respect to any Place of Payment, means each Monday, Tuesday, Wednesday, Thursday and Friday which is not a day on which banking institutions in that Place of Payment are authorized or obligated by law or executive order to close. "Capitalized Lease" means any lease the obligation for Rentals with respect to which is required to be capitalized on a balance sheet of the lessee in accordance with generally accepted accounting principles. "Capitalized Rentals" of any Person means as of the date of any determination thereof the amount at which the aggregate Rentals due and to become due under all Capitalized Leases under which such Person is a lessee would be reflected as a liability on a balance sheet of such Person in accordance with generally accepted accounting principles. "Commission" means the Securities and Exchange Commission, from time to time constituted, created under the Exchange Act, or, if at any time after the execution of this instrument such Commission is not existing and performing the duties now assigned to it under the Trust Indenture Act, then the body performing such duties at such time. "Company" means the Person named as the "Company" in the first paragraph of this instrument until a successor Person shall have become such pursuant to the applicable provisions of this Indenture, and thereafter "Company" shall mean such successor Person. "Company Request" or "Company Order" means a written request or order signed in the name of the Company by its Chairman of the Board, its Vice Chairman of the Board, its President or a Vice President, and by its Controller, Treasurer, an Assistant Treasurer, its Secretary or an Assistant Secretary, and delivered to the Trustee. "Consolidated Net Tangible Assets of the Company and its Restricted Subsidiaries" means the aggregate amount of assets (less applicable reserves and other properly deductible items) after deducting therefrom (a) all current liabilities (excluding any thereof constituting Funded Debt) and (b) all goodwill, trade names, trademarks, patents, copyrights, franchises, experimental expense, organization expense, unamortized debt discount and expenses, deferred charges (other than unamortized deferred dry dock costs, unterminated voyage expenses, prepaid insurance, prepaid taxes, prepaid charter hire and other prepaid items properly excludable from intangibles under generally accepted accounting principles) and other like intangibles, all as set forth on or included in the most recent consolidated balance sheet of the Company and its Restricted Subsidiaries, such balance sheet to be prepared (except for the exclusion of Subsidiaries which are not Restricted Subsidiaries) in accordance with generally accepted accounting principles. "Corporate Trust Office" means the principal office of the Trustee in The City of New York at which at any particular time its corporate trust business shall be administered. "corporation" means a corporation, association, company, joint-stock company or business trust. "Covenant Defeasance" has the meaning specified in Section 1303. "Debt" of a Person means, without duplication, (i) any indebtedness for money borrowed, whether or not evidenced by notes, bonds, debentures or other similar evidences of indebtedness for money borrowed, (ii) all Capitalized Rentals of such Person (other than Rentals owing from the Company or any Restricted Subsidiary to the Company or another Restricted Subsidiary), and (iii) all Guaranties by such Person of any obligation described in clause (i) or (ii) of any other Person (other than any such obligation of the Company or any Subsidiary). "Defaulted Interest" has the meaning specified in Section 307. "Defeasance" has the meaning specified in Section 1302. "Depositary" means, with respect to Securities of any series issuable in whole or in part in the form of one or more Global Securities, a clearing agency registered under the Exchange Act that is designated to act as Depositary for such Securities as contemplated by Section 301. "Event of Default" has the meaning specified in Section 501. "Exchange Act" means the Securities Exchange Act of 1934 and any statute successor thereto, in each case as amended from time to time. "Expiration Date" has the meaning specified in Section 104. "Funded Debt" means all Debt having (a) a maturity of more than 12 months from the date as of which the amount thereof is to be determined or (b) a maturity of less than 12 months and that is (i) by its terms renewable or extendable beyond 12 months from such date at the option of the borrower or (ii) included in long- term Debt on the consolidated balance sheet of the Company in accordance with generally accepted accounting principles. "Global Security" means a Security that evidences all or part of the Securities of any series and bears the legend set forth in Section 204 (or such legend as may be specified as contemplated by Section 301 for such Securities). "Guaranties" by any Person shall mean all obligations (other than endorsements in the ordinary course of business of negotiable instruments for deposit or collection) of such Person guaranteeing, or in effect guaranteeing, any indebtedness, dividend or other obligation of any other Person (the "primary obligor") in any manner, whether directly or indirectly, including, without limitation, all obligations incurred through an agreement, contingent or otherwise, by such Person: (i) to purchase such indebtedness or obligation or any property or assets constituting security therefor, (ii) to advance or supply funds (x) for the purchase or payment of such indebtedness or obligation, (y) to maintain working capital or other balance sheet condition or otherwise to advance or make available funds for the purchase or payment of such indebtedness or obligation, (iii) to lease property or to purchase securities or other property or services primarily for the purpose of assuring the owner of such indebtedness or obligation of the ability of the primary obligor to make payment of the indebtedness or obligation, or (iv) otherwise to assure the owner of the indebtedness or obligation of the primary obligor against loss in respect thereof. For the purposes of all computations made under this Indenture, a Guaranty in respect of any indebtedness for borrowed money shall be deemed to be indebtedness equal to the principal amount of such indebtedness for borrowed money which has been guaranteed, and a Guaranty in respect of any other obligation or liability or any dividend shall be deemed to be indebtedness equal to the maximum aggregate amount of such obligation, liability or dividend. "Holder" means a Person in whose name a Security is registered in the Security Register. "Incur", with respect to any Debt, means to incur, create, issue, assume, guarantee or otherwise become liable for any such Debt (and "Incurrence", "Incurred", "Incurrable" and "Incurring" shall have meanings correlative to the foregoing). "Indenture" means this instrument as originally executed and as it may from time to time be supplemented or amended by one or more indentures supplemental hereto entered into pursuant to the applicable provisions hereof, including, for all purposes of this instrument and any such supplemental indenture, the provisions of the Trust Indenture Act that are deemed to be a part of and govern this instrument and any such supplemental indenture, respectively. The term "Indenture" shall also include the terms of particular series of Securities established as contemplated by Section 301. "interest", when used with respect to an Original Issue Discount Security which by its terms bears interest only after Maturity, means interest payable after Maturity. "Interest Payment Date", when used with respect to any Security, means the Stated Maturity of an instalment of interest on such Security. "Investment Company Act" means the Investment Company Act of 1940 and any statute successor thereto, in each case as amended from time to time. "Maturity", when used with respect to any Security, means the date on which the principal of such Security or an instalment of principal becomes due and payable as therein or herein provided, whether at the Stated Maturity or by declaration of acceleration, call for redemption or otherwise. "Mortgage" means any pledge of, conditional sale or other title retention of, or mortgage or other lien or security interest or encumbrance of any kind on, any property or assets owned or leased by the Company or any Subsidiary, or any shares of stock or Debt of any Subsidiary. "Notice of Default" means a written notice of the kind specified in Section 501(4) or 501(5). "Officers' Certificate" means a certificate signed by the Chairman of the Board, a Vice Chairman of the Board, the President or a Vice President, and by the Controller, the Treasurer, an Assistant Treasurer, the Secretary or an Assistant Secretary, of the Company, and delivered to the Trustee. One of the officers signing an Officers' Certificate given pursuant to Section 1004 shall be the principal executive, financial or accounting officer of the Company. "Opinion of Counsel" means a written opinion of counsel, who may be counsel for the Company (whether inside counsel or outside counsel). "Original Issue Discount Security" means any Security which provides for an amount less than the principal amount thereof to be due and payable upon a declaration of acceleration of the Maturity thereof pursuant to Section 502. "Outstanding", when used with respect to Securities, means, as of the date of determination, all Securities theretofore authenticated and delivered under this Indenture, except: (1) Securities theretofore cancelled by the Trustee or delivered to the Trustee for cancellation; (2) Securities for whose payment or redemption money in the necessary amount has been theretofore deposited with the Trustee or any Paying Agent (other than the Company) in trust or set aside and segregated in trust by the Company (if the Company shall act as its own Paying Agent) for the Holders of such Securities; provided that, if such Securities are to be redeemed, notice of such redemption has been duly given pursuant to this Indenture or provision therefor satisfactory to the Trustee has been made; (3) Securities as to which Defeasance has been effected pursuant to Section 1302; and (4) Securities which have been paid pursuant to Section 306 or in exchange for or in lieu of which other Securities have been authenticated and delivered pursuant to this Indenture, other than any such Securities in respect of which there shall have been presented to the Trustee proof satisfactory to it that such Securities are held by a bona fide purchaser in whose hands such Securities are valid obligations of the Company; provided, however, that in determining whether the Holders of the requisite principal amount of the Outstanding Securities have given, made or taken any request, demand, authorization, direction, notice, consent, waiver or other action hereunder as of any date, (A) the principal amount of an Original Issue Discount Security which shall be deemed to be Outstanding shall be the amount of the principal thereof which would be due and payable as of such date upon acceleration of the Maturity thereof to such date pursuant to Section 502, (B) if, as of such date, the principal amount payable at the Stated Maturity of a Security is not determinable, the principal amount of such Security which shall be deemed to be Outstanding shall be the amount as specified or determined as contemplated by Section 301, (C) the principal amount of a Security denominated in one or more foreign currencies or currency units which shall be deemed to be Outstanding shall be the U.S. dollar equivalent, determined as of such date in the manner provided as contemplated by Section 301, of the principal amount of such Security (or, in the case of a Security described in Clause (A) or (B) above, of the amount determined as provided in such Clause), and (D) Securities owned by the Company or any other obligor upon the Securities or any Affiliate of the Company or of such other obligor shall be disregarded and deemed not to be Outstanding, except that, in determining whether the Trustee shall be protected in relying upon any such request, demand, authorization, direction, notice, consent, waiver or other action, only Securities which the Trustee knows to be so owned shall be so disregarded. Securities so owned which have been pledged in good faith may be regarded as Outstanding if the pledgee establishes to the satisfaction of the Trustee the pledgee's right so to act with respect to such Securities and that the pledgee is not the Company or any other obligor upon the Securities or any Affiliate of the Company or of such other obligor. "Paying Agent" means any Person authorized by the Company to pay the principal of or any premium or interest on any Securities on behalf of the Company. "Person" means any individual, corporation, partnership, joint venture, trust, unincorporated organization or government or any agency or political subdivision thereof. "Place of Payment", when used with respect to the Securities of any series, means the place or places where the principal of and any premium and interest on the Securities of that series are payable as specified as contemplated by Section 301. "Predecessor Security" of any particular Security means every previous Security evidencing all or a portion of the same debt as that evidenced by such particular Security; and, for the purposes of this definition, any Security authenticated and delivered under Section 306 in exchange for or in lieu of a mutilated, destroyed, lost or stolen Security shall be deemed to evidence the same debt as the mutilated, destroyed, lost or stolen Security. "Redemption Date", when used with respect to any Security to be redeemed, means the date fixed for such redemption by or pursuant to this Indenture. "Redemption Price", when used with respect to any Security to be redeemed, means the price at which it is to be redeemed pursuant to this Indenture. "Regular Record Date" for the interest payable on any Interest Payment Date on the Securities of any series means the date specified for that purpose as contemplated by Section 301. "Rentals" means, as of the date of any determination thereof, all rent payable by the lessee under a lease of any property or assets, after excluding amounts required to be paid on account of maintenance and repairs, insurance, taxes, assessments, water rates and similar charges. Rents under any "percentage leases" shall be computed solely on the basis of minimum rents, if any, required to be paid by the lessee regardless of sales volume or gross revenues. In the case of any lease which is terminable by the lessee upon the payment of a penalty, such net amount shall also include the amount of such penalty, but no rent shall be considered as required to be paid under such lease subsequent to the first date upon which it may be so terminated. "Responsible Officer", when used with respect to the Trustee, means the chairman or any vice-chairman of the board of directors, the chairman or any vice-chairman of the executive committee of the board of directors, the chairman of the trust committee, the president, any vice president, the secretary, any assistant secretary, the treasurer, any assistant treasurer, the cashier, any assistant cashier, any trust officer or assistant trust officer, the controller or any assistant controller or any other officer of the Trustee customarily performing functions similar to those performed by any of the above designated officers and also means, with respect to a particular corporate trust matter, any other officer to whom such matter is referred because of his knowledge of and familiarity with the particular subject. "Restricted Subsidiary" means any Subsidiary existing on the date hereof and any Subsidiary existing, created or acquired subsequent to the date hereof unless designated by the Board of Directors as an Unrestricted Subsidiary in accordance with Section 1012. "Securities" has the meaning stated in the first recital of this Indenture and more particularly means any Securities authenticated and delivered under this Indenture. "Securities Act" means the Securities Act of 1933 and any statute successor thereto, in each case as amended from time to time. "Security Register" and "Security Registrar" have the respective meanings specified in Section 305. "Special Record Date" for the payment of any Defaulted Interest means a date fixed by the Trustee pursuant to Section 307. "Stated Maturity", when used with respect to any Security or any instalment of principal thereof or interest thereon, means the date specified in such Security as the fixed date on which the principal of such Security or such instalment of principal or interest is due and payable. "Subsidiary" means a corporation more than 50% of the outstanding voting stock of which is owned, directly or indirectly, by the Company or by one or more other Subsidiaries, or by the Company and one or more other Subsidiaries. For the purposes of this definition, "voting stock" means stock which ordinarily has voting power for the election of directors, whether at all times or only so long as no senior class of stock has such voting power by reason of any contingency. "Trust Indenture Act" means the Trust Indenture Act of 1939 as in force at the date as of which this instrument was executed; provided, however, that in the event the Trust Indenture Act of 1939 is amended after such date, "Trust Indenture Act" means, to the extent required by any such amendment, the Trust Indenture Act of 1939 as so amended. "Trustee" means the Person named as the "Trustee" in the first paragraph of this instrument until a successor Trustee shall have become such pursuant to the applicable provisions of this Indenture, and thereafter "Trustee" shall mean or include each Person who is then a Trustee hereunder, and if at any time there is more than one such Person, "Trustee" as used with respect to the Securities of any series shall mean the Trustee with respect to Securities of that series. "Unrestricted Subsidiary" means any Subsidiary that is not a Restricted Subsidiary. "U.S. Government Obligation" has the meaning specified in Section 1304. "Vice President", when used with respect to the Company or the Trustee, means any vice president, whether or not designated by a number or a word or words added before or after the title "vice president". SECTION 102. COMPLIANCE CERTIFICATES AND OPINIONS. Upon any application or request by the Company to the Trustee to take any action under any provision of this Indenture, the Company shall furnish to the Trustee such certificates and opinions as may be required under the Trust Indenture Act. Each such certificate or opinion shall be given in the form of an Officers' Certificate, if to be given by an officer of the Company, or an Opinion of Counsel, if to be given by counsel, and shall comply with the requirements of the Trust Indenture Act and any other requirements set forth in this Indenture. Every certificate or opinion with respect to compliance with a condition or covenant provided for in this Indenture (except for certificates provided for in Section 1004) shall include, (1) a statement that each individual signing such certificate or opinion has read such covenant or condition and the definitions herein relating thereto; (2) a brief statement as to the nature and scope of the examination or investigation upon which the statements or opinions contained in such certificate or opinion are based; (3) a statement that, in the opinion of each such individual, he has made such examination or investigation as is necessary to enable him to express an informed opinion as to whether or not such covenant or condition has been complied with; and (4) a statement as to whether, in the opinion of each such individual, such condition or covenant has been complied with. SECTION 103. FORM OF DOCUMENTS DELIVERED TO TRUSTEE. In any case where several matters are required to be certified by, or covered by an opinion of, any specified Person, it is not necessary that all such matters be certified by, or covered by the opinion of, only one such Person, or that they be so certified or covered by only one document, but one such Person may certify or give an opinion with respect to some matters and one or more other such Persons as to other matters, and any such Person may certify or give an opinion as to such matters in one or several documents. Any certificate or opinion of an officer of the Company may be based, insofar as it relates to legal matters, upon a certificate or opinion of, or representations by, counsel, unless such officer knows, or in the exercise of reasonable care should know, that the certificate or opinion or representations with respect to the matters upon which his certificate or opinion is based are erroneous. Any such certificate or opinion of counsel may be based, insofar as it relates to factual matters, upon a certificate or opinion of, or representations by, an officer or officers of the Company stating that the information with respect to such factual matters is in the possession of the Company, unless such counsel knows, or in the exercise of reasonable care should know, that the certificate or opinion or representations with respect to such matters are erroneous. Where any Person is required to make, give or execute two or more applications, requests, consents, certificates, statements, opinions or other instruments under this Indenture, they may, but need not, be consolidated and form one instrument. SECTION 104. ACTS OF HOLDERS; RECORD DATES. Any request, demand, authorization, direction, notice, consent, waiver or other action provided or permitted by this Indenture to be given, made or taken by Holders may be embodied in and evidenced by one or more instruments of substantially similar tenor signed by such Holders in person or by agent duly appointed in writing; and, except as herein otherwise expressly provided, such action shall become effective when such instrument or instruments are delivered to the Trustee and, where it is hereby expressly required, to the Company. Such instrument or instruments (and the action embodied therein and evidenced thereby) are herein sometimes referred to as the "Act" of the Holders signing such instrument or instruments. Proof of execution of any such instrument or of a writing appointing any such agent shall be sufficient for any purpose of this Indenture and (subject to Section 601) conclusive in favor of the Trustee and the Company, if made in the manner provided in this Section. The fact and date of the execution by any Person of any such instrument or writing may be proved by the affidavit of a witness of such execution or by a certificate of a notary public or other officer authorized by law to take acknowledgments of deeds, certifying that the individual signing such instrument or writing acknowledged to him the execution thereof. Where such execution is by a signer acting in a capacity other than his individual capacity, such certificate or affidavit shall also constitute sufficient proof of his authority. The fact and date of the execution of any such instrument or writing, or the authority of the Person executing the same, may also be proved in any other manner which the Trustee deems sufficient. The ownership of Securities shall be proved by the Security Register. Any request, demand, authorization, direction, notice, consent, waiver or other Act of the Holder of any Security shall bind every future Holder of the same Security and the Holder of every Security issued upon the registration of transfer thereof or in exchange therefor or in lieu thereof in respect of anything done, omitted or suffered to be done by the Trustee or the Company in reliance thereon, whether or not notation of such action is made upon such Security. The Company may set any day as a record date for the purpose of determining the Holders of Outstanding Securities of any series entitled to give, make or take any request, demand, authorization, direction, notice, consent, waiver or other action provided or permitted by this Indenture to be given, made or taken by Holders of Securities of such series, provided that the Company may not set a record date for, and the provisions of this paragraph shall not apply with respect to, the giving or making of any notice, declaration, request or direction referred to in the next paragraph. If any record date is set pursuant to this paragraph, the Holders of Outstanding Securities of the relevant series on such record date, and no other Holders, shall be entitled to take the relevant action, whether or not such Holders remain Holders after such record date; provided that no such action shall be effective hereunder unless taken on or prior to the applicable Expiration Date by Holders of the requisite principal amount of Outstanding Securities of such series on such record date. Nothing in this paragraph shall be construed to prevent the Company from setting a new record date for any action for which a record date has previously been set pursuant to this paragraph (whereupon the record date previously set shall automatically and with no action by any Person be cancelled and of no effect), and nothing in this paragraph shall be construed to render ineffective any action taken by Holders of the requisite principal amount of Outstanding Securities of the relevant series on the date such action is taken. Promptly after any record date is set pursuant to this paragraph, the Company, at its own expense, shall cause notice of such record date, the proposed action by Holders and the applicable Expiration Date to be given to the Trustee in writing and to each Holder of Securities of the relevant series in the manner set forth in Section 106. The Trustee may set any day as a record date for the purpose of determining the Holders of Outstanding Securities of any series entitled to join in the giving or making of (i) any Notice of Default, (ii) any declaration of acceleration referred to in Section 502, (iii) any request to institute proceedings referred to in Section 507(2) or (iv) any direction referred to in Section 512, in each case with respect to Securities of such series. If any record date is set pursuant to this paragraph, the Holders of Outstanding Securities of such series on such record date, and no other Holders, shall be entitled to join in such notice, declaration, request or direction, whether or not such Holders remain Holders after such record date; provided that no such action shall be effective hereunder unless taken on or prior to the applicable Expiration Date by Holders of the requisite principal amount of Outstanding Securities of such series on such record date. Nothing in this paragraph shall be construed to prevent the Trustee from setting a new record date for any action for which a record date has previously been set pursuant to this paragraph (whereupon the record date previously set shall automatically and with no action by any Person be cancelled and of no effect), and nothing in this paragraph shall be construed to render ineffective any action taken by Holders of the requisite principal amount of Outstanding Securities of the relevant series on the date such action is taken. Promptly after any record date is set pursuant to this paragraph, the Trustee, at the Company's expense, shall cause notice of such record date, the proposed action by Holders and the applicable Expiration Date to be given to the Company in writing and to each Holder of Securities of the relevant series in the manner set forth in Section 106. With respect to any record date set pursuant to this Section, the party hereto which sets such record dates may designate any day as the "Expiration Date" and from time to time may change the Expiration Date to any earlier or later day; provided that no such change shall be effective unless notice of the proposed new Expiration Date is given to the other party hereto in writing, and to each Holder of Securities of the relevant series in the manner set forth in Section 106, on or prior to the existing Expiration Date. If an Expiration Date is not designated with respect to any record date set pursuant to this Section, the party hereto which set such record date shall be deemed to have initially designated the 180th day after such record date as the Expiration Date with respect thereto, subject to its right to change the Expiration Date as provided in this paragraph. Notwithstanding the foregoing, no Expiration Date shall be later than the 180th day after the applicable record date. Without limiting the foregoing, a Holder entitled hereunder to take any action hereunder with regard to any particular Security may do so with regard to all or any part of the principal amount of such Security or by one or more duly appointed agents each of which may do so pursuant to such appointment with regard to all or any part of such principal amount. SECTION 105. NOTICES, ETC., TO TRUSTEE AND COMPANY. Any request, demand, authorization, direction, notice, consent, waiver or Act of Holders or other document provided or permitted by this Indenture to be made upon, given or furnished to, or filed with, (1) the Trustee by any Holder or by the Company shall be sufficient for every purpose hereunder if made, given, furnished or filed in writing to or with the Trustee at its Corporate Trust Office, Attention: Corporate Trust Administration, or (2) the Company by the Trustee or by any Holder shall be sufficient for every purpose hereunder (unless otherwise herein expressly provided) if in writing and mailed, first-class postage prepaid, to the Company addressed to it to the attention of its Secretary at the address of its principal office specified in the first paragraph of this instrument or at any other address previously furnished in writing to the Trustee by the Company. SECTION 106. NOTICE TO HOLDERS; WAIVER. Where this Indenture provides for notice to Holders of any event, such notice shall be sufficiently given (unless otherwise herein expressly provided) if in writing and mailed, first-class postage prepaid, to each Holder affected by such event, at his address as it appears in the Security Register, not later than the latest date (if any), and not earlier than the earliest date (if any), prescribed for the giving of such notice. In any case where notice to Holders is given by mail, neither the failure to mail such notice, nor any defect in any notice so mailed, to any particular Holder shall affect the sufficiency of such notice with respect to other Holders. Where this Indenture provides for notice in any manner, such notice may be waived in writing by the Person entitled to receive such notice, either before or after the event, and such waiver shall be the equivalent of such notice. Waivers of notice by Holders shall be filed with the Trustee, but such filing shall not be a condition precedent to the validity of any action taken in reliance upon such waiver. In case by reason of the suspension of regular mail service or by reason of any other cause it shall be impracticable to give such notice by mail, then such notification as shall be made with the approval of the Trustee shall constitute a sufficient notification for every purpose hereunder. SECTION 107. CONFLICT WITH TRUST INDENTURE ACT. If any provision hereof limits, qualifies or conflicts with a provision of the Trust Indenture Act which is required under such Act to be a part of and govern this Indenture, the latter provision shall control. If any provision of this Indenture modifies or excludes any provision of the Trust Indenture Act which may be so modified or excluded, the latter provision shall be deemed to apply to this Indenture as so modified or to be excluded, as the case may be. SECTION 108. EFFECT OF HEADINGS AND TABLE OF CONTENTS. The Article and Section headings herein and the Table of Contents are for convenience only and shall not affect the construction hereof. SECTION 109. SUCCESSORS AND ASSIGNS. All covenants and agreements in this Indenture by the Company shall bind its successors and assigns, whether so expressed or not. SECTION 110. SEPARABILITY CLAUSE. In case any provision in this Indenture or in the Securities shall be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions shall not in any way be affected or impaired thereby. SECTION 111. BENEFITS OF INDENTURE. Nothing in this Indenture or in the Securities, express or implied, shall give to any Person, other than the parties hereto and their successors hereunder and the Holders, any benefit or any legal or equitable right, remedy or claim under this Indenture. SECTION 112. GOVERNING LAW. This Indenture and the Securities shall be governed by and construed in accordance with the law of the State of New York. SECTION 113. LEGAL HOLIDAYS. In any case where any Interest Payment Date, Redemption Date or Stated Maturity of any Security shall not be a Business Day at any Place of Payment, then (notwithstanding any other provision of this Indenture or of the Securities (other than a provision of any Security which specifically states that such provision shall apply in lieu of this Section)) payment of interest or principal (and premium, if any) need not be made at such Place of Payment on such date, but may be made on the next succeeding Business Day at such Place of Payment with the same force and effect as if made on the Interest Payment Date or Redemption Date, or at the Stated Maturity. SECTION 114. NO RECOURSE. A director, officer, employee, stockholder or Affiliate, as such, of the Company shall not have any liability for any obligations of the Company under the Securities or this Indenture. Each Holder by accepting a Security waives and releases all such liability; provided, however, that nothing in this Section shall be deemed to relieve any Person referred to herein for any liability imposed by the Securities Act or the Trust Indenture Act. ARTICLE TWO SECURITY FORMS SECTION 201. FORMS GENERALLY. The Securities of each series shall be in substantially the form set forth in this Article, or in such other form as shall be established by or pursuant to a Board Resolution or in one or more indentures supplemental hereto, in each case with such appropriate insertions, omissions, substitutions and other variations as are required or permitted by this Indenture, and may have such letters, numbers or other marks of identification and such legends or endorsements placed thereon as may be required to comply with the rules of any securities exchange or Depositary therefor or as may, consistently herewith, be determined by the officers executing such Securities, as evidenced by their execution thereof. If the form of Securities of any series is established by action taken pursuant to a Board Resolution, a copy of an appropriate record of such action shall be certified by the Secretary or an Assistant Secretary of the Company and delivered to the Trustee at or prior to the delivery of the Company Order contemplated by Section 303 for the authentication and delivery of such Securities. The definitive Securities shall be printed, lithographed or engraved on steel engraved borders or may be produced in any other manner, all as determined by the officers executing such Securities, as evidenced by their execution of such Securities. SECTION 202. FORM OF FACE OF SECURITY. [Insert any legend required by the Internal Revenue Code and the regulations thereunder.] OVERSEAS SHIPHOLDING GROUP, INC. ........................................................ No. ......... $ ...... Overseas Shipholding Group, Inc., a corporation duly organized and existing under the laws of Delaware (herein called the "Company", which term includes any successor Person under the Indenture hereinafter referred to), for value received, hereby promises to pay to ............................................, or registered assigns, the principal sum of .................................................. Dollars on ............................................... [if the Security is to bear interest prior to Maturity, insert -- , and to pay interest thereon from ............. or from the most recent Interest Payment Date to which interest has been paid or duly provided for, semi-annually on ............ and ............ in each year, commencing ........., at the rate of ....% per annum, until the principal hereof is paid or made available for payment [if applicable, insert --, provided that any principal and premium, and any such instalment of interest, which is overdue shall bear interest at the rate of ...% per annum (to the extent that the payment of such interest shall be legally enforceable), from the dates such amounts are due until they are paid or made available for payment, and such interest shall be payable on demand]. The interest so payable, and punctually paid or duly provided for, on any Interest Payment Date will, as provided in such Indenture, be paid to the Person in whose name this Security (or one or more Predecessor Securities) is registered at the close of business on the Regular Record Date for such interest, which shall be the ....... or ....... (whether or not a Business Day), as the case may be, next preceding such Interest Payment Date. Any such interest not so punctually paid or duly provided for will forthwith cease to be payable to the Holder on such Regular Record Date and may either be paid to the Person in whose name this Security (or one or more Predecessor Securities) is registered at the close of business on a Special Record Date for the payment of such Defaulted Interest to be fixed by the Trustee, notice whereof shall be given to Holders of Securities of this series not less than 10 days prior to such Special Record Date, or be paid at any time in any other lawful manner not inconsistent with the requirements of any securities exchange on which the Securities of this series may be listed, and upon such notice as may be required by such exchange, all as more fully provided in said Indenture]. [If the Security is not to bear interest prior to Maturity, insert -- The principal of this Security shall not bear interest except in the case of a default in payment of principal upon acceleration, upon redemption or at Stated Maturity and in such case the overdue principal and any overdue premium shall bear interest at the rate of ....% per annum (to the extent that the payment of such interest shall be legally enforceable), from the dates such amounts are due until they are paid or made available for payment. Interest on any overdue principal or premium shall be payable on demand. [Any such interest on overdue principal or premium which is not paid on demand shall bear interest at the rate of ......% per annum (to the extent that the payment of such interest on interest shall be legally enforceable), from the date of such demand until the amount so demanded is paid or made available for payment. Interest on any overdue interest shall be payable on demand.]] Payment of the principal of (and premium, if any) and [if applicable, insert -- any such] interest on this Security will be made at the office or agency of the Company maintained for that purpose in The City of New York, in such coin or currency of the United States of America as at the time of payment is legal tender for payment of public and private debts [if applicable, insert --; provided, however, that at the option of the Company payment of interest may be made by check mailed to the address of the Person entitled thereto as such address shall appear in the Security Register]. Reference is hereby made to the further provisions of this Security set forth on the reverse hereof, which further provisions shall for all purposes have the same effect as if set forth at this place. Unless the certificate of authentication hereon has been executed by the Trustee referred to on the reverse hereof by manual signature, this Security shall not be entitled to any benefit under the Indenture or be valid or obligatory for any purpose. In Witness Whereof, the Company has caused this instrument to be duly executed under its corporate seal. Dated: Overseas Shipholding Group, Inc. ................................ Attest: ................... SECTION 203. FORM OF REVERSE OF SECURITY. This Security is one of a duly authorized issue of securities of the Company (herein called the "Securities"), issued and to be issued in one or more series under an Indenture, dated as of ........ ..., 199.. (herein called the "Indenture", which term shall have the meaning assigned to it in such instrument), between the Company and ..................., as Trustee (herein called the "Trustee", which term includes any successor trustee under the Indenture), and reference is hereby made to the Indenture for a statement of the respective rights, limitations of rights, duties and immunities thereunder of the Company, the Trustee and the Holders of the Securities and of the terms upon which the Securities are, and are to be, authenticated and delivered. This Security is one of the series designated on the face hereof [if applicable, insert -- , limited in aggregate principal amount to $...........]. [If applicable, insert -- The Securities of this series are subject to redemption upon not less than 30 days' notice by mail, [if applicable, insert -- (1) on ........... in any year commencing with the year ...... and ending with the year ...... through operation of the sinking fund for this series at a Redemption Price equal to 100% of the principal amount, and (2)] at any time [if applicable, insert -- on or after .........., 19..], as a whole or in part, at the election of the Company, at the following Redemption Prices (expressed as percentages of the principal amount): If redeemed [if applicable, insert -- on or before ..............., ...%, and if redeemed] during the 12-month period beginning ............. of the years indicated, Redemption Redemption Year Price Year Price ---- ---------- ---- ---------- and thereafter at a Redemption Price equal to .....% of the principal amount, together in the case of any such redemption [if applicable, insert -- (whether through operation of the sinking fund or otherwise)] with accrued interest to the Redemption Date, but interest instalments whose Stated Maturity is on or prior to such Redemption Date will be payable to the Holders of such Securities, or one or more Predecessor Securities, of record at the close of business on the relevant Record Dates referred to on the face hereof, all as provided in the Indenture.] [If applicable, insert -- The Securities of this series are subject to redemption upon not less than 30 days' notice by mail, (1) on ............ in any year commencing with the year .... and ending with the year .... through operation of the sinking fund for this series at the Redemption Prices for redemption through operation of the sinking fund (expressed as percentages of the principal amount) set forth in the table below, and (2) at any time [if applicable, insert -- on or after ............], as a whole or in part, at the election of the Company, at the Redemption Prices for redemption otherwise than through operation of the sinking fund (expressed as percentages of the principal amount) set forth in the table below: If redeemed during the 12- month period beginning ............ of the years indicated, Redemption Price For Redemption Redemption Price For Through Operation Redemption Otherwise of the Than Through Operation Year Sinking Fund of the Sinking Fund ---- ----------------- ---------------------- and thereafter at a Redemption Price equal to .....% of the principal amount, together in the case of any such redemption (whether through operation of the sinking fund or otherwise) with accrued interest to the Redemption Date, but interest instalments whose Stated Maturity is on or prior to such Redemption Date will be payable to the Holders of such Securities, or one or more Predecessor Securities, of record at the close of business on the relevant Record Dates referred to on the face hereof, all as provided in the Indenture.] [If applicable, insert -- Notwithstanding the foregoing, the Company may not, prior to ............., redeem any Securities of this series as contemplated by [if applicable, insert -- Clause (2) of] the preceding paragraph as a part of, or in anticipation of, any refunding operation by the application, directly or indirectly, of moneys borrowed having an interest cost to the Company (calculated in accordance with generally accepted financial practice) of less than .....% per annum.] [If applicable, insert -- The sinking fund for this series provides for the redemption on ............ in each year beginning with the year ....... and ending with the year ...... of [if applicable, insert -- not less than $.......... ("mandatory sinking fund") and not more than] $......... aggregate principal amount of Securities of this series. Securities of this series acquired or redeemed by the Company otherwise than through [if applicable, insert -- mandatory] sinking fund payments may be credited against subsequent [if applicable, insert -- mandatory] sinking fund payments otherwise required to be made [if applicable, insert -- , in the inverse order in which they become due].] [If the Security is subject to redemption of any kind, insert -- In the event of redemption of this Security in part only, a new Security or Securities of this series and of like tenor for the unredeemed portion hereof will be issued in the name of the Holder hereof upon the cancellation hereof.] [If applicable, insert paragraph regarding subordination of the Security.] [If applicable, insert -- The Indenture contains provisions for defeasance at any time of [the entire indebtedness of this Security] [or] [certain restrictive covenants and Events of Default with respect to this Security] [, in each case] upon compliance with certain conditions set forth in the Indenture.] [If the Security is not an Original Issue Discount Security, insert -- If an Event of Default with respect to Securities of this series shall occur and be continuing, the principal of the Securities of this series may be declared due and payable in the manner and with the effect provided in the Indenture.] [If the Security is an Original Issue Discount Security, insert -- If an Event of Default with respect to Securities of this series shall occur and be continuing, an amount of principal of the Securities of this series may be declared due and payable in the manner and with the effect provided in the Indenture. Such amount shall be equal to -- insert formula for determining the amount. Upon payment (i) of the amount of principal so declared due and payable and (ii) of interest on any overdue principal, premium and interest (in each case to the extent that the payment of such interest shall be legally enforceable), all of the Company's obligations in respect of the payment of the principal of and premium and interest, if any, on the Securities of this series shall terminate.] The Indenture permits, with certain exceptions as therein provided, the amendment thereof and the modification of the rights and obligations of the Company and the rights of the Holders of the Securities of each series to be affected under the Indenture at any time by the Company and the Trustee with the consent of the Holders of 66 2/3% in principal amount of the Securities at the time Outstanding of each series to be affected. The Indenture also contains provisions permitting the Holders of specified percentages in principal amount of the Securities of each series at the time Outstanding, on behalf of the Holders of all Securities of such series, to waive compliance by the Company with certain provisions of the Indenture and certain past defaults under the Indenture and their consequences. Any such consent or waiver by the Holder of this Security shall be conclusive and binding upon such Holder and upon all future Holders of this Security and of any Security issued upon the registration of transfer hereof or in exchange herefor or in lieu hereof, whether or not notation of such consent or waiver is made upon this Security. As provided in and subject to the provisions of the Indenture, the Holder of this Security shall not have the right to institute any proceeding with respect to the Indenture or for the appointment of a receiver or trustee or for any other remedy thereunder, unless such Holder shall have previously given the Trustee written notice of a continuing Event of Default with respect to the Securities of this series, the Holders of not less than 25% in principal amount of the Securities of this series at the time Outstanding shall have made written request to the Trustee to institute proceedings in respect of such Event of Default as Trustee and offered the Trustee reasonable indemnity, and the Trustee shall not have received from the Holders of a majority in principal amount of Securities of this series at the time Outstanding a direction inconsistent with such request, and shall have failed to institute any such proceeding, for 60 days after receipt of such notice, request and offer of indemnity. The foregoing shall not apply to any suit instituted by the Holder of this Security for the enforcement of any payment of principal hereof or any premium or interest hereon on or after the respective due dates expressed herein. No reference herein to the Indenture and no provision of this Security or of the Indenture shall alter or impair the obligation of the Company, which is absolute and unconditional, to pay the principal of and any premium and interest on this Security at the times, place and rate, and in the coin or currency, herein prescribed. As provided in the Indenture and subject to certain limitations therein set forth, the transfer of this Security is registrable in the Security Register, upon surrender of this Security for registration of transfer at the office or agency of the Company in any place where the principal of and any premium and interest on this Security are payable, duly endorsed by, or accompanied by a written instrument of transfer in form satisfactory to the Company and the Security Registrar duly executed by, the Holder hereof or his attorney duly authorized in writing, and thereupon one or more new Securities of this series and of like tenor, of authorized denominations and for the same aggregate principal amount, will be issued to the designated transferee or transferees. The Securities of this series are issuable only in registered form without coupons in denominations of $....... and any integral multiple thereof. As provided in the Indenture and subject to certain limitations therein set forth, Securities of this series are exchangeable for a like aggregate principal amount of Securities of this series and of like tenor of a different authorized denomination, as requested by the Holder surrendering the same. No service charge shall be made for any such registration of transfer or exchange, but the Company may require payment of a sum sufficient to cover any tax or other governmental charge payable in connection therewith. Prior to due presentment of this Security for registration of transfer, the Company, the Trustee and any agent of the Company or the Trustee may treat the Person in whose name this Security is registered as the owner hereof for all purposes, whether or not this Security be overdue, and neither the Company, the Trustee nor any such agent shall be affected by notice to the contrary. All terms used in this Security which are defined in the Indenture shall have the meanings assigned to them in the Indenture. SECTION 204. FORM OF LEGEND FOR GLOBAL SECURITIES. Unless otherwise specified as contemplated by Section 301 for the Securities evidenced thereby, every Global Security authenticated and delivered hereunder shall bear a legend in substantially the following form: THIS SECURITY IS A GLOBAL SECURITY WITHIN THE MEANING OF THE INDENTURE HEREINAFTER REFERRED TO AND IS REGISTERED IN THE NAME OF A DEPOSITARY OR A NOMINEE THEREOF. THIS SECURITY MAY NOT BE EXCHANGED IN WHOLE OR IN PART FOR A SECURITY REGISTERED, AND NO TRANSFER OF THIS SECURITY IN WHOLE OR IN PART MAY BE REGISTERED, IN THE NAME OF ANY PERSON OTHER THAN SUCH DEPOSITARY OR A NOMINEE THEREOF, EXCEPT IN THE LIMITED CIRCUMSTANCES DESCRIBED IN THE INDENTURE. SECTION 205. FORM OF TRUSTEE'S CERTIFICATE OF AUTHENTICATION. The Trustee's certificates of authentication shall be in substantially the following form: This is one of the Securities of the series designated therein referred to in the within-mentioned Indenture. The Chase Manhattan Bank (National Association), As Trustee By /s/ Kathleen Perry ------------------------- Authorized Officer ARTICLE THREE THE SECURITIES SECTION 301. AMOUNT UNLIMITED; ISSUABLE IN SERIES. The aggregate principal amount of Securities which may be authenticated and delivered under this Indenture is unlimited. The Securities may be issued in one or more series. There shall be established in or pursuant to a Board Resolution and, subject to Section 303, set forth, or determined in the manner provided, in an Officers' Certificate, or established in one or more indentures supplemental hereto, prior to the issuance of Securities of any series, (1) the title of the Securities of the series (which shall distinguish the Securities of the series from Securities of any other series); (2) any limit upon the aggregate principal amount of the Securities of the series which may be authenticated and delivered under this Indenture (except for Securities authenticated and delivered upon registration of transfer of, or in exchange for, or in lieu of, other Securities of the series pursuant to Section 304, 305, 306, 906 or 1107 and except for any Securities which, pursuant to Section 303, are deemed never to have been authenticated and delivered hereunder); (3) the Person to whom any interest on a Security of the series shall be payable, if other than the Person in whose name that Security (or one or more Predecessor Securities) is registered at the close of business on the Regular Record Date for such interest; (4) the date or dates on which the principal of any Securities of the series is payable; (5) the rate or rates at which any Securities of the series shall bear interest, if any, the date or dates from which any such interest shall accrue, the Interest Payment Dates on which any such interest shall be payable and the Regular Record Date for any such interest payable on any Interest Payment Date; (6) the place or places where the principal of and any premium and interest on any Securities of the series shall be payable; (7) the period or periods within which, the price or prices at which and the terms and conditions upon which any Securities of the series may be redeemed, in whole or in part, at the option of the Company and, if other than by a Board Resolution, the manner in which any election by the Company to redeem the Securities shall be evidenced; (8) the obligation, if any, of the Company to redeem or purchase any Securities of the series pursuant to any sinking fund or analogous provisions or at the option of the Holder thereof and the period or periods within which, the price or prices at which and the terms and conditions upon which any Securities of the series shall be redeemed or purchased, in whole or in part, pursuant to such obligation; (9) if other than denominations of $1,000 and any integral multiple thereof, the denominations in which any Securities of the series shall be issuable; (10) if the amount of principal of or any premium or interest on any Securities of the series may be determined with reference to an index or pursuant to a formula, the manner in which such amounts shall be determined; (11) if other than the currency of the United States of America, the currency, currencies or currency units in which the principal of or any premium or interest on any Securities of the series shall be payable and the manner of determining the equivalent thereof in the currency of the United States of America for any purpose, including for purposes of the definition of "Outstanding" in Section 101; (12) if the principal of or any premium or interest on any Securities of the series is to be payable, at the election of the Company or the Holder thereof, in one or more currencies or currency units other than that or those in which such Securities are stated to be payable, the currency, currencies or currency units in which the principal of or any premium or interest on such Securities as to which such election is made shall be payable, the periods within which and the terms and conditions upon which such election is to be made and the amount so payable (or the manner in which such amount shall be determined); (13) if other than the entire principal amount thereof, the portion of the principal amount of any Securities of the series which shall be payable upon declaration of acceleration of the Maturity thereof pursuant to Section 502; (14) if the principal amount payable at the Stated Maturity of any Securities of the series will not be determinable as of any one or more dates prior to the Stated Maturity, the amount which shall be deemed to be the principal amount of such Securities as of any such date for any purpose thereunder or hereunder, including the principal amount thereof which shall be due and payable upon any Maturity other than the Stated Maturity or which shall be deemed to be Outstanding as of any date prior to the Stated Maturity (or, in any such case, the manner in which such amount deemed to be the principal amount shall be determined); (15) if applicable, that the Securities of the series, in whole or any specified part, shall be defeasible pursuant to Section 1302 or Section 1303 or both such Sections and, if other than by a Board Resolution, the manner in which any election by the Company to defease such Securities shall be evidenced; (16) if applicable, that any Securities of the series shall be issuable in whole or in part in the form of one or more Global Securities and, in such case, the respective Depositaries for such Global Securities, the form of any legend or legends which shall be borne by any such Global Security in addition to or in lieu of that set forth in Section 204 and any circumstances in addition to or in lieu of those set forth in Clause (2) of the last paragraph of Section 305 in which any such Global Security may be exchanged in whole or in part for Securities registered, and any transfer of such Global Security in whole or in part may be registered, in the name or names of Persons other than the Depositary for such Global Security or a nominee thereof; (17) any addition to or change in the Events of Default which applies to any Securities of the series and any change in the right of the Trustee or the requisite Holders of such Securities to declare the principal amount thereof due and payable pursuant to Section 502; (18) any addition to or change in the covenants set forth in Article Ten which applies to Securities of the series; and (19) any other terms of the series (which terms shall not be inconsistent with the provisions of this Indenture, except as permitted by Section 901(5)). All Securities of any one series shall be substantially identical except as to denomination and except as may otherwise be provided in or pursuant to the Board Resolution referred to above and (subject to Section 303) set forth, or determined in the manner provided, in the Officers' Certificate referred to above or in any such indenture supplemental hereto. If any of the terms of the series are established by action taken pursuant to a Board Resolution, a copy of an appropriate record of such action shall be certified by the Secretary or an Assistant Secretary of the Company and delivered to the Trustee at or prior to the delivery of the Officers' Certificate setting forth the terms of the series. SECTION 302. DENOMINATIONS. The Securities of each series shall be issuable only in registered form without coupons and only in such denominations as shall be specified as contemplated by Section 301. In the absence of any such specified denomination with respect to the Securities of any series, the Securities of such series shall be issuable in denominations of $1,000 and any integral multiple thereof. SECTION 303. EXECUTION, AUTHENTICATION, DELIVERY AND DATING. The Securities shall be executed on behalf of the Company by its Chairman of the Board, its Vice Chairman of the Board, its President or one of its Vice Presidents, under its corporate seal reproduced thereon attested by its Secretary or one of its Assistant Secretaries. The signature of any of these officers on the Securities may be manual or facsimile. Securities bearing the manual or facsimile signatures of individuals who were at any time the proper officers of the Company shall bind the Company, notwithstanding that such individuals or any of them have ceased to hold such offices prior to the authentication and delivery of such Securities or did not hold such offices at the date of such Securities. At any time and from time to time after the execution and delivery of this Indenture, the Company may deliver Securities of any series executed by the Company to the Trustee for authentication, together with a Company Order for the authentication and delivery of such Securities, and the Trustee in accordance with the Company Order shall authenticate and deliver such Securities. If the form or terms of the Securities of the series have been established by or pursuant to one or more Board Resolutions as permitted by Sections 201 and 301, in authenticating such Securities, and accepting the additional responsibilities under this Indenture in relation to such Securities, the Trustee shall be entitled to receive, and (subject to Section 601) shall be fully protected in relying upon, an Opinion of Counsel stating, (1) if the form of such Securities has been established by or pursuant to Board Resolution as permitted by Section 201, that such form has been established in conformity with the provisions of this Indenture; (2) if the terms of such Securities have been established by or pursuant to Board Resolution as permitted by Section 301, that such terms have been established in conformity with the provisions of this Indenture; and (3) that such Securities, when authenticated and delivered by the Trustee and issued by the Company in the manner and subject to any conditions specified in such Opinion of Counsel, will constitute valid and legally binding obligations of the Company enforceable in accordance with their terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles. If such form or terms have been so established, the Trustee shall not be required to authenticate such Securities if the issue of such Securities pursuant to this Indenture will affect the Trustee's own rights, duties or immunities under the Securities and this Indenture or otherwise in a manner which is not reasonably acceptable to the Trustee. Notwithstanding the provisions of Section 301 and of the preceding paragraph, if all Securities of a series are not to be originally issued at one time, it shall not be necessary to deliver the Officers' Certificate otherwise required pursuant to Section 301 or the Company Order and Opinion of Counsel otherwise required pursuant to such preceding paragraph at or prior to the authentication of each Security of such series if such documents are delivered at or prior to the authentication upon original issuance of the first Security of such series to be issued. Each Security shall be dated the date of its authentication. No Security shall be entitled to any benefit under this Indenture or be valid or obligatory for any purpose unless there appears on such Security a certificate of authentication substantially in the form provided for herein executed by the Trustee by manual signature, and such certificate upon any Security shall be conclusive evidence, and the only evidence, that such Security has been duly authenticated and delivered hereunder. Notwithstanding the foregoing, if any Security shall have been authenticated and delivered hereunder but never issued and sold by the Company, and the Company shall deliver such Security to the Trustee for cancellation as provided in Section 309, for all purposes of this Indenture such Security shall be deemed never to have been authenticated and delivered hereunder and shall never be entitled to the benefits of this Indenture. SECTION 304. TEMPORARY SECURITIES. Pending the preparation of definitive Securities of any series, the Company may execute, and upon Company Order the Trustee shall authenticate and deliver, temporary Securities which are printed, lithographed, typewritten, mimeographed or otherwise produced, in any authorized denomination, substantially of the tenor of the definitive Securities in lieu of which they are issued and with such appropriate insertions, omissions, substitutions and other variations as the officers executing such Securities may determine, as evidenced by their execution of such Securities. If temporary Securities of any series are issued, the Company will cause definitive Securities of that series to be prepared without unreasonable delay. After the preparation of definitive Securities of such series, the temporary Securities of such series shall be exchangeable for definitive Securities of such series upon surrender of the temporary Securities of such series at the office or agency of the Company in a Place of Payment for that series, without charge to the Holder. Upon surrender for cancellation of any one or more temporary Securities of any series, the Company shall execute and the Trustee shall authenticate and deliver in exchange therefor one or more definitive Securities of the same series, of any authorized denominations and of like tenor and aggregate principal amount. Until so exchanged, the temporary Securities of any series shall in all respects be entitled to the same benefits under this Indenture as definitive Securities of such series and tenor. SECTION 305. REGISTRATION, REGISTRATION OF TRANSFER AND EXCHANGE. The Company shall cause to be kept at the Corporate Trust Office of the Trustee a register (the register maintained in such office and in any other office or agency of the Company in a Place of Payment being herein sometimes collectively referred to as the "Security Register") in which, subject to such reasonable regulations as it may prescribe, the Company shall provide for the registration of Securities and of transfers of Securities. The Trustee is hereby appointed "Security Registrar" for the purpose of registering Securities and transfers of Securities as herein provided. Upon surrender for registration of transfer of any Security of a series at the office or agency of the Company in a Place of Payment for that series, the Company shall execute, and the Trustee shall authenticate and deliver, in the name of the designated transferee or transferees, one or more new Securities of the same series, of any authorized denominations and of like tenor and aggregate principal amount. At the option of the Holder, Securities of any series may be exchanged for other Securities of the same series, of any authorized denominations and of like tenor and aggregate principal amount, upon surrender of the Securities to be exchanged at such office or agency. Whenever any Securities are so surrendered for exchange, the Company shall execute, and the Trustee shall authenticate and deliver, the Securities which the Holder making the exchange is entitled to receive. All Securities issued upon any registration of transfer or exchange of Securities shall be the valid obligations of the Company, evidencing the same debt, and entitled to the same benefits under this Indenture, as the Securities surrendered upon such registration of transfer or exchange. Every Security presented or surrendered for registration of transfer or for exchange shall (if so required by the Company or the Trustee) be duly endorsed, or be accompanied by a written instrument of transfer in form satisfactory to the Company and the Security Registrar duly executed, by the Holder thereof or his attorney duly authorized in writing. No service charge shall be made for any registration of transfer or exchange of Securities, but the Company may require payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in connection with any registration of transfer or exchange of Securities, other than exchanges pursuant to Section 304, 906 or 1107 not involving any transfer. If the Securities of any series (or of any series and specified tenor) are to be redeemed in part, the Company shall not be required (A) to issue, register the transfer of or exchange any Securities of that series (or of that series and specified tenor, as the case may be) during a period beginning at the opening of business 15 days before the day of the mailing of a notice of redemption of any such Securities selected for redemption under Section 1103 and ending at the close of business on the day of such mailing, or (B) to register the transfer of or exchange any Security so selected for redemption in whole or in part, except the unredeemed portion of any Security being redeemed in part. The provisions of Clauses (1), (2), (3) and (4) below shall apply only to Global Securities: (1) Each Global Security authenticated under this Indenture shall be registered in the name of the Depositary designated for such Global Security or a nominee thereof and delivered to such Depositary or a nominee thereof or custodian therefor, and each such Global Security shall constitute a single Security for all purposes of this Indenture. (2) Notwithstanding any other provision in this Indenture, no Global Security may be exchanged in whole or in part for Securities registered, and no transfer of a Global Security in whole or in part may be registered, in the name of any Person other than the Depositary for such Global Security or a nominee thereof unless (A) such Depositary (i) has notified the Company that it is unwilling or unable to continue as Depositary for such Global Security or (ii) has ceased to be a clearing agency registered under the Exchange Act, (B) there shall have occurred and be continuing an Event of Default with respect to such Global Security or (C) there shall exist such circumstances, if any, in addition to or in lieu of the foregoing as have been specified for this purpose as contemplated by Section 301. (3) Subject to Clause (2) above, any exchange of a Global Security for other Securities may be made in whole or in part, and all Securities issued in exchange for a Global Security or any portion thereof shall be registered in such names as the Depositary for such Global Security shall direct. (4) Every Security authenticated and delivered upon registration of transfer of, or in exchange for or in lieu of, a Global Security or any portion thereof, whether pursuant to this Section, Section 304, 306, 906 or 1107 or otherwise, shall be authenticated and delivered in the form of, and shall be, a Global Security, unless such Security is registered in the name of a Person other than the Depositary for such Global Security or a nominee thereof. SECTION 306. MUTILATED, DESTROYED, LOST AND STOLEN SECURITIES. If any mutilated Security is surrendered to the Trustee, the Company shall execute and the Trustee shall authenticate and deliver in exchange therefor a new Security of the same series and of like tenor and principal amount and bearing a number not contemporaneously outstanding. If there shall be delivered to the Company and the Trustee (i) evidence to their satisfaction of the destruction, loss or theft of any Security and (ii) such security or indemnity as may be required by them to save each of them and any agent of either of them harmless, then, in the absence of notice to the Company or the Trustee that such Security has been acquired by a bona fide purchaser, the Company shall execute and the Trustee shall authenticate and deliver, in lieu of any such destroyed, lost or stolen Security, a new Security of the same series and of like tenor and principal amount and bearing a number not contemporaneously outstanding. In case any such mutilated, destroyed, lost or stolen Security has become or is about to become due and payable, the Company in its discretion may, instead of issuing a new Security, pay such Security. Upon the issuance of any new Security under this Section, the Company may require the payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in relation thereto and any other expenses (including the fees and expenses of the Trustee) connected therewith. Every new Security of any series issued pursuant to this Section in lieu of any destroyed, lost or stolen Security shall constitute an original additional contractual obligation of the Company, whether or not the destroyed, lost or stolen Security shall be at any time enforceable by anyone, and shall be entitled to all the benefits of this Indenture equally and proportionately with any and all other Securities of that series duly issued hereunder. The provisions of this Section are exclusive and shall preclude (to the extent lawful) all other rights and remedies with respect to the replacement or payment of mutilated, destroyed, lost or stolen Securities. SECTION 307. PAYMENT OF INTEREST; INTEREST RIGHTS PRESERVED. Except as otherwise provided as contemplated by Section 301 with respect to any series of Securities, interest on any Security which is payable, and is punctually paid or duly provided for, on any Interest Payment Date shall be paid to the Person in whose name that Security (or one or more Predecessor Securities) is registered at the close of business on the Regular Record Date for such interest. Any interest on any Security of any series which is payable, but is not punctually paid or duly provided for, on any Interest Payment Date (herein called "Defaulted Interest") shall forthwith cease to be payable to the Holder on the relevant Regular Record Date by virtue of having been such Holder, and such Defaulted Interest may be paid by the Company, at its election in each case, as provided in Clause (1) or (2) below: (1) The Company may elect to make payment of any Defaulted Interest to the Persons in whose names the Securities of such series (or their respective Predecessor Securities) are registered at the close of business on a Special Record Date for the payment of such Defaulted Interest, which shall be fixed in the following manner. The Company shall notify the Trustee in writing of the amount of Defaulted Interest proposed to be paid on each Security of such series and the date of the proposed payment, and at the same time the Company shall deposit with the Trustee an amount of money equal to the aggregate amount proposed to be paid in respect of such Defaulted Interest or shall make arrangements satisfactory to the Trustee for such deposit prior to the date of the proposed payment, such money when deposited to be held in trust for the benefit of the Persons entitled to such Defaulted Interest as in this Clause provided. Thereupon the Trustee shall fix a Special Record Date for the payment of such Defaulted Interest which shall be not more than 15 days and not less than 10 days prior to the date of the proposed payment and not less than 10 days after the receipt by the Trustee of the notice of the proposed payment. The Trustee shall promptly notify the Company of such Special Record Date and, in the name and at the expense of the Company, shall cause notice of the proposed payment of such Defaulted Interest and the Special Record Date therefor to be given to each Holder of Securities of such series in the manner set forth in Section 106, not less than 10 days prior to such Special Record Date. Notice of the proposed payment of such Defaulted Interest and the Special Record Date therefor having been so mailed, such Defaulted Interest shall be paid to the Persons in whose names the Securities of such series (or their respective Predecessor Securities) are registered at the close of business on such Special Record Date and shall no longer be payable pursuant to the following Clause (2). (2) The Company may make payment of any Defaulted Interest on the Securities of any series in any other lawful manner not inconsistent with the requirements of any securities exchange on which such Securities may be listed, and upon such notice as may be required by such exchange, if, after notice given by the Company to the Trustee of the proposed payment pursuant to this Clause, such manner of payment shall be deemed practicable by the Trustee. Subject to the foregoing provisions of this Section, each Security delivered under this Indenture upon registration of transfer of or in exchange for or in lieu of any other Security shall carry the rights to interest accrued and unpaid, and to accrue, which were carried by such other Security. SECTION 308. PERSONS DEEMED OWNERS. Prior to due presentment of a Security for registration of transfer, the Company, the Trustee and any agent of the Company or the Trustee may treat the Person in whose name such Security is registered as the owner of such Security for the purpose of receiving payment of principal of and any premium and (subject to Section 307) any interest on such Security and for all other purposes whatsoever, whether or not such Security be overdue, and neither the Company, the Trustee nor any agent of the Company or the Trustee shall be affected by notice to the contrary. SECTION 309. CANCELLATION. All Securities surrendered for payment, redemption, registration of transfer or exchange or for credit against any sinking fund payment shall, if surrendered to any Person other than the Trustee, be delivered to the Trustee and shall be promptly cancelled by it. The Company may at any time deliver to the Trustee for cancellation any Securities previously authenticated and delivered hereunder which the Company may have acquired in any manner whatsoever, and may deliver to the Trustee (or to any other Person for delivery to the Trustee) for cancellation any Securities previously authenticated hereunder which the Company has not issued and sold, and all Securities so delivered shall be promptly cancelled by the Trustee. No Securities shall be authenticated in lieu of or in exchange for any Securities cancelled as provided in this Section, except as expressly permitted by this Indenture. All cancelled Securities held by the Trustee shall be disposed of as directed by a Company Order. SECTION 310. COMPUTATION OF INTEREST. Except as otherwise specified as contemplated by Section 301 for Securities of any series, interest on the Securities of each series shall be computed on the basis of a 360-day year of twelve 30-day months. ARTICLE FOUR SATISFACTION AND DISCHARGE SECTION 401. SATISFACTION AND DISCHARGE OF INDENTURE. This Indenture shall upon Company Request cease to be of further effect (except as to any surviving rights of registration of transfer or exchange of Securities herein expressly provided for), and the Trustee, at the expense of the Company, shall execute proper instruments acknowledging satisfaction and discharge of this Indenture, when (1) either (A) all Securities theretofore authenticated and delivered (other than (i) Securities which have been destroyed, lost or stolen and which have been replaced or paid as provided in Section 306 and (ii) Securities for whose payment money has theretofore been deposited in trust or segregated and held in trust by the Company and thereafter repaid to the Company or discharged from such trust, as provided in Section 1003) have been delivered to the Trustee for cancellation; or (B) all such Securities not theretofore delivered to the Trustee for cancellation (i) have become due and payable, or (ii) will become due and payable at their Stated Maturity within one year, or (iii) are to be called for redemption within one year under arrangements satisfactory to the Trustee for the giving of notice of redemption by the Trustee in the name, and at the expense, of the Company, and the Company, in the case of (i), (ii) or (iii) above, has deposited or caused to be deposited with the Trustee as trust funds in trust for the purpose money in an amount sufficient to pay and discharge the entire indebtedness on such Securities not theretofore delivered to the Trustee for cancellation, for principal and any premium and interest to the date of such deposit (in the case of Securities which have become due and payable) or to the Stated Maturity or Redemption Date, as the case may be; (2) the Company has paid or caused to be paid all other sums payable hereunder by the Company; and (3) the Company has delivered to the Trustee an Officers' Certificate and an Opinion of Counsel, each stating that all conditions precedent herein provided for relating to the satisfaction and discharge of this Indenture have been complied with. Notwithstanding the satisfaction and discharge of this Indenture, the obligations of the Company to the Trustee under Section 607, the obligations of the Trustee to any Authenticating Agent under Section 614 and, if money shall have been deposited with the Trustee pursuant to subclause (B) of Clause (1) of this Section, the obligations of the Trustee under Section 402 and the last paragraph of Section 1003 shall survive. SECTION 402. APPLICATION OF TRUST MONEY. Subject to the provisions of the last paragraph of Section 1003, all money deposited with the Trustee pursuant to Section 401 shall be held in trust and applied by it, in accordance with the provisions of the Securities and this Indenture, to the payment, either directly or through any Paying Agent (including the Company acting as its own Paying Agent) as the Trustee may determine, to the Persons entitled thereto, of the principal and any premium and interest for whose payment such money has been deposited with the Trustee. ARTICLE FIVE REMEDIES SECTION 501. EVENTS OF DEFAULT. "Event of Default", wherever used herein with respect to Securities of any series, means any one of the following events (whatever the reason for such Event of Default and whether it shall be voluntary or involuntary or be effected by operation of law or pursuant to any judgment, decree or order of any court or any order, rule or regulation of any administrative or governmental body): (1) default in the payment of any interest upon any Security of that series when it becomes due and payable, and continuance of such default for a period of 30 days; or (2) default in the payment of the principal of or any premium on any Security of that series at its Maturity; or (3) default in the deposit of any sinking fund payment, when and as due by the terms of a Security of that series; or (4) default in the performance, or breach, of any covenant or warranty of the Company in this Indenture (other than a covenant or warranty a default in whose performance or whose breach is elsewhere in this Section specifically dealt with or which has expressly been included in this Indenture solely for the benefit of series of Securities other than that series), and continuance of such default or breach for a period of 30 days after there has been given, by registered or certified mail, to the Company by the Trustee or to the Company and the Trustee by the Holders of at least 25% in principal amount of the Outstanding Securities of that series a written notice specifying such default or breach and requiring it to be remedied and stating that such notice is a "Notice of Default" hereunder; or (5) a default under any bond, debenture, note or other evidence of indebtedness for money borrowed by the Company or any Restricted Subsidiary (including a default with respect to Securities of any series other than that series) having an aggregate principal amount outstanding of at least $10,000,000, or under any Mortgage, indenture or instrument (including this Indenture) under which there may be issued or by which there may be secured or evidenced any indebtedness for money borrowed by the Company or any Restricted Subsidiary having an aggregate principal amount outstanding of at least $10,000,000, whether such indebtedness now exists or shall hereafter be created, which default shall have resulted in such indebtedness becoming or being declared due and payable prior to the date on which it would otherwise have become due and payable, without such indebtedness having been discharged, or such acceleration having been rescinded or annulled, within a period of 10 days after there shall have been given, by registered or certified mail, to the Company by the Trustee or to the Company and the Trustee by the Holders of at least 25% in principal amount of the Outstanding Securities of that series a written notice specifying such default and requiring the Company to cause such indebtedness to be discharged or cause such acceleration to be rescinded or annulled, as the case may be, and stating that such notice is a "Notice of Default" hereunder; provided, however, that, subject to the provisions of Sections 601 and 602, the Trustee shall not be deemed to have knowledge of such default unless either (A) a Responsible Officer of the Trustee shall have actual knowledge of such default or (B) the Trustee shall have received written notice thereof from the Company, from any Holder, from the holder of any such indebtedness or from the trustee under any such mortgage, indenture or other instrument; or (6) the entry by a court having jurisdiction in the premises of (A) a decree or order for relief in respect of the Company in an involuntary case or proceeding under any applicable Federal or State bankruptcy, insolvency, reorganization or other similar law or (B) a decree or order adjudging the Company a bankrupt or insolvent, or approving as properly filed a petition seeking reorganization, arrangement, adjustment or composition of or in respect of the Company under any applicable Federal or State law, or appointing a custodian, receiver, liquidator, assignee, trustee, sequestrator or other similar official of the Company or of any substantial part of its property, or ordering the winding up or liquidation of its affairs, and the continuance of any such decree or order for relief or any such other decree or order unstayed and in effect for a period of 60 consecutive days; or (7) the commencement by the Company of a voluntary case or proceeding under any applicable Federal or State bankruptcy, insolvency, reorganization or other similar law or of any other case or proceeding to be adjudicated a bankrupt or insolvent, or the consent by it to the entry of a decree or order for relief in respect of the Company in an involuntary case or proceeding under any applicable Federal or State bankruptcy, insolvency, reorganization or other similar law or to the commencement of any bankruptcy or insolvency case or proceeding against it, or the filing by it of a petition or answer or consent seeking reorganization or relief under any applicable Federal or State law, or the consent by it to the filing of such petition or to the appointment of or taking possession by a custodian, receiver, liquidator, assignee, trustee, sequestrator or other similar official of the Company or of any substantial part of its property, or the making by it of an assignment for the benefit of creditors, or the admission by it in writing of its inability to pay its debts generally as they become due, or the taking of corporate action by the Company in furtherance of any such action; or (8) any other Event of Default provided with respect to Securities of that series. SECTION 502. ACCELERATION OF MATURITY; RESCISSION AND ANNULMENT. If an Event of Default (other than an Event of Default specified in Section 501(6) or 501(7)) with respect to Securities of any series at the time Outstanding occurs and is continuing, then in every such case the Trustee or the Holders of not less than 25% in principal amount of the Outstanding Securities of that series may declare the principal amount of all the Securities of that series (or, if any Securities of that series are Original Issue Discount Securities, such portion of the principal amount of such Securities as may be specified by the terms thereof) to be due and payable immediately, by a notice in writing to the Company (and to the Trustee if given by Holders), and upon any such declaration such principal amount (or specified amount) shall become immediately due and payable. If an Event of Default specified in Section 501(6) or 501(7) with respect to Securities of any series at the time Outstanding occurs, the principal amount of all the Securities of that series (or, if any Securities of that series are Original Issue Discount Securities, such portion of the principal amount of such Securities as may be specified by the terms thereof) shall automatically, and without any declaration or other action on the part of the Trustee or any Holder, become immediately due and payable. At any time after such a declaration of acceleration with respect to Securities of any series has been made and before a judgment or decree for payment of the money due has been obtained by the Trustee as hereinafter in this Article provided, the Holders of a majority in principal amount of the Outstanding Securities of that series, by written notice to the Company and the Trustee, may rescind and annul such declaration and its consequences if (1) the Company has paid or deposited with the Trustee a sum sufficient to pay (A) all overdue interest on all Securities of that series, (B) the principal of (and premium, if any, on) any Securities of that series which have become due otherwise than by such declaration of acceleration and any interest thereon at the rate or rates prescribed therefor in such Securities, (C) to the extent that payment of such interest is lawful, interest upon overdue interest at the rate or rates prescribed therefor in such Securities, and (D) all sums paid or advanced by the Trustee hereunder and the reasonable compensation, expenses, disbursements and advances of the Trustee, its agents and counsel; and (2) all Events of Default with respect to Securities of that series, other than the non-payment of the principal of Securities of that series which have become due solely by such declaration of acceleration, have been cured or waived as provided in Section 513. No such rescission shall affect any subsequent default or impair any right consequent thereon. SECTION 503. COLLECTION OF INDEBTEDNESS AND SUITS FOR ENFORCEMENT BY TRUSTEE. The Company covenants that if (1) default is made in the payment of any interest on any Security when such interest becomes due and payable and such default continues for a period of 30 days, or (2) default is made in the payment of the principal of (or premium, if any, on) any Security at the Maturity thereof, the Company will, upon demand of the Trustee, pay to it, for the benefit of the Holders of such Securities, the whole amount then due and payable on such Securities for principal and any premium and interest and, to the extent that payment of such interest shall be legally enforceable, interest on any overdue principal and premium and on any overdue interest, at the rate or rates prescribed therefor in such Securities, and, in addition thereto, such further amount as shall be sufficient to cover the costs and expenses of collection, including the reasonable compensation, expenses, disbursements and advances of the Trustee, its agents and counsel. If an Event of Default with respect to Securities of any series occurs and is continuing, the Trustee may in its discretion proceed to protect and enforce its rights and the rights of the Holders of Securities of such series by such appropriate judicial proceedings as the Trustee shall deem most effectual to protect and enforce any such rights, whether for the specific enforcement of any covenant or agreement in this Indenture or in aid of the exercise of any power granted herein, or to enforce any other proper remedy. SECTION 504. TRUSTEE MAY FILE PROOFS OF CLAIM. In case of any judicial proceeding relative to the Company (or any other obligor upon the Securities), its property or its creditors, the Trustee shall be entitled and empowered, by intervention in such proceeding or otherwise, to take any and all actions authorized under the Trust Indenture Act in order to have claims of the Holders and the Trustee allowed in any such proceeding. In particular, the Trustee shall be authorized to collect and receive any moneys or other property payable or deliverable on any such claims and to distribute the same; and any custodian, receiver, assignee, trustee, liquidator, sequestrator or other similar official in any such judicial proceeding is hereby authorized by each Holder to make such payments to the Trustee and, in the event that the Trustee shall consent to the making of such payments directly to the Holders, to pay to the Trustee any amount due it for the reasonable compensation, expenses, disbursements and advances of the Trustee, its agents and counsel, and any other amounts due the Trustee under Section 607. No provision of this Indenture shall be deemed to authorize the Trustee to authorize or consent to or accept or adopt on behalf of any Holder any plan of reorganization, arrangement, adjustment or composition affecting the Securities or the rights of any Holder thereof or to authorize the Trustee to vote in respect of the claim of any Holder in any such proceeding; provided, however, that the Trustee may, on behalf of the Holders, vote for the election of a trustee in bankruptcy or similar official and be a member of a creditors' or other similar committee. SECTION 505. TRUSTEE MAY ENFORCE CLAIMS WITHOUT POSSESSION OF SECURITIES. All rights of action and claims under this Indenture or the Securities may be prosecuted and enforced by the Trustee without the possession of any of the Securities or the production thereof in any proceeding relating thereto, and any such proceeding instituted by the Trustee shall be brought in its own name as trustee of an express trust, and any recovery of judgment shall, after provision for the payment of the reasonable compensation, expenses, disbursements and advances of the Trustee, its agents and counsel, be for the ratable benefit of the Holders of the Securities in respect of which such judgment has been recovered. SECTION 506. APPLICATION OF MONEY COLLECTED. Any money collected by the Trustee pursuant to this Article shall be applied in the following order, at the date or dates fixed by the Trustee and, in case of the distribution of such money on account of principal or any premium or interest, upon presentation of the Securities and the notation thereon of the payment if only partially paid and upon surrender thereof if fully paid: First: To the payment of all amounts due the Trustee under Section 607; and Second: To the payment of the amounts then due and unpaid for principal of and any premium and interest on the Securities in respect of which or for the benefit of which such money has been collected, ratably, without preference or priority of any kind, according to the amounts due and payable on such Securities for principal and any premium and interest, respectively. SECTION 507. LIMITATION ON SUITS. No Holder of any Security of any series shall have any right to institute any proceeding, judicial or otherwise, with respect to this Indenture, or for the appointment of a receiver or trustee, or for any other remedy hereunder, unless (1) such Holder has previously given written notice to the Trustee of a continuing Event of Default with respect to the Securities of that series; (2) the Holders of not less than 25% in principal amount of the Outstanding Securities of that series shall have made written request to the Trustee to institute proceedings in respect of such Event of Default in its own name as Trustee hereunder; (3) such Holder or Holders have offered to the Trustee reasonable indemnity against the costs, expenses and liabilities to be incurred in compliance with such request; (4) the Trustee for 60 days after its receipt of such notice, request and offer of indemnity has failed to institute any such proceeding; and (5) no direction inconsistent with such written request has been given to the Trustee during such 60-day period by the Holders of a majority in principal amount of the Outstanding Securities of that series; it being understood and intended that no one or more of such Holders shall have any right in any manner whatever by virtue of, or by availing of, any provision of this Indenture to affect, disturb or prejudice the rights of any other of such Holders, or to obtain or to seek to obtain priority or preference over any other of such Holders or to enforce any right under this Indenture, except in the manner herein provided and for the equal and ratable benefit of all of such Holders. SECTION 508. UNCONDITIONAL RIGHT OF HOLDERS TO RECEIVE PRINCIPAL, PREMIUM AND INTEREST. Notwithstanding any other provision in this Indenture, the Holder of any Security shall have the right, which is absolute and unconditional, to receive payment of the principal of and any premium and (subject to Section 307) interest on such Security on the respective Stated Maturities expressed in such Security (or, in the case of redemption, on the Redemption Date) and to institute suit for the enforcement of any such payment, and such rights shall not be impaired without the consent of such Holder. SECTION 509. RESTORATION OF RIGHTS AND REMEDIES. If the Trustee or any Holder has instituted any proceeding to enforce any right or remedy under this Indenture and such proceeding has been discontinued or abandoned for any reason, or has been determined adversely to the Trustee or to such Holder, then and in every such case, subject to any determination in such proceeding, the Company, the Trustee and the Holders shall be restored severally and respectively to their former positions hereunder and thereafter all rights and remedies of the Trustee and the Holders shall continue as though no such proceeding had been instituted. SECTION 510. RIGHTS AND REMEDIES CUMULATIVE. Except as otherwise provided with respect to the replacement or payment of mutilated, destroyed, lost or stolen Securities in the last paragraph of Section 306, no right or remedy herein conferred upon or reserved to the Trustee or to the Holders is intended to be exclusive of any other right or remedy, and every right and remedy shall, to the extent permitted by law, be cumulative and in addition to every other right and remedy given hereunder or now or hereafter existing at law or in equity or otherwise. The assertion or employment of any right or remedy hereunder, or otherwise, shall not prevent the concurrent assertion or employment of any other appropriate right or remedy. SECTION 511. DELAY OR OMISSION NOT WAIVER. No delay or omission of the Trustee or of any Holder of any Securities to exercise any right or remedy accruing upon any Event of Default shall impair any such right or remedy or constitute a waiver of any such Event of Default or an acquiescence therein. Every right and remedy given by this Article or by law to the Trustee or to the Holders may be exercised from time to time, and as often as may be deemed expedient, by the Trustee or by the Holders, as the case may be. SECTION 512. CONTROL BY HOLDERS. The Holders of a majority in principal amount of the Outstanding Securities of any series shall have the right to direct the time, method and place of conducting any proceeding for any remedy available to the Trustee, or exercising any trust or power conferred on the Trustee, with respect to the Securities of such series, provided that (1) such direction shall not be in conflict with any rule of law or with this Indenture, and (2) the Trustee may take any other action deemed proper by the Trustee which is not inconsistent with such direction. SECTION 513. WAIVER OF PAST DEFAULTS. The Holders of not less than a majority in principal amount of the Outstanding Securities of any series may on behalf of the Holders of all the Securities of such series waive any past default hereunder with respect to such series and its consequences, except a default (1) in the payment of the principal of or any premium or interest on any Security of such series, or (2) in respect of a covenant or provision hereof which under Article Nine cannot be modified or amended without the consent of the Holder of each Outstanding Security of such series affected. Upon any such waiver, such default shall cease to exist, and any Event of Default arising therefrom shall be deemed to have been cured, for every purpose of this Indenture; but no such waiver shall extend to any subsequent or other default or impair any right consequent thereon. SECTION 514. UNDERTAKING FOR COSTS. In any suit for the enforcement of any right or remedy under this Indenture, or in any suit against the Trustee for any action taken, suffered or omitted by it as Trustee, a court may require any party litigant in such suit to file an undertaking to pay the costs of such suit, and may assess costs against any such party litigant, in the manner and to the extent provided in the Trust Indenture Act; provided that neither this Section nor the Trust Indenture Act shall be deemed to authorize any court to require such an undertaking or to make such an assessment in any suit instituted by the Company. SECTION 515. WAIVER OF USURY, STAY OR EXTENSION LAWS. The Company covenants (to the extent that it may lawfully do so) that it will not at any time insist upon, or plead, or in any manner whatsoever claim or take the benefit or advantage of, any usury, stay or extension law wherever enacted, now or at any time hereafter in force, which may affect the covenants or the performance of this Indenture; and the Company (to the extent that it may lawfully do so) hereby expressly waives all benefit or advantage of any such law and covenants that it will not hinder, delay or impede the execution of any power herein granted to the Trustee, but will suffer and permit the execution of every such power as though no such law had been enacted. ARTICLE SIX THE TRUSTEE SECTION 601. CERTAIN DUTIES AND RESPONSIBILITIES. The duties and responsibilities of the Trustee shall be as provided by the Trust Indenture Act. Notwithstanding the foregoing, no provision of this Indenture shall require the Trustee to expend or risk its own funds or otherwise incur any financial liability in the performance of any of its duties hereunder, or in the exercise of any of its rights or powers, if it shall have reasonable grounds for believing that repayment of such funds or adequate indemnity against such risk or liability is not reasonably assured to it. Whether or not therein expressly so provided, every provision of this Indenture relating to the conduct or affecting the liability of or affording protection to the Trustee shall be subject to the provisions of this Section. SECTION 602. NOTICE OF DEFAULTS. If a default occurs hereunder with respect to Securities of any series, the Trustee shall give the Holders of Securities of such series notice of such default as and to the extent provided by the Trust Indenture Act; provided, however, that in the case of any default of the character specified in Section 501(4) with respect to Securities of such series, no such notice to Holders shall be given until at least 30 days after the occurrence thereof. For the purpose of this Section, the term "default" means any event which is, or after notice or lapse of time or both would become, an Event of Default with respect to Securities of such series. SECTION 603. CERTAIN RIGHTS OF TRUSTEE. Subject to the provisions of Section 601: (1) the Trustee may rely and shall be protected in acting or refraining from acting upon any resolution, certificate, statement, instrument, opinion, report, notice, request, direction, consent, order, bond, debenture, note, other evidence of indebtedness or other paper or document believed by it to be genuine and to have been signed or presented by the proper party or parties; (2) any request or direction of the Company mentioned herein shall be sufficiently evidenced by a Company Request or Company Order, and any resolution of the Board of Directors shall be sufficiently evidenced by a Board Resolution; (3) whenever in the administration of this Indenture the Trustee shall deem it desirable that a matter be proved or established prior to taking, suffering or omitting any action hereunder, the Trustee (unless other evidence be herein specifically prescribed) may, in the absence of bad faith on its part, rely upon an Officers' Certificate; (4) the Trustee may consult with counsel and the written advice of such counsel or any Opinion of Counsel shall be full and complete authorization and protection in respect of any action taken, suffered or omitted by it hereunder in good faith and in reliance thereon; (5) the Trustee shall be under no obligation to exercise any of the rights or powers vested in it by this Indenture at the request or direction of any of the Holders pursuant to this Indenture, unless such Holders shall have offered to the Trustee reasonable security or indemnity against the costs, expenses and liabilities which might be incurred by it in compliance with such request or direction; (6) the Trustee shall not be bound to make any investigation into the facts or matters stated in any resolution, certificate, statement, instrument, opinion, report, notice, request, direction, consent, order, bond, debenture, note, other evidence of indebtedness or other paper or document, but the Trustee, in its discretion, may make such further inquiry or investigation into such facts or matters as it may see fit, and, if the Trustee shall determine to make such further inquiry or investigation, it shall be entitled to examine the books, records and premises of the Company, personally or by agent or attorney; and (7) the Trustee may execute any of the trusts or powers hereunder or perform any duties hereunder either directly or by or through agents or attorneys and the Trustee shall not be responsible for any misconduct or negligence on the part of any agent or attorney appointed with due care by it hereunder. SECTION 604. NOT RESPONSIBLE FOR RECITALS OR ISSUANCE OF SECURITIES. The recitals contained herein and in the Securities, except the Trustee's certificates of authentication, shall be taken as the statements of the Company, and neither the Trustee nor any Authenticating Agent assumes any responsibility for their correctness. The Trustee makes no representations as to the validity or sufficiency of this Indenture or of the Securities. Neither the Trustee nor any Authenticating Agent shall be accountable for the use or application by the Company of Securities or the proceeds thereof. SECTION 605. MAY HOLD SECURITIES. The Trustee, any Authenticating Agent, any Paying Agent, any Security Registrar or any other agent of the Company, in its individual or any other capacity, may become the owner or pledgee of Securities and, subject to Sections 608 and 613, may otherwise deal with the Company with the same rights it would have if it were not Trustee, Authenticating Agent, Paying Agent, Security Registrar or such other agent. SECTION 606. MONEY HELD IN TRUST. Money held by the Trustee in trust hereunder need not be segregated from other funds except to the extent required by law. The Trustee shall be under no liability for interest on any money received by it hereunder except as otherwise agreed with the Company. SECTION 607. COMPENSATION AND REIMBURSEMENT. The Company agrees (1) to pay to the Trustee from time to time such reasonable compensation for all services rendered by it hereunder as shall be agreed upon in writing (which compensation shall not be limited by any provision of law in regard to the compensation of a trustee of an express trust); (2) except as otherwise expressly provided herein, to reimburse the Trustee upon its request for all reasonable expenses, disbursements and advances incurred or made by the Trustee in accordance with any provision of this Indenture (including the reasonable compensation and the expenses and disbursements of its agents and counsel), except any such expense, disbursement or advance as may be attributable to its negligence or bad faith; and (3) to indemnify the Trustee for, and to hold it harmless against, any loss, liability or expense incurred without negligence or bad faith on its part, arising out of or in connection with the acceptance or administration of the trust or trusts hereunder, including the costs and expenses of defending itself against any claim or liability in connection with the exercise or performance of any of its powers or duties hereunder. When the Trustee incurs expenses or renders services in connection with an Event of Default specified in Section 501(6) or 501(7), such expenses (including the reasonable charges and expenses of its counsel) and the compensation for such services are intended to constitute expenses of administration under any bankruptcy law. SECTION 608. CONFLICTING INTERESTS. If the Trustee has or shall acquire a conflicting interest within the meaning of the Trust Indenture Act, the Trustee shall either eliminate such interest or resign, to the extent and in the manner provided by, and subject to the provisions of, the Trust Indenture Act and this Indenture. To the extent permitted by such Act, the Trustee shall not be deemed to have a conflicting interest by virtue of being a trustee under this Indenture with respect to Securities of more than one series. SECTION 609. CORPORATE TRUSTEE REQUIRED; ELIGIBILITY. There shall at all times be one (and only one) Trustee hereunder with respect to the Securities of each series, which may be Trustee hereunder for Securities of one or more other series. Each Trustee shall be a Person that is eligible pursuant to the Trust Indenture Act to act as such, has a combined capital and surplus of at least $50,000,000. If any such Person publishes reports of condition at least annually, pursuant to law or to the requirements of its supervising or examining authority, then for the purposes of this Section and to the extent permitted by the Trust Indenture Act, the combined capital and surplus of such Person shall be deemed to be its combined capital and surplus as set forth in its most recent report of condition so published. If at any time the Trustee with respect to the Securities of any series shall cease to be eligible in accordance with the provisions of this Section, it shall resign immediately in the manner and with the effect hereinafter specified in this Article. SECTION 610. RESIGNATION AND REMOVAL; APPOINTMENT OF SUCCESSOR. No resignation or removal of the Trustee and no appointment of a successor Trustee pursuant to this Article shall become effective until the acceptance of appointment by the successor Trustee in accordance with the applicable requirements of Section 611. The Trustee may resign at any time with respect to the Securities of one or more series by giving written notice thereof to the Company. If the instrument of acceptance by a successor Trustee required by Section 611 shall not have been delivered to the Trustee within 30 days after the giving of such notice of resignation, the resigning Trustee may petition any court of competent jurisdiction for the appointment of a successor Trustee with respect to the Securities of such series. The Trustee may be removed at any time with respect to the Securities of any series by Act of the Holders of a majority in principal amount of the Outstanding Securities of such series, delivered to the Trustee and to the Company. If at any time: (1) the Trustee shall fail to comply with Section 608 after written request therefor by the Company or by any Holder who has been a bona fide Holder of a Security for at least six months, or (2) the Trustee shall cease to be eligible under Section 609 and shall fail to resign after written request therefor by the Company or by any such Holder, or (3) the Trustee shall become incapable of acting or shall be adjudged a bankrupt or insolvent or a receiver of the Trustee or of its property shall be appointed or any public officer shall take charge or control of the Trustee or of its property or affairs for the purpose of rehabilitation, conservation or liquidation, then, in any such case, (A) the Company by a Board Resolution may remove the Trustee with respect to all Securities, or (B) subject to Section 514, any Holder who has been a bona fide Holder of a Security for at least six months may, on behalf of himself and all others similarly situated, petition any court of competent jurisdiction for the removal of the Trustee with respect to all Securities and the appointment of a successor Trustee or Trustees. If the Trustee shall resign, be removed or become incapable of acting, or if a vacancy shall occur in the office of Trustee for any cause, with respect to the Securities of one or more series, the Company, by a Board Resolution, shall promptly appoint a successor Trustee or Trustees with respect to the Securities of that or those series (it being understood that any such successor Trustee may be appointed with respect to the Securities of one or more or all of such series and that at any time there shall be only one Trustee with respect to the Securities of any particular series) and shall comply with the applicable requirements of Section 611. If, within one year after such resignation, removal or incapability, or the occurrence of such vacancy, a successor Trustee with respect to the Securities of any series shall be appointed by Act of the Holders of a majority in principal amount of the Outstanding Securities of such series delivered to the Company and the retiring Trustee, the successor Trustee so appointed shall, forthwith upon its acceptance of such appointment in accordance with the applicable requirements of Section 611, become the successor Trustee with respect to the Securities of such series and to that extent supersede the successor Trustee appointed by the Company. If no successor Trustee with respect to the Securities of any series shall have been so appointed by the Company or the Holders and accepted appointment in the manner required by Section 611, any Holder who has been a bona fide Holder of a Security of such series for at least six months may, on behalf of himself and all others similarly situated, petition any court of competent jurisdiction for the appointment of a successor Trustee with respect to the Securities of such series. The Company shall give notice of each resignation and each removal of the Trustee with respect to the Securities of any series and each appointment of a successor Trustee with respect to the Securities of any series to all Holders of Securities of such series in the manner provided in Section 106. Each notice shall include the name of the successor Trustee with respect to the Securities of such series and the address of its Corporate Trust Office. SECTION 611. ACCEPTANCE OF APPOINTMENT BY SUCCESSOR. In case of the appointment hereunder of a successor Trustee with respect to all Securities, every such successor Trustee so appointed shall execute, acknowledge and deliver to the Company and to the retiring Trustee an instrument accepting such appointment, and thereupon the resignation or removal of the retiring Trustee shall become effective and such successor Trustee, without any further act, deed or conveyance, shall become vested with all the rights, powers, trusts and duties of the retiring Trustee; but, on the request of the Company or the successor Trustee, such retiring Trustee shall, upon payment of its charges, execute and deliver an instrument transferring to such successor Trustee all the rights, powers and trusts of the retiring Trustee and shall duly assign, transfer and deliver to such successor Trustee all property and money held by such retiring Trustee hereunder. In case of the appointment hereunder of a successor Trustee with respect to the Securities of one or more (but not all) series, the Company, the retiring Trustee and each successor Trustee with respect to the Securities of one or more series shall execute and deliver an indenture supplemental hereto wherein each successor Trustee shall accept such appointment and which (1) shall contain such provisions as shall be necessary or desirable to transfer and confirm to, and to vest in, each successor Trustee all the rights, powers, trusts and duties of the retiring Trustee with respect to the Securities of that or those series to which the appointment of such successor Trustee relates, (2) if the retiring Trustee is not retiring with respect to all Securities, shall contain such provisions as shall be deemed necessary or desirable to confirm that all the rights, powers, trusts and duties of the retiring Trustee with respect to the Securities of that or those series as to which the retiring Trustee is not retiring shall continue to be vested in the retiring Trustee, and (3) shall add to or change any of the provisions of this Indenture as shall be necessary to provide for or facilitate the administration of the trusts hereunder by more than one Trustee, it being understood that nothing herein or in such supplemental indenture shall constitute such Trustees co- trustees of the same trust and that each such Trustee shall be trustee of a trust or trusts hereunder separate and apart from any trust or trusts hereunder administered by any other such Trustee; and upon the execution and delivery of such supplemental indenture the resignation or removal of the retiring Trustee shall become effective to the extent provided therein and each such successor Trustee, without any further act, deed or conveyance, shall become vested with all the rights, powers, trusts and duties of the retiring Trustee with respect to the Securities of that or those series to which the appointment of such successor Trustee relates; but, on request of the Company or any successor Trustee, such retiring Trustee shall duly assign, transfer and deliver to such successor Trustee all property and money held by such retiring Trustee hereunder with respect to the Securities of that or those series to which the appointment of such successor Trustee relates. Upon request of any such successor Trustee, the Company shall execute any and all instruments for more fully and certainly vesting in and confirming to such successor Trustee all such rights, powers and trusts referred to in the first or second preceding paragraph, as the case may be. No successor Trustee shall accept its appointment unless at the time of such acceptance such successor Trustee shall be qualified and eligible under this Article. SECTION 612. MERGER, CONVERSION, CONSOLIDATION OR SUCCESSION TO BUSINESS. Any corporation into which the Trustee may be merged or converted or with which it may be consolidated, or any corporation resulting from any merger, conversion or consolidation to which the Trustee shall be a party, or any corporation succeeding to all or substantially all the corporate trust business of the Trustee, shall be the successor of the Trustee hereunder, provided such corporation shall be otherwise qualified and eligible under this Article, without the execution or filing of any paper or any further act on the part of any of the parties hereto. In case any Securities shall have been authenticated, but not delivered, by the Trustee then in office, any successor by merger, conversion or consolidation to such authenticating Trustee may adopt such authentication and deliver the Securities so authenticated with the same effect as if such successor Trustee had itself authenticated such Securities. SECTION 613. PREFERENTIAL COLLECTION OF CLAIMS AGAINST COMPANY. If and when the Trustee shall be or become a creditor of the Company (or any other obligor upon the Securities), the Trustee shall be subject to the provisions of the Trust Indenture Act regarding the collection of claims against the Company (or any such other obligor). SECTION 614. APPOINTMENT OF AUTHENTICATING AGENT. The Company may appoint an Authenticating Agent or Agents with respect to one or more series of Securities which shall be authorized to act on behalf of the Trustee to authenticate Securities of such series issued upon original issue and upon exchange, registration of transfer or partial redemption thereof or pursuant to Section 306, and Securities so authenticated shall be entitled to the benefits of this Indenture and shall be valid and obligatory for all purposes as if authenticated by the Trustee hereunder. Wherever reference is made in this Indenture to the authentication and delivery of Securities by the Trustee or the Trustee's certificate of authentication, such reference shall be deemed to include authentication and delivery on behalf of the Trustee by an Authenticating Agent and a certificate of authentication executed on behalf of the Trustee by an Authenticating Agent. Each Authenticating Agent shall be acceptable to the Trustee and shall at all times be a corporation organized and doing business under the laws of the United States of America, any State thereof or the District of Columbia, authorized under such laws to act as Authenticating Agent, having a combined capital and surplus of not less than $50,000,000 and subject to supervision or examination by Federal or State authority. If such Authenticating Agent publishes reports of condition at least annually, pursuant to law or to the requirements of said supervising or examining authority, then for the purposes of this Section, the combined capital and surplus of such Authenticating Agent shall be deemed to be its combined capital and surplus as set forth in its most recent report of condition so published. If at any time an Authenticating Agent shall cease to be eligible in accordance with the provisions of this Section, such Authenticating Agent shall resign immediately in the manner and with the effect specified in this Section. Any corporation into which an Authenticating Agent may be merged or converted or with which it may be consolidated, or any corporation resulting from any merger, conversion or consolidation to which such Authenticating Agent shall be a party, or any corporation succeeding to the corporate agency or corporate trust business of an Authenticating Agent, shall continue to be an Authenticating Agent, provided such corporation shall be otherwise eligible under this Section, without the execution or filing of any paper or any further act on the part of the Trustee or the Authenticating Agent. An Authenticating Agent may resign at any time by giving written notice thereof to the Trustee and to the Company. The Company may at any time terminate the agency of an Authenticating Agent by giving written notice thereof to such Authenticating Agent and to the Trustee. Upon receiving such a notice of resignation or upon such a termination, or in case at any time such Authenticating Agent shall cease to be eligible in accordance with the provisions of this Section, the Company may appoint a successor Authenticating Agent which shall be acceptable to the Trustee and shall give notice of such appointment in the manner provided in Section 106 to all Holders of Securities of the series with respect to which such Authenticating Agent will serve. Any successor Authenticating Agent upon acceptance of its appointment hereunder shall become vested with all the rights, powers and duties of its predecessor hereunder, with like effect as if originally named as an Authenticating Agent. No successor Authenticating Agent shall be appointed unless eligible under the provisions of this Section. The Company agrees to pay to each Authenticating Agent from time to time reasonable compensation for its services under this Section. If an appointment with respect to one or more series is made pursuant to this Section, the Securities of such series may have endorsed thereon, in addition to the Trustee's certificate of authentication, an alternative certificate of authentication in the following form: This is one of the Securities of the series designated therein referred to in the within-mentioned Indenture. The Chase Manhattan Bank (National Association) .............................. As Trustee By..........................., As Authenticating Agent By............................ Authorized Officer ARTICLE SEVEN HOLDERS' LISTS AND REPORTS BY TRUSTEE AND COMPANY SECTION 701. COMPANY TO FURNISH TRUSTEE NAMES AND ADDRESSES OF HOLDERS. The Company will furnish or cause to be furnished to the Trustee (1) semi-annually, not later than 15 days after the Regular Record Date for each series of Securities, a list, in such form as the Trustee may reasonably require, of the names and addresses of the Holders of Securities of each series as of such Regular Record Day, and (2) at such other times as the Trustee may request in writing, within 30 days after the receipt by the Company of any such request, a list of similar form and content as of a date not more than 15 days prior to the time such list is furnished; excluding from any such list names and addresses received by the Trustee in its capacity as Security Registrar. SECTION 702. PRESERVATION OF INFORMATION; COMMUNICATIONS TO HOLDERS. The Trustee shall preserve, in as current a form as is reasonably practicable, the names and addresses of Holders contained in the most recent list furnished to the Trustee as provided in Section 701 and the names and addresses of Holders received by the Trustee in its capacity as Security Registrar. The Trustee may destroy any list furnished to it as provided in Section 701 upon receipt of a new list so furnished. The rights of Holders to communicate with other Holders with respect to their rights under this Indenture or under the Securities, and the corresponding rights and privileges of the Trustee, shall be as provided by the Trust Indenture Act. Every Holder of Securities, by receiving and holding the same, agrees with the Company and the Trustee that neither the Company nor the Trustee nor any agent of either of them shall be held accountable by reason of any disclosure of information as to names and addresses of Holders made pursuant to the Trust Indenture Act. SECTION 703. REPORTS BY TRUSTEE. The Trustee shall transmit to Holders such reports concerning the Trustee and its actions under this Indenture as may be required pursuant to the Trust Indenture Act at the times and in the manner provided pursuant thereto. A copy of each such report shall, at the time of such transmission to Holders, be filed by the Trustee with each stock exchange upon which any Securities are listed, with the Commission and with the Company. The Company will notify the Trustee when any Securities are listed on any stock exchange. SECTION 704. REPORTS BY COMPANY. The Company shall file with the Trustee and the Commission, and transmit to Holders, such information, documents and other reports, and such summaries thereof, as may be required pursuant to the Trust Indenture Act at the times and in the manner provided pursuant to such Act; provided that any such information, documents or reports required to be filed with the Commission pursuant to Section 13 or 15(d) of the Exchange Act shall be filed with the Trustee within 15 days after the same is so required to be filed with the Commission. ARTICLE EIGHT CONSOLIDATION, MERGER, CONVEYANCE, TRANSFER OR LEASE SECTION 801. COMPANY MAY CONSOLIDATE, ETC., ONLY ON CERTAIN TERMS. The Company shall not consolidate with or merge into any other Person or convey, transfer or lease its properties and assets substantially as an entirety to any Person, and the Company shall not permit any Person to consolidate with or merge into the Company or convey, transfer or lease its properties and assets substantially as an entirety to the Company, unless: (1) in case the Company shall consolidate with or merge into another Person or convey, transfer or lease its properties and assets substantially as an entirety to any Person, the Person formed by such consolidation or into which the Company is merged or the Person which acquires by conveyance or transfer, or which leases, the properties and assets of the Company substantially as an entirety shall expressly assume, by an indenture supplemental hereto, executed and delivered to the Trustee, in form satisfactory to the Trustee, the due and punctual payment of the principal of and any premium and interest on all the Securities (and any Successor Additional Amounts in respect thereof) and the performance or observance of every covenant of this Indenture on the part of the Company to be performed or observed; (2) immediately after giving effect to such transaction and treating any Debt which becomes an obligation of the Company or any Restricted Subsidiary as a result of such transaction as having been Incurred by the Company or such Restricted Subsidiary at the time of such transaction, no Event of Default, and no event which, after notice or lapse of time or both, would become an Event of Default, shall have happened and be continuing; (3) if, as a result of any such consolidation or merger or such conveyance, transfer or lease, properties or assets of the Company would become subject to a Mortgage which would not be permitted by this Indenture, the Company or such successor Person, as the case may be, shall take such steps as shall be necessary effectively to secure the Securities equally and ratably with (or prior to) all Debt secured thereby; and (4) any Person formed by the consolidation with the Company or into which the Company is merged or which acquires by conveyance or transfer, or which leases, the properties and assets substantially as an entirety of the Company and which is not organized and validly existing under the laws of the United States, any State thereof or the District of Columbia, shall expressly agree, by an indenture supplemental hereto, executed and delivered to the Trustee, in form satisfactory to the Trustee, (A) to indemnify the Holder of each Security against (i) any tax, assessment or governmental charge imposed on such Holder or required to be withheld or deducted from any payment to such Holder as a consequence of such consolidation, merger, conveyance, transfer or lease, to the extent that, in the aggregate, such tax, assessment or governmental charge imposed upon such Holder (net of deductions or credits) exceeds the aggregate amount of such tax, assessment or governmental charge which would have been imposed on such Holder if the successor Person had been organized and validly existing under the laws of the United States, any State thereof or the District of Columbia; provided, however, that such successor Person will not be required to agree to indemnify, pursuant to this clause (A), against any tax, assessment or governmental charge of the type described in clause (a) or (d) below that is imposed by the jurisdiction of organization of such Person or any of its territories or political subdivisions, and (ii) any costs or expenses of the act of such consolidation, merger, conveyance, transfer or lease, and (B) that all payments pursuant to the Securities in respect of the principal of and any premium and interest on the Securities shall be made without withholding or deduction for, or on account of, any present or future taxes, duties, assessments or governmental charges of whatever nature imposed or levied by or on behalf of the jurisdiction of organization of such Person or any political subdivision or taxing authority thereof or therein, unless such taxes, duties, assessments or governmental charges are required by such jurisdiction or any such subdivision or authority to be withheld or deducted, in which case such Person will pay such additional amounts of, or in respect of, principal and any premium and interest ("Successor Additional Amounts") as will result (after deduction of such taxes, duties, assessments or governmental charges and any additional taxes, duties, assessments or governmental charges payable in respect of such) in the payment to each Holder of a Security of the amounts which would have been payable pursuant to the Securities had no such withholding or deduction been required, except that no Successor Additional Amounts shall be so payable for or on account of: (a) any tax, duty, assessment or other governmental charge which would not have been imposed but for the fact that such Holder: (i) was a resident, domiciliary or national of, or engaged in business or maintained a permanent establishment or was physically present in, the jurisdiction of organization of such Person or any of its territories or any political subdivision thereof or otherwise had some connection with such jurisdiction other than the mere ownership of, or receipt of payment under, such Security; (ii) presented such Security for payment in such jurisdiction or any of its territories or any political subdivision thereof, unless such Security could not have been presented for payment elsewhere; or (iii) presented such Security more than thirty (30) days after the date on which the payment in respect of such Security first became due and payable or provided for, whichever is later, except to the extent that the Holder would have been entitled to such Successor Additional Amounts if it had presented such Security for payment on any day within such period of thirty (30) days; (b) any estate, inheritance, gift, sale, transfer, personal property or similar tax, assessment or other governmental charge; (c) any tax, assessment or other governmental charge which is payable otherwise than by withholding or deduction from payments of (or in respect of) principal of or any premium or interest on, the Securities; (d) any tax, assessment or other governmental charge that is imposed or withheld by reason of the failure to comply by the Holder or the beneficial owner of a Security with a request of the Company addressed to the Holder (i) to provide information concerning the nationality, residence or identity of the Holder or such beneficial owner or (ii) to make any declaration or other similar claim or satisfy any information or reporting requirement, which, in the case of (i) or (ii), is required or imposed by statute, treaty, regulation or administrative practice of the taxing jurisdiction as a precondition to exemption from all or part of such tax, assessment or other governmental charge; or (e) any combination of items (a), (b), (c) and (d); nor shall Successor Additional Amounts be paid with respect to any payment of the principal of or any premium or interest on any such Security to any Holder who is a fiduciary or partnership or other than the sole beneficial owner of such Security to the extent such payment would be required by the laws of the jurisdiction of organization of such Person (or any political subdivision or taxing authority thereof or therein) to be included in the income for tax purposes of a beneficiary or settlor with respect to such fiduciary or a member of such partnership or a beneficial owner who would not have been entitled to such Successor Additional Amounts of interest had it been the Holder of the Security; and (5) the Company has delivered to the Trustee an Officers' Certificate and an Opinion of Counsel, each stating that such consolidation, merger, conveyance, transfer or lease and, if a supplemental indenture is required in connection with such transaction, such supplemental indenture comply with this Article and that all conditions precedent herein provided for relating to such transaction have been complied with. SECTION 802. SUCCESSOR SUBSTITUTED. Upon any consolidation of the Company with, or merger of the Company into, any other Person or any conveyance, transfer or lease of the properties and assets of the Company substantially as an entirety in accordance with Section 801, the successor Person formed by such consolidation or into which the Company is merged or to which such conveyance, transfer or lease is made shall succeed to, and be substituted for, and may exercise every right and power of, the Company under this Indenture with the same effect as if such successor Person had been named as the Company herein, and thereafter, except in the case of a lease, the predecessor Person shall be relieved of all obligations and covenants under this Indenture and the Securities. ARTICLE NINE SUPPLEMENTAL INDENTURES SECTION 901. SUPPLEMENTAL INDENTURES WITHOUT CONSENT OF HOLDERS. Without the consent of any Holders, the Company, when authorized by a Board Resolution, and the Trustee, at any time and from time to time, may enter into one or more indentures supplemental hereto, in form satisfactory to the Trustee, for any of the following purposes: (1) to evidence the succession of another Person to the Company and the assumption by any such successor of the covenants of the Company herein and in the Securities; or (2) to add to the covenants of the Company for the benefit of the Holders of all or any series of Securities (and if such covenants are to be for the benefit of less than all series of Securities, stating that such covenants are expressly being included solely for the benefit of such series) or to surrender any right or power herein conferred upon the Company; or (3) to add any additional Events of Default for the benefit of the Holders of all or any series of Securities (and if such additional Events of Default are to be for the benefit of less than all series of Securities, stating that such additional Events of Default are expressly being included solely for the benefit of such series); or (4) to add to or change any of the provisions of this Indenture to such extent as shall be necessary to permit or facilitate the issuance of Securities in bearer form, registrable or not registrable as to principal, and with or without interest coupons, or to permit or facilitate the issuance of Securities in uncertificated form; or (5) to add to, change or eliminate any of the provisions of this Indenture in respect of one or more series of Securities, provided that any such addition, change or elimination (A) shall neither (i) apply to any Security of any series created prior to the execution of such supplemental indenture and entitled to the benefit of such provision nor (ii) modify the rights of the Holder of any such Security with respect to such provision or (B) shall become effective only when there is no such Security Outstanding; or (6) to secure the Securities pursuant to the requirements of Section 1009 or otherwise; or (7) to establish the form or terms of Securities of any series as permitted by Sections 201 and 301; or (8) to evidence and provide for the acceptance of appointment hereunder by a successor Trustee with respect to the Securities of one or more series and to add to or change any of the provisions of this Indenture as shall be necessary to provide for or facilitate the administration of the trusts hereunder by more than one Trustee, pursuant to the requirements of Section 611; or (9) to cure any ambiguity, to correct or supplement any provision herein which may be defective or inconsistent with any other provision herein, or to make any other provisions with respect to matters or questions arising under this Indenture, provided that such action pursuant to this Clause (9) shall not adversely affect the interests of the Holders of Securities of any series in any material respect. SECTION 902. SUPPLEMENTAL INDENTURES WITH CONSENT OF HOLDERS. With the consent of the Holders of not less than 66_% in principal amount of the Outstanding Securities of each series affected by such supplemental indenture, by Act of said Holders delivered to the Company and the Trustee, the Company, when authorized by a Board Resolution, and the Trustee may enter into an indenture or indentures supplemental hereto for the purpose of adding any provisions to or changing in any manner or eliminating any of the provisions of this Indenture or of modifying in any manner the rights of the Holders of Securities of such series under this Indenture; provided, however, that no such supplemental indenture shall, without the consent of the Holder of each Outstanding Security affected thereby, (1) change the Stated Maturity of the principal of, or any instalment of principal of or interest on, any Security, or reduce the principal amount thereof or the rate of interest thereon or any premium payable upon the redemption thereof, or reduce the amount of the principal of an Original Issue Discount Security or any other Security which would be due and payable upon a declaration of acceleration of the Maturity thereof pursuant to Section 502, or change the coin or currency in which, any Security or any premium or interest thereon is payable, or impair the right to institute suit for the enforcement of any such payment on or after the Stated Maturity thereof (or, in the case of redemption, on or after the Redemption Date), or (2) reduce the percentage in principal amount of the Outstanding Securities of any series, the consent of whose Holders is required for any such supplemental indenture, or the consent of whose Holders is required for any waiver (of compliance with certain provisions of this Indenture or certain defaults hereunder and their consequences) provided for in this Indenture, or (3) modify any of the provisions of this Section, Section 513 or Section 1013, except to increase any such percentage or to provide that certain other provisions of this Indenture cannot be modified or waived without the consent of the Holder of each Outstanding Security affected thereby; provided, however, that this clause shall not be deemed to require the consent of any Holder with respect to changes in the references to "the Trustee" and concomitant changes in this Section and Section 1013, or the deletion of this proviso, in accordance with the requirements of Sections 611 and 901(8). A supplemental indenture which changes or eliminates any covenant or other provision of this Indenture which has expressly been included solely for the benefit of one or more particular series of Securities, or which modifies the rights of the Holders of Securities of such series with respect to such covenant or other provision, shall be deemed not to affect the rights under this Indenture of the Holders of Securities of any other series. It shall not be necessary for any Act of Holders under this Section to approve the particular form of any proposed supplemental indenture, but it shall be sufficient if such Act shall approve the substance thereof. SECTION 903. EXECUTION OF SUPPLEMENTAL INDENTURES. In executing, or accepting the additional trusts created by, any supplemental indenture permitted by this Article or the modifications thereby of the trusts created by this Indenture, the Trustee shall be entitled to receive, and (subject to Section 601) shall be fully protected in relying upon, an Opinion of Counsel stating that the execution of such supplemental indenture is authorized or permitted by this Indenture. The Trustee may, but shall not be obligated to, enter into any such supplemental indenture which affects the Trustee's own rights, duties or immunities under this Indenture or otherwise. SECTION 904. EFFECT OF SUPPLEMENTAL INDENTURES. Upon the execution of any supplemental indenture under this Article, this Indenture shall be modified in accordance therewith, and such supplemental indenture shall form a part of this Indenture for all purposes; and every Holder of Securities theretofore or thereafter authenticated and delivered hereunder shall be bound thereby. SECTION 905. CONFORMITY WITH TRUST INDENTURE ACT. Every supplemental indenture executed pursuant to this Article shall conform to the requirements of the Trust Indenture Act. SECTION 906. REFERENCE IN SECURITIES TO SUPPLEMENTAL INDENTURES. Securities of any series authenticated and delivered after the execution of any supplemental indenture pursuant to this Article may, and shall if required by the Trustee, bear a notation in form approved by the Trustee as to any matter provided for in such supplemental indenture. If the Company shall so determine, new Securities of any series so modified as to conform, in the opinion of the Trustee and the Company, to any such supplemental indenture may be prepared and executed by the Company and authenticated and delivered by the Trustee in exchange for Outstanding Securities of such series. ARTICLE TEN COVENANTS SECTION 1001. PAYMENT OF PRINCIPAL, PREMIUM AND INTEREST. The Company covenants and agrees for the benefit of each series of Securities that it will duly and punctually pay the principal of and any premium and interest on the Securities of that series in accordance with the terms of the Securities and this Indenture. SECTION 1002. MAINTENANCE OF OFFICE OR AGENCY. The Company will maintain in each Place of Payment for any series of Securities an office or agency where Securities of that series may be presented or surrendered for payment, where Securities of that series may be surrendered for registration of transfer or exchange and where notices and demands to or upon the Company in respect of the Securities of that series and this Indenture may be served. The Company will give prompt written notice to the Trustee of the location, and any change in the location, of such office or agency. If at any time the Company shall fail to maintain any such required office or agency or shall fail to furnish the Trustee with the address thereof, such presentations, surrenders, notices and demands may be made or served at the Corporate Trust Office of the Trustee, and the Company hereby appoints the Trustee as its agent to receive all such presentations, surrenders, notices and demands. The Company may also from time to time designate one or more other offices or agencies where the Securities of one or more series may be presented or surrendered for any or all such purposes and may from time to time rescind such designations; provided, however, that no such designation or rescission shall in any manner relieve the Company of its obligation to maintain an office or agency in each Place of Payment for Securities of any series for such purposes. The Company will give prompt written notice to the Trustee of any such designation or rescission and of any change in the location of any such other office or agency. SECTION 1003. MONEY FOR SECURITIES PAYMENTS TO BE HELD IN TRUST. If the Company shall at any time act as its own Paying Agent with respect to any series of Securities, it will, on or before each due date of the principal of or any premium or interest on any of the Securities of that series, segregate and hold in trust for the benefit of the Persons entitled thereto a sum sufficient to pay the principal and any premium and interest so becoming due until such sums shall be paid to such Persons or otherwise disposed of as herein provided and will promptly notify the Trustee of its action or failure so to act. Whenever the Company shall have one or more Paying Agents for any series of Securities, it will, prior to each due date of the principal of or any premium or interest on any Securities of that series, deposit with a Paying Agent a sum sufficient to pay such amount, such sum to be held as provided by the Trust Indenture Act, and (unless such Paying Agent is the Trustee) the Company will promptly notify the Trustee of its action or failure so to act. The Company will cause each Paying Agent for any series of Securities other than the Trustee to execute and deliver to the Trustee an instrument in which such Paying Agent shall agree with the Trustee, subject to the provisions of this Section, that such Paying Agent will (1) comply with the provisions of the Trust Indenture Act applicable to it as a Paying Agent and (2) during the continuance of any default by the Company (or any other obligor upon the Securities of that series) in the making of any payment in respect of the Securities of that series, upon the written request of the Trustee, forthwith pay to the Trustee all sums held in trust by such Paying Agent for payment in respect of the Securities of that series. The Company may at any time, for the purpose of obtaining the satisfaction and discharge of this Indenture or for any other purpose, pay, or by Company Order direct any Paying Agent to pay, to the Trustee all sums held in trust by the Company or such Paying Agent, such sums to be held by the Trustee upon the same trusts as those upon which such sums were held by the Company or such Paying Agent; and, upon such payment by any Paying Agent to the Trustee, such Paying Agent shall be released from all further liability with respect to such money. Any money deposited with the Trustee or any Paying Agent, or then held by the Company, in trust for the payment of the principal of or any premium or interest on any Security of any series and remaining unclaimed for two years after such principal, premium or interest has become due and payable shall be paid to the Company on Company Request, or (if then held by the Company) shall be discharged from such trust; and the Holder of such Security shall thereafter, as an unsecured general creditor, look only to the Company for payment thereof, and all liability of the Trustee or such Paying Agent with respect to such trust money, and all liability of the Company as trustee thereof, shall thereupon cease; provided, however, that the Trustee or such Paying Agent, before being required to make any such repayment, may at the expense of the Company cause to be published once, in a newspaper published in the English language, customarily published on each Business Day and of general circulation in the Borough of Manhattan, The City of New York, notice that such money remains unclaimed and that, after a date specified therein, which shall not be less than 30 days from the date of such publication, any unclaimed balance of such money then remaining will be repaid to the Company. SECTION 1004. STATEMENT BY OFFICERS AS TO DEFAULT. The Company will deliver to the Trustee, within 120 days after the end of each fiscal year of the Company ending after the date hereof, an Officers' Certificate, stating whether or not to the best knowledge of the signers thereof the Company is in default in the performance and observance of any of the terms, provisions and conditions of this Indenture (without regard to any period of grace or requirement of notice provided hereunder) and, if the Company shall be in default, specifying all such defaults and the nature and status thereof of which they may have knowledge. SECTION 1005. EXISTENCE. Subject to Article Eight, the Company will do or cause to be done all things necessary to preserve and keep in full force and effect its existence, rights (charter and statutory) and franchises; provided, however, that the Company shall not be required to preserve any such right or franchise if the Board of Directors shall determine that the preservation thereof is no longer desirable in the conduct of the business of the Company and that the loss thereof is not disadvantageous in any material respect to the Holders. SECTION 1006. MAINTENANCE OF PROPERTIES. The Company will cause all properties used or useful in the conduct of its business or the business of any Subsidiary to be maintained and kept in good condition, repair and working order, ordinary wear and tear excepted, and supplied with all necessary equipment and will cause to be made all necessary repairs, renewals, replacements, betterments and improvements thereof, all as in the judgment of the Company may be necessary so that the business carried on in connection therewith may be properly and advantageously conducted at all times; provided, however, that nothing in this Section shall prevent the Company from discontinuing the operation or maintenance of any of such properties if such discontinuance is, in the judgment of the Company, desirable in the conduct of its business or the business of any Subsidiary and not disadvantageous in any material respect to the Holders. SECTION 1007. INSURANCE. The Company will maintain, and cause its Subsidiaries to maintain, insurance coverage by financially sound and reputable insurers in such forms and amounts and against such risks as are at that time customary for corporations of established reputation engaged in the same or a similar business and owning and operating similar properties including general liability insurance and (but without duplication) protection and indemnity insurance, hull and machinery insurance, oil pollution insurance and, if available at commercially reasonable rates, loss of hire insurance. SECTION 1008. PAYMENT OF TAXES AND OTHER CLAIMS. The Company will pay or discharge or cause to be paid or discharged, (1) before the same shall become delinquent, all material taxes, assessments and governmental charges levied or imposed upon the Company or any Subsidiary or upon the income, profits or property of the Company or any Subsidiary, and (2) all material lawful claims for labor, materials and supplies which give rise to a lien or which, if unpaid, might by law become a lien upon the property of the Company or any Subsidiary, prior to the time the holder of such lien evidences its intention to realize upon its lien; provided, however, that the Company shall not be required to pay or discharge or cause to be paid or discharged any such tax, assessment, charge or claim whose amount, applicability or validity is being contested in good faith by appropriate proceedings. SECTION 1009. LIMITATION ON LIENS. The Company will not itself, and will not permit any Restricted Subsidiary to, Incur any Debt secured by a Mortgage on any property or assets owned or leased by the Company or any Restricted Subsidiary, or any shares of stock or Debt of any Subsidiary, without effectively providing that the Securities (together with, if the Company shall so determine, any other Debt of the Company or such Restricted Subsidiary then existing or thereafter created which is not subordinate to the Securities) shall be secured equally and ratably with (or prior to) such secured Debt, so long as such secured Debt shall be so secured, unless, after giving effect thereto, the aggregate amount of all such secured Debt Incurred after the date hereof and then outstanding plus all Attributable Debt Incurred after the date hereof and then outstanding of the Company and its Restricted Subsidiaries in respect to sale and leaseback transactions (as defined in Section 1010) would not exceed 15% of Consolidated Net Tangible Assets of the Company and its Restricted Subsidiaries; provided, however, that this Section shall not apply to, and there shall be excluded from secured Debt in any computation under this Section, Debt secured by: (1) Mortgages on property of, or on any shares of stock or Debt of, any corporation existing at the time such corporation becomes a Subsidiary; (2) Mortgages in favor of the Company or any Restricted Subsidiary; (3) Mortgages in favor of the United States of America, or any agency, department or other instrumentality thereof, to secure progress, advance or other payments pursuant to any contract or provision of any statute; (4) Mortgages on property, shares of stock or Debt existing at the time of acquisition thereof (including acquisition through merger or consolidation) or to secure the payment of all or any part of the purchase price or construction cost thereof or to secure any Debt Incurred or committed to under a binding agreement prior to, at the time of, or within 120 days after, the acquisition of such property or shares or Debt or the completion of any such construction for the purpose of financing all or any part of the purchase price or construction cost thereof; and (5) any extension, renewal or replacement (or successive extensions, renewals or replacements), as a whole or in part, of any Mortgage referred to in the foregoing clauses (1) to (4), inclusive whether existing now or hereafter or of any Mortgage existing on the date hereof; provided, that (i) such extension, renewal or replacement Mortgage shall be limited to all or a part of the same property, shares of stock or Debt that secured the Mortgage extended, renewed or replaced (plus improvements on such property) and (ii) the Debt secured by such Mortgage at such time is not increased. SECTION 1010. LIMITATION ON SALES AND LEASEBACKS. The Company will not itself, and it will not permit any Restricted Subsidiary to, enter into any arrangement with any bank, insurance company or other lender or investor (not including the Company or any Restricted Subsidiary) or to which any such lender or investor is a party, providing for the leasing by the Company or any such Restricted Subsidiary for a period, including renewals, in excess of three years of any property or assets owned or leased by the Company or such Restricted Subsidiary which has been or is to be sold or transferred, more than 120 days after the acquisition thereof or after the completion of construction and commencement of full operation thereof, by the Company or any such Restricted Subsidiary to such lender or investor or to any person to whom funds have been or are to be advanced by such lender or investor on the security of such property or assets (herein referred to as a "sale and leaseback transaction") unless either: (1) the Company or such Restricted Subsidiary could create Debt secured by a Mortgage pursuant to Section 1009 on the property or assets to be leased back in an amount equal to the Attributable Debt with respect to such sale and leaseback transaction without equally and ratably securing the Securities, or (2) the Company or such Restricted Subsidiary within 120 days after the sale or transfer shall have been made by the Company or by any such Restricted Subsidiary, applies an amount not less than the greater of (i) the net proceeds of the sale of the property or assets sold and leased back pursuant to such arrangement or (ii) the fair market value of the property or assets so sold and leased back at the time of entering into such arrangement (as determined by any two of the following: the Chairman of the Board of the Company, its President, any Executive or Senior Vice President of the Company, its Chief Financial Officer, its Treasurer and its Controller) to (a) the purchase, acquisition or construction of property or assets to be used in the business of the Company and its Restricted Subsidiaries (which shall include the entering into, within such 120 day period, of an agreement for such purchase, acquisition or construction of property or assets) or (b) to the retirement of Funded Debt of the Company or any Restricted Subsidiary; provided, that (x) the amount to be applied to the retirement of Funded Debt of the Company shall be reduced by the principal amount of any Securities delivered within 120 days after such sale to the Trustee for retirement and cancellation and (y) the amount to be applied to the retirement of Funded Debt of the Company or any Restricted Subsidiary shall be reduced by the principal amount of Funded Debt of the Company, other than Securities, or the principal amount of Funded Debt of any Restricted Subsidiary, as the case may be, voluntarily retired by the Company or any Restricted Subsidiary within 120 days after such sale. Notwithstanding the foregoing, no retirement referred to in this clause (2) may be effected by payment at maturity or pursuant to any mandatory prepayment provision. SECTION 1011. LIMITATION ON INCURRENCE OF INDEBTEDNESS BY RESTRICTED SUBSIDIARIES. The Company will not permit any of its Restricted Subsidiaries to Incur any Funded Debt unless after giving effect to the Incurrence of such Funded Debt by such Restricted Subsidiary and the receipt and application of the proceeds thereof, the aggregate outstanding amount of Funded Debt of all Restricted Subsidiaries of the Company shall not exceed 10% of Consolidated Net Tangible Assets of the Company and its Restricted Subsidiaries; provided, however, that this sentence shall not apply to, and there shall be excluded from Funded Debt at the time of any computation under this sentence, (a) any Funded Debt owed to the Company or to any other Restricted Subsidiary, (b) any Funded Debt of a Restricted Subsidiary outstanding on the date hereof, (c) any Funded Debt that (i) is supported in full by a direct-pay or standby letter of credit or letter of guarantee on which the Company (but not any of its Restricted Subsidiaries) is the account party and as to which the terms of the related reimbursement agreement shall not permit the issuing bank any recourse against any Restricted Subsidiary of the Company and (ii) is not supported by any other letter of credit, letter of guarantee or similar instrument in respect of which any Restricted Subsidiary of the Company has any obligation and (d) any Funded Debt of a Restricted Subsidiary Incurred pursuant to a United States Government sponsored vessel financing program, including Title XI or a successor or similar program. SECTION 1012. RESTRICTED SUBSIDIARIES. Each Subsidiary of the Company shall be a Restricted Subsidiary unless such Subsidiary has been designated as an Unrestricted Subsidiary in accordance with the provisions set forth herein. The Board of Directors may designate any Person as an Unrestricted Subsidiary if and only if (A) the Company has delivered to the Trustee an Officer's Certificate within 60 days after such Person became a Subsidiary (the "Notice Period") designating such Person as an Unrestricted Subsidiary and (B) (i) such Person is not a Subsidiary on the date hereof, (ii) such Person was not a Restricted Subsidiary prior to the commencement of the Notice Period, (iii) an Officers' Certificate is delivered to the Trustee stating that the Board of Directors has determined that at the time of such Person's acquisition or formation it was not contemplated that such Person would own, acquire or lease under a lease which would be considered a Capitalized Lease any ocean going vessel designed to carry cargo in bulk which vessel was originally contracted for by the Company or one of its Subsidiaries, (iv) neither the Company nor any Restricted Subsidiary has guaranteed or in any other manner become liable for or otherwise created a Mortgage on its property as security for any Funded Debt of such Person, and (v) such Person does not own or hold, directly or indirectly, any Funded Debt or equity securities of any Restricted Subsidiary or own, lease or operate any assets or properties (other than cash, cash equivalents or marketable securities) transferred to it by the Company or any Restricted Subsidiary. The Company may change the designation of any Subsidiary from Unrestricted Subsidiary to Restricted Subsidiary by giving written notice to the Trustee that the Board of Directors has made such change, provided that no such change shall be effective if after giving effect to such change the aggregate amount of Funded Debt of all Restricted Subsidiaries of the Company then outstanding (after giving effect to the exclusions provided for in Section 1011 hereof) would exceed 10% of the Consolidated Net Tangible Assets of the Company and its Restricted Subsidiaries. If at any time (i) the Company or a Restricted Subsidiary guarantees or in any other manner becomes liable for or otherwise creates a Mortgage on its property as security for any Funded Debt of an Unrestricted Subsidiary, (ii) an Unrestricted Subsidiary owns or holds, directly or indirectly, any Funded Debt or equity securities of any Restricted Subsidiary or (iii) an Unrestricted Subsidiary owns, leases or operates any assets or properties (other than cash, cash equivalents and marketable securities) transferred to it by the Company or any Restricted Subsidiary, the designation of such Unrestricted Subsidiary shall thereupon, without further action, but subject to the condition set forth in the proviso to the first sentence of this paragraph, be deemed to have been changed to a Restricted Subsidiary. The Company will not itself, and it will not permit any Subsidiary to, take any of the actions referred to in clauses (i), (ii) or (iii) of the preceding sentence unless the Unrestricted Subsidiary referred to in such sentence can be designated a Restricted Subsidiary in conformity with the provisions of this Section. The acquisition of a Restricted Subsidiary or the change of designation of an Unrestricted Subsidiary to a Restricted Subsidiary shall, as of the date of such acquisition or change, constitute an Incurrence by Restricted Subsidiaries of the Company of Funded Debt in the amount of the Funded Debt of such Restricted Subsidiary as of such date, and, for purposes of determining Consolidated Net Tangible Assets of the Company and its Restricted Subsidiaries as of such date, pro forma effect shall be given to such acquisition or change. SECTION 1013. WAIVER OF CERTAIN COVENANTS. Except as otherwise specified as contemplated by Section 301 for Securities of such series, the Company may, with respect to the Securities of any series, omit in any particular instance to comply with any term, provision or condition set forth in any covenant provided pursuant to Section 301(18), 901(2) or 901(7) for the benefit of the Holders of such series or in any of Sections 1006 to 1012, inclusive, if before the time for such compliance the Holders of at least 66_% in principal amount of the Outstanding Securities of such series shall, by Act of such Holders, either waive such compliance in such instance or generally waive compliance with such term, provision or condition, but no such waiver shall extend to or affect such term, provision or condition except to the extent so expressly waived, and, until such waiver shall become effective, the obligations of the Company and the duties of the Trustee in respect of any such term, provision or condition shall remain in full force and effect. ARTICLE ELEVEN REDEMPTION OF SECURITIES SECTION 1101. APPLICABILITY OF ARTICLE. Securities of any series which are redeemable before their Stated Maturity shall be redeemable in accordance with their terms and (except as otherwise specified as contemplated by Section 301 for such Securities) in accordance with this Article. SECTION 1102. ELECTION TO REDEEM; NOTICE TO TRUSTEE. The election of the Company to redeem any Securities shall be evidenced by a Board Resolution or in another manner specified as contemplated by Section 301 for such Securities. In case of any redemption at the election of the Company of less than all the Securities of any series (including any such redemption affecting only a single Security), the Company shall, at least 60 days prior to the Redemption Date fixed by the Company (unless a shorter notice shall be satisfactory to the Trustee), notify the Trustee of such Redemption Date, of the principal amount of Securities of such series to be redeemed and, if applicable, of the tenor of the Securities to be redeemed. In the case of any redemption of Securities prior to the expiration of any restriction on such redemption provided in the terms of such Securities or elsewhere in this Indenture, the Company shall furnish the Trustee with an Officers' Certificate evidencing compliance with such restriction. SECTION 1103. SELECTION BY TRUSTEE OF SECURITIES TO BE REDEEMED. If less than all the Securities of any series are to be redeemed (unless all the Securities of such series and of a specified tenor are to be redeemed or unless such redemption affects only a single Security), the particular Securities to be redeemed shall be selected not more than 60 days prior to the Redemption Date by the Trustee, from the Outstanding Securities of such series not previously called for redemption, by such method as the Trustee shall deem fair and appropriate and which may provide for the selection for redemption of a portion of the principal amount of any Security of such series, provided that the unredeemed portion of the principal amount of any Security shall be in an authorized denomination (which shall not be less than the minimum authorized denomination) for such Security. If less than all the Securities of such series and of a specified tenor are to be redeemed (unless such redemption affects only a single Security), the particular Securities to be redeemed shall be selected not more than 60 days prior to the Redemption Date by the Trustee, from the Outstanding Securities of such series and specified tenor not previously called for redemption in accordance with the preceding sentence. The Trustee shall promptly notify the Company in writing of the Securities selected for redemption as aforesaid and, in case of any Securities selected for partial redemption as aforesaid, the principal amount thereof to be redeemed. The provisions of the two preceding paragraphs shall not apply with respect to any redemption affecting only a single Security, whether such Security is to be redeemed in whole or in part. In the case of any such redemption in part, the unredeemed portion of the principal amount of the Security shall be in an authorized denomination (which shall not be less than the minimum authorized denomination) for such Security. For all purposes of this Indenture, unless the context otherwise requires, all provisions relating to the redemption of Securities shall relate, in the case of any Securities redeemed or to be redeemed only in part, to the portion of the principal amount of such Securities which has been or is to be redeemed. SECTION 1104. NOTICE OF REDEMPTION. Notice of redemption shall be given by first-class mail, postage prepaid, mailed not less than 30 nor more than 60 days prior to the Redemption Date, to each Holder of Securities to be redeemed, at his address appearing in the Security Register. All notices of redemption shall state: (1) the Redemption Date, (2) the Redemption Price, (3) if less than all the Outstanding Securities of any series consisting of more than a single Security are to be redeemed, the identification (and, in the case of partial redemption of any such Securities, the principal amounts) of the particular Securities to be redeemed and, if less than all the Outstanding Securities of any series consisting of a single Security are to be redeemed, the principal amount of the particular Security to be redeemed, (4) that on the Redemption Date the Redemption Price will become due and payable upon each such Security to be redeemed and, if applicable, that interest thereon will cease to accrue on and after said date, (5) the place or places where each such Security is to be surrendered for payment of the Redemption Price, and (6) that the redemption is for a sinking fund, if such is the case. Notice of redemption of Securities to be redeemed at the election of the Company shall be given by the Company or, at the Company's request, by the Trustee in the name and at the expense of the Company and shall be irrevocable. SECTION 1105. DEPOSIT OF REDEMPTION PRICE. Prior to any Redemption Date, the Company shall deposit with the Trustee or with a Paying Agent (or, if the Company is acting as its own Paying Agent, segregate and hold in trust as provided in Section 1003) an amount of money sufficient to pay the Redemption Price of, and (except if the Redemption Date shall be an Interest Payment Date) accrued interest on, all the Securities which are to be redeemed on that date. SECTION 1106. SECURITIES PAYABLE ON REDEMPTION DATE. Notice of redemption having been given as aforesaid, the Securities so to be redeemed shall, on the Redemption Date, become due and payable at the Redemption Price therein specified, and from and after such date (unless the Company shall default in the payment of the Redemption Price and accrued interest) such Securities shall cease to bear interest. Upon surrender of any such Security for redemption in accordance with said notice, such Security shall be paid by the Company at the Redemption Price, together with accrued interest to the Redemption Date; provided, however, that, unless otherwise specified as contemplated by Section 301, instalments of interest whose Stated Maturity is on or prior to the Redemption Date will be payable to the Holders of such Securities, or one or more Predecessor Securities, registered as such at the close of business on the relevant Record Dates according to their terms and the provisions of Section 307. If any Security called for redemption shall not be so paid upon surrender thereof for redemption, the principal and any premium shall, until paid, bear interest from the Redemption Date at the rate prescribed therefor in the Security. SECTION 1107. SECURITIES REDEEMED IN PART. Any Security which is to be redeemed only in part shall be surrendered at a Place of Payment therefor (with, if the Company or the Trustee so requires, due endorsement by, or a written instrument of transfer in form satisfactory to the Company and the Trustee duly executed by, the Holder thereof or his attorney duly authorized in writing), and the Company shall execute, and the Trustee shall authenticate and deliver to the Holder of such Security without service charge, a new Security or Securities of the same series and of like tenor, of any authorized denomination as requested by such Holder, in aggregate principal amount equal to and in exchange for the unredeemed portion of the principal of the Security so surrendered. ARTICLE TWELVE SINKING FUNDS SECTION 1201. APPLICABILITY OF ARTICLE. The provisions of this Article shall be applicable to any sinking fund for the retirement of Securities of any series except as otherwise specified as contemplated by Section 301 for such Securities. The minimum amount of any sinking fund payment provided for by the terms of any Securities is herein referred to as a "mandatory sinking fund payment", and any payment in excess of such minimum amount provided for by the terms of such Securities is herein referred to as an "optional sinking fund payment". If provided for by the terms of any Securities, the cash amount of any sinking fund payment may be subject to reduction as provided in Section 1202. Each sinking fund payment shall be applied to the redemption of Securities as provided for by the terms of such Securities. SECTION 1202. SATISFACTION OF SINKING FUND PAYMENTS WITH SECURITIES. The Company (1) may deliver Outstanding Securities of a series (other than any previously called for redemption) and (2) may apply as a credit Securities of a series which have been redeemed either at the election of the Company pursuant to the terms of such Securities or through the application of permitted optional sinking fund payments pursuant to the terms of such Securities, in each case in satisfaction of all or any part of any sinking fund payment with respect to any Securities of such series required to be made pursuant to the terms of such Securities as and to the extent provided for by the terms of such Securities; provided that the Securities to be so credited have not been previously so credited. The Securities to be so credited shall be received and credited for such purpose by the Trustee at the Redemption Price, as specified in the Securities so to be redeemed, for redemption through operation of the sinking fund and the amount of such sinking fund payment shall be reduced accordingly. SECTION 1203. REDEMPTION OF SECURITIES FOR SINKING FUND. Not less than 45 days prior to each sinking fund payment date for any Securities, the Company will deliver to the Trustee an Officers' Certificate specifying the amount of the next ensuing sinking fund payment for such Securities pursuant to the terms of such Securities, the portion thereof, if any, which is to be satisfied by payment of cash and the portion thereof, if any, which is to be satisfied by delivering and crediting Securities pursuant to Section 1202 and will also deliver to the Trustee any Securities to be so delivered. Not less than 30 days prior to each such sinking fund payment date, the Trustee shall select the Securities to be redeemed upon such sinking fund payment date in the manner specified in Section 1103 and cause notice of the redemption thereof to be given in the name of and at the expense of the Company in the manner provided in Section 1104. Such notice having been duly given, the redemption of such Securities shall be made upon the terms and in the manner stated in Sections 1106 and 1107. ARTICLE THIRTEEN DEFEASANCE AND COVENANT DEFEASANCE SECTION 1301. COMPANY'S OPTION TO EFFECT DEFEASANCE OR COVENANT DEFEASANCE. The Company may elect, at its option at any time, to have Section 1302 or Section 1303 applied to any Securities or any series of Securities, as the case may be, designated pursuant to Section 301 as being defeasible pursuant to such Section 1302 or 1303, in accordance with any applicable requirements provided pursuant to Section 301 and upon compliance with the conditions set forth below in this Article. Any such election shall be evidenced by a Board Resolution or in another manner specified as contemplated by Section 301 for such Securities. SECTION 1302. DEFEASANCE AND DISCHARGE. Upon the Company's exercise of its option (if any) to have this Section applied to any Securities or any series of Securities, as the case may be, the Company shall be deemed to have been discharged from its obligations with respect to such Securities as provided in this Section on and after the date the conditions set forth in Section 1304 are satisfied (hereinafter called "Defeasance"). For this purpose, such Defeasance means that the Company shall be deemed to have paid and discharged the entire indebtedness represented by such Securities and to have satisfied all its other obligations under such Securities and this Indenture insofar as such Securities are concerned (and the Trustee, at the expense of the Company, shall execute proper instruments acknowledging the same), subject to the following which shall survive until otherwise terminated or discharged hereunder: (1) the rights of Holders of such Securities to receive, solely from the trust fund described in Section 1304 and as more fully set forth in such Section, payments in respect of the principal of and any premium and interest on such Securities when payments are due, (2) the Company's obligations with respect to such Securities under Sections 304, 305, 306, 1002 and 1003, (3) the rights, powers, trusts, duties and immunities of the Trustee hereunder and (4) this Article. Subject to compliance with this Article, the Company may exercise its option (if any) to have this Section applied to any Securities notwithstanding the prior exercise of its option (if any) to have Section 1303 applied to such Securities. SECTION 1303. COVENANT DEFEASANCE. Upon the Company's exercise of its option (if any) to have this Section applied to any Securities or any series of Securities, as the case may be, (1) the Company shall be released from its obligations under Section 801(3), Sections 1006 through 1012, inclusive, and any covenants provided pursuant to Section 301(18), 901(2) or 901(7) for the benefit of the Holders of such Securities and (2) the occurrence of any event specified in Sections 501(4) (with respect to any of Section 801(3), Sections 1006 through 1012, inclusive, and any such covenants provided pursuant to Section 301(18), 901(2) or 901(7)), 501(5) and 501(8) shall be deemed not to be or result in an Event of Default in each case with respect to such Securities as provided in this Section on and after the date the conditions set forth in Section 1304 are satisfied (hereinafter called "Covenant Defeasance"). For this purpose, such Covenant Defeasance means that, with respect to such Securities, the Company may omit to comply with and shall have no liability in respect of any term, condition or limitation set forth in any such specified Section (to the extent so specified in the case of Section 501(4)), whether directly or indirectly by reason of any reference elsewhere herein to any such Section or by reason of any reference in any such Section to any other provision herein or in any other document, but the remainder of this Indenture and such Securities shall be unaffected thereby. SECTION 1304. CONDITIONS TO DEFEASANCE OR COVENANT DEFEASANCE. The following shall be the conditions to the application of Section 1302 or Section 1303 to any Securities or any series of Securities, as the case may be: (1) The Company shall irrevocably have deposited or caused to be deposited with the Trustee (or another trustee which satisfies the requirements contemplated by Section 609 and agrees to comply with the provisions of this Article applicable to it) as trust funds in trust for the purpose of making the following payments, specifically pledged as security for, and dedicated solely to, the benefits of the Holders of such Securities, (A) money in an amount, or (B) U.S. Government Obligations which through the scheduled payment of principal and interest in respect thereof in accordance with their terms will provide, not later than one day before the due date of any payment, money in an amount, or (C) a combination thereof, in each case sufficient, in the opinion of a nationally recognized firm of independent public accountants expressed in a written certification thereof delivered to the Trustee, to pay and discharge, and which shall be applied by the Trustee (or any such other qualifying trustee) to pay and discharge, the principal of and any premium and interest on such Securities on the respective Stated Maturities, in accordance with the terms of this Indenture and such Securities. As used herein, "U.S. Government Obligation" means (x) any security which is (i) a direct obligation of the United States of America for the payment of which the full faith and credit of the United States of America is pledged or (ii) an obligation of a Person controlled or supervised by and acting as an agency or instrumentality of the United States of America the payment of which is unconditionally guaranteed as a full faith and credit obligation by the United States of America, which, in either case (i) or (ii), is not callable or redeemable at the option of the issuer thereof, and (y) any depositary receipt issued by a bank (as defined in Section 3(a)(2) of the Securities Act) as custodian with respect to any U.S. Government Obligation which is specified in Clause (x) above and held by such bank for the account of the holder of such depositary receipt, or with respect to any specific payment of principal of or interest on any U.S. Government Obligation which is so specified and held, provided that (except as required by law) such custodian is not authorized to make any deduction from the amount payable to the holder of such depositary receipt from any amount received by the custodian in respect of the U.S. Government Obligation or the specific payment of principal or interest evidenced by such depositary receipt. (2) In the event of an election to have Section 1302 apply to any Securities or any series of Securities, as the case may be, the Company shall have delivered to the Trustee an Opinion of Counsel stating that (A) the Company has received from, or there has been published by, the Internal Revenue Service a ruling or (B) since the date of this instrument, there has been a change in the applicable Federal income tax law, in either case (A) or (B) to the effect that, and based thereon such opinion shall confirm that, the Holders of such Securities will not recognize gain or loss for Federal income tax purposes as a result of the deposit, Defeasance and discharge to be effected with respect to such Securities and will be subject to Federal income tax on the same amount, in the same manner and at the same times as would be the case if such deposit, Defeasance and discharge were not to occur. (3) In the event of an election to have Section 1303 apply to any Securities or any series of Securities, as the case may be, the Company shall have delivered to the Trustee an Opinion of Counsel to the effect that the Holders of such Securities will not recognize gain or loss for Federal income tax purposes as a result of the deposit and Covenant Defeasance to be effected with respect to such Securities and will be subject to Federal income tax on the same amount, in the same manner and at the same times as would be the case if such deposit and Covenant Defeasance were not to occur. (4) The Company shall have delivered to the Trustee an Officer's Certificate to the effect that neither such Securities nor any other Securities of the same series, if then listed on any securities exchange, will be delisted as a result of such deposit. (5) No event which is, or after notice or lapse of time or both would become, an Event of Default with respect to such Securities or any other Securities shall have occurred and be continuing at the time of such deposit or, with regard to any such event specified in Sections 501(6) and (7), at any time on or prior to the 90th day after the date of such deposit (it being understood that this condition shall not be deemed satisfied until after such 90th day). (6) Such Defeasance or Covenant Defeasance shall not cause the Trustee to have a conflicting interest within the meaning of the Trust Indenture Act (assuming all Securities are in default within the meaning of such Act). (7) Such Defeasance or Covenant Defeasance shall not result in a breach or violation of, or constitute a default under, any other agreement or instrument to which the Company is a party or by which it is bound. (8) Such Defeasance or Covenant Defeasance shall not result in the trust arising from such deposit constituting an investment company within the meaning of the Investment Company Act unless such trust shall be registered under such Act or exempt from registration thereunder. (9) The Company shall have delivered to the Trustee an Officer's Certificate and an Opinion of Counsel, each stating that all conditions precedent with respect to such Defeasance or Covenant Defeasance have been complied with. SECTION 1305. DEPOSITED MONEY AND U.S. GOVERNMENT OBLIGATIONS TO BE HELD IN TRUST; MISCELLANEOUS PROVISIONS. Subject to the provisions of the last paragraph of Section 1003, all money and U.S. Government Obligations (including the proceeds thereof) deposited with the Trustee or other qualifying trustee (solely for purposes of this Section and Section 1306, the Trustee and any such other trustee are referred to collectively as the "Trustee") pursuant to Section 1304 in respect of any Securities shall be held in trust and applied by the Trustee, in accordance with the provisions of such Securities and this Indenture, to the payment, either directly or through any such Paying Agent (including the Company acting as its own Paying Agent) as the Trustee may determine, to the Holders of such Securities, of all sums due and to become due thereon in respect of principal and any premium and interest, but money so held in trust need not be segregated from other funds except to the extent required by law. The Company shall pay and indemnify the Trustee against any tax, fee or other charge imposed on or assessed against the U.S. Government Obligations deposited pursuant to Section 1304 or the principal and interest received in respect thereof other than any such tax, fee or other charge which by law is for the account of the Holders of Outstanding Securities. Anything in this Article to the contrary notwithstanding, the Trustee shall deliver or pay to the Company from time to time upon Company Request any money or U.S. Government Obligations held by it as provided in Section 1304 with respect to any Securities which, in the opinion of a nationally recognized firm of independent public accountants expressed in a written certification thereof delivered to the Trustee, are in excess of the amount thereof which would then be required to be deposited to effect the Defeasance or Covenant Defeasance, as the case may be, with respect to such Securities. SECTION 1306. REINSTATEMENT. If the Trustee or the Paying Agent is unable to apply any money in accordance with this Article with respect to any Securities by reason of any order or judgment of any court or governmental authority enjoining, restraining or otherwise prohibiting such application, then the obligations under this Indenture and such Securities from which the Company has been discharged or released pursuant to Section 1302 or 1303 shall be revived and reinstated as though no deposit had occurred pursuant to this Article with respect to such Securities, until such time as the Trustee or Paying Agent is permitted to apply all money held in trust pursuant to Section 1305 with respect to such Securities in accordance with this Article; provided, however, that if the Company makes any payment of principal of or any premium or interest on any such Security following such reinstatement of its obligations, the Company shall be subrogated to the rights (if any) of the Holders of such Securities to receive such payment from the money so held in trust. ------------------------------ This instrument may be executed in any number of counterparts, each of which so executed shall be deemed to be an original, but all such counterparts shall together constitute but one and the same instrument. IN WITNESS WHEREOF, the parties hereto have caused this Indenture to be duly executed, and their respective corporate seals to be hereunto affixed and attested, all as of the day and year first above written. OVERSEAS SHIPHOLDING GROUP, INC. By /s/ Gabriel Kahana Attest: ---------------------- /s/ Robert N. Cowen - ---------------------- THE CHASE MANHATTAN BANK (NATIONAL ASSOCIATION) By /s/ Ann L. Edmonds Attest: ---------------------- /s/ Kathleen Perry - ---------------------- State of New York ) ) ss.: County of New York ) On the 2nd day of December, 1993, before me personally came Gabriel Kahana, to me known, who, being by me duly sworn, did depose and say that he is Senior Vice President and Treasurer of Overseas Shipholding Group, Inc., one of the corporations described in and which executed the foregoing instrument; that he knows the seal of said corporation; that the seal affixed to said instrument is such corporate seal; that it was so affixed by authority of the Board of Directors of said corporation; and that he signed his name thereto by like authority. /s/Burt H. Liebman ................................ Burt H. Liebman Notary Public, State of New York State of New York ) ) ss.: County of Kings ) On the 2nd day of December, 1993, before me personally came Ann L. Edmonds, to me known, who, being by me duly sworn, did depose and say that she is Vice President of The Chase Manhattan Bank, N.A., one of the corporations described in and which executed the foregoing instrument; that he knows the seal of said corporation; that the seal affixed to said instrument is such corporate seal; that it was so affixed by authority of the Board of Directors of said corporation; and that he signed his name thereto by like authority. /s/Della K. Benjamin ................................. Della K. Benjamin Notary Public, State of New York ----------------- PAGE PARTIES 1 RECITALS OF THE COMPANY 1 ARTICLE ONE DEFINITIONS AND OTHER PROVISIONS OF GENERAL APPLICATION SECTION 101. Definitions: 1 Act 2 Affiliate; control 2 Attributable Debt 2 Authenticating Agent 2 Board of Directors 2 Board Resolution 2 Business Day 2 Capitalized Lease 3 Capitalized Rentals 3 Commission 3 Company 3 Company Request; Company Order 3 Consolidated Net Tangible Assets 3 Consolidated Net Tangible Assets of the Company and its Restricted Subsidiaries 3 Corporate Trust Office 3 corporation 4 Covenant Defeasance 4 Debt 4 Defaulted Interest 4 Defeasance 4 Depositary 4 Event of Default 4 Exchange Act 4 Expiration Date 4 Funded Debt 4 Global Security 4 Guaranties 4 Holder 5 Incur 5 Indenture 5 interest 5 Interest Payment Date 5 Investment Company Act 5 Maturity 5 Mortgage 6 Notice of Default 6 Officers' Certificate 6 Opinion of Counsel 6 Original Issue Discount Security 6 Outstanding 6 Paying Agent 7 Person 7 Place of Payment 7 Predecessor Security 7 Redemption Date 8 Redemption Price 8 Regular Record Date 8 Rentals 8 Responsible Officer 8 Restricted Subsidiary 8 Securities 8 Securities Act 9 Security Register; Security Registrar 9 Special Record Date 9 Stated Maturity 9 Subsidiary 9 Trust Indenture Act 9 Trustee 9 Unrestricted Subsidiary 9 U.S. Government Obligation 9 Vice President 9 SECTION 102. Compliance Certificates and Opinions 10 SECTION 103. Form of Documents Delivered to Trustee 10 SECTION 104. Acts of Holders; Record Dates 11 SECTION 105. Notices, Etc., to Trustee and Company 13 SECTION 106. Notice to Holders; Waiver 14 SECTION 107. Conflict with Trust Indenture Act 14 SECTION 108. Effect of Headings and Table of Contents 14 SECTION 109. Successors and Assigns 15 SECTION 110. Separability Clause 15 SECTION 111. Benefits of Indenture 15 SECTION 112. Governing Law 15 SECTION 113. Legal Holidays 15 SECTION 114. No Recourse 15 ARTICLE TWO SECURITY FORMS SECTION 201. Forms Generally 16 SECTION 202. Form of Face of Security 16 SECTION 203. Form of Reverse of Security 18 SECTION 204. Form of Legend for Global Securities 22 SECTION 205. Form of Trustee's Certificate of Authentication 23 ARTICLE THREE THE SECURITIES SECTION 301. Amount Unlimited; Issuable in Series 23 SECTION 302. Denominations 26 - ------------ NOTE: This table of contents shall not, for any purpose, be deemed to be a part of the Indenture. SECTION 303. Execution, Authentication, Delivery and Dating 26 SECTION 304. Temporary Securities 28 SECTION 305. Registration, Registration of Transfer and Exchange 28 SECTION 306. Mutilated, Destroyed, Lost and Stolen Securities 30 SECTION 307. Payment of Interest; Interest Rights Preserved 31 SECTION 308. Persons Deemed Owners 32 SECTION 309. Cancellation 32 SECTION 310. Computation of Interest 33 ARTICLE FOUR SATISFACTION AND DISCHARGE SECTION 401. Satisfaction and Discharge of Indenture 33 SECTION 402. Application of Trust Money 34 ARTICLE FIVE REMEDIES SECTION 501. Events of Default 35 SECTION 502. Acceleration of Maturity; Rescission and Annulment 37 SECTION 503. Collection of Indebtedness and Suits for Enforcement by Trustee 38 SECTION 504. Trustee May File Proofs of Claim 39 SECTION 505. Trustee May Enforce Claims Without Possession of Securities 39 SECTION 506. Application of Money Collected 39 SECTION 507. Limitation on Suits 40 SECTION 508. Unconditional Right of Holders to Receive Principal, Premium and Interest 41 SECTION 509. Restoration of Rights and Remedies 41 SECTION 510. Rights and Remedies Cumulative 41 SECTION 511. Delay or Omission Not Waiver 41 SECTION 512. Control by Holders 42 SECTION 513. Waiver of Past Defaults 42 SECTION 514. Undertaking for Costs 42 SECTION 515. Waiver of Usury, Stay or Extension Laws 43 ARTICLE SIX THE TRUSTEE SECTION 601. Certain Duties and Responsibilities 43 SECTION 602. Notice of Defaults 43 SECTION 603. Certain Rights of Trustee 43 SECTION 604. Not Responsible for Recitals or Issuance of Securities 45 SECTION 605. May Hold Securities 45 SECTION 606. Money Held in Trust 45 SECTION 607. Compensation and Reimbursement 45 SECTION 608. Conflicting Interests 46 SECTION 609. Corporate Trustee Required; Eligibility 46 SECTION 610. Resignation and Removal; Appointment of Successor 46 SECTION 611. Acceptance of Appointment by Successor 48 SECTION 612. Merger, Conversion, Consolidation or Succession to Business 49 SECTION 613. Preferential Collection of Claims Against Company 49 SECTION 614. Appointment of Authenticating Agent 49 ARTICLE SEVEN HOLDERS' LISTS AND REPORTS BY TRUSTEE AND COMPANY SECTION 701. Company to Furnish Trustee Names and Addresses of Holders 52 SECTION 702. Preservation of Information; Communications to Holders 52 SECTION 703. Reports by Trustee 53 SECTION 704. Reports by Company 53 ARTICLE EIGHT CONSOLIDATION, MERGER, CONVEYANCE, TRANSFER OR LEASE SECTION 801. Company May Consolidate, Etc., Only on Certain Terms 53 SECTION 802. Successor Substituted 56 ARTICLE NINE SUPPLEMENTAL INDENTURES SECTION 901. Supplemental Indentures Without Consent of Holders 56 SECTION 902. Supplemental Indentures With Consent of Holders 58 SECTION 903. Execution of Supplemental Indentures 59 SECTION 904. Effect of Supplemental Indentures 59 SECTION 905. Conformity with Trust Indenture Act 59 SECTION 906. Reference in Securities to Supplemental Indentures 59 ARTICLE TEN COVENANTS SECTION 1001. Payment of Principal, Premium and Interest 60 SECTION 1002. Maintenance of Office or Agency 60 SECTION 1003. Money for Securities Payments to Be Held in Trust 60 SECTION 1004. Statement by Officers as to Default 62 SECTION 1005. Existence 62 SECTION 1006. Maintenance of Properties 62 SECTION 1007. Insurance 62 SECTION 1008. Payment of Taxes and Other Claims 62 SECTION 1009. Limitation on Liens 63 SECTION 1010. Limitation on Sales and Leasebacks 64 SECTION 1011. Limitation on Incurrence of Indebtedness by Restricted Subsidiaries 65 SECTION 1012. Restricted Subsidiaries 66 SECTION 1013. Waiver of Certain Covenants 67 ARTICLE ELEVEN REDEMPTION OF SECURITIES SECTION 1101. Applicability of Article 67 SECTION 1102. Election to Redeem; Notice to Trustee 68 SECTION 1103. Selection by Trustee of Securities to Be Redeemed 68 SECTION 1104. Notice of Redemption 69 SECTION 1105. Deposit of Redemption Price 69 SECTION 1106. Securities Payable on Redemption Date 70 SECTION 1107. Securities Redeemed in Part 70 ARTICLE TWELVE SINKING FUNDS SECTION 1201. Applicability of Article 70 SECTION 1202. Satisfaction of Sinking Fund Payments with Securities 71 SECTION 1203. Redemption of Securities for Sinking Fund 71 ARTICLE THIRTEEN DEFEASANCE AND COVENANT DEFEASANCE SECTION 1301. Company's Option to Effect Defeasance or Covenant Defeasance 72 SECTION 1302. Defeasance and Discharge 72 SECTION 1303. Covenant Defeasance 72 SECTION 1304. Conditions to Defeasance or Covenant Defeasance 73 SECTION 1305. Deposited Money and U.S. Government Obligations to Be Held in Trust; Miscellaneous Provisions 75 SECTION 1306. Reinstatement 76 Testimonium 76 Signatures and Seals 76 Acknowledgements 77 Exhibit 4(d)(2) Resolutions dated December 2, 1993 Fixing the Terms of Debt Securities RESOLVED, that pursuant to Section 301 of the Indenture, the Debt Securities authorized hereby shall have the following terms: 1. The title of the Debt Securities shall be: (i) "8% Notes due December 1, 2003" (the "Notes"); and (ii) "8-3/4% Debentures due December 1, 2013" (the "Debentures"). 2. The aggregate principal amount of each of the Notes and the Debentures which may be authenticated and delivered under the Indenture is limited in each case to $100,000,000 (subject to the exceptions set forth in Section 301(2) of the Indenture). 3. The principal of the Notes shall be payable on December 1, 2003, and the principal of the Debentures shall be payable on December 1, 2013, in each case in immediately available funds. 4. The Notes shall bear interest at the rate of 8% per annum, and the Debentures shall bear interest at the rate of 8- 3/4% per annum, in each case from December 1, 1993 or from the most recent Interest Payment Date to which interest has been paid or duly provided for, to the persons in whose names the Notes and the Debentures, respectively, are registered at the close of business on the May 15 or November 15, as the case may be (each, a "Regular Record Date"), next preceding such Interest Payment Date. 5. Until otherwise notified to the Trustee pursuant to Section 1002 of the Indenture, principal of and interest on the Notes and Debentures shall be made at the Corporate Trust office (as defined in the Indenture) of the Trustee. 6. Interest on the Notes and the Debentures shall be payable semi-annually on June 1 and December 1 of each year commencing June 1, 1994, in each case in immediately available funds. 7. The Notes and the Debentures may be redeemable at the option of OSG, in whole or from time to time in part, upon not less than 30 nor more than 60 days' notice mailed to each Holder of Securities to be redeemed at the address of such Holder appearing in the Security Register, on any date prior to maturity at (i) a Redemption Price equal to 100% of the principal amount thereof plus (ii) accrued interest to the Redemption Date (subject to the right of Holders of record on the relevant Regular Record Date to receive interest due on an Interest Payment Date that is due on or prior to the Redemption Date), plus (iii) a Make-Whole Premium, if any, as provided in the Pricing Agreement authorized below. 8. The Notes and the Debentures will not be entitled to the benefit of any sinking fund. 9. The Notes and the Debentures shall have the events of default as provided in Section 501 of the Indenture; the Trustee shall have the right to accelerate the payment of the principal of the Notes and Debentures as provided in Section 502 of the Indenture; and the Notes and the Debentures shall be subject to defeasance and covenant defeasance as provided in Article Thirteen of the Indenture. 10. The Notes and the Debentures shall be represented by one or more Global Securities, registered in the name of a nominee of The Depository Trust Company, as Depositary, and the Global Securities shall bear the legends set forth in the forms of Notes and Debentures attached as Annex A and Annex B hereto, respectively. ------------- [EXCERPT FROM PRICING AGREEMENT] REDEMPTION PROVISIONS The Designated Securities may be redeemed at the Company's option, in whole or from time to time in part, upon not less than 30 nor more than 60 days' notice mailed to each Holder of Securities to be redeemed at the address of such Holder appearing in the Security Register, on any date prior to maturity at (i) a Redemption Price equal to 100% of the principal amount thereof plus (ii) accrued interest to the Redemption Date (subject to the right of Holders of record on the relevant Regular Record Date to receive interest due on an Interest Payment Date that is on or prior to the Redemption Date), plus (iii) a Make-Whole Premium, if any. The amount of the Make-Whole Premium in respect of the principal amount of any Designated Security to be redeemed will be the excess, if any, of (i) the sum of the present values, as of the Redemption Date of such Designated Security, of (A) the respective interest payments (exclusive of the amount of accrued interest to the Redemption Date) on such Designated Security that, but for such redemption, would have been payable on their respective Interest Payment Dates after such Redemption Date, and (B) the payment of such principal amount that, but for such redemption, would have been payable at maturity over (ii) the amount of such principal to be redeemed. Such present values will be determined in accordance with generally recognized principles of financial analysis by discounting the amounts of such payments of interest and principal from their respective Stated Maturities to such Redemption Date at a discount rate equal to the Treasury Yield. The Make-Whole Premium will be calculated by an independent investment banking institution of national standing appointed by the Company which may be one of the Underwriters; provided, that if the Company fails to make such appointment at least 10 days prior to the Redemption Date, or if the institution so appointed is unwilling or unable to make such calculation, such calculation will be made by Goldman, Sachs & Co. or, if Goldman, Sachs & Co. is unwilling or unable to make such calculation, by an independent investment banking institution of national standing appointed by the Trustee (in any such case, an "Independent Investment Banker"). For purposes of determining the Make-Whole Premium with respect to any Designated Securities, "Treasury Yield" means a rate of interest per annum, determined by the Independent Investment Banker as of the third Business Day preceding the applicable Redemption Date, equal to the weekly average yield to maturity of United States Treasury Notes having a constant maturity as set forth in the most recent weekly statistical release (or any successor release) published by the Federal Reserve Bank of New York and designated "H.15(519) Selected Interest Rates" (the "H.15 Statistical Release") corresponding to the remaining term of such Designated Securities (calculated to the nearest 1/12 of a year) (the "Remaining Term"); such yield to be calculated by the Independent Investment Banker, by interpolation (unless the Remaining Term of such Designated Securities equals a constant maturity set forth in the H.15 Statistical Release) on a straight-line basis, between the weekly average yields (rounded, if necessary, to four decimal places) on (a) the United States Treasury Notes with a constant maturity closest to and greater than the Remaining Term and (b) the United States Treasury Notes with a constant maturity closest to and less than the Remaining Term, or if such weekly average yields are not available, by interpolation of comparable rates selected by the Independent Investment Banker. EXHIBIT 4(d)(3) FACE OF SECURITY. THIS SECURITY IS A GLOBAL SECURITY WITHIN THE MEANING OF THE INDENTURE HEREINAFTER REFERRED TO AND IS REGISTERED IN THE NAME OF A DEPOSITARY OR A NOMINEE THEREOF. THIS SECURITY MAY NOT BE EXCHANGED IN WHOLE OR IN PART FOR A SECURITY REGISTERED, AND NO TRANSFER OF THIS SECURITY IN WHOLE OR IN PART MAY BE REGISTERED, IN THE NAME OF ANY PERSON OTHER THAN SUCH DEPOSITARY OR A NOMINEE THEREOF, EXCEPT IN THE LIMITED CIRCUMSTANCES DESCRIBED IN THE INDENTURE. OVERSEAS SHIPHOLDING GROUP, INC. 8% NOTES DUE DECEMBER 1, 2003 CUSIP NO. 690368AA3 No. R-1 $100,000,000 Overseas Shipholding Group, Inc., a corporation duly organized and existing under the laws of Delaware (herein called the "Company", which term includes any successor Person under the Indenture hereinafter referred to), for value received, hereby promises to pay to CEDE & CO., or registered assigns, the principal sum of ONE HUNDRED MILLION DOLLARS ($100,000,000) on December 1, 2003, and to pay interest thereon from December 1, 1993 or from the most recent Interest Payment Date to which interest has been paid or duly provided for, semi-annually on June 1 and December 1 in each year, commencing June 1, 1994, at the rate of 8% per annum, until the principal hereof is paid or made available for payment. The interest so payable, and punctually paid or duly provided for, on any Interest Payment Date will, as provided in such Indenture, be paid to the Person in whose name this Security (or one or more Predecessor Securities) is registered at the close of business on the Regular Record Date for such interest, which shall be the May 15 or November 15 (whether or not a Business Day), as the case may be, next preceding such Interest Payment Date. Any such interest not so punctually paid or duly provided for will forthwith cease to be payable to the Holder on such Regular Record Date and may either be paid to the Person in whose name this Security (or one or more Predecessor Securities) is registered at the close of business on a Special Record Date for the payment of such Defaulted Interest to be fixed by the Trustee, notice whereof shall be given to Holders of Securities of this series not less than 10 days prior to such Special Record Date, or be paid at any time in any other lawful manner not inconsistent with the requirements of any securities exchange on which the Securities of this series may be listed, and upon such notice as may be required by such exchange, all as more fully provided in said Indenture. Payment of the principal of (and premium, if any) and interest on this Security will be made at the office or agency of the Company maintained for that purpose in The City of New York, in such coin or currency of the United States of America as at the time of payment is legal tender for payment of public and private debts. Reference is hereby made to the further provisions of this Security set forth on the reverse hereof, which further provisions shall for all purposes have the same effect as if set forth at this place. Unless the certificate of authentication hereon has been executed by the Trustee referred to on the reverse hereof by manual signature, this Security shall not be entitled to any benefit under the Indenture or be valid or obligatory for any purpose. IN WITNESS WHEREOF, the Company has caused this instrument to be duly executed under its corporate seal. Dated: December 9, 1993 [Seal] Overseas Shipholding Group, Inc. By /s/ Gabriel Kahana ----------------------------- Name: Gabriel Kahana Title: Senior Vice President and Treasurer Attest: /s/ Robert N. Cowen - --------------------------- Name: Robert N. Cowen Title: Senior Vice President, Secretary and General Counsel Unless this certificate is presented by an authorized representative of The Depository Trust Company, a New York corporation ("DTC"), to Issuer or its agent for registration of transfer, exchange, or payment, and any certificate issued is registered in the name of Cede & Co. or in such other name as is requested by an authorized representative of DTC (and any payment is made to Cede & Co. or to such other entity as is requested by an authorized representative of DTC), ANY TRANSFER, PLEDGE, OR OTHER USE HEREOF FOR VALUE OR OTHERWISE BY OR TO ANY PERSON IS WRONGFUL inasmuch as the registered owner hereof, Cede & Co., has an interest herein. This is one of the Securities of the series designated therein referred to in the within-mentioned Indenture. THE CHASE MANHATTAN BANK (NATIONAL ASSOCIATION), As Trustee By: /s/ Ann L. Edmonds ------------------------ Authorized Officer REVERSE OF SECURITY. This Security is one of a duly authorized issue of securities of the Company (herein called the "Securities"), issued and to be issued in one or more series under an Indenture, dated as of December 1, 1993, (herein called the "Indenture", which term shall have the meaning assigned to it in such instrument), between the Company and The Chase Manhattan Bank (National Association), as Trustee (herein called the "Trustee", which term includes any successor trustee under the Indenture), and reference is hereby made to the Indenture for a statement of the respective rights, limitations of rights, duties and immunities thereunder of the Company, the Trustee and the Holders of the Securities and of the terms upon which the Securities are, and are to be, authenticated and delivered. This Security is one of the series designated on the face hereof, limited in aggregate principal amount to $100,000,000. The Securities of this series may be redeemed at the Company's option, in whole or from time to time in part, upon not less than 30 nor more than 60 days' notice mailed to each Holder of Securities to be redeemed at the address of such Holder appearing in the Security Register, on any date prior to maturity at (i) a Redemption Price equal to 100% of the principal amount thereof plus (ii) accrued interest to the Redemption Date (subject to the right of Holders of record on the relevant Regular Record Date to receive interest due on an Interest Payment Date that is on or prior to the Redemption Date), plus (iii) a Make-Whole Premium, if any. The amount of the Make-Whole Premium in respect of the principal amount of this Security to be redeemed shall be the excess, if any, of (i) the sum of the present values, as of the Redemption Date of this Security, of (A) the respective interest payments (exclusive of the amount of accrued interest to the Redemption Date) on this Security that, but for such redemption, would have been payable on their respective Interest Payment Dates after such Redemption Date, and (B) the payment of such principal amount that, but for such redemption, would have been payable at maturity over (ii) the amount of such principal to be redeemed. Such present values will be determined in accordance with generally recognized principles of financial analysis by discounting the amounts of such payments of interest and principal from their respective Stated Maturities to such Redemption Date at a discount rate equal to the Treasury Yield. The Make-Whole Premium shall be calculated by an independent investment banking institution of national standing appointed by the Company, which may be one of the Underwriters named in the Prospectus Supplement, dated December 2, 1993; provided, that if the Company fails to make such appointment at least 10 days prior to the Redemption Date, or if the institution so appointed is unwilling or unable to make such calculation, such calculation will be made by Goldman, Sachs & Co. or, if Goldman, Sachs & Co. is unwilling or unable to make such calculation, by an independent investment banking institution of national standing appointed by the Trustee (in any such case, an "Independent Investment Banker"). For purposes of determining the Make-Whole Premium, "Treasury Yield" means a rate of interest per annum, determined by the Independent Investment Banker as of the third Business Day preceding the applicable Redemption Date, equal to the weekly average yield to maturity of United States Treasury Notes having a constant maturity as set forth in the most recent weekly statistical release (or any successor release) published by the Federal Reserve Bank of New York and designated "H.15(519) Selected Interest Rates" (the "H.15 Statistical Release") corresponding to the remaining term of this Security (calculated to the nearest 1/12 of a year) (the "Remaining Term"); such yield to be calculated by the Independent Investment Banker, by interpolation (unless the Remaining Term of this Security equals a constant maturity set forth in the H.15 Statistical Release) on a straight-line basis, between the weekly average yields (rounded, if necessary, to four decimal places) on (a) the United States Treasury Notes with a constant maturity closest to and greater than the Remaining Term and (b) the United States Treasury Notes with a constant maturity closest to and less than the Remaining Term, or if such weekly average yields are not available, by interpolation of comparable rates selected by the Independent Investment Banker. In the event of redemption of this Security in part only, a new Security or Securities of this series and of like tenor for the unredeemed portion hereof will be issued in the name of the Holder hereof upon the cancellation hereof. The Indenture contains provisions for defeasance at any time of the entire indebtedness of this Security or certain restrictive covenants and Events of Default with respect to this Security, in each case upon compliance with certain conditions set forth in the Indenture. If an Event of Default with respect to Securities of this series shall occur and be continuing, the principal of the Securities of this series may be declared due and payable in the manner and with the effect provided in the Indenture. The Indenture permits, with certain exceptions as therein provided, the amendment thereof and the modification of the rights and obligations of the Company and the rights of the Holders of the Securities of each series to be affected under the Indenture at any time by the Company and the Trustee with the consent of the Holders of 66 2/3% in principal amount of the Securities at the time Outstanding of each series to be affected. The Indenture also contains provisions permitting the Holders of specified percentages in principal amount of the Securities of each series at the time Outstanding, on behalf of the Holders of all Securities of such series, to waive compliance by the Company with certain provisions of the Indenture and certain past defaults under the Indenture and their consequences. Any such consent or waiver by the Holder of this Security shall be conclusive and binding upon such Holder and upon all future Holders of this Security and of any Security issued upon the registration of transfer hereof or in exchange herefor or in lieu hereof, whether or not notation of such consent or waiver is made upon this Security. As provided in and subject to the provisions of the Indenture, the Holder of this Security shall not have the right to institute any proceeding with respect to the Indenture or for the appointment of a receiver or trustee or for any other remedy thereunder, unless such Holder shall have previously given the Trustee written notice of a continuing Event of Default with respect to the Securities of this series, the Holders of not less than 25% in principal amount of the Securities of this series at the time Outstanding shall have made written request to the Trustee to institute proceedings in respect of such Event of Default as Trustee and offered the Trustee reasonable indemnity, and the Trustee shall not have received from the Holders of a majority in principal amount of Securities of this series at the time Outstanding a direction inconsistent with such request, and shall have failed to institute any such proceeding, for 60 days after receipt of such notice, request and offer of indemnity. The foregoing shall not apply to any suit instituted by the Holder of this Security for the enforcement of any payment of principal hereof or any premium or interest hereon on or after the respective due dates expressed herein. No reference herein to the Indenture and no provision of this Security or of the Indenture shall alter or impair the obligation of the Company, which is absolute and unconditional, to pay the principal of and any premium and interest on this Security at the times, place and rate, and in the coin or currency, herein prescribed. As provided in the Indenture and subject to certain limitations therein set forth, the transfer of this Security is registrable in the Security Register, upon surrender of this Security for registration of transfer at the office or agency of the Company in any place where the principal of and any premium and interest on this Security are payable, duly endorsed by, or accompanied by a written instrument of transfer in form satisfactory to the Company and the Security Registrar duly executed by, the Holder hereof or his attorney duly authorized in writing, and thereupon one or more new Securities of this series and of like tenor, of authorized denominations and for the same aggregate principal amount, will be issued to the designated transferee or transferees. The Securities of this series are issuable only in registered form without coupons in denominations of $1000 and any integral multiple thereof. As provided in the Indenture and subject to certain limitations therein set forth, Securities of this series are exchangeable for a like aggregate principal amount of Securities of this series and of like tenor of a different authorized denomination, as requested by the Holder surrendering the same. No service charge shall be made for any such registration of transfer or exchange, but the Company may require payment of a sum sufficient to cover any tax or other governmental charge payable in connection therewith. Prior to due presentment of this Security for registration of transfer, the Company, the Trustee and any agent of the Company or the Trustee may treat the Person in whose name this Security is registered as the owner hereof for all purposes, whether or not this Security be overdue, and neither the Company, the Trustee nor any such agent shall be affected by notice to the contrary. All terms used in this Security which are defined in the Indenture shall have the meanings assigned to them in the Indenture. EXHIBIT 4(d)(4) FACE OF SECURITY. THIS SECURITY IS A GLOBAL SECURITY WITHIN THE MEANING OF THE INDENTURE HEREINAFTER REFERRED TO AND IS REGISTERED IN THE NAME OF A DEPOSITARY OR A NOMINEE THEREOF. THIS SECURITY MAY NOT BE EXCHANGED IN WHOLE OR IN PART FOR A SECURITY REGISTERED, AND NO TRANSFER OF THIS SECURITY IN WHOLE OR IN PART MAY BE REGISTERED, IN THE NAME OF ANY PERSON OTHER THAN SUCH DEPOSITARY OR A NOMINEE THEREOF, EXCEPT IN THE LIMITED CIRCUMSTANCES DESCRIBED IN THE INDENTURE. OVERSEAS SHIPHOLDING GROUP, INC. 8 3/4% DEBENTURES DUE DECEMBER 1, 2013 CUSIP NO. 690368AB1 No. R-1 $100,000,000 Overseas Shipholding Group, Inc., a corporation duly organized and existing under the laws of Delaware (herein called the "Company", which term includes any successor Person under the Indenture hereinafter referred to), for value received, hereby promises to pay to CEDE & CO. or registered assigns, the principal sum of ONE HUNDRED MILLION DOLLARS ($100,000,000) on December 1, 2013, and to pay interest thereon from December 1, 1993 or from the most recent Interest Payment Date to which interest has been paid or duly provided for, semi-annually on June 1 and December 1 in each year, commencing June 1, 1994, at the rate of 8 3/4% per annum, until the principal hereof is paid or made available for payment. The interest so payable, and punctually paid or duly provided for, on any Interest Payment Date will, as provided in such Indenture, be paid to the Person in whose name this Security (or one or more Predecessor Securities) is registered at the close of business on the Regular Record Date for such interest, which shall be the May 15 or November 15 (whether or not a Business Day), as the case may be, next preceding such Interest Payment Date. Any such interest not so punctually paid or duly provided for will forthwith cease to be payable to the Holder on such Regular Record Date and may either be paid to the Person in whose name this Security (or one or more Predecessor Securities) is registered at the close of business on a Special Record Date for the payment of such Defaulted Interest to be fixed by the Trustee, notice whereof shall be given to Holders of Securities of this series not less than 10 days prior to such Special Record Date, or be paid at any time in any other lawful manner not inconsistent with the requirements of any securities exchange on which the Securities of this series may be listed, and upon such notice as may be required by such exchange, all as more fully provided in said Indenture. Payment of the principal of (and premium, if any) and interest on this Security will be made at the office or agency of the Company maintained for that purpose in The City of New York, in such coin or currency of the United States of America as at the time of payment is legal tender for payment of public and private debts. Reference is hereby made to the further provisions of this Security set forth on the reverse hereof, which further provisions shall for all purposes have the same effect as if set forth at this place. Unless the certificate of authentication hereon has been executed by the Trustee referred to on the reverse hereof by manual signature, this Security shall not be entitled to any benefit under the Indenture or be valid or obligatory for any purpose. IN WITNESS WHEREOF, the Company has caused this instrument to be duly executed under its corporate seal. Dated: December 9, 1993 [Seal] Overseas Shipholding Group, Inc. By /s/ Gabriel Kahana ------------------------------ Name: Gabriel Kahana Title: Senior Vice President Attest: and Treasurer /s/ Robert N. Cowen - ---------------------------- Name: Robert N. Cowen Title: Senior Vice President, Secretary and General Counsel Unless this certificate is presented by an authorized representative of The Depository Trust Company, a New York corporation ("DTC"), to Issuer or its agent for registration of transfer, exchange, or payment, and any certificate issued is registered in the name of Cede & Co. or in such other name as is requested by an authorized representative of DTC (and any payment is made to Cede & Co. or to such other entity as is requested by an authorized representative of DTC), ANY TRANSFER, PLEDGE, OR OTHER USE HEREOF FOR VALUE OR OTHERWISE BY OR TO ANY PERSON IS WRONGFUL inasmuch as the registered owner hereof, Cede & Co., has an interest herein. This is one of the Securities of the series designated therein referred to in the within-mentioned Indenture. THE CHASE MANHATTAN BANK (NATIONAL ASSOCIATION), As Trustee By: /s/ Ann L. Edmonds ----------------------- Authorized Officer REVERSE OF SECURITY. This Security is one of a duly authorized issue of securities of the Company (herein called the "Securities"), issued and to be issued in one or more series under an Indenture, dated as of December 1, 1993, (herein called the "Indenture", which term shall have the meaning assigned to it in such instrument), between the Company and The Chase Manhattan Bank (National Association), as Trustee (herein called the "Trustee", which term includes any successor trustee under the Indenture), and reference is hereby made to the Indenture for a statement of the respective rights, limitations of rights, duties and immunities thereunder of the Company, the Trustee and the Holders of the Securities and of the terms upon which the Securities are, and are to be, authenticated and delivered. This Security is one of the series designated on the face hereof, limited in aggregate principal amount to $100,000,000. The Securities of this series may be redeemed at the Company's option, in whole or from time to time in part, upon not less than 30 nor more than 60 days' notice mailed to each Holder of Securities to be redeemed at the address of such Holder appearing in the Security Register, on any date prior to maturity at (i) a Redemption Price equal to 100% of the principal amount thereof plus (ii) accrued interest to the Redemption Date (subject to the right of Holders of record on the relevant Regular Record Date to receive interest due on an Interest Payment Date that is on or prior to the Redemption Date), plus (iii) a Make-Whole Premium, if any. The amount of the Make-Whole Premium in respect of the principal amount of this Security to be redeemed shall be the excess, if any, of (i) the sum of the present values, as of the Redemption Date of this Security, of (A) the respective interest payments (exclusive of the amount of accrued interest to the Redemption Date) on this Security that, but for such redemption, would have been payable on their respective Interest Payment Dates after such Redemption Date, and (B) the payment of such principal amount that, but for such redemption, would have been payable at maturity over (ii) the amount of such principal to be redeemed. Such present values will be determined in accordance with generally recognized principles of financial analysis by discounting the amounts of such payments of interest and principal from their respective Stated Maturities to such Redemption Date at a discount rate equal to the Treasury Yield. The Make-Whole Premium shall be calculated by an independent investment banking institution of national standing appointed by the Company, which may be one of the Underwriters named in the Prospectus Supplement, dated December 2, 1993; provided, that if the Company fails to make such appointment at least 10 days prior to the Redemption Date, or if the institution so appointed is unwilling or unable to make such calculation, such calculation will be made by Goldman, Sachs & Co. or, if Goldman, Sachs & Co. is unwilling or unable to make such calculation, by an independent investment banking institution of national standing appointed by the Trustee (in any such case, an "Independent Investment Banker"). For purposes of determining the Make-Whole Premium, "Treasury Yield" means a rate of interest per annum, determined by the Independent Investment Banker as of the third Business Day preceding the applicable Redemption Date, equal to the weekly average yield to maturity of United States Treasury Notes having a constant maturity as set forth in the most recent weekly statistical release (or any successor release) published by the Federal Reserve Bank of New York and designated "H.15(519) Selected Interest Rates" (the "H.15 Statistical Release") corresponding to the remaining term of this Security (calculated to the nearest 1/12 of a year) (the "Remaining Term"); such yield to be calculated by the Independent Investment Banker, by interpolation (unless the Remaining Term of this Security equals a constant maturity set forth in the H.15 Statistical Release) on a straight-line basis, between the weekly average yields (rounded, if necessary, to four decimal places) on (a) the United States Treasury Notes with a constant maturity closest to and greater than the Remaining Term and (b) the United States Treasury Notes with a constant maturity closest to and less than the Remaining Term, or if such weekly average yields are not available, by interpolation of comparable rates selected by the Independent Investment Banker. In the event of redemption of this Security in part only, a new Security or Securities of this series and of like tenor for the unredeemed portion hereof will be issued in the name of the Holder hereof upon the cancellation hereof. The Indenture contains provisions for defeasance at any time of the entire indebtedness of this Security or certain restrictive covenants and Events of Default with respect to this Security, in each case upon compliance with certain conditions set forth in the Indenture. If an Event of Default with respect to Securities of this series shall occur and be continuing, the principal of the Securities of this series may be declared due and payable in the manner and with the effect provided in the Indenture. The Indenture permits, with certain exceptions as therein provided, the amendment thereof and the modification of the rights and obligations of the Company and the rights of the Holders of the Securities of each series to be affected under the Indenture at any time by the Company and the Trustee with the consent of the Holders of 66 2/3% in principal amount of the Securities at the time Outstanding of each series to be affected. The Indenture also contains provisions permitting the Holders of specified percentages in principal amount of the Securities of each series at the time Outstanding, on behalf of the Holders of all Securities of such series, to waive compliance by the Company with certain provisions of the Indenture and certain past defaults under the Indenture and their consequences. Any such consent or waiver by the Holder of this Security shall be conclusive and binding upon such Holder and upon all future Holders of this Security and of any Security issued upon the registration of transfer hereof or in exchange herefor or in lieu hereof, whether or not notation of such consent or waiver is made upon this Security. As provided in and subject to the provisions of the Indenture, the Holder of this Security shall not have the right to institute any proceeding with respect to the Indenture or for the appointment of a receiver or trustee or for any other remedy thereunder, unless such Holder shall have previously given the Trustee written notice of a continuing Event of Default with respect to the Securities of this series, the Holders of not less than 25% in principal amount of the Securities of this series at the time Outstanding shall have made written request to the Trustee to institute proceedings in respect of such Event of Default as Trustee and offered the Trustee reasonable indemnity, and the Trustee shall not have received from the Holders of a majority in principal amount of Securities of this series at the time Outstanding a direction inconsistent with such request, and shall have failed to institute any such proceeding, for 60 days after receipt of such notice, request and offer of indemnity. The foregoing shall not apply to any suit instituted by the Holder of this Security for the enforcement of any payment of principal hereof or any premium or interest hereon on or after the respective due dates expressed herein. No reference herein to the Indenture and no provision of this Security or of the Indenture shall alter or impair the obligation of the Company, which is absolute and unconditional, to pay the principal of and any premium and interest on this Security at the times, place and rate, and in the coin or currency, herein prescribed. As provided in the Indenture and subject to certain limitations therein set forth, the transfer of this Security is registrable in the Security Register, upon surrender of this Security for registration of transfer at the office or agency of the Company in any place where the principal of and any premium and interest on this Security are payable, duly endorsed by, or accompanied by a written instrument of transfer in form satisfactory to the Company and the Security Registrar duly executed by, the Holder hereof or his attorney duly authorized in writing, and thereupon one or more new Securities of this series and of like tenor, of authorized denominations and for the same aggregate principal amount, will be issued to the designated transferee or transferees. The Securities of this series are issuable only in registered form without coupons in denominations of $1000 and any integral multiple thereof. As provided in the Indenture and subject to certain limitations therein set forth, Securities of this series are exchangeable for a like aggregate principal amount of Securities of this series and of like tenor of a different authorized denomination, as requested by the Holder surrendering the same. No service charge shall be made for any such registration of transfer or exchange, but the Company may require payment of a sum sufficient to cover any tax or other governmental charge payable in connection therewith. Prior to due presentment of this Security for registration of transfer, the Company, the Trustee and any agent of the Company or the Trustee may treat the Person in whose name this Security is registered as the owner hereof for all purposes, whether or not this Security be overdue, and neither the Company, the Trustee nor any such agent shall be affected by notice to the contrary. All terms used in this Security which are defined in the Indenture shall have the meanings assigned to them in the Indenture. Exhibit 10(h)(2) November 9, 1993 Overseas Shipholding Group, Inc. 1114 Avenue of the Americas New York, New York 10036 Re: MARITIME OVERSEAS CORPORATION 1990 STOCK OPTION PLAN Gentlemen: Reference is made to the Agreement between us dated April 1, 1992 (the "Agreement") with respect to the Maritime Overseas Corporation 1990 Stock Option Plan, as amended. This is to confirm that (i) the Agreement is hereby amended by increasing the number of shares of common stock of Overseas Shipholding Group, Inc. referred to in the second sentence of Paragraph 1 thereof from 584,435 to 784,435 shares, (ii) except as so amended the Agreement shall remain unaltered and in full force and effect, (iii) any references in the Agreement to the "Plan" include the amendment adopted by our Board of Directors on November 9, 1993, a copy of which is enclosed herewith and (iv) said amendment is subject to ratification by your Board of Directors at its next meeting. Please confirm your agreement to the foregoing by signing below as indicated. Very truly yours, MARITIME OVERSEAS CORPORATION By: /s/ Michael A. Recanati --------------------------- Michael A. Recanati Executive Vice President CONFIRMED: Overseas Shipholding Group, Inc. By: /s/ Robert N. Cowen ------------------------------ Robert N. Cowen Senior Vice President Exhibit 10(k)(1) Supplementary Retirement Plan of Maritime Overseas Corporation Article 1 PURPOSE OF THE PLAN 1.1 This Plan is established to provide as supplementary retirement income benefits, those benefits no longer payable under the Pension Plan for Employees of Maritime Overseas Corporation due to the passage of the Tax Equity and Fiscal Responsibility Act of 1982 to a certain select group of management or highly compensated persons in the employ of Maritime Overseas Corporation and/or other employers participating in the Pension Plan for Employees of Maritime Overseas Corporation. 1.2 The Employees designated for coverage under the Plan are: [ names omitted ] Article 2 DEFINITIONS 2.1 As used herein, all terms defined in the Pension Plan for Employees of Maritime Overseas Corporation except those defined below shall have the meaning defined therein, unless the context clearly indicates otherwise. 2.2 "Participant" means an employee designated in Section 1.2 to participate in the Plan. 2.3 "Plan" means the Supplementary Retirement Plan of Maritime Overseas Corporation. 2.4 "Post TEFRA Maximum Benefit" means the maximum pension payable under the Qualified Plan to an employee participating in the Plan. 2.5 "Pre TEFRA Maximum Benefit" means the maximum pension that would have been payable under the Qualified Plan prior to its reduction as required by TEFRA including Cost-of-Living Adjustments as described in Section 4.15(d) of the Internal Revenue Code prior to amendment. 2.6 "Qualified Plan" means the Pension Plan for Employees of Maritime Overseas Corporation. 2.7 "TEFRA" means the Tax Equity and Fiscal Responsibility Act of 1982. Article 3 BENEFITS 3.1 A Participant, or any other person whose rights to receive benefits under the Qualified Plan derive from a Participant, shall be entitled to benefits under the Plan on his entitlement to receive benefits under the Qualified Plan. 3.2 The amount of the gross benefit under this Plan shall be determined as provided under the Qualified Plan except that the Post TEFRA Maximum Benefit shall be replaced by the Pre TEFRA Maximum Benefit. The benefit payable under the Plan shall be the gross benefit less the benefit payable under the Qualified Plan. 3.3 Benefits shall be payable under the Plan under the same terms and conditions as under the Qualified Plan. Any election of an option, or failure to elect an option under the Qualified Plan shall be an election, or failure to make an election, of an option under this Plan. Article 4 ADMINISTRATION 4.1 The Plan shall be administered by a Committee composed of [ names omitted ]; the Plan shall be administered and interpreted in a manner which is as consistent with the interpretations of the Qualified Plan as the context reasonably permits. Article 5 FUNDING 5.1 The Plan shall be unfunded. Neither a Company nor the Committee shall segregate any assets in connection with the Plan. Neither a Company nor the Committee shall be deemed to be a trustee of any amounts to be paid under the Plan. Any liability to any person with respect to benefits payable under the Plan shall be based solely upon such contractual obligations of the Company, if any, as may be created by the Plan. Such liability, if any, will be a claim against the general assets of the Company and shall become a claim only if the Company fails to make a payment due under the Plan. No such liability, or claim, shall be deemed to be secured by any pledge or any other encumbrance or specific property of the Company or held in trust by the Company. Article 6 AMENDMENT AND TERMINATION 6.1 While the Company intends to maintain this Plan in conjunction with the Qualified Plan for so long as necessary or desirable, the Company reserves the right to itself to amend or to terminate this Plan by action of its Board of Directors, in its sole discretion, for whatever reason it may deem appropriate. 6.2 In the event the Company terminates or amends the Plan, the Pre TEFRA Maximum Benefit shall be determined at the time of such termination or amendment on the basis of credited service rendered to, and Average Final Compensation determined as of, said date of termination or amendment. The benefit under the Qualified Plan shall be the benefit under said Qualified Plan as actually paid and may be based on credited service rendered after, and Average Final Compensation determined later than, said date of termination or amendment in which case the benefit under the Plan will be reduced accordingly. 6.3 Notwithstanding Section 6.1 hereof, and subject to the limitations of Section 6.2, each Company hereby makes a contractual commitment to pay the benefits theretofore accrued in respect of Participants hereunder to the extent it is financially capable of meeting such obligations from its general assets. Article 7 GENERAL PROVISIONS 7.1 Except as may be required by law, no benefit payable under the Plan is subject in any manner to anticipation, assignment, garnishment, or pledge; and any attempt to anticipate, assign, garnish or pledge the same shall be void. No such benefits will in any manner be liable for or subject to the debts, liabilities, engagements, or torts of any Participant or other person entitled to receive the same and if such person is adjudicated bankrupt or attempts to anticipate, assign, or pledge any benefits, the Committee shall have the authority to cause the same or any part thereof to be held or applied to or for the benefit of such Participant, his spouse, children or other dependents, or any of them, in such manner and in such proportion as the Committee may deem proper. 7.2 Anything in this Plan to the contrary notwithstanding, if the Committee determines that a Participant or former Participant has, without the consent of the Committee, engaged in any occupation or activity which is in competition with a Company, after notice by registered mail directed to his last known address, the Committee may suspend his benefit under this Plan or his right thereto hereunder, as the case may be, which suspension shall continue until rescinded by notice from the Committee. After such suspension has continued for one year, the Committee shall cancel such person's benefits under this Plan or his right thereto hereunder and the right of any beneficiary of such person under the Plan. The action by the Committee shall be final and conclusive. 7.3 Nothing contained in the Plan shall be construed as a contract of employment between a Company and any Participant, or as a right of any Participant to be continued in the employment of a Company, or as a limitation on the right of a Company to discharge any of its employees, with or without cause. 7.4 Requests for settlement of claims under provisions of the Plan shall be directed in writing to the Committee. If additional information is required from a Participant, the Committee shall have 15 days to request such information in writing. After receiving such information, the Committee shall notify the Participant within 90 days if any claim for benefits is denied. The Committee may notify a Participant that more time is required and may take up to 90 additional days. When replying, the Committee shall state the reasons for such denial, the Plan provisions that apply, the information to be provided in order to appeal the decision, and the steps to be taken for a claim to be reviewed. 7.5 The provisions of this Plan shall be construed in accordance with the laws of the State of New York. Exhibit 13 GLOBAL BULK SHIPPING MARKETS The bulk shipping industry is highly fragmented, with no one organization holding more than 2% of the total world fleet. With 58 ships totaling 5.4 million dwt, OSG ranks among the ten largest owners, including fleets owned by oil companies. Approximately 75% of the Company's voyage revenues in 1993, 78% in 1992 and 75% in 1991 came from carrying petroleum and its derivatives. These liquid cargoes also accounted for the majority of the voyage revenues of OSG's bulk shipping joint ventures. International Tanker Markets In 1993, the international tanker markets improved somewhat from the depressed levels of 1992, but remained difficult throughout the year due to: - - weakness in key industrial economies, - - moderate increases in oil demand from major oil-importing countries, - - shifts in oil supply patterns that on balance muted the increase in tonnage demand, and - - an expansion of the world tanker fleet over the last few years. Oil Supply and Demand Developments Both Europe and Japan experienced severe recessions in 1993, adversely affecting global oil demand. Total world oil demand remained flat with 1992. Excluding the former Soviet Union (FSU), however, oil consumption increased by nearly 2%, almost all of which occurred in the developing economies of Asia and Latin America. Supply patterns also shifted. U.S. and FSU oil production fell while the North Sea and Latin America registered increases in export volumes. Together, these developments resulted in a change of incremental crude sources from long- haul to short-haul routes, as the North Sea and Latin America provided most of the additional crude imports to the United States. This dampened the rise in tonnage requirements. Growth in the World Tanker Fleet In 1993, the world tanker fleet registered its sixth straight year of growth, increasing by 5 million dwt to 265 million dwt by year- end. Newbuilding deliveries amounted to 17 million dwt, the highest since 1977. The lack of a solid recovery in the international tanker markets in 1993 was partially attributable to the delivery of a significant number of newbuildings ordered during the recent tanker market peak of 1990-91. From the long-term perspective, fleet growth over the last two years has not been excessive. However, it has outpaced growth in tonnage demand. Scrappings rose to 12 million dwt versus 10 million dwt in 1992. Over the next few years, scrappings are likely to continue to be significant, reflecting both the age of the fleet and stricter regulatory requirements. About 57% of the world's tanker fleet is 15 years old or more, including two thirds of all VLCCs (very large crude carriers --tankers more than 200,000 dwt). At year-end, the amount of international tanker tonnage in lay- up remained flat at 3 million dwt, still a relatively low level. Tanker newbuilding prices weakened early in 1993, and this trend has continued into 1994, in part reflecting current difficult charter markets. Secondhand prices for modern vessels strengthened somewhat, but generally remained weak for vessels more than ten years of age. Contracting for new orders increased over 1992 but did not keep pace with deliveries. Thus, the newbuilding orderbook for delivery over the next three years fell by 5 million dwt to 24 million dwt (10 million dwt scheduled in 1994), and fleet growth is expected to moderate over the next year or two. Environmental Concerns During the past five years, the tanker business has experienced a more stringent regulatory environment, a greater emphasis on quality, and more inspections by governmental authorities and charterers. It is anticipated that in the coming years these trends will make it increasingly difficult for poorly maintained ships to find employment and will improve the market for high-quality owners such as OSG. Between 1995 and 2015, the Oil Pollution Act of 1990 (OPA 90) phases in a requirement that all tankers entering U.S. waters have double hulls. OPA 90 also significantly expands the potential liability of tanker owners for environmental accidents in U.S. waters. In addition, the International Maritime Organization (IMO) will phase out all single-hulled tankers in international waters at 25 years of age unless other environmental safety steps are taken. IMO regulations also require double hulls or equivalent tanker designs for newbuilding orders. Since OSG maintains a modern fleet, these double-hull requirements will not apply to most of the Company's existing tanker fleet until the next decade, at which time these ships will have operated for substantially all of their economic lives. All of the tankers OSG has on order will be double- hulled. International Dry Bulk Markets Overall seaborne shipments in 1993 of the major dry bulk commodities --coal, iron ore and grain --decreased marginally from the prior year. The major economic forces at work were the persistent recessions in Europe and Japan counterbalanced by booming growth in the developing nations, most notably China, Korea and Taiwan. Rates in the dry bulk markets moved higher during the first five months of 1993, recovering from their lows in the fall of 1992, but relinquished much of those gains by year-end as demand slackened, particularly for seaborne shipments of coal and iron ore. Rising Industrial Demand in the Far East Weak demand for steel in Europe resulted in a decrease in seaborne iron ore imports in 1993 relative to 1992. Japanese imports of iron ore and coking coal rose modestly in 1993 versus the prior year. These increases reflected the strong demand for steel exports to China, not improved economic conditions in Japan, where steel consumption declined in 1993. Besides importing a large quantity of steel, China stepped up its domestic production, resulting in a substantial year-over-year rise in its seaborne imports of iron ore. Reduced Grain Imports Grain, which was the only one of the three major dry bulk commodities to show a significant increase in seaborne trade in 1992, experienced a decline in 1993. The major purchasers of grain in recent years, the FSU and China, both had increased domestic supplies in 1993, enabling them to decrease their purchases on the world market. As southern Africa began to recover from its drought, local corn production rose in 1993, reducing the region's requirements for substantial seaborne imports of grain. Moderate Increase in Dry Bulk Fleet After remaining virtually unchanged during 1992, the dry bulk fleet increased by nearly 2% to 221 million dwt by year-end. Newbuilding deliveries of 8 million dwt were well above 1992 but still not historically high. Scrappings moved up slightly to over 4 million dwt. Dry bulk tonnage in lay-up remained small at less than 2 million dwt. The newbuilding orderbook for delivery over the next three years expanded in 1993, reaching 21 million dwt, up from 15 million dwt in 1992, as shipowners sought to replace aging vessels to meet more stringent environmental and safety requirements. Of this total, 9 million dwt are scheduled for delivery in 1994. U.S. Markets Shipping between U.S. coastal ports, including the movement of Alaskan oil, is reserved by law primarily to U.S. flag vessels owned by U.S. citizens, crewed by U.S. seafarers, and built in the United States without construction subsidies and operated without operating differential subsidies. U.S. flag vessels also receive preference in carrying U.S. military and U.S. government-sponsored shipments throughout the world. With 13 tankers and product carriers, OSG is the largest independent owner and operator of unsubsidized U.S. flag vessels. The Company has two dry bulk carriers, which participate in the preference trades, and one car carrier on long-term charter transporting vehicles to and from Japan. In recent years, the size of the U.S. flag fleet has been declining because of eroding commercial opportunities, higher U.S. construction and operating costs, and a stricter operating environment mandated under OPA 90. There has been no significant U.S. flag tanker construction in the last five years, and the average age of the unsubsidized (Jones Act) tanker fleet is now approximately 19 years. At year-end 1993, the unsubsidized U.S. flag tanker fleet totaled 8 million dwt, down by 540,000 dwt from a year earlier and by over 2 million dwt since the end of 1988. Of the current fleet, seven vessels, totaling about 620,000 dwt, were laid up at year-end. Alaskan Crude Developments Alaskan crude oil shipments provide the main source of employment for U.S. flag crude carriers. All eight of OSG's U.S. flag crude carriers are employed in the Alaskan trade. In 1993, Alaskan crude shipments declined as production decreased 7% to 1.66 million barrels per day (b/d). This drop partly reflects the ongoing decline in mature Alaska North Slope fields, but last year's decrease was exacerbated by production equipment maintenance and weather problems as well as temporary shutdowns to upgrade gas-handling facilities. The first phase of the upgrading was completed last fall, resulting in a 50,000 b/d rise in crude output. A similar increase is expected in 1994 when the second phase of the project is completed. In addition, a new field, Point McIntyre, came on-stream in October, initially producing 80,000 b/d. Together these increases are mitigating the production decline in Prudhoe Bay and other mature fields, particularly over the next couple of years. Significantly more tanker tonnage is required for longer haul shipments of Alaskan crude to the U.S. Gulf and East Coasts, via the Panama Pipeline, than for movements to the West Coast. As Alaskan production fell in 1993, the marginal volume for long-haul shipment via Panama to the U.S. Gulf and East Coasts was nonexistent in some months, resulting in a 15% drop year-over-year in the amount of tonnage required to transport Alaskan crude. Weak U.S. Flag Product Tanker Markets U.S. flag product tankers, ranging in size up to 60,000 dwt, carry gasoline, diesel fuel, jet fuel and other refined petroleum products. These ships compete with pipelines, oceangoing barges and, with regard to imports, foreign flag product carriers. OSG has five ships that participate in the U.S. flag product market. Tonnage demand in the domestic product tanker trades continued to decline in 1993, especially on the key Gulf to East Coast route, as pipeline shipments and East Coast refinery output rose. The decline was mitigated by sales for scrap. Rates showed slight improvement from the poor levels achieved in 1992. Government Requirements Rise U.S. government-related cargoes also generate demand for U.S. flag vessels, including OSG's two U.S. flag dry bulk carriers. Federal law requires that preference be given to U.S. flag vessels, if available at reasonable rates, in the shipment of at least half of all U.S. government-generated cargoes and 75% of food aid cargoes. The volume of U.S. preference cargoes shipped in 1993 nearly doubled, largely as a result of a $700 million agricultural aid package for Russia. This attracted idle U.S. flag tankers into the preference trades. Regulatory Matters Exports of Alaskan crude oil have been restricted by law since 1973. Additional, more stringent limitations were incorporated in the Export Administration Act of 1979, which has been extended to June 30, 1994. A lawsuit brought by the State of Alaska challenging the legality of these export restrictions was recently dismissed by the Federal District Court. By law, vessels built with construction differential subsidies and operated with operating differential subsidies (ODS) have not been permitted in the Jones Act trade. Under a recent Maritime Administration interpretation, product tankers and crude carriers built with subsidies may be eligible for full coastwise privileges when they reach 20 years of age and their ODS contracts expire. The Company believes that this interpretation is contrary to law and has commenced litigation seeking to overrule it. Should the lawsuit fail, it is possible that several older product and crude carriers may enter the coastwise trade over the next few years. - ---------- Primary Data Sources: Fearnleys Review 1993, Clarkson Research Studies, Maritime Administration, State of Alaska and U.S. Department of Energy CELEBRITY CRUISE LINES INC. Nineteen ninety-three marked the first full year of operation for Celebrity Cruise Lines Inc. (CCLI), a joint venture between OSG and the Chandris Cruise Division. While this joint venture represents a major diversification for OSG, it continues a business begun by Chandris more than 30 years ago. Today the fleet of CCLI is marketed under two distinct brand names: Celebrity Cruises and Fantasy Cruises. Celebrity Cruises is positioned firmly in the premium segment of the cruise market with three ships -- the Zenith, Horizon and Meridian --having a total of 3,834 berths. Traveling mainly to the Caribbean and Bermuda, Celebrity Cruises draws passengers from around the world to these popular destinations. Attention to passenger comfort and enjoyment is the hallmark of a Celebrity Cruise. Fantasy Cruises, with two ships --the Britanis and Amerikanis - --and 1,543 berths, appeals to more budget-conscious passengers and travels mainly to the Caribbean, Mexico, South America and Europe. Many of Fantasy's passengers are first-time cruisers. Last year, Celebrity and Fantasy Cruises' five ships sailed on 48 different itineraries that ranged from two to 52 nights and called at 114 destinations on five continents. CCLI markets its cruises through a dedicated sales team in the United States as well as an extensive network of general sales agents in Mexico, Central America, South America, the Caribbean and Europe. Within the United States, more than 95% of all cruises are sold through travel agencies. Approximately 20,000 travel agencies market cruises; over half of them actively promote CCLI's programs. Besides targeting individual vacationers, CCLI also pursues the incentive market, one of the fastest growing areas of the cruise industry. The North American Cruise Market North America dominates the global cruise market, with more than 80% of the total passengers carried. The cruise industry in North America is characterized by large and generally well-capitalized companies and is highly competitive. According to the Cruise Lines International Association (CLIA), the largest six companies, including CCLI, have approximately 68% of total capacity, and the largest 15 companies have approximately 94% of total capacity. Today there are over 60 cruise brands from which to choose. Growth in Cruise Demand Growth in demand, as measured by the number of passengers carried, averaged approximately 10% per annum between 1984 and 1993 for the North American market. In 1993, U.S. and Canadian passengers carried reached an industry record, rising 9% to an estimated 4.5 million. Even though demand growth in 1993 was less than the ten- year average, discounting abated somewhat from the previous year. Growth in the cruise industry stems from a number of factors. The all-inclusive price for dining, entertainment, accommodations and air transportation is perceived by consumers as a convenience and an excellent value. Over the years, cruise companies have added new ships, expanded itineraries, and increased shipboard and shoreside activities, thus attracting a wider range of age and income groups, stimulating industry growth and capturing a growing percentage of the $285 billion leisure market. Supply Outlook From 1990 to 1992, the cruise industry experienced significant discounting and substantial increases in supply as new capacity averaged 10% each year and the U.S. economy experienced negative or slow growth. Both of CCLI's lines participated in stronger markets during 1993 as the U.S. economy improved and capacity additions lessened. In 1993, supply increases slowed to 6%, as 13,500 berths were added and nearly 7,500 berths were removed through retirements, redeployments and shutdowns. At year-end 1993, North American cruise capacity was estimated to be 104,000 berths. Based on the newbuilding orderbook, CLIA forecasts that capacity will grow 3% in 1994 and 10% in 1995 and in 1996, before taking into account any retirements and deletions from the existing fleet. Given the three-year lead time needed to construct new ships, it is unlikely that any other new vessels will enter service before 1996. One factor certain to influence the industry in the next several years is the International Maritime Organization's Safety of Life At Sea (SOLAS) convention, which established minimum safety, fire prevention and fire fighting standards. Under SOLAS requirements, all passenger ships must have upgraded fire detection and fire fighting systems by October 1, 1997. Since substantial capital expenditures may be needed to bring older vessels into compliance with these requirements, it is likely that some ships for which such capital expenditures would not be economical will be removed from the market. Two of CCLI's Celebrity vessels were delivered in 1990 and 1992, respectively, and the third was rebuilt in 1990. On the basis of present estimates, any work necessary for these ships to meet 1997 SOLAS requirements can be done without material capital expenditures. Celebrity Earns Recognition Celebrity's focus on quality and service has won acclaim from passengers, travel agents and industry followers alike. In October 1993, Celebrity Cruises was rated one of the top ten cruise lines by the readers of CONDE NAST TRAVELER for the third year in a row. Since its creation just four years ago, Celebrity Cruises has received numerous awards for outstanding quality and service, including a prestigious five-star rating by Berlitz, top honors in cuisine from the World Ocean & Cruise Liner Society, the top service award from ONBOARD SERVICE magazine and the International Cruise Passenger Association's "Cruise Line of the Year" award. Celebrity Newbuilding Program In March 1993, CCLI announced that it had signed a contract with Jos. L. Meyer GmbH & Co., Papenburg, Germany for the construction of a 1,760-passenger cruise ship at a price of approximately $317.5 million. The ship will be delivered in late 1995. CCLI subsequently committed to purchase a sistership for delivery in the fall of 1996 and continues to hold an option for a third, which it intends to exercise. Upon delivery of the third sistership, Celebrity Cruises' capacity in the premium segment of the cruise industry will more than double. These ships will inaugurate CCLI's new "Century" series of vessels, designed to meet the needs of cruise vacationers into the next century. The expansion is expected to provide economies of scale in operations and marketing, and to increase brand recognition of the Celebrity Cruise experience. Looking Ahead While the cruise industry has enjoyed substantial growth over the past decade, the next several years will be challenging ones as new ships enter service and the impact of SOLAS is felt in the market. For strong, well-financed companies such as CCLI, there will be many opportunities. The newbuildings on order, the company's commitment to customer satisfaction and its innovative marketing efforts will reinforce CCLI's position as a significant participant in the cruise industry during the years ahead. MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION OVERSEAS SHIPHOLDING GROUP, INC. AND SUBSIDIARIES Operations Income from Vessel Operations Revenues and income from vessel operations of the Company are highly sensitive to patterns of supply and demand for vessels of the types and sizes owned and operated by the Company and the markets in which those vessels operate. Freight rates for major bulk commodities are determined by market forces including local and worldwide demand for such commodities, volumes of trade, distances between sources and destinations of cargoes and amount of available tonnage both at the time such tonnage is required and over periods of projected requirements. Available tonnage is affected, over time, by the amount of newbuilding deliveries and removal of existing tonnage from service. See "Global Bulk Shipping Markets" on pages 14-17 hereof. Results in particular periods are also affected by such factors as the mix between voyage and time charters, the timing of the completion of voyage charters, the time and prevailing rates when charters that are currently being performed were negotiated, the levels of applicable rates and the business available as particular vessels come off existing charters, and the timing of drydocking of vessels. Historically, the diversity of the Company's fleet has tended to cushion the effects of weakness in particular markets. However, 1992 was a particularly difficult year in that there was simultaneous weakness in all of the Company's major markets. Some of the effects of this weakness carried over into the results of the Company's operations in 1993, primarily in the first half. In general, market rates improved during 1993 from the depressed rates that prevailed in 1992, but still remain at levels below those of the years 1989 through 1991. Beginning in the fourth quarter of 1993, spot market freight rates for foreign flag VLCCs (over 200,000 dwt) and dry bulk carriers have weakened somewhat, while rates for foreign and U.S. flag products carriers have experienced seasonal increases. Income from vessel operations for 1993 increased by approximately $10,100,000 from the results for 1992. This increase was attributable to improvements of $9,500,000 in income from foreign flag bulk vessel operations and $7,100,000 in the Company's equity in the results of Celebrity Cruise Lines Inc., which was acquired in October 1992. The foreign flag bulk shipping improvement reflects increased charter market rates obtained in 1993 for certain Suezmax (approximately 128,000 dwt) and Aframax (approximately 96,000 dwt) tonnage, primarily in the second half of the year, compared to the rates obtained during 1992 for those vessels. The favorable effects of less tonnage being idle due to lack of employment in 1993 as compared to 1992 and reduced agency fees are also reflected. Income from foreign flag vessel operations in 1993 was adversely affected by lower charter rates in the first half of 1993 (primarily in the first quarter) for most classes of tankers and dry bulk vessels compared with rates obtained in 1992, and by substantially lower VLCC rates for certain tonnage throughout 1993. During 1992, certain foreign flag vessels were operating on time charters negotiated in prior periods when rates were more favorable. Income from operations of the U.S. flag fleet declined approximately $6,500,000 in 1993 compared to 1992, resulting primarily from a crude carrier being idle due to lack of employment. This was partially offset by better operating results for two U.S. flag dry bulk carriers, reflecting fewer idle days and better rates. Income from vessel operations for 1992 decreased by approximately $72,600,000 from the results for 1991. Over 90% of this decrease was attributable to a decline in income from foreign flag vessel operations, reflecting reduced charter market rates in 1992 for all classes of the Company's international flag tanker and dry cargo fleets compared with rates prevailing during 1991. Included in the 1992 foreign flag results was the effect on revenues of more tonnage being idle due to lack of employment. The 1992 decrease also reflects reduced income from operations of the U.S. flag fleet, resulting from lower charter rates for certain of OSG's petroleum products carriers and certain crude carrier tonnage; the effect on revenues of increased drydockings in 1992 as compared to 1991 is also included. The U.S. flag decline for all of 1992 was net of first-quarter 1992 charter rate improvements for certain of OSG's crude carriers. Voyage expenses, such as fuel and port costs, are paid by the vessel owner under a voyage charter and by the charterer under a time charter. The increases in vessel and voyage expenses in 1993 and 1992 from the respective preceding years each reflect a higher proportion of voyage charters to time charters. Vessel operating expenses were also higher in 1993 and 1992 as compared to 1992 and 1991, respectively, because of increased manning on most U.S. flag tankers to comply with provisions of the Oil Pollution Act of 1990 and increases in certain other expense categories (see Effects of Inflation below). The 1992 increase reflects charter hire expense on a vessel delivered to the Company in 1992 on a seven-year time charter. The effect of vessels sold is also reflected. The increase in income attributable to bulk shipping joint ventures in 1993 as compared to 1992 resulted from improved rates on certain tonnage and decreases in certain expenses. Provision for loss on sale of a 50%-owned vessel subsequent to year-end is reflected in 1993. The decline in income attributable to bulk shipping joint ventures in 1992 as compared to 1991 resulted primarily from decreases in charter rates obtained for certain tonnage and increases in costs of operations. Other Income (Net) The details of other income for the three-year period are shown in Note K on page 39 of this report. Interest and dividends decreased in 1993 from 1992 because of reduced amounts utilized for interest- bearing deposits and investments and generally lower rates of return on such deposits and investments. Gain on disposal of vessels was approximately $12,100,000 in 1993 compared to a provision for loss of approximately $1,300,000 in 1992. Gain on sale of securities approximated $9,100,000 in 1993 compared to approximately $14,100,000 in the preceding year. Other income also reflects the results of foreign currency transactions and the effect of minority interest in both years, and an increase in 1993 compared to 1992 in income earned from other investments (included in miscellaneous--net). In 1992, the Company took a reserve of $20,000,000 ($13,100,000, or $.40 per share, net of income tax) for its entire investment in GPA Group plc. Interest and dividends in 1992 decreased from 1991 because of lower rates of return on interest-bearing deposits and investments and reduced amounts utilized for such deposits and investments. Gain on sale of securities was approximately $14,100,000 in 1992 compared to approximately $5,500,000 in 1991. There was a provision for loss on disposal of vessels of approximately $1,300,000 in 1992 compared to a gain of approximately $4,100,000 in 1991. Other income also reflects the results of foreign currency transactions and the effect of minority interest in both years, and a decrease in 1992 compared to 1991 in income earned from other investments (included in miscellaneous--net). Interest Expense Interest expense decreased in 1993 and 1992 from the respective preceding years, as a result of reduced rates on floating rate debt and increased interest costs capitalized in connection with vessel construction. The decreases were net of the effect of more debt being outstanding in 1993 and 1992 compared to 1992 and 1991, respectively. Interest expense in 1993 and 1992 also reflects $13,300,000 and $5,600,000, respectively, of net benefit from the interest rate swaps referred to below in Liquidity and Sources of Capital. Provision for Federal Income Taxes The provision for Federal income taxes in 1993 includes $2,900,000, or $.09 per share, of additional deferred taxes resulting from the increase in the Federal statutory rate from 34% to 35% enacted in 1993 and reflects the effect of the dividends received deduction and other nontaxable items. The tax credit in 1992 results from the pretax loss adjusted to reflect the dividends received deduction and other nontaxable items. Federal income taxes for each of the three years reflect the effects of the Tax Reform Act of 1986, including current taxation of the post-1986 results of the Company's foreign-owned bulk vessels. Cumulative Effect of Accounting Change The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), starting in 1992. In accordance with FAS 109, financial statements of years prior to 1992 have not been restated. The impact of applying FAS 109 was to reduce deferred tax liabilities by $16,000,000, with a corresponding increase in net income (cumulative effect of change in accounting) for 1992. Liquidity and Sources of Capital Working capital at December 31, 1993 was approximately $99,000,000 as compared to $101,000,000 at year-end 1992 and $91,000,000 at year-end 1991. Current assets are highly liquid, consisting principally of cash, interest-bearing deposits and receivables. The Company also has investments in marketable securities carried as noncurrent assets, other than securities included in restricted funds, with a market value of approximately $21,000,000 at December 31, 1993. Net cash provided by operating activities approximated $69,000,000 in 1993, $10,000,000 in 1992 and $110,000,000 in 1991. The reserve in 1992 of $20,000,000 referred to in Other Income (Net) above had no effect on the Company's cash flow or cash resources. In addition to payments of current installments of long- term debt in all three years, the Company prepaid long-term debt aggregating $62,332,000 in 1992. Current financial resources, together with cash anticipated to be generated from operations, are expected to be adequate to meet requirements for short-term funds in 1994. The Company has an unsecured long-term credit facility of $500,000,000, of which $92,000,000 was used at December 31, 1993, and an unsecured short-term credit facility of $30,000,000, which was unused at that date. The Company finances vessel additions with cash provided by operating activities, long-term borrowings and capital lease obligations. In 1993, the Company sold an aggregate of $110,000,000 of long-term, unsecured senior notes to major institutional investors in a private placement. The notes have a weighted average life of approximately 12.25 years and a weighted average interest rate of 8.01%. The net proceeds were used to reduce amounts outstanding under the Revolving Credit Agreement. The Company also completed in 1993 a public debt offering of $100,000,000 of 8%, 10-year notes and $100,000,000 of 8.75%, 20- year debentures. The net proceeds were used to prepay predelivery vessel construction costs and to reduce amounts outstanding under the Revolving Credit Agreement. As of December 31, 1993, the Company is a party to fixed to floating interest rate swaps ranging between three and fifteen years with various banks covering notional amounts aggregating $685,000,000, pursuant to which it pays LIBOR and receives fixed rates ranging from 5.3% to 8.1% calculated on the notional amounts. These agreements have various maturity dates from 1995 to 2008. The Company is also a party to a five-year interest rate swap with a notional amount of $24,000,000, expiring in 1996, pursuant to which it pays a fixed interest rate of 8.4% and receives LIBOR, calculated on the notional amount. In March 1994, the Company sold 3,450,000 shares of its common stock for net proceeds of approximately $76,000,000, of which $50,000,000 will be used to reduce amounts outstanding under the Revolving Credit Agreement. The remaining proceeds will be added to working capital. In 1993, 1992 and 1991, cash used for vessel additions approximated $164,000,000, $81,000,000 and $59,000,000, respectively. At March 7, 1994, commitments with an aggregate unpaid cost of approximately $86,100,000 (net of $54,000,000 of prepayments made in January 1994) exist for the construction of six foreign flag bulk vessels, scheduled for delivery in 1994 and 1995. In 1992, the Company invested cash of approximately $220,000,000 for 49% of the equity of Celebrity Cruise Lines Inc. ("CCLI"), an owner and operator of five cruise ships. The cash invested by the Company in CCLI is being used primarily to finance the expansion of CCLI's fleet. Long-term borrowings in 1993 and 1992 aggregated approximately $310,000,000 and $292,000,000 (including amounts borrowed in connection with the investment in CCLI), respectively. Effects of Inflation Additions to the costs of operating the fleet due to wage increases and price level increases in certain other expense categories were experienced over the three-year period. In some cases, these increases were offset by rates available to tonnage open for chartering and to some extent by charter escalation provisions. Environmental Matters See "Environmental Concerns" on page 15 hereof for a discussion regarding OPA 90 and certain regulations of the IMO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Overseas Shipholding Group, Inc. and Subsidiaries Note A - Summary of Significant Accounting Policies: 1. The consolidated financial statements include the accounts of the Company and its subsidiaries ("Company"). All subsidiaries are wholly owned, except four which are 80%-owned. Significant intercompany items and transactions have been eliminated in consolidation. Investments in Celebrity Cruise Lines Inc. and the bulk shipping joint ventures (which are 50%-owned except one small venture which is 49%-owned) are stated at the Company's cost thereof adjusted for its proportionate share of the undistributed operating results of such companies. 2. As required by Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows," only interest-bearing deposits that are highly liquid investments and have a maturity of three months or less when purchased are included in cash. 3. Depreciation of vessels is computed for financial reporting purposes based on cost, less estimated salvage value, by the straight-line method using a vessel life of 25 years. 4. Certain subsidiaries have bareboat charters-in on vessels that are accounted for as capital leases. Amortization of capital leases is computed by the straight-line method over 22 or 25 years, representing the terms of the leases (see Note M). 5. Time charters and a bareboat charter that are operating leases are reported on the accrual basis. Voyage charters are reported on the completed voyage basis. 6. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), starting in the first quarter of 1992. In accordance with FAS 109, the financial statements of years prior to 1992 have not been restated. The impact of applying FAS 109 was to reduce deferred tax liabilities by $16,000,000, with a corresponding increase in net income (cumulative effect of change in accounting) for 1992. The effect on income before cumulative effect of accounting change for 1992 was not material (see Note J). 7. Interest costs incurred during the construction of vessels (until the vessel is substantially complete and ready for its intended use) are capitalized. Interest capitalized aggregated $7,416,000 (1993), $6,158,000 (1992) and $399,000 (1991). Interest paid amounted to $42,093,000 (1993), $42,865,000 (1992) and $55,841,000 (1991), excluding capitalized interest. 8. The Company adopted the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("FAS 115"), as of December 31, 1993. Adoption of this standard had no significant effect on the Company's financial statements. Under FAS 115 the Company's investments in marketable securities are classified as available- for-sale and are carried at market value. Net unrealized gains or losses are reported as a separate component of shareholders' equity. For prior years, the Company's investments in marketable equity securities were carried at the lower of aggregate cost or market, and the amount of the allowance for net unrealized loss on the noncurrent marketable equity securities was shown as a reduction of shareholders' equity. Note B - Business--Domestic and Foreign Operations: The Company is principally engaged in the ocean transportation of liquid and dry bulk cargoes in both the worldwide markets and the self-contained U.S. markets through the ownership and operation of a diversified fleet of bulk cargo vessels (principally tankers and dry bulk carriers). It also owns an equity investment in Celebrity Cruise Lines Inc. (see Note D), an owner and operator of cruise ships. Information about the Company's operations for the three years ended December 31, 1993 follows: See Note J for information relating to taxation of income and undistributed earnings of foreign companies. The Company had one charterer (a U.S. oil company) during the above periods from which revenues exceeded 10% of revenues from voyages. Revenues from such charterer amounted to $73,656,000 in 1993, $84,349,000 in 1992 and $65,041,000 in 1991. Note C - Assets and Liabilities of Foreign Subsidiaries: A condensed summary of the combined assets and liabilities of the Company's foreign (incorporated outside the U.S.) subsidiaries, whose operations are principally conducted in U.S. dollars, follows: Note D - Investment in Celebrity Cruise Lines Inc.: In October 1992, the Company invested cash of approximately $220 million for 49% of the equity of Celebrity Cruise Lines Inc. ("CCLI"), a newly formed joint venture that owns and operates five cruise vessels contributed to it by the co-venturer. In May 1993, the Company invested additional cash of approximately $2.7 million upon the final determination by CCLI's shareholders of the value of certain of its assets. Pursuant to the related agreements, CCLI functions as an equal joint venture and the approval of both shareholders is required for all substantive policy matters. A condensed summary of the assets and liabilities of CCLI and the results of its operations follows: As of March 7, 1994, CCLI has commitments with an aggregate unpaid cost of $570,000,000 for the construction of two cruise ships, one scheduled for delivery in late 1995 and the other in late 1996. Unpaid costs are net of $64,300,000 of progress payments (of which $15,400,000 was paid subsequent to December 31, 1993). Long-term financing arrangements exist for substantially all of the unpaid cost of these ships. Note E - Bulk Shipping Joint Ventures: Certain subsidiaries have investments in bulk shipping joint ventures (see Note A1). A condensed summary of the combined assets and liabilities and results of operations of the bulk shipping joint ventures follows: Income attributable to bulk shipping joint ventures for 1993 reflects the Company's loss ($815,000) from the sale of a 50%-owned vessel subsequent to year-end. In December 1992, a 50%-owned partnership that owned two 64,200 dwt bulk carriers built in 1983 sold one vessel. It distributed the remaining vessel to the Company and the proceeds of sale to the other partner (a subsidiary of a company whose chairman is a director and shareholder of the Company). The vessel distributed to the Company continues to operate in its international fleet. Note F - Investments in Marketable Securities: Certain information concerning the Company's marketable securities (including securities in Capital Construction and Restricted Funds), which consist of available-for-sale equity securities, follows: The decrease in the unrealized loss on marketable securities included as a separate component of shareholders' equity was $7,261,000 (1993), $10,775,000 (1992) and $17,156,000 (1991). At December 31, 1993, there were gross unrealized gains of $972,000 and losses of $4,562,000. At December 31, 1992, there were gross unrealized gains of $599,000 and losses of $11,450,000. At March 7,1994, the approximate aggregate market quotation of the above marketable securities was $70,600,000 and the net unrealized loss was reduced to approximately $2,350,000. Note G - Debt: Long-term debt exclusive of current installments follows: The Revolving Credit Agreement provides for borrowings of up to $500,000,000 on a revolving credit basis through February 1996, which date may be extended a year at a time by mutual consent, after which the outstanding balance converts to a five-year term loan payable in ten equal semiannual installments. Interest during the revolving period is at the rate of 3/4% above the London Interbank Offered rate ("LIBOR") and during the term loan period is from 7/8% to 1% above LIBOR. The Company also has interest rate options related to either the certificate of deposit or prime rates. Agreements related to long-term debt provide for prepayment privileges (in certain instances with penalties), limitations on the amount of secured debt and total borrowings, and acceleration of payment under certain circumstances, including if any of the minimum consolidated financial covenants contained in certain of such agreements are not met. The most restrictive of these covenants require the Company to maintain positive consolidated working capital, consolidated net worth as of December 31, 1993 of approximately $575,000,000 (increasing quarterly by an amount related to net income), a ratio of total debt to net worth of not more than 1.75:1, and a liquid cash flow coverage ratio of at least 2.00:1. The amount that the Company can use for Restricted Payments, as defined, including dividends and purchases of its capital stock, is limited as of December 31, 1993, to $23,000,000. As of December 31, 1993, the Company is a party to fixed to floating interest rate swaps ranging between three and fifteen years with various banks covering notional amounts aggregating $685,000,000, pursuant to which it pays LIBOR and receives fixed rates ranging from 5.3% to 8.1% calculated on the notional amounts. These agreements have various maturity dates from 1995 to 2008. The Company is also a party to a five-year interest rate swap with a notional amount of $24,000,000, expiring in 1996, pursuant to which it pays a fixed interest rate of 8.4% and receives LIBOR, calculated on the notional amount. Payments and receipts under the swaps are being reflected as adjustments of interest expense, since such swaps are all designated as hedges in connection with existing debt and capital lease obligations. Approximately 25% of the net book amount of the Company's vessels, representing approximately 11% of the number of foreign flag and 55% of the number of U.S. flag vessels, is pledged as collateral for certain long-term debt. In some instances, debt is collateralized by revenues from certain charters. The aggregate annual principal payments required to be made on long-term debt for the five years subsequent to December 31, 1993 are $15,003,000 (1994), $16,414,000 (1995), $30,537,000 (1996), $37,736,000 (1997) and $32,174,000 (1998). The Company also has a $30,000,000 committed short-term line of credit facility with a bank, under which there were no outstanding borrowings as of December 31, 1993. Note H - Agency Fees and Brokerage Commissions: All subsidiaries with vessels and certain joint ventures are parties to agreements with Maritime Overseas Corporation ("Maritime") that provide, among other matters, for Maritime and its subsidiaries to render services related to the chartering and operation of the vessels and certain general and administrative services for which Maritime and its subsidiaries receive specified compensation. Vessel and voyage expenses include $6,009,000 (1993), $5,743,000 (1992) and $6,299,000 (1991) of brokerage commissions to Maritime. By agreement, Maritime's compensation for any year is limited to the extent Maritime's consolidated net income from shipping operations would exceed a specified amount (approximately $758,000 (1993), $689,000 (1992) and $627,000 (1991)). Maritime is owned by a director of the Company; directors or officers of the Company constitute all four of the directors and the majority of the principal officers of Maritime. Note I - Disclosures About Fair Value of Financial Instruments: The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and interest-bearing deposits The carrying amount reported in the balance sheet for interest- bearing deposits approximates its fair value. Investment securities The fair value for marketable securities is based on quoted market prices or dealer quotes. Debt The carrying amounts of the borrowings under the Revolving Credit Agreement approximate their fair value. The fair values of the Company's other debt are estimated using discounted cash flow analyses, based on the rates currently available for debt with similar terms and remaining maturities. Interest rate swaps The fair value of interest rate swaps (used for hedging purposes) is the estimated amount that the Company would receive or pay to terminate the swaps at the reporting date. Any gain or loss resulting from the termination of an interest rate swap would be recognized as an adjustment of interest expense over the average remaining term of the hedged debt. Foreign currency swaps The fair value of foreign currency swaps (used for hedging purposes- - -see Note M2) is the estimated amount that the Company would receive or pay to terminate the swaps at the reporting date. Any gain or loss resulting from the termination of the foreign currency swaps would be recognized as an adjustment of voyage revenues over the remaining term of the related charter. The estimated fair value of the Company's financial instruments follows: Note J - Taxes: See Note A6. Effective from January 1, 1987, earnings of the foreign shipping companies (exclusive of CCLI) are subject to U.S. income taxation currently; post-1986 taxable income may be distributed to the U.S. parent without further tax. The foreign companies' shipping income earned from January 1, 1976 through December 31, 1986 ("Deferred Income") is excluded from U.S. income taxation to the extent that such income is reinvested in foreign shipping operations and the foreign shipping income earned before 1976 is not subject to tax unless distributed to the U.S. parent. A determination of the amount of qualified investments in foreign shipping operations, as defined, is made at the end of each year and such amount is compared to the corresponding amount at December 31, 1986. If during any determination period there is a reduction of qualified investments in foreign shipping operations, Deferred Income, limited to the amount of such reduction, would become subject to tax. Treasury Department regulations regarding the foregoing have not been revised to reflect law changes effective for post-1986 years. The Company believes that it will be reinvesting sufficient amounts in foreign shipping operations so that any significant U.S. income taxes on the undistributed income of its foreign companies accumulated through December 31, 1986 will be postponed indefinitely. U.S. income taxes on the income of its foreign companies accumulated through December 31, 1986 will be provided at such time as it becomes probable that a liability for such taxes will be incurred and the amount thereof can reasonably be estimated. No provision for U. S. income taxes on the income of the foreign shipping companies accumulated through December 31, 1986 was required at December 31, 1993 since undistributed earnings of foreign shipping companies have been reinvested or are intended to be reinvested in foreign shipping operations. As of December 31, 1993, such undistributed earnings aggregated approximately $475,000,000, including $114,000,000 earned prior to 1976; the unrecognized deferred U.S. income tax attributable to such undistributed earnings approximated $165,000,000. Further, no provision for U.S. income taxes on the Company's share of the undistributed earnings of CCLI was required, since it is intended that such undistributed earnings ($6,700,000 at December 31, 1993) will be indefinitely reinvested; the unrecognized deferred U.S. income tax attributable thereto approximated $2,300,000. Pursuant to the Merchant Marine Act of 1936, as amended, the Company is a party to an agreement that permits annual deposits, related to taxable income of certain of its domestic subsidiaries, into a Capital Construction Fund. Payments of Federal income taxes on such deposits and earnings thereon are deferred until, and if, such funds are withdrawn for nonqualified purposes or termination of the agreement; however, if withdrawn for qualified purposes (acquisition of vessels or retirement of debt on vessels), such funds remain tax deferred and the Federal income tax basis of any such vessel is reduced by the amount of such withdrawals. Under the agreement, the general objective is (by use of assets accumulated in the fund) for two vessels to be constructed or acquired by the end of 1999. Monies can remain tax-deferred in the fund for a maximum of 25 years (commencing January 1, 1987 for deposits prior thereto). The Company has historically provided deferred taxes on amounts in the fund. The significant components of the Company's deferred tax liabilities and assets follow: A Federal income tax refund of $6,221,000 was received in 1993. Federal income taxes paid amounted to $6,400,000 in 1992 and $11,000,000 in 1991. The components of income/(loss) before Federal income taxes and cumulative effect of accounting change follow: Substantially all of the above foreign income was earned by companies that were not subject to income taxes in their countries of incorporation. The components of the provision/(credit) for Federal income taxes follow: The sources of differences resulting in deferred income taxes and their related tax effects follow: Reconciliations of the actual Federal income tax rate and the U.S. statutory income tax rate follow: Note K - Other Income (Net): Other income (net) consists of: Gross realized gains on sales of securities were $10,802,000 (1993), $15,728,000 (1992) and $6,931,000 (1991), and gross realized losses were $1,674,000 (1993), $1,616,000 (1992) and $1,478,000 (1991). Note L - Commitments and Other Comments: 1. As of March 7, 1994, commitments with an aggregate unpaid cost of approximately $86,100,000 exist for the construction of six foreign flag bulk vessels, scheduled for delivery in 1994 and 1995. Unpaid costs are net of $303,000,000 of progress payments and prepayments (of which $249,000,000 was paid prior to December 31, 1993) and of discounts resulting from such prepayments. 2. Sundry liabilities and accrued expenses consist of: 3. Certain subsidiaries make contributions to union-sponsored multi- employer pension plans covering seagoing personnel. The Employee Retirement Income Security Act requires employers who are contributors to domestic multi-employer plans to continue funding their allocable share of each plan's unfunded vested benefits in the event of withdrawal from or termination of such plans. The Company has been advised by the trustees of such plans that it has no withdrawal liability as of December 31, 1993. Certain other seagoing personnel of U.S. flag vessels are covered under a subsidiary's defined contribution plan, the cost of which is funded as accrued. Note M - Leases: 1. Charters-in: The approximate minimum commitments under capital leases for eight U.S. flag vessels were: Certain of the capital leases provide for deposits in restricted funds under certain circumstances. Such deposits aggregated approximately $4,950,000 at December 31, 1993 and are held as collateral for the related obligations. The Company has a time charter (which is an operating lease) for a 1992-built foreign flag tanker, which charter has a remaining term of approximately five years, at an annual time charter rental of approximately $8,800,000, assuming a full year's operations. Under the charter, the Company has renewal and purchase options. Time charter rental expense is not payable when the vessel is off-hire. 2. Charters-out: The Company's subsidiaries, as the owners of a diversified fleet of bulk vessels, engage in chartering out the vessels primarily on time and voyage charters and occasionally on bareboat charters. Revenues from vessels on time charter are dependent upon the ability to deliver and operate vessels in accordance with charter terms. Revenues from a time charter are not received when a vessel is off- hire, including time required for normal periodic maintenance of the vessel. The minimum future revenues expected to be received subsequent to December 31, 1993 on noncancelable time charters and a bareboat charter are $86,678,000 (1994), $29,154,000 (1995), $25,872,000 (1996), $23,032,000 (1997) and $19,535,000 (1998); the aggregate for 1999 and later years is $118,011,000. The foregoing amounts do not include escalations and do not purport to be an estimate of aggregate voyage revenues for any of the years. In arriving at the minimum future charter revenues, an estimated time off-hire to perform periodic maintenance on each vessel has been deducted, although there is no assurance that such estimate will be reflective of the actual off-hire in the future. The Company has hedged its exchange rate risk with respect to contracted future charter revenues receivable in a foreign currency by entering into currency swaps with a major financial institution to deliver such foreign currency at rates which will result in the Company receiving approximately $150,000,000 for such foreign currency through 2004. Changes in the value of the currency swaps are deferred and are offset against corresponding changes in the value of the charter hire, over the related charter periods. Note N - Capital Stock and Per Share Amounts: The Company's 1989 nonqualified stock option plan, as amended, covered 570,000 treasury shares. Options were granted to certain officers of the Company and a subsidiary for the purchase of all the shares covered by the amended plan, at $14.00 per share, which was in excess of the market price at the date of grant; 20% of the options vest and become exercisable on each October 9, from 1991 through 1995. These options remain exercisable until October 2000. During 1993, options for 10,000 shares were exercised. Options for 560,000 shares are outstanding and options for 332,000 shares are exercisable at December 31, 1993. At December 31, 1993, the Company has reserved 764,511 treasury shares for issuance pursuant to (i) its 1990 nonqualified stock option plan, which covered options for 5,520 shares granted by the Company to employees (except senior officers), and (ii) an agreement, as amended, to make available for purchase by Maritime (see Note H) 758,991 shares (including an increase of 200,000 shares in 1993). Maritime can acquire the shares reserved for it only for the purpose of fulfilling its obligations under its 1990 nonqualified stock option plan, as amended. The exercise price of the options granted by the Company to its employees is $16.00 per share, and the prices for any shares Maritime purchases from the Company range from $16.00 to $19.63 per share (the market prices at dates of grant). The options granted have a term of approximately nine years and become exercisable in annual increments of 20% upon the option holder's completion of five years of service. Certain details of activity in the Company's 1990 plan and Maritime's plan are summarized as follows: Net income per share is based on the weighted average number of common shares outstanding during each year, 32,678,031 shares (1993), 32,805,549 shares (1992) and 33,012,233 shares (1991). The aforementioned stock options have not been included in the computation of net income per share since their effect thereon would not be material. In March 1994, the Company sold 3,450,000 shares of its common stock for net proceeds of approximately $76,000,000, of which $50,000,000 will be used to reduce amounts outstanding under the Revolving Credit Agreement. The remaining proceeds will be added to working capital. The effect on net income per share assuming this transaction had occurred at the beginning of 1993 was not material. Note O - 1993 and 1992 Quarterly Results of Operations (Unaudited): SHAREHOLDER INFORMATION The Company's stock is listed for trading on the New York Stock Exchange and the Pacific Stock Exchange. Stock Symbol: OSG Shareholders of Record March 7, 1994: 1,205 Exhibit 21 as of 3/7/94 SUBSIDIARIES OF OVERSEAS SHIPHOLDING GROUP, INC. The following table lists all subsidiaries of the registrant and all companies in which the registrant directly or indirectly owns at least a 49% interest, except for certain companies which, if considered in the aggregate as a single entity, would not constitute a significant entity. All the entities named below are corporations, unless otherwise noted. Where Incorporated Name or Organized Ajax Navigation Corporation ..................... Liberia Alice Tankships Corporation ..................... New York American Shipholding Group, Inc. ................ New York Amity Products Carriers, Inc. ................... Delaware Ania Tanker Corporation ......................... Liberia Antilles Bulk Holdings N.V. ..................... Netherlands Antilles Atlantia Tanker Corporation .................... Liberia Baywatch Marine Inc. ............................ Liberia Blue Sapphire Marine Inc. ....................... Liberia Cambridge Tankers, Inc. ......................... New York Canopus Tankers, Inc. ........................... Liberia Caribbean Tanker Corporation .................... Liberia Celebrity Cruises Inc. .......................... Liberia Celebrity Cruise Lines Inc. ..................... Cayman Islands Celebrity Cruises (Management) Inc. ............. Liberia Chrismir Shipping Corporation ................... Liberia Columbia Tanker Corporation ..................... Liberia Commonwealth Shipping Company Limited ........... Bermuda Community Ocean Services, Inc. .................. New York Concert Tanker Corporation ...................... Liberia Concord Tanker S.A. ............................. Panama Corolla Shipping S.A. ........................... Panama Cruise Mar Investment Inc. ...................... Liberia Cruise Mar Shipping Holdings Ltd. ............... Liberia Delphina Tanker Corporation ..................... Delaware Diane Tanker Corporation ........................ Liberia Edinburgh Bulk Carriers Limited ................. Bermuda Enterprise Shipping Company Limited ............. Bermuda ERN Holdings Inc. ............................... Panama Esker Marine Shipping Inc. ...................... Liberia Excelsior Bulk Carriers Limited ................. Bermuda Exemplar Bulk Carriers Limited .................. Bermuda Explorer Bulk Carriers, Inc. .................... Liberia Fantasia Cruising Inc. .......................... Liberia Fifth Transoceanic Shipping Company Limited ..... Liberia First Aframax Tanker Corporation ................ Liberia First Pacific Corporation ....................... Liberia First Products Tankers, Inc. .................... Liberia First Shipco Inc. ............................... Liberia * First Shipmor Associates ........................ Delaware First United Shipping Corporation ............... Liberia Fourth Aframax Tanker Corporation ............... Liberia Fourth Products Tankers, Inc. ................... Liberia * Fourth Shipmor Associates ....................... Delaware Fourth Spirit Holding N.V. ...................... Netherlands Antilles Fourth Transoceanic Shipping Company Limited .... Liberia Friendship Marine Inc. .......................... Liberia General Ship Services, Inc. ..................... Delaware Glasgow Bulk Carriers Limited ................... Bermuda Global Bulk Carriers, Inc. ...................... Liberia Global Bulk Oil S.A. ............................ Panama Global Tankers S.A. ............................. Panama Hyperion Shipping Corporation ................... Liberia Hyperion Transportation S.A. .................... Panama Imperial Tankers Corporation .................... Liberia Intercontinental Bulktank Corporation ........... New York Intercontinental Coal Transport Inc. ............ Delaware Intercontinental Coal Transport Limited ......... Bermuda International Seaways, Inc. ..................... Delaware International Seaways, Inc. ..................... Liberia Interocean Tanker Corporation ................... Liberia Island Tanker S.A. .............................. Panama ITI Shipping S.A. ............................... Panama Jostelle Shipping Company Limited ............... Bermuda Juneau Tanker Corporation ....................... New York Kaigai Shipping Corporation ..................... Liberia Lake Michigan Bulk Carriers, Inc. ............... New York Lake Ontario Bulk Carriers, Inc. ................ New York Lion Insurance Company Ltd. ..................... Bermuda Lion Shipping Ltd. .............................. Liberia Mansfield Marine Corporation .................... Liberia Marina Tanker Corporation ....................... Liberia Matilde Tanker Corporation ...................... Liberia Mediterranean Blue Sea Holdings Ltd. ............ Liberia Mercury Bulkcarriers S.A. ....................... Panama Mermi Shipping Holdings Ltd. .................... Liberia Monarch Tanker S.A. ............................. Panama * Moran Maritime Associates ....................... Delaware New Orleans Tanker Corporation .................. Delaware North American Ship Agencies, Inc. .............. New York Northanger Shipping Corporation ................. Liberia Ocean Bulk Ships, Inc. .......................... Delaware Oleron Tanker S.A. .............................. Panama Olympia Tanker Corporation ...................... Liberia Ore-Oil Carriers S.A. ........................... Panama OSG Bulk Ships, Inc. ............................ New York OSG Car Carriers, Inc. .......................... New York OSG Financial Corp. ............................. Delaware OSG Foundation .................................. New York OSG International, Inc. ......................... Liberia * OSG International Partners ...................... Liberia Overseas Airship Corporation .................... Delaware Overseas Bulktank Corporation ................... New York Overseas Coal Transport Inc. .................... Delaware Overseas Coal Transport Limited ................. Bermuda Overseas Cruiseship Inc. ........................ Cayman Islands Overseas Petroleum Carriers, Inc. ............... Delaware Phaidon Navegacion S.A. ......................... Panama Philadelphia Tanker Corporation ................. Delaware Pluto Tankers, Inc. ............................. Liberia Polycon Investment Inc. ......................... Liberia Reliance Shipping B.V. .......................... Netherlands Reunion Tanker Corporation ...................... Liberia Rex Shipholdings Inc. ........................... Liberia Royal Tankers Corporation ....................... Liberia San Diego Tankers, Inc. ......................... Delaware San Jose Tankers, Inc. .......................... Delaware Santa Barbara Tankers, Inc. ..................... Delaware Santa Monica Tankers, Inc. ...................... Delaware Sargasso Tanker Corporation ..................... Liberia Saturn Bulk Carriers, Inc. ...................... Liberia Seabrook Maritime Inc. .......................... Liberia Second Pacific Corporation ...................... Liberia Second Products Tankers, Inc. ................... Liberia * Second Shipmor Associates ....................... Delaware Second United Shipping Corporation .............. Liberia Ship Paying Corporation No. 1 ................... Delaware Ship Paying Corporation No. 2 ................... Delaware Ship Paying Corporation No. 3 ................... Liberia Spirit Shipping B.V. ............................ Netherlands Third Aframax Tanker Corporation ................ Liberia Third Products Tankers, Inc. .................... Liberia Third Shipco Inc. ............................... Delaware * Third Shipmor Associates ........................ Delaware Third United Shipping Corporation ............... Liberia Timor Navigation Ltd. ........................... Liberia TRA Shipping S.A. ............................... Panama Trader Shipping Corporation ..................... Liberia Transbulk Carriers, Inc. ........................ Delaware Tropical United Shipping Corporation ............ Liberia TSC Shipping S.A. ............................... Panama U.S. Shipholding Group, Inc. .................... New York * United Partners ................................. Liberia United Steamship Corporation .................... Panama Universal Cruise Holdings Limited ............... British Virgin Islands Upperway Investments Ltd. ....................... Liberia Valdez Tankships Corporation .................... New York Vega Tanker Corporation ......................... Delaware Venus Tanker Corporation ........................ Liberia Vivian Tankships Corporation .................... New York Western Ship Agencies Limited ................... England Wolcon Corp. .................................... Delaware Zenith Shipping Corporation ..................... Liberia - ------------------------- * Partnership EXHIBIT 23(a) Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statements, Form S-8 (No. 33-44013) pertaining to the Overseas Shipholding Group, Inc. 1989 Stock Option Plan, the Overseas Shipholding Group, Inc. 1990 Stock Option Plan, and the Maritime Overseas Corporation 1990 Stock Option Plan, and Form S-3 (No. 33-50441) pertaining to the registration of $500,000,000 of Overseas Shipholding Group, Inc. debt securities, of our report dated March 7, 1994, with respect to the consolidated financial statements of Overseas Shipholding Group, Inc., incorporated herein by reference and the financial statement schedules included in this Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG New York, New York March 25, 1994 EXHIBIT 23(b) Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statements, Form S-8 (No. 33-44013) pertaining to the Overseas Shipholding Group, Inc. 1989 Stock Option Plan, the Overseas Shipholding Group, Inc. 1990 Stock Option Plan, and the Maritime Overseas Corporation 1990 Stock Option Plan, and Form S-3 (No. 33-50441) pertaining to the registration of $500,000,000 of Overseas Shipholding Group, Inc. debt securities, of our report dated March 7, 1994, with respect to the consolidated financial statements and schedules of Celebrity Cruise Lines Inc. included in the Overseas Shipholding Group, Inc. Annual Report (Form 10-K) for the year ended December 31, 1993. MOORE STEPHENS ERNST & YOUNG Athens, Greece March 25, 1994

353944_1993.txt

353944_1993

1993

353944

ITEM 1. BUSINESS General International Game Technology (the "Company") was incorporated in December 1980 to acquire the gaming licensee and operating entity, IGT (recently renamed IGT-North America), and facilitate the Company's initial public offering. In addition to its 100% ownership of IGT-North America, the Company directly or indirectly owns 100% of IGT-International, ("IGT- International"), 100% of IGT-Australia, Pty. Ltd. ("IGT-Australia"), 100% of IGT-Europe b.v. ("IGT-Europe"), 99.75% of IGT-Iceland Ltd. ("IGT- Iceland") and 100% of IGT-Japan k.k. ("IGT-Japan"). In December 1993 the Company sold its interest in its riverboat partnerships and on September 30, 1993 sold its interest in CMS-International ("CMS"). See "Discontinued Operations." IGT-North America is the largest manufacturer of computerized casino gaming products and proprietary systems in the world. The Company believes it manufactures the broadest range of microprocessor-based gaming machines available. The Company also develops and manufactures "SMART" systems which monitor slot machine play and track player activity. In addition to gaming product sales and leases, the Company has developed and sells computerized linked proprietary systems to monitor video gaming terminals and has developed specialized video gaming terminals for lotteries and other applications. IGT-North America also develops and operates proprietary software linked progressive systems. The Company derives revenues related to the operations of these systems as well as collects license and franchise fees for the use of the systems. IGT-International was established in September 1993 to oversee all operations outside of North America by the Company's foreign subsidiaries. IGT-International also conducts sales either directly or through distributors in countries not served by the Company's foreign subsidiaries. IGT-Australia, located in Sydney, Australia, manufactures microprocessor-based gaming products and proprietary systems, and performs engineering, manufacturing, sales and marketing and distribution operations for the Australian markets as well as other gaming jurisdictions in the Southern Hemisphere and Pacific Rim. IGT-Europe was established in The Netherlands in February 1992 to distribute and market gaming products in Eastern and Western Europe and Africa. Prior to providing direct sales, the Company sold its products in these markets through a distributor. IGT-Iceland was established in September 1993 to provide system software, machines, equipment and technical assistance to support Iceland's video lottery operations. IGT-Japan was established in July 1990, and in November 1992 opened an office in Tokyo, Japan. On April 16, 1993, IGT-Japan was approved to supply Pachisuro gaming machines to the Japanese market, and the Company began delivery of these machines during the third quarter of fiscal 1993. ITEM 1. BUSINESS (continued) Discontinued Operations During fiscal 1993, the Company divested its investments in casino operations through the sale of its interest in the President Riverboat Casinos, Inc. ("PRC") and CMS. These dispositions were made as part of the Company's strategy to focus on its core businesses of manufacturing machines and the development of proprietary systems software. Iowa Riverboat Corporation ("IRC"), a wholly-owned subsidiary of the Company, established in March 1990, was a 40% partner in an Iowa partnership that owned and operated the President riverboat casino and the Blackhawk Hotel in Davenport, Iowa. International Acceptance Corporation ("IAC"), also a wholly-owned subsidiary of the Company, owned 45% of a riverboat excursion operation and the permanently docked Admiral riverboat in St. Louis, Missouri. In December 1992, the Company contributed the assets of IRC and IAC to PRC in exchange for 1,671,429 shares of PRC common stock. These shares were subsequently sold to the public as part of an initial public offering of PRC common stock on December 17, 1992 (see Note 12 to the Consolidated Financial Statements). CMS, established in August 1988, operated casinos and hotel/casinos for the Company including the Silver Club hotel and casino and The Treasury Club casino in Sparks, Nevada, the El Capitan Club in Hawthorne, Nevada and the King's Casino on the island of Antigua in the Caribbean. Effective September 30, 1993, the Company sold its ownership interest in CMS. Unless the context indicates otherwise, references to "International Game Technology", "IGT" or the "Company" include International Game Technology and its wholly-owned subsidiaries and their subsidiaries. The principal executive offices of the Company are located at 520 South Rock Boulevard, Reno, Nevada 89502; its telephone number is (702) 688-0100. The following table shows the revenues, operating results and identifiable assets for the continuing operations of the Company's two principal lines of business. Years Ended September 30, 1993 1992 1991 (Amounts in thousands) Manufacture of Gaming Products: Revenues . . . . . . . . . . $335,641 $236,372 $155,682 Operating Profit. . . . . . 175,888 115,705 69,378 Identifiable Assets . . . . 262,454 188,852 95,515 Gaming Operations: Revenues . . . . . . . . . . 142,389 $127,222 $ 77,320 Operating Profit. . . . . . 62,391 59,381 26,842 Identifiable Assets: Discontinued Casino Operations. . . . . . . . - 30,737 29,785 Gaming Operations . . . . 151,234 117,595 78,328 ITEM 1. BUSINESS (continued) Years Ended September 30, 1993 1992 1991 (Amounts in thousands) Geographic Area Data: United States: Revenues: Unaffiliated Customers. $413,121 $326,136 $207,835 Inter-area Transfers. . 14,576 6,163 1,153 Operating Profit. . . . . 224,152 163,597 87,228 Identifiable Assets . . . 600,472 460,686 328,239 Australia: Revenues. . . . . . . . . $ 39,681 $ 34,580 $ 25,166 Operating Profit. . . . . 15,269 13,671 8,723 Identifiable Assets . . . 27,067 24,465 17,366 Europe: Revenues. . . . . . . . . $ 11,485 $ 2,878 $ - Operating Profit. . . . . 1,025 513 - Identifiable Assets . . . 11,007 4,822 - Canada: Revenues. . . . . . . . . $ 13,743 $ - $ - Operating Profit. . . . . 4,241 - - Identifiable Assets . . . 8,047 - - See also Note 2 of Notes to Consolidated Financial Statements. Gaming Products Products The Company develops its gaming products for two major markets: the traditional casino gaming market and the government sponsored video gaming terminal market. During 1993, the Company also began producing pachisuro machines, a Japanese style slot machine. The Company was the first to develop computerized video gaming and today, under the Players Edge Plus trademark, the Company sells a variety of different games. The games include the video poker and "blackjack" products in the upright, slant-top and drop-in bar models. The Players Edge Plus line is also available in slant-top keno, dual screen keno and large screen video poker and video slots. Players Edge Plus machines offer player appeal and security including multilevel progressives, embedded and side-mount bill acceptors, enhanced sound packages, embedded progressive meters and data communication devices. The Company also offers a complete line of spinning reel slot machines sold under the trademark S-Plus. The S-Plus series slot machines use an advanced microprocessor system that accommodates several progressive link configurations, enhanced audit trail functions, selection of game software and optional side-mount or embedded bill acceptors. S-Plus machines run existing S-slot programs or the latest partitioned software ITEM 1. BUSINESS (continued) which facilitates program updates. A game change can occur quickly by selecting a new program chip from IGT's extensive game library and by changing the glass and reel strips. The S-Plus machines are manufactured in various sizes and colors and are offered in several designs including upright, slant top and drop-in-bar. IGT-North America also develops, manufactures and markets microprocessor based Slot Marketing and Revenue Tracking "SMART" systems. The SMART computer system identifies frequent players, records playing history, provides direct marketing information, automates slot accounting and provides additional security to casino customers. IGT provides SMART system 24-hour technical support and a software maintenance agreement for on-site service by specially trained system engineers. Over the past decade, advancements in gaming machine technology have attracted a greater number of players to slot and video machines due primarily to higher jackpots and enhanced player appeal. These improvements have significantly influenced casino gaming revenues. Generally, annual slot and video revenues of domestic casinos exceed revenues from table games. The Company's innovations in slot and video technology have increased the machines' earning potential by improving the ease and speed of play, and by decreasing down-time through improved reliability and added service features. All new gaming machines offer a wide variety of games, innovative designs, sophisticated security features, self-diagnostic capabilities, and various accounting and data retention functions. The Company's engineering and design staff continually provide technological improvements and ongoing game development. The Company has obtained numerous patents on various aspects of the video and reel-type gaming machines and systems. The visual aspects of the product are upgraded and customized by the Company's graphic design and silkscreen departments. The Company manufactures and markets video gaming terminals ("VGTs") for government sponsored gaming programs. The VGTs are similar to the Company's video gaming machines, although the wagering and payment of jackpots differ. After inserting money in a VGT, the player is issued credit and plays the machine like a traditional video machine. Player losses are deducted from the credit and winnings are added, instead of coins being dropped into a tray. Upon completion of play, the VGT prints out a ticket showing the remaining amount of credit, and the ticket is redeemable for cash. Unlike traditional gaming machines, VGTs are typically linked to a central computer for accounting and security purposes, which is monitored by the state lotteries or other government agencies. The following schedule illustrates revenues derived from the sale of gaming products for the fiscal years ended September 30, 1993 and 1992. Fiscal Years Ended September 30, 1993 1992 1991 (Amounts in Thousands) Traditional Gaming Products Reel-Type Slot Machines $194,126 $105,818 $ 61,356 Video Products $ 75,506 $ 62,338 $ 61,953 Video Gaming Terminals $ 15,100 $ 22,172 $ 5,312 ITEM 1. BUSINESS (continued) Markets The Company markets its gaming products in North America and in jurisdictions throughout the world. The largest established North American markets are Nevada and Atlantic City. The Company estimates that it manufactured approximately 10,700 of the estimated 24,000 gaming machines currently in place in Atlantic City. Nevada is both the oldest and largest market for the Company's products with an installed base of approximately 160,000 machines. The Company estimates it manufactured approximately 140,000 of the total machines currently in use in Nevada. Within Nevada, there has been increased demand for the Company's products attributable to the construction of new casinos and the refurbishment of existing casinos. The increased demand began with the opening of the Mirage hotel and casino in 1989 and the Excalibur hotel and casino in 1990. In fiscal 1991 and fiscal 1992, the Company's sales volume in Nevada increased due to additional casino expansions and the replacement of older machines with new games, designs and technological advancements. During calendar 1993, three additional new major properties began operating in Nevada. These are the Luxor, Treasure Island and the MGM Grand. These three hotel casinos added more than 8,000 gaming machines or approximately 5% to the installed base of gaming machines in Nevada, and of these machines approximately 6,500 were manufactured by the Company. The market for the Company's products in Nevada will continue to grow in the event casino expansions and refurbishment continue. In addition, the construction of new casinos has increased competitive pressures for casino operators to replace existing machines with new or upgraded machines. Product sales outside of Nevada and New Jersey exceeded 70% of sales during fiscal 1993 as gaming spread to new jurisdictions in North America. These new jurisdictions include "limited stakes" gaming in the western United States, riverboats, Indian gaming and government-sponsored video and slot gaming. Riverboat gaming began in Iowa during 1991 and as of September 30, 1993 was operating in three states: Iowa, Illinois and Mississippi. Riverboat gaming is also legal in Louisiana, Missouri, and Indiana although not yet operational at the end of fiscal year 1993. Additionally, riverboat legislation is under consideration in Massachusetts, Minnesota, Ohio, Pennsylvania, South Carolina, Texas and Virginia. At the end of fiscal year 1993, the riverboat installed base approximated 16,000 gaming machines operating on 24 riverboats in three states. IGT estimates that it manufactured more than 13,000 of these machines. Casino-style gaming continues to expand on American Indian lands. Indian gaming is regulated under the Indian Gaming Regulatory Act of 1988 which permits specific types of gaming. Pursuant to these regulations, permissible gaming devices are denoted as "Class III Gaming" which requires, as a condition to implementation, that the Indian tribe and the state government in which the Indian lands are located enter into a compact governing the terms of the proposed gaming. IGT machines are placed only with Indian gaming operators who have negotiated a compact with the state and received approval by the U. S. Department of the Interior. The Company, through its distributor Sodak Gaming, Inc., began selling machines to authorized Indian casinos in 1990. The Company has either directly or through its distributor sold machines in the following 10 states: ITEM 1. BUSINESS (continued) Arizona, Colorado, Connecticut, Iowa, Louisiana, Minnesota, Montana, North Dakota, South Dakota and Wisconsin. Compacts have also been approved in Mississippi, Michigan and Oregon, although no deliveries were made in these jurisdictions during fiscal 1993. In addition to the approved states, Class III compacts are under consideration in several states including Alabama, California, Maine, Massachusetts, New Mexico, Rhode Island, Texas and Washington. The installed base of Indian gaming machines at September 30, 1993 was approximately 26,000 units, and the Company estimates it manufactured 19,500 of these machines. Government-sponsored gaming in North America also creates a market for the Company's video and slot products. The Company's video gaming terminals are currently operational in Louisiana, Oregon Rhode Island, South Dakota and the Canadian Provinces of Manitoba, New Brunswick, Newfoundland, Nova Scotia and Prince Edward Island. The Company supplied the central computer systems for government sponsored gaming in Manitoba, Oregon and Louisiana and estimates that it manufactured approximately 12,500 of the approximately 50,000 video gaming terminals installed. The Province of Quebec recently legalized video gaming terminals with an estimated start up in the first half of calendar year 1994. In addition to video terminal gaming, various Canadian governments recently approved slot and video gaming in casino environments. The Province of Manitoba opened two casino style entertainment centers during September 1993 with approximately 600 slot machines of which the Company supplied 540. The Province of Quebec began casino-style gaming in Montreal during October 1993, and the Company supplied 480 of the 1,200 units initially installed. Quebec has plans at this time for three additional casinos. A casino is also planned for Windsor, Ontario, with a scheduled opening date of early 1994. Casino gaming will commence there in a temporary facility housing 1,600 slot machines, with the permanent facility scheduled for a 1996 start up. In addition to the traditional and emerging U. S. markets, gaming is also expanding in the Company's international markets. Australia is the most important market for the Company's gaming machine products outside of North America. The State of New South Wales is the second largest market in the world for the Company's gaming machines with an estimated total of 68,000 machines in 2,100 pubs and 1,500 clubs. The Company began selling machines in Australia in 1986 and has supplied approximately 13,000 of the machines in New South Wales. In 1991, the State of Queensland legalized the operation of gaming machines in private pubs and clubs. The State of Queensland awarded the Company a contract to provide the central computer system linking the machines for accounting and security purposes. The central computer system was installed and accepted in October 1991 and gaming commenced in February 1992. The Company estimates that it supplied 5,300 machines or 38% of the 14,000 total machines. Gaming began in the State of Victoria during July 1992 using two separate central systems. The systems are operated by competing agencies that are each allowed to place up to 10,000 machines. South Australia legalized gaming in September of 1992, but it has not yet been implemented. Other Australian jurisdictions are considering the legalization or expansion of gaming operations and New South Wales is considering the expansion of its gaming operation. The Company has had a direct sales presence in Europe since February 1992. Since that time, increasing customer awareness of product ITEM 1. BUSINESS (continued) availability, combined with service and training assistance, has contributed to improved sales. There have been previous sales in Western Europe with recent activity in France, Austria, Switzerland and The Netherlands. Central Europe sales have been made primarily in Turkey, Slovenia and Poland. IGT-International completed an agreement in fiscal 1993 with the University of Iceland Lottery, ("UIL") whereby the Company will supply video lottery terminals and a central system linking the video lottery terminals. The central system incorporates a progressive jackpot feature. The Iceland system, managed by the UIL, began operating in December 1993 with 350 video lottery terminals manufactured by the Company. The Companys Pachisuro machine was approved in April 1993 for sale in Japan by the Japanese technical testing laboratory (Security Electronics and Communications Technology Association). The machine market in Japan consists of 3,000,000 Pachinko machines and 800,000 Pachisuro machines which operate in Pachinko parlors throughout the country of Japan. IGT is the first U.S. company authorized to supply Pachisuro machines and will compete with approximately 20 Japan-based companies that currently supply this market. Gaming Operations Proprietary Systems The Company developed and introduced the world's first electronically- linked, inter-casino proprietary gaming machine system in 1986. These systems link gaming machines in various casinos to a central computer. The systems build a large "progressive" jackpot which increases with every wager made throughout the system. The systems are designed to increase gaming machine play for participating casinos by giving players the opportunity to win jackpots substantially larger than those available from gaming machines which are not linked to a progressive system. The following are linked progressive systems developed by the Company: * In Nevada, five systems under the names Megabucks, Quartermania, Nevada Nickels, Fabulous Fifties, and High Rollers are operated by the Company. Of the total 3,600 gaming machines linked to these systems, approximately 1,800 are owned by the Company and approximately 1,800 are owned by casinos. * In Atlantic City, New Jersey, seven systems under the names Megabucks, Quartermania, Fabulous Fifties, High Rollers, Progressive "21", Megapoker and Pokermania are operated by a trust managed by representatives from participating casinos. The Company owns all of the approximately 1,200 machines linked to these progressive systems. * In Mississippi, four systems under the names Megabucks, Quartermania, Fabulous Fifties and Mississippi Nickels are operated by the Company. Approximately 230 machines are operated on these systems. Two additional systems are expected to commence operations in Mississippi in early fiscal 1994: Pokermania and High Rollers. ITEM 1. BUSINESS (continued) * Other systems include a Megabucks system in Macau which consists of approximately 180 machines owned by the casinos; a Quartermania system in Colorado linking 156 machines owned by the casinos; and a Deadwood, South Dakota Quartermania system which includes approximately 60 casino-owned machines. A Colorado Megabucks and Colorado Nickels system are planned for installation in the second fiscal quarter of 1994. The operation of linked progressive systems varies between jurisdictions as a result of different gaming regulations. In Nevada, Mississippi and South Dakota, the casinos retain the net win, less a percentage paid to the Company to fund the progressive jackpots. These jackpots are paid out in equal installments over a twenty year period. The Company also earns interest on these funds until jackpots are paid. In Atlantic City, the casinos retain the net win, less a percentage paid to a trust managed by representatives of the participating casinos to fund the jackpots and pay other system expenses. The trust records a liability to the Company for an annual casino licensing fee as well as an annual machine rental fee for each machine. In Colorado, the casinos retain the net win less a percentage paid to a separate fund managed by the Company which pays the jackpots. Progressive system lease fees are paid to the Company from this fund. The Company also offers a "leased" link progressive system which links gaming machines within a single casino or multiple casinos of common ownership. Currently four major hotel casinos operate such systems, with from three to seven hotel casinos linked per system. Approximately 420 gaming machines are linked between all such systems as of October 31, 1993. In September 1992, Rhode Island began operation of a video lottery system linking approximately 850 video lottery terminals at two pari-mutuel facilities. As of September 30, 1993, an estimated 1,260 terminals were operating on the system. IGT, one of four manufacturers providing terminals, has approximately 310 terminals installed on this system and receives a percentage of the net win from its terminals. Video gaming in Oregon commenced in March of 1992, and IGT was awarded the contract to supply the central computer system that currently links approximately 6,000 terminals. The Company currently leases approximately 1,750 machines to the Oregon State Lottery. Route and Lease Operations Until August 1992, the Company operated one of Nevada's largest route operations, consisting of machines located in bars and taverns with the Company responsible for the operation, servicing and collection of the monies from these machines. The location either shared the net win from the gaming machines on a percentage basis or received a fee for rental of space. In August 1992, the Company sold all of its route equipment and operating contracts which included approximately 1,380 gaming machines at approximately 160 locations. On November 23, 1992, the Company sold all of the equipment and operating contracts of the Megapoker route (a linked progressive system for video poker machines located throughout the state of Nevada) as well as licensing the purchaser to use, in Nevada, all Megapoker software, ITEM 1. BUSINESS (continued) trademarks and trade names. This transaction included approximately 280 gaming machines owned and operated by the Company at 62 locations. The Company leases gaming equipment to its customers and at September 30, 1993 leased approximately 4,000 gaming machines primarily in the Colorado, Nevada and riverboat markets. In January 1993, the Company began operating approximately 180 gaming machines at the Reno Cannon International Airport under a contract with the Airport Authority. The Airport Authority shares in the net win of the machines with a minimum annual guaranteed amount. Marketing The Company markets gaming products and proprietary systems through its internal sales staff, agents and distributors. The Company employs more than 150 direct sales personnel in offices in several United States locations as well as Canada, Australia and Europe. The Company uses distributors for sales to specific markets including Louisiana, South Carolina, a Canadian maritime province, Atlantic City, the Caribbean, France, Japan and North American Indian reservations. The Company's agreements with distributors do not specify minimum purchases but provide that the Company may terminate the distribution agreement if certain performance standards are not met. The Company's marketing strategy is to offer its customers not only the broadest product line but also ongoing game development. IGT's game library contains numerous game variations. Reprogramming machines for the newest games and changing the glass design can be accomplished quickly. In addition to offering an expansive product line, the Company provides customized services in response to specific casino requests. These services include high quality silkscreen printing of gaming machine glass, video graphics, customized game development and interior design services. IGT developed more than 20 new games which included a variety of custom artwork for the Luxor and Treasure Island casinos that opened in fiscal 1993 and the MGM casino that opened in fiscal 1994 in Las Vegas. The Company also offers customized design services that utilize computer aided design and three-dimensional studio software programs. The Company's design department generates a casino floor layout and can create a proposed casino slot mix for its customers. The final design incorporates casino colors, themes, signage, customer glass and includes either an overhead floor plan layout, viewable from any angle, or a three-dimensional moving walk-through of the casino. The Company also considers its customer service department an important aspect of the overall marketing strategy. The Company typically provides a 90 day service and parts warranty for its gaming machines and charges on a time and material basis thereafter. The Company currently has more than 300 trained service personnel and maintains service offices in Australia, Canada, Colorado, Florida, Japan, Mississippi, Missouri, Montana, Nevada, New Jersey, New Zealand and in The Netherlands. The Company also maintains a customer hot-line available 24-hours a day, seven days a week to respond to customer questions. ITEM 1. BUSINESS (continued) During fiscal 1993, the Company's ten largest customers accounted for 34% of its gaming product sales. Sodak Gaming, the Company's principal distributor of gaming products to American Indian reservations, was the largest purchaser of the Company's products, accounting for 12.0% of total product sales. The Company believes the loss of this customer would not have a long term material adverse effect on product sales of the Company as other means of distribution to this market is available. The nature of the Company's business encompasses large initial orders of gaming products upon the opening, expansion or renovation of a casino as well as for the start-up of government sponsored video gaming operations. Subsequent orders from established customers result from remodeling or expansion of existing facilities as well as replacement of machines due to technological advancements, new designs and upgrades. Sales of the Company's products can fluctuate from quarter to quarter as new jurisdictions throughout the world legalize gambling and new casinos in established gaming markets are opened. The Company believes that its revenues from gaming product sales would not be materially affected by the loss of any single customer. Competition Product Sales The Company competes with substantial U.S. and foreign manufacturers. In the casino style gaming machine market, the primary competitors are Bally Gaming International, Inc. ("Bally"), Sigma Game, Inc. ("Sigma"), and Universal Distributing of Nevada, Inc. ("Universal"). Bally is a Nevada company while Sigma and Universal are Japanese companies. In the slot management and revenue tracking market, the Company competes with Casino Data Systems. Competitors in the video gaming terminal market include domestic and Japanese manufacturers, including three large domestic lottery suppliers, G-Tech, Williams and Video Lottery Consultants. G-Tech, Williams and Video Lottery Consultants have an established presence in the lottery market, substantial resources, and specialize in the development and marketing of gaming terminals to governments. Gaming Operations Competition in the progressive systems business is currently limited but could increase in the future. Manufacturing and Suppliers The Company's manufacturing operations primarily involve assembly of electronic and computer components, including chips, video monitors and prefabricated parts purchased from outside sources. The Company does, however, operate metal fabricating, custom wood cabinet manufacturing and silkscreen facilities. The Company is not dependent upon any one supplier for any raw material. The Company purchases certain components from subcontractors and believes that alternative sources of these components are available. The Company believes its relations with its vendors are good. The Company uses technical staff to assure quality control. The Company generally carries a significant amount of inventory due to the broad range of products it manufactures and to facilitate its capacity to fill customer orders on a timely basis. In 1993, the Company's ITEM 1. BUSINESS (continued) production of gaming machines increased approximately 17% resulting in inventory growth of approximately 20% in order to meet increased demand related to existing and developing markets. Patents, Copyrights and Trade Secrets The Company's computer programs and technical know-how are its main trade secrets, and management believes that they can best be protected by using technical devices to protect the computer programs and by enforcing contracts with certain employees and others with respect to the use of proprietary information, trade secrets and covenants not to compete. The Company has obtained patents and copyrights with respect to aspects of its games, and has patent applications on file for protection of certain developments it has created. No assurance can be given that the pending applications will be granted. These patents range in subject matter from coin-handling apparatus, fiber-optic light pens, coin-escalator mechanisms through optical door interlock and other aspects of video and mechanical slot machines and systems. There can be no assurance that the patents will not be infringed or that others will not develop technology that does not violate the patents. Employees As of September 30, 1993, the Company, including all subsidiaries, employed approximately 2,100 persons, including 297 in administrative positions, 153 in sales and 311 in engineering. Of the total employees, International Game Technology accounted for 39; IGT-North America, 1787; IGT-Australia, 230; IGT-Europe, 19; and IGT-Japan, 3. None of the Company's employees is a member of a collective bargaining unit. Government Regulation Nevada Regulation The manufacture, sale and distribution of gaming devices in Nevada are subject to extensive state laws, regulations of the Nevada Gaming Commission and State Gaming Control Board (the "Nevada Commission"), and various county and municipal ordinances. These laws, regulations and ordinances primarily concern the responsibility, financial stability and character of gaming equipment manufacturers, distributors and operators, as well as persons financially interested or involved in gaming operations. The manufacture, distribution and operation of gaming devices require separate licenses. The laws, regulations and supervisory procedures of the Nevada Commission seek to (i) prevent unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity, (ii) establish and maintain responsible accounting practices and procedures, (iii) maintain effective control over the financial practices of licensees, including establishing minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Commission, (iv) prevent cheating and fraudulent practices, and (v) provide a source of state and local revenues through taxation and licensing fees. Changes in such laws, regulations and procedures could have an adverse effect on the Company's operations. ITEM 1. BUSINESS (continued) A Nevada gaming licensee is subject to numerous restrictions. Licenses must be renewed periodically and licensing authorities have broad discretion with regard to such renewals. Licenses are not transferable. Each type of machine sold by the Company in Nevada must first be approved by the Nevada Commission, which may require subsequent machine modification. Substantially all loans, leases, sales of securities and similar financing transactions must be reported to or approved by the Nevada Commission. Changes in legislation or in judicial or regulatory interpretations could occur which could adversely affect the Company. No publicly traded corporation is eligible to hold a gaming license, but must be registered and found suitable to hold an interest in a corporate subsidiary which holds a gaming license. International Game Technology has been registered by the Nevada Commission as a publicly traded holding company and was permitted to acquire IGT-North America as its wholly-owned subsidiary. As a registered holding company, it is required periodically to submit detailed financial and operating reports to such Commission and furnish any other information which the Commission may require. No person may become a stockholder of, or receive any percentage of profits from, a licensed subsidiary without first obtaining licenses and approvals from the Nevada Commission. Officers, directors and key employees of a licensed subsidiary and of the Company who are actively engaged in the administration or supervision of gaming must be found suitable. No proceeds from any public sale of securities of a registered holding corporation may be used for gaming operations in Nevada or to acquire a gaming property without the prior approval of the Nevada Commission. The Company believes it has all required licenses to carry on its business in Nevada. Officers, directors and certain key employees of the Company and its licensed gaming subsidiary are required to be licensed by the Nevada Commission, and employees associated with gaming must obtain work permits which are subject to immediate suspension under certain circumstances. In addition, anyone having a material relationship or involvement with the Company may be required to be found suitable or licensed, in which case those persons would be required to pay the costs and fees of the State Gaming Control Board (the "Control Board") in connection with the investigation. An application for licensure may be denied for any cause deemed reasonable by the Nevada Commission. Changes in licensed positions must be reported to the Nevada Commission. In addition to its authority to deny an application for a license, the Nevada Commission has jurisdiction to disapprove a change in position by such officer or key employee. The Nevada Commission has the power to require licensed gaming subsidiaries to suspend or dismiss officers, directors or other key employees and to sever relationships with other persons who refuse to file appropriate applications or whom the authorities find unsuitable to act in such capacities. The Company and its licensed gaming subsidiary are required to submit detailed financial and operating reports to the Nevada Commission. If it were determined that gaming laws were violated by a licensee, the gaming licenses it holds could be limited, conditioned, suspended or revoked. In addition to the licensee, the Company and the persons involved could be subject to substantial fines for each separate violation of the gaming laws at the discretion of the Nevada Commission. In addition, a supervisor ITEM 1. BUSINESS (continued) could be appointed by the Nevada Commission to operate the Company's gaming property and, under certain circumstances, earnings generated during the supervisor's appointment could be forfeited to the State of Nevada. The limitation, conditioning or suspension of any gaming license or the appointment of a supervisor could (and revocation of the gaming license would) materially and adversely affect the Company's operations. The Nevada Commission may also require any individual who has a material relationship with the Company to be investigated and licensed or found suitable. Any person who acquires 5% or more of the Company's voting securities must report the acquisition to the Nevada Commission; any person who becomes a beneficial owner of 10% or more of the Company's voting securities must apply for a finding of suitability. Under certain circumstances, an Institutional Investor, as such term is defined in the Nevada Regulations, which acquires more than 10% of the Company's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability requirements. The Nevada Commission has the power to investigate any debt or equity security holder of the Company. The Clark County Liquor and Gaming Licensing Board, which has jurisdiction over gaming in the Las Vegas area, may similarly require a finding of suitability for a security holder. The applicant stockholder is required to pay all costs of such investigation. The bylaws of the Company provide for the Company to pay such costs as to its officers, directors or employees. Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Nevada Commission may be found unsuitable. The same restrictions apply to a beneficial owner if the record owner, after request, fails to identify the beneficial owner. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the Common Stock beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a gross misdemeanor. The Company is subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with the Company, the Company (i) pays that person any dividend or interest upon voting securities of the Company, (ii) allows that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) gives renumeration in any form to that person, or (iv) makes any payment to the unsuitable person by way of principal redemption, conversion, exchange or similar transaction. If a security holder is found unsuitable, the Company may itself be found unsuitable if it fails to pursue all lawful efforts to require such unsuitable person to relinquish his voting securities for cash at fair market value. Additionally the Clark County authorities have taken the position that they have the authority to approve all persons owning or controlling the stock of any corporation controlling a gaming license. The Company is required to maintain a current stock ledger in Nevada which may be examined by the Nevada Commission at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Commission. A failure to make such disclosure may be grounds for finding the record holder unsuitable. The Company is also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power at any time to require the Company's stock certificates to bear a legend indicating that the ITEM 1. BUSINESS (continued) securities are subject to the Nevada Gaming Control Act ("the "Nevada Act") and the regulations of the Nevada Commission. To date, the Nevada Commission has not imposed such a requirement. The Company may not make a public offering of its securities without the approval of the Nevada Commission if the securities or proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Nevada, or retire or extend obligations incurred for such purposes. Changes in control of the Company through merger, consolidation, acquisition of assets, management or consulting agreements or any form of takeover cannot occur without the prior investigation of the Control Board and approval of the Nevada Commission. The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and other corporate defense tactics that affect corporate gaming licensees in Nevada, and corporations whose stock is publicly-traded that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to (i) assure the financial stability of corporate gaming operators and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Company can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. Nevada's gaming regulations also require prior approval by the Nevada Commission if the Company were to adopt a plan of recapitalization proposed by the Company's Board of Directors in opposition to a tender offer made directly to its stockholders for the purpose of acquiring control of the Company. Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada is required to deposit with the Control Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation of the Control Board of the licensee's participation in foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. A licensee is also subject to disciplinary action by the Nevada Commission if it knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engages in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability. Other Jurisdictions Each other jurisdiction in which the Company does business requires various licenses, permits, and approvals in connection with the manufacture ITEM 1. BUSINESS (continued) and/or the distribution of gaming devices, and operation of progressive systems typically involving restrictions similar in most respects to those of Nevada. Thus far the Company has never been denied any such necessary governmental licenses, permits or approvals. No assurances, however, can be given that such required licenses, permits or approvals will be given or renewed in the future. ITEM 2. ITEM 2. PROPERTIES In August 1993, the Company purchased adjoining 46,000 square foot office buildings in Reno, Nevada for use as its corporate offices. IGT- North America leases approximately 545,700 square feet of office, warehouse and production facility space in Reno, Nevada and approximately 184,400 square feet of office and warehouse space in Las Vegas, Nevada. IGT- International currently uses a portion of the facilities leased by IGT- North America in Reno and Las Vegas, Nevada. Additional office and production facilities are leased by the Company's subsidiaries in various other states and countries where the Company conducts business, including Colorado, Florida, Mississippi, Missouri, Montana, New Jersey, Australia, Canada, Japan and The Netherlands. The Company believes that its facilities, which are fully utilized by the Company except for a portion of the owned office buildings which is sublet to third parties, currently are suitable for its business and adequate for its current needs. The Company has entered into an agreement for the purchase of approximately 78 acres in Reno, Nevada which the Company considers suitable for future construction of expanded manufacturing, warehouse and corporate office facilities (see Note 19 to the Consolidated Financial Statements). ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has been named in and has brought lawsuits in the normal course of business. Management does not expect the outcome of these suits to have a material adverse effect on the Company's financial position or results of future operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's common stock is listed on the New York Stock Exchange under the symbol "IGT". Two-for-one stock splits of the Company's common stock were effected on July 16, 1990, August 23, 1991, March 24, 1992 and March 17, 1993. The following table sets forth the high and low sales prices of the common stock (adjusted to reflect the above mentioned stock splits) on the NYSE composite tape: High Low Fiscal 1992 First Quarter. . . . . . . . . . . $ 12 $ 6-1/4 Second Quarter . . . . . . . . . . 17-3/8 10-7/8 Third Quarter. . . . . . . . . . . 17-1/8 11-1/4 Fourth Quarter . . . . . . . . . . 22-1/8 12-7/8 Fiscal 1993 First Quarter. . . . . . . . . . . $ 26-3/8 $ 17-7/8 Second Quarter . . . . . . . . . . 33 23-3/4 Third Quarter. . . . . . . . . . . 39-3/4 28-1/2 Fourth Quarter . . . . . . . . . . 41-3/8 32-1/8 As of December 15, 1993 there were approximately 6,759 record holders of the Company's common stock which had a closing price of $29-5/8 on the same date. On April 14, 1993 the Company declared its first quarterly dividend of $.03 per share, payable on June 1, 1993. The Company declared its second and third quarterly dividends of $.03 per share on June 30, 1993 and September 21, 1993 payable on September 1, 1993 and December 1, 1993, respectively. It is anticipated that comparable cash dividends will continue to be paid in the future. The Company's transfer agent and registrar is Continental Stock Transfer & Trust Company, 2 Broadway, New York, NY 10004, (212) 509-4000. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following information has been derived from the Company's consolidated financial statements: (Amounts in thousands, Years Ended except per share data) September 30, 1993 1992 1991 1990 1989 Selected Income Statement Data: Total revenues. . . . $478,030 $363,594 $233,002 $204,807 $149,825 Income from continuing operations. . . . . $105,578 $63,284 $ 29,780 $ 19,674 $ 14,573 Income (loss) from discontinued operations1 . . . . $ 13,447 $ 1,500 $ 450 $ 329 $( 1,092) Net income. . . . . . $119,025 $ 64,784 $ 30,230 $ 20,003 $ 13,481 Income per primary share from continuing operations. . . . . $ 0.85 $ 0.53 $ 0.26 $ 0.17 $ 0.11 Net income per primary share2. . . . . . . $ 0.96 $ 0.54 $ 0.26 $ 0.17 $ 0.11 Net income per fully diluted share2. . . $ 0.90 $ 0.52 $ 0.26 $ 0.17 $ 0.11 Cash dividends declared per common share. . $ 0.09 $ - $ - $ - $ - Average primary common and common equivalent shares outstanding2. . . . 123,618 120,081 116,818 117,135 122,558 Average common and common equivalent shares outstanding assuming full dilution2. . . 136,611 135,448 117,491 117,135 122,558 Selected Balance Sheet Data: Working capital . . . $376,386 $257,063 $184,092 $ 80,474 $ 68,245 Total assets. . . . . $646,593 $489,973 $345,605 $208,523 $170,492 Convertible Subordinated Notes Payable . . . $ 59,998 $ 93,999 $ 92,536 $ - $ - Long-term notes payable and capital lease obligations . . . . $ 617 $ 19,965 $ 20,767 $ 27,584 $ 23,909 Stockholders' Equity. $378,549 $214,062 $123,747 $ 92,697 $ 82,028 1 Discontinued operations consist of casino operations which the Company sold during fiscal 1993. See Note 12 to the Consolidated Financial Statements for further discussion. 2 Restated to give retroactive effect for two-for-one stock splits in 1990, 1991, 1992 and 1993. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Fiscal 1993 Compared to Fiscal 1992 Net income for fiscal 1993 increased 84% to $119,025,000 or $.96 ($.90 fully diluted) per share compared to net income of $64,784,000 or $.54 per share (adjusted to reflect a two-for-one stock split effective March 17, 1993) for fiscal 1992. Net income in both years included income from discontinued casino and riverboat operations of $13,447,000 in fiscal 1993 and $1,500,000 in fiscal 1992. Income from continuing operations increased 67% to $105,578,000 or $.85 per share compared to $63,284,000 or $.53 per share in fiscal 1992. This increase in income from continuing operations resulted primarily from a 42% increase in product sales and a 17% increase in revenues from the Company's linked progressive systems business. Revenues and Cost of Sales Total revenues for fiscal 1993 increased 31% to $478.0 million. This increase included a 42% or $99.3 million increase in product sales and a 12% or $15.2 million increase in gaming operations revenues. In fiscal 1993 gaming machine shipments grew to 68,900 (compared to 46,100 in fiscal 1992) primarily as a result of increased product demand in the North American riverboat and Indian casino markets and the Southern Nevada casino market. The riverboat sales occurred primarily in the states of Mississippi, Illinois and Iowa. Currently six states have approved riverboat gaming and seven states either have bills in legislation or are considered likely to introduce or re-introduce riverboat legislation. The Company sells machines to casino operations on Indian lands through an independent distributor. In fiscal 1993, sales to this distributor totaled $40.2 million compared to $27.1 million in fiscal 1992. It is anticipated that the Indian casino market will continue to grow as currently approved Indian gaming facilities commence operations and as additional Indian tribes receive approvals to conduct casino style gaming. The Las Vegas, Nevada market continued to expand with the opening of the Luxor and Treasure Island hotel casinos in late fiscal 1993, and the MGM Grand Hotel in early fiscal 1994. The Company shipped 3,250 Pachisuro machines to its Japanese distributor, following successful licensing efforts. In addition, product sales continued to increase in Canada, Europe and Australia as the Company increased its efforts in these international markets. Gaming operations revenue increased $15.2 million or 12% to $142.4 million in fiscal 1993 as a result of a higher volume of play on the Nevada progressive systems, the introduction of new systems in Mississippi and Rhode Island and growth in the number of units leased to the Oregon state lottery and North American riverboat markets. These increases were partially offset by the sale of the Company's Nevada route operations and the Megapoker systems route in August and November 1992, respectively. IGT-International recently signed a contract with the University of Iceland Lottery to supply the video lottery terminals and a central system with a progressive jackpot feature. This system began operating in December 1993 with 350 video lottery terminals. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) The gross margin on product sales increased to 50.2% in fiscal 1993 compared to 48.3% in fiscal 1992, reflecting improved production efficiencies at both the IGT-North America and IGT-Australia manufacturing facilities. Expenses Gaming operations expense increased $8.0 million or 14.7% primarily as a result of the growth in jackpot expenses associated with the Company's linked progressive systems. This increase in jackpot expense reflects increases in play on the Nevada systems and the introduction of new systems. Also contributing to this increase were the expenses associated with the operation of approximately 180 gaming machines at the Reno Cannon International Airport under an agreement which began in January 1993. Offsetting these expense increases was the Company's sale of its Nevada route operations and the Megapoker route to Jackpot Enterprises. Selling, general and administrative expenses increased $4.9 million or 9.3% due to growth in the number of employees, incentive and benefit plan cost increases, the February 1992 opening and 1993 expansion of a sales and distribution facility in Amsterdam, The Netherlands, and the establishment of a manufacturing facility in Manitoba, Canada in late fiscal 1992. Depreciation and amortization expense increased $3.4 million or 20% as a result of increased lease financing, wherein the Company retains ownership of and depreciates the machines in the Colorado and Riverboat markets and expansion of the proprietary systems business. The growth in research and development expense from $11.8 million to $16.5 million resulted from the addition of engineering personnel, increased consulting services expense, and increased incentive compensation and benefit costs. The provision for bad debts declined to $3.8 million for fiscal 1993 compared to $4.6 million in the prior year. Other Income and Expense As a result of the sales growth and the Company's ability to finance customer sales, notes and contracts receivable increased $36.8 million or 52%, causing interest income to increase in fiscal 1993. Also contributing to the $7.9 million increase in interest income in fiscal 1993 was increased income on the Company's investment of excess cash and the growth in the systems business in which income is recognized on the Company's cash investments used to pay progressive system jackpot winners. Interest expense increased $2.0 million to $12.7 million in fiscal 1993 due to additional interest recorded on the liabilities to the progressive systems jackpot winners. This was partially offset by a reduction in interest expense from the conversion of approximately $42.7 million of the Company's convertible subordinated notes to common stock. The continued growth of the Company's progressive systems increases both interest income and interest expense. The Company records interest income on funds invested to secure jackpot payments and records commensurate interest expense on the outstanding liabilities to jackpot winners. During fiscal 1993 the Company recorded a gain of $10.1 million on the sale of assets primarily consisting of gains on the sale of certain securities held in the Company's investment portfolio, and to a lesser ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) extent a gain on the sale of the Megapoker route (see Note 14 of the Notes to the Consolidated Financial Statements). Discontinued Operations During fiscal 1993, the Company divested its investments in casino operations through the sale of its interest in the President Riverboat Casinos, Inc. ("PRC") and the sale of CMS. This is in connection with the Company's strategy to focus on its core businesses of manufacturing machines and the development of proprietary systems software. In December 1992 the Company sold its interest in PRC for $28.7 million, recognizing a gain of $23.6 million. The net gain on the discontinued riverboat operation after including fiscal 1993 income from operations and after deducting the effective income taxes was $14.3 million. In September 1993 the Company sold its ownership interest in CMS for $3.0 million recognizing a pre-tax loss of $2.0 million. The net loss on the discontinued CMS operation after including fiscal 1993 income from operations and after adding back the effective income tax benefit was $811,000. Fiscal 1992 Compared to Fiscal 1991 Net income for fiscal 1992 increased 114.3% to $64,784,000 or $.54 ($.52 fully diluted) per share compared to net income of $30,230,000 or $.26 per share (adjusted to reflect two-for-one stock splits effective March 24, 1992 and March 17, 1993) for fiscal 1991. This growth in earnings is attributable to the combination of increased unit sales, improved margin on product sales as well as higher revenues from the Company's linked progressive systems including machine lease revenues. Net income for fiscal 1992 was adversely affected by a charge of $3.2 million to record the write-down of goodwill relating to the acquisition of EDT in January 1992, as well as the application of an additional $2.9 million of the EDT goodwill to the net losses on the dispositions of the Nevada route and keno systems sales operations. Revenues and Cost of Sales Total revenues for fiscal 1992 increased 56.0% to $363.6 million from $233.0 million for fiscal 1991. The growth in revenue was composed of increases in product sales and gaming operations revenue of $80.7 million and $49.9 million, respectively. The increase in product sales revenue of 51.8% to $236.4 million during fiscal 1992 resulted from strong demand in expanding markets including three Colorado mining towns, U.S. military markets, Native American casinos, riverboats in Illinois, Iowa and Mississippi, and increased sales in Queensland, Australia. Product sales to traditional markets, including Nevada, the Company's single largest market, were about the same as the prior year. Approximately 66% of fiscal 1992 unit sales were to new and emerging markets while 34% of product sales were to traditional gaming markets. The growth in product sales revenue during the current fiscal year is also attributable to video gaming terminal (VGT) ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) sales to Louisiana and to the Manitoba Lottery Foundation in Canada. Worldwide product sales for the year ended September 30, 1992, included over 46,000 gaming machines as compared to approximately 31,000 during the prior year. Revenues from gaming operations grew to $127.2 million in fiscal 1992 from $77.3 million during fiscal 1991, an increase of 64.5%. This percentage increase is primarily due to a higher volume of play on the Nevada progressive systems and higher revenues for franchise and licensing fees for linked progressive systems in Atlantic City casinos. Additionally, income generated from leased machines to the Oregon State Lottery and to customers in Colorado provided new sources of gaming and casino operations revenue in fiscal 1992. The increased play on the Nevada systems is primarily a result of enhancements to existing systems including Megabucks and Quartermania, the record Megabucks jackpot of over $9 million which was won on May 30, 1992, as well as the introduction of Fabulous Fifties in August of 1991. Additions to the number of Nevada Nickels system locations also contributed to this growth. The increase in the Atlantic City progressive systems revenue resulted primarily from greater revenues recognized from the Megabucks and Quartermania systems, as well as from the addition of Fabulous Fifties in April 1991 and Star Poker in September 1991. The gross profit on product sales grew to 48.3% for fiscal 1992 as compared to 44.6% for fiscal 1991. The improved margin resulted from production efficiencies associated with higher sales volume as well as lower discounts offered during fiscal 1992. Expenses Gaming operations expense increased $10.0 million to $54.7 million as a result of the growth in the linked progressive systems business mentioned above, as well as increased costs associated with purchasing investments to fund liabilities to jackpot winners. As the number of jackpots won on the Nevada progressive systems increases and the jackpot payouts grow, the costs associated with purchasing investments to fund the liabilities to jackpot winners increase gaming operations expense correspondingly. Selling, general and administrative expenses grew 39.2% to $52.6 million for the fiscal year ended September 30, 1992, as compared to $37.8 million for the same prior year period. The increase was due to the Company's sales and marketing efforts in new and existing markets, including international sales in Europe and Australia and the expansion of gaming in Colorado. Additionally, costs associated with the acquisition of the EDT publicly owned common stock, expenses incurred in the public offering of the shares held by the Company in the riverboat operation and increased employee benefits and incentive programs attributable to improved earnings provided for the overall increase in selling, general and administrative expense. Depreciation and amortization expense increased $6.9 million to $16.8 million for fiscal 1992, compared to $9.9 million for fiscal 1991, resulting from depreciation recorded on machines leased in Colorado and Oregon as well as amortization of goodwill related to the acquisition of ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) the EDT publicly owned common stock in January 1992. Research and development expense grew to $11.8 million from $9.4 million attributable to expenses related to product upgrades and enhancements and developments of new proprietary software systems. The provision for bad debts decreased $207,000 to $4.6 million as the Company feels the reserves for uncollectible receivables are adequate. Other Income and Expense Interest income for fiscal 1992 increased $6.4 million or 53.7% to $18.4 million over the prior year period primarily as a result of the investment of proceeds received from the issuance in May 1991 of $115 million principal amount of Convertible Subordinated Notes. Additionally, the growth is attributable to the income recognized on the Company's cash investments utilized to pay progressive systems jackpot winners. Interest expense increased 80.3% to $10.8 million as a result of the issuance of the Convertible Subordinated Notes, and the additional interest expense recorded on the liabilities to progressive systems jackpot winners. The Company recorded a benefit of $256,000 related to the minority interest in losses of EDT. This compares to a benefit of $1,248,000 for the minority interest in losses of EDT in fiscal 1991. The Company recorded a net loss of $1.0 million on the sale of assets primarily composed of the $893,000 net loss on the sale of the Nevada Route operations (see Note 14 of the Notes to the Consolidated Financial Statements). During fiscal 1992, the Company recorded a $3.2 million charge to other non-operating expense resulting from the write-down of goodwill associated with the acquisition of EDT publicly owned common stock in January 1992. The goodwill was assigned proportionally to the separable asset groups acquired and the remaining goodwill in which the Company could not justifiably assign was written-off. LIQUIDITY AND CAPITAL RESOURCES Working Capital Working capital increased $119.3 million during the year to $376.4 million at September 30, 1993 primarily as a result of a $51.8 million increase in short-term investments, a $25.4 million increase in accounts receivable, a $16.2 million increase in cash and cash equivalents, a $16.1 million increase in current maturities of long-term notes and contracts receivable and a $12.4 million increase in inventories. The increase in accounts receivable is due to large sales in September 1993 to two new hotel casinos in Las Vegas, Nevada mentioned above and increased sales in the fourth quarter to the Company's Indian casino distributor. The increase in short-term investments and cash and cash equivalents resulted from the generation of cash from operating and investing activities. The increase in the current maturities of long-term notes and contracts receivable is a result of an increase in the amount of sales financed in fiscal 1993, particularly in the last two quarters of the year. Of the $12.4 million increase in inventories, $11.8 million represents an increase ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) in raw materials used to support increased production levels and greater product diversification. Cash Flow During fiscal 1993, the Company's cash and cash equivalents increased $16.2 million to $85.3 million. Cash provided by operating activities for the years ended September 30, 1993, 1992 and 1991 totaled $56.1 million, $38.6 million and $59.0 million, respectively. Cash provided by operating activities was reduced by significant increases in receivables and inventories during 1992 and 1993. Larger inventories have been required to support increased sales. The Company has also been able to provide financing for the product sales growth. The primary sources of cash from financing activities included $48.0 million, $33.5 million and $26.8 million in proceeds from systems to fund liabilities to jackpot winners for the years ended September 30, 1993, 1992 and 1991, respectively. In 1993, for the first time in the Company's history, cash dividends were paid, totaling $7.4 million. Additionally, during the fiscal year ended September 30, 1991, the Company received net proceeds of $89.4 million from the issuance of $115 million principal amount of Convertible Subordinated Notes. Purchases of property, plant, and equipment totaling $46.0 million, $32.5 million and $20.4 million in fiscal 1993, 1992 and 1991, respectively, partially offset increases in cash and cash equivalents during these periods. The additions to property, plant, and equipment consist primarily of the capitalization of gaming machines and equipment leased in certain gaming jurisdictions along with purchases of office furniture and computer equipment to support the Company's expansion. Additionally in fiscal 1993, the Company acquired land and office buildings of $5.2 million for use by corporate and engineering personnel and a $10.0 million aircraft for regional and international travel needs. The Company entered into an agreement to purchase approximately 78 acres for the Company's future plant and facilities expansion for a total purchase price of approximately $6,129,000, (see Note 19 to the Consolidated Financial Statements). The funds for this purchase, as well as the other capital expenditures anticipated during fiscal 1994, will be derived from the Company's existing cash flow. The Company's cash requirements for purposes of principal payments on outstanding debt declined substantially from $28.5 million in fiscal 1991 to $0.9 million in fiscal 1993, as a result of the repayment of outstanding debt through the issuance of the Convertible Subordinated Notes. Assuming no material change in the financial markets, the Company anticipates that all of the $60.0 million principal amount of outstanding notes at September 30, 1993 will be converted to common stock by the third quarter of fiscal 1994. During December 1992, the Company received $44.7 million in proceeds from the initial public offering of the Company's ownership of certain riverboat operations. These proceeds consisted of $16.2 million as payment for outstanding loans including interest from the riverboat operations and $28.5 million as proceeds from the sale of 100% of its equity in the riverboat operations. The Company also received $1,000,000 as cash proceeds from the sale of its ownership in CMS International. See Note 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) to the Consolidated Financial Statements for discussion of Discontinued Operations. Stock Repurchase Plan On October 3, 1989, the Board of Directors authorized the repurchase of up to ten percent of the Company's then outstanding shares. Pursuant to such Board action a total of 8,338,904 shares (as adjusted for the two-for- one stock splits effective July 16, 1990, August 23, 1991, March 24, 1992, and March 17, 1993) had been repurchased as of September 30, 1990. On October 4, 1990, the Board reaffirmed this authorization and authorized a further repurchase of 12.0 million shares to a total of 23.6 million shares. During the three years ended September 30, 1993,the Company repurchased an additional 2,768,876 shares for an aggregate purchase price of $8,895,000. Recently Issued Accounting Standards to be Adopted The Financial Accounting Standards Board issued in May 1993 SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities." This statement, effective for the Company's fiscal year ending September 30, 1995, will require that unrealized gains and losses on securities defined as "trading securities" be included in income and that unrealized gains and losses on securities defined as "available-for-sale" will be excluded from income and reported in a separate component of stockholders' equity. If this standard had been adopted at September 30, 1993, the unrealized gains and losses on trading securities would have increased income from continuing operations before income taxes by $258,000 in fiscal 1993, and the unrealized gains and losses on available-for-sale securities would have increased stockholders' equity by $14,871,000 at September 30, 1993. Lines of Credit As of September 30, 1993, IGT-North America had a $7.5 million unsecured bank line of credit with various interest rate options available to the Company. The line of credit is used for the purpose of facilitating standby letters of credit, and the Company is charged a nominal fee on amounts used against the line as security for letters of credit. Funds available under this line are reduced by any amounts used as security for letters of credit. At September 30, 1993, $4,092,000 was available under this line of credit. IGT-Australia had a $440,000 (Australian) bank line of credit available as of September 30, 1993. Interest is paid at the lender's reference rate plus 1%. This line is secured by equitable mortgages, and has a provision for review and renewal annually in May. At September 30, 1993, no funds were drawn under this line. The Company is required to comply, and is in compliance, with certain covenants contained in its line of credit agreement which, among other things, limit financial commitments the Company may make without the written consent of the lender and require the maintenance of certain financial ratios, minimum working capital and net worth of the Company. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Riverboat Disposition During December 1992, the Company transferred 100% of its ownership interest in three riverboat partnerships to President Riverboat Casinos, ("PRC") a company incorporated to facilitate a public offering of the riverboat gaming operations. In exchange for the transfer of its ownership interests, the Company received 1,671,429 shares of PRC common stock representing an approximate 32% ownership of PRC. The Company subsequently sold all of its 1,671,429 shares of PRC common stock in an initial public offering (the "IPO") of PRC effective December 17, 1992. The Company realized net proceeds from the IPO of $28.5 million and recognized a pre-tax gain of $23.6 million on the sale. PRC additionally repaid $16.2 million in outstanding notes to the Company, plus accrued interest. CMS Disposition Effective September 30, 1993, the Company sold its equity ownership interest in CMS to Summit Casinos-Nevada, Inc., ("Summit"), whose owners include senior management of CMS. The sale consisted of $750,000 in cash for the Company's ownership of CMS's preferred stock and $250,000 in cash and a note of $2,043,529 for CMS's common stock. Additionally, the Company acquired a stock purchase warrant entitling the Company to purchase a 4.84% of CMS at a per share price approximately equal to the book value of CMS ("the CMS Warrant"). The CMS Warrant, which expires on the earlier of September 30, 2003 or the closing of an underwritten public offering of CMS, is exchangeable for a Warrant to purchase shares of common stock of any other affiliate of Summit which proposes an underwritten public offering of its common stock. The Company will remain as guarantor on certain indebtedness of CMS, which had an aggregate balance of $18.6 million at September 30, 1993. Management believes the likelihood of losses relating to these guarantees is remote (see Note 12 of the Notes to the Consolidated Financial Statements). IMPACT OF INFLATION Inflation has not had a significant effect on the Company's operations during the three fiscal years ended September 30, 1993. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements Page Independent Auditors' Report . . . . . . . . . . . . . . . . . 30 Consolidated Statements of Income for the years ended September 30, 1993, 1992 and 1991. . . . . . . . . 31 Consolidated Balance Sheets, September 30, 1993 and 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Consolidated Statements of Cash Flows for the years ended September 30, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Consolidated Statements of Changes in Stockholders' Equity for the years ended September 30, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . 37 Notes to Consolidated Financial Statements . . . . . . . . . . 38 INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of International Game Technology: We have audited the accompanying consolidated balance sheets of International Game Technology and Subsidiaries as of September 30, 1993 and 1992, and the related consolidated statements of income, cash flows and changes in stockholders' equity for each of the three years in the period ended September 30, 1993. Our audits also included the consolidated financial statement schedules listed in the Index at Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of International Game Technology and Subsidiaries as of September 30, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Reno, Nevada November 9, 1993 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands except per share amounts) Years Ended September 30, REVENUES: 1993 1992 1991 Product sales . . . . . . . $ 335,641 $ 236,372 $ 155,682 Gaming operations . . . . . 142,389 127,222 77,320 Total revenues (including related party transactions of $6,680, $5,027 and $12,108 . . . . . . 478,030 363,594 233,002 COSTS AND EXPENSES: Cost of product sales . . . 167,017 122,125 86,185 Gaming operations . . . . . 62,715 54,680 44,684 Selling, general and administrative. . . . . . . 57,526 52,646 37,831 Depreciation and amortization. . . . . . . 20,196 16,826 9,883 Research and development. . 16,523 11,807 9,361 Provision for bad debts . . 3,815 4,608 4,815 Total costs and expenses. . 327,792 262,692 192,759 INCOME FROM OPERATIONS. . . . 150,238 100,902 40,243 OTHER INCOME (EXPENSE): Interest income . . . . . . 26,283 18,409 11,974 Interest expense . . . . . ( 12,749) ( 10,790) ( 5,986) Gain (loss) on the sale of assets. . . . . . . . . . 10,090 ( 1,049) ( 202) Other . . . . . . . . . . . 282 ( 2,785) 2,340 Other income (expense), net . . . . . . . . . . . 23,906 3,785 8,126 INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES . . . . 174,144 104,687 48,369 PROVISION FOR INCOME TAXES. . 68,566 41,403 18,589 INCOME FROM CONTINUING OPERATIONS. . . . . . . . . 105,578 63,284 29,780 DISCONTINUED OPERATIONS: Income from operations, net of taxes of $257, $893, and $18 . . . . . . . . . 705 1,500 450 Gain on disposition, net of taxes of $8,888. . . . 12,742 - - Income from discontinued operations. . . . . . . . 13,447 1,500 450 NET INCOME. . . . . . . . . . $ 119,025 $ 64,784 $ 30,230 (continued) INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (continued from previous page) (Dollars in thousands except per share amounts) Years Ended September 30, 1993 1992 1991 PRIMARY EARNINGS PER SHARE: Income from continuing operations. . . . . . . . $ 0.85 $ 0.53 $ 0.26 Income from discontinued operations. . . . . . . . 0.11 0.01 0.00 Net Income. . . . . . . . . $ 0.96 $ 0.54 $ 0.26 FULLY DILUTED EARNINGS PER SHARE: Income from continuing operations. . . . . . . . $ 0.80 $ 0.51 $ 0.26 Income from discontinued operations. . . . . . . . 0.10 0.01 0.00 Net Income. . . . . . . . . $ 0.90 $ 0.52 $ 0.26 WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING . . . . . . . . 123,617,815 120,081,086 116,818,236 WEIGHTED AVERAGE COMMON SHARES OUTSTANDING ASSUMING FULL DILUTION. . . . . . . . . . 136,610,507 135,448,282 117,491,004 The accompanying notes are an integral part of these consolidated financial statements. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS September 30, (Dollars in thousands) 1993 1992 CURRENT ASSETS: Cash and cash equivalents . . . . . . . . . $ 85,346 $ 69,159 Short-term investments, at cost (market value of $147,123 and $91,003). . 131,994 80,200 Accounts receivable (including $829 and $148 due from related parties), net of allowances for doubtful accounts of $7,935 and $7,058. . . . . . . . . . . 81,857 56,439 Current maturities of long-term notes and contracts receivable (including $175 and $1,766 due from related parties), net of allowances . . . . . . . 60,673 44,535 Inventories: Raw materials . . . . . . . . . . . . . . . 40,225 28,421 Work-in-process . . . . . . . . . . . . . . 4,998 2,306 Finished goods. . . . . . . . . . . . . . . 29,855 31,960 Total inventories . . . . . . . . . . . . . 75,078 62,687 Deferred income taxes . . . . . . . . . . . 10,932 - Prepaid expenses and other. . . . . . . . . 14,255 10,189 Total current assets. . . . . . . . . . 460,135 323,209 LONG-TERM NOTES AND CONTRACTS RECEIVABLE (including $651 and $3,021 due from related parties), net of allowances and current maturities. . . . . . . . . . . 46,908 26,238 PROPERTY, PLANT AND EQUIPMENT, at cost: Land. . . . . . . . . . . . . . . . . . . . 989 5,654 Buildings . . . . . . . . . . . . . . . . . 4,213 14,345 Gaming operations equipment . . . . . . . . 39,375 42,006 Manufacturing machinery and equipment . . . 43,456 28,554 Leasehold improvements. . . . . . . . . . . 5,529 9,388 Total . . . . . . . . . . . . . . . . . . . 93,562 99,947 Less accumulated depreciation and amortization. . . . . . . . . . . . . . . ( 42,689) ( 39,920) Property, plant and equipment, net . . . . . . . . . . . . . . . . . . 50,873 60,027 INVESTMENTS IN UNCONSOLIDATED AFFILIATES. . . - 4,672 LONG-TERM NOTES RECEIVABLE FROM UNCONSOLIDATED AFFILIATES . . . . . . . . . - 13,167 INVESTMENTS TO FUND LIABILITIES TO JACKPOT WINNERS. . . . . . . . . . . . . 82,266 50,550 OTHER ASSETS. . . . . . . . . . . . . . . . . 6,411 12,110 Total Assets. . . . . . . . . . . . . . . $646,593 $ 489,973 The accompanying notes are an integral part of these consolidated financial statements. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS LIABILITIES AND STOCKHOLDERS' EQUITY (Dollars in thousands) September 30, 1993 1992 CURRENT LIABILITIES: Current maturities of long-term notes payable and capital lease obligations . . . . . . . . . . . . . . . . $ 462 $ 1,865 Accounts payable. . . . . . . . . . . . . . . 22,620 18,454 Jackpot liabilities . . . . . . . . . . . . . 11,882 8,604 Accrued employee benefit plan liabilities . . . . . . . . . . . . . . . . 19,651 14,555 Accrued interest payable. . . . . . . . . . . 1,352 2,150 Accrued vacation liability. . . . . . . . . . 3,771 3,031 Accrued and deferred income taxes . . . . . . 11,649 4,634 Other accrued liabilities . . . . . . . . . . 12,362 12,853 Total current liabilities . . . . . . . . . 83,749 66,146 LONG-TERM NOTES PAYABLE AND CAPITAL LEASE OBLIGATIONS NET OF CURRENT MATURITIES. . . . . . . . . . . . . . . . . 617 19,965 CONVERTIBLE SUBORDINATED NOTES PAYABLE . . . . . . . . . . . . . . . . . . . 59,998 93,999 LONG-TERM JACKPOT LIABILITIES . . . . . . . . . 106,476 72,889 DEFERRED INCOME TAXES . . . . . . . . . . . . . 17,187 21,577 OTHER LIABILITIES . . . . . . . . . . . . . . . 17 1,335 Total liabilities . . . . . . . . . . . . . 268,044 275,911 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Common stock, $.000625 par value; 320,000,000 shares authorized; 138,938,605 and 130,601,920 shares issued. . . . . . . . . . . . . . . . . . . 87 82 Additional paid-in capital. . . . . . . . . . 146,869 85,584 Retained earnings . . . . . . . . . . . . . . 259,125 151,922 Treasury stock; 14,071,460 and 13,909,218, at cost . . . . . . . . . . . . ( 27,532) ( 23,526) Total stockholders' equity. . . . . . . . . 378,549 214,062 Total liabilities and stockholders' equity. . . . . . . . . . . $646,593 $489,973 The accompanying notes are an integral part of these consolidated financial statements. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Years Ended September 30, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES: Net income. . . . . . . . . . . . . . . $ 119,025$ 64,784 $ 30,230 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization . . . . 20,196 16,826 9,883 Amortization of long-term debt discount and offering costs . . . . 1,517 1,724 527 Provision for bad debts . . . . . . . 3,815 4,608 4,815 Gain (loss) on sale of assets . . . . ( 10,090) 1,049 202 Gain on sale of discontinued operations. . . . . . . . . . . . . ( 12,742) - - Donated common stock. . . . . . . . . 250 1,060 - (Increase) decrease in assets: Receivables . . . . . . . . . . . . ( 64,763) ( 66,176) ( 3,716) Inventories . . . . . . . . . . . . ( 12,866) ( 25,777) 1,155 Prepaid expenses and other. . . . . ( 12,440) ( 864) 2,561 Increase (decrease) in other assets. . . . . . . . . . . . . . . 4,110 ( 45) 1,519 Increase in liabilities: Accounts payable and accrued liabilities . . . . . . . . . . . 7,520 18,817 6,167 Accrued and deferred income taxes payable, net of tax benefit of stock option and purchase plans . . . . . . . . . . . . . . 12,583 22,963 6,237 Other . . . . . . . . . . . . . . . . ( 22)( 402) ( 563) Total adjustments . . . . . . . . . ( 62,932) ( 26,217) 28,787 Net cash provided by operating activities. . . . . . . . . . . . 56,093 38,567 59,017 CASH FLOWS FROM INVESTING ACTIVITIES: Investment in property, plant and equipment . . . . . . . . ( 46,064) ( 32,487) ( 20,429) Proceeds from sale of property, plant and equipment . . . . . . . . 9,408 6,524 6,884 Purchase of short-term investments. . (154,515) (132,127) ( 67,740) Proceeds from sale of short term investments. . . . . . . . . . 110,460 120,217 - Proceeds from investments to fund liabilities to jackpot winners. . . 11,139 6,754 5,651 Purchase of investments to fund liabilities to jackpot winners. . . ( 46,262) ( 20,763) ( 22,643) Investment in and advances to unconsolidated affiliates . . . . . 29,749 - - Net cash used in investing activities. . . . . . . . . . . . ( 86,085) ( 51,882) ( 98,277) (continued) INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued from previous page) (Dollars in thousands) Years Ended September 30, 1993 1992 1991 CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on debt. . . . . . ( 870) ( 1,331) ( 28,482) Payments on liabilities to jackpot winners . . . . . . . . . . . . . . ( 11,139) ( 6,754) ( 5,651) Collections from systems to fund liabilities to jackpot winners. . . 48,003 33,546 26,806 Proceeds from stock options exercised . . . . . . . . . . . . . 7,520 2,807 1,213 Proceeds from employee stock purchases . . . . . . . . . . . . . 869 563 350 Payments for purchase of treasury stock . . . . . . . . . . . . . . . ( 4,006) ( 1,669) ( 3,220) Payments of cash dividends. . . . . . ( 7,350) - - Long-term debt issue costs. . . . . . - - ( 2,636) Proceeds from long-term debt. . . . . - - 103,524 Foreign currency exchange loss. . . . ( 726) ( 1,737) ( 352) Net cash provided by financing activities. . . . . . . . . . . . 32,300 25,425 91,552 NET CASH PROVIDED BY CONTINUING OPERATIONS. . . . . . . . . . . . . . 2,308 12,110 52,292 CASH PROVIDED BY (USED IN) DISCONTINUED OPERATIONS . . . . . . . 13,879 ( 887) ( 16,367) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR . . . . . . . . . . 69,159 57,936 22,011 CASH AND CASH EQUIVALENTS AT END OF YEAR . . . . . . . . . . . . . $ 85,346 $ 69,159 $ 57,936 The accompanying notes are an integral part of these consolidated financial statements. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Amounts in Additional thousands) Common Stock Paid-in Retained Treasury Shares Amount Capital Earnings Stock Total BALANCE AT OCTOBER 1, 1990.... 124,144 $78 $53,474 $57,782 $(18,637) $ 92,697 Stock options exercised.......... 1,908 1 1,212 - - 1,213 Currency translation adjustments........ - - - ( 353) - ( 353) Tax benefit of stock options...... - - 2,830 - - 2,830 Purchase of treasury stock.............. - - - - ( 3,220) ( 3,220) Employee stock purchases.......... 208 - 350 - - 350 Net income.......... - - - 30,230 - 30,230 BALANCE AT SEPTEMBER 30, 1991.. 126,260 79 57,866 87,659 (21,857) 123,747 Stock options exercised.......... 3,155 3 2,802 - - 2,805 Donated stock....... 93 - 1,060 - - 1,060 Currency translation adjustments........ - - - ( 1,737) - ( 1,737) Tax benefit of stock options...... - - 12,358 - - 12,358 Purchase of treasury stock.............. - - - - ( 1,669) ( 1,669) Employee stock purchases.......... 209 - 563 - - 563 Conversion of subordinated notes. 11 - 85 - - 85 EDT share exchange.. 874 - 10,850 1,216 - 12,066 Net income.......... - - - 64,784 - 64,784 BALANCE AT SEPTEMBER 30, 1992.. 130,602 82 85,584 151,922 (23,526) 214,062 Stock options exercised.......... 2,731 2 7,518 - - 7,520 Donated stock....... 9 - 250 - - 250 Currency translation adjustments........ - - - ( 727) - ( 727) Tax benefit of stock options...... - - 18,137 - - 18,137 Purchase of treasury stock.............. - - - - ( 4,006) ( 4,006) Employee stock purchases.......... 70 - 869 - - 869 Conversion of subordinated notes. 5,527 3 34,511 - - 34,514 Dividends declared.. - - - ( 11,095) - (11,095) Net income.......... - - - 119,025 - 119,025 BALANCE AT SEPTEMBER 30, 1993. 138,939 $87 $146,869 $259,125 $(27,532) $378,549 The accompanying notes are an integral part of these consolidated financial statements. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies Organization - International Game Technology (the "Company") was incorporated in December 1980 to acquire the gaming licensee and operating entity, IGT (recently renamed IGT-North America), and facilitate the Company's initial public offering. In addition to its 100% ownership of IGT-North America, the Company directly or indirectly owns 100% of IGT- International, ("IGT-International"), 100% of IGT-Australia, Pty. Ltd. ("IGT-Australia"), 100% of IGT-Europe b.v. ("IGT-Europe"), 99.75% of IGT- Iceland Ltd. ("IGT-Iceland") and 100% of IGT-Japan k.k. ("IGT-Japan"). In December 1993 the Company sold its interest in its riverboat partnerships and additionally on September 30, 1993 sold its interest in CMS- International ("CMS"). IGT-North America is the largest manufacturer of computerized casino gaming products and proprietary systems in the world. IGT-North America believes it manufactures the broadest range of microprocessor-based gaming machines available. The Company also develops and manufactures "SMART" systems which monitor slot machine play and track player activity. In addition to gaming product sales and leases, IGT-North America has developed and sells computerized linked proprietary systems to monitor video gaming terminals and has developed specialized video gaming terminals for lotteries and other applications. IGT-North America also develops and operates proprietary software linked progressive systems. The Company derives revenues related to the operations of these systems as well as collects license and franchise fees for the use of the systems. IGT-International was established in September 1993 to oversee all sales of gaming products outside of North America by the Company's foreign subsidiaries and to conduct sales either directly or through distributors in countries not served by the Company's foreign subsidiaries. IGT-Australia, located in Sydney, Australia, manufactures microprocessor-based gaming products and proprietary systems, and performs engineering, manufacturing, sales and marketing and distribution operations for the Australian markets as well as other gaming jurisdictions in the Southern Hemisphere and Pacific Rim. IGT-Europe was established in The Netherlands in February 1992 to distribute and market gaming products in Eastern and Western Europe and Africa. Prior to providing direct sales, the Company sold its products in these markets through a distributor. IGT-Iceland was established in September 1993 to provide video lottery system software, machines, equipment and technical assistance to support Iceland's video lottery operations. IGT-Japan was established in July 1990, and in November 1992 opened an office in Tokyo, Japan. On April 16, 1993, IGT-Japan was approved to supply Pachisuro gaming machines to the Japanese market, and the Company began delivery of these machines during the third quarter of fiscal 1993. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARI NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies (continued) Discontinued Operations Iowa Riverboat Corporation ("IRC"), a wholly-owned subsidiary of the Company, established in March 1990, was a 40% partner in an Iowa partnership that owned and operated the President riverboat casino and the Blackhawk Hotel in Davenport, Iowa. International Acceptance Corporation ("IAC"), also a wholly-owned subsidiary of the Company, owned 45% of a riverboat excursion operation and the permanently docked Admiral riverboat in St. Louis, Missouri. In December 1992, the Company contributed the assets of IRC and IAC to PRC in exchange for 1,671,429 shares of PRC common stock. These shares were subsequently sold to the public as part of an initial public offering of PRC common stock on December 17, 1992 (see Note 12). CMS, established in August 1988, operated casinos and hotel/casinos for the Company including the Silver Club hotel and casino and The Treasury Club casino in Sparks, Nevada, the El Capitan Club in Hawthorne, Nevada and the King's Casino on the island of Antigua in the Caribbean. Effective September 30, 1993 the Company sold its ownership interest in CMS to Summit Casinos Nevada, Inc. (see Note 12). The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. All material intercompany accounts and transactions have been eliminated. The disposal of interests in riverboat partnerships and CMS (collectively, "casino operations") has been accounted for as discontinued operations. Accordingly, operating results and cash flows of casino operations are segregated and reported as discontinued operations in the accompanying consolidated statements of income and cash flows. Prior year financial statements have been restated to conform to the current year presentation. Common Stock Split - On March 17, 1993, the Company effected a two- for-one split of its common stock and a corresponding reduction in the par value of its common stock from $.00125 to $.000625 per share. Prior years' shares outstanding and per share amounts have been restated to reflect the stock split. Product Sales - The Company makes product sales for cash, on normal credit terms (90 days or less), over longer term installments, and through participation in the net winnings of the machines until the purchase price is paid. Generally, sales are recorded when title passes to the customer. Participation sales are recorded when the product is installed unless the customer does not agree in writing to keep the product installed until the purchase price is paid, in which case the installment method is used. Sales of slot management systems generally involve contracts covering periods up to twelve months. Billings on such contracts are made periodically in accordance with contract terms. Revenues are recognized when the title passes to the customer. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies (continued) Gaming Operations - Gaming operations revenues consist of revenues relating to the operations of the proprietary systems division, a share of the net gaming winnings from the operation of machines at customer locations, and the lease and rental of gaming and video lottery machines. Revenue from systems products installed in New Jersey casinos is not recognized until receipt is assured. The Company's proprietary systems are primarily operated in Nevada and Atlantic City, New Jersey. In Atlantic City, each system is operated by an independent trust managed by representatives from the participating casinos. The trust records a liability to the Company for annual casino fees as well as machine rental fees. In Nevada, the systems are operated by the Company. The Nevada casinos retain the net win, less a percentage paid to the Company to fund the progressive jackpots. The Company earns interest on these funds until jackpots are paid. These jackpots are paid out in equal installments without interest over a twenty year period. The Company records the percentage received as revenue and records as expense all costs associated with its obligation to fund the jackpot liabilities. The following table shows the revenues recorded from gaming operations. Years Ended (Dollars in thousands) September 30, 1993 1992 1991 Proprietary Systems. . . . $124,275 $106,639 $ 61,345 Lease Operations . . . . . 18,114 20,583 15,975 Total. . . . . . . . . . . $142,389 $127,222 $ 77,320 At September 30, 1993 and 1992, the Company had accrued approximately $118.4 million and $81.5 million, respectively, for its share of outstanding progressive jackpot liabilities. This liability includes the amount required to provide for payments to systems jackpot winners. The Company is required to maintain cash and investments relating to systems liabilities in separate accounts. Cash and Cash Equivalents - This includes cash required for funding current systems jackpot payments as well as purchasing investments to meet obligations for making payments to jackpot winners. Cash in excess of daily requirements is generally invested in various marketable securities. If these securities have original maturities of three months or less they are considered cash equivalents. Such investments are stated at cost, which approximates market, and are deemed to be cash equivalents for purposes of the consolidated statements of cash flows. Short-Term Investments - This represents a portfolio of marketable securities consisting primarily of U.S. government securities, corporate bonds with original maturities beyond three months and common and preferred stocks. Similar items with original maturities of three months or less are considered to be cash equivalents. Marketable securities are carried at the lower of their aggregate cost or market value. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies (continued) Inventories - Inventories are stated at the lower of cost (first-in, first-out method) or market. Depreciation and Amortization - Depreciation and amortization are provided on the straight-line method over the following useful lives: Gaming operations equipment . . . . . . . . . 1 to 5 years Manufacturing machinery and equipment . . . . 3 to 5 years Buildings . . . . . . . . . . . . . . . . . . 40 years Leasehold improvements. . . . . . . . . . . . Term of Lease Building under capital lease. . . . . . . . . Term of Lease Maintenance and repairs are expensed as incurred. The costs of improvements are capitalized. Gains or losses on the disposition of assets are included in income. Investments to Fund Liabilities to Jackpot Winners - These investments represent discounted U.S. Treasury Securities purchased to meet obligations for making payments to Nevada, Mississippi, Colorado and South Dakota linked progressive systems winners. Such investments are stated at cost. Nevada and Mississippi gaming regulations provide how these funds are to be maintained. Other Assets - Other assets include debt issue costs, deposits, patents, goodwill and gaming rights. Debt issue costs are amortized as a component of interest expense on the Convertible Subordinated Notes (see Note 11). The cost of gaming rights is amortized on a straight-line basis over the terms of the agreements. Patents and goodwill are amortized over periods of seven years and five years, respectively. Earnings Per Share - Earnings per share is computed based upon the weighted average number of common and common equivalent shares outstanding. Prior period weighted average shares outstanding and earnings per share have been restated to reflect the effects of the Company's 1993 stock split. The Convertible Subordinated Notes (see Note 11) are not common stock equivalents, and they were excluded from the calculation of fully- diluted earnings per share in 1991 when their effect was anti-dilutive. Foreign Currency Translation - The financial statements of foreign subsidiaries have been translated into U.S. dollars for consolidated reporting purposes in accordance with SFAS No. 52. All asset and liability accounts have been translated using the current exchange rate at the balance sheet date. Income statement amounts have been translated using the average exchange rate for the year. The gains and losses resulting from the translation adjustments have been accumulated as a component of stockholders' equity, being netted against retained earnings due to the immateriality of the amounts. The effect on the consolidated statements of operations of translation gains and losses is insignificant for all years presented. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies (continued) Recently Issued Accounting Standards to be Adopted - The Financial Accounting Standards Board issued in May 1993 SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities." This statement, effective for the Company's fiscal year ending September 30, 1995, will require that unrealized gains and losses on securities defined as "trading securities" be included in income and that unrealized gains and losses on securities defined as "available-for-sale" will be excluded from income and reported in a separate component of stockholders' equity. If this standard had been adopted at September 30, 1993, the unrealized gains and losses on trading securities would have increased income from continuing operations before income taxes by $258,000 in fiscal 1993, and the unrealized gains and losses on available-for-sale securities would have increased stockholders' equity by $14,871,000 at September 30, 1993. Reclassification - Certain amounts in the 1992 and 1991 consolidated financial statements have been reclassified to be consistent with the presentation used in fiscal year 1993. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Business Segments The Company operates principally in two lines of business: the manufacture of gaming products and gaming operations. The table below presents information as to the Company's operations in different industries. Years Ended (Dollars in thousands) September 30, 1993 1992 1991 REVENUES: Manufacture of Gaming Products. . $335,641 $236,372 $155,682 Gaming Operations . . . . . . . . 142,389 127,222 77,320 Total . . . . . . . . . . . . . $478,030 $363,594 $233,002 OPERATING PROFIT: Manufacture of Gaming Products. . $175,888 $115,705 $ 69,378 Gaming Operations . . . . . . . . 62,391 59,381 26,842 Total . . . . . . . . . . . . . 238,279 175,086 96,220 OTHER EXPENSES, INCLUDING INTEREST EXPENSE. . . . . . . . . 64,135 70,399 47,851 INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES . . . . . . . $174,144 $104,687 $ 48,369 CAPITAL EXPENDITURES: Manufacture of Gaming Products. . . . . . . . . . . . . $ 8,499 $ 3,560 $ 1,919 Casino Operations . . . . . . . . - 1,182 2,132 Gaming Operations . . . . . . . . 20,269 22,808 13,302 Corporate . . . . . . . . . . . . 17,345 7,587 6,181 Total . . . . . . . . . . . . . $ 46,113 $ 35,137 $ 23,534 DEPRECIATION AND AMORTIZATION: Manufacture of Gaming Products. . $ 1,740 $ 1,655 $ 1,436 Gaming Operations . . . . . . . . 14,699 11,860 5,956 Corporate . . . . . . . . . . . . 3,757 3,311 2,491 Total . . . . . . . . . . . . . $ 20,196 $ 16,826 $ 9,883 September 30, 1993 1992 1991 IDENTIFIABLE ASSETS: Manufacture of Gaming Products. . $262,454 $188,852 $95,515 Casino Operations . . . . . . . . - 30,737 29,785 Gaming Operations . . . . . . . . 151,234 117,595 78,328 Corporate . . . . . . . . . . . . 232,905 152,789 141,977 Total . . . . . . . . . . . . . $646,593 $489,973 $345,605 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Business Segments (continued) The Company has operations based in the United States, Canada, Australia and Europe. The table below presents information as to the Company's operations by geographic region. (Dollars in thousands) Years Ended September 30, 1993 1992 1991 REVENUES: United States . . . . . . . . $ 427,697 $ 332,299 $ 208,988 Canada. . . . . . . . . . . . 13,743 - - Australia . . . . . . . . . . 39,681 34,580 25,166 Europe. . . . . . . . . . . . 11,485 2,878 - Eliminations. . . . . . . . . ( 14,576) ( 6,163) ( 1,153) Total . . . . . . . . . . . $ 478,030 $ 363,594 $ 233,002 OPERATING PROFIT: United States . . . . . . . . $ 224,152 $ 163,597 $ 87,228 Canada. . . . . . . . . . . . 4,241 - - Australia . . . . . . . . . . 15,269 13,671 8,723 Europe. . . . . . . . . . . . 1,025 513 - Eliminations. . . . . . . . . ( 6,408) ( 2,695) 269 Total . . . . . . . . . . . 238,279 175,086 96,220 OTHER EXPENSES, INCLUDING INTEREST EXPENSE. . . . . . . 64,135 70,399 47,851 INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES . . . . . $174,144 $104,687 $ 48,369 September 30, 1993 1992 1991 IDENTIFIABLE ASSETS: United States . . . . . . . . $600,472 $460,686 $328,239 Canada. . . . . . . . . . . . 8,047 - - Australia . . . . . . . . . . 27,067 24,465 17,366 Europe. . . . . . . . . . . . 11,007 4,822 - Total . . . . . . . . . . . $646,593 $489,973 $345,605 On a consolidated basis the Company does not recognize intersegment revenues or expenses upon the transfer of gaming products between segments. Operating profit is revenue and interest income less cost of sales and operating expenses, including related operating depreciation and amortization, and provisions for bad debts. Other expenses include selling, general and administrative expense, interest expense, interest income and research and development expense. During the fiscal years ended September 30, 1993 and 1992, the Company made net sales of $40.2 million and $27.1 million, respectively, to Sodak Gaming, the Company's principal distributor of gaming products to Native American Indian reservations in Wisconsin, Minnesota and to other areas in the midwest and western United States. These sales aggregated approximately 11.1% and 11.4% of the Company's total product sales for the INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIAR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Business Segments (continued) fiscal years 1993 and 1992, respectively. The Company believes the loss of this customer would not have a long term material adverse effect on product sales of the Company as other means of distribution to this market is available. No single customer accounted for more than 10% of total product sales of the Company during the fiscal year ended September 30, 1991. The Company had total export sales from the United States of approximately $13,522,000, $29,006,000 and $25,514,000 during the fiscal years ended September 30, 1993, 1992 and 1991, respectively. This amount declined in the year ended September 30, 1993 primarily due to the exclusion of Canadian sales in fiscal 1993 as a result of the Company's production of gaming machines in Canada starting in late fiscal 1992. 3. Notes and Contracts Receivable The Company grants customers extended payment terms under contracts of sale. These contracts are generally for terms of one to five years, with interest recognized at prevailing rates, and are secured by the related equipment sold. The Company has provided loans, principally for financial assistance, to several customers. At September 30, 1993 and 1992, the balance of such loans totaled $994,000 and $936,000, respectively, net of the related allowance for doubtful accounts of $25,000 and $321,000, respectively. These loans are generally for terms of one to five years with interest at prevailing rates. The following table represents, at September 30, 1993, the estimated future collections of notes and contracts receivable (net of allowances): Years Ending September 30, Estimated Receipts (Dollars in thousands) 1994 . . . . . . . . . . . . . . . . $ 60,673 1995 . . . . . . . . . . . . . . . . 27,202 1996 . . . . . . . . . . . . . . . . 7,697 1997 . . . . . . . . . . . . . . . . 3,432 1998 . . . . . . . . . . . . . . . . 1,607 1999 and after. . . . . . . . . . . . . . 6,970 $107,581 At September 30, 1993 and 1992, the following allowances for doubtful notes and contracts were netted against current and long-term maturities: (Dollars in thousands) September 30, 1993 1992 Allowance for doubtful notes and contracts: Current . . . . . . . . . . . . $5,588 $2,438 Long-term . . . . . . . . . . . 3,363 4,361 $8,951 $6,799 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. Lines of Credit As of September 30, 1993, IGT-North America had a $7.5 million unsecured bank line of credit with various interest rate options available to the Company. The line of credit is used for the purpose of facilitating standby letters of credit, and the Company is charged a nominal fee on amounts used against the line as security for letters of credit. Funds available under this line are reduced by any amounts used as security for letters of credit. At September 30, 1993 $4,092,000 was available under this line of credit. IGT-Australia had a $440,000 (Australian) bank line of credit available as of September 30, 1993. Interest is paid at the lender's reference rate plus 1%. This line is secured by equitable mortgages, and has a provision for review and renewal annually in May. At September 30, 1993, no funds were drawn under this line. The Company is required to comply, and is in compliance, with certain covenants contained in the IGT line of credit agreement which, among other things, limit financial commitments the Company may make without written consent of the lender and require the maintenance of certain financial ratios, minimum working capital and net worth of the Company. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Notes Payable,Capital Lease Obligations and Liabilities to Jackpot Winners Notes payable and capital lease obligations consist of the following as of: (Dollars in thousands) September 30, 1993 1992 CMS notes payable to bank, (see Note 12). Notes assumed by Summit Casinos Nevada, Inc . . . . . $ - $ 19,701 Capital lease obligations (see Note 8). . . . . . 1,079 1,943 Other note payable repaid in 1993 . . . . . . . . - 186 Total . . . . . . . . . . . . . . . . . . . . . 1,079 21,830 Less current maturities . . . . . . . . . . . . . ( 462) ( 1,865) Long-term notes payable and capital lease obligations, net of current maturities. . . . . $ 617 $ 19,965 Future fiscal year principal payments of these notes and capital lease obligations at September 30, 1993, are as follows: (Dollars in thousands) 1999 and 1994 1995 1996 1997 1998 Later $ 462 $ 349 $ 195 $ 73 $ - $ - In Nevada, Mississippi and South Dakota, the Company receives a percentage of the net win from the linked progressive systems to fund the related jackpot payments. The jackpots are paid off in equal annual installments over either a ten or twenty year period. The following schedule sets forth the future principal payments for the jackpot winners under these systems at September 30, 1993: (Dollars in thousands) Years Ending September 30, 1994 . . . . . . . . . . $ 9,352 1995 . . . . . . . . . . 8,604 1996 . . . . . . . . . . 7,916 1997 . . . . . . . . . . 7,282 1998 . . . . . . . . . . 6,358 1999 and after . . . . . 53,256 Liabilities to jackpot winners. . . . . . . . $ 92,768 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Income Taxes The effective income tax rates on income attributable to continuing operations differ from the statutory U. S. federal income tax rates as follows: Years Ended (Dollars in thousands) September 30, 1993 1992 1991 Amount Rate Amount Rate Amount Rate Taxes at federal statutory rate. . . $60,602 34.8% $35,594 34.0% $16,445 34.0% Acquisition goodwill and minority interest-EDT 455 .3 2,300 2.2 424 .9 Foreign subsidiaries tax . . . . . . . . 2,402 1.4 1,295 1.2 ( 66) ( .1) State income tax, net 2,273 1.3 563 .5 175 .3 Foreign sales corporation . . . . ( 1,280) ( .7) ( 740) (.7) - - Other, net. . . . . . 4,114 2.3 2,391 2.3 1,611 3.3 Actual provision for income taxes. . $68,566 39.4% $41,403 39.5% $18,589 38.4% Total fiscal 1993 pre-tax income consists of $164,625,000 subject to U.S. taxation and $9,519,000 of foreign taxable income. Total fiscal 1992 pre-tax income consists of $98,434,000 subject to U.S. taxation and $6,253,000 of foreign taxable income. Total fiscal 1991 pre-tax income consists of $49,031,000 domestic taxable income and a loss of $662,000 for foreign operations. Components of the provision for income taxes on income from continuing operations were as follows: Years Ended (Dollars in thousands) September 30, 1993 1992 1991 Current: Federal . . . . . . . . . . $ 78,544 $ 33,997 $ 17,844 State . . . . . . . . . . . 3,497 659 210 Foreign . . . . . . . . . . 5,111 1,392 - Total current . . . . . . . 87,152 36,048 18,054 Deferred (primarily federal). ( 18,586) 5,355 535 Total provision from continuing operations. . . . . . . . . $ 68,566 $ 41,403 $ 18,589 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Income Taxes (continued) The deferred tax provisions (benefits) are attributable to the following: Years Ended (Dollars in thousands) September 30, 1993 1992 1991 Excess of accelerated depreciation over straight-line depreciation . $( 1,017) $( 268) $( 238) Provisions for bad debts and receivables deductible when written off . . . ( 792) (1,519) (1,029) Provisions for inventory and fixed asset valuation adjustments deductible for taxes when realized ( 226) ( 1,092) ( 583) Book provisions for accrued gaming activities reported differently for tax purposes. . . . . . . . . (18,975) 9,151 3,220 Other, net. . . . . . . . . . . . . 2,424 ( 917) ( 835) $(18,586) $ 5,355 $ 535 During 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes." The impact of adopting this new standard was not material to any of the consolidated financial statements of the Company for 1993. Prior to 1993, the Company accounted for income taxes under SFAS No. 96. Statement 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) operating loss and tax credit carryforwards. The tax items comprising the Company's net deferred tax liability as of September 30, 1993 are as follows: Year Ended (Dollars in thousands)September 30, 1993 Deferred tax liabilities: Reserve differential for gaming activities. . . . . . . . . . . . . $16,561 Other . . . . . . . . . . . . . . . . 1,450 . . . . . . . . . . . . . . . . 18,011 Deferred tax assets: Receivable reserve. . . . . . . . . . 5,023 Reserves not currently deductible . . 3,722 Difference between book and tax basis of property . . . . . . . . . 2,154 Operating loss carryforwards. . . . . 263 Other . . . . . . . . . . . . . . . . 594 . . . . . . . . . . . . . . . . 11,756 Valuation allowance . . . . . . . . . - Net deferred tax liability. . . . . . $ 6,255 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Income Taxes (continued) In August of 1993, enacted changes in Federal legislation increased the income tax rate for the fiscal year ended September 30, 1993. The rate increased from 34% to 35%, with a blended rate being applied in fiscal 1993. 7. Employee Benefit Plans Employee Profit Sharing Plans In 1980, IGT-North America adopted a qualified profit sharing retirement plan for its employees. Company contributions to the plan are at the sole discretion of the Company's Board of Directors. Benefits vest over a seven-year period of employment. Under a discretionary program effective January 1, 1986, and reviewable by the Board annually, contributions are based on 5% of annual IGT-North America pre-tax operating profits above a set minimum. Effective for 1993, 1992 and 1991, the minimum pre-tax operating profits were $44,000,000, $28,000,000 and $12,000,000, respectively, before any allocation to the Plan. Additionally, a cash sharing plan was adopted by IGT-North America effective January 1, 1986, in which 5% of annual pre-tax operating profits of IGT-North America (in excess of $44,000,000, $28,000,000 and $12,000,000, for 1993, 1992 and 1991, respectively), are distributed to employees on a semiannual basis. Contributions to the plan are reviewed annually by the Board. The Company's other subsidiaries have similar retirement and cash sharing plans with one of the plans designed as a superannuation program. Total consolidated profit sharing and cash sharing expense was $12,564,000, $9,893,000 and $4,573,000 for the fiscal years ended September 30, 1993, 1992 and 1991, respectively. IGT-North America maintains a discretionary management bonus and a marketing management bonus plan in which key employees participate. Effective January 1, 1986, 5% of IGT's annual pre-tax operating profits (in excess of $44,000,000, $28,000,000 and $12,000,000 for 1993, 1992 and 1991, respectively) are distributed under the management bonus plan. Bonuses for marketing management are computed using a formula based on product sales levels and gross profit margins achieved. The Company's other operating subsidiaries maintain similar plans. Total consolidated expense under these plans was $8,435,000, $5,598,000 and $3,430,000 for the fiscal years ended September 30, 1993, 1992 and 1991, respectively. Stock Option Plans In 1981, the Company adopted a Stock Option Plan under which nonqualified and incentive stock options to purchase up to 27,104,000 shares may be granted and, in 1993, the Company adopted a Stock Option Plan under which nonqualified and incentive stock options to purchase up to 3,000,000 shares may be granted to employees and up to 250,000 nonqualified stock options may be granted to non-employee directors of the Company. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Employee Benefit Plans (continued) Options granted have been granted at fair market value on the date of grant and, except for non-employee director options, typically become exercisable in five annual installments although a shorter period may be provided. At September 30, 1993, options to purchase 4,011,696 shares were available for grant under the plans. Number Option Price of Shares Per Share Outstanding at September 30, 1992. . . . . . . . 5,283,254 $ .51 - $18.88 Granted . . . . . . . . 857,160 $22.81 - $38.63 Cancelled . . . . . . . ( 17,320) $ 1.26 - $25.44 Exercised . . . . . . . (2,730,622) $ .51 - $18.875 Outstanding at September 30, 1993. . . . . . . . 3,392,472 $ .51 - $38.63 Exercisable at September 30, 1993. . . . . . . . 1,677,632 $ .51 - $18.88 Employee Stock Purchase Plan Effective February 26, 1987, the Company adopted a Qualified Employee Stock Purchase Plan. Under this Plan, each eligible employee may be granted an option to purchase a specific number of shares of the Company's common stock. The term of each option is twelve months, and the exercise date is the last day of the option period. Eligible employees include only those employees who have completed twelve months of continuous service with the Company. The Plan excludes employees who are officers, 5% or more shareholders, employees receiving more than $64,245 in annual compensation and employees of certain subsidiaries. An aggregate of 2,400,000 shares may be made available under this plan. Employees may participate in this plan only through payroll deductions up to a maximum of 10% of their base pay. The option price is equal to the lesser of 85% of the fair market value of the common stock on the date of grant or on the date of exercise. At September 30, 1993, 1,100,472 shares were available under this plan. 401(k) Matching Program Effective January 1, 1993, the Company offered a 401(k) retirement plan contribution matching program. Under the plan agreement, the Company matches 100% of employee contributions up to $500 and an additional 50% of the next $500 contributed by the employee. This allows for maximum annual Company contributions of $750 to each employee's 401(k) account. The employees will be 100% vested in Company contributions at the date the contribution is made. In fiscal 1993 the Company contributed $512,000 under this plan. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Commitments The Company leases certain of its facilities and equipment under various agreements for periods through the year 2002. The following table shows the future minimum rental payments required under these operating and capital leases which have initial or remaining non-cancelable lease terms in excess of one year as of September 30, 1993. (Dollars in thousands) Years Ending Operating Capital September 30, Leases Leases Total 1994 . . . . . . . . . $ 4,840 $ 577 $ 5,417 1995 . . . . . . . . . 4,224 402 4,626 1996 . . . . . . . . . 3,597 218 3,815 1997 . . . . . . . . . 2,832 74 2,906 1998 . . . . . . . . . 2,044 - 2,044 1999 and after . . . . . 5,768 - 5,768 Total minimum payments . . . . . . . $ 23,305 1,271 $ 24,576 Amount representing interest ( 192) Capital lease obligations 1,079 Less current portion ( 462) Long-term capital lease obligations $ 617 The cost and related accumulated depreciation of equipment under capital leases as of September 30, 1993, was $2,010,000 and $1,308,901, respectively, and at September 30, 1992 was $2,979,000 and $1,107,000, respectively. Certain of the leases provide that the Company pay utilities, maintenance, property taxes, and certain other operating expenses applicable to the leased property, including liability and property damage insurance. The lease for the Company's existing manufacturing facility in Reno extends through 2001. The lease provides for periodic rental increases. The total rental expense for the fiscal years ended September 30, 1993, 1992 and 1991 was approximately $4,753,000, $5,746,000 and $4,562,000, respectively. 9. Contingencies The Company has been named in and brought lawsuits in the normal course of its business. Management does not expect the outcome of these suits to have a material adverse effect on the Company's financial position or results of future operations. 10. Related Party Transactions Members of the Company's Board of Directors A member of the Company's Board of Directors is an officer of, and has INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Related Party Transactions (continued) an equity interest in, a Nevada gaming business from which the Company recognized revenues of $889,000, $549,000 and $623,000 during the fiscal years ended September 30, 1993, 1992 and 1991, respectively. The Company had contracts and accounts receivable balances from this customer of $836,000 and $724,000 at September 30, 1993 and 1992, respectively. He is also a director and officer of a parent to four additional gaming businesses in Nevada, from which the Company recognized revenues of $3,727,000, $3,668,000 and $7,478,000 during the fiscal years ended September 30, 1993, 1992 and 1991, respectively. The Company had contracts and accounts receivable balances from these businesses of $804,000 and $97,000 at September 30, 1993 and 1992, respectively. Additionally, a member of the Company's Board of Directors is the Chairman of the Board of a Nevada gaming business from which the Company recognized revenues of $2,064,000, $631,000, and $229,000 during the fiscal years ended September 30, 1993, 1992 and 1991, respectively. The Company had contracts and accounts receivable balances from this business of $15,000 at both September 30, 1993 and 1992. Riverboat Operations The Company had an equity ownership interest in riverboat operations based in Davenport, Iowa and St. Louis, Missouri (see Note 12). The Company recognized revenues from sales to these operations, net of intercompany eliminations for its equity ownership, of $179,000 and $3,778,000 during the fiscal years ended September 30, 1992 and 1991, respectively. The Company had accounts and notes receivable from these businesses of $4,196,000 at September 30, 1992. The Company made loans totalling $11.8 million during the fiscal year ended September 30, 1991, to the partnerships which manage the riverboat operations. Each of the loans included interest at 13%, with annual payments of principal and interest. The principal balance outstanding on the notes at September 30, 1992, was $13,167,000. The Company accrued interest income related to these loans totalling $393,000, $1,645,000 and $757,000 during the fiscal years ended September 30, 1993, 1992 and 1991, respectively. The loans and accrued interest receivable were paid from the proceeds of the public offering discussed in Note 12. 11. Debt Offering In May 1991, the Company completed a $115,000,000 public offering of 5-1/2% Convertible Subordinated Notes (the "Notes") maturing June 1, 2001. The Notes are convertible at the option of the holder at any time prior to maturity, unless previously redeemed, into common stock of the Company at a conversion rate of 129.384 shares per each $1,000 principal amount, subject to adjustments in certain events. During fiscal 1993 and 1992, notes with a face amount of $42,719,000 and $85,000 were converted to 5,527,133 and 10,998 shares of the Company's common stock, respectively. The Notes may be redeemed by the Company on or after June 1, 1994, in INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Debt Offering (continued) whole at any time, or in part from time to time, at specified percentages, graduating annually, of principal amount due at maturity together with accrued and unpaid interest to the date of redemption. Interest payments at 5-1/2% are payable semiannually. The Notes were issued at a price of 80.055% of the principal amount due at maturity, representing an original issue discount of 19.945% from the principal amount payable at maturity. The 5-1/2% semiannual interest payments and the original issue discount represent a yield of 8.5% per annum. The Notes are subordinated to prior payment in full of all senior indebtedness of the Company as defined in the indenture governing the Notes, including such indebtedness incurred in the future by the Company and its subsidiaries. Net proceeds from the issue and sale of the Notes were $89,426,800. Approximately $18 million of the proceeds were used to repay indebtedness. The remainder of the proceeds will be used for general corporate purposes, including capital expenditures and working capital. 12. Discontinued Operations In connection with the Company's focus on gaming machine manufacture and proprietary software systems development, the Company has divested its investments in casino operations during fiscal 1993 through the sale of its interest in CMS and President Riverboat Casinos, Inc. ("PRC"). The disposition of these investments has been accounted for as discontinued operations. The revenues from these operations totaled $34,807,000, $35,849,000 and $33,865,000 for fiscal years 1993, 1992 and 1991, respectively. The separate sales transactions of these investments are described below. Riverboat Operations During December 1992, the Company transferred 100% of its ownership interest in three riverboat partnerships to PRC. In exchange for the transfer of its ownership interests, the Company received 1,671,429 shares of PRC common stock representing an approximate 32% ownership of PRC. The Company, under a selling agreement with the principal stockholders of PRC, offered all of its 1,671,429 shares of PRC common stock as a selling shareholder in the initial public offering ("IPO") of PRC, effective December 17, 1992. The Company received proceeds from the IPO of $28.7 million and recognized a pre-tax gain of $23.6 million on the sale. PRC additionally repaid $16.2 million in outstanding notes to the Company, plus all accrued interest. CMS International Effective September 30, 1993, the Company sold its equity ownership interest in CMS to Summit Casinos-Nevada, Inc., ("Summit"), whose owners include senior management of CMS. The sale consisted of $750,000 in cash for the Company's ownership of CMS's preferred stock and $250,000 in cash and a note of $2,043,529 for CMS's common stock. Additionally, the Company acquired a stock purchase warrant entitling the Company to purchase a 4.84% INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Discontinued Operations (continued) of CMS at a per share price approximately equal to the book value of CMS ("the CMS Warrant"). The CMS Warrant, which expires on the earlier of September 30, 2003 or the closing of an underwritten public offering of CMS, is exchangeable for a Warrant to purchase shares of common stock of any other affiliate of Summit which proposes an underwritten public offering of its common stock. The Company recognized a pre-tax loss of approximately $2.0 million on the sale and will remain as guarantor on certain indebtedness of CMS, which had at September 30, 1993 an aggregate balance of $18.6 million. The notes that have been guaranteed are also collateralized by the respective casino properties. Summit has agreed to indemnify and hold the Company harmless against any liability arising under these guarantees. Management believes the likelihood of losses relating to these guarantees is remote. The composition of income from discontinued operations in fiscal 1993 is as follows: (Dollars in Thousands) Riverboat CMS Operations Int'l Total Income from operations. . . . . $ 245 $ 717 $ 962 Gain (loss) on disposal . . . . 23,586 ( 1,956) 21,630 Income (loss) on discontinued operations before taxes . . . . 23,831 ( 1,239) 22,592 Income tax (provision) benefit . . . . . . . . . . . . ( 9,573) 428 ( 9,145) Income (loss) on discontinued operations, net of taxes. . . . $ 14,258 $( 811) $ 13,447 13. EDT Common Stock On January 31, 1992, the stockholders of EDT, previously a 43% owned subsidiary of the Company, approved the exchange of 57% of the EDT common stock owned by the public for common stock of the Company. Under the exchange agreement, the market value of the Company's stock used in the conversion was equal to the average of the per share closing prices of the Company's stock on the NYSE for the ten consecutive days ending on the sixth trading day immediately preceding the January 31, 1992, EDT stockholders meeting at which the exchange was approved. As defined, the average price of the Company's stock applied on the conversion date was $49.65, as adjusted to reflect two-for-one stock splits effective March 24, 1992 and March 17, 1993. Accordingly, the outstanding EDT public shares were converted to approximately 876,000 shares of the Company's common stock and EDT became a wholly-owned subsidiary of the Company. The operations of EDT have been merged into those of IGT-North America. 14. Disposition of Other Operations The route and Megapoker operations and Keno systems business were sold during fiscal 1992 and 1993. The Company's route and Megapoker operations INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. Disposition of Other Operations (continued) were sold to Jackpot Enterprises, a Nevada corporation in August and November of 1992, respectively. The route operations included all the route equipment and operating contracts for the Nevada participation locations involving approximately 1,380 gaming machines in 160 locations. This sale resulted in a net loss of $893,000. The Megapoker sale included all gaming services and associated equipment used on the Megapoker route along with licenses for all Megapoker software, trademarks, and tradenames. A net gain of $242,000 was realized on this sale. In the first quarter of 1993, the Company completed the sale of its computerized keno system business to Imagineering Systems, Inc. of Reno, Nevada. All development, manufacturing, sales and service functions for the keno systems were included in the sale. The sale did not have a material effect on the Company's consolidated financial statements. 15. Supplemental Statement of Cash Flows Information Certain noncash investing and financing activities are not reflected in the consolidated statements of cash flows. The Company incurred capital lease obligations to obtain property, plant and equipment in the years ended September 30, 1993, 1992 and 1991 of $46,000, $1,429,000, and $651,000, respectively. Additionally, the Company exchanged common stock of the Company for EDT common stock (see Note 13). The Company had no additions to long-term notes payable during the fiscal years ended September 30, 1993 and 1992. In fiscal 1991 the Company recorded additions to long-term notes payable of $58,000. Payments of interest for the years ended September 30, 1993, 1992 and 1991 were $12,030,000, $12,132,000 and $6,803,000, respectively. Payments for income taxes for the years ended September 30, 1993, 1992 and 1991 were $65,699,000, $31,825,000 and $12,045,000, respectively. During fiscal 1993 and 1992 notes with a face amount of $42,719,000 and $85,000 were converted to 5,527,133 and 10,998 shares of the Company's common stock, respectively. The Company had dividends declared, but not yet paid at September 30, 1993 totaling $3,746,000. The tax benefit of stock options totaled $20,147,000, $12,358,000 and $1,810,000 for the years ended September 30, 1993, 1992, and 1991, respectively. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. Selected Quarterly Financial Data (Unaudited) (Dollars in thousands, except per share amounts and stock prices) First Qtr Second Qtr Third Qtr Fourth Qtr Total revenues. . . . $ 52,442 $ 56,819 $ 61,033 $ 62,708 Income from operations 7,130 10,576 10,884 11,653 Income from continuing operations . . . . . 5,461 7,374 7,817 9,128 Income (loss) from discontinued operations . . . . 61 ( 1,415) 34 61,458 Net income. . . . . . 5,522 5,959 8,163 10,586 Primary earnings per share: Income from continuing operations . . . . . $ .05 $ .06 $ .07 $ .08 Income (loss) from discontinued operations . . . . .00 ( 01) .00 .01 Net income . . . . . $ .05 $ .05 $ .07 $ .09 Stock price High . . . . . . . . $ 2-1/8 $ 3-3/4 $ 6-1/8 $ 7-1/4 Low . . . . . . . . 1-1/8 1-7/8 3-3/8 5-1/2 First Qtr Second Qtr Third Qtr Fourth Qtr Total revenues. . . . $ 65,163 $ 66,835 $114,043 $ 117,553 Income from operations 13,826 17,528 33,089 36,459 Income from continuing operations . . . . . 9,909 11,551 19,476 22,348 Income (loss) from discontinued operations . . . . 613 ( 564) 497 954 Net income. . . . . . 10,522 10,987 19,973 23,302 Primary earnings per share: Income from continuing operations . . . . . $ .08 $ .10 $ .16 $ .18 Income (loss) from discontinued operations . . . . .01 ( .01) .00 .01 Net income . . . . . $ .09 $ .09 $ .16 $ .19 Stock price High . . . . . . . . $ 12 $ 17-3/8 $ 17-1/8 $ 22-1/8 Low . . . . . . . . 6-1/4 10-7/8 11-1/4 12-7/8 (continued) INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. Selected Quarterly Financial Data (Unaudited) (Dollars in thousands, except per share amounts and stock prices) (continued from previous page) First Qtr Second Qtr Third Qtr Fourth Qtr Total revenues. . . . $ 87,264 $ 98,721 $131,987 $ 160,058 Income from operations 25,191 27,468 42,315 55,264 Income from continuing operations . . . . . 21,180 18,878 29,647 35,873 Income (loss) from discontinued operations . . . . 14,369 ( 139) 363 ( 1,146) Net income . . . . . 35,549 18,739 30,010 34,727 Primary earnings per share: Income from continuing operations . . . . . $ .17 $ .15 $ .24 $ .29 Income (loss) from discontinued operations . . . . .12 .00 .00 ( .01) Net income . . . . . $ . 29 $ .15 $ .24 $ .28 Stock price High . . . . . . . . $ 26-3/8 $ 33 $ 39-3/4 $ 41-3/8 Low . . . . . . . . 17-7/8 23-3/4 28-1/2 32-1/8 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 17. Fair Value of Financial Instruments The following table presents the carrying amount and estimated fair value of the Company's financial instruments in accordance with Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments." September 30, 1993 Carrying Estimated Amount Fair Value Assets: Cash and cash equivalents. . . . . . . . . $ 85,346 $ 85,346 Short term investments . . . . . . . . . . 131,994 147,123 Investments to fund liabilities to Jackpot winners. . . . . . . . . . . . . 92,048 108,027 Notes and contracts receivable . . . . . . 107,581 127,458 Liabilities: Convertible subordinated notes payable. . . . . . . . . . . . . . . . . 59,998 379,219 Liabilities to Jackpot winners . . . . . . 92,768 108,747 Notes payable and capital lease obligations. . . . . . . . . . . . . . . 1,079 1,079 The carrying value of cash and cash equivalents, short term investments to fund liabilities to jackpot winners, accounts receivable, accounts payable, and notes payable and capital lease obligations approximate fair value because of the short term maturity of those instruments. The estimated fair value of short term investments, long term investments to fund liabilities to jackpot winners, and the convertible subordinated notes payable are based on quoted market prices. The fair value of the Company's notes and contracts receivable is estimated by discounting the future cash flows using interest rates determined by management to reflect the credit risk and remaining maturities of the related notes and contracts. In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk such as performance bonds and other guarantees, which are not reflected in the accompanying balance sheets. Management does not expect any material losses to result from these off- balance-sheet instruments. 18. Concentrations of Credit Risk The financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts, contracts, and notes receivable. The Company maintains cash and cash equivalents with various financial institutions in amounts, which at times, may be in excess of the FDIC insurance limits. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. Concentrations of Credit Risk (continued) Product sales and the resulting receivables are concentrated in specific legalized gaming regions. The Company also distributes a significant portion of its products through third party distributors resulting in significant distributor receivables. At September 30, 1993 accounts, contracts, and notes receivable by region as a percentage of total receivables are as follows: Regions Nevada . . . . . . . . . . . . 29.3% Riverboats (greater Mississippi River area). . . 18.6% Indian Casinos (distributor) . 11.1% Colorado . . . . . . . . . . . 8.8% Louisiana (distributor). . . . 6.5% 19. Subsequent Event - Agreement to Purchase 78 acres The Company has entered into an agreement to purchase approximately 78 acres for $78,571 per acre or a total price of approximately $6,129,000. The closing of this purchase is subject to the seller receiving certain approvals from the City of Reno including approval to include the acquired parcel within the existing South Meadows Properties Planned Unit Development. Closing is expected to occur in the quarter ending March 31, 1994. The property has been purchased as a site suitable for future construction of expanded manufacturing, warehouse and corporate office facilities. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Items 10, 11, 12 and 13 is incorporated by reference from the 1994 Proxy Statement to be filed with the Securities and Exchange Commission within 120 days of the end of the fiscal year covered by this report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Consolidated Financial Statements: Reference is made to the Index to Financial Statements and Related Information under item 8 in Part II hereof where these documents are listed. (a)(2) Consolidated Financial Statement Schedules: Page I Marketable Securities-Other Security Investments 62 II Amounts receivable from related parties and underwriters, promoters, and employees other than related parties 63 IV Indebtedness of Related Parties 64 VIII Valuation and Qualifying Accounts 65 IX Short-term Borrowings 67 X Supplementary Income Statement Information 67 Parent Company Financial Statements - Financial Statements of the Registrant only are omitted under Rule 3-05 as modified by ASR 302. (a)(3) Exhibits 3.1 Articles of Incorporation of International Game Technology, as amended. 3.2 Second Restated Code of Bylaws of International Game Technology, dated November 11, 1987. 4.1 Indenture for the 5-1/2% Convertible Subordinated Notes due June 1, 2001 (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-3 No. 33-39856 filed by the Registrant) 4.2 Form of Convertible Subordinated Notes due June 1, 2001 (incorporated by reference to Exhibit 4.1 to Form 10-K for the year ended September 30, 1991.) PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (continued) 10.1 Stock Option Plan for Key Employees of International Game Technology, as amended (incorporated by reference to Exhibit 10.26 to Registration Statement No. 33-12610 filed by Registrant). 10.2 International Game Technology 1993 Stock Option Plan (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8, File No. 33-69400 filed by the Registrant). 10.3 Employee Stock Purchase Plan (incorporated by reference to Exhibit 28.1 to Registration Statement on Form S-8, File No. 33-20308 filed by the Registrant). 10.4 Route Operating and Purchase Agreement and Megapoker Distribution Agreement dated August 14, 1992, by and between International Game Technology and Jackpot Enterprises, Inc. (incorporated by reference to Exhibit 10.3 to Form 10-K for the year ended September 30, 1992). 10.5 Exclusive Distributorship Agreement dated May 5, 1993, between IGT and Sodak Gaming, Inc. 10.6 Underwriting Agreement dated December 10, 1992, between President Riverboat Casinos, Inc. and International Game Technology (incorporated by reference to Exhibit 10.15 of Form 10-K for the year ended September 30, 1992). 10.7 Stock Purchase and Redemption Agreement dated December 4, 1992, by and between International Game Technology and Golden Eagle Casinos International (renamed Summit Casinos International, Inc.)(incorporated by reference to Exhibit 10.6 of Form 10-K for the year ended September 30, 1992). 10.8 First Amendment to Stock Purchase and Redemption Agreement between International Game Technology and Golden Eagle Casinos International (renamed Summit Casinos International, Inc.) dated March 15, 1993. 10.9 Second Amendment to Stock Purchase and Redemption Agreement between International Game Technology and Summit Casinos International, Inc. (formerly named Golden Eagle Casinos International) dated March 24, 1993. 11 Computation of Earnings Per Share 22 Subsidiaries 24 Independent Auditors' Consent 25 Power of Attorney (See page 63 hereof) (b) Reports on Form 8-K No report on Form 8-K was filed during the three-month period ended September 30, 1993. POWER OF ATTORNEY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 21st day of December, 1993. INTERNATIONAL GAME TECHNOLOGY By:s/John J. Russell John J. Russell Director, President, Chief Executive Officer and Chief Operating Officer Each person whose signature appears below hereby authorizes G. Thomas Baker and Scott H. Shackelton, or either of them, as attorneys-in-fact to sign on his behalf, individually, and in each capacity stated below, and to file all amendments and/or supplements to this Annual Report on Form 10-K. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated. Signature Title Date s/Charles N. Mathewson Chairman, Board of December 22, 1993 Charles N. Mathewson Directors s/John J. Russell Director, President, December 22, 1993 John J. Russell Chief Executive Officer and Chief Operating Officer s/G. Thomas Baker Vice President Finance December 22, 1993 G. Thomas Baker and Chief Financial Officer (Principal Financial Officer) s/Scott H. Shackelton Chief Accounting Officer December 22, 1993 Scott H. Shackelton (Principal Accounting Officer) Director December 22, 1993 Warren L. Nelson s/Wilbur K. Keating Director December 22, 1993 Wilbur K. Keating s/Frederick B. Rentschler Director December 22, 1993 Frederick B. Rentschler s/Albert J. Crosson Director December 22, 1993 Albert J. Crosson Director December 22, 1993 Claudine B. Williams INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE I - CONSOLIDATED MARKETABLE SECURITIES-OTHER SECURITY INVESTMENTS September 30, 1993 (Dollars in Thousands) ORIGINAL MARKET CARRYING TYPE OF INVESTMENT COST VALUE VALUE Fixed Maturities: Corporate bonds: Investment firms . . . . . . . $ 5,155 $ 5,383 $ 5,146 Chemical . . . . . . . . . . . 2,300 2,220 2,217 Entertainment. . . . . . . . . 4,690 4,687 4,631 Banking . . . . . . . . . . . 8,744 8,890 8,666 Financial services . . . . . . 5,434 5,407 5,359 General industry . . . . . . . 3,976 4,188 3,984 Municipals . . . . . . . . . . 5,153 5,105 5,099 Retailers. . . . . . . . . . . 3,179 3,164 3,110 Transportation . . . . . . . . 5,297 5,325 5,245 Total Corporate Bonds . . . . . 43,928 44,369 43,457 Equity Securities: Chemicals. . . . . . . . . . 2,404 2,500 2,404 Financial services . . . . . . 2,192 2,255 2,192 Banking . . . . . . . . . . . 10,266 11,587 10,266 Food service . . . . . . . . . 1,000 1,090 1,000 General industry . . . . . . . 5,735 5,680 5,735 Leisure industry . . . . . . . 7,786 16,488 7,786 Transportation . . . . . . . . 4,825 5,221 4,825 Utilities. . . . . . . . . . . 1,000 1,070 1,000 Total Equity Securities . . . . 35,208 45,891 35,208 U.S. Government and agency obligations. . . . . . . . . . 36,226 39,001 36,136 Foreign government obligations. 3,761 3,796 3,761 Managed funds . . . . . . . . . 6,509 6,767 6,509 Mutual funds. . . . . . . . . . 5,925 6,304 5,925 Mortgage-backed instruments . . 995 995 998 Total investment in marketable securities . . . . . . . . . . $132,552 $147,123 $131,994 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE II - CONSOLIDATED AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (Dollars in Thousands) Balance at Balance at End of Period Beginning Non Name of Debtor of Period Additions Deductions Current Current Robert McMonigle(1) Year Ended 9/30/93 $ - $191 $ - $ 191 $ - (1) On September 23, 1993 the Company made a loan to enable Mr. McMonigle, an employee, to exercise certain stock options. This note bears no interest and was repaid on October 5, 1993. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE IV - CONSOLIDATED INDEBTEDNESS OF RELATED PARTIES (Dollars in thousands) INDEBTEDNESS OF: Current Balance at Balance Portion Beginning at End at End Name of Person of Period Additions Deductions of Period of Period Warren Nelson, Board of Directors(1) Year ended 9/30/91 $ 2,906 $ 5,407 $ 6,797 $ 1,516(2) $ 1,495 Year ended 9/30/92 $ 1,516 $ 4,105 $ 4,897 $ 724(2) $ 690 Year ended 9/30/93 $ 724 $ 4,070 $ 3,946 $ 848(2) $ 814 The Connelly Group(1) Year ended 9/30/91 $ - $17,913(3)$ 351 $17,562(4) $ 1,608 Year ended 9/30/92 $17,562 $ 1,963(3)$ 2,061 $17,464(4) $ 1,209 Year ended 9/30/93 $17,464 $ 393 $17,857 $ - $ - (1) See Note 10 of Notes to the Consolidated Financial Statements. (2) Included in long-term notes and contracts receivable. (3) Resulted from sales to riverboat operations managed by and loans to The Connelly Group partnerships. (4) Included in long-term notes and contracts receivable and long-term notes receivable from unconsolidated affiliates. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE VIII - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS (Dollars in thousands) Balance at Accounts Balance Beginning Written at End of Period Provisions Recoveries Off of Period Allowance for Doubtful Accounts: Year ended 9/30/91 $2,931 $2,248 $ 36 $1,611 $3,604 Year ended 9/30/92 $3,604 $3,764 $ 25 $ 335 $7,058 Year ended 9/30/93 $7,058 $3,240 $ 420 $2,783 $7,935 Allowance for Doubtful Notes and Contracts Receivable: Year ended 9/30/91 $4,201 $2,636 $ 135 $ 924 $6,048 Year ended 9/30/92 $6,048 $ 916 $ 288 $ 453 $6,799 Year ended 9/30/93 $6,799 $2,006 $ 208 $ 62 $8,951 Balance at Balance Beginning Income Income at End of Period Deferred Recognized of Period Income Deferred under the Installment Method: Year ended 9/30/91 $ 142 $ 689 $ 330 $ 501 Year ended 9/30/92 $ 501 $ - $ 200 $ 301 Year ended 9/30/93 $ 301 $ - $ 280 $ 21 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE VIII - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS (continued) (Dollars in thousands) Inventories Balance at Disposed Balance Beginning of and at End of Period Provisions Written Off of Period Obsolete Inventory Reserve: Year ended 9/30/91 $2,917 $8,821 $6,995 $4,743 Year ended 9/30/92 $4,743 $6,030 $2,978 $7,795 Year ended 9/30/93 $7,795 $ 981 $1,660 $7,116 Fixed Assets Balance at Disposed Balance Beginning of and at End of Period Provisions Written Off of Period Obsolete Fixed Assets Reserve: Year ended 9/30/91 $ 548 $ 157 $ 355 $ 350 Year ended 9/30/92 $ 350 $ 489 $ 542 $ 297 Year ended 9/30/93 $ 297 $ 634 $ 664 $ 267 INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE IX - CONSOLIDATED SHORT-TERM BORROWING (Dollars in thousands) Weighted Maximum Average Average Weighted Amount Amount Interest Balance Average Outstanding Outstanding Rate at End Interest During During During of Period Rate Period Period* Period** Advances under lines of credit: Year ended 9/30/91 $ - - % $13,350 $ 6,253 9.1% Year ended 9/30/92 $ - - % $ - $ - - % Year ended 9/30/93 $ - - % $ - $ - - % * Average of month-end balances. ** Computed on outstanding month-end balances during the period. INTERNATIONAL GAME TECHNOLOGY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION EXPENSE ITEMS IN EXCESS OF ONE PERCENT OF TOTAL REVENUES: (Dollars in thousands) AMOUNT CHARGED TO COSTS AND EXPENSES FISCAL YEARS ENDED SEPTEMBER 30 1993 1992 1991 1. Advertising and promotions $3,069 $2,951 $2,431

92416_1993.txt

92416_1993

1993

92416

ITEM 1. BUSINESS The registrant, Southwest Gas Corporation (the Company), is incorporated under the laws of the State of California effective March 10, 1931, and is comprised of two segments: natural gas operations and financial services. The natural gas operations segment (gas segment) includes natural gas transmission and distribution operations in Arizona, Nevada and California. The financial services segment consists of PriMerit Bank (the Bank), a wholly owned subsidiary, which operates principally in the thrift industry. See Selected Financial Data for financial information related to each business segment. The executive offices of the Company are located at 5241 Spring Mountain Road, P.O. Box 98510, Las Vegas, Nevada 89193-8510, telephone number (702) 876-7237. NATURAL GAS OPERATIONS GENERAL DESCRIPTION The Company is subject to regulation by the Arizona Corporation Commission (ACC), the Public Service Commission of Nevada (PSCN) and the California Public Utilities Commission (CPUC). These commissions regulate public utility rates, practices, facilities and service territories in their respective states. The service areas certificated to the Company by the respective regulatory commissions having jurisdiction over it are exclusive. They remain exclusive unless the Company defaults on its obligations to provide adequate service and another utility can be found that is willing and able to supply the service. The CPUC also regulates the issuance of all securities by the Company, with the exception of short-term borrowings. Certain of the Company's accounting practices, transmission facilities and rates are subject to regulation by the Federal Energy Regulatory Commission (FERC). The Company purchases, transports and distributes natural gas to 932,000 residential, commercial and industrial customers in geographically diverse portions of Arizona, Nevada and California. There were 35,000 customers added to the system during 1993. The Company expects to add approximately 36,000 customers by the end of 1994. See Natural Gas Operations Segment -- Capital Resources and Liquidity of Management's Discussion and Analysis (MD&A) for discussion of capital requirements to meet this growth. The table below lists the Company's percentage of operating margin (operating revenues less net cost of gas) by major customer class for the years indicated: The volume of sales and transportation activity for electric utility generating plants varies greatly according to demand for electricity and the availability of alternative energy sources; however, it is not material in relation to the Company's earnings. In addition, the Company is not dependent on any one or a few customers to the extent that the loss of any one or several would have a significant adverse impact on the Company. Transportation of customer-secured gas to end-users on the Company's system continues to have a significant impact on the Company's throughput, accounting for 46 percent of total system throughput in 1993. Although the volumes were significant, these customers provide a much smaller proportionate share of the Company's operating margin as indicated in the table above. In 1993, there were 96 customers throughout the Company's service territories who utilized this service, transporting 725 million therms. The demand for natural gas is seasonal, and it is management's opinion that comparisons of earnings for interim periods do not reliably reflect overall trends and changes in the Company's operations. Also, earnings for interim periods can be significantly affected by the timing of general rate relief. PROPERTIES The plant investment of the Company consists primarily of transmission and distribution mains, compressor stations, peak shaving/storage plants, service lines, meters and regulators which comprise the pipeline systems and facilities located in and around the communities it serves. The Company also includes other properties such as land, buildings, furnishings, work equipment and vehicles in plant investment. In addition, the Company leases several properties, including a Liquefied Natural Gas (LNG) storage plant on its northern Nevada system and a portion of the corporate headquarters office complex located in Las Vegas, Nevada. See Note 9 of the Notes to Consolidated Financial Statements for additional discussion regarding these leases. Total gas plant, exclusive of leased property, at December 31, 1993, was $1.4 billion, including construction work in progress. It is the opinion of management that the properties of the Company are suitable and adequate for its purposes. Substantially all of the Company's gas mains and service lines are constructed across property owned by others under right-of-way grants obtained from the record owners thereof, on the streets and grounds of municipalities under authority conferred by franchises or otherwise, or on public highways or public lands under authority of various federal and state statutes. None of the Company's numerous county and municipal franchises are exclusive, and some are of limited duration. These franchises are renewed regularly as they expire, and the Company anticipates no serious difficulties in obtaining future renewals. With respect to the right-of-way grants, the Company has had continuous and uninterrupted possession and use of all such rights-of-way, and the associated gas mains and service lines, commencing with the initial stages of the construction of such facilities. Permits have been obtained from public authorities in certain instances to cross, or to lay facilities along, roads and highways. These permits typically are revocable at the election of the grantor, and the Company occasionally must relocate its facilities when requested to do so by the grantor. Permits have also been obtained from railroad companies to cross over or under railroad lands or rights-of-way, which in some instances require annual or other periodic payments and are revocable at the grantors' elections. The Company operates two major pipeline transmission systems: (i) a system owned by Paiute Pipeline Company (Paiute), a wholly owned subsidiary of the Company, extending from the Idaho-Nevada border to the Reno, Sparks and Carson City areas and communities in the Lake Tahoe area in both California and Nevada and other communities in northern and western Nevada; and (ii) a system extending from the Colorado River at the southern tip of Nevada to the Las Vegas distribution area. The Company's northern Nevada and northern California properties are referred to as the northern system. The Company serves various communities in northern Nevada including Carson City, Elko, Fallon, Fernley, Lovelock, Winnemucca and Yerington. The Company also provides service to the north Lake Tahoe area. In addition, the Company also owns a Liquefied Petroleum Gas (LPG) facility located near Reno, Nevada. The Arizona, southern Nevada and southern California properties of the Company are referred to as the southern system. The Company's service areas in Arizona include most of the central and southern areas of the state including Phoenix, Tucson, Yuma and surrounding communities. Service is provided in southern Nevada throughout the Las Vegas valley and Bullhead City. Communities served by the Company in southern California include Barstow, Big Bear, Needles and Victorville. The Company also owns a 35,000 acre site in northern Arizona which was acquired for the purpose of constructing an underground natural gas storage facility, known as the Pataya Gas Storage Project (Pataya), to serve its southern system. Based upon current studies and the continued restructuring of the natural gas industry, the Company believes that it will need an underground natural gas storage facility, such as Pataya, in the future to meet the needs of its customers on the southern system. In addition to the gas storage facility, the Company is considering other opportunities for other portions of the site, such as the partial sale of its water rights. Other potential uses for the land include sites for solar generating facilities, cogeneration facilities and various other business ventures. Project costs of $11.1 million have been capitalized through December 1993 and include land acquisition and related development costs. RATES AND REGULATION Rates that the Company is authorized to charge its distribution system customers are determined by the ACC, CPUC and PSCN in general rate cases and are derived using rate base, cost of service and cost of capital experienced in a historical test year, as adjusted in Arizona and Nevada, and projected for a future test year in California. The FERC regulates the northern Nevada transmission and LNG storage facilities of Paiute and the rates it charges for transportation of gas directly to certain end-users and to various local distribution companies (LDCs). The LDCs transporting on Paiute's system are: Sierra Pacific Power Company (Reno and Sparks, Nevada), Washington Water Power Company (South Lake Tahoe, California) and Southwest Gas Corporation (North Lake Tahoe, California and various locations throughout northern Nevada). Rates charged to customers vary according to customer class and are fixed at levels allowing for the recovery of all prudently incurred costs, including a return on rate base sufficient to pay interest on debt and a reasonable return on equity. The Company's rate base consists generally of the original cost of utility plant in service, plus certain other assets such as working capital and inventories, less accumulated depreciation on utility plant in service, net deferred income tax liabilities, and certain other deductions. The Company's rate schedules in all of its service areas contain purchased gas adjustment (PGA) clauses which permit the Company to adjust its rates as the cost of purchased gas changes. Generally, the Company's tariffs provide for annual adjustment dates for changes in purchased gas costs. However, the Company may request to adjust its rates more often than once each year, if conditions warrant. These changes have no significant impact on the Company's profit margin. Except for California, the Company is allowed to make a general rate case filing whenever management believes there is a need for additional rate relief. Within California, general rate case filings are required every three years, and attrition filings are made annually for the interim periods. The table below lists the docketed rate filings initiated and/or completed within each ratemaking area in 1993 and the first quarter of 1994: - --------------- (1) See Natural Gas Operations Segment -- Rates and Regulatory Proceedings of MD&A for a discussion of the Company's motion for reconsideration and the PSCN's decision to rehear several rate case issues. (2) Interim rates reflecting the increased revenues became effective in April 1993. However, the rates are subject to refund until a final order is issued. See Natural Gas Operations Segment - Rates and Regulatory Proceedings of MD&A for a discussion of each of the Company's recent rate filings. COMPETITION Electric utilities are the Company's principal competitors for the residential and small commercial markets throughout the Company's service areas. Competition for space heating, general household and small commercial energy needs generally occurs at the initial installation phase when the customer typically makes the decision as to which type of equipment to install and operate. The customer will generally continue to use the chosen energy source for the life of the equipment due to its relatively high replacement cost. As a result of its success in these markets, the Company has experienced consistent growth among the residential and small commercial customer classes. Unlike residential and small commercial customers, certain large commercial, industrial and electric generation customers have the capability to switch to alternative energy sources. Rates for these customers are set at levels competitive with alternative energy sources such as fuel oils and coal. The Company has been able to maintain the maximum allowable prices for most of its alternate fuel capable customers. As a result of the Company's continued success in these competitive situations, management does not anticipate any material adverse impact on its operating margin. The Company maintains no backlog on its orders for gas service. The Company continues to compete with interstate transmission pipeline companies, such as El Paso Natural Gas Company (El Paso) and Kern River Gas Transmission Company (Kern River), to provide service to end-users. End-use customers located in close proximity to these interstate pipelines pose a potential bypass threat and, therefore, require the Company to closely monitor each customer's situation and provide competitive service in order to retain the customer. The Company has experienced no significant financial impact to date from the threat of bypass, although industry restructuring as a result of the capacity release provisions of FERC Order No. 636 could increase the viability of enduse customer bypass directly to interstate pipeline companies. A new interstate pipeline company, Tuscarora Gas Transmission Company (Tuscarora), has applied for FERC certification to build a pipeline which would compete with Paiute's fully subscribed pipeline by providing transportation services within a portion of Paiute's current service area. The FERC, which has jurisdiction over interstate gas pipelines, is currently reviewing the application. A final decision from the FERC is expected in late 1994. Tuscarora's primary proposed customer would be Sierra Pacific Power Company (Sierra), Paiute's largest customer and an entity which is affiliated with Tuscarora. Sierra has indicated it would utilize the Tuscarora pipeline, if it is constructed, for transportation of a significant portion of its natural gas requirements related to its electric generation plants and its LDC customers. However, Sierra has also signed a ten-year contract with Paiute, which became effective in February 1993, through which Paiute provides firm transportation service to Sierra for these same electric generation plants and LDC customers. A significant portion of the revenues associated with this long-term contract are fixed, regardless of the volumes transported. During 1993, Sierra contributed $9.7 million, or three percent, of total Company margin. It is not yet known if Tuscarora will proceed with the project. If constructed, competition from the Tuscarora pipeline could affect the future growth of Paiute. However, Sierra has indicated it plans to continue using Paiute for natural gas deliveries, regardless of whether the Tuscarora pipeline is constructed, because of the strong and steady demand for natural gas in the area. Paiute is continuing with its current expansion plans to meet the demands associated with other customer commitments. DEMAND FOR NATURAL GAS Deliveries of natural gas by the Company are made under a priority system established by each regulatory commission having jurisdiction over the Company. The priority system is intended to ensure that the gas requirements of higher-priority customers, primarily residential customers and nonresidential customers who use 50,000 cubic feet of gas per day or less, are fully satisfied on a daily basis before lower-priority customers, primarily electric utility and large industrial customers able to use alternative fuels, are provided any quantity of gas or capacity. Demand for natural gas is greatly affected by temperature. On cold days, use of gas by residential and commercial customers may be as much as eight times greater than on warm days because of increased use of gas for space heating. To fully satisfy this increased high-priority demand, gas is withdrawn from storage, peaking supplies are purchased from suppliers, or service to interruptible lower priority customers is curtailed as necessary to provide the needed delivery system capacity. The industrial and commercial sectors are expected to demand greater quantities of natural gas in meeting new environmental standards enacted by local, state and federal governments. The Clean Air Act Amendments of 1990, for example, set new national clean air standards which will continue to increase the use of natural gas in industrial and power plant boilers, and in the fueling of motor vehicle fleets. A key element of the law allows industries to choose cost-effective options to meet the new standards. The comparatively low cost and clean-burning characteristics of natural gas make it an economical and environmentally safe option for industrial applications. The Company is supplying these expanding markets. NATURAL GAS SUPPLY With respect to natural gas supply, there is a free market for natural gas at the wellhead. During 1991, price ceilings on wells drilled after July 1989 were abolished and the remaining price ceilings on existing wells were abolished in January 1993. The elimination of price ceilings has had no direct impact on the Company because natural gas is selling well below the previous regulatory ceilings, and supplies are adequate. The last few years have generally demonstrated seasonal volatility in the price of natural gas, with higher prices in the heating season and lower prices during the summer or off-peak consumption period. The Company believes that natural gas supplies will remain plentiful and readily available. The Company primarily obtains its gas supplies for its southern system from producing regions in New Mexico (San Juan basin), Texas (Permian basin) and Oklahoma (Anadarko basin). For its northern system, the Company primarily obtains gas from Rocky Mountain producing areas and from Canada. The Company arranges for transportation of gas to its Arizona, Nevada and California service territories through the pipeline systems of El Paso, Kern River, Northwest Pipeline Corporation and Southern California Gas Company (SoCal). The Company continually monitors supply availability on both short-term and long-term bases to ensure the continued reliability of service to its customers. The Company's primary objective with respect to gas supply is to ensure that adequate, as well as economical, supplies of natural gas are available from reliable sources. The Company acquires its gas from a wide variety of sources, including suppliers on the spot market and those who provide firm supplies over short-term and longer-term durations. Balancing firm supply assurances against the associated costs dictate a continually changing natural gas purchasing mix within the Company's supply portfolio. The Company believes its portfolio provides security as well as the operating flexibility needed to meet changing market conditions. During 1993, the Company acquired gas supplies from nearly 60 suppliers. In March 1993, the Company signed a "Wholesale Gas Transportation and Storage Service Agreement" with SoCal, in which SoCal agreed to serve as the Company's primary gas transporter to its southern California jurisdiction. The agreement also provided limited gas storage to the Company for use in its southern California jurisdiction. CPUC approval of the agreement was granted in July 1993. The agreement was effective in August 1993 for an initial period of 15 years. The Company concurrently terminated its relationship with Pacific Gas and Electric Company (PG&E) as its wholesale gas supplier and restructured its tariff to offer a wider array of unbundled sales and transportation services. The Company now secures all of its gas supplies for its southern California jurisdiction directly from suppliers, as it does for its other jurisdictions. Natural Gas Industry Changes. In 1992, the FERC issued Order No. 636 and amendments thereto (Order No. 636). Order No. 636 required open-access interstate pipelines to significantly restructure their services prior to the 1993/94 winter heating season. Open-access interstate pipelines were required to implement a new method of rate design and to provide the information necessary for natural gas buyers and sellers to arrange gas sales and transportation service on a more flexible basis. Additionally, pipelines were required to offer storage as a separate service, and to release this storage, if available, for use by transportation customers. Order No. 636 also required the implementation of a capacity release program whereby shippers can release available pipeline capacity on a temporary or permanent basis. The complete impact of implementation of Order No. 636 on the pipelines servicing the Company is not fully determinable at this time. However, as a result of the new method of rate design, the Company is experiencing higher costs. Management anticipates full recovery of the costs through its PGA provisions. Because of these and other natural gas industry changes, the Company continues to evaluate natural gas storage as an option to enable the Company to take advantage of seasonal price differentials and to otherwise protect the Company from the uncertainties associated with spot market purchases and the Company's need to obtain natural gas from a variety of sources. In November 1992, in order to increase its options concerning gas supplies, the Company and SoCal signed an agreement allowing the Company to use a portion of SoCal's underground natural gas storage facilities, subject to the precedent satisfaction of certain conditions. The agreement, subject to the precedent conditions, would allow the Company to store up to ten billion cubic feet of natural gas in SoCal's storage facilities and provide for firm redeliveries of the storage gas at a maximum rate of 300 million cubic feet of gas per day. The agreement becomes effective, for a term of 15 years, only if certain significant precedent conditions are fully satisfied. The conditions include regulatory approvals, negotiation of agreements with third parties integrally involved in transporting gas to and from the storage facilities, and completion of economic feasibility studies. In November 1993, the CPUC issued a resolution approving the agreement, subject to the condition that the CPUC reserve the right to reevaluate the rates underlying the agreement at any time and at its own discretion. The Company believes the resolution, and the conditions therein, seriously impaired the original long-term intent of the parties, and has formally rejected the resolution. The agreement will, therefore, require modification or cancellation and may be renegotiated to a shorter term than originally desired. There is currently no assurance that the agreement can be successfully renegotiated or that all of the precedent conditions can be satisfactorily resolved. Each of the conditions is significant and, individually or cumulatively, if not satisfactorily resolved, could result in cancellation of this agreement. It is currently anticipated that each of these issues will be addressed during 1994. ENVIRONMENTAL MATTERS The Company's activities do not pollute air, land or water in any significant manner. Accordingly, federal, state and local laws and regulations governing the discharge of materials into the environment have little direct impact upon either the Company or its subsidiaries. The Company is committed to protecting and improving the environment. Management believes that the practices and procedures of the Company are environmentally sound and do not harm the environment in any significant manner. Environmental efforts, with respect to matters such as protection of endangered species and archeological finds, have resulted in the Company spending a greater amount of time in obtaining pipeline rights-of-way and sites for other facilities. However, increased environmental legislation and regulation are also perceived to be beneficial to the natural gas industry. Because natural gas is one of the most environmentally safe fuels currently available, its use will allow energy users to comply with stricter environmental standards. For example, management is of the opinion that legislation, such as the Clean Air Act Amendments of 1990 and the Energy Policy Act of 1992, has a positive effect on natural gas demand, including provisions encouraging the use of natural gas vehicles, cogeneration and independent power production. EMPLOYEES At December 31, 1993, the natural gas operations segment had 2,318 regular full-time employees. The Company believes it has a good relationship with its employees. None of the employees are represented by a union. Reference is hereby made to Item 10 in Part III of this report on Form 10-K for information relative to the executive officers of the Company. FINANCIAL SERVICES ACTIVITIES GENERAL DESCRIPTION The Bank is a federally chartered stock savings bank conducting business through branch offices in Nevada. During 1993, the Bank exited the metropolitan Phoenix, Arizona market through the sale of its Arizona branch operations. The Bank was organized in 1955 as Nevada Savings and Loan Association which, in 1988, changed its name to PriMerit Bank and its charter from a state chartered stock savings and loan association to a federally chartered stock savings bank. The Bank's deposit accounts are insured to the maximum extent permitted by law by the Federal Deposit Insurance Corporation (FDIC) through the Savings Association Insurance Fund (SAIF). The Bank is regulated by the Office of Thrift Supervision (OTS) and the FDIC, and is a member of the Federal Home Loan Bank (FHLB) system. The Bank's principal business is to attract deposits from the general public and make loans secured by real estate and other collateral to enable borrowers to purchase, refinance, construct or improve such property. Revenues are derived from interest on real estate loans and debt securities and, to a lesser extent, from interest on nonmortgage loans, gains on sales of loans and debt securities, and fees received in connection with loans and deposits. The Bank's major expense is the interest it pays on savings deposits and borrowings. The Bank had been active in single-family residential real estate development until stringent regulatory capital requirements were imposed by the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). The Bank has ceased making further investments in new real estate projects and is divesting its remaining real estate investments. Since December 31, 1989 total assets have declined from $2.8 billion to $1.8 billion at December 31, 1993 as management restructured the balance sheet to more effectively operate under the guidelines of the FIRREA. The decrease is also part of a long-term Strategic Business Plan "right size-right structure" strategy to optimize the Bank's size. While the low interest rate environment has had a beneficial impact on the Bank's cost of funds, it has also accelerated prepayments in the Bank's loan and debt security portfolios as borrowers refinance variable-rate and higher fixed-rate debt with relatively low fixed-rate loans. The replacement of these higher rate assets with lower yielding assets, partially offsets the benefit of the lower cost of funds. The following table sets forth certain ratios for the Bank for each of the periods stated: LENDING ACTIVITIES The Bank's loan portfolio totaled $837 million at December 31, 1993, representing 48 percent of total assets at that date. The loan portfolio consists principally of intermediate-term and long-term real estate loans and, to a lesser extent, secured and unsecured commercial loans, and consumer loans including: credit cards, home improvement, recreational vehicle, mobile home, marine and auto loans. During 1993, the Bank agreed to sell its credit card portfolio and enter into an agent bank relationship with the purchaser to issue credit cards to the Bank's customers. The sale was completed in 1994 at which time the Bank recognized a gain of $1.7 million. The contractual maturity of loans secured by single-family dwellings has historically been 30 years, although in recent years the Bank has made a number of loans with maturities of 23 years or less. As interest rates have declined, particularly during 1992 and 1993, prepayments of existing mortgages have substantially accelerated. The following table sets forth the composition of the loan portfolio by type of loan at the dates indicated (thousands of dollars): - --------------- (1) The Bank's portfolio of construction loans is generally due in one year or less. Loan Origination and Credit Risk One of the Bank's primary businesses is to make and acquire loans secured by real estate and other collateral to enable borrowers to purchase, refinance, construct and improve such property. These activities entail potential credit losses, the size of which depends on a variety of economic factors affecting borrowers and the real estate collateral. While the Bank has adopted underwriting guidelines and credit review procedures to minimize credit losses, some losses will inevitably occur. Therefore, periodic reviews are made of the assets in an attempt to identify and deal appropriately with potential credit losses. The Bank originates both fixed and adjustable-rate loans in the single-family residential, commercial mortgage, and consumer home equity portfolios. The Bank's adjustable-rate loans in these portfolios are based on various indices, including the prime rate, the 11th District cost of funds, the one-year U.S. Treasury yield, and various other indices to a lesser extent. Other consumer loans are generally fixed-rate, while construction and non-real estate commercial loans are generally adjustable-rate prime-based loans. Many of the Bank's adjustable-rate loans contain limitations as to both the amount and the interest rate change at each repricing date (periodic caps) and the maximum rates the loan can be repriced over the life of the loan (lifetime caps). At December 31, 1993, periodic caps in the adjustable loan portfolio ranged from .25 percent to eight percent. Lifetime caps ranged from 9.75 percent to 22 percent. See Financial Services Segment -- Risk Management -- Interest Rate Risk Management of MD&A for the Bank's static gap table which includes the maturity and repricing sensitivity of the Bank's loan portfolio. The Bank's loan policies and underwriting standards are the primary means used to reduce credit risk exposure. The loan approval process is intended to assess both: (i) the borrower's ability to repay the loan by determining whether the borrower meets the established underwriting criteria; and (ii) the adequacy of the proposed collateral by determining whether the appraised value of (and, if applicable, the cash flow from) the collateral property is sufficient for the proposed loan. Under OTS regulations, management is held responsible for developing, implementing and maintaining prudent appraisal policies. The Bank's Credit Administration Department is responsible for adherence to approved lending policies and procedures, including proper approvals, timely completion of quarterly asset reviews, early identification of problem loans, reviewing the quality of underwriting and appraisals, tracking trends in asset quality and evaluating the adequacy of the allowance for credit losses. As part of the regular asset review process, management reviews factors relating to the possibility and magnitude of prospective loan and real estate losses, including historical loss experience, prevailing market conditions and classified asset levels. The Bank is required to classify assets and establish prudent valuation allowances in accordance with OTS regulations. Each loan portfolio contains unique credit risks for which the Bank has developed policies and procedures to manage as follows: Single-Family Residential Lending. Single-family residential mortgage loans comprise 55 percent of the Bank's loan portfolio at December 31, 1993 compared to 55 percent at December 31, 1992. This portfolio represents the largest lending component and is the component which contains the least credit risk. It is the general policy of the Bank not to make single-family residential loans which have a loan-to-value ratio in excess of 80 percent unless insured by private mortgage insurance, Federal Housing Authority (FHA) insurance or guaranteed by the Veterans Administration (VA). Single-family loans are generally underwritten to underwriting guidelines established by FHA, VA, Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA) or preapproved private investors. The Bank requires title insurance on all loans secured by liens on real property. The Bank also requires fire and other hazard insurance be maintained in amounts at least equal to the replacement cost of improvements on all properties securing its loans. If the subject property is located in a flood plain, special flood insurance is required. Consumer Lending. Consumer loans include installment loans secured by recreational vehicles, boats, autos and mobile homes, credit card receivables, home equity loans, and loans secured by deposit accounts. Approximately 86 percent of the consumer loan portfolio is collateralized. The credit risk of the consumer loan portfolio is managed through both the origination function and the collection process. All consumer loan origination and collection efforts, except those secured by deposits, are performed at a central location in order to provide greater control in the process and a more uniform application of credit standards. The Bank originates a majority of its installment loans through automobile, recreational vehicle and marine vehicle dealers. These loans are subject to underwriting by Bank personnel. Additionally, credit reviews of the dealers are performed on a periodic basis. The Bank utilizes a bankruptcy predictor model to assist in the analysis of loan applications and credit reports. Additionally, as a follow up to the application process, a review of selected originations is performed to monitor adherence to credit standards. Commercial and Construction. The commercial and construction portfolios consist of amortizing mortgage loans on multi-family residential and nonresidential real estate, construction and development loans secured by real estate, and commercial loans secured by collateral other than real estate. Construction loans and commercial/income property loans are generally underwritten with a discounted loan-to-value ratio of less than 75 percent. The Bank manages its risk in these portfolios through its credit evaluation, approval and monitoring processes. In addition to obtaining appraisals on real estate collateral based loans, a review of actual and forecasted financial statements and cash flow analyses is performed. After such loans are funded, they are monitored by obtaining and analyzing current financial and cash flow information on a periodic basis. To further control its credit risk in this portfolio, the Bank monitors and manages credit exposure on portfolio concentrations. The Bank's Risk Management Committee and Credit Administration Department regularly monitor portfolio concentrations by collateral types, industry groups, loan types, and individual and related borrowers. Such concentrations are assessed and exposures managed through establishment of limitations of aggregate exposures. The Bank has ceased originating new construction and commercial loans in California and Arizona to reduce the level of credit risk in its portfolio. Construction loans and commercial real estate loans (including multi-family) generally have higher default rates than single-family residential loans. See Financial Services Segment -- Risk Management -- Credit Risk Management of MD&A for a table that sets forth the amounts of classified assets by type of loan. Origination, Purchase and Sale of Loans The Bank originates the majority of its loans within the state of Nevada; however, under current laws and regulations, the Bank may also originate and purchase loans or purchase participating interests in loans without regard to the location of the secured property. During 1993, the Bank originated $500 million in new loans, of which 90 percent were secured by property located in Nevada, eight percent were secured by property located in Arizona and two percent were secured by property located in California. During 1992, the Bank originated $518 million in new loans, of which 84 percent were secured by property located in Nevada, ten percent were secured by property located in Arizona, and six percent were secured by property in California. As of December 31, 1993, 80 percent of the Bank's loan portfolio was secured by property located in Nevada, 11 percent secured by property located in California and eight percent secured by property located in Arizona. The Bank originates real estate and commercial loans principally through its in-house personnel. Secondary Marketing Activity The Bank has been involved in secondary mortgage market transactions through the sale of whole loans. In accordance with the Bank's accounting policy, fixed-rate residential loans with maturities greater than 25 years have been designated as held for sale. At December 31, 1993, $8.6 million of residential loans are designated as held for sale. See Note 4 of the Notes to Consolidated Financial Statements for additional discussion relating to such loans. The Bank developed a comprehensive long-term Strategic Business Plan (the Plan) in order to reduce the level of interest rate, liquidity and prepayment risks. The Plan included a review of the Bank's balance sheet size, asset mix between fixed-rate and variable-rate assets, and interest rate risk. As a result of this review, the Bank began execution of a strategy to restructure its balance sheet, and changed its accounting policy with regard to loans held for investment versus held for sale. The Bank's balance sheet restructuring involved the sale of all fixed-rate singlefamily mortgage loans and mortgage-backed securities (MBS) with remaining maturities greater than or equal to 25 years, canceling interest rate swaps which hedged the interest rate risk of those assets, and reinvesting the proceeds of these sales in adjustable-rate debt securities and five-year fixed-rate balloon debt securities. The Bank's accounting policy was amended to designate all fixed-rate loans with maturities greater than or equal to 25 years (which possess normal qualifying characteristics required for sale) as held for sale, along with loans originated for specific sales commitments. Fixed-rate loans with maturities less than 25 years, and all adjustable-rate loans continue to be held for investment. In conjunction with the balance sheet restructuring, during 1992, the Bank sold $152 million of single-family residential fixed-rate loans, $241 million of fixed-rate debt securities with contractual maturities greater than 25 years, and canceled $300 million (notional amount) of interest rate swaps hedging these assets. Under its loan participation and whole loan sale agreements, the Bank may continue to service the loans and collect payments on the loans as they become due. The amount of loans serviced for others was $477 million at December 31, 1993, compared to $576 million at year-end 1992, including $93 million and $145 million, respectively, of loans serviced for MBS originated and owned by the Bank. The Bank pays the participating lender, under the terms of the participation agreement, a yield on the participant's portion of the loan, which is usually less than the interest agreed to be paid by the borrower. The difference is retained by the Bank as servicing income. In connection with mortgage loan sales, the Bank makes representations and warranties customary in the industry relating to, among other things, compliance with laws, regulations and program standards and accuracy of information. In the event of a breach of these representations and warranties, or under certain limited circumstances, regardless of whether there has been such a breach, the Bank may be required to repurchase such mortgage loans. Typically, any documentation defects with respect to these mortgage loans that caused them to be repurchased, are corrected and the mortgage loans are resold. Certain repurchased mortgage loans may remain in the Bank's loan portfolio and, in some cases, repurchased mortgage loans are foreclosed and the acquired real estate sold. Loan Fees The Bank receives loan origination fees for originating loans and commitment fees for making commitments to originate construction, income property and multi-family residential loans. It also receives loan fees and charges related to existing loans, including prepayment charges, late charges and assumption fees. The amount of loan origination fees, commitment fees and discounts received varies with loan volumes, loan types, purchase commitments made, and competitive and economic conditions. Loan origination and commitment fees, offset by certain direct loan origination costs, are being deferred and recognized over the contractual life of such loans as yield adjustments. ASSET QUALITY Nonperforming Assets. Nonperforming assets may be comprised of nonaccrual assets, restructured loans and real estate acquired through foreclosure. Nonaccrual assets are those on which management believes the timely collection of interest is doubtful. Assets are transferred to nonaccrual status when payments of interest or principal are 90 days past due or if, in management's opinion, the accrual of interest should be ceased sooner. There are no assets on accrual status which are over 90 days delinquent or past maturity. Management reviews and takes into consideration the results of internal loan reviews and assessments of the effect of current and expected future economic conditions on the loan and debt security portfolios. As part of the internal loan review process and through regulatory examination, assets are classified when deemed to contain more than acceptable levels of risk. Once an asset is placed on nonaccrual status, all previously accrued but uncollected interest is reversed from income and interest income is no longer recognized unless paid. Nonaccrual assets are restored to accrual status when, in the opinion of management, the financial condition of the borrower and/or debt service capacity of the security property has improved to the extent that collectibility of interest and principal appears assured and interest payments sufficient to bring the asset current are received. Loans to joint ventures for real estate development in which the Bank is either a participant or an equity participant are excluded from nonperforming assets because these types of loans are classified and accounted for as real estate investments under generally accepted accounting principles (GAAP). The following table summarizes nonperforming assets as of the dates indicated (thousands of dollars): At December 31, 1993, all nonaccrual loans and real estate acquired through foreclosure are classified substandard. Additionally, $280,000 of the restructured loans are classified substandard. The amount of interest income that would have been recorded on the nonaccrual and restructured assets if they had been current under their original terms was $1.5 million for 1993. Actual interest income recognized on these assets was $870,000, resulting in $640,000 of interest income foregone for the year. See further discussion below in Provision and Allowance for Credit Losses. Classified Assets. OTS regulations require the Bank to classify certain assets and establish prudent valuation allowances. Classified assets fall in one of three categories -- "substandard," "doubtful" and "loss." In addition, the Bank can designate an asset as "special mention." Assets classified as "substandard" are inadequately protected by the current net worth or paying capacity of the obligor or the collateral pledged, if any. Assets which are designated as "special mention" possess weaknesses or deficiencies deserving close attention, but do not currently warrant classification as "substandard." See Financial Services Segment -- Risk Management -- Credit Risk Management of MD&A for the amounts of the Bank's classified assets and ratio of classified assets to total assets, net of charge-offs. Provision and Allowance for Credit Losses. The provision for credit losses is dependent upon management's evaluation as to the amount needed to maintain the allowance for losses at a level considered appropriate to the perceived risk of future losses. A number of factors are weighed by management in determining the adequacy of the allowance, including internal analyses of portfolio quality measures and trends, specific economic and market conditions affecting valuation of the security properties and certain other factors. In addition, the OTS considers the adequacy of the allowance for credit losses and the net carrying value of real estate owned in connection with periodic examinations of the Bank. The OTS may require the Bank to recognize additions to the allowance or reductions in the net carrying value of real estate owned based on their judgement at the time of such examinations. The OTS completed its examination of the Bank in February 1994. It deemed that the Bank's allowance for credit losses was adequate. The FDIC has indicated that it will not examine the Bank during 1994. Activity in the allowances for credit losses on loans and real estate is summarized as follows (thousands of dollars): - --------------- * Ratio = Net charge-offs to average loans and real estate outstanding Included in net charge-offs are $421,000, $1.7 million, $1.4 million, $1.9 million, and $2.6 million of recoveries for 1989 through 1993, respectively. The real estate write-downs for 1992 were primarily the result of a decrease in the net realizable value and slower sales activity of five California single-family real estate development projects. The largest of these involved write-downs of $9.3 million as a result of an appraisal reflecting the continuing market decline in the California market and difficulty in obtaining third party construction financing. The increase in the allowance for estimated credit losses as a percentage of nonperforming loans from 85 percent at December 31, 1992 to 92 percent at December 31, 1993, was due primarily to higher provisions for the single-family and consumer loan portfolios and debt security portfolio offset by decreases in real estate acquired through foreclosure. Prior to the fourth quarter of 1991, the Bank established specific valuation allowances for identified probable losses on assets in its portfolio. During the fourth quarter of 1991, the Bank adopted a policy of charging off assets against previously established specific valuation allowances and directly charging off any newly identified probable losses on specific assets, thus directly reducing the carrying value of the asset. Allocation of Allowance for Credit Losses. The following is a breakdown of allocated loan loss allowance amounts by major categories. However, in management's opinion, the allowance must be viewed in its entirety. REAL ESTATE DEVELOPMENT ACTIVITIES The Bank's investment in real estate held for development, net of allowance for estimated losses, excluding real estate acquired through foreclosure, decreased from $28.1 million at December 31, 1991 to $4.1 million at December 31, 1993. The Bank's pretax loss from real estate operations was $910,000 in 1993, $15.3 million in 1992 and $50.5 million in 1991. At December 31, 1993, real estate held for sale or development principally includes two former branch facilities not included in the sale of the Arizona branch operations. See Note 5 of the Notes to Consolidated Financial Statements for a summary of real estate held for sale or development and a summary of income from real estate operations. The Bank and its subsidiaries have ceased making investments in new real estate development activities as a result of legislative and regulatory actions which have placed certain restrictions on the Bank's ability to invest in real estate. See Regulation -- General herein for additional discussion. The Bank and its subsidiaries are actively pursuing the development and sale of the remaining real estate investments. INVESTMENT ACTIVITIES Federal regulations require thrifts to maintain certain levels of liquidity and to invest in various types of liquid assets. The Bank invests in a variety of securities, including commercial paper, certificates of deposit, U.S. government and U.S. agency obligations, short-term corporate debt, municipal bonds, repurchase agreements and federal funds. The Bank also invests in longer term investments such as MBS and collateralized mortgage obligations (CMO) to supplement its loan production and to provide liquidity to meet unforeseen cash outlays. Income from cash equivalents and debt securities provides a significant source of revenue for the Bank, constituting 48 percent, 43 percent and 39 percent of total revenues for each of the years ended December 31, 1991, 1992 and 1993, respectively. On December 31, 1993, the Bank adopted Statement of Financial Accounting Standards (SFAS) No. 115 "Accounting for Certain Investments in Debt and Equity Securities." In conjunction with adoption, the Bank designated the vast majority of its debt security portfolio as available for sale. At December 31, 1993, no securities were designated as "trading securities." See Note 2 of the Notes to Consolidated Financial Statements for further discussion. The following tables present the composition of the debt security portfolios as of the dates indicated. See Financial Services Segment -- Capital Resources and Liquidity of MD&A and Note 3 of the Notes to Consolidated Financial Statements for further discussion of the portfolios: The following schedule of the expected maturity of debt securities held to maturity is based upon dealer prepayment expectations and historical prepayment activity (thousands of dollars): The expected maturities of MBS and CMO are based upon dealer prepayment expectations and historical prepayment activity. The following schedule reflects the expected maturities of MBS and CMO and the contractual maturity of all other debt securities available for sale (thousands of dollars): DEPOSIT ACTIVITIES Deposit accounts are the Bank's primary source of funds constituting 77 percent of the Bank's total liabilities at December 31, 1993. The Bank solicits both short-term and long-term deposits in the form of transaction related and certificate of deposit accounts, primarily through its 25 branch offices. The Bank operates 17 branches in southern Nevada and eight branches in northern Nevada. During 1993, the Bank exited the metropolitan Phoenix, Arizona market through the sale of its Arizona branch operations. The Bank's average retail deposit base has remained steady during the past three years, despite the effect of the Arizona sale, as a result of the strategic decision to alter the Bank's liability mix from wholesale to retail funding sources. Average retail deposits, as a percentage of average interest-bearing liabilities, were 79 percent in 1993, compared to 83 percent in 1992 and 72 percent in 1991. The Bank has emphasized retail deposits over wholesale funding sources in an effort to reduce the volatility of its cost of funds. Additionally, the Bank has emphasized growth in transaction based accounts versus term accounts in order to reduce its overall cost of funds. The growth in retail deposits has been achieved through marketing programs, increased emphasis on customer service and strong growth in southern Nevada. In conjunction with the strategy to increase the core retail deposit base, the Bank discontinued accepting long-term brokered deposits in 1988. At December 31, 1993, the Bank had no brokered deposits, compared to $6.9 million at December 31, 1992. The FDIC has issued regulations regarding a depository institution's acceptance of brokered deposits. See Regulation -- General -- Deposit Activities herein for additional discussion. The Bank's deposits decreased $414 million during 1993. During 1993, the Bank sold its Arizona branch operations, including $321 million in deposit accounts, in conjunction with the goals to reduce the Bank's total asset size and to shift the deposit mix toward a greater percentage of transaction accounts. The Bank's deposit base in Arizona was largely term CD based. The sale of the Arizona deposits was funded through the sale of debt securities. In accordance with the Bank's strategy of reducing its reliance on wholesale funding sources, wholesale deposits declined $4.5 million. The Bank has also experienced an outflow of deposits during 1993 as a result of customers seeking alternative investments to relatively low yielding insured deposits. Loan and debt security repayments produced adequate sources of funds to compensate for the deposit outflows. At December 31, 1993, the Bank maintained over $265 million in collateral, at market value, which could be borrowed against or sold to offset any run-offs which could occur in retail deposits in the current low interest rate environment. The Bank considers this level of excess collateral to be adequate and considers the likelihood of substantial run-offs occurring to be remote. The average balances in and average rates paid on deposit accounts for the years indicated are summarized as follows (thousands of dollars): See Note 7 of the Notes to Consolidated Financial Statements for further discussion. Certificates of deposit include approximately $152 million, $223 million and $245 million in time certificates of deposits in amounts of $100,000 or more at December 31, 1993, 1992 and 1991, respectively. The following table represents time certificates of deposits, none of which are brokered, in amounts of $100,000 or more by time remaining until maturity as of December 31, 1993 (thousands of dollars): BORROWINGS Sources of funds other than deposits have included advances from the FHLB, reverse repurchase agreements and other borrowings. FHLB Advances. As a member of the FHLB system, the Bank may obtain advances from the FHLB pursuant to various credit programs offered from time to time. The Bank borrows these funds from the FHLB principally on the security of its FHLB capital stock and certain of its mortgage loans. See Regulation -- Federal Home Loan Bank System herein for additional discussion. Such advances are made on a limited basis to supplement the Bank's supply of lendable funds, to meet deposit withdrawal requirements and to lengthen the maturities of its borrowings. See Note 11 of the Notes to Consolidated Financial Statements for additional discussion. Securities Sold Under Repurchase Agreements. The Bank sells securities under agreements to repurchase (reverse repurchase agreements). Reverse repurchase agreements involve the Bank's sale of debt securities to an investment banking firm with a simultaneous agreement to repurchase the same debt securities on a specified date at a specified price. The initial price paid to the Bank under reverse repurchase agreements is less than the fair market value of the debt securities sold, and the Bank may be required to pledge additional collateral if the fair market value of the debt securities sold declines below the price paid to the Bank for these debt securities. See Note 8 of the Notes to Consolidated Financial Statements for additional discussion of the terms and description of the reverse repurchase agreements. Reverse repurchase agreements are summarized as follows (thousands of dollars): At December 31, 1993, the balance of reverse repurchase agreements included $49 million in long-term fixed-rate flexible reverse repurchase agreements with a weighted average interest rate of 8.62 percent. EMPLOYEES At December 31, 1993 the Bank had 622 full-time equivalent employees. None of the employees are represented by any union or collective bargaining group and the Bank considers its relations with its employees to be good. COMPETITION The Bank experiences substantial competition in attracting and retaining deposit accounts and in making mortgage and other loans. The primary factors in competing for deposit accounts are interest rates paid on deposits, the range of financial services offered, the quality of service, convenience of office locations and the financial strength of an institution. Direct competition for deposit accounts comes from savings and loan associations, commercial banks, money market mutual funds, credit unions and insurance companies. During 1993, the Bank experienced deposit outflows from certificate of deposit accounts as customers sought higher yielding alternative investments in this low interest rate environment. The Bank has sought to retain relationships with these customers by establishing an agreement with a third party broker to offer uninsured investment alternatives in the Bank's branches. The primary factors in competing for loans are interest rates, loan origination fees, quality of service and the range of lending services offered. Competition for origination of first mortgage loans normally comes from savings and loan associations, mortgage banking firms, commercial banks, insurance companies, real estate investment trusts and other lending institutions. PROPERTIES The Bank occupies facilities at 25 locations in Nevada, of which 12 are owned. The Bank leases the remaining facilities. The Bank may add branches in the future in order to achieve the deposit goals set forth in the Bank's Plan. The Bank received approval from the Board of Directors to enter into negotiations for four new branches (three in Las Vegas and one in Reno). During 1994, specific sites are expected to be identified. See Note 9 of the Notes to Consolidated Financial Statements for a schedule of net future minimum rental payments that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993. REGULATION General In August 1989, FIRREA was enacted into law. FIRREA had and will continue to have a significant impact on the thrift industry including, among other things, imposing significantly higher capital requirements and providing funding for the liquidation of insolvent thrifts. In December 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was enacted into law. This legislation included changes in the qualified thrift lender test, deposit insurance assessments and capital standards. Regulatory Infrastructure. The Bank's principal supervisory agency is the OTS, an agency reporting to the U.S. Treasury Department. The OTS is responsible for the examination and regulation of all thrifts and for the organization, incorporation, examination and regulation of federally chartered thrifts. The FDIC is the Bank's secondary regulator and is the administrator of the SAIF which generally insures the deposits of thrifts. Deposit Insurance Premiums. During 1993, the FDIC implemented a risk-based deposit insurance premium assessment. Under the regulation, annual deposit insurance premiums ranging from 23 to 31 basis points are imposed on institutions based upon the institution's level of capital and a supervisory risk assessment. For the year ended December 31, 1993, the deposit insurance premium was $3.7 million. Capital Standards. Effective December 1989, the OTS issued the minimum regulatory capital regulations (capital regulations) required by FIRREA. The capital regulations require that all thrifts meet three separate capital standards as follows: 1. A tangible capital requirement equal to at least 1.5 percent of adjusted total assets (as defined). 2. A core capital requirement equal to at least three percent of adjusted total assets (as defined). 3. A risk-based capital requirement equal to at least eight percent of risk-weighted assets (as defined). The OTS may establish, on a case by case basis, individual minimum capital requirements for a thrift institution which may vary from the requirements which would otherwise be applicable under the capital regulations. The OTS has not established such minimum capital requirements for the Bank. A thrift institution which fails to meet one or more of the applicable capital requirements is subject to various regulatory limitations and sanctions, including a prohibition on growth and the issuance of a capital directive by the OTS requiring the following: an increase in capital, a reduction of rates paid on savings accounts, cessation of or limitations on deposit taking and lending, limitations on operational expenditures, an increase in liquidity, and such other actions as are deemed necessary or appropriate by the OTS. In addition, a conservator or receiver may be appointed under certain circumstances. FDICIA required the federal banking agencies to adopt regulations which implemented a system of progressive constraints as capital levels decline at banks and savings institutions. The federal banking agencies have enacted uniform "prompt corrective action" rules which classifies banks and savings institutions into one of five categories based upon capital adequacy, ranging from "well capitalized" to "critically undercapitalized." As of December 31, 1993, the Bank is categorized as "well capitalized" under the regulation. FDICIA also requires the appropriate federal banking agencies to take corrective action to restrict asset growth, acquisitions, branching and new business with respect to an "undercapitalized" institution and to take increasingly severe additional actions if the institution becomes "significantly undercapitalized" or "critically undercapitalized." FDICIA also prohibits dividends and other capital distributions and payment of management fees to a controlled entity, if following such distribution or payment, the institution would fall within one of the three "undercapitalized" categories. See Financial Services Segment -- Financial and Regulatory Capital of MD&A for further discussion. An institution that fails to meet the minimum level for any relevant capital measure (an "undercapitalized institution") may be: (i) subject to increased monitoring by the appropriate federal banking regulator; (ii) required to submit an acceptable capital restoration plan within 45 days; (iii) subject to asset growth limits; and (iv) required to obtain prior regulatory approval for acquisitions, branching and new lines of businesses. The capital restoration plan must include a guarantee by the institution's holding company that the institution will comply with the plan until it has been adequately capitalized on average for four consecutive quarters, under which the holding company would be liable up to the lesser of five percent of the institution's total assets or the amount necessary to bring the institution into capital compliance as of the date it failed to comply with its capital restoration plan. A significantly undercapitalized institution, as well as any undercapitalized institution that does not submit an acceptable capital restoration plan, may be subject to regulatory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations on interest rates paid on deposits, asset growth and other activities, possible replacement of directors and officers, and restrictions on capital distributions by any bank holding company controlling the institution. Any company controlling the institution may also be required to divest the institution. If an institution's ratio of tangible capital to total assets falls below a level established by the appropriate federal banking regulator, the institution will be subject to conservatorship or receivership within 90 days unless periodic determinations are made that forbearance from such action would better protect the deposit insurance fund. Unless appropriate findings and certifications are made by the appropriate federal regulatory agencies, a critically undercapitalized institution must be placed in receivership if it remains critically undercapitalized on average during the calendar quarter beginning 270 days after the date it became critically undercapitalized. These new capital requirements and applicable banking regulations became effective in December 1992. FDICIA also amends the grounds for appointment of a conservator or receiver for an insured depository institution to include the following events: (i) consent by the board of directors of the institution; (ii) cessation of the institution's status as an insured depository institution; (iii) the institution is undercapitalized and has no reasonable prospect of becoming adequately capitalized when required to do so, fails to submit an acceptable capital plan or materially fails to implement an acceptable capital plan and (iv) the institution is critically undercapitalized or otherwise has substantially insufficient capital. FDIC imposed regulations provide that any insured institution which falls below a two percent minimum level ratio will be subject to FDIC deposit insurance termination proceedings unless it has submitted, and is in compliance with, a capital plan with its primary federal regulator and the FDIC. Additionally, an insured institution may be subject to deposit insurance termination proceedings, under certain circumstances, even if it meets or exceeds the two percent minimum level ratio requirement. In January 1993, the OTS issued a Thrift Bulletin limiting the amount of deferred tax assets that can be used to meet capital requirements. Under the bulletin, for purposes of calculating regulatory capital, net deferred tax assets are limited to the amount which could be theoretically realized from carryback potential plus the lesser of the tax on one year's projected earnings or ten percent of core capital. Transitional provisions apply to deferred tax assets existing at December 31, 1992 which are not subject to the limitation. At December 31, 1993 the Bank has recorded a net deferred tax liability and, therefore, is not subject to the regulation at this time. Management does not anticipate this regulation will impact the Bank's compliance with capital standards in the foreseeable future. The capital regulations specify that only the following elements may be included in tangible capital: stockholder's equity, noncumulative perpetual preferred stock, retained earnings and minority interests in the equity accounts of fully consolidated subsidiaries. Further, goodwill and investments in and loans to subsidiaries engaged in activities not permitted of national banks must be deducted from assets and capital. See Regulation -- General -- Separate Capitalization of Nonpermissible Activities herein for additional discussion. In calculating adjusted total assets under the capital regulations, certain adjustments are made to total assets to give effect to the exclusion of certain assets from tangible capital and to appropriately account for the investments in and assets of both includable and nonincludable activities. Core capital under the current regulations may include only tangible capital, plus certain intangible assets up to a limit of 25 percent of core capital, provided such assets are: (i) separable from the thrift's assets; (ii) valued at an established market value through an identifiable stream of cash flows with a high degree of certainty that the asset will hold this market value notwithstanding the prospects of the thrift and (iii) salable in a market that is liquid. In addition, certain qualifying "supervisory" goodwill is includable as core capital as follows: At December 31, 1993 and 1992, $27 million and $28.8 million, respectively, of the Bank's goodwill qualified as supervisory goodwill. At December 31, 1993, $12.6 million of supervisory goodwill was includable in core capital. Due to the 0.375 percent limitation, on January 1, 1994 only $6.3 million of the Bank's supervisory goodwill was includable in core capital. Regarding the risk-based capital requirement, under the capital regulations, assets are assigned to one of four "risk-weighted" categories (zero percent, 20 percent, 50 percent or 100 percent) based upon the degree of perceived risk associated with the asset. The total amount of a thrift's risk-weighted assets is determined by multiplying the amount of each of its assets by the risk weight assigned to it, and totaling the resulting amounts. The capital regulation also establishes the concept of "total capital" for the risk-based capital requirement. As defined, total capital consists of core capital and supplementary capital. Supplementary capital includes: (i) permanent capital instruments such as cumulative perpetual preferred stock, perpetual subordinated debt and mandatory convertible subordinated debt (capital notes), (ii) maturing capital instruments such as subordinated debt, intermediate-term preferred stock, mandatory convertible subordinated debt (commitment notes) and mandatory redeemable preferred stock, subject to an amortization schedule and (iii) general valuation loan and lease loss allowances up to 1.25 percent of risk-weighted assets. The OTS has issued a regulation which adds a component to an institution's risk-based capital calculation in 1994. The regulation will require a reduction of an institution's risk-based capital by 50 percent of the decline in the institution's net portfolio value (NPV) exceeding two percent of assets under a hypothetical 200 basis point increase or decrease in market interest rates. Based upon management's estimate of its interest rate risk (IRR) exposure, and using data as of December 31, 1993, the Bank will not be subjected to a reduction of its risk-based capital requirement because the hypothetical change in the Bank's NPV is less than two percent of the estimated market value of the Bank's assets. In order to strengthen the Bank's regulatory capital ratios, the Bank undertook numerous actions in 1993 and 1992. See Financial Services Segment -- Capital Resources and Liquidity of MD&A and Note 2 of the Notes to Consolidated Financial Statements for the calculation of the Bank's tangible capital, core capital and risk-based capital and related excesses as of December 31, 1993 and 1992, and a discussion of the proposed changes in capital requirements. Separate Capitalization of Nonpermissible Activities. For purposes of determining a thrift's capital under all three capital requirements, its entire investment in and loans to any subsidiary engaged in an activity not permissible for a national bank must be deducted from the capital of the thrift. The capital regulations provide for a transition period with respect to this provision. During the transition period, a thrift is permitted to include in its calculation the applicable percentage (as provided below) of the lesser of the thrift's investments in and loans to such subsidiaries on: (i) April 12, 1989 or (ii) the date on which the thrift's capital is being determined, unless the FDIC determines with respect to any particular thrift that a lesser percentage should be applied in the interest of safety and soundness. In July 1992, legislation was enacted which delayed the increased transitional deduction from capital for real estate investments, and allowed thrifts to apply to the OTS for use of a delayed schedule. The Bank applied for and received approval for use of the following delayed phase-out schedule: As of December 31, 1993, the Bank had $5.5 million in investments in and loans to nonpermissible activities which fall under this section of FIRREA, all of which are grandfathered according to the phase-out schedule outlined above. Included in this amount are investments in real estate, land loans and certain foreclosed real estate. At December 31, 1993, under fully phased-in capital rules applicable to the Bank at July 1, 1996, the Bank would have exceeded its fully phased-in tangible, core and risk-based capital requirements by $81.8 million, $56.6 million, and $43.1 million, respectively. See Financial Services Segment -- Financial and Regulatory Capital of MD&A for further discussion. Lending Activities. FIRREA limits the amount of commercial real estate loans that a federally chartered thrift may make to four times its capital (as defined). Based on core capital of $120 million at December 31, 1993, the Bank's commercial real estate lending limit was $480 million. At December 31, 1993, the Bank had $192 million invested in commercial real estate loans; therefore, this limitation should not unduly restrict the Bank's ability to engage in commercial real estate loans. FIRREA conformed thrifts' loans-to-one-borrower limitations to those applicable to national banks. After December 31, 1991 thrifts generally are not permitted to make loans to a single borrower in excess of 15 percent to 25 percent of the thrift's unimpaired capital and unimpaired surplus (depending upon whether the loan is collateralized and the type of collateral), except that a thrift may make loans-to-one-borrower in excess of such limits under one of the following circumstances: (i) for any purpose, in any amount not to exceed $500,000 and (ii) to develop domestic residential housing units, in an amount not to exceed the lesser of $30 million, or 30 percent, of the thrift's unimpaired capital and unimpaired surplus, provided the thrift meets fully phased-in capital requirements and certain other conditions are satisfied. The Bank's loans-to-one-borrower limitation was $17.6 million at December 31, 1993. This limitation is not expected to materially affect the operations of the Bank. At December 31, 1993 the Bank was in compliance with the limitation. In December 1992, the OTS issued a regulation regarding real estate lending standards, as mandated by FDICIA, which became effective in March 1993. The regulation requires insured depository institutions to adopt and maintain comprehensive written real estate lending policies which include prudent underwriting standards, loan administration procedures, portfolio diversification standards, and documentation, approval and reporting requirements. The policies must be reviewed and approved annually to ensure appropriateness for current market conditions. The regulation also provides supervisory loan-to-value limits for various types of real estate based loans. Loans may be originated in excess of these limitations up to a maximum of 100 percent of total regulatory capital. Management does not anticipate that the regulation will have a material impact on the Bank's lending operations. In August 1993, the OTS issued revised guidance for the classification of assets and a new policy on the classification of collateral-dependent loans (where proceeds from repayment can be expected to come only from the operation and sale of the collateral). With limited exceptions, effective September 1993, for troubled collateral-dependent loans where it is probably that the lender will be unable to collect all amounts due, an institution must classify as "loss" any excess of the recorded investment in the loan over its "value," and classify the remainder as "substandard." The "value" of a loan is either the present value of the expected future cash flows, the loan's observable market price or the fair value of the collateral. The Bank does not anticipate any adverse impact from the implementation of the revised guidance for classification of assets or collateral-dependent loans. The federal agencies regulating financial institutions issued a joint policy statement in December 1993 providing quantitative guidance and qualitative factors to consider in determining the appropriate level of general valuation allowances that institutions should maintain against various asset portfolios. The policy statement also requires institutions to maintain effective asset review systems and to document the institution's process for evaluating and determining the level of its general valuation allowance. Management believes the Bank's current policies and procedures regarding general valuation allowances and asset review procedures are consistent with the policy statement. FDICIA amended the Qualified Thrift Lender (QTL) test prescribed by FIRREA by reducing the qualified percentage to 65 percent and adding certain investments as qualifying investments. A savings institution must meet the percentage in at least nine of every 12 months. At December 31, 1993, the Bank's QTL ratio was approximately 79 percent. A thrift that fails to meet the QTL test must either become a commercial bank or be subject to a series of restrictions. Deposit Activities. FDIC rules permit well capitalized institutions to obtain brokered deposits in most circumstances. Adequately capitalized institutions may obtain brokered deposits only if they obtain a waiver from the FDIC. Undercapitalized institutions are prohibited from accepting brokered deposits. The Bank is classified as well capitalized for purposes of this rule. The Bank does not anticipate that there will be any impact on its business operations or deposit pricing as a result of this rule because the Bank is not currently accepting new brokered deposits and does not anticipate soliciting brokered deposits or deposits at rates significantly higher than prevailing rates. Supervisory Restrictions. In October 1991, the Bank entered into a Supervisory Agreement (the Agreement) with the OTS. Among other things, the Bank agreed to: retain competent management, improve the review and monitoring of problem assets, develop comprehensive business plans which support decisions concerning real estate development projects and foreclosed real estate, and reduce interest rate risk. In November 1993, the Agreement was terminated based upon corrective actions taken by the Bank. Safety and Soundness Standards. Pursuant to statutory requirements, the OTS issued a proposed rule on November 17, 1993, that prescribes certain "safety and soundness standards." The standards are intended to enable the OTS to address problems at savings associations before the problems cause significant deterioration in the financial condition of the association. The proposed regulation provides operational and managerial standards for internal controls and information systems, loan documentation, internal audit systems, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. The proposed regulation also requires a savings association to maintain a ratio of classified assets to total capital and ineligible allowances that is no greater than 1.0. A minimum earnings standard is also included in the proposed regulation requiring earnings sufficient to absorb losses without impairing capital. Earnings would be sufficient under the proposed regulation if the institution meets applicable capital requirements and would remain in capital compliance if its net income or loss over the last four quarters of earnings continued over the next four quarters of earnings. An institution that fails to meet any of the standards must submit a compliance plan. Failure to submit an acceptable compliance plan or to implement the plan could result in an OTS order or other enforcement action against the association. The Bank's level of adversely classified assets is less than its total capital plus ineligible allowances at December 31, 1993 as defined under the proposed rule. Federal Home Loan Bank System The FHLB system consists of 12 regional FHLB banks, which provide a central credit facility primarily for member institutions. The Bank, as a member of the FHLB of San Francisco, is required to own capital stock in that institution in an amount at least equal to: one percent of the aggregate outstanding balance at the beginning of the year of its outstanding residential mortgage loans, home purchase contracts and similar obligations; 0.3 percent of total assets; or five percent of its advances from the FHLB, whichever is greater. The Bank is in compliance with this requirement, with an investment in FHLB stock at December 31, 1993 of $16.5 million. Liquidity The Bank is required to maintain an average daily balance of liquid assets equal to at least five percent of its liquidity base (as defined in the Regulation) during the preceding calendar month. The Bank is also required to maintain an average daily balance of short-term liquid assets equal to at least one percent of its liquidity base. The Bank has complied with these regulatory requirements. For the month of December 1993, the Bank's liquidity ratios were 18 percent and ten percent, respectively. See Financial Services Segment -- Capital Resources and Liquidity of MD&A for additional discussion. Investments In December 1991, the Federal Financial Institutions Examinations Council (FFIEC) issued its Supervisory Policy Statement on Securities Activities (Policy Statement). The Policy Statement: (1) addresses the selection of securities dealers, (2) requires depository institutions to establish prudent policies and strategies for securities transactions, (3) defines securities trading or sales practices that are viewed by the agencies as being unsuitable when conducted in an investment portfolio, (4) indicates characteristics of loans held for sale or trading, and (5) establishes a framework for identifying when certain mortgage derivative products are high-risk mortgage securities which must be held either in a trading or held for sale account. Management believes that items (1) through (4) will not unduly restrict the present operating strategies of the Bank. Item (5) will not affect the Bank's treatment of its $5 million investment in CMO residuals since the Policy Statement includes a grandfathering provision whereby any mortgage derivative owned prior to the date of adoption by the OTS is exempt from the tests. However, the Bank will have to apply the specified tests to any mortgage derivative product, including CMO, Real Estate Mortgage Investment Conduits (REMIC), CMO and REMIC residuals and stripped MBS purchases in the future. Insurance of Deposits The Bank's deposits are insured by the FDIC through the SAIF up to the maximum amount permitted by law, currently $100,000 per insured depositor. The SAIF requires semiannual insurance premium payments in January and July of each year. See Regulation -- General -- Deposit Insurance Premiums herein for additional discussion of insurance premiums to be paid by SAIF members. Insurance of deposits may be terminated by the FDIC, after notice and hearing, upon a finding by the FDIC that a thrift has engaged in unsafe or unsound practices, or is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the OTS and FDIC. Management of the Bank is not aware of any practice, condition, or violation that might lead to termination of its deposit insurance. Community Reinvestment Act The Community Reinvestment Act of 1977 (CRA) and regulations promulgated under the act encourage savings associations to help meet the credit needs of the communities they do business in, particularly the credit needs of low and moderate income neighborhoods. The OTS periodically evaluates the Bank's performance under CRA. This evaluation is taken into account in determining whether to grant approval for new branches, relocations, mergers, acquisitions and dispositions. The Bank received a "satisfactory" evaluation in its most recent examination. Federal Reserve System The Board of Governors of the Federal Reserve System (the Federal Reserve) has adopted regulations that require depository institutions to maintain noninterest earning reserves against their transaction accounts (primarily negotiable order of withdrawal (NOW), demand deposit accounts, and Super NOW accounts) and nonpersonal money market deposit accounts. These regulations generally require that reserves of three percent be maintained against aggregate transaction accounts in an institution, up to $47.9 million, and an initial reserve of ten percent be maintained against that portion of total transaction accounts in excess of such amount. In addition, an initial reserve of three percent must be maintained on nonpersonal money market deposit accounts (which include borrowings with maturities of less than four years). These accounts and percentages are subject to adjustment by the Federal Reserve. The balances maintained to meet the reserve requirements imposed by the Federal Reserve may be used to satisfy liquidity requirements which may be imposed by the OTS. At December 31, 1993, the Bank was required to maintain approximately $1.8 million in noninterest earning reserves and was in compliance with this requirement. As a creditor and financial institution, the Bank is subject to additional regulations promulgated by the Federal Reserve, including, without limitation, Regulation B (Equal Credit Opportunity Act), Regulation E (Electronics Funds Transfers Act), Regulation F (Interbank Liabilities), Regulation Z (Truth in Lending Act), Regulation CC (Expedited Funds Availability Act) and Regulation DD (Truth in Savings Act). HOLDING COMPANY MATTERS The Bank is a wholly owned subsidiary of the Company. As a unitary savings bank holding company, the Company is subject to certain OTS regulation, examination, supervision and reporting requirements. The Bank is generally prohibited from engaging in certain transactions with the Company and is subject to certain OTS restrictions on the payment of dividends to the Company. In 1990, the OTS issued a regulation governing limitations of capital distributions, including dividends. Under the regulation, a tiered system keyed to capital is imposed on capital distributions. Insured thrifts fall under one of three tiers. 1. Tier 1 includes those thrifts with net capital exceeding fully phased-in requirements and with Management, Asset quality, Capital adequacy, Risk management and Operating results (MACRO) ratings of 1 or 2. (The MACRO system was established by the OTS to comprehensively and uniformly grade all thrifts with regard to financial condition, compliance with laws and regulations, and overall operating soundness.) 2. Tier 2 includes those thrifts having net capital above their regulatory capital requirement, but below the fully phased-in requirement. 3. Tier 3 includes those thrifts with net capital below the current regulatory requirement. Under the regulation, insured thrifts are permitted to make dividend payments as follows: 1. Tier 1 thrifts are permitted to make (without application but with notification) capital distributions of half their surplus capital (as defined) at the beginning of a calendar year plus 100 percent of their earnings to date for the year. 2. Tier 2 thrifts can make (without application but with notification) capital distributions ranging from 25, 50 or 75 percent of their net income over the most recent four quarter period, depending upon their level of capital in relation to the fully phased-in requirements. 3. Tier 3 thrifts are prohibited from making any capital distributions without prior supervisory approval. Based upon these regulations, the Bank is currently restricted to paying no more than 75 percent of its net income over the last four quarters in dividends to its parent. The Bank did not pay any cash dividends during the past three years and does not anticipate paying cash dividends to its parent during 1994. Generally transactions between a savings and loan association and its affiliates are required to be on terms as favorable to the association as comparable transactions with nonaffiliates. In addition, certain of these transactions are restricted to a percentage of the association's capital. Affiliates of the Bank include the Company. In addition, a savings and loan association may not lend to any affiliate engaged in activities not permissible for a bank holding company or acquire the securities of such affiliates. It is not permissible for bank holding companies to operate a gas utility. Therefore, all loans by the Bank to the Company and all purchases of the Company's securities by the Bank are prohibited. The Company, at the time that it acquired the Bank, agreed to assist the Bank in maintaining levels of net worth required by the regulations in effect at the time or as they were thereafter in effect so long as it controlled the Bank. The enforceability of a net worth maintenance agreement of this type is uncertain. However, under current regulations, a holding company that has executed a capital maintenance obligation of this type may not divest control of a thrift, if the thrift has a capital deficiency, unless the holding company either provides the OTS with an agreement to infuse sufficient capital into the thrift to remedy the deficiency or the deficiency is satisfied. The Company is prohibited from issuing any bond, note, lien, guarantee or indebtedness of any kind pledging its utility assets or credit for or on behalf of a subsidiary which is not engaged in or does not support the business of the regulated public utility. As a result, there are limitations on the Company's ability to assist the Bank in maintaining levels of capital required by applicable regulations. The Company also stipulated in connection with the acquisition of the Bank that dividends by the Bank to the Company would not exceed 50 percent of the Bank's cumulative net income after the date of acquisition, without approval of the regulators. In addition, the Company agreed that the Bank would not at any time declare a dividend that would reduce the Bank's regulatory net worth below minimum regulatory requirements as in effect at the time of the acquisition or thereafter. Since the acquisition, the Bank's cumulative net income is $29.5 million resulting in maximum dividends payable of $14.7 million as of December 31, 1993. Since the acquisition, the Bank has paid the Company $1.8 million in capital distributions, net of the $20 million of capital contributions received from the Company. ITEM 2. ITEM 2. PROPERTIES The information appearing in Part I, Item 1, pages 2 and 18 in this report is incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has been involved with several lawsuits related to the May 4, 1988 fire and explosion at the Pacific Engineering & Production Company of Nevada (PEPCON) rocket fuel oxidizer plant in Henderson, Nevada. The lawsuits related to this incident, some of which named the Company as one of the defendants, were consolidated in the District Court for Clark County, Nevada under Case No. A264974. All claims have been settled by the various defendants. On December 14, 1992, a jury returned a verdict in favor of the Company on the PEPCON insurer's subrogation claim and the Court thereafter entered judgement in favor of the Company. During 1993, the Company's motions on behalf of its insurers to recover its costs and attorneys' fees resulted in a recovery of $1.6 million through a negotiated settlement. The settlement also resulted in the dismissal by the Nevada Supreme Court of two insurance companies' subrogation claims which were on appeal. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market in which the common stock of the Company is traded is the New York Stock Exchange. At March 18, 1994, there were 21,681 holders of record of common stock. The market price of the common stock was $17.13 as of March 18, 1994. Prices shown are those as quoted by the Wall Street Journal. COMMON STOCK PRICE AND DIVIDEND INFORMATION See Holding Company Matters and Note 2 of the Notes to Consolidated Financial Statements for a discussion of limitations on the Bank's ability to make capital distributions to the Company. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA CONSOLIDATED SELECTED FINANCIAL STATISTICS (THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS) SEGMENT DATA NATURAL GAS OPERATIONS (THOUSANDS OF DOLLARS) SEGMENT DATA FINANCIAL SERVICES (THOUSANDS OF DOLLARS) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company is comprised of two business segments; natural gas operations and financial services. The gas segment purchases, transports and distributes natural gas to residential, commercial and industrial customers in geographically diverse portions of Arizona, Nevada and California. The financial services segment (the Bank) is engaged in retail and commercial banking. The Bank's principal business is to attract deposits from the general public and make consumer and commercial loans secured by real estate and other collateral. During 1993, the gas segment contributed $13.7 million and the financial services segment contributed $1.7 million towards consolidated net income of $15.4 million. CONSOLIDATED CAPITAL RESOURCES AND LIQUIDITY The capital requirements and resources of the Company generally are determined independently for the gas and financial services segments. Each business segment is generally responsible for securing its own financing sources. Liquidity refers to the ability of an enterprise to generate adequate amounts of cash to meet its cash requirements. General factors that could affect consolidated capital resources and liquidity significantly in future years include inflation, growth in the economy and changes in income tax laws. In addition, other factors specific to the two operating segments of the Company include: the level of natural gas prices and changes in the ratemaking policies of regulatory commissions for the gas segment; and new banking regulations, interest rate sensitivity, credit risk and competition for the financial services segment. The Bank has continued to improve its capital position by reducing its asset base and its level of real estate investment which require higher levels of capitalization. However, in light of regulatory changes, including more stringent capital requirements, and in order to enhance the Bank's capital position, the Company did not receive cash dividends from the Bank during 1993 and does not anticipate receiving cash dividends from the Bank during 1994. The Company's Board of Directors (the Board) will continue to evaluate the Bank's cash dividend policy subject to regulatory limitations. The Board will also continue to review the Company's investment in the Bank with an emphasis on the Bank's capital position relative to its capital requirements. The impact of any new capital requirements imposed on the Bank will be analyzed, and the appropriate strategic adjustments will be determined. The Company presently does not anticipate having to contribute additional capital to the Bank. In May 1993, the Board of Directors declared a quarterly common stock dividend of 19.5 cents per share payable September 1, 1993, a two cents per share or 11.4 percent increase from the previous level. The increase was established in accordance with the Company's dividend policy which states that the Company will pay common stock dividends at a prudent level that is within the normal dividend payout range for its respective businesses, and that the dividend will be established at a level considered sustainable in order to minimize business risk and maintain a strong capital structure throughout all economic cycles. Consolidated cash and cash equivalents decreased $11.3 million during 1993, the result of decreased cash flow from the financial services segment of $13 million, offset somewhat by a $1.7 million increase from the gas segment. The increase from the gas segment is mainly attributable to the proceeds from the issuance of notes payable, offset by increased construction expenditures. The decrease from the financial services segment is primarily due to repayment of fixed rate long-term borrowings and deposit outflows resulting from lower prevailing interest rates paid on deposit accounts. Inflation, as measured by the Consumer Price Index for all urban consumers averaged 2.7 percent in 1993, 2.9 percent in 1992 and 3.1 percent in 1991. Inflation primarily impacts the Company's labor costs, materials, purchased gas costs and cost of capital investment. The Bank's assets and liabilities consist primarily of monetary assets (cash, cash equivalents, debt securities and loans receivable) and liabilities (savings deposits and borrowings) which are, or will be, converted into a fixed amount of dollars in the ordinary course of business regardless of changes in prices. Monetary assets lose purchasing power due to inflation, but this is offset by gains in the purchasing power of liabilities, as these obligations are repaid with inflated dollars. In June 1993, Moody's Investors Service, Inc. upgraded the Company's unsecured debt rating from Ba2 to Ba1. In November 1993, Duff and Phelps Credit Rating Company lowered the Company's unsecured debt rating from BBB-(triple B minus) to BB+ (double B plus). Standard and Poor's Corporation affirmed the Company's unsecured long-term debt rating at BBB-during 1993. See Capital Resources and Liquidity for separate discussions of each business segment. RESULTS OF CONSOLIDATED OPERATIONS 1993 vs. 1992 Consolidated net income decreased $2.3 million compared to consolidated net income from the same period a year ago. The decrease resulted from an $18.5 million decrease in net income contributed by the gas segment, offset by a $16.2 million improvement in net income contributed by the financial services segment ($13.2 million before cumulative effect of accounting change). See separate discussions of each business segment for an analysis of these changes. Operating income increased $11.7 million in 1993 from the same period a year ago. This was primarily the result of a $25.2 million decrease in the provision for estimated credit losses, offset by increases in operating expense, depreciation and general taxes. Net interest deductions in 1993 increased $6.6 million, or 15 percent, compared to 1992. See discussion of the natural gas operations segment for an analysis of this change. Other expenses increased $9.9 million compared to 1992. See discussion of the natural gas operations segment for an analysis of this change. In January 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes," and applied the provisions prospectively. The cumulative effect of this change in method of accounting was an increase in net income of $3 million. See Note 14 of the Notes to Consolidated Financial Statements for additional discussion. Earnings per share decreased 10 cents to 71 cents per share in 1993. Dividends paid increased four cents to 74 cents per share, the result of the Board's decision to increase the quarterly dividend in May 1993. Average shares outstanding increased by 131,000 shares. 1992 vs. 1991 Consolidated net income increased $31.8 million in 1992 compared to 1991 consolidated net income. The increase resulted from a $17.9 million improvement from the financial services segment and an increase of $13.9 million contributed by the gas segment. See separate discussions of each business segment for an analysis of these changes. Operating income increased $46.7 million in 1992 compared to 1991 operating income. This was primarily the result of a $30.3 million decrease in the provision for estimated real estate and loan losses. An increase in natural gas operating margin, partially offset by higher operating expenses, depreciation and general taxes, also contributed to the increase in operating income. Net interest deductions decreased $1.3 million, or three percent, in 1992 compared to 1991. Lower interest rates in the prevailing market and lower average short-term debt, including amounts owed to ratepayers, were the primary factors contributing to the decrease in 1992. Earnings per share increased $1.57 to 81 cents in 1992. Dividends paid decreased 35 cents to 70 cents, the result of the Board's decision to reduce the quarterly dividend in September 1991. Average shares outstanding increased by 209,000 shares. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In November 1992, the Financial Accounting Standards Board (FASB) issued SFAS No. 112, "Employer's Accounting for Postemployment Benefits." The statement, which is effective for 1994 financial statements, requires an employer to recognize the cost of benefits provided to former or inactive employees, after employment but before retirement, on an accrual basis, as employees perform services to earn the benefit. The Company offers no financially significant postemployment benefits. As a result, adoption of SFAS No. 112 will have no material impact on the Company's financial position or results of operations. In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This statement is applicable to all creditors and to all loans, uncollateralized as well as collateralized, except for large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, loans that are measured at fair value or at lower of cost or fair value, leases, and debt securities as defined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 114 requires that impaired loans be measured at the present value of expected future cash flows by discounting those cash flows at the loan's effective interest rate or, in the case of collateral dependent loans such as mortgage loans, at the fair value of the collateral. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The statement amends SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," to require a creditor to account for a troubled debt restructuring involving a modification of terms at fair value as of the date of the restructuring. The statement also amends SFAS No. 5, "Accounting for Contingencies," to clarify that a creditor should evaluate the collectibility of both contractual interest and principal of a receivable when assessing the need for a loss accrual. The provisions of the statement apply to financial statements issued for fiscal years beginning after December 15, 1994, with earlier application permitted. Retroactive restatement of previously issued annual financial statements is not permitted. The Company is analyzing its loan portfolios to determine the impact, if any, of the statement on its results of operations at the date of implementation. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." On December 31, 1993, the Company early adopted SFAS No. 115. See Notes 1 and 3 of the Notes to Consolidated Financial Statements for additional discussion. NATURAL GAS OPERATIONS SEGMENT The Company is engaged in the business of purchasing, transporting, and distributing natural gas in portions of Arizona, Nevada and California. Its several service areas are geographically as well as economically diverse. The Company is the largest distributor in Arizona, distributing and transporting gas in most of southern, central and northwestern Arizona. The Company is also the largest distributor and transporter of natural gas in Nevada. The Company also distributes and transports gas in portions of California, including the Lake Tahoe area and high desert and mountain areas in San Bernardino County. As of December 31, 1993, the Company had approximately 932,000 distribution customers, of which 563,000 customers were located in Arizona, 266,000 in Nevada and 103,000 in California. Residential and commercial customers represented over 99 percent of the Company's customer base. During 1993, the Company's customer base expanded by 13,000 customers in Arizona, 20,000 in Nevada, and 2,000 in California. These increases are largely attributable to continued population growth in the Company's service areas and represent four percent growth in the Company's customer base. Customer growth over the past three years averaged four percent annually, excluding customers obtained through the 1991 acquisition of CP National Corporation (CPN) gas properties in Nevada and southern California. During 1993, 56 percent of operating margin was earned in Arizona, 32 percent in Nevada, and 12 percent in California. This pattern is consistent with prior years. The Company's total gas plant in service increased from $1.1 billion to $1.3 billion, or at an annual rate of seven percent, during the three-year period ended December 31, 1993, reflecting continued customer growth within the Company's service territories. CAPITAL RESOURCES AND LIQUIDITY The growth of the gas segment during the last several years has required capital resources in excess of the amount of cash flow generated from operating activities (net of dividends paid). During 1993, the gas segment's capital expenditures were $114 million. Cash flow from operating activities (net of dividends) provided $34 million, or approximately 30 percent, of the required capital resources pertaining to these construction expenditures. The remainder was provided from net external financing activities. The Company received no dividends from the Bank during 1993 and is not dependent upon such dividends to meet the gas segment's cash requirements. In December 1993, the Company borrowed $75 million in Clark County, Nevada, tax-exempt industrial development revenue bonds (IDRB). The IDRB have an annual coupon rate of 6.5 percent, are noncallable for 10 years and have a final maturity of December 2033. The proceeds from the sale of the IDRB will be used to finance certain additions and improvements to the Company's natural gas distribution and transmission system in Clark County, Nevada. In December 1993, the Company borrowed $50 million in City of Big Bear Lake, California, tax-exempt IDRB. The IDRB bear interest at a variable rate and have a final maturity of December 2028. The proceeds from the sale of the IDRB will be used to finance certain additions and improvements to the Company's natural gas distribution and transmission system in San Bernardino County, California. The Company currently estimates that construction expenditures for its gas segment during 1994 through 1996 will be approximately $410 million, and debt maturities and repayments, and other cash requirements are expected to approximate $190 million. Often times there are differences between estimated and actual results, because actual events and circumstances frequently do not occur as expected, and those differences may be significant. Applications to proceed with a Paiute capacity expansion project were filed with the FERC in September and October 1993. The first component of the project will expand service to seven northern Nevada industrial gas users. The Company has executed firm long-term transportation service agreements with these industrial gas users. The estimated total cost of this component is $3.5 million. The second component of the project will include the construction of new transmission pipeline facilities which will allow the Company to serve the City of Truckee, California, an area not currently serviced by the Company, and to provide additional capacity to existing service areas. The estimated total cost of the second component of the expansion project is $35 million. Proceedings on the applications are expected to commence in early 1994. Construction is expected to take place during 1994/1995 with the projects being placed in service before the 1995/1996 heating season. In December 1993, the Company filed an application for certification with the CPUC to provide natural gas service to the Truckee, California area. The cost of the proposed expansion is estimated at $25 million and would take approximately three years to complete. The Company must also apply for various permits and negotiate agreements before the expansion can take place. An additional 9,200 customers could potentially be added through the expansion. The Company plans to begin construction once the required regulatory approvals are received. It is currently estimated that cash flow from operating activities (net of dividends) will generate approximately 45 percent of the gas segment's total cash requirements during 1994 through 1996. A portion of the remaining funding requirements will be provided by $117 million of IDRB funds held in trust from the 1993 Clark County, Nevada, Series A issue and 1993 City of Big Bear Lake, California, Series A issue. The remaining cash requirements, including debt refundings, are expected to be provided by external financing sources. The timing, types, and amounts of these additional external financings will be dependent on a number of factors, including conditions in the capital markets, timing and amounts of rate relief, and growth factors in the Company's service areas. These external financings may include the issuance of both debt and equity securities, bank and other short-term borrowings, and other forms of financing. The gas segment's costs of natural gas, labor and construction are the categories most significantly impacted by inflation. Changes to the Company's cost of gas are generally recovered through PGA mechanisms and do not significantly impact net earnings. Labor is a component of the cost of service, and construction costs are the primary component of rate base. In order to recover increased costs, and earn a fair return on rate base, general rate cases are filed by the Company, when deemed necessary, for review and approval by the ACC, PSCN and FERC. In California, general rate cases are filed every three years and attrition filings (a mechanism to adjust rates primarily for inflation) are made annually for the interim periods. Regulatory lags, that is, the time between the date increased costs are incurred and the time such increases are recovered through the ratemaking process, do, however, impact earnings as do disallowances of certain costs. RESULTS OF NATURAL GAS OPERATIONS 1993 vs. 1992 Contribution to consolidated net income was $13.7 million, a decrease of $18.5 million from 1992, the result of increased operations and maintenance expenses, depreciation expense and general taxes partially offset by increased operating margin. An increase in net interest deductions and the recognition of the Arizona pipe replacement program disallowances also contributed to the decrease in net income. Operating margin during 1993 increased $6.7 million, or two percent, over the same period a year ago. This increase was primarily due to increased transportation volumes, and continued customer growth in all of the Company's service areas, combined with annualized rate relief of $1.4 million effective January 1993 in its southern California jurisdiction, rate relief in its FERC jurisdiction (subject to refund) effective April 1993, and $6.5 million in its central Arizona jurisdiction effective September 1993. Weather also had a significant impact on margin. Operating margin from weather-sensitive customers increased $1.3 million due to the rate relief in Arizona and California, and the addition of 35,000 customers system-wide during the 12-month period. However, differences in heating demand between periods negatively impacted operating margin from these customers largely offsetting the favorable occurrences. Operating margin from other customers, primarily transportation, increased $5.4 million. Transportation volumes increased by 11 percent over the prior year as cogeneration and electric generation customers increased throughput. Operations and maintenance expenses increased $10 million, or six percent, reflecting a general increase in labor costs, increased costs of materials and contractor services related to maintenance and other operating expenses. These increases are attributable to the incremental costs of providing service to the Company's steadily growing customer base. Depreciation expense and other operating expenses (primarily property taxes) increased $4.6 million, or six percent. During 1993, average gas plant in service increased $105 million, or nine percent. This is attributable to capital expenditures for the continued upgrade of existing operating facilities and the expansion of the system to accommodate substantial customer growth, including the capacity expansion project on Paiute's pipeline system. Net interest deductions increased $6.6 million, or 15 percent, in 1993. Higher average outstanding long-term debt balances with associated higher average interest rates are the primary reasons for the increased interest expense. The increase in the average long-term debt balance is attributable to the net impact of the issuances of $100 million in Series F Debentures and $130 million in tax-exempt IDRB during the second half of 1992. The Company used $80 million from the sale of the fixed-rate Series F Debentures to retire existing variable-rate indebtedness, which included $40 million of short-term borrowings. The remaining $20 million was used for general corporate purposes, including the planned expansion and replacement of utility plant. The Company used $80 million from the sale of the fixed-rate IDRB to retire existing variable-rate IDRB. The remaining $50 million was used to finance qualifying construction expenditures in the Company's Southern Nevada Division. The Company replaced the variable-rate long-term debt instruments with fixed-rate debt instruments in order to take advantage of the low interest rate environment. While interest costs have increased in the short term, the Company believes that it will achieve overall interest cost savings in the long term. Arizona Pipe Replacement Program Disallowances. In August 1990, the ACC issued its opinion and order (Decision No. 57075) on the Company's 1989 general rate increase requests applicable to the Company's Central and Southern Arizona Divisions. Among other things, the order stated that $16.7 million of the total capital expenditures incurred as part of the Company's Central Arizona Division pipe replacement program were disallowed for ratemaking purposes and all costs incurred as part of the Company's Southern Arizona Division pipe replacement program were excluded from the rate case and rate consideration was deferred to the Company's next general rate application, which was filed in November 1990. In October 1990, the Company filed a Complaint in the Superior Court of the State of Arizona, against the ACC, to seek a judgement modifying or setting aside this decision. In February 1991, the Company filed a Motion for Summary Judgement in the Superior Court to seek a judgement summarily determining that Decision No. 57075 of the ACC is unreasonable and unlawful and, in accordance with that determination, modifying or setting aside Decision No. 57075 and allowing the Company to establish and collect reasonable, temporary rates under bond, pending the establishment of reasonable and lawful rates by the Commission. In June 1991, the Court affirmed the ACC's rate order without explanation or opinion. In August 1991, the Company appealed to the Arizona Court of Appeals from the Superior Court's judgement. In April 1993, Division Two of the Arizona Court of Appeals issued a Memorandum Decision affirming the ACC's opinion and order. Based on this decision, the Company filed a Motion for Reconsideration in the Court of Appeals in May 1993. The Motion for Reconsideration was denied and the Company, in July 1993, filed a Petition for Review with the Arizona Supreme Court. On February 25, 1994, immediately following the denial of the Petition for Review by the Arizona Supreme Court, the Court of Appeals issued its Mandate ordering the Company to comply with its April 1993 Memorandum Decision. As a result of the Arizona Court of Appeals Division Two Mandate, the Company has written off $15.9 million in gross plant related to the central and southern Arizona pipe replacement program disallowances. The impact of these disallowances, net of accumulated depreciation, tax benefits and other related items, was a non-cash reduction to 1993 net income of $9.3 million, or $0.44 per share. See Note 17 of the Notes to Consolidated Financial Statements for further discussion. 1992 vs. 1991 Contribution to consolidated net income during 1992 increased $13.9 million, or 76 percent, compared to the 1991 contribution, the result of increased operating margin partially offset by increased operations and maintenance expenses, depreciation expense and general taxes. A decrease in net interest deductions also contributed to the increase in net income. Both operating revenues and net cost of gas decreased significantly from 1991 primarily due to the termination of a nonregulated sales agreement between a subsidiary of the Company and its natural gas supplier. The termination did not materially affect operating margin. Also impacting the declines was the conversion of Paiute to a transportation-only pipeline effective in June 1991. Although margin was not affected, both revenues and cost of gas decreased because Paiute no longer provides a gas sales service. Operating margin during 1992 increased $32 million, or 11 percent, compared to 1991. Operating margin from weather-sensitive customers increased $33.7 million during 1992. This increase was due, in part, to continued customer growth in all of the Company's service areas, combined with annualized rate relief of $4.8 million effective January 1992 in its California jurisdiction and $8.3 million effective March 1992 in its southern Arizona rate jurisdiction. During 1992, the Company billed an average of 40,000 more customers per month than in 1991. In addition to continued customer growth within the Company's service territories, this increase in the average number of customers was impacted by the first full year of billings of the 11,800 customers, in Henderson, Nevada, and Needles, California, acquired from CPN in late 1991. Operating margin from weather-sensitive customers was also favorably impacted by differences in heating demand between years, especially during December 1992 as compared to December 1991. Although total degree days (a measure of relative coldness which is used as an indicator of natural gas usage) were slightly lower in 1992, degree days in December 1992 were 20 percent greater than in December 1991. The Company experienced colder-than-normal weather in heating demand throughout its service territories during December 1992, whereas warmer-than-normal weather occurred during December 1991. Operations and maintenance expenses increased $5.6 million during 1992, or four percent, reflecting a general increase in labor costs, and increased costs of materials and contractor services related to maintenance. These increases were attributable to the incremental costs of providing quality service to the Company's steadily growing customer base. Depreciation expense and other expenses (primarily property taxes) increased $7.1 million during 1992, or 11 percent. During 1992, average gas plant increased $80 million, or seven percent. This was attributable to capital expenditures for the continued upgrade of existing operating facilities and the expansion of the system to accommodate substantial customer growth, including the capacity expansion project on Paiute's pipeline system. Net interest deductions decreased $1.3 million, or three percent, in 1992 compared to 1991. Lower interest rates in the prevailing market and lower average short-term debt, including amounts owed to ratepayers, were the primary reasons for the decrease in 1992. RATES AND REGULATORY PROCEEDINGS California Effective January 1, 1993, the Company received approval of an attrition allowance to increase annual margin by $1.4 million in its southern and northern California rate jurisdictions. Effective January 1, 1994, the Company received approval of an attrition allowance to increase annual margin by $1.5 million for its southern and northern California rate jurisdictions. Pursuant to the CPUC rate case processing plan, the Company filed a general rate application in January 1994 to increase annual margin by $1.1 million for its southern and northern California rate jurisdictions effective January 1995. Nevada In March 1993, the Company filed general rate cases with the PSCN seeking approval to increase revenues by $9.4 million, or eight percent, annually for its southern Nevada rate jurisdiction and $3.3 million, or nine percent, annually for its northern Nevada rate jurisdiction. The Company's last general rate cases were September 1987 for southern Nevada and December 1988 for northern Nevada. Since that time, general rate cases had not been necessary in these jurisdictions primarily because of ongoing customer growth and Company initiated cost containment measures. The Company was seeking recovery of increased operating costs in these ratemaking areas and the restructuring of its tariffs and rates to reflect current changes within the natural gas industry. The PSCN issued its rate order in October 1993 and ordered the Company to reduce general rates by $648,000 in southern Nevada and authorized a $799,000 increase in northern Nevada. The primary reasons for the difference between the Company's requested annual revenue increases and the amounts authorized by the PSCN included lower authorized returns on rate base and lower authorized depreciation expenses. The Company filed a motion for reconsideration and rehearing on several issues following the issuance of the rate order. In January 1994, the PSCN granted the rehearing of certain rate case issues. A hearing on these issues is expected to commence in the second quarter of 1994. The resolution of these issues is not expected to have a material effect on the Company's results of operations. Arizona Current Arizona Rate Cases. In October 1993, the Company filed a rate application with the ACC seeking approval to increase revenues by $10 million, or 9.3 percent, annually for its southern Arizona jurisdiction. The Company is seeking to recover increased operating costs and obtain a return on construction expenditures, and has proposed tariff restructurings which are consistent with the tariff modifications authorized by the ACC in its August 1993 central Arizona decision. Hearings on the application are to commence in June 1994. A final rate order from the ACC is expected in the fourth quarter of 1994. In October 1992, the Company filed a rate application with the ACC seeking approval to increase revenues by $15.9 million, or 7.9 percent, annually for its central Arizona jurisdiction. The Company sought recovery of increased operating costs as well as modification and simplification of its tariff to accommodate changes occurring within the industry as a result of open access transportation. In August 1993, the ACC ruled on this case and granted the Company a $6.5 million annual revenue increase for its central Arizona rate jurisdiction, effective September 1993. The primary reason for the difference between the Company's $15.9 million requested annual revenue increase and the $6.5 million annual revenue increase granted in the opinion and order was a lower authorized return on rate base. The ACC also reduced the prior rate case disallowance related to the Company's capital expenditures for the Central Arizona Division pipe replacement program from $16.7 million to $14.6 million. The revision was based on lower actual costs incurred under the program than were previously projected. See Note 17 of the Notes to Consolidated Financial Statements for further discussion regarding pipe replacement program disallowances. Arizona Gas Procurement. During 1991, the ACC Staff conducted a comprehensive audit of the Company's natural gas procurement practices. The audit covered the period January 1986 through November 1990. Issues addressed included a review of the Company's contractual arrangement with a subsidiary and its gas supplier for the acquisition of natural gas from nontraditional sources, two-tiered gas cost allocation methods, unaccounted-for gas and a review of the recovery of take-or-pay settlement costs. In July 1992, the ACC issued its order directing the Company to refund through its PGA mechanism $5.7 million of profits earned through the contractual arrangement with its subsidiary and its gas supplier. The Company made the required refunds in 1992. In July 1992, the Company filed a motion with the ACC for reconsideration of the gas procurement decision. The ACC failed to act on this motion within the specified 20 days, and it was, therefore, deemed denied by operation of law. In September 1992, the Company filed a Notice of Appeal with the Arizona Court of Appeals. In January 1994, the Arizona Court of Appeals issued an opinion affirming the decision of the ACC. The Company decided not to seek a review of the decision in the Arizona Supreme Court. FERC In October 1992, Paiute filed a general rate case with the FERC requesting approval to increase revenues by $6.8 million annually. Paiute is seeking recovery of increased costs associated with its capacity expansion project that was placed into service in February 1993. Interim rates reflecting the increased revenues became effective in April 1993 and are subject to refund until a final order is issued. The final order is expected in 1994. In December 1992, Paiute filed tariff revisions to comply with Order No. 636. The filing, among other things, restructured rates to reflect a new mandatory method of pipeline rate design. The FERC accepted Paiute's filing in May 1993, but ordered Paiute to submit additional compliance filings, which were filed through October 1993. By order issued October 1993, the FERC approved Paiute's restructured tariff effective November 1993. The restructured rates are not expected to have a significant impact on the Company's results of operations. TAKE-OR-PAY At December 31, 1993, the Company had $4.3 million remaining in regulatory asset accounts for direct bill take-or-pay (TOP) costs. These accounts included $3.3 million related to Arizona rate jurisdictions and $1 million related to the southern Nevada jurisdiction. The Company received authorization from the ACC to recover the Arizona portion of TOP costs from all Arizona jurisdictional customers effective June 1991 over periods of time not to exceed six years. In January 1992, authority was granted by the PSCN to begin recovering the southern Nevada portion of TOP costs, effective February 1992, over negotiable periods of time. Management expects full recovery of the Arizona and southern Nevada approved TOP costs. FINANCIAL SERVICES SEGMENT The Bank recorded net income of $6.6 million for the year ended December 31, 1993 compared to net losses of $9.8 million and $28.4 million for the years ended December 31, 1992 and 1991, respectively. The Bank's 1993 net income is comprised of $7.9 million from core banking operations and a $3 million gain from the change in method of accounting for income taxes. These items were partially offset by a $1 million net loss, after tax, from the sale of the Bank's Arizona branch operations (the Arizona sale) and a $3.4 million net loss, after tax, from goodwill amortization and noncore banking operations, including real estate development activities. Income from core banking operations improved in 1993 as a result of lower provisions for estimated credit losses and an improved net interest margin. In August 1993, the Bank sold its Arizona branch operations to World Savings and Loan Association (World) of California. The Bank sold $334 million of MBS to effect the sale of approximately $321 million of Arizona branch deposits. The final disposition of the Bank's Arizona branch operations resulted in an after-tax loss of approximately $1 million. See Long Term Strategic Business Plan section of MD&A and Note 2 of the Notes to Consolidated Financial Statements for further discussion. FINANCIAL AND REGULATORY CAPITAL At December 31, 1993, stockholder's equity totaled $177 million. Stockholder's equity increased $15.4 million compared to December 31, 1992, as a result of net income and unrealized gains, after tax, on debt securities available for sale. The Bank has not paid any cash dividends to the Company since 1989. By regulation, the Bank is restricted from paying dividends to the Company in excess of 75 percent of its net income over the preceding four quarters. In order to continue to build its capital position, the Bank does not anticipate paying cash dividends to the Company during 1994. During 1993, the Bank's regulatory capital levels and ratios increased under each of the three capital standards. The increase in capital levels resulted from net income, unrealized gains, after tax, on debt securities available for sale, and lower levels of real estate investments and goodwill which require deductions from capital. The Arizona sale enhanced the Bank's capital ratios by lowering its total asset base and eliminating $5.9 million of goodwill. The Bank's regulatory capital and resulting ratios are summarized as follows (thousands of dollars): As set forth above and discussed in Note 2 of the Notes to Consolidated Financial Statements, as of December 31, 1993 and 1992, the Bank exceeded all three minimum capital requirements (tangible, core and risk-based) under the regulatory capital regulations issued by the OTS. These regulatory capital regulations contain two transition rules, among others, that have impacted the Bank's business strategies. The first transition rule covers certain of the Bank's residential real estate development investments. The rule was designed to encourage the phase-out of certain activities which are not permissible for national banks and thus, requires the Bank to deduct from its assets and capital a percentage of its investment in real estate development activities as measured against the level of investment at April 12, 1989. At December 31, 1993, the Bank was required to deduct $478,000 from its capital base as a result of these rules. The Bank applied and received approval for use of a delayed phase-out schedule which extends until July 1, 1996, the date for which all investments in real estate development activities made subsequent to April 12, 1989 must be fully deducted from assets and capital, thus requiring dollar for dollar capitalization. The second transition rule requires an immediate deduction of "nonqualifying" goodwill and a phased deduction for qualifying "supervisory" goodwill. At December 31, 1993, the Bank had $69.5 million of goodwill, of which $42.5 million was nonqualifying. The remaining $27 million of qualifying supervisory goodwill must be phased out by January 1, 1995. Effective January 1, 1992, qualifying supervisory goodwill may be included in regulatory capital in an amount limited to 1.0 percent of tangible assets. This percentage limit decreased to 0.75 percent effective January 1, 1993, 0.375 percent on January 1, 1994 and will reach zero percent on January 1, 1995. Due to this limitation, the Bank is required to deduct an additional $6.3 million of supervisory goodwill from regulatory capital on January 1, 1994. See Financial Services Activities -- Regulation for further discussion. At December 31, 1993, under fully phased-in capital rules applicable to the Bank on July 1, 1996, the Bank exceeded its fully phased-in tangible, core and risk-based capital requirements by $81.8 million, $56.6 million, and $43.1 million, respectively. In December 1991, FDICIA was enacted into law. FDICIA requires federal banking regulators to take prompt corrective action if an institution fails to satisfy minimum capital requirements. Under FDICIA, capital requirements include a leverage limit, a risk-based capital requirement, and any other measure of capital deemed appropriate by the federal banking regulators for measuring the capital adequacy of an insured depository institution. All institutions, regardless of their capital levels, are restricted from making any capital distribution or paying management fees while not in capital requirement compliance or if such payment would cause the institution to fail to satisfy minimum levels for any of its capital requirements. Insured institutions are divided into five capital categories -- (1) well capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized. The categories are defined as follows: Critically undercapitalized if tangible equity to total assets ratio less than or equal to 2%. Institutions must meet all three capital ratios in order to qualify for a given category. At December 31, 1993, the Bank was classified as "well capitalized." The Bank's capital ratios can be enhanced by certain actions, including the retention of earnings, the reduction of the asset base on which the requirements are calculated, the reduction of goodwill, the reduction of the level of real estate investments which are required to be deducted from capital and capital contributions from the Company. Management has pursued all of these alternatives in order to increase its capital ratios. During 1993, the Bank achieved "well capitalized" status through a combination of increased capital from net earnings and unrealized gains from debt securities, and the reduction of assets and goodwill through the Arizona sale. It is management's intent to maintain and improve the level of capital through earnings and the stabilization of the asset base. During 1992, management pursued a strategy of reducing the size of the Bank's asset base through a combination of sales and portfolio attrition resulting from payoff activity in the loan and MBS portfolios. The Bank sold $241 million of loans and received $327 million in principal repayments. Additionally, the Bank sold $275 million of debt securities and received $294 million in principal repayments. These were partially offset by new loan originations of $517 million and debt security purchases of $546 million. Additionally, the Company contributed $10 million to the Bank in October 1991 and $10 million in February 1992, in exchange for common stock of the Bank. Regulatory Developments. The Office of the Comptroller of the Currency (OCC), which is the primary regulator for national banks, has adopted a final rule increasing the leverage ratio requirements for all but the most highly rated national banks. The OTS is required to issue capital standards for savings institutions that are no less stringent than those applicable to national banks. Accordingly, the OTS has proposed to amend its capital requirements so that all but the most highly rated savings institutions will be required to maintain a core capital ratio between four percent and five percent. Although this regulation has not yet been issued, FDICIA allows regulators to establish individualized capital requirements for institutions as deemed appropriate. No such individualized capital requirement has been imposed on the Bank. The OTS has issued a regulation which adds a component to an institution's risk-based capital calculation in 1994. The regulation will require a reduction of an institution's risk-based capital by 50 percent of the decline in the institution's NPV exceeding two percent of assets under a hypothetical 200 basis point increase or decrease in market interest rates. Based upon management's estimate of its IRR exposure, the Bank will not be subjected to a reduction from its risk-based capital requirement, using data as of December 31, 1993, as a result of implementation of this standard. The federal banking regulators have also proposed a similar regulation which may result in a more stringent capital requirement for IRR than the current OTS regulations. FIRREA requires that the OTS regulations be no less stringent than the federal banking regulators, therefore, the impact of this proposed regulation on the Bank is unknown at this time. On December 31, 1993, the Company implemented SFAS No. 115. See Note 1 of the Notes to Consolidated Financial Statements for further discussion. Under SFAS No. 115, unrealized holding gains and losses, net of tax, on securities available for sale are recorded as an adjustment to stockholder's equity. Under current OTS regulations, this component of equity is included as regulatory capital under all three capital measures. The OTS and other Federal banking regulators are considering issuing regulations regarding the future treatment of this component in regulatory capital. Possible alternatives discussed include exclusion of this component from core and tangible capital, inclusion of only unrealized losses in regulatory capital, or excluding this component entirely from regulatory capital. The Bank will review the impact of any new capital requirements when they are issued, and appropriate strategic adjustments will be considered. At December 31, 1993, the Bank has included $8.8 million in regulatory capital as a result of implementation of this standard. Because unrealized gains and losses on debt securities are highly correlated to changes in interest rates, this component of equity may be volatile regardless of regulatory treatment. The Bank estimates that a 200 basis point increase in interest rates would decrease this component of capital by approximately $11 million based on the December 31, 1993 debt securities available for sale portfolio. CAPITAL RESOURCES AND LIQUIDITY Liquidity is defined as the Bank's ability to have sufficient cash reserves on hand and unencumbered assets, which can be sold or utilized as collateral for borrowings, at a reasonable cost, or with minimal losses. The Bank's debt security portfolio provides the Bank with adequate levels of liquidity so that the Bank is able to meet any unforeseeable cash outlays and regulatory liquidity requirements. The Bank's primary sources of funds are earnings from its operations, deposits, FHLB borrowings, securities sold under agreements to repurchase, other borrowings and payments on loans and MBS. These sources are expected to generate sufficient liquidity for the Bank. Potential liquidity demands may include funding loan commitments, deposit withdrawals, and other funding needs. In order to achieve sufficient liquidity for the Bank without taking a large liquid or illiquid position and avoiding funding concentrations, the Bank has taken the following actions: 1) maintaining lines of credit with authorized investment bankers; 2) managing the debt security portfolio to ensure that maturities meet liquidity needs; 3) limiting investment and lending activities at certain times and 4) establishing maximum borrowing limits for meeting liquidity needs. The OTS has issued regulations regarding liquidity requirements which state that the Bank is required to maintain an average daily balance of liquid assets equal to at least five percent of its liquidity base (as defined in the OTS Regulations) during the preceding calendar month. The Bank is also required to maintain an average daily balance of short-term liquid assets equal to at least one percent of its liquidity base as defined in the regulations. Throughout 1993, the Bank exceeded both regulatory liquidity requirements. For the month of December the Bank's liquidity ratios were 18 percent and ten percent, respectively. The Bank's liquidity ratio is substantially higher than the regulatory requirement due to the Bank's increasing level of transaction accounts. The regulatory requirement is aimed at a more traditional savings institution which has a higher level of certificate of deposit accounts versus transaction accounts. The Bank's long-term Strategic Business Plan, as further discussed below, focuses on reducing the Bank's cost of funds by primarily increasing the Bank's retail deposit base through additional transaction accounts which carry lower interest costs and allow for customer cross-sale opportunities. The Bank's retail deposit base decreased by $410 million during 1993 from $1.6 billion at December 31, 1992, of which $61.1 million related to transaction accounts and $349 million to certificate of deposit accounts of these amounts. The Arizona sale reduced transaction accounts by $40.3 million and certificate of deposit accounts by $281 million. Transaction accounts also decreased $31 million due to the Bank utilizing a third party to issue official checks (cashiers checks and money orders). Excluding the Arizona sale and the aforementioned official checks, transaction accounts increased $10.2 million and certificate of deposit accounts decreased $67.5 million for a net decrease of $57.3 million, which was due to disintermediation as the result of the low interest rate environment that existed during 1993 and the elimination of brokered certificate of deposits of $6.9 million. In addition, during 1993 the Bank repaid fixed rate long-term borrowings, including $10 million of FHLB advances, $25 million of unsecured senior notes, $10.4 million of notes payable and $29.5 million of flexible reverse repurchase agreements. The overall effect of the Arizona sale and the repayment of such borrowings on the Bank's cost of funds was an improvement of 149 basis points. It is the responsibility of the Investment Committee to establish adequate levels of liquidity and unencumbered assets to meet the day-to-day operational needs of the Bank and to meet the regulatory requirements for liquidity. The daily operational liquidity needs of the Bank in 1993 were primarily met through $624 million of repayments on loans and debt securities, $65 million of borrowings from the FHLB and $78.4 million of loan sales. In order to fund the transfer of deposit balances involved with the Arizona sale, the Bank sold $334 million in debt securities for a gain of $7.4 million ($4.9 million after-tax). The Bank's borrowing capacity is a function of the availability of its readily marketable, unencumbered assets and the Bank's financial condition. Secured borrowings may be obtained from the FHLB in the form of advances and from authorized investment bankers in the form of reverse repurchase agreements. At December 31, 1993, the Bank maintained in excess of $281 million of unencumbered assets, with a market value of $282 million, which could be borrowed against, or sold, to increase liquidity levels. The primary management objective of the investment portfolio is to invest the excess funds of the Bank. This includes ensuring that the Bank maintains adequate levels of liquidity so it is able to meet any unforeseeable cash outlays. This task is accomplished by active investment in securities that provide the greatest return, for a given price and credit risk, in order to maximize the total return to the Bank. The secondary management objective of the investment portfolio is to serve as the Bank's primary short-term tool to manage the IRR exposure of the institution. The Bank's asset/liability management objective generally requires a trade-off between achieving the highest profitability in terms of net interest income, while maintaining acceptable levels of IRR. To accomplish these objectives, management can change the composition of the investment portfolio allowing management to quickly adjust the IRR exposure of the Bank, and take advantage of interest rate changes in the markets. The tables in Note 3 of the Notes to Consolidated Financial Statements depict the amortized cost, estimated fair values, contractual maturity, and yields of the debt security portfolios. As of December 31, 1993, the Bank's debt security portfolio was composed of securities with a fair value of $664 million (amortized cost of $652 million) with a yield of 6.17 percent compared to a debt security portfolio with a fair value of $1.2 billion (which was $11 million greater than the amortized cost) yielding 6.52 percent at December 31, 1992. During 1993, the debt security portfolio balance declined by $500 million. Purchases of debt securities totaled $113 million and sales totaled $361 million. The two primary reasons for the decline in the portfolio were: 1) the funding of the Arizona sale and 2) the significant increase in debt security prepayment rates, which provided funding for the increasing loan production and deposit run-off experienced during most of 1993. The Bank has historically been a portfolio investor with most purchases and securitizations maintained within the investment portfolio. During 1992, the Bank restructured its balance sheet and changed its accounting policy as part of a long term strategic plan to minimize IRR. As a result of this strategy, the Bank sold $241 million of fixed-rate debt securities and changed its accounting policy to designate all fixed-rate debt securities with maturities greater than or equal to 25 years as available for sale. The Bank's assets and liabilities consist primarily of monetary assets (cash, cash equivalents, debt securities and loans receivable) and liabilities (savings deposits and borrowings) which are, or will be converted into a fixed amount of dollars in the ordinary course of business regardless of changes in prices. Monetary assets lose purchasing power due to inflation, but this is offset by gains in the purchasing power of liabilities, as these obligations are repaid with inflated dollars. The level and movement of interest rates is of much greater significance. Inflation is but one factor that can cause interest rate volatility and changes in interest levels. The results of operations of the Bank are dependent upon its ability to manage such movements. See Risk Management -- Interest Rate Risk Management herein for additional discussion. RISK MANAGEMENT The financial services industry has certain risks. In order to be successful and profitable, in an increasingly volatile and competitive marketplace, the Bank must accept some forms of risk and manage these risks in a safe and sound manner. Generally, transactions that the Bank enters into require the Bank to accept some measure of credit and IRR, and utilize equity capital. The Bank has established certain guidelines in order to manage the Bank's assets and liabilities. These guidelines will help ensure that the risks taken and consumption of capital are optimized to achieve maximum profitability, while minimizing risks to equity and the federal deposit insurance fund. Interest Rate Risk Management. IRR management is a complex and evolving financial management discipline which represents an ongoing challenge for financial institutions. Changes in the Bank's IRR exposure affect the current market values of the Bank's loan, debt securities, and deposit portfolios, as well as the Bank's future earnings. The level of the Bank's IRR exposure can also affect the Bank's regulatory capital requirements. IRR can result from (a) timing differences in the maturity and/or repricing of the Bank's assets, liabilities, and off-balance sheet contracts; (b) the exercise of options embedded in the Bank's financial instruments and accounts, such as prepayments of loans before scheduled maturity, caps on the amounts of interest rate movement permitted for adjustable-rate loans, and withdrawals of funds on deposit with and without stated terms to maturity; and (c) differences in the behavior of lending and funding rates, referred to as basis risk. The role of the Bank's asset/liability management function is to prevent the erosion of the Bank's earnings and equity capital due to interest rate fluctuations. The Bank's Board of Directors (BOD) has established certain guidelines to prudently manage the exposure of the Bank's net interest income, net income, and market value of portfolio equity (MVPE) or NPV to interest rate fluctuations. The guidelines include limits on the Bank's overall IRR exposure, methods of accountability and specific reports to be provided to it by management for periodic review, and established acceptable activities and instruments to manage IRR. The BOD has delegated responsibility for IRR measurement and management to the Bank's Asset/Liability Management Committee (ALCO). To enable it to measure and manage the Bank's IRR, ALCO has developed and maintains an IRR simulation model. The model enables the Bank to measure IRR exposure using various assumptions and interest rate scenarios, and to incorporate alternative strategies for the reduction of IRR exposure. ALCO measures the Bank's IRR using several methods to provide a comprehensive view of IRR from various perspectives. These methods include projection of current MVPE and future periods' net interest income after rapid and sustained interest rate movements, static analysis of repricing and maturity mismatches, or gaps, between assets and liabilities, and analysis of the size and sources of basis risk. Each of these analyses is a tool for the assessment of the Bank's IRR, and is reviewed independently as well as collectively by ALCO to accurately assess the Bank's IRR exposure. The analyses are also used as a basis for the formulation of strategies to reduce the Bank's IRR exposure where and as needed, thus ensuring that the Bank remains within BOD limits for overall IRR exposure. Static gap analysis measures the difference between financial assets and financial liabilities scheduled and expected to mature or reprice within a specified time period. The gap for that period is positive when repricing and maturing assets exceed repricing and maturing liabilities. The gap for that period is negative when repricing and maturing liabilities exceed repricing and maturing assets. A positive or negative cumulative gap indicates in a general way how the Bank's net interest income should respond to interest rate fluctuations. A positive cumulative gap for a period generally means that rising interest rates would be reflected sooner in financial assets than in financial costing liabilities, thereby increasing net interest income over that period. A negative cumulative gap for a period would produce an increase in net interest income over that period if interest rates declined. At December 31, 1993, the Bank had financial assets of $1.7 billion with a weighted average yield of 6.83 percent, and financial liabilities of $1.5 billion with a weighted average rate of 3.72 percent. The Bank's cumulative one-year static gap was a negative $39.4 million, or two percent of financial assets. The Bank's financial assets and financial liabilities are presented according to their frequency of repricing, and scheduled and expected maturities in the following table (thousands of dollars): STATIC GAP AS OF DECEMBER 31, 1993 - --------------- Note: Loans receivable exclude allowance for credit losses, discount reserves, deferred loan fees, and accrued interest on loans. Static Gap Assumptions as of December 31, 1993 (1) Based on the contractual maturity or term to next repricing of the instrument(s). (2) Maturity sensitivity is based upon characteristics of underlying loans. Portions represented by adjustable-rate certificates are included in the "Within 1 Year" category, as underlying loans are subject to interest rate adjustment at least semiannually or annually. Portions represented by fixed rate loans are based on contractual maturity, and projected repayments and prepayments of principal. (3) Adjustable-rate loans are included in each respective category depending on the term to next repricing and projected repayments and prepayments of principal. (4) Maturity sensitivity is based upon contractual maturity, and projected repayments and prepayments of principal. (5) FHLB stock has no contractual maturity. The Bank receives quarterly dividends on all shares owned and the balance is therefore included in the "Within 1 Year" category. The amount of such dividends is not fixed, and varies quarterly. (6) Interest-bearing demand, money market deposits, and savings deposits may be subject to daily interest rate adjustment and withdrawal on demand, and are therefore included in the "Within 1 Year" category. (7) Noninterest-bearing demand deposits have no contractual maturity, and are included in each repricing category based on the Bank's historical attrition of such accounts. (8) Floating-rate reverse repurchase agreements are included in the "Within 1 Year" category. Principal repayments of flexible reverse repurchase agreements are based on the projected timing of construction or funding of the underlying project. (9) Hedging consisted of a fixed interest rate swap as of December 31, 1993. While the static gap analysis is a useful asset/liability management tool, it does not fully assess IRR. Static gap analysis does not address the effects of customer options (such as early withdrawal of time deposits, withdrawal of deposits with no stated maturity, and mortgagors' options to prepay loans) and Bank strategies (such as delaying increases in interest rates paid on certain interest-bearing demand and money market deposit accounts) on the Bank's net interest income, net income, and MVPE. In addition, the static gap analysis assumes no changes in the spread relationships between market rates on interest-sensitive financial instruments (basis risk), or in yield curve relationships. Therefore, a static gap analysis is only one tool with which to analyze IRR, and must be reviewed in conjunction with other asset/liability management reports. Using the Bank's IRR simulation model, management also estimates the effects of rapid and sustained interest rate movements on the Bank's current MVPE. Beginning in 1994, the OTS will use a similar methodology to determine the Bank's IRR component of risk-based capital, if the Bank's IRR exposure is above the threshold established by the regulation. See Financial and Regulatory Capital -- Regulatory Developments for further discussion. The following table presents management's estimate of the Bank's MVPE after a hypothetical, instantaneous 200 basis points (bp) change in market interest rates at December 31, 1993 (thousands of dollars): The financial instruments approved by the BOD to manage the Bank's IRR exposure in its balance sheet include the Bank's debt security portfolio, interest rate swaps, interest rate caps, interest rate collars, interest rate futures, and put and call options. These financial instruments provide effective methods of reducing the impact of changes in interest rates on the market values of and earnings provided by the Bank's assets and liabilities. The Bank also actively manages its retail and wholesale funding sources to minimize its cost of funds and provide stable funding sources for its loan and investment portfolios. Management's use of particular financial instruments is based on a complete analysis of the Bank's current IRR exposure and the projected effect of any proposed strategy on the Bank's IRR exposure. In addition, to manage the IRR exposure associated with the Bank's held for sale loan portfolio, the Bank utilizes forward sale commitments. Credit Risk Management. One of the Bank's primary businesses is to make and acquire loans secured by residential and other real estate to enable borrowers to purchase, refinance, construct and improve such property. These activities entail potential credit losses, the size of which depends on a variety of economic factors affecting borrowers and the real estate collateral. The Bank continues to emphasize consumer and commercial loan originations which are generally secured by non-real estate-based collateral. During 1993, consumer loans increased 67 percent to $137 million. While the Bank has adopted underwriting guidelines and credit review procedures to minimize credit losses, some losses will inevitably occur. Periodic reviews are made of the Bank's assets in an attempt to identify and deal appropriately with potential credit losses at an early date. The Bank continues its efforts to diversify its asset portfolio, thereby reducing its credit risk. The Bank's Credit Administration Department is responsible for ensuring adherence to the Bank's approved lending policies and procedures, including proper approvals, timely completion of periodic asset reviews, early identification of problem loans, reviewing the quality of underwriting and appraisals, tracking trends in the Bank's asset quality and evaluating the adequacy of the Bank's allowance for losses. To further control its credit risk, the Bank monitors and manages its credit exposure in portfolio concentrations. Portfolio concentrations, including collateral types, industry groups, geographic locations, and loan types are assessed and the exposure is managed through the establishment of limitations of aggregate exposures. The Bank has also strengthened its underwriting guidelines, performs periodic credit reviews, and established limitations on loans to one borrower which are more stringent than regulatory requirements. As part of the regular asset review process, management reviews factors relating to the possibility and magnitude of prospective loan and real estate losses, including historical loss experience, prevailing market conditions and classified asset levels. The Bank is required to classify assets and establish prudent valuation allowances in accordance with OTS regulations. The Bank's Credit Administration Department is also responsible for the maintenance of a comprehensive risk-rating system used in determining classified assets and allowances for estimated credit losses. The system involves an ongoing review of all assets containing an element of credit risk including loans, real estate and investment securities. The review process assigns a risk rating to each asset reviewed based upon various credit criteria. If the review indicates that it is probable that some portion of an asset will result in a loss, the asset is written down to its expected recovery value. An allocated general valuation allowance is established for each asset reviewed which has been assigned a risk classification. The allowance is determined, subject to certain minimum percentages, based upon probability of default (in the case of loans), estimated ranges of recovery, and probability of each estimate of recovery value. An allowance for estimated credit losses on classified assets not subject to a detailed review is established by multiplying a percentage by the aggregate balances of the assets outstanding in each risk category. The percentages assigned increase based on the degree of risk and reflect management's estimate of potential future losses from assets in a specific risk category. With respect to loans not subject to specific reviews, principally single-family residential and consumer loans, the allowance is established based upon historical loss experience. Additionally, an unallocated allowance is established to reflect economic conditions that may negatively affect the portfolio in the aggregate. The Bank has also established certain guidelines and criteria in order to manage the credit risk of investment security portfolios, including concentration limits, credit rating and geographic distribution requirements. The following table presents the credit quality of debt security portfolios: The other category primarily includes the Bank's investment in the privately issued MBS classified as substandard, as further explained in this section. OTS regulations require the Bank to classify certain assets into one of three categories -- "substandard," "doubtful" and "loss." An asset which does not currently warrant classification as substandard but which possesses weaknesses or deficiencies deserving close attention is considered a criticized asset and is designated as "special mention." The Bank designated $27.6 million of its assets as "special mention" at December 31, 1993. The following table sets forth the amounts of the Bank's classified assets and ratio of classified assets to total assets, net of specific reserves and charge-offs, as of the dates indicated (thousands of dollars): The Bank's "substandard" assets decreased from $82 million at December 31, 1992 to $79 million at December 31, 1993, primarily as a result of payoffs of real estate loans and disposition of foreclosed real estate. This decrease was partially offset by the classification of an investment in a privately issued adjustable-rate commercial MBS. Assets classified as "substandard" are inadequately protected by the current net worth or paying capacity of the obligor or the collateral pledged, if any. Foreclosed real estate decreased $14.8 million during 1993 principally as a result of the disposition of a $10.4 million multi-family property located in southern Nevada. It is the Bank's practice to charge off all assets which it considers to be "loss." As a result, none of the Bank's assets, net of charge-offs, were classified as "loss" at December 31, 1993. The security classified as substandard represents a privately issued MBS collateralized by apartments, office buildings, town homes, shopping centers and day care centers located in various states along the southeastern seaboard and is further supported by a credit enhancement feature. The single A credit rating of this security was withdrawn by the rating agency in January 1993, due to the delinquency of a large number of the loans underlying the security. Because of the limited number of owners of the security, no quoted market value is available on the MBS. Therefore, the Bank's management performed a credit review of the loans underlying the MBS to determine the appropriate fair value of the security. Based on these credit reviews, the Bank determined the total estimated fair value of each security, taking into account the credit enhancement structure. Also, based on the credit reviews, the Bank designated $10.6 million of the security as substandard, $5.2 million was designated as special mention, and the remainder was not classified as of September 30, 1993. The Bank presented the results of its valuation analysis and revised classification of the investment to the OTS during the third quarter of 1993. The OTS had no objection to the Bank's valuation methodology or classification at that time. During the Bank's regular OTS examination in the first quarter of 1994, the OTS concurred with the Bank's valuation methodology, but classified the entire security balance as substandard, stating there was no policy allowing for "split rating" of a security. The Bank has reflected the entire balance of the security as substandard at December 31, 1993. During 1992, the Bank created a Special Assets Department with responsibility for resolution and/or disposition of classified assets. The department's goal is to reduce the level of classified assets through sales of foreclosed and other real estate and resolution of classified loans. The current level of the Bank's classified assets reflects significant improvement from the prior two years. Aggressive management of the resolution of these assets along with some stabilization within the economy contributed to the success in reducing the classified asset portfolio. Although progress has been positive, the Bank is unable to predict at this time what level, if any, of these assets may subsequently be charged off or may result in actual losses. Steady economic growth and low interest rates should assist in the further reduction of classified assets. During 1993, the Bank established provisions for estimated credit losses totaling $7.2 million, of which $1 million was related to the Bank's real estate portfolio and $6.2 million to its loan, foreclosed real estate, and debt security portfolio. In 1992, the Bank established provisions for estimated credit losses totaling $32.4 million, of which $18.3 million related to the Bank's real estate portfolio and $14.1 million related to its loan and foreclosed real estate portfolio. Of the $50.7 million provision for estimated real estate losses recorded in 1991, $32.2 million was applicable to the Bank's investment and loan to Margarita Village Development Company (MVDC) located in Temecula, California. As a result of the Bank's internal review process, the general allowance for estimated credit losses decreased to $16.3 million at December 31, 1993 from $17.2 million at December 31, 1992. The reduced level of classified assets, reduced charge-off activity, and the stabilization of the economy contributed to the decrease. The Bank's loan portfolio is concentrated primarily in Nevada, California and Arizona. The following table summarizes the geographic concentrations of the Bank's loan portfolios at December 31, 1993 (thousands of dollars): LOANS BY REGION The following table sets forth by geographic location the amount of classified assets at December 31, 1993 (thousands of dollars): CLASSIFIED ASSETS BY GEOGRAPHIC LOCATION The mortgage loans of $29.5 million in other states represent the classified MBS collateralized by loans in states along the southeastern seaboard. Classified construction and land loans include committed but undisbursed loan amounts. The following table sets forth by type of collateral, the amount of classified assets at December 31, 1993 (thousands of dollars): CLASSIFIED ASSETS BY TYPE OF LOAN The largest substandard loan at December 31, 1993 was an $8.6 million multi-family real estate loan in Nevada. In addition, the Bank had six other substandard loans at December 31, 1993 in excess of $1 million: two multi-family loans in Nevada, three commercial mortgage properties in Nevada, and one single-family residential development project in California. The largest parcel of foreclosed real estate owned by the Bank at December 31, 1993, was a $2.1 million single-family residential development project in California. The Bank also owned three parcels of foreclosed real estate at December 31, 1993 with book values in excess of $1 million: one apartment complex located in Nevada and two single-family residential development projects located in California. Substandard real estate held for investment includes a $1.4 million Arizona branch facility not included as part of the Arizona sale. This branch facility was formerly included in premises and equipment. See Notes 2 and 5 of the Notes to Consolidated Financial Statements for further discussion. The following table presents the Bank's net charge-off experience for loans receivable and real estate acquired through foreclosure by loan type (thousands of dollars): The $2.3 million of commercial mortgage charge-offs for the year ended December 31, 1993 were comprised principally of two apartment complex properties for $800,000 each in Nevada. One was an insubstance foreclosure and the other was foreclosed real estate subsequently sold during 1993. Construction and land losses in 1993 consisted primarily of two California loans totaling $1.5 million. Nonmortgage loan charge-offs were principally comprised of $1 million of losses in installment loans and $591,000 of credit card charge-offs in 1993. LONG-TERM STRATEGIC BUSINESS PLAN In 1992, the Bank developed a comprehensive long-term Strategic Business Plan (the Plan) in order to reduce the Bank's level of interest rate, liquidity and prepayment risks. The Plan included a review of the Bank's balance sheet size, asset mix between fixed-rate and adjustable-rate assets, and IRR. As a result of this review, during 1992 the Bank began execution of a strategy to restructure its balance sheet, and changed its investment policy with regard to loans held for investment versus held for sale. The Bank's balance sheet restructuring involved the sale of all fixed-rate single-family mortgage loans and MBS with remaining maturities greater than or equal to 25 years, canceling interest rate swaps which hedged the IRR of such assets, and reinvesting the proceeds of the sales in adjustable-rate MBS and five-year fixed-rate balloon MBS. The Bank's accounting policy was amended to designate all fixed-rate loans and debt securities with maturities greater than or equal to 25 years (which possess normal qualifying characteristics required for sale) as available/held for sale, along with single-family residential loans originated for specific sales commitments. Fixed-rate loans with maturities less than 25 years, and all adjustable-rate loans continue to be held for investment, while fixed-rate debt securities with maturities of less than 25 years and all adjustable-rate debt securities are either designated as held for investment or available for sale. In conjunction with the balance sheet restructuring during 1992, the Bank sold $152 million of single-family residential fixed-rate loans, $241 million of fixed-rate MBS, and canceled $300 million (notional amount) of interest rate swaps hedging these assets. The Bank purchased $394 million of adjustable-rate and balloon MBS. Additionally, the Plan included organizational restructuring, which in some cases involved the elimination of positions. General and administrative expenses for the year ended December 31, 1992, include $1 million for severance benefits related to this restructuring. In the course of the development of the Bank's Plan, the BOD and management established several core strategies. One of the primary strategies was to "right size and right structure" the Bank in terms of balance sheet, revenue and expenses. In the comprehensive analysis performed to determine the appropriate balance sheet size, management determined that the Bank's total asset base should be approximately $1.8 billion by December 1996. This analysis indicated that an immediate reduction of the wholesale assets and liabilities of the Bank without a corresponding decrease in noninterest expense would severely damage core earnings and hamper the success of the Plan. As the Plan evolved, it became more clear that the asset side of the Bank must be restructured to replace lower yielding debt securities with higher yielding loans and that higher costing CDs and borrowings must be replaced with lower costing transaction accounts. The implementation of the Plan emphasized the building of the Bank's retail deposit base and the meshing of customers' deposit and loan needs. The expansion of the Business Banking Department has contributed to the Bank's increased focus on customer relationships. Consumer lending is expected to increase as the Bank continues to serve its local communities. In May 1993, the Bank signed a Definitive Agreement with World Savings and Loan Association (World) of Oakland, California, whereby World agreed to acquire the Bank's Arizona branch operations, including all related deposit liabilities of approximately $321 million. The transaction was approved by the appropriate regulatory authorities and closed in August 1993. As a result of the sale, the Bank recorded a $6.3 million loss, which included a write-off of $5.9 million in goodwill (excess of cost over net assets acquired) and $367,000 of other related net costs. The Bank sold $334 million of MBS to effect the sale of the Bank's Arizona-based deposit liabilities to World and to maintain the Bank's interest rate risk position. The sale of the securities resulted in a gain of $7.4 million ($4.9 million after tax) included in gain on sale of debt securities in the Consolidated Statements of Income. The final disposition resulted in an after-tax loss of approximately $1 million. The transaction resulted in an improved net interest margin, lower general and administrative expenses, and improved regulatory capital ratios. In January 1994, the Bank sold its credit card portfolio for a gain of approximately $1.7 million. The decision to sell this portfolio was based on the profitability of credit cards versus other lines of business and the inability to compete with the large, highly efficient credit card issuers with economies and market penetration advantages. The Bank will maintain an agent bank relationship with the holder of the credit card portfolio which will provide fee income and cross-selling opportunities while reducing general and administrative expenses. RESULTS OF FINANCIAL SERVICES OPERATIONS The Bank's net earnings depend in large part on the difference, or interest rate spread, between the yield it earns from its loan and debt security portfolios and the rates it pays on deposits and borrowings. The following table reflects the components of net interest income of the Bank for each of the three years in the period ended December 31, 1993, setting forth average assets, liabilities and equity; interest income on interest-earning assets and interest expense on interest-bearing liabilities; average yields on interest-earning assets and interest-bearing liabilities; and net interest income (thousands of dollars): Note: Loans receivable include accrued interest and loans on nonaccrual, and are net of undisbursed funds, valuation allowances, discounts and deferred loan fees. The net yields on average interest-earning assets have steadily increased (total dollar difference between interest earned and interest paid, divided by average interest-earning assets) and were 3.15 percent, 2.70 percent and 2.47 percent for the years ended December 31, 1993, 1992 and 1991, respectively. The following table shows, for the periods indicated, the effects of the two primary determinants of the Bank's net interest income: interest rate spread and the relative amounts of interest-sensitive assets and liabilities. The table also shows the extent to which changes in interest rates and changes in the volumes of interest sensitive assets and liabilities have affected the Bank's interest income and expense for the periods indicated. Changes from period to period are attributed to: (i) changes in rate (change in weighted average interest rate multiplied by prior period average portfolio balance); (ii) changes in volume (change in average portfolio balance multiplied by prior period rate); and (iii) net or combined changes in rate and volume. Any changes attributable to both rate and volume that cannot be segregated have been allocated proportionately between the two factors. 1993 vs. 1992 The Bank recorded net income of $6.6 million for the year ended December 31, 1993 compared to a net loss of $9.8 million for the year ended December 31, 1992. The increase in net earnings was principally due to the decrease in provisions for estimated credit losses, the gain recorded on the sale of debt securities in connection with the Arizona sale, the cumulative effect of change in method for accounting for income taxes and an improved net interest margin, offset partially by the write-off of goodwill as the result of the Arizona sale as described in Note 2 of the Notes to Consolidated Financial Statements. The lower interest-earning asset base is the result of the Bank's previously described strategy of reducing its total asset size. The decline in the average yield on interest-earning assets is the result of the repricing of interest sensitive loans and debt securities, repayment of higher yielding loans and debt securities and the replacement of such loans and debt securities with lower yielding originations and purchases. The following summarizes the significant effects of these factors: (i) Interest on cash equivalents decreased due to the lower yield which was a result of the lower interest rates during the year. (ii) Interest on debt securities, in total, decreased principally as a result of $294 million of payoffs and principal amortization in the portfolio and the third quarter effect of the sale of $334 million to fund the transfer of the Arizona-based deposit liabilities, offset partially by $113 million in debt security purchases. The decrease in debt securities held to maturity was the result of the reclassification of the majority of the portfolio to debt securities available for sale category during the second quarter. This resulted in the increase in debt securities available for sale offset partially by the sale of $334 million to fund the transfer of the Arizona-based deposit liabilities. The decrease in yield was due to sales of higher coupon securities in 1992 and 1993 and to repricing of adjustable-rate debt securities, repayments and purchase of lower yielding debt securities. (iii) The average loans receivable portfolio decreased principally due to payoffs exceeding originations of loans held for investment. The average yield on loans declined as a result of lower interest rates on newly funded loans, repricing of adjustable loans, and payoffs of higher yielding loans. (iv) Dividends on FHLB stock increased as a result of a higher declared dividend rate in 1993. (v) The average balance for deposits decreased as a result of the Arizona sale of $321 million. The decrease in the cost of savings was due to the lower interest rates and the disintermediation of certificates of deposit accounts to transaction accounts. (vi) The increase in interest on reverse repurchase agreements was due to new borrowings during the first part of 1993 partially offset by a decrease in the cost. (vii) The decrease in the average balance for FHLB advances was due to the repayment of advances in the early part of 1993 somewhat offset by new borrowings later in the year. The decrease in the cost of these advances was due to lower interest rates on the new borrowings versus the higher rates on these advances paid off. (viii) The decrease in interest on bonds payable was the result of the payoff of mortgage-backed bonds during the second quarter of 1992. These bonds were called on June 30, 1992. (ix) Interest on notes payable declined as a result of the repayment of $10.4 million in the third quarter of 1993. (x) Interest on unsecured senior notes declined as a result of the pay-off of the $25 million balance in the third quarter of 1993. The Bank's cost of hedging activities decreased principally as a result of the cancellation of $300 million (notional amount) of interest rate swaps outstanding during the second and third quarters of 1992 and only $7.5 million (notional amount) of interest rate swaps were entered into in late 1993. Provisions for estimated credit losses decreased in 1993 versus 1992 as a result of management's evaluation of the adequacy of the allowances for estimated credit losses. See Risk Management -- Credit Risk Management herein and Note 6 of the Notes to Consolidated Financial Statements for further discussion. The net gain on sale of loans decreased $2.9 million from $4.6 million in 1992 to $1.7 million in 1993 due to a decrease in the amount of loans sold from $240 million in 1992 to $78 million in 1993. The gain on sale of mortgage loan servicing decreased $1.9 million in 1993 as there were no sales of mortgage loan servicing in 1993. Net gains on the sale of debt securities, including the interest rate swap loss, increased from a net loss of $809,000 in 1992 to a net gain of $8 million in 1993, primarily due to the sale of $361 million in debt securities, of which $334 million were sold to fund the transfer of the Arizona-based deposit liabilities. The net loss on the termination of the interest rate swaps in 1992 was $14.1 million. No similar activity occurred in 1993. The net loss on the termination of the interest rate swaps was related to the cancellation of $300 million (notional amount) of interest rate swaps which hedged loans and debt securities sold during 1992 as part of the balance sheet restructuring. Loan related fees decreased $1.3 million due to the decrease in loan servicing volume. Deposit fees increased $984,000 due to an increase in the fee structure. Other income increased principally due to a legal settlement received of $1.2 million. General and administrative expenses increased $3 million, or seven percent, in 1993. This increase was due to the reinstatement of employee merit increases and incentive awards during 1993, a scheduled rent increase on office space, and increased professional services fees from legal efforts related to California real estate development projects. The Bank's effective tax rate was 64.1 percent in 1993 primarily as a result of goodwill amortization and goodwill write-offs not deductible for tax purposes. 1992 vs. 1991 The Bank recorded a net loss of $9.8 million for the year ended December 31, 1992 compared to a net loss of $28.4 million for the year ended December 31, 1991. The net loss was principally due to the Bank recording $32.4 million in provisions for estimated credit losses. See Risk Management -- Credit Risk Management herein for additional discussion. Pretax earnings from core banking operations, which exclude real estate development activities and amortization of excess of cost over net assets acquired, for the year ended December 31, 1992, declined to $9.7 million from $17.5 million in 1991, principally as a result of increased provisions for estimated credit losses and increased general and administrative expenses. Net interest income decreased in 1992 as a result of a lower interest-earning asset base and a decline in the Bank's average yield on interest-earning assets offset partially by a 159 basis point decline in the Bank's cost of funds. The decline in the Bank's cost of funds was a result of the lower interest rate environment during 1992 and a decline in the Bank's level of wholesale borrowings. The lower interest-earning asset base was the result of the Bank's previously described strategy of reducing its total asset size. The decline in the average yield on interest-earning assets was the result of the repricing of interest sensitive loans, payoffs and sales of higher yielding fixed-rate loans and debt securities being replaced by lower yielding originations and purchases. The following summarizes the significant effects of these factors: (i) The decrease in the average loans receivable portfolio was a result of 1992 sales of $240 million, along with payoffs, principal amortization and securitizations exceeding new loan originations. The average yield declined as a result of payoffs of higher yielding fixed-rate loans as individuals opted to refinance their mortgage loans, repricing of interest rate sensitive loans and sales of fixed-rate loans. (ii) Debt securities in total declined, principally as a result of $294 million of payoffs and principal amortization in the portfolio and sales of $275 million during the year, offset by $546 million in debt securities purchased. There were no debt securities designated as available for sale in 1991. (iii) Interest on deposits decreased in 1992 principally as a result of deposit outflows due to the low interest rate environment. (iv) Interest on reverse repurchase agreements declined as a result of repayments and a decline in average rates. (v) Interest on FHLB advances declined as a result of repayments which was partially offset by an increase in the average rate. (vi) Interest on bonds payable decreased principally as a result of the payoff of $74.1 million of bonds payable during 1992. (vii) Interest on unsecured senior notes declined due to repayment of $150 million in late 1991. The declines in the average balances of reverse repurchase agreements, FHLB advances, bonds payable and unsecured senior notes were a result of the previously described strategy of the Bank to shift its liability mix from wholesale borrowings to retail deposits. The declines in average yields on reverse repurchase agreements and unsecured senior notes resulted from the continuing decline in short-term interest rates during 1992. The Bank's cost of hedging activities decreased $1.9 million, principally as a result of the cancellation of $300 million (notional amount) of interest rate swaps outstanding during the second and third quarters of 1992. Provisions for estimated credit losses increased $2.1 million in 1992 versus 1991 as a result of management's evaluation of the adequacy of the allowances for estimated credit losses. See Risk Management -- Credit Risk Management herein and Note 6 of the Notes to Consolidated Financial Statements for additional discussion. In conjunction with the restructuring of the balance sheet, the Bank sold $394 million of loans and debt securities, which resulted in net gains of $17.6 million. These gains were partially offset by the loss of $14.1 million related to the cancellation of interest rate swaps ($300 million -- notional amount) which served as a hedge to the assets sold. Gains on sales of loans and debt securities not related to the restructuring amounted to $2.2 million. Loan related fees decreased $1.1 million principally due to a lower balance in the loan portfolio and lower interest rates. Deposit related fees and other income increased $3.3 million principally due to increases in merchant services fee income and fees from sales of mutual fund products. General and administrative expenses increased $4.1 million, or ten percent, in 1992 due principally to expenses incurred in restructuring the Bank's organization, including severance benefits and changes in staffing, and increased regulatory assessments. The Bank recorded a $15.3 million net loss from real estate operations in 1992, compared to a net loss of $50.5 million in 1991. The 1992 and 1991 losses are a result of recording $18.3 million and $50.7 million, respectively, in provisions for estimated credit losses and fewer unit sales. See Risk Management -- Credit Risk Management herein and Note 6 of the Notes to Consolidated Financial Statements for additional discussion. The lower unit sales volume in 1992 and 1991 was the result of the impact of the economic recession on the California real estate market and the fewer number of active projects in which the Bank was participating. The effective tax rate (benefit) for 1992 was 0.9 percent compared to (23.6) percent in 1991, primarily as a result of increased provisions for estimated losses in 1992, which were not deductible for tax purposes. (This page intentionally left blank) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA SOUTHWEST GAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (THOUSANDS OF DOLLARS) ASSETS The accompanying notes are an integral part of these statements. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The accompanying notes are an integral part of these statements. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (THOUSANDS OF DOLLARS) The accompanying notes are an integral part of these statements. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) The accompanying notes are an integral part of these statements. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation -- The accompanying financial statements are presented on a consolidated basis and include the accounts of the Company, including the Bank. Intercompany balances and transactions have been eliminated. Certain amounts for prior years have been reclassified to conform to the current year's presentation. See Selected Financial Data for information related to each business segment. Such information should be read in conjunction with these financial statements. For purposes of reporting consolidated cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and other financial instruments with a maturity of three months or less. The Company follows generally accepted accounting principles (GAAP) in all of its businesses. Accounting for the Company's gas utility operations conforms with GAAP as applied to regulated companies and as prescribed by federal agencies and the commissions of the various states in which the utility operates. Debt Securities -- On December 31, 1993, the Bank adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement requires classification of investments in debt and equity securities into one of three categories: held to maturity, available for sale, or trading. At the time of purchase, the Bank will designate a security into one of these three categories. Debt securities classified as held to maturity are those which the Bank has the positive intent and ability to hold to maturity. These securities are carried at cost adjusted for the amortization of the related premiums or accretion of the related discounts into interest income using the level-yield method over the remaining period until maturity. The Bank has the ability and it is its policy to hold the debt securities so designated until maturity. The Bank's accounting policy states that no security with a remaining maturity greater than 25 years may be designated as held to maturity. Securities classified as available for sale are those which the Bank intends to hold for an indefinite period and may be sold in response to changes in market interest rates, changes in the security's prepayment risk, the Bank's need for liquidity, changes in the availability and yield of alternative investments, and other asset/liability management needs. Securities classified as available for sale are stated at fair value at December 31, 1993 in the Consolidated Statements of Financial Position. Changes in fair value are reported net of tax as a separate component of stockholders' equity but are not included in net income. At December 31, 1993, the Bank included an $8.8 million unrealized gain, net of tax, on $596 million of debt securities available for sale as a separate component of stockholders' equity. Realized gains or losses are recorded into income when sold. Debt securities available for sale at December 31, 1992 were accounted for at the lower of cost or fair value. Trading securities are those which are bought and held principally for the purpose of selling in the near term. Trading securities include MBS held for sale in conjunction with mortgage banking activities. Trading securities are measured at fair value with changes in fair value included in earnings. At December 31, 1993, no securities were designated as "trading securities." Mortgage Banking Activities -- The Bank's accounting policy is to designate all fixed-rate interest-sensitive assets with maturities greater than or equal to 25 years (which possess normal qualifying characteristics required for sale) as held for sale or available for sale, along with single-family residential loans originated for specific sales commitments. Fixed-rate interest-sensitive assets with maturities less than 25 years, and all adjustable-rate interestsensitive assets continue to be held for investment or available for sale unless designated as held for sale at time of origination. Loans held for sale are carried at the lower of amortized cost or fair value as determined by outstanding investor commitments or, in the absence of such commitments, current investor yield requirements calculated SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) on an aggregate basis. Valuation adjustments are charged against gain on sale of loans. Gains and losses on loan and MBS sales are determined using the specific identification method. Gains and losses are recognized to the extent that sales proceeds exceed or are less than the carrying value of the loans and MBS. Loans sold with servicing retained have included a normal servicing fee to be earned by the Bank as income over the life of the loan. Loans held for sale may be securitized into MBS and designated as trading securities. Prior to December 31, 1993, and implementation of SFAS No. 115, MBS created from mortgage banking activities were designated as held for sale and recorded at the lower of aggregate cost or market. Subsequently, these MBS will be designated as trading securities and recorded at fair value. The Bank hedges interest rate risk on fixed-rate loan commitments expected to close and the inventory of loans held for sale through a combination of commitments from permanent investors, optional delivery commitments, and mandatory forward contracts. Related hedging gains and losses are recognized at the time gains and losses are recognized on the related loans. Loans Receivable -- Real estate loans are recorded at cost, net of the undisbursed loan funds, loan discounts, unearned interest, deferred loan fees and provisions for estimated losses. Interest on loans receivable is credited to income when earned. Generally, when a loan becomes 90 days contractually delinquent, the accrual of interest is ceased and all previously accrued, but uncollected, interest income is reversed. Interest income on loans placed on nonaccrual status is generally recognized on a cash basis. Fees are charged for originating and in some cases, for committing to originate loans. Loan origination and commitment fees, offset by certain direct origination costs, are deferred, and the net amounts amortized as an adjustment of the related loans' yields over the contractual lives thereof. Unamortized fees are recognized as income upon the sale or payoff of the loan. Unearned interest, premiums and discounts on consumer installment, equity and property improvement loans are amortized to income over the expected lives of the loans using a method which approximates the level-yield method. Concentrations of Credit Risk -- The Company's business activity with respect to gas utility operations is conducted with customers located within the three state region of Arizona, Nevada and California. Any credit risk the Company is exposed to related to utility operations is minimized by the taking of security deposits. Provisions for uncollectible accounts are recorded monthly and are recovered from customers through billed rates. The Bank's portfolio of loans is collateralized by real estate located principally in Nevada, California and Arizona. Collectibility is, therefore, somewhat dependent upon these areas' economies and real estate values. Gas Utility Property, Net -- Gas utility property, net includes gas plant at original cost, less the accumulated provision for depreciation and amortization, plus the unamortized balance of acquisition adjustments. Original cost includes contracted services, material, payroll and related costs such as taxes and benefits, general and administrative expenses, and an allowance for funds used during construction less contributions in aid of construction. Acquisition adjustments are amortized over the estimated remaining life of the acquired properties. Real Estate Acquired Through Foreclosure -- Real estate acquired through foreclosure is stated at the lower of cost or fair value less cost to sell. Included in real estate acquired through foreclosure is $5.5 million and $21.7 million of loans foreclosed in-substance at December 31, 1993 and 1992, respectively. Write downs to fair value, disposition gains and losses, and operating income and costs are charged to the allowance for estimated credit losses. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Loans foreclosed in-substance consist of loans accounted for as foreclosed property even though actual foreclosure has not occurred. Although the collateral underlying these loans has not been repossessed, the borrower has little or no equity in the collateral at its current estimated fair value. Proceeds for repayment are expected to come only from the operation or sale of the collateral, and it is doubtful the borrower will rebuild equity in the collateral or repay the loan by other means in the foreseeable future. The amounts ultimately recovered from loans foreclosed in-substance could differ from the amounts used in arriving at the net carrying value of the assets because of future market factors beyond management's control or changes in strategy for recovering the investment. Allowance for Estimated Credit Losses -- On a routine basis, management evaluates the adequacy of the allowances for estimated losses on loans, investments and real estate, and establishes additions to the allowances through provisions to expense. The Bank utilizes a comprehensive internal asset review system and general valuation allowance methodology. General valuation allowances are established for each of the loan, investment and real estate portfolios for unforeseen losses. A number of factors are taken into account in determining the adequacy of the level of allowances including management's review of the extent of existing risks in the portfolios, prevailing and anticipated economic conditions, actual loss experience, delinquencies, regular reviews of the quality of the Bank's loan and real estate portfolios by the Bank's Risk Management Committee and examinations by regulatory authorities. Charge-offs are recorded on particular assets when it is determined that the fair or net realizable value of an asset is below the carrying value. When a loan is foreclosed, the asset is written down to fair value based on a current appraisal of the subject property. While management uses currently available information to evaluate the adequacy of allowances and estimate identified losses for charge off, ultimate losses may vary from current estimates. Adjustments to estimates are charged to earnings in the period in which they become known. Interest Rate Exchange Agreements -- The Bank uses interest rate swaps and interest rate collars to hedge its exposure to interest rate risk. These instruments are used only to hedge asset and liability portfolios and are not used for speculative purposes. Premiums, discounts and fees associated with these interest rate exchange agreements are amortized to expense on a straight-line basis over the lives of the agreements. The net interest received or paid is reflected as interest expense. Gains or losses resulting from the cancellation of agreements hedging assets and liabilities which remain outstanding are deferred and amortized over the remaining contract lives. Gains or losses are recognized in the current period if the hedged asset or liability is retired. Deferred Gas Costs -- The gas segment is authorized by the various regulatory authorities having jurisdiction to adjust its billing rates for changes in the cost of gas purchased. The difference between the current cost of gas purchased and the cost of gas recovered in billed rates is deferred. Generally, these deferred amounts are recovered or refunded within one year. Revenues -- Gas revenues are accrued from the date the customer was last billed to the end of the accounting period. In California, the Company is authorized to adjust gas revenues to reflect changes in operating margins from authorized levels related to all customer classes. Depreciation and Amortization -- Depreciation is computed on the straight-line remaining life method at composite rates considered sufficient to amortize costs over estimated service lives. Excess of cost over net assets acquired is amortized on a straight-line basis over 25 years. Costs related to refunding utility debt and debt issuance expenses are deferred and amortized over the weighted average lives of the new issues. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Capitalization of Interest -- The Company capitalized $381,000, $934,000 and $631,000 of interest expense and a portion of the cost of equity funds related to natural gas utility operations for each of the years ended December 31, 1993, 1992 and 1991. The cost of equity funds used to finance the construction of utility plant are reported net within the consolidated statements of income as a reduction of interest charges. Utility plant construction costs, including cost of equity funds, are recovered in authorized rates through depreciation when completed projects are placed into operation. Income Taxes -- Effective January 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes," which required a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. For years prior to 1993, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes were not adjusted for subsequent changes in tax rates. Investment tax credits (ITC) related to gas utility operations are deferred and amortized over the life of related fixed assets. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA Summarized consolidated financial statement data for the Bank is as follows. Certain reclassifications have been made to conform presentations for prior years with the current year's presentation: CONSOLIDATED STATEMENTS OF INCOME (THOUSANDS OF DOLLARS) - --------------- (1) Includes after-tax allocation of costs from parent. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA -- (CONTINUED) CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (THOUSANDS OF DOLLARS) - --------------- * These items are not comprised of financial instruments and, therefore, are not applicable under SFAS No. 107. See SFAS No. 107 discussion herein. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA -- (CONTINUED) FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," requires that the Bank disclose estimated fair values for its financial instruments. The fair value estimates were made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of the Bank's financial instruments, fair value estimates were based on judgements regarding current economic conditions, risk characteristics of various financial instruments, prepayment assumptions, future expected loss experience and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgement and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the fair value estimates were based on existing on-balance sheet and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that were not considered financial instruments. Significant assets and liabilities that were not considered financial assets or liabilities include the Bank's retail branch network, deferred tax assets and liabilities, furniture, fixtures and equipment, and goodwill. Additionally, the Bank intends to hold a significant portion of its assets and liabilities to their stated maturities. Therefore, the Bank does not intend to realize any significant differences between carrying value and fair value through sale or other disposition. No attempt should be made to adjust shareholders' equity to reflect the fair value disclosures. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA -- (CONTINUED) Methods and assumptions used to determine estimated fair values are set forth below for the Bank's financial instruments as of December 31, 1993 and 1992. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA -- (CONTINUED) SALE OF ARIZONA BRANCH OPERATIONS In May 1993, the Bank signed a Definitive Agreement with World Savings and Loan Association (World) of Oakland, California, whereby World agreed to acquire the Bank's Arizona branch operations, including all related deposit liabilities of approximately $321 million. The transaction was approved by the appropriate regulatory authorities and closed in August 1993. As a result of the sale, the Bank recorded a $6.3 million loss, which included a write-off of $5.9 million in goodwill (excess of cost over net assets acquired) and $367,000 of other related net costs. The Bank sold $334 million of MBS to effect the sale of the Bank's Arizona-based deposit liabilities to World and to maintain the Bank's interest rate risk position. The sale of the securities resulted in a gain of $7.4 million ($4.9 million after tax) included in gain on sale of debt securities in the Consolidated Statements of Income. The final disposition resulted in an after-tax loss of approximately $1 million. REGULATORY CAPITAL Under FIRREA, thrifts must maintain minimum capital ratios of tangible capital equal to 1.5 percent of tangible assets, core capital equal to three percent of core assets and risk-based capital equal to eight percent of risk-based assets. In determining capital under the three standards, certain adjustments are required to be made to stockholder's equity. The Bank was in compliance with all three capital requirements as of December 31, 1993 and all prior years. A reconciliation of stockholder's equity, as shown in the accompanying SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA -- (CONTINUED) Consolidated Statements of Financial Position, to the three capital standards and the Bank's resulting ratios are set forth in the table below (thousands of dollars): The regulatory capital standards contain certain phase-in requirements concerning the amount of supervisory goodwill which is includable in core and risk-based capital as well as the amount of real estate investments which are required to be deducted from capital under all three standards. On January 1, 1994, the maximum supervisory goodwill includable in risk-based and core capital is limited to .375 percent of tangible assets. Based upon this limitation, the Bank's risk-based and core capital levels declined by $6.3 million on January 1, 1994. The improvement in the Bank's capital ratios over prior year-end is principally the result of the Bank's net earnings, implementation of SFAS No. 115, lower asset base, and reduced level of goodwill. At December 31, 1993, under fully phased-in capital rules applicable at July 1, 1996, the Bank would have exceeded its fully phased-in tangible, core and risk-based capital requirements by $81.8 million, $56.6 million and $43.1 million, respectively. The OTS has issued a regulation which will add a component to an institution's risk-based capital calculation in 1994. The regulation will require a reduction of an institution's risk-based capital by 50 percent of the decline in the institution's net portfolio value exceeding two percent of assets under a hypothetical 200 basis point increase or decrease in market interest rates. Based upon management's estimate of its interest rate risk exposure, the Bank will not be subjected to a reduction of its risk-based capital using data as of December 31, 1993. FDICIA required the federal banking agencies to adopt regulations implementing a system of progressive constraints as capital levels decline at banks and savings institutions. The federal banking agencies have enacted uniform "prompt corrective action" rules which classify banks and savings institutions into one of five categories based upon capital adequacy, ranging from "well capitalized" to "critically undercapitalized." As of December 31, 1993, the Bank is categorized as "well capitalized" under the regulation. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 -- SUMMARIZED FINANCIAL STATEMENT DATA -- (CONTINUED) OTHER REGULATORY MATTERS In conjunction with the acquisition of the Bank in 1986, the Company agreed that as long as it controls the Bank, adequate capital as required by applicable regulations, will be maintained at the Bank and if required, the Company will infuse additional capital into the Bank to assure compliance with such requirements. Even though the Bank met all existing regulatory capital requirements, in October 1991, the Company committed to make an additional $20 million capital contribution to the Bank in order to further improve the Bank's capital position. Under this commitment, the Company contributed $10 million to the Bank in October 1991 and $10 million in February 1992, in exchange for common stock of the Bank. The Company does not anticipate making future capital contributions to the Bank. Pursuant to the acquisition of the Bank by the Company, the OTS stipulated that dividends paid by the Bank to the Company could not exceed 50 percent of the Bank's cumulative net income after the date of acquisition. Since the acquisition, the Bank's cumulative net income is $29.5 million, resulting in maximum dividends payable of $14.7 million as of December 31, 1993. Since the acquisition, the Bank has paid the Company $1.8 million in capital distributions, net of the $20 million of capital contributions received from the Company. Capital distributions, including dividends, are also governed by an OTS regulation which limits distributions by applying a tiered system based on capital levels. Under the regulation, the Bank is restricted to paying no more than 75 percent of its net income over the preceding four quarters to the Company. The Bank did not pay any dividends to the Company during the last three years. In October 1991, the Bank entered into a Supervisory Agreement (the Agreement) with the OTS. Among other things, the Bank agreed to: retain competent management, improve the review and monitoring of problem assets, develop comprehensive business plans which support decisions concerning real estate development projects and foreclosed real estate, and reduce interest rate risk. In November 1993, the Agreement was terminated based upon corrective action taken by the Bank. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3 -- DEBT SECURITIES Debt securities held to maturity are stated at amortized cost. The yields are computed based upon amortized cost. The amortized cost, estimated fair values and yields of debt securities held to maturity are as follows (thousands of dollars): The following schedule of the expected maturity of debt securities held to maturity is based upon dealer prepayment expectations and historical prepayment activity (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3 -- DEBT SECURITIES -- (CONTINUED) Debt securities available for sale are stated at fair value at December 31, 1993 and at the lower of cost or fair value at December 31, 1992. The yields are computed based upon amortized cost. The amortized cost, estimated fair values and yields of debt securities available for sale are as follows (thousands of dollars): The following schedule reflects the expected maturity of MBS and CMO and the contractual maturity of all other debt securities available for sale. The expected maturity of MBS and CMO are based upon dealer prepayment expectations and historical prepayment activity (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 -- LOANS RECEIVABLE Loans receivable held for investment, recorded at amortized cost, are summarized as follows (thousands of dollars): Loans receivable held for sale, recorded at lower of aggregate cost or market, are summarized as follows (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 -- LOANS RECEIVABLE -- (CONTINUED) Outstanding commitments to originate loans represent agreements to originate real estate secured loans to customers at specified rates of interest. Commitments generally expire in 45 to 60 days and may require payment of a fee. Some of the commitments are expected to expire without being drawn upon, therefore the total commitments do not necessarily represent future cash requirements. The Bank has designated portions of its portfolio of residential real estate loans and credit card accounts as held for sale. These loans are carried at the lower of aggregate cost, market or sales commitment price. In January 1994, the Bank sold its credit card portfolio held for sale and recognized a gain of approximately $1.7 million. The Bank's loan approval process is intended to assess both: (i) the borrower's ability to repay the loan by determining whether the borrower meets the Bank's established underwriting criteria, and (ii) the adequacy of the proposed security by determining whether the appraised value of the security property is sufficient for the proposed loan. It is the general policy of the Bank not to make single-family residential loans when the loan-to-value ratio exceeds 80 percent unless the loans are insured by private mortgage insurance, FHA insurance or VA guarantee. Construction loans and commercial/income property loans are generally underwritten with a discounted loan-to-value ratio of less than 75 percent. Management considers the above mentioned factors when evaluating the adequacy of the allowance for estimated credit losses. Many of the Bank's adjustable-rate loans contain limitations as to both the amount the interest rate can change at each repricing date (periodic caps) and the maximum rates the loan can be repriced to over the life of the loan (lifetime caps). At December 31, 1993, periodic caps in the adjustable loan portfolio ranged from .25 percent to eight percent. Lifetime caps ranged from 9.75 percent to 22 percent. NOTE 5 -- REAL ESTATE Real estate held for sale or development includes the following (thousands of dollars): During the third quarter of 1993, the Bank designated two Arizona branch facilities, not included as part of the sale to World, as real estate held for sale, development or investment. These facilities, with a net book value of $3.4 million at December 31, 1993, were previously included in premises and equipment. The net realizable value of the real estate held for sale or development is dependent upon real estate values, the local economies, and real estate sales activity. Management evaluates the adequacy of the allowance for estimated real estate losses by incorporating these factors. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5 -- REAL ESTATE -- (CONTINUED) Pretax loss from real estate operations, excluding interest income on loans to real estate ventures, is summarized as follows (thousands of dollars): - --------------- (1) Allocated general and administrative expenses include labor and other costs incurred in the Bank's real estate operations. Interest is allocated based upon the Bank's average cost of funds devoted to such operations. Summarized below is condensed financial information for the Bank's real estate ventures (thousands of dollars): Beginning in 1987, the Bank participated in a real estate development project, Margarita Village Development Company (MVDC), as both lender and investor, to develop and build a 468 acre restricted community in Temecula, California. In December 1991, MVDC entered Chapter 11 bankruptcy proceedings. Due to significant legal and economic uncertainties, the Bank charged off its entire $32.2 million investment in and loan to MVDC in 1991. In 1993, an agreement was reached whereby the Bank assigned its interests as lender to the first trust deed holder and allowed the first trust deed holder to foreclose on the real estate owned by MVDC. In exchange, the first trust deed holder assumed certain liabilities of the Bank and MVDC, and the Bank received the right to receive a portion of future proceeds from the development and sale of the real estate. Management believes the Bank's ability to recover any of its advances to MVDC will depend largely on SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5 -- REAL ESTATE -- (CONTINUED) favorable resolution of various pending legal uncertainties and the recovery of the residential sector of the California real estate market. NOTE 6 -- ALLOWANCES FOR ESTIMATED CREDIT LOSSES Activity in the allowances for losses on loans, real estate acquired through foreclosure and real estate held for sale or development is summarized as follows (thousands of dollars): The Bank establishes allowances for estimated losses by portfolio through charges to expense. On a regular basis, management reviews the level of loss allowances which have been provided against the portfolios. Adjustments are made thereto in light of the level of problem loans and current economic conditions. Included in net charge-offs are $1.4 million, $1.9 million and $2.6 million of recoveries for 1991, 1992 and 1993, respectively. Prior to the fourth quarter of 1991, the Bank established specific valuation allowances for identified probable losses on assets in its portfolio. During the fourth quarter of 1991, the Bank adopted a policy of charging off portions of these assets against the previously established specific valuation allowances and directly charging off any newly identified probable losses on specific assets, thus directly reducing the carrying value of the asset. Write-downs to fair value, disposition gains and losses, and operating income and costs affiliated with real estate acquired through foreclosure are charged to the allowance for estimated credit losses. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 7 -- DEPOSITS Deposits are summarized as follows (thousands of dollars): The above balance includes $5.8 million deposited by the State of Nevada that is collateralized by real estate loans and debt securities with a fair value of approximately $8.8 million at December 31, 1993. Certificates of deposit include approximately $6.9 million of brokered deposits at December 31, 1992. At December 31, 1993, there were no brokered deposits. Certificates of deposit maturity schedule (thousands of dollars): NOTE 8 -- CASH EQUIVALENTS AND SECURITIES SOLD UNDER REPURCHASE AGREEMENTS Cash Equivalents Cash equivalents are stated at cost, which approximates fair value, and include the following (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8 -- CASH EQUIVALENTS AND SECURITIES SOLD UNDER REPURCHASE AGREEMENTS -- (CONTINUED) Securities purchased under resale agreements of $55.1 million at December 31, 1993 and $66 million at December 31, 1992 matured within 24 days and 25 days, respectively, and called for delivery of the same securities. The collateral for these agreements consisted of debt securities which at December 31, 1993 and 1992 were held on the Bank's behalf by its safekeeping agents and safekeeping agents for various investment bankers. The securities purchased under resale agreements represented 31 percent of the Bank's stockholder's equity at December 31, 1993 and 41 percent at December 31, 1992. The average amount of securities purchased under resale agreements outstanding during the years ended December 31, 1993 and 1992 were $26.6 million and $20.2 million, respectively. The maximum amount of resale agreements outstanding at any month end was $60 million during 1993 and $120 million during 1992. Securities Sold Under Repurchase Agreements The Bank sells securities under agreements to repurchase (reverse repurchase agreements). Reverse repurchase agreements are treated as borrowings and are reflected as liabilities in the accompanying Consolidated Statements of Financial Position. Reverse repurchase agreements are summarized as follows (thousands of dollars): The Bank transacted $210 million in reverse repurchase agreements with Morgan Stanley & Co., Incorporated (primary dealer) in accordance with a long-term agreement. The agreement, which allows for a maximum borrowing of $400 million with no minimum, matures in July 1997. The interest rate on the borrowings is adjusted monthly based upon a spread over or under the one month London Interbank Offering Rate (LIBOR), dependent upon the underlying collateral. The Bank is also party to three separate flexible reverse repurchase agreements (flex repos) totaling $49 million at December 31, 1993. A flex repo represents a long-term fixed-rate contract to borrow funds through the primary dealer, collateralized by MBS with a flexible repayment schedule. The principal balance of the Bank's flex repo agreements will decline over the stated maturity period based upon the counterparty's need for the funds. Principal payments on flex repos at December 31, 1993 are projected as follows (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8 -- CASH EQUIVALENTS AND SECURITIES SOLD UNDER REPURCHASE AGREEMENTS -- (CONTINUED) Actual principal payments may differ from those shown above due to the actual timing of the funding being faster or slower than originally projected. All agreements are collateralized by MBS and require the Bank to repurchase identical securities as those which were sold. The MBS collateralizing the agreements are reflected as assets with a carrying value of $18.1 million in excess of borrowing amount and a weighted average maturity of 3.12 years. All agreements were transacted with the primary dealer. Reverse repurchase agreements are collateralized as follows (thousands of dollars): The Bank has entered into interest rate swap agreements as the fixed-rate payer to reduce the Bank's exposure to changes in interest rates. At December 31, 1993, the Bank was party to one interest rate swap agreement with a nationally recognized investment banking firm, having a total notional amount of $7.5 million with a remaining term of seven years. The agreement requires the Bank to make fixed-rate interest payments of 5.45 percent and in turn, the Bank receives floating interest payments based on the six month LIBOR, 3.55 percent at December 31, 1993. The interest rate swap agreement at December 31, 1993 is collateralized with MBS with a fair value of $254,000. During 1992, in conjunction with the restructuring of the Bank's balance sheet, through sale of long-term fixed-rate assets, $300 million (notional amount) of interest rate swaps hedging such assets were cancelled at a cost of $14.1 million, which is included as an expense in the accompanying Consolidated Statements of Income. In addition, $35 million (notional amount) of interest rate swaps matured during 1992. At December 31, 1992 no agreements were outstanding. The net expense on interest rate swaps of $24,000, $4.8 million, and $3.2 million in 1993, 1992 and 1991, respectively, was included in interest expense as a cost of hedging activities in the accompanying Consolidated Statements of Income. During 1991 the Bank was party to two interest rate collars with nationally recognized investment banking firms, having a total notional principal amount of $400 million used to reduce the Bank's exposure to changes in interest rates. During 1991, the cost of such collars of $3.5 million was included in interest expense as a cost of hedging activities in the accompanying Consolidated Statements of Income. There were no interest rate collars outstanding during 1993 and 1992. NOTE 9 -- COMMITMENTS AND CONTINGENCIES Construction Program -- Capital expenditures for the year ending December 31, 1994 are estimated at $119 million. Leases and Rentals -- The Company leases a portion of its corporate headquarters office complex in Las Vegas and the LNG facilities on its northern Nevada system. The leases provide for initial terms which expire in 1997 and 2003, respectively, with optional renewal terms available at the expiration dates. The rental payments are $3.1 million annually, and $10.8 million in the aggregate over the remaining initial term for the Las Vegas facility, and $6.7 million annually and $63.3 million in the aggregate for the LNG facilities. Rentals included in operating expenses with respect to these leases amounted to $9.8 million in each of the three years in the period ended December 31, 1993. Both of these leases are accounted for as operating SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9 -- COMMITMENTS AND CONTINGENCIES (CONTINUED) leases and are treated as such for regulatory purposes. Other operating leases of the Company are immaterial individually and in the aggregate. The Bank leases certain of its facilities under noncancelable operating lease agreements. The more significant of these leases expire between 1994 and 2029 and provide for renewals subject to certain escalation clauses. Net rental expense for the Bank was $3.1 million in 1993, $3 million in 1992 and $2.5 million in 1991. The following is a schedule of net future minimum rental payments for the Bank under various operating lease agreements that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993 (thousands of dollars): Legal Proceedings -- The Company has been named as defendant in various legal proceedings. The ultimate dispositions of these proceedings are not presently determinable; however, it is the opinion of management that no litigation to which the Company is subject will have a material adverse impact on its financial position or results of operations. NOTE 10 -- SHORT-TERM DEBT The Company has agreements with several banks for committed credit lines which aggregate $110 million at December 31, 1993. The agreements provide for the payment of interest at competitive market rates. The lines of credit also require the payments of facility fees based on the long-term debt rating of the Company. The committed credit lines have no compensating balance requirements and expire in July 1994. At December 31, 1993, $86 million of short-term borrowings were outstanding. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 -- LONG-TERM DEBT In December 1993, the Company borrowed $75 million in Clark County, Nevada, tax-exempt IDRB. The IDRB have an annual coupon rate of 6.50 percent, are noncallable for 10 years and have a final maturity in December 2033. The proceeds from the sale of the IDRB will be used to finance certain additions and improvements to the Company's natural gas distribution and transmission system in Clark County, Nevada. In December 1993, the Company borrowed $50 million in City of Big Bear Lake, California, tax-exempt IDRB. The IDRB bear interest at a variable rate and have a final maturity in December 2028. The interest rate as of December 31, 1993 was 3.15 percent. The proceeds from the sale of the IDRB will be used to SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 -- LONG-TERM DEBT -- (CONTINUED) finance certain additions and improvements to the Company's natural gas distribution and transmission system in San Bernardino County, California. The Company has two term loan facilities totaling $165 million. The fair value of these term loan facilities approximates carrying value. The first term loan facility is a Restated and Amended Credit Agreement dated April 1990 in the amount of $125 million which provides for a revolving period through April 1995 at which time any amounts borrowed under the agreement become payable on demand. Direct borrowing options provide for the payment of interest at either the prime rate, LIBOR, or a certificate of deposit rate plus a margin based on the Company's credit rating. In addition to direct borrowing options, a letter of credit is available to provide credit support for the issuance of commercial paper. At December 31, 1993 and 1992, there was $125 million of commercial paper outstanding. During 1993 and 1992, the average cost of this facility was 3.89 percent and 4.45 percent, respectively. The second term loan facility is an Amended and Restated Domestic Credit Agreement dated December 1986 in the original amount of $80 million with a final maturity in December 1994. The first $40 million principal payment was made in June 1992. The final principal payment is due at maturity. The agreement provides for the payment of interest at either the prime rate, a certificate of deposit based rate, or a LIBOR based rate, and the payment of a commitment fee equal to 3/8 of one percent of the unused portion of the commitment. During 1993 and 1992, the average interest rates were 3.80 percent and 4.84 percent, respectively. Market values for long-term debt of the Company, excluding the Bank, were determined based on dealer quotes using trading records for December 31, 1993 and 1992, as applicable, and other secondary sources which are customarily consulted for data of this kind. The carrying value of the IDRB Series due 2028 was used as the estimate of fair value based upon the variable interest rate of the bonds. Requirements to retire long-term debt, excluding those of the Bank, at December 31, 1993 for the next five years are expected to be $45 million, $130 million, $5 million, $5 million, and $11 million, respectively. Principal payments on Bank borrowings at December 31, 1993 are due as follows (thousands of dollars): Coupon interest rates on Bank borrowings are as follows: The effective rate of the advances from the FHLB at December 31, 1993 was 4.70 percent. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 -- LONG-TERM DEBT -- (CONTINUED) In 1992, the FHLB established a Financing Availability for the Bank which is currently 20 percent of the Bank's assets with terms up to 120 months. All borrowings from the FHLB must be collateralized by mortgages or securities. In December 1993, the Bank obtained the capability of borrowing up to $5 million in federal funds from Bank of America. At December 31, 1993, no funds had been drawn from this line of credit which expires in August 1994. Bank borrowings are collateralized as follows (thousands of dollars): NOTE 12 -- PREFERRED AND PREFERENCE STOCKS The Company is authorized to issue up to 500,000 shares each of its Cumulative Preferred and Second Preference Stock, respectively. The Company is required to redeem 8,000 shares annually, through 1999, of the $100 Cumulative Preferred Stock, 9.5 percent Series. The Company is required to redeem the remaining 32,580 shares of its Second Preference Stock, Third Series, in 1994. All outstanding Cumulative Preferred and Second Preference Stock shares are redeemable by the Company at any time at par plus accrued dividends. Requirements for the next five years to redeem preferred and preference stock outstanding at December 31, 1993 amount to $4.1 million in 1994, and $800,000 in each year for 1995 through 1998. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12 -- PREFERRED AND PREFERENCE STOCKS -- (CONTINUED) The dividend rate on the Second Preference Stock is cumulative and varies from three percent to 16 percent, based on a formula tied to operating results with respect to the gas distribution system purchased from APS. During each of the last three years, the dividend rate was three percent. The estimated fair value of the Company's Cumulative Preferred Stock at December 31, 1993 and 1992 is $5 million and $5.6 million, respectively. These figures are based on a yield-to-maturity of 8.14 percent and 9.53 percent, respectively, and a required redemption of 8,000 shares per year. Since this issue is not traded, yield-to-maturity was estimated based on the weighted average yield-to-maturity of the Company's outstanding debentures, adjusted for historical spreads between Moody's Baa rated utility debt, and Baa utility preferred stock issues. The Company's Second Preference Stock is solely owned by APS, and is not publicly traded. These issues have a final redemption, at par, in December 1994, and they can be redeemed at par on any quarterly interest payment date. Due to the unique nature of these issues, no ready market exists to trade the securities. Consequently, for purposes of valuation, fair value is estimated to approximate book value. The Articles of Incorporation provide that in the event of involuntary liquidation, (i) before distributions may be made to holders of any other class of stock, holders of the Cumulative Preferred Stock are entitled to payment at par value, together with any accumulated and unpaid dividends, and (ii) before distributions may be made to holders of common stock, the holder of the Second Preference Stock is entitled to payment at par value, together with any accumulated and unpaid dividends. NOTE 13 -- EMPLOYEE POSTRETIREMENT BENEFITS The Company has separate retirement plans covering the employees of its natural gas operations and financial services segments. Both plans are noncontributory with defined benefits, and cover substantially all employees. It is the Company's policy to fund the plans at not less than the minimum required contribution nor more than the tax deductible limit. Plan assets consist of investments in common stock, corporate bonds, government obligations, real estate, an insurance company contract and cash or cash equivalents. The plan covering the natural gas operations provides that an employee may earn benefits for a period of up to 30 years and will be vested after 5 years of service. Retirement plan costs were $6.6 million, $6.1 million and $5.5 million, respectively, for each of the three years ended December 31, 1993, 1992 and 1991, respectively. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13 -- EMPLOYEE POSTRETIREMENT BENEFITS -- (CONTINUED) The following table sets forth, for the gas segment, the plan's funded status and amounts recognized on the Company's consolidated statements of financial position and statements of income. The cost and liability of the financial services plan are not significant. In addition to the basic retirement plans, the Company has separate unfunded supplemental retirement plans for its natural gas operations and financial services segments, which are limited to certain officers. The gas segment's plan is noncontributory with defined benefits. Senior officers who retire with ten years or more of service with the Company are eligible to receive benefits. Other officers who retire with 20 years or more of service with the Company are eligible to receive benefits. Plan costs were $1.5 million, $1.5 million and $1.1 million for each of the three years ended December 31, 1993, 1992 and 1991, respectively. The accumulated benefit obligation of the plan was $13.9 million, including vested benefits of $12.7 million, at December 31, 1993. The cost and liability of the financial services supplemental retirement plan are not significant. The Company also has an unfunded retirement plan for directors not covered by the employee retirement plan. The cost and liability for this plan are not significant. The Company has a deferred compensation plan for all officers and members of the Board. The plan provides the opportunity to defer from a minimum of $2,000 up to 50 percent of annual compensation. The Company matches one-half of amounts deferred up to six percent of an officer's annual salary. Payments of compensation deferred, plus interest, commence upon the participant's retirement in equal monthly SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13 -- EMPLOYEE POSTRETIREMENT BENEFITS -- (CONTINUED) installments over 10, 15 or 20 years, as determined by the Company. Deferred compensation earns interest at a rate determined each January. The interest rate represents 150 percent of Moody's Seasoned Corporate Bond Index. The Employees' Investment Plan (401k) provides for purchases of the Company's common stock or certain other investments by eligible gas segment employees through deductions of up to 16 percent of base compensation, subject to IRS limitations. The Company matches one-half of amounts deferred up to six percent of an employee's annual compensation. The cost of the plan was $1.9 million, $1.7 million and $1.6 million for each of the three years ended December 31, 1993, 1992 and 1991, respectively. The Bank has a separate 401k plan which provides for purchases of certain securities by eligible employees through deductions of up to ten percent of base compensation, subject to IRS limitations. The Bank matches one-half of amounts deferred up to six percent of employee base compensation. The cost of this plan is not significant. At December 31, 1993, 748,448 common shares were reserved for issuance under provisions of the Employee Investment Plan and the Company's Dividend Reinvestment and Stock Purchase Plan. During 1993, the Company purchased shares of common stock in the open market and issued original common shares to meet the requirements of these plans. The Company provides postretirement benefits other than pensions (PBOP) to its qualified gas segment retirees for health care, dental and life insurance. The Bank does not provide PBOP to its retirees. In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The statement requires the Company to account for PBOP on an accrual basis rather than reporting these benefits on a pay-as-you-go basis. The Company adopted SFAS No. 106 in January 1993. The PSCN, CPUC and FERC have approved the use of SFAS No. 106 for ratemaking purposes, subject to certain conditions, including funding. The Company did not receive approval to recover PBOP costs on an accrual basis in its Arizona rate jurisdictions, but was authorized to continue to recover the pay-as-you-go costs for ratemaking purposes. The Company plans to begin funding the non-Arizona portion of the PBOP liability in 1994. The following table sets forth, for the gas segment, the PBOP funded status and amounts recognized on the Company's consolidated statements of financial position and statements of income. Assumptions used to develop postretirement benefit obligations were: SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13 -- EMPLOYEE POSTRETIREMENT BENEFITS -- (CONTINUED) The Company makes fixed contributions, based on age and years of service, to retiree spending accounts for the medical and dental costs of employees who retire after 1988. The Company pays up to 100 percent of the medical coverage costs for employees who retired prior to 1989. The medical inflation assumption in the table above applies to the benefit obligations for pre-1989 retirees only. This inflation assumption was estimated at 12 percent for 1993 and decreases one percent per year until 1997 and one-half of one percent per year until 2003, at which time the annual increase is projected to be five percent. A one percent increase in these assumptions would change the accumulated postretirement benefit obligation by approximately $1.1 million and the 1994 annual benefit cost by approximately $160,000. NOTE 14 -- INCOME TAXES Effective January 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." The statement requires the use of the asset and liability approach for financial reporting of income taxes. As permitted under SFAS No. 109, prior years' financial statements have not been restated. The cumulative effect of adopting this statement was an increase in net deferred income tax liabilities of $11.7 million, an increase in net regulatory assets of $14.7 million and an increase in net income of $3 million. Income tax expense (benefit) consists of the following (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14 -- INCOME TAXES -- (CONTINUED) Deferred income tax expense (benefit) consists of the following significant components (thousands of dollars): The consolidated effective income tax rate for each of the three years in the period ended December 31, 1993 varies from the federal statutory income tax rate. The sources of these differences and the effect of each are summarized as follows: SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14 -- INCOME TAXES -- (CONTINUED) Deferred tax assets and liabilities consisted of the following (thousands of dollars): Prior to 1981, federal income tax expense for the gas segment was reduced to reflect additional depreciation and other deductions claimed for income tax purposes (flow-through method). Subsequently, deferred taxes have been provided for all differences between book and taxable income (normalization method) in all jurisdictions. The various utility regulatory authorities have consistently allowed the recovery of previously flowed-through income tax benefits on property related items by means of increased federal income tax expense in determining cost of service for ratemaking purposes. Pursuant to SFAS No. 109, a deferred tax liability and corresponding regulatory asset of approximately $31 million are included in the financial statements to reflect the expected recovery of income tax benefits previously flowed-through. In August 1993, President Clinton signed into law the Omnibus Budget Reconciliation Act of 1993 (the Act). The Act increased the federal income tax rate for corporations from 34 percent to 35 percent, retroactive to January 1, 1993. As a result of the increase, the Company recognized additional net deferred income tax liabilities and associated net regulatory assets at December 31, 1993, of approximately $4.5 million. The Company anticipates full recovery of the additional regulatory assets. The increase in net deferred income tax liabilities related to the Company's nonregulated operations was not significant. For financial reporting purposes, the Company has deferred recognition of investment tax credits (ITC) by amortizing the benefit over the depreciable lives of the related properties. Pursuant to SFAS No. 109, a deferred tax asset and corresponding regulatory liability of approximately $14.3 million are included in the financial statements to reflect the Company's expected reduction to future income tax expense that will result from the amortization of ITC through utility rates. Under the Internal Revenue Code, the Bank is allowed a special bad debt deduction (unrelated to the amount of losses charged to earnings) based on a percentage of taxable income (currently eight percent). SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14 -- INCOME TAXES -- (CONTINUED) Under SFAS No. 109, no deferred taxes are provided on bad debt reserves arising prior to December 31, 1987, unless it becomes apparent that these differences will reverse in the foreseeable future. At December 31, 1993, the portion of tax bad debt reserves not expected to reverse was $13.4 million, which resulted in a retained earnings benefit of $4.5 million, recognized in years prior to 1988. NOTE 15 -- SEGMENT INFORMATION The financial information pertaining to the Company's gas and financial services segments for each of the three years in the period ended December 31, 1993, is as follows (thousands of dollars): SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 16 -- QUARTERLY FINANCIAL DATA (UNAUDITED) CONSOLIDATED QUARTERLY FINANCIAL DATA - --------------- * The sum of quarterly earnings (loss) per average common share may not equal the annual earnings (loss) per share due to the ongoing change in the weighted average number of common shares outstanding. The demand for natural gas is seasonal, and it is management's opinion that comparisons of earnings for the interim periods do not reliably reflect overall trends and changes in the Company's operations. Also, the timing of general rate relief can have a significant impact on earnings for interim periods. See MD&A for additional discussion of the Company's operating results. SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 16 -- QUARTERLY FINANCIAL DATA (UNAUDITED) -- (CONTINUED) BANK QUARTERLY FINANCIAL DATA NOTE 17 -- SUBSEQUENT EVENT -- ARIZONA PIPE REPLACEMENT PROGRAM DISALLOWANCES Arizona Rate Cases. In August 1990, the ACC issued its opinion and order (Decision No. 57075) on the Company's 1989 general rate increase requests applicable to the Company's Central and Southern Arizona Divisions. Among other things, the order stated that $16.7 million of the total capital expenditures incurred as part of the Company's Central Arizona Division pipe replacement program were disallowed for ratemaking purposes and all costs incurred as part of the Company's Southern Arizona Division pipe replacement program were excluded from the rate case and rate consideration was deferred to the Company's next general rate application, which was filed in November 1990. In October 1990, the Company filed a Complaint in the Superior Court of the State of Arizona, against the ACC, to seek a judgement modifying or setting aside this decision. In February 1991, the Company filed a Motion for Summary Judgement in the Superior Court to seek a judgement summarily determining that Decision No. 57075 of the ACC is unreasonable and unlawful and, in accordance with that determination, modifying or setting aside Decision No. 57075 and allowing the Company to establish and collect reasonable, temporary rates under bond, pending the establishment of reasonable and lawful rates by the Commission. In June 1991, the Court affirmed the ACC's rate order without explanation or opinion. In August 1991, the Company appealed to the Arizona Court of Appeals from the Superior Court's judgement. In April 1993, Division Two of the Arizona Court of Appeals issued a Memorandum Decision affirming the ACC's opinion and order. Based on this decision, the Company filed a Motion for Reconsideration in the Court of Appeals in May 1993. The Motion for Reconsideration was denied and the Company, in July 1993, filed a Petition for Review with the Arizona Supreme Court. On February 25, 1994, immediately following the denial of the SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 17 -- SUBSEQUENT EVENT -- ARIZONA PIPE REPLACEMENT PROGRAM DISALLOWANCES -- (CONTINUED) Petition for Review by the Arizona Supreme Court, the Court of Appeals issued its Mandate ordering the Company to comply with its April 1993 Memorandum Decision. As a result of the Arizona Court of Appeals Division Two Mandate, the Company has written off $15.9 million in gross plant related to the central and southern Arizona pipe replacement program disallowances. The impact of these disallowances, net of accumulated depreciation, tax benefits and other related items, was a non-cash reduction to 1993 net income of $9.3 million, or $0.44 per share. Discussions relative to each replacement program follows. Central Arizona Division In November 1984, the Company acquired all of the gas utility assets of Arizona Public Service Company (APS) for $111 million, which was $31 million less than net book value. By Order dated May 30, 1984, the ACC authorized the Company to include the acquired gas assets in the Company's rate base at the same original cost (irrespective of the Company's purchase price) assigned to such assets for ratemaking purposes in the last APS gas general rate case prior to the November closing. At the same time, the Company committed to replace certain distribution pipe purchased from APS because the pipe was aging prematurely, and thus was not adequate to meet long-term safety requirements. The Company invested $123 million in the central Arizona pipe replacement program. The project was completed, under budget, in 1991. In Decision No. 57075, the ACC found that at the time it authorized the Company to acquire the APS assets, it was aware of the cost estimates of the Company's pipe replacement program; the Company's management and implementation of the replacement program had been sound; and there were no allegations of imprudence in connection with the replacement program. Despite these findings, the ACC disallowed a total of $16.7 million of the Company's capital expenditures pertaining to the pipe replacement program. This disallowance was reduced to $14.6 million in August 1993. The Company maintained that the reasons implicit in the ACC's decision to cause the disallowance of a portion of the costs of the pipe replacement program were erroneous and led to the denial of rate base treatment -- a result which is contrary to the Arizona Constitution, statutes and existing case law. Prior Commissions approved the terms and conditions, including the purchase price, for the acquisition of the APS system. The Company had continuously kept the ACC informed of the progress, including the costs, of the replacement program. In addition, existing case law in Arizona makes the purchase price immaterial for ratemaking purposes. The Arizona Constitution requires the ACC to first establish a rate base by finding the fair value of a utility company's property, and existing case law provides that a utility is entitled to earn a fair and reasonable rate of return on its system that is used and useful in the service of the public. The Company believed that the disallowance was illegal and, therefore, had not previously written off any plant assets. Southern Arizona Division In April 1979, the Company acquired all of the gas utility assets of TEP. As part of the purchase agreement, TEP warranted that the gas facilities had been properly installed according to applicable codes. The Company replaced certain distribution pipe purchased from TEP and it was the Company's contention that, unbeknown to the Company at the time of acquisition, TEP used questionable pipe installation practices which resulted in the need for this replacement program. Citing the warranty provided at the time of purchase, the Company filed suit against TEP seeking damages as compensation for its pipe replacement costs. In April 1990, the Company and TEP reached an out-of-court settlement in which the Company agreed to dismiss its lawsuit in exchange for payment from TEP of $25 million, plus $3 million in interest, over a three year period. To reflect the settlement, a $25 million receivable was recorded and gas utility property reduced by SOUTHWEST GAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 17 -- SUBSEQUENT EVENT -- ARIZONA PIPE REPLACEMENT PROGRAM DISALLOWANCES -- (CONTINUED) $22.6 million. The remaining $2.4 million was used as a recovery of litigation expenses. As of December 31, 1993, all amounts due from TEP were fully collected. The August 1990 opinion and order stated that all southern Arizona pipe replacement costs, including all related interest costs, property taxes and depreciation expenses, were eliminated from the rate case revenue requirement and deferred for rate consideration to the next general rate application of the Company. In addition, the ACC ordered that all related interest costs, property taxes and depreciation expenses were to be deferred until the allowable portion of the pipe replacement costs was ultimately determined by the ACC and reflected in rates. In November 1990, the Company filed a new general rate case with the ACC applicable to its southern Arizona rate jurisdiction. The application included a request for full recovery of all capitalized and deferred costs related to the pipe replacement program as ordered by the ACC in the prior general rate case. In February 1992, the ACC issued its opinion and order on the Company's rate request. Among other things, the opinion and order stated that $1.3 million of the $35 million in capital expenditures incurred as part of the Company's southern Arizona pipe replacement program were disallowed for ratemaking purposes. The Company believes that future disallowances of pipe replacement costs, if any, associated with the southern Arizona pipe replacement program will not materially impact the results of operations. In April 1992, the Company filed a Notice of Appeal with the Arizona Court of Appeals Division One challenging the lawfulness of the February 1992 decision issued by the ACC. The Company maintains that the Arizona constitution requires the ACC to first establish a rate base by finding the fair value of a utility company's property, and existing case law provides that a utility is entitled to earn a fair and reasonable rate of return on its system that is used and useful in the service of the public. Although this case has not yet been considered by Division One of the Arizona Court of Appeals, the Company considers the issues involved to be controlled by the February 1994 denial of the Petition for Review by the Arizona Supreme Court and the Mandate of Division Two of the Arizona Court of Appeals and, therefore, has written off the applicable pipe replacement costs. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders, Southwest Gas Corporation: We have audited the accompanying consolidated statements of financial position of Southwest Gas Corporation (a California corporation, hereinafter referred to as the Company) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in notes 1, 13 and 14 of the notes to consolidated financial statements, and as required by generally accepted accounting principles, the Company changed its methods of accounting for investments in certain debt and equity securities, postretirement benefits other than pensions and income taxes in 1993. ARTHUR ANDERSEN & CO. Las Vegas, Nevada February 25, 1994 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Identification of Directors. Information with respect to Directors is set forth under the heading "Election of Directors" in the Company's definitive Proxy Statement dated March 31, 1994, which by this reference is incorporated herein. (b) Identification of Executive Officers. The name, age, position and period during which held for each of the Executive Officers of the Company are as follows: (c) Identification of Certain Significant Employees. None. (d) Family Relationships. None of the Company's Directors or Executive Officers are related to any other either by blood, marriage or adoption. (e) Business Experience. Information with respect to Directors is set forth under the heading "Election of Directors" in the Company's definitive Proxy Statement dated March 31, 1994, which by this reference is incorporated herein. All Executive Officers, except George C. Biehl and Dan J. Cheever, have held responsible positions with the Company for at least five years as described in (b) above. Dan J. Cheever began his employment with the Bank in January 1989. Positions held at the Bank by Cheever from 1989 through 1991 include Senior Vice President and Treasurer, and Executive Vice President and Chief Financial Officer. George C. Biehl began his employment with the Company in January 1990. Biehl was the Chief Financial Officer of the Bank in 1989. (f) Involvement in Certain Legal Proceedings. None. (g) Item 405 Review. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission (SEC) and the New York Stock Exchange. Officers, directors and greater than ten-percent shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on review of the copies of such forms furnished to the Company, or written representations that no Form No. 5's were required, the Company believes that during 1993, all Section 16(a) filing requirements applicable to its officers, directors and greater than ten-percent beneficial owners were complied with. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information with respect to executive compensation is set forth under the heading "Executive Compensation and Benefits" in the Company's definitive Proxy Statement dated March 31, 1994, which by this reference is incorporated herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Not applicable. (b) Information with respect to security ownership of management is set forth under the heading "Securities Ownership by Nominees and Executive Officers" in the Company's definitive Proxy Statement dated March 31, 1994, which by this reference is incorporated herein. (c) Not applicable. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information with respect to certain relationships and related transactions is set forth under the heading "Certain Relationships and Related Transactions" in the Company's definitive Proxy Statement dated March 31, 1994, which by this reference is incorporated herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K (a) The following documents are filed as part of this report on Form 10-K: (1) The following are included in Part II, Item 8 of this form: (3) See list of exhibits. (b) Reports on Form 8-K The Company filed a Form 8-K, dated February 25, 1994, reporting on the Arizona Court of Appeals Division Two Mandate ordering the write-off of Arizona pipe replacement program costs. (c) See Exhibits. (d) See Schedules. LIST OF EXHIBITS - --------------- (1) Incorporated herein by reference to the Company's Registration Statement on Form S-16, No. 2-68833. (2) Incorporated herein by reference to the Company's report on Form 10-K for the year ended December 31, 1982. (3) Incorporated herein by reference to Exhibit 4.01 to the Company's Registration Statement on Form S-2, No. 2-92938. (4) Incorporated herein by reference to Exhibit 4.02 to the Company's Registration Statement on Form S-3, No. 33-7931. (5) Incorporated herein by reference to the Company's report on Form 10-K for the year ended December 31, 1986. (6) Incorporated herein by reference to the Company's report on Form 10-Q for the quarter ended March 31, 1987. (7) Incorporated herein by reference to the Company's report on Form 8-K dated August 23, 1988. (8) Incorporated herein by reference to the Company's report on Form 10-K for the year ended December 31, 1991. (9) Incorporated herein by reference to the Company's report on Form 10-Q for the quarter ended June 30, 1992. (10) Incorporated herein by reference to the Company's report on Form 10-Q for the quarter ended September 30, 1992. (11) Incorporated herein by reference to the Company's report on Form 10-K for the year ended December 31, 1992. (12) Incorporated herein by reference to the Company's report on Form 10-Q for the quarter ended June 30, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To the Shareholders, Southwest Gas Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of Southwest Gas Corporation and subsidiaries included elsewhere in this annual report and have issued our report thereon dated February 25, 1994. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Las Vegas, Nevada February 25, 1994 SCHEDULE V SOUTHWEST GAS CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) SCHEDULE VI SOUTHWEST GAS CORPORATION SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) SCHEDULE VIII SOUTHWEST GAS CORPORATION SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) SCHEDULE IX SOUTHWEST GAS CORPORATION SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - --------------- (a) Computed by totaling daily outstanding borrowings during each year and dividing the resultant total by 365 days. (b) Computed by dividing total interest expense related to short-term borrowings during each year by the average amount of such borrowings outstanding. SCHEDULE X SOUTHWEST GAS CORPORATION SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) During the years presented, no royalties were paid and advertising costs incurred were not significant. Amounts charged to income with respect to amortization of intangible assets, and taxes, other than payroll and income taxes, during the three years ended December 31, 1993, are as follows: - --------------- * Separately disclosed on the Consolidated Statements of Income. ** Less than one percent of operating revenues. SIGNATURES Pursuant to the requirements of Section 15(d) 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. SOUTHWEST GAS CORPORATION By MICHAEL O. MAFFIE ------------------------------------ Michael O. Maffie, President (Chief Executive Officer) Date: March 28, 1994 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURES Pursuant to the requirements of Section 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. GLOSSARY OF TERMS

78128_1993.txt

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ITEM 1. BUSINESS Philadelphia Suburban Corporation ('PSC' or the 'Registrant'), a Pennsylvania corporation, was incorporated in 1968. The business of PSC is conducted almost entirely through its subsidiary Philadelphia Suburban Water Company ('PSW'), a regulated public utility. PSC also owns a small data processing service operation, Utility & Municipal Services, Inc. The information appearing in 'Management's Discussion and Analysis' from the portions of PSC's 1993 Annual Report to shareholders filed as Exhibit 13 to this Form 10-K Report is incorporated by reference herein. In the third quarter of 1990, the Board of Directors authorized the sale of Mentor Information Systems, Inc., Digital Systems, Inc., American Tele/Response Group, Inc., Stoner Associates, Inc., and its subsidiary Kesler Engineering, Inc.; and during the first quarter of 1991, the Board of Directors authorized the sale of PSC Engineers & Consultants, Inc. During 1991, all the businesses were sold except for American Tele/Response Group, Inc. and Kesler Engineering, Inc., which were sold in the first quarter of 1993. The results of operations of these businesses are accounted for as discontinued operations. Unless otherwise indicated, as used herein the 'Company' includes the continuing operations of both PSC and its consolidated subsidiaries. The sales of the non-water service subsidiaries were authorized in order to allow the Company to concentrate its activities on its core water utility operations. Consistent with that decision, in December 1993, PSW acquired the water utility assets and franchise rights of the Borough of Malvern for $1,323,000 in cash. The acquisition of this water system added approximately 859 customers or .3% to PSW's customer base and one square mile of service territory or .3% to PSW's existing service territory. PSW has made a proposal to acquire a municipal water system serving approximately 13,000 customers in an area contiguous to PSW's service territory for a purchase price in excess of $20,000,000, although there can be no assurance that the proposal will be accepted or that such a transaction will be consummated. PSW is not currently a party to any definitive agreement with respect to any pending acquisition. In December 1992, PSW acquired the water utility assets of the West Whiteland Township and the Uwchlan Township Municipal Authority water systems for $9,128,257 in cash and the issuance of $1,776,947 in debt. The December 1992 acquisitions added approximately 6,900 customers or 2.9% to PSW's customer base and 40 square miles of service territory or 11.8% to PSW's existing service territory. PHILADELPHIA SUBURBAN WATER COMPANY General. PSW is an operating public utility company, which supplies water to approximately 247,195 residential, commercial, industrial and public customers. PSW's contiguous service territory is approximately 380 square miles, comprising a large portion of the suburban area west and north of the City of Philadelphia. This territory is primarily residential in nature and is completely metered, except for fire hydrant service. Based on the 1990 census, PSW estimates that the total number of persons currently served is approximately 800,000. Excluding the customers that were added as a result of the acquisitions in December 1993 and 1992, customer accounts have grown at an average rate of approximately .6% per annum for the last three years. Operating revenues during the twelve months ended December 31, 1993 were derived approximately as follows: Selected operating statistics. Set forth below is a table showing certain selected operating statistics for PSW for the past three years. Revenues from water sales (000's omitted) Water sales (million gallons) System delivery by source (million gallons) Number of metered customers (end of year) Water supplies and usage. PSW derives its principal supply of water from the Schuylkill River, five rural streams which are tributaries of the Schuylkill and Delaware Rivers, and the Upper Merion Reservoir, a former quarry now impounding groundwater. All of these are either within or adjacent to PSW's service territory. PSW acquired the right to remove water from these sources, and in connection with such rights, PSW has secured the necessary regulatory approvals. PSW has constructed five impounding reservoirs and four treatment and pumping facilities to provide storage and purification of these surface water supplies. The Pennsylvania Department of Environmental Resources ('DER') has regulatory power with respect to sources of supply and the construction, operation and safety practices for certain dams and other water containment structures under the Pennsylvania Dam Safety and Encroachments Act of 1979. PSW's dams are in compliance with these requirements in all material respects. PSW's surface supplies are supplemented by 39 wells. PSW also has interconnections with: the Chester Water Authority, which permits PSW to withdraw up to 6.2 million gallons per day ('mgd'); the Bucks County Water and Sewer Authority, which provides for a supply of up to 7.0 mgd; and the West Chester Area Municipal Authority, which provides up to a maximum of 1.0 mgd. Agreements regarding the first two interconnections require PSW to purchase certain minimum amounts of water. PSW believes it possesses all the necessary permits to obtain its supply of water from the sources indicated above. The minimum safe yield of all sources of supply described above, based on low stream flows of record with respect to surface supplies, is as follows: During periods of normal precipitation, the safe yield is more than the minimum shown above. Under normal operating conditions, PSW can deliver a maximum of 139 mgd to its distribution system for short periods of time. The average daily send-out for 1993, 1992 and 1991 was 89.1, 85.4, and 87.2 mgd, respectively. The maximum demand ever placed upon PSW's facilities for one month occurred during June 1988, when send-out averaged 101.4 mgd. The peak day of record occurred during July 1993 when water use reached 118.8 mgd. Actual water usage (as measured by the water meters installed at each service location) is less than the amount of water delivered into the system due to leaks, PSW's operational use of water, fire hydrant usage and other similar uses. Water consumption per customer is affected by local weather conditions during the year. In general, during the late spring and summer, an increase in rainfall reduces water consumption, while a decrease in rainfall increases it. Also, an increase in the average temperature generally causes an increase in water consumption. Energy supplies. PSW does all of its pumping using electric power purchased from PECO Energy Company. Energy supplies have been sufficient to meet customer demand. Water shortages. The Delaware River Basin, which is the drainage area of the Delaware River from New York State to Delaware, periodically experiences water shortages during the summer months. To the extent that the reservoirs in the upper part of the Basin are affected by a lack of precipitation, the Delaware River Basin Commission (the 'DRBC') may impose either voluntary or mandatory water use restrictions on portions or all of the Basin. PSW's raw water supplies have generally been adequate to meet customer demand for the past five years principally because of its five impounding reservoirs. However, since PSW's service territory is within the Basin, PSW's customers may be required to comply with DRBC water use restrictions, even if PSW's supplies are adequate, if the availability of water in the entire DRBC area is inadequate. During 1988 and the two preceding years, the lower regions of the Basin experienced hot, dry weather conditions while the upper regions of the Basin enjoyed normal or above normal precipitation. During all three years PSW had sufficient quantities of raw water available and no drought restrictions were imposed by the DRBC. However, in the summer of 1988, with the record breaking heat and the resulting high water demand created by lawn sprinkling, PSW imposed restrictions banning nonessential water uses in order to maintain adequate storage levels of treated water and to reduce peak demands in the distribution system. No water use restrictions were imposed by PSW in the years subsequent to 1988. The addition of the 15 mgd Pickering Creek treatment plant in 1991 and improvements to the distribution system in the past five years have reduced the possibility of PSW issuing water use restrictions in the future due to demands on its system. Regulation by the Pennsylvania Public Utility Commission. PSW is subject to regulation by the Pennsylvania Public Utility Commission (the 'PUC') which has jurisdiction with respect to rates, service, accounting procedures, issuance of securities and other matters. Under applicable Pennsylvania statutes, PSW has rights granted under its Articles of Incorporation and by certificates of public convenience from the PUC authorizing it to conduct its present operations in the manner in which such operations are now conducted and in the territory in which it now renders service, to exercise the right of eminent domain and to maintain its mains in the streets and highways of such territory. Such rights are generally nonexclusive, although it has been the practice of the PUC to allow only one water company to actually provide service to a given area. Consequently, PSW is subject to competition only with respect to potential customers located on the fringe of areas that it presently serves who also may have access to the service of another water supplier. In 1992, the PUC issued a policy statement which, under certain circumstances, required utilities to extend service to new customers without the benefit of a customer advance for construction. As a result of various problems and uncertainties associated with the implementation of this policy statement, the PUC initiated a rulemaking procedure in December 1993, intended to facilitate the development of practical standards by which the broad policy statement can be applied. The Company believes that when instituted, the new standards will reflect the position that the cost of service extensions should be justified by anticipated revenues from the extension or should be paid by the service applicant. Water Quality & Environmental Issues. PSW is subject to regulation of water quality by the U.S. Environmental Protection Agency ('EPA') under the Federal Safe Drinking Water Act (the 'SDWA') and by the Pennsylvania Department of Environmental Resources ('DER') under the Pennsylvania Safe Drinking Water Act. The SDWA provides for the establishment of uniform minimum national water quality standards, as well as governmental authority to specify the type of treatment process to be used for public drinking water. PSW is presently in compliance with all standards and treatment requirements promulgated to date. The EPA has an ongoing directive to issue additional regulations under the SDWA. The directive was clarified in 1986 when Congress amended the SDWA to require, among other revisions, disinfection of all drinking water, additional maximum contaminant level ('MCL') specifications, and filtration of all surface water supplies. PSW has already installed the necessary equipment to provide for the disinfection of the drinking water throughout the system and is monitoring for the additional specified contaminants. PSW's principal surface water supplies are currently filtered. PSW began to provide full filtration of its supply from the Upper Merion Reservoir in November 1993 upon the completion of a filtration facility at that location. This facility was necessary in order to maintain PSW's compliance with the SDWA. In addition, the 1986 SDWA Amendments require the EPA to promulgate MCLs for many chemicals not previously regulated. EPA has to date promulgated MCLs for numerous additional contaminants and is required to mandate further MCLs every three years. Promulgation of additional MCLs by the EPA in the future may require PSW to change some of its treatment techniques, however, PSW meets all existing MCL requirements and believes that the currently proposed MCLs will not have a significant impact on its capital requirements or operating expenses. In 1991, the EPA proposed regulations pertaining to radionuclides (including radon). Recently, the Congress placed a one year moratorium on radon regulations. Depending upon the final MCLs permitted, PSW will likely be required to take remedial action at certain of its groundwater facilities. The remediation options presently under evaluation include dilution, treatment, or replacement of the supply with other groundwater or surface water supplies. Based on the MCL initially proposed, it is anticipated that the capital costs of compliance will range from $2.5 to $3.5 million over the next 10 years. PSW may, in the future, have to change its method of treating drinking water at certain of its sources of supply if additional regulations become effective. In June, 1991, EPA promulgated final regulations for lead and copper (the 'Lead and Copper Rule'). Under the Lead and Copper Rule, large water utilities are required to conduct corrosion control studies and to sample certain high-risk customer homes to determine the extent of treatment techniques that may be required. PSW conducted the two required rounds of sampling in 1992 and did not exceed the EPA action levels for either lead or copper. Additional sampling will be required in the future. PSW has developed a corrosion control program for its surface sources of supply and does not foresee the need to make any major additional treatment changes or capital expenditures as a result of the Lead and Copper Rule. On January 1, 1993, new federal regulations ('Phase II') became effective for certain volatile organics, herbicides, pesticides and inorganic parameters. Although PSW will not be required by the DER to monitor for most of these parameters until 1995, PSW has already done substantial monitoring. In the few cases where Phase II contaminants were detected, concentrations were below MCLs. Future monitoring will be required, but no major treatment modifications are anticipated as a result of these regulations. PSW is also subject to other environmental statutes administered by the EPA and DER. These include the Federal Clean Water Act and the Resource Conservation and Recovery Act ('RCRA'). Under the Federal Clean Water Act, the Company must obtain National Pollutant Discharge Elimination System ('NPDES') permits for discharges from its treatment stations. PSW currently maintains three NPDES permits relating to its surface water treatment plants, which are subject to renewal every five years. During the past five years, PSW has installed the required waste water treatment facilities and presently meets all NPDES requirements. Although management recognizes that permit renewal may become more difficult if more stringent guidelines are imposed, no significant obstacles to permit renewal are presently foreseen. Under RCRA, PSW is subject to specific regulations regarding the solid waste generated from the water treatment process. The DER promulgated 'Final Rulemaking' for solid waste (Residual Waste Management) in July 1992. PSW has retained an engineering consultant to assist with the extensive monitoring, record keeping and reporting required under these regulations. A preliminary application for permitting has been filed, and formal permitting of these facilities should be completed by 1996 in accordance with regulatory requirements. Where PSW is required to make certain capital investments in order to maintain its compliance with any of the various regulations discussed above, it is management's belief that all such expenditures would be fully recoverable in PSW's water rates. However, the capital costs, under current law, would have to be financed prior to their inclusion in PSW's rate structure, and the resulting rate increases would not necessarily be timely. UTILITY & MUNICIPAL SERVICES, INC. Utility & Municipal Services, Inc. ('UMS') provides data processing services to several water utilities including PSW, and to several municipal water and sewer systems. The services provided to the utilities and municipalities include billing services and the processing of financial reports. EMPLOYEE RELATIONS As of December 31, 1993, the Registrant employed a total of 523 persons, of which 511 are employees of PSW. Hourly employees of PSW are represented by the International Brotherhood of Firemen and Oilers, Local No. 473. The contract with the union expires on December 1, 1994. Management considers its employee relations to be satisfactory. ITEM 2. ITEM 2. PROPERTIES The Registrant believes that the facilities used in the operation of its various businesses are generally in excellent condition in terms of suitability, adequacy and utilization. The property of PSW consists of a waterworks system devoted to the collection, storage, treatment and distribution of water in its service territory. Management considers that its properties are maintained in good operating condition and in accordance with current standards of good waterworks practice. The following table summarizes the principal physical properties owned by PSW: In addition, PSW also owns 45 standpipes with a combined distribution storage capacity of 137.9 million gallons and five surface water impounding reservoirs. The water utility also owns approximately 2,960 miles of transmission and distribution mains, has 247,195 active metered services and 10,991 fire hydrants. PSW's properties referred to herein, with certain minor exceptions which do not materially interfere with their use, are owned and are subject to the lien of an Indenture of Mortgage dated as of January 1, 1941, as supplemented. In the case of properties acquired through the exercise of the power of eminent domain and certain properties acquired through purchase, it has title only for water supply purposes. The Registrant's corporate offices and the facilities of UMS are leased from PSW and located in Bryn Mawr, Pennsylvania. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no pending legal proceedings to which the Registrant or any of its subsidiaries is a party or to which any of their properties is the subject that present a reasonable likelihood of a material adverse impact on the Registrant. In March of 1992, PSW received notice of an arbitration proceeding against the New Jersey Spill Fund by a party claiming damages of approximately $2.5 million as a result of a fire at a warehouse in Newark, New Jersey, where hazardous substances had been stored. The Spill Fund had previously denied this claim, but the claimant demanded an arbitration proceeding to review the claim. If the claimant is successful in the arbitration proceeding, the Spill Fund could commence a civil action seeking to recover the amount of its payment to the claimant from a group of over 70 entities, including PSW, who have been identified as having some of their material stored at the warehouse. The Company does not believe that any assessment against the Company as a result of the arbitration proceeding will be material to the business or financial condition of the Company. PSW has also been advised that on February 15, 1994 the State of New Jersey and the Spill Fund instituted a separate action against approximately 100 entities in the Superior Court of New Jersey Law Division -- Essex County seeking to recover, among other related expenses, the State's cost of $3.82 million in cleaning up the site of the Newark warehouse. PSW is one of the defendants named in the Complaint, but PSW has not been served with a Complaint as of March 24, 1994. PSC does not believe that any assessment against PSW as a result of this action will be material to the business or financial condition of PSC. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. Information with respect to the executive officers of the Company is contained in Item 10 hereof and is hereby incorporated by reference herein. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The Company's common stock is traded on the New York Stock Exchange and the Philadelphia Stock Exchange. As of March 1, 1994, there were approximately 10,968 holders of record of the Company's common stock. The following selected quarterly financial data of the Company is in thousands of dollars, except for per share amounts: Following is a recent history of income from continuing operations and dividends of the Company: Dividends have averaged approximately 80% of income from continuing operations during this period. In March 1993, the annual dividend increased by 4% to $1.08 beginning with the June 1993 dividend. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information appearing in the section captioned 'Summary of Selected Financial Data' from the portions of the Company's 1993 Annual Report to shareholders filed as Exhibit 13 to this Form 10-K Report is incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information appearing in the section captioned 'Management's Discussion and Analysis' from the portions of the Company's 1993 Annual Report to shareholders filed as Exhibit 13 to this Form 10-K Report is incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information appearing under the captions 'Consolidated Statements of Income', 'Consolidated Balance Sheets', 'Consolidated Cash Flow Statements' and 'Notes to Consolidated Financial Statements' from the portions of the Company's 1993 Annual Report to shareholders filed as Exhibit 13 to this Form 10-K Report is incorporated by reference herein. Also, the information appearing in the section captioned 'Reports on Financial Statements' from the portions of the Company's 1993 Annual Report to shareholders filed as Exhibit 13 to this Form 10-K Report is incorporated by reference herein. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS OF THE REGISTRANT The information appearing in the section captioned 'Information Regarding Nominees and Directors' of the Proxy Statement relating to the May 19, 1994, annual meeting of shareholders of the Company, to be filed within 120 days after the end of the fiscal year covered by this Form 10-K Report, is incorporated by reference herein. EXECUTIVE OFFICERS OF THE REGISTRANT The following table and the notes thereto set forth information with respect to the executive officers of the Registrant, including their names, ages, positions with the Registrant and business experience during the last five years: - ------------------ (1) In addition to the capacities indicated, the individuals named in the above table hold other offices or directorships with subsidiaries of the Registrant. Officers serve at the discretion of the Board of Directors. (2) Mr. DeBenedictis was Secretary of the Pennsylvania Department of Environmental Resources from 1983 to 1986. From December 1986 to April 1989, he was President of the Greater Philadelphia Chamber of Commerce. Mr. DeBenedictis was Senior Vice President for Corporate and Public Affairs of Philadelphia Electric Company from April 1989 to June 1992. (3) Mr. Boyer has served as Vice Chairman of PSW from July 1992 to May 1993, and from June 1976 to July 1992 he was Chairman of this subsidiary. He also served as the utility's Chief Executive Officer from June 1976 to May 1983 and from January 1986 to July 1992. (4) Mr. Luksa was Executive Vice President of PSW from April 1982 to October 1986 and from 1971 to April 1982 he was Vice President and Chief Engineer of this subsidiary. (5) From January 1984 to August 1985, Mr. Stahl was Corporate Counsel, from August 1985 to May 1988 he was Vice President - Administration and Corporate Counsel of the Registrant, and from May 1988 to April 1991 he was Vice President and General Counsel of the Registrant. (6) Mr. Graham was Controller of the Company from 1984 to September 1990, and from September 1990 to May 1991 he was Chief Financial Officer and Treasurer. From May 1991 to March 1993, Mr. Graham was Vice President -- Finance and Treasurer. ITEM 11. ITEM 11. MANAGEMENT REMUNERATION The information appearing in the sections captioned 'Compensation of Directors and Executive Officers' of the Proxy Statement relating to the May 19, 1994, annual meeting of shareholders of the Company, to be filed within 120 days after the end of the fiscal year covered by this Form 10-K Report, is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing in the sections captioned 'Ownership of Common Stock' of the Proxy Statement relating to the May 19, 1994, annual meeting of shareholders of the Company, to be filed within 120 days after the end of the fiscal year covered by this Form 10-K Report, is incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing in the sections captioned 'Other Remuneration and Certain Transactions' of the Proxy Statement relating to the May 19, 1994, annual meeting of shareholders of the Company, to be filed within 120 days after the end of the fiscal year covered by this Form 10-K Report, is incorporated by reference herein. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Financial Statements. The following is a list of the consolidated financial statements of the Company and its subsidiaries and supplementary data incorporated by reference in Item 8 hereof: Management's Report Independent Auditors' Report Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- 1993, 1992 and 1991 Consolidated Statements of Cash Flow -- 1993, 1992, and 1991 Notes to Consolidated Financial Statements Financial Statement Schedules. The following is a list of financial statement schedules, or supplemental schedules, filed as part of this annual report on Form 10-K. All other schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto. Auditors' Report on Additional Financial Data Schedule III -- Condensed Financial Information of Registrant Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation of Property, Plant and Equipment Schedule IX -- Short-Term Borrowings Schedule X -- Supplementary Income Statement Information Reports on Form 8-K. The Company filed no report on Form 8-K during the quarter ended December 31, 1993. Exhibits, Including Those Incorporated by Reference. The following is a list of exhibits filed as part of this annual report on Form 10-K. Where so indicated by footnote, exhibits which were previously filed are incorporated by reference. For exhibits incorporated by reference, the location of the exhibit in the previous filing is indicated in parenthesis. The page numbers listed refer to page number where such exhibits are located using the sequential numbering system specified by Rules 0-3 and 403. EXHIBIT INDEX NOTES DOCUMENTS INCORPORATED BY REFERENCE SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PHILADELPHIA SUBURBAN CORPORATION By _____NICHOLAS DEBENEDICTIS_________ Nicholas DeBenedictis President and Chairman Date: March 29, 1994 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Each person in so signing also makes, constitutes and appoints Nicholas DeBenedictis, President and Chairman of Philadelphia Suburban Corporation, Michael P. Graham, Senior Vice President -- Finance and Treasurer of Philadelphia Suburban Corporation, and each of them, his or her true and lawful attorneys-in-fact, in his or her name, place and stead to execute and cause to be filed with the Securities and Exchange Commission any and all amendments to this report. AUDITORS' REPORT ON ADDITIONAL FINANCIAL DATA The Board of Directors Philadelphia Suburban Corporation Under date of February 1, 1994, we reported on the consolidated balance sheets of Philadelphia Suburban Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related additional financial data listed in Item 14. -- Financial Statement Schedules of this report on Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such additional financial data, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects the information set forth therein. KPMG PEAT MARWICK Philadelphia, Pennsylvania February 1, 1994 SCHEDULE III PHILADELPHIA SUBURBAN CORPORATION (PARENT COMPANY) CONDENSED BALANCE SHEETS (IN THOUSANDS OF DOLLARS) DECEMBER 31, 1993 AND 1992 - ------------------ * The Company's investment in Philadelphia Suburban Water Company amounted to $133,967 and $101,086 at December 31, 1993 and 1992, respectively, which includes $51,000 and $47,000, respectively, of retained earnings, free of dividend restrictions imposed by PSW's debt agreements. See accompanying notes to the consolidated financial statements. PHILADELPHIA SUBURBAN CORPORATION (PARENT COMPANY) CONDENSED STATEMENTS OF INCOME (IN THOUSANDS OF DOLLARS) DECEMBER 31, 1993 AND 1992 - ------------------ * Parent expenses of $510, $329 and $1,887 in 1993, 1992 and 1991, respectively, have been charged to the reserves related to discontinued operations. See accompanying notes to the consolidated financial statements. PHILADELPHIA SUBURBAN CORPORATION (PARENT COMPANY) CONDENSED CASH FLOW STATEMENTS (IN THOUSANDS OF DOLLARS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to the consolidated financial statements. SCHEDULE V PHILADELPHIA SUBURBAN CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) - ------------------ * Represents net assets of water systems acquired during the year. ** Includes $2,633 related to the final allocation of 1992 water system acquisitions, and $919 related to the implementation of Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes'. See accompanying notes to the consolidated financial statements. SCHEDULE VI PHILADELPHIA SUBURBAN CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) See accompanying notes to the consolidated financial statements. SCHEDULE IX PHILADELPHIA SUBURBAN CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) - ------------------ (1) Short-term line of credit with interest at prime or rates based on the federal funds. (2) Computed based on the varying interest rates in effect at the time the funds were borrowed. See accompanying notes to the consolidated financial statements. SCHEDULE X PHILADELPHIA SUBURBAN CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) See accompanying notes to the consolidated financial statements.

30547_1993.txt

30547_1993

1993

30547

Item 1. Business (a) General description of business The Registrant and its subsidiary (herein referred to collectively as the "Company") manufacture and sell a diversified line of business forms and related services for commercial and industrial use, including, without limitation, continuous and unit-set business forms, forms-related services, pressure-sensitive labels, envelopes, and other specialties. The Company's products are primarily sold through its direct sales force. The Company has sales offices, manufacturing facilities, Business Service Centers, and warehouses throughout the United States and in Puerto Rico. Business Service Centers combine a warehousing facility with a computerized forms management system for customers. 1. The industry is maturing. Factors influencing this include a move away from paper-based information systems by larger companies, smaller companies moving away from unit sets, the use of laser printers moving users to cut sheet in place of continuous forms, and slow economic growth. The competitive environment consists of about 600 companies, with the ten largest accounting for more than half the market. There is over-capacity and consequent pricing pressures. Other non-forms companies are also affecting the market by offering substitute products and systems. They include software systems and more sophisticated user-friendly printing equipment. Distribution is through direct sales, distributor sales and mail order channels. 2. No single customer accounts for more than 10% of the Company's consolidated net sales. 3. The amount of backlog of orders is not material in terms of annual sales volume. 4. The Company's principal raw material is paper, which is purchased in a wide variety of sizes, colors, widths and weights. Other raw materials include printing ink, lithographic plate material, rubber and chemicals. The Company has a policy of purchasing raw materials from several major suppliers and believes paper and other raw materials will be sufficiently available in 1994. 5. The Company holds no material patents, licenses, franchises or concessions. The Company believes that its performance is substantially dependent upon its engineering, manufacturing and marketing abilities. 6. The Company continues to be involved in research activities relating to development of new products and improvement of existing products (none of which is customer sponsored). The Company does not regard either the number of people involved in or amounts expended on research activities to be significant in relation to annual sales volume. 7. Compliance with federal, state and local provisions governing the discharge of materials into the environment has not had and, it is anticipated, will not have any material effect on the Company's capital expenditures, earnings or competitive position. 8. The number of persons employed was 2,036 as of October 30, 1993. 9. The Company's principal line of business is not subject to significant seasonal variations. 10. The Company's business is in a single industry segment, and only the business forms class of product exceeds 10% of total sales. 11. No material part of net sales is derived from foreign customers. Item 2. Item 2. Properties The Baltimore, Maryland facility is being marketed for sale. All facilities are in good condition, and total production capacity is considered to be adequate for current needs. The Company also leases space in various locations for sales offices and for warehousing, as indicated in the note to consolidated financial statements entitled "Lease Commitments." Item 3. Item 3. Legal Proceedings The Company is not a party to, nor is its property subject, to any material pending legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters Duplex common stock is traded on the American Stock Exchange. As of October 30, 1993, the Company had 1,451 common shareholders of record, excluding beneficial owners whose stock was held in nominee name. The following table sets forth, for fiscal years ended October 30, 1993, and October 31, 1992, the range of high and low closing sales prices for the Company's common stock, as well as the dividends paid per share for each year. Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Net sales for 1993 were $258.9 million, or 4% less than the $270.1 million reported for 1992. About 2% of 1992's sales were attributable to it being a 53-week year, versus the normal 52-week year. In 1992, sales decreased 5% from the $285.3 million in 1991, which in turn was 4% less than the $297.7 million in 1990. For the last three years, business conditions have been difficult. Industry sales data for manifold business forms show a sales decline from 1990 to 1991 of 2%, and from 1991 to 1992 of 3%. For 1992 to 1993, the industry forecast is for a decrease of 2%. Certain segments of the forms-related market, however, continue to provide steady growth. This Includes forms management services, preprinted cut sheets, and pressure-sensitive labels. In response to this maturing market, the Company has taken significant steps to adjust its manufacturing capacity, reorganize and change its management team, retrain its sales force and improve its focus for functioning in this highly competitive marketplace. This is expected to result in a gain of market share. The Company continued to reduce its dependence on commodity products while focusing on custom forms, pressure-sensitive labels, and value-added services. Strategic alliances were developed to supplement product offerings and improve margins. The sales of continuous stock forms, a commodity-type product, were down 20% in 1993. This product, in combination with the extra week in 1992, accounted for most of 1993's sales decline. The sales of continuous stock forms were down 19% in 1992, in comparison with 1991. In 1993, sales of continuous stock forms represented slightly less than 11% of total revenues. Average selling price increases are very difficult to determine for the Company's various products. However, inflation is estimated to have had minimal impact on sales in the past three years. Paper is the Company's primary raw material, and it accounts for a significant percentage of the cost of most business forms. In 1993, the cost of white paper was volatile throughout the year, as it had been in 1992 and 1991. The LIFO provision was a credit in 1993, 1992, and 1991, respectively, of $.1 million, $.7 million, and $2.0 million. The gross profit percentage in 1993 was affected by a midyear increase in paper prices. It was 24.7%, 25.3%, and 25.7%, for 1993, 1992, and 1991, respectively. The closing of two plants in May of 1993, and subsequent increased utilization of the remaining plants, allowed the Company to hold manufacturing expense percentages despite a decline in manufactured sales. As part of a strategy to expand product and service capabilities and improve margins, the Company is developing a program of partnering for procurement of products the Company cannot produce and/or are not cost-competitive. Out-sourcing represented 18% and 15% of sales in 1993 and 1992, respectively. This is expected to increase and should have a positive effect on gross profit in the future. In 1993, selling and administrative expenses were $61.0 million, down $2.1 million or 3%, from the $63.1 million reported in 1992. Administrative expenses in the second half of 1993 were lower because of a corporate restructuring which reduced administrative staffing by approximately 30%. In 1992, selling and administrative expenses of $63.1 million were also down from the $64.6 million in 1991. Earnings in 1993, 1992, and 1991 were reduced by a pretax restructuring charge of $1.5 million, $7.0 million, and $2.0 million, respectively. This represents the cost associated with reducing administrative expenses, closing plants, consolidating distribution facilities, and the scaling back of other operations. These actions reflect the impact of the weak economy and excess capacity in the business forms industry. Savings from these cost-reduction efforts are expected to exceed the charges. Lower interest rates in 1993 and 1992 resulted in reduced interest expense and investment income. In 1993, miscellaneous income increased due to the gain on sale of real estate and equipment associated with the closing of certain plants. The sum of other income and expense items was income of $.9 million, $.6 million, and $.1 million, respectively, in 1993, 1992, and 1991. The effective tax rate was 35% in 1993, compared to a credit of 57% in 1992, and a charge of 37% in 1991. See Notes to the Consolidated Financial Statements for a reconciliation of effective income tax rates to the statutory rate. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Adoption resulted in an increase of $1.0 million and $.13 per share in income in the first quarter of 1993. This was attributable to a reduction in deferred tax rates to the current, lower, federal tax rate. Net earnings (loss) were $2.5 million, ($.6) million, and $4.3 million in 1993, 1992, and 1991, respectively. Earnings (loss) as a percentage of sales were .9% in 1993, compared with (.2%) in 1992 and 1.5% in 1991. Liquidity and Capital Resources Working capital was $83.4 million at the end of fiscal 1993, as compared with $77.5 million and $81.4 million at the end of fiscal 1992 and 1991, respectively. The current ratio remained strong at 4.3 to 1 at the end of 1993, despite the fact that net cash of $1.3 million was used in operations. In 1992 and 1991, cash was provided by operations in the amounts of $10.2 million and $16.3 million, respectively. A significant factor in the 1993 use was strong billings at the end of the fourth quarter resulting in an increase in Accounts and Notes Receivable. Receivables increased to $76.0 million at the end of fiscal 1993, as compared to $68.0 million and $71.4 million at the end of fiscal 1992 and 1991, respectively. It is projected that operations will provide cash in fiscal 1994. Capital expenditures, dividend, and working capital requirements of the Company for the past seven years have been generated internally. The Company has made no short-term borrowings over the past 13 years. Long-term debt as a percentage of total capitalization was 6% at the end of fiscal year 1993, as compared with 7% and 8% for the previous two years. No long-term financings are planned for 1994. Stockholders' equity at October 30, 1993, was $117.3 million, as compared with $114.4 million at the end of fiscal 1992. At the end of fiscal year 1993, equity per common share was $15.24. Capital expenditures in 1993 were $3.7 million, compared to $4.9 million and $7.6 million in 1992 and 1991, respectively. Dividend and Common Stock Data No cash dividends were paid in fiscal 1993, as compared to $3.7 million and $5.4 million in 1992 and 1991, respectively. Duplex common stock is traded on the American Stock Exchange. As of October 30, 1993, the Company had 1,451 common shareholders of record, excluding beneficial owners whose stock was held in nominee name. Item 8. Item 8. Financial Statements and Supplementary Data Listed below are the financial statements included in this part of the Annual Report on Form 10-K: (a) Financial Statements REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholders of Duplex Products Inc. We have audited the accompanying consolidated balance sheet of Duplex Products Inc. and Subsidiary as of October 30, 1993, and October 31, 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for the years ended October 30, 1993, October 31, 1992, and October 26, 1991. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Duplex Products Inc. and Subsidiary at October 30, 1993, and October 31, 1992, and the consolidated results of their operations and their consolidated cash flows for the years ended October 30, 1993, October 31, 1992, and October 26, 1991, in conformity with generally accepted accounting principles. As discussed in the income tax footnote, the Company changed its method of accounting for income taxes for the year ended October 30, 1993. Grant Thornton Chicago, Illinois December 2, 1993 DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEET OCTOBER 30 AND OCTOBER 31, DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEET - CONTINUED OCTOBER 30 AND OCTOBER 31, LIABILITIES AND STOCKHOLDERS' EQUITY The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED STATEMENT OF EARNINGS YEARS ENDED OCTOBER 30, OCTOBER 31 AND OCTOBER 26, The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED OCTOBER 26, 1991, OCTOBER 31, 1992, AND OCTOBER 30, 1993 The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED OCTOBER 30, OCTOBER 31 AND OCTOBER 26, The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS OCTOBER 30, 1993, AND OCTOBER 31, 1992 SUMMARY OF ACCOUNTING POLICIES The Company is in the business of manufacturing and marketing continuous and unit set business forms, forms-related services, pressure-sensitive labels, envelopes, and other specialties. The Company's significant accounting policies, which have been applied in the preparation of the accompanying consolidated financial statements, follow. The Company's fiscal year ends on the last Saturday in October. The fiscal years ended October 30, 1993, October 31, 1992, and October 26, 1991 were comprised of fifty-two, fifty-three and fifty-two weeks, respectively. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary after elimination of intercompany transactions and balances. The Company recognizes sales for custom-made business forms upon customer acceptance and completion of the manufacturing process. Stock form sales are recognized at the time of shipment to the customer. The Company considers all highly liquid debt instruments purchased with a maturity of three months and less to be cash equivalents. The Company currently provides for doubtful receivables. The allowances for doubtful receivable account balances were $800,000 and $900,000 at October 30, 1993, and October 31, 1992, respectively. The Company values its inventories at the lower of cost or market, with cost for substantially all of its inventories being based on the last-in, first-out (LIFO) method. Property, plant and equipment are valued at cost. Depreciation and amortization are provided for in amounts sufficient to relate the costs of depreciable assets to operations over their estimated useful lives or the terms of leases, which approximate the lives of the leased property. The Company primarily uses the straight-line method of depreciation for financial reporting purposes and accelerated methods for tax reporting purposes. Earnings per share is computed on the basis of the weighted average number of common shares outstanding during the year. Certain reclassifications have been made to the 1992 and 1991 financial statements to conform them to the 1993 presentation. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993, AND OCTOBER 31, 1992 INVENTORIES If the Company had used the first-in, first-out (FIFO) method of inventory accounting instead of the last-in, first-out (LIFO) method, inventories would have been $8,334,000, $8,389,000 and $9,091,000 higher at October 30, 1993, October 31, 1992, and October 26, 1991, respectively. Use of the FIFO method would have decreased earnings before income taxes by $55,000 in 1993, increased the loss before income tax credits by $702,000 in 1992 and decreased earnings before income taxes by $2,027,000 in 1991. Inventories, by classification determined by the first-in, first-out (FIFO) cost method, are as follows: It is not practicable to separate the LIFO inventory into its components (raw materials, work-in-process and finished goods) because the dollar value LIFO method is used. ACCRUED EXPENSES - OTHER The accrued expenses - other consist of the following items as of year-end: DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993, AND OCTOBER 31, 1992 ACCRUED EXPENSES - OTHER - CONTINUED The Financial Accounting Standards Board issued its Statement No. 112, "Employers' Accounting for Postemployment Benefits," in November, 1992, which is effective for fiscal years beginning after December 15, 1993. The Financial Accounting Standards Board issued its Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in December, 1990, which is effective for fiscal years beginning after December 15, 1992. Adoption of these standards is not expected to materially affect the Company's financial statements. LONG-TERM OBLIGATIONS Long-term obligations consist of the following: Prime rate at October 30, 1993 was 6%. Principal payments due on the long-term debt, exclusive of the capitalized lease, for the five years subsequent to October 30, 1993 are: 1994 - $1,212,000; 1995 - $872,000; 1996 - $883,000; 1997 - $895,000; 1998 - $600,000. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993, AND OCTOBER 31, 1992 LEASE COMMITMENTS The Company has entered into operating leases for certain plant and office facilities and equipment which expire over the next eight years. In most cases, management expects that, in the normal course of business, leases will be renewed or replaced by other leases. Rental expenses for operating leases were $6,110,000 in fiscal 1993, $6,021,000 in fiscal 1992, and $6,715,000 in fiscal 1991. At October 30, 1993, the Company was obligated under capitalized and operating leases to make future minimum lease payments as follows: PROFIT SHARING PLANS The Employees' Savings and Profit Sharing Plan provides for contributions from both the Company and eligible employees. Company contributions are voluntary and at the discretion of the Board of Directors. Any annual contribution by the Company cannot exceed 15% of earnings before deducting the contribution and federal income taxes. The Company has made no provision for a profit sharing contribution in 1993 and 1992. The provision amounted to $500,000 in 1991. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 KEY EMPLOYEE BENEFIT PLANS For key executives, the Company has established the following: restricted stock purchase plan, stock appreciation rights plan, incentive stock option plan and supplemental executive retirement plan. During 1993, 60,700 common shares previously issued under the restricted stock purchase plan were repurchased at a cost of $852,000. During 1992, 16,100 common shares were issued under the plan at a purchase price of $25,000, and 15,800 common shares previously issued under the plan were repurchased at a cost of $241,000. During 1991, 23,500 common shares were issued under the plan at a purchase price of $35,000. Compensation expense related to the plan is charged to income over periods earned and amounted to $187,000, $330,000 and $312,000 in 1993, 1992 and 1991, respectively. There was no activity in the stock appreciation rights plan during the three years ended October 30, 1993. During 1993, incentive stock options for 75,000 shares were issued. No incentive stock options were granted, exercised or cancelled for the years ended October 31, 1992 and October 26, 1991. At October 30, 1993, options for 2,700 and 75,000 common shares were outstanding at an exercise price of $11.875 and $11.375, respectively. At October 30, 1993, 178,000 common shares were available for offering to key executives under the three plans. During 1989, the Company adopted an unfunded supplemental executive retirement plan for certain key executives. The plan provides for benefits which supplement those provided by the Company's other retirement plans. At October 30, 1993, the projected benefit obligation of the plan totalled $1,160,000, all of which has been recognized. The expense for this plan was $140,000, $221,000 and $205,000 in 1993, 1992 and 1991, respectively. wwwDUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 INCOME TAXES Through October 31, 1992, the Company accounted for income taxes under Accounting Principles Board Opinion (APB) No. 11. In February, 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" which supersedes the provisions of APB 11. SFAS 109 changes the Company's method of accounting for income taxes from the deferred method required under APB 11 to the asset and liability method. The objective of the asset and liability method is to establish deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The cumulative effect of the change in the method of accounting for income taxes was to increase net earnings $1,000,000. Prior year's financial statements have not been restated to apply the provisions of SFAS 109. The provision for income taxes consists of the following: DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 INCOME TAXES - CONTINUED The tax effects of existing temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets as of October 30, 1993 were as follows: The effective tax rate was 34.8% in 1993, (57.2)% in 1992 and 36.8% in 1991. The differences between the amounts recorded and the amounts computed by applying the U.S. federal statutory rates of 34.0% in 1993, 1992 and 1991 are explained as follows: DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 SHAREHOLDERS' RIGHTS PLAN On June 8, 1989, the Board of Directors adopted a Shareholders' Rights Plan to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of the Company's stockholders. Under the plan, stockholders of record on June 23, 1989 received a dividend distribution of one right for each outstanding share of the Company's common stock. If an acquiring person becomes the beneficial owner of, or commences a tender or exchange offer for, 25% or more of the Company's outstanding common stock, each right will entitle the holder (other than such acquiring person) to purchase a unit consisting of one one-hundredth of a share of Series A preferred stock, $1.00 par value, for $80.00 per unit. In addition, if an acquiring person becomes the beneficial owner of more than 30% of the Company's outstanding common stock, or upon the occurrence of certain other events, each right will entitle the holder (other than such acquiring person) to receive, upon exercise, common stock of the Company having a value equal to two times the exercise price of the right or $160.00. If the Company is acquired in a merger or other business combination in which the Company would not be the surviving corporation, or if 50% or more of the Company's assets or earning power is sold or transferred, each holder shall have the right to receive, upon exercise, common stock of the acquiring corporation having a value equal to two times the exercise price of the right or $160.00. The Company may redeem the rights in whole for $.05 per right, under certain circumstances. The rights expire on June 23, 1999. PREFERRED STOCK The Company's capitalization includes the following authorized preferred stock, none of which has been issued: 1,000,000 shares of $1 par value cumulative convertible preferred stock 150,000 shares of $1 par value Series A convertible preferred stock DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 RESTRUCTURING COST In the second quarter of fiscal 1993, a provision of $1,500,000 was made to cover the cost associated with corporate staff reductions. In the fourth quarter of fiscal 1992, a provision of $7,000,000 was made to cover the cost associated with closing two additional manufacturing plants and the scaling back of other operations. In the fourth quarter of fiscal 1991, a provision of $2,000,000 was made to cover the cost associated with closing a plant in Florida and consolidation in distribution operations. QUARTERLY FINANCIAL RESULTS (UNAUDITED) Item 9. Item 9. Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Certain information regarding directors of the Company is incorporated herein by reference to the descriptions on pages 2 and 3 under "Election of Directors" of the Company's 1994 Proxy Statement. The names, ages and positions of all the executive officers of the Company as of January 21, 1994 are listed below, along with their business experience during the past five years. Officers are appointed annually by the Board of Directors at the meeting of directors immediately following the Annual Meeting of Shareholders. There are no family relationships among these officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. Item 11. Item 11. Executive Compensation Information regarding executive compensation is incorporated by reference to the material under the caption "Executive Compensation" on pages 4 through 8 of the Company's 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference to the material under the caption "Election of Directors" on pages 2 and 3, and under the caption "Beneficial Ownership of Common Stock By Certain Persons" on page 10 of the Company's 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is incorporated herein by reference to the material "Business Affiliations and Securities Ownership of Nominees for Director and Directors Whose Terms Continue" on pages 2 and 3 of the Company's 1994 Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K The following documents are filed as a part of this report: (a)(1) Financial statements The consolidated financial statements of the Company are included in Part II, Item 8 of this report. (a)(2) Schedules All other schedules have been omitted for the reason that they are not applicable or not required. (b) Reports on Form 8-K: None. (c) Exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index which is incorporated herein by reference. Grant Thorton [Letterhead] REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON SCHEDULES Board of Directors Duplex Products Inc. In connection with our audit of the consolidated financial statements of Duplex Products Inc. and Subsidiary, referred to in our report dated December 2, 1993, we have also audited Schedules V, VI, and VIII as of October 30, 1993, and for each of the three years in the period then ended. In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein. /s/ GRANT THORNTON GRANT THORNTON Chicago, Illinois December 2, 1993 Schedule V Duplex Products Inc. and Subsidiary PROPERTY, PLANT, AND EQUIPMENT Depreciation for financial reporting purposes is based on estimated useful lives of assets, which are as follows: Land improvements 5 to 10 years Buildings and improvements 5 to 40 years Machinery and equipment 3 to 15 years Furniture and fixtures 5 to 15 years Leasehold improvements Lives of leases Automotive equipment 4 to 5 years Schedule VI Duplex Products Inc. and Subsidiary ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Schedule VIII Duplex Products Inc. and Subsidiary VALUATION AND QUALIFYING ACCOUNTS AND RESERVES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. DUPLEX PRODUCTS INC. (Registrant) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. EXHIBITS FILED WITH SECURITIES AND EXCHANGE COMMISSION Number and Description of Exhibit 3. Articles of Incorporation - Duplex Products Inc.* 11. Computation of Earnings per Share 22. Subsidiary 24. Consent of Independent Certified Public Accountants * Document has heretofore been filed with the Commission and is incorporated by reference.

86521_1993.txt

86521_1993

1993

86521

ITEM 1. BUSINESS - --------------------------------------------------------------------------- DESCRIPTION OF BUSINESS San Diego Gas & Electric Company is an operating public utility organized and existing under the laws of the State of California. SDG&E is engaged principally in the electric and natural gas business. It generates and purchases electric energy and distributes it to 1.1 million customers in San Diego County and a portion of Orange County, California. It also purchases natural gas and distributes it to 690,000 customers in San Diego County. In addition, it transports electricity and natural gas for others. Factors affecting SDG&E's utility operations include competition, population growth, customers' bypass of its electric and gas system, nonutility generation, changes in interest and inflation rates, environmental and other laws, regulation, and deregulation. SDG&E's diversified interests include three wholly owned subsidiaries: Enova Corporation, which invests in affordable-housing projects; Califia Company, which conducts leasing activities; and Pacific Diversified Capital Company, which is a holding company for SDG&E's other subsidiaries. PDC owns an 80-percent share in Wahlco Environmental Systems, a supplier of air pollution control and energy-saving products and services for utilities and other industries. PDC's wholly owned subsidiary, Phase One Development is a commercial real estate developer. Additional information concerning SDG&E's subsidiaries is described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 in the 1993 Annual Report to Shareholders and in Note 2 of the "Notes to Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. GOVERNMENT REGULATION Local Regulation SDG&E has separate electric and gas franchises with the two counties and 25 cities in its service territory. These franchises allow SDG&E to locate facilities for the transmission and distribution of electricity and gas in the streets and other public places. The franchises do not have fixed terms, except for the following: GRANTOR TYPE EXPIRATION - -------------------------------------------------------------- City of Chula Vista Electric and gas 1997 City of Encinitas Electric and gas 2012 City of San Diego Electric and gas 2021 City of Coronado Electric and gas 2028 City of Escondido Gas 2036 County of San Diego Gas 2030 - -------------------------------------------------------------- State Regulation The California Public Utilities Commission consists of five members appointed by the governor and confirmed by the senate. The commissioners serve six-year terms and have the authority to regulate SDG&E's rates and conditions of service, sales of securities, rate of return, rates of depreciation, uniform systems of accounts, examination of records, and long-term resource procurement. The CPUC also conducts various reviews of utility performance and conducts investigations into various matters, such as the environment, deregulation and competition, to determine its future policies. The California Energy Commission has discretion over electric demand forecasts for the state and for specific service territories. Based upon these forecasts, the CEC determines the need for additional plants and for conservation programs. The CEC sponsors alternative-energy research and development projects, promotes energy conservation programs, and maintains a statewide plan of action in case of energy shortages. In addition, the CEC certifies power plant sites and related facilities within California. Federal Regulation The Federal Energy Regulatory Commission regulates electric rates involving sales for resale, transmission access, rates of depreciation and uniform systems of accounts. The FERC also regulates the interstate sale and transportation of natural gas. The Nuclear Regulatory Commission oversees the licensing, construction and operation of nuclear facilities. NRC regulations require extensive review of the safety, radiological and environmental aspects of these facilities. Periodically, the NRC requires that newly developed data and techniques be used to reanalyze the design of a nuclear power plant and, as a result, requires plant modifications as a condition of continued operation in some cases. Licenses and Permits SDG&E obtains a number of permits, authorizations and licenses in connection with the construction and operation of its electric generating plants. Discharge permits, San Diego Air Pollution Control District permits and NRC licenses are the most significant examples. The licenses and permits may be revoked or modified by the granting agency if facts develop or events occur that differ significantly from the facts and projections assumed in granting the approval. Furthermore, discharge permits and other approvals are granted for a term less than the expected life of the facility. They require periodic renewal, which results in continuing regulation by the granting agency. Other regulatory matters are described throughout this report. COMPETITION This topic is discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and in "Rate Regulation" and "Electric Operations" herein. SOURCES OF REVENUE (In Millions of Dollars) 1993 1992 1991 - ----------------------------------------------------------------------------- Utility revenue by type of customer: Electric - Residential $ 615 $ 601 $ 561 Commercial 572 543 503 Industrial 250 245 230 Other 77 58 64 - ----------------------------------------------------------------------------- Total Electric 1,514 1,447 1,358 - ----------------------------------------------------------------------------- Gas - Residential 195 181 184 Commercial 63 61 67 Industrial 40 54 68 Other 49 41 19 - ----------------------------------------------------------------------------- Total Gas 347 337 338 - ----------------------------------------------------------------------------- Total Utility 1,861 1,784 1,696 - ----------------------------------------------------------------------------- Diversified Operations 119 87 93 - ----------------------------------------------------------------------------- Total $1,980 $1,871 $1,789 - ----------------------------------------------------------------------------- Industry segment information is contained in "Statements of Consolidated Financial Information by Segments of Business" on Page 31 of the 1993 Annual Report to Shareholders. ELECTRIC OPERATIONS INTRODUCTION SDG&E's philosophy of providing adequate energy at the lowest possible cost has been based on a combination of production from its own plants and purchases from other producers. The purchases have been a combination of short-term and long-term contracts and spot purchases. All resource acquisitions are obtained through a competitive bidding process. This method of acquisition is encouraged by both the CPUC and the CEC. It is likely this process will continue into the foreseeable future in California. To date, competitive bidding has been limited to generation sources and has not included energy conservation measures that could reduce the need for generation capacity. However, the CPUC has recently ordered utilities in the state to implement pilot demonstration projects to allow others to competitively bid to supply energy conservation services to utilities' customers. RESOURCE PLANNING In 1992 the CPUC issued a decision on the Biennial Resource Plan Update proceedings. As a result of the decision, SDG&E was required to allow qualified nonutility power producers that cogenerate or use renewable energy technologies to competitively bid for a portion of SDG&E's future capacity needs. The decision also required SDG&E to implement energy-conservation programs which would reduce SDG&E's future need for additional capacity. In addition, the CPUC granted SDG&E the flexibility to determine how best to meet its remaining capacity requirements. In 1993 SDG&E was involved in various stages of completing three separate solicitations for new power sources. These three solicitations include contract negotiations for short-term purchased power ranging from 200 to 700 mw for the period 1994 through 1997, the BRPU auction for 491 mw of capacity by 1997, and competitive bidding to determine whether the proposed 500-mw South Bay Unit 3 Repower project could be replaced by lower-cost power. Additional information concerning resource planning is discussed in "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. ELECTRIC RESOURCES Based on generating plants in service and purchased power contracts in place as of January 31, 1994, the net megawatts of firm electric power available to SDG&E during the next summer (normally the time of highest demand) are as follows: SOURCE NET MEGAWATTS - ------------------------------------------------------------------ Nuclear generating plants 430 Oil/gas generating plants 1,611 Combustion turbines 332 Long-term contracts with other utilities 675 Short-term contracts with other utilities 342 Contracts with others 217 - ------------------------------------------------------------------ Total 3,607 - ------------------------------------------------------------------ SDG&E'S 1993 system peak demand of 2,850 mw occurred on September 8, when the net system capability, including power purchases, was 3,474 mw. SDG&E's record system peak demand of 3,285 mw occurred on August 17, 1992, when the net system capability was 3,669 mw. NUCLEAR GENERATING PLANTS SDG&E owns 20 percent of the three nuclear units at San Onofre Nuclear Generating Station. The cities of Riverside and Anaheim own a total of 5 percent of SONGS 2 and 3. Southern California Edison Company owns the remaining interests and operates the units. In November 1992 the CPUC issued a decision to permanently shut down SONGS 1. The NRC requires that SDG&E and Edison file a decommissioning plan in 1994, although final dismantling will not occur until SONGS 2 and 3 are also retired. The unit's spent nuclear fuel has been removed from the reactor and stored on-site. In March 1993 the NRC issued a Possession-Only License for SONGS 1, and the unit is expected to be in its final long-term permanently defueled storage condition by April 1994. SONGS 2 and 3 began commercial operation in August 1983 and April 1984, respectively. SDG&E's share of the capacity is 214 mw of SONGS 2 and 216 mw of SONGS 3. Between 1991 and 1993, SDG&E spent $83 million on capital modifications and additions for all three units and expects to spend $26 million in 1994 on SONGS 2 and 3. SDG&E deposits funds in an external trust to provide for the future dismantling and decontamination of the units. The shutdown of SONGS 1 will not affect contributions to the trust. For additional information, see Note 5 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. In 1983 the CPUC adopted performance incentive plans for SONGS that set a Target Capacity Factor range of 55 to 80 percent for SONGS 2 and 3. Energy costs or savings outside that range are shared equally by SDG&E and its customers. Since the TCF was adopted, these units have operated above 55 percent for each of their fuel cycles. In addition to always attaining the minimum TCF, SONGS 2 and 3 have exceeded the range a total of four times in the eleven completed cycles. However, there can be no assurance that they will continue to achieve a 55 percent capacity factor. Additional information concerning the SONGS units is described under "Environmental, Health and Safety" and "Legal Proceedings" herein and in "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and in Notes 5 and 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. OIL/GAS GENERATING PLANTS SDG&E's South Bay and Encina power plants are equipped to burn either fuel oil or natural gas. The four South Bay units went into operation between 1960 and 1971 and can generate 690 mw. The five Encina units began operation between 1954 and 1978 and can generate 921 mw. SDG&E sold and leased back Encina Unit 5 (315 mw) in 1978. The lease term is through 2004, with renewal options for up to 15 additional years. SDG&E has 19 combustion turbines that were placed in service from 1966 to 1979. They are located at various sites and are used only in times of peak demand. The Silver Gate plant is in storage and its 230 mw are not included in the system's capability. Silver Gate is not currently scheduled to return to service. The plant would have to comply with various environmental rules and regulations before returning to service. The cost of compliance could be significant. Additional information concerning SDG&E's power plants is described under "Environmental, Health and Safety," "Electric Resources" and "Electric Properties" herein and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. PURCHASED POWER The following table lists significant contracts with other utilities and others: Megawatt Supplier Period Commitment Source - --------------------------------------------------------------------------- Long-Term Contracts with Other Utilities: Bonneville Power May Through September 300 Hydro Power Administration (1994, 1995, 1996) Comision Federal de Through September 1997 150 Geothermal Electricidad (Mexico) Portland General Through December 1998 50 Hydro storage Electric Company Through December 2013 75 Coal Public Service Company Through April 2001 100 System supply of New Mexico Short-Term Contracts with Other Utilities: Imperial Irrigation Through March 1994 150 System Supply District PacifiCorp Through December 1994 200 System Supply Rocky Mountain Through December 1994 67 Coal Generation Cooperative Salt River Project Through December 1994 75 System Supply Contracts with Others: Bayside Cogeneration June 1995 through 50 Cogeneration June 2025 Cities of Azusa, Banning Through December 1994 65 Coal and Colton January-December 1995 40 Goal Line Limited November 1994 through 50 Cogeneration Partnership November 2024 Sithe Energies Through December 2019 102 Cogeneration USA, Inc. Yuma Cogeneration June 1994 through 50 Cogeneration Associates June 2024 The commitment with CFE is for energy and capacity. The others are for capacity only. The capacity charges are based on the costs of the generating facilities from which purchases are made. These charges generally cover costs such as lease payments, operating and maintenance expenses, transmission expenses, administrative and general expenses, depreciation, state and local taxes, and a return on the seller's rate base (if a utility) or other markup on the seller's cost. Energy costs under the CFE contract are indexed to changes in Mayan crude oil prices and the dollar/peso exchange rate. Energy costs under the other contracts are based primarily on the cost of fuel used to generate the power. The locations of the suppliers which have long-term contracts with SDG&E and the primary transmission lines (and their capacities) used by SDG&E are shown on the following map of the Western United States. The transmission capacity shown for the Pacific Intertie does not reflect the effects of the temporary earthquake damage discussed under "Transmission Arrangements - Pacific Intertie" herein. Where applicable, interconnection to the primary lines is provided by contract. [MAP] LONG-TERM CONTRACTS WITH OTHER UTILITIES BONNEVILLE POWER ADMINISTRATION: In 1993 SDG&E and BPA entered into an agreement for the exchange of capacity and energy. SDG&E provides BPA with off-peak, non-firm energy in exchange for capacity and associated energy. In addition, SDG&E makes energy available for BPA to purchase during the period January through April of each year. To facilitate the exchange, SDG&E has an agreement with Edison for 100 mw of firm transmission service from the Nevada-Oregon border to SONGS. COMISION FEDERAL DE ELECTRICIDAD: In 1986 SDG&E began the 10-year term of a purchase agreement under which SDG&E purchases firm energy and capacity of 150 mw from CFE. In March 1990 SDG&E obtained an option, exercisable on or before September 1, 1994, to extend the purchase agreement by up to 13 months. PORTLAND GENERAL ELECTRIC COMPANY: In 1985 SDG&E and PGE entered into an agreement for the purchase of 75 mw of capacity from PGE's Boardman Coal Plant from January 1989 through December 2013. SDG&E pays a monthly capacity charge plus a charge based upon the amount of energy received. In addition, SDG&E has 50 mw of available firm hydro storage service with PGE through December 1998. SDG&E has also purchased from PGE 75 mw of transmission service in the northern section of the Pacific Intertie through December 2013. PUBLIC SERVICE COMPANY OF NEW MEXICO: In 1985 SDG&E and PNM entered into an agreement for the purchase of 100 mw of capacity from PNM's system from June 1988 through April 2001. SDG&E pays a capacity charge plus a charge based on the amount of energy received. SHORT-TERM CONTRACTS WITH OTHER UTILITIES IMPERIAL IRRIGATION DISTRICT: In September 1993 SDG&E and IID entered into an agreement for the purchase of 150 mw of firm energy through March 1994. The energy charge is based on the amount of energy received. PACIFICORP: In October 1993 SDG&E entered into an agreement with PacifiCorp for the purchase of 200 mw of capacity during 1994. SDG&E pays a capacity charge plus a charge based on the amount of energy received. ROCKY MOUNTAIN GENERATION COOPERATIVE: In October 1993 SDG&E and RMGC entered into an agreement for the purchase of 67 mw of capacity through December 1994. SDG&E pays a capacity charge plus a charge based on the amount of energy received. SALT RIVER PROJECT: In December 1993 SDG&E and SRP entered into an agreement for the purchase of 75 mw of capacity through December 1994. SDG&E pays a capacity charge plus a charge based on the amount of energy received. CONTRACTS WITH OTHERS BAYSIDE COGENERATION: SDG&E and Bayside have entered into a 30-year agreement for the purchase of 50 mw of capacity which is scheduled to begin in June 1995. SDG&E will pay a capacity charge plus a charge based on the amount of energy received. CITIES OF AZUSA, BANNING AND COLTON: In 1993 SDG&E and the cities entered into an agreement for the purchase of 65 mw of capacity from January 1994 through December 1994 and 40 mw of capacity from January 1995 through December 1995. SDG&E pays a capacity charge plus a charge based on the amount of energy received. GOAL LINE LIMITED PARTNERSHIP: SDG&E and Goal Line have entered into a 30-year agreement for the purchase of 50 mw of capacity which is scheduled to begin in November 1994. SDG&E will pay a capacity charge plus a charge based on the amount of energy received. SITHE ENERGIES USA, INC.: In April 1985 SDG&E entered into three 30-year agreements for the purchase of 102 mw of capacity from December 1989 through December 2019. SDG&E pays a capacity charge plus a charge for the amount of energy received. YUMA COGENERATION ASSOCIATES: SDG&E and Yuma Cogeneration Associates have entered into a 30-year agreement for 50 mw of capacity which is scheduled to begin in June 1994. SDG&E will pay a capacity charge plus a charge for the amount of energy received. Additional information concerning SDG&E's purchased power contracts is described in "Legal Proceedings" herein and in Note 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. POWER POOLS In 1964 SDG&E, Pacific Gas & Electric and Edison entered into the California Power Pool Agreement. It provides for the transfer of electrical capacity and energy by purchase, sale or exchange during emergencies and at other mutually determined times. SDG&E is a participant in the Western Systems Power Pool, which involves an electric power and transmission rate agreement with utilities and power agencies located from British Columbia through the western states and as far east as the Mississippi River. The 54 investor-owned and municipal utilities, state and federal power agencies, and energy brokers share power and information in order to increase efficiency and competition in the bulk power market. Participants are able to target and coordinate delivery of cost-effective sources of power from outside their service territories through a centralized exchange of information. TRANSMISSION ARRANGEMENTS In addition to interconnections with other California utilities, SDG&E has firm transmission capabilities for purchased power from the Northwest, the Southwest and Mexico. Pacific Intertie SDG&E, PG&E and Edison share transmission capacity on the Pacific Intertie under an agreement that expires in July 2007. The Pacific Intertie enables SDG&E to purchase and receive surplus coal and hydroelectric power from the Northwest. SDG&E's share of the intertie is 266 mw. SDG&E recently purchased up to an additional 200 mw of firm rights on the Pacific Intertie through 1996. In January 1994 a major earthquake centered in Los Angeles County, California temporarily reduced SDG&E's share of the intertie's available capacity to about 100 mw. Repairs to the transmission facilities are scheduled to be completed in December 1994. SDG&E does not expect this to have a significant impact on its transmission capabilities within California. Southwest Powerlink SDG&E's 500-kilovolt Southwest Powerlink transmission line, which it shares with Arizona Public Service Company and IID, extends from Palo Verde, Arizona to San Diego and enables SDG&E to import power from the Southwest. SDG&E's share of the line is 914 mw, although it can be less, depending on specific system conditions. Mexico Interconnection Mexico's Baja California Norte system is connected to SDG&E's system via two 230-kilovolt interconnections with firm capability of 408 mw. SDG&E uses this interconnection for transactions with CFE. Additional Transmission Capabilities Through an agreement with Edison, SDG&E has obtained the option to purchase 100 mw of transmission service on the existing Palo Verde - Devers transmission line in the late 1990s. The agreement is contingent upon Edison's construction of its second transmission line connecting the Palo Verde Nuclear Generating Station in Arizona to the Devers substation near Palm Springs, California. This agreement also provides SDG&E with the option to exchange up to 200 mw of Southwest Powerlink transmission rights for up to 200 additional mw of Edison's rights on the first Palo Verde - Devers transmission line. This exchange would enable both utilities to further diversify their transmission paths. SDG&E has indicated an interest in projects to obtain additional transmission capabilities from the Rocky Mountain and Southwest regions and within California. TRANSMISSION ACCESS As a result of the enactment of the National Energy Policy Act of 1992, the FERC has established rules to implement the Act's transmission access provisions. These rules specify FERC-required procedures for others' requests for transmission service. Additional information regarding transmission access is described in "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. FUEL AND PURCHASED-POWER COSTS The following table shows the percentage of each electric fuel source used by SDG&E and compares the costs of the fuels with each other and with the total cost of purchased power: Percent of Kwh Cents per Kwh - ---------------------------------------------------------------------------- 1993 1992 1991 1993 1992 1991 - ---------------------------------------------------------------------------- Fuel oil 3.7% 0.6% 0.7% 2.7 4.0 4.2 Natural gas 24.4 27.4 22.7 3.4 3.1 3.2 Nuclear fuel 17.2 22.3 20.9 0.6 0.8 0.9 - ---------------------------------------------------------------------------- Total generation 45.3 50.3 44.3 Purchased power-net 54.7 49.7 55.7 3.5 3.8 3.5 - ---------------------------------------------------------------------------- Total 100.0% 100.0% 100.0% - ---------------------------------------------------------------------------- The cost of purchased power includes capacity costs as well as the costs of fuel. The cost of natural gas includes transportation costs. The costs of fuel oil, natural gas and nuclear fuel do not include SDG&E's capacity costs. While fuel costs are significantly less for nuclear units than for other units, capacity costs are higher. ELECTRIC FUEL SUPPLY Uranium The nuclear fuel cycle includes services performed by others. These services and the dates through which they are under contract are as follows: Mining and milling of uranium concentrate(1) 1994 Conversion of uranium concentrate to uranium hexafluoride 1995 Enrichment of uranium hexafluoride(2) 1998 Fabrication of fuel assemblies 2000 Storage and disposal of spent fuel(3) _ 1 SDG&E's contracted supplier of uranium concentrate is Pathfinder Mines Corporation. However, the majority of the requirements will be supplied by purchases from the spot market. 2 The Department of Energy is committed to offer any required enrichment services through 2014. 3 Spent fuel is being stored at SONGS, where storage capacity will be adequate at least through 2003. If necessary, modifications in fuel-storage technology can be implemented that would provide, at additional cost, on-site storage capacity for operation through 2014, the expiration date of the NRC operating license. The DOE's plan is to make a permanent storage site for the spent nuclear fuel available by 2010. To the extent not currently provided by contract, the availability and the cost of the various components of the nuclear fuel cycle for SDG&E's nuclear facilities cannot be estimated at this time. Pursuant to the Nuclear Waste Policy Act of 1982, SDG&E entered into a contract with the DOE for spent fuel disposal. Under the agreement, the DOE is responsible for the ultimate disposal of spent fuel. SDG&E is paying a disposal fee of $1 per megawatt-hour of net nuclear generation. Disposal fees average $3 million per year. SDG&E recovers these disposal fees in customer rates. Additional information concerning nuclear fuel costs is discussed in Note 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. Fuel Oil SDG&E has no long-term commitments to purchase fuel oil. The use of fuel oil is dependent upon price differences between it and alternative fuels, primarily natural gas. During 1993 SDG&E burned 1.1 million barrels of fuel oil. Fuel oil usage in 1994 will depend on its price relative to natural gas and the availability of natural gas and other alternatives. The lowest-priced fuel will be used in order to minimize fuel costs for electric generation. NATURAL GAS OPERATIONS - --------------------------------------------------------------------------- SDG&E purchases natural gas for resale to its customers and for fuel in its electric generating plants. All natural gas is delivered to SDG&E under transportation and storage agreement with Southern California Gas Company through two transmission pipelines with a combined capacity of 400 million cubic feet per day. During 1993 SDG&E purchased approximately 102 billion cubic feet of natural gas. The majority of SDG&E's natural gas requirements are met through contracts of less than one year. SDG&E purchases natural gas primarily from various spot-market suppliers and from suppliers under short-term contracts. These supplies originate in New Mexico, Oklahoma and Texas and are transported by El Paso Natural Gas Company and by Transwestern Pipeline Company. In November 1993 natural gas deliveries to SDG&E commenced under long-term contracts with four Canadian suppliers when the Alberta-to-California pipeline expansion project began commercial operation. This natural gas is transported over Pacific Gas Transmission and PG&E pipelines to SDG&E's system. The contracts have varying terms through 2004. Additional information concerning SDG&E's gas operations is described under "Legal Proceedings" herein and in "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and Note 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. RATE REGULATION - ----------------------------------------------------------------------------- The following ratemaking procedures are changing under SDG&E's proposed incentive-based ratemaking process which is described further under "Performance-Based Ratemaking" below: BASE RATES Traditionally, SDG&E has filed a general rate application with the CPUC every three years to determine its base rates. This allows SDG&E to recover its basic non-fuel business costs such as the cost of operating and maintaining the utility system, taxes, depreciation and the cost of accommodating system growth. Between these general rate cases, an attrition procedure allows adjustments in rates based on inflation and system growth. In addition, SDG&E files an annual application to establish its cost of capital, which reflects the cost of debt and equity. The most recent attrition and cost of capital proceeding went into effect on January 1, 1994. FUEL AND ENERGY RATES The CPUC requires balancing accounts for fuel and purchased energy costs and for sales volumes. The CPUC sets balancing account rates based on estimated costs and sales volumes. Revenues are adjusted upward or downward to reflect the differences between the authorized and actual volumes and costs. These differences are accumulated in the balancing accounts and represent amounts to be either recovered from customers or refunded to them. Periodically, the CPUC adjusts SDG&E's rates to amortize the accumulated differences. As a result, changes in SDG&E's fuel and purchased power costs or changes in electric and gas sales volumes normally have not affected SDG&E's net income. ELECTRIC FUEL COSTS AND SALES VOLUMES Rates to recover electric fuel and purchased power costs are determined in the Energy Cost Adjustment Clause proceeding. This proceeding take place annually, although a semi-annual review is required if the anticipated rate change exceeds a specified threshold. The proceedings take place in two phases: In the forecast phase, prices are set based on the estimated cost of fuel and purchased power for the following year and are adjusted to reflect any changes from the previous period. These adjustments are made by amortizing any accumulation in the balancing accounts described above. In the other phase, the reasonableness review, the CPUC evaluates the prudence of SDG&E's fuel and purchased power transactions, electric operations, and natural gas transactions and operations. As described under "Performance-Based Ratemaking" these reviews will now only be required if SDG&E's recorded fuel and energy expenses result in significant variances from the established benchmarks. The Electric Revenue Adjustment Mechanism compensates for variations in sales volume compared to the estimates used for setting the non-fuel component of rates. ERAM is designed to stabilize revenues, which may otherwise vary due to changes in sales volumes largely resulting from weather fluctuations. Any accumulation in the ERAM balancing account is amortized when new rates are set in the ECAC proceeding. NATURAL GAS COSTS AND SALES VOLUMES Customer rates to recover the cost of purchasing and transporting natural gas are determined in the Biennial Cost Allocation Proceeding. The BCAP proceeding normally occurs every two years and is updated in the following year for purposes of amortizing any accumulation in the gas balancing accounts. Transportation costs include intrastate and interstate pipeline charges, take-or-pay obligations, industry restructuring costs resulting from changes in federal and state regulations, and transportation and storage fees. Balancing accounts for natural gas costs and sales volumes are similar to those for electric costs and sales volumes. The natural gas balancing accounts include the Purchased Gas Account for gas costs and the Gas Fixed Cost Account for sales volumes. Balancing account coverage includes both core customers (primarily residential and commercial customers) and noncore customers (primarily large industrial customers). However, SDG&E receives balancing account coverage on 75 percent of noncore GFCA overcollections and undercollections. OTHER COSTS Energy Conservation Programs Over the past several years, SDG&E has promoted conservation programs to encourage efficient use of energy. The programs are designed to conserve energy through the use of energy-efficiency measures that will reduce customers' energy costs and offset the need to build additional power plants. The costs of these programs are being recovered through electric and natural gas rates. The programs contain an incentive mechanism that could increase or decrease SDG&E's earnings, depending upon the performance of the programs in meeting specified efficiency and expenditure targets. The CPUC has encouraged expansion of these programs, authorizing expenditures annually of $54 million for 1993 through 1995. However, the CPUC has also ordered utilities to conduct a test program to determine if others could offer energy conservation services at a lower cost than the utilities'. Low Emission Vehicle Programs Since 1991 SDG&E has conducted a CPUC-approved natural gas vehicle program. The program includes building refueling stations, demonstrating new technology, providing incentives and converting portions of SDG&E's fleet vehicles to natural gas. The cost of this program is being recovered in natural gas rates. In 1993 SDG&E opened 14 refueling stations at existing gasoline stations under cost-sharing arrangements with major oil companies in order to demonstrate that natural gas is an economical alternative vehicle fuel that could assist automobile companies in meeting federal and state clean air standards. SDG&E plans to add eight more natural gas refueling stations in 1994. During 1993 there were 356 natural gas vehicles operating in San Diego. In July 1993 the CPUC issued a decision adopting guidelines for utility participation in the CPUC's low-emission vehicle program to encourage the use of electric and natural gas-powered vehicles. The six-year program will provide funding to build natural gas vehicle refueling stations and electric vehicle recharging stations, offer incentives for purchasing EVs and NGVs, convert existing vehicles, and educate the public on the benefits of alternative fuels. On November 1, 1993 SDG&E filed an application with the CPUC, requesting $26 million to fund an EV program and to expand its existing NGV program beginning in 1995. On February 3 the CPUC approved a portion of SDG&E's EV program request by establishing a memorandum account for planned expenditures of $530,000 for EV recharging stations and customer incentives to purchase EVs. A final CPUC decision is expected in late 1994. PERFORMANCE-BASED RATEMAKING In October 1992 SDG&E applied to the CPUC to implement performance-based ratemaking, requesting incentive regulation for: 1) natural gas procurement and transportation; 2) electric generation and purchased energy; 3) base rates and 4) long-term electric resource procurement. On June 23, 1993 the CPUC approved the first two mechanisms on a two-year experimental basis beginning August 1, 1993. These mechanisms will measure SDG&E's ability to purchase and transport natural gas, and to generate energy or purchase short-term energy at the lowest possible cost, by comparing SDG&E's performance against various market benchmarks. SDG&E's shareholders and customers will share in any savings or excess costs within predetermined ranges. Under the natural gas procurement and transportation mechanism, if SDG&E's natural gas supply and transportation expenses exceed the benchmark by more than 2 percent, SDG&E will recover one-half of the excess. However, if expenses fall below the index, SDG&E's shareholders and customers will share equally in the savings. The benchmark to measure SDG&E's electric generation and purchased energy performance is based upon the difference between SDG&E's actual and authorized electric fuel and short-term purchased energy expenses. SDG&E would be at risk for about one-half of the expenses that exceed the authorized amount by 6 percent or less. SDG&E would be allowed to recover expenses exceeding the 6 percent range, subject to a reasonableness review by the CPUC. However, SDG&E would receive about one-half of the savings if expenses fall below the authorized amount by 6 percent or less. SDG&E's customers would receive 100 percent of the savings if expenses fall below the 6 percent range. Under the proposed base-rate mechanism, SDG&E would forego its next General Rate Case, scheduled for 1996, and utilize the proposed base-rate mechanism for a 5-year period beginning in May 1994. SDG&E's initial revenue requirements would be based on its 1993 General Rate Case Decision. This would replace the CPUC's requirement for a costly and detailed examination of SDG&E's costs every three years in the traditional General Rate Case. However, SDG&E's annual cost of capital proceeding would be continued. This streamlined approach would also allow SDG&E to respond more effectively to competition and to other factors affecting rates. The proposed base-rate mechanism has three components. The first is a formula similar to the current attrition mechanism used to determine SDG&E's annual revenue requirement for operating, maintenance and capital expenditures. The second is a set of indicators which determine performance standards for customer rates, employee safety, electric system reliability and customer satisfaction. Each indicator specifies a range of possible shareholder benefits and risks. SDG&E could be penalized up to a total of $21 million should it fall significantly below these standards or earn up to $19 million if it exceeds all of the performance targets. The third component would set limits on SDG&E's rate of return. If SDG&E realizes an actual rate of return that exceeds its authorized rate of return by one percent to one and a half percent, it would be required to refund 25 percent of the excess over one percent to customers. If SDG&E's rate of return exceeds the authorized level by more than one and a half percent, SDG&E would also refund 50 percent of that excess to customers. SDG&E would be at risk if its rate of return falls less than three percent below the authorized level. However, if SDG&E's rate of return falls three percent or more below the authorized level, a rate case review would automatically occur. SDG&E may request a rate case review any time its rate of return drops one and one half percent or more below the authorized level. A CPUC decision is expected in the second quarter of 1994. SDG&E expects the long-term electric resource procurement mechanism to be addressed after proceedings on the base-rate mechanism. This mechanism calls for a bidding system under which SDG&E would compete with other utilities and nonutility producers to provide long-term generating resources, including long-term purchased-power capacity, to SDG&E customers. This mechanism would eliminate the Biennial Resource Plan Update proceeding, replacing it with a market-based approach to long-term electric-resource procurement. The CPUC would have final approval of the resources selected by SDG&E. ELECTRIC RATES The average price per kilowatt-hour charged to electric customers was 9.4 cents in 1993 and 9.3 cents in 1992. NATURAL GAS RATES The average price per therm of natural gas charged to customers was to 55.1 cents in 1993 and 50.7 cents in 1992. Additional information concerning rate regulation is described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. ENVIRONMENTAL, HEALTH AND SAFETY - --------------------------------------------------------------------------- SDG&E's operations are guided by federal, state and local environmental laws and regulations governing air quality, water quality, hazardous substance handling and disposal, land use, and solid waste. Compliance programs to meet these laws and regulations increase the cost of electric and natural gas service by requiring changes or delays in the location, design, construction and operation of new facilities. SDG&E may also incur significant costs to operate its facilities in compliance with these laws and regulations and to mitigate or clean up the environment as a result of prior operations of SDG&E or others. The costs of compliance with environmental laws and regulations are normally recovered in customer rates. The CPUC is expected to continue allowing the recovery of such costs, subject to reasonableness reviews. ELECTRIC AND MAGNETIC FIELDS Scientists are researching the possibility that exposure to power frequency magnetic fields causes adverse health effects. This research, although often referred to as relating to electric and magnetic fields, or EMFs, focuses on magnetic fields. To date, some laboratory studies suggest that such exposure creates biological effects, but those effects have not been shown to be harmful. The studies that have most concerned the public are epidemiological studies. Some of those studies reported a weak correlation between the proximity of homes to certain power lines and equipment and childhood leukemia. Other studies reported weak correlations between computer estimates of historic exposure and disease. Various wire configuration categories and the historical computer calculations were used as substitutes for actual personal exposure measurements, which were not available. When actual field levels were measured in those studies, no correlation was found with disease. Other epidemiological studies found no correlation between estimated exposure and any disease. Scientists cannot explain why some studies using estimates of past exposure report correlations between estimated fields and disease, while others do not. Neither can scientists explain why no studies correlate measured fields with disease. In November 1993 the CPUC adopted an interim policy regarding EMFs. Consistent with the more than twenty major scientific reviews of available research literature, the CPUC concluded that no health risk has been identified with exposure to low-frequency magnetic fields. To be responsive to public concern and scientific uncertainty, the CPUC created two utility-funded programs, a $2-million public-education program and a $6-million research program, and directed utilities to adopt a low-cost EMF reduction policy for new projects. The latter program, which will be implemented until science provides more direction, entails reasonable design changes to new projects to achieve a noticeable reduction of magnetic-field levels. The CPUC indicated that these low-cost measures to reduce field levels should not exceed 4 percent of the cost of new or upgraded facilities. Such design changes will be subject to safety, reliability, efficiency and other normal operational criteria. It is difficult at this time to predict the impact of the CPUC's directives on SDG&E's operations. Final design guidelines should be completed by mid-1994, following a series of workshops scheduled by the CPUC. Litigation concerning EMFs is discussed under "Legal Proceedings" herein. HAZARDOUS SUBSTANCES BKK Corporation SDG&E was one of several hundred companies using the BKK Corporation's West Covina facility, which operated under a permit for the disposal of hazardous waste prior to its 1984 closure. The site is listed for cleanup in the California Superfund Site Priority List under the Hazardous Substance Account Act, which imposes cleanup liability on the sites' owners, operators or users. The California Department of Toxic Substances Control is working with the site owner/operator to determine whether a post-closure permit should be issued for the facility. In addition, the U.S. Environmental Protection Agency is overseeing BKK's assessment of potential releases from the site, including releases into the groundwater, to determine whether any remediation will be required. SDG&E believes the site owner/operator will perform any required assessment and remedial activities. SDG&E is unable to estimate the cost of cleaning up the site or what liability, if any, it may have for such cleanup costs. SDG&E was named as a potentially responsible party with respect to two other sites, the Rosen's Electrical Equipment Supply Company site in Pico Rivera, California and the North American Environmental, Inc. site in Clearfield, Utah. Additional information concerning these sites is described in "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. Waste Water Treatment SDG&E is authorized to operate the waste water treatment facilities at the Encina and South Bay power plants under the California Hazardous Waste Treatment Permit Reform Act of 1992. To comply with the state's regulations, construction of secondary containment for the waste water treatment facilities will be completed in 1994 at a total cost of $3 million. New waste water storage tanks for these facilities, completed in 1991, may not be operated under the plants' existing permits. SDG&E received authorization to operate the new tanks from the California Department of Toxic Substances Control pursuant to a variance from the hazardous waste facility permitting requirements. In June 1993 this variance was withdrawn due to a change in the department's policy. SDG&E is negotiating the terms and conditions of a stipulation and order which would allow the continued operation of these storage tanks. However, the state could withhold authorization and initiate an enforcement action (and the imposition of fines and penalties), preventing continued operation of the storage tanks. Alternative treatment methods, which would not require the use of such tanks, may require additional expenditures of approximately $2 million per year. However, the state is expected to issue new regulations in 1994 which would allow continued operation of the existing storage tanks. Aboveground Tanks California's 1989 Aboveground Petroleum Storage Act requires SDG&E to establish and maintain monitoring programs to detect leaks in fuel oil storage tanks. All diesel oil storage tanks which could pose a threat to the environment have been reconstructed with a secondary bottom and a leak detection system. The conversion began in 1991 and was completed in 1993 at a total cost of $2 million. Underground Storage California has enacted legislation to protect ground water from contamination by hazardous substances. Underground storage containers require permits, inspections and periodic reports, as well as specific requirements for new tanks, closure of old tanks and monitoring systems for all tanks. SDG&E's capital program to comply with these requirements has cost $3 million to date. It is expected that cleanup of sites previously contaminated by underground tanks will occur for an unknown number of years. SDG&E cannot predict the cost of such cleanup. Additionally, if a facility is reactivated, the removal and replacement of existing tanks may be required. Specific underground locations requiring assessment and/or remediation are indicated below: On May 29, 1987 the San Diego Regional Water Quality Control Board issued SDG&E a cleanup and abatement order for gasoline contamination originating from an underground storage tank located at SDG&E's Mountain Empire operation and maintenance facility. To comply with the order SDG&E has implemented a "pump and treat" program to remediate the site. Because the source of the area's drinking water is near the contamination, the Department of Health Services and the Board are expected to require SDG&E to further assess the extent of the contamination and undertake alternative remediation to further protect the drinking water from contamination. SDG&E is unable to estimate the costs for the assessment or for alternative remediation. On January 7, 1993 SDG&E was issued a notice of corrective action by the Department of Health Services relative to soil contamination from used lubrication oil associated with an underground tank located at SDG&E's South Bay Operation and Maintenance facility. At present, SDG&E is unable to estimate the extent of the contamination or the potential cleanup costs. In 1993 SDG&E discovered a shallow underground tank-like structure while installing underground electric facilities. The structure was located under a public street immediately west of SDG&E's Station A facility. The past ownership, operation and use of the structure is unknown. Hydrocarbon contamination has been found in the vicinity of the structure, but it has not been established whether the structure was the source of the contamination. The San Diego County Department of Health Services has issued a cleanup and abatement order to SDG&E. The order requires SDG&E to conduct a site assessment to delineate the nature and scope of the contamination. SDG&E is unable to estimate the nature and extent of the contamination or the potential cleanup costs. Station B Station B is located in downtown San Diego and was operated as a generating facility from 1911 until June 1993. During 1986, three 100,000-gallon underground diesel-fuel storage tanks were removed. Pursuant to a cleanup and abatement order, SDG&E remediated the existing hydrocarbon contamination. Further analysis of PCB contamination in the area is required before site closure. SDG&E is unable to estimate the extent of such PCB contamination or what remediation, if any, will be required. In addition, asbestos was used in the construction of the facility. Renovation, reconditioning or demolition of the facility will require the removal of the asbestos in a manner complying with all applicable environmental, health and safety laws. The estimated capital cost of this removal is between $6 million and $12 million. Additionally, reuse of the facility would require the removal or cleanup of PCBs, paints containing heavy metals and fuel oil. SDG&E is unable to estimate the extent of this contamination or the cost of cleaning up these materials. Encina Power Plant During 1993 SDG&E discovered the presence of hydrocarbon contamination in subsurface soil at its Encina power plant. This contamination is located north of its western fuel-storage facilities and is believed to be fuel oil originating from a 1950s refueling spill. SDG&E has reported the discovery of the contamination to governmental agencies and has determined it does not pose a significant risk to the environment or to public health. SDG&E is unable to estimate the cost of assessment and of cleaning up the contamination. Manufactured Gas Plant Sites During the late 1800s and early 1900s SDG&E and its predecessors manufactured gas from the combustion of fuel oil at a manufactured gas plant in downtown San Diego (Station A) and at small facilities in the nearby cities of Escondido and Oceanside. Although no tar pits common to town gas sites have been found at the facilities, ash and other residual hazardous byproducts from the gas-manufacturing process were found at the Escondido site during grading for expansion of a substation. Remediation of the Escondido site has been completed at a total cost of about $3 million. Based upon its assessment and remediation activities, SDG&E has applied to the Department of Health Services for a closure certification for the Escondido site. SDG&E and the Department of Health Services are aware that hazardous substances resulting from the operation of the Escondido manufactured gas plant may be present on adjacent locations. SDG&E will coordinate any required assessment or cleanup of any such locations with the department. SDG&E has not found any similar town gas site residuals at the Station A site. However, ash residue similar to that at Escondido was found on property adjacent to SDG&E's Oceanside gas regulator station. This ash residue has been covered with asphalt to prevent public exposure. Some ash residue has also been observed in soil adjacent to Station A. Due to the possibility that town gas residuals exist under the Station A and Oceanside sites, SDG&E will implement an environmental assessment of the sites in 1994 and 1995. SDG&E is unable to estimate the cost of assessment and cleanup of these sites. However, the CPUC has approved SDG&E's application to recover these costs in a future rate proceeding through the reasonableness review process. Litigation concerning hazardous substances is discussed in "Legal Proceedings - - Graybill/Metropolitan Transit Development Board" herein. AIR QUALITY The San Diego Air Pollution Control District regulates air quality in San Diego County in conformance with the California and federal Clean Air Acts. California's standards are more restrictive than federal government standards. Although SDG&E facilities already comply with very strict emission limits and contribute only about 3 percent of the air emissions in San Diego County, the APCD is obligated to quantify the benefits of further reducing emissions from all San Diego industry. The APCD has adopted Rule 69 to further reduce nitrogen oxide emissions. This rule will require the retrofit of the Encina and South Bay power plants with catalytic converters to remove approximately 87 percent of current nitrogen oxide emissions. The estimated capital cost to comply with Rule 69 is $130 million. In addition, annual operating costs will increase about $6 million after all units have been retrofitted. SDG&E expects this to be completed by 2001. The acid rain section of the federal Clean Air Act Amendments of 1990 requires SDG&E to upgrade the continuous emission monitors at its Encina and South Bay power plants to provide more-complete emissions data. Installation of the required continuous emission monitor upgrades will be completed in 1994 at an estimated cost of $5 million. In 1990 the South Coast Air Quality Management District passed a rule which will require SDG&E's older natural gas compressor engines at its Moreno facility to either meet new stringent nitrogen oxide emission levels or be converted to electric drive. In October 1993 the Air Quality District adopted a new program called RECLAIM, which will replace existing rules and require SDG&E's natural gas compressor engines at its Moreno facility to reduce their nitrogen oxide emission levels by about 10 percent a year through 2003. This will be accomplished through the installation of new emission monitoring equipment, operational changes to take advantage of low emitting engines, and engine retrofits. The cost of complying with the proposed rule is expected to be $3 million. WATER QUALITY Discharge permits are required to enable SDG&E to discharge its cooling water and its treated in-plant waste water, and are, therefore, a prerequisite to the continued operation of SDG&E's power plants. The promulgation of water quality-control plans by state and federal agencies may impose increasingly stringent cooling-water and treated waste water discharge requirements on SDG&E. SDG&E is unable to predict the terms and conditions of any renewed permits or their effects on plant or unit availability, the cost of constructing new cooling water treatment facilities, or the cost of modifying the existing treatment facilities. However, any modifications required by such permits could involve substantial expenditures, and certain plants or units may be unavailable for electric generation during such modification. Additional information concerning discharge permits for the South Bay, Encina and SONGS plants is provided in "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. ASBESTOS The corporate office building at 101 Ash Street in San Diego is being retrofitted with sprinklers over a two-year period in response to a City of San Diego ordinance requiring all high-rise office buildings to be retrofitted for fire protection by 1996. This is expected to be completed in 1994. Asbestos is being removed in the areas where the sprinklers are being installed. The total cost of the asbestos removal will be about $2 million. TRANSMISSION LINE AERIAL SAFETY Criteria have been established by the State of California to determine the necessity for installing aerial warning devices on overhead powerlines to promote air-space safety. Nine spans on the Southwest Powerlink transmission line in Imperial County fall within the criteria and will be marked at a cost of approximately $115,000. Study of another 132 spans will determine whether or not additional spans will be marked at a cost of approximately $13,000 per span. Based upon FAA recommendation, SDG&E is also installing aerial warning markers on various segments of the 230-kv and other transmission lines within its service territory. The cost of this project through 1993 was $2 million, and $1 million is budgeted for 1994. Additional information concerning SDG&E's environmental matters is described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and in Note 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. OTHER - --------------------------------------------------------------------------- RESEARCH, DEVELOPMENT AND DEMONSTRATION SDG&E conducts research and development in areas that provide value to SDG&E and its customers. The Research, Development and Demonstration activities are focused in the following areas: 1. The improvement of electric generation efficiency. 2. Development of technologies that enhance electric transmission, distribution and customer utilization efficiency. 3. Participation in the Gas Research Institute and the Electric Power Research Institute. Highlights of the program include demonstration of molten carbonate fuel cells, evaluation and implementation of distributed generation systems, application of advanced telecommunication systems, and the development of technology to reduce service interruptions and make other power quality improvements for customers. Research, development and demonstration costs averaged $7 million annually over the past three years. The CPUC historically has permitted rate recovery of research, development and demonstration expenditures. WAGES SDG&E and Local 465, International Brotherhood of Electrical Workers have a labor agreement that ended on February 28, 1994. Negotiations for a new agreement are expected to be concluded in early 1994. EMPLOYEES OF REGISTRANT As of December 31, 1993 SDG&E had 4,166 full-time employees and 63 part-time employees compared to 4,249 full-time and 61 part-time employees at December 31, 1992. SDG&E's subsidiaries had 818 full-time employees at December 31, 1993 compared to 793 at December 31, 1992. FOREIGN OPERATIONS SDG&E foreign operations in 1993 included power purchases and sales with CFE in Mexico and purchases of energy and natural gas from suppliers in Canada and purchases of uranium from suppliers in Canada, Germany and Namibia. SDG&E's subsidiaries operated in various foreign locations in 1993, including Great Britain, Australia, Canada and Italy. Additional information concerning foreign operations is described under "Electric Operations" and "Natural Gas Operations" herein and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and in Note 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. ITEM 2. ITEM 2. PROPERTIES - --------------------------------------------------------------------------- Substantially all utility plant is subject to the lien of the July 1, 1940 mortgage and deed of trust and its supplemental indentures between SDG&E and the First Trust of California N.A. as trustee, securing the outstanding first mortgage bonds. ELECTRIC PROPERTIES - -------------------------------------------------------------------------- As of December 31, 1993 SDG&E's installed generating capacity in megawatts, based on summer ratings, was as follows: PLANT LOCATION NET MEGAWATTS - ------------------------------------------------------------------------- Encina Carlsbad 921 South Bay Chula Vista 690 San Onofre South of San Clemente 430* Combustion Turbines (19) Various 332 Silver Gate** San Diego 0 - ------------------------------------------------------------------------- *SDG&E's 20 percent share. **Placed in storage in 1984. Net generating capability is 230 mw. Except for San Onofre and some of the combustion turbines, these plants are equipped to burn either fuel oil or natural gas. The system load factor was 64.2 percent in 1993 and ranged from 55.1 percent to 64.2 percent for the past five years. SDG&E's electric transmission and distribution facilities include sufficient substations, and overhead and underground lines to accommodate current customer needs. Various areas of the service territory require expansion periodically to handle customer growth. SDG&E owns an approved nuclear power plant site near Blythe, California. NATURAL GAS PROPERTIES - --------------------------------------------------------------------------- SDG&E's natural gas facilities are located in San Diego and Riverside counties and consist of the Encanto storage facility in San Diego, transmission facilities and various high-pressure transmission pipelines, high-pressure and low-pressure distribution mains, and service lines. SDG&E's natural gas system is sufficient to meet customer demand and short- term growth. SDG&E is currently undergoing an expansion of its high-pressure transmission lines to accommodate expected long-term customer growth. GENERAL PROPERTIES - --------------------------------------------------------------------------- The 21-story corporate office building at 101 Ash Street, San Diego is occupied pursuant to an operating lease through the year 2005. The lease has four separate five-year renewal options. The building is currently undergoing a $15 million renovation which is expected to be completed during 1994. Additional information is provided under "Environmental, Health and Safety" herein. SDG&E also occupies an office complex at Century Park Court in San Diego pursuant to a lease ending in the year 2007. The lease can be renewed for two five-year periods. SDG&E also leases other office space in San Diego to house its computer center under a three-year lease with options to renew for an additional five years. In addition, SDG&E occupies eight operating and maintenance centers, two business centers, seven district offices, and five branch offices. SUBSIDIARY PROPERTIES - --------------------------------------------------------------------------- Wahlco Environmental Systems, Inc. has manufacturing facilities in the continental United States, Puerto Rico, Canada, Great Britain, Australia and Italy, and a sales office in Singapore. Additional information concerning SDG&E's properties is described under "Electric Operations" and "Gas Operations" herein and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and in Notes 2, 5 and 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ----------------------------------------------------------------------------- The following proceedings, described in SDG&E's 1992 Annual Report on Form 10-K, were concluded during the year ended December 31, 1993: San Onofre Nuclear Generating Station Unit 1, Springerville, Zuidema, Energy Factors, American Tool and NCR. Information concerning the conclusion of these proceedings is contained in SDG&E's Quarterly Reports on Form 10-Q for the three-month periods ended March 31, 1993 and September 30, 1993 and in SDG&E's Current Report on Form 8-K dated March 19, 1993. CENTURY POWER LITIGATION - --------------------------------------------------------------------------- On April 1, 1987 Century Power Corporation, formerly Alamito Company, submitted a filing to justify its rates for the following 24 months under a power sales and interconnection agreement with SDG&E. The Federal Energy Regulatory Commission permitted the rates to become effective as of June 1, 1987 subject to refund. In 1988 an administrative law judge ruled unreasonable a component of rates based on the return on equity of Tucson Electric Power Company, a supplier and former affiliate of Century. If the decision stands, demand charges paid by SDG&E could be reduced by $12 million, plus interest, to be refunded principally to SDG&E customers. On September 23, 1993 SDG&E filed a motion requesting the FERC to decide this matter. On December 23, 1993 the FERC issued an order denying SDG&E's motion on the grounds that the matter had been resolved under a settlement reached by the parties in 1991 and approved by the FERC. On January 24, 1994 SDG&E filed a request for rehearing. On February 11, 1993 SDG&E filed a complaint with the FERC against Tucson and Century seeking to adjust its purchase costs under the power sales and interconnection agreement with Century. The complaint seeks summary disposition and moves for an order directing Century and Tucson to refund amounts that they improperly billed SDG&E in violation of the agreement. If successful, SDG&E would be entitled to approximately $15 million, plus interest, which would be refunded principally to SDG&E's customers. On April 23, 1993 Tucson and Century filed answers to the complaint, denying liability. In addition, Tucson brought a counterclaim of approximately $3 million against SDG&E based on alleged underbillings. SDG&E is unable to predict the ultimate outcome of this litigation. CITY OF SAN DIEGO FRANCHISE - --------------------------------------------------------------------------- On February 13, 1990 following the announcement of the proposed merger of SDG&E into Southern California Edison Company, the City of San Diego filed a lawsuit in San Diego County Superior Court to confirm its position that SDG&E's franchises with the city could not be transferred to Edison without the consent of the city pursuant to the city charter and to SDG&E's franchises. On December 28, 1993 the parties dismissed the complaint without prejudice. AMERICAN TRAILS - --------------------------------------------------------------------------- On August 23, 1985 Michael Bessey and others who owned American Trails, a membership campground company, filed a complaint against Wahlco, Inc. and others in the Superior Court of San Diego County for breach of contract, negligence, fraud, intentional interference with contract, breach of the implied covenant of good faith and fair dealing, and breach of fiduciary duty in connection with contingent payments, which were not realized following the redemption of plaintiffs' interest in American Trails Partners No. 1. The plaintiffs are seeking compensatory damages in the amount of approximately $12 million and punitive damages in an unspecified amount. Wahlco has cross-complained against the plaintiffs for defrauding Wahlco into investing $3 million in American Trails. The trial took place in late 1991 before a superior court judge sitting without a jury. On March 25, 1992 the trial judge indicated that the plaintiffs would be awarded approximately $2 million plus fees. However, on April 20, 1992, prior to entry of any judgments, the trial judge removed himself from the case. Another judge was assigned to the case and a new trial began on February 8, 1993. On March 24, 1993 the jury returned verdicts favorable to all defendants on all of the plaintiffs' causes of action, except for breach of contract and interference with contract claims against defendants Wahlco and Robert Wahler, as to which the jury was not able to reach a verdict. On July 23, 1993 the trial court granted the motions of Wahlco and Robert Wahler for summary judgment on the two remaining causes of action against them and denied the plaintiffs' motion for a new trial. On September 21, 1993 judgment was entered by the court in favor of Wahlco and the other defendants. As a result, all claims and causes of action by the plaintiffs against Wahlco have been determined in favor of Wahlco. On October 7, 1993 the plaintiffs filed a notice of appeal from the court's judgment. Wahlco intends to continue defending this lawsuit vigorously. By agreements dated September 19, 1987, October 28, 1987, and March 1, 1990, Robert R. Wahler, as Trustee of the Wahler Family Trust; John H. McDonald; and Westfore, a California limited partnership, agreed, subject to certain exceptions, to indemnify Pacific Diversified Capital Company and its subsidiaries in connection with the American Trails litigation in diminishing amounts through 1992, when the indemnification amount would decrease to zero. Wahlco, Inc. notified these parties that it has a claim for indemnification pursuant to the indemnification agreements. However, they have denied that a current claim for indemnification exists. SDG&E is unable to predict the ultimate outcome of this litigation. SUBSIDIARY SHAREHOLDER - --------------------------------------------------------------------------- On June 22, 1990 an action was instituted in the U.S. District Court for the Southern District of California against SDG&E; PDC; Wahlco Environmental Systems, Inc.; each of the persons who was a director and/or an officer at the time of WES's initial public offering (including an officer and certain directors of SDG&E); and the managing underwriters for the offering, Prudential-Bache Securities, Inc. and Salomon Brothers, Inc. This action, for which class certification has been granted, was brought by Ronald Kassover on behalf of all persons (other than defendants in the action) who purchased WES's common stock during the class period of April 25, 1990 to June 15, 1990. The complaint, as amended, alleges various violations of federal and state securities laws and various state law claims based upon alleged misrepresentations made in WES's registration statement and prospectus prepared in connection with the offering, WES's Report on Form 10-Q for the first quarter of 1990, press releases, and other public documents and statements. The alleged misrepresentations relate to WES's earnings, customer orders, financial condition and future prospects. The amended complaint further purports that, based upon these alleged misrepresentations and omissions, the price of WES's common stock was inflated during the class period and the plaintiff and the plaintiff class suffered damages as a result of purchasing WES's common stock at inflated prices. The amended complaint seeks a judgment for damages incurred by the plaintiff class during the class period, for costs and attorneys' fees, for punitive damages, and for injunctive relief against the disposition of defendants' assets. On November 5, 1990 a second complaint was filed by Ralph Amanna. The amended Amanna complaint makes allegations similar to those made in the Kassover complaint and has been consolidated with the Kassover action. On November 9, 1992 the court granted the defendants' motion for partial summary judgment, resolving the majority of the material allegations in favor of the defendants. The remaining allegations concern alleged wrong-doing associated with an attempted debenture offering after the initial public offering. The plaintiffs have filed a motion for reconsideration of the partial summary judgment. The underwriters have filed a motion to dismiss all claims against them, and the other defendants have joined in this motion. Hearings on these motions were taken off the court's calendar pending the conclusion of settlement negotiations. In November 1993 a settlement in principle was reached whereby the entire action would be resolved. The settlement requires the defendants to pay a total of approximately $1 million to the plaintiffs in exchange for a dismissal of the action in its entirety. The settlement will bind all of the plaintiff class members who elect to participate in the settlement. It is anticipated that the court will approve the settlement, and the action will be dismissed. PUBLIC SERVICE COMPANY OF NEW MEXICO - ----------------------------------------------------------------------------- On October 27, 1993 SDG&E filed a complaint with the FERC against Public Service Company of New Mexico, alleging that charges under a 1985 power purchase agreement are unjust, unreasonable and discriminatory. SDG&E requested that the FERC investigate the rates charged under the agreement and establish a refund date effective December 26, 1993. The relief, if granted, would reduce annual demand charges paid by SDG&E to PNM by up to $11 million per year through April 2001. If approved, the proceeds principally would be used to reduce customer bills. On December 8, 1993 PNM answered the complaint and moved that it be dismissed. PNM denied that the rates are unjust, unreasonable or discriminatory and asserted that SDG&E's claims were barred by certain orders issued by the FERC in 1988. SDG&E expects a decision from the FERC in 1994. SDG&E is unable to predict the ultimate outcome of this litigation. CANADIAN NATURAL GAS - ----------------------------------------------------------------------------- During early 1991 SDG&E signed four long-term natural gas supply contracts with Husky Oil Ltd., Canadian Hunter Ltd. and Noranda Inc., Bow Valley Energy Inc., and Summit Resources Ltd. Canadian-sourced natural gas began flowing to SDG&E under these contracts on November 1, 1993. Disputes have arisen with each of these producers with respect to events which are alleged by the producers to have occurred justifying a revision to the pricing terms of each contract, and possibly their termination. Consequently, during December 1993 SDG&E filed complaints in the United States Federal District Court, Southern District of California, seeking a declaration of SDG&E's contract rights. Specifically, SDG&E states that, neither price revision nor contract termination is warranted. SDG&E is unable to predict the ultimate outcome of this litigation. Additional information concerning these contracts is provided under "Natural Gas Operations" herein and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders and in Note 9 of the "Notes to Consolidated Financial Statements" beginning on Page 32 of the 1993 Annual Report to Shareholders. ELECTRIC AND MAGNETIC FIELDS - ----------------------------------------------------------------------------- MCCARTIN On November 13, 1992 a group of 25 individual plaintiffs filed a complaint against SDG&E in the Orange County Superior Court for medical monitoring, intentional infliction of emotional distress, negligent infliction of emotional distress, strict products liability, negligent product liability, trespass, nuisance, diminution in property value, inverse condemnation and injunctive relief, alleging that plaintiffs have been damaged by EMF radiation from SDG&E's power lines. The plaintiffs have not specified damages. On March 31, 1993 the trial court denied SDG&E's request to set aside all but two of the plaintiffs' claims. On May 25, 1993 the California Court of Appeals denied SDG&E's appeal of the trial court's denial of SDG&E's request to set aside. A subsequent petition for review filed with the California Supreme Court was also denied. On May 27, 1993 SDG&E filed its answer to the complaint and discovery commenced. On December 16, 1993 Martin and Joyce Covalt filed a complaint against SDG&E in Orange County Superior Court for claims identical to those of the original McCartin plaintiffs. The attorneys for the Covalts have indicated that they will attempt to consolidate their complaint with the McCartin complaint. SDG&E believes that the allegations made in both complaints are without merit and intends to defend the lawsuit vigorously. The trial is scheduled to begin on April 11, 1994. SDG&E is unable to predict the ultimate outcome of this litigation. NORTH CITY WEST On June 14, 1993 the Peninsula at Del Mar Highlands Homeowners Association filed a complaint with the Superior Court of San Diego County against the City of San Diego and SDG&E to prevent SDG&E from continuing construction of an electric substation in an area which is known as North City West. In the complaint, plaintiffs sought to have the city either revoke previously issued permits or reopen the hearing process to address alleged EMF concerns. On July 6, 1993 the court denied the plaintiffs' motion for a temporary restraining order. On July 30, 1993 the court denied the plaintiffs' motion for a preliminary injunction. On September 28, 1993 the plaintiffs withdrew their complaint and the court dismissed it without prejudice. On August 18, 1993 the plaintiffs filed a complaint with the CPUC requesting that construction of the substation be immediately halted until the CPUC conducts an initial environmental assessment and determines whether an environmental impact report is necessary. On September 22, 1993 SDG&E moved to dismiss the complaint on the grounds that the city's environmental review of the project in 1989 was proper and that the city, not the CPUC, has the authority, under the California Environmental Quality Act, to review the potential environmental impacts of substations. On January 7, 1994 the CPUC dismissed the plaintiffs' complaint, ruling that the city had performed all appropriate environmental reviews. One of the plaintiffs has filed an application with the CPUC asking it to reconsider its January 7 decision. SDG&E is unable to predict the ultimate outcome of this litigation. BLACKBURN VS. WATT Beginning on April 4, 1991 approximately 30 homeowners in the "Mar Lado Highlands" real estate development filed a series of complaints in San Diego Superior Court against the developer of the subdivision, TBSD Development, and certain of its affiliates. The complaints allege, among other things, that the defendants made fraudulent and negligent misrepresentations to the plaintiffs in the course of the sale of the plaintiffs' homes. One of the allegations involves the defendants' failure to adequately disclose the siting of a SDG&E electric transmission line near a gasoline pipeline, which the plaintiffs allege creates a significant risk of accident. Furthermore, the plaintiffs allege that the defendants failed to disclose the health risks associated with living in proximity to such power lines. The plaintiffs are seeking rescission, restitution, certain specified and unspecified compensatory damages, punitive damages, and attorneys' fees. Beginning on June 23, 1993 the defendants filed a series of cross-complaints against several other parties, including SDG&E, for indemnity, breach of warranty, breach of contract, negligence, contribution, declaratory relief and other remedies. The cross-complaints pertaining to SDG&E essentially allege that the defendants had no duty to independently investigate the risks associated with the power lines and that they merely passed along information regarding such risks provided by SDG&E. Therefore, the defendants allege that any liability arising from disclosures or nondisclosures relative to the power lines are the sole responsibility of SDG&E. SDG&E has filed answers to all of the cross-complaints. SDG&E believes the cross-complaints are without merit and intends to defend these lawsuits vigorously. SDG&E is unable to predict the ultimate outcome of this litigation. GRAYBILL/ METROPOLITAN TRANSIT DEVELOPMENT BOARD - ----------------------------------------------------------------------------- GRAYBILL On February 14, 1992 Graybill Terminal Company and others who own an oil storage tank farm in San Diego filed a complaint against Union Oil Company of California and others in the U.S. District Court for the Southern District of California. The complaint alleges that the land on which the tank farm is situated is contaminated with petroleum products and other chemicals. On July 21, 1992 three of the defendants, Olson Development Company, 550 El Camino Company and Carl Olson, filed a complaint in the same court against SDG&E and others, alleging, among other things, violation of the Comprehensive Environmental Response Compensation and Liability Act, California Superfund, and other environmental laws. Olson Development and 550 El Camino are previous owners of the allegedly contaminated property. This complaint alleges that SDG&E leased certain tanks, property and pipelines on or adjacent to the allegedly contaminated property and that contamination of soil, ground water, sewer systems and the San Diego Bay occurred during the course of SDG&E's leasing of the tanks, property and pipelines. The plaintiffs are seeking unspecified compensatory damages, indemnity or contribution, and certain declaratory and equitable relief. On August 10, 1992 SDG&E filed a counterclaim to the third-party complaint. On August 17, 1992 SDG&E also filed a third-party complaint against Union Oil Company. The court has dismissed all negligence causes of action against SDG&E, but all other causes of action remain. Trial has been set for April 1994. SDG&E is unable to predict the ultimate outcome of this litigation. METROPOLITAN TRANSIT DEVELOPMENT BOARD On October 13, 1993 MTDB filed a complaint in the San Diego County Superior Court against certain of the defendants in the Graybill litigation, including SDG&E. MTDB owns property located adjacent to the Graybill site and has alleged that contamination from the Graybill site migrated beneath its property, contaminating the soil and ground water. (MTDB had attempted to intervene in the Graybill litigation, but the judge denied its motion.) MTDB has alleged that SDG&E stored petroleum products at the Graybill site and was also responsible for certain renovations to the site's fixtures and equipment which stored and/or transported hazardous substances. MTDB has also stated that SDG&E, at one time, owned and operated the MTDB property and also owned certain fuel oil pipelines located on the property. MTDB's complaint alleges, among other things, nuisance, trespass and negligence, and seeks unspecified compensatory and special damages, indemnity, and certain equitable and declaratory relief. On November 24, 1993 SDG&E filed an answer to the complaint denying all of MTDB's allegations. SDG&E is unable to predict the ultimate outcome of this litigation. TRANSPHASE SYSTEMS LITIGATION - --------------------------------------------------------------------------- On May 3, 1993 Transphase Systems, Inc. filed a complaint against Southern California Edison Company and SDG&E in the United States District Court for the Central District of California. The complaint alleged that Edison and SDG&E unlawfully constrained Transphase from selling its thermal energy storage systems under utility-sponsored demand-side management programs in violation of federal and state antitrust and unfair competition laws. The plaintiff claimed not less than $50 million in actual damages, attorneys' fees, prejudgment interest and costs. The plaintiff also sought certain injunctive relief. On August 25, 1993 Transphase filed a motion for a preliminary injunction to order SDG&E to cease competitive bidding activities for all generation resources until demand-side-resource providers were permitted to participate. On October 7, 1993 the court dismissed all of Transphase's causes of action with prejudice. On October 19, 1993 Transphase filed a notice of appeal of the court's dismissal. The appeal is scheduled to be heard by the Ninth Circuit Court of Appeals in May 1994. SDG&E is unable to predict the ultimate outcome of this litigation. Additional information concerning competitive bidding is described under "Resources Planning" herein and in the "Management's Discussion & Analysis of Financial Condition and Results of Operations" beginning on Page 18 of the 1993 Annual Report to Shareholders. TANG LITIGATION - ----------------------------------------------------------------------------- On August 10, 1993 R.C. Tang filed a complaint in the Los Angeles County Superior Court against Southern California Edison Company, SDG&E, and SONGS contractors Westinghouse, Bechtel and Combustion Engineering, for negligence, strict products liability, express and implied warranty, statutory liability, negligent and fraudulent misrepresentation, fraudulent concealment, and negligent infliction of emotional distress, alleging that the plaintiff was damaged by the emission of radiation while serving as an on-site Nuclear Regulatory Commission inspector at SONGS from June 1985 through December 1986. The plaintiff has asked for general compensatory damages and punitive damages. The defendants removed the case to the United States District Court for the Southern District of California in San Diego on September 2, 1993 and filed an answer on September 14, 1993. On December 13, 1993 the court denied the defendants' motion for summary judgment based on the defendants' compliance with applicable permissive-dose limits of radiation. On February 7, 1994 the judge declared a mistrial after the jury deadlocked with a vote of seven to two in favor of R.C. Tang. A new trial date for the case has been set for March 15, 1994. The defendants believe that the allegations made in this complaint are without merit and intend to defend this lawsuit vigorously. SDG&E is unable to predict the ultimate outcome of this litigation. ENVIRONMENTAL ISSUES - --------------------------------------------------------------------------- Other legal matters related to environmental issues are described under "Environmental, Health and Safety" herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - --------------------------------------------------------------------------- None. ITEM 4. EXECUTIVE OFFICERS OF THE REGISTRANT - --------------------------------------------------------------------------- NAME AGE POSITIONS (1989 - CURRENT) - --------------------------------------------------------------------------- Thomas A. Page 60 Chairman and Chief Executive Officer since January 1983 and President from 1983 through 1991 and since January 1994. - --------------------------------------------------------------------------- Jack E. Thomas 61 President and Chief Operating Officer from January 1992 until his retirement in January 1994. Executive Vice President and Chief Operating Officer from 1986 through 1991. - --------------------------------------------------------------------------- Stephen L. Baum 53 Executive Vice President since January 1993. Senior Vice President - Law and Corporate Affairs and General Counsel from January 1992 through December 1992. Senior Vice President and General Counsel from 1987 through 1991. - ---------------------------------------------------------------------------- Donald E. Felsinger 46 Executive Vice President since January 1993. Senior Vice President - Marketing and Resource Development from January 1992 through December 1992. Vice President - Marketing and Resource Development from February 1989 through 1991. Vice President - Marketing from 1986 through January 1989. - --------------------------------------------------------------------------- Gary D. Cotton 53 Senior Vice President - Customer Operations since January 1993. Senior Vice President - Customer Services from January 1992 through December 1992. Senior Vice President - Engineering and Operations from 1986 through 1991. - ----------------------------------------------------------------------------- Edwin A. Guiles 44 Senior Vice President - Energy Supply since January 1993. Vice President - Engineering and Operations from January 1992 through December 1992. Vice President - Corporate Planning from 1990 through 1991. Director - Merger Transition from January through December 1989. - --------------------------------------------------------------------------- R. Lee Haney 54 Senior Vice President - Customer and Marketing Services since January 1993. Senior Vice President - Finance and Chief Financial Officer from 1990 through 1992. Vice President - Finance, Chief Financial Officer and Treasurer from 1988 through 1989. - --------------------------------------------------------------------------- Nad A. Peterson 67 Senior Vice President and General Counsel since June 1993 and Corporate Secretary since January 1994. - --------------------------------------------------------------------------- Frank H. Ault 49 Vice President and Controller since January 1993. Controller from May 1986 through December 1992. - --------------------------------------------------------------------------- Ronald K. Fuller 56 Vice President - Governmental and Regulatory Services since April 1984. - --------------------------------------------------------------------------- Margot A. Kyd 40 Vice President - Human Resources since January 1993. Vice President - Administrative Services from 1988 through 1992. - --------------------------------------------------------------------------- Malyn K. Malquist 41 Vice President - Finance and Treasurer since January 1993. Treasurer from 1990 through 1992. Assistant Treasurer and Director - Finance from 1988 through 1989. - ---------------------------------------------------------------------------- Delroy M. Richardson 55 Secretary from December 1986 until his retirement in January 1994. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS SDG&E's common stock is traded on the New York and Pacific stock exchanges. At December 31, 1993, there were 70,389 holders of SDG&E common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - ----------------------------------------------------------------------------- The information required by Item 6 is incorporated by reference from the Ten-Year Summary beginning on Page 16 of SDG&E's 1993 Annual Report to Shareholders. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ----------------------------------------------------------------------------- The information required by Item 7 is incorporated by reference from page 18 of SDG&E's 1993 Annual Report to Shareholders. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ----------------------------------------------------------------------------- The information required by Item 8 is incorporated by reference from Pages 24 through 39 of SDG&E's 1993 Annual Report to Shareholders. See Item 14 of this Form 10-K for a listing of financial statements included in the 1993 Annual Report to Shareholders. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------------------------------------------------------------------------- None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------------------- The information required on Identification of Directors is incorporated by reference from "Election of Directors" in SDG&E's March 1994 Proxy Statement. The information required on executive officers is incorporated by reference from Item 4. Item 11. Item 11. Executive Compensation The information required by Item 11 is incorporated by reference from "Executive Compensation and Transactions with Management and Others" in SDG&E's March 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by Item 12 is incorporated by reference from "Security Ownership of Management and Certain Beneficial Holders" in SDG&E's March 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions None. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial statements Page in Annual Report* Responsibility Report for the Consolidated Financial Statements 24 Statements of Consolidated Income for the years ended December 31, 1993, 1992 and 1991. 25 Consolidated Balance Sheets at December 31, 1993 and 1992. 26 Statements of Consolidated Cash Flows for the years ended December 31, 1993, 1992 and 1991 27 Statements of Consolidated Changes in Capital Stock and Retained Earnings for the years ended December 31, 1993, 1992 and 1991. 28 Statements of Consolidated Capital Stock at December 31, 1993 and 1992. 29 Statements of Consolidated Long-Term Debt at December 31, 1993 and 1992. 30 Statements of Consolidated Financial Information by Segments of Business for the years ended December 31, 1993, 1992 and 1991 31 Notes to Consolidated Financial Statements 32 Independent Auditors' Report 38 Quarterly Financial Data (Unaudited). 39 *Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. 2. Financial statement schedules The following schedules for the years ended December 31, 1993, 1992 and 1991 and the related independent auditors' report will be filed as an amendment to this report: Schedule II Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Schedules V and VI Property, Plant and Equipment; and Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule VIII Valuation and Qualifying Accounts Schedule IX Short-Term Borrowings Schedule X Supplementary Income Statement Information All other schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the consolidated financial statements and the notes to consolidated financial statements included herein. 3. Exhibits The Forms 8, 8-K, 10-K and 10-Q referred to herein were filed under Commission File Number 1-3779. Exhibit 3 -- Bylaws and Articles of Incorporation - - Bylaws 3.1 Restated Bylaws - December 20, 1993 - - Articles of Incorporation 3.2 Restated Articles of Incorporation - December 2, 1992 (Incorporated by reference from SDG&E's 1992 Form 10-K, Ex 3.2) 3.3 Certificate of Determination of Preferences of Preference Stock (cumulative), $1.82 series, without par value, of San Diego Gas & Electric Company. 3.4 Certificate of Determination of Preferences of Preference Stock (cumulative), $1.70 series, without par value, of San Diego Gas & Electric Company. Exhibit 4 -- Instruments Defining the Rights of Security Holders, Including Indentures 4.1 Mortgage and Deed of Trust dated July 1, 1940. (Incorporated by reference from Registration No. 2-49810, Ex. 2A.) 4.2 Second Supplemental Indenture dated as of March 1, 1948. (Incorporated by reference from Registration No. 2-49810, Ex. 2C.) 4.3 Ninth Supplemental Indenture dated as of August 1, 1968. (Incorporated by reference from Registration No. 2-68420, Ex. 2D.) 4.4 Tenth Supplemental Indenture dated as of December 1, 1968. (Incorporated by reference from Registration No. 2-36042, Ex. 2K.) 4.5 Sixteenth Supplemental Indenture dated August 28, 1975. (Incorporated by reference from Registration No. 2-68420, Ex. 2E.) 4.6 Thirtieth Supplemental Indenture dated September 28, 1983. (Incorporated by reference from Registration No. 33-34017, Ex. 4.3.) Exhibit 10 -- Material Contracts 10.1 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #3 (1994 compensation). 10.2 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #1 (1994 compensation, 1995 incentive). 10.3 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Nonemployee Directors (1994 compensation). 10.4 Form of San Diego Gas & Electric Company 1986 Long-Term Incentive Plan 1993 restricted stock award agreement. 10.5 Supplemental Executive Retirement Plan adopted on July 15, 1981 and amended on April 24, 1985, October 20, 1986, April 28, 1987, October 24, 1988, November 21, 1988, October 28, 1991, May 28, 1992, May 24, 1993 and November 22, 1993. 10.6 Amended 1986 Long-Term Incentive Plan, Restatement as of October 25, 1993. 10.7 Loan agreement with CIBC Inc. dated as of December 1, 1993. 10.8 Amendment to San Diego Gas & Electric Company and Southern California Gas Company Restated Long-Term Wholesale Natural Gas Service Contract (see Exhibit 10.53) dated March 26, 1993. THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S JUNE 30, 1993 FORM 10-Q AS REFERENCED BELOW. 10.9 Loan agreement with the California Pollution Control Financing Authority in connection with the issuance of $80 million of Pollution Control Bonds dated as of June 1, 1993 (Exhibit 10.1). 10.10 Loan agreement with the City of San Diego in connection with the issuance of $92.7 million of Industrial Development Bonds 1993 Series C dated as of July 1, 1993 (Exhibit 10.2). THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S MARCH 31, 1993 FORM 10-Q AS REFERENCED BELOW. 10.11 Loan agreement with Mellon Bank, N.A dated as of April 15, 1993 (Exhibit 10.1). 10.12 Loan agreement with First Interstate Bank dated as of April 15, 1993 (Exhibit 10.2). 10.13 Loan agreement with the City of San Diego in connection with the issuance of Industrial Development Bonds 1993 Series A dated as of April 1, 1993 (Exhibit 10.3). 10.14 Loan agreement with the City of San Diego in connection with the issuance of Industrial Development Bonds 1993 Series B dated as of April 1, 1993 (Exhibit 10.4). THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S 1992 FORM 10-K AS REFERENCED BELOW. 10.15 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #3 (1993 compensation) (Exhibit 10.1). 10.16 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #1 (1993 compensation, 1994 incentive) (Exhibit 10.2). 10.17 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Nonemployee Directors (1993 compensation) (Exhibit 10.3). 10.18 Form of San Diego Gas & Electric Company 1986 Long-Term Incentive Plan 1992 restricted stock award agreement (Exhibit 10.4). 10.19 Loan agreement with the City of Chula Vista in connection with the issuance of $250 million of Industrial Development Revenue Bonds, dated as of December 1, 1992 (Exhibit 10.5). 10.20 Loan agreement with the City of San Diego in connection with the issuance of $25 million of Industrial Development Revenue Bonds, dated as of September 1, 1987 (Exhibit 10.6). 10.21 Nuclear Facilities Qualified CPUC Decommissioning Master Trust Agreement for San Onofre Nuclear Generating Station, approved November 25, 1987 (Exhibit 10.7). 10.22 Nuclear Facilities Non-Qualified CPUC Decommissioning Master Trust Agreement for San Onofre Nuclear Generating Station, approved November 25, 1987 (Exhibit 10.8). 10.23 Amended 1986 Long-Term Incentive Plan (Exhibit 10.9). 10.24 Loan agreement between Mellon Bank, N.A. and San Diego Gas & Electric Company dated December 15, 1992, as amended (Exhibit 10.10). 10.25 Fuel Lease dated as of September 8, 1983 between SONGS Fuel Company, as Lessor and San Diego Gas & Electric Company, as Lessee, and Amendment No. 1 to Fuel Lease, dated September 14, 1984 and Amendment No. 2 to Fuel Lease, dated March 2, 1987 (Exhibit 10.11). THE FOLLOWING EXHIBIT IS INCORPORATED BY REFERENCE FROM SDG&E'S SEPTEMBER 30, 1992 FORM 10-Q AS REFERENCED BELOW. 10.26 Loan Agreement with the City of San Diego in connection with the issuance of $118.6 million of Industrial Development Revenue Bonds dated as of September 1, 1992 (Exhibit 10.1). THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S 1991 FORM 10-K AS REFERENCED BELOW. 10.27 Gas Purchase Agreement, dated March 12, 1991 between Husky Oil Operations Limited and San Diego Gas & Electric Company (Exhibit 10.1). 10.28 Gas Purchase Agreement, dated March 12, 1991 between Canadian Hunter Marketing Limited and San Diego Gas & Electric Company (Exhibit 10.2). 10.29 Gas Purchase Agreement, dated March 12, 1991 between Bow Valley Industries Limited and San Diego Gas & Electric Company (Exhibit 10.3). 10.30 Gas Purchase Agreement, dated March 12, 1991 between Summit Resources Limited and San Diego Gas & Electric Company (Exhibit 10.4). 10.31 Service Agreement Applicable to Firm Transportation Service under Rate Schedule FS-1, dated May 31, 1991 between Alberta Natural Gas Company Ltd. and San Diego Gas & Electric Company (Exhibit 10.5). 10.32 Firm Transportation Service Agreement, dated December 31, 1991 between Pacific Gas and Electric Company and San Diego Gas & Electric Company (Exhibit 10.7). 10.33 Supplemental Executive Retirement Plan adopted on July 15, 1981 and amended on April 24, 1985, October 20, 1986, April 28, 1987, October 24, 1988, November 21, 1988 and October 28, 1991 (Exhibit 10.8). 10.34 Uranium enrichment services contract between the U. S. Department of Energy and Southern California Edison Company, as agent for SDG&E and others; Contract DE-SC05-84UEO7541, dated November 5, 1984, effective June 1, 1984, as amended by modifications dated September 13, 1985, January 8, April 10, June 17 and August 8, 1986, March 26, 1987, February 20 and July 25, 1990, and October 7, 1991 (Exhibit 10.9). 10.35 Loan agreement with California Pollution Control Financing Authority, dated as of December 1, 1985, in connection with the issuance of $35 million of pollution control bonds (Exhibit 10.10). 10.36 Loan agreement with California Pollution Control Financing Authority, dated as of December 1, 1991, in connection with the issuance of $14.4 million of pollution control bonds (Exhibit 10.11). 10.37 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #3 (1992 compensation) (Exhibit 10.16). 10.38 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #1 (1992 compensation, 1993 incentive) (Exhibit 10.17). 10.39 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Nonemployee Directors (1992 compensation) (Exhibit 10.18). 10.40 Form of San Diego Gas & Electric Company Deferred Compensation Agreement for Officers #1 (1991 compensation, 1992 incentive) (Exhibit 10.20). 10.41 Loan agreement with the City of San Diego in connection with the issuance of $44.25 million of Industrial Development Revenue Bonds, dated as of July 1, 1986 (Exhibit 10.36). 10.42 Loan agreement with the City of San Diego in connection with the issuance of $81.35 million of Industrial Development Revenue Bonds, dated as of December 1, 1986 (Exhibit 10.37). 10.43 Loan agreement with the City of San Diego in connection with the issuance of $100 million of Industrial Development Revenue Bonds, dated as of September 1, 1985 (Exhibit 10.38). 10.44 Executive Incentive Plan dated April 23, 1985 (Exhibit 10.39). 10.45 Loan agreement with California Pollution Control Financing Authority dated as of December 1, 1984, in connection with the issuance of $27 million of pollution control bonds (Exhibit 10.40). 10.46 Loan agreement with California Pollution Control Financing Authority dated as of May 1, 1984, in connection with the issuance of $53 million of pollution control bonds (Exhibit 10.41). 10.47 Lease agreement dated as of July 14, 1975 with New England Mutual Life Insurance Company, as lessor (Exhibit 10.42). THE FOLLOWING EXHIBIT IS INCORPORATED BY REFERENCE FROM SDG&E'S MARCH 31, 1991 FORM 10-Q AS REFERENCED BELOW. 10.48 Firm Transportation Service Agreement, dated April 25, 1991 between Pacific Gas Transmission Company and San Diego Gas & Electric Company (Exhibit 28.2). THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S 1990 FORM 10-K AS REFERENCED BELOW. 10.49 Agreement dated March 19, 1987, for the Purchase and Sale of Uranium Concentrates between SDG&E and Saarberg-Interplan Uran GmbH (assigned to Pathfinder Mines Corporation in June 1993) (Exhibit 10.5). 10.50 Second Amended San Onofre Agreement among Southern California Edison Company, SDG&E, the City of Anaheim and the City of Riverside, dated February 26, 1987 (Exhibit 10.6). 10.51 San Diego Gas & Electric Company Retirement Plan for Directors, adopted December 17, 1990 Exhibit 10.7). 10.52 San Diego Gas & Electric Company Executive Severance Allowance Plan, as Amended and Restated, December 17, 1990 (Exhibit 10.8). 10.53 San Diego Gas & Electric Company and Southern California Gas Company Restated Long-Term Wholesale Natural Gas Service Contract, dated September 1, 1990 (Exhibit 10.9). THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S 1989 FORM 10-K AS REFERENCED BELOW. 10.54 Amendment to the San Diego Gas & Electric Company 1986 Long-Term Incentive Plan adopted January 23, 1989 (Exhibit 10B). 10.55 Loan agreement between San Diego Trust & Savings Bank and SDG&E dated January 1, 1989 as amended (Exhibit 10H). 10.56 Loan agreement between Union Bank and SDG&E dated November 1, 1988 as amended (Exhibit 10I). 10.57 Loan agreement between Bank of America National Trust & Savings Association and SDG&E dated November 1, 1988 as amended (Exhibit 10J). 10.58 Loan agreement between First Interstate Bank of California and SDG&E dated November 1, 1988 as amended (Exhibit 10K). THE FOLLOWING EXHIBITS ARE INCORPORATED BY REFERENCE FROM SDG&E'S 1988 FORM 10-K AS REFERENCED BELOW. 10.59 Severance Plan as amended August 22, 1988 (Exhibit 10A). 10.60 U. S. Navy contract for electric service, Contract N62474-70-C-1200-P00414, dated September 29, 1988 (Exhibit 10C). 10.61 Employment agreement between San Diego Gas & Electric Company and Thomas A. Page, dated June 15, 1988 (Exhibit 10E). 10.62 Public Service Company of New Mexico and San Diego Gas & Electric Company 1988-2001 100 MW System Power Agreement dated November 4, 1985 and Letter of Agreement dated April 28, 1986, June 4, 1986 and June 18, 1986 (Exhibit 10H). 10.63 San Diego Gas & Electric Company and Portland General Electric Company Long-Term Power Sale and Transmission Service agreements dated November 5, 1985 (Exhibit 10I). 10.64 Comision Federal de Electricidad and San Diego Gas & Electric Company Contract for the Purchase and Sale of Electric Capacity and Energy dated November 20, 1980 and additional Agreement to the contract dated March 22, 1985 (Exhibit 10J). 10.65 U. S. Department of Energy contract for disposal of spent nuclear fuel and/or high-level radioactive waste, entered into between the DOE and Southern California Edison Company, as agent for SDG&E and others; Contract DE-CR01-83NE44418, dated June 10, 1983 (Exhibit 10N). 10.66 Agreement with Arizona Public Service Company for Arizona transmission system participation agreement - contract 790116 (Exhibit 10P). 10.67 City of San Diego Electric Franchise (Ordinance No.10466) (Exhibit 10Q). 10.68 City of San Diego Gas Franchise (Ordinance No.10465) (Exhibit 10R). 10.69 County of San Diego Electric Franchise (Ordinance No.3207) (Exhibit 10S). 10.70 County of San Diego Gas Franchise (Ordinance No.5669) (Exhibit 10T). 10.71 Supplemental Pension Agreement with Thomas A. Page, dated as of April 3, 1978 (Exhibit 10V). 10.72 Lease agreement dated as of June 15, 1978 with Lloyds Bank California, as owner-trustee and lessor - Exhibit B to financing agreement of SDG&E's Encina Unit 5 equipment trust (Exhibit 10W). Exhibit 12 -- Statement re computation of ratios 12.1 Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. Exhibit 13 -- The financial statements and other documents listed under Part IV Item 14(a)1. and Management's Discussion and Analysis of Financial Condition and Results of Operations listed under Part II Item 7 of this form 10-K are incorporated by reference from the 1993 Annual Report to Shareholders. Exhibit 22 - Subsidiaries - See "Part I, Item 1. Description of Business." Exhibit 24 - Independent Auditors' Consent, Page 37. (b) Reports on Form 8-K: A Current Report on Form 8-K was filed on December 22, 1993 to report the resignation of Douglas O. Allred from SDG&E's Board of Directors. INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference of our report dated February 25, 1994 (which report contains an explanatory paragraph referring to the Company's consideration of alternative strategies for its 80 percent-owned subsidiary, Wahlco Environmental Systems, Inc.) appearing on page 38 of the 1993 Annual Report to Shareholders of San Diego Gas & Electric Company in this Annual Report on Form 10-K for the year ended December 31, 1993. We also consent to the incorporation by reference of the above-mentioned report in San Diego Gas & Electric Company Post-Effective Amendment No. 1 to Registration Statement No. 33-46736 on Form S-3, Post-Effective Amendment No. 4 to Registration Statement No. 2-71653 on Form S-8, Registration Statement No. 33-7108 on Form S-8, Amendment No. 1 to Registration Statement No. 33-21971 on Form S-3, Registration Statement No. 33-45599 on Form S-3, Registration Statement No. 33-52834 on Form S-3 and Registration Statement No. 33-49837 on Form S-3; and SDO Parent Co., Inc. Registration Statement No. 2-98332 on Form S-4 as amended by Post-Effective Amendment No. 1 on Form S-3. Deloitte & Touche San Diego, California March 3, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. SAN DIEGO GAS & ELECTRIC COMPANY February 28, 1994 By: /s/ Thomas A. Page ----------------------------- Thomas A. Page Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. Signature Title Date - ------------------------------------------------------------------------- Principal Executive Officer: /s/ Thomas A. Page - --------------------------- Thomas A. Page Chairman, President and Chief February 28, 1994 Executive Officer and a Director Principal Financial Officer: /s/ Malyn K. Malquist - --------------------------- Malyn K. Malquist Vice President-Finance and February 28, 1994 Treasurer Principal Accounting Officer: /s/ Frank H. Ault - --------------------------- Frank H. Ault Vice President and Controller February 28, 1994 Directors: /s/ Richard C. Atkinson - --------------------------- Richard C. Atkinson Director February 28, 1994 /s/ Ann Burr - --------------------------- Ann Burr Director February 28, 1994 /s/ Richard A. Collato - --------------------------- Richard A. Collato Director February 28, 1994 /s/ Daniel W. Derbes - --------------------------- Daniel W. Derbes Director February 28, 1994 /s/ Robert H. Goldsmith - --------------------------- Robert H. Goldsmith Director February 28, 1994 /s/ Ralph R. Ocampo - ------------------------- Ralph R. Ocampo Director February 28, 1994 /s/ Catherine Fitzgerald Wiggs - -------------------------------- Catherine Fitzgerald Wiggs Director February 28, 1994

768170_1993.txt

768170_1993

1993

768170

Item 1. Business -------- GENERAL ------- Pitney Bowes Credit Corporation (the Company or PBCC) operates primarily in the United States and is a wholly-owned subsidiary of Pitney Bowes Inc. (PBI or Pitney Bowes). The Company is principally engaged in the business of providing lease financing for PBI products as well as other financial services for the commercial and industrial markets. The Internal Financing Division of PBCC provides marketing support to PBI and PBI subsidiaries, including Dictaphone Corporation (Dictaphone) and Monarch Marking Systems, Inc. (Monarch). Equipment leased or financed for these Internal Division programs include mailing, paper handling and shipping equipment, scales, copiers, facsimile units, voice processing systems and retail price marking and identification equipment. The transaction size for this equipment generally ranges from $1,000 to $500,000, although historically most transactions occur in the $5,000 to $10,000 range, with lease terms generally from 36 to 60 months. Since 1991, a significant portion of new business transactions for equipment costing approximately $1,000 were completed under a program designed for entry-level mailing customers. PBCC's External Financing Division operates in the large-ticket external market by offering financial services to its customers for products not manufactured or sold by PBI or its subsidiaries. Products financed through these External Division programs include both commercial and non-commercial aircraft, over-the-road trucks and trailers, railcars and high-technology equipment such as data processing and communications equipment. Transaction sizes (other than aircraft leases) range from $50,000 to several million dollars, with lease terms generally from 36 to 180 months. Aircraft transaction sizes range from $1 million to $27 million for non-commercial aircraft and up to $43 million for commercial aircraft. Lease terms are generally between two and 13 years for non-commercial aircraft and from 10 to 24 years for commercial aircraft. The Company has also participated in five commercial aircraft leveraged lease transactions. The Company's investment in these transactions totaled $122.2 million at December 31, 1993. The Company's External Financing Division has also participated, on a select basis, in certain other types of financial transactions including syndication of certain lease transactions which do not satisfy PBCC's investment criteria, senior secured loans in connection with acquisition, leveraged buyout and recapitalization financings, and certain project financings. PBCC's External Financing Division is also responsible for managing Pitney Bowes Real Estate Financing Corporation (PREFCO), a wholly-owned subsidiary of PBCC providing lease financing for commercial real estate properties. Both PBCC and Pitney Bowes provide capital for PREFCO's investments. Colonial Pacific Leasing Corporation (Colonial Pacific or CPLC), a wholly-owned subsidiary of PBCC, located near Portland, Oregon operates in the small-ticket external market. Colonial Pacific provides lease financing services to small- and medium-sized businesses throughout the United States, marketing exclusively through a nationwide network of brokers and independent lessors. Transaction sizes range from $2,000 to $250,000, with lease terms generally from 24 to 60 months. In January 1993, the Company announced a change in management responsibility for its Vendor Investment Program (VIP). VIP, which provided sales-aid and funding source financing programs for non-affiliated vendors selling equipment with a cost, generally in the range of $5,000 to $100,000, was previously managed and reported as part of the Internal small-ticket financing programs. This operation was reorganized with the funding source programs consolidated into the operations of the Company's External Financing Division and the name changed to Custom Vendor Finance (CVF); the sales-aid programs were consolidated into the operations of Colonial Pacific Leasing Corporation. This change was made to improve efficiency through the elimination of redundant processes. CPLC and CVF are reported as "External small-ticket programs" in this report. Atlantic Mortgage & Investment Corporation (AMIC), a wholly-owned subsidiary of PBCC, located in Jacksonville, Florida, specializes in servicing residential first mortgages for a fee. AMIC does not originate, or generally hold or assume the credit risk on mortgages it services. In return for a servicing fee, AMIC provides billing services and collects principal, interest and tax and insurance escrow payments for mortgage investors such as Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Government National Mortgage Association and private investors. Substantially all lease financing is done through full payout leases or security agreements whereby PBCC recovers its costs plus a return on investment over the initial, noncancelable term of the contract. The Company has also entered into a limited amount of leveraged and operating lease structures. The Company's gross finance assets (contracts receivable plus estimated residual values) outstanding for Internal and External financing programs at December 31, 1989 through 1993 are presented in Item 6, Selected Financial Data. Total Company gross finance assets at December 31, 1993 were $4.6 billion of which approximately 27 percent were related to mailing, paper handling and shipping products, 21 percent were commercial aircraft, 12 percent were railcars, eight percent were data processing equipment products and five percent were over-the-road trucks and trailers. In 1993, total gross finance contracts acquired amounted to $1.406 billion compared to $1.425 billion in 1992. External large-ticket programs accounted for 22 percent of gross finance contracts acquired in 1993 compared to 23 percent in 1992. The decrease in External large-ticket volume is consistent with the Company's strategy to control growth in large-ticket, longer-term finance assets and debt levels. As of December 31, 1993, PBCC had approximately 516,000 active accounts compared with 474,000 active accounts at December 31, 1992. At December 31, 1993, PBCC's largest customer accounted for $186.4 million, or 4.6 percent of gross finance receivables, and the Company's ten largest customers accounted for $939.7 million in gross finance receivables, or 23.0 percent of the receivable portfolio. CREDIT EXPERIENCE ----------------- At December 31, 1993, 1.9 percent of gross finance receivables were over 30 days delinquent compared with 2.2 percent at December 31, 1992 and 2.6 percent at December 31, 1991. Delinquency levels decreased in 1993, principally as a result of continued strong collection efforts and an improving economy. CREDIT POLICIES --------------- PBCC's management and Board of Directors establish credit approval limits at region, division, subsidiary and corporate levels based on the credit quality of the customer and the type of equipment financed. The Company and PBI have established an Automatic Approval Program (AAP) for certain products within the Internal Financing Division. The AAP dictates the criteria under which PBCC will accept a customer without performing the Company's usual credit investigation. The AAP considers criteria such as maximum equipment cost, a customer's time in business and current payment experience with PBCC. PBCC bases credit decisions primarily on a customer's financial strength. However, with the Company's External Financing Division programs, collateral values may also be considered. LOSS EXPERIENCE --------------- PBCC has charged against the allowance for credit losses $51.1 million, $46.5 million and $43.7 million in 1993, 1992 and 1991, respectively. The increase in write-offs in 1993 was due to $11.2 million of write-offs related to assets purchased from the Company's German affiliate, Adrema Leasing Corporation (Adrema). Excluding the losses related to assets purchased from Adrema, losses as a percentage of average net lease receivables (net investments before allowance for credit losses and deferred investment tax credits plus the uncollected principal balance of receivables sold) were 1.03 percent for 1993, 1.27 percent for 1992 and 1.29 percent for 1991. For further information see Note 5 and Note 7 to the Company's consolidated financial statements. RELATIONSHIP WITH PITNEY BOWES INC. ----------------------------------- PBCC is PBI's domestic finance subsidiary and the largest part of PBI's Financial Services segment. Approximately 13 percent of PBI's consolidated revenue in 1993, and 11 percent in 1992 and 1991 resulted from sales made to PBCC for lease to third parties. Business relationships between PBCC and PBI are defined by several agreements including an Operating Agreement, Finance Agreement and Tax Sharing Agreement. Operating Agreement: The Operating Agreement with PBI, dated March 3, 1977, as amended (the Operating Agreement), which can be modified or cancelled on a prospective basis by either party upon 90 days prior written notice, governs among other things: the terms and prices of equipment purchases by PBCC for lease to third parties; computation and payment of fees for referrals and services provided by PBI sales personnel; the AAP for PBI equipment; buyback allowances; and the handling of contract terminations, cancellations, trade-ups and trade-ins. In connection with the sales of finance assets of the Internal small-ticket financing programs referred to in Note 3 to the Company's consolidated financial statements, PBI agreed not to cancel or modify, in any material respect, its obligations under the Operating Agreement concerning the sold receivables, without the prior written consent of PBCC and the transferee. Pursuant to the Operating Agreement, the purchase of equipment by the Company is contingent upon a lessee entering into a full payout lease with the Company and delivery to and acceptance of the equipment by the lessee. Service and maintenance of the equipment leased is the responsibility of the lessee and is generally arranged through a separate equipment maintenance agreement between the lessee and PBI. In connection with the buyback provisions of the Operating Agreement, PBCC has the option to request a buyback from PBI for non-copier equipment leased which is terminated or cancelled, provided the equipment is available for repossession. Following such buyback, PBI is responsible for the repossession and disposition of equipment. The buyback provision sets forth a stipulated amount that is payable by PBI to PBCC for certain terminated leases; such amount is calculated on the basis of a declining percentage, based upon the passage of time, of the original total invoice value to PBCC. The difference between the buyback amount received from PBI and the remaining value of the lease usually results in a loss that is charged against PBCC's allowance for credit losses. PBCC has similar operating agreements with Pitney Bowes subsidiaries, Dictaphone and Monarch, for the financing of certain products. In September 1990, Pitney Bowes Inc. changed its copier marketing strategy and announced plans to discontinue the remanufacture of used copier equipment. The copier organization now concentrates on new, higher-margin equipment consistent with its marketing strategy directed at serving larger corporations and multi-unit installations. In connection with this change in strategy, buyback provisions for copier equipment leased after December 31, 1990 were eliminated. In addition, for copier equipment leases, PBCC eliminated the Automatic Approval Program and performs the Company's standard credit review investigation. Finance Agreement: Under the Finance Agreement, dated July 5, 1978, PBI has agreed to make payments to PBCC, if necessary, to enable PBCC to maintain a ratio of income available for fixed charges as defined to such fixed charges of 1.25 to 1 as of the end of each fiscal year. No such payments have ever been required. The Finance Agreement, or any term, covenant, agreement or condition thereof, may be amended or compliance may be waived (either generally or in a particular instance and either retroactively or prospectively) by either PBI or PBCC, with the written consent of the other party, at any time. The agreement may be terminated (i) by PBCC on five days notice or (ii) by PBI prior to the end of any fiscal year of PBCC and following the making of the determination and payment, if any, required pursuant to the provisions of the Finance Agreement, as described in the preceding paragraph, with respect to the fiscal year of PBCC most recently ended. In connection with certain financing agreements, PBI has agreed with PBCC's lenders that PBI will not modify or terminate the Finance Agreement unless approval is received from holders of 66 2/3 percent of the principal amount of the notes outstanding under each such note agreement. Under the Indenture dated as of May 1, 1985 (together with all Supplemental Indentures as noted in Part IV Item 14 (a) 3, the Indenture) between PBCC and Bankers Trust Company as Trustee (the Trustee), PBCC agreed that it would not waive compliance with, or amend in any material respect, the Finance Agreement without the consent of the holders of a majority in principal amount of the outstanding securities of each series of debt securities issued under the Indenture. In addition, PBI has entered into a Letter Agreement with the Trustee pursuant to which it agreed, among other things, that it would not default under the Finance Agreement nor terminate the Finance Agreement without the consent of the holders of a majority in principal amount of the outstanding securities issued under the Indenture. Tax Sharing Agreement: The Company's taxable results are included in the consolidated Federal and certain state income tax returns of Pitney Bowes. Under the Tax Sharing Agreement, dated April 1, 1977, between the Company and Pitney Bowes, the Company makes payment to Pitney Bowes for its share of consolidated income taxes, or receives cash equal to the benefit of tax losses utilized in consolidated returns in exchange for which it issues non-interest bearing subordinated notes with a maturity one day after all senior debt is repaid. PBCC is also reimbursed for investment tax credits utilized in PBI's consolidated Federal income tax return. The Tax Sharing Agreement can be cancelled by either PBI or PBCC upon twelve months written notice. Real Estate Transactions: During 1993, PBCC received $2.4 million from PBI representing a contribution to capital surplus of the Company in connection with investments in real estate financing projects. When the Company entered into real estate lease financing, PBI agreed to make capital contributions up to a maximum of $15.0 million to provide a portion of the financing for such transactions, of which $13.8 million has been received to date. There is no formal agreement in place and PBI is under no obligation to continue to make capital contributions. PITNEY BOWES INC. ----------------- PBI, a Delaware corporation organized in 1920, is listed on the New York Stock Exchange. Headquartered in Stamford, Connecticut, PBI employs approximately 32,500 people throughout the United States, Europe, Canada and other countries. PBI manufactures and markets products, and provides services in two industry segments: Business Equipment, and Business Supplies and Services; and provides financing in a third industry segment: Financial Services. Business Equipment includes: postage meters and mailing, shipping and facsimile systems, copying systems and supplies, and voice processing systems which include dictating systems, automatic telephone answering systems and voice communications recorders. In accordance with postal regulations, postage meters may not be sold in the United States; they are rented to users and therefore are not subject to lease by PBCC. Business Supplies and Services includes: equipment and supplies used to encode and track price, content, item identification and other merchandise information and mailroom, reprographics and related facilities management services. The Financial Services segment, of which PBCC is the largest individual component, provides lease financing for PBI products as well as other financial services for the commercial and industrial markets. As of December 31, 1993, PBI and its consolidated subsidiaries had total assets of $6.8 billion and stockholders' equity of $1.9 billion. For the year ended December 31, 1993, PBI's consolidated revenue and income before effect of a change in accounting for nonpension postretirement benefits were $3.5 billion and $353.2 million, respectively, compared with $3.4 billion and $314.9 million for 1992. COMPETITION AND REGULATION -------------------------- The finance business is highly competitive with aggressive rate competition. Leasing companies, commercial finance companies, commercial banks and other financial institutions compete in varying degrees in the several markets in which PBCC does business and range from very large diversified financial institutions to many small, specialized firms. In view of the market fragmentation and absence of any dominant competitors which result from such competition, it is not possible to provide a meaningful description of PBCC's competitive position in its markets. While financing rates are generally considered by customers to be the principal factor in choosing a financing source, the Company believes there are additional important factors related to a customer's decision, including simplicity of documentation, flexibility and ease of doing business over the duration of the contract. PBCC seeks to distinguish itself from its competition by providing excellent service to its customers. PBCC considers its documentation and systems to be among the best in the industry. The Company has an established communication network in its region offices to eliminate costly delays and to increase the quality of service offered to vendors and customers. PBI has historically been a leading supplier of certain products and services in its business segments, particularly postage meters and mailing equipment, price marking supplies and equipment, and voice processing systems. However, in all segments it has strong competition from a number of companies. In the United States, PBI is facing competition for new placements from several postage meter and mailing equipment vendors, and its mailing systems products face competition from products and services offered as alternative means of message communications. PBI's long experience and reputation for product quality, and its sales and support service organizations, along with PBCC, are believed to be important factors in influencing customer choices with respect to its products and services. Several states have ceilings on interest rates which may be charged to commercial customers on secured lending transactions. These limitations have been mitigated by a provision in 1980 Federal legislation permitting business financing in such states at a rate five percent higher than the Federal Reserve Bank's discount rate plus any surcharge assessed. The legislation permits each state to preempt this provision; however, as of December 31, 1993, no state in which PBCC has or expects to have a material amount of business has exercised its right of preemption. Nevertheless, as a result of state preemption, PBCC may, in the future, be required to charge lower interest rates in certain jurisdictions than it charges elsewhere, or to cease offering secured lending transactions in such states. PBCC does not extend consumer credit as defined in the Federal Consumer Credit Protection Act. Accordingly, PBCC's financing transactions are not subject to that Act. FUNDING POLICY -------------- PBCC's borrowing strategy is to use a balanced mix of debt maturities, variable- and fixed-rate debt and interest rate swap agreements to control its sensitivity to interest rate volatility. The Company may borrow through the sale of commercial paper, under its confirmed bank lines of credit and by private and public offerings of intermediate- or long-term debt securities. The Company may also issue debt securities having maturities ranging from nine months to 30 years through a medium-term note program. While the Company's funding strategy of balancing short-term and longer-term borrowings and variable- and fixed-rate debt may reduce sensitivity to interest rate changes over the long-term, effective interest costs have been and will continue to be impacted by interest rate changes. The Company periodically adjusts prices on its new leasing and financing transactions to reflect changes in interest rates; however, the impact of these rate changes on revenue is usually less immediate than the impact on borrowing costs. EMPLOYEE RELATIONS ------------------ At December 31, 1993, 749 people were employed by PBCC and its subsidiaries. Employee relations are considered highly satisfactory.- Item 2. Item 2. Properties ---------- All of the Company's office space is occupied under operating leases with original terms ranging from one to ten years. PBCC's executive and administrative offices are located in Norwalk, Connecticut. PBCC has seven regional offices located throughout the United States and five district sales offices located in or near major metropolitan areas. Colonial Pacific's executive and administrative offices are located in Tualatin, Oregon. Atlantic Mortgage & Investment Corporation's executive and administrative offices are located in Jacksonville, Florida. Item 3. Item 3. Legal proceedings ----------------- The Company is not currently involved in any material litigation. Item 4. Item 4. Submission of matters to a vote of security holders --------------------------------------------------- Omitted pursuant to General Instruction J. Part II Item 5. Item 5. Market for the registrant's common equity and related stockholder matters ----------------------------------------------------- All of the Company's common stock is owned by PBI. Accordingly, there is no public trading market for the Company's common stock. The Board of Directors declared and the Company paid dividends to PBI of $36.0 million in 1993, $31.0 million in 1992, and $27.0 million in 1991. The Company intends to continue to pay dividends to PBI in 1994. Item 6. Item 6. Selected financial data ----------------------- Item 7. Item 7. Management's discussion and analysis of financial condition and results of operations ----------------------------------------------------------------- Overview - -------- During 1993, PBCC achieved earnings growth for the sixteenth consecutive year despite the impact of $12.3 million of additional tax expense, a result of the enactment of the Omnibus Budget Reconciliation Act of 1993 (the Tax Act), which increased U.S. corporate income tax rates from 34 percent to 35 percent. Compared with 1992, the major factors that affected PBCC's operations in 1993 were lower short-term interest rates and higher levels of earning assets. Gross finance contracts acquired in 1993 amounted to $1.406 billion, down 1.4 percent from $1.425 billion in 1992. The decrease is due to lower investment levels generated in the External large-ticket financing programs, which represented 22 percent of gross finance contracts acquired in 1993 compared with 23 percent in 1992. This is consistent with PBCC's strategy to control growth in large-ticket, longer-term finance assets and debt levels. Accounting Changes - ------------------ In the fourth quarter of 1992, the Company adopted retroactively to January 1, 1992, Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106), which addresses health care and other welfare benefits provided to retirees. FAS 106 required a change from the cash basis of accounting to the accrual basis of accounting for nonpension postretirement benefits. The transition effect of adopting this standard on the immediate recognition basis, which was recorded in the first quarter of 1992, was a one-time, after-tax charge of $1.9 million; the 1992 incremental after-tax cost amounted to $.4 million. In early 1993, Pitney Bowes announced several changes to its health care plans which are expected to significantly reduce the ongoing incremental impact of FAS 106 on future earnings. Among these changes was the establishment of plan cost maximums in order to more effectively control future health care costs. Additional information with respect to accounting for nonpension postretirement benefits is disclosed in Note 14 to the Company's consolidated financial statements. The Company also adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", in 1992, which did not significantly affect the Company's reported results. In November 1992, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112), was issued addressing benefits provided by an employer to former or inactive employees after employment but before retirement. FAS 112 requires that postemployment benefit costs be recognized on the accrual basis of accounting effective for fiscal years beginning after December 15, 1993. Postemployment benefits include the continuation of salary, health care, life insurance and disability-related benefits to former or inactive employees, their beneficiaries and covered dependents. The Company will adopt FAS 112 during the first quarter of 1994, as required. Upon adoption, Pitney Bowes anticipates recognizing a one-time, non-cash after-tax charge of approximately $60 to $120 million for the cumulative effect on prior years of such adoption, some of which may be allocated back to the Company. In May 1993, Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan", which must be adopted by January 1, 1995, and Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", which must be adopted by January 1, 1994, were issued. These pronouncements are not expected to materially affect the Company. Results of Operations - --------------------- The Company's finance income increased 3.8 percent to $513.5 million in 1993 compared with $494.5 million in 1992, which was up 7.3 percent from 1991. Finance income for Internal small-ticket financing programs increased 5.6 percent to $262.0 million in 1993 compared with $248.1 million in 1992, which was up 16.5 percent from 1991. The increase in 1993 is primarily due to higher levels of earning assets and a greater impact from the sale of Internal small-ticket finance assets in 1993 as compared to asset sales in 1992, partly offset by lower lease rates on new business. Finance income for External large-ticket financing programs decreased 6.3 percent to $148.2 million in 1993 compared with $158.3 million in 1992, which was up 1.9 percent from 1991. The decrease in 1993 compared with 1992 is consistent with the Company's strategy to control growth in large-ticket, longer-term finance assets. The decrease was also the result of lower lease rates on new business in 1993. Finance income for External small-ticket financing programs increased 5.2 percent to $86.6 million in 1993 compared with $82.4 million in 1992, which was down 10.8 percent from 1991. The increase in 1993 is due to higher levels of earning assets, while the decrease in 1992 was primarily due to a greater impact from the sale of External small-ticket finance assets in 1991 as compared to asset sales in 1992. Revenue generated from mortgage servicing was $16.7 million in 1993 compared to $5.7 million in 1992. The increase is due to the acquisition of Atlantic Mortgage & Investment Corporation (AMIC), a mortgage servicing company, on July 1, 1992 and to a lesser extent, a larger mortgage servicing portfolio in 1993. Selling, general and administrative (SG&A) expenses increased 10.3 percent to $99.3 million in 1993 compared with $90.1 million in 1992, which was up 8.6 percent from 1991. SG&A expenses for Internal small-ticket financing programs decreased 3.0 percent to $52.9 million in 1993 compared to $54.5 million in 1992, an increase of 20.4 percent from 1991. The decrease in 1993 is primarily due to lower marketing fees paid to Pitney Bowes and cost savings related to organizational changes made to the Company's Vendor Investment Program in January 1993. VIP, which provided sales-aid and funding source financing programs for non-affiliated vendors, was previously managed and reported as part of the Internal small-ticket financing programs. This operation was reorganized with funding source programs consolidated into the operations of the Company's External Financing Division and the sales-aid programs consolidated into the operations of Colonial Pacific Leasing Corporation. This change was made to improve efficiency through the elimination of redundant processes. The increase in 1992 was primarily due to higher marketing fees paid to Pitney Bowes and higher personnel related costs. SG&A expenses for External large-ticket financing programs decreased 3.7 percent to $12.8 million in 1993 compared with $13.3 million in 1992, which were up .9 percent from 1991. The decrease in 1993 is due to lower personnel related costs. SG&A expenses for External small-ticket financing programs increased 32.8 percent to $25.7 million in 1993 compared with $19.4 million in 1992, which were down 21.1 percent from 1991. The increase in 1993 is primarily due to higher marketing fees paid to brokers and higher amortization of deferred initial direct costs together with costs incurred in connection with the assets transferred from the Company's German affiliate, which is further discussed in the following paragraphs. The decrease in 1992 was primarily due to a greater impact from the sale of External small-ticket finance assets in 1991. SG&A expenses related to mortgage servicing were $7.9 million in 1993 compared to $2.9 million in 1992. The increase in SG&A expenses related to mortgage servicing are primarily due to the acquisition of AMIC on July 1, 1992 and a larger mortgage servicing portfolio in 1993. The Company entered the operating lease business on a limited basis in 1990. Depreciation on operating leases was $8.8 million in 1993 and $12.1 million in 1992 reflecting a lower average operating lease investment balance during 1993. Amortization of purchased mortgage servicing rights was $7.7 million in 1993 compared to $1.9 million in 1992. This increase is principally due to the acquisition of AMIC on July 1, 1992 and a larger mortgage servicing portfolio in 1993. The provision for credit losses for 1993 increased 20.7 percent to $70.2 million compared to $58.2 million for 1992, which was up 18.9 percent from 1991. The provision for credit losses for the Internal small-ticket financing programs decreased 5.3 percent to $30.7 million in 1993 compared with $32.5 million in 1992. The decrease is due to a greater impact from the sale of Internal small-ticket finance assets in 1992. The provision for credit losses for the External large-ticket financing programs was $4.5 million in 1993 compared with $4.6 million in 1992. The provision for credit losses for the External small-ticket financing programs was $35.0 million in 1993 compared with $21.1 million in 1992. The increase in 1993 is due to provisions recorded in connection with assets purchased from the Company's German affiliate, which is further discussed in the following paragraphs. In December 1992, as part of the restructuring and reincorporation of its German affiliate, Adrema Leasing Corporation (Adrema), the Company purchased certain finance receivables and other assets from Adrema. In connection with these assets, Pitney Bowes and the Company are continuing an inquiry and evaluation of the conduct by former management personnel of the German leasing business. The results of this inquiry to date indicate that former management caused the German leasing operation to enter into transactions which were not consistent with Company policy and guidelines and, in certain cases, lacked appropriate documentation and collateral. Additionally, in certain instances, Pitney Bowes and the Company are continuing to locate, repossess and remarket collateral where possible. These circumstances, together with deteriorating economic conditions in Germany, caused management, in the second quarter of 1993, to conclude that losses would be larger than previously anticipated. Accordingly, at that time, the Company recorded additional loss provisions of $14.4 million, the effect of which was substantially offset by a gain on the sale of finance assets. At the current time, the Company believes that with the additional loss provisions taken in the second quarter of 1993, sufficient reserves for expected losses are in place. As the inquiry continues, the Company may determine that additional loss provisions are necessary. If such additional provisions are required, it is anticipated that resulting charges against income would be offset by gains on additional asset sales. Pitney Bowes and the Company expect to complete their inquiry by the end of the second quarter of 1994. The Company's allowance for credit losses as a percentage of net lease receivables (net investments before allowance for credit losses and deferred investment tax credits plus the uncollected principal balance of receivables sold) was 2.44 percent at December 31, 1993, 2.05 percent at December 31, 1992 and 1.90 percent at December 31, 1991. PBCC charged $51.1 million, $46.5 million and $43.7 million against the allowance for credit losses in 1993, 1992 and 1991, respectively. The increase in write-offs in 1993 was due to $11.2 million of write-offs related to assets purchased from Adrema. Interest expense was $137.4 million in 1993 compared with $146.6 million in 1992, a decrease of 6.3 percent. The decrease reflects lower short-term interest rates in 1993, partly offset by higher average borrowings required to fund additional investment in earning assets. The effective interest rate on short-term average borrowings was 3.05 percent in 1993 compared to 3.80 percent in 1992. The Company does not match fund its financing investments and does not apply different interest rates to its various financing programs. Excluding ITC amortization, which is included in finance income, and excluding the impacts of the partnership transaction and the tax law changes described below, the effective income tax rate for 1993 was 35.2 percent compared with 35.6 percent for 1992. In the fourth quarter of 1993, the Company completed a transaction whereby it contributed certain commercial aircraft, subject to direct finance leases, to a majority owned partnership. The partnership transaction had the effect of reducing the Company's obligation for previously accrued deferred taxes, resulting in after-tax earnings of $8.4 million after provision for certain costs associated with the transaction. The reduction in deferred taxes has been recognized as a reduction in 1993 income tax expense. On August 10, 1993, the Tax Act was enacted increasing U.S. corporate income tax rates from 34 percent to 35 percent, retroactive to January 1, 1993. The liability method of accounting for income taxes requires the effect of a change in tax laws or rates on current or accumulated deferred income taxes to be reflected in the period that includes the enactment date of the new legislation. Accordingly, in the third quarter of 1993, the Company recorded additional tax expense reflecting the retroactive tax law changes, $9.3 million of which represented the effect of the rate change on deferred tax balances at January 1, 1993. Income before effect of a change in accounting for nonpension postretirement benefits was $123.5 million in 1993 compared with $120.8 million in 1992, an increase of 2.3 percent. The increase in 1993 is primarily attributable to lower short-term interest rates and higher investment levels, partly offset by additional tax expense recorded in 1993 as a result of the Tax Act. Excluding the impact of the Tax Act, income before effect of a change in accounting for nonpension postretirement benefits would have increased 11.0 percent. The Company's ratio of earnings to fixed charges was 2.37 times for 1993 compared with 2.25 times for 1992, reflecting a lower short-term interest rate environment in 1993. Liquidity and Capital Resources - ------------------------------- The Company's principal sources of funds are from operations and borrowings. It has been PBCC's practice to use a balanced mix of debt maturities, variable- and fixed-rate debt and interest rate swap agreements to control its sensitivity to interest rate volatility. PBCC's swap adjusted debt mix was 58 percent short-term and 42 percent long-term at December 31, 1993 and 50 percent short-term and 50 percent long-term at December 31, 1992. The Company may borrow through the sale of commercial paper, under its confirmed bank lines of credit, and by private and public offerings of intermediate- or long-term debt securities. In October 1992, the Company filed a $500 million shelf registration statement with the Securities and Exchange Commission. This registration statement, together with the carryover of $100 million from a previous shelf registration, should be sufficient to meet the Company's long-term financing needs for the next two years. The Company also had unused lines of credit and revolving credit facilities totaling $1.525 billion at December 31, 1993, largely supporting commercial paper borrowings. This includes an $825 million five year revolving credit facility arranged in 1991 and a $700 million five year revolving credit facility arranged in 1992. In March 1993, the Company redeemed $75 million of 8.75 percent notes due in 1996. The Company has also exercised the option to redeem $100 million of 10.65 percent notes due in 1999, on April 1, 1994. The Company had previously sold an option on a notional principal amount of $100 million to enable a counterparty to require the Company to pay a fixed rate of 10.67 percent for five years starting April 1, 1994. The counterparty has exercised that option. The Company also received $2.4 million from Pitney Bowes Inc. representing a contribution to capital surplus of the Company in connection with investments in real estate financing projects. During 1993, the Company sold approximately $26 million of Internal small-ticket finance assets with recourse in a privately-placed transaction with a third-party investor. In 1992 and 1991, the Company sold approximately $92 million and $90 million, respectively, of finance assets in similarly structured transactions. The uncollected principal balance of receivables sold at December 31, 1993 and 1992 was $168 million and $281 million, respectively. The proceeds from the sale of receivables were used to repay a portion of the Company's commercial paper borrowings. The Company continues to develop strategies in support of ongoing debt level management. Emphasis on fee-based transactions and consideration of the sale of certain financing transactions are expected to continue to slow growth in finance assets and debt levels. Additional financing will continue to be arranged as deemed necessary. Borrowing requirements will be primarily dependent upon the level of equipment purchases from Pitney Bowes and its subsidiaries, the level of External Division financing activity and the refinancing of maturing debt. As previously reported, the Company has made senior secured loans and commitments in connection with acquisition, leveraged buyout and recapitalization financings. At December 31, 1993, the Company had a total of $13.9 million of such senior secured loans and commitments outstanding compared to $25.2 million at December 31, 1992. In April 1993, the Company sold its $6.6 million senior secured loan with a company that had previously filed under Chapter 11 of the Federal Bankruptcy Code and recovered 100 percent of its investment. The Company has not participated in unsecured or subordinated debt financing in any highly leveraged transactions. The Company's liquidity ratio (finance contracts receivable, including residuals, expected to be realized in cash over the next 12 months to current maturities of debt over the same period) was .66 times and .69 times at December 31, 1993 and 1992, respectively. In some instances, the Company has entered into interest rate swap agreements to convert interest payments on variable-rate debt to a fixed-rate payment. On a swap adjusted basis, the liquidity ratio is .76 times at December 31, 1993 and .83 times at December 31, 1992. Under the Finance Agreement between Pitney Bowes and the Company, Pitney Bowes is obligated to make payments to the extent necessary, so that the Company's income available for fixed charges shall not be less than 1.25 times its fixed charges. No such payments have ever been required. The Company will continue to use cash to invest in finance assets with emphasis on Internal and External small-ticket leasing transactions and controlled investment in External large-ticket financing programs. The Company believes that cash generated from operations and collections on existing lease contracts will provide the majority of cash needed for such investment activities. Additional cash, to the extent needed, is expected to be provided from commercial paper and intermediate- or long-term debt securities. While the Company expects that market acceptance of its short- and long-term debt will continue to be strong, additional liquidity is available, if needed, under revolving credit facilities and credit lines. Item 8. Item 8. Financial statements and supplementary data ------------------------------------------- Report of Independent Accountants To the Stockholder and Board of Directors of Pitney Bowes Credit Corporation In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on pages 40 and 41 present fairly, in all material respects, the financial position of Pitney Bowes Credit Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 14 to the consolidated financial statements, the Company elected to adopt a new accounting standard for postretirement benefits other than pensions in 1992. PRICE WATERHOUSE Stamford, Connecticut February 1, 1994 Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Note 1. - Summary of Significant Accounting Policies Consolidation: The consolidated financial statements include the accounts of Pitney Bowes Credit Corporation and all of its subsidiaries (the Company). All significant intercompany transactions have been eliminated. Basis of accounting for financing transactions: At the time a finance transaction is consummated, the Company records on its balance sheet the total receivable, unearned income and the estimated residual value of leased equipment. Unearned income represents the excess of the total receivable plus the estimated residual value and deferred investment tax credits over the cost of equipment or contract acquired. Unearned income is recognized as finance income under the interest method over the term of the transaction. Initial direct costs incurred in consummating transactions, including fees paid to Pitney Bowes, are accounted for as part of the investment in a direct financing lease and amortized to income using the interest method over the term of the lease. Deferred investment tax credits are amortized ($1.3 million, $3.3 million and $5.5 million in 1993, 1992 and 1991, respectively) on a straight-line basis over the depreciable life of equipment manufactured by Pitney Bowes and under the interest method for products not manufactured by Pitney Bowes. The Company has, from time-to-time, sold selected finance assets. The Company follows Statement of Financial Accounting Standards No. 77, "Reporting by Transferors for Transfers of Receivables with Recourse", when accounting for its sale of finance assets. The difference between the sale price and the net receivable, exclusive of residuals, is recognized as a gain or loss. Allowance for credit losses: The Company evaluates the collectibility of its net investment in finance assets based upon its loss experience and assessment of prospective risk, and does so through ongoing reviews of its exposures to net asset impairment. The Company adjusts the carrying value of its net investment in finance assets to the estimated collectible amount through adjustments to the allowance for credit losses. Losses are charged against the allowance for credit losses. For further information see Note 7. Income taxes: The Company's taxable results are included in the consolidated Federal and certain state income tax returns of Pitney Bowes. For tax purposes, income from leases is recognized under the operating method and represents the difference between gross rentals billed and operating expenses. Under a tax-sharing agreement between the Company and Pitney Bowes, the Company makes payment to Pitney Bowes for its share of consolidated income taxes, or receives cash equal to the benefit of tax losses utilized in consolidated returns in exchange for which it issues non-interest bearing subordinated notes. Deferred taxes reflected in the Company's balance sheet represent the difference between Federal and state income taxes reported for financial and tax reporting purposes, less non-interest bearing subordinated notes issued, including those capitalized. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Investment in operating leases: Equipment under operating leases is depreciated over the firm term of the lease to its estimated residual value. Rental revenue is recognized on a straight-line basis over the related lease term. Note 2. - Business Combination In July 1992, the Company purchased 100 percent of the common stock of Atlantic Mortgage & Investment Corporation (AMIC) for a total purchase price of $15.6 million. On a pro forma basis, had the two companies been combined at the beginning of 1992, total revenue and net income for the year ending December 31, 1992, would have been $499.6 million and $119.3 million, respectively. Note 3. - Finance Assets Gross finance receivables are generally due in monthly, quarterly or semi- annual installments over periods ranging from 36 to 180 months. In addition, gross finance receivables for the Company's External large-ticket programs include commercial jet aircraft transactions with lease terms up to 24 years and other non-commercial jet aircraft transactions with lease terms ranging from two to 13 years. The balance due at December 31, 1993, including estimated residual realizable at the end of the lease term, is payable as follows: Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Net equipment financed for Pitney Bowes and its subsidiaries' products were $533.2 million, $447.7 million, and $416.9 million in 1993, 1992, and 1991, respectively. During 1993, the Company sold approximately $26 million of Internal small-ticket finance assets with recourse in a privately-placed transaction with a third-party investor. In 1992 and 1991, the Company sold approximately $92 million and $90 million, respectively of finance assets in similarly structured transactions. The uncollected principal balance of receivables sold at December 31, 1993 and 1992 was $168 million and $281 million, respectively. As of December 31, 1993, $588 million (17 percent) of the Company's finance assets and $947.5 million (21 percent) of the Company's gross finance assets were related to aircraft leased to commercial airlines. The Company considers its credit risk for these leases to be minimal since all commercial aircraft lessees are making payments in accordance with lease agreements. The Company believes any potential exposure in commercial aircraft investment is mitigated by the value of the collateral as the Company retains a security interest in the leased aircraft. The Company has issued a conditional commitment to guarantee the lease payments of a third party for a corporate aircraft. In the event of default under the lease by the third party, the Company has the right to take title to the aircraft and to assume the obligation under the lease. The Company's maximum exposure under the guarantee is $15.2 million. In addition, the Company has sold receivables while retaining residual value exposure of $18.9 million. The Company does not anticipate any exposure in connection with these financial agreements. Note 4. - Net Investment in Leveraged Leases Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Leveraged lease assets acquired by the Company are financed primarily through nonrecourse loans from third-party debt participants. These loans are secured by the lessee's rental obligations and the leased property. Net rents receivable represent gross rents less the principal and interest on the nonrecourse debt obligations. Unguaranteed residual values are principally based on independent appraisals of the values of leased assets remaining at the expiration of the lease. Leveraged lease investments totaling $176.7 million are related to commercial real estate facilities, with original lease terms ranging from 17 to 24 years. Also included are five aircraft transactions with major commercial airlines, with a total investment of $122.2 million and with original lease terms ranging from 22 to 24 years. Note 5. - Transfer of Assets from Affiliate In December 1992, as part of the restructuring and reincorporation of its German affiliate, Adrema Leasing Corporation (Adrema), the Company purchased certain finance receivables and other assets from Adrema. In connection with these assets, Pitney Bowes and the Company are continuing an inquiry and evaluation of the conduct by former management personnel of the German leasing business. The results of this inquiry to date indicate that former management caused the German leasing operation to enter into transactions which were not consistent with Company policy and guidelines and, in certain cases, lacked appropriate documentation and collateral. Additionally, in certain instances, Pitney Bowes and the Company are continuing to locate, repossess and remarket collateral where possible. These circumstances, together with deteriorating economic conditions in Germany, caused management, in the second quarter of 1993, to conclude that losses would be larger than previously anticipated. Accordingly, at that time, the Company recorded additional loss provisions of $14.4 million in the second quarter of 1993, the effect of which was substantially offset by a gain on the sale of finance assets. At the current time, the Company believes that with the additional loss provisions taken in the second quarter of 1993, sufficient reserves for expected losses are in place. As the inquiry continues, the Company may determine that additional loss provisions are necessary. If such additional provisions are required, it is anticipated that resulting charges against income would be offset by gains on additional asset sales. Pitney Bowes and the Company expect to complete their inquiry by the end of the second quarter of 1994. Note 6. - Investment in Operating Leases, Net The Company is the lessor of various types of equipment under operating leases including data processing, transportation and production equipment. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Minimum future rental payments to be received in each of the next five years under noncancelable operating leases are $14.1 million in 1994, $10.1 million in 1995, $8.9 million in 1996, $7.5 million in 1997, $5.9 million in 1998 and $19.2 million in later years. Note 7. - Allowance for Credit Losses The increase in the amount of additions charged to operations in 1993 versus 1992 is due to provisions for losses totaling $14.4 million recorded in the second quarter of 1993 relating to assets purchased from the Company's German affiliate, Adrema Leasing Corporation, partly offset by provisions recorded in 1992 in conjunction with the sale of Internal small-ticket finance assets. The increase in the amounts written-off in 1993 compared to 1992 reflect $11.2 million of write-offs related to assets purchased from Adrema. Excluding the impact of the write-offs related to assets purchased from Adrema, the lower level of write-offs is due to continued strong collection and asset management efforts and an improving economy. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) In establishing the provision for credit losses, the Company utilizes an asset based percentage. This percentage varies depending on the nature of the asset, recent historical experience, vendor recourse, management judgement, and for large-ticket external transactions, the credit rating assigned by Moody's and Standard & Poor's. In evaluating the adequacy of reserves, estimates of expected losses, again by nature of the asset, are utilized. While historical experience is the principal factor in determining loss percentages, adjustments will also be made for current economic conditions, deviations from historical aging patterns, seasonal write-off patterns and levels of non-earning assets. If the resulting evaluation of expected losses differs from the actual aggregate reserve, adjustments are made to the reserve. For transactions in the Internal Financing Division, the Company discontinues income recognition for finance receivables past due over 120 days. The Company has utilized this period because historically internal collection efforts have continued for this time period. In large-ticket external financing, income recognition is discontinued as soon as it is apparent, such as in the event of bankruptcy, that the obligor will not be making payments in accordance with lease terms. In small-ticket external financing, income recognition is discontinued when accounts are past due over 90 days. Finance receivables are charged to the allowance for credit losses (i.e. written-off) after collection efforts are exhausted and the account is deemed uncollectible. For internal and external small-ticket transactions, this usually occurs near the point in time when the transaction is placed in a non-earning status. For large-ticket external transactions, write-offs are normally made after efforts are made to repossess the underlying collateral, the repossessed collateral is sold and efforts to recover remaining balances are exhausted. On large-ticket external transactions, periodic adjustments also may be made and/or a cost recovery approach for cash proceeds utilized to reduce the face value to an estimated present value of future expected recovery. All write-offs and adjustments are performed on a transaction by transaction basis. Resumption of income recognition on internal and external small-ticket non-earning accounts occurs when payments are reduced to 60 days or less past due. On large-ticket external transactions, resumption of income recognition has occurred after the Company has had sufficient experience on resumption of payments to be satisfied that such payments will continue in accordance with the original or restructured contract terms. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) The carrying values of non-performing, restructured and troubled finance assets are outlined below. There are no leveraged leases falling under these categories. The increase in non-performing and troubled transactions in 1993 relates to assets purchased from Adrema in December 1992, which is further discussed in Note 5. For non-performing (non-accrual) transactions, the amount of finance income that would have been recorded in 1993 if the transactions had been current in accordance with their original contract terms was $2.8 million. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Historically, the Company has not allocated a specific amount of credit loss reserve to non-performing and troubled transactions. This is due to the historically low level of write-offs in the large-ticket external area and the limited number of transactions with material credit loss exposure in other areas. As stated above, the Company evaluates its aggregate reserve position in comparison to estimates of aggregate expected losses. However, for certain non-performing large-ticket external transactions, the Company has adjusted the face value of these receivables through the following adjustments: Purchased mortgage servicing rights are recorded at cost and are being amortized in proportion to, and over the period of, estimated net servicing income. Mortgage receivables represent loans in the process of payoff and are recorded at cost. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) In the fourth quarter of 1993, the Company completed a transaction whereby it contributed certain commercial aircraft, subject to direct finance leases, to a majority-owned partnership. Partnership fees incurred in connection with this transaction are amortized on a straight- line basis over the term of the transaction. Equipment and leasehold improvements are stated at cost. Leasehold improvements are amortized on a straight-line basis over the remaining lease terms. Equipment is depreciated on a straight-line basis over the anticipated useful life generally ranging from 5 to 10 years. Deferred debt placement fees incurred in connection with placing senior and subordinated notes are amortized on a straight-line basis over the term of the notes. Note 9. - Accounts Payable and Accrued Liabilities Note 10. - Notes Payable Short-term notes payable at December 31, 1993 and 1992 totaled $1.7 billion and $1.5 billion, respectively. These notes were issued as commercial paper, loans against bank lines of credit, or to trust departments of banks and others at below the prevailing prime rate. At year-end 1993, the Company had unused lines of credit and revolving credit facilities totaling $1.525 billion largely supporting commercial paper borrowings. The Company paid fees of $2.5 million, $1.8 million and $1.2 million in 1993, 1992 and 1991 to maintain its lines of credit. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Senior and subordinated notes payable at December 31, 1993 mature as follows: $1,736.3 million in 1994, $29.8 million in 1995, $145.5 million in 1997 and $708.1 million thereafter. Lending Arrangements: Under terms of its senior and subordinated loan agreements, the Company is required to maintain earnings before taxes and interest charges at prescribed levels. With respect to such loan agreements, Pitney Bowes will endeavor to have the Company maintain compliance with such terms and, under certain loan agreements, is obligated, if necessary, to pay to the Company amounts sufficient to maintain a prescribed ratio of income available for fixed charges. No such payments have ever been required to maintain income available for fixed charge coverage. In March 1993, the Company redeemed $75 million of 8.75 percent notes due in 1996. The Company has also exercised the option to redeem $100 million of 10.65 percent notes due in 1999, on April 1, 1994. The Company had previously sold an option on a notional principal amount of $100 million to enable a counterparty to require the Company to pay a fixed rate of 10.67 percent for five years starting April 1, 1994. The counterparty has exercised that option. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) In October 1992, the Company filed a $500 million shelf registration statement with the Securities and Exchange Commission. This registration statement, together with the carryover of $100 million from a previous shelf registration, should meet the Company's long-term financing needs for the next two years. The Company has entered into interest rate swap agreements as a means of managing interest rate exposure. The interest differential to be paid or received is recognized over the life of the agreements as an adjustment to interest expense. At December 31, 1993, outstanding notional principal amounts were $621 million for interest rate swap agreements. The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements to the extent of the differential between the fixed- and variable-rates; such exposure is considered minimal. In 1993 and 1992, the Company issued $22.8 million and $12.0 million, respectively, of non-interest bearing subordinated notes to Pitney Bowes in exchange for funds equal to tax losses generated by the Company and utilized by Pitney Bowes in the 1992 and 1991 consolidated tax returns. Any non-interest bearing subordinated notes payable to Pitney Bowes mature after all senior notes now outstanding and executed hereafter are paid. Note 11. - Stockholder's Equity At December 31, 1993, 10,000 shares of common stock, no-par with a stated value of $100,000 per share were authorized and 460 shares were issued and outstanding and amounted to $46.0 million at December 31, 1993 and 1992. All of the Company's stock is owned by Pitney Bowes. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Contributions to capital surplus from PBI for 1991 to 1993 were made in connection with investments in real estate financing projects. When the Company entered into real estate lease financing, PBI agreed to make capital contributions up to a maximum of $15.0 million to provide a portion of the financing for such transactions, of which $13.8 million has been received to date. There is no formal agreement in place and PBI is under no obligation to continue with capital contributions. Note 12. - Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash, accounts payable and senior notes payable with original maturities less than one year. The carrying amounts approximate fair value because of the short maturity of these instruments. Investment securities. The fair value of investment securities is estimated based on quoted market prices, dealer quotes and other estimates. Loans receivable. The fair value of loans receivable is estimated based on quoted market prices, dealer quotes or by discounting the future cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings and similar remaining maturities. Senior notes payable with original maturities greater than one year. The fair value of long-term debt is estimated based on quoted dealer prices for the same or similar issues. Interest rate swap and swap option agreements and foreign currency exchange contracts. The fair values of interest rate swaps, swap options and foreign currency exchange contracts are obtained from dealer quotes. These values represent the estimated amount the Company would receive or pay to terminate the agreements taking into consideration current interest rates, the credit worthiness of the counterparties and current foreign currency exchange rates. Transfers of receivables with recourse. The fair value of the recourse liability represents the estimate of expected future losses. The Company periodically evaluates the adequacy of reserves and estimates of expected losses, if the resulting evaluation of expected losses differs from the actual reserve, adjustments are made to the reserve. Financial guarantee contracts. The Company has provided standby guarantees for its foreign affiliates under a $250 million European commercial paper program, a $100 million revolving line of credit, and in connection with receivable transfers with recourse. Aggregate exposure under the guarantees at December 31, 1993 and 1992 was $153 million and $349 million, respectively. The fair value of the European Commercial Paper program and the revolving letter of credit is based on the cost to the Company for obtaining a letter of credit to support performance under the guarantees. The fair value of the guarantees under the receivable transfers with recourse represents the estimate of expected future losses. In certain instances, reserves established in connection with these receivable transfers have been established on the affiliated companies financial statements approximately equal to the fair value disclosures presented below. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Residual and conditional commitment guarantee contracts. The fair value of residual and conditional commitment guarantee contracts is based on the projected fair market value of the collateral as compared to the guaranteed amount plus a commitment fee generally required by the counterparty to assume the guarantee. Commitments to extend credit. The fair value of commitments to extend credit is estimated by comparing current market conditions taking into account the remaining terms of existing agreements and the present credit worthiness of the counterparties. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Note 13. - Taxes on Income In 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109), effective retroactively to January 1, 1992. Application of FAS 109 required no cumulative effect adjustment primarily due to the Company's previous use of the liability method of accounting for income taxes. The adoption of this standard had no significant effect on the Company's tax provision for 1992. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 was enacted increasing U.S. corporate income tax rates from 34 percent to 35 percent, retroactive to January 1, 1993. The liability method of accounting for income taxes requires the effect of a change in tax laws or rates on current or accumulated deferred income taxes to be reflected in the period that includes the enactment date of the new legislation. Accordingly, in the third quarter of 1993, the Company recorded additional tax expense reflecting the retroactive tax law changes, $9.3 million of which was the effect of the rate change on deferred tax balances at January 1, 1993. In the fourth quarter of 1993, the Company completed a transaction whereby it contributed certain commercial aircraft, subject to direct finance leases, to a majority owned partnership. The partnership transaction had the effect of reducing the Company's obligation for previously accrued deferred taxes. The reduction in deferred taxes has been recognized as a reduction in 1993 income tax expense. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Note 14. - Retirement Plan and Nonpension Postretirement Benefit Plan The Company participates in the Pitney Bowes retirement plan which covers substantially all PBCC employees. Colonial Pacific employees are covered under a separate plan. The assets of these plans fully fund vested benefits. Pitney Bowes' plan assumptions were 7.50 percent in 1993 and 8.50 percent in 1992 for the discount rate, 5.00 percent in 1993 and 6.00 percent in 1992 for the expected rate of increase in future compensation levels and 9.50 percent in 1993 and 1992 for the expected long-term rate of return on plan assets. The Company's pension expense was $1.4 million in 1993, $1.0 million in 1992 and $.9 million in 1991. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) The Company also participates in the Pitney Bowes nonpension postretirement benefit plan which provides certain health care and life insurance benefits to eligible retirees and their dependents. In the fourth quarter of 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106). This statement requires that the cost of these benefits be recognized over the period the employee provides credited service to the Company rather than recognized on a cash basis, when incurred. The transition effect of adopting FAS 106 on the immediate recognition basis, as of January 1, 1992, was a one-time, after-tax charge of $1.9 million (net of approximately $1.2 million of income taxes). In the first quarter of 1993, Pitney Bowes announced certain changes to its health care plans, including plan cost maximums, which should significantly reduce the ongoing incremental impact of FAS 106 on future earnings. In November 1992, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112), was issued addressing benefits provided by an employer to former or inactive employees after employment but before retirement. FAS 112 requires that postemployment benefit costs be recognized on the accrual basis of accounting effective for fiscal years beginning after December 15, 1993. Postemployment benefits include the continuation of salary, health care, life insurance and disability-related benefits to former or inactive employees, their beneficiaries and covered dependents. The Company will adopt FAS 112 during the first quarter of 1994, as required. Upon adoption, Pitney Bowes anticipates recognizing a one-time, non-cash after-tax charge of approximately $60 to $120 million for the cumulative effect on prior years of such adoption, some of which may be allocated back to the Company. Note 15. - Legal Proceedings The Company is not currently involved in any material litigation. Note 16. - Commitments and Contingent Liabilities The Company is the lessee under noncancelable operating leases for office space and automobiles. Future minimum lease payments under these leases are as follows: $4.8 million in 1994, $4.5 million in 1995, $4.0 million in 1996, $3.3 million in 1997, $3.0 million in 1998, and $8.7 million thereafter. Rental expense under operating leases was $4.7 million, $4.5 million and $4.2 million in 1993, 1992 and 1991, respectively. The Company has $10.8 million in unfunded loan commitments. The Company has also entered into agreements with another leasing company to guarantee a portion of the leasing company's residual position in lease contracts. In consideration for these guarantees, the Company received a fee. The aggregate exposure under these guarantees is $22.8 million. Pitney Bowes Credit Corporation Notes to Consolidated Financial Statements (Dollars in thousands) Note 17. - Quarterly Financial Information Item 9. Item 9. Changes in and disagreements with accountants on accounting and --------------------------------------------------------------- financial disclosure -------------------- None. Part III Item 10. Item 10. Directors and executive officers of the Registrant -------------------------------------------------- Omitted pursuant to General Instruction J. Item 11. Item 11. Executive compensation ---------------------- Omitted pursuant to General Instruction J. Item 12. Item 12. Security ownership of certain beneficial owners and management -------------------------------------------------------------- Omitted pursuant to General Instruction J. Item 13. Item 13. Certain relationships and related transactions ---------------------------------------------- Omitted pursuant to General Instruction J. Part IV Item 14. Item 14. Exhibits, financial statement schedules and reports on Form 8-K --------------------------------------------------------------- (a) Index of documents filed as part of this report: 1. Consolidated Financial Statements Page(s) --------------------------------- ------- Included in Part II of this report: Report of Independent Accountants 18 Consolidated Statements of Income and of Retained Earnings for each of the three years in the period ended December 31, 1993 19 Consolidated Balance Sheet at December 31, 1993 and 1992 20 Consolidated Statement of Cash Flows for each of the three years in the period ended December 31, 1993 21-22 Notes to Consolidated Financial Statements 23-39 2. Financial Statement Schedules ----------------------------- Valuation and qualifying accounts and reserves (Schedule VIII) 44 Short-term borrowings (Schedule IX) 45 The additional financial data should be read in conjunction with the financial statements included in Item 8 to this Form 10-K. Schedules not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Index to Exhibits (numbered in accordance with Item 601 of Regulation S-K) --------------------------------------------------------------------- Reg. S-K State or Incorporation Exhibits Description by Reference -------- ----------------------------- -------------------------- (3) .1 Articles of Incorporation, Incorporation by reference as amended to Exhibits (3.1) and (3.2) .2 By-Laws, as amended respectively, to Form 10 on Registration Statement No. 0-13497 as filed with the Commission on May 1, 1985. (4) (a) Form of Indenture dated as Incorporated by reference of May 1, 1985 between the to Exhibit (4a) to Company and Bankers Trust Registration Statement on Company, as Trustee Form S-3 (No. 2-97411) as filed with the Commission on May 1, 1985. (b) Form of First Supplemental Incorporated by reference Indenture dated as of to Exhibit (4b) to December 1, 1986 between Registration Statement on the Company and Bankers Form S-3 (No. 33-10766) Trust Company, as Trustee as filed with the Commission on December 12, 1986. (c) Form of Second Supplemental Incorporated by reference Indenture dated as of to Exhibit (4c) to February 15, 1989 between Registration Statement on the Company and Bankers Form S-3 (No. 33-27244) Trust Company, as Trustee as filed with the Commission on February 24, 1989. (d) Form of Third Supplemental Incorporated by reference Indenture dated as of May 1, to Exhibit (1) on Form 8-K 1989 between the Company and as filed with the Bankers Trust Company, as Commission on May 16, Trustee. 1989. (e) Letter Agreement between Incorporated by reference Pitney Bowes Inc. and to Exhibit (4b) to Bankers Trust Company, Registration Statement on as Trustee Form S-3 (No. 2-97411) as filed with the Commission on May 1, 1985. (10) Material contracts .1 Operating Agreement dated Incorporated by reference March 3, 1977, as amended, to Exhibits (10.1), between Pitney Bowes (10.2), and (10.3), Credit Corporation and respectively, to Pitney Bowes Inc. Form 10 as filed with the Commission on May 1, 1985. .2 Finance Agreement, dated July 5, 1978 between Pitney Bowes Credit Corporation and Pitney Bowes Inc. .3 Tax Sharing Agreement, dated April 1, 1977 between Pitney Bowes Credit Corporation and Pitney Bowes Inc. (12) Computation of ratio of earnings to fixed charges Exhibit (i) (21) Subsidiaries of the registrant Exhibit (ii) (23) Consent of independent Exhibit (iii) accountants (b) No reports on Form 8-K were filed for the three months ended December 31, 1993. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15 (d) 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. Pitney Bowes Credit Corporation By /s/ Michael J. Critelli -------------------------------- Michael J. Critelli President and Chief Executive Officer Date March 11, 1994 ------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By /s/ Michael J. Critelli Date 3/11/94 Michael J. Critelli -------------------------- ------- Director, President and Chief Executive Officer By /s/ G. Kirk Hudson Date 3/11/94 G. Kirk Hudson -------------------------- ------- Vice President-Finance (principal financial officer) By /s/ Thomas P. Santora Date 3/11/94 Thomas P. Santora -------------------------- ------- Controller (principal accounting officer) By /s/ George B. Harvey Date 3/11/94 George B. Harvey-Director -------------------------- ------- By /s/ Carmine F. Adimando Date 3/11/94 Carmine F. Adimando-Director -------------------------- ------- By /s/ Marc C. Breslawsky Date 3/11/94 Marc C. Breslawsky-Director -------------------------- ------- By /s/ Douglas A. Riggs Date 3/11/94 Douglas A. Riggs-Director -------------------------- ------- By /s/ Hiro R. Hiranandani Date 3/11/94 Hiro R. Hiranandani-Director -------------------------- ------- By Date Harry W. Neinstedt-Director -------------------------- -------

819793_1993.txt

819793_1993

1993

819793

ITEM 1. BUSINESS The Registrant designs, manufactures and markets paper machine clothing for each section of the paper machine. It is the largest producer of paper machine clothing in the world. Paper machine clothing consists of large continuous belts of custom designed and custom manufactured, engineered fabrics that are installed on paper machines and carry the paper stock through each stage of the paper production process. Paper machine clothing is a consumable product of technologically sophisticated design that is made with synthetic monofilament and fiber materials. The Registrant produces a substantial portion of its monofilament requirements. The design and material composition of paper machine clothing can have a considerable effect on the quality of paper products produced and the efficiency of the paper machines on which it is used. In addition to paper machine clothing, the Registrant manufactures other engineered fabrics which include fabrics for the non-woven industry, corrugator belts, filtration media and rapid roll doors. Practically all press fabrics are woven tubular or endless from monofilament yarns. After weaving, the base press fabric goes to a needling operation where a thick fiber layer, called a batt, is laid on the base just before passing through the needling machine. The needles are equipped with tiny barbs that grab batt fibers locking them into the body of the fabric. After needling, the fabrics are usually washed, and water is removed. The fabric then is heat set, treatments may be applied, and it is measured and trimmed. The Registrant's manufacturing process is similar for forming fabrics and drying fabrics. Monofilament screens are woven on a loom. The fabrics are seamed to produce an endless loop, and heat stabilized by running them around two large cylinders under heat and drawn out by tension. After heat setting, the fabrics are seamed and boxed. INDUSTRY FACTORS There are approximately 1,250 paper machines in the United States located in approximately 490 paper mills. It is estimated that, excluding China, there are 8,100 paper machines in the world and approximately 1,000, mostly very small, paper machines in China. Demand for paper machine clothing is tied to the volume of paper production, which in turn reflects economic growth. According to published data, world production volumes have grown in excess of 4% annually over the last ten years. The Registrant anticipates continued growth for the long-term in world paper production. The profitability of the paper machine clothing business has generally been less cyclical than the profitability of the papermaking industry. Papermaking capacity utilization does not vary significantly because in periods of declining demand for paper, paper mills still operate near capacity but at lower profitability. Because the paper industry has been characterized by an evolving but essentially stable manufacturing technology based on the wet forming papermaking process, which requires a very large capital investment, the Registrant does not believe that a commercially feasible substitute technology that does not employ paper machine clothing is likely to be developed and incorporated into the paper production process by paper manufacturers in the foreseeable future. Accordingly, the prospects for continued stability of industry demand for paper machine clothing appear excellent. Over the last few years, paper manufacturers have generally reduced the number of suppliers of paper machine clothing per machine position. This trend has increased opportunities for market leaders to expand their market share. INTERNATIONAL OPERATIONS The Registrant maintains wholly-owned manufacturing facilities in Australia, Brazil, Canada, Finland, France, Germany, Great Britain, Holland, Mexico, Sweden and the United States. The Registrant has a 50% interest in a partnership in South Africa which is engaged primarily in the paper machine clothing business (see Note 1 of Notes to Consolidated Financial Statements). The Registrant's geographically diversified operations allow it to serve the world's paper markets more efficiently and to provide superior technical service to its customers. The Registrant benefits from the transfer of research and development product innovations between geographic regions. The worldwide scope of the Registrant's manufacturing and marketing efforts also limits the impact on the Registrant of economic downturns that are limited to a geographic region. The Registrant's widespread presence subjects it to certain risks, including controls on foreign exchange and the repatriation of funds. However, the Registrant has been able to repatriate earnings in excess of working capital requirements from each of the countries in which it operates without substantial governmental restrictions and does not foresee any material changes in its ability to continue to do so in the future. In addition, the Registrant believes that the risks associated with its operations and locations outside the United States are those normally associated with doing business in these locations. In countries in which the Registrant operates that have experienced high inflation rates, the Registrant frequently reprices its products. This practice has enabled the Registrant to quickly pass on to its customers most of the increased costs due to local inflation. Although government imposed price freezes have occasionally occurred in some of the Registrant's markets, including the United States, neither controls nor high inflation rates have had a long-term material adverse impact on the Registrant's operating results. MARKETING, CUSTOMERS AND BACKLOG Paper machine clothing is custom designed for each user depending upon the type, size and speed of the papermaking machine, the machine section, the grade of paper being produced, and the quality of the pulp stock used. Judgment and experience are critical in designing the appropriate clothing for each position on the machine. As a result, the Registrant employs highly skilled sales and technical service personnel in 21 countries who work directly with paper mill operating management. The Registrant's technical service van program in the United States gives its service engineers field access to the measurement and analysis equipment needed for troubleshooting and application engineering. Sales, service and technical expenses are major cost components of the Registrant. The Registrant employs approximately 900 people in the sales and technical functions combined, many of whom have engineering degrees or paper mill experience. The forming and pressing sections of the papermaking process have been characterized by a greater frequency of technological and design innovations that improve performance than has the drying section. The Registrant's market leadership position in forming and pressing fabrics and the 1993 acquisition of Mount Vernon which produces dryer fabrics, reflects the Registrant's commitment to technological innovation. Typically, the Registrant experiences its highest quarterly sales levels in the fourth quarter of each fiscal year and its lowest levels in the first quarter. The Registrant believes that this pattern only partially reflects seasonal shifts in demand for its products but is more directly related to purchasing policies of the Registrant's customers. Payment terms granted to customers reflect general competitive practices. Terms vary with product and competitive conditions, but generally require payment within 30 to 90 days, depending on the country of operation. Historically, bad debts have been insignificant. No single customer, or group of related customers, accounted for more than 5% of the Registrant's sales of paper machine clothing in any of the past three years. Management does not believe that the loss of any one customer would have a material adverse effect on the Registrant's business. The Registrant's order backlogs at December 31, 1993 and 1992 were approximately $407 million and $351 million, respectively. Orders recorded at December 31, 1993 are expected to be invoiced during the next 12 months. RESEARCH AND DEVELOPMENT The Registrant invests heavily in research, new product development and technical analysis to maintain its leadership in the paper machine clothing industry. The Registrant's expenditures fall into two primary categories, research and development and technical expenditures. Research and development expenses totaled $17.6 million in 1993 and $18.5 million in 1992 and 1991. While most research activity supports existing products, the Registrant engages in research for new products. New product research has focused primarily on more sophisticated paper machine clothing and has resulted in a stream of new products such as DUOTEX-R- and TRIOTEX-TM- forming fabrics, for which the technology has been licensed to several competitors, the patented, on-machine-seamed press fabric, long nip press belts which are essential to water removal in the press section and Thermonetics-TM- a dryer fabric. Technical expenditures, primarily at the plant level, totaled $21.4 million in 1993, $22.9 million in 1992, and $23.5 million in 1991. Technical expenditures are focused on design, quality assurance and customer support. Although the Registrant has focused most of its research and development efforts on paper machine clothing products and design, the Registrant also has made considerable progress in developing non-paper machine clothing products. Through its major research facility in Mansfield, Massachusetts, the Registrant conducts research under contract for the U.S. government and major corporations. In addition to its Mansfield facility, the Registrant has four other research and development centers located at manufacturing locations in Halmstad, Sweden; Selestat, France; Albany, New York; and Menasha, Wisconsin. The Registrant has developed and is developing proprietary processes for manufacturing structural and insulation products using polyimide and other fibers, which have potential applications in aircraft, automotive and other industries. A number of products that include properties such as thermal stability, non-flammability, non-melting and low generation of smoke and toxic gasses at high temperatures are currently being tested. Another innovative engineered fabric development unrelated to paper machine clothing is Primaloft, a synthetic down which is believed to have properties superior to goose down. This product continues to gain acceptance in the marketplace for cold weather clothing and bedding. The Registrant holds a number of patents, trademarks and licenses, none of which are material to the continuation of the Registrant's business. Consistent with industry practice, the Registrant frequently licenses its patents to competitors primarily to enhance customer acceptance of the new products. The revenue from such licenses is less than 1 percent of consolidated net sales. COMPETITION While there are more than 50 paper machine clothing suppliers worldwide, only six major paper machine clothing companies compete on a global basis. Market shares vary depending on the country and the type of paper machine clothing produced. In the paper machine clothing market, the Registrant believes that it has a market share of approximately 26% in the United States and Canadian markets, taken together, 16% in the rest of the world and approximately 20% in the world overall. Together, the United States and Canada constitute approximately 38% of the total world market for paper machine clothing. Competition is intense in all areas of the Registrant's business. While price competition is, of course, a factor, the primary bases for competition are the performance characteristics of the Registrant's products, which are principally technology-driven, and the quality of customer service. The Registrant, like its competitors, provides diverse services to customers through its sales and technical service personnel including: (1) consulting on performance of the paper machine; (2) consulting on paper machine configurations, both new and rebuilt; (3) selection and custom manufacture of the appropriate paper machine clothing; and (4) storing fabrics for delivery to the user. EMPLOYEES The Registrant employs 5,286 persons, of whom approximately 75% are engaged in manufacturing the Registrant's products. Wages and benefits are competitive with those of other manufacturers in the geographic areas in which the Registrant's facilities are located. The Registrant considers its relations with its employees in general to be excellent. EXECUTIVE OFFICERS OF REGISTRANT The following table sets forth certain information with respect to the executive officers of the Registrant: J. SPENCER STANDISH joined the Registrant in 1952. He has served the Registrant as Chairman of the Board since 1984, Vice Chairman from 1976 to 1984, Executive Vice President from 1974 to 1976, and Vice President from 1972 to 1974. He has been a Director of the Registrant since 1958. He is a director of Berkshire Life Insurance Company. FRANCIS L. MCKONE joined the Registrant in 1964. He has served the Registrant as Chief Executive Officer since 1993, President since 1984, Executive Vice President from 1983 to 1984, Group Vice President -- Papermaking Products Group from 1979 to 1983, and prior to 1979 as a Vice President of the Registrant and Division President -- Papermaking Products U.S. He has been a Director of the Registrant since 1983. MICHAEL C. NAHL joined the Registrant in 1981. He has served the Registrant as Senior Vice President and Chief Financial Officer since 1983 and prior to 1983 as Group Vice President. MANFRED F. KINCAID joined the Registrant in 1960. He has served the Registrant as Senior Vice President since 1983, Vice President -- Papermaking Products Europe from 1981 to 1983, and prior to 1981 as Vice President and General Manager of the Appleton Wire Division. THOMAS H. RICHARDSON joined the Registrant in 1965. He has served the Registrant since 1993 as Senior Vice President -- International. Prior to 1993, he served as Vice President and General Manager of Euroscan from 1986 to 1993, as Senior Vice President -- Canada and Europe from 1983 to 1986, as Senior Vice President -- International from 1981 to 1983, and prior to 1981 as General Manager of Albany International Industria e Comercio Ltda. in Brazil. FRANK R. SCHMELER joined the Registrant in 1964. He has served the Registrant as Senior Vice President since 1988, as Vice President and General Manager of the Felt Division from 1984 to 1988, as Division Vice President and General Manager, Albany International Canada from 1978 to 1984 and as Vice President of Marketing, Albany International Canada from 1976 to 1978. CHARLES B. BUCHANAN joined the Registrant in 1957. He has served the Registrant as Vice President and Secretary since 1980 and as Vice President and Assistant to the President from 1976 to 1980. He has been a Director of the Registrant since 1969. He is a Director of Fox Valley Corporation and of CMP Industries, Inc. RICHARD A. CARLSTROM joined the Registrant in 1972. He has served the Registrant as Vice President -- Controller since 1993, as Controller since 1980, as Controller of a U.S. division from 1975 to 1980, and prior to 1975 as Financial Controller of Albany International Pty. in Australia. RAYMOND D. DUFRESNE joined the Registrant in 1973. He has served the Registrant as Vice President -- Treasurer since 1993, as Treasurer since 1985, as Business Analyst and Assistant Treasurer from 1978 to 1985 and Financial Manager of Albany International Industria e Comercio Ltda. in Brazil from 1975 to 1977. WILLIAM H. DUTT joined the Registrant in 1958. He has served the Registrant since 1983 as Vice President -- Technical, and prior to 1983 he served in various technical, engineering, and research capacities including Director of Research and Development and Vice President -- Operations for Albany Felt. HUGH A. MCGLINCHEY joined the Registrant in 1991. He has served the Registrant as Vice President -- Information Systems since 1993 and from 1991 to 1993 as Director -- Information Systems. Prior to 1991 he served as Director -- Corporate Information and Communications Systems for Avery Dennison Corporation. JAMES W. SHERRER, SR. joined the Registrant in 1992. He has served the Registrant since 1993 as Vice President -- Administration and from 1992 to 1993 as Vice President. Prior to joining the Registrant, he held various technical and managerial positions with a company in the paper machine clothing business. THOMAS H. HAGOORT joined the Registrant as General Counsel on January 1, 1991. From 1968 until December 31, 1990 he was a partner in Cleary, Gottlieb, Steen and Hamilton, an international law firm with headquarters in New York City, to which he became of counsel on January 1, 1991. RAW MATERIALS AND INVENTORY Primary raw materials for the Registrant's products are synthetic fibers, which are generally available from a number of suppliers. The Registrant, therefore, is not required to maintain inventories in excess of its current needs to assure availability. In addition, the Registrant manufactures monofilament, a basic raw material for all types of paper machine clothing, at its facility in Homer, New York, which supplies approximately 25% of its world-wide monofilament requirements. This manufacturing capability assists the Registrant in its negotiations with monofilament producers for the balance of its supply requirements, and enhances the ability of the Registrant to develop proprietary products. The Registrant believes it is in compliance with all Federal, State and local provisions which have been enacted or adopted regarding the discharge of materials into the environment, or otherwise relating to the protection of the environment, and does not have knowledge of environmental regulations which do or might have a material effect on future capital expenditures, earnings, or competitive position. The Registrant is incorporated under the laws of the State of Delaware and is the successor to a New York corporation which was originally incorporated in 1895 and which was merged into the Registrant in August 1987 solely for the purpose of changing the domicile of the corporation. Upon such merger, each outstanding share of Class B Common Stock of the predecessor New York corporation was changed into one share of Class B Common Stock of the Registrant. References to the Registrant that relate to any time prior to the August 1987 merger should be understood to refer to the predecessor New York corporation. ITEM 2. ITEM 2. PROPERTIES The Registrant's principal manufacturing facilities are located in the United States, Canada, Europe, Brazil, Mexico and Australia. The aggregate square footage of the Registrant's facilities in the United States and Canada is approximately 2,407,000, of which 2,298,200 square feet are owned and 108,800 square feet are leased. Most of the leased facilities in the United States are used for the warehousing of finished goods. The Registrant's facilities located outside the United States and Canada comprise approximately 2,506,000 square feet, of which 2,255,000 square feet are owned and 251,000 square feet are leased. The Registrant considers these facilities to be in good condition and suitable for their purpose. The capacity associated with these facilities is adequate to meet production levels required and anticipated through 1994. The Registrant's capital expenditures are expected to approximate $39 million during 1994 in order to meet anticipated sales growth. The Registrant believes it has modern, efficient production equipment. In the last five years, it has spent $280 million on new plants and equipment or upgrading existing facilities, including the completion of, a dryer fabric plant in Cowansville, Quebec, Canada, new forming fabric plants in Sweden and Holland and new press fabric plants in Sweden and Finland. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted during the fourth quarter of 1993 to a vote of security holders. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS "Stock and Shareholders" and "Quarterly Financial Data" on page 31 of the Annual Report are incorporated herein by reference. Restrictions on dividends and other distributions are described in Note 6, on pages 20 and 21 of the Annual Report. Such description is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA "Ten Year Summary" on page 32 of the Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Review of Operations" on pages 27 to 30 of the Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Registrant and its subsidiaries, included on pages 15 to 18 in the Annual Report, are incorporated herein by reference: Consolidated Statements of Income and Retained Earnings -- years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Cash Flows -- years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT a) DIRECTORS. The information set out in the section captioned "Election of Directors" of the Proxy Statement is incorporated herein by reference. b) EXECUTIVE OFFICERS OF REGISTRANT. Information about the officers of the Registrant is set forth in Item 1 above. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth in the sections of the Proxy Statement captioned "Executive Compensation", "Summary Compensation Table", "Option/SAR Grants in Last Fiscal Year", "Option/SAR Exercises during 1993 and Year-End Value", "Pension Plan Table", "Compensation and Stock Option Committee Report on Executive Compensation" and "Stock Performance Graph" is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set out in the section captioned "Share Ownership" of the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a)(1) FINANCIAL STATEMENTS. The consolidated financial statements included in the Annual Report are incorporated by reference in Item 8. a)(2) SCHEDULES. The following consolidated financial statement schedules for each of the three years in the period ended December 31, 1993 are included pursuant to Item 14(d): Report of Independent Accountants on Financial Statement Schedules Schedule V -- Property, plant and equipment Schedule VI -- Accumulated depreciation and amortization of property, plant and equipment Schedule VIII -- Valuation and qualifying accounts Schedule IX -- Short-term borrowings a)(3)(b) No reports on Form 8-K were filed during the quarter ended December 31, 1993. (3) EXHIBITS All other schedules and exhibits are not required or are inapplicable and, therefore, have been omitted. (1) Previously filed as an Exhibit to the Company's Registration Statement on Form S-1, No. 33-16254, as amended, declared effective by the Securities and Exchange Commission on September 30, 1987, which previously-filed Exhibit is incorporated by reference herein. (2) Previously filed as an Exhibit to the Company's Registration Statement on Form S-1, No. 33-20650, declared effective by the Securities and Exchange Commission on March 29, 1988, which previously-filed Exhibit is incorporated by reference herein. (3) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated August 8, 1988, which previously-filed Exhibit is incorporated by reference herein. (4) Previously filed as an Exhibit to the Registrant's Registration Statement on Form 8-A, File No. 1-10026, declared effective by the Securities and Exchange Commission on August 26, 1988 (as to The Pacific Stock Exchange, Inc.), and on September 7, 1988 (as to The New York Stock Exchange, Inc.), which previously-filed Exhibit is incorporated by reference herein. (5) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated January 6, 1989, which previously-filed Exhibit is incorporated by reference herein. (6) Previously filed as an Exhibit to the Registrant's Registration Statement on Form S-1, No. 33-30581, declared effective by the Securities and Exchange Commission on September 26, 1989, which previously-filed Exhibit is incorporated by reference herein. (7) Previously filed as an Exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, which previously-filed Exhibit is incorporated by reference herein. (8) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated June 29, 1990, which previously-filed Exhibit is incorporated by reference herein. (9) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated February 28, 1991, which previously-filed Exhibit is incorporated by reference herein. (10) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated April 8, 1991, which previously-filed Exhibit is incorporated by reference herein. (11) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated May 28, 1991, which previously-filed Exhibit is incorporated by reference herein. (12) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form 10Q dated November 8, 1991, which previously-filed Exhibit is incorporated by reference herein. (13) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated January 18, 1993, which previously-filed Exhibit is incorporated by reference herein. (14) Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated July 21, 1993, which previously-filed Exhibit is incorporated by reference herein. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 on the 22nd day of March, 1994. ALBANY INTERNATIONAL CORP. by ______/s/ MICHAEL C. NAHL_____ Michael C. Nahl Principal Financial Officer Senior Vice President and Chief Financial Officer SCHEDULES REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To The Shareholders and Board of Directors Albany International Corp. Our report on the consolidated financial statements of Albany International Corp. has been incorporated by reference in this form 10-K from page 14 of the 1993 Annual Report to Shareholders of Albany International Corp. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 8 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Albany, New York January 27, 1994 SCHEDULE V ALBANY INTERNATIONAL CORP. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) SCHEDULE VI ALBANY INTERNATIONAL CORP. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION (DOLLARS IN THOUSANDS) SCHEDULE VIII ALBANY INTERNATIONAL CORP. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (DOLLARS IN THOUSANDS) SCHEDULE IX ALBANY INTERNATIONAL CORP. AND SUBSIDIARIES SHORT TERM BORROWINGS YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS)

784014_1993.txt

784014_1993

1993

784014

ITEM 1. BUSINESS Development and Description of Business --------------------------------------- Information concerning the business of American Insured Mortgage Investors L.P.-Series 86 (the Partnership) is contained in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations and in Notes 1, 4 and 5 of the notes to the financial statements of the Partnership contained in Part IV (filed in response to Item 8 hereof), which is incorporated herein by reference. Also see Schedule XII- Mortgage Loans on Real Estate, contained in Item 14, for the table of the Insured Mortgages (as defined below), including Assets Held for Sale Under Coinsurance Program (as defined below), invested in by the Partnership as of December 31, 1993. Employees --------- The business of the Partnership is managed by CRIIMI, Inc. (the General Partner), while its portfolio of mortgages is managed by AIM Acquisition Partners, L. P. (the Advisor) and CRI/AIM Management, Inc. (the Sub-advisor). CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). CRI is also an affiliate of the Sub-advisor. The Partnership has no employees. Competition ----------- In acquiring Insured Mortgages, the Partnership competes with private investors, mortgage banking companies, mortgage brokers, state and local government agencies, lending institutions, trust funds, pension funds, and other entities, some with similar objectives to those of the Partnership and some of which are or may be affiliates of the Partnership, its General Partner, the Advisor or their respective affiliates. Some of these entities may have substantially greater capital resources and experience than the Partnership in acquiring mortgages which are fully insured or guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association (GNMA), the Federal Housing Administration (FHA) or the Federal Home Loan Mortgage Corporation. Pursuant to the Sub-advisory Agreements, the Advisor retained the Sub-advisor to perform the services required of the Advisor under the Advisory Agreements. The Sub-advisor performs advisory services for American Insured Mortgage Investors (AIM 84), American Insured Mortgage Investors - Series 85, L.P. (AIM 85) and American Insured Mortgage Investors L.P.-Series 88 (AIM 88), as well as the Partnership (collectively, the AIM Partnerships). CRI also serves as a general partner of the advisers to CRIIMI MAE and CRI Liquidating REIT, Inc., which have investment objectives similar to those of the AIM Partnerships. CRI and its affiliates are also general partners of a number of other real estate limited partnerships. CRI and its affiliates also may serve as general partners, sponsors or managers of real estate limited partnerships, real estate investment trusts (REITs) or other entities in the future. With respect to mortgage acquisitions, CRI may from time to time be faced with a conflict in determining whether to place a particular mortgage with the Partnership, one of the other AIM Partnerships, or other entities which CRI and its affiliates may sponsor or manage. CRIIMI, Inc., as General Partner, may also face a similar conflict. Both CRI and CRIIMI, Inc., however, are subject to their fiduciary duties in evaluating the appropriate action to be taken when faced with such conflicts. ITEM 2. ITEM 2. PROPERTIES Although the Partnership does not own the underlying real estate, the Insured Mortgages in which the Partnership has invested are first liens on the respective multifamily residential developments or retirement homes. PART I ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings to which the Partnership is a party. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the security holders to be voted on during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS Principal Market and Market Price for Units ------------------------------------------- The United States Congress recently repealed portions of the Federal tax code which have had an adverse impact on tax-exempt investors in "publicly traded partnerships." This tax code change, effective January 1, 1994, cleared away the major impediment standing in the way of listing the Partnership's Depository Units of Limited Partnership Interest ("Units") for trading on a national stock exchange. As a result, the General Partner listed the Partnership's Units for trading on the American Stock Exchange (AMEX) on January 18, 1994 in order to provide investment liquidity as contemplated in the Partnership's original prospectus. The Units are traded under the symbol "AIJ." Prior to listing of the Partnership's Units for trading on the AMEX, the Units were only tradable through an informal market called the "secondary market". Distribution Information ------------------------ Distributions per Unit, payable out of the cash flow of the Partnership during 1993 and 1992 were as follows: Distributions for the Amount of Distribution Quarter Ended Per Unit --------------------- ---------------------- March 31, 1993 $ .23 June 30, 1993 .21 September 30, 1993 .29(1) December 31, 1993 .28(2) -------- $ 1.01 ======== March 31, 1992 $ .30 June 30, 1992 .22 September 30, 1992 .30 December 31, 1992 .32 -------- $ 1.14 ======== (1) In September 1993, the Partnership received $591,872 (approximately $.06 per Unit) from the mortgage on Victoria Pointe Apartments-Phase II, representing mortgage interest from October 1991 through June 1992, and a partial payment for July 1992. The Partnership distributed approximately $.03 per Unit of this previously undistributed interest and reserved approximately $.03 per Unit for the continued funding of coinsurance expenses. The Partnership distributed the remaining interest of approximately $.03 per Unit to Unitholders as part of the fourth quarter distribution, as discussed below. PART II ITEM 5. MARKET FOR REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS - Continued (2) Includes a special distribution of approximately $.10 per Unit comprised of (i) $.03 per Unit of previously undistributed accrued interest from the mortgage on Victoria Pointe Apartments-Phase II which was reserved as part of the third quarter distribution, described above, and (ii) $.07 per Unit representing previously undistributed accrued interest received in December 1993 resulting from the disposition of the mortgage on Victoria Pointe Apartments-Phase II. Approximate Number of Unitholders Title of Class as of December 31, 1993 --------------------------- ------------------------------- Depository Units of Limited 15,000 Partnership Interest PART II ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per Unit amounts) PART II ITEM 6. SELECTED FINANCIAL DATA - Continued The selected statements of operations data presented above for the years ended December 31, 1993, 1992 and 1991, and the balance sheet data as of December 31, 1993 and 1992, are derived from and are qualified by reference to the Partnership's financial statements which have been included elsewhere in this Form 10-K. The statements of operations data for the years ended December 31, 1990 and 1989 and the balance sheet data as of December 31, 1991, 1990 and 1989 are derived from audited financial statements not included in this Form 10-K. This data should be read in conjunction with the financial statements and the notes thereto. PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General ------- American Insured Mortgage Investors L.P. - Series 86 (the Partnership) was formed under the Uniform Limited Partnership Act of the State of Delaware on October 31, 1985. During the period from May 2, 1986 (the initial closing date of the Partnership's public offering) through June 6, 1987 (the termination date of the offering), the Partnership, pursuant to its public offering of Units, raised a total of $191,523,300 in gross proceeds. In addition, the initial limited partner contributed $2,500 to the capital of the Partnership and received 125 units of limited partnership interest in exchange therefor. From inception through September 6, 1991, AIM Capital Management Corp. served as managing general partner (with a partnership interest of 4.8%), IRI Properties Capital Corp. served as corporate general partner (with a partnership interest of 0.1%) and Second Group Partners, an affiliate of the former general partners, served as the associate general partner (with a partnership interest of 0.1%). All of the foregoing general partners are sometimes collectively referred to as former general partners. At a special meeting of the limited partners and Unitholders of the Partnership held on September 4, 1991, a majority of these interests approved, among other items, the assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (IFI) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and directs the acquisition and disposition of the Partnership's mortgages. Until the change in the Partnership's investment policy, as discussed below, the Partnership was in the business of originating mortgage loans (Originated Insured Mortgages) and acquiring mortgage loans (Acquired Insured Mortgages, and together with Originated Insured Mortgages, referred to herein as Insured Mortgages). As of December 31, 1993, the Partnership had invested in either Originated Insured Mortgages which are insured or guaranteed, in whole or in part, by the FHA or Acquired PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Insured Mortgages which are fully insured (as more fully described below). The Partnership's reinvestment period expires on December 31, 1994 and the Partnership Agreement states that the Partnership will terminate on December 31, 2020, unless previously terminated under the provisions of the Partnership Agreement. The Partnership's principal investment objectives are to invest in Insured Mortgages which (i) preserve and protect the Partnership's invested capital; (ii) provide quarterly distributions of adjusted cash from operations which may be increased over time as a result of Participations (as defined below), when obtainable, on Originated Insured Mortgages; and (iii) provide appreciation by selecting Acquired Insured Mortgages which present the possibility of early prepayment. Effective September 19, 1991, the General Partner changed, at the Advisor's recommendation, the investment policies of the Partnership to invest only in Acquired Insured Mortgages which are fully insured or guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association (GNMA), FHA or the Federal Home Loan Mortgage Corporation. The Partnership had invested in 18 Insured Mortgages, including Mortgages Held for Disposition and Assets Held for Sale under Coinsurance Program (AHFS), with an aggregate carrying value of $167,145,316 and a face value of $165,972,392 as of December 31, 1993, as discussed below. As of December 31, 1993, the Partnership had available approximately $7.5 million for reinvestment in Acquired Insured Mortgages. Results of Operations --------------------- 1993 versus 1992 ---------------- Net earnings for 1993 increased as compared to 1992 primarily due to an increase in mortgage investment income, as discussed below. Mortgage investment income increased during 1993 as compared to 1992 primarily as a result of the Partnership beginning, effective January 1, 1993, to recognize mortgage investment income for the mortgages classified as AHFS in the amount coinsured by the United States Department of Housing and Urban Development (HUD). Given the improved financial performance of the borrowers and the General Partner's assessment of the collateral underlying the mortgages, the General Partner determined that it was appropriate to begin recognizing interest income at least to the level of insurance provided by HUD. To the extent the borrower remits interest in excess of the HUD insured amount, this excess amount is recognized as income on the cash basis. Interest and other income decreased during 1993 as compared to 1992 primarily due to a reduction in funds available for short-term investment and a reduction in short-term interest rates. In 1992, the Partnership had proceeds from a December 1991 mortgage disposition approximating $3 million which were invested in short-term investments pending the acquisition of two Acquired Insured Mortgages during the first quarter of 1992. General and administrative expenses decreased for 1993 as compared to 1992 due primarily to reductions in payroll reimbursements and nonrecurring professional fees incurred in 1992, in connection with the mortgages with performance problems, as discussed below. Also contributing to the decrease in general and administrative expenses was a reduction in quarterly and annual reporting expense resulting from reduced mailing costs. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following is a discussion of the types of Insured Mortgages, along with the risks related to each type of investment: Fully Insured Originated Insured Mortgages and Acquired Insured Mortgages ------------------------------------------------------- The former managing general partner, on behalf of the Partnership, had invested in eight fully insured Originated Insured Mortgages with an aggregate carrying value of $69,539,851 and $69,888,943 as of December 31, 1993 and 1992, respectively, and an aggregate face value of $66,934,689 and $67,240,257 as of December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, the Partnership had invested in two fully insured Acquired Insured Mortgages with an aggregate carrying value of $3,012,158 and $3,026,972, respectively, and an aggregate face value of $3,034,084 and $3,049,283, respectively. As of December 31, 1993, all of the fully insured Originated Insured Mortgages and Acquired Insured Mortgages are current with respect to the payment of principal and interest. In connection with Originated Insured Mortgages, the Partnership has sought, in addition to base interest pay- ments, additional interest (commonly termed Participations) based on a percentage of the net cash flow from the develop- ment and of the net proceeds from the refinancing, sale or other disposition of the underlying development. All eight of the Originated Insured Mortgages made by the Partnership contain such Participations. During the years ended December 31, 1993, 1992 and 1991, the Partnership received additional interest of $113,822, $104,350 and $52,816, respectively, from the Participations. These amounts are included in mortgage investment income in the accompanying statements of operations. In the case of fully insured Originated Insured Mortgages and Acquired Insured Mortgages, the Partnership's maximum exposure for purposes of determining loan losses would generally be approximately 1% of the unpaid principal balance of the Originated Insured Mortgage or Acquired Insured Mortgage (an assignment fee charged by FHA) at the date of a default, plus the unamortized balance of acquisi- tion fees and closing costs paid in connection with the acquisition of the Insured Mortgages and the loss of approximately 30-days accrued interest. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Coinsured Mortgages ------------------- Under the HUD coinsurance program, both HUD and the coinsurance lender are responsible for paying a portion of the insurance benefits if a mortgagor defaults and the sale of the development collateralizing the mortgage produces insufficient net proceeds to repay the mortgage obligation. In such case, the coinsurance lender will be liable to the Partnership for the first part of such loss in an amount up to 5% of the outstanding principal balance of the mortgage as of the date foreclosure proceedings are instituted or the deed is acquired in lieu of foreclosure. For any loss greater than 5% of the outstanding principal balance, the responsibility for paying the insurance benefits will be borne on a pro-rata basis, 85% by HUD and 15% by the coinsurance lender. While the Partnership is due payment of all amounts owed under the mortgage, the coinsurance lender is responsible for the timely payment of principal and interest to the Partnership. The coinsurance lender is prohibited from entering into any workout arrangement with the borrower without the Partnership's consent and must file a claim for coinsurance benefits with HUD, upon default, if the Partnership so directs. As an ongoing HUD-approved coinsurance lender, and under the terms of the participation documents, the coinsurance lender is required to satisfy minimum net worth requirements as set forth by HUD. However, it is possible that the coinsurance lender's potential liability for loss on these developments, and others, could exceed its HUD-required minimum net worth. In such case, the Partnership would bear the risk of loss if the coinsurance lenders were unable to meet their coinsurance obligations. In addition, HUD's obligation for the payment of its share of the loss could be diminished under certain conditions, such as the lender not adequately pursuing regulatory violations of the borrower or the failure to comply with other terms of the mortgage. However, the General Partner is not aware of any conditions or actions that would result in HUD diminishing its insurance coverage. 1. Coinsured by third parties -------------------------- As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in eight and nine coinsured mortgages respectively, five of which are coinsured by an unaffiliated third party coinsurance lender under the HUD coinsurance program. Two of the coinsured mortgages which are coinsured by an unaffiliated third party are classified as Mortgages Held for Disposition as of December 31, 1993 and are discussed below. The remaining three coinsured mortgages which are coinsured by unaffiliated third parties are current with respect to the payment of principal and interest and are classified as investment in mortgages as of December 31, 1993 and 1992. As of December 31, 1993 and 1992, these three coinsured mortgages had an aggregate carrying value of $22,680,052 and $22,792,326, respectively, and an aggregate face value of $21,945,884 and $22,047,027 respectively. The following is a discussion of actual and potential performance problems with respect to certain mortgage investments coinsured by an unaffiliated third party: The Originated Insured Mortgage on The Villas, a 405-unit apartment complex located in Lauderhill, Florida, is coinsured by the Patrician Mortgage Company PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (Patrician) and had a carrying value equal to its face value of $15,856,842 and $15,878,027 as of December 31, 1993 and 1992, respectively. Since August 1, 1990, the mortgagor has not made the full monthly payments of principal and interest to Patrician. Patrician began collecting rents from the project and continued to make the monthly debt service payments to the Partnership through February 1992. The Partnership and Patrician entered into a modification agreement which provided for reduced payments through July 1992, regular scheduled payments from August 1992 to December 1992, and then increased payments for a period lasting approximately 10 years. The mortgagor of the mortgage on The Villas was unable to comply with the terms of the modification. As a result, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of The Villas filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. As of March 4, 1994, Patrician had made payments of principal and interest due through November 1993. The mortgagor of The Villas mortgage is also the mortgagor of the Originated Insured Mortgage on St. Charles Place-Phase II, a 156-unit apartment complex located in Miramar, Florida, which is also coinsured by Patrician. The St. Charles Place-Phase II mortgage had a carrying value and a face value of $3,098,630 and $3,107,542 as of December 31, 1993 and December 31, 1992, respectively. These amounts represent the Partnership's approximately 45% ownership interest in the mortgage. The remaining 55% ownership interest is held by AIM 88, an affiliated entity. During 1993, the mortgagor of St. Charles Place-Phase II paid its monthly principal and interest payments to Patrician in arrears, and did not make the monthly payment of principal and interest due to Patrician for the period of October 1993 through December 1993. However, Patrician has remitted monthly payments of principal and interest due for these months to the Partnership. As the mortgagor was unable to bring the loan current, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of the mortgage on St. Charles Place-Phase II filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. The General Partner is overseeing Patrician's efforts to complete the foreclosure action, including the subsequent acquisition and disposition of the above two properties. As the coinsurance lender, Patrician is liable to the Partnership for the outstanding principal balance of both mortgages plus all accrued but unpaid interest through the date of such payment. If the sale of the properties collateralizing the mortgages produces insufficient net proceeds to repay the mortgage obligations to the Partnership, Patrician will be liable to the Partnership for the coinsurance lender's share of the deficiency. Based on the General Partner's assessment of the collateral underlying the mortgages, including information related to the PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued financial condition of Patrician, the General Partner believes the carrying value of these assets is realizable. As a result of Patrician's coinsurance obligation these mortgages were classified as Mortgages Held for Disposition as of December 31, 1993. The Partnership intends to reinvest any net disposition proceeds from these mortgages in Acquired Insured Mortgages. The General Partner intends to continue to oversee the Partnership's interest in these mortgages to ensure that Patrician meets its coinsurance obligations. The General Partner's assessment of the realizability of The Villas and St. Charles Place-Phase II mortgages is based on current information, and to the extent current conditions change or additional information becomes available, then the General Partner's assessment may change. However, the General Partner does not believe that there would be a material adverse impact on the Partnership's financial condition or its results of operations should Patrician be unable to comply with its full coinsurance obligation. 2. Coinsured by affiliate ---------------------- a. The former managing general partner, on behalf of the Partnership, had invested in coinsured originated mortgages where the coinsurance lender is IFI. As of December 31, 1993 and 1992, the Partnership had investments remaining in three and four coinsured originated mortgages, respectively, where the coinsurance lender is IFI. As structured by the former managing general partner, with respect to these mortgages, the Partnership bears the risk of loss upon default for IFI's portion of the coinsurance loss. As of December 31, 1993 and 1992, one and two of these mortgages, respectively, were classified as AHFS and are discussed below. As of December 31, 1993, the remaining two IFI coinsured mortgages, as shown in the table below, are classified as investment in mortgages and are current with respect to the payment of principal and interest. The General Partner believes there is adequate collateral value underlying the mortgages. Therefore, no loan losses were recognized on these mortgages during the years ended December 31, 1993, 1992 and 1991. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued b. Assets Held for Sale Under Coinsurance Program As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in one and two coinsured mortgages which are accounted for as AHFS, respectively. The coinsurer on these mortgages is IFI and the Partnership bears the risk of any coinsurance loss. Coinsured mortgage loans are deemed to be AHFS when a determination has been made that the borrower meets the following criteria: 1. The borrower has little or no equity in the collateral, considering the current fair value of the collateral; and 2. proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral; and 3. the borrower has either: a. formally or effectively abandoned control of the collateral to the creditor; or, b. retained control of the collateral, but because of the current financial condition of the borrower or the economic prospects for the borrower and/or the collateral in the foreseeable future, it is doubtful that the borrower will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. AHFS represent the estimated cash flow to be received from any claims filed with HUD, including the estimated asset disposition proceeds. The disposition proceeds are based on the estimated fair value of the collateral underlying the mortgage which represents the amount that could reasonably be expected to be received in a current sale between a willing buyer and a willing seller. The General Partner initially determined the estimated fair values of the AHFS and the General Partner periodically assesses the estimated current fair value of the properties to determine whether additional loan losses are appropriate due to, among other factors, a change in market conditions affecting the properties. The loan losses related to these AHFS reduce the carrying value of the Originated Insured Mortgages. On the AHFS determination date for the applicable mortgages and through December 31, 1993, the Partnership discontinued accruing interest income in accordance with the original terms of the mortgage. For the years ended December 31, 1992 and 1991, the Partnership recognized $1,170,700 and $572,572, respectively, as interest income and received $2,794,186 and $1,461,309, respectively, representing the borrowers interest payments on the mortgages which were applied to reduce the outstanding basis in the mortgage investment. Beginning on January 1, 1993, the Partnership began to recognize mortgage investment income for the mortgages classified as AHFS in the amount coinsured by HUD. Given the improved financial performance of the borrowers and the General Partner's assessment of the collateral underlying the mortgages, the General Partner determined that it was appropriate to begin recognizing interest income at least to the level of insurance provided by HUD. To the extent the borrower remits interest in excess of the HUD insured amount, this excess amount is recognized as income on the cash basis. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued During 1993, the Partnership recognized $2,898,882 in interest income. Cash totalling $639,756 was received from mortgages classified as AHFS. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following table summarizes the coinsured mortgages accounted for as AHFS as of December 31, 1993 and 1992, respectively: PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following is a discussion of performance problems with respect to those mortgage investments accounted for as AHFS: 1. In December 1993, the General Partner entered into a Modification Agreement with the mortgagor of the mortgage on One East Delaware wherein the mortgagor had until April 30, 1994 to pay off the mortgage at a discount. The mortgagor prepaid the loan in January 1994. Total proceeds received were approximately $33.6 million, which resulted in a financial statement gain of approximately $1.2 million which was recognized in 1994. The Partnership intends to reinvest the net disposition proceeds from this mortgage in Acquired Insured Mortgages. 2. In December 1993, the Partnership settled, for approximately $9,050,000, the mortgage on Victoria Pointe Apartments-Phase II. As of December 31, 1993, the Partnership recognized a loan loss amounting to $63,488 which is reflected in the accompanying statement of operations for the year ended December 31, 1993. As of December 31, 1993, the Partnership had committed to reinvest the net disposition proceeds in Acquired Insured Mortgages. 1992 versus 1991 ---------------- Net earnings for 1992 increased compared to 1991 primarily due to the recognition of loan losses of approximately $4.9 million in 1991 as a result of the General Partner's evaluation of certain coinsured mortgages considered AHFS. This increase was partially offset by a decrease in mortgage investment income during 1992, as discussed below. Mortgage investment income decreased for 1992 as compared to 1991 primarily due to the discontinuance of the accrual of mortgage interest income for the two coinsured mortgages classified as AHFS, partially offset by income from accreting the discount on these two mortgages. Also contributing to the reduction in mortgage investment income was temporarily reduced interest payments from the mortgage on The Villas resulting from a modification agreement. The decrease in mortgage investment income was partially offset by the mortgage investment income recognized on the two Acquired Insured Mortgages which the Partnership purchased in January and March 1992. The Asset Management Fee decreased during 1992 compared to 1991 primarily as a result of a reduction in the Asset Management Fee percentage, effective October 1, 1991. At a special meeting held on September 4, 1991, the limited partners and Unitholders consented to, among other items, a reduction in the Asset Management Fee payable by the Partnership to the Advisor from the previous level of 1.25% to .95%, effective October 1, 1991 through December 31, 1991, and a reduction in the Asset Management Fee payable from January 1, 1992 through December 31, 1996 from the previous level of 1.00% to .95%. As provided for in the Partnership Agreement, the annual Asset Management Fee will be reduced from the previous level of .95% to .75% as of January 1, 1997 and will remain at that level thereafter. The limited partners and Unitholders also consented to the elimination of the subordinated fees. General and administrative expenses increased during 1992 as compared to 1991 primarily as a result of an increase in payroll expense and professional fees incurred in connection with the property issues, as previously discussed, partially offset by a reduction in investor services expenses. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Fair Value of Financial Instruments ----------------------------------- The following estimated fair values of the Partnership's financial instruments are presented in accordance with generally accepted accounting principles which define fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. These estimated fair values, however, do not represent the liquidation value or the market value of the Partnership. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages and mortgages held for disposition ---------------------------------------------------------- The fair value of the fully insured mortgages is based on the average of the quoted market prices from three investment banking institutions which trade these investments as part of their day-to-day activities. In order to determine the fair value of the coinsured mortgage portfolio, the Partnership valued the coinsured mortgages as though they were fully insured (in the same manner fully insured mortgages were valued). From this amount, the Partnership deducted five percent of the face value of the loan and fifteen percent of the difference between the remaining face value and the value of these loans as though they were uninsured. These deductions are based on HUD's coinsurance limitations. The uninsured values were based on the average of the quoted market prices from two investment banking institutions which trade these types of investments as part of their day-to-day activities. Liquidity and Capital Resources ------------------------------- The Partnership's operating cash receipts, derived from payments of principal and interest on Insured Mortgages, plus cash receipts from interest on short-term investments, were sufficient during 1993 to meet operating requirements. The basis for paying distributions to Unitholders is cash flow from operations, which is comprised of regular interest income and principal from Insured Mortgages and gain, if any, from mortgage dispositions. Although Insured Mortgages yield a fixed monthly mortgage payment once purchased, the cash distributions paid to the Unitholders will vary during each quarter due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly distributions, (2) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow attributable to the delinquency or default of Insured Mortgages and professional fees and foreclosure and acquisition costs incurred in connection with those Insured Mortgages and (4) variations in the Partnership's operating expenses. If necessary, the Partnership has the right to establish reserves either from the Net Proceeds of the Offering or from Cash Flow (as defined in the Partnership Agreement). It should be noted, however, that the Partnership also has the right to reinvest the Proceeds of Mortgage Prepayments, Sales and Insurance in Acquired Insured Mortgages through December 31, 1994 and generally intends to distribute substantially all of its Cash Flow from operations. If any reserves are deemed to be necessary by the Partnership, they will be invested in short-term, interest-bearing investments. The Partnership anticipates that reserves generally would only be necessary in the event the Partnership elected to foreclose on an Originated Insured Mortgage insured by FHA and take over the operations of the underlying development. In such case, there may be a need for additional capital. Since foreclosure proceedings can be expensive and time-consuming, the Partnership expects that it will generally assign the fully insured Originated Insured Mortgages to HUD for insurance proceeds rather than foreclose. In the case of an Originated Insured Mortgage insured under the HUD coinsurance program, the likelihood of foreclosure (and the potential need for reserves) exists since these coinsured mortgages generally cannot be PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued assigned to HUD and the coinsurance lender would be required to acquire title to the property and hold the property for 12 months or until an earlier sale in order to realize the benefit of HUD insurance. The determination of whether to assign the mortgage to HUD or institute foreclosure procedures or whether to set aside any reserves will be made on a case-by-case basis by the General Partner, the Advisor and the Sub-advisor. As of December 31, 1993 and 1992, the Partnership had not set aside any reserves. Cash flow - 1993 versus 1992 ---------------------------- Net cash provided by operating activities decreased during 1993 as compared to 1992 principally due to mortgage investment income accrued for mortgages classified as AHFS. Also contributing to the decrease was an increase in receivables and other assets in 1993 due to the balance of disposition proceeds, received in January 1994, from the disposition of the mortgage on Victoria Pointe Apartments-Phase II. Net cash provided by investing activities increased in 1993 as compared to 1992 principally due to disposition proceeds received in 1993 of approximately $9.0 million from the mortgage on Victoria Pointe Apartments-Phase II, partially offset by the acquisition in 1992 of two Acquired Insured Mortgages of approximately $3.0 million. Net cash used in financing activities decreased during 1993 compared to 1992 as a result of a decrease in 1993 distributions to Unitholders as compared to 1992 distributions. This decrease in distributions to Unitholders was due, in part, to the delinquencies and subsequent cessation of the receipt of principal and interest from the mortgage on One East Delaware and the delinquency of the monthly payments by the mortgagor of the mortgages on The Villas and St. Charles Place-Phase II. Cash flow - 1992 versus 1991 ---------------------------- Net cash provided by operating activities decreased in 1992 as compared to 1991 principally due to a decrease in mortgage investment income, partially offset by a net decrease in expenses, as previously discussed. This decrease was partially offset by payments received from the AHFS mortgages, principally One East Delaware, during 1992 and the payment of the Accrued Fees, as discussed below, in 1991. Net cash used in investing activities increased in 1992 as compared to 1991 principally due to the acquisition in 1992 of two Acquired Insured Mortgages. Net cash used in financing activities decreased during 1992 as compared to 1991 as a result of the decrease in distributions paid to investors. This decrease was primarily the result of the one to two month delay of monthly payments by the mortgagor of the mortgage on One East Delaware and the modification agreement entered into in May 1992 with the mortgagor on The Villas mortgage which provided for a temporary reduction in the monthly principal and interest payments during 1992. In addition, the distributions for 1992 decreased from 1991 as a result of the default by the mortgagor of the Victoria Pointe Apartments-Phase II mortgage in 1991. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), effective for fiscal years beginning after December 15, 1993. This statement requires that investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. The General Partner believes that the majority of securities held by the Partnership will fall into either the Held to Maturity or Available for Sale categories. However, the General Partner has not yet determined the ultimate impact of the implementation of this statement in the Partnership's financial statements. Also in May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114 "Accounting by Creditors for Impairment of a Loan" (SFAS 114), effective for fiscal years beginning after December 15, 1994. This statement requires that applicable loans which are impaired be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's market price, or the fair value of the collateral for impaired loans that are collateral dependent. The General Partner does not believe the ultimate impact of the implementation of this statement will materially affect the Partnership's financial statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is contained in Part IV. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a),(b),(c),(e) The Partnership has no officers or directors. The affairs of the Partnership are generally managed by the General Partner, which is wholly-owned by CRIIMI MAE, a company whose shares are listed on the New York Stock Exchange. CRIIMI MAE is managed by an adviser whose general partner is CRI. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (IFI) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and directs the acquisition and disposition of the Partnership's mortgages. The General Partner is also the general partner of AIM 84, AIM 85 and AIM 88, limited partnerships with investment objectives similar to those of the Partnership. (d) There is no family relationship between any of the officers and directors of the General Partner. (f) Involvement in certain legal proceedings. None. (g) Promoters and control persons. Not applicable. (h) Based solely on its review of Forms 3 and 4 and amendments thereto furnished to the Partnership, and written representations from certain reporting persons that no Form 5s were required for those persons, the Partnership believes that all reporting persons have filed on a timely basis Forms 3, 4 and 5 as required in the fiscal year ended December 31, 1993. PART III ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to Note 7 of the notes to the financial statements of the Partnership contained in Part IV. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT As of December 31, 1993, no person was known by the Partner- ship to be the beneficial owner of more than five percent (5%) of the outstanding Units of the Partnership. As of December 31, 1993, neither the officers and directors, as a group, of the General Partner nor any individual director of the General Partner, are known to own more than 1% of the out- standing Units of the Partnership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. Note 7 of the notes to the Partnership's financial statements contained in Part IV of this report which contains a discussion of the amounts, fees and other compensation paid or accrued by the Partnership to the directors and executive officers of the General Partner and their affiliates, is incorporated herein by reference. (b) Certain business relationships. Other than as set forth in Item 11 of this report which is incorporated herein by reference, the Partnership has no business relationship with entities of which the former general partners or the current General Partner of the Partnership are officers, directors or equity owners. (c) Indebtedness of management. None. (d) Transactions with promoters. Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements: See Item 8. "Financial Statements and Supplementary Data." (a)(2) Financial Statement Schedules: XII - Mortgage Loans on Real Estate All other schedules have been omitted because they are inapplicable, not required, or the information is included in the Financial Statements or Notes thereto. (a)(3) Exhibits: 3. Amended and Restated Certificate of Limited Partnership is incorporated by reference to Exhibit 4(a) to Amendment No. 1 to the Partnership's Registration Statement on Form S-11 (No. 33-1735) dated March 6, 1986 (such Registration Statement, as amended, is referred to herein as the "Amended Registration Statement"). 4. Second Amended and Restated Agreement of Limited Partnership is incorporated by reference in Exhibit 3 to the Amended Registration Statement. 4.(a) Material Amendments to the Second Amended and Restated Agreement of Limited Partnership are incorporated by reference to Exhibit 4(a) to the Annual Report on Form 10-K for the year ended December 31, 1987. 4.(b) Amendment to the Second Amended and Restated Agreement of Limited Partnership of the Partnership dated February 12, 1990, incorporated by reference to Exhibit 4(b) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1989. 10.(a) Escrow Agreement is incorporated by reference to Exhibit 10(a) to the Amended Registration Statement. 10.(b) Origination and Acquisition Services Agreement is incorporated by reference to Exhibit 10(b) to the Amended Registration Statement. 10.(c) Management Services Agreement is incorporated by reference to Exhibit 10(c) to the Amended Registration Statement. 10.(d) Disposition Services Agreement is incorporated by reference to Exhibit 10(d) to the Amended Registration Statement. 10.(e) Agreement among the former managing general partner, the former associate general partner and Integrated Resources, Inc. is incorporated by reference to Exhibit 10(e) to the Amended Registration Statement. 10.(f) Reinvestment Plan is incorporated by reference to the Prospectus contained in the Amended Registration Statement. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - Continued 10.(g) Mortgagor-Participant Agreement regarding the One East Delaware Originated Insured Mortgage is incorporated by reference to Exhibit 10(g) to the Annual Report on Form 10-K for the year ended December 31, 1987. 10.(h) Mortgage, Assignment of Rents and Security Agreements regarding One East Delaware Originated Insured Mortgage is incorporated by reference to Exhibit 10(h) to the Annual Report on Form 10-K for the year ended December 31, 1987. 28. Pages A-1 - A-5 of the Partnership Agreement of Registrant. 28.(a) Purchase Agreement among AIM Acquisition, the former managing general partner, the former corporate general partner, IFI and Integrated dated as of December 13, 1990, as amended January 9, 1991. 28.(b) Purchase Agreement among CRIIMI, Inc., AIM Acquisition, the former managing general partner, the former corporate general partner, IFI and Integrated dated as of December 13, 1990 and executed as of March 1, 1991. 28.(c) Amendment to Partnership Agreement dated September 4, 1991. Incorporated by reference to Exhibit 28.(a), above. 28.(d) Non-negotiable promissory note to American Insured Investors - Series 85, L.P. in the amount of $1,737,722 dated December 31, 1991. 28.(e) Sub-Management Agreement by and between AIM Acquisition and CRI/AIM Management, Inc., dated as of March 1, 1991. 28.(f) Expenses Reimbursement Agreement by Integrated Funding Inc. and the AIM Funds, effective December 31, 1992. (b) Reports on Form 8-K filed during the last quarter of the fiscal year: None. All other items are not applicable. 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. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 (Registrant) By: CRIIMI, Inc. General Partner March 16, 1994 /s/H. William Willoughby --------------------------- ------------------------- DATE H. William Willoughby President and Principal Financial Officer and Board Member March 16, 1994 /s/William B. Dockser --------------------------- ----------------------- DATE William B. Dockser Chairman of the Board and Principal Executive Officer March 15, 1994 /s/Garrett G. Carlson, Sr. --------------------------- ------------------------- DATE Garrett G. Carlson, Sr. Director March 10, 1994 /s/G. Richard Dunnells --------------------------- ------------------------- DATE G. Richard Dunnells Director March 10, 1994 /s/Robert F. Tardio --------------------------- ------------------------- DATE Robert F. Tardio Director AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 Financial Statements as of December 31, 1993 and 1992 and for the Years Ended December 31, 1993, 1992 and 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of American Insured Mortgage Investors L.P. - Series 86: We have audited the accompanying balance sheets of American Insured Mortgage Investors L.P. - Series 86 (the Partnership) as of December 31, 1993 and 1992, and the related statements of operations, changes in partners' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. These financial statements and the schedule referred to below are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Partnership as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the years ended December 31, 1993, 1992 and 1991, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule XII-Mortgage Loans on Real Estate as of December 31, 1993 is presented for purposes of complying with the Securities and Exchange Commission's rules and regulations and is not a required part of the basic financial statements. The information in this schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. Washington, D.C. Arthur Andersen & Co. March 4, 1994 AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 BALANCE SHEETS ASSETS As of December 31, 1993 1992 ------------ ------------ Investment in mortgages: Originated insured mortgages $108,995,765 $128,470,730 Acquired insured mortgages 3,034,084 3,049,283 ------------ ------------ 112,029,849 131,520,013 Plus: unamortized premium, net of unamortized discount 4,056,467 4,122,136 ------------ ------------ 116,086,316 135,642,149 Assets held for sale under coinsurance program 32,103,528 38,110,016 Mortgages held for disposition, at lower of cost or market 18,955,472 -- Cash and cash equivalents 9,095,255 2,557,009 Investment in affiliate 1,730,087 1,730,910 Receivables and other assets 2,805,604 1,105,832 ------------ ------------ Total assets $180,776,262 $179,145,916 ============ ============ LIABILITIES AND PARTNERS' EQUITY Distributions payable $ 2,819,518 $ 3,222,311 Note payable to affiliate 1,737,723 1,730,910 Accounts payable and accrued expenses 212,428 185,706 ------------ ------------ Total liabilities 4,769,669 5,138,927 ------------ ------------ Partners' equity: Limited partners' equity 176,783,204 174,881,580 General partner's deficit (776,611) (874,591) ------------ ------------ Total partners' equity 176,006,593 174,006,989 ------------ ------------ Total liabilities and partners' equity $180,776,262 $179,145,916 ============ ============ The accompanying notes are an integral part of these financial statements. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION American Insured Mortgage Investors L.P. - Series 86 (the Partnership) was formed under the Uniform Limited Partnership Act of the state of Delaware on October 31, 1985. From inception through September 6, 1991, AIM Capital Management Corp. served as the managing general partner (with a partnership interest of 4.8%), IRI Properties Capital Corp. served as corporate general partner (with a partnership interest of 0.1%) and Second Group Partners, an affiliate of the former general partners, served as the associate general partner (with a partnership interest of 0.1%). All of the foregoing general partners are sometimes collectively referred to as former general partners. At a special meeting of the limited partners and Unitholders of the Partnership held on September 4, 1991, a majority of these interests approved, among other items, assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (IFI) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and directs the acquisition and disposition of the Partnership's mortgages. Until the change in the Partnership's investment policy, as discussed below, the Partnership was in the business of originating mortgage loans (Originated Insured Mortgages) and acquiring mortgage loans (Acquired Insured Mortgages, and together with Originated Insured Mortgages, referred to herein as Insured Mortgages). As of December 31, 1993, the Partnership had invested in either Originated Insured Mortgages which are insured or guaranteed, in whole or in part, by the Federal Housing Administration (FHA) or Acquired Insured Mortgages which are fully insured (as more fully described below). The Partnership's reinvestment period expires on December 31, 1994 and the Partnership Agreement states that the Partnership will terminate on December 31, 2020, unless previously terminated under the provisions of the Partnership Agreement. The Partnership's principal investment objectives are to invest in Insured Mortgages which (i) preserve and protect the Partnership's invested capital; (ii) provide quarterly distributions of adjusted cash from operations which may be increased over time as a result of Participations (as defined AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION - Continued below), when obtainable, on Originated Insured Mortgages; and (iii) provide appreciation by selecting Acquired Insured Mortgages which present the possibility of early prepayment. Effective September 19, 1991, the General Partner changed, at the Advisor's recommendation, the investment policies of the Partnership to invest only in Acquired Insured Mortgages which are fully insured or guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association (GNMA), FHA or the Federal Home Loan Mortgage Corporation. The United States Congress recently repealed portions of the Federal tax code which have had an adverse impact on tax-exempt investors in "publicly traded partnerships." This tax code change, effective January 1, 1994, cleared away the major impediment standing in the way of listing the Partnership's Units for trading on a national stock exchange. As a result, the General Partner listed the Partnership's Units for trading on the American Stock Exchange (AMEX) on January 18, 1994 in order to provide investment liquidity as contemplated in the Partnership's original prospectus. The Units are traded under the symbol "AIJ." 2. SIGNIFICANT ACCOUNTING POLICIES Method of Accounting -------------------- The financial statements are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Investment in Mortgages ----------------------- As of December 31, 1993 and 1992, the Partnership accounted for its investment in mortgages at amortized cost. The difference between the cost and the unpaid principal balance at the time of purchase is carried as a discount or premium and amortized over the remaining contractual term of the mortgage using the effective interest method. The effective interest method provides a constant yield of income over the term of the mortgage. Mortgage investment income is comprised of amortization of the discount plus the stated mortgage interest received or accrued less the amortization of the premium. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), effective for fiscal years beginning after December 15, 1993. This statement requires that investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. The General Partner believes that the majority of securities held by the Partnership will fall into either the Held to Maturity or Available for Sale categories. However, the General Partner has not yet determined the ultimate impact of the implementation of this statement in the Partnership's financial statements. Also in May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114 "Accounting by Creditors for Impairment of a Loan" (SFAS 114), effective for fiscal years beginning after December 15, 1994. This statement requires that applicable loans which are impaired be measured based on the present value of expected future cash flows discounted at the loan's AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 2. SIGNIFICANT ACCOUNTING POLICIES - Continued effective interest rate, or at the loan's market price, or the fair value of the collateral for impaired loans that are collateral dependent. The General Partner does not believe the ultimate impact of the implementation of this statement will materially affect the Partnership's financial statements. Mortgages Held for Disposition ------------------------------ At any point in time, the Partnership may be aware of certain mortgages which have been (i) assigned to the United States Department of Housing and Urban Development (HUD) or (ii) for which the servicer has received proceeds from a prepayment or (iii) in the case of mortgages coinsured by unaffiliated third parties, the borrower is displaying continuous operating difficulties and the realization of the mortgage is dependent on a third party coinsurer (see Notes 4 B.1). In these cases, the Partnership will classify these mortgages as Mortgages Held for Disposition. Gains from dispositions of mortgages are recognized upon the receipt of cash or HUD debentures. Losses on dispositions of mortgages are recognized when it becomes probable that a mortgage will be disposed of and that the disposition will result in a loss. In the case of Insured Mortgages fully insured by HUD, the Partnership's maximum exposure for purposes of determining the loan losses would generally be an assignment fee charged by HUD repre- senting approximately 1% of the unpaid principal balance of the Insured Mortgage at the date of default, plus the unamortized balance of acquisition fees and closing costs paid in connection with the acquisition of the Insured Mortgage and the loss of approximately 30-days accrued interest (see discussion below for losses on mortgages accounted for as AHFS, as defined below). Assets Held for Sale Under Coinsurance Program (AHFS) ----------------------------------------------------- As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in one and two coinsured mortgages which are accounted for as AHFS, respectively. The coinsurer on these mortgages is IFI and the Partnership bears the risk of any coinsurance loss. Coinsured mortgage loans are deemed to be AHFS when a determination has been made that the borrower meets the following criteria: 1. The borrower has little or no equity in the collateral, considering the current fair value of the collateral; and 2. proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral; and 3. the borrower has either: a. formally or effectively abandoned control of the collateral to the creditor; or, b. retained control of the collateral, but because of the current financial condition of the borrower or the economic prospects for the borrower and/or the collateral in the foreseeable future, it is doubtful that the borrower will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. AHFS represent the estimated cash flow to be received from any claims filed with HUD, including the estimated asset disposition proceeds. The disposition proceeds are based on the estimated fair value of the collateral underlying the mortgage which represents the amount that AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 2. SIGNIFICANT ACCOUNTING POLICIES - Continued could reasonably be expected to be received in a current sale between a willing buyer and a willing seller. The General Partner initially determined the estimated fair values of the AHFS and the General Partner periodically assesses the estimated current fair value of the properties to determine whether additional loan losses are appropriate due to, among other factors, a change in market conditions affecting the properties. The loan losses related to these AHFS reduce the carrying value of the Originated Insured Mortgages. The Partnership accounts for the AHFS at the lower of cost or market since its intent is to dispose of the assets in the short term and file coinsurance claims with HUD. Cash and Cash Equivalents ------------------------- Cash and cash equivalents consist of time and demand deposits and commercial paper with original maturities of three months or less. Reclassification ---------------- Certain amounts in the statements of operations for the year ended December 31, 1992 have been reclassified to conform with the 1993 presentation. Income Taxes ------------ No provision has been made for Federal, state or local income taxes since they are the personal responsibility of the Unitholders. Net Earnings Per Limited Partnership Unit ----------------------------------------- Net earnings per Limited Partnership Unit are computed based upon the weighted average number of Units outstanding of 9,576,290 for each of the years ended December 31, 1993, 1992 and 1991. 3. FAIR VALUE OF FINANCIAL INSTRUMENTS The following estimated fair values of the Partnership's financial instruments are presented in accordance with generally accepted accounting principles which define fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. These estimated fair values, however, do not represent the liquidation value or the market value of the Partnership. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 3. FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 3. FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages and mortgages held for disposition ---------------------------------------------------------- The fair value of the fully insured mortgages is based on the average of the quoted market prices from three investment banking institutions which trade these investments as part of their day-to-day activities. In order to determine the fair value of the coinsured mortgage portfolio, the Partnership valued the coinsured mortgages as though they were fully insured (in the same manner fully insured mortgages were valued). From this amount, the Partnership deducted five percent of the face value of the loan and fifteen percent of the difference between the remaining face value and the value of these loans as though they were uninsured. These deductions are based on HUD's coinsurance limitations. The uninsured values were based on the average of the quoted market prices from two investment banking institutions which trade these types of investments as part of their day-to-day activities. Cash and cash equivalents and accrued interest receivable --------------------------------------------------------- The carrying amount approximates fair value because of the short maturity of these instruments. 4. INVESTMENT IN MORTGAGES The following is a discussion of the types of Insured Mortgages, along with the risks related to each type of investment: A. Fully Insured Originated Insured Mortgages and Acquired Insured Mortgages ---------------------------------------------- The former managing general partner, on behalf of the Partnership, had invested in eight fully insured Originated Insured Mortgages with an aggregate carrying value of $69,539,851 and $69,888,943 as of December 31, 1993 and 1992, respectively, and an aggregate face value of $66,934,689 and $67,240,257 as of December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, the Partnership had invested in two fully insured Acquired Insured Mortgages with an aggregate carrying value of $3,012,158 and $3,026,972, respectively, and an aggregate face value of $3,034,084 and $3,049,283, respectively. As of December 31, 1993, all of the fully insured Originated Insured Mortgages and Acquired Insured Mortgages are current with respect to the payment of principal and interest. In connection with Originated Insured Mortgages, the Partnership has sought, in addition to base interest pay- ments, additional interest (commonly termed Participations) based on a percentage of the net cash flow from the develop- ment and of the net proceeds from the refinancing, sale or other disposition of the underlying development. All eight of the Originated Insured Mortgages made by the Partnership contain such Participations. During the years ended December 31, 1993, 1992 and 1991, the Partnership received additional interest of $113,822, $104,350 and $52,816, respectively, from the Participations. These amounts are included in mortgage investment income in the accompanying statements of operations. In the case of fully insured Originated Insured Mortgages and Acquired Insured Mortgages, the Partnership's maximum exposure for purposes of determining loan losses would generally be approximately 1% of the unpaid principal balance of the Originated Insured Mortgage or Acquired Insured Mortgage (an assignment fee charged by FHA) at the AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued date of a default, plus the unamortized balance of acquisi- tion fees and closing costs paid in connection with the acquisition of the Insured Mortgages and the loss of approximately 30-days accrued interest. B. Coinsured Mortgages ------------------- Under the HUD coinsurance program, both HUD and the coinsurance lender are responsible for paying a portion of the insurance benefits if a mortgagor defaults and the sale of the development collateralizing the mortgage produces insufficient net proceeds to repay the mortgage obligation. In such case, the coinsurance lender will be liable to the Partnership for the first part of such loss in an amount up to 5% of the outstanding principal balance of the mortgage as of the date foreclosure proceedings are instituted or the deed is acquired in lieu of foreclosure. For any loss greater than 5% of the outstanding principal balance, the responsibility for paying the insurance benefits will be borne on a pro-rata basis, 85% by HUD and 15% by the coinsurance lender. While the Partnership is due payment of all amounts owed under the mortgage, the coinsurance lender is responsible for the timely payment of principal and interest to the Partnership. The coinsurance lender is prohibited from entering into any workout arrangement with the borrower without the Partnership's consent and must file a claim for coinsurance benefits with HUD, upon default, if the Partnership so directs. As an ongoing HUD-approved coinsurance lender, and under the terms of the participation documents, the coinsurance lender is required to satisfy minimum net worth requirements as set forth by HUD. However, it is possible that the coinsurance lender's potential liability for loss on these developments, and others, could exceed its HUD-required minimum net worth. In such case, the Partnership would bear the risk of loss if the coinsurance lenders were unable to meet their coinsurance obligations. In addition, HUD's obligation for the payment of its share of the loss could be diminished under certain conditions, such as the lender not adequately pursuing regulatory violations of the borrower or the failure to comply with other terms of the mortgage. However, the General Partner is not aware of any conditions or actions that would result in HUD diminishing its insurance coverage. 1. Coinsured by third parties -------------------------- As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in eight and nine coinsured mortgages, respectively, five of which are coinsured by an unaffiliated third party coinsurance lender under the HUD coinsurance program. Two of the coinsured mortgages which are coinsured by an unaffiliated third party are classified as Mortgages Held for Disposition as of December 31, 1993 and are discussed below. The remaining three coinsured mortgages which are coinsured by unaffiliated third parties are current with respect to the payment of principal and interest and are classified as investment in mortgages as of December 31, 1993 and 1992. As of December 31, 1993 and 1992, these three coinsured mortgages had an aggregate carrying value of $22,680,052 and $22,792,326, respectively, and an aggregate face value of $21,945,884 and $22,047,027, respectively. The following is a discussion of actual and potential performance problems with respect to certain mortgage investments coinsured by an unaffiliated third party: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued The Originated Insured Mortgage on The Villas, a 405-unit apartment complex located in Lauderhill, Florida, is coinsured by the Patrician Mortgage Company (Patrician) and had a carrying value equal to its face value of $15,856,842 and $15,878,027 as of December 31, 1993 and 1992, respectively. Since August 1, 1990, the mortgagor has not made the full monthly payments of principal and interest to Patrician. Patrician began collecting rents from the project and continued to make the monthly debt service payments to the Partnership through February 1992. The Partnership and Patrician entered into a modification agreement which provided for reduced payments through July 1992, regular scheduled payments from August 1992 to December 1992, and then increased payments for a period lasting approximately 10 years. The mortgagor of the mortgage on The Villas was unable to comply with the terms of the modification. As a result, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of The Villas filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. As of March 4, 1994, Patrician had made payments of principal and interest due through November 1993. The mortgagor of The Villas mortgage is also the mortgagor of the Originated Insured Mortgage on St. Charles Place-Phase II, a 156-unit apartment complex located in Miramar, Florida, which is also coinsured by Patrician. The St. Charles Place-Phase II mortgage had a carrying value and a face value of $3,098,630 and $3,107,542 as of December 31, 1993 and December 31, 1992, respectively. These amounts represent the Partnership's approximately 45% ownership interest in the mortgage. The remaining 55% ownership interest is held by American Insured Mortgage Investors L.P. - Series 88 (AIM 88), an affiliated entity. During 1993, the mortgagor of St. Charles Place-Phase II paid its monthly principal and interest payments to Patrician in arrears, and did not make the monthly payment of principal and interest due to Patrician for the period of October 1993 through December 1993. However, Patrician has remitted monthly payments of principal and interest due for these months to the Partnership. As the mortgagor was unable to bring the loan current, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of the mortgage on St. Charles Place-Phase II filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. The General Partner is overseeing Patrician's efforts to complete the foreclosure action, including the subsequent acquisition and disposition of the above two properties. As the coinsurance lender, Patrician is liable to the Partnership for the outstanding principal balance of both mortgages plus all accrued but unpaid interest through the date of such payment. If the sale of the properties collateralizing the mortgages produces insufficient net proceeds to repay the mortgage obligations to the Partnership, Patrician will be liable to the Partnership for the coinsurance lender's share of the deficiency. Based on the General AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued Partner's assessment of the collateral underlying the mortgages, including information related to the financial condition of Patrician, the General Partner believes the carrying value of these assets is realizable. As a result of Patrician's coinsurance obligation these mortgages were classified as Mortgages Held for Disposition as of December 31, 1993. The Partnership intends to reinvest any net disposition proceeds from these mortgages in Acquired Insured Mortgages. The General Partner intends to continue to oversee the Partnership's interest in these mortgages to ensure that Patrician meets its coinsurance obligations. The General Partner's assessment of the realizability of The Villas and St. Charles Place-Phase II mortgages is based on current information, and to the extent current conditions change or additional information becomes available, then the General Partner's assessment may change. However, the General Partner does not believe that there would be a material adverse impact on the Partnership's financial condition or its results of operations should Patrician be unable to comply with its full coinsurance obligation. 2. Coinsured by affiliate ---------------------- a. The former managing general partner, on behalf of the Partnership, had invested in coinsured originated mortgages where the coinsurance lender is IFI. As of December 31, 1993 and 1992, the Partnership had investments remaining in three and four coinsured originated mortgages, respectively, where the coinsurance lender is IFI. As structured by the former managing general partner, with respect to these mortgages, the Partnership bears the risk of loss upon default for IFI's portion of the coinsurance loss. As of December 31, 1993 and 1992, one and two of these mortgages, respectively, were classified as AHFS and are discussed below. As of December 31, 1993, the remaining two IFI coinsured mortgages, as shown in the table below, are classified as investment in mortgages and are current with respect to the payment of principal and interest. The General Partner believes there is adequate collateral value underlying the mortgages. Therefore, no loan losses were recognized on these mortgages during the years ended December 31, 1993, 1992 and 1991. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued b. Assets Held for Sale Under Coinsurance Program On the AHFS determination date for the applicable mortgages and through December 31, 1993, the Partnership discontinued accruing interest income in accordance with the original terms of the mortgage. For the years ended December 31, 1992 and 1991, the Partnership recognized $1,170,700 and $572,572, respectively, as interest income and received $2,794,186 and $1,461,309, respectively, representing the borrowers interest payments on the mortgages which were applied to reduce the outstanding basis in the mortgage investment. Beginning on January 1, 1993, the Partnership began to recognize mortgage investment income for the mortgages classified as AHFS in the amount coinsured by HUD. Given the improved financial performance of the borrowers and the General Partner's assessment of the collateral underlying the mortgages, the General Partner determined that it was appropriate to begin recognizing interest income at least to the level of insurance provided by HUD. To the extent the borrower remits interest in excess of the HUD insured amount, this excess amount is recognized as income on the cash basis. During 1993, the Partnership recognized $2,898,882 in interest income. Cash totalling $639,756 was received from mortgages classified as AHFS. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued The following table summarizes the coinsured mortgages accounted for as AHFS as of December 31, 1993 and 1992, respectively: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued The following is a discussion of performance problems with respect to those mortgage investments accounted for as AHFS: 1. In December 1993, the General Partner entered into a Modification Agreement with the mortgagor of the mortgage on One East Delaware wherein the mortgagor had until April 30, 1994 to pay off the mortgage at a discount. The mortgagor prepaid the loan in January 1994. Total proceeds received were approximately $33.6 million, which resulted in a financial statement gain of approximately $1.2 million which was recognized in 1994. The Partnership intends to reinvest any net disposition proceeds from this mortgage in Acquired Insured Mortgages. 2. In December 1993, the Partnership settled, for approximately $9,050,000, the mortgage on Victoria Pointe Apartments-Phase II. As of December 31, 1993, the Partnership recognized a loan loss amounting to $63,488 which is reflected in the accompanying statement of operations for the year ended December 31, 1993. As of December 31, 1993 the Partnership had committed to reinvest the net disposition proceeds in Acquired Insured Mortgages. 5. DISTRIBUTIONS TO UNITHOLDERS The composition of distributions paid or accrued to Unitholders on a per Limited Partnership Unit basis for the years ended December 31, 1993, 1992 and 1991 are as follows: 1993 1992 1991 Quarter ended March 31, $ .230 $ .300 $ .325 Quarter ended June 30, .210 .220 .325 Quarter ended September 30, .290(1) .300 .285 Quarter ended December 31, .280(2) .320 .327 ------ ------ ------ $1.010 $1.140 $1.262 ====== ====== ====== (1) In September 1993, the Partnership received $591,872 (approximately $.06 per Unit) from the mortgage on Victoria Pointe Apartments-Phase II, representing mortgage interest from October 1991 through June 1992, and a partial payment for July 1992. The Partnership distributed approximately $.03 per Unit of this previously undistributed interest and reserved approximately $.03 per Unit for the continued funding of coinsurance expenses. The Partnership distributed the remaining interest of approximately $.03 per Unit to Unitholders as part of the fourth quarter distribution, as discussed below. (2) This includes a special distribution of approximately $.10 per Unit comprised of (i) $.03 per Unit of previously undistributed accrued interest from the mortgage on Victoria Pointe Apartments-Phase II which was reserved as part of the third quarter distribution, described above, and (ii) $.07 per Unit representing previously undistributed accrued interest received in December 1993 resulting from the disposition of the mortgage on Victoria Pointe Apartments-Phase II. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 5. DISTRIBUTIONS TO UNITHOLDERS - Continued The basis for paying distributions to Unitholders is cash flow from operations, which is comprised of regular interest income and principal from Insured Mortgages and gain, if any, from mortgage dispositions. Although Insured Mortgages yield a fixed monthly mortgage payment once purchased, the cash distributions paid to the Unitholders will vary during each quarter due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly distributions, (2) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow attributable to the delinquency or default of Insured Mortgages and professional fees and foreclosure and acquisition costs incurred in connection with those Insured Mortgages and (4) variations in the Partnership's operating expenses. 6. INVESTMENT IN AFFILIATE AND NOTE PAYABLE TO AFFILIATE Effective December 31, 1991, American Insured Mortgage Investors-Series 85, L.P. (AIM 85) transferred a GNMA security in the amount of $4,696,548 to IFI in order to capitalize IFI with sufficient net worth under HUD regulations. The Partnership and AIM 88 each issued a demand note payable to AIM 85 and recorded an investment in IFI through an affiliate (AIM Mortgage, Inc.) at an amount proportionate to each entity's coinsured mortgages for which IFI was the mortgagee of record as of December 31, 1991. The Partnership accounts for its investment in IFI on the equity method of accounting. Interest expense on the note, based on an interest rate of 8% per annum, was $139,018 for each of the years ended December 31, 1993 and 1992. In 1992, IFI entered into an expense reimbursement agreement with the Partnership, AIM 85 and AIM 88 (the AIM Funds) whereby IFI reimburses the AIM Funds for general and administrative expenses incurred on behalf of IFI. The expense reimbursement is allocated to the AIM Funds based on an amount proportionate to each entity's coinsured mortgages. The expense reimbursement, along with the Partnership's equity interest in IFI's net income or loss, substantially equals the interest expense on the note payable. 7. TRANSACTIONS WITH RELATED PARTIES In addition to the related party transactions described above in Note 6, the General Partner, former general partners and certain affiliated entities, during the years ended December 31, 1993, 1992 and 1991, earned or received compensation or payments for services from the Partnership as follows: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 7. TRANSACTIONS WITH RELATED PARTIES - Continued AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 7. TRANSACTIONS WITH RELATED PARTIES - Continued (1) The General Partner, pursuant to amendments to the Partnership Agreement, effective September 6, 1991, is entitled to receive 4.9% of the Partnership's income, loss, capital and distributions including, without limitation, the Partnership's Adjusted Cash from Operations and Proceeds of Mortgage Prepayments, Sales or Insurance (both as defined in the Partnership Agreement). The principal officers of the General Partner for the period September 7, 1991 through December 31, 1993 did not receive fees for serving as officers of the General Partner, nor are any fees expected to be paid to the officers in the future. (2) The Advisor, pursuant to the Purchase Agreement and amendments to the Partnership Agreement, is entitled to an Asset Management Fee equal to .95% of Total Invested Assets (as defined in the Partnership Agreement), effective October 1, 1991. The Asset Management Fee was based on 1.25% of Total Invested Assets from September 7, 1991 through September 30, 1991. Of the amounts paid to the Advisor, the Sub-advisor earned a fee equal to $499,332, $497,716 and $158,545, or .28% of Total Invested Assets, for the years ended December 31, 1993 and 1992 and for the period September 7, 1991 through December 31, 1991, respectively. (3) The former general partners were entitled to receive an aggregate 5% of the Partnership's income, loss, capital and distributions through September 6, 1991 (4.8% to the former managing general partner, 0.1% to the former corporate general partner and 0.1% to the former associate general partner). (4) Asset management fees for managing the Partnership's mortgage portfolio for the period January 1, 1991 through September 6, 1991 were based on 1.25% of Total Invested Assets. (5) These amounts are paid to CRI as reimbursement for expenses incurred on behalf of the General Partner and the Partnership. 8. PARTNERS' EQUITY Depository Units representing economic rights in limited partnership interests were issued at a stated value of $20. A total of 9,576,165 depository Units of limited partnership interest were issued for an aggregate capital contribution of $191,523,300. In addition, the initial limited partner contributed $2,500 to the capital of the Partnership and received 125 Units of limited partnership interests in exchange therefor and the former general partners contributed a total of $1,000 to the Partnership. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 9. SUMMARY OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) (In Thousands, Except Per Unit Data) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993 and 1992: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 (1) Under the Section 221 program of the National Housing Act of 1937, as amended, a mortgagee has the right to assign a mortgage (put) to the Federal Housing Administration (FHA) at the expiration of 20 years from the date of final endorsement, if the mortgage is not in default at such time. Any mortgagee electing to assign an FHA insured mortgage to FHA will receive in exchange HUD debentures having a total face value equal to the then outstanding principal balance of the FHA insured mortgage plus accrued interest to the date of assignment. These HUD debentures will mature 10 years from the date of assignment and will bear interest at the "going Federal" rate at such date. This assignment procedure is applicable to a mortgage which had a firm or conditional FHA commitment for insurance on or before November 30, 1983 and, in the case of mortgages sold in a GNMA auction, was sold in an auction prior to February of 1984. Certain of the Partnership's mortgages may have the right of assignment under this program. Certain mortgages that do not qualify under this program possess a special assignment option, in certain mortgage documents, which allows the Partnership, anytime after this date, the option to require payment of the unpaid principal balance of the mortgages. At such time, the borrowers must make payment to the Partnership or the Partnership may cancel the FHA insurance and institute foreclosure proceedings. (2) Inclusive of closing costs and acquisition fees. (3) Prepayment of these mortgages would be based upon the unpaid principal balance at the time of prepayment. (4) This represents the base interest rate during the permanent phase of this mortgage loan. Additional interest (referred to as Participations) measured as a percentage of the net cash flow from the development and of the net proceeds from sale, refinancing or other disposition of the underlying development (as defined in the Participation Agreements), will also be due. During the years ended 1993, 1992 and 1991, the Partnership received additional interest of $113,822, $104,350 and $52,816, respectively, as a result of the Participations. (5) In addition, the servicer or the sub-servicer of the mortgage, primarily unaffiliated third parties, is entitled to receive compensation for certain services rendered. Effective January 1993, CRICO Mortgage Company, Inc., an affiliate of CRI, became the sub-servicer of 3 of the 8 coinsured mortgages. (6) These mortgages are insured under the HUD coinsurance program, as previously discussed. The HUD-approved coinsurance lenders for these mortgages are Patrician Mortgage Company (The Villas and St. Charles Place-Phase II) and M-West Mortgage Corporation (Woodland Apartments, Woodbine at Lakewood Apartments and Carmen Drive Estates). (7) These mortgages are insured under the HUD coinsurance program. IFI is the HUD-approved coinsurance lender, and the Partnership bears the risk of any principal loss, as previously discussed. (8) These amounts represent the Partnership's 45% interest in these mortgages. The remaining 55% interest was acquired by AIM 88. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 (9) A reconciliation of the carrying value of the Insured Mortgages, including Mortgages Held for Disposition and Assets Held for Sale Under Coinsurance Program, for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ------------ ------------ Beginning balance $173,752,165 $173,017,756 Investment in Acquired Insured Mortgages -- 3,032,831 Principal receipts on mortgages (600,361) (573,537) Mortgage acquisition costs -- 5,471 Payments made (received) for AHFS/mortgage investment income accrued/accreted on AHFS 3,106,783 (1,623,486) Loan losses (63,488) (106,870) Disposition of AHFS (9,049,783) -- ------------ ------------ Ending balance $167,145,316 $173,752,165 ============ ============ (10) The Partnership's mortgages are non-recourse first liens on multifamily residential developments or retirement homes. (11) Principal and interest are payable at level amounts over the life of the mortgages. (12) Represents principal amount subject to delinquent principal or interest. See Note 4 to financial statements. (13) Annual payment reflects required principal and interest payments for 1993 as per the modification agreement. (14) As of December 31, 1993 and 1992, the tax basis of the Insured Mortgages, including Mortgages Held for Disposition and Assets Held for Sale Under Coinsurance Program, was approximately $168.0 million and $176.1 million, respectively.

740582_1993.txt

740582_1993

1993

740582

Item 1. Business Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership (the "Registrant") is a limited partnership governed by the laws of the State of Maryland. The Registrant raised $87,037,000 from sales of Limited Partnership Interests. The Registrant's operations consist exclusively of investment in and operation of income-producing real properties, and all financial information included in this report relates to this industry segment. The Registrant utilized the net offering proceeds to acquire fourteen real property investments. Titles to Southern Hills, Rancho Mirage and Highland Ridge apartment complexes were relinquished through foreclosure during January 1990, March 1993 and May 1993, respectively. The Registrant also sold Butterfield Village Apartments in April 1993. As of December 31, 1993, the Registrant owned the remaining ten properties described under "Properties" (Item 2). The Partnership Agreement generally provides that the proceeds of any sale or refinancing of the Registrant's properties will not be reinvested in new acquisitions. During 1993, the multi-family residential real estate industry in certain cities and regions of the country experienced improvements in occupancy levels and rental rates. These improvements are due in part to recoveries in local economies along with low levels of new construction of rental units in recent years, which has led to higher occupancies and increased rental revenues for existing properties. As discussed in Item 7. Liquidity and Capital Resourses, of the Registrant's ten remaining properties, during 1993, eight generated positive cash flow while two generated marginal cash flow deficits. Many rental markets continue to remain extremely competitive; therefore, the general partner's goals are to maintain high occupancy levels, while increasing rents where possible, and to monitor and control operating expenses and capital improvement requirements at the properties. Historically, real estate investments have experienced the same cyclical characteristics affecting most other types of long-term investments. While real estate values have generally risen over time, the cyclical character of real estate investments, together with local, regional and national market conditions, has resulted in periodic devaluations of real estate in particular markets, as has been experienced in the last few years. As a result of these factors, it has become necessary for the Registrant to retain ownership of many of its properties for longer than the holding period for the assets originally described in the prospectus. The General Partner examines the operations of each property and each local market individually when determining the optimal time to sell each of the Registrant's properties. Although investors have received certain tax benefits, the Registrant has not commenced distributions. Future distributions will depend on improved cash flow from the Registrant's remaining properties and proceeds from future property sales, as to both of which there can be no assurances. In light of the results to date and current market conditions, the General Partner does not anticipate that the investors will recover a substantial portion of their investment. The Registrant is largely dependent on loans from the General Partner and owes approximately $7,776,000 to the General Partner at December 31, 1993 in connection with funds advanced for working capital purposes. These loans are expected to be repaid from available cash flow from future property operations, or from proceeds received from the disposition of the Registrant's real estate investments prior to any distributions to the Limited Partners from these sources. The General Partner may continue to provide additional short-term loans to the Registrant or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Registrant would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Registrant may be required to dispose of some of its properties to satisfy these obligations. In instances where the General Partner concludes that the Registrant's investment objectives cannot be met by continuing to own a particular property and fund operating deficits, the Registrant has suspended and may in the future suspend debt service payments or sell the property at a price less than its original cost. Suspension of debt service payments may lead to a renegotiation of terms with lenders which would permit the Registrant to continue to own properties or may lead to foreclosure or other action by lenders which would result in the relinquishment of title to properties in satisfaction of the outstanding mortgage loan balances. In the case of each property, the General Partner will pursue modification of underlying debt, consider suspending debt service payments and/or deferring non-critical repair and maintenance costs and analyze present and projected market conditions and projections for operations prior to determining the disposition of a property. During 1993, the Registrant relinquished titles to the Rancho Mirage and Highland Ridge apartment complexes. See Item 7. Liquidity and Capital Resources for additional information. Effective February 1, 1993, the Registrant suspended debt service payments on the loans collateralized by the Ridgepoint Green and Ridgepoint Way apartment complexes and the lender placed the loans in default. In April 1993, the Registrant, through its subsidiaries owning these properties, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. While the bankruptcy proceedings continue, the Partnership will remit partial debt service payments to the lender equal to monthly net cash flow from the properties. The Registrant and the lender have tentatively agreed on the terms of a modification of the loans and an agreement is expected to be finalized in March 1994. See Item 3. Legal Proceedings for additional information. During April 1993, the Registrant sold the Butterfield Village Apartments located in Tempe, Arizona in all cash sale for $9,385,000. After payment of the underlying mortgage and selling costs, the Registrant received proceeds of approximately $2,950,000 from the sale. See Note 12 of Notes to Financial Statements for additional information. During 1993, the Registrant refinanced the loans collateralized by the Ridgetree II and Meadow Creek apartment complexes and modified the loan collateralized by the Park Colony Apartments. See Item 7. Liquidity and Capital Resourses for additional information. The officers and employees of Balcor Partners-84 II, Inc., the General Partner of the Registrant, and its affiliates perform services for the Registrant. The Registrant currently has 74 full-time and 18 part-time employees engaged in its operations. Item 2. Item 2. Properties As of December 31, 1993, the Registrant owns the ten properties described below: Location Description of Property Tempe, Arizona La Contenta Apartments: a 274-unit apartment complex located on approximately 13 acres. Pineville, North Carolina * Meadow Creek Apartments: a 250-unit apartment complex located on approximately 23 acres. Gwinnett County, Georgia Park Colony Apartments: a 352-unit apartment complex located on approximately 29 acres. Dallas, Texas Ridgepoint Green Apartments: a 284-unit apartment complex located on approximately 10 acres. Dallas, Texas Ridgepoint Way Apartments: a 310-unit apartment complex located on approximately 12 acres. Dallas, Texas Ridgetree Apartments (Phase II): a 354-unit apartment complex located on approximately 9 acres. Lenexa, Kansas ** Rosehill Pointe Apartments: a 498-unit apartment complex located on approximately 35 acres. Orange County, Florida ** Seabrook Apartments: a 200-unit apartment complex located on approximately 16 acres. Columbus, Ohio Spring Creek Apartments: a 288-unit apartment complex located on approximately 19 acres. Irving, Texas Westwood Village Apartments: a 320-unit apartment complex located on approximately 16 acres. * Owned by the Registrant through a joint venture with the seller. ** Owned by the Registrant through a joint venture with one or more affiliated partnerships. Each of the above properties is held subject to various mortgages and other forms of financing. In the opinion of the General Partner, the Registrant has provided for adequate insurance coverage for its real estate investment properties. See Notes to Financial Statements for other information regarding real property investments. Item 3. Item 3. Legal Proceedings (a & b) Ridgepoint Green Apartments and Ridgepoint Way Apartments In March 1983, the Registrant acquired, through subsidiary partnerships, the Ridgepoint Green and Ridgepoint Way apartment complexes, utilizing $4,659,620 and $5,007,315 of offering proceeds, respectively. The Registrant acquired the properties subject to first mortgage loans from an unaffiliated lender in the then outstanding amounts of $8,370,000 and $9,118,000, respectively. Effective January 1993, the Registrant suspended debt service payments while negotiating with Travelers Insurance Company, the current holder of the loans ("Travelers"), for loan modifications. Subsequently, in April 1993, the subsidiaries commenced proceedings under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court, Northern District of Texas, In re Ridgepoint Green Investors, Case No.: 393-32455-RCM-11, and In re Ridgepoint Way Investors, Case No.: 393-32456-RCM-11. In May 1993, the cases were consolidated by the Bankruptcy Court and in June 1993, cash collateral orders were entered pursuant to which all cash flow after payment of the operating expenses of the properties is paid to Travelers. The Registrant and Travelers have tentatively agreed on the terms of a modification of the loans and an agreement is expected to be finalized in April 1994. Item 4. Item 4. Submission of Matters to a Vote of Security Holders (a, b, c & d) No matters were submitted to a vote of the Limited Partners of the Registrant during 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There has not been an established public market for Limited Partnership Interests and it is not anticipated that one will develop; therefore, the market value of the Limited Partnership Interests cannot reasonably be determined. The Registrant has not made distributions to date to investors. For additional information, see Item 7. - "Management's Discussion and Analysis of Financial Condition and Results of Operations" below. As of December 31, 1993, the number of record holders of Limited Partnership Interests of the Registrant was 8,495. Item 6. Item 6. Selected Financial Data Year ended December 31, 1993 1992 1991 1990 1989 Rental and service income $17,953,526 $21,494,257 $21,092,058 $20,988,232 $20,779,131 Interest on short- term investments 31,346 161,231 192,197 265,821 265,637 Admin. expenses 679,625 653,998 584,826 438,035 505,203 Gain on sale of property 3,606,825 None None None None Extraordinary items: Gain on forgive- ness of debt 1,234,176 None None None None Gain on fore- closure of properties 8,432,686 None None None None Net income (loss) 9,901,817 (5,099,275) (5,662,553) (5,484,230) (7,509,077) Net income (loss) per Limited Part- nership Interest 112.63 (58.00) (64.41) (62.38) (85.41) Tax income (loss) 19,678,422 (8,936,053) (9,011,828) (7,759,553)(10,053,658) Tax income (loss) per Limited Part- nership Interest 210.88 (70.82) (88.80) (67.70) (105.11) Cash and cash equivalents 1,160,704 223,828 427,569 413,669 353,928 Total investment properties, net of accumulated depreciation 69,892,901 98,081,597 101,655,358 105,218,999 114,405,379 Total assets 73,333,165 100,416,387 104,489,888 110,712,217 117,303,591 Purchase price, promissory and mortgage notes payable 84,130,907 120,086,011 120,708,225 122,370,278 127,406,328 Properties owned on December 31 10 13 13 13 14 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership (the "Partnership") is a limited partnership formed in 1983 to invest in and operate income-producing real property. The Partnership raised $87,037,000 through the sale of Limited Partnership Interests and utilized these proceeds to acquire fourteen real property investments. Titles to the Southern Hills, Rancho Mirage and Highland Ridge apartment complexes were relinquished through foreclosure during January 1990, March 1993 and May 1993, respectively. The Partnership also sold the Butterfield Village Apartments in April 1993. The Partnership continues to operate the ten remaining properties. Operations Summary of Operations The Partnership sold Butterfield Village Apartments in April 1993 and relinquished titles to the Rancho Mirage and Highland Ridge apartment complexes to the lenders through foreclosure in March and May 1993, respectively. The latter two properties were in receivership in 1993 and, in accordance with the Partnership's accounting policies, no operations were recorded during 1993. Both of these properties generated losses during 1992. This, along with the gain recognized on the sale of Butterfield Village Apartments during 1993, resulted in the recognition of income before extraordinary items during 1993 as compared to a loss during 1992. The Partnership realized further income during 1993 as a result of the extraordinary gains recognized in connection with the foreclosures, as well as the gain recognized in connection with the forgiveness of debt related to the Ridgetree II refinancing in April 1993. During 1992 and the latter part of 1991, the Partnership modified or refinanced loans collateralized by four of its properties. In addition, the Partnership placed two of its properties in substantive foreclosure as of September 30, 1992 whereby interest expense is recognized only to the extent paid. The combined effect of these events resulted in a decrease in interest expense on purchase price, promissory and mortgage notes payable during 1992. This decrease in interest expense was the primary reason for the decrease in the net loss during 1992 as compared to 1991. Further discussion of the Partnership's operations are summarized below. 1993 Compared to 1992 As mentioned above, the Partnership sold the Butterfield Village Apartments in April 1993 and did not record operations during 1993 for the Highland Ridge and Rancho Mirage apartment complexes as a result of their receivership status. As a result, the Partnership experienced decreases in rental and service income, interest expense on purchase price, promissory and mortgage notes payable, depreciation, property operating expense, maintenance and repair expense, real estate taxes and property management fees during 1993 as compared to 1992. Increased occupancy levels and/or rental rates at seven of the Partnership's properties during 1993 partially offset the above decrease in rental and service income, and consequently, property management fees. The loan collateralized by the Seabrook Apartments was originally financed by a bond issuance which matured in 1992. During the third quarter of 1992, the Partnership received interest income from the trustee of the bonds. This, as well as lower interest rates earned on short-term investments in 1993, resulted in a decrease in interest income on short-term investments during 1993 as compared to 1992. In May and June 1992, the Partnership reached settlements with the sellers of the Rosehill Pointe and Ridgetree II apartment complexes. As a result, settlement income of $273,294 was recognized in connection with these transactions during 1992. During July 1992 and April and May 1993, the loans collateralized by the Seabrook, Ridgetree II and Meadow Creek apartment complexes, respectively, were refinanced. In addition, in accordance with the loan agreements, the interest rates on the loans collateralized by the Rosehill Pointe and Westwood Village apartment complexes were adjusted to lower rates during July and October 1993, respectively. These events contributed to the decrease in interest expense on purchase price, promissory and mortgage notes payable discussed above. Due to the sale of the Butterfield Village Apartments and the foreclosure of the Highland Ridge Apartments, as well as the Ridgetree II and Meadow Creek refinancings and the Park Colony modification, the Partnership fully amortized the remaining financing fees related to the corresponding mortgage notes payable during 1993. This resulted in an increase in amortization expense during 1993 as compared to 1992. Increased administrative and maintenance staff payroll expenses at the Rosehill Pointe and Spring Creek apartment complexes during 1993 partially offset the decrease in property operating expense discussed above. During 1992, the Partnership incurred substantial expenditures for painting and cleaning and carpet replacement at the Park Colony Apartments in an effort to lease vacant units. In addition, the Partnership deferred non-critical maintenance and repair costs during 1993 at the Ridgepoint Green and Ridgepoint Way apartment complexes due to the bankruptcy filings. This contributed to the decrease in maintenance and repair expense discussed above. During 1993, higher real estate taxes were incurred at the Meadow Creek, Spring Creek and Westwood Village apartment complexes as a result of increased tax rates and/or assessments. The additional expense partially offset the reduction in real estate tax expense due to the property dispositions discussed above and lower assessments at the La Contenta and Ridgetree II apartment complexes. During 1993, Rosehill Pointe Apartments experienced an increase in rental rates and a decrease in interest expense, as discussed above. This improvement in operations resulted in a decrease in the affiliates' participation in losses from joint ventures during 1993 as compared to 1992. In addition, interest income received during the third quarter of 1992 from the trustee of the bonds, which were collateralized by the Seabrook Apartments and matured in 1992, offset the above decrease. During April 1993, the Partnership recognized a gain of $3,606,825 on the sale of Butterfield Village Apartments located in Tempe, Arizona. During 1993, the Partnership recognized an extraordinary gain on forgiveness of debt of $1,234,276 in connection with the April 1993 refinancing of the Ridgetree II Apartments located in Dallas, Texas. The Partnership also recognized extraordinary gains on foreclosures of $8,432,686 in connection with the March 1993 foreclosure of the Rancho Mirage Apartments located in Phoenix, Arizona and the May 1993 foreclosure of the Highland Ridge Apartments located in Oklahoma City, Oklahoma. These properties were classified as real estate in substantive foreclosure at December 31, 1992. 1992 Compared to 1991 Increased occupancy and/or rental rates at eight of the Partnership's properties resulted in an increase in rental and service income during 1992 as compared to 1991. During the first quarter of 1991, the Partnership was required to have restricted cash invested in short-term interest bearing instruments in connection with letters of credit pledged to lenders relating to certain of the Partnership's properties. These restricted investments were released and used to repay Partnership obligations later in 1991. This, as well as lower interest rates earned on short-term investments during 1992, resulted in a decrease in interest income on short-term investments during 1992 as compared to 1991. The Partnership reached a settlement with the seller of the Ridgetree II Apartments, which was executed in June 1992. Prorations due from the seller pursuant to the terms of the original management and guarantee agreement on this property were previously written off due to uncertain collectibility. Pursuant to the settlement agreement, the parties have released all claims and causes of action against one another, and the Partnership received cash of $157,000 and was relieved of certain other liabilities by the seller. Settlement income of $153,057 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. The Partnership also reached a settlement with the seller of the Rosehill Pointe Apartment for proration amounts the seller owed the Partnership pursuant to the terms of the original management and guarantee agreement. The joint venture which owns the property received $70,266 in June 1992 and $140,554 in December 1992, pursuant to the terms of the settlement which was executed in May 1992. Settlement income of $120,237 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. The principal paydown made during November 1991 on a portion of the loan collateralized by the Meadow Creek Apartments, the July 1992 refinancing of the loan collateralized by the Seabrook Apartments, and the November 1991 modification of the loan collateralized by the Butterfield Village Apartments resulted in a decrease in interest expense on purchase price, promissory and mortgage notes payable during 1992 as compared to 1991. In addition, the placement of the Rancho Mirage and Highland Ridge apartment complexes in substantive foreclosure as of September 30, 1992, whereby the Partnership recognizes interest only to the extent paid, also contributed to the decrease in interest expense. Interest rates incurred on working capital borrowings from the General Partner were lower during 1992 as compared to 1991. This is the primary reason for the decrease in interest expense on short-term loans during 1992 as compared to 1991. As a result of higher expenditures for utilities, insurance and payroll expenses at the Highland Ridge, Park Colony, Rancho Mirage, Ridgepoint Green and Ridgepoint Way apartment complexes, property operating expenses increased during 1992 as compared to 1991. The Partnership incurred higher expenditures in 1992 for roof and structural repairs and carpet replacement at the Butterfield Village, Rancho Mirage, Ridgepoint Green and Ridgepoint Way apartment complexes. In addition, the Partnership incurred expenditures for balcony repairs and floor coverings at the Meadow Creek Apartments, and incurred substantial expenditures for painting and cleaning and carpet replacement at the Park Colony Apartments in an effort to lease certain vacant units. As a result, maintenance and repair expenses increased during 1992 as compared to 1991. Legal fees incurred in connection with the bankruptcy filing for the La Contenta Apartments caused administrative expenses to increase during 1992 as compared to 1991. Interest expense decreased at the Seabrook Apartments during 1992 due to the July 1992 refinancing of the loan collateralized by the property. As a result, the affiliates' participation in losses from joint ventures decreased during 1992 as compared to 1991. Liquidity and Capital Resources The Partnership received funds from investing activities relating to the sale of the Butterfield Village Apartments in April 1993. The Partnership used cash to fund certain of its financing activities which included the repayment of the mortgage note on the Butterfield Village Apartments in connection with the sale, the net repayment of a portion of the borrowings from the General Partner and the payment of principal on the loans collateralized by the Partnership's properties. Proceeds received from the refinancings of the Meadow Creek and Ridgetree II loans were not sufficient to repay the prior loans and related fees, and the Partnership also used its cash reserves to fund the respective shortfalls. In addition, cash was used to fund the Partnership's operating activities. The payment of administrative expenses, interest expense on the General Partner loan and the funding of capital and operating escrows related to the refinancings offset the cash flow generated by the Partnership's properties. The Partnership is largely dependent on loans from the General Partner and owes approximately $7,776,000 to the General Partner at December 31, 1993 in connection with funds advanced for working capital purposes. These loans are expected to be repaid from available cash flow from future property operations, or from proceeds received from the disposition of the Partnership's real estate investments prior to any distributions to the Limited Partners from these sources. The General Partner may continue to provide additional short-term loans to the Partnership or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Partnership would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Partnership may be required to dispose of some of its properties to satisfy these obligations. During 1993, eight of the Partnership's remaining ten properties generated positive cash flow while two generated marginal cash flow deficits. During 1992, five of the Partnership's thirteen properties generated positive cash flow while five generated marginal cash flow deficits and three generated significant cash flow deficits. As discussed above, titles to the Rancho Mirage and Highland Ridge apartment complexes were relinquished to the lenders through foreclosure in March 1993 and May 1993, respectively and the Butterfield Village Apartments were sold in April 1993. The Partnership classifies the cash flow performance of its properties as either positive, a marginal or a significant cash flow deficit, each after consideration of debt service payments unless otherwise indicated. A deficit is considered to be significant if it exceeds $250,000 annually or 20% of the property's rental and service income. The Park Colony Apartments generated a significant cash flow deficit during 1992, whereas during 1993 the property generated a marginal deficit. Substantial expenditures were incurred in 1992 to repair vacant units which has resulted in increased occupancy and improved operations. The La Contenta and Meadow Creek apartment complexes, which generated marginal cash flow deficits during 1992, generated positive cash flow during 1993 due to increased occupancy and/or rental rates, as well as decreased operating expenses. The Ridgetree II Apartments, which also generated a marginal cash flow deficit during 1992, generated positive cash flow during 1993 due to the reduced debt service payments required by the refinancing. The Ridgepoint Green and Ridgepoint Way apartment complexes, which generated significant cash flow deficits during 1992, generated positive cash flow during 1993 due to the suspension of debt service payments by the Partnership effective January 1993. Debt service payments were suspended in an effort to negotiate a modification of the loans collateralized by the properties. The lender subsequently placed the loans in default, and in April 1993, the Partnership, through its subsidiaries owning these properties, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. Had the Partnership paid the suspended debt service payments, both properties would have generated marginal cash flow deficits for 1993. While the bankruptcy proceedings continue, the Partnership will remit partial debt service payments to the lender equal to monthly net cash flow from the property. The Partnership and the lender have tenatively agreed on the terms of a modification of the loans and an agreement is expected to be finalized in March 1994. See Item 3. Legal Proceedings for additional information. Suspension of debt service payments may lead to a renegotiation of terms with lenders which would permit the Partnership to continue to own properties or may lead to foreclosure or other action by lenders which would result in the relinquishment of title to properties in satisfaction of the outstanding mortgage loan balances. While the cash flow of certain of the Partnership's properties has improved, the General Partner continues to pursue a number of actions aimed at improving the cash flow of the Partnership's properties including refinancing of mortgage loans, improving property operating performance, and seeking rent increases where market conditions allow. Despite improvements during 1993 in the local economies and rental markets where certain of the Partnership's properties are located, the General Partner believes that continued ownership of many of the properties is in the best interests of the Partnership in order to maximize potential returns to Limited Partners. As a result, the Partnership will continue to own these properties for longer than the holding period for the assets originally described in the prospectus. Each of the Partnership's properties is owned through the use of third-party mortgage loan financing and, therefore, the Partnership is subject to the financial obligations required by such loans. See Note 3 of Notes to Financial Statements for information concerning outstanding balances, maturity dates, interest rates, etc. related to each of these mortgage loans. During 1994, the $7,100,000 mortgage loan collateralized by the Spring Creek Apartments matures. As a result of the downturn experienced by the real estate industry over the last few years, many banks, savings and loans and other lending institutions have tightened mortgage lending criteria and are generally willing to advance less funds with respect to a property than many lenders were willing to advance during the 1980's. As a result, in certain instances it may be difficult for the Partnership to refinance a property in an amount sufficient to retire in full the current mortgage financing with respect to the property. In the event negotiations with the existing lender for a loan modification or with new lenders for a refinancing are unsuccessful, the Partnership may sell the collateral property or other properties to satisfy an obligation or may relinquish title to the collateral property in satisfaction of the outstanding mortgage loan balance. In July 1991, the Partnership suspended debt service payments on the loan collateralized by the Rancho Mirage Apartments in an effort to negotiate a modification of the loan. Negotiations were unsuccessful, and in March 1993, the Partnership relinquished title to the lender through foreclosure. See Note 13 of Notes to Financial Statements for additional information. In April 1992, the modification period relating to the mortgage loan collateralized by the Highland Ridge Apartments expired and the loan reverted to its previous terms. While negotiating for a further modification of the loan, the Partnership remitted partial debt service payments to the lender equal to monthly net cash flow from the property. During July 1992, the lender filed foreclosure proceedings and a receiver was appointed in September 1992. Negotiations for a modification were unsuccessful, and in May 1993, the Highland Ridge Apartments was relinquished to the lender through foreclosure. See Note 13 of Notes to Financial Statements for additional information. In April 1993, the first mortgage loan collateralized by Ridgetree II Apartments was refinanced with new first and second mortgage loans from an unaffiliated lender. Simultaneously, other first mortgage loans collateralized by properties owned by partnerships affiliated with the General Partner were also refinanced. All of these loans had been held directly or indirectly by the Resolution Trust Corporation and have been purchased by Lexington Mortgage Company, an independent third party. While the mortgage loan collateralized by Ridgetree II Apartments was current, many of the other mortgage loans were in default either with respect to monthly debt service requirements or the loan had matured and the properties were unable to repay the balloon payments that were due. The new loans were deposited into a trust, the beneficial interests of which were sold to unaffiliated investors. Lehman Brothers, an affiliate of the General Partner, acted as firm underwriter for the sale of the beneficial interests in the trust and received underwriting compensation from a third party in accordance with market practices. A subordinated portion of the beneficial interests in the trust continues to be owned by Lehman Brothers. The new loans include, among other things, principal balance or mortgage rate reductions, or maturity extensions, or a combination thereof. The terms of the new loans on Ridgetree II Apartments decreased the interest rate from 11% to 10.05%, extended the maturity date from September 1, 1996 to May 1, 2000, and included a principal reduction which was partially funded by a principal payment by the Partnership and was partially due to forgiveness of debt by the lender or a voluntary contribution from an affiliate of the General Partner. See Note 4 of Notes to Financial Statements for additional information. In May 1993, the first mortgage loan collateralized by Meadow Creek Apartments was refinanced with a new $5,200,000 first mortgage loan from an unaffiliated lender. The original loan bore interest at 10% and was to mature in September 1993, whereas the new loan bears interest at 8.54% and matures on June 1, 1998. See Note 4 of Notes to Financial Statements for additional information. In December 1993, the General Partner completed a modification of the loan collateralized by the Park Colony Apartments, whereby the interest rate was reduced from 10.25% to 9.375% and the maturity date was extended from July 1, 1996 to January 1, 1999. See Note 4 of Notes to Financial Statements for additional information. In April 1993, the Partnership sold the Butterfield Village Apartments located in Tempe, Arizona in an all cash sale for $9,385,000. After payment of the underlying mortgage and selling costs, the Partnership received proceeds of approximately $2,950,000 from the sale. A portion of these proceeds was used to reduce the outstanding short-term borrowings due to the General Partner. See Note 12 of Notes to Financial Statements for additional information. The Westwood Village Apartments is located near the Dallas/Ft. Worth Airport. As previously reported, the airport board is pursuing an expansion plan with the Federal Aviation Authority to build two additional runways on airport property. A proposed plan provides for varying levels of compensation to single family homeowners for the expected loss in value to their homes as a result of increased air traffic and heightened noise levels. However, no similar compensation is planned for the majority of apartment complex owners in the area, including the Partnership. In July 1993, the Partnership, certain affiliates of the General Partner which also own affected properties and other unaffiliated property owners jointly filed a lawsuit to obtain equitable compensation. The plaintiffs expect to file a motion for summary judgement with a hearing expected to be held during the first half of 1994. Although investors have received certain tax benefits, the Partnership has not commenced distributions. Future distributions will depend on improved cash flow from the Partnership's remaining properties and proceeds from future property sales, as to both of which there can be no assurances. In light of the results to date and current market conditions, the General Partner does not anticipate that the investors will recover a substantial portion of their investment. Inflation has several types of potentially conflicting impacts on real estate investments. Short-term inflation can increase real estate operating costs which may or may not be recovered through increased rents depending on general or local economic conditions. In the long-term, inflation will increase operating costs and replacement costs and may lead to increased rental revenues and real estate values. Item 8. Item 8. Financial Statements and Supplementary Data See Index to Financial Statements and Schedule in this Form 10-K. The supplemental financial information specified by Item 302 of Regulation S-K is not applicable. The net effect of the differences between the financial statements and the tax returns is summarized as follows: December 31, 1993 December 31, 1992 Financial Tax Financial Tax Statements Returns Statements Returns Total assets $ 73,333,165$ 53,841,280 $100,416,387 $72,183,361 Partners' capital accounts (deficit): General Partner (962,524)(10,521,827) (1,061,542) (11,845,474) Limited Partners (19,589,059)(25,523,423) (29,391,858) (43,878,198) Net income (loss): General Partner 99,018 1,323,647 (50,993) (2,771,031) Limited Partners 9,802,799 18,354,775 (5,048,282) (6,165,022) Per Limited Part- nership Interest 112.63 210.88 (58.00) (70.82) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no changes in or disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) The Registrant does not have a Board of Directors; however, Balcor Partners-84 II, Inc., the General Partner, does have a Board of Directors which consists of Thomas Meador and Allan Wood. The term of office as a director of the General Partner is one year. Directors are elected at the annual meeting of shareholders. (b, c & e) The names, ages and business experiences of the executive officers, directors and significant employees of the General Partner of the Registrant are as follows: Name Title Marvin H. Chudnoff Chairman Thomas E. Meador President and Chief Operating Officer Allan Wood Executive Vice President, Chief Financial Officer and Chief Accounting Officer Alexander J. Darragh Senior Vice President Robert H. Lutz, Jr. Senior Vice President Michael J. O'Hanlon Senior Vice President Gino A. Barra First Vice President Daniel A. Duhig First Vice President David S. Glasner First Vice President Josette V. Goldberg First Vice President G. Dennis Hartsough First Vice President Lawrence B. Klowden First Vice President Alan G. Lieberman First Vice President Lloyd E. O'Brien First Vice President Brian D. Parker First Vice President John K. Powell, Jr. First Vice President Jeffrey D. Rahn First Vice President Reid A. Reynolds First Vice President Marvin H. Chudnoff (April 1941) joined Balcor in March 1990 as Chairman. He has responsibility for all strategic planning and implementation for Balcor, including management of all real estate projects in place and financing and sales for a varied national portfolio valued in excess of $6.5 billion. Mr. Chudnoff also holds the position of Vice Chairman of Edward S. Gordon Company Incorporated, New York, a major national commercial real estate firm, which he joined in 1983. He has also served on the Board of Directors of Skippers, Inc. and Acorn Inc., both publicly held companies, and of Waxman Laboratories of Mt. Sinai Hospital, New York. Mr. Chudnoff has been a guest lecturer at the Association of the New York Bar and at Yale and Columbia Universities. Thomas E. Meador (July 1947) joined Balcor in July 1979. He is President and Chief Operating Officer and has responsibility for all ongoing day-to-day activities at Balcor. He is a Director of The Balcor Company. Prior to joining Balcor, Mr. Meador was employed at the Harris Trust and Savings Bank in the commercial real estate division where he was involved in various lending activities. Mr. Meador received his M.B.A. degree from the Indiana University Graduate School of Business. Allan Wood (January 1949) joined Balcor in August 1983 and, as Balcor's Chief Financial Officer and Chief Accounting Officer, is responsible for all financial and administrative functions. He is directly responsible for all accounting, treasury, data processing, legal, risk management, tax and financial reporting activities. He is also a Director of The Balcor Company. Mr. Wood is a Certified Public Accountant. Prior to joining Balcor, he was employed by Price Waterhouse where he was involved in auditing public and private companies. Alexander J. Darragh (February 1955) joined Balcor in September 1988 and has primary responsibility for the Portfolio Advisory Group. He is responsible for due diligence analysis in support of asset management, institutional advisory and capital markets functions as well as for Balcor Consulting Group, Inc., which provides real estate advisory services to Balcor affiliated entities and third party clients. In addition, Mr. Darragh has supervisory responsibility of Balcor's Investor Services Department. Mr. Darragh received masters' degrees in Urban Geography from Queens's University and in Urban Planning from Northwestern University. Robert H. Lutz, Jr. (September 1949) joined Balcor in October 1991. He is President of Allegiance Realty Group, Inc., formerly known as Balcor Property Management, Inc. and, as such, has primary responsibility for all its management and operations. He is also a Director of The Balcor Company. From March 1991 until he joined Balcor, Mr. Lutz was Executive Vice President of Cousins Properties Incorporated. From March 1986 until January 1991, he was President and Chief Operating Officer of The Landmarks Group, a real estate development and management firm. Mr. Lutz received his M.B.A. from Georgia State University. Michael J. O'Hanlon (April 1951) joined Balcor in February 1992 as Senior Vice President in charge of Asset Management, Investment/Portfolio Management, Transaction Management and the Capital Markets Group which includes sales and refinances. From January 1989 until joining Balcor, Mr. O'Hanlon held executive positions at Citicorp in New York and Dallas, including Senior Credit Officer and Regional Director. He holds a B.S. degree in Accounting from Fordham University, and an M.B.A. in Finance from Columbia University. He is a full member of the Urban Land Institute. Gino A. Barra (December 1954) joined Balcor's Property Sales Group in September 1983. He is First Vice President of Balcor and assists with the supervision of Balcor's Asset Management Group, Transaction Management, Quality Control and Special Projects. Daniel A. Duhig (October 1956) joined Balcor in November 1986 and is responsible for various asset management matters relating to investments made by Balcor and its affiliated partnerships, including negotiations for modifications or refinancings of real estate mortgage investments and the disposition of real estate investments. David S. Glasner (December 1955) joined Balcor in September 1986 and has primary responsibility for special projects relating to investments made by Balcor and its affiliated partnerships and risk management functions. Mr. Glasner received his J.D. degree from DePaul University College of Law in June 1984. Josette V. Goldberg (April 1957) joined Balcor in January 1985 and has primary responsibility for all human resources matters relating to Balcor personnel, including training and development, employment, salary and benefit administration, corporate communications and the development, implementation and interpretation of personnel policy and procedures. Ms. Goldberg also supervises Balcor's payroll operations and Human Resources Information Systems (HRIS). In addition, she has supervisory responsibility for Balcor's Facilities, Corporate and Field Services and Telecommunications Departments. Ms. Goldberg has been designated as a Senior Human Resources Professional (SHRP). G. Dennis Hartsough (October 1942) joined Balcor in July 1991 and is responsible for asset management matters relating to all investments made by Balcor and its affiliated partnerships in office and industrial properties. From July 1989 until joining Balcor, Mr. Hartsough was Senior Vice President of First Office Management (Equity Group) where he directed the firm's property management operations in eastern and central United States. From June 1985 to July 1989, he was Vice President of the Angeles Corp., a real estate management firm, where his primary responsibility was that of overseeing the company's property management operations in eastern and central United States. Lawrence B. Klowden (March 1952) joined Balcor in November 1981 and is responsible for supervising the administration of the investment portfolios of Balcor and its loan and equity partnerships. Mr. Klowden is a Certified Public Accountant and received his M.B.A. degree from DePaul University's Graduate School of Business. Alan G. Lieberman (June 1959) joined Balcor in May 1983 and is responsible for the Property Sales and Capital Markets Groups. Mr. Lieberman is a Certified Public Accountant. Lloyd E. O'Brien (December 1945) joined Balcor in April 1987 and has responsibility for the operations and development of Balcor's Information and Communication systems. Mr. O'Brien received his M.B.A. degree from the University of Chicago in 1984. Brian D. Parker (June 1951) joined Balcor in March 1986 and is responsible for Balcor's corporate and property accounting, treasury, budget activities and corporate purchasing. Mr. Parker is a Certified Public Accountant and holds an M.S. degree in Accountancy from DePaul University and an M.A. degree in Social Service Administration from the University of Illinois. John K. Powell, Jr. (June 1950) joined Balcor in September 1985 and is responsible for Balcor Consulting Group, Inc. which provides real estate advisory services to Balcor affiliated entities and third party clients. Mr. Powell received a Master of Planning degree from the University of Virginia. Jeffrey D. Rahn (June 1954) joined Balcor in February 1983 and has primary responsibility for Balcor's Asset Management Department. He is responsible for the supervision of asset management matters relating to equity and loan investments held by Balcor and its affiliated partnerships. Mr. Rahn received his M.B.A. degree from DePaul University's Graduate School of Business. Reid A. Reynolds (April 1950) joined Balcor in March 1981 and is involved with the asset management of residential properties for Balcor. Mr. Reynolds is a licensed Real Estate Broker in the State of Illinois. The directors of Balcor Partners-84 II, Inc. are directors of the General Partners of two additional limited partnerships each with a class of securities registered pursuant to Section 12 of the Securities Exchange Act of 1934 or subject to the requirements of Section 15 (b) of that Act; however, they are not directors of any company registered as an investment company under the Investment Company Act of 1940. (d) There is no family relationship between any of the foregoing officers or directors. (f) None of the foregoing officers, directors or employees are currently involved in any material legal proceedings nor were any such proceedings terminated during the fourth quarter of 1993. Item 11. Item 11. Executive Compensation The Registrant has not paid and does not propose to pay any compensation, retirement or other termination of employment benefits to any of the five mostly highly compensated executive officers of the General Partner. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No person owns of record or is known by the Registrant to own beneficially more than 5% of the outstanding Limited Partnership Interests of the Registrant. (b) Balcor Partners-84 II, Inc. and its shareholders and officers own as a group the following Limited Partnership Interests in the Registrant. Amount Beneficially Title of Class Owned Percent of Class Limited Partnership Interests 95 Interests Less than 1% Relatives and affiliates of the partners and officers of the General Partner own 10 Interests. (c) The Registrant is not aware of any arrangements, the operation of which may result in a change of control of the Registrant. Item 13. Item 13. Certain Relationships and Related Transactions (a & b) See Note 2 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses. See Note 11 of Notes to Financial Statements for additional information relating to transactions with affiliates. (c) No management person is indebted to the Registrant. (d) The Registrant has no outstanding agreements with any promoters. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1 & 2) See Index to Financial Statements and Schedule in this Form 10-K. (3) Exhibits: (3) The Amended and Restated Agreement and Certificate of Limited Partnership is set forth as Exhibit 3 to Amendment No. 2 to Registrant's Registration Statement on Form S-11 dated July 6, 1984 (Registration No. 2-89319), and said Agreement and Certificate is incorporated herein by reference. (4) Form of Subscription Agreement set forth as Exhibit 4.1 to Amendment No. 2 of the Registrant's Registration Statement on Form S-11 dated May 16, 1984 (Registration No. 2-89319), and Form of Confirmation regarding Interests in the Registrant set forth as Exhibit 4.2 to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1992 (Commission File No. 0-13334) are incorporated herein by reference. (b) Reports on Form 8-K: No reports were filed on Form 8-K during the quarter ended December 31, 1993. (c) Exhibits: See Item 14(a)(3) above. (d) Financial Statement Schedules: See Index to Financial Statements and Schedules in this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP By: /s/ Allan Wood Allan Wood Executive Vice President, Chief Accounting and Financial Officer and Director (Principal Accounting and Financial Officer) of Balcor Partners-84 II, Inc., the General Partner Date: March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date President, Chief Executive Officer (Principal Executive Officer) and Director of Balcor Partners-84 II, /s/ Thomas E. Meador Inc., the General Partner March 18,1994 Thomas E. Meador Executive Vice President, and Chief Accounting and Financial Officer and Director (Principal Accounting and Financial Officer) of Balcor Partners-84 II, Inc., the General /s/ Allan Wood Partner March 18, 1994 Allan Wood INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE Report of Independent Accountants Financial Statements: Balance Sheets, December 31, 1993 and 1992 Statements of Partners' Capital, for the years ended December 31, 1993, 1992 and 1991 Statements of Income and Expenses, for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Financial Statement Schedule: XI - Real Estate and Accumulated Depreciation, as of December 31, 1993 Schedules, other than that listed, are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein. REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Balcor Realty Investors 84-Series II A Real Estate Limited Partnership: We have audited the financial statements and the financial statement schedule of Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership (A Maryland Limited Partnership) as listed in the index of this Form 10-K. These financial statements and the financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. /s/Coopers & Lybrand COOPERS & LYBRAND Chicago, Illinois March 14, 1994 BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 ------------- ------------- Cash and cash equivalents $ 1,160,704 $ 223,828 Escrow deposits 1,149,671 788,948 Accounts and accrued interest receivable 65,276 230,720 Deferred expenses, net of accumulated amortization of $1,084,192 in 1993 and $1,108,141 in 1992 1,064,613 1,091,294 ------------- ------------- 3,440,264 2,334,790 ------------- ------------- Investment in real estate, at cost: Land 15,412,784 16,496,523 Buildings and improvements 86,867,741 94,111,222 ------------- ------------- 102,280,525 110,607,745 Less accumulated depreciation 32,387,624 32,387,868 ------------- ------------- 69,892,901 78,219,877 Investment in real estate in substantive foreclosure, net of accumulated depreciation of $8,478,201 in 1992 19,861,720 ------------- ------------- Investment in real estate, net of accumulated depreciation 69,892,901 98,081,597 ------------- ------------- $ 73,333,165 $100,416,387 ============= ============= LIABILITIES AND PARTNERS' CAPITAL Loans payable - affiliate $ 7,775,723 $ 8,118,490 Accounts payable 115,493 301,037 Due to affiliates 268,432 168,846 Accrued liabilities, principally interest and real estate taxes 2,274,720 2,648,600 Security deposits 372,855 504,183 Purchase price, promissory and mortgage notes payable 84,130,907 120,086,011 ------------- ------------- Total liabilities 94,938,130 131,827,167 Affiliates' participation in joint ventures (1,053,382) (957,380) Partners' capital (87,037 Limited Partnership Interests issued and outstanding) (20,551,583) (30,453,400) ------------- ------------- $ 73,333,165 $100,416,387 ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL for the years ended December 31, 1993, 1992 and 1991 Partners' Capital Accounts ----------------------------------------- General Limited Total Partner Partners(A) ------------- ------------- ------------- Balance at December 31, 1990 $(19,691,572) $ (953,923) $(18,737,649) Net loss for the year ended December 31, 1991 (5,662,553) (56,626) (5,605,927) ------------- ------------- ------------- Balance at December 31, 1991 (25,354,125) (1,010,549) (24,343,576) Net loss for the year ended December 31, 1992 (5,099,275) (50,993) (5,048,282) ------------- ------------- ------------- Balance at December 31, 1992 (30,453,400) (1,061,542) (29,391,858) Net income for the year ended December 31, 1993 9,901,817 99,018 9,802,799 ------------- ------------- ------------- Balance at December 31, 1993 $(20,551,583) $ (962,524) $(19,589,059) ============= ============= ============= (A) Includes a $95,000 investment by the General Partner. The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Income: Rental and service $ 17,953,526 $ 21,494,257 $ 21,092,058 Interest on short-term investments 31,346 161,231 192,197 Settlement income 273,294 ------------- ------------- ------------- Total income 17,984,872 21,928,782 21,284,255 ------------- ------------- ------------- Expenses: Interest on purchase price, promissory and mortgage notes payable 8,287,777 10,864,977 11,895,679 Interest on short-term loans 290,389 281,481 395,535 Depreciation 2,712,857 3,573,761 3,568,791 Amortization of deferred expenses 441,513 271,755 271,977 Property operating 4,729,076 6,092,794 5,435,882 Maintenance and repairs 1,838,831 2,613,933 2,136,103 Real estate taxes 1,553,880 1,708,931 1,739,666 Property management fees 893,859 1,047,321 1,049,470 Administrative 679,625 653,998 584,826 ------------- ------------- ------------- Total expenses 21,427,807 27,108,951 27,077,929 ------------- ------------- ------------- Loss before gain on sale of property, participations in joint ventures and extraordinary items (3,442,935) (5,180,169) (5,793,674) Gain on sale of property 3,606,825 Affiliates' participation in losses from joint ventures 70,965 80,894 131,121 ------------- ------------- ------------- Income (loss) before extraordinary items 234,855 (5,099,275) (5,662,553) ------------- ------------- ------------- Extraordinary items: Gain on forgiveness of debt 1,234,276 Gains on foreclosure of properties 8,432,686 ------------- Total extraordinary items 9,666,962 ------------- ------------- ------------- Net income (loss) $ 9,901,817 $ (5,099,275) $ (5,662,553) ============= ============= ============= Income (loss) before extraordinary items allocated to General Partner $ 2,349 $ (50,993) $ (56,626) ============= ============= ============= Income (loss) before extraordinary items allocated to Limited Partners $ 232,506 $ (5,048,282) $ (5,605,927) ============= ============= ============= Income (loss) before extraordinary items per Limited Partnership Interest (87,037 issued and outstanding) $ 2.68 $ (58.00) $ (64.41) ============= ============= ============= Extraordinary items allocated to General Partner $ 96,669 None None ============= ============= ============= Extraordinary items allocated to Limited Partners $ 9,570,293 None None ============= ============= ============= Extraordinary items per Limited Partnership Interest (87,037 issued and outstanding) $ 109.95 None None ============= ============= ============= Net income (loss) allocated to General Partner $ 99,018 $ (50,993) $ (56,626) ============= ============= ============= Net income (loss) allocated to Limited Partners $ 9,802,799 $ (5,048,282) $ (5,605,927) ============= ============= ============= Net income (loss) per Limited Partnership Interest (87,037 issued and outstanding) $ 112.63 $ (58.00) $ (64.41) ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) STATEMENTS OF CASH FLOWS for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Operating activities: Net income (loss) $ 9,901,817 $ (5,099,275) $ (5,662,553) Adjustments to reconcile net income (loss) to net cash used in operating activities: Gain on forgiveness of debt (1,234,276) Gain on foreclosure of properties (8,432,686) Gain on sale of property (3,606,825) Affiliates' participation in losses from joint ventures (70,965) (80,894) (131,121) Depreciation of properties 2,712,857 3,573,761 3,568,791 Amortization of deferred expenses 441,513 271,755 271,977 Deferred interest expense 689,421 870,315 Net change in: Escrow deposits (360,723) 1,166 (288,964) Accounts and accrued interest receivable 165,444 81,663 (44,847) Accounts payable (185,544) (467,175) 554,829 Due to affiliates 99,586 15,662 8,837 Accrued liabilities 341,199 (218,889) 492,315 Security deposits (102,146) (17,016) (22,972) ------------- ------------- ------------- Net cash used in operating activities (330,749) (1,249,821) (383,393) ------------- ------------- ------------- Investing activities: Redemption of restricted investments 2,803,250 Additions to properties (105,150) Reduction of property basis due to seller deficit funding 100,000 Proceeds from sale of property 9,385,000 Costs incurred in connection with sale of real estate (164,056) ------------- ------------- Net cash provided by investing activities 9,220,944 2,798,100 ------------- ------------- Financing activities: Capital contributions by joint venture partners - affiliates 114,741 9,452 Distributions to joint venture partners - affiliates (25,037) (82,416) (63,213) Proceeds from loans payable - affiliate 1,086,469 2,383,975 1,285,186 Repayment of loans payable - affiliate (1,429,236) (1,031,036) Proceeds from issuance of mortgage notes payable 13,236,340 Principal payments on purchase price, promissory and mortgage notes payable (614,974) (1,311,635) (2,532,368) Repayments of mortgage notes payable (19,792,049) Payment of deferred expenses (414,832) (58,585) (68,828) ------------- ------------ ------------ Net cash (used) in or provided by financing activities (7,953,319) 1,046,080 (2,400,807) ------------- ------------ ------------ Net change in cash and cash equivalents 936,876 (203,741) 13,900 Cash and cash equivalents at beginning of year 223,828 427,569 413,669 ------------- ------------- ------------- Cash and cash equivalents at end of year $ 1,160,704 $ 223,828 $ 427,569 ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies: (a) Depreciation expense is computed using the straight-line and accelerated methods. Rates used in the determination of depreciation are based upon the following estimated useful lives: Years Buildings, building appurtenances and land improvements 30 Furniture and fixtures 5 Maintenance and repairs are charged to expense when incurred. Expenditures for improvements are charged to the related asset account. Interest incurred while properties were under construction was capitalized. (b) Deferred expenses consist of loan refinancing and modification fees which are amortized over the terms of the respective loan agreements. (c) Cash equivalents include all highly liquid investments with a maturity of three months or less when purchased. (d) The Partnership is not liable for Federal income taxes and each partner recognizes his proportionate share of the Partnership income or loss in his tax return; therefore, no provision for income taxes is made in the financial statements of the Partnership. (e) Properties are classified in substantive foreclosure when the lender has taken actions that result in the Partnership relinquishing control of the operations of the property, and/or the General Partner anticipates the property may be lost through foreclosure. Once a property has been classified in substantive foreclosure, expenses which are not general obligations of the Partnership, but rather are liabilities collateralized by an interest in the property (such as mortgage interest expense and real estate taxes), are recorded only to the extent such items are paid. The Partnership classified the Rancho Mirage and Highland Ridge apartment complexes in substantive foreclosure as of September 30, 1992. These properties were subsequently lost through foreclosure in March and May 1993, respectively. 2. Partnership Agreement: The Partnership was organized in February 1983. The Partnership Agreement provides for Balcor Partners-84 II, Inc. to be the General Partner and for the admission of Limited Partners through the sale of up to 110,000 Limited Partnership Interests at $1,000 per Interest, 87,037 of which were sold on or prior to September 28, 1984, the termination date of the offering. The Partnership Agreement provides that the General Partner will be allocated 1% of the profits and losses and the Limited Partners will be allocated 99% of the profits and losses. One hundred percent of Net Cash Receipts available for distribution shall be distributed to the holders of Interests in proportion to their participating percentages as of the record date for such distributions. However, there shall be accrued for the benefit of the General Partner as its distributive share from operations, an amount equivalent to approximately 1% of the total Net Cash Receipts being distributed, which will be paid only out of Net Cash Proceeds. Under certain circumstances, the General Partner may participate in the Net Cash Proceeds of the sale or refinancing of Partnership properties. The General Partner's participation is limited to 15% of Net Cash Proceeds, including its share of accrued Net Cash Receipts, and is subordinated to the return of Original Capital plus any deficiency in a Cumulative Distribution of 6% on Adjusted Original Capital to the holders of Interests, as defined in the Partnership Agreement. 3. Purchase Price, Promissory and Mortgage Notes Payable: Purchase price, promissory and mortgage notes payable at December 31,1993 and 1992 consisted of the following: See notes (A) through (O). (A) In April 1993, the Partnership sold this property in an all cash sale. See Note 12 of Notes to Financial Statements for additional information. (B) Title to this property was relinquished to the lender through foreclosure in May 1993. See Note 13 of Notes to Financial Statements for additional information. (C) This loan was modified during August 1992. See Note 4 of Notes to Financial Statements for additional information. (D) The difference between the balloon payments on the previously outstanding interim financing and the assumed balance on the permanent loans is payable in accordance with a non-interest bearing promissory note payable in various years beginning in the year 2000. These amounts on an individual basis do not exceed $109,000, and are reflected in the "Carrying Amount of Notes at December 31, 1993 and 1992." (E) Represents monthly principal and interest payments through the due date of the balloon payment. (F) This balloon payment will require the sale or refinancing of the property. (G) This loan was refinanced during May 1993. See Note 4 of Notes to Financial Statements for additional information. (H) This loan was modified during December 1993. See Note 4 of Notes to Financial Statements for additional information. (I) Represents monthly interest-only payments through January 1, 1996. Thereafter, monthly principal and interest payments of $84,294 are payable through the due date of the balloon payment. (J) Title to this property was relinquished to the lender through foreclosure in March 1993. See Note 13 of Notes to Financial Statements for additional information. (K) Monthly interest-only payments are due through the maturity date. Effective February 1, 1993, debt service payments on this loan were suspended and the lender placed the loan in default in February 1993. In April 1993, the Partnership, through its subsidiaries owning this property, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. While the bankruptcy proceedings continue, the Partnership will remit partial debt service payments to the lender equal to net cash flow from the property. The Partnership and the lender have engaged in discussions in order to reach an agreement on a modification of this loan. A resolution has not been reached as of December 31, 1993. (L) This loan was refinanced during April 1993. See Note 4 of Notes to Financial Statements for additional information. (M) Represents monthly interest-only payments through the due date of the balloon payment. (N) The second mortgage loans on these properties were modified in April 1990. The Partnership did not pay or accrue interest through December 31, 1992, retroactive to August 1, 1988 on the Rosehill Pointe loan and to December 1, 1988 on the Westwood Village loan, and has made interest-only payments at the original contract rate of 9.75% on both loans beginning February 1, 1993 through the extended maturity date of January 1, 1995. (O) This loan originally matured on May 1, 1992. In July 1992, the loan was refinanced and a partial principal paydown of $750,000 was made. The interest rate is adjusted monthly and the rate disclosed is as of December 31, 1993. See Note 4 of Notes to Financial Statements for additional information. Five-year maturities of the purchase price, promissory and notes payable are approximately as follows: 1994 $ 7,657,000 1995 2,107,000 1996 7,631,000 1997 23,704,000 1998 25,496,000 During 1993, 1992 and 1991, the Partnership incurred interest expense on purchase price, promissory and mortgage notes payable of $8,287,777, 10,864,977, and $11,895,679 and paid interest expense of $7,888,588, $10,255,657 and $10,643,001, respectively. 4. Loan Modifications and Refinancings: (a) In December 1993, the General Partner completed a modification of the loan collateralized by the Park Colony Apartments, whereby the interest rate was reduced from 10.25% to 9.375%. The Partnership will make monthly interest-only payments through January 1, 1996. Thereafter, monthly principal and interest payments are payable through the extended maturity date of January 1, 1999. The Partnership paid loan modification fees totaling $142,329 which are being amortized over the term of the loan. (b) In May 1993, the Partnership completed the refinancing of the loan collateralized by the Meadow Creek Apartments. The refinancing resulted in the Partnership obtaining a new first mortgage loan from an unaffiliated lender in the amount of $5,200,000. The loan bears interest at 8.54% per annum and monthly principal and interest payments of $40,131 will be payable through maturity, June 1, 1998. The Partnership used the proceeds from the new mortgage loan to repay the prior loan in the amount of $5,178,672. The Partnership paid refinancing costs of $133,946 which are being amortized over the term of the loan. (c) In April 1993, the first mortgage loan collateralized by the Ridgetree II Apartments was refinanced. The original loan, which had an outstanding balance of $9,578,078, including accrued interest of $95,153, was repaid for a price of $8,343,802 which represents a discount to the Partnership of $1,234,276. The Partnership used proceeds from the new loans of $7,943,500 and made a principal payment of $400,302 to repay the loan. Lehman Brothers, an affiliate of the General Partner, acted as firm underwriter for the sale of the Securities representing ownership of the new loans, and earned underwriting compensation from a third party in accordance with market practices. The new loans from an unaffiliated lender consist of a first mortgage loan of $7,784,630 and a second mortgage loan of $158,870, bear interest at 10.05%, require monthly payments of principal and interest totaling $70,004 and mature on May 1, 2000. The Partnership funded capital and operating reserves of $190,000 and paid related closing costs of $138,557 which are being amortized over the term of the loan. (d) The mortgage loan collateralized by the La Contenta Apartments matured October 1, 1991 and the lender agreed not to take action against the Partnership while an extension of terms was negotiated. In January 1992, the Partnership, through a subsidiary, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. During August 1992, the General Partner completed a modification with the lender, whereby the Partnership will make monthly payments of principal and interest at a rate of 9.5% through the extended maturity date of October 1, 1996. As a result of the agreement with the lender, the Chapter 11 proceedings were dismissed. The Partnership paid loan modification fees of $34,769 which are being amortized over the term of the loan. (e) During July 1992, the General Partner completed the refinancing of the loan collateralized by the Seabrook Apartments. The original loan, in the amount of $5,950,000, which was originally financed by a bond issuance, matured on May 1, 1992. This loan was replaced with a conventional loan from the same lender in the amount of $5,200,000 after a partial paydown of $750,000 was made. The replacement loan bears interest at a floating rate equal to the greater of the lender's prime rate plus 1% or the three-month certificate of deposit rate plus 2% through June 1994, at which time it will increase by .5% annually until maturity, August 15, 1997. Semi-annual payments will be made from a portion of the property's excess cash flow, which will be applied against the outstanding principal balance. The Partnership paid loan refinancing fees totaling $23,816 which are being amortized over the term of the loan. (f) In April 1990, the Partnership completed a modification of the loan collateralized by the Butterfield Village Apartments, whereby the lender granted a nine month extension with a new maturity date of January 18, 1991. The monthly payments were interest-only at an interest rate equal to the preceeding month's three month Treasury Bill rate plus 3%. The Partnership paid a fee of approximately $84,000 relating to this extension during January 1991. During February 1991, the Partnership was granted a second nine month extension by the lender of this loan with a new maturity date of October 1991. Monthly payments continued to include interest equal to the preceeding month's three month Treasury Bill rate plus 3%, but also included principal based on a twenty year amortization period. The Partnership paid a monthly extension fee of approximately $9,300 relating to this second extension, which was included in interest expense. During November 1991, the lender granted a third extension with a new maturity date of October 31, 1994. The Partnership paid a fee of approximately $66,000 relating to this extension together with a principal payment of $100,000. Under the terms of this extension, the Partnership was to pay principal and interest through maturity equal to the prime rate plus 1% with a minimum rate of 8% and a maximum rate of 13%. 5. Management Agreements: As of December 31, 1993, all of the properties owned by the Partnership are under management agreements with Allegiance Realty Group, Inc. (formerly Balcor Property Management, Inc.), an affiliate of the General Partner. These management agreements provide for annual fees of 5% of gross operating receipts. 6. Seller's Participation in Joint Venture: Meadow Creek Apartments located in Pineville, North Carolina is owned by a joint venture between the Partnership and the seller. Consequently, the seller retains an interest in the property through an interest in the joint venture. All assets, liabilities, income and expenses of the joint venture are included in the financial statements of the Partnership with the appropriate deduction from income, if any, for the seller's participation in the joint venture. 7. Affiliates' Participation in Joint Ventures: Rosehill Pointe Apartments is owned by a joint venture between the Partnership and an affiliated partnership. Profits and losses are allocated 61.62% to the Partnership and 38.38% to the affiliate. In addition, Seabrook Apartments is owned by a joint venture between the Partnership and two affiliates of the Partnership. Profits and losses are allocated 83.72% to the Partnership and 16.28% to the affiliates. All assets, liabilities, income and expenses of the joint ventures are included in the financial statements of the Partnership with appropriate adjustment of profit or loss for the affiliate's participation in the joint venture. 8. Settlement Income: (a) In May 1992, the Partnership reached a settlement with the seller of the Rosehill Pointe Apartment for proration amounts the seller owed the Partnership pursuant to the terms of the original management and guarantee agreement. The joint venture which owns the property received $70,266 in June 1992 and $140,554 in December 1992, pursuant to the terms of the settlement. Settlement income of $120,237 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. (b) In June 1992, the Partnership reached a settlement with the seller of the Ridgetree II Apartments. Under the terms of the settlement, the Partnership received cash of $157,000, and was relieved of certain other liabilities by the seller. In addition, the Partnership and seller have released all claims and causes of action against one another. Settlement income of $153,057 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. 9. Tax Accounting: The Partnership keeps its books in accordance with the Internal Revenue Code, rules and regulations promulgated thereunder and existing interpretations thereof. The accompanying financial statements, which are prepared in compliance with generally accepted accounting principles, will differ from the tax returns due to the different treatment of various items as specified in the Internal Revenue Code. The net effect of these accounting differences is that the net income for 1993 in the financial statements is $9,776,605 less than the tax income of the Partnership for the same period. 10. Rentals Under Operating Leases: Minimum rentals under operating leases with lease terms of one year or less expected to be received in 1994 from the following apartment complexes based on December 31, 1993 rental and occupancy rates, are approximately as follows: Occupancy Minimum Property Rate Rentals La Contenta Apartments 97% $ 1,418,000 Meadow Creek Apartments 92% 1,345,000 Park Colony Apartments 97% 2,111,000 Ridgepoint Green Apartments 96% 1,610,000 Ridgepoint Way Apartments 93% 1,706,000 Ridgetree Apartments (Phase II) 92% 1,828,000 Rosehill Pointe Apartments 96% 2,995,000 Seabrook Apartments 98% 1,252,000 Spring Creek Apartments 96% 1,646,000 Westwood Village Apartments 95% 1,697,000 ----------- $17,608,000 =========== The Partnership is subject to the usual business risks regarding the collection of the above-mentioned rentals. 11. Transactions with Affiliates: Fees and expenses paid and payable by the Partnership to affiliates are: Year Ended Year Ended Year Ended 12/31/93 12/31/92 12/31/91 Paid Payable Paid Payable Paid Payable Property manage- ment fees $866,889 $104,097 $976,555 $77,127 $1,053,345 $81,226 Reimbursement of expenses to General Partner at cost: Accounting 64,215 5,310 65,890 4,813 54,315 13,467 Data processing 36,471 6,722 41,631 3,428 50,283 3,666 Investment processing 10,056 831 1,711 125 755 187 Investor com- munications 8,223 680 10,182 744 7,141 1,770 Legal 16,178 1,338 20,582 1,504 17,439 4,324 Portfolio management 73,612 8,332 53,175 12,888 50,053 12,409 Other 15,075 1,246 19,106 1,396 10,033 2,487 As of December 31, 1992, the General Partner had advanced $8,118,490 to the Partnership to provide working capital and meet other Partnership obligations. During 1993, the Partnership borrowed $1,086,469 from the General Partner for additional working capital and repaid $1,429,236 of the loan from a portion of the funds received in connection with the sale of the Butterfield Village Apartments. As of December 31, 1993, $7,775,723 is outstanding to the General Partner. During 1993, 1992 and 1991, the Partnership incurred interest expense of $290,389, $281,481 and $395,535, respectively, in connection with these loans. As of December 31, 1993, interest of $139,876 is payable. Interest expense subsequent to June 30, 1991, was computed at the American Express Company cost of funds rate plus a spread to cover administrative costs. As of December 31, 1993, this rate was 3.93%. This rate is similar to the Shearson Lehman Brothers Holdings Inc. cost of funds rate used to compute interest expense to these loans through June 30, 1991. As of January 1, 1992, the Partnership had outstanding letters of credit in the amount of $508,917 which were guaranteed by an affiliate of the General Partner. These letters of credit were required by the lending institutions of the mortgage loans collateralized by the Highland Ridge, Seabrook and Ridgetree II apartment complexes. During 1992, the lender released a $116,667 letter of credit relating to the Highland Ridge Apartments and the lender on the Seabrook Apartments drew upon the $92,250 letter of credit relating to this loan. During 1993, the $300,000 guarantee relating to the Ridgetree II Apartments was released. The General Partner may continue to provide additional short-term loans to the Partnership or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Partnership would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Partnership may be required to dispose of some of its properties to satisfy these obligations. 12. Property Sale: In April 1993, the Partnership sold the Butterfield Village Apartments located in Tempe, Arizona in an all cash sale for $9,385,000. From the proceeds of the sale, the Partnership paid $6,269,575 in full satisfaction of the first mortgage loan collateralized by the property, $140,775 to an unaffiliated party as a brokerage commission and $23,281 in closing costs. The Partnership received the remaining proceeds of $2,951,369. Neither the General Partner nor its affiliates received a commission in connection with the sale. The basis of the property sold was $5,614,119 (net of accumulated depreciation of $2,713,101). The Partnership recognized a gain on this sale of $3,606,825 in the second quarter financial statements. 13. Extraordinary Items: (a) In April 1993, the Partnership paid $8,343,802 to the lender of the first mortgage loan collateralized by the Ridgetree II Apartments to fully satisfy the Partnership's indebtedness. This transaction produced an extraordinary gain of $1,234,276 on the forgiveness of debt. (b) In March 1993, title to the Rancho Mirage Apartments located in Phoenix, Arizona was relinquished to the lender through foreclosure. The Partnership suspended debt service payments on the mortgage loan collateralized by the property on July 1, 1991 in an effort to negotiate a modification of the loan. In October 1991, the loan was placed in default, and in December 1991, a receiver was appointed. This property was classified as real estate in substantive foreclosure at December 31, 1992. During the first quarter of 1993, the Partnership was released of the obligations through foreclosure and wrote off the mortgage balance of $12,553,714, plus accrued and unpaid interest expense, and real estate taxes of $583,561, security deposits of $29,182 and the property basis of $9,206,393 (net of accumulated depreciation of $4,021,036), resulting in an extraordinary gain on foreclosure of $3,960,064. (c) In April 1992, the modification period relating to the mortgage loan collateralized by the Highland Ridge Apartments located in Oklahoma City, Oklahoma expired and the loan reverted to its previous terms. While negotiating for a further modification of the loan, the Partnership remitted partial debt service payments to the lender equal to monthly net cash flow from the property. During July 1992, the lender filed foreclosure proceedings and subsequently a receiver was appointed. In May 1993, the property was relinquished to the lender through foreclosure. This property was classified as real estate in substantive foreclosure at December 31, 1992. During the second quarter of 1993, the Partnership was released of the obligations through foreclosure and wrote-off the mortgage balance of $15,091,584, plus accrued and unpaid real estate taxes of $36,365, and the property basis of $10,655,327 (net of accumulated depreciation of $4,457,165), resulting in an extraordinary gain on foreclosure of $4,472,622. BALCOR REALTY INVESTORS 84-SERIES II A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) See Notes (a) through (g). BALCOR REALTY INVESTORS 84-SERIES II A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) See Notes (a) through (g). BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) NOTES TO SCHEDULE XI (a) Consists of legal fees, appraisal fees, title costs, other related professional fees and capitalized construction-period interest. (b) The aggregate cost of land for Federal income tax purposes is $16,253,870 and the aggregate cost of buildings and improvements for Federal income tax purposes is $78,834,377. The total of the above-mentioned is $95,088,247. (c) Reconciliation of Real Estate 1993 1992 1991 Balance at beginning of year $138,947,666 $138,947,666 $138,942,516 Additions during the year: Improvements 105,150 Reductions during the year: Foreclosure of properties (28,339,921) Cost of real estate sold (8,327,220) Seller deficit funding adjustment (100,000) ------------ ------------ ------------ Balance at end of year $102,280,525 $138,947,666 $138,947,666 ============ ============ ============ Reconciliation of Accumulated Depreciation 1993 1992 1991 Balance at beginning of year $40,866,069 $ 37,292,308 $ 33,723,517 Depreciation expense for the year 2,712,857 3,573,761 3,568,791 Foreclosure of properties (8,478,201) Accumulated depreciation of real estate sold (2,713,101) ------------ ------------ ------------ Balance at end of year $ 32,387,624 $ 40,866,069 $ 37,292,308 ============ ============ ============ (d) See description of Purchase Price, Promissory and Mortgage Notes Payable in Note 3 of Notes to Financial Statements. (e) Depreciation expense is computed based upon the following estimated useful lives: Years Buildings, building appurtenances and land improvements 30 Furniture and fixtures 5 (f) Guaranteed income earned on properties under the terms of certain management and guarantee agreements is recorded by the Partnership as a reduction of the basis of the property to which the guaranteed income relates. (g) A reduction of basis was made to write down the property to its December 31, 1988 mortgage liability balance (net of an outstanding letter of credit of $500,000).

100826_1993.txt

100826_1993

1993

100826

ITEM 1. BUSINESS. GENERAL The registrant, Union Electric Company (the "Company"), incorporated in Missouri in 1922, is successor to a number of companies, the oldest of which was organized in 1881. The Company, which is the largest electric utility in the State of Missouri, supplies electric service in territories in Missouri and Illinois having an estimated population of 2,600,000 within an area of approximately 24,500 square miles, including the greater St. Louis area. Natural gas purchased from non-affiliated pipeline companies is distributed in 90 Missouri communities and in the City of Alton, Illinois and vicinity. For the year 1993, 95.2% of total operating revenues was derived from the sale of electric energy and 4.8% from the sale of natural gas. Electric operating revenues as a percentage of total operating revenues for the years 1989, 1990, 1991, and 1992 were 96%, 95.9%, 95.7%, and 95.7% respectively. The Company employed 6,417 persons at December 31, 1993. Approximately 70% of the Company's employees are represented by local unions affiliated with the AFL-CIO. Labor agreements representing approximately 4,400 employees will expire in 1996. One agreement covering 107 employees expires in 1994, and one agreement covering 21 employees will expire in 1997. CONSTRUCTION PROGRAM AND FINANCING The Company is engaged in a construction program under which expenditures averaging approximately $310 million are anticipated during each of the next five years. Capital expenditures for compliance with the Clean Air Act Amendments of 1990 are included in the construction program -- also see "Regulation", below. The Company does not anticipate a need for additional electric generating capacity before the year 2000. During the five-year period ended 1993 gross additions to the property of the Company, including allowance for funds used during construction and excluding nuclear fuel, were approximately $1.2 billion (including $266 million in 1993) and property retirements were $190 million. In addition to the funds required for construction during the 1994-1998 period, $174 million will be required to repay long-term debt and preferred stock as follows: $31 million in 1994, $38 million in 1995, $60 million in 1996, and $45 million in 1997. Amounts for years subsequent to 1994 do not include nuclear fuel lease payments since the amounts of such payments are not currently determinable. For information on the Company's external cash sources, see "Liquidity and Capital Resources" under "Management's Discussion and Analysis" on Page 18 of the 1993 Annual Report pages incorporated herein by reference. Financing Restrictions. Under the most restrictive earnings test contained in the Company's principal Indenture of Mortgage and Deed of Trust ("Mortgage") relating to its First Mortgage Bonds ("Bonds"), no Bonds may be issued (except in certain refunding operations) unless the Company's net earnings available for interest after depreciation for 12 consecutive months within the 15 months preceding such issuance are at least two times annual interest charges on all Bonds and prior lien bonds then outstanding and to be issued (all calculated as provided in the Mortgage). Such ratio for the 12 months ended December 31, 1993 was 6.3, which would permit the Company to issue an additional $2.9 billion of Bonds (7% annual interest rate assumed). Additionally, the Mortgage permits issuance of new bonds up to (a) 60% of defined property additions, or (b) the amount of previous bonds retired or to be retired, or (c) the amount of cash put up for such purpose. At December 31, 1993, the aggregate amount of Bonds issuable under (a) and (b) above was approximately $1.5 billion. The Company's Articles of Incorporation restrict the Company from selling Preferred Stock unless its net earnings for a period of 12 consecutive months within 15 months preceding such sale are at least two and one-half times the annual dividend requirements on its Preferred Stock then outstanding and to be issued. Such ratio for the 12 months ended December 31, 1993 was 22.0, which would permit the Company to issue an additional $1.5 billion stated value of Preferred Stock (7% annual dividend rate assumed). Certain other financing arrangements require the Company to obtain prior consents to various actions by the Company, including any future borrowings, except for permitted financings such as borrowings under revolving credit agreements, the nuclear fuel lease, unsecured short-term borrowings (subject to certain conditions), and the issuance of additional Bonds. RATES For the year 1993, approximately 89%, 8%, and 3% of the Company's electric operating revenues were based on rates regulated by Missouri Public Service Commission, Illinois Commerce Commission, and the Federal Energy Regulatory Commission ("FERC") of the Department of Energy, respectively. For additional information on rates, see the penultimate paragraph of Note 10 to the "Notes to Financial Statements" on Page 32 of the 1993 Annual Report pages incorporated herein by reference. FUEL SUPPLY Coal. Because of uncertainties of supply due to potential work stoppages, equipment breakdowns and other factors, the Company has a policy of maintaining a coal inventory of 75 days, based on normal annual burn practices. See "Regulation" for additional reference to the Company's coal requirements. Nuclear. The components of the nuclear fuel cycle required for nuclear generating units are as follows: (1) uranium; (2) conversion of uranium into uranium hexafluoride; (3) enrichment of uranium hexafluoride; (4) conversion of enriched uranium hexafluoride into uranium dioxide and the fabrication into nuclear fuel assemblies; and (5) disposal and/or reprocessing of spent nuclear fuel. The Company has contracts to fulfill its needs for uranium, enrichment, and fabrication services through 2002. The Company's contract for conversion services is sufficient to supply the Callaway Plant through 1995. Additional contracts will have to be entered into in order to supply nuclear fuel during the remainder of the estimated life of the Plant, at prices which cannot now be accurately predicted. The Callaway Plant normally requires re-fueling at 18- month intervals and re-fuelings are presently scheduled for the spring of 1995 and fall of 1996. Under the Nuclear Waste Policy Act of 1982, the U. S. Department of Energy (DOE) is responsible for the permanent storage and disposal of spent nuclear fuel. DOE currently charges one mill per kilowatt-hour sold for future disposal of spent fuel. Electric rates charged to customers provide for recovery of such costs. DOE is not expected to have its permanent storage facility for spent fuel available until at least 2010. The Company has sufficient storage capacity at the Callaway Plant site until 2004 and has viable storage alternatives under consideration that would provide additional storage facilities. Each alternative will likely require Nuclear Regulatory Commission approval and may require other regulatory approvals. The delayed availability of DOE's disposal facility is not expected to adversely affect the continued operation of the Callaway Plant. Oil and Gas. The actual and prospective use of such fuels is minimal, and the Company has not experienced and does not expect to experience difficulty in obtaining adequate supplies. REGULATION The Company is subject to regulation by the Missouri Commission and Illinois Commission as to rates, service, accounts, issuance of equity securities, issuance of debt having a maturity of more than twelve months, and various other matters. The Company is also subject to regulation by the FERC as to rates and charges in connection with the transmission of electric energy in interstate commerce and the sale of such energy at wholesale in interstate commerce, and certain other matters. Authorization to issue debt having a maturity of twelve months or less is obtained from the FERC. Operation of the Company's Callaway Plant is subject to regulation by the Nuclear Regulatory Commission. The Company's Facility Operating License for the Callaway Plant expires on October 18, 2024. The Company's Osage hydroelectric plant and its Taum Sauk pumped-storage hydro plant, as licensed projects under the Federal Power Act, are subject to certain federal regulations affecting, among other things, the general operation and maintenance of the projects. The Company's license for the Osage Plant expires on February 28, 2006, and its license for the Taum Sauk Plant expires on June 30, 2010. The Company's Keokuk Plant and dam located in the Mississippi River between Hamilton, Illinois and Keokuk, Iowa, are operated under authority, unlimited in time, granted by an Act of Congress in 1905. The Company is exempt from the provisions of the Public Utility Holding Company Act of 1935, except Section 9(a)(2) relating to the acquisition of securities of other public utility companies and Section 11(b)(2) with respect to concluding matters relating to the 1974 acquisition of the common stock of a former subsidiary. When the Securities and Exchange Commission approved such acquisition it reserved jurisdiction to pass upon the right of the Company to retain its gas properties. The Company is regulated, in certain of its operations, by air and water pollution and hazardous waste regulations at the city, county, state and federal levels. The Company is in substantial compliance with such existing regulations. Under the Clean Air Act Amendments of 1990, the Company is required to reduce total annual emissions of sulfur dioxide by approximately two-thirds by the year 2000. Significant reductions in nitrogen oxide will also be required. With switching to low-sulfur coal and early banking of emission credits, the Company anticipates that it can comply with the requirements of the law with no significant increase in revenue needs because the related capital costs, currently estimated at about $300 million, will be largely offset by lower fuel costs. The Company's Clean Air Act compliance program is subject to approval by regulatory authorities. As of December 31, 1993, the Company was designated a potentially responsible party (PRP) by federal and state environmental protection agencies for five hazardous waste sites. Other hazardous waste sites have been identified for which the Company may be responsible but has not been designated a PRP. The Company is presently investigating the remedial costs that will be required for all of these sites. Such costs are not expected to have a material adverse effect on the Company's financial position. Other aspects of the Company's business are subject to the jurisdiction of various regulatory authorities. INDUSTRY ISSUES The Company is facing issues common to the electric and gas utility industries which have emerged during the past several years. These issues include: changes in the structure of the industry as a result of amendments to federal laws regulating ownership of generating facilities and access to transmission systems; continually developing environmental laws, regulations and issues; public concern about the siting of new facilities; increasing public attention on the potential public health consequences of exposure to electric and magnetic fields emanating from power lines and other electric sources; proposals for demand side management programs; and public concerns about the disposal of nuclear wastes and about global climate issues. The Company is monitoring these issues and is unable to predict at this time what impact, if any, these issues will have on its operations or financial condition. OPERATING STATISTICS The information on Page 33 in the Company's 1993 Annual Report is incorporated herein by reference. OTHER STATISTICAL INFORMATION ITEM 2. ITEM 2. PROPERTIES. The following table sets forth information with respect to the Company's generating facilities and capability at the time of the expected 1994 peak. In planning its construction program, the Company is presently utilizing a forecast of kilowatthour sales growth of approximately 1.8% and peak load growth of 1.0%, each compounded annually, and is providing for a minimum reserve margin of approximately 18% to 20% above its anticipated peak load requirements. See "Operating Statistics", incorporated by reference in Part I of this Form 10-K, for information on loads and capability during the five-year period ended 1993. See "Liquidity and Capital Resources" under "Management's Discussion and Analysis" on Pages 17 and 18 of the 1993 Annual Report pages incorporated herein by reference for information on the 1992 purchase and sale of certain properties. The Company is a member of one of the nine regional electric reliability councils organized for coordinating the planning and operation of the nation's bulk power supply - MAIN (Mid-America Interconnected Network) operating primarily in Wisconsin, Illinois and Missouri. The Company has interconnections for the exchange of power, directly and through the facilities of others, with fifteen private utilities and with Associated Electric Cooperative, Inc., the City of Columbia, Missouri, the Southwestern Power Administration and the Tennessee Valley Authority. The Company owns 40% of the capital stock of Electric Energy, Inc. ("EEI"), the balance of which is held by three other sponsoring companies -- Kentucky Utilities Company ("KU"), Central Illinois Public Service ("CIPS"), and Illinois Power Company ("IP"). EEI owns and operates a generating plant with a nominal capacity of 1,000 mW. As of January 1, 1994, 60% of the plant's output is committed to the Paducah Project of the DOE, 20% is committed to KU, 10% to the Company, and 5% each to IP and CIPS. As of December 31, 1993, the Company owned approximately 3,297 circuit miles of electric transmission lines and 731 substations with a transformer capacity of approximately 44,324,000 kVA. The Company owns four propane-air plants with an aggregate daily natural gas equivalent capacity of 31,590 million cubic feet and 2,599 miles of gas mains. Other properties of the Company include distribution lines, underground cable, steam distribution facilities in Jefferson City, Missouri and office buildings, warehouses, garages and repair shops. The Company has fee title to all principal plants and other important units of property, or to the real property on which such facilities are located (subject to mortgage liens securing outstanding indebtedness of the Company and to permitted liens and judgment liens, as defined), except that (i) a portion of the Osage Plant reservoir, certain facilities at the Sioux Plant, certain of the Company's substations and most of its transmission and distribution lines and gas mains are situated on lands occupied under leases, easements, franchises, licenses or permits; (ii) the United States and/or the State of Missouri own, or have or may have, paramount rights to certain lands lying in the bed of the Osage River or located between the inner and outer harbor lines of the Mississippi River, on which certain generating and other properties of the Company are located; and (iii) the United States and/or State of Illinois and/or State of Iowa and/or City of Keokuk, Iowa own, or have or may have, paramount rights with respect to, certain lands lying in the bed of the Mississippi River on which a portion of the Company's Keokuk Plant is located. Substantially all of the Company's property and plant is subject to the direct first lien of an Indenture of Mortgage and Deed of Trust dated June 15, 1937, as amended and supplemented. As part of the 1983 merger of the Company with its utility subsidiaries, the Company assumed the mortgage indenture of each subsidiary. Currently, the prior liens of two former subsidiary indentures extend to the property and franchises acquired by the Company from such subsidiaries. Such indentures also contain provisions subjecting to the prior lien thereof after-acquired property of the Company constituting (with certain exceptions) additions, extensions, improvements, repairs, and replacements appurtenant to property acquired in the merger. In addition, one such indenture contains a provision subjecting to the prior lien thereof after- acquired property of the Company situated in the territory served by the former subsidiary prior to the merger. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is involved in legal and administrative proceedings before various courts and agencies with respect to matters arising in the ordinary course of business, some of which involve substantial amounts. Management is of the opinion that the final disposition of these proceedings will not have a material adverse effect on the Company's financial position. INFORMATION REGARDING EXECUTIVE OFFICERS REQUIRED BY ITEM 401(b) OF REGULATION S-K: All officers are elected or appointed annually by the Board of Directors following the election of such Board at the annual meeting of stockholders held in April. There are no family relationships between the foregoing officers of the Company except that Charles J. Schukai and Robert J. Schukai are brothers. Each of the above-named executive officers has been employed by the Company for more than five years in executive or management positions. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information required to be reported by this item is included on page 37 of the 1993 Annual Report and is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Information for the 1989-1993 period required to be reported by this item is included on pages 34 and 35 of the 1993 Annual Report and is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information required to be reported by this item is included on pages 16, 17 and 18 of the 1993 Annual Report and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements of the Company on pages 20 through 32, the report thereon of Price Waterhouse appearing on page 19 and the Selected Quarterly Information on page 18 of the 1993 Annual Report are incorporated herein by reference. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Any information concerning directors required to be reported by this item is included under "Item (1): Election of Directors" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. Information concerning executive officers required by this item is reported in Part I of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Any information required to be reported by this item is included under "Compensation" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Any information required to be reported by this item is included under "Security Ownership of Management" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Any information required to be reported by this item is included under "Item (1): Election of Directors" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: 1. Financial Statements: * *Incorporated by reference from the indicated pages of the 1993 Annual Report 2. Financial Statement Schedules: The following schedules, for the years ended December 31, 1993, 1992, and 1991, should be read in conjunction with the aforementioned financial statements (schedules not included have been omitted because they are not applicable or the required data is shown in the aforementioned financial statements). 3. Exhibits: See EXHIBITS, Page 24 (b) Reports on Form 8-K. None REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- ON FINANCIAL STATEMENT SCHEDULES -------------------------------- To the Board of Directors of Union Electric Company Our audits of the financial statements referred to in our report dated February 2, 1994 appearing on page 19 of the 1993 Annual Report to Stockholders of Union Electric Company (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. /s/ PRICE WATERHOUSE PRICE WATERHOUSE One Boatmen's Plaza St. Louis, Missouri February 2, 1994 UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (Continued on following page) UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Continued) FOR THE YEAR ENDED DECEMBER 31, 1992 Notes: (a) Includes $58,027,040 property, plant and equipment related to Iowa and northern Illinois electric properties sold by the registrant in December, 1992. (b) Reflects Missouri retail electric properties of Arkansas Power & Light Company purchased by the registrant in March, 1992. UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Continued on following page) UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Continued) FOR THE YEAR ENDED DECEMBER 31, 1991 UNION ELECTRIC COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 Note: Includes $46,441,378 amortization of nuclear fuel and $9,076,951 principally reflecting depreciation of transportation and related work equipment charged to clearing accounts and amortization of electric plant acquisition adjustments. UNION ELECTRIC COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 Notes: (a) Includes $47,815,755 amortization of nuclear fuel and $7,827,375 principally reflecting depreciation of transportation and related work equipment charged to clearing accounts and amortization of electric plant acquisition adjustments. (b) Includes $24,135,487 accumulated depreciation related to Iowa and northern Illinois electric properties sold by the registrant in December, 1992. (c) Reflects accumulated depreciation and amortization on Missouri retail electric properties of Arkansas Power & Light Company purchased by the registrant in March, 1992. UNION ELECTRIC COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 Note: Includes $71,964,150 amortization of nuclear fuel and $5,967,364 principally reflecting depreciation of transportation and related work equipment charged to clearing accounts. UNION ELECTRIC COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Note: Uncollectible accounts charged off, less recoveries. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. UNION ELECTRIC COMPANY (Registrant) CHARLES W. MUELLER President and Chief Executive Officer Date March 29, 1994 By /s/ James C. Thompson ------------------------ ------------------------------------- (James C. Thompson, Attorney-in-Fact) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title --------- ----- CHARLES W. MUELLER President, Chief Executive Officer and Director (Principal Executive Officer) DONALD E. BRANDT Senior Vice President (Principal Financial and Accounting Officer) SAM B. COOK Director WILLIAM E. CORNELIUS Director THOMAS A. HAYS Director THOMAS H. JACOBSEN Director RICHARD A. LIDDY Director JOHN PETERS MacCARTHY Director PAUL L. MILLER, JR. Director ROBERT H. QUENON Director HARVEY SALIGMAN Director JANET MCAFEE WEAKLEY Director By /s/ James C. Thompson March 29, 1994 ---------------------------------------- (James C. Thompson, Attorney-in-Fact) EXHIBITS Exhibits Filed Herewith ----------------------- Exhibit No. Description - ----------- ----------- 3(i) - Restated Articles of Incorporation of the Company as filed with the Secretary of the State of Missouri. 4.6 - Supplemental Indenture dated May 1, 1993, creating First Mortgage Bonds, 6 3/4% Series due 2008. 4.7 - Supplemental Indenture dated August 1, 1993, creating First Mortgage Bonds, 7.15% Series due 2023. 4.8 - Supplemental Indenture dated October 1, 1993, creating First Mortgage Bonds, 5.45% Series due 2028. 4.9 - Supplemental Indenture dated January 1, 1994, creating First Mortgage Bonds, 7% Series due 2024. 12(a) - Statement re Computation of Ratios of Earnings to Fixed Charges, 12 Months Ended December 31, 1993. 12(b) - Statement re Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividend Requirements, 12 Months Ended December 31, 1993. 13 - Those pages of the 1993 Annual Report incorporated herein by reference. 23 - Consent of Independent Accountants. 24 - Powers of Attorney. Exhibits Incorporated By Reference ---------------------------------- The following exhibits heretofore have been filed with the Securities and Exchange Commission pursuant to requirements of the Acts administered by the Commission. Such exhibits are identified by the references following the listing of each such exhibit, and they are hereby incorporated herein by reference under Rule 24 of the Commission's Rules of Practice. Exhibit No. Description - ----------- ----------- 3(ii) - By-Laws of the Company as amended to June 12, 1992. (1992 Form 10-K, Exhibit 3.4.) 4.1 - Order of the Securities and Exchange Commission dated October 16, 1945 in File No. 70-1154 permitting the issue of Preferred Stock, $3.70 Series. (Registration No. 2-27474, Exhibit 3-E.) 4.2 - Order of the Securities and Exchange Commission dated April 30, 1946 in File No. 70-1259 permitting the issue of Preferred Stock, $3.50 Series. (Registration No. 2-27474, Exhibit 3-F.) 4.3 - Order of the Securities and Exchange Commission dated October 20, 1949 in File No. 70-2227 permitting the issue of Preferred Stock, $4.00 Series. (Registration No. 2-27474, Exhibit 3-G.) 4.4 - Indenture of Mortgage and Deed of Trust of the Company dated June 15, 1937, as amended May 1, 1941, and Second Supplemental Indenture dated May 1, 1941. (Registration No. 2-4940, Exhibit B-1.) 4.5 - Supplemental Indentures to Mortgage Dated as of File Reference Exhibit No. ----------- -------------- ----------- April 1, 1965 Form 8-K, April 1965 3 May 1, 1966 2-56062 2.33 March 1, 1967 2-58274 2.9 April 1, 1971 Form 8-K, April 1971 6 February 1, 1974 Form 8-K, February 1974 3 July 7, 1980 2-69821 4.6 May 1, 1990 Form 10-K, 1990 4.6 December 1, 1991 33-45008 4.4 December 4, 1991 33-45008 4.5 January 1, 1992 Form 10-K, 1991 4.6 October 1, 1992 Form 10-K, 1992 4.6 December 1, 1992 Form 10-K, 1992 4.7 February 1, 1993 Form 10-K, 1992 4.8 Exhibit No. Description ----------- ----------- 4.10 - Indenture of Mortgage and Deed of Trust of Missouri Power & Light Company dated July 1, 1946 and Supplemental Indentures dated July 1, 1946, November 1, 1949, June 1, 1951, July 1, 1954, December 1, 1959, July 1, 1962, March 1, 1966, April 1, 1967, June 15, 1969, April 15, 1973, December 1, 1974, May 1, 1976 and July 1, 1979. (Registration No. 2-87469, Exhibit 4.1.) 4.11 - Fourteenth Supplemental Indenture dated as of December 30, 1983 to the Mortgage and Deed of Trust dated July 1, 1946, of Missouri Power & Light Company. (1983 Form 10-K, Exhibit 4.23.) 4.12 - Instrument of Substitution of Individual Trustee dated as of November 1, 1988 under the Mortgage and Deed of Trust dated July 1, 1946 of Union Electric Company (successor to Missouri Power & Light Company). (1988 Form 10-K, Exhibit 4.8.) 4.13 - Indenture of Mortgage or Deed of Trust of Missouri Edison Company dated July 1, 1945 and Supplemental Indentures dated January 1, 1952, June 1, 1961, June 1, 1965, August 1, 1975, September 1, 1976, November 1, 1977, February 1, 1981 and July 1, 1982. (Registration No. 2-87469, Exhibit 4.2.) 4.14 - Ninth Supplemental Indenture dated as of December 30, 1983 to the Indenture of Mortgage or Deed of Trust dated as of July 1, 1945 of Missouri Edison Company. (1983 Form 10-K, Exhibit 4.24.) 4.15 - Instrument of Substitution of Trustee dated as of March 1, 1985 under the Indenture of Mortgage or Deed of Trust dated July 1, 1945 of Union Electric Company (successor to Missouri Edison Company). (1984 Form 10-K, Exhibit 4.10.) 4.16 - Instrument of Substitution of Trustee dated as of October 14, 1986 under the Indenture of Mortgage or Deed of Trust dated July 1, 1945 of Union Electric Company (successor to Missouri Edison Company). (September 30, 1986 Form 10-Q, Exhibit 4.2.) 4.17 - Series A Agreement of Sale dated as of June 1, 1984 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Letter of Credit and Reimbursement Agreement dated as of June 1, 1984 between Citibank, N.A. and the Company and Series A Trust Indenture dated as of June 1, 1984 between the Authority and Mercantile Trust Company National Association, as trustee. (Registration No. 2-96198, Exhibit 4.25.) 4.18 - Reimbursement Agreement dated as of April 21, 1992 among Swiss Bank Corporation, various financial institutions, and the Company, providing for an alternate letter of credit to serve as a source of payment for bonds issued under the Series A Trust Indenture dated as of June 1, 1984. (1992 Form 10-K, Exhibit 4.23.) Exhibit No. Description ----------- ----------- 4.19 - Series B Agreement of Sale dated as of June 1, 1984 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Reimbursement Agreement dated as of June 1, 1984 between Chemical Bank and the Company and Series B Trust Indenture dated as of June 1, 1984 between the Authority and Mercantile Trust Company National Association, as trustee. (Registration No. 2-96198, Exhibit 4.26.) 4.20 - Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company, providing for an alternate letter of credit to serve as a source of payment for bonds issued under the Series B Trust Indenture dated as of June 1, 1984. (June 30, 1988 Form 10-Q, Exhibit 4.2.) 4.21 - Amendment and Extension Agreement dated as of June 1, 1990 to the Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company. (1990 Form 10-K, Exhibit 4.29.) 4.22 - Amendment and Extension Agreement dated as of June 1, 1991 to the amended Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.27.) 4.23 - Amendment Agreement dated as of June 1, 1992 to the amended Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.28.) 4.24 - Series 1985 A Reaffirmation Agreement and Second Supplement to Agreement of Sale dated as of June 1, 1985 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Series 1985 A Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company and Series 1985 A Trust Indenture dated as of June 1, 1985 between the Authority and Mercantile Trust Company National Association, as trustee and Texas Commerce Bank National Association, as co-trustee. (June 30, 1985 Form 10-Q, Exhibit 4.1.) 4.25 - Amendment and Extension Agreement dated as of June 1, 1988 revising the Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company. (June 30, 1988 Form 10-Q, Exhibit 4.4.) 4.26 - Amendment and Extension Agreement dated as of June 1, 1990 revising the Reimbursement Agreement dated as of June 1, 1985, as amended, between Union Bank of Switzerland and the Company. (1990 Form 10-K, Exhibit 4.37.) 4.27 - Amendment and Extension Agreement dated as of June 1, 1991 to the amended Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.32.) Exhibit No. Description ----------- ----------- 4.28 - Amendment Agreement dated as of June 1, 1992 to the amended Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.33.) 4.29 - Series 1985 B Reaffirmation Agreement and Third Supplement to Agreement of Sale dated as of June 1, 1985 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Series 1985 B Reimbursement Agreement dated as of June 1, 1985 between The Long- term Credit Bank of Japan, Limited and the Company and Series 1985 B Trust Indenture dated as of June 1, 1985 between the Authority and Mercantile Trust Company National Association, as trustee and Texas Commerce Bank National Association, as co-trustee. (June 30, 1985 Form 10-Q, Exhibit 4.2.) 4.30 - Reimbursement Agreement dated as of February 1, 1993 between Westdeutsche Landesbank Girozentrale and the Company, providing for an alternate letter of credit to serve as a source of payment for bonds issued under the Series 1985 B Trust Indenture dated as of June 1, 1985. (1992 Form 10-K, Exhibit 4.35.) 4.31 - Loan Agreement dated as of May 1, 1990 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Indenture of Trust dated as of May 1, 1990 between the Authority and Mercantile Bank of St. Louis, N.A., as trustee. (1990 Form 10-K, Exhibit 4.40.) 4.32 - Loan Agreement dated as of December 1, 1991 between the State Environmental Improvement and Energy Resources Authority and the Company, together with Indenture of Trust dated as of December 1, 1991 between the Authority and Mercantile Bank of St. Louis, N.A., as trustee. (1992 Form 10-K, Exhibit 4.37.) 4.33 - Loan Agreement dated as of December 1, 1992, between the State Environmental Improvement and Energy Resources Authority and the Company, together with Indenture of Trust dated as of December 1, 1992 between the Authority and Mercantile Bank of St. Louis, N.A., as trustee. (1992 Form 10-K, Exhibit 4.38.) 4.34 - Fuel Lease dated as of February 24, 1981 between the Company, as lessee, and Gateway Fuel Company, as lessor, covering nuclear fuel. (1980 Form 10-K, Exhibit 10.20.) 4.35 - Amendments to Fuel Lease dated as of May 8, 1984 and October 15, 1984, respectively, between the Company, as lessee, and Gateway Fuel Company, as lessor, covering nuclear fuel. (Registration No. 2- 96198, Exhibit 4.28.) 4.36 - Amendment to Fuel Lease dated as of October 15, 1986 between the Company, as lessee, and Gateway Fuel Company, as lessor, covering nuclear fuel. (September 30, 1986 Form 10-Q, Exhibit 4.3.) Exhibit No. Description ----------- ----------- 4.37 - Credit Agreement dated as of August 15, 1989 among the Company, Certain Lenders, The First National Bank of Chicago, as Agent and Swiss Bank Corporation, Chicago Branch, as Co-Agent. (September 30, 1989 Form 10-Q, Exhibit 4.) 4.38 - Credit Agreement dated as of November 8, 1991 between the Company, Certain Banks and Chemical Bank, as Agent. (1991 Form 10-K, Exhibit 4.44.) 4.39 - Amendment dated as of October 26, 1992, to the Credit Agreement dated as of November 8, 1991 between the Company, Certain Banks and Chemical Bank, as Agent. (1992 Form 10-K, Exhibit 4.44.) 10.1 - Deferred Compensation Plan for Members of the Board of Directors. (1992 Form 10-K, Exhibit 10.1.) 10.2 - Retirement Plan for Certain Directors. (1992 Form 10-K, Exhibit 10.2.) 10.3 - Deferred Compensation Plan for Members of the General Executive Staff. (1992 Form 10-K, Exhibit 10.3.) 10.4 - Executive Incentive Plan. (1992 Form 10-K, Exhibit 10.4.) Note: Reports of the Company on Forms 8-K, 10-Q and 10-K are on file with the SEC under file number 1-2967.

200138_1993.txt

200138_1993

1993

200138

ITEM 2. PROPERTIES The Company's principal banking subsidiary, Chittenden Trust, operates banking facilities in 41 locations in Vermont. The offices of the Company and its non-banking subsidiaries are located in the main office of the Chittenden Trust, which occupied all of the five-floor Chittenden Building at Two Burlington Square in Burlington as of December 31, 1993. The Chittenden Building is owned by Chittenden Trust. The offices of Chittenden Trust are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities serviced. ITEM 3. ITEM 3. Legal Proceedings A number of legal claims against the Company arising in the normal course of business were outstanding at December 31, 1993. Management, after reviewing these claims with legal counsel, is of the opinion that these matters, when resolved, will not have a material effect on the consolidated financial statements. Note 12 of the Consolidated Financial Statements appearing on page 31 of the Company's 1993 Annual Report to Stockholders contains a discussion of one legal claim, Walsh v. Chittenden Corp., et.al., which is a class action, and is specifically incorporated herein by reference. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders No matters. PART II ITEM 5. ITEM 5. Market For Registrant's Common Equity and Related Stockholder Matters Information regarding the market in which the Company's common stock is traded, the quarterly high and low bid quotations for the Company's common stock during the past five years is included in the Company's 1993 Annual Report to Stockholders on page 55, and is specifically incorporated herein by reference. The approximate number of stockholders at March 4, 1994 was 3,063. Note 8 of the Consolidated Financial Statements appearing on page 26 of the Company's 1993 Annual Report to Stockholders contains a discussion of restrictions on dividends, which is specifically incorporated herein by reference. ITEM 6. ITEM 6. Selected Financial Data A five-year summary of selected consolidated financial data for the Company and its subsidiaries is included on page 39 of the Company's 1993 Annual Report to Stockholders, and is specifically incorporated herein by reference. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations is included on pages 40-52 of the Company's 1993 Annual Report to Stockholders specifically incorporated herein by reference. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The following consolidated financial statements of the Company and its subsidiaries appear in the Company's 1993 Annual Report to Stockholders at the pages indicated and are incorporated herein by reference: Page Independent Auditors' Reports 37-38 Consolidated Balance Sheets at December 31, 1993 and 1992 13 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992, and 1991 14 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992, and 1991 15 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992, and 1991 16 Notes to Consolidated Financial Statements 17-36 ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There were no disagreements with accountants on accounting principles, or practices, or financial statement disclosure. Arthur Andersen & Co. are the principal accountants for Chittenden Corporation as of and for the year ended December 31, 1993. KPMG Peat Marwick were the principal accountants for Chittenden Corporation for prior periods presented in this Annual Report. On December 28, 1992, that firm was notified that they would be terminated as principal accountants upon completion of the audit of the consolidated financial statements of the Chittenden Corporation as of and for the year ended December 31, 1992, and Arthur Andersen & Co. would be engaged as principal accountants. The decision to change accountants was approved by the Audit Committee of the Board of Directors and by the Board of Directors. In connection with the audits of the fiscal years ended December 31, 1993, 1992, and 1991, there were no disagreements with Arthur Andersen & Co. or KPMG Peat Marwick on any matter of accounting principles or practices, financial statement disclosure, or auditing scope. The audit reports of Arthur Andersen & Co. and KPMG Peat Marwick on the consolidated financial statements of Chittenden Corporation and as of and for the years ended December 31, 1993, 1992, 1991 did not contain any adverse opinion or disclaimers of opinion nor were they qualified or modified as to uncertainty, audit scope, or accounting principles. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant Information regarding the directors and director-nominees of the Registrant is included in the Company's definitive Proxy Statement for the 1994 Annual Meeting of Stockholders at pages 5-10, and is specifically incorporated herein by reference. At December 31, 1993, the principal officers of the Company and its principal subsidiary, Chittenden Trust, with their ages, positions, and years of appointment, were as follows: Year Name and Age Appointed Positions Barbara W. Snelling, 66 1990 Chair of the Company Paul A. Perrault, 42 1990 President and Chief Executive Officer of the Company and Chittenden Trust Lawrence W. Deshaw, 47 1990 Executive Vice President of the Company and Chittenden Trust William R. Heaslip, 49 1988 Executive Vice President of the Company and of Chittenden Trust for Trust Services John W. Kelly, 44 1990 Executive Vice President of the Company and Chittenden Trust Nancy Rowden Brock, 37 1984 Treasurer of the Company and Senior Vice President, Chief Financial Officer, and Treasurer of Chittenden Trust F. Sheldon Prentice, 43 1985 Secretary of the Company and Senior Vice President, General Counsel, and Secretary of Chittenden Trust John P. Barnes, 38 1990 Senior Vice President of Chittenden Trust Danny H. O'Brien, 43 1990 Senior Vice President of Chittenden Trust All of the current officers, with the exceptions of Messrs. Perrault and Kelly, have been principally employed in executive positions with Chittenden Trust for more than five years. Mr. Perrault was President of Bank of New England - Old Colony Bank located in Providence, Rhode Island. Mr. Kelly was Executive Vice President and the head of commercial lending division of Bank of New England - Old Colony in Providence, Rhode Island. In accordance with the provisions of the Company's By-Laws, the officers, with the exception of the Secretary, hold office at the pleasure of the Board of Directors. The Secretary is elected annually by the Board of Directors. ITEM 11. ITEM 11. Executive Compensation Information regarding remuneration of the directors and officers of the Company is included in the Company's definitive Proxy Statement for the 1994 Annual Meeting of Stockholders at pages 4-10 and is specifically incorporated herein by reference. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management Information regarding the security ownership of directors and director-nominees of the Company, all directors and officers of the Company as a group, and certain beneficial owners of the Company's common stock, as of February 3, 1994, is included in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, at pages 4-10, and is specifically incorporated herein by reference. There are no arrangements known to the registrant which may, at a subsequent date, result in a change of control of the registrant. ITEM 13. ITEM 13. Certain Relationships and Related Transactions Information regarding certain relationships and transactions between the Company and its Directors, Director-Nominees, Executive Officers, and family members of these individuals, is included in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders at page 10, and is specifically incorporated herein by reference. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents Filed as Part of this Report were filed as a full document and a segment filing on the EDGAR system called Annual. (l) Financial Statements The following consolidated financial statements of the Company and its subsidiaries appear in the Company's 1993 Annual Report to Stockholders Page Independent Auditors' Reports 37-38 Consolidated Balance Sheets at December 31, 1993 and 1992 13 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992, and 1991 14 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992, and 1991 15 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992, and 1991 16 Notes to Consolidated Financial Statements 17-34 (2)Financial Statement Schedules There are no financial statement schedules required to be included in this report. (4) Exhibits The following are included as exhibits to this report: 3. By-Laws of the Company, as amended, incorporated herein by reference to Exhibit 3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985. 3.01 Amendment to the By-Laws of the Company, dated February 16, 1988, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. 3.02 Amendment to the By-Laws of the Company, dated January 17, 1990, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. 3.03 Amendment to the By-Laws of the Company, dated June 19, 1991, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 3.1 Articles of Association of the Company, as amended, incorporated herein by reference to the Proxy Statement for the 1994 Annual Meeting of Stockholders. 4.2 Agreement regarding furnishing the instruments defining rights of holders of long-term debt, incorporated herein by reference to Exhibit 4.5 to Registration No. 2-89460 under the Securities Act of 1933. 4.31 Statement of the Company regarding its Dividend Reinvestment Plan is attached and made part of the Company's Annual Report on Form 10-K for the year ended December 31, 1993. 10.1 The Company's Employee Stock Purchase Plan, incorporated herein by reference to Appendix A to Registration No. 2-69030 under the Securities Act of 1933. 10.2 Deferred Directors Compensation Plan, dated April 1972, as amended December 1976, August 1980, and March 1983, incorporated herein by reference to Exhibit 10.2 to Registration No.2-89460 under the Securities Act of 1933. 10.21 1986 and 1987 Amendments to Directors Deferred Compensation Plan, incorporated here in by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. 10.22 1990 Amendment to Directors Deferred Compensation Plan, incorporated herein by reference to the Company's Annual Report on form 10-K for the year ended December 31, 1991. 10.23 1992 Amendment to Deferred Directors Compensation Plan,incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10.3 Trust Agreement and Pension Plan of Chittenden Trust, dated December 1, 1969, with amendments thereto, incorporated herein by reference to Exhibit 15 to Registration No. 2-50893 under the Securities Act of 1933. 10.4 Amendments to Trust Agreement and Pension Plan of the Company are attached and made part of the Company's Annual Report on form 10-K for the year ended December 31, 1993. 10.8 Executive Incentive Compensation Plan dated May l, 1984, incorporated herein by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985. 10.9 Incentive Savings and Profit Sharing Plan, incorporated herein by reference to Exhibit 10.10 to the Company Annual Report on Form 10-K for the year ended December 31, 1984. 10.10 The Company's Stock Option Plan, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1984. 10.11 The Company's Stock Option Plan, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. 10.12 The Company's Restricted Stock Plan, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1984. 11. Computation of fully diluted earnings per share. 13. The Company's 1993 Annual Report to Stockholders. 22. List of subsidiaries of the Registrant. 28. The Proxy Statement for the Company's 1994 Annual Meeting of Stockholders. EXHIBIT 4.31 DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN THE COMPANY Chittenden Corporation (the "Company") is a holding company whose principal subsidiary is Chittenden Bank. The Bank provides a full range of financial services and has 40 locations throughout Vermont. Executive offices are located at Two Burlington Square, Burlington, Vermont 05401. DESCRIPTION OF THE PLAN The Dividend Reinvestment and Stock Purchase Plan (the "Plan") for Stockholders of Chittenden Corporation gives participants the opportunity to reinvest dividends in additional shares of the Company's common stock and make optional cash investments in a convenient and cost-free manner without commissions or fees. 1) What is the purpose of the Plan? The purpose of the Plan is to provide each eligible holder of Chittenden Corporation Common Stock with a convenient method of investing cash dividends and making optional cash investments. 2) What are the advantages to stockholders participating in the Plan? a) Cash dividends on all shares of Common Stock are automatically reinvested. b) Additional amounts may be invested by making payments of between $25 and $10,000 quarterly. c) Dividends are reinvested and optional cash investments are made without commissions or fees. d) Dividends on fractions as well as full shares will be reinvested in additional shares and credited to participants' accounts. e) Quarterly statements of account provide participants with a record of each transaction. f) The Agent provides safekeeping of stock certificates. 3) Who administers the Plan for participants? Bank of Boston is the Agent for participating stockholders and keeps a continuing record of participants' accounts, sends quarterly statements to participants and performs other duties relating to the Plan. Common Stock purchased under the Plan is registered in the name of the nominee of the Agent. Should Bank of Boston cease to act as Agent under the Plan, another agent will be appointed by the Company. 4) Who is eligible to participate? All stockholders of record of Common Stock are eligible to participate in the Plan. Shares registered in the name of a broker or nominee must be transferred to the owner's name before they can be enrolled in the Plan. 5) How can an eligible stockholder participate? An eligible stockholder may participate in the Plan by reviewing this brochure, signing the authorization card, and returning it to Bank of Boston. A postage- paid envelope is provided for this purpose. Additional authorization cards may be obtained at any time by contacting Stockholder Relations, Chittenden Corporation, or Bank of Boston. 6) When may a stockholder join the Plan? A stockholder of record may join the Plan at any time if the authorization card is received by Bank of Boston ten days prior to a record date for a dividend. That dividend and any optional cash investment will be invested in additional shares of Common Stock. If the authorization card is received by Bank of Boston after the tenth day before a record date for a dividend, plan membership will not start until the next following dividend. Record dates are usually about two weeks before dividend payment dates, which are normally in the first business week of February, May, August and November. 7) Are there any expenses to participants in connection with purchases under the Plan? No. Participants pay no commissions or fees for purchases made under the Plan. All administration costs are paid by the Company. However, a participant who withdraws from the Plan and directs Bank of Boston to sell Plan shares will pay a fee of 5% of the value of the transaction ($1.00 minimum up to a maximum of $10,000). 8) How many shares of Common Stock will be purchased for participants? The number of shares purchased for a participant's account is determined by the amount of the dividend, the amount of any optional cash payments and the price of Common Stock. Accordingly, you cannot purchase a previously specified number of shares. Your account will be credited on the settlement date with the number of shares, including fractions computed to three decimal places, equal to the total amount invested in your name divided by the purchase price per share. 9) What will be the price of Common Stock purchased under the Plan? The price paid by participants for their shares will be the average purchase price of all shares purchased on the investment date. Purchase(s) may be made in the over-the-counter market or in negotiated transactions and may take more than one day to complete. In making purchases for a participant's account, the Agent may commingle the participant's funds with those of other stockholders participating in the Plan. The Agent has no responsibility for the value of stock acquired for a participant's account. The Agent will invest dividends promptly, and in no event more than 30 days after their receipt except where temporary curtailment or suspension of purchases is necessary to comply with applicable provisions of the Federal Securities Law. 10) Will certificates be issued automatically to participants for shares of Common Stock purchased under the Plan? No. Shares of Common Stock purchased under the Plan will be registered in the name of the Agent (or its nominee) as Agent for the participant. However, at any time, a participant may request in writing that the Agent issue, at no cost to the participant, certificates for any number of whole shares credited to the participant's account under the Plan. A withdrawal/termination form is provided on the reverse side of the quarterly account statement for this purpose or participants may contact Stockholder Relations, Chittenden Corporation. Any remaining whole or fractional shares, for which certificates are not requested, will continue to be credited to the participant's account under the Plan. 11) What is safekeeping of certificates? Certificates representing the Common Stock of the Company now held by you may be submitted to Bank of Boston and consolidated with shares purchased for you under the Plan. The certificates, together with a letter of instruction, must be sent to Bank of Boston by certified or registered mail, return receipt requested. The certificates need not be endorsed. The Agent will cancel the certificates, credit your account with the appropriate number of shares and will treat such shares in the same manner as shares purchased for your account under the Plan. 12) How are optional cash investments made? Optional cash investments may be made after a stockholder has submitted an authorization form and has become a participant in the Plan. Any number of checks between $25 and $10,000 may be sent for investment in each quarter, total not to exceed $10,000 per calendar quarter, checks for more or less than these amounts will be returned to the participant. For investments to be processed, checks must be received by Bank of Boston between 5 business and 30 calendar days before a quarterly dividend date. Interest will not be paid on funds being held for investment. It is in your best interest to deliver any optional cash payments before the 5th business day preceding the dividend payment date. Checks in U.S. funds should be sent payable to: Bank of Boston Dividend Reinvestment Department Box 1681, Mail Stop 45-01-06 Boston, MA 02105 Payments to any other address do not constitute valid delivery. Dividends on all shares purchased through optional investments, and credited to the participant's account, will be reinvested in additional shares on subsequent dividend payment dates. 13) What reports will be sent to participants in the Plan? Each participant will receive a quarterly statement shortly after each dividend payment date. These statements are the record of the cost of purchases and should be retained for tax purposes. In addition, each participant will receive copies of all of the Company's mailings to stockholders. 14) When may a participant withdraw from the Plan? A participant may withdraw by notifying the Agent, in writing, so that the Agent receives the notice before a record date. All subsequent dividends will then be paid to the participant in cash unless the participant re-enrolls in the Plan. If notice of withdrawal is received by the Agent after a record date, that dividend will be reinvested, but all subsequent dividends will be paid in cash. Any optional cash payments which have not yet been invested will be refunded if a written request for refund or withdrawal from the Plan is received by the Agent at least 48 hours prior to a dividend payment date. 15) How does a participant withdraw from the Plan? To withdraw from the Plan, a participant must contact Stockholder Relations at Chittenden Corporation or fill out the form on the top of the quarterly statement and send it to the Agent. The participant may choose one of two options when withdrawing: 1) Ask that certificates for whole shares be issued and sent with a check for any fractional share. The fractional share will be valued at the current market price of Common Stock. 2) Request that all full and fractional shares be sold and that a check for the proceeds be sent less 5% of the value of the transaction ($1.00 minimum up to a maximum of $10.00). The sale will be made at the then current market price. All information regarding the sale of stock is furnished to the Internal Revenue Service. Selling participants should be aware that Common Stock prices may fall during the period between a request for sale, its receipt by the Agent and the ultimate sale in the open market within ten trading days after receipt. This risk is borne solely by the participant. No check will be mailed prior to settlement of funds which is five business days (one week) after the sale of shares. 16) What happens when a participant sells or transfers stock held in certificate form? A Plan participant holds shares in two ways: in certificate form and through nominee name under the Agent. If certificates are sold or transferred, but the participant does not withdraw from the Plan, dividends on any remaining whole or fractional shares held for the participant in nominee name under the Plan will continue to be reinvested. 17) What happens if the Company issues a stock dividend or declares a stock split? Full and fractional shares from stock dividends or splits on all shares participating in the Plan, whether held by the Agent or by the participant, will be credited to a participant's account and subsequent dividends will be reinvested. 18) How will a participant's stock be voted at meetings of stockholders? If a properly signed proxy card is returned, it will be voted as instructed or, if there are not any contradictory instructions, it will be voted with management. If the proxy card is not returned, or is returned unsigned, it will not be voted unless the participant votes in person. 19) What are the federal income tax consequences of participation in the Plan? The calculated dividend payment which is reinvested for a participant in a given tax year is taxable in that year as income. The reinvestment of dividends does not relieve the Participant of any income taxes which may be payable on such dividends. The Agent will report to each participant and the IRS for tax purposes the dividends credited to an account in each calendar year. There is no additional taxable income on certificates for whole shares which have previously been credited to the participant's account under the Plan. However, a participant who receives a cash adjustment for a fraction of a share may have a gain or loss on that fraction. A taxable gain or loss, which is the difference between the amount the participant receives for shares and the tax basis thereof, may be realized by the participant when shares are sold. All participants are urged to consult with their own tax advisors regarding the particular federal, state and local tax consequences of their participation in the Plan. 20) What is the responsibility of the Company and the Agent under the Plan? Neither the Company nor the Agent will be liable for any act or omission to act done in good faith. This includes, without limitation, any claim of liability arising out of failure to terminate a participant's account upon a participant's death prior to receipt of notice in writing of such death. The Company and the Agent cannot assure a profit or protect the participant against a loss on the shares purchased under the Plan. The Company and the Agent reserve the right to interpret and regulate the Plan as may be necessary or desirable. 21) What provision is made for foreign stockholders whose dividends are subject to income tax withholding? In the case of participating foreign holders of Common Stock, whose dividends are subject to United States income tax withholding, the Agent will reinvest an amount equal to the dividends less the amount of tax required to be withheld. Quarterly statements will be mailed confirming purchases made for foreign participants. Optional cash investments received from foreign stockholders must be in United States dollars. 22) Can the Plan be changed or discontinued? The Company reserves the right to suspend, modify or terminate the Plan at any time. Notice of any such suspension, modification or termination will be sent to all participants. 23) How can I get more information about the Plan? To make inquires or obtain additional information please contact: F. Sheldon Prentice, Secretary Eugenie J. Fortin, Assistant Secretary Chittenden Corporation Two Burlington Square Burlington, VT 05401 (802) 660-1412 (800) 642-3158 or Bank of Boston Shareholder Services P.O. Box 644, Mail Stop 45-02-09 Boston, MA 02102-0644 (617) 575-2900 Plan revised January 1994 EXHIBIT 10.4 FIRST AMENDMENT TO THE PENSION PLAN FOR EMPLOYEES OF THE CHITTENDEN CORPORATION (As Amended and Restated Effective December 1, 1984) WHEREAS, Chittenden Corporation (the "Corporation") presently provides retirement benefits for certain of its employees pursuant to the terms of the Pension Plan for Employees of the Chittenden Corporation (the "Plan"); and WHEREAS, the Corporation desires to amend the Plan to provide a cost of living increase to retirement benefits in pay status for Plan participants; NOW THEREFORE, the Plan is hereby amended by adding the following new Section 5.11 to Article V: "Any member or Beneficiary whose Pension entered pay status not later than December 31, 1985 shall have such Pension increases by a cost of living increase percentage determined in accordance with the following schedule: Such percentage increase shall, however, be applied to the amount of Pension in pay status as of December 31, 1986 to such Members or Beneficiaries, and shall commence with the payment due on January 1, 1987." This First Amendment shall be effective as of December 31, 1986. IN WITNESS WHEREOF, the foregoing amendment having been duly approved and adopted by the Board of Directors of Chittenden Corporation, the Board has caused this amendment to be executed in their name and on their behalf by the Chairman and Chief Executive of the Corporation thereunto duly authorized this 15th day of October, 1986. CHITTENDEN CORPORATION BY: Cynthia D. LaWare ----------------------- TITLE: Senior Vice President ------------------------ ATTEST: John F. McAteer -------------------- Secretary AMENDMENT NUMBER TWO TO THE PENSION PLAN FOR EMPLOYEES OF THE CHITTENDEN CORPORATION (As Amended and Restated Effective December 1, 1984) WHEREAS, Chittenden Corporation (the "Principal Employer") adopted the Pension Plan for Employees of the Chittenden Corporation (the "Plan") as amended and restated effective December 1, 1984; and WHEREAS, Section 11.1 permits the Principal Employer to Amend the Plan; and WHEREAS, the Principal Employer desires to amend the Plan to change the Plan Year; NOW, THEREFORE, the Plan is hereby amended effective December 1, 1992, and follows: Section 2.1.27 is amended by adding the following to the end thereof: "Effective January 1, 1993, the Plan Year shall be the calendar year, with a short Plan Year for the period beginning December 1, 1992, and ending December 31, 1992." IN WITNESS WHEREOF, the foregoing amendment having been duly approved and adopted by the Board of Directors of Chittenden Corporation, the Board has caused this amendment to be executed in their name and on their behalf by the Officer of the Corporation thereunto duly authorized this 31st day of December, 1992. CHITTENDEN CORPORATION BY: F. Sheldon Prentice ---------------------- TITLE: Secretary ----------------------- ATTEST: Eugenie J. Fortin ---------------------- Asst. Secretary AMENDMENT NUMBER THREE TO THE PENSION PLAN FOR EMPLOYEES OF THE CHITTENDEN CORPORATION (As Amended and Restated Effective December 1, 1984) WHEREAS, Chittenden Corporation (the "Principal Employer") adopted the Pension Plan for Employees of the Chittenden Corporation (the "Plan") as amended and restated effective December 1, 1984; and WHEREAS, Section 11.1 permits the Principal Employer to amend the Plan; and WHEREAS, the Principal Employer desires to amend the Plan; NOW, THEREFORE, the Plan is hereby amended effective July 1, 1993, and follows: Section 3.2 is amended by adding the following to the end thereof: (E) Notwithstanding anything herein to the contrary, an Employee of the Principal Employer who was an Employee of Bellows Falls Trust Company before it was acquired by the Principal Employer shall receive credit for purposes of this Section 3.2 for any service with the former Bellows Falls Trust Company, provided such service would have been considered Eligibility Service in accordance with paragraph (A) of Section 3.2. Section 3.3 is amended by adding the following to the end of thereof: (F) An Employee of Bellows Falls Trust Company who becomes a Member of this plan shall receive credit for purposes of this Section 3.3 for all services with the former Bellows Falls Trust Company through June 30, 1993 which would have been credited under the Bellows Falls Trust Company Pension Plan in the determination of the amount of accrued benefit under the provisions of the Bellows Falls Trust Pension Plan. In no event shall the Employee receive a lesser benefit than accrued as of June 30, 1993, under the provisions of that former plan. Section 5.5 is amended by adding the following to the end of thereof: (G) Notwithstanding anything herein to the contrary, the amount of deferred Vested Pension of any Member of this Plan who was a Member of the Bellows Falls Trust Company Pension Plan as of June 30, 1993, shall not be less than the deferred Vested Pension to which he was entitled as of June 30, 1993, under the provisions of that former plan. IN WITNESS WHEREOF, the foregoing amendment having been duly approved and adopted by the Board of Directors of Chittenden Corporation, the Board has caused this amendment to be executed in their name and on their behalf by the Officer of the Corporation thereunto duly authorized this 20th day of October, 1993. CHITTENDEN CORPORATION BY: F. Sheldon Prentice --------------------- TITLE: Secretary ---------------------- ATTEST: Eugenie J. Fortin ----------------------- Assistant Secretary EXHIBIT 11 Chittenden Corporation EXHIBIT 13, CHITTENDEN'S 1993 ANNUAL REPORT HAS BEEN FILED AS A SUBORDINATE SEGMENT FILING TO FORM 10K. EXHIBIT 22 LIST OF SUBSIDIARIES OF CHITTENDEN CORPORATION Chittenden Trust Company SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) 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. Date: March 16, 1994 CHITTENDEN CORPORATION By: Paul A. Perrault Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on the dates indicated. Name Title Date Barbara W. Snelling, Chair of the Board of 3/16/94 Directors Paul A. Perrault, President and Chief 3/16/94 Executive Officer and Director Nancy Rowden Brock, Treasurer 3/16/94 Frederic H. Bertrand, Director 3/16/94 David M. Boardman, Director 3/16/94 Paul J. Carrara, Director 3/16/94 Eugene P. Cenci, Director 3/16/94 Robert E. Cummings, Jr., Director 3/16/94 Marvin B. Gameroff, Director 3/16/94 Philip A. Kolvoord, Director 3/16/94 Maureen A. McNamara, Director 3/16/94 James C. Pizzagalli, Director 3/16/94 Pall D. Spera, Director 3/16/94 Martel D. Wilson, Jr., Director 3/16/94

794323_1993.txt

794323_1993

1993

794323

ITEM 1. BUSINESS. Peter Kiewit Sons', Inc. (the "Company") was incorporated in Delaware in 1941 to continue a construction business founded in Omaha, Nebraska in 1884. The Company entered the coal mining business in 1943 and the telecommunications business in 1988. Since 1990, the Company's subsidiary, PKS Information Services, Inc. has provided computer services to third parties. Financial information about the construction, mining, and telecommunications segments, as well as geographical information, is contained in Note 17 to the Company's consolidated financial statements. In connection with a reclassification of the Company's securities in January 1992, the business units of the Company were realigned into two groups. The Construction & Mining Group contains the Company's traditional construction operations and Kiewit Mining Group Inc., which performs mining management services for the Company's mining properties. The Diversified Group (through Kiewit Diversified Group Inc., or "KDG") contains mining properties and miscellaneous investments, as well as interests in MFS Communications Company, Inc., California Energy Company, Inc., and C-TEC Corporation. Additional detailed information about each of those three companies can be obtained from their separate Forms 10-K filed with the U.S. Securities and Exchange Commission. CONSTRUCTION The construction business is conducted by operating subsidiaries of Kiewit Construction Group Inc., a wholly-owned subsidiary of the Company (collectively, "KCG"). KCG and its joint ventures perform construction services for a wide range of public and private customers primarily in North America. New contract awards during 1993 were distributed among the following construction markets: transportation, including highways, bridges, airports and railroads (58%), sewer and waste disposal (13%), buildings (11%), oil and gas (7%), power (6%), residential (2%), and water supply systems (1%), with smaller awards in the dams and reservoirs, marine, and mining markets. As general contractors, KCG's operating subsidiaries are responsible for the overall direction and management of construction projects and for completion of each contract in accordance with terms and specifications. KCG plans and schedules the projects, procures materials, hires workers as needed, and awards subcontracts. KCG generally requires performance and payment bonds or other assurances of operational capability and financial capacity from its subcontractors. KCG's construction contracts generally provide for the payment of a fixed price for the work performed. Profit is realized by the difference between the contract price and the actual cost of construction, and the contractor bears the risk that it may not be able to perform all the work for the specified amount. The contracts generally provide for progress payments as work is completed, with a retainage to be paid when performance is substantially complete. Construction contracts frequently contain penalties or liquidated damages for late completion and infrequently provide bonuses for early completion. Government Contracts. Public contracts accounted for 67% of the combined prices of contracts awarded to KCG during 1993. Most of these contracts were awarded by government agencies after competitive bidding. Most public contracts are subject to termination at the election of the government. In the event of termination, the contractor is entitled to receive the contract price on completed work and payment of termination related costs. The volume of available government work is affected by budgetary and political considerations. A significant decrease in the amount of new government contracts, for whatever reasons, would have a material adverse effect on KCG. Demand. The volume and profitability of KCG's construction work depends to a significant extent upon the general state of the economies of the United States and Canada, and the volume of work available to contractors. Fluctuating demand cycles are typical of the industry, and such cycles determine to a large extent the degree of competition for available projects. KCG's construction operations could be adversely affected by labor stoppages or shortages, adverse weather conditions, shortages of supplies, or governmental action. Joint Ventures. KCG enters into joint ventures to efficiently allocate expertise and resources among the venturers and to spread risks associated with particular projects. In most joint ventures, if one venturer is financially unable to bear its share of costs and expenses, the other venturers may be required to pay those costs and expenses. KCG prefers to act as the sponsor of joint ventures. KCG's share of joint venture revenue accounted for 24% of its 1993 total revenue. Locations. KCG structures its construction operations around 20 principal operating offices located throughout the U.S. and Canada, with headquarters in Omaha, Nebraska. Through its decentralized system of management, KCG has been able to quickly respond to changes in the local markets. Internationally, a KCG subsidiary is participating in the construction of a tunnel under Denmark's Great Belt Channel and other subsidiaries have operations in Hermosillo, Mexico. Backlog. At the end of 1993, KCG had a backlog (work contracted for but not yet completed) of $2.1 billion. Of this amount, $700 million is not expected to be completed during 1994. Backlog was $2.2 billion at the end of 1992. Competition. A substantial portion of KCG's business involves construction contracts obtained through competitive bidding. A contractor's competitive position is based primarily on its prices for construction services and its reputation for quality, reliability and timeliness. The construction industry is highly competitive and lacks firms with dominant market power. For 1992, Engineering News Record ranked KCG as the 22nd largest contractor in the United States. It ranked KCG 6th in the transportation market and 7th in the domestic heavy construction market. These rankings were based on the prices of contracts awarded in 1992. The U.S. Department of Commerce reports that the total value of construction put in place in 1993 was $486 billion. KCG's U.S. revenues for the same period were $1.8 billion, or 0.4% of the total market. In 1993 KCG was low bidder on 253 contracts, three of which had a contract price exceeding $50 million; the average contract price was $5.8 million. Properties. KCG has 20 district offices, of which 14 are in owned facilities and 6 are leased. KCG owns or leases numerous shops, equipment yards, storage facilities, warehouses, and construction material quarries. Since construction projects are inherently temporary and location-specific, KCG owns approximately 800 portable offices and shops, and 400 transport trailers. KCG has a large equipment fleet, including approximately 3,000 trucks, pickups, and automobiles, and 1,500 heavy construction vehicles, such as graders, scrapers, backhoes, and cranes. Subsequent Event. On February 28, 1994, KCG acquired APAC-Arizona, Inc. ("APAC") from Ashland Oil Company, Inc. for $49 million cash, subject to various adjustments. APAC is engaged in construction and construction materials businesses in Arizona. The APAC businesses will be divided between PKS' construction and mining segments. MINING The Company is engaged in coal mining through its subsidiaries, Kiewit Mining Group Inc. ("KMG") and Kiewit Coal Properties Inc. ("KCP"). KCP has a 50% interest in three mines, which are operated by KMG. Decker Coal Company ("Decker") is a joint venture with Western Minerals, Inc., a subsidiary of NERCO, Inc. Black Butte Coal Company ("Black Butte") is a joint venture with Bitter Creek Coal Company, a subsidiary of Union Pacific Corporation. Walnut Creek Mining Company ("Walnut Creek") is a general partnership with Phillips Coal Company, a subsidiary of Phillips Petroleum Company. The Decker Mine is located in southeastern Montana, the Black Butte Mine is in southwestern Wyoming, and the Walnut Creek Mine is in east-central Texas. Kiewit also has interests in two smaller coal mines, a precious metals mine, and construction aggregate quarries. Production and Distribution. The coal mines use the surface mining method. During surface mining operations, topsoil is removed and stored for later use in land reclamation. After removal of topsoil, overburden in varying thicknesses is stripped from above coal seams. Stripping operations are usually conducted by means of large, earth-moving machines called draglines, or by fleets of trucks, scrapers and power shovels. The exposed coal is fractured by blasting and is loaded into haul trucks or onto overland conveyors for transportation to processing and loading facilities. Coal delivered by rail from Decker originates on the Burlington Northern Railroad. Coal delivered by rail from Black Butte originates on the Union Pacific Railroad. Coal is also hauled by trucks from Black Butte to the nearby Jim Bridger Power Plant. Coal is delivered by trucks from Walnut Creek to the adjacent facilities of the Texas-New Mexico Power Company. Customers. The coal is sold primarily to electric utilities, which burn coal in order to generate steam to produce electricity. Approximately 94% of sales are made under long-term contracts, and the remainder are made on the spot market. Approximately 84, 55, and 58 percent of KCP's revenues in 1993, 1992 and 1991, respectively, were derived from long-term contracts with Commonwealth Edison Company (with Decker and Black Butte) and The Detroit Edison Company (with Decker). The sole customer of Walnut Creek is the Texas- New Mexico Power Company. Contracts. Customers enter into long-term contracts for coal primarily to secure a reliable source of supply at a predictable price. KCP's major long-term contracts have remaining terms ranging from 6 to 35 years. A majority of KCP's long-term contracts provide for periodic price adjustments. The price is typically adjusted through the use of various indices for items such as materials, supplies, and labor. Other portions of the price are adjusted for changes in production taxes, royalties, and changes in cost due to new legislation or regulation, and in most cases, such cost items are passed through directly to the customer as incurred. In most cases the price is also adjusted based on the heating content of the coal. Beginning in 1993 the amended contract between Commonwealth Edison Company and Black Butte Coal Company provides that Commonwealth's delivery commitments will be satisfied, not with coal produced from the Black Butte mine, but with coal purchased from two unaffiliated mines in the Powder River Basin of Wyoming and Decker. Coal Production. Coal production commenced at the Decker, Black Butte, and Walnut Creek mines in 1972, 1979, and 1989, respectively. Coal mined in 1993 at the Decker, Black Butte, and Walnut Creek mines was 11, 3, and 2 million tons, respectively. Revenue. KCP's total revenue in 1993 was $210 million. Revenue attributable to the Decker, Black Butte, and Walnut Creek entities, and other mining operations was $98 million, $92 million, $19 million, and $1 million, respectively. Backlog. At the end of 1993, the backlog of coal sold under KCP's long- term contracts approximated $2.0 billion, based on December 1993 market prices. Of this amount, approximately $243 million is to be sold in 1994. Reserves. At the end of 1993, KCP's share of assigned coal reserves at Decker, Black Butte, and Walnut Creek was 184, 60, and 90 million tons, respectively. Of these amounts, KCP's share of the committed reserves of Decker, Black Butte, and Walnut Creek was 68, 7, and 22 million tons, respectively. Assigned reserves represent coal which can be mined using KCP's current mining practices. Committed reserves (excluding alternate source coal) represent KCP's maximum contractual amounts. These coal reserve estimates represent total proved and probable reserves. Leases. The coal reserves and deposits of the mines are held pursuant to leases with the federal government through the Bureau of Land Management, with two state governments (Montana and Wyoming), and with numerous private parties. Competition. The coal industry is highly competitive. KCP competes not only with other domestic and foreign coal suppliers, some of whom are larger and have greater capital resources than KCP, but also with alternative methods of generating electricity and alternative energy sources. In 1992, KCP's production represented 2.0% of total U.S. coal production. Demand for KCP's coal is affected by economic, political and regulatory factors. For example, recent "clean air" laws may stimulate demand for low sulphur coal. KCP's western coal reserves generally have a low sulfur content (less than one percent) and are currently useful principally as fuel for coal- fired steam-electric generating units. KCP's sales of its western coal, like sales by other western coal producers, typically provide for delivery to customers at the mine. A significant portion of the customer's delivered cost of coal is attributable to transportation costs. Most of the coal sold from KCP's western mines is currently shipped by rail to utilities outside Montana and Wyoming. The Decker and Black Butte mines are each served by a single railroad. Many of their western coal competitors are served by two railroads and such competitors' customers often benefit from lower transportation costs because of competition between railroads for coal hauling business. Other western coal producers, particularly those in the Powder River Basin of Wyoming, have lower stripping ratios (i.e. the amount of overburden that must be removed in proportion to the amount of minable coal) than the Black Butte and Decker mines, often resulting in lower comparative costs of production. Environmental Regulation. Kiewit is required to comply with various federal, state and local laws and regulations concerning protection of the environment. KCP's share of land reclamation expenses in 1993 was $5 million. KCP's share of accrued estimated reclamation costs was $99 million at the end of 1993. Kiewit does not expect to make significant capital expenditures for environmental compliance in 1994. Kiewit believes its compliance with environmental protection and land restoration laws will not affect its competitive position since its competitors in the industry are similarly affected by such laws. TELECOMMUNICATIONS The Company provides telecommunication services through two partially- owned subsidiaries, MFS Communications Company, Inc. and C-TEC Corporation. MFS COMMUNICATIONS COMPANY, INC. The Company owns 71% of the common stock of MFS Communications Company, Inc. ("MFS"). The remaining shares are publicly-owned and are traded on the NASDAQ National Market System. Shares were sold in an initial public offering in May of 1993 and in another public offering in September of 1993. MFS operates in two business segments: telecommunications services, and network systems integration and facilities management services. Telecommunications Services. MFS Telecom, Inc. ("MFS Telecom") is a major competitive access provider, offering business and government users an alternative to the local telephone companies for various telecommunication services. At the end of 1993, MFS Telecom operated telecommunication networks in 14 metropolitan areas: New York City, Los Angeles, Chicago, San Francisco, Philadelphia, Boston, Washington, D.C., Dallas, Houston, Minneapolis, Baltimore, Pittsburgh, Atlanta and northern New Jersey. At the end of 1993, MFS Telecom provided service to over 900 users. Its network covers approximately 1,300 route miles, including approximately 62,000 miles of optical fiber, with nearly 1,600 office buildings connected to the network. MFS Telecom's primary service offerings are special access and private line. Special access service connects a long distance carrier to an end user or another carrier. Private line service consists of dedicated circuits connecting two end users, typically two offices of a single business. To the extent that transmissions over circuits on the MFS Telecom network do not pass through facilities of the local telephone company, access charges for long distance service are avoided. MFS Telecom's digital fiber optic networks employ advanced fault-tolerant electronics and dual path architecture to ensure reliable and secure telecommunications. MFS Telecom has an active program to expand its existing networks and to develop new networks in other metropolitan areas throughout the United States and internationally. It currently contemplates expansion into more than 60 additional markets (including a number of international markets) over the next three to five years. In 1993, MFS Telecom commenced construction of new fiber optic networks in London, England, the San Jose-Silicon Valley area of California, and Tampa, Florida. In 1993, MFS developed two new services which utilize the existing MFS Telecom networks. MFS Datanet, Inc. offers high-speed data telecommunications services, including an innovative service designed to connect geographically separate local area networks ("LAN"') at the same native speed and protocol at which each LAN operates. MFS Intelenet, Inc. ("Intelenet") is providing a single source for local and long distance telecommunication services to small and medium sized businesses in New York City. As regulatory barriers are removed, the services offered by Intelenet will be provided in all of MFS Telecom's network cities. Network Systems Integration and Facilities Management Services. MFS' subsidiary, MFS Network Technologies, Inc. ("MFS-NT"), designs, engineers, develops and manages the installation of MFS Telecom's new fiber optic networks and its network expansions. MFS-NT also offers its network systems integration services and facilities management services to third parties. MFS-NT had a third-party backlog of approximately $110 million at the end of 1993, an increase of 49% from year-end 1992. A substantial portion of the backlog is related to federal, state or local government contracts. Although some of these contracts are subject to cancellation and/or to a revision of funding, MFS believes that MFS-NT is adequately protected for all incurred costs and the reasonable costs of termination. Customers. MFS Telecom's customers include long distance carriers as well as financial service companies, government departments and agencies, and academic, scientific and other major institutions, each of which has a significant volume of traffic and/or requires extremely reliable communications. During 1993, MFS Telecom's top ten customers accounted for approximately 50% of its total recurring revenue; however, no single customer of MFS Telecom accounted for more than 10% of MFS' consolidated revenues. MFS-NT's third party customers include major local and long distance carriers, cable television operators, government units, and large corporations. During 1993, a contract with the State of Iowa for remote interactive learning facilities accounted for 30% of MFS' consolidated revenues. Competition. In each of its markets, MFS Telecom faces significant competition for its special access and private line telecommunications services from local telephone companies, which currently dominate their local telecommunications markets. Existing competition for private line and special access services is not based on proprietary technology, but on the quality and reliability of the network facilities, customer service, and service features and price. As a result of the comparatively recent installation of its fiber optic networks, its dual path architecture and the state-of-the-art technology used in its networks, MFS Telecom may, in some cases, have cost and service quality advantages over some currently available local telephone company networks. MFS-NT's network systems integration and facilities management competitors are primarily the regional Bell operating companies, long distance carriers, equipment manufacturers and major independent telephone companies. Regulation. MFS is subject to varying degrees of federal, state and local regulation. MFS is not subject to price cap or rate of return regulation, nor is it currently required to obtain Federal Communication Commission ("FCC") authorization for installation or operation of its network facilities used for domestic services. FCC approval is required, however, for the installation and operation of its international facilities and services. The FCC has determined that nondominant carriers, such as MFS, are required to file interstate tariffs on an ongoing basis. MFS subsidiaries that provide intrastate service are generally subject to certification and tariff filing requirements by state regulators. C-TEC CORPORATION On October 29, 1993, the Company purchased a controlling interest in C-TEC Corporation ("C-TEC") for $207 million. Through subsidiaries, the Company acquired 7.5% of the outstanding shares of C-TEC common stock and 59.6% of the C-TEC Class B common stock. Holders of common stock are entitled to one vote per share; holders of Class B stock are entitled to 15 votes per share. The Company thus owns 34.5% of the outstanding shares, but is entitled to 56.6% of the available votes. C-TEC common stock is traded on the NASDAQ National Market System, and the Class B Stock is quoted on NASDAQ and traded over the counter. C-TEC Corporation has headquarters in Wilkes-Barre, Pennsylvania (it has announced plans to move certain key corporate and operating group functions to Princeton, New Jersey). C-TEC has five operating groups. Commonwealth Telephone Company provides local telephone service in 19 counties in eastern Pennsylvania. With more than 211,000 main access lines, Commonwealth is the 20th largest U.S. telephone company. The Cable Group is a cable television operator with systems located in New York, New Jersey, Michigan, Delaware, and Pennsylvania. The Cable Group owns and operates systems serving 224,000 customers and manages systems with an additional 34,000 customers, ranking it among the top 35 U.S. multiple systems operators. The Mobile Services Group offers cellular telephone service in northeastern and central Pennsylvania and southeastern Iowa, as well as paging and message management services in northeastern Pennsylvania. The Long Distance Group sells long distance telephone services in the Commonwealth Telephone local service area and resells services elsewhere. The Communications Group provides telecommunications- related engineering and technical services in the northeastern U.S. Regulation. Commonwealth Telephone Company and C-TEC's long distance telephone subsidiary are subject to FCC regulation. Commonwealth Telephone Company is subject to extensive regulation by the Pennsylvania Public Utility Commission, including its rate-making process. Consequently, the ability of Commonwealth Telephone Company to generate increased income is largely dependent on its ability to increase its subscriber base, obtain higher message volume, and control its expenses. C-TEC's cable television operations are regulated by local and state franchise authorities and by the FCC. The federal Cable Television Consumer Protection and Competition Act of 1992 has increased FCC oversight, including increased regulation of subscriber rates. OTHER OPERATIONS CALIFORNIA ENERGY COMPANY, INC. California Energy Company, Inc. ("CECI") is an independent power producer and a developer and owner of geothermal and other environmentally responsible power generating facilities. CECI currently operates five geothermal facilities, producing in excess of 250 megawatts of electricity, and controls leases to 450,000 areas of geothermal development property in the western United States. CECI, with KCG and others, is developing geothermal facilities in the Philippines. Kiewit Energy Company ("KEC"), a Company subsidiary, owns 21 percent of the outstanding common stock (7.4 million shares) of CECI; CECI common stock is traded on the New York Stock Exchange. KEC has options to purchase 5.5 million common shares, at exercise prices below the current market price. In 1991, KEC purchased $50 million of CECI voting convertible preferred stock, on which dividends are payable at an 8.125% rate. The combined common stock and preferred stock voting rights presently entitle KEC to 28% of the available votes. If the options were exercised and the preferred stock converted, KEC would own approximately 37% of CECI's common stock. A 1991 agreement provides for three KEC representatives on the CECI board of directors and prohibits KEC from acquiring more than 49% of CECI's voting stock before March 1996. In December 1993, KDG and KCG (together "Kiewit") signed a joint venture agreement with CECI, covering international power project development activities in Asia, particularly in the Philippines and Indonesia, and in other regions (excluding the Caribbean, South America, and Central America). The agreement, which has an initial term of three years, provides each party a right of first refusal to pursue jointly all "build, own and operate" or "build, own, operate and transfer" power projects identified by the other party or its affiliates. If both parties agree to participate in a project, they will share all development costs equally, each of CECI and Kiewit will provide 50% of the equity required for financing a project developed by the joint venture, and CECI will operate and manage any such project. The agreement contemplates a joint development structure under which, on a project by project basis, CECI will be the development manager, managing partner and/or project operator, an equal equity participant with Kiewit and a preferred participant in the construction consortium and Kiewit will be an equal equity participant and the preferred turnkey construction contractor, with the construction consortium providing customary security to project lenders (including CECI) for liquidated damages and completion guarantees. INFORMATION SERVICES In addition to providing information services to the Company and its subsidiaries, PKS Information Services, Inc. ("PKSIS") provides remote computing services, or "computer outsourcing", to users of IBM and DEC systems under long-term contracts. The primary focus of PKSIS is on the systems operations segment of the computer outsourcing market. Voice and data telecommunications services and professional services practices are in place to support existing and prospective customers. PKSIS provides its services to firms who desire to focus resources on their core businesses while avoiding the capital and overhead costs of operating their own computer centers. In 1993, 55 percent of PKSIS' revenue was from external customers. PKSIS operations and computing equipment are located in a specially designed 50,000 square foot computer center in Omaha, Nebraska. Construction will begin in 1994 on a 39,000 square foot addition to the existing facility. GENERAL INFORMATION Environmental Protection. Compliance with federal, state, and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not and is not expected to have a material effect upon the capital expenditures, earnings, or competitive position of the Company and its subsidiaries. Employees. At the end of 1993, the Company and its majority-owned subsidiaries employed approximately 10,620 people -- 7,200 in construction, 750 in mining, 2,200 in telecommunications (920 at MFS, 1,280 at C-TEC), 140 in information services, and 330 in corporate positions. ITEM 2. ITEM 2. PROPERTIES. The properties used in the construction segment are described under a separate heading in Item 1 above. Properties relating to the Company's mining and telecommunications segments are described as part of the general business descriptions of those segments in Item 1 above. The Company considers its properties to be adequate for its present and foreseeable requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. General. The Company and its subsidiaries are parties to many pending legal proceedings. Management believes that any resulting liabilities for legal proceedings, beyond amounts reserved, will not materially affect the Company's financial condition and results of operations. Environmental Proceedings. In a large number of proceedings, the Company or its predecessors is one of numerous defendants who may be "potentially responsible parties" liable for the cleanup of hazardous substances deposited in landfills or other sites. Management believes that any resulting liabilities for environmental legal proceedings, beyond amounts reserved, will not materially affect the Company's financial condition. Whitney Litigation. In 1974, a subsidiary of the Company ("Kiewit"), entered into a lease with Whitney Benefits, Inc., a Wyoming charitable corporation ("Whitney"). Whitney is the owner, and Kiewit is the lessee, of a coal deposit underlying a 1,300 acre tract in Sheridan County, Wyoming. The coal was rendered unmineable by the Surface Mining Control and Reclamation Act of 1977 ("SMCRA"), which prohibited surface mining of coal in certain alluvial valley floors significant to farming. In 1983, Kiewit and Whitney filed an action, now titled Whitney Benefits, Inc. and Peter Kiewit Sons' Co. v. The United States, in the U.S. Court of Federal Claims ("Claims Court"), alleging that the enactment of SMCRA constituted a taking of their coal without just compensation. In 1989, the Claims Court ruled that a taking had occurred and awarded plaintiffs the 1977 fair market value of the property ($60 million) plus interest. In 1991, the U.S. Court of Appeals for the Federal Circuit affirmed the decision of the Claims Court and the U.S. Supreme Court denied certiorari. On February 10, 1994, the Claims Court issued an opinion which provided that the $60 million judgment would bear interest compounded annually from 1977 until payment. Kiewit has calculated the interest for the 1977-1993 period to be $230 million. Kiewit and Whitney have agreed that Kiewit and Whitney will receive 67.5 and 32.5 percent, respectively, of any award. At year-end 1993, Kiewit and Whitney would be entitled to $196 million and $94 million, respectively. The government filed two post-trial motions in the Claims Court during 1992. The government requested a new trial to redetermine the 1977 value of the property. The government also filed a motion to reopen and set aside the 1989 judgment as void and to dismiss plaintiffs' complaint for lack of jurisdiction. In August 1992, the Claims Court indicated that both motions would be denied, but a written order has not yet been entered. The government may appeal from that order, as well as the order regarding compound interest. It is not presently known when these proceedings will be concluded, what amount Kiewit will ultimately receive, nor when payment will occur. MFS Litigation. On March 4, 1994, several former stockholders of MFS Telecom filed a lawsuit against MFS, KDG, and the chief executive officer of MFS, in the United States District Court for the Northern District of Illinois, Case No. 94C-1381. These shareholders sold shares of MFS Telecom to MFS in September 1992. MFS completed an initial public offering in May 1993. Plaintiffs allege that MFS fraudulently concealed material information about its plans from them, causing them to sell their shares at an inadequate price. Plaintiffs have alleged damages of at least $100 million. Defendants have meritorious defenses and intend to vigorously contest this lawsuit. Prior to the initial public offering, KDG agreed to indemnify MFS against any liabilities arising from the September 1992 sale; if MFS is deemed to be liable to plaintiffs, KDG will be required to satisfy MFS's liabilities in accordance with the indemnification agreement. If KDG does make payments as a result of this litigation, the Company's earnings and stockholders' equity will not immediately decline, because such payments will be recorded in the financial statements as an increase to the original purchase price of the MFS Telecom shares, resulting in goodwill which will be amortized against earnings in future periods. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT. The table below shows information as of March 15, 1994 about each executive officer of the Company, including his business experience during the past five years (1989-1994). The Company considers its executive officers to be its directors who are employed by the Company or one of its subsidiaries. The Company's directors and officers are elected annually and each was elected on June 5, 1993 to serve until his successor is elected and qualified or until his death, resignation or removal. Name Business Experience (1989-1994) Age Walter Scott, Jr. Chairman of the Board and President 62 William L. Grewcock Vice Chairman 68 Robert E. Julian Executive Vice President-Chief Financial 54 Officer (since 1991); Vice President- Chief Financial Officer (1989-1991); Treasurer (1990-1993) Kenneth E. Stinson Executive Vice President (since 1991) 51 Vice President (1989-1991) John Bahen President, Peter Kiewit Sons Co. 66 Ltd. (1989-1993) Richard Geary Executive Vice President, KCG; President, 59 Kiewit Pacific Co. Leonard W. Kearney Vice President, KCG; President, Kiewit 53 Construction Company and Kiewit Western Co. James Q. Crowe Chairman and Chief Executive Officer 44 of MFS Richard R. Jaros Executive Vice President (since 1993); 42 Vice President (1990-1992); Chairman (since 1993), President and CEO (1992-1993) of CECI; Vice President, KDG (1989-1990) George B. Toll, Jr. Executive Vice President, KCG (1994); Vice 58 President, Kiewit Pacific Co. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Market Information. There is no established public trading market for the Company's common stock. Under the Company's Restated Certificate of Incorporation effective January 1992, the Company now has three classes of common stock: Class B Construction & Mining Group Nonvoting Restricted Redeemable Convertible Common Stock ("Class B"), Class C Construction & Mining Group Restricted Redeemable Convertible Exchangeable Common Stock ("Class C"), and Class D Diversified Group Convertible Exchangeable Common Stock ("Class D"). In connection with a reclassification in January 1992, each "old" Class B share was exchanged for one "new" Class B share and one Class D share, and each "old" Class C share was exchanged for one "new" Class C share and one Class D share. New Class B and Class C shares can be issued only to Company employees and can be resold only to the Company at a formula price based on the year-end book value of the Construction & Mining Group. The Company is generally required to repurchase Class B and Class C shares for cash upon stockholder demand. Class D shares have a formula price based on the year- end book value of the Diversified Group. The Company must generally repurchase Class D shares for cash upon stockholder demand at the formula price, unless the Class D shares become publicly traded. Although the Class D shares are predominantly owned by employees and former employees, such shares are not subject to ownership or transfer restrictions. Dividends. During 1992 and 1993 the Company declared the following dividends on its common stock: Date Declared Date Paid Dividend Per Share Class January 4, 1992 January 4, 1992 $0.50 Old B&C March 20, 1992 May 1, 1992 0.15 New B&C March 20, 1992 May 1, 1992 0.35 D March 20, 1992 June 1, 1992 1.00 D October 23, 1992 January 5, 1993 0.30 B&C October 23, 1992 January 5, 1993 0.35 D March 19, 1993 May 1, 1993 0.30 B&C March 19, 1993 May 1, 1993 0.35 D March 19, 1993 June 1, 1993 0.15 D October 29, 1993 January 6, 1994 0.40 B&C The Board of Directors announced on August 27, 1993 that the Company did not intend to pay dividends on Class D shares in the foreseeable future. Holders. On March 1, 1994, the Company had the following number of stockholders for each class of its common stock: Holders Class 4 B 1121 C 1327 D ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. _________________________________ PETER KIEWIT SONS', INC. SELECTED CONSOLIDATED FINANCIAL DATA The Selected Financial Data of Peter Kiewit Sons', Inc. ("PKS") and the Kiewit Construction & Mining Group ("B&C Stock") and the Kiewit Diversified Group ("D Stock") appear below and on the next four pages. The consolidated data of PKS are presented below with the exception of per common share data which is presented in the Selected Financial Data of the respective groups. Fiscal Year Ended (dollars in millions, _________________________________________________ except per share amounts) 1993 1992 1991 1990 1989 _______________________________________________________________________________ Results of Operations: Revenue (1) $ 2,179 $ 2,020 $ 2,086 $ 1,917 $ 1,701 Earnings from continuing operations before cumulative effect of change in accounting principle (2) 261 150 49 108 92 Net earnings (2) 261 181 441 80 140 Financial Position: Total assets (1) 3,684 2,599 2,632 2,966 3,762 Current portion of long-term debt (1) 15 3 15 31 178 Long-term debt, less current portion (1) 462 30 110 269 302 Stockholders' equity (3) 1,671 1,458 1,396 1,185 1,141 _______________________________________________________________________________ (1) In October 1993, the Company acquired 34.5% of the outstanding shares of C-TEC Corporation that have 56.6% of the available voting rights. (2) In 1993, through two public offerings, the Company sold 29% of its subsidiary, MFS Communications Company, Inc., resulting in a $137 million after-tax gain. (3) The aggregate redemption value of common stock at December 25, 1993 was $1.6 billion. KIEWIT CONSTRUCTION & MINING GROUP SELECTED FINANCIAL DATA The following selected financial data for each of the years in the period 1989 to 1993 have been derived from audited financial statements. The historical financial information for the Kiewit Construction & Mining and Kiewit Diversified Groups supplements the consolidated financial information of PKS and, taken together, includes all accounts which comprise the corresponding consolidated financial information of PKS. Fiscal Year Ended (dollars in millions, ____________________________________________ except per share amounts) 1993 1992 1991 1990 1989 ____________________________________________________________________________ Results of Operations: Revenue $ 1,777 $ 1,671 $ 1,834 $ 1,671 $ 1,481 Earnings before cumulative effect of change in accounting principle 80 69 23 57 52 Net earnings 80 82 23 57 52 Per Common Share (1): Earnings before cumulative effect of change in accounting principle 4.63 3.79 1.12 2.47 2.13 Net earnings 4.63 4.48 1.12 2.47 2.13 Dividends (2) 0.70 0.70 0.30 0.25 0.30 Stock price (3) 22.35 18.70 14.40 10.35 8.40 Book value 27.43 23.31 19.25 14.99 12.65 Financial Position: Total assets 889 862 849 762 678 Current portion of long-term debt 4 2 7 15 26 Long-term debt, less current portion 10 12 13 14 11 Stockholders' equity (4) 480 437 400 350 313 Formula value (3) 391 351 299 249 215 ____________________________________________________________________________ KIEWIT CONSTRUCTION & MINING GROUP SELECTED FINANCIAL DATA (continued) (1) In connection with the January 8, 1992 reorganization, each share of previous Class B and Class C Stock was exchanged for one share of new Class B&C Stock and one share of new Class D Stock. Therefore, for purposes of computing Class B&C Stock per share data, the number of shares for years 1989 to 1991 are assumed to be the same as the corresponding number of shares of previous Class B and Class C Stock. Fully diluted earnings per share have not been presented because it is not materially different from earnings per share. (2) The 1993 and 1992 dividends include $.40 and $.30 for dividends declared in 1993 and 1992, respectively, but paid in January of the subsequent year. Years 1989 to 1991 reflect dividends paid by PKS on its previous Class B and Class C Stock that have been attributed to Kiewit Construction & Mining Group and Kiewit Diversified Group based upon the relative formula values of each group which were determined at the end of each preceding year. Accordingly, the dividends may bear no relationship to the dividends that would have been declared by the Board in such years had the new Class B&C Stock and the Class D Stock been outstanding. (3) Pursuant to the Restated Certificate of Incorporation, the stock price and formula value calculations are computed annually at the end of the fiscal year. (4) Ownership of the Class B&C Stock is restricted to certain employees conditioned upon the execution of repurchase agreements which restrict the employees from transferring the stock. PKS is generally committed to purchase all Class B&C Stock at the amount computed, when put to PKS by a stockholder, pursuant to the Restated Certificate of Incorporation. The aggregate redemption value of the B&C Stock at December 25, 1993 was $391 million. KIEWIT DIVERSIFIED GROUP SELECTED FINANCIAL DATA The following selected financial data for each of the years in the period 1989 to 1993 have been derived from audited financial statements. The historical financial information for the Kiewit Diversified and Kiewit Construction & Mining Groups supplements the consolidated financial information of PKS and, taken together, includes all accounts which comprise the corresponding consolidated financial information of PKS. Fiscal Year Ended (dollars in millions ______________________________________ except per share amounts) 1993 1992 1991 1990 1989 _____________________________________________________________________________ Results of Operations: Revenue (1) $ 402 $ 349 $ 252 $ 246 $ 220 Earnings from continuing operations before cumulative effect of change in accounting principle (2) 181 81 26 51 40 Net earnings (2) 181 99 418 23 88 Per Common Share (3): Earnings from continuing operations before cumulative effect of change in accounting principle 9.08 4.00 1.26 2.20 1.63 Net earnings 9.08 4.92 20.30 1.03 3.59 Dividends (4) 0.50 1.95 0.70 0.70 0.90 Stock price (5) 59.40 50.65 47.85 35.00 32.65 Book value 59.52 50.75 47.93 35.75 33.47 Financial Position: Total assets (1) 2,809 1,759 1,801 2,204 3,084 Current portion of long-term debt (1) 11 1 8 16 152 Long-term debt, less current portion (1) 452 18 97 255 291 Stockholders' equity (6) 1,191 1,021 996 835 828 Formula value (5) 1,191 1,021 996 835 828 _____________________________________________________________________________ KIEWIT DIVERSIFIED GROUP SELECTED FINANCIAL DATA (continued) (1) In October 1993, the Group acquired 34.5% of the outstanding shares of C-TEC Corporation that have 56.6% of the available voting rights. (2) In 1993, through two public offerings, the Group sold 29% of MFS Communications Company, Inc., resulting in a $137 million after-tax gain. (3) In connection with the January 8, 1992 reorganization, each share of previous Class B and Class C Stock was exchanged for one share of new Class B&C Stock and one share of new Class D Stock. Therefore, for purposes of computing Class D Stock per share data, the number of shares for years 1989 to 1991 are assumed to be the same as the corresponding number of shares of previous Class B and Class C Stock. Fully diluted earnings per share have not been presented because it is not materially different from earnings per share. (4) The 1992 dividends include $.35 for dividends declared in 1992 but paid January 5, 1993. Years 1989 to 1991 reflect dividends paid by PKS on its previous Class B and Class C Stock that have been attributed to Kiewit Diversified Group and Kiewit Construction & Mining Group based upon the relative formula values of each group which were determined at the end of each preceding year. Accordingly, the dividends may bear no relationship to the dividends that would have been declared by the Board in such years had the new Class D Stock and the new Class B&C Stock been outstanding. (5) Pursuant to the Restated Certificate of Incorporation, the stock price and formula value calculations are computed annually at the end of the fiscal year. (6) Until public trading begins, PKS is generally committed to purchase all Class D Stock at the amount computed, in accordance with the Restated Certificate of Incorporation, when put to PKS by a stockholder. The aggregate redemption value of the Class D Stock at December 25, 1993 was $1.2 billion. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Separate management's discussion and analysis of financial condition and results of operations for the Kiewit Construction & Mining Group and the Kiewit Diversified Group have been filed as Exhibits 99.A and 99.B to this report. The Company will furnish without charge a copy of such exhibits upon the written request of a stockholder addressed to Stock Registrar, Peter Kiewit Sons', Inc., 1000 Kiewit Plaza, Omaha, Nebraska 68131. Revenue from each of the Company's business segments was (in millions): 1993 1992 1991 _______ _______ _______ Construction $ 1,757 $ 1,659 $ 1,825 Mining 230 246 219 Telecommunications 189 109 37 Other Operations 3 6 5 _______ _______ _______ $ 2,179 $ 2,020 $ 2,086 ======= ======= ======= General _______ Additional financial information about the Company's industry segments, including operating earnings, identifiable assets, capital expenditures and depreciation, depletion and amortization, as well as geographic information, is contained in Note 17 to the Company's consolidated financial statements. Results of Operations 1993 vs. 1992 ___________________________________ Construction ____________ Construction revenue increased by $98 million or 6% in 1993. The Company's share of joint venture revenue rose by 60% and accounted for 24% of total construction revenue for the period as compared to 16% for 1992. Several large contracts awarded in 1992 and early 1993 contributed to the overall increase, the largest of which was the San Joaquin Toll Road Joint Venture ("San Joaquin"). The increase in joint venture revenue was partially offset by a small decrease in sole contract revenue due to a decrease in the average size of sole contracts awarded. Contract backlog at December 25, 1993 was $2.1 billion, of which 6% is attributable to foreign operations, principally, Canada. Projects on the west coast comprise 50% of the total backlog of which San Joaquin accounts for $435 million. San Joaquin is scheduled for completion in 1997. Direct costs associated with construction contracts increased $66 million or 4% to $1.569 billion in 1993. The increase is net of a $20 million reduction in reserves previously established for the non-sponsored Denmark tunnel project. The overall rise in costs is directly attributable to the increase in volume. Costs as a percentage of revenue, excluding the reduction in reserves, approximated 90% and 91% for 1993 and 1992, respectively. Results of Operations 1993 vs. 1992 (continued) _______________________________________________ Construction (continued) ________________________ Management of the non-sponsored Denmark tunnel project completed a cost estimate which indicated a favorable variance in the estimated costs of the project. As a result of this revised cost estimate and negotiations with the owner, management reduced reserves maintained to provide for the Company's share of estimated losses on the project. This reduction contributed to the increase in gross margin to 11% in 1993 from 9% in 1992. Mining ______ Mining revenue decreased 6.5% in 1993. The renegotiation of the agreements with Commonwealth Edison Company ("Commonwealth"), ceased sales of undivided interests in coal reserves. Such sales accounted for approximately $40 million or 16% of the total mining revenue recognized in 1992. The absence of the sale of undivided interests to Commonwealth in 1993, was partially offset by a $9 million increase in precious metal sales, a rise in tonnage shipped and an approximate $4 increase in the average price per ton of coal shipped. The sales of precious metals improved in 1993 due to improved market conditions. Alternate source coal sales by the Black Butte mine produced the increase in the average price per ton of coal shipped. Alternate source coal consists of coal purchased from two unaffiliated mines located in the Powder River Basin area of Wyoming and from the Company's Decker mine. The purchased coal is sold to Commonwealth under terms of the renegotiated agreements. Alternate source coal sales in 1993 comprised 31% of 1993 mining revenue. The gross margin on mining revenue increased to 48% in 1993 from 43% in 1992. Alternate source coal sales, which result in larger margins than mined coal, led to the increase. See "Legal Proceedings" with respect to the Whitney Benefits case. Telecommunications __________________ In 1993, the components of telecommunications revenue were as follows: 37% - MFS Communications Company, Inc. ("MFS") telecommunications services; 38% - MFS network systems integration and facilities management services; and 25% - C-TEC operations (two months). In 1992, revenue was comprised of 44% telecommunications services and 56% network systems integration and facilities management services. MFS telecommunications revenue increased from $48 million to $70 million, an increase of 46%. The majority of the increase in revenue resulted from sales of additional services to existing customers and, to a lesser extent, further market penetration. The growth of services in New York City, the expansion of networks in Boston, Chicago and the Washington, D.C. metropolitan area, and new services provided by MFS Datanet and MFS Intelenet also contributed to the revenue increase. Results of Operations 1993 vs. 1992 (continued) _______________________________________________ Telecommunications (continued) ______________________________ Third party revenue from services offered by the MFS network systems integration and facilities management segment increased from $61 million in 1992 to $71 million in 1993, a 16% increase. The increase primarily resulted from network systems integration projects in the United Kingdom and for the State of Iowa. MFS purchased the other 50% interest in a partnership providing network systems integration services to customers in the United Kingdom, thereby increasing revenue from that country. The network systems integration and facilities management services segment had third party backlog of $110 million at December 31, 1993. Two months of C-TEC activity accounted for $48 million of telecommunications revenues. The telephone and cable television groups generated the majority of the revenues. Telecommunications operating expenses increased 78% in 1993. Components of 1993 operating expenses were: 45% - MFS telecommunications services; 32% - MFS network systems integration and facilities management services; and 23% - C-TEC operating expenses. In 1992, operating expenses were 51% MFS telecommunications services and 49% MFS network systems integration and facilities management services. MFS telecommunications operating expenses increased from $48 million to $80 million in 1993, a 67% increase. The increase reflects operating costs associated with MFS Datanet and MFS Intelenet services and higher costs associated with the new and expanded networks. Increased depreciation of existing networks accounted for nearly 41% of the increase. MFS network systems integration and facilities management services operating expenses increased from $49 million to $55 million in 1993, a 12% increase. The increase directly relates to increased activity on several network systems integration projects, primarily direct costs associated with the projects in the United Kingdom and for the State of Iowa. Two months of C-TEC activity accounted for $42 million of telecommunications operating expenses. The telephone and cable television groups generated the majority of these costs. Progress on the network systems integration project for the State of Iowa was delayed in June and July 1993 by significant rainfall and flooding. Management believes that any additional costs resulting from the floods will not materially impact the Company's telecommunications operations. Other Income ____________ Other income decreased from $128 million in 1992 to $62 million in 1993, a decrease of 52%. The decline primarily relates to a $40 million increase in realized losses and permanent valuation adjustments on marketable securities, including certain derivative securities. Interest income declined by $20 million due to lower interest rates and to a change in portfolio mix. Dividend income decreased by $10 million due to dividends accrued in 1992 on an investment in United States Can Company preferred stock redeemed in March of 1993. Slight increases in equity earnings and miscellaneous income partially offset the declines noted above. Results of Operations 1993 vs. 1992 (continued) _______________________________________________ Selling and Administrative Expenses ___________________________________ Selling and administrative expenses increased 15% or $26 million in 1993. Costs incurred in developing MFS Datanet and MFS Intelenet account for a large portion of the increase. MFS expects to incur significant expense developing the high-speed data communications and integrated, single-source telecommunication services in 1994. Increased legal costs, primarily reserves established for environmental matters (see "Legal Proceedings"), also contributed to the increase. Interest Expense ________________ Interest expense increased by $3 million or 27% in 1993. The increase is due to the C-TEC debt assumed in the acquisition. Interest on C-TEC debt during the last two months, approximated $6 million. The extinguishment of significant debt in 1992 partially offset C-TEC interest. The Company anticipates significant increases in interest expense due to the C-TEC acquisition, the MFS debt issuance of $500 million in January 1994, and project financing on the Company's 65% equity interest in a privately-owned toll road in southern California. Gain on Sale of Subsidiary's Stock __________________________________ In May 1993, MFS sold 12.7 million shares of common stock to the public at an initial offering price of $20 per share for $233 million, net of certain transaction costs. An additional 4.6 million shares were sold to the public on September 15, 1993 at a price of $50 per share for $218 million, net of certain transaction costs. These transactions have reduced the Company's ownership interest in MFS to 71% at December 25, 1993. Substantially all of the net proceeds from the offerings are intended to fund MFS' growth. Prior to the initial public offering, MFS was a wholly-owned subsidiary of the Company. As a result of the above transactions, the Company recognized a pre-tax gain of $211 million representing the increase in the Company's equity in the underlying net assets of MFS. Deferred income taxes have been provided on this gain. Income Taxes ____________ The effective income tax rate for earnings from continuing operations is 30% in 1993 and 32% in 1992. The decrease in rates is due to adjustments to prior year tax provisions which more than offset the effects of the increase in 1993 Federal income tax rates. In both years, dividend exclusions and mineral depletion expenses also reduced the overall effective rate. Results of Operations - 1992 vs. 1991 _____________________________________ Construction ____________ Revenue from construction activity in 1992 decreased 9% compared to 1991. Although the number of new contracts awarded in 1992 increased approximately 15%, the average size of new contracts, excluding the $520 million contract awarded to San Joaquin, decreased by approximately 20%. Contract backlog at the end of 1992 was $2.2 billion, a $300 million increase from backlog at the end of 1991. Of the 1992 backlog, 9% related to foreign projects mainly in Canada and the remainder related to projects in the United States. Sixty-four percent of the U.S. projects were on the west coast. The decrease in revenue as well as in contract backlog (excluding San Joaquin) was the result of the general state of the economy in Canada and the United States. Fluctuating demand cycles are typical of the industry. The gross margin was 9% in 1992 and 6% in 1991. The 1991 gross margin was unfavorably impacted primarily by losses on the Denmark tunnel project and on several U.S. projects. In 1992, management of the nonsponsored Denmark tunnel project completed negotiations with respect to the settlement of claims against the project owner and equipment supplier. The new agreement with the project owner covered the reimbursement of certain costs incurred and time extensions due to differing soil conditions at the site of the tunnels. Costs incurred with respect to the flooding of two of the four tunnels being drilled as part of the project have been covered by insurers. Because of the remaining uncertainties involved in completing the tunnels, due primarily to the adverse soil conditions, no adjustments were made in 1992 for the Company's share of the estimated losses. Management believes that the resolution of the uncertainties should not materially effect of the Company's financial position. Mining ______ Mining revenue increased 12% in 1992 as compared to 1991. The increase was due to the mines collectively shipping 20% more tons of coal and lignite in 1992. The increase in tonnage was due principally to new short-term contracts at the Black Butte mine and sales on the spot market. This increase was partially offset by a 4% decrease in the average price per ton, the result of increased lower-priced spot sales from the Decker mine. Revenue recognition on previously consummated sales of undivided interests in coal reserves to be mined in the future represented $40 million of 1992 revenue and $39 million of 1991 revenue. The gross margin on mining revenue, including reserve coal, approximated 43% in 1992, exceeds the gross margin in 1991. The 1991 gross margin was unfavorably impacted by certain one-time charges for production taxes and reclamation costs, and expenses expenses incurred to repair a dragline. In 1992, the agreements with Commonwealth Edison Company ("Commonwealth") were renegotiated. Beginning January 1, 1993, the Black Butte mine discontinued coal shipments to Commonwealth. Coal is now purchased from two unaffiliated mines located in the Powder River Basin area of Wyoming and from the Company's Decker mine to satisfy the delivery commitments under the renegotiated Commonwealth agreements. Results of Operations 1992 vs. 1991 (continued) _______________________________________________ Mining (continued) __________________ Also in accordance with the renegotiation, there were no sales of interests in coal reserves subsequent to January 1, 1993. The Company does not expect that the financial impact of the renegotiation will be material to its mining operations, cash flows, or financial position. Telecommunications __________________ Revenue in 1992 was comprised of 56% network systems integration and facilities management and 44% telecommunications services. Revenue in 1991 was comprised of 38% network systems integration and facilities management and 62% telecommunications services. Network systems integration and facilities management backlog at December 26, 1992 was $74 million, of which $16 million relates to the United Kingdom joint venture and the remainder relates mainly to the State of Iowa project. Revenue increased from $37 million in 1991 to $109 million in 1992, representing a 192% increase. Of the increase, 66% was from network systems integration and facilities management. This increase resulted primarily from network systems integration projects in Iowa, Minnesota and the United Kingdom. Telecommunications services accounted for the remaining increase in total revenue. This increase in revenue primarily reflects increased services provided on networks in New York City and Dallas which commenced operations in early 1991 and a full year of results for the Washington, D.C. metropolitan area network which was acquired in October 1991. The balance of the increase in telecommunications services revenue resulted from continued market growth of other networks. The Atlanta network became operational during the fourth quarter of 1992, but generated insignificant revenues. The cost of revenue in 1992 increased 112% compared to 1991. Seventy-three percent of the increase relates to direct costs incurred on network systems integration and facilities management projects for third parties. Another 17% of the increase is due to increased depreciation and amortization expense primarily on the telecommunications networks in Washington, D.C., New York City and Dallas. The balance of the increase relates to an increase in other costs associated directly with network operations; primarily from the Washington, D.C., New York City and Dallas networks. The cost of revenue, as a percentage of total revenue, has decreased from 123% in 1991 to 89% in 1992. This change resulted generally from increased utilization of existing network capacity. Results of Operations 1992 vs. 1991 (continued) _______________________________________________ Other Income ____________ The Company recognized investment income of $98 million in 1992 and $108 million in 1991. The decrease in investment income is generally attributable to the collection of various receivables from the sales of the discontinued packaging operations. In 1992 the Company recognized $11 million of interest on these receivables compared to $20 million in 1991. Included in 1992 investment income are $4 million of dividends in kind received from an investment in California Energy Company, Inc. ("California Energy") preferred stock and $11 million of dividends accrued on an investment in United States Can Company ("U.S. Can") preferred stock which was redeemed in March 1993. Included in 1991 investment income is $12 million of dividends received from U.S. Can preferred stock. Other Income in 1992 and 1991 also reflects gains on the sales of timberlands of $5 million and $3 million, respectively, net equity earnings from an investment in California Energy of $4 million and $3 million, respectively, and information services income of $7 million and $5 million, respectively. The increase in Other Income in 1992 was partially offset by a decline in market value considered to be other than temporary of $12 million recorded for two of the Company's marketable securities, one of which was sold in 1993. Selling and Administrative Expenses ___________________________________ Selling and administrative expenses increased 5% in 1992 compared to 1991 due in part to increases within the telecommunications operations. The Company incurred $4 million in 1992 developing new telecommunications services. The increase is also attributable to modest increases in several of the Company's administrative departments. Interest Expense ________________ Interest expense in 1992 reflects the anticipated decrease due to the significant reductions during 1991 in both short-term borrowings and long-term debt. All short-term borrowings were repaid in July 1991 and no new borrowings were incurred until December 1992. The Company also redeemed $150 million of debt in October 1991 and extinguished $73 million of debt in 1992 with no new material debt incurred since year-end 1991. Taxes _____ The effective income tax rate, with respect to continuing operations before cumulative effect of change in accounting principle, is 32% in 1992 and 46% in 1991. The 1992 rate is lower than the 1991 rate primarily due to 1991 foreign taxes and adjustments to the prior year tax provision. In both 1992 and 1991, dividend exclusions and mineral depletion expenses reduced the overall effective rate. Results of Operations 1992 vs. 1991 (continued) _______________________________________________ Discontinued Packaging Operations _________________________________ The gain on disposal of discontinued operations in 1992 resulted from a $19 million adjustment to prior year tax estimates and an $8 million payment, net of tax, received from BTR Nylex Limited and a $1 million accrual, net of tax, relating to additional sales proceeds from the 1990 sale of Continental PET Technologies, Inc. The gain was partially offset by miscellaneous sales adjustments related to the 1991 and 1990 sales of certain discontinued packaging operations. The gain on disposal of discontinued operations in 1991 reflects the sales of the European packaging operations, Continental Can International Corporation, Continental White Cap, Inc. and Continental Plastic Containers, Inc. The significant decrease in 1992 in earnings from discontinued operations is due to the sales of the remaining packaging operations in 1991. Earnings in 1992 reflect the equity earnings from the Company's investment in a plastics joint venture, which was sold to Ball Corporation in July 1992. No significant gain or loss was recognized as a result of this transaction. Financial Condition - December 25, 1993 _______________________________________ The Company's working capital increased $227 million or 20% to $1,365 million in 1993. For the year, the Company generated positive cash flows of $286 million from operating activities, an increase of $86 million over 1992. Cash used in investing activities in 1993 includes the net purchase of marketable securities of $304 million, capital expenditures of $192 million which consists of $127 million for communications, $48 million for construction and $5 and $12 million for mining and corporate, respectively, and the purchase of a controlling interest in C-TEC Corporation for $146 million, net of cash acquired. These investments were necessary to support existing operations and develop new opportunities for future growth. Overall, net cash used in investing activities was $655 million in 1993. Cash from financing activities was derived principally from the issuances of the common stock of MFS and PKS. The Company raised $451 million in cash from the sale of 17.3 million shares or 29% of MFS' common stock in two public offerings. The net proceeds are intended to fund MFS' growth. The Company also raised $24 million in cash from the sale of its Class C and Class D common stock, which will be used for general corporate purposes. Uses of cash in financing activities in 1993 consisted of paying dividends of $27 million to Class B & C and Class D stockholders, repurchasing Class C and Class D common stock for $54 million and repaying 1992 short-term borrowings of $80 million. Throughout 1993, the Company borrowed funds to meet short-term liquidity needs. These additional borrowings have all been repaid. During 1993, the Company collected $110 million related to notes receivable from sales of discontinued operations. The Company's existing working capital position together with anticipated cash flows from operations, debt issuances and existing lines of credit, should be sufficient for 1994's working capital and investing requirements. It is expected that C-TEC will be able to independently finance its working capital and investment requirements in 1994. In addition to investing between $45 million and $85 million annually in its construction and mining businesses, the Company anticipates making significant investments in its energy business - including its joint venture agreement with California Energy covering international power project development activities - and searching for opportunities to acquire operating businesses that are capital intensive and provide long-term growth. In February 1994, the Company completed the purchase of APAC-Arizona, Inc. from Ashland Oil Company, Inc. for approximately $49 million, subject to adjustments. APAC is engaged in the construction materials and contracting businesses in Arizona and surrounding states. The Company has been and continues to investigate other investment opportunities. These investments, along with the payment of income taxes and the repurchases of common stock, will be the significant long-term uses of liquidity. The Company's existing cash and cash equivalents, marketable securities, cash flows from future operations and existing borrowing capacity are expected to fund these expenditures. Financial Condition - December 25, 1993 (continued) ___________________________________________________ MFS requires significant capital to fund future building, expansion or acquisition of communications networks in major metropolitan areas. In January 1994, MFS issued $500 million of Senior Discount Notes due in 2004. In June 1993, MFS entered into a secured revolving credit agreement in the amount of $75 million. The indenture pursuant to which the Senior Discount Notes were issued permits MFS to have a $150 million secured credit facility. These transactions will provide liquidity to fund future expansion, including the proposed acquisition of Centex Telemanagement, Inc., for net consideration of approximately $150 million, announced by MFS on March 16, 1994. MFS may fund future capital expenditures and acquisitions through additional issuances of debt and equity securities. MFS intends to invest $250 million in 1994 and in excess of $1 billion over the next five years to expand its networks to an additional 55 markets. In July 1993, financing was approved to construct a 10-mile privately-owned toll road in southern California. The Company has a 65% interest in this project. Management expects $107 million of third party debt to be incurred. by the project's completion in 1995. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Financial statements and supplementary financial information for Peter Kiewit Sons', Inc. and Subsidiaries begin on page P1. Separate financial statements and financial statement schedules for the Kiewit Construction & Mining Group and the Kiewit Diversified Group have been filed as Exhibits 99.A and 99.B to this report. The Company will furnish without charge a copy of such exhibits upon the written request of a stockholder addressed to Stock Registrar, Peter Kiewit Sons', Inc., 1000 Kiewit Plaza, Omaha, Nebraska 68131. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Part III is incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on June 4, 1994. However, certain information is set forth under the caption "Executive Officers of the Registrant" following Item 4 above. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial statements and financial statement schedules required to be filed for the registrant under Items 8 or 14 are set forth following the index page at page P1. Exhibits filed as a part of this report are listed below. Exhibits incorporated by reference are indicated in parentheses. Exhibit Number Description 3.1 Restated Certificate of Incorporation, effective January 8, 1992 (Exhibit 3.1 to Company's Form 10-K for 1991). 3.4 By-laws, composite copy, including all amendments, as of March 19, 1993 (Exhibit 3.4 to Company's Form 10-K for 1992). 10.11 Kiewit Construction and Mining Long-Term Incentive Plan, Construction and Mining Appreciation Rights (Exhibit 10.11 to Company's Form 10-K for 1988). 10.12 Kiewit Long-Term Incentive Plan, Stock Appreciation Rights (Exhibit 10.12 to Company's Form 10-K for 1988). 21 List of subsidiaries of the Company. 99.A Kiewit Construction & Mining Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations. 99.B Kiewit Diversified Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations. (b) No Form 8-K was filed during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 24th day of March, 1994. PETER KIEWIT SONS', INC. By: /s/ R. E. Julian ________________________ Robert E. Julian Executive Vice President - Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 24th day of March, 1994. /s/ Walter Scott, Jr. _________________________ Chairman of the Board Walter Scott, Jr. and President (principal executive officer) /s/ R. E. Julian _________________________ Director, Executive Vice Robert E. Julian President-Chief Financial Officer (principal financial officer) /s/ Frank V. Yelick _________________________ Vice President and Controller Frank V. Yelick (principal accounting officer) _________________________ ___________________________ John Bahen, Director Charles M. Harper, Director /s/ Richard L. Coyne /s/ Richard R. Jaros _________________________ ___________________________ Richard L. Coyne, Director Richard R. Jaros, Director /s/ James Q. Crowe /s/ Leonard W. Kearney _________________________ ___________________________ James Q. Crowe, Director Leonard W. Kearney, Director _________________________ ___________________________ Robert B. Daugherty, Director Peter Kiewit, Jr., Director /s/ Richard Geary /s/ Kenneth E. Stinson _________________________ ___________________________ Richard Geary, Director Kenneth E. Stinson, Director /s/ W. L. Grewcock /s/ George B. Toll, Jr. _________________________ ___________________________ William L. Grewcock, Director George B. Toll, Jr., Director PETER KIEWIT SONS', INC. AND SUBSIDIARIES Index to Financial Statements and Financial Statement Schedules Pages ___________________________________________________________________________ Report of Independent Accountants Consolidated Financial Statements as of December 25, 1993 and December 26, 1992 and for the three years ended December 25, 1993: Consolidated Statements of Earnings Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Changes in Stockholders' Equity Notes to Consolidated Financial Statements Consolidated Financial Statement Schedules for the three years ended December 25, 1993: VIII--Valuation and Qualifying Accounts and Reserves IX--Short-Term Borrowings X--Supplementary Income Statement Information ___________________________________________________________________________ Schedules not indicated above have been omitted because of the absence of the conditions under which they are required or because the information called for is shown in the consolidated financial statements or in the notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS _________________________________ The Board of Directors and Stockholders Peter Kiewit Sons', Inc. We have audited the consolidated financial statements and the financial statement schedules of Peter Kiewit Sons', Inc. and Subsidiaries as listed in the index on the preceding page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Peter Kiewit Sons', Inc. and Subsidiaries as of December 25, 1993 and December 26, 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 25, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 1 to the financial statements, the Company has changed its method of accounting for income taxes in 1992, and its method of accounting for certain investments in debt and equity securities in 1993. COOPERS & LYBRAND Omaha, Nebraska March 18, 1994 PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Earnings For the three years ended December 25, 1993 (dollars in millions) 1993 1992 1991 _____________________________________________________________________________ Revenue $ 2,179 $ 2,020 $ 2,086 Other Income 62 128 125 _______ _______ _______ 2,241 2,148 2,211 Costs and Expenses: Cost of revenue 1,866 1,741 1,905 Selling and administrative 203 177 169 Interest 14 11 47 _______ _______ _______ 2,083 1,929 2,121 _______ _______ _______ 158 219 90 Gain on Sale of Subsidiary's Stock 211 - - _______ _______ _______ Earnings from Continuing Operations Before Income Taxes, Minority Interest and Cumulative Effect of Change in Accounting Principle 369 219 90 Provision for Income Taxes (111) (69) (41) Minority Interest in Loss of Subsidiaries 3 - - _______ _______ _______ Earnings from Continuing Operations Before Cumulative Effect of Change in Accounting Principle 261 150 49 Cumulative Effect of Change in Accounting Principle - 12 - _______ _______ _______ Earnings from Continuing Operations 261 162 49 Discontinued Operations: Earnings from discontinued operations net of income taxes of $- and $26 in 1992 and 1991, respectively - 1 19 Gain on disposal of discontinued operations net of income taxes (benefit) of $(19) and $221 in 1992 and 1991, respectively - 18 373 _______ _______ _______ Net Earnings $ 261 $ 181 $ 441 ======= ======= ======= _____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Earnings (continued) For the three years ended December 25, 1993 (dollars in millions, except per share data) 1993 1992 1991 _____________________________________________________________________________ Earnings Attributable to Class B&C Stock: Earnings Before Cumulative Effect of Change in Accounting Principle $ 80 $ 69 $ 23 Cumulative Effect of Change in Accounting Principle - 13 - _______ _______ _______ Net Earnings $ 80 $ 82 $ 23 ======= ======= ======= Earnings Attributable to Class D Stock: Earnings from Continuing Operations Before Cumulative Effect of Change in Accounting Principle $ 181 $ 81 $ 26 Cumulative Effect of Change in Accounting Principle - (1) - _______ _______ _______ Earnings from Continuing Operations 181 80 26 Discontinued Operations: Earnings - 1 19 Gain on disposal - 18 373 _______ _______ _______ Net Earnings $ 181 $ 99 $ 418 ======= ======= ======= Earnings Per Common and Common Equivalent Share: Class B&C: Earnings Before Cumulative Effect of Change in Accounting Principle $ 4.63 $ 3.79 $ 1.12 Cumulative Effect of Change in Accounting Principle - .69 - _______ _______ _______ Net Earnings $ 4.63 $ 4.48 $ 1.12 ======= ======= ======= Class D: Continuing Operations: Earnings Before Cumulative Effect of Change in Accounting Principle $ 9.08 $ 4.00 $ 1.26 Cumulative Effect of Change in Accounting Principle - (.05) - _______ _______ _______ Earnings from Continuing Operations 9.08 3.95 1.26 Discontinued Operations: Earnings - .04 .94 Gain on disposal - .93 18.10 _______ _______ _______ Net Earnings $ 9.08 $ 4.92 $ 20.30 ======= ======= ======= _____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Balance Sheets December 25, 1993 and December 26, 1992 (dollars in millions) 1993 1992 ____________________________________________________________________________ Assets Current Assets: Cash and cash equivalents $ 296 $ 203 Marketable securities 1,082 905 Receivables, less allowance of $7 and $7 291 271 Note receivable from sale of discontinued operations 5 60 Costs and earnings in excess of billings on uncompleted contracts 79 53 Investment in construction joint ventures 81 48 Deferred income taxes 66 55 Other 54 90 _______ _______ Total Current Assets 1,954 1,685 Property, Plant and Equipment, at cost: Land 29 26 Buildings 200 48 Equipment 1,251 895 _______ _______ 1,480 969 Less accumulated depreciation and amortization (636) (575) _______ _______ Net Property, Plant and Equipment 844 394 Note Receivable from Sale of Discontinued Operations 29 84 Investments 233 180 Intangible Assets, net 415 75 Other Assets 209 181 _______ _______ $ 3,684 $ 2,599 ======= ======= ____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Balance Sheets December 25, 1993 and December 26, 1992 (dollars in millions, except share data) 1993 1992 ____________________________________________________________________________ Liabilities and Stockholders' Equity Current Liabilities: Accounts payable $ 260 $ 198 Short-term borrowings - 80 Current portion of long-term debt: Telecommunications 7 - Other 8 3 Accrued costs and billings in excess of revenue on uncompleted contracts 107 107 Accrued insurance costs 67 66 Other 140 93 _______ _______ Total Current Liabilities 589 547 Long-Term Debt, less current portion: Telecommunications 420 - Other 42 30 Deferred Income Taxes 385 267 Retirement Benefits 71 74 Accrued Reclamation Costs 92 94 Other Liabilities 116 117 Minority Interest 298 12 Stockholders' Equity: Preferred stock, no par value, authorized 250,000 shares: no shares outstanding in 1993 and 1992 - - Common stock, $.0625 par value, $1.6 billion aggregate redemption value: Class B, authorized 8,000,000 shares: 1,180,400 outstanding in 1993 and 1,257,000 outstanding in 1992 - - Class C, authorized 125,000,000 shares: 16,316,070 outstanding in 1993 and 17,505,535 outstanding in 1992 1 1 Class D, authorized 50,000,000 shares: 20,010,696 outstanding in 1993 and 20,104,478 outstanding in 1992 1 1 Additional paid-in capital 164 145 Foreign currency adjustment (3) 3 Net unrealized holding gain 9 - Retained earnings 1,499 1,308 _______ _______ Total Stockholders' Equity 1,671 1,458 _______ _______ $ 3,684 $ 2,599 ======= ======= ____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the three years ended December 25, 1993 (dollars in millions) 1993 1992 1991 ___________________________________________________________________________ Cash flows from operations: Earnings from continuing operations $ 261 $ 162 $ 49 Adjustments to reconcile earnings from continuing operations to net cash provided by continuing operations: Cumulative effect of change in accounting principle - (12) - Depreciation, depletion and amortization 99 86 82 (Gain) loss on sale of property, plant and equipment, and other investments 23 (18) (11) Gain on sale of subsidiary's stock (211) - - Decline in market value of investments 21 12 - Retirement benefits paid (17) (8) (5) Change in retirement benefits and other noncurrent liabilities 10 19 68 Deferred income taxes 49 (4) (4) Change in working capital items: Receivables 9 (16) 13 Other current assets (48) 18 4 Payables 47 (12) 23 Other liabilities 13 (33) 10 Other 30 6 (38) _______ _______ _______ Net cash provided by continuing operations 286 200 191 Cash flows from investing activities: Proceeds from sales and maturities of marketable securities 4,927 6,542 3,717 Purchases of marketable securities (5,231) (6,629) (4,116) Acquisition of C-TEC, excluding cash acquired (146) - - Proceeds from sale of property, plant and equipment, and other investments 38 31 34 Capital expenditures (192) (129) (122) Investments in affiliates (14) (42) (135) Acquisition of minority interest (2) (27) - Deferred development costs and other (35) 6 (6) _______ _______ _______ Net cash used in investing activities (655) (248) (628) ____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the three years ended December 25, 1993 (continued) (dollars in millions) 1993 1992 1991 ___________________________________________________________________________ Cash flows from financing activities: Long-term debt borrowings 21 3 21 Payments on long-term debt, including current portion (8) (98) (199) Net change in short-term borrowings (80) 80 (231) Issuances of common stock 24 24 21 Issuances of subsidiary's stock 458 - - Repurchases of common stock (54) (85) (137) Dividends paid (27) (40) (21) Other - (1) (3) _______ _______ _______ Net cash provided by (used in) financing activities 334 (117) (549) Cash flows from discontinued packaging operations: Proceeds from sales of discontinued packaging operations 110 163 1,285 USW ERISA Litigation settlement installment payment - - (207) Other cash provided by (used in) discontinued packaging operations 20 (34) (105) _______ _______ _______ Net cash provided by discontinued packaging operations 130 129 973 Effect of exchange rates on cash (2) (4) - _______ _______ _______ Net increase (decrease) in cash and cash equivalents 93 (40) (13) Cash and cash equivalents at beginning of year 203 243 256 _______ _______ _______ Cash and cash equivalents at end of year $ 296 $ 203 $ 243 ======= ======= ======= Supplemental disclosure of cash flow information for continuing and discontinued operations: Taxes $ 83 $ 183 $ 213 Interest 7 14 53 ___________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity For the three years ended December 25, 1993 (dollars in millions) Class Class Net B & C D Additional Foreign Unrealized Common Common Paid-in Currency Holding Retained Stock Stock Capital Adjustment Gain Earnings Total _______________________________________________________________________________ Balance at December 30, 1990 $ 1 $ 1 $ 123 $ 102 $ - $ 958 $ 1,185 Issuances of stock - - 21 - - - 21 Repurchases of stock - - (16) - - (121) (137) Foreign currency adjustment - - - (93) - - (93) Net earnings - - - - - 441 441 Dividends ($1.00 per common share) - - - - - (21) (21) _____ _____ _____ _____ _____ _______ _______ Balance at December 28, 1991 1 1 128 9 - 1,257 1,396 Issuances of stock - - 24 - - - 24 Repurchases of stock - - (7) - - (78) (85) Foreign currency adjustment - - - (6) - - (6) Net earnings - - - - - 181 181 Dividends: (a) Class B&C ($.70 per common share) - - - - - (13) (13) Class D ($1.95 per common share) - - - - - (39) (39) _____ _____ _____ _____ _____ _______ _______ Balance at December 26, 1992 1 1 145 3 - 1,308 1,458 ______________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity For the three years ended December 25, 1993 (continued) (dollars in millions) Class Class Net B & C D Additional Foreign Unrealized Common Common Paid-in Currency Holding Retained Stock Stock Capital Adjustment Gain Earnings Total ________________________________________________________________________________ Balance at December 26, 1992 $ 1 $ 1 $ 145 $ 3 $ - $ 1,308 $ 1,458 Issuances of stock - - 24 - - - 24 Repurchases of stock - - (5) - - (49) (54) Foreign currency adjustment - - - (6) - - (6) Net unrealized holding gain - - - - 9 - 9 Net earnings - - - - - 261 261 Dividends: (b) Class B&C ($.70 per common share) - - - - - (11) (11) Class D ($.50 per common share) - - - - - (10) (10) ___ ___ _____ _____ ____ ________ _______ Balance at December 25, 1993 $ 1 $ 1 $ 164 $ (3) $ 9 $ 1,499 $ 1,671 === === ===== ===== ==== ======== ======= _______________________________________________________________________________ (a) Includes $.30 and $.35 per share for dividends on Class B & C Stock and Class D Stock, respectively, declared in 1992 but paid in January 1993. (b) Includes $.40 per share for dividends on Class B&C Stock declared in 1993 but paid on January 6, 1994. See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies __________________________________________ Principles of Consolidation ___________________________ The consolidated financial statements include the accounts of Peter Kiewit Sons', Inc. and subsidiaries in which it owns more than 50% of the voting stock ("PKS" or "the Company"), which are engaged in enterprises primarily related to construction, mining and telecommunications. See Note 2 with respect to discontinued packaging operations. Fifty-percent-owned mining joint ventures are consolidated on a pro rata basis. All significant intercompany accounts and transactions have been eliminated. Investments in other companies in which the Company exercises significant influence over operating and financial policies and construction joint ventures are accounted for by the equity method. The Company accounts for its share of the operations of the construction joint ventures on a pro rata basis in the consolidated statements of earnings. Construction Contracts ______________________ The Company operates generally within North America as a general contractor and engages in various types of construction projects for both public and private owners. Credit risk is minimal with public (government) owners since the Company ascertains that funds have been appropriated by the governmental project owner prior to commencing work on public projects. Most public contracts are subject to termination at the election of the government. In the event of termination, the Company is entitled to receive the contract price on completed work and reimbursement of termination related costs, plus a reasonable profit on such costs. Credit risk with private owners is minimized because of statutory mechanics liens, which give the Company high priority in the event of lien foreclosures following financial difficulties of private owners. The Company recognizes revenue on long-term construction contracts and joint ventures on the percentage-of-completion method based upon engineering estimates of the work performed on individual contracts. Provisions for losses are recognized on uncompleted contracts when they become known. Claims for additional revenue are recognized in the period when allowed. Assets and liabilities arising from construction activities, the operating cycle of which extends over several years, are classified as current in the financial statements. A one-year time period is used as the basis for classification of all other current assets and liabilities. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Accounting Policies (continued) __________________________________________ Coal Sales Contracts ____________________ The Company and its mining ventures have entered into various agree- ments with its customers which stipulate delivery and payment terms for the sale of coal. Prior to 1993, one of the primary customers deferred receipt of certain commitments by purchasing undivided fractional interests in coal reserves of the Company and the mining ventures. Under the arrangements, revenue was recognized when cash was received. The agreements with this customer were renegotiated in 1992. In accordance with the renegotiated agreements, there were no sales of interests in coal reserves subsequent to January 1, 1993. The Company has the obligation to extract and deliver the coal reserves to the customer in the future if the customer exercises its option. If the option is exercised, the Company presently intends to deliver coal from an unaffiliated mine. In the opinion of management, the Company has sufficient coal reserves to cover the above sales commitments. The Company's coal sales contracts are with several electric utility and industrial companies. In the event that these customers do not fulfill contractual responsibilities, the Company would pursue the available legal remedies. Telecommunications Revenues ___________________________ A subsidiary of the Company, MFS Communications Company, Inc. ("MFS"), provides private line and special access telecommunications services to major businesses, governmental entities and long distance carriers in major metropolitan areas of the United States through a competitive access provider subsidiary. Another subsidiary of MFS is a network systems integrator that designs, engineers, develops and installs telecommunications networks and systems and also provides facilities management services. MFS recognizes revenue on telecommunications services in the month the related service is provided. Network systems integration revenue is recognized on the percentage-of-completion method of accounting. In October 1993, the Company acquired 34.5% of the outstanding shares of C-TEC Corporation ("C-TEC") that have 56.6% of the available voting rights. C-TEC's results of operations have been consolidated from the acquisition date. C-TEC's most significant operating groups are its local telephone service and cable system operations. C-TEC's telephone network access revenues are derived from net access charges, toll rates and settlement arrangements for traffic that originates or terminates within C-TEC's local telephone company. Revenues from basic and premium cable programming services are recorded in the month the service is provided. Concentration of credit risk with respect to accounts receivable are limited due to the dispersion of customer base among different industries and geographic areas and remedies provided by terms of contracts and statutes. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (continued) ______________________________________________________ Depreciation and Amortization _____________________________ Depreciation and amortization for the majority of the Company's property, plant and equipment are computed on accelerated and straight-line methods. Depletion of mineral properties is provided primarily on a units-of-extraction basis determined in relation to estimated reserves. In accordance with industry practice, certain telephone plant owned by C-TEC valued at $216 million is depreciated based on the estimated remaining lives of the various classes of depreciable property and straight-line composite rates. When property is retired, the original cost, plus cost of removal, less salvage, is charged to accumulated depreciation. Intangible Assets _________________ Intangible assets consist of amounts allocated upon purchase of assets of existing operations and development costs. These assets are amortized on a straight-line basis over the expected period of benefit, which does not exceed 40 years. Pension Plans _____________ The Company maintains defined benefit plans primarily for retired packaging employees. Benefits paid under the plans are based on years of service for hourly employees and years of service and rates of pay for salaried employees. Substantially all of C-TEC's employees are included in a trusteed noncontributory defined benefit plan. Upon retirement, employees are provided a monthly pension based on length of service and compensation. The plans are funded in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Reserves for Reclamation ________________________ The Company follows the policy of providing an accrual for reclamation of mined properties, based on the estimated cost of restoration of such properties, in compliance with laws governing strip mining. Foreign Currencies __________________ The local currencies of foreign subsidiaries are the functional currencies for financial reporting purposes. Assets and liabilities are translated into U.S. dollars at year-end exchange rates. Revenue and expenses are translated using average exchange rates prevailing during the year. Gains or losses resulting from currency translation are recorded as adjustments to stockholders' equity. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policices (continued) _______________________________________________________ Subsidiary Stock Sales ______________________ The Company recognizes gains and losses from the sales of stock by its subsidiaries. Earnings Per Share __________________ Primary earnings per share of common stock have been computed using the weighted average number of shares outstanding during each year. For purposes of computing earnings per share data for periods prior to January 8, 1992, the number of Class B&C and Class D shares are assumed to be the same as the aggregate number of previous Class B and Class C shares. Fully diluted earnings per share have not been presented because it is not materially different from primary earnings per share. The number of shares used in computing earnings per share was as follows: 1993 1992 1991 __________ __________ __________ Class B&C 17,290,971 18,262,680 20,588,236 Class D 19,941,885 20,126,768 20,588,236 Marketable Securities and Investments _____________________________________ On December 25, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which addresses the accounting and reporting of investments in equity securities with readily determinable fair values and all investments in debt securities. The statement does not apply to investments in equity securities accounted for under the equity method nor to investments in consolidated subsidiaries. At December 25, 1993, a net unrealized holding gain of $9 million, net of income taxes, was reported in stockholders' equity. See Note 6 for additional disclosures. Income Taxes ____________ At the beginning of 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial and tax basis for assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. In 1992, the Company recorded income of $12 million which represented the decrease in the net deferred tax liabilities as a result of the accounting change. This amount has been reflected in the consolidated statements of earnings as a cumulative effect of a change in accounting principle. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (continued) ______________________________________________________ Reclassifications _________________ Where appropriate, items within the consolidated financial statements and notes thereto have been reclassified from previous years to conform to current year presentation. Fiscal Year ___________ The Company's fiscal year ends on the last Saturday in December. There were 52 weeks each in the fiscal years 1993, 1992 and 1991. MFS and C-TEC's fiscal years end on December 31. (2) Discontinued Operations _______________________ In 1990, the Company's management authorized the disposition of its packaging businesses. As a result, the consolidated financial statements reflect the packaging businesses as discontinued operations. Discontinued Packaging Operations for the year ended December 26, 1992 reflect the equity earnings of the Company's investment in a plastics joint venture, net of tax at the statutory rate. Summary financial information relative to the discontinued packaging operations, which primarily reflects earnings from packaging operations which were sold during 1991, for the year ended December 28, 1991 is provided below: (dollars in millions) 1991 _____________________________________________________________________ Revenue $ 1,145 Earnings Before Income Taxes 45 Net Earnings 19 _____________________________________________________________________ The effective income tax rate for 1991 is higher than the statutory rate of 34%, primarily resulting for the effects of purchase accounting, state income taxes, higher taxes on foreign earnings and minority interest. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (3) Acquisitions ____________ In October 1993, the Company acquired 34.5% of the outstanding shares of C-TEC that have 56.6% of the available voting rights. The acquisition of C-TEC for $207 million in cash was accounted for as a purchase, and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed, as follows: Assets: Cash and cash equivalents $ 61 Other current assets 49 Property, plant and equipment 354 Investments 17 Intangible assets 303 Other 8 Liabilities: Current liabilities (64) Deferred income taxes (46) Other liabilities (8) Long-term debt (427) Minority interest (40) _______ $ 207 ======= Results of C-TEC operations are included in the Company's consolidated results of operations since the date of acquisition. The following unaudited pro forma information shows the results of the Company as though the acquisition occurred at the beginning of 1992. These results include certain adjustments, primarily increased amortization, and are not necessarily indicative of what the results would have been had the acquisition been made as of that date or results that will occur in the future. 1993 1992 _______ _______ Revenue $ 2,415 $ 2,277 Net Earnings 255 175 Earnings Per Share of Class D Stock 8.78 4.63 PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (4) MFS Stock Sales _______________ In May 1993, MFS sold 12.7 million shares of common stock to the public at an initial offering price of $20 per share for $233 million, net of certain transaction costs. An additional 4.6 million shares were sold to the public in September 1993, at a price of $50 per share for $218 million, net of certain transaction costs. These transactions have reduced the Company's ownership interest in MFS to 71% at December 25, 1993. Substantially all of the net proceeds from the offerings are intended to fund MFS' growth. Prior to the initial public offering, MFS was a wholly-owned subsidiary of the Company. The 29% outside ownership interest has been included in the consolidated condensed balance sheet minority interest caption. As a result of the above transactions, the Company recognized a gain of $211 million representing the increase in the Company's equity in the underlying net assets of MFS. Deferred income taxes have been provided on this gain. (5) Disposal of Packaging Businesses ________________________________ In July 1992, the Company sold its equity investment in a plastics joint venture to Ball Corporation for $7 million. No significant gain or loss was recognized as a result of this transaction. The gain on disposal of discontinued operations in 1992 resulted from a $19 million adjustment to prior year tax estimates and an $8 million payment, net of tax, received from BTR Nylex Limited and a $1 million accrual, net of tax, relating to additional sales proceeds from the 1990 sale of Continental PET Technologies, Inc. This gain was partially offset by miscellaneous sales adjustments related to the 1991 and 1990 sales of certain discontinued packaging operations. In April 1991, certain subsidiaries of the Company sold their European packaging operations ("Europe") to VIAG Aktiengesellschaft, a German company. The transaction closed in June 1991. Europe was engaged in developing, manufacturing and marketing metal and plastic containers, closures and related packaging products principally in western Europe. Revenue from these businesses was $818 million prior to the transaction close in 1991. Europe's net earnings for this same period was $34 million. The net proceeds were $853 million in cash. With the net proceeds, the Company repaid in July 1991 short-term borrowings of $252 million. The short-term borrowings consisted of $123 million which was borrowed in June 1991 to repay intercompany loans made to the Company by a subsidiary of Europe and $129 million which was directly related to financing Europe's capital expenditures. In May 1991, the Company sold Continental Can International Corporation ("CCIC"), a wholly-owned subsidiary that held the Company's interests in metal packaging operations in Latin America, the Far East and the Middle East, to Crown Cork & Seal Company, Inc. Revenue and net earnings were not material during the period prior to closing in 1991. Proceeds from the transaction consisted of $35 million paid in cash at closing and a receivable of $94 million which was collected in November 1991. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (5) Disposal of Packaging Businesses (continued) ____________________________________________ In August 1991, the Company sold Continental White Cap, Inc. ("White Cap"), a wholly-owned subsidiary that manufactured metal, plastic and composite closures for food vacuum-packed in both glass and plastic containers to Schmalbach Lubeca A.G., a German company, for $279 million, after certain adjustments. Revenue from this business was $119 million prior to the transaction close in 1991. Net earnings for this same period was $13 million. The proceeds consisted of a promissory note, with interest at the LIBOR rate plus .625%, receivable in installments over the next five years with the final installment due on December 31, 1995. The first installment payment of $50 million was received in October 1991. Additional payments totalling $25 million were received in December 1991 and January 1992, $60 million was received in December 1992, and $110 million was received in 1993. In November 1991, the Company sold Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively "PCD"), two wholly-owned subsidiaries that manufactured blow-molded rigid plastic containers for household, automotive, industrial and food products, to Plastic Containers, Inc., a newly formed corporation, for approximately $150 million, after adjustments. Revenue from this business was $190 million prior to the transaction close in 1991. Net earnings for this same period was $4 million. The proceeds consisted of $50 million in cash at the closing and a $100 million bridge note receivable which was collected in April 1992. The table below summarizes the gain on disposal for each sale and for the combined sales (in millions) during 1991: Europe CCIC White Cap PCD Total ______ _____ _________ _____ _______ Net Proceeds $ 853 $ 129 $ 279 $ 150 $ 1,411 Financial Reporting Basis 560 41 109 96 806 _____ _____ _____ _____ _______ Pre-Tax Gain 293 88 170 54 605 Estimated Tax Provision 94 33 78 28 233 _____ _____ _____ _____ _______ Gain on Disposal $ 199 $ 55 $ 92 $ 26 $ 372 ===== ===== ===== ===== ======= The effective income tax rates differ from the expected statutory income tax rates due to state income taxes and the tax bases being different than the financial reporting bases. Included in the gain on disposal of Europe is $43 million of cumulative translation adjustments, consisting of $95 million of foreign currency adjustments, recorded at December 29, 1990, offset by $52 million of foreign currency losses incurred in 1991. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (5) Disposal of Packaging Businesses (continued) ____________________________________________ The difference between the gain summarized above and the gain per the consolidated statement of earnings is $1 million, net of tax, consisting of the following (in millions): Purchase price adjustment for Continental PET Technologies, Inc. $ 17 Gain on sale of investment in unconsolidated subsidiary 6 Reserves for various sales of discontinued packaging operations (22) _____ $ 1 ===== During 1991, the Company received $176 million in cash related to the remaining receivable, along with accrued interest, from the sale of the Company's domestic Beverage and Food packaging businesses in 1990. In 1990, the Company sold Continental PET Technologies, Inc. ("PET") to BTR Nylex Limited ("BTR"), an Australian company. Closing date proceeds, subject to adjustment, approximated $110 million. BTR paid an additional $40 million for revenue recognized by PET during 1991-1993 from certain new products. At closing, the Company received a note receivable of $110 million, which was collected in cash in January 1991. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (6) Disclosures about Fair Value of Financial Instruments _____________________________________________________ The following methods and assumptions were used to determine classification and fair values of financial instruments: Cash and Cash Equivalents _________________________ Cash equivalents generally consist of highly liquid debt instruments purchased with an original maturity of three months or less. The securities are stated at cost, which approximates fair value. Marketable Securities and Investments _____________________________________ The Company has classified all marketable securities and non-current investments not accounted for under the equity method as available- for-sale. The amortized cost of the securities used in computing unrealized and realized gains and losses are determined by specific identification. Fair values are estimated based on quoted market prices for the securities on hand or for similar investments. Fair values of certificates of deposit approximate cost. Net unrealized holding gains and losses are reported as a separate component of stockholders' equity, net of tax. At December 26, 1992 the cost of marketable securities approximated fair value. At December 25, 1993 the cost, unrealized holding gains and losses, and estimated fair values of marketable securities and noncurrent investments are as follows: Unrealized Unrealized Amortized Holding Holding Fair Cost Gains Losses Value _________ __________ __________ _____ Marketable Securities: Equity securities $ 79 $ 2 $ 2 $ 79 U.S. debt securities 536 - - 536 State and political subdivision debt securities 136 1 - 137 Foreign government debt securities 84 - - 84 Corporate debt securities 204 - 1 203 Collateralized mortgage obligations 27 - - 27 Certificates of deposit 16 - - 16 _______ ____ ____ _______ $ 1,082 $ 3 $ 3 $ 1,082 ======= ==== ==== ======= Noncurrent Investments: Equity Securities $ 80 $ 13 $ - $ 93 ======= ==== ==== ======= For debt securities, amortized costs do not vary significantly from principal amounts. Realized gains and losses on sales of marketable securities were $31 million and $64 million, respectively, in 1993. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (6) Disclosures about Fair Value of Financial Instruments (continued) _________________________________________________________________ The contractual maturities of the debt securities are as follows: Amortized Cost Fair Value ______________ __________ U.S. debt securities: less than 1 year $ 517 $ 517 1-5 years 19 19 _______ _______ $ 536 $ 536 ======= ======= State and political subdivision debt securities: less than 1 year $ 4 $ 4 1-5 years 114 115 5-10 years 5 5 over 10 years 13 13 _______ _______ $ 136 $ 137 ======= ======= Foreign government debt securities: 1-5 years $ 67 $ 67 5-10 years 17 17 _______ _______ $ 84 $ 84 ======= ======= Corporate debt securities: less than 1 year $ 65 $ 65 1-5 years 103 102 5-10 years 16 16 over 10 years 20 20 _______ _______ $ 204 $ 203 ======= ======= Certificates of deposit: less than 1 year $ 16 $ 16 ======= ======= Maturities for the collateralized mortage obligations have not been presented as they do not have a single maturity date. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (6) Disclosures about Fair Value of Financial Instruments (continued) _________________________________________________________________ Note Receivable from Sale of Discontinued Operations: ____________________________________________________ The carrying amount approximates fair value for both the current and the long-term portion due to the interest rate provided in the note. Short-term Borrowings and Long-term Debt: ________________________________________ The fair value of debt was estimated using the incremental borrowing rates of the Company for debt of the same remaining maturities and approximates the carrying amount, except for certain Rural Telephone Bank debt which C-TEC may refinance. (See Note 11). (7) Retainage on Construction Contracts ___________________________________ Marketable securities at December 25, 1993 and December 26, 1992 include approximately $56 million and $48 million, respectively, of investments which are being held by the owners of various construction projects in lieu of retainage. Receivables at December 25, 1993 and December 26, 1992 include approximately $37 million and $35 million, respectively, of retainage on uncompleted projects, the majority of which is expected to be collected within one year. (8) Investment in Construction Joint Ventures _________________________________________ The Company has entered into a number of construction joint venture arrangements. Under these arrangements, if one venturer is financially unable to bear its share of costs, the other venturers will be required to pay those costs. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (8) Investment in Construction Joint Ventures (continued) _____________________________________________________ Summary joint venture financial information follows: Financial Position (dollars in millions) 1993 1992 _____________________________________________________________________ Total Joint Ventures ____________________ Current assets $ 563 $ 395 Other assets (principally construction equipment) 71 39 ______ ______ 634 434 Current liabilities (481) (181) ______ ______ Net assets $ 153 $ 253 ====== ====== Company's Share _______________ Equity in net assets $ 80 $ 51 Receivable (payable) from (to) joint ventures 1 (3) ______ ______ Investment in construction joint ventures $ 81 $ 48 ====== ====== _____________________________________________________________________ Operations (dollars in millions) 1993 1992 1991 _____________________________________________________________________ Total Joint Ventures ____________________ Revenue $ 906 $ 575 $ 565 Costs 841 522 703 ______ ______ ______ Operating income (loss) $ 65 $ 53 $ (138) ====== ====== ====== Company's Share _______________ Revenue $ 430 $ 269 $ 337 Costs 372 243 352 ______ ______ ______ Operating income (loss) $ 58 $ 26 $ (15) ====== ====== ====== _____________________________________________________________________ Management of the nonsponsored Denmark tunnel project completed a cost estimate in 1993 which indicated a favorable variance in the estimated costs of the project. As a result of this cost estimate and negotiations with the owner, the Company's management reduced reserves by $20 million which had been maintained to provide for the Company's share of estimated losses on the project. Management believes that the resolution of the the uncertainties in completing the tunnel, primarily due to adverse soil conditions, should not materially affect the Company's financial position. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (8) Investment in Construction Joint Ventures (continued) _____________________________________________________ Operating income in 1991 was unfavorably impacted by losses on certain joint venture contracts including recording estimated losses on the nonsponsored Denmark tunnel project of $32 million. (9) Investments ___________ During 1992, the Company purchased additional shares of California Energy Company, Inc. ("California Energy") common stock for $23 million, increasing its ownership interest to 21%. The cumulative investment in common stock, accounted for on the equity method, totals $80 million. The Company has certain options to purchase additional shares of California Energy common stock. The excess purchase price over the under- lying equity is being amortized over 20 years. Equity earnings, net of the amortization of the excess purchase price over the underlying equity, were $7 million, $4 million and $3 million in 1993, 1992 and 1991, respectively. California Energy common stock is traded on the New York Stock Exchange. On December 25, 1993, the market value of the Company's investment in California Energy common stock was $138 million. In 1993 and 1992, the Company also recorded dividends in kind declared by California Energy consisting of voting convertible preferred stock valued at $5 million and $4 million, respectively. The stock dividends brought the Company's total investment in convertible preferred stock to $59 million at December 25, 1993. Investments also include equity securities classified as noncurrent and carried at the fair value of $93 million (See Note 6). (10) Intangible Assets _________________ Intangible assets consist of the following at December 25, 1993 and December 26, 1992 (dollars in millions): 1993 1992 _____ _____ Goodwill $ 234 $ 52 Franchise and subscriber lists 60 5 Noncompete agreements 36 - Licenses and right-of-ways 32 11 Deferred development costs 64 13 _____ _____ 426 81 Less accumulated amortization (11) (6) _____ _____ $ 415 $ 75 ===== ===== PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (11) Long-Term Debt and Unutilized Borrowing Arrangements ____________________________________________________ At December 25, 1993 and December 26, 1992, long-term debt was as follows: (dollars in millions) 1993 1992 ______________________________________________________________________ C-TEC Long-term Debt (with recourse only to C-TEC) ____________________ Mortgage notes payable to the United States of America - Rural Telephone Bank (RTB) 5% - 6.05%, with monthly payments through 2009 $ 64 $ - 6.5% - 7%, with quarterly sinking fund payments through 2015 58 - Federal Financing Bank (FFB) 7.69% - 8.36%, with quarterly sinking fund payments through 2012 14 - Senior Secured Notes 9.65%, with annual principal payments 1996 through 1999 (includes unamortized premium of $7 based on imputed rate of 6.12%) 157 - 9.52%, with annual principal payments 1996 through 2001 (includes unamortized premium of $4 based on imputed rate of 6.93%) 104 - Revolving Credit Agreements and Other 30 - _____ _____ 427 - Other PKS Long-term Debt ________________________ 7.5% to 11.6% Notes to former stockholders due 1994-2001 16 17 6.25% to 10.5% Convertible debentures due 1999-2003 7 5 Other 27 11 _____ _____ 50 33 _____ _____ 477 33 Less current portion (15) (3) _____ _____ $ 462 $ 30 ===== ===== _______________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (11) Long-term Debt and Unutilized Borrowing Arrangements (continued) ________________________________________________________________ Substantially all of the assets of C-TEC's telephone group ($353 million) collateralize the mortgage notes payable to the United States of America. These note agreements restrict telephone group dividends. The Senior Secured notes are collateralized by pledges of the stock of C-TEC's telephone, mobile services, and cable group subsidiaries. The notes contain restrictive covenants which require, among other things, specific debt to cash flow ratios. C-TEC's Revolving Credit agreements are collaterlized by a pledge of the stock of C-TEC's telephone and mobile services subsidiaries. The convertible debentures are convertible during October of the fifth year preceding their maturity date. Each annual series may be redeemed in its entirety prior to the due date except during the conversion period. Debentures were converted into 14,322, 10,468, and 36,598, shares of Class C and Class D common stock in 1993, 1992 and 1991, respectively. At December 25, 1993, 215,180 shares of Class C common stock and 86,736 shares of Class D common stock are reserved for future conversions. Other PKS long-term debt consists primarily of construction financing of a privately owned toll road which will be converted to term debt upon completion of the project. Variable interest rates on this debt ranged from 5% to 9% at December 25, 1993. Scheduled maturities of long-term debt through 1998 are as follows (in millions): 1994 - $11; 1995 - $25; 1996 - $56; 1997 - $68 and $70 in 1998. The Company has the following unutilized borrowing arrangements at December 25, 1993: C-TEC's telephone group's agreement with the RTB provides for an additional $23 million of borrowings. The agreement requires C-TEC to invest in RTB stock for approximately 5% of the available amount. C-TEC's Revolving Credit agreements provide for an additional $11 million of borrowings collateralized by stock pledges. The total commitments are reduced on a quarterly basis through maturity in September 1996. An additional $50 million Credit Agreement collateralized by stock pledges may be utilized by C-TEC. The agreement provides revolving borrowings through June 1, 1994 at which time the outstanding balance converts to a term loan with quarterly payments through 1997. Under the arrangement, C-TEC must maintain specified debt to cash flow ratios. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (11) Long-term Debt and Unutilized Borrowing Arrangements (continued) ________________________________________________________________ C-TEC also has an unused line of credit for $13 million under which unsecured borrowings may be made. Unused lines are cancelable at the option of the lenders. MFS has a $75 million secured revolving credit agreement dependent in part on their ability to attain certain cash flow requirements. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (12) Income Taxes ____________ An analysis of the provision for income taxes related to continuing operations before minority interest and cumulative effect of change in accounting principle for the three years ended December 25, 1993 follows: (dollars in millions) 1993 1992 1991 _____________________________________________________________________ Current: U.S. federal $ 52 $ 62 $ 32 Foreign 2 5 7 State 8 6 6 _____ _____ _____ 62 73 45 _____ _____ _____ Deferred: U.S. federal 51 (2) (4) Foreign (1) (4) - State (1) 2 - _____ _____ _____ 49 (4) (4) _____ _____ _____ $ 111 $ 69 $ 41 ===== ===== ===== _____________________________________________________________________ The United States and foreign components of earnings, for tax reporting purposes, from continuing operations before minority interest, income taxes and cumulative effect of change in accounting principle follow: (dollars in millions) 1993 1992 1991 ____________________________________________________________________ United States $ 362 $ 215 $ 74 Foreign 7 4 16 _____ _____ _____ $ 369 $ 219 $ 90 ===== ===== ===== ____________________________________________________________________ The components of the deferred income tax benefit, prior to adopting SFAS No. 109, in 1991 were as follows: (dollars in millions) 1991 ____________________________________________________________________ Depreciation and fixed assets $ 4 Retirement benefits and other compensation 1 Mining revenue and costs 5 Insurance reserves (3) Construction contract accounting (18) Equity earnings 4 Accrued revenue 4 Other (1) _____ $ (4) ===== ____________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (12) Income Taxes (continued) ________________________ A reconciliation of the actual provision for income taxes and the tax computed by applying the U.S. federal rate (35% in 1993 and 34% in 1992 and 1991) to the earnings from continuing operations before minority interest, income taxes and cumulative effect of change in accounting principle for the three years ended December 25, 1993 follows: (dollars in millions) 1993 1992 1991 ___________________________________________________________________ Computed tax at statutory rate $ 129 $ 74 $ 31 State income taxes 4 5 4 Depletion (4) (4) (4) Dividend exclusion (4) (3) (2) Equity earnings - (3) - Foreign taxes - - 3 Prior year tax adjustments (13) - 3 Nondeductible expenses - - 3 Other (1) - 3 _____ ____ ____ $ 111 $ 69 $ 41 ===== ==== ==== ___________________________________________________________________ The Company and its domestic subsidiaries file a consolidated federal income tax return. Possible taxes, beyond those provided, on remittances of undistributed earnings of foreign subsidiaries are not expected to be material. The components of the net deferred tax liabilities for the years ended December 25, 1993 and December 26, 1992 were as follows: (dollars in millions) 1993 1992 _____________________________________________________________________ Deferred tax liabilities: Investments in joint ventures $ 112 $ 108 Investments in subsidiaries 84 - Asset bases - accumulated depreciation 198 149 Deferred coal sales 26 25 Other 48 34 _____ _____ Total deferred tax liabilities 468 316 _____ _____ Deferred tax assets: Construction accounts 16 8 Insurance claims 20 22 Compensation - retirement benefits 22 38 Provision for estimated expenses 8 10 Net operating losses of subsidiaries 52 7 Alternative minimum tax credits realizable by subsidiary 11 - Other 37 26 Valuation adjustments (17) (7) _____ _____ Total deferred tax assets 149 104 _____ _____ Net deferred tax liabilities $ 319 $ 212 ===== ===== _____________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (12) Income Taxes (continued) ________________________ The Company's subsidiaries have federal income tax net operating loss carryforwards of $120 million which begin to expire in 2001. (13) Employee Benefit Plans ______________________ The Company makes contributions, based on collective bargaining agreements related to its construction operations, to several multi-employer union pension plans. These contributions are included in the cost of revenue. Under federal law, the Company may be liable for a portion of plan deficiencies; however, there are no known deficiencies. The Company's defined benefit pension plans cover primarily packaging employees who retired prior to the disposition of the packaging operations. The expense related to these plans was approximately $7 million in 1993 and $1 million in 1992 and 1991. C-TEC maintains a separate defined benefit plan for substantially all of its employees. The prepaid pension cost and income related to this plan is not significant at December 25, 1993 or for the period from the acquisition date through December 25, 1993. The Company also has a long-term incentive plan, consisting of stock appreciation rights, for certain employees. The expense related to this plan was $3 million, $6 million, and $8 million in 1993, 1992 and 1991, respectively. Substantially all employees of the Company, with the exception of stockholders and MFS and C-TEC employees, are covered under the Company's profit sharing plans. The expense related to these plans was $2 million, $3 million and $2 million in 1993, 1992 and 1991, respectively. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (14) Postretirement Benefits _______________________ In addition to providing pension and other supplemental benefits, the Company provides certain health care and life insurance benefits primarily for packaging employees who retired prior to the disposition of certain packaging operations and C-TEC employees. Employees become eligible for these benefits if they meet minimum age and service requirements or if they agree to contribute a portion of the cost. These benefits have not been funded. The net periodic costs for health care benefits were $4 million in 1993, 1992, and 1991. The net perioidic costs for life insurance benefits were $2 million, $2 million, and $1 million in 1993, 1992, and 1991, respectively. In all years, the costs related entirely to interest on accumulated benefits. The accrued postretirement benefit liability as of December 25, 1993 was as follows: Health Life (dollars in millions) Insurance Insurance ______________________________________________________________________ Retirees $ 34 $ 17 Fully eligible active plan participants - - Other active plan participants - - _____ _____ Total accumulated postretirement benefit obligation 34 17 Unrecognized prior service cost 24 1 Unrecognized net loss (7) (2) _____ _____ Accrued postretirement benefit liability $ 51 $ 16 ===== ===== ______________________________________________________________________ The unrecognized prior service cost resulted from certain modifications to the postretirement benefit plan which reduced the accumulated postretirement benefit obligation. The Company may make additional modifications in the future. A 8.3% increase in the cost of covered health care benefits was assumed for fiscal 1993. This rate is assumed to gradually decline to 6.2% in the year 2020 and remain at that level thereafter. A 1% increase in the health care trend rate would increase the accumulated postretirement benefit obligation ("APBO") by $1 million at year-end 1993. The weighted average discount rate used in determining the APBO was 7.0%. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (15) Stockholders' Equity ____________________ Under the Company's Restated Certificate of Incorporation, effective January 8, 1992, the Company now has three classes of common stock: Class B Construction and Mining Group Nonvoting Restricted Redeemable Convertible Common Stock ("Class B"), Class C Construction and Mining Group Restricted Redeemable Convertible Exchangeable Common Stock ("Class C"), and Class D Diversified Group Convertible Exchangeable Common Stock ("Class D"). In connection with a reclassification in January 1992, each "old" Class B share was exchanged for one "new" Class B share and one Class D share, and each "old" Class C share was exchanged for one "new" Class C share and one Class D share. New Class B and Class C shares can be issued only to Company employees and can be resold only to the Company at a formula price based on the book value of the Construction & Mining Group. The Company is generally required to repurchase Class B and Class C shares for cash upon stockholder demand. Class D shares have a formula price based on the book value of the Diversified Group. The Company must generally repurchase Class D shares for cash upon stockholder demand at the formula price, unless the Class D shares become publicly traded. Although the Class D shares are predominantly owned by employees and former employees, such shares are not subject to ownership or transfer restrictions. In accordance with the January 8, 1992 reorganization, the number of authorized shares of Class B, C and D common stock were increased to 8 million, 125 million and 50 million, respectively. In the event of liquidation, after the holders of any preferred stock have been paid the par value and any accrued and unpaid dividends, the Board of Directors will establish two liquidation accounts, the "B&C Liquidation Account" and the "D Liquidation Account." The assets of the liquidation accounts will be distributed as follows: first, Class B&C stockholders will receive an amount equal to $1.00 per share, reducing the B&C Liquidation Account; second, Class D stockholders will receive an amount equal to $2.00 per share, reducing the D Liquidation Account; and third, any amount remaining in the B&C Liquidation Account shall be distributed pro rata to the Class B&C stockholders, and any amount remaining in the D Liquidation Account shall be distributed pro rata to the Class D stockholders. For comparative purposes, the table below presents issuances and repurchases of common shares assuming the plan of exchange was effected at the beginning of 1991 since each outstanding share of existing Class B and Class C stock was exchanged for one share of new Class B&C stock and one share of new Class D stock. PETER KIEWIT SONS' INC. Notes to Consolidated Financial Statements (15) Stockholders' Equity (continued) ________________________________ For the three years ended December 25, 1993, issuances and repurchases of common shares including conversions were as follows: _______________________________________________________________________ Class B Class C Class D Common Common Common Stock Stock Stock ______ _______ _______ Shares issued in 1991 - 514,518 514,518 Shares repurchased in 1991 206,000 2,897,335 3,103,335 Shares issued in 1992 - 2,886,418 1,019,553 Shares repurchased in 1992 137,000 4,765,161 1,693,353 Shares issued in 1993 - 1,027,657 748,026 Shares repurchased in 1993 76,600 2,217,122 841,808 ______________________________________________________________________ (16) Other Income ____________ Other income includes net investment income of $16 million, $86 million, and $108 million in 1993, 1992 and 1991, respectively, gains and losses on sales of property, plant and equipment and other assets, and other miscellaneous income. Net investment income in 1993 includes $59 million of losses on the sale and permanent writedown of certain derivative securities. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (17) Industry and Geographic Data ____________________________ The Company operates primarily in three reportable segments: construction, mining and telecommunications. The packaging segment is reported as discontinued operations. A summary of the Company's operations by geographic area and industry follows: Geographic Data (dollars in millions) 1993 1992 1991 _____________________________________________________________________ Revenue: United States $ 1,930 $ 1,808 $ 1,834 Canada 175 182 238 Other 74 30 14 _______ _______ _______ $ 2,179 $ 2,020 $ 2,086 ======= ======= ======= Operating earnings: United States $ 107 $ 131 $ 48 Canada 4 (2) 13 Other 22 - (32) _______ _______ _______ 133 129 29 Gain on sales of subsidiary's stock 211 - - Interest income, net 41 63 35 Nonoperating income (expense), net (16) 27 26 _______ _______ _______ Earnings from continuing operations before income taxes, minority interest and cumulative effect of change in accounting principle $ 369 $ 219 $ 90 ======= ======= ======= Identifiable assets: United States $ 2,445 $ 1,049 $ 861 Canada 82 90 102 Other areas 17 10 - Corporate (1) 1,140 1,450 1,657 Discontinued packaging operations - - 12 _______ _______ _______ $ 3,684 $ 2,599 $ 2,632 ======= ======= ======= _____________________________________________________________________ (1) Principally cash, cash equivalents, marketable securities, notes receivable from sales of discontinued operations and investments in all years. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (17) Industry and Geographic Data (continued) ________________________________________ Industry Data (dollars in millions) 1993 1992 1991 ______________________________________________________________________ Revenue: Construction $ 1,757 $ 1,659 $ 1,825 Mining 230 246 219 Telecommunications 189 109 37 Other 3 6 5 _______ _______ _______ $ 2,179 $ 2,020 $ 2,086 ======= ======= ======= Operating earnings: Construction $ 94 $ 72 $ 29 Mining 99 96 71 Telecommunications (26) (12) (27) Other (34) (27) (44) _______ _______ _______ 133 129 29 Gain on sale of subsidiary's stock 211 - - Interest income, net 41 63 35 Nonoperating income (expense), net (16) 27 26 _______ _______ _______ Earnings from continuing operations before income taxes, minority interest and cumulative effect of change in accounting principle $ 369 $ 219 $ 90 ======= ======= ======= Identifiable assets: Construction $ 594 $ 543 $ 527 Mining 206 217 196 Telecommunications 1,682 363 205 Other 62 26 35 Corporate 1,140 1,450 1,657 Discontinued packaging - - 12 _______ _______ _______ $ 3,684 $ 2,599 $ 2,632 ======= ======= ======= Capital expenditures: Construction $ 48 $ 37 $ 57 Mining 5 8 6 Telecommunications 127 80 51 Other - - 5 Corporate 12 4 3 _______ _______ _______ $ 192 $ 129 $ 122 ======= ======= ======= Depreciation, depletion and amortization: Construction $ 43 $ 45 $ 53 Mining 13 12 11 Telecommunications 35 21 12 Other 2 3 3 Corporate 6 5 3 _______ _______ _______ $ 99 $ 86 $ 82 ======= ======= ======= ____________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (18) Summarized Financial Information ________________________________ Holders of Class B&C Stock (Construction & Mining Group) and Class D Stock (Diversified Group) are stockholders of PKS. The Construction & Mining Group contains the Company's traditional construction operations performed by Kiewit Construction Group Inc. and certain mining services, performed by Kiewit Mining Group Inc. The Diversified Group contains coal mining properties owned by Kiewit Coal Properties Inc., communications companies owned by MFS, the 34.5% interest in C-TEC, a minority interest in California Energy and miscellaneous investments. Corporate assets and liabilities which are not separately identified with the ongoing operations of the Construction & Mining Group or the Diversified Group are allocated equally between the groups. A summary of the results of operations and financial position for the Construction & Mining Group and the Diversified Group follows. These summaries were derived from the audited financial statements of the respective groups which are exhibits to this Annual Report. All significant intercompany accounts and transactions, except those directly between the Construction & Mining Group and the Diversified Group, have been eliminated. Construction & Mining Group: 1993 1992 1991 _______ _______ _______ Results of Operations: Revenue $ 1,777 $ 1,671 $ 1,834 ======= ======= ======= Earnings before cumulative effect of change in acounting principle $ 80 $ 69 $ 23 Cumulative effect of change in accounting principle - 13 - _______ _______ _______ Net Earnings $ 80 $ 82 $ 23 ======= ======= ======= Earnings per Share: Earnings before cumulative effect of change in accounting principle $ 4.63 $ 3.79 $ 1.12 Cumulative effect of change in accounting principle - .69 - _______ _______ _______ Net Earnings $ 4.63 $ 4.48 $ 1.12 ======= ======= ======= PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (18) Summarized Financial Information (continued) _____________________________________________ Construction & Mining Group (continued): 1993 1992 1991 _______ _______ _______ Financial Position: Working capital $ 372 $ 342 $ 285 Total assets 889 862 849 Long-term debt, less current portion 10 12 13 Stockholders' equity 480 437 400 Included within earnings before income taxes is mine service income from the Diversified Group of $29 million in 1993 and 1992 and $8 million in 1991. Diversified Group: 1993 1992 1991 _______ _______ _______ Results of Operations: Revenue $ 402 $ 349 $ 252 ======= ======= ======= Earnings from continuing operations before cumulative effect of change in accounting principle $ 181 $ 81 $ 26 Cumulative effect of change in accounting principle - (1) - Discontinued Operations - 19 392 _______ _______ _______ Net Earnings $ 181 $ 99 $ 418 ======= ======= ======= Earnings per Share: Earnings from continuing operations before cumulative effect of change in accounting principle $ 9.08 $ 4.00 $ 1.26 Cumulative effect of change in accounting principle - (.05) - Discontinued operations - .97 19.04 _______ ______ _______ Net Earnings $ 9.08 $ 4.92 $ 20.30 ======= ====== ======= PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (18) Summarized Financial Information (continued) _____________________________________________ Diversified Group: 1993 1992 1991 _______ _______ _______ Financial Position: Working capital $ 993 $ 796 $ 788 Total assets 2,809 1,759 1,801 Long-term debt, less current portion 452 18 97 Stockholders' equity 1,191 1,021 996 Included within earnings from continuing operations before income taxes is mine management fees paid to the Kiewit Construction & Mining Group of $29 million in 1993 and 1992 and $8 million in 1991. (19) Other Matters _____________ The Company is involved in various lawsuits, claims and regulatory proceedings incidental to its business. Management believes that any resulting liability, beyond that provided, should not materially affect the Company's financial position or results of operations. In many pending proceedings, the Company is one of numerous defendants who may be "potentially responsible parties" liable for the cleanup of hazardous substances deposited in landfills or other sites. The Company has established reserves to cover its probable liabilities for environmental cases and believes that any additional liabilities will not materially affect the Company's financial condition or results of operations. On March 4, 1994, several former stockholders of an MFS subsidiary filed a lawsuit against MFS, Kiewit Diversified Group, Inc. ("KDG") and the chief executive officer of MFS, in the United States District Court for the Northern District of Illinois, Case No. 94C-1381. These shareholders sold shares of the subsidiary to MFS in September 1992. MFS completed an initial public offering in May 1993. Plaintiffs allege that MFS fraudulently concealed material information about its plans from them, causing them to sell their shares at an inadequate price. Plaintiffs have alleged damages of at least $100 million. Defendants have meritorious defenses and intend to vigorously contest this lawsuit. Prior to the initial public offering, KDG agreed to indemnify MFS against any liabilities arising from the September 1992 sale; if MFS is deemed to be liable to plaintiffs, KDG will be required to satisfy MFS' liabilities pursuant to the indemnity agreement. Any settlement amount would be treated as an adjustment of the original purchase price and recorded as additional goodwill. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (19) Other Matters (continued) _________________________ It is customary in the Company's industries to use various financial instruments in the normal course of business. These instruments include items such as letters of credit. Letters of credit are conditional commitments issued on behalf of the Company in accordance with specified terms and conditions. As of December 25, 1993, the Company had outstanding letters of credit of approximately $141 million. A subsidiary of the Company, Continental Holdings Inc. remains contingently liable as a guarantor of $111 million of debt relating to various businesses which have been sold. The Company leases various buildings and equipment under both operating and capital leases. Minimum rental payments on buildings and equipment subject to noncancelable operating leases during the next 24 years aggregate $104 million. In 1974, a subsidiary of the Company ("Kiewit"), entered into a lease agreement with Whitney Benefits, Inc., a Wyoming charitable corporation ("Whitney"). Whitney is the owner, and Kiewit is the lessee, of a coal deposit underlying approximately a 1,300 acre tract in Sheridan County, Wyoming. The coal was rendered unmineable by the Surface Mining Control and Reclamation Act of 1977 ("SMCRA"), which prohibited surface mining of coal in certain alluvial valley floors significant to farming. In 1983, Whitney and Kiewit filed an action now titled Whitney Benefits, Inc. and Peter Kiewit Sons', Co. v. The United States, in the U.S. Court of Federal Claims ("Claims Court") alleging that the enactment of SMCRA constituted a taking of their coal without just compensation. In 1989, the Claims Court ruled that a taking had occurred and awarded plaintiffs the 1977 fair market value of the property ($60 million) plus interest. In 1991, the U.S. Court of Appeals for the Federal Circuit affirmed the decision of the Claims Court. In 1991, the U.S. Supreme Court denied certiorari. On February 10, 1994, the Claims Court issued an opinion which provided that the $60 million judgement would bear interest compounded annually from 1977 until payment. Interest for the 1977-1993 period is $230 million. Kiewit and Whitney have agreed that Kiewit and Whitney will receive 67.5 and 32.5 percent, respectively, of any award. The government filed two post-trial motions in the Claims Court during 1992. The government requested a new trial to redetermine the value of the property. The government also filed a motion to reopen and set aside the 1989 judgement as void and to dismiss plaintiffs' complaint for lack of jurisdiction. In August 1992, the Claims Court indicated that both motions would be denied. A written order has not yet been entered. The government may appeal from the order, as well as the order regarding compound interest. It is not presently known when these proceedings will be concluded, what amount Kiewit will ultimately receive, nor when payment of that amount will occur. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (19) Other Matters (continued) _________________________ C-TEC has an outstanding interest rate swap agreement which expires in December 1994. Under this agreement, the Company received a fixed rate of 9.52% on $100 million and pays a floating rate of LIBOR plus 502 basis points (8.52% at December 31, 1993), as determined in six-month intervals. The transaction effectively changes C-TEC's interest rate exposure from a fixed-rate to a floating-rate basis on the $100 million underlying debt. The counter-party to the interest rate swap contract is a major financial institution. C-TEC is exposed to economic loss in the event of nonperformance by the counter-party, however, it does not anticipate such non-performance. (20) Subsequent Events _________________ On January 19, 1994, MFS issued 9 3/8% Senior Discount Notes due January 15, 2004. Cash interest will not accrue on the notes prior to January 15, 1999. Commencing July 15, 1999 cash interest will be payable semi-annually. Accordingly, MFS will initially record the proceeds it received from the offering of $500 million and accrue to the principal amount of the notes of $788 million through January 1999. On or after January 15, 1999, the notes will be redeemable at the option of MFS, in whole or in part, as stipulated in the note agreement. The notes contain certain covenants which, among other things, will restrict MFS' ability to incur additional debt, create liens, enter into sale and leaseback transactions, pay dividends, make certain restricted payments, enter into transactions with affiliates, and sell assets or merge with another company. On February 28, 1994 the Company completed the purchase of APAC- Arizona, Inc. ("APAC") from Ashland Oil Company, Inc. for approximately $49 million, subject to adjustments. APAC is engaged in the construction materials and contracting businesses in Arizona and surrounding states. The acquisition will be accounted for as a purchase, and accordingly, the purchase price will be allocated to the assets and liabilities of APAC based upon their estimated fair values at the acquisition date. Results of operations of APAC will be included in the Company's consolidated results of operations subsequent to the date of acquisition. On March 16, 1994, MFS made an offer to purchase all outstanding shares of common stock and associated preferred share purchase rights to Centex Telemanagement, Inc. at $9 per share. The net consideration of the offer approximates $150 million. The offer, which will expire on April 12, 1994, is conditioned upon, among other things, acquiring a majority of the common shares and the preferred share purchase rights being redeemed or invalidated. SCHEDULE VIII PETER KIEWIT SONS', INC. AND SUBSIDIARIES Valuation and Qualifying Accounts and Reserves Amounts Balance, Charged to Charged Balance Beginning Costs and to End of (dollars in millions) of Period Expenses Reserves Other Period _____________________________________________________________________________ Year ended December 25, 1993 ____________ Allowance for doubtful trade accounts $ 7 $ 5 $ (6) $ 1 $ 7 Reserves: Insurance claims 66 14 (13) - 67 Retirement benefits 74 12 (17) 2 71 Year ended December 26, 1992 ____________ Allowance for doubtful trade accounts $ 7 $ 1 $ (1) $ - $ 7 Reserves: Insurance claims 61 20 (15) - 66 Retirement benefits 58 8 (8) 16 (a) 74 Year ended December 28, 1991 ___________________ Allowance for doubtful trade accounts $ 8 $ 1 $ (2) $ - $ 7 Reserves: Insurance claims 45 25 (9) - 61 Retirement benefits 21 37 (5) 5 58 _____________________________________________________________________________ (a) In 1992, adjustments made in accordance with SFAS No. 109 to adjust remaining retirement benefits, acquired in prior business acquisitions, recorded net of tax, to their pre-tax amounts. SCHEDULE IX PETER KIEWIT SONS', INC. AND SUBSIDIARIES Short-Term Borrowings Weighted Maximum Weighted Average Month-End Average Average Interest Amount Amount Interest Balance, Rate, Outstanding Outstanding Rate End of End of During the During the During (dollars in milions) Period Period Period Period (a) the Period ____________________________________________________________________________ Year ended December 25, 1993 ___________________ Bank Borrowings $ - -% $ 50 $ 24 3.4% Year ended December 26, 1992 ___________________ Bank Borrowings $ 80 3.4% $ 80 $ - -% Year ended December 28, 1991 ___________________ Bank Borrowings $ - -% $ 264 $ 92 10.8% __________________________________________________________________________ (a) Determined on the basis of average daily balances of short-term borrowings. The 1992 bank borrowings were made during the last week of the year. The bank borrowings provided for interest at various rates and matured on various dates within one year. SCHEDULE X PETER KIEWIT SONS', INC. AND SUBSIDIARIES Supplementary Income Statement Information Charged to Costs and Expenses _____________________________ (dollars in millions) 1993 1992 1991 ____________________________________________________________________________ Royalties (a) $ 22 $ 27 $ 24 Production taxes (a) 16 26 19 ____________________________________________________________________________ (a) The Company incurred royalty costs and production taxes with respect to its mining operations based on the tons of coal mined or sold from various properties. Advertising costs and amortization of intangible assets are not presented as such amounts represent less than one percent of revenue as reported in the related consolidated statements of earnings. The costs to repair equipment used on construction contracts, which are charged against such contracts, are excluded because it is impractical to segregate them from other contract costs. Maintenance and repair costs in 1993 and 1992 were less than one percent of revenue. Maintenance and repair costs, primarily related to the Company's discontinued packaging operations, were $50 million in 1991. PETER KIEWIT SONS', INC. AND SUBSIDIARIES INDEX TO EXHIBITS Exhibit No. Description of Exhibit ____________________________________________________________________________ 21 List of Subsidiaries of the Company. 99.A Kiewit Construction & Mining Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations. 99.B Kiewit Diversified Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations.

63814_1993.txt

63814_1993

1993

63814

ITEM 1. BUSINESS GENERAL MAXXAM Inc. and its majority and wholly owned subsidiaries are collectively referred to herein as the "Company" or "MAXXAM" unless otherwise indicated or the context indicates otherwise. The Company, through Kaiser Aluminum Corporation ("Kaiser") and Kaiser's principal operating subsidiary, Kaiser Aluminum & Chemical Corporation ("KACC"), is a fully integrated aluminum company. The Company's voting interest in Kaiser is approximately 61% on a fully diluted basis. See "--Aluminum Operations." In addition, the Company is engaged in forest products operations through its wholly owned subsidiary, MAXXAM Group Inc. ("MGI") and MGI's wholly owned subsidiaries, The Pacific Lumber Company and its wholly owned subsidiaries (collectively referred to herein as "Pacific Lumber," unless the context indicates otherwise), and Britt Lumber Co., Inc. ("Britt"). See "--Forest Products Operations." The Company is also engaged in real estate management and development, principally through MAXXAM Property Company (and its subsidiaries), MCO Properties Inc. ("MCOP"), Palmas del Mar Properties, Inc. and various other wholly owned subsidiaries. See "--Real Estate Operations." The Company, through its subsidiaries, also has various interests in a Class 1 thoroughbred and quarter horse racing facility currently under construction just northwest of Houston. See "--Sam Houston Race Park." See Note 11 to the Consolidated Financial Statements for certain financial information by industry segment and geographic area. ALUMINUM OPERATIONS INDUSTRY OVERVIEW Primary aluminum is produced by the refining of bauxite (the major aluminum-bearing ore) into alumina (the intermediate material) and the reduction of alumina into primary aluminum. Approximately two pounds of bauxite are required to produce one pound of alumina, and approximately two pounds of alumina are required to produce one pound of primary aluminum. Aluminum's valuable physical properties include its light weight, corrosion resistance, thermal and electrical conductivity and high tensile strength. Demand The packaging and transportation industries are the principal consumers of aluminum in the United States, Japan and Western Europe. In the packaging industry, which accounted for approximately 22% of consumption in 1992, aluminum's recyclability and weight advantages have enabled it to gain market share from steel and glass, primarily in the beverage container area. The aluminum packaging market in the United States, Japan and Western Europe grew at a rate of approximately 4.0% per year during the period 1982-1992, and total United States aluminum beverage can shipments increased at a rate of approximately 2.5% in 1993, 1.5% in 1992 and 3.9% in 1991. Nearly all beer cans and approximately 95% of the soft drink cans manufactured for the United States market are made of aluminum. Despite the flat demand currently being experienced in the can stock market, growth in the packaging area is generally expected to continue in the 1990's due to general population increase and to further penetration of the beverage can market in Western Europe and Japan, where aluminum cans are a substantially lower percentage of the total beverage container market than in the United States. In the transportation industry, which accounted for approximately 28% of aluminum consumption in the United States, Japan and Western Europe in 1992, automotive manufacturers use aluminum instead of steel or copper for an increasing number of components, including radiators, wheels and engines, in order to meet more stringent environmental and fuel efficiency requirements through vehicle weight reduction. Management believes that sales of aluminum to the transportation industry have considerable growth potential due to projected increases in the use of aluminum in automobiles. According to industry sources, aluminum content in United States automobiles nearly doubled in the last 15 years to an average of 191 pounds per vehicle and the amount of aluminum consumed in the manufacture of Japanese automobiles more than doubled from 1983 to 1990. Management believes that the use of aluminum in automobiles in the United States and Japan will approximately double between 1991 and 2006. Supply As of year-end 1993, Western world aluminum capacity from 109 smelting facilities was approximately 16.4 million tons per year. Net exports of aluminum from the Commonwealth of Independent States (the "C.I.S.") increased substantially from 1990 levels during the period from 1991 through 1993 and have contributed to a significant increase in London Metal Exchange stocks of primary aluminum. Based upon information currently available, Kaiser believes that only moderate additions will be made during 1994-1995 to Western world alumina and primary aluminum production capacity; however, due to the decline of primary aluminum prices since January 1, 1991, and other factors, curtailments or permanent shutdowns have been announced, to management's knowledge, with respect to approximately 3 million tons of primary aluminum production capacity (all references to tons herein are to metric tons of 2,204.6 pounds). See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Trends- -Aluminum Operations" on pages 34 and 35 of the Company's 1993 Annual Report to Stockholders. The increases in alumina capacity during 1994 -1995 will come from incremental expansions of existing refineries and not from new plants, which generally require a four to five year design, engineering and construction period. Recent Industry Trends The aluminum industry has been cyclical and market prices of alumina and primary aluminum have been volatile from time to time. During 1989, tight supply conditions for alumina and strong demand for primary aluminum resulted in unusually high spot prices for alumina. During 1990, a moderate surplus of alumina supply developed due to new alumina production from two facilities restarted in prior years (including Kaiser's Alpart refinery) and increased production at other refineries. Furthermore, curtailments of primary aluminum production in response to declining ingot prices have increased the surplus of alumina supply. Since 1990, spot prices of alumina have declined substantially due to these factors and slow economic growth in major aluminum consuming countries. Contract prices for deliveries of alumina in 1993 were in a lower range than the ranges applicable during the past several years. As a result of these factors and the continuing expansion of existing alumina refineries during 1992-1993, the current surplus of alumina is expected to continue. During 1989 and 1990, primary aluminum smelters throughout the world operated at near capacity levels. This factor, combined with increased production from smelter capacity additions during 1989 and 1990, resulted in a reduction of the market price of primary aluminum from 1988 peak prices. Additions to smelter capacity in 1991, 1992 and 1993, continued high operating rates in the Western world and slow economic growth in major aluminum consuming countries as well as exports from the C.I.S. have contributed to an oversupply of primary aluminum and a significant increase in primary aluminum inventories in the world. If Western world production and exports from the C.I.S. continue at current levels, primary aluminum inventory levels are expected to increase further in 1994. The foregoing factors have contributed to a significant reduction in the market price of primary aluminum, and may continue to adversely affect the market price of primary aluminum in the future. The average price of primary aluminum was at historic lows in real terms for the year ended 1993. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations --Trends--Aluminum Operations" on pages 34 and 35 of the Company's 1993 Annual Report to Stockholders. Government officials from the European Union, the United States, Canada, Norway, Australia and the Russian Federation met in a multilateral conference in January 1994 to discuss the current excess global supply of primary aluminum. All participants have ratified as a trade agreement the resulting Memorandum which provides, in part, for (i) a reduction in Russian Federation primary aluminum production by 300,000 tons per year within three months of the date of ratification of the Memorandum and an additional 200,000 tons within the following three months, (ii) improved availability of comprehensive data on Russian aluminum production, and (iii) certain assistance to the Russian aluminum industry. A Russian Federation Trade Ministry official has publicly stated that the output reduction would remain in effect for 18 months to two years, provided that other worldwide production cutbacks occur, existing trade restrictions on aluminum are eliminated, and no new trade restrictions on aluminum are imposed. The Memorandum does not require specific levels of production cutbacks by other producing nations. The Memorandum was finalized at a second meeting of the participants held at the end of February 1994. KAISER ALUMINUM General Kaiser operates in all principal aspects of the aluminum industry--the mining of bauxite, the refining of bauxite into alumina, the production of primary aluminum from alumina, and the manufacture of fabricated (including semi-fabricated) aluminum products. In addition to the production utilized by Kaiser in its operations, Kaiser sells significant amounts of alumina and primary aluminum in the domestic and international markets. In 1993, Kaiser produced approximately 2,826,600 tons of alumina, of which approximately 71% was sold to third parties, and produced 436,200 tons of primary aluminum, of which approximately 56% was sold to third parties. Kaiser is also a major domestic supplier of fabricated aluminum products. In 1993, Kaiser shipped approximately 373,200 tons of fabricated aluminum products to third parties, which accounted for approximately 6% of the total tonnage of United States domestic shipments in 1993. A majority of Kaiser's fabricated products are used by customers as components in the manufacture and assembly of finished end-use products. The following table sets forth total shipments and intracompany transfers of Kaiser's alumina, primary aluminum and fabricated aluminum operations: Business Strategy Kaiser has made significant changes in the mix of products sold to customers by disposing of selected assets, restarting and increasing its percentage ownership interest in the Alumina Partners of Jamaica ("Alpart") alumina refinery, and increasing production of alumina at Gramercy, Louisiana, and Queensland Australia Limited ("QAL") in Australia. The percentage of Kaiser's alumina production sold to third parties increased from approximately 35% in 1987 to approximately 71% in 1993, and the percentage of its primary aluminum production sold to third parties increased from approximately 20% in 1987 to approximately 56% in 1993. Kaiser has concentrated its fabricated products operations on the beverage container market (which historically has been recession- resistant); high value-added, heat-treated sheet and plate products for the aerospace industry; hubs, wheels and other products for the truck, trailer and shipping container industry; parts for air bag canisters and other automotive components; and distributor markets for a variety of semifabricated aluminum products. Since January 1, 1989, Kaiser has constructed four new fabrication facilities and has modernized and expanded others, with the objective of reducing manufacturing costs and expanding sales in selected product markets in which Kaiser has production expertise, high quality capability and geographic and other competitive advantages. Kaiser has taken steps to control and reduce costs, improve the efficiency and increase the capacity of its alumina and primary aluminum production and fabricating operations, modernize its facilities, and streamline and decentralize its management structure to reduce corporate overhead and shift decision making and accountability to its business units. In October 1993, Kaiser announced that it is restructuring its flat-rolled products operation at its Trentwood plant in Spokane, Washington, to reduce that facility's annual operating costs. This effort is in response to over-capacity in the aluminum rolling industry, flat demand in can stock markets, and declining demand for aluminum products sold to customers in the commercial aerospace industry, all of which have resulted in declining prices in Trentwood's key markets. The Trentwood restructuring is expected to result in annual cost savings of approximately $50.0 million after it has been fully implemented (which is expected to occur by the end of 1995). See "Fabricated Products--Flat- Rolled Products" below. Primary aluminum production at Kaiser's Mead and Tacoma smelters was curtailed in 1993 because of a power reduction imposed by the Bonneville Power Administration (the "BPA"), which reduced the operating rates for such smelters. See "--Primary Aluminum Products" below. Furthermore, Kaiser announced on February 24, 1994 that it will curtail approximately 9.3% of its annual production capacity currently available from its primary aluminum smelters. Kaiser has also attempted to lessen its exposure to possible future declines in the market prices of alumina and primary aluminum by entering into fixed and variable rate power and fuel supply contracts, and a labor contract with the United Steelworkers of America (the "USWA") which provides for semi-variable compensation with respect to approximately 73% of Kaiser's domestic hourly work force. See "- -Production Operations" and "--Employees" below. Sensitivity to Prices and Hedging Programs Kaiser's earnings are sensitive to changes in the prices of alumina, primary aluminum and fabricated aluminum products, and also depend to a significant degree upon the volume and mix of all products sold. Through its variable cost structures, forward sales and hedging program, Kaiser has attempted to mitigate its exposure to possible further declines in the market prices of alumina and primary aluminum while retaining the ability to participate in favorable pricing environments that may materialize. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations -Trends--Aluminum Operations--Sensitivity to Prices and Hedging Programs" on pages 34 and 35 of the Company's 1993 Annual Report to Stockholders. Production Operations Kaiser's operations are conducted through decentralized business units which compete throughout the aluminum industry. - The Alumina Business Unit, which mines bauxite and obtains additional bauxite tonnage under long term contracts, produced approximately 8% of Western world alumina in 1993. During 1993, Kaiser utilized approximately 82% of its bauxite production at its alumina refineries and the remainder was either sold to third parties or tolled into alumina by a third party. In addition, during 1993 Kaiser utilized approximately 29% of its alumina for internal purposes and sold the remainder to third parties. Kaiser's share of total Western world alumina capacity was 8% in 1993. - The Primary Aluminum Products Business Unit operates two domestic smelters wholly owned by KACC and two foreign smelters in which KACC holds significant ownership interests. In 1993, Kaiser utilized approximately 44% of its primary aluminum for internal purposes and sold the remainder to third parties. Kaiser's share of total Western world primary aluminum capacity was 3% in 1993. - Fabricated products are manufactured by three Business Units -- Flat-Rolled Products, Extruded Products (including rod and bar), and Forgings -- which manufacture a variety of fabricated products (including body, lid and tab stock for beverage containers, sheet and plate products, screw machine stock, redraw rod, forging stock, truck wheels and hubs, air bag canisters and other forgings and extruded products) and operate plants located in principal marketing areas of the United States and Canada. Substantially all of the primary aluminum utilized in Kaiser's fabricated products operations is obtained internally, with the balance of the metal utilized in its fabricated products operations obtained from scrap metal purchases. In 1993, Kaiser shipped approximately 373,200 tons of fabricated aluminum products to third parties, which accounted for approximately 6% of the total tonnage of United States domestic fabricated shipments for such year. Alumina The following table lists Kaiser's bauxite mining and alumina refining facilities as of December 31, 1993: Bauxite mined in Jamaica by Kaiser Jamaica Bauxite Company ("KJBC") is refined into alumina at Kaiser's plant at Gramercy, Louisiana, or is sold to third parties. In 1979, the Government of Jamaica granted Kaiser a mining lease for the mining of bauxite sufficient to supply Kaiser's then-existing Louisiana alumina refineries at their annual capacities of 1,656,000 tons per year until January 31, 2020. Alumina from the Gramercy plant is sold to third parties. Kaiser has entered into a series of medium term contracts for the supply of natural gas to the Gramercy plant. The price of such gas varies based upon certain spot natural gas prices, with floor and ceiling prices applicable to approximately one-half of the delivered gas. Kaiser has, however, established a fixed price for a portion of the delivered gas through a hedging program. Alpart holds bauxite reserves and owns an alumina plant located in Jamaica. KACC has a 65% interest in Alpart and Hydro Aluminium a.s. ("Hydro") owns the remaining 35% interest. KACC has management responsibility for the facility on a fee basis. KACC and Hydro have agreed to be responsible for their proportionate shares of Alpart's costs and expenses. Alpart began a program of modernization and expansion of its facilities in 1991. As a part of that program, the capacity of the Alpart alumina refinery has been increased to 1,450,000 tons per year as of December 31, 1992. In 1981, the Government of Jamaica granted Alpart a mining lease covering bauxite reserves sufficient to operate the Alpart plant until December 31, 2019. In connection with the expansion program, the Alpart partners have entered into an agreement with the Government of Jamaica designed to assure that sufficient reserves of bauxite will be available to Alpart to operate its refinery, as it has been expanded and as it may be expanded through the year 2024 (to a capacity of 2,000,000 tons per year). In mid-1990, Alpart entered into a five-year agreement for the supply of substantially all of its fuel oil, the refinery's primary energy source. In February 1992, the term of this agreement was extended for one year and the quantity of fuel oil to be supplied was increased. The price for 80% of the initial quantity remains fixed at a price which prevailed in the fourth quarter of 1989; the price for 80% of the increased quantity is fixed at a negotiated price; and the price for the balance of the initial and increased quantities was based upon certain spot fuel oil prices plus transportation costs. Alpart has purchased all of the quantities of fuel oil which could be purchased based upon certain spot fuel oil prices under both the initial and extended agreements. KACC holds a 28.3% interest in QAL, which owns the largest and one of the most efficient alumina refineries in the world, located in Queensland, Australia. QAL refines bauxite into alumina, essentially on a cost basis, for the account of its stockholders pursuant to long-term tolling contracts. The stockholders, including KACC, purchase bauxite from another QAL stockholder pursuant to long-term supply contracts. KACC has contracted to take approximately 751,000 tons per year of capacity or pay standby charges. KACC is unconditionally obligated to pay amounts calculated to service its share ($73.6 million at December 31, 1993) of certain debt of QAL, as well as other QAL costs and expenses, including bauxite shipping costs. QAL's annual production capacity is approximately 3,300,000 tons, of which approximately 934,000 tons are available to KACC. Kaiser's principal customers for bauxite and alumina consist of large and small domestic and international aluminum producers that purchase bauxite and reduction-grade alumina for use in their internal refining and smelting operations and trading intermediaries who resell raw materials to end-users. In 1993, Kaiser sold all of its bauxite to one customer, and sold alumina to 13 customers, the largest and top five of which accounted for approximately 22% and 79% of such sales, respectively. Among alumina producers, the Company believes Kaiser is now the world's second largest seller of alumina to third parties. Kaiser's strategy is to sell a substantial portion of the bauxite and alumina available to it in excess of its internal refining and smelting requirements pursuant to forward sales contracts. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations --Trends--Sensitivity to Prices and Hedging Programs" on pages 34 and 35 of the Company's 1993 Annual Report to Stockholders. Marketing and sales efforts are conducted by executives of the Alumina Business Unit and Kaiser. Primary Aluminum Products The following table lists Kaiser's primary aluminum smelting facilities as of December 31, 1993: Kaiser owns two smelters located at Mead and Tacoma, Washington, where alumina is processed into primary aluminum. The Mead facility uses pre-bake technology and produces primary aluminum, almost all of which is used at Kaiser's Trentwood fabricating facility and the balance of which is sold to third parties. The Tacoma plant uses Soderberg technology and produces primary aluminum and high-grade, continuous cast, redraw rod, which currently commands a premium price in excess of the price of primary aluminum. Both smelters have achieved significant production efficiencies in recent years through retrofit technology, cost controls and semi-variable wage and power contracts, leading to increases in production volume and enhancing their ability to compete with newer smelters. At the Mead plant, Kaiser has converted to welded anode assemblies to increase energy efficiency, reduced the number of anodes used in the smelting process, changed from pencil to liquid pitch to produce carbon anodes which achieved environmental and operating savings, and engaged in efforts to increase production through the use of improved, higher-efficiency reduction cells. Electrical power represents an important production cost for Kaiser at its Mead and Tacoma smelters. The electricity supply contracts between the BPA and the Company expire in 2001. The electricity supply contracts between the BPA and its direct service industry customers (which consist of fifteen energy intensive companies, principally aluminum producers, including Kaiser) permit the BPA to interrupt up to 25% of the amount of power which it normally supplies to such customers. Both the Mead and Tacoma plants operated at approximately full rated capacity during 1991-1992, but operated at less than rated capacity throughout 1993. As a result of drought conditions, in January 1993 the BPA reduced the amount of power it normally supplies to its direct service industry customers. In response to such reduction, Kaiser removed three reduction potlines from production (two at the Mead smelter and one at the Tacoma smelter) and purchased substitute power in the first quarter of 1993 at increased costs. Despite the temporary availability of such power through July 1993, Kaiser has operated its Mead and Tacoma smelters at the reduced operating rates introduced in January 1993, and has operated its Trentwood fabrication facility without any curtailment of its production. The Company currently anticipates that in 1994 it will operate the Mead and Tacoma smelters at rates which do not exceed the current operating rates of 75% of full capacity for such smelters. The BPA has recently notified its direct service industry customers that it intends to restore full power through July 31, 1994. Through June 1996, Kaiser pays for power on a basis which varies, within certain limits, with the market price of primary aluminum, and thereafter Kaiser will pay for power at variable rates to be negotiated. During 1993, Kaiser paid for power under its power supply contract with the BPA at the floor rate. Effective October 1, 1993, an increase in the base rate BPA charges to its direct service industry customers for electricity was adopted which will increase Kaiser's production costs at the Mead and Tacoma smelters by approximately $15.0 million per year (approximately $9.1 million per year based on Kaiser's current operating rate of approximately 75% of full capacity). The rate increase generally is expected to remain in effect for two years. In the event that the BPA's revenues fall below certain levels prior to April 1994, the BPA may impose up to a 10% surcharge on the base rate it charges to its direct service industry customers, effective during the period from October 1994 through October 1995 (which would increase Kaiser's production costs at the Mead and Tacoma smelters by approximately $9.1 million per year based on Kaiser's current operating rate of approximately 75% of full capacity). In addition, in order to comply with certain federal laws and regulations applicable to endangered fish species, the BPA may be required in the future to reduce its power generation and to purchase substitute power (at greater expense) from other sources. KACC manages, and holds a 90% interest in, the Volta Aluminium Limited ("Valco") aluminum smelter in Ghana. The Valco smelter uses prebake technology and processes alumina supplied by KACC and the other participant into primary aluminum under long-term tolling contracts which provide for proportionate payments by the participants in amounts intended to pay not less than all of Valco's operating and financing costs. KACC's share of the primary aluminum is sold to third parties. Power for the Valco smelter is supplied under an agreement which expires in 1997, subject to Valco's right to extend the agreement for 20 years. The agreement indexes the price of two-thirds of the contract quantity to the market price of primary aluminum and fixes the price for the remainder. The agreement also provides for a review and adjustment of the base power rate and the price index every five years. The Valco smelter restarted production early in 1985 after being closed for more than two years due to lack of rainfall and the resultant hydroelectricity shortage. The Company believes that there has been sufficient rainfall and water storage such that an adequate supply of electricity for the Valco plant at its current operating rate is probable for at least one year. KACC has a 49% interest in the Anglesey Aluminium Limited ("Anglesey") aluminum smelter and port facility at Holyhead, Wales. The Anglesey smelter uses prebake technology. KACC supplies 49% of Anglesey's alumina requirements and purchases 49% of Anglesey's aluminum output. KACC sells its share of Anglesey's output to third parties. Power for the Anglesey aluminum smelter is supplied under an agreement which expires in 2001. Kaiser has developed and installed proprietary retrofit technology in all of its smelters. This technology -- which includes the redesign of the cathodes and anodes that conduct electricity through reduction cells, improved "feed" systems that add alumina to the cells, and a computerized system that controls energy flow in the cells -- enhances Kaiser's ability to compete more effectively with the industry's newer smelters. Kaiser is actively engaged in efforts to license this technology and sell technical and managerial assistance to other producers worldwide, and may participate in joint ventures or similar business partnerships which employ Kaiser's technical and managerial knowledge. See "--Research and Development" below. Kaiser's principal primary aluminum customers consist of large trading intermediaries and metal brokers, who resell primary aluminum to fabricated product manufacturers, and large and small international aluminum fabricators. In 1993, Kaiser sold the approximately 56% of its primary aluminum production not utilized for internal purposes to approximately 50 customers, the largest and top five of which accounted for approximately 44% and 64% of such sales, respectively. Marketing and sales efforts are conducted by a small staff located at the business unit's headquarters in Pleasanton, California, and by senior executives of Kaiser who participate in the structuring of major sales transactions. A majority of the business unit's sales are based upon long-term relationships with metal merchants and end-users. Fabricated Products Kaiser manufactures and markets fabricated aluminum products for the packaging, transportation, construction, and consumer durables markets in the United States and abroad. Sales in these markets are made directly and through distributors to a large number of customers, both domestic and foreign. In 1993, seven domestic beverage container manufacturers constituted the leading customers for Kaiser's fabricated products and accounted for approximately 19% of Kaiser's sales revenue. Kaiser's fabricated products compete with those of numerous domestic and foreign producers and with products made with steel, copper, glass, plastic and other materials. Product quality, price and availability are the principal competitive factors in the market for fabricated aluminum products. As a result, Kaiser has refocused its fabricated products operations to concentrate on selected products in which Kaiser has production expertise, high quality capability, and geographic and other competitive advantages. Flat-Rolled Products. The Flat-Rolled Products Business Unit, the largest of Kaiser's fabricated products businesses, operates the Trentwood sheet and plate mill at Spokane, Washington. The Trentwood facility is Kaiser's largest fabricating plant and accounted for substantially more than one-half of Kaiser's 1993 fabricated products shipments. The business unit supplies the beverage container market (producing body, lid and tab stock), the aerospace market, and the tooling plate, heat-treated alloy and common alloy coil markets, both directly and through distributors. Kaiser announced in October 1993 that it is restructuring its flat-rolled products operation at its Trentwood plant to reduce that facility's annual operating costs. This effort is in response to over-capacity in the aluminum rolling industry, flat demand in can stock markets, and declining demand for aluminum products sold to customers in the commercial aerospace industry, all of which have resulted in declining prices in Trentwood's key markets. The Trentwood restructuring is expected to result in annual cost savings of approximately $50.0 million (which is expected to occur by the end of 1995). In connection with the restructuring, Trentwood completed an organizational streamlining that included a reduction of approximately 80 salaried employees. In addition, Kaiser has reached an agreement with the USWA that will reduce the total number of hourly employees at Trentwood by approximately 300 employees, or about 25%, by the end of 1995. The agreement with the USWA also includes a commitment by Kaiser to spend up to $50 million of capital at Trentwood over three years provided that goals on cost reduction and profitability are met or exceeded. Kaiser's flat-rolled products are sold primarily to beverage container manufacturers located in the western United States where Kaiser has a transportation advantage. Quality of products for the beverage container industry, timeliness of delivery and price are the primary bases on which Kaiser competes. The Company believes that capital improvements at Trentwood have enhanced the quality of Kaiser's products for the beverage container industry and the capacity and efficiency of Kaiser's manufacturing operations. The Company believes that Kaiser is one of the highest quality producers of aluminum beverage can stock in the world. In 1993, the Flat-Rolled Products Business Unit had 22 foreign and domestic can stock customers, the majority of which were beverage can manufacturers (including seven of the eight major domestic beverage can manufacturers) and the balance of which were brewers. The largest and top five of such customers accounted for approximately 25% and 56%, respectively, of the business unit's sales revenue. In 1993, the business unit shipped products to over 200 customers in the aerospace, transportation and industrial ("ATI") markets, most of which were distributors who sell to a variety of industrial end-users. The top five customers in the ATI markets for flat-rolled products accounted for approximately 10% of the business unit's sales revenue. The marketing staff for the Flat-Rolled Products Business Unit is headquartered in Pleasanton, California, and is also located at the Trentwood facility. Sales are made directly to customers (including distributors) from ten sales offices located throughout the United States. International customers are served by a sales office in the Netherlands and by independent sales agents in Asia and Latin America. See also Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Trends--Sensitivity to Prices and Hedging Programs-- Aluminum Processing" on page 34 and 35 of the Company's Annual Report to Stockholders for a discussion of demand for fabricated products in the aerospace market. Extruded Products. The Extruded Products Business Unit is headquartered in Dallas, Texas, and operates soft alloy extrusion facilities in Los Angeles, California; Santa Fe Springs, California; Sherman, Texas; and London, Ontario, Canada; a cathodic protection business located in Tulsa, Oklahoma, that also extrudes both aluminum and magnesium; and rod and bar facilities in Newark, Ohio, and Jackson, Tennessee, which produce screw machine stock, redraw rod, forging stock and billet. Each of the soft alloy extrusion facilities has fabricating capabilities and provides finishing services. The Extruded Products Business Unit's major markets are in the transportation industry, to which it provides extruded shapes for automobiles, trucks, trailers, cabs and shipping containers, and distribution, durable goods, defense, building and construction, ordnance, and electrical markets. In 1993, the Extruded Products Business Unit had over 900 customers for its products, the largest and top five of which accounted for approximately 6% and 19%, respectively, of its sales revenue. Sales are made directly from plants as well as marketing locations across the United States. Forgings. The Forgings Business Unit operates forging facilities at Erie, Pennsylvania; Oxnard, California; and Greenwood, South Carolina; and a machine shop at Greenwood, South Carolina. The Forgings Business Unit is one of the largest producers of aluminum forgings in the United States and is a major supplier of high quality forged parts to customers in the automotive, commercial vehicle and ordnance markets. The high strength-to-weight properties of forged aluminum make it particularly well suited for automotive applications. The Forgings Business Unit entered the castings business by purchasing the assets of Winters Industries, which supplies cast aluminum engine manifolds to the automobile, truck and marine markets. The casting production facilities include two foundries and a machining facility in Ohio. Kaiser has recently implemented a plan to discontinue its castings operations at these facilities. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Aluminum Operations--Operating Income (Loss)--Aluminum Processing" on pages 21 and 22 of the Company's 1993 Annual Report to Stockholders. In 1993, the Forgings Business Unit had over 500 customers for its products, the largest and top five of which accounted for approximately 20% and 57%, respectively, of the Forgings Business Unit's sales revenue. The Forgings Business Unit's headquarters is located in Erie, Pennsylvania, and additional sales, marketing and engineering groups are located in the midwestern and western United States. Competition Aluminum products compete in many markets with steel, copper, glass, plastic and numerous other materials. Within the aluminum business, Kaiser competes with both domestic and foreign producers of bauxite, alumina and primary aluminum, and with domestic and foreign fabricators. Kaiser's principal competitors in the sale of alumina include Alcoa of Australia Ltd., Billiton International Metals B.V., Clarendon Ltd. and Pechiney S.A. In addition to the foregoing, Kaiser competes with most aluminum producers in the production of primary aluminum. Many of Kaiser's competitors have greater financial resources than Kaiser. In addition, the C.I.S. has been supplying large quantities of primary aluminum to the Western world. Primary aluminum and, to some degree, alumina are commodities with generally standard qualities, and competition in the sale of these commodities is based primarily upon price, quality and availability. The Company believes that, assuming the current relationship between worldwide supply and demand for alumina and primary aluminum does not change materially, the loss of any one of Kaiser's customers, including intermediaries, would not have a material adverse effect on Kaiser's business or operations. Kaiser also competes with a wide range of domestic and international fabricators in the sale of fabricated aluminum products. Competition in the sale of fabricated products is based upon quality, availability, price and service, including delivery performance. Kaiser concentrates its fabricating operations on selected products in which Kaiser has production expertise, high quality capability, and geographic and other competitive advantages. Research and Development Kaiser conducts research and development activities principally at three facilities dedicated to that purpose -- the Center for Technology ("CFT") in Pleasanton, California; the Primary Aluminum Products Division Technology Center ("DTC") adjacent to the Mead smelter in Washington; and the Alumina Development Laboratory ("ADL") at the Gramercy, Louisiana refinery. Net expenditures for Kaiser-sponsored research and development activities were $18.5 million in 1993, $13.5 million in 1992, and $11.4 million in 1991. Kaiser's research staff totaled 160 at December 31, 1993. Kaiser estimates that research and development net expenditures will be in the range of approximately $17-- $19 million in 1994. Kaiser actively engages in efforts to license its technology and sell technical and managerial assistance. CFT provided technology and technical assistance to Samyang Metal Co. Ltd. in building an aluminum rolling mill in Yongju, Korea. CFT also is engaged in cooperative research and development projects with Furukawa Electric Co., Ltd., Pechiney Rhenalu and Kawasaki Steel Corporation of Japan, with respect to the ground transportation market. DTC-developed technology has been installed in aluminum smelters located in the C.I.S., West Virginia, Ohio, Missouri, Kentucky, Sweden, Germany, India, Australia, New Zealand, Ghana and the United Kingdom. Kaiser's alumina refinery technology is in use in alumina refineries in the Americas, Australia, India and Europe. Kaiser's technology sales and revenue from technical assistance to third parties were $12.8 million in 1993, $14.1 million in 1992 and $10.9 million in 1991. Employees During 1993, Kaiser employed an average of approximately 10,220 persons, compared with an average of approximately 10,130 employees in 1992, and approximately 9,970 employees in 1991. As of December 31, 1993, Kaiser's workforce was approximately 10,030, including a domestic workforce of approximately 5,930, of whom approximately 4,150 were paid at an hourly rate. Most hourly paid domestic employees are covered by collective bargaining agreements with various labor unions. Approximately 73% of such employees are covered by a master agreement (the "Labor Contract") with the USWA which expires on October 31, 1994. The Labor Contract covers Kaiser's plants in Spokane (Trentwood); Mead and Tacoma, Washington; Gramercy, Louisiana; and Newark, Ohio. The Labor Contract provides for floor level wages at all covered plants. In addition, for workers covered by the Labor Contract at the Mead and Newark plants, for any quarterly period when the average Midwest U.S. transaction price of primary aluminum is $.54 per pound or above, a bonus payment is made. The amount of the quarterly bonus payment changes incrementally with each full cent change in the price of primary aluminum between $.54 per pound and $.61 per pound, remains constant when the price is $.61 or more per pound but is below $.74 per pound, changes incrementally again with each full cent change in the price between $.74 per pound and $.81 per pound, and remains at the ceiling when the price is $.81 per pound or more. Workers covered by the Labor Contract at the Trentwood, Tacoma and Gramercy plants may receive quarterly bonus payments based on various indices of productivity, efficiency and other aspects of specific plant performance, as well as, in certain cases, the price of alumina or primary aluminum. The particular quarterly bonus variable compensation formula currently applicable at each plant will remain applicable for the remainder of the contract term. Pursuant to the Labor Contract, base wage rates were raised $.50 per hour effective November 1, 1993. Each of the employees covered by the Labor Contract has received $2,000 in lump-sum signing and special bonuses. In addition, in the first quarter of 1991, Kaiser acquired up to $4,000 of preference stock held in the stock bonus plan for the benefit of approximately 80% of the employees covered by the Labor Contract, and in February 1994 acquired an additional $2,000 of such preference stock held in the stock bonus plan for the benefit of substantially the same employees. In the first quarter of 1991, Kaiser also acquired up to $4,000 of preference stock which had been held for the benefit of each of certain salaried employees, and in February 1994 acquired an additional $2,000 of such preference stock held in the stock bonus plan for the benefit of substantially the same employees. The February 1994 acquisitions of preference stock aggregated $5.4 million. Kaiser considers its employee relations to be satisfactory. Environmental Matters Kaiser and KACC are subject to a wide variety of international, state and local environmental laws and regulations (the "Environmental Laws") which continue to be adopted and amended. The Environmental Laws regulate, among other things, air and water emissions and discharges; the generation, storage, treatment, transportation and disposal of solid and hazardous waste; the release of hazardous or toxic substances, pollutants and contaminants into the environment; and, in certain instances, the environmental condition of industrial property prior to transfer or sale. In addition, Kaiser is subject to various federal, state and local workplace health and safety laws and regulations (the "Health Laws"). From time to time, Kaiser is subject, with respect to its current and former operations, to fines or penalties assessed for alleged breaches of the Environmental and Health Laws and to claims and litigation brought by federal, state or local agencies and by private parties seeking remedial or other enforcement action under the Environmental and Health Laws or damages related to alleged injuries to health or to the environment, including claims with respect to certain waste disposal sites and the remediation of sites presently or formerly operated by Kaiser. See Item 3. "Legal Proceedings--Kaiser Environmental Litigation." Kaiser is currently subject to a number of lawsuits under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments and Reauthorization Act of 1986 ("CERCLA"). Kaiser, along with several other entities, has been named as a Potentially Responsible Party ("PRP") for remedial costs at certain third-party sites listed on the National Priorities List under CERCLA and in certain instances, may be exposed to joint and several liability for those costs or damages to natural resources. Kaiser's Mead, Washington facility has been listed on the National Priorities List under CERCLA. In addition, in connection with certain of its asset sales, Kaiser has indemnified the purchasers of assets with respect to certain liabilities (and associated expenses) resulting from acts or omissions arising prior to such dispositions, including environmental liabilities. While the ultimate extent of Kaiser's liability for pending or potential fines, penalties, remedial costs, claims and litigation relating to environmental and health and safety matters cannot be determined at this time and, in light of evolving case law relating to insurance coverage for environmental claims, the Company is unable to determine definitively the extent of such coverage, the Company believes that the resolution of these matters (even without giving effect to potential insurance recovery) should not have a material adverse effect on Kaiser's consolidated financial position or results of operations. Environmental capital spending was $12.6 million in 1993, $13.1 million in 1992 and $11.2 million in 1991. Annual operating costs for pollution control, not including corporate overhead or depreciation, were approximately $22.4 million in 1993, $21.6 million in 1992, and $17.8 million in 1991. Legislative, regulatory and economic uncertainties make it difficult to project future spending for these purposes; however, Kaiser currently anticipates that in the 1994-1995 period, environmental capital spending will be within the range of approximately $7.0--$20.0 million per year, and operating costs for pollution control will be within the range of $20.0--$22.0 million per year. These expenditures will be made to assure compliance with applicable Environmental Laws and are expected to include, among other things, additional "red mud" disposal facilities and improved levees at the Gramercy, Louisiana refinery (which are being financed by the industrial revenue bonds), bath crushing improvements, baking furnace modernization, and improved calcining controls at the Mead, Washington facility, new and continuing environmental projects at the Trentwood, Washington facility, and environmental projects required under the Clean Air Act Amendments of 1990. In addition, $7.2 million in cash expenditures in 1993, $9.6 million in 1992 and $14.0 million in 1991 were charged to previously established reserves relating to environmental cost. Approximately $7.0 million is expected to be charged to such reserves in 1994. See also Note 10 to the Consolidated Financial Statements. Other Kaiser's obligations under its 1994 Credit Agreement are secured by, among other things, mortgages on Kaiser's plants located in Spokane (the Trentwood and Mead plants) and Tacoma, Washington; Erie, Pennsylvania; Newark, Ohio; and Sherman, Texas. FOREST PRODUCTS OPERATIONS GENERAL The Company also engages in forest products operations through MGI and MGI's wholly owned subsidiaries, Pacific Lumber and Britt. Pacific Lumber, which has been in continuous operation for 125 years, engages in all principal aspects of the lumber industry--the growing and harvesting of redwood and Douglas-fir timber, the milling of logs into lumber products and the manufacturing of lumber into a variety of value-added finished products. Britt manufactures redwood and cedar fencing and decking products from small diameter logs, a substantial portion of which Britt acquires from Pacific Lumber. PACIFIC LUMBER REFINANCING On March 23, 1993 (the "Closing Date"), Pacific Lumber transferred (the "Transfer") approximately 179,000 acres of timberlands (the "Subject Timberlands"), its geographical information system and certain other assets to its newly-formed wholly owned subsidiary, Scotia Pacific Holding Company ("SPHC"), in exchange for (i) the assumption by SPHC of $323.4 million of Pacific Lumber's public indebtedness consisting of all of Pacific Lumber's 12% Series A Senior Notes due July 1, 1996 (the "Series A Notes") and a portion of Pacific Lumber's 12.2% Series B Senior Notes due July 1, 1996 (the "Series B Notes") and (ii) all of SPHC's outstanding common stock. SPHC was organized as a special purpose Delaware corporation to facilitate the Transfer and the offering of the Timber Notes described below. The Subject Timberlands consist substantially of residual old growth and young growth redwood and Douglas-fir timber. On the Closing Date, Pacific Lumber and SPHC entered into a Master Purchase Agreement, a Services Agreement, an Additional Services Agreement and certain other agreements providing for a variety of ongoing relationships. See "--Pacific Lumber Operations-- Relationships among Pacific Lumber, SPHC and Britt Lumber." On the Closing Date, Pacific Lumber also transferred to its newly-formed wholly owned subsidiary, Salmon Creek Corporation ("Salmon Creek"), in exchange for all of Salmon Creek's common stock, approximately 3,000 contiguous acres of its virgin old growth redwood timber, together with approximately 3,000 additional acres of adjacent timberlands owned by Pacific Lumber which could not be readily segregated from such virgin old growth redwood timberlands (collectively, the "Salmon Creek Property"). Pacific Lumber retained the exclusive right to harvest (the "Pacific Lumber Harvest Rights") approximately 8,000 non-contiguous acres of the Subject Timberlands consisting substantially of virgin old growth redwood and virgin old growth Douglas-fir timber located on numerous small parcels throughout the Subject Timberlands. In addition, Pacific Lumber retained its lumber milling, manufacturing, cogeneration and related facilities, as well as approximately 11,000 acres of real property located in Humboldt County, California, which do not constitute part of the Subject Timberlands (collectively, the "Pacific Lumber Real Property"). The Pacific Lumber Real Property consists of the town of Scotia, the land on which Pacific Lumber's sawmills, manufacturing facilities and related facilities are located and areas adjacent thereto, certain potential residential and commercial development sites and other areas, including timberlands owned by Pacific Lumber which cannot be readily segregated from the foregoing properties. Pacific Lumber is milling logs and producing and marketing lumber products from timber located on the timberlands of SPHC, Pacific Lumber and Salmon Creek in substantially the same manner as conducted prior to the Transfer. Pacific Lumber is, pursuant to the Master Purchase Agreement, harvesting and purchasing from SPHC all or substantially all of the logs harvested from the Subject Timberlands. See "--Pacific Lumber Operations-- Relationships among Pacific Lumber, SPHC and Britt Lumber" below. On the Closing Date, Pacific Lumber consummated its offering of $235 million aggregate principal amount of 10 1/2% Senior Notes due 2003 (the "Pacific Lumber Senior Notes") and SPHC consummated its offering of $385 million aggregate principal amount of 7.95% Timber Collateralized Notes due 2015 (the "Timber Notes"). The net proceeds of such offerings, together with cash and marketable securities, were used to redeem all of Pacific Lumber's outstanding public indebtedness (including the amounts assumed by SPHC), to make required deposits into certain accounts for the benefit of the holders of the Timber Notes, to repay Pacific Lumber's cogeneration loan and to pay a $25.0 million dividend to MAXXAM Properties Inc., a subsidiary of the Company ("MPI"). Substantially all of SPHC's assets, including the Subject Timberlands, were pledged as security for the Timber Notes. PACIFIC LUMBER OPERATIONS Timberlands Pacific Lumber owns and manages approximately 187,000 acres of commercial timberlands in Humboldt County in northern California. These timberlands contain approximately three-quarters redwood and one-quarter Douglas-fir timber. Pacific Lumber's acreage is virtually contiguous, is located in close proximity to its sawmills and contains an extensive (1,100 mile) network of roads. These factors significantly reduce harvesting costs and facilitate Pacific Lumber's forest management techniques. The extensive roads throughout Pacific Lumber's timberlands facilitate log hauling, serve as fire breaks and allow Pacific Lumber's foresters access to employ forest stewardship techniques which protect the trees from forest fires, erosion, insects and other damage. The forest products industry grades lumber in various classifications according to quality. The two broad categories within which all grades fall, based on the absence or presence of knots, are called "upper" and "common" grades, respectively. "Old growth" trees, often defined as trees which have been growing for approximately 200 years or longer, have a higher percentage of upper grade lumber than "young growth" trees (those which have been growing for less than 200 years). "Virgin" old growth trees are located in timber stands that have not previously been harvested. "Residual" old growth trees are located in timber stands which have been selectively harvested in the past. Pacific Lumber has engaged in extensive efforts, at relatively low cost, to supplement the natural regeneration of timber and increase the amount of timber on its timberlands. Regeneration of redwood timber generally is accomplished through the natural growth of redwood sprouts from the stump remaining after a redwood tree is harvested. Such new redwood sprouts grow quickly, thriving on existing mature root systems. In addition, Pacific Lumber supplements natural redwood generation by planting redwood seedlings. Douglas-fir timber grown on Pacific Lumber's timberlands is regenerated almost entirely by planting seedlings. During the 1992-93 planting season (December through March), Pacific Lumber planted approximately 488,000 redwood and Douglas-fir seedlings at a cost of approximately $215,500. Harvesting Practices The ability of Pacific Lumber to sell logs or lumber products will depend, in part, upon its ability to obtain regulatory approval of timber harvesting plans ("THPs"). THPs are required to be filed with the California Department of Forestry ("CDF") prior to the harvesting of timber and are designed to comply with existing environmental laws and regulations. The CDF's evaluation of proposed THPs incorporates review and analysis of such THPs provided by several California and federal agencies and public comments received with respect to such THPs. An approved THP is applicable to specific acreage and specifies the harvesting method and other conditions relating to the harvesting of the timber covered by such THP. The method of harvesting as set forth in a THP is chosen from among a number of accepted methods based upon suitability to the particular site conditions. Pacific Lumber maintains a detailed geographical information system covering its timberlands (the "GIS"). The GIS covers numerous aspects of Pacific Lumber's properties, including timber type, tree class, wildlife data, roads, rivers and streams. By carefully monitoring and updating this data base, Pacific Lumber's foresters are able to develop detailed THPs which are required to be filed with and approved by the CDF prior to the harvesting of timber. Pacific Lumber principally harvests trees through selective harvesting, which harvests only a portion of the trees in a given area, as opposed to clearcutting, which harvests an entire area of trees in one logging operation. Selective harvesting generally accounts for over 90% (by volume on a net board foot basis) of Pacific Lumber's timber harvest in any given year. Harvesting by clearcutting is used only when selective harvesting methods are impractical due to unique conditions. Selective harvesting allows the remaining trees to obtain more light, nutrients and water thereby promoting faster growth rates. Due to the size of its timberlands and conservative harvesting practices, Pacific Lumber has historically conducted harvesting operations on approximately 5% of its timberlands in any given year. Production Facilities Pacific Lumber owns four highly mechanized sawmills and related facilities located in Scotia, Fortuna and Carlotta, California. The sawmills historically have been supplied almost entirely from timber harvested from Pacific Lumber's timberlands. Since 1986, Pacific Lumber has implemented numerous technological advances which have increased the operating efficiency of its production facilities and the recovery of finished products from its timber. Over the past three years, Pacific Lumber's annual lumber production has averaged approximately 249 million board feet, with approximately 228, 264 and 256 million board feet produced in 1993, 1992 and 1991, respectively. Pacific Lumber operates a finishing plant which processes rough lumber into a variety of finished products such as trim, fascia, siding and paneling. These finished products include the industry's largest variety of customized trim and fascia patterns. Pacific Lumber also enhances the value of some grades of common grade lumber by cutting out knot-free pieces and reassembling them into longer or wider pieces in Pacific Lumber's state-of-the-art end and edge glue plant. The result is a standard sized upper grade product which can be sold at a significant premium over common grade products. Pacific Lumber dries the majority of its upper grade lumber before it is sold. Upper grades of redwood lumber are generally air-dried for six to eighteen months and then kiln-dried for seven to twenty-four days to produce a dimensionally stable and high quality product which generally commands higher prices than "green" lumber (which is lumber sold before it has been dried). Upper grade Douglas-fir lumber is generally kiln-dried immediately after it is cut. Pacific Lumber owns and operates 34 kilns, having an annual capacity of approximately 95 million board feet, to dry its upper grades of lumber efficiently in order to produce a quality, premium product. Pacific Lumber also maintains several large enclosed storage sheds which hold approximately 25 million board feet of lumber. In addition, Pacific Lumber owns and operates a modern 25-megawatt cogeneration power plant which is fueled almost entirely by the wood residue from Pacific Lumber's milling and finishing operations. This power plant generates substantially all of the energy requirements of Scotia, California, the town adjacent to Pacific Lumber's timberlands owned by Pacific Lumber where several of its manufacturing facilities are located. Pacific Lumber sells surplus power to Pacific Gas and Electric Company. In 1993, the sale of surplus power to Pacific Gas and Electric Company accounted for approximately 2% of Pacific Lumber's total revenues. In April 1992, an earthquake and a series of aftershocks occurred in northern California which produced a significant amount of damage in and around the area where Pacific Lumber's forest products operations are located. Standing timber on Pacific Lumber's timberlands suffered virtually no damage; however, among other damage, a large number of kilns used to dry upper grade redwood lumber and two sawmills were damaged, including one sawmill which was not operational for a period of approximately six weeks. Pacific Lumber maintains insurance coverage with respect to damage to its property and the disruption of its business from earthquakes. Consistent with its past practices and the owners of most other timber tracts in the United States, Pacific Lumber does not maintain earthquake or fire insurance in respect of standing timber. Products Lumber. Pacific Lumber primarily produces and markets lumber. In 1993, Pacific Lumber sold approximately 240 million board feet of lumber, which accounted for approximately 82% of Pacific Lumber's total revenues. Lumber products vary greatly by the species and quality of the timber from which it is produced. Lumber is sold not only by grade (such as "upper" grade versus "common" grade), but also by board size and the drying process associated with the lumber. Redwood lumber is Pacific Lumber's largest product category, constituting approximately 81% of Pacific Lumber's total lumber revenues and 67% of Pacific Lumber's total revenues in 1993. Redwood is commercially grown only along the northern coast of California and possesses certain unique characteristics which permit it to be sold at a premium to many other wood products. Such characteristics include its natural beauty, superior ability to retain paint and other finishes, dimensional stability and innate resistance to decay, insects and chemicals. Typical applications include exterior siding, trim and fascia for both residential and commercial construction, outdoor furniture, decks, planters, retaining walls and other specialty applications. Redwood also has a variety of industrial applications because of its chemical resistance and because it does not impart any taste or odor to liquids or solids. Upper grade redwood lumber, which is derived primarily from old growth trees and is characterized by an absence of knots and other defects and a very fine grain, is used primarily in more costly and distinctive interior and exterior applications. During 1993, upper grade redwood lumber products accounted for approximately 25% of Pacific Lumber's total lumber production volume (on a net board foot basis), 49% of its total lumber revenues and 40% of its total revenues. Common grade redwood lumber, Pacific Lumber's largest volume product, has many of the same aesthetic and structural qualities of redwood uppers, but has some knots, sapwood and a coarser grain. Such lumber is commonly used for construction purposes, including outdoor structures such as decks, hot tubs and fencing. In 1993, common grade redwood lumber accounted for approximately 48% of Pacific Lumber's total lumber production volume (on a net board foot basis), 32% of its total lumber revenues and 26% of its total revenues. Douglas-fir lumber is used primarily for new construction and some decorative purposes and is widely recognized for its strength, hard surface and attractive appearance. Douglas-fir is grown commercially along the west coast of North America and in Chile and New Zealand. Upper grade Douglas-fir lumber is derived primarily from old growth Douglas-fir timber and is used principally in finished carpentry applications. In 1993, upper grade Douglas-fir lumber accounted for approximately 5% of Pacific Lumber's total lumber production volume (on a net board foot basis), 8% of its total lumber revenues and 6% of its total revenues. Common grade Douglas-fir lumber is used for a variety of general construction purposes and is largely interchangeable with common grades of other whitewood lumber. In 1993, common grade Douglas-fir lumber accounted for approximately 22% of Pacific Lumber's total lumber production volume, 11% of its total lumber revenues and 9% of its total revenues. Logs. Pacific Lumber currently sells certain logs that, due to their size or quality, cannot be efficiently processed by its mills into lumber. The purchasers of these logs are largely Britt, and surrounding mills which do not own sufficient timberlands to support their mill operations. In 1993, log sales accounted for approximately 10% of Pacific Lumber's total revenues. See "--Relationships among Pacific Lumber, SPHC and Britt Lumber" below. Except for the agreement with Britt described below, Pacific Lumber does not have any significant contractual relationships with any third parties relating to the purchase of logs. Pacific Lumber has historically not purchased significant quantities of logs from third parties; however, Pacific Lumber may from time to time purchase logs from third parties for processing in its mills or for resale to third parties if, in the opinion of management, economic factors are advantageous to the Company. See also Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations-- Forest Products Operations--Operating Income" for a description of 1993 log purchases by Pacific Lumber due to inclement weather conditions. Wood Chips. In 1990, Pacific Lumber installed a whole-log chipper to produce wood chips from hardwood trees which were previously left as waste. These chips primarily are sold to third parties for the production of facsimile and other specialty papers. In 1993, hardwood chips accounted for approximately 3% of Pacific Lumber's total revenues. Pacific Lumber also produces softwood chips from the wood residue and waste from its milling and finishing operations. These chips are sold to third parties for the production of wood pulp and paper products. In 1993, softwood chips accounted for approximately 3% of Pacific Lumber's total revenues. Backlog and Seasonality Pacific Lumber's backlog of sales orders at December 31, 1993 and 1992 was approximately $16.0 million and $15.4 million, respectively, the substantial portion of which was delivered in the first quarter of the succeeding fiscal year. Pacific Lumber has historically experienced lower first and fourth quarter sales due largely to the general decline in construction-related activity during the winter months. As a result, Pacific Lumber's results in any one quarter are not necessarily indicative of results to be expected for the full year. Marketing The housing, construction and remodeling markets are the primary markets for Pacific Lumber's lumber products. Pacific Lumber's policy is to maintain a wide distribution of its products both geographically and in terms of the number of customers. Pacific Lumber sells its lumber products throughout the country to a variety of accounts, the large majority of which are wholesalers, followed by retailers, industrial users, exporters and manufacturers. Upper grades of redwood and Douglas-fir lumber are sold throughout the entire United States, as well as to export markets. Common grades of redwood lumber are sold principally west of the Mississippi river, with California accounting for approximately 60% of these sales in 1993. Common grades of Douglas-fir lumber are sold primarily in California. In 1993, no single customer accounted for more than 6% of Pacific Lumber's total revenues. Exports of lumber accounted for approximately 4% of Pacific Lumber's total lumber revenues in 1993. Pacific Lumber markets its products through its own sales staff which focuses primarily on domestic sales. Pacific Lumber actively follows trends in the housing, construction and remodeling markets in order to maintain an appropriate level of inventory and assortment of product. Due to its high quality products, large inventory, competitive prices and long history, Pacific Lumber believes that it has a strong degree of customer loyalty. Competition Pacific Lumber's lumber is sold in highly competitive markets. Competition is generally based upon a combination of price, service and product quality. Pacific Lumber's products compete not only with other wood products but with metals, masonry, plastic and other construction materials made from non-renewable resources. The level of demand for Pacific Lumber's products is dependent on such broad factors as overall economic conditions, interest rates and demographic trends. In addition, competitive considerations, such as total industry production and competitors' pricing, as well as the price of other construction products, affect the sales prices for Pacific Lumber's lumber products. Pacific Lumber currently enjoys a competitive advantage in the upper grade redwood lumber market due to the quality of its timber holdings and relatively low cost production operations. Competition in the common grade redwood and Douglas-fir lumber market is more intense, and Pacific Lumber competes with numerous large and small lumber producers. Employees As of March 1, 1994, Pacific Lumber had approximately 1,200 employees. Relationships among Pacific Lumber, SPHC and Britt Lumber On the Closing Date, Pacific Lumber and SPHC entered into a Services Agreement (the "Services Agreement") and an Additional Services Agreement (the "Additional Services Agreement"). Pursuant to the Services Agreement, Pacific Lumber provides operational, management and related services with respect to the Subject Timberlands containing timber of SPHC ("SPHC Timber") not performed by SPHC's own employees. Such services include the furnishing of all equipment, personnel and expertise not within the SPHC's possession and reasonably necessary for the operation and maintenance of the Subject Timberlands containing the SPHC Timber. In particular, Pacific Lumber is required to regenerate SPHC Timber, prevent and control loss of the SPHC Timber by fires, maintain a system of roads throughout the Subject Timberlands, take measures to control the spread of disease and insect infestation affecting the SPHC Timber and comply with environmental laws and regulations, including measures with respect to waterways, habitat, hatcheries and endangered species. Pacific Lumber also is required (to the extent necessary) to assist SPHC personnel in updating the GIS and to prepare and file, on SPHC's behalf, all pleadings and motions and otherwise diligently pursue appeals of any denial of any THP and related matters. As compensation for these and the other services to be provided by Pacific Lumber, SPHC pays a fee which is adjusted on January 1 of each year based on a specified government index relating to wood products. The fee was $100,000 per month in 1993 and is expected to be approximately $114,000 per month in 1994. Pursuant to the Additional Services Agreement, SPHC provides Pacific Lumber with a variety of services, including (a) assisting Pacific Lumber to operate, maintain and harvest its own timber properties, (b) updating and providing access to the GIS with respect to information concerning Pacific Lumber's own timber properties, and (c) assisting Pacific Lumber with its statutory and regulatory compliance. Pacific Lumber pays SPHC a fee for such services equal to the actual cost of providing such services, as determined in accordance with generally accepted accounting principles. Pacific Lumber and SPHC also entered into the Master Purchase Agreement on the Closing Date. The Master Purchase Agreement governs all purchases of logs by the Company from SPHC. Each purchase of logs by Pacific Lumber from SPHC is made pursuant to a separate log purchase agreement (which incorporates the terms of the Master Purchase Agreement) for the SPHC Timber covered by an approved THP. Each log purchase agreement generally constitutes an exclusive agreement with respect to the timber covered thereby, subject to certain limited exceptions. The purchase price must be at least equal to the SBE Price (as defined below). The Master Purchase Agreement provides that if the purchase price equals or exceeds (i) the price for such species and category thereof set forth on the structuring schedule applicable to the Timber Notes, and (ii) the SBE Price, then such price shall be deemed to be the fair market value of such logs. The Master Purchase Agreement defines the "SBE Price," for any species and category of timber, as the stumpage price for such species and category as set forth in the most recent "Harvest Value Schedule" published by the California State Board of Equalization applicable to the timber sold during the period covered by such Harvest Value Schedule. Such Harvest Value Schedules are published for purposes of computing yield taxes and generally are established every six months. As Pacific Lumber purchases logs from SPHC pursuant to the Master Purchase Agreement, Pacific Lumber is responsible, at its own expense, for harvesting and removing the standing SPHC Timber covered by approved THPs and, thus, the purchase price thereof is based upon "stumpage prices." Title to the harvested logs does not pass to Pacific Lumber until the logs are transported to Pacific Lumber's log decks and measured. Substantially all of SPHC's revenues are derived from the sale of logs to Pacific Lumber under the Master Purchase Agreement. In connection with the Transfer, Pacific Lumber, SPHC and Salmon Creek also entered into a Reciprocal Rights Agreement granting to each other certain reciprocal rights of egress and ingress through their respective properties in connection with the operation and maintenance of such properties and their respective businesses. In addition, on the Closing Date, Pacific Lumber entered into an Environmental Indemnification Agreement with SPHC pursuant to which Pacific Lumber agreed to indemnify SPHC from and against certain present and future liabilities arising with respect to hazardous materials, hazardous materials contamination or disposal sites, or under environmental laws with respect to the Subject Timberlands. On the Closing Date, Pacific Lumber entered into an agreement with Britt which governs the sale of logs by Pacific Lumber and Britt to each other, the sale of hog fuel (wood residue) by Britt to Pacific Lumber for use in Pacific Lumber's cogeneration plant, the sale of lumber by Pacific Lumber and Britt to each other, and the provision by Pacific Lumber of certain administrative services to Britt (including accounting, purchasing, data processing, safety and human resources services). The logs which Pacific Lumber sells to Britt and which are used in Britt's manufacturing operations are sold at approximately 75% of applicable SBE prices (to reflect the lower quality of these logs). Logs which either Pacific Lumber or Britt purchases from third parties and which are then sold to each other are transferred at the actual cost of such logs. Hog fuel is sold at applicable market prices, and administrative services are provided by Pacific Lumber based on Pacific Lumber's actual costs and an allocable share of Pacific Lumber's overhead expenses consistent with past practice. BRITT LUMBER OPERATIONS Business Britt is located in Arcata, California, approximately 45 miles north of Pacific Lumber's headquarters. Britt's primary business is the processing of small diameter redwood logs into wood fencing products for sale to retail and wholesale customers. Britt was incorporated in 1965 and operated as an independent manufacturer of fence products until July 1990, when it was purchased by a subsidiary of the Company. Britt purchases small diameter (6 to 14 inch) and short length (6 to 12 feet) redwood logs from Pacific Lumber and a variety of different diameter and different length logs from various timberland owners. Britt processes logs at its mill into a variety of different fencing products, including "dog-eared" 1" to 6" fence stock in six and eight foot lengths, 4" x 4" fence posts in 6 through 12 foot lengths, and other fencing products in 6 through 12 foot lengths. Britt's purchases of logs from third parties are generally consummated pursuant to short-term contracts of twelve months or less. See "--Relationships among Pacific Lumber, SPHC, and Britt Lumber" for a description of Britt's log purchases from Pacific Lumber. Marketing In 1993, Britt sold approximately 73 million board feet of lumber products to approximately 90 different customers, compared to 1992 sales of approximately 68 million board feet of lumber products to approximately 100 customers. In both years, over one-half of its sales were in northern California. The remainder of its 1993 and 1992 sales were in southern California, Arizona, Colorado, Hawaii and Nevada. The largest and top five of such customers accounted for approximately 33% and 46%, respectively, of such 1993 sales and 33% and 80%, respectively, of 1992 sales. Britt markets its products through its own sales person to a variety of customers, including distribution centers, industrial remanufacturers, wholesalers and retailers. Facilities and Employees Britt's manufacturing operations are conducted on 12 acres of land, 10 acres of which are leased on a long-term fixed-price basis from an unrelated third party. Fence production is conducted in a 46,000 square foot mill. An 18 acre log sorting and storage yard is located 1/4 mile away. The mill was constructed in 1980, and capital expenditures to enhance its output and efficiency are made on a yearly basis. Britt's (single shift) mill capacity, assuming 40 production hours per week, is estimated at 40.3 million board feet of fencing products per year. As of March 1, 1994, Britt employed approximately 100 people. Competition Management estimates that Britt accounted for approximately 24% of the redwood fence market in 1993 in competition with the northern California mills of Louisiana Pacific and Georgia Pacific. REGULATORY AND ENVIRONMENTAL FACTORS Regulatory and environmental issues play a significant role in Pacific Lumber's forest products operations. Pacific Lumber's forest products operations are subject to a variety of California, and in some cases, federal laws and regulations dealing with timber harvesting, endangered species, and air and water quality. These laws include the California Forest Practice Act (the "Forest Practice Act"), which requires that timber harvesting operations be conducted in accordance with detailed requirements set forth in the Forest Practice Act and in the regulations promulgated thereunder by the California Board of Forestry (the "BOF"). The federal Endangered Species Act (the "ESA") and the California Endangered Species Act (the "CESA") provide in general for the protection and conservation of specifically listed fish, wildlife and plants which have been declared to be endangered or threatened. The California Environmental Quality Act ("CEQA") provides, in general, for protection of the environment of the state, including protection of air and water quality and of fish and wildlife. In addition, the California Water Quality Act requires, in part, that Pacific Lumber's operations be conducted so as to reasonably protect the water quality of nearby rivers and streams. Pacific Lumber does not expect that compliance with such existing laws and regulations will have a material adverse effect on its timber harvesting practices or future operating results. There can be no assurance, however, that future legislation, governmental regulations or judicial or administrative decisions would not adversely affect Pacific Lumber. Additional BOF regulations (i.e., late succession forest stand rules and sensitive watershed rules) went into effect March 1, 1994. These new regulations require, among other things, the inclusion of more information in THPs (concerning, among other things, timber generation systems, the presence or absence of fish, wildlife and plant species, and potentially impacted watersheds) and modification of certain timber harvesting practices to comply with the new regulations. In early March 1994, the BOF also approved silviculture with sustained yield rules. The Office of Administrative Law (the "OAL") is expected to (i) approve these proposed regulations, (ii) request additional review, information or action and resubmittal to the OAL, or (iii) reject the proposed regulations. These proposed regulations are scheduled to become effective on May 1, 1994, and if approved, will require additional information to be included in THPs (concerning, among other things, compliance with long-term sustained yield objectives) and modifications of certain timber harvesting practices (including the creation of buffer zones between harvest areas and increases in the amount of timber required to be retained in a harvest area). Various groups and individuals have filed objections with the CDF regarding the CDF's actions and rulings with respect to certain of Pacific Lumber's THPs, and the Company expects that such groups and individuals will continue to file objections to certain of Pacific Lumber's THPs. In addition, lawsuits are pending which seek to prevent Pacific Lumber from implementing certain of its approved THPs. These challenges have severely restricted Pacific Lumber's ability to harvest virgin old growth timber on its property during the past few years. To date, litigation with respect to Pacific Lumber's THPs relating to young growth and residual old growth timber has been limited; however, no assurance can be given as to the extent of such litigation in the future. In June 1990, the U.S. Fish and Wildlife Service (the "USFWS") designated the northern spotted owl as threatened under the ESA. The State of California also has adopted regulations designed to protect the northern spotted owl, although the northern spotted owl has not been listed as threatened or endangered under the CESA. The owl's range includes all of Pacific Lumber's timberlands. The ESA and its implementing regulations generally prohibit harvesting operations in which individual owls might be killed, displaced or injured or which result in significant habitat modification that could impair the survival of individual owls or the species as a whole. Since 1988, biologists have conducted inventory and habitat utilization studies of northern spotted owls on Pacific Lumber's timberlands. The USFWS has given its full concurrence to a northern spotted owl management plan (the "Owl Plan"), a comprehensive wildlife management plan submitted by Pacific Lumber with respect to the northern spotted owl. Pacific Lumber incorporates this plan into each THP filed with the CDF and is no longer required to receive individual approval of its northern spotted owl conservation practices in connection with each THP it submits. The Owl Plan enables Pacific Lumber to expedite the approval process with respect to its THPs. Both federal and state agencies continue to review and consider possible additional regulations regarding the northern spotted owl. It is uncertain if such additional regulations will become effective or their ultimate content. On March 12, 1992, the marbled murrelet was approved for listing as endangered under the CESA. Pacific Lumber has incorporated, and will continue to incorporate, additional mitigation measures into its THPs to protect and maintain habitat for marbled murrelets on its timberlands. The California Department of Fish and Game (the "CDFG") requires Pacific Lumber to conduct pre-harvest marbled murrelet surveys and to provide certain other site specific mitigations in connection with its THPs covering virgin old growth timber and unusually dense stands of residual old growth timber. Such surveys can only be conducted during April to July, the murrelets' nesting and breeding season. Accordingly, such surveys are expected to delay the approval process with respect to certain of the THPs filed by Pacific Lumber. The results of such surveys could prevent Pacific Lumber from conducting certain of its harvesting operations. In October 1992, the USFWS issued its final rule listing the marbled murrelet as a threatened species under the ESA in the tri-state area of Washington, Oregon and California. In January 1994, the USFWS proposed designation of critical habitat for the marbled murrelet under the ESA. This proposal is subject to public comment, hearings and possible future modification. Both federal and state agencies continue to review and consider possible additional regulations regarding the marbled murrelet. It is uncertain if such additional regulations will become effective or their ultimate content. Pacific Lumber's wildlife biologist is conducting research concerning the marbled murrelet on Pacific Lumber's timberlands and is currently developing a comprehensive management plan for the marbled murrelet (the "Murrelet Plan") similar to the Owl Plan. Pacific Lumber is continuing to work with the USFWS and the other government agencies on the Murrelet Plan. It is uncertain when the Murrelet Plan will be completed and approved. In October 1993, the USFWS received a petition proposing listing the coho salmon (which is found on Pacific Lumber's property) as threatened or endangered. Laws and regulations dealing with Pacific Lumber's operations are subject to change and new laws and regulations are frequently introduced concerning the California timber industry. A variety of bills are currently pending in the California legislature and the U.S. Congress which relate to the business of Pacific Lumber, including the protection and acquisition of old growth and other timberlands, endangered species, environmental protection and the restriction, regulation and and administration of timber harvesting practices. For example, the U.S. Congressman for the congressional district in which Pacific Lumber is located has introduced a bill which would, among other things, incorporate within the boundaries of an existing national forest approximately 42,000 acres of Pacific Lumber's timberlands and would designate approximately 12,000 acres of Pacific Lumber's timberlands to be studied for possible inclusion within such national forest. Corresponding legislation has been introduced in the California legislature. These 54,000 acres constitute approximately 30% of Pacific Lumber's timberlands. Since this and the other bills are subject to amendment, it is premature to assess the ultimate content of these bills, the likelihood of any of the bills passing, or the impact of any of these bills on the consolidated financial position or results of operations of the Company. Furthermore, any bills which are passed are subject to executive veto and court challenge. In addition to existing and possible new or modified statutory enactments, regulatory requirements, administrative and legal actions, the California timber industry remains subject to potential California or local ballot initiatives and evolving federal and California case law which could affect timber harvesting practices. It is, however, impossible to assess the effect of such matters on the future operating results or consolidated financial position of the Company. REAL ESTATE OPERATIONS The Company, principally through its wholly owned subsidiaries, is also engaged in the business of real estate development and commercial real estate investment in Arizona, California, Colorado, New Mexico, Texas and Puerto Rico. The Company has outstanding receivables from the financing of real estate sales in its developments and may continue to finance such real estate sales in the future. The Company also holds other receivables as a portion of its commercial real estate investments. Properties Texas. In 1991, a subsidiary of the Company purchased for approximately $122.0 million a portfolio of real property and loans secured by real property at auction from the Resolution Trust Corporation. Substantially all of the real property was located in Texas, with the largest concentration in the vicinity of San Antonio, Houston, Austin and Dallas. During 1993 and the first two months of 1994, an aggregate of $12.5 million of the loans were sold or paid off, approximately $20.9 million of real property securing loans was acquired in lieu of foreclosure and eighteen properties were sold. The largest of these sales was completed in December 1993 and resulted in the sale of sixteen properties for $113.6 million. As of March 1, 1994, the Company had six loans and seventeen properties remaining. Certain of the remaining assets are being marketed by the Company. Palmas del Mar. Palmas del Mar ("Palmas"), a resort, time- sharing and land development and sales business, located on the southeastern coast of Puerto Rico near Humacao, was acquired in 1984. Originally 2,762 acres, Palmas now includes approximately 2,160 acres of undeveloped land, 100 condominiums utilized in its time-sharing program (comprising 5,300 time-share intervals of which approximately 1,135 remain to be sold), a 100-room hotel and adjacent executive convention center known as the Candelero Hotel, a 23-room luxury hotel known as the Palmas Inn, a casino, a Gary Player-designed 18-hole golf course, 20 tennis courts, golf and tennis pro shops, restaurants, beach and pool facilities, an equestrian center and a sailing center. Certain stores and restaurants and the equestrian center are operated by third parties. Approximately 1,300 private residences and a marina are owned by third parties. A number of these private residences are made available to Palmas by their owners throughout the year for rental to vacationers. Since 1985, the Company has been actively engaged in the development and sale of condominiums, estate lots and villas. In 1993, Palmas sold approximately twenty-five condominium units, one estate lot and thirty-one time-shares intervals. Fountain Hills. In 1968, a subsidiary of the Company purchased and began developing approximately 12,100 acres of real property at Fountain Hills, Arizona, which is located near Phoenix and adjacent to Scottsdale, Arizona. As of March 1, 1994, Fountain Hills had approximately 5,000 acres of undeveloped land, 90 commercial tracts and 65 developed residential lots available for sale. The population of Fountain Hills is approximately 11,000. The Company is planning the development of certain of its remaining acreage. Future sales are expected to consist mainly of undeveloped acreage, semi-developed parcels and fully-developed lots, although the Company expects to continue limited construction and direct sale of residential units. In 1993, approximately 150 lots and 20 acres were sold. Lake Havasu City. In 1963, a subsidiary of the Company purchased and began developing approximately 16,700 acres of real property at Lake Havasu City, Arizona, which were offered for sale in the form of subdivided single and multiple family residential, commercial and industrial sites. The Company has sold substantially all of its lot inventory in Lake Havasu City and is currently planning the development of its remaining acreage. Rancho Mirage. In 1991, a subsidiary of the Company acquired Mirada, a 195-acre luxury resort-residential project located in Rancho Mirage, California. The Company is currently marketing the project's fully-developed lots. Other. The Company, through its subsidiaries, owns a number of other properties in Arizona, New Mexico, Texas and Colorado. Efforts are underway to sell most of these properties. Marketing The Company is engaged in marketing and sales programs of varying magnitudes at its real estate developments. In recent years, the Company has constructed residential units and sold time-share intervals at certain of its real estate developments. The Company intends to continue selling land to builders and developers and lots to individuals and expects to continue to construct and sell completed residential units at certain of its developments. It also expects to sell certain of its commercial real estate assets. All sales are made directly to purchasers through the Company's marketing personnel, independent contractors or through independent real estate brokers who are compensated through the payment of customary real estate brokerage commissions. Competition and Regulation and Other Industry Factors There is intense competition among companies in the real estate development business and the commercial real estate business for sales to residential and commercial lot purchasers and to commercial property investors. Sales and payments on real estate sales obligations depend, in part, on available financing and disposable income and, therefore, are affected by changes in general economic conditions and other similar factors. The real estate development business and commercial real estate business are subject to other risks such as shifts in population, fluctuations in the real estate market, and unpredictable changes in the desirability of residential, commercial and industrial areas. Palmas' resort and time-sharing business competes with similar businesses in the Caribbean, Florida and other locations. Palmas' resort operations are seasonal and are subject to, among other things, the condition of the United States economy and tourism business in Puerto Rico. The Company's real estate operations are subject to comprehensive federal, state and local regulation. Applicable statutes and regulations may require disclosure of certain information concerning real estate developments and credit policies of the Company and its subsidiaries. Periodic approval is required from various agencies in connection with the layout and design of developments, the nature and extent of improvements, construction activity, land use, zoning, and numerous other matters. Failure to obtain such approval, or periodic renewal thereof, could adversely affect real estate development and marketing operations of the Company and its subsidiaries. Various jurisdictions also require inspection of properties by appropriate authorities, approval of sales literature, disclosure to purchasers of specific information, bonding for property improvements, approval of real estate contract forms and delivery to purchasers of a report describing the property. SAM HOUSTON RACE PARK General and Financing On July 8, 1993, subsidiaries of the Company acquired various interests in a Class 1 thoroughbred and quarter horse racing facility (the "Race Park") currently under construction just northwest of Houston. Houston is the fourth largest city in the United States and the largest city without pari-mutuel horse racing. Sam Houston Race Park, Ltd. (the "Partnership") owns the land, facilities and the racing license with respect to the Race Park. On July 8, 1993, the Partnership obtained the funds required to finance the construction and initial start-up costs of the Race Park through (i) the sale by the Partnership and its wholly owned subsidiary, SHRP Capital Corp., of $75,000,000 principal amount of 11 3/4% Senior Secured Notes due 1999 (ii) the sale by the sole general partner of the Partnership (the "SHRP General Partner") of warrants to acquire shares of Class A Common Stock, and (iii) the sale and issuance of limited partnership interests by the Partnership (collectively, the "Offering"). In connection with the Offering, subsidiaries of the Company acquired, for a total investment of $9.1 million, (i) a 28.7% equity interest in the Partnership through the purchase of existing limited partnership interests (thereby becoming the largest limited partner in the Partnership), (ii) all of the outstanding Class B Common Stock of SHRP General Partner (representing a further 1% equity interest in the Partnership), and (iii) a 75% interest in Race Track Management Enterprises, the manager of the Race Park (the "Manager"). The Race Park is expected to be substantially completed and open for live racing by April 29, 1994. Racing Operations The ownership and operation of horse racetracks in Texas are subject to significant regulation by the Texas Racing Commission (the "Racing Commission") under the Texas Racing Act and related regulations (collectively, the "Racing Act"). The Racing Act provides, among other things, for the allocation of each wagering pool among the state of Texas, purses, special equine programs, the racetrack and betting participants and empowers the Racing Commission to license and regulate substantially all aspects of horse racing in the state. Only four Class 1 racetracks may be licensed and operated in Texas under the Racing Act. While an unlimited number of Class 2, 3 and 4 racetracks may be licensed, the Company believes Class 1 racetracks will be the "flagship" Texas racetracks, having the largest facilities and the highest caliber horses and offering the greatest number of live race and simulcasting days (discussed below). The Racing Commission, in settlement of a lawsuit, has also granted an existing Class 2 racetrack located to the west of Fort Worth ("Trinity Meadows") an upgrade to a Class 1 license, subject to the fulfillment of certain conditions. The Racing Commission has licensed two additional prospective Class 1 horse racetracks, one in Dallas and the other in San Antonio. The Company does not expect the Race Park to compete with the other Class 1 tracks for patrons. The Company expects the Race Park to offer pari-mutuel wagering on live thoroughbred or quarter horse racing or simulcast racing generally six days a week throughout the year. Simulcasting is the process by which live races held at one facility are broadcast simultaneously to other locations at which additional wagers are placed on the race being broadcast. In Texas, the broadcast may only be sent to licensed racetracks, as the Racing Act does not provide for off-track betting. Class 1 and Class 2 racetracks in Texas must take simulcast signals from Texas Class 1 tracks in preference to signals from other tracks when such signals are made available to them. The Race Park may offer simulcast wagering only on races simulcast from other Class 1 Texas racetracks on those days when the other Class 1 tracks make their signals available to the Race Park. On days that signals are not made available from other Texas Class 1 racetracks, the Race Park may simulcast out-of-state horse races with the approval of the Racing Commission. The Partnership intends to enter into revenue-sharing arrangements both with racetracks that will send simulcast signals to the Race Park and with racetracks that will receive simulcast signals of races held at the Race Park. The Racing Commission must approve the number of live race days that may be offered at the Race Park each year, as well as all simulcast arrangements. The number and scheduling of race days at the Racing Facility will depend on the scheduling of live race days at other Class 1 horse racing facilities. Under the Racing Act, Class 1 racetracks generally may not have overlapping live race schedules for the same breed of horse with other Class 1 racetracks unless the tracks with the overlapping schedules each consent. In its settlement with the Racing Commission, Trinity Meadows agreed that it would not participate in a Texas racing circuit and that its race dates would not be exclusive. If the other three Class 1 racetracks in Texas were open and operating on a six-day live race week and the live race schedule were equally divided among the three tracks to avoid overlapping race dates, each track would generally be allocated 102 live race days for each breed of horse. The Racing Commission has allocated to the Race Park 45 thoroughbred racing days commencing April 29, 1994 and ending on June 19, 1994 and an additional 66 thoroughbred racing days starting again October 11 and continuing through the end of the year. The Racing Commission has also allocated to the Race Park 69 quarter horse racing days commencing July 1, 1994 and ending on September 18, 1994. When the Dallas and San Antonio Class 1 racetracks are constructed and operational, the Company believes that it is likely that a Texas horse racing circuit will develop. Under such a circuit, the Class 1 racetracks would coordinate their activities such that, in general, at any one time and for several months at a time, there would be thoroughbred racing at one track, quarter horse racing at another track and the third track would have wagering on races simulcast from both of the other Class 1 tracks. No assurance can be given, however, that a Texas racing circuit will develop. In addition to revenues from wagering and simulcasting, the Partnership will derive revenues from admission fees, food services, club memberships, luxury suites, advertising sales and other sources. Race Park Facilities The Race Park is located on approximately 240 acres of land in northwest Harris County approximately 18 miles from the Houston central business district and approximately 15 miles from Houston Intercontinental Airport. The Race Park, which will have a one-mile dirt track and a one and one-eighth mile turf course, has been designed for an average patron capacity of approximately 18,000, with additional capacity for approximately 12,000 patrons on the infield. The Race Park is bordered by the Sam Houston Parkway on the north and is accessible by freeway and expects that access to the Race Park by nearby surface streets will improve within the near future. The Partnership has delegated to the Manager, pursuant to a management agreement, the right, power and authority to manage, conduct and make all decisions relating to the business and affairs of the Partnership insofar as they relate to the Race Park, except that The Partnership has retained pre-approval rights over certain major decisions by the Manager. Marketing and Competition The Race Park intends to focus its marketing on the greater Houston metropolitan area, including encouraging family attendance at the facility. The Race Park will compete with other forms of entertainment, including a greyhound racetrack located 60 miles from the Race Park and a wide range of live and televised professional and collegiate sporting events that are available in the Houston area. The Race Park could in the future also be competing with other forms of gambling in Texas, including riverboat gambling and casino gambling on Indian reservations or otherwise. In this regard, the Alabama and Coushatta Tribe, whose reservation is approximately 95 miles from the Race Park, has applied for a license to construct a casino and/or conduct gambling operations. In addition, two bills which would have authorized riverboat gambling were introduced in the last session of the Texas legislature, although neither passed. Employees As of March 1, 1994, the Partnership had approximately 55 employees. The Company expects that the Race Park will employ approximately 75 year-round employees and an additional 600 employees during live racing seasons. EMPLOYEES At March 1, 1994, the Company and its subsidiaries employed approximately 2,320 persons, exclusive of those involved in Aluminum Operations. ITEM 2. ITEM 2. PROPERTIES For information concerning the principal properties and operations of the Company, see Item 1. "Business." ITEM 3. ITEM 3. LEGAL PROCEEDINGS KAISER ENVIRONMENTAL LITIGATION Aberdeen Pesticide Dumps Site Matter The Aberdeen Pesticide Dumps Site, listed on the Superfund National Priorities List, is composed of five separate sites around the town of Aberdeen, North Carolina (collectively, the "Sites"). The Sites are of concern to the United States Environmental Protection Agency (the "EPA") because of their past use as either pesticide formulation facilities or pesticide disposal areas from approximately the mid-1930's through the late-1980's. The United States originally filed a cost recovery complaint (as amended, the "Complaint") in the United States District Court for the Middle District of North Carolina, Rockingham Division, No. C-89-231-R, which, as amended, includes KACC and a number of other defendants. The Complaint seeks reimbursement for past and future response costs and a determination of liability of the defendants under Section 107 of CERCLA. The EPA has performed a Remedial Investigation/Feasibility Study and issued a Record of Decision ("ROD") for the Sites in September 1991. The major remedy selected for the Sites would have a cost of $32 million. Other possible remedies described in the ROD would have estimated costs of approximately $53 million and $222 million, respectively. Kaiser understands that the EPA is also investigating contamination of groundwater at the Sites. The EPA has stated that it has incurred past costs at the Sites in the range of $7.5--$8 million as of February 9, 1993, and alleges that response costs will continue to be incurred in the future. On May 20, 1993, the EPA issued three unilateral Administrative Orders under Section 106(a) of CERCLA ordering the respondents, including KACC, to perform the remedial design and remedial action described in the ROD for three of the Sites. The estimated cost as set forth in the ROD for the remedial action at the three Sites is approximately $27 million. A number of other companies are also named as respondents. KACC has entered into an Agreement in Principle with certain of the respondents to participate jointly in responding to the Administrative Orders, to share costs incurred on an interim basis, and to seek to reach a final allocation of costs through agreement or to allow such final allocation and determination of liability to be made by the United States District Court. A definitive PRP Participation Agreement is currently awaiting execution by the group. By letter dated July 6, 1993, KACC has notified the EPA of its ongoing participation with such group of respondents which, as a group, are intending to comply with the Administrative Orders to the extent consistent with applicable law. By letters dated December 30, 1993, the EPA notified KACC of its potential liability for, and requested that KACC, along with a number other companies, undertake or agree to finance, groundwater remediation at certain of the Sites. The ROD-selected remedy for the groundwater remediation selected by EPA includes a variety of techniques. The EPA has estimated the total present worth cost, including 30 years of operation and maintenance, at approximately $11.8 million. KACC, along with other notified parties, plans to meet with representatives of the EPA to discuss whether an agreement to perform this remediation is possible. Based upon the information presently available to it, Kaiser is unable to determine whether KACC has any liability with respect to any of the Sites or, if there is any liability, the amount thereof. Two government witnesses have testified that KACC acquired pesticide products from the operator of the formulation site over a two to three year period. KACC has been unable to confirm the accuracy of this testimony. United States of America v. Kaiser Aluminum & Chemical Corporation In February 1989, a civil action was filed by the United States Department of Justice at the request of the EPA against KACC in the United States District Court for the Eastern District of Washington, Case Number C-89-106-CLQ. The complaint alleged that emissions from certain stacks at Kaiser's Trentwood facility in Spokane, Washington intermittently violated the opacity standard contained in the Washington State Implementation Plan ("SIP"), approved by the EPA under the federal Clean Air Act. The complaint sought injunctive relief, including an order that KACC take all necessary action to achieve compliance with the Washington SIP opacity limit and the assessment of civil penalties of not more than $25,000 per day. In the course of the litigation, questions arose as to whether the observers who recorded the alleged exceedances were qualified under the Washington SIP to read opacity. In July 1990, KACC and the Department of Justice agreed to a voluntary dismissal of the action. At that time, however, the EPA had arranged for increased surveillance of the Trentwood facility by consultants and the EPA's personnel. From May 1990 through May 1991, these observers recorded approximately 130 alleged exceedances of the SIP opacity rule. Justice Department representatives have stated their intent to file a second lawsuit against KACC based on the opacity observations recorded during that period. The second lawsuit has not yet been filed. Instead, KACC has entered into negotiations with the EPA to resolve the claims against KACC through a consent decree. Although the EPA and KACC have made substantial progress in negotiating the terms of the consent decree, key issues remain to be resolved. Anticipated elements of any settlement would include a commitment by KACC to improve the emission control equipment at the Trentwood facility and a civil penalty assessment against KACC, in an amount to be determined. At this time, Kaiser cannot predict the likelihood that the EPA and KACC will reach an agreement upon the terms of a consent decree. In the event that the negotiations are not successful the matter likely would be resolved in federal court. Catellus Development Corporation v. Kaiser Aluminum & Chemical Corporation and James L. Ferry & Son Inc. In January 1991, the City of Richmond, et al. (the "Plaintiffs") filed a Second Amended Complaint for Damages and Declaratory Relief against Catellus Development Corporation ("Catellus") and other defendants (collectively, the "Defendants") alleging, among other things, that the Defendants caused or allowed hazardous substances, pollutants, contaminants, debris and other solid wastes to be discharged, deposited, disposed of or released on certain property located in Richmond, California (the "Property") formerly owned by Catellus and leased to KACC for the purpose of shipbuilding activities conducted by KACC on behalf of the United States during World War II. Plaintiffs allege, among other things, that the Defendants are jointly and severally liable for response costs, declaratory relief and natural resources damages under CERCLA, and that Defendant Catellus is strictly liable on grounds of continuing nuisance, continuing trespass and negligence for such discharge, deposit, disposal or release, and is liable for fraudulent concealment of the alleged contamination. KACC is alleged to have performed certain excavation activities on the Property and, as a result thereof, to have released contaminants on the Property and to have arranged for the transportation, treatment and disposal of such contaminants Catellus has filed a third party complaint (the "Third Party Complaint") against KACC in the United States District Court for the Northern District of California, Case No. C-89-2935 DLJ. The Third Party Complaint, as amended, seeks contribution and indemnity from KACC and another party under a variety of theories (including negligence, nuisance, waste and alleged contractual indemnities) for, among other things, Catellus' response costs and natural resources damages under CERCLA, any liability or judgment imposed against Cattelus, and treble damages for the injury to its interest in the Property, and treble damages from KACC pursuant to California Code of Civil Procedure Section 732. By an October 1992 letter, counsel for certain underwriters at Lloyd's London and certain London Market insurance companies (the "London Insurers") advised that the London Insurers agreed to reimburse KACC for defense expenses in the third party action filed by Catellus, subject to a full reservation of rights. The Plaintiffs filed a motion for leave to file a Third Amended Complaint which would have added KACC as a first party defendant. This motion was denied. In October 1992, the Plaintiffs served a separate Complaint against KACC for damages and declaratory relief. The claims asserted by the Plaintiffs are for, among other things, (i) response costs, recovery of costs, natural resources damages and declaratory relief under CERCLA; (ii) damages for injury to the Property arising from negligence, and (iii) damages under a theory of strict liability. This matter has been tendered to the London Insurers. Picketville Road Landfill Matter In July, 1991, the EPA served on KACC and thirteen other PRPs a Unilateral Administrative Order For Remedial Design and Remedial Action (the "Order") at the Picketville Road Landfill site in Jacksonville, Florida. The EPA seeks remedial design and remedial action pursuant to CERCLA from some, but apparently not all, PRPs based upon a Record of Decision outlining remedial cleanup measures to be undertaken at the site adopted by the EPA in September 1990. The site was operated as a municipal and industrial waste landfill from 1968 to 1977 by the City of Jacksonville. KACC was first notified by the EPA in January 1991, that wastes from one of KACC's plants may have been transported to and deposited in the site. In its Record of Decision, the EPA estimated that the total capital, operations and maintenance costs of its elected remedy for the site would be approximately $9.9 million. In addition, the EPA has reserved the right to seek recovery of its costs incurred relating to the Order, including, but not relating to, reimbursement of the EPA's cost of response. Through negotiations with the EPA and other PRPs, KACC has reached an agreement with such PRPs under which KACC will fund $146,700 of the cost of the remedial action (unless remedial costs exceed $19 million in which event the settlement agreement will be re-opened). The implementation of the foregoing agreement is subject to continuing discussions among the EPA, the other PRPs and KACC. Asbestos-related Litigation KACC is a defendant in a number of lawsuits in which the plaintiffs allege that certain of their injuries were caused by exposure to asbestos during, and as a result of, their employment with KACC or to products containing asbestos produced or sold by KACC. The lawsuits generally relate to products KACC has not manufactured for at least 15 years. The number of such lawsuits instituted against KACC increased substantially in 1993 and management believes the number of such lawsuits will continue to increase at a greater annualized rate than in prior years. For additional information, see Note 10 to the Consolidated Financial Statements. The Company currently believes that there is no more than a remote possibility (under generally accepted accounting principles) that KACC's ultimate asbestos-related costs net of related insurance recoveries will exceed those accrued as of December 31, 1993 and, accordingly, that the resolution of such uncertainties and the incurrence of such net costs should not have a material adverse effect on Kaiser's consolidated financial position or results of operations. OTHER KAISER LITIGATION Various other lawsuits and claims are pending against Kaiser. The Company believes that resolution of the lawsuits and claims made against Kaiser, including the matters discussed above, will not have a material adverse effect on Kaiser's consolidated financial position. PACIFIC LUMBER MERGER LITIGATION During the mid-to-late 1980's, Pacific Lumber was named as defendant along with several other entities and individuals, including the Company and MGI, in various class, derivative and other actions brought in the Superior Court of Humboldt County by former stockholders of Pacific Lumber relating to the cash tender offer (the "Tender Offer") for the shares of Pacific Lumber by a subsidiary of MGI and the subsequent merger (the "Merger"), as a result of which Pacific Lumber became a wholly-owned subsidiary of MGI (the "Humboldt County Lawsuits"). The Humboldt County Lawsuits which remain open are captioned: Fries, et al. v. Carpenter, et al. (No. 76328) ("Fries State"); Omicini, et al. v. The Pacific Lumber Company, et al. (No. 76974) ("Omicini"); Thompson, et al. v. Elam, et al. (No. 78467) ("Thompson State"); and Russ, et al. v. Milken, et al. (No. DR-85429) ("Russ"). The Humboldt County Lawsuits generally allege, among other things, that in documents filed with the Securities and Exchange Commission (the "Commission"), the defendants made false statements concerning, among other things, the estimated value of Pacific Lumber's assets, financing for the Tender Offer and the Merger and minority stockholders' appraisal rights, and that the individual directors of Pacific Lumber breached certain fiduciary duties owed stockholders and other constituencies of Pacific Lumber. The Company and MGI are alleged to have aided and abetted these violations and committed other wrongs. The Thompson State, Omicini and Fries State suits seek compensatory damages in excess of $1 billion, exemplary damages in excess of $750 million, rescission and other relief. The Russ suit does not specify the amount of damages sought. There has been no activity in the Fries State case since 1987 nor in the Omicini case since 1986. The Thompson State and Russ actions are stayed pending the outcome of the In re Ivan F. Boesky Multidistrict Securities Litigation described below. In 1988, the plaintiffs in the Fries State action filed another action entitled Fries, et al. v. Hurwitz, et al. (No. 88-3493 RMT), in United States District Court, Central District of California ("Fries Federal") against the Company, Pacific Lumber, MGI and others. Fries Federal repeats many of the allegations and seeks damages and relief similar to that contained in the Humboldt County Lawsuits, and, among other things, asserts that the defendants violated RICO and the Hart-Scott-Rodino Antitrust Improvements Act, and further alleges that, as a result of alleged arrangements between Ivan F. Boesky and others, MGI beneficially owned, for purposes of Pacific Lumber's bylaws, more than 5% of Pacific Lumber's outstanding shares so that the Merger required the approval of 80% of the outstanding shares rather than a majority. In 1988, plaintiffs in the Thompson State action and others filed a complaint in the United States District Court, Central District of California, entitled Thompson, et al. v. MAXXAM Group Inc., et al. (No. 88-06274) ("Thompson Federal"). The defendants in the Thompson Federal action include Pacific Lumber, the Company, MGI and others. This action, as amended, repeats the allegations, asserts claims and seeks damages and relief similar to that contained in the Fries Federal and Fries State actions. In May 1989, the Thompson Federal and Fries Federal actions were consolidated in the In re Ivan F. Boesky Multidistrict Securities Litigation in the United States District Court, Southern District of New York (MDL No. 732 M 21-45-MP) ("Boesky"). An additional action filed in November 1989, entitled American Red Cross, et al. v. Hurwitz, et al. (No. 89 Civ 7722) ("American Red Cross"), has been consolidated with the Boesky action. The American Red Cross action contains allegations and seeks damages and relief similar to that contained in the Russ, Thompson Federal and Fries Federal actions. In September 1990, the Court in the Boesky action certified a class of plaintiffs comprised of persons who sold their shares in Pacific Lumber on or after September 27, 1985. Various plaintiffs in the Boesky action have opted out of the certified class of plaintiffs and are prosecuting their claims individually within the Boesky proceeding. The Boesky action has been set for trial commencing April 11, 1994. In September 1989, seven past and present employees of Pacific Lumber brought an action against Pacific Lumber, the Company, MGI, certain current and former directors and officers of the Company, Pacific Lumber and MGI, and First Executive Life Insurance Company ("First Executive") (subsequently dismissed as a defendant) in the United States District Court, Northern District of California, entitled Kayes, et al. v. Pacific Lumber Company, et al. (No. C89-3500) ("Kayes"). Plaintiffs purport to be participants in or beneficiaries of Pacific Lumber's former Retirement Plan (the "Retirement Plan") for whom a group annuity contract was purchased from Executive Life Insurance Company ("Executive Life") in 1986 after termination of the Retirement Plan. The Kayes action alleges that the Company, Pacific Lumber and MGI defendants breached their ERISA fiduciary duties to participants and beneficiaries of the Retirement Plan by purchasing the group annuity contract from First Executive and selecting First Executive to administer the annuity payments. Plaintiffs seek, among other things, a new group annuity contract on behalf of the Retirement Plan participants and beneficiaries. This case was dismissed on April 14, 1993 and was refiled as Jack Miller, et al. v. Pacific Lumber Company, et al. (No. C-89-3500-SBA) ("Miller") on April 26, 1993; the Miller case was dismissed on May 14, 1993. These dismissals have been appealed. On October 28, 1993, a bill amending ERISA, was passed by the U.S. Senate which appears to be intended, in part, to overturn the District Court's dismissal of the Miller action and to make available certain remedies. This bill has not been voted upon by the House of Representatives. It is impossible to say if the bill will be enacted or if enacted its ultimate content. In June 1991, the U.S. Department of Labor filed a civil action entitled Lynn Martin, Secretary of the U.S. Department of Labor v. The Pacific Lumber Company, et al. (No. 91-1812-RHS) ("DOL civil action") in the United States District Court, Northern District of California, against the Company, Pacific Lumber, MGI and certain of their current and former officers and directors. The allegations in the DOL civil action are substantially similar to that in the Kayes action. The DOL civil action has been stayed pending resolution of the Kayes and Miller appeals. Management is of the opinion that the outcome of the foregoing litigation is unlikely to have a material adverse effect on the Company's consolidated financial position. Management is unable to express an opinion as to whether the outcome of such litigation is unlikely to have a material adverse effect on the Company's results of operations in respect of any fiscal year. In April 1991, the California Commissioner of Insurance (the "Commissioner") filed for conservatorship of Executive Life in Los Angeles County Superior Court in proceedings entitled Insurance Commissioner of the State of California v. Executive Life Insurance Co. and Does 1-1000 (Case No. BS006912) ("Executive Life Conservatorship"). In September 1993, the final rehabilitation plan for Executive Life (the "Plan") was closed. The Commissioner expects that for nearly all policyholders who chose to remain with Aurora National Life Assurance Corporation, the new owner and successor of Executive Life ("Aurora"), such persons will receive full payments. Policyholders who chose to "opt-out" of the Plan (i.e., chose to terminate their policy and cash in at a discounted rate), will be paid in accordance with their choice to opt-out. ZERO COUPON NOTE LITIGATION In April 1989, an action was filed against the Company, MGI, MAXXAM Properties Inc. ("MPI") and certain of the Company's directors in the Court of Chancery of the State of Delaware, entitled Progressive United Corporation v. MAXXAM Inc., et al., Civil Action No. 10785. Plaintiff purports to bring this action as a stockholder of the Company derivatively on behalf of the Company and MPI. In May 1989, a second action containing substantially similar allegations was filed in the Court of Chancery of the State of Delaware, entitled Wolf v. Hurwitz, et al. (No. 10846) and the two cases were consolidated (collectively, the "Zero Coupon Note" actions). The Zero Coupon Note actions relate a Put and Call Agreement entered into between MPI and Mr. Charles Hurwitz (Chairman of the Board of the Company, MGI and MPI), as well as a predecessor agreement (the "Prior Agreement"). Among other things, the Put and Call Agreement provided that Mr. Hurwitz had the option (the "Call") to purchase from MPI certain notes (or the common stock of the Company into which they were converted) for $10.3 million. In July 1989, Mr. Hurwitz exercised the Call and acquired 990,400 shares of the Company's common stock. The Zero Coupon Note actions generally allege that in entering into the Prior Agreement Mr. Hurwitz usurped a corporate opportunity belonging to the Company, that the Put and Call Agreement constituted a waste of corporate assets of the Company and MPI, and that the defendant directors breached their fiduciary duties in connection with these matters. Plaintiffs seek to have the Put and Call Agreement declared null and void, among other remedies. RANCHO MIRAGE LITIGATION In May 1991, a derivative action entitled Progressive United Corporation v. MAXXAM Inc., et al. (No. 12111) ("Progressive United") was filed in the Court of Chancery, State of Delaware against the Company, Federated Development Company ("Federated"), MCO Properties Inc. ("MCOP"), a wholly-owned subsidiary of the Company, and the Company's Board of Directors. The action alleges abuse of control and breaches of fiduciary obligations based on, and unfair consideration for, the Company's Agreement in Principle with Federated to (a) forgive payments of principal and interest of approximately $32.2 million due from Federated under two loan agreements entered into between MCOP and Federated in 1987, and (b) grant an additional $11.0 million of consideration to Federated, in exchange for certain real estate assets valued at approximately $42.9 million in Rancho Mirage, California, held by Federated (the "Mirada transactions"). See Note 10 to the Consolidated Financial Statements for a description of the exchange to which this action and the actions referenced below relate. Plaintiff seeks to have the Agreement in Principle rescinded, an accounting under the loan agreements, repayment of any losses suffered by the Company or MCOP, costs and attorneys fees. The following six additional lawsuits similar to the Progressive United case were filed in Delaware Chancery Court challenging the now-completed Mirada transactions action has been: NL Industries, et al. v. MAXXAM Inc., et al. (No. 12353); Kahn, et al. v. Federated Development Company, et al. (No. 12373); Thistlethwaite, et al. v. MAXXAM Inc., et al. (No. 12377); Glinert, et al. v. Hurwitz, et al. (No. 12383); Friscia, et al. v. MAXXAM Inc., et al. (No. 12390); and Kassoway, et al. v MAXXAM Inc., et al. (No. 12404). The Kahn, Glinert, Friscia and Kassoway actions have been consolidated with the Progressive United action into In re MAXXAM Inc./Federated Development Shareholders Litigation (No. 12111); the NL Industries action has been "coordinated" with the consolidated actions; the Thistlethwaite action has been stayed pending the outcome of the consolidated actions. In January 1994, a derivative action entitled NL Industries, Inc., et al. v. Federated Development Company, et al. (No. 94-00630) was filed in the District Court of Dallas County, Texas, against the Company (as nominal defendant) and Federated. This action contains allegations and seeks relief similar to that contained in the In re MAXXAM Inc./Federated Development Shareholders Litigation. OTHER LITIGATION MATTERS The Company and certain of its subsidiaries are also involved in other claims and litigation, both as plaintiffs and defendants, in the ordinary course of business. Management is of the opinion that the outcome of such other litigation will not have a material adverse effect upon the Company's consolidated financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reference is made to this section in the portions of the Company's 1993 Annual Report to Stockholders (the "Annual Report") which are included as part of Exhibit 13.1 hereto and incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to this section in the portions of the Annual Report which are included as part of Exhibit 13.1 hereto and incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to this section in the portions of the Annual Report which are included as part of Exhibit 13.1 hereto and incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the consolidated financial statements and notes thereto and the quarterly financial information in the portions of the Annual Report which are included as part of Exhibit 13.1 hereto and incorporated herein by reference. ITEM 9. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Information required under Part III (Items 10, 11, 12 and 13) has been omitted from this report since the Company intends to file with the Securities and Exchange Commission, not later than 120 days after the close of its fiscal year, a definitive proxy statement pursuant to Regulation 14A which involves the election of directors. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8- K (A) INDEX TO FINANCIAL STATEMENTS All other schedules are inapplicable or the required information is included in the consolidated financial statements or the notes thereto. (B) REPORTS ON FORM 8-K None. (C) EXHIBITS Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 49), which index is incorporated herein by reference. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of MAXXAM Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in MAXXAM Inc.'s 1993 Annual Report to Stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 24, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index on page 36 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Houston, Texas February 24, 1994 SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET (UNCONSOLIDATED) STATEMENT OF OPERATIONS (UNCONSOLIDATED) STATEMENT OF CASH FLOWS (UNCONSOLIDATED) NOTES TO FINANCIAL STATEMENTS (IN MILLIONS OF DOLLARS, EXCEPT SHARE AMOUNTS) A. SIGNIFICANT TRANSACTIONS On August 4, 1993, contemporaneously with the consummation of the MAXXAM Group Inc. ("MGI," a wholly owned subsidiary of the Company) refinancing transaction (as described below), MGI (i) transferred to the Company 50 million common shares of Kaiser Aluminum Corporation ("Kaiser," a majority owned subsidiary of the Company) held by a subsidiary of MGI, representing MGI s (and the Company s) entire interest in Kaiser s common stock, (ii) transferred to the Company 60,075 shares of the Company's common stock held by a subsidiary of MGI, (iii) transferred to the Company certain notes receivable, long-term investments, and other assets, each net of related liabilities, collectively having a carrying value to MGI of approximately $1.1 and (iv) exchanged with the Company 2,132,950 Depositary Shares, acquired from Kaiser on June 30, 1993 for $15.0, such exchange being in satisfaction of a $15.0 promissory note evidencing a cash loan made by the Company to MGI in January 1993 (the "MGI Loan"). On the same day, the Company assumed approximately $17.5 of certain liabilities of MGI that were unrelated to MGI s forest products operations or were related to operations which have been disposed of by MGI. Contemporaneously with these transfers, MGI issued $100.0 aggregate principal amount of 11 1/4% Senior Secured Notes due 2003 (the "MGI Senior Notes") and $126.7 aggregate principal amount (approximately $70.0 net of original issue discount) of 12 1/4% Senior Secured Discount Notes due 2003 (the "MGI Discount Notes," which, together with the MGI Senior Notes, are referred to collectively as the "MGI Notes"). The MGI Notes are secured by MGI s pledge of 100% of the common stock of The Pacific Lumber Company, Britt Lumber Co., Inc. and MAXXAM Properties Inc. (wholly owned subsidiaries of MGI) and by the Company s pledge of 28 million shares of Kaiser s common stock it received from MGI. Additionally, on September 28, 1993, MGI transferred to the Company its interest in the real estate management and development operation located at Palmas del Mar in Puerto Rico. On October 13, 1993, Kaiser filed a registration statement with the Securities and Exchange Commission for the sale to the public of the 2,132,950 Depositary Shares the Company exchanged for the MGI Loan, as described above. The registration statement was declared effective by the Securities and Exchange Commission on November 15, 1993. The Company may consummate the sale of all or any portion of such Depositary Shares at any time. B. DEFERRED INCOME TAXES The Company's net deferred income tax assets relate primarily to the excess of the tax basis over financial statement basis with respect to timber and timberlands and real estate of subsidiaries. The Company has concluded that it is more likely than not that these net deferred income tax assets will be realized based in part upon the estimated values of the underlying assets which are in excess of their tax basis. C. LONG-TERM DEBT Long-term debt consists of the following: Maturities Scheduled maturities of long-term debt outstanding at December 31, 1993 are as follows: years ending December 31, 1994 - $4.1; 1995 - $4.1; 1996 - $3.6; 1997 - $3.3; 1998 - $3.3; thereafter - $36.1. D. NOTE PAYABLE TO SUBSIDIARY At December 31, 1993, the Company had a $181.9 unsecured note payable to a real estate subsidiary which bears interest at 6% per annum. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (CONSOLIDATED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Amounts for 1992 and 1991 are principally due to various reclassifications. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONSOLIDATED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Amounts for 1992 and 1991 are principally due to various reclassifications. SCHEDULE X - SUPPLEMENTARY CONSOLIDATED STATEMENT OF OPERATIONS INFORMATION SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MAXXAM INC. INDEX OF EXHIBITS

811553_1993.txt

811553_1993

1993

811553

ITEM 1. BUSINESS GENERAL Washington Bancorp, Inc. (the "Company"), a Delaware business corporation, is a bank holding company whose principal subsidiary is Washington Savings Bank (the "Bank"), a New Jersey-chartered capital stock savings bank, headquartered in Hoboken, New Jersey, whose deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"). The sole activity of the Company at this time is its ownership of all of the outstanding capital stock of the Bank. At December 31, 1993, the Company had unconsolidated total assets and stockholders' equity of $33.5 million. The Bank, organized in 1857, is headquartered in Hoboken, New Jersey. The Bank conducts its business through three full-service banking offices and a Loan Center in Hoboken, and five other full-service banking offices located in Guttenberg, Lyndhurst, Ridgefield Park, Wallington and Weehawken, New Jersey. At December 31, 1993, the Bank had total assets of $282.8 million, deposits of $247.0 million and stockholder's equity of $32.7 million. The Bank is principally engaged in the business of attracting deposits from the general public and investing those funds in adjustable-rate residential mortgage loans and investment securities. For information regarding the Bank's lending business, securities portfolio, results of operations, asset quality and financial condition, see Item 7 of this Annual Report on Form 10-K. On November 8, 1993, the Company and the Bank signed a definitive agreement (the "Agreement") providing for the merger of the Company with and into Hubco, Inc. ("Hubco") and, immediately following, the merger of the Bank with and into Hudson United Bank, both of Union City, New Jersey. Under the terms of the Agreement, shareholders of the Company will receive either $16.10 in cash or .6708 of a share of a new Series A Convertible Preferred Stock of Hubco for each share of the Company's common stock. In addition, the Company issued an option to Hubco, exercisable in certain circumstances, to acquire 765,000 shares of its authorized but unissued common stock at a price of $11.50 per share. The Agreement is subject to several conditions, including regulatory and shareholder approvals. COMPETITION The Bank faces significant competition both in originating mortgage, consumer and other loans and in attracting deposits. The Bank's competition for loans comes principally from savings and loan associations, savings banks, mortgage banking companies (many of which are subsidiaries of major commercial banks), insurance companies and other institutional lenders. Its most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks, credit unions and other financial institutions. Competition may increase as a result of the continuing reduction in the restrictions on the interstate operations of financial institutions. The Bank faces additional competition for deposits from short-term money market funds and other corporate and government securities funds. Many of the Bank's competitors, whether traditional financial institutions or otherwise, have much greater financial and marketing resources than those of the Bank. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers and their real estate brokers. The Bank competes for deposits through pricing, the offering of a variety of deposit accounts and by providing personal service. PERSONNEL As of December 31, 1993, the Bank had 108 employees, of whom 80 were full-time and 28 were part-time. The employees are not represented by a collective bargaining unit. REGULATION AND SUPERVISION GENERAL The Company owns all of the capital stock of the Bank and is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended ("BHCA"). As a bank holding company, the Company is subject to regulation by the Board of Governors of the Federal Reserve System ("FRB") under the BHCA. As a company whose stock is publicly-traded, the Company is also subject to the reporting, proxy solicitation, and other regulations of the Securities and Exchange Commission ("SEC"). The Bank is a New Jersey-chartered capital stock savings bank, the accounts of which are insured by the FDIC, and, as such, is subject to the regulation, supervision and examination of the New Jersey Department of Banking and the FDIC. NEW JERSEY LAW The New Jersey Department of Banking (the "Banking Department") regulates the Bank's internal organization as well as its deposit, lending and investment activities. The Banking Department must approve changes to the Bank's certificate of incorporation, the establishment or relocation of branch offices and mergers involving the Bank. In addition, the Banking Department conducts periodic examinations of the Bank. Many of the areas regulated by the Banking Department are subject to similar regulation by the FDIC. Recent federal and state legislative developments have reduced distinctions between commercial banks and savings banks in New Jersey with respect to lending and investment authority as well as interest rate limitations. As federal law has expanded the authority of federally-chartered savings institutions to engage in activities previously reserved for commercial banks, New Jersey legislation and regulations ("parity legislation") have given New Jersey-chartered savings banks, such as the Bank, the powers of federally-chartered savings institutions, including the authority to make ARM loans, consumer loans, second mortgage loans, mortgage checking advances and commercial loans. INSURANCE OF DEPOSITS The Bank's deposit accounts are insured by the FDIC up to a maximum of $100,000 per insured depositor. The FDIC issues regulations, conducts periodic examinations, requires the filing of reports and generally supervises the operations of its insured banks. This supervision and regulation is intended for the protection of depositors. Any insured bank which does not operate in accordance with or conform to FDIC regulations, policies and directives may be sanctioned for non-compliance. For example, proceedings may be instituted against any insured bank or any director, officer or employee of such bank who engages in unsafe and unsound practices, including the violation of applicable laws and regulations. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose. Federal banking legislation has substantially increased the deposit insurance premiums which depository institutions are required to pay. A system of risk-based premiums for Federal deposit insurance has been developed pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). See "FDICIA". FEDERAL REGULATION OF HOLDING COMPANIES The Company and its subsidiary are subject to examination, regulation and periodic reporting under the BHCA, as administered by the FRB. The Company is required to obtain the prior approval of the FRB in order to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior FRB approval is also required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than 5% of any voting shares of such bank or bank holding company. In addition to the approval of the FRB, before any bank acquisition can be completed, prior approval thereof may also be required from other agencies having supervisory jurisdiction over the bank to be acquired. In addition, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of any company engaged in, non-banking activities. One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the principal activities that the FRB has determined by regulation to be so closely related to banking are: (i) making or servicing loans; (ii) performing certain data processing services; (iii) providing discount brokerage services; (iv) acting as fiduciary or investment or financial advisor; (v) leasing personal or real property; and (vi) making investments in corporations or projects designed primarily to promote community welfare. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extension of credit to the bank holding company or any of its subsidiaries, on investments in the stock or other securities of such holding company or its subsidiaries, and on the acceptance of such stocks or securities as collateral for loans. Moreover, subsidiaries of bank holding companies are prohibited from engaging in certain tie-in arrangements (with the holding company or any of its subsidiaries) in connection with any extension of credit or lease or sale of property or furnishing of services. DIVIDEND RESTRICTIONS On January 18, 1994, the FRB rescinded a Memorandum of Understanding which had prevented the Company from paying dividends. During 1993, the FDIC and the Banking Department rescinded a Memorandum of Understanding which had imposed a similar restriction on the Bank. Dividends payable by the Bank to the Company and dividends payable by the Company to stockholders are subject to various limitations imposed by federal and state laws, regulations and policies adopted by federal and state regulatory agencies. The Bank is required by federal law to obtain FDIC approval for the payment of dividends if the total of all dividends declared by the Bank in any year exceed the total of the Bank's net profits (as defined) for that year and the retained net profits (as defined) for the preceding two years, less any required transfers to surplus. Under New Jersey law, the Bank may not pay dividends unless, following payment, the capital stock of the Bank would be unimpaired and (a) the Bank will have a surplus of not less than 50% of its capital stock, or, if not, (b) the payment of such dividends will not reduce the surplus of the Bank. If, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may require that such bank cease and desist from such practice or, as a result of an unrelated practice, require the bank to limit dividends in the future. The Federal Reserve Board has similar authority with respect to bank holding companies. In addition, the Federal Reserve Board and FDIC have issued policy statements which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. Regulatory pressures to reclassify and charge-off loans and to establish additional loan loss reserves can have the effect of reducing current operating earnings and thus impacting an institution's ability to pay dividends. Finally, as referred to below and in Item 7 of this Annual Report on Form 10-K, the regulatory authorities have established guidelines with respect to the maintenance of appropriate levels of capital by banks and bank holding companies under their jurisdiction. Compliance with the standards set forth in such policy statements and guidelines could limit the amount of dividends which the Bank may pay to the Company and the dividends which the Company may pay to stockholders. In addition, the Company must satisfy dividend restrictions imposed on all Delaware business corporations in order to be able to pay dividends to stockholders. See "FDICIA" for information regarding the impact of FDICIA upon the capacity to pay dividends. FDICIA FDICIA substantially revised the bank regulatory provisions of the Federal Deposit Insurance Act and several other federal banking statutes. Among other things, FDICIA requires federal banking agencies to broaden the scope of regulatory corrective action taken with respect to banks that do not meet minimum capital requirements and to take such actions promptly in order to minimize losses to the FDIC. Under FDICIA, federal banking agencies established five capital tiers: "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" or "critically undercapitalized". FDICIA imposes significant restrictions on the operations of a depository institution that is not in either of the first two of such categories. A depository institution's capital tier will depend upon the relationship of its capital to various capital measures. A depository institution will be deemed to be "well capitalized" if it significantly exceeds the minimum level required by regulation for each relevant capital measure, "adequately capitalized" if it meets each such measure, "undercapitalized" if it fails to meet any such measure, "significantly undercapitalized" if it is significantly below any such measure and "critically undercapitalized" if it fails to meet any critical capital level set forth in the regulations. An institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating or is deemed to be in an unsafe or unsound condition or to be engaging in unsafe or unsound practices. Under regulations adopted under these provisions, for an institution to be well capitalized it must have a total risk-based capital ratio of at least 10%, a Tier I risk-based capital ratio of at least 6% and a Tier I leverage ratio of at least 5% and not be subject to any specific capital order or directive. For an institution to be adequately capitalized it must have a total risk-based capital ratio of at least 8%, a Tier I risk-based capital ratio of at least 4% and a Tier I leverage ratio of at least 4% (or in some cases 3%). Under the regulations, an institution will be deemed to be undercapitalized if the bank has a total risk-based capital ratio that is less than 8%, a Tier I risk-based capital ratio that is less than 4%, or a Tier I leverage ratio of less than 4% (or in some cases 3%). An institution will be deemed to be significantly undercapitalized if the bank has a total risk-based capital ratio that is less than 6%, a Tier I risk-based capital ratio that is less than 3%, or a leverage ratio that is less than 3% and will be deemed to be critically undercapitalized if it has a ratio of tangible equity to total assets that is equal to or less than 2%. FDICIA generally prohibits an insured depository institution from making a capital distribution (including the payment of dividends) or paying management fees to any person that controls the institution if it thereafter would be undercapitalized. If an institution becomes undercapitalized, it will be generally restricted from borrowing from the Federal Reserve, increasing its average total assets, making any acquisitions, establishing any branches or engaging in any new line of business. An undercapitalized institution must submit an acceptable capital restoration plan to the appropriate federal banking agency, which plan must, in the opinion of such agency, be based on realistic assumptions and be "likely to succeed" in restoring the institution's capital. In connection with the approval of such a plan, the holding company of the institution must guarantee that the institution will comply with the plan, subject to a limitation of liability equal to a portion of the institution's assets. If an undercapitalized institution fails to submit an acceptable plan or fails to implement such a plan, it will be treated as if it is significantly uncapitalized. Under FDICIA, bank regulators are directed to require "significantly undercapitalized" institutions, among other things, to restrict business activities, raise capital through a sale of stock, merge with another institution and/or take any other action which the agency determines would better carry out the purposes of FDICIA. Within 90 days after an institution is determined to be "critically undercapitalized", the appropriate federal banking agency must, in most cases, appoint a receiver or conservator for the institution or take such other action as the agency determines would better achieve the purposes of FDICIA. In general, "critically undercapitalized" institutions will be prohibited from paying principal or interest on their subordinated debt and will be subject to other substantial restrictions. Under FDICIA, an institution that is not well capitalized is generally prohibited from accepting brokered deposits. Undercapitalized institutions are prohibited from offering interest rates on deposits significantly higher than prevailing rates. The provisions of FDICIA governing capital regulations became effective on December 19, 1992. FDICIA also directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, a maximum ratio of classified assets to capital, a minimum ratio of market value to book value for publicly traded shares (if feasible) and such other standards as the agency deems appropriate. FDICIA also contains a variety of other provisions that could affect the operations of the Company, including new reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions, the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch, limitations on credit exposure between banks, restrictions on loans to a bank's insiders and guidelines governing regulatory examinations. Pursuant to FDICIA, the FDIC has developed a risk-based assessment system, under which the assessment rate for an insured depository institution varies according to its level of risk. An institution's risk category will depend upon whether the institution is well capitalized, adequately capitalized or less than adequately capitalized and whether it is assigned to Subgroup A, B, or C. Subgroup A institutions are financially sound institutions with few minor weaknesses; Subgroup B institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration; and Subgroup C institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. Based on its capital and supervisory subgroups, each member institution will be assigned an annual FDIC assessment rate per $100 of insured deposits varying between 0.23% per annum (for well capitalized Subgroup A institutions) and 0.31% per annum (for undercapitalized Subgroup C institutions), although the FDIC may expand the difference between the maximum and minimum rates. Although it remains possible that insurance assessments could be further increased and/or that there may be a special additional assessment, based upon public statements by regulatory authorities regarding the insurance funds, the Company does not anticipate that there will be any material increase in assessments in the near future. A significant increase in the assessment could have an adverse impact on the Company's results of operations. FIRREA Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain condition indicating that a "default" is likely to occur in the absence of regulatory assistance. FIRREA and the Crime Control Act of 1990 expand the enforcement powers available to federal banking regulators, including providing greater flexibility to impose enforcement action, expanding the category of persons dealing with a bank who are subject to enforcement action, and increasing the potential civil and criminal penalties. In addition, in the event of a holding company insolvency, the Crime Control Act of 1990 affords a priority in respect of capital commitments made by the holding company on behalf of its subsidiary banks. FEDERAL HOME LOAN BANK SYSTEM The Bank is a member of the FHLB System, which consists of 12 regional Federal Home Loan Banks ("FHL Banks"), each subject to Federal Housing Finance Board ("FHFB") supervision and regulation. The FHL Banks provide a central credit facility for member insured institutions. As a member of the FHL Bank of New York, the Bank is required to own shares of capital stock in the FHL Bank of New York in an amount equal to the greater of (a) 1% of the aggregate principal amount of its unpaid home mortgage loans, home purchase contracts, and similar obligations, (b) 5% of advances (borrowings) from the FHL Bank or (c) 1% of 30% of total assets. The Bank is in compliance with this requirement with an investment in FHL Bank of New York stock at December 31, 1993 of $1.711 million. RESTRICTIONS ON THE ACQUISITION OF THE COMPANY Federal and state statutes require prior approval by or notice to the appropriate bank regulatory authority before any person would be permitted to acquire control of the Company or a specific percentage of its common stock. Under the BHCA, any company (other than an existing bank holding company) is required to obtain prior approval from the FRB before it may obtain control of the Company. Control generally is defined to mean (i) directly or indirectly owning, controlling or having the power to vote 25% or more of any class of voting securities of the Company, (ii) controlling the election of a majority of the Company's directors, or (iii) directly or indirectly exercising a controlling influence over the Company's management or policies. Prior FRB approval is required before an existing bank holding company can acquire more than 5% of the Company's Common Stock. Under the Federal Change in Bank Control Act ("CIBCA"), a prior written notice must be submitted to the FRB if any individual or other person, or group acting in concert, seeks to acquire 10% or more of the shares of the Company's outstanding Common Stock. Under the CIBCA, a proposed acquisition may be consummated unless the FRB disapproves of the acquisition within 60 days after a complete notice is filed or the FRB extends such 60 day period. New Jersey banking law provides that, except in certain emergency situations, no person shall, without the prior approval of the Commissioner, directly or indirectly obtain or exercise control of a capital stock savings bank or offer to acquire beneficial ownership or control of more than 5% of the then outstanding voting shares of a capital stock savings bank. Delaware law prohibits a Delaware corporation, such as the Company, from engaging in a "business combination" with an "interested stockholder" for 3 years following the date that a person becomes an interested stockholder. An interested stockholder is a person who owns 15% or more of the corporation's outstanding voting stock, or an affiliate or associate of the corporation who owned 15% in the previous 3 years, and his or her affiliates and associates. Stockholders who owned 15% prior to December 23, 1987, or who acquired their shares pursuant to a pre-existing tender or exchange offer, are not covered by the statute whether or not they acquire additional shares. The 3-year moratorium imposed on business combinations does not apply if: (1) prior to a person becoming an interested stockholder, the board of directors approves the business combination or the transaction which resulted in the person becoming an interested stockholder, or (2) the interested stockholder owns 85% of the corporation's voting stock upon consummation of the transaction which made him or her an interested stockholder (excluding from the 85% calculation shares owned by directors who are also officers and shares held by ESOPs or other employee stock plans which do not permit employees to decide confidentially whether to accept a tender offer), or (3) on or after the date a person becomes an interested stockholder, the board approves the business combination and it is also approved at a meeting by two-thirds of the voting stock not owned by the interested stockholder. EFFECT OF GOVERNMENTAL POLICIES The earnings of the Bank and, therefore, of the Company are affected not only by economic conditions, but also by the monetary and fiscal policies of the United States and its agencies (particularly the Federal Reserve Board) and other official agencies. The Federal Reserve Board can and does implement national monetary policy, such as the curbing of inflation and combating of recession, by its open market operation in United States Government securities, control of the discount rate applicable to borrowings and the establishment of reserve requirements against deposits and certain liabilities of depository institutions. The actions of the Federal Reserve Board influence the level of loans, investments and deposits and also affect interest rates charged on loans or paid on deposits. The nature and impact of future changes in monetary and fiscal policies are not predictable. From time to time, various proposals are made in the United States Congress and the New Jersey legislature and before various regulatory authorities which would alter the powers of different types of banking organizations or remove restrictions on such organizations and which would change the existing regulatory framework for bank, bank holding companies and other financial institutions. It is impossible to predict whether any of such proposals will be adopted and the impact, if any, of such adoption on the business of the Company. ITEM 2. ITEM 2. PROPERTIES The following table sets forth the location of the Bank's offices and other related information as of December 31, 1993. Year Expiration Lease Facility Date of Renewal Location Opened Owned Leased Lease Option -------- ----- ------ ----------- ------ Hoboken Main Office . . . . 1929 X -- -- -- 101 Washington Street Hoboken, NJ 07030 Hoboken . . . . . . . . . . 1973 X -- -- -- 609-611 Washington Street Hoboken, NJ 07030 Hoboken . . . . . . . . . . 1973 X -- -- -- 1018 Washington Street Hoboken, NJ 07030 Weehawken . . . . . . . . . 1974 X -- -- -- 4200 Park Avenue Weehawken, NJ 07087 Ridgefield Park . . . . . . 1974 X -- -- -- 240 Main Street Ridgefield Park, NJ 07660 Lyndhurst . . . . . . . . . 1974 -- X 2/98 -- 425 Valley Brook Avenue Lyndhurst Shopping Plaza Lyndhurst, NJ 07071 Guttenberg . . . . . . . . 1975 X -- -- -- 6812 Park Avenue Guttenberg, NJ 07093 Wallington . . . . . . . . 1977 -- X 3/97 -- 357 Paterson Avenue Wallington, NJ 07057 ITEM 3. ITEM 3. LEGAL PROCEEDINGS In October 1991, a complaint was filed by a former officer in New Jersey Superior Court against the Company, the Bank and certain directors and officers seeking unspecified damages relating to the termination of such officer's employment. The Company and individual defendants have filed an answer and have asserted certain counterclaims. Although this complaint was recently dismissed, it was dismissed without prejudice to the plaintiff's right to refile the complaint by March 31, 1994. In April 1992, a complaint was filed in the New Jersey Superior Court against the Company and the Bank seeking unspecified damages and alleging violations of state securities laws, certain banking laws and state common law. In February 1994, the plaintiffs amended their complaint to add claims against nine individual defendants, including current and former officers and directors of the Company and the Bank. This lawsuit is in the discovery stage. Management believes that the defendants have meritorious defenses in both of these actions and intends to vigorously defend these actions. Given the uncertainties involved in judicial proceedings and the preliminary stage of discovery in these matters, management cannot determine the precise amount of any potential loss that may arise in these matters. Accordingly, no provision for loss, if any, that may result upon resolution of these matters has been recorded in the Company's financial statements. The Bank is also subject to other legal proceedings involving collection matters, contract claims and miscellaneous items arising in the normal course of business. It is the opinion of management that the resolution of such legal proceedings will not have a material impact on the financial statements of the Company or the Bank. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS No matters were submitted to a vote of the stockholders during the fourth quarter of the year ended December 31, 1993. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT. The following table sets forth the names, ages and business experience of the Company's executive officers. Where dates are not given, the periods extend back until at least January 1, 1989. Positions Held and Business Experience for Name Age Past Five Years - ---- --- ------------------------------------------ Paul C. Rotondi...... 69 Chairman of the Board and Chief Executive Officer of the Company and the Bank. Theodore J. Doll..... 49 President and Chief Operating Officer of the Company and the Bank since December 26, 1989. Executive Vice President of the Company and the Bank from October through December 1989. Prior to October 1989, Mr. Doll had been retired. Ronald J. Pearce..... 46 Senior Vice President and Senior Lending Officer of the Bank since December 1989. Prior to December 1989, Vice President and Senior Mortgage Lending Officer of the Bank. Thomas S. Bingham.... 34 Secretary, Treasurer and Chief Financial Officer of the Company since April 1990. Senior Vice President and Treasurer of the Bank since December 1989. Prior to December 1989, Comptroller of the Bank. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Common Stock is traded over-the-counter on the Nasdaq National Market under the symbol: WBNC. The quarterly price range of Common Stock for the last two years is as follows: Closing sale price ------------------ High Low ---- --- 1992 1st Quarter . . . . . . . . . $ 5.00 $3.50 2nd Quarter . . . . . . . . . 5.75 4.00 3rd Quarter . . . . . . . . . 6.00 4.75 4th Quarter . . . . . . . . . 7.50 5.75 1993 1st Quarter . . . . . . . . . $ 8.25 $6.50 2nd Quarter . . . . . . . . . 8.00 6.25 3rd Quarter . . . . . . . . . 8.00 6.25 4th Quarter . . . . . . . . . 14.50 7.50 For information regarding the agreed upon sale price in the Agreement, see Item 1 of this Annual Report on Form 10-K. As of December 31, 1993, the number of shareholders of record was 759. DIVIDENDS DECLARED ON COMMON STOCK During 1993 and 1992, the Company was subject to a Memorandum of Understanding with the FRB which required FRB approval prior to the payment of any cash dividends. The Memorandum of Understanding was rescinded in January 1994. No dividends have been declared subsequent to that date. Due to the Agreement with Hubco, the Company does not anticipate declaring a dividend. For additional information regarding dividend restrictions, see Item 1 of this Annual Report on Form 10-K and Note 13 of the Notes to Consolidated Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the Consolidated Financial Statements of the Company and the accompanying Notes thereto, which are presented elsewhere herein. Year ended December 31, --------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (dollars in thousands, except per share data) Operating data: Interest income . . . . . . $ 18,557 $ 21,879 $ 27,594 $ 31,301 $ 33,142 Interest expense. . . . . . 8,812 12,190 19,119 22,543 23,730 -------- -------- -------- -------- -------- Net interest income . . . . 9,745 9,689 8,475 8,758 9,412 Provision for losses on loans. . . . . . . . . . . 420 1,100 1,500 2,350 6,927 -------- -------- -------- -------- -------- Net interest income after provision for losses on loans. . . . . . . . . . . 9,325 8,589 6,975 6,408 2,485 Other income. . . . . . . . 949 2,290 2,569 859 585 Other expenses. . . . . . . 8,768 8,694 9,306 10,674 7,959 -------- -------- -------- -------- -------- Income/(loss) before income taxes, extraordinary items and change in accounting principle. . . . . . . . . 1,506 2,185 238 (3,407) (4,889) Income tax expense/ (benefit) . . . . . . . . . (1,018) 628 552 (1,538) (989) -------- -------- -------- -------- -------- Income/(loss) before extraordinary items and change in accounting principle. . . . . . . . . 2,524 1,557 (314) (1,869) (3,900) Extraordinary items . . . . -- 539 (1,034) -- -- Change in accounting principle. . . . . . . . . 300 -- -- -- -- -------- -------- -------- -------- -------- Net income/(loss) . . . . . $ 2,824 $ 2,096 $ (1,348) $ (1,869) $ (3,900) ======== ======== ======== ======== ======== Per Share Data: Weighted average number of common shares outstanding (in thousands) . . . . . . 2,297 2,276 2,264 2,264 2,262 Dividends per share . . . . $ -- $ -- $ -- $ 0.07 $ 0.28 Income/(loss) per share: Income/(loss) before extraordinary item and cumulative effect of change in accounting principle. . . . . . . . . $ 1.10 $ 0.68 $ (0.14) $ (0.83) $ (1.72) Extraordinary items. . . . -- 0.24 (0.46) -- -- Cumulative effect of change in accounting principle. . .13 -- -- -- -- -------- -------- -------- -------- -------- Net income/(loss) per share . . . . . . . . . . $ 1.23 $ 0.92 $ (0.60) $ (0.83) $ (1.72) ======== ======== ======== ======== ======== Balance Sheet Summary: Investment and mortgage- backed securities. . . . . $ 92,264 $ 67,576 $ 56,455 $ 79,904 $ 57,677 Loans, net. . . . . . . . . 170,185 191,501 195,508 230,557 244,714 Total assets. . . . . . . . 282,635 285,771 293,727 337,626 351,281 Deposits. . . . . . . . . . 246,043 252,623 259,021 275,327 273,383 Advances from FHLB. . . . . 400 -- -- 28,500 40,500 Stockholders' equity. . . . 33,541 30,469 28,216 29,215 30,830 Performance Ratios: Return on average assets. . 0.99% 0.72% (0.42%) (0.54%) (1.08%) Return on average equity. . 8.98 7.21 (4.72) (6.16) (11.16) Dividend payout . . . . . . -- -- -- (8.43) (16.54) Average equity to average assets . . . . . . . . . . 11.04 10.03 8.91 8.78 9.70 Net interest margin . . . . 3.58 3.55 2.80 2.65 2.69 Asset Quality Ratios: Allowance for losses on loans to total loans, net. . . . . . . . . . . . 1.66% 1.45% 1.53% 1.12% 1.93% Allowance for losses on loans to nonperforming loans. . . . . . . . . . . 21.84 31.52 17.97 14.86 27.01 Allowance for losses on loans and REO to non- performing assets. . . . . 21.49 19.39 14.14 12.00 18.77 Non-performing loans to total loans, net. . . . . 7.61 4.60 8.51 7.52 7.14 Non-performing assets to total loans, net plus other real estate, net . . 11.30 10.66 14.03 11.83 9.96 Net charge-offs to average loans, net . . . . . . . . 0.19 0.66 0.47 1.89 2.07 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is an analysis of the financial condition and results of operations of the Company for the years ended December 31, 1993, 1992 and 1991 and should be read in conjunction with the Consolidated Financial Statements of the Company and accompanying Notes thereto, which are presented elsewhere herein. OVERVIEW During 1993, the Company and the Bank experienced the following: (A) The Bankruptcy Loan During the first quarter, a Chapter 11 bankruptcy petition was filed by the obligor of an approximately $9.0 million loan, a loan on which the Bank currently has a first mortgage and an assignment-of-rents (the "Bankruptcy Loan"). On November 10, 1993, the Court dismissed the bankruptcy petition. Nevertheless, the Bank did not receive any of the rental payments from April 1993 through November 1993, as the payments were made to a debtor-in-possession account and, pursuant to a Court Order, were released to the City of Philadelphia to pay a substantial portion of property tax arrearages. Rental payments were resumed to the Bank in December 1993. On January 29, 1994, the Bank paid approximately $450,000 to the City of Philadelphia to resolve all remaining property tax arrearages and to pay 1994 property taxes. The amount of such payment was capitalized into the Bankruptcy Loan balance. The interest income which would have been recorded had the rental payments been received and the actual income recorded approximated $580,000 and $295,000, respectively, for the year ended December 31, 1993. The Bank continues to classify the Bankruptcy Loan as a nonaccrual loan. Management believes that, based on an August 2, 1993 appraisal of $12.2 million, the Company has adequate collateral with respect to the Bankruptcy Loan and anticipates collection of the outstanding principal balance thereof. The Bank anticipates that the Bankruptcy Loan will be renegotiated during 1994. At December 31, 1993, there was no accrued interest receivable on the Company's financial statements for the Bankruptcy Loan and approximately $264,000 of the general reserve of the allowance for losses on loans was allocated for the Bankruptcy Loan. The Bankruptcy Loan is secured by an approximately 450,000 square foot building which is rented to the Internal Revenue Service (the "IRS") under a lease which is cancelable by the IRS upon 60 days' notice. The building is situated in northeast Philadelphia in a site with two other IRS facilities. The IRS announced in early December 1993 that this site will be converted into a customer service center with an approximate loss of 2,500 permanent and seasonal jobs. It has been reported in the press that the process of reducing the workforce at the northeast Philadelphia center will begin in 1996 and be completed in 1999. The effect, if any, of the conversion and reduction in workforce on the building securing this loan is unknown at this time. (B) Regulatory Restrictions Rescinded During the third quarter, the FDIC completed its examination of the Bank as of August 2, 1993. As a result of that examination, the FDIC and the Banking Department rescinded the Memorandum of Understanding which the Bank had signed on December 22, 1992 with the FDIC and the Banking Department in connection with their examination as of July 13, 1992. Subsequently, the FRB completed an off-site analysis of the Company. As a result of that analysis, in January 1994, the FRB rescinded the Memorandum of Understanding, which the Company had signed on August 13, 1991 with the FRB in connection with its examination as of December 31, 1990. (C) Prepayment During the fourth quarter, a first mortgage of $7.0 million and a revolving line of credit of $1.4 million to one borrower were prepaid (the "Prepaid Loan"). These performing loans, which had a weighted average yield of 9.8%, had collectively been the Bank's second largest loan concentration and had been one of two loan concentrations, the other being the Bankruptcy Loan, with a concentration greater than 10% of stockholders' equity. (D) Merger With Hubco, Inc. On November 8, 1993, the Company and the Bank signed a definitive agreement (the "Agreement") providing for the merger of the Company with and into Hubco, Inc. ("Hubco") and, immediately following, the merger of the Bank with and into Hudson United Bank, both of Union City, New Jersey. Under the terms of the Agreement, shareholders of the Company will receive either $16.10 in cash or .6708 of a share of new Series A Convertible Preferred Stock of Hubco for each share of the Company's common stock. In addition, the Company issued an option to Hubco, exercisable in certain circumstances, to acquire 765,000 shares of its authorized but unissued common stock at a price of $11.50 per share. The Agreement is subject to several conditions, including regulatory and shareholder approvals. Since significant conditions to effect the merger have not occurred, most merger costs are not included in the 1993 results of operations. NET INCOME Net income for the year ended December 31, 1993 was $2.8 million, or $1.23 per share, as compared with net income of $2.1 million, or $0.92 per share, for the year ended December 31, 1992. Income before extraordinary item and change in accounting principle for the year ended December 31, 1993 was $2.5 million, or $1.10 per share, as compared with income before extraordinary item and change in accounting principle of $1.6 million, or $.68 per share, for the year ended December 31, 1992. Included in 1993 net income is $300,000, or $0.13 per share, due to the cumulative effect of a change in accounting for income taxes. During 1992, an extraordinary credit in the amount of $539,000, or $.24 per share, was recorded to utilize net operating loss carryforwards. There were no extraordinary items in 1993. A comparison between the two most recent years' net income, and income before extraordinary items and cumulative effect of change in accounting principle, is significantly affected by income tax matters. In 1993, an income tax benefit of $1.0 million was recorded as a result of a $809,000 reduction in the deferred tax asset valuation allowance (to a zero balance) and an income tax refund of $747,000, offset by current taxes of approximately $538,000. In 1992, income tax expense of $628,000 was a result of current taxes. Excluding the above items, income before income taxes, extraordinary items, and cumulative effect of change in accounting principle decreased to $1.5 million for the year ended December 31, 1993 from $2.2 million for the year ended December 31, 1992. The decrease of approximately $700,000 was primarily the result of a decrease in net security gains of $1.6 million; an increase in REO expense (net) of $286,000; and a decrease in gains on sale of loans of $40,000. These items were partially offset by a decrease in the provision for losses on loans of $680,000; a decrease of $214,000 in occupancy and equipment expense; a $187,000 gain on sale of a bank building in 1993; interest income of $136,000 on the aforementioned income tax refund; and an increase in net interest income of $57,000. For a more detailed discussion of each such item, see "Results of Operations--1993 Compared to 1992." SECURITIES PORTFOLIO Two main objectives of the securities portfolio is to maintain a high standard of quality and liquidity. Quality is dictated by the investment policy which permits, but is not limited to, investment in Federal funds sold, U.S. Treasury securities, U.S. government agency securities, corporate bonds and notes with a minimum rating of AA, commercial paper, bankers acceptances and certain mortgage-backed securities. Except for the required investment in equity securities of the Federal Home Loan Bank of New York (the "FHLB"), investment in equity securities is not permitted by the investment policy. The liquidity objective is to maintain sufficient liquidity for deposit withdrawals, loan demand and operating expenses. During 1993, the Financial Accounting Standards Board (the "FASB") issued and the Company adopted Statement of Financial Accounting Standards No. 115: "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 requires entities to classify their securities into either a held-to-maturity, available-for-sale or trading category. Most of the Company's securities are classified as available-for-sale securities because such securities may be sold prior to maturity for various reasons, even though management currently does not intend to sell such securities. Available-for-sale securities are accounted for at fair value with fair value changes reported as a separate component of stockholders' equity, net of applicable taxes. The cumulative effect of the change in accounting principle as of the end of fiscal year 1993 was to increase the carrying value of securities by $286,000, decrease the net deferred tax asset by $100,000 and increase stockholders' equity by $186,000. Below are the combined carrying values of securities available-for-sale and held-to-maturity at year-end for the last three years: December 31, -------------------------- 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Short-term securities: Federal funds sold . . . . . $ 1,900 $ 3,000 $18,300 ------- ------- ------- Investment securities: U.S. Treasury. . . . . . . . 65,368 19,090 52,786 U.S. Government agencies . . 505 5,611 -- Corporate bonds and notes. . 4,139 24,841 -- Other securities . . . . . . 1,577 9,188 -- ------- ------- ------- Total investment securities 71,589 58,730 52,786 ------- ------- ------- Mortgage-backed securities. . 18,964 7,213 1,517 ------- ------- ------- Total securities portfolio. $92,453 $68,943 $72,603 ======= ======= ======= At December 31, 1993 and 1991, there were no securities to any one issuer (other than the Federal government) which exceeded 10% of stockholders' equity. At December 31, 1992, aggregate securities totalling $4.2 million with General Electric Corporation and $3.6 million with IBM Credit Corporation were the only securities to any one issuer (other than the Federal government) which exceeded 10% of stockholders' equity. Reference is made to footnote 3 of the Notes to Consolidated Financial Statements for information concerning market values, gross unrealized gains and losses, and weighted average yields of investment and mortgage-backed securities. Short-term securities Short-term securities are comprised solely of overnight Federal funds sold. Federal funds sold averaged $6 million, $12 million and $7 million in 1993, 1992 and 1991, respectively, while year end balances were $1.9 million, $3.0 million and $18.3 million, respectively. The average amount of Federal funds sold for 1992 was higher than comparable years because the Company had excess funds from the sale of U.S. Treasury securities which were invested in overnight Federal funds sold until certain callable securities were available. The large Federal funds position at year end 1991 was due to sales of performing loans during the last week of 1991. Investment securities Investment securities (including securities available for sale) were $71.6 million at December 31, 1993 as compared to $58.7 million at December 31, 1992, and averaged $54.3 million in 1993 as compared to $53.0 million in 1992. The 1993 year end balance is significantly higher than the comparable 1992 balance because funds from the Prepaid Loan were placed in investment securities. The 1993 average balance is only slightly more than the comparable 1992 average balance because the Prepaid Loan was prepaid in the fourth quarter of 1993. As of December 31, 1992, 75% of U.S. Government agencies and corporate bonds and notes had call dates at various times during 1993 and 1994. As anticipated, $18.8 million of such investment securities were called during 1993. In addition, there were $12.6 million of sales and $17.0 million of maturities. A portion of the proceeds from such calls, sales, and maturities were used to purchase $62.6 million of investment securities with a weighted average yield of 4.28% and a weighted average maturity of 3.1 years. The majority of the purchases were U.S. Treasury securities. At December 31, 1993, there were $5.6 million of securities with 1994 call dates. Mortgage-Backed Securities Mortgage-backed securities (including securities available for sale) were $19.0 million at December 31, 1993 as compared to $7.2 million at December 31, 1992, and averaged $18.9 million in 1993 as compared to $2.6 million in 1992. The increases in both the 1993 year-end balance and 1993 average balance were due to a change in investment strategy. Proceeds from loan payoffs and investment security maturities and calls were used to purchase mortgage-backed securities of $23.2 million during 1993. At the time of purchase, these securities had an estimated weighted average life of approximately 2.9 years and a weighted average yield to average life of 6.05%. However, due to declining interest rates during 1993, prepayments on the mortgage-backed securities portfolio occurred more rapidly than originally anticipated, resulting in increased premium amortization of $227,000 during 1993. The effect of increasing premium amortization was to decrease the weighted average yield on the mortgage-backed portfolio 120 basis points to 4.85% for 1993. LOANS; NONPERFORMING ASSETS; REO; AND ALLOWANCE FOR LOSSES ON LOANS AND REO Loans Total loans (including loans held for sale) were $174.0 million at December 31, 1993 as compared to $195.4 million at December 31, 1992, and averaged $189.2 million in 1993 as compared to $201.8 million in 1992. The primary reasons for the decrease in loans was the prepayment of the Prepaid Loan and the sale of $8.7 million of one-to-four family performing mortgage loans. As of December 31, 1993, there were approximately $4.9 million of loans classified as held for sale as compared to $9.0 million at December 31, 1992. The primary market area for lending encompasses Hudson and Bergen counties, New Jersey. Below are the year-end balances and percentages of year-end total loans, excluding loans held for sale, for the most recent five years: One-to-Four Family Mortgage Loans--Conventional mortgage loans collateralized by mortgages on one-to-four family residences are obtained primarily from existing customers, mortgage brokers, and referrals by real estate brokers and local attorneys. The Company offers fixed rate loans and adjustable rate mortgage ("ARM") loans, the interest rates on which adjust generally based on half-year, 1 year and 3 year Treasury indices. During 1993, the Company originated approximately $11.4 million of one-to-four family loans, sold or identified for sale $9.5 million, transferred to REO $1.5 million, incurred charge offs of $0.3 million and received principal payments of $16.8 million. Of the one-to-four family loans, 82.2% and 88.1% were ARM loans at December 31, 1993 and 1992, respectively. ARM loans generally have annual interest rate adjustment limitations of 1% to 2% and a lifetime interest rate adjustment limitation of 6%. These limitations, based on the initial rate, limit the interest rate sensitivity of such loans during a period of rapidly changing interest rates. The interest rate adjustments of ARM loans may increase the likelihood of refinances during periods of substantial declining interest rates and increase the likelihood of delinquencies during periods of substantial rising interest rates. Multi-family/Commercial Real Estate Loans--The mortgage loan portfolio includes mortgage loans collateralized by multi-family, mixed-use and commercial real property. The multi-family real property serving as collateral for these loans consists primarily of residential buildings with ten or fewer residential units, as well as buildings with four or fewer residential units where at least one of the units is used for commercial purposes. During 1993, the Company originated $11.6 million of multi-family/commercial real estate loans, transferred to REO $1.9 million, charged off $0.2 million and received principal payments of $8.3 million, the largest of which was the $7.0 million first mortgage relating to the Prepaid Loan. As of December 31 1993, there were seven commercial real property loans greater than $1 million, which loans approximated $20.2 million, or 37.5%, of the multi-family/commercial real estate portfolio. The largest of these loans is the Bankruptcy Loan. The remaining six loans are performing. Refer to the "Overview" section for a discussion of the Bankruptcy Loan. Certain of the multi-family/commercial mortgage loans are "balloon" loans, which are amortized over significantly longer periods than their term to maturity. These loans involve a greater risk to the Company because the principal amount may not be significantly reduced prior to maturity. Moreover, upon maturity, changes in the financial condition of the borrower may affect the ability of the borrower to repay the loan. At December 31, 1993 and 1992, the multi-family/commercial mortgage loan portfolio included $29.4 million and $17.9 million of "balloon" loans, comprising 54.6% and 34.0% of multi-family/commercial loans, and comprising 17.4% and 9.6% of total loans (excluding loans held for sale), respectively. Construction Loans--The Company has granted construction loans primarily for the purpose of rehabilitating multi-family/commercial dwellings. Such loans are generally one year, floating-rate loans. During 1993, the Bank originated $3.5 million of construction loans, transferred to REO $0.3 million and refinanced $2.4 million into first mortgages. The amount of undisbursed construction funds was $0.9 million as of December 31, 1993 and $0.2 million as of the prior year-end. Commercial/Financial Loans--At year end 1993, the commercial/financial loan portfolio consisted primarily of two revolving lines of credit to one borrower whose collective balance was $1.2 million. These lines of credit are used for real estate development and are collateralized by various properties with an aggregate loan-to-value ratio of less than than 50%. The Company has discontinued making commercial and financial loans except to honor existing revolving lines of credit to such borrower. During 1993, the Company honored $1.1 million of drawdowns against existing lines of credit to performing loan borrowers, transferred to REO $0.2 million, and received principal payments of $3.1 million, the largest of which was a $1.4 million line of credit prepayment relating to the Prepaid Loan. Consumer and Other Loans--The Company has granted both collateralized and uncollateralized personal loans, automobile loans, loans collateralized by deposit accounts, second mortgages on principal residences and second mortgages on investment residential properties. Such second mortgages represented $0.7 million, or 53.8%, of total consumer and other loans as of December 31, 1993, as compared to $1.1 million, or 64.5%, of total consumer and other loans as of December 31, 1992. Such second mortgages generally are limited to the difference between 75% of the appraised value of the property and the amount of other indebtedness collateralized thereby. Generally, the current terms of second mortgage loans have maturities of 1 or 3 years with a maximum 15-year amortization. Upon maturity, the Company will either demand repayment or renegotiate the loan. Also during 1993, a new home improvement loan product was offered to low and moderate income households and provided home improvement loans aggregating $106,000 to homeowners in Bergen County. During 1993, the Bank granted $0.4 million of consumer and other loans, transferred to REO $0.3 million, charged-off $0.1 million and received principal payments of $0.4 million. Nonperforming Assets Nonperforming assets are comprised of nonperforming loans (i.e., nonaccrual loans, loans past due over 90 days and still accruing, and troubled-debt restructurings) and REO. Reference is made to footnote 1 of the Notes to Consolidated Financial Statements for an explanation of the accounting policies regarding nonaccrual loans and REO. Troubled-debt restructurings represent loans (other than loans to individuals for household, family, and other expenditures; and real estate loans secured by one-to-four family residential properties) to borrowers who experienced repayment difficulties for which concessions were granted that provide for more preferential terms than the current market for new debt with similar risks. Interest on loans that have been restructured is recognized according to the new terms. Below are year-end balances of nonperforming assets and the ratio of nonperforming assets to total assets for the most recent five years: December 31, ------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (Dollars in thousands) Nonaccrual loans. . . . . . $12,798 $ 8,599 $16,022 $17,351 $17,474 Troubled-debt restructurings . . . . . . 152 207 612 -- -- Loans past due over 90 days and still accruing . . . . -- -- -- -- -- ------- ------- ------- ------- ------- Nonperforming loans. . . . 12,950 8,806 16,634 17,351 17,474 REO, net. . . . . . . . . . 7,078 12,998 12,563 11,294 7,674 ------- ------- ------- ------- ------- Nonperforming assets . . . $20,028 $21,804 $29,197 $28,645 $25,148 ======= ======= ======= ======= ======= Nonperforming assets to total assets . . . . . . . 7.1% 7.6% 9.9% 8.5% 7.2% === === === === === During 1993, nonperforming loans and nonaccrual loans increased 47.1% and 48.8%, respectively, primarily due to the addition of the Bankruptcy Loan to nonaccrual status. Excluding the Bankruptcy Loan, nonaccrual loans were $4.0 million as of December 31, 1993 as compared to $8.6 million as of December 31, 1992, a decrease of 53.5%. The decrease in nonperforming loans, excluding the Bankruptcy Loan, was primarily attributable to bringing current $2.9 million, transferring to REO $2.5 million, receiving repayments of $2.0 million and charging off $0.3 million, offset by additional nonperforming loans of $3.1 million. Refer to the "Overview" section for a discussion of the Bankruptcy Loan. With regards to the $152,000 troubled-debt restructured loan, the borrower has remained current with the restructured terms since the restructuring in 1991. At that time, the loan was $616,000; it has been reduced to $612,000 as of December 31, 1991 through payments. During 1992, the loan was partially charged-off in the amount of $285,000 based on data available to the Bank. That amount may be recovered in the future if the borrower continues to remain current, although no assurances can be given that such a recovery will occur. All other declines in the loan balance are attributable to repayment of principal. The Company did not recognize any income on this loan during 1993. Based upon the accounting policies as more fully described in Note 1 to the Consolidated Financial Statements, there are no loans past due more than 90 days and still accruing. Interest on nonperforming loans which would have been recorded based upon original contract terms would have approximated $826,000, $609,000, $975,000, $824,000 and $222,000 for the years 1993, 1992, 1991, 1990 and 1989, respectively. Interest income on those loans, which was recorded only when received, amounted to $223,000, $416,000, $548,000, $536,000 and $140,000 for the years 1993, 1992, 1991, 1990 and 1989, respectively. Other Real Estate Owned REO consists of real estate properties acquired through foreclosure or deed in lieu of foreclosure and "in-substance" foreclosures ("ISF"). ISF represent loans accounted for as foreclosed property even though the Bank does not have title to the property. (For an explanation as to why a loan is classified as an ISF, refer to footnote 1 of the Notes to Consolidated Financial Statements). When all other efforts to restructure a loan have failed to produce an equitable resolution of the delinquency, the often time-consuming foreclosure process is initiated. Foreclosure is the final step in the process of realizing some value on a seriously delinquent loan. Management would prefer not to have to foreclose but in order to protect its interest this action sometimes must be taken. For the most part, REO is geographically concentrated in New Jersey as described in the table below: Amount Percentage ------ ---------- (Dollars in thousands) Hudson County . . . . . . . . . . . . . . . . $4,704 66.4% Bergen County . . . . . . . . . . . . . . . . 804 11.4 Other Counties. . . . . . . . . . . . . . . . 1,570 22.2 ------ ----- Total REO . . . . . . . . . . . . . . . . . . $7,078 100.0% ====== ===== Such geographic concentration has enabled management to develop some expertise in ascertaining property market values and establishing contact with potential purchasers. Below is the activity in REO for the last three years: Management generally attempts to sell REO as quickly as possible, as is illustrated by the sales of REO as a percent of prior year balances. However, in most situations, the lengthy foreclosure process has hindered management from taking title to REO for at least two years. In certain other cases, management has decided to hold collateral until it is more marketable. In such instances, management may seek to enhance the value of such properties through various means, including capital improvements, tax appeals, and procurement of development approvals. Of the properties that were in REO as of December 31, 1992, 33 were still in REO as of December 31, 1993 and had a carrying value of $4.2 million as of year-end 1993. Of such 33 properties, the titles to 15 properties aggregating $1.6 million have still not been obtained, primarily due to the lengthy foreclosure process. The dollar distribution of REO properties, as of December 31, 1993, is as follows: The largest REO property is a six-story 128,000 square foot commercial use building located in Jersey City, New Jersey. The carrying value of $1.5 million at December 31, 1993 represented 21.1% of REO, net at December 31, 1993. For the year ended December 31, 1993, this property incurred carrying costs (net of rental income) of $101,000, while being approximately 70% rented. Allowance for Losses on Loans and Allowance for Losses on REO The following table presents, for the past five years, information demonstrating the relationship among the allowance for losses on loans, the provision for losses on loans, charge-offs, recoveries, and total and average loans outstanding. December 31, -------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (Dollars in thousands) Allowance, beginning of year . . . . . . . . . . . $ 2,776 $ 2,989 $ 2,579 $ 4,720 $ 3,782 -------- -------- -------- -------- -------- Loans charged-off: Real estate. . . . . . . . 524 932 719 1,525 2,503 Commercial . . . . . . . . 26 325 194 1,434 2,123 Consumer . . . . . . . . . 79 313 418 1,880 1,420 -------- -------- -------- -------- -------- Total loans charged-off . 629 1,570 1,331 4,839 6,046 -------- -------- -------- -------- -------- Recoveries on loans: Real estate. . . . . . . . 124 97 32 105 1 Commercial . . . . . . . . 81 67 165 77 6 Consumer . . . . . . . . . 56 93 44 166 51 -------- -------- -------- -------- -------- Total recoveries. . . . . 261 257 241 348 58 -------- -------- -------- -------- -------- Net loans charged-off . . . 368 1,313 1,090 4,491 5,988 -------- -------- -------- -------- -------- Provision for losses on loans. . . . . . . . . . . 420 1,100 1,500 2,350 6,926 -------- -------- -------- -------- -------- Allowance, end of year. . . $ 2,828 $ 2,776 $ 2,989 $ 2,579 $ 4,720 ======== ======== ======== ======== ======== Total loans outstanding . . $169,098 $186,417 $199,779 $234,931 $251,347 ======== ======== ======== ======== ======== Average loans outstanding during the year. . . . . . $189,233 $201,829 $236,267 $240,008 $294,046 ======== ======== ======== ======== ======== Net loans charged-off as a percent of average loans outstanding. . . . . . . . 0.19% 0.65% 0.46% 1.87% 2.04% ====== ====== ====== ====== ====== Allowance for losses on loans as a percent of: total loans outstanding . 1.67% 1.49% 1.50% 1.10% 1.88% ====== ====== ====== ====== ====== total nonperforming loans outstanding. . . . . . . 21.84% 31.52% 17.97% 14.86% 27.01% ====== ====== ====== ====== ====== The 62% reduction in the provision for losses on loans for 1993 reflects a 53% decrease in nonaccrual loans (excluding the Bankruptcy Loan, the principal of which is perceived by management to be adequately collateralized) to $4.0 million; a 6.2% reduction in average loan balances, of which one was the Prepaid Loan; and a decrease in the ratio of net loans charged-off as a percentage of average loans outstanding to 0.19% in 1993 from 0.65% in 1992. Asset quality and adequacy of the allowance for losses is monitored on a periodic basis. Additions to the allowance for losses on loans are made through charges against earnings (the provision for losses on loans) and recoveries on previously charged-off loans; the allowance is reduced when loans are determined to be uncollectible and are charged-off. In establishing the amount of the allowance (and hence the amount of the provision) for losses on loans, management establishes percentage allocations with respect to the performing loan portfolio and classified loans. In addition, specific allocations are made for classified loans. In determining percentage allocations for the performing loan portfolio and classified loans, management considers prevailing and anticipated economic conditions, past and anticipated loss experience, the diversification and size of the portfolio, off-balance sheet risks, and the nature and level of nonperforming assets. In analyzing classified loans, management considers the financial status and credit history of the borrower, the value of collateral, the sufficiency of loan documentation, analyses of bank regulators, and other factors considered relevant by management on a loan-by-loan basis. The entire allowance for losses on loans is available to absorb potential losses from all loans. At the same time, the allowance may be allocated to specific loans or loan categories. For purposes of complying with Securities and Exchange Commission disclosure requirements, the table below presents an allocation of the entire allowance for losses on loans for the past five years. The allocation of the allowance for losses on loans should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the implied proportions. See the table at the beginning of "Loans; Nonperforming Assets; REO; and Allowance for Losses on Loans and REO" for information regarding loans outstanding in each loan category. December 31, ------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (Dollars in thousands) Real estate: 1-4 family . . . . . . . . . . . . $1,485 $1,313 $ 953 $1,081 $ 905 Multifamily/commercial . . . . . . 1,287 1,286 1,324 665 1,334 Construction . . . . . . . . . . . 17 11 4 5 35 ------ ------ ------ ------ ------ Total allowance for losses on real estate loans . . . . . . . 2,789 2,610 2,281 1,751 2,274 Commercial/financial. . . . . . . . 21 110 458 447 1,219 Consumer and other loans. . . . . . 18 56 250 381 1,227 ------ ------ ------ ------ ------ Total allowance for losses on loans. . . . . . . . . . . . . . $2,828 $2,776 $2,989 $2,579 $4,720 ====== ====== ====== ====== ====== The following table presents, for the past five years, information demonstrating the relationship among the allowance for losses on REO, the provision for losses on REO, charge-offs on REO sold, and total and average REO outstanding: The allowance for losses on REO is established through charges to operations in the form of a provision for losses on REO that is reflected (along with real estate taxes, repairs and maintenance, and insurance, net of rental income and net gains on sales of REO) in the expense caption--"REO expense, net." Factors considered in establishing the allowance for losses on REO include appraisals of the fair market value of each property and/or management's assessment of the overall real estate market for that type of property in its condition and location. The 1993 provision for losses on REO increased over the 1992 provision for losses on REO primarily due to reducing the carrying value on the Bank's largest REO property by $100,000 in 1993. The provision for losses on REO as a percent of average REO outstanding increased to 9.58% from 6.01% due to the sale of a $3.2 million parcel of REO in early 1993. The average balance of REO in 1992 included the $3.2 million and thus lowered the provision for losses as a percent of average REO outstanding. There was no allowance established against the $3.2 million loan. The allowance for losses on REO as a percent of total REO outstanding increased to 20.99% in 1993 from 12.18% in 1992 partly due to the aforementioned sale of a $3.2 million parcel of REO, as well as accumulated provisions against the 33 properties aggregating $4.2 million which were included in REO as of December 31, 1993 and 1992. In total, during 1993, the provision for losses on loans and REO approximated $1.4 million, of which $420,000 was a provision for losses on loans and $1.0 million was a reduction in the carrying value of REO. The allowances for losses on loans and REO represented 36% of gross non-performing assets (excluding the Bankruptcy Loan) at December 31, 1993 as compared to 21% at December 31, 1992, and represented 21% of gross non-performing assets (including the Bankruptcy Loan) at December 31, 1993 and 1992. DEPOSITS AND FHLB ADVANCES The Company offers a broad line of deposit accounts, including, but not limited to, savings accounts, certificates of deposit ("CDs"), interest and non-interest bearing checking accounts, individual retirement accounts, holiday club accounts, business checking accounts and low-cost checking accounts. The low-cost checking accounts are offered in connection with the New Jersey Consumer Checking Account Law which recognizes the need to offer low cost checking accounts to all people. Company policy does not permit funding by brokered certificates of deposit. During 1993, the Company continued to reduce rates on its deposit base, reflecting market conditions. The rates on passbook savings decreased 75 basis points to 2.50% at December 31, 1993 from 3.25% at December 31, 1992, a decrease of 23%. The weighted average cost of funds for CDs at December 31, 1993 was 3.98%, as compared to 5.01% at December 31, 1992. As a result of the lower yields on interest-bearing deposits, net withdrawals of CDs were $10.7 million and total interest-bearing deposits decreased $7.2 million during 1993. The average balance of CDs decreased from $142.1 million in 1992 to $127.2 million in 1993, while the average balance of regular savings increased from $95.3 million in 1992 to $102.1 million in 1993. The migration into regular savings accounts improved net interest income since, on average, the rates on regular savings accounts were 141 basis points less than the rates on CDs. A maturity distribution of the Company's CDs of $100,000 and over at December 31, 1993 is presented in the following table: December 31, 1993 --------------------------- Average effective interest rate Amount ------------- ------------ Market-rate certificates $100,000 and over maturing: Three months or less . . . . . . . . . . . . . . 4.02% $2,754,760 Three months to six months . . . . . . . . . . . 3.32 1,710,739 Six months to one year . . . . . . . . . . . . . 4.12 1,819,949 One to two years . . . . . . . . . . . . . . . . 4.51 527,622 Two to three years . . . . . . . . . . . . . . . 4.99 701,366 Three to five years. . . . . . . . . . . . . . . 5.05 1,113,268 ---- ---------- Total certificates of deposit $100,000 and over. 4.14% $8,627,704 ==== ========== The Company borrowed $400,000 in long term advances from the FHLB through its Community Investment Program at a below-market interest rate of 4.88% during 1993. The funds were used to originate a below-market interest rate loan to a borrower that provides training and job placement assistance for vocationally handicapped and economically disadvantaged individuals. RESULTS OF OPERATIONS--1993 COMPARED TO 1992 Net Interest Income The Company is principally engaged in the business of attracting deposits from the general public and investing those funds in adjustable-rate mortgage loans and investment securities. Accordingly, net interest income (the difference between the income from interest-earning assets, such as loans and investments, and the cost of interest-bearing liabilities, such as deposit accounts and borrowed funds) remains a significant element in earnings. The Yield/Cost Analysis sets forth, for the three years ended December 31, 1993, (i) average assets, liabilities and stockholders' equity, (ii) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (iii) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (iv) the interest rate spread (i.e., the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities), (v) the net yield on interest-earning assets (i.e., net interest income as a percentage of average interest-earning assets), and (vi) the ratio of average interest-earning assets to average interest-bearing liabilities. Yields and costs are derived by dividing the interest income and interest expense by the average balance of interest-earning assets and interest-bearing liabilities, respectively, for the years shown. As a result, the effect of including nonperforming loans in the average balances of loans outstanding is to reduce the average yield earned on loans. Changes in net interest income are a result of the relative volume of interest-earning assets and interest-bearing liabilities and the rates earned and paid on them, respectively. Net interest income can also be analyzed in terms of the impact of changing rates and changing volumes. The Bank's Rate/Volume Analysis reflects the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Bank's interest income and interest expense during the periods indicated. Changes attributable to both volume and rate have been allocated proportionately. Rate/Volume Analysis Net interest income increased $57,000, or 0.60%, to $9.7 million in 1993. During 1993, net interest-earning assets increased (primarily due to a reduction in REO), yields of interest-bearing liabilities declined more rapidly than yields of interest-earning assets, and higher costing CDs migrated into lower costing passbook savings accounts. These factors were largely offset by $580,000 of foregone interest from the Bankruptcy Loan. During 1993, the interest rate spread increased slightly to 3.18% from 3.11% in 1992. Total interest income decreased $3.3 million, or 15.2%, during 1993, primarily due to $580,000 of foregone interest from the Bankruptcy Loan, lower yields earned on substantially all interest-earning asset categories, and a change in the mix of interest-earning assets. Average yields on the Company's two largest interest-earning assets, the mortgage loan and investment portfolios, declined 118 basis points during 1993. Such declines reflect declining market interest rates and the foregone interest on the Bankruptcy Loan. In addition, the mix of interest-earning assets negatively impacted interest income, as higher yielding assets, such as mortgage loans which earned 7.79% on average in 1993, were sold and reinvested in lower yielding assets, such as mortgage-backed securities which yielded 4.85%. The average balance of mortgage-backed securities increased from $2.6 million in 1992 to $18.9 million in 1993, while the average balances of mortgages loans and commercial and consumer loans decreased from $195.6 million and $6.3 million, respectively, in 1992 to $185.0 million and $4.2 million, respectively, in 1993. The average balance of mortgage-backed securities increased due to purchases which were funded by calls and maturities of investment securities and loan payoffs. The average balance of mortgage loans decreased due to sales of one-to-four family performing mortgage loans and the prepayment of the first mortgage portion of the Prepaid Loan. The decrease in the average balance of commercial and consumer loans reflects the prepayment of the line of credit portion of the Prepaid Loan and other prepayments. Total interest expense decreased $3.4 million, or 27.7%, in 1993 due to lower rates paid on most interest-bearing liabilities, a lower average balance of interest-bearing liabilities and a change in the liability mix. Lower rates paid were a result of the declining rate environment. On average, interest rates paid on CDs and regular savings accounts declined 130 basis points and 103 basis points, respectively. The average balance of interest-bearing liabilities decreased $7.7 million, primarily due to a decrease in the average balance of CDs of $14.9 million partially offset by an increase of $6.8 million in the average balance of regular savings accounts. Such liability mix change decreased interest expense since, on average, regular savings accounts cost 141 basis points less than CDs. Provision for Losses on Loans (Reference is made to "Loans; Nonperforming Assets; REO and Allowance for Losses on Loans and Allowance for Losses on REO" and to footnotes 1 and 4 of the Notes to Consolidated Financial Statements). A provision for losses on loans of $420,000 was recorded in 1993 as compared to $1.1 million in 1992, a decline of 62%. Such lower amount of a provision for losses on loans in 1993 versus 1992 reflects a decrease of 53% in nonaccrual loans (excluding the Bankruptcy Loan, the principal of which is perceived by management to be adequately collateralized) to $4.0 million; a 6.2% reduction in net average loan balances, of which one was the Prepaid Loan; and a decrease in the ratio of net loans charged-off as a percentage of average loans outstanding to 0.19% in 1993 from 0.65% in 1992. There can be no assurance that the decreasing provision trend over the last five years will continue into the future. Other Income Total other (i.e. non-interest) income decreased $1.3 million, or 58.6%, during 1993 primarily due to a decrease in gains on sales of securities of $1.6 million, partially offset by a gain on sale of a bank building of $187,000 and interest income of $136,000 on an income tax refund. The decline in gains on sale of securities was due to a decrease in sales volume of $59.6 million, to $14.6 million in 1993 versus $74.2 million in 1992. Other Expenses Total other (i.e. non-interest) expenses increased $74,000, or 0.86%, for 1993 versus 1992. The increase was due to an increase of $286,000, or 24.4%, in REO expense (net) as described in the following table and an increase of $93,000, or 15.7%, in FDIC expense due to an increase in the assessment rate. Offsetting such increases were a decrease of $213,000, or 21.1%, in occupancy expense, due primarily to recognizing costs for a branch closing which took place during 1992; a decrease of $52,000, or 1.5%, in salaries and employee benefits due to reductions in the number of employees and some employee benefits; and a decrease of $40,000, or 1.7%, in other expenses. The components of REO expense, net are as follows: Year ended December 31, ------------------------ 1993 1992 ----- ----- (Dollars in thousands) REO expense, net: Provision for losses . . . . . . $1,024 $ 852 Carrying costs, net of rental income . 737 721 Gain on sale, net. . . . . . . . . . . (304) (401) ------ ------ Total REO expense, net . . . . . . . $1,457 $1,172 ====== ====== The increase in the provision for losses on REO was primarily due to recognizing market value writedowns of $100,000 on the Bank's largest REO property in 1993. Income Tax Expense On January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109: "Accounting for Income Taxes" ("SFAS 109"), which resulted in a change in accounting principle and a cumulative benefit of $300,000, or $.13 per share. SFAS 109 requires an asset and liability approach, the objective of which is to establish deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. During 1993, an income tax benefit of $1.0 million was recorded, reflecting an income tax refund of $747,000, a deferred tax adjustment of $809,000 in order to reduce the valuation allowance since the time of adopting SFAS 109, and a tax provision of $538,000. Excluding the income tax refund and the deferred tax adjustment, the effective tax rate was 35.7% for 1993. In 1992, income tax expense was $628,000, which was partially offset by the utilization of $539,000 of the 1991 net operating loss carryforward. The effective tax rate in 1992 was 28.7%. RESULTS OF OPERATIONS--1992 COMPARED TO 1991 General During 1992, the Company reported a profit for the first time in five years, reporting net income of $2.1 million as compared to a net loss of $1.3 million in 1991. Results from core business operations were $500,000 (net of tax and extraordinary item), while gains from the sale of securities were $1.6 million (net of tax and extraordinary item). Much of the improvement in operations resulted from an increase in net interest income. A substantial part of the improvement in net interest income stemmed from an increase in the interest rate spread caused by the downward spiral of interest rates and the reduction in the cost of funds resulting from the prepayment of FHLB advances at the conclusion of 1991. The gain from the sales of securities was also a direct reflection of the downward spiral of interest rates, since the market value of such assets move in the opposite direction of interest rates. Net interest income Net interest income increased $1.2 million, or 14.3%, to $9.7 million in 1992. The increase from 1991 was partially due to an improvement in the interest rate spread as the cost of "borrowing" funds from depositors declined more rapidly than the decline in interest rates earned on loans to mortgage customers and partially due to a decrease in the average balance of nonperforming assets from December 31, 1991 to December 31, 1992. As a result, the interest rate spread and net yield on interest-earning assets increased from 2.29% and 2.80%, respectively, in 1991 to 3.11% and 3.55%, respectively, in 1992. Total interest income decreased $5.7 million, or 20.7%, during 1992 due to a reduction in the volume of most interest-earning assets, lower yields earned on substantially all interest-earning asset categories, and a change in the mix of interest-earning assets. The average balance of mortgage-backed securities, mortgage loans, and commercial and consumer loans decreased from $10.4 million, $227.1 million and $9.1 million, respectively, in 1991 to $2.6 million, $195.6 million and $6.3 million, respectively, in 1992. The average balance of mortgage-backed securities decreased due to liquidating the portfolio at the end of 1991; the average balance of mortgage loans decreased due to sales of one to four family performing mortgage loans during the fourth quarter of 1991 and during 1992; and the decrease in the average balance of commercial and consumer loans reflects the fact that the Bank has virtually discontinued originating commercial and consumer loans since 1988. Average yields on the two largest earning assets, the mortgage loan and investment portfolios, declined 62 and 178 basis points, respectively, during 1992. Such declines reflected declining market interest rates. In addition, the mix of interest-earning assets negatively impacted interest income as the higher yielding assets mentioned above (mortgage loans earning 8.97%, commercial and consumer loans earning 7.87%, and mortgage-backed securities earning 7.41%) were sold in 1991 and reinvested in lower yielding assets, such as investment securities yielding 5.76% and federal funds sold yielding 3.07%. Total interest expense decreased $6.9 million, or 36.2%, in 1992 due to lower rates paid on all interest-bearing liabilities, a lower average balance of interest-bearing liabilities and a change in the liability mix. Lower rates paid were a result of the declining rate environment. On average, interest rates paid on CDs and regular savings accounts declined 174 basis points and 147 basis points, respectively. The average balance of interest-bearing liabilities decreased $31.4 million partially due to repayments of FHLB and ESOP borrowings during 1991, which lowered the average balance $23.6 million, and secondarily, to net withdrawals of $6.7 million in other interest-bearing deposits. The total decrease in the average balance of CDs of $22.6 million was partially offset by a $15.0 million increase in the average balance of regular savings accounts, from $80.3 million in 1991 to $95.3 million in 1992. The liability mix change continued a trend that began in 1991 whereby CD withdrawals are "temporarily" placed in regular savings accounts. Such liability mix change decreased interest expense since the cost of regular savings accounts during 1992 was 10 basis points and 30 basis points less on average than a six-month and one year CD, respectively. Provision for Losses on Loans A provision for losses on loans of $1.1 million was recorded in 1992 as compared to $1.5 million in 1991, a decline of 27%. Such lower amount of a provision for losses on loans in 1992 versus 1991 reflected a decrease of $6.8 million, or 34%, in the average balance of nonaccrual loans to $13.4 million in 1992 as compared to $20.2 million in 1991. Although the 1992 provision represented an improvement over the provision for the four preceding years, the absolute dollar amount of the provision, especially when coupled with net REO expenses, continued to act as a limitation on profitability. Other Income Total other (i.e. non-interest) income decreased $279,000, or 10.9%, during 1992 due to a decrease in gains on sales of one-to-four family performing mortgage loans of $1.1 million, offset by an increase in net gains on security sales of $781,000. The lower gains on sales of one-to-four family performing mortgage loans was due to a decrease in sales volume of $24.8 million, or 61.5%, to $15.5 million in 1992 versus $40.3 million in 1991. Other Expenses Total other (i.e. non-interest) expenses decreased $612,000, or 6.6%, for 1992 versus 1991. Contributing to the improvement in other expenses were a decrease of $764,000, or 39.5%, in REO expense (net); and a $405,000, or 10.3%, decrease in salaries and employee benefits due to lower deferred compensation expense as a result of the fully funded ESOP, a decrease of 9% in full-time equivalent employees and lower costs for some employee benefit plans. Offsetting such improvements were increases in other expenses of $397,000, or 19.9%, due primarily to legal matters, consulting fees, and miscellaneous other operating expenses, and occupancy expense (net) of $141,000, or 16.2%, due primarily to recognizing costs for a branch closing which took place during the third quarter of 1992. Income Tax Expense During 1992, income tax expense of $628,000 was recorded which reflects an effective tax rate of 28.7%. The effective tax rate differed from the statutory Federal income tax rate of 34% due to a greater bad debts deduction for tax purposes than for financial reporting purposes. Partially offsetting income tax expense was the utilization of $539,000 of the 1991 net operating loss carryforward. Total income tax expense during 1991 was $552,000, primarily due to writing-off the net deferred tax asset as a result of the tax loss carryforward position. ASSET AND LIABILITY MANAGEMENT The principal objectives of asset and liability management are to manage exposure to changes in the interest rate environment, maintain adequate liquidity and sustain a strong capital base. Asset and liability management is directed by the Bank's Operations Committee, whose members consist of certain members of the Board of Directors and senior management. The Asset and Liability Committee ("ALCO"), comprised of certain key officers, is a subcommittee of the Operations Committee that makes recommendations to the Operations Committee regarding the objectives described above. Interest Rate Sensitivity One of the tools that ALCO utilizes to manage exposure to changes in the interest rate environment is a static GAP analysis, which is a general indicator of the potential future effect that changing rates may have on net interest income. A static GAP analysis demonstrates, as of a particular date, the extent to which assets and liabilities will mature or reprice within a specific time frame. A financial institution is considered asset sensitive within a particular time frame if maturing and repricing assets exceed maturing and repricing liabilities during such time frame. Likewise, a financial institution is considered liability sensitive within a particular time frame if maturing and repricing liabilities exceed maturing and repricing assets during such time frame. In general, asset sensitive positions will maximize net interest income during periods of increasing interest rates and liability sensitive positions will maximize net interest income during periods of declining interest rates. A static GAP analysis is not a complete picture of the impact of interest rate changes on net interest income. First, changes in the general level of interest rates will not affect all categories of assets and liabilities in the same manner or at the same time. Second, a static GAP analysis represents a one-day position; variations actually occur on a daily basis as financial institutions adjust their interest sensitivity throughout the year. Third, assumptions must be made regarding the manner in which specific assets and liabilities will reprice. A goal of the current operating strategy is to have interest-bearing liabilities maturing and repricing within one year exceed interest-earning assets maturing and repricing within that period. The static cumulative one-year GAP position was a negative $34.9 million, or 12.3%, at December 31, 1993. The following Interest Sensitivity Static GAP Analysis presents the consolidated interest rate sensitivity position at December 31, 1993. LIQUIDITY Liquidity is the ability to meet current cash needs in order to fund loans and deposit withdrawals, make debt payments, and cover operating expenses. The primary sources of funds are deposits, amortization, prepayments and sales of loans, maturities of investment securities, and amortization and prepayments of mortgage-backed securities. While scheduled loan payments and maturing investment securities represent a relatively predictable source of funds, deposit flows and loan and mortgage-backed securities prepayments are greatly influenced by the general interest rate climate, economic conditions, and competition. The FDIC defines a bank's liquidity ratio as the sum of net cash, short-term investments and marketable securities divided by the sum of net deposits and short-term liabilities. The Bank's liquidity ratio at December 31, 1993 and 1992, as calculated according to FDIC guidelines, was 38.8% and 28.8%, respectively. The amount of assets used in the liquidity ratio calculation was $96.4 million and $73.4 million as of December 31, 1993 and 1992, respectively. The increase in the liquidity ratio is due to loan prepayments, especially the Prepaid Loan, and sales of REO. In addition to the liquidity ratio, liquidity can also be described in terms of cash and cash equivalents. Cash and cash equivalents, which are cash on hand, amounts due from banks and Federal funds sold (generally due within one-week periods), declined $1.2 million during 1993. During 1993, operating activities provided $4.3 million and investment activities provided $829,000 in cash flow while financing activities used $6.3 million. The $4.3 million of cash provided by operating activities was primarily the result of interest income earned on loans, and an income tax refund received and interest thereon; these items were offset by interest paid on deposits, cash paid to employees and for other expenses, and loans originated for resale. The $6.3 million used in financing activities primarily funded net deposit outflows. As of December 31, 1993 and 1992, the Company held $1.0 million of cash and cash equivalents at the holding company level. Management does not regard the amount of such cash and cash equivalents to be significant from a liquidity perspective except in terms of a potential source of future contributions to the Bank. A line of credit in the amount of $14.3 million with the FHLB is also available to meet liquidity purposes. Such line of credit, none of which was in use at December 31, 1993, must be renewed annually. CAPITAL RESOURCES Under banking policies issued by the FRB and the FDIC, an adequate level of regulatory capital sufficient to meet minimum leverage, core and total risk-based capital ratios must be maintained. The minimum leverage capital ratio is calculated by dividing core capital by average total assets of the most recent quarter-end. The risk-based capital ratios require assets and certain off-balance-sheet activities to be classified into categories, and specified levels of capital to be maintained for each category. The least capital is required for the category deemed to have the least risk, and the most capital is required for the category deemed to have the greatest risk. For purposes of leverage and risk-based capital guidelines, core capital (also known as Tier I capital) consists of common equity in accordance with generally accepted accounting principles ("GAAP"), excluding net unrealized gains or losses on available-for-sale securities and deferred tax assets that are dependent on projected taxable income greater than one year in the future, and total capital consists of core capital plus a portion of the allowance for losses on loans. The qualifying portion of the allowance for losses on loans approximated $1.8 million as of December 31, 1993 and $2.3 million as of December 31, 1992. As of December 31, 1993 and 1992, capital ratios were as follows: December 31, ------------------------------------- 1993 1992 ---------------- ------------------ Capital ratios: Required* Company Bank Company Bank -------------- ---------- ------- ---- ------- ---- Leverage. . . . . . . . . 5.00% 11.70% 11.38% 10.62% 10.33% Core risk-based . . . . . 6.00 23.55 22.90 16.32 15.87 Total risk-based. . . . . 10.00 24.81 24.16 17.58 17.12 - --------------- * For qualification as a well-capitalized institution. As noted in the above table, the Company's and the Bank's capital ratios substantially exceed the minimum capital requirements of a well-capitalized institution. The increase during 1993 in the leverage ratio is due primarily to net income and, secondarily, to a lower level of assets in 1993 than in 1992. The increase in the risk-based capital ratios is due primarily to increases in U.S. Treasury and mortgage-backed securities, and decreases in loans and corporate bonds and notes. The FDIC and the FRB (collectively referred to as the "Regulators") have issued proposed guidelines to the risk-based capital ratios which would incorporate an interest-rate risk component. Complete implementation of the guidelines for assessing the adequacy of capital would become effective December 31, 1994. However, the Regulators have also proposed that examiners apply the guidelines on an advisory basis beginning with examinations starting after December 31, 1993. If such proposed guidelines were applied as of December 31, 1993, the revised risk-based capital ratios would still be in compliance with minimum capital requirements. Stockholders' equity increased from $30.5 million at December 31, 1992 to $33.5 million at December 31, 1993, reflecting net income of $2.8 million and credits resulting from recognition of deferred compensation of the Management Retention Plan and adoption of SFAS 115. RECENTLY ISSUED ACCOUNTING STANDARDS In May 1993, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). SFAS 114 establishes criteria for accounting for loans that have been impaired. It requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company has not fully evaluated the effect of SFAS 114 on its financial statements. SFAS 114 is effective for fiscal years beginning after December 15, 1994. The Company plans to adopt SFAS 114 in 1995 with no prior period adjustment In December 1992, the FASB issued Statement of Financial Accounting Standards No. 112. "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 requires accrual accounting for benefits provided to former or inactive employees after employment but before retirement--including salary continuation, disability benefits, severance pay and continuation of health care benefits. Under SFAS 112, each benefit will be accrued either over the employee's working career for benefits that vest or vary based on an employee's years of service, or as an expense at the date of the event giving rise to the benefits (e.g., at the date of disability). SFAS 112 is effective for fiscal years beginning after December 15, 1993. Earlier application is not required by the FASB. The Company plans to adopt SFAS 112 in 1994 with no prior period restatement. Management believes that the effect of adopting SFAS 112 will not be significant on the financial position or results of operations of the Company. IMPACT OF INFLATION AND CHANGING PRICES The impact of inflation is reflected primarily in the increased cost of operations. Unlike most industrial companies, the primary assets and liabilities of the Company are monetary. As a result, interest rates have a more significant impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (a) The following audited consolidated financial statements and related documents are presented herein on the following pages: Report of Independent Accountants ............................... 29 The Company and Subsidiary: Consolidated Balance Sheets ................................... 30 Consolidated Statements of Operations ......................... 31 Consolidated Statements of Changes in Stockholders' Equity..... 32 Consolidated Statements of Cash Flows ......................... 33 Notes to Consolidated Financial Statements .................... 35 (b) The following supplementary financial information is presented herein on the following page: Summary of Quarterly Results .................................. 53 REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors and Stockholders of Washington Bancorp, Inc. Hoboken, New Jersey We have audited the accompanying consolidated balance sheets of Washington Bancorp, Inc. and Subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Washington Bancorp, Inc. and Subsidiary as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes and its method of accounting for investments in debt and equity securities. As discussed in Note 11 to the consolidated financial statements, the Company is presently a defendant in two lawsuits. One lawsuit seeks unspecified damages and alleges violations of state securities laws, certain banking laws and state common law. The other was filed by a former Bank officer and alleges wrongful termination and seeks unspecified damages. Legal counsel has advised the Company that the effect, if any, of the ultimate outcome of these actions cannot presently be determined, and accordingly, no provision for loss, if any, that may result upon resolution of these matters has been made in the accompanying consolidated financial statements. /s/COOPERS & LYBRAND Coopers & Lybrand Parsippany, New Jersey January 28, 1994 WASHINGTON BANCORP, INC. & SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, ------------------------- 1993 1992 ----- ----- Assets Cash and due from banks . . . . . . . . $ 4,283,032 $ 4,336,433 Federal funds sold. . . . . . . . . . . 1,900,000 3,000,000 ------------ ------------ Cash and cash equivalents. . . . . . . 6,183,032 7,336,433 Investment securities: Available-for-sale . . . . . . . . . . 57,740,195 1,936,700 Held-to-maturity (market value $14,128,000 and $57,430,000). . . . . 13,848,830 56,793,662 Mortgage-backed securities: Available-for-sale . . . . . . . . . . 9,516,832 -- Held-to-maturity (market value $9,365,000 and $7,197,000). . . . . . 9,447,366 7,213,343 Loans: Held-for-sale (market value $4,909,000 and $9,032,000). . . . . . 4,852,000 9,000,000 In portfolio (net of allowance for losses of $2,828,000 and $2,776,000) . . . . . . . . . . . . . 165,332,900 182,500,728 Other real estate owned ("REO") (net of allowance for losses of $1,880,000 and $1,802,000). . . . . . . . . . . . 7,078,038 12,998,022 Accrued interest receivable . . . . . . 2,563,176 2,606,893 Premises and equipment, net . . . . . . 2,614,031 2,840,090 Federal Home Loan Bank stock, at cost . 1,711,300 1,632,000 Income tax refund . . . . . . . . . . . -- 320,000 Deferred income tax asset . . . . . . . 1,369,000 250,000 Other assets. . . . . . . . . . . . . . 378,636 342,758 ------------ ------------ TOTAL ASSETS. . . . . . . . . . . . . $282,635,336 $285,770,629 ============ ============ Liabilities and Stockholders' Equity Liabilities: Interest-bearing deposits. . . . . . . $237,026,264 $244,249,625 Noninterest-bearing deposits . . . . . 9,016,464 8,373,055 ------------ ------------ Total deposits. . . . . . . . . . . . 246,042,728 252,622,680 Advances from Federal Home Loan Bank ("FHLB") . . . . . . . . . . . . 400,000 -- Mortgage escrow deposits . . . . . . . 1,276,819 1,393,709 Accrued interest payable . . . . . . . 189,154 336,657 Other liabilities. . . . . . . . . . . 1,185,136 948,538 ------------ ------------ TOTAL LIABILITIES . . . . . . . . . . 249,093,837 255,301,584 ------------ ------------ Commitments and Contingencies Stockholders' Equity: Preferred stock, par value $.10 per share, 3,000,000 shares authorized, no shares issued and outstanding. . . -- -- Common stock, par value $.10 per share, 6,000,000 shares authorized, shares issued and outstanding-- 2,307,687 in 1993 and 2,307,187 in 1992 . . . . . . . . 230,768 230,718 Paid-in capital. . . . . . . . . . . . 22,500,728 22,498,778 Retained earnings. . . . . . . . . . . 10,744,003 7,919,549 Unrealized gain on available-for-sale securities, net of tax. . . . . . . . 186,000 -- ------------ ------------ 33,661,499 30,649,045 Deferred compensation--Management Recognition and Retention Plan ("MRP"). . . . . . . . . . . . . . . . (120,000) (180,000) ------------ ------------ TOTAL STOCKHOLDERS' EQUITY . . . . . 33,541,499 30,469,045 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY. . . . . . . . . . . . . . . $282,635,336 $285,770,629 ============ ============ See notes to consolidated financial statements WASHINGTON BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS Year ended December 31, ------------------------------------- 1993 1992 1991 ---- ---- ---- Interest income: Loans, including fees . . . . . . $14,781,686 $18,041,437 $22,616,388 U.S. Treasury obligations . . . . 1,766,978 2,833,951 1,995,094 Mortgage-backed securities. . . . 915,652 193,365 849,600 Federal funds sold. . . . . . . . 171,990 380,910 372,369 Dividends . . . . . . . . . . . . 150,639 155,715 199,088 Due from banks. . . . . . . . . . 48,311 50,378 22,719 Other investment securities . . . 722,669 223,335 1,538,383 ----------- ----------- ----------- Total interest income . . . . . . 18,557,925 21,879,091 27,593,641 ----------- ----------- ----------- Interest expense: Deposits. . . . . . . . . . . . . 8,794,623 12,189,233 17,148,425 Borrowed funds. . . . . . . . . . 17,809 1,350 1,970,423 ----------- ----------- ----------- Total interest expense. . . . . . 8,812,432 12,190,583 19,118,848 ----------- ----------- ----------- Net interest income. . . . . . . 9,745,493 9,688,508 8,474,793 ----------- ----------- ----------- Provision for losses on loans. . . 420,000 1,100,000 1,500,000 ----------- ----------- ----------- Net interest income after provision for losses on loans. . . . . . . 9,325,493 8,588,508 6,974,793 ----------- ----------- ----------- Other income: Service charges on deposit accounts . . . . . . . . . . . . 186,459 181,743 149,163 Gain on sale of loans, net. . . . 157,030 196,845 1,275,976 Security gains, net . . . . . . . 22,450 1,638,132 856,843 Gain on sale of bank building . . 186,519 -- -- Other . . . . . . . . . . . . . . 396,675 273,536 287,286 ----------- ----------- ----------- Total other income. . . . . . . . 949,133 2,290,256 2,569,268 ----------- ----------- ----------- Other expenses: Salaries and employee benefits. . 3,468,089 3,519,704 3,924,724 REO expense, net. . . . . . . . . 1,457,341 1,171,544 1,935,927 Occupancy and equipment expenses, net . . . . . . . . . . . . . . 797,303 1,010,739 869,705 Federal Deposit Insurance Corporation ("FDIC") assessment. 690,516 597,054 577,945 Other . . . . . . . . . . . . . . 2,354,923 2,394,742 1,997,571 ----------- ----------- ----------- Total other expenses. . . . . . . 8,768,172 8,693,783 9,305,872 ----------- ----------- ----------- Income before income taxes, extraordinary items and cumulative effect of change in accounting principle. . . . . . 1,506,454 2,184,981 238,189 Income tax benefit/(expense) . . 1,018,000 (628,000) (552,000) ----------- ----------- ----------- Income/(loss) before extraordinary items and cumulative effect of change in accounting principle . . . . . . . . . . . 2,524,454 1,556,981 (313,811) Extraordinary items: Utilization of net operating loss ("NOL") carryforward. . . -- 539,000 -- Loss on early extinguishment of FHLB advances (net of applicable income tax effect of $-0-) . . -- -- (1,034,319) Cumulative effect of change in accounting principle. . . . . . 300,000 -- -- ----------- ----------- ----------- NET INCOME/(LOSS). . . . . . . . $ 2,824,454 $ 2,095,981 $(1,348,130) =========== =========== =========== Income/(loss) per share: Income/(loss) before extraordinary items and cumulative effect of change in accounting principle . . . . . . . . . . . $ 1.10 $ 0.68 $ (0.14) Extraordinary items. . . . . . . -- 0.24 (0.46) Cumulative effect of change in accounting principle. . . . . . .13 -- -- ----------- ----------- ----------- NET INCOME/(LOSS). . . . . . . . $ 1.23 $ 0.92 $ (0.60) =========== =========== =========== Weighted average number of shares outstanding . . . . . . . . . . . 2,296,876 2,276,035 2,263,547 =========== =========== =========== See notes to consolidated financial statements WASHINGTON BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS Year ended December 31, -------------------------------------- 1993 1992 1991 ---- ---- ---- Cash Flows from Operating Activities: Interest received . . . . . . . $ 20,368,341 $ 22,383,276 $ 27,978,824 Loan fees received . . . . . . 288,037 449,833 406,092 Service charges on deposits received . . . . . . . . . . . 186,459 181,743 149,163 Miscellaneous other income received . . . . . . . . . . . 260,392 273,536 287,286 Income tax refund received . . 1,196,969 -- 1,105,511 Income taxes paid . . . . . . . (545,107) (609,000) -- Loans originated for resale . . (852,000) -- -- Interest paid . . . . . . . . . (8,959,935) (12,520,427) (19,699,816) Cash paid to employees and for other expenses . . . . . . . . (7,630,874) (7,863,590) (5,278,204) ----------- ----------- ------------ Net cash provided by operating activities . . . . . . . . . 4,312,282 2,295,371 4,948,856 ----------- ----------- ------------ Cash Flows from Investing Activities: Proceeds from maturity of term federal funds sold. . . . . . . -- 9,000,000 -- Purchase of term federal funds sold . . . . . . . . . . . . . -- -- (9,000,000) Proceeds from sales of securities available-for-sale . . . . . . 3,375,706 19,834,531 -- Proceeds from maturities of securities available-for- sale. . . . . . . . . . . . . . 500,000 -- -- Purchase of securities available- for-sale . . . . . . . . . . . (60,197,058) (21,353,814) -- Principal collected on mortgage- backed securities available- for-sale. . . . . . . . . . . . 2,967,578 -- -- Purchase of mortgage-backed securities available- for-sale .. . . . . . . . . . . (10,847,957) -- -- Proceeds from sales of loans held for sale . . . . . . . . . 7,021,863 15,717,358 34,600,519 Proceeds from sales of investment securities . . . . . . . . . . 9,248,633 54,466,694 68,049,943 Proceeds from maturities of investment securities . . . . . 35,371,615 10,445,843 52,378,000 Purchase of investment securities (2,452,068) (68,592,457)(117,910,408) Principal collected on mortgage-backed securities. . . 5,769,780 532,190 1,042,580 Proceeds from sales of mortgage-backed securities. . . 2,028,385 1,533,314 27,191,360 Purchase of mortgage-backed securities . . . . . . . . . . (10,534,937) (7,785,292) -- Purchase of loans . . . . . . . -- (10,086,000) -- Net decrease/(increase) in loans and loans held for sale . . . . 14,240,619 (7,095,165) (11,481,243) Recoveries on loans charged-off 261,348 257,045 240,898 Proceeds from sale of bank building . . . . . . . . . . . 224,100 -- -- Capital expenditures . . . . . (64,614) (312,723) (261,474) Proceeds from sales of REO, net of financed sales and closing costs 3,995,466 1,126,761 2,658,486 Proceeds from redemption of FHLB stock . . . . . . . . . . . . -- 520,300 104,600 Purchase of FHLB stock . . . . (79,300) -- -- ----------- ----------- ------------ Net cash (used in)/provided by investing activities . . . . . 829,159 (1,791,415) 47,613,261 ----------- ----------- ------------ Cash Flows from Financing Activities: Net increase in savings and transaction accounts. . . . . . 4,164,930 14,330,173 5,693,096 Net decrease in certificates of deposit . . . . . . . . . . . (10,744,882) (20,728,505) (21,998,795) Net increase/(decrease) in mortgage escrow deposits . . . . . . . (116,890) (739,381) 149,309 Repayment of advances from FHLB -- -- (45,134,319) Advances from FHLB . . . . . . 400,000 -- 15,600,000 Exercise of stock options . . . 2,000 -- -- ----------- ----------- ------------ Net cash used in financing activities . . . . . . . . . (6,294,842) (7,137,713) (45,690,709) ----------- ----------- ------------ Net Increase/(Decrease) in Cash and Cash Equivalents . . . . . . . (1,153,401) (6,633,757) 6,871,408 Cash and Cash Equivalents, beginning of year. . . . . . . . 7,336,433 13,970,190 7,098,782 ----------- ----------- ------------ Cash and Cash Equivalents, end of year . . . . . . . . . . . . . $ 6,183,032 $ 7,336,433 $ 13,970,190 =========== =========== ============ See notes to consolidated financial statements WASHINGTON BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued) Year ended December 31, --------------------------------- 1993 1992 1991 ---- ---- ---- Reconciliation of Net Income/(Loss) to Net Cash Provided by Operating Activities: Net income/(loss) . . . . . . . . $ 2,824,454 $ 2,095,981 $ (1,348,130) Adjustments to reconcile net income/ (loss) to net cash provided by operating activities: Depreciation . . . . . . . . . 253,092 372,186 319,678 Provision for losses on loans and REO . . . . . . . . . . . . . 1,443,965 1,951,900 2,670,206 Recognition of deferred compensation expense . . . . . 60,000 156,600 349,800 Deferred loan fees . . . . . . (194,779) (163,765) (248,842) Deferred taxes . . . . . . . . (699,000) (250,000) 552,000 Gain on sales of investment and mortgage-backed securities . (67,623) (1,671,946) (1,078,931) Loss on sales of investment and mortgage-backed securities . 45,173 33,814 222,088 Gain on sale of bank building (186,519) -- -- Gain on sales of REO . . . . . (429,255) (454,734) (329,927) Loss on sales of REO . . . . . 125,355 53,887 153,157 Gain on sale of loans . . . . (157,030) (206,314) (1,275,976) Loss on sale of loans . . . . -- 9,469 -- Premium amortization, net of discount earned. . . . . . . . 2,249,515 817,490 243,249 Extraordinary loss on early extinguishment of FHLB advances . . . . . . . . . . -- -- 1,034,319 Changes in operating assets and liabilities: (Increase) in loans originated for resale. . . . . . . . . . (852,000) -- -- (Increase)/decrease in income tax refund receivable . . . . 320,000 (320,000) 243,000 (Increase)/decrease in accrued interest receivable . . . . 43,717 300,293 796,868 (Increase)/decrease in other assets . . . . . . . . . . (35,878) 83,567 890,585 Increase/(decrease) in accrued interest payable . . . . . . (147,503) (329,844) (580,968) Increase/(decrease) in other liabilities . . . . . . . . (283,402) (183,213) 2,336,680 ----------- ----------- ----------- Net cash provided by operating activities . . . . . . . . . . . $ 4,312,282 $ 2,295,371 $ 4,948,856 =========== =========== =========== Supplemental Schedule of Noncash Investing and Financing Activities: Transfer of loans to REO . . . $ 3,705,035 $ 5,330,339 $ 9,571,387 =========== =========== =========== Portion of REO sales financed by the Bank. . . . . . . . . . $ 5,427,475 $ 3,486,900 $ 4,700,200 =========== =========== =========== Transfer of loans to loans held for sale, net . . . . . . . . $ -- $24,520,513 $ -- =========== =========== =========== Exchange of loans for mortgage-backed securities . . $ 1,788,408 $ -- $ 6,732,250 =========== =========== =========== Available-for-sale securities market value change. . . . . . $ 186,000 $ -- $ -- =========== =========== =========== See notes to consolidated financial statements WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of Washington Bancorp, Inc. and Subsidiary follow generally accepted accounting principles and general practices applicable to the banking industry. The policies which materially affect the determination of financial position, results of operations and cash flows are summarized below. BASIS OF PRESENTATION The consolidated financial statements include the accounts of Washington Bancorp, Inc, (the "Company") and its wholly-owned subsidiary, Washington Savings Bank (the "Bank"). All significant intercompany balances and transactions have been eliminated. STATEMENTS OF CASH FLOWS The statements of cash flows are presented using the direct method. For purposes of reporting cash flows, cash and cash equivalents are cash on hand, amounts due from banks and Federal funds sold (generally due within a one-week period). SECURITIES During 1993, the Financial Accounting Standards Board (the "FASB") issued and the Company adopted Statement of Financial Accounting Standards No. 115: "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 requires entities to classify their securities into either a held-to-maturity, available-for-sale or trading category. Each of these classifications require a different basis of accounting. Securities in which there is both the positive intent and ability to hold until call date, if any, or maturity are classified as held-to-maturity and carried at cost, adjusted for amortization of premiums and accretion of discounts. Premiums are amortized and discounts are accreted using the level yield method over the period to call, if any, or maturity for investments, and over the estimated remaining lives based on anticipated prepayments for mortgage-backed securities. Gains and losses, if any, are recognized when securities are sold by the specific identification method. Securities which may be sold prior to maturity for either asset/liability purposes or for other reasons are classified as available-for-sale and are accounted for at fair value with fair value changes, net of tax, reported as a net amount in a separate component of stockholders' equity. The Company does not engage in trading securities; however, such securities would be accounted for at fair value with fair value changes reported in the income statement. The effect of adopting SFAS 115 as of December 31, 1993 was to increase securities by $286,000, reduce the net deferred tax asset by $100,000 and increase stockholders' equity by $186,000. There was no effect on the results of operations. The Bank, as a member of the Federal Home Loan Bank of New York ("FHLB"), is required to hold shares of capital stock in the FHLB in an amount equal to one percent of the outstanding balance of mortgage loans or five percent of its outstanding advances from the FHLB, whichever is greater. LOANS Loans in which there is both the intent and ability to hold until maturity are carried at their principal amounts outstanding. Generally, when a loan is past due as to payment of principal or interest for ninety days or when, in the opinion of management, the accrual of interest should be ceased before ninety days, it is the Company's policy to cease accruing interest and to place such a loan on a "nonaccrual status". Any accrued but unpaid interest previously recorded, if not adequately collateralized, is charged against current period interest income. Cash receipts on nonaccrual loans are recorded as either income or as a reduction of principal, according to management's judgement as to the collectibility of principal. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Loan origination fees and certain direct loan origination costs are offset, and the resulting net amount is deferred and amortized as an adjustment of the loans' yields. Net loan fees are generally amortized over the contractual lives of the related loans. Loans held for sale are carried at the lower of aggregate cost or market. No valuation allowance was required at December 31, 1993 or 1992. Gains and losses, including deferred loan origination fees, are recognized when loans are sold by the specific identification method. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). SFAS 114 establishes criteria for accounting for loans that have been impaired. It requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company has not fully evaluated the effect of SFAS 114 on its financial statements. SFAS 114 is effective for fiscal years beginning after December 15, 1994. The Company plans to adopt SFAS 114 in 1995 with no prior period restatement. ALLOWANCE FOR LOSSES ON LOANS The allowance for losses on loans is established through charges to operations in the form of a provision for losses on loans. Loans which are determined to be uncollectible are charged against the allowance account and subsequent recoveries, if any, are credited to the account. The provision for losses on loans is based upon percentage allocations with regard to the performing loan portfolio, as well as specific allocations for classified loans. Loans are classified in accordance with their estimated risk based on various factors, including: (a) the financial status and credit history of the borrower; (b) collateral value; (c) loan documentation; (d) prevailing and anticipated economic conditions; and (e) such other factors that, in management's judgement, warrant current recognition in providing an adequate allowance. OTHER REAL ESTATE OWNED ("REO"), NET REO consists of real estate properties acquired through foreclosure or deed in lieu of foreclosure and "in-substance" foreclosures ("ISF"). A loan is classified as an in-substance foreclosure even though actual foreclosure has not occurred based upon the following criteria: the borrower has little or no equity in the collateral based upon its current estimated fair value; proceeds for repayment are expected to come only from the operations or sale of the collateral; and either the borrower has abandoned control of the collateral or it is doubtful that the borrower will rebuild equity in the collateral or repay the loan by other means in the foreseeable future. REO is carried at the lower of cost (principal balance of the former loan plus cost of obtaining title and possession) or net realizable value. When a property is transferred to ISF, the excess of the loan balance over market or the estimated net realizable value is charged to the allowance for losses on loans. The allowance for losses on REO is established through charges to operations in the form of a provision for losses on REO that is reflected in the expense caption--"REO expense, net." Factors considered in establishing the allowance for losses on REO include appraisals of the fair market value of a property and management's assessment of the overall real estate market for that type of property and its location. In addition, carrying costs (e.g. real estate taxes, repairs and maintenance, and insurance), net of rental income, are charged to operations in the current period and are reflected in the expense caption--"REO expense, net". PREMISES AND EQUIPMENT, NET Land is carried at cost. Buildings, building improvements, and furniture and equipment are stated at cost less accumulated depreciation computed on the straight-line basis over the estimated useful lives of each type of asset. Leasehold improvements are stated at cost less accumulated amortization computed on a straight-line basis over the term of the lease or useful life, whichever is less. Expenditures for maintenance and repairs are charged to expense; major replacements and betterments are capitalized. Gains and losses on dispositions are reflected in current operations. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) INCOME TAXES The Company and the Bank file a consolidated federal income tax return. State income tax returns are filed on a separate basis. Prior to 1993, the Company recorded income tax provisions in accordance with Accounting Principles Board Opinion No.11: "Income Taxes" ("APB 11"), which recorded deferred income taxes on transactions which are reported for financial statement purposes in different years than for income tax purposes--principally loan fees, interest on nonaccrual loans and carrying costs of REO. On January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109: "Accounting for Income Taxes" ("SFAS 109") with no prior period adjustment. SFAS 109 requires an asset and liability approach, the objective of which is to establish deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The effect of adopting SFAS 109, as of January 1, 1993, was to increase assets and net earnings by $300,000, or $.13 per share. PENSION PLAN AND POSTRETIREMENT BENEFITS A noncontributory defined benefit pension plan is provided through Retirement System Group Inc. that covers substantially all employees. Benefits are based upon years of service and generally upon the employee's average compensation during the three consecutive years prior to normal retirement. The funding policy is generally to make the minimum annual contributions required by applicable regulations. Pension cost is determined by Statement of Financial Accounting Standards No. 87: "Employers' Accounting for Pensions." The Entry Age Normal Cost Method was used to determine the actuarial present value of accumulated and projected benefit obligations. During 1992, the Company undertook a policy to eliminate its balance sheet liability under the new Statement of Financial Accounting Standards No. 106: "Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"). This goal was achieved in a two step process. First, current retirees were offered, and accepted, a lump sum payment equal to a percentage of the estimated cost to the Company of each retiree's future health insurance premiums in exchange for the Company's liability for future coverage. The aggregate lump sum amount for all such retirees approximated $77,000 and was paid in two equal installments in January 1992 and 1993. Second, the obligation for future retirees was moved to the tax-qualified pension plan. Future retirees who meet certain age and service requirements will be awarded a supplemental pension benefit equal to a percentage of estimated future health insurance premiums. During 1992 and prior periods, postretirement health care benefits were recognized in the year that the benefits were paid to certain retired employees--the "pay-as-you-go" or cash basis. The costs of providing postretirement health care benefits approximated $42,000 and $38,000 for the years ended December 31, 1992 and 1991, respectively. POSTEMPLOYMENT BENEFITS In December 1992, the FASB issued Statement of Financial Accounting Standards No. 112: "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 requires accrual accounting for benefits provided to former or inactive employees after employment but before retirement--including salary continuation, disability benefits, severance pay and continuation of health care benefits. Under SFAS 112, each benefit will be accrued either over the employee's working career for benefits that vest or vary based on an employee's years of service, or as an expense at the date of the event giving rise to the benefits (e.g., at the date of disability). SFAS 112 is effective for fiscal years beginning after December 15, 1993. Earlier application is not required by the FASB. The Company plans to adopt SFAS 112 in 1994 with no prior period restatement. Management believes that the effect of adopting SFAS 112 will not be significant on the financial position or results of operations of the Company. FINANCIAL INSTRUMENTS Disclosures are made of the fair value of financial instruments, both assets and liabilities recognized and not recognized in the consolidated balance sheet, for which it is practicable to estimate fair value as of the balance sheet WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) date. Changes in market conditions subsequent to that date are not reflected and the fair value of financial instruments are not representative of the Company's total value. For example, when quoted market prices are not available, the Company calculates the present value of anticipated future cash flows. In that regard, the estimated fair value will be affected by prepayment and discount rate assumptions. Such method may not provide the actual amount which would be realized in the ultimate sale of the financial instrument. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practical to estimate that value: Cash and short-term investments The carrying amount is a reasonable estimate of fair value. Securities Fair values are based on quoted market prices as published by various quotation services or, if quoted market prices are not available, on dealer quotes. Fair value of the investment in FHLB is its carrying amount. Loan receivables and commitments to extend credit Loans are grouped into homogeneous categories, such as one-to-four family mortgages, consumer loans, and loans held for sale. Fair value is based on either a quoted market price from a dealer for similar maturities, interest rate and type of collateral or the present value of anticipated future cash flows using the current rates at which similar loans would be made to borrowers with similar credit risks and for the same remaining maturities. Deposit liabilities Carrying amount is a reasonable estimate of fair value for savings, demand deposit, and money market accounts. Fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities. PER SHARE DATA Income/(loss) per share was computed by dividing net income/(loss) for each year by the weighted average number of shares outstanding (which excludes unvested shares of the MRP). RECLASSIFICATIONS Certain reclassifications have been made to the 1992 and 1991 financial statements to conform to the 1993 presentation. 2. CASH AND DUE FROM BANKS Reserves maintained to meet Federal Reserve Board regulations amounted to $331,000 and $280,000 during the bi-weekly maintenance periods that included December 31, 1993 and 1992, respectively. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) During 1993, the Company adopted SFAS 115 which increased the carrying value of the available-for-sale securities by $286,000 for unrealized gains. The carrying value of securities pledged to collateralize public deposits approximated $828,000 and $1,454,000 at December 31, 1993 and 1992, respectively. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 4. LOANS AND REO Loans The primary market area for lending encompasses Hudson and Bergen Counties, New Jersey. The following table sets forth the composition of the loan portfolio: December 31, --------------------------- 1993 1992 ------------ ------------ Real estate: 1-4 family . . . . . . . . . . . . . . . . . $109,211,067 $125,858,058 Multi-family/commercial. . . . . . . . . . . 53,860,461 52,742,859 Construction . . . . . . . . . . . . . . . . 3,282,555 2,533,164 ------------ ------------ Total real estate loans . . . . . . . . . . 166,354,083 181,134,081 Commercial/financial. . . . . . . . . . . . . 1,421,985 3,551,679 Consumer and other loans. . . . . . . . . . . 1,322,178 1,731,241 ------------ ------------ Total loans . . . . . . . . . . . . . . . . 169,098,246 186,417,001 Less: Unearned interest. . . . . . . . . . . . . . 79,393 87,541 Deferred loan fees . . . . . . . . . . . . . 857,953 1,052,732 Allowance for losses . . . . . . . . . . . . 2,828,000 2,776,000 ------------ ------------ Loans, net. . . . . . . . . . . . . . . . . $165,332,900 $182,500,728 ============ ============ Nonperforming loans Nonperforming loans, which are a component of loans, include loans which are accounted for on a nonaccrual basis and troubled debt restructurings. December 31, --------------------------- 1993 1992 ------------ ------------ Nonaccrual loans: Real estate loans: 1-4 family. . . . . . . . . . . . . . . . . $ 2,783,813 $5,527,941 Multi-family/commercial . . . . . . . . . . 9,981,691 1,648,146 Construction. . . . . . . . . . . . . . . . -- 944,000 ----------- ---------- Total real estate loans. . . . . . . . . . 12,765,504 8,120,087 Commercial/financial . . . . . . . . . . . . -- 224,591 Consumer and other loans . . . . . . . . . . 32,647 254,571 ----------- ---------- Total nonaccrual loans . . . . . . . . . . 12,798,151 8,599,249 Troubled debt restructurings: Commercial/financial. . . . . . . . . . . . 151,788 207,088 ----------- ---------- Total nonperforming loans. . . . . . . . . $12,949,939 $8,806,337 =========== ========== Interest on nonperforming loans which would have been recorded had such loans been performing (based upon original contract terms) throughout the period approximated $826,000, $609,000 and $975,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Interest income on those loans, which is recorded only when received, amounted to $223,000, $416,000 and $548,000 for the years ended December 31, 1993, 1992 and 1991, respectively. During the first quarter of 1993, a Chapter 11 bankruptcy petition was filed by the obligor of an approximately $9.0 million loan, a loan on which the Bank currently has a first mortgage and an assignment-of-rents (the WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) "Bankruptcy Loan"). On November 10, 1993, the Court dismissed the bankruptcy petition. Nevertheless, the Bank did not receive any of the rental payments from April 1993 through November 1993, as the payments were made to a debtor-in-possession account and pursuant to a Court Order were released to the City of Philadelphia (and not to the Bank) to pay a substantial portion of property tax arrearages. Rental payments were resumed to the Bank in December 1993. On January 29, 1994, the Bank paid approximately $450,000 to the City of Philadelphia to resolve all remaining property tax arrearages and to pay 1994 property taxes. The amount of such payment was capitalized into the Bankruptcy Loan balance. The Bank anticipates that the Bankruptcy Loan will be renegotiated during 1994. The Bank has classified the Bankruptcy Loan as a nonaccrual loan included in the multi-family/commercial category. Management believes that the Bank has adequate collateral with respect to the Bankruptcy Loan and anticipates collection of the outstanding principal balance. REO December 31, ----------------------- 1993 1992 --------- ----------- Acquired by foreclosure or deed in lieu of foreclosure. . . . . . . . $3,920,667 $ 7,460,541 Loans foreclosed in-substance . . . 5,037,371 7,339,481 Less: Allowance for losses on REO . 1,880,000 1,802,000 ---------- ----------- REO, net . . . . . . . . . . . . . $7,078,038 $12,998,022 ========== =========== Allowance for losses on loans and REO Loans REO Total ---------- ---------- ---------- Balance, December 31, 1990. . . . . $2,579,000 $ 976,000 $3,555,000 Provision for losses. . . . . . . . 1,500,000 1,170,206 2,670,206 Recoveries. . . . . . . . . . . . . 240,898 -- 240,898 Losses charged off. . . . . . . . . (1,330,898) (818,206) (2,149,104) ---------- ---------- ---------- Balance, December 31, 1991. . . . . 2,989,000 1,328,000 4,317,000 Provision for losses. . . . . . . . 1,100,000 851,900 1,951,900 Recoveries. . . . . . . . . . . . . 257,045 -- 257,045 Losses charged off. . . . . . . . . (1,570,045) (377,900) (1,947,945) ---------- ---------- ---------- Balance, December 31, 1992. . . . . 2,776,000 1,802,000 4,578,000 Provision for losses. . . . . . . . 420,000 1,023,965 1,443,965 Recoveries. . . . . . . . . . . . . 261,319 -- 261,319 Losses charged off. . . . . . . . . (629,319) (945,965) (1,575,284) ---------- ---------- ---------- Balance, December 31, 1993. . . . . $2,828,000 $1,880,000 $4,708,000 ========== ========== ========== Related-Party Loans An analysis of activity with respect to loans outstanding to directors, officers, their entities and immediate family is as follows: Year ended December 31, ---------------------- 1993 1992 --------- ---------- Balance, beginning of year. . . . . . . . . . . $ 866,000 $1,007,000 New loans. . . . . . . . . . . . . . . . . . . -- 356,000 Repayments/reductions. . . . . . . . . . . . . (320,000) (497,000) --------- ---------- Balance, end of year. . . . . . . . . . . . . . $ 546,000 $ 866,000 ========= ========== As of December 31, 1993 and 1992, $543,000 and $842,000, respectively, of such loans represented collateralized real estate loans and $3,000 and $24,000, respectively, represented uncollateralized loans. All such loans were, in the opinion of management, made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with outside third parties. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 5. PREMISES AND EQUIPMENT December 31, ------------ 1993 1992 ---------- ---------- Land. . . . . . . . . . . . . . . . . . . . . . . . $ 513,570 $ 532,496 Buildings . . . . . . . . . . . . . . . . . . . . . 3,185,933 3,211,426 Leasehold improvements. . . . . . . . . . . . . . . 145,123 356,462 Equipment . . . . . . . . . . . . . . . . . . . . . 2,483,214 2,423,942 ---------- ---------- 6,327,840 6,524,326 Less: Accumulated depreciation and amortization . . 3,713,809 3,684,236 ---------- ---------- $2,614,031 $2,840,090 ========== ========== During 1993, a building used to store bank-owned vehicles (i.e., a garage) with a net book value of $37,000 was sold for $224,000. 6. INTEREST-BEARING DEPOSITS 7. BORROWINGS On February 1, 1993, the FHLB advanced the Company $400,000, maturing on February 1, 1996. There were no advances during 1992. The average amount outstanding during 1993 and 1991 was $367,000 and $23,308,000, respectively, with a weighted average rate of 4.9% and 8.4%, respectively. The FHLB advance is collateralized by WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) mortgage-backed securities and the mortgage loan portfolio. During the fourth quarter of 1991, the proceeds primarily from the sale of one-to-four family performing mortgage loans and investment securities were used to prepay $15,900,000 of FHLB advances, incurring approximately $1,034,000 of early extinguishment costs. The costs have been included in the consolidated statements of operations as an extraordinary item. Due to the net operating loss carryforward position, there was no income tax effect for these transactions. In 1987, the Bank established an Employee Stock Ownership Plan ("ESOP"), which borrowed $l,449,000 from an unrelated third party lender to acquire 138,000 shares of the Company's Common Stock at $10.50 per share (secured by the shares purchased). The loan was scheduled to mature in 1997; however, the ESOP, at its option, repaid the remaining balance of the loan during 1992 with no penalty. The ESOP repaid the loan as contributions were received from the Bank. Interest was paid and accrued monthly at a variable rate which approximated the prime rate. The related interest expense incurred for the years ended December 31, 1992 and 1991 approximated $1,000 and $23,000, at an effective rate of 3.9% and 9.3%, respectively. The Bank also has a line of credit, which expires on September 1, 1994, of approximately $14.3 million with the FHLB, none of which was in use at December 31, 1993. 8. PENSION PLAN The components of net periodic pension cost include the following: Year ended December 31, ------------------------------- 1993 1992 1991 -------- -------- -------- Service cost of benefits earned . . . . . $131,925 $122,405 $102,672 Interest cost on projected benefit obligation . . . . . . . . . . . . . . . 220,512 209,194 205,182 Actual return on plan assets. . . . . . . (408,089) (279,886) (210,743) Net amortization: Deferred investment liability. . . . . . 147,402 33,433 -- Unrecognized net transition asset. . . . (58,356) (58,356) (58,356) Unrecognized prior service liability . . (254) 1,456 1,456 -------- -------- -------- Net periodic pension cost . . . . . . . . $ 33,140 $ 28,246 $ 40,211 ======== ======== ======== WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The funded status of the plan, which invests primarily in marketable equity and debt securities, and the amounts recognized in the consolidated balance sheets are as follows: December 31, -------------------------- 1993 1992 ----------- ----------- Actuarial present value of accumulated benefit obligation: Vested benefits. . . . . . . . . . . . . . . . $(2,838,600) $(2,338,576) Nonvested benefits . . . . . . . . . . . . . . (182,800) (150,610) ----------- ----------- Accumulated benefit obligation . . . . . . . . (3,021,400) (2,489,186) Effect of assumed increase in future compensation levels. . . . . . . . . . . . . . (415,000) (341,898) ----------- ----------- Projected benefit obligation. . . . . . . . . . (3,436,400) (2,831,084) Plan assets at fair value . . . . . . . . . . . 3,617,300 3,333,266 ----------- ----------- Plan assets in excess of projected benefit obligation. . . . . . . . . . . . . . . 180,900 502,182 Unrecognized net transition asset . . . . . . . (242,200) (300,524) Unrecognized net (gain)/loss. . . . . . . . . . 87,200 (142,334) Unrecognized prior service liability. . . . . . (7,500) (7,784) ----------- ----------- Net pension asset . . . . . . . . . . . . . . . $ 18,400 $ 51,540 ========== ========== The expected long-term rate of return on plan assets used in determining the net periodic pension cost was 8.00% in 1993, 1992 and 1991. The projected benefit obligation is based on an assumed discount rate of 7.00% in 1993 and 8.00% in 1992, and an assumed rate of compensation increase of 5.5% and 6.00% in 1993 and 1992, respectively. The original net transition asset of $650,660 is being amortized over approximately eleven years and is due to expire in 1998. 9. BENEFIT PLANS The expense charged to operations for the following benefit plans during the years ended December 31, 1993, 1992 and 1991 approximated $151,000, $193,000 and $376,000, respectively. Incentive Stock Option Plan ("Option Plan") The Option Plan authorizes the granting of 172,500 nonqualified and incentive stock options through 1997 to certain officers and other key employees. Each option entitles the holder to purchase one share of Common Stock at an exercise price equal to the fair market value as of the date of grant. Options may be exercisable at such times (not after ten years from grant) as the Stock Option Plan Committee determines. The exercise price may be paid in cash or Common Stock. The following table summarizes stock option transactions during the three years ended December 31, 1993: Balance at January 1, 1991, exercisable between $5.25 and $18.75 . . . . . . . . . . . . . . . . . . . . . . . . 58,000 Granted in 1992 at $4.00. . . . . . . . . . . . . . . . . 26,500 Granted in 1993 at $7.25. . . . . . . . . . . . . . . . . 88,000 Exercised in 1993 at $4.00. . . . . . . . . . . . . . . . (500) ------- Balance at December 31, 1993, exercisable between $4.00 and $18.75 . . . . . . . . . . . . . . . . . . . . . . . . 172,000 ======= Exercisable at December 31, 1993. . . . . . . . . . . . . . 74,700 ======= Available for future grant of stock options . . . . . . . . -- ======= WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Employee Stock Ownership Plan ("ESOP") The ESOP, established for employees age 21 or older who have at least one year of credited service, was funded by discretionary cash contributions that are invested in the Common Stock. Benefits may be paid either in shares of Common Stock or in cash. Shares purchased with such proceeds are held in a suspense account by the ESOP Trustee for allocation among members. Benefits become 20% vested each year of credited service, with 100% vesting after 5 years of credited service. Forfeitures will be reallocated among remaining participating employees. Benefits may be payable upon retirement, early retirement, disability or separation from service. The ESOP Trustee must vote all allocated shares held in the ESOP in accordance with the instructions of the participating employees. Shares for which employees do not give instructions, shares held by the ESOP trustee and unallocated shares will be voted in the same proportion as the shares with respect to which instructions have been given. The ESOP is subject to the requirements of the Employee Retirement Income Security Act of 1974, as amended (which applies to all employee stock ownership plans), and the regulations of the Internal Revenue Service and the Department of Labor thereunder. The Company has begun to terminate the ESOP. The effect of terminating the ESOP will not be significant to the financial position or results of operations of the Company. Management Recognition Plan ("MRP") The MRP was established as a method of providing employees in key positions with a proprietary interest in a manner designed to encourage such key employees to remain with the Company. The Company contributed $630,000 to the MRP to enable it to acquire 60,000 shares of Common Stock. Such amount represents deferred compensation and has been accounted for as a reduction of stockholders' equity. Awards generally vest over either a three or five year period and will be 100% vested upon termination of employment by death, disability, retirement, or following a change in control of the Company. Option Plan for Outside Directors ("Directors' Option Plan") Each member of the Board of Directors who is not an officer or employee of the Company was granted a single non-qualified option to purchase 7,187.5 shares (aggregate 57,500 shares) of the Common Stock at an exercise price equal to the fair market value as of the date of grant. Each option granted under the Directors' Option Plan expires upon the earlier of ten years following the date of the option or thirty days following the date the optionee ceases to be a director. The following table summarizes the Directors' Option Plan transactions during the three years ended December 31, 1993: Balance at January 1, 1991, exercisable between $10.50 and $13.00 . . . . . . . . . . . . . . . . . . . . . . . . 50,312.50 Granted in 1993 at $7.25. . . . . . . . . . . . . . . . . 10,782.00 Options returned for granting in 1993 . . . . . . . . . . (10,782.00) ---------- Balance at December 31, 1993, excersisable between $7.25 and $13.00 . . . . . . . . . . . . . . . . . . . . . . . . 50,312.50 ========== Exercisable at December 31, 1993. . . . . . . . . . . . . . 50,312.50 ========== Available for future grant of stock options . . . . . . . . -- ========== Deferred Compensation Plan for Outside Directors ("DCP") During 1993, the DCP, a plan which covers any outside director who has served in that capacity for at least five consecutive calendar years, was approved in principle subject to certain conditions. Eligibility, benefits and vesting will continue should an outside director subsequently become an officer or employee. An outside director becomes fully vested upon either fifteen years of service as director, sixty-five years of age, death, or change in control of the Company, as described below. Subsequent to retirement, the DCP provides an annual benefit equal to (a) 50% of the outside director's annual retainer in effect at the time of retirement (the "then current retainer"), plus (b) 5% of the then current retainer for each additional year of service in excess of 5 years (up to a maximum of 10 additional years). WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Benefits are based on actuarial assumptions then in effect under the Retirement Plan of the Bank. Benefits payable under the DCP shall be paid directly from the general assets of the Company. The Company is not obligated to set aside, earmark or escrow funds or other assets to satisfy its obligations under the DCP. At December 31, 1993, the accumulated postretirement benefit obligation reflected on the consolidated balance sheet in other liabilities was $25,000. In the event of a change in control of the Company, each outside director (regardless of whether he has served as a director for five years) who is neither an officer nor an employee shall receive a single cash payment equal to four times the then current retainer. The cumulative liability under a change in control of the Company is approximately $252,000. Such cumulative liability in excess of the aforementioned $25,000 was not reflected in the consolidated financial statements as of December 31, 1993. Bonus programs Employees of the Bank are awarded cash bonuses based upon length of service, responsibility level and performance. 10. INCOME TAX EXPENSE/(BENEFIT) Year ended December 31, ---------------------- 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Current: Federal. . . . . . . . . . . . . . . . . . . $ 396 $ 288 $ -- State. . . . . . . . . . . . . . . . . . . . 32 51 -- ------- ----- ----- 428 339 -- Deferred. . . . . . . . . . . . . . . . . . . 110 (250) -- Elimination of valuation allowance. . . . . . (809) -- -- Income tax refund . . . . . . . . . . . . . . (747) -- -- Charge in lieu of income taxes. . . . . . . . -- 539 -- Write-off of net deferred tax asset . . . . . -- -- 552 ------- ----- ----- $(1,018) $ 628 $ 552 ======= ===== ===== Upon adoption of SFAS 109, deferred tax assets of $2.4 million, deferred tax liabilities of $1.0 million and a valuation allowance of $809,000 were established, resulting in a net deferred tax asset of $550,000 as of January 1, 1993. As of December 31, 1993, the $809,000 valuation allowance was reduced to zero as a result of taxes paid in prior and current years and anticipated future taxable income sufficient to realize these tax benefits. Based upon the Company's historical and current pretax earnings, management believes it is more likely than not that the Company will generate future net taxable income in sufficient amounts to realize its net deferred tax asset at December 31, 1993, however, there can be no assurance that the Company will generate any earnings or any specific level of continuing earnings. In addition during 1993, an income tax refund of $747,000 was received as a result of an overassessment of previously paid federal income taxes. During 1992, the Company utilized its remaining net operating loss carryforwards of approximately $754,000 for federal income tax purposes and approximately $1,700,000 for financial reporting purposes to record an extraordinary credit in the amount of $539,000, which partially offset income tax expense of $628,000. During 1991, the $552,000 of expense was primarily a result of the write-off of the net deferred tax asset as a result of the Company's tax loss carryforward position. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) A reconciliation between the reported income tax expense/(benefit) and the amount computed by multiplying income before income taxes, extraordinary items and cumulative effect of change in accounting principle by the statutory Federal income tax rate is as follows: Temporary differences, which give rise to deferred tax assets and liabilities under SFAS 109, as of December 31, 1993, are as follows: Deferred Tax --------------------- Assets Liabilities ------ ----------- (Dollars in thousands) Financial basis reserve for losses on loans and REO . . $1,710 $ -- Tax basis reserve for losses on loans and REO in excess of base year tax reserve . . . . . . . . . . -- 1,088 Deferred loan origination fees. . . . . . . . . . . . . 309 -- Interest on nonaccrual loans. . . . . . . . . . . . . . 262 -- Premises and equipment. . . . . . . . . . . . . . . . . 146 -- Deferred compensation . . . . . . . . . . . . . . . . . 83 -- Unrealized gain on available for sale securities. . . . -- 100 Other . . . . . . . . . . . . . . . . . . . . . . . . . 54 7 ------ ------ Deferred taxes/liabilities. . . . . . . . . . . . . . . $2,564 $1,195 ====== ====== Net deferred tax asset. . . . . . . . . . . . . . . . . $1,369 ====== Under APB 11, the provision for losses on loans and REO was treated as a permanent difference which did not require deferred taxes. Under SFAS 109, differences between the book and tax basis reserve for losses on loans and REO are treated as temporary differences requiring deferred taxes, except that no deferred tax liability is required for the base year tax reserve of approximately $270,000 as of December 31, 1993. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The deferred income tax provision/(benefit) on income from operations is due to the following items: Year ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Financial basis reserve for losses on loans and REO. . . . . . . . . . . . . . . . . . . . . . $ 63 $ -- $ -- Tax basis reserve for losses on loans and REO in excess of base year tax reserve. . . . . . . . (87) -- -- Deferred loan origination fees. . . . . . . . . (70) (248) -- Interest on nonaccrual loans. . . . . . . . . . 186 23 -- Deferred compensation . . . . . . . . . . . . . (26) (28) -- Other . . . . . . . . . . . . . . . . . . . . . 44 3 -- ---- ----- ---- $110 $(250) $ -- ==== ===== ==== 11. COMMITMENTS AND CONTINGENCIES Total rent expense for all bank branches under operating leases was approximately $73,000, $130,000 and $105,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Future minimum lease payments required under noncancellable operating leases for bank branches as of December 31, 1993 are as follows: 1994 . . . . . . . . . . . . . $ 71,000 1995 . . . . . . . . . . . . . 71,000 1996 . . . . . . . . . . . . . 71,000 1997 . . . . . . . . . . . . . 50,000 1998 . . . . . . . . . . . . . 7,000 Thereafter . . . . . . . . . . -- -------- $270,000 ======== Certain of the above leases contain renewal options which provide for increased rental payments as a result of increases in real estate taxes. It is generally expected that in the normal course of business, leases that expire will be renewed or replaced by other leases with similar terms. The Company has entered into a severance agreement with a certain key executive. In the event of a change in control of the Company (such as the Merger referred to in Note 15), this executive will receive a payment equal to three times his average annual compensation over the five previous years of his employment with the Bank, if terminated for other than cause or upon certain other events of termination of employment. In the event that severance payments combined with other payments to be made to this executive by the Company in connection with the Merger would constitute an excess parachute payment under Section 280 G of the Internal Revenue Code of 1986, as amended, then the executive will receive a combination of benefits and payments which will equal the maximum aggregate amount which can be paid to the executive without constituting such an excess parachute payment. In October 1991, a complaint was filed by a former officer in New Jersey Superior Court against the Company, the Bank and certain directors and officers seeking unspecified damages relating to the termination of such officer's employment. The Company and individual defendants have filed an answer and have asserted certain counterclaims. Although this complaint was recently dismissed, it was dismissed without prejudice to the plaintiff's right to refile the complaint by March 31, 1994. In April 1992, a complaint was filed in the New Jersey Superior Court against the Company and the Bank seeking unspecified damages and alleging violations of state securities laws, certain banking laws and state common law. This lawsuit is in the discovery stage. The plaintiffs recently amended their complaint to add claims against nine individual defendants, including current and former officers and directors of the Company and the Bank. Management believes that the defendants have meritorious defenses in both of these matters and intends to vigorously defend these matters. Given the uncertainties involved in judicial proceedings and the preliminary stage of discovery in these matters, management cannot determine the precise amount of any potential loss that may arise in these matters. Accordingly, no provision for loss, if any, that may result upon resolution of these matters has been recorded in the Company's consolidated financial statements. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Bank is also subject to other legal proceedings involving collection matters, contract claims and miscellaneous items arising in the normal course of business. It is the opinion of management that the resolution of such legal proceedings will not have a material impact on the financial statements of the Company or the Bank. 12. FINANCIAL INSTRUMENTS Off-Balance-Sheet Risk In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk which are properly not recorded in the consolidated financial statements. These financial instruments principally represent commitments to extend credit to potential borrowers and involve, to varying degrees, elements of credit and interest-rate risk. At December 31, 1993 and 1992, the exposure to credit loss in the event of nonperformance by potential customers was represented by the contractual amount of the financial instruments as follows: Expiration Contractual Interest Dates Amount Rates Through ---------- ------- ---------- At December 31, 1993: Loan commitments--variable . . . . . $1,575,000 6.3%- 9.5% March 1994 Loan commitments--fixed. . . . . . . 4,939,000 6.3 -10.5 March 1994 Lines of credit--variable. . . . . . 1,081,000 7.5 -11.0 September 1994 Undisbursed construction loans-- fixed . . . . . . . . . . . . . . . 853,000 8.0 -10.0 August 1995 At December 31, 1992: Loan commitments--variable . . . . . $2,628,000 5.8%- 8.0% March 1993 Loan commitments--fixed. . . . . . . 2,519,000 7.8 -10.5 March 1993 Lines of credit--variable. . . . . . 808,000 8.0 -11.0 November 1993 Undisbursed construction loans-- fixed . . . . . . . . . . . . . . . 197,000 7.0 -10.0 October 1993 Since loan commitments and lines of credit may expire without being exercised, the total commitment amount does not necessarily represent future cash requirements. In addition, expiration dates may be extended. The amount of collateral obtained upon originating the loan is based upon management's credit evaluation of the potential borrower and the real estate financed. Concentrations of Credit Risk The Company's exposure to credit risk is dependent upon the economic condition of its primary market areas for lending--Bergen and Hudson counties, New Jersey. In addition, as of December 31, 1993, the Bankruptcy Loan is the only loan to any one borrower whose aggregate loan concentration was greater than 10% of stockholders' equity. Refer to Note 4 for a discussion of the Bankruptcy Loan. Furthermore, another borrower whose aggregate loan balance was greater than 10% of stockholders' equity as of December 31, 1992, prepaid such loan during 1993. The Company originates adjustable-rate loans to manage its interest exposure on its deposits. The adjustable-rate loans have interest rate adjustment limitations with annual and lifetime caps and are generally indexed to the 1 and 3 year Treasury indices. Future market factors may affect the correlation of the interest rate adjustment with the rates paid on deposits that have been primarily utilized to fund such loans. No loans had reached their interest rate adjustment limitation ceiling as of December 31, 1993. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Fair Value of Financial Instruments The estimated fair values of financial instruments, for which it is practicable to estimate fair values, as of December 31, 1993 and 1992 are as follows: December 31, --------------------------------------- 1993 1992 ------------------ ----------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- ------- ----- (in thousands) Financial assets: Cash and Federal funds sold. . . $ 6,183 $ 6,183 $ 7,336 $ 7,336 Investments available for sale . 57,740 57,740 1,936 1,954 Mortgage-backed securities available for sale. . . . . . . 9,517 9,517 -- -- Loans held for sale. . . . . . . 4,852 4,909 9,000 9,032 Investment securities. . . . . . 13,849 14,128 56,794 57,430 Mortgage-backed securities . . . 9,447 9,365 7,213 7,197 Loans. . . . . . . . . . . . . . 169,098 186,417 Less: allowance for losses. . . (2,828) (2,776) unearned income. . . . . . . (937) (1,140) ------- ------- 165,333 169,292 182,501 182,283 Investment in FHLB . . . . . . . 1,711 1,711 1,632 1,632 Financial liabilities: Deposits . . . . . . . . . . . . 246,043 246,305 252,623 253,287 Advances . . . . . . . . . . . . 400 401 -- -- 13. STOCKHOLDERS' EQUITY AND DIVIDEND RESTRICTIONS In 1987, when the Bank converted from a savings bank in mutual form to a savings bank in stock form, the Company established a liquidation account in an amount equal to the Bank's surplus and reserves at December 31, 1986 ($14,351,000). The liquidation account will be maintained for the benefit of eligible depositors who held deposit accounts of $50 or more in the Bank as of December 31, 1985 and who continue to maintain their accounts in the Bank. The liquidation account is reduced annually to the extent that eligible depositors have reduced their eligible deposits (subsequent increases will not restore an interest in the liquidation account). In the unlikely event of a complete liquidation, each eligible depositor will be entitled to receive a distribution from the liquidation account in a proportionate amount to the then current adjusted eligible balances for accounts then held. No dividends may be paid to stockholders if such dividends reduce stockholders' equity below the liquidation account, which was approximately $1.4 million at December 31, 1993. Certain restrictions exist regarding the ability of the Bank to transfer funds to the Company in the form of cash dividends, loans or advances. FDIC regulations limit the amount of dividends that may be paid by the Bank to the Company without prior approval of the FDIC to net profits (as defined) for the current year and the retained net profits (as defined) for the preceding two years. In addition, State banking regulations allow for the payment of dividends in any amount provided that capital stock will be unimpaired and there remains an additional amount of paid-in capital of not less than 50% of the capital stock amount. As of December 31, 1993, the undistributed earnings of the Bank approximated $11.6 million, of which $3.6 million was available for the payment of dividends to the Company. 14. REGULATORY MATTERS During the third quarter, the Federal Deposit Insurance Corporation (the "FDIC") completed its examination of the Bank as of August 2, 1993. As a result of that examination, the FDIC rescinded its Memorandum of Understanding which the Bank had signed on December 22, 1992 with the FDIC and the State of New Jersey Department of Banking in connection with their examination as of July 13, 1992. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Subsequently, the Federal Reserve Bank of New York (the "FRB") completed an off-site analysis of the Company. As a result of that analysis, the FRB rescinded its Memorandum of Understanding, which the Company had originally signed on August 13, 1991 in connection with the FRB's examination as of December 31, 1990. Under banking policies issued by the FDIC and the FRB, the Company and the Bank must maintain an adequate level of capital sufficient to meet a leverage capital ratio, a core risk-based capital ratio and a total risk-based capital ratio. The leverage capital ratio is calculated by dividing core capital by average total assets of the most recent quarter-end. The risk-based capital ratios require the Company and the Bank to classify their assets and certain off-balance-sheet activities into categories, and maintain specified levels of capital for each category. The least capital is required for the category deemed to have the least risk, and the most capital is required for the category deemed to have the greatest risk. For purposes of leverage and risk-based capital guidelines, core capital (also known as Tier 1 capital) consists of common equity in accordance with generally accepted accounting principles ("GAAP") excluding net unrealized gains or losses on available-for-sale securities and deferred tax assets that are dependent on the future taxable income greater than one year, and total capital consists of core capital plus a portion of the allowance for losses on loans. The qualifying portion of the allowance for losses on loans for the Company and the Bank was approximately $1.8 million and $2.3 million as of December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, capital ratios were as follows: December 31, ------------------------------------ 1993 1992 ---------------- ---------------- Capital ratios: Required* Company Bank Company Bank - --------------- -------- ------- ---- ------- ---- Leverage. . . . . . . . . . 5.00% 11.70% 11.38% 10.62% 10.33% Core risk-based . . . . . . 6.00 23.55 22.90 16.32 15.87 Total risk-based. . . . . . 10.00 24.81 24.16 17.58 17.12 - ------------ *For qualification as a well-capitalized institution. 15. MERGER AGREEMENT On November 8, 1993, the Company signed a definitive agreement (the "Agreement") providing for the merger of the Company with and into Hubco, Inc. of Union City, New Jersey. Under the terms of the Agreement, shareholders of the Company will receive either $16.10 in cash or .6708 of a share of new Series A Convertible Preferred Stock of Hubco, Inc. for each share of the Company's common stock. In addition, the Company issued an option to Hubco, Inc., exercisable in certain circumstances, to acquire 765,000 shares of its authorized but unissued stock at a price of $11.50 per share. The Agreement is subject to several conditions, including regulatory and shareholder approvals. Since significant conditions to effect the merger have not occurred, most merger costs are not included in the 1993 results of operations in the accompanying financial statements. WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 16. PARENT ONLY FINANCIAL INFORMATION The following are the balance sheets as of December 31, 1993 and 1992, and the statements of operations and retained earnings and the statements of cash flows for the years ended December 31, 1993, 1992 and 1991 for Washington Bancorp, Inc. (parent company only). BALANCE SHEETS December 31, -------------------------- 1993 1992 ----------- ----------- Assets: Due from banks. . . . . . . . . . . . . . . . . $ 1,002,000 $ 1,000,000 Investment in wholly-owned subsidiary, equity basis . . . . . . . . . . . . . . . . . 32,539,499 29,469,045 ----------- ----------- $33,541,499 $30,469,045 =========== =========== Stockholders' Equity: Preferred stock, par value $.10 per share, 3,000,000 shares authorized, no shares issued and outstanding. . . . . . . . . . . . . . . . $ -- $ -- Common stock, par value $.10 per share, 6,000,000 shares authorized, shares issued and outstanding-- 2,307,687 in 1993 and 2,307,187 in 1992 . . . 230,768 230,718 Paid-in capital . . . . . . . . . . . . . . . . 22,500,728 22,498,778 Retained earnings . . . . . . . . . . . . . . . 10,744,003 7,919,549 Unrealized gain on available-for-sale securities, net of tax . . . . . . . . . . . . . . . . . . 186,000 -- ----------- ----------- 33,661,499 30,649,045 Deferred compensation--MRP. . . . . . . . . . . (120,000) (180,000) ----------- ----------- $33,541,499 $30,469,045 =========== =========== STATEMENTS OF OPERATIONS AND RETAINED EARNINGS Year ended December 31, ---------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Equity in undistributed earnings/ (loss) of subsidiary . . . . . . $ 2,824,454 $ 2,095,981 $ (1,348,130) Retained earnings, beginning of year . . . . . . . . . . . . . . 7,919,549 5,823,568 7,171,698 ----------- ----------- ------------ Retained earnings, end of year. . $10,744,003 $ 7,919,549 $ 5,823,568 =========== =========== ============ STATEMENTS OF CASH FLOWS Year ended December 31, ---------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Cash Flows from Financing Activities: Exercise of stock options . . . . $ 2,000 $ -- $ -- Cash, at beginning of year. . . . 1,000,000 1,000,000 1,000,000 ---------- ---------- ---------- Cash, at end of year. . . . . . . $1,002,000 $1,000,000 $1,000,000 ========== ========== ========== WASHINGTON BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 17. Summary of Quarterly Results (Unaudited) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10. Item 10. Directors of the Registrant The Company responds to this Item by incorporating herein by reference the material responsive to such Item in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders. Item 11. Item 11. Executive Compensation The Company responds to this Item by incorporating herein by reference the material responsive to such Item in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The Company responds to this Item by incorporating herein by reference the material responsive to such Item in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders. Item 13. Item 13. Certain Relationships and Related Transactions The Company responds to this Item by incorporating herein by reference the material responsive to such Item in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a)(1) Financial Statements Financial Statements have been included in Item 8. (a)(2) Financial Statement Schedules All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. (b) Exhibits The following exhibits are filed as part of this Report. EXHIBIT NUMBER DESCRIPTION - ------- ----------- 3.1* Articles of Incorporation 3.2* Bylaws 10.1* Washington Savings Bank Employee Stock Ownership Plan 10.2** Washington Savings Bank Management Recognition Plan, as amended 10.3*** Washington Bancorp, Inc. Incentive Stock Option Plan 10.4*** Washington Bancorp, Inc. Option Plan for Outside Directors 10.5**** Severance Agreement between Washington Savings Bank, Washington Bancorp, Inc. and Paul Rotondi 10.6***** Agreement and Plan of Merger among Washington Bancorp, Inc., Washington Savings Bank, Hubco, Inc. and Hudson United Bank, dated November 8, 1993. 10.7 Washington Savings Bank Deferred Compensation Plan for Outside Directors 22.1****** Subsidiaries of the Registrant 24.1 Consent of Coopers & Lybrand 25.1 Power of Attorney - ------------ * Incorporated by reference to Exhibits 3.1, 3.2 and 10.1 filed with the Company's Registration Statement on Form S-1, No. 33-12637. ** Incorporated by reference to Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991. *** Incorporated by reference to Exhibits A and B, respectively, of the Company's 1989 Proxy Statement. **** Incorporated by reference to Exhibit 10.4 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989. ***** Incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. ****** Incorporated by reference to Exhibit 22.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. (c) Reports on Form 8-K The Company did not file any Current Reports on Form 8-K during the three months ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. WASHINGTON BANCORP, INC. By /s/ PAUL C. ROTONDI ----------------------------- (PAUL C. ROTONDI) CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER Dated: March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 30, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. /s/ PAUL C. ROTONDI Chairman of the Board and Chief - ------------------------------ Executive Officer and* (PAUL C. ROTONDI) as attorney in fact */s/ THOMAS S. BINGHAM Chief Financial and Accounting Officer - ------------------------------ (THOMAS S. BINGHAM) Directors: */s/ THEODORE DOLL, JR. - ------------------------------ ----------------------------- (WILSON A. BRITTEN) (THEODORE DOLL JR.) */s/ JOSEPH A. TIGHE, JR. /s/ PAUL C. ROTONDI - ------------------------------ ----------------------------- (JOSEPH A. TIGHE, JR.) (PAUL C. ROTONDI) */s/ ROBERT A. HAND */s/ JAMES M. UNGERLEIDER - ------------------------------ ----------------------------- (ROBERT A. HAND) (JAMES M. UNGERLEIDER) */s/ THEODORE J. DOLL - ------------------------------ (THEODORE J. DOLL) */s/ DUNCAN M. LASHER */s/ CHARLES A. ROTONDI - ------------------------------ ----------------------------- (DUNCAN M. LASHER) (CHARLES A. ROTONDI) EXHIBIT INDEX WASHINGTON BANCORP, INC. EXHIBIT Page NUMBER DESCRIPTION Number - ------- ----------- ------ 3.1* Articles of Incorporation 3.2* Bylaws 10.1* Washington Savings Bank Employee Stock Ownership Plan 10.2** Washington Savings Bank Management Recognition Plan, as amended 10.3*** Washington Bancorp, Inc. Incentive Stock Option Plan 10.4*** Washington Bancorp, Inc. Option Plan for Outside Directors 10.5**** Severance Agreement between Washington Savings Bank, Washington Bancorp, Inc. and Paul Rotondi 10.6***** Agreement and Plan of Merger among Washington Bancorp, Inc., Washington Savings Bank, Hubco, Inc. and Hudson United Bank, dated November 8, 1993. 10.7 Washington Savings Bank Deferred Compensation Plan for Outside Directors 60 22.1****** Subsidiaries of the Registrant 24.1 Consent of Coopers & Lybrand 58 25.1 Power of Attorney 59 - ------------ * Incorporated by reference to Exhibits 3.1, 3.2 and 10.1 filed with the Company's Registration Statement on Form S-1, No. 33-12637. ** Incorporated by reference to Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991. *** Incorporated by reference to Exhibits A and B, respectively, of the Company's 1989 Proxy Statement. **** Incorporated by reference to Exhibit 10.4 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989. ***** Incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. ****** Incorporated by reference to Exhibit 22.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the inclusion in the 1993 Annual Report on Form 10-K and to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-8 No. 33-25089 and No. 33-25090 of Washington Bancorp, Inc. of our report, which includes an explanatory paragraph regarding changes in accounting principles and includes an explanatory paragraph regarding an action seeking unspecified damages and alleging violations of state securities laws, certain banking laws and state common law and a lawsuit filed by a former Bank officer which alleges wrongful termination and seeks unspecified damages, dated January 28, 1994, on our audits of the consolidated financial statements of Washington Bancorp, Inc. and Subsidiary as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which report appears on page 29 of the 1993 Annual Report on Form 10-K. /s/COOPERS & LYBRAND Coopers & Lybrand Parsippany, New Jersey March 30, 1994 POWER OF ATTORNEY WHEREAS, the undersigned officers and directors of Washington Bancorp, Inc. desire to authorize Paul C. Rotondi, Theodore J. Doll and Thomas S. Bingham to act as their attorneys in fact and agents, for the purpose of executing and filing the Annual Report described below, including all amendments and supplements thereto, NOW THEREFORE, NOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Paul C. Rotondi, Theodore J. Doll and Thomas S. Bingham and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, to sign the Annual Report on Form 10-K for the year ended December 31, 1993, including any and all amendments thereto, and to file the same with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully and to all intents and purposes as he might or could in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Report on the 22nd day of March, 1994. SIGNATURE TITLE --------- ----- /s/ PAUL C. ROTONDI Chairman of the Board - ----------------------------------- (PAUL C. ROTONDI) Director - ----------------------------------- (WILSON A. BRITTEN) /s/ THEODORE DOLL, JR. Director - ----------------------------------- (THEODORE DOLL, JR.) /s/ THEODORE J. DOLL Director - ----------------------------------- (THEODORE J. DOLL) /s/ ROBERT A. HAND Director - ----------------------------------- (ROBERT A. HAND) /s/ CHARLES A. ROTONDI Director - ----------------------------------- (CHARLES A. ROTONDI) /s/ JOSEPH A. TIGHE, JR. Director - ----------------------------------- (JOSEPH A. TIGHE, JR.) /s/ JAMES M. UNGERLEIDER Director - ----------------------------------- (JAMES M. UNGERLEIDER) /s/ DUNCAN M. LASHER Director - ----------------------------------- (DUNCAN M. LASHER) /s/ THOMAS S. BINGHAM Chief Financial and Accounting Officer - ----------------------------------- (THOMAS S. BINGHAM) Washington Savings Bank Deferred Compensation Plan For Outside Directors Washington Savings Bank Deferred Compensation Plan For Outside Directors ARTICLE PAGE I Definitions 62 II Eligibility 64 III Benefits 64 IV Vesting 65 V Death Benefits 66 VI Payment of Benefits 67 VII Funding 67 VIII Administration of the Plan 67 IX Miscellaneous 70 Washington Savings Bank Deferred Compensation Plan For Outside Directors WHEREAS, Washington Savings Bank (the "Company") desires to reward certain members of its Board of Directors for services provided to the Company. NOW THEREFORE, the Company does hereby adopt the Washington Savings Bank Deferred Compensation Plan for Outside Directors (the "Plan"), effective September 14, 1993. ARTICLE I Definitions In this Plan, unless the context clearly implies otherwise, the singular includes the plural, the masculine includes the feminine, and initially capitalized words have the following meanings: 1.1 Actuarial Assumptions. An amount or benefit of equivalent current value to the amount or benefit which would have been provided to or on account of a Qualified Outside Director determined on the basis of such actuarial assumptions then in effect under the Retirement Plan of Washington Savings Bank in Retirement System for Savings Institutions (the "Retirement Plan"). In the event that the Retirement Plan has been terminated at the time a benefit is to be determined, then the interest rate used shall be fifty percent (50%) of the sum of (i) the prime rate of Citibank plus (ii) the 10 year constant maturity U.S. Treasury bond as of the relevant date. 1.2 Board. The Board of Directors of Washington Savings Bank as constituted from time to time. 1.3 Change in Control. For purposes of this Plan, a Change in Control of the Company shall mean a change in control of a nature that: (i) would be required to be reported in response to Item 1 of a Current Report on Form 8-K, as in effect on the date hereof, pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"); or (ii) results in a change in the outstanding voting stock of the Holding Company such that a change in control of the Holding Company has occurred within the meaning of 12 U.S.C. (sec)1817, Change in Bank Control Act, or Section 303.4(a) of the Rules and Regulations for FDIC Insured Institutions promulgated thereunder; (iii) provided that, without limitation, such a Change in Control shall be deemed to have occurred at such time as (a) any "person" (as such term is used in Sections 13(d) and 14(d) of the Exchange Act) is or becomes the "beneficial owner" (as defined in Rule 13d-3 issued under the Exchange Act), directly or indirectly, of securities of the Holding Company representing 20% or more of the combined voting power of the Holding Company's outstanding securities ordinarily having the right to vote on the election of directors (except for any securities purchased by the ESOP of the Company); or (b) individuals who constitute the Board on the date hereof (the "Incumbent Board") cease for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to the date hereof whose election was approved by a vote of at least three-quarters of the directors comprising the Incumbent Board, or whose nomination for election by the Holding Company's shareholders was approved by the Holding Company's Nominating Committee, shall be, for purposes of this clause (b), considered as though he were a member of the Incumbent Board; or (c) a merger, consolidation or sale of all or substantially all the assets of the Holding Company occurs; or (d) a proxy statement soliciting proxies from stockholders of the Holding Company, by someone other than the current management of the Holding Company, seeking stockholder approval of the reorganization, merger or consolidation of the Holding Company with one or more corporations as a result of which the outstanding shares of the class of securities then subject to the 1987 Incentive Stock Option Plan of the Holding Company (the "Stock Option Plan") are exchanged for or converted into cash or property or securities not issued by the Holding Company shall be distributed, regardless of whether the reorganization, merger or consolidation shall have been affirmatively recommended to the Holding Company's stockholders by a majority of the members of its Board of Directors. 1.4 Committee. The Washington Savings Bank Deferred Compensation Plan Committee appointed by the Board to administer this Plan. The Committee shall be responsible for the administration of this Plan in accordance with Article VIII. 1.5 Company. Washington Savings Bank or any successor thereto. 1.6 Holding Company. Washington Bancorp, Inc. 1.7 Outside Director. Any member of the Board who is neither an officer nor an employee of the Company or its affiliates at the time appointed to the Board. 1.8 Plan. The Washington Savings Bank Deferred Compensation Plan for Outside Directors as amended and/or restated from time to time. 1.9 Plan Year. Each twelve (12) consecutive month period beginning January 1 and ending December 31. 1.10 Qualified Outside Director. Any Outside Director who has served in that capacity for at least five consecutive calendar years. In the event of a Change in Control, each Outside Director then a member of the Board shall be a Qualified Outside Director even if service to the Board has been less then five consecutive calendar years. ARTICLE II Eligibility 2.1 Any Qualified Outside Director shall be eligible to receive retirement benefits as set forth in Article III. 2.2 The Board may withhold approval for benefits for a Qualified Outside Director only if the Qualified Outside Director's retirement is due to conduct which would support termination of an employee for "cause." 2.3 If an Outside Director becomes an officer or employee of the Company or its affiliates, then service on the Board while such an officer or employee will count towards eligibility, benefits, and vesting. ARTICLE III Benefits 3.1 In the absence of a Change in Control, and subject to sections 3.3 and 3.4 herein, a vested Qualified Outside Director will receive an annual benefit equal to: (a) 50% of the Board's annual retainer in effect at the time of retirement or separation (the "Then Current Retainer") plus (b) 5% of the Then Current Retainer for each additional year of service in excess of 5 years (up to a maximum of 10 additional years). 3.2 Upon the occurrence of a Change in Control, each Qualified Outside Director who is neither an officer nor an employee of the Company or the Holding Company at the time of such occurrence, shall (i) be eligible for benefits under the Plan, (ii) be treated as fully vested, regardless of whether he has 15 years of service or has attained age 65, and (iii) receive a benefit as follows: (a) The benefit for a Qualified Outside Director shall be equal to the product of four times the Then Current Retainer (as defined in section 3.1). (b) Subject to section 3.3 herein, each Qualified Outside Director will receive the value of the benefit determined pursuant to this section 3.2(a) in a single cash payment as soon as possible following the Change in Control. 3.3 Upon the occurrence of a Change in Control, payment of benefits pursuant to section 3.1 shall cease and the Qualified Outside Director shall instead receive a single cash payment as soon as possible following the Change in Control equal to the benefit for which the Qualified Outside Director is eligible under section 3.2(a) reduced, but not below zero, by the sum of all payments previously paid to such Qualified Outside Director pursuant to section 3.1. If the Qualified Outside Director is ineligible to receive any benefits under section 3.2, then, notwithstanding the provisions of the Plan to the contrary, the Qualified Outside Director shall receive no benefits pursuant to this Plan after the occurrence of a Change in Control. The Committee shall notify each Qualified Outside Director of the occurrence of a Change in Control, the total amount of benefits previously paid pursuant to section 3.1, and the amount of benefits, if any, to be paid in a single cash payment following the Change in Control. For purposes of this section 3.3, any Qualified Outside Director entitled to no additional benefits pursuant to this section 3.3 shall be deemed paid in full upon delivery of the Committee's notice. Once benefits have been paid in accordance with this section 3.3, no other payments shall be due under this Plan. 3.4 Notwithstanding sections 3.1 and 3.2, benefits which are prohibited or limited by the Comprehensive Thrift and Bank Fraud Prosecution and Taxpayer Recovery Act of 1990 shall not be payable without the consent of the appropriate federal banking agency and the written concurrence of the Federal Deposit Insurance Corporation. The Company shall exert its best efforts to obtain such consent and concurrence. ARTICLE IV Vesting A Qualified Outside Director will vest in his or her benefit while such director is serving on the Board upon the first of the following to occur: (i) the completion of 15 years as a director of the Company; (ii) the Qualified Outside Director's 65th birthday; (iii) the Qualified Outside Director's death; or (iv) the occurrence of a Change in Control. ARTICLE V Death Benefits 5.1 Subject to section 5.4, if a Qualified Outside Director otherwise eligible for benefits dies, then 50% of such benefits shall be payable to his surviving spouse depending on such Outside Director's age at the date of death. 5.2 If the deceased Qualified Outside Director had already attained age 65, the surviving spouse will receive such benefits for which the Qualified Outside Director was otherwise eligible until the death or remarriage of the spouse or the occurrence of a Change in Control. In the absence of a Change in Control benefits shall be paid monthly. 5.3 If the deceased Qualified Outside Director had not attained age 65 at the date of death, then the surviving spouse will receive such benefits, payable in monthly installments, for which the Qualified Outside Director was otherwise eligible until the first of the following occurs: (i) the spouse remarries; (ii) the spouse dies; (iii) the occurrence of a Change in Control; or (iv) 180 monthly payments are made. 5.4 Upon the occurrence of a Change in Control, payment of death benefits to the surviving spouse pursuant to section 5.2 or 5.3, as applicable, shall cease and the surviving spouse shall instead receive a single cash payment as soon as possible following the Change in Control equal to the benefit for which the Qualified Outside Director (to whom the surviving spouse was married) was eligible under section 3.2(a) reduced, but not below zero, by the sum of all payments previously paid pursuant to section 5.3 or 5.4, as applicable, to such surviving spouse. If the Qualified Outside Director was ineligible to receive any benefits under section 3.2, then, notwithstanding the provisions of this Plan to the contrary, the surviving spouse shall receive no benefits pursuant to this Plan after the occurrence of a Change in Control. The Committee shall notify each surviving spouse of a deceased Qualified Outside Director of the occurrence of a Change in Control, the total amount of benefits previously paid pursuant to this Article V and the amount of benefits, if any, to be paid in a single cash payment following the Change in Control. For purposes of this section 5.4, any surviving spouse entitled to no additional benefits pursuant to this section 5.4 shall be deemed paid in full upon delivery of the Committee's notice. Once benefits have been paid in accordance with this section 5.4, no other payments shall be due under this Plan. ARTICLE VI Payment of Benefits 6.1 Timing. Except as otherwise provided in Section 3.2, a Qualified Outside Director shall be entitled to receive benefits under the Plan on the later of his retirement or separation from the Board or his 65th birthday. 6.2 Form of Payment. Except as otherwise provided in Section 3.2, a Qualified Outside Director's benefits shall be paid in the form of a life annuity payable in monthly installments. ARTICLE VII Funding Benefits payable under this Plan shall be paid directly from the general assets of the Company. The Company shall not be obligated to set aside, earmark or escrow any funds or other assets to satisfy its obligations under this Plan, and the Qualified Outside Director and his spouse shall not have any property interest in any specific assets of the Company other than the unsecured right to receive payments from the Company as provided herein. ARTICLE VIII Administration of the Plan 8.1 The Committee shall be generally responsible for the operation and administration of the Plan. To the extent that powers are not delegated to others pursuant to the provisions of this Plan, the Committee shall have such powers as may be necessary to carry out the provisions of the Plan and to perform its duties hereunder, including, without limiting the generality of the foregoing, the power: (a) To appoint, retain, and terminate such persons as it deems necessary or advisable to assist in the administration of the Plan or to render advice with respect to the responsibilities of the Committee under the Plan, including accountants, actuaries, administrators and attorneys. (b) To make use of the services of the employees of the Company in administrative matters. (c) To obtain and act on the basis of all tables, valuations, certificates, opinions, and reports furnished by the persons described in paragraph (a) or (b) above. Any determination based on Actuarial Assumptions by the actuary selected by the Committee shall be conclusive and binding on the Company, the Committee, and all Qualified Outside Directors. (d) To review the manner in which benefit claims and other aspects of the Plan administration have been handled by the employees of the Company. (e) To determine all benefits and resolve all questions pertaining to the administration and interpretation of the Plan provisions, either by rules of general applicability or by particular decisions. To the maximum extent permitted by law, all interpretations of the Plan and other decisions of the Committee shall be conclusive and binding on all parties. (f) To adopt such forms, rules and regulations as it shall deem necessary or appropriate for the administration of the Plan and the conduct of its affairs, provided that any such forms, rules and regulations shall not be inconsistent with the provisions of the Plan. (g) To remedy any inequity resulting from incorrect information received, communicated or resulting from administrative error. (h) To commence or defend any litigation arising from the operation of the Plan in any legal or administrative proceeding. 8.2 Required Information. Any Qualified Outside Director and any spouse eligible to receive benefits under the Plan shall furnish to the Committee any information or proof requested by the Committee and reasonably required for the proper administration of the Plan. Failure on the part of the Qualified Outside Director or spouse to comply with any such request within a reasonable period of time shall be sufficient grounds for delay in the payment of benefits under the Plan until such information or proof is received by the Committee. 8.3 Expenses. All expenses incident to the operation and administration of the Plan reasonably incurred, including, without limitation by way of specification, the fees and expenses of attorneys and advisors, and for such other professional, technical and clerical assistance as may be required, shall be paid by the Company. 8.4 Indemnification. To the extent coverage is not provided by any applicable insurance policy, the Company hereby agrees to indemnify the Committee and each of its members, and the Board and each of its members, and to hold them harmless against all liability, joint and several, for their acts, omissions and conduct and for the acts, omissions and conduct of their duly appointed agents made in good faith pursuant to the provisions of the Plan, including any out-of-pocket expenses reasonably incurred in the defense of any claim relating thereto; provided, however, that no person or entity so indemnified shall voluntarily assume or admit any liability, nor, except at its or his own cost, shall any of the foregoing make any payment, assume any obligations or incur any expense without the prior written consent of the Board. The Company may purchase, at its expense, liability insurance to protect the Company and the persons indemnified hereunder from liability incurred in the good faith administration of this Plan. 8.5 Claims Procedure and Review. (a) Claims for benefits under the Plan shall be filed in writing by a claimant with the Committee. Within sixty (60) days after receipt of such claim, the Committee shall act on the claim and shall notify the claimant in writing as to whether the claim has been granted in whole or in part; provided, however, if the claimant has not received written notice of such decision within such sixty-day period, the claimant shall, for the purpose of subsection (c) of this Section, regard his claim as having been denied. (b) Any notice of denial of a claim in whole or in part shall set forth (i) the specific reason or reasons for the denial, (ii) reference to the Plan provisions on which the denial is based, and (iii) a copy of the Plan's claim and review provisions. (c) Any claimant who has been denied a claim in whole or in part under the Plan shall be entitled, upon the filing of a written request for review with the Committee within sixty (60) days after receipt by the claimant of written notice of denial of his claim (or, if the claimant had not received written notice of the decision within the sixty-day period described in subsection (a) of this Section, within one hundred twenty (120) days of receipt of the claim form by the Committee), to appeal the denial of his claim to the Committee. (d) The claimant shall be entitled in connection with such appeal to examine pertinent documents and submit issues and comments in writing to the Committee. Any decision on review by the Committee shall be in writing, and shall include specific reasons for the decision (including reference to the Plan provisions on which the decision is based). Such decision shall be made by the Committee not later than sixty (60) days after receipt by it of the claimant's request for review. ARTICLE IX Miscellaneous 9.1 Amendment or Termination. (a) The Board reserves the right to amend, modify, restate or terminate the Plan; provided, however, that no such action by the Board shall reduce a Qualified Outside Director's benefit accrued as of the time thereof. Provided, further that no such amendment or termination may occur as a result of a Change in Control, within three years after a Change in Control, or as part of any plan to effect a Change in Control. (b) If the Plan is terminated or amended, a determination shall be made of the Qualified Outside Director's benefit as of the Plan termination or amendment date. Neither the termination nor an amendment of the Plan shall adversely affect any person who, at the time of such action, satisfies the Plan's definition of Qualified Outside Director without such person's consent. 9.2 Status as Director. Nothing herein contained shall be deemed: (a) to give any Qualified Outside Director the right to be retained as a director of the Company; (b) to give the Company the right to require any Qualified Outside Director to remain on the Board; or (c) to affect any Qualified Outside Director's membership on the Board. 9.3 Payments to Incompetents. If a Qualified Outside Director or spouse entitled to receive any benefits hereunder is adjudged to be legally incapable of giving a valid receipt and discharge for such benefits, they will be paid to the duly appointed guardian of such incompetent or to such other legally appointed person as the Committee may designate. Such payment shall, to the extent made, be deemed a complete discharge of any liability for such payment under the Plan. 9.4. Inalienability of Benefits. The right of any person to any benefit or payment under the Plan shall not be subject to voluntary or involuntary transfer, alienation or assignment, and, to the fullest extent permitted by law, shall not be subject to attachment, execution, garnishment, sequestration or other legal or equitable process. In the event a person who is receiving or is entitled to receive benefits under the Plan attempts to assign, transfer or dispose of such right, or if an attempt is made to subject said right to such process, then such assignment, transfer or disposition shall be null and void. 9.5 Governing Law. Except to the extent preempted by Federal law, the Plan shall be governed by and construed in accordance with the laws of the State of New Jersey. 9.6 Arbitration. Any dispute or controversy arising under or in connection with this Agreement which cannot be resolved informally by the parties, including the arbitrability of the dispute itself, shall be submitted to arbitration and adjudicated pursuant to the rules of the American Arbitration Association then in effect, except that the parties to such arbitration shall be entitled to engage in pre-trial discovery, to the extent permitted by and according to the provisions of the Federal Rules of Civil Procedure. Pending the resolution of any such dispute or controversy, the Participant shall continue to receive all benefits to which he was entitled immediately prior to the time such controversy or dispute arose. The decision of the arbitrator shall be final and binding on all parties hereto, and judgment may be entered on the arbitrator's award in any court having jurisdiction thereof. 9.7 Severability. In case any provision of this Plan shall be held illegal or invalid for any reason, such illegality or invalidity shall not affect the remaining provi- sions of the Plan, and the Plan shall be construed and enforced as if such illegal and invalid provisions had never been set forth. 9.8 Income and Payroll Tax Withholding. To the extent required by the laws in effect at the time payments are made under this Plan, the Company shall withhold from such payments any taxes required to be withheld for federal, state or local government purposes. IN WITNESS WHEREOF, WASHINGTON SAVINGS BANK has adopted this plan effective as of the 14th day of September, 1993. ATTEST (SEAL): WASHINGTON SAVINGS BANK /s/ANTONIA GADALETA BY:/s/PAUL C. ROTONDI - ------------------- -------------------

858470_1993.txt

858470_1993

1993

858470

ITEM 1. BUSINESS GENERAL Cabot Oil & Gas Corporation (or, the "Company") develops, produces, explores for, stores, transports, purchases and markets natural gas and, to a lesser extent, produces and sells crude oil. Substantially all of the Company's operations are in the Appalachian Region of West Virginia, Pennsylvania and New York, and in the Anadarko Region of southwestern Kansas, Oklahoma and the Texas Panhandle. At December 31, 1993, the Company had approximately 825 Bcfe of proved reserves, 98% of which was natural gas. A significant portion of the Company's natural gas reserves is located in long-lived fields with extended production histories. The Company, a Delaware corporation, was organized in 1989 as the successor to the oil and gas business of Cabot Corporation ("Cabot"), which was founded in 1891. In 1990, the Company completed its initial public offering of approximately 18% of the outstanding common stock held by Cabot. Cabot distributed the remaining common stock of the Company to the shareholders of Cabot in 1991. Since that time, the Company has been widely held and publicly traded on the New York Stock Exchange. See Note 1 of the Notes to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof for further discussion. Unless the context otherwise requires, all references herein to the Company include Cabot Oil & Gas Corporation, its predecessors and subsidiaries. Similarly, all references to Cabot include Cabot Corporation and its affiliates. All references to wells are gross, unless otherwise stated. The following table summarizes certain information, at December 31, 1993, regarding the Company's proved reserves, productive wells, developed and undeveloped acreage and infrastructure. SUMMARY OF RESERVES, PRODUCTION, ACREAGE AND OTHER INFORMATION BY AREAS OF OPERATION (1)(2) - --------------- (1) As of December 31, 1993. For additional information regarding the Company's estimates of proved reserves and other data, see "Business -- Reserves," "Business -- Acreage," "Business -- Productive Well Summary" and "Supplemental Oil and Gas Information to the Consolidated Financial Statements." (2) Certain numbers may not add due to rounding. (3) Includes all properties outside the Appalachian Region, most notably properties located in the Anadarko Region. EXPLORATION, DEVELOPMENT AND PRODUCTION The Company is one of the largest producers of natural gas in the Appalachian Region, where it has conducted operations for more than a century. The Company has had operations in the Anadarko Region for over 50 years. Historically, the Company has maintained its reserve base through low-risk development drilling. The Company continues to focus its operations in the Appalachian and Anadarko Regions through development of undeveloped reserves and acreage, acquisition of oil and gas producing properties and, to a lesser extent, exploration. However, the Company has adopted a strategic plan to continue the exploitation of its existing asset base, exploring possible acquisition opportunities both within and outside of the Company's core areas and expanding its marketing capabilities. APPALACHIAN REGION The Company's exploration, development and production activities in the Appalachian Region are concentrated in Pennsylvania, West Virginia and New York. Operations are managed by a regional office in Pittsburgh. At December 31, 1993, the Company had approximately 557 Bcfe of proved reserves (substantially all natural gas) in the Appalachian Region, constituting 67% of the Company's total proved reserves. The Appalachian Region also accounted for 55 percent of the Company's 1993 production. The Company has 4,017 productive wells (3,688.4 net) of which 3,905 wells are operated by the Company. There are multiple producing intervals which include the Medina, Berea and Big Line trend formations at depths ranging from 1,500 to 8,700 feet. Average net daily production in 1993 was 72.0 MMcfe. While natural gas production volumes from Appalachian reservoirs are relatively low on a per-well basis compared to other areas of the United States, the productive life of Appalachian reserves is relatively long. The Company's finding and development costs for its Appalachian reserves are lower than the U.S. industry average because of the comparatively shallow reservoir depths and a lower incidence of dry holes. In 1993, the Company drilled 126 wells (122.1 net) wells in the Appalachian Region (122 development wells). Capital and exploration expenditures for the year were approximately $86.5 million, including the $46.4 million EMAX Acquisition (described in "Acquisitions" below). In the 1994 drilling program year, the Company has plans to drill approximately 158 wells. At December 31, 1993, the Company had approximately 1.23 million net acres, including 759 thousand net developed acres. At year end, the Company had identified 298.5 additional net development drilling locations. The Company also owns and operates a brine treatment plant near Franklin, Pennsylvania. The plant, which began operating in 1985, processes and treats waste fluid generated during the drilling, completion and subsequent production of oil and gas wells. The plant provides services to the Company and certain other oil and gas producers in southwestern New York, eastern Ohio and western Pennsylvania. The Company believes that it gains operational efficiency, and therefore maximizes the return on its investment in the Appalachian Region because of its large acreage position, its high concentration of wells, its substantial ongoing drilling program conducted over a number of years, its natural gas gathering and pipeline systems and its storage capacity. ANADARKO REGION The Company's exploration, development and production activities in the Anadarko Region are primarily focused in Kansas, Oklahoma and Texas. Operations are managed by a regional office in Oklahoma City. At December 31, 1993, the Company had approximately 269 Bcfe of proved reserves (substantially all natural gas) in the Anadarko Region, constituting 33% of the Company's total proved reserves. The Company has an interest in 1,163 productive wells (547 net) of which 701 wells are operated by the Company. Principal producing intervals are in the Chase, Chester and Marrow formations at depths ranging from 1,500 to 11,000 feet. Average net daily production in 1993 was 59.8 MMcfe. In 1993, the Company drilled 36 wells (27.7 net) in the Anadarko Region (all development wells). Capital and exploration expenditures for the year were approximately $48.7 million, including the non-cash $34.6 million Harvard Acquisition (described in "Acquisitions" below). In the 1994 drilling program year, the Company has plans to drill approximately 30 wells. At December 31, 1993, the Company had approximately 208 thousand net acres, including 176 thousand net developed acres. At year end, the Company had identified 54.3 additional net development drilling locations. ACQUISITIONS As part of its long-term growth strategy, the Company placed greater emphasis on acquiring proved oil and gas properties in 1993. The Company's focus is on the acquisition of producing properties with additional development drilling potential that would complement the Company's existing operations. The objective is to acquire properties where low-risk development drilling or improved production methods can increase proved reserves attributable to acquired oil and gas properties. In May 1993, the Company purchased oil and natural gas properties located in the Anadarko Region of Texas and Oklahoma, and in the East Texas Basin from Harken Anadarko Partners, L.P. (the "Harvard Acquisition"). The Company issued 692,439 shares of $3.125 convertible preferred stock to Harvard University. The preferred stock has a total stated value of $34.6 million, or $50 per share, and is convertible, subject to certain adjustments, into 1,648,662 shares of Common Stock at $21 per share, also subject to certain adjustments. As of the acquisition date, the properties had approximately 38.2 billion cubic feet equivalent of proved reserves which were 80% natural gas and included 518 (166 net) wells. Almost 45% of the wells are operated by the Company. Average net daily production on these properties in 1993 was 10.95 million cubic feet equivalent ("MMcfe"). In September 1993, the Company purchased oil and natural gas properties and related assets located in the Appalachian Region of West Virginia and Pennsylvania from Emax Oil Company (the "EMAX Acquisition") for approximately $44.1 million, subject to certain adjustments. As of the acquisition date, the properties had approximately 47.1 billion cubic feet equivalent of proved reserves of which 99% were natural gas. The properties include 300 (291 net) wells, all but one of which are operated by the Company. Average net daily production on these properties in 1993 was 8.70 MMcfe. As part of the acquisition, the Company entered into a development agreement that provides for the acquisition of additional drilling locations for approximately $106 thousand per location. The agreement provides for the drilling of 78 such wells under a farmout from a local producer. Total expected drilling costs for these 78 wells are estimated at $13.6 million. The Company drilled 22 of these wells in 1993, which added approximately 5.2 Bcfe to the proved reserves acquired and increased the total acquisition cost by $2.3 million. At year end the Company had identified 69 future drilling locations, including the remaining locations associated with the farm-out agreement mentioned above. On February 25, 1994, the Company entered into a merger agreement with Washington Energy Company ("WECO") to merge its subsidiary Washington Energy Resources Company ("WERCO") into COG Acquisition Company, a subsidiary of the Company (the "Merger Agreement"). The Company will acquire the common stock of WERCO in a tax-free exchange for total consideration of $180 million, subject to certain adjustments. As of January 1, 1994, WERCO held 230 Bcfe of proved reserves located in the Green River Basin of Wyoming and in South Texas. The reserves are 82% natural gas. WERCO's current net production is 43 mmcf of natural gas, 450 barrels of natural gas liquids and 1,550 barrels of oil and condensate per day. WERCO produces from 376 wells, 116 net to their interest and operates 184 wells, 87 net. The Company will issue 2,133,000 shares of its common stock, par value $.10 (the "Common Stock") and 1,134,000 shares of a 6% Convertible Redeemable Preferred Stock (the "6% Preferred Stock") in exchange for the common stock of WERCO. The 6% Preferred Stock has a stated value of $50.00 per share and is convertible into 1,972,174 shares of Common Stock at $28.75 per share. Because of the size of WECO's investment in the Company, WECO will be able to nominate two directors to serve on the Company's Board of Directors. In addition, the Company will advance cash to repay intercompany indebtedness outstanding at closing and assume $5.9 of third party debt. The amount of intercompany debt of WERCO at December 31, 1993 was $69,100,000, as adjusted. The Merger Agreement contains a provision that WECO may terminate the transaction if the average of the Company's Common Stock price for the ten trading days ending on the third business day prior to the closing is less than $19.00; provided, however, that the Company may cure such deficit in cash up to $10 million. The closing of the transaction is anticipated to take place three business days following the satisfaction of the conditions of closing. One closing condition is that certain firm transportation, storage and other contractual arrangements be transferred from WERCO's marketing affiliate to a newly formed subsidiary of WECO. The Company anticipates that the closing of the transaction will occur in early spring. GAS MARKETING The Company is engaged in a wide array of marketing activities designed to offer its customers long-term reliable supplies of natural gas. Utilizing its pipeline and storage facilities, gas procurement ability and transportation and natural gas swap expertise, the Company provides a menu of services that include gas supply management, short and long-term supply contracts, capacity brokering and risk management alternatives. The marketing of natural gas has changed significantly as a result of Order 636 (the "Order"), which was issued by the Federal Energy Regulatory Commission (the "FERC") in 1992. The Order required interstate pipelines to unbundle their gas sales, storage and transportation services. As a result, local distribution companies and end-users will separately contract these services from gas marketers and producers. The Order has created greater competition in the industry while providing the Company the opportunity to reach broader markets. In 1993, this has meant an increase in the number of third-party producers that use the Company to market their gas and margin pressures from increased competition for markets. APPALACHIAN REGION The Company's principal markets for Appalachian Region natural gas are in the northeastern United States. The Company's marketing subsidiary purchases substantially all of the Company's natural gas production as well as production from local third-party producers and other suppliers in order to aggregate larger volumes of natural gas for resale. This marketing subsidiary sells natural gas to industrial customers, interstate pipelines, local distribution companies and gas marketers. A substantial portion of the Company's natural gas sales volume in the Appalachian Region currently is sold under short-term contracts (a year or less) at market-responsive prices. The Company's spot market sales are made under month-to-month contracts while the Company's industrial and utility sales generally are made under year-to-year contracts. Spot market and term sales constituted 60% and 40%, respectively, of total Appalachian gas sales in 1993. The Company's Appalachian production is generally sold at a premium price to production from certain other producing regions due to its close proximity to markets. However, that premium has been reduced from historic levels due to increased competition in the market place resulting, in part, from changes in transportation and sales arrangements due to the implementation of pipeline open access tariffs. The Company operates a number of gas gathering and pipeline systems, made up of approximately 3,500 miles of pipeline with interconnects to four interstate and five local distribution companies ("LDCs"). The Company's natural gas gathering and pipeline systems enable the Company to connect new wells quickly and to transport natural gas from the wellhead directly to interstate pipelines, local distribution companies and industrial end-users. Control of its gathering and pipeline systems also enables the Company to purchase, transport and sell natural gas produced by third parties. In addition, the Company can undertake development drilling operations without relying upon third parties to transport its natural gas while incurring only the incremental costs of additions to its system and lease operations. The Company has two natural gas storage fields, with a combined working capacity of approximately 4 Bcf of natural gas, located in West Virginia. The Company uses these storage fields to take advantage of the seasonal variations in the demand for natural gas and the higher prices typically associated with winter natural gas sales, while maintaining its production at a nearly constant rate throughout the year. The storage fields also enable the Company to increase periodically the volume of natural gas it can deliver by more than 35% above the volume that it could deliver solely from its production in the Appalachian Region. The pipeline systems and storage fields are fully integrated with the Company's producing operations. ANADARKO REGION The Company's principal markets for Anadarko Region natural gas are in the midwestern United States. The Company's marketing subsidiary purchases substantially all of the Company's natural gas production. The marketing subsidiary sells natural gas to interstate pipelines, natural gas processors, LDCs, industrial customers and marketing companies. Currently, the Company's natural gas production in the Anadarko Region is being sold primarily under short-term contracts (a year or less) at market-responsive prices. The Anadarko Region properties are connected to the majority of the midwestern interstate pipelines, affording the Company access to multiple markets. RISK MANAGEMENT From time to time, the Company enters into certain transactions to manage price risks associated with the purchase and sale of oil and gas including, swaps and options. The Company utilized certain gas price swap agreements ("price swaps") to manage price risk more effectively and improve the Company's realized gas prices. These price swaps call for payments to (or to receive payments from) counterparties based upon the differential between a fixed and a variable gas price. The current price swaps run for periods of a year or less and have a remaining notional contract amount of 4,080,000 MMbtu of natural gas at December 31, 1993. The Company plans to continue this strategy in the future. RESERVES CURRENT RESERVES The Company's drilling program, combined with acquisitions in its core areas, created a 12 percent increase in proved reserves. Reserve replacement for the Company's drilling program was 127% in 1993, and the 1993 reserve replacement including acquisitions was 287 percent. The following table sets forth information regarding the Company's estimates of its net proved reserves at December 31, 1993. - --------------- (1) Liquids include crude oil and condensate. (2) Natural Gas Equivalents are determined using the ratio of 6.0 Mcf of natural gas to 1.0 Bbl of crude oil or condensate. The reserve estimates presented herein were prepared by the Company and reviewed by Miller and Lents, Ltd., independent petroleum engineers. For additional information regarding the Company's estimates of proved reserves, the review of such estimates by Miller and Lents, Ltd. and certain other information regarding the Company's oil and gas reserves, see the Supplemental Oil and Gas information to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof. A copy of the review letter by Miller and Lents, Ltd., has been filed as an exhibit to this Form 10-K. The Company's estimates of reserves set forth in the foregoing table do not differ materially from those filed by the Company with other federal agencies. The Company's reserves are sensitive to gas sales prices and their effect on economic producing rates. The Company's reserves are based on oil and gas prices in effect at December 31, 1993. There are numerous uncertainties inherent in estimating quantities of proved reserves, including many factors beyond the control of the Company. The reserve data set forth in this Form 10-K represent only estimates. Reserve engineering is a subjective process of estimating underground accumulations of crude oil and natural gas that cannot be measured in an exact manner, and the accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. As a result, estimates of different engineers often vary. In addition, results of drilling, testing and production subsequent to the date of an estimate may justify revision of such estimate. Accordingly, reserve estimates are often different from the quantities of crude oil and natural gas that are ultimately recovered. The meaningfulness of such estimates is highly dependent upon the accuracy of the assumptions upon which they are based. In general, the volume of production from oil and gas properties owned by the Company declines as reserves are depleted. Except to the extent the Company acquires additional properties containing proved reserves or conducts successful exploration and development activities or both, the proved reserves of the Company will decline as reserves are produced. THREE-YEAR RESERVES The following table sets forth certain information regarding the Company's estimated proved reserves for the periods indicated. - --------------- Note: Natural gas equivalents are determined using the ratio of 6.0 Mcf of natural gas to 1.0 Bbl of crude oil or condensate. VOLUMES AND PRICES; PRODUCTION COSTS The following table sets forth historical information regarding the Company's sales and production volumes of average sales prices received for, and average production costs associated with, its sales of natural gas and crude oil and condensate for the periods indicated. - --------------- (1) Equal to the aggregate of production and the net changes in storage and exchanges less fuel and line loss. (2) Represents the average sales prices for all volumes (including royalty volumes) sold by the Company during the periods shown. (3) Production costs include direct lifting costs (labor, repairs and maintenance, materials and supplies), and the costs of administration of production offices, insurance and property and severance taxes but is exclusive of depreciation and depletion application to capitalized lease acquisition, exploration and development expenditures. ACREAGE The following tables summarize the Company's gross and net developed and undeveloped leasehold and mineral acreage at December 31, 1993. Acreage in which the Company's interest is limited to royalty and overriding royalty interests is excluded. The undeveloped mineral fee acreage in West Virginia is unleased. LEASEHOLD ACREAGE MINERAL FEE ACREAGE TOTAL NET ACREAGE BY AREA OF OPERATION PRODUCTIVE WELL SUMMARY (1) The following table reflects the Company's ownership at December 31, 1993 in natural gas and oil wells in the Appalachian Region (consisting of various fields located in West Virginia, Pennsylvania, New York, Ohio, Virginia and Kentucky) and in the Anadarko Region (consisting of various fields located in Oklahoma, Texas, Kansas, North Dakota and Wyoming). - --------------- (1) "Productive" wells are producing wells and wells capable of production. DRILLING ACTIVITY The Company drilled, participated in the drilling of, or acquired wells as set forth in the table below for the periods indicated: - --------------- (1) At December 31, 1993, the Company had no waterfloods in the process of installation and was not conducting any pressure maintenance operations. (2) Includes the acquisition of net interest in certain wells in the Appalachian Region and in the Anadarko Region in 1993, 1992 and 1991 in which the Company already held an ownership interest. COMPETITION Competition in the Company's primary producing areas is intense. The Company believes that its competitive position is affected by price, contract terms and quality of service, including pipeline connection times, distribution efficiencies and reliable delivery record. The Company believes that its extensive acreage position, substantial ongoing drilling program and existing natural gas gathering and pipeline systems and storage fields give it a competitive advantage over certain other producers in the Appalachian Region which do not have such systems or facilities in place. The Company also believes that its competitive position in the Appalachian Region is enhanced by the absence of significant competition from major oil and gas companies. The Company also actively competes against some companies with substantially larger financial and other resources, particularly in the Anadarko Region. OTHER BUSINESS MATTERS MAJOR CUSTOMER The Company had no sales to any customer that exceeded 10% of the Company's total revenues in 1993. SEASONALITY Demand for natural gas is seasonal in nature, with peak demand and typically higher prices occurring during the colder winter months. REGULATION OF OIL AND GAS PRODUCTION The Company's oil and gas production and transportation operations are subject to various types of regulation, including regulation by state and federal agencies. Although such regulations have an impact on the Company and others in the oil, gas and pipeline industry, the Company does not believe that it is affected in a significantly different manner by these regulations than others in the oil and gas industry. Legislation affecting the oil and gas industry is under constant review for amendment or expansion. Numerous departments and agencies, both federal and state, are authorized by statute to issue, and have issued, rules and regulations binding on the oil and gas industry and its individual members. The failure to comply with such rules and regulations can result in substantial penalties. Many states require permits for drilling operations, drilling bonds and reports concerning operations. Many states also have statutes or regulations addressing, conservation matters, including provisions for the utilization or pooling of oil and gas properties, the establishment of maximum rates of production from oil and gas wells and the regulation of spacing, plugging and abandonment of such wells. Some state statutes and regulations limit the rate at which oil and gas can be produced from the Company's properties. With respect to the establishment of maximum production rates from gas wells, certain producing states, in an attempt to limit production to market demand, have recently adopted (Texas and Oklahoma) or are considering adopting (Louisiana) measures that alter the methods previously used to prorate gas production from wells located in these states. For example, the new Texas rules provide for reliance on information filed monthly by well operators, in addition to historical production data for the well during comparable past periods, to arrive at an allowable. This is in contrast to historic reliance on forecasts of upcoming takes filed monthly by purchasers of natural gas in formulating allowable, a procedure which resulted in substantial excess allowable over volumes actually produced. The Company cannot predict whether other states will adopt similar or other gas prorationing procedures. While it is still unclear how these new regulations will be administered, the effect of these regulations could be to decrease allowable production on the Company's properties, and thereby to decrease revenues. However, management believes that such regulation would not have a significant impact on the Company's revenues. By decreasing the amount of natural gas available in the market, such regulations could also have the effect of increasing prices of natural gas, although there can be no assurance that any such increase will occur. The company cannot predict whether these new prorationing regulations will be challenged in the courts or the outcome of such challenges. The Natural Gas Act of 1938 (the "NGA") regulates the interstate transportation and certain sales for resale of natural gas. The Natural Gas Policy Act of 1978 (the "NGPA") regulated the maximum selling prices of certain categories of natural gas, when sold in so-called "first sales" in interstate or intrastate commerce and provided for phased deregulation of price controls of the first sales of several categories of natural gas. These statutes are administered by the FERC. As a result of the enactment of the Natural Gas Wellhead Decontrol Act of 1989 ("Decontrol Act") on July 26, 1989, all remaining "first sales" price regulations imposed by the NGA and NGPA terminated on January 1, 1993. Commencing in late 1985 and early 1986, the FERC issued a series of orders which significantly altered the marketing and pricing of natural gas. Among other things, the new regulations require interstate pipelines that elect to transport natural gas for others under self-implementing authority to provide transportation services to all shippers (e.g., producers, marketers, local distributors and end-users) on an open and non-discriminatory basis, and permit each existing firm sales customer of such pipelines to modify, over at least a five-year period, its existing firm purchase obligations. Order No. 500 was issued by the FERC on August 7, 1989, in response to the remand of Order No. 436 by the United States Court of Appeals for the District of Columbia. Order No. 500 repromulgated most of the provisions of Order No. 436 and resulted in an almost complete affirmation of the Order No. 500 "open access" rules, with the exception of the pregranted abandonment issue and the use of certain types of pass through mechanisms by interstate pipelines to recover take-or-pay costs. In April 1992, the FERC issued Order 636, a complex regulation which is expected to have a major impact on natural gas pipeline operations, services and rates. Among other things, Order 636 requires each interstate pipeline company to "unbundle" its traditional wholesale services and create and make available on an open and nondiscriminatory basis numerous constituent services (such as gathering services, storage services, firm and interruptible transportation services, and stand-by sales services) and to adopt a new rate making methodology to determine appropriate rates for those services. To the extent the pipeline company or its sales affiliate makes gas sales as a merchant in the future, it will do so in direct competition with all other sellers pursuant to private contracts; however, pipeline companies are not required to remain "merchants" of gas, and many of the interstate pipeline companies have or will become "transporters only." On August 3, 1992, the FERC issued Order 636-A, which largely reaffirmed Order 636 and denied a stay of the implementation of the new rules pending judicial review. On November 27, 1992, the FERC issued Order 636-B which uniformly upheld the requirements and regulations adopted in Order 636 and 636-A. As a result of these events, individual so-called "restructuring" proceedings are on-going before FERC by which each interstate pipeline company will develop and propose particularized features and procedures for its system to implement Order 636 requirements. These new rules are already the subject of appeals in the United States Courts of Appeals. The Company cannot predict whether Order 636 will be affirmed on appeal. However "open access" transportation under Order 636 has provided the Company with the opportunity to market gas to a wide variety of markets. The Company's pipeline systems and storage fields are regulated for safety compliance by the Department of Transportation, the West Virginia Public Service Commission, the Pennsylvania Department of Natural Resources and the New York Department of Public Service. The Company's pipeline systems in each state operate independently and are not interconnected. ENVIRONMENTAL REGULATIONS The Company's operations are subject to extensive federal, state and local laws and regulations relating to the generation, storage, handling, emission, transportation and discharge of materials into the environment. Permits are required for the operation of various facilities of the Company, and these permits are subject to revocation, modification and renewal by issuing authorities. Governmental authorities have the power to enforce compliance with their regulations, and violations are subject to fines, injunctions or both. It is possible that increasingly strict requirements will be imposed by environmental laws and enforcement policies thereunder. The Company is also subject to the Federal Clean Air Act and the Federal Clean Air Act Amendments of 1990 which added significantly to the existing requirements established by the Federal Clean Air Act. It is not anticipated that the Company will be required in the near future to expend amounts that are material in relation to its total capital expenditures program by reason of environmental laws and regulations, but inasmuch as such laws and regulations are frequently changed, the Company is unable to predict the ultimate cost of such compliance. The Company owns and operates a brine treatment plant in Pennsylvania which processes fluids generated by drilling and production operations. See "Exploration, Development and Production -- Appalachian Region." The plant's operations are regulated by Pennsylvania's Department of Environmental Regulation. EMPLOYEES The Company had approximately 433 active employees as of December 31, 1993. The Company believes that its relations with its employees are satisfactory. The Company has not entered into any collective bargaining agreements with its employees. ITEM 2. ITEM 2. PROPERTIES See "Item 1. Business." ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are defendants or parties in numerous lawsuits or other governmental proceedings arising in the ordinary course of business. See Note 10 of the Notes to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof for a discussion of Company contingencies. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the period from October 1, 1993 to December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following table shows certain information about the executive officers of the Company as of March 1, 1994, as such term is defined in Rule 3b-7 promulgated under the Securities Exchange Act of 1934, as amended. With the exception of the following, all officers of the Company have been employed by the Company for more than the last five years. John H. Lollar joined the Company in October 1992 being elected President and Director. In January 1994. Mr. Lollar was elected Chairman of the Board and Chief Executive Officer. Prior to joining the Company, Mr. Lollar was President and Chief Operating Officer of Transco Exploration and Production Company from 1982 to 1992 and Executive Vice President and Chief Operating Officer, in addition to holding other positions, of Gulf Resources & Chemical Corporation from 1968 to 1982. John U. Clarke joined the Company in August 1993 as Executive Vice President -- Chief Financial Officer and Chief Administrative Officer. Prior to joining the Company, he was employed by Transco Energy Company from April 1981 to May 1993, most recently in the position of Senior Vice President, Chief Financial Officer and Treasurer. Previously, he was employed by Tenneco Inc. in the finance department. Richard T. Parrish joined the Company in August 1993 as Vice President, Engineering. Prior to joining the Company, Mr. Parrish was Vice President, Engineering and Planning, for Transco Exploration and Production Company from 1977 to 1992 and Assistant District Engineer, Reservoir and Production for Texaco, Inc. from 1974 to 1977. Prior thereto, Mr. Parrish was employed in various engineering capacities with Texaco, Inc. from 1969 to 1974. Kirk O. Kuwitzky joined the Company in January, 1994 as Vice President, Marketing. Prior to joining the Company, he was employed by Enron Corp. from 1981-1993, most recently as Vice President-Marketing for Enron Gas Marketing. In addition, he previously held various marketing positions with Enron Gas Marketing and several positions in Enron Corp.'s law department. From 1978 until 1981, he was an attorney with Minnesota Power. Steven W. Tholen has been Treasurer of the Company since June 1992. Prior thereto, Mr. Tholen was Assistant Treasurer from January 1992 to June 1992 and was Manager, Treasury Operations from May 1990 to January 1992. Prior to joining the Company, Mr. Tholen was employed in a treasury capacity for Reading & Bates Corporation from February 1989 to May 1990. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company has furnished to the Securities and Exchange Commission pursuant to Rule 14a-3(c) an annual report to security holders for the year ended December 31, 1993 (the "Annual Report"), that contains the information required by Rule 14a-3. The information required by this item appears under the caption "Price Range of Common Stock and Dividends" on page 42 of the Annual Report, which is incorporated herein by reference, and in Note 12 of the Notes to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof. ITEM 6. ITEM 6. SELECTED HISTORICAL FINANCIAL DATA The information required by this item appears under the caption "Selected Historical Financial Data" on page 17 of the Annual Report and is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item appears under the caption "Financial Review" on pages 18 through 23 of the Annual Report and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item appears on pages 24 through 43 of the Annual Report and is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information to be set forth under the caption "I. Election of Directors" in the Company's definitive proxy statement ("Proxy Statement") in connection with the 1994 annual stockholders meeting, is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the caption "II. Executive Compensation" in the Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the caption "I. Election of Directors" in the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K A. INDEX Other financial statement schedules have been omitted because they are inapplicable or the information required therein is included elsewhere in the consolidated financial statements or notes thereto. 3. EXHIBITS The following instruments are included as exhibits to this report. Those exhibits below incorporated by reference herein are indicated as such by the information supplied in the parenthetical thereafter. If no parenthetical appears after an exhibit, copies of the instrument have been included herewith. B. REPORTS ON FORM 8-K (1) Form 8-K/A, Amendment No. 1 to Current Report, dated September 30, 1993. Filed on November 15, 1993. (2) Form 8-K/A, Amendment No. 2 to Current Report, dated September 30, 1993. Filed on December 14, 1993. 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, in the City of Houston, State of Texas, on the 25th day of February 1994. CABOT OIL & GAS CORPORATION By: /s/ JOHN H. LOLLAR John H. Lollar, Chairman of the Board and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of Cabot Oil & Gas Corporation: Our report on the consolidated financial statements of Cabot Oil & Gas Corporation has been incorporated by reference in this Form 10-K from page 24 of the 1993 Annual Report to Stockholders. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 17 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Houston, Texas February 25, 1994 S-1 SCHEDULE V CABOT OIL & GAS CORPORATION PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) - --------------- (1) Includes a reclassification to accumulated depreciation, depletion and amortization (Schedule VI). S-2 SCHEDULE VI CABOT OIL & GAS CORPORATION ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) - --------------- (1) Includes a reclassification to accumulated depreciation, depletion and amortization (Schedule VI). (2) Accumulated depreciation, depletion and amortization of property, plant and equipment includes a reserve for dismantlement, restoration and abandonment of proved oil and gas properties. Accordingly, actual expenditures will result in a retirement on Schedule VI without any corresponding retirement on Schedule V. S-3 SCHEDULE X CABOT OIL & GAS CORPORATION SUPPLEMENTAL INCOME STATEMENT INFORMATION (DOLLARS IN THOUSANDS) S-4

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Item 1.BUSINESS - -------------------------------------------------------------------------------- GENERAL AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company which owns, directly or indirectly, all of the outstanding common stock of its operating electric utility subsidiaries. Substantially all of the operating revenues of AEP and its subsidiaries are derived from the furnishing of electric service. The service area of AEP's electric utility subsidiaries covers portions of the states of Indiana, Kentucky, Michigan, Ohio, Tennessee, Virginia and West Virginia. The generating and transmission facilities of AEP's subsidiaries are physically interconnected, and their operations are coordinated, as a single integrated electric utility system. Transmission networks are interconnected with extensive distribution facilities in the territories served. At December 31, 1993, the subsidiaries of AEP had a total of 20,007 employees. AEP, as such, has no employees. The principal operating subsidiaries of AEP are: APCo (organized in Virginia in 1926), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 838,000 customers in the southwestern portion of Virginia and southern West Virginia, and in supplying electric power at wholesale to other electric utility companies and municipalities in those states and in Tennessee. At December 31, 1993, APCo and its wholly owned subsidiaries had 4,587 employees. A generating subsidiary of APCo, Kanawha Valley Power Company, which owns and operates under Federal license three hydroelectric generating stations located on Government lands adjacent to Government- owned navigation dams on the Kanawha River in West Virginia, sells its net output to APCo. Among the principal industries served by APCo are coal mining, primary metals, chemicals, textiles, paper, stone, clay, glass and concrete products and furniture. In addition to its AEP System interconnection, APCo also is interconnected with the following unaffiliated utility companies: Carolina Power & Light Company, Duke Power Company and VEPCo. A comparatively small part of the properties and business of APCo is located in the northeastern end of the Tennessee Valley. APCo has several points of interconnection with TVA and has entered into agreements with TVA under which APCo and TVA interchange and transfer electric power over portions of their respective systems. CSPCo (organized in Ohio in 1937, the earliest direct predecessor company having been organized in 1883), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 578,000 customers in Ohio, and in supplying electric power at wholesale to other electric utilities and to municipally owned distribution systems within its service area. At December 31, 1993, CSPCo had 2,143 employees. CSPCo's service area is comprised of two areas in Ohio, which include portions of twenty-five counties. One area includes the City of Columbus and the other is a predominantly rural area in south central Ohio. Approximately 80% of CSPCo's retail revenues are derived from the Columbus area. Among the principal industries served are food processing, chemicals, primary metals, electronic machinery and paper products. In addition to its AEP System interconnection, CSPCo also is interconnected with the following unaffiliated utility companies: CG&E, DP&L and Ohio Edison Company. I&M (organized in Indiana in 1925), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 525,000 customers in northern and eastern Indiana and southwestern Michigan, and in supplying electric power at wholesale to other electric utility companies, rural electric cooperatives and municipalities. At December 31, 1993, I&M had 3,944 employees. Among the principal industries served are transportation equipment, primary metals, fabricated metal products, electrical and electronic machinery, rubber and miscellaneous plastic products and chemicals and allied products. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana. In addition to its AEP System interconnection, I&M also is interconnected with the following unaffiliated utility companies: Central Illinois Public Service Company, CG&E, Commonwealth Edison Company, Consumers Power Company, Illinois Power Company, Indianapolis Power & Light Company, Louisville Gas and Electric Company, Northern Indiana Public Service Company, PSI Energy Inc. and Richmond Power & Light Company. KEPCo (organized in Kentucky in 1919), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 161,000 customers in an area in eastern Kentucky, and in supplying electric power at wholesale to other utilities and municipalities in Kentucky. At December 31, 1993, KEPCo had 842 employees. In addition to its AEP System interconnection, KEPCo also is interconnected with the following unaffiliated utility companies: Kentucky Utilities Company and East Kentucky Power Cooperative Inc. KEPCo is also interconnected with TVA. Kingsport Power Company (organized in Virginia in 1917), which provides electric service to approximately 41,000 customers in Kingsport and eight neighboring communities in northeastern Tennessee. Kingsport Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from APCo. At December 31, 1993, Kingsport Power Company had 102 employees. OPCo (organized in Ohio in 1907 and reincorporated in 1924), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 657,000 customers in the northwestern, east central, eastern and southern sections of Ohio, and in supplying electric power at wholesale to other electric utility companies and municipalities. At December 31, 1993, OPCo and its wholly owned subsidiaries had 5,749 employees. Among the principal industries served by OPCo are primary metals, stone, clay, glass and concrete products, rubber and plastic products, petroleum refining, chemicals and metal and wire products. In addition to its AEP System interconnection, OPCo also is interconnected with the following unaffiliated utility companies: CG&E, The Cleveland Electric Illuminating Company, DP&L, Duquesne Light Company, Kentucky Utilities Company, Monongahela Power Company, Ohio Edison Company, The Toledo Edison Company and West Penn Power Company. Wheeling Power Company (organized in West Virginia in 1883 and reincorporated in 1911), which provides electric service to approximately 41,000 customers in northern West Virginia. Wheeling Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from OPCo. At December 31, 1993, Wheeling Power Company had 143 employees. Another principal electric utility subsidiary of AEP is AEGCo, which was organized in Ohio in 1982 as an electric generating company. AEGCo sells power at wholesale to I&M, KEPCo and VEPCo. AEGCo has no employees. See Item 2 Item 2.PROPERTIES - -------------------------------------------------------------------------------- At December 31, 1993, subsidiaries of AEP owned (or leased where indicated) generating plants with the net power capabilities (winter rating) shown in the following table: - -------- (a) Unit 1 of the Rockport Plant is owned one-half by AEGCo and one-half by I&M. Unit 2 of the Rockport Plant is leased one-half by AEGCo and one-half by I&M. The leases terminate in 2022 unless extended. (b) Unit 3 of the John E. Amos Plant is owned one-third by APCo and two-thirds by OPCo. (c) Represents CSPCo's ownership interest in generating units owned in common with CG&E and DP&L. (d) I&M plans to close the Breed Plant on March 31, 1994. (e) Leased from the City of Fort Wayne. Indiana. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana under a 35-year lease with a provision for an additional 15-year extension at the election of I&M. See Item 1 under Fuel Supply, for information concerning coal reserves owned or controlled by subsidiaries of AEP. The following table sets forth the total circuit miles of transmission and distribution lines of the AEP System, APCo, CSPCo, I&M, KEPCo and OPCo and that portion of the total representing 765,000-volt lines: - -------- (a)Includes jointly owned lines. (b)Includes lines of other AEP System companies not shown. TITLES The AEP System's electric generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of the System in the realty on which its facilities are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. System companies generally have the right of eminent domain whereby they may, if necessary, acquire, perfect or secure titles to or easements on privately-held lands used or to be used in their utility operations. Substantially all the physical properties of APCo, CSPCo, I&M, KEPCo and OPCo are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of each such company. SYSTEM TRANSMISSION LINES AND FACILITY SITING Legislation in the states of Indiana, Kentucky, Michigan, Ohio, Virginia, and West Virginia requires prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. Delays and additional costs in constructing facilities have been experienced as a result of proceedings conducted pursuant to such statutes, as well as in proceedings in which operating companies have sought to acquire rights-of-way through condemnation, and such proceedings may result in additional delays and costs in future years. PEAK DEMAND The AEP System is interconnected through 119 high-voltage transmission interconnections with 29 neighboring electric utility systems. The all-time and 1993 one-hour peak demands were 25,174,000 and 22,142,000 kilowatts, respectively, (including 6,459,000 and 4,043,000 kilowatts, respectively, of scheduled deliveries to unaffiliated systems which the System might, on appropriate notice, have elected not to schedule for delivery) and occurred on January 18, 1994 and July 26, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual obligations, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time and 1993 one-hour internal peak demands were 19,236,000 and 18,085,000 kilowatts, respectively, and occurred on January 19, 1994 and July 28, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual arrangements, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time one-hour integrated and internal net system peak demands and 1993 peak demands for AEP's generating subsidiaries are shown in the following tabulation: HYDROELECTRIC PLANTS Licenses for hydroelectric plants, issued under the Federal Power Act, reserve to the United States the right to take over the project at the expiration of the license term, to issue a new license to another entity, or to relicense the project to the existing licensee. In the event that a project is taken over by the United States or licensed to a new licensee, the Federal Power Act provides for payment to the existing licensee of its "net investment" plus severance damages. Licenses for six System hydroelectric plants expired in 1993 and applications for new licenses for these plants were filed in 1991. The existing licenses for these plants were extended on an annual basis and will be renewed automatically until new licenses are issued. No competing license applications were filed. One new license was issued in March 1994. COOK NUCLEAR PLANT Unit 1 of the Cook Plant, which was placed in commercial operation in 1975, has a nominal net electric rating of 1,020,000 kilowatts. Unit 1's availability factor was 100% during 1993 and 64.8% during 1992. Unit 2, of slightly different design, has a nominal net electrical rating of 1,090,000 kilowatts and was placed in commercial operation in 1978. Unit 2's availability factor was 96.6% during 1993 and 19.5% during 1992. The availability of Units 1 and 2 was affected in 1992 by outages to refuel and Unit 2 main turbine/generator vibrational problems. Units 1 and 2 are licensed by the NRC to operate at 100% of rated thermal power to October 25, 2014 and December 23, 2017, respectively. NUCLEAR INSURANCE The Price-Anderson Act limits public liability for a nuclear incident at any nuclear plant in the United States to $9.4 billion. I&M has insurance coverage for liability from a nuclear incident at its Cook Plant. Such coverage is provided through a combination of private liability insurance, with the maximum amount available of $200,000,000, and mandatory participation for the remainder of the $9.4 billion liability, in an industry retrospective deferred premium plan which would, in case of a nuclear incident, assess all licensees of nuclear plants in the U.S. Under the deferred premium plan, I&M could be assessed up to $158,600,000 payable in annual installments of $20,000,000 in the event of a nuclear incident at Cook or any other nuclear plant in the U.S. There is no limit on the number of incidents for which I&M could be assessed these sums. I&M also has property damage, decontamination and decommissioning insurance for loss resulting from damage to the Cook Plant facilities in the amount of $2.75 billion. Nuclear insurance pools provide $1.265 billion of coverage and Nuclear Electric Insurance Limited (NEIL) and Energy Insurance Bermuda (EIB) provide the remainder. If NEIL's and EIB's losses exceed their available resources, I&M would be subject to a total retrospective premium assessment of up to $15,327,023. NRC regulations require that, in the event of an accident, whenever the estimated costs of reactor stabilization and site decontamination exceed $100,000,000, the insurance proceeds must be used, first, to return the reactor to, and maintain it in, a safe and stable condition and, second, to decontaminate the reactor and reactor station site in accordance with a plan approved by the NRC. The insurers then would indemnify I&M for property damage up to $2.5 billion less any amounts used for stabilization and decontamination. The remaining $250,000,000, as provided by NEIL (reduced by any stabilization and decontamination expenditures over $2.5 billion), would cover decommissioning costs in excess of funds already collected for decommissioning. See Fuel Supply--Nuclear Waste. NEIL's extra-expense program provides insurance to cover extra costs resulting from a prolonged accidental outage of a nuclear unit. I&M's policy insures against such increased costs up to approximately $3,500,000 per week (starting 21 weeks after the outage) for one year, $2,350,000 per week for the second and third years, or 80% of those amounts per unit if both units are down for the same reason. If NEIL's losses exceed its available resources, I&M would be subject to a total retrospective premium assessment of up to $8,929,456. POTENTIAL UNINSURED LOSSES Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to the Cook Plant and costs of replacement power in the event of a nuclear incident at the Cook Plant. Future losses or liabilities which are not completely insured, unless allowed to be recovered through rates, could have a material adverse effect on results of operation and the financial condition of AEP, I&M and other AEP System companies. Item 3. Item 3.LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- In February 1990 the Supreme Court of Indiana overturned an order of the IURC, affirmed by the Indiana Court of Appeals, which had awarded I&M the right to serve a General Motors Corporation light truck manufacturing facility located in Fort Wayne. In August 1990 the IURC issued an order transferring the right to serve the GM facility to an unaffiliated local distribution utility. In October 1990 the local distribution utility sued I&M in Indiana under a provision of Indiana law that allows the local distribution utility to seek damages equal to the gross revenues received by a utility that renders retail service in the designated service territory of another utility. On November 30, 1992, the DeKalb Circuit Court granted I&M's motion for summary judgment to dismiss the local distribution utility's complaint. The local distribution utility has begun an appeal to the Indiana Court of Appeals. I&M received revenues of approximately $29,000,000 from serving the GM facility. It is not clear whether the plaintiffs claim will be upheld on appeal because the service was rendered in accordance with an IURC order I&M believed in good faith to be valid. On April 4, 1991, then Secretary of Labor Lynn Martin announced that the U.S. Department of Labor ("DOL") had issued a total of 4,710 citations to operators of 847 coal mines who allegedly submitted respirable dust sampling cassettes that had been altered so as to remove a portion of the dust. The cassettes were submitted in compliance with DOL regulations which require systematic sampling of airborne dust in coal mines and submission of the entire cassettes (which include filters for collecting dust particulates) to the Mine Safety and Health Administration ("MSHA") for analysis. The amount of dust contained on the cassette's filter determines an operator's compliance with respirable dust standards under the law. OPCo's Meigs No. 2, Meigs No. 31, Martinka, and Windsor Coal mines received 16, 3, 15 and 2 citations, respectively. MSHA has assessed civil penalties totalling $56,900 for all these citations. OPCo's samples in question involve about 1 percent of the 2,500 air samples that OPCo submitted over a 20-month period from 1989 through 1991 to the DOL. OPCo is contesting the citations before the Federal Mine Safety and Health Review Commission. An administrative hearing was held before an administrative law judge with respect to all affected coal operators. On July 20, 1993, the administrative law judge rendered a decision in this case holding that the Secretary of Labor failed to establish that the presence of a "white center" on the dust sampling filter indicated intentional alteration. The administrative law judge has set for trial the case of an unaffiliated mine to determine if there was an intentional alteration of the dust sampling filter. All remaining cases, including the citations involving OPCo's mines, have been stayed. On September 21, 1993, CSPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Conesville Plant of the Toxic Substances Control Act and proposed a penalty of $41,000. On October 4, 1993, I&M was served with a complaint issued by Region V, Federal EPA which alleged violations by Breed Plant of the Clean Water Act and proposed a penalty of $70,000. On October 4, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by OPCo's General Service Center (Canton, Ohio) of the Toxic Substances Control Act and proposed a penalty of $24,000. Settlement discussions have been held in each of these cases and it is expected that these matters will be resolved shortly. On June 18, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Muskingum River Plant of the Toxic Substances Control Act and proposed a penalty of $87,000. In February 1994, OPCo paid a penalty of $12,185 and agreed to undertake supplemental environmental projects in 1994 valued at $61,547. On February 28, 1994, Ormet Corporation filed a complaint in the U.S. District Court, Northern District of West Virginia, against AEP, OPCo, the Service Corporation and two of its employees, Federal EPA and the Administrator of Federal EPA. Ormet is the operator of a major aluminum reduction plant in Ohio and is a customer of OPCo. See Certain Industrial Contracts. Pursuant to the Clean Air Act Amendments of 1990, OPCo received sulfur dioxide emission allowances for its Kammer Plant. See Environmental and Other Matters. Ormet's complaint seeks a declaration that it is the owner of approximately 89% of the Phase I and Phase II allowances issued for use by the Kammer Plant. OPCo believes that since it is the owner and operator of Kammer Plant and Ormet is a contract power customer, Ormet is not entitled to any of the allowances attributable to the Kammer Plant. See Item 1 for a discussion of certain environmental and rate matters. Meigs Mine--On July 11, 1993, water from an adjoining sealed and abandoned mine owned by Southern Ohio Coal Company ("SOCCo"), a mining subsidiary of OPCo, entered Meigs 31 mine, one of two mines currently being operated by SOCCo. Ohio EPA approved a plan to pump water from the mine to certain Ohio River tributaries under stringent conditions for biological and water quality monitoring and restoring the streams after pumping. On July 30, pumping commenced in accordance with the Ohio EPA approved plan. Since September 16, 1993, SOCCo has processed all water removed from the mine through its expanded treatment system and is in compliance with the effluent limitations in its water discharge permit. Pumping has removed most of the water that entered the mine on July 11 and the mine was returned to service in February 1994. On July 26, 1993, the Ohio Department of Natural Resources Division of Reclamation issued an administrative order directing SOCCo to cease pumping due to that agency's concern over possible environmental harm. On July 26, 1993, following SOCCo's appeal of the cessation order, the chairman of the Reclamation Board of Review issued a temporary stay pending a hearing by the full Reclamation Board. On January 14, 1994, the administrative proceeding was settled on the basis of agreements by the Division of Reclamation to dismiss the administrative order and by SOCCo to treat all water removed from the mine in accordance with its discharge permit and to pay certain expenses of the Division of Reclamation. On August 19, 1993, the U.S. District Court for the Southern District of Ohio granted SOCCo's motion for a preliminary injunction against the Federal Office of Surface Mining Reclamation and Enforcement ("OSM") and Federal EPA preventing them from exercising jurisdiction to issue orders to cease pumping. On August 30, 1993, the U.S. Court of Appeals for the Sixth Circuit denied OSM's motion for a stay of the District Court's preliminary injunction but granted Federal EPA's motion for a stay in part which allowed Federal EPA to investigate and make findings with respect to alleged violations of the Clean Water Act and thereafter to exercise its enforcement authority under the Clean Water Act if a violation was identified. On September 2, 1993, Federal EPA issued an administrative order requiring a partial cessation of pumping, the effect of which was delayed by Federal EPA until September 8, 1993. On September 8, 1993, the District Court granted SOCCo's motion requesting that enforcement of the Federal EPA order be stayed. On September 23, 1993, the Court of Appeals ruled that the District Court could not review the Federal EPA order in the absence of a civil enforcement action and lifted the stay. A further decision of the Court of Appeals with respect to the appeal of the preliminary injunction is pending. On January 3, 1994, the District Court held that the complaint filed by SOCCo should not be dismissed and concluded that sufficient legal and factual grounds existed for the court to consider SOCCo's claim that Federal EPA could not override Ohio EPA's authorization for SOCCo to bypass its water treatment system on an emergency basis during pumping activities. In a separate opinion, the District Court denied Federal EPA's request that the District Court defer consideration of SOCCo's motion involving a request for a Declaration of Rights with respect to the mine water releases into area streams. The West Virginia Division of Environmental Protection ("West Virginia DEP") has proposed fining SOCCo $1,800,000 for violations of West Virginia Water Quality Standards and permitting requirements alleged to have resulted from the release of mine water into the Ohio River. SOCCo is meeting with the West Virginia DEP in an attempt to resolve this matter. Although management is unable to predict what enforcement action Federal EPA or OSM may take, the resolution of the aforementioned litigation, environmental mitigation costs and mine restoration costs are not expected to have a material adverse impact on results of operations or financial condition. Item 4. Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - -------------------------------------------------------------------------------- AEP, APCO, I&M AND OPCO. None. AEGCO, CSPCO AND KEPCO. Omitted pursuant to Instruction J(2)(c). ---------------- EXECUTIVE OFFICERS OF THE REGISTRANTS AEP The following persons are, or may be deemed, executive officers of AEP. Their ages are given as of March 15, 1994. - -------- (a) All of the executive officers listed above have been employed by the Service Corporation or System companies in various capacities (AEP, as such, has no employees) during the past five years, except E. Linn Draper, Jr. who was Chairman of the Board, President and Chief Executive Officer of Gulf States Utilities Company from 1987 until 1992 when he joined AEP and the Service Corporation. All of the above officers are appointed annually for a one-year term by the board of directors of AEP, the board of directors of the Service Corporation, or both, as the case may be. APCO The names of the executive officers of APCo, the positions they hold with APCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appears below. The directors and executive officers of APCo are elected annually to serve a one-year term. - -------- (a)Positions are with APCo unless otherwise indicated. OPCO The names of the executive officers of OPCo, the positions they hold with OPCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of OPCo are elected annually to serve a one-year term. - -------- (a)Positions are with OPCo unless otherwise indicated. PART II --------------------------------------------------------------------- Item 5. Item 5.MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------------------------------------- AEP. AEP Common Stock is traded principally on the New York Stock Exchange. The following table sets forth for the calendar periods indicated the high and low sales prices for the Common Stock as reported on the New York Stock Exchange Composite Tape and the amount of cash dividends paid per share of Common Stock. - -------- (1) See Note 5 of the Notes to the Consolidated Financial Statements of AEP for information regarding restrictions on payment of dividends. At December 31, 1993, AEP had approximately 194,000 shareholders of record. AEGCO, APCO, CSPCO, I&M, KEPCO AND OPCO. The information required by this item is not applicable as the common stock of all these companies is held solely by AEP. Item 6. Item 6.SELECTED FINANCIAL DATA - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). AEP. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). I&M. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). OPCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the AEGCo 1993 Annual Report (for the fiscal year ended December 31, 1993). AEP. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the CSPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). I&M. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the KEPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). OPCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 8. Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - -------------------------------------------------------------------------------- AEGCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. AEP. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. APCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. CSPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. I&M. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. KEPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. OPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. Item 9. Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - -------------------------------------------------------------------------------- AEGCO, AEP, APCO, CSPCO, I&M, KEPCO AND OPCO. None. PART III -------------------------------------------------------------------- Item 10. Item 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Nominees for Director and Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. APCO. The information required by this item is incorporated herein by reference to the material under Election of Directors of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. The names of the directors and executive officers of I&M, the positions they hold with I&M, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of I&M are elected annually to serve a one- year term. - -------- (a)Positions are with I&M unless otherwise indicated. (b)Dr. Draper is a director of Pacific Nuclear Systems, Inc. and Mr. Lhota is a director of Huntington Bancshares Incorporated. (c)Messrs. DeMaria, Dowd, Draper, Lhota and Maloney are directors of AEGCo, APCo, CSPCo, KEPCo and OPCo. Messrs. DeMaria, Dowd, Draper and Maloney are also directors of AEP. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under the heading Election of Directors of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. Item 11. Item 11.EXECUTIVE COMPENSATION - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Compensation of Directors, Executive Compensation and the performance graph of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. I&M Certain executive officers of I&M are employees of the Service Corporation. The salaries of these executive officers are paid by the Service Corporation and a portion of their salaries has been allocated and charged to I&M. The following table shows for 1993, 1992 and 1991 the compensation earned from all AEP System companies by (i) the chief executive officer and four other most highly compensated executive officers (as defined by regulations of the SEC) of I&M at December 31, 1993 and (ii) a chief executive officer and executive officer, both of whom retired in 1993. Summary Compensation Table - -------- (1) Reflects payments under the AEP Management Incentive Compensation Plan ("MICP") in which individuals in key management positions with AEP System companies participate. Amounts for 1993 are estimates but should not change significantly. For 1991 and 1993, these amounts included both cash paid and a portion deferred in the form of restricted stock units. These units are paid out in cash after three years based on the price of AEP Common Stock at that time. Dividend equivalents are paid during the three- year period. At December 31, 1993, Dr. Draper and Messrs. DeMaria, Maloney, Dowd and Lhota held 813, 746, 715, 593 and 639 units having a value of $30,177, $27,701, $26,526, $22,020 and $23,730, respectively, based upon a $37 1/8 per share closing price of AEP's Common Stock as reported on the New York Stock Exchange. For 1992, MICP payments were made entirely in cash. (2) Includes amounts contributed by AEP System companies under the American Electric Power System Employees Savings Plan on behalf of their employee participants. For 1993 this amount was $7,075 for Dr. Draper and Messrs. Katlic, Maloney, Dowd and Lhota and $6,000 for Mr. Disbrow and $7,006 for Mr. DeMaria. The AEP System Savings Plan is available to all employees of AEP System companies (except for employees covered by certain collective bargaining agreements) who have met minimum service requirements. Includes director's fees for AEP System companies. For 1993 these fees were: Dr. Draper, $11,105; Mr. Disbrow, $3,580; Mr. DeMaria, $10,805; Mr. Katlic, $2,300; Mr. Maloney, $10,925; Mr. Dowd, $8,685; and Mr. Lhota, $10,085. Includes payments of $93,173 and $36,077 for unused accrued vacation which Messrs. Disbrow and Katlic, respectively, received upon their retirement. (3) Dr. Draper was elected chairman of the board and chief executive officer of I&M and other AEP System companies and chairman of the board, president and chief executive officer of AEP and the Service Corporation, succeeding Mr. Disbrow, who retired, effective April 28, 1993. Retirement Benefits The American Electric Power System Retirement Plan provides pensions for all employees of AEP System companies (except for employees covered by certain collective bargaining agreements), including the executive officers of I&M. The Retirement Plan is a noncontributory defined benefit plan. The following table shows the approximate annual annuities under the Retirement Plan that would be payable to employees in certain higher salary classifications, assuming retirement at age 65 after various periods of service. The amounts shown in the table are the straight life annuities payable under the Plan without reduction for the joint and survivor annuity. Retirement benefits listed in the table are not subject to any deduction for Social Security or other offset amounts. The retirement annuity is reduced 3% per year in the case of retirement between ages 60 and 62 and further reduced 6% per year in the case of retirement between ages 55 and 60. If an employee retires after age 62, there is no reduction in the retirement annuity. PENSION PLAN TABLE Compensation upon which retirement benefits are based consists of the average of the 36 consecutive months of the employee's highest salary, as listed in the Summary Compensation Table, out of the employee's most recent 10 years of service. With respect to Messrs. Disbrow and Katlic, since they retired in 1993, the amounts of $600,000 and $316,944, respectively, are the actual salaries upon which their retirement benefits are based. Mr. Disbrow's retirement benefit was enhanced by computing his benefit based on his 1992 base salary. As of December 31, 1993, the number of full years of service credited under the Retirement Plan to each of the executive officers of I&M named in the Summary Compensation Table were as follows: Dr. Draper, 1 year; Mr. Disbrow, 39 years; Mr. DeMaria, 34 years; Mr. Katlic, 10 years; Mr. Maloney, 38 years; Mr. Dowd, 31 years; and Mr. Lhota, 29 years. Dr. Draper's employment agreement described below provides him with a supplemental retirement annuity that credits him with 24 years of service in addition to his years of service credited under the Retirement Plan less his actual pension entitlement under the Retirement Plan and any pension entitlements from prior employers. Mr. Katlic has a contract with the Service Corporation under which the Service Corporation agrees to provide him with a supplemental retirement annuity equal to the annual pension that Mr. Katlic would have received with service of 30 years under the AEP System Retirement Plan as then in effect, less his actual annual pension entitlement under the Retirement Plan. Mr. Katlic commenced receiving his supplemental annuity upon his retirement effective October 31, 1993. AEP has determined to pay supplemental retirement benefits to 23 AEP System employees (including Messrs. Disbrow, DeMaria, Maloney and Lhota) whose pensions may be adversely affected by amendments to the Retirement Plan made as a result of the Tax Reform Act of 1986. Such payments, if any, will be equal to any reduction occurring because of such amendments. Upon his retirement on April 28, 1993, Mr. Disbrow began receiving an annual supplemental benefit of $2,642. Assuming retirement of the remaining eligible employees in 1994, none would be eligible to receive supplemental benefits. AEP made available a voluntary deferred-compensation program in 1982 and 1986, which permitted certain executive employees of AEP System companies to defer receipt of a portion of their salaries. Under this program, an executive was able to defer up to 10% or 15% annually (depending on the terms of the program offered), over a four-year period, of his or her salary, and receive supplemental retirement or survivor benefit payments over a 15-year period. The amount of supplemental retirement payments received is dependent upon the amount deferred, age at the time the deferral election was made, and number of years until the executive retires. The following table sets forth, for the executive officers named in the Summary Compensation Table, the amounts of annual deferrals and, assuming retirement at age 65, annual supplemental retirement payments under the 1982 and 1986 programs. Employment Agreement Dr. Draper has a contract with AEP and the Service Corporation which provides for his employment for an initial term from no later than March 15, 1992 until March 15, 1997. Dr. Draper commenced his employment with AEP and the Service Corporation on March 1, 1992. AEP or the Service Corporation may terminate the contract at any time and, if this is done for reasons other than cause and other than as a result of Dr. Draper's death or permanent disability, the Service Corporation must pay Dr. Draper's then base salary through March 15, 1997, less any amounts received by Dr. Draper from other employment. -------------- Directors of I&M receive a fee of $100 for each meeting of the Board of Directors attended in addition to their salaries. -------------- The AEP System is an integrated electric utility system and, as a result, the member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity, transportation and handling of fuel, sales or rentals of property and interest or dividend payments on the securities held by the companies' respective parents. Item 12. Item 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. All 1,400,000 outstanding shares of Common Stock, no par value, of I&M are directly and beneficially held by AEP. Holders of the Cumulative Preferred Stock of I&M generally have no voting rights, except with respect to certain corporate actions and in the event of certain defaults in the payment of dividends on such shares. The table below shows the number of shares of AEP Common Stock that were beneficially owned, directly or indirectly, as of December 31, 1993, by each director and nominee of I&M and each of the executive officers of I&M named in the summary compensation table, and by all directors and executive officers of I&M as a group. It is based on information provided to I&M by such persons. No such person owns any shares of any series of the Cumulative Preferred Stock of I&M. Unless otherwise noted, each person has sole voting power and investment power over the number of shares of AEP Common Stock set forth opposite his name. Fractions of shares have been rounded to the nearest whole share. - -------- (a) The amounts include shares held by the trustee of the AEP Employees Savings Plan, over which directors, nominees and executive officers have voting power, but the investment/disposition power is subject to the terms of such Plan, as follows: Mr. Bailey, 550 shares; Mr. DeMaria, 2,081 shares; Mr. Disbrow, 4,027 shares; Mr. D'Onofrio, 2,889 shares; Mr. Katlic, 2,230 shares; Mr. Lhota, 5,245 shares; Mr. Maloney, 2,142 shares; Mr. Menge, 2,566 shares; Mr. Prater, 1,561 shares; Mr. Synowiec, 1,754 shares; Mr. Walters, 3,685 shares; and all directors and executive officers as a group, 33,806 shares. Messrs. Disbrow's, Dowd's and Maloney's holdings include 85 shares each; Messrs. Bailey's, DeMaria's, D'Onofrio's, Katlic's, Lhota's, Menge's, Prater's, Synowiec's, and Walter's holdings include 44, 83, 59, 60, 60, 62, 48, 53 and 45 shares, respectively; and the holdings of all directors and executive officers as a group include 738 shares, each held by the trustee of the AEP Employee Stock Ownership Plan, over which shares such persons have sole voting power, but the investment/disposition power is subject to the terms of such Plan. (b) Includes shares with respect to which such directors, nominees and executive officers share voting and investment power as follows: Mr. DeMaria, 3,624 shares; Mr. Disbrow, 283 shares; Mr. Draper, 115 shares; Mr. Lhota, 1,368 shares; Mr. Maloney, 2,000 shares; Mr. Menge, 24 shares; and all directors and executive officers as a group, 7,883 shares. Mr. DeMaria disclaims beneficial ownership of 807 shares. (c) 85,231 shares in the American Electric Power System Educational Trust Fund, over which Messrs. DeMaria, Lhota and Maloney share voting and investment power as trustees (they disclaim beneficial ownership of such shares), are not included in their individual totals, but are included in the group total. (d) Represents less than 1 percent of the total number of shares outstanding on December 31, 1993. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Item 13. Item 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------------------------------- AEP. The information required by this item is incorporated herein by reference to the material under Transactions With Management of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO, I&M AND OPCO. None. AEGCO, CSPCO, AND KEPCO. Omitted pursuant to Instruction J(2)(c). PART IV ------------------------------------------------------------------- Item 14. Item 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------------- (a) The following documents are filed as a part of this report: (b) No Reports on Form 8-K were filed during the quarter ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. AEP Generating Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Henry Fayne *John R. Jones, III *Wm. J. Lhota *James J. Markowsky /s/ G. P. Maloney *By: ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. American Electric Power Company, Inc. By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Treasurer and March 23, 1994 - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Robert M. Duncan *Arthur G. Hansen *Lester A. Hudson, Jr. *Angus E. Peyton *Toy F. Reid *W. Ann Reynolds *Linda Gillespie Stuntz *Morris Tanenbaum *Ann Haymond Zwinger *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Appalachian Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Luke M. Feck *Wm. J. Lhota *James J. Markowsky *J. H. Vipperman *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Columbus Southern Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: Vice President, March 23, 1994 /s/ P. J. DeMaria Treasurer and - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Indiana Michigan Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *Mark A. Bailey *W. N. D'Onofrio *A. Joseph Dowd *Wm. J. Lhota *Richard C. Menge *R. E. Prater *D. B. Synowiec *W. E. Walters *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Kentucky Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *C. R. Boyle, III *A. Joseph Dowd *Wm. J. Lhota *Ronald A. Petti *By: /s/ G. P. Maloney --------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Ohio Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURES TITLE DATE ---------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) INDEX TO FINANCIAL STATEMENT SCHEDULES S-1 INDEPENDENT AUDITORS' REPORT American Electric Power Company, Inc. and Subsidiaries: We have audited the consolidated financial statements of American Electric Power Company, Inc. and its subsidiaries and the financial statements of certain of its subsidiaries, listed in Item 14 herein, as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our reports thereon dated February 22, 1994; such financial statements and reports are included in your respective 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of American Electric Power Company, Inc. and its subsidiaries and of certain of its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the respective Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Columbus, Ohio February 22, 1994 S-2 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $676,404,000 in 1993, $718,154,000 in 1992 and $733,909,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $278,435,000 in 1993, $297,460,000 in 1992 and $198,352,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 3 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-3 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-4 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Recoveries on accounts previously written off. (b)Uncollectible accounts written off. (c)Billings to others. (d)Payments and accrual adjustments. (e)Includes interest on trust funds. (f)Adjust royalty provision. S-5 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-6 AEP GENERATING COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $4,089,000 in 1993, $4,512,000 in 1992 and $3,796,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $1,038,000 in 1993, $1,830,000 in 1992 and $1,450,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-7 AEP GENERATING COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-8 AEP GENERATING COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-9 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $201,169,000 in 1993, $198,116,000 in 1992 and $196,937,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $47,254,000 in 1993, $42,926,000 in 1992 and $32,428,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-10 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-11 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments and transfers. S-12 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-13 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $97,455,000 in 1993, $80,279,000 in 1992 and $111,856,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $18,161,000 in 1993, $21,999,000 in 1992 and $19,773,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 2 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-14 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Reflects the write-off of accumulated depreciation related to a portion of the Zimmer Plant investment that was disallowed by the PUCO as discussed in Note 2 of the Notes to Consolidated Financial Statements. S-15 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-16 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-17 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $125,247,000 in 1993, $175,728,000 in 1992 and $149,187,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $61,586,000 in 1993, $25,301,000 in 1992 and $40,396,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-18 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-19 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments and accrual adjustments. (e) Includes interest on trust funds. (f) Adjust Royalty Provision. S-20 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-21 KENTUCKY POWER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $37,808,000 in 1993, $35,203,000 in 1992 and $31,369,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $12,000,000 in 1993, $11,352,000 in 1992 and $8,092,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-22 KENTUCKY POWER COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-23 KENTUCKY POWER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-24 KENTUCKY POWER COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-25 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $197,089,000 in 1993, $201,737,000 in 1992 and $228,500,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $128,775,000 in 1993, $191,662,000 in 1992 and $90,472,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions for other than mining assets were determined using the following composite rates for functional classes of property: The current provisions for mining assets were calculated by use of the following methods: S-26 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-27 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments. S-28 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-29 EXHIBIT INDEX Certain of the following exhibits, designated with an asterisk(*), are filed herewith. The exhibits not so designated have heretofore been filed with the Commission and, pursuant to 17 C.F.R. (S)201.24 and (S)240.12b-32, are incorporated herein by reference to the documents indicated in brackets following the descriptions of such exhibits. Exhibits, designated with a dagger (+), are management contracts or compensatory plans or arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. AEGCO E-1 AEGCO (continued) E-2 AEP++ (continued) E-3 AEP++ (continued) E-4 APCO++ (continued) E-5 APCO++ (continued) E-6 CSPCO++ (continued) E-7 I&M++ (continued) E-8 I&M++ (continued) E-9 KEPCO (continued) E-10 OPCO++ (continued) E-11 OPCO++ (continued) -------------- ++Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. E-12

203596_1993.txt

203596_1993

1993

203596

876858_1993.txt

876858_1993

1993

876858

Item 1. Business The Sears Credit Account Trust 1991 C (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of July 1, 1991 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2. Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in June, 1991 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3. Item 3. Legal Proceedings None Item 4. Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13. Item 13. Certain Relationships and Related Transactions None PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 25th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 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. Sears Credit Account Trust 1991 C (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1991 C 8.65% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated September 5, 1991 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$86.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$86.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.....................................$454,076,419.73 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.....................................$130,374,092.38 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$330,262,728.83 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates.................................$94,789,916.87 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$123,813,690.90 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$35,584,175.51 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest.............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest.......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest..............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer..........$9,999,999.96 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods..$0.00 15) The aggregate amount of Investment Income during the related Due Periods...................................$0.00 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year.....$0.00 17) The Deficit Accumulation Amount, as of the end of the reportable year.......................................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods...............$43,250,000.04 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year....................18,020,833.35 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1991A March 1, 1991 Sears Credit Account Trust 1991B May 15, 1991 Sears Credit Account Trust 1991C July 1, 1991 Sears Credit Account Trust 1991D September 15, 1991 Sears Credit Account Master Trust I November 18, 1992 It is understood that this report is solely for your information and is not be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations report. We found such amounts to be in agreement. Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Association as Trustee As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

38009_1993.txt

38009_1993

1993

38009

ITEM 1. BUSINESS The registrant, Ford Motor Credit Company, was incorporated in Delaware in 1959 and is a wholly owned subsidiary of Ford Motor Company (the "Company" or "Ford"). As used herein "Ford Credit" refers to Ford Motor Credit Company and its subsidiaries unless the context otherwise requires. Ford Credit provides wholesale financing and capital loans to franchised Ford Motor Company vehicle dealers and other dealers associated with such dealers and purchases retail installment sale contracts and retail leases from them. Ford Credit also makes loans to vehicle leasing companies, the majority of which are affiliated with such dealers. In addition, a wholly owned subsidiary of Ford Credit provides these financing services in the U.S. to other vehicle dealers. Vehicle financing accounted for 97.5% of the dollar volume of financing done by Ford Credit in 1993 and 97.3% in 1992. More than 85% of all new vehicles financed by Ford Credit are manufactured by Ford or its affiliates. Ford Credit also provides retail financing for used vehicles built by Ford and other manufacturers, which accounted for 19% of the dollar volume of retail vehicle financing done by Ford Credit in both 1993 and 1992. In addition to vehicle financing, Ford Credit makes loans to affiliates of Ford, finances certain receivables of Ford and its subsidiaries, and offers diversified financing services which are managed by USL Capital Corporation (formerly United States Leasing International, Inc.) ("USL Capital"), a wholly owned subsidiary of Ford Holdings, Inc. ("Ford Holdings"). In 1993 and 1992, United States operations, conducted in all 50 states, the District of Columbia and Puerto Rico, accounted for 93.8% and 93.2%, respectively, of the dollar volume of Ford Credit's financing business; Canadian operations accounted for 4.6% and 5.0%, respectively, of such volume in these periods. The balance was in Australia. In addition, Ford Credit manages the vehicle financing operations of Ford in other foreign countries which are conducted through other subsidiaries of Ford. Ford Credit manages the insurance business of The American Road Insurance Company ("American Road"), a wholly owned subsidiary of Ford Holdings. Ford Credit is a significant equity participant in Ford Holdings whose primary activities consist of consumer and commercial financing operations, insurance underwriting and equipment leasing. The business of Ford Credit is substantially dependent upon Ford Motor Company. See "Vehicle Financing" and "Borrowings and Other Sources of Funds" under the caption "Business of Ford Credit". Also see Item 7 -- "Management's Discussion and Analysis of Financial Condition and Results of Operations". Any protracted reduction or suspension of Ford's production or sale of vehicles, resulting from a decline in demand, a work stoppage, governmental action, adverse publicity, or other event, could have a substantial adverse effect on Ford Credit. For additional information concerning Ford's results of operations, see Ford Motor Company's Annual Report on Form 10-K for the year ended December 31, 1993 filed with the Securities and Exchange Commission and for additional information concerning the business of Ford Holdings, see Ford Holdings' Annual Report on Form 10-K for the year ended December 31, 1993 filed with the Securities and Exchange Commission. The mailing address of Ford Credit's executive offices is The American Road, Dearborn, Michigan 48121. The telephone number of such offices is (313) 322-3000. SEGMENT INFORMATION Segment information called for by Item 1 is set forth in Note 11 of Notes to Financial Statements and is incorporated herein by reference. BUSINESS OF FORD CREDIT Ford Credit accounts for its financing business in four categories -- retail (which consists of vehicle installment sale financing and vehicle lease financing), wholesale, diversified and other. Total gross finance receivables and net investment in operating leases outstanding in these four categories were as follows at the end of the years indicated: *Includes net investment in operating leases. Dollar volume of financing by Ford Credit was as follows during the years indicated: * Includes operating lease volume. VEHICLE FINANCING RETAIL. Retail financing consists primarily of installment sale financing and retail lease financing of vehicles and loans to vehicle leasing companies, most of which are affiliated with franchised Ford Motor Company dealers. The number of installment sale and lease vehicles financed by Ford Credit was as follows during the years indicated: The levels of Ford Credit's retail financing volume and outstanding receivables and lease investments are dependent on several factors, including new and used vehicle sales and leases, Ford Credit's share of those vehicle sales and leases and the average cost of vehicles financed. See "Competition in Vehicle Financing". In addition, receivables levels will vary depending on sales of receivables. Installment sale financing consists principally of purchasing and servicing installment sale contracts covering sales of new and used vehicles by vehicle dealers to retail customers. The purchase price paid by Ford Credit to the dealer for an installment sale contract generally is the amount financed. In addition, a portion of the finance charge is paid or credited to the dealer. Ford Credit requires a retail customer to carry fire, theft and collision insurance on the vehicle. For 1993 in the U.S., the average repayment obligation for new vehicles covered by installment sale contracts purchased by Ford Credit was $17,471. The corresponding average monthly payment was $331 and the average original term was 54 months. Retail lease financing consists principally of purchasing and servicing lease contracts covering new and used vehicles leased to retail customers by vehicle dealers. In recent years, vehicle leasing has increased in popularity by offering the retail customer a lower initial cash outlay for the vehicle and lower monthly payments when compared with conventional installment sale financing. Since 1990, retail lease financing has become a larger percentage of Ford Credit's total retail financing dollar volume, increasing from 15% in 1990 to 26% in 1993. The number of new and used vehicles for which Ford Credit provided retail lease financing increased from approximately 186,000 units in 1990 to approximately 521,000 units in 1993. The amount paid by Ford Credit to the dealer for the vehicle and lease (the "acquisition cost") represents a negotiated amount agreed to between the dealer and the customer, less any trade-in or downpayment. The monthly lease payment equals the acquisition cost of the vehicle less the residual value of the vehicle established by Ford Credit, amortized over the lease term, plus the lease charge. A retail lessee is required to carry fire, theft, collision and liability insurance. The acquisition cost to Ford Credit of the vehicle, less the residual value, is depreciated on a straight line basis over the life of the lease. Residual values are determined by Ford Credit after analyzing residual values published by the Automotive Lease Guide and Ford Credit's own historical experience in the used car market. In addition, joint marketing programs with Ford's vehicle divisions can affect established residual values. At lease termination, Ford Credit either sells the vehicle to the dealer for the established residual value or sells the vehicle at auction for the market price. Retail lease terms range from 12 to 60 months with 24 month and 36 month terms being by far the most popular. The average monthly payment and the average original term of U.S. retail lease contracts purchased by Ford Credit in 1993 were $370 and 29 months compared with $337 and 30 months in 1992. The average original term of the lease financing extended to leasing companies and daily rental companies by Ford Credit in 1993 was 35 months and 15 months, respectively. Financing charges in connection with such lease financing generally are based on short-term interest rates in effect at the time the financing is extended. These rates may be supplemented by payments from Ford whenever the rate payable is less than the specified minimum rate agreed upon between Ford Credit and Ford. At December 31, 1993, 8 leasing companies each accounted for more than $10 million of such lease financing, three of which accounted for $402.1 million, $287.7 million and $82.6 million of such lease financing, respectively. WHOLESALE. Wholesale financing consists principally of loans, under approved lines of credit, to dealers to assist them in carrying inventories of new vehicles. Ford Credit generally finances 100% of the wholesale price. Vehicles are insured against fire, theft and other risks under policies issued to Ford Credit by American Road. Ford Credit's United States car and truck wholesale receivables that liquidated were outstanding an average of about 68 days in 1993 and 74 days in 1992. The levels of Ford Credit's wholesale financing volume and outstanding wholesale receivables are dependent on several factors, including sales by Ford to dealers, the level of dealer inventories, Ford Credit's share of Ford's sales to dealers, vehicle prices and sales of wholesale receivables. COMPETITION IN VEHICLE FINANCING. The vehicle financing field is highly competitive, particularly in the case of retail financing. Ford Credit's principal competitors for retail installment sale financing have been banks and credit unions. Banks and other leasing companies are Ford Credit's principal competitors for wholesale financing and lease financing. Ford Credit financed the following percentages of new Ford and Lincoln-Mercury cars and trucks sold or leased at retail and sold at wholesale in the United States during each of the years indicated: * As a percentage of total sales and leases, including cash sales DIVERSIFIED FINANCING Diversified finance receivables consist primarily of leases and loans secured by transportation equipment and facilities, some of which represent tax-exempt financing for state and local governments, energy related equipment and other equipment, real estate loans collateralized by first and second mortgages on improved property and privately negotiated investments in preferred stock. Most diversified finance receivables represent transactions in an original amount in excess of $1 million each. Because of the relatively large size of individual diversified financing transactions, any individual loss arising out of such transactions could be substantial. Diversified finance receivables generally are intermediate-term; at December 31, 1993 approximately 28.4% of the outstanding receivables were scheduled to mature within five years. In 1988, management responsibility for coordinating diversified financing activities was transferred to USL Capital. No transfer of assets was involved. In August 1990, USL Capital began funding for its own account certain diversified receivables that previously were funded by Ford Credit. As a result, the dollar volume of diversified financing has decreased since 1990. At December 31, 1993 diversified finance receivables outstanding represented 4.4% of Ford Credit's total gross finance receivables and net investment in operating leases. OTHER FINANCING ACTIVITIES Ford Credit makes capital loans to vehicle dealers for facilities expansion and working capital and to enable them to purchase dealership real estate. Such loans totaled $1,769.3 million at December 31, 1993. From time to time, Ford Credit purchases accounts receivable of certain divisions and affiliates of Ford. The amount of such receivables as of the end of each month during 1993 fluctuated between $905.8 million and $1,076.9 million. At December 31, 1993, such receivables totaled $1,076.9 million, all of which represent accounts receivable purchased by Ford Credit from Ford pursuant to agreements under which Ford Credit may purchase such receivables. In addition to the foregoing receivables, Ford Credit held $780.3 million of other finance receivables at December 31, 1993. CREDIT LOSS EXPERIENCE The following table sets forth information concerning Ford Credit's credit loss experience with respect to the various categories of financing during the years indicated: - - - - - - ----------- *Includes net losses on operating leases - - - - - - ----------- *Includes net investment in operating leases Allowances for estimated credit losses are established as required based on historical experience. Other factors that affect collectibility also are evaluated and additional allowances may be provided. The provision for credit losses generally varies with changes in the amount of loss exposure and the absolute level of financing. Ford Credit's retail loss experience is dependent upon the number of repossessions, the unpaid balance outstanding at the time of repossession, and the resale value of repossessed vehicles. Wholesale losses generally reflect the financial condition of dealers. For additional information regarding credit losses, see Notes 1 and 6 of Notes to Financial Statements. SECURITY Ford Credit generally either holds security interests in or is the title owner of the vehicles which it finances or leases and generally is able to repossess a vehicle in the event of a default. The right to repossess under a security interest securing wholesale obligations generally is ineffectual, as a matter of law, against a retail buyer of a vehicle from a dealer. Under the wholesale installment sale plan, dealers are permitted to delay payment of up to 10% of a vehicle's financed balance for up to 60 days after the dealer sells the vehicle. A portion of such delayed payments may, under certain circumstances, be unsecured. Obligations arising from lease financing extended to leasing companies are collateralized to the extent practicable by assignments of rentals under the related leases and, in almost all instances, by liens on the vehicles (which liens are not perfected against third parties in some cases). Diversified finance receivables generally consist of leases and financings of personal property or real estate in which Ford Credit has ownership or security interests. BORROWINGS AND OTHER SOURCES OF FUNDS Ford Credit relies heavily on its ability to raise substantial amounts of funds. These funds are obtained primarily by sales of commercial paper and issuance of term debt. Funds also are provided by retained earnings and sales of receivables. The level of funds can be affected by certain transactions with Ford, such as capital contributions, interest supplements and other support costs from Ford for vehicles financed and leased by Ford Credit under Ford sponsored special financing and leasing programs, and dividend payments, and the timing of payments for the financing of dealers' wholesale inventories and for income taxes. Ford Credit's ability to obtain funds is affected by its debt ratings, which are closely related to the outlook for, and financial condition of, Ford, and the nature and availability of support facilities, such as revolving credit and receivables sales agreements. In addition, Ford Credit from time to time sells its receivables in public offerings or private placements. For additional information regarding Ford Credit's association with Ford, see "Certain Transactions with Ford and Affiliates". Ford Credit's outstanding debt at the end of each of the last five years was as follows: Memo: (a) Short-term borrowing agreements with bank trust departments (b) Includes $150 million and $800 million with an affiliated company at December 31, 1993 and December 31, 1992, respectively Outstanding commercial paper totaled $24.5 billion at December 31, 1993, up $3.3 billion from a year earlier. In 1993, long-term debt placements were $12.9 billion compared with maturities and early redemptions of $6.3 billion. Long-term debt placements in 1992 were $6.5 billion. In 1993, Ford Credit also received $2.5 billion from sales of receivables compared with $3.3 billion in 1992. Support facilities represent additional sources of funds, if required. At January 1, 1994, Ford Credit had $15,716 million of contractually committed facilities for use in the United States, 83% of which are available through June 1998. These facilities included $12,841 million of revolving credit agreements with banks (which included $4,835 million of Ford bank lines that may be used either by Ford or Ford Credit at Ford's option) and $2,875 million of agreements to sell retail receivables. At January 1, 1994, all of these U.S. facilities were unused. Outside of the United States, an additional $1,185 million of facilities support borrowing operations in Canada, Australia and Puerto Rico, of which 82% are contractually committed and available through June 1998. Canadian facilities of $759 million included $210 million of Ford Motor Company of Canada Limited and Ford Ensite International Inc. lines which are available to Ford Credit Canada Limited at the option of these two companies. Australian facilities of $401 million include $155 million of Ford Motor Company of Australia Limited lines which are available to Ford Credit Australia Limited at the option of Ford Motor Company of Australia Limited. Ford Motor Credit Company of Puerto Rico, Inc. had $25 million in support facilities at January 1, 1994. Substantially all of these facilities were unused at January 1, 1994. FORD HOLDINGS Ford Holdings was incorporated on September 1, 1989 for the principal purpose of acquiring, owning and managing certain assets of Ford. Ford Credit owns 45% of the common stock of Ford Holdings representing 33.8% of the voting power and Ford owns the remaining common stock representing 41.2% of the voting power. The balance of the capital stock, consisting of shares of Flexible Rate Auction Preferred Stock (Exchange), Series A Cumulative Preferred Stock, Series B Cumulative Preferred Stock and Series C Cumulative Preferred Stock, is held by persons other than Ford and accounts for the remaining 25% of the total voting power. Ford Holdings' primary activities consist of consumer and commercial financing operations, insurance underwriting and equipment leasing through its wholly owned subsidiaries, Associates First Capital Corporation ("The Associates"), American Road and USL Capital. Ford Credit accounts for its investment in Ford Holdings common stock using the equity method of accounting. For further information regarding Ford Holdings, see Notes 1, 2 and 12 of Notes to Financial Statements. See "Financial Review of Ford Motor Company Results - 1993 Results of Operations - Financial Services Operations" and "Liquidity and Capital Resources - Financial Services Operations" for a discussion of 1993 results of operations and liquidity and capital resources, respectively, of The Associates, American Road and USL Capital. ASSOCIATES FIRST CAPITAL CORPORATION The Associates conducts its operations primarily through its principal operating subsidiary, Associates Corporation of North America. The Associates' primary business activities are consumer finance, commercial finance and insurance underwriting. The consumer finance operation is engaged in making and investing in residential real estate-secured loans to individuals, making secured and unsecured installment loans to individuals, purchasing consumer retail installment obligations, investing in credit card receivables, financing manufactured housing purchases and providing other consumer financial services. The commercial finance operation is principally engaged in financing sales of transportation and industrial equipment and leasing, and providing other financial services, including automobile club, mortgage banking, and relocation services. The insurance operation is engaged in underwriting credit life, credit accident and health, property, casualty and accidental death and dismemberment insurance, principally for customers of the finance operations of The Associates. The Associates' finance receivables were as follows at the dates indicated (in millions): Credit loss experience, net of recoveries, of The Associates' finance business was as follows for the years indicated (dollar amounts in millions): The following table shows total balances delinquent sixty days and more by type of business at the dates indicated (dollar amounts in millions): An analysis of The Associates' allowance for losses on finance receivables is as follows for the years indicated (in millions): THE AMERICAN ROAD INSURANCE COMPANY American Road was incorporated as a wholly owned subsidiary of Ford Credit in 1959 and was transferred to Ford Holdings in 1989. The operations of American Road consist primarily of underwriting floor plan insurance related to substantially all new vehicle inventories of dealers financed at wholesale by Ford Credit in the United States and Canada, credit life and disability insurance in connection with retail vehicle financing, and insurance related to retail contracts sold by automobile dealers to cover vehicle repairs. In addition, Ford Life Insurance Company ("Ford Life"), a wholly owned subsidiary of American Road, offers single premium deferred annuities which are sold primarily through banks and brokerage firms. The obligations of Ford Life, including annuities, are guaranteed by American Road. In the second quarter of 1992, Ford Credit discontinued purchasing collateral protection insurance ("CPI") from American Road for vehicles financed at retail by Ford Credit. As a result, total premiums written by American Road in 1992 were down 38% from 1991. The discontinuance of Ford Credit's purchase of CPI was a significant factor in American Road's 1992 profit decline from 1991 and had a negative but smaller impact on 1993 earnings. American Road exited the CPI market for vehicles and homes financed by other institutions by the end of 1993. USL CAPITAL CORPORATION USL Capital, a diversified commercial leasing and financing organization, originally incorporated in 1956, was acquired by Ford in 1987 and was transferred to Ford Holdings in 1989. In November 1993, the corporation's name was changed from United States Leasing International, Inc. to USL Capital Corporation. The primary operations of USL Capital include the leasing, financing, and management of office, manufacturing and other general-purpose business equipment; commercial fleets of automobiles, vans, and trucks; large-balance transportation equipment (principally commercial aircraft, rail, and marine equipment); industrial and energy facilities; and essential-use equipment for state and local governments. It also provides intermediate-term, first-mortgage loans on commercial properties and invests in corporate preferred stock and debt instruments. Certain of these financing transactions are carried on the books of Ford affiliates. The following table sets forth certain information regarding USL Capital's earning assets, credit losses, and delinquent accounts at the dates indicated (dollar amounts in millions): FORD CREDIT EMPLOYEE RELATIONS At December 31, 1993, Ford Credit and its subsidiaries had 8,972 employees. All such employees are salaried, and none is represented by a union. Ford Credit considers its employee relations to be satisfactory. FORD CREDIT GOVERNMENTAL REGULATIONS Various aspects of Ford Credit's financing operations are regulated under both Federal and state law. Various states require licenses to conduct retail financing. Interest rates, particularly those with respect to consumer financing, generally are limited by state law and, in periods of high interest rates, these limitations can have a substantial adverse effect on operations in certain states if Ford Credit is unable to pass on its increased interest costs to its customers. During the past several years, legislative, judicial, and administrative authorities have evidenced a growing concern for the protection of the interest of consumers, especially in connection with consumer financing transactions. As a result, significant changes have been made in the methods by which Ford Credit and the financing industry conduct business, and many proposals have been made which would require further changes. None of the changes to date has had a substantial adverse effect on the operations of Ford Credit. CERTAIN TRANSACTIONS WITH FORD AND AFFILIATES For information concerning transactions between Ford Credit and Ford or affiliates, see Note 12 of Notes to Financial Statements, "Business of Ford Credit - Other Financing Activities", "Business of Ford Credit - Borrowings and Other Sources of Funds" and Item 6 - "Selected Financial Data--Selected Income Statement Data." The profit maintenance agreement referred to in the first paragraph of Note 12 of Notes to Financial Statements, under which Ford has agreed to maintain the income of Ford Credit at certain minimum levels, has been amended and restated and expires at the end of 1998. BUSINESS OF FORD Ford was incorporated in Delaware in 1919 and acquired the business of a Michigan company, also known as Ford Motor Company, incorporated in 1903 to produce automobiles designed and engineered by Henry Ford. Ford is the second- largest producer of cars and trucks in the world, and ranks among the largest providers of financial services in the United States. GENERAL The Company's two principal business segments are Automotive and Financial Services. The activities of the Automotive segment consist of the manufacture, assembly and sale of cars and trucks and related parts and accessories. Substantially all of Ford's automotive products are marketed through retail dealerships, most of which are privately owned and financed. The Financial Services segment is comprised of the following subsidiaries: Ford Credit, Ford Credit Europe plc ("Ford Credit Europe"), First Nationwide Financial Corporation ("First Nationwide"), The Hertz Corporation ("Hertz"), Ford Holdings, The Associates, American Road and USL Capital. The activities of these subsidiaries include financing operations, insurance operations, savings and loan operations and vehicle and equipment leasing. AUTOMOTIVE OPERATIONS The worldwide automotive industry is affected significantly by a number of factors over which the industry has little control, including general economic conditions. In the United States, the automotive industry is a highly-competitive, cyclical business characterized by a wide variety of product offerings. The level of industry demand (retail deliveries of cars and trucks) can vary substantially from year to year and, in any year, is dependent to a large extent on general economic conditions, the cost of purchasing and operating cars and trucks and the availability and cost of credit and of fuel, and reflects the fact that cars and trucks are durable items, the replacement of which can be postponed. The automotive industry outside of the United States consists of many producers, with no single dominant producer. Certain manufacturers, however, account for the major percentage of total sales within particular countries, especially their respective countries of origin. Most of the factors that affect the U.S. automotive industry and its sales volumes and profitability are equally relevant outside the United States. The worldwide automotive industry also is affected significantly by a substantial amount of government regulation. In the United States and Europe, for example, government regulation has arisen primarily out of concern for the environment, for greater vehicle safety and for improved fuel economy. Many governments also regulate local content and/or impose import requirements as a means of creating jobs, protecting domestic producers or influencing their balance of payments. Unit sales of Ford vehicles vary with the level of total industry demand and Ford's share of industry sales. Ford's share is influenced by the quality, price, design, driveability, safety, reliability, economy and utility of its products compared with those offered by other manufacturers. Ford's ability to satisfy changing consumer preferences with respect to type or size of vehicle and its design and performance characteristics can affect Ford's sales and earnings significantly. The profitability of vehicle sales is affected by many factors, including unit sales volume, the mix of vehicles and options sold, the level of "incentives" (price discounts) and other marketing costs, the costs for customer warranty claims and other customer satisfaction actions, the costs for government-mandated safety, emission and fuel economy technology and equipment, the ability to control costs and the ability to recover cost increases through higher prices. Further, because the automotive industry is capital intensive, it operates with a relatively high percentage of fixed costs which can result in large changes in earnings with relatively small changes in unit volume. In recent years, due to competitive pressures, vehicle manufacturers have both expanded the coverages and extended the terms of warranties on vehicles sold in the U.S. Ford presently provides warranty coverage on most vehicles sold by it in the U.S. that extends for 36 months or 36,000 miles (whichever occurs first) and covers nearly all components of the vehicle. Different warranty coverages are provided on vehicles sold outside the U.S. In addition, as discussed below under "Governmental Standards - Mobile Source Emissions Control", amendments to the Federal Clean Air Act extend the required useful life for emissions equipment on vehicles sold in the U.S. to 10 years or 100,000 miles (whichever occurs first). As a result of these coverages and the increased concern for customer satisfaction, costs for warranty repairs, emissions equipment repairs and customer satisfaction actions ("warranty costs") can be substantial. Estimated warranty costs for each vehicle sold by Ford are accrued at the time of sale. Such accruals, however, are subject to adjustment from time to time depending on actual experience. UNITED STATES Sales Data. The following table shows U.S. industry demand for the years indicated: Ford classifies cars by small, middle, large and luxury segments and trucks by compact pickup, compact van/utility, full-size pickup, full-size van/utility and medium/heavy segments. The large and luxury car segments and the compact van/utility, full-size pickup and full- size van/utility truck segments include the industry's most profitable vehicle lines. The following tables show the proportion of retail car and truck sales by segment for the industry (including Japanese and other foreign-based manufacturers) and Ford for the years indicated: * Includes Jaguar sales since 1990. As shown in the first table above, the percentages of industry sales in the various car segments have remained relatively stable since 1989. As shown in the second table above, Ford's proportion of sales in 1992 and 1993 has increased in the middle segment and decreased in the small and luxury segments, reflecting higher sales of Thunderbird, Cougar, Taurus, Sable, Tempo and Topaz models and lower sales of Escort, Festiva, Mark and Continental models. As shown in the tables above, for both the industry and Ford, the compact van/utility segment has grown significantly since 1989, while the full-size segments (pickups and van/utility) have declined as a percentage of total truck sales. Market Share Data. The following tables show changes in car and truck market shares of United States and foreign-based manufacturers for the years indicated: ____________________ * All U.S. retail sales data are based on publicly available information from the American Automobile Manufacturers Association, the media and trade publications. ** Includes Jaguar sales since 1990. *** Share data include cars and trucks assembled and sold in the U.S. by Japanese-based manufacturers selling through their own dealers as well as vehicles imported by them into the U.S. "All Other" includes primarily companies based in various European countries and in Korea and Taiwan. ___________________ * All U.S. retail sales data are based on publicly available information from the American Automobile Manufacturers Association, the media and trade publications. ** Includes Jaguar sales since 1990. *** Share data include cars and trucks assembled and sold in the U.S. by Japanese-based manufacturers selling through their own dealers as well as vehicles imported by them into the U.S. "All Other" includes primarily companies based in various European countries and in Korea and Taiwan. Japanese Competition. The market share of Ford and other domestic manufacturers in the U.S. is affected by sales from Japanese manufacturers. As shown in the table above, the share of the U.S. combined car and truck industry held by the Japanese manufacturers increased from 21.6% in 1989 to 25.5% in 1991, but declined to 22.8% in 1993, reflecting in part the effects of the strengthening of the Japanese yen on the prices of vehicles produced by the Japanese manufacturers. In the 1980s and continuing in the 1990s, Japanese manufacturers added assembly capacity in North America (frequently referred to as "transplants") in response to a variety of factors, including export restraints, the significant growth of Japanese car sales in the U.S. and international trade considerations. Production in the U.S. by Japanese transplants reached 1.6 million units in 1993 and is expected to reach about 2.5 million units a year when additional Japanese transplant capacity becomes fully operational. Excess Capacity In North America. In 1993, automotive capacity in North America, including Japanese transplants, exceeded industry sales by over 5.2 million units. This excess capacity (which includes overtime capacity) reflected the effect of productivity gains made by manufacturers, added capacity of Japanese transplants and lower-than-normal industry-wide sales resulting from modest economic growth. Marketing Incentives and Fleet Sales. As a result of intense competition from new product offerings (from both domestic and foreign manufacturers), excess industry capacity as discussed above and the desire to maintain economic production levels, automotive manufacturers that sell vehicles in the U.S. have provided marketing incentives (price discounts) to retail and fleet customers (i.e., daily rental companies, commercial fleets, leasing companies and governments). Ford's U.S. marketing costs as a percentage of net sales revenue for each of 1993, 1992 and 1991 were: 10.9%, 12% and 16%, respectively. During the 1983-1988 period, such costs as a percentage of sales revenue were in the 4% to 7% range. "Marketing costs" include (i) marketing incentives such as retail rebates and special financing rates, (ii) reserves for residual guaranties on retail vehicle leases; (iii) reserves for costs and/or losses associated with obligatory repurchases of certain vehicles sold to daily rental companies and (iv) costs for advertising and sales promotions. Sales by Ford to fleet customers were as follows for the years indicated: Fleet sales generally are less profitable than retail sales. Within total fleet sales, the mix between sales to daily rental companies and sales to other fleet purchasers improved in 1992 and 1993; sales to daily rental companies declined, while other fleet sales (which tend to be more profitable) increased. EUROPE Europe is the largest market for the sale of Ford cars and trucks outside the United States. The automotive industry in Europe is intensely competitive; for the past 12 years, the top six manufacturers have each achieved a car market share in about the 10% to 16% range. (Manufacturers' shares, however, vary considerably by country.) This competitive environment is expected to intensify further as Japanese manufacturers, which together had a European car market share of 11.6% for 1993, increase their production capacity in Europe and import restrictions on Japanese built-up vehicles gradually are removed. In 1993, European car industry sales were 10.8 million cars, down 16% from 1992 levels. Truck sales were 1.7 million units, down 17% from 1992 levels. Ford's European car share for 1993 was 11.8%, compared with 11.5% for 1992, and its European truck share for 1993 was 12.6%, compared with 11.7% for 1992. For Ford, Great Britain and Germany are the most important markets within Europe, although the Southern European countries are becoming increasingly significant. Great Britain traditionally has been Ford's major source of European automotive profits, and any adverse change in this market has a strong effect on total automotive profits. For 1993 compared with 1992, total industry sales were up 10% in Great Britain and down 19% in Germany. OTHER FOREIGN MARKETS Mexico and Canada. Mexico and Canada also are important markets for Ford. Generally, industry conditions in Canada closely follow conditions in the U.S. market; however, Canada continues to be in a recessionary period. In 1993, industry sales of cars and trucks in Canada were down 3% from 1992 levels, while the U.S. experienced an 8% increase in industry sales. Mexico has been a growing market; however, in 1993, industry sales were down 15% to 603,000 units. The North American Free Trade Agreement ("NAFTA") became effective January 1, 1994. NAFTA unites Canada, Mexico and the United States into the world's largest trading region by phasing out regulations which restricted trade between Mexico and the U.S. and Canada. The Company believes that NAFTA will benefit the economies of the three countries and the North American automobile industry in particular. Latin America. Brazil, Argentina and Venezuela are the principal markets for Ford in South America. The economic environment in those countries has been volatile in recent years, leading to large variations in profitability. Results also have been influenced by government actions to reduce inflation and public deficits, and improve the balance of payments. In 1993, Ford's profitability in the region improved significantly compared with 1992, primarily reflecting strong results in Brazil. Autolatina (Ford's joint venture with Volkswagen in Brazil and Argentina) remained the market leader in Brazil. In Brazil, a new economic plan aimed at stabilizing the Brazilian economy and reducing inflation was unveiled in late 1993. It is presently unclear to what extent the new plan will affect overall economic conditions. In addition, duties on vehicles imported into Brazil have declined progressively from 85% in 1990 to 35% in October 1993. As a result, imports are expected to gain a progressively larger share of the car market in Brazil. Autolatina's future results largely will be dependent on the political and economic environments in Brazil and Argentina, which historically have been unpredictable. Asia-Pacific. In the Asia-Pacific region, Australia and Taiwan are the principal markets for Ford products. In both markets, Ford is the car market share leader. In Taiwan (where sales of built-up vehicles manufactured in Japan are prohibited), Ford has total vehicle sales leadership. Ford's principal competition in the Asia-Pacific region has been the Japanese manufacturers. It is anticipated that the continuing relaxation of import restrictions (including duty reductions) in Australia and Taiwan will intensify competition in those markets. Ford believes that the Asia-Pacific region offers many important opportunities for the future. Ford is investigating automotive component manufacturing and vehicle assembly opportunities in China and is expanding the number of right-hand-drive vehicles it will offer in Japan. A key element of Ford's presence in the Asia-Pacific region is its long-standing relationship with Mazda Motor Corporation, in which it has held a 25% ownership interest since 1979. Recent management appointments by Mazda of Ford personnel have been made to improve coordination of business and product plans in the Asia-Pacific region. FINANCIAL SERVICES OPERATIONS For information regarding the businesses of Ford Credit, Ford Holdings, The Associates, American Road and USL Capital, see "Business of Ford Credit" and "Ford Holdings". Ford Credit Europe plc. In 1993, most of the European credit operations of Ford, which generally had been organized as subsidiaries of the respective automotive affiliates of Ford throughout Europe, were consolidated into a single company, Ford Credit Europe. Ford Credit Europe, which was originally incorporated in 1963 in England as a private limited company, is wholly owned by Ford and certain of its subsidiaries. Ford Credit Europe's primary business is to support the sale of Ford vehicles in Europe through the Ford dealer network. A variety of retail, leasing and wholesale finance plans is provided in most countries in which it operates. The business of Ford Credit Europe is substantially dependent upon Ford's automotive operations in Europe. Ford Credit Europe issues commercial paper, certificates of deposits and term debt to fund its credit operations. One of the purposes of the consolidation described above is to facilitate Ford Credit Europe's access to public debt markets. Ford Credit Europe's ability to obtain funds in these markets is affected by its credit ratings, which are closely related to the financial condition of and outlook for Ford. First Nationwide Financial Corporation. First Nationwide, a savings and loan holding company organized in Delaware in 1959, was acquired by Ford in December 1985. It is a wholly owned subsidiary of Ford. The principal asset of First Nationwide is the capital stock of First Nationwide Bank, A Federal Savings Bank ("First Nationwide Bank" or the "Bank"). The Bank is a federally chartered, capital stock savings bank which, with its predecessor institutions, has been in the savings and loan business since 1885. The principal business of the Bank consists of attracting savings deposits from the public and making loans collateralized by liens on residential and other real estate. Income is derived from interest charges on real estate loans and, to a lesser extent, from fees received in connection with such loans and interest on securities investments. The major expense of the Bank is the interest it pays on savings accounts and on borrowings. First Nationwide's loans receivable (including those of the Bank) were as follows at the dates indicated (in millions): * Certain amounts for 1992 have been restated to conform with presentations adopted in 1993. Included in the above receivables at December 31, 1993 and 1992 were $9.0 billion and $10.2 billion, respectively, of variable rate real estate loans. Loans held for sale, not included above, were $288 million and $195 million at December 31, 1993 and 1992, respectively. The percentages of real estate loans by state were as follows at December 31, 1993, excluding accrued interest receivable, discounts and premiums, and loss reserves, and including $288 million of loans held for sale: California - 55.4%; New York - 10.8%; Florida - 3.8%; Illinois - 3.2%; and 46 other states, none of which exceeded 3.0% of total real estate loans. The following table reflects at the dates indicated the amount of non-accrual, past due, and troubled debt restructured loans including the interest income recognized and total interest income that would have been recognized had the borrowers performed under the original terms of the loans (in millions): * Certain amounts for 1992 have been restated to conform with presentations adopted in 1993. At December 31, 1993, there were no commitments to lend additional funds to borrowers whose loans were on non-accrual status or were restructured. An analysis of First Nationwide's allowance for losses on loans is as follows for the years indicated (in millions): Federally chartered savings and loan institutions are regulated principally by the Office of Thrift Supervision ("OTS"), a bureau of the Department of Treasury. Deposit insurance for these institutions is provided by the Federal Deposit Insurance Corporation ("FDIC"). Regulated areas include: capital requirements, payments of dividends, transactions with affiliates and activities that might create a serious risk to insured institutions. The Bank is subject to regular concurrent examinations of its operations by the OTS and the FDIC, the most recent of which were completed in December 1993. In response to examiners' concerns expressed in recent examinations, the Bank has taken positive steps to improve asset quality and other areas of its operations. The Bank filed its response to the most recent OTS examination report in January 1994. Pursuant to an agreement with the OTS, the FDIC did not issue a separate examination report. For a discussion of the losses incurred by First Nationwide in 1993 and 1992, see "Financial Review of Ford Motor Company Results". Ford presently is investigating strategic actions with respect to First Nationwide. Such actions could include the sale of a substantial portion of the Bank's assets. It is premature at this time, however, to determine whether any actions will occur and what impact, if any, such actions could have on Ford's financial results. The Hertz Corporation. On March 8, 1994, Ford purchased from Commerzbank Aktiengesellschaft, a German bank, additional shares of common stock of Hertz aggregating 5% of the total outstanding voting stock, thereby bringing Ford's ownership of the total voting stock of Hertz to 54% from 49%. Since the Company was a principal shareholder of Hertz prior to the purchase from Commerzbank, no significant change in the relationship between Ford and Hertz is expected. The effect of this transaction on Ford's consolidated financial statements is not expected to be material. Hertz had been accounted for on an equity basis; following the purchase, Hertz's operating results, assets, liabilities, and cash flows will be consolidated in Ford's financial statements, as part of the Financial Services business segment. Hertz is engaged principally in the business of renting automobiles and renting and leasing trucks, without drivers, in or through approximately 5,200 locations throughout the U.S. and in over 140 foreign countries. GOVERNMENTAL STANDARDS A number of governmental standards and regulations relating to safety, corporate average fuel economy ("CAFE"), emissions control, noise control, damageability and theft prevention are applicable to new motor vehicles, engines, and equipment manufactured for sale in the United States and Europe. In addition, manufacturing and assembly facilities in the United States and Europe are subject to stringent standards regulating air emissions, water discharges and the handling and disposal of hazardous substances. Such facilities in the United States also are subject to a comprehensive federal-state permit program relating to air emissions. Many of the standards will become increasingly stringent. Moreover, additional and even more stringent standards and regulations, notably car and truck emissions and CAFE standards, may be made applicable to future model vehicles as well as to existing and future facilities. The technological feasibility of achieving compliance with some of these standards and regulations has not been established on a commercial basis. Assuming that compliance with all applicable standards and regulations can be achieved within the prescribed time frame, it will be extremely costly and it could be necessary for Ford to take such actions as curtailing or eliminating production of certain cars, trucks and engines. Such actions could have substantial adverse effects on Ford's sales volume and profits. Mobile Source Emissions Control -- As amended in November 1990, the Federal Clean Air Act (the "Clean Air Act" or the "Act") imposes significantly more stringent limits on the amount of regulated pollutants that lawfully may be emitted by new motor vehicles and engines produced for sale in the United States than those previously in effect. The effective dates of these standards, some of which have phase-in periods, vary depending upon the type of vehicle, but begin to apply as early as the 1994 model year. In addition, the Act doubles the length of the "useful life" during which compliance with the applicable standards must be achieved. Passenger cars, for example, must comply for 10 years or 100,000 miles, whichever first occurs. The Act prohibits, among other things, the sale in or importation into the United States of any new motor vehicle or engine which is not covered by a certificate of conformity issued by the United States Environmental Protection Agency (the "EPA"). The Act also may require production of certain new cars and trucks capable of operating on fuels other than gasoline or diesel fuel ("alternative fuels") under a pilot test program to be conducted in California beginning in the 1996 model year. Under this pilot program, each manufacturer will be required to sell its pro rata share of 150,000 vehicles in each of the 1996, 1997 and 1998 model years and its pro rata share of 300,000 vehicles in each model year thereafter. The Act also authorizes certain states to establish programs to encourage the purchase of such vehicles. Motor vehicle emissions standards even more stringent than those referred to above will become effective as early as the 2003 model year, unless the EPA determines that such standards are not necessary, technologically feasible or cost-effective. The Act authorizes California to establish unique emissions control standards that, in the aggregate, are at least as stringent as the federal standards if it secures the requisite waiver of federal preemption from the EPA. The Health and Safety Code of the State of California prohibits, among other things, the sale to an ultimate purchaser who is a resident of or doing business in California of a new motor vehicle or engine which is intended for use or registration in that state which has not been certified by the California Air Resources Board (the "CARB"). The CARB received a waiver from the EPA for a series of passenger car and light truck emissions standards (the "low emission vehicle", or "LEV", standards), effective beginning between the 1994 and 2003 model years, that are more stringent than those prescribed by the Act for the corresponding periods of time. These California standards are intended to promote the development of various classes of low emission vehicles. California also requires that a specified percentage of each manufacturer's vehicles produced for sale in California, beginning at 2% in 1998 and increasing to 10% in 2003, must be "zero-emission vehicles" ("ZEVs"), which produce no emissions of regulated pollutants. Electric vehicles are the only presently known type of zero-emission vehicles. However, despite intensive research activities, technologies have not been identified that would allow manufacturers to produce a commercially viable electric vehicle. To comply with the mandate, manufacturers may have to offer substantial discounts on electric vehicles, selling them well below cost, or increase the price or curtail the sale of non-electric vehicles. The California emissions standards present significant technological challenges to manufacturers and compliance may require costly actions that would have a substantial adverse effect on Ford's sales volume and profits. The Act also permits other states with air quality problems to adopt new motor vehicle emissions standards identical to those adopted by California, if such states lawfully adopt such standards two years before commencement of the affected model year. In October 1991, a group of twelve northeastern states and the District of Columbia, the Ozone Transport Commission (the "OTC"), organized under provisions of the Act and executed a Memorandum of Understanding under which they agreed to propose adoption of the California LEV standards. On February 1, 1994, the OTC voted to recommend to the EPA that it require all member states to adopt the California LEV standards in their state implementation programs. The EPA must act on the petition within nine months after its receipt. Adoption of the California LEV standards by any state will present challenges and potential adverse effects similar to those that will be experienced in California, which may be further aggravated by conditions in a particular state. In November 1990, the Department of Environmental Conservation (the "DEC") of the State of New York adopted regulations, effective beginning in the 1993 model year, that are intended to require that vehicles sold in that state comply with California's 1993 model year (pre- LEV) emissions standards. In May 1992, the DEC adopted regulations purporting to implement the California LEV standards beginning in the 1994 model year. The American Automobile Manufacturers Association ("AAMA"), of which Ford is a member, and the Association of International Automobile Manufacturers ("AIAM") challenged the legality of the DEC's adoption of the LEV standards, as inconsistent with its legal authority under the Act. A ruling by the U.S. District Court in Binghamton, New York, that the DEC's adoption of the LEV standards violated certain provisions of the Act (and was, therefore, invalid) was appealed to the U.S. Court of Appeals for the Second Circuit (the "Second Circuit Court"). On February 4, 1994, the Second Circuit Court upheld certain aspects of the State of New York's adoption of the California LEV standards, including the ZEV sales mandate. However, the Second Circuit Court also held that the standard would not apply to 1995 model year vehicles, thereby making the standard applicable to 1996 and beyond model year vehicles. A 1990 Massachusetts law, as implemented by regulations issued in 1992, purports to adopt the California LEV standards beginning in the 1995 model year. A special study commission established by the Massachusetts legislature to re-evaluate adoption of the California Act and standards recommended proceeding with their adoption. The AAMA and AIAM are challenging the adoption of the standards in the U.S. District Court in Massachusetts. Under the Act, if the EPA determines that a substantial number of any class or category of vehicles, although properly maintained and used, do not conform to applicable emissions standards, a manufacturer may be required to recall and remedy such nonconformity at its expense. Further, if the EPA determines through testing of production vehicles that emission control performance requirements are not met, it can halt shipment of motor vehicles of the configuration tested. California has similar, and in some respects greater, authority to order manufacturers to recall vehicles. Ford has been required, and may in the future be required, to recall vehicles for such purposes from time to time. The costs of related repairs or inspections associated with such recalls can be substantial. The European Union has established standards which, in many cases, will require motor vehicle emissions control equipment similar to that used in the U.S. These standards, which are of generally equivalent stringency to 1983 model year U.S. standards for gasoline-powered vehicles and 1987 model year standards for diesel-powered vehicles, are applicable to vehicles type-approved after July 1, 1992, and registered after December 31, 1992. The EU Council of Ministers has unanimously adopted a common position approving a proposal by the European Commission to adopt more stringent motor vehicle emission standards. Under the European Union's new co-decision procedure, the Council's common position must be referred to the European Parliament (which may accept, modify or reject the proposal) for further action before the proposal can be adopted. Under the co-decision procedure, adoption is expected to be completed in the first half of 1994. The proposed standards would apply to vehicle homologations (i.e., the European regulatory certification process) beginning January 1, 1996 and to new vehicle registrations beginning January 1, 1997 and are of generally equivalent numerical stringency to those which begin to apply in the U.S. for the 1994 model year. The common position also provides for the European Commission to propose by the end of 1994 supplementary reductions in motor vehicle emissions that would take effect beginning January 1, 2000. Such supplemental reductions would be a function of technical progress achieved between now and 2000. When the more stringent standards are adopted, European Union member countries would be permitted to provide "green" incentives for the purchase of vehicles that comply with the new standards before their effective date. Certain other European countries also have established, and may in the future establish, unique automotive emissions standards. Certain European countries, including member countries of the European Union, are conducting in-use emissions testing to ascertain compliance of motor vehicles with applicable emissions standards. These actions could lead to recalls of vehicles and the future costs of related repairs or inspections could be substantial. Motor Vehicle Safety -- Under the National Traffic and Motor Vehicle Safety Act of 1966, as amended (the "Safety Act"), the National Highway Traffic Safety Administration (the "Safety Administration") is required to establish appropriate federal motor vehicle safety standards that are practicable, meet the need for motor vehicle safety and are stated in objective terms. Since 1968 the Safety Act has prohibited the sale in the United States of any new motor vehicle or item of motor vehicle equipment that does not conform to applicable federal motor vehicle safety standards. The Safety Administration has announced its intention to establish additional such standards in the near future, which Ford supports in principle. Ford expects to be able to comply with those standards but only at significantly increased costs, because doing so will tend to conflict with the need to reduce vehicle weight in order to meet stringent emissions and fuel economy standards. The Safety Administration also is required to make a determination on the basis of its investigation whether motor vehicles or equipment contain defects related to motor vehicle safety or fail to comply with applicable safety standards and, generally, to require the manufacturer to remedy any such condition at its own expense. The same obligation is imposed on a manufacturer which obtains knowledge that any motor vehicle manufactured by it contains a defect determined in good faith by it to be related to motor vehicle safety. There currently are pending before the Safety Administration a number of major investigations relating to alleged safety defects or alleged noncompliance with applicable safety standards in vehicles built, imported or sold by Ford. The cost of recall programs to remedy safety defects or noncompliance, should any be determined to exist as a result of certain of such investigations, could be substantial. The European Union, individual Member States within the European Union and other countries in Europe also have safety standards applicable to motor vehicles and are likely to adopt additional or more stringent standards in the future. The cost of complying with these standards, as well as the cost of any recall programs to remedy safety defects or noncompliance, could be substantial. Motor Vehicle Fuel Economy -- Passenger cars and trucks rated at less than 8,500 pounds gross vehicle weight are required by regulations issued by the Safety Administration pursuant to the Motor Vehicle Information and Cost Savings Act (the "Cost Savings Act") to meet separate minimum CAFE standards. Failure to meet the CAFE standard in any model year, after taking into account all available credits, is deemed to be unlawful conduct and would subject a manufacturer to the imposition of a civil penalty equivalent to $5 for each one-tenth of a mile per gallon ("mpg") under the applicable standard multiplied by the number of vehicles in the class (i.e., domestic cars, domestic trucks, imported cars or imported trucks) produced in that model year. Each such class of vehicle may earn credits either as a result of exceeding the standard in one or more of the preceding three model years ("carryforward credits") or pursuant to a plan, approved by the Safety Administration, under which a manufacturer expects to exceed the standard in one or more of the three succeeding model years ("carryback credits") but credits earned by a class may not be applied to any other class of vehicles. The Cost Savings Act established a passenger car CAFE standard of 27.5 mpg for the 1985 and later model years, which the Safety Administration asserts it has the authority to amend to a level it determines to be the "maximum feasible" level (considering the following factors: technological feasibility, economic practicality, the effect of other federal motor vehicle standards on fuel economy, and the need of the nation to conserve energy). Pursuant to the Cost Savings Act, the Safety Administration established CAFE standards applicable to 1994 and 1995 model year light trucks (under 8,500 lbs. GVW) at 20.5 mpg and 20.6 mpg, respectively (on a combined two-wheel drive/four-wheel drive basis). It also has issued a Notice of Proposed Rulemaking ("NPRM") proposing to set standards for light trucks within the range of 20.5 mpg to 21.5 mpg for model years 1996 and 1997. If the Safety Administration sets light truck standards for the 1996 and 1997 model years within the range proposed in the NPRM referred to above, Ford expects to be able to comply with the CAFE standards applicable to its 1994 through 1997 model year "domestic" and "import" cars and light trucks, although it may be necessary to use credits to do so. Despite Ford's expectations of compliance, however, there are factors that could jeopardize its ability to comply. These factors include the possibility of changes in market conditions, including a shift in demand for larger vehicles and a decline in demand for small and middle-size vehicles; or conversely, a shortage of reasonably priced gasoline resulting in a decreased demand for more profitable vehicles and a corresponding increase in demand for relatively less profitable vehicles. It is anticipated that efforts may be made to raise the CAFE standard because of concerns for CO2 emissions, energy security or other reasons. President Clinton's Climate Change Action Plan sets a goal to improve new vehicle fuel efficiency in an amount equivalent to at least 2% per year over a 10 to 15 year period, using a combination of regulatory and non-regulatory measures. If the entire goal, or a substantial portion of the goal, is to be achieved through higher CAFE standards, Ford would find it necessary to take various costly actions that would have substantial adverse effects on its sales volume and profits. For example, Ford could find it necessary to curtail or eliminate production of larger family-size and luxury passenger cars and full-size light trucks, restrict offerings of engines and popular options, and continue or increase market support programs for its most fuel-efficient passenger cars and light trucks. The Energy Tax Act of 1978, as amended, imposes a federal excise tax on automobiles which do not achieve prescribed fuel economy levels. Additional legislative proposals could be introduced that, if enacted, would increase excise taxes or create economic disincentives to purchase any except the least fuel consuming vehicles. Because of the uncertainties and variables inherent in testing for fuel economy and the uncertain effect on fuel economy of other government requirements, it is not possible to predict the amount of excise tax, if any, which may be incurred. LEGAL PROCEEDINGS Various legal actions, governmental investigations and proceedings and claims are pending or may be instituted or asserted in the future against the Company and its subsidiaries, including those arising out of alleged defects in the Company's products, governmental regulations relating to safety, emissions and fuel economy, financial services, intellectual property rights, product warranties and environmental matters. Certain of the pending legal actions are, or purport to be, class actions. Some of the foregoing matters involve or may involve compensatory, punitive or antitrust or other treble damage claims in very large amounts, or demands for recall campaigns, environmental remediation programs, sanctions or other relief which, if granted, would require very large expenditures. See "Business of Ford --Governmental Standards". Included among the foregoing matters are the following: Product Matters -- Three suits purporting to be nationwide class actions were filed by some of the plaintiffs of a previously dismissed federal action that allege claims that are substantially the same as those in the dismissed federal action -- i.e., that they are or were purchasers or owners of or passengers in 1976 through 1979 model year Ford vehicles equipped with certain automatic transmissions who have incurred property damage, personal injury, economic losses or liability for such losses by reason of an alleged tendency of the vehicles to slip from park to reverse. A judgment dismissing the first such suit by the Superior Court for the District of Columbia was vacated by the local Court of Appeals for the District of Columbia, and renewed motions to dismiss are under consideration by the Superior Court. The second suit was filed in the Court of Common Pleas in Philadelphia, Pennsylvania, and has been stayed pending the entry of final and non-appealable orders in the action referred to in the immediately preceding sentence. The third suit was filed in the Circuit Court of Cook County, Illinois. That court granted the Company's motion to stay proceedings indefinitely and the plaintiffs have appealed that ruling to the Appellate Court of Illinois for the First Judicial District-Third Division. Ford is a defendant in various actions for damages arising out of automobile accidents where plaintiffs claim that the injuries resulted from (or were aggravated by) alleged defects in the occupant restraint systems in vehicle lines of various model years. The damages specified by the plaintiffs in these actions, including both actual and punitive damages, aggregated approximately $439 million at January 1, 1994. Ford is a defendant in various actions involving the alleged propensity of Bronco II utility vehicles to roll over. The damages specified in these actions, including both actual and punitive damages, aggregated approximately $367 million at January 1, 1994. In some of the actions described in the foregoing paragraphs no dollar amount of damages is specified or the specific amount referred to is only the jurisdictional minimum. In addition to the pending actions, accidents have occurred and claims have arisen which also may result in lawsuits in which such a defect may be alleged. Ford is a defendant in various actions for injuries claimed to have resulted from alleged contact with certain Ford parts and other products containing asbestos. Damages specified by plaintiffs in complaints in these actions, including both actual and punitive damages, aggregated approximately $163 million at January 1, 1994. (In some of these actions no dollar amount of damages is specified or the specific amount referred to is only the jurisdictional minimum.) As distinguished from most lawsuits against Ford, in most of these asbestos-related cases, Ford is but one of many defendants, and many of these co-defendants have substantial resources. Environmental Matters -- Ford has received notices from two government environmental enforcement agencies concerning two separate matters, each potentially involving monetary sanctions exceeding $100,000. One agency believes a Ford facility may have violated regulations relating to the management of certain of the facility's wastes and the other agency believes a Ford facility may violate or may have violated limits established by regulations or permits for emissions or discharges. Ford has received notices under RCRA, the Superfund Act and applicable state laws that it (along with others) may be a potentially responsible party for the costs associated with remediating numerous hazardous substance storage, recycling or disposal sites in many states and, in some instances, for natural resource damages. Ford also may have been a generator of hazardous substances at a number of other sites. The amount of any such costs or damages for which Ford may be held responsible could be substantial. Contingent losses expected to be incurred by Ford in connection with many of these sites have been accrued and are reflected in Ford's financial statements in accordance with generally accepted accounting principles. However, for many other of these sites the remediation costs and other damages for which Ford ultimately may be responsible are not reasonably estimable because of the uncertainties with respect to factors such as Ford's connection to the site or to materials there, the involvement of other potentially responsible parties, the application of laws and other standards or regulations, site conditions, and the nature and scope of investigations, studies and remediation to be undertaken (including the technologies to be required and the extent, duration and success of remediation). As a result, Ford is unable to determine or reasonably estimate the amount of costs or other damages for which it is potentially responsible in connection with these sites, although it could be substantial. Other Matters -- A number of claims have been made or may be asserted in the future against Ford alleging infringement of patents held by others. Ford believes that it has valid defenses with respect to the claims that have been asserted. If some of such claims should lead to litigation, however, and if the claimant were to prevail, Ford could be required to pay substantial damages. On August 7, 1992, Ford was sued in federal court in Nevada by an individual patent owner seeking damages and an injunction for alleged infringement of three (later amended to four) U.S. patents characterized by the individual as covering machine vision inspection technologies, including bar code reading. Ford and one of its suppliers, Motorola, have filed a declaratory judgment action in the same court to have those patents and several other patents directed to machine vision, radiation beam (e.g., laser and electron beam) uses and semiconductor manufacturing (17 patents in all) declared invalid, unenforceable and not infringed. If the patent holder were to prevail, Ford could be required to pay substantial damages of an as yet indeterminate amount and could become subject to an injunction preventing future uses of any process or product found to be covered by a valid patent. On March 15, 1993, Ford was served with a private purported class action lawsuit in Texas relating to allegations of paint peeling on unspecified Ford vehicles. The purported class would include all persons who purchased new or used Ford vehicles in Texas and who experienced paint peeling as a result of unspecified defects in Ford's paint process. The plaintiffs seek an unspecified amount of damages. Ford has been served with various private purported class action lawsuits seeking economic damages (including damages for diminution in value and rescission of purchase agreements) on behalf of Bronco II vehicle owners relating to the alleged propensity of such vehicles to roll over. The purported classes include all Bronco II owners in the United States. Each lawsuit expressly excludes personal injury claimants, whose claims are discussed above. Several of the lawsuits seek recovery of unspecified punitive damages. In addition, several of the lawsuits seek an order requiring the Company to recall and retrofit these vehicles. Ford of Germany and Volkswagen AG have formed a joint venture to produce a multi-purpose vehicle ("MPV") in Portugal. The Portuguese government has agreed to grant an incentive package to the joint venture. On June 15, 1993 the European Court of Justice rejected a claim filed by a French manufacturer of MPVs challenging the legality of the grant. The same manufacturer has filed an appeal with the European Court challenging the decision of the European Commission in December 1992 granting antitrust approval of the joint venture. Ford has intervened in these proceedings. If the French manufacturer succeeds in the antitrust case, which Ford considers unlikely, the joint venture could be dissolved, the grants may have to be repaid and the participants in the joint venture might have to write off substantial development costs. EMPLOYEE RELATIONS Substantially all hourly employees of Ford in the United States are included in collective bargaining units represented by unions. Approximately 99% of these unionized hourly employees are represented by the United Automobile Workers (the "UAW"). Approximately 3% of salaried employees are represented by unions. Most hourly employees and many nonmanagement salaried employees of subsidiaries outside the United States also are represented by unions. Affiliates of Ford also are parties to collective bargaining agreements in Britain, Spain, Germany and France. Collective bargaining agreements between Ford and the UAW and between Ford of Canada and the Canadian Automobile Workers were entered into in 1993 and are scheduled to expire in September 1996. SELECTED FINANCIAL DATA OF FORD The following tables set forth selected financial data and other data concerning Ford for each of the last ten years (dollar amounts in millions except per share amounts): (1) 1989 includes an after-tax loss of $424 million from the sale of Rouge Steel Company. (2) Share data have been adjusted to reflect stock dividends and stock split. (3) The cumulative effects of changes in accounting principles reduced equity by $6,883 million in 1992. (4) Per hour worked (in dollars). Excludes data for subsidiary companies. (5) Includes units manufactured by other companies and sold by Ford. (6) Factory sales are by source of manufacture, except that Canadian, Mexican and Australian exports to the United States are included as U.S. vehicle sales, and U.S. exports to Canada are included as Canadian vehicle sales. (7) Includes units sold by Ford in Brazil and Argentina through June 30, 1987, and excludes units sold by Autolatina. (8) Ford's tractor operation, Ford New Holland, was sold on May 6, 1991. FINANCIAL REVIEW OF FORD MOTOR COMPANY RESULTS Overview The Company's worldwide net income in 1993 was $2,529 million, or $4.55 per share of Common and Class B Stock, compared with a loss of $7,385 million, or $15.61 per share in 1992. Sales and revenues totaled $108.5 billion in 1993, up 8% from 1992. Factory unit sales of cars and trucks were 5,964,000, up 200,000 or 3%. In 1992, Ford adopted new accounting standards for postretirement benefits (principally retiree health care) and income taxes that resulted in a one-time charge to net income in 1992 for prior years of $6,883 million. Excluding the one-time effects of these accounting changes, the Company incurred a net loss of $502 million or $1.46 per share in 1992. The Company's financial results in 1993 showed substantial improvement compared with 1992. Improvements in U.S. Automotive operations included the favorable effects of higher industry volume, higher share, and improved margins. Automotive operations outside the U.S. also improved, despite lower industry volumes in Europe. Earnings from Financial Services operations were a record and increased 54% compared with 1992. The Company continued its product development and cost reduction programs to strengthen its competitive position. In 1993, capital spending for new products and facilities was $6.8 billion, up $1 billion from 1992. Automotive debt at the end of 1993 was $8,016 million, down $301 million from year-end 1992. Cash and marketable securities for the Company's Automotive segment totaled $9,752 million, up $717 million from year-end 1992. In 1994, the Company expects continued improvements in operating results from cost reduction efforts, new product introductions, and a moderate rate of economic growth in the United States. The Company expects sales for the U.S. car and truck industry to reach about 15 million units in 1994. Several new products will be introduced in 1994, including the Ford Windstar, Ford Aspire, Ford Contour and Mercury Mystique. Per-unit U.S. marketing costs for Ford, which declined in 1993, should decline further in 1994 as industry sales increase and new products are introduced. The Company expects industry sales in Europe to be up slightly in 1994, compared with 1993. As a result of an expected continuation of the gradual economic recovery in Great Britain and the restructuring actions undertaken in Europe during 1993, the operating results of European Automotive operations are projected to improve in 1994, compared with 1993. In Latin America, the near-term business outlook is favorable, but business conditions have historically been volatile and subject to rapid change. FOURTH QUARTER OF 1993 In the fourth quarter of 1993, the Company's worldwide net income was $719 million or $1.30 per share of Common and Class B Stock, compared with a loss of $840 million, or $1.85 per share in the fourth quarter of 1992. Worldwide Automotive operations earned $297 million in the fourth quarter of 1993, compared with a loss of $1,037 million a year ago. U.S. Automotive operations earned $669 million in the fourth quarter of 1993, compared with a loss of $128 million a year ago, while Automotive operations outside the U.S. incurred a loss of $372 million, compared with a loss of $909 million a year ago. Financial Services earned $422 million in the fourth quarter of 1993, compared with $197 million a year ago. Net income for Automotive operations outside the U.S. were adversely affected in the fourth quarter of 1993 by restructuring actions at Jaguar ($109 million) and Ford of Australia ($57 million), offset partially by the favorable one-time effects of a reduction in German tax rates ($59 million). Automotive operations in the U.S. were favorably affected by the gain on the sale of Ford's North American automotive seating and seat trim business ($73 million). The loss a year ago included one-time European restructuring charges of $334 million for Automotive operations and $85 million for Financial Services operations. The following discussion of the results of operations excludes the one-time effects associated with accounting changes in 1992 as discussed above. 1993 RESULTS OF OPERATIONS AUTOMOTIVE OPERATIONS Net income from Ford's worldwide Automotive operations was $940 million in 1993 on sales of $91.6 billion. In 1992, worldwide Automotive operations incurred a loss of $1,534 million (excluding the accounting changes) on sales of $84.4 billion. In the U.S., Ford's Automotive operations earned $1,482 million on sales of $61.6 billion, compared with a loss of $405 million in 1992 on sales of $51.9 billion. Higher vehicle production, reflecting higher industry sales and a higher Ford market share, accounted for most of the improvement. Improved margins, reflecting mainly favorable material costs, manufacturing efficiencies, and lower marketing costs, were offset partially by higher costs for new products and related facilities. Results in 1993 included the one-time favorable effect of tax legislation ($171 million) for the restatement of U.S. deferred tax balances for the Federal income tax rate increase from 34% to 35% and the gain on the sale of Ford's North American automotive seating and seat trim business ($73 million). On an ongoing basis, the effect of the tax rate change on future tax expense will be unfavorable. In 1993, the U.S. economy continued to grow at a modest rate. In the eleven quarters since the recovery began in the Spring of 1991, the rate of growth in the gross domestic product (GDP) has averaged 2.7%, 60% of the rate over the comparable period during the last six recoveries. Slow growth has helped reduce interest rates and inflation to low levels. Industry sales of cars and trucks in the United States have gradually increased from 12.5 million units in 1991 to 14.2 million units in 1993. Over this period, Ford's combined U.S. car and truck market share has improved -- from 23.2% in 1991 to 25.5% in 1993 -- to the highest level since 1978. The Company also has benefited from reduced marketing incentives, lower supplier cost increases, and other cost efficiencies. Full year U.S. car and truck industry volumes increased from 13.1 million units in 1992 to 14.2 million units in 1993. Over 70% of the increase in industry sales was attributable to trucks (including minivans, compact utility vehicles, and compact pickups). Ford's share of the U.S. car market (including Jaguar) was 22.3%, up 5/10 of a point from 1992. The Company's U.S. truck share was 30.5%, up 8/10 of a point from 1992. The improved market share for cars and trucks reflected strong product acceptance. Outside the U.S., Ford's Automotive operations lost $542 million in 1993 on sales of $30.0 billion, compared with a loss of $1,129 million in 1992 on sales of $32.5 billion. Results improved despite a weak economy in Europe that resulted in the lowest level of industry sales in eight years. Savings from cost reduction actions in Europe and improved results in Latin America, reflecting primarily higher industry volume in Brazil, more than offset the effects of lower volume in Europe. The loss in 1993 included restructuring charges at Jaguar ($174 million), primarily for resourcing stamping and restructuring other operations to improve efficiency, and at Ford of Australia ($57 million), related to discontinuing production of the Capri and Laser model, offset partially by the favorable one-time effect of a reduction in German tax rates ($59 million). Losses in 1992 included restructuring charges of $334 million. Ford's European Automotive operations (excluding Jaguar) lost $407 million, compared with a loss of $647 million in 1992. The improvement reflected nonrecurrence of the one-time restructuring charge ($334 million) in the fourth quarter of 1992, primarily for planned reductions in employment levels. Lower vehicle production, reflecting lower industry sales (down 16%), higher costs for new products, and the unfavorable effect of fluctuations in foreign currency exchange rates were partially offset by manufacturing efficiencies and other cost improvements. Car and truck industry sales in Europe were 12.5 million units in 1993, compared with 15 million units in 1992. Ford's European car market share (including Jaguar) was 11.8% in 1993, up 3/10 of a point from 1992. Ford's European truck share improved 9/10 of a point to 12.6%. FINANCIAL SERVICES OPERATIONS The Company's Financial Services operations earned a record $1,589 million in 1993, up $557 million from 1992. Higher volume, reduced interest rates and operating costs, and lower credit losses contributed to record earnings at Financial Services operations, including Ford Credit, The Associates, and USL Capital. Results in 1993 included an unfavorable one-time effect of $31 million from tax legislation in the U.S. Results in 1992 of $1,032 million excluded a favorable effect of $211 million associated with one-time accounting changes, mainly for income taxes, but include organizational restructuring charges relating to European Financial Services operations ($85 million). See Item 7. -- "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the discussion of Ford Credit's 1993 results of operations. In addition, international operations managed by Ford Credit earned $199 million in 1993, up $11 million from 1992, primarily reflecting improved net interest margins and lower credit lossess offset partially by the unfavorable effect of exchange rates. The Associates earned a record $470 million in the U.S. in 1993, up $77 million from 1992. The improvement was more than explained by improved credit loss performance and higher levels of earning assets. In addition, international operations managed by The Associates earned $38 million in 1993, the same as in 1992. First Nationwide incurred a loss of $55 million in 1993, compared with a loss of $81 million in 1992. The improvement resulted primarily from reduced borrowing costs, continued improvements in operating costs, a lower adjustment in 1993 to the carrying value of derivative securities and the gain on sale of certain branches. These factors were partially offset by lower levels of earning assets, lower yields from the reinvestment of FDIC proceeds, and a reduction in income tax benefits. First Nationwide's 1993 revenues included $72 million from the Federal Savings and Loan Insurance Corporation Resolution Fund (FSLIC/RF), compared with $221 million in 1992. These revenues represented reimbursements for losses or guaranteed yields on covered assets paid pursuant to First Nationwide's agreements with FSLIC/RF to acquire certain savings and loan institutions. USL Capital earned a record $77 million in 1993, up $17 million from 1992. The improvement resulted primarily from higher earning assets and continued operating cost reductions. American Road earned $79 million in 1993, compared with $47 million in 1992. The increase resulted primarily from improved underwriting experience in extended service plan and floor plan products, partially offset by lower investment income. LIQUIDITY AND CAPITAL RESOURCES AUTOMOTIVE OPERATIONS Cash and marketable securities of the Company's Automotive operations were $9,752 million at December 31, 1993, up $717 million from December 31, 1992. The Company paid $1,086 million in cash dividends on its capital stock during 1993. In 1993, the Company contributed $1 billion to its pension funds. Automotive capital expenditures were $6.7 billion in 1993, up $1 billion from 1992. Over the last five years (1989 through 1993), the Company's worldwide capital spending totaled $32 billion. During the next several years, the pace of spending for product change at Ford will continue at similar or higher levels. At December 31, 1993, Automotive debt totaled $8,016 million, which was 34% of total capitalization (stockholders' equity and Automotive debt), compared with $8,317 million, or 36% of total capitalization, at year-end 1992. At December 31, 1993, Ford (parent company only) had long-term contractually committed credit agreements for use in the U.S. under which $4.8 billion is available from various banks at least through June 30, 1998. The entire $4.8 billion may be used, at Ford's option, by either Ford or Ford Credit. As of December 31, 1993, these facilities were unused. Outside the U.S., Ford has additional long-term contractually committed credit-line facilities of approximately $2.4 billion. These facilities are available in varying amounts from 1994 through 1998; none had been utilized at December 31, 1993. FINANCIAL SERVICES OPERATIONS The Financial Services operations rely heavily on their ability to raise substantial amounts of funds in capital markets in addition to collections on loans and retained earnings. The levels of funds for certain Financial Services operations are affected by certain transactions with Ford, such as capital contributions, dividend payments and the timing of payments for income taxes. Their ability to obtain funds also is affected by their debt ratings which, for certain operations, are closely related to the financial condition and outlook for Ford and the nature and availability of support facilities, such as revolving credit and receivables sales agreements. For information relating to Ford Credit's liquidity and capital resources, see "Business of Ford Credit - Borrowings and Other Sources of Funds" and Item 7. - "Management's Discussion and Analysis of Financial Condition and Results of Operations". In addition, at December 31, 1993, international subsidiaries and other credit operations managed by Ford Credit had $14.2 billion of support facilities available outside the U.S., approximately 44% of which were contractually committed. At December 31, 1993, approximately 42% of these support facilities outside the U.S. were in use. First Nationwide's principal sources of funds include borrowings, collections on loans, proceeds from the sale of loans, and customers' deposits. In addition, the Federal Home Loan Bank System provides both short- and long-term alternative sources of funds. Other sources include the sale of mortgage pass-through securities and reverse repurchase agreements. Federal regulations require that an insured institution maintain certain regulatory capital requirements. New minimum regulatory capital standards were established in 1989 and will be phased in through 1994. First Nationwide Bank met all of the minimum capital requirements in effect at December 31, 1993. At December 31, 1993, The Associates had contractually committed lines of credit with banks of $3.1 billion, with various maturities ranging from January 30, 1994 to December 31, 1994, none of which was utilized at December 31, 1993. Also, at December 31, 1993, The Associates had $4.1 billion of contractually committed revolving credit facilities with banks, with maturity dates ranging from February 1, 1994 through October 1, 1997, and $1 billion of contractually committed receivables sale facilities, $500 million of which are available through April 15, 1994 and $500 million of which are available through April 30, 1995; none of these facilities was in use at December 31, 1993. At December 31, 1993, foreign operations managed by The Associates had $195 million of support facilities available outside the U.S., approximately 64% of which were contractually committed. At December 31, 1993, about 15% of these support facilities outside the U.S. were in use. At December 31, 1993, Ford Holdings had outstanding debt of $1.9 billion, all of which was long-term. All of the Ford Holdings debt held by nonaffiliated persons is guaranteed by Ford. Ford Holdings had no contractually committed lines of credit at December 31, 1993. In 1993, Ford Holdings sold 1,728 shares of its Series B Cumulative Preferred Stock having an aggregate liquidation preference of $173 million and 2,000 shares of its Series C Cumulative Preferred Stock having an aggregate liquidation preference of $200 million. American Road's principal sources of funds are insurance premiums, annuity deposits and investment income. American Road had no debt or credit lines at December 31, 1993. At December 31, 1993, USL Capital had $1.4 billion of contractually committed credit facilities, 70% of which are available through September 1998. These facilities included $200 million of contractually committed receivables sale facilities, of which about 86% were in use at December 31, 1993. At December 31, 1993, foreign operations managed by USL Capital had approximately $90 million of contractually committed support facilities available outside the U.S., of which about 75% were in use at December 31, 1993. NEW ACCOUNTING STANDARDS In November 1992, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postemployment Benefits", which requires companies to account for employee benefits on an accrual basis for periods when employees are no longer actively employed but have not yet reached retirement. The effect on the Company's financial statements was not material. In May 1993, the FASB issued SFAS 114, "Accounting by Creditors for Impairment of a Loan". The standard requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. The Company does not plan to adopt this standard until January 1, 1995, and the effect is not expected to be material. In May 1993, the FASB issued SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". The standard establishes financial accounting and reporting requirements for investments in equity securities (excluding those accounted for under the equity method and investments in consolidated subsidiaries) that have readily determinable fair values and for all investments in debt securities. The Company has adopted this standard effective January 1, 1994, and the effect is not expected to be material. ITEM 2. ITEM 2. FORD CREDIT PROPERTIES Substantially all of Ford Credit's branch operations presently are being conducted from leased properties. At December 31, 1993, Ford Credit's aggregate obligation under leases of real property was $52.2 million. In 1990, Ford Credit purchased from Ford its central office building in Dearborn, Michigan. ITEM 3. ITEM 3. FORD CREDIT LEGAL PROCEEDINGS Various legal actions, governmental proceedings, and other claims are pending or may be instituted or asserted in the future against Ford Credit and its subsidiaries. Ford Credit is a defendant in actions asserting claims under the antitrust laws and the Automobile Dealers' Day in Court Act resulting from Ford Credit's termination of financing relationships with former automobile dealers, and actions alleging violations of various state and federal regulatory laws concerning financing and insurance, based upon technical interpretations of their requirements. Some of these matters involve or may involve class actions, compensatory, punitive or treble damage claims and attorneys fees in very large amounts, or other requested relief which, if granted, would require very large expenditures. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All shares of the registrant's Common Stock are owned by Ford and, accordingly, there is no market for such stock. During 1993, Ford Credit declared and paid to Ford cash dividends of $250 million. Dividends also were paid to Ford in 1992 and 1991. Ford Credit may pay additional dividends from time to time depending on Ford Credit's receivables levels, capital requirements, and profitability. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA SELECTED INCOME STATEMENT DATA (IN MILLIONS) * Includes income of American Road through September 30, 1989 ** Includes income of Ford Holdings for period October 1 - December 31, 1989 SELECTED BALANCE SHEET DATA (IN BILLIONS) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The principal factors that influence the earnings of Ford Credit are interest margins, the levels of finance receivables and net investment in operating leases, and its investment in, and the profitability of, Ford Holdings. Interest margins reflect the difference between interest rates earned on finance receivables and operating leases ("yields"), and the rates paid on borrowed funds. Yields on most receivables and operating leases generally are fixed at the time the contracts are acquired. On some receivables, primarily wholesale financing, yields vary with changes in short-term interest rates. Borrowed funds include short-term debt, the cost of which reflects changes in short-term interest rates, and long-term debt, the cost of which generally is fixed at the time of the debt placement. Interest-rate swap agreements are used to hedge movements in interest rates related to borrowings and to manage the match between the interest rates of assets and liabilities. The levels of finance receivables and net investment in operating leases depend primarily on the volume of Ford Motor Company vehicle sales, the extent to which Ford Credit provides the wholesale and retail financing of those sales, and sales of receivables. Ford periodically sponsors special financing programs that are available exclusively through Ford Credit which provide payments to Ford Credit for interest supplements and other support costs on certain financing and leasing transactions. These programs can increase Ford Credit's financing volume of Ford Motor Company vehicles. RESULTS OF OPERATIONS 1993 COMPARED WITH 1992 Ford Credit's consolidated net income in 1993 was $1,194 million, up $155 million or 15% from 1992. Excluding a one-time gain resulting from the net effect of the adoption of new accounting standards for income taxes and postretirement benefits in 1992, net income was up $302 million or 34% from a year ago. The following comparison of 1993 results with 1992 results excludes the one-time net gain associated with the accounting changes. Net income from financing operations was $996 million, up $259 million or 35% from the prior year. The increase in financing profits was more than accounted for by higher financing volumes, lower credit losses and higher net income from gains on sales of retail automotive receivables, partially offset by the increase in U. S. income taxes and lower net interest margins. Lower credit losses reflect lower losses per repossession and fewer repossessions. Actual credit losses were $228 million (0.35% of average finance receivables including net investment in operating leases) compared with $343 million (0.60%) last year. Ford Credit released a portion of the loss reserves reflecting the continued improvement in actual credit loss experience. The credit loss coverage ratio for 1993 was 4.0 compared with 2.7 in the prior year. The decline in net interest margins, including depreciation on operating leases, reflects primarily the decline in net U.S. borrowing rates from 6.3% in 1992 to 5.3% in 1993, more than offset by lower yields on finance receivables and net investment in operating leases. For 1993, equity in net income of affiliated companies (primarily Ford Holdings) was $198 million, up $43 million from 1992. The increase reflected higher Ford Holdings net income available to common shareholders, partially offset by a reduction in Ford Credit's ownership of Ford Holdings common stock in 1992 as discussed below. At December 31, 1993, Ford Credit owned about 45% of Ford Holdings common stock, representing about 34% of the voting power. Total gross finance receivables and net investment in operating leases at December 31, 1993 were $69.6 billion, up $9.4 billion (16%) from a year earlier. The higher financing volume reflects primarily an increase in short-term operating leases and higher wholesale receivables. Depreciation expense on operating leases in 1993 was $2,676 million, up $1,023 million or 62% from 1992. The increase reflected the higher levels of operating leases and was more than offset by higher revenue earned on the lease contracts. For 1993, Ford Credit financed 38.5% of all new cars and trucks sold by Ford Motor Company dealers in the U.S. compared with 37.7% in 1992. Ford Credit provided retail financing for 2,246,000 new and used vehicles in the United States. Ford Credit provided wholesale financing for 81.4% of Ford Motor Company U.S. factory sales in 1993 compared with 77.6% in 1992. 1992 COMPARED WITH 1991 Ford Credit's consolidated net income in 1992 was $1,039 million. Included in net income was a one-time net gain of $147 million that resulted from the adoption of new accounting standards for income taxes and postretirement benefits (principally retiree health care). Net income increased by $239 million for the tax accounting standard partially offset by a decrease in net income of $92 million for retiree health care. Excluding this one-time gain, Ford Credit earned net income of $892 million, up $143 million or 19% from $749 million earned in 1991. The following comparison of 1992 results with 1991 results excludes the one-time net gain associated with the accounting changes. Net income from financing operations in 1992 was $737 million, up $179 million or 32% from 1991. The increase was more than accounted for by lower credit losses and higher net interest margins. Lower gains on sales of receivables were a partial offset. The improvement in credit losses reflected fewer retail repossessions, a decline in loss per repossessed unit and reduced wholesale losses. Actual credit losses were $343 million (0.60% of average finance receivables including net investment in operating leases) compared with $529 million (0.92%) a year earlier. The credit loss coverage ratio for 1992 was 2.7 compared with 1.6 in 1991. The higher net interest margins reflected primarily a decline in Ford Credit's net average U.S. borrowing rate from 7.9% in 1991 to 6.3% in 1992, partially offset by lower prime-based revenue. For 1992, equity in net income of affiliated companies (primarily Ford Holdings) was $155 million compared with $191 million in 1991. The decline reflected lower Ford Holdings net income available to common shareholders and a reduction in Ford Credit's ownership of Ford Holdings common stock. The reduction in ownership was the result of a dividend paid in 1992 to Ford in the form of Ford Holdings common stock. At December 31, 1992, Ford Credit owned about 45% of Ford Holdings common stock, representing about 34% of the voting power. Total gross finance receivables and net investment in operating leases at December 31, 1992 were $60.2 billion, up $3.6 billion or 6% from a year earlier. The increase reflected primarily higher levels of shorter-term operating leases. Depreciation expense on operating leases in 1992 was $1,653 million, up $622 million or 60% from 1991. The increase reflected the higher levels of operating leases and was more than offset by higher revenue earned on the lease contracts. For 1992, Ford Credit financed 37.7% of all new cars and trucks sold by Ford Motor Company dealers in the U.S. compared with 35.2% in 1991. Ford Credit provided retail customers with financing for 1,871,000 new and used vehicles in the United States in 1992. Ford Credit provided wholesale financing for 77.6% of Ford Motor Company U.S. factory sales in 1992 compared with 74.9% in 1991. NEW ACCOUNTING STANDARDS In May 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan". The standard requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. Ford Credit does not plan to adopt this standard until January 1, 1995, and the effect is not expected to be material. In May 1993, the FASB also issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The standard establishes financial accounting and reporting requirements for investments in equity securities (excluding those accounted for under the equity method and investments in consolidated subsidiaries) that have readily determinable fair values and for all investments in debt securities. Ford Credit has adopted this standard effective January 1, 1994, and the effect is not expected to be material. Additional information called for by Item 7 is incorporated herein by reference from Item 1 - Business - "Business of Ford Credit - Credit Loss Experience", "Business of Ford Credit - Borrowings and Other Sources of Funds", "Ford Holdings" and "Certain Transactions with Ford and Affiliates", and Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by Item 8 is set forth at pages FC-1 through FC-26 of this Form 10-K Report, is incorporated herein by reference and is listed in the Index to Financial Statements as set forth in Item 14(a)(1) and 14(a)(2). PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements Report of Independent Accountants Ford Motor Credit Company and Subsidiaries Consolidated Statement of Income and of Earnings Retained for Use in the Business for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheet, December 31, 1993 and 1992. Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. Notes to Financial Statements. The financial statements and notes to financial statements listed above and the schedule listed below are incorporated by reference in Item 8 of this Report from pages FC-1 through FC-26 of this Form 10-K Report. Information regarding significant restrictions on the ability of subsidiaries to transfer funds to the registrant, and condensed financial information of the registrant are omitted because the amounts related to such restrictions are not sufficient to require submission. (a) 2. Financial Statement Schedules Schedule IX. Ford Motor Credit Company and Subsidiaries -- Short-Term Borrowings. Schedules other than that indicated above have been omitted because the subject matter is disclosed elsewhere in the financial statements and notes thereto, is not required, is not present, or is not present in amounts sufficient to require submission. (a) 3. Exhibits Instruments defining the rights of holders of certain issues of long-term debt of the registrant have not been filed as exhibits to this Report because the authorized principal amount of any one of such issues does not exceed 10% of the total assets of the registrant. The registrant agrees to furnish a copy of each of such instruments to the Commission upon request. (b) Reports on Form 8-K Ford Credit filed the following Reports on Form 8-K during the quarter ended December 31, 1993, none of which contained financial statements: SIGNATURES Pursuant to the requirements of Section 13 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. Ford Motor Credit Company By WILLIAM E. ODOM* (William E. Odom, Chairman of the Board of Directors) Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Ford Motor Credit Company and Subsidiaries REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholder of Ford Motor Credit Company: We have audited the consolidated balance sheet of Ford Motor Credit Company and Subsidiaries at December 31, 1993 and 1992, and the related consolidated statements of income and of earnings retained for use in the business and cash flows for each of the three years in the period ended December 31, 1993 and the financial statement schedule listed in Item 14(a) of this Form 10-K. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ford Motor Credit Company and Subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. As discussed in Notes 2, 3 and 10 to the consolidated financial statements, the Company changed its methods of accounting for postretirement health care benefits and income taxes in 1992. COOPERS & LYBRAND Detroit, Michigan February 1, 1994 FC-1 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME AND OF EARNINGS RETAINED FOR USE IN THE BUSINESS (in millions) The accompanying notes are part of the financial statements. FC-2 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (in millions) The accompanying notes are part of the financial statements. FC-3 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (in millions) The accompanying notes are part of the financial statements. FC-4 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Ford Motor Credit Company ("Ford Credit") and its majority-owned domestic and foreign subsidiaries and joint ventures. Affiliates that are 20-50 percent owned, principally Ford Holdings, Inc. ("Ford Holdings"), are included in the consolidated financial statements on an equity basis. Ford Credit is a wholly owned subsidiary of Ford Motor Company ("Ford"). Net unrealized gains on marketable equity securities reported in a separate component of stockholder's equity relate to Ford Credit's equity interest in Ford Holdings' insurance investment portfolio. Revenue Recognition Revenue from finance receivables is recognized using the interest (actuarial) method. Certain loan origination costs are deferred and amortized to financing revenue over the life of the related loans using the interest method. Rental revenue on operating leases is recognized as scheduled payments become due. Allowance for Credit Losses Allowances for estimated credit losses are established as required based on historical experience. Other factors that affect collectibility also are evaluated and additional amounts may be provided. Finance receivables and lease investments are charged to the allowance for credit losses when an account is deemed to be uncollectible taking into consideration the financial condition of the borrower or lessee, the value of the collateral, recourse to guarantors and other factors. Collateral held for resale included in other assets is carried at the lower of the recorded investment in the receivable or its estimated fair value at the date of repossession. Any difference between the recorded investment in the receivable or lease and the actual sales price of the underlying collateral is charged to the allowance for credit losses. Recoveries on finance receivables and lease investments previously charged off as uncollectible are credited to the allowance for credit losses. Continued FC-5 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 1. ACCOUNTING POLICIES (continued) Foreign Currency Translation Assets and liabilities of foreign subsidiaries are translated at year-end exchange rates with the effects of these translation adjustments being reported in a separate component of stockholder's equity. The change in this account results from translation adjustments recorded during the year. Cash Equivalents Ford Credit considers investments purchased with a maturity of three months or less to be cash equivalents. Financial Statement Reclassifications Certain amounts in prior year financial statements have been reclassified to conform with presentations adopted in 1993. NOTE 2. EQUITY INVESTMENT IN FORD HOLDINGS Ford Holdings' primary activities consist of consumer and commercial financing operations, insurance underwriting, and equipment leasing through its wholly owned subsidiaries, Associates First Capital Corporation, The American Road Insurance Company, and USL Capital Corporation (formerly United States Leasing International, Inc.). In 1992 and 1991, Ford Credit transferred $200 million and $316 million, respectively, of Ford Holdings' common stock to Ford as dividends. At December 31, 1993 and 1992, Ford Credit owned 45% of the common stock representing 33.8% of the voting power of Ford Holdings. Ford owns the remaining common stock representing 41.2% of the voting power. The balance of the voting power is represented by preferred stock owned by persons other than Ford or Ford Credit. At December 31, 1991, Ford Credit owned 54 percent of Ford Holdings' common stock. Continued FC-6 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 2. EQUITY INVESTMENT IN FORD HOLDINGS (continued) Condensed financial information of Ford Holdings as of December 31 was as follows: Ford Credit's equity in the net assets of Ford Holdings at December 31, 1993 and 1992 was $ 1,199 million and $1,002.6 million, respectively. *Ford Credit's equity in Ford Holdings' cumulative effects of changes in accounting principles related to postretirement benefits and income taxes in the amount of $11.6 million is included in Ford Credit's 1992 cumulative effects of changes in accounting principles. Continued FC-7 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 3. INCOME TAXES Ford Credit and certain of its domestic subsidiaries join Ford in filing consolidated United States federal and state income tax returns. Pursuant to an arrangement with Ford, United States income tax liabilities or credits are allocated to Ford Credit in accordance with the contribution of Ford Credit and its subsidiaries to Ford's consolidated tax position. The provision for income taxes consisted of the following: * Excludes the tax provision related to cumulative effects of changes in accounting principles. Ford Credit adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"), as of January 1, 1992. The cumulative effect of this change in accounting principle increased 1992 net income by $216.6 million. Financial statements for prior years were not restated to apply the provisions of SFAS No. 109. Continued FC-8 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 3. INCOME TAXES (continued) Under SFAS No. 109, deferred income taxes reflect the estimated tax effect of temporary differences between assets and liabilities for financial reporting purposes and those amounts as measured by tax laws and regulations. The components of deferred income tax assets and liabilities as of December 31 were as follows: Deferred income taxes for 1991 were derived using the guidelines in Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" ("APB No. 11"). Under APB No. 11, deferred income taxes result from timing differences in the recognition of revenues and expenses between financial statements and tax returns. The principal sources of these differences and the related effect of each on Ford Credit's provision for income taxes were as follows: Continued FC-9 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 3. INCOME TAXES (continued) A reconciliation of the provision for income taxes as a percentage of income before income taxes, excluding equity in net income of affiliated companies, with the United States statutory tax rate for the last three years is shown below: *Excludes cumulative effects of changes in accounting principles. Continued FC-10 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 4. FINANCE RECEIVABLES Finance receivables at December 31 were as follows: Included in finance receivables is a total of $1.5 billion owed by three customers with the largest receivable balances. During 1993, Ford Credit issued irrevocable standby letters of credit in the amount of $223.5 million on behalf of one of these customers. A major portion of these amounts are guaranteed by Ford. At December 31, 1993, other finance receivables primarily consisted of capital and other dealer loans. The majority of retail receivables, a portion of diversified receivables and certain other finance receivables include finance charges that represent income to be earned in future periods. The remaining finance receivables only include principal. The maturities of finance receivables outstanding at December 31, 1993 were as follows: It is Ford Credit's experience that a substantial portion of finance receivables are repaid before contractual maturity dates. The above table, therefore, is not to be regarded as a forecast of future cash collections. Continued FC-11 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 4. FINANCE RECEIVABLES (continued) Installments, including interest, past-due 60 days or more and the aggregate receivable balances related to such past-due installments were as follows: Installments past-due less than 60 days included in finance receivables at December 31, 1993 and 1992 were $297.8 million and $231.1 million, respectively. The average yield on net earning finance receivables and operating leases was as follows: 1993 - 13.4%; 1992 - 13.2%; 1991 - 13.0%. Included in retail and diversified receivables are investments in direct financing and leveraged leases related to the leasing of motor vehicles and various types of transportation and other equipment: Minimum direct financing lease rentals (including executory costs of $50.5 million) for each of the five succeeding years are as follows (in millions): 1994 - $842.3; 1995 - $533.3; 1996 - $261.8; 1997 - $94.0; 1998 - $16.4; thereafter - $55.3. Continued FC-12 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 4. FINANCE RECEIVABLES (continued) NOTE 5. NET INVESTMENT, OPERATING LEASES Operating leases at December 31 were as follows: Future minimum rentals on operating leases are as follows (in millions): 1994 - - - - - - - $3,346.2; 1995 - $1,632.6; 1996 - $226.4; 1997 - $7.1. Depreciation expense on operating leases is provided for on a straight-line basis over the term of the lease and includes gains or losses upon disposal or impairment of the vehicle. Continued FC-13 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 6. ALLOWANCE FOR CREDIT LOSSES Following is an analysis of the allowance for credit losses relating to finance receivables and operating leases for the past three years: NOTE 7. OTHER ASSETS Other assets consist of: Continued FC-14 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 8. DEBT Debt at December 31 was as follows: * Includes $150 million and $800 million with an affiliated company at December 31, 1993 and 1992, respectively. Continued FC-15 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 8. DEBT (continued) Rates were variable on approximately 11.6 percent of the debt payable after one year including the effects of interest rate swap agreements. The average amount of commercial paper outstanding during the past three years was as follows (in millions): 1993 - $22,683; 1992 - $19,358; 1991 - $19,078. The weighted average commercial paper interest rates per annum for these years were as follows: 1993 - 3.2%; 1992 - 4.2%; 1991 - 6.9%. The average remaining term of commercial paper was 28 days at December 31, 1993 and 1992. The aggregate principal amounts of notes with terms of more than one year from dates of issue, maturing for each of the five succeeding years are as follows (in millions): 1994 - $7,882.6; 1995 - $4,662.6; 1996 - $6,260.6; 1997 - $2,065.6; 1998 - $6,561.1; thereafter - $5,977.4. Included in debt at December 31, 1993 were obligations payable in foreign currencies: $2,348.6 million in Canadian dollars; $840.6 million in Australian dollars; $517.9 million in Japanese yen; $377.6 million in German deutsche marks; $220.7 million in Luxembourg francs; $156.4 million in Italian lire; $147.4 million in European currency units; and $136.6 million in Swiss francs. Certain of these obligations are denominated in currencies other than the currency of the country of the issuer. Foreign currency forward contracts are purchased and currency swaps are used to hedge exposure to changes in exchange rates of such obligations. These obligations are translated in the financial statements at the rates of exchange established under the related foreign currency forward contracts and currency swaps and would have been $64.7 million lower if translated at current exchange rates as of December 31, 1993. The convertible subordinated debentures are convertible into common stock of Ford. Ford Credit has entered into an agreement with Ford to purchase from Ford the common stock required to effect conversion. Continued FC-16 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 9. SUPPORT FACILITIES Support facilities represent additional sources of funds, if required. At January 1, 1994, Ford Credit had approximately $15.7 billion of contractually committed facilities for use in the United States, 83 percent of which are available through June 1998. These facilities included $12.8 billion of revolving credit agreements with banks (which included $4.8 billion of Ford bank lines that may be used either by Ford or Ford Credit at Ford's option) and $2.9 billion of agreements to sell retail receivables. At January 1, 1994, all of these U. S. facilities were unused. Outside of the United States, an additional $1,185 million of facilities support borrowing operations in Canada, Australia and Puerto Rico, of which 82 percent are contractually committed and available through June 1998. Canadian facilities of $759 million included $210 million of Ford Motor Company of Canada Limited and Ford Ensite International Inc. lines which are available to Ford Credit Canada Limited at the option of these two companies. Australian facilities of $401 million included $155 million of Ford Motor Company of Australia Limited lines which are available to Ford Credit Australia Limited at the option of Ford Motor Company of Australia Limited. Ford Motor Credit Company of Puerto Rico, Inc. had $25 million in support facilities at January 1, 1994. Substantially all of these facilities were unused at January 1, 1994. NOTE 10. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS Ford Credit and certain of its subsidiaries provide selected health care and life insurance benefits for retired employees under unfunded plans sponsored by Ford and certain of its subsidiaries. Ford Credit's U.S. and Canadian employees may become eligible for those benefits if they retire while working for Ford Credit; however, benefits and eligibility rules may be modified from time to time. Prior to 1992, the expense recognized for postretirement health care benefits was based on actual expenditures for the year. Beginning in 1992, the estimated cost for postretirement health care benefits is accrued on an actuarially determined basis, in accordance with the requirements of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106"). Implementation of SFAS No. 106 has not increased Ford Credit's cash expenditures for postretirement benefits. Ford Credit elected to recognize immediately the prior-year unaccrued accumulated postretirement benefit obligation, resulting in an adverse effect on income of $81.7 million in the first quarter of 1992. The charge reflected an unaccrued retiree benefit obligation liability of $131.6 million, offset partially by projected tax benefits of $49.9 million. Continued FC-17 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 10. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS (continued) Net postretirement benefit expense included the following (in millions): Changing the assumed health care cost trend rates by one percentage point would change the aggregate service and interest cost components of net periodic postretirement benefit cost for 1993 by $3.5 million and the accumulated postretirement benefit obligation at December 31, 1993 by $29.3 million. Continued FC-18 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 11. INDUSTRY SEGMENTS AND FOREIGN OPERATIONS Ford Credit, its subsidiaries and affiliates operate in two industry segments - financing and insurance. Financing operations primarily consist of: the purchase from franchised Ford vehicle dealers of retail installment sale contracts and retail leases; wholesale financing and capital loans to franchised Ford vehicle dealers and other dealers associated with such dealers; loans to vehicle leasing companies; and diversified financing. In addition, a wholly owned subsidiary of Ford Credit provides these financing services in the U.S. to other vehicle dealers. Insurance operations conducted through Ford Credit's equity investment in Ford Holdings consist of: the issuance of single premium deferred annuities; property and casualty insurance relating to extended service plan contracts for new and used vehicles manufactured by affiliated and nonaffiliated companies, primarily originating from Ford dealers; credit life and credit disability insurance for retail purchasers of vehicles and equipment; and physical damage insurance covering vehicles and equipment financed at wholesale by Ford Credit and its subsidiaries. Ford Credit, through certain of its subsidiaries, operates in several foreign countries, the most significant of which are Canada and Australia. Total revenue, income before income taxes and cumulative effects of changes in accounting principles, and assets identifiable with United States and foreign operations were as follows: Continued FC-19 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 12. TRANSACTIONS WITH AFFILIATED COMPANIES An agreement with Ford provides for payments by Ford to Ford Credit that would maintain Ford Credit's consolidated income before income taxes and net income at specified minimum levels. No payments were required under the agreement during 1993, 1992, or 1991. Ford Credit and its subsidiaries, from time to time, purchase accounts receivable of certain divisions and subsidiaries of Ford. The amount of such receivables outstanding was $1,076.9 million at December 31, 1993 and $948.0 million at December 31, 1992. Agreements with Ford also provide for payment to Ford Credit for interest supplements and other support costs on certain financing and leasing transactions. Amounts included in total revenue from these and other transactions with Ford were as follows (in millions): 1993 - $583.0; 1992 - $622.8; 1991 - $618.9. Ford Credit and its subsidiaries purchase from Ford and affiliates certain vehicles which were previously acquired by Ford principally from its fleet and rental car customers. The cost of these vehicles held for resale and included in other assets at December 31 was as follows (in millions): 1993 - $456.5; 1992 - $368.1. Ford Credit also has entered into a sale/leaseback agreement with Ford for vehicles leased to employees of Ford and its subsidiaries. The net investment in these lease vehicles included in operating leases at December 31 was as follows (in millions): 1993 - $562.3; 1992 - $501.3. Investments in securities include preferred stock of a nonaffiliate ($324 million) and of an affiliate ($335.9 million) which were acquired from Ford. Investments in these securities are recorded at cost. Ford has provided Ford Credit with certain guarantees related to Ford Credit's initial investment and return on investment in this preferred stock, and for certain related finance receivables. Amounts related to these transactions included in investment and other income were as follows (in millions): 1993 - $52.7; 1992 - $47.2; 1991 - - - - - - - $57.2. Ford Credit and its subsidiaries receive technical and administrative advice and services from Ford and its subsidiaries, occupy office space furnished by Ford and its subsidiaries and utilize data processing facilities maintained by Ford. Payments to Ford and its subsidiaries for such services are charged to operating expenses and were as follows (in millions): 1993 - $57.1; 1992 - $53.6; 1991 - $59.4. Continued FC-20 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 12. TRANSACTIONS WITH AFFILIATED COMPANIES (continued) Retirement benefits are provided under defined benefit plans for employees of Ford Credit and its subsidiaries in the United States by the Ford General Retirement Plan and for employees of the foreign subsidiaries in Australia and Canada by the respective Ford retirement plans. Employee retirement plan costs allocated to Ford Credit and its subsidiaries from Ford and charged to operating expenses were as follows (in millions): 1993 - $5.8; 1992 - $6.1; 1991 - $11.0. At December 31, 1993 and 1992, Ford Credit had guaranteed $94.6 million and $81.0 million of debt outstanding of other subsidiaries of Ford. See other notes for additional information regarding transactions with affiliated companies. NOTE 13. LITIGATION AND CLAIMS Various legal actions, governmental proceedings and other claims are pending or may be instituted or asserted in the future against Ford Credit and its subsidiaries. Certain of the pending legal actions are, or purport to be, class actions. Some of these matters involve or may involve compensatory, punitive or antitrust or other treble damage claims in very significant amounts or other relief which, if granted, would require very significant expenditures. Litigation is subject to many uncertainties, the outcome of individual litigated matters is not predictable with assurance and it is reasonably possible that some of the foregoing matters could be decided unfavorably to Ford Credit or the subsidiary involved. Although the amount of liability at December 31, 1993 with respect to these matters cannot be ascertained, Ford Credit believes that any resulting liability should not materially affect the consolidated financial position of Ford Credit and its subsidiaries at December 31, 1993. Continued FC-21 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 14. FINANCIAL INSTRUMENTS Book and Estimated Fair Value of Financial Instruments The estimated fair value of financial instruments held by Ford Credit and its subsidiaries at December 31, and the valuation techniques used to estimate the fair value, were as follows: CASH AND CASH EQUIVALENTS. The book value approximates fair value because of the short maturity of these instruments. INVESTMENTS IN SECURITIES. Investments in securities include common stock of a nonaffiliate, preferred stock of an affiliate and a nonaffiliate which were acquired from Ford, and subordinated retained interests in receivable sales. At December 31, 1993, the formula determined fair value of the common stock exceeded its book value by $58.5 million. Preferred stock is recorded at cost, which approximates fair value, as Ford provides Ford Credit with certain guarantees related to Ford Credit's initial investment and return on investment. Subordinated retained interests in receivable sales are recorded at the present value of estimated future cash flows discounted at rates commensurate with this type of instrument, which approximates fair value. FINANCE RECEIVABLES. The fair value of most receivables is estimated by discounting future cash flows using an estimated discount rate which reflects the credit, interest rate and prepayment risks associated with similar types of instruments. For receivables with short maturities, the book values approximate fair values. Finance receivables excluded from fair market valuation include direct financing and leveraged lease investments, and other miscellaneous accounts receivable. DEBT. The fair value is estimated based on quoted market prices or on current rates for similar debt with the same remaining maturities. Continued FC-22 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 14. FINANCIAL INSTRUMENTS (continued) Financial Instruments With Off-Balance-Sheet Risk The following sections describe the various off-balance-sheet financial instruments that Ford Credit held as of December 31, 1993 and 1992. Also included is a brief discussion of the fair value of those contracts and certain risks associated with holding those contracts through maturity. FOREIGN EXCHANGE INSTRUMENTS. Ford Credit and certain of its subsidiaries have entered into foreign exchange agreements to manage exposure to foreign exchange rate fluctuations. These exchange agreements hedge principal and interest payments on debt that are denominated in foreign currencies. Agreements entered into to manage these exposures include foreign currency forward contracts and currency swaps. Foreign currency forward contracts and currency swaps involve agreements to purchase or sell specified amounts of foreign currencies at specified rates on specific future dates. The fair value of these foreign exchange agreements was estimated using current market rates. The fair value was estimated to be a net receivable of $54.1 million at December 31, 1993 and $107.2 million at December 31, 1992. In the unlikely event that a counterparty fails to meet the terms of the contract, Ford Credit's market risk is limited to the currency rate differential. In the case of currency swaps, Ford Credit's market risk also may include an interest rate differential. At December 31, 1993 and 1992, the total notional amount of Ford Credit's foreign currency forward contracts and currency swaps outstanding was $2.1 billion. INTEREST RATE INSTRUMENTS. Ford Credit and certain of its subsidiaries have entered into arrangements to manage exposure to fluctuations in interest rates. These arrangements include primarily interest rate swap agreements and, to a lesser extent, interest rate options. Continued FC-23 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 14. FINANCIAL INSTRUMENTS (continued) Interest rate swap agreements involve the exchange of interest obligations on fixed and floating interest rate debt without the exchange of the underlying principal amounts. The differential paid or received on interest rate swap agreements is recognized as an adjustment to interest expense over the term of the underlying debt agreement. Interest rate option contracts allow the holder of the option to purchase or sell a financial instrument at a specified price and within a specified period of time. The fair value of interest rate instruments is the estimated amount Ford Credit would receive or pay to terminate the agreement or contract. The fair value is calculated using current market rates and the remaining terms of the agreements or contracts. At December 31, 1993 and 1992, the fair value of these interest rate instruments was estimated to be $458.2 million and $273.4 million, respectively, including unrealized gains of $410.6 million and $221.5 million, respectively. In the unlikely event that a counterparty fails to meet the terms of an interest rate instrument, Ford Credit's exposure is limited to the interest rate differential. The underlying notional amount on which Ford Credit has interest rate swap and option agreements outstanding aggregated $31.1 billion at December 31, 1993 and $16.9 billion at December 31, 1992. Concentrations of Credit Risk Ford Credit controls its credit risk through credit standards, limits on exposure and by monitoring the financial conditions of other parties. The majority of Ford Credit's finance receivables are geographically diversified throughout the United States. Foreign finance receivables are concentrated in Canada and Australia. Continued FC-24 FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Selected financial data by calendar quarter for the past two years were as follows: ____________ * The provision for credit losses for the fourth quarter of 1993 was reduced by $78.8 million as a result of continued improvement in credit loss experience. FC-25 SCHEDULE IX FORD MOTOR CREDIT COMPANY AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS(1) FOR THE YEARS 1993, 1992 AND 1991 __________ (1) U.S. commercial paper, the majority of commercial paper outstanding, is comprised of short-term, unsecured promissory notes with maturities ranging from one day to 270 days. Borrowings under short-term borrowing agreements (STBAs) are payable on demand. Bank debt outstandings range from short-term borrowings to bank notes payable on specific dates. (2) The average amount outstanding during the period represents the daily average debt outstanding. (3) The weighted average interest rate represents total annual short-term interest expense divided by the daily average debt outstanding. (4) Other short-term debt primarily consists of notes having either a provision for optional redemption within one year or original maturities of less than one year, and for 1993 and 1992 excludes $150 million and $800 million, respectively, due to an affiliated company. FC-26 EXHIBIT INDEX

748015_1993.txt

748015_1993

1993

748015

ITEM 1. BUSINESS GENERAL Sealy Corporation (the "Company") is the largest bedding manufacturer in North America. The Company manufactures through its subsidiaries a broad range of mattresses and boxsprings, wood furniture and convertible sleep sofas. The Company's conventional bedding products (mattresses and boxsprings) include the SEALY Registered Trade-mark POSTUREPEDIC Registered Trade-mark brand and the STEARNS & FOSTER Registered Trade-mark CORRECT COMFORT Registered Trade-mark brand and account for approximately 90% of the Company's total net sales for the year ended November 30, 1993. The Company also manufactures Sealy and Stearns & Foster brand convertible sleep sofas and markets its wood furniture under the SAMUEL LAWRENCE Trade-mark and WOODSTUFF Registered Trade-mark brands. The Company has a components parts manufacturing subsidiary which produces approximately 75% of the Company's mattress innerspring requirements and a significant portion of the Sealy brand boxspring component parts units. Another subsidiary, Sealy, Inc., provides corporate and administrative services for the Company. HISTORY OF THE COMPANY The Company was founded in 1907 under the name Ohio Mattress Company. In 1924, the Company was granted its first license to produce Sealy-brand products. Starting in 1956, the Company began acquiring Sealy-brand licenses in other geographic areas, and by 1987, had acquired all of the capital stock of its licensor Sealy, Incorporated (which prior to that time was independent of the Company), along with all but one of the remaining Sealy conventional bedding domestic licensees (the "Sealy Acquisitions"). The Company expanded its bedding manufacturing operations in 1983 by acquiring Stearns & Foster, a producer of top quality premium mattresses, boxsprings and convertible sleep sofas. In 1985, the Company acquired Woodstuff Manufacturing, Inc., a manufacturer of bedroom furniture. In 1989, the Company's common stock was acquired through a leveraged buyout (the "LBO") which was financed in part by First Boston Securities Corporation ("FBSC"), an affiliate of The First Boston Corporation ("First Boston"). In April 1990, the Company exchanged (the "Exchange") certain outstanding debt issued to FBSC for new debt at lower interest rates plus additional common stock. In December 1990, FBSC transferred its equity and debt interest in the Company to MB L.P. I, an affiliate of First Boston ("MBLP"). In November 1991, the Company successfully completed a recapitalization (the "Recapitalization") in which the Company's capital structure was significantly improved, the face amount of its indebtedness and interest thereon was reduced by approximately $417 million, the Company's interest expense obligations were substantially reduced and the principal repayment schedule on a portion of its existing bank term loan facility was extended. As a result of the Recapitalization, MBLP's equity interest in the Company increased to approximately 94%. On February 12, 1993, Zell/Chilmark Fund, L.P., a Delaware limited partnership ("Zell/Chilmark"), led an investor group (the "Zell/Chilmark Purchasers") which purchased Class A Common Stock of the Company (the "Shares") from MBLP, representing approximately 94% of the equity of the Company (the "Acquired Shares") for a cash purchase price of $250 million (the "Acquisition"). On May 7, 1993, the Company consummated a refinancing transaction (the "Refinancing"). The Refinancing consisted of (i) the public offering and sale of $200.0 million aggregate principal amount of 9 1/2% Senior Subordinated Notes Due 2003 (the "Notes"), (ii) the application of the net proceeds therefrom to redeem all of the Company's previously outstanding 12.4% Senior Subordinated Notes Due 2001 (the "Subordinated Notes") and to reduce amounts outstanding under the Company's pre-existing senior secured credit agreement (the "Old Credit Agreement"), and (iii) execution of a new senior secured credit agreement by and among the Company, certain banks and other financial institutions and Banque Paribas, Citicorp USA, Inc., Continental Bank N.A. and General Electric Capital Corporation, as Managing Agents (the "New Credit Agreement") providing for two term loan facilities together aggregating $250.0 million and a $75.0 million revolving credit facility in connection with the refinancing of the Old Credit Agreement. CONVENTIONAL BEDDING INDUSTRY AND COMPETITION. According to industry sales data compiled by the International Sleep Products Association ("ISPA"), a bedding industry trade group, more than 750 manufacturers of mattresses and boxsprings make up the domestic conventional bedding industry, generating wholesale revenues of approximately $2.7 billion during calendar year 1993. The market for conventional bedding represents more than 85% of the entire bedding market in North America. Approximately 60% of conventional bedding is sold to furniture stores, national mass merchandisers and department stores. Most of the remaining conventional bedding is sold to specialty sleep shops and contract customers such as motels, hotels and hospitals. Management estimates that approximately two-thirds of conventional bedding is sold for replacement purposes and that the average time between consumer purchases of conventional mattresses is approximately 10 to 12 years. According to ISPA, factors such as sales of existing homes, housing starts and disposable income, as well as birth and marriage rates, affect bedding purchases. Management believes that sales by companies with recognized national brands account for more than half of total conventional bedding sales. The Company supplies such nationally recognized brands as Sealy, Sealy Posturepedic and Stearns & Foster. Competition in conventional bedding is generally based on quality, brand name recognition, service and price. The following table sets forth certain information regarding the domestic market shares of major producers of conventional bedding, and is based upon industry executives' estimates as published in the December 27, 1993 edition of HFD, THE WEEKLY HOME FURNISHINGS NEWSPAPER , an industry trade publication: PRODUCTS. The Company manufactures a variety of Sealy and Stearns & Foster brand and private label conventional bedding in various sizes ranging in retail price from under $200 to $2,400. Sealy Posturepedic brand mattress is the largest selling mattress brand in North America. Approximately 97% of the Sealy brand conventional bedding products sold in North America are produced by the Company, with the remainder being produced by Sealy Mattress Company of New Jersey, Inc. ("Sealy New Jersey"), a licensee. The Stearns & Foster product line consists of top quality, premium mattresses sold under the Correct Comfort trademark, as well as a range of other bedding products sold under the Stearns & Foster brand name. CUSTOMERS. The Company serves over 7,000 retail outlets (approximately 3,200 customers), which include furniture stores, national mass merchandisers, department stores, specialty sleep shops, contract customers and other stores. The top five conventional bedding customers accounted for approximately 24% of net sales for the year ended November 30, 1993, with sales to Sears accounting for approximately 13% of such net sales. The following table sets forth the customer profile for the Company's conventional bedding sales, the percentage of total net sales made to that group of customers in fiscal year 1993 and the names of representative customers: SALES AND MARKETING. The Company's sales depend primarily on its ability to provide quality products with recognized brand names at competitive prices. The Company's marketing emphasis has been on increasing the brand loyalty of its ultimate consumers, principally through more extensive national advertising and through cooperative advertising with its dealers along with improved "point-of-sale" materials designed to emphasize the various features and benefits of the Company's products which differentiate them from other brands. The Company engages in extensive national and cooperative advertising to promote the brand names of its products. For fiscal year 1993 the Company spent approximately $20 million on national advertising and approximately $85 million on cooperative advertising and promotional expenses. The Company's sales force is generally structured based on regions of the country and the plants located within those regions, and also includes a sales staff for specific national accounts operated out of the Company's Chicago, Illinois office. The Company believes that it has one of the most comprehensive training and development programs for its sales force, including its University of Sleep curriculum, which provides on-going training sessions with programs focusing on advertising, merchandising and sales education, including techniques to help analyze a dealer's business and profitability. The Company's sales force emphasizes follow-up service to retail stores and provides retailers with promotional and merchandising assistance as well as extensive specialized professional training and instructional materials. Training for retail sales personnel focuses on several programs, designed to assist retailers in maximizing the effectiveness of their own sales personnel, store operations, and advertising and promotional programs, thereby creating loyalty to, and enhanced sales of, the Company's products. At December 31, 1993, the Company had a conventional bedding sales and marketing force of 240 people who receive a base salary, plus expenses, and quarterly and annual sales incentive bonuses. Approximately 25 independent sales representative organizations service the Company's contract customers. SUPPLIERS. The Company purchases fabric, polyfiber, wire and foam from a variety of vendors. The Company purchases a significant portion of its Sealy boxspring parts from a single source, which has patents on various interlocking wire configurations (the "Wire Patents"), and also purchases 100% of its Stearns & Foster boxspring parts from another single source. In order to eliminate certain of the risks of dependence on external supply sources and to enhance profitability, the Company has expanded its own internal components parts manufacturing capacity and, as a licensee of the Wire Patents, internally produces the remainder of its Sealy boxspring parts. See "-- Components Division." The Company believes that this vertical integration provides it with a significant competitive advantage, as it is the only conventional bedding manufacturer in the United States with substantial innerspring and form wire components making capacity. As is the case with all of the Company's product lines, the Company does not consider itself dependent upon any single outside vendor as a source of supply to its conventional bedding business and believes that sufficient alternative sources of supply for the same or similar components are available. MANUFACTURING AND FACILITIES. The Company manufactures most conventional bedding to order and has adopted "just-in-time" inventory techniques in its manufacturing process to more efficiently serve its dealers' needs and minimize their inventory carrying costs. Most bedding orders are scheduled, produced and shipped within 24 to 72 hours of receipt. This rapid delivery capability allows the Company to minimize its inventory of finished products and better satisfy customer demand for prompt shipments. The Company operates 28 plants which manufacture conventional bedding in 21 states, three Canadian provinces and Puerto Rico. See Item 2. Item 2. "-- Properties," included elsewhere herein. Over the last three years, the Company has made substantial commitments to ensure that the coil-making equipment at its component plants remains state-of-the-art. Since 1989, the Company has installed 26 automated coil-producing machines. This equipment has resulted in higher capacity at lower per-unit costs and has increased self-production capacity for the Company's innerspring requirements from approximately 60% to 75%. WOOD FURNITURE The Company manufactures and markets bedroom furniture through its Woodstuff subsidiary ("Samuel Lawrence") under the Samuel Lawrence and Woodstuff labels. During 1993, conventional bedroom furniture sales accounted for approximately 70% of Samuel Lawrence's total sales. Samuel Lawrence has approximately 500 customers, six in-house sales people, 20 independent sales representatives, and is one of many manufacturers of wood furniture. CONVERTIBLE SLEEP SOFAS The Company manufactures and sells primarily convertible sleep sofas under the Sealy and Stearns & Foster brand names in one facility with six sales employees and 18 commissioned, self-employed sales representatives. The sleep sofa industry is fragmented, and management believes that no single manufacturer comprises more than 10% of that market. LICENSING The Company's licensing division generates royalties by licensing Sealy brand technology and trademarks to manufacturers located throughout the world. The Company also provides its licensees with product specifications, quality control inspections, research and development, statistical services and marketing programs. There are currently 14 separate license arrangements in effect with independent licensees, international bedding licensees and upholstered furniture licensees. In fiscal year 1993, the licensing division as a whole generated royalties of approximately $5 million, which were accounted for as a reduction of selling, general and administrative expenses in the Consolidated Financial Statements included herein. Sealy New Jersey and a crib mattress licensee are the only domestic bedding manufacturers that are licensed to use the Sealy trademark subject to the terms of license agreements. Subject to the terms of a license agreement between Sealy New Jersey and the Company, Sealy New Jersey has the perpetual right to use certain Sealy trademarks, including the Sealy "Butterfly" logo, in the manufacture and sale of Sealy brand products in the United States. In return, Sealy New Jersey pays the Company royalties, which vary by product, on all of its Sealy brand net dollar sales and such royalties can be changed over time upon the occurrence of certain events and subject to limitations contained in the license agreement. The Company sells component parts to Sealy New Jersey and provides it with various research and development, advertising, marketing, and other services, for which Sealy New Jersey may be required to pay additional compensation to the Company under varying circumstances. In accordance with a currently effective waiver provided by the Company, the license agreement no longer restricts Sealy New Jersey's manufacturing territory to any defined areas of primary responsibility in New Jersey. To date, Sealy New Jersey has not engaged in manufacturing outside such area and its sales efforts outside such area have been limited to specific situations. The license precludes the Company from manufacturing its Sealy brand products in the licensee's area of primary responsibility in New Jersey. Subject to certain conditions and limitations, as specified in the license agreement, the Company has a right of first refusal with respect to any sale of Sealy New Jersey. WARRANTIES Sealy and Stearns & Foster bedding offer limited warranties on their currently manufactured products. Such warranties range from one year on promotional bedding to 15 years on Posturepedic and Stearns & Foster Correct Comfort bedding. The periods for "no- charge" warranty service varies among products. All currently manufactured Posturepedic and Correct Comfort products offer a 15 year non-prorated warranty service period. Sealy and Stearns & Foster convertible sleep sofas offer a 10-year limited warranty on mattresses, mechanisms and frames, with no warranty on upholstery fabric. Historically, the Company's warranty costs have been immaterial for each of its product lines. TRADEMARKS AND LICENSES The Company owns, among others, the Sealy, Stearns & Foster and Samuel Lawrence trademarks and tradenames and also owns the Posturepedic, Correct Comfort, Dataman and University of Sleep trademarks, service marks and certain related logos and design marks. EMPLOYEES As of December 31, 1993, the Company had 4,844 full-time employees. Approximately 2,553 employees at 25 plants are represented by various labor unions, generally with separate collective bargaining agreements. Due to the large number of collective bargaining agreements, the Company is periodically in negotiations with certain of its employees. The Company considers its overall relations with its work force to be satisfactory. The following table sets forth certain information regarding employees in each division of the Company as of December 31, 1993: SEASONALITY The Company's business is somewhat seasonal, with lower sales usually experienced during the first quarter of each fiscal year. See Note 12 to the Consolidated Financial Statements of the Company included in Part II, Item 8 herein. ITEM 2. PROPERTIES The offices of the Company are located at 520 Pike Street, Seattle, Washington 98101. Corporate, licensing and marketing services are provided to the Company by Sealy, Inc. (a wholly-owned subsidiary of the Company), located in Cleveland, Ohio. The principal address of Sealy, Inc. is Halle Building, 10th Floor, 1228 Euclid Avenue, Cleveland, Ohio 44115. The Company services certain national account customers in offices located in Chicago, Illinois, and also administers component operations at its Rensselaer, Indiana facility. The Company leases a research and development facility in Cleveland, Ohio. The Company's leased facilities are occupied under leases which expire from 1994 to 2015, including renewal options. The following table sets forth certain information regarding manufacturing facilities operated by the Company at February 1, 1994: (a) The Company has granted a mortgage or otherwise encumbered its interest in this facility as collateral for secured indebtedness. (b) The Company has leased 154,800 square feet to an unrelated tenant. (c) The Company has subleased 76,000 square feet to an unrelated tenant. (d) The Company has the option to purchase the property for specified costs at certain intervals during the lease term. The Company considers its present facilities to be generally well maintained, in sound operating condition and adequate for its needs. When viewed as a whole, the Company has excess capacity available in its facilities and the necessary equipment (as owner or lessee) to carry on its business. REGULATORY MATTERS The Company's principal wastes are wood, cardboard and other nonhazardous materials derived from product component supplies and packaging. The Company also periodically disposes of small amounts of used machine lubricating oil and waste glue used in connection with product components. The furniture operations of the Company in Phoenix, Arizona use some volatile solvent-based wood stains, although non-volatile solvent and/or water-based wood stains are used whenever possible. The Company, generally, is subject to the Federal Water Pollution Control Act, the Comprehensive Environmental Response, Compensation and Liability Act and amendments and regulations thereunder and corresponding state statutes and regulations. The Company's furniture operations are also subject to the Resource Conservation and Recovery Act, the Clean Air Act and amendments and regulations thereunder and corresponding state statutes and regulations. The Company believes that it is in material compliance with all applicable federal and state environmental statutes and regulations. Except as set forth in Item 3. ITEM 3. LEGAL PROCEEDINGS In accordance with procedures established under the Environmental Cleanup Responsibility Act ("ECRA"), Sealy Corporation and one of its subsidiaries are parties to an Administrative Consent Order (the "ACO") issued by the New Jersey Department of Environmental Protection and Energy (the "Department"), pursuant to which the Company and such subsidiary agreed to conduct soil and groundwater sampling to determine the extent of environmental contamination found at the plant owned by the subsidiary in South Brunswick, New Jersey. The Company does not believe that any of its manufacturing processes was a source of any of the contaminants found to exist above regulatorily acceptable levels in the groundwater, and the Company is exploring other possible sources of the contamination, including former owners of the facility. As the current owners of the facility, however, the Company and its subsidiary are primarily responsible for site investigation and any necessary clean-up plan approved by the Department under the terms of the ACO. The Company and its environmental consultant have been conducting investigation and remediation activities since preliminary evidence of contamination was first discovered in August, 1991. On November 15, 1993, the Company received a letter from the Department approving the findings and substantially all of the recommendations of the Company's consultant contained in a June 4, 1993 report submitted to the Department, but also requiring the Company to undertake additional remedial and investigative activities, including the installation of shallow groundwater monitoring wells off-site. On December 1, 1993, the Company's consultant submitted to the Department a report updating and supplementing the June, 1993 report with regard to activities completed prior to receipt of the Department's November 15, 1993 letter. On December 23, 1993, the Company submitted to the Department a Remedial Investigation Schedule of activities to be conducted within the next six (6) months in accordance with the Department's November 15, 1993 letter. In its November 15, 1993 letter, the Department postponed any required activity by the Company to delineate and/or remediate contaminants in the fractured bedrock, which it had previously requested the Company to undertake. The Company, however, still has reservations regarding any such required activities which the Department may attempt to impose in the future. Because of the nature of certain of the contaminants and their geological location in fractured bedrock, the Company and its consultant remain unaware of any accepted technology for successfully remediating the contamination either in the shallow groundwater or the fractured bedrock. The Company has established an accrual for further site investigation and remediation. Based on the facts currently known by the Company, management believes that the accrual is adequate to cover the Company's probable liability and does not believe that resolution of this matter will have a material adverse effect on the Company's financial position or future operations. However, because of many factors, including the uncertainties surrounding the nature and application of environmental regulations, the practical and technical difficulties in obtaining complete delineation of the contamination, the level of clean-up that may be required, if any, or the technology that could be involved, and the possible involvement of other potentially responsible parties, the Company cannot presently predict the ultimate cost to remediate this facility, and there can be no assurance that the Company will not incur material liability with respect to this matter. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's merger warrants to acquire shares of Class B common stock (which warrants were issued in conjunction with the LBO, and which do not become exercisable until August 9, 1995, except under certain limited circumstances) (the "Merger Warrants") are registered for trading in the over-the-counter market; however, because of the extremely limited and sporadic nature of quotations for such Merger Warrants, there is no established public trading market for the Merger Warrants. There is no established public trading market for any other class of common equity of the Company. As of February 20, 1994, there are 57 holders of record of the Company's shares, 1,281 holders of record of the Merger Warrants and 45 holders of record of the Restructure Warrants. No dividends have been paid on any class of common equity of the Company during the last three fiscal years. The Company's New Credit Agreement prohibits the paying of cash dividends on any of its classes of common equity. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following tables set forth selected consolidated financial and other data of the Company (some periods of which are less than one year due to accounting requirements for acquisition transactions) for the ten months ended November 30, 1993, for the two months ended January 31, 1993, for the year ended November 30, 1992, for the one month ended November 30, 1991, for the eleven months ended October 31, 1991, for the year ended November 30, 1990, for the seven months ended November 30, 1989, and for the five months ended April 30, 1989. During the period from December 1, 1988 through November 30, 1993, the Company's capital structure and business changed significantly, in large part as a result of (i) the LBO, (ii) the Recapitalization, and (iii) the Acquisition in February 1993. Due to required purchase accounting adjustments relating to such transactions, and the resultant changes in control, the consolidated financial and other data for each period reflected in the following tables during this period are not comparable to such data for the other such periods. The selected consolidated financial and other data set forth in the following tables have been derived from the Company's audited consolidated financial statements. The report of KPMG Peat Marwick, independent auditors, covering the Company's Consolidated Financial Statements for the ten months ended November 30, 1993 (Successor period), for the two months ended January 31, 1993, the year ended November 30, 1992, and the one month ended November 30, 1991 (Pre-Successor Periods); and for the eleven months ended October 31, 1991 (Predecessor Period), is included elsewhere herein. These tables should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company included elsewhere herein. (a) The Company employed the purchase method of accounting for the February, 1993 Acquisition, the April 1990 Exchange and the November 1991 Recapitalization, and the LBO. Accordingly, historical financial and other data for the Successor, Pre- Successor, Predecessor and Pre-Predecessor periods are not comparable. (b) During 1993, the Company recorded an extraordinary loss of $2.9 million, net of income tax of $1.5 million, representing the remaining unamortized debt issuance costs related to long term obligations repaid as a result of the Refinancing. (c) Operating income is calculated by adding interest expense, net to net sales less costs and expenses. (d) EBITDA is calculated by adding interest expense, net, income tax (benefit) and depreciation and amortization of intangibles to net income (loss) before extraordinary item. EBITDA is presented because it is a widely accepted financial indicator of a company's ability to service and incur debt. EBITDA does not represent net income or cash flows from operations as those terms are defined by generally accepted accounting principles ("GAAP") and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. (e) For purposes of calculating the ratio of earnings to fixed charges, earnings represent income before income tax and extraordinary item plus fixed charges. Fixed charges consist of interest expense, net, including amortization of discount and financing costs and the portion of operating rental expense which management believes is representative of the interest component of rent expense. (f) Amounts reflected for long-term obligations and total debt at November 30, 1990 are net of debt discount of $74.9 million. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The Company employed the purchase method of accounting for both the Acquisition in February 1993 and the Recapitalization in November 1991. As a result of the required purchase accounting adjustments, the post-Acquisition financials for the ten months ended November 30, 1993 (the "Successor Financials") are not comparable to the pre-Acquisition financials for the two months ended January 31, 1993, the year ended November 30, 1992 and the one month ended November 30, 1991 (collectively, the "Pre-Successor Financials"), which were prepared on the Recapitalization basis of accounting, and are not comparable to the pre-Recapitalization financials for the eleven months ended October 31, 1991 (the "Predecessor Financials"), which were prepared on the basis of accounting resulting from a 1989 acquisition of the Company (see Note 2 to the Consolidated Financial Statements, Part II, Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA SEALY CORPORATION Consolidated Financial Statements November 30, 1993 and 1992 (With Independent Auditors' Report Thereon) REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Sealy Corporation: We have audited the accompanying consolidated balance sheets of Sealy Corporation and subsidiaries (Company) as of November 30, 1993 (Successor) and 1992 (Pre-Successor), and the related consolidated statements of operations, stockholders' equity, and cash flows for the ten months ended November 30, 1993 (Successor period); for the two months ended January 31, 1993, the year ended November 30, 1992 and the one month ended November 30, 1991 (Pre-Successor periods); and for the eleven months ended October 31, 1991 (Predecessor period). In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules for the Successor period, Pre-Successor periods, and Predecessor period, as listed in Item 14(a)(2) of Form 10-K of Sealy Corporation for the year ended November 30, 1993. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements present fairly, in all material respects, the financial position of Sealy Corporation and subsidiaries at November 30, 1993 and 1992, and the results of their operations and their cash flows for the Successor period, Pre-Successor periods, and Predecessor period, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules for the Successor period, Pre-Successor periods, and Predecessor period, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated financial statements, on February 12, 1993 a majority of the outstanding common stock of the Company was acquired in a business combination accounted for as a purchase. Further, on November 6, 1991, the Company completed a recapitalization which resulted in a change in control of the Company. These transactions have been accounted for under the purchase method and accordingly the consolidated financial statements of the Company for the Successor period, Pre-Successor periods, and Predecessor period are presented on a different cost basis and therefore, are not comparable. As discussed in Notes 1 and 7 to the consolidated financial statements, in connection with the application of purchase accounting, effective February 1, 1993 the Company changed its method of accounting for income taxes to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". KPMG Peat Marwick Cleveland, Ohio January 28, 1994 SEALY CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PAR VALUE AMOUNTS) SEALY CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PAR VALUE AMOUNTS) See accompanying notes to consolidated financial statements. SEALY CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. SEALY CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) See accompanying notes to consolidated financial statements. SEALY CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) In November 1991, the Company completed a Recapitalization under which approximately $534 million in face amount of, and interest on, its outstanding subordinated indebtedness to an affiliate ("MBLP") of First Boston Securities Corporation was exchanged for 26.3 million additional shares of common stock of the Company and a $116.7 million 12.4% Senior Subordinated Note. See accompanying notes to consolidated financial statements. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Significant accounting policies used in the preparation of the consolidated financial statements are summarized below. (a) BUSINESS Sealy Corporation (the "Company"), is engaged in the home furnishings business and produces mattresses, boxsprings, bedroom furniture and convertible sleep sofas. Substantially all of the Company's trade accounts receivable are from retail businesses. Sales to Sears, Roebuck & Co., the Company's largest customer, were approximately 12%, 17%, 13%, 15% and 12% of total net sales for the ten months ended November 30, 1993, the two months ended January 31, 1993, the year ended November 30, 1992, the one month ended November 30, 1991 and the eleven months ended October 31, 1991 (the "Reporting Periods"). The Company recognizes revenue upon shipment of goods to customers. (b) PRINCIPLES OF OF SOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. (c) CASH EQUIVALENTS For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents are stated at cost which approximates market value. (d) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are depreciated over their expected useful lives principally by the straight-line method for financial reporting purposes and by both accelerated and straight-line methods for tax reporting purposes. (e) AMORTIZATION OF INTANGIBLES Goodwill represents the excess of the purchase price paid over the fair value of net assets acquired and is amortized on a straight-line basis over the expected periods to be benefitted. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through projected undiscounted future earnings. The amount of goodwill impairment, if any, would be measured based on projected discounted future results using a discount rate reflecting the Company's average cost of funds. Other intangibles include patents and trademarks which are amortized on the straight-line method over periods ranging from 5 to 17 years. (f) NET EARNINGS (LOSS) PER COMMON SHARE Net earnings (loss) per common share is based upon weighted average number of shares of the Company's common stock and common stock equivalents outstanding for the periods presented. Common stock equivalents included in the computation, using the treasury stock method, represent shares issuable upon the assumed exercise of warrants, stock options and performance shares that would have a dilutive effect in periods in which there were earnings. Common stock equivalents had no material effect on the computation of earnings (loss) per common share in the Reporting Periods. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (g) INCOME TAXES In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 109, "Accounting For Income Taxes" ("Statement 109"). Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company adopted Statement 109 effective February 1, 1993, in connection with the Acquisition of the Company disclosed in Note 2. The adoption of Statement 109 had no material effect on the amount of income tax expense reported in the ten months ended November 30, 1993. Prior to February 1, 1993, the Company followed Statement of Financial Accounting Standard No. 96 ("Statement 96") to account for income taxes. (h) RECLASSIFICATION Certain items in the consolidated financial statements for 1992 and 1991 have been reclassified to conform to the 1993 presentation. (2) BASIS OF ACCOUNTING On February 12, 1993, Zell/Chilmark Fund, L.P. ("Zell/Chilmark") led an investor group (the "Zell/Chilmark Purchasers") which purchased the 93.6% equity interest in the Company (the "Acquired Shares") held by MB L.P. I, an affiliate of The First Boston Corporation ("MBLP"), for a cash purchase price of $250 million (the "Acquisition"). The Company employed the purchase method of accounting for the Acquisition. The consolidated financial statements as of November 30, 1993 and for the ten months then ended reflect an allocation of the sum of the total consideration paid in the Acquisition for the approximately 94% equity interest and the remaining 6% equity interest valued at historical book value (collectively, the "New Basis"). A summary of the New Basis follows: The New Basis has been allocated to the tangible and identifiable intangible assets and liabilities of the Company as of February 1, 1993 based, in large part, upon independent appraisals of their fair values, with the remainder of the New Basis allocated to goodwill. The New Basis in excess of historical book value of the identifiable net assets acquired is as follows: SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The excess New Basis has been allocated as follows: Increase (decrease) in net assets: A favorable ruling with respect to certain tax contingencies and the recognition of available net operating loss carryforwards has been reflected as purchase accounting adjustments in the allocation of the New Basis. On November 6, 1991, the Company completed a recapitalization (the "Recapitalization") in which the Company's capital structure was significantly improved, the face amount of its indebtedness and interest thereon held by MBLP was reduced by approximately $417 million, the Company's interest expense obligations were substantially reduced and the principal repayment schedule on a portion of the Company's existing bank term loan facility was extended. As a result of an exchange in April 1990 of certain outstanding debt issued to First Boston Securities Corporation ("FBSC") for new debt at lower interest rates plus additional common stock (the "Exchange"), and subsequent Recapitalization in November 1991, MBLP (as successor transferee by FBSC) obtained a controlling interest in the Company. These transactions have been accounted for under the purchase method of accounting as a step acquisition. As a result of the required purchase accounting adjustments, the post-Acquisition financials as of and for the ten months ended November 30, 1993, (the "Successor Financials") are not comparable to the pre-Acquisition financials for the two months ended January 31, 1993, the year ended November 30, 1992 and the one month ended November 30, 1991 (collectively, the "Pre-Successor Financials", which were prepared on the Recapitalization basis of accounting), and are not comparable to the pre-Recapitalization financials for the eleven months ended October 31, 1991 (the "Predecessor Financials"). (3) INVENTORIES Inventories are valued at cost not in excess of market, using the first-in, first-out (FIFO) method. The major components of inventory as of November 30, 1993 and 1992 were as follows: SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (4) LONG-TERM OBLIGATIONS On May 7, 1993, the Company completed a refinancing plan (the "Refinancing"), which consisted of (i) the sale of $200.0 million of 9 1/2% Senior Subordinated Notes Due 2003 (the "Notes") pursuant to a public offering, (ii) the application of $194.5 million of net proceeds therefrom to redeem all of the then outstanding 12.4% Senior Subordinated Notes of the Company Due 2001 (approximately $139.6 million), and to reduce amounts outstanding under the Company's existing credit agreement prior thereto (the "Old Credit Agreement") and (iii) the execution of a new secured credit agreement (the "New Credit Agreement") with a new group of senior lenders providing for two term loan facilities (together, the "New Term Loan Facility") and a revolving credit facility (the "New Revolving Credit Facility") in connection with the refinancing of the Old Credit Agreement. During May 1993, the Company recorded a $2.9 million extraordinary loss, net of income tax of $1.5 million, representing the remaining unamortized debt issuance costs related to the long term obligations repaid as a result of the Refinancing. The Notes mature on May 1, 2003 and bear interest at the rate of 9 1/2% per annum from May 7, 1993, payable semiannually in cash on May 1 and November 1 of each year, commencing November 1, 1993. The Notes may be redeemed at the option of the Company on or after May 1, 1998, under the conditions and at the redemption prices as specified in the note indenture, dated as of May 7, 1993, under which the Notes were issued (the "Note Indenture"). Notwithstanding the foregoing, at any time prior to May 1, 1996, the Company may redeem with the net proceeds of one or more Public Equity Offerings as defined in the Note Indenture, up to $60.0 million aggregate principal amount of the Notes at the redemption prices as specified in the Note Indenture. The Notes are subordinated to all existing and future Senior Debt of the Company as defined in the Note Indenture. The New Credit Agreement provides for loans of up to $325 million and consists of the $75 million New Revolving Credit Facility and the $250 million New Term Loan Facility. The New Revolving Credit Facility provides sublimits for a $30 million discretionary letter of credit facility ("Letters of Credit") and a discretionary swing loan facility of up to $5 million ("Swing Loans"). The New Revolving Credit Facility terminates and is due and payable on November 30, 1998 unless extended as provided for in the New Credit Agreement. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The New Term Loan Facility consists of a $175 million term loan (the "Tranche A Term Loan") and a $75 million term loan (the "Tranche B Term Loan") (collectively, the "Term Loans"). Under the terms of the New Credit Agreement, the Company is required to make certain mandatory principal prepayments of the Term Loans in the event of the sale of any of the Company's principal operating subsidiaries, certain sales of assets, excess cash flow, sales of stock and issuances of new debt securities and in certain other circumstances. In addition, the Company is permitted to make voluntary prepayments. During the year ended November 30, 1993, the Company made prepayments of $33.2 million under these provisions. Such prepayments will reduce pro rata future annual amounts to be amortized under the New Credit Agreement. In addition, the Company made the scheduled principal payments aggregating $20 million in 1993. After application of the 1993 prepayments, the Term Loans amortize according to the following schedule: In addition, the outstanding principal amount under the New Revolving Credit Facility must not exceed a certain amount for a thirty day period during each fiscal year of the Company. The Company is also subject to certain affirmative and negative covenants under both the New Credit Agreement and the Note Indenture, including, without limitation, requirements and restrictions with respect to capital expenditures, dividends, working capital, cash flow, net worth and other financial ratios. At November 30, 1993, the Company had approximately $53 million available under the Revolving Credit Facility, with $3 million outstanding and letters of credit issued totalling approximately $19 million. A commitment fee of 0.50% per annum on the unused portion of the New Revolving Credit Facility is payable quarterly in arrears. Two separate interest rate options exist and are available to the Company at its option as follows: (a) A Base Rate plus a Base Rate Applicable Margin; or (b) A Eurodollar Rate plus a Eurodollar Applicable Margin. Borrowings under the Revolving Credit Facility and the Tranche A Term Loan initially have a Base Rate Applicable Margin of 1.25% and a Eurodollar Applicable Margin of 2.50%. The Tranche B Term Loan initially has a Base Rate Applicable Margin of 1.75% and a Eurodollar Applicable Margin of 3.00%. The initial Base Rate Applicable Margin and Eurodollar Applicable Margin are in effect until May 6, 1994, and thereafter are subject to decreases or increases (not in excess of initial applicable margins) based on the Company's leverage ratio as defined in the New Credit Agreement. The Secured Credit Agreement requires that interest rate protection be maintained on an aggregate notional amount at least equal to 50% of outstanding Term Loans during the period from August 5, 1993 through at least May 7, 1996. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) All obligations of the Company under the Credit Agreement are jointly and severally guaranteed by each direct and indirect domestic subsidiary of the Company and secured by first priority liens on and security interests in substantially all of the assets of the Company and its domestic subsidiaries and by first priority pledges of substantially all of the capital stock of most of the subsidiaries of the Company. (5) LEASE COMMITMENTS The Company leases certain operating facilities, offices and equipment. The following is a schedule of future minimum annual lease commitments and sublease rentals at November 30, 1993. At November 30, 1993, property, plant and equipment included approximately $2.2 million of aggregate cost and $0.1 million of accumulated depreciation related to assets under capitalized leases. Rental expense charged to operations is as follows: The Company has the option to renew certain plant operating leases, with the longest renewal period extending through 2015. Most of the operating leases provide for increased rent through increases in general price levels. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (6) STOCK OPTION PLAN The Company adopted the 1989 Stock Option Plan ("1989 Plan") in 1989 and the 1992 Stock Option Plan ("1992 Plan") in 1992 and reserved 100,000 shares and 600,000 shares, respectively, of Class A Common Stock for future issuance. Options under the 1989 Plan and the 1992 Plan may be granted either as Incentive Stock Options as defined in Section 422A of the Internal Revenue Code or Nonqualified Stock Options subject to the provisions of Section 83 of the Internal Revenue Code. During fiscal years 1990 and 1991, the Company issued options under the 1989 Plan totalling 8,250 shares (net of subsequent forfeitures) of which 7,937 are exercisable at November 30, 1993. The remaining 1989 Plan options are cumulatively exercisable as to one quarter of the underlying shares on each of the first through fourth anniversaries of date of grant. Any unexercised options terminate on the tenth anniversary of the date of grant or earlier, in connection with termination of employment. The exercise price for all 1989 Plan options exercisable or outstanding as of November 30, 1993 is $50.00 per share. No 1989 Plan options have been exercised since the date of grant. During fiscal years 1992 and 1993, the Company granted nonqualified options totalling 198,000 shares (net of subsequent forfeitures) under the 1992 Plan. The options granted in 1992 totalled 92,000 with an exercise price of $7.52 per share, and the options granted in June, 1993 totalled 106,000 and have an exercise price of $9.05 per share. The 1992 Plan options are exercisable 25% upon grant and 25% per year thereafter. The exercise price is equal to the estimated fair value of the Company's stock at the date of grant. 1992 Plan options totalling 750 shares were exercised during 1993. At November 30, 1993, options for 72,500 shares issued under the 1992 Plan are exercisable. During fiscal year 1993 the Company adopted the 1993 Non-Employee Director Stock Option Plan, providing for the one-time automatic grant of ten-year options to acquire up to 10,000 shares of Class A Common Stock of the Company (the "Shares") to all current and future directors who are not employed by the Company, by Zell/Chilmark or by their respective affiliates ("Non-Employee Directors"). Options granted under the 1993 Non-Employee Director Stock Option Plan vest immediately and are initially exercisable at a price equal to the fair market value of the Shares on the date of grant. The exercise price of options granted pursuant to this Plan increases on each anniversary date of such grant by 4% compounded annually. Pursuant to this Plan, the Company granted options to acquire up to 50,000 Shares to Non-Employee Directors in fiscal year 1993 at an initial exercise price of $9.05 per Share. (7) INCOME TAXES As discussed in Note 1(g), the Company adopted Statement 109 effective February 1, 1993. Prior years' financial statements have not been restated to apply the provisions of Statement 109. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company and its domestic subsidiaries file a consolidated U.S. Federal income tax return. Income tax expense (benefit) attributable to income from continuing operations consists of: Income before income taxes from Canadian operations amount to $7,255, $1,140, $7,972, $25 and $8,933 for the Reporting Periods. The differences between the effective tax rate and the statutory U.S. Federal income tax rate are explained as follows: As required by Statement 109, the significant components of deferred income tax expense attributable to income from continuing operations for the ten months ended November 30, 1993 include adjustments to deferred tax assets and liabilities for enacted changes in tax rates of $216, and the recognition of the benefit of Successor net operating losses of $1,936. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) As required under Statement 96, deferred income taxes are provided for temporary differences between the financial reporting bases and the tax bases of the Company's assets and liabilities. The sources of these differences and the effects of changes from these differences on the deferred tax expense (benefit) are as follows: At November 30, 1993, the total deferred tax assets are $44,464, the total deferred tax liabilities are $33,257, and the valuation allowance is $13,123. The significant components of the deferred tax assets are accrued salaries and benefits of $11,699 and the net operating loss carryforwards of $19,579, and of the deferred tax liabilities are property, plant and equipment of $26,439 and intangible assets of $7,154. As a result of the Recapitalization, the future usage of net operating losses created prior to November 6, 1991 will be substantially limited. The Company has net operating loss carryforwards of approximately $43 million for U.S. Federal income tax purposes. These losses cannot be carried back against income of prior periods, and will expire, if not utilized, by the year 2008. The entire amount of the valuation allowance, the amount which has not changed since the adoption of Statement 109, shall be allocated to goodwill should the tax benefit for deferred tax assets, to which the valuation allowance relates, be subsequently realized. A provision has not been made for U.S. or foreign taxes on undistributed earnings of subsidiaries which operate in Canada and Puerto Rico. Upon repatriation of such earnings, withholding taxes might be imposed that are then available for use as credits against a U.S. Federal income tax liability, subject to certain limitations. The amount of taxes that would be payable on repatriation of the entire amount of undistributed earnings is immaterial. (8) RETIREMENT PLANS Substantially all employees are covered by profit sharing plans, where specific amounts are set aside in trust for retirement benefits. The Company has defined benefit pension plans covering a limited number of employees pursuant to negotiated labor contracts. The funded status of the defined benefit pension plans, as well as the amounts expensed for the Reporting Periods, are considered immaterial. The total profit sharing and pension expense was $4.0 million, $0.8 million, $4.1 million, $0.3 million and $4.5 million for the Reporting Periods, respectively. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (9) WARRANTS SERIES A AND SERIES B WARRANTS As part of the Recapitalization, the Series A and Series B Warrants (collectively, "Restructure Warrants") were issued under a Warrant Agreement ("Agreement I") dated as of November 6, 1991 between the Company and its subsidiary, Sealy, Inc., as warrant agent. Each holder (other than MBLP) of the Company's common stock immediately prior to the Recapitalization received warrants entitling all such holders to future ownership (when added to their then existing holdings) of up to 21.6% of the fully diluted common stock of the Company upon exercise. The Restructure Warrants, when exercised, will entitle the Holder thereof to receive one share of Class A Common Stock of the Company in exchange for the exercise price of $16.00 per share for Series A warrants and $22.50 per share for Series B warrants, subject to adjustment under certain circumstances. The Series A and Series B Warrants are exercisable into 4,288,700 and 1,649,500 shares of Class A Common Stock of the Company, respectively. The Restructure Warrants are exercisable at any time and from time to time on or prior to November 6, 2001 ("Expiration Date"). The Restructure Warrants may terminate and become void prior to the Expiration Date in the event that such warrants are redeemed as described below or if, prior to November 6, 1996 (after notice to Restructure Warrant holders, who may then exercise such warrants), the Company merges or consolidates with another entity with the other entity as the survivor. The Company has the right to redeem the Restructure Warrants on any date after November 6, 1996 at a redemption price per share as defined in Agreement I. MERGER WARRANTS Merger Warrants were issued under a Warrant Agreement ("Agreement II") dated as of August 1, 1989 between the Company and First Chicago Trust Company of New York, as warrant agent. Each Merger Warrant, when exercised, will entitle the holder thereof to receive one fiftieth of one share of Class B Common Stock of the Company in exchange for the exercise price of $.01 per share, subject to adjustment under certain circumstances. The Merger Warrants are exercisable after August 9, 1995 or upon the occurrence of certain other events as described in Agreement II. Within 90 days after August 9, 1994 (or sooner, under certain circumstances), the Company will offer to repurchase for cash all outstanding Merger Warrants and shares issued under such Agreement II ("Warrant Shares") in a single transaction ("Repurchase Offer") at a purchase price as defined in Agreement II, provided certain conditions are met. At the present time, the Company's debt Agreements restrict its ability to repurchase such Merger Warrants or Warrant Shares. Due to the possible occurrence of the Repurchase Offer, the Merger Warrants are not considered to be a part of the Company's stockholders' equity and therefore, are included in other noncurrent liabilities in the accompanying consolidated balance sheets. The Merger Warrants, subject to certain conditions, are exercisable into an aggregate of 212,500 shares of Class B Common Stock. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (10) COMMON STOCK Holders of Class A Common Stock are entitled to one vote per share on all matters submitted to a vote of stockholders while the holders of Class B Common Stock are entitled to one-half vote per share. Except with respect to voting rights, the terms of the Class A Common Stock and the Class B Common Stock are identical. Shares of Class B Common Stock, under certain circumstances, are convertible into shares of Class A Common Stock. (11) PERFORMANCE SHARE PLAN Effective April 1, 1992, the Company adopted a Performance Share Plan ("Plan") for certain employees of the Company. Under the Plan, the Board of Directors may approve the issuance of up to 3.0 million performance share units each representing the right to receive up to one share of Class A Common Stock of the Company ("Shares") if the Company meets specified cumulative operating cash flow targets over the five-year period ended November 30, 1996. As of November 30, 1993, there are 2.4 million performance share units outstanding under the Plan which represent the right to receive Shares having an estimated fair value of $19.7 million. The performance share units vest over the five years ending November 30, 1996 and, as of November 30, 1993, none of the units were convertible into Shares. The Plan is a variable stock compensation plan pursuant to which the fair value of Shares issuable under the Plan will be recorded as compensation expense over the Plan's five-year term ending November 30, 1996. In addition to the annual amount of compensation expense under the Plan, such amount will be adjusted to give cumulative effect to any change in the amount of non-cash compensation expense previously recorded in prior reporting periods, resulting from subsequent increases or decreases in the fair value of the Shares or the number of performance share units outstanding since such reporting period and to any change in management's estimate of its ability to achieve the cumulative operating cash flow targets as defined in the Plan. During the ten months ended November 30, 1993, the two months ended January 31, 1993 and the year ended November 30, 1992, the Company recorded $2.2 million, $0.9 million and $5.4 million, respectively, of non-cash compensation expense under the Plan. Based on the value of the Shares at November 30, 1993, and giving consideration to management's estimate of the expected cumulative operating cash flow target to be achieved over the five year period ended November 30, 1996, the Company expects to record future non-cash charges totalling approximately $11 million. To the extent that the fair value of the Shares or the number of performance share units outstanding increases or decreases, such non-cash expense will also increase or decrease in future reporting periods. (12) SUMMARY OF INTERIM FINANCIAL INFORMATION (UNAUDITED) SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) During the second quarter of fiscal year 1993, the Company recorded an extraordinary loss of $2.9 million, net of income taxes ($.10 per share), from early extinguishment of debt in connection with the Refinancing. During the fourth quarter of fiscal year 1993, the Company recorded a $3.0 million charge for estimated costs of closing certain manufacturing facilities which is expected to be completed during fiscal year 1994. (13) CONTINGENCIES Sealy Corporation and one of its subsidiaries are parties to an Administrative Consent Order (the "ACO") issued by the New Jersey Department of Environmental Protection and Energy (the "Department"), pursuant to which the Company and such subsidiary agreed to conduct soil and groundwater sampling to determine the extent of environmental contamination found at the plant owned by the subsidiary in South Brunswick, New Jersey. The Company does not believe that any of its manufacturing processes was a source of any of the contaminants found to exist above regulatorily acceptable levels in the groundwater, and the Company is exploring other possible sources of the contamination, including former owners of the facility. As the current owners of the facility, however, the Company and its subsidiary are primarily responsible for site investigation and any necessary clean-up plan approved by the Department under the terms of the ACO. The Company and its environmental consultant have been conducting investigation and remediation activities since preliminary evidence of contamination was first discovered in August, 1991. On November 15, 1993, the Company received a letter from the Department approving the findings and substantially all of the recommendations of the Company's consultant contained in a June 4, 1993 report submitted to the Department, but also requiring the Company to undertake additional remedial and investigative activities, including the installation of shallow groundwater monitoring wells off-site. On December 1, 1993, the Company's consultant submitted to the Department a report updating and supplementing the June, 1993 report with regard to activities completed prior to receipt of the Department's November 15, 1993 letter. On December 23, 1993, the Company submitted to the Department a Remedial Investigation Schedule of activities to be conducted within the next six (6) months in accordance with the Department's November 15, 1993 letter. In its November 15, 1993 letter, the Department postponed any required activity by the Company to delineate and/or remediate contaminants in the fractured bedrock, which it had previously requested the Company to undertake. The Company, however, still has reservations regarding any such required activities which the Department may attempt to impose in the future. Because of the nature of certain of the contaminants and their geological location in fractured bedrock, the Company and its consultant remain unaware of any accepted technology for successfully remediating the contamination either in the shallow groundwater or the fractured bedrock. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company has established an accrual for further site investigation and remediation. Based on the facts currently known by the Company, management believes that the accrual is adequate to cover the Company's probable liability and does not believe that resolution of this matter will have a material adverse effect on the Company's financial position or future operations. However, because of many factors, including the uncertainties surrounding the nature and application of environmental regulations, the practical and technical difficulties in obtaining complete delineation of the contamination, the level of clean-up that may be required, if any, or the technology that could be involved, and the possible involvement of other potentially responsible parties, the Company cannot presently predict the ultimate cost to remediate this facility, and there can be no assurance that the Company will not incur material liability with respect to this matter. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS The following table sets forth the name, age, principal occupation and employment and business experience during the last five years of each of the Company's directors: Mr. Zell is a director of Revco D.S., Inc., Carter Hawley Hale Stores, Inc., The Delta Queen Steamboat Co., The Vigoro Corporation and Jacor Communications, Inc. Mr. Schulte is a director of Revco D.S., Inc., Carter Hawley Hale Stores, Inc. and Jacor Communications, Inc. Mr. Fenster serves on the board of American Management Systems, Inc. Ms. Hefner is a director of Playboy Enterprises, Inc. Mr. Johnston serves as a director of The Wachovia Corporation, RJR Nabisco, Inc., RJR Nabisco Holdings Corp, R.J. Reynolds Tobacco Co. and R.J. Reynolds Tobacco International, Inc. Mr. Towe is a director of The American Heritage Life Insurance Company and Long John Silver's Restaurants, Inc. EXECUTIVE OFFICERS The following table sets forth the name, title, age, and certain other information with respect to the executive and certain other appointed officers of the Company: COMPLIANCE WITH SECTION 16 (A) OF THE EXCHANGE ACT Based solely upon a review of Forms 3 and 4, and amendments thereto, furnished to the Company pursuant to Rule 16a-3(e) during Fiscal 1993 and Form 5, and amendments thereto, furnished to the Company with respect to Fiscal 1993, the Company is not aware of any person that is subject to Section 16 of the Securities Exchange Act of 1934 (the "Exchange Act") with respect to the Company, that has failed to file, on a timely basis, (as disclosed in the aforementioned Forms) reports required by Section 16 (a) of the Exchange Act during Fiscal 1993 or prior fiscal years. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth information concerning the annual and long-term compensation for services in all capacities to the Company for each of the years ended November 30, 1993, 1992 and 1991, of those persons who were, at November 30, 1993 (i) the chief executive officer and (ii) the other four most highly compensated executive officers of the Company for the year ended November 30, 1993 (collectively, the "Named Executive Officers"): SUMMARY COMPENSATION TABLE (a) Pursuant to his Employment Agreement (as hereinafter defined), Mr. Beggs commenced employment with the Company as of August 24, 1992. Under the terms of his Employment Agreement, Mr. Beggs received $117,045 and $180,850 in 1993 and 1992, respectively, as the result of: (i) the forgiveness of a portion of an equity loan from the Company to Mr. Beggs, reflecting the loss of equity in his previous residence (1993-$44,034; 1992-$91,751); (ii) closing costs on a new home, moving expenses, temporary living expenses and costs relating to the termination of a contract to purchase another residence (1993-$44,000; 1992-$89,099); (iii) professional fees, travel and entertainment expenses; and (iv) payments to cover Mr. Beggs' tax liabilities on the foregoing items, all as described more fully in "--Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements." (b) Such amount reflects the Company's determination of the fair value at the date of grant of 100,000 Shares issued to Mr. Beggs in 1992 pursuant to his Employment Agreement, certain of which are subject to forfeiture under certain circumstances. Although the New Credit Agreement and the indenture relating to the Notes contain restrictions on the Company's ability to pay dividends, if dividends were declared and paid on the Company's Shares, such dividends would be paid on such Shares issued to Mr. Beggs. The Employment Agreement also provides for the future issuance to Mr. Beggs of an additional 100,000 Shares, subject to certain conditions. See "-- Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements." Hence, Mr. Beggs' aggregate stock holdings consist of 200,000 Shares with an estimated fair market value of $2,696,000 at the end of fiscal year 1993. No other Named Executive Officer had any holdings of stock which were subject to forfeiture at the end of fiscal year 1993. (c) Represents amounts paid in fiscal year 1993 on behalf of each of the Named Executive Officers for the following three respective categories of compensation: (i) Company premiums for life and accidental death and dismemberment insurance, (ii) Company premiums for long-term disability benefits, and (iii) Company contributions to the Company's defined contribution plans. Amounts for each of the Named Executive Officers for each of the three respective preceding categories is as follows: Mr. Beggs: (1993- $2,220, $1,000, $16,020; 1992- $510, $0, $0); Mr. Fazio: (1993- $1,159, $870, $12,180; 1992- $1,040, $850, $11,900); Mr. McIlquham: (1993- $1,026, $770, $10,780; 1992- $887, $725, $10,150); Mr. Fellmy: (1993- $999, $750, $10,500; 1992- $765, $625, $9,042); and Mr. Claypool: (1993- $1,039, $780, $10,920; 1992- $918, $750, $0). (d) The bonus amounts reflected for such persons include a portion of such bonus paid in Shares, valued at $7.52 per Share, which the Company determined was the fair value of such Shares on the date of the bonus award. (e) All of Mr. McIlquham's amount and $33,331 of such amount for Mr. Fellmy represent payments made by the Company to cover their respective tax liabilities relating to the portion of their bonuses paid in Shares in fiscal year 1992. The balance of such amount for Mr. Fellmy represents payment made by the Company to reimburse moving expenses and cover the tax liability thereon. LONG-TERM INCENTIVE PLAN AWARDS IN LAST FISCAL YEAR (a) The Company's Performance Share Plan (the "Plan") effective in 1992 provides for the issuance to key employees of the Company and its subsidiaries (the "Participants") of performance share units ("Performance Shares"), each of which represents the right to receive, without any additional consideration, up to one Share, based on the extent to which the Company achieves specified cumulative operating cash flow ("COCF") targets over the five-year period ending November 30, 1996 (the "Measurement Period"). An aggregate of 2,366,000 Performance Shares, net of forfeitures, have been granted to Participants, and up to 247,100 Performance Shares have been granted and reserved for individuals who will occupy certain open positions effective, in each case, upon the hire date of any such individual, under the Plan. The maximum number of Performance Shares authorized to be granted is 3,000,000. Generally, the Plan provides that if the Company's COCF for the Measurement Period is $500 million, then each vested Performance Share shall convert into .10 Shares (the "Threshold"); if COCF is $575 million, then each vested Performance Share shall convert into .417 Shares (the "Target"), and if COCF equals or exceeds $650 million, then each vested Performance Share shall convert into one Share (the "Maximum"). If COCF for such period is between $500 million and $650 million, then the conversion ratio will be interpolated on a straight-line basis between the two closest of the three aforementioned target ratios. If COCF is less than $500 million, then all Performance Shares shall be forfeited without conversion. The estimated fair value of one Share on November 30, 1993 was $13.48. In the event that the Company is a party to an acquisition, merger or other significant corporate event or makes an in-kind distribution on any equity security, the COCF targets or ratios may be equitably adjusted to reflect an equivalent value. The Performance Shares generally vest over a five-year period. If a Participant incurs a termination of employment during the periods indicated, the following percentages of Initial Performance Shares become vested: from December 1, 1992 through November 30, 1993 -- 30%; from December 1, 1993 through November 30, 1994 -- 45%; from December 1, 1994 through November 30, 1995 -- 60%; from December 1, 1995 through November 29, 1996 -- 80%; and on or after November 30, 1996 -- 100%. In the event that a Participant incurs a termination of employment for cause (as defined in the Plan) or engages in a breach of certain noncompetition covenants following a voluntary termination, the Participant shall forfeit all Performance Shares, whether or not vested. The Human Resources Committee of the Board (the "Human Resources Committee") may, in its sole discretion, terminate the Plan at any time without the consent of any Participant. The Plan shall terminate automatically on the date upon which the Performance Shares are converted into Shares (or are forfeited) following the Measurement Period (the "Payment Date") or, if earlier, upon a Change in Control (as defined in the Plan) unless the person(s) who purchased 50% or more of the common stock or substantially all of the assets of the Company in effecting such a Change in Control (a "Third Party Purchaser") agrees to continue the Plan or a replacement plan in a manner that is fair and equitable to the Participants. As part of the Acquisition, Zell/Chilmark consented to the continuation of the Plan. In the event that the Plan is terminated because of changes in the laws or accounting rules which frustrate the intent of the Plan or because of the inability to preserve the integrity of the COCF formula by reason of material changes to the business or operations of the Company, then the disinterested members of the Board may replace the Plan with an alternative plan that is comparable in scope and effect or the Board may have the Company distribute that number of Shares as would be arrived at by multiplying the unforfeited Performance Shares by a fraction (which may not be greater than one) the numerator of which is the COCF through the date of termination and the denominator of which is $650 million. In all other cases of termination of the Plan, all Performance Shares awarded to a Participant, which have not previously been forfeited, shall become vested Performance Shares and the Participant shall receive that number of Shares equal to the number of that Participant's vested Performance Shares on the date of termination of the Plan. Notwithstanding any of the foregoing, upon the termination of the Plan because of a Change in Control where the Third Party Purchaser did not offer the same or a replacement plan, the Company shall, unless the common stock of the Company is publicly traded on the termination date of the Change in Control, make a lump-sum cash payment to the Participant equal to the fair market value of the applicable number of Shares, less applicable withholdings, in satisfaction of all rights of such Participant under the Plan. Upon the conversion of the Performance Shares into Shares following the Payment Date, the Company will, at the discretion of the Participant, lend to those Participants that are still employees a sum (bearing interest at the prime rate) sufficient to cover his or her estimated tax liability (a "Tax Loan") or, alternatively, the Participant can elect to have the Company withhold a sufficient number of Shares as necessary to cover such estimated tax liability, and pay such withholding tax liability, in cash, on behalf of the Participants. The holders of Shares issued under the Plan also will have certain registration rights which will apply after an initial public offering of Shares (the "Initial IPO"), for a period of five years following the Payment Date. The Tax Loans, if any, would be due and payable 30 days following the Initial IPO or such other time as designated by the Human Resources Committee. Mr. Beggs was granted his Performance Shares in connection with his execution of the Employment Agreement. See "-- Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements." COMPENSATION PURSUANT TO PLANS AND OTHER ARRANGEMENTS SEVERANCE BENEFIT PLANS. Effective December 1, 1992, the Company established the Sealy Executive Severance Benefit Plan (the "Executive Severance Plan") for employees in certain salary grades. Benefit eligibility includes, with certain exceptions, termination as a result of a permanent reduction in work force or the closing of a plant or other facility, termination for inadequate job performance, termination of employment by the participant following a reduction in base compensation, reduction in salary grade which would result in the reduction in potential plan benefits or involuntary transfer to another location. Benefits include cash severance payments calculated using various multipliers varying by salary grade, subject to specified minimums and maximums depending on such salary grades. Such cash severance payments are made in equal semi-monthly installments calculated in accordance with the Executive Severance Plan until paid in full. Certain executive-level officers would be entitled to a minimum of one-year's salary and a maximum of two-year's salary under the Executive Severance Plan. However, if a Participant becomes employed prior to completion of the payment of benefits, such semi-monthly installments shall be reduced by the Participant's base compensation for the corresponding period from the Participant's new employer. Participants receiving cash severance payments under the Executive Severance Plan also would receive six months of contributory health and dental coverage and six months of group term life insurance coverage. The Company currently follows the terminal accrual approach to accounting for severance benefits under the Executive Severance Plan and records the estimated cost of these benefits as expense at the date of the event giving rise to payment of the benefits. EXECUTIVE EMPLOYMENT AGREEMENT. Effective October 31, 1992, the Company entered into an employment agreement and related reimbursement letter agreement (collectively, the "Employment Agreement") with Mr. Beggs, pursuant to which Mr. Beggs became employed as Chairman, President and Chief Executive Officer of the Company for a period (the "Employment Period") commencing on August 24, 1992 and continuing through November 30, 1997 (the "Expiration Date"). Pursuant to the Employment Agreement, Mr. Beggs' base salary was $500,000 for Fiscal 1993. Such salary may be increased but not decreased in an annual review, and Mr. Beggs is entitled to receive an annual cash bonus in an amount to be determined on the basis of certain corporate and individual performance targets determined by the Board of Directors, or a committee thereof. Pursuant to the Employment Agreement, Mr. Beggs was granted an aggregate of 200,000 Shares, 100,000 of which were issued as of October 31, 1992 (the "Issued Shares"). If Mr. Beggs is terminated for cause or voluntarily terminates his employment with the Company, other than for "good reason" (as such terms are defined in the Employment Agreement), 55,000 or 35,000 of such Issued Shares are forfeitable through November 30, 1994, and November 30, 1995, respectively. In addition, the following number of additional Shares will be issued if he remains employed by the Company on the dates indicated: November 30, 1995 -- 10,000 shares; November 30, 1996 --40,000 shares; and November 30, 1997 -- 50,000 shares. Mr. Beggs also entered into a Stockholder's Agreement with the Company (the "Stockholder's Agreement") in connection with the Employment Agreement, which provides that, prior to the Expiration Date, Mr. Beggs may sell his Shares only after an Initial IPO or approval by the Board of Directors and, after the Expiration Date, the Company shall have certain rights of first refusal with respect to any proposed transfers of Mr. Beggs' Shares (other than to certain permitted transferees). The Stockholder's Agreement also provides that the holders of the Shares issued to Mr. Beggs under the Employment Agreement shall have certain ""piggyback'' registration rights with respect to such Shares. Mr. Beggs recognized taxable income in 1992 in connection with the Issued Shares and borrowed $279,300 from the Company (the "Stock Loan") to be used in payment of the required withholding taxes. The Stock Loan bears interest at the applicable federal rate in effect on the date of the loan, with all unpaid and outstanding principal and interest due and payable on November 30, 1995. In addition, Mr. Beggs was granted an award of 1,000,000 Performance Shares, representing the right to receive up to 1,000,000 Shares pursuant to, and subject to the terms of, the Performance Share Plan. See Note (a) to "--Long-Term Incentive Plan Awards in Last Fiscal Year." Pursuant to the Employment Agreement, Mr. Beggs is entitled to health and life insurance and certain other benefits and he also received relocation expenses. The relocation expenses included closing costs on a new home, moving expenses, temporary living expenses, and costs relating to the termination of a contract to purchase another residence (collectively, "Relocation Expenses"). The Company increased its payments to Mr. Beggs for Relocation Expenses by the resulting income tax liability created by such reimbursements. Mr. Beggs has agreed to reimburse the Company for any Relocation Expenses received by him if he voluntarily terminates his employment within two years after his relocation is completed unless such termination is for good reason (as defined in the Employment Agreement). The Company purchased Mr. Beggs' previous residence from him for $712,500 and sold such residence for $690,000 in February 1993. Mr. Beggs borrowed $157,673 from the Company (the "Equity Loan") upon the purchase of a new home in the Cleveland area, reflecting the loss of equity in his previous residence. Such Equity Loan is interest free to the extent allowed under applicable tax laws and otherwise bears interest at the applicable federal rate. In accordance with the terms of the Employment Agreement, $20,000 and $57,673 of such Equity Loan was forgiven on November 30, 1993 and December 31, 1992, respectively. In addition, $4,070 in interest related to such equity loan was also forgiven on November 30, 1993, and the Company paid Mr. Beggs an additional $44,034 and $34,077, as additional compensation for his tax liability as a result of such forgiveness of indebtedness in each period, respectively. The balance of the Equity Loan has four equal annual payments of principal due on November 30, 1994 and each November 30 thereafter for three years. If Mr. Beggs remains employed by the Company through the date when a payment is due, such indebtedness will be forgiven by the Company and the Company will pay Mr. Beggs an amount necessary to offset any tax liability to him as a result of such forgiveness of indebtedness. If Mr. Beggs voluntarily terminates his employment with the Company, other than for good reason, the remaining balance of the Equity Loan and any accrued interest will become immediately due and payable. If Mr. Beggs' employment is terminated prior to the Expiration Date other than for cause, (as defined in the Employment Agreement), death or disability or if Mr. Beggs terminates his employment for good reason, he will continue to receive his base salary until the later of November 30, 1997 or one year, plus the forgiveness of the Equity Loan, the payment of a portion of any then-applicable bonus on a pro-rata basis and the issuance of the remainder of the unissued Shares noted above. In addition, if Mr. Beggs' employment is terminated prior to the Expiration Date under such circumstances or because of his death or disability, then the Stockholder's Agreement grants to Mr. Beggs or his representative the right to cause the Company to repurchase all of Mr. Beggs' Shares at their "fair market value" (determined in accordance with the Shareholders' Agreement). In the event that Mr. Beggs' employment is terminated prior to the Expiration Date for "cause" or if he voluntarily terminates his employment other than for "good reason," then the Company shall have the option to repurchase Mr. Beggs' Shares for their "fair market value." REMUNERATION OF DIRECTORS. Effective upon the Acquisition, the Company began compensating its directors who are not employees with a retainer at the rate of $30,000 on an annual basis, reduced by $1,000 for each Board meeting not attended, plus $1,000 ($1,250 for Committee Chairmen, if any) for each Committee meeting attended if such meeting is on a date other than a Board meeting date, and incidental expenses in connection with traveling to or attending such meetings. Directors Zell, Schulte, Friedland, Davis, Fenster, Towe, Johnston and Hefner are eligible for such remuneration. During 1993, the Company adopted the 1993 Non-Employee Director Stock Option Plan, providing for the one-time automatic grant of ten-year options to acquire up to 10,000 Shares to all current and future directors who are not employed by the Company, by Zell/Chilmark or by their respective affiliates ("Non-Employee Directors"). Options granted under the 1993 Non-Employee Director Stock Option Plan vest immediately and are initially exercisable at a price equal to the fair market value of the Shares on the date of grant. The exercise price of options granted pursuant to this Plan increases on each anniversary date of such grant by 4% compounded annually. Pursuant to this Plan, during 1993, the Company granted options to acquire up to 10,000 Shares to each of Messrs. Davis, Fenster, Towe and Johnston and Ms. Hefner at an initial exercise price of $9.05 per Share. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION At the end of fiscal year 1992, Messrs. Robert B. Calhoun, Jr. and John F. Maypole, former directors of the Company, and Rolf H. Towe were the directors who served as the members of the Human Resources Committee at that time (which functions as the Compensation Committee of the Board of Directors). For information regarding certain relationships or transactions that Messrs. Towe and Calhoun, or entities with which they are affiliated, have with the Company, see "Certain Relationships and Related Transactions - Compensation Committee Interlocks and Insider Participation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information with respect to those holders which, according to the records of the Company, beneficially own more than 5% of the outstanding Shares as of February 20, 1994: (a) The percent of class calculation assumes that the stockholder for whom the percent of class is being calculated has exercised all Restructure Warrants (as described in Note 9 of the Notes to the Consolidated Financial Statements) owned by such stockholder and that no other stockholder has exercised any other Restructure Warrants. Accordingly, the total of the percentages for all the stockholders listed exceeds 100%. (b) For further information with respect to Zell/Chilmark, see Item 10. "Directors and Executive Officers" and Item 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION At the end of fiscal year 1992, Messrs. Robert B. Calhoun, Jr. and John F. Maypole, former directors of the Company, and Rolf H. Towe were the directors who served as the members of the Human Resources Committee at that time (which functions as the Compensation Committee of the Board of Directors)(the "Committee"). Effective March 4, 1993, the Committee consisted of Messrs. Zell, Towe, Fenster and Johnston. FBSC, an affiliate of First Boston, owns, directly and through its subsidiaries, all of the common stock of FBMB I, Inc., a Delaware corporation and a general partner of MBLP. Messrs. Calhoun and Towe each own 50% of the common stock of, and are executive officers of, CIG, Inc., the sole general partner of The Clipper Group L.P. ("Clipper"), which had managed the investments of MBLP in the Company, including the 12.4% Senior Subordinated Notes (the "Subordinated Notes"). During the period between the Recapitalization and the Acquisition, MBLP owned 27,630,000 Shares and all of the Subordinated Notes, and, following the Acquisition, and until the Refinancing, owned a warrant to purchase up to 4,000,000 million shares of the stock acquired by Zell/Chilmark in the Acquisition (the "MBLP Warrant") and the Subordinated Notes. Through the repayment of the Subordinated Notes on May 7, 1993, MBLP received, or had accrued, interest payments on the Subordinated Notes aggregating approximately $23 million. In connection with the Acquisition, MBLP waived its right, as holder of the Subordinated Notes, to require the Company to repurchase the Subordinated Notes upon the change in control of the Company effected by the Acquisition. In addition, MBLP consented to and caused the Company and the Trustee under the Subordinated Note Indenture to enter into a supplemental indenture which (i) granted the Company the option to redeem the Subordinated Notes at any time at a redemption price of 100% of the principal amount, plus accrued interest thereon to the redemption date, (ii) provided that the Subordinated Notes would no longer be convertible into Preferred Stock of the Company and (iii) modified certain ratios relating to the issuance of certain debt obligations of the Company. In consideration of MBLP executing the supplemental indenture, Zell/Chilmark agreed to pay, or to cause the Company to pay, all out-of-pocket costs and expenses (including reasonable fees and expenses) incurred by MBLP in connection with the sale or redemption of the Subordinated Notes. As part of the Refinancing, the MBLP Warrant was cancelled and all of the outstanding Subordinated Notes were repaid and redeemed. Zell/Chilmark assigned a portion of its rights and obligations under the Stock Purchase Agreement to Mr. Towe, pursuant to which he acquired 27,630 Shares from MBLP at the same cash price per Share as paid by the other Zell/Chilmark Purchasers. As part of the Acquisition and pursuant to the Stock Purchase Agreement, Zell/Chilmark, MBLP and the Company entered into a Registration Rights Agreement relating to the Acquired Shares, including the 27,630 Shares purchased by Mr. Towe. Pursuant to such Stock Purchase Agreement, the holders of a majority of such Acquired Shares have the right to demand, up to five times but no more than once every six months, registration of their Acquired Shares under the Securities Act. In addition, under certain conditions, the holders of the Acquired Shares have a right to include some or all of their Acquired Shares in any subsequent registration statement filed by the Company with respect to the sale of Shares. The Company has agreed to bear all expenses associated with any registration statement relating to the Acquired Shares other than any underwriting discounts or commissions, brokerage commissions and fees. In connection with the Acquisition, the Company and Zell/Chilmark executed a release (the "Release") dated February 12, 1993 of MBLP and its affiliates, subsidiaries, stockholders, partners, controlling persons and their respective directors, officers, employees and certain other related persons (collectively, the "Related Persons"), which would include, among others, First Boston, FBSC, Robert B. Calhoun, Jr. (a director of the Company prior to the Acquisition) and Rolf H. Towe (collectively, MBLP and MBLP's Related Persons shall be referred to collectively as the "MBLP Released Parties") from any obligation or liability in any way relating to (i) the acquisition, ownership or operation of the Company or (ii) the negotiation, execution and closing of the Stock Purchase Agreement and related documents (the "Stock Purchase Documents"). The Release does not release the MBLP Released Parties from any obligation or liability in connection with (i) covenants contained in the Stock Purchase Documents required to be performed following the Acquisition, (ii) breaches of certain representations made by MBLP in the Stock Purchase Agreement, or (iii) actions taken by any MBLP Released Party after February 12, 1993. MBLP executed a similar release of Zell/Chilmark and the Company and their respective Related Persons which was substantially equivalent in scope and coverage (except that such release did not cover any obligations in respect of the Subordinated Notes). Pursuant to the Stock Purchase Agreement, Zell/Chilmark and the Company have agreed that, so long as MBLP (or any of its affiliates) held any Subordinated Notes, First Boston would have the exclusive right (for competitive fees and terms) to act (i) as the Company's exclusive financial advisor with respect to any acquisitions or divestitures in which the Company engaged a financial advisor (other than Zell/Chilmark or its affiliates) and (ii) as lead underwriter or placement agent with respect to any transactions in which the Company employed the services of an underwriter or placement agent. Pursuant to such agreed terms, First Boston served as the lead underwriter in connection the issuance of the Notes as part of the Refinancing. Zell/Chilmark and the Company agreed that for three years following the date of the Refinancing, First Boston will have the right to act (for competitive fees and terms) as a co-manager or co-placement agent in any transaction in which the Company employs the services of an underwriter or placement agent. In addition, the Stock Purchase Agreement provides that, until three years following the Refinancing, MBLP and First Boston will not (i) directly or indirectly participate, anywhere in the United States, in the business in which the Company is currently engaged; (ii) induce or influence any employee of the Company or Zell/Chilmark to terminate such employee's employment or become an employee of MBLP or First Boston; or (iii) disclose or furnish to any other person any of the Company's confidential business information, trade secrets or manner of conducting its business. MBLP and First Boston further agreed not to use certain trademarks owned by the Company and, for a period of time, not to serve as underwriter or placement agent with respect to the sale of securities by certain entities that use such trademarks. THE ACQUISITION. On January 27, 1993, Zell/Chilmark, MBLP and the Company entered into the Stock Purchase Agreement pursuant to which MBLP agreed to sell to Zell/Chilmark up to 27,630,000 Shares (representing a 93.6% equity interest in the Company). In accordance with the terms of the Stock Purchase Agreement, Zell/Chilmark acquired 88.7% of the outstanding common stock of the Company (26,143,506 Shares) and assigned a portion of its rights and obligations under the Stock Purchase Agreement to Bankers Trust New York Corporation ("BT") and Rolf H. Towe, a director of the Company. In the Acquisition, BT acquired 1,458,864 Shares and Mr. Towe acquired 27,630 Shares. Zell/Chilmark has informed the Company that the monies used to fund the cash purchase price that it paid for its portion of the Acquired Shares were obtained from partnership capital contributions. All of the Zell/Chilmark Purchasers paid the same $9.05 cash price per Share for their Acquired Shares. The Acquisition was completed on February 12, 1993. As part of the Acquisition, Zell/Chilmark granted to MBLP a warrant, exercisable on or after November 30, 1993, to purchase up to 4,000,000 Acquired Shares (the "MBLP Warrant") held by Zell/Chilmark, which Warrant expired upon repayment of the Subordinated Notes. As part of the Acquisition and pursuant to the Stock Purchase Agreement, Zell/Chilmark and the Company entered into the Capital Contribution Agreement whereby Zell/Chilmark agreed to purchase or cause to be purchased, and the Company agreed to issue, Shares having an aggregate purchase price of $50.0 million (subject to adjustment), computed at a price of $9.05 per Share on or before November 30, 1993. The Capital Contribution Agreement terminated with the Refinancing. See "-- Compensation Committee Interlocks and Insider Participation," above for certain additional information regarding the Acquisition. MANAGEMENT SUBSCRIPTION AND BENEFIT ARRANGEMENTS. See "Management -- Compensation Pursuant to Plans and Other Arrangements -- Severance Arrangements" for a description of the Company's severance arrangements with certain executive officers. See "Management -- Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements" for a description of the Company's employment arrangements with Mr. Beggs. STOCK REPURCHASE AGREEMENTS. Certain officers, key employees of the Company and a former employee of the Company (collectively, the "Management Investors") are the beneficial owners of 90,426 Shares, not including 100,000 Shares held by Mr. Beggs pursuant to his Employment Agreement (the "Management Investors' Shares"). Such Shares were acquired in connection with the LBO pursuant to subscription agreements between the Company and such individuals (the "Subscription Agreements") or subsequently acquired as stock bonuses pursuant to the same Subscription Agreements. The Subscription Agreements provide that the Management Investors' Shares are subject to "put" options whereby the Company may be required to redeem such Shares at fair market value in the event of a Management Investor's death, disability, or termination of employment under certain circumstances, at the option of the Management Investor or his estate. Under certain circumstances, such Shares also are subject to "call" options whereby the Company, at its option, may purchase such Shares from a Management Investor at fair market value, so long as the Company has not effected a public offering of its common stock, in the event of either (i) a Management Investor's voluntary termination of employment on or before January 1, 1994, or (ii) a Management Investor's termination for cause (as defined). Due to the possibility of repurchase, such Management Investors' Shares were not considered to be part of the Company's stockholders' equity for periods prior to Fiscal 1993. The Subscription Agreements also grant to the Management Investors certain registration rights in the event that the Company (or, in certain circumstances, other investors in the Company) registers any common stock under the Securities Act. FULCRUM. In connection with the LBO, The Fulcrum III Limited Partnership and The Second Fulcrum III Limited Partnership (together, the "Fulcrum Partnerships"), purchased, after giving effect to the reverse stock split, 961,400 Shares pursuant to a stock subscription agreement with the Company (the "Fulcrum Stock Subscription Agreement") which provides that, under certain circumstances, the Company has a right of first refusal in the event of a proposed sale of such Shares by the Fulcrum Partnerships. The Fulcrum Subscription Agreement also grants to the Fulcrum Partnerships certain rights to demand the registration of their Shares and certain registration rights in the event that the Company (or, in certain circumstances, other investors in the Company) registers any common stock under the Securities Act. In addition, in connection with the Recapitalization, the Fulcrum Partnerships were issued Restructure Warrants to acquire up to an aggregate of 3,461,040 Shares. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) The following consolidated financial statements of Sealy Corporation and its subsidiaries are included in Part II, Item 8: Sealy Corporation Report of Independent Auditors Consolidated Balance Sheets at November 30, 1993 and 1992 Consolidated Statements of Operations for the ten months ended November 30, 1993 (Successor), the two months ended January 31, 1993, year ended November 30, 1992, one month ended November 30, 1991 (Pre-Successor), and the eleven months ended October 31, 1991 (Predecessor). Consolidated Statements of Stockholders' Equity for the ten months ended November 30, 1993 (Successor), the two months ended January 31, 1993, year ended November 30, 1992, one month ended November 30, 1991 (Pre-Successor), and the eleven months ended October 31, 1991 (Predecessor). Consolidated Statements of Cash Flows for the ten months ended November 30, 1993 (Successor), the two months ended January 31, 1993, year ended November 30, 1992, one month ended November 30, 1991 (Pre-Successor), and the eleven months ended October 31, 1991 (Predecessor). Notes to consolidated financial statements (a)(2) Financial Statement Schedules Schedule VIII -- Valuation Accounts Schedule X -- Supplementary Income Statement Information (b) The Company filed no reports on Form 8-K during the fourth quarter of its fiscal year ended November 30, 1993. (c) Exhibits: - -------------- * Management contract or compensatory plan or arrangement identified pursuant to Item 14(a) of this Form 10-K. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, SEALY CORPORATION HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SEALY CORPORATION Date: February 28, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED: SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 SCHEDULES TEN MONTHS ENDED NOVEMBER 30, 1993, TWO MONTHS ENDED JANUARY 31, 1993, YEAR ENDED NOVEMBER 30, 1992, ONE MONTH ENDED NOVEMBER 30, 1991, ELEVEN MONTHS ENDED OCTOBER 31, 1991 FORMING A PART OF ANNUAL REPORT PURSUANT TO THE SECURITIES EXCHANGE ACT OF 1934 FORM 10-K OF SEALY CORPORATION SEALY CORPORATION SCHEDULE VIII -- VALUATION ACCOUNTS SEALY CORPORATION SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION

771298_1993.txt

771298_1993

1993

771298

ITEM 1. BUSINESS Fruit of the Loom, Inc. ("Fruit of the Loom" or the "Company") is a leading international basic apparel company, emphasizing branded products for consumers ranging from infants to senior citizens. It is the largest domestic producer of underwear and of activewear for the imprinted market, selling products principally under the FRUIT OF THE LOOM , BVD , SCREEN STARS , BEST , MUNSINGWEAR and WILSON brand names. The Company sells licensed sports apparel for major American sports leagues, professional players and many American colleges and universities under the SALEM , SALEM SPORTSWEAR AND OFFICIAL FAN brand names. The Company manufactures and markets men's and boys' basic and fashion underwear, activewear, casualwear, licensed sports apparel, women's and girls' underwear, infants' and toddlers' apparel and family socks. Activewear consists primarily of screen print T-shirts and fleecewear and also includes casualwear (principally a broad range of lightweight knit tops and fleece styles sold directly to retailers) and licensed sports apparel. The Company is a fully integrated manufacturer, performing its own spinning, knitting, cloth finishing, cutting, sewing and packaging. Management believes that the Company is the low cost producer in the markets it serves. Management considers the Company's primary strengths to be its excellent brand recognition, low cost production, strong relationships with mass merchandisers and discount chains and its ability to effectively service its customer base. The Company manufactures and markets underwear and activewear (which both include T-shirts) as part of the basic retail product. Management believes that consumer awareness of the value and excellent quality at competitive prices of FRUIT OF THE LOOM brand products will benefit the Company in the current retail marketplace where consumers are more value conscious. During the last five calendar years, the Company has been the market leader in men's and boys' underwear, with an annual market share ranging from approximately 39% to 41%. In 1993, the Company's share in the men's and boys' underwear market was approximately 40% compared to an approximate 31% share for its closest competitor. The Company offers a broad array of men's and boys' underwear, including: briefs, boxer shorts, T-shirts and A-shirts, colored and "high fashion" (as well as RIBBED WHITES ) underwear. It sells all-cotton and cotton-blend underwear under the FRUIT OF THE LOOM and BVD brand names. Products sold under the BVD brand name are priced higher than those sold under the FRUIT OF THE LOOM brand name and are generally designed to appeal to a more premium market. The Company also manufactures and markets boys' decorated underwear (generally with pictures of licensed movie or cartoon characters) under the FUNPALS brand name. The Company manufactures and markets men's and boys' underwear bearing the MUNSINGWEAR and KANGAROO trademarks as well as certain activewear bearing the MUNSINGWEAR trademark in the United States and certain foreign markets. ITEM 1. BUSINESS - (Continued) Management believes the Company is the largest of the approximately 70 domestic activewear manufacturers that supply screen printers and that it has a market share of approximately 34% of the screen print T-shirt market. The Company produces and sells blank shirts and fleecewear under the SCREEN STARS brand name and premium fleecewear and T-shirts under the FRUIT OF THE LOOM and BEST labels. These products are manufactured in a variety of styles and colors and are sold to distributors, screen printers and specialty retailers, who generally apply a screen print prior to sale at retail. Product quality, delivery responsiveness and price are important factors in the sale of activewear. Management believes that the Company's recent capacity additions and its low cost position afford it a competitive advantage in this market. The Company markets casualwear under the FRUIT OF THE LOOM, BVD and MUNSINGWEAR brands. There are separate Spring and Fall lines with updated color selections for each of the men's, women's, boys' and girls' categories. A national marketing program includes national advertising and local cooperative advertising, promotions and in-store merchandising. The casualwear market is fragmented and has no dominant brands. The continued expansion of the FRUIT OF THE LOOM casualwear line including the introduction in 1993 of twenty new styles with more fashion treatments, color selections and heavier fabric combined with sixty-three new styles for 1994 which emphasize casualwear tailored specifically for ladies and girls will, management believes, contribute significantly to casualwear sales growth. In February 1993, the Company and Wilson Sporting Goods Company announced an exclusive licensing agreement for the Company to manufacture and market a complete line of sweatshirts and sweatpants, T-shirts, shorts and other athletic activewear featuring the WILSON brand in the United States and Mexico. The Company began shipping WILSON brand activewear products in January of 1994. In November 1993, the Company acquired Salem Sportswear Corporation (the "Salem Acquisition"), a Delaware corporation ("Salem") for approximately $157,600,000, including approximately $23,000,000 of Salem debt which was repaid by the Company. Salem is a leading domestic designer, manufacturer and marketer of sports apparel under licenses granted by the National Basketball Association, Major League Baseball, the National Football League, the National Hockey League, professional players, many American colleges and universities and the World Cup '94. Salem sells a wide variety of quality sportswear, including T-shirts, sweatshirts, shorts and light outerwear. For the fiscal year ended August 31, 1992 Salem Sportswear had sales of approximately $119,800,000. In January 1994, the Company acquired Artex Manufacturing Co., Inc. ("Artex") for approximately $44,500,000, or approximately book value, (the "Artex Acquisition"). Artex operates as Jostens Sportswear and manufactures and sells a wide variety of decorated sportswear primarily to retail stores and college bookstores under the JOSTENS label and to mass merchants under the ARTEX label. Jostens Sportswear pioneered the dual license concept of combining cartoon characters with major professional sports leagues and is currently one of only three companies to have dual license agreements. Jostens Sportswear has licenses from all the major professional sports leagues as well as from The Walt Disney Company, United Feature Syndicate for PEANUTS and Warner Bros. for Looney Tunes . For the fiscal year ended June 30, 1993 Jostens Sportswear had sales of approximately $76,000,000. ITEM 1. BUSINESS - (Continued) In March 1994, the Company entered into a contract to purchase certain assets of the Gitano Group, Inc. ("Gitano") for approximately $100,000,000. Gitano designs, manufactures, arranges for the manufacture of, distributes and sells women's, men's and children's jeanswear, sportswear and other apparel. Gitano also provides marketing services and licenses the production and sale of a variety of accessories and other products bearing the Gitano name. The Company produces women's briefs, high thigh briefs and bikinis and girls' briefs, in white and colors, under the FRUIT OF THE LOOM brand name. The Company introduced its women's and girls' lines in 1984 using the branded, packaged product strategy that it had successfully employed in the men's and boys' market. The Company's products are packaged, typically three to a pack, making them convenient for the merchant to handle and display. During the last five calendar years, in the highly fragmented women's and girls' underwear market, the Company was one of the branded market leaders with a market share ranging from approximately 11% to 17%. In 1993, the Company's share in the women's and girls' underwear market was approximately 14%, compared to a market share of 24% for the largest competing brand. The Company has a licensing agreement with Warnaco Inc. whereby Warnaco Inc. manufactures and sells bras, slips, camisoles, tap pants and other products under the FRUIT OF THE LOOM brand name in North America. The Company entered the family sock market in mid-1986 through acquisitions and management believes the Company is now one of the two largest domestic manufacturers and that no manufacturer has more than a 12% market share. Sales of FRUIT OF THE LOOM branded socks in 1993 were 40.8% higher than in 1992. Marketing and Distribution The Company sells its products to over 21,000 customers, including all major discount and mass merchandisers, wholesale clubs and screen printers. The Company also sells to many department, specialty, drug and variety stores, national chains, supermarkets and sports specialty stores. The Company's products are sold by a nationally organized direct sales force of full-time employees. Underwear, activewear and hosiery are shipped from the Company's fourteen primary distribution centers to over 82,000 customer locations. Management believes that one of the Company's primary strengths is its excellent relationships with mass merchandisers and discount chains. These retailers accounted for approximately 62% of the men's and boys' underwear and approximately 59% of the women's and girls' underwear sold in the United States in 1993, up from approximately 56% and 52%, respectively, in 1989. The Company supplied approximately 53% of the men's and boys' underwear and approximately 20% of the women's and girls' underwear sold by discount and mass merchandisers in the United States in 1993. Sales to one customer amounted to approximately 13.4%, 11.8% and 9.6% of consolidated net sales in 1993, 1992 and 1991, respectively. Additionally, sales to a second customer amounted to approximately 12.3%, 10.2% and 8.8% of consolidated net sales in 1993, 1992 and 1991, respectively. Management does not feel the loss of any one customer would adversely affect its business as a large percentage of these sales would shift to other outlets due to the high degree of brand awareness and consumer loyalty to the Company's products. The Company's business is seasonal to the extent that approximately 55% of annual sales occur in the second and third quarters. Sales are generally the lowest in the first quarter. ITEM 1. BUSINESS - (Continued) International Operations The Company sells activewear through its foreign operations, principally in the United Kingdom, continental Europe and Canada. The Company's approach has been to establish production in foreign markets by both acquiring existing manufacturing facilities and building new plants in order to decrease the impact of foreign currency fluctuations on international sales and to better serve these markets. The Company has established manufacturing plants in Canada, the Republic of Ireland, Northern Ireland (United Kingdom), Mexico and Honduras as a means of accomplishing these objectives. Since 1989, the Company's international sales of activewear have almost tripled. Sales from international operations during 1993 were $249,800,000, substantially all of which were generated from products manufactured at the Company's foreign facilities. These international sales accounted for approximately 13.3% of the Company's net sales in 1993. Management believes international sales will continue to be a source of growth for the Company, particularly on the European continent. This growth will depend on continued demand for the Company's products in diverse international marketplaces. See "Business Segment and Major Customer Information" in the Notes to Consolidated Financial Statements. Manufacturing Principal manufacturing operations consist of spinning, knitting, cloth finishing, cutting, sewing and packaging. The Company's licensed sportswear is generally produced by applying decorative images, most often by screen printing or embroidery, to blank garments. The Company knits yarn into fabric using a multiple-knitting technique that produces long tubes of fabric corresponding in weight and diameter to various sizes and styles required to make underwear and activewear. All of the Company's products are either bleached to remove the ecru color of natural cotton or dyed for colored products. To achieve certain colors, the fabric must be bleached and dyed. Computer controlled die cutting is used in all areas where management believes it is more efficient. Fabric is distributed to employees operating individual sewing machines. To increase efficiency, each employee specializes in a particular function, such as sewing waistbands on briefs. Quality checkpoints occur at many intervals in the manufacturing process, and each garment is inspected prior to packaging. Competition All of the Company's markets are highly competitive. Competition in the underwear and activewear markets is generally based upon quality, price and delivery. Certain of the Company's domestic competitors utilize foreign manufacturing facilities to supply product to the domestic markets. The Company's vertically integrated manufacturing structure allows it to produce high quality products at costs which management believes are generally lower than those of its competitors. Management also believes the Company's ability to deliver its products rapidly gives it a significant competitive advantage. In response to market conditions, the Company, from time to time, reviews and adjusts its product offerings and pricing structure. Where appropriate, the Company uses contract manufacturing to further minimize its costs. Such contract manufacturing accounted for less than 5% of the Company's total production in 1993. ITEM 1. BUSINESS - (Continued) Licensing and Trademarks The Company owns the FRUIT OF THE LOOM, BVD, SCREEN STARS, BEST and certain other trademarks, which are registered in the United States and in many foreign countries. These trademarks are used on men's, women's and children's underwear and activewear marketed by the Company. The Company licenses properties from different companies for its decorated underwear products. Among the characters licensed are: THE LITTLE MERMAID , BEAUTY AND THE BEAST , 101 DALMATIANS , DINOSAURS , BARNEY THE DINOSAUR and BATMAN RETURNS . The Company also licenses the MUNSINGWEAR and KANGAROO trademarks for use on its men's and boys' underwear and certain activewear. The Company has a license to use the WILSON brand on its sweatshirts and sweatpants, T-shirts, shorts and other athletic activewear. In addition, the Company owns the SALEM, SALEM SPORTSWEAR, OFFICIAL FAN, BABY SALEM and ARTEX trademarks. The Company licenses properties, including team insignia, images of professional athletes and college logos, from the National Basketball Association, Major League Baseball, the National Football League, the National Hockey League, professional players' associations and certain individual players, many American colleges and universities and the World Cup '94. These owned and licensed trademarks are used on sports apparel, principally T-shirts, shorts, sweatshirts and jerseys, marketed by the Company. Imports In 1993, imports accounted for approximately 19.6% (39.3% including Section 9802) of the men's and boys' underwear market and approximately 33.8% (74.1% including Section 9802) of the women's and girls' underwear market. For activewear, imports accounted for approximately 35% of the market in 1992, which is the latest period for which information is available. Management does not believe that direct imports presently pose a significant threat to any of its businesses. United States tariffs along with quotas, implemented under an international agreement known as the Multifiber Arrangements (MFA), limit the growth of imports and increase the cost of imported apparel. The MFA quota system will be phased out over ten years, beginning in 1995, if the Uruguay Round/GATT agreement is adopted by the United States Congress. Management is studying the impact of the MFA phase out on each aspect of the Company's United States manufacturing process. Management does not believe that the elimination of quotas and tariffs with Mexico under the North American Free Trade Agreement (NAFTA) will adversely effect the Company. To the contrary, the elimination of Mexican tariffs on the Company's United States manufactured products will enhance its sales in that market. Imports from Mexico are expected to rise more rapidly under NAFTA. However, the strict rule of origin, which generally requires apparel to be made from North American spun yarn, and North American Knit or woven fabric, should prevent Mexico from becoming an export platform for low-wage manufacturers from outside the region. ITEM 1. BUSINESS - (Concluded) Imports - (Concluded) Likewise, imports from the Caribbean and Central American nations likely will continue to rise more rapidly than imports from other parts of the world. This is because Section 9802 (previously Section 807) of the United States tariff schedule grants preferential quotas when made and cut fabrics are used, and duty is paid only on the value added outside the United States. United States apparel and textile manufacturers will continue to use Section 9802 to compete with direct imports. Employees The Company employs approximately 35,000 persons. Approximately 2,700 employees are covered by collective bargaining agreements. Miscellaneous Materials and Supplies. Materials and supplies used by the Company are available in adequate quantities. The primary raw materials used in the manufacturing processes are cotton and polyester. The Company periodically enters into futures contracts as hedges for its purchases of cotton for inventory. Other. The Company was incorporated under the laws of the state of Delaware in 1985. The principal executive offices of the Company are located at 233 South Wacker Drive, 5000 Sears Tower, Chicago, Illinois 60606, telephone (312)876-1724. As used in this Annual Report on Form 10-K, the term "the Company" refers to Fruit of the Loom, Inc. and its subsidiaries, together with its predecessor, Northwest Industries, Inc. ("Northwest"), unless otherwise stated or indicated by the context. Market share data contained herein are for domestic markets and are based upon information supplied to the company by the National Purchase Diary, which management believes to be reliable. ITEM 2. ITEM 2. PROPERTIES The Company has properties and facilities aggregating approximately 17,000,000 square feet of usable space, of which approximately 7,000,000 square feet of facilities are under leases expiring through 2013. Management believes that the Company's facilities and equipment are in good condition and that the Company's properties, facilities and equipment are adequate for its current operations. The Company has invested approximately $1.1 billion in capacity expansion and plant modernization programs during the past eight calendar years. Capital spending, primarily to enhance distribution capabilities, is expected to approximate $150,000,000 to $175,000,000 in 1994. Management believes that these prior investments, together with planned capital expenditures, will allow the Company to accommodate current and anticipated sales growth and remain a low cost producer in the next several years. Set forth below is a summary of the principal facilities owned or leased by the Company: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in certain legal proceedings and have retained liabilities, including certain environmental liabilities, such as those under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, its regulations and similar state statutes ("Superfund Legislation") in connection with the sale of certain discontinued operations, some of which were significant generators of hazardous waste. The Company's retained liability reserves at December 31, 1993 related to discontinued operations, consisting primarily of certain environmental reserves of approximately $46,200,000 reflect management's belief that the Company will recover at least $28,600,000 from insurance and other sources. Management and outside environmental consultants evaluate, on a site-by-site basis, the extent of environmental damage, the type of remediation that will be required and the Company's proportionate share of those costs. The Company's retained liability reserves related to discontinued operations principally pertain to ten specifically identified environmental sites. Four sites individually represent more than 10% of the net reserve and in the aggregate represent approximately 67% of the net reserve. Management believes they have adequately estimated the impact of remediating identified sites, the expected contribution from other potentially responsible parties and recurring costs for managing sites. Management currently estimates actual payments before recoveries to range from approximately $8,500,000 to $17,700,000 annually between 1994 and 1997 and $22,000,000 in total subsequent to 1997. Only the long- term monitoring costs of approximately $7,500,000, primarily scheduled to be paid in 1998 and beyond, have been discounted. The discount rate used was 10%. The undiscounted aggregate long- term monitoring costs, to be paid over approximately the next 20 years, is approximately $19,500,000. Management believes that adequate reserves have been established to cover potential claims based on facts currently available and current Superfund Legislation. The Company has provided the foregoing information in accordance with the recently issued Staff Accounting Bulletin 92. Generators of hazardous wastes which were disposed of at offsite locations which are now superfund sites are subject to claims brought by state and Federal regulatory agencies under Superfund Legislation and by private citizens under Superfund Legislation and common law theories. Since 1982, the United States Environmental Protection Agency (the "EPA") has actively sought compensation for response costs and remedial action at offsite disposal locations from waste generators under the Superfund Legislation, which authorizes such action by the EPA regardless of fault, legality of original disposal or ownership of a disposal site. The EPA's activities under the Superfund Legislation can be expected to continue during 1994 and future years. In February 1986, the Company completed the sale of stock of its then wholly owned subsidiary, Universal Manufacturing Corporation ("Universal"), to MagneTek, Inc., ("MagneTek"). At the time of the sale there was a suit pending against Universal and Northwest by L.M.P. Corporation ("LMP"). The suit (the "LMP Litigation") alleged that Universal and Northwest fraudulently induced LMP to sell its business to Universal and then suppressed the development of certain electronic lighting ballasts in breach of the agreement of sale, which required Universal to pay to LMP a percentage of the net profits from such business from 1982 through 1986. Two additional plaintiffs, Stevens Luminoptics Partnership and Calmont Technologies Inc., joined the litigation in 1986. In December 1989 and January 1990, a jury returned certain verdicts against Universal and also returned verdicts in favor of Northwest and on certain issues in favor of Universal. A judgment totalling $25,800,000, of which $7,500,000 represented punitive damages, reflecting these verdicts was entered by the Alameda County, California Superior Court in January 1990 against Universal. ITEM 3. LEGAL PROCEEDINGS - (Continued) In April 1992, the California Court of Appeals reversed the $25,800,000 judgment against Universal and affirmed those verdicts favorable to Universal and Northwest. In July 1992, the California Supreme Court denied the plaintiffs' petition for review. The case has been remanded to the trial court where it is schedule to be retried beginning in March 1994. In March 1988, a class action suit entitled Endo et al. v. Albertine, et al. was filed in the United States District Court for the Northern District of Illinois (the "District Court") against the Company, its then directors, certain of its then executive officers, its then underwriters and the Company's current and former independent auditors in connection with the Company's initial public offering of Class A Common Stock and certain debt securities in March 1987. The suit alleges, among other things, violations of Federal and state securities laws against all of the defendants, as well as breaches of fiduciary duties by the director and officer defendants, and seeks unspecified damages. Motions to dismiss the complaint were filed by all defendants. In December 1990, a magistrate judge recommended that the District Court dismiss all of the plaintiffs' claims with prejudice. On January 29, 1993, the District Court adopted in part and rejected in part the magistrate judge's recommendation for dismissal of the complaint. As a result, the litigation will continue as to various remaining counts of the complaint. Both the defendants and the plaintiffs recently filed motions for summary judgment. It is uncertain as to when rulings on these motions will be issued. Management and the Board of Directors believe that this suit is without merit and intend to continue to defend themselves vigorously in this litigation. On December 23, 1993, James J. Locke, as Trustee of Locke Family Trust, and I. Jack Saline filed a lawsuit against the Company and certain of its then officers and directors, including William Farley and John B. Holland in the District Court. The lawsuit was then amended to add additional plaintiffs. The lawsuit was filed as a class action, but the issue of class certification has not yet been addressed by the parties or the court. The plaintiffs claim that all of the defendants engaged in conduct violating Section 10b of the Securities Exchange Act of 1934, as amended (the "Act"), and that Mr. Farley and Mr. Holland also violated Section 20a of the Act. According to the plaintiffs, beginning before June 1992 and continuing through early June 1993, the Company, with the knowledge and assistance of the individual defendants, issued positive public statements about its expected sales increases and growth through 1993 and afterwards. They also allege that beginning in approximately mid-1992 and continuing afterwards, the Company's business was not as strong and its growth prospects were not as certain as represented. The plaintiffs further allege that during the end of 1992 and beginning of 1993, certain of the individual defendants traded the stock of the Company while in the possession of material, non-public information. The plaintiffs ask for unspecified amounts as compensatory damages, pre-judgment and post-judgment interest, attorneys' fees, expert witness fees and costs and ask the District Court to impose a constructive trust on the proceeds of the individual defendants' trades to satisfy any potential judgment. Although the lawsuit is at a preliminary stage, the Company believes that this suit is without merit and intends to defend itself vigorously in this litigation. ITEM 3. LEGAL PROCEEDINGS - (Concluded) Management believes, based on information currently available, that the ultimate resolution of the aforementioned litigation will not have a material adverse effect on the financial condition or operations of the Company. In March 1992, the Company received a refund of approximately $60,000,000 relating to Federal income taxes plus interest paid by Northwest. However, in September 1992, the Internal Revenue Service (the "IRS") issued a statutory notice of deficiency in the amount of approximately $7,300,000 for the taxable years from which the March 1992 refund arose, exclusive of interest which would have accrued from the date the IRS asserted the tax was due until payment, presently a period of about 24 years. Based on discussions with tax counsel, the Company believes that the asserted legal basis for the IRS's position in this matter is without merit. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS William Farley, an executive officer and director of the Company, holds 100% of the common stock of Farley Inc. ("FI"). William Farley and FI together own all of the Class B Common Stock of the Company outstanding. See "Consolidated Statement of Common Stockholders' Equity" in the Notes to Consolidated Financial Statements. William Farley also owns 318,000 shares of the Class A Common Stock of the Company. As of March 10, 1994, there were 2,798 holders of record of the Class A Common Stock of the Company. Common Stock Prices and Dividends Paid The Company's Class A Common Stock is listed on the New York Stock Exchange. Prior to December 3, 1993, the Company's Class A Common Stock was listed on the American Stock Exchange. The following table sets forth the high and low market prices of the Class A Common Stock for 1993 and 1992: No dividends were declared on the Company's common stock issues during 1993 or 1992. The Company does not currently anticipate paying any dividends in 1994. For restrictions on the present or future ability to pay dividends, see "Long-Term Debt" in the Notes to Consolidated Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (In Millions, Except Per Share Data) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The table below sets forth selected operating data (in millions of dollars and as percentages of net sales) of the Company: Operations 1993 Compared to 1992 Net sales increased 1.6% in 1993 from 1992. The increased net sales for 1993 as compared to 1992 are due to volume increases in casualwear, international activewear and underwear combined with price increases (principally for domestic activewear and casualwear). These increases more than offset the adverse effects of volume declines in domestic activewear, unfavorable foreign currency exchange rate comparisons on international sales between the two periods and increased sales of promotional and closeout merchandise in 1993. In the international operations, the Company's approach has been to establish production in foreign markets by both acquiring existing manufacturing facilities and building new plants in order to better serve these markets. Management believes international unit sales will continue to be a source of growth for the Company, particularly on the European continent. However, any such growth is subject to the risk that the Company's products in diverse international marketplaces will not be widely accepted. Gross earnings decreased 2.0% in 1993 as compared to 1992. The gross margin was 34.4% in 1993 as compared to 35.6% in 1992. The decrease in gross earnings in 1993 is due primarily to the unfavorable effects of operating certain plants on reduced production schedules in response to lower than expected consumer demand, inventory valuation adjustments and unfavorable changes in product mix due to promotions and closeouts. These decreases more than offset the favorable effects of the sales price and volume increases discussed above and lower raw material costs. Operating earnings decreased 6.9% compared to 1992 and the operating margin decreased 1.9 percentage points to 20.2% in 1993. The decreases are due to lower gross earnings and gross margin as well as higher selling, general and administrative expenses. Selling, general and administrative expenses increased to 12.7% of net sales in 1993 compared to 12.1% in the prior year. The spending increase is primarily attributable to increased selling expenses resulting from increased royalty payments and increased shipping expenses. The shipping expense increase results from a shift in product mix to more casualwear and an increased number of shipments as customer order patterns have changed to include an increased number of smaller quantity shipments. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Operations - (Continued) 1993 Compared to 1992 - (Continued) Interest expense for 1993 decreased 11.4% from 1992. Lower interest expense is principally attributable to the effect of lower interest rates on the Company's debt instruments which more than offset the effects of higher average debt levels during 1993. The lower interest rates are principally due to the Company's refinancing of its 10-3/4% Notes (as hereinafter defined) with a 7-7/8% senior note issue in the fourth quarter of 1992. In addition, lower average prime and LIBOR interest rates on the Company's variable rate debt instruments in 1993 as compared to 1992 contributed to the lower average interest rates. In 1993 the Company received approximately $72,900,000 from Acme Boot representing the entire unpaid principal and liquidation preference (including accrued interest and dividends) on its investment in the securities of the affiliate. The Company recorded a pretax gain of $67,300,000 related to the investment in Acme Boot upon the receipt of the above mentioned proceeds. See "Related Party Transactions" in the Notes to Consolidated Financial Statements. The effective income tax rate before extraordinary items and cumulative effect of change in accounting for 1993 and 1992 differed from the Federal statutory rate of 35% and 34%, respectively, primarily due to the impact of goodwill amortization, which is not deductible for Federal income tax purposes, state income taxes and the provision for interest related to prior years' taxes. In 1993 the Company recorded an extraordinary charge of $8,700,000 ($.11 per share) in connection with the refinancing of its bank credit agreements and the redemption of its 12-3/8% Senior Subordinated Debentures due 2003 (the "12-3/8% Notes"). The extraordinary charge consists principally of the non-cash write-off of the related unamortized debt expense on the bank credit agreements, the 12-3/8% Notes and other debt issues and the premiums paid in connection with the early redemption of the 12-3/8% Notes, both net of income tax benefits. In 1992, the Company redeemed all of its $280,000,000 principal amount of 10-3/4% Senior Subordinated Notes due July 15, 1995 (the "10-3/4% Notes"). The Company recorded an extraordinary charge of approximately $9,900,000 ($.13 per share) in connection with the redemption of the 10-3/4% Notes, which consisted principally of the premiums paid in connection with the early redemption of the 10-3/4% Notes and the non-cash write-off of the related unamortized debt expense, both net of income tax benefits. In the first quarter of 1993, the Company recorded the cumulative effect of an accounting change related to the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", ("Statement No. 109") resulting in a $3,400,000 ($.04 per share) benefit. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Operations - (Continued) 1993 Compared to 1992 - (Concluded) Earnings per share before extraordinary items and cumulative effect of change in accounting principle were $2.80 for 1993 compared to $2.48 for 1992, a 12.9% increase. Net earnings per share in 1993 were $2.73 and include an $.11 extraordinary charge related to the early retirement of debt and a $.04 benefit related to the cumulative effect of a change in accounting for income taxes. Included in earnings per share before extraordinary items and cumulative effect of change in accounting principle and net earnings per share in 1993 is the effect of a gain related to the Company's investment in Acme Boot of $.55 per share. Management believes that the relatively moderate rate of inflation over the past few years has not had a significant impact on the Company's sales or profitability. 1992 Compared to 1991 Net sales increased 13.9% in 1992 from 1991 primarily due to higher unit shipments and price increases in both activewear and underwear. The sales growth was driven by aggressive marketing campaigns for underwear products, expanded distribution for activewear (particularly in casualwear and in Europe) and continued new product introductions in activewear. Gross earnings increased 25.6% in 1992 compared to 1991. The gross margin was 35.6% in 1992 compared to 32.3% in 1991. Price increases (principally effected in the first quarter of 1992), manufacturing efficiencies (due to higher plant utilization), lower raw material costs and the continuing shift within the activewear line to higher margin products favorably impacted the gross earnings and gross margin in 1992. Operating earnings increased 28.4% compared to 1991 and the operating margin increased 2.5 percentage points to 22.1% in 1992. The increase is due to the higher gross earnings and gross margin and was slightly offset by higher selling, general and administrative expenses. Selling, general and administrative expenses increased to 12.1% of net sales in 1992 compared to 11.1% the prior year. The increase is primarily attributable to higher advertising costs and increased selling and shipping costs attributable to higher unit volume. Interest expense for 1992 decreased 28.5% from 1991. Lower interest expense is principally attributable to the effect of lower interest rates on the Company's variable rate debt instruments due to lower average prime and LIBOR interest rates in 1992 compared to 1991. Interest expense has also been reduced by lower debt levels in 1992 compared to 1991. Debt levels have been reduced from their 1991 levels as a result of the strong operating cash flows of the Company, the use of proceeds from the Stock Offering to repay a portion of the Company's bank debt and the Conversion. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Operations - (Concluded) 1992 Compared to 1991 - (Concluded) The effective income tax rate on earnings before extraordinary items and cumulative effect of change in accounting principle for 1992 and 1991 differed from the Federal statutory rate of 34% primarily due to the impact of goodwill amortization, which is not deductible for Federal income tax purposes, state income taxes and the provision for interest related to prior years' taxes. The tax rate in 1991 was also reduced by the effect of the Federal tax refund from prior years and was increased for the nondeductible portions of the special charges and writedowns discussed below. Earnings before extraordinary items and cumulative effect of change in accounting principle per share on both a primary and fully diluted basis were $2.48 for 1992 compared to $1.60 and $1.55, respectively, for 1991. The increased net earnings in 1992 were partially offset by the dilutive effect on earnings per share in 1992 of the greater average number of shares outstanding after the Stock Offering and, for primary earnings per share, the dilutive effect of the Conversion. See "Statement of Common Stockholders' Equity" in the Notes to Consolidated Financial Statements. Included in net earnings per share in 1991 are the effect of a court ordered refund of Federal income taxes (plus interest) of $.57 per share, special charges related to former subsidiaries of $.12 per share and a write down of the Company's investment in Acme Boot to its then market value, resulting in a charge to earnings of $.45 per share. Liquidity and Capital Resources Funds generated from the Company's operations are the major internal source of liquidity and are supplemented by funds derived from capital markets including its bank facilities. The Company has available for the funding of its operations an $800,000,000 revolving demand line of credit. As of March 10, 1994 approximately $299,700,000 was available and unused under this facility. During 1993, approximately $262,500,000 was spent on capital additions. Capital spending, primarily to enhance distribution capabilities, is anticipated to approximate $150,000,000 to $175,000,000 in 1994. In December 1993, the Company completed the issuance of $150,000,000 of notes due 2003 and $150,000,000 of debentures due 2023 (collectively, the "Offering"). The net proceeds of the Offering of approximately $294,000,000 were used to repay amounts outstanding under the New Credit Agreement (hereinafter defined) and will be available for general corporate purposes, which may include acquisitions. In November 1993 the Company completed the Salem Acquisition. The total funds required to acquire Salem, including the repayment of certain debt of Salem and the fees and expenses of the Salem Acquisition, totalled approximately $157,600,000. Such funds were provided from borrowings under the New Credit Agreement. The Company does not have any present agreements or understandings with regard to future acquisitions other than the Artex Acquisition completed in January 1994 and the contract to acquire certain assets of Gitano entered into in March 1994 which are described below. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Concluded) Liquidity and Capital Resources - (Concluded) In January 1994 the Company completed the Artex Acquisition. The total funds required to acquire Artex totalled approximately $44,500,000. Such funds were provided from borrowings under the New Credit Agreement. In March 1994 the Company entered into a contract to purchase certain assets of Gitano for approximately $100,000,000. The total funds required to acquire Gitano will be provided from borrowings under the New Credit Agreement. Management believes the funding available to it is sufficient to meet anticipated requirements for capital expenditures, working capital and other needs. The Company's debt instruments, principally its bank agreements, contain covenants restricting its ability to sell assets, incur debt, pay dividends and make investments and requiring the Company to maintain certain financial ratios. See "Long-Term Debt" in the Notes to Consolidated Financial Statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FRUIT OF THE LOOM, INC. AND SUBSIDIARIES Report of Ernst & Young, Independent Auditors . . . . . . 34 Consolidated Balance Sheet - December 31, 1993 and 1992 . 35 Consolidated Statement of Earnings for Each of the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . 37 Consolidated Statement of Cash Flows for Each of the Years Ended December 31, 1993, 1992 and 1991 . . . . . 38 Notes to Consolidated Financial Statements . . . . . . . . 40 Supplementary Data (Unaudited) . . . . . . . . . . . . . . 80 Financial Statement Schedules: Schedule V - Property, Plant and Equipment . . . . . . 91 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment . . . . 92 Schedule VIII - Valuation and Qualifying Accounts . . . 93 Schedule IX - Short-Term Borrowings . . . . . . . . . . 94 Schedule X - Supplementary Income Statement Information . . . . . . . . . . . . . . . . . . . . . 95 Note: All other schedules are omitted because they are not applicable or not required. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS To the Board of Directors of Fruit of the Loom, Inc. We have audited the accompanying consolidated balance sheet of Fruit of the Loom, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings and cash flows for each of the three years in the period ended December 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Fruit of the Loom, Inc. and Subsidiaries at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as whole, present fairly in all material respects the information set forth therein. As discussed in the Notes to Consolidated Financial Statements, the Company changed its method of accounting for income taxes in 1993. ERNST & YOUNG Chicago, Illinois February 12, 1994 FRUIT OF THE LOOM, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET See accompanying notes. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS See accompanying notes. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying notes. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Summary of Significant Accounting Policies Principles of Consolidation. The consolidated financial statements of the Company include the accounts of the Company and all of its subsidiaries. All material intercompany accounts and transactions have been eliminated. Inventories. Inventory costs include material, labor and factory overhead. Inventories are stated at the lower of cost or market (net realizable value). Approximately 78.9% and 78.6% of year-end inventory amounts at December 31, 1993 and 1992, respectively, are determined using the last-in, first-out cost method. If the first-in, first-out method had been used, such inventories would have been $29,400,000 and $3,500,000 higher than reported at December 31, 1993 and 1992, respectively. The remainder of the inventories are determined using the first-in, first-out method. Property, Plant and Equipment. Property, plant and equipment is stated at cost. Depreciation, which includes amortization of assets under capital leases, is based on the straight-line method over the estimated useful lives of depreciable assets. Interest costs incurred in the construction or acquisition of property, plant and equipment are capitalized. Goodwill. Goodwill is amortized using the straight-line method over periods ranging from 20 to 40 years. Pre-operating Costs. Pre-operating costs associated with the start-up of significant new production facilities are deferred and amortized over three years. Futures Contracts. The Company periodically enters into futures contracts as hedges for its purchases of cotton for inventory. Gains and losses on these hedges are matched to inventory purchases and charged or credited to cost of sales as such inventory is sold. Forward Contracts. The Company has entered into forward contracts to cover its principal and interest obligations on foreign currency denominated bank loans of certain of its foreign subsidiaries. The original discount on these contracts is amortized over the life of the contract and serves to reduce the effective interest cost of these loans. At December 31, 1993 and 1992, the Company had contracts maturing in 1994 and 1993, totaling $22,800,000 and $55,200,000, respectively. In addition, the Company had entered into forward contracts to cover the future obligations of certain foreign subsidiaries for certain inventory and fixed asset purchases. At December 31, 1992, the Company had contracts which matured in 1993 totaling approximately $10,000,000. The fair value of the Company's foreign currency exchange forward contracts was estimated based on quoted market prices of comparable contracts. At December 31, 1993 and 1992, the fair value of the Company's forward contracts approximated their face value. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Summary of Significant Accounting Policies - (Concluded) Deferred Grants. Commencing in 1987 and during 1993 and 1992, the Company negotiated grants from the governments of the Republic of Ireland and of Northern Ireland. The grants are being used for employee training, the acquisition of property and equipment and other governmental business incentives such as general employment. Employee training grants are recognized in income in the year in which the costs to which they relate are incurred by the Company. Grants for the acquisition of property and equipment are netted against the related capital expenditure. Grants for property and equipment under operating leases are amortized to income as a reduction of rents paid. Unamortized amounts netted against fixed assets under these grants at December 31, 1993 and 1992, were $28,500,000 and $27,700,000, respectively. At December 31, 1993 and 1992, the Company has a contingent liability to repay, in whole or in part, grants received of approximately $43,500,000 and $42,100,000, respectively, in the event that the Company does not meet defined average employment levels or terminates operations in the Republic of Ireland or Northern Ireland. Income Taxes. Effective January 1, 1993, the Company adopted Statement No. 109. Under Statement No. 109, the liability method is used in accounting for income taxes. Prior to the adoption of Statement No. 109 income tax expense was determined using the deferred method. Pension Plans. The Company maintains pension plans which cover substantially all employees. The plans provide for benefits based on an employee's years of service and compensation. The Company funds the minimum contributions required by the Employee Retirement Income Security Act of 1974. Acquisition of Salem In November 1993 the Company acquired Salem for approximately $157,600,000, including approximately $23,900,000 of Salem debt which was repaid by the Company. The Salem Acquisition has been accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated preliminarily to assets and liabilities based on their estimated fair values as of the date of the Salem Acquisition. A final allocation of the purchase price will be made during 1994. The cost in excess of the net assets acquired was approximately $112,000,000 and is being amortized over 20 years. Salem's results of operations have been included in the Company's consolidated financial statements since November 1993. Salem's operations are not material in relation to the Company's consolidated financial statements and pro forma financial information has therefore not been presented. Cash, Cash Equivalents and Restricted Cash The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Short-term investments (consisting primarily of certificates of deposit, overnight deposits or Eurodollar deposits) totaling $16,100,000 and $31,100,000 were included in cash and cash equivalents at December 31, 1993 and 1992, respectively. These investments were carried at cost, which approximated quoted market value. Included in short-term investments at December 31, 1993 and 1992 was $6,400,000 and $13,800,000, respectively, of restricted cash collateralizing domestic and certain foreign subsidiaries' letters of credit and bank loans of certain of the Company's foreign subsidiaries. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Short-Term Notes Payable In August 1993, the Company entered into a new unsecured bank agreement (the "New Credit Agreement"). See "Long-Term Debt." Certain indebtedness of the Company under preexisting secured domestic bank agreements was refinanced with the proceeds of loans under the New Credit Agreement and the preexisting bank agreements were terminated at that time. Prior to August 1993, the Company's domestic bank agreements consisted of revolving lines of credit, bank term loans (the"Term Loan Facilities"), a special purpose loan, a capital expenditure facility (the "Capital Expenditure Facility") and a letter of credit facility (collectively, the "Credit Agreements"). All borrowings under the Credit Agreements represented loans to the Company's principal operating subsidiary. Under the Credit Agreements, the Company had $350,000,000 available for the funding of its operations under revolving lines of credit (the "Revolving Credit Facilities"). The Revolving Credit Facilities were scheduled to expire on June 30, 1995. At December 31, 1992, the Company had borrowed, under its Revolving Credit Facilities, approximately $163,600,000 of which $100,000,000 was classified as long-term debt as a result of the Company's refinancing of this debt on a long-term basis in February 1993. The carrying amounts of the Company's borrowings under the Revolving Credit Facilities approximated their fair value at December 31, 1992. Borrowings under the Revolving Credit Facilities bore interest at a rate approximating the prime rate (6% at December 31, 1992) or, at the election of the Company, at a rate approximating one percentage point over LIBOR (approximately 3.5% at December 31, 1992). The weighted average interest rate for borrowings outstanding at December 31, 1992 was approximately 5%. Borrowings under the Revolving Credit Facilities were due on demand and were collateralized under the terms of the Credit Agreements. The Credit Agreements were refinanced during 1993. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Long-Term Debt (In thousands of dollars) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Long-Term Debt - (Continued) The New Credit Agreement provides the Company with an $800,000,000 revolving line of credit which expires in August 1996 and includes a letter of credit facility. At December 31, 1993 approximately $59,800,000 of letters of credit were issued under the New Credit Agreement to secure certain insurance and debt obligations reflected in the accompanying Consolidated Balance Sheet. Borrowings under the New Credit Agreement bear interest at a rate approximating the prime rate (6% at December 31, 1993) or, at the election of the Company, at rates approximating LIBOR (3.25% at December 31, 1993) plus 30 basis points. The Company also pays a facility fee (the "Facility Fee") under the New Credit Agreement equal to 20 basis points on the aggregate commitments thereunder. Interest rates and the Facility Fee are subject to increase or decrease based upon the Company's unsecured debt rating. The weighted average interest rate for borrowings outstanding under the New Credit Agreement at December 31, 1993 was approximately 4.3%. Borrowings under the New Credit Agreement are guaranteed by certain of the Company's subsidiaries. In August 1993, the Company's wholly-owned subsidiary, Fruit of the Loom Canada, Inc. issued an unsecured senior note due 2008 (the "Canadian Note") in a private placement transaction with certain insurance companies. The Canadian Note is fully guaranteed by the Company and its principal operating subsidiaries and ranks pari passu in right of payment with the New Credit Agreement. In 1993, the Company redeemed its 12-3/8% Notes. The Company recorded an extraordinary charge in 1993 of approximately $8,700,000 ($.11 per share) relating to the early extinguishment of debt, primarily in connection with the refinancing of the Credit Agreements and the redemption of the 12-3/8% Notes. The extraordinary charge consists principally of the non-cash write- off of the related unamortized debt expense on the Credit Agreements, the 12-3/8% Notes and other debt issues and the premiums paid in connection with the early redemption of the 12- 3/8% Notes, both net of income tax benefits. In 1993, the Company issued $150,000,000 principal amount of its 6-1/2% Notes due 2003 (the "6-1/2% Notes") and $150,000,000 principal amount of its 7-3/8% Debentures due 2023 (the "7-3/8% Debentures"). The 6-1/2% Notes and the 7-3/8% Debentures will mature November 15, 2003 and November 15, 2023, respectively, and may not be redeemed by the Company prior to maturity. The 6-1/2% Notes and the 7-3/8% Debentures are general, unsecured obligations of the Company. However, the obligations of the Company under the New Credit Agreement and the Canadian Note are guaranteed by certain of the Company's subsidiaries and such debt effectively ranks ahead of the 6-1/2% Notes and the 7-3/8% Debentures with respect to such guarantees. In addition to refinancing its Revolving Credit Facilities under the New Credit Agreement, the Company also refinanced its Term Loan Facilities and its Capital Expenditure Facility. Under the terms of the Credit Agreements, the Company had a term loan which required quarterly principal payments with final maturity at June 30, 1995. The Company also had an additional $100,000,000 term loan which had a final maturity of June 30, 1995. Borrowings under the Term Loan Facilities were collateralized under the terms of the Credit Agreements on a pari passu basis with borrowings under the Revolving Credit Facilities. All borrowings under the Term Loan Facilities were repaid through borrowings under the New Credit Agreement in 1993. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Long-Term Debt - (Continued) Under the Credit Agreements, the Company originally had a Capital Expenditure Facility of up to $75,000,000 to be drawn down at various times prior to March 31, 1991, if necessary, to finance capital expenditures. At December 31, 1992, $44,100,000 was outstanding under the Capital Expenditure Facility and no additional borrowings were available under this facility. The Capital Expenditure Facility required quarterly principal payments which commenced in June 1991 with final maturity scheduled on June 30, 1995. All borrowings under the Capital Expenditure Facility were repaid through borrowings under the New Credit Agreement in 1993. Under the Credit Agreements, the Company had a letter of credit facility of $75,000,000. At December 31, 1992 approximately $71,300,000 of letters of credit were issued under this facility to secure certain insurance and debt obligations reflected in the accompanying Consolidated Balance Sheet. These letters of credit were refinanced through the New Credit Agreement in 1993. During 1993, the Company entered into a new facility loan (the "New Term Loan") which replaced a previous loan (the "Old Domestic Facility Loan"), the borrowings under which were secured by one of the Company's domestic facilities. At December 31, 1993 $40,000,000 was outstanding under the New Term Loan and no additional borrowings were available under this facility. The New Term Loan matures in December 1998 and is unsecured. The New Term Loan bears interest at a rate approximating one-eighth of a percentage point over the prime rate or, at the election of the Company, at a rate approximating seven-eighths of a percentage point over LIBOR. Interest rates are subject to increase or decrease based upon the Company's unsecured debt rating. The weighted average interest rate for borrowings outstanding under the New Term Loan at December 31, 1993 was approximately 4.1%. At December 31, 1992, $41,900,000 was outstanding under the Old Domestic Facility Loan and no additional borrowings were available under this facility. The Old Domestic Facility Loan required semi-annual principal payments with final maturity at July 15, 1998. The Old Domestic Facility Loan bore interest at a rate approximating two and one-half percentage points over the rate on certain United States Treasury securities or 1.3 percentage points over LIBOR at the election of the Company. The Company has an agreement with an institutional lender to provide funding to certain of the Company's foreign subsidiaries (the "Foreign Facility Loans"). At December 31, 1993 and 1992, $22,100,000 and $53,600,000, respectively, was outstanding under this agreement. The Foreign Facility Loans require semi-annual principal payments which commenced in 1992. In 1993, the Foreign Facility Loans bore interest at effective rates ranging from approximately .5% to 9.2%. The Foreign Facility Loans are secured by letters of credit issued under the New Credit Agreement, restricted cash balances and inventory, receivables and fixed assets of certain foreign subsidiaries. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Long-Term Debt - (Concluded) In 1992, the Company issued $250,000,000 principal amount of its 7-7/8% Senior Notes Due 1999 (the "7-7/8% Notes"). The 7- 7/8% Notes will mature on October 15, 1999 and may not be redeemed by the Company prior to maturity. The 7-7/8% Notes are general, unsecured obligations of the Company and rank pari passu in right of payment with all existing and future senior obligations of the Company. However, the obligations of the Company under the New Credit Agreement and the Canadian Note are guaranteed by certain of the Company's subsidiaries and such debt effectively ranks ahead of the 7-7/8% Notes with respect to such guarantees. In 1992, the Company redeemed all of its 10-3/4% Notes. The redemption was funded through borrowings under the Credit Agreements and the proceeds from the issuance of the 7-7/8% Notes. The Company recorded an extraordinary charge of approximately $9,900,000 ($.13 per share) in connection with the redemption of the 10-3/4% Notes, which consisted principally of the premiums paid in connection with the early redemption of the 10-3/4% Notes and the non-cash write-off of the related unamortized debt expense, both net of income tax benefits. The New Credit Agreement imposes certain limitations on, and requires compliance with covenants from, the Company and its subsidiaries including, among other things: (i) maintenance of certain financial ratios and compliance with certain financial tests and limitations; (ii) limitations on incurrence of additional indebtedness and granting of certain liens and guarantees; and (iii) restrictions on mergers, sale and leaseback transactions, asset sales and investments. The New Credit Agreement also allows the Company to pay dividends on its common stock so long as, among other things, the aggregate amount of such dividends paid since August 16, 1993 does not exceed the sum of $75,000,000 and fifty percent of the Company's consolidated net earnings since June 30, 1993. The New Credit Agreement provides for the acceleration of amounts outstanding thereunder should any person or entity other than William Farley, or any person or entity controlled by William Farley, control more than 50% of the voting stock or voting rights associated with such stock of the Company. The aggregate amount of scheduled annual maturities of long-term debt for each of the next five years is: $34,000,000 in 1994; $22,600,000 in 1995; $343,900,000 in 1996; $22,500,000 in 1997; and $50,300,000 in 1998. Cash payments of interest on debt were $67,100,000, $89,700,000 and $124,100,000 in 1993, 1992 and 1991, respectively. These amounts exclude amounts capitalized. The fair values of the Company's non-publicly traded long- term debt were estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Fair values for publicly traded long-term debt were based on quoted market prices. At December 31, 1993 and 1992, the fair value of the Company's long-term debt was approximately $1,305,800,000 and $928,700,000, respectively. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Contingent Liabilities The Company and its subsidiaries are involved in certain legal proceedings and have retained liabilities, including certain environmental liabilities, such as those under Superfund Legislation, in connection with the sale of certain discontinued operations, some of which were significant generators of hazardous waste. The Company's retained liability reserves at December 31, 1993 related to discontinued operations, consisting primarily of certain environmental reserves of approximately $46,200,000, reflect management's belief that the Company will recover at least $28,600,000 from insurance and other sources. Management and outside environmental consultants evaluate, on a site-by-site basis, the extent of environmental damage, the type of remediation that will be required and the Company's proportionate share of those costs. The Company's retained liability reserves related to discontinued operations principally pertain to ten specifically identified environmental sites. Four sites individually represent more than 10% of the net reserve and in the aggregate represent approximately 67% of the net reserve. Management believes they have adequately estimated the impact of remediating identified sites, the expected contribution from other potentially responsible parties and recurring costs for managing sites. Management currently estimates actual payments before recoveries to range from approximately $8,500,000 to $17,700,000 annually between 1994 and 1997 and $22,000,000 in total subsequent to 1997. Only the long-term monitoring costs of approximately $7,500,000, primarily scheduled to be paid in 1998 and beyond, have been discounted. The discount rate used was 10%. The undiscounted aggregate long-term monitoring costs, to be paid over approximately the next 20 years, is approximately $19,500,000. Management believes that adequate reserves have been established to cover potential claims based on facts currently available and current Superfund Legislation. The Company has provided the foregoing information in accordance with the recently issued Staff Accounting Bulletin 92. Generators of hazardous wastes which were disposed of at offsite locations which are now superfund sites are subject to claims brought by state and Federal regulatory agencies under Superfund Legislation and by private citizens under Superfund Legislation and common law theories. Since 1982, the EPA has actively sought compensation for response costs and remedial action at offsite disposal locations from waste generators under the Superfund Legislation, which authorizes such action by the EPA regardless of fault, legality of original disposal or ownership of a disposal site. The EPA's activities under the Superfund Legislation can be expected to continue during 1994 and future years. In August 1991, two creditors of a former subsidiary, Lone Star (a wholly owned subsidiary of Lone Star Technologies, Inc., a publicly owned company) brought suit against the Company in the Superior Court of the State of Delaware. In this suit, the creditors sought damages of approximately $13,100,000, plus interest, against the Company for what they alleged was the remaining liability under certain leases. In January 1993, the superior Court of Delaware issued an Opinion and Order finding that the leases were in default, but made no findings as to the amount of damages. The Company appealed the ruling and on June 4, 1993 the Supreme Court of Delaware entered an order affirming the Opinion and Order of the Superior Court of Delaware issued in January 1993. In December 1993, the Company paid the lessors approximately $9,500,000 in settlement of this suit. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Contingent Liabilities - (Continued) In February 1986, the Company completed the sale of stock of its then wholly owned subsidiary, Universal, to MagneTek. At the time of the sale there was a suit pending against Universal and Northwest by LMP. The suit alleged that Universal and Northwest fraudulently induced LMP to sell its business to Universal and then suppressed the development of certain electronic lighting ballasts in breach of the agreement of sale, which required Universal to pay to LMP a percentage of the net profits from such business from 1982 through 1986. Two additional plaintiffs, Stevens Luminoptics Partnership and Calmont Technologies Inc., joined the litigation in 1986. In December 1989 and January 1990, a jury returned certain verdicts against Universal and also returned verdicts in favor of Northwest and on certain issues in favor of Universal. A judgment totalling $25,800,000, of which $7,500,000 represented punitive damages, reflecting these verdicts was entered by the Alameda County, California Superior Court in January 1990 against Universal. In April 1992, the California Court of Appeals reversed the $25,800,000 judgment against Universal and affirmed those verdicts favorable to Universal and Northwest. In July 1992, the California Supreme Court denied the plaintiffs' petition for review. The case has been remanded to the trial court where it is scheduled to be retried beginning in March 1994. Pursuant to the stock purchase agreement (the "Stock Purchase Agreement") under which Universal was sold, the Company agreed to indemnify MagneTek for a two-year period following the sale of Universal for certain contingent liabilities. MagneTek brought suit against the Company for declaratory and other relief in connection with the indemnification under the Stock Purchase Agreement. In April 1992, the Los Angeles County, California Superior Court found that the Company was obligated by the Stock Purchase Agreement to indemnify MagneTek for any liability that may be assessed against MagneTek or Universal in the LMP Litigation and to reimburse MagneTek for, among other things, its costs and expenses in defending that case. The court entered a judgment requiring the Company to reimburse and indemnify MagneTek in two stages: currently, to reimburse MagneTek for costs of defense and related expenses in the LMP Litigation, plus costs of litigating the indemnity case with the Company; and at a later date, if and when any liability in the LMP Litigation is finally determined or a settlement is reached in that case, to reimburse and/or indemnify MagneTek for that amount as well. In 1993 the Company paid approximately $9,600,000 in settlement of its obligations to MagneTek related to the litigation expenses incurred by MagneTek. In March 1988, a class action suit entitled Endo et al. v. Albertine, et al. was filed in the District Court against the Company, its then directors, certain of its then executive officers, its then underwriters and the Company's current and former independent auditors in connection with the Company's initial public offering of Class A Common Stock and certain debt securities in March 1987. The suit alleges, among other things, violations of Federal and state securities laws against all of the defendants, as well as breaches of fiduciary duties by the director and officer defendants, and seeks unspecified damages. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Contingent Liabilities - (Concluded) Motions to dismiss the complaint were filed by all defendants. In December 1990, a magistrate judge recommended that the District Court dismiss all of the plaintiffs' claims with prejudice. In January 1993, the District Court adopted in part and rejected in part the magistrate judge's recommendation for dismissal of the complaint. As a result, the litigation will continue as to various remaining counts of the complaint. Both the defendants and the plaintiffs recently filed motions for summary judgment. It is uncertain as to when rulings on these motions will be issued. Management and the Board of Directors believe that this suit is without merit and intend to continue to defend themselves vigorously in this litigation. On December 23, 1993, James J. Locke, as Trustee of Locke Family Trust, and I. Jack Saline filed a lawsuit against the Company and certain of its then officers and directors, including William Farley and John B. Holland in the District Court. The lawsuit was then amended to add additional plaintiffs. The lawsuit was filed as a class action, but the issue of class certification has not yet been addressed by the parties or the court. The plaintiffs claim that all of the defendants engaged in conduct violating Section 10b of the Securities Exchange Act of 1934 and that Mr. Farley and Mr. Holland also violated Section 20a of the Act. According to the plaintiffs, beginning before June 1992 and continuing through early June 1993, the Company, with the knowledge and assistance of the individual defendants, issued positive public statements about its expected sales increases and growth through 1993 and afterwards. They also allege that beginning in approximately mid-1992 and continuing afterwards, the Company's business was not as strong and its growth prospects were not as certain as represented. The plaintiffs further allege that during the end of 1992 and beginning of 1993, certain of the individual defendants traded the stock of the Company while in the possession of material, non-public information. The plaintiffs ask for unspecified amounts as compensatory damages, pre-judgment and post-judgment interest, attorneys' fees, expert witness fees and costs and ask the District Court to impose a constructive trust on the proceeds of the individual defendants' trades to satisfy any potential judgment. Although the lawsuit is at a preliminary stage, the Company believes that this suit is without merit and intends to defend itself vigorously in this litigation. Management believes, based on information currently available, that the ultimate resolution of the aforementioned litigation will not have a material adverse effect on the financial condition or operations of the Company. In 1992, the Company was named in a suit seeking to enforce the terms of a former subsidiary's lease on which the Company was contingently obligated. The Company paid approximately $17,500,000 in 1992 in settlement of the suit and its contingent obligations under the lease. In connection with the Company's transaction with Acme Boot during 1993, the Company guaranteed, on an unsecured basis, the repayment of debt incurred or created by Acme Boot under Acme Boot's bank credit facility. See "Related Party Transactions." At December 31, 1993 Acme Boot's bank credit facility provides for up to $30,000,000 of loans and letters of credit subject to a borrowing base. Acme Boot's bank credit facility is secured by first liens on substantially all of the assets of Acme Boot and its subsidiaries (which are approximately $80,000,000 at December 31, 1993). At December 31, 1993 approximately $9,000,000 in loans and letters of credit were outstanding under Acme Boot's bank credit facility. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Lease Commitments The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities and equipment. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. The leases on most of the properties contain renewal provisions. Following is a summary of future minimum payments under capitalized leases and under operating leases that have initial or remaining noncancelable lease terms in excess of one year at December 31, 1993 (in thousands of dollars): Assets recorded under capital leases are included in Property, Plant and Equipment as follows (in thousands of dollars): Rental expense for operating leases amounted to $11,600,000, $9,100,000 and $8,200,000 in 1993, 1992 and 1991, respectively. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Stock Plans At December 31, 1993 and 1992, approximately 1,546,600 and 1,653,000 shares, respectively, of Class A Common Stock were reserved for issuance under the Company's 1987 Stock Option Plan (the "Plan"). Under the terms of the Plan, options may be granted to eligible employees of the Company, its parent and its subsidiaries at a price not less than the market price on the date of grant. Option shares must be exercised within the period prescribed by the Compensation Committee of the Board of Directors at the time of grant but not later than ten years and one day from the date of grant. The Plan provides for the granting of qualified and nonqualified stock options. The following summarizes the activity of the Plan for 1993: In 1993, the Company's stockholders approved the Company's Directors' Stock Option Plan (the "Directors' Plan"). The Directors' Plan provides for the issuance of options to purchase up to 175,000 shares of Class A Common Stock, which shares are reserved and available for purchase upon the exercise of options granted under the Directors' Plan. Only directors who are not employees of the Company, any parent or subsidiary of the Company or Farley Industries, Inc. ("FII") are eligible to participate in the Directors' Plan. The Directors' Plan is administered by the Company's Board of Directors. Under the Directors' Plan each non-employee director is initially granted an option to purchase 7,500 shares of Class A Common Stock (the "Initial Options"). On the date of each annual meeting at which such person is elected or after which the person continues as a non-employee director, such non-employee director shall be granted an option to purchase 2,500 shares of Class A Common Stock (the "Annual Options"). The options are exercisable at a price per share equal to the fair market value per share of the Class A Common Stock on the date of grant. Option shares must be exercised not later than ten years from the date of grant and do not become exercisable until the first anniversary of the date of grant. The following summarizes the activity of the Directors' Plan for 1993: FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Stock Plans - (Concluded) In 1992, the Company established the 1992 Executive Stock Option Plan (the "1992 Plan"). The 1992 Plan provides for the issuance of options to purchase up to 975,000 shares of Class A Common Stock, which shares are reserved and available for purchase upon the exercise of stock options granted under the 1992 Plan. The 1992 Plan is administered by the Compensation Committee of the Board of Directors. In 1992, options to purchase 975,000 shares of Class A Common Stock were granted under the 1992 Plan to two directors of the Company who are also employees of the Company. The options are exercisable at a price of $28.88 per share (which was the closing price of the Class A Common Stock on the date of grant). Pursuant to the terms of the grants, options for the shares vest (subject to acceleration under certain circumstances) as follows: (i) one-third of the options granted vest immediately upon grant; (ii) one-third of the options granted vest if the closing price of the Class A Common Stock reaches or exceeds $45 per share for 90 consecutive days within six years from the date of grant; and (iii) the remaining one-third of the options granted vest if the closing price of the Class A Common Stock reaches or exceeds $60 per share for 90 consecutive days within six years from the date of grant. All vested options expire 10 years and one day after the date of grant. Options which do not vest because the Company's stock price has not reached the targeted price levels for vesting expire six years after the date of grant. As of December 31, 1993, 325,000 of these options are exercisable and none of these options have been exercised or canceled. In July 1991, the Company granted an option to purchase 50,000 shares of the Class A Common Stock to a director of the Company who is also an employee of FII at a purchase price of $10.25 per share. The exercise period of the option terminates ten years and one day from the date of grant. At the date of grant the market price of the Class A Common Stock was $15 and, accordingly, the Company recorded a charge to earnings of approximately $200,000 in 1991. As of December 31, 1993, none of these options have been exercised or canceled. At December 31, 1993 and 1992, approximately 268,000 and 280,000 shares, respectively, of Class A Common Stock were reserved for issuance under the Company's 1989 Stock Grant Plan. Under the terms of this plan, eligible employees of the Company, its parent and its subsidiaries are awarded shares, subject to forfeitures or certain restrictions which generally expire three years from the date of the grant. Shares are awarded in the name of the employee, who has all the rights of a shareholder, subject to the above mentioned restrictions. The Company canceled 3,900 previously issued shares during 1993. The Company granted approximately 15,900 shares to eligible employees during 1993. At December 31, 1993 and 1992, approximately 344,900 and 396,700 shares, respectively, of Class A Common Stock were reserved for issuance under the Company's 1987 Long-Term Bonus Plan. Under the terms of this plan, eligible employees of the Company's operating subsidiary participate in cash and stock bonus pools for four year plan periods. Awards under this plan are payable in a combination of cash and stock. No new four year plan period began subsequent to December 31, 1990. The Company issued approximately 51,800 shares to eligible employees during 1993. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Consolidated Statement of Common Stockholders' Equity Holders of Class A Common Stock are entitled to receive, on a cumulative basis, the first dollar per share of dividends declared. Thereafter, holders of Class A Common Stock and Class B Common Stock will share ratably in any dividends declared. Each share of Class A Common Stock is entitled to one vote and each share of Class B Common Stock is entitled to five votes. The Class B Common Stock is convertible into the Class A Common Stock on a share for share basis. In May 1991, the Company completed the Stock Offering. The proceeds were used by the Company to prepay its $38,000,000 special purpose term loan, which was obtained in March 1991, and to prepay $63,500,000 of its Term Loan Facilities. FI and William Farley combined also sold 5,250,000 shares in the Stock Offering. In July 1991, the Company called for redemption all of its Debentures due March 1, 2002 totaling $59,900,000. All of the Debentures were converted into Class A Common Stock of the Company at a conversion price of $11.25 per share. Approximately 5,325,000 shares were issued in the Conversion. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Consolidated Statement of Common Stockholders' Equity - (Concluded) As a result of the Stock Offering, other issuances of Class A Common Stock (primarily through the Conversion) during 1991 and the disposition of certain shares by FI during 1991, 1992 and 1993, approximately 9.3% of the Company's common stock at December 31, 1993 is held by FI and William Farley. Because these affiliates hold all of the Class B Common Stock of the Company outstanding, which has five votes per share, they control approximately 33% of all voting rights of the Company. All actions submitted to a vote of stockholders are voted on by holders of Class A Common Stock and Class B Common Stock voting together as a single class, except for the election of directors. With respect to the election of directors, holders of the Class A Common Stock vote as a separate class and are entitled to elect 25% of the total number of directors constituting the entire Board of Directors and, if not a whole number, then the holders of the Class A Common Stock are entitled to elect the nearest higher whole number of directors that is at least 25% of the total number of directors. If, at the record date for any stockholder meeting at which directors are elected, the number of shares of Class B Common Stock outstanding is less than 12.5% of the total number of shares of both classes of common stock outstanding, then the holders of Class A Common Stock would vote together with the holders of Class B Common Stock to elect the remaining directors to be elected at such meeting, with the holders of Class A Common Stock having one vote per share and the holders of Class B Common Stock having five votes per share. At December 31, 1993, FI and William Farley's combined ownership of Class B Common Stock is approximately 8.8% of the total common stock of the Company outstanding. As a result, Mr. Farley does not have the sole ability to elect those members of the Company's Board of Directors who are not separately elected by the holders of the Company's Class A Common Stock. Business Segment and Major Customer Information The Company operates in only one business segment consisting of the manufacturing and marketing of basic apparel. Sales to one customer amounted to approximately 13.4%, 11.8% and 9.6% of consolidated net sales in 1993, 1992 and 1991, respectively. Additionally, sales to a second customer amounted to approximately 12.3%, 10.2% and 8.8% of consolidated net sales in 1993, 1992 and 1991, respectively. Sales, operating earnings and identifiable assets are as follows (in thousands of dollars): FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Business Segment and Major Customer Information - (Concluded) Corporate assets presented above consist primarily of cash and other short-term investments, deferred financing costs, the investment in Acme Boot in 1992 and 1991 and, in 1991, income taxes and interest receivable. Pension Plans Pension expense was $5,500,000, $4,900,000 and $3,000,000 in 1993, 1992 and 1991, respectively. The net pension expense is comprised of the following (in thousands of dollars): The following table sets forth the funded status of the plans and amounts recognized in the Company's Consolidated Balance Sheet (in thousands of dollars): FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Pension Plans - (Concluded) The discount rate for purposes of determining the funded status of the plans at December 31, 1993 and 1992 was 7.75% and 9%, respectively. Plan assets, which are primarily invested in United States Government and corporate debt securities, equity securities, real estate and fixed income insurance contracts, are commingled in a master trust which includes the assets of the pension plans of substantially all affiliated companies controlled directly and indirectly by William Farley (the "Master Trust"). Plan assets, except those that are specifically identified to a particular plan, are shared by all of the plans in the Master Trust ("Allocated Assets"). Any gains and losses associated with the Allocated Assets are spread among each of the plans based on each plan's respective share of the total Allocated Assets' market value. The Company's plan assets represent approximately 51.8% and 32.7% of the Master Trust Allocated Assets at December 31, 1993 and 1992, respectively. Included in the Master Trust Allocated Assets at December 31, 1993 and 1992 were 647,852 and 1,007,860 shares,respectively, (with a cost of $5,100,000 and $7,900,000, respectively, and a market value of $15,600,000 and $49,000,000, respectively) of the Company's Class A Common Stock. Also included in the Master Trust Allocated Assets at December 31, 1991 was $7,000,000 principal amount (with a market value of $400,000) of West Point Acquisition Corp. 18.75% Subordinated Increasing Rate Notes due April 6, 1996. West Point Acquisition Corp. was formerly a majority owned subsidiary of FI. Such debentures were sold by the Master Trust in 1992 for approximately $1,600,000. As of December 31, 1993 and 1992, the Master Trust holds 348,000 shares (with a cost of $7,700,000 and a market value of $8,400,000 and $16,900,000, respectively) of the Company's Class A Common Stock that is specifically identified to the retirement plans of FI. Any change in market value associated with these shares is allocated entirely to the FI plans and does not effect the Master Trust Allocated Assets. Depreciation Expense Depreciation expense, including amortization of capital leases, approximated $84,300,000, $67,800,000 and $58,900,000 in 1993, 1992 and 1991, respectively. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Income Taxes Income taxes are included in the Consolidated Statement of Earnings as follows (in thousands of dollars): Included in earnings before extraordinary items and cumulative effect of change in accounting principle are foreign earnings of $17,000,000, $34,600,000 and $16,600,000, in 1993, 1992 and 1991, respectively. The components of income tax expense (benefit) related to earnings before extraordinary items and cumulative effect of change in accounting principle were as follows (in thousands of dollars): FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Income Taxes - (Continued) Deferred income taxes related to earnings before extraordinary items and cumulative effect of change in accounting principle were as follows (in thousands of dollars): The income tax rate on earnings before extraordinary items and cumulative effect of change in accounting principle differed from the Federal statutory rate as follows: Deferred income taxes are provided for temporary differences between income tax and financial statement recognition of revenues and expenses. Deferred tax liabilities (assets) are comprised of the following (in thousands of dollars): FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Income Taxes - (Concluded) Effective January 1, 1993, the Company recorded the cumulative effect of a change in accounting principle related to the initial adoption of Statement No. 109 resulting in a $3,400,000 ($.04 per share) benefit. The Company paid the IRS approximately $28,300,000 in 1993 in settlement of Federal income tax assessments for the tax periods ended December 31, 1984 and July 31, 1985 (the final predecessor tax periods). This amount included approximately $14,800,000 of accrued interest. The Company had previously established reserves for these matters and these payments did not have an impact on the current year's tax provision. The IRS previously asserted income tax deficiencies, excluding statutory interest which accrues from the date the tax was due until payment, for the Company of approximately $93,000,000 for the years 1978-1980 and $15,400,000 for the years 1981-1983. The Company had protested the IRS's asserted tax deficiencies for these six years with respect to a number of issues and also had raised certain affirmative tax issues that bear on these years. Settlement agreements with respect to all the 1978-1980 and 1981-1983 protested and affirmative issues resulted in the Company receiving a refund of approximately $5,900,000, including interest, in January 1993. In an unrelated matter, the IRS declined to seek United States Supreme Court review of a decision by the United States Court of Appeals for the Third Circuit which reversed a lower court ruling and directed the lower court to order a refund to the Company of approximately $10,500,000 in Federal income taxes collected from a predecessor of the Company, plus approximately $49,400,000 in interest. The Company received the full refund of approximately $60,000,000 in March 1992. However, in September 1992 the IRS issued a statutory notice of deficiency in the amount of approximately $7,300,000 for the taxable years from which the March 1992 refund arose, exclusive of interest which would accrue from the date the IRS asserted the tax was due until payment, presently a period of about 24 years. Based on discussions with tax counsel, the Company believes that the asserted legal basis for the IRS's position in this matter is without merit and that the ultimate resolution will not have a material effect on the financial condition or the operations of the Company. Cash payments for income taxes were $137,500,000, $131,600,000 and $80,200,000 in 1993, 1992 and 1991, respectively. Other Expense-Net Included in other expense-net in 1993, 1992 and 1991 is deferred debt fee amortization and bank fees of approximately $7,900,000, $10,100,000 and $9,000,000, respectively. Other expense-net in 1991 includes interest income of $49,400,000 on a court-ordered refund of Federal income taxes. See "Income Taxes." Other expense-net in 1991 also includes charges of $10,200,000 to provide for certain obligations and other matters related to former subsidiaries and $39,200,000 to write down the Company's investment in Acme Boot to its then market value. See "Related Party Transactions." FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Earnings Per Share Primary earnings per share are based on the weighted average number of common shares and equivalents outstanding during the year. Fully diluted earnings per share, for those periods prior to the Conversion, further assumed the conversion of the Debentures into Class A Common Stock and an increase in earnings to eliminate the after tax equivalent of interest expense on the Debentures. Related Party Transactions Under the terms of a management agreement between FII and the Company, FII provides the Company, to the extent that the Company may request, (i) general management services which include, but are not limited to, financial management, legal, tax, accounting, corporate development, human resource and personnel advice; (ii) investment banking services in connection with the acquisition or disposition of the assets or operations of a business or entity; (iii) financing services in connection with the arrangement by FII of public or private debt (including letter of credit facilities); and (iv) other financial, accounting, legal and advisory services rendered outside the ordinary course of the Company's business. FII is owned and controlled by Mr. Farley; its approximately 60 employees provide services to companies owned or controlled by Mr. Farley, including the Company. Certain of the executive officers of the Company, including Mr. Farley for periods prior to December 31, 1991, are employed by, and receive their compensation from, FII. These officers devote their time as needed to those companies owned and controlled by Mr. Farley and, accordingly, do not devote full time to any single company, including the Company. In consideration for investment banking and financing services, the Company pays FII fees established by FII and determined to be reasonable by FII in relation to (i) the size and complexity of the transaction; and (ii) the fees customarily charged by other advisors for similar investment banking and financing services; provided, such fees shall not exceed two percent of the total consideration paid or received by the Company or two percent of the aggregate amount available for borrowing or use under the subject agreement or facility. Fees for investment banking and financing services are generally payable to FII upon the closing of the subject transaction or agreement. Effective January 1993, the Company entered into a new management agreement (the "Management Agreement") with FII pursuant to which FII agreed to render substantially similar services to the Company as under the prior management agreements. Under the terms of a management agreement, the Company pays a fee to FII based on FII's cost of providing management services. The Company also paid a financing fee to FII during 1992 under the terms of a management agreement. The Company paid FII $9,900,000 in 1993 and $9,300,000 in 1992, of which approximately none and $2,300,000 was capitalized as deferred financing costs in 1993 and 1992, respectively. It is anticipated that the Company will enter into a management agreement for 1994 under substantially the same terms and conditions as the Management Agreement. FRUIT OF THE LOOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Concluded) Related Party Transactions - (Concluded) Concurrently with entering into the management agreement with FII in 1992, the Company's Board of Directors determined to employ Mr. Farley directly as Chairman and Chief Executive Officer of the Company. Mr. Farley did not receive compensation in 1993 or 1992 from FII for his services as Chairman and Chief Executive Officer of the Company. In consideration for general management services rendered prior to 1992, the Company paid FII an annual fee, subject to certain limitations imposed by the Company's Board of Directors, based on a percentage of net sales, which fees were limited to $10,000,000 in 1991. For the year ended December 31, 1991 the Company paid management service fees to FII of approximately $10,000,000. No financing fees were charged to the Company by FII in 1991. The Company completed the sale of the stock of Acme Boot at book value, which approximated fair market value, to an affiliate in June 1987 for an aggregate of $38,400,000 of cash and preferred stock and subordinated debentures of the affiliate. The Company recognized no earnings in 1992 or 1991 related to its investment in the securities of the affiliate because of the inability of the affiliate to make payments under the terms of the securities. In the fourth quarter of 1991, the Company recognized a pretax charge of $39,200,000 in other expense-net to write down its investment in Acme Boot to its then market value. In the fourth quarter of 1993, the Company received approximately $72,900,000 from Acme Boot representing the entire unpaid principal and liquidation preference (including accrued interest and dividends) on its investment in the securities of the affiliate. The Company recorded a pretax gain of approximately $67,300,000 in connection with the investment in Acme Boot upon the receipt of the above mentioned proceeds. See "Contingent Liabilities." FRUIT OF THE LOOM, INC. AND SUBSIDIARIES SUPPLEMENTARY DATA Quarterly Financial Summary (Unaudited) (In millions of dollars, except per share amounts) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company as of December 31, 1993 were as follows: Name Age Position William Farley 51 Chairman of the Board and Chief Executive Officer John B. Holland 61 President and Chief Operating Officer Richard C. Lappin 49 Vice-Chairman of the Board Richard M. Cion 50 Senior Executive Vice President- Corporate Development Michael F. Bogacki 39 Vice President and Controller Kenneth Greenbaum 49 Vice President and General Counsel Burgess D. Ridge 49 Vice President-Administration Earl C. Shanks 37 Vice President and Treasurer Officers serve at the discretion of the Board of Directors. Messrs. Farley (for periods prior to January 1, 1992), Lappin, Cion, O'Hara, Bogacki, Greenbaum, Ridge and Shanks are employed by FII which provides management services to companies owned or controlled by Mr. Farley. They devote their time to those companies as needed and, accordingly, do not devote full time to any single company, including the Company. Certain of the executive officers, as noted below, are also executive officers of FI and VBQ, Inc. ("VBQ"), formerly a defense contractor and an affiliate of FI. Certain of the executive officers, as noted below, were also executive officers of Valley Fashions Corp. (formerly West Point Acquisition Corp.). During 1992, FI and Valley Fashions Corp. emerged from bankruptcy proceedings and VBQ became the subject of a Chapter 7 liquidation. William Farley. Mr. Farley has been Chairman of the Board and Chief Executive Officer of the Company since May 1985. During the past five years, Mr. Farley has also been Chairman and Chief Executive Officer of FII. He has held substantially similar positions with FI since 1982, VBQ since 1984, West Point- Pepperell, Inc. ("West Point") from April 1989 until October 1992 and Valley Fashions Corp. from March 1989 until October 1992. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - (Continued) John B. Holland. Mr. Holland has been a director of the Company since November 1992 and President of the Company since May 1992. Mr. Holland has served as Chief Operating Officer of the Company for more than the past five years. Mr. Holland served as Vice Chairman of West Point from April 1989 until September 1992 and as a director of West Point from April 1989 until September 1992. Mr. Holland served as Vice Chairman of Valley Fashions Corp. from March 1989 until June 1990. Mr. Holland is also a director of Dollar General Corp. and First Kentucky National Corp. Richard C. Lappin. Mr. Lappin has been a director of the Company since December 1990 and Vice Chairman of the Company since October 1991. Mr. Lappin has been President and Chief Operating Officer of FII since February 1991. From October 1989 to February 1991, Mr. Lappin served in various capacities with FI, including President and Chief Executive Officer of the Doehler Jarvis and Southern Fastening Systems divisions of FI. From 1988 to October 1989, Mr. Lappin served as President of the North American Operations of the Champion Spark Plug Company, a manufacturer of automotive products. Richard M. Cion. Mr. Cion has been Senior Executive Vice President of the Company since June 1990, of FII since February 1990 and of West Point from February 1990 until October 1992. Mr. Cion was also a director of West Point from April 1989 until October 1992. Mr. Cion served as a director of Valley Fashions Corp. from April 1989 until June 1992. Mr. Cion was also Senior Executive Vice President of Valley Fashions Corp. from March 1992 until October 1992. From April 1988 to February 1990, Mr. Cion was a Managing Director with Drexel Burnham Lambert Incorporated, an investment banking firm. Paul M. O'Hara. Mr. O'Hara has been Executive Vice President and Chief Financial Officer of the Company, FII and FI since April 1988, West Point from April 1989 until November 1992 and Valley Fashions Corp from March 1989 until November 1992. Mr. O'Hara resigned from the Company effective March 1, 1994. Michael F. Bogacki. Mr. Bogacki has been Corporate Controller of the Company, FII and FI since October 1988. Mr. Bogacki was appointed Vice President of FII in November 1989, of the Company in May 1990 and of FI in June 1990. In June 1991, Mr. Bogacki was appointed Assistant Secretary of the Company. Mr. Bogacki was Corporate Controller of Valley Fashions Corp. from March 1989 until November 1992. Mr. Bogacki was also Vice President of Valley Fashions Corp. from June 1991 until November 1992. Kenneth Greenbaum. Mr. Greenbaum has served as Vice President, General Counsel and Secretary of the Company, FII and FI for more than the past five years. Mr. Greenbaum was Vice President of West Point from April 1989 until November 1992. Mr. Greenbaum served as Vice President of Valley Fashions Corp. from March 1989 until November 1992. During the past five years, Mr. Greenbaum has been General Counsel of VBQ. Burgess D. Ridge. Mr. Ridge was Assistant Treasurer of the Company, FII and FI from before 1989 until October 1991. Mr. Ridge was appointed Vice President Administration of FII and FI in August 1991 and of the Company in October 1991. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - (Concluded) Earl C. Shanks. Mr. Shanks served as Vice President-Taxes and Assistant Secretary of the Company, FII and FI from May 1986 until June 1991. In June 1991, Mr. Shanks became Treasurer of the Company, FII, FI and VBQ. Mr. Shanks was Vice President and Assistant Secretary of West Point from April 1989 until November 1992. Mr. Shanks served as Vice President-Taxes and Assistant Secretary of Valley Fashions Corp. from March 1989 until June 1991. Mr. Shanks was Vice President and Treasurer of Valley Fashions Corp. from June 1991 until November 1992. During the past five years Mr. Shanks has been Vice President-Taxes of VBQ. Information relating to the directors of the Company is set forth in the Registrant's proxy statement for its Annual Meeting of Stockholders to be held on May 17, 1994 (the "Proxy Statement") to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, and is hereby incorporated by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation is set forth in the Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, and is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to the security ownership of certain beneficial owners and management is set forth in the Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, and is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Under the terms of a management agreement between FII and the Company, FII provides the Company, to the extent that the Company may request, (i) general management services which include, but are not limited to, financial management, legal, tax, accounting, corporate development, human resource and personnel advice; (ii) investment banking services in connection with the acquisition or disposition of the assets or operations of any business or entity; (iii) financing services in connection with the arrangement by FII of public or private debt (including letter of credit facilities); and (iv) other financial, accounting, legal and advisory services rendered outside the ordinary course of the Company's business. FII is owned and controlled by Mr. Farley; its approximately 60 employees provide services to companies owned or controlled by Mr. Farley, including the Company. Certain of the executive officers of the Company, including Mr. Farley for periods prior to December 31, 1991, are employed by, and receive their compensation from, FII. These officers devote their time as needed to those companies owned and controlled by Mr. Farley and, accordingly, do not devote full time to any single company, including the Company. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - (Concluded) In consideration for investment banking and financing services, the Company pays FII fees established by FII and determined to be reasonable by FII in relation to (i) the size and complexity of the transaction; and (ii) the fees customarily charged by other advisors for similar investment banking and financing services; provided, such fees shall not exceed two percent of the total consideration paid or received by the Company or two percent of the aggregate amount available for borrowing or use under the subject agreement or facility. Fees for investment banking and financing services are generally payable to FII upon the closing of the subject transaction or agreement. Effective January 1993, the Company entered into a new management agreement (the "Management Agreement") with FII pursuant to which FII agreed to render substantially similar services to the Company as under the prior management agreement. Under the terms of a management agreement, the Company pays a fee to FII based on FII's cost of providing management services. The Company also paid a financing fee to FII during 1992 under the terms of a management agreement. The Company paid FII $9,900,000 in 1993 and $9,300,000 in 1992, of which approximately none and $2,300,000 was capitalized as deferred financing costs in 1993 and 1992, respectively. It is anticipated that the Company will enter into a management agreement for 1994 under substantially the same terms and conditions as the Management Agreement. Concurrently with entering into the new management agreement with FII in 1992, the Company's Board of Directors determined to employ Mr. Farley directly as Chairman and Chief Executive Officer of the Company. Mr. Farley did not receive compensation in 1993 or 1992 from FII for his services as Chairman and Chief Executive Officer of the Company. In consideration for general management services rendered prior to 1992, the Company paid FII an annual fee, subject to certain limitations imposed by the Company's Board of Directors, based on a percentage of net sales, which fees were limited to $10,000,000 in 1991. For the year ended December 31, 1991 the Company paid management service fees to FII of approximately $10,000,000. No financing fees were charged to the Company by FII in 1991. The Company completed the sale of the stock of Acme Boot at book value, which approximated fair market value, to an affiliate in June 1987 for an aggregate of $38,400,000 of cash and preferred stock and subordinated debentures of the affiliate. The Company recognized no income in 1992 or 1991 related to its investment in the securities of the affiliate because of the inability of the affiliate to make payments under the terms of the securities. In the fourth quarter of 1991, the Company recognized a pretax charge of $39,200,000 in other expense-net to write down its investment in Acme Boot to its then market value. In the fourth quarter of 1993, the Company received approximately $72,900,000 from Acme Boot representing the entire unpaid principal and liquidation preference (including accrued interest and dividends) on its investment in the securities of the affiliate. The Company recorded a pretax gain of approximately $67,300,000 in connection with the investment in Acme Boot. Information relating to certain relationships and related transactions is set forth in the Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, and is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial statements, financial statement schedules and exhibits 1. Financial Statements The financial statements listed in the index to Financial Statements and Supplementary Data on page 33 are filed as part of this Annual Report. 2. Financial Statement Schedules The schedules listed in the index to Financial Statements and Supplementary Data on page 33 are filed as part of this Annual Report. 3. Exhibits The exhibits listed in the Index to Exhibits on page 96 are filed as part of this Annual Report. (b) Reports on Form 8-K No report on Form 8-K was filed during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Chicago, State of Illinois, on March 21, 1994. FRUIT OF THE LOOM, INC. BY: MICHAEL F. BOGACKI (Michael F. Bogacki Vice President and Controller) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on March 21, 1994. Name Capacity WILLIAM FARLEY Chairman of the Board and (William Farley) Chief Executive Officer (Principal Executive Officer) and Director MICHAEL F. BOGACKI Vice President and (Michael F. Bogacki) Controller (Principal Accounting and Financial Officer) OMAR Z. AL ASKARI Director (Omar Z. Al Askari) DENNIS S. BOOKSHESTER Director (Dennis S. Bookshester) JOHN B. HOLLAND Director (John B. Holland) LEE W. JENNINGS Director (Lee W. Jennings) HENRY A. JOHNSON Director (Henry A. Johnson) RICHARD C. LAPPIN Director (Richard C. Lappin) A. LORNE WEIL Director (A. Lorne Weil) SIR BRIAN G. WOLFSON Director (Sir Brian G. Wolfson) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) FRUIT OF THE LOOM, INC. AND SUBSIDIARIES INDEX TO EXHIBITS (Item 14(a)(3) and 14(c)) Sequential Description page number 3(a)* - Restated Certificate of Incorporation of the Company and Certificate of Amendment of the Restated Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). 3(b)* - By-Laws of the Company (incorporated herein by reference to Exhibit 4(b) to the Company's Registration Statement on Form S-2, Reg. No. 33-8303 (the "S-2")). 4(a)* - $800,000,000 Credit Agreement dated as of August 16, 1993, among the several banks and other financial institutions from time to time parties thereto (the "Lenders"), Bankers Trust Company, a New York banking corporation, as administrative agent for the Lenders thereunder, Chemical Bank, National Bank of North Carolina N.A., The Bank of New York and the Bank of Nova Scotia, as co-agents. (incorporated herein by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-3, Reg. No. 33-50567 (the "1993 S-3")). 4(b)* - Subsidiary Guarantee Agreements dated as of August 16, 1993 by each of the guarantors signatory thereto in favor of the beneficiaries referred to therein (incorporated herein by reference to Exhibit 4.4 to the 1993 S-3). 10(a)* - Fruit of the Loom 1989 Stock Grant Plan dated January 1, 1989 (incorporated herein by reference to Exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1988). 10(b)* - Fruit of the Loom 1987 Stock Option Plan (incorporated herein by reference to Exhibit 10(b) to the S-2). 10(c)* - Fruit of the Loom, Inc. Stock Option Agreement for Richard C. Lappin (incorporated herein by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991). 10(d)* - Fruit of the Loom 1992 Executive Stock Option Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, Reg. No. 33- 57472). 10(e)* - Fruit of the Loom, Inc. Directors' Stock Option Plan (incorporated herein by reference to the Company's Registration Statement on Form S-8, Reg. No. 33-50499). 10(f)* - Agreement and Plan of Merger, dated as of October 11, 1993, by and among Salem Sportswear Corporation, Fruit of the Loom, Inc.and FTL Acquisition Corp. (incorporated herein by reference to Exhibit 2.1 to the 1993 S-3). 10(g) - Purchase Agreement dated as of February 28, 1994 98 among The Gitano Group, Inc., each of the direct and indirect subsidiaries of Gitano and Fruit of the Loom, Inc. 11 - Computation of Earnings Per Common Share. 133 22 - Subsidiaries of the Company. 135 24 - Consent of Ernst & Young. 138 * Document is available at the Public Reference Section of the Securities and Exchange Commission, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 (Commission file #1-8941). The Registrant has not listed or filed as Exhibits to this Annual Report certain instruments with respect to long-term debt representing indebtedness of the Company and its subsidiaries which do not individually exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Registrant agrees to furnish such instruments to the Securities and Exchange Commission upon request. EXHIBIT 10(g) PURCHASE AGREEMENT AGREEMENT dated as of February 28, 1994 among THE GITANO GROUP, INC., a Delaware corporation having an office at 1411 Broadway, New York, New York 10018 ("Gitano"); each of the direct and indirect subsidiaries of Gitano signatory hereto (such subsidiaries being referred to herein as the "Subsidiaries" and, together with Gitano, as "SELLER"); and FRUIT OF THE LOOM, INC., a Delaware corporation having an office at 233 South Wacker Drive, 5000 Sears Tower, Chicago, Illinois 60606 ("BUYER"). R E C I T A L S : This Agreement sets forth the terms and conditions upon which BUYER agrees to purchase from SELLER, and SELLER agrees to sell to BUYER, the business of SELLER as presently conducted (the "Business"), including substantially all of its assets, free and clear of all Liens (as defined below) and debt, and certain executory contracts. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants set forth herein, the parties agree as follows: 1. Definitions The following terms, as used herein, have the following meanings: "Accounts Receivable" means all accounts receivable of SELLER arising in the ordinary course of the Business from SELLER's marketing services program (known as the "advanced integration program"), the sale of goods at wholesale and SELLER's licensing activities, excluding all such accounts receivable that are more than 90 days past due. "Additional Designated Contract" has the meaning assigned to that term in Section 2(c). "Agreement" means this Purchase Agreement, including all exhibits and schedules hereto. "Approval Order" means an order of the Bankruptcy Court, in form and substance reasonably satisfactory to BUYER, approving and authorizing SELLER to enter into this Agreement and to consummate the transactions contemplated hereby, ordering that (i) the Assets sold to BUYER pursuant to this Agreement shall be free and clear of all Liens, such Liens to attach to the Purchase Price payable pursuant to Section 3; provided, however, that such Liens shall not attach to any portion of the Purchase Price to be returned to BUYER as a result of the adjustments set forth in Sections 3(b), 3(c) or 3(d); (ii) BUYER has acted in good faith within the context of Section 363(m) of the Bankruptcy Code; (iii) BUYER is not acquiring any of SELLER's liabilities except as expressly provided in this Agreement; (iv) except with respect to claims expressly assumed by BUYER pursuant to this Agreement, all Persons are enjoined from in any way pursuing BUYER by suit or otherwise, to recover on any claim which it had, has or may have against SELLER; (v) all Designated Contracts (other than Additional Designated Contracts referred to in clause (B) of the second paragraph of Section 2(c)) shall be rejected by SELLER and all Assigned Contracts shall be assumed by SELLER and assigned to BUYER pursuant to Section 365 of the Bankruptcy Code (in each case in accordance with Section 2(c)); and (vi) the caption of the Chapter 11 petitions filed by The Gitano Group, Inc., Gitano Licensing, Inc., the Gitano Manufacturing Group, Inc. and Gitano Sportswear LTD. shall be amended so as to eliminate from the names of such entities the name "Gitano" or any name similar to such name or any variants or abbreviations of such name (e.g., such caption may read: The XYZ Group, Inc., f/k/a The Gitano Group, Inc.; XYZ Licensing, Inc., f/k/a Gitano Licensing, Inc.; The XYZ Manufacturing Group, Inc., f/k/a The Gitano Manufacturing Group, Inc.; and XYZ Sportswear LTD., f/k/a Gitano Sportswear LTD., respectively). "Assets" has the meaning assigned to that term in Section 2. "Assigned Contracts" has the meaning assigned to that term in Section 2(c). "Assumed A/R Amount" has the meaning assigned to that term in Section 3(b)(ii). "Assumed Inventory Amount" has the meaning assigned to that term in Section 3(b)(i). "Assumed Obligations" has the meaning assigned to that term in Section 4(b). "Bankruptcy Code" means Title 11 of the United States Code, commonly known as the Bankruptcy Code, as it may be amended. "Bankruptcy Court" means the United States Bankruptcy Court for the District in which SELLER files the Bankruptcy Petition. "Bankruptcy Petition" has the meaning assigned to that term in Section 5. "Business" has the meaning assigned to that term in the first paragraph of the Recitals hereof. "Closing" means the closing of the purchase and sale of the Assets pursuant to this Agreement. "Closing Date" means the time and date of the Closing determined pursuant to Section 5. "Designated Contracts" has the meaning assigned to that term in Section 2(c). "Employment Agreements" has the meaning assigned to that term in Section 7(e). "Equipment" has the meaning assigned to that term in Section 2(a)(i). "Equipment Leases" has the meaning assigned to that term in Section 7(e). "Escrow Agent" means Kronish, Lieb, Weiner & Hellman, counsel to SELLER. "Escrow Agreement" means the escrow agreement dated as of the date hereof among BUYER, SELLER and the Escrow Agent in the form of Exhibit A hereto. K:\CORP\MSF\GITANO\BNKR-SAL.8 "Foreign Subsidiaries" means the direct or indirect wholly owned subsidiaries of Gitano listed on Schedule 1 hereto. "G.G. Licensing" means G.G. Licensing, Inc., a Delaware corporation. "Gitano's Best Knowledge" means the conscious awareness of facts or other information by Robert E. Gregory, Jr., Robert J. Pines, C. William Crain, Eddie Albert, Steven M. Gerber, Wendy Nacht, George Soffron or Camillo Faraone. "HSR Act" means the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the related regulations and published interpretations. "Initial Designated Contracts" has the meaning assigned to that term in Section 2(c). "Inventory" has the meaning assigned to that term in Section 2(a)(ii). "Inventory Cost" means SELLER's aggregate standard cost for each item of its Inventory (including work-in- progress) on the Closing Date, "WIP Closing Value" means SELLER's aggregate standard cost for each unit of its work-in-progress included within the Inventory on the Closing Date, "WIP Unit Number" means the number of units of SELLER's work-in-progress included within the Inventory on the Closing Date, and "WIP Average Cost" means an amount equal to the WIP Closing Value divided by the WIP Unit Number, in each case determined in accordance with SELLER's letter to BUYER dated the date hereof. "Licenses" has the meaning assigned to that term in Section 7(e). "Lien" means any lien, security interest, pledge, hypothecation, encumbrance or other interest or claim (including but not limited to any and all "claims" as defined in Section 101(5) of the Bankruptcy Code and any and all rights and claims under any bulk transfer statutes and similar laws) in or with respect to any of the Assets (including but not limited to any options or rights to purchase such Assets and any mechanic's or tax liens), whether arising by agreement, by statute or otherwise and whether arising prior to, on or after the date of the filing by SELLER pursuant to Section 5 of the Bankruptcy Petition. "Net Accounts Receivable" means the amount of the Accounts Receivable, net of reserves for returns, allowances, chargebacks and doubtful accounts, as of the Closing Date, determined in accordance with SELLER's past practice consistently applied. "Other Excluded Contracts" has the meaning assigned to that term in Section 2(c). "PBGC" means Pension Benefit Guaranty Corporation. "Person" means any individual, corporation, partner- ship, joint venture, trust, association, unincorporated organization, other entity, or governmental body or subdivision, agency, commission or authority thereof. K:\CORP\MSF\GITANO\BNKR-SAL.8 "Real Property Leases" has the meaning assigned to that term in Section 7(e). "Scheduling Order" means an order of the Bankruptcy Court, in form and substance reasonably satisfactory to BUYER, (i) approving the Topping Fee and Sections 7(m), 12(d) and 17(l), (ii) approving such bidding procedures as may be reasonably acceptable to BUYER, including, without limitation, (x) that "higher and better" offers for the Assets be filed with the Bankruptcy Court no later than three days prior to the hearing to consider the Approval Order and (y) that "higher and better" offers must be fully financed and contain a cash purchase price that exceeds the Purchase Price by $3,000,000, (iii) scheduling a hearing to approve the Approval Order, (iv) providing that notice of the hearing and the relief requested in the Approval Order be given to all creditors of SELLER, including, without limitation, all Persons holding a Lien on any of the Assets, all licensees, the PBGC, International Union, United Automobile, Aerospace and Agricultural Implement Workers of America and its Local 260, and all relevant taxing authorities, (v) providing for publication of the hearing notice in the Wall Street Journal, National Edition, (vi) requiring SELLER to serve a notice upon each non-SELLER party to each License that does not constitute an Initial Designated Contract or an Additional Designated Contract referred to in clause (A) of the second paragraph of Section 2(c) in advance of the hearing to consider the Approval Order, advising of the existence of any default of SELLER under such License (whether monetary or otherwise) and the dollar amount believed to be necessary to cure such default, and (vii) providing that any non- SELLER party to such a License who fails to timely file a response alleging the existence of other defaults and/or contesting the dollar amount believed to be necessary to cure any default shall be forever barred from subsequently asserting any claim or default that existed under such License as of the date of the notice sent by SELLER to the non-SELLER party. "SELLER LCs" means all letters of credit for the purchase of Inventory which have been issued on behalf of SELLER and remain outstanding as of the Closing Date. "Topping Fee" means a fee payable by SELLER to BUYER equal to $1.5 million. "Topping Fee Event" means a sale or other disposition of Assets, Licenses, Real Property Leases or Equipment Leases (whether in one or more transactions) to another buyer pursuant to an order of the Bankruptcy Court in which the amount of the consideration payable in respect of the Assets, Licenses, Real Property Leases or Equipment Leases in the aggregate is greater than the Purchase Price payable by BUYER pursuant to Section 3. 2. Purchase and Sale (a) Subject to the terms and conditions of this Agree- ment, on the Closing Date SELLER shall sell, transfer, assign and K:\CORP\MSF\GITANO\BNKR-SAL.8 deliver to BUYER, free and clear of any and all Liens, and BUYER shall purchase and acquire from SELLER, all right, title and interest of SELLER in and to the following assets (collectively, the "Assets"), in each case as of the Closing Date: (i) All furniture, machinery, equipment, furnishings, operating equipment, supplies and tools, and all parts thereof and accessions thereto, owned by SELLER (collectively, the "Equipment"); (ii) All current first-quality jeans replenishment inventory (including raw materials and other supplies, work-in-progress, in-transit inventory and finished goods), owned by SELLER, which is held for sale to customers in the ordinary course of the Business (collec- tively, the "Inventory"), including all returns after the Closing Date; (iii) all other inventory (in addition to the Inventory) used or held for use by SELLER in the Business; (iv) Subject to Section 2(a)(iv), all of the names, trademarks, trade names, service marks and copyrights, logos, slogans and patents, if any, (including any and all applications, registrations, extensions and renewals thereof) owned by SELLER (excluding G.G. Licensing), as set forth on Schedule 2(a)(iv) hereto, together with all associated goodwill; (v) All of the assets of G.G. Licensing (which consist of the trademarks set forth on Schedule 2(a)(v) hereto), subject to certain perpetual licenses referred to in such Schedule; (vi) All of the stock in each of the Foreign Subsidiaries, provided that such Foreign Subsidiary is either (A) designated by BUYER on Schedule 1 hereto or (B) designated by BUYER by notice to SELLER at least one business day prior to the hearing in the Bankruptcy Court to consider the Approval Order (it being understood that the stock and assets of any Foreign Subsidiary not so designated will be excluded from the Assets); (vii) All customer and mailing lists of SELLER, and existing telephone numbers, telecopier numbers and telex numbers used by SELLER at any of its places of business; (viii) All outstanding Accounts Receivable of SELLER; (ix) All outstanding orders for the purchase of goods from SELLER (including orders under the advanced integration program referred to in the definition of "Accounts Receivable" in Section 1); (x) All invoices, bills of sale and other instruments and documents evidencing SELLER's title to Assets (including those relating to SELLER LCs) that are in the possession of SELLER; (xi) All data processing systems, records, files, data bases, and other papers and information of SELLER used in connection with the Business or in any way relating to the Assets; K:\CORP\MSF\GITANO\BNKR-SAL.8 (xii) All stationery and other imprinted material and office supplies, and packaging and shipping materials, of SELLER; (xiii) The name "Gitano" and all corporate and other names (excluding "Regatta" and related names) used by SELLER in the Business or which are the subject of any filing by SELLER including in any jurisdictions in which SELLER is registered as a domestic or foreign corporation and all variations of the foregoing; and (xiv) All rights of SELLER or any Foreign Subsidiary designated on Schedule 1 hereto with respect to any insurance policy to the extent covering liabilities of any such Foreign Subsidiary or liabilities assumed by BUYER and to the extent assignable to BUYER. (b) Notwithstanding anything to the contrary contained in this Agreement, the Assets do not include the following: (i) The corporate seals, minute books, stock record books and other corporate records having exclusively to do with the corporate organization and capitalization of SELLER; (ii) Any tax or customs refunds to which SELLER is or may be entitled (other than with respect to any tax or customs paid by BUYER); (iii) Shares of the capital stock of Gitano and each direct or indirect subsidiary of Gitano, including the Subsidiaries and the Foreign Subsidiaries (other than those designated by BUYER to SELLER pursuant to Section 2(a)(vi)(A) or (B)). (iv) The "Regatta" and related trademarks, together with all license agreements relating to such trademarks; (v) Any payments to which SELLER is or may be entitled from any sale of assets, property or stock by SELLER prior to the date hereof, including without limitation the return of escrowed funds (excluding Accounts Receivable outstanding as of the Closing Date); (vi) SELLER's right, title and interest in, to and under (including all amounts received or to be received by SELLER pursuant to) (A) the Promissory Note Due December 31, 1994 made by The Childrens' Place Retail Stores Inc. in favor of Gitano in the principal amount of $1.35 million, and (B) (x) the Settlement Agreement dated as of November 1, 1993, among Gitano, certain of its subsidiaries, Gypsy Imports, Inc. and Nessim Dabah, and (y) the Stock Purchase Agreement and the license and commission agreements, promissory notes, guaranties and affidavits of confession referred to in such Settlement Agreement. (vii) All cash on hand and in bank accounts, prepaid insurance, prepaid interest and other prepaid items and deposits, of SELLER as of the Closing Date, including without limitation any refund of insurance premiums paid by SELLER, or dividends with respect to any insurance policy the premiums for which were paid by SELLER (except that BUYER shall be entitled to all right, title and interest of SELLER in and to any leasehold improvements, K:\CORP\MSF\GITANO\BNKR-SAL.8 prepaid rent and security deposits in respect of any Lease assigned to it pursuant to Section 2(c)); and provided that, if and to the extent that for payroll or other corporate purposes the parties agree to include cash on hand or in bank accounts within the Assets, the Purchase Price shall be increased, dollar for dollar, by the amount of cash so included; (viii) All choses in action and causes of action, claims and rights of recovery or setoff of every kind or character of or for the benefit of SELLER arising out of or in connection with the actions listed on Schedule 2(b)(viii) hereto or that otherwise do not relate to the Assets, irrespective of the date on which any such cause of action, claim or right may arise or accrue; (ix) Accounting records (including workpapers, general ledgers and financial statements) and tax returns, and other business records and reports that do not relate to the Assets; (x) All right, title and interest of SELLER in, to and under insurance policies (except to the extent provided in Section 2(a)(xiv)), including without limitation directors and officers insurance policies, and indemnification agreements with directors and officers; and (xi) Any other assets (including rights) not specifically enumerated in Sections 2(a) and 2(c). (c) Concurrently with its execution of this Agreement, BUYER has designated in the appropriate place on Schedule 7(e) certain Real Property Leases, Equipment Leases, Licenses and other agreements that BUYER desires SELLER to reject pursuant to Section 365 of the Bankruptcy Code (each Real Property Lease, Equipment Lease, License and other agreement so designated being referred to as an "Initial Designated Contract") and certain Real Property Leases and Equipment Leases (in addition to the Initial Designated Contracts) that BUYER does not desire to assume ("Other Excluded Contracts"). At the Closing, BUYER shall acquire all right, title and interest of SELLER in all Real Property Leases, Equipment Leases and Licenses and other agreements listed on Schedule 7(e) which are not Initial Designated Contracts or Other Excluded Contracts (the "Assigned Contracts"); provided that not less than five days prior to the hearing on the Approval Order, BUYER, in its sole discretion, may (i) designate as "Additional Designated Contracts" any contracts listed on Schedule 7(e) (other than those to which G.G. Licensing or any Foreign Subsidiary is a party) which do not constitute Initial Designated Contracts and which BUYER wishes SELLER to reject (such Additional Designated Contracts, together with the Initial Designated Contracts, the "Designated Contracts"); and (ii) designate as "Other Excluded Contracts" any contracts listed on Schedule 7(e) (other than those to which G.G. Licensing or any Foreign Subsidiary is a party) which do not already constitute "Other Excluded Contracts" and which BUYER does not wish to assume; and further provided that the Employment Agreements will not be assumed by BUYER. K:\CORP\MSF\GITANO\BNKR-SAL.8 SELLER shall cause (A) all Initial Designated Contracts and all Additional Designated Contracts that are so designated by BUYER in accordance with this Section 2(c) at least 12 hours prior to the filing of the Bankruptcy Petition to be rejected pursuant to the Approval Order, and (B) all other Additional Designated Contracts to be rejected within 25 days after the Closing; provided, that the foregoing shall not apply to any License that constitutes a Designated Contract if the Bankruptcy Court fails to agree to SELLER's request to reject such License, in which event such License shall constitute an Assigned Contract. In addition, if and to the extent the documents described on Schedule 7(e)(iii)(A) are contracts of SELLER or to the extent SELLER has any binding oral commitments to the parties referenced on such schedule, they shall be rejected by SELLER as of the Closing Date. 3. Purchase Price (a) In consideration of the sale and transfer of the Assets and the Assigned Contracts (in addition to the assumption by BUYER of the Assumed Obligations pursuant to Section 4), subject to the terms and conditions of this Agreement, BUYER shall pay to SELLER an amount (the "Purchase Price") equal to $100,000,000, subject to adjustment pursuant to Sections 3(b), 3(c) and 3(d). The Purchase Price shall be payable as follows: (i) Concurrently with the execution of this Agreement, BUYER shall pay to the Escrow Agent by federal funds wire transfer the sum of $5,000,000, such sum (together with any interest thereon, the "Deposit") to be held in escrow subject to the terms of the Escrow Agreement; (ii) On the Closing Date, BUYER shall pay to SELLER by federal funds wire transfer the sum of $80,000,000; (iii) On the Closing Date, the excess of (A) the Purchase Price (before adjustment pursuant to Sections 3(b), 3(c) and 3(d)) over (B) the sum of the Deposit plus the amount paid pursuant to Section 3(a)(ii) shall be paid by federal funds wire transfer or a certified or bank check payable to the order of SELLER to be deposited in a debtor-in-possession account (the "Account") and to be held in trust for BUYER, to the extent of the net adjustments, if any, payable to BUYER pursuant to Sections 3(b), 3(c) and 3(d); (iv) Within 10 days after determination of the amount, if any, of the net adjustments payable pursuant to Sections 3(b) and 3(c), BUYER shall pay to SELLER as additional Purchase Price the net amount, if any, by which the Purchase Price is increased pursuant to Section 3(b), or SELLER shall pay to BUYER from the Account as a reduction of the Purchase Price the net amount by which the Purchase Price is reduced pursuant to Sections 3(b) and 3(c). Such payment shall be made by federal funds wire transfer or certified or bank check. Upon the payment of the net adjustments pursuant to Sections 3(b) and 3(c) in accordance with this Section 3(a)(iv) all amounts held in the Account (other than any amount specified in Section 3(d)) shall be released to SELLER. K:\CORP\MSF\GITANO\BNKR-SAL.8 (b) (i) The parties acknowledge that the Purchase Price is based upon the Inventory Cost being $13,900,000 (the "Assumed Inventory Amount"). An agent designated by BUYER and an agent designated by SELLER shall take a physical count of the Inventory as of the Closing Date and, within 30 days thereafter, shall produce a statement listing (A) the Inventory as of the Closing Date, and (B) the WIP Closing Value, the WIP Unit Number, the WIP Average Cost, and the Inventory Cost (which shall be final and binding on the parties). If the Inventory Cost as so determined exceeds the Assumed Inventory Amount, the Purchase Price shall be increased by the dollar amount of such excess. If the Assumed Inventory Amount exceeds the Inventory Cost as so determined, the Purchase Price shall be reduced by the dollar amount of such excess. Any such increase or reduction shall be paid in accordance with Section 3(a)(iv). (ii) The parties further acknowledge that the Purchase Price is based upon the Net Accounts Receivable being $10,400,000 (the "Assumed A/R Amount"). Within 30 days after the Closing Date, BUYER and SELLER shall jointly (A) determine the Net Accounts Receivable and (B) produce a statement listing the Net Accounts Receivable as so determined. If the Net Accounts Receivable as so determined exceeds the Assumed A/R Amount, the Purchase Price shall be increased by the dollar amount of such excess. If the Assumed A/R Amount exceeds the Net Accounts Receivable as of the Closing Date as so determined, the Purchase Price shall be reduced by the dollar amount of such excess. Any such increase or reduction shall be paid in accordance with Section 3(a)(iv). (iii) If, within the 30-day period following the Closing Date, SELLER and BUYER (or their agents) are unable to jointly determine the Inventory Cost or the Net Accounts Receivable in accordance with Section 3(b)(i) or (ii), as the case may be, either party may submit such determination to the Bankruptcy Court. (c) In the event of a material breach of any representation or warranty made by SELLER in this Agreement or any breach of the representation and warranty made by SELLER in Section 7(g), BUYER shall have a period of 45 days following the Closing Date to make a claim against SELLER with respect to such breach, by sending to SELLER a written notice specifying the nature of the breach and the dollar amount of loss, damage, injury, diminution in value, cost or expense (collectively, "Losses") incurred by BUYER as a result of such breach. If SELLER does not object (in accordance with the following sentence) to BUYER's claim, the Purchase Price shall be reduced by the amount of such Losses and such reduction shall be paid in accordance with Section 3(a)(iv). If SELLER notifies BUYER in writing, within 10 days of receipt of BUYER's notice, that it objects to the amount of such Losses or the nature of BUYER's claim, the Bankruptcy Court shall determine the appropriate adjustment, if any, to be made to the Purchase Price in respect of such claim. (d) The parties understand that, because the present value of the benefit liabilities (within the meaning of Section 4001(a)(16) of the Employee Retirement Income Security Act of K:\CORP\MSF\GITANO\BNKR-SAL.8 1974, as amended ("ERISA")) of SELLER's defined benefit plan (the "Plan") may exceed the value of the assets of the Plan, SELLER may have liability to the PBGC ("Termination Liability") in the event of a termination of the Plan (as determined in accordance with Title IV of ERISA and the regulations thereunder). Accordingly, a portion of the Account mutually agreed to by the parties (in an amount equal to the parties' estimate of possible Termination Liability) shall be held in trust for BUYER until the earliest to occur of the following: (i) BUYER or any of its subsidiaries (including any subsidiary that acquires Assets or the stock of which is acquired by BUYER pursuant to this Agreement) shall be held to have liability to the PBGC for any portion of the Termination Liability as a result of BUYER'S acquisition of any of the Assets, in which case the amount of such liability shall be released to BUYER and the remainder of the amount held in the Account pursuant to this Section 3(d) shall be released to SELLER; or (ii) SELLER shall have satisfied BUYER that no grounds for such liability shall exist, or shall have provided BUYER with indemnification reasonably satisfactory to BUYER against any such liability, in which case the entire amount held in the Account pursuant to this Section 3(d) shall be released to SELLER; or (iii) following termination of the Plan it is established pursuant to Section 4048(a) of ERISA that the date of termination of the Plan is after the Closing Date, in which case the entire amount held in the Account pursuant to this Section 3(d) shall be released to SELLER. 3A. Interim Services and Removal of Assets from Gitano Premises (a) The parties acknowledge that, although BUYER is not assuming the lease of the premises occupied by SELLER in Dayton, New Jersey (the "Dayton Facility"), BUYER will need a limited period of time following the Closing to integrate the distribution services provided by SELLER out of its Dayton Facility into BUYER's own distribution facilities. Accordingly, the parties agree that during the 90-day period following the Closing (the "Interim Period") SELLER, to the extent reasonably requested by BUYER, will use its reasonable efforts to receive at, and distribute from, the Dayton Facility BUYER's goods in a manner consistent with past practices. SELLER shall be paid within 10 days of BUYER's receipt of SELLER's invoice for such services in an amount equal to SELLER's cost of providing such services plus 10%. SELLER shall perform such services as an independent contractor and not as an agent for BUYER and shall retain exclusive control over its work force. Until the expiration of the Interim Period, SELLER shall provide BUYER and its agents or representatives reasonable access to the Dayton Facility for the purpose of removing Assets (including, without limitation, racks, computer and other equipment and supplies and inventory) remaining on the premises. (b) If BUYER fails to designate Noel of Jamaica Ltd. (the "Jamaican Subsidiary") pursuant to Section 2(a)(vi) and thereby elects not to acquire the stock of the Jamaican Subsidiary pursuant to this Agreement, then, during the Interim Period, SELLER will use its reasonable efforts to cause the Jamaican Subsidiary to complete the manufacture of all work-in- progress included within the Inventory as of the Closing Date K:\CORP\MSF\GITANO\BNKR-SAL.8 (there being no obligation to cut uncut raw materials) and to deliver to BUYER, from time to time in accordance with SELLER's past practice, finished goods from such work-in-progress (in such sizes, styles and quantities as previously determined in accordance with the Jamaica Subsidiary's production schedule), and BUYER shall pay SELLER for such goods the amounts determined in accordance with the letter from SELLER to BUYER referred to in the definition of "Inventory Cost" in Section 1, subject to adjustment at the end of the Interim Period as provided in such letter; provided, that SELLER shall provide BUYER with the appropriate documentation (including quota, if applicable) to import such goods into the United States. SELLER shall safeguard all uncut raw materials included within the Inventory on the Closing Date in accordance with its past practice and deliver such raw materials at BUYER's expense to such location in the United States as BUYER may request before such final shipment is made by SELLER. (c) SELLER shall provide BUYER and its agents or representatives access to the premises occupied by SELLER in Edison, New Jersey during the 90-day period following the Closing Date (excluding that portion of the premises not currently used by SELLER), and to the premises occupied by SELLER at 1411 Broadway, New York, New York (on the 7th and 8th floors) during the 45-day period following the Closing Date, for the purpose of removing Assets therefrom, except that if SELLER ceases to have the right to use any such premises at any time during such period (provided that SELLER shall take all actions reasonably requested by BUYER so as to continue to have such right during such post- Closing period so long as SELLER is not required to pay for any space not currently used by SELLER), SELLER shall give notice to BUYER and SELLER shall arrange for the delivery of the Assets located at such premises at BUYER's expense to such location in the United States as BUYER may request. (d) If and to the extent that following the Closing Date, SELLER wishes to use (i) a portion of the premises currently occupied by SELLER at 1411 Broadway, New York, New York (or any other premises in such building) and BUYER (or any of its subsidiaries) occupies any such premises or (ii) the services of certain of BUYER's employees at any such premises, BUYER shall reasonably cooperate with SELLER to accommodate such wishes for a period of up to 180 days following the Closing Date so long as doing so does not unreasonably interfere with BUYER's business and SELLER reimburses BUYER for its costs to the extent allocable to SELLER's usage of such employees. 4. Assumption of Liabilities; Letters of Credit (a) Except as expressly set forth in this Section 4, BUYER is not assuming, and shall have no responsibility or obligation whatsoever for, any liability or other obligation of SELLER, including, without limitation, any liability arising under applicable federal or state environmental protection laws and any liability arising under or in connection with any collective bargaining agreement or pension plan maintained by SELLER. (b) At the Closing, BUYER shall assume all of SELLER's obligations arising from and after the Closing Date under all of K:\CORP\MSF\GITANO\BNKR-SAL.8 the Assigned Contracts. Prior to the assignment by SELLER to BUYER of each of the Assigned Contracts, and as a condition to SELLER's obligation to effect each such assignment, BUYER shall pay all amounts required to cure all defaults under the Real Property Leases, Equipment Leases and Licenses that constitute Assigned Contracts so as to permit the assumption and assignment of such Assigned Contracts pursuant to Section 365 of the Bankruptcy Code (the amounts so paid to cure such defaults, together with the other obligations to be assumed by BUYER pursuant to this Section 4(b) and Section 4(d), being referred to herein as "Assumed Obligations"), and BUYER shall not be entitled to any reduction in the Purchase Price for any amounts required to be so paid. SELLER does not assume any obligation whatsoever to cure any existing default, or to make any payment due after the date hereof, under the Real Property Leases, Equipment Leases or Licenses which constitute Assigned Contracts. (c) Schedule 4(c) lists all letters of credit for Inventory issued on behalf of SELLER outstanding as of February 28, 1994. SELLER shall provide BUYER a list of all SELLER LCs that will be outstanding on the Closing Date at least five business days prior to the Closing Date. On the Closing Date, BUYER shall (at BUYER's sole expense) comply with either of the following clauses (i) or (ii): (i) BUYER shall cause the SELLER LCs to be returned to SELLER and canceled (and any collateral securing SELLER's reimbursement obligations in respect of such SELLER LCs to be refunded or returned to SELLER), by causing new letters of credit to be issued to the beneficiaries of the SELLER LCs and to be substituted therefor. Such new letters of credit shall be issued by a United States bank acceptable to BUYER (such as NationsBanc or Bankers Trust Company, acting through its principal offices in the United States) (a "BUYER Bank"). Prior to issuance of the SELLER LCs, SELLER shall use reasonable efforts to obtain the agreement of the beneficiaries of the SELLER LCs to accept such new letters of credit and BUYER shall provide such cooperation in connection with such endeavor as SELLER may reasonably request. (ii) BUYER shall (A) cause a Buyer Bank to issue letters of credit in favor of the banks that have issued the SELLER LCs (the "SELLER Banks") in amounts equal to the obligations payable under the SELLER LCs, (B) cause such BUYER Bank to enter into an agreement with the SELLER Banks providing for the indemnification by letter of credit of the SELLER Banks with respect to the SELLER LCs, pursuant to which the SELLER Banks will agree not to seek reimbursement from SELLER with respect to the SELLER LCs, and (C) enter into an agreement with SELLER providing for the indemnification of SELLER by BUYER with respect to the liabilities of SELLER under the agreement described in clause (B) above, such letters of credit and agreements to be in form and substance reasonably satisfactory to SELLER and satisfactory to the SELLER Banks. (d) On the Closing Date, BUYER shall register as "importer of record" for all Inventory in transit upon receipt of all necessary documentation (including, without limitation, quota, if applicable), and BUYER shall assume all of SELLER's K:\CORP\MSF\GITANO\BNKR-SAL.8 obligations for all costs, including customs and import duties and taxes, to be incurred in connection with the import and shipment of such Inventory into the United States. 5. Bankruptcy Filing; Obtaining of Approval Order; Closing (a) Within five business days following the date hereof and after giving reasonable advance notice to BUYER, SELLER (excluding G.G. Licensing) shall file in the Bankruptcy Court a voluntary petition for relief under the Bankruptcy Code (the "Bankruptcy Petition"), together with an application to the Bankruptcy Court for the Scheduling Order and the Approval Order in forms reasonably satisfactory to the parties, which SELLER shall diligently attempt to obtain (subject to its obligations under the Bankruptcy Code). (b) If the Approval Order is entered, then, subject to the satisfaction or waiver by the parties of the conditions to their respective obligations to effect the Closing, the Closing shall take place at the offices of Kronish, Lieb, Wiener & Hellman, 1114 Avenue of the Americas, New York, New York at 10:00 a.m. (New York City time) on the third business day after the Bankruptcy Court has issued the Approval Order (the effectiveness of which shall not have been stayed or, if stayed, such stay shall no longer be in effect), or, if later, on the third business day after the waiting period under the HSR Act shall have expired or been terminated, or at such other place, date and time as the parties may agree in writing. 6. Deliveries at Closing (a) At the Closing, SELLER shall deliver, or cause to be delivered (in addition to any other instruments required by this Agreement to be delivered by SELLER at the Closing), to BUYER the following (in form and substance reasonably satisfactory to BUYER): (i) a duly executed bill of sale transferring title to all of the Assets to BUYER; (ii) instruments of assignment sufficient to assign to BUYER all of SELLER's right, title and interest in and to the intangible property referred to on Schedules 2(a)(iv) and 2(a)(v); (iii) instruments of assignment sufficient to assign to BUYER all of SELLER's right, title and interest in, to and under the stock of each Foreign Subsidiary designated by BUYER to SELLER pursuant to Section 2(a)(vi)(A) or (B)); (iv) instruments of assignment sufficient to assign to BUYER all of SELLER's right, title and interest in, to and under the Assigned Contracts; (v) a certified copy of the Approval Order; (vi) possession of all of the Assets and all Equipment and leasehold interests subject to Assigned Contracts; (vii) such other instruments or documents as BUYER may reasonably request to fully effect the transfer of the Assets and to confer upon BUYER the benefits contemplated by this Agreement; (viii) notices executed by SELLER, addressed to (A) each obligor with respect to the Accounts Receivable as of the Closing Date and (B) each licensee with respect to K:\CORP\MSF\GITANO\BNKR-SAL.8 Licenses that are Assigned Contracts, notifying such obligor or licensee of the assignment to BUYER of such Accounts Receivable or License, as the case may be, and directing such obligor or licensee to make payment to BUYER of such Accounts Receivable for which it is the obligor or such fees payable under the License, as the case may be; (ix) such documents as BUYER may reasonably request in connection with the consent or approval or filing requirements to effect the change of the name of Gitano and each subsidiary in their respective states of incorporation and in the states and jurisdictions in which they do business, including "doing business as" designations, to eliminate the name "Gitano" or any name similar to such name or any variants or abbreviations of such name; and (x) evidence reasonably satisfactory to BUYER of compliance with the notice provisions set forth in the Scheduling Order. (b) At the Closing, BUYER shall deliver, or cause to be delivered (in addition to any other instruments required by this Agreement to be delivered by BUYER at the Closing), to SELLER the following: (i) the excess of the Purchase Price (before adjustment pursuant to Section 3(b), 3(c) or 3(d)) over the Deposit, payable in the manner described in Section 3(a); and (ii) a duly executed assumption of liabilities in form and substance reasonably satisfactory to SELLER, whereby BUYER will assume and agree to pay, perform and discharge the Assumed Obligations. 7. Representations, Warranties and Covenants of SELLER Gitano represents and warrants (both as of the date of this Agreement and as of the Closing Date) to, and agrees with, BUYER as follows (such representations and warranties, except for the representation and warranty set forth in Section 7(g), being made to Gitano's Best Knowledge): (a) Gitano and each of the Subsidiaries is a corporation duly organized, validly existing and in good standing under the laws of the state of its incorporation. Each of the Foreign Subsidiaries the stock of which is included within the Assets is a corporation duly organized under the laws of the place of its incorporation (it being acknowledged that such Foreign Subsidiaries may not be in good standing). Gitano has no direct or indirect active subsidiaries other than the Subsidiaries and the Foreign Subsidiaries (and subsidiaries of the Foreign Subsidiaries). No representation or warranty is made as to any of the Foreign Subsidiaries (or its assets) except as to its due organization and title to its stock as set forth in this Section 7(a) and Section 7(c). Between the date hereof and the Closing Date, SELLER will use reasonable efforts to cause each of the Foreign Subsidiaries designated by BUYER to SELLER pursuant to Section 2(a)(vi)(A) or (B) to be in good standing provided that SELLER shall not be required to incur substantial expenditures in connection with such endeavor. K:\CORP\MSF\GITANO\BNKR-SAL.8 (b) SELLER has the full right, power and authority to enter into this Agreement and to sell, transfer, assign and deliver the Assets to BUYER pursuant to this Agreement, subject to obtaining the Approval Order. This Agreement has been duly and validly executed and delivered by SELLER and, subject to obtaining the Approval Order, constitutes a legal, valid and binding obligation of SELLER, enforceable in accordance with its terms. (c) SELLER has good and marketable title to all of the Assets and SELLER has possession of all of the tangible Assets. Subject to obtaining the Approval Order, SELLER shall, at the Closing, transfer and assign to BUYER good and marketable title to each of the Assets, free and clear of all Liens. (d) All of the Equipment is in all material respects in good repair, ordinary wear and tear excepted. (e) Schedule 7(e) lists (except as otherwise provided in such Schedule) all material agreements to which SELLER or a Foreign Subsidiary is a party and which are currently used by SELLER in connection with the Business, consisting of the following: (i) leases pursuant to which SELLER or a Foreign Subsidiary leases real property used by it in connection with the Business, as set forth on Schedule 7(e)(i) ("Real Property Leases"), (ii) leases pursuant to which SELLER leases equipment or other personal property or computer software used by it in connection with the Business, as set forth on Schedule 7(e)(ii) ("Equipment Leases"), (iii) license agreements pursuant to which SELLER licenses intangible property to third parties, as set forth on Schedule 7(e)(iii) ("Licenses") and, to the extent they constitute agreements, the agreements set forth on Schedule 7(e)(iii)(A), and (iv) employment or union agreements to which SELLER is a party, as set forth on Schedule 7(e)(iv) ("Employment Agreements"). Schedule 7(e)(i) and 7(e)(ii) also respectively list for each of the Real Property Leases and Equipment Leases the annual or monthly rental (as the case may be), the date through which such rental has been paid, and the amount in default through February 14, 1994. Copies of all written agreements and written descriptions of all oral agreements listed on Schedule 7(e) have been delivered to BUYER on or prior to the date of this Agreement. (f) Except as expressly set forth in this Section 7, SELLER makes no representations or warranties of any kind or nature as to the condition of the Assets (or any equipment or leasehold improvements subject to Assigned Contracts). THE ASSETS (AND ANY EQUIPMENT OR LEASEHOLD IMPROVEMENTS SUBJECT TO ASSIGNED CONTRACTS) SHALL BE TRANSFERRED "AS IS" AND "WHERE IS" AND SELLER MAKES NO REPRESENTATIONS OR WARRANTIES OF ANY KIND OR NATURE (EXCEPT AS SET FORTH HEREIN). NO STATUTORY OR OTHER WARRANTIES AS TO THE CONDITION OF THE ASSETS OR THE MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OF THE ASSETS (OR SUCH EQUIPMENT OR LEASEHOLD IMPROVEMENTS) SHALL BE IMPLIED, AND SELLER HEREBY EXPRESSLY DISCLAIMS ANY REPRESENTATION OR WARRANTY AS TO THE CONDITION OF THE ASSETS (OR SUCH EQUIPMENT OR LEASEHOLD IMPROVEMENTS) OR THEIR MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. K:\CORP\MSF\GITANO\BNKR-SAL.8 (g) All Accounts Receivable as of the Closing Date will be valid and existing and result from transactions in the ordinary course of the Business. SELLER has not agreed (except as set forth on Schedule 7(e)(iii)), and prior to the Closing Date will not agree, to any reduction of any of such Accounts Receivable. In the case of goods sold giving rise to such Accounts Receivable, no defect in the quality of such goods will cause either returns or chargebacks in excess of the portion of the reserves, if any, that is allocated to returns and chargebacks and included within the Net Accounts Receivable. (h) All finished goods Inventory is current and of "first quality" in accordance with SELLER's past practice. All Inventory is owned by SELLER. (i) SELLER (excluding G.G. Licensing) owns the registered trademarks (including applications therefor) listed on Schedule 2(a)(iv), subject to the Licenses and the other restrictions described on such Schedule. G.G. Licensing owns the registered trademarks (including applications therefor) listed on Schedule 2(a)(v), subject to certain perpetual licenses referred to on such Schedule. Schedules 2(a)(iv) and 2(a)(v) contain accurate and complete lists of all of the registered trademarks (including applications therefor) other than "Regatta" and related trademarks owned by SELLER (excluding G.G. Licensing) and G.G. Licensing, respectively. Except for the licensees and the Licenses referred to on Schedules 2(a)(iv) and 2(a)(v) and except as otherwise described on such Schedule, SELLER is not aware of any other Person with rights to use the trademarks set forth on Schedules 2(a)(iv) and 2(a)(v). (j) Except for the rights, properties and other assets of SELLER specifically excluded pursuant to Section 2(b) from the Assets and SELLER's rights in, to and under the Real Property Leases, Equipment Leases, Licenses and Employment Agreements that will not constitute Assigned Contracts, the Assets, together with SELLER's rights in, to and under the Assigned Contracts, include all rights, properties and other assets necessary (assuming the hiring of all or substantially all of SELLER's employees) to permit the conduct of the Business in all material respects in the same manner as the Business is conducted on the date of this Agreement. (k) As of the date of this Agreement, all of the contracts listed in Schedules 7(e)(i), 7(e)(ii), 7(e)(iii) and 7(e)(iii)(A) (other than the Initial Designated Contracts) and, as of the Closing Date, all of the Assigned Contracts are valid, binding and enforceable in accordance with their terms, and are in full force and effect. Except as set forth in Schedule 7(e) and except for defaults of the type referred to in Section 365(b)(2) of the Bankruptcy Code, there are no defaults as of the date of this Agreement (or events that, with notice or lapse of time or both, would constitute a default) by SELLER or any other party under any of the contracts listed on Schedules 7(e)(i), 7(e)(ii), 7(e)(iii) and 7(e)(iii)(A) (other than the Initial Designated Contracts). No representation or warranty is made as to whether any consent is required pursuant to any Real Property Lease of any of the Foreign Subsidiaries by reason of the transfer to BUYER of the stock of any such Foreign Subsidiaries. K:\CORP\MSF\GITANO\BNKR-SAL.8 (l) Prior to the Closing Date, SELLER shall (x) maintain all of the Equipment in good repair, ordinary wear and tear excepted; and (y) conduct its business only in the ordinary course and consistent with past practice (subject to the effect of the Bankruptcy Petition to be filed by SELLER pursuant to Section 5). In furtherance of and without limiting the foregoing, SELLER shall not, without the prior written consent of BUYER (i) sell or dispose of Inventory except through arm's- length sales in the ordinary course of business. (ii) except in accordance with their terms, terminate, allow to expire, renew or renegotiate, or (subject to the last sentence of Section 4(b)) default in any of its obligations under any contract listed on Schedules 7(e)(i), 7(e)(ii) and 7(e)(iii), other than the Initial Designated Contracts and Real Property Leases not being assumed by BUYER pursuant to this Agreement; or (iii) dispose of or permit to lapse any rights to the use of any trademarks or trademark applications or registrations owned by SELLER (other than the "Regatta" and related trademarks) which are currently used by SELLER in the Business (it being acknowledged that certain such trademarks are no longer used by SELLER); or (iv) sell, transfer, mortgage, encumber or otherwise dispose of any Assets, except (A) inventory in the ordinary course of business or (B) in connection with obtaining debtor-in-possession financing pursuant to Section 364 of the Bankruptcy Code providing for up to $4 million of letters of credit for the purchase of goods in connection with the Business; or (v) agree to or make any commitment to take any actions prohibited by this Section 7(1). (m) From the date hereof and until the earlier of (i) the denial of the Approval Order by the Bankruptcy Court and (ii) the termination of this Agreement, SELLER shall not solicit offers to acquire, or otherwise seek to sell, the Assets to any party other than BUYER whether privately, through an auction or otherwise except as contemplated by this Section 7(m). BUYER and SELLER acknowledge and agree that obtaining the Approval Order as contemplated by this Agreement will necessitate the good faith consideration by SELLER of bona fide offers or expressions of interest received from third parties. The parties further acknowledge and agree that a principal purpose of the provisions of this Agreement relating to the Topping Fee and the reimbursement of expenses is to provide BUYER with compensation if the process of considering such offers or expressions of interest leads to a transaction with a third party. Accordingly, prior to the issuance of the Approval Order, SELLER may (i) respond to inquiries from third parties; (ii) review written expressions of interest; (iii) enter into a confidentiality agreement with such party and provide such party with access to information, confidential or otherwise, relating to SELLER and the Assets and, if such party requests, with information concerning, or a term sheet summarizing, or a copy of, this Agreement; and (iv) take any action in furtherance of the K:\CORP\MSF\GITANO\BNKR-SAL.8 foregoing permitted by the Scheduling Order. SELLER shall promptly (x) notify BUYER of the execution of a confidentiality agreement with any party, (y) notify BUYER of any conversation with, or inquiry or offer received from, potential bidders and provide BUYER with a copy of any written communication sent to or received from bidders or potential bidders and provide BUYER with a copy of any information sent by SELLER to any potential bidder and (z) provide BUYER with any sale documentation that is in substantially final form and notify BUYER of the execution of definitive sale documentation. (n) Unless exempt under Section 1146(c) of the Bankruptcy Code, SELLER shall pay any and all sales, transfer or transaction taxes imposed by any taxing authority, including without limitation, any state, county, municipality or other subdivision thereof, in connection with the consummation of the transactions contemplated by this Agreement. (o) To the extent that the rights of SELLER under any insurance policy described in Section 2(a)(xiv) are not assignable to BUYER, SELLER shall take all actions reasonably requested by BUYER and otherwise endeavor to provide BUYER with the benefits of any such insurance policy; it being understood that all costs and expenses incurred by SELLER in connection with such actions and endeavors shall be borne by BUYER. K:\CORP\MSF\GITANO\BNKR-SAL.8 8. Representations, Warranties and Covenants of BUYER BUYER represents and warrants (both as of the date of this Agreement and as of the Closing Date) to, and covenants with, SELLER as follows: (a) BUYER is a corporation duly organized, validly existing and in good standing under the laws of the state of its incorporation, with full corporate power and authority to enter into this Agreement and to perform its obligations hereunder. (b) BUYER has taken all requisite corporate action in order to authorize the execution and delivery of this Agreement and the consummation of the transactions contemplated hereby. This Agreement has been duly and validly executed and delivered by BUYER and constitutes a legal, valid and binding obligation of BUYER, enforceable in accordance with its terms. (c) Neither the execution and delivery of this Agreement nor the consummation of the transactions contemplated hereby will (a) violate or result in a breach of or default under (i) any provision of the certificate of incorporation or by-laws (or other governing instrument) of BUYER, as currently in effect, or (ii) any mortgage, indenture, contract, agreement, license, franchise, permit, instrument, trust, power, judgment, decree, order, ruling or federal or state statute or regulation to which BUYER is presently a party or to which it or its properties may be subject, (b) result in the creation or imposition of any lien, claim, charge, restriction or encumbrance of any kind whatsoever upon, or give to any other Person any interest or right (including any right of termination or cancellation) in or with respect to any properties, assets, business, agreements or contracts of BUYER, or (c) require any consent, approval or waiver of, filing with, or notification to any Person (including, without limitation, any governmental or regulatory authority), other than as required by the HSR Act. (d) No investigation, action, suit or proceeding before any court or any governmental or regulatory authority has been commenced, and no investigation, action, suit or proceeding by any governmental or regulatory authority has been threatened (other than as described in Section 5), against BUYER or any of its principals, officers or directors (i) seeking to restrain, prevent, delay or change the transactions contemplated hereby or (ii) questioning the validity or legality of this Agreement or the transactions contemplated hereby or (iii) seeking damages in connection with any such transactions. (e) BUYER hereby acknowledges that, as of the date of this Agreement, SELLER sells its Inventory to only one customer. (f) BUYER hereby acknowledges that (i) BUYER has made such investigation into the Assets, Assigned Contracts, Designated Contracts and Other Excluded Contracts of SELLER, and has been offered the opportunity to ask such questions of appropriate officers of SELLER relating to the Assets, Assigned Contracts, Designated Contracts and Other Excluded Contracts, as BUYER deems appropriate to enter into this Agreement, and (ii) except for the specific representations and warranties contained in Section 7, BUYER is not relying on any representation or warranty by SELLER or any other Person in entering into this K:\CORP\MSF\GITANO\BNKR-SAL.8 Agreement (and will not rely on any other representation or warranty in effecting the Closing). 8A. Covenants of BUYER and SELLER BUYER and SELLER each hereby covenant as follows: (a) SELLER shall give prompt notice to BUYER, and BUYER shall give prompt notice to SELLER, of (i) the occurrence, or failure to occur, of any event that would be likely to cause any representation or warranty contained in this Agreement to be untrue or inaccurate in any material respect at any time from the date of this Agreement to the Closing Date, and (ii) any failure of BUYER or SELLER, as the case may be, to comply with or satisfy, in any material respect, any covenant, condition or agreement to be complied with or satisfied by it under this Agreement. (b) As promptly as practicable but in any event within seven business days after the date of this Agreement, SELLER and BUYER shall make any and all filings required to be made under the HSR Act. SELLER and BUYER shall furnish each other such necessary information and reasonable assistance as the other may request in connection with the preparation of necessary filings or submissions under the provisions of the HSR Act. SELLER and BUYER shall supply each other with copies of all correspondence, filings or communications, including file memoranda evidencing telephonic conferences with representatives of either the Federal Trade Commission ("FTC"), the Antitrust Division of the United States Department of Justice ("Department of Justice"), or any other governmental entity or members of their respective staffs, with respect to the transactions contemplated by this Agreement, except for documents filed pursuant to Item 4(c) of the Notification and Report Form or communications regarding the same. (c)Following the date hereof SELLER shall give BUYER and its authorized representatives, full access to its books and records (and permit BUYER to make copies thereof) to the extent relating to taxes or tax returns of the Business, as BUYER may reasonably request, permit BUYER to make inspections thereof, and cause SELLER's officers and advisors to furnish BUYER with such financial, tax and other operating data and other information with respect to the taxes or tax returns of the Business for periods ending before or including the Closing Date as BUYER may reasonably request. BUYER shall give SELLER and its authorized representatives, access to its books and records (and permit SELLER to make copies thereof), permit SELLER to make inspections thereof, and cause BUYER's officers and advisors to furnish SELLER with such financial, tax and other operating data and other information with respect to the Business to the extent relating to periods prior to or including the Closing Date as SELLER may reasonably request. SELLER hereby agrees that it will retain, until all appropriate statutes of limitation (including any extensions) expire, copies of all tax returns, supporting work schedules and other records or information which may be relevant to such tax returns, except for such tax returns, supporting work schedules and other records which BUYER shall acquire as a consequence of this Agreement (provided, that SELLER may elect not to retain any such copies if SELLER gives such K:\CORP\MSF\GITANO\BNKR-SAL.8 copies or makes such copies available to BUYER), and that it will not destroy or otherwise dispose of such materials without first providing BUYER with a reasonable opportunity to review and copy such materials. (g) BUYER and SELLER shall cooperate with each other in good faith in the preparation of any tax return or form required to be filed with respect to the transactions contemplated hereby, and BUYER shall provide such certificates as SELLER may reasonably request, to minimize the tax liability of SELLER as described in Section 7(n) (provided BUYER shall not be required to take any action that increases BUYER's tax liability). 9. Conditions to BUYER's Obligation to Effect Closing The obligation of BUYER to effect the Closing shall be subject to the satisfaction, on or before the Closing Date, of the following conditions, any one or more of which may be waived by BUYER: (a) (i) The representations and warranties of SELLER set forth in this Agreement shall be true and correct in all material respects as of the date of this Agreement and as of the Closing Date as though made at such time, (ii) SELLER shall have performed and complied in all material respects with the agreements contained in this Agreement required to be performed and complied with by SELLER on or before the Closing, and (iii) BUYER shall have received certificates to the effect set forth in clauses (i) and (ii) above signed by the Chief Executive Officer or the President of SELLER. (b) The Bankruptcy Court shall have issued the Scheduling Order and the Approval Order, the effectiveness of which shall not have been stayed or, if stayed, such stay shall no longer be in effect. (c) The condition of the Assets shall not have deteriorated in any material respect after the date hereof. (d) No action or proceeding shall have been instituted by any court or other governmental body, and, at what would otherwise have been the Closing Date, remain pending before any court or governmental body to restrain or prohibit BUYER's acquisition of the Assets; nor shall any court or other governmental body have notified any party to this Agreement that BUYER's acquisition of the Assets would constitute a violation of the laws of any jurisdiction or that it intends to commence an action or proceeding to restrain or prohibit BUYER's acquisition of the Assets, unless such court or other governmental body shall have withdrawn such notice and abandoned such action or proceeding. (e) Any applicable waiting period under the HSR Act shall have expired or been terminated. (f) SELLER shall have complied with all requirements of the Scheduling Order, including, without limitation, the notice requirements with respect to the hearing on the Approval Order. (g) Each lender (or, if applicable, any successor to such lender) under (i) the Note Purchase Agreement, dated as of September 20, 1989, as amended and restated to date, with respect to the 9.88% Senior Secured Notes of Gitano due February 28, 1995 and (ii) the Credit Agreement, dated as of April 30, 1993, as amended and restated to date, among Gitano, the guarantors named K:\CORP\MSF\GITANO\BNKR-SAL.8 therein, the banks named therein (the "Banks") and The Chase Manhattan Bank, N.A., as agent for the Banks shall have consented to release the guarantee of SELLER's obligations to it by G.G. Licensing and any Lien it may have against any Asset owned by G.G. Licensing, so long as such Lien attaches to the portion of the Purchase Price attributable to such Assets (other than any amounts retained in trust for BUYER pursuant to Sections 3(b), (c) or (d)). 10. Conditions to SELLER's Obligation to Effect Closing The obligation of SELLER to effect the Closing shall be subject to the satisfaction, on or before the Closing Date, of the following conditions, any one or more of which may be waived by SELLER: (a) (i) The representations and warranties of BUYER set forth in this Agreement shall be true and correct in all material respects as of the date of this Agreement and as of the Closing Date as though made at such time, (ii) BUYER shall have performed and complied in all material respects with the agreements contained in this Agreement required to be performed and complied with by BUYER on or before the Closing, and (iii) SELLER shall have received certificates to the effect set forth in clauses (i) and (ii) above signed by the Chief Executive Officer or a Vice President of BUYER. (b) The Bankruptcy Court shall have issued the Approval Order, the effectiveness of which shall not have been stayed or, if stayed, such stay shall no longer be in effect. (c) Any applicable waiting period under the HSR Act shall have expired or been terminated. 11. Employees Schedule 11A lists, by department, the employees of SELLER (other than direct labor). BUYER currently intends to offer employment following the Closing Date on a fair trial basis to all employees of SELLER who are within the departments designated by BUYER on Schedule 11B. On or prior to the date of the hearing at which the Bankruptcy Court will consider the Approval Order, BUYER shall deliver to SELLER a final list of the employees of each department of SELLER to whom BUYER agrees to offer employment following the Closing Date on a fair trial basis (and BUYER shall not be required to offer employment to any other employees of SELLER). The provisions of this Section 11 shall not obligate BUYER to continue the employment of any employee of SELLER if after offering such person employment on a fair trial basis BUYER elects to terminate such person's employment. Nothing contained in this Agreement shall be construed to require BUYER to assume any employment agreement, employee benefit plan or other arrangement maintained by SELLER for the benefit of any such employees or to which SELLER contributed or was obligated to make payments. For the purposes hereof, if the benefits under any vacation, disability, severance, insurance, or other similar plan or program of BUYER is based on an employee's years of service with BUYER (or its subsidiaries), then, for the purposes of determining the eligibility for and vesting of (but not, in the case of any pension, 401(k) or similar plan, the amount of) benefits to which an employee of SELLER hired by BUYER following the Closing is entitled under such plan or program, such K:\CORP\MSF\GITANO\BNKR-SAL.8 employee's years of service with SELLER shall be counted toward his or her years of service with BUYER (or its subsidiaries). 12. Termination; Effect of Termination (a) This Agreement may be terminated before the Closing occurs only as follows: (i) By written agreement of SELLER and BUYER at any time. (ii) By BUYER, by notice to SELLER, if (A) the Bankruptcy Petition shall not have been filed on or before March 4, 1994, or (B) the Closing shall not have occurred for any reason on or before April 4, 1994. (iii) By SELLER, by notice to BUYER, if the Closing shall not have occurred for any reason on or prior to the tenth day following the issuance of the Approval Order or, if later, on or prior to the third business day after the waiting period under the HSR Act shall have expired or been terminated. (iv) By BUYER, by notice to SELLER, if one or more of the conditions specified in Section 9 is not satisfied on the Closing Date or if satisfaction of such a condition is or becomes impossible. (v) By SELLER, by notice to BUYER, if one or more of the conditions specified in Section 10 is not satisfied on the Closing Date or if satisfaction of such a condition is or becomes impossible. (vi) By SELLER or BUYER, by notice to the other, at any time prior to the entry of the Approval Order upon the occurrence of a Topping Fee Event. (b) If this Agreement is terminated by either or both of SELLER and BUYER pursuant to Section 12(a)(i), 12(a)(ii), 12(a)(iii) or 12(a)(vi), or by BUYER pursuant to Section 12(a)(iv), or by SELLER pursuant to Section 12(a)(v), neither party shall have any further obligation or liability under this Agreement except as provided in this Section 12 and except for those provisions expressly provided to survive the termination hereof and except that the Deposit shall be refunded to BUYER. (c) If the Closing does not occur by reason of a willful default or intentional misrepresentation or breach of warranty by BUYER (rather than the failure of one or more conditions precedent to BUYER's obligations to effect the Closing), SELLER may elect to retain the Deposit (A) on account of the Purchase Price, (B) as monies to be applied to SELLER's damages, or (C) as liquidated damages for such default. If SELLER elects so to retain the Deposit as liquidated damages, neither party shall have any further obligation or liability under this Agreement except for those provisions expressly provided to survive the termination hereof. (d) If this Agreement is terminated in accordance with Section 12(a)(vi) SELLER shall (i) make the payments provided for in Section 17(l) and (ii) pay BUYER the Topping Fee. Any payment by SELLER to BUYER of a Topping Fee shall be made promptly and in no event later than 10 days after the Topping Fee Event. If SELLER is obligated to make payment to BUYER pursuant to Section 17(l), such amounts shall be paid within 10 days following receipt by SELLER of documentation of such amounts. The parties K:\CORP\MSF\GITANO\BNKR-SAL.8 acknowledge that in determining the payments upon termination provided for in this Section 12(d), BUYER and SELLER have taken into account the fact that BUYER's damages arising from a failure to consummate this transaction are not readily calculable. BUYER and SELLER agree that this Section 12(d) is a reasonable and appropriate method of determining damages and other compensation. (e) Upon the termination of this Agreement prior to Closing, BUYER shall immediately return to SELLER all financial, operational and other information (and all copies thereof) regarding SELLER provided by SELLER to BUYER. 13. Brokers The parties hereto represent and warrant to each other that they have not employed or dealt with any broker or finder in connection with any transactions contemplated by this Agreement, except for Kurt Salmon Associates, Inc., which shall be compensated by SELLER. 14. Access; Confidentiality (a) From and after the date hereof and until the Closing, representatives of BUYER shall have the right, upon reasonable notice and at reasonable times to visit and inspect SELLER's premises and any other locations at which any of the Assets are located and shall have the right to test, operate and otherwise evaluate the Assets and their condition and to inspect, examine and make copies of SELLER's books, accounts and records to the extent that they relate to any of the Assets. (b) SELLER will promptly deliver to BUYER copies of all pleadings, motions, notices, statements, schedules, applications, reports and other papers filed in SELLER's Chapter 11 case relating to this Agreement or the transactions contemplated hereby. (c) BUYER confirms its obligations under the confidentiality agreement previously signed by it with SELLER, which obligations shall be deemed to be incorporated by reference herein and made a part hereof. 15. Jurisdiction The parties agree that the Bankruptcy Court shall retain jurisdiction to resolve any controversy or claim arising out of or relating to this Agreement, or the breach hereof. 16. Collection of Accounts Receivable; Mail If, following the Closing, BUYER or SELLER shall collect any accounts receivable belonging to, or receive any mail that was intended for, the other party, the party collecting such accounts receivable, or receiving such mail, shall hold the same in trust and, in the case of accounts receivable, shall promptly pay the same over to the party entitled thereto and, in the case of mail, deliver such mail to the party for which it is intended (in the case of mail intended for SELLER, BUYER shall deliver such mail to SELLER'S counsel), and shall not be entitled to apply any of such funds against any amounts due from the party entitled to such accounts receivable. K:\CORP\MSF\GITANO\BNKR-SAL.8 17. Miscellaneous (a) All notices, requests, demands, consents and other communications required or permitted under this Agreement shall be in writing and shall be considered to have been duly given when (i) delivered by hand, (ii) sent by telecopier (with receipt confirmed), provided that a copy is mailed (on the same date) by certified or registered mail, return receipt requested, postage prepaid, or (iii) received by the addressee, if sent by Express Mail, Federal Express or other express delivery service (receipt requested), or by first class certified or registered mail, return receipt requested, postage prepaid, in each case to the appropriate addresses and telecopier numbers set forth below (or to such other addresses and telecopier numbers as a party may from time to time designate as to itself by notice similarly given to the other party in accordance herewith). A notice of change of address shall not be deemed given until received by the addressee. If to BUYER, to it at: Fruit of the Loom, Inc. 10 Sasco Hill Road Fairfield, Connecticut 06430 Attention: Richard M. Cion Telecopier No.: 203-254-2627 with a copies to: Fruit of the Loom, Inc. 233 South Wacker Drive 5000 Sears Tower Chicago, Illinois 60606 Attention: Kenneth Greenbaum, Esq. Telecopier No.: 312-993-1749 and Kaye, Scholer, Fierman, Hays & Handler 425 Park Avenue New York, New York 10022 Attention: Nancy E. Fuchs, Esq. Telecopier No.: 212-836-8689 If to SELLER, to it at: 1411 Broadway New York, New York 10018 Attention: Robert E. Gregory, Jr., Chairman and Chief Executive Officer Telecopier No.: 212-768-3936 K:\CORP\MSF\GITANO\BNKR-SAL.8 with a copy to: Kronish, Lieb, Weiner & Hellman 1114 Avenue of the Americas New York, New York 10036 Attention: Peter J. Mansbach, Esq. Telecopier No.: 212-997-3525 (b) No public release or announcement concerning the transactions contemplated hereby shall be issued by BUYER or SELLER without the prior consent (which shall not be unreasonably withheld) of the other party, except as such release or announcement may be required by law or the rules or regulations of any United States or foreign securities exchange, in which case each party shall allow the other party reasonable time to comment on such release or announcement in advance of such issuance. (c) This Agreement and the instruments, agreements, exhibits and other documents contemplated hereby supersede all prior discussions and agreements between the parties with respect to the matters contained herein, and this Agreement and the instruments, agreements and other documents contemplated hereby contain the entire agreement between the parties hereto with respect to the transactions contemplated hereby. (d) The representations and warranties of SELLER and BUYER made pursuant to this Agreement shall survive for a period of 45 days following the Closing. (e) After the Closing, each of the parties hereto shall hereafter, at the reasonable request of the other party hereto, execute and deliver such other instruments of transfer or assumption and further documents and agreements, and do such further acts and things as may be necessary or expedient to carry out the provisions of this Agreement. (f) Any term or condition of this Agreement may be waived at any time by the party thereto which is entitled to the benefit thereof, but such waiver shall only be effective if evidenced by a writing signed by such party. A waiver on one occasion shall not be deemed to be a waiver of the same of any other breach on a future occasion. (g) Except as otherwise expressly provided herein, this Agreement may be amended only by a writing signed by all the parties hereto. (h) This Agreement may be executed in any number of counterparts, each of which shall be deemed an original and all of which together shall constitute one and the same instrument. (i) This Agreement shall be binding upon and shall inure to the benefit of the parties hereto and their respective successors and permitted assigns. This Agreement may not be assigned by any party hereto, without the prior written consent of the other party, except that BUYER may assign this Agreement to a direct or indirect wholly owned subsidiary of BUYER without the prior written consent of SELLER, provided that no such assignment shall relieve BUYER from its obligations and liabilities hereunder. This Agreement is not made for the K:\CORP\MSF\GITANO\BNKR-SAL.8 benefit of any third party, and no third party shall be deemed to be a beneficiary hereof. (j) This Agreement shall be governed by the internal law of the State of New York, without regard to the conflicts of law principles thereof. (k) The headings in this Agreement are for convenience of reference only and should not be deemed a part of this Agreement. (l) Each of the parties hereto shall pay its own expenses incidental to the preparation of this Agreement, the carrying out of the provisions of this Agreement and the consummation of the transactions contemplated hereby, except that if this Agreement shall terminate for any reason (other than because of BUYER'S breach of its obligations or because of a breach of BUYER's representations and warranties hereunder), SELLER shall upon such termination be obligated to reimburse BUYER for up to $500,000 of its out-of-pocket expenses, including K:\CORP\MSF\GITANO\BNKR-SAL.8 legal, accounting and other expenses (excluding any commitment fees paid to financing sources). IN WITNESS WHEREOF, the parties have caused this Agreement to be duly executed on the date first above written. SELLER: THE GITANO GROUP, INC. AMERICO LIMITED A.N. SURVIVOR CORP. EVA JOIA INCORPORATED G.G. LICENSING, INC. GITANO LICENSING, LTD. THE GITANO MANUFACTURING GROUP, INC. GITANO SPORTSWEAR, LTD. GLOBAL SOURCING, INC. G.V. LICENSING, INC. G.V. PRODUCTS CORP. NOEL INDUSTRIES, INC. NORTH AMERICAN UNDERWEAR COMPANY, INC. THE ORIT CORPORATION ORIT IMPORTS, INC. ORIT MENSWEAR COMPANY, INC. ORIT RETAIL HOLDING COMPANY, INC. By:_____________________________ Name: Title: BUYER: FRUIT OF THE LOOM, INC. By:_____________________________ Name: Title: K:\CORP\MSF\GITANO\BNKR-SAL.8 AMENDMENT NO. 1 AMENDMENT NO. 1 dated as of March 14, 1994 to the Purchase Agreement, dated as of February 28, 1994 (the "Purchase Agreement"), among THE GITANO GROUP, INC., a Delaware corporation having an office at 1411 Broadway, New York, New York 10018 ("Gitano"); each of the direct and indirect subsidiaries of Gitano signatory hereto (such subsidiaries being referred to herein as the "Subsidiaries" and, together with Gitano, as "SELLER"); and FRUIT OF THE LOOM, INC., a Delaware corporation having an office at 233 South Wacker Drive, 5000 Sears Tower, Chicago, Illinois 60606 ("BUYER"). Capitalized terms used but not otherwise defined herein shall have the respective meanings ascribed to such terms in the Purchase Agreement R E C I T A L S : Upon the terms and conditions of the Purchase Agreement, BUYER has agreed to purchase from SELLER, and SELLER has agreed to sell to BUYER, substantially all of the assets of SELLER, including all the assets of G.G. Licensing (subject to certain perpetual licenses referred to on Schedule 2(a)(v) of the Purchase Agreement). The parties wish to clarify their intentions with respect to certain matters covered by the Purchase Agreement. NOW, THEREFORE, in consideration of the foregoing and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties agree as follows: 1. The definition of "Approval Order" in Section 1 is hereby amended to add the following phrase after the words "Assigned Contracts" in clause (v) on the 24th line of such definition: "(other than the Dayton Lease, the G.G. Licensing Agreements and the G.G./Gitano Licensing Agreement to the extent of G.G. Licensing's interest in the G.G./Gitano Licensing Agreement)". 2. Section 1 is hereby amended to delete the definition "Assigned Contracts" and replace it with the following: " 'Assigned Contracts' means all Real Property Leases, Equipment Leases and Licenses and other agreements listed on Schedule 7(e) which are not Designated Contracts or Other Excluded Contracts, including without limitation the G.G. Licensing Agreements and G.G./Gitano Licensing Agreement." 3. Section 1 is hereby further amended to add the following defined terms: " 'Dayton Lease'" means the lease, dated March 20, 1991 between Isaac Heller and The Orit Corporation, as amended." " 'G.G. Licensing Agreements' means the license agreements listed on Schedule 2(a)(v) of the Purchase Agreement between G.G. Licensing and New Accessories Holdings, Inc. and G.G. Licensing and Hocalar B.V." " 'G.G./Gitano Licensing Agreement' means the license agreement, dated as of September 24, 1993, between G.G. Licensing and Gitano Licensing, Ltd." 4. The definition of "Scheduling Order" in Section 1 is hereby amended to insert in subsection (vi) the parenthetical "(other than the G.G. Licensing Agreements)" immediately after the phrase "requiring SELLER to serve a notice upon each non- SELLER party to each License". 5. Section 2(c) of the Purchase Agreement is hereby amended to delete the following phrase in lines 11 through 15 of such section: "all Real Property Leases, Equipment Leases and Licenses and other agreements listed on Schedule 7(e) which are not Initial Designated Contracts or Other Excluded Contracts (the "Assigned Contracts");" and to substitute in its place the phrase "Assigned Contracts other than the Dayton Lease;". 6. Section 3A(a) of the Purchase Agreement is hereby amended to delete the first two sentences of such Section and to substitute in their place the following: "The parties acknowledge that BUYER wishes to assume the lease of the premises occupied by SELLER in Dayton, New Jersey (the "Dayton Facility"). Subject to Section 4(b), SELLER shall use all reasonable efforts to assign to BUYER within 25 days after Closing all of SELLER's interest in and to the Dayton Lease, at which time BUYER shall assume all of SELLER's obligations arising under the Dayton Lease. The parties agree that during the period (the "Interim Period") commencing on the Closing Date and ending on the earlier of (i) the 90th day following the Closing Date and (ii) the date of the assignment to BUYER of the Dayton Lease, SELLER, to the extent reasonably requested by BUYER, will use its reasonable efforts to receive at, and distribute from, the Dayton Facility BUYER's goods in a manner consistent with past practices." 7. Section 4(b) is hereby amended to insert in the 3rd line the parenthetical "(other than the Dayton Lease)" immediately after the phrase "the Assigned Contracts". 8. Section 4(b) is hereby further amended to add the following parenthetical in the 9th line of such Section after the words "Assigned Contracts": "(other than the Dayton Lease, the G.G. Licensing Agreements and the G.G./Gitano Licensing Agreement to the extent of G.G. Licensing's interest in such agreement)". 9. Schedule 7(e)(i) is hereby amended to delete the "X" from the box marked by SELLER, therefore indicating that BUYER wishes to assume the Dayton Lease pursuant to Section 3A(a). 10. Schedule 7(e)(iii) of the Purchase Agreement is hereby amended to include the G.G. Licensing Agreements and the G.G./Gitano Licensing Agreement. 11. The Purchase Agreement, as amended, hereby shall continue in full force and effect. IN WITNESS WHEREOF, the parties have executed and delivered this Amendment No. 1 as of the date first above written. SELLER: THE GITANO GROUP, INC. AMERICO LIMITED A.N. SURVIVOR CORP. EVA JOIA INCORPORATED GITANO LICENSING, LTD. G.G. LICENSING, INC. THE GITANO MANUFACTURING GROUP, INC. GITANO SPORTSWEAR, LTD. GLOBAL SOURCING, INC. G.V. LICENSING, INC. G.V. PRODUCTS CORP. NOEL INDUSTRIES, INC. NORTH AMERICAN UNDERWEAR COMPANY, INC. THE ORIT CORPORATION ORIT IMPORTS, INC. ORIT MENSWEAR COMPANY, INC. ORIT RETAIL HOLDING COMPANY, INC. By:_____________________________ BUYER: FRUIT OF THE LOOM, INC. By:_____________________________ Name: Title: March 7, 1994 Via Facsimile and Certified Return Receipt Mail The Gitano Group, Inc. 1411 Broadway New York, New York 10018 Attention: Robert E. Gregory, Jr. Chairman and Chief Executive Officer Dear Mr. Gregory: Reference is made to that certain Purchase Agreement (the "Agreement") dated as of February 28, 1994 among The Gitano Group, Inc. ("Gitano"); each of the direct and indirect subsidiaries of Gitano signatories to the Agreement (such subsidiaries and Gitano being hereafter collectively referred to as "Seller"); and Fruit of the Loom, Inc. ("Buyer"). Defined terms used herein shall have the meanings assigned to such terms in the Agreement unless the context otherwise requires. Pursuant to Section 2(c) of the Agreement, Buyer hereby notifies Seller that the following Licenses are hereby designated as Additional Designated Contracts which Buyer does not wish to assume and requests that Seller reject: Schedule 7(e)(iii) Description Item 18 License Agreement, dated as of August 25, 1987, between Gitano Licensing, Ltd. and NuShoes, Inc. as modified by letters dated July 17, 1992, February 17, 1993 and July 26, 1993 and an oral agreement entered into in late 1993 regarding mens and boys footwear. The Gitano Group, Inc. March 7, 1994 Page Two Item 28 License Agreement, dated as of September 11, 1992, between Gitano Licensing, Ltd. and the John Forsyth Company, Inc. Please acknowledge receipt of this letter and Buyers request that Seller reject the aforementioned Licenses by signing and returning the enclosed copy of the letter. Very truly yours, FRUIT OF THE LOOM, INC. By: Kenneth Greenbaum Vice President Receipt Acknowledged: THE GITANO GROUP, Inc. By: Its: cc: Kronish, Lieb, Weiner & Hellman (Via Facsimile and Certified Return Receipt) 1114 Avenue of the Americas New York, New York 10036 Attention: Peter J. Mansbach, Esq. Steven Gerber Nancy E. Fuchs March 10, 1994 Via Facsimile and Certified RRR The Gitano Group, Inc. 1411 Broadway New York, New York 10018 Attention: Robert E. Gregory, Jr. Chairman and Chief Executive Officer Dear Mr. Gregory: Reference is made to that certain Purchase Agreement (the "Agreement") dated as of February 28, 1994 among The Gitano Group, Inc. ("Gitano"); each of the direct and indirect subsidiaries of Gitano signatories to the Agreement (such subsidiaries and Gitano being hereafter collectively referred to as "Seller"); and Fruit of the Loom, Inc. ("Buyer"). Defined terms used herein shall have the meanings assigned to such terms in the Agreement unless the context otherwise requires. Pursuant to Section 2(a)(vi)(B) of the Agreement, Buyer hereby notifies Seller that it hereby designates the stock of Noel of Jamaica Ltd. as one of the Assets that Buyer will acquire at the Closing. The Gitano Group, Inc. March 7, 1994 Page Two Please acknowledge receipt of this letter by signing and returning the enclosed copy of the letter. Very truly yours, FRUIT OF THE LOOM, INC. By: Kenneth Greenbaum Vice President Receipt Acknowledged: THE GITANO GROUP, Inc. By: Its: cc: Kronish, Lieb, Weiner & Hellman (Via Facsimile and Certified RRR) 1114 Avenue of the Americas New York, New York 10036 Attention: Peter J. Mansbach, Esq. Steven Gerber Nancy E. Fuchs FRUIT OF THE LOOM, INC. AND SUBSIDIARIES EXHIBIT 11 Computation of Earnings Per Common Share (In thousands, except per share data) EXHIBIT 22 SUBSIDIARIES OF FRUIT OF THE LOOM, INC. Jurisdiction of Incorporation Union Underwear Company, Inc. New York NWI Land Management Corporation Delaware Subsidiaries of Union Underwear Company, Inc. Aliceville Cotton Mill, Inc. Alabama Apparel Outlet Stores, Inc. Delaware Brundidge Shirt Corp. Alabama The B.V.D. Licensing Corporation Delaware Camp Hosiery Company, Inc. Tennessee Fayette Cotton Mill, Inc. Alabama Fruit of the Loom, Inc. (a New York corporation) New York FTL Sales Company, Inc. New York Greenville Manufacturing, Inc. Mississippi Jet Sew Technologies, Inc. New York Leesburg Knitting Mills, Inc. Alabama Martin Mills, Inc. Louisiana Panola Mills, Inc. Mississippi Rabun Apparel, Inc. Georgia Russell Hosiery Mills, Inc. North Carolina Salem Sportswear Corporation Delaware Sherman Warehouse Corporation Mississippi Union Sales, Inc. Delaware Union Yarn Mills, Inc. Alabama Woodville Apparel Corporation Mississippi Winfield Cotton Mill, Inc. Alabama Whitmire Manufacturing, Inc. South Carolina Fruit of the Loom Caribbean, Inc. Delaware Fruit of the Loom Canada, Inc. Ontario Fruit of the Loom Arkansas, Inc. Arkansas Fruit of the Loom Texas, Inc. Texas Fruit of the Loom Italy, S.r.l. Italy AVX Management Co., Inc. Kentucky Superior Acquisition Corporation Delaware Superior Underwear Mill, Inc. New York FOL International Republic of Ireland [FN] Excludes some subsidiaries which, if considered in the aggregate as a single subsidiary, would not constitute a "significant subsidiary" at December 31, 1993. EXHIBIT 22 SUBSIDIARIES OF (Continued) FRUIT OF THE LOOM, INC.-(Continued) Jurisdiction of Incorporation Subsidiaries of Russell Hosiery Mills, Inc. (a North Carolina corporation) Leesburg Yarn Mills, Inc. Alabama Subsidiaries of Camp Hosiery Company, Inc. (a Tennessee corporation) Russmont Hosiery Mill, Inc. North Carolina Subsidiaries of Union Sales, Inc. (a Delaware corporation) Fruit of the Loom Trading Company Delaware Subsidiaries of Union Yarn Mills, Inc. (an Alabama corporation) DeKalb Knitting Corporation Alabama Subsidiaries of Superior Acquisition Corporation (a Delaware corporation) Prendas Tejidas de Mexico, S.A. de C.V. Mexico Tejidos de Valle Hermosa, S.A. de C.V. Mexico Confecciones dos Caminos, S.A. Honduras Subsidiaries of FOL International (a Republic of Ireland corporation) W.P. McCarter & Co., Ltd. Republic of Ireland Fruit of the Loom France, S.a.r.l. France Fruit of the Loom GmbH Germany Fruit of the Loom International, Ltd. Republic of Ireland Fruit of the Loom International S.P. Z.0.0 Poland Fruit of the Loom Investments, Ltd. United Kingdom Fruit of the Loom Spain, S.A. Spain Fruit of the Loom Benelux, S.A. Belgium [FN] Excludes some subsidiaries which, if considered in the aggregate as a single subsidiary, would not constitute a "significant subsidiary" at December 31, 1993. EXHIBIT 22 SUBSIDIARIES OF (Concluded) FRUIT OF THE LOOM, INC.-(Concluded) Subsidiaries of Fruit of the Loom International, Ltd. (a Republic of Ireland corporation) McCarters Ireland, Ltd. Republic of Ireland Subsidiaries of Fruit of the Loom Investments, Ltd. (a United Kingdom corporation) Fruit of the Loom, Ltd. United Kingdom Fruit of the Loom Management Co., Ltd. United Kingdom Fruit of the Loom Manufacturing Co., Ltd. United Kingdom Subsidiaries of The Fruit of the Loom Trading Company (a Delaware corporation) Controladora Fruit of the Loom, S.A. de C.V. Mexico Fruit of the Loom Sales Mexico, S.A. de C.V. Mexico Subsidiaries of Controladora Fruit of the Loom, S.A. de C.V. (a Mexico corporation) Distribuidora Fruit of the Loom, S.A. de C.V. Mexico [FN] Excludes some subsidiaries which, if considered in the aggregate as a single subsidiary, would not constitute a "significant subsidiary" at December 31, 1993. EXHIBIT 24 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Forms S-8 Nos. 33-18250, 33-56214, 33- 57472 and 33-50499 and Forms S-3 Nos. 33-56376, 33-56378 and 33- 52023) pertaining to the Fruit of the Loom, Inc. 1987 Stock Option Plan, the Richard C. Lappin Stock Option Plan, the 1992 Executive Stock Option Plan, the Fruit of the Loom, Inc. Directors' Stock Option Plan, the registration of 800,000 shares of Class A Common Stock, 1,550,391 shares of Class A Common Stock and 1,800,000 shares of Class A Common Stock and in the related Prospectuses of our report dated February 12, 1994 with respect to the consolidated financial statements of Fruit of the Loom, Inc. and subsidiaries included in the Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG Chicago, Illinois March 16, 1994 March 21, 1994 OFICS Filer Support SEC Operations Center 6432 General Green Way Alexandria, VA 22312-2413 Gentlemen: Attached to this transmission please find Fruit of the Loom's Annual Report on Form 10-K for the year ended December 31, 1993. Hard copies of this document follow via special courier. Sincerely, John R. Carroll Assistant Controller, Farley Industries JRC/kd Enclosures

75072_1993.txt

75072_1993

1993

75072

Item 1. Business --------- (a) O'Sullivan Corporation was established in 1896 as O'Sullivan Rubber Company in Lowell, Massachusetts as a manufacturer of rubber heels for the shoe industry. In 1932, O'Sullivan Rubber Company was moved to Winchester, Virginia. In September 1945, O'Sullivan Rubber Company was incorporated as O'Sullivan Rubber Corporation to acquire O'Sullivan Rubber Company, Inc., a Delaware Company incorporated in 1932. In 1970, the Company changed its name to O'Sullivan Corporation to reflect the increasing importance of plastics in the business mix, and in 1986, yielding to foreign competitive pressure, the Company sold its rubber manufacturing operations to Vulcan Corporation, located in Cincinnati, Ohio. During 1988 the Company began construction of a new plastic calendering facility, located in Winchester, Virginia. Originally this facility was scheduled for completion and start-up activity during the last quarter of 1989. At the end of 1989, this facility was not yet completed and start-up was delayed until the second half of 1990. The facility was completed during 1990 and was in operation during 1991. By the end of 1991 the facility had reached break even status but was still below projected capacity levels. During 1992, the new plastic calendering facility was in operation for the entire year. However, due to the recessionary economy, this facility was operated at production levels significantly below its ultimate capacity. During 1993, this facility contributed positively to Corporate earnings. Significant improvements were made to capacity utilization due to product mix changes and the improvement in the general economy. With the design capabilities of this facility continued improvement in capacity utilization and profit contribution is expected during 1994. In February, 1989, the Company announced that it had executed a purchase contract to buy (70) acres of land in Huron, Ohio. The proposed purchase of this land was to construct a 175,000 square foot facility to house an injection molding operation. This facility was originally scheduled to begin start-up activities during the second half of 1990. The facility began operations during the third quarter of 1990, according to plan. However, due to customer driven program delays, this facility operated well below optimum capacity levels during 1991. During 1992, this facility continued to operate at sales and production levels below original customer driven capacity estimates. In 1993, the Huron facility performed far below management expectations and predetermined production standards. The new plant is the most complex of all O'Sullivan Corporation injection molding plants because of " In Line Vehicle Sequencing" which is a highly advanced stage of the " Just-In-Time " concept of delivering parts to the customer. The impact of this system created unexpected - 2 - Item 1. Business -------- (Continued) inefficiencies due to the volatile swings in scheduling driven by significant changes in customer demand. This, coupled with significantly lower than planned sales volumes, resulted in higher costs associated with current sales volume. To correct these problems, the Company has added additional machinery and warehouse space in order to more efficiently operate equipment for longer runs and more efficient rates and has agressively pursued incremental new business for the Huron operations. During the first half of 1994 the Company does not expect any significant improvement in operations for the Huron facility. Although sales volumes will improve compared to 1993, costs of sales will continue to be greater than original expectations. During 1992 the Company made a significant departure from its general line of business activity through an entry into a consumer products oriented business. On November 24, 1992, O'Sullivan Corporation acquired substantially all the assets of Melnor Industries, Inc. and its wholly-owned Canadian subsidiary, Melnor Manufacturing, Ltd. With this acquisition O'Sullivan Corporation entered the consumer products manufacturing, marketing and distribution business. The new Company, which is a wholly-owned subsidiary of O'Sullivan Corporation, is now called Melnor Inc. and has as its wholly-owned subsidiary Melnor Canada Ltd. With the acquisition of Melnor, the Company acquired a well known brand name in water sprinkler systems and other products. The new business not only allows for diversification of the Company's products but allows for the opportunity to develop, manufacture and sell non-automotive related products through an established distribution system. During 1992, Melnor was insignificant to total operations as it was acquired in November of 1992. During 1993, although significant improvements were accomplished, profit objectives were not achieved. Sales were negatively affected by extremely unfavorable weather conditions in the Mid-West and Eastern United States. Currently, the economic outlook for Melnor is promising for 1994 and management expects positive contributions to consolidated earnings during 1994. On April 1, 1993, the Company acquired Capitol Plastics of Ohio, Inc. Capitol Plastics is a custom injection molding manufacturing operation with one plant located in Bowling Green, Ohio. Capitol Plastics of Ohio, Inc. is a wholly-owned subsidiary of O'Sullivan Corporation and is part of the Plastics Products business segment. Capitol's largest customer is Honda of North America. During the Fall of 1993, Capitol Plastics experienced difficulties with the launch of the 1994 Honda Accord. At the same time the 1993 model sales were depressed due to anticipation of the new 1994 model. During 1994, the Company expects Capitol to contribute positively to Corporate earnings as the economy improves and as no new program launches are anticipated for this facility. - 3 - Item 1. Business -------- (Continued) (b) The Corporation's operations are classified principally into two business segments; Calendered and Molded Plastics Products ("Plastics Products") and Lawn and Garden Consumer Products ("Consumer Products"). The Plastics Products segment primarily involves the manufacture of calendered and injection-molded plastics products for the automotive and specialty plastics manufacturing industries. The Consumer Products segment primarily involves the manufacture and distribution of a wide range of lawn and garden products. Operating profit represents net sales less operating expenses for each segment and excludes general corporate expenses and non-operating revenues and expenses. Identifiable assets for each segment represent those assets used in the Corporation's operations and exclude general corporate assets. General corporate assets include cash, investments and other non- operating assets. Net Sales for the Plastics Products segment to the divisions and subsidiaries of one customer amounted to $86,589,527 (29.6% of net sales) in 1993, $84,100,032 (38.5% of net sales) in 1992 and $76,782,607 (39.1% of net sales) in 1991. Business Segment Information 1993 1992 1991 ------------ ------------ ------------ Net Sales By Classes of Similar Products Plastics Products $251,742,441 $216,055,429 $196,374,954 Consumer Products 40,513,273 2,402,836(a) - - ------------ ------------ ------------ Total Net Sales $292,255,714 $218,458,265 $196,374,954 ============ ============ ============ Operating Profit (Loss) Plastics Products $ 26,401,507 $ 23,574,503 $ 7,653,508(b) Consumer Products 2,057,052 (279,775)(a) - - ------------ ------------ ------------ Total Operating Profit $ 28,458,559 $ 23,294,728 $ 7,653,508 General Corporate Expenses 9,485,791 5,573,761 4,696,264 Non-operating Revenue(Expense) (2,175,286) (175,999) (554,330) ------------ ------------ ------------ Income Before Income Taxes and Cumulative Effect of Accounting Changes $ 16,797,482 $ 17,544,968 $ 2,402,914 ============ ============ ============ - 4 - Item 1. Business -------- (Continued) 1993 1992 1991 ------------ ------------ ------------ Identifiable Assets Plastics Products $165,660,063 $135,855,781 $137,413,010 Consumer Products 25,394,702 23,560,028 - - ------------ ------------ ------------ Total Identifiable Assets $191,054,765 $159,415,809 $137,413,010 General Corporate Assets 13,820,941 14,646,660 13,169,773 ------------ ------------ ------------ Total Assets $204,875,706 $174,062,469 $150,582,783 ============ ============ ============ Capital Expenditures Plastics Products $ 15,193,167 $ 6,384,938 $ 7,180,186 Consumer Products 1,351,516 32,502(a) - - General Corporate 86,531 299,654 189,371 ------------ ------------ ------------ Total Capital Expenditures $ 16,631,214 $ 6,717,094 $ 7,369,557 ============ ============ ============ Depreciation and Amortization Plastics Products $ 9,651,506 $ 9,164,057 $ 9,503,197 Consumer Products 1,402,596 104,520(a) - - General Corporate 384,268 354,635 355,877 ------------ ------------ ------------ Total Depreciation and Amortization $ 11,438,370 $ 9,623,212 $ 9,859,074 ============ ============ ============ (a) Includes activity only from acquisition of businesses at November 24, 1992 through December 31, 1992. (b) Includes restructuring charge of $5,025,000. (c) The Corporation's Plastic Products segment manufactures calendered and molded plastic products for the automotive and specialty plastics manufacturing industries. Distribution is by direct sales to manufacturers and distributors. Calendered plastic products manufactured include vinyl sheeting for automobile dashboard pads, swimming pool liners and covers, note book binders, luggage, upholstered furniture, golf bags, floor tile, pond liners, protective clothing, mine curtains, boat and automobile windows and medical grade materials. Injection molded plastic products include exterior and interior plastic trim parts for the automotive industry; such as door panels, fender extensions, glove boxes, garnish moldings, map pockets and a variety of other related products. - 5 - Item 1. Business -------- (Continued) During the last three years revenues generated by the Plastics Products segment of the registrant by class of products were as follows: 1993 1992 1991 ------ ------ ------ Calendered Plastic Products 53% 57% 58% Injection Molded Plastic Products 47% 43% 42% All essential raw materials are readily available to the Plastics Products segment of the Corporation. For the most significant raw materials, the Company has secondary sources of supply if needed. Major suppliers of raw materials to the segment include: Geon, Occidental Chemical, Dow Chemical, G.E. Plastics, Magee Carpet Company, Weyerhaeuser, and Penn Color. The Plastics Products segment of the Corporation possesses significant technology in the compounding and formulation as well as in the manufacture of its products. The business of the Plastics Products segment of the Corporation is not seasonal. Significant customers of the Plastics Products Segment of the Corporation in 1993 were Ford Motor Company and Honda of North America. These customers were the only customers accounting for 10 percent ( or more) of the segment's 1993 sales. Generally, the normal back log consists of thirty to forty five days of firm orders. Although the Corporation has contracts totaling several million dollars in orders (some for multi-year periods), these are not considered firm until specific production releases are received. The Plastics Products segment products are sold in markets in which there is competition from many plastic manufacturers, both domestic and foreign. While no one competitor offers all of the products produced by this segment, there are many competitors for any single product. Some of the segment's major competitors are Canadian General Tower, Automotive Industries, Inc., Gen Corp. Polymer Products, Becker Manufacturing, Formosa Plastics Inc., Davidson Interior Trim (Division of Textron), as well as wholly- owned subsidiaries and divisions of Ford, Chrysler, and General Motors. The Company's Consumer Products segment was established on November 24, 1992 with the creation of Melnor Inc., a wholly-owned subsidiary of O'Sullivan Corporation. Distribution is by direct sales to distributors and direct retail outlets. The primary activity of the segment is the manufacture, assembly, sale and distribution of home lawn and garden watering products. The products produced and sold by this segment include: oscillating, rotary and traveling sprinklers, hose storage units, watering timers, aqua guns and air spray tanks. Secondary product lines - 6 - Item 1. Business -------- (Continued) which represent less than 10 percent of sales volume include humidification systems, snow shovels and buy-sell distribution of ceiling fans and thermostats. All essential raw materials are readily available to the Consumer Products segment. Although some raw material items are supplied by foreign sources, primarily Taiwan and Israel, they are not of significant volume. In many cases, the components that are purchased are deemed commodity in nature, representing designs that are stable and available in other markets, should supply be threatened. Major raw material suppliers to the segment include: Diehl PTE, Stax Ltd., Jamieson Plastics, Landen Enterprises, Armada Tool, CPC of Vermont, Himont Canada, and Concept Plastics. The Consumer Products segment of the Corporation holds many patents and trademarks for products produced and sold in the lawn and garden market. However, due to the nature of the segment's business activity, the Corporation does not believe that the nature of these patents and trademarks are significant to the long-term success of the business operations. The business of the Consumer Products segment of the Corporation is seasonal in nature. Lawn and garden products are traditionally distributed to distribution and retail outlets commencing in late November and early December reaching peak sales volume during the months of March and April. Significant customers of the Consumer Products segment of the Corporation during 1993 were Canadian Tire and Home Depot, Inc. These customers were the only customers accounting for 10 percent (or more) of the segment's 1993 sales. The Consumer Products segment products are sold in markets in which there is competition from many lawn and garden water products suppliers. While no one competitor offers all the products produced by this segment, there are many competitors for any single product. Some of the segment's major competitors are Rain Bird Corporation, Suncast Company, Gilmour Corporation and Nelson Company. No material effects upon the capital expenditures, earnings and competitive position of the registrant are anticipated to result from the enactment or adoption of federal, state or local environmental laws. The Corporation currently employs approximately 2,800 full-time employees. - 7 - Item 1. Business -------- (Continued) (d) O'Sullivan Corporation is not engaged in any significant transactions with customers or suppliers located in foreign countries. Item 2. Item 2. Properties ---------- O'Sullivan Corporation owns approximately 969,000 square feet of manufacturing, warehouse and office space on approximately 144 acres of land in Winchester, Virginia; 76,000 square feet of manufacturing, warehouse and office space on six acres of land in Lebanon, Pennsylvania; 110,000 square feet of manufacturing and warehouse space on approximately 5 acres of land in Newton Upper Falls, Massachusetts; 85,000 square feet of manufacturing space on 13 acres of land in Yerington, Nevada; 147,000 square feet of manufacturing, warehouse and office space on approximately 20 acres in Luray, Virginia; 315,270 square feet of manufacturing, warehouse and office space on 75 acres of land in Huron, Ohio; 144,000 square feet of manufacturing, warehouse and office space on approximately 9 acres of land in Bowling Green, Ohio; and 82,000 square feet of manufacturing, warehousing and office space on approximately 7 acres of land in Brantford, Ontario, Canada. The Corportion currently leases 29,250 square feet of warehouse space in St. Louis, Missouri; 15,600 square feet of warehouse space in Bell, California and 347,000 square feet of manufacturing, warehousing and office space in Moonachie, New Jersey. The Corporation also has a sales office located in Chicago, Illinois. The percentage utilization of the Corporation's manufacturing facilities is difficult to measure due to the Corporation's policy of adding machinery, equipment and other appropriate facilities as required. During 1993, the Corporation had additional unused capacity in the Plastic Products and the Consumer Products segments. Item 3. Item 3. Legal Proceedings ----------------- As of December 31, 1993, O'Sullivan Corporation and its subsidiaries had no material legal proceedings pending to which the Corporations were a party or of which any of their property was the subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- None Executive Officers of the Registrant ------------------------------------ See information provided under Part III, Item 10, included in this Form 10-K. - 8 - PART II ------- Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder ---------------------------------------------------------------- Matters. -------- The principal market on which the Corporation's common stock is traded is the American Stock Exchange. The table below presents the high and low market prices, and dividend information for the Corporation's common shares. Price Range Cash Low High Dividend 1993 - 1st quarter 9.250 11.875 .07 2nd quarter 9.625 12.625 .07 3rd quarter 10.000 12.000 .07 4th quarter 8.500 11.375 .07 1992 - 1st quarter 7.500 9.875 .07 2nd quarter 7.875 9.500 .07 3rd quarter 8.250 9.875 .07 4th quarter 7.875 9.875 .07 The approximate number of holders of the Corporation's common stock as of December 31, 1993 was 3,000. No change is anticipated regarding the Corporation's dividend policy. At the current time, there are no restrictions on the payment of dividends. - 9 - Item 6. Item 6. Selected Financial Data. ------------------------ 1993 1992 1991 1990 1989 ------------ ------------ ------------ ------------ ------------ Net sales $292,255,714 $218,458,265 $196,374,954 $198,659,566 $218,609,089 Net income 10,014,456 10,802,412 1,539,500 14,685,324 16,098,800 Net income per common share* 0.61 0.66 0.09 0.89 0.98 Cash dividends per common share* 0.28 0.28 0.28 0.28 0.27 Total assets 204,875,706 174,062,469 150,582,783 156,733,681 140,431,056 Long-term debt 39,565,448 25,487,818 13,670,864 19,804,493 16,500,000 Shareholders' equity 108,753,363 103,613,242 97,393,079 100,472,453 90,405,516 Return on equity 9.7% 11.1% 1.5% 16.2% 20.5% * Amounts reported reflect retroactive adjustments for all stock dividends and distributions. - 10 - Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations. ---------------------- O'Sullivan Corporation currently operates in two principal business segments. The primary activity of the Company is the manufacture of calendered and molded plastics products for the automotive and specialty plastics manufacturing industries. This activity includes designing, engineering, compounding, laminating, printing, painting and assembling a variety of plastics products for sale to manufacturers and distributors. On April 1, 1993, the Company acquired Capitol Plastics of Ohio, Inc. Capitol Plastics is a custom injection molding manufacturing operation with one plant located in Bowling Green, Ohio. Capitol Plastics of Ohio, Inc., which is a wholly-owned subsidiary of O'Sullivan Corporation, is part of the plastics products operations segment of the Company. On November 24, 1992 O'Sullivan Corporation acquired substantially all of the assets of Melnor Industries, Inc. and its wholly-owned Canadian subsidiary Melnor Manufacturing Ltd. With this acquisition, O'Sullivan Corporation entered the consumer products manufacturing, marketing and distribution business which represents its second business operations segment. The new Company, which is a wholly-owned subsidiary of O'Sullivan Corporation, is now called Melnor Inc. and has as its wholly-owned subsidiary, Melnor Canada Ltd. The principal source of income for the Company is from sales of those products produced by each business segment to manufacturers, distributors and retail outlets. Consolidated net sales for 1993 were $292.3 million, compared to $218.5 million in 1992, up 33.8%. Sales increases experienced during 1993 were primarily the result of sales from the newly acquired consumer products segment of the Company and the additional sales volume generated by the acquisition of Capitol Plastics of Ohio, Inc. in the plastics products segment of the Company's operations. Core business sales, discounting the effect of Melnor and Capitol Plastics, in the plastics products segment of the business increased $16.1 million, or 7.5%. In 1994, and during the next few years, the Company expects continuing sales growth in all of its business segment operations. Sales prices for products produced by the Company will be subject to downward pressure due to extremely competitive conditions. The Company's proactive supplier and employee involvement programs are expected to offset this pressure through productivity improvements and cost savings. Consolidated net income for the year ended December 31, 1993 decreased 7.3% from $10.8 million in 1992 to $10.0 million in 1993. The primary reasons for this decrease are as follows: the acquisitions of Melnor Inc. and Capitol Plastics of Ohio Inc.; the new program launch problems associated with the Huron, Ohio injection molding plant; and finally, the disruptive effects of two union organization attempts by the United Auto Workers at our Huron, Ohio plant and both of our plant operations in Winchester, Virginia. All of the above-referenced events combined to negative- ly affect the earnings capability of the Company during 1993. - 11 - O'Sullivan Corporation's plastic products business segment accounted for 86.1% of consolidated sales for the year ended December 31, 1993. Sales increased 16.5% from $216.1 million in 1992 to $251.7 million in 1993. The major factor responsible for this increase in sales volume was the acquisition of Capitol Plastics of Ohio, Inc. Sales generated by Capitol Plastics accounted for 54.8% of the total increase in volume generated in the plastics products business segment. The remaining sales increase registered by the plastics products segment amounted to 7.5%. This increase in sales revenue was primarily volume related rather than increases in sales prices. For the year ended December 31, 1993, the plastics products operations segment contributed $26.4 million in pre-tax operating profit compared to $23.6 million for the same period last year, up 12.0%. Contributing to the increase in this income was the reversal of $1.0 million of estimated restructuring costs provided for during 1991. Selling and warehousing expenses associated with the plastics products segment increased 19.6% during 1993 when compared to the same period last year. The increase was directly related to sales volume increases experienced by the Company. During 1993, selling and warehousing expenses represented 2.9% of each sales dollar compared to 2.8% for the same period last year. During 1994, the Company anticipates that core business sales will increase at a stronger pace than in 1993. The greatest potential for increased sales growth for the plastics products segment will come from those products produced by the Company for the domestic automobile and truck industries, with modest sales increases in other product lines within this business segment. The Company's consumer products segment was established with the acquisition of Melnor Inc. The primary activity of the consumer products segment is the manufacture, sale and distribution of home lawn and garden watering products to distributors and retail outlets. Financial comparisons for prior operating periods are not applicable as the new operating segment commenced operations in November of 1992. Sales for the year ended December 31, 1993 were $40.5 million which represented 13.9% of the total consolidated net sales revenue for the Company in 1993. For the period ended December 31, 1993 the consumer products segment recorded a $2.1 million pre-tax operating profit. After adjusting for general and administrative expenses, other income and expenses the consumer products segment of the Company recorded a loss before taxes of $1.5 million. Selling and warehousing expenses inclusive of bad debt expense represented 14.1% of net sales for the period ended December 31, 1993. Although the loss was disappointing to management, improvements in operations have been accomplished. Additional work is necessary to bring the combination of product mix and stable profitability to this business segment. During 1993, sales were negatively affected by extreme wet weather conditions in the Mid-West and Eastern United States. Currently, the economic outlook for this business segment is promising for 1994 and management expects the consumer products segment to contribute to positive earnings in 1994. - 12 - Consolidated corporate administration expense increased 70.2% for the period ended December 31, 1993, compared to the same period last year. As a percent of net sales, general corporate administrative expenses represented 3.2% of each sales dollar in 1993 compared to 2.6% in 1992. Melnor Inc. represented 58.0% of the total increase in general and administrative expenses during 1993 compared to 1992. After eliminating the effects of Melnor Inc., general and administrative expenses represented 2.8% of each sales dollar for the period ended December 31, 1993 compared to 2.6% during 1992. Consolidated non-operating expenses increased during the year ending December 31, 1993 when compared to the same period last year, primarily due to the increased debt financing costs incurred by the Company. The increase in debt was necessary to fund the acquisition of Capitol Plastics of Ohio Inc., complete the necessary capital expenditure projects underway by the Company and to provide adequate working capital for the expansion of inventories and receivables to meet sales requirements. Consolidated capital spending increased 147.6% during 1993. For the year ended December 31, 1993 the Company invested $16.6 million in new property, plant and equipment compared to $6.7 million during 1992. Based upon current capital expenditures estimates, the Company expects that capital expenditures will be less in 1994 than experienced during 1993. Currently the Company has additional capacity in both the plastics products and consumer products business segment operations. As has been the Company's practice, additions to property, plant and equipment are implemented when additional business cannot be absorbed into existing facilities or product specifications require new or improved technology. Total consolidated debt for the Company increased $18.8 million during 1993. Melnor Inc., had current and long-term debt obliga- tions totaling $13.5 million or 26.2% of the total debt of the Company. During 1993 the Company secured long-term debt in the form of a $25 million senior private note placement, dated May 27, 1993. The notes are for seven years with a five year average life maturing May 1st in the year 2000. Currently the Company is negotiating with a financial institution to refinance the debt of Melnor Inc. The new debt will consist of a two year facility with terms substantially the same as the current debt structure and is expected to be closed before the end of the first quarter of 1994. Also, during 1993 the Company renegotiated its $25 million unsecured operating line of credit with its principal bank, First Union National Bank of Virginia, which now has a maturity of June 22, 1995. With the current debt structure and lines of credit that are available, the Company believes that working capital require- ments for the short and long-term are adequately provided for. At the close of 1993, even with additional debt to fund acquisitions, the Company's financial condition remained strong, with shareholder's equity at 53.1% of total assets. Current assets compared to current liabilities were 2.2 to 1. Total debt to equity of the Company was 47.4% and net worth was $108.8 million, up 5.0% from 1992. - 13 - Item 8. Item 8. Financial Statements and Supplementary Data. -------------------------------------------- This page left blank intentionally. See following pages for financial Statements. - 14 - INDEPENDENT AUDITOR'S REPORT To the Stockholders and Board of Directors of O'Sullivan Corporation We have audited the accompanying consolidated balance sheets of O'Sullivan Corporation and Subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of O'Sullivan Corporation and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for the years ended December 31, 1993, 1992 and 1991 in conformity with generally accepted accounting principles. As described in the notes to financial statements, the Company changed its methods of accounting for income taxes and postretirement benefits in 1993. /s/ YOUNT, HYDE & BARBOUR, P.C. Winchester, Virginia February 1, 1994 - 15 - O'SULLIVAN CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 1993 1992 ASSETS ------------ ------------ Current Assets Cash and cash equivalents $ 3,099,636 $ 3,545,943 Receivables 53,389,817 35,231,399 Inventories 42,514,692 36,441,982 Deferred income tax assets 2,076,524 1,960,998 Other current assets 1,879,516 1,641,492 ------------ ------------ Total current assets $102,960,185 $ 78,821,814 ------------ ------------ Property, Plant and Equipment $ 93,847,484 $ 86,761,473 ------------ ------------ Intangibles $ 1,017,266 $ 988,438 ------------ ------------ Other Assets $ 7,050,771 $ 7,490,744 ------------ ------------ Total assets $204,875,706 $174,062,469 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Short-term debt $ 8,483,977 $ 6,748,982 Current portion of long-term debt 3,584,142 556,208 Accounts payable 24,011,203 16,036,001 Accrued expenses 11,528,330 12,245,726 ------------ ------------ Total current liabilities $ 47,607,652 $ 35,586,917 ------------ ------------ Long-Term Debt $ 39,565,448 $ 25,487,818 ------------ ------------ Other Long-Term Liabilities $ 1,691,753 $ 1,855,765 ------------ ------------ Deferred Income Tax Liabilities $ 7,257,490 $ 7,518,727 ------------ ------------ Commitments and Contingencies $ - - $ - - ------------ ------------ Shareholders' Equity Common stock, par value $1.00 per share; authorized 30,000,000 shares $ 16,484,948 $ 16,485,268 Additional paid-in capital 9,964,574 9,967,758 Retained earnings 82,524,869 77,126,131 Cumulative translation adjustments (101,732) 34,085 Unrecognized pension costs, net of deferred tax effect (119,296) - - ------------ ------------ Total shareholders' equity $108,753,363 $103,613,242 ------------ ------------ Total liabilities and shareholders' equity $204,875,706 $174,062,469 ============ ============ The accompanying notes are an integral part of the consolidated financial statements. - 16 - O'SULLIVAN CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Net sales $ 292,255,714 $ 218,458,265 $ 196,374,954 Cost of products sold 251,803,879 187,993,698 177,532,380 ------------- ------------- ------------- Gross profit $ 40,451,835 $ 30,464,567 $ 18,842,574 ------------- ------------- ------------- Operating expenses Selling and warehousing $ 12,752,808 $ 6,459,396 $ 5,614,066 General and administrative 9,485,791 5,573,761 4,696,264 Provision for doubtful accounts 209,719 710,443 550,000 Provision for (recovery of) restructuring charge (969,251) - - 5,025,000 ------------- ------------- ------------- $ 21,479,067 $ 12,743,600 $ 15,885,330 ------------- ------------- ------------- Income from operations $ 18,972,768 $ 17,720,967 $ 2,957,244 ------------- ------------- ------------- Other income (expense) Interest income $ 106,105 $ 242,319 $ 526,243 Interest expense (2,471,269) (785,542) (1,405,430) Other, net 189,878 367,224 324,857 ------------- ------------- ------------- $ (2,175,286) $ (175,999) $ (554,330) ------------- ------------- ------------- Income before income taxes and cumulative effect of accounting changes $ 16,797,482 $ 17,544,968 $ 2,402,914 Income taxes 7,088,364 6,742,556 863,414 ------------- ------------- ------------- Income before cumulative effect of accounting changes $ 9,709,118 $ 10,802,412 $ 1,539,500 Cumulative effect of accounting changes 305,338 - - - - ------------- ------------- ------------- Net income $ 10,014,456 $ 10,802,412 $ 1,539,500 ============= ============= ============= Net income per common share: Income before cumulative effect of accounting changes $ 0.59 $ 0.66 $ 0.09 Cumulative effect of accounting changes 0.02 - - - - ------------- ------------- ------------- Net income per common share $ 0.61 $ 0.66 $ 0.09 ============= ============= ============= The accompanying notes are an integral part of the consolidated financial statements. - 17 - O'SULLIVAN CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------ ------------ ------------ Cash Flows From Operating Activities Net income $ 10,014,456 $ 10,802,412 $ 1,539,500 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 11,438,370 9,623,212 9,859,074 Provision for doubtful accounts 209,719 710,443 550,000 Deferred income taxes 938,091 410,313 (1,932,068) Loss on disposal of assets 210,128 72,906 130,929 Cumulative effect of accounting changes (305,338) - - - - Provision for (recovery of) restructuring and withdrawal of non-productive assets (969,251) - - 4,055,749 Changes in operating assets and liabilities, net of effect of acquisition of business: Receivables (14,970,510) 1,638,544 882,241 Inventories (4,192,871) (5,139,325) (1,277,985) Other current assets (967,404) 419,735 (1,384,955) Accounts payable 3,601,697 (2,080,612) (5,157,428) Accrued expenses (545,949) 1,159,646 1,893,022 ------------ ------------ ------------ Net cash provided by operating activities $ 4,461,138 $ 17,617,274 $ 9,158,079 ------------ ------------ ------------ Cash Flows From Investing Activities Purchase of property, plant and equipment $(16,631,214)$ (6,717,094)$ (7,369,557) Purchase of intangible assets (249,723) - - - - Acquisition of business, less cash acquired (1,153,643) (5,708,695) - - Payments received from non- operating notes receivable 729,176 624,119 27,278 Proceeds from disposal of assets 127,917 354,123 1,152,503 Other, net (127,956) (368,256) 624,633 ------------ ------------ ------------ Net cash (used in) investing activities $(17,305,443)$(11,815,803)$ (5,565,143) ------------ ------------ ------------ Cash Flows From Financing Activities Changes in short-term debt $ 1,734,995 $ 4,300,558 $ - - Cash overdraft reduction - - (413 615) - - Net change in line of credit borrowings (7,500,000) 7,000,000 (5,500,000) Proceeds from long-term debt 25,000,000 - - - - Repayment of long-term debt (2,152,412) (500,000) (2,000,000) ------------ ------------ ------------ Balance forward $ 17,082,583 $ 10,386,943 $ (7,500,000) - 18 - O'SULLIVAN CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (Continued) 1993 1992 1991 ------------ ------------ ------------ Cash Flows From Financing Activities (Continued) Balance forwarded $ 17,082,583 $ 10,386,943 $ (7,500,000) Principal payments under capital lease obligations (65,338) (270,256) (240,664) Cash dividends paid (4,615,743) (4,615,791) (4,617,176) Purchase of common stock (3,504) (550) (3,043) Advance payments (repayments) from customers - - (9,729,529) 9,729,529 ------------ ------------ ------------ Net cash provided by (used in) financing activities $ 12,397,998 $ (4,229,183)$ (2,631,354) ------------ ------------ ------------ Increase (decrease) in cash and cash equivalents $ (446,307) $ 1,572,288 $ 961,582 Cash and cash equivalents at beginning of year 3,545,943 1,973,655 1,012,073 ------------ ------------ ------------ Cash and cash equivalents at end of year $ 3,099,636 $ 3,545,943 $ 1,973,655 ============ ============ ============ The accompanying notes are an integral part of the consolidated financial statements. - 19 - O'SULLIVAN CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 Additional Common Paid-in Retained Stock Capital Earnings ------------ ------------ ------------ Balance at January 1, 1991 $ 16,485,628 $ 9,970,991 $ 74,015,834 Net income - - - - 1,539,500 Purchase of common stock (300) (2,743) - - Dividends declared, $.28 per share - - - - (4,615,831) ------------ ------------ ------------ Balance at December 31, 1991 $ 16,485,328 $ 9,968,248 $ 77,126,131 Net income - - - - 10,802,412 Purchase of common stock (60) (490) - - Dividends declared, $.28 per share - - - - (4,615,784) Translation adjustments - - - - - - ------------ ------------ ------------ Balance at December 31, 1992 $ 16,485,268 $ 9,967,758 $ 70,939,503 Net income - - - - 10,014,456 Purchase of common stock (320) (3,184) - - Dividends declared, $.28 per share - - - - (4,615,718) Translation adjustments - - - - - - Unrecognized pension costs - - - - - - ------------ ------------ ------------ Balance at December 31, 1993 $ 16,484,948 $ 9,964,574 $ 82,524,869 ============ ============ ============ CUMULATIVE UNRECOGNIZED TRANSLATION PENSION SHAREHOLDERS' ADJUSTMENTS COSTS EQUITY ------------ ------------ ------------ Balance at January 1, 1991 $100,472,453 Net income 1,539,500 Purchase of common stock (3,043) Dividends declared, $.28 per share (4,615,831) ------------ ------------ ------------ Balance at December 31, 1991 $ - - $ - - $ 97,393,079 Net income - - - - 10,802,412 Purchase of common stock - - - - (550) Dividends declared, $.28 per share - - - - (4,615,784) Translation adjustments 34,085 - - 34,085 ------------ ------------ ------------ Balance at December 31, 1992 $ 34,085 $ - - $103,613,242 Net income - - - - 10,014,456 Purchase of common stock - - - - (3,504) Dividends declared, $.28 per share - - - - (4,615,718) Translation adjustments (135,817) - - (135,817) Unrecognized pension costs - - (119,296) (119,296) ------------ ------------ ------------ Balance at December 31, 1993 $ (101,732) $ (119,296) $108,753,363 ============ ============ ============ The accompanying notes are an integral part of the consolidated financial statements. - 20 - O'SULLIVAN CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts and transactions of the Corporation and all of its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. Cash and Cash Equivalents The Corporation considers all highly liquid investments with a ma- turity of three months or less at the time of purchase to be cash equivalents. Receivables and Concentration of Credit Risk Receivables from trade customers are generally due within thirty to sixty days. The Corporation performs periodic reviews of its major customers' financial condition and grants trade credit based upon evaluations of the credit worthiness of each customer. Credit losses have been within the expectations of management. Receivables are presented net of an allowance for doubtful accounts of $1,133,793 at December 31, 1993 and $1,804,676 at December 31, 1992. Accounts receivable balances for automotive related business at December 31, 1993 and 1992 were $34,341,947 and $23,419,658, respectively. Inventories Inventories are valued at the lower of cost or market, with cost being determined substantially by the first-in, first-out or average cost method. Property, Plant and Equipment and Depreciation Property, plant and equipment are stated at historical cost, adjusted to current exchange rates where applicable. Depreciation is computed primarily by the straight-line method over the estimated useful lives of assets. The estimated useful lives are twenty to forty years for buildings and three to fourteen years for machinery and other equipment. Accelerated methods of depreciation are utilized for tax purposes. Expenditures for repairs and maintenance are charged to operations as incurred. Betterments and improvements that extend the useful life of an asset are capitalized. Upon sale and other dispositions of assets, the cost and related accumulated depreciation is removed from the accounts and the resulting gain or loss is reflected in operations. - 21 - Intangibles Intangible assets are stated at cost less accumulated amortization. Amortization is determined on a straight-line basis over the estimated useful lives of the assets that have been determined to range from two to seven years. Amortization expense for 1993 and 1992 was $197,224 and $13,047, respectively. Income Taxes Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and tax credit carryforwards and deferred tax liabilities are recog- nized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and lia- bilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Reference should also be made to Note 7 regarding a change in the method in accounting for income taxes. Research and Development Product and process research and development are charged to expense as incurred. Per Share Information Net income and dividends per share were calculated on the weighted average common shares outstanding for 1993, 1992 and 1991 which were 16,485,103, 16,485,323 and 16,485,504, respectively. Stock options were not dilutive for 1993, 1992 and 1991. Foreign Currency Translation Financial statements for the Corporation's foreign subsidiary are translated into U.S. dollars at year-end exchange rates as to assets and liabilities and weighted average exchange rates as to revenues and expenses. The resulting translation adjustments are recorded in shareholders' equity. Transaction gains and losses are reflected in net income. Pension Plans The Corporation and its subsidiaries have retirement plans that cover substantially all employees who meet certain eligibility requirements. Employees not covered under a retirement plan maintained by the Corporation and its subsidiaries are generally participants in multiemployer plans sponsored by other entities. The plans include noncontributory defined benefit plans providing benefits to certain salaried employees based on years of service and final years' average earnings and to certain hourly employees based on a dollar unit multiplied by years of eligible service. The Corporation's policy is to fund at least the minimum amounts required by the applicable governing bodies. - 22 - The Corporation also maintains a Retirement Savings Plan ("Plan") to provide retirement benefits to employees not covered by a defined benefit plan. The Plan provides that the Corporation will make a basic contribution of three percent of eligible compensation for participants. The Plan also provides that the Corporation will make an additional contribution of up to two percent of eligible compensation if the participant is making voluntary contributions to the Plan. Participants may generally contribute up to five percent of their eligible compensation. The Corporation is not required to make any contributions during a plan year if it elects to not do so. Postretirement Benefits The Corporation provided health care benefits to certain of its retired employees under a plan which was terminated January 1, 1993. Upon termination of the plan this group of retired employees was allowed to continue to be covered by the Corporation's group insurance plan. Effective January 1, 1993 the Corporation adopted Financial Accounting Standards Board Statement No. 106 to account for its share of the costs of benefits provided to this group. To effect adoption of Statement No. 106, the Corporation accrued as of January 1, 1993 its share of the estimated costs to insure this group of retirees. Prior to January 1, 1993, the Corporation expensed its share of these expenses as they were incurred. Reclassification of Amounts Certain amounts for 1992 and 1991 have been reclassified to reflect comparability with account classifications for 1993. Note 2. Inventories Inventories at December 31 were composed of the following: 1993 1992 ------------ ------------ Finished goods $ 12,878,160 $ 10,589,433 Work in process 6,398,783 6,716,121 Raw materials 19,068,449 15,564,262 Supplies 4,169,300 3,572,166 ------------ ------------ $ 42,514,692 $ 36,441,982 ============ ============ Slow-moving inventories at December 31, 1993 amounted to $640,539 less a reserve of $306,320. At December 31, 1992 slow-moving in- ventories amounted to $1,588,844 less a reserve of $988,844. Slow-moving inventories is an estimate of inventory held in excess of one year's requirements, based on historical sales volumes. - 23 - Note 3. Property, Plant and Equipment Property, plant and equipment at December 31 were composed of the following: 1993 1992 ------------ ------------ Land $ 2,053,067 $ 1,931,340 Buildings 49,134,149 43,888,616 Machinery and equipment 102,382,300 89,614,728 Transportation equipment 3,510,243 3,510,186 ------------ ------------ $157,079,759 $138,944,870 Less accumulated depreciation 63,232,275 52,183,397 ------------ ------------ $ 93,847,484 $ 86,761,473 ============ ============ Depreciation expense totaled $11,241,146, $9,610,165 and $9,589,074 in 1993, 1992 and 1991, respectively. Note 4. Accrued Expenses Accrued expenses at December 31 were composed of the following: 1993 1992 ------------ ------------ Accrued compensation $ 3,748,107 $ 2,992,094 Dividends payable 1,153,497 1,152,926 Income taxes payable - - 1,162,443 Other accrued expenses 6,626,726 6,938,263 ------------ ------------ $ 11,528,330 $ 12,245,726 ============ ============ Note 5. Debt Short-term debt Melnor Inc., a subsidiary of the Corporation, had short-term debt at December 31, 1993 and 1992 consisting of a revolving credit fa- cility ("revolving loan") with a finance company in an aggregate amount not to exceed $20,000,000 that expires November 24, 1994. The aggregate amount of the revolving loan cannot exceed the lesser of (i) the Current Asset Base minus the Letter of Credit Reserve and (ii) the Total Seasonal Revolving Loan Facility of $20,000,000 during the period of February 1 through July 31 of each year and the Total Permanent Revolving Loan Facility of $11,000,000 during the period of August 1 through January 31 of the succeeding calendar year. - 24 - The Current Asset Base equals 85% of the face amount of eligible accounts receivable plus 55% of eligible inventory for Melnor Inc. Eligible inventory cannot exceed $6,500,000 between August 1 and January 31 of the succeeding calendar year and $7,500,000 between February 1 and July 31 of each year. The Letter of Credit Reserve equals the sum of 45% of the face amount of letters of credit is- sued for purchase of inventory and 100% of the face amount of all other letters of credit outstanding. Total loan availability at December 31, 1993 and 1992 amounted to $9,000,000 and $7,940,572, respectively. At December 31, 1993 and 1992 $8,843,977 and $6,748,982, respectively, was borrowed. Melnor Inc. and its subsidiary have established lock box accounts to which all account debtors shall directly remit all payments on accounts and in which Melnor Inc. and its subsidiary will immedi- ately deposit all cash payments made for inventory or other cash payments constituting proceeds of collateral. All amounts held or deposited in or payments made to the lock box accounts are the sole and exclusive property of the lender and shall be applied to the loan balance. Any amounts contained in the lock box accounts or otherwise received by the lender in excess of the loan obliga- tion then due and payable shall be the property of Melnor Inc. and its subsidiary and shall promptly be paid over by the lender. Interest is payable monthly at a fluctuating rate equal to prime plus 1.5%. The rate at both December 31, 1993 and 1992 was 7.5%. In addition, underutilization and letter of credit fees are payable monthly. The loan security agreement provides, among other things, for certain reporting and collateral requirements. The loan is collateralized by substantially all assets of Melnor Inc. and its subsidiary. The loan agreement provides for certain financial covenants such as maintenance of a certain level of earnings before interest, depreciation, amortization and income taxes; interest expense coverage quotient; cash flow coverage; limitation of capital expenditures and maintenance of net worth. The financial covenants were originally scheduled to begin October 31, 1993, but were extended during the year ended December 31, 1993 to January 31, 1994. Negative covenants provide, among other things, limitations on encumbrances, indebtedness, merger or other acquisition, disposal of property, compensation plans, dividend or other distributions and lease obligations. Long-Term Debt 7.05% Senior Notes dated May 27, 1993, payable to various insurance companies. The notes bear an inter- est rate of 7.05% payable semiannu- ally on the first day of May and November, commencing November 1, 1993. Interest is due on any over- due principal, premium amount and interest installment at the rate of 8.05% per annum until paid. - 25 - December 31, ------------------------- 1993 1992 ----------- ----------- Principal payments of the lesser of (a) $5,000,000 or (b) the principal amounts of the notes then outstand- ing are due on May 1 of each year, commencing May 1, 1996, and ending May 1, 1999. Prepayment of the notes may be done at any time prior to the scheduled payment dates with a prepayment premium. The entire remaining principal amount of the notes shall become due and payable on May 1, 2000. The note agreement provides, among other things, for certain financial covenants in re- gard to the Corporation, such as consolidated net worth requirements, interest charge coverage ratios and limitations on liens and additional debt. Negative covenants provide for, among other things, limitations on indebtedness; mergers, consolida- tions and sale of assets; and divi- dends and other distributions. The Corporation is in compliance with these covenants. $25,000,000 $ - - Line of credit notes payable to First Union National Bank of Virginia. The Corporation has a $25,000,000 unsecured line of credit to support general corporate activi- ties. Borrowings against the line of credit are at or below prevailing prime interest rates, (6.0% at December 31, 1993 and 5.1% at December 31, 1992). The line of credit matures June 22, 1995. 13,000,000 20,500,000 7.5% promissory note payable from Melnor Inc. to a finance company due in monthly payments of $41,000 plus interest at a fluctuating rate equal to 1.5% per annum in excess of the prime rate (7.5% at December 31, 1993 and 1992) with the outstanding balance payable in full on November 24, 1994, collateralized by all as- sets of Melnor Inc. and its sub- sidiary. The loan is provided under the same security agreement as the revolving credit facility described in the Short-Term Debt section and - 26 - December 31, ------------------------- 1993 1992 ----------- ----------- is subject to the same covenants and items as the revolving credit facility. 508,000 1,000,000 7.0% senior subordinated note payable from Melnor Inc. to an in- surance company due November 24, 1994 with interest payable at the prime rate plus 1.0% (7.0% at December 31, 1993 and 1992) on November 24, 1993, May 24, 1994 and November 24, 1994. Interest pay- ments are guaranteed by O'Sullivan Corporation. The note purchase agreement provides, among other things, restrictions on indebtedness and liens, capital expenditures and various financial covenants begin- ning January 31, 1994. 2,695,000 2,695,000 7.0% senior subordinated note payable from Melnor Inc. to an af- filiate of Melnor Industries, Inc. due December 24, 1994 with interest payable at the prime rate plus 1.0% (7.0% at December 31, 1993 and 1992) on December 24, 1993, June 24, 1994 and December 24, 1994. Interest payments are guaranteed by O'Sullivan Corporation. 305,000 305,000 Unsecured non-interest bearing promissory note payable to Melnor Industries, Inc. discounted at 9.0% due on November 24, 1996. The initial principal amount of the note was $2,900,000 subject to adjustment for the decrease that occurred in the net asset values purchased at November 24, 1992 since August 28, 1992, the date of the purchase price negotiations. On the basis of the preliminary closing date balance sheet, the discounted amount due under the note was $611,250. Since the amount of the note at December 31, 1992 was con- tingent upon the final closing date balance sheet that had not been agreed upon between the Seller and - 27 - December 31, ------------------------- 1993 1992 ----------- ----------- the Buyer, an additional discounted value of the note amounting to $541,258 was included in the recorded note balance at December 31, 1992 until all contingencies were removed. During the year ended December 31, 1993 the final closing date balance sheet was agreed upon. The discounted value of the note at December 31, 1993 reflects the ad- justed agreed upon balance. 1,243,747 1,152,508 Non-interest bearing obligation payable to Melnor Industries, Inc., discounted at 9.0%. Payment is con- tingent upon Melnor Industries, Inc. satisfying its obligation under the New Jersey Environmental Cleanup Responsibility Act and the release by the State of the escrow fund of $300,000 established to fund envi- ronmental cleanup activities. 230,966 211,156 Notes payable from Melnor Inc. to equipment finance companies due in monthly payments totaling $906 in- cluding interest at rates from 11.7% to 15.5%. The notes are secured by equipment with a book value of $17,964. 17,052 - - Capital lease obligations 149,825 180,362 ----------- ----------- $43,149,590 $26,044,026 Less current maturities 3,584,142 556,208 ----------- ----------- $39,565,448 $25,487,818 =========== =========== Long-term debt matures as follows: 1994 $ 3,584,142 1995 13,074,272 1996 6,260,210 1997 5,000,000 1998 5,000,000 Later Years 10,230,966 ----------- $43,149,590 =========== - 28 - Interest incurred and capitalized are as follows: 1993 1992 1991 ----------- ----------- ----------- Interest incurred $ 2,552,661 $ 809,647 $ 1,605,364 Less interest capitalized 81,392 24,105 199,934 ----------- ----------- ----------- $ 2,471,269 $ 785,542 $ 1,405,430 =========== =========== =========== Debt Refinancing Melnor Inc. is currently negotiating with a financial institution to refinance a majority of its debt. The new debt will consist of a two year facility with terms substantially the same as the cur- rent debt structure. In conjunction with the refinancing Melnor Inc. obtained a loan in the amount of $12,500,000 from First Union National Bank of Virginia on January 31, 1994. The proceeds of the loan were used to pay the short-term debt, the 7.5% promissory note payable to a finance company and the 7.0% senior subordinated note payable to an insurance company. Melnor Inc. expects to complete the refi- nancing of its debt structure during the first quarter of 1994 and will retire this loan. The loan is guaranteed by O'Sullivan Corporation. Note 6. Business Combinations On April 1, 1993 the Corporation acquired all of the outstanding stock of Capitol Plastics of Ohio, Inc., a company engaged in the business of custom injection molding, at an acquisition cost of $1,153,643. The acquisition was accounted for as a purchase and the accounts and transactions of the acquired business have been included in the consolidated financial statements from the date of acquisition. Unaudited pro forma consolidated net sales, net income and net in- come per common share, assuming the acquisition had occurred as of the beginning of 1993, would have been approximately as follows: Pro forma net sales $ 299,000,000 Pro forma net income $ 10,100,000 Pro forma net income per common share $ .61 On November 24, 1992 the Corporation acquired substantially all of the assets of Melnor Industries, Inc., including the outstanding stock of Melnor Manufacturing, Ltd., a Canadian corporation owned 100% by Melnor Industries, Inc. The businesses are engaged in the manufacture and distribution of lawn and garden consumer products. The total acquisition cost was $13,655,967 adjusted for the as- sumption of certain liabilities. The acquisition was accounted for as a purchase and the accounts and transactions of the ac- quired businesses have been included in the consolidated financial statements from the date of acquisition. - 29 - Unaudited pro forma consolidated net sales, net income and net in- come per common share, assuming the acquisition had occurred as of the beginning of 1992 would have been approximately as follows: Pro forma net sales $ 259,900,000 Pro forma net income $ 9,800,000 Pro forma net income per common share $ .59 Note 7. Income Tax Matters Pretax income from operations for the years ended December 31, 1993, 1992 and 1991 was taxed by the following jurisdictions: 1993 1992 1991 ------------ ------------ ------------ Domestic $ 15,210,035 $ 17,408,510 $ 2,402,914 Foreign 1,587,447 136,458 - - ------------ ------------ ------------ $ 16,797,482 $ 17,544,968 $ 2,402,914 ============ ============ ============ Effective January 1, 1993, the Corporation adopted Statement of Financial Standards No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 changes the Corporation's method of accounting for income taxes from the deferred method to a liabil- ity met hod. Under the deferred method the Corporation deferred the past tax effects of a timing difference between financial re- porting and tax reporting. The liability method requires the recognition of deferred tax assets and liabilities for the ex- pected future tax consequences of temporary differences between the reported amounts of assets and liabilities and their tax bases. The cumulative effect of the adoption of Statement No. 109 was to increase net income determined for 1993 by $680,488. Financial statements for prior years have not been restated. Net deferred tax liabilities at December 31, 1993 consisted of the following components: Deferred tax assets: Provision for doubtful accounts $ 318,425 Employee benefits 1,890,949 Inventory basis differences 344,057 Other 460,823 ------------ $ 3,014,254 ------------ Deferred tax liabilities: Property, plant and equipment $ 7,940,364 Like-kind exchange 254,856 ------------ $ 8,195,220 ------------ $ (5,180,966) ============ - 30 - The deferred tax amounts mentioned above have been classified on the accompanying balance sheet as of December 31, 1993 as follows: Noncurrent (liabilities) $ (7,257,490) Current assets 2,076,524 ------------ $ (5,180,966) ============ The provision for income taxes charged to operations for the year ended December 31, 1993 consists of the following: Current: Federal $ 4,175,706 Foreign 611,451 State 1,363,116 ------------ $ 6,150,273 ============ Deferred: Federal $ 786,459 Foreign - - State 151,632 ------------ $ 938,091 ============ $ 7,088,364 ============ The income tax provision differs from the amount of income tax de- termined by applying the U.S. federal income tax rate to pretax income for the year ended December 31, 1993 due to the following: % Income Before Taxes ------------ Computed "expected" tax expense 35.0% Increase (reduction) in taxes resulting from: Income taxed at lower U.S. federal rates (.6%) State taxes, net of federal benefit 6.2% Higher rate on earnings of foreign operations .3% Federal tax credits (.6%) Other 1.9% ------------ 42.2% ============ - 31 - As discussed above, the Corporation accounted for income taxes us- ing the deferred method as prescribed by APB 11 for the years ended December 31, 1992 and 1991. The provision for income taxes charged to operations for the years ended December 31, 1992 and 1991 consist of the following: 1992 1991 ------------ ------------ Current: Federal $ 5,341,103 $ 2,282,490 Foreign 58,014 - - State 933,126 512,992 ------------ ------------ $ 6,332,243 $ 2,795,482 ============ ============ Deferred: Federal (benefit) $ 337,681 $ (1,719,902) Foreign - - - - State (benefit) 72,632 (212,166) ------------ ------------ $ 410,313 $ (1,932,068) ============ ============ $ 6,742,556 $ 863,414 ============ ============ The components of deferred income taxes (benefits) are as follows: 1992 1991 ------------ ------------ Depreciation $ 978,439 $ 316,389 Provision for doubtful accounts (131,092) 130,613 Employee benefits (223,157) (198,208) Inventory basis differences (152,242) 67,488 Provision for restructuring charge - - (378,008) Differences arising from asset disposals - - (1,870,342) Other (61,635) - - ------------ ------------ $ 410,313 $ (1,932,068) ============ ============ - 32 - A comparison of the federal statutory tax rate for 1992 and 1991 to the Corporation's effective tax rate is as follows: 1992 1991 ------------ ------------ U.S. Federal income tax rate 34.0% 34.0% Increases (reductions) in taxes resulting from: State taxes, net of federal benefit 3.9% 5.3% Federal tax credits (.2%) (3.4%) Other .7% - - ------------ ------------ Effective tax rate 38.4% 35.9% ============ ============ Note 8. Benefit Plans Defined Benefit Plans The net pension cost for defined benefit plans included the fol- lowing components: 1993 1992 1991 ---------- ---------- ---------- Benefits earned during the year $ 242,837 $ 332,385 $ 150,752 Interest cost on projected benefit obligation 654,682 376,887 274,856 Actual (return) on assets (592,401) (238,740) (541,640) Net amortization and deferral 94,403 (76,955) 324,714 ---------- ---------- ---------- Net pension cost $ 399,521 $ 393,577 $ 208,682 ========== ========== ========== The funded status of the defined benefit pension plans as of December 31, 1993 was as follows: Overfunded Underfunded ------------ ------------ Actuarial present value: Vested benefit obligation $ 3,621,125 $ 4,872,868 Nonvested benefit obligation 33,993 135,445 ------------ ------------ Accumulated benefit obligation $ 3,655,118 $ 5,008,313 Effect of projected compensation increases 245,505 835,731 ------------ ------------ Projected benefit obligation $ 3,900,623 $ 5,844,044 Fair value of plan assets 4,515,461 3,559,672 ------------ ------------ Plan assets in excess of (less than) projected benefit obligation $ 614,838 $ (2,284,372) Unrecognized net loss 26,088 681,322 Unrecognized prior service costs - - 629,931 Unrecognized net (asset) obligation at initial adoption of FAS 87 (436,385) 30,286 Adjustment required to recognize minimum liability - - (505,808) ------------ ------------ Prepaid (accrued) pension cost $ 204,541 $ (1,448,641) ============ ============ - 33 - The funded status of the defined benefit pension plans as of December 31, 1992 was as follows: Overfunded Underfunded ------------ ------------ Actuarial present value: Vested benefit obligation $ 3,180,848 $ 4,429,309 Nonvested benefit obligation 35,393 118,666 ------------ ------------ Accumulated benefit obligation $ 3,216,241 $ 4,547,975 Effect of projected compensation increases 239,882 987,956 ------------ ------------ Projected benefit obligation $ 3,456,123 $ 5,535,931 Fair value of plan assets 4,255,962 3,306,366 ------------ ------------ Plan assets in excess of (less than) projected benefit obligation $ 799,839 $ (2,229,565) Unrecognized net (gain) loss (265,771) 790,874 Unrecognized prior service costs - - 692,336 Unrecognized net (asset) obligation at initial adoption of FAS 87 (395,048) 142,482 Adjustment required to recognize minimum liability - - (729,969) ------------ ------------ Prepaid (accrued) pension cost $ 139,020 $ (1,333,842) ============ ============ Discount rates for the plans ranged from 7% to 8%. The assumed long-term rates of return on plan assets were also 7% to 8%. The assumed rate of increase in future compensation levels ranged from 5% to 7%. The unrecognized asset(liability) at the initial adop- tion of FAS 87 is being amortized on a straight-line basis over the average remaining service period of plan participants. Plan assets consist of listed common stocks, corporate and government bonds and short-term investments. Retirement Savings Plan The expense associated with the Retirement Savings Plan was $2,218,558 for 1993, $1,685,623 for 1992 and $848,112 for 1991. Deferred Compensation Plan During 1985, the Corporation initiated a deferred compensation program for key employees of the Corporation. Under this program, the Corporation has agreed to pay each covered employee a certain sum annually for fifteen years upon their retirement or, in the event of their death, to their designated beneficiary. A benefit is also paid if the employee terminates employment (other than by his voluntary action or discharge for cause) before they attain age 65. In that event, the amount of the benefit depends on the employee's years of service with the Corporation (with full bene- fit paid only if the employee has completed 25 years of service). The Corporation has purchased individual life insurance contracts with respect to each employee covered by this program. - 34 - The Corporation is the owner and beneficiary of the insurance con- tracts. The employees are general creditors of the Corporation with respect to these benefits. The expense associated with the Deferred Compensation plan was $196,064 for 1993, $91,213 for 1992 and $41,472 for 1991. Postretirement Benefit Plan At January 1, 1993 the Corporation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement re- quires the Corporation to recognize the estimated costs of provid- ing certain postretirement benefits to former employees of the Corporation. The Corporation elected to recognize the transition obligation immediately as the effect of an accounting change. This change resulted in a one-time charge to income in 1993 of $375,150, net of deferred income taxes of $239,850. Annual net postretirement benefit costs are determined on a actuarial basis. Net periodic postretirement benefit cost included the following components for the year ended December 31, 1993: Interest expense on accumulated postretirement benefit obligation of $40,000 and net experience gains of $95,000. Postretirement benefit obligations at December 31, 1993, none of which are funded, are summarized as follows: Accumulated postretirement benefit obligation, retirees $ 460,000 Plan assets - - ------------ Accumulated postretirement benefit obligation in excess of plan assets $ 460,000 Unrecognized transition obligation - - Unrecognized net experience losses (gains) - - ------------ Accrued postretirement benefit obligation $ 460,000 ============ For measurement purposes, a 16% annual rate of increase in per capita health care costs of covered benefits was assumed for 1993, with such annual rate of increase gradually declining to 6% in 2003. If assumed health care cost trend rates were increased by one percentage point in each year, the accumulated postretirement benefit obligation at December 31, 1993 would be increased by $12,000 and the interest cost component of net periodic postre- tirement benefit cost for the year ended December 31, 1993 would be increased by $1,000. Note 9. Leases The Corporation and its subsidiaries lease various plant and ware- house facilities along with various equipment. Leases for the plant and warehouse facilities and capitalized leases for machin- ery and equipment generally require the payment of appropriate taxes, insurance and maintenance costs. Most non-capitalized - 35 - leases, except for the lease of facilities in New Jersey by a sub- sidiary, are cancelable within a limited period of time. The facility in New Jersey is leased under a noncancelable agreement that expires June 30, 1997. Minimum Rental Capitalized Commitments Leases ------------ ------------ 1994 $ 462,922 $ 80,426 1995 444,629 72,103 1996 439,717 16,981 1997 219,672 - - 1998 735 - - ------------ ------------ $ 1,567,675 $ 169,510 ============ Less amount representing interest 19,685 ------------ Present value of net minimum lease payments $ 149,825 ============ Net rental expense for all non-capitalized leases for the years ended 1993, 1992 and 1991 was $1,283,084, $471,795 and $435,208, respectively. Note 10. Research and Development Research and development costs charged to expense were $2,126,346 in 1993, $1,572,547 in 1992 and $1,292,722 in 1991. Note 11. Restructuring of Operations In 1991, in response to economic pressures, the Corporation implemented a business strategy designed to improve operating efficiency. Activities associated with the restructuring in- cluded the abandonment and disposal of non-productive assets, consolidation of operations including rigging and relocation of molding machines and related support facilities and severance costs associated with terminated employees. During 1993, the Corporation reduced operating expenses $969,251 due to a change in accounting estimate for restructuring charges that the Corporation recorded against operations in 1991. The effect of the change in accounting estimate was to increase net income $591,243, net of related income tax effect of $378,008. Net income per common share increased by $0.04 due to the change. Note 12. Commitments and Contingencies Environmental Matters The Corporation continues to modify, on an ongoing, regular basis, certain of its processes which may have an environmental impact. The Corporation's efforts in this regard include the removal of many of its underground storage tanks and the reduction or elimi- nation of certain chemicals and wastes in its operations. - 36 - Although it is very difficult to quantify the potential impact of compliance with environmental protection laws, the Corporation's financial statements reflect the cost of these ongoing modifica- tions. Management believes that the continuing costs to the Corporation of environmental compliance will not result in a mate- rial adverse effect on its future financial condition or results of operations. Note 13. Business Segment Information The Corporation's operations are classified principally into two business segments; Calendered and Molded Plastics Products ("Plastics Products") and Lawn and Garden Consumer Products ("Consumer Products"). The Plastics Products segment primarily involves the manufacture of calendered and injection-molded plas- tics products for the automotive and specialty plastics manufac- turing industries. The Consumer Products segment primarily in- volves the manufacture and distribution of a wide range of lawn and garden products. Operating profit represents net sales less operating expenses for each segment and excludes general corporate expenses and non-operating revenues and expenses. Identifiable as- sets for each segment represent those assets used in the Corporation's operations and exclude general corporate assets. General corporate assets include cash, investments and other non- operating assets. Net Sales for the Plastics Products segment to the divisions and subsidiaries of Ford Motor Company amounted to $86,589,527 (29.6% of net sales) in 1993, $84,100,032 (38.5% of net sales) in 1992 and $76,782,607 (39.1% of net sales) in 1991. Receivables at December 31, 1993 and 1992 from Ford Motor Company were $20,285,433 and $13,927,855, respectively. Business Segment Information 1993 1992 1991 ------------ ------------ ------------ Net Sales By Classes of Similar Products Plastics Products $251,742,441 $216,055,429 $196,374,954 Consumer Products 40,513,273 2,402,836(a) - - ------------ ------------ ------------ Total Net Sales $292,255,714 $218,458,265 $196,374,954 ============ ============ ============ Operating Profit (Loss) Plastics Products $ 26,401,507 $ 23,574,503 $ 7,653,508(b) Consumer Products 2,057,052 (279,775)(a) - - ------------ ------------ ------------ Total Operating Profit $ 28,458,559 $ 23,294,728 $ 7,653,508 General Corporate Expenses 9,485,791 5,573,761 4,696,264 Non-operating Revenue(Expense) (2,175,286) (175,999) (554,330) ------------ ------------ ------------ Income Before Income Taxes and Cumulative Effect of Accounting Changes $ 16,797,482 $ 17,544,968 $ 2,402,914 ============ ============ ============ - 37 - 1993 1992 1991 ------------ ------------ ------------ Identifiable Assets Plastics Products $165,660,063 $135,855,781 $137,413,010 Consumer Products 25,394,702 23,560,028 - - ------------ ------------ ------------ Total Identifiable Assets $191,054,765 $159,415,809 $137,413,010 General Corporate Assets 13,820,941 14,646,660 13,169,773 ------------ ------------ ------------ Total Assets $204,875,706 $174,062,469 $150,582,783 ============ ============ ============ Capital Expenditures Plastics Products $ 15,193,167 $ 6,384,938 $ 7,180,186 Consumer Products 1,351,516 32,502(a) - - General Corporate 86,531 299,654 189,371 ------------ ------------ ------------ Total Capital Expenditures $ 16,631,214 $ 6,717,094 $ 7,369,557 ============ ============ ============ Depreciation and Amortization Plastics Products $ 9,651,506 $ 9,164,057 $ 9,503,197 Consumer Products 1,402,596 104,520(a) - - General Corporate 384,268 354,635 355,877 ------------ ------------ ------------ Total Depreciation and Amortization $ 11,438,370 $ 9,623,212 $ 9,859,074 ============ ============ ============ (a) Includes activity only from acquisition of business at November 24, 1992 through December 31, 1992. (b) Includes restructuring charge of $5,025,000. Note 14. Incentive Stock Option Plan The Corporation has an incentive stock option plan under which options may be granted to certain key employees for the purchase of the Corporation's common stock. The effective date of the plan was January 29, 1985. The plan will expire on January 28, 1995 unless terminated by the Board of Directors at an earlier date. The original number of shares authorized under the plan totaled 50,000 shares. Antidulutive provisions in the plan required an increase in authorized shares to 165,886 shares for stock dividends and distributions that occurred during 1989, 1988, 1987, 1986 and 1985. The option price covered by an option cannot be less than 100% of fair market value of the common stock on the date of grant. As of December 31, 1993, options for 161,018 shares remained unex- ercised and 4,868 shares are reserved for the grant of future options. Options for 1,000 shares at an exercise price of $10.50 per share were granted during 1993. Options for 55,820 shares at an exercise price of $8.42 per share were granted during 1992. No options were granted during 1991. - 38 - Options for 2,000 shares during 1993, 41,831 shares in 1992 and 13,500 shares in 1991 were forfeited. No options were exercised during 1993, 1992 or 1991. Note 15. Fair Value of Financial Instruments The Corporation estimates that each category of financial instruments; including cash, trade receivables and payables, investments and debt instruments, approximate current value at December 31, 1993. Note 16. Supplemental Cash Flow Information Supplemental Disclosure of Cash Flow Information 1993 1992 1991 ---------- ---------- ---------- Cash payments for interest, net of interest capitalized $2,028,606 $ 777,636 $1,398,337 ========== ========== ========== Cash payment for income taxes $7,964,853 $5,356,385 $3,166,256 ========== ========== ========== Supplemental Schedule of Noncash Investment Activities The Corporation's 1993 business acquisition involved the following: Fair value of assets acquired, other than cash and cash equivalents $ 8,173,416 Liabilities assumed ( 7,019,773) ------------ Cash payments made $ 1,153,643 ============ The Corporation's 1992 business acquisition involved the following: Fair value of assets acquired, other than cash and cash equivalents $ 20,803,464 Liabilities assumed (7,288,802) Notes issued to others (6,143,424) Notes issued to sellers (1,662,543) ------------ Cash payments made $ 5,708,695 ============ In 1991 the Corporation received notes receivable totaling $1,215,000 as the proceeds from the sale of certain business operations. - 39 - Note 17. Supplemental Financial Data (Unaudited) Quarter Ended -------------------------------------------------- 1993 March 31 June 30 September 30 December 31 ----------- ----------- ----------- ----------- Net sales $70,847,999 $80,243,845 $66,507,215 $74,656,655 Gross profit $ 9,704,477 $13,607,242 $ 7,812,656 $ 9,327,460 Net income $ 2,290,286 $ 4,282,031 $ 1,961,678 $ 1,480,461 Earnings per share $ .14 $ .26 $ .12 $ .09 Dividends declared $ .07 $ .07 $ .07 $ .07 Market price per share: High 11 7/8 12 5/8 12 11 3/8 Low 9 1/4 9 5/8 10 8 1/2 Quarter Ended -------------------------------------------------- 1992 March 31 June 30 September 30 December 31 ----------- ----------- ----------- ----------- Net sales $52,491,921 $56,628,552 $52,636,445 $56,701,347 Gross profit $ 5,811,959 $ 8,029,174 $ 7,706,237 $ 8,917,197 Net income $ 1,705,374 $ 3,222,212 $ 2,930,266 $ 2,944,560 Earnings per share $ .10 $ .20 $ .18 $ .18 Dividends declared $ .07 $ .07 $ .07 $ .07 Market price per share: High 9 7/8 9 1/2 9 7/8 9 7/8 Low 7 1/2 7 7/8 8 1/4 7 7/8 - 40 - Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure. --------------------- None. - 41 - PART III -------- Item 10. Item 10. Directors and Executive Officers of the Registrant. --------------------------------------------------- For information with respect to the Corporation's Directors and Director nominees, see pages 3 through 6 of the Corporation's definitive Proxy Statement dated April 1, 1994, which pages are incorporated herein by reference. Executive Officers of the Registrant The names, ages, and positions of the executive officers of O'Sullivan Corporation as of January 31, 1994, are listed below. All officers are elected by the Board for a one-year term. There are no family relationships among officers, or any arrangement or understanding between any officer and any other person pursuant to which the officer was elected. Served as Officer Name Age Office Since --------------------- --- --------------------------- -------- Arthur H. Bryant, II 51 Chairman of the Board 1975 James T. Holland 53 President 1976 Anthony A. Barone 44 Vice President and Secretary 1984 Robert C. Westfall 51 Vice President 1979 John S. Campbell 43 Vice President 1986 James L. Tremoulis 40 Vice President 1986 Phillip S. Griffin 55 Vice President 1975 William O. Bauserman 50 Vice President 1987 Dee S. Johnston 57 Vice President 1992 Ewen A. Campbell 46 Vice President 1993 Edgar W. Roller 64 Vice President 1994 C. Bryant Nickerson 47 Treasurer 1986 Mr. Bryant held the office of Executive Vice President from April, 1975 until his election as President in April, 1976. He was elected Chairman of the Board and Chief Executive Officer in April, 1984. Mr. Holland was elected Treasurer in July, 1976, Vice President and Treasurer in April, 1979, Executive Vice President and Chief Operating Officer in April, 1984 and President and Chief Operating Officer in April, 1986. He also was elected to the Board of Directors in October, 1984. - 42 - Mr. Barone joined O'Sullivan Corporation in 1984 serving as Treasurer and Chief Financial Officer. He was elected Secretary of the Corporation in July, 1985 and Vice President and Secretary in April, 1986. Mr. Westfall has been employed by the Corporation since 1965. He has progressed from chemist, to quality control manager, to plant manager, to Vice President, Research and Development in April, 1979. Mr. J. S. Campbell has been employed by the Corporation since 1973. He has served the Corporation both in the sales area and in the management of manufacturing operations for the calendered plastics products area of the Corporation. He has served as Vice President since April, 1986. Mr. Tremoulis has been employed by the Corporation since 1980 in the sales area. He has served as Vice President since April, 1986. Mr. Griffin has been employed by the Corporation since 1968. Mr. Griffin has served the Company in various capacities in sales, manufacturing and management related areas. Elected as Vice President in 1975, Mr. Griffin now serves as President of Melnor Inc., a subsidiary of O'Sullivan Corporation. Mr. Bauserman has been employed by the Corporation since 1968. During his employment he has served in various capacities within the data processing environment. He has served as Vice President, Management Information Services since April, 1987. Mrs. Johnston has been employed by the Corporation since 1976. During that time she has served in various capacities within the corporate purchasing department, most recently as Director of Purchasing for O'Sullivan Corporation. Mrs. Johnston has served as Vice President since January, 1992. Mr. E. A. Campbell has been employed by the Corporation since 1991, as Director of Technical Services. Mr. Campbell received his BSC. in chemistry and his PhD. in Organic Chemistry from the University of Edinburg, Scotland. Prior to his employment with O'Sullivan Corporation he was employed with Duraplex Industries, in Scotland, Tenneco Chemicals and Haygro Sales, Inc. in the United States. Mr. Campbell's technical background in chemistry has allowed him to work in various areas of the Company's compounding and research and development activities. Mr. Campbell has served as Vice President since July, 1993. Mr. Roller has been employed by the Corporation since 1986, originally as an industrial engineer. In 1988, Mr. Roller was reassigned to the Human Resources Department where he became Corporate Manager of Compensation. He remained in that position until his promotion to Vice President of Human Resources in January, 1994. Prior to his employment with O'Sullivan Corporation, Mr. Roller was employed by U.S. Steel in various industrial engineering capacities. - 43 - Mr. Nickerson has been employed by the Corporation since 1973. He has held various responsibilities within the corporate financial area, progressing from general accountant, to Controller, to Treasurer and Chief Accounting Officer in April, 1986. - 44 - Item 11. Item 11. Executive Compensation. ----------------------- See Page 7 through 11 of the Corporation's Proxy Statement dated April 1, 1994, which pages are incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. --------------------------------------------------------------- See Pages 3 through 6 of the Corporation's Proxy Statement dated April 1, 1994, which information in incorporated herein by reference. - 45 - Item 13. Item 13. Certain Relationships and Related Transactions. ----------------------------------------------- There were no transactions during 1993 that would be applicable for disclosure under this item. - 46 - PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. ---------------------------------------------------------------- Page ---- (a) 1. Financial Statements -------------------- Included in Part II, Item 8, of this report: Report of Independent Auditors 15 Consolidated Balance Sheets at December 31, 1993 and 1992 16 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 17 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 18-19 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 20 Consolidated Notes to Financial Statements 21-40 (a) 2. Financial Statement Schedules ----------------------------- Included in Part IV of this report: Report of Independent Auditors on Financial Statement Schedules 49 For the years ended December 31, 1993, 1992 and 1991: Schedule V - Property, Plant and Equipment 50-51 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 52 Schedule VIII - Valuation and Qualifying Accounts and Reserves 53 Schedule IX - Short-Term Borrowings 54 Schedule X - Supplementary Income Statement Information 55 - 47 - Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. ---------------------------------------------------------------- (Continued) (a) 3. Exhibits: Page --------- ---- 3.1 O'Sullivan Corporation Amended and Restated Articles of Incorporation, including the Articles of Amendment, dated April 30, 1985, filed with the State Corporation Commission of Virginia on May 6, 1985, adopted by stock- holders of O'Sullivan Corporation at the annual meeting held April 30, 1985. (Incorporated by reference to the March 31, 1985, Quarterly Report on Form 10-Q of the Company.) 3.2 O'Sullivan Corporation bylaws as amended to January 29, 1985. (Incorporated by reference to the March 31, 1985, Quarterly Report on Form 10-Q of the Company.) 3.3 O'Sullivan Corporation bylaws Amended and Restated Articles of Incorporation dated April 25, 1989, filed with the State Corporation Commission of Virginia on May 5, 1989, adopted by stockholders of O'Sullivan Corporation at the annual meeting held April 25, 1989 (Incorporated by reference to the March 31, 1989 Quarterly Report on Form 10-Q of the Company.) 23. Consent of Experts - filed herewith. 24. Power of Attorney - filed herewith. 99.2 Form 11-K for 1985 Incentive Stock Option Plan - filed herewith. 99.3 1985 Incentive Stock Option Plan. Amended and Restated as of July 27, 1993, and filed herewith as part of the Form 11-K for the fiscal year ended December 31, 1993. (b). Reports on Form 8-K. -------------------- There were no Form 8-K filings during 1993. (c). Index to Exhibits. 58 ------------------ - 48 - INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of the O'Sullivan Corporation The examination referred to in our opinion dated February 1, 1994 of the consolidated financial statements as of December 31, 1993 and 1992 and for the three years ended December 31, 1993, 1992 and 1991 included the related supplemental financial schedules as listed in Item 14(a)2, which, when considered in relation to the basic financial statements, present fairly in all material respects the information shown therein. /s/ YOUNT, HYDE & BARBOUR, P.C. - 49 - O'SULLIVAN CORPORATION AND SUBSIDIARIES Schedule V PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 Column A Column B Column C Column D Column E Column F - ------------ ----------- ----------- ----------- ----------- ------------ Balance at Other Balance Beginning Additions Changes at End Class of Year at Cost Retirements Add (Deduct) of Year - ------------ ----------- ------------ ----------- ----------- ------------ 1993: Land $ 1,931,340 $ 124,050 $ - - $ (2,323) $ 2,053,067 Buildings 43,888,616 5,288,407 - - (42,874) 49,134,149 Machinery and Equipment 88,729,643 11,924,651 564,296 2,292,302 102,382,300 Transportation Equipment 3,510,186 57 - - - - 3,510,243 Property under Capital Leases 885,085 - - - - (885,085) - - ------------ ------------ ----------- ----------- ------------ Totals $138,944,870 $ 17,337,165(A)$ 564,296 $ 1,362,020(E)$157,079,759 ============ ============ =========== =========== ============ 1992: Land $ 1,690,713 $ 239,985 $ - - $ 642 $ 1,931,340 Buildings 40,769,034 3,107,726 - - 11,856 43,888,616 Machinery and Equipment 78,983,605 11,066,850 1,340,358 19,546 88,729,643 Transportation Equipment 3,449,578 77,650 17,042 - - 3,510,186 Property under Capital Leases 871,585 13,500 - - - - 885,085 ------------ ------------ ----------- ----------- ------------ Totals $125,764,515 $ 14,505,711(B)$ 1,357,400 $ 32,044(F)$138,944,870 ============ ============ =========== =========== ============ 1991: Land $ 1,738,713 $ - - $ 48,000 $ - - $ 1,690,713 Buildings 41,389,720 280,313 165,131 (735,868) 40,769,034 Machinery and Equipment 78,142,330 4,121,222 10,771,053 7,491,106 78,983,605 Transportation Equipment 3,417,177 545,990 540,437 26,848 3,449,578 Property under Capital Lease 724,765 146,820 - - - - 871,585 Construction in Progress 4,353,661 2,428,425 - - (6,782,086) - - ------------ ------------ ----------- ----------- ------------ Totals $129,766,366 $ 7,522,770(C)$11,524,621(D)$ - -(G)$125,764,515 ============ ============ =========== =========== ============ - 50 - Note (A) - Represents additions purchased for cash, except for assets with a value of $59,202 acquired through the incurring of capital lease obligations and long-term debt. Note (B) - 1992 additions include the following assets acquired as part of a business acquisition treated as a purchase: Land - $58,078; Buildings - $1,422,842; and Machinery and Equipment - $6,294,197. Note (C) - Represents additions purchased for cash, except for the incur- ring of capital lease obligations in the amount of $146,820. Additions for Construction in Progress includes $2,428,425 in current year expenditures to complete projects initiated in prior years. These expenditures include $2,179,464 for completion of injection molding machines committed for under a machine replacement program. Note (D) - Retirements include $6,221,214 of machinery and equipment with- drawn as non-productive assets as part of a restructuring plan, net of estimated salvage value. Note (E) - Includes foreign currency translation adjustments of $(122,186), net account reclassifications of $(70,096) and other adjustments of $1,554,302 resulting from a business acquisition. Note (F) - Foreign currency translation adjustment. Note (G) - Reclassification of accounts. Note (H) - The method and rates used in computing the annual provision for depreciation are described in Note 1. of the Accompanying Notes to Consolidated Financial Statements. - 51 - O'SULLIVAN CORPORATION AND SUBSIDIARIES Schedule VI ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 Column A Column B Column C Column D Column E Column F - -------------- ----------- ----------- ---------- ---------- ----------- Additions Balance at Charged to Other Balance Beginning Costs and Changes at End Classification of Year Expense Retirements Add(Deduct) of Year - -------------- ----------- ----------- ---------- ---------- ----------- 1993: Buildings $10,213,511 $ 1,861,690 $ - - $ (10,956) $12,064,245 Machinery and Equipment 39,284,640 9,260,867 226,251 715,549 49,034,805 Transportation Equipment 2,084,505 48,720 - - - - 2,133,225 Property under Capital Leases 600,741 69,869 - - (670,610) - - ----------- ----------- ---------- ---------- ----------- Totals $52,183,397 $11,241,146 $ 226,251 $ 33,983(C)$63,232,275 =========== =========== ========== ========== =========== 1992: Buildings $ 8,359,646 $ 1,851,024 $ - - $ 2,841 $10,213,511 Machinery and Equipment 31,165,589 8,949,852 843,927 13,126 39,284,640 Transportation Equipment 2,053,412 43,753 12,660 - - 2,084,505 Property under Capital Leases 399,856 200,885 - - - - 600,741 ----------- ----------- ----------- ---------- ----------- Totals $41,978,503 $11,045,514(A)$ 856,587 $ 15,967(D)$52,183,397 =========== =========== =========== ========== =========== 1991: Buildings $ 7,116,916 $ 1,569,445 $ 30,394 $ (296,321) $ 8,359,646 Machinery and Equipment 27,283,418 7,918,264 4,326,964 290,871 31,165,589 Transportation Equipment 2,280,038 113,976 346,052 5,450 2,053,412 Property under Capital Leases 142,467 257,389 - - - - 399,856 ----------- ----------- ----------- ---------- ----------- Totals $36,822,839 $ 9,859,074 $ 4,703,410(B)$ - -(E)$41,978,503 =========== =========== =========== ========== =========== Note (A) - 1992 additions include the following accumulated depreciation amounts established in conjunction with a business acquisition treated as a purchase: Buildings - $256,322; Machinery and Equipment - $1,179,027. Note (B) - Retirements include accumulated depreciation of $2,165,466 for machinery and equipment withdrawn as non-productive assets as part of a restructuring plan. Note (C) - Includes foreign currency translations adjustment of $(63,385), account reclassifications and other adjustment of $97,368 resulting from a business acquisition. Note (D) - Foreign currency translation adjustments. Note (E) - Reclassification of accounts. - 52 - O'SULLIVAN CORPORATION AND SUBSIDIARIES Schedule VIII VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Years Ended December 31, 1993, 1992 and 1991 Column A Column B Column C Column D Column E - ------------ ---------- ----------------------------- ---------- ---------- Additions ----------------------------- (1) (2) (3) Addition Balance at Charged to Charged from Balance Beginning Costs and To Other Business At End Description of Year Expense Accounts Acquisition Deductions of Year - ------------ ---------- -------- -------- -------- ---------- ---------- 1993: Allowance for Doubtful Accounts $1,804,676 $209,719 $118,633(A)$ 27,013(B)$1,026,248(C)$1,133,793 ========== ======== ======== ======== ========== ========== 1992: Allowance for Doubtful Accounts $ 683,601 $710,443 $ 40,614(A)$871,056(B)$ 501,038(C)$1,804,676 ========== ======== ======== ======== ========== ========== 1991: Allowance for Doubtful Accounts $1,018,487 $550,000 $ 5,241(A)$ - - $ 890,127(C)$ 683,601 ========== ======== ======== ======== ========== ========== Note (A) - Recoveries of accounts written off. Note (B) - Allowance for doubtful accounts established at acquisition date for businesses acquired in 1993 and 1992. Note (C) - Write-offs of uncollectible accounts. - 53 - O'SULLIVAN CORPORATION AND SUBSIDIARIES Schedule IX SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 Column A Column B Column C Column D Column E Column F - ---------------------- ----------- ------- ----------- ----------- ------- Weighted Maximum Average Average Category of Balance Weighted Amount Amount Interest Aggregate at Average Outstanding Outstanding Rate Short-Term End of Interest During the During the During Borrowings Year Rate Year Year the Year - ---------------------- ----------- ------- ----------- ----------- ------- 1993: Notes payable to finance company (A) $ 8,483,977 7.50% $13,562,380 $ 9,533,571(B) 7.50% Notes payable to banks (C) $ - - - - $ - - $ - - - - 1992: Notes payable to finance company (A) $ 6,748,982 7.50% $ 6,748,982 $ 4,843,479(B) 7.50% Notes payable to banks (C) $ - - - - $ - - $ - - - - 1991: Notes payable to banks (C) $ - - - - $ - - $ - - - - Note (A) - Refer to Note 5. (Short-Term Debt section) of the Accompanying Notes to Consolidated Financial Statements for a detailed explanation of Notes Payable to a finance company, including interest rates. Note (B) - The average amount outstanding during the year was computed by dividing the total of daily outstanding principal balances by the number of days short-term borrowing was utilized (365 days for 1993 and 37 days for 1992). Note (C) - The line of credit against which the Corporation has obtained funds is scheduled to expire June 22, 1995. Note 5. of the Accompanying Notes to Consolidated Financial Statements contains additional pertinent information regarding the line of credit loans. - 54 - O'SULLIVAN CORPORATION AND SUBSIDIARIES Schedule X SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 Column A Column B ----------------------- --------------------------------------- Charged to Costs and Expenses --------------------------------------- Item 1993 1992 1991 ----------- ----------- ----------- Maintenance and Repairs $ 6,073,207 $ 4,611,707 $ 4,962,780 ----------- ----------- ----------- Depreciation and Amortization of Intangible Assets * * * Taxes, Other than Payroll and Income Taxes * * * Royalties * * * Advertising * * * * Less than 1% of Net Sales - 55 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. O'SULLIVAN CORPORATION March 29, 1994 By: /s/ Anthony A. Barone --------------- --------------------------- Date Anthony A. Barone Vice President, Secretary and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the dates given. Arthur H. Bryant, II * March 29, 1994 ---------------------- -------------- Arthur H. Bryant, II Chairman, Chief Executive Date Officer and Director /s/ James T. Holland March 29, 1994 ---------------------- -------------- James T. Holland President, Chief Operating Date Officer and Director /s/ Anthony A. Barone March 29, 1994 ---------------------- -------------- Anthony A. Barone Vice President, Secretary Date and Chief Financial Officer /s/ C. Bryant Nickerson March 29, 1994 ---------------------- -------------- C. Bryant Nickerson Treasurer and Chief Date Accounting Officer John J. Armstrong * March 29, 1994 ---------------------- -------------- John J. Armstrong Director Date Harry F. Byrd, Jr. * March 29, 1994 ---------------------- -------------- Harry F. Byrd, Jr. Director Date Max C. Chapman, Jr. * March 29, 1994 ---------------------- -------------- Max C. Chapman, Jr. Director Date James P. Jamieson * March 29, 1994 ---------------------- -------------- James P. Jamieson Director Date Paul Terretta * March 29, 1994 ---------------------- -------------- Paul Terretta Director Date Alexander W. Neal, Jr. * March 29, 1994 ---------------------- -------------- Alexander W. Neal, Jr. Director Date - 56 - Magalen O. Bryant * March 29, 1994 ---------------------- -------------- Magalen O. Bryant Director Date C. Hugh Bloom, Jr. * March 29, 1994 ---------------------- -------------- C. Hugh Bloom, Jr. Director Date C. Ridgely White * March 29, 1994 ---------------------- -------------- C. Ridgely White Director Date * By: /s/ James T. Holland --------------------- James T. Holland Attorney - In - Fact - 57 - EXHIBIT INDEX Page ----- 21. Subsidiaries of the Registrant 59 23. Consent of Experts 60 24. Powers of Attorney 61-71 99.2 Form 11-K for 1985 Incentive Stock Option Plan 72-74 99.3 1985 Incentive Stock Option Plan, Amended and Restated as of July 27, 1993 75-80 - 58 -

814071_1993.txt

814071_1993

1993

814071

ITEM 1. DESCRIPTION OF BUSINESS: History Sunlite Technologies Corp. (the "Company"), formerly known as Hospitality Concepts, Inc., is a Delaware Corporation which was organized on December 10, 1986 for the purpose of obtaining capital to participate in business ventures which have potential for profit. The Company's name was changed on March 16, 1990. On December 10, 1986, the Company issued 4.5 million shares of common stock par value $.0001. to officers and directors for $7,350 in cash which is approximately $.001633 per share. In October 1987, the Company successfully completed a public offering of 3,000,000 equity units at a price of $.10, this raised the Company $300,000. Each unit consisted of one share $.0001 par value common stock, one class "A" redeemable warrant, and one class "B" redeemable warrant. In March 1988, the Company, decided to enter into the Restaurant/Bakery business, and exchanged all the shares of Bedford Street Bakers Corp. for 4,000,000 shares of its common stock. Bedford Street Bakers Corp. was a restaurant/bakery which operated under a franchise agreement with "The Glass Oven International," thus becoming a wholly owned subsidiary of the Company. The on going operations were not up to expectations with a shortage of available key personnel, the store shortened its hours of operations and even closed for periods of time when help was not available. This became an unprofitable business venture, and in June 1988, the Company decided to sell its business to a former employee so as to prevent further losses to the Company. Bedford was originally incorporated and, organized by Fast N' Fancy Foods Inc.. Mr. Scala who since June 1990, has served as President of Sunlite, was also an officer director and principal shareholder of Fast N' Fancy Foods Inc. Fast N' Fancy Foods Inc. established the operations of Bedford including negotiating the franchise agreement with The Glass Oven International, two years prior to being purchased by Sunlite. The stock of Bedford was, distributed to Fast N' Fancy shareholders. On October 1, 1988, the Company sold an additional one million unregistered common shares, at $.05 per share, to a group of four individuals for an aggregate $50,000. The purpose of this sale was to replenish the Company's available working capital so as to allow it to continue operations and explore other potential business opportunities. On October 18, 1988, the Company found another business opportunity and entered into a license agreement with MJR Co., pursuant to this agreement, the Company would attempt to market a new solar rechargeable battery ("SRB.") The Company paid $20,000 to the MJR Company and its principal owners Raymond F. and Mary J. Curiel as a non-refundable deposit on an exclusive licensing agreement for the ("SRB") invention, developed by the MJR Company. The parties consummated this agreement on January 6, 1989. At that time the Company Issued 20,000,000 shares of its common stock to Raymond F. and Mary J. Curiel. This original agreement was superseded by a new agreement which became effective on November 30, 1989. The Company had attempted to manufacture and market the ("SRB"), first under a licensing agreement with MJR and then in November 1990, the Company purchased all the Issued U.S. Patents and foreign applications pending thereby canceling any, and all agreements with MJR Co. and/or Raymond Curiel. The success of this endeavor would ultimately depend on the Company's ability to manufacture and market this item as well as obtaining sufficient capital to fund an appropriate business plan. Furthermore, there was no assurance that other products would not be developed by other companies that would be competitive to the Company's "SRB" or even render the solar battery obsolete. On May 15, 1991, the Company entered into a manufacturing and joint marketing agreement with Burbud Management Corp. This agreement was to provide the Company with the necessary manufacturing facility in the Dominican Republic. Burbud was to assist Sunlite in developing and coordinating a comprehensive marketing campaign and overall strategy for developing the most effective sales outlets for the product. Under the Burbud agreement, the Company was to issue Burbud Management Corp. 8,000,000 shares of its common stock in lieu of payment for cost of raw materials, tooling up charges, and labor costs for the assembly of the initial production of 20,000 SRB'S. These shares were also intended to cover any future technical improvements to the product developed by Burbud. Since August 1992, the Company issued only 500,000 shares of the 8,000,000 shares of its common stock as partial payment under its agreement with Burbud. Through fiscal year ended November 30, 1993, Burbud had not delivered any additional batteries against its agreement. The Company had tried to obtain the necessary capital to continue its efforts to manufacture and market its "SRB." The Company had explored a few possible licensing arrangements with other Companies and individuals, but nothing had developed from these discussions. However, the Company would pursue this avenue if it were unable to raise the necessary funding needed to continue manufacturing and marketing its "SRB." Subsequent to November 30, 1993 In August 1995, the Company declared its contract with Burbud void due to the non-performance of the original contract commitment to deliver 20,000 SBR's. However, at present certain disputes continue between the Company and Burbud whereby Burbud has made demands which could obligate the Company to issue up to an additional 1,500,000 shares of its common stock to Burbud for services performed during the term of the contract. Management plans to vigorously fight the issuance of these shares due to damages sustained by the Company in the form of lost "SRB" sales. Burbud has not complied with many of the terms of the agreement and management continues to resist any claims by Burbud for additional compensation. On August 30, 1995, the Company entered into a licensing agreement with an individual and received a $5,000 non refundable initial licensing fee. Under the terms of the licensing agreement the Company will also receive a royalty equal to 5% of the gross selling price on such items manufactured and sold by the licensee for all sales up to $1,000,000 and 2% of sales more than $1,000,000. However, the Company will receive a minimum royalty of $1000 per month for a term of sixty months which began in January 1996. Between August 1995 and December 1995, the Company began to look for other business opportunities to enter. In December 1995, the Company purchased from Lewis Scala all the necessary hardware equipment, Galacticomm's World Group software, and all existing telephone connections to run an Online Bulletin Board Service that provides Internet connectivity. The service can handle up to 256 simultaneous users. The most common need for Internet access is to allow users to "surf the web" with software such as Netscape, Microsoft explorer and many other "web" browsers. The Worldgroup software provides a pass-through SLIP, CSLIP and PPP connections for authorized users. The agreed price was $5,000. From November 1993 to May 1996, the company has sold 560,000 shares of common unregistered stock to nine individuals at $.025 per share and had raised an additional $14,000. Patents. The Company owns three patents in the United States for the "SRB." Patent No. 4,563,727 was issued on January 7, 1986 and Patent No. 4,648,013 was issued on March 3, 1987. These patents together cover all claims for the battery and its applications and adaptations. Patent No. 291,798 was issued September 8, 1987 which covers the ornamental design for the "D" size type battery. In addition to the U.S. patents obtained the company has a patent in Mexico. Trademark, Service Marks, Trade name and Copyrights. The Company does not have any registered trademarks, service marks, trade names or copyrights in connection with its products. Employees. The Company's only full time personnel is its President. Competition. Competition for the "SRB" in the battery business primarily consists of the standard Ni-Cad "D" Size batteries as sold nationwide in a wide variety of retail stores. Producers of electrically rechargeable batteries include such established and well-financed companies as General Electric, Saft, Panasonic and Eveready. In addition, there are producers of private-label batteries sold primarily in discount retail outlets. Products and devices have also been designed and are being sold, which provide a recharging capability by use of electricity. The Company believes its "SRB" is superior to other chargeable and non chargeable batteries in that the "SRB" has the capability of being recharged solely by the sun, or other light source, to maintain its usability while keeping the ability to be recharged electrically and does not require an external power source. ITEM 2. ITEM 2. PROPERTIES The Company is occupying office space under an agreement with Lewis Scala, the Company's President to use its present facilities. The Company is paying $500.00 per month rent at this time. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has one legal proceeding threatened by Mr. Gerald Webner, Phoenix, Arizona. Mr. Webner lent the Company $15,000 and has threatened legal action if the money's were not returned to him. The Company has repaid $3000 to date. However, to date, no legal proceedings have been commenced. The Company knows of no other litigation pending, threatened or contemplated, or unsatisfied judgments against it. The Company knows of no legal action pending or threatened or judgments entered against any officers or directors of the Company in their capacity as such. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO a VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of the fiscal year ended November 30, 1993 to a vote of security holders through the solicitation of proxies or otherwise. PART 11 ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON AND RELATED STOCKHOLDER MATTERS The Company currently has one class of stock outstanding which had been offered to the public in the form of Units. Each Unit had consisted of one share of Common Stock, par value $.0001, one Class A Redeemable Common Stock Purchase Warrant and one Class B Redeemable Common Stock Purchase Warrant. Each Class A Warrant entitles the holder to purchase one share of Common Stock at a price of $.10 per share until November 30, 1996. Each Class B Warrant entitles the holder to purchase one share of Common Stock at a price of $.15 per share until November 30, 1996. These warrants have been extended by approval of the Board of Directors. The Company's securities are not listed in any known quote publication. There is no known trading market for its Units, common and/or Class "A" and "B" Warrants. The following table sets forth a range of high low bid quotations as reported by the Market Makers of the Company's stock in 1992: Fiscal year 1993 Fiscal year 1992 High Bid Low Bid High Bid Low Bid 1st Quarter $.0 $.0 $.10 $.04 2nd Quarter .0 $.0 .08 .02 3rd Quarter .0 $.0 .08 .04 4th Quarter .0 $.0 .08 .03 The above market quotations reflect interdealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The number of record holders of Common Stock as of: November 30, 1993 was approximately 275. None of the warrants have been exercised and no trading market exists. No dividends have been declared with respect to the Common Stock since the Company's inception, and the Company does not anticipate paying dividends in the foreseeable future. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS: During the year ended Nov. 30, 1993, the Company had no gross revenue, as compared to $2,616 gross revenue for the year ending Nov. 30, 1992. During fiscal year 1993 the Company had not received any product against its manufacturing agreement. The total operating expenses were $59,000, of which interest expense amounted to $22,305 as compared to operating expenses of $66,668 in fiscal 1992, of which interest expense amounted to $17,900 for year ended November 30, 1992. The Company had continued its efforts to raise the necessary capital to marketing and manufacture its product. In subsequent events after year ended November 30, 1993 the Company in August 1995, canceled its agreement with BURBUD for the manufacture and marketing of its product. Burbud had not delivered any product during fiscal 1993 and fiscal 1994. In August 1995, the Company entered into a license agreement with an individual for the exclusive marketing and manufacturing rights for the technology covered by the Company's patents. See subsequent notes in financial statements. LIQUIDITY AND CAPITAL RESOURCES: During fiscal 1993, the Company continued to seek the necessary funds for its daily operating expenses. The Company in a private transaction sold stock to two individuals and raised additional working capital, the Company continually tried to raise the necessary capital to produce and assemble the "SRB." Late in 1995 the Company decided to explore an alternative way to utilize its "SRB" technology. Then in August 1995, the Company entered into a licensing agreement with an individual and has received a $5,000 non refundable initial licensing fee. The Company, under the terms of the agreement, will also receive a royalty equal to 5% of the gross selling price on such items manufactured and sold by the licensee for all sales up to $1,000,000 and 2% of sales over $1,000,000. However, the Company will receive a minimum royalty of $1000 per month for a term of sixty months which began in January, 1996. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements of the Company are included in this Form 10-K: Financial Statements Page Auditors' Opinion- -F2 Balance Sheet- Statement of Operations- Statement of Stockholder Equity- -F6 Statement of Cash Flows- Notes to Financial Statements- to Supplementary Data: None ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART 111 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers and directors of the Company are as follows: Name Age Position Lewis Scala 49 President and Director John Somma 41 Secretary-Chairman of the Board of Directors All officers and Directors hold office for one year or until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of majority of the Board of Directors. Principal occupations of the directors and executive officers for at least five years are as follows: Lewis Scala has served as President and member of the Board of Directors since June 19, 1990. From 1985 to November 1986, Mr. Scala was a stockbroker and security trader with Norbay Securities, Inc. From November 1986 to March 1990 he was employed by Douglas Bremen & Co. Inc., as a stockbroker and security trader. Mr. Scala was President of Fast N' Fancy Foods, Inc. which had operated a fast food restaurant in Stamford, Ct. from Feb. 1983 until Oct. 1990. In Oct. 1990, Fast N' Fancy Foods, Inc., filed for protection under Chapter 11 of The Federal Bankruptcy Law, and on January 11, 1991 the case was dismissed from Chapter 11 proceedings. John Somma has served as Secretary and Chairman of the Board of Directors from November 13, 1990 to the present, Mr. Somma also served on the board of directors from September 1988 to November 1988. Mr. Somma is currently devoting about 25% of his time to the business affairs of Sunlite, and manages his own personal real estate holdings. From 1979 to 1990, Mr. Somma served as President of Logo Realty Inc. which was a real estate holding Co. Prior to that Mr. Somma has been a consultant to several restaurants. ITEM 11. EXECUTIVE COMPENSATION In fiscal 1993 Mr. Scala was compensated in the amount of $15,600. No other officers or directors were compensated during fiscal 1993. The Company has no agreement or understanding, express or implied, with any officer or director, or any other person regarding employment with the Company or compensation for services. Compensation of officers and directors is determined by the Company's Board of Directors and is not subject to shareholder approval. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the holdings of common stock by each person who, as of November 30, 1992, held of record or was known by the Company to hold beneficially or of record, more than 5% of the Company's common stock, by each officer and director, and by all officers and directors as a group. Lewis Scala 8,050,000 shares 21 % John Somma 8,130,000 shares 22 % Officers & Directors as a group ( 3 persons ) 16,180,000 shares 43 % ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In fiscal 1993 the Company leased office space from Mr. Scala at the rate of $500 per month. In October 1993, the Company sold Mr. Scala 1,250,000 of common unregistered stock at the rate of $.01 per share and reduced its total debt liability to Mr. Scala by $12,500. PART 1V ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS FORM 8-K (a) All financial statements are included commencing on page Reports on Form 8-K None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Sunlite Technologies Corp. By: /s/Lewis Scala Lewis Scala DATE: August 05, 1996 President Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. DATE: August 05, 1996 By: /s/Lewis Scala Lewis Scala President Director DATE: August 05, 1996 By: /s/John Somma John Somma Secretary Chairman of Board of Directors REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Shareholders and Board of Directors Sunlite Technologies Corp. (a development stage company) Douglaston, New York We have audited the financial statements of Sunlite Technologies Corp. (Delaware Corporation in the development stage) listed in the accompanying index to financial statements and schedules (Item 14 (a)). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of Sunlite Technologies Corp. As of November 30, 1988 were audited by other auditors whose report dated December 22, 1988 expressed an unqualified opinion on those statements, and has been furnished to us, and our opinion expressed herein so far as it relates to amounts from inception (December 10, 1986) to November 30, 1993 is based in part upon the report of other auditors for the period from inception (December 10, 1986) to November 30, 1988. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion and based upon the report of other auditors, the financial statements listed in the accompanying index to financial statements (ITEM 14 (a)) present fairly in all material respects, the financial position of Sunlite Technologies Corp. As of November 30, 1993 and 1992 and the results of operations and cash flows for each of the three years in the period ended November 30, 1993 and for the period from inception (December 10, 1986) to November 30, 1993 in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note (1) to the financial statements, the Company has suffered recurring losses from operations and unaudited information subsequent to November 30, 1993 indicates that losses from operations, primarily from development stage activities are continuing. These losses together with the Company's inability to obtain additional financing, raise a substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note (1). The financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. Ronald Seroda, P.C., C.P.A. Dix Hills, New York January 6, 1996 Blumenthal Squire & Company Certified Public Accountants 419 Whalley Avenue New Haven, Connecticut 06511 INDEPENDENT AUDITOR'S REPORT To Sunlite Technologies Corp. (A Development Stage Company) We have audited the statement of Sunlite Technologies Corp. (a Delaware corporation in the development stage) as of November 30, 1988, and the related statements of changes in stockholders' equity, and cash flows for the year ended November 30, 1988 and for the period from inception (December 10, 19986) to November 30, 1988, which are not separtely presented herein. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about weather the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial referred to above present fairly in all material respects, the results of operations, cash flows and changes in stockholders' equity of Sunlite Technologies Corp. for the year ended November 30, 1988 and for the period from inception (December 10, 1086) to November 30, 1988 in conformity with generally accepted accounting principles. The financial statements referred to above have been prepared assuming that the Company will continue as a going concern. Communications with management and with the successor auditor indicate that the Company has suffered recurring losses which raise substantial doubt the Company's ability to continue as a going concern. These financial statements do not include any adjustments that might result should the Company be unable to continue as a going concern. BLUMENTHAL SQUIRE & COMPANY New Haven, Connecticut December 22, 1988 and February 27, 1993 as to Subsequent Events Ref: Letters.4 (Pg. 18) Sunlite Technologies Corp. (a development stage company) BALANCE SHEETS ASSETS NOVEMBER 30, 1993 1992 Current assets: Cash $ 19 $ - Accounts receivable - 1,176 Inventory - 137 Prepaid expenses - 1.286 ----- ------ Total current assets 19 2,599 Property, plant and equipment: Equipment and fixtures 6,500 6,500 Less accumulated depreciation 4,675 3,375 ----- ----- Property, plant, & equip. net 1,825 3,125 Intangible assets: Patents at cost 62,030 62,030 Less accumulated amortization 18,670 13,898 ------ ------ Patents, net 43,360 48,132 ------ ------ $ 45,204 $ 53,856 ====== ====== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY) Current liabilities: Accounts payable $ 13,837 $ 21,168 Accrued interest 44,950 28,170 Accrued interest (related parties) 11,879 6,632 Accrued rent (related parties) 1,644 1,500 Payroll taxes payable 2,737 - Notes payable 108,634 123,134 Notes payable (related parties) 50,796 46,525 ------- ------- Total current liabilities 234,477 227,129 Stockholder's equity (deficiency): Common stock $.0001 par value; 500,000,000 shares authorized; 37,000,000 & 34,000,000 shares issued & outstanding in 93 & 92 3,700 3,400 Additional paid in capital 553,820 511,120 Deficit accumulated during development stage (746,793) (687,793) ------- ------- (189,273) (173,273) ------- ------- $ 45,204 $ 53,856 ====== ====== Sunlite Technologies Corp. (a development stage company) STATEMENT OF OPERATIONS For the Years Ended November 30, Period from Inception Dec. 10, 1986 Through 1993 1992 1991 Nov. 30, 1993 ---- ---- ---- ------------- Revenues: Sales $ - $ 2,616 $ - $ 12,614 Interest income - - - 3,756 ----- ----- ---- ------ - 2,616 - 16,370 Cost and expenses: Cost of sales 135 2,140 - 22,204 Selling & administrative expenses 58,865 67,144 64,163 341,106 ------ ------ ------ ------- 59,000 66,668 64,163 363,310 Income (Loss) before taxes & discontinued operations (59,000) (66,668) (64,163) (346,940) Income taxes - - - 1,269 ------ ----- ------ ------- Income (Loss) from continuing operations (59,000) (66,668) (64,163) (348,209) Discontinued operations: Operating (Loss) from discontinued operations - - - (205,060) Net (loss) from sale of discontinued operations - - - (193,524) ------ ------ ------ ------- - - - (398,584) ------- ------ ------ ------- Net loss $(59,000) $(66,668) $(64,163) $(746,793) ====== ====== ====== ======= (Loss) per share from continuing operations $ nil $ nil $ nil $ (.01) Net (loss) per share $ nil $ nil $ nil $ (.03) Sunlite Technologies Corp. (a development stage company) STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY) Sunlite Technologies Corp. (a development stage company) STATEMENT OF CASH FLOWS For The Years Ended November 30, Sunlite Technologies Corp. (a development stage company) (NOTES TO FINANCIAL STATEMENTS) NOTE 1- Organization, History, and going concern assumptions: Sunlite Technologies Corp., (hereafter referred to as the "Company") was incorporated in Delaware on December 10, 1986, for the purpose of obtaining capital to participate in business ventures which have a potential for profit. The Company's name was changed on March, 16, 1990. The Company had attempted to market and manufacture a solar rechargeable battery ("SRB") under three patents it purchased (NOTE 5). Subsequent to November 30, 1993, the Company entered into a licencing agreement with an individual (NOTE 11). The success of this endeavor will ultimately depend on the Company's and/or Licensee's (NOTE 11) ability to market and manufacture this item as well as obtaining sufficient capital to fund an appropriate business plan. Furthermore, there is no assurance that other products would not be developed by other Companies that would be competitive to the Company's "SRB" or even render the solar battery obsolete. Also, the Company subsequent to November 30, 1993 has entered into the "Internet" business (NOTE 11). On December 10, 1986, the Company issued 4.5 million shares of common stock par value $.0001 to officers and directors for $7,350 in cash which is approximately $.001633 per share. On October 30, 1987, the Company successfully completed a sale of three million equity units at $.10 per unit. The gross proceeds to the Company was $300,000. Each unit consisted of one share of $.0001 par value common stock, one class a redeemable warrant, and one class B redeemable warrant. (NOTE 7) The underwriters compensation in connection with this offering was equal to 10% of the gross proceeds and a non-accountable expense allowance of 3% of the gross proceeds. These items have been charged against paid in capital. In addition, the underwriters received 300,000 warrants to purchase 300,000 shares of the Company's common stock at $.12 per share. These warrants expired July 16, 1992. On March 18 1988, the Company exchanged four million shares of its common stock for all the outstanding shares of Bedford Street Bakers Corp., thus becoming a wholly owned subsidiary of the Company. Management assigned a value of $.05 per share for the four million shares exchanged. Bedford Street Bakers Corp. was a restaurant/Bakery which operated under a franchise agreement with "The Glass Oven International". Bedford Street Bakers Corp. was originally incorporated and organized by Fast N' Fancy Foods, Inc. Mr. Scala who in June 1990 became a shareholder and president of Sunlite Technologies Corp., was also an Officer and Director and principal shareholder of Fast N' Fancy Foods Inc. Fast N' Fancy Foods Inc., established the operations of Bedford Street Bakers Corp., two years prior to being purchased by Sunlite. The stock of Bedford was distributed to Fast N' Fancy shareholders. For the period March 18 1988 through June 30 1988, Bedford's on going operations were not as expected. The Bakery/Restaurant was located in a business district and when the districts main office building lost its major tenant store sales plummeted. Not only were sales off, but with shortage of available key personnel, the store shortened its hours of operation and even closed for periods of time when help was not available. During this period, the Company incurred an operating loss from discontinued operations of $205,060. By the end of May 1988, the Bedford store was placed on the market for sale privately and through several brokers. On June 30 1988, the management with the consent of the Board of Directors of the Company, sold Bedford to a former employee, so as to prevent further losses to the Company. The consideration for the sale was the assumption of all its debt in exchange for the return of its assets and an agreement to indemnify and hold the Company harmless for any and all matters arising from the Company's ownership of Bedford. In addition, the new owners had promised to repay the advances made by the parent in the amount of $221,524 of which $13,000 had been repaid as of November 30, 1988 and an additional $15,000 was repaid in 1989. However, management currently believes that the balance in the amount of $193,524 is currently uncollectible resulting in a loss on disposal of discontinued operations in the amount of $193,524. (Note 4) The Company, on October 1, 1988, sold an additional one million unregistered common shares at $.05 per share to a group of four individuals for an aggregate $50,000. The purpose of this sale was to replenish the Company's available working capital so as to allow it to continue operations and explore other potential business opportunities. Accordingly, on October 18, 1988 the Company found another business opportunity and entered into an agreement with Raymond Curiel and Mary Curiel d/b/a MJR Company (NOTE 5.) The Company subsequently purchased three patents from MJR Co. These patents cover certain features which was then the Company's only product: a size "D" solar rechargeable battery. The Company at this time remained in the development stage, and entered into several agreements with MJR Company including a licensing agreement, option to purchase the "SRB" patents, lease of office space in Scottsdale Arizona and a employment agreement with Mr. Curiel. During fiscal 1989, the Company moved its base of operations from Connecticut to Arizona and paid MJR Co. $11,500 in rent, and did not comply with the terms of the employment agreement (Note 3.) However, late in fiscal 1989, control of the Company had changed. All prior agreements with the Curiels were modified and the Company moved its base of operations to Long Island N.Y. The above resulted in a write off and abandonment of office equipment. Furthermore, all costs, incurred by the Company in the amount of approximately $27,000 during the Curiel's term of management relating to its attempt to raise capital for the manufacture and marketing of the "SRB" have been expended and in November 1990, the Company purchased the patents from Raymond Curiel (See NOTE 5.) The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the financial statements the Company has suffered recurring losses of approximately $746,793 from inception through November 30, 1993. As of November 30 1993, total liabilities exceeded total assets by $189,273 and the Company had defaulted in note payments and interest due on these notes in the amount of $216,259. These factors as well as the uncertainty that the Company's licensing agreement and new business venture will ultimately be profitable raise an uncertainty about the Company's ability to continue as a going concern. The financial statements do not include any adjustments relating to the recovery and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. In response, the Company in a subsequent event has licensed its technology to an individual (NOTE 11) The minimum royalty payment will give the Company a temporary cash flow and will allow the Company to pursue its new business venture. The Company is also considering a debt equity swap to its note holders but no definite terms have been formulated as yet. It is impossible to determine if any of the above will be successful and management has not ruled out the possibility to seek protection under chapter 11 of the Federal Bankruptcy act. NOTE 2- Significant Accounting Policies: The financial statements presented herein are of a development stage company. Therefore, the form and context conform to the accounting principles governing a development stage company. Stock Offering Costs: Stock offering costs incurred in connection with the sale of common stock have been charged against paid in capital. Revenue recognition: Revenue and accounts receivable are recorded only when products are shipped (Accrual basis) Inventory: Inventory is carried at cost on a first in first out basis. Net Loss per Common share: Net loss per common share has been computed based on the weighted average number of shares outstanding during each period. Reclassifications: Certain amounts in prior years have been reclassified to conform to the current year's presentation. Fixed Assets: Fixed assets are stated at cost. Maintenance and repairs are expended as incurred. When fixed assets are disposed, the related cost and reserve for depreciation are removed from the respective accounts, and any gains or losses are included in income. Depreciation: is computed on the straight line-method. Patent License & Purchase Agreement (NOTE 5): The patent was purchased in fiscal year November 30, 1990 and is recorded at cost plus the unamortized cost of the license agreement and the cost of the option. Amortization is provided on a straight line basis over 13 years. Fair value: Assets and liabilities are recorded at cost with the exception of the patent (note 5) and the historical cost approximates fair value. However, if the Company was forced to liquidate it would be very unlikely that the Company would realize any of the unamortized patent cost of $43,360. NOTE 3- Employment contract- termination: In fiscal year ending November 30, 1989, the Company had advanced $32,407 to MJR Co. The company had defaulted on the original licensing agreement dated October 18, 1988 (Note 5,) and an employment agreement dated January 6, 1989. In settlement and consideration to the MJR Co. for entering a new and final license agreement dated November 30, 1989 as fully described in Note 5, the above amount of $32,407 was applied by management against a two year employment contract in which Mr. Curiel was to receive $5,000 per month. NOTE 4- Loss on Discontinued Operations: On March 18, 1988, the Company acquired all the shares of Bedford Street Bakers Corp. in exchange for four million shares of its own common stock valued at $.05 per share. On June 30, 1988, the Company disposed of its investment by transferring to a former employee all of the issued and outstanding shares of Bedford for the consideration of $1.00 and the promise to be indemnified and held harmless against any and all matters arising from the Company's ownership of Bedford. In addition, Bedford promised to repay $221,524 of advances made by the Company to Bedford. From the period March 18, 1988 through June 30, 1988, the Company incurred an operating loss from discontinued operations in the amount of $205,060, which approximately equals the Company's investment in Bedford, and a loss on the sale from discontinued operations in the amount of $193,524 when the Company only received $28,000 of the original $221,524 Bedford promised to repay. The amount of $193,524 management currently believes to be uncollectible. NOTE 5- Licensing Agreement and Purchase of Patents: On October 18, 1988, the Company paid $20,000 to Raymond and Mary Curiel d/b/a MJR Company of Scottsdale, Arizona as a non-refundable deposit on an exclusive licensing agreement for a patented invention (Solar Rechargeable Battery) developed and invented by Raymond Curiel. The parties consummated an agreement in January, 1989. This agreement called for the issuance of 20,000,000 shares of the Company's stock to MJR Co. for this exclusive license, and an option to purchase all the patents issued, and foreign applications then pending in connection with the solar rechargeable battery. The shares issued in the above agreement were valued at par value and resulted in a nominal increase in stockholders equity of $2,000. Management assigned a nominal value to the shares issued in the above transaction for the following reasons: 1) During fiscal year November 30, 1989, unlike in fiscal year 1987, no ready market existed for the registrant's common shares compounded by the fact that the shares issued were restricted and unregistered. Therefore, the fair market value of the consideration given in this transaction could not be readily determined. 2) Furthermore, management could not reasonably ascertain the fair market value of the licensing agreement, and option to purchase the patent since no similar product currently exists. The value of the above assets depend largely on how well the Company manufacturers and markets this product in the future. Therefore, these assets were recorded on the Company's balance sheet at cost in cash plus par value of the stock issued. This required the Company to pay an additional $20,000 in licensing fees to MJR Co. until the option to purchase the patent was exercised. The agreement of November 30, 1989 was revised on November 23, 1990. The Company under this agreement purchased all the issued U.S. Patents and all foreign applications pending from MJR for a cash payment of $40,000 and the issuance of 300,000 shares of its common unregistered stock. The Company valued these shares at par value for the same reason as stated earlier when the Company issued its common shares in consideration for the license agreement. Furthermore, all prior agreements by and between the Company and MJR and/or the Curiels were canceled. The patent cost is determined as follows: Cash paid for deposit $ 20,000 Par value common shares issued for option to purchase patents 2,000 Cash paid for purchase of patents 40,000 Par value common shares issued for purchase of patents 30 ------ Total cost $ 62,030 ====== NOTE 6 - Notes Payable: 1993 1992 ---- ---- Due and in default as of March 31, 1990. Interest at 18% per annum.. $ 12,000 $ 12,000 Due shareholder in default as of August 30, 1990 Interest at 10% per annum.. 10,000 10,000 Due shareholder in default as of June 30, 1992 Interest at 12% per annum.. 50,000 50,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 5,000 5,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 10,000 10,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 10,000 10,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 2,000 2,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 4,945 4,945 Due shareholder June 30, 1993 Interest at 10% per annum.. 4,689 19,189 ------- ------- $ 108,634 $ 123,134 ======= ======= During 1993, only one note holder agreed to extend its due date until June 30, 1993. The balance of the notes are in default. Notes Payable-Related Parties Due and payable to Officers & Directors June 30, 1993 (John Somma) Interest at 10% per annum.. $ 13,850 $ 12,850 Due and payable to Officers & Directors June 30, 1993 (Lew Scala) Interest at 10 % per annum 36,946 32,675 ----- ------ $ 50,796 $ 46,525 ====== ====== Interest expense totaled $22,305, $17,900 and $14,623 in 1993, 1992 and 1991, respectively. The average effective rate of interest was 12%, 11% and 11% in 1993, 1992 and 1991, respectively. NOTE 7- Common Stock- Warrants: The Company currently has one class of stock outstanding which had been offered to the public in the form of a unit. Each unit consisted of one share common stock, par value $.0001, one class a redeemable common stock purchase warrant and one class B redeemable common stock purchase warrant. Each class a warrant entitles the holder to purchase one share of common stock at a price of $.10 until Nov. 30, 1993. Each class B warrant entitles the holder to purchase one share of common stock at a price of $.15 until Nov. 30, 1994. The Redeemable Warrants are redeemable by the Company upon 30 days prior written notice. The redemption price is $.0001 per Warrant for both the Class a and Class B warrants. NOTE 8- Income Taxes: At November 30, 1993, the Company had a net operating loss carry forward for financial accounting purposes of approximately $746,192. Theses carry forwards expire through the year 2008. Such carry forwards for federal income tax purpose are approximately only $281,541, and will be available to offset future "ordinary" taxable income. In addition, the Company had a capital loss carry forward for federal income tax of approximately $440,991 which had expired. The difference between the accounting loss and that for federal income taxes is due to the fact that the write off of Bedford is a capital transaction for federal tax purposes and therefore could only be used to offset capital gains. Since the capital loss in the amount of $430,991 expired for federal income tax purposes, no other material timing difference exists between accounting and tax income. The Company did not pay any federal income tax during fiscal years ending November 30, 1993, 1992, and 1991 and the tax expense, as reflected herein, is for state and local taxes only. Statements of Financial Accounting Standards (SFAS) No. 109 has been issued regarding accounting for income taxes. The statement, as amended, is effective for fiscal years beginning after December 15, 1992. The Company is required to implement SFAS No. 109 for its fiscal year ending November 30, 1994. The effect on the Company's reported financial position and results of operations resulting from the implementation of SFAS No. 96 has not yet been quantified by the Company. NOTE 9- Commitments: On May 15, 1991, the Company entered into an agreement with Burbud Management Corp.("Burbud") Burbud is organized under the laws of Panama and its U.S. location is New Rochelle, NY. Pursuant to this agreement, the Company will issue 8,000,000 shares of its common unregistered stock to "Burbud" in lieu of payment for the initial production of 20,000 solar rechargeable batteries("SRB") In addition "Burbud" will provide future research and product development of the "SRB" as well as assisting in the marketing of the product. As of November 30, 1993, the Company received 1,250 "SRB'S" from Burbud and in partial consideration for the above the Company issued 500,000 shares of its common unregistered stock. The Company values the transaction at the fair market value of the consideration received and estimates the cost of each battery at the cost the Company could have purchased and assembled them in the United States (Replacement costs) During fiscal year ending November 30, 1993 Burbud did not deliver any product against its commitment. (See Note 11) NOTE 10- Other Related Party Transactions: In fiscal 1993 the Company leased office space from Mr. Scala at a rate of $500.00 per month. Mr. Scala was compensated during fiscal year 1993 in the amount of $15,600. The Company continues to borrow money from Mr. Somma and Mr. Scala to fund the daily operations of the Company. Mr. Somma and Mr. Scala are officers, directors and principal shareholders of the Company. In October 1993 the Company sold Mr. Scala 1,250,000 of common stock at the rate of $.01 per share and reduced its total debt liability to Mr. Scala by $12,500. NOTE 11- Subsequent Events: In August 1995, the Company considered it's contract with Burbud void and has terminated it due to the no performance clause in the original contract. However, the Company may be obligated to issue an additional 1,500,000 shares of it's common unregistered stock to Burbud for services performed during the duration of the contract. The Company would vigorously fight the issuance of these shares due to damages in the form of lost "SRB" sales. Burbud has not substantially complied with many of the terms of the entire agreement. On August 30, 1995, the Company entered into a licensing agreement with an individual and has received a $5,000 non refundable initial licensing fee. The Company, under the terms of the agreement, will also receive a royalty equal to 5% of the gross selling price on such items manufactured and sold by the licensee for all sales up to $1,000,000 and 2% of sales over $1,000,000. However, the Company will receive a minimum royalty of $1000 per month for a term of sixty months which began in January, 1996. Between August 1995 and December 1995, the Company began to look for other business opportunities to enter. In December 1995, the Company purchased from Lewis Scala all the necessary hardware equipment, Galacticomm's WorldGroup software, and all existing telephone connections to run an Online Bulletin Board Service that provides Internet connectivity. The service can handle up to 256 simultaneous users. The most common need for Internet access is to allow users to "surf the web" with software such as Netscape, Microsoft explorer and many other "web" browsers. The Worldgroup software provides a pass-through SLIP, CSLIP and PPP connections for authorized users. The agreed price was $5,000. From November 1993 to May 1996, the company has sold 560,000 shares of common unregistered stock to 9 individuals at $.025 per share and had raised an additional $14,000. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS: During the year ended Nov. 30, 1993, the Company had no gross revenue, as compared to $2,616 gross revenue for the year ending Nov. 30, 1992. During fiscal year 1993 the Company had not received any product against its manufacturing agreement. The total operating expenses were $59,000, of which interest expense amounted to $22,305 as compared to operating expenses of $66,668 in fiscal 1992, of which interest expense amounted to $17,900 for year ended November 30, 1992. The Company had continued its efforts to raise the necessary capital to marketing and manufacture its product. In subsequent events after year ended November 30, 1993 the Company in August 1995, canceled its agreement with BURBUD for the manufacture and marketing of its product. Burbud had not delivered any product during fiscal 1993 and fiscal 1994. In August 1995, the Company entered into a license agreement with an individual for the exclusive marketing and manufacturing rights for the technology covered by the Company's patents. See subsequent notes in financial statements. LIQUIDITY AND CAPITAL RESOURCES: During fiscal 1993, the Company continued to seek the necessary funds for its daily operating expenses. The Company in a private transaction sold stock to two individuals and raised additional working capital, the Company continually tried to raise the necessary capital to produce and assemble the "SRB." Late in 1995 the Company decided to explore an alternative way to utilize its "SRB" technology. Then in August 1995, the Company entered into a licensing agreement with an individual and has received a $5,000 non refundable initial licensing fee. The Company, under the terms of the agreement, will also receive a royalty equal to 5% of the gross selling price on such items manufactured and sold by the licensee for all sales up to $1,000,000 and 2% of sales over $1,000,000. However, the Company will receive a minimum royalty of $1000 per month for a term of sixty months which began in January, 1996. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements of the Company are included in this Form 10-K: Financial Statements Page Auditors' Opinion- -F2 Balance Sheet- Statement of Operations- Statement of Stockholder Equity- -F6 Statement of Cash Flows- Notes to Financial Statements- to Supplementary Data: None ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART 111 ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers and directors of the Company are as follows: Name Age Position Lewis Scala 49 President and Director John Somma 41 Secretary-Chairman of the Board of Directors All officers and Directors hold office for one year or until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of majority of the Board of Directors. Principal occupations of the directors and executive officers for at least five years are as follows: Lewis Scala has served as President and member of the Board of Directors since June 19, 1990. From 1985 to November 1986, Mr. Scala was a stockbroker and security trader with Norbay Securities, Inc. From November 1986 to March 1990 he was employed by Douglas Bremen & Co. Inc., as a stockbroker and security trader. Mr. Scala was President of Fast N' Fancy Foods, Inc. which had operated a fast food restaurant in Stamford, Ct. from Feb. 1983 until Oct. 1990. In Oct. 1990, Fast N' Fancy Foods, Inc., filed for protection under Chapter 11 of The Federal Bankruptcy Law, and on January 11, 1991 the case was dismissed from Chapter 11 proceedings. John Somma has served as Secretary and Chairman of the Board of Directors from November 13, 1990 to the present, Mr. Somma also served on the board of directors from September 1988 to November 1988. Mr. Somma is currently devoting about 25% of his time to the business affairs of Sunlite, and manages his own personal real estate holdings. From 1979 to 1990, Mr. Somma served as President of Logo Realty Inc. which was a real estate holding Co. Prior to that Mr. Somma has been a consultant to several restaurants. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION In fiscal 1993 Mr. Scala was compensated in the amount of $15,600. No other officers or directors were compensated during fiscal 1993. The Company has no agreement or understanding, express or implied, with any officer or director, or any other person regarding employment with the Company or compensation for services. Compensation of officers and directors is determined by the Company's Board of Directors and is not subject to shareholder approval. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the holdings of common stock by each person who, as of November 30, 1992, held of record or was known by the Company to hold beneficially or of record, more than 5% of the Company's common stock, by each officer and director, and by all officers and directors as a group. Lewis Scala 8,050,000 shares 21 % John Somma 8,130,000 shares 22 % Officers & Directors as a group ( 3 persons ) 16,180,000 shares 43 % ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In fiscal 1993 the Company leased office space from Mr. Scala at the rate of $500 per month. In October 1993, the Company sold Mr. Scala 1,250,000 of common unregistered stock at the rate of $.01 per share and reduced its total debt liability to Mr. Scala by $12,500. PART 1V ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS FORM 8-K (a) All financial statements are included commencing on page Reports on Form 8-K None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Sunlite Technologies Corp. By: /s/Lewis Scala Lewis Scala DATE: August 05, 1996 President Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. DATE: August 05, 1996 By: /s/Lewis Scala Lewis Scala President Director DATE: August 05, 1996 By: /s/John Somma John Somma Secretary Chairman of Board of Directors REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Shareholders and Board of Directors Sunlite Technologies Corp. (a development stage company) Douglaston, New York We have audited the financial statements of Sunlite Technologies Corp. (Delaware Corporation in the development stage) listed in the accompanying index to financial statements and schedules (Item 14 (a)). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of Sunlite Technologies Corp. As of November 30, 1988 were audited by other auditors whose report dated December 22, 1988 expressed an unqualified opinion on those statements, and has been furnished to us, and our opinion expressed herein so far as it relates to amounts from inception (December 10, 1986) to November 30, 1993 is based in part upon the report of other auditors for the period from inception (December 10, 1986) to November 30, 1988. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion and based upon the report of other auditors, the financial statements listed in the accompanying index to financial statements (ITEM 14 (a)) present fairly in all material respects, the financial position of Sunlite Technologies Corp. As of November 30, 1993 and 1992 and the results of operations and cash flows for each of the three years in the period ended November 30, 1993 and for the period from inception (December 10, 1986) to November 30, 1993 in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note (1) to the financial statements, the Company has suffered recurring losses from operations and unaudited information subsequent to November 30, 1993 indicates that losses from operations, primarily from development stage activities are continuing. These losses together with the Company's inability to obtain additional financing, raise a substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note (1). The financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. Ronald Seroda, P.C., C.P.A. Dix Hills, New York January 6, 1996 Blumenthal Squire & Company Certified Public Accountants 419 Whalley Avenue New Haven, Connecticut 06511 INDEPENDENT AUDITOR'S REPORT To Sunlite Technologies Corp. (A Development Stage Company) We have audited the statement of Sunlite Technologies Corp. (a Delaware corporation in the development stage) as of November 30, 1988, and the related statements of changes in stockholders' equity, and cash flows for the year ended November 30, 1988 and for the period from inception (December 10, 19986) to November 30, 1988, which are not separtely presented herein. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about weather the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial referred to above present fairly in all material respects, the results of operations, cash flows and changes in stockholders' equity of Sunlite Technologies Corp. for the year ended November 30, 1988 and for the period from inception (December 10, 1086) to November 30, 1988 in conformity with generally accepted accounting principles. The financial statements referred to above have been prepared assuming that the Company will continue as a going concern. Communications with management and with the successor auditor indicate that the Company has suffered recurring losses which raise substantial doubt the Company's ability to continue as a going concern. These financial statements do not include any adjustments that might result should the Company be unable to continue as a going concern. BLUMENTHAL SQUIRE & COMPANY New Haven, Connecticut December 22, 1988 and February 27, 1993 as to Subsequent Events Ref: Letters.4 (Pg. 18) Sunlite Technologies Corp. (a development stage company) BALANCE SHEETS ASSETS NOVEMBER 30, 1993 1992 Current assets: Cash $ 19 $ - Accounts receivable - 1,176 Inventory - 137 Prepaid expenses - 1.286 ----- ------ Total current assets 19 2,599 Property, plant and equipment: Equipment and fixtures 6,500 6,500 Less accumulated depreciation 4,675 3,375 ----- ----- Property, plant, & equip. net 1,825 3,125 Intangible assets: Patents at cost 62,030 62,030 Less accumulated amortization 18,670 13,898 ------ ------ Patents, net 43,360 48,132 ------ ------ $ 45,204 $ 53,856 ====== ====== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY) Current liabilities: Accounts payable $ 13,837 $ 21,168 Accrued interest 44,950 28,170 Accrued interest (related parties) 11,879 6,632 Accrued rent (related parties) 1,644 1,500 Payroll taxes payable 2,737 - Notes payable 108,634 123,134 Notes payable (related parties) 50,796 46,525 ------- ------- Total current liabilities 234,477 227,129 Stockholder's equity (deficiency): Common stock $.0001 par value; 500,000,000 shares authorized; 37,000,000 & 34,000,000 shares issued & outstanding in 93 & 92 3,700 3,400 Additional paid in capital 553,820 511,120 Deficit accumulated during development stage (746,793) (687,793) ------- ------- (189,273) (173,273) ------- ------- $ 45,204 $ 53,856 ====== ====== Sunlite Technologies Corp. (a development stage company) STATEMENT OF OPERATIONS For the Years Ended November 30, Period from Inception Dec. 10, 1986 Through 1993 1992 1991 Nov. 30, 1993 ---- ---- ---- ------------- Revenues: Sales $ - $ 2,616 $ - $ 12,614 Interest income - - - 3,756 ----- ----- ---- ------ - 2,616 - 16,370 Cost and expenses: Cost of sales 135 2,140 - 22,204 Selling & administrative expenses 58,865 67,144 64,163 341,106 ------ ------ ------ ------- 59,000 66,668 64,163 363,310 Income (Loss) before taxes & discontinued operations (59,000) (66,668) (64,163) (346,940) Income taxes - - - 1,269 ------ ----- ------ ------- Income (Loss) from continuing operations (59,000) (66,668) (64,163) (348,209) Discontinued operations: Operating (Loss) from discontinued operations - - - (205,060) Net (loss) from sale of discontinued operations - - - (193,524) ------ ------ ------ ------- - - - (398,584) ------- ------ ------ ------- Net loss $(59,000) $(66,668) $(64,163) $(746,793) ====== ====== ====== ======= (Loss) per share from continuing operations $ nil $ nil $ nil $ (.01) Net (loss) per share $ nil $ nil $ nil $ (.03) Sunlite Technologies Corp. (a development stage company) STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY) Sunlite Technologies Corp. (a development stage company) STATEMENT OF CASH FLOWS For The Years Ended November 30, Sunlite Technologies Corp. (a development stage company) (NOTES TO FINANCIAL STATEMENTS) NOTE 1- Organization, History, and going concern assumptions: Sunlite Technologies Corp., (hereafter referred to as the "Company") was incorporated in Delaware on December 10, 1986, for the purpose of obtaining capital to participate in business ventures which have a potential for profit. The Company's name was changed on March, 16, 1990. The Company had attempted to market and manufacture a solar rechargeable battery ("SRB") under three patents it purchased (NOTE 5). Subsequent to November 30, 1993, the Company entered into a licencing agreement with an individual (NOTE 11). The success of this endeavor will ultimately depend on the Company's and/or Licensee's (NOTE 11) ability to market and manufacture this item as well as obtaining sufficient capital to fund an appropriate business plan. Furthermore, there is no assurance that other products would not be developed by other Companies that would be competitive to the Company's "SRB" or even render the solar battery obsolete. Also, the Company subsequent to November 30, 1993 has entered into the "Internet" business (NOTE 11). On December 10, 1986, the Company issued 4.5 million shares of common stock par value $.0001 to officers and directors for $7,350 in cash which is approximately $.001633 per share. On October 30, 1987, the Company successfully completed a sale of three million equity units at $.10 per unit. The gross proceeds to the Company was $300,000. Each unit consisted of one share of $.0001 par value common stock, one class a redeemable warrant, and one class B redeemable warrant. (NOTE 7) The underwriters compensation in connection with this offering was equal to 10% of the gross proceeds and a non-accountable expense allowance of 3% of the gross proceeds. These items have been charged against paid in capital. In addition, the underwriters received 300,000 warrants to purchase 300,000 shares of the Company's common stock at $.12 per share. These warrants expired July 16, 1992. On March 18 1988, the Company exchanged four million shares of its common stock for all the outstanding shares of Bedford Street Bakers Corp., thus becoming a wholly owned subsidiary of the Company. Management assigned a value of $.05 per share for the four million shares exchanged. Bedford Street Bakers Corp. was a restaurant/Bakery which operated under a franchise agreement with "The Glass Oven International". Bedford Street Bakers Corp. was originally incorporated and organized by Fast N' Fancy Foods, Inc. Mr. Scala who in June 1990 became a shareholder and president of Sunlite Technologies Corp., was also an Officer and Director and principal shareholder of Fast N' Fancy Foods Inc. Fast N' Fancy Foods Inc., established the operations of Bedford Street Bakers Corp., two years prior to being purchased by Sunlite. The stock of Bedford was distributed to Fast N' Fancy shareholders. For the period March 18 1988 through June 30 1988, Bedford's on going operations were not as expected. The Bakery/Restaurant was located in a business district and when the districts main office building lost its major tenant store sales plummeted. Not only were sales off, but with shortage of available key personnel, the store shortened its hours of operation and even closed for periods of time when help was not available. During this period, the Company incurred an operating loss from discontinued operations of $205,060. By the end of May 1988, the Bedford store was placed on the market for sale privately and through several brokers. On June 30 1988, the management with the consent of the Board of Directors of the Company, sold Bedford to a former employee, so as to prevent further losses to the Company. The consideration for the sale was the assumption of all its debt in exchange for the return of its assets and an agreement to indemnify and hold the Company harmless for any and all matters arising from the Company's ownership of Bedford. In addition, the new owners had promised to repay the advances made by the parent in the amount of $221,524 of which $13,000 had been repaid as of November 30, 1988 and an additional $15,000 was repaid in 1989. However, management currently believes that the balance in the amount of $193,524 is currently uncollectible resulting in a loss on disposal of discontinued operations in the amount of $193,524. (Note 4) The Company, on October 1, 1988, sold an additional one million unregistered common shares at $.05 per share to a group of four individuals for an aggregate $50,000. The purpose of this sale was to replenish the Company's available working capital so as to allow it to continue operations and explore other potential business opportunities. Accordingly, on October 18, 1988 the Company found another business opportunity and entered into an agreement with Raymond Curiel and Mary Curiel d/b/a MJR Company (NOTE 5.) The Company subsequently purchased three patents from MJR Co. These patents cover certain features which was then the Company's only product: a size "D" solar rechargeable battery. The Company at this time remained in the development stage, and entered into several agreements with MJR Company including a licensing agreement, option to purchase the "SRB" patents, lease of office space in Scottsdale Arizona and a employment agreement with Mr. Curiel. During fiscal 1989, the Company moved its base of operations from Connecticut to Arizona and paid MJR Co. $11,500 in rent, and did not comply with the terms of the employment agreement (Note 3.) However, late in fiscal 1989, control of the Company had changed. All prior agreements with the Curiels were modified and the Company moved its base of operations to Long Island N.Y. The above resulted in a write off and abandonment of office equipment. Furthermore, all costs, incurred by the Company in the amount of approximately $27,000 during the Curiel's term of management relating to its attempt to raise capital for the manufacture and marketing of the "SRB" have been expended and in November 1990, the Company purchased the patents from Raymond Curiel (See NOTE 5.) The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the financial statements the Company has suffered recurring losses of approximately $746,793 from inception through November 30, 1993. As of November 30 1993, total liabilities exceeded total assets by $189,273 and the Company had defaulted in note payments and interest due on these notes in the amount of $216,259. These factors as well as the uncertainty that the Company's licensing agreement and new business venture will ultimately be profitable raise an uncertainty about the Company's ability to continue as a going concern. The financial statements do not include any adjustments relating to the recovery and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. In response, the Company in a subsequent event has licensed its technology to an individual (NOTE 11) The minimum royalty payment will give the Company a temporary cash flow and will allow the Company to pursue its new business venture. The Company is also considering a debt equity swap to its note holders but no definite terms have been formulated as yet. It is impossible to determine if any of the above will be successful and management has not ruled out the possibility to seek protection under chapter 11 of the Federal Bankruptcy act. NOTE 2- Significant Accounting Policies: The financial statements presented herein are of a development stage company. Therefore, the form and context conform to the accounting principles governing a development stage company. Stock Offering Costs: Stock offering costs incurred in connection with the sale of common stock have been charged against paid in capital. Revenue recognition: Revenue and accounts receivable are recorded only when products are shipped (Accrual basis) Inventory: Inventory is carried at cost on a first in first out basis. Net Loss per Common share: Net loss per common share has been computed based on the weighted average number of shares outstanding during each period. Reclassifications: Certain amounts in prior years have been reclassified to conform to the current year's presentation. Fixed Assets: Fixed assets are stated at cost. Maintenance and repairs are expended as incurred. When fixed assets are disposed, the related cost and reserve for depreciation are removed from the respective accounts, and any gains or losses are included in income. Depreciation: is computed on the straight line-method. Patent License & Purchase Agreement (NOTE 5): The patent was purchased in fiscal year November 30, 1990 and is recorded at cost plus the unamortized cost of the license agreement and the cost of the option. Amortization is provided on a straight line basis over 13 years. Fair value: Assets and liabilities are recorded at cost with the exception of the patent (note 5) and the historical cost approximates fair value. However, if the Company was forced to liquidate it would be very unlikely that the Company would realize any of the unamortized patent cost of $43,360. NOTE 3- Employment contract- termination: In fiscal year ending November 30, 1989, the Company had advanced $32,407 to MJR Co. The company had defaulted on the original licensing agreement dated October 18, 1988 (Note 5,) and an employment agreement dated January 6, 1989. In settlement and consideration to the MJR Co. for entering a new and final license agreement dated November 30, 1989 as fully described in Note 5, the above amount of $32,407 was applied by management against a two year employment contract in which Mr. Curiel was to receive $5,000 per month. NOTE 4- Loss on Discontinued Operations: On March 18, 1988, the Company acquired all the shares of Bedford Street Bakers Corp. in exchange for four million shares of its own common stock valued at $.05 per share. On June 30, 1988, the Company disposed of its investment by transferring to a former employee all of the issued and outstanding shares of Bedford for the consideration of $1.00 and the promise to be indemnified and held harmless against any and all matters arising from the Company's ownership of Bedford. In addition, Bedford promised to repay $221,524 of advances made by the Company to Bedford. From the period March 18, 1988 through June 30, 1988, the Company incurred an operating loss from discontinued operations in the amount of $205,060, which approximately equals the Company's investment in Bedford, and a loss on the sale from discontinued operations in the amount of $193,524 when the Company only received $28,000 of the original $221,524 Bedford promised to repay. The amount of $193,524 management currently believes to be uncollectible. NOTE 5- Licensing Agreement and Purchase of Patents: On October 18, 1988, the Company paid $20,000 to Raymond and Mary Curiel d/b/a MJR Company of Scottsdale, Arizona as a non-refundable deposit on an exclusive licensing agreement for a patented invention (Solar Rechargeable Battery) developed and invented by Raymond Curiel. The parties consummated an agreement in January, 1989. This agreement called for the issuance of 20,000,000 shares of the Company's stock to MJR Co. for this exclusive license, and an option to purchase all the patents issued, and foreign applications then pending in connection with the solar rechargeable battery. The shares issued in the above agreement were valued at par value and resulted in a nominal increase in stockholders equity of $2,000. Management assigned a nominal value to the shares issued in the above transaction for the following reasons: 1) During fiscal year November 30, 1989, unlike in fiscal year 1987, no ready market existed for the registrant's common shares compounded by the fact that the shares issued were restricted and unregistered. Therefore, the fair market value of the consideration given in this transaction could not be readily determined. 2) Furthermore, management could not reasonably ascertain the fair market value of the licensing agreement, and option to purchase the patent since no similar product currently exists. The value of the above assets depend largely on how well the Company manufacturers and markets this product in the future. Therefore, these assets were recorded on the Company's balance sheet at cost in cash plus par value of the stock issued. This required the Company to pay an additional $20,000 in licensing fees to MJR Co. until the option to purchase the patent was exercised. The agreement of November 30, 1989 was revised on November 23, 1990. The Company under this agreement purchased all the issued U.S. Patents and all foreign applications pending from MJR for a cash payment of $40,000 and the issuance of 300,000 shares of its common unregistered stock. The Company valued these shares at par value for the same reason as stated earlier when the Company issued its common shares in consideration for the license agreement. Furthermore, all prior agreements by and between the Company and MJR and/or the Curiels were canceled. The patent cost is determined as follows: Cash paid for deposit $ 20,000 Par value common shares issued for option to purchase patents 2,000 Cash paid for purchase of patents 40,000 Par value common shares issued for purchase of patents 30 ------ Total cost $ 62,030 ====== NOTE 6 - Notes Payable: 1993 1992 ---- ---- Due and in default as of March 31, 1990. Interest at 18% per annum.. $ 12,000 $ 12,000 Due shareholder in default as of August 30, 1990 Interest at 10% per annum.. 10,000 10,000 Due shareholder in default as of June 30, 1992 Interest at 12% per annum.. 50,000 50,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 5,000 5,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 10,000 10,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 10,000 10,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 2,000 2,000 Due shareholder in default as of June 30, 1992 Interest at 10% per annum.. 4,945 4,945 Due shareholder June 30, 1993 Interest at 10% per annum.. 4,689 19,189 ------- ------- $ 108,634 $ 123,134 ======= ======= During 1993, only one note holder agreed to extend its due date until June 30, 1993. The balance of the notes are in default. Notes Payable-Related Parties Due and payable to Officers & Directors June 30, 1993 (John Somma) Interest at 10% per annum.. $ 13,850 $ 12,850 Due and payable to Officers & Directors June 30, 1993 (Lew Scala) Interest at 10 % per annum 36,946 32,675 ----- ------ $ 50,796 $ 46,525 ====== ====== Interest expense totaled $22,305, $17,900 and $14,623 in 1993, 1992 and 1991, respectively. The average effective rate of interest was 12%, 11% and 11% in 1993, 1992 and 1991, respectively. NOTE 7- Common Stock- Warrants: The Company currently has one class of stock outstanding which had been offered to the public in the form of a unit. Each unit consisted of one share common stock, par value $.0001, one class a redeemable common stock purchase warrant and one class B redeemable common stock purchase warrant. Each class a warrant entitles the holder to purchase one share of common stock at a price of $.10 until Nov. 30, 1993. Each class B warrant entitles the holder to purchase one share of common stock at a price of $.15 until Nov. 30, 1994. The Redeemable Warrants are redeemable by the Company upon 30 days prior written notice. The redemption price is $.0001 per Warrant for both the Class a and Class B warrants. NOTE 8- Income Taxes: At November 30, 1993, the Company had a net operating loss carry forward for financial accounting purposes of approximately $746,192. Theses carry forwards expire through the year 2008. Such carry forwards for federal income tax purpose are approximately only $281,541, and will be available to offset future "ordinary" taxable income. In addition, the Company had a capital loss carry forward for federal income tax of approximately $440,991 which had expired. The difference between the accounting loss and that for federal income taxes is due to the fact that the write off of Bedford is a capital transaction for federal tax purposes and therefore could only be used to offset capital gains. Since the capital loss in the amount of $430,991 expired for federal income tax purposes, no other material timing difference exists between accounting and tax income. The Company did not pay any federal income tax during fiscal years ending November 30, 1993, 1992, and 1991 and the tax expense, as reflected herein, is for state and local taxes only. Statements of Financial Accounting Standards (SFAS) No. 109 has been issued regarding accounting for income taxes. The statement, as amended, is effective for fiscal years beginning after December 15, 1992. The Company is required to implement SFAS No. 109 for its fiscal year ending November 30, 1994. The effect on the Company's reported financial position and results of operations resulting from the implementation of SFAS No. 96 has not yet been quantified by the Company. NOTE 9- Commitments: On May 15, 1991, the Company entered into an agreement with Burbud Management Corp.("Burbud") Burbud is organized under the laws of Panama and its U.S. location is New Rochelle, NY. Pursuant to this agreement, the Company will issue 8,000,000 shares of its common unregistered stock to "Burbud" in lieu of payment for the initial production of 20,000 solar rechargeable batteries("SRB") In addition "Burbud" will provide future research and product development of the "SRB" as well as assisting in the marketing of the product. As of November 30, 1993, the Company received 1,250 "SRB'S" from Burbud and in partial consideration for the above the Company issued 500,000 shares of its common unregistered stock. The Company values the transaction at the fair market value of the consideration received and estimates the cost of each battery at the cost the Company could have purchased and assembled them in the United States (Replacement costs) During fiscal year ending November 30, 1993 Burbud did not deliver any product against its commitment. (See Note 11) NOTE 10- Other Related Party Transactions: In fiscal 1993 the Company leased office space from Mr. Scala at a rate of $500.00 per month. Mr. Scala was compensated during fiscal year 1993 in the amount of $15,600. The Company continues to borrow money from Mr. Somma and Mr. Scala to fund the daily operations of the Company. Mr. Somma and Mr. Scala are officers, directors and principal shareholders of the Company. In October 1993 the Company sold Mr. Scala 1,250,000 of common stock at the rate of $.01 per share and reduced its total debt liability to Mr. Scala by $12,500. NOTE 11- Subsequent Events: In August 1995, the Company considered it's contract with Burbud void and has terminated it due to the no performance clause in the original contract. However, the Company may be obligated to issue an additional 1,500,000 shares of it's common unregistered stock to Burbud for services performed during the duration of the contract. The Company would vigorously fight the issuance of these shares due to damages in the form of lost "SRB" sales. Burbud has not substantially complied with many of the terms of the entire agreement. On August 30, 1995, the Company entered into a licensing agreement with an individual and has received a $5,000 non refundable initial licensing fee. The Company, under the terms of the agreement, will also receive a royalty equal to 5% of the gross selling price on such items manufactured and sold by the licensee for all sales up to $1,000,000 and 2% of sales over $1,000,000. However, the Company will receive a minimum royalty of $1000 per month for a term of sixty months which began in January, 1996. Between August 1995 and December 1995, the Company began to look for other business opportunities to enter. In December 1995, the Company purchased from Lewis Scala all the necessary hardware equipment, Galacticomm's WorldGroup software, and all existing telephone connections to run an Online Bulletin Board Service that provides Internet connectivity. The service can handle up to 256 simultaneous users. The most common need for Internet access is to allow users to "surf the web" with software such as Netscape, Microsoft explorer and many other "web" browsers. The Worldgroup software provides a pass-through SLIP, CSLIP and PPP connections for authorized users. The agreed price was $5,000. From November 1993 to May 1996, the company has sold 560,000 shares of common unregistered stock to 9 individuals at $.025 per share and had raised an additional $14,000.

44545_1993.txt

44545_1993

1993

44545

ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2 ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: *Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: *Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: *Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. * Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: *Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand * Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: *Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company * Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) *(d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) *(f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) *(a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) *(a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. *(a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. *(a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. *(a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. *(c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. *(c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. *(c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. *(a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. *(c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 *(c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. *(c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. *(f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. *(f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) *SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN *(a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA *(b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA *(c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF *(d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI *(e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH *(f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN *(a) - Power of Attorney and resolution. ALABAMA *(b) - Power of Attorney and resolution. GEORGIA *(c) - Power of Attorney and resolution. GULF *(d) - Power of Attorney and resolution. MISSISSIPPI *(e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20

716006_1993.txt

716006_1993

1993

716006

Item 1. Business. (a) Yellow Corporation and its wholly-owned subsidiaries are collectively referred to as "the company". The company changed its name in 1993 from Yellow Freight System, Inc. of Delaware to Yellow Corporation. This was done to more clearly distinguish the company as a holding company of transportation services and to eliminate confusion with the name of the company's principal operating subsidiary (Yellow Freight System, Inc.). In February 1993 the company completed its acquisition of the stock of Preston Corporation (Preston). Preston is the holding company for three regional less-than-truckload (LTL) carriers serving the Northeast, Upper Midwest and Southeast United States. The 1993 financial statements include the results of Preston effective March 1, 1993. The acquisition provided $497 million of operating revenue for the company in 1993. This accounted for 21.9% of the 26.2% increase in operating revenue over 1992. (b) The operation of the company is conducted through one predominant industry segment, which is the interstate transportation of general commodity freight by motor vehicle. (c) Yellow Corporation is a holding company providing freight transportation services through its subsidiaries, Yellow Freight System, Inc. (Yellow Freight), Preston Trucking Company, Inc. (Preston Trucking), Saia Motor Freight Line, Inc. (Saia), Smalley Transportation Company (Smalley Transportation), CSI/Reeves, Inc. (CSI/Reeves), Yellow Logistics Services, Inc. (Yellow Logistics) and Yellow Technology Services, Inc. (Yellow Technology). The company employed an average of 35,000 persons in 1993. Yellow Freight is the company's principal subsidiary, and up until the company's completion of the Preston Corporation acquisition in February 1993 contributed substantially all of the company's consolidated revenue. Yellow Freight had operating revenue of $2.358 billion in 1993 (83% of the company's total revenue) and is based in Overland Park, Kansas. It is the nation's largest provider of LTL transportation services with direct service to over 35,000 points in all 50 states, Puerto Rico, Canada and Mexico. Yellow Freight services Europe via an alliance with The Royal Frans Maas Group based in the Netherlands. Preston Trucking is primarily a regional LTL carrier serving the Northeast and Upper Midwest markets of the United States. Preston Trucking had operating revenue of $338 million for the ten months ended December 31, 1993 (12% of the company's total revenue) and is headquartered in Preston, Maryland. Saia is a regional LTL carrier that provides overnight and second-day service in nine southeastern states. It had operating revenue of $102 million for the ten months ended December 31, 1993 and is based in Houma, Louisiana. Smalley Transportation is a regional carrier providing service to customers in Georgia and throughout Florida. It had operating revenue of $32 million for the ten months ended December 31, 1993 and is based in Tampa, Florida. CSI/Reeves is in the business of transporting, warehousing and distributing carpet and related products. It had operating revenue of $25 million for the ten months ended December 31, 1993 and is based in Calhoun, Georgia. Item 1. Business. (cont.) Yellow Logistics offers a full range of integrated logistics management services including transportation management, warehousing, information systems, distribution, and package design and testing. Yellow Logistics specializes in serving the chemical, retail, computer hardware, electronic and pharmaceutical industries. Its headquarters are in Overland Park, Kansas. Yellow Technology supports the company's subsidiaries - primarily Yellow Freight - with information technology. It ensures that information systems anticipate and meet customers' needs and that the systems are an integral part of the transportation process. Its headquarters are in Overland Park, Kansas. The operations of the freight transportation companies are regulated by the Interstate Commerce Commission and state regulatory bodies. Competition includes contract motor carriers, private fleets, railroads and other motor carriers. No single carrier has a dominant share of the motor freight market. The company operates in a highly price-sensitive and competitive industry, making pricing and customer service major competitive factors. Pricing discipline and cost control are critical to improving profit levels in 1994. Traditionally, rate increases have been implemented to offset increases in labor and other operating costs. These increases have been difficult to retain because of the competitive pressures on pricing. The full impact of these increases is not realized immediately as a result of pricing that is on a contract basis and can only be increased when the contract is renewed or renegotiated. Pricing pressures were extremely competitive in the first half of 1993. They moderated in the second half of the year, aided by a two percent discount rollback implemented in August 1993 at Yellow Freight. The company's subsidiaries are continuing to work toward improved account profitability and maintaining pricing stability. The Yellow operating companies have implemented rate increases of between four and five percent during the first quarter of 1994 to cover increases in operating costs. The company attempts to control operating costs by maintaining efficient operations, optimum capacity utilization and strict budgetary controls. During 1993, Yellow Freight began an extensive multi-year network development process by consolidating and realigning terminals to improve customer service and reduce costs. A charge of $18.0 million before taxes was accrued for the costs to close certain facilities and dispose of excess property. This network development will result in better use of assets, reduced overhead, improved transit times and lower freight handling costs without reducing customer service. Salaries, wages and employees' benefits decreased as a percent of revenue in 1993 despite wage and benefit increases of approximately 3% effective April 1 for employees who are members of the International Brotherhood of Teamsters (Teamsters). This is due to a wage reduction of 9% effective April 1 for employees of Preston Trucking, a small decrease in the total number of employees and a reduction in workers' compensation expense. The current labor agreement with the Teamsters expires March 31, 1994. In the second quarter of 1993, Yellow Freight reaffiliated with Trucking Management, Inc. (TMI), a multi-employer bargaining group representing the trucking industry in labor contract negotiations. Preston Trucking is also a member of TMI. TMI is currently negotiating the renewal of this contract. An agreement that allows greater operational flexibility and the opportunity to reduce costs is necessary to allow Yellow Freight and Preston Trucking to better compete in the marketplace. Item 1. Business. (cont.) In addition, Preston Trucking's wage reduction expires March 31, 1994. Preston Trucking feels it is essential to continue this wage reduction in the near future to maintain its progress toward restoring profitability. Extension of the wage reduction requires a contract provision allowing the reduction and approval of Preston's Teamster employees. The company's differentiation strategy focuses on introducing new customer services, improving existing services and providing service to new markets. Yellow Freight's revenue growth was moderate in 1993 as compared to 1992. Growth was due to increased tonnage, which grew faster than the Industrial Production Index, and contributions from new services started in 1992. Yellow Freight expects moderate revenue growth in 1994. A service which reduces transit times by a full day on traditional three, four and five-day lanes experienced good revenue growth in 1993. A guaranteed expedited service that provides shippers an economical alternative to air freight in selected markets experienced a healthy revenue growth rate in 1993 and operated at a very high on-time service ratio. The Canadian and Mexican markets continued to provide good growth for Yellow Freight in 1993. This growth is expected to continue in 1994, partly as a result of NAFTA's simplified trade provisions between those countries and the United States. Service to and from Western Europe, through an alliance with The Royal Frans Maas Group of The Netherlands is expected to grow in 1994 as a result of expanded consolidation and deconsolidation points in North America and improvements in streamlining documentation processing. Preston Trucking continued to experience declines in both revenue and tonnage after the acquisition by the company, but benefited in June 1993 from the bankruptcy of a major competitor in the Northeast. Preston Trucking opened four new terminals and increased their revenue and tonnage during the last half of the year. They expect continued revenue growth in 1994 and are planning to broaden service with a new distribution center in Ohio. The company expects to benefit from Saia's expansion into Texas and Tennessee as well as their introduction of intrastate service in Texas. Combined with Saia's strong market position and profitable operations, revenue growth in 1994 is expected to be much improved. The operations of the company are generally funded by cash flows generated from operating activities except in periods of accelerated capital spending. The company requires working capital to fund capital expenditures and pay shareholder dividends. The rapid turnover of accounts receivable, effective cash management and ready access to credit provided by commercial paper, medium-term notes and flexible banking agreements allows the company to effectively manage its working capital. It is anticipated that 1994 capital expenditures and shareholder dividends will be primarily financed through internally-generated funds. The company made commercial paper borrowings in early 1993 to fund a portion of the Preston stock acquisition ($8 million) and to repay certain Preston indebtedness ($82 million). Revisions to the medium-term note program in 1993 provided for increased amounts outstanding and longer maturity periods. During the last six months of 1993, $37 million was borrowed under the medium-term note program, primarily to replace commercial paper borrowings. Modest capital expenditures and good cash flow from operations in 1993 enabled the company to further reduce commercial paper borrowings to $25 million at December 31, 1993. Item 2. Item 2. Properties. At December 31, 1993, the company operated 696 freight terminals located in 50 states, Puerto Rico, parts of Canada and Mexico. Of this total, 331 were owned terminals and 365 were leased, generally for terms of three years or less. The number of vehicle back-in doors totaled 19,243, of which 14,802 were at owned terminals and 4,441 were at leased terminals. The freight terminals vary in size ranging from one to three doors at small local terminals, up to 304 doors at Yellow Freight's largest consolidation and distribution terminal. Substantially all of the larger terminals, containing the greatest number of doors, are owned. In addition, the company and most of its subsidiaries own and occupy general office buildings in their headquarters city. The company also maintains a significant investment in revenue equipment. At December 31, 1993, the company's subsidiaries operated the following number of linehaul units: tractors - 4,918, 45' and 48' trailers - 7,738, and 27' and 28' trailers - 31,698. The number of city units operated were: trucks and tractors - 8,165 and trailers - 5,535. The above facilities and equipment are used in the company's predominant industry, the interstate transportation of general commodity freight. The company expects moderate growth in 1994 and has projected no significant changes to its operational capacity. A small number of facilities will be closed at Yellow Freight as part of the network development process started in 1993. Projected facility expenditures of $30 million will target expansion of existing locations and the construction or purchase of new locations to improve efficiency and enter new markets in selected areas. Equipment expenditures of $90 million are expected to consist primarily of replacement units with some expansion units at certain of the subsidiaries. Revenue equipment replacement units are expected to be approximately 70% higher than in the last three years. Other operating property expenditures of $55 million are primarily for improving efficiency through technological enhancements and advanced information systems. Item 3. Item 3. Legal Proceedings. The information set forth under the caption "Commitments and Contingencies" in the Notes to Consolidated Financial Statements on page 32 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. Executive Officers of the Registrant The names, ages and positions of the executive officers of the company as of March 18, 1994 are listed below. Officers are appointed annually by the Board of Directors at their meeting which immediately follows the annual meeting of shareholders. Executive Officers of the Registrant (cont.) The terms of each officer of the company designated above are scheduled to expire April 21, 1994. The terms of each officer of the subsidiary companies are scheduled to expire on the date of the next annual meeting of shareholders of that company. No family relationships exist between any of the executive officers named above. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. The information set forth under the caption "Common Stock" on page 34 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Item 6. Item 6. Selected Financial Data. The information set forth under the caption "Financial Summary" on pages 18 and 19 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Additionally, long-term debt at December 31 for each of the last five years was as follows (in thousands): 1993 - $214,176, 1992 - $123,027, 1991 - $145,584, 1990 - $163,703, 1989 - $186,680. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing on pages 14 through 17 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Item 8. Item 8. Financial Statements and Supplementary Data. The financial statements and supplementary information, appearing on pages 20 through 34 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated by reference under Item 14 herein. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The information regarding Directors of the registrant has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. For information with respect to the executive officers of the registrant, see "Executive Officers of the Registrant" at the end of Part I of this report. Item 11. Item 11. Executive Compensation. This information has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. This information has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. Item 13. Item 13. Certain Relationships and Related Transactions. This information has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) Financial Statements The following information appearing in the 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report as Exhibit (13): With the exception of the aforementioned information, the 1993 Annual Report to Shareholders is not deemed filed as part of this report. Financial statements other than those listed are omitted for the reason that they are not required or are not applicable. The following additional financial data should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Shareholders. (a) (2) Financial Statement Schedules Schedules other than those listed are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. (a) (3) Exhibits (13) - 1993 Annual Report to Shareholders. (24) - Consent of Independent Public Accountants. The remaining exhibits required by Item 7 of Regulation S-K are omitted for the reason that they are not applicable or have previously been filed. (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended December 31, 1993. However, on March 21, 1994, a Form 8-K was filed under Item 5, Other Events, which reported that due primarily to the impact of severe winter weather in January and February, the company expects to report a net loss in the first quarter of 1994 greater than the net loss of $.06 per share recorded in the first quarter of 1993. Severe winter weather caused significant business disruptions and higher operating expenses for both the company's largest motor carrier subsidiary, Yellow Freight System, Inc. and for Preston Trucking Company, Inc. Preston Trucking, whose operations are concentrated in the Northeast and Upper Midwest, was especially hard hit by the weather. Report of Independent Public Accountants on Financial Statement Schedules To Yellow Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Yellow Corporation and Subsidiaries' annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 31, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of revenue recognition in 1992, as discussed in the notes to the consolidated financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(a)(2) are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commissions rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Kansas City, Missouri, January 31, 1994 Schedule II Yellow Corporation and Subsidiaries Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties For the Years Ended December 31, 1993, 1992 and 1991 (1) Represent an interest-free loan secured by real property, payable in annual installments from January 15, 1990 to January 15, 1996 at which time the remaining balance is due. As of December 31, 1993, Stephen P. Murphy is no longer an employee of the company. This does not affect the repayment terms of the loan. (2) Represents an interest-free loan secured by real property, payable on May 1, 2006. Schedule V Yellow Corporation and Subsidiaries Property, Plant and Equipment For the Years Ended December 31, 1993, 1992 and 1991 (1) In 1993, primarily property, plant and equipment of Preston Corporation and subsidiaries acquired in February 1993. In 1992 and 1991, foreign equity translation adjustments. Schedule VI Yellow Corporation and Subsidiaries Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment For the Years Ended December 31, 1993, 1992 and 1991 (1) Foreign equity translation adjustments. Schedule VIII Yellow Corporation and Subsidiaries Valuation and Qualifying Accounts For the Years Ended December 31, 1993, 1992 and 1991 (1) Addition from Preston Corporation and subsidiaries acquired in February 1993. (2) Primarily uncollectible accounts written off - net of recoveries. Schedule X Yellow Corporation and Subsidiaries Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991 * Less than 1% of total sales Signatures Pursuant to the requirements of Section 13 or 15(d) 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. Yellow Corporation BY: /s/ George E. Powell III ----------------------------------- George E. Powell III March 21, 1994 President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

62142_1993.txt

62142_1993

1993

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ITEM 1. BUSINESS. BUSINESS OF MAPCO MAPCO Inc. ("MAPCO" or the "Company") is a diversified energy company which, through separate subsidiaries and affiliates, is engaged in the production of natural gas liquids and coal; the transportation by pipeline of natural gas liquids, anhydrous ammonia and refined petroleum products; the refining of crude oil; the marketing of natural gas liquids, refined petroleum products, coal, fertilizers and crude oil; the trading of crude oil, refined petroleum products and natural gas liquids ("NGLs"); NGL storage; and the marketing of motor fuel and merchandise through convenience store operations. MAPCO was incorporated in Delaware in 1958 and has its principal executive offices in Tulsa, Oklahoma. For convenience of reference and simplification of this report, references herein to MAPCO or the Company include its subsidiaries or affiliates, unless the context requires otherwise. SEGMENT INFORMATION The segment reporting structure for MAPCO is as follows: In 1992, MAPCO resegmented its operations from four segments into three by combining certain operating units of the previous Gas Products and Transportation segments, creating the Natural Gas Liquids segment. The resegmentation also involved combining certain operating units of the Gas Products segment into the Petroleum segment. The Natural Gas Liquids subsidiary was created to capitalize on and provide added emphasis for MAPCO in the growing natural gas liquids industry, an area identified for future growth and expansion. All prior year amounts have been restated to reflect this consolidation. Financial information about these segments for each of the three years ended December 31, 1993 is set forth in Note 8 to the consolidated financial statements on pages and and Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 15 through 23. NATURAL GAS LIQUIDS GENERAL During 1992, the Company combined certain operating units of its Gas Products and Transportation segments into the MAPCO Natural Gas Liquids Segment. The Natural Gas Liquids segment operations include the transportation and processing of natural gas liquids ("NGLs") as well as pipeline transportation of anhydrous ammonia, refined products and crude oil, fractionation, underground storage and the wholesale and retail marketing of NGLs and fertilizers. The 1993 Natural Gas Liquids segment revenues were $465.2 million and operating profit was $118.8 million compared to $453.5 million of revenues and $113.7 million of operating profit in 1992. NATURAL GAS LIQUIDS MARKETING Propane is used principally as a fuel in various domestic, agricultural, commercial, industrial and vehicle motor fuel applications. Residential customers (generally in areas not served by natural gas) use propane for home heating, cooking and other domestic uses. The major portion of MAPCO's propane sales is for domestic usage. Agricultural uses include crop drying, fuel for tractors and irrigation engines and other agricultural heating purposes. Commercial and industrial uses include fuel for shopping centers and industrial plants. The marketing of propane and related appliances is carried on primarily under the trade name "Thermogas" through 140 Company-owned and operated retail plants in states in the upper Midwest and the Southeast regions of the United States. Propane is also supplied to dealers operating in the same area, as well as to wholesale outlets and industrial accounts. Based upon published industry data, Thermogas is currently the fourth largest retail propane marketer in the United States. In 1993, MAPCO sold 232.4 million gallons of retail propane compared to 218.5 million gallons in 1992. Approximately 89% of the propane sold by MAPCO in 1993 was purchased from outside sources. The largest propane supplier accounted for approximately 14% of such outside purchases during 1993. MAPCO's propane supply arrangements are standard for the industry with prices being subject to adjustment in accordance with changes in industry-wide market price levels. MAPCO, at 47 of its Thermogas retail plants, also blends, markets and applies nitrogen solutions, fertilizers, mixed fertilizers and agricultural chemicals. Fluid fertilizers are sold under the trade name "Thermogas Fluid Fertilizer." In 1993, 139,393 tons of wholesale and retail fluid fertilizer ingredients were sold in the Midwest and Southeast as compared to 166,631 tons in 1992. Most of these sales were made during the Spring. NGL AND GAS PROCESSING MAPCO owns certain liquefiable hydrocarbons in natural gas under 234,000 acres in the West Panhandle gas field of Texas. MAPCO obtains its liquids through the processing of the gas at three processing plants it owns and operates in this field. Although only two of the plants are currently operational, these plants have a combined processing capacity of 260 million cubic feet of gas per day. In 1993, an average of 5,021 barrels per day of NGLs was produced and sold from the West Panhandle field, compared to 6,026 barrels per day in 1992. The extracted liquids are moved through MAPCO's Mid-America pipeline system for sale in Midwestern and Gulf Coast markets. Since 1991, MAPCO's West Panhandle field gas supplier has taken more than its percentage ownership share of the field's production. The cumulative effect of this acceleration in gas taken has resulted in the Westpan operations having a 25.3 billion cubic feet and $23.7 million over-take position. This imbalance will be adjusted by offsets from future field production. MAPCO uses the sales method of accounting for its gas balancing arrangements which allows the immediate recognition of all revenues on natural gas liquids sold. The acceleration in gas taken contributed an estimated $4.3 million, $9.0 million and $10.4 million to MAPCO's consolidated operating profit in 1993, 1992 and 1991, respectively. MAPCO owns a 50% interest in and operates a 107,000 barrel per day fractionator at Conway, Kansas. This fractionator receives mixed NGLs from the gathering areas in the Overthrust Belt area of Wyoming and Utah, New Mexico, West Texas, Western Oklahoma and Kansas for separation into ethane-propane mix, propane, normal butane, iso-butane and natural gasoline. After separation, the products are moved principally to markets in the Midwest and on the Texas Gulf Coast. MAPCO also owns and operates a 5,000 barrel per day depropanizer at Hobbs, New Mexico. MID-AMERICA PIPELINE Mid-America Pipeline Company ("Mid-America"), a wholly-owned subsidiary of MAPCO Natural Gas Liquids Inc., owns and operates 7,150 miles of pipeline and related storage facilities. The Mid-America pipeline system transports NGLs which consist of: propane used as fuel and petrochemical feedstock; butane and natural gasoline used as refinery and petrochemical feedstock; ethane-propane mixtures and ethylene used as petrochemical feedstock; and mixed natural gas liquids for further fractionation. The pipeline system consists of 7,131 miles of pipe varying in diameter from two to twelve inches. The main line of this pipeline system runs from the Wyoming-Utah Overthrust Belt area through the northwestern New Mexico portion of the Four Corners area to near Hobbs, New Mexico, and from Hobbs to Conway, Kansas, where it branches into east and west legs. The west leg extends to near Minneapolis, Minnesota, and the east leg leads to near Janesville, Wisconsin. Spurs from these legs extend into southeast Kansas, Iowa and Illinois. Mid-America's Illini II is a 116-mile pipeline connecting a chemical customer's plants in Illinois and transports ethylene. Mid-America also transports crude oil from St. James, Louisiana to Memphis, Tennessee. This crude oil is transported in pipeline space leased by Mid-America in the Capline Pipeline system, which extends from St. James to near Collierville, Tennessee. Crude oil is then transported through a 32-mile pipeline, operated and partially owned (19 miles only) by Mid-America to MAPCO Petroleum's Memphis Refinery. Mid-America also transports jet fuel by pipeline from the Memphis Refinery to the nearby Memphis International Airport. MAPCO AMMONIA PIPELINE MAPCO Ammonia Pipeline Inc. (the "Ammonia System") transports liquid anhydrous ammonia for use as fertilizer. This system consists of 1,093 miles of pipe varying from four to eight inches in diameter. It receives ammonia from plants in the Texas Panhandle and near Enid and Tulsa, Oklahoma for delivery to points principally in Kansas, Nebraska, Iowa and southern Minnesota. LIQUID MOVEMENTS The following table summarizes the Mid-America and Ammonia Systems' total movements of liquids in millions of barrel miles (barrels of liquids times number of miles transported) and revenue per 100 barrel miles for each of the past five years: The Mid-America and Ammonia Systems operate as common carriers. The single largest shipper accounted for approximately 18.6% of pipeline transportation revenues during 1993. Total pipeline deliveries in 1993 were 236 million barrels, compared with 218 million barrels in 1992. SEMINOLE PIPELINE Seminole Pipeline Company ("Seminole") owns 1,311 miles of pipeline, predominantly fourteen inches in diameter, extending from Hobbs Station in West Texas to the Mont Belvieu Terminal on the Texas Gulf Coast, together with related pumping, metering and storage facilities. MAPCO owns 80% of the stock of Seminole and operates and manages the pipeline. Seminole operates as a batch system moving demethanized mix, ethane-propane mix and specification liquid products. Products are received from gas processing plants and from Mid-America Pipeline for delivery to various destinations along the pipeline system. The Texas Gulf Coast market served by Seminole is predominantly for petrochemical and refining feedstock. During 1993, Seminole completed an expansion of the pipeline which consists of an additional 544-mile, 14-inch pipeline from West Texas to Mont Belvieu, Texas, increasing the potential capacity of the line to 300,000 barrels per day. See "Legal Proceedings" Item 3 beginning on page 12 for information concerning litigation proceedings connected with Seminole. LIQUIDS SUPPLY The Department of Energy estimates of total proved reserves of NGLs for Mid-America's and Seminole's source of supply areas in Texas, New Mexico, Oklahoma, Kansas, Colorado, Wyoming and Utah are as follows: Mid-America's and Seminole's supply areas are also served by other pipelines. STORAGE Underground storage facilities for NGLs are owned or operated by MAPCO at locations along its pipeline system in the States of Iowa, Kansas, Nebraska, Oklahoma and Texas. The capacity of these facilities on December 31, 1993 was approximately 16 million barrels. Other storage operations compete with MAPCO for storage leasing in the Conway and Hutchinson, Kansas areas. Competition is intense in the storage business. COMPETITIVE CONDITIONS The marketing of NGLs and fertilizer and the transportation businesses in which MAPCO operates are highly competitive. MAPCO competes with a number of companies engaged in propane marketing, some of which are larger than MAPCO and may have more significant financial resources. In addition, other pipelines, tank cars, trucks, barges and local sources of supply (refineries, gasoline plants and ammonia plants) and other sources of energy such as natural gas, coal, oil and electricity, all provide competition for pipeline operations. Propane competes with natural gas in areas served by natural gas distribution systems and extension of natural gas service may result in the loss of customers. Competition for retail and wholesale fertilizer customers is intense in all of the areas served by MAPCO. REGULATIONS AND ENVIRONMENTAL MATTERS Federal, state and local environmental and safety laws and regulations affect the Natural Gas Liquids segment's marketing of NGLs, nitrogen solution fertilizers, mixed fertilizers and agricultural chemicals and the operation of its natural gas processing plants. It is the policy of the Natural Gas Liquids segment to comply with such laws and regulations. At this time, MAPCO cannot accurately predict the effect which such laws and regulations may have on such activities and future earnings. Pipeline operations are subject to the provisions of the Interstate Commerce Act applicable to interstate common carrier pipelines and the Hazardous Liquid Pipeline Safety Act. The Federal Energy Regulatory Commission regulates tariff rates, shipping regulations and other practices of Mid-America and Seminole. Tariff rates for liquid anhydrous ammonia as transported by the Ammonia System are regulated by the Interstate Commerce Commission. Under the Interstate Commerce Act, MAPCO is required to file reasonable and nondiscriminatory tariff rates and is subject to certain other regulations relating to, among other things, permissible depreciation charges. The United States Department of Transportation has prescribed safety regulations for common carrier pipelines. The pipeline systems are subject to various state laws and regulations concerning safety standards, exercise of eminent domain and similar matters. Mid-America and Seminole also file tariff rates covering intrastate movements with various state commissions. The Natural Gas Liquids segment did not incur in 1993 and does not at this time anticipate any material capital expenditures for environmental control facilities in 1994. PETROLEUM GENERAL The Petroleum segment operates two refining and marketing systems: the Alaska System and the Mid-South System. The Alaska System includes a refinery at North Pole, Alaska, the wholesale marketing of refined petroleum products, and a 20-unit chain of retail motor fuel and convenience store outlets. The Mid-South System includes a refinery at Memphis, Tennessee, the wholesale and spot marketing of refined petroleum products and NGLs, a 222-store chain of retail motor fuel convenience stores and interstate fuel stops in 9 Southeastern states and 79 dealers in Florida. The 1993 Petroleum segment revenues were $1,978.2 million, and operating profit was $108.9 million compared to $2,028.0 million of revenues and $73.9 million of operating profit in 1992. ALASKA SYSTEM NORTH POLE REFINERY MAPCO's refinery, located near Fairbanks at North Pole, Alaska ("North Pole Refinery"), is the largest refinery in the State. The refinery is located approximately two miles from its supply point for crude oil, the Trans-Alaska Pipeline System ("TAPS"). The North Pole Refinery's processing capability is approximately 125,000 barrels per day. At maximum crude throughput, 43,000 barrels per day of refined product can be produced. These products are gasoline, commercial and military jet fuel, heating oil, diesel fuel, fuel oil, naphtha and asphalt. MAPCO's principal market for these products in Alaska is to governmental, wholesale, commercial and industrial customers and to MAPCO's retail marketing operations. MAPCO's retail marketing operations, as described below, accounted for about 10% of the North Pole Refinery's 1993 product sales volume, and MAPCO Express' retail gasoline sales, as described below, accounted for about 75% of the Refinery's gasoline production. In 1993, average throughput at the North Pole Refinery was 124,971 barrels per day of crude oil which resulted in the average production of 37,699 barrels per day of petroleum products. The North Pole Refinery's crude oil is purchased from the State of Alaska or is purchased or received on exchanges from other crude oil producers. The North Pole Refinery has an agreement with the State of Alaska for the purchase of State royalty oil which is scheduled to expire on December 31, 2003. The agreement provides for the purchase of up to 35,000 barrels per day of the State's royalty share of crude oil produced from Prudhoe Bay, Alaska. These volumes, along with crude oil either purchased or received under exchange agreements, are utilized as throughput in the production of products at the refinery. Approximately 28% of the throughput is refined and sold as finished product and the remainder is returned to the TAPS and either delivered to repay exchange obligations or sold. Effective February 1, 1992, the North Pole Refinery discontinued its receipt of crude oil under an assignment of rights of Golden Valley Electric Association to purchase 5,000 barrels per day of State of Alaska royalty oil. See "Legal Proceedings" Item 3 beginning on page 12 for information concerning litigation connected with state royalty oil contracts. RETAIL MARKETING MAPCO, under the brand name "MAPCO Express," is engaged in the retail marketing of gasoline, diesel fuel, other petroleum products, convenience merchandise and deli snack foods at 20 stores primarily in Anchorage, Fairbanks and Juneau, Alaska. In 1993, convenience merchandise and deli fast food accounted for approximately 38% of MAPCO Express' gross margin. All of the motor fuel sold by MAPCO Express stores is supplied either by exchanges or directly from the North Pole Refinery. In June 1993, the Company sold its retail heating fuel operation, "MAPCO Express Fuels." MAPCO Express Fuels previously operated in the Fairbanks residential and commercial heating fuels markets and in rural interior Alaska and on the waterborne Yukon River and Norton Sound markets, selling primarily gasoline, heating fuels, diesel and lubricants. MAPCO Express Fuels operations were not material to the operating results of the Petroleum segment. MID-SOUTH SYSTEM MEMPHIS REFINERY MAPCO's refinery in Memphis, Tennessee ("Memphis Refinery") currently has a throughput capacity of approximately 85,000 barrels per day. In 1993, the Memphis Refinery processed an average 77,141 barrels per day. Products produced by the Memphis Refinery are gasoline, low sulfur diesel fuel, jet fuel, K-1 kerosene, No. 6 fuel oil, propane and elemental sulfur. These products are marketed primarily in the Mid-South region of the United States to wholesale customers, such as industrial and commercial consumers, jobbers, independent dealers, other refiner/marketers and MAPCO's retail marketing operations. Sales to MAPCO's retail marketing operations accounted for about 27% of the Memphis Refinery's 1993 sales volume, with no other single customer accounting for more than 7% of total sales. During 1993, the Memphis Refinery's gasoline sales to MAPCO's retail marketing operations were 50% of the refinery's gasoline production. The Memphis Refinery has access to crude oil from the Gulf Coast via common carrier pipeline and by river barges. In addition to domestic crude oil, the Memphis Refinery has the capability of receiving and processing certain foreign crudes. During 1993, the majority of the crude oil processed at the Memphis Refinery was purchased from various suppliers on a posted-plus price basis. Although this method of purchase reduces the financial effect of volatile crude oil markets, the financial results of the refinery may be significantly impacted by changes in the market prices for crude oil and refined products. MAPCO cannot with any assurance predict the future of crude oil and product prices or their impact on the financial results of the Petroleum segment. RETAIL MARKETING MAPCO, primarily under the brand names "MAPCO Express" and "Shell," is engaged in the retail marketing of gasoline, diesel fuel, other petroleum products, convenience merchandise and deli fast food items at 222 stores in Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, Mississippi, Tennessee and Texas. MAPCO's stores have been designed to be modern neighborhood-type facilities, attracting convenience-oriented customers with a variety of today's most widely-used products and services. In 1993, convenience merchandise and deli fast food accounted for approximately 47% of MAPCO's retail marketing operations' gross margin. During 1993, MAPCO sold 15 stores in its Mid-South System. OTHER PETROLEUM OPERATIONS CRUDE AND REFINED PRODUCTS SUPPLY AND TRADING MAPCO buys, sells and exchanges domestic and foreign crude oil to supply its refinery systems in Tennessee and Alaska. During 1993, in addition to refinery supply, MAPCO purchased and sold an average of 17,012 barrels per day of crude oil compared to 3,685 barrels per day in 1992. All of the 1992 activity occurred during the fourth quarter. During that quarter MAPCO purchased and sold an average of 14,659 barrels per day. NGL PRODUCTS SUPPLY AND TRADING MAPCO buys, sells and exchanges domestic and imported NGLs in the Midwest, Gulf Coast and Rocky Mountain regions. Although some NGLs are produced by MAPCO, the majority is purchased from outside sources and sold under both short and long-term arrangements. NGL sales for 1993 averaged 49,864 barrels per day, compared with 65,011 barrels per day in 1992. The supply of and demand for NGLs can materially affect the volume of product available to MAPCO and also the market for such product. COMPETITIVE CONDITIONS The petroleum industry is highly competitive in all phases from the procurement of crude oil to the refining, distribution and marketing of refined products. Many of MAPCO's competitors are large integrated oil companies, which, because of their diverse operations, strong capitalization and recognized brand names may be better able to withstand volatile industry conditions, shortages of crude oil or intense price competition. The principal competitive forces affecting MAPCO's refining businesses are feedstock costs, refinery efficiency, refinery product mix, product distribution and marketing costs. Some of MAPCO's larger competitors have refineries which are larger and more efficient, and, as a result, may have lower per barrel costs of operation. In addition, some of MAPCO's competitors in the refining business can more easily process sour crudes, and accordingly, are more flexible in the crudes which may be processed. Since MAPCO has no crude oil reserves and does not engage in crude oil exploration, it must obtain its crude oil requirements from unaffiliated sources. MAPCO believes that it will be able to obtain adequate crude oil and other feedstocks at generally competitive prices for the foreseeable future. The principal competitive factors affecting MAPCO's retail marketing businesses are location, product price and quality, appearance and cleanliness of stores and brand-name identification. REGULATIONS AND ENVIRONMENTAL MATTERS Federal, state and local pricing and environmental laws and regulations affect MAPCO's refining and marketing operations. It is the policy of the Petroleum segment to comply with such laws and regulations. MAPCO's refining operations are subject to regulations relating to air emissions, water discharges and soil and groundwater contamination which may result from spillage or discharge of petroleum and hazardous materials at its refineries, terminals and retail outlets. Groundwater remediation is ongoing at both refineries and at various MAPCO retail outlets. Air and water pollution control equipment is operating at both refineries to comply with applicable regulations. The Clean Air Act Amendments of 1990 (the "CAAA") will impact the Petroleum segment, particularly its refinery operations, through a number of programs and provisions of the CAAA. The provisions impacting the Petroleum segment include Maximum Achievable Control Technology (MACT) rules to be developed for the refining industry, controls on individual chemical substances present at its facilities and new operating permit rules which may be applicable to its facilities. These provisions impact other companies in the industry in similar ways and are not expected to adversely impact the Company's competitive position. MAPCO's retail petroleum operations are subject to federal, state and local regulations regarding petroleum underground storage tanks ("USTs"). The United States Environmental Protection Agency ("EPA") and several states in which MAPCO conducts retail operations have adopted laws requiring owners and operators of USTs used for petroleum products to register such tanks with state offices. In addition, these UST regulations have imposed new technical standards, corrective action and financial responsibility requirements relating to such tanks. The regulations establish requirements for owners and operators of USTs, including leak detection systems, corrosion protection systems, tank system repairs and replacement, tank closure and corrective action for leaking tanks. EPA regulations were issued in late 1988 and compliance is to be phased in over the course of a ten (10) year period. The Petroleum segment incurred approximately $15.7 million in capital expenditures for environmental control facilities in 1993 and has budgeted $6.2 million in capital expenditures for environmental control facilities in 1994. Such expenditures are not deemed by the segment to be material. COAL GENERAL MAPCO's Coal Segment operations produce and market bituminous coal for domestic and foreign markets from one surface and seven underground mining complexes located in Kentucky, Maryland, Illinois and Virginia. MAPCO also operates a coal terminal on the Ohio River near Mt. Vernon, Indiana, used for the transloading of coal. The 1993 Coal Segment revenues were $414.4 million and operating profit was $46.9 million, compared to $429.6 million in revenues and $36.0 million in operating profit in 1992. Tonnage produced by the Coal Segment in 1993 was 13,151,820 tons(1), compared with 13,351,512 tons in 1992. Tonnage sold in 1993 was 14,357,619 tons, compared with 14,710,824 tons in 1992. Tonnage transloaded at the Mt. Vernon coal terminal in 1993 was 3,213,978 compared with 3,197,030 in 1992. In 1993, approximately 89% of MAPCO's production was mined by underground mining methods and approximately 11% by surface mining methods. Of the total amount of tons sold by MAPCO's Coal Segment, approximately 44% consisted of low sulfur coal (27% steam and 17% metallurgical coal), 17% medium sulfur steam coal, and 39% high sulfur steam coal. The following table sets forth the volume of coal sold by MAPCO's Coal Segment and the average sales price per ton for each of the five years ended December 31, 1993: COAL MARKETING MAPCO's steam coal is sold primarily to electric utilities and industrial and cogeneration customers located in the Eastern United States and, to a lesser extent, in Europe. MAPCO's metallurgical coal is sold to steel and coke producers located in the United States, South America, Japan, Europe and North Africa. Of the 14.4 million tons sold during 1993, approximately 70.5% was to domestic utilities, 14.9% to export customers, 8.2% to domestic industrial users, 4.3% to cogeneration customers, and 2.1% to other coal-related entities. During 1993, approximately 85% of the total tons marketed by MAPCO's Coal Segment was sold under contracts having a term of more than one year ("long-term contracts"), many of which contain price adjustment provisions designed to reflect changes in market conditions, labor and other production costs and, when the coal is sold other than FOB the mine, changes in railroad and/or barge freight rates. The relevant provisions of such long-term contracts, however, are not identical, and the selling price of the coal does not necessarily reflect every change in production costs incurred by the producing coal mine. Certain of MAPCO's long-term contracts may be reopened periodically for price renegotiation. The remainder of MAPCO's coal production is sold under spot market arrangements having terms of one year or less. In the case of metallurgical coal sold in the domestic market and both metallurgical and steam coal sold in the export market, such contracts are generally subject to negotiation each year or have annual price renegotiation provisions if longer than one year. See "Legal Proceedings," Item 3 beginning on page 12 for information concerning litigation connected with a coal sales contract at the Retiki Mine. During 1993, total demand for coal produced in the U.S. was 958 million tons as determined by the U.S. Department of Energy. This was 3.13% less than the 1992 demand level of 989 million tons. While 1993 demand was down from 1992 levels, consumption increased slightly (i.e., .91%) during 1993. Consumption for 1993 was approximately 1,003 million tons while 1992 consumption was 994 million tons. Domestic utility coal consumption, which represented approximately eighty-seven percent (87%) of total domestic consumption, increased by approximately 34 million tons compared to 1992, while domestic industrial and coking coal - --------------- (1) As referred to throughout the description of the Coal Segment, "tons" are defined as short tons of 2,000 pounds, unless otherwise indicated. consumption increased by 2 million tons. Domestic coal production was impacted by the eight-month long selective United Mine Workers of America ("UMWA") strike against certain member companies of the Bituminous Coal Operators' Association, Inc. This action resulted in a 45 million ton draw-down in utility coal stockpiles and decreased production by approximately 51 million tons from 1992 levels. As a result of the strike, spot coal prices increased nominally from the 1992 levels. International demand for U.S.-produced steam and metallurgical coals declined approximately 26% with total deliveries of approximately 75 million tons. In general, demand for U.S. steam and metallurgical coals was impacted by the slow economic recovery worldwide and availability of coals from other lower-cost or government-subsidized coal-producing countries. Consequently, there was a reduction in the sales price of coals placed in the export market. LABOR MATTERS On February 1, 1993, the collective bargaining agreement between MC Mining, Inc. ("MC Mining"), a wholly-owned subsidiary of MAPCO Inc., and the UMWA expired. Previously, in December, 1992, MC Mining had given the UMWA notice of its intention to enter into decision-and-effects bargaining concerning MAPCO's decision to either sell MC Mining or contract out its operation. Collective bargaining with the UMWA concerning the effects of the sale or contracting out of MC Mining is ongoing. In early June, 1993, the UMWA filed a petition with the National Labor Relations Board ("NLRB") seeking an election to decide whether the UMWA should represent hourly employees at MAPCO Coal's Pontiki Coal Corporation ("Pontiki"). On August 13, 1993, the NLRB conducted a representation election and the unofficial vote count was 78 votes opposed to unionization, 101 votes supporting the UMWA, and 23 votes challenged by the UMWA and consequently not counted. The number of challenged ballots are determinative of the election. Presuming all of the contested votes are "no" votes, the election would be a tie and the UMWA would not be elected to represent Pontiki employees. In late August, 1993, Pontiki filed formal objections with the NLRB against the UMWA for illegal activities, including personal threats, illegal promises, and intimidation during the organizing campaign. After a hearing before an investigatory agent of the NLRB, the Board agent recommended that the 23 challenged ballots be allowed, but the conduct of the UMWA was not sufficient to set aside the election. Both the UMWA and Pontiki have taken exceptions to the Board agent's recommendations to the NLRB, where the matter is currently pending. A dispositive ruling from the NLRB is not expected until mid-1994. RESERVES The following table sets forth MAPCO's Coal Segment's estimated economically recoverable coal reserves for 1992 and 1993: Estimated economically-recoverable coal reserves in 1993 for MAPCO's Coal Segment by type of coal is set forth in the following table: - --------------- (2) Included in MAPCO's coal reserve figures for 1992 and 1993 are 35,072,000 tons owned or controlled by MC Mining, an affiliate of MAPCO Coal Inc. In the normal course, the Coal Segment continuously reviews its coal assets and properties for the purpose of purchasing or disposing of coal assets and businesses to optimize operating profit and cash flow potentials. (3) Definitions for low, medium and high sulfur coal are as follows: (a) low sulfur coal means coal containing less than 1.0% sulfur; (b) medium sulfur coal means coal containing between 1.0% and 2.0% sulfur; and (c) high sulfur coal means coal containing in excess of 2.0% sulfur. MAPCO's reserve base is estimated using guidelines defined by the U.S. Geological Survey in its publication Circular 891 entitled "Coal Resource Classification System of the U.S. Geological Survey" ("USGS 891"). The estimates of economically-recoverable coal reserves are based upon MAPCO's analysis of local seam conditions in keeping with USGS 891 and upon the operating experience of the appropriate technical mining personnel. In general, such reserve estimates are based on yearly evaluations made by the Coal Segment's professional engineers and geologists. As discussed herein, MAPCO's Coal Segment periodically modifies estimates of reserves owned or controlled by MAPCO which may increase or decrease previously reported amounts. The annual reserve evaluations are based on information developed by core hole drilling programs, examination of outcrops, acquisitions, dispositions, actual production amounts, changes in mining methods, abandonments and other relevant information. All measured or indicated reserves referred to in the table above can be mined by current mining practices and techniques. In addition, MAPCO's available coal resources include incremental tons in excess of the noted indicated or measured tons that may be mined in the future following potential improvements in mining equipment and techniques. For economic and other operational reasons, a portion of MAPCO's reserves described above may be mined only after the construction of additional mining facilities and additional capital investment. Nevertheless, the extent to which all of the coal in MAPCO's recoverable reserves will eventually be mined will depend on a myriad of factors, including but not limited to, future domestic and foreign economic and energy supply conditions, coal mining practices and capabilities, and governmental regulations. See Regulations and Environmental Matters at page 11. The reserve classifications in the table referred to above have been determined using the following criteria: Measured -- Accessed and virgin coal that lies within a radius of 1/4 mile of a point of thickness of coal measurement. The sites for thickness measurement are so closely spaced and the geologic character so well defined that the average thickness, areal extent, size, shape and depth of coal beds are well established. This classification has the highest degree of geologic assurance. Indicated -- Virgin coal that lies between 1/4 mile and 3/4 mile from a point of thickness of coal measurement. The assurance, although lower than for measured, is high enough to assume continuity between points of measurement. There are no sample and measurement sites in areas of indicated coal and the classification has a moderate degree of geologic assurance. COMPETITIVE CONDITIONS The coal industry is highly competitive. MAPCO's Coal Segment competes with many other large coal producers, several of which may have greater coal reserves or more substantial financial resources, as well as the hundreds of small and medium-sized producers in North America and abroad. Additionally, in the last several years, a consolidation of the coal industry has been occurring as evidenced by various mergers and/or reorganizations involving coal companies and coal properties. In many cases, the Coal Segment faces competitors, particularly in the export market, which benefit from favorable exchange rates, government-supported or subsidized coal production, lower costs by virtue of such factors as less difficult mining conditions, less severe governmental regulation, and lower transportation costs, all of which may provide a competitive advantage with respect to price. Steam coal also competes with other fuels and energy sources, including oil, natural gas hydroelectric power, solar and nuclear energy. In addition to the factors of price, availability, and public acceptance of alternative energy sources, the impact of Federal energy policies and taxation may have an impact on MAPCO's Coal Segment. MAPCO is not able to predict at this time the effect, if any, on the Coal Segment's operations of any changes in Federal energy or tax policy and its concurrent impact or the particular pricing levels of competing fuels (i.e., oil and natural gas). Nevertheless, any sustained and marked increase in the cost of coal sold resulting from any governmental imposition, tax or other, could have a material adverse effect on such business, both domestic and abroad. In 1993, based upon data established by the U.S. Department of Labor's Mine Safety and Health Administration, MAPCO ranked 24th in total production among U.S. coal producers. While MAPCO's Coal Segment's annual production accounts for only about 1.5% of the United States' coal production, MAPCO believes that it will remain competitive due to its above-average productivity per man day and sufficient financial resources, the latter of which enables MAPCO to employ reasonably modern and efficient production equipment. REGULATIONS AND ENVIRONMENTAL MATTERS MAPCO's Coal Segment, as well as the domestic coal industry, is subject to the U.S. Department of Labor's Mine Safety and Health Administration's comprehensive regulatory requirements and guidelines. In addition, MAPCO's coal mining operations are subject to regulation with respect to its environmental effects, including air and water quality control, reclamation of disturbed surface land, limitations on land use, solid waste and industrial waste disposal, noise, aesthetics and other matters by various Federal, regional, state and local authorities. In this connection, numerous permits are required for construction projects and for the operation of existing facilities. Additionally, such operations are subject to state and Federal health and safety rules and regulations. In general, compliance with these health and safety laws is a cost common to all producers to some extent. MAPCO believes that the Coal Segment's competitive position has not been, nor should it be, adversely impacted by these laws and regulations, except in the export market where MAPCO's Coal Segment competes with various foreign producers subject to less stringent health and safety regulations. In 1990, Congress enacted the Clean Air Act Amendments of 1990 ("Clean Air Act") which imposed, among other things, additional controls on the emissions of sulfur dioxide ("SO(')") and nitrogen oxides from coal-fired power plants. About two-thirds of the high sulfur coal produced from MAPCO's Illinois Basin operations is sold pursuant to long-term agreements for use in electric utility generating units which are currently fitted with flue gas desulfurization systems for the removal of SO(') emissions. Since implementation of the provisions of the Clean Air Act, these generating units have used, and MAPCO believes they will continue to use, its Illinois Basin coals. The primary utility customers for the medium sulfur coal produced at MAPCO's Mettiki Mine in western Maryland have announced that they have decided to install scrubbers as their compliance strategy. MAPCO does not believe that the market for these coals will be adversely impacted. MAPCO's East Kentucky and Virginia operations produce both low sulfur and compliance coals. Compliance coals are generally coals that have SO(') content less than or equal to 1.20 lbs. per million BTU. Since the Clean Air Act permits utilities to use low sulfur and compliance coals in lieu of constructing expensive sulfur dioxide removal systems, implementation of Phase 1 of this legislation in 1995 should have a favorable impact on the marketability of and pricing for MAPCO's extensive reserves of low sulfur and compliance coal. MAPCO cannot predict at this moment the timing or extent of such favorable impact, if any. MAPCO's Coal Segment is subject to various Federal, state, and local environmental laws, including but not limited to, the Clean Water Act, the Clean Air Act, and the Safe Drinking Water Act as well as mining and reclamation standards of the Surface Mining Control and Reclamation Act of 1977 and the regulations promulgated thereunder. It is the policy of the Coal Segment to operate in compliance with such standards, laws and regulations. MAPCO believes that this policy will not substantially affect its ability to compete with similarly situated and complying competitors in the marketplace. Present compliance is largely a result of capital expenditures made in prior years and of current maintenance and monitoring activities conducted in the ordinary course. Although the coal industry is subject to these numerous environmental regulations, MAPCO's Coal Segment did not incur in 1993 any material capital expenditures in order to comply with applicable Federal, state and local environmental laws and regulations. No material capital expenditures are anticipated for environmental control facilities for 1994 with respect to MAPCO's Coal Segment's operations. EXECUTIVE OFFICERS OF MAPCO INC. Each of the executive officers named above are elected annually by the directors of MAPCO and serve at the directors' discretion. Each individual named above has been an officer or employee of MAPCO for at least the past five years except for Gordon E. Schaechterle, who, prior to joining MAPCO on August 6, 1990 as General Manager, Federal Income Taxes, was Tax Manager for Arthur Andersen & Co. Messrs. Wellendorf, Scalet and Schaechterle were elected by the Board of Directors as officers of the Company effective as of February 1, 1994. There are no family relationships between or among any of the above-named persons or between or among any of the above-named persons and any directors of MAPCO. EMPLOYEES As of December 31, 1993, MAPCO and its subsidiaries had 5,677 employees. Of the total number of employees, 1,418 were employed in the Coal segment; 1,507 in the Natural Gas Liquids segment; 2,332 in the Petroleum segment; and 420 in the general corporate area. Less than three percent of MAPCO's work force is unionized and covered by collective bargaining agreements. Such agreements have been entered into with the Oil Chemical and Atomic Workers Union covering 149 employees in the Petroleum segment and with United Mine Workers of America covering 10 employees employed by a Company subsidiary in the Coal area. ITEM 2. ITEM 2. PROPERTIES. All the various physical properties are discussed in PART I, Item 1, SUPRA, pertaining to MAPCO's business. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Retiki Mine Contract Litigation The Coal Segment's Retiki Mine sells all of its production to Big Rivers Electric Corporation ("Big Rivers") under a cost-plus management fee contract that terminates in mid-January, 1996. The Retiki Mine is expected to close concurrently with contract expiration. Through December 31, 1993, MAPCO Coal has invoiced Big Rivers approximately $5.0 million for certain costs associated with the operation of the Retiki Mine. Big Rivers has declined to pay MAPCO the invoiced amount. A breach of contract and declaratory judgment action was initiated by MAPCO against Big Rivers in mid-January, 1994, in order to collect the invoiced amount as well as obtain a declaratory judgment by which Big Rivers would be determined to be liable for other operating costs associated with the Retiki Mine. State Royalty Oil Claim The refining and marketing arm of the Company, MAPCO Petroleum Inc., operates a refinery in Alaska through its subsidiary, MAPCO Alaska Petroleum Inc. ("MAPI"). Since 1978, MAPI (and/or its predecessor) has had long-term agreements with the State of Alaska (the "State") to purchase royalty oil from the State at prices linked to amounts payable by North Slope oil producers in satisfaction of their royalty obligations to the State. In 1977, the State commenced suit against the producers (in an action entitled State of Alaska v. Amerada Hess, et al.) alleging that they incorrectly calculated their royalty payments. As of April 1992, the State had settled its royalty oil claims against all of the producers. On the basis of these settlements, the State billed MAPI for retroactive increases in the prices paid by MAPI under all four of its royalty oil purchase agreements. The State's claim against MAPI is based upon the difference between the volume weighted average paid by the producers and the revised royalty values adopted by the State. MAPI has been paying the State under a contractual pricing formula which resulted in prices in excess of the volume weighted average of the producers' past royalty reports. On August 28, 1992, MAPI commenced suit against the State in an Anchorage State Court seeking a declaratory judgment that MAPI is not liable to the State for any retroactive price increase under its primary royalty oil purchase agreement (the "1978 Agreement"). That same date, MAPI invoked the arbitration provision of the agreement under which it had purchased the second largest amount of State royalty oil (the "1977 Agreement"), again seeking a determination that it is not liable for any retroactive price increase. On February 5, 1993, MAPI filed suit in Anchorage State Court as to the remaining two agreements (the "1984 and 1985 Agreements"). The State's claim, based upon invoices submitted to MAPI on October 1, 1992, is comprised of claims for retroactive price adjustments (including interest through varying dates in October 1992) of $98 million, $9.2 million, $2.9 million and $6.4 million under the 1978, 1977, 1984 and 1985 Agreements, respectively. In addition, MAPI could be responsible for interest subsequent to the billing dates. MAPI is the only royalty-in-kind purchaser that has not settled the State's retroactive billing claims. The Company believes that it has defenses of considerable merit as to the State's claims and is vigorously litigating all pending disputes but is not able to predict the ultimate outcome at this time. The Company has accrued an estimate of certain amounts, including legal fees, which it may incur in connection with the final resolution of these matters; however, a resolution unfavorable to the Company could result in material liabilities which have not been reflected in the accompanying consolidated financial statements. Texas Explosion Litigation On April 7, 1992, a liquefied petroleum gas ("LPG") explosion occurred near an underground salt dome storage facility located near Brenham, Texas and owned by an affiliate of the Company, Seminole Pipeline Company ("Seminole"). The matter was investigated by the National Transportation Safety Board ("NTSB") who determined in a Pipeline Accident Report that the explosion was the result of overfilling the storage facility and that the probable cause was the failure of MAPCO Natural Gas Liquids Inc. ("MNGL") to incorporate fail-safe features in the facility's wellhead safety system. The NTSB report further stated that (i) the cause of the overfilling was the inadequacy of procedures for managing cavern storage, (ii) contributing to the accident was the lack of federal and state regulations governing the design and operation of underground storage systems and (iii) contributing to the severity of the accident were inadequate emergency response procedures. As a result of the investigation, the NTSB issued safety recommendations to the Department of Transportation, the Research and Special Programs Administration, MNGL, the State of Texas Department of Public Safety, Washington County, the American Petroleum Institute, the American Gas Association and the International Association of Fire Chiefs. Seminole has responded to the NTSB's safety recommendations. The response states that Seminole believes it has accomplished or is in the process of accomplishing all of the NTSB recommendations. In addition, the response seeks to clarify that it is Seminole, not MNGL, that is the owner and operator of the facility, that Mid-America Pipeline Company ("Mid-America"), a subsidiary of MNGL, is the contractor for the operator, and that the report contains mistaken conclusions as to fault of one Mid-America employee. The incident has also been investigated by the Texas Railroad Commission (the "Commission"). In its investigation summary dated June 18, 1992, the Commission stated that the probable cause of the incident was the overfilling of the storage facility resulting in the escape of LPG which was subsequently ignited by an unknown source, but that it would not issue a final report on its investigation until all of the data had been received and analyzed. The Company, as well as Seminole, Mid-America and other non-MAPCO entities have been named as defendants in civil actions filed in state district courts in Texas. During the first quarter of 1993, the Company received reimbursements from its insurers for settlements which disposed of all of the death claims and substantially all of the serious injury claims resulting from the incident. The settlements resulted in an insurance premium penalty to the Company in 1992 of approximately $19.6 million to be paid over a seven-year period beginning in 1993. The Company believes that complete resolution of this matter by litigation or settlement, after reimbursement of insurance coverage, will not have a material adverse effect on the Company's business, results of operations or consolidated financial position. General The Company and its subsidiaries are involved in various other lawsuits, claims and regulatory proceedings incidental to their businesses. In the opinion of management, the outcome of such matters will not have a material adverse effect on the Company's business, consolidated financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information regarding the market for MAPCO's common equity and related stockholder matters is set forth herein at pages 22 and 23. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table contains selected consolidated financial data for the five years indicated: During 1993, 1992, 1991, 1990 and 1989, MAPCO repurchased a total of 101,949, 288,100, 463,871, 4,651,647 and 7,823,600 shares, respectively, of its common stock at a cost of approximately $6.2 million, $16.5 million, $20.2 million, $182.1 million and $290.8 million, respectively. At January 23, 1991, MAPCO had the authority from its Board of Directors to repurchase 2.5 million shares primarily for employee stock option and other benefit plans. As of March 24, 1994, 876,820 shares had been purchased at a cost of $44.3 million under this authority. Dividends paid per common share were restated in 1989 to reflect the two-for-one common stock split declared in 1989. The significant decline in stockholders' equity in 1990 was attributable to common stock repurchases. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of MAPCO Inc.'s ("MAPCO") financial condition and results of operations should be read in conjunction with the financial statements and segment information on pages through of this report. FINANCIAL CONDITION CASH GENERATION Cash generation was as follows (in millions): Funds provided by operations in 1993 as compared to 1992 increased primarily due to reduced operating costs, higher refinery margins and lower interest expense. (See comments under Results of Operations for additional information regarding segment operating results.) Capital expenditures and acquisitions in 1993 were $144 million, of which $52 million was for capital items necessary to maintain existing operations, compared to capital expenditures and acquisitions of $214 million in 1992, of which $67 million was for capital items necessary to maintain existing operations. The 1993 capital expenditures include $52 million for expansion of the Seminole Pipeline and $18 million for environmental projects. 1992 capital expenditures included $76 million for expansion of the Seminole Pipeline, $19 million for environmental projects, $32 million for the acquisition of 34 retail propane plants and $12 million for new longwall shields at the Mettiki Mine. In 1993 cash was used in financing activities to reduce debt including a reduction in short-term borrowings of $140 million, payment of a scheduled maturity of a Medium Term Note of $10 million and the redemption of the Mt. Vernon Economic Development Bonds for $7 million, partially offset by Seminole Pipeline's issuance of $75 million of 6.67% Senior Notes. The Company also paid $30 million of dividends and repurchased 101,949 shares of MAPCO common stock for $6 million. CAPITALIZATION Capitalization, which includes long-term debt (excluding current maturities) and stockholders' equity, increased from $1,147 million at December 31, 1992 to $1,160 million at December 31, 1993. MAPCO's long-term debt as a percent of capitalization decreased to 50% at December 31, 1993 from 58% at December 31, 1992, reflecting the favorable impact of 1993 operating results on stockholders' equity and the utilization of increased cash flow from operations to reduce commercial paper which is classified as long-term debt. Various loan agreements contain restrictive covenants which, among other things, limit the payment of advances or dividends by two Natural Gas Liquids' subsidiaries to MAPCO. At December 31, 1993, $192 million of net assets were restricted by such provisions. LIQUIDITY AND CAPITAL RESOURCES MAPCO's primary sources of liquidity are its cash and cash equivalents, internal cash generation, and external financing. At December 31, 1993, MAPCO had $70 million of cash and cash equivalents compared to $56 million at December 31, 1992. MAPCO's external financing sources include its bank credit agreement, its uncommitted bank credit lines, and its ability to issue public or private debt, including commercial paper. MAPCO has amended its bank credit agreement to reduce the committed line of credit from $400 million to $300 million and to change a certain debt covenant. The total commitment under the bank credit agreement reduces in quarterly amounts of $25 million commencing March 31, 1994. This agreement serves as a back-up for outstanding commercial paper and bank borrowings. As of December 31, 1993, no borrowings were outstanding under the bank credit agreement. In 1990, MAPCO filed a shelf registration statement with the Securities and Exchange Commission providing for the issuance of up to $400 million of debt securities. As of December 31, 1993, MAPCO had outstanding $343 million of Medium Term Notes under this registration. MAPCO has the authorization to issue up to an additional $47 million of Medium Term Notes. The proceeds from any debt issued under the shelf registration statement have been and will continue to be used for general corporate purposes, including working capital, capital expenditures, reduction of other debt and acquisitions. MAPCO's existing debt and credit agreements contain covenants which limit the amount of additional indebtedness the Company can incur. Management believes, however, that MAPCO has sufficient capacity to fund its anticipated needs. Capital expenditures in 1994 are expected to be approximately $181 million, of which approximately $109 million will be for expansion projects and $7 million for environmental projects. MAPCO's long-term liquidity is expected to increase since cash generated from operations is anticipated to exceed currently projected capital expenditures, environmental projects, debt service and dividends. MAPCO anticipates that future excess internal cash generation will be used primarily to fund new capital projects. INFLATION The impact of inflation on MAPCO has been less significant during the past five years because of the relatively low rates of inflation experienced in the United States. MAPCO's operating costs are influenced to a larger extent by specific price changes in oil and gas and allied industries than by changes in general inflation. Crude and NGL prices are particularly sensitive to OPEC production levels and/or the attitudes of traders concerning the supply and demand balance in the near future. These costs could increase, with a possible adverse effect on MAPCO's profitability. Although every effort will be made to do so, it is possible that MAPCO, like many other companies, may not be able to adjust its sales prices to maintain parity with inflation-driven operating costs. The Company attempts to minimize the impact of inflation on operating costs through on-going productivity improvements and cost reduction programs. Significant volumes of MAPCO Coal's production are sold pursuant to long-term contracts, many of which contain cost adjustment provisions which are generally inflation related. Also, one mine's sales price is based upon actual costs plus a per ton profit. MAPCO Petroleum uses the last-in, first-out method of inventory valuation for crude oil, refined petroleum products and retail merchandise inventories. This method of inventory valuation results in cost of sales which more closely represent current costs. OTHER The Financial Accounting Standards Board ("FASB") has issued Statement of Financial Accounting Standards ("SFAS") No. 112, Employers' Accounting for Postemployment Benefits. This standard will require accrual of estimated future costs over premiums collected for individuals electing to continue benefits coverage after employment under COBRA. Adoption of this standard in 1994 will not materially affect MAPCO's financial position or annual expense for postemployment benefits. The FASB has also issued SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Adoption of these standards is not expected to materially affect MAPCO's financial position, liquidity or results of operations. MAPCO expects to adopt these standards in 1995 and 1994, respectively. MAPCO maintains property and liability insurance at limits believed to be sufficient to cover estimated potential risks. Losses up to deductible amounts of the various coverages would not have a material effect on MAPCO's financial position. RESULTS OF OPERATIONS INCOME STATEMENT 1993 Results Compared to 1992 Net income in 1993 increased $26 million over the $101 million reported in 1992. Earnings per common share were a record $4.24 in 1993 compared to $3.37 in 1992. Net income and earnings per share in 1992 would have been $121 million and $4.06, respectively, excluding $0.69 per share of mostly non-recurring charges. Average common shares outstanding were 30.0 million in 1993 and 29.9 million in 1992. Sales and operating revenues by segment were as follows (in millions): Sales and operating revenues decreased $72 million because of lower sales in the Petroleum and Coal segments. The $50 million decline in sales for the Petroleum segment was due principally to lower sales prices at both the Memphis and North Pole Refineries. Coal revenues declined primarily because of slightly lower sales volumes and a price decrease on 2.2 million tons under a contract price reopener provision. Natural Gas Liquids' sales and operating revenues increased because of additional propane sales volumes from operating more retail plants, completion of the Seminole Pipeline Loop project and the negative impact on last year's revenues of an explosion at Seminole's facilities near Brenham, Texas ("Brenham explosion") in April, 1992. Natural Gas Liquids' revenues in 1992 included $7 million for the termination and buyout of a pipeline transportation agreement. Outside purchases and operating expenses by segment are provided below (in millions): Outside purchases and operating expenses in 1993 decreased $118 million from 1992. Petroleum's outside purchases declined $89 million because of lower average crude prices at both refineries. Operating expenses in Petroleum increased $3 million due primarily to higher environmental costs and higher maintenance costs on the fluid catalytic cracker at the Memphis Refinery. Coal's operating expenses decreased $26 million because of the resolution of prior year operational problems and the installation of new longwall shields in early 1993 at the Mettiki Mine, lower production levels at Pontiki and the Virginia Region Mines in 1993, and legislatively imposed retiree medical obligations of $5.6 million which were included in 1992 expenses. Natural Gas Liquids' operating expenses decreased $6 million in 1993; however, excluding a $19.6 million insurance premium penalty charged against 1992 operations, as a result of the Brenham explosion, operating expenses increased $14 million. The increase in expense was primarily attributable to higher power, pension and benefit, and property tax expenses in transportation, and higher operating costs from the increased number of retail propane plants. Depreciation, depletion and amortization was $97 million in both 1993 and 1992. Increases in depreciation expense from the Seminole Loop expansion project and additional retail propane plants acquired in 1992 were largely offset by lower Coal Segment depreciation expense. Coal's depreciation expense decreased $3 million primarily because of changes in the estimated useful lives of certain long lived assets. Interest and debt expense was $47 million in 1993 compared to $54 million in 1992. Lower interest rates and debt levels were the primary reasons for the decrease. Also, 1992 expenses included $4 million of debt retirement expense. Other income-net was $8 million higher than in 1992, primarily because of $8 million received by the North Pole Refinery in settlement of a contract dispute. MAPCO's effective tax rate for 1993 was 36.7% compared to 31.1% in 1992. The difference between the statutory Federal income tax rate of 35% in 1993 and 34% in 1992 and the effective tax rate for 1993 and 1992 was primarily due to statutory depletion and state income taxes and, for 1993, the deferred tax impact of the increase in the corporate income tax rate included in the Omnibus Budget Reconciliation Act of 1993. 1992 Results Compared to 1991 Net income in 1992 was $101 million, compared to $126 million in 1991. Earnings per share were $3.37 in 1992, compared to $4.20 in 1991. Average common shares were 29.9 million in 1992 and 30.0 million in 1991. Sales and operating revenues increased $44 million in the Natural Gas Liquids segment from 1991 to 1992. The increase was primarily attributable to increased retail propane sales and transportation revenues. Retail propane sales increased 61 million gallons primarily because of a strong crop drying season and the retail stores acquired in late 1991 and 1992. Pipeline revenues increased because of a strong 1992 crop drying season, an increase in home heating demand, and $7 million from a contract termination and buyout. Petroleum revenues declined slightly because of lower average refined product prices. Coal revenues decreased $10 million principally because of a 1992 tonnage reduction agreement with a large contract customer and the effect of a 1992 price decrease on one million contract tons under a price reopener provision. Outside purchases and operating expenses increased $34 million in 1992 over 1991. The increase was attributable to higher purchases and higher operating expenses in the Natural Gas Liquids and Coal segments, partially offset by decreased purchases and lower operating expenses in Petroleum. Natural Gas Liquids' outside purchases increased primarily because of the increased volume of retail propane sales, and operating expenses increased because of a $19.6 million insurance premium penalty accrued relative to the Brenham explosion and an increased number of retail stores in operation. Coal's outside purchases increased because of higher brokerage volumes, and operating expenses increased primarily because of a $5.6 million charge in 1992 for legislatively imposed retiree medical obligations. Petroleum's outside purchases decreased because of lower average crude costs, lower North Pole Refinery volumes and lower purchases of refined products in 1992 by the Memphis Refinery. Petroleum's average crude costs were lower in 1992 compared to the Persian Gulf War-influenced prices of 1991. North Pole Refinery volumes decreased primarily due to a decline in demand for jet fuels. Outside purchases of refined products at the Memphis Refinery declined because purchases of refined products made during the turnaround and expansion in 1991 were not required in 1992. Depreciation, depletion and amortization increased $5 million primarily due to: accelerating depreciation on equipment scheduled for replacement earlier than anticipated in the Coal segment, retail plant acquisitions made in late 1991 and in 1992 in the Natural Gas Liquids segment, and the expansion of the Memphis Refinery in 1991 in the Petroleum segment. Interest and debt expense decreased $3 million because of lower interest rates. Interest and debt expense was lower even though 1992 amounts included $4 million of debt retirement expense and average debt levels were 15% higher in 1992 as compared to 1991. Other income-net decreased $5 million principally due to liability provision increases in 1992 relative to a non-operating business unit, partially offset by a $3.7 million business interruption insurance recovery. MAPCO's effective income tax rate for 1992 was 31.1% compared to 29.7% in 1991. The difference between the statutory Federal income tax rate of 34% and the effective tax rate for 1992 and 1991 was primarily due to statutory depletion and state income taxes. OPERATING PROFIT Operating Profit Operating profit by segment was as follows (in millions): 1993 Results Compared to 1992 Natural Gas Liquids Segment Results The $5 million increase in 1993 operating profit is primarily attributable to higher transportation and retail propane operating profits. Transportation revenues increased because of the completion of the Seminole Loop project in May 1993, and because of the negative impact of the Brenham explosion on 1992 revenues. Although revenues grew in 1993, volumes on the Rocky Mountain Extension and Seminole Pipeline were negatively impacted as a result of producers leaving ethane in the natural gas stream rather than extracting the liquids for shipment to the Texas Gulf Coast. Transportation expenses were lower in 1993 primarily because of the Brenham explosion which also negatively impacted 1992 expenses. Retail propane operating profit increased because volumes were higher in 1993; however, higher expenses and lower margins partially offset the favorable impact of the higher volumes. The increases in volumes and expenses were attributable primarily to additional retail plants in operation. Lower margins were principally due to the intense price competition faced throughout 1993. The expansion of the 80-percent-owned Seminole Pipeline was completed at a cost of $130 million. The expansion consists of an additional 544-mile, 14-inch pipeline from West Texas to Mont Belvieu, Texas, and increases the potential capacity of the line to over 300,000 barrels per day. Petroleum Segment Results Petroleum segment operating profit increased $35 million over 1992. The increase was attributable to higher refinery margins, $8 million received in 1993 relative to a North Pole Refinery contract settlement, and higher Mid-South Retail fuel margins and lower expenses, partially offset by higher Memphis Refinery expenses. The increase in refinery margins primarily reflects the effect of lower average crude costs during 1993. Mid-South Retail fuel margins increased due to lower average fuel costs in 1993. Mid-South Retail's lower expenses were primarily attributable to fewer stores in operation and lower environmental expenses. Expenses at the Memphis Refinery increased primarily due to operating problems with the fluid catalytic cracker unit during the first quarter of 1993 and higher maintenance and environmental costs. Coal Segment Results Coal segment operating profit increased $11 million over 1992 primarily because of lower production costs at both the Mettiki and Martiki Mines and the negative impact on 1992 of a $5.6 million charge for legislatively imposed retiree medical obligations. These factors were partially offset by lower revenues in the current year. Aging longwall shields at Mettiki were replaced and the other operational problems encountered in 1992 at the mine were resolved, resulting in a 16% decrease in per ton production costs. Overburden stripping ratios at the Martiki Mine were lower in 1993 which is the primary reason for Martiki's lower per ton production costs. Revenues for the Coal Segment decreased primarily as a result of a price reopener on a long-term sales contract with a major customer. 1992 Results Compared to 1991 Natural Gas Liquids Segment Results The $26 million decrease in operating profit for the Natural Gas Liquids segment was primarily attributable to an increase in transportation operating expenses, partially offset by higher revenues. The higher transportation operating expenses were principally due to the Brenham explosion, higher power, outside services and materials and supply costs. Revenues increased in 1992 over 1991 despite the negative impact on 1992 revenues from the Brenham explosion primarily because of $7 million from the termination and buyout of a pipeline transportation agreement and increased demand in the Midwest propane markets. Petroleum Segment Results The Petroleum segment's operating profit increased $10 million in 1992. The increase was primarily attributable to higher refined product margins and lower expenses at the Memphis Refinery, and higher Mid-South Retail fuel and merchandise margins, partially offset by lower North Pole Refinery volumes and margins. Margins at the Memphis Refinery in 1992 were higher because 1991 margins were negatively impacted by the turnaround and expansion project and a fluid catalytic cracker blower failure. The higher 1992 Mid-South Retail fuel margins were attributable to decreased fuel costs, and merchandise margins were higher in 1992 because sales price increases outpaced increases in merchandise costs. North Pole Refinery's margins declined in 1992 because of the positive impact of the Persian Gulf War on 1991 margins. North Pole Refinery volumes declined because of weak jet fuel demand in the Alaskan markets. Coal Segment Results The Coal segment's operating profit decreased $19 million due primarily to a $5.6 million charge in 1992 relating to legislatively imposed retiree medical obligations, increased per ton expenses due to continued operating problems at the Mettiki Mine and lower per ton sales prices reflecting a contract price reopener. ENVIRONMENTAL ISSUES Estimated liabilities for environmental costs, primarily in the Petroleum segment, were determined without consideration of possible recoveries from third parties; however, where recoveries from state funds are involved and management assesses that the recovery of state funds is probable (i.e., the state is required by law to reimburse MAPCO for the Company's expenditures), the liability is recorded at its net amount. Estimated liabilities for environmental matters were $33.7 million and $34.3 million at December 31, 1993 and December 31, 1992, respectively. Of these amounts, $20.3 million at December 31, 1993, and $21.6 million at December 31, 1992, has been recognized as recoverable from state funds in connection with laws requiring reimbursement by the states of certain expenses associated with underground storage tank failures and repairs. OTHER ISSUES Natural Gas Liquids Segment Since 1991, MAPCO's West Panhandle field gas supplier has taken more than its percentage ownership share of the field's production. The cumulative effect of this acceleration in gas taken has resulted in the Westpan operations having a 25.3 billion cubic feet and $23.7 million over-take position. This imbalance will be adjusted by offsets from future field production. MAPCO uses the sales method of accounting for its gas balancing arrangements which allows the immediate recognition of all revenues on natural gas liquids sold. The acceleration in gas taken contributed an estimated $4.3 million, $9.0 million and $10.4 million to MAPCO's consolidated operating profit in 1993, 1992 and 1991, respectively. On April 7, 1992, a liquefied petroleum gas explosion occurred near an underground salt dome storage facility located near Brenham, Texas and owned by an affiliate of the Company, Seminole Pipeline Company. The matter was investigated by the National Transportation Safety Board and the Texas Railroad Commission. A discussion of this matter and its effect on MAPCO and its affiliate is contained in Note 10 to the consolidated financial statements contained herein. Petroleum Segment Since 1978, MAPCO Alaska Petroleum Inc. (and/or its predecessor) has had long-term agreements with the State of Alaska (the "State") to purchase royalty oil from the State at prices linked to amounts payable by North Slope oil producers in satisfaction of their royalty obligations to the State. In 1977, the State commenced suit against the producers (in an action entitled State of Alaska v. Amerada Hess, et al.) alleging that they incorrectly calculated their royalty payments. A discussion of this dispute as it relates to MAPCO is contained in Note 10 to the consolidated financial statements included herein. Coal Segment The Coal segment has significant volumes of coal committed under long-term contracts which provide for sales prices in excess of current spot market prices. Long-term contracts for 1.4 million annual tons, 0.5 million annual tons and 3.1 million annual tons will expire during 1994, 1995 and 1996, respectively. In addition, an extension on one million annual tons originally scheduled to expire on December 31, 1994, has been extended through December 31, 1996, at a slightly lower sales price. The Retiki Mine sells all of its production to Big Rivers Electric Corporation ("Big Rivers") under a cost-plus management fee contract that expires in January 1996. The mine is expected to close following expiration of the contract. Operations at the Retiki Mine have contributed less than 2% of MAPCO's consolidated operating profit during the past three years. As of December 31, 1993, Retiki had invoiced Big Rivers approximately $5.0 million for certain costs associated with the operation of the mine, which costs Big Rivers has disputed. Retiki will continue to invoice Big Rivers for similar costs through the contract termination date. Retiki has initiated litigation with respect to this matter and management believes that substantially all of the receivable will ultimately be collected. During 1993 the United Mine Workers Association ("UMWA") filed a petition with the National Labor Relations Board ("NLRB") seeking an election to decide whether the UMWA should represent hourly employees at MAPCO Coal's Pontiki mine. In August 1993 the NLRB conducted a representation election and the unofficial vote count was 78 opposed to unionization, 101 votes supporting the UMWA and 23 votes challenged by the UMWA. The challenged votes are determinative of the election. Presuming all of the contested votes are "no" votes, the election would be a tie and the UMWA would not be elected to represent Pontiki employees. The matter is pending with the NLRB and a dispositive ruling is not expected until mid-1994. Management believes that an unfavorable ruling relative to this matter would not have a material impact on MAPCO's overall costs and profitability. The Clean Air Act is expected to alter the pattern of U.S. coal consumption resulting in a general decrease of demand for higher sulfur coals and increase of demand for lower sulfur coals. Legislation of this type is not expected to materially impact the Coal Segment's future operating profit results primarily because most of MAPCO Coal's higher sulfur coals are sold to customers with scrubbers, or to customers that have indicated their intentions to install scrubbers. Additionally, MAPCO Coal management believes the anticipated favorable impact of the marketability and pricing for low sulfur and compliance coal should offset the financial impact, if any, of the Clean Air Act. GENERAL MANAGEMENT DISCUSSION The consolidated financial statements of MAPCO have been prepared by management, which is responsible for the integrity and objectivity of the statements. These financial statements, which include amounts that are based on management's best estimates and judgments, have been prepared in accordance with generally accepted accounting principles. The consolidated financial statements have been audited by the Company's independent auditors, Deloitte & Touche, whose report appears on page. MAPCO maintains a system of internal controls that is designed to provide reasonable assurance that the financial records are accurate, assets are protected, and the consolidated financial statements fairly present the financial position and results of operations of the Company. This system is augmented by the selection and training of qualified personnel, management oversight, proper division of responsibilities, the dissemination of written policies and procedures, and an internal audit program to monitor the system's effectiveness. In the opinion of management, the system of internal controls is effective and provides the assurance described above. The Board of Directors, through its Audit Committee (comprised of four outside Directors), monitors management's financial reporting responsibilities. The Audit Committee meets periodically with representatives of management, the independent auditors, and the Company's internal auditors to discuss specific accounting, reporting, internal control and regulatory compliance matters. Deloitte & Touche and the Company's internal auditors have full and free access to meet with the Audit Committee. Approximately 16% of MAPCO stockholders participate in the voluntary Dividend Investment Plan whereby cash dividends are used to purchase additional MAPCO common stock as directed by the participating stockholder. There is no charge to stockholders for this service. The plan is administered by Harris Trust Company of New York and stockholders having questions about their accounts may contact Harris Bank, Dividend Reinvestment, P.O. Box A-3309, Chicago, Illinois 60690-9939. During 1993 and 1992, MAPCO declared quarterly dividends of $0.25 per share. Dividends were payable in March, June, September and December. The annual dividend in 1993 and 1992 was $1.00 per share. MAPCO common stock is traded on the New York, Chicago, and Pacific Stock Exchanges under the symbol MDA. MAPCO has approximately 5,900 stockholders of record. The high and low closing prices of MAPCO's common stock on the New York Stock Exchange during the quarterly periods of 1993 and 1992 were as follows: The closing price of MAPCO's common stock on the New York Stock Exchange on March 24, 1994 was $61.125. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of MAPCO Inc., together with the report thereon of Deloitte & Touche dated February 1, 1994 and the supplementary financial data specified by Item 302 of Regulation S-K are set forth on pages through hereof. (See Item 14 for Index). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding directors of MAPCO is incorporated by reference herein from MAPCO's Proxy Statement to be filed for its 1994 Annual Meeting of Stockholders. (See "Executive Officers of MAPCO Inc." in PART I, Item 1, SUPRA, regarding executive officers of MAPCO). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Incorporated by reference herein from MAPCO's Proxy Statement to be filed for its 1994 Annual Meeting of Stockholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Incorporated by reference herein from MAPCO's Proxy Statement to be filed for its 1994 Annual Meeting of Stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Incorporated by reference herein from MAPCO's Proxy Statement to be filed for its 1994 Annual Meeting of Stockholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements. (a) 2. Financial Statement Schedules. Other schedules of MAPCO Inc. and its subsidiaries are omitted because of the absence of the conditions under which they are required or because the required information is included in the Financial Statements or Notes thereto. (a) 3. Exhibits. MANAGEMENT CONTRACTS AND COMPENSATORY PLANS OR ARRANGEMENTS - --------------- * Incorporated herein by reference All other schedules and exhibits are omitted because they are not required or are not applicable. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, MAPCO Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MAPCO INC. Dated: March 24, 1994 By /s/ JAMES E. BARNES JAMES E. BARNES Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. We, the undersigned officers and directors of MAPCO Inc. hereby severally constitute James E. Barnes and Frank S. Dickerson, III, and each of them singly, our true and lawful attorneys with full power to them, and each of them singly, to sign for us and in our names in the capacities indicated below, any and all amendments to this report, and generally to do all such things in our names and behalf in our capacities as officers and directors to enable MAPCO Inc. to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all requirements of the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorneys, or either of them, to any and all amendments to this report. INDEPENDENT AUDITORS' REPORT MAPCO Inc., its Directors and Stockholders: We have audited the accompanying consolidated financial statements of MAPCO Inc. and subsidiaries, listed at Item 14(a)1 herein. Our audits also included the financial statement schedules listed at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of MAPCO Inc. and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 10 to the consolidated financial statements, the Company is involved in litigation relating to retroactive increases in prices paid to the State of Alaska under its royalty oil purchase agreements. The ultimate outcome of the litigation cannot presently be determined. The Company has accrued an estimate of certain amounts which it may incur in connection with the final resolution of the dispute. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990 and 1989, and the related consolidated statements of income, cash flows, and changes in stockholders' equity for the years ended December 31, 1990 and 1989 (none of which are presented herein); and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing in Item 6 herein, is fairly stated, in all material respects, in relation to the consolidated financial statements from which it has been derived. Deloitte & Touche Tulsa, Oklahoma February 1, 1994 MAPCO INC. CONSOLIDATED STATEMENTS OF INCOME - --------------- (1) Includes consumer excise taxes of $148.7 million, $146.5 million and $140.3 million in 1993, 1992 and 1991, respectively. See notes to consolidated financial statements. MAPCO INC. CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. MAPCO INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. MAPCO INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY See notes to consolidated financial statements. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES Consolidation -- The consolidated financial statements include the accounts of MAPCO Inc. and its subsidiaries. Certain reclassifications have been made to prior year amounts to conform to current year presentations. All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents -- Cash equivalents consist of short-term, highly liquid investments which are readily convertible into cash. All investments classified as cash equivalents have original maturities of three months or less. Inventories -- Inventories include crude oil, refined petroleum products, natural gas liquids, coal, fertilizer and retail merchandise. Inventories are valued at the lower of cost or market. Crude oil, refined petroleum products and retail merchandise inventories in the Petroleum segment are determined on a last-in, first-out basis. Appliances, chemicals, fertilizer and other inventories related to fertilizer in the Natural Gas Liquids segment are determined on an average cost basis. All other inventories are determined on a first-in, first-out basis. Net exchange balances are classified as inventory. Advance Royalties -- Rights to leased coal lands are often acquired through royalty payments. Royalty payments recoupable against future production are deferred, and amounts expected to be recouped within one year are classified as a current asset. As mining occurs on those leases, the prepayment is amortized and included in the cost of mined coal. Amounts estimated to be nonrecoupable are expensed. Depreciation and Depletion -- Depreciation and depletion is computed on the straight-line method at rates based upon estimated useful lives or, if applicable, on the units-of-production method based on estimated recoverable reserves. Maintenance, repairs and minor replacements are expensed. Costs of replacements constituting improvements are capitalized. Gains or losses arising from retirements are included in income currently. Excess of Purchase Price over Net Assets of Companies Acquired -- Amounts applicable to acquisitions prior to 1971 ($4.7 million) are not amortized. Amounts applicable to acquisitions after 1970 are amortized on a straight-line basis over periods not exceeding forty years. MAPCO continually evaluates the periods of amortization to determine whether subsequent events and circumstances warrant revision of the estimated useful lives of acquired assets. Revenue Recognition -- MAPCO's revenue recognition policies provide that revenues are recognized at the point of sale (i.e. transfer of title) or delivery. Environmental Expenditures -- Environmental expenditures that relate to current or future revenues are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations that do not contribute to current or future revenue generation are expensed. Environmental liabilities are recorded independently of any potential claim for recovery, except in cases where reimbursements of remediation costs are available from MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) state funds and the realization of those funds is considered probable. Accruals related to environmental matters are generally determined based on site-specific plans for remediation, taking into account prior remediation experience of MAPCO and other companies. Debt Discount and Expense -- Debt discount and expense arising from the issuance of debt securities are capitalized and amortized using the principal outstanding method. Gas Balancing Arrangements -- MAPCO uses the sales method of accounting for its gas balancing arrangements. Under the sales method, MAPCO recognizes revenues on all West Panhandle gas field gas liquids sold to its customers. Imbalances resulting from any under/over-take position with MAPCO's gas supplier will be adjusted by future field production. Treasury Stock -- Common stock purchased is recorded as treasury stock, at cost. Income Taxes -- Deferred income tax expense is recognized based on the net change for the year in the deferred income tax liability, except for changes resulting from differences between the assigned values and tax basis of assets acquired and liabilities assumed in purchase business combinations. Deferred income tax assets and liabilities are based on enacted tax laws and the expected reversal of the temporary differences between the book and tax bases of assets and liabilities. Earnings Per Common Share -- Earnings per common share are based on the weighted average number of common shares outstanding. Average common shares outstanding were 30.0 million in 1993, 29.9 million in 1992 and 30.0 million in 1991. ESOP -- MAPCO's loan to its Employee Stock Ownership Plan ("ESOP") is recorded as a reduction of stockholders' equity in MAPCO's Consolidated Balance Sheets. Compensation and interest expense are recognized based on MAPCO's cash contributions to the ESOP. Nature of Business -- Natural Gas Liquids segment operations include the transportation, processing and underground storage of natural gas liquids ("NGLs"), the pipeline transportation of anhydrous ammonia, refined products and crude oil and the sale of liquid propane gas and fertilizer. The pipeline main line runs from the Wyoming-Utah Overthrust Belt to Hobbs, New Mexico and from Hobbs through the Midwest into Minnesota and Wisconsin. The main line also runs from Hobbs across Texas to the Gulf Coast. Tariff charges for pipeline operations are made on account to shippers who are engaged in energy or energy-related businesses. Operations at three gas processing plants in the West Panhandle gas field in Texas produce natural gas liquids which are sold in the Midwestern and Gulf Coast markets. Propane and fertilizer are marketed through retail plants to residential, agricultural and industrial customers located in the upper Midwest and the Southeast regions of the United States. Sales are generally made on account. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Petroleum segment operations include two refining and marketing systems: the Alaska System and the Mid-South System. The Alaska System includes a refinery at North Pole, Alaska, whose non-affiliated customers include wholesale, commercial, governmental and industrial consumers. Sales are generally made on account. The Alaska system also includes retail convenience stores in Fairbanks, Anchorage and Juneau, Alaska. The Mid-South system includes a refinery at Memphis, Tennessee, whose non-affiliated customers include industrial and commercial consumers, jobbers, independent dealers and other refiner/marketers who are primarily located in the Mid-South region of the United States. Sales are generally made on account. The Mid-South system also includes retail convenience store operations and commission and tank wagon dealerships located throughout the Southeastern United States. Dealer sales are generally made on account. MAPCO buys, sells and exchanges crude oil to supply its refinery systems. These transactions are with companies engaged in energy or energy-related businesses and sales are generally made on account. Coal segment operations produce and market steam and metallurgical coal for sale in domestic and foreign markets. Steam coal is sold primarily to electric utilities located in the Eastern United States and, to a lesser extent, Europe. Metallurgical coal is sold to steel and coke producers located primarily in the United States, South America, Japan, Europe and North Africa. Sales are generally made on account. Export shipments are generally secured by letters of credit or other similar guarantees prior to the coal being delivered to the customer. NOTE 2. CONSOLIDATED STATEMENTS OF CASH FLOWS SUPPLEMENTAL DISCLOSURES Other items not requiring (providing) cash reported in cash flows from operating activities consist of (in millions): Changes in operating assets and liabilities consist of (in millions): MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Income taxes paid were $64.8 million, $49.2 million and $55.2 million during 1993, 1992 and 1991, respectively. Interest paid, net of amounts capitalized, was $47.3 million, $54.1 million and $59.4 million during 1993, 1992 and 1991, respectively. Total accrued interest costs were $49.3 million, $56.4 million and $58.3 million during 1993, 1992 and 1991, respectively. Interest capitalized during 1993, 1992 and 1991 amounted to $2.8 million, $2.0 million and $1.2 million, respectively. Included in capital expenditures and acquisitions in 1992 is $6.0 million for MAPCO common stock issued in connection with acquisitions in which MAPCO received assets with a fair value of $11.9 million and assumed liabilities of $5.9 million. NOTE 3. INVENTORIES Inventories consist of (in millions): The cost to replace crude oil, refined petroleum products and retail merchandise inventories in excess of last-in, first-out (LIFO) carrying values was approximately $6.5 million and $16.0 million at December 31, 1993 and 1992, respectively. NOTE 4. LONG-TERM DEBT Long-term debt consists of (in millions): MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Interest rates on commercial paper, bankers' acceptances, bank borrowings and money market funds ranged from 3.10% to 4.27% and from 3.70% to 4.27% at December 31, 1993 and 1992, respectively. Commercial paper, bankers' acceptances, bank borrowings and money market funds outstanding at December 31, 1993 and 1992 were classified as long-term debt. MAPCO has the ability and the intent, if necessary, under a bank credit agreement to refinance commercial paper, bankers' acceptances, bank borrowings and money market funds with long-term debt having maturities in excess of one year. MAPCO has a bank credit agreement for a line of credit of $300 million. The bank credit agreement provides for reduction of the total commitment in quarterly increments of $25 million commencing March 31, 1994 and continuing through December 31, 1996. Interest on borrowings under the bank credit agreement would be at rates generally less than the prime interest rate. MAPCO must pay a commitment fee to maintain the bank credit agreement. The bank credit agreement serves as a back-up for MAPCO's outstanding commercial paper, bankers' acceptances, bank borrowings and money market funds. To date, MAPCO has not borrowed under the bank credit agreement. The ESOP Notes' interest rate is subject to revision in the event there is a change in Internal Revenue Service regulations regarding taxability of the interest to the lenders. Effective January 1, 1993 the interest rate changed from 8.51% to 8.43%. MAPCO had $342.8 million of Medium Term Notes outstanding as of December 31, 1993. The Notes mature at various times through 2022 and bear interest at rates ranging from 7.00% to 8.87%. $10 million of previously issued Medium Term Notes matured during 1993. On August 10, 1993, the Company redeemed all the outstanding variable rate Mt. Vernon Economic Development Bonds due May 10, 2012 in the principal amount of $6.5 million plus accrued interest. In December 1993, Seminole Pipeline Company issued $75 million of 6.67% Senior Notes in the private placement market. These notes are payable at $15 million annually from 2001 through 2005. The scheduled amounts to be paid on long-term debt during the next five years are: 1994 -- $13 million, 1995 -- $31 million, 1996 -- $26 million, 1997 -- $31 million, and 1998 -- $36 million. Various loan agreements contain restrictive covenants which, among other things, limit the payment of advances or dividends by two Natural Gas Liquids' subsidiaries to MAPCO. At December 31, 1993, $192 million of net assets were restricted by such provisions. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5. INCOME TAXES MAPCO adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective January 1, 1993. This Statement supersedes SFAS No. 96, "Accounting for Income Taxes," which was adopted by the Company in 1987. The cumulative effect of adopting SFAS No. 109 on the Company's financial statements was to increase 1993 net income by $.4 million. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The tax effects of significant items comprising the Company's net deferred tax liability at December 31, 1993, are as follows (in millions): Income before provision for income taxes is substantially all derived from domestic operations. Significant components of the provision for income taxes are as follows (in millions): MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A reconciliation of the statutory U.S. Federal income tax rate and MAPCO's effective income tax rate is as follows (in percents): At December 31, 1993, MAPCO had Federal income tax net operating loss and tax credit carryforwards of $7.0 million which expire in various years through 2003. NOTE 6. STOCK RIGHTS Under a Rights Agreement (as amended in 1989), MAPCO has one Right outstanding for each outstanding share of MAPCO common stock. Under certain limited conditions as defined in the Rights Agreement, each Right entitles the registered holder to purchase from MAPCO one two-hundredth of a share of Series A Junior Participating Preferred Stock ("Preferred Stock") at $175 subject to adjustment. At December 31, 1993, there were 30.0 million Rights outstanding that, if exercised, would result in the issuance of 149,935 shares of Preferred Stock. The Rights are not exercisable until the Distribution Date (as defined in the Rights Agreement) which will occur upon the earlier of (i) ten days following a public announcement that an Acquiring Person (as defined in the Rights Agreement) has acquired beneficial ownership of 15% or more of MAPCO's outstanding common stock or (ii) ten business days following the commencement of a tender offer or exchange offer that would result in a person or group owning 15% or more of MAPCO's outstanding common stock. The Rights have certain anti-takeover effects. The Rights will cause substantial dilution to a person or group that attempts to acquire MAPCO without conditioning the offer on a substantial number of Rights being acquired. Upon exercise and the occurrence of certain events as defined in the Rights Agreement, each holder of a Right, except the Acquiring Person, will have the right to receive MAPCO common stock or common stock of the acquiring company having a value equal to two times the exercise price of the Right. The Rights should not interfere with any merger or other business combination approved by MAPCO since the Board of Directors may, at its option, at any time prior to the close of business on the earlier of the tenth day following the Stock Acquisition Date (as defined in the Rights Agreement) or July 7, 1996, redeem all but not less than all of the then outstanding Rights at $.05 per Right. The Rights expire on July 7, 1996, and do not have voting power or dividend privileges. NOTE 7. STOCK INCENTIVE PLANS Under the MAPCO Inc. 1989 Stock Incentive Plan (the "Plan"), stock options, stock appreciation rights, restricted stock, phantom stock and stock purchase rights may be issued to key employees. At December 31, 1993, only stock options and restricted stock had been awarded under the Plan. Each stock option entitles the holder to purchase from MAPCO one share of Common Stock at the option price, which is determined by the closing sales price of MAPCO Common Stock on the grant date. Options must be exercised within ten years from the date of the grant. One-third of the options granted in 1993 will vest under the Plan in 1997, one-third in 1998 and one-third in 1999. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Options granted under the Plan contain a Replacement Option feature which is triggered when an optionee uses stock, rather than cash, to exercise an option. Upon exercise by an exchange of stock, Replacement Options are granted equal to the number of shares tendered for the exercise of the option plus the number of shares of stock withheld for income tax purposes. The exercise price per share for any Replacement Option is equal to the fair market value of a share of common stock on the date the Replacement Option is granted. A Replacement Option is not exercisable for at least six months from the grant date for those granted prior to January 22, 1992 and twelve months for those granted after January 22, 1992. In May 1992, MAPCO stockholders approved an amendment to the Plan which increased the number of gross shares (i.e., the number of shares issuable, including shares forfeited for tax withholding and shares surrendered to exercise an option) which may be issued under the Plan to 7 million; however, the maximum number of actual net shares which may be issued under the Plan remained at 2 million (plus a small number of shares from prior plans). The number of gross shares available for future grants under the Plan was 4,631,194 at December 31, 1993. The cumulative number of actual net shares issued under the Plan was 165,254 at December 31, 1993. A summary of employee stock option activity for options issued pursuant to the Plan and prior plans is as follows: NOTE 8. SEGMENT INFORMATION MAPCO's operations are organized into three segments -- Natural Gas Liquids, Petroleum and Coal. Natural Gas Liquids includes the movement by pipeline of natural gas liquids, refined products, crude oil, and anhydrous ammonia, and includes the retail and wholesale marketing of natural gas liquids including propane, ethane, butane and natural gasolines, and fertilizer, and the operation of natural gas processing plants and underground storage facilities; Petroleum includes the refining of crude oil and refined petroleum products, the wholesale and retail marketing of refined petroleum products, the retail marketing of merchandise and deli fast food, and the trading of crude oil, NGLs and refined petroleum products; Coal includes the production and MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) marketing of coal. Intersegment sales and operating revenues are generally made at prevailing market prices. Segment information is as follows (in millions): In 1992, MAPCO resegmented its operations from four segments into three by combining certain operating units of the previous Gas Products and Transportation segments, creating the Natural Gas Liquids segment. The resegmentation also involved combining certain operating units of Gas Products into the Petroleum segment. All prior year amounts have been restated to reflect the resegmentation. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. EMPLOYEE BENEFIT PLANS MAPCO has two defined benefit plans covering substantially all employees. One of the plans is the MAPCO Inc. and Subsidiaries Pension Plan which has two separate benefit structures. The benefit formula for the MAPCO Inc. and subsidiaries (except Coal) structure is a step rate plan formula based on final average pay and years of service, while the benefit formula for the Coal structure is a flat dollar unit formula based on years of service. The second plan, for employees of South Atlantic Coal Company, has a career average pay formula based on years of service. MAPCO's funding policy for both of these plans is to make the minimum annual contributions required by the Employee Retirement Income Security Act. No contributions were required for 1993 due to the current favorable funded status of these plans. The assets in these plans are primarily comprised of equity securities, but also include fixed income securities, guaranteed investment contracts and equity real estate investments. Net periodic pension income from MAPCO's defined benefit pension plans includes the following components (in millions): The funded status of MAPCO's defined benefit pension plans and the amounts recognized in MAPCO's Consolidated Balance Sheets are as follows (in millions): The rates used in determining the funded status of the two pension plans on December 31, 1993 are as follows: MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The rates used in determining pension income for the two pension plans for the years 1993 and 1992 and the funded status of the plans on December 31, 1992 are as follows: The rates used in determining pension income for the two pension plans for 1991 are as follows: The excess of the assets in the MAPCO Pension Plan over the projected benefit obligation at the date MAPCO changed its method of accounting for its pension plan is being amortized on a straight line basis over the average remaining service period of plan participants. The Coal Industry Retiree Health Benefit Act of 1992 ("Coal Act") imposed obligations for certain retiree medical costs on MAPCO. The undiscounted liability at December 31, 1993, relative to MAPCO's obligations under the Coal Act was $25.2 million. The expected payments under the Coal Act are $.3 million in 1994, $.3 million in 1995, $.4 million in 1996, $.4 million in 1997, $.4 million in 1998 and $23.4 million thereafter. MAPCO's liability relative to the Coal Act as of December 31, 1993, was $5.8 million. The difference between the expected aggregate undiscounted liability of $25.2 million and the liability reflected in the financial statements is the result of discounting the expected payments, which span more than 35 years. Effective December 31, 1993, MAPCO terminated its Retiree Group Health Plan (the "Retiree Plan"), which was entirely funded by participants' contributions. MAPCO did not incur any material liabilities by terminating the Retiree Plan. MAPCO has an ESOP that includes substantially all employees through voluntary participation. Allocation of the MAPCO common stock held by the ESOP to individual employees is based on the employee's eligible contribution to the ESOP and the number of shares of common stock available for allocation. The common stock available for allocation will be released in quarterly installments over the term of the ESOP's loan from MAPCO. MAPCO's cash contributions to the ESOP will equal the ESOP's principal and interest payments on its loan from MAPCO reduced by the dividends the ESOP receives on the MAPCO common stock held by the ESOP. Dividends of $2.5 million in 1993 and $2.4 million in both 1992 and 1991 on the MAPCO common stock owned by the ESOP were used for debt service. MAPCO made cash contributions to the ESOP of $7.8 million in 1993 and $8.0 million in both 1992 and 1991. MAPCO recognized compensation expense in connection with the ESOP of $1.7 million, $1.5 million and $1.2 million and interest expense of $6.1 million, $6.5 million and $6.8 million in 1993, 1992 and 1991, respectively. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10. COMMITMENTS AND CONTINGENCIES MAPCO leases land, buildings and equipment under lease agreements which provide for the payment of both minimum and contingent rentals. The annual rental expense under operating leases is not significant to MAPCO's results of operations. Future minimum payments under operating leases are $118 million in total and during the next five years are: 1994 -- $15 million, 1995 -- $14 million, 1996 -- $12 million, 1997 -- $11 million and 1998 -- $10 million. STATE ROYALTY OIL CLAIM The refining and marketing arm of the Company, MAPCO Petroleum Inc., operates a refinery in Alaska through its subsidiary, MAPCO Alaska Petroleum Inc. ("MAPI"). Since 1978, MAPI (and/or its predecessor) has had long-term agreements with the State of Alaska (the "State") to purchase royalty oil from the State at prices linked to amounts payable by North Slope oil producers in satisfaction of their royalty obligations to the State. In 1977, the State commenced suit against the producers (in an action entitled State of Alaska v. Amerada Hess, et al.) alleging that they incorrectly calculated their royalty payments. As of April 1992, the State had settled its royalty oil claims against all of the producers. On the basis of these settlements, the State billed MAPI for retroactive increases in the prices paid by MAPI under all four of its royalty oil purchase agreements. The State's claim against MAPI is based upon the difference between the volume weighted average paid by the producers and the revised royalty values adopted by the State. MAPI has been paying the State under a contractual pricing formula which resulted in prices in excess of the volume weighted average of the producers' past royalty reports. On August 28, 1992, MAPI commenced suit against the State in an Anchorage State Court seeking a declaratory judgment that MAPI is not liable to the State for any retroactive price increase under its primary royalty oil purchase agreement (the "1978 Agreement"). That same date, MAPI invoked the arbitration provision of the agreement under which it had purchased the second largest amount of State royalty oil (the "1977 Agreement"), again seeking a determination that it is not liable for any retroactive price increase. On February 5, 1993, MAPI filed suit in Anchorage State Court as to the remaining two agreements (the "1984 and 1985 Agreements"). The State's claim, based upon invoices submitted to MAPI on October 1, 1992, is comprised of claims for retroactive price adjustments (including interest through varying dates in October 1992) of $98 million, $9.2 million, $2.9 million and $6.4 million under the 1978, 1977, and 1984 and 1985 Agreements, respectively. In addition, MAPI could be responsible for interest subsequent to the billing dates. MAPI is the only royalty-in-kind purchaser that has not settled the State's retroactive billing claims. The Company believes that it has defenses of considerable merit as to the State's claims and is vigorously litigating all pending disputes, but is not able to predict the ultimate outcome at this time. The Company has accrued an estimate of certain amounts, including legal fees, which it may incur in connection with the final resolution of these matters; however, a resolution unfavorable to the Company could result in material liabilities which have not been reflected in the accompanying consolidated financial statements. TEXAS EXPLOSION LITIGATION On April 7, 1992, a liquefied petroleum gas ("LPG") explosion occurred near an underground salt dome storage facility located near Brenham, Texas and owned by an affiliate of the Company, Seminole Pipeline Company ("Seminole"). The matter was investigated by the National Transportation Safety Board ("NTSB") who determined in a Pipeline Accident Report that the explosion was the result of overfilling the storage facility and that the probable cause was the failure of MAPCO Natural Gas Liquids Inc. ("MNGL") MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to incorporate fail-safe features in the facility's wellhead safety system. The NTSB report further stated that (i) the cause of the overfilling was the inadequacy of procedures for managing cavern storage, (ii) contributing to the accident was the lack of federal and state regulations governing the design and operation of underground storage systems and (iii) contributing to the severity of the accident were inadequate emergency response procedures. As a result of the investigation, the NTSB issued safety recommendations to the Department of Transportation, the Research and Special Programs Administration, MNGL, the State of Texas Department of Public Safety, Washington County, the American Petroleum Institute, the American Gas Association and the International Association of Fire Chiefs. Seminole has responded to the NTSB's safety recommendations. The response states that Seminole believes it has accomplished or is in the process of accomplishing all of the NTSB recommendations. In addition, the response seeks to clarify that it is Seminole, not MNGL, that is the owner and operator of the facility, that Mid-America Pipeline Company ("Mid-America"), a subsidiary of MNGL, is the contractor for the operator, and that the report contains mistaken conclusions as to fault of one Mid-America employee. The incident has also been investigated by the Texas Railroad Commission (the "Commission"). In its investigation summary dated June 18, 1992, the Commission stated that the probable cause of the incident was the overfilling of the storage facility resulting in the escape of LPG which was subsequently ignited by an unknown source, but that it would not issue a final report on its investigation until all of the data had been received and analyzed. The Company, as well as Seminole, Mid-America and other non-MAPCO entities have been named as defendants in civil actions filed in state district courts in Texas. During the first quarter of 1993, the Company received reimbursements from its insurers for settlements which disposed of all the death claims and substantially all of the serious injury claims resulting from the incident. The settlements resulted in an insurance premium penalty to the Company in 1992 of approximately $19.6 million to be paid over a seven-year period beginning in 1993. The Company believes that complete resolution of this matter by litigation or settlement, after reimbursement of insurance coverage, will not have a material adverse effect on the Company's business, results of operations or consolidated financial position. GENERAL LITIGATION The Company and its subsidiaries are involved in various other lawsuits, claims and regulatory proceedings incidental to their businesses. In the opinion of management, the outcome of such matters will not have a material adverse effect on the Company's business, consolidated financial position or results of operations. NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, Disclosures about Fair Value of Financial Instruments. The estimated fair value amounts have been determined by the Company, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Cash and cash equivalents, receivables and accounts payable: The carrying amounts reported in the consolidated balance sheet for cash and cash equivalents, receivables and accounts payable approximate their fair value. Advance royalties: The fair value of the Company's advance royalty payments, which represents royalty payments paid in advance of mining by a subsidiary of the Company and recovered as actual mining takes place, is estimated based on discounted cash flow analyses using the Company's incremental borrowing rate as the discount rate. Long and short-term debt: The carrying amounts of commercial paper and other variable-rate debt instruments approximate their fair value. The fair values of fixed-rate long-term debt are estimated using discounted cash flow analyses, based on the Company's incremental borrowing rates for similar types of borrowing arrangements. Retiree medical payments and supplemental benefits: The carrying amounts reported in the consolidated balance sheets for retiree medical payments and supplemental benefits approximate their fair value. Insurance accruals: The fair value of the insurance accruals, which represent contractual obligations to pay cash in the future, is estimated based on a discounted cash flow analyses using the Company's incremental borrowing rate as the discount rate. The carrying amounts and fair values of the Company's and its subsidiaries' financial instruments at December 31, 1993 and 1992, are as follows (in millions): The fair value estimates presented herein are based on pertinent information available to management as of December 31, 1993 and 1992. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and current estimates of fair value may differ significantly from the amounts presented herein. The assumed incremental borrowing rates used to determine fair value are provided below. Different rates were used to match the incremental borrowing rates associated with the various maturities of the financial instruments. MAPCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12. ENVIRONMENTAL MATTERS Environmental expenditures that relate to current or future revenues are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations that do not contribute to current or future revenue generation are expensed. Environmental liabilities are determined without consideration of possible recoveries from third parties and are recorded independently of any potential claim for recovery, except in cases where reimbursements of remediation costs are available from state funds and the realization of those funds is considered probable. Accruals related to environmental matters are generally determined based on site-specific plans for remediation, taking into account prior remediation experience of MAPCO and other companies. Environmental liabilities are discounted only if the aggregate obligation of a specific matter and the amount and timing of the related cash payments are fixed or reliably determinable. The effect of discounting environmental liabilities is not material to MAPCO's financial statements. Estimated liabilities for environmental costs, primarily in the Petroleum segment, at December 31, 1993 and 1992 were $33.7 million and $34.3 million, respectively. Offsetting these amounts are $20.3 million and $21.6 million, respectively, which have been recognized as recoverable from state funds in connection with laws requiring reimbursement by the states of certain expenses associated with underground storage tank failures and repairs. NOTE 13. SUPPLEMENTAL QUARTERLY INFORMATION (UNAUDITED) In the fourth quarter of 1992, net income was reduced by approximately $21 million primarily from charges associated with: an insurance premium penalty made in connection with claims arising from the Brenham explosion; liabilities imposed by the Coal Industry Retiree Health Benefit Act of 1992; the realignment and consolidation of certain business lines, and anticipated divestiture of non-strategic assets; and environmental and litigation issues. MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See notes to condensed financial statements. S-1 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE III-CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See notes to condensed financial statements. S-2 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See notes to condensed financial statements. S-3 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES Consolidation -- The financial statements of MAPCO Inc. reflect the investment in subsidiaries using the equity method. Statements of Cash Flow -- MAPCO Inc. made cash payments for interest of $41.3 million, $48.2 million and $52.6 million in 1993, 1992 and 1991, respectively. Income Taxes -- MAPCO Inc. files a consolidated Federal income tax return with its subsidiaries. Members of the consolidated group are allocated income tax expense or benefit based upon their results as reflected in the consolidated Federal income tax return. NOTE 2. CONSOLIDATED FINANCIAL STATEMENTS Reference is made to the Consolidated Financial Statements and related notes of MAPCO Inc. and subsidiaries for additional information. NOTE 3. DEBT AND GUARANTEES Information on the long-term debt of MAPCO Inc. is disclosed in Note 4 to the Consolidated Financial Statements. MAPCO Inc. has guaranteed certain trade payable obligations and performance guarantees arising in the ordinary course of business. The scheduled amounts to be paid on long-term debt during the next five years are: 1994 -- $12.6 million, 1995 -- $31.0 million, 1996 -- $25.4 million, 1997 -- $30.9 million, and 1998 -- $36.4 million. NOTE 4. DIVIDENDS RECEIVED Subsidiaries of MAPCO Inc. do not make formal cash dividend declarations and distributions to the parent. MAPCO Inc. receives and disburses cash on behalf of its subsidiaries. Any restrictions in debt agreements on the transfer of cash to MAPCO Inc. by its subsidiaries did not have any impact during 1993, 1992 or 1991. S-4 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (1) Depreciation and depletion methods and rates are disclosed in Notes 1 and 8 respectively, of the notes to the Consolidated Financial Statements on pages through. (2) Primarily includes the expansion of the Seminole Pipeline Company and retail plant acquisitions. (3) Primarily consists of the sale of retail propane plants. (4) Primarily consists of scrapped continuous miners from the Pontiki mine and the retirement of the old longwall shields and conveyor and stageloader equipment at the Mettiki mine. (5) Primarily consists of scrapped equipment from the Mettiki mine. (6) In January 1991, MAPCO acquired an additional 10% interest in the common stock of Seminole Pipeline Company for $14.8 million, bringing its ownership interest to 80%. (7) Primarily includes expansion of the Memphis Refinery. (8) Primarily consists of the sale of foreign properties and convenience stores. S-5 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-6 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (IN MILLIONS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (1) Bad debts written off, less recoveries (net). S-7 MAPCO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN MILLIONS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (1) Less than 1% of sales and operating revenues. S-8 INDEX TO EXHIBITS

94673_1993.txt

94673_1993

1993

94673

ITEM 1. BUSINESS General - ------- Storage Technology Corporation and its subsidiaries (StorageTek or the Company) design, manufacture, market and service information storage and retrieval subsystems for high-performance and midrange computer systems, as well as computer networks. The Company's three principal product lines are serial access storage subsystems, random access storage subsystems and midrange computer products. Serial access storage subsystems include tape devices and automated library systems. Random access storage subsystem products currently include rotating magnetic disk and solid-state direct access storage devices (DASD). Midrange computer products include serial access, random access and other products for IBM AS/400 and other midrange systems. The Company also offers software and network communication products that expand applications for its library and random access products for efficient storage management and access. StorageTek operates in one principal industry segment and sells its products to end-user customers, value-added resellers and original equipment manufacturers (OEMs) of computer systems. The Company markets its products worldwide through sales and service offices located in major metropolitan areas of the United States, Canada, Europe, Japan and Australia, as well as through distributors in Africa, Asia, Europe, Mexico and South America. In 1993, international revenue accounted for 37% of the Company's total revenue. The Company's strategy is to continue to: Make significant investments in research and development; expand its product offerings permitting interface to and between IBM and non-IBM mainframes and midrange computers; develop software products and services, as well as distribution channels, to address the non-IBM mainframe market; and, invest in new technologies and businesses which complement its business and product strategy. To this end, the Company has established alliances with other manufacturers, distributors and suppliers. As a result of these alliances, it is possible for companies to be at various times collaborators, competitors and customers in different markets. Storage Technology Corporation was incorporated in Delaware in 1969. Its principal executive offices are located at 2270 South 88th Street, Louisville, Colorado 80028-0001, telephone (303) 673-5151. Principal Products - ------------------ StorageTek has three principal information storage and retrieval product lines: serial access subsystems (tape devices and automated library systems); random access subsystems (rotating and solid-state DASD); and midrange computer products. Product sales, including software revenue, accounted for approximately 64% of total revenue in 1993, while service and rental income accounted for the balance. Sales, service and rental revenue from the Company's product lines for 1993, 1992 and 1991 were as follows: REVENUE BY PRODUCT LINE Fiscal Year Ended December -------------------------- 1993 1992 1991 --------------------------------------------- $ million % $ million % $ million % --------- --- --------- --- --------- --- Serial Access 875.5 62.3 936.6 60.4 907.4 56.0 Subsystems Random Access 126.0 9.0 193.3 12.5 218.8 13.5 Subsystems Midrange 306.8 21.8 324.7 20.9 393.5 24.3 Systems Other Products 96.5 6.9 96.3 6.2 99.8 6.2 ----- ---- ----- ---- ----- ---- Total 1,404.8 100.0 1,550.9 100.0 1,619.5 100.0 ======= ===== ======= ===== ======= ===== Additional information concerning revenue from each of the Company's product lines is found in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", and geographic information is found in Part III, Item 14, under Note 15, of this Form 10-K. Serial Access Subsystems StorageTek is a principal producer and seller of high-performance serial access, or tape, subsystems for the end-user and OEM markets. StorageTek's current line of serial access subsystems is based on its automated cartridge system (ACS) library and magnetic tape products. In 1993, the Company introduced several key products in its serial access subsystems product lines, including the PowderHorn 9310 (PowderHorn TM), the Company's second-generation ACS library, WolfCreek 9360 (WolfCreek TM), a smaller, high-performance lower-cost library, and Silverton 4490 (Silverton TM), a 36-track cartridge subsystem. Also, the Company and Mobius Management Systems, Inc. introduced new software, View Direct TM, which is designed to expand the range of applications for ACS libraries. The serial access subsystems product line has generated substantially more revenue than any other product line of the Company and continues to be a major element of the Company's plans for the foreseeable future. Currently, the Company is developing a number of new products for the serial access subsystem market, including the TimberLine TM and Redwood TM subsystems. TimberLine, designed as a next-generation, high-performance cartridge subsystem that is IBM 3490E compatible, is based on a new architecture and is expected to provide performance and capacity improvements associated with tape subsystems. TimberLine is currently scheduled for availability in the second half of 1994. RedWood is designed as a high-capacity, high-performance mass storage cartridge subsystem which is expected to employ helical-scan technology. RedWood is expected to be compatible with StorageTek libraries and is currently scheduled for availability in the first half of 1995. Random Access Subsystems StorageTek's current Online Plus product line consists of a number of online random access DASD products, including solid-state disk subsystems (SSD) and rotating magnetic disk subsystems. The characteristics of these products differ principally in information storage capacity, transfer rate and access time. The Company discontinued sales of add-on memory products in the third quarter of 1993 but continues to service its installed base of memory products. The Company announced a multi-faceted Online Plus strategy in the second quarter of 1993. The Online Plus strategy includes a number of new DASD products which are expected to serve as the cornerstone for future DASD product offerings and as a significant source of revenue for the Company commencing in 1994. As part of its strategy, the Company effected a merger with Amperif Corporation (Amperif) in October 1993. See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", of this Form 10-K for a discussion of operating results and certain risks that may affect future results. The new DASD products being developed by the Company include: Iceberg 9200 Disk Array Subsystem (Iceberg TM), software products for Iceberg, Nordique 9100 (Nordique TM), Arctic Fox and Kodiak. Iceberg is an advanced, fault-tolerant disk array (RAID) subsystem for the IBM and IBM-compatible mainframe environment. Beta testing at customer sites commenced in the fourth quarter of 1993 and revenue contribution from Iceberg is expected to begin in the first half of 1994. Iceberg Extended Facilities Product and Iceberg Extended Operator Facility are software products designed for use with Iceberg subsystems and will be generally available in the first half of 1994. The Company also plans to introduce additional features to expand the capabilities of Iceberg's Extended Storage Architecture. Nordique is a RAID storage subsystem for the intermediate, IBM-compatible mainframe environment. The Company expects to begin shipment of Nordique in the first half of 1994. Arctic Fox and Kodiak are new DASD products based on disk technology developed by Amperif. Arctic Fox, a solid-state disk subsystem, and Kodiak, a high-capacity RAID device, are expected to become available in the second half of 1994. Midrange Systems StorageTek's midrange products include serial access, random access and other products for IBM AS/400 and other midrange markets. The Company markets its midrange products directly through its subsidiary, XL/Datacomp, Inc., and indirectly through OEM and distributor channels. In the third quarter of 1993, the Company introduced several new products, including the Alpine 9600 Storage Manager (Alpine TM), a fault-tolerant disk array subsystem, and a series of smaller, low-cost libraries. The Company restructured its midrange business in the third quarter of 1993 in response to disappointing customer acceptance for Alpine and significant price erosion within the midrange market. The Company is changing its midrange product line, organization, distribution network and service operations to improve operating performance. New products being developed by the Company for the midrange market include the Highlands, Northfield and Twin Peaks subsystems. Highlands and Northfield are DASD products designed for the IBM AS/400 market and are each currently scheduled for availability in the first half of 1994. The Twin Peaks subsystem (Twin Peaks) is designed as a small form factor cartridge tape drive and is currently scheduled for availability in the first half of 1995. Other Products StorageTek has increased its software development expenditures during the last several years and plans to continue to invest in the development of new software products. In the fourth quarter of 1993, the Company introduced NearNet 7900 (NearNet TM), a combination of hardware and software that automates storage management over a workstation network. StorageTek expects NearNet to serve as the first building block in a series of network solutions. In connection with its introduction of new hardware products, the Company also plans to introduce new software applications which are expected to enhance storage subsystem performance, capability, and storage allocation for better data management and access. In 1991, the Company and Siemens Nixdorf Information Systems, Inc. merged their U.S. high-performance, non-impact printer operations into a joint venture. The Company began winding-down production of its impact printer in 1993 and expects to sell its interest in the joint venture back to Siemens Nixdorf in the first quarter of 1994. The Company currently plans to support the installed service base of printers within the United States and in certain areas outside the United States. Marketing, Distribution and Services - ------------------------------------ StorageTek markets its products through a network of sales and service offices located in major metropolitan areas in the United States, Canada, Europe, Japan and Australia. The Company also sells its products through international distributors in Africa, Mexico, South America and parts of Asia and Europe not covered by the Company's sales and service offices or subsidiaries. In 1993, international revenue accounted for 37% of total revenue, compared to 41% in 1992, and 39% in 1991. As of December 31, 1993, the order backlog was approximately $71 million, compared to approximately $109 million as of December 25, 1992. Approximately 17% in 1993 and 26% in 1992 of the backlog amount is attributable to the Company's library products. Backlog amounts are calculated on an "if sold" basis and include orders from end-users, OEM customers and distributors for products that StorageTek expects to deliver during the following 12 months. Backlog amounts do not, however, include orders for Iceberg subsystems or other new DASD products. Units being evaluated or covered by letters of intent are not included in backlog amounts. Unfilled orders can generally be canceled at will by the customer. The Company does not believe that its backlog is necessarily indicative of future shipments, nor can it give any assurance that customers will purchase products in accordance with orders included in the backlog. StorageTek has a worldwide customer support network to install, maintain and service its own equipment as well as the equipment of others. The Company warrants the performance of products marketed into the end-user market for a specified period of time, after which it services those products under maintenance agreements. The installed service base of data storage products and the expertise of the Company's service engineers is considered to be a valuable asset of the Company and is expected to continue to be an important element of the Company's business. Manufacturing and Materials - --------------------------- Products currently are manufactured by the Company at its facilities located in Colorado, Puerto Rico, California, Florida and England. In 1993, the Company announced plans to manufacture and develop products in France. In late 1994, the Company expects to begin manufacturing and engineering operations in Toulouse, France, in facilities currently under construction. The Company also currently manufactures several significant subassemblies, including thin-film heads for tape as well as printed circuit assemblies for many products. Across the Company's product lines, a substantial majority of its production costs are subassemblies, parts and components purchased from outside vendors. For a discussion of factors that may affect the Company's ability to obtain materials, see Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Other Factors that May Affect Future Results", of this Form 10-K. The balance of the Company's production costs relate to in-house assembly and testing. Competition - ----------- The Company competes with several large multinational companies having substantially greater resources, principally, IBM, Fujitsu Limited and Hitachi Ltd., as well as other midsized companies. Because of the significance of the IBM mainframe and midrange operating environments, many of the Company's products are designed to be compatible with certain IBM operating systems and many of its products function like IBM equipment. As a result, the Company's business has been and in the future may be adversely affected by modification in the design or configuration of IBM computer systems, the announcement and introduction of new products by IBM and other competitors, and reductions in the pricing of comparable systems, equipment or service. For further discussion of competitive conditions, see Part II, Item 7, - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Other Factors that May Affect Future Results", of this Form 10-K. New Product Development - ----------------------- In 1993, the Company devoted approximately 12% of its revenue to develop new products and improve the performance of existing ones. In an attempt to mitigate the substantial investment required to develop its products for the market place, and to expand the Company's access to new technologies, the Company develops relationships with other companies. The Company spent approximately $163 million for research and product development activities in 1993, as compared to approximately $153 million in 1992 and approximately $123 million in 1991. Current development projects include: New products in the Online Plus family of DASD products, data management software, new library and tape drive products, and enhancements to the Company's existing information storage and retrieval products. The Company expects to continue to invest significant amounts on research and development. As of December 31, 1993, approximately 1,500 employees were engaged on a full-time basis in engineering and product development activities. For further discussion of factors concerning product development, See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Other Factors that May Affect Future Results", of this Form 10-K. Intellectual Property - --------------------- StorageTek's policy is to apply for patents, or other appropriate proprietary or statutory protection, when it develops valuable new or improved technology. It presently owns a number of U.S. and foreign patents relating to its products which are considered valuable assets of the Company. The Company also owns, has license rights to, and/or has applied to register, trademarks, mask works, copyrights and proprietary information, which are also considered to be valuable assets of the Company. Certain areas of the computer industry have been the subject of extensive patent coverage, and from time to time it has been necessary to obtain rights or licenses under existing patents held by others. Currently, StorageTek and IBM are operating under a long-term cross-license agreement. From time to time, the Company has commenced actions against other companies to protect or enforce its intellectual property rights. Similarly, the Company from time to time has been notified that it may be infringing certain patent or other intellectual property rights of others. Although licenses are generally offered in such situations, there can be no assurance that litigation will not be commenced in the future regarding patents, mask works, copyrights, trademarks or trade secrets, or that any licenses or other rights can be obtained on acceptable terms. The Company is currently engaged in certain proceedings relating to its intellectual property and patent infringement. See Part I, Item 3, "Legal Proceedings", and Part III, Item 14, Note 12 to the consolidated financial statements, of this Form 10-K. Environment - ----------- Compliance by StorageTek with provisions of federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had a material adverse effect on the Company. However, liability under environmental legislation is on-going, regardless of whether or not the Company has disposed of such waste in accordance with existing governmental guidelines. Moreover, government regulation of the environment and related compliance costs have increased in recent years. Therefore, the Company is unable to anticipate whether future compliance will have any material effect on the Company. For further discussion of specific environmental proceedings involving the Company and/or its properties, see Part I, Item 3, "Legal Proceedings", of this Form 10-K. Other Matters - ------------- The Company employed approximately 10,100 persons on a full-time basis worldwide as of December 31, 1993. The Company does not consider its business to be highly seasonal, although it historically has experienced increased sales revenue in the fourth quarter compared to other quarters due to customers' tendencies to make purchase decisions near the end of the calendar year. The Company expects this trend to continue in 1994, and to be further affected by the growing revenue expected from new DASD products introduced in 1994. For the year ended December 31, 1993, no single customer accounted for 10% or more of the Company's consolidated sales revenue. No material portion of the Company's business is subject to contract termination at the election of the U.S. government. Reference is made to the following notes to the consolidated financial statements set forth in Part III, Item 14, of this Form 10-K for certain additional information: Note 2 Description of the Company's business combinations with Amperif Corporation, Edata Scandinavia AB and XL/Datacomp, Inc. Note 15 Information on the geographic operations of the Company's single business segment. Reference is made to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", of this Form 10-K, for information regarding liquidity, including working capital, and other factors that may affect future results. ITEM 2. ITEM 2. PROPERTIES StorageTek occupies facilities in 15 separate buildings in Boulder County, Colorado, comprising approximately 2.3 million square feet. Of these, approximately 2.2 million square feet are owned by StorageTek and the remaining space is leased. In the Palm Bay - Melbourne, Florida area, StorageTek owns approximately 199,000 square feet. StorageTek also occupies 126,000 square feet of manufacturing facilities in Puerto Rico, of which approximately 72,000 square feet are leased, and leases approximately 37,000 square feet of manufacturing facilities in England. The Company occupies approximately 63,000 square feet of leased development and manufacturing facilities in Chatsworth, California. In addition, StorageTek occupies leased facilities at approximately 295 other locations throughout the world, primarily for sales, customer service and parts storage, as well as for limited research and product development purposes. At the present time, such facilities are adequate for the Company's purposes. The Company has entered into an agreement with the French government to begin leasing in late 1994 approximately 180,000 square feet of manufacturing and engineering facilities currently under construction in Toulouse, France. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Additional information regarding other legal proceedings is incorporated by reference from Note 12 to the consolidated financial statements identified in Part III, Item 14, of this Form 10-K. In October 1992, Cigna Insurance Company (Cigna), the issuer of the Company's primary director's and officer's liability insurance policy, filed suit against the Company and its directors and officers seeking to rescind the policy based on a clerical error. The parties subsequently settled this matter in the fourth quarter of 1993. StorageTek, via its predecessor-in-interest, Documation Inc., has been identified as a potentially responsible party with respect to real property located in Orlando, Florida. The Environmental Protection Agency has agreed to settle the matter for approximately $96,000 plus the Company's "fair share" of unrecouped response costs (estimated at less than $25,000), all payable out of the bankruptcy reserve. StorageTek believes this arrangement is viable and will file a claim in this amount against the bankruptcy reserve and, consequently, this settlement will have no material adverse effect on the Company's financial condition and results of operations. On June 10, 1993, the Company filed a complaint against EMC Corp. in U.S. District Court for the District of Colorado. The complaint alleges that EMC Corp. has infringed three patents pertaining to the Company's disk storage technology. The complaint seeks an injunction prohibiting further infringement, treble damages in an unspecified amount, and an award of attorney fees and costs. EMC Corp. filed an answer and counterclaim on July 20, 1993, alleging, among other things, patent misuse and seeking the invalidation of the Company's patents, damages in an unspecified amount and an award of attorney fees, costs and interest. Discovery has commenced and a trial has been scheduled for October 1994. On January 21, 1994, Bell Atlantic Business Systems Services, Inc. (BABSS) filed suit in federal District Court for the Northern District of California, alleging that a number of the Company's service business policies are illegal, including price increases and parts and maintenance software availability. BABSS has asked the court to order the Company to stop or change these practices. A hearing on a motion of preliminary injunction is scheduled for March 18, 1994. The complaint appears to focus on conduct of the Company since December 1, 1993. On February 11, 1994, the Company and its subsidiary XL/Datacomp, Inc., filed suit in Boulder County, Colorado, District Court against Array Technology Corporation and Tandem Computers Incorporated. The suit asks that the court order defendants to either support certain disk drives purchased from defendants or provide the Company with the technical data necessary for it to provide such customer support. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of StorageTek security holders during the fourth quarter of the year ended on December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Name Position with Company Age ---- --------------------- --- Ryal R. Poppa Chairman of the Board, President, 60 and Chief Executive Officer Lowell Thomas Gooch Executive Vice President Operations 49 Derek A. Thompson Executive Vice President Worldwide 63 Field Operations David E. Weiss Executive Vice President Systems 49 Development & Program Management Gregory A. Tymn Senior Corporate Vice President 44 and Chief Financial Officer John V. Williams Senior Corporate Vice President 50 Americas Joseph E. Beal Corporate Vice President 51 Customer Satisfaction David E. Lacey Corporate Vice President and 47 Controller Fred G. Moore Corporate Vice President 46 Strategic Planning Sewell I. Sleek Corporate Vice President 57 Human Resources W. Russell Wayman Corporate Vice President 49 General Counsel and Secretary Mr. Poppa became Chairman of the Board, Chief Executive Officer and a director of the Company in January 1985, and also became President of the Company in January 1988. Mr. Gooch became Executive Vice President of Operations of the Company in January 1989. From June 1987 to January 1989, he was Corporate Vice President of Manufacturing; from January 1987 to June 1987, he was Vice President of Americas/Pacific Operations; from January 1986 to January 1987, he was Vice President of Federal Systems Operations. Mr. Gooch has been employed by the Company in various capacities since 1972. Mr. Thompson became Executive Vice President of Worldwide Field Operations in March 1991. From July 1984 to March 1991, he was the Vice President of Europe, Africa and Middle East. Mr. Weiss became Executive Vice President Systems Development & Program Management in January 1993. He was a Senior Vice President Marketing from June 1992 to January 1993 and Corporate Vice President Market Planning from August 1991 to June 1992. From March 1991 through August 1991, he was a staff vice president reporting to the Chief Executive Officer. Prior to joining StorageTek, Mr. Weiss was employed by IBM for 23 years. Most recently, he was the DASD Controller Development Director for IBM. Mr. Tymn became Senior Vice President and Chief Financial Officer in March 1991. He was Corporate Vice President of Program Management from November 1989 until June 1992. From November 1987 through October 1989, he was the Vice President and General Manager of StorageTek Printer Operations; and, from July 1983 to November 1987, he was Vice President and Corporate Controller of the Company. Mr. Williams became Senior Corporate Vice President, Americas in August 1993. He was Corporate Vice President from February 1992 through August 1993 and Vice President of North America from September 1990 through February 1992. Prior to rejoining StorageTek, Mr. Williams was employed by GRiD Systems Corp, purchased by Tandy Corp. in 1988, where he served as vice president of marketing. Mr. Beal became Corporate Vice President Customer Satisfaction in August 1993. He was a Vice President from 1988 through August 1993. Mr. Lacey became a Corporate Vice President of the Company in December 1990 and Corporate Controller of the Company in October 1989. From February 1985 to October 1989, he was the Company's Director of Tax. Prior to joining StorageTek, Mr. Lacey was employed by Price Waterhouse in various tax and accounting capacities. Mr. Moore became Corporate Vice President Strategic Planning in June 1990. He was Vice President of Strategic Planning from January 1989 to June 1990; from January 1988 to January 1989, he was Vice President of Systems Marketing; and from June 1986 to January 1988, he was Director of Worldwide Product Marketing. Mr. Sleek became Corporate Vice President of Human Resources of the Company in January 1989. From September 1985 to January 1989, he was Corporate Vice President of Systems Development. Mr. Sleek has been employed by the Company in various capacities since 1978. Mr. Wayman became Corporate Vice President in March 1991; General Counsel since January 1990 and Corporate Secretary of the Company since February 1990. From May 1984 through January 1990, he was the General Counsel of VLSI Technology, Inc. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The common stock of Storage Technology Corporation is traded on the New York Stock Exchange under the symbol STK. The table below reflects the high and low closing sales prices of the common stock on the New York Stock Exchange for 1993 and 1992 as reported by the New York Stock Exchange. On December 31, 1993 there were 23,128 record holders of common stock of StorageTek. 1993 High Low ---- ---- --- 1st Quarter $27.250 $18.625 2nd Quarter 44.000 23.375 3rd Quarter 41.125 24.500 4th Quarter 33.625 25.000 1992 High Low ---- ---- --- 1st Quarter $76.625 $39.625 2nd Quarter 63.125 29.125 3rd Quarter 37.625 26.625 4th Quarter 32.000 19.625 Dividends - --------- StorageTek has never paid cash dividends on its common stock and currently plans to continue to retain future earnings for use in its business. Further, the Company's existing multicurrency credit agreement and 9.53% Senior Secured Notes contain certain restrictions which limit the payment of cash dividends based, primarily, upon the Company's consolidated net income. As of December 31, 1993, under the terms of both the multicurrency credit agreement and 9.53% Senior Secured Notes the Company did not have cumulative consolidated net income available for the payment of cash dividends on its common stock. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following data, insofar as it relates to the three fiscal years 1991 through 1993 (except for the 1991 Balance Sheet Data), has been derived from the consolidated financial statements appearing elsewhere herein, including the Consolidated Balance Sheet as of December 31, 1993, and December 25, 1992, and the related Consolidated Statement of Operations for each of the three years in the period ended December 31, 1993, and notes thereto. The data, insofar as it relates to the Balance Sheet Data as of December 27, 1991, December 28, 1990, and December 29, 1989, and the Statement of Operations Data for the fiscal years 1990 and 1989, has been derived from the historical financial statements of the Company, XL/Datacomp, Inc. and Amperif Corporation, as pooled entities for such periods (see Note 2). The following data (in thousands of dollars, except per share amounts) should be read in conjunction with the consolidated financial statements and notes thereto. (a) In 1990, the Company recognized a net charge of $1,304,000 related to repurchases of 8% Convertible Subordinated Debentures due 2015, and the redemption and repurchase of 13.5% Senior Debentures. (b) In 1989, the Company recognized an extraordinary gain of $11,300,000 from the liquidation of its wholly owned subsidiary, Storage Technology Products, B.V. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL - ------- The Company reported a net loss for the year ended December 31, 1993, of $77.8 million on revenue of $1.40 billion, compared to net income for the year ended December 25, 1992, of $9.3 million on revenue of $1.55 billion and net income for the year ended December 27, 1991, of $89.8 million on revenue of $1.62 billion. As further discussed in Note 2 to the consolidated financial statements, the Company completed a merger with Amperif Corporation (Amperif) in October 1993 which was accounted for as a pooling of interests. Accordingly, the Company's consolidated financial statements have been restated for all periods to include the operations of Amperif with adjustments to conform with StorageTek's accounting policies and presentation. The decrease in the Company's revenue in 1993 compared to 1992 was due primarily to the continuation of a weak European economy, a strengthening U.S. dollar, intense price competition within the midrange marketplace, the lack of new DASD product offerings, and the lack of a 36-track tape product offering for the first three quarters of 1993. These factors, coupled with restructuring and other charges of $74.8 million and losses associated with Amperif's operations, resulted in a net loss for 1993. The net loss was partially offset by a $40.0 million benefit from the cumulative effect of a change in the method of accounting for income taxes. The decrease in the Company's revenue in 1992 compared to 1991 was primarily a result of worldwide recessionary pressures, the introduction of automated tape products by its competitors, the lack of a 36-track tape offering, and intense price competition within the midrange marketplace. The Company's earnings in 1992 compared to 1991 were unfavorably affected by a decline in overall sales margin due primarily to a product mix shift in customer orders to the Company's smaller configuration (Junior) 4400 ACS library; increased marketing, general and administrative expenses; and increased tax expense. The Company expects to report a loss in the first quarter of 1994. This loss will be partially attributable to a one-time charge of between $5 million and $10 million associated with the required adoption of a new accounting standard for postemployment benefits. The Company also expects to report a loss from operations due to the continuation of the weak economic conditions in Europe; the strong U.S. dollar; and the requirement for significant investments associated with the manufacturing, marketing and servicing of new products. The Company anticipates increasing its worldwide workforce by as much as 10% in 1994 to support its new products. The Company anticipates a return to profitability for the remainder of 1994; however, this plan is dependent upon the timely completion and successful market introduction of a number of new DASD products, including Iceberg and Nordique. While the library product family has generated substantially more revenue for the Company than its other product lines in the last several years, the Company's profitability in 1994 is dependent upon revenue growth from these new DASD programs. Accordingly, there can be no assurance that the Company will be profitable in 1994. The following table, stated as a percentage of total revenue, presents consolidated statement of operations information and revenue by product line which includes product sales, service and rental, and software revenue. Year Ended December ---------------------------------- 1993 1992 1991 ---------------------------------- Revenue: Serial Access Subsystems 62.3% 60.4% 56.0% Random Access Subsystems 9.0 12.5 13.5 Midrange Systems 21.8 20.9 24.3 Other 6.9 6.2 6.2 ----- ----- ----- Total revenue 100.0 100.0 100.0 Cost of revenue 68.8 69.3 68.2 ----- ----- ----- Gross profit 31.2 30.7 31.8 Research and product development costs 11.6 9.8 7.6 Marketing, general, administrative and other income and expense, net 23.1 20.3 18.6 Restructuring and other charges 5.3 0.3 ----- ----- ----- Operating profit (loss) (8.8) 0.6 5.3 Interest (income) expense, net (0.8) (1.1) (1.0) ----- ----- ----- Income (loss) before income taxes and cumulative effect of accounting change (8.0) 1.7 6.3 Provision for income taxes 0.4 1.1 0.8 ----- ----- ----- Income (loss) before cumulative effect of accounting change (8.4) 0.6 5.5 Cumulative effect on prior years of change in method of accounting for income taxes 2.9 ----- ----- ----- Net income (loss) (5.5)% 0.6% 5.5% ===== ===== ===== REVENUE - ------- Total revenue decreased 9% in 1993 compared to 1992, as a result of a decrease in product sales of 16% which was partially offset by an increase in service and rental revenue of 6%. Total revenue decreased 4% in 1992 compared to 1991, as a result of a decrease in product sales of 10% which was partially offset by an increase in service and rental revenue of 13%. Serial Access Subsystems Revenue from serial access subsystem products decreased 7% in 1993 compared to 1992, due primarily to the weak economic conditions in Europe, a strengthening U.S. dollar and the lack of a 36-track tape product offering for the first three quarters of 1993. While the weak economic conditions in Europe and the strength of the U.S. dollar continued into the fourth quarter, these pressures were offset partially by incremental sales revenue in the fourth quarter from PowderHorn, the next generation of the Company's 4400 ACS library, and Silverton, the Company's new 36-track tape offering. Revenue from serial access subsystem products increased 3% in 1992 compared to 1991, due primarily to incremental revenue from the Company's acquisition of Edata Scandinavia AB in the second quarter of 1992 and additional tape service revenue reflecting growth in the Company's installed base of tape products. The Company anticipates its serial access product revenue will decrease slightly in 1994 as a result of the strength of the U.S. dollar, and declining revenue from the Company's first generation 4400 ACS library and 4480 18-track cartridge subsystem. These decreases are expected to be partially offset by incremental revenue associated with PowderHorn, Silverton and the Company's new WolfCreek 9360 ACS, a high-performance library with a lower cartridge capacity than the 4400 ACS library. The library product family generates substantially more revenue than any other product line of the Company and continues to be a major element of the Company's plans for the foreseeable future. Random Access Subsystems Revenue from random access subsystem products decreased 35% in 1993 compared to 1992, due primarily to decreased sales of the Company's rotating DASD products and decreased sales of Amperif's disk subsystems in the Unisys marketplace. Revenue from the Company's rotating DASD decreased 44% in 1993, reflecting the discontinuance of production of the Company's 8380 disk subsystem, which was completed during the second quarter in anticipation of new DASD product offerings. DASD revenue from Amperif decreased 50% due to competition from new products offered by Unisys. Sales of add-on memory products also decreased 23% in 1993 as the Company discontinued sales of these products in the third quarter due to declining business prospects. Revenue from solid-state DASD products was largely unchanged in 1993 compared to 1992. Revenue from random access subsystem products decreased 12% in 1992 compared to 1991. This reflects a 44% decrease in revenue from solid-state DASD, due to volume and pricing declines, and a 15% decrease in Amperif's DASD revenue. These decreases were partially offset by a 27% increase in add-on memory sales. Rotating DASD revenue was largely unchanged in 1992 compared to 1991. The Company anticipates that its random access subsystem revenue will continue to decline until it begins volume shipments of its new high-end random access subsystems. The Company anticipates it will commit substantial resources to the development, product ramp-up and support of these new products in 1994. The Company began limited production of Iceberg in late 1993 and expects revenue contribution from Iceberg in the first half of 1994. Nordique, an IBM-compatible disk array product positioned below Iceberg, is expected to begin shipment and revenue contribution during the first half of 1994. Other new DASD products, based on technology developed by Amperif, are under development and are targeted for availability in the second half of 1994. The Company anticipates significant revenue growth from Iceberg, Nordique and its other new DASD products in 1994. Delays in the timely completion and successful marketing of these DASD products could adversely affect the Company's financial performance. Midrange Systems Revenue from midrange system products decreased 6% in 1993 and 17% in 1992. These decreases primarily reflect delays in the availability of the Company's Alpine 9600 Storage Manager and, subsequently, disappointing customer acceptance of this product. The decreases in revenue from midrange system products were also a result of the significant price erosion within the midrange DASD marketplace, and the limited acceptance of the Company's midrange tape product offerings. In response to these factors, the Company restructured its midrange business in the third quarter of 1993. The Company is changing its midrange product line, organization, distribution network and service operations to improve operating performance. The Company anticipates the operating performance of its midrange product line will improve in 1994; however, this improvement is dependent upon the Company's ability to successfully introduce cost-competitive DASD and tape products in this rapidly evolving marketplace. Two new DASD products for the midrange marketplace, Highlands and Northfield, are currently scheduled for availability in the first half of 1994. Other Revenue from other products was largely unchanged in 1993 and decreased 3% in 1992, due primarily to decreased printer product revenue. Revenue from printer products is expected to continue to decline as the Company is winding down its production of impact printers and the installed service base of printers maintained by the Company continues to decline. The decrease in revenue from printer products in 1994 is expected to be offset by incremental revenue from software and network storage management products introduced in late 1993 which expand the applications for library and random access products. The NearNet network storage manager, which became generally available in the fourth quarter of 1993, simplifies management of data for networks of UNIX servers and workstations. GROSS PROFIT - ------------ Overall gross profit was 31% for 1993 and 1992, compared to 32% in 1991, as decreased product sales margins were largely offset by improved service and rental margins. Gross profit on product sales decreased to 29% in 1993, compared to 30% in 1992 and 33% in 1991. The decrease in 1993 was due largely to lower production volumes, start-up costs associated with new product offerings, and price erosion within the midrange DASD market. Additionally, the Company's profit margins from its international operations were affected by the weak economic conditions in Europe and a strengthening U.S. dollar. These factors were offset partially by benefits resulting from the Company's cost-cutting measures. The decrease in 1992 was due largely to a shift in customer orders towards 4400 ACS Junior libraries, which have lower margins; decreased sales of full-configuration libraries; higher costs associated with longer warranty periods offered for the 4480 18-track cartridge subsystem; underabsorbed overhead due to lower than expected manufacturing volumes; and start-up costs associated with new product offerings. Gross profit on service and rental increased to 35% in 1993, compared to 33% in 1992 and 27% in 1991, reflecting increased product reliability and economies created by an increased installed service base, coupled with effective operating expense controls. The Company expects continued pressure on its product sales margins into 1994 due to the weak economic conditions in Europe, a strong U.S. dollar, and the heavy investment in product support for new DASD, tape and library products. The Company's product sales margins are expected to improve in 1994 as the Company begins volume shipments of these new products. The Company's service and rental margins in 1994 are expected to be adversely affected by incremental costs associated with the installation of new products, coupled with longer warranty periods for new DASD products. RESEARCH AND PRODUCT DEVELOPMENT - -------------------------------- Research and product development expenditures increased 7% in 1993 and 24% in 1992 due to the continuing investment in a significant number of new products. The increase in 1993 was offset partially by ongoing cost containment efforts. Research and product development expenses for 1992 and 1991 were reduced by development funding received by Amperif from third parties of $5.0 million and $2.5 million, respectively. The Company continues to invest in the development of new random access subsystem, tape and library products, software and network communication products that expand applications for its library and random access products. MARKETING, GENERAL, ADMINISTRATIVE AND OTHER - -------------------------------------------- Marketing, general, administrative and other income and expense (MG&A) was largely unchanged in 1993 compared to 1992. The Company realized a $4.1 million gain on the sale of an equity investment in 1993. Foreign currency translation adjustments, net of associated hedging results, and foreign currency transaction losses were $8.8 million in 1993, compared to $8.4 million in 1992. MG&A increased 5% in 1992 compared to 1991 reflecting increased advertising and promotional expenses and incremental expenses following the acquisition of Edata. These increases were offset partially by a decrease of $5.3 million in losses associated with discontinued software operations and a decrease of $3.9 million in foreign exchange losses. Foreign currency translation adjustments, net of associated hedging results, and foreign currency transaction losses were $8.4 million in 1992, compared to $12.3 million in 1991. See "INTERNATIONAL OPERATIONS AND HEDGING ACTIVITIES" for further discussion of the foreign exchange risks associated with the Company's international operations and the related foreign currency hedging activities. RESTRUCTURING AND OTHER CHARGES - ------------------------------- As further discussed in Note 14 to the Company's consolidated financial statements, the Company recognized restructuring and other charges of $74.8 million during 1993. Restructuring charges of $69.3 million principally relate to the reorganization of the Company's midrange business. Merger and consolidation expenses of $5.5 million in 1993 and $5.1 million in 1991 were also recognized in connection with the mergers with Amperif and Datacomp, respectively. The restructuring is expected to yield both improved operating performance and expense reductions. The restructuring yielded expense reductions of more than $10 million in the fourth quarter of 1993 and is expected to yield expense reductions of almost $40 million during 1994. INTEREST INCOME AND EXPENSE - --------------------------- Interest income decreased 18% in 1993 and 2% in 1992, due primarily to a reduction in net investment in sales-type lease balances and lower interest rates. The decrease in 1993, compared to 1992, was partially offset by an increase in the invested cash balances. Interest expense decreased 10% in 1993 primarily as a result of lower interest rates and a reduction in the Company's nonrecourse borrowings. Interest expense decreased 7% in 1992 primarily as a result of reduced nonrecourse borrowings. INCOME TAXES - ------------ As further discussed in Note 8 to the Company's consolidated financial statements, effective as of the beginning of the fiscal year 1993, the Company was required to change its method of accounting for income taxes from Statement of Financial Accounting Standards (SFAS) No. 96 to SFAS No. 109. A one-time benefit of $40 million was recognized in the first quarter of 1993 as a result of the adoption of the new income tax accounting standard on a prospective basis. The adoption of SFAS No. 109 had no cash flow impact. The most significant difference for the Company between SFAS No. 96 and SFAS No. 109 is the criteria for recognition of deferred income tax assets associated with net operating loss and tax credit carryforwards. While recognition of deferred income tax assets was limited to very specific situations under SFAS No. 96, the new standard requires that deferred income tax assets be recognized to the extent realization of such assets is more likely than not. The Company evaluated a variety of factors in determining the amount of the deferred income tax assets to be recognized pursuant to SFAS No. 109, including the number of years the Company's operating loss and tax credits can be carried forward, the existence of taxable temporary differences, the Company's earnings history, the Company's near-term earnings expectations and possible reductions in the Company's net operating loss carryforwards as a result of proposed adjustments by the Internal Revenue Service to the Company's previously filed federal income tax returns. Based on the currently available information, management has determined that the Company will more likely than not realize $52 million of its deferred income tax assets as of December 31, 1993. Future changes in facts and circumstances which result in changes in the assessment of realizability of the Company's deferred income tax assets are required to be reflected within the Company's provision for income taxes on the Consolidated Statement of Operations. See Note 8 to the consolidated financial statements for information with respect to the current status of the Internal Revenue Service examinations. The Company's provision for income taxes relates primarily to taxable earnings associated with its international operations. The Company's effective tax rate can be subject to significant fluctuations due to dynamics associated with the mix of its U.S. and international taxable earnings. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- Financings In March 1993, the Company completed a public offering of 3.45 million shares of $3.50 Convertible Exchangeable Preferred Stock, $.01 par value (the Preferred Stock), at a price of $50.00 per share. The net proceeds of the Preferred Stock offering, after deducting all associated costs, were approximately $166.5 million. The net proceeds are being used by the Company for working capital and capital expenditures associated with the development and introduction of new products and for other general corporate purposes. In May 1991, the Company completed an offering of 3.45 million shares of common stock which yielded net proceeds of $135.4 million. In September 1991, the Company completed a $55 million private placement of 9.53% Senior Secured Notes due August 31, 1996 (the Notes), collateralized by U.S. lease and installment purchase receivables. The proceeds from the common stock offering, as well as the net proceeds from the Notes, were used for acquisitions, working capital, financing customer lease commitments, capital expenditures and other general corporate purposes. Under the terms of the Notes, the Company is required to comply with certain financial and other covenants, including restrictions on the payment of cash dividends on its common and preferred stock. Working Capital The Company's cash balances increased $137.1 million and short-term investments increased $16.0 million from December 25, 1992, to December 31, 1993. Net cash from operating activities was $87.5 million for 1993 compared to $107.1 million for 1992 and $183.1 million for 1991. The increase in cash and short-term investments in 1993 reflects the net proceeds from the Preferred Stock offering, coupled with the net cash generated by operating activities, partially offset by investments in property, plant and equipment, and the partial paydown of nonrecourse borrowings. The current ratio increased to 2.2 at December 31, 1993, from 1.8 at December 25, 1992. Accounts receivable decreased from $313.4 million at December 25, 1992, to $218.7 million at December 31, 1993, due primarily to lower comparable revenue. Inventories increased from $156.1 million at December 25, 1992, to $203.3 million at December 31, 1993, principally as a result of a build-up of inventories associated with new DASD products to be introduced in 1994, and an increase in midrange disk and tape inventories. Available Financing Lines In March 1993, the Company entered into a $150 million two-year secured multicurrency credit agreement with a group of U.S. and international banks (the Revolver). The interest rates available under the Revolver depend on the type of advance selected; however, the primary advance rate is the agent bank's prime lending rate (6% at December 31, 1993). The total amount available under the Revolver is limited to a percentage of the Company's eligible U.S. accounts receivable and lease assets (primarily net investments in sales-type leases not previously utilized for secured borrowings). To obtain funds under the Revolver, the Company is required to comply with certain financial and other covenants, including restrictions on the payment of cash dividends on its common stock. There were no advances under the Revolver during 1993. Based on the amount of eligible accounts receivable and lease assets assigned to the Revolver, the Company had approximately $50 million of available credit under the Revolver as of December 31, 1993. As of December 31, 1993, the Company had unused committed lease discounting lines of approximately $41 million available in the United States for recourse and nonrecourse borrowings. The Company also had unused committed lease discounting lines of approximately $38 million available through its foreign subsidiaries for nonrecourse borrowings. Furthermore, the Company believes it has the ability to increase its committed lease discounting lines in the future, if needed. The ability to use these committed lease discounting lines is limited by the availability of lease assets which meet the credit standards of the lenders. The Company had, subject to lender credit approval, approximately $58 million of lease assets available for discounting under these lines as of December 31, 1993. At the Company's option, a portion of these lease assets can be utilized for borrowings under the Revolver. The Company believes it has adequate working capital and financing capabilities to meet its anticipated 1994 operating and capital requirements, including new product offerings. Long-Term Debt-to-Equity The Company's long-term debt-to-equity ratio decreased to 36% as of December 31, 1993, from 40% as of December 25, 1992, principally as a result of the completion of the Preferred Stock offering. These debt-to-equity ratios include $97.0 million and $143.1 million, respectively, of long-term nonrecourse borrowings secured by customer lease commitments included within total assets (primarily net investment in sales-type leases). Excluding long- term nonrecourse borrowings, the Company's long-term debt-to-equity ratio increased to 26% as of December 31, 1993, from 24% as of December 25, 1992. Repayment Obligations Pursuant to the indenture related to the Company's 8% Convertible Subordinated Debentures due 2015 (Convertible Debentures), the Company is required to make semiannual interest payments on the $145.6 million principal amount of Convertible Debentures outstanding. The Convertible Debentures became redeemable at the option of StorageTek beginning May 31, 1993, at a premium of 5.6%, and are redeemable at decreasing premiums through May 30, 2000. Convertible Debentures in the principal amount of $8 million per annum, plus accrued interest, must be redeemed beginning May 31, 2000, through a sinking fund which provides for the retirement of 75% of the Convertible Debentures prior to their maturity on May 31, 2015. Convertible Debentures purchased by the Company in the open market and Convertible Debentures converted to common stock may be applied to the sinking fund requirements. As of December 31, 1993, the Company held Convertible Debentures in the principal amount of $14.3 million available for sinking fund payments. In connection with the Company's 9.53% Senior Secured Notes due August 31, 1996 (the Notes), the Company is required to make semiannual interest payments on the $55 million principal amount outstanding. The Notes are redeemable at the option of the Company, in whole or in part, from time to time, at a premium which is determined based on current interest rates and the time remaining until maturity. Any principal amounts not previously redeemed are due and payable on August 31, 1996. The Company's Preferred Stock provides for cumulative dividends payable quarterly in arrears at an annual rate of $3.50 per share, when and as declared by the Company's board of directors. Based on the 3.45 million shares outstanding as of December 31, 1993, annual dividends will aggregate $12.1 million. The Notes contain restrictions which limit the payment of dividends; however, these restrictions are not expected to limit the ability of the Company to pay dividends on its Preferred Stock. INTERNATIONAL OPERATIONS AND HEDGING ACTIVITIES - ----------------------------------------------- A significant portion of the Company's revenue is generated by its international operations. As a result, the Company's operations and financial results can be materially affected by changes in foreign currency exchange rates. An increase in the exchange value of the U.S. dollar reduces the U.S. dollar value of revenue and profits generated by the Company's international operations because the functional currency for the Company's foreign subsidiaries is the U.S. dollar and a significant portion of the costs associated with this revenue are incurred in the United States. In an attempt to mitigate the impact of foreign currency fluctuations, the Company employs a hedging program which utilizes foreign currency options and forward exchange contracts. The Company utilizes foreign currency options, generally with maturities of less than one year, to hedge its exposure to exchange-rate fluctuations in connection with anticipated sales revenue from its international operations. Gains and losses on the options are deferred and subsequently recognized as an adjustment to the associated sales revenue. The Company also utilizes forward exchange contracts, generally with maturities of less than two months, to hedge its exposure to exchange-rate fluctuations in connection with monetary assets and liabilities held in foreign currencies. Gains and losses on forward contracts are recognized currently within MG&A as adjustments to the foreign exchange gains and losses on the translation of net monetary assets. OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS - -------------------------------------------- The Company believes that successful and timely development and shipment of its new products will play a key role in determining its competitive strength during the next several years. During 1994, the Company plans to introduce a number of new products. There can be no assurance that the Company will successfully develop, manufacture or market these products. The Company's strategic plans assume that its new Online Plus DASD product family will serve as a significant source of revenue beginning in 1994. One of these new DASD products, Iceberg, is expected to begin revenue contribution in the first half of 1994. While the Company believes this schedule is achievable, there is no assurance that it can be met. This schedule is two years later than that originally anticipated and announced in early 1992. Iceberg is currently in beta testing in various operating environments and the Company is continuing to integrate additional highly sophisticated software on the subsystem. If, as a result of the testing, significant problems arise which result in material delays in the availability of Iceberg, expected revenue from Iceberg would be further delayed or may be lost, and such delays would continue to adversely affect the Company's financial results. Delays in the introduction of the other new DASD products under development could also adversely affect the Company's future financial performance. The Company competes with several large, multinational companies having substantially greater resources than the Company's, principally, IBM, Fujitsu Limited and Hitachi Ltd., as well as other midsized companies. Because of the significance of the IBM mainframe and midrange operating environments, many of the Company's products are designed to be compatible with certain IBM operating systems and many of its products function like IBM equipment. As a result, the Company's business has been and in the future may be adversely affected by a number of factors including, among others, modifications in the design or configuration of IBM computer systems; the announcement and introduction of new products by competitors; continuing changes in customer requirements such as migration toward networked computing and reductions in the pricing of comparable systems, equipment or services. The Company's ability to sustain or increase sales levels depends to a significant extent upon acceptance of the many new and enhanced products it has introduced in 1993 and products planned for introduction in 1994. There can be no assurance that the Company's current products, products in development, or products in the early stages of market introduction will achieve or sustain market acceptance. The market for the Company's products is characterized by rapid technological advances which can result in frequent product introductions and enhancements, unpredictable product transitions and shortened product life cycles. To be successful in this market, the Company must make significant investments in research and product development and introduce competitive new products and enhancements to existing products on a timely basis. These factors can reduce the effective life of product-line-specific assets. There can be no assurance that new products developed by the Company will be accepted in the marketplace. Moreover, certain components of the Company's products operate near the present limits of electronic and physical capabilities of performance and are designed and manufactured with relatively small tolerances. If flaws in design or production occur, the Company may experience a rate of failure in its products that results in substantial costs for the repair or replacement of defective products and potential damage to the Company's reputation. The Company's manufacturing process has increased in complexity as it has increased the number and diversity of products offered to customers. The Company generally uses standard parts and components for its products and believes that, in most cases, there are a number of alternative, competent vendors for most of those parts and components. The Company purchases certain important components and products from single suppliers that the Company believes are currently the only manufacturers of the particular components that meet the Company's specification. In addition, the Company manufactures some key components or its products include components for which alternative sources of supply are not readily available. In the past, certain suppliers have experienced occasional technical, financial or other problems that have delayed deliveries to the Company, without significant effect on it. An unanticipated failure of any sole-source supplier to meet the Company's requirements for an extended period, or an interruption of the Company's ability to secure comparable components, could have a material adverse effect on its revenue and profitability. In addition, the Company markets a number of products acquired from other manufacturers on an OEM basis. These products are often available only from a single manufacturer. Some of these OEM suppliers are, or may in the future be, competitors of the Company. In the event that an OEM product is no longer available, second sourcing is not always feasible and there could be a material adverse effect on the Company's profitability. The Company's earnings can fluctuate significantly from quarter to quarter due to the effects of (i) customers' tendencies to make purchase decisions near the end of the calendar year, (ii) the timing of the announcement and availability of products and product enhancements by the Company and its competitors, and (iii) fluctuating foreign currency exchange rates. As further discussed in Note 1 to the Company's consolidated financial statements, the Company is required to adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits" not later than fiscal 1994. The Company plans to adopt the standard in the first quarter of 1994. The Company has not finally determined the impact of adopting SFAS No. 112; however, it expects to recognize a one-time charge of between $5 million and $10 million as a result of the adoption of the new standard. The adoption of SFAS No. 112 will have no cash flow impact. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index to Consolidated Financial Statements at Item 14, of this Form 10-K. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES There have been no disagreements on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure or any reportable events. As described in the Company's filing on Form 8-K dated as of May 26, 1992, at a meeting of the Company's Audit Committee held on May 26, 1992, the Committee determined to engage the accounting firm of Price Waterhouse as independent accountants for all subsidiaries of the Company for 1992, subject to approval of shareholders. The shareholders ratified the appointment on May 27, 1992, at the Annual Meeting of Shareholders. As a result, the Company's subsidiary, XL/Datacomp, Inc. (Datacomp), disengaged the accounting firm of KPMG Peat Marwick (KPMG) and retained the accounting firm of Price Waterhouse to perform the annual audit of the financial statements of Datacomp. Price Waterhouse, who had been auditing the Company and all subsidiaries except Datacomp, had expressed reliance upon KPMG's report in their report on the consolidated financial statements of the Company for the year ended December 31, 1991. KPMG's report on the financial statements for 1991 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty or audit scope. Additionally, there were no report modifications for accounting principles, with the exception of an explanatory paragraph referencing Datacomp's change in its method of accounting for income taxes in the year ended December 31, 1991, a change with which KPMG concurred. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information concerning the identity, background and experience of the Company's directors is set forth in the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held May 25, 1994 (the Proxy Statement) and is incorporated herein by reference. Also, see the information concerning executive officers set forth under the caption "Executive Officers of the Registrant" in Part I of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information concerning compensation of executive officers required under this item is contained in the Company's Proxy Statement and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information concerning certain principal holders of securities and security ownership of executive officers required under this item is contained in the Company's Proxy Statement and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information concerning certain relationships and related transactions required under this item is contained in the Company's Proxy Statement and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: PAGE 1. Financial Statements: -------------------- Consolidated Balance Sheet at December 31, 1993, and December 25, 1992 Consolidated Statement of Operations for the Years Ended December 31, 1993, December 25, 1992, and December 27, 1991 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, December 25, 1992, and December 27, 1991 Consolidated Statement of Changes in Stockholders' Equity for the Years Ended December 31, 1993, December 25, 1992, and December 27, 1991 Notes to Consolidated Financial Statements Report of Independent Accountants for Storage Technology Corporation Report of Independent Accountants for XL/Datacomp, Inc. 2. Financial Statement Schedules: ----------------------------- VIII - Valuation and Qualifying Accounts and Reserves IX - Short-Term Borrowings All other schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto. 3. Exhibits: -------- (a) The exhibits listed below are filed as part of this Annual Report on Form 10-K or are incorporated into this Annual Report on Form 10-K by reference: 4.1 Restated Certificate of Incorporation and Restated By-Laws of Storage Technology Corporation dated July 28, 1987, as currently in effect (filed as Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 25, 1987, and incorporated herein by reference). 4.2 Certificate of Amendment to the Restated Certificate of Incorporation dated May 22, 1989 (filed as Exhibit (c)(1) to the Registrant's Current Report on Form 8-K dated June 2, 1989, and incorporated herein by reference). 4.3 Certificate of Second Amendment to the Restated Certificate of Incorporation dated June 2, 1992 (filed as Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 26, 1992, and incorporated herein by reference). 4.4 First Amendment to the Restated Bylaws of Storage Technology Corporation, amending Section IV (filed as Exhibit 3(c) to the Company's Annual Report on Form 10-K for the fiscal year ended December 25, 1987, and incorporated herein by reference). 4.5 Specimen Certificate of Common Stock, $0.10 par value of Registrant (filed as Exhibit (c)(2) as to the Registrant's Current Report on Form 8-K dated June 2, 1989, and incorporated herein by reference). 4.6 Indenture dated as of May 31, 1990, between Storage Technology Corporation and Manufacturers Hanover Trust Company of California, Trustee, relating to the Company's 8% Convertible Subordinated Debentures due May 31, 2015 (filed as Exhibit 4.6 to the Company's Registration Statement on Form S-3 filed May 11, 1990, File No. 33-34876, and incorporated herein by reference). 4.7 Registration Statement of the Registrant on Form 8-A dated August 13, 1981 (filed as Exhibit 4.7 to the Registrant's Registration Statement on Form S-3 filed January 29, 1993, File No. 33-57678, and incorporated herein by reference). 4.8 Registration Statement of the Registrant on Form 8-A dated August 23, 1990 (filed as Exhibit 4.8 to the Registrants' Registration Statement on Form S-3 filed January 29, 1993, File No. 33-57678, and incorporated herein by reference). 4.9 Rights Agreement dated as of August 20, 1990, between Storage Technology Corporation and First Fidelity Bank, N.A., New Jersey, Rights Agent, (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K on August 20, 1990, and incorporated herein by reference). 4.10 Certificate of Designations of Series B Junior Participating Preferred Stock (filed as Exhibit A to Exhibit 4.1 to the Registrant's Current Report on Form 8-K filed with the Commission on August 8, 1990, and incorporated herein by reference). 4.11 Form of certificate for $3.50 Convertible Exchangeable Preferred Stock (filed as Exhibit 4.11 to the Registrants Registration Statement on Form S-3 filed January 29, 1993, File No. 33-57678, and incorporated herein by reference). 4.12 Form of Certificate of Designations of $3.50 Convertible Exchangeable Preferred Stock (filed as Exhibit 4.12 to the Registrants Registration Statement on Form S-3 filed January 29, 1993, File No. 33-57678, and incorporated herein by reference). 4.13 Form of Indenture between the Registrant and American Stock Transfer and Trust Company, as Trustee, relating to the Registrant's 8% Convertible Subordinated Debentures due 2008, (filed as Exhibit 4.13 to the Registrants Registration Statement on Form S-3 filed January 29, 1993, File No. 33-57678, and incorporated herein by reference). 4.14 Form of 8% Convertible Subordinated Debentures due 2008 (filed as Exhibit 4.13 to the Registrant's Registration Statement on Form S-3 filed January 29, 1993, File No. 33-57678, and incorporated herein by reference). *10.1 1982 Employee Stock Purchase Plan (filed as part of the Company's Registration Statement on Form S-8, filed November 4, 1982, File No. 2-80183, and incorporated herein by reference). *10.2 1987 Employee Stock Purchase Plan, as amended (filed as part of the Company's Registration Statement on Form S-8, filed November 10, 1989, as Registration No. 33-32243, and incorporated herein by reference). *10.3 1984 Stock Option Plan (filed as part of the Company's Registration Statement on Form S-8, filed February 10, 1984, File No. 2-89417, and incorporated herein by reference). - ------------------------ * Contract or compensatory plan or arrangement in which directors and/or officers participate. *10.4 1987 Equity Participation Plan (filed as part of the Company's Registration Statement on Form S-8, filed December 28, 1987, File No. 33-19426, and incorporated herein by reference). *10.5 Amendment to the 1987 Equity Participation Plan (filed as Exhibit 10(h) to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1990, and incorporated herein by reference). *10.6 Storage Technology Corporation Amended and Restated Stock Option Plan for Non-Employee Directors (filed as part of the Company's Registration Statement on Form S-8, filed November 12, 1989, File No. 33-32235, and incorporated herein by reference). *10.7 Employment Agreement between Storage Technology Corporation and Harris Ravine, dated February 27, 1987 (filed as Exhibit 10(t) to the Company's Annual Report on Form 10-K for the fiscal year ended December 25, 1987, and incorporated herein by reference). *10.8 Amendment to the 1987 Employee Stock Purchase Plan (filed as part of the Registrant's Registration Statement on Form S-8 filed September 18, 1991, File No. 33-42818, and incorporated herein by reference). *10.9 Storage Technology Corporation Amended and Restated Stock Option Plan for Non-Employee Directors (filed as part of the Registrant's Registration Statement on Form S-8, filed September 18, 1991, file No. 33-42817, and incorporated herein by reference). *10.10 Employment Agreement between Storage Technology Corporation and Ryal R. Poppa, dated December 13, 1989 (filed as Exhibit 10(k) to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1989, and incorporated herein by reference). *10.11 Employment Agreement between the Company and Geoffroy de Belloy, dated September 13, 1990 (filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for fiscal year ended December 27, 1991, and incorporated herein by reference). *10.12 Employment Agreement between the Company and Harris Ravine dated June 6, 1991 (filed as Exhibit 10.12 to the Company's Annual - ------------------------ * Contract or compensatory plan or arrangement in which directors and/or officers participate. Report on Form 10-K for fiscal year ended December 27, 1991, and incorporated herein by reference). *10.13 Employment Agreement between the Company and Derek A. Thompson dated February 26, 1991 (filed as Exhibit 10.13 to the Company's Annual Report on Form 10-K for fiscal year ended December 25, 1992, and incorporated herein by reference). *10.14 Employment Agreement between the Company and John V. Williams dated February 13, 1992 (filed as Exhibit 10(n) to the Registrant's Annual Report on Form 10-K for the year ended December 25, 1992, and incorporated herein by reference). 10.15 Form of Note Agreement dated as of August 30, 1991 relating to Registrant's 9.53% Senior Secured Notes due August 31, 1996 (filed as Exhibit 4(e) to the Registrant's Registration Statement on Form S-4 filed October 25, 1991, File No. 33-43536, and incorporated herein by reference). 10.16 Multicurrency Credit Agreement dated as of March 31, 1993, among the Registrant, Storage Technology De Puerto Rico, Inc., XL/Datacomp, Inc. and StorageTek Financial Services Corporation as Borrowers and Bank of America National Trust and Savings Association as Agent, Swing Line Bank and Issuing Bank, and the other banks and financial institutions parties thereto (the "Credit Agreement") (filed as Exhibit 10.15 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 26, 1993, and incorporated herein by reference). **10.17 First Amendment to the Multicurrency Credit Agreement dated as of August 6, 1993. **10.18 Second Amendment to the Multicurrency Credit Agreement dated as of September 24, 1993. */**10.19 Agreement between the Company and Harris Ravine dated October 8, 1993. - ------------------------ * Contract or compensatory plan or arrangement in which directors and/or officers participate. ** Indicates Exhibits filed with this Annual Report. **11.0 Computation of Earnings (Loss) per Common Share. **21.0 Subsidiaries of Registrant. **23.1 Consent of Price Waterhouse. **23.2 Consent of KPMG Peat Marwick. (b) Reports on Form 8-K. During the last quarter of the fiscal year covered by this report the Company filed two reports on Form 8-K. On October 15, 1993, the Company filed a Form 8-K in connection with a publicly disseminated news release concerning third-quarter 1993 financial results. The Company filed a Form 8-K on October 20, 1993 in connection with a publicly disseminated news release announcing the effectiveness of the merger with Amperif Corporation. - ------------------------ ** Indicates Exhibits filed with this Annual Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Storage Technology Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 11, 1994 STORAGE TECHNOLOGY CORPORATION By: /s/RYAL R. POPPA ------------------------------------ Ryal R. Poppa Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) By: /s/GREGORY A. TYMN ------------------------------------ Gregory A. Tymn Senior Corporate Vice President and Chief Financial Officer (Principal Financial Officer) By: /s/DAVID E. LACEY ------------------------------------ David E. Lacey Corporate Vice President and Controller (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Title Date /s/JUDITH E.N. ALBINO - ---------------------------- Judith E.N. Albino Director March 11, 1994 /s/WILLIAM L. ARMSTRONG - ---------------------------- William L. Armstrong Director March 11, 1994 /s/ROBERT A. BURGIN - ---------------------------- Robert A. Burgin Director March 11, 1994 /s/PAUL FRIEDMAN - ---------------------------- Paul Friedman Director March 11, 1994 /s/STEPHEN J. KEANE - ---------------------------- Stephen J. Keane Director March 11, 1994 /s/ROBERT E. LABLANC - ---------------------------- Robert E. LaBlanc Director March 11, 1994 /s/ROBERT E. LEE - ---------------------------- Robert E. Lee Director March 11, 1994 /s/HARRISON SHULL - ---------------------------- Dr. Harrison Shull Director March 11, 1994 /s/RICHARD C. STEADMAN - ---------------------------- Richard C. Steadman Director March 11, 1994 /s/ROBERT C. WILSON - ---------------------------- Robert C. Wilson Director March 11, 1994 STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Thousands of Dollars) December 31, December 25, 1993 1992 --------------------------- ASSETS Cash, including cash equivalents of $181,583 in 1993 and $70,128 in 1992, and restricted cash of $3,857 in 1993 and $4,187 in 1992 $ 255,062 $ 117,954 Short-term investments 16,042 Accounts receivable, net of allowance for doubtful accounts of $12,452 in 1993 and $11,949 in 1992 218,701 313,350 Notes and installment receivables 9,973 9,625 Net investment in sales-type leases (Note 3) 171,165 193,078 Inventories, at lower of cost (first-in, first-out) or market (Note 4) 203,257 156,136 --------- --------- Total current assets 874,200 790,143 Notes and installment receivables 13,968 21,228 Net investment in sales-type leases (Note 3) 252,678 309,160 Computer equipment, at cost net of accumulated depreciation of $96,454 in 1993 and $78,743 in 1992 (Note 5) 97,324 103,281 Spare parts for field service, at cost net of accumulated amortization of $55,317 in 1993 and $48,268 in 1992 50,150 51,389 Property, plant and equipment, at cost net of accumulated depreciation (Note 6) 306,034 305,097 Deferred income tax assets, net of valuation allowance (Note 8) 52,260 Other assets 146,395 158,745 --------- --------- $1,793,009 $1,739,043 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Nonrecourse borrowings secured by lease commitments (Note 7) $ 74,191 $ 88,548 Current portion of other long-term debt (Note 7) 32,581 18,211 Accounts payable 91,890 129,978 Accrued liabilities 192,874 183,939 Income taxes payable (Note 8) 14,167 11,525 --------- --------- Total current liabilities 405,703 432,201 Nonrecourse borrowings secured by lease commitments (Note 7) 96,975 143,148 Other long-term debt (Note 7) 264,743 226,840 Deferred income tax liabilities (Note 8) 8,285 8,941 --------- --------- Total liabilities 775,706 811,130 --------- --------- Commitments and contingencies (Notes 7 and 12) STOCKHOLDERS' EQUITY Preferred stock, $.01 par value, 40,000,000 shares authorized; 3,450,000 shares of $3.50 Convertible Exchangeable Preferred Stock issued in 1993, and none issued in 1992, $172,500,000 aggregate liquidation preference (Note 9) 35 Common stock, $.10 par value, 150,000,000 shares authorized; 43,097,788 shares issued in 1993, and 42,613,422 shares issued in 1992 4,310 4,261 Capital in excess of par value 1,421,860 1,244,471 Accumulated deficit (401,623) (314,368) Treasury stock of 34,349 shares in 1993 and 33,936 shares in 1992 (735) (729) Cumulative translation adjustment 2,872 Unearned compensation (6,544) (8,594) --------- --------- Total stockholders' equity 1,017,303 927,913 --------- --------- $1,793,009 $1,739,043 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In Thousands, Except Per Share Amounts) Year Ended --------------------------------------- December 31, December 25, December 27, 1993 1992 1991 --------------------------------------- Sales $ 902,482 $1,079,130 $1,201,114 Service and rental revenue 502,270 471,815 418,406 --------- --------- --------- Total revenue 1,404,752 1,550,945 1,619,520 --------- --------- --------- Cost of sales 641,411 757,369 801,138 Cost of service and rental revenue 324,502 316,830 303,939 --------- --------- --------- Total cost of revenue 965,913 1,074,199 1,105,077 --------- --------- --------- Gross profit 438,839 476,746 514,443 Research and product development costs 163,286 152,702 123,269 Marketing, general, administrative and other income and expense, net 324,823 315,475 300,253 Restructuring and other charges (Note 14) 74,772 5,104 --------- --------- --------- Operating profit (loss) (124,042) 8,569 85,817 Interest expense 43,670 48,706 52,157 Interest income (54,916) (67,171) (68,552) --------- --------- --------- Income (loss) before income taxes and cumulative effect of accounting change (112,796) 27,034 102,212 Provision for income taxes (Note 8) 5,000 17,700 12,400 --------- --------- --------- Income (loss) before cumulative effect of accounting change (117,796) 9,334 89,812 Cumulative effect on prior years of change in method of accounting for income taxes (Note 8) 40,000 --------- --------- --------- Net income (loss) (77,796) 9,334 89,812 Preferred dividend requirement (Note 9) 9,805 --------- --------- --------- Income (loss) applicable to common shares $ (87,601) $ 9,334 $ 89 812 ========= ========= ========= EARNINGS (LOSS) PER COMMON SHARE Income (loss) before cumulative effect of accounting change $ (2.98) $ 0.22 $ 2.17 Cumulative effect on prior years of change in method of accounting for income taxes 0.93 --------- --------- --------- $ (2.05) $ 0.22 $ 2.17 ========= ========= ========= Weighted average common shares and equivalents 42,800 43,347 41,298 ========= ========= ========= The accompanying notes are an integral part of the consolidated financial statements. STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands of Dollars) Year Ended --------------------------------------- December 31, December 25, December 27, 1993 1992 1991 --------------------------------------- OPERATING ACTIVITIES Cash received from customers $ 1,532,183 $ 1,572,892 $ 1,589,841 Cash paid to suppliers and employees (1,446,321) (1,456,835) (1,415,976) Interest received 54,251 67,136 66,765 Interest paid (40,519) (47,751) (52,603) Income taxes paid (12,048) (28,327) (2,089) Net cash adjustment to conform year end of Datacomp (Note 2) (2,816) ---------- ---------- ---------- Net cash from operating activities 87,546 107,115 183,122 ---------- ---------- ---------- INVESTING ACTIVITIES Short-term investments, net (15,377) 40,227 (39,778) Purchase of property, plant and equipment (67,720) (106,119) (111,094) Business acquisitions, net of cash acquired (51,761) Other assets, net (6,945) (4,136) (25,484) ---------- ---------- ---------- Net cash used in investing activities (90,042) (121,789) (176,356) ---------- ---------- ---------- FINANCING ACTIVITIES Proceeds from preferred stock offering, net (Note 9) 166,479 Proceeds from common stock offering, net (Note 9) 135,362 Borrowings (repayments) under revolving credit agreements, net (19,000) (72,293) Proceeds from nonrecourse borrowings 87,508 114,935 145,985 Repayments of nonrecourse borrowings (147,647) (150,005) (200,519) Proceeds from other debt 79,740 21,320 79,331 Repayments of other debt (44,144) (27,538) (39,099) Proceeds from employee stock plans and warrants 11,468 16,126 15,509 Preferred stock dividend payments (Note 9) (9,459) Proceeds from sale of lease receivables (Note 13) 50,022 Purchases of treasury stock (5,098) ---------- ---------- ---------- Net cash from financing activities 143,945 762 64,276 Effect of exchange rate changes on cash (4,341) (4,884) (6,675) ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents 137,108 (18,796) 64,367 Cash and cash equivalents - beginning of the year 117,954 136,750 72,383 ---------- ---------- ---------- Cash and cash equivalents - end of the year $ 255,062 $ 117,954 $ 136,750 ========== ========== ========== RECONCILIATION OF NET INCOME (LOSS) TO NET CASH FROM OPERATING ACTIVITIES Net income (loss) $ (77,796) $ 9,334 $ 89,812 Cumulative effect of accounting change (Note 8) (40,000) Restructuring and other charges (Note 14) 74,772 5,104 Depreciation and amortization expense 149,891 143,605 113,899 Loss on disposal of property, plant and equipment 5,113 4,675 1,804 (Increase) decrease in accounts receivable 81,197 19,873 (14,680) (Increase) decrease in notes receivable and sales-type leases 54,605 18,524 (16,499) (Increase) decrease in inventories (62,997) 4,354 24,416 Increase in computer equipment, net (48,730) (57,532) (43,943) Increase in spare parts, net (19,599) (30,849) (17,239) (Increase) decrease in net deferred income tax asset (12,535) 578 (1,571) Increase (decrease) in accounts payable (37,113) 14,937 16,193 Increase (decrease) in accrued liabilities (5,360) (24,241) 21,635 Increase (decrease) in income taxes payable 5,487 (11,205) 11,882 Translation loss 8,069 12,062 1,025 Net cash adjustment to conform year end of Datacomp (Note 2) (2,816) Other 12,542 3,000 (5,900) ---------- ---------- ---------- Net cash from operating activities $ 87,546 $ 107,115 $ 183,122 ========== ========== ========== The accompanying notes are an integral part of the consolidated financial statements. STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (In Thousands of Dollars) The accompanying notes are an integral part of the consolidated financial statements. STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of Storage Technology Corporation and its wholly owned subsidiaries (collectively hereinafter referred to as StorageTek or the Company). Intercompany accounts and transactions have been eliminated. As further discussed in Note 2, the consolidated financial statements have been restated for all periods presented to reflect the merger with Amperif Corporation as a pooling of interests. REVENUE RECOGNITION Revenue from end-user equipment sales, including sales-type leases, is recognized at the time of acceptance by the customer, generally after installation at a customer site. Revenue from original equipment manufacturers and distributors is recognized at the time of shipment. Costs associated with post-installation equipment support are estimated and accrued at the time of the sale. Rental revenue associated with operating leases is recorded ratably over the rental period. End users of equipment sold or leased by StorageTek generally contract with the Company for equipment service which includes normal maintenance and repair or replacement of product components. Revenue from these contracts is recognized as earned and the cost of performing these activities is expensed as incurred. CASH EQUIVALENTS, SHORT-TERM INVESTMENTS AND RESTRICTED CASH Cash equivalents are short-term, highly liquid investments that are both readily convertible to cash and have remaining maturities of three months or less at the time of acquisition. Investments that do not qualify as cash equivalents are classified as short-term investments. The carrying amount of short-term investments is equal to cost, adjusted for premium or discount amortization, plus accrued interest. The carrying value of short-term investments approximates fair value. Restricted cash balances relate primarily to funds received on behalf of third parties. CAPITALIZED SOFTWARE COSTS The Company capitalized costs of $23,092,000 in 1993, $9,148,000 in 1992, and $7,486,000 in 1991 associated with acquiring and developing software products to be marketed to customers. Other assets as shown on the Consolidated Balance Sheet include unamortized software product costs of $36,068,000 as of December 31, 1993, and $20,461,000 as of December 25, 1992. Amortization is based on the greater of straight-line amortization over estimated useful lives, generally four years, or the percentage of actual revenue versus total anticipated revenue. Amortization of software costs was $7,485,000 in 1993, $6,818,000 in 1992, and $2,877,000 in 1991. DEPRECIATION AND AMORTIZATION Computer equipment, and property, plant and equipment are recorded at cost and depreciated on a straight-line basis over their estimated useful lives. Capitalized machinery and equipment leases are amortized over the estimated service lives or the periods of the leases, as applicable. Manufactured spare parts are recorded at cost and amortized over their estimated useful service lives. Goodwill, included within other assets on the Consolidated Balance Sheet, represents the excess of purchase price over fair value of net assets acquired and is amortized on a straight-line basis not exceeding 10 years. INCOME TAXES The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." See Note 8 for additional information regarding the Company's accounting for income taxes. TRANSLATION OF FOREIGN CURRENCIES The functional currency for StorageTek's foreign subsidiaries is the U.S. dollar. Accordingly, monetary assets and liabilities are translated at year- end exchange rates while non-monetary items are translated at historical rates. Revenue and expenses are translated at the average rates in effect during the year, except for cost of sales and depreciation which are translated at historical rates. Foreign currency translation adjustments, net of associated hedging results, and foreign currency transaction losses were $8,802,000 in 1993, compared to losses of $8,372,000 in 1992 and $12,321,000 in 1991. See Note 13 for information with respect to the Company's accounting policies for financial instruments utilized in its foreign currency hedging program. EARNINGS (LOSS) PER COMMON SHARE Earnings (loss) per common share is computed under the treasury stock method using the weighted average number of common shares and dilutive common stock equivalent shares outstanding during the year. The Preferred Stock (see Note 9) and 8% Convertible Subordinated Debentures (see Note 7) are not common stock equivalents and, therefore, have been excluded from the computation of earnings (loss) per common share. The Preferred Stock and 8% Convertible Subordinated Debentures presently have an anti-dilutive effect on the annual computation of fully diluted earnings per common share. RECENT PRONOUNCEMENTS In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits" which generally requires the accrual of the estimated cost of postemployment benefits provided over the related service periods of active employees. The Company provides certain severance and disability-related benefits to its employees. SFAS No. 112 is required to be adopted no later than fiscal 1994 and the Company plans to adopt the new standard in the first quarter of 1994. The Company has not finally determined the impact of adopting SFAS No. 112; however, it expects to recognize a one-time charge of between $5,000,000 and $10,000,000 as a result of the adoption of the new standard. The adoption of SFAS No. 112 will have no cash flow impact. NOTE 2 - BUSINESS COMBINATIONS AMPERIF CORPORATION In October 1993, the Company issued approximately 1,300,000 shares of StorageTek common stock in exchange for all of the outstanding common and preferred stock of Amperif Corporation (Amperif). The Company has also reserved approximately 600,000 shares for issuance in connection with Amperif's outstanding warrants and employee stock options. The merger was accounted for as a pooling of interests and, accordingly, the consolidated financial statements have been restated for all periods prior to the merger to include the operations of Amperif, adjusted to conform with StorageTek's accounting policies and presentation Merger and consolidation expenses in the amount of $5,522,000, included within restructuring and other charges on the Consolidated Statement of Operations, were recognized in 1993 in connection with the merger. Amperif designs, manufactures, markets and services high-performance, information storage and retrieval subsystems for mainframe computers. Separate pre-merger revenue and net income of StorageTek and Amperif were as follows (in thousands of dollars): Year Ended ---------------------------------------- 1993 1992 1991 ---------------------------------------- Revenue: Pre-merger StorageTek $1,065,438 $1,521,487 $1,584,904 Amperif 14,311 30,165 35,879 Merger adjustments (1,917) (707) (1,263) --------- --------- --------- 1,077,832 1,550,945 1,619,520 Post-merger 326,920 --------- --------- --------- $1,404,752 $1,550,945 $1,619,520 ========= ========= ========= Net income (loss): Pre-merger StorageTek $ (68,572) $ 15,494 $ 93,074 Amperif (21,266) (5,828) (2,342) Merger adjustments (2,983) (332) (920) --------- --------- --------- (92,821) 9,334 89,812 Post-merger 15,025 --------- --------- --------- $ (77,796) $ 9,334 $ 89,812 ========= ========= ========= EDATA In the second quarter of 1992, the Company acquired all of the outstanding equity securities of Edata Scandinavia AB (Edata) for approximately $75,000,000. The acquisition was accounted for as a purchase. Goodwill associated with the acquisition (the excess of purchase price over the estimated fair value of the net assets acquired) of $44,700,000 is included within other assets on the Consolidated Balance Sheet and is being amortized on a straight-line basis over 10 years. Edata markets and distributes equipment and systems for storage and management of large volumes of data, and for automation and control of computer centers and information networks in Belgium, Denmark, Finland, Luxembourg, the Netherlands, Norway and Sweden. XL/DATACOMP, INC. In November 1991, the Company issued approximately 3,250,000 shares of StorageTek common stock in exchange for all of the outstanding common stock of XL/Datacomp, Inc. (Datacomp). The Company also reserved approximately 450,000 shares for issuance in connection with Datacomp's outstanding employee stock options and to satisfy Datacomp's employee stock purchase plan obligations. The merger was accounted for as a pooling of interests and, accordingly, the consolidated financial statements for 1991 include the operations of Datacomp. An adjustment to accumulated deficit of $1,560,000 was made in 1991 to conform Datacomp's reporting periods with StorageTek's fiscal year. Merger expenses in the amount of $5,104,000, included within restructuring and other charges on the Consolidated Statement of Operations, were recognized in 1991 in connection with the merger. Datacomp is a full-service distributor of midrange computer systems. NOTE 3 - SALES-TYPE AND OPERATING LEASES The components of net investment in sales-type leases are as follows (in thousands of dollars): December 31, December 25, 1993 1992 --------------------------- Total minimum lease and maintenance payments $ 499,295 $ 550,201 Less: Executory costs (maintenance payments) (50,017) (41,464) -------- -------- Net minimum lease payments 449,278 508,737 Estimated unguaranteed residual values 24,879 73,206 Less: Unearned interest income (50,314) (79,705) -------- -------- 423,843 502,238 Less: Current portion (171,165) (193,078) -------- -------- $ 252,678 $ 309,160 ======== ======== Future minimum lease payments due from customers under sales-type leases and noncancellable operating leases as of December 31, 1993, are as follows (in thousands of dollars): Sales-Type Operating Leases Leases ------------------------- 1994 $210,110 $17,276 1995 155,363 10,450 1996 86,354 2,775 1997 37,431 170 1998 9,654 23 Thereafter 383 ------- ------ $499,295 $30,694 ======= ====== Of the future minimum lease payments due from customers under sales-type leases, the following amounts will be remitted under recourse and nonrecourse borrowing arrangements (see Note 7): $109,007,000 in 1994; $84,487,000 in 1995; $45,330,000 in 1996; $17,361,000 in 1997; and $4,607,000 in 1998. NOTE 4 - INVENTORIES Inventories, including material, labor and factory overhead, consist of the following (in thousands of dollars): December 31, December 25, 1993 1992 --------------------------- Raw materials $ 38,991 $ 45,060 Work-in-process 66,668 54,213 Finished goods 97,598 56,863 ------- ------- $203,257 $156,136 ======= ======= NOTE 5 - COMPUTER EQUIPMENT Computer equipment held for sale or lease to customers consists of the following (in thousands of dollars): December 31, December 25, 1993 1992 --------------------------- Equipment on-rent $40,038 $ 31,015 Equipment shipped awaiting revenue recognition 38,612 32,412 Equipment off-rent 18,674 39,854 ------ ------- $97,324 $103,281 ====== ======= NOTE 6 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following (in thousands of dollars): December 31, December 25, 1993 1992 --------------------------- Land and land improvements $ 12,160 $ 11,711 Buildings and building improvements 135,575 129,212 Machinery and equipment 525,083 495,609 -------- -------- 672,818 636,532 Less: Accumulated depreciation (366,784) (331,435) -------- -------- $ 306,034 $ 305,097 ======== ======== Machinery and equipment includes capitalized leases of $45,544,000 as of December 31, 1993, and $38,861,000 as of December 25, 1992. Accumulated depreciation includes accumulated amortization on such capitalized leases of $20,381,000 as of December 31, 1993 and $18,636,000 as of December 25, 1992. Maintenance and repairs, which are expensed as incurred, totalled $19,834,000 in 1993; $18,798,000 in 1992; and $15,210,000 in 1991. NOTE 7 - DEBT, BANKING ARRANGEMENTS AND LEASE OBLIGATIONS Long-term debt, including capitalized lease obligations, but excluding nonrecourse borrowings, consists of the following (in thousands of dollars): December 31, December 25, 1993 1992 --------------------------- 8% Convertible Subordinated Debentures due 2015 $145,645 $145,645 Recourse borrowings secured by lease commitments 60,533 9.53% Senior Secured Notes due 1996 55,000 55,000 Capitalized lease obligations 28,272 22,174 Other 7,874 22,232 ------- ------- 297,324 245,051 Less: Current portion (32,581) (18,211) ------- ------- $264,743 $226,840 ======= ======= 8% CONVERTIBLE DEBENTURES In May 1990, the Company issued $160,000,000 of 8% Convertible Subordinated Debentures due 2015 (Convertible Debentures), which are unsecured subordinated obligations of the Company and are convertible into common stock at a price of $35.25 per share. The costs incurred in connection with the offering ($4,300,000) have been included in other assets on the Consolidated Balance Sheet and are being amortized over the 25-year term of the Convertible Debentures. Interest on the Convertible Debentures is payable semiannually in arrears on November 30 and May 31. The Convertible Debentures became redeemable at the option of StorageTek beginning May 31, 1993, at a premium of 5.6%, and are redeemable at decreasing premiums thereafter through May 30, 2000. Convertible Debentures in the principal amount of $8,000,000 per annum, plus accrued interest, must be redeemed beginning May 31, 2000, through a sinking fund which provides for the retirement of 75% of the Convertible Debentures prior to their maturity on May 31, 2015. Convertible Debentures purchased by the Company in the open market and Convertible Debentures converted to common stock may be applied to the sinking fund requirements. As of December 31, 1993, the Company held Convertible Debentures in the principal amount of $14,300,000 available for sinking fund payments. The Company has reserved 4,132,000 shares of common stock for issuance upon conversion of the Convertible Debentures. The aggregate fair value of the Convertible Debentures, based on the quoted closing sales price on the New York Stock Exchange, was $158,389,000 as of December 31, 1993. RECOURSE BORROWINGS SECURED BY LEASE COMMITMENTS The Company's recourse borrowings are secured by customer lease commitments included within total assets (primarily net investment in sales-type leases -- see Note 3) and by the underlying equipment. The borrowings also provide for limited recourse to the Company in the event of a default by a customer with respect to the lease commitments. The weighted average interest rate as of December 31, 1993, related to the borrowings was approximately 7.5%. Based on the borrowing rates currently available to the Company for borrowings with similar terms and maturities, the aggregate carrying value of the recourse borrowings approximated fair value as of December 31, 1993. 9.53% SENIOR SECURED NOTES In September 1991, the Company completed a $55,000,000 private placement of 9.53% Senior Secured Notes due August 31, 1996 (the Notes), collateralized by U.S. lease and installment purchase receivables. Interest on the Notes is payable semiannually in arrears on February 28 and August 31. The Notes are redeemable at the option of the Company, in whole or in part, from time to time, at a premium which is determined based on current interest rates and the time remaining until maturity of the Notes. Under the terms of the Note agreement, the Company is required to comply with certain financial and other covenants, including restrictions on the payment of cash dividends on its common and preferred stock. The aggregate fair value of the Notes, based on the interest rates currently available for comparable notes with similar maturities, was approximately $60,100,000 as of December 31, 1993. BANKING AND CREDIT ARRANGEMENTS In March 1993, the Company entered into a $150,000,000 two-year secured multicurrency credit agreement with a group of U.S. and international banks (the Revolver). The interest rates available under the Revolver depend on the type of advance selected; however, the primary advance rate is the agent bank's prime lending rate (6% as of December 31, 1993). The total amount available under the Revolver is limited to a percentage of the Company's eligible U.S. accounts receivable and lease assets (primarily net investments in sales-type leases not previously utilized for secured borrowings). In order to obtain funds under the Revolver, the Company is required to comply with certain financial and other covenants, including restrictions on the payment of cash dividends on its common stock. There were no advances under the Revolver during 1993. Based on the amount of eligible accounts receivable and leased assets assigned to the Revolver, the Company had approximately $50,000,000 of available credit under the Revolver as of December 31, 1993. As of December 31, 1993, the Company had unused committed lease discounting lines of approximately $41,000,000 available in the United States for recourse and nonrecourse borrowings. The Company also had unused committed lease discounting lines of approximately $38,000,000 available through its foreign subsidiaries for nonrecourse borrowings. The ability to use these committed lease discounting lines is limited by the availability of lease assets which meet the credit standards of the lenders. The Company had, subject to lender credit approval, approximately $58,000,000 of lease assets available for discounting under these lines as of December 31, 1993. At the Company's option, a portion of these lease assets can be utilized for borrowings under the Revolver. SCHEDULED DEBT MATURITIES Scheduled maturities of long-term debt, including future minimum lease payments under capitalized lease obligations, but excluding nonrecourse borrowings, as of December 31, 1993, are as follows (in thousands of dollars): Total Long- Capitalized Other Term Debt Leases Debt Commitments --------------------------------------- 1994 $10,198 $ 24,206 $ 34,404 1995 9,393 23,217 32,610 1996 7,353 69,150 76,503 1997 2,773 5,675 8,448 1998 1,706 1,159 2,865 Thereafter 1,107 145,645 146,752 ------ ------- ------- 32,530 $269,052 $301,582 ======= ======= Less: Amount representing interest (4,258) ------ Present value of capitalized lease obligations (including $8,375 classified as current) $28,272 ====== NONRECOURSE BORROWINGS SECURED BY LEASE COMMITMENTS Nonrecourse borrowings incurred in connection with the financing of certain of the Company's customer lease obligations are secured by the lease commitments and by the underlying equipment. The related lease receivables are also reflected in the Consolidated Balance Sheet as accounts receivable to the extent they represent amounts due on or prior to the balance sheet date, and as part of net investment in sales-type leases for any amounts due thereafter (see Note 3). The weighted average interest rate as of December 31, 1993, related to the borrowings was approximately 9%. Based on the borrowing rates currently available to the Company for nonrecourse borrowings with similar terms and maturities, the aggregate carrying value of the nonrecourse borrowings approximated fair value as of December 31, 1993. OPERATING LEASE OBLIGATIONS StorageTek had various operating leases in effect for certain buildings, sales offices, and machinery and equipment. Rent expense was $37,086,000 in 1993; $37,539,000 in 1992; and $32,363,000 in 1991. Future minimum rental commitments required under all noncancellable operating leases with terms of one year or more are as follows: $28,243,000 in 1994; $22,428,000 in 1995; $17,769,000 in 1996; $13,178,000 in 1997; $10,761,000 in 1998; and $37,163,000 thereafter. The Company has also entered into an agreement with the French government to begin leasing in late 1994 manufacturing and engineering facilities currently under construction in France. NOTE 8 - INCOME TAXES Effective as of the beginning of fiscal 1993, the Company changed its method of accounting for income taxes to comply with the provisions of SFAS No. 109. A one-time benefit of $40,000,000 was recognized in the first quarter of 1993 as a result of the adoption of the new income tax accounting standard on a prospective basis. This benefit results largely from the requirement under SFAS No. 109 to recognize the tax benefits associated with net operating loss and tax credit carryforwards to the extent their future realization is determined, based on the weight of the available evidence, to be more likely than not. The adoption of SFAS No. 109 had no cash flow impact. Income (loss) before income taxes and cumulative effect of accounting change consists of the following (in thousands of dollars): Year Ended ------------------------------------------ December 31, December 25, December 27, 1993 1992 1991 ------------------------------------------ United States $(114,196) $(5,545) $ 50,180 International 1,400 32,579 52,032 -------- ------ ------- $(112,796) $27,034 $102,212 ======== ====== ======= The provision for income taxes attributable to income (loss) before income taxes and cumulative effect of accounting change consists of the following (in thousands of dollars): Year Ended ------------------------------------------- December 31, December 25, December 27, 1993 1992 1991 ------------------------------------------- Current tax provision (benefit): U.S. federal $ 3,200 $(2,500) $ 200 International 11,100 17,100 14,600 State 3,100 300 200 -------- ------ ------ 17,400 14,900 15,000 -------- ------ ------ Deferred tax provision (benefit): U.S. federal (4,800) 2,800 (1,600) International (4,200) 100 (1,400) State (3,400) (100) 400 -------- ------ ------ (12,400) 2,800 (2,600) -------- ------ ------ $ 5,000 $17,700 $12,400 ======== ====== ====== The provision for income taxes attributable to income (loss) before income taxes and cumulative effect of accounting change includes benefits of $1,422,000 in 1993; $4,074,000 in 1992; and $53,671,000 in 1991 from the utilization of net operating loss carryforwards as well as benefits of $7,432,000 in 1993; $11,284,000 in 1992; and $11,186,000 in 1991 as a result of the Company's Grant of Industrial Tax Exemption issued by the Commonwealth of Puerto Rico (the Tax Grant). On a per common share basis, the benefit of the Tax Grant was $0.17 in 1993; $0.27 in 1992; and $0.27 in 1991. The benefits from the Tax Grant, which expires in 2007, include reduced tax rates, as well as the ability to utilize U.S. net operating losses through 1994 to further reduce Puerto Rico tax liabilities. To the extent cumulative U.S. and Puerto Rico taxable income exceeds the U.S. net operating loss carryforwards in the future, the benefit from the utilization of U.S. operating losses will be payable to Puerto Rico. The cumulative benefit of the grant provision relating to the use of net operating losses was $14,449,000 as of December 31, 1993. The Company reported the following deferred income tax balances on its Consolidated Balance Sheet as of December 31, 1993 (in thousands of dollars): Deferred income tax assets, net of valuation allowance $52,260 Deferred income tax liabilities (8,285) ------ Net deferred income tax asset, December 31, 1993 $43,975 ====== The Company's net deferred income tax asset consists of the following as of December 31, 1993 (in thousands of dollars): Gross deferred income tax assets: Net operating loss carryforwards $ 123,844 Tax credit carryforwards 63,265 Accrued liabilities and reserves 55,314 Foreign currency translation losses 11,779 Deferred intercompany profit 11,290 Other 26,193 -------- 291,685 Less: Valuation allowance (165,456) -------- 126,229 -------- Gross deferred income tax liabilities: Investment in sales-type leases (45,979) Depreciation (24,130) Other (12,145) -------- (82,254) -------- Net deferred income tax asset, December 31, 1993 $ 43,975 ======== The valuation allowance associated with the Company's deferred income tax assets increased from $110,695,000 as of the beginning of fiscal 1993 to $165,456,000 as of December 31, 1993. The valuation allowance relates primarily to net operating loss carryforwards, tax credit carryforwards, and net deductible temporary differences. The Company evaluated a variety of factors in determining the amount of the deferred income tax assets to be recognized pursuant to SFAS No. 109, including the number of years the Company's operating loss and tax credits can be carried forward, the existence of taxable temporary differences, the Company's earnings history, the Company's near-term earnings expectations and possible reductions in the Company's net operating loss carryforwards as a result of proposed adjustments by the Internal Revenue Service to the Company's previously filed federal income tax returns. The deferred income tax provision for 1992 and the deferred income tax benefit for 1991 resulted from the recognition of transactions in different periods for financial reporting purposes than those allowed for tax purposes, and primarily relate to deferred intercompany profit and sales-type leases. StorageTek has not provided for income taxes on the cumulative undistributed earnings of its foreign subsidiaries to the extent they are considered to be reinvested indefinitely (approximately $55,264,000 as of December 31, 1993). The amount of the unrecognized deferred tax liability for these unremitted earnings was $3,144,000 as of December 31, 1993. The provision for income taxes differs from the amount computed by applying the U.S. federal income tax rates of 35% in 1993, and 34% in 1992 and 1991 to income (loss) before income taxes and cumulative effect of accounting change for the following reasons (in thousands of dollars): Year Ended ------------------------------------------ December 31, December 25, December 27, 1993 1992 1991 ------------------------------------------ U.S. federal income tax at statutory rate $(39,479) $ 9,192 $ 34,752 Increase (decrease) in income taxes resulting from: Increase (decrease) in unrecognized net operating losses and future deductions 36,989 (7,746) (47,642) Nondeductible items 10,390 4,746 2,867 Effect of Puerto Rico operations (4,936) (6,541) (5,947) State income taxes, net of federal benefits 759 378 6,603 Foreign tax rate and translation differentials 682 6,436 4,638 Restructuring of international subsidiaries 9,758 15,735 Capital loss carryover (2,368) Other, net 595 1,477 3,762 ------- -------- ------- Income tax expense attributable to income (loss) before cumulative effect of accounting change $ 5,000 $ 17,700 $ 12,400 ======= ======= ======= As of December 31, 1993, StorageTek had U.S. net operating loss carryforwards of approximately $500,000,000 which expire in the years 2000 through 2006. As a result of a change in ownership of the Company's capital stock, as defined under Section 382 of the Internal Revenue Code, the Company is limited to using approximately $106,000,000 of its operating loss carryforwards in each taxable year, with unused amounts (approximately $310,000,000 as of December 31, 1993) being added to the annual limitations in future years. Additionally, approximately $10,000,000 of the Company's net operating loss carryforwards relate to acquired losses of Amperif which are subject to substantial limitations. Approximately $31,000,000 of the Company's net operating loss carryforwards relate to tax deductions associated with stock option plans and, accordingly, the related benefit will be recognized as an adjustment to additional paid-in capital when realized. StorageTek is also subject to alternative minimum tax and, as such, has alternative minimum tax net operating loss carryforwards of approximately $267,000,000 and alternative minimum tax credit carryforwards of approximately $15,000,000. StorageTek's federal income tax returns for the years 1985 through 1987 have been examined by the Internal Revenue Service (the IRS) and the Company's federal income tax returns for the years 1988 through 1990 are currently under examination. The IRS has proposed adjustments of approximately $360,000,000. The Company agrees with approximately $70,000,000 of these adjustments. The remaining adjustments relate principally to tax accruals for post-petition interest, professional fees and other deductions associated with distributions made to implement the Company's reorganization under Chapter 11 of the U.S. Bankruptcy Code. The Company is protesting these remaining adjustments through the IRS appeals process. Although the Company believes it has meritorious legal defenses to these proposed adjustments, to the extent it is unsuccessful in sustaining these items, the Company's net operating loss carryforwards and resulting future cash savings from utilizing such carryforwards, will be reduced accordingly. NOTE 9 - SALE OF PREFERRED AND COMMON STOCK In March 1993, the Company completed a public offering of 3,450,000 shares of $3.50 Convertible Exchangeable Preferred Stock, $.01 par value (Preferred Stock), at a price of $50.00 per share. The proceeds of the Preferred Stock offering, after deducting all associated costs, were $166,479,000. Dividends on the Preferred Stock are cumulative and payable quarterly in arrears at an annual rate of $3.50 per share, when and as declared by the Company's Board of Directors. The liquidation value of each share of Preferred Stock is $50.00, plus unpaid dividends. The Preferred Stock is convertible at any time at the option of the holder, unless previously redeemed, into shares of StorageTek common stock at an initial conversion rate of 2.128 shares of common stock for each share of Preferred Stock (equivalent to a conversion price of $23.50 per share of common stock). The Preferred Stock is redeemable for cash at any time on and after March 15, 1996, in whole or in part, at the option of the Company, initially at a redemption price of $52.45 per share, and thereafter at prices decreasing ratably annually to $50.00 per share on and after March 15, 2003, plus accrued and unpaid dividends. The Preferred Stock is also exchangeable, in whole but not in part, at the option of the Company on any dividend payment date beginning March 15, 1995, for 7% Convertible Subordinated Debentures due 2008 at the rate of $50.00 principal amount of debentures for each share of Preferred Stock. The debentures contain conversion and optional redemption provisions substantially identical to those of the Preferred Stock, and are subject to a mandatory sinking fund. In May 1991, the Company completed a public offering of 3,450,000 shares of common stock at a price of $41.00 per share. The proceeds of the common stock offering, after deducting all associated costs, were $135,362,000. NOTE 10 - EMPLOYEE BENEFIT PLANS, OPTIONS AND WARRANTS EMPLOYEE STOCK PURCHASE PLAN Under the Company's 1987 Employee Stock Purchase Plan (Purchase Plan), as amended, employees may be offered the right to collectively purchase a maximum of 150,000 shares of StorageTek's common stock, plus any remaining shares from earlier offering periods, in six-month consecutive offering periods through April 30, 1995. Eligible employees may contribute up to 10% of their pay toward purchase of StorageTek common stock at a price equal to 85% of the lower of the market price on the first or the last day of each offering period. Proceeds received from the issuance of shares are credited to stockholders' equity in the fiscal year the shares are issued. The Company issued 446,699, 320,082 and 624,845 shares of StorageTek common stock under the Purchase Plan in 1993, 1992 and 1991, respectively. STOCK OPTION AND RESTRICTED STOCK PLANS As of December 31, 1993, the Company had an aggregate of 3,337,698 common shares reserved for issuance under its employee equity plans (Employee Plans). These plans provide for the issuance of common shares pursuant to stock option exercises, restricted stock awards and other equity awards. There were 502,732 shares available for grant under the Employee Plans as of December 31, 1993. Employee stock options are granted under the Employee Plans at the fair market value of the common stock on the date of grant and generally vest over three years. Options granted under the Employee Plans must be exercised no later than 10 years from the date of grant. The Company awarded a total of 139,144 and 95,338 shares of common stock under its Employee Plans in 1992 and 1991, respectively, pursuant to restricted stock agreements, at a price per share equal to par value. The restricted stock generally vests upon the participants' retirement; however, the vesting period can be accelerated if, in the Board of Directors' view, the Company achieves certain pre-established financial goals. The restricted stock may not be transferred in any manner until such time as it is vested. If a participant ceases employment prior to the time of vesting, the stock must be resold to the Company at par value. Unearned compensation, which is determined as the difference between par value and market value on the date of the award, is charged to stockholders' equity and amortized to expense over the anticipated vesting period of the stock. The Company also has a Nonemployee Director Stock Option Plan (Director Plan) under which the Company grants stock options to nonemployee directors for the purchase of an aggregate maximum of 350,000 shares of common stock. All Director Plan stock options are granted at the fair market value of the common stock on the date of grant. There were 100,000 shares available for grant under the Director Plan as of December 31, 1993. The following summarizes information with respect to options granted under the Company's Employee and Director Plans: Number of Shares Option Price Per Share ------------------------------------------ Outstanding, December 27, 1991 2,351,990 $ 0.93 - $49.00 Granted 314,370 17.28 - 75.50 Exercised (450,929) 0.93 - 36.76 Cancelled or expired (64,210) 0.93 - 49.00 --------- ---------------- Outstanding, December 25, 1992 2,151,221 0.93 - 75.50 Granted 1,065,775 17.28 - 37.63 Exercised (72,552) 0.93 - 35.51 Cancelled or expired (79,478) 0.93 - 64.25 --------- ---------------- Outstanding, December 31, 1993 3,064,966 $ 3.43 - $75.50 ========= ================ Exercisable, December 31, 1993 1,652,554 $ 3.43 - $75.50 ========= ================ WARRANTS AND DEFERRED PURCHASE RIGHTS Warrants to purchase 5,013 and 64,294 shares of StorageTek common stock were exercised in 1993 and 1991, respectively, at prices of $9.97 and $19.29 per share. In connection with the Amperif merger, the Company assumed Amperif's obligations with respect to warrants for the purchase of 59,778 shares of common stock at a price of $16.73 per share which expire in 1995, and warrants for the purchase of 324,000 shares of common stock at a price of $30.86 per share which expire in 1996. All of these warrants were outstanding as of December 31, 1993. In connection with the Edata acquisition in 1992, the Company granted deferred purchase rights for 101,000 shares of common stock with a purchase price per share equal to par value. The deferred purchase rights vest upon the attainment of certain financial goals or upon the passage of time. As of December 31, 1993, deferred purchase rights for 66,663 shares of the Company's common stock remained outstanding. EMPLOYEE PROFIT SHARING AND THRIFT PLAN Under StorageTek's Profit Sharing and Thrift Plan, StorageTek contributions are contingent upon realization of profits by the Company which, at the sole discretion of the Board of Directors, are adequate to justify a corporate contribution. No contributions from StorageTek were authorized for 1993 and 1992. StorageTek authorized contributions of $7,000,000 for 1991. NOTE 11 - STOCKHOLDER RIGHTS PLAN In 1990, the Board of Directors adopted a new Stockholder Rights Plan (Rights Plan). The Rights Plan is designed to deter coercive or unfair takeover tactics and to prevent an acquiring entity from gaining control of the Company without offering a fair price to all of the Company's shareholders. Each right would entitle the holder of the Company's common stock to purchase one one-hundredth of a share of Series B Junior Participating Preferred Stock at an exercise price of $150, subject to adjustment to prevent dilution. The rights are evidenced by the common stock certificates and will not separate from the common stock until the earlier of (i) 20 days following the date on which any person or entity acquires beneficial ownership of 15% or more of the common stock (an Acquiring Person) and the right of redemption has not been reinstated; or (ii) 10 days after a public announcement of a tender or exchange offer by any person or entity if upon consummation such person would be an Acquiring Person. Further, upon the occurrence of certain events described below, the rights generally entitle each right holder (except the Acquiring Person) to purchase that number of shares of the Company's common stock which equals the $150 exercise price of the right divided by one-half of the current market price of the common stock. Those events generally include (i) 20 days after any person or entity becomes an Acquiring Person; and (ii) if any person or entity becomes an Acquiring Person and thereafter, (a) the Company is merged with or into an Acquiring Person and the Company's common stock is changed, converted or exchanged; or (b) 50% or more of the Company's assets or earning power is sold; or (c) an Acquiring Person engages in one or more "self-dealing" transactions as described in the Rights Agreement. The Company is generally entitled to redeem the rights for $.01 per right at any time prior to the earlier of the date on which any person or entity becomes an Acquiring Person or August 31, 2000. The rights will expire on August 31, 2000, unless redeemed or exchanged earlier by the Company pursuant to the Rights Plan. NOTE 12 - LITIGATION In the second quarter of 1992, seven purported class actions were filed in the U.S. District Court for the District of Colorado against the Company and certain of its officers and directors. These actions were subsequently consolidated into a single action, and a consolidated amended complaint was filed on July 7, 1992, seeking an unspecified amount of damages. The complaint alleged that the defendants failed to properly disclose the status of development of a new product and the Company's business prospects. The complaint further alleged that the individual defendants sold shares of the Company's common stock based on material inside information, in violation of federal securities and common law. Following the court's ruling on the defendants' motion to dismiss, a ruling which dismissed several of the fraud and insider trading claims against a number of the individual defendants, the class plaintiffs filed a second, and then a third, amended complaint which renewed many of the dismissed fraud and insider trading claims and sought to extend the class period to November 9, 1992. In response to the defendants' second motion to dismiss, the court refused to extend the class period, but did not dismiss any of the claims as pleaded in the third amended complaint. The court has certified a class consisting (with certain exceptions) of those who purchased StorageTek's common stock and related securities from December 23, 1991, to August 8, 1992. Depositions of Company employees and other potential witnesses commenced in August 1993 and are expected to continue into 1994. In addition to the class action, a shareholder derivative action was filed in the second quarter of 1992 based on substantially similar factual allegations and the derivative action has been consolidated with the class action. The Company believes the suits are without merit and intends to vigorously defend against them. There can be no guarantee; however, that the cases will result in decisions favorable to the Company. In the event of an adverse decision, neither the amount nor the likelihood of any potential liability which might result is reasonably estimable. In the derivative action, any recovery would be the property of the Company. In June 1993, the Company received a subpoena from the Denver Regional Office of the Securities and Exchange Commission (the Commission) to produce certain documents in connection with the Commission's order for an investigation of possible violations of federal disclosure, reporting and insider trading requirements. The requests by the Commission relate principally to announcements and related disclosures concerning the status of development of a new product in 1992. In April 1992, Unisys Corporation (Unisys) filed a suit against Amperif and in September 1993, Unisys filed additional suits against both Amperif and the Company. All of the suits relate to patents (seven patents in all) which Unisys alleges are violated by certain Amperif and StorageTek disk products. Unisys has not specified the extent of damages it claims, but has asked the court to enjoin further infringement. On October 18, 1993, StorageTek and Amperif filed an action for declaratory relief against Unisys with respect to some of the same patents, seeking the court's declaration that the patents are not infringed and are invalid. The cases are pending in U.S. District Courts for the Districts of Pennsylvania and Colorado. On October 19, 1993, Amperif became a wholly owned subsidiary of StorageTek (see Note 2). In November 1993, Amperif and the Company moved to consolidate and transfer the Pennsylvania cases to California. On December 29, 1993, the Pennsylvania court held a hearing on the consolidation and transfer, but has not issued a decision. The Company believes that neither the Company's nor Amperif's products infringe the Unisys patents. Further, the Company believes that there are questions as to the validity of many of the Unisys patents, and that the conduct of Unisys in its dealings with Amperif may make the patents unenforceable. There can be no guarantee; however, that the cases will result in decisions favorable to the Company. In the event of an adverse decision, neither the amount nor the likelihood of any potential liability which might result is reasonably estimable. On January 24, 1994, Stuff Technology Partners II, a Colorado Limited Partnership (Stuff), filed suit in Boulder County, Colorado, District Court against the Company and certain subsidiaries. The suit alleges that the Company breached a 1990 settlement agreement which had resolved earlier litigation between the parties. The suit seeks injunctive relief and damages in the amount of $2,400,000,000. The Company believes that the claims in the suit are bound by the 1990 settlement between the Company and Stuff, the claims are without merit, and the Company intends to vigorously defend against them. The Company has not yet answered the complaint and no other proceedings have taken place. In addition, the Company is involved in various other less significant legal proceedings. The outcomes of these legal proceedings are not expected to have a material adverse effect on the financial condition or operations of the Company based on the Company's current understanding of the relevant facts and law. NOTE 13 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK A significant portion of the Company's revenue is generated by its international operations. As a result, the Company's operations and financial results can be materially affected by changes in foreign currency exchange rates. In an attempt to mitigate the impact of foreign currency fluctuations, the Company employs a hedging program which utilizes foreign currency options and forward exchange contracts. The Company utilizes foreign currency options, generally with maturities of less than one year, to hedge its exposure to exchange-rate fluctuations in connection with anticipated sales revenue from its international operations. Realized and unrealized gains and losses on the options are deferred and subsequently recognized as an adjustment to the associated sales revenue on the Consolidated Statement of Operations. The Company held foreign currency options with a face value of approximately $117,100,000 as of December 31, 1993, and $100,600,000 as of December 25, 1992. Unrealized gains, net of hedging costs, of approximately $1,400,000 as of December 31, 1993, and $5,400,000 as of December 25, 1992, existed in connection with option contracts. The Company also utilizes forward exchange contracts, generally with maturities of less than two months, to hedge its exposure to exchange-rate fluctuations in connection with monetary assets and liabilities held in foreign currencies. The carrying amounts of these forward foreign exchange contracts equal their fair value as the contracts are adjusted at each balance sheet date for changes in exchange rates. Realized and unrealized gains and losses on the forward contracts are recognized currently within marketing, general, administrative and other income and expense, net, on the Consolidated Statement of Operations as adjustments to the foreign exchange gains and losses on the translation of net monetary assets. The Company held forward foreign exchange contracts with a face value of approximately $94,200,000 as of December 31, 1993, and $110,200,000 as of December 25, 1992. The forward exchange contracts and foreign currency options do not subject the Company to risk due to exchange rate movements as gains and losses on the contracts offset gains and losses on the transactions being hedged. Further, the Company does not believe there is significant credit risk associated with these contracts as the counterparties to these contracts consist of major international financial institutions, and the Company limits the amount of the contracts it enters into with any one party. In December 1992, the Company received proceeds of $50,022,000 as a result of an agreement with a financial institution to sell, on a limited recourse basis, lease receivables. A gain of $1,678,000 was recognized in 1992 related to the sale of these receivables. As a result of the agreement, net investment in sales-type leases, as shown on the Consolidated Balance Sheet, is reported net of lease receivables remaining to be collected of $30,917,000 as of December 31, 1993, and $48,442,000 as of December 25, 1992. The Company remains contingently liable for up to $10,369,000 of the outstanding balance pursuant to the recourse provisions as of December 31, 1993. Based upon the Company's experience, no material credit risk exists under the recourse provisions of the agreement. Other financial instruments which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and trade receivables. The Company has a cash investment policy which generally restricts investments to ensure preservation of principal and maintenance of liquidity. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across many different industries and geographies. As of December 31, 1993, the Company had no significant concentrations of credit risk. NOTE 14 - RESTRUCTURING AND OTHER CHARGES In 1993, the Company recognized restructuring and other charges totaling $74,772,000. Restructuring charges, which totaled $69,250,000, principally relate to the reorganization of the Company's midrange business. The restructuring charges included the writedown of residual interests associated with net investments in sales-type leases of approximately $19,400,000; inventory writedowns of approximately $13,500,000; the writedown of goodwill associated with midrange products which are being de-emphasized or discontinued of approximately $12,800,000; and estimated severance costs of approximately $8,500,000. Merger and consolidation expenses of $5,522,000 in 1993 and $5,104,000 in 1991 were also recognized in connection with the mergers with Amperif and Datacomp, respectively. NOTE 15 - OPERATIONS OF BUSINESS SEGMENTS AND IN GEOGRAPHIC AREAS BUSINESS SEGMENTS StorageTek operates in one principal business segment - the design, manufacturing, marketing, and servicing of information storage and retrieval subsystems for high-performance and midrange computer systems, as well as computer networks. GEOGRAPHIC AREAS StorageTek operates principally in the United States, Europe, Canada, Australia and Japan. Operations in Canada, Australia and Japan individually account for less than 10% of the consolidated revenue and identifiable assets, and have been combined and shown in the table below as "Other." U.S. operating profit includes profit recognized in the United States on transfers to other geographic areas. Information regarding each geographic area on an unconsolidated basis for each of the last three years is shown below (in thousands of dollars): (1) U.S. revenue from unaffiliated customers includes international export sales to customers (principally in Europe) of $52,797,000 in 1993; $63,458,000 in 1992; and $82,363,000 in 1991. (2) General corporate expenses include merger and consolidation expenses of $5,522,000 in 1993 and $5,104,000 in 1991. Sales between geographic areas are generally priced to reflect market value and to provide an appropriate gross margin to the affiliate. Operating profit, for the purpose of this footnote, consists of total revenue less operating expenses, and excludes interest income, interest expense and general corporate expenses for all years presented, and the cumulative effect of the accounting change in 1993. Identifiable assets are those assets that are associated with the operations in each geographic area. General corporate assets are primarily cash and short-term investments not used in the operations of the individual geographic regions. NOTE 16 - QUARTERLY INFORMATION (UNAUDITED) The following quarterly results of operations for the years ended December 31, 1993, and December 25, 1992, have been restated to account for the merger with Amperif (see Note 2) as a pooling of interests (in thousands of dollars, except per share amounts): Quarter Ended 1993 ------------------------------------------------ March 26 June 25 September 24 December 31 ------------------------------------------------ Revenue $338,992 $358,503 $ 307,058 $400,199 Cost of revenue 224,505 249,935 228,407 263,066 ------- ------- -------- ------- Gross profit 114,487 108,568 78,651 137,133 Operating expenses 109,837 115,670 132,582 130,020 Restructuring and other charges 363 69,537 4,872 ------- ------- -------- ------- Operating profit (loss) 4,650 (7,465) (123,468) 2,241 Interest (income) expense, net (2,367) (2,784) (2,491) (3,604) ------- ------- -------- ------- Income (loss) before income taxes and accounting change 7,017 (4,681) (120,977) 5,845 Provision for income taxes 3,000 600 1,900 (500) ------- ------- -------- ------- Income (loss) before accounting change 4,017 (5,281) (122,877) 6,345 Cumulative effect of accounting change 40,000 ------- ------- -------- ------- Net income (loss) $ 44,017 $ (5,281) $(122,877) $ 6,345 ======= ======= ======== ======= Earnings (loss) per common share: Primary: Income (loss) before accounting change $ 0.08 $ (0.19) $ (2.94) $ 0.08 Cumulative effect of accounting change 0.92 ------- ------- -------- ------- $ 1.00 $ (0.19) $ (2.94) $ 0.08 ======= ======= ======== ======= Fully diluted: Income before accounting change $ 0.13 Cumulative effect of accounting change 0.81 ------- $ 0.94 N/A N/A N/A ======= ======= ======== ======= Quarter Ended 1992 ------------------------------------------------ March 27 June 26 September 25 December 25 ------------------------------------------------ Revenue $339,369 $395,826 $394,479 $421,271 Cost of revenue 225,241 278,815 270,755 299,388 ------- ------- -------- ------- Gross profit 114,128 117,011 123,724 121,883 Operating expenses 108,151 113,520 122,237 124,269 ------- ------- -------- ------- Operating profit (loss) 5,977 3,491 1,487 (2,386) Interest (income) expense, net (5,877) (5,016) (4,474) (3,098) ------- ------- -------- ------- Income before income taxes 11,854 8,507 5,961 712 Provision for income taxes 2,000 3,600 1,400 10,700(a) ------- ------- -------- ------- Net income (loss) $ 9,854 $ 4,907 $ 4,561 $ (9,988) ======= ======= ======== ======= Earnings (loss) per common share: Net income (loss) $ 0.23 $ 0.11 $ 0.11 $ (0.24) ======= ======= ======== ======= (a) Provision for income taxes for the quarter ended December 25, 1992, includes a charge of $9,200,000 related to taxable income earned in the first nine months of 1992. This adjustment in the fourth quarter of 1992 was necessitated by differences between the Company's forecasted and actual effective tax rate for 1992. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- FOR STORAGE TECHNOLOGY CORPORATION ---------------------------------- To the Stockholders and Board of Directors of Storage Technology Corporation In our opinion, based upon our audits and the report of other auditors, the consolidated financial statements listed in the index appearing under Item 14.(a) 1. and 2. on page 27 present fairly, in all material respects, the financial position of Storage Technology Corporation and its subsidiaries at December 31, 1993 and December 25, 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the consolidated statements of operations, of cash flows and of changes in stockholders' equity of XL/Datacomp, Inc. for the year ended December 31, 1991. These statements reflect total revenue of $333,808,000 for the year ended December 31, 1991. Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for XL/Datacomp, Inc., is based solely on the report of the other auditors. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for the opinion expressed above. As discussed in Note 8 to the consolidated financial statements, the Company changed its method of accounting for income taxes to adopt Statement of Financial Accounting Standards No. 109 in 1993. We concur with this change in accounting. PRICE WATERHOUSE Denver, Colorado February 17, 1994 REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- FOR XL/DATACOMP, INC. --------------------- To the Board of Directors of Storage Technology Corporation We have audited the consolidated statements of operations and cash flows of XL/Datacomp, Inc. and subsidiaries for the year ended December 31, 1991, and the consolidated statement of stockholder's equity for the fifteen month period ended December 31, 1991 (not presented separately herein). In connection with our audit of the consolidated financial statements, we also have audited the financial statement schedules (not presented separately herein). These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of XL/Datacomp, Inc. and subsidiaries for the periods specified above, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 4 to the Company's consolidated financial statements, the Company changed its method of accounting for income taxes in the year ended December 31, 1991. Chicago, Illinois KPMG PEAT MARWICK January 31, 1992 STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES ----------------------------------------------- SCHEDULE VIII ------------- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES ---------------------------------------------- (In Thousands of Dollars) Additions - Charged to Balance Cost of Deductions - Balance Beginning Service Spare Parts End of Year and Rental Written Off of Year --------------------------------------------------- Amortization of spare parts for customer services: For the year ended: December 31, 1993 $48,268 $20,208 $13,159 $55,317 ====== ====== ====== ====== December 25, 1992 $41,896 $20,746 $14,374 $48,268 ====== ====== ====== ====== December 27, 1991 $49,189 $14,216 $21,509 $41,896 ====== ====== ====== ====== Deductions - Accounts Additions - Receivable Balance Charged to Written Off Balance Beginning Cost and Net of End of Year Expenses Recoveries of Year --------------------------------------------------- Allowance for doubtful accounts on accounts receivable: For the year ended: December 31, 1993 $11,949 $ 7,228 $ 6,725 $12,452 ====== ====== ====== ====== December 25, 1992 $10,733 $10,987 $ 9,771 $11,949 ====== ====== ====== ====== December 27, 1991 $ 8,259 $ 4,494 $ 2,020 $10,733 ====== ====== ====== ====== STORAGE TECHNOLOGY CORPORATION AND SUBSIDIARIES ----------------------------------------------- SCHEDULE IX ----------- SHORT-TERM BORROWINGS --------------------- (In Thousands of Dollars) Weighted Weighted Weighted Average Maximum Average Average Interest Amount Amount Interest Balance Rate at Outstanding Outstanding Rate End of End of During the During the During the Category Year Year Year Year Year (a) - ----------------------------------------------------------------------------- December 31, 1993: Amounts payable to banks under credit agreements $ 0 N/A $ 4,500 $ 1,794(b) 8.5% Amounts payable to financial services company under a working capital financing arrangement $ 0 N/A $ 5,248 $ 1,921(c) 12.3% December 25, 1992: Amounts payable to banks under credit agreements $ 2,300 8.8% $49,824 $10,560(b) 7.5% Amounts payable to financial services company under a working capital financing arrangement $ 5,220 11.5% $ 5,325 $ 1,627(c) 15.9% December 27, 1991: Amounts payable to banks under credit agreements $28,814 7.3% $93,637 $34,196(b) 9.7% (a) The weighted average interest rate during the period was calculated by dividing actual interest expense for the year by the weighted average amount outstanding during the period. (b) The weighted average amount outstanding during the period was calculated based on the total of the daily balance outstanding divided by the number of days in the year. (c) The weighted average amount outstanding during the period was calculated based on the total of the month-end balances divided by 12. FORM 10-K For The Fiscal Year Ended December 31, 1993 EXHIBIT INDEX ------------- The exhibits listed below are filed as part of this Annual Report on Form 10-K: Exhibit Number - -------------- 10.17 First Amendment to the Multicurrency Credit Agreement dated as of August 6, 1993. 10.18 Second Amendment to the Multicurrency Credit Agreement dated as of September 24, 1993. 10.19 Agreement between the Company and Harris Ravine dated October 8, 1993. 11.0 Computation of Earnings (Loss) per Common Share. 21.0 Subsidiaries of Registrant. 23.1 Consent of Price Waterhouse. 23.2 Consent of KPMG Peat Marwick.

92259_1993.txt

92259_1993

1993

92259

ITEM 1.BUSINESS. ITEM 2. ITEM 2.PROPERTIES. ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ------------------------- Southern Pacific Transportation Company ("SPT" or the "Company") is a wholly- owned subsidiary of Southern Pacific Rail Corporation (formerly Rio Grande Industries, Inc.) ("SPRC"). Unless the content otherwise requires, references herein to the Company include SPT and its subsidiaries, including St. Louis Southwestern Railway Company ("SSW") and SPCSL Corp. ("SPCSL"), and references to SPRC include SPRC and its subsidiaries, including SPT and its subsidiaries and Rio Grande Holding, Inc. ("RGH") and its subsidiaries, which include The Denver and Rio Grande Western Railroad Company ("D&RGW") and its subsidiaries. References herein to SPRC prior to August 18, 1993 include SPTC Holding, Inc. ("SPTCH"), a wholly-owned subsidiary of SPRC and the parent of SPT that was merged into SPRC on such date. ------------------------- PART I ITEMS 1 AND 2. BUSINESS AND PROPERTIES GENERAL The Company transports freight over approximately 12,600 route miles of track throughout the western United States. The Company operates in 14 states over five main routes described in "--Service Territory." The Company serves most west coast ports and large population centers west of the Mississippi and connects with eastern railroads at all major gateways at Chicago, St. Louis, Kansas City, Memphis and New Orleans. The Company's rail lines reach the principal Gulf ports south from Chicago and east from the Los Angeles basin. In addition, the Company's rail lines connect with those of the D&RGW at Ogden, Utah and Herington, Kansas and together constitute continuous routes, one from the Pacific Coast through the Southwestern United States to East St. Louis and on to Chicago and the other from the Pacific Coast through the Midwestern United States to East St. Louis and on to Chicago. It interchanges with Mexican railroads at six gateways into Mexico, which is more than any other U.S. railroad. The Company's lines provide the extensive distribution network needed by its customers to deliver their products to a wide range of major industrial markets. The principal commodities hauled in its carload operations are chemicals and petroleum products, food and agricultural products, forest products (including paper, paper products and lumber) and coal. Intermodal container and trailer operations continue to be the Company's largest single traffic unit. The Company is the industry leader in the U.S. for container traffic, based on both containers originated and total container traffic handled. Nearly all of the Company's traffic either originates on or is destined to points served directly by the Company. In addition, nearly half of the Company's traffic both originates and terminates on its lines and is not interchanged with another rail carrier, thus enabling the Company to provide service without the need to coordinate the commercial and operational aspects of freight movements with other railroads. The Company was acquired by SPRC in October 1988 from Santa Fe Pacific Corporation ("Santa Fe"). In 1989 and 1990, the Company acquired access to Chicago from St. Louis and Kansas City, respectively. For the five years preceding its acquisition by SPRC, SPT had been held in trust pending the decision of the Interstate Commerce Commission (the "ICC") that denied Santa Fe's requested merger with SPT. During this period, SPT fell significantly behind other Class I railroads that were then consolidating, streamlining and strengthening their railroads. At the time of its acquisition SPT was burdened with excess, unprofitable and low density track, inefficient operation and a generally higher and less competitive cost structure than other Class I railroads. In addition to its rail business, the Company historically has received substantial cash flow from "traditional" real estate sales and leasing activities. More recently, transit corridor sales have become a dominant component of the Company's asset sales program, with the Company usually retaining operating rights over these corridors to continue freight rail service to its customers. Many of the Company's urban and intercity corridors are unique, and in turn valuable, properties in terms of their geographic composition and ready availability for transit use. Real estate sales have been in the past, and for the next several years will continue to be, necessary for the Company to meet its capital expenditure, debt service and other cash needs. Management considers the Company's extensive supply of assets available for sale to be sufficient for that purpose, although sales for 1993 declined sharply from levels for the preceding four years. The supply of properties that may be sold diminishes as sales occur and the timing of sales cannot be accurately predicted. BUSINESS STRATEGY Based on the experience gained since SPRC's acquisition of SPT, and the addition of key management personnel during the past three years, including the Company's President and Chief Executive Officer, Edward L. Moyers, who joined the Company in July 1993, the Company has developed and is implementing a strategy to improve the Company's operating results by improving customer service and increasing revenues while lowering the cost and improving the productivity of its railroad operations. Significant elements of the Company's strategy, similar to those implemented by other railroads, include the following: Cost Reductions and Operating Efficiencies The Company's cost reduction strategy is focused principally on the continued reduction of surplus employees; increased efforts to rationalize its physical plant through the sale or lease of low-density, high cost lines, the consolidation of rail yards and other facilities and the sharing of rail line and facilities with other railroads; the implementation of programs to reduce derailments, accidents and personal injuries; and the enhancement of its operating efficiency and asset utilization. . Labor Productivity. A critical element of the Company's cost reduction strategy is to lower labor expenses by continuing to improve labor productivity. From January 1, 1993 to December 31, 1993 the Company reduced the number of its employees (both labor and management) by approximately 3,525, including a reduction of approximately 2,785 employees achieved from July 1, 1993 through December 31, 1993. Revenue ton-miles per employee increased approximately 15 percent in 1993 as compared to 1992. . Locomotive Fleet Upgrades. A key to improving the Company's customer service is increasing the Company's reliability and on time performance, which have generally lagged behind competitors. To improve transit time consistency the Company plans to continue to improve the reliability and utilization of its locomotive fleet through the acquisition of new and remanufactured locomotives and an extensive program to rebuild and perform heavy repairs on locomotives it already owns. The Company has ordered and has financed through capital leases (i) 50 new locomotives, 17 of which were delivered in the last quarter of 1993 and the balance of which are to be delivered by the end of the first half of 1994, and (ii) 133 remanufactured locomotives to be delivered in 1994. The Company also has ordered an additional 100 new locomotives for delivery in 1994, of which 50 are expected to be delivered in May and June 1994. The Company expects that financing for these acquisitions will be arranged in the near future. . Operating Efficiencies. The Company has developed programs to improve the efficiency and productivity of its rail operations including the centralization of certain functions, the computerization of its operations management system and the standardization of certain operating procedures. In November 1993, the Company and Integrated Systems Solutions Corporation ("ISSC"), a subsidiary of International Business Machines Corp. ("IBM"), entered into an agreement under which ISSC will handle all of the Company's management information services ("MIS") functions. Outsourcing MIS is expected to reduce the Company's MIS costs while improving the Company's information systems. In addition, the Company is taking steps to implement more scheduled train operations. The Company's intermodal services were operating on a scheduled system during 1993, and a scheduled system of operations was implemented for moving most of its carload traffic on its five major corridors by the end of March 1994. . Plant Rationalization. Through the rationalization of physical plant, which involves disposition (by sale, lease or abandonment) of low- density, high cost branch lines and concentration on core routes, the Company expects to reduce on-going operating costs. At January 1, 1993, the Company had identified approximately 2,300 miles of branch lines for disposition, of which 833 miles were sold, leased or abandoned as of December 31, 1993. The Company will continue in its efforts to dispose of the balance of these branch lines and will continue to identify additional properties, including other branch lines, rail yards and terminals, that can be made available for sale, lease or abandonment. The Company is also taking steps to identify opportunities to share rail line and facility capacity with other railroads. In addition, the Company has instituted a program to eliminate unnecessary double track and reuse the rails and ties to reduce the Company's maintenance of way costs. . Improved Safety Record and Reduced Personal Injury. In 1992 the Company implemented expanded safety programs designed to reduce accidents and personal injuries. The Company believes the initiatives it has undertaken, including enhanced employee safety education and training programs, increased use of protective equipment, the implementation of improved standardized operating procedures and the establishment of safety improvement goals for which managers are held accountable, should enable it to reduce the incidence of injury and thereby better contain future cost increases. Marketing Efforts The Company seeks to capitalize on the strategic advantages of its route structure, which provides access for service between many key industrial centers, eastern gateways and Mexico, to serve customers in commodity areas such as chemicals and forest products and in intermodal transport. In its intermodal business, the Company has long-standing relationships and multi-year contracts and other shipping arrangements with major steamship companies which use the Company's west coast intermodal facilities and has established marketing arrangements with premier nationwide truckload companies. The Company is placing additional emphasis on attracting new business in Mexico and Canada and adding business to specific routes where carload capacity is not fully utilized. The Company believes these efforts will benefit to some extent from the recent passage of the North American Free Trade Agreement ("NAFTA"). The Company has implemented programs to improve its customer service and responsiveness including the establishment of centralized transportation and customer service centers and increased training and standardized procedures. Customer Service Fundamental to the Company's business strategy to increase revenues is improving customer services. Through the quality management system implemented in 1991, the Company has identified specific areas for improvement and continues to benchmark the Company's performance against the industry leader in each area. The quality improvement programs include detailed annual objectives together with monthly cross functional management reviews and ongoing performance appraisals. A critical element in improving the Company's customer service is increasing the Company's reliability and on-time performance, which have generally lagged behind those of its competitors. The locomotive improvement initiative and efforts to improve the efficiency of the Company's terminal operations are intended to improve the Company's transit time consistency. The Company is continuing a multi-year program implemented in 1991 to refurbish approximately 9,000 railcars. Since 1991 the Company has almost doubled the number of customer service representatives, increased training and standardized procedures, and organized its customer service efforts to serve the needs of specific customer groups. Investment in Plant and Equipment A key element of the Company's strategy is the continued investment in its plant and equipment in order to enhance its long-term operating performance. The condition of the physical plant plays an important role in transit time reliability. The Company believes its physical plant is in excellent condition as a result of the significant investments it has made during the past decade. Operations at the Company's expanded and upgraded Burnham locomotive repair facility in Denver, Colorado will have a substantial role in the Company's locomotive upgrade program. In 1993, a total of 53 locomotives were rebuilt and 273 locomotives underwent heavy repairs, 53 and 166 of which, respectively, were completed at Burnham. Through an increase in the number of crew shifts and personnel and improved operating efficiencies, management believes that the Burnham facility will be in a position to rebuild or perform heavy repairs on up to 300 locomotives a year as part of an ongoing scheduled maintenance program. The Company has embarked on rail car refurbishment and purchase and lease programs designed to improve the efficiency and reliability of the Company's rail car fleet, as well as meet the specialized needs of its customers. The Company has an agreement with a leading rail car manufacturer to refurbish approximately 9,000 rail cars and lease them back to the Company or third parties under a full maintenance lease agreement. From 1990 through 1993, approximately 5,700 cars were refurbished, with the balance of the program to be completed in 1994 and 1995. To complement its rail car refurbishment program, the Company purchases and leases rail cars on an ongoing basis. In 1993, the Company leased 345 aluminum coal cars, 177 steel coil flatcars, 30 double stack intermodal cars (with an additional 70 to be delivered in 1994) and approximately 125 specialized cars for various uses. Asset Sales A key component of the Company's strategy has been and will continue to be the sale of assets non-essential to its railroad operations. The Company possesses sizeable holdings that fall into two distinct types: "transit corridors" and "traditional" real estate. Each type of property has significant value for different classes of buyers. Historically, the Company has received substantial cash flow from "traditional" real estate sales and leasing activities involving industrial and commercial properties located in developed areas on the Company's system. Many of these properties are targeted for sale to fit the specific purpose of potential buyers, such as locating a facility near a customer or supplier or taking advantage of the availability of transportation service, while others are suited for large scale industrial or commercial development. More recently, transit corridor sales have become a dominant component of the Company's asset sales program. The Company expects that increasing highway congestion and other transportation problems will continue to create demand for both passenger corridors and, to a lesser extent, consolidated freight corridors and facilities. The Company has substantial remaining property which it is in the process of selling, preparing to sell or holding for an appropriate time to sell. In addition, the Company continues to release property from its rail business and has a substantial portfolio of leased properties. CAPITAL AND DEBT TRANSACTIONS On August 17, 1993 SPRC closed the offering and sale of 30,783,750 shares of common stock and issued and sold $375 million principal amount of 9 3/8 percent Senior Notes due 2005. In connection with the foregoing transactions, the Company issued 200 shares of common stock for total consideration of $445.5 million from SPRC. The proceeds from this transaction were used to repay $169 million outstanding under the SPT Term Loan, to purchase $107.7 million of D&RGW property including principally the Burnham locomotive repair facility and certain non-operating properties, to purchase for $99.1 million equipment operated pursuant to operating leases, to pay fees and expenses of $3.8 million and for general corporate purposes. In addition, as part of the foregoing transactions, the Company entered into a $200 million three-year unsecured credit agreement (the "Credit Agreement") replacing its then existing secured bank credit facility. On March 2, 1994, SPRC closed an offering of 25,000,000 shares of common stock. In connection with this transaction, the Company issued 150 shares of common stock for consideration of $294.5 million from SPRC. The proceeds were used to repay the $175 million then outstanding balance on the Credit Agreement and to purchase $118.9 million of D&RGW rail properties. The proceeds of the purchase from D&RGW were used to repay the amounts outstanding under the RGH credit facilities. SERVICE TERRITORY The Company's routes and service territory are briefly described below. Central Corridor Route. The Central Corridor Route links northern California and the Pacific Northwest with the nation's heartland, traversing the Rocky Mountain states (via the D&RGW), Kansas, Missouri and Illinois. The eastern end of this route reaches the key gateway cities of Kansas City, St. Louis and Chicago. This route handles a diverse mix of traffic including eastbound forest products, perishables and processed foods as well as significant volumes of finished automobiles and other manufactured goods. Pacific Coast Route. This north-south route is the most direct and efficient rail line connecting the forest product resource base of the Pacific Northwest with the major consuming markets in California and Arizona. The Company enjoys a strong position in this key corridor. It is the only railroad with operations which extend from the Oregon border through the state of California to Mexico. Sunset Route. The Company's Sunset Route is well-positioned as the shortest, most direct line from the Los Angeles Basin to Houston and other Gulf Coast ports. As the only single-line rail carrier in the Southern Corridor between Los Angeles and the key eastern gateways of Memphis and New Orleans, this route is favored by international container shippers and carload shippers alike. This route structure advantage creates an excellent fit with the Company's strong presence in carload originations of chemicals and plastics in the Gulf region. Golden State Route. This route connects Southern California and Arizona with the industrial midwest and the major rail gateways of Kansas City, St. Louis and Chicago. A wide range of products is handled in the corridor including intermodal, metals and ores, agricultural products and miscellaneous manufactured products. Mid-America Route. The Mid-America Route (also known as the "Cotton Belt Route") links the petrochemical producing region along the Gulf of Mexico with industrial users and consuming markets in the midwest and northeast. The Cotton Belt serves the cities of Dallas/Ft. Worth, Shreveport, Memphis and St. Louis. Mexico. The Company serves Mexico through interchanges with Mexican railroads at six gateways in California, Texas and Arizona. RAILROAD OPERATIONS The following table sets forth certain freight and operating statistics relating to the Company's rail operations for the periods indicated. The operating ratios show consolidated operating expenses expressed as a percentage of operating revenues. The indicated increases in revenue ton-miles and carloads in part reflect implementation in 1992 and 1993 of the Company's business strategy. The decrease in revenue per ton-mile evidences the intense competitive pressures under which the Company operates, particularly those affecting its intermodal activities. - -------- (1) Includes intermodal carloads with an assumed two containers per carload. Intermodal carloads hold from two to ten containers. (2) Includes a special charge of $270.0 million. The operating ratio excluding the special charge would have been 103.3%. As the results in the table below show, crew size reductions on Company lines and efforts initiated in 1992 and continued in 1993 to rehabilitate and upgrade the Company's locomotive fleet and improve locomotive utilization have resulted in increased labor productivity. In addition to improvements in labor productivity, the Company's initiatives in rehabilitating and upgrading the quality of its locomotive fleet and improving locomotive utilization are also intended to achieve improvements in fuel efficiency. The following table provides information concerning the Company's diesel fuel consumption for the periods indicated. Improvements in labor productivity and overall efficiency of operations have not translated directly into operating ratio decreases because revenue per ton- mile has been affected by continued pressure for lower rates, increased competition for new traffic and a shift in traffic mix from automotive and lumber products to traffic that historically generates lower rates on a revenue per ton-mile basis. In addition, the 1993 midwest flooding adversely affected the operating ratio. TRAFFIC The Company's marketing strategy is implemented by business development groups, each of which is organized to serve a particular customer or commodity base. The Company seeks to maintain and enhance its competitive position by tailoring its service capabilities to fit each customer base in terms of equipment availability, loading facilities, scheduling and contract terms. In 1993, the largest five shippers accounted for less than 16 percent of the Company's gross freight revenues, with no shipper providing more than five percent of such revenue. Set out below is a comparison of volumes and gross freight revenues (before contract allowances and adjustments) by commodity groups in 1993. A more detailed discussion of the traffic generated by each group follows the table. Intermodal. The intermodal freight business consists of hauling freight containers or truck trailers by a combination of water, rail and motor carriers, with rail carriers serving as the link between motor carriers and between ports and motor carriers. Intermodal traffic accounted for $706.4 million of gross freight revenues for 1993 or 27.4 percent of total gross freight revenues. The Company's intermodal revenues are derived in large part from goods produced in the Pacific Rim and shipped by rail from west coast ports to east coast markets. This traffic is carried on the Company's lines from its terminals at Portland, Oakland or Los Angeles/Long Beach to Chicago, St. Louis, New Orleans or Houston, or, through connecting carriers, beyond to the U.S. eastern seaboard. Chemical and Petroleum Products. The Company transports a wide range of industrial chemical and plastic products, which constitute the primary commodity and product groups included in this traffic. Total chemical and petroleum products accounted for $598.0 million of gross freight revenues for 1993 or 23.2 percent of total gross freight revenues. Most of the traffic originates within Texas, where the Company directly serves chemical and plastics plants. The Company's routes enable it to transport these products from Texas directly to end-user markets on the west coast and through interchanges at major gateways to end-user markets on the east coast. Food and Agricultural Products. Grain and grain products constitute the primary commodity groups included in this traffic. Total food and agricultural products accounted for gross freight revenues of $352.9 million for 1993 or 13.7 percent of total gross freight revenues. The Company primarily receives, rather than originates, shipments of grain and grain products for delivery to feed lots and poultry farms located along its routes. It also is a major transporter of grain products to Mexico. Shipper demand is affected by competition among sources of grain and grain products as well as price fluctuations in international markets for key commodities. Other food and consumer goods included in this traffic tend to be more stable flows from sources in California to consumer markets in the eastern part of the United States. Forest Products. This traffic includes lumber stock, plywood and various paper products. It accounted for $362.8 million of gross freight revenues for 1993 or 14.1 percent of total gross freight revenues. Most of the traffic originates in Oregon and Northern California. However, certain product sources in the Pacific Northwest have been adversely affected by environmental concerns. In response, the Company is developing alternative Canadian sources as well as developing a significant presence in the market as a transporter, through interchange at eastern gateways, of lumber and paper products from the southeastern United States to end-user markets in the western United States. The transportation market for lumber is affected by housing starts and remodeling activity, while the transportation market for paper products is driven by end-user demand for packaging and newsprint. Coal. Coal accounted for gross freight revenues of $100.2 million for 1993 or 3.9 percent of total gross freight revenues. The traffic is subject to intense competition from other coal sources, particularly the Powder River Basin in Wyoming. Metals and Ores. Metals and ores accounted for $199.6 million of gross freight revenues for 1993 or 7.7 percent of total gross freight revenues. This traffic includes both ferrous and non-ferrous metals and is concentrated on the origination of shipments from copper mines and smelters in Arizona and steel mini-mills in the West. These transportation markets are sensitive to end-user demand for automobiles, appliances and other consumer goods with substantial metal components. The markets also are affected by commodity prices in international markets and subject to the substitution of imported metals. Other. The traffic generated by the business development groups discussed above amounted to approximately 90.0 percent of the Company's gross freight revenues for 1993. Other commodity and product groups included in the Company's traffic mix include automobiles, automotive parts, construction materials, non- metallic minerals and government traffic. All are subject to fluctuations in end-user demand and competition from other railroads and motor carriers. Mexico. The Company's Mexico Group, headquartered in Houston, serves as a marketing and service link between the Company's business development groups and markets in Mexico. The Company maintains a strong working relationship with FNM. Approximately $213.7 million of the Company's gross freight revenues for 1993 or 8.3 percent of total gross freight revenues were attributable to shipments to and from Mexico. The Company works closely with FNM's "El Maquiladora" train between Ciudad Juarez and Chihuahua. FNM and the Company are working on establishing through rates for carload shipments of selected commodities through all six of the gateways to Mexico served by the Company. PHYSICAL PLANT AND EQUIPMENT Roadway, Yards and Structures. At December 31, 1993, the Company had approximately 19,500 miles of track in operation, consisting of approximately 12,580 miles of first main track (route miles) and approximately 6,940 miles of additional main track, passing track, way switching track and yard switching track. Route miles include operating rights on 1,787 miles of track owned by other railroads. Sales and abandonments are intended to increase the density (gross ton-miles per route mile operated) of the Company's railroad system and eliminate maintenance costs for underutilized track. Principal railroad yard facilities owned by the Company are located at Eugene, Oregon; Sacramento, Roseville, Oakland, Los Angeles and West Colton, California; Houston, Texas; Pine Bluff, Arkansas; and Kansas City, Kansas. As part of its effort to rationalize operations, the Company is identifying and assessing opportunities for consolidation of its railroad yard facilities. In August 1993, the Company acquired the Burnham locomotive repair facility in Denver, Colorado from the D&RGW. Equipment. At December 31, 1993, the Company owned or leased equipment described in the table below. The table excludes equipment held under short- term leases. At December 31, 1993 there were 295 locomotives subject to short- term leases. At December 31, 1993, there were approximately 3,850 non- serviceable freight cars in storage, which included approximately 1,000 freight cars awaiting sale to a third party for rehabilitation and leaseback, 750 previously leased freight cars awaiting return to the lessor, 775 freight cars scheduled for repair and the remainder awaiting retirement. In addition to the locomotive program described below, the Company has embarked on rail car refurbishment and purchase and lease programs designed to improve the efficiency and reliability of the Company's rail car fleet, as well as meet the specialized needs of its customers. The Company has an agreement with a leading rail car manufacturer to refurbish approximately 9,000 rail cars and lease them back to the Company or third parties under a full maintenance lease agreement. From 1990 through 1993, approximately 5,700 cars were refurbished, with the balance of the program to be completed in 1994 and 1995. To complement its rail car refurbishment program, the Company purchases and leases rail cars on an ongoing basis. In 1993, the Company leased 345 aluminum coal cars, 177 steel coil flatcars, 30 double stack intermodal cars (with an additional 70 to be delivered in 1994) and approximately 125 specialized cars for various uses. The Company also has an extensive program to enhance the quality of the locomotives it already owns. The Company plans to rebuild 207 locomotives and perform heavy repairs on 93 locomotives in 1994, of which all 207 locomotives are expected to be rebuilt and 41 locomotives are to undergo heavy repairs at Burnham. Thereafter, in order to maintain high locomotive availability, the Company plans to rebuild or perform heavy repairs on approximately 300 locomotives each year at its Burnham facility as part of an ongoing scheduled program to rebuild and perform heavy repairs on the Company's locomotive fleet. Pending the acquisition (through capital and operating leases and by purchase) of new and remanufactured locomotives, the Company has substantially increased the number of locomotives it leases on a short-term basis in order to meet the anticipated demands of its customers. Capital Expenditures and Maintenance. Improvement and ongoing maintenance of roadway, structures and equipment are essential components of the Company's efforts to improve service and reduce operating costs. The Company has made the following railroad capital expenditures (exclusive of capital leases) in order to maintain and improve train service (in millions of dollars): CAPITAL EXPENDITURES - -------- (1) Excludes equipment previously under operating leases purchased with $65.3 million of the proceeds of capital and debt transactions ($30.1 million for locomotives and $35.2 million for freight cars). Also excludes $107.7 million of D&RGW property purchased by the Company in 1993 with proceeds provided to the Company in connection with the SPRC Common Stock and Debt Transactions. The Company's capital expenditures for railroad operations for 1994 are expected to be approximately $230 million (exclusive of capital leases) including $159 million for roadway and structures and $71 million for railroad equipment and other items. In addition, in connection with the recent decision to consolidate the Company's dispatching, crew calling and other operations, the Company expects to incur approximately $30 million of capitalized costs for facility improvements and communication equipment. The Company has ordered and has financed through capital leases 50 new locomotives, 17 of which were delivered in the last quarter of 1993 and 33 of which will be delivered by the end of the first half of 1994, and 133 remanufactured locomotives to be delivered in 1994. These 183 locomotives will be financed by capital leases (which are expected to have a total present value of minimum lease payments of approximately $131 million) and therefore are not included in the 1994 capital expenditure budget. The Company also has ordered an additional 100 new locomotives for delivery in 1994 at a cost of approximately $135 million (which amount also is not included in the 1994 capital expenditure budget because final determination regarding the method of financing (e.g. capital lease or purchase) has not been made). The Company acquired 1,651 freight cars in 1993 under capital leases with a total present value of minimum lease payments of approximately $43 million and expects to acquire more by capital lease in 1994. The following table shows the Company's expenses for ongoing maintenance and repairs of roadway and structure and railroad equipment (including administrative and inspection costs) for the periods indicated (in millions of dollars): MAINTENANCE EXPENDITURES TRANSIT CORRIDOR AND REAL ESTATE SALES The disposition of urban and intercity transit corridors and surplus real estate, mostly in metropolitan areas along the Company's rights of way, is a major component of the Company's business strategy and is conducted as a part of the Company's ordinary course of business. While SPT historically has sold property not required for its core transportation operations, the Company's new management aggressively markets a large portfolio of properties that are classified generally into two distinct types: "transit corridors," which are typically sold to public agencies, and "traditional" real estate, which is typically sold to different groups of potential buyers. The Company had gains from the sale of property and real estate of $24.5 million, $301.3 million and $469.8 million in 1993, 1992 and 1991, respectively. Transit Corridors. The Company's sales efforts focus particularly on, and most of the proceeds since January 1, 1989 resulted from, the sale of transit corridor properties that consist of the Company's rights of way and related tracks and rail stations that provide a natural corridor over which a metropolitan, regional or other geographic area can establish and operate public transportation systems or consolidated freight corridors (for use by more than one railroad). Many of the Company's urban and intercity corridors are unique, and in turn valuable, properties in terms of their geographic composition and ready availability for transit use. The Company expects that increasing highway congestion and other transportation problems will continue to create demand for both passenger corridors and, to a lesser extent, consolidated freight corridors and facilities. The Company usually retains freight operating rights over these corridors to continue rail service to its customers. The Company obtains other benefits as a part of these sales, such as reduced ongoing maintenance costs for the lines and creating higher traffic density on substitute lines. The Company has identified a number of additional urban and intercity line sale opportunities which it will pursue as part of its normal course of business. Past sales include the Los Angeles County Transportation Commission's purchase of over $400 million of SPT's property and the Peninsula Corridor Joint Powers Board's purchase of SPT's Peninsula Corridor for approximately $220 million, with an additional $110 million of property covered by purchase options. The funding to purchase transit corridors often comes through either accumulated funds from past taxes or new bond issues. Recent federal and some state legislation is encouraging development of public transit lines by, among other things, creating an awareness on the part of local, state and regional entities of the availability of funds and the opportunities for projects. The timing of corridor sales is difficult to predict and varies from period to period depending on market conditions at the time, differences or delays in targeted or scheduled sales dates and other factors, such as political considerations that are typically involved in negotiations with public agencies. As a result of these and other variables, an effective program for the sale of the Company's inventory of transit corridors and other facilities involves patient and careful work with city and county governments, relevant state agencies and various interested local community organizations. In the future, in order to facilitate sales or otherwise enhance values of transit corridors and other facilities, the Company may form joint ventures with private partners or public entities or engage in other innovative transactions. Traditional Real Estate. In addition to transit corridors, the Company sells traditional real estate that consists principally of industrial and commercial properties located in developed areas on the Company's system. Many of these properties are targeted for sale to fit the specific purpose of potential buyers, such as locating a facility near a customer or supplier or taking advantage of the availability of transportation services, while others are suited for large scale industrial or commercial development. The Company also owns buildings and other facilities that can be made available for sale or other disposition as the Company further rationalizes its operations. The Company's supply of properties includes several thousand parcels that are available or could be made available for sale within the next few years (without including properties currently leased by the Company to tenants). In order to enhance the value of certain properties and facilitate their disposition, the Company has in the past and may in the future participate with others in the development of such properties by contributing the property and funding to joint ventures or other entities, participating in sale and leaseback arrangements and engaging in other transactions that do not involve immediate cash proceeds. EMPLOYEES AND LABOR Labor and related expenses accounted for approximately 40 percent of the Company's railroad operating expenses in 1993. At December 31, 1993, the Company employed 16,894 persons, which represents a reduction of approximately 3,525 from January 1, 1993 (including a reduction of over 2,785 employees achieved from July 1, 1993 through December 31, 1993). SPRC expects to further reduce the number of its employees (both labor and management) by approximately 900 employees through 1994 (a substantial portion of which will come from the Company), subject to certain temporary increases from time to time. These reductions resulted from attrition and voluntary separations, severance, early retirement programs and furloughs. At December 31, 1993, approximately 86 percent of the Company's railroad employees were covered by collective bargaining agreements with railway labor organizations that are organized along craft lines, where employees are grouped together by job and historical practice. Historically, many collective bargaining agreements in the railroad industry have been negotiated on a nationwide basis with the national railways represented by a bargaining committee. Labor relations in the railroad industry are subject to extensive governmental regulation under the RLA. The most recent national collective bargaining agreements with the major railway labor organizations and the railroads, including the Company, expired in 1988, and negotiations failed to resolve the wage and work rule issues. After various presidential and legislative actions in 1991, because of its constrained financial condition, the Company was authorized to negotiate separately with certain of its employee unions, rather than on a nationwide basis with the railroads being represented by a bargaining committee, as is typically the case. These negotiations resulted in wage rates that are lower than the national rates for most of the Company's union employees and relieved the Company of the requirement to make certain lump sum payments to employees. These concessions represent a substantial savings to the Company in terms of the labor costs it would have otherwise incurred. In total, new agreements covering over 15,400 union employees of SPRC have been reached. In addition, the Company was able to avoid the establishment of reserve boards (employees who are paid a percentage of salary but stay at home awaiting recall) on all of the Company's lines except the Western Lines, in connection with reductions in its train crew size from three to two. On November 16, 1993 the Company's employees ratified a new four-year labor agreement with the United Transportation Union, which represents approximately 2,300 trainman and switchmen on the Company's Western Lines. The agreement provided for a reduction of 210 surplus employees, the elimination of the reserve board for the Western Lines, and a wage freeze through the end of 1997. As a result, the Company became the only Class I railroad without reserve boards for any of its lines. Also in November 1993, the Company withdrew from the National Railway Labor Conference, indicating it would negotiate wage and work-rule agreements separately from any nationwide negotiations conducted by other Class I railroads. In total, new agreements covering all but approximately 150 union employees of the Company have been reached, most of which are open for modification in 1995, except that the agreement related to employees on the Company's Western Lines is open for modification in 1998. The Company will be required to renegotiate its labor agreements at those times. Wages for approximately half of the Company's employees covered by these new agreements (other than the agreement related to employees on the Company's Western Lines) are required to return to wage levels prevailing under nationwide railway collective bargaining agreements in 1995. Wages for the other employees covered by the new agreements (including the Western Lines) do not require restoration to national wage levels and will be subject to resolution in the next round of negotiations scheduled to begin in late 1994 (1997 for the Western Lines). No assurance can be given as to the terms of any of the Company's new agreements. In addition, all of the Company's labor agreements (except for the agreement related to employees on the Company's Western Lines) provide for cost of living increases on a semi-annual basis beginning July 1, 1995. The additional cost to the Company of these automatic increases could be substantial. In 1992, the Company completed the reduction of all through freight train crew sizes to an engineer and one conductor (instead of an engineer and two or three train service employees) on all of its lines. Through arbitration the Company was also able to settle certain issues relating to surplus employees, resulting in, among other things, the Company's exemption from the establishment of reserve boards on all lines except the Western Lines. As part of the Company's labor agreement relating to the Western Lines entered into in November 1993, the Company is now exempt from the establishment of reserve boards on all of its lines. As a result of its arbitration efforts and its recent labor agreement with respect to the Western Lines, 307 employees accepted voluntary severance effective April 1992 and an additional 210 employees accepted voluntary severance effective by the end of 1993, at an aggregate cost to the Company of approximately $37 million. Under the RLA, labor agreements are renegotiated when they become open for modification, but their terms remain in effect until new agreements are reached. Typically neither management nor labor is permitted to take economic action until extended procedures are exhausted. Railroad industry personnel are covered by the Railroad Retirement Act ("RRA") instead of the Social Security Act. Employer contributions under the RRA are currently substantially higher than those under the Social Security Act and may rise further because of the increasing proportion of retired employees receiving benefits relative to the number of working employees. Railroad industry personnel are also covered by the Federal Employer's Liability Act ("FELA") rather than by state workers' compensation systems. FELA is a fault-based system, with compensation for injuries settled by negotiation and litigation. By contrast, most other industries are covered under state- administered no-fault plans with standard compensation schedules. GOVERNMENTAL REGULATION The Company is subject to environmental, safety, health and other regulations generally applicable to all businesses. In addition, the Company, like other rail common carriers, is subject to regulation by the ICC, the Federal Railroad Administration, state departments of transportation and some state and local regulatory agencies. The ICC has jurisdiction over, among other things, rates charged by rail carriers for certain traffic movements, service levels, car rental payments and issuance or guarantee of railroad securities. It also has jurisdiction over the situations and terms under which one railroad may gain access to another railroad's traffic or facilities, extension or abandonment of rail lines, consolidation, merger or acquisition of control of rail common carriers and of other carriers by rail, and labor protection provisions in connection with the foregoing. Its power to exercise its jurisdiction is limited in certain circumstances. The Federal Railroad Administration has jurisdiction over railroad safety and equipment standards. State and local regulatory agencies also have jurisdiction over certain local safety and operating matters and these agencies are becoming more aggressive in their exercise of jurisdiction. State legislatures also recently have enacted new laws that are intended to regulate railroads more extensively. Government regulation of the railroad industry is a significant determinant of the competitiveness and profitability of railroads. Deregulation of certain rates and services under the Staggers Act has substantially increased the flexibility of railroads to respond to market forces, while the deregulated environment has resulted in highly competitive and steadily decreasing rates. Various interests have sought and continue to seek reimposition of government controls on the railroad industry in areas deregulated in whole or in part by the Staggers Act. Additional regulation, changes in regulation and re- regulation of the industry through legislative, administrative, judicial or other action could materially affect the Company. COMPETITION The Company's business is intensely competitive, with competition for freight traffic coming from other major railroads and motor carriers depending upon the particular market served. Principal railroad competitors include the Union Pacific Railroad Company ("Union Pacific") in the central corridor and The Atchison, Topeka and Santa Fe Railway Company ("ATSF") in the southern corridor. Competition with other railroads and modes of transportation is generally based on the rates charged, as well as the quality and reliability of the service provided. Some rail competitors have substantially greater financial and other resources than the resources of the Company. This factor and other competitive pressures have resulted in a downward pressure on rates. In addition, the consolidation in recent years of major western rail systems has resulted in particularly strong competition in the service territory of the Company among the Company's rail system, Union Pacific, ATSF and the Burlington Northern Railroad Company ("BN"). Further consolidation of its rail competitors could adversely affect the Company's competitive position. For example, such further consolidation could result from the acquisition of control of the Chicago and North Western Holdings Corp. by the Union Pacific if its pending application is approved by the ICC. Continuing competitive pressures and declining margins could have a material adverse effect on the Company's operating results. Certain segments of the Company's freight traffic, notably intermodal, face highly price sensitive competition from trucks, although improvements in railroad operating efficiencies are tending to lessen the truckers' cost advantages. Trucks are not obligated to provide or to maintain rights of way and they do not have to pay real estate taxes on their routes. In recent years, the trucking industry diverted a substantial amount of freight from the railroads as truck operators' efficiency over long distances increased. Because fuel costs constitute a larger percentage of the trucking industry's costs, declining fuel prices disproportionately benefit trucking operations as compared to railroad operations. Truck competition has also increased because of legislation removing many of the barriers to entry into the trucking business and allowing the use of wider, longer and heavier trailers and multiple trailer combinations in many areas. While deregulation of freight rates under the Staggers Act has enhanced the ability of railroads to compete with each other and alternate forms of transportation, the resulting intense competition has pushed rates downward. In addition, changes in the structure of governmental regulation could significantly affect the Company's competitive position and profitability. The railroad industry in general is susceptible to changes in the economic conditions of the industries and metropolitan areas that produce and consume the freight they transport. Because the end users of most of the freight shipped by the Company are primarily industrial and home consumers, and because the Company lacks a single large commodity base (such as grain or coal), changes in general economic conditions particularly affect the Company's operating results. ENVIRONMENTAL MATTERS The Company's operations are subject to extensive federal, state and local regulation under environmental laws and regulations concerning, among other things, emissions to the air, discharges to waters and the generation, handling, storage, transportation, treatment and disposal of waste and other materials. Inherent in the railroad operations and the real estate ownership and sales activity of the Company is the risk of environmental liabilities as a result of both current and past operations. The Company regularly transports chemicals and other hazardous materials for shippers, as well as using hazardous materials in its own operations. Environmental liability can extend to previously owned properties, leased properties and properties owned by third parties, as well as properties currently owned and used by the Company. Environmental liabilities can be asserted by adjacent landowners or other third parties in toxic tort litigation. Also, the Company has indemnified certain property purchasers as to environmental contingencies. In addition to costs incurred on an ongoing basis associated with regulatory compliance in its businesses, the Company may have environmental liability in three general situations. First, it might have liability for having disposed of wastes at waste disposal sites that are believed to pose threats to the public health or the environment. CERCLA imposes liability, without regard to fault or the legality of waste generation or of the original disposal, on certain classes of persons, including the current and certain prior owners or operators of the disposal site and persons that arranged for the disposal or treatment of hazardous substances found at the site at which problems are alleged to exist. CERCLA also authorizes the Environmental Protection Agency ("EPA"), the states and in some circumstances third parties to take actions in response to public health or environmental threats and to seek to recover certain clean-up and legal costs they incur from the same classes of persons. Governmental authorities can also seek recovery for damages to natural resources. Second, under CERCLA and applicable state statutes, the current owner or operator of any real property, not just waste disposal sites, may incur liability for hazardous substances located on the property, or that have migrated to adjoining properties, even though such wastes were deposited by a prior owner, operator or tenant. A former owner or operator of real property may incur liability for hazardous substances located on the property even though such wastes were deposited by another owner, operator or tenant; and a former owner or operator of real property may incur liability after the sale of the property for hazardous wastes disposed on the property during the time that it owned, operated or leased the property. The third general area is that associated with the accidental release of hazardous materials or substances during a transportation incident, such as a derailment. Federal, state and local laws and regulations may impose (again, without regard to fault), requirements for clean-up of contaminated soils and surface or groundwater resulting from a derailment; and there may also be long-term monitoring requirements to evaluate the impacts on the environment and natural resources. Certain federal and state laws also require that the discharger of hazardous substances reimburse agencies for certain costs in responding to a hazardous materials incident (also without regard to fault). In addition, adjacent land owners or other third parties sometimes initiate toxic tort litigation against the type of sites described above. State and local agencies, particularly in California where the Company has extensive operations, have become increasingly active in the environmental area. The increased regulation by multiple agencies can be expected to increase the Company's future environmental costs. In particular, properties under federal and state scrutiny frequently result in significant clean-up costs and litigation expenses related to a party's clean-up obligation. The Company has made and will continue to make substantial expenditures relating to the assessment and remediation of environmental conditions on its properties, including properties held for sale. During 1993 and 1992 the Company spent approximately $16.2 million and $15.7 million, respectively, relating to the assessment and remediation of environmental conditions of operating properties and non-operating properties not held for sale, excluding the effects of the 1991 derailment at Dunsmuir, California. In 1993 and 1992, the Company also incurred and expensed approximately $12.4 million and $17.6 million, respectively, for environmental matters relating to properties held for sale. Costs associated with environmental remediation of properties held for sale may be deferred to the extent such costs, together with estimated future costs and the existing cost basis of the property do not exceed, in the aggregate, the amount expected to be realized upon sale. In assessing its potential environmental liabilities, the Company typically causes ongoing examinations of newly identified sites and evaluations of existing clean-up efforts to be performed by environmental engineers employed both by it and by consulting engineering firms. These assessments, which usually consider a combination of factors such as the engineering reports, site visits, area investigations and other steps, are reviewed periodically by counsel. The Company's analysis includes, among other things, the number of potentially responsible parties ("PRPs") at many sites that the Company considers to be financially viable participants with the Company; considerations such as the estimated allocation of liability among such PRPs, the selected method of remediation, the timing of work, the effect of inflation, the ability to recover costs from former and current insurance carriers and the development of new remediation technologies; information contained in the Company's historical, operating and compliance files; regulatory guidelines and the regulatory comment and approval process; information contained in regulatory agency files regarding certain sites; settlements made at some sites; the volume and nature of wastes attributable to the Company at certain sites; and decisions that have been made regarding clean-up at some of the sites. The Company owns or previously owned two properties and has a partial interest in four properties that are on the national priorities list ("NPL") under CERCLA, the federal "superfund" statute. The Company has been informed that it is or may be a PRP, together with multiple other PRPs, with respect to the remediation of eight other properties on such list. Certain other Company properties are included on lists of sites maintained under similar state laws. Inclusion of a site on such lists would allow federal or state "superfund" monies to be spent on clean-up at the sites if PRPs do not perform the clean- up. The law governing "superfund" sites provides that PRPs may be jointly and severally liable for the total costs of remediation. In some instances, liability may be allocated through litigation or negotiation among the PRPs based on equitable factors, including volume contribution. Of its properties, including the NPL and PRP properties described above, the Company has only three sites that individually involved future cost estimates for environmental matters as of December 31, 1993 in excess of $5 million. None of such estimates exceeded $10 million at that date. The Company's total costs for its environmental matters cannot be predicted with certainty; however, the Company has accrued reserves for environmental matters with respect to operating and non-operating properties not held for sale, as well as certain properties previously sold, based on the costs estimated to be incurred when such estimated amounts (or at least a minimum amount) can be reasonably determined based on information available. At December 31, 1993 and 1992, the Company had accrued reserves for environmental contingencies of $58.8 million and $67.8 million, respectively. Based on the Company's assessments described above, other available information and the amounts of the Company's established reserves, management does not believe that disposition of environmental matters known to the Company will have a material adverse effect on the Company's financial condition. However, there can be no assurance that material liabilities or costs related to environmental matters will not be incurred in the future. See Note 12 to the Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Union Pacific--Missouri Pacific, Western Pacific Control; ICC Finance Docket No. 30,000, 366 ICC 462 (October 20, 1982). On October 20, 1982, the ICC approved the consolidation of Union Pacific, Missouri Pacific Railroad Company ("MP") and Western Pacific Railroad Company, over vigorous opposition of SPT and others. As a condition to its approval, the ICC awarded SSW trackage rights to operate over the MP lines between Kansas City and St. Louis, which operations commenced on January 6, 1983. The ICC's initial decision did not fix the compensation SSW would pay for the trackage rights. In a series of decisions the ICC set forth new principles to govern the computation of the "rent" portion of the trackage charges (payment for maintenance expenses has not been a major issue). Court appeals from those decisions were concluded, and Union Pacific filed a collection action for rent in Federal District Court. Union Pacific claims approximately $60 million (including interest) as of December 31, 1993, representing Union Pacific's calculation of the effect of the ICC decisions. SPT has contested the amount claimed as overstated, and further has asserted that Union Pacific failed to provide the service ordered by the Commission, specifically, equal treatment of the trains of the two companies on the trackage rights lines, a different issue from the previously-litigated issue of rent. On October 29, 1993, the ICC issued an order holding in abeyance, pending action from the District Court, SPT's petition to modify or further interpret its order. On December 6, 1993, the District Court dismissed Union Pacific's action without prejudice. Union Pacific requested the District Court reconsider and set aside its decision; and on March 14, 1994, the District Court vacated its order dismissing Union Pacific's complaint. The amount that SPT may ultimately owe Union Pacific will be substantial, but management has made provision that it believes to be adequate for this matter in current liabilities in its financial statements. 1991 Dunsmuir Derailment. In July 1991, a derailment near Dunsmuir, California resulted in the escape from a tank car of metam sodium (a weed killer) into the Sacramento River. The derailment allegedly resulted in environmental damage, particularly the loss of fish, plants and other organisms in approximately 38 miles of the Sacramento River. Certain individuals and businesses have alleged that they incurred costs or damages for medical expenses, personal injuries, property damage and other losses resulting from the incident. Originally there were approximately 46 lawsuits by private plaintiffs pending against SPT and others in connection with the July 1991 derailment. Most of these cases were consolidated before a single judge in San Francisco Superior Court and certified as class actions. After the certification, approximately 3,350 claimants completed claims forms as members of the class. In June 1993, the class action plaintiffs and SPT entered into an agreement to settle the class action litigation and, on September 17, 1993, the coordinating trial judge issued his final approval of that settlement agreement. Under the terms of the agreement the class action plaintiffs and their counsel will receive a total of $14 million from SPT and the other remaining defendants (GATX, Huber, Trinity Chemical and Transmatrix). Thirteen class action plaintiffs have filed timely appeals. Unless settled earlier, the appeals will be determined by the California Court of Appeals for the First District. The only remaining civil cases arising from the derailment involve six personal injury-only cases against SPT of which four have been brought by class members who opted out of the class and are pursuing their individual claims. In addition, the State of California and the United States filed separate suits against SPT and other parties in the United States District Court in Sacramento, California. The State asserted claims for natural resource damages under federal and state environmental statutes and state common law, civil penalties under state statutory law and requests injunctive relief. The federal suit asserted claims for natural resource damages, penalties, recovery of costs, and other relief under federal environmental statutes and for damages pursuant to theories of common law negligence and ultrahazardous activity liability. Several environmental and angling advocacy groups intervened in the federal suit, seeking both injunctive relief and the creation of a fund to cover environmental restoration costs. Prior to the institution of the State and federal cases, SPT instituted litigation in the United States District Court in Los Angeles against the State, the United States and private parties (including the manufacturer of the metam sodium and the manufacturer of the tank car), seeking declaratory relief with respect to issues of potential CERCLA liability and damages and other relief against certain potentially responsible private parties involved in the incident. By judicial directive and by stipulation of the parties, all claims between and among the parties were transferred to the United States District Court in Sacramento, California. In late 1993, that court stayed all litigation among the parties to facilitate settlement negotiations. Those negotiations recently culminated in a settlement between the governments and all defendants in the form of two consent decrees that were lodged with the federal court on March 14, 1994. The consent decree provides that the Company will pay $30 million and the other defendants collectively will pay $8 million in settlement of all of the government claims. The settlement, however, is subject to the condition that the intervenors' claims are dismissed with prejudice and the court approves the consent decrees after public comment. The governments and the Company have filed supplemental motions to dismiss the intervenors' claims, which the Company expects will be decided shortly. If the motions to dismiss are granted, and the court approves the consent decrees after public comment, the settlement will be final and the litigation terminated, except for any appeals. The California Public Utilities Commission also instituted an investigation into the causes of the derailment. While the total amount of damages and related costs cannot be determined at this time, SPT is insured against most types of damages and related costs involved with the Dunsmuir derailment to the extent they exceed $10.0 million. As of December 31, 1993, SPT had paid approximately $44.7 million related to the Dunsmuir derailment, of which $12 million was charged to expense primarily to cover the $10 million deductible. The balance has been or is in the process of being collected from insurance carriers. As of December 31, 1993, approximately $24.9 million had been recovered by SPT from insurers. SPT expects to recover substantially all additional damages and costs under its insurance policies (including amounts payable pursuant to the settlement of private suits described above, as well as amounts payable pursuant to settlement of the federal court action described above, except for $750,000 which constitutes penalties). As a result, disposition of these matters is not expected to have a material adverse effect on the Company's financial condition. Houston--Metro. In 1992, SPT received $45 million from the sale of property to the Metropolitan Transit Authority (Metro) in Houston, Texas. SPT believes that the contract of sale in 1992 also requires Metro to acquire an additional $30 million of SPT right-of-way properties. Metro, on the other hand, has indicated that it believes an adjustment or credit should be made with respect to the purchase price for the property it already purchased. Negotiations between SPT and Metro to resolve the matter have been unsuccessful. On March 29, 1994, SPT filed a lawsuit in the U.S. District Court in Houston, Texas seeking damages and/or specific performance in connection with Metro's decision not to purchase the additional $30 million of SPT right-of-way properties and further seeking a declaratory judgment that SPT is not required to refund any amounts to Metro under the 1992 sales contract. On the same day, Metro filed a lawsuit in the U.S. District Court in Houston, Texas seeking a refund from SPT of $19.7 million under the 1992 sales contract between SPT and Metro. General. SPT is involved in certain income tax cases relating to prior periods, but pursuant to an agreement with SPT's former parent as part of the Company's acquisition of SPT, the former parent has assumed the liability for any adjustments to taxes due or reportable on or before October 13, 1988, the date of acquisition. Accordingly, the Consolidated Financial Statements of the Company do not make provision for any taxes and interest of SPT that may have been due or reportable relating to periods ending on or before October 13, 1988. Although the Company has purchased insurance, the Company has retained certain risks (consisting principally of a substantial deductible per occurrence) with respect to losses for third-party liability and property claims. In addition, various claims, lawsuits and contingent liabilities are pending against the Company. Management has made provisions for these matters which it believes to be adequate. As a result, the ultimate disposition of these matters is not expected to have any material adverse effect on the Company's financial condition. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All issued and outstanding Common Stock of the Company is owned by SPRC. No dividends were declared or paid in 1993, 1992 or 1991. As of December 31, 1993, there were certain restrictions on the payment of dividends by the Company and net worth covenants. See Notes 6 and 8 to the Consolidated Financial Statements. The advances to SPRC of $684.2 million at December 31, 1993 are not interest bearing. It is anticipated that the Company will make dividend payments or advances in the future to SPRC in order for SPRC to meet its debt service obligation. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in connection with the Consolidated Financial Statements and related Notes. RESULTS OF OPERATIONS Year Ended December 31, 1993 Compared to Year Ended December 31, 1992 The Company had a net loss of $204.8 million for 1993 compared to a net income of $109.5 million for 1992. The 1993 amount includes a $98.9 million after-tax charge for the cumulative effect of a change in accounting for post- retirement benefits other than pensions under Statement of Financial Accounting Standards ("FAS") No. 106 adopted by the Company effective January 1, 1993. See "--Accounting Matters." The Company had an operating loss of $53.9 million for 1993 compared to an operating loss of $24.7 million for 1992. Operating results for 1993 were adversely affected by severe weather and flooding in certain western states during the first quarter of the year and in certain midwestern states during the third and fourth quarters of the year. In addition, the Company experienced a significant decline in automotive shipments, a shortage of power due to a temporary reduction in the number of locomotives leased by the Company and a slower than anticipated recovery in certain segments of the economy. The Company addressed the power shortage by continuing to lease additional locomotives on a short-term basis. Management of SPRC estimates that the midwest floods in the second half of 1993, which caused delays, detours and additional repair costs, resulted in additional costs and revenue shortfalls of approximately $60 million to $65 million for 1993, much of which occurred on Company-owned and used rail lines. The foregoing estimate is based on a number of assumptions and the actual amount of additional costs and revenue shortfalls is uncertain. Partially offsetting an increase in operating expenses for 1993 were reduced joint facility rent expense of approximately $10.0 million as a result of the negotiated settlement of a joint facility case, as well as reduced property tax expense of approximately $16.7 million due to revised state property tax assessments and to the favorable settlement of prior years' disputed property taxes in California. Operating Revenues. In 1993, railroad operating revenues increased $14.8 million compared to 1992. Railroad freight operating revenues increased $26.6 million primarily due to increased intermodal and coal carloads partially offset by decreased automobile and food and agricultural carloads. Other railroad revenues (primarily passenger, switching and demurrage) decreased $11.8 million compared to 1992. Passenger revenues decreased because the Company discontinued operating commuter service in 1992, following the sale of the Company's peninsula corridor in the San Francisco Bay Area (the "Peninsula Corridor"). There was a similar decrease in commuter operating expense. Partially offsetting this decline were increased demurrage and other incidental revenues associated with increased traffic volume. For 1993, carloads increased 3.8 percent and revenue ton-miles increased 6.9 percent compared to 1992. The average freight revenue per ton-mile declined by 5.4 percent compared to 1992 due to continued competitive pressures on rates and changes in traffic to lower revenue per ton-mile commodities and routes. In 1993 lower than average revenue per ton-mile coal traffic carloads increased by 39.5 percent, while higher than average revenue per ton-mile automobile traffic carloads decreased by 30.0 percent principally due to a plant closing and the loss of a major contract, contributing to the decline in average freight revenue per ton-mile. The following table compares traffic volume (in carloads), gross freight revenues (before contract allowances and adjustments) and gross freight revenues per carload by commodity group for 1993 compared to 1992. CARLOAD AND GROSS FREIGHT REVENUE COMPARISON YEARS ENDED DECEMBER 31, 1993 AND 1992 . Both segments of the intermodal business, container-on-flatcar ("COFC") and trailer-on-flatcar ("TOFC"), contributed to the increase in 1993 intermodal volume and revenue over 1992 levels. COFC growth primarily came from increased business with major steamship customers and increases in domestic doublestack business. TOFC volumes grew primarily as a result of increased business with motor carriers. . Chemical and petroleum products carloads were down 1.8% in 1993 due to reduced demand by Company-served plastics shippers, a corresponding reduction in plastic feedstocks, reduced carloads of soda ash and crude oil and completion of an environmental waste contract in 1992. Revenue per carload increased due to an increase in long-haul traffic and yield improvement strategies, particularly in plastics. . Coal carloads and revenue increased in 1993 due in large part to the United Mine Workers strike affecting eastern mine operations between June and December 1993, which increased demand for coal from Company-served mines. The strike was settled in December 1993. The increased coal carloads and revenues in 1993 were also due to strong summer demand by utilities and continued demand for western coal to be used in utility test burns. The Company expects that settlement of the coal strike, which was a significant factor in the increase in coal carloads and revenues in 1993, will result in reductions or eliminations of coal shipments for certain customers, but the Company cannot predict the effect of such settlement on total coal carloads in the future. . Carload volume in forest products increased in 1993 through growth in shipments of paper products, while lumber product carloadings maintained 1992 levels primarily due to weak construction markets. Revenue for forest products grew at a slower rate than carloads due to a reduction in revenue per carload which was brought about by changes in product and market mix. . Automobile traffic declined in 1993 as compared to 1992 because of the closing of a General Motors plant in California and the loss of a contract for transportation of finished automobiles. Operating Expenses. Railroad operating expenses for 1993 increased $41.6 million, or 1.7 percent, compared to 1992. Management of SPRC estimates that approximately $50 million to $55 million of increased operating expenses were associated with the severe flooding that occurred in the midwest during the third and fourth quarters of 1993, much of which occurred on Company-owned and used rail lines. The foregoing estimate is based on a number of assumptions and the actual amount of additional operating expenses is uncertain. Equipment rental costs and fuel costs also increased in 1993, while labor and fringe benefits costs and materials and supplies costs decreased in 1993 compared to 1992 as discussed below. The following table sets forth a comparison of the Company's operating expenses for 1993 and 1992. RAILROAD OPERATING EXPENSE COMPARISON YEARS ENDED DECEMBER 31, 1993 AND 1992 . Labor and fringe benefit expenses decreased $24.7 million, or 2.4 percent, for 1993 compared to 1992. At December 31, 1993 Company employment had substantially declined compared to December 31, 1992, primarily due to a decline in roadway maintenance employees during the last four months of 1993 resulting in reduced labor costs for day-to-day repair and maintenance activities, as well as to a decline in transportation employees in December 1993 resulting from the November 1993 ratification of a UTU agreement. During 1993, train crew starts declined by 2.1 percent compared to 1992, even though adversely impacted by the midwest floods in the third and fourth quarters of 1993, contributing to the overall decline in labor costs. In addition, included in the expense reduction above is reduced payroll tax expense due to reduced employment and the elimination in 1993 of the railroad unemployment insurance repayment tax. . Fuel expense increased $14.8 million, or 7.5 percent, due primarily to increased fuel consumption associated with increased traffic volume, partially offset by a 2.1 percent decline in the average cost per gallon of fuel from $.61 in 1992 to $.59 in 1993. . Materials and supplies expenses decreased $27.9 million, or 14.7 percent, for 1993 compared to 1992 due primarily to reduced running repairs on locomotives, reduced roadway repair and maintenance activity, the use of recycled and reconditioned second-hand materials, as well as to reduced purchases of material during the first quarter of 1993 in response to reduced revenues in that quarter compared to 1992. There was also a $5.0 million non-recurring inventory adjustment during 1993. During the year, the Company rebuilt or performed heavy repairs on 203 locomotives compared to heavy repairs on 141 locomotives in 1992. Costs associated with the rebuilding of 60 locomotives in 1993 were capitalized. . Equipment rental costs increased $42.3 million, or 14.9 percent, due to a combination of the effects of the midwest floods causing increased equipment cycle time and increased short-term locomotive lease costs associated with increased traffic volume and a shortage of locomotives in certain areas. Included in the increase is a $19.1 million increase in net car hire, and a $13.4 million increase in locomotive lease costs over 1992. . Depreciation and amortization expense increased $1.0 million, or 0.4 percent, due primarily to an increased depreciable property base in 1993. . Other expenses increased $36.1 million, or 6.4 percent, for 1993 compared to 1992. This category of expense includes purchased repairs and services, joint facility rent and maintenance costs, casualty costs and property and other taxes. The 1993 increase is due primarily to detour fees and joint facility maintenance and operations costs associated with the midwest floods which SPRC estimated to be approximately $27 million, much of which occurred on Company-owned and used rail lines. The foregoing estimate is based on a number of assumptions and the actual amount of additional flood-related costs is uncertain. Also showing an increase for 1993 were casualty costs (due in part to the fact that 1992 casualty costs were reduced by insurance recoveries received with respect to claims accrued in 1992 and prior years), environmental cost accruals, data processing equipment rental costs as well as an increase in taxes on fuel beginning in the fourth quarter of 1993. Partially offsetting the expense increases in this category were reduced joint facility rent expense of approximately $10.0 million as a result of the negotiated settlement of a joint facility case earlier in the year, as well as reduced property tax expense of approximately $16.7 million due to revised state property tax assessments and to a favorable settlement of prior years' disputed property taxes in California. Other Income and Interest Expense. Other income in total was $8.6 million in 1993 compared to $292.1 million in 1992, a decrease of $283.5 million. Gains on sales of property and real estate decreased $276.8 million to a total of $24.5 million in 1993. Rental income increased $3.7 million due in part to non- recurring rental income associated with a fiber optic conduit easement with Southern Pacific Telecommunications Company ("SP Telecom"). Interest income remained relatively stable with a decrease of $0.6 million during 1993. The remaining portion of other income was an expense of $41.1 million in 1993 compared to an expense of $31.3 million in 1992, an increased expense of $9.8 million. This increase is due in part to the write-off of $12.3 million of deferred loan costs and to increased expenses of $10.6 million in 1993 associated with the sale of accounts receivable which were partially offset by reduced expenses associated with properties held for sale. In addition, in November 1993, the Company received $27.1 million in cash from SP Telecom in full redemption of the SP Telecom preferred stock owned by the Company plus accrued dividends on the preferred stock, resulting in other income of $14.9 million. Interest expense was $101.5 million in 1993 compared to $89.2 million in 1992, an increase of $12.3 million due primarily to a higher level of outstanding debt during 1993. ENERGY TAX On August 10, 1993, the President signed into law legislation which imposes a tax on certain fuels. The tax is expected to increase the Company's fuel costs for 1994 by approximately $10 million to $15 million. However, certain of the Company's freight contracts have escalation clauses that would help to offset such increased fuel costs. The Company also posted certain rate increases effective October 1, 1993 that represent a surcharge intended to mitigate the impact of the fuel tax. INFLATION In prior years, the Company has experienced increased costs due to the effect of inflation on the cost of compensation and benefits, and in the replacement of or additions to property and equipment. A portion of the increased labor costs directly affects expenses through increased operating costs. Fuel costs have fluctuated with market conditions and have directly affected operating results. Operating efficiencies have, however, partially offset this impact. Competition and other market factors have adversely affected the Company's ability to price services to fully recover cost increases. Certain of the wage agreements obtained in 1991, 1992 and 1993 have reduced the effects of inflation on future operating costs until they expire and become subject to renegotiation in 1995 (1998 with respect to the agreement covering the Western Lines). ACCOUNTING MATTERS In 1991, the Company recorded the 1991 Special Charge of $270.0 million. The 1991 Special Charge provided for employee separation and relocation related primarily to labor agreements reached in 1991, sale, lease or abandonment of low density lines, restoration and clean-up costs and certain legal matters. See Note 2 to the Consolidated Financial Statements included elsewhere herein. The Company adopted FAS 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993, thus incurring an after-tax charge of $98.9 million for the cumulative effect of change in accounting principle relating to the Company's retiree welfare plan. The Company has amended its retiree benefit policies and estimates that its liability for such retiree benefits at January 1, 1993 was approximately $160.1 million before tax, after reflecting these policy amendments. See Note 10 to the Company's Consolidated Financial Statements included elsewhere herein. In February 1992, FAS 109 "Accounting for Income Taxes" was issued. Through December 31, 1992, the Company accounted for income taxes under the asset and liability method prescribed by FAS 96, "Accounting for Income Taxes". Management adopted FAS 109 prospectively in the first quarter of 1993. The impact of adoption of FAS 109 did not have a material effect on the Company's Consolidated Financial Statements. Under both FAS 96 and FAS 109, deferred tax liabilities and assets are recorded based on the enacted income tax rates which are expected to be in effect in the periods in which the deferred tax liability or asset is expected to be settled or realized. A change in the tax laws or rates results in adjustments to the deferred tax liabilities and assets. The effect of such adjustments shall be included in income in the period in which the tax laws or rates are changed. In November 1992, FAS 112 "Employers' Accounting for Postemployment Benefits" was issued. FAS 112 requires employers to recognize the obligation to provide benefits to former or inactive employees after employment but before retirement, if certain conditions are met. The initial effect of applying FAS 112 is to be reported as the effect of a change in accounting method and previously issued financial statements are not to be restated. The Company will adopt FAS 112 and take a pre-tax charge of approximately $6.6 million in the first quarter of 1994 as required by FAS 112. See Note 1 to the Company's Consolidated Financial Statements included elsewhere herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements, including supplementary data, and accompanying report of independent auditors are listed in the Index to Consolidated Financial Statements and Consolidated Financial Statement Schedules filed as part of this annual report. SSW, a 99.9% owned subsidiary of SPT has not filed an annual report on Form 10-K by reason of its guarantee of the Senior Secured Notes of SPT because: (a) summarized financial information concerning SSW as required by Rule 1-02(aa) of Regulation S-X is contained in Note 16 to SPT's Consolidated Financial Statements on pages to; and (b) SPT and SSW are jointly and severally liable with respect to the Senior Secured Notes and the aggregate of total assets, net earnings and net equity of SPT and SSW constitute a substantial portion of the total assets, net earnings and net equity of SPT on a consolidated basis. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH AUDITORS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K A. Documents filed as part of this report: 1. Financial statements and schedules: The financial statements, financial statement schedules and accompanying report of independent auditors are listed in the Index to Financial Statements and Financial Statement Schedules filed as part of this Annual Report. 2. Exhibits: The Registrant will furnish to a requesting security holder any Exhibit requested upon payment of the Registrant's reasonable copying charges and expenses in furnishing the Exhibit. - -------- * Management contract or compensatory plan, contract or arrangement required to be filed as an Exhibit pursuant to Item 14(c). B. Reports on Form 8-K: The Company did not file any reports on Form 8-K during the three months ended December 31, 1993. C. Other Exhibits: No exhibits in addition to those previously filed or listed in Item 14(a)(3) are filed herein. D. Other Financial Statement Schedules: No additional financial statement schedules are required. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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 PACIFIC TRANSPORTATION COMPANY /s/ B.C. Kane By: _________________________________ B.C. Kane Controller (Principal Accounting Officer) Date: March 24, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT IN THE CAPACITIES AND ON THE DATES INDICATED. Date: March 24, 1994 /s/ Edward L. Moyers By: _________________________________ Edward L. Moyers Chairman, President, Chief Executive Officer and Director (Principal Executive Officer) Date: March 24, 1994 /s/ Robert F. Starzel By: _________________________________ Robert F. Starzel Vice Chairman and Director Date: March 24, 1994 /s/ Donald C. Orris By: _________________________________ Donald C. Orris Executive Vice President-- Distribution Services and Director Date: March 24, 1994 /s/ Thomas J. Matthews By: _________________________________ Thomas J. Matthews Vice President--Administration and Director Date: March 24, 1994 /s/ Glenn P. Michael By: _________________________________ Glenn P. Michael Vice President--Operations and Director Date: March 24, 1994 /s/ Lawrence C. Yarberry By: _________________________________ Lawrence C. Yarberry Vice President--Finance (Principal Financial Officer) SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules are omitted because they are not applicable or because the required information is shown in the financial statements or the notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. Financial statements and summarized financial information of companies accounted for by the equity method have been omitted because considered in the aggregate, or individually, they would not constitute a significant subsidiary. INDEPENDENT AUDITORS' REPORT The Board of Directors Southern Pacific Transportation Company: We have audited the accompanying consolidated balance sheets of Southern Pacific Transportation Company and Subsidiary Companies as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity, and cash flows for each of the years in the three year period ended December 31, 1993. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules V, VI, VIII and X as of and for the years ended December 31, 1993, 1992 and 1991. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southern Pacific Transportation Company and Subsidiary Companies as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, as of and for the years ended December 31, 1993, 1992 and 1991, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the financial statements, effective January 1, 1993 the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. KPMG Peat Marwick San Francisco, California February 17, 1994, except as to the third paragraph of Note 15, which is as of March 2, 1994 SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES CONSOLIDATED BALANCE SHEETS (Continued) See accompanying notes to consolidated financial statements. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES CONSOLIDATED BALANCE SHEETS (CONTINUED) See accompanying notes to consolidated financial statements. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes to consolidated financial statements. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Ownership, Principles of Consolidation and Basis of Presentation--Southern Pacific Transportation Company ("SPT") was a wholly-owned subsidiary of SPTC Holding, Inc. ("SPTCH") until August 1993 at which time, SPTCH, a wholly-owned subsidiary of Southern Pacific Rail Corporation ("SPRC") (formerly Rio Grande Industries, Inc.) was merged into SPRC; therefore, per share data are not shown in the accompanying consolidated financial statements. As used in this document, the Company refers to SPT together with its subsidiaries. The consolidated financial statements are prepared on the historical cost basis of accounting and include the accounts of SPT and all significant subsidiary companies, including St. Louis Southwestern Railway Company ("SSW") and SPCSL Corp. ("SPCSL"), on a consolidated basis. SPRC also owns Rio Grande Holding, Inc. ("RGH") which owns The Denver and Rio Grande Western Railroad Company ("D&RGW"). SPRC management continues to review and consider the placement of various subsidiaries within the corporate structure of SPRC. Cash and Cash Equivalents--For statement of cash flows purposes, the Company considers commercial paper, municipal securities and certificates of deposit with original maturities when purchased of three months or less to be cash equivalents. Investments--Investments in affiliated companies (those in which the Company has a 20 percent to 50 percent ownership interest) are accounted for by the equity method. Other investments are stated at cost which does not exceed market. Property--Property accounting procedures followed by the Company and its railroad subsidiaries are prescribed by the ICC. In accordance with the Company's definition of unit of property, all costs associated with the installation of rail, ties, ballast and other track improvements are capitalized. Other costs are capitalized to the extent they increase asset values or extend useful lives. Retirements are generally recorded using a system wide first-in first-out basis. The cost of property and equipment (including removal and restoration costs) is depreciated on the straight line composite group method, generally based on estimated service lives. Pursuant to ICC regulation, periodic depreciation studies are required and changes in service life estimates are subject to the review and approval of the ICC. Gains or losses from disposition of depreciable railroad operating property are credited or charged to accumulated depreciation except for significant disposals of equipment. Certain railroad properties that are not essential to transportation operations are being held for sale. Gains or losses resulting from sales of real estate no longer required for railroad operations are recognized as other income in the consolidated statement of operations. Revenues--Freight revenues from rail transportation operations are recognized based on the percentage of completed service method. Other railroad revenues and other revenues are recognized as earned. Retiree Welfare Benefits--Prior to January 1, 1993, the Company expensed retiree welfare benefits when paid. Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and recorded the estimate of its liability under Statement No. 106 of $160.1 million, which net of income taxes resulted in a charge to earnings of $98.9 million (See Note 10). Statement No. 106 requires that all employers sponsoring a retiree welfare plan use a single actuarial cost method as is required for pension plan accounting and that they disclose specific information about their plan in their financial statements. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Postemployment Benefits--In November 1992, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" was issued. Statement No. 112 requires employers to recognize the obligation to provide benefits to former or inactive employees after employment but before retirement, if certain conditions are met. The initial effect of applying Statement No. 112 is to be reported as the effect of a change in accounting method and previously issued financial statements are not to be restated. The Company will adopt Statement No. 112 and take a pre-tax charge of approximately $6.6 million in the first quarter of 1994. Income Taxes--Prior to January 1, 1993 income taxes were reported using the liability method prescribed by Statement of Financial Accounting Standards No. 96 "Accounting for Income Taxes." Under Statement No. 96, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Effective January 1, 1993, the Company prospectively adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The impact of adoption of Statement No. 109 was not material to the Company's consolidated financial statements. Under both Statement No. 96 and Statement No. 109, deferred tax liabilities and assets are recorded based on the statutory income tax rates which are expected to be settled or realized. A change in the tax laws or rates results in adjustments to the deferred tax liabilities and assets. The effect of such adjustments shall be included in income in the period in which the tax laws or rates are changed. Reclassifications--Certain of the amounts previously reported have been reclassified to conform to the current consolidated financial statement presentation. 2. SPECIAL CHARGE In the fourth quarter of 1991, the Company recorded a $270 million Special Charge. Approximately $125 million of the Special Charge is related to labor agreements then recently concluded and then in progress which have resulted in crew size reduction and payments to approximately 1,000 employees and relocation costs over the next several years. Approximately $55 million of the Special Charge was credited to accumulated depreciation to reserve for 1,200 miles of low density rail lines identified for sale or abandonment. The remainder of the charge was to provide for restoration and clean up costs on certain properties ($74 million) and for various legal matters ($16 million). Expenditures in 1993 and 1992 applied against the reserves were $54.7 million and $72.2 million for employee separation and relocation and $16.2 million and $15.7 million for restoration and cleanup costs, respectively. 3. SALE OF RECEIVABLES Beginning in 1989, the Company began selling certain net recievables (including interline accounts), without recourse, to Rio Grande Receivables, Inc. ("RGR"), a subsidiary of SPRC. Also in 1989, RGR began selling the receivables purchased from the Company, with certain limited recourse provisions, to ABS Commercial Paper, Inc. ("ABS"), an unaffiliated third party, on a continuing basis for a period of up to five years subject to certain terms and conditions. The Company has agreed to service the receivables sold and is paid a fee for such services. The sale price for the receivables sold is based upon the face amount of the receivables and is reduced by discounts for expected defaults, servicing costs and anticipated collection periods. The Company retains a residual interest in the receivables should actual collections exceed the projected collections upon which the default discounts are calculated. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) ABS purchases an undivided interest in the receivables up to an aggregate amount of approximately $300.0 million, net of discounts, at any one time, for a period up to five years subject to certain conditions. ABS finances its purchases by the sale of its commercial paper, secured by the receivables it purchases, up to a maximum aggregate principal amount of $300.0 million at any time outstanding. The ability of ABS to sell commercial paper is supported by certain banks which have agreed to provide liquidity to ABS on an as-needed basis. The liquidity banks must maintain a P-1 rating or there would need to be one or more replacement banks or a reduction in the maximum amount of commercial paper which ABS could issue. During 1991, one bank's rating was reduced and additional bank commitments were obtained from the remaining banks. As of December 31, 1993, 1992 and 1991, the Company had sold $338.3 million, $317.9 million and $369.2 million of net outstanding receivables, respectively, and had notes receivables from RGR for receivables sold of $51.9 million, $42.5 million and $81.5 million, of which $27.8 million were interest bearing at December 31, 1993, 1992 and 1991, and are included in other assets. Included in other income (expense), net is approximately ($37.9) million in 1993, ($27.8) million in 1992, and ($58.0) million in 1991 of discounts and other expenses associated with the sales of accounts receivable. The initial term of the agreements expire on October 31, 1994. The Company has obtained commitments of the banks to extend the facility for a period of one year. 4. PROPERTY The average depreciation rates for the Company's property and equipment were approximately 3.1 percent for roadway and structures, 4.9 percent for locomotives and 4.2 percent for freight cars for 1993. The Company received cash proceeds from sales and retirements of real estate and property of $28.1 million, $322.9 million and $513.4 million in 1993, 1992 and 1991, respectively. The 1992 amount includes $124.0 million from sales to the Peninsula Corridor Joint Powers Board ("JPB"), $45.0 million from sales to Metro Transit of Houston, Texas and $83.0 million from sales to the Los Angeles County Transportation Commission ("LACTC"). The 1991 amount includes $321.7 million from sales to the LACTC and $91.9 million from sales to the JPB. The Company incurred and capitalized approximately $12 million in 1993 and $18 million in each of 1992 and 1991 in costs relating to environmental conditions on properties held for sale. The Company has granted the JPB options to purchase additional rights-of-way and land within five years after the closing of the sale of the Peninsula Main Line for approximately $110 million. The Company will retain exclusive freight rights on the sold properties. 5. OTHER CURRENT LIABILITIES AND OTHER LIABILITIES Other current liabilities include the following amounts at December 31, 1993 and 1992: SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Included in other non-current liabilities are $312.7 million and $299.6 million for casualty and freight-related claims and $35.3 million and $66.0 million for employee separation and relocation at December 31, 1993 and 1992, respectively, in addition to $140.6 million for post-retirement benefits other than pensions at December 31, 1993. 6. LONG-TERM DEBT Long-term debt is summarized as follows (in millions): On May 12, 1992, SPT completed a refinancing of its $525 million bank loan and other credit facilities and obtained a $450 million credit facility from a group of banks (the "Bank Credit Facility"), which consisted of a $325 million four-year amortizing term loan (the "SPT Term Loan") and a $125 million four- year non-amortizing revolver (the "SPT Revolver"). On August 17, 1993, the Bank Credit Facility was repaid as part of the SPRC common stock and debt transactions and the issuance of 200 shares of common stock by the Company to SPRC. SPT closed $290 million of 10 1/2% Senior Secured Notes on April 6, 1993. The Notes are secured by the rail lines of SSW and are required to be repaid over the three-year period 1997-1999. Proceeds of the financing were used to make a $100 million payment on the SPT Term Loan, a $125 million payment on the SPT Revolver, and for general corporate purposes. The Notes contain certain covenants and restrictions on dividends, loans and affiliate transactions, and provided registration rights to their holders. The registration rights were satisfied by an exchange offer of substantially identical notes completed in November 1993. In August 1993 SPT entered into a $200 million three-year unsecured credit agreement (the "Credit Agreement") (replacing the SPT Revolver) and made an initial $125 million drawdown thereunder. The Credit Agreement contains several quarterly financial covenants including, subject to certain exceptions, required minimum tangible net worth; a maximum funded debt to tangible net worth ratio; and a minimum fixed charge coverage ratio. As a result of delays in asset sales and the continuing effects of severe midwestern floods, SPT was required to obtain waivers of compliance with certain financial covenants applicable as of September 30,1993 contained in the Credit Agreement. Further, because of the delays in asset sales and continuing effects of the flooding, SPT entered into amendments to the Credit Agreement with its banking group in December 1993 to modify certain financial covenant tests. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) As part of an on-going program to improve its locomotive fleet, the Company acquired through capital lease 15 new locomotives in 1993 and borrowed a total of $103.8 million in 1991 and 1992 to purchase a total of 55 new and 45 remanufactured locomotives. Contractual maturities of long-term debt (including capital lease obligations) during each of the five years subsequent to 1993 and thereafter are as follows (in millions): Management estimates the fair value of the Company's debt at December 31, 1993 and 1992 was approximately $1,067 million and $944 million, respectively, based on interest rates for similar issues and financings. At December 31, 1993 the Company is a party to interest rate swap agreements with an aggregate notional amount of $100 million, which is used to hedge its interest rate exposure and is accounted for as an adjustment of interest expense over the life of the debt. A significant portion of railroad equipment and certain railroad property is subject to liens securing the mortgage bonds, equipment obligations, or other debt. 7. INCOME TAXES The following summarizes income tax expense (benefit) for the years indicated: Deferred tax expense in 1993 includes $18.7 million related to the change in the Federal tax rate. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Total income tax expense (benefit) from continuing operations differed from the amounts computed by applying the statutory federal income tax rate to income before income taxes as a result of the following for the years ended December 31, 1993, 1992 and 1991: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and January 1, 1993 are presented below (in millions): The Company has analyzed the sources and expected reversal periods of its deferred tax assets and liabilities. The Company believes that the tax benefits attributable to deductible temporary differences and operating loss carryforwards will be realized by the recognition of future taxable amounts related to taxable temporary differences for which deferred tax liabilities have been recorded. Accordingly, the Company believes a valuation allowance for its deferred tax assets is not necessary. The former parent of the Company has agreed to indemnify SPRC, SPT and its subsidiaries against any federal income tax liability that may be imposed on the Company or its 80%-owned subsidiaries for tax periods ending on or prior to October 13, 1988 (the "Acquisition Date"). Years prior to 1984 are closed. SPRC agreed to pay or cause SPT and its subsidiaries to pay to the former parent any refund of federal income taxes attributable to the 80%-owned subsidiaries received by SPRC, SPT or its subsidiaries after the Acquisition Date for any tax period ending on or prior to the Acquisition Date. Further, the former parent will also indemnify SPRC, SPT and its subsidiaries, at least in part, for state, local and other taxes in respect of periods to and including the Acquisition Date, but only to the extent that such taxes are due or reportable for periods prior to the Acquisition Date. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The intercompany tax allocation agreement among the Company and SPRC, which became effective following the closing of the Acquisition, was amended effective January 1, 1992 to provide that the Company will pay to SPRC the lessor of either the amount equal to that which the Company would have paid (or received) had the Company filed a separate consolidated tax return or which SPRC would pay as current taxes. As of December 31, 1993 the Company had approximately $1.3 billion of net operating loss carryforwards ("NOLs") which expire in 2003 through 2008. The NOLs are subject to review and potential disallowance, in whole or in part, by the Internal Revenue Service ("IRS") upon audit of the federal income tax returns of the Company. SPRC's consolidated federal income tax returns, in which the Company is included, are currently being examined for the period October 14, 1988 through 1990. Management believes adequate provision has been made for any potential adverse result. 8. REDEEMABLE PREFERENCE SHARES OF A SUBSIDIARY SSW, a 99.9 percent owned subsidiary of SPT, originally issued $53.5 million ($48.5 million Series A and $5 million Series B) of SSW's non-voting redeemable preference shares. The current carrying amount on the balance sheets at December 31, 1993 and 1992 reflects the outstanding balances of the redeemable preference shares of $46.0 million and $48.2 million, respectively. The Series A shares are subject to mandatory redemption at face value over a 20-year period commencing in 1991, at which time mandatory dividends shall be declared and paid over the same period. The overall effective interest rate since the date of issue is approximately 2.0%. The Series B shares are subject to mandatory redemption at face value over a 15-year period commencing in 1989. Mandatory dividends shall be declared and paid over a 10-year period commencing in 1994. The overall effective interest rate since the date of issue is approximately 4.9%. Mandatory redemptions and mandatory dividends of Series A and Series B shares scheduled for payment during each of the five years subsequent to 1993 are as follows (in millions): The Series A and Series B shares restrict certain dividend payments by SSW to its common and preferred shareholders. Under these provisions, at December 31, 1993, $35.5 million of SSW's historical cost basis retained income was not restricted. No estimate of the fair value of the preference shares was made by the Company. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. LEASES The Company leases certain freight cars, locomotives, data processing equipment and other property. Future minimum lease payments under noncancellable leases as of December 31, 1993 are summarized as follows: Rental expense for noncancellable operating leases with terms over one year was $146.7 million, $106.3 million and $138.2 million for the years ended December 31, 1993, 1992 and 1991, respectively. Contingent rentals and sublease rentals were not significant. During the fourth quarter of 1993, the Company committed to a capital lease financing for 50 new locomotives. The locomotives will be leased for a term of 21 years. The first 17 locomotives were delivered in the fourth quarter, 1993, with the remainder to be delivered in the first half of 1994. In addition, the Company committed to acquire 133 remanufactured locomotives in 1994 to be financed with a capital lease. The total present value of minimum lease payments relating to the 183 locomotives is expected to be approximately $131 million. In 1984, the Company entered into a long-term lease agreement with the Ports of Los Angeles and Long Beach. Under the terms of the lease, the Company is obligated to make certain future minimum lease payments and is subject to additional contingent rentals which are based on the annual volume of container movement at the Intermodal Container Transfer Facility. The minimum lease payments, ranging from approximately $3.0 million to $4.5 million per year for 1994 to 1998 are included in the table above. However, for each 5-year period from 1998 through 2036, the amount of the annual minimum lease payments and contingent rentals will be determined by the Ports based on independent appraisals of the fair rental value of the property, and therefore, no amounts are included in the above table for such years. The 1993 expense was $6.5 million. In late 1990, the Company entered into an agreement to sell up to 9,000 of its freight cars to a company which would recondition the cars and lease them back to the Company or third parties under a full-maintenance lease agreement. As of December 31, 1993, approximately 5,680 freight cars have been sold under the agreement for approximately $43 million in cash and notes receivable. The Company realized a gain of $19.3 million from these sales, which has been deferred and is being amortized over the terms of the leases. Annual rental for the reconditioned freight cars leased back to the Company under operating leases for periods up to 10 years is expected to be approximately $30.9 million in 1994. In 1993, the Company entered into a capital lease covering 1,651 freight cars with a total present value of minimum lease payments of approximately $43 million. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In 1992, the Company commenced a sale/leaseback transaction consisting of 100 locomotives which were sold to a rebuilder for their net book value of approximately $10.2 million, and were leased back (when rebuilt) under an operating lease agreement over a term of nine years. The Company leases operating rights on track owned by other railroads and shares costs of transportation facilities and operations with other railroads. These include rights on Union Pacific lines between Kansas City and St. Louis and on Burlington Northern Railroad Company lines between Kansas City and Chicago. The Company has the right to terminate its usage with certain notice periods. Net rent expense for trackage rights was a benefit of $2.2 million in 1993, $8.7 million in 1992, and $15.0 million in 1991. The 1993 amount includes the benefit of the negotiated settlement of a joint facility case of approximately $10 million. The Company pays for the use of transportation equipment owned by others and receives income from others for the use of its equipment. It also shares the cost of other transportation facilities with other railroads. Rental expense and income from equipment and the operation of joint facilities are included in operating expenses on a net basis. Total net equipment lease, rent and car hire expense was $326 million, $283 million and $255 million for 1993, 1992 and 1991, respectively. 10. EMPLOYEE BENEFIT AND COMPENSATION PLANS Pension Plan. The Company is a participating employer under the SPRC Pension Plan (the "SPRC Pension Plan"). The SPRC Pension Plan is a defined benefit noncontributory pension plan covering employees not covered by a collective bargaining agreement. The SPRC Pension Plan is subject to the provisions of the Employee Retirement Income Security Act of 1974 ("ERISA"). Pension benefits for normal retirement are calculated under a formula which utilizes average compensation, years of benefit service, and Railroad Retirement and Social Security pay levels. The Company's funding policy is to contribute each year an amount not less than the minimum required contribution under ERISA nor greater than the maximum tax deductible contribution. The assets of the SPRC Pension Plan consist of a variety of investments including U.S. Government and agency securities, corporate stocks and bonds and money market funds. The following summarizes the components of SPRC's net periodic pension cost under the provisions of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (in millions): The Company's pension expenses related to its participation in the SPRC Pension Plan were $6.1 million in 1993, $6.2 million in 1992 and $7.3 million in 1991. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following summarizes the funded status and amounts recognized in SPRC's consolidated balance sheets for the SPRC Pension Plan at December 31, 1993 and 1992 (in millions): At December 31, 1993 and 1992, the Company's consolidated balance sheets included pension liabilities of $35.9 million and $29.9 million, respectively. The following summarizes the significant assumptions used in accounting for the SPRC Pension Plan: Thrift Plan. SPRC has established a defined contribution plan (the "SPRC Thrift Plan") as an individual account savings and investment plan for employees of SPRC who are not subject to a collective bargaining agreement. Eligible participants may contribute a percentage of their compensation and the Company also contributes using a formula based on participant contributions. Postretirement Benefits Other Than Pensions. The Company sponsors several plans which provide health care and life insurance benefits to retirees who have met age and service requirements. The contribution rates that are paid by retirees are adjusted annually to offset increases in health care costs, if any, and fix the amounts payable by the Company. The life insurance plans provide life insurance benefits for certain retirees. The amount of life insurance is dependent upon length of service, employment dates, and several other factors, and increases in coverage beyond certain minimum levels are borne by the employee. Prior to January 1, 1993, the Company's policy was to expense and fund the cost of all retiree welfare benefits only as the benefits were payable. The Company charged to expense $21.8 million and $18.9 million in 1992 and 1991, respectively, for these benefits. The Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective January 1, 1993. The effect of adopting Statement No. 106 on net income and the net periodic benefit cost (expense) for 1993 was a charge to earnings of $160.1 SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) million (less income taxes of $61.2 million) and an increase in expense of $0.8 million, respectively. The Company's policy continues to be to fund the cost of all retiree welfare benefits only as the benefits are payable. Accordingly, there are no plan assets. The following table summarizes the plan's accumulated postretirement benefit obligation at December 31, 1993 (in millions): As of December 31, 1993, the current portion of accrued post-retirement benefit cost was approximately $19.9 million and the long-term portion was approximately $140.4 million. The net periodic post-retirement benefit costs for 1993 includes the following components (in millions): For measurement purposes, the Company has not assumed an annual rate of increase in the per capita cost of covered benefits for future years, since the Company has limited its future contributions to current levels. The weighted average discount rate used in determining the benefit obligation was 7.25 percent. 1990-1994 Long Term Earnings Growth Incentive Plan and Annual Incentive Compensation Plans. Certain officers of the Company participate in the 1990- 1994 Long Term Earnings Growth Incentive Plan of the Company. The 1992 and 1993 Incentive Compensation Plans covered all exempt employees of the Company. Based on the provisions of these plans, no amounts were charged to expense in 1993, 1992 or 1991. Executive Compensation Plans. SPRC has an employment agreement with its chief executive officer ("CEO") which provides for an annual base salary and provides that, if SPRC achieves an operating ratio of 89.5% for 1994, 88.0% for 1995 or 85.0% for 1996, the CEO will receive 200,000 shares, 300,000 shares and 350,000 shares of SPRC Common Stock, respectively, as a stock bonus under SPRC's Equity Incentive Plan. If the required SPRC operating ratio for any year is not achieved, the SPRC Compensation Committee of the Board of Directors may in its discretion award a portion of such shares. The SPRC Compensation Committee has authorized the grant of stock bonuses covering up to 1,375,000 shares of SPRC Common Stock, in the aggregate, to 27 additional key executive employees of the Company in addition to the CEO, contingent upon the attainment of certain pre-established corporate financial and individual performance objectives based on many of the same criteria as the CEO's agreement. A portion of each stock bonus grant is subject to the achievement of such corporate financial and individual performance objectives during each of 1994, 1995, 1996 and 1997. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 11. RELATED PARTIES SPRC has maintained separate accountability for the operating activities of its principal railroad subsidiaries as to the sharing of freight revenues and charges for use of railroad equipment and joint facilities. Interline accounts receivable and payable continue to be settled through the traditional clearing process between railroads. The railroads are coordinating and, where considered appropriate, consolidating the marketing, administration, transportation and maintenance operations of the railroads. In 1992 the Company started using D&RGW's new locomotive repair facility in Denver, Colorado for major locomotive repair work. D&RGW charged the Company $33.8 in 1993 and $35.8 million in 1992 for locomotive repairs performed for the Company. In addition, D&RGW charged the Company $2.0 million, $2.4 million and $1.1 million for locomotives leased to the Company in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company owed D&RGW approximately $8.4 million for such items. Commencing in 1990, the Company charges D&RGW for a portion of costs incurred relating to the marketing and administrative functions of the railroads. Such charges amounted to $16.4 million, $14.3 million and $9.5 million in 1993, 1992 and 1991, respectively. As part of the capital and debt transactions completed in August 1993 and March 1994, the Company purchased a total of $226.6 million of D&RGW property, including the Burnham locomotive repair facility in Denver, Colorado (See Note 15). The Company paid $6.8 million, $4.2 million and $4.1 million in 1993, 1992 and 1991, respectively, to SP Environmental Systems, Inc. ("SPES"), a wholly owned subsidiary of SPRC, for professional services regarding environmental matters, excluding services provided by third parties billed through SPES. The Company and The Anschutz Corporation ("TAC") have engaged in a variety of transactions primarily related to administration and equipment owned and used by the companies for which amounts are billed to and from the Company and functions relating to the purchase of fuel and entering fuel futures contracts on behalf of the Company. Such transactions are based on the usage or services performed. In addition, the Company has entered into an arrangement with TAC whereby TAC administers the Company's mineral interests, including but not limited to oil and gas and hard mineral estates. The Company believes that the terms of these transactions are comparable to those that could be obtained from unaffiliated parties. 12. COMMITMENTS AND CONTINGENCIES It is anticipated that the Company will pay dividends or make advances to SPRC in order for SPRC to make principal and interest payments relating to the $375 million 9 3/8% Senior Notes due 2005. In addition, in order for the Company to meet its consolidated debt obligations and to make payments to buy- out surplus employees and make capital expenditures expected to be required, the Company must improve operating results and sell property, real estate and other assets with substantial values that are not necessary to its transportation operations. The various debt agreements of the Company contain restrictions as to payment of dividends to SPRC. The Company is permitted to make advances or dividends to its parent in order for certain specified interest to be paid by its parent. On November 4, 1993 the Company and Integrated Systems Solutions Corporation ("ISSC"), a subsidiary of IBM, entered into a ten-year agreement under which ISSC will handle all of the Company's management information services ("MIS") functions. These include systems operations, application SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) development and implementation of a disaster recovery plan. Pursuant to the agreement, the Company is obligated to pay annual base charges of between $45 million and $50 million (which covers, among other things, payments for MIS equipment) over a ten year period, subject to adjustments for cost of living increases and variations in the levels of service provided under the agreement. Inherent in the operations of the transportation and real estate business is the possibility that there may exist environmental conditions as a result of current and past operations which might be in violation of various federal and state laws relating to the protection of the environment. In certain instances, the Company has received notices of asserted violation of such laws and regulations and has taken or plans to take steps to address the problems cited or to contest the allegations of violation. The Company has recorded reserves to provide for environmental costs on certain operating and non-operating properties as a result of past operations. Environmental costs include site remediation and restoration on a site-by-site basis as well as costs for initial site surveys and environmental studies of potentially contaminated sites. The Company has made and will continue to make substantial expenditures relating to environmental conditions on its properties, including properties held for sale. In assessing its potential environmental liabilities, the Company typically causes ongoing examinations of newly identified sites and evaluations of existing clean-up efforts to be performed by environmental engineers. These assessments, which usually consider a combination of factors such as the engineering reports, site visits, area investigations and other steps, are reviewed periodically by counsel. Due to uncertainties as to various issues such as the required level of remediation and the extent of participation in clean-up efforts by others, the Company's total clean-up costs for environmental matters cannot be predicted with certainty. The Company has accrued reserves for environmental matters with respect to operating and non- operating properties not held for sale, as well as certain properties previously sold, based on the costs estimated to be incurred when such estimated amounts (or at least a minimum amount) can be reasonably determined based on information available. During the years ended December 31, 1993, 1992 and 1991, the Company recognized expenses of $10.5 million, $5.0 million and $74.0 million, respectively, related to environmental matters. At December 31, 1993 and 1992, the Company had accrued reserves for environmental contingencies of $58.8 million and $67.8 million, respectively, which includes $13.6 million and $15.8 million, respectively, in current liabilities. These reserves relate to estimated liabilities for operating and non-operating properties not held for sale and certain properties previously sold, and were exclusive of any significant future recoveries from insurance carriers. Based on the Company's assessments described above, other available information and the amounts of the Company's established reserves, management does not believe that disposition of environmental matters known to the Company will have a material adverse effect on the Company's financial position. However, there can be no assurance that material liabilities or costs related to environmental matters will not be incurred in the future. A substantial portion of the Company's railroad employees are covered by collective bargaining agreements with national railway labor organizations that are organized along craft lines. These agreements are generally negotiated on a multi-employer basis, with the railroad industry represented by a bargaining committee. The culmination of various Presidential and legislative events in 1992 resulted in the Company negotiating most of its labor agreements separately. Certain of the completed agreements allowed the Company not to make lump sum payments previously accrued and to incur smaller wage increases in the future than other railroads. A substantial number of the labor agreements expire in 1995. As a condition to its approval of the consolidation of Union Pacific, Missouri Pacific Railroad Company ("MP") and Western Pacific Railroad Company in 1982, the ICC awarded SSW trackage rights to operate over the MP lines between Kansas City and St. Louis. The ICC's initial decision did not fix the compensation SSW would pay for the trackage rights, which commenced in January 1983. After a series of hearings, the ICC set forth new principles to govern the computation of charges. Union Pacific has asserted a claim for SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) additional amounts due against the Company of approximately $60 million (including interest) as of December 31, 1993 and has filed a collection action in Federal District Court. SPT has contested the amounts claimed for various reasons. Union Pacific has requested the District Court to reconsider and set aside its decision. Whether or not the Company's position is sustained, the amount owed Union Pacific will be substantial. Management has made provision that it believes to be adequate for this matter in current liabilities in its financial statements. In July 1991, a derailment near Dunsmuir, California, occurred. While certain litigation continues and the total amount of damages and related costs cannot be determined at this time, SPT is insured against most types of damages and related costs involved with the Dunsmuir derailment to the extent that they exceed $10 million. As of December 31, 1993, SPT had paid approximately $44.7 million related to the Dunsmuir derailment, of which $12 million was charged to expense primarily to cover the $10 million deductible. The balance has been or is in the process of being collected from insurance carriers. As of December 31, 1993, approximately $24.9 million had been recovered by SPT from insurers. SPT expects to recover substantially all additional damages and costs under its insurance policies. As a result, disposition of these matters is not expected to have a material adverse effect on the Company's financial condition. Although the Company has purchased insurance, the Company has retained certain risks with respect to losses for third-party liability and property claims. In addition, various claims, lawsuits and contingent liabilities are pending against the Company. Management has made provisions for these matters which it believes to be adequate. As a result, the ultimate disposition of these matters is not expected to have a material adverse effect on the Company's consolidated financial position. 13. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information for the years ended December 31, 1993, 1992, and 1991 is as follows (in millions): SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 14. QUARTERLY DATA (UNAUDITED) - -------- (a) First quarter 1993 data includes an extraordinary charge of $98.9 million (net of taxes) for the change in accounting for postretirement benefits other than pensions. 15. CAPITAL AND DEBT TRANSACTIONS On August 17, 1993 SPRC closed the offering and sale of 30,783,750 shares of common stock and issued and sold $375 million principal amount of 9 3/8 percent Senior Notes due 2005. In connection with the foregoing transactions, the Company issued 200 shares of common stock for total consideration of $445.5 million from SPRC. The proceeds from this transaction were used to repay $169 million outstanding under the SPT Term Loan, to purchase $107.7 million of D&RGW property including principally the Burnham locomotive repair facility and certain non-operating properties, to purchase for $99.1 million equipment operated pursuant to operating leases, to pay fees and expenses of $3.8 million and for general corporate purposes. In addition, as part of the foregoing transactions, the Company entered into a $200 million three-year unsecured Credit Agreement replacing its then existing secured bank credit facility. On March 2, 1994, SPRC closed an offering of 25,000,000 shares of common stock. In connection with this transaction, the Company issued 150 shares of common stock for consideration of $294.5 million from SPRC. The proceeds were used to repay the $175 million then outstanding balance on the Credit Agreement and to purchase $118.9 million of D&RGW rail properties. The proceeds of the purchase from D&RGW were used to repay the amounts outstanding under the RGH credit facilities. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 16. SUPPLEMENTAL CONDENSED COMBINING FINANCIAL INFORMATION The following presents supplemental condensed combining financial information (in millions). SUPPLEMENTAL CONDENSED COMBINING BALANCE SHEETS--DECEMBER 31, 1993 SUPPLEMENTAL CONDENSED COMBINING BALANCE SHEETS--DECEMBER 31, 1992 SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) SUPPLEMENTAL CONDENSED COMBINING STATEMENTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1993 SUPPLEMENTAL CONDENSED COMBINING STATEMENTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1992 SUPPLEMENTAL CONDENSED COMBINING STATEMENTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1991 SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) SUPPLEMENTAL CONDENSED COMBINING STATEMENTS OF CASH FLOWS--YEAR ENDED DECEMBER 31, 1993 SUPPLEMENTAL CONDENSED COMBINING STATEMENTS OF CASH FLOWS--YEAR ENDED DECEMBER 31, 1992 SUPPLEMENTAL CONDENSED COMBINING STATEMENTS OF CASH FLOWS--YEAR ENDED DECEMBER 31, 1991 SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V. PROPERTY AND EQUIPMENT - -------- (a) Equipment acquired under capitalized lease agreement. (b) Locomotives delivered in 1991 and paid for in 1992. (c) Property acquired in connection with the acquisition of SPCSL. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI. ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT - -------- (a) Amount reserved for 1,200 miles of low density rail lines identified for sale or abandonment as part of the 1991 Special Charge. SOUTHERN PACIFIC TRANSPORTATION COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES SOUTHERN PACIFIC RAIL CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION

357019_1993.txt

357019_1993

1993

357019

Item 1. Business The principal business of GATX Capital Corporation (the "Company") is to provide asset-based financing of transportation and industrial equipment through capital leases, secured equipment loans, and operating leases. The Company also provides related financial services which include the arrangement of lease transactions for investment by other lessors and the management of lease portfolios for third parties. GATX Capital Corporation is a wholly-owned subsidiary of GATX Corporation. GATX Capital Corporation, a Delaware corporation, was founded in 1968 as GATX Leasing Corporation to own, sell and finance equipment independent of GATX Corporation's other specialized equipment activities. During 1968 and 1969, the Company emphasized the leasing of commercial aircraft. Since that time, however, it has developed a portfolio of earning assets diversified across a wide range of industries. At December 31, 1993, the Company had approximately 750 financing contracts with 509 customers, aggregating $1.3 billion of investments before reserves. Of this amount, 47% consisted of investments associated with commercial jet aircraft, 15% railroad equipment, 8% real estate, 8% golf courses, 7% warehouse and production equipment, 6% marine equipment and 9% other equipment. Although GATX Capital's original business purpose was to invest in tax-oriented capital equipment financing leases, the equipment knowledge and financial expertise derived from these activities have enabled the Company to pursue other financial services objectives as well. In addition to pursuing financing leases, operating leases and equipment secured loans for its own account, GATX Capital also arranges such investment opportunities for others. The Company also develops and manages lease portfolios on behalf of other owners. In these underwriting and management activities, the Company seeks fee income and residual participation income. Item 2. Item 2. Properties The Company leases all of its office space and owns no materially important physical properties other than those related directly to its investment portfolio. The Company's principal offices are rented under a twelve year lease expiring in 2003. Item 3. Item 3. Legal Proceedings There are no legal proceedings pending to which the Company is a party, other than routine litigation in the normal course of business of the Company. The Company believes that the outcome of any lawsuit or claim which is pending or threatened will not have a material adverse effect on its financial condition or operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Omitted under provisions of the reduced disclosure format. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters Not applicable. All common stock of the Registrant is held by GATX Financial Services, Inc. (a wholly-owned subsidiary of GATX Corporation). Information regarding dividends is shown on the consolidated statement of stockholder's equity included in Item 8. Item 6. Item 6. Selected Financial Data GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operation - Comparison of 1993 to 1992 GATX Capital Corporation reported net income of $21.5 million for 1993. The increase from the 1992 net loss of $7.2 million was primarily due to the reduction in the provision for losses, coupled with an increase in gains on disposition of equipment. Earned income increased between the years as a result of increases in lease income and gains on disposition, partially offset by decreases in fee income and income from joint ventures. Disposition gains, which do not fall evenly from year to year, were higher in 1993 due to a $16.6 million gain from an insurance settlement related to marine equipment and a greater number of lease terminations in 1993. Lease income reached an all-time high in 1993 as a result of the significant amount ($216.0 million) invested in new leases during the year. Partially offsetting this increase was a decline in fee income due to a reduced number of transactions in the international market. The slight decrease in interest income corresponds to the decrease in the average secured loan balance between the years. Income generated by the Company s investments in joint ventures was lower in 1993 due in part to a revision of residual estimates at one of the Company s technology finance joint ventures which resulted in no income recognition in 1993. Also, during 1992, a $2.7 million gain was recognized on the sale of a real estate investment. The decrease in total expenses is primarily due to the $52 million reduction in the loss provision. The large 1992 loss provision reflected the continued deterioration in older Boeing 747 aircraft, primarily freighters, and real estate areas of the Company s portfolio. Interest expense declined due to the decrease in the average outstanding debt balance between years and generally lower interest rates. These were offset by an increase in operating lease expense stemming from a full year of aircraft depreciation and the acquisition and subsequent sale leaseback of a significant rail operating lease portfolio. The federal tax rate increase of 1%, which was retroactive to January 1, 1993, resulted in an increase to tax expense of $2.1 million. Of this, $1.6 million was related to the cumulative effect of the rate increase on the deferred tax balance as of December 31, 1992. Total investments before the allowance for possible losses declined $88.6 million. Much of this decline resulted from real estate sales and various asset write-downs which are reflected in the reduction in assets held for sale or lease. Also, in the fourth quarter of 1993, the Company sold half of its investment in a cogeneration facility, the remainder of which is now accounted for using the equity method. The impact of this sale on the Company s balance sheet was primarily a reduction in other investments of $36.3 million and a reduction in nonrecourse debt of $37.8 million. During 1993, the Company entered into a lease transaction for the sale leaseback of a large portfolio of rail equipment. The net book value of the equipment is not shown on the balance sheet, although the cash investment and subsequent disposition proceeds appear on the cash flow statement. This transaction continues to produce revenue and has certain associated operating expenses. The provision for losses was $29.0 million in 1993 reflecting continued concern for certain aircraft type values. After charges to the allowance of $44.2 million and recoveries of $2.1 million, the allowance for possible losses stood at $88.2 million, or 6.92% of total investments at December 31, 1993. The outlook for both GATX Capital and the leasing industry in the near-term is one of cautious optimism. The leasing industry, in general, has weathered a rough four to five year transition period due to tax law changes, the weak economy, low interest rates, weakness in certain equipment sectors and company consolidations. As the economy slowly recovers, which in turn should increase capital spending, we see many opportunities for GATX Capital s leasing activities. At the same time, we expect increased competition via new entrants to the leasing marketplace. In the commercial airline industry, there have been some signs of improvement in cost control. Losses for the worldwide industry, while still significant, are less than in the two previous years. Overcapacity in nearly all aircraft types is slowly being absorbed, however, near-term aircraft demand will remain weak. New aircraft production rates are being lowered and older aircraft are forecasted to be retired at higher than historical rates. This bodes well for aircraft leasing in the long-term. The prospects for the rail industry and GATX Rail in 1994 appear to be very good. The railroads seem to be preparing for significant traffic growth, based on accelerating economic activity and the continuing diversion of domestic highway traffic to railroad intermodal service. 1993 ended with very high utilization rates for GATX Rail s operating lease fleet and we expect this trend to continue in 1994. The outlook for Golf Capital continues to be guardedly positive. More equity capital is finding its way into the golf industry, which in turn will provide a more active secondary market for golf courses. This will have a positive effect relative to the courses already financed, but could also have a negative effect if it results in increased competition for our financing activities. Certain segments of the commercial real estate marketplace have shown signs of recovery as more capital is flowing into this industry, largely from REITs (Real Estate Investment Trusts). This has had a positive effect on us as evidenced by our increased liquidation activity in 1993. There has been so much volatility in the real estate marketplace, however, that drawing a trend conclusion is difficult. Results of Operation - Comparison of 1992 to 1991 GATX Capital Corporation reported a net loss of $7.2 million for 1992. The decrease from 1991 s net income of $28.5 million was principally due to an increased provision for losses and a decline in disposition gains. Earned income decreased between 1991 and 1992 primarily as a result of a $28.2 million decline in gains from disposition of equipment. Significantly fewer equipment and aircraft leases reached termination in 1992 compared with 1991, resulting in the expected decline in disposition income. The decrease in interest income between 1991 and 1992 was due in part to an increase in the number of real estate loans on which income ceased to be recognized and in part to the early repayment of an aircraft loan in late 1991. The increase in lease income between years was primarily a result of the increase in the lease portfolio during the year. Fee income was higher than 1991 due to the development of new equity sources in the international market. The Company s investments in joint ventures yielded $3.0 million less total income in 1992 than in 1991. The Company s share of income from GATX-Airlog, a joint venture to convert Boeing 747 passenger and combi aircraft into freighters, was down $4.3 million due to the softening of the aircraft freighter market. The Company s investment in GATX/CL Air Leasing Cooperative Association (GATX/CL Air), a commercial aircraft operating lease joint venture, generated $1.3 million less joint venture income due to lower operating lease rates and the effect of a change in depreciation policy discussed below. These decreases were partially offset by $2.7 million of joint venture income in 1992 from the sale of a real estate investment. The decrease in other income was partially due to lower income from the Company s investment in a cogeneration facility and partially due to a reduction in income generated from the accretion of future residuals as certain assets came to normal lease termination. Effective July 1, 1992, the Company and its aircraft leasing joint ventures changed their estimates of the useful lives and salvage values of aircraft in their operating lease fleet. The useful lives and salvage values of such aircraft previously varied depending on a number of factors but are now standardized. The aircraft are being depreciated on a straight-line basis over their useful lives, which range from 25-40 years. Depreciation expense related to aircraft in the operating lease fleet is recorded in operating lease expense. The change in estimate had the impact of decreasing joint venture income and increasing operating lease expense for 1992 by $0.6 million and $1.7 million, respectively. Total expenses were higher in 1992 compared to 1991 principally as a result of the $43.0 million increase in the provision for possible losses. The increase in the provision was due to a $60.0 million additional provision reflecting continuing deterioration in older Boeing 747 aircraft, primarily freighters, and real estate. After charges to the allowance of $52.2 million and recoveries of $0.7 million during 1992, the allowance for possible losses had a balance of $101.3 million, or 7.4% of total gross investments at December 31, 1992. Interest expense was virtually unchanged between years as higher average outstanding debt balances were offset by lower interest rates. Selling, general and administrative expenses were down from the prior year due primarily to a decrease in the average number of employees, lower outside service expenses, and reduced insurance costs. The increase in operating lease expense is directly related to the increase in the average operating lease portfolio between 1991 and 1992. Liquidity and Capital Resources The Company derives cash from operations and the proceeds from its investment portfolio. This cash, supplemented as required by short-term and long-term borrowing, is invested in activities to expand the business. Disposition proceeds are a major component of the annual cash in-flow and can vary significantly between years. Historically, the largest components of proceeds from disposition of equipment have been generated from aircraft and rail equipment disposed at the end of a lease. Occasionally, significant amounts of cash will be generated from unusual or nonrecurring transactions. Proceeds from disposition of other assets in 1993 included $90.6 million from a single transaction whereby the Company purchased an operating lease portfolio and subsequently sold it and is leasing it back from the purchaser. Also, several real estate investments were liquidated in 1993 for total sales proceeds of $32.0 million and a loan repayment of $7.4 million. During 1992, cash distributed from the Company s investments in joint ventures included $17.4 million of proceeds from the sale of a real estate investment. During 1991, the Company received a prepayment of rent on an operating lease transaction of $80.0 million in cash. The Company s backlog was $224.2 million as of December 31, 1993. Of this amount, $151.0 million is scheduled for 1994 and the remainder for 1995 and beyond. The Company expects to fund a portion of future growth through issuance of medium term notes, commercial paper, and bankers acceptances. The commercial paper and bankers acceptances are backed by credit agreements from a syndicate of domestic and international commercial banks. The Company had unused capacity under these agreements of $185.3 million at December 31, 1993. In addition, the Company has a $300.0 million shelf registration for Series C medium term notes, under which none have been issued. Historically, dividends have been paid on the Company s common stock at the rate of 50% of net income. During 1992, however, dividends were not declared due to the net loss generated by the Company. The 50% rate was resumed in 1993 for earnings before the effect of the federal tax rate increase and is expected to continue in the future. Total debt financing decreased $56.4 million during 1993, while stockholder s equity increased $10.2 million. As a result, the Company s debt to equity ratio declined from 2.98:1 in 1992 to 2.68:1 in 1993. The leverage ratio as defined in the Company s credit agreements remains well within the 4:1 limit. The Company ensures a stable margin over its cost of funds by managing the relationship of its fixed and floating rate lease and loan financing to its fixed and floating rate borrowing. At December 31, 1993, the Company had $51.1 million more floating rate assets than floating rate debt. The following table provides additional information with respect to the Company s liquidity and financial position: Item 8. Item 8. Financial Statements and Supplementary Data GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES GATX CAPITAL CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements Note A: Significant Accounting Policies Business The principal business of GATX Capital Corporation and subsidiaries ("the Company") is to provide or arrange lease and loan financing of equipment for commercial users. The Company also provides loans to golf management companies which are collateralized by the associated golf courses. GATX Capital Corporation is a wholly-owned subsidiary of GATX Corporation. At December 31, 1993, the Company had approximately 750 financing contracts with 509 customers, aggregating $1.3 billion of in- vestments before reserves. Of this amount, 47% consisted of investments associated with commercial jet aircraft, 15% railroad equipment, 8% real estate, 8% golf courses, 7% warehouse and production equipment, 6% marine equipment and 9% other equipment. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries after elimination of significant intercompany accounts and transactions. Investments in minority- owned or non-controlled affiliated companies are accounted for using the equity method. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equiv- alents. The carrying amounts reported in the balance sheet for cash and cash equivalents approximate the fair value of those assets. Intangible Assets Intangible assets consist of goodwill related to the cost of the parent s investment in the Company in excess of underlying net assets at the date of acquisition and the cost of acquired companies in excess of the values assigned to their net assets. The balance is amortized on a straight-line basis by annual charges to income over periods ranging from 22 to 25 years. Deferred Income Deferred income primarily represents payments received from customers for which the earnings process has not been completed. Included in the balance at December 31, 1993 is $8.0 million of advance rental payments which will be amortized to lease income through the fourth quarter of 1994 and $48.0 million which will either be recorded as disposition proceeds or returned to the customer in 1994 upon exercise of their option to purchase or return equipment currently on lease. Reclassification Certain amounts in the financial statements presented have been reclassified to conform prior years data to the current presentation. Note B: Investments Direct Financing Leases The Company s investment in direct financing leases includes lease contracts receivable plus the estimated residual value of the equipment at the lease termination date, less unearned income. Lease contracts receivable includes the total rent to be received over the life of the lease reduced by rent already collected. Initial unearned income is the amount by which the lease contract receivable plus the estimated residual exceeds the initial investment in the leased equipment at lease inception. The remaining unearned income is amortized to lease income over the lease term in a manner which produces a constant rate of return on the net investment in the lease. Initial direct costs for originated leases are capitalized and amortized to affect an adjustment of yield over the term of the lease. The components of the Company s investment in direct financing leases are as follows (in thousands): Leveraged Leases Financing leases which are financed principally with nonrecourse borrowings at lease inception, and which meet certain other criteria, are accounted for as leveraged leases. Leveraged lease contracts receivable are stated net of the related nonrecourse debt service, which includes unpaid principal and aggregate remaining interest on such debt. Unearned income represents the excess of anticipated cash flows (including estimated residual values and after taking into account the related debt service) over the Company s investment in the lease. Initial direct costs associated with the origination of leveraged leases are charged to unearned income at lease inception. The components of the Company s net investment in leveraged leases are as follows (in thousands): Operating Leases Leases that do not qualify as direct financing or leveraged leases are accounted for as operating leases. Equipment subject to operating leases are stated at cost less accumulated depreciation plus accrued rent and are generally depreciated to their estimated residual values using the straight-line method. Aircraft are depreciated over their useful lives, ranging from 25-40 years, while other equipment is generally depreciated over the term of the lease. Depreciation expense of $26.0 million, $16.4 million, and $11.6 million is included in operating lease expense for 1993, 1992 and 1991, respectively. Effective July 1, 1992, the Company and its aircraft leasing joint ventures changed their estimates of the useful lives and salvage values of aircraft in their operating lease fleet. The change in estimate had the impact of decreasing joint venture income and increasing operating lease expense for 1992 by $0.6 million and $1.7 million, respectively. Secured Loans Investments in secured loans are stated at the principal amount outstanding plus accrued interest. The loans are collateralized by equipment, golf courses or real estate. At December 31, 1993, $15.5 million of the Company s $226.1 million loan portfolio were on nonaccrual status. The Company does not believe an estimate of the fair value of these loans on nonaccrual can be made at this time without incurring excessive cost inasmuch as active markets for these loans do not currently exist. The Company s estimate of potential impairment due to collectibility concerns related to these loans is included in the allowance for possible losses. The fair value of the remaining loan portfolio ($210.6 million at December 31, 1993 and $214.6 million at December 31, 1992) is estimated to be $212.8 million and $220.7 million at December 31, 1993 and 1992, respectively. For variable-rate loans totaling $108.1 million at December 31, 1993 and $104.9 million at December 31, 1992, fair values are based on carrying amounts. The fair values of the fixed rate loans ($102.5 million at December 31, 1993 and $109.7 million at December 31, 1992) are estimated using discounted cash flow analyses, using interest rates currently offered for loans with similar terms to borrowers of similar credit quality. Financing Lease and Operating Lease Receivables and Loan Balance As of December 31, 1993, financing lease receivables (net of nonrecourse debt service related to leveraged leases), minimum future rentals under operating leases and secured loan principal by year due are as follows (in thousands): Investment in Joint Ventures Investments in joint ventures include aircraft, real estate, cogeneration, and equipment leasing ventures which are accounted for using the equity method. The extent of the Company s effective ownership interest and/or level of management control dictates the use of the equity method. Under such method, original investments are recorded at cost and adjusted by the Company s share of undistributed earnings or losses of these ventures and reduced by cash distributions. Interest capitalized on investments in joint ventures was $0.3 million, $0.7 million and $1.8 million in 1993, 1992 and 1991, respectively. Cash recovered from joint venture investments was $24.6 million, $52.6 million and $22.6 million in 1993, 1992 and 1991, respectively. The Company makes certain adjustments to net income as reported by some of the joint ventures prior to the Company s calculation of its share of that net income in order to provide consistency with the Company s accounting policies. Due to the significance of the adjustments made to two of the joint ventures, the combined and condensed operating and balance sheet data have been restated to reflect these adjustments. Pre-tax income has been increased by $22.6 million in 1992 to adjust for equipment write-downs recorded as a loss by one joint venture; the Company charged its share of the write-downs to the allowance for possible losses. Pre-tax income also has been increased by $20.8 million, $15.1 million and $12.7 million in 1993, 1992 and 1991, respectively, to reverse interest expense recognized on loans to a joint venture from its partners; the Company records these loans as equity contributions. The partner loan balances of $482.3 million, $393.6 million and $251.3 million at December 31, 1993, 1992 and 1991, respectively, have been reclassified from long-term liabilities to partners equity. Unaudited combined and condensed operating and balance sheet data as adjusted are as follows (in thousands): Assets Held for Sale or Lease Assets held for sale or lease consist of equipment which has been repossessed or returned by the lessee after normal lease termination, and real estate upon which the Company foreclosed when the debtors owning the property were unable to discharge their obligations or which has been recorded as an in-substance foreclosure. Upon foreclosure, properties are recorded at the lower of their then carrying amount or fair market value. Generally, depreciation is only recorded on aircraft available for sale or lease which is held for more than six months. The major classes of assets held for sale or lease are as follows (in thousands): Other Investments Other investments, as of December 31, 1993, primarily consist of the Company s investment in a residential and commercial real estate development, payments toward the acquisition of leased assets and progress payments for assets under construction. In 1993, a wholly-owned subsidiary of the Company became the majority owner of a residential and commercial real estate development which was formerly accounted for using the equity method and is now fully consolidated. Also during 1993, the Company sold half of its interest in a cogeneration facility, the remainder of which is now accounted for using the equity method. Prior to the sale, there was depreciation expense on the facility of $1.5 million, $1.8 million, and $1.8 million in 1993, 1992 and 1991, respectively, included in other expense. The other investment balance at December 31, 1992 is net of $3.8 million of accumulated depreciation. The facility was financed by nonrecourse debt (see Note D) having a balance of $37.8 million at December 31, 1992. The components of other investments are as follows (in thousands): Investment in Future Residuals The Company has purchased interests in the residual values of leased equipment. Residuals purchased prior to July 1, 1985 are accreted to their estimated future value. For lease residuals purchased after June 30, 1985, the Company does not accrete the carrying value over time; the difference between initial cost and future value is recognized upon disposition. Under certain lease underwriting compensation formulas, the Company earns a fee based on the future residual owned by the equity investor for whom the lease was arranged. With respect to transactions concluded prior to June 18, 1986, fees may be recognized as income at lease inception at the net present value of estimated future cash flows from residual realization. Such stated amounts are accreted in a manner designed to produce a constant rate of return on such net present value. This accretion is also included in fee income. Recognition of all fees from transactions concluded after June 17, 1986 occur upon realization. The components of the Company s recorded investment in future residuals are as follows (in thousands): Note C: Allowance for Possible Losses The Company maintains an allowance for possible losses through periodic provisions. The purpose of the allowance is to provide for potential credit and collateral losses and permanent declines in investment values. It is the Company s policy to charge off amounts which, in the opinion of management, are not recoverable from obligors or the disposition of collateral. Activity within the allowance for possible losses account was as follows (in thousands): The increase in the 1992 provision reflected continued deterioration in older Boeing 747 aircraft, primarily freighters, and real estate areas of the Company s portfolio. Note D: Debt and Capital Lease Financing At December 31, 1993, the Company had commitments under its credit agreements with a group of banks for revolving credit loans aggregating up to $290 million. The credit agreements contain various covenants which include, among other factors, minimum net worth, restrictions on dividends and requirements to maintain certain financial ratios. At December 31, 1993, such covenants limited the Company s ability to transfer net assets to its parent to no more than $82.9 million. The revolving commitments are available for borrowing, repaying and reborrowing at any time and contain various pricing options. The Company pays a facility fee on one facility and a commitment fee on the unused commitments of the other two facilities, but is not obligated to maintain compensating balances. At December 31, 1993, $185.3 million of the commitments in excess of amounts backing commercial paper and bankers acceptances were available and unused. The Company obtains short-term financing by issuance of commercial paper and bankers acceptances through its dealers in the United States and Canada, and from notes payable to banks. At December 31, 1993, the majority of such borrowings were backed by or under the principal credit agreements. Activity related to these short-term financings was as follows (in thousands): The carrying amounts reported in the balance sheet for commercial paper and bankers acceptances and variable notes payable approximate the fair value of those liabilities. The variable rate debt, including fixed rate debt subject to variable rate swaps, at December 31, 1993 and 1992 approximates its fair value. At December 31, 1993, the fair value of the fixed rate senior term notes less the $180.0 million which were swapped for variable rates ($404.9 million) is $458.7 million. At December 31, 1992, the fair value of fixed rate senior term notes was $551.9 million. Fair value was estimated by aggregating the notes and performing discounted cash flow analyses using a weighted average note term and the current market rate for similar types of borrowing arrangements. Nonrecourse obligations include the following: Nonrecourse obligations consist primarily of debt collateralized by aircraft, and their related lease contracts, and real estate projects. The nonrecourse obligation associated with one aircraft will become recourse to the Company to the extent of the then remaining debt balance in 2002 when a balloon payment of $7.3 million is due. The carrying amount of the variable rate debt at December 31, 1993 and 1992 approximates its fair value. The fair value of the fixed rate notes at December 31, 1993 and 1992 is $8.4 million and $44.4 million, respectively. Fair value was estimated by aggregating the notes and performing a discounted cash flow analysis using a weighted average note term and the current market rate for similar types of borrowing arrangements. Obligations under capital leases consist of equipment subject to capital lease financing which has been subleased. Such subleases are classified as direct financing leases having a carrying value of $23.6 million and $32.1 million at December 31, 1993 and 1992, respectively. Minimum future lease payments receivable under the subleases aggregate $29.8 million receivable over a period ending in 2003. The obligations under capital leases and the related subleases have the same term and call for fixed rental payments. The Company has purchase or renewal options under the leases which allow it to accommodate similar options exercisable by sublessees. Maturities of debt financings, obligations under capital leases and nonrecourse obligations for each of the years 1994 through 1998 and in total thereafter are presented in the following table (in thousands). This table assumes that the commercial paper, notes payable and bankers acceptances are retired by the unused revolving commitments. The Company uses interest rate swaps in addition to commercial paper and floating rate medium term notes to fund its floating rate lease and loan investments. The Company pays interest on the notional principal amounts of the swaps based on a widely used floating rate index (6 month Libor). No actual lending or borrowing is involved. The total notional principal of all swaps as of December 31, 1993 was $180.0 million with termination dates ranging from 1995 to 2003. The fair value of the swaps at December 31, 1993 approximate their notional principal amounts. Note E: Capital Stock As of December 31, 1993 and 1992, all issued common and preferred stock of the Company was indirectly owned by GATX Corporation through its wholly-owned subsidiary, GATX Financial Services, Inc. The preferred stock has a conversion price of $100 per share and may be exchanged for common stock on a one-for-one basis. Dividends on preferred stock are payable on a share-for-share basis at the same rate per share as common stock when and as declared by the board of directors. Conversions of preferred stock will commence in the year 2003 unless GATX Corporation continues to extend the initial redemption date. The preferred stock redemption schedule calls for 51,355 shares to be redeemed in each of the first two conversion years, 77,030 shares in each of the subsequent two years, 102,705 shares in each of the following three years and 154,055 shares in each of the succeeding three years. Conversion is conditioned on the Company being in compliance with provisions of all of its debt agreements. Note F: Income Taxes Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The cumulative effect of adopting Statement 109 as of January 1, 1992 was to increase net income by $10.1 million. GATX Corporation files a consolidated federal income tax return which includes the Company and its subsidiaries. Under an intercompany tax agreement, the parent reimburses the Company to the extent the Company s operating losses and investment tax credits are utilized in the consolidated federal return. Should the Company generate taxable income, the agreement provides for payment by the Company of any resulting additional federal tax liability incurred by GATX Corporation. However, in the past the Company had deferred a portion of such payments to the parent arising from certain types of transactions as permitted under the intercompany tax agreement. Such deferrals of tax payments to the parent were reflected as a component of due to/from GATX Corporation. During 1991, the majority of the remaining balance of such deferrals, $9.4 million, was converted into an additional investment by the parent in the Company. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company has recorded these differences in its deferred tax accounts, inter-company accounts receivable, and equity accounts. In exchange for cash payments, GATX Corporation has assumed a portion of GATX Capital s deferred tax liability. GATX Corporation re-contributed these amounts through the purchase of Redeemable Preferred Stock over the period from 1975 to 1985. In addition, GATX Capital has an account receivable due from GATX Corporation resulting from the reassumption of a portion of these deferred taxes through December 31, 1993 of $46.1 million (see Note H). Significant components of the Company s deferred tax liabilities and assets are as follows (in thousands): The components of the provision for deferred income tax benefits for the year ended December 31, 1991 under the deferred method were as follows (in thousands): Income before income taxes from foreign operations was $3.0 million, $2.1 million, and $2.2 million in 1993, 1992 and 1991, respectively. Foreign tax expense was $2.0 million, $1.2 million, and $0.9 million in 1993, 1992, and 1991, respectively. The differences between total income tax expense and the amount computed by applying the statutory federal income tax rate of 35% in 1993 and 34% in prior years to pre-tax income are as follows (in thousands): Note G: Operating Lease Obligations The Company is a lessee under certain aircraft, railroad rolling stock, and office leases which are classified as operating leases. Total rental expense was $9.8 million, $7.7 million and $7.6 million in 1993, 1992 and 1991, respectively. The aircraft and rolling stock under these leases have been subleased, generating lease income of $12.8 million, $4.9 million and $4.9 million in 1993, 1992 and 1991, respectively. During 1993, the Company entered into a lease transaction for the sale leaseback of a large portfolio of rail equipment. The net book value of the equipment is not shown on the balance sheet. The gain realized on the sale has been deferred and is being credited to income over the lease term. Future rentals payable by the Company and sublease receivables under noncancellable operating leases over a period ending in 2012 are as follows (in thousands): Note H: Intercompany Transaction and Obligations The amount due from GATX Corporation at December 31, 1993 consists primarily of an advance of $46.1 million related to the reassumption of deferred taxes (see Note F). Offsetting this receivable is $3.4 million due to GATX Corporation which consists of amounts owed for overhead and taxes pursuant to an intercompany tax agreement (see Note F). Note I: Foreign Operations In addition to its domestic operations, the Company provides or arranges equipment financing for nonaffiliated entities outside the United States. Selected information related to foreign operations is summarized below (in thousands): Note J: Retirement Benefits The Company participates in the GATX Non-Contributory Pension Plan for Salaried Employees (the "Plan"), a defined benefit pension plan with GATX Corporation covering substantially all employees. Pension cost for each GATX subsidiary included in the plan is determined by independent actuaries. However, accumulated plan obligation information, plan assets and the components of net periodic pension costs pertaining to each subsidiary have not been separately determined. Pension expense allocated to the Company for 1993, 1992 and 1991 was $0.7 million, $0.6 million and $0.5 million, respectively. Contributions to the Plan were made by the Company through GATX Corporation and amounted to $0.4 million, $0.5 million and $0.5 million in 1993, 1992 and 1991, respectively. In addition to pension benefits, the Company provides other postretirement benefits, including limited health care and life insurance benefits, for certain retired employees who meet established criteria. Most domestic employees are eligible if they retire from the Company with immediate pension benefits under the GATX Pension Plan. Effective January 1, 1992, the Company adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions , which changed the accounting for postretirement benefits to the accrual method. The cumulative effect of this accounting change as of January 1, 1992 on years prior to 1992 was a $0.6 million liability, net of the income tax effect, which resulted in a decrease in net income for 1992. Note K: Commitments The Company s backlog was $224.2 million and $198.3 million, respectively at December 31, 1993 and 1992. Loans comprised $16.5 million and $12.5 million of the total at December 31, 1993 and 1992, respectively. The fair value of these loans was $0.3 million at December 31, 1993 and $0.2 million at December 31, 1992. Fair value was calculated by estimating the current fees which would be charged for similar commitments. The Company is a party to financial instruments with off-balance- sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees and forward purchase contracts. Such instruments involve, to varying degrees, elements of credit and market risk which are not recognized in the consolidated balance sheets. The contractual amount of the instruments are shown below (in thousands): Guarantees are commitments issued by the Company to guarantee a certain return on an asset at the end of the lease, or to guarantee performance of an affiliate to a third party. These commitments have fixed expiration dates ranging from 1994 to 2012. Since many of the assets on lease are expected to retain their value, the total amount guaranteed does not necessarily represent future cash requirements. Stand-by loan commitments represent an agreement to lend funds to a customer upon the occurrence of certain events as defined in the contract. Collateral related to this commitment is an income- producing commercial property. Future purchase contracts are contracts to purchase leased assets at the end of their lease term (1995) for a specified purchase price. Risk arises when the fair market value of an asset at the end of the lease term is less than the contractual purchase price. It is not practicable to estimate the fair value of the Company s off-balance sheet financial instruments because there are few active markets for these transactions, and the Company is unable at this time to estimate fair value without incurring excessive costs. The Company uses essentially the same credit policies in making commitments and conditional obligations as it does for funded transactions. All investments are subject to normal credit policies, collateral requirements and senior management review. For example, lease provisions require lessees to meet certain standards for maintenance and return conditions, and provide for repossession upon default. Loans are generally secured by equipment or real estate, and occasionally involve guarantees or other assets as collateral. All the commitments having off-balance-sheet risk are reviewed quarterly for potential exposure and a provision for possible loss is made if required. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10(a). Directors of the Registrant Name Office Held Since Age - ------------------------------------------------------------------------------ James J. Glasser Chairman of the Board 1971 59 Ronald H. Zech President and Director 1984 50 John F. Chlebowski,Jr. Director 1985 48 Frederick L. Hatton Executive Vice President and Director 1984 51 Paul A. Heinen Director 1985 64 Joseph C. Lane Executive Vice President and Director 1987 40 David M. Edwards Senior Vice President and Director 1990 42 Item 10(b). Executive Officers of the Registrant Name Office Held Since Age - ------------------------------------------------------------------------------ Ronald H. Zech President, Director, and Chief 1984 50 Executive Officer Frederick L. Hatton Executive Vice President and Director 1984 51 Joseph C. Lane Executive Vice President and Director 1987 40 David M. Edwards Senior Vice President - Finance and Administration, Chief Financial Officer, and Director 1990 42 Thomas C. Nord Vice President, General Counsel, And Secretary 1980 53 George R. Prince Vice President and Treasurer 1983 49 Curt F. Glenn Principal Accounting Officer, 1992 39 Vice President & Controller Valerie C. Williams Vice President - Human Resources 1989 49 RONALD H. ZECH, President, Director and Chief Executive Officer since 1984. Mr. Zech joined the Company in 1977 and served as Vice President - Finance for one year. He was promoted to Senior Vice president Finance and Administration in 1978 and Executive Vice President in 1983. Prior to joining GATX, he served in a variety of managerial capacities for The First National Bank of Chicago, including Vice President and Manager of First Chicago's San Francisco office. Prior to 1970, he was an Assistant Professor of Business Administration at Valparaiso University for four years. Mr. Zech received a BSEE from Valparaiso University in 1965 and an MBA from the University of Wisconsin in 1967. FREDERICK L. HATTON, Executive Vice President, Director and Air Division President since 1984. Mr. Hatton joined the Company in 1983 as Senior Vice President. Prior to 1983, he served as Vice President-Marketing for two years, and Executive Vice President for four years with International Air Service Company (IASCO). Prior to IASCO, Mr. Hatton served in a number of managerial capacities for Flying Tiger Lines. He received a BS from Yale University in 1964, an MS in aerospace management from the University of Southern California in 1971, and an MBA from the Wharton School in 1972. Mr. Hatton served as a U.S. Marine Corps fighter pilot from 1964 to 1970 including a tour in Vietnam. JOSEPH C. LANE, Executive Vice President, Director, President of GATX Leasing. Mr. Lane joined the Company in 1979 as a Financial Analyst and has served as District Manager, Regional Manager, Vice President and Senior Vice President. Mr. Lane was formerly Vice President - Corporate Finance for Rotan Mosle Investment Bankers (two years) and a member of the Yale University Development Faculty (three years). Mr. Lane received a BA from Yale University in 1975. DAVID M. EDWARDS, Senior Vice President - Finance and Administration, Chief Financial Officer and Director since 1990. Mr. Edwards joined the Company in 1981 as Director-Credit Management. He was promoted to Vice President-Credit and Contracts Administration in 1981. In 1985, he was promoted to Assistant to the President of GATX Corporation. In 1988, he was promoted to Vice President-Finance and Administration of GATX Realty. Prior to 1981, Mr. Edwards was Vice President for Security Pacific National Bank. Mr. Edwards received his BA in 1973 and MA in 1975 in Economics from the University of California, Davis. THOMAS C. NORD, Vice President and General Counsel since 1980. Mr. Nord joined the Company as Associate Counsel in 1977 and became Assistant General Counsel in 1978. Prior to 1977, Mr. Nord served as Counsel for Charter New York Leasing, an affiliate of Irving Trust Company (three years), and as an Associate in the New York law firm of Seward and Kissel (five years). Mr. Nord received a BA from Northwestern University in 1962 and a JD from the University of North Carolina in 1969. GEORGE R. PRINCE, Vice President and Treasurer since 1983. Mr. Prince joined the Company in 1981 as Assistant Vice President - Corporate Development. In 1983, he was promoted to Vice President and Treasurer. Prior to 1981, Mr. Prince was Vice President for Continental Bank. Mr. Prince received his BS in 1966 from Cornell University and MBA in 1968 from Michigan State. CURT F. GLENN, Principal Accounting Officer, Vice President & Controller since 1992. Mr. Glenn joined the company in 1980 as Assistant Tax Manager, was appointed Tax Manager in 1985 and elected Vice President in 1989. Prior to joining the Company, Mr. Glenn was a Senior Tax Analyst at GATX Corporation (two years) and a Senior Tax Accountant with Trans Union Corporation (four years). Mr. Glenn received a B.S. in Accounting from DePaul University in 1977. Mr. Glenn is currently Chairman of the Federal Tax Committee of the Equipment Leasing Association of America. VALERIE C. WILLIAMS, Vice President - Human Resources since 1989. Prior to joining GATX, Ms. Williams was President of VC Williams & Associates, a human resources consulting firm; director, Corporate Compensation and Incentives at Carson Pirie Scott & Co. and Consultant, Compensation with A.S. Hansen, Inc. Ms. Williams received her MBA from Lake Forest College in 1980. Items 11, 12 & 13 Items 11, 12 and 13 are omitted under provisions of the reduced disclosure format. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial statements The following consolidated financial statements of GATX Capital Corporation are included in Item 8. Consolidated Balance Sheets - As of December 31, 1993 and Consolidated Statements of Income - Years Ended December 31, 1993, 1992, and 1991 Consolidated Statements of Stockholder's Equity - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial statement schedules All financial statement schedules have been omitted because they are not applicable or because required information is provided in the financial statements, including the notes thereto, which are included in Item 8. 3. Exhibits Required by Item 601 of Regulation S-K Exhibit Number 3(a) Restated Certificate of Incorporation of the Company 1 3(b) By-laws of the Company 2 4(d) Term Loan Agreement between the Company and a Bank dated as of December 26, 1990. 3 10(a) Office Leases, Four Embarcadero Center, dated October 1, 1990 and June 1, 1991, between the Company and Four Embarcadero Center Venture. 3 10(b) Tax Operating Agreement dated January 1, 1983 between GATX Corporation and GATX Leasing Corporation. 4 10(c) Preferred Stock and Tax Assumption program and Issuance of Common Stock. 5 10(d) Preferred Stock Redemption Agreement 6 10(e) Credit Agreement among the Company, the Subsidiaries listed in Schedule II thereto, the Banks listed on the signature pages thereto, and Chase Manhattan Bank, as agent for the Banks, dated December 14, 1992 7 10(f) Credit Agreement among the Company, its two subsidiaries operating in Canada, and the Bank of Montreal, dated December 14, 1992 7 10(g) Credit Agreement among the Company, its two subsidiaries operating in Canada, and the Canadian Imperial Bank of Commerce, dated December 14, 1992 7 12 Computation of Ratio of Earnings to Fixed Charges 8 24 Consent of Independent Auditors 8 28 Listing of Medium Term Notes 8 The Registrant agrees to furnish to the Commission upon request a copy of each instrument with respect to issues of long-term debt of the Registrant the authorized principal amount of which does not exceed 10% of the total assets of Registrant. 1 Incorporated by reference to Form 10-K filed with the Commission on March 30, 1990. 2 Incorporated by reference to Registration Statement on Form S-1, as amended, (file number 2-75467) filed with the Commission on December 23, 1981, page II-4. 3 Incorporated by reference to Form 10-K filed with the Commission on March 30, 1991. 4 Incorporated by reference to Form 10-K filed with the Commission on March 28, 1983. 5 Incorporated by reference to Form 10-K filed with the Commission on March 24, 1986. 6 Included in the Restated Certificate of Incorporation incorporated by reference herein. 7 Incorporated by reference to Form 10-K filed with the Commission on March 31, 1993. 8 Included as an Exhibit hereto. Item 14(b). Reports on Form 8-K No reports on Form 8-K have been filed during the last quarter of the period covered by this report. Item 14(c)(1). Separate Financial Statements of Subsidiaries not Consolidated and Fifty Percent or Less Owned Persons Report of Independent Auditors The General Members of GATX/CL Air Leasing Cooperative Association and the Board of Management and Stockholders of GATX/CL Air N.V. We have audited the accompanying combined balance sheet as of December 31, 1993 and 1992 of GATX/CL Air Leasing Cooperative Association and GATX/CL Air N.V. and the related combined statements of operations, stockholders' and members' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the companies' management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the combined financial position of GATX/CL Air Leasing Cooperative Association and GATX/CL Air N.V. at December 31, 1993 and 1992, and the combined results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. MORET ERNST & YOUNG March 11, 1994 Except for Note 11, as to which the date is March 24,1994. GATX/CL Air Leasing Cooperative Association and GATX/CL Air N.V. GATX/CL Air Leasing Cooperative Association and GATX/CL Air N.V. GATX/CL Air Leasing Cooperative Association and GATX/CL Air N.V. GATX/CL Air Leasing Cooperative Association and GATX/CL Air N.V. Notes to Combined Financial Statements December 31, 1993 1. Basis of Presentation and Summary of Significant Accounting Policies Basis of Reporting The accompanying combined financial statements are prepared in accordance with accounting principles generally accepted in the United States and presented in U.S. dollars. Organization GATX/CL Air Leasing Cooperative Association (the Association) was formed in September 1990 as a Cooperative Vereniging under the laws of the Netherlands Antilles to engage in the acquisition and lease of aircraft for use in international commercial routes. The Initial Members of the Association, each having a 30% share, are GATX Capital Corporation (GATX) through its wholly owned subsidiary, GATX Air Antilles, Inc. (GATX Air), and Credit Lyonnais (CL), a bank organized under the laws of France. Additional Members are four financial institutions, each having a 10% share. The initial term of the Association shall expire on December 31, 2009. GATX/CL Air N.V. (Air N.V.) was incorporated as a limited- liability corporation on July 11, 1989 under the laws of the Netherlands as a holding and leasing company. The authorized share capital of Air N.V. is 500,000 Dutch guilders. It is divided into 5,000 shares of 100 Dutch guilders each. Each shareholder of Air N.V. is a member of the Association and holds shares in Air N.V. in proportion to its interest in the Association. CL is the Managing Director and Co-Manager of the Association. CLN Oyens Trust B.V. (an affiliate of CL) is a Managing Director and administrative manager of Air N.V. GATX is the manager of the Association and a Managing Director of Air N.V. Basis of Combination The accompanying financial statements combine the assets, liabilities, equity, results of operations and cash flows of the Association and Air N.V. (collectively, the Companies) in recognition of their common ownership and control. All significant intercompany transactions and accounts have been eliminated. Cash and Cash Equivalents Cash and cash equivalents include highly liquid investments with a maturity of twelve months or less when purchased. The carrying amounts reported in the balance sheet for cash and cash equivalents at December 31, 1993 approximate the fair value of these assets. Operating Leases Leases that do not qualify as direct financing leases are accounted for as operating leases. Equipment subject to operating leases is stated at cost less accumulated depreciation plus accrued rent and is depreciated using the straight-line method over its useful life, ranging from 25-30 years. Effective July 1, 1992, the Companies changed their estimates of useful lives and salvage values which had the impact of increasing depreciation expense for 1992 by $884,000. The Companies review the carrying value of equipment on operating leases at least annually. If the review indicates that such values have been permanently impaired, the carrying value is reduced accordingly. Management believes that no such impairment has occurred through the date of these financial statements. Direct Financing Leases The Companies' investment in direct financing leases includes lease contracts receivable plus the estimated unguaranteed residual value of the equipment at the lease termination date, less unearned income. Lease contracts receivable includes the total rent to be received over the life of the lease reduced by rent collected. Initial unearned income is the amount by which the lease contract receivable plus the estimated residual exceeds the initial investment in the leased equipment at lease inception. Unearned income is amortized to produce a level yield over the lease term. The residual value of equipment under direct financing leases is the estimated amount to be received by the Companies from the disposition of equipment upon expiration of the lease. Management reviews residual value estimates at least annually. If the review results in a lower estimate than had been previously established and the decline is judged to be other than temporary, the accounting for the transaction is revised using the new estimate, and the resulting reduction in the net investment is recognized as an expense in the period in which the change is made. The Companies have had no such revisions to their residual value estimates. Aircraft Delivery Progress Payments Payments made toward the future delivery of aircraft under construction are recorded at cost, including capitalized interest, and are classified as progress payments. Credit Risk The Companies' customers are concentrated in the commercial airline industry. All investments are subject to normal credit policies, collateral requirements and senior management review. Lease provisions require lessees to meet certain standards for maintenance and return conditions, and provide for repossession upon default. Profit and Income Taxes Pursuant to Article 1, paragraph 1(a), of the Netherlands Antilles National Profit Tax Ordinance of 1940, the Association is subject to Netherlands Antilles profit tax. An advance tax ruling has been obtained from the Netherlands Antilles tax authorities in order to determine the tax position of the Association. Based on this tax ruling, $96,000, $104,000 and $96,000 have been recorded as an estimate for profit taxes in 1993, 1992 and 1991, respectively. The Air N.V. is subject to Netherlands corporate income tax. An advance tax ruling has been obtained from the Netherlands tax authorities in order to determine the tax position of the Air N.V. Based on this tax ruling $43,000, $36,000, and $42,000 have been recorded as an estimate for corporate income taxes in 1993, 1992, and 1991, respectively. No temporary differences exist between the computation of tax liability for book and tax purposes which would give rise to deferred income taxes. Reclassification Certain amounts in the financial statements presented have been reclassified to conform the prior years' data to the current presentation. 2. Association Capital Contributions, Loans and Allocation of Income, Losses and Cash Distributions Exposure Cap Members are only committed to contribute to the Association a maximum of equity contributions (excluding Premium Contributions) and loans aggregating $300,000,000 and $100,000,000 for each Initial Member and each Additional Member, respectively (Exposure Cap) for a total of $1,000,000,000. Also, Premium Contributions which may be required by the Additional Members may not exceed $2,500,000 for each Additional Member. The amount of unused and available equity and loan contributions from the Members at December 31, 1993 is $201,000,000. Capital Contributions Each Initial Member and each Additional Member are committed to contribute to the equity of the Association amounts aggregating up to each member's Equity Commitment (Initial Contributions). Such Equity Commitments aggregate $120,000,000 for the Initial Members and $80,000,000 for the Additional Members. Amounts contributed to the Association under this commitment through December 31, 1993 aggregated approximately $171,315,000 and represent each member's Equity Contribution. Each member's pro- rata share of such Equity Contributions represents its Venture Share of the Association. Each Additional Member is also required to make Premium Contributions at the time the Initial Contributions are paid. A portion of the Premium Contributions are then reallocated to the Initial Members. Premium Contributions contributed to the Association through December 31, 1993 aggregated approximately $8,566,000. Allocation of Income and Losses Income and losses are allocated to each member according to its Venture Share. Allocations of Cash Flow Available cash flow, as defined by the Cooperative Agreement, will be distributed to the members, and shall be allocated in part as a Contingent Return to all members and in part as a Contingent Management Fee to the Initial Members (Note 10). Upon liquidation of the Association, remaining net assets of the Association will be distributed among the members in proportion to their respective Investment Share, as defined by the Cooperative Agreement. 3. Operating Leases The Companies lease aircraft and related equipment to South American, Central American, European and Asian commercial airlines under operating leases. Earned income from operating leases in 1993, 1992, and 1991 was $50,910,000, $39,519,000, and $22,526,000, respectively. As of December 31, 1993, minimum future rentals under operating leases are due as follows (in thousands): 4. Direct Financing Leases The Association leases aircraft and related equipment to a South American commercial airline under direct-financing leases with initial terms of 12 years. Earned income from direct financing leases in 1993, 1992, and 1991 was $5,401,000, $6,303,000, and $15,725,000, respectively. The components of the Association's net investment in direct financing leases are as follows (in thousands): As of December 31, 1993, minimum lease payments to be received are as follows (in thousands): 5. Lessee Deposits Lessee deposits consist of security deposits and maintenance reserves including accrued interest. At December 31, 1993 and 1992, security deposits are $9,740,000 and $9,945,000, respectively, and maintenance reserves are $32,339,000 and $20,979,000, respectively. Lessee deposits are paid by the lessee prior to the inception of the lease and are refundable to the lessee based on the terms of the various leases. Maintenance reserves are charged to lessees based upon usage of the leased aircraft. Such amounts will be reimbursed to the lessee as required maintenance is performed. Interest due to lessees is accrued on the outstanding security deposits and maintenance reserves at rates ranging from 2.6250% to 3.5625% (based on 30- day LIBOR). Accrued interest payable on lessee deposits at December 31, 1993 and 1992 aggregated $3,169,000 and $2,454,000, respectively. 6. Capital Lease Obligation In November 1991, the Association sold delivery positions for the two aircraft delivering that month to a third party and leased back the aircraft for a term of ten years. No gain or loss was recognized on the sale-leaseback. The terms of the agreement require capital lease treatment by the Association. The aircraft secure third party financing obtained by the lessor. This financing is recourse to the Members in their respective ownership shares. As of December 31, 1993, future minimum lease payments on the capital lease obligation are as follows (in thousands): The capital lease obligation was reduced in 1991 by $11,891,000 which the Association irrevocably placed in a trust to be used solely for the satisfaction of the obligation. The Association has entered into an interest rate swap to manage interest rate exposure by effectively converting the capital lease obligation from a fixed rate to a floating rate borrowing. The Association receives or pays interest on a notional principal amount of $55,605,000 at December 31, 1993 based on the difference between a nominal rate of 9.07% and the 180-day LIBOR. No actual borrowing or lending is involved. The swap agreement terminates in 2001. The aircraft subject to capital lease financing were subleased to a commercial airline on four-year operating leases commencing in March 1992. Such subleases are classified as operating leases with carrying values of $73,637,000, and $76,442,000 at December 31, 1993 and 1992, respectively. Depreciation expense of $2,753,000 was recorded in 1993. Minimum future rentals to be received under noncancelable subleases aggregate $14,939,000 receivable over a period ending in 1996. Such rentals are included in the minimum future rentals under operating leases disclosed in Note 3. 7. Nonrecourse Obligations Nonrecourse obligations are secured by the underlying leases and leased assets. In the event of lessee default, the lenders have recourse only to the pledged equipment and the obligation is nonrecourse to the general credit of the Association. The Companies' investment in such leases at December 31, 1993 and 1992 (net of the related outstanding debt principal of $116,827,000 and $124,841,000, respectively, included in nonrecourse obligations) is $46,747,000 and $43,604,000, respectively. The carrying amount of the nonrecourse obligations at December 31, 1993 approximate their fair value. Nonrecourse obligations include the following (in thousands): As of December 31, 1993, future principal payments on nonrecourse obligations are as follows (in thousands): 8. Loans from Members At December 31, 1993 and 1992, loans from members bearing interest at rates from 150 to 294 basis points over the 30-to-180-day LIBOR, aggregated $482,302,000 and $393,046,000 respectively, with accrued interest payable aggregating $4,580,880 and $2,422,000 respectively. Such borrowings are collateralized by the aircraft delivery progress payments and leased assets. The future principal payments on loans from members as of December 31, 1993 are based upon leases and approved amortization schedules then in existence. Re-lease of the aircraft upon termination of the current leases will extend the term of the loans. As of December 31 1993, future principal payments on loans from members are due as follows (in thousands): Interest on loans from members for 1993, 1992 and 1991 is as follows (in thousands): The Association has entered into an interest rate swap to manage interest rate exposure by effectively converting a member loan from a floating rate to a fixed rate borrowing. The Association receives or pays interest on a notional principal amount of $70,438,000 and $73,092,000 at December 31, 1993 and 1992, respectively, based on the difference between a 10.47% fixed rate and the 90-day LIBOR. No actual borrowing or lending is involved. The swap agreement terminates in 2002. The carrying amount of variable rate loans from members of $411,864,000 and $319,954,000 at December 31, 1993 and 1992, respectively, approximates their fair value. The fair value of the fixed rate loans from members at December 31, 1993 and 1992 is $83,131,000 and $90,322,000, respectively. The fair value was estimated by performing a discounted cash flow analysis using the term and current market rate for similar types of borrowing arrangements. 9. Aircraft Delivery Progress Payments and Commitments At December 31, 1993, the Association had lease commitments outstanding for equipment with a net book value of $38,954,000 to a commercial airline. Interest cost incurred during 1993, 1992 and 1991 aggregated $34,347,000, $32,476,000 and $34,363,000, respectively, of which $1,338,000, $3,280,000 and $7,489,000, respectively, was capitalized into progress payments. During 1993, 1992 and 1991, $35,558,000, $48,296,000 and $109,232,000, respectively, were transferred from aircraft delivery progress payments to investments in leased assets. At December 31, 1993, remaining obligations to vendors under aircraft delivery positions aggregated $118,686,000. Obligations under delivery positions, for which the final payments upon delivery of the aircraft are subject to escalation clauses, will be paid in each of the subsequent years ended December 31, as follows (in thousands): 10. Related Party Transactions The Companies had related-party transactions as follows: Management of the Association and Air N.V. Pursuant to the Association Agreement and a Management Agreement, both dated September 4, 1990, between the Association and GATX as Manager and CL as Co-Manager, GATX and CL are to manage, lease and administer the Association property, among other duties, for an initial term of five years. As consideration for the performance of their duties under the Management Agreement, the Manager and Co- Manager jointly receive a monthly management fee. The management fee is calculated for each leased item of equipment and is based upon the amount by which the sum of rents, interest and loan or commitment fees received by the Association exceed an assumed rate of interest paid with respect to each leased asset (the Management Fee). A Contingent Management fee will be paid to the Initial Members after the repayment of all principal and interest on any third-party debt, member loans, and member contributions and member returns, as defined by the Cooperative Agreement. However, minimum fees paid to the Manager and Co-Manager will not be less than $1,200,000 per year. Also, as consideration for certain management services provided by the Manager and Co-Manager prior to the organization of the Association, the Association was charged $1,268,000 by the Manager and Co-Manager. The unamortized balance is reflected in other assets. The Association also reimburses the Manager and Co-Manager for costs as allowed in the Management Agreement. GATX and CLN Oyens Trust B.V, an affiliate of CL, are the Managing Directors of Air N.V. They receive no consideration for performance of their management duties. In accordance with an informal Member agreement, guarantee fees were accrued aggregating $1,131,985 for the Members guaranteeing certain obligations of the Association from inception in 1991 through December 31, 1992. In August 1993, the Members agreed to forego such fees. The reversal of such fees is shown as a reduction of the 1993 guarantee fee expense in the statement of operations. The Association and Air N.V. are charged administrative fees by CLN Oyens Trust N.V. (Curacao) and CLN Oyens Trust B.V., respectively, both of which are affiliates of CL. Cash on hand at December 31, 1993 and 1992 is on deposit with CL or its affiliates. Amounts owed to GATX and CL at December 31, 1993 and 1992, management fees incurred and costs reimbursed for each of the three years in the period ended December 31, 1993 are as follows (in thousands): 11. Subsequent Event In March 1994, the Association was notified that the lessee of the five aircraft under direct-financing leases intends to suspend rent payments temporarily. Action may be required to respond to this situation. At this time the Association has not determined the impact of this matter, if any, on its financial position or future operating results. Report of Independent Auditors Board of Directors GATX Capital Corporation We have audited the consolidated financial statements of GATX Capital Corporation (a wholly owned subsidiary of GATX Corporation) and subsidiaries listed in the accompanying index to financial statements (Item 14(a)). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements listed in the accompanying index to financial statements (Item 14(a)) present fairly, in all material respects, the consolidated financial position of GATX Capital Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In 1992, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1992. ERNST & YOUNG January 25, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. GATX CAPITAL CORPORATION (Registrant) By /s/ Ronald H. Zech ---------------------- Ronald H. Zech President, Director, and Chief Executive Officer March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. By /s/ Ronald H. Zech By /s/ David M. Edwards - ---------------------- ----------------------- Ronald H. Zech David M. Edwards President, Director, and Senior Vice President - Chief Executive Officer Finance and Administration, Chief Financial Officer, and Director Dated: March 18, 1994 Dated: March 18, 1994 By /s/ Curt F. Glenn By /s/ John F. Chlebowski,Jr. - -------------------- ----------------------------- Curt F. Glenn John F. Chlebowski, Jr. Principal Accounting Officer and Director Vice President & Controller Dated: March 18, 1994 Dated: March 18, 1994 By /s/ Frederick L. Hatton By /s/ Joseph C. Lane - -------------------------- --------------------- Frederick L. Hatton Joseph C. Lane Executive Vice President Executive Vice President and Director and Director Dated: March 18, 1994 Dated: March 18, 1994

732717_1993.txt

732717_1993

1993

732717

Item 1. Business The Company Southwestern Bell Corporation (Corporation) is a communications holding company whose subsidiaries are engaged principally in communications services. The Corporation has several subsidiaries, which include: Southwestern Bell Telephone Company (Telephone Company), Southwestern Bell Mobile Systems, Inc. (Mobile Systems), SBC International, Inc. (SBC International), Southwestern Bell Yellow Pages, Inc. (Yellow Pages), Associated Directory Services, Inc. (ADS), Southwestern Bell Telecommunications, Inc. (Telecom), Southwestern Bell Printing Company (SB Printing) and Southwestern Bell Enterprises, Inc. (Enterprises). The Telephone Company provides telephone services in the states of Arkansas, Kansas, Missouri, Oklahoma and Texas (five-state area) and is the Corporation's largest subsidiary, accounting for approximately 71 percent of the Corporation's 1993 income before extraordinary loss and cumulative effect of changes in accounting principles; Mobile Systems principally provides wireless communication services; SBC International is a holding company owning interests in directory, cable television and telecommunications businesses in Australia, Israel, Mexico and the United Kingdom; Yellow Pages engages principally in the sale of advertising for and publication of Yellow Pages and White Pages directories and in other directory-related activities; ADS engages principally in the production and distribution of non- Bell telephone directories and in other directory-related activities; Telecom is engaged in the sale of customer premises and private business exchange equipment; and SB Printing is engaged in the general directory and commercial printing business. The Corporation was incorporated under the laws of the State of Delaware in 1983 by AT&T as one of seven regional holding companies (RHCs) formed to hold AT&T's local telephone companies. AT&T divested the Corporation by means of a spin-off of stock to its shareowners on January 1, 1984 (divestiture). The divestiture was made pursuant to a consent decree, referred to as the Modification of Final Judgment (MFJ), issued by the United States District Court for the District of Columbia (Court). Operations Under the MFJ The MFJ, as originally approved by the Court in 1982, placed restrictions on the types of businesses in which the Corporation could engage. The principal restriction prohibits the Corporation from providing interexchange telecommunications services. An exchange in this context refers to a Local Access and Transport Area (LATA), which is generally centered on a standard metropolitan service area or other identifiable community of interest. Interexchange service refers to the provision of telecommunications services between exchanges. The MFJ initially restricted the Corporation from providing information services and from manufacturing or providing telecommunications products, other than the provision of customer premises equipment (CPE) manufactured by others. CPE, as defined in the MFJ, represents equipment used on customers' premises to originate, route or terminate telecommunications. The MFJ also initially restricted the Corporation from engaging in nontelecommunications lines of business. These services and products are collectively known as "restricted lines of business". The MFJ permits the Corporation to obtain relief from these restrictions upon a showing that there is no substantial possibility that it could use its monopoly power to impede competition in the specific market it seeks to enter (waiver standard). The Department of Justice (DOJ) initiated a review of the MFJ's line of business restrictions in 1987. After that review, the Court removed the restriction against entry into nontelecommunications lines of business, as well as that portion of the information services restriction which prohibited voice messaging services (VMS), electronic mail, electronic White Pages services and certain gateway functions (i.e., a telecommunications arrangement, either by video or audio, in which customers can communicate with many different information service providers). In April 1990, the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit Court) affirmed the Court's decision not to remove the interexchange and manufacturing restrictions, but clarified the waiver standard in a manner beneficial to future waiver requests by the Corporation. The D.C. Circuit Court also reversed the decision not to lift the information services restriction in its entirety, and remanded the issue to the Court for reconsideration under a more lenient public interest standard which is to apply when AT&T and the DOJ, the original parties to the MFJ, do not oppose relief. In July 1991, the Court applied this public interest standard and issued an order which removed the information services restriction in its entirety, but stayed the effectiveness of the relief it granted the RHCs, pending appeals. The D.C. Circuit Court has affirmed the order and the United States Supreme Court (Supreme Court) has refused to review the matter. Thus, the removal of the information services restriction on an intraexchange basis (within the LATA) has become final. Also as a result of proceedings before the Court since divestiture, the Corporation has been authorized to engage in the restricted lines of business outside the United States, subject to certain conditions designed to prevent an impact on United States markets. The Corporation has also obtained relief from the Court to provide interexchange cellular services in various markets throughout the United States, as well as intersystem handoff and automatic call delivery capabilities. Recent Waivers Granted or Denied In February 1993, the Corporation and the other RHCs were granted a waiver for generic international relief. The relief allows the Corporation and other RHCs, through foreign telecommunications entities, to provide the foreign portion of international telecommunications traffic between the United States and any foreign country and to own minority interests in international satellite and submarine cable facilities. The relief granted allows the RHCs to pursue international opportunities without the need to obtain transactional relief on a country-by-country basis. Also in February 1993, the Corporation and the other RHCs were granted a waiver to provide interLATA cellular service for rural service areas (RSAs). The relief permits clustering of RSAs with metropolitan service areas (MSAs), and RHC switching for independent adjoining RSAs, regardless of LATA boundaries. In September 1993, the Corporation was granted a waiver to purchase two cable television systems located in Montgomery County, Maryland and Arlington County, Virginia from Hauser Communications, Inc. The relief allows the Corporation to own and operate certain facilities in the provision of video programming despite LATA boundaries. The Corporation, jointly with the other RHCs, had appealed a July 1990 order of the Court holding that the RHCs were not permitted to transport common channel signaling 7 (CCS7) information across LATA boundaries for handoff to interexchange carriers at centralized signal transport points (STPs). CCS7 is the AT&T version of the internationally standardized signaling system which transmits signaling and service definition information between components of the telephone network. The STP is a type of switch which routes the signaling messages within the signaling network. The Court held that the MFJ requires that signaling information be given to the interexchange carriers in the LATA where the call originated, and also denied the RHCs' requests for waivers to establish the centralized STP service arrangement. The order was affirmed by the D.C. Circuit Court, and in February 1993 the Supreme Court refused to review the decision. Pending Waiver Requests and Appeals The Corporation has initiated other requests with the Court which seek the removal of some of the remaining restrictions. This includes a generic request, filed jointly by all the RHCs, seeking relief from the interexchange prohibition to provide wireless services without regard to geographic boundaries. In addition, the Corporation has requested relief to provide interexchange cellular services in certain of its own regional markets. The Corporation has also filed waiver requests seeking relief from the manufacturing restriction, to permit the design and development of CPE, and the provision of telecommunications equipment to third parties. All of these requests are pending. In June 1993, the Corporation, along with the other RHCs, filed a joint request for a waiver to provide information services on an interLATA basis. A condition of the request is that the RHCs lease the interLATA transport from independent interexchange carriers. Opposition briefs were filed in October 1993. In January 1992, the Court denied a waiver to allow Ameritech Corporation (Ameritech), an RHC, to receive royalties from the sale to third parties of telecommunication equipment designed, developed and/or manufactured by the unaffiliated party with the financial assistance of Ameritech. The Court also denied the DOJ's request for a declaratory ruling that a funding/royalty agreement with a firm in which an RHC has neither a significant equity interest nor influence over operations does not constitute manufacturing. The ruling was appealed to determine whether an otherwise independent company over which an RHC has no operating control and only a minimal ownership interest, may be labelled an "affiliated enterprise" of the RHC under the MFJ, and whether a funding/royalty relationship such as that proposed by Ameritech is permissible under the MFJ. In December 1993, the D.C. Circuit Court ruled that the MFJ bans all arrangements in which RHCs have a direct and continuing share in the revenues of entities engaged in restricted activities. However, Ameritech's waiver request was remanded to the Court for further consideration and is pending. The Corporation has requested relief with regard to certain paging services, as described below. Although the Corporation recently sold its paging services subsidiary, these requests are being pursued as they may have relevance to other aspects of the Corporation's business. In February 1989, the Court granted a waiver permitting the RHCs to provide multi-LATA one-way paging services regardless of geographic scope, but included a condition requiring the interexchange links for multi-LATA paging services to be obtained from unaffiliated interexchange carriers. The Corporation appealed that portion of the order which prohibited it from owning the interexchange links outside the service territory of the Telephone Company. In October 1990, the D.C. Circuit Court reversed the Court's decision and remanded the matter to the Court for reconsideration. This matter is still pending. In January 1993, the Corporation filed a request for a waiver to provide interLATA paging origination and access to voice storage and retrieval services. This waiver would permit the origination of pages from outside of LATA boundaries and permit paging subscribers to access their voice-mail messages from outside of a LATA. This request is pending with the Court. Principal Services The Corporation provides its services through subsidiaries. These services (which are described more fully below) include landline and wireless telecommunications services, the sale of advertising for and publication of Yellow Pages and White Pages directories, the provision of customer premises, private business exchange (PBX) and cellular equipment, and cable television services. Telecommunications services include local services, network access and long-distance (i.e., toll) services. Landline telecommunications services are provided in the five-state area by the Telephone Company and in the United Kingdom by SBC International. Wireless telecommunications services are provided by Mobile Systems. Landline and wireless local services involve the transport of telecommunications traffic between telephones and other CPE located within the same local service calling area. Local services include: basic local exchange service, extended area service, dedicated private line services for voice and special services, directory assistance and various vertical services. Vertical services represent discretionary, generally nonregulated, services which a customer may choose to supplement his/her basic line, such as: call waiting, call forwarding, call blocking, etc. Landline and wireless toll services involve the transport of traffic between local calling areas and include such services as Wide Area Telecommunications Service (WATS or 800 services) and other special services. Local calling areas are within the same LATA, except for certain wireless service areas in which MFJ waivers apply. Network access services link a subscriber's telephone or other equipment to the transmission facilities of other non-Telephone Company carriers which, in turn, provide long-distance and other communications services. Network access is either switched, which uses a switched communications path between the carrier and the customer, or special, which uses a direct nonswitched path. For financial reporting purposes, the Corporation's revenues are categorized as local service (principally provided by the Telephone Company and Mobile Systems), network access (provided by the Telephone Company), long-distance service (principally provided by the Telephone Company), directory advertising (provided by Yellow Pages, the Telephone Company and ADS) and other (including equipment sales at Mobile Systems, Telecom and SBC International, the Telephone Company's nonregulated products and services, billing and collection services for interexchange carriers provided by the Telephone Company, cable television services provided by SBC International, printing services provided by SB Printing, and paging services and equipment sales provided by Metromedia Paging Services, Inc. (Metromedia Paging) until it was sold in December 1993). The following table sets forth for the Corporation the percentage of total operating revenues by any class of service which accounted for 10 percent or more of total operating revenues in any of the last three fiscal years. Percentage of Total Operating Revenues 1993 1992 1991 Charges for local service: Landline 37% 37% 38% Wireless 12% 10% 7% Charges to interexchange carriers for network access 20% 20% 20% Charges for long- distance (i.e., toll) service 9% 10% 11% Major Customer See Note 14, "Segment and Major Customer Information," on page 43 of the Corporation's annual report to shareowners for the fiscal year ended December 31, 1993, which is incorporated herein by reference pursuant to General Instruction G(2). Government Regulation In the five-state area, the Telephone Company is subject to regulation by state commissions which have the power to regulate intrastate rates and services, including local, toll, private line and network access (both intraLATA and interLATA access within the state) services. The Telephone Company is also subject to the jurisdiction of the Federal Communications Commission (FCC) with respect to foreign and interstate rates and services, including interstate access charges. Access charges are designed to compensate the Telephone Company for the use of its facilities for the origination or termination of long- distance and other communications by non-Telephone Company carriers. Additional information relating to federal and state regulation of the Telephone Company is contained in the registrant's annual report to shareowners for the fiscal year ended December 31, 1993, under the heading "Regulatory Environment" on page 25 which is incorporated herein by reference pursuant to General Instruction G(2). The Corporation's recently acquired cable systems are subject to federal and local regulation, including regulation by the FCC and local franchising authorities concerning rates, service, and programming access. Principal Markets Telecommunications The Telephone Company provides its services along approximately 9 million residential and 4 million business access lines in the five-state area. During 1993, more than half of the Telephone Company's access line growth occurred in Texas. In 1993, 1992 and 1991, approximately 73 percent of the Telephone Company's total operating revenues were attributable to intrastate operations. The intrastate operations of the Telephone Company represented approximately 56 percent, 57 percent and 59 percent of the Corporation's total operating revenues for 1993, 1992 and 1991, respectively. All intrastate operations of the Corporation (including the Telephone Company and Mobile Systems) represented approximately 68 percent, 67 percent and 66 percent of its total operating revenues in 1993, 1992 and 1991, respectively. At the end of 1993, Mobile Systems provided cellular services to 2,049,000 customers, or 5.7 out of every 100 people living in its service areas. These services are provided in 28 metropolitan markets, including five of the nation's top 15 metropolitan areas, as follows: Washington, D.C.; Chicago, Illinois; Boston, Massachusetts; St. Louis, Missouri; and Dallas, Texas. Mobile Systems (or partnerships in which it has an ownership interest) is licensed to provide service in 26 RSAs and is currently providing service in all of these markets. All RSAs are contiguous to an existing MSA or another RSA operated by Mobile Systems, which allows for the expansion of service in a way that adds value to customers' service. Mobile Systems operates in certain areas under the name of Cellular One, by means of a partnership arrangement with McCaw Cellular Communications, Inc. and Vanguard Cellular Systems, Inc., which holds the Cellular One service mark. These areas include both metropolitan and rural service areas, such as Washington, D.C.; Chicago, Illinois; and other service areas in Illinois, Massachusetts, Virginia and West Virginia. In February 1994, the Corporation announced an agreement to purchase, for stock valued at $680, the domestic cellular business of Associated Communications Corporation, including cellular systems in Buffalo, Rochester, Albany and Glens Falls, New York. These properties are adjacent to cellular systems in Syracuse, Utica and Ithaca, New York, which the Corporation agreed to purchase from other parties in November 1993. These acquisitions will increase the number of markets served by Mobile Systems to 61 and increase Mobile Systems' potential customer base to more than 40 million. These transactions are expected to close during 1994. International In December 1990, a consortium consisting of SBC International, together with a subsidiary of France Telecom and a group of Mexican investors led by Grupo Carso, S.A. de C.V., purchased from the Mexican government all of the Class AA shares of Telefonos de Mexico, S.A. de C.V. (Telmex), Mexico's national telecommunications company. The consortium has voting control of Telmex through its ownership of Class AA shares. SBC International's interest in the Class AA shares held by the consortium represents approximately 5 percent of the total equity capitalization of Telmex. SBC International also holds 530,157,101 Class L shares, which have limited voting rights. The Class L shares held by SBC International represent approximately 5 percent of the total equity capitalization of Telmex, bringing SBC International's total interest to 10 percent. Telmex provides complete landline and wireless telecommunications services within Mexico. At the end of 1993, Telmex had 7.6 million access lines in service and provided cellular service to more than 195,000 subscribers. As of December 31, 1993, telephone service reached approximately 41 of every 100 Mexican households. For additional information regarding the Corporation's investment in Telmex, see Note 13, "Equity Investments," on page 42 of the Corporation's annual report to shareowners for the fiscal year ended December 31, 1993, which is incorporated herein by reference pursuant to General Instruction G(2). SBC International cable television operations are managed by SBC Cable Communications Group, Ltd., and include Midlands Cable Communications and Northwest Cable Communications, both in the United Kingdom, with combined service areas including 1.1 million potential households. In May 1993, the Corporation completed the sale of 25 percent of its United Kingdom cable operations to Cox Cable Communications (Cox). The Corporation and Cox share management of the cable operations. At the end of 1993, SBC International cable television in the United Kingdom served approximately 80,000 subscribers. SBC International's penetration rate at the end of 1993 in the United Kingdom was 21.9 percent. Penetration rate is defined as the number of customers as a percentage of solicited households that have network access. Cable operators in the United Kingdom may provide both cable television and local exchange service. At the end of 1993, SBC International provided local exchange service to approximately 39,000 subscribers. SBC International also holds a minority interest in Golden Channels, a cable television provider in Israel. Golden Channels holds franchises in areas containing 412,000 potential households. At the end of 1993, Golden Channels served approximately 194,000 households and had a penetration rate (as defined above) of approximately 55 percent. In Israel and Australia, SBC International also has interests in companies involved in the publication of yellow pages directory advertising. Directory Publishing Yellow Pages publishes nearly 40 million copies of 389 classified directories within the Telephone Company's five-state area. The ten largest revenue-producing Yellow Pages directories are currently published in the second half of the Corporation's fiscal year. Directory advertising revenues and expenses associated with Yellow Pages directories are recognized in the month the related directory is published. ADS engages principally in the production and distribution of 269 telephone directories for GTE Telephone companies throughout 29 states of the continental United States. ADS also publishes telephone directories for 17 non-Bell telephone companies, some of which are co-bound with GTE directories. To a less significant extent, ADS produces and publishes a number of other directories unaffiliated with any telephone company. Customer Premises Equipment and Other Equipment Sales Telecom markets business and residential communications equipment through two divisions, Business Systems and Original Equipment. Telecom's offerings range from single-line and cordless telephones to sophisticated digital PBX systems. PBX is a private telephone switching system, usually located on a customer's premises, which provides intra-premise telephone services as well as access to the public switched network. The Business Systems division markets a wide variety of telecommunications products and services to business customers in the Telephone Company's five-state area. The Original Equipment division, through an exclusive, long-term distribution agreement with Conair Corporation effective April 1993, markets a full line of residential telephones to retailers nationwide, under the Freedom Phone name. Separately, the Original Equipment division markets residential and business products to U.S. telephone companies, and internationally, in 39 countries. Mobile Systems markets cellular communications equipment in each of its service areas. Printing In February 1993, the Corporation sold the assets of the commercial printing operations of Gulf Printing Company (Gulf), including the Gulf name. The remaining operations are continuing under the name "Southwestern Bell Printing Company." SB Printing provides directory printing in the Telephone Company five-state service area, and prints more than 62 million copies of 809 directories annually. SB Printing maintains a sales office in St. Louis, Missouri, and also operates one plant in Houston, Texas. SB Printing's wholly-owned subsidiary, Times Journal Publishing Company (Times Journal), operates two plants in Oklahoma City, Oklahoma, and prints smaller telephone directories and provides commercial printing services. During 1993, SB Printing was awarded a five-year contract to print 15.5 million directory copies for Telmex's directory operations, beginning in 1994. Domestic Cable Television In February 1993, the Corporation reached an agreement to purchase, for $650 million, two cable television systems located in Montgomery County, Maryland, and Arlington County, Virginia, from Hauser Communications, Inc. The purchase was closed in January 1994. In December 1993, the Corporation and Cox Cable Communications (Cox) entered into a non-binding Memorandum of Understanding with respect to the formation of a $4.9 billion partnership to own and operate cable television systems. In return for a 40 percent general partnership interest, the Corporation would contribute $1.6 billion in cash or other assets within four years of formation. The Corporation would have the option to increase its initial ownership stake to 50 percent within specified time frames, through additional cash or asset contributions. Cox would contribute 21 cable television systems, located throughout the United States, based on a negotiated value of $3.3 billion, and would hold a 60 percent general partnership interest and a $1 billion preferred partnership interest. The transaction is subject to completion of negotiations and regulatory approvals, with the formation of the partnership expected to be completed by late 1994. Paging Services In December 1993, the Corporation sold Metromedia Paging, which provided paging services in 76 markets throughout the United States, to Local Area Telecommunications, Inc., a New York-based telecommunications service company. Status of New Services Telecommunications During 1993, the Telephone Company continued to expand its offering of optional services, known as Easy Options. These options include, among others: Caller ID, a feature which displays the telephone number of the person calling and, by next year, will also display the caller's name in certain markets; Call Return, a feature that redials the number of the last incoming call; and Call Blocker, a feature which allows customers to automatically reject calls from a designated list of telephone numbers. Recent changes in Texas law will allow the Telephone Company to introduce Caller ID in its largest markets during 1994 and 1995. Caller ID is now being offered in certain markets in all of the states in the Telephone Company's five-state area. The FCC has promulgated certain rules that impact the manner in which the Telephone Company may offer enhanced services, which generally include services which are more than basic transmission services. Under FCC decisions known as Computer Inquiry III, the Telephone Company is permitted to offer enhanced services either on its own or jointly with its affiliates, subject to nonstructural safeguards, designed to permit the Telephone Company's competitors to acquire needed network services on an efficient, non-discriminatory basis and to reduce the risk of cross-subsidization. These safeguards include accounting and reporting procedures, and Open Network Architecture (ONA) requirements, which represent the Telephone Company's plan essentially to provide equal access to its network to all enhanced service providers. Enhanced services are deregulated at the federal level, and none of the Telephone Company's state commissions have, as yet, asserted jurisdiction over intrastate enhanced services. In December 1991, after various court proceedings, the FCC slightly modified the original Computer Inquiry III nonstructural competitive safeguards. The Telephone Company received FCC acknowledgement of its initial ONA implementation in November 1992. However, the current modified Computer Inquiry III nonstructural safeguards are subject to an appeal now pending at the U.S. Court of Appeals for the Ninth Circuit. In July 1993, Mobile Systems launched the largest digital deployment program in North America with commercial digital service in Chicago. Digital service improves sound quality, provides a greater degree of privacy on individual calls, increases call-handling capacity of the networks and reduces exposure to billing fraud. In September, Mobile Systems launched commercial digital service in its St. Louis market. During 1994, Mobile Systems plans to provide digital service in Washington, D.C., Boston, Dallas-Fort Worth and the West Texas markets of Midland-Odessa, Abilene, Amarillo and Lubbock. During March 1993, Mobile Systems introduced FreedomLink, a new wireless business phone system which employs cellular technology to provide anywhere, anytime communications, using cellular frequencies. Voice Messaging Services Southwestern Bell Messaging Services, Inc. (SMSI), a subsidiary of Enterprises, currently offers residential and small business voice messaging services in Dallas-Fort Worth, Houston, Oklahoma City, Tulsa, St. Louis, Kansas City, Little Rock, San Antonio and certain other portions of Texas. Effective June 1, 1993, Telecom assumed SMSI's voice messaging services sales to medium and large business. Importance, Duration and Effect of Licenses The FCC authorizes the licensing of only two cellular carriers in each geographic market. These cellular licenses have a standard duration of ten years and are renewable upon application and a showing of compliance with FCC use and conduct standards. The FCC licenses granted to Mobile Systems in Washington, D.C.; Baltimore, Maryland; Kansas City, Missouri/Kansas; St. Louis, Missouri; and Dallas, Texas all expired on October 1, 1993. Renewal applications were filed in each of these markets during August 1993. To date, Mobile Systems has received no competing applications in these markets nor have any petitions to deny been filed. Final license grants are expected to be received by mid-1994. Renewal applications are to be filed in the following markets during August 1994: Chicago, Illinois; San Antonio, Texas; Boston, Massachusetts; Oklahoma City, Oklahoma; and Wichita, Kansas. Cable television systems generally are operated under nonexclusive permits or "franchises" granted by local governmental authorities. The Corporation operates its recently acquired cable systems under franchises granted by Montgomery County, Maryland (expires May 25, 1998); Arlington County, Virginia (expires October 18, 2000); and the City of Gaithersburg, Maryland (expires November 2, 2001). Each franchise is renewable upon a showing of compliance with established local and federal standards. Competition Telecommunications Information relating to competition in the telecommunications industry is contained in the registrant's annual report to shareowners for the fiscal year ended December 31, 1993, under the heading "Competition" on page 27 which is incorporated herein by reference pursuant to General Instruction G(2). International Most major and several minor cable operators in the United Kingdom have begun to offer both cable television and local exchange services in selected franchise service areas. Domestic United Kingdom telephone companies are restricted from offering video entertainment over their networks until 1998. The United Kingdom currently has two major domestic telephone companies. In addition to cable, viewers in the United Kingdom may select television programming from four television stations which are broadcast free, or may subscribe to programming directly from satellite broadcasting services. Both are sources of programming for cable companies. Directory Publishing Yellow Pages faces competition from numerous directory publishing companies as well as other advertising media. There are 42 other directory publishers in the five-state area producing yellow page directories. ADS publishes the majority of its directories under a long-term contract with GTE/Contel. ADS also faces competition from other publishers and non-directory advertising media. Voice Messaging Services SMSI and Telecom face competition in each market in which voice messaging services are offered. Competition is primarily from telephone answering services and other voice messaging services providers. In addition, answering machines and voice messaging equipment used as adjuncts to PBX systems provide competing alternatives to voice messaging services. Customer Premises Equipment Telecom faces significant price competition from numerous companies within both its Business Systems division and Original Equipment division. Printing SB Printing and its subsidiary, Times Journal, engage in general directory and commercial printing and face significant competition in each of these operations. In the United States and Canada, there are at least seven large directory printing companies and over 100 large commercial printing companies in direct competition with SB Printing. Research and Development The majority of company-sponsored basic and applied research activities are conducted at Bell Communications Research, Inc. (Bellcore). The Telephone Company owns a one-seventh interest in Bellcore along with the other six RHCs. Bellcore is also the coordinator for the federal government's telecommunications requirements on national security and emergency preparedness. Basic and applied research is also conducted at Southwestern Bell Technology Resources, Inc. (TRI), a subsidiary of the Corporation. TRI provides technology planning and assessment services to the Corporation and its subsidiaries. Employees As of January 31, 1994, the Corporation and its subsidiaries employed 59,040 persons. Approximately 67 percent of the employees are represented by the Communications Workers of America (CWA). Effective in August 1992, a three-year contract was negotiated between the CWA and the Telephone Company. Effective in December 1992, a three-year contract was negotiated between the CWA and Yellow Pages. These contracts will be subject to renegotiation in mid-1995. In March 1991, Telecom negotiated a three-year contract with the CWA. This contract will be subject to renegotiation in 1994. The CWA also represents a minor number of employees in other subsidiaries of the Corporation. Item 2. Item 2. Properties. The properties of the Corporation do not lend themselves to description by character and location of principal units. Ninety-two percent of the property, plant and equipment of the Corporation is owned by the Telephone Company. At December 31, 1993, network access lines represented 45 percent of the Telephone Company's investment in telephone plant; central office equipment represented 36 percent; land and buildings represented 10 percent; other miscellaneous property, comprised principally of furniture and office equipment and vehicles and other work equipment, represented 7 percent; and information origination/termination equipment represented 2 percent. Item 3. Item 3. Legal Proceedings. Not applicable. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted to a vote of shareowners in the fourth quarter of the fiscal year covered by this report. Executive Officers of the Registrant as of January 31, 1994. Name Age Position Held Since Edward E. Whitacre 52 Chairman and 1-90 Jr. Chief Executive Officer James R. Adams 54 Group President 7-92 Robert A. Dickemper 50 Senior Vice 7-93 President- Staff/Administration William E. Dreyer 55 Senior Executive Vice 7-93 President-External Affairs James D. Ellis 50 Senior Executive Vice 3-89 President and General Counsel Charles E. Foster 57 Group President 10-90 Richard A. Harris 53 Senior Executive Vice 10-90 President- Human Resources James S. Kahan 46 Senior Vice 7-93 President- Strategic Planning and Corporate Development Donald E. Kiernan 53 Senior Vice 7-93 President, Treasurer and Chief Financial Officer Robert G. Pope* 58 Vice Chairman of 7-93 Southwestern Bell Corporation and President and Chief Executive Officer of Southwestern Bell Telephone Company *Mr. Robert G. Pope has announced his intention to retire effective March 31, 1994. All of the above Executive Officers have held high-level managerial positions with the Corporation, its subsidiaries or former affiliates for more than the past five years, except for Messrs. Kiernan and Kahan who have held such high-level managerial positions since May 1990 and January 1992, respectively. Prior to their appointments as Executive Officers, Mr. Kiernan was a partner with Ernst & Young and Mr. Kahan held responsible managerial positions with the Corporation. Officers of the Corporation are appointed by the Corporation's Board of Directors. Officers are not appointed to a fixed term of office but hold office until their successors are elected and qualified. PART II Items 5 through 8. The information required by these Items is included in the "Stock Performance" section on page 1, page 20 through page 43 and in the "Stock Data" section on the back cover of the registrant's annual report to shareowners for the fiscal year ended December 31, 1993. Such information is incorporated herein by reference pursuant to General Instruction G(2). Item 9. Item 9. Changes in and disagreements with Accountants on Accounting and Financial Disclosure. No changes in accountants or disagreements with accountants on any accounting or financial disclosure matters occurred during the period covered by this report. PART III Items 10 through 13. Information regarding executive officers required by Item 401 of Regulation S-K is furnished in a separate disclosure in Part I of this report since the registrant did not furnish such information in its definitive proxy statement prepared in accordance with Schedule 14A. The other information required by these Items is included in the registrant's definitive proxy statement, dated March 18, 1994, from page 4 through page 9 and beginning with the last paragraph on page 16 through page 24 and is incorporated herein by reference pursuant to General Instruction G(3). PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as a part of the report: Page (1) Consolidated Financial Statements: Consolidated Statements of Income * Consolidated Balance Sheets * Consolidated Statements of Cash Flows * Consolidated Statements of Shareowners' Equity * Notes to Consolidated Financial Statements * Report of Independent Auditors * __________ * Incorporated herein by reference to the appropriate portions of the registrant's annual report to shareowners for the fiscal year ended December 31, 1993. (See Part II.) Page (2)Financial Statement Schedules: Consent of Independent Auditors 25 V-Property, Plant and Equipment 26 VI-Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 30 VIII-Valuation and Qualifying Accounts 31 X-Supplementary Income Statement Information 33 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated by reference as exhibits hereto. 3-a Certificate of Incorporation of Southwestern Bell Corporation (restated), dated June 6, 1988. (Exhibit 3-a to Form 10-K for 1988, File 1-8610.) 3-b Bylaws of Southwestern Bell Corporation, dated June 28, 1991. (Exhibit 3-b to Form 10-Q for the second quarter 1991, File 1-8610.) 4-a Pursuant to Regulation S-K, Item 601(b)(4)(iii)(A), no instrument which defines the rights of holders of long and intermediate term debt of the registrant or any of its consolidated subsidiaries is filed herewith. Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 4-b Support Agreement dated November 10, 1986, between Southwestern Bell Corporation and Southwestern Bell Capital Corporation. (Exhibit 4-b to Registration Statement No. 33-11669) 4-c Form of Rights Agreement, dated as of January 27, 1989, between Southwestern Bell Corporation and American Transtech, Inc., the Rights Agent, which includes as Exhibit B thereto the form of Rights Certificate. (Exhibit 4-a to Form 8-A dated February 9, 1989, File 1-8610.) 4-d Amendment of Rights Agreement, dated as of August 5, 1992, between Southwestern Bell Corporation, American Transtech, Inc., and The Bank of New York, the successor Rights Agent, which includes the Form of Rights Certificate as an attachment identified as Exhibit B. (Exhibit 4-a to Form 8-K, dated August 7, 1992, File 1-8610.) 4-e Form of Rights Certificate (included in the attachment to the Amendment of Rights Agreement and identified as Exhibit B.) (Exhibit 4-b to Form 8-K, dated August 7, 1992, File 1-8610.) 10-a Southwestern Bell Corporation Senior Management Short Term Incentive Plan, revised January 1, 1991. (Exhibit 10-a to Form 10-K for 1990, File 1-8610.) 10-b Southwestern Bell Corporation Senior Management Long Term Incentive Plan, revised effective January 1, 1993. (Exhibit 10-b to Form 10-K for 1992, File 1-8610.) 10-c Southwestern Bell Corporation Senior Management Survivor Benefit Plan. (Exhibit 10-c to Form 10-K for 1986, File 1-8610.) 10-d Southwestern Bell Corporation Senior Management Supplemental Retirement Income Plan, revised effective January 1, 1993. (Exhibit 10-d to Form 10-K for 1992, File 1-8610.) 10-e Southwestern Bell Corporation Senior Management Deferred Compensation Plan Effective for Units of Participation Having a Unit Start Date Prior to January 1, 1988, revised October 27, 1989. (Exhibit 10-e to Form 10-K for 1989, File 1-8610.) 10-f Southwestern Bell Corporation Senior Management Deferred Compensation Plan of 1988 Effective for Units of Participation Having a Unit Start Date of January 1, 1988 or Later, revised and restated October 27, 1989. (Exhibit 10-f to Form 10-K for 1989, File 1-8610.) 10-g Southwestern Bell Corporation Senior Management Long Term Disability Plan. (Exhibit 10-f to Form 10-K for 1986, File 1-8610.) 10-h Southwestern Bell Corporation Senior Management Incentive Award Deferral Plan. (Exhibit 10-g to Form 10-K for 1986, File 1-8610.) 10-i Southwestern Bell Corporation Senior Management Financial Counseling Program. (Exhibit 10-h to Form 10-K for 1986, File 1-8610.) 10-j Southwestern Bell Corporation Senior Management Executive Health Plan, effective January 1, 1987. (Exhibit 10-i to Form 10-K for 1986, File 1-8610.) 10-k Southwestern Bell Corporation Retirement Plan for Non- Employee Directors. (Exhibit 10-t to Form 10-K for 1985, File 1-8610.) 10-l Form of Indemnity Agreement, effective July 1, 1986, between Southwestern Bell Corporation and each of its directors and officers. (Appendix 1 to Definitive Proxy Statement dated March 18, 1987, File 1-8610.) 10-m Form of Southwestern Bell Corporation Change of Control Severance Agreements for all Officers of the Corporation and certain Officers of the Corporation's subsidiaries. (Exhibit 10-p to Form 10-K for 1988, File 1-8610.) 10-n Southwestern Bell Corporation Stock Savings Plan, revised effective January 1, 1994. (Appendix A to Definitive Proxy Statement dated March 18, 1994, File 1-8610.) 10-o Southwestern Bell Corporation 1992 Stock Option Plan. (Appendix A to Definitive Proxy Statement dated March 12, 1992, File 1-8610.) 10-p Key Executive Officer Short Term Incentive Plan. (Appendix B to Definitive Proxy Statement dated March 18, 1994, File 1-8610.) 12 Computation of Ratios of Earnings to Fixed Charges. 13 Portions of Southwestern Bell Corporation's annual report to shareowners for the fiscal year ended December 31, 1993 which are incorporated by reference. 21 Subsidiaries of Southwestern Bell Corporation 23 Consent of Independent Auditors 24 Powers of Attorney 99-a Annual Report on Form 11-K for the Southwestern Bell Corporation Savings Plan for Salaried Employees for the year 1993 to be filed under Form 10-K/A 99-b Annual Report on Form 11-K for the Southwestern Bell Corporation Savings and Security Plan (Non-Salaried Employees) for the year 1993 to be filed under Form 10- K/A Southwestern Bell Corporation will furnish to shareowners upon request, and without charge, a copy of the annual report to shareowners and the proxy statement, portions of which are incorporated by reference in the Form 10-K. Southwestern Bell Corporation will furnish any other exhibit at cost. (b)Reports on Form 8-K: On December 7, 1993, Southwestern Bell Corporation filed a Current Report on Form 8-K, dated December 6, 1993, reporting on Item 5, Other Events. SOUTHWESTERN BELL CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Dollars in Millions Column B - Charged to Column A - Item Expense Year 1993 1. Maintenance and repairs $1,530.4 2. Taxes, other than payroll and income taxes Property $ 306.4 Gross receipts $ 179.0 3. Advertising costs $ 89.5 Year 1992 1. Maintenance and repairs $1,676.9 2. Taxes, other than payroll and income taxes Property $ 283.1 Gross receipts $ 148.8 3. Advertising costs $ 85.0 Year 1991 1. Maintenance and repairs $1,534.6 2. Taxes, other than payroll and income taxes Property $ 274.9 Gross receipts $ 131.3 3. Advertising costs $ 79.0 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on the 18th day of March, 1994. SOUTHWESTERN BELL CORPORATION By /s/ Donald E. Kiernan (Donald E. Kiernan Senior Vice President, Treasurer and Chief Financial Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Principal Executive Officer: Edward E. Whitacre Jr.* Chairman and Chief Executive Officer Principal Financial and Accounting Officer: Donald E. Kiernan Senior Vice President, Treasurer and Chief Financial Officer /s/ Donald E. Kiernan Directors: (Donald E. Kiernan, as attorney- in-fact and on his own behalf as Principal Financial Officer Edward E. Whitacre Jr.* and Principal Clarence C. Barksdale* Accounting Officer) James E. Barnes* Jack S. Blanton* August A. Busch III* March 18, 1994 Ruben R. Cardenas* Martin K. Eby, Jr.* Tom C. Frost* Jess T. Hay* Bobby R. Inman* Charles F. Knight* Sybil C. Mobley* Haskell M. Monroe, Jr.* Robert G. Pope * Carlos Slim Helu* Patricia P. Upton * * by power of attorney EXHIBIT INDEX Exhibits identified in parentheses below, on file with the SEC, are incorporated by reference as exhibits hereto. 3-a Certificate of Incorporation of Southwestern Bell Corporation (restated), dated June 6, 1988. (Exhibit 3-a to Form 10-K for 1988, File 1-8610.) 3-b Bylaws of Southwestern Bell Corporation, dated June 28, 1991. (Exhibit 3-b to Form 10-Q for the second quarter 1991, File 1-8610.) 4-a Pursuant to Regulation S-K, Item 601(b)(4)(iii)(A), no instrument which defines the rights of holders of long and intermediate term debt of the registrant or any of its consolidated subsidiaries is filed herewith. Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 4-b Support Agreement dated November 10, 1986, between Southwestern Bell Corporation and Southwestern Bell Capital Corporation. (Exhibit 4-b to Registration Statement No. 33-11669) 4-c Form of Rights Agreement, dated as of January 27, 1989, between Southwestern Bell Corporation and American Transtech, Inc., the Rights Agent, which includes as Exhibit B thereto the form of Rights Certificate. (Exhibit 4-a to Form 8-A dated February 9, 1989, File 1-8610.) 4-d Amendment of Rights Agreement, dated as of August 5, 1992, between Southwestern Bell Corporation, American Transtech, Inc., and The Bank of New York, the successor Rights Agent, which includes the Form of Rights Certificate as an attachment identified as Exhibit B. (Exhibit 4-a to Form 8-K, dated August 7, 1992, File 1-8610.) 4-e Form of Rights Certificate (included in the attachment to the Amendment of Rights Agreement and identified as Exhibit B.) (Exhibit 4-b to Form 8-K, dated August 7, 1992, File 1-8610.) 10-a Southwestern Bell Corporation Senior Management Short Term Incentive Plan, revised January 1, 1991. (Exhibit 10-a to Form 10-K for 1990, File 1-8610.) 10-b Southwestern Bell Corporation Senior Management Long Term Incentive Plan, revised effective January 1, 1993. (Exhibit 10-b to Form 10-K for 1992, File 1-8610.) 10-c Southwestern Bell Corporation Senior Management Survivor Benefit Plan. (Exhibit 10-c to Form 10-K for 1986, File 1-8610.) 10-d Southwestern Bell Corporation Senior Management Supplemental Retirement Income Plan, revised effective January 1, 1993. (Exhibit 10-d to Form 10-K for 1992, File 1-8610.) 10-e Southwestern Bell Corporation Senior Management Deferred Compensation Plan Effective for Units of Participation Having a Unit Start Date Prior to January 1, 1988, revised October 27, 1989. (Exhibit 10-e to Form 10-K for 1989, File 1-8610.) 10-f Southwestern Bell Corporation Senior Management Deferred Compensation Plan of 1988 Effective for Units of Participation Having a Unit Start Date of January 1, 1988 or Later, revised and restated October 27, 1989. (Exhibit 10-f to Form 10-K for 1989, File 1-8610.) 10-g Southwestern Bell Corporation Senior Management Long Term Disability Plan. (Exhibit 10-f to Form 10-K for 1986, File 1-8610.) 10-h Southwestern Bell Corporation Senior Management Incentive Award Deferral Plan. (Exhibit 10-g to Form 10-K for 1986, File 1-8610.) 10-i Southwestern Bell Corporation Senior Management Financial Counseling Program. (Exhibit 10-h to Form 10-K for 1986, File 1-8610.) 10-j Southwestern Bell Corporation Senior Management Executive Health Plan, effective January 1, 1987. (Exhibit 10-i to Form 10-K for 1986, File 1-8610.) 10-k Southwestern Bell Corporation Retirement Plan for Non- Employee Directors. (Exhibit 10-t to Form 10-K for 1985, File 1-8610.) 10-l Form of Indemnity Agreement, effective July 1, 1986, between Southwestern Bell Corporation and each of its directors and officers. (Appendix 1 to Definitive Proxy Statement dated March 18, 1987, File 1-8610.) 10-m Form of Southwestern Bell Corporation Change of Control Severance Agreements for all Officers of the Corporation and certain Officers of the Corporation's subsidiaries. (Exhibit 10-p to Form 10-K for 1988, File 1-8610.) 10-n Southwestern Bell Corporation Stock Savings Plan, revised effective January 1, 1994. (Appendix A to Definitive Proxy Statement dated March 18, 1994, File 1-8610.) 10-o Southwestern Bell Corporation 1992 Stock Option Plan. (Appendix A to Definitive Proxy Statement dated March 12, 1992, File 1-8610.) 10-p Key Executive Officer Short Term Incentive Plan. (Appendix B to Definitive Proxy Statement dated March 18, 1994, File 1-8610.) 12 Computation of Ratios of Earnings to Fixed Charges. 13 Portions of Southwestern Bell Corporation's annual report to shareowners for the fiscal year ended December 31, 1993 which are incorporated by reference. 21 Subsidiaries of Southwestern Bell Corporation 23 Consent of Independent Auditors 24 Powers of Attorney 99-a Annual Report on Form 11-K for the Southwestern Bell Corporation Savings Plan for Salaried Employees for the year 1993 to be filed under Form 10-K/A 99-b Annual Report on Form 11-K for the Southwestern Bell Corporation Savings and Security Plan (Non-Salaried Employees) for the year 1993 to be filed under Form 10-K/A

36672_1993.txt

36672_1993

1993

36672

Item 1. Business. THE CORPORATION Bank of Boston Corporation (the "Corporation") is a registered bank holding company, organized in 1970 under Massachusetts law with both national and international operations. Through its subsidiaries, the Corporation is engaged in providing a wide variety of financial services to individuals, corporate and institutional customers, governments and other financial institutions. These services include individual and community banking, consumer finance, mortgage origination and servicing, domestic corporate and investment banking, leasing, international banking, commercial real estate lending, private banking, trust, correspondent banking, and securities and payments processing. The Corporation's principal subsidiary is The First National Bank of Boston ("FNBB"), a national banking association with its headquarters in Massachusetts. Other major banking subsidiaries of the Corporation are Casco Northern Bank, N.A. ("Casco") in Maine, Bank of Boston Connecticut ("BKB Connecticut"), Rhode Island Hospital Trust National Bank ("Hospital Trust"), Bank of Vermont, and in Massachusetts, South Shore Bank, Mechanics Bank and Multibank West. As of December 31, 1993, approximately 78% of the Corporation's total loan volume consisted of domestic loans and leases, with the balance overseas. The Corporation's banking subsidiaries maintain approximately 320 branches in Massachusetts, Rhode Island, Connecticut, Maine and Vermont. The Corporation, through its subsidiaries, has a presence in approximately 33 states of the United States and in approximately 23 foreign countries. As of December 31, 1993, the Corporation's subsidiaries employed in the aggregate approximately 18,600 full-time equivalent employees in their domestic and foreign operations. The executive office of the Corporation and the head office of FNBB are located at 100 Federal Street, Boston, Massachusetts 02110 (Telephone (617) 434-2200). BUSINESS OF THE CORPORATION The Corporation's business is generally focused in the areas of retail banking, corporate banking and international banking. In October of 1993, the Corporation announced certain organizational and management changes, including the creation of a new Chairman's Office and the establishment of a twenty-nine member Corporate Working Committee. The Chairman's Office consists of Chairman and Chief Executive Officer Ira Stepanian, President and Chief Operating Officer Charles K. Gifford, Vice Chairman, Chief Financial Officer and Treasurer William J. Shea, and Vice Chairman Edward A. O'Neal. The Corporation's businesses were previously organized into five major groups and a number of other major centralized functions. This group structure was replaced by fifteen core business and ten corporate-wide support areas, each led by an executive with authority to operate and manage his or her respective area. These twenty-five executives and the members of the Chairman's Office comprise the Corporate Working Committee. These core business and corporate wide support areas work closely with one another and each is linked to one of the members of the Chairman's Office. For discussions of the Corporation's business activities, including its lending activities, its cross-border outstandings, and the management of its foreign currency exposure, see "Management's Financial Review," "Cross-Border Outstandings," and "Off-Balance-Sheet Financial Markets Instruments" on pages 32 through 51, 86 and 87, and 47 and 48, respectively, of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto and which discussions are incorporated herein by reference. Activities in which the Corporation and its subsidiaries are presently engaged or which they may undertake in the future are subject to certain statutory and regulatory restrictions. Banks and bank holding companies are extensively regulated under both federal and state law. There are various legal limitations upon the extent to which banking subsidiaries of the Corporation can finance or otherwise supply funds to the Corporation or certain of its affiliates. See "Supervision and Regulation." COMPETITION AND INDUSTRY CONSOLIDATION The Corporation's subsidiaries compete with other major financial institutions, including commercial banks, investment banks, mutual savings banks, savings and loan associations, credit unions, consumer finance companies, money market funds and other non-banking institutions, such as insurance companies, major retailers, brokerage firms, and investment companies in New England, throughout the United States, and internationally. One of the principal methods of competing effectively in the financial services industry is to improve customer service through the quality and range of services available, easing access to facilities and pricing. See "Supervision and Regulation" with respect to the impact of legislation upon the Corporation and its subsidiaries. One outgrowth of the competitive environment discussed above has been a significant number of consolidations in the banking industry both on a national and regional level. The Corporation engages on an ongoing basis in reviewing and discussing possible acquisitions of financial institutions, as well as banking and other assets in order to expand its business incident to the implementation of its business strategy. The Corporation intends to continue to explore acquisition opportunities as they arise in order to take advantage of the continuing consolidation in the banking industry. In July 1993, the Corporation completed its acquisitions of Society for Savings Bancorp, Inc., a $2.4 billion registered bank holding company based in Hartford, Connecticut ("Bancorp") and Multibank Financial Corp., a $2.4 billion registered bank holding company based in Dedham, Massachusetts ("Multibank"). In addition, in September 1993, the Corporation announced that it had reached a definitive agreement to acquire BankWorcester Corporation ("BankWorcester") for $34.00 for each share of BankWorcester common stock outstanding, subject to an upward adjustment if the transaction is not consummated on or before June 30, 1994. It is expected that the total purchase price will be approximately $247 million. BankWorcester, the holding company for Worcester County Institution for Savings, had approximately $1.5 billion of assets, approximately $1.3 billion of deposits and 28 branches at December 31, 1993. The transaction has been approved by the boards of directors of both companies and by BankWorcester's stockholders. In March 1994, the Corporation announced that it had reached a definitive agreement to acquire Pioneer Financial, A Co-operative Bank ("Pioneer Bank") for $118 million in cash. Pioneer Bank, which is based in Middlesex County, Massachusetts had approximately $773 million in assets, $720 million in deposits and 20 branches at December 31, 1993. The Pioneer Bank transaction has been approved by the boards of directors of both companies. Both pending transactions are subject to the approval of the Office of the Comptroller of the Currency (the "OCC") and the Board of Bank Incorporation of the Commonwealth of Massachusetts (the "Massachusetts BBI"), and applications for approval for the BankWorcester acquisition have been submitted to the OCC and the Massachusetts BBI. Neither transaction may be consummated until the 30th day after OCC approval is received, during which time the United States Department of Justice may challenge the transactions on antitrust grounds. The Corporation's objective is to consummate the BankWorcester transaction by mid-year 1994 and the Pioneer Bank transaction in the fall of 1994 although no assurances can be given that the requisite regulatory approvals will be granted or, if granted, that such approvals will be received within these time frames. SUPERVISION AND REGULATION The business in which the Corporation and its subsidiaries are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities and other agencies of federal and state governments. The Corporation and its subsidiaries are engaged on a regular basis in discussions with such regulators and agencies on a variety of matters which arise in connection with this regulatory and supervisory process. The supervisory or regulatory activities may, but need not, be directly related to the financial services provided by the Corporation and its subsidiaries. The supervision, regulation and examination to which the Corporation and its subsidiaries are subject are often intended by the regulators primarily for the protection of depositors or are aimed at carrying out broad public policy goals rather than for the protection of security holders. Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Corporation and its subsidiaries are subject are noted below along with certain current regulatory matters concerning the Corporation and its banking subsidiaries. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Corporation. The Corporation The Corporation, as a bank holding company under the Bank Holding Company Act of 1956, as amended, (the "BHCA"), is registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") and is regulated under the provisions of the BHCA. Under the BHCA, the Corporation is prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing or controlling banks or furnishing services to, or acquiring premises for, its affiliated banks. The Corporation may, however, engage in, and own voting shares of companies engaging in, certain activities determined by the Federal Reserve Board, by order or by regulation, to be so closely related to banking or to managing or controlling banks "as to be a proper incident thereto." The location of such "non-bank" subsidiaries of the Corporation is not restricted geographically under the BHCA. The Corporation is required by the BHCA to file with the Federal Reserve Board periodic reports and such additional reports as the Federal Reserve Board may require. The Federal Reserve Bank of Boston (the "Federal Reserve") performs examinations of the Corporation and certain of its subsidiaries. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. Since the Corporation is also a bank holding company under the laws of Massachusetts, the Commissioner of Banks for the Commonwealth of Massachusetts (the "Massachusetts Commissioner") has authority to require certain reports from the Corporation from time to time and to examine the Corporation and each of its subsidiaries other than national banking associations. Prior approval of the Massachusetts BBI also may be required before the Corporation may acquire any additional commercial banks located in Massachusetts. Acquisitions by the Corporation of non-Massachusetts banks or bank holding companies may be subject to the prior approval by both the Massachusetts and the applicable state or federal banking regulators. Massachusetts has an interstate bank acquisition law which permits banking organizations outside Massachusetts to acquire Massachusetts banking organizations if the state law of the acquirer permits acquisitions of banking organizations in that state by Massachusetts-based banking organizations. In addition, Massachusetts has a business combinations law which provides that if any acquirer buys 5% or more of a target company's stock without the prior approval of the target company's board of directors, it generally may not (i) complete the acquisition through a merger, (ii) pledge or sell any assets of the target company, or (iii) engage in other self-dealing transactions with the target company for a period of three years. The prior board approval requirement does not apply if the acquirer buys at least 90% of the target company's outstanding stock in the transaction in which it crosses the 5% threshold or if the acquirer, after crossing the threshold, obtains the approval of the target company's board and two-thirds of the target company's stock held by persons other than the acquirer. This legislation automatically applies to Massachusetts corporations, including the Corporation, which did not elect to "opt out" of the statute. Massachusetts law also provides for classified boards of directors for most public companies incorporated in Massachusetts, unless the company elected to "opt out" of the law. As a result of this law, the Corporation's Board of Directors is divided into three classes of Directors and the three-year terms of the classes are staggered. Other Massachusetts legislation exists which is intended to provide limited anti-takeover protection to certain Massachusetts corporations by preventing an acquirer of certain percentages of such corporation's stock from obtaining voting rights in such stock unless the corporation's other stockholders authorize such voting rights. The legislation automatically applies to certain Massachusetts corporations which have not elected to "opt out" of the statute. The Corporation, by vote of its Board of Directors, has "opted out" of the statute's coverage. In June 1990, the Board of Directors of the Corporation adopted a stockholder rights plan providing for a dividend of one preferred stock purchase right for each outstanding share of common stock of the Corporation (the "Rights"). Under certain circumstances, the Rights would enable stockholders to purchase common stock of the Corporation or of an acquiring Corporation at a substantial discount. The dividend was distributed on July 12, 1990 to stockholders of record on that date. Holders of shares of the Corporation's common stock issued subsequent to that date receive the Rights with their shares. The Rights trade automatically with shares of the Corporation's common stock and become exercisable only under certain circumstances. The purpose of the Rights is to encourage potential acquirers to negotiate with the Corporation's Board of Directors prior to attempting a takeover and to provide the Board with leverage in negotiating on behalf of all stockholders the terms of any proposed takeover. The Rights may have certain anti-takeover effects. The Rights should not interfere, however, with any merger or other business combination approved by the Board of Directors. For a further discussion of the Corporation's stockholder rights plan see the description of the Rights set forth in the Corporation's registration statement on Form 8-A relating to the Rights (including the Rights Agreement, dated as of June 28, 1990, between the Corporation and FNBB, as Rights Agent, which is attached as an exhibit to the Form 8-A), which is incorporated herein by reference. The Banking Subsidiaries General The Corporation's banking subsidiaries that are national banks are subject to the supervision of, and are regularly examined by, the OCC. The Corporation's state-chartered banking subsidiaries are subject to the supervision of, and are regularly examined by, the Federal Deposit Insurance Corporation (the "FDIC") as well as by their respective state regulators. The Corporation's domestic subsidiary banks' deposits are insured by the FDIC to the extent allowed by law and, accordingly, the banks are subject to the regulations of the FDIC. As members of the Federal Reserve System, the nationally chartered banks are also subject to regulation by the Federal Reserve Board. Bank of Vermont and Hospital Trust, as members of the Federal Home Loan Bank of Boston, are also subject to the regulations of the Federal Housing Finance Board. FIRREA Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), an FDIC insured institution can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. The term "default" is defined to mean the appointment of a conservator or receiver for such institution and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. In addition, FIRREA broadened the enforcement powers of the federal banking agencies, including the power to impose fines and penalties over all financial institutions. Further, under FIRREA the failure to meet capital guidelines could subject a financial institution to a variety of regulatory actions, including the termination of deposit insurance by the FDIC. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), also provides for expanded regulation of financial institutions. Under FDICIA, banks are placed in one of five capital categories, for which the federal banking agencies have established specific capital ratio levels. Pursuant to the agencies' regulations, an institution is considered "well capitalized" if it has a total risk-based capital ratio of at least 10%, a tier 1 risk-based capital ratio of at least 6% and a leverage capital ratio of at least 5%. In addition, regardless of a bank's capital level, a bank is not considered "well capitalized" if it is subject to a cease and desist order, formal agreement, capital directive, or prompt corrective action directive that requires it to achieve or maintain a higher level of capital. An institution is considered "adequately capitalized" if it has a total risk-based capital ratio of at least 8%, a tier 1 risk-based capital ratio of at least 4% and a leverage capital ratio of at least 4%. Institutions with capital levels below those necessary to qualify as "adequately capitalized" are deemed to be either "undercapitalized," "significantly undercapitalized" or "critically undercapitalized," depending on their specific capital levels. FDICIA, through its prompt corrective action ("PCA") system, imposes significant operational and management restrictions on banks that are not considered at least "adequately capitalized". At December 31, 1993, FNBB satisfied the requirements of the "well capitalized" category and the Corporation's other banking subsidiaries satisfied the requirements of the "adequately capitalized" or "well capitalized" categories. The capital categories of the Corporation's banking subsidiaries are determined solely for purposes of applying FDICIA's PCA provisions, and such capital categories may not constitute an accurate representation of the overall financial condition or prospects of any of the Corporation's banking subsidiaries. Under FDICIA's PCA system, a bank in the "undercapitalized" category must submit a capital restoration plan guaranteed by its parent company. The liability of the parent company under any such guarantee is limited to the lesser of 5% of the bank's assets at the time it became undercapitalized, or the amount needed to comply with the plan. A bank in the "undercapitalized" category also is subject to limitations in numerous areas including, but not limited to: asset growth; acquisitions; branching; new business lines; acceptance of brokered deposits; and borrowings from the Federal Reserve. Progressively more burdensome restrictions are applied to banks in the "undercapitalized" category that fail to submit or implement a capital plan and to banks that are in the "significantly undercapitalized" or "critically undercapitalized" categories. In addition, a bank's primary federal banking agency is authorized to downgrade the bank's capital category to the next lower category upon a determination that the bank is in an unsafe or unsound condition or is engaged in an unsafe or unsound practice. An unsafe or unsound practice can include receipt by the institution of a rating on its most recent examination of three or worse (on a scale of 1 (best) to 5 (worst)), with respect to its asset quality, management, earnings or liquidity. The FDIC's deposit insurance assessments have moved under FDICIA from a flat-rate system to a risk-based system. The risk-based system places a bank in one of nine risk categories, principally on the basis of its capital level and an evaluation of the bank's risk to the Bank Insurance Fund, and bases premiums on the probability of loss to the FDIC with respect to each individual bank. During 1993, the FDIC's risk-based system provided that the highest and lowest premiums assessable per $100 of insured deposits were $.31 and $.23, respectively, with a greater difference between the rates possible in 1994 or 1995. FDICIA and the regulations issued thereunder also have (i) limited the use of brokered deposits to well capitalized banks, and adequately capitalized banks that have received waivers from the FDIC; (ii) established restrictions on the permissible investments and activities of FDIC-insured state chartered banks and their subsidiaries; (iii) implemented uniform real estate lending rules; (iv) prescribed standards to limit the risks posed by credit exposure between banks; (v) revised risk-based capital rules to include components for measuring the risk posed by interest rate changes; (vi) amended various consumer banking laws; (vii) increased restrictions on loans to a bank's insiders; (viii) established standards in a number of areas to assure bank safety and soundness; and (ix) implemented additional requirements for institutions that have $500 million or more in total assets with respect to annual independent audits, audit committees, and management reports related to financial statements, internal controls and compliance with designated laws and regulations. The Corporation continues to analyze the effect of, and address its ongoing compliance with, the various regulations issued under FDICIA. It is anticipated that FDICIA, and the regulations enacted thereunder, will continue to result in more limitations on banking activities generally, and increased costs for the Corporation and the banking industry because of higher FDIC assessments and higher costs of compliance, documentation and record keeping. Other Regulatory Restrictions The Corporation's domestic subsidiary banks and the subsidiaries of such banks are subject to a large number of other regulatory restrictions, including certain restrictions upon: (i) any extensions of credit by such banks to, from or for the benefit of the Corporation and the Corporation's non-banking affiliates (collectively with the Corporation, the "Affiliates"), (ii) the purchase of assets or services from or the sale of assets or the provision of services to Affiliates, (iii) the issuance of a guarantee, acceptance or letter of credit on behalf of or for the benefit of Affiliates, (iv) the purchase of securities of which an Affiliate is a principal underwriter during the existence of the underwriting and (v) investments in stock or other securities issued by Affiliates or acceptance thereof as collateral for an extension of credit. The Corporation and all its subsidiaries, including FNBB, are also subject to certain restrictions with respect to engaging in the issue, flotation, underwriting, public sale or distribution of certain types of securities. In addition, under both the BHCA and regulations which have been issued by the Federal Reserve Board, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of any property or the furnishing of any service. In operations in other countries, the Corporation and FNBB are also subject to restrictions imposed by the laws and banking authorities of such countries. The Corporation's banking subsidiaries are also required to maintain cash reserves against deposits and are subject to restrictions, among others, upon (i) the nature and amount of loans which they may make to a borrower; (ii) the nature and amount of securities in which they may invest; (iii) the portion of their respective assets which may be invested in bank premises; (iv) the geographic location of their branches; and (v) the nature and extent to which they can borrow money. Dividends The payment of dividends by the Corporation is determined by the Board of Directors based on the Corporation's liquidity, asset quality profile, capital adequacy, and recent earnings history (excluding significant non-recurring transactions) as well as economic conditions and other factors, including applicable government regulations and policies and the amount of dividends payable to the Corporation by its subsidiary banks. In 1993, the aggregate dividends declared by the Corporation on its common stock and preferred stock were approximately $73 million. For each quarter of 1993, a dividend of $.10 per share was declared and paid on the Corporation's common stock. In the first quarter of 1994, the Corporation declared a dividend on its common stock of $.22 per share. The declaration and payment of dividends on the Corporation's common stock was previously subject to the prior approval of the Federal Reserve and the Division of Banking Supervision and Regulation of the Federal Reserve Board pursuant to an agreement between the Corporation and the Federal Reserve entered into in 1991. In October 1993, the Federal Reserve terminated the agreement. The Corporation is a legal entity separate and distinct from its subsidiary banks and its other non-bank subsidiaries. The Corporation's revenues (on a parent company only basis) result primarily from interest and dividends paid to the Corporation by its subsidiaries. The right of the Corporation, and consequently the right of creditors and stockholders of the Corporation, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of banking subsidiaries), except to the extent that claims of the Corporation in its capacity as a creditor may be recognized. It is the policy of the OCC and the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if after paying such dividends the bank or bank holding company would remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the Federal Reserve Board that a bank holding company is expected to act as a source of financial strength to its subsidiary banks. Various federal and state laws, regulations and policies limit the ability of the Corporation's banking subsidiaries to pay dividends to the Corporation. Federal banking law requires the approval of the OCC if the aggregate total of the dividends declared by any of the Corporation's national banking subsidiaries in any calendar year will exceed the bank's net profits, as defined by applicable regulation, for that year combined with retained net profits for the preceding two years. Also, state law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed certain prescribed limits. In 1993, approximately $7 million of dividends were declared by one of the Corporation's banking subsidiaries. The payment of any future dividends by the Corporation's banking subsidiaries will be determined based on a number of factors, including the subsidiary's liquidity, asset quality profile, capital adequacy and recent earnings history. In addition, as discussed below, two of the Corporation's banking subsidiaries, BKB Connecticut and South Shore Bank, are subject to regulatory agreements which require prior regulatory approval and prior notice, respectively, for the payment of dividends. See the related discussions set forth below in "Capital," "Legislation" and "Regulatory Agreements." Capital Information concerning the Corporation and its banking subsidiaries with respect to capital is set forth in the discussion of "Capital Management" contained in the Corporation's 1993 Annual Report to Stockholders on pages 49 and 50, which pages are included in Exhibit 13 hereto and which discussion is incorporated herein by reference. See also "Legislation" and "Regulatory Agreements" discussed below and "Dividends" discussed above. Legislation In addition to extensive existing government regulation, federal and state statutes and regulations can change in unpredictable ways, often with significant effects on the way in which financial institutions may conduct business. Legislation which has been enacted in recent years has substantially increased the level of competition among commercial banks, thrift institutions and non-banking institutions, including insurance companies, brokerage firms, mutual funds, investment banks and major retailers. Similarly, the enactment of banking legislation such as FIRREA and FDICIA has affected the banking industry by, among other things, broadening the powers of the federal banking agencies in a number of areas. Other legislation, which is considered from time to time, such as interstate branching, could, if enacted, significantly affect the business of the Corporation. See also "Supervision and Regulation -- the Corporation" discussed above. Regulatory Matters During 1993, certain regulatory agreements between the Corporation or its banking subsidiaries and their respective banking agencies were terminated by the agencies as a result of improvements in the areas addressed in those agreements. Information on the terminated and remaining agreements is set forth below. As previously reported, in 1989, FNBB entered into an agreement with the OCC to address certain areas, and the Corporation entered into a similar memorandum of understanding with the Federal Reserve. In 1991 the Corporation entered into a written agreement with the Federal Reserve that was essentially a formalization of the then existing memorandum of understanding. In February 1993 and October 1993, respectively, the OCC and the Federal Reserve terminated the agreements as a result of the progress made by FNBB and the Corporation in the areas addressed by the agreements. As previously reported, in 1991 Casco and Hospital Trust entered into agreements with the OCC that were substantially similar to the OCC's agreement with FNBB. In February 1993, the OCC terminated the agreements with Casco and Hospital Trust as a result of the progress made by Casco and Hospital Trust in the areas addressed in their respective agreements. As previously reported, Bank of Vermont and its regulators, the FDIC and the Commissioner of Banking, Insurance and Securities of the State of Vermont (the "Vermont Commissioner"), entered into a memorandum of understanding in 1992. In October 1993, the FDIC and the Vermont Commissioner terminated the memorandum as a result of Bank of Vermont's compliance with its provisions. As previously reported, in 1992 Bancorp and Multibank entered into written agreements with the Federal Reserve. In September 1993, the Federal Reserve terminated the agreements with Bancorp and Multibank as a result of the progress made by Bancorp and Multibank in the areas addressed in their respective agreements. As previously reported, in connection with the acquisition of Bancorp, BKB Connecticut was merged with and into Bancorp's subsidiary bank, Society for Savings ("Society"), and Society changed its name to "BKB Connecticut" following the merger. The resulting bank remains subject to a stipulation and agreement entered into by BKB Connecticut with the Connecticut Banking Commissioner in 1991 pursuant to which BKB Connecticut is required, among other things, to reduce the level of its classified assets, to maintain appropriate reserves, and to maintain its tier 1 leverage capital ratio in excess of minimum regulatory requirements. As of December 31, 1993, BKB Connecticut's tier 1 leverage capital ratio was above the minimum required under its agreement. The agreement requires the prior written consent of the Connecticut Banking Commissioner and the Regional Director of the FDIC for the payment of dividends by BKB Connecticut. The agreement, as amended, also requires BKB Connecticut to submit semiannual progress reports to the regulators of actions taken under the agreement. BKB Connecticut has implemented or is implementing improvements in the various areas addressed in its agreement. As previously reported, Mechanics Bank entered into a memorandum of understanding with the FDIC and the Massachusetts Commissioner in 1991. In January 1994, the FDIC and the Massachusetts Commissioner terminated the agreement with Mechanics Bank as a result of the progress made by Mechanics Bank in the areas addressed in the agreement. As previously reported, South Shore Bank entered into a memorandum of understanding with the FDIC and the Massachusetts Commissioner in 1992, which incorporated the terms of an earlier memorandum of understanding entered into in 1991. The memorandum of understanding addresses certain areas, including management, asset quality, reserves, profitability, capital ratios, and dividends. South Shore Bank is also subject to the ongoing conditions of the FDIC's approval order relating to the merger of two other banks into South Shore Bank. The conditions of the approval order require, among other things, a plan to reduce classified asset levels and that South Shore Bank have, as of December 31, 1993, a minimum tier 1 leverage capital ratio of at least 6.0%. As of December 31, 1993, South Shore Bank was in compliance with the capital ratio aspects of, and had adopted or was implementing improvements in the various areas addressed in, the agreement and approval order. As previously reported, as part of the 1991 merger of two of Multibank's banking subsidiaries, the FDIC issued an approval order which requires that the resulting bank, Multibank West, comply with certain conditions. The approval order addresses, among other things, uniform policies and procedures, risk ratings, asset quality, reserves and funds management, and requires that Multibank West maintain an equity-to-assets ratio of at least 5%. Multibank West, which is required to file periodic progress reports with the FDIC, has complied with all of the aspects of the approval order. The Corporation is currently in the process of seeking regulatory approval to merge Mechanics Bank, South Shore Bank and Multibank West into FNBB. While it is anticipated that the mergers will be consummated by mid-year 1994, there can be no assurances that the requisite regulatory approvals will be granted or, if granted, that such approvals will be received within this time frame. As previously reported, in January 1994, the Securities and Exchange Commission (the "Commission") commenced an administrative proceeding against the Corporation. The administrative proceeding relates to the Commission's claim that the Corporation's second quarter 1989 Form 10-Q did not disclose known trends or uncertainties with respect to the Corporation's credit portfolio and specifically its domestic commercial real estate portfolio. The Corporation reported a significant loss in the third quarter of 1989 as a result of adding to its reserve for credit losses, primarily due to deterioration in the credit quality of its domestic commercial real estate portfolio. Management believes that the disclosures made in its second quarter 1989 Form 10-Q were appropriate and intends to defend the action vigorously. Although management cannot predict the outcome of this proceeding, an unfavorable outcome will not result in any monetary penalties to the Corporation. GOVERNMENTAL POLICIES AND ECONOMIC CONDITIONS The earnings and business of the Corporation and its subsidiaries are affected by a number of external influences. The economic and political conditions in which the Corporation and its subsidiaries operate can vary greatly. Such conditions include volatile foreign exchange markets and, in certain countries, high rates of inflation and foreign exchange liquidity problems. In 1993, the economies of New England and the United States reflected modest improvement and for most of 1993, the Corporation experienced improved domestic loan demand. The economic downturn in New England, however, predated the national recession and since the state of the regional economy reflects structural as well as cyclical forces, New England's economic recovery may be slower and more uneven than for the country as a whole. The Corporation's earnings and business are also affected by the policies of various government and regulatory authorities in New England and throughout the United States, as well as foreign governments and international agencies, including, in the United States, the Federal Reserve Board. Important functions of the Federal Reserve Board, in addition to those enumerated under "Supervision and Regulation," are to regulate the supply of money and of bank credit, to deal with general economic conditions within the United States and to be responsive to international economic conditions. From time to time, the Federal Reserve Board and the central banks of foreign countries have taken specific steps to effect changes in the value of the United States dollar in foreign currency markets as well as to control domestic inflation and to control the country's money supply. The instruments of monetary policy employed by the Federal Reserve Board for these purposes (including interest rates and the level of cash reserves banks are required to maintain against deposits) influence in various ways the interest rates paid on interest bearing liabilities and the interest received on earning assets, as well as the overall level of bank loans, investments and deposits. Inflation has generally had a minimal impact on the Corporation because substantially all of its assets and liabilities are of a monetary nature and a large portion of its operations are based in the United States, where inflation has been low. As discussed in "Management's Financial Review," a currency position maintained by the Corporation in Brazil, a country with a hyperinflationary economy, has had an effect on the levels of net interest revenue, noninterest income and net interest margin, while modestly benefiting total revenue. Prospective domestic and international economic and political conditions and the policies of the Federal Reserve Board, as well as other domestic and international regulatory authorities, may effect the future business and earnings of the Corporation. This section should be read in conjunction with "Management's Financial Review" contained in the Corporation's 1993 Annual Report to Stockholders on pages 32 through 51, which pages are included in Exhibit 13 hereto and which discussion is incorporated herein by reference. CONSOLIDATED STATISTICAL INFORMATION The "Consolidated Statistical Information" is incorporated herein by reference from the following pages of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto. This information should be read in conjunction with the financial statements incorporated by reference in Item 8 of this Report. Page of 1993 Annual Report to Stockholders Average Balances and Interest Rates: Consolidated 79 United States Operations 80 International Operations 81 Change in Net Interest Revenue-Volume and Rate Analysis: 1993 compared with 1992 82 1992 compared with 1991 83 Geographic Segment Information 84 Cross-border Outstandings 86 and 87 Loans and Lease Financing 88 Nonaccrual Loans and Leases 89 Reserve for Credit Losses: Allocation of Reserve for Credit Losses 90 Analysis of Reserve for Credit Losses 91 Securities 92 Deposits 92 Short-term Borrowings 93 Consolidated Selected Financial Data-Selected Ratios 31 Item 2. Item 2. Properties. The head offices of the Corporation and FNBB are located in a 37-story building at 100 Federal Street, Boston, Massachusetts. In 1993, FNBB leased approximately 70% of the building's approximately 1.3 million square feet. FNBB's securities and payments processing center is located in Canton, Massachusetts, where FNBB leases approximately 85% of the Canton office building's approximately 275,000 square feet. FNBB's data processing and record keeping operations are located at Columbia Park in Boston. The Columbia Park facility, comprising approximately 405,000 square feet, and the land on which it is situated are owned by FNBB. In addition, FNBB leases Multibank's former operations facility in Dedham, Massachusetts, which comprises approximately 158,000 square feet. The headquarters for FNBB's operations in Argentina and Brazil are located in a 10-story building in Buenos Aires and a 20-story building in Sao Paulo, respectively. The Buenos Aires and Sao Paulo facilities, comprising approximately 256,000 and 187,000 square feet, respectively, are owned by FNBB. Hospital Trust owns a 30-story building and a building adjacent thereto at One Hospital Trust Plaza, Providence, Rhode Island. Hospital Trust occupies approximately 40% of the complex's approximately 546,000 square feet. In addition, Hospital Trust maintains an operations center in East Providence, Rhode Island that also serves as the primary backup for FNBB's Columbia Park facility. The East Providence operations center, which consists of approximately 141,000 square feet, is owned by Hospital Trust. BKB Connecticut has recently moved its headquarters to Hartford, Connecticut where it has offices at 31 Pratt Street and 100 Pearl Street. BKB Connecticut owns and occupies approximately 50,000 square feet at the Pratt Street location, which was the former Bancorp headquarters. BKB Connecticut owns an undivided one-half interest in the Pearl Street location and currently occupies approximately 54,000 square feet. BKB Connecticut also maintains regional offices in Connecticut, the largest of which is in Waterbury and comprises approximately 157,000 square feet of owned space in three interconnected buildings. Casco's headquarters are located at One and Two Monument Square in Portland, Maine. Casco leases approximately 135,000 square feet of the complex and currently occupies approximately 76,000 square feet of that space. Bank of Vermont's headquarters in Burlington, Vermont consist of approximately 77,000 square feet of owned space in four interconnected buildings. None of these properties is subject to any material encumbrance. The Corporation's subsidiaries also own or lease numerous other premises used in domestic and foreign operations. Item 3. Item 3. Legal Proceedings. The Corporation and its subsidiaries in 1993 were or currently are parties to a number of legal proceedings that have arisen in connection with the normal course of business activities of the Corporation, FNBB and the Corporation's other subsidiaries, including the following matters: Arnold/Society for Savings Bancorp, Inc. As previously reported, in March, 1993, a complaint was filed in Delaware Chancery Court against the Corporation, Bancorp and Bancorp's directors who voted in favor of the Corporation's acquisition of Bancorp. The action was brought by a Bancorp stockholder, individually and as a class action on behalf of all Bancorp stockholders of record on the date the acquisition was announced, and sought an injunction with respect to the proposed acquisition and damages in an unspecified amount. In May 1993, the Chancery Court denied the plaintiff's motion for a preliminary injunction and in July 1993, the Corporation acquired Bancorp. In December 1993, the Chancery Court granted summary judgment in favor of the Corporation, Bancorp and Bancorp's former directors. The plaintiff has appealed that decision to the Delaware Supreme Court, where the matter is currently pending. Bancorp Class Action. As previously reported, a class action complaint was filed in U.S. District Court for the District of Connecticut against Bancorp, two of its then senior officers and one former officer. The complaint, as subsequently amended, alleges that Bancorp's financial reports for fiscal years 1988, 1989, and the first half of 1990 contained material misstatements or omissions concerning its real estate loan portfolio and other matters, in violation of Connecticut common law and of Sections 10(b) and 20 of the Securities Exchange Act of 1934. The action was brought by a Bancorp shareholder, individually and as a class action on behalf of purchasers of Bancorp's stock from January 19, 1989 through November 30, 1990 and seeks damages in an unspecified amount. Bancorp and the defendant officers have denied the allegations of the amended complaint and intend to defend the action vigorously. Lender Liability Litigation. The Corporation's subsidiaries, in the normal course of their business in collecting outstanding obligations, are named as defendants in complaints or counterclaims filed in various jurisdictions by borrowers or others who allege that lending practices by such subsidiaries have damaged the borrowers or others. Such claims, commonly referred to as lender liability claims, frequently request not only relief from repayment of the debt obligation, but also recovery of actual, consequential, and punitive damages, some in very large dollar amounts. During 1991, one such claim resulted in a judgment being entered against Hospital Trust for approximately $4.0 million, plus interest. The judgment against Hospital Trust remains on appeal. Stranway/Elmendorf Case. As previously reported, in June 1985 a complaint was filed against FNBB in the U.S. District Court for the District of New Hampshire by private plaintiffs on behalf of the United States in a qui tam action under 3l U.S.C. # 3729, known as the False Claims Act. The complaint alleges that FNBB failed to disclose, or made false statements, to the Farmer's Home Administration ("FmHA") in connection with securing and inducing payment on guarantees from the FmHA on loans by FNBB and certain investors to Stranway Corporation and its subsidiary Elmendorf Board Corporation. Damages are alleged in the amount of $50,000,000, plus interest, costs and attorneys fees. The United States, which must decide at the outset whether to take over civil prosecution of a False Claims Act suit initiated by a private plaintiff, has declined to enter an appearance in and take over the action. The action was transferred to the District of Massachusetts. In 1986, FNBB filed a motion to dismiss the suit for lack of subject matter jurisdiction and the motion was denied by the District Court in 1988. Discovery has been essentially completed in the case. FNBB denies the allegations in the complaint and intends to continue to defend the action vigorously. Management, after reviewing all actions and proceedings pending against the Corporation and its subsidiaries, considers that the aggregate loss, if any, resulting from the final outcome of these proceedings will not be material. Item 3A. Executive Officers of the Corporation. Information with respect to the executive officers of the Corporation, as of March 1, 1994, is set forth below. Executive Officers are generally elected annually by the Board of Directors and hold office until the following year and until their successors are chosen and qualified, unless they sooner resign, retire, die or are removed. Except where otherwise noted, the positions listed for the officers are for both the Corporation and FNBB. All of the foregoing individuals have been officers of the Corporation or one of its subsidiaries for the past five years except for Ms. Haney and Messrs. Blake, Champion, Gallery, O'Neal, Ott and Shea. Prior to joining the Corporation in 1990, Ms. Haney was Senior Vice President/Manager of Portfolio Accounting for The Boston Company since 1988 and Mr. Champion was Senior Vice President and Department Head, General Services for Continental Bank from 1976. Mr. Gallery came to the Corporation in 1991 from The First National Bank of Chicago where he was Division Manager, Midwest since 1989. Prior to joining the Corporation in 1992, Mr. O'Neal was employed by Chemical Banking Corporation as Senior Executive Vice President, Operating Services and Nationwide Consumer in 1992, Vice Chairman and Director from 1990 to 1991 and Group Executive Consumer Banking Group from 1987 to 1990. Mr. Blake also joined the Corporation in 1992 and prior to that time was Vice President of the MAC Group/Gemini Consulting since 1988. Mr. Ott also came to the Corporation in 1992 from Constellation Bancorp where he served as Executive Vice President, Community Banking Division, and prior to that time was an Associate at TAC Associates from 1991 to 1992, Senior Vice President, Community Banking Division of Fleet Bank from 1990 to 1991 and Vice President of Bank of America from 1975 to 1990. Mr. Shea joined the Corporation in 1993 from Coopers & Lybrand, where he had served as a partner since 1983 and as Vice Chairman since 1991. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The information required by this Item is presented on pages 30, 31 and 95 of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto, and such information is hereby incorporated by reference. Item 6. Item 6. Selected Financial Data. The "Consolidated Selected Financial Data" of the Corporation for the six years ended December 31, 1993 appears on pages 30 and 31 of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto, and such information is hereby incorporated by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information in response to this Item is included in "Management's Financial Review" on pages 32 through 51 of the Corporation's 1993 Annual Report to Stockholders, which pages are included in Exhibit 13 hereto, and such information is hereby incorporated by reference. Item 8. Item 8. Financial Statements and Supplementary Data. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Information concerning the Executive Officers of the Corporation which responds to this Item is contained in the response to Item 3A contained in Part I of this Report and is hereby incorporated by reference herein. The information that responds to this Item with respect to Directors, is contained under the heading "Election of Directors" in the Corporation's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which is required to be filed pursuant to Regulation 14A of the Exchange Act and which will be filed with the Commission not later than 120 days after the end of the Corporation's fiscal year (the "Proxy Statement"). Information with respect to compliance by the Corporation's directors and executive officers with Section 16(a) of the Exchange Act is contained under the heading "Compliance with Section 16(a) of the Exchange Act" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement is hereby incorporated by reference. Item 11. Item 11. Executive Compensation. The information required in response to this Item is contained under the heading "Compensation of Executive Officers" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement, with the exception of the sections entitled "Compensation Committee Report on Executive Compensation" and "Five-Year Stockholder Return Comparison," is hereby incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required in response to this Item is contained under the heading "Beneficial Ownership of Securities" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement is hereby incorporated by reference. Item 13. Item 13. Certain Relationships and Related Transactions. The information required in response to this Item is contained under the heading "Indirect Interest of Directors and Executive Officers in Certain Transactions" in the Proxy Statement. Pursuant to General Instruction G(3) to Form 10-K, the foregoing information from the Proxy Statement is hereby incorporated by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a)(1) The financial statements required in response to this Item are listed in response to Item 8 of this Report and are incorporated herein by reference. (a)(2) Financial Statement Schedules. Schedules have been omitted because the information is either not required, not applicable, or is included in the financial statements or notes thereto. (a)(3) Exhibits 3(a) - Restated Articles of Organization of the Corporation, as amended through November 24, 1993. 3(b) - By-Laws of the Corporation, as amended through October 28, 1993. 4(a) - Indenture dated as of January 15, 1986 defining rights of holders of the Corporation's 7 3/4% Convertible Subordinated Debentures Due 2011, incorporated herein by reference to Exhibit 4(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 (File No. 1-6522). 4(b) - Fiscal and Paying Agency Agreement dated as of February 10, 1986 defining rights of holders of the Corporation's Subordinated Floating Rate Notes Due 2001, incorporated herein by reference to Exhibit 4(d) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 (File No. 1-6522). 4(c) - Fiscal and Paying Agency Agreement dated as of August 26, 1986 defining rights of holders of the Corporation's Floating Rate Subordinated Equity Commitment Notes Due 1998 incorporated herein by reference to Exhibit 4(e) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-6522). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 4(d) - Indenture dated as of June 15, 1987 defining the rights of holders of the Corporation's 9 1/2% Subordinated Equity Contract Notes due 1997, incorporated herein by reference to Exhibit 4(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, l987 (File No. 1-6522). 4(e) - Indenture dated as of July 15, 1988 and form of note defining rights of the holders of the Corporation's 10.30% Subordinated Notes due September 1, 2000, incorporated herein by reference to Exhibit 4(i) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 1-6522). 4(f) - Fiscal and Paying Agency Agreement dated as of September 12, 1985 defining rights of holders of the Corporation's Floating Rate Notes Due 2000, incorporated herein by reference to Exhibit 4(c) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 (File No. 1-6522). 4(g) - Subordinated Indenture dated as of June 15, 1992, as amended by the First Supplemental Indenture dated as of June 24, 1993, and forms of notes defining rights of the holders of the Corporation's 6 7/8% Subordinated Notes due 2003, the 6 5/8% Subordinated Notes due 2005, and the 6 5/8% Subordinated Notes due 2004, incorporated herein by reference to Exhibit 4(d) to the Corporation's Registration Statement on Form S-3 (Registration Number 33-48418), to Exhibits 4(e) and 4(f) to the Corporation's Current Report on Form 8-K dated June 24, 1993, to Exhibit 4 to the Corporation's Current Report on Form 8-K dated November 15, 1993 and to Exhibit 4 to the Corporation's Current Report on Form 8-K dated January 5, 1994 (File No. 1-6522). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 4(h) - Rights Agreement, dated as of June 28, 1990, between the Corporation and FNBB, as Rights Agent, and the description of the Rights, incorporated herein by reference to the Corporation's registration statement on Form 8-A relating to the Rights and to Exhibit 1 of such registration statement (File No. 1-6522). 4(i) - Deposit Agreement, dated August 13, 1992 between the Corporation and FNBB, as Depositary, relating to the Corporation's Depositary Shares, each representing a one-tenth interest in the Corporation's 8.60% Cumulative Preferred Stock, Series E, incorporated herein by reference to Exhibit 4(b) to the Corporation's Current Report on Form 8-K dated August 13, 1992 (File No. 1-6522). 4(j) - Deposit Agreement, dated as of June 30, 1993 between the Corporation and FNBB, as Depositary, relating to the Corporation's Depositary Shares, each representing a one-tenth interest in the Corporation's 7 7/8% Cumulative Preferred Stock, Series F, incorporated herein by reference to Exhibit 4(b) to the Corporation's Current Report on Form 8-K dated June 24, 1993 (File No. 1-6522). 10(a) Bank of Boston Corporation 1982 Stock Option Plan as amended through August 24, 1989, incorporated herein by reference to Exhibit 10(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-6522).* ____________________________________________________________ * Indicates that document is a management contract or compensatory plan or arrangement that is required to be filed as an exhibit to this Report pursuant to Item 14(c) of Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 10(b) Bank of Boston Corporation 1986 Stock Option Plan as amended through August 24, 1989, incorporated herein by reference to Exhibit 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-6522).* 10(c) Bank of Boston Corporation and its Subsidiaries Performance Recognition Opportunity Plan, as amended effective January 27, 1994.* 10(d) Bank of Boston Corporation Executive Non-Qualified Deferred Compensation Plan, as amended through March 12, 1991, incorporated herein by reference to Exhibit 10(d) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-6522).* 10(e) The First National Bank of Boston Bonus Supplemental Employee Retirement Plan, as amended through September 13, 1990, incorporated herein by reference to Exhibit 10(e) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-6522).* 10(f) Description of the Corporation's Supplemental Life Insurance Plan, incorporated herein by reference to Exhibit 10(h) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 1-6522).* 10(g) The First National Bank of Boston Excess Benefit Supplemental Employee Retirement Plan, effective as of January 1, 1989, incorporated herein by reference to Exhibit 10(g) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-6522).* ____________________________________________________________ * Indicates that document is a management contract or compensatory plan or arrangement that is required to be filed as an exhibit to this Report pursuant to Item 14(c) of Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 10(h) Bank of Boston Corporation 1991 Long-Term Stock Incentive Plan, as amended through January 27, 1994.* 10(i) Employment Agreement dated July 7, 1992 between The First National Bank of Boston and Edward A. O'Neal, incorporated herein by reference to Exhibit 10(k) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-6522).* 10(j) Employment Agreement dated December 4, 1992 between The First National Bank of Boston and William J. Shea, incorporated herein by reference to Exhibit 10(l) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-6522).* 10(k) Bank of Boston Corporation Relocation Policy, as amended through October, 1990, incorporated herein by reference to Exhibit 10(j) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-6522).* 10(l) - Description of the Corporation's Supplemental Long-Term Disability Plan effective as of February 10, 1994.* 10(m) Bank of Boston Corporation's Director Stock Award Plan effective as of May 1, 1993.* 10(n) Lease dated as of September 1, 1991 between The First National Bank of Boston and The Equitable Federal Street Realty Company Limited Partnership, incorporated herein by reference to Exhibit 10(l) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-6522). _____________________________________________________________ * Indicates that document is a management contract or compensatory plan or arrangement that is required to be filed as an exhibit to this Report pursuant to Item 14(c) of Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 11 - Computation of earnings per common share. 12(a) Computation of the Corporation's Consolidated Ratio of Earnings to Fixed Charges (excluding interest on deposits). 12(b) Computation of the Corporation's Consolidated Ratio of Earnings to Fixed Charges (including interest on deposits). 12(c) Computation of the Corporation's Consolidated Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements (excluding interest on deposits). 12(d) Computation of the Corporation's Consolidated Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements (including interest on deposits). 13 - Pages 30 through 51, 53 through 93 and 95 of the Corporation's 1993 Annual Report to Stockholders. 21 - List of subsidiaries of Bank of Boston Corporation. 23 - Consent of Independent Accountants. 24 - Power of attorney of certain officers and directors (included on pages II-1 through II-2). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (cont'd). (a)(3) Exhibits (cont'd) 99 - Notice of Annual Meeting and Proxy Statement for the Annual Meeting of the Corporation's Stockholders to be held April 28, 1994. (Pursuant to General Instruction G(3) to Form 10-K, the information required to be filed by Part III hereof is incorporated by reference from the Corporation's definitive proxy statement which is required to be filed pursuant to Regulation 14A and which will be filed with the Commission not later than 120 days after the end of the Corporation's fiscal year.) (b) During the fourth quarter of 1993, the Corporation filed three Current Reports on Form 8-K. The current reports, dated October 28, 1993, November 2, 1993 and November 15, 1993, contained information pursuant to Items 5 and 7 of Form 8-K. The Corporation also filed one Current Report on Form 8-K, dated January 5, 1994, which contained information pursuant to Items 5 and 7 of Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Boston, and Commonwealth of Massachusetts, on the 4th day of March, 1994. BANK OF BOSTON CORPORATION By /s/ IRA STEPANIAN ------------------------------- (Ira Stepanian) (Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates listed below. By so signing, each of the undersigned, in his or her capacity as a director or officer, or both, as the case may be, of the Corporation, does hereby appoint Ira Stepanian, Charles K. Gifford, William J. Shea, Bradford H. Warner, Robert T. Jefferson and Gary A. Spiess, and each of them severally, or if more than one acts, a majority of them, his or her true and lawful attorneys or attorney to execute in his or her name, place and stead, in his or her capacity as a director or officer or both, as the case may be, of the Corporation, any and all amendments to said report and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of each of the undersigned, in any and all capacities, every act whatsoever requisite or necessary to be done in the premises as fully and to all intents and purposes as each of the undersigned might or could do in person, hereby ratifying and approving the acts of said attorneys and each of them. II-1 II-2

48732_1993.txt

48732_1993

1993

48732

ITEM 1. BUSINESS: THE COMPANY AND ITS SUBSIDIARIES. The Company, incorporated in Texas in 1976, is a holding company operating principally in two business segments, the electric utility business and the cable television business. The Company conducts its operations primarily through three subsidiaries: HL&P, its principal operating subsidiary, KBLCOM and HI Energy. See "Regulation of the Company" for a description of the Company's status under the 1935 Act. HL&P is engaged in the generation, transmission, distribution and sale of electric energy and serves over 1.4 million customers in an approximately 5,000 square-mile area of the Texas Gulf Coast, including Houston. As of December 31, 1993, the total assets and common stock equity of HL&P represented 88% of the Company's consolidated assets and 113% of the Company's consolidated common stock equity, respectively. For the year ended December 31, 1993, the operations of HL&P accounted for 108% of the Company's consolidated net income. See "Business of HL&P." The cable television operations of the Company are conducted through KBLCOM and its subsidiaries. This segment includes five cable television systems located in four states and a 50% interest in Paragon, a partnership which owns systems located in seven states. As of December 31, 1993, KBLCOM's systems served approximately 605,000 basic cable customers subscribing to approximately 488,000 premium programming units. According to information provided by Paragon's managing partner, Paragon served approximately 932,000 basic cable customers subscribing to approximately 542,000 premium programming units. See "Business of KBLCOM." HI Energy was recently organized by the Company to participate in domestic and foreign power generation projects and to invest in the privatization of foreign electric utilities. HI Energy is actively engaged in the evaluation of several such projects, but has not yet committed significant financial or other resources to any single project. See "Businesses of Other Subsidiaries - HI Energy." As of December 31, 1993, the Company and its subsidiaries had 11,350 full-time employees. HL&P had 9,578 full-time employees, and KBLCOM and its subsidiaries had 1,581 full-time employees (excluding employees of joint ventures and partnerships in which the Company holds less than a majority interest). For certain financial information with respect to each of the Company's two principal business segments, see Note 16 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. BUSINESS OF HL&P. HL&P, incorporated in Texas in 1906, is engaged in the generation, transmission, distribution and sale of electric energy. Sales are made to residential, commercial and industrial customers in an approximately 5,000 square-mile area of the Texas Gulf Coast, including Houston. CERTAIN FACTORS AFFECTING THE ELECTRIC UTILITY BUSINESS As an electric utility, HL&P has been affected, to varying degrees, by a number of factors that have affected the electric utility industry in general. These factors include, among others, difficulty in obtaining rate increases sufficient to provide an adequate return on invested capital, high costs and delays associated with environmental and nuclear regulations, changes in regulatory climate, prudence audits, competition from other energy suppliers and difficulty in obtaining regulatory approval for construction of new generating plants. HL&P is unable to predict the future effect of these or other factors upon its operations and financial condition. HL&P's results of operations are significantly affected by decisions of the Utility Commission primarily in connection with rate increase applications filed prior to 1991 by HL&P. Although Utility Commission action on those applications has been completed, a number of the orders of the Utility Commission are currently subject to judicial review. Rate issues relating to a possible proceeding to review HL&P's rate levels and to review costs associated with the outage of the South Texas Project are also pending before the Utility Commission. For a discussion of these matters, see Notes 9, 10, 11 and 12 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. HL&P is project manager and one of four co-owners of the South Texas Project, which consists of two 1,250 MW nuclear generating units. HL&P owns a 30.8% interest in the South Texas Project. Both generating units at the South Texas Project were out of service from February 1993 to February 1994 when Unit No. 1 was authorized by the NRC to return to service. In June 1993, the NRC placed the South Texas Project on its "watch list" of plants with "weaknesses that warrant increased NRC attention." Such action followed the NRC's issuance of a report issued by its Diagnostic Evaluation Team which identified a number of areas requiring improvement. For a description of litigation and regulatory proceedings relating to the South Texas Project including, among other things, the NRC's diagnostic evaluation of the South Texas Project, the operating status of the South Texas Project and Austin's lawsuit filed on February 22, 1994, see "Regulatory Matters" below, Item 3 of this Report, "Results of Operations - HL&P - United States Nuclear Regulatory Commission (NRC) Diagnostic Evaluation of the South Texas Project" in Item 7 of this Report and Notes 9(b), 9(c), 9(f), 10 and 11 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. In 1992, Congress enacted the Energy Act which, among other changes, exempts from the 1935 Act EWGs, a class of electric power producers engaged in sales of electric energy exclusively at wholesale. For information with respect to the Energy Act, see "Competition" and "Regulatory Matters" below and Note 8(a) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. In 1995, the Texas legislature is expected to consider various proposals regarding the organization and responsibilities of the Utility Commission. For information regarding the Sunset Act review process and Utility Commission rulemaking activities regarding IRP, see "Regulatory Matters - Rates and Services" below. SERVICE AREA While employment, personal income and industrial activity in the Houston area steadily increased from 1987 to 1990, the effects of the national recession have since slowed growth in HL&P's service area. While the local economy continues to slowly expand and diversify in numerous areas, such as medical, professional and engineering services, it is still dependent, to a large degree, on oil, gas, refined products, petrochemicals and related businesses. HL&P operates under a certificate of convenience and necessity granted by the Utility Commission which covers HL&P's present service area and facilities. In addition, HL&P holds franchises to provide electric service within the incorporated municipalities in its service territory. None of such franchises expires before 2007. MAXIMUM HOURLY FIRM DEMAND AND CAPABILITY The following table sets forth, for the years indicated, information with respect to HL&P's net capability, maximum hourly firm demand and the resulting reserve margin: - ------------------- (1) Reflects firm capacity purchased. (2) Does not include interruptible load at time of peak. At December 31, 1993, HL&P owned and operated generating facilities with installed net generating capability of 13,679 MW. HL&P experienced a maximum hourly firm demand in 1993, a year of unusually warm summer weather, of 11,397 MW, a 5.7% increase over the maximum hourly firm demand in 1992, a year of unusually mild summer weather. Including interruptible demand, the maximum hourly firm demand actually served in 1993 was 12,472 MW compared to 11,638 MW in 1992. For planning purposes, HL&P currently expects maximum hourly firm demand for electricity to grow at a compound annual rate of about 1.6% over the next ten years. Assuming average weather conditions, reserve margins are projected to decrease from an estimated 25% in 1994 to an estimated 21% in 1997 as a result of growth in maximum hourly firm demand and the expiration of certain firm cogeneration contracts. Assuming average weather conditions, HL&P projects that reserve margins in 1998 will decrease to 18%. For long-term planning purposes, HL&P expects to maintain a reserve margin in the range of 17%-20% in excess of its estimate of maximum hourly firm demand load requirements. See "Capital Program" and "Competition" below. HL&P experiences significant seasonal variation in its sales of electricity. Sales during the summer months are typically higher than sales during other months of the year due, in large part, to the reliance on air conditioning in HL&P's service territory. See Note 20 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report for a presentation of certain quarterly unaudited financial information for 1992 and 1993. CAPITAL PROGRAM HL&P has a continuous program to maintain its existing facilities and to expand its physical plant as needed to meet customer requirements. Such program and the estimated construction costs set forth below are subject to periodic review and revision because of changes in load forecasts, the need to retire older plants, changing regulatory and environmental standards and other factors. HL&P's capital program is currently estimated to cost approximately $1.28 billion during the three-year period 1994-1996 with approximately $478 million, $381 million and $418 million to be spent in 1994, 1995 and 1996, respectively, excluding AFUDC. In 1993, total capital expenditures and nuclear fuel were approximately $329 million. HL&P's capital program for 1994-1996 consists of the following principal estimated expenditures: HL&P's near-term construction program includes the installation of two gas turbines with attendant heat recovery steam generators at the DuPont chemical plant located in the Houston area. The project, which is estimated to cost $117 million, is expected to be available for peak demand in 1995 and is designed to add approximately 160 MW of electrical capacity to HL&P's system while providing needed process steam to the DuPont chemical plant. For further information regarding the DuPont project, see "Liquidity and Capital Resources - - HL&P - Capital Program" in Item 7 of this Report. The remaining construction expenditures relating to generating facilities expected in 1994-1996 are primarily associated with improvements to existing generating stations. HL&P does not forecast additional capacity needs until 1999-2001. HL&P currently believes that future capacity needs will likely be met through the construction of combined cycle gas turbines at existing HL&P plant sites, the development of additional steam sale projects or through other means, such as purchased power or additional DSM activities. The scheduled in-service dates for the Malakoff units have been indefinitely postponed. For information with respect to expenditures on Malakoff, see Note 12 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Expenditures for environmental protection facilities for the five years ended December 31, 1993 aggregated $34.5 million (excluding AFUDC), including expenditures of $12.8 million and $7.6 million in 1993 and 1992, respectively. Environmental protection expenditures for 1994-1996 are estimated to be $71 million (excluding AFUDC), primarily for nitrogen oxide emissions controls and monitoring equipment. See "Regulatory Matters - Environmental Quality" below. Actual construction expenditures and scheduled in-service dates may vary from estimates as a result of numerous factors including, but not limited to, changes in the rate of inflation, changes in equipment delivery schedules, construction delays and deferrals, the availability and relative cost of fuel, the availability and cost of purchased power, environmental protection requirements, regulatory requirements related to the South Texas Project, the availability of adequate and timely rate relief and other regulatory approvals, ability to secure external financing, legislative changes, and changes in anticipated customer demand and business conditions. In connection with its construction program planning, HL&P employs value-based planning techniques that take into account energy conservation and load management programs along with traditional utility supply options and renewable energy resources to select the plan utilizing the most appropriate and cost-effective alternatives. In 1993, HL&P spent approximately $9.5 million, excluding AFUDC, for uranium concentrate and nuclear fuel processing services for its share of the fuel for the South Texas Project. See "Fuel - Nuclear Fuel Supply" below. Total gross additions to the plant of HL&P during the five years ended December 31, 1993 amounted to approximately $2.9 billion and, during the same period, retirements amounted to approximately $351 million. Gross additions during the five-year period amounted to approximately 25% of total utility plant at December 31, 1993. COMPETITION HL&P and the electric utility industry in general are experiencing increased competition as a result of legislative and regulatory changes, technological advances, the cost and availability of natural gas, consumer demands, environmental needs and other factors. A number of cogeneration facilities have been built in HL&P's service area as a result of the high concentration of process industries located in the Gulf Coast region and the availability of attractively priced fuels. Cogeneration is the simultaneous generation of two forms of energy, usually steam and electricity. The Public Utility Regulatory Policy Act of 1978 generally requires utilities to purchase all electricity offered to them by qualifying cogeneration facilities at or below avoided costs. In Texas, however, cogenerators generally are not permitted to make sales of electricity to parties other than electric utilities or the thermal purchaser. HL&P has experienced the loss of a number of industrial customers and continues to be faced with further customer losses as a result of cogeneration. As of December 31, 1993, HL&P purchased energy from fourteen cogeneration facilities, representing over 3,400 MW of total generating capability. As of December 31, 1993, HL&P had contracts totaling 720 MW of firm cogeneration capacity and associated energy which expire as follows: 1994 - 325 MW; 1998 - 125 MW and 2005 - 270 MW. In addition, a ten-year contract for 50 MW of firm capacity and associated energy becomes effective in 1994. Electric utilities in Texas are required to provide transmission wheeling service for power sales by cogenerators to other electric utilities at a compensatory rate. During 1993, approximately 1,400 MW of cogenerated power was transmitted or "wheeled" by HL&P to other utilities in Texas. Given the uncertainties associated with efforts to obtain additional commitments for firm power on reasonable terms, HL&P is continuing to pursue plans to meet its needs for increased generation in 1999-2001, which plans include new construction. See "Capital Program" above. In October 1992, the Energy Act became law. The Energy Act contains provisions which affect the regulatory structure of the electric utility industry. First, the legislation amends the 1935 Act, exempting a class of power producers known as EWGs. Companies that are already exempt from registration under the 1935 Act, as well as companies not otherwise engaged in the electric utility business, will be permitted to own EWGs without being subject, as a result of such ownership, to the registration requirements and the geographic, ownership and other restrictions imposed by the 1935 Act on non-exempt holding companies and their subsidiaries. Companies registered under the 1935 Act are also permitted to own EWGs. Although the Energy Act instructs state regulatory commissions to consider standards applicable to wholesale power purchases by electric utilities, including purchases from EWGs, EWG generation sources, to the extent any may be located in Texas, currently would be treated as regulated public utilities under PURA. In addition, the Energy Act permits exempt and registered holding companies to acquire and maintain an interest in "foreign utility companies" that meet certain requirements for an exemption from the 1935 Act. Second, the Energy Act significantly expands the authority of the FERC to order owners of transmission lines, such as HL&P, to carry power at the request of any electric utility, federal power marketing agency or any person generating electric energy for sale or for resale over such transmission lines. The Energy Act requires transmission for third parties to wholesale customers, provided the reliability of service to the utility's local customer base is protected and the local customer base does not subsidize the third-party service. The Energy Act prohibits the FERC from ordering the transmission of electric energy directly to an ultimate consumer (i.e. retail wheeling); however, it does not affect any authority of any state or local government under state law concerning transmission of electric energy directly to an ultimate consumer. The Energy Act is expected to have significant implications for the utility industry by moving utilities toward a more competitive environment. Competition may be increased in connection with the generation of electricity. Pressure for access to utility retail customers is also expected to increase. The Company will actively oppose any access to its retail customers by third-party generators. In addition, the amendments to the 1935 Act will remove barriers to the Company, allowing it to develop independent electric generating plants in the United States for sales to wholesale customers as well as to contract for utility projects internationally, without becoming subject to registration under the 1935 Act as an electric utility holding company. HL&P continues to address the issue of increased competition, among other things, by focusing on the energy needs of its customers and by controlling and, where possible, reducing the cost to serve its customers. HL&P undertook a major operating performance improvement program in 1992 to improve the effectiveness and efficiency of its operations and continues to seek ways to improve its operations and lower costs. HL&P is attempting to control its fuel costs, which compose a substantial portion of its operating cost, by (1) purchasing gas at generally low prices and utilizing gas storage facilities to mitigate significant variations in gas demand, (2) purchasing spot coal at prices below existing contract terms and (3) contracting for additional purchased power when available on attractive terms. For information on HL&P's operating performance improvement programs, see "Results of Operations - HL&P - STEP Program" in Item 7 of this Report and Note 18 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Additionally, HL&P continues to encourage industrial expansion in its service area by offering an economic development tariff and economically attractive interruptible rates for those customers capable of taking such service. FUEL Approximately 42% of HL&P's energy requirements during 1993 were met with natural gas, 40% with coal and lignite and 1% with nuclear fuel. The remaining 17% was purchased power, principally cogenerated power. However, both nuclear-fueled units of the South Texas Project were out of service during most of 1993. During 1992, the most recent year not affected by the outage of the South Texas Project, HL&P's energy requirements were obtained from the following sources: natural gas (34%); coal and lignite (39%); nuclear fuel (9%) and purchased power (18%). Based upon various assumptions relating to the cost and availability of fuels, plant operation schedules, actual in-service dates of HL&P's planned generating facilities, load growth, load management and environmental protection requirements, HL&P currently expects its future energy mix to be in the following proportions for the indicated periods: There can be no assurance that the various assumptions upon which the estimates set forth in the table above are based will prove to be correct, and HL&P's actual energy mix in future years may vary from the percentages shown in the table. For information on the outage of the South Texas Project, see Note 9(f) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which is incorporated herein by reference. NATURAL GAS SUPPLY. During 1993, HL&P purchased approximately 63% of its natural gas requirements pursuant to long-term contracts with various suppliers. No individual supplier provided more than approximately 24% of HL&P's natural gas requirements during 1993. Substantially all of HL&P's natural gas supply contracts contain pricing provisions based on fluctuating market prices. HL&P's natural gas supply contracts have expiration dates ranging from 1994 to 2002. HL&P believes that it will be able to renew such contracts as they expire or enter into similar contractual arrangements with other natural gas suppliers. HL&P expects to purchase its remaining natural gas requirements on the spot market. HL&P has a long-term contract for gas storage and gas transportation arrangements with gas pipelines connected to certain of its generating facilities. The contract for gas storage provides working storage capacity of up to 3,500 BBtu of natural gas. HL&P's average daily gas consumption during 1993 was 749 BBtu per day with peak consumption of 1,427 BBtu per day. Although natural gas has been relatively plentiful in recent years, supplies available to HL&P and other consumers are vulnerable to disruption due to weather conditions, transportation disruptions, price changes and other events. Large boiler fuel users of natural gas, including electric utilities, generally have the lowest priority among gas users in the event pipeline suppliers are forced to curtail deliveries due to inadequate supplies. As a result of this vulnerability, supplies of natural gas may become unavailable from time to time, or prices may increase rapidly in response to temporary supply disruptions or other factors. Such events could require HL&P to withdraw gas from its gas storage facility or shift its gas-fired generation to alternative fuel sources such as fuel oil to the extent it has the capability to burn those alternative fuels. Since most of the purchased power capacity available to HL&P is also gas-fired, gas supply disruptions may also affect these suppliers. Currently, HL&P anticipates that its alternate fuel capability, combined with its solid-fueled generating resources and available gas storage capability is adequate to meet fuel needs during any temporary gas supply interruptions. However, there is no assurance that adequate levels of gas supply will be available over the long term. HL&P's average cost of natural gas was $2.15 per MMBtu in 1993 (excluding storage costs). HL&P's average cost of natural gas in 1992 and 1991 was $1.85 and $1.54 per MMBtu, respectively. COAL AND LIGNITE SUPPLY. Substantially all of the coal for HL&P's four coal-fired units at W. A. Parish is purchased under two long- term contracts from mines in the Powder River Basin area of Wyoming. Additional coal is obtained on the spot market. The coal is transported under terms of a long-term rail transportation contract to the W. A. Parish coal handling facilities in HL&P's fleet of approximately 2,300 railcars. A substantial portion of the coal requirements for the projected operating lives of the four coal-fired units at W. A. Parish is expected to be met under such contracts. The lignite for the Limestone units is obtained from a mine adjacent to the plant. HL&P owns the mining equipment, facilities and a portion of the lignite leases at the mine, which is operated by a contract miner under the terms of a long-term agreement. The lignite reserves currently under lease and contract are expected to provide a substantial portion of the fuel requirement for the projected operating lives of the Limestone units. Prior to October 1993, coal and lignite purchasing, transportation and handling services were provided to HL&P by a subsidiary of the Company, Utility Fuels, which has since been merged into HL&P. See "Businesses of Other Subsidiaries - Utility Fuels." NUCLEAR FUEL SUPPLY. The supply of fuel for nuclear generating facilities involves the acquisition of uranium concentrates, conversion to uranium hexafluoride, enrichment of the uranium hexafluoride and fabrication of nuclear fuel assemblies. Contracts have been entered into with various suppliers to provide the South Texas Project with converted uranium hexafluoride to permit operation through 1996, enrichment services through 2014 (except as noted below) and fuel fabrication services for the initial cores and 16 additional years of operation. Contracts for enrichment services from October 2000 through September 2002 have been terminated by HL&P, as Project Manager for the South Texas Project, under a ten-year termination notice provision, because HL&P believes that other, lower-cost options will be available. In addition to the above, flexible contracts for the supply of uranium concentrates and uranium hexafluoride have been entered into that will provide approximately 50% of the uranium needed for South Texas Project operation from 1997 through 2000. Contracts for the balance of the uranium requirements will soon be under negotiation; however, HL&P does not presently anticipate difficulty in obtaining contracts for those requirements. By contract, the DOE will ultimately take possession of all spent fuel generated by the South Texas Project. HL&P has been advised that the DOE plans to place the spent fuel in a permanent underground storage facility in an as-yet undetermined location. The DOE contract currently requires payment of a spent fuel disposal fee on nuclear plant generated electricity of one mill (one-tenth of a cent) per net KWH sold. This fee is subject to adjustment to ensure full cost recovery by the DOE. The South Texas Project is designed to have sufficient on-site storage facilities to accommodate over 40 years of the spent fuel discharges for each unit. For information relating to a fee assessment upon domestic utilities having purchased enrichment services from the DOE, see Note 8(a) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. OIL SUPPLY. Fuel oil is maintained in inventory by HL&P to provide for fuel needs in emergency situations in the event sufficient supplies of natural gas are not available. In addition, certain of HL&P's generating plants have the ability to use fuel oil if oil becomes a more economical fuel than incremental gas supplies. HL&P has storage facilities for over six million barrels of oil located at those generating plants capable of burning oil. HL&P's oil inventory is adjusted periodically to accommodate changes in the availability of primary fuel supplies. RECOVERY OF FUEL COSTS. For information relating to the cost of fuel over the last three years, see "Operating Statistics of HL&P" below and "Results of Operations - HL&P - Fuel and Purchased Power Expense" in Item 7 of this Report. Utility Commission rules provide for the recovery of certain fuel and purchased power costs through an energy component of electric rates (fixed fuel factor). The fixed fuel factor is established during either a utility's general rate proceeding or an interim fuel proceeding and is to be generally effective for a minimum of six months, unless a substantial change in a utility's cost of fuel occurs. In that event, a utility may be authorized to revise the fixed fuel factor in its rates appropriately. In any event, a fuel reconciliation is required every three years. In October 1991, the Utility Commission approved HL&P's fixed fuel factor as contemplated in the settlement agreement reached in February 1991 by HL&P and most other parties to Docket No. 9850. See Note 10(c) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. In November 1993, the Utility Commission authorized HL&P to implement a higher fuel factor under Docket No. 12370. The Company can request a revision to its fuel factor in April and October each year. Reconciliation of fuel costs after March 1990 is required in 1994, and under Utility Commission rules, HL&P has anticipated that a filing would be required in May 1994. However, the Utility Commission staff has requested that such filing be delayed to the fourth quarter of 1994. If that request is granted by the Utility Commission, HL&P anticipates that fuel costs through some time in 1994 will be submitted for reconciliation at that time. No hearing would be anticipated in that reconciliation proceeding before 1995, and the schedule for reconciliation of those costs could be affected by the institution of a rate proceeding by the Utility Commission and/or a prudence inquiry concerning the outage at the South Texas Project. For a discussion of that outage and the possibility that a rate proceeding may be instituted, see Notes 9(f), 10(f) and 10(g), respectively, to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. REGULATORY MATTERS ENERGY ACT. In October 1992, the Energy Act became law. For a description of the Energy Act, see "Competition" above and Note 8(a) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. RATES AND SERVICES. Pursuant to the PURA, the Utility Commission has original jurisdiction over electric rates and services in unincorporated areas of the State of Texas and in the incorporated municipalities that have relinquished original jurisdiction. Original jurisdiction over electric rates and services in the remaining incorporated municipalities served by HL&P is exercised by such municipalities, including Houston, but the Utility Commission has appellate jurisdiction over electric rates and services within those incorporated municipalities. In 1993, the Texas Legislature considered changes to PURA as part of a required review under the Sunset Act. None of the proposed changes to the Utility Commission or Texas utility regulation were enacted. However, the legislature passed legislation continuing the current PURA until September 1, 1995. The legislature also established a joint interim committee to study certain regulatory issues prior to the next legislative session which begins in January 1995. These issues include, among other items, tax issues relating to public utilities, the organization and authority of the Utility Commission and IRP. Recommendations from this study period will be considered during the next legislative session. UTILITY COMMISSION PROCEEDINGS. For information concerning the Utility Commission's orders with respect to HL&P's applications for general rate increases with the Utility Commission (Docket No. 8425 for the 1988 rate case and Docket No. 9850 for the 1990 rate case) and the municipalities within HL&P's service area and the appeals of such orders, see Notes 10(b) and 10(c) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. HL&P's 1986 general rate case (Docket Nos. 6765 and 6766) and 1984 rate case (Docket No. 5779) have been affirmed and are no longer subject to appellate review. For a discussion of the possibility that a rate proceeding may be instituted, see Notes 10(f) and 10(g) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. PRUDENCE REVIEW OF CONSTRUCTION OF THE SOUTH TEXAS PROJECT. For information concerning the Utility Commission's orders with respect to a prudence review of the planning, management and construction of the South Texas Project (Docket No. 6668) and the appeals of such orders, see Note 10(d) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which note is incorporated herein by reference. DEFERRED ACCOUNTING DOCKETS. For information concerning the Utility Commission's orders allowing deferred accounting treatment for certain costs associated with the South Texas Project (Docket Nos. 8230, 9010 and 8425), the appeals of such orders and related proceedings, see Notes 10(b), 10(e) and 11 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. ENVIRONMENTAL QUALITY. General. HL&P is subject to regulation with respect to air and water quality, solid waste management and other environmental matters by various federal, state and local authorities. Environmental regulations continue to be affected by legislation, administrative actions and judicial review and interpretation. As a result, the precise effect of potential regulations upon existing and proposed facilities and operations cannot presently be determined. However, developments in these and other areas of regulation have required HL&P to make substantial expenditures to modify, supplement or replace equipment and facilities and may, in the future, delay or impede construction and operation of new facilities or require expenditures to modify existing facilities. For information regarding environmental expenditures, see "Capital Program" above. Air. The TNRCC has jurisdiction and enforcement power to determine the permissible level of air contaminants emitted in the State of Texas. The standards established by the Texas Clean Air Act and the rules of the TNRCC are subject to modification by standards promulgated by the EPA. Compliance with such standards has resulted, and is expected to continue to result, in substantial expenditures by HL&P. In addition, expanded permit and fee systems and enforcement penalties may discourage industrial growth within HL&P's service area. In November 1990, significant amendments to the Clean Air Act became law. The law is designed to control emissions of air pollutants which contribute to acid rain, to reduce urban air pollution and to reduce emissions of toxic air pollutants. Parts of the Clean Air Act are directed at reducing emissions of sulfur dioxide from electric utility generating units. This reduction program includes an "allowance" system which sets forth formulas and criteria to establish a cap on sulfur dioxide emissions from utility generating units. HL&P has been allocated allowances sufficient to permit continued operation of its existing facilities and some expansion of its solid-fuel generating facilities without substantial additional expense relating to modification of its facilities. HL&P has already made substantial investments in pollution control facilities, and all of its generating facilities currently comply in all material respects with sulfur dioxide emission standards established by the Clean Air Act. As a result of this previous investment, HL&P does not anticipate that significant expenditures for sulfur dioxide removal equipment will be required. Provisions of the Clean Air Act dealing with urban air pollution require establishing new emission limitations for nitrogen oxides from existing sources. Although initial limitations were finalized in 1993, further reductions may be required in the future. The cost of modifications necessary to reduce nitrogen oxide emissions from existing sources has been estimated at $29 million in 1994 and $10.5 million in 1995. The Clean Air Act also calls for additional stack gas continuous emissions monitoring equipment to be installed on various HL&P generating facilities. Capital expenditures of $12 million in 1994 and $2 million in 1995 are anticipated for installation of this new monitoring equipment. See "Capital Program" above. The Clean Air Act established a new permitting program to be administered in Texas by the TNRCC. The precise requirements of the program cannot be determined until the permit program is approved by the EPA. However, based on regulations promulgated by the TNRCC, HL&P anticipates that additional expenditures may be required for administering the permitting process. The legislation could also substantially increase the cost of constructing new generating units. Water. The TNRCC has jurisdiction over water discharges in the State of Texas and is empowered to set water quality standards and issue permits regulating water quality. The TNRCC jurisdiction is currently shared with the EPA, which also issues water discharge permits and reviews the Texas water quality standards program. HL&P has obtained permits from both the TNRCC and the EPA for all facilities currently in operation which require such permits. Applications for renewal of permits for existing facilities have been submitted as required. The reissued permits reflect changes in federal and state regulations which may increase the cost of maintaining compliance. Although compliance with the new regulations has resulted and will continue to result in additional costs to HL&P, the costs are not expected to have a material impact on HL&P's financial condition or results of operations. For a description of certain Administrative Orders issued by the EPA to HL&P under the Clean Water Act and for a description of certain other environmental litigation, see Item 3 of this Report. SOLID AND HAZARDOUS WASTE. HL&P is also subject to regulation by the TNRCC and the EPA with respect to the handling and disposal of solid waste generated on-site. Although legislation that would expand the scope of the RCRA was not adopted in 1993, the TNRCC has promulgated new rules regulating the classification of industrial solid waste. These regulations will result in increased analytical and disposal costs to HL&P. Although the precise amount of these costs is unknown at this time, HL&P does not believe, based on its current analysis, that such costs will be material. The EPA has promulgated a number of regulations to protect human health and the environment from hazardous waste. Compliance with the regulations promulgated to date has not materially affected the operation of HL&P's facilities, but such compliance has increased operating costs. The EPA has identified HL&P as a "potentially responsible party" for the costs of remediation of a CERCLA site located adjacent to one of HL&P's transmission lines in Harris County. For information regarding this site, see "Liquidity and Capital Resources - HL&P - Environmental Expenditures" in Item 7 of this Report. FEDERAL REGULATION OF NUCLEAR POWER. Under the Atomic Energy Act of 1954 and the Energy Reorganization Act of 1974, operation of nuclear plants is extensively regulated by the NRC, which has broad power to impose licensing and safety requirements. In the event of non-compliance, the NRC has the authority to impose fines or shut down nuclear plants, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. For information concerning a diagnostic evaluation that was completed by the NRC at the South Texas Project, the placement of the South Texas Project on the NRC's watch list and related matters, see "Results of Operations - HL&P - - United States Nuclear Regulatory Commission (NRC) Diagnostic Evaluation of the South Texas Project" in Item 7 of this Report and Note 9(f) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which note is incorporated herein by reference. LOW-LEVEL RADIOACTIVE WASTE. The federal Low-Level Radioactive Waste Policy Act assigns responsibility for low-level waste disposal to the states. Texas created the Texas Low-Level Radioactive Waste Disposal Authority to build and operate a low-level waste disposal facility. HL&P was assessed approximately $5.9 million in 1993 by the State of Texas for the development work on this facility and estimates that the assessment for 1994 and 1995 will be $2.2 million and $4.2 million, respectively. Texas currently has access to the low-level waste disposal facility at Barnwell, South Carolina through June 1994. Extended access beyond June will depend upon action by the governor and state legislature of South Carolina. HL&P has constructed a temporary low-level radioactive waste storage facility at the South Texas Project. The facility was completed in late 1992 and will be utilized for interim storage of low-level radioactive waste after access to the Barnwell facility is suspended and prior to the opening of the Texas Low-Level Radioactive Waste Site. NUCLEAR INSURANCE AND NUCLEAR DECOMMISSIONING For information concerning nuclear insurance and nuclear decommissioning, see Notes 9(d) and 9(e) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. LABOR MATTERS As of December 31, 1993, HL&P had 9,578 full-time employees of whom 3,715 were hourly-paid employees represented by the International Brotherhood of Electrical Workers under a collective bargaining agreement which expires on May 25, 1995. For a discussion of HL&P's STEP program and related employee matters, see "Results of Operations - HL&P - STEP Program" in Item 7 of this Report and Note 18 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. OPERATING STATISTICS OF HL&P (1) Both generating units of the South Texas Project were out of service from February 1993 to February 1994 when Unit No. 1 was authorized by the NRC to return to service. See "Results of Operations-HL&P-Fuel and Purchased Power Expense" in Item 7 of this Report. BUSINESS OF KBLCOM. GENERAL The cable television operations of the Company are conducted through KBLCOM and its subsidiaries. KBL Cable, a subsidiary of KBLCOM, owns and operates five cable television systems located in four states. Another subsidiary of KBLCOM owns a 50% interest in Paragon, a Colorado partnership, which in turn owns twenty systems located in seven states. KBLCOM's 50% interest in Paragon is recorded in the financial statements using the equity method of accounting. The remaining 50% interest in Paragon is owned by subsidiaries of ATC, which is a subsidiary of Time Warner Inc. ATC serves as the general manager for all but one of the Paragon systems. The partnership agreement provides that, at any time after December 31, 1993, either partner may elect to divide the assets of the partnership under certain predefined procedures set forth in the agreement. To date, neither party has initiated such procedures. As of December 31, 1993, KBL Cable served approximately 605,000 basic cable customers who subscribed to approximately 488,000 premium programming units. As of the same date, Paragon served approximately 932,000 basic cable customers who subscribed to approximately 542,000 premium programming units. The Company has engaged an investment banking firm to assist in finding a strategic partner or investor for KBLCOM in the telecommunications industry. Unless otherwise indicated or the context otherwise requires, all references in this section to "KBLCOM" mean KBLCOM and its subsidiaries. All references to KBL Cable mean KBL Cable and its subsidiaries, and all references to Paragon mean the Paragon partnership. All information pertaining to Paragon has been provided to KBLCOM by Paragon's managing partner, ATC, unless stated otherwise. For a discussion regarding recent developments in regulations affecting the cable television industry, see "Regulation - Rate Regulation" and "Regulation - Recent Developments in Rate Regulation" below. CABLE TELEVISION SERVICES The cable television business of KBLCOM consists primarily of selling to subscribers, for a monthly fee, television programming that is distributed through a network of coaxial and fiber optic cables. KBLCOM offers its subscribers both basic services and, for an extra monthly charge, premium services. Each of the KBLCOM systems carries the programming of all three major television networks, programming from independent and public television stations and certain other local and distant (out-of-market) broadcast television stations. KBLCOM also offers to its subscribers locally produced or originated video programming, advertiser-supported cable programming (such as ESPN and CNN), premium programming (such as HBO and Showtime) and a variety of other types of programming services such as sports, family and children, news, weather and home shopping programming. As is typical in the industry, KBLCOM subscribers may terminate their cable television service on notice. KBLCOM's business is generally not considered to be seasonal. All of KBL Cable's systems are "addressable," allowing individual subscribers, among other things, to electronically select pay-per-view programs. Approximately 48% of KBL Cable's customers presently have converters permitting addressability. This allows KBL Cable to offer pay-per-view services for various movies, sports events, concerts and other entertainment programming. OVERVIEW OF SYSTEMS AND DEVELOPMENT The KBL Cable systems are located in the areas of greater San Antonio and Laredo, Texas; Minneapolis, Minnesota; Portland, Oregon and Orange County, California. All of these systems other than the Laredo system, which is the smallest system, were built between 1979 and 1986 and have channel capacities ranging from 46 channels (San Antonio and California) to 132 channels (Minneapolis). The Laredo system was originally wired for cable in the 1960s and upgraded in 1979. It has a 42-channel capacity. Although all of these systems are considered fully built, annual capital expenditures will be required to accommodate growth within the service areas and to replace and upgrade existing equipment. Capital expenditures, which were approximately $54 million in 1993, are expected to be approximately $276 million over the 1994-1996 period. KBL Cable has projected an increase in its capital expenditures over the next three years in order to stay competitive in the increasingly complex cable environment. KBL Cable anticipates increased investments in rebuilds, fiber plant and addressable converter boxes. For additional information with respect to capital expenditures, see "Liquidity and Capital Resources - KBLCOM" in Item 7 of this Report and Note 8(b) to the Company's Consolidated Financial Statements in Item 8 of this Report. Paragon owns cable television systems that serve a number of cities, towns or other areas in Texas (including El Paso), Arizona, Florida (including the Tampa Bay area), New Hampshire, New York (including a portion of Manhattan), Maine and southern California (areas in Los Angeles County). Paragon made capital expenditures of approximately $54 million in 1993 and expects to make capital expenditures of approximately $200.8 million during the 1994-1996 period. For information regarding KBLCOM's financial results and liquidity and the financing of KBLCOM, see "Results of Operations - KBLCOM" in Item 7 of this Report and Note 4 to the Company's Consolidated Financial Statements in Item 8 of this Report. The following table summarizes certain information relating to the cable television systems owned by KBL Cable and Paragon: 1) A KBLCOM subsidiary has a 50% interest in Paragon. Information has been furnished by ATC, the general manager of Paragon. 2) A home is "passed by cable" if it can be connected to cable service without extension of the distribution system. 3) Basic subscribers means the sum of (i) the number of homes receiving cable services, (ii) all units in multiple dwellings which receive one bill and (iii) each commercial establishment (hotels, hospitals, etc.) less (iv) complimentary accounts. 4) Premium (or pay) units consist of the number of subscriptions to premium programming services counting, as separate subscriptions, each service received by a subscriber. Over the three-year period ended December 31, 1993, growth in the number of subscribers in the KBLCOM systems was achieved through marketing efforts aimed at existing homes passed by cable, population growth in the franchise areas and increased access to potential subscribers through the construction of additional distribution facilities within existing franchise areas. KBLCOM believes these same factors will contribute to continued growth. In addition, KBLCOM may, from time to time, acquire additional cable television systems. In 1993, KBL Cable acquired a small cable television system (comprising approximately 1,150 basic subscribers) which adjoined one of the existing systems. KBLCOM is also actively marketing premium programming services and intends to introduce new services as they become commercially feasible. On February 17, 1994, KBLCOM entered into an agreement to acquire three cable companies serving approximately 47,000 customers in the Minneapolis area. KBLCOM will acquire the stock of the companies in exchange for the issuance of common stock of the Company. The amount of common stock of the Company to be issued, currently estimated to be approximately $24 million, is dependent on the amount of liabilities assumed, currently estimated to be approximately $63 million. Approximately 40,000 of the cable customers served by the properties to be acquired are in the Minneapolis metropolitan area. The remaining 7,000 customers are located in small communities south and west of the metropolitan area. Closing of the transaction is subject to the satisfaction of certain conditions. SOURCES OF REVENUES AND RATES TO SUBSCRIBERS For the year ended December 31, 1993, the average monthly revenue per subscriber for KBL Cable was approximately $34.43. Approximately 67% of KBL Cable's revenue was derived from monthly fees paid by subscribers for basic cable services, and 16% was derived from premium programming services. Rates to subscribers vary from system to system and in accordance with the type of service selected. As of December 31, 1993, the average monthly basic revenue per subscriber for the KBL Cable systems generally ranged from $18.36 to $23.00. As of December 31, 1993, approximately 39% of KBL Cable's customers subscribed to one or more premium channels. KBL Cable's premium units increased during 1993 and 1992; however, the premium revenue has declined during this period due to the reduction of rates. The rates have been reduced for a variety of reasons including the effect of recessionary economic conditions, value perception and competition from other forms of entertainment such as pay-per-view and home video rental. KBL Cable implemented a number of strategies designed to strengthen this service category including new packaging of premium units and multiplexing, which is the delivery of multiple channels of a premium service (with programs beginning at different times) with no change in price to the subscriber. The fourth quarter of 1993 showed results from these efforts as the premium revenues increased over the corresponding period in the prior year. The remainder of KBL Cable's revenues for the year ended December 31, 1993 was derived from advertising, pay-per-view services, installation fees and other ancillary services. KBL Cable's management believes, within its present markets, the sale of commercial advertising to local, regional and national advertisers, pay-per-view services and other ancillary services offer the potential for increased revenues. Advertising revenues for the year ended December 31, 1993 increased $1.4 million or 10% over the previous year while pay-per-view and the other ancillary revenues increased by $2.0 million or 8%. For the year ended December 31, 1993, the average monthly revenue per subscriber for the Paragon systems was approximately $30.99. Approximately 68% of Paragon's revenues was derived from monthly fees for basic services, and 19% was derived from premium services. As of December 31, 1993, the average monthly basic revenue per subscriber for the Paragon systems ranged from $18.13 to $24.10. As of December 31, 1993, approximately 31% of Paragon's customers subscribed to one or more premium channels. FRANCHISES KBLCOM's cable television systems generally operate pursuant to non-exclusive franchises or permits awarded by local governmental authorities, and accordingly, other applicants may obtain franchises or permits in franchise areas served by KBLCOM. See "Regulation" below. As of December 31, 1993, KBL Cable held 56 franchises with unexpired terms ranging from under one year to approximately 18 years. A single franchise agreement with San Antonio, which expires in 2003, covered approximately 32% of KBL Cable's subscribers as of December 31, 1993. The expiration periods and approximate percentages of subscribers for KBL Cable's franchises are as follows: As of December 31, 1993, Paragon held 147 franchises with unexpired terms ranging from 1994 to 2010. The single largest franchise, which covers a portion of Manhattan, included more than 20% of Paragon's subscribers as of December 31, 1993. This franchise expires in 2003. The provisions of state and local franchises are subject to Federal regulation under the Cable Act. See "Regulation" below. Cable television franchises generally can be terminated prior to their stated expiration date under certain circumstances such as a material breach of the franchise by the cable operator. Franchises typically contain a number of provisions dealing with, among other things, minimum technical specifications for the systems; operational requirements; total channel capacity; local governmental, community and educational access; franchise fees (which range up to 5% of cable system revenues) and procedures for renewal of the franchise. Sometimes conditions of franchise renewal require improved facilities, increased channel capacity or enhanced services. One franchise, with approximately 58,000 subscribers as of December 31, 1993, held by a subsidiary of KBL Cable, provides that the city granting the franchise may, at any time, require the KBL Cable subsidiary to sell, at fair market value, its franchise and operations in the city to another cable television operator with a franchise for another portion of the city. KBLCOM's franchises are also subject to renewal and generally are not transferable without the prior approval of the franchising authority. In addition, some franchises provide for the purchase of the franchise under certain circumstances, such as a failure to renew the franchise. To date, KBLCOM's franchises have generally been renewed or extended upon their stated expirations, but there can be no assurance of renewal of franchises in the future. PROGRAMMING CONTRACTS A substantial portion of KBLCOM's programming is obtained under contracts with terms that typically extend for more than one year. KBLCOM generally pays program suppliers a monthly fee per subscriber. Certain of these contracts have price escalation provisions. COMPETITION Cable television systems experience competition from a variety of sources, including broadcast television signals, multipoint microwave distribution systems, direct broadcast satellite systems (satellite signals directly to a subscriber's satellite dish) and satellite master antenna systems (a satellite dish which receives signals and distributes them within a multiple dwelling unit). The effectiveness of such competition depends, in part, upon the quality of the signals and the variety of the programming offered over such competitive technologies and the cost thereof as compared with cable television systems. These competitive technologies are not generally subject to the same form of local regulation that affects cable television. Cable television systems also compete, to varying degrees, with other communications and entertainment media such as motion picture theaters and video cassette rental stores, and such competition may increase with the development and growth of new technologies. It is expected that, in April 1994, two national direct broadcast satellite (DBS) systems will commence operation. These national DBS providers will compete in all KBLCOM franchise areas and it is expected that they will constitute significant new competition to such KBLCOM systems. As a result of the programming access requirements contained in the 1992 Cable Act, these two national DBS providers will have access to virtually all cable television programming services. Additionally, within the next two years, there may be significant development in the provision of "Video Dialtone" programming over telephone company facilities. This new source of competition will result from telephone companies leasing video capacity to independent programmers in KBLCOM service areas. Finally, both federal legislation and FCC proceedings are currently underway which may allow telephone companies to own and distribute their own programming over their own facilities in direct competition with cable systems. Specifically, US West has indicated, in an FCC filing, that it intends to upgrade facilities in at least one KBLCOM service area in order to provide either Video Dialtone service or to own and distribute its own video programming services. KBLCOM is addressing increased competition by focusing on (i) improving customer service; (ii) carrying a greater variety of local and national programming, some of which will be available in its markets only through KBLCOM and (iii) furthering the development of the interactive use of its cable systems. Since KBLCOM's systems operate under non-exclusive franchises, other companies may obtain permission to build cable television systems in areas where KBLCOM presently operates. A 1986 United States Supreme Court decision has raised questions regarding the constitutionality of the cable television franchising process. The decision requires lower courts to decide whether, in areas where more than one cable operator can be physically accommodated by local utilities, franchising authorities may refuse to grant more than one franchise to serve that area. No prediction can be made at this time as to whether additional franchises will be granted to any competitors, or if granted and a cable television system is constructed, what the impact on KBLCOM and the Company might be. KBLCOM competes with a variety of other media in the sale of advertising time on its cable television systems. REGULATION Cable television is subject to regulation at the federal, local and, in some cases, state level. In October 1992, the 1992 Cable Act became law. The 1992 Cable Act expands the scope of cable industry regulation beyond that imposed by the Cable Act. The following are new and significant areas of regulation imposed by the 1992 Cable Act as interpreted by the FCC. RATE REGULATION. Under the 1992 Cable Act, virtually all of the Company's cable systems are subject to rate regulation. The 1992 Cable Act mandates that the FCC establish rate standards and procedures governing regulation of basic cable service rates. Franchising authorities may certify to the FCC that they will follow the FCC standards and procedures in regulating basic rates, and once such certification is made, the franchising authorities will assume such rate regulation authority over basic rates. The 1992 Cable Act also requires that the FCC, upon complaint from a franchising authority or a cable subscriber, review the reasonableness of rates for additional tiers of cable service. Only rates for premium pay channels, single-event, pay-per-view services and a la carte (pay-per-channel) services are excluded entirely from rate regulation. Pursuant to the congressional directive in the 1992 Cable Act, the FCC issued rules implementing, among other things, the provisions of the 1992 Act establishing rate standards and procedures governing regulation of cable television services. Prior to the release of its rate regulation rules, the FCC entered an order, effective April 5, 1993, freezing rates for all cable television services, other than premium and pay-per-view services, for 120 days (Rate Freeze Order). Under the Rate Freeze Order, the rate frozen is the average monthly subscriber rate for non-premium cable services for the most recent billing cycle ending prior to April 5, 1993. The Rate Freeze Order was subsequently extended by the FCC through May 15, 1994. On May 3, 1993, the FCC issued its rate regulation rules (Rate Rule), which became effective on September 1, 1993. The Rate Rule relies primarily on a "benchmark" approach. Current rates charged by cable operators are to be evaluated initially against "competitive benchmark" rate formulas established by the FCC based upon a nationwide cable rate survey previously conducted by the FCC. At that time, the FCC estimated that, on average, the cable industry's existing rates exceed its "benchmark" levels by approximately 10%, and that up to 75% of all cable television systems have rates which exceed applicable benchmarks. Under the Rate Rule, if a cable system's rates exceed the applicable benchmark, the cable operator can be required to reduce its rates to the higher of (i) a level 10% below the level that existed as of September 30, 1992 or (ii) the applicable benchmark. For additional information regarding rate reductions, see the discussion regarding the FCC's announcement of further changes in the Rate Rule in "Recent Developments in Rate Regulation" below. The benchmarks published in the Rate Rule vary depending on the size of cable systems, the total number of channels subject to regulation and the total number of channels which contain satellite-delivered programming. Using the benchmark tables published in the Rate Rule, the cable operator calculates a permitted monthly "per channel/per subscriber" charge. In making this calculation, the operator must include all revenues it derives from the lease of equipment to customers, such as converters, remote control devices and additional outlets, and installation services, such as installation fees, disconnect fees, reconnect fees and tier change fees, during the operator's last fiscal year. The benchmark tables apply to both basic cable services and the tier services, known in the 1992 Act as "cable programming services". Once calculated, the same monthly per channel/per subscriber rate applies to all regulated channels. In addition, once calculated and approved by the applicable regulating authority, this benchmark rate functions as a price cap. In the future, rates for regulated channels must remain at or below this benchmark rate, adjusted for inflation measured on the gross national product-price index (GNP-PI) published by the United States government. Certain limited "external" costs beyond the cable operator's control, such as franchise fees or program license fee increases which exceed the level of GNP-PI inflation, can be charged directly through to cable consumers. Under the Rate Rule, a cable operator which believes that the benchmark approach produces a rate which does not adequately cover its actual costs can choose to defend its current rates in a cost-of-service hearing before the applicable regulating authority. Election of this cost-of-service mode of rate regulation preempts the application of the benchmark approach and may result in rates for regulated channels below the indicated benchmark levels. On July 15, 1993, the FCC adopted a notice of proposed rulemaking requesting comment on the substance of, and the procedure for the cost-of-service mode of rate regulation. For additional information regarding the cost-of-service mode of rate regulation, see the discussion regarding the FCC's announcement of interim cost-of-service standards (Interim COS Standards) in "Recent Developments in Rate Regulation" below. The Rate Rule implements the requirement in the 1992 Act that local franchising authorities have the opportunity to regulate rates for basic cable service, defined as that level of service containing all local broadcast channels, all public, educational and governmental access channels and all equipment used to receive that level of service. In order for a local franchising authority to exercise regulatory authority under the Rate Rule, the local franchising authority must seek certification from the FCC. A local franchising authority must, among other things, represent in its application to the FCC that it will follow all provisions of the Rate Rule. Certification will be granted no earlier than 30 days after the date the local franchising authority's application is filed with the FCC. The 1992 Cable Act and the Rate Rule vest regulatory authority regarding regulation of cable programming services with the FCC. The FCC's regulatory authority must be triggered, if at all, by the filing of a complaint concerning a cable operator's rate for cable programming service tier(s). Both local franchising authorities and subscribers may file such rate complaints. The Rate Rule defines a new rate standard for commercial leased channels on a cable system. Under this standard, the FCC will allow the cable operator to charge a rate equal to the highest equivalent value which the operator could otherwise secure by distributing commercial programming of its own choice on that channel. The FCC order establishing the September 1, 1993 effective date for the Rate Rule preempted all local, state and federal advance notice requirements, thus permitting KBLCOM to restructure its rates and service offerings up until September 1, 1993 without prior notice to subscribers. Local franchise authorities with jurisdiction over KBLCOM's franchises covering significant numbers of cable television subscribers have given KBLCOM notice that they have obtained, or are seeking, certification from the FCC to regulate basic service level rates. RECENT DEVELOPMENTS IN RATE REGULATION. On February 22, 1994, the FCC announced further changes in the Rate Rule in several Executive Summaries. The Commission stated that it has determined that the differential between average cable system rates and rates charged by cable systems in markets with effective competition is 17%, rather than 10% as stated in the Rate Rule. Therefore, the FCC will issue revised benchmark formulas which will produce lower benchmarks, effective on May 15, 1994 (Revised Benchmarks). At that time, cable operators will be required to reduce their rates for regulated services by 17% below the level in effect in September 1992, or to the new benchmark, whichever is higher. The FCC stated that the Revised Benchmarks will require approximately 90% of all cable operators to reduce their regulated rates by about an additional 7% from their current rate levels. In announcing the Revised Benchmarks, the FCC stated that they would apply prospectively. Therefore, the existing Rate Rule governs regulated rates from September 1, 1993 until May 15, 1994, while the Revised Benchmarks will govern regulated rates effective May 15, 1994. The FCC also announced new criteria for determining whether a la carte carriage of previously regulated channels was valid under the 1992 Cable Act. Among other criteria, the FCC stated it will look to: (1) whether a la carte carriage avoids a rate reduction that would otherwise have been required under the FCC's rules; (2) whether an entire tier of regulated services has been converted to a la carte carriage; (3) whether the services involved have been traditionally offered a la carte; (4) whether there is a significant equipment charge to order a la carte services rather than a discounted package of such services; (5) whether the individual subscriber is able to select the channels which comprise the a la carte package and (6) how significantly the package of a la carte services is discounted from the per channel charges for those services. A la carte packages which are found to evade rate regulation rather than enhance subscriber choice will be treated as regulated tiers, and operators engaging in such practices may be subject to sanctions. The FCC also announced, in an Executive Summary, its Interim COS Standards. Under the Interim COS Standards which the FCC characterized as based upon principles similar to those which govern rate regulation of telephone companies, cable operators facing "unusually" high costs, may recover through their regulated rates, their normal operating expenses and a "reasonable" return on investment. The FCC provided, in the Executive Summary, that the presumptive permissible rate of return on investment under the Interim COS Standard is 11.25%. The FCC presumptively excluded acquisition costs above book value from the rate base because such "excess acquisition costs" represent the value of the monopoly rents the acquirer expected to earn during the period when an acquired cable system was effectively an unregulated monopoly. The FCC further stated that it will, under certain unspecified circumstances, allow cable operators to rebut this presumption excluding "excess acquisition costs." Under the Interim COS Standards, cable operators which opt for the cost-of-service approach may make such filings only once every two years. The FCC also announced a streamlined cost-of-service procedure under which cable systems regulated under the Revised Benchmarks will be allowed to recover a share of system upgrade costs, offset for savings in operating expenses due to efficiencies gained by the upgrade. While KBLCOM believes that the Revised Benchmarks will impose some further reduction in rates and new obligations which are burdensome and will increase KBLCOM's costs of doing business, it is impossible to assess the detailed impact of the Revised Benchmarks on KBLCOM until the FCC completes and issues the actual text of its rules on the Revised Benchmarks and the Interim COS Standards. MUST CARRY/RETRANSMISSION CONSENT. The 1992 Cable Act specified certain rights for mandatory carriage on cable systems for local broadcast stations, known as must-carry rights. As an alternative, local broadcast stations were authorized to elect retransmission consent rights. Under the must carry option, a cable operator can be compelled to allocate up to one-third of its channel capacity for carriage of local commercial broadcast television stations. In addition, a cable operator can also be required to allocate up to three additional channels to local non-commercial broadcast television stations. Such non-commercial broadcasters do not have the retransmission consent option under the 1992 Cable Act. Under the retransmission consent option, a local commercial broadcasters can require a cable operator to make payments as a condition to granting its consent for the carriage of the broadcast station's signal on the cable system. Established "super stations" are exempted from this provision. On March 29, 1993, the FCC issued its rules clarifying and implementing the must carry/retransmission consent portions of the 1992 Cable Act (Must Carry Rule). By June 17, 1993, the deadline specified by the Must Carry Rule, approximately 40% of the local broadcasters in KBL Cable's markets elected retransmission consent. According to the terms of the 1992 Cable Act and the Must Carry Rule, if the local commercial broadcast stations that had elected retransmission consent rights had not granted such consent by October 6, 1993, KBL Cable was required to remove them from carriage on the relevant cable system. To date, all local broadcast stations having elected retransmission consent rights have granted to KBL Cable their consent to carriage at no material cost to KBL Cable. Paragon has also reached retransmission consent agreements with all of the local broadcast affiliates in its service areas. A challenge to the Must Carry portion of the 1992 Cable Act is presently pending in the Supreme Court of the United States, Turner Broadcasting System, Inc., et al. v. Federal Communications Commission, et al., No. 93-44. Appellants argue that the Must Carry provisions violate their rights under the First Amendment of the United States Constitution. The Supreme Court has heard oral argument, and a decision is expected by the end of June 1994. BUY-THROUGH PROHIBITION. The 1992 Cable Act prohibits cable systems which have addressable technology and addressable converters in place from requiring cable subscribers to purchase service tiers above basic as a condition to purchasing premium channels, such as HBO or Showtime. If cable systems do not have such addressable technology or addressable converters in place, they are given up to ten years to comply with this provision. PROGRAMMING ACQUISITION. The 1992 Cable Act directs the FCC to promulgate regulations regarding the sale and acquisition of cable programming between cable operators and programming services in which the cable operator has an attributable interest. The legislation and the subsequent FCC regulations will preclude most exclusive programming contracts, will limit volume discounts that can be offered to affiliated cable operators and will generally prohibit cable programmers from providing terms and conditions to affiliated cable operators that are more favorable than those provided to unaffiliated operators. Furthermore, the 1992 Cable Act requires that such cable programmers make their programming services available to competing video technologies, such as multi-channel, microwave distribution systems and direct broadcast satellite systems on terms and conditions that do not discriminate against such competing technologies. PROGRAMMING CARRIAGE AGREEMENTS. The 1992 Cable Act requires the FCC to adopt regulations that will prohibit cable operators from (1) requiring ownership of a financial interest in a program service as a condition to carriage of such service, (2) coercing exclusive rights in a programming service or (3) favoring affiliated programmers so as to restrain unreasonably the ability of unaffiliated programmers to compete. OWNERSHIP RESTRICTIONS. The 1992 Cable Act requires the FCC to (1) prescribe rules and regulations establishing reasonable limits on the number of cable subscribers a person is authorized to reach through cable systems owned by such person, or in which such person has an attributable interest; (2) prescribe rules and regulations establishing reasonable limits on the number of channels on a cable system that can be occupied by a video programmer in which a cable operator has an attributable interest and (3) consider the necessity and appropriateness of imposing limitations on the degree to which multi-channel video programming distributors may engage in the creation or production of video programming. Additionally, cable operators are prohibited from selling a cable system within three years of acquisition or construction of such cable system. CUSTOMER SERVICE/TECHNICAL STANDARDS. The 1992 Cable Act requires the FCC to promulgate regulations establishing minimum standards for customer service and technical system performance. Franchising authorities are allowed to enforce stricter customer service requirements than the standards so promulgated by the FCC. The majority of the provisions of the Cable Act remain in place. The Cable Act continues to: (a) restrict the ownership of cable systems by prohibiting cross-ownership by a telephone company within its operating area and cross-ownership by local television broadcast station owners; (b) require cable television systems with 36 or more "activated" channels to reserve a percentage of such channels for commercial use by unaffiliated third parties; (c) permit franchise authorities to require the cable operator to provide channel capacity, equipment and facilities for public, educational and governmental access; (d) limit the amount of fees required to be paid by the cable operator to franchise authorities to a maximum of 5% of annual gross revenues; (e) grant cable operators access to public rights of way and utility easements; (f) establish a federal privacy policy regulating the use of subscriber lists and subscriber information; (g) establish civil and criminal liability for unauthorized reception or interception of programming offered over a cable television system or satellite delivered service; (h) authorize the FCC to preempt state regulation of rates, terms and conditions for pole attachments unless the state has issued effective rules; (i) require the sale or lease to subscribers of devices enabling them to block programming considered offensive and (j) contain provisions governing cable operators' compliance with equal employment opportunity requirements. The 1992 Cable Act, together with the Cable Act, creates a comprehensive regulatory framework for cable television. Violation by a cable operator of the statutory provisions or the rules and regulations of the FCC can subject the operator to substantial monetary penalties and other significant sanctions. While many of the specific obligations imposed on cable television systems under the 1992 Cable Act are complex, burdensome and will increase KBLCOM's costs of doing business, it is impossible to assess the detailed impact of the 1992 Cable Act, other than the Rate Rule and the Must Carry Rule on KBLCOM. Telephone companies continue in their efforts to repeal legislative prohibitions against their ownership of cable television systems. At this time, RBOCs are still prohibited by the Cable Act from owning or operating a cable television system within their service areas. However, in a decision rendered in The Chesapeake and Potomac Telephone Company of Virginia, et al. v. United States, et al., No. 92-1751-A, on August 24, 1993, the U. S. District Court for the Eastern District of Virginia ruled that the portion of the Cable Act prohibiting subsidiaries of Bell Atlantic from owning a cable television system within their service areas violated the First Amendment to the United States Constitution. The court, in subsequent rulings, refused to extend its ruling to other RBOCs and refused to stay its decision pending appeal. As a consequence, the Bell Atlantic subsidiaries can engage in the cable television business, including owning cable television systems, despite the Cable Act's language. A final affirmation of the court's decision could result in additional direct competition for KBLCOM. No prediction can be made at this time concerning the impact, if any, of this decision on KBLCOM and the Company. Any changes to the ownership prohibitions could result in additional direct competition for KBLCOM. FINANCIAL IMPACT ON KBLCOM. KBLCOM's responses to the Rate Rule included, among other things, restructuring of certain program offerings, a reduction in rates for services regulated according to the Rate Rule and an increase in rates for programming services previously offered in the basic service or cable programming service tier which are not subject to rate regulation and for which fees will be charged on a per-channel basis. KBLCOM estimates that revenues in 1993 from its owned and operated cable systems were reduced by approximately $6.8 million. A large portion of this decrease in revenues is derived from a reduction in revenue from additional outlets. There can be no assurance at this time, however, that the reaction of customers to these changes will continue, and variations in such matters could change the financial impact on KBLCOM. For information regarding the impact of the Cable Act regulations on KBLCOM's financial condition and results of operation, see "KBLCOM - Financial Impact on KBLCOM" in Item 7 of this Report. EMPLOYEES Excluding employees of Paragon, KBLCOM had 1,581 full-time employees as of December 31, 1993, none of whom are represented by a union. As of December 31, 1993, Paragon had 1,820 full-time employees of whom 583 were represented by unions. BUSINESSES OF OTHER SUBSIDIARIES. HI ENERGY HI Energy was recently organized by the Company to participate in domestic and foreign power generation projects and to invest in the privatization of foreign electric utilities. HI Energy is actively engaged in the evaluation of several such projects, but has not yet committed significant financial or other resources to any single project. HOUSTON ARGENTINA Houston Argentina, a subsidiary of the Company located in Buenos Aires, Argentina, acquired a 32.5% interest in Compania de Inversiones en Electricidad S.A. (COINELEC), an Argentine holding company which acquired, in December 1992, a 51% interest in Empresa Distribuidora La Plata S.A. (EDELAP), an electric utility company operating in La Plata, Argentina and surrounding areas. Houston Argentina's share of the purchase price was $37.4 million in cash. Subsequent to the acquisition, the generating assets of EDELAP were transferred to Central Dique S.A., an Argentine corporation, 51% of the stock of which is owned by COINELEC. Houston Argentina provides technical and managerial service to EDELAP and Central Dique S.A. UTILITY FUELS On October 8, 1993, Utility Fuels, the Company's coal supply subsidiary, was merged into HL&P. The Company's consolidated financial statements have been reclassified, and HL&P's financial statements have been restated to reflect the merger. See Note 1(b) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Prior to the merger, Utility Fuels provided coal and lignite purchasing, transportation and handling services to HL&P. For information with respect to HL&P's sources of coal and lignite, see "Business of HL&P - Fuel - Coal and Lignite Supply." REGULATION OF THE COMPANY. FEDERAL 1935 ACT. The Company is a holding company as defined in the 1935 Act. It is exempt from regulation under the 1935 Act except with respect to the acquisition of certain voting securities of other domestic public utility companies and holding companies. The Company's exemption is based upon the intrastate character of the operations of its public utility subsidiary, HL&P, and the filing with the SEC of an annual exemption statement pursuant to Section 3(a)(1) of the 1935 Act and Rule 2 thereunder. The SEC is authorized by the 1935 Act and by its own rules to deny or terminate such an exemption upon a determination that it is detrimental to the public interest or to the interest of investors or consumers. Based on past SEC policy, there may be limits on the extent to which the Company and its non-utility subsidiaries may engage in non-utility activity without affecting the Company's exempt status. The Company has no present intention, however, of becoming a registered holding company subject to regulation by the SEC under the 1935 Act. The Energy Act, which amended the 1935 Act, provides that, subject to certain conditions, foreign utility companies are exempt from the provisions of the 1935 Act and will not be deemed to be "public utility companies" under the 1935 Act. For information with respect to the Energy Act, see "Business of HL&P - Competition" and "Business of HL&P - Regulatory Matters" and Note 8(a) to the Company's and HL&P's Financial Statements in Item 8 of this Report. STATE The Company is not subject to regulation by the Utility Commission under PURA or by the incorporated municipalities served by HL&P. Those regulatory bodies do, however, have authority to review accounts, records and contracts relating to transactions by HL&P with the Company and its other subsidiaries. The exemption for foreign utility affiliates of the Company from regulation under the 1935 Act as "public utility companies" is dependent upon certification by the Utility Commission to the SEC to the effect that it has the authority to protect HL&P's ratepayers from any adverse consequences of the Company's investment in foreign utilities and that it intends to exercise its authority. The Utility Commission provided to the SEC such certification at the time of the Company's acquisition of an indirect interest in an Argentine utility company. The certification is subject, however, to being revised or withdrawn by the Utility Commission as to any future acquisition. EXECUTIVE OFFICERS OF THE COMPANY (1) AS OF MARCH 1, 1994 - ----------------- (1) All of the officers have been elected to serve until the annual meeting of the Board of Directors scheduled to occur on May 4, 1994 and until their successors qualify. (2) At December 31, 1993. EXECUTIVE OFFICERS OF HL&P (1)(2) AS OF MARCH 1, 1994 - ----------------- (1) All of the officers have been elected to serve until the annual meeting of the Board of Directors scheduled to occur on May 4, 1994 and until their successors qualify. (2) For the purposes of the requirements of this Report, the HL&P officers listed may also be deemed to be executive officers of the Company. (3) At December 31, 1993. ITEM 2. ITEM 2. PROPERTIES. The Company considers its property and the property of its subsidiaries to be well maintained, in good operating condition and suitable for their intended purposes. HL&P All of HL&P's electric generating stations and all of the other operating property of HL&P are located in the State of Texas. ELECTRIC GENERATING STATIONS. As of December 31, 1993, HL&P owned eleven electric generating stations (61 generating units) with a combined turbine nameplate rating of 13,425,868 KW, including a 30.8% interest in one station (two units) with a combined turbine nameplate rating of 2,623,676 KW. SUBSTATIONS. As of December 31, 1993, HL&P owned 204 major substations (with capacities of at least 10.0 Mva) having a total installed rated transformer capacity of 55,257 Mva (exclusive of spare transformers), including a 30.8% interest in one major substation with an installed rated transformer capacity of 3,080 Mva. ELECTRIC LINES-OVERHEAD. As of December 31, 1993, HL&P operated 24,084 pole miles of overhead distribution lines and 3,569 circuit miles of overhead transmission lines including 534 circuit miles operated at 69,000 volts, 2,005 circuit miles operated at 138,000 volts and 1,030 circuit miles operated at 345,000 volts. ELECTRIC LINES-UNDERGROUND. As of December 31, 1993, HL&P operated 7,840 circuit miles of underground distribution lines and 12.6 circuit miles of underground transmission lines including 8.1 circuit miles operated at 138,000 volts and 4.5 circuit miles operated at 69,000 volts. GENERAL PROPERTIES. HL&P owns various properties including division offices, service centers, telecommunications equipment and other facilities used for general purposes. TITLE. The electric generating plants and other important units of property of HL&P are situated on lands owned in fee by HL&P. Transmission lines and distribution systems have been constructed in part on or across privately owned land pursuant to easements or on streets and highways and across waterways pursuant to authority granted by municipal and county permits, and by permits issued by state and federal governmental authorities. Under the laws of the State of Texas, HL&P has the right of eminent domain pursuant to which it may secure or perfect rights-of-way over private property, if necessary. The major properties of HL&P are subject to liens securing its long-term debt, and title to some of its properties are subject to minor encumbrances and defects, none of which impairs the use of such properties in the operation of its business. KBLCOM The principal tangible assets (other than real estate) relating to KBLCOM's cable television operations consist of operating plant and equipment for each of its cable television systems. These include signal receiving apparatus, "headend" facilities, coaxial and fiber optic cable or wire and related electronic equipment over which programming and data are distributed, and decoding converters attached to subscribers' television receivers. The signal receiving apparatus typically includes a tower, antennae, ancillary electronic equipment and earth stations for reception of video, audio and data signals transmitted by satellite. Headend facilities, which consist of associated electronic equipment necessary for the reception, amplification, switching and modulation of signals, are located near the signal receiving apparatus and control the programming and data signals distributed on the cable system. For certain information with respect to property owned directly or indirectly by KBLCOM, see "Business of KBLCOM" in Item 1 of this Report. OTHER SUBSIDIARIES For certain information with respect to property owned directly or indirectly by the other subsidiaries of the Company, see "Businesses of Other Subsidiaries" in Item 1 of this Report. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. For a description of certain legal and regulatory proceedings affecting the Company and its subsidiaries, see Notes 9 through 12 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. In August 1993, HL&P entered into a Consent Agreement with the EPA that resolved three Administrative Orders issued by the EPA in 1991 and 1992 regarding alleged violations of certain provisions of the Clean Water Act at Limestone during the period 1989 through 1992. Pursuant to the Consent Agreement, HL&P, while neither admitting nor denying the allegations contained in the complaint, agreed to pay the EPA $87,500. On August 29, 1991, the EPA issued an Administrative Order related to alleged noncompliance at W. A. Parish. HL&P has taken action to address the issues cited by the EPA and believes them to be substantially resolved at this time. From time to time, HL&P sells equipment and material it no longer requires for its business. In the past, some purchasers may have improperly handled the material, principally through improper disposal of oils containing PCBs used in older transformers. Claims have been asserted against HL&P for clean-up of environmental contamination as well as for personal injury and property damages resulting from the purchasers' alleged improper activities. Although HL&P has disputed its responsibility for the actions of such purchasers, HL&P has, in some cases, participated in or contributed to the remediation of those sites. Such undertakings in the past have not required material expenditures by HL&P. In 1990, HL&P, together with other companies, participated in the clean-up of one such site. Three suits have been brought against HL&P and a number of other parties for personal injury and property damages in connection with that site and its cleanup. In two of the cases, Dumes, et al. vs. Houston Lighting & Power Company, et al., pending in the United States District Court for the Southern District of Texas, Corpus Christi Division, and Trevino, et al. vs. Houston Lighting & Power Company, et al., pending before the 117th District Court of Nueces County, Texas, landowners near the site are seeking damages primarily for lead contamination to their property. A third lawsuit, Holland vs. Central Power and Light Company, et al., involving an allegation of exposure to PCBs disposed of at the site, was dismissed pursuant to a settlement agreement entered into by the parties in July 1993. The terms of the settlement were not material. In all these cases, HL&P has disputed its responsibility for the actions of the disposal site operator and whether injuries or damages occurred. In addition, Gulf States has filed suit in the United States District Court for the Southern District of Texas, Houston Division, against HL&P and two other utilities concerning another site in Houston, Texas, which allegedly has been contaminated by PCBs and which Gulf States has undertaken to remediate pursuant to an EPA order. Gulf States seeks contribution from HL&P and the other utilities for Gulf States' remediation costs. HL&P does not currently believe that it has any responsibility for that site, and HL&P has not been determined by the EPA to be a responsible party for that site. Discovery is underway in all these pending cases and, although their ultimate outcomes cannot be predicted at this time, HL&P and the Company believe, based on information currently available, that none of these cases will result in a material adverse effect on the Company's or HL&P's financial condition or results of operations. For information with respect to the EPA's identification of HL&P as a "potentially responsible party" for remediation of a CERCLA site adjacent to one of HL&P's transmission lines in Harris County, see "Liquidity and Capital Resources - HL&P - Environmental Expenditures" in Item 7 of this Report, which information is incorporated herein by reference. HL&P and the other owners of the South Texas Project have filed suit against Westinghouse in the District Court for Matagorda County, Texas (Cause No. 90-S-0684-C), alleging breach of warranty and misrepresentation in connection with the steam generators supplied by Westinghouse for the South Texas Project. In recent years, other utilities have encountered stress corrosion cracking in steam generator tubes in Westinghouse units similar to those supplied for the South Texas Project. Failure of such tubes can result in a reduction of plant efficiency, and, in some cases, utilities have replaced their steam generators. During an inspection concluded in the fall of 1993, evidence was found of stress corrosion cracking consistent with that encountered with Westinghouse steam generators at other facilities, and a small number of tubes were found to require plugging. To date, stress corrosion cracking has not had a significant impact on operation of either unit; however, the owners of the South Texas Project have approved remedial operating plans and have undertaken expenditures to minimize and delay further corrosion. The litigation, which is in discovery, seeks appropriate damages and other relief from Westinghouse and is currently scheduled for trial in the fall of 1994. No prediction can be made as to the ultimate outcome of that litigation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock, which at February 1, 1994 was held of record by approximately 70,730 shareholders, is listed on the New York, Chicago (formerly Midwest) and London Stock Exchanges (symbol: HOU). The following table sets forth the high and low sales prices of the Common Stock on the composite tape during the periods indicated, as reported by The Wall Street Journal, and the dividends declared for such periods. Third quarter 1993 includes two quarterly dividends of $.75 per share due to a change in the timing of the Company's Board of Directors' declaration of dividends. Dividend payout was $3.00 per share for 1993. The dividend declared during the fourth quarter of 1993 is payable in March 1994. On December 31, 1993, the consolidated book value of the Company's common stock was $25.06 per share, and the closing market price was $47.63 per share. There are no contractual limitations on the payment of dividends on the common stock of the Company or on the common stock of the Company's subsidiaries other than KBL Cable. Restrictions on distributions and other financial covenants in KBL Cable credit agreements and other debt instruments affecting KBL Cable will effectively prevent the payment of common stock dividends by these subsidiaries for the foreseeable future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA OF THE COMPANY The following table sets forth selected financial data with respect to the Company's consolidated financial condition and consolidated results of operations and should be read in conjunction with the Consolidated Financial Statements and the related notes included elsewhere herein. (1) Reflects reclassification for the years 1989-1992 due to the merger of Utility Fuels into HL&P. (2) The 1990 cumulative effect reflects the effects for years prior to 1990 of the adoption of SFAS No. 109, "Accounting for Income Taxes." The 1992 cumulative effect relates to the change in accounting for revenues. See also Note 19 to the Company's Consolidated and HL&P's Financial Statements. (3) Year ended December 31, 1993 includes five quarterly dividends of $.75 per share due to a change in the timing of the Company's Board of Directors declaration of dividends. Dividend payout was $3.00 per share for 1993. (4) Amounts differ from previously reported amounts for 1991 and 1992 because of the reclassification of interest income on ESOP note. (5) Includes Cumulative Preferred Stock subject to mandatory redemption. ITEM 6. SELECTED FINANCIAL DATA OF HL&P The following table sets forth selected financial data with respect to HL&P's financial condition and results of operations and should be read in conjunction with the Financial Statements and the related notes included elsewhere herein. (1) The 1992 cumulative effect relates to the change in accounting for revenues. See also Note 19 to HL&P's Financial Statements. (2) Includes Cumulative Preferred Stock subject to mandatory redemption. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS COMPANY. Selected financial data for Houston Industries Incorporated (Company) is set forth below: Consolidated earnings per share were $3.20 for 1993 as compared to $3.36 per share in 1992 and $3.24 per share in 1991. The Company's 1992 earnings were increased by non-recurring items at Houston Lighting & Power Company (HL&P), the Company's electric utility subsidiary, as discussed below. Without these items, the Company's earnings for the year ended 1992 would have been $397.5 million or $3.07 per share. HL&P contributed $3.46 to the 1993 consolidated earnings per share on income of $449.8 million after preferred dividends. KBLCOM Incorporated (KBLCOM), the Company's cable television subsidiary, posted a loss of $13.0 million or $.10 per share. The Company and its other subsidiaries posted a combined loss of $.l6 per share. Omnibus Budget Reconciliation Act of 1993 (OBRA). As a result of the 1% general corporate income tax rate increase imposed by OBRA, the Company's 1993 results were negatively impacted by $14.3 million. For additional information regarding the effect of OBRA on the Company, see Note 14 to the Company's Consolidated and HL&P's Financial Statements in Item 8 Item 8 of this Report. THE COMPANY. Sources of Capital Resources and Liquidity. The Company has consolidated its financing activities in order to provide a coordinated, cost-effective method of meeting short and long-term capital requirements. As part of the consolidated financing program, the Company has established a "money fund" through which its subsidiaries can borrow or invest on a short-term basis. The funding requirements of individual subsidiaries are aggregated and borrowing or investing is conducted by the Company based on the net cash position. Net funding requirements are met with borrowings under the Company's commercial paper program except that HL&P's borrowing requirements are generally met with HL&P's commercial paper program. As of December 31, 1993, the Company had a bank credit facility of $500 million (exclusive of bank credit facilities of subsidiaries), which was used to support its commercial paper program. At December 31, 1993, the Company had approximately $420 million of commercial paper outstanding. Rates paid by the Company on its short-term borrowings are generally lower than the prime rate. Subsequent to December 31, 1993, the Company's bank line of credit was increased to $600 millon. The Company has registered with the Securities and Exchange Commission (SEC) $250 million principal amount of debt securities which remain unissued. Proceeds from any sales of these debt securities are expected to be used for general corporate purposes including investments in and loans to subsidiaries. The Company also has registered with the SEC five million shares of its common stock. Proceeds from the sale of these securities will be used for general corporate purposes, including, but not limited to, the redemption, repayment or retirement of outstanding indebtedness of the Company or the advance or contribution of funds to one or more of the Company's subsidiaries to be used for their general corporate purposes, including, without limitation, the redemption, repayment or retirement of indebtedness or preferred stock. Employee Stock Ownership Plan (ESOP). In October 1990, the Company amended its existing savings plan to add an ESOP component to the plan. The ESOP component of the plan allows the Company to satisfy a portion of its obligations to make matching contributions under the plan. The ESOP trustee purchased shares of the Company's common stock in open market transactions with funds provided by loans from the Company and completed the purchase of stock under the ESOP in December 1991 after purchasing 9,381,092 shares at a cost of $350 million. As the ESOP loans are repaid by the ESOP trustee over a period of up to 20 years, the common stock purchased for the plan will be allocated to the participants' accounts. The loans will be repaid with dividends on the common stock in, and Company contributions to, the plan. The loans to the plan were funded initially by the Company from short-term borrowings which have been refinanced with long-term debt. At December 31, 1993, the balance of the ESOP loans was approximately $332 million. For a further discussion, see Note 7(b) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Houston Argentina. Houston Argentina S. A. (Houston Argentina), a subsidiary of the Company, owns a 32.5% interest in Compania de Inversiones en Electricidad S. A. (COINELEC), an Argentine holding company which acquired, in December 1992, a 51% interest in Empresa Distribuidora La Plata S. A. (EDELAP), an electric utility company operating in La Plata, Argentina and surrounding regions. Houston Argentina's share of the purchase price was approximately $37.4 million, of which $1.6 million was paid in December 1992 with the remainder paid in March 1993. Subsequent to the acquisition, the generating assets of EDELAP were transferred to Central Dique S. A., an Argentine corporation, 51% of the stock of which is owned by COINELEC. HL&P. HL&P's cash requirements stem primarily from operating expenses, capital expenditures, payment of common stock dividends, payment of preferred stock dividends, and interest and principal payments on debt. HL&P's net cash provided by operating activities for 1993 totaled approximately $1.1 billion. Net cash used in HL&P's investing activities for 1993 totaled $345.9 million. HL&P's financing activities for 1993 resulted in a net cash outflow of $782.4 million. Included in these activities were the payment of dividends, the payment and extinguishment of long-term debt and redemption of preferred stock, partially offset by the issuance of long-term debt. For information with respect to these matters, see Notes 3 and 4 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Capital Program. HL&P's construction and nuclear fuel expenditures (excluding AFUDC) for 1993 totaled $329 million, which was below the authorized budgeted level of $345 million. Estimated expenditures for 1994, 1995 and 1996 are $478 million, $381 million and $418 million, respectively. Maturities of long-term debt and preferred stock with mandatory redemption provisions and capital leases for this same period include $45 million in 1994, $50 million in 1995 and $200 million in 1996. HL&P's construction program for the next three years is expected to relate to costs for production, transmission, distribution, and general plant. HL&P began construction of the E.I. du Pont de Nemours Company (DuPont) project in 1993 in order to provide generating capacity in 1995. The DuPont project is based on a contractual agreement between HL&P and DuPont, whereby HL&P will construct, own, and operate two 80 megawatt gas turbine units located at DuPont's LaPorte, Texas facility. The project will supply DuPont with process steam while all electrical energy will be used in the HL&P system. HL&P's capital program is subject to periodic review and portions may be revised from time to time due to changes in load forecasts, changing regulatory and environmental standards and other factors. Financing Activities. In January 1993, HL&P repaid at maturity $136 million aggregate principal amount of its 9 3/8% first mortgage bonds. In March 1993, HL&P issued $250 million principal amount of 7 3/4% first mortgage bonds due 2023 and $150 million principal amount of 6.10% collateralized medium-term notes due 2000. In April 1993, HL&P issued $150 million principal amount of 6.50% collateralized medium-term notes due 2003. Proceeds of the offerings were used to provide funds for the purchases and redemptions of HL&P's first mortgage bonds (including those series described below) and for general corporate purposes, including the repayment of short-term indebtedness of HL&P. In April 1993, HL&P purchased the following first mortgage bonds pursuant to tender offers for any and all bonds of such series: In April 1993, HL&P called for redemption the remaining $18,220,500 of its 8 3/4% first mortgage bonds due 2005 at 100.61% of their principal amount, the remaining $50,473,500 of its 8 3/8% first mortgage bonds due 2006 at 100.38% of their principal amount, the remaining $52,565,000 of its 8 3/8% first mortgage bonds due 2007 at 100.64% of their principal amount, the remaining $54,045,000 of its 8 1/8% first mortgage bonds due 2004 at 101.13% of their principal amount, the outstanding $50,000,000 of its 7 1/2% first mortgage bonds due 2001 at 100.85% of their principal amount and the outstanding $30,000,000 of its 7 1/2% first mortgage bonds due 1999 at 100.68% of their principal amount. Approximately $263 million deposited in the Replacement Fund in March 1993 was applied to the May 1993 redemption of these bonds. In June 1993, HL&P redeemed 400,000 shares of its $8.50 cumulative preferred stock at $100 per share pursuant to sinking fund provisions. In July 1993, HL&P issued $200 million principal amount of 7 1/2% first mortgage bonds due 2023. Proceeds were used to provide funds for the redemption of HL&P's first mortgage bonds referenced in the following paragraph and the repayment of approximately $80 million aggregate principal amount of intercompany debt owed to the Company, which was assumed by HL&P upon the merger of Utility Fuels, Inc. into HL&P. In October 1993, HL&P redeemed, at 106.57% of their principal amount, $390,519,000 aggregate principal amount of its 9% first mortgage bonds due 2017. In December 1993, the Brazos River Authority (BRA) and the Gulf Coast Waste Disposal Authority (GCWDA) issued on behalf of HL&P $100,165,000 aggregate principal amount of revenue refunding bonds collateralized by HL&P's first mortgage bonds. The BRA issuance of $83,565,000 principal amount has an interest rate of 5.6% and matures in 2017. The GCWDA issuance of $16,600,000 principal amount has an interest rate of 4.9% and matures in 2003. Proceeds were used in 1994 to redeem, at 102% of their aggregate principal amount, $83,565,000 principal amount of pollution control revenue bonds previously issued on behalf of HL&P by the BRA and, at 100% of their aggregate principal amount, $16,600,000 principal amount of pollution control revenue bonds previously issued on behalf of HL&P by the GCWDA. Sources of Capital Resources and Liquidity. HL&P expects to finance its capital program for the period 1994-1996 with funds generated internally from operations. HL&P has registered with the SEC $230 million aggregate liquidation value of preferred stock and $580 million aggregate principal amount of debt securities that may be issued as first mortgage bonds and/or as debt securities collateralized by first mortgage bonds. Proceeds from the sales of these securities are expected to be used for general corporate purposes including the purchase, redemption (to the extent permitted by the terms of the outstanding securities), repayment or retirement of outstanding indebtedness or preferred stock of HL&P. HL&P's interim financing requirements are met through the issuance of short-term debt, primarily commercial paper. At December 31, 1993, HL&P had outstanding commercial paper of approximately $171 million, which was supported by a bank credit facility of $250 million. Subsequent to December 31, 1993, HL&P's line of credit was increased to $400 millon. HL&P's capitalization at December 31, 1993 was 43% long-term debt, 7% preferred stock and 50% common equity. Environmental Expenditures. In November 1990, the Clean Air Act was extensively amended by Congress. HL&P has already made an investment in pollution control facilities, and all of its generating facilities currently comply in all material respects with sulfur dioxide emission standards established by the statute. Provisions of the Clean Air Act dealing with urban air pollution required establishing new emission limitations for nitrogen oxides from existing sources. The cost of modifications necessary to reduce nitrogen oxide emissions from existing sources has been estimated at $29 million in 1994 and $10.5 million in 1995. In addition, continuous emission monitoring regulations are anticipated to require expenditures of $12 million in 1994 and $2 million in 1995. Capital expenditures are expected to total $71 million for the years 1994 through 1996. The United States Environmental Protection Agency (EPA) has identified HL&P as a "potentially responsible party" for the costs of remediation of a Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) site located adjacent to one of HL&P's transmission lines in Harris County. Although HL&P did not contribute waste to or operate the site, the party primarily responsible for contributing waste to the site and possibly other potentially responsible parties have alleged that waste disposal pits dug by the site operator encroach onto HL&P's property and therefore HL&P is responsible as a site owner. Although HL&P admits that it owns an adjacent strip of land onto which substances from the site appear to have migrated, it denies that it ever owned the strip of land containing the pits. In June 1993, a Galveston County District Court entered a final judgment to the effect that HL&P did not own the disputed strip of land. In October 1992, the EPA issued an Administrative Order to HL&P and several other companies purporting to require those parties to implement the management of migration remediation at the site. A related Administrative Order had been issued in June 1990. Neither the EPA nor any other responsible party has presented HL&P with a claim for a share of costs for the management of the migration remediation design or operation. However, in the event HL&P were ultimately held to be a responsible party for the remediation of this site and if other responsible parties do not complete the management of migration remediation, CERCLA provides for substantial remedies that could be pursued by the United States, including substantial fines, punitive damages and treble damages for costs incurred by the United States in completing such remediation. The aggregate potential clean-up costs for the entire site have been estimated to be approximately $80 million. Although no prediction can be made at this time as to the ultimate outcome of this matter, in light of all the circumstances, the Company and HL&P do not believe that any costs that HL&P incurs in this matter will have a material adverse effect on the Company's or HL&P's financial condition or results of operations. KBLCOM. KBLCOM's cash requirements stem primarily from operating expenses, capital expenditures, and interest and principal payments on debt. KBLCOM's net cash provided by operating activities was $13.9 million in 1993. Net cash used in KBLCOM's investing activities for 1993 totaled $61.9 million, primarily due to property additions which approximated $54.5 million. These amounts were financed principally through internally generated funds and intercompany advances. A substantial portion of KBLCOM's 1994-1996 capital requirements is expected to be met through internally generated funds. It is expected that any shortfall will be met through intercompany borrowings. KBLCOM's financing activities for 1993 resulted in a net cash inflow of $47.9 million. Included in these activities were the reduction of third party debt, proceeds from additional paid-in capital and an increase in borrowings from the Company. Financing Activities. In the first quarter of 1993, KBL Cable repaid $6.4 million principal amount of its senior notes and senior subordinated notes. In the second and third quarters of 1993, KBL Cable repaid borrowings under its senior bank credit facility in the amounts of $15 million and $56 million, respectively. These repayments were partially offset by $20 million in additional borrowing under the senior bank credit facility during the first quarter of 1993. In the first quarter of 1993, KBLCOM prepaid $167.3 million of senior bank debt funded with proceeds from the Company's additional equity investment. The Company obtained the funds for such investment from the sale of commercial paper. This KBLCOM debt was included in current portion of long-term debt and preferred stock at December 31, 1992 on the Company's Consolidated Balance Sheets. Sources of Capital Resources and Liquidity. In the first quarter of 1993, KBLCOM reduced its outstanding indebtedness by approximately $153.7 million. This was accomplished through an equity investment of approximately $167.3 million from the Company (funded with proceeds from the sale of commercial paper by the Company) and offset by net additional borrowing of $13.6 million. In the second quarter of 1993, the Company made capital contributions to KBLCOM aggregating approximately $114.3 million. The capital contributions included KBL Cable senior notes aggregating approximately $29 million and KBL Cable senior subordinated notes aggregating approximately $36 million that had been previously acquired by the Company. The Company contributed such notes to KBLCOM which, in turn, contributed such notes to KBL Cable, a subsidiary of KBLCOM which retired and canceled the notes. The balance of the capital contributions resulted from the conversion to equity of intercompany debt payable by KBLCOM to the Company. The capital contributions will have no impact on the consolidated earnings of the Company. Additional borrowing under KBL Cable's bank facility is subject to certain covenants which relate primarily to the maintenance of certain financial ratios, principally debt to cash flow and interest coverages. KBL Cable presently is in compliance with such covenants. Cash requirements for 1994 are expected to be met through intercompany borrowing and contributions, internally generated funds, and borrowing under existing credit lines of KBLCOM's subsidiaries. At December 31, 1993, KBL Cable had $108.5 million available for borrowing under its bank facility. The line of credit has scheduled reductions in March of each year until it is eliminated in March 1999. Recent Developments. The Company has engaged an investment banking firm to assist in finding a strategic partner or investor for KBLCOM in the telecommunications industry. On February 17, 1994, KBLCOM entered into an agreement to acquire three cable companies serving approximately 47,000 customers in the Minneapolis area. KBLCOM will acquire the stock of the companies in exchange for the issuance of common stock of the Company. The amount of common stock of the Company to be issued, currently estimated to be approximately $24 million, is dependent on the amount of liabilities assumed, currently estimated to be approximately $63 million. Approximately 40,000 of the cable customers served by the properties to be acquired are in the Minneapolis metropolitan area. The remaining 7,000 customers are located in small communities south and west of the metropolitan area. Closing of the transaction is subject to the satisfaction of certain conditions. HOUSTON INDUSTRIES FINANCE. During 1992, Houston Industries Finance, Inc. (Houston Industries Finance) purchased accounts receivable of HL&P and of certain KBLCOM subsidiaries. In January 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to a third party. As of January 12, 1993, Houston Industries Finance ceased operations and its $300 million bank revolving credit facility and related commercial paper program were terminated. The subsidiary was merged into the Company effective June 8, 1993. NEW ACCOUNTING PRONOUNCEMENTS In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This accounting standard, effective for fiscal years beginning after December 15, 1993 requires companies to recognize the liability for benefits provided to former or inactive employees, their beneficiaries and covered dependents after employment but before retirement. Those benefits include, but are not limited to, salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including worker's compensation), job training and counseling, and continuation of benefits such as health care and life insurance. The Company will adopt SFAS No. 112 in 1994. The transition obligation of approximately $20 million will be expensed upon adoption and reported similar to the cumulative effect of a change in accounting principle. The Company estimates that benefit costs for 1994 (exclusive of the transition obligation) will be approximately $1 million over the expected pay-as-you-go amount. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED INCOME (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED INCOME (THOUSANDS OF DOLLARS) (CONTINUED) See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED RETAINED EARNINGS (THOUSANDS OF DOLLARS) See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (THOUSANDS OF DOLLARS) ASSETS See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (THOUSANDS OF DOLLARS) CAPITALIZATION AND LIABILITIES See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (CONTINUED) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (CONTINUED) See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (THOUSANDS OF DOLLARS) See Notes to Consolidated Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF INCOME (THOUSANDS OF DOLLARS) See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF RETAINED EARNINGS (THOUSANDS OF DOLLARS) See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY BALANCE SHEETS (THOUSANDS OF DOLLARS) ASSETS See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY BALANCE SHEETS (THOUSANDS OF DOLLARS) CAPITALIZATION AND LIABILITIES See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (CONTINUED) See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents (Thousands of Dollars) (continued on next page) HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents (Thousands of Dollars) (Continued) See Notes to Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) SYSTEM OF ACCOUNTS. The accounting records of Houston Lighting & Power Company (HL&P), the principal subsidiary of Houston Industries Incorporated (Company), are maintained in accordance with the Federal Energy Regulatory Commission's Uniform System of Accounts as adopted by the Public Utility Commission of Texas (Utility Commission). (B) PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Effective October 8, 1993, the Company merged Utility Fuels Inc. (Utility Fuels), the Company's coal supply subsidiary, into HL&P. Accounting for the merger did not affect consolidated earnings. All significant intercompany transactions and balances are eliminated in consolidation except sales of accounts receivable to Houston Industries Finance, Inc. (Houston Industries Finance), a former subsidiary of the Company, which were not eliminated because of the distinction for regulatory purposes between utility and non-utility operations. As of January 12, 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries and ceased operations. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to a third party. Investments in affiliates in which the Company has a 20% to 50% interest, which include the investment in Paragon Communications (Paragon), are recorded using the equity method of accounting. See Note 17. (C) ELECTRIC PLANT. Additions to electric plant, betterments to existing property and replacements of units of property are capitalized at cost. Cost includes the original cost of contracted services, direct labor and material, indirect charges for engineering supervision and similar overhead items and an Allowance for Funds Used During Construction (AFUDC). Customer advances for construction reduce additions to electric plant. HL&P computes depreciation using the straight-line method. The depreciation provision as a percentage of the depreciable cost of plant was 3.1% for 1993, and 3.2% for 1992 and 1991. (D) CABLE TELEVISION PROPERTY. KBLCOM Incorporated (KBLCOM), the Company's cable television subsidiary, records additions to property at cost which include amounts for material, labor, overhead and interest. Depreciation is computed using the straight-line method. Depreciation as a percentage of the depreciable cost of property was 11.3% for 1993, 12.1% for 1992, and 11.7% for 1991. Expenditures for maintenance and repairs are expensed as incurred. (E) CABLE TELEVISION FRANCHISES AND INTANGIBLE ASSETS. KBLCOM has recorded the acquisition cost in excess of the fair market value of the tangible assets and liabilities of RCA Cablesystems Holding Co. (Cablesystems) in cable television franchises and intangible assets acquired in 1989. Such amount is being amortized over periods ranging from 8 to 40 years on a straight-line basis. KBLCOM periodically reviews the carrying value of cable television franchises and intangible assets in relation to current and expected operating results of the business in order to assess whether there has been a permanent impairment of such amounts. (F) ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION. HL&P accrues AFUDC on construction projects and nuclear fuel payments, except for amounts included in the rate base pursuant to regulatory authorization. The accrual rates were 7.25% in 1993 and 8.75% in 1992 and 1991. (G) REVENUES. Effective January 1, 1992, HL&P changed its method of recording electricity sales from cycle billing to a full accrual method, whereby unbilled electricity sales are estimated and recorded each month in order to better match revenues with expenses. Prior to January 1, 1992, electric revenues were recognized as bills were rendered (see Note 19). The Utility Commission provides for the recovery of certain fuel and purchased power costs through an energy component of base electric rates. Cable television revenues are recognized as the services are provided to subscribers, and advertising revenues are recorded when earned. (H) INCOME TAXES. The Company follows a policy of comprehensive interperiod income tax allocation. Investment tax credits are deferred and amortized over the estimated lives of the related property. In 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," with restatement to January 1, 1990 (see Note 14). Under current tax laws, the Company may realize tax savings by deducting for tax purposes dividends on the Company's common stock that are used to pay debt service on the Employee Stock Ownership Plan (ESOP) loans (see Note 7). (I) EARNINGS PER COMMON SHARE. Earnings per common share for the Company is computed by dividing net income by the weighted average number of shares outstanding during the respective period. (J) STATEMENTS OF CONSOLIDATED CASH FLOWS. For purposes of reporting cash flows, cash equivalents are considered to be short-term, highly liquid investments readily convertible to cash. (2) COMMON STOCK In May 1993, the Company's shareholders approved an increase in the Company's authorized common stock from 200,000,000 shares to 400,000,000 shares. In 1993, the Company paid four regular quarterly dividends aggregating $3.00 per share on its common stock pursuant to dividend declarations made in 1993. In December 1993, the Company declared its regular quarterly dividend of $.75 per share to be paid in March 1994. All dividends declared in 1993 have been included in 1993 common stock dividends on the Company's Statements of Consolidated Retained Earnings and, with respect to the dividends declared in December 1993, in dividends accrued at December 31, 1993 on the Company's Consolidated Balance Sheets. In May 1989, the Company adopted, with shareholder approval, a long-term incentive compensation plan (1989 LICP Plan), which provided for the issuance of certain stock incentives (including performance-based restricted shares and stock options). A maximum of 500,000 shares of common stock may be issued under the 1989 LICP Plan, of which 300,090 shares were available for issuance as of December 31, 1993. In 1993, 73,282 shares of performance-based restricted shares were issued to plan participants. In January 1992, non-statutory stock options for 67,984 shares of the Company's stock were granted to key employees of the Company and its subsidiaries at an option price of $43.50 per share, of which 679 shares were exercised during 1993. Options for 21,430 shares from the January 1992 grant were exercisable on December 31, 1993. In January 1993, non- statutory stock options for 65,776 shares of the Company's stock were granted at an option price of $46.25 per share. Beginning one year after the grant date, the options become exercisable in one-third increments each year. The options expire ten years from the grant date. At December 31, 1993, 7,132 shares had been canceled under provisions of the plan. In May 1993, the Company adopted, with shareholder approval, a new long-term incentive compensation plan (1994 LICP Plan), providing for the issuance of certain stock incentives (including performance-based restricted shares and stock options) of the general nature provided by the 1989 LICP Plan. A maximum of 2,000,000 shares of common stock may be issued under the 1994 LICP Plan. No stock incentives were awarded under the 1994 LICP Plan during the year ended December 31, 1993. However, in January of 1994, the Company granted to certain of its key employees non-statutory stock options under the 1994 LICP Plan for 65,726 shares of common stock at an option price of $46.50 per share. Beginning one year after the grant date, the options will become exercisable in one-third increments each year. The options expire ten years from the grant date. In July 1990, the Company adopted a shareholder rights plan and declared a dividend of one right for each outstanding share of the Company's common stock. The rights, which under certain circumstances entitle their holders to purchase one one-hundredth of a share of Series A Preference Stock for an exercise price of $85, will expire on July 11, 2000. The rights will become exercisable only if a person or entity acquires 20% or more of the Company's outstanding common stock or if a person or entity commences a tender offer or exchange offer for 20% or more of the outstanding common stock. At any time after the occurrence of such events, the Company may exchange unexercised rights at an exchange ratio of one share of common stock, or equity securities of the Company of equivalent value, per right. The rights are redeemable by the Company for $.01 per right at any time prior to the date the rights become exercisable. When the rights become exercisable, each right will entitle the holder to receive, in lieu of the right to purchase Series A Preference Stock, upon the exercise of such right, a number of shares of the Company's common stock (or under certain circumstances cash, property, other equity securities or debt of the Company) having a current market price (as defined in the plan) equal to twice the exercise price of the right, except pursuant to an offer for all outstanding shares of common stock which a majority of the independent directors of the Company determines to be a price which is in the best interests of the Company and its shareholders (Permitted Offer). In the event that the Company is a party to a merger or other business combination (other than a merger that follows a Permitted Offer), rights holders will be entitled to receive, upon the exercise of a right, a number of shares of common stock of the acquiring company having a current market price (as defined in the plan) equal to twice the exercise price of the right. In October 1990, the Company amended its savings plan to add an ESOP component. The ESOP component of the plan allows the Company to satisfy a portion of its obligation to make matching contributions under the plan. For additional information with respect to the ESOP component of the plan, see Note 7(b). (3) PREFERRED STOCK OF HL&P HL&P's cumulative preferred stock may be redeemed at the following per share prices, plus any unpaid accrued dividends to the date of redemption: (a) Rates for Variable Term Preferred stock as of December 31, 1993 were as follows: (b) HL&P is required to redeem 200,000 shares of this series annually. This series is redeemable at the option of HL&P at $100 per share beginning June 1, 1994. (c) HL&P is required to redeem 257,000 shares annually beginning April 1, 1995. This series is redeemable at the option of HL&P at $100 per share beginning April 1, 1997. Annual mandatory redemptions of HL&P's preferred stock are $20 million in 1994, $45.7 million for 1995 and 1996, and $25.7 million for 1997 and 1998. (4) LONG-TERM DEBT HL&P. Sinking or improvement fund requirements of HL&P's first mortgage bonds outstanding will be approximately $37 million for each of the years 1994 through 1998. Of such requirements, approximately $34 million for each of the years 1994 through 1998 may be satisfied by certification of property additions at 100% of the requirements, and the remainder through certification of such property additions at 166 2/3% of the requirements. Sinking or improvement fund requirements for 1993 and prior years have been satisfied by certification of property additions. HL&P has agreed to expend an amount each year for replacements and improvements in respect of its depreciable mortgaged utility property equal to $1,450,000 plus 2 1/2% of net additions to such mortgaged property made after March 31, 1948 and before July 1 of the preceding year. Such requirement may be met with cash, first mortgage bonds, gross property additions or expenditures for repairs or replacements, or by taking credit for property additions at 100% of the requirements. At the option of HL&P, but only with respect to first mortgage bonds of a series subject to special redemption, deposited cash may be used to redeem first mortgage bonds of such series at the applicable special redemption price. The replacement fund requirement to be satisfied in 1994 is approximately $271 million. The amount of HL&P's first mortgage bonds is unlimited as to issuance, but limited by property, earnings, and other provisions of the Mortgage and Deed of Trust dated as of November 1, 1944, between HL&P and South Texas Commercial National Bank of Houston (Texas Commerce Bank National Association, as Successor Trustee) and the supplemental indentures thereto. Substantially all properties of HL&P are subject to liens securing HL&P's long-term debt under the mortgage. HL&P's annual maturities of long-term debt and minimum capital lease payments are approximately $25 million in 1994, $4 million in 1995, $155 million in 1996, $229 million in 1997, and $40 million in 1998. KBLCOM and Subsidiaries. As of December 31, 1993, all borrowings under KBLCOM's letter of credit and term loan facility had been repaid and such facility was utilized only in the form of letters of credit aggregating $89.3 million. In January 1994, KBLCOM terminated this facility. KBL Cable, Inc. (KBL Cable), a subsidiary of KBLCOM, is a party to a $510.3 million revolving credit and letter of credit facility agreement with annual mandatory commitment reductions (which may require principal payments). At December 31, 1993, KBL Cable had $108.5 million available on such lines of credit. The available line of credit has scheduled reductions in March of each year until it is eliminated in March 1999. Loans have generally borne interest at an interest rate of LIBOR plus an "applicable margin." The margin was .625% at December 31, 1993. The bank credit agreement also contains certain restrictions, including restrictions on dividends, sales of assets and limitations on total indebtedness. The amount of indebtedness outstanding at December 31, 1993 and 1992 was $364 million and $415 million, respectively. KBL Cable has interest rate swap agreements with four banks which, as of December 31, 1993 and 1992, effectively fixed the rates on the $200 million of debt under the KBL Cable senior bank credit facility at approximately 9% plus the applicable margin. As of December 31, 1993 and 1992, the effective interest rates on such debt were approximately 9.625% and 9.875%, respectively. Interest rate swaps aggregating $75 million terminated in October 1992. The remaining interest rate swaps terminate in 1994 and 1996. The differential to be paid or received under the interest rate swap agreements is accrued and is recognized over the life of the agreement. KBL Cable is exposed to risk of nonperformance by the other parties to the interest rate swap agreements. However, KBL Cable does not anticipate nonperformance by the parties. Commitment fees are required on the unused capacity of the KBL Cable bank credit facility. As of December 31, 1993, KBL Cable had outstanding $67.1 million of 10.95% senior notes and $83.9 million of 11.30% senior subordinated notes. Both series mature in 1999 with annual principal payments which began in 1992. The agreement under which the notes were issued contains restrictions and covenants similar to those contained in the KBL Cable senior bank facility. During the second quarter of 1993, the Company contributed to KBLCOM KBL Cable senior notes aggregating approximately $29 million and KBL Cable senior subordinated notes aggregating approximately $36 million previously held by the Company. KBLCOM subsequently contributed such notes to KBL Cable, which retired and canceled the notes. Annual Maturities of Company Long-Term Debt. Consolidated annual maturities of long-term debt and minimum capital lease payments for the Company are approximately $35 million in 1994, $20 million in 1995, $431 million in 1996, $359 million in 1997 and $181 million in 1998. (5) SHORT-TERM FINANCING The interim financing requirements of the Company's operating subsidiaries are met through short-term bank loans, the issuance of commercial paper and short-term advances from the Company. The Company and its subsidiaries had bank credit facilities aggregating $750 million at December 31, 1993 and $1.05 billion at December 31, 1992, under which borrowings are classified as short-term indebtedness. Such bank facilities limit total short-term borrowings and provide for interest at rates generally less than the prime rate. Outstanding commercial paper was $591 million at December 31, 1993 and $564 million at December 31, 1992. Commitment fees are required on the bank facilities. For a description of bank credit facilities of KBLCOM and KBL Cable, borrowings under which are classified as long-term debt or current maturities of long-term debt, see Note 4. In January 1994, the Company's bank credit facility was increased from $500 million to $600 million and HL&P's bank credit facility was increased from $250 million to $400 million. The increased facilities aggregate $1 billion. Borrowings under these facilities continue to be available at rates generally less than the prime rate. (6) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount and estimated fair value of the Company's financial instruments at December 31, 1993 and 1992 are as follows: The fair values of cash and short-term investments, short-term and other notes payable and bank debt are equivalent to the carrying amounts. The fair values of the ESOP loan, the Company's debentures, HL&P's cumulative preferred stock subject to mandatory redemption, HL&P's first mortgage bonds, pollution control revenue bonds issued on behalf of HL&P and KBL Cable senior and senior subordinated notes are estimated using rates currently available for securities with similar terms and remaining maturities. The fair value of interest rate swaps is the estimated amount that the swap counterparties would receive or pay to terminate the swap agreements, taking into account current interest rates and the current creditworthiness of the swap counterparties. (7) RETIREMENT PLANS (A) PENSION. The Company has noncontributory retirement plans covering substantially all employees. The plans provide retirement benefits based on years of service and compensation. The Company's funding policy is to contribute amounts annually in accordance with applicable regulations in order to achieve adequate funding of projected benefit obligations. The assets of the plans consist principally of common stocks and high quality, interest-bearing obligations. Net pension cost for the Company includes the following components: The funded status of the Company's retirement plans was as follows: The projected benefit obligation was determined using an assumed discount rate of 7.25% in 1993 and 8.5% in 1992. A long-term rate of compensation increase ranging from 3.9% to 6% was assumed for 1993 and ranging from 6.9% to 9.0% was assumed in 1992. The assumed long- term rate of return on plan assets was 9.5% in 1993 and 1992. The transitional asset at January 1, 1986, is being recognized over approximately 17 years, and the prior service cost is being recognized over approximately 15 years. (B) SAVINGS PLANS. In 1993, the Company (which includes HL&P) and KBLCOM had employee savings plans that qualified as cash or deferred arrangements under Section 401(k) of the Internal Revenue Code of 1986, as amended (IRC). Under the plans, participating employees could contribute a portion of their compensation, pre-tax or after-tax, up to a maximum of 16% of compensation limited by an annual deferral limit ($8,994 for calendar year 1993) prescribed by IRC Section 402(g) and the IRC Section 415 annual additions limits. The Company matched 70% (KBLCOM matched 50%) of the first 6% of each employee's compensation contributed, subject to a vesting schedule which entitled the employee to a percentage of the matching contributions depending on years of service. Substantially all of the Company's and KBLCOM's match was invested in the Company's common stock. Effective January 1, 1994, KBLCOM's plan was merged with the Company's plan and KBLCOM's matching contribution was increased to 70% of the first 6% of each employee's contributions. Under the ESOP component of the Company's savings plan, the ESOP trustee purchased shares of the Company's common stock in open-market transactions with funds provided by loans from the Company and completed the purchase of stock under the ESOP in December 1991, after purchasing 9,381,092 shares at a cost of $350 million. At December 31, 1993, the balance of the ESOP loans was approximately $332 million. The loans from the Company to the ESOP are shown on the Company's Consolidated Balance Sheets as a reduction in common stock equity. Principal and interest on the loans will be paid with dividends on the common stock in, and Company contributions to, the ESOP. Repayment of the loan is scheduled to occur over a 20-year period with the first mandatory repayment in 1997. The loans to the ESOP were funded initially by the Company from short-term borrowings which have been refinanced with long-term debt. Interest expense related to the ESOP debt service was $32.5 million in 1993, $32.6 million in 1992, and $17.9 million in 1991. ESOP benefit expense was $17.3 million, $20.0 million, and $21.3 million in 1993, 1992 and 1991, respectively. The Company match for the savings plan is satisfied with the allocation to employee accounts of released shares of stock and with cash contributions. Shares are released from the encumbrance of the loans upon the payment of debt service using dividends on unallocated shares in the ESOP, interest earnings and cash contributions by the Company. A summary of dividends on unallocated ESOP shares and ESOP cash contributions for the three years ended December 31, 1993 is as follows: (C) POSTRETIREMENT BENEFITS. The Company and HL&P adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993. SFAS No. 106 requires companies to recognize the liability for postretirement benefit plans other than pensions, primarily health care. The Company and HL&P previously expensed the cost of these benefits as claims were incurred. SFAS No. 106 allows recognition of the transition obligation (liability for prior years' service) in the year of adoption or to be amortized over the plan participants' future service period. The Company and HL&P have elected to amortize the estimated transition obligation of approximately $213 million (including $211 million for HL&P) over 22 years. In March 1993, the Utility Commission adopted a rule governing the ratemaking treatment of postretirement benefits other than pensions. This rule provides for recovery in ratemaking proceedings (which, in HL&P's case, has not occurred) of the cost of postretirement benefits calculated in accordance with SFAS No. 106 including amortization of the transition obligation. For 1992, the Company and HL&P continued to fund postretirement benefit costs other than pensions on a "pay-as-you-go" basis. The Company made postretirement benefit payments in 1992 of $8.6 million. The Company's postretirement benefit costs were $38 million for 1993, an increase of $27 million over the 1993 "pay-as-you-go" amount. The net postretirement benefit cost for the Company in 1993 includes the following components, in thousands of dollars: The funded status of postretirement benefit costs for the Company at December 31, 1993 was as follows, in thousands of dollars: The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation in 1993 are as follows: The assumed health care rates gradually decline to 5.4% for both medical categories and 3.7% for dental by the year 2001. The accumulated postretirement benefit obligation was determined using an assumed discount rate of 7.25% for 1993. If the health care cost trend rate assumptions were increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by approximately 8%. The annual effect of the 1% increase on the total of the service and interest costs would be an increase of approximately 10%. (8) COMMITMENTS AND CONTINGENCIES (a) HL&P. HL&P has various commitments for capital expenditures, fuel, purchased power, cooling water and operating leases. Commitments in connection with HL&P's capital program are generally revocable by HL&P subject to reimbursement to manufacturers for expenditures incurred or other cancellation penalties. HL&P's other commitments have various quantity requirements and durations. However, if these requirements could not be met, various alternatives are available to mitigate the cost associated with the contracts' commitments. HL&P's capital program (exclusive of AFUDC) is presently estimated to cost $478 million in 1994, $381 million in 1995 and $418 million in 1996. These amounts do not include expenditures on projects for which HL&P expects to be reimbursed by customers or other parties. HL&P has entered into several long-term coal, lignite and natural gas contracts which have various quantity requirements and durations. Minimum obligations for coal and transportation agreements are approximately $167 million in 1994, and $165 million in 1995 and 1996. In addition, the minimum obligations under the lignite mining and lease agreements will be approximately $14 million annually during the 1994-1996 period. HL&P has entered into several gas purchase agreements containing contract terms in excess of one year which provide for specified purchase and delivery obligations. Minimum obligations for natural gas purchase and natural gas storage contracts are approximately $57.4 million in 1994, $58.9 million in 1995 and $60.5 million in 1996. Collectively, the gas supply contracts included in these figures could amount to 11% of HL&P's annual natural gas requirements. The Utility Commission's rules provide for recovery of the coal, lignite and natural gas costs described above through the energy component of HL&P's electric rates. Nuclear fuel costs are also included in the energy component of HL&P's electric rates based on the cost of nuclear fuel consumed in the reactor. HL&P has commitments to purchase firm capacity from cogenerators of approximately $145 million in 1994, $32 million in 1995 and $22 million in 1996. The Utility Commission's rules allow recovery of these costs through HL&P's base rates for electric service and additionally authorize HL&P to charge or credit customers for any variation in actual purchased power cost from the cost utilized to determine its base rates. In the event that the Utility Commission, at some future date, does not allow recovery through rates of any amount of purchased power payments, the three principal firm capacity contracts contain provisions allowing HL&P to suspend or reduce payments and seek repayment for amounts disallowed. In November 1990, the Clean Air Act was extensively amended by Congress. HL&P has already made an investment in pollution control facilities, and all of its generating facilities currently comply in all material respects with sulfur dioxide emission standards established by the legislation. Provisions of the Clean Air Act dealing with urban air pollution required establishing new emission limitations for nitrogen oxides from existing sources. The cost of modifications necessary to reduce nitrogen oxide emissions from existing sources has been estimated at $29 million in 1994 and $10.5 million in 1995. In addition, continuous emission monitoring regulations are anticipated to require expenditures of $12 million in 1994 and $2 million in 1995. Capital expenditures are expected to total $71 million for the years 1994 through 1996. The Energy Policy Act of 1992, which became law in October 1992, includes a provision that assesses a fee upon domestic utilities having purchased enrichment services from the Department of Energy before October 22, 1992. This fee is to cover a portion of the cost to decontaminate and decommission the enrichment facilities. It is currently estimated that the assessment to the South Texas Project Electric Generating Station (South Texas Project) will be approximately $4 million in 1994 and approximately $2 million each year thereafter (subject to escalation for inflation), of which HL&P's share is 30.8%. This assessment will continue until the earlier of 15 years or when $2.25 billion (adjusted for inflation) has been collected from domestic utilities. Based on HL&P's actual payment of $579,810 in 1993, it recorded an estimated liability of $8.7 million. HL&P's service area is heavily dependent on oil, gas, refined products, petrochemicals and related business. Significant adverse events affecting these industries would negatively impact the revenues of the Company and HL&P. (b) KBLCOM COMMITMENTS AND OBLIGATIONS UNDER CABLE FRANCHISE AGREEMENTS. KBLCOM's capital additions are estimated to be $77 million in 1994, $110 million in 1995 and $89 million in 1996. KBLCOM and its subsidiaries presently have certain cable franchises containing provisions for construction of cable plant and service to customers within the franchise area. In connection with certain obligations under existing franchise agreements, KBLCOM and its subsidiaries obtain surety bonds and letters of credit guaranteeing performance to municipalities and public utilities. Payment is required only in the event of non-performance. KBLCOM and its subsidiaries have fulfilled all of their obligations such that no payments have been required. (c) IMPACT OF THE 1992 CABLE ACT ON KBLCOM. In May 1993, the Federal Communications Commission (FCC) issued its rate regulation rules (Rate Rule) which became effective on September 1, 1993. As a result of the Rate Rule, KBLCOM estimates that revenues in 1993 were reduced by approximately $6.8 million. In February 1994, the FCC announced further changes in the Rate Rule and announced its interim cost-of- service standards (Interim COS Standards). The FCC will issue revised benchmark formulas which will produce lower benchmarks, effective May 15, 1994 (Revised Benchmarks). It is impossible to assess the detailed impact of the revised Rate Rule and Interim COS Standards on KBLCOM until the FCC completes and issues the actual text of its rules on the Revised Benchmarks and the Interim COS Standards. (9) JOINTLY-OWNED NUCLEAR PLANT (a) HL&P INVESTMENT. HL&P is project manager and one of four co-owners in the South Texas Project, which consists of two 1,250 megawatt nuclear generating units. Unit Nos. 1 and 2 of the South Texas Project achieved commercial operation in August 1988 and June 1989, respectively. Each co-owner funds its own share of capital and operating costs associated with the plant, with HL&P's interest in the project being 30.8%. HL&P's share of the operation and maintenance expenses is included in electric operation and maintenance expenses on the Company's Statements of Consolidated Income and in the corresponding operating expense amounts on HL&P's Statements of Income. As of December 31, 1993, HL&P's investments (net of accumulated depreciation and amortization) in the South Texas Project and in nuclear fuel, including AFUDC, were $2.1 billion and $119 million, respectively. (b) CITY OF AUSTIN LITIGATION. In 1983, the City of Austin (Austin), one of the four co-owners of the South Texas Project, filed a lawsuit against the Company and HL&P alleging that it was fraudulently induced to participate in the South Texas Project and that HL&P failed to perform properly its duties as project manager. After a jury trial in 1989, judgment was entered in favor of HL&P, and that judgment was affirmed on appeal. In May 1993, following the expiration of Austin's rights to appeal to the United States Supreme Court, the judgment in favor of the Company and HL&P became final. On February 22, 1994, Austin filed a new suit against HL&P. In that suit, filed in the 164th District Court for Harris County, Texas, Austin alleges that the outages at the South Texas Project since February 1993 are due to HL&P's failure to perform obligations it owed to Austin under the Participation Agreement among the four co-owners of the South Texas Project (Participation Agreement). Austin asserts that such failures have caused Austin damages of at least $125 million, which are continuing, due to the incurrence of increased operating and maintenance costs, the cost of replacement power and lost profits on wholesale transactions that did not occur. Austin states that it will file a "more detailed" petition at a later date. For a discussion of the 1993 outage, see Note 9(f). As it did in the litigation filed against HL&P in 1983, Austin asserts that HL&P breached obligations HL&P owed under the Participation Agreement to Austin, and Austin seeks a declaration that HL&P had as duty to exercise reasonable care in the operation and maintenance of the South Texas Project. In that earlier litigation, however, the courts concluded that the Participation Agreement did not impose on HL&P a duty to exercise reasonable skill and care as Project Manager. Austin also asserts in its new suit that certain terms of a settlement reached in 1992 among HL&P and Central and South West Corporation (CSW) and its subsidiary, Central Power and Light Company (CPL), are invalid and void. The Participation Agreement permits arbitration of certain disputes among the owners, and the challenged settlement terms provide that in any future arbitration, HL&P and CPL would each appoint an arbitrator acceptable to the other. Austin asserts that, as a result of this agreement, the arbitration provisions of the Participation Agreement are void and Austin should not be required to participate in or be bound by arbitration proceedings; alternatively, Austin asserts that HL&P's rights with respect to CPL's appointment of an arbitrator should be shared with all the owners or canceled, and Austin seeks injunctive relief against arbitration of its dispute with HL&P. For a further discussion of the settlement among HL&P, CSW and CPL, see Note 9(c) below. HL&P and the Company do not believe there is merit to Austin's claims, and they intend to defend vigorously against them. However, there can be no assurance as to the ultimate outcome of this matter. (c) ARBITRATION WITH CO-OWNERS. During the course of the litigation filed by Austin in 1983, the City of San Antonio (San Antonio) and CPL, the other two co-owners in the South Texas Project, asserted claims for unspecified damages against HL&P as project manager of the South Texas Project, alleging HL&P breached its duties and obligations. San Antonio and CPL requested arbitration of their claims under the Participation Agreement. This matter was severed from the Austin litigation and is pending before the 101st District Court in Dallas County, Texas. The 101st District Court ruled that the demand for arbitration is valid and enforceable under the Participation Agreement, and that ruling has been upheld by appellate courts. Arbitrators were appointed by HL&P and each of the other co-owners in connection with the District Court's ruling. The Participation Agreement provides that the four appointed arbitrators will select a fifth arbitrator, but that action has not yet occurred. In 1992, the Company and HL&P entered into a settlement with CPL and CSW with respect to various matters including the arbitration and related legal proceedings. Pursuant to the settlement, CPL withdrew its demand for arbitration under the Participation Agreement, and the Company, HL&P, CSW and CPL dismissed litigation associated with the dispute. The settlement also resolved other disputes between the parties concerning various transmission agreements and related billing disputes. In addition, the parties also agreed to support, and to seek consent of the other owners of the South Texas Project to, certain amendments to the Participation Agreement, including changes in the management structure of the South Texas Project through which HL&P would be replaced as project manager by an independent entity. Although settlement with CPL does not directly affect San Antonio's pending demand for arbitration, HL&P and CPL have reached certain other understandings which contemplate that: (i) CPL's arbitrator previously appointed for that proceeding would be replaced by CPL; (ii) arbitrators approved by CPL and HL&P for any future arbitrations will be mutually acceptable to HL&P and CPL; and (iii) HL&P and CPL will resolve any future disputes between them concerning the South Texas Project without resorting to the arbitration provision of the Participation Agreement. The settlement with CPL did not have a material adverse effect on the Company's or HL&P's financial position and results of operations. In February 1994, San Antonio indicated a desire to move forward with its demand for arbitration and suggested that San Antonio considers all allegations of mismanagement against HL&P to be appropriate subjects for arbitration in that proceeding, not just allegations related to the planning and construction of the South Texas Project. It is unclear what additional allegations San Antonio may make, but it is possible that San Antonio will assert that HL&P has liability for all or some portion of the additional costs incurred by San Antonio due to the 1993 outage of the South Texas Project. For a discussion of that outage see Note 9(f). HL&P and the Company continue to regard San Antonio's claims to be without merit. From time to time, HL&P and other parties to these proceedings have held discussions with a view toward settling their differences on these matters. While HL&P and the Company cannot give definite assurance regarding the ultimate resolution of the San Antonio litigation and arbitration, they presently do not believe such resolutions will have a material adverse impact on HL&P's or the Company's financial position and results of operations. (d) NUCLEAR INSURANCE. HL&P and the other owners of the South Texas Project maintain nuclear property and nuclear liability insurance coverages as required by law and periodically review available limits and coverage for additional protection. The owners of the South Texas Project currently maintain $500 million in primary property damage insurance from American Nuclear Insurers (ANI). Effective November 15, 1993, the maximum amounts of excess property insurance available through the insurance industry increased from $2.125 billion to $2.2 billion. This $2.2 billion of excess property insurance coverage includes $800 million of excess insurance from ANI and $1.4 billion of excess property insurance coverage through participation in the Nuclear Electric Insurance Limited (NEIL) II program. The owners of the South Texas Project have approved the purchase of the additional available excess property insurance coverage. Additionally, effective January 1, 1994, ANI will be increasing their excess property insurance limits to $850 million, and the owners of the South Texas Project have also approved the purchase of the additional limits at the March 1, 1994 renewal for ANI excess property insurance. Under NEIL II, HL&P and the other owners of the South Texas Project are subject to a maximum assessment, in the aggregate, of approximately $15.9 million in any one policy year. The application of the proceeds of such property insurance is subject to the priorities established by the United States Nuclear Regulatory Commission (NRC) regulations relating to the safety of licensed reactors and decontamination operations. Pursuant to the Price Anderson Act, the maximum liability to the public for owners of nuclear power plants, such as the South Texas Project, was increased from $7.9 billion to $9.3 billion effective February 18, 1994. Owners are required under the Act to insure their liability for nuclear incidents and protective evacuations by maintaining the maximum amount of financial protection available from private sources and by maintaining secondary financial protection through an industry retrospective rating plan. Effective August 20, 1993, the assessment of deferred premiums provided by the plan for each nuclear incident has increased from $63 million to up to $75.5 million per reactor subject to indexing for inflation, a possible 5% surcharge (but no more than $10 million per reactor per incident in any one year) and a 3% state premium tax. HL&P and the other owners of the South Texas Project currently maintain the required nuclear liability insurance and participate in the industry retrospective rating plan. There can be no assurance that all potential losses or liabilities will be insurable, or that the amount of insurance will be sufficient to cover them. Any substantial losses not covered by insurance would have a material effect on HL&P's and the Company's financial condition. (e) NUCLEAR DECOMMISSIONING. HL&P and the other co-owners of the South Texas Project are required by the NRC to meet minimum decommissioning funding requirements to pay the costs of decommissioning the South Texas Project. Pursuant to the terms of the order of the Utility Commission in Docket No. 9850, HL&P is currently funding decommissioning costs for the South Texas Project with an independent trustee at an annual amount of $6 million. As of December 31, 1993, the trustee held approximately $18.7 million for decommissioning, for which the asset and liability are reflected on the Company's Consolidated and HL&P's Balance Sheets in deferred debits and deferred credits, respectively. HL&P's funding level is estimated to provide approximately $146 million in 1989 dollars, an amount which currently exceeds the NRC minimum. However, the South Texas Project co-owners have engaged an outside consultant to review the estimated decommissioning costs of the South Texas Project which review should be completed by the end of 1994. While changes to present funding levels, if any, cannot be estimated at this time, a substantial increase in funding may be necessary. No assurance can be given that the amounts held in trust will be adequate to cover the decommissioning costs. (f) NRC INSPECTIONS AND OPERATIONS. Both generating units at the South Texas Project were out of service from February 1993 to February 1994, when Unit No. 1 was authorized by the NRC to return to service. Currently, Unit No. 1 is out of service for repairs to a small steam generator leak encountered following the unit's shutdown to repair a feedwater control valve. Those repairs are scheduled for completion by mid-March 1994, and no formal NRC approval is required to resume operation of Unit No. 1. Unit No. 2 is currently scheduled to resume operation after completion of regulatory reviews, in the spring of 1994. HL&P removed the units from service in February 1993 when a problem was encountered with certain pumps. At that time HL&P concluded that the units should not resume operation until HL&P had determined the root cause of the failure and had briefed the NRC and corrective action had been taken. The NRC formalized that commitment in a Confirmatory Action Letter, which confirmed that HL&P would not resume operations until it had briefed the NRC on its findings and actions. Subsequently, that Confirmatory Action Letter was supplemented by the NRC to require HL&P, prior to resuming operations, to address additional matters which were identified during the course of analyzing the issues associated with the original pump failure and during various subsequent NRC inspections and reviews. In June 1993, the NRC announced that the South Texas Project had been placed on the NRC's "watch list" of plants with "weaknesses that warrant increased NRC attention." Plants in this category are authorized to operate but are subject to close monitoring by the NRC. The NRC reviews the status of plants on this list semi-annually, but HL&P does not anticipate that the South Texas Project would be removed from that list until there has been a period of operation for both units, and the NRC concludes that the concerns which led the NRC to place the South Texas Project on that list have been satisfactorily addressed. The NRC's decision to place the South Texas Project on its "watch list" followed the June 1993 issuance of a report by its Diagnostic Evaluation Team (DET) which conducted a review of the South Texas Project in the spring of 1993 and identified a number of areas requiring improvement at the South Texas Project. Conducted infrequently, NRC diagnostic evaluations do not evaluate compliance with NRC regulations but are broad-based evaluations of overall plant operations and are intended to review the strengths and weaknesses of the licensee's performance and to identify the root cause of performance problems. The DET report found, among other things, weaknesses in maintenance and testing, deficiencies in training and in the material condition of some equipment, strained staffing levels in operations and several weaknesses in engineering support. The report cited the need to reduce backlogs of engineering and maintenance work and to simplify work processes which, the DET found, placed excessive burdens on operating and other plant personnel. The report also identified the need to strengthen management communications, oversight and teamwork as well as the capability to identify and correct the root causes of problems. The DET also expressed concern with regard to the adequacy of resources committed to resolving issues at the South Texas Project but noted that many issues had already been identified and were being addressed by HL&P. In response to the DET report, HL&P presented its plan to address the issues raised in that report and began its action program to address those concerns. While those programs were being implemented, HL&P also initiated additional activities and modifications that were not previously scheduled during 1993 but which are designed to eliminate the need for some future outages and to enhance operations at the South Texas Project. The NRC conducted additional inspections and reviews of HL&P's plans and agreed in February 1994 that HL&P's progress in addressing the NRC's concerns had satisfied the issues raised in the Confirmatory Action Letter with respect to Unit No. 1. The NRC concurred in HL&P's determination that Unit No. 1 could resume operation. Work is now underway to address the NRC's concerns with respect to Unit No. 2, which HL&P anticipates will not require as extensive an effort as was required by the NRC for Unit No. 1. However, difficulties encountered in completing actions required on Unit No. 2 and any additional issues which may be raised in the conduct of those activities or in the operation of Unit No. 1 could adversely affect the anticipated schedule for resuming operation of Unit No. 2. During the outage, HL&P has not had, and does not anticipate having, difficulty in meeting its energy needs. During the outage, both fuel and non-fuel expenditures have been higher for HL&P than levels originally projected for the year. HL&P's non-fuel expenditures for the South Texas Project during 1993 were approximately $115 million greater than originally budgeted levels (of which HL&P's share was $35 million) for work undertaken in connection with the DET and for other initiatives taken during the year. It is expected that, subsequent to 1993, operation and maintenance costs will continue to be higher than previous levels in order to support additional initiatives developed in 1993. Fuel costs also were necessarily higher due to the use of higher cost alternative fuels. However, these increased expenditures are expected to be offset to some extent by savings from future outages that can now be avoided as a result of activities accelerated into 1993 and from overall improvement in operations resulting from implementing the programs developed during the outage. For a discussion of regulatory treatment related to the outage, see Notes 10(f) and 10(g). During 1993, the NRC imposed a total of $500,000 in civil penalties (of which HL&P's share was $154,000) in connection with violations of NRC requirements. In March 1993, a Houston newspaper reported that the NRC had referred to the Department of Justice allegations that the employment of three former employees and an employee of a contractor to HL&P had been terminated or disrupted in retaliation for their having made safety-related complaints to the NRC. Such retaliation, if proved, would be contrary to requirements of the Atomic Energy Act and regulations promulgated by the NRC. The NRC has confirmed to HL&P that these matters have been referred to the Department of Justice for consideration of further action and has notified HL&P that the NRC is considering enforcement action against HL&P and one or more HL&P employees in connection with one of those cases. HL&P has been advised by counsel that most referrals by the NRC to the Department of Justice do not result in prosecutions. The Company and HL&P strongly believe that the facts underlying these events would not support action by the Department of Justice against HL&P or any of its personnel; accordingly, HL&P intends to defend vigorously against such charges. HL&P also intends to defend vigorously against civil proceedings filed in the state court in Matagorda County, Texas, by the complaining employees and against administrative proceedings before the Department of Labor and the NRC, which, independently of the Department of Justice, could impose administrative sanctions if they find violations of the Atomic Energy Act or the NRC regulations. These administrative sanctions may include civil penalties in the case of the NRC and, in the case of the Department of Labor, ordering reinstatement and back pay and/or imposing civil penalties. Although the Company and HL&P do not believe these allegations have merit or will have a material adverse effect on the Company or HL&P, neither the Company nor HL&P can predict at this time their outcome. (10) UTILITY COMMISSION PROCEEDINGS Pursuant to a series of applications filed by HL&P in recent years, the Utility Commission has granted HL&P rate increases to reflect in electric rates HL&P's substantial investment in new plant construction, including the South Texas Project. Although Utility Commission action on those applications has been completed, judicial review of a number of the Utility Commission orders is pending. In Texas, Utility Commission orders may be appealed to a District Court in Travis County, and from that Court's decision an appeal may be taken to the Court of Appeals for the 3rd District at Austin (Austin Court of Appeals). Discretionary review by the Supreme Court of Texas may be sought from decisions of the Austin Court of Appeals. The pending appeals from the Utility Commission orders are in various stages. In the event the courts ultimately reverse actions of the Utility Commission in any of these proceedings, such matters would be remanded to the Utility Commission for action in light of the courts' orders. Because of the number of variables which can affect the ultimate resolution of such matters on remand, the Company and HL&P generally are not in a position at this time to predict the outcome of the matters on appeal or the ultimate effect that adverse action by the courts could have on the Company and HL&P. On remand, the Utility Commission's action could range from granting rate relief substantially equal to the rates previously approved, to a reduction in the revenues to which HL&P was entitled during the time the applicable rates were in effect, which could require a refund to customers of amounts collected pursuant to such rates. Judicial review has been concluded or currently is pending on the final orders of the Utility Commission described below. (a) DOCKET NOS. 6765, 6766 AND 5779. In February 1993, the Austin Court of Appeals granted a motion by the Office of Public Utility Counsel (OPC) to voluntarily dismiss its appeal of the Utility Commission's order in HL&P's 1984 rate case (Docket No. 5779). In December 1993, the Supreme Court of Texas granted a similar motion by OPC to dismiss its appeal of the Utility Commission's order in HL&P's 1986 rate case (Docket Nos. 6765 and 6766). As a result, appellate review of the Utility Commission's orders in those dockets has been concluded, and the orders have been affirmed. (b) DOCKET NO. 8425. In October 1992, a District Court in Travis County, Texas affirmed the Utility Commission's order in HL&P's 1988 rate case (Docket No. 8425). An appeal to the Austin Court of Appeals is pending. In its final order in that docket, the Utility Commission granted HL&P a $227 million increase in base revenues, allowed a 12.92% return on common equity, authorized a qualified phase-in plan for Unit No. 1 of the South Texas Project (including approximately 72% of HL&P's investment in Unit No. 1 of the South Texas Project in rate base) and authorized HL&P to use deferred accounting for Unit No. 2 of the South Texas Project. Rates substantially corresponding to the increase granted were implemented by HL&P in June 1989 and remained in effect until May 1991. In the appeal of the Utility Commission's order, certain parties have challenged the Utility Commission's decision regarding deferred accounting, treatment of federal income tax expense and certain other matters. A recent decision of the Austin Court of Appeals, in an appeal involving another utility (and to which HL&P was not a party), adopted some of the arguments being advanced by parties challenging the Utility Commission's order in Docket No. 8425. In that case, Public Utility Commission of Texas vs. GTE-SW, the Austin Court of Appeals ruled that when a utility pays federal income taxes as part of a consolidated group, the utility's ratepayers are entitled to a fair share of the tax savings actually realized, which can include savings resulting from unregulated activities. The Texas Supreme Court has agreed to hear an appeal of that decision, but on points not involving the federal income tax issues, though tax issues could be decided in such opinion. In its final order in Docket No. 8425, the Utility Commission did not reduce HL&P's tax expense by any of the tax savings resulting from the Company's filing of a consolidated tax return. Although the GTE decision was not legally dispositive of the tax issues presented in the appeal of Docket No. 8425, it is possible that the Austin Court of Appeals could utilize the reasoning in GTE in addressing similar issues in the appeal of Docket No. 8425. However, in February 1993 the Austin Court of Appeals, considering an appeal involving another telephone utility, upheld Utility Commission findings that the tax expense for the utility included the utility's fair share of the tax savings resulting from a consolidated tax return, even though the utility's fair share of the tax savings was determined to be zero. HL&P believes that the Utility Commission findings in Docket No. 8425 and in Docket No. 9850 (see Note 10(c)) should be upheld on the same principle (i.e., that the Utility Commission determined that the fair share of tax savings to be allocated to ratepayers is determined to be zero). However, no assurance can be made as to the ultimate outcome of this matter. The Utility Commission's order in Docket No. 8425 may be affected also by the ultimate resolution of appeals concerning the Utility Commission's treatment of deferred accounting. For a discussion of appeals of the Utility Commission's orders on deferred accounting, see Notes 10(e) and 11. (c) DOCKET NO. 9850. In August 1992, a district court in Travis County affirmed the Utility Commission's final order in HL&P's 1991 rate case (Docket No. 9850). That decision was appealed by certain parties to the Austin Court of Appeals, raising issues concerning the Utility Commission's approval of a non-unanimous settlement in that docket, the Utility Commission's calculation of federal income tax expense and the allowance of deferred accounting reflected in the settlement. In August 1993, the Austin Court of Appeals affirmed on procedural grounds the ruling by the Travis County District Court, and applications for writ of error were filed with the Supreme Court of Texas by one of the other parties to the proceeding. The Supreme Court has not yet ruled on these applications. In Docket No. 9850, the Utility Commission approved a settlement agreement reached with most parties. That settlement agreement provided for a $313 million increase in HL&P's base rates, termination of deferrals granted with respect to Unit No. 2 of the South Texas Project and of the qualified phase-in plan deferrals granted with respect to Unit No. 1 of the South Texas Project, and recovery of deferred plant costs. The settlement authorized a 12.55% return on common equity for HL&P, and HL&P agreed not to request additional increases in base rates that would be implemented prior to May 1, 1993. Rates contemplated by that settlement agreement were implemented in May 1991 and remain in effect. The Utility Commission's order in Docket No. 9850 found that HL&P would have been entitled to more rate relief than the $313 million agreed to in the settlement, but certain recent actions of the Austin Court of Appeals could, if ultimately upheld and applied to the appeal of Docket No. 9850, require a remand of that settlement to the Utility Commission. HL&P believes that the amount which the Utility Commission found HL&P was entitled to would exceed any disallowance that would have been required under the Austin Court of Appeals' ruling regarding deferred accounting (see Notes 10(e) and 11) or any adverse effect on the calculation of tax expense if the court's ruling in the GTE decision were applied to that settlement (see Note 10(b) above). However, the amount of rate relief to which the Utility Commission found HL&P to be entitled in excess of the $313 million agreed to in the settlement may not be sufficient if the reasoning in both the GTE decision and the ruling on deferred accounting were to be applied to the settlement agreement in Docket No. 9850. Although HL&P believes that it should be entitled to demonstrate entitlement to rate relief equal to that agreed to in the stipulation in Docket No. 9850, HL&P cannot rule out the possibility that a remand and reopening of that settlement would be required if decisions unfavorable to HL&P are rendered on both the deferred accounting treatment and the calculation of tax expense for ratemaking purposes. (d) DOCKET NO. 6668. In June 1990, the Utility Commission issued the final order in Docket No. 6668, the Utility Commission's inquiry into the prudence of the planning, management and construction of the South Texas Project. The Utility Commission's findings and order in Docket No. 6668 were incorporated in Docket No. 8425, HL&P's 1988 general rate case. Pursuant to the findings in Docket No. 6668, the Utility Commission found imprudent $375.5 million out of HL&P's $2.8 billion investment in the two units of the South Texas Project. The Utility Commission's findings did not reflect $207 million in benefits received in a settlement of litigation with the former architect-engineer of the South Texas Project or the effects of federal income taxes, investment tax credits or certain deferrals. In addition, accounting standards require that the equity portion of AFUDC accrued for regulatory purposes under deferred accounting orders be utilized to determine the cost disallowance for financial reporting purposes. After taking all of these items into account, HL&P recorded an after-tax charge of $15 million in 1990 and continued to reduce such loss with the equity portion of deferrals in 1991 related to Unit No. 2 of the South Texas Project. The findings in Docket No. 6668 represent the Utility Commission's final determination regarding the prudence of expenditures associated with the planning and construction of the South Texas Project. Unless the order is modified or reversed on appeal, HL&P will be precluded from recovering in rate proceedings the amount found imprudent by the Utility Commission. Appeals by HL&P and other parties of the Utility Commission's order in Docket No. 6668 were dismissed by a District Court in Travis County in May 1991. However, in December 1992 the Austin Court of Appeals reversed the District Court's dismissals on procedural grounds. HL&P and other parties have filed applications for writ of error with the Supreme Court of Texas concerning the order by the Austin Court of Appeals, but unless the order is modified on further review, HL&P anticipates that the appeals of the parties will be reinstated and that the merits of the issues raised in those appeals of Docket No. 6668 will be considered by the District Court, with the possibility of subsequent judicial review once the District Court has acted on those appeals. In addition, separate appeals are pending from Utility Commission orders in Dockets Nos. 8425 and 9850, in which the findings of the order in Docket No. 6668 are reflected in rates. See Notes 10(b) and 10(c). (e) DOCKET NOS. 8230 AND 9010. Deferred accounting treatment for Unit No. 1 of the South Texas Project was authorized by the Utility Commission in Docket No. 8230 and was extended in Docket No. 9010. Similar deferred accounting treatment with respect to Unit No. 2 of the South Texas Project was authorized in Docket No. 8425. For a discussion of the deferred accounting treatment granted, see Note 11. In September 1992, the Austin Court of Appeals, in considering the appeal of the Utility Commission's final order in Docket Nos. 8230 and 9010, upheld the Utility Commission's action in granting deferred accounting treatment for operation and maintenance expenses, but rejected such treatment for the carrying costs associated with the investment in Unit No. 1 of the South Texas Project. That ruling followed the Austin Court of Appeals decision rendered in August 1992, on a motion for rehearing, involving another utility which had been granted similar deferred accounting treatment for another nuclear plant. In its August decision, the court ruled that Texas law did not permit the Utility Commission to allow the utility to place the carrying costs associated with the investment in the utility's rate base, though the court observed that the Utility Commission could allow amortization of such costs. The Supreme Court of Texas has granted applications for writ of error with respect to the Austin Court of Appeals decision regarding Docket Nos. 8230 and 9010. The Supreme Court of Texas has also granted applications for writ of error on three other decisions by the Austin Court of Appeals regarding deferred accounting treatment granted to other utilities by the Utility Commission. The Supreme Court heard oral arguments on these appeals on September 13, 1993. The court has not yet ruled. (f) DOCKET NO. 12065. HL&P is not currently seeking authority to change its base rates for electric service, but the Utility Commission has authority to initiate a rate proceeding pursuant to Section 42 of the Public Utility Regulatory Policy Act (PURA) to determine whether existing rates are unjust or unreasonable. In 1993, the Utility Commission referred to an administrative law judge (ALJ) the complaint of a former employee of HL&P seeking to initiate such a proceeding. On February 23, 1994, the ALJ concluded that a Section 42 proceeding should be conducted and that HL&P should file full information, testimony and schedules justifying its rates. The ALJ acknowledged that the decision was a close one, and is subject to review by the Utility Commission. However, he concluded that information concerning HL&P's financial results as of December 1992 indicated that HL&P's adjusted revenues could be approximately $62 million (or 2.33% of its adjusted base revenues) more than might be authorized in a current rate proceeding. The ALJ's conclusion was based on various accounting considerations, including use of a different treatment of federal income tax expense than the method utilized in HL&P's last rate case. The ALJ also found that there could be a link between the 1993 outage at the South Texas Project, the NRC's actions with respect to the South Texas Project and possible mismanagement by HL&P, which in turn could result in a reduction of HL&P's authorized rate of return as a penalty for imprudent management. HL&P and the Company believe that the examiner's analysis is incorrect, that the South Texas Project has not been imprudently managed, and that ordering a Section 42 proceeding at this time is unwarranted and unnecessarily expensive and burdensome. HL&P has appealed the ALJ's decision to the Utility Commission. If HL&P ultimately is required to respond to a Section 42 inquiry, it will assert that it remains entitled to rates at least at the levels currently authorized. However, there can be no assurance as to the outcome of a Section 42 proceeding if it is ultimately authorized, and HL&P's rates could be reduced following a hearing. HL&P believes that any reduction in base rates as a result of a Section 42 inquiry would take effect prospectively. HL&P is also a defendant in a lawsuit filed in a Fort Bend County, Texas, district court by the same former HL&P employee who originally initiated the Utility Commission complaint concerning HL&P's rates. In that suit, Pace and Scott v. HL&P, the former employee contends that HL&P is currently charging illegal rates since the rates authorized by the Utility Commission do not allocate to ratepayers tax benefits accruing to the Company and to HL&P by virtue of the fact that HL&P's federal income taxes are paid as part of a consolidated group. HL&P is seeking dismissal of that suit because in Texas exclusive jurisdiction to set electric utility rates is vested in municipalities and in the Utility Commission, and the courts have no jurisdiction to set such rates or to set aside authorized rates except through judicial appeals of Utility Commission orders in the manner prescribed in applicable law. Although substantial damages have been claimed by the plaintiffs in that litigation, HL&P and the Company consider this litigation to be wholly without merit, and do not presently believe that it will have a material adverse effect on the Company's or HL&P's results of operations, though no assurances can be given as to its ultimate outcome at this time. (g) FUEL RECONCILIATION. HL&P recovers fuel costs incurred in electric generation through a fixed fuel factor that is set by the Utility Commission. The difference between fuel revenues billed pursuant to such factor and fuel expense incurred is recorded as an addition to or a reduction of revenues, with a corresponding entry to under- or over-recovered fuel, as appropriate. Amounts collected pursuant to the fixed fuel factor must be reconciled periodically by the Utility Commission against actual, reasonable costs as determined by the Utility Commission. Any fuel costs which the Utility Commission determines are unreasonable in a fuel reconciliation proceeding would not be recoverable from customers, and a charge against earnings would result. Under Utility Commission rules, HL&P is required to file an application to reconcile those costs in 1994. Such a filing would also be required in conjunction with any rate proceeding that may be filed, such as the Section 42 proceeding described in Note 10(f). Unless filed earlier in conjunction with a rate proceeding, HL&P currently anticipates filing its fuel reconciliation application in the fourth quarter of 1994 in accordance with a schedule proposed by the Utility Commission staff. If that schedule is approved by the Utility Commission, HL&P anticipates that fuel costs through some time in 1994 will be submitted for reconciliation. No hearing would be anticipated in that reconciliation proceeding before 1995. The schedule for a fuel reconciliation proceeding could be affected by the institution of a prudence inquiry concerning the outage at the South Texas Project. The Utility Commission staff has indicated a desire to conduct an inquiry into the prudence of HL&P's management prior to and during the outage, but it is currently unknown what action the Utility Commission will take on that request or what the nature and scope of any such proceeding would be. Such an inquiry could also be conducted in connection with a rate proceeding under Section 42 of PURA if one is instituted by the Utility Commission. Through the end of 1993, HL&P had recovered through the fuel factor approximately $115 million (including interest) less than the amounts expended for fuel, a significant portion of which under recovery occurred in 1993 during the outage at the South Texas Project. In any review of costs incurred during the period of the 1993 outage at the South Texas Project, it is anticipated that other parties will contend that a portion of fuel costs incurred should be attributed to imprudence on the part of HL&P and thus should be disallowed as unreasonable, with recovery from rate payers denied. Those amounts could be substantial. HL&P intends to defend vigorously against any allegation that its actions have been imprudent or that any portion of its costs incurred should be judged to be unreasonable, but no prediction can be made as to the ultimate outcome of such a proceeding. (11) DEFERRED PLANT COSTS Deferred plant costs were authorized for the South Texas Project by the Utility Commission in two contexts. In the first context, or "deferred accounting," the Utility Commission orders permitted HL&P, for regulatory purposes, to continue to accrue carrying costs in the form of AFUDC (at a 10% rate) on its investment in the two units of the South Texas Project until costs of such units were reflected in rates (which was July 1990 for approximately 72% of Unit No. 1, and May 1991 for the remainder of Unit No. 1 and 100% of Unit No. 2) and to defer and capitalize depreciation, operation and maintenance, insurance and tax expenses associated with such units during the deferral period. Accounting standards do not permit the accrual of the equity portion of AFUDC for financial reporting purposes under these circumstances. However, in accordance with accounting standards, such amounts were utilized to determine the amount of plant cost disallowance for financial reporting purposes. The deferred expenses and the debt portion of the carrying costs associated with the South Texas Project are included on the Company's Statements of Consolidated Income in deferred expenses and deferred carrying costs, respectively. Beginning with the June 1990 order in Docket No. 8425, deferrals were permitted in a second context, a "qualified phase-in plan" for Unit No. 1 of the South Texas Project. Accounting standards require allowable costs deferred for future recovery under a qualified phase-in plan to be capitalized as a deferred charge if certain criteria are met. The qualified phase-in plan as approved by the Utility Commission meets these criteria. During the period June 1990 through May 15, 1991, HL&P deferred depreciation and property taxes related to the 28% of its investment in Unit No. 1 of the South Texas Project not reflected in the Docket No. 8425 rates and recorded a deferred return on that investment as part of the qualified phase-in plan. Deferred return represents the financing costs (equity and debt) associated with the qualified phase-in plan. The deferred expenses and deferred return related to the qualified phase-in plan are included on the Company's Statements of Consolidated Income and HL&P's Statements of Income in deferred expenses and deferred return under phase-in plan, respectively. Under the phase-in plan, these accumulated deferrals will be recoverable within ten years of the June 1990 order. On May 16, 1991, HL&P implemented under bond, in Docket No. 9850, a $313 million base rate increase consistent with the terms of the settlement. Accordingly, HL&P ceased all cost deferrals related to the South Texas Project and began the recovery of such amounts. These deferrals are being amortized on a straight-line basis as allowed by the final order in Docket No. 9850. The amortization of these deferrals totaled $25.8 million for both 1993 and 1992 and $16.1 million in 1991, and is included on the Company's Statements of Consolidated Income and HL&P's Statements of Income in depreciation and amortization expense. See also Notes 10(b), 10(c) and 10(e). The following table shows the original balance of the deferrals and the unamortized balance at December 31, 1993. __________ (a) Amortized over the estimated depreciable life of the South Texas Project. (b) Amortized over nine years beginning in May 1991. As of December 31, 1993, HL&P has recorded deferred income taxes of $200.9 million with respect to deferred accounting and $14.5 million with respect to the deferrals associated with the qualified phase-in plan. (12) MALAKOFF ELECTRIC GENERATING STATION The scheduled in-service dates for the Malakoff Electric Generating Station (Malakoff) units were postponed during the 1980's as expectations of continued strong load growth were tempered. These units have been indefinitely deferred due to the availability of other cost effective resource options. In 1987, all developmental work was stopped and AFUDC accruals ceased. Due to the indefinite postponement of the in-service date for Malakoff, the engineering design work is no longer considered viable. The costs associated with this engineering design work are currently included in rate base and are earning a return per the Utility Commission's final order in Docket No. 8425. Pursuant to HL&P's determination that such costs will have no future value, $84.1 million was reclassified from plant held for future use to recoverable project costs as of December 31, 1992. An additional $7.0 million was reclassified to recoverable project costs in 1993. Amortization of these amounts began in 1993. Amortization amounts will correspond to the amounts being earned as a result of the inclusion of such costs in rate base. The Utility Commission's action in allowing treatment of those costs as plant held for future use has been challenged in the pending appeal of the Utility Commission's final order in Docket No. 8425. Also, recovery of such Malakoff costs may be addressed if rate proceedings are initiated such as that proposed under Section 42 of PURA. See Notes 10(b) and 10(f) for a discussion of these respective proceedings. In June 1990, HL&P purchased from its then fuel supply affiliate, Utility Fuels, all of Utility Fuels' interest in the lignite reserves and lignite handling facilities for Malakoff. The purchase price was $138.2 million, which represented the net book value of Utility Fuels' investment in such reserves and facilities. As part of the June 1990 rate order (Docket No. 8425), the Utility Commission ordered that issues related to the prudence of the amounts invested in the lignite reserves be considered in HL&P's next general rate case which was filed in November 1990 (Docket No. 9850). However, under the October 1991 Utility Commission order in Docket No. 9850, this determination was postponed to a subsequent docket. HL&P's remaining investment in Malakoff through December 31, 1993 of $167 million, consisting primarily of lignite reserves and land, is included on the Company's Consolidated and HL&P's Balance Sheets in plant held for future use. For the 1994-1996 period, HL&P anticipates $14 million of expenditures relating to lignite reserves, primarily to keep lignite leases and other related agreements in effect. (13) RECOVERABLE PROJECT COSTS The Utility Commission has allowed recovery of certain costs over a period of time by amortizing those costs for rate making purposes. However, recoverable project costs have not been included in rate base and, as a result, no return on investment is being earned during the recovery period. Malakoff is the only remaining project with an unrecovered amount of $118 million at December 31, 1993, with remaining recovery periods of 72 months ($78 million) and 78 months ($40 million). (14) INCOME TAXES The Company records income taxes under SFAS No. 109, which among other things, (i) requires the liability method be used in computing deferred taxes on all temporary differences between book and tax bases of assets other than goodwill; (ii) requires that deferred tax liabilities and assets be adjusted for an enacted change in tax laws or rates; and (iii) prohibits net-of-tax accounting and reporting. SFAS No. 109 requires that regulated enterprises recognize such adjustments as regulatory assets or liabilities if it is probable that such amounts will be recovered from or returned to customers in future rates. KBLCOM has significant temporary differences related to its 1986 and 1989 acquisitions of cable television systems, the tax effect of which were recognized when SFAS No. 109 was adopted. During 1993, federal tax legislation was enacted that changes the income tax consequences for the Company and HL&P. The principal provision of the new law which affects the Company and HL&P is the change in the corporate income tax rate from 34% to 35%. A net regulatory asset and the related deferred federal income tax liability of $71.3 million was recorded by HL&P in 1993. The effect of the new law, which decreased the Company's net income by $14.3 million was recognized as a component of income tax expense in 1993. The effect on the Company's deferred taxes for the change in the new law was $10.9 million in 1993. The Company's current and deferred components of income tax expense are as follows: The Company's effective income tax rates are lower than statutory corporate rates for each year as follows: Following are the Company's tax effects of temporary differences resulting in deferred tax assets and liabilities: At December 31, 1993, pursuant to the acquisition of Cablesystems, KBLCOM has unutilized Separate Return Limitation Year (SRLY) net operating loss tax benefits of approximately $23.1 million and unutilized SRLY investment tax credits of approximately $15.5 million which expire in the years 1995 through 2003, and 1994 through 2003, respectively. In addition, KBLCOM has unutilized restricted state loss tax benefits of $17.2 million, which expire in the years 1994 through 2008, and unutilized minimum tax credits of $1.8 million. The Company does not anticipate full utilization of these losses and tax credits and, therefore, has established a valuation allowance. Utilization of preacquisition carryforwards in the future would not affect income of the Company and KBLCOM but would be applied to reduce the carrying value of cable television franchises and intangible assets. (15) SUPPLEMENTARY EXPENSE INFORMATION Taxes, other than income taxes, were charged to expense as follows: (16) BUSINESS SEGMENT INFORMATION The Company operates principally in two business segments: electric utility and cable television. Financial information by business segment is summarized as follows: (a) Amounts do not include amounts attributable to Paragon, which is accounted for under the equity method. (b) 1992 amounts include the effect of a charge of $86.4 million which relates to HL&P's restructuring of operations as a result of the implementation of the Success Through Excellence in Performance (STEP) program (see Note 18). (17) INVESTMENTS (a) Cable Television Partnership. A KBLCOM subsidiary owns a 50% interest in Paragon, a Colorado partnership that owns cable television systems. The remaining interest in the partnership is owned by American Television and Communications Corporation (ATC), a subsidiary of Time Warner Inc. The partnership agreement provides that at any time after December 31, 1993 either partner may elect to divide the assets of the partnership under certain pre-defined procedures set forth in the agreement. Paragon is party to a $275 million revolving credit and letter of credit facility agreement with a group of banks. Paragon also has outstanding $100 million principal amount of 9.56% senior notes due 1995. In each case, borrowings are non-recourse to the Company and to ATC. (b) Foreign Electric Utility. Houston Argentina owns a 32.5% interest in Compania de Inversiones en Electricidad S. A. (COINELEC), an Argentine holding company which acquired, in December 1992, a 51% interest in Empresa Distribuidora La Plata S. A. (EDELAP), an electric utility company operating in La Plata, Argentina and surrounding regions. Houston Argentina's share of the purchase price was approximately $37.4 million, of which $1.6 million was paid in December 1992 with the remainder paid in March 1993. Subsequent to the acquisition, the generating assets of EDELAP were transferred to Central Dique S. A., an Argentine Corporation, 51% of the stock of which is owned by COINELEC. (18) RESTRUCTURING HL&P recorded a one-time, pre-tax charge of $86.4 million in the first quarter of 1992 to reflect the implementation of the STEP program, a restructuring of its operations. This charge includes $42 million related to the acceptance of an early retirement plan by 468 employees of HL&P, $31 million for severance benefits related to the elimination of an additional 1,100 positions and $13 million in other costs associated with the restructuring. (19) CHANGE IN ACCOUNTING METHOD FOR REVENUES During the fourth quarter of 1992, HL&P adopted a change in accounting method for revenue from a cycle billing to a full accrual method, effective January 1, 1992. Unbilled revenues represent the estimated amount customers will be charged for service received, but not yet billed, as of the end of each month. The accrual of unbilled revenues results in a better matching of revenues and expenses. This change impacts the pattern of revenue recognition, which had the effect of increasing revenues and earnings in the second and third quarters (periods of higher usage) and decreasing revenues and earnings in the first and fourth quarters (periods of lower usage). The cumulative effect of this accounting change, less income taxes of $48.5 million, amounted to $94.2 million, and was included in 1992 income. If this change in accounting method were applied retroactively, the effect on consolidated net income in 1991 would not have been material. (20) UNAUDITED QUARTERLY INFORMATION The following unaudited quarterly financial information includes, in the opinion of management, all adjustments (which comprise only normal recurring accruals) necessary for a fair presentation. Quarterly results are not necessarily indicative of a full year's operations because of seasonality and other factors, including rate increases and variations in operating expense patterns. (a) Quarterly earnings per common share are based on the weighted average number of shares outstanding during the quarter, and the sum of the quarters may not equal annual earnings per common share. (b) Adjustment required to reclassify quarterly amounts for the merger of Utility Fuels into HL&P. (see Note 1(b)). (c) Adjustment required to reclassify quarterly amounts for certain advertising expenses at KBLCOM. (d) Amounts include the effect of a pre-tax charge of $86.4 million which relates to HL&P's restructuring of operations as a result of the implementation of the STEP program and pre-tax income of $142.7 million associated with the adoption of a change in accounting principle reflecting a change in the timing of recognition of revenue from electricity sales. (see Notes 18 and 19, respectively). (e) Loss from continuing operations per share for the first quarter of 1992 was $.33. (21) RECLASSIFICATION Certain amounts from the previous years have been reclassified to conform to the 1993 presentation of financial statements. Such reclassifications do not affect earnings. (22) SUBSEQUENT EVENT On February 17 1994, KBLCOM entered into an agreement to acquire three cable companies serving approximately 47,000 customers in the Minneapolis area. KBLCOM will acquire the stock of the companies in exchange for the issuance of common stock of the Company. The amount of common stock of the Company to be issued, currently estimated to be approximately $24 million, is dependent on the amount of liabilities assumed, currently estimated to be approximately $63 million. Approximately 40,000 of the cable customers served by the properties to be acquired are in the Minneapolis metropolitan area. The remaining 7,000 customers are located in small communities south and west of the metropolitan area. Closing of the transaction is subject to the satisfaction of certain conditions. HOUSTON LIGHTING & POWER COMPANY NOTES TO FINANCIAL STATEMENTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Except as modified below, the Notes to Consolidated Financial Statements of the Company are incorporated herein by reference insofar as they relate to HL&P: (1) Summary of Significant Accounting Policies, (3) Preferred Stock of HL&P, (4) Long-Term Debt, (5) Short-Term Financing, (7) Retirement Plans, (8) Commitments and Contingencies, (9) Jointly-Owned Nuclear Plant, (10) Utility Commission Proceedings, (11) Deferred Plant Costs, (12) Malakoff Electric Generating Station, (13) Recoverable Project Costs, (14) Income Taxes, (15) Supplementary Expense Information, (18) Restructuring, (19) Change in Accounting Method for Revenues, and (21) Reclassification. (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (b) MERGER OF UTILITY FUELS INTO HL&P. The merger has been accounted for in a manner similar to a pooling of interests. HL&P's financial statements have been restated to reflect the combined operations for the current and previous periods, with the appropriate eliminating entries. The merger increased HL&P's previously reported earnings by $28.3 million and $24.4 million in 1992 and 1991, respectively. (i) EARNINGS PER COMMON SHARE. All issued and outstanding Class A voting common stock of HL&P is held by the Company and all issued and outstanding Class B non-voting common stock of HL&P is held by Houston Industries (Delaware) Incorporated (Houston Industries Delaware), a wholly owned subsidiary of the Company. Accordingly, earnings per share is not computed. (j) STATEMENT OF CASH FLOWS. At December 31, 1993, HL&P did not have any investments with affiliated companies (considered to be cash equivalents). At December 31, 1992 and 1991, HL&P had affiliate investments of $2.1 million and $9.7 million, respectively. (2) COMMON STOCK All issued and outstanding Class A voting common stock of HL&P is held by the Company and all issued and outstanding Class B non-voting common stock of HL&P is held by Houston Industries Delaware. (5) SHORT-TERM FINANCING The interim financing requirements of HL&P are primarily met through the issuance of commercial paper. HL&P had a bank credit facility of $250 million at December 31, 1993 and 1992, which limits total short-term borrowings and provides for interest at rates generally less than the prime rate. Outstanding commercial paper was approximately $171 million at December 31, 1993 and $139 million at December 31, 1992. Commitment fees are required on HL&P's bank credit facility. (6) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount and estimated fair value of HL&P's financial instruments at December 31, 1993 and 1992 are as follows: The fair values of cash and short-term investments, short-term and other notes payable, and notes payable to affiliated company are equivalent to the carrying amounts. The fair values of cumulative preferred stock subject to mandatory redemption, first mortgage bonds and pollution control revenue bonds issued on behalf of HL&P are estimated using rates currently available for securities with similar terms and remaining maturities. (7) RETIREMENT PLANS (a) PENSION. The Company maintains a noncontributory retirement plan covering substantially all employees of HL&P. Net pension cost for HL&P includes the following components: The funded status of HL&P's retirement plan was as follows: The projected benefit obligation was determined using an assumed discount rate of 7.25% in 1993 and 8.5% in 1992. A long-term rate of compensation increase ranging from 3.9% to 6% was assumed for 1993 and ranging from 6.9% to 9.0% was assumed in 1992. The assumed long- term rate of return on plan assets was 9.5% in 1993 and 1992. The transitional asset at January 1, 1986, is being recognized over approximately 17 years, and the prior service cost is being recognized over approximately 15 years. (c) POSTRETIREMENT BENEFITS. HL&P adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993. For 1992, HL&P continued to fund postretirement benefit costs on a "pay-as-you-go" basis and made payments of $8.6 million. HL&P's 1993 postretirement benefit costs under SFAS No. 106 were $37 million, an increase of approximately $27 million over the 1993 "pay-as-you-go" amount. The net postretirement benefit cost for HL&P in 1993 includes the following components, in thousands of dollars: The funded status of postretirement benefit costs for HL&P at December 31, 1993 was as follows, in thousands of dollars: The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation in 1993 are as follows: The assumed health care rates gradually decline to 5.4% for both medical categories and 3.7% for dental by the year 2001. The accumulated postretirement benefit obligation was determined using an assumed discount rate of 7.25% for 1993. If the health care cost trend rate assumptions were increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by approximately 8%. The annual effect of the 1% increase on the total of the service and interest costs would be an increase of approximately 10%. (14) INCOME TAXES HL&P records income taxes under SFAS No. 109. During 1993, federal tax legislation was enacted that changes the income tax consequences for HL&P. The principal provision of the new law which affects HL&P is the change in the corporate income tax rate from 34% to 35%. A net regulatory asset and the related deferred federal income tax liability of $71.3 million was recorded by HL&P in 1993. The effect of the new law, which decreased HL&P's net income by $8.0 million was recognized as a component of income tax expense in 1993. The effect on HL&P's deferred taxes for the change in the new law was $4.5 million in 1993. HL&P's current and deferred components of income tax expense are as follows: HL&P's effective income tax rates are lower than statutory corporate rates for each year as follows: Following are HL&P's tax effects of temporary differences resulting in deferred tax assets and liabilities: (20) UNAUDITED QUARTERLY INFORMATION The following unaudited quarterly financial information includes, in the opinion of management, all adjustments (which comprise only normal recurring accruals) necessary for a fair presentation. Quarterly results are not necessarily indicative of a full year's operations because of seasonality and other factors, including rate increases and variations in operating expense patterns. (a) Adjustment required to restate quarterly amounts for the merging of Utility Fuels into HL&P. (See Note 1(b)) (b) Amounts include the effect of a pre-tax charge of $86.4 million which relates to HL&P's restructuring of operations as a result of the implementation of the STEP program and pre-tax income of $142.7 million associated with the adoption of a change in accounting principle reflecting a change in the timing of recognition of revenue from electricity sales. (see Notes 18 and 19, respectively). (23) PRINCIPAL AFFILIATE TRANSACTIONS (a) Included in Operating Expenses (b) Included in Other Income (Expense) During 1992 and 1991, Houston Industries Finance purchased accounts receivable of HL&P. In January 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries and ceased operations. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to an unaffiliated third party. INDEPENDENT AUDITORS' REPORT HOUSTON INDUSTRIES INCORPORATED We have audited the accompanying consolidated balance sheets and the consolidated statements of capitalization of Houston Industries Incorporated and its subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated income, consolidated retained earnings and consolidated cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the Company's financial statement schedules listed in Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company and its subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 19 to the consolidated financial statements, the Company changed its method of accounting for revenues in 1992. DELOITTE & TOUCHE Houston, Texas February 23, 1994 INDEPENDENT AUDITORS' REPORT HOUSTON LIGHTING & POWER COMPANY We have audited the accompanying balance sheets and the statements of capitalization of Houston Lighting & Power Company (HL&P) as of December 31, 1993 and 1992 and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules of HL&P listed in Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of HL&P's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of HL&P at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the financial statements, Utility Fuels, Inc., HL&P's coal supply affiliate, was merged into HL&P in 1993. The merger has been accounted for in a manner similar to a pooling of interests with restatement of all years presented. As discussed in Note 19 to the financial statements, HL&P changed its method of accounting for revenues in 1992. DELOITTE & TOUCHE Houston, Texas February 23, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY AND HL&P. (a) The Company The information called for by Item 10, to the extent not set forth under Item 1 "Business - Executive Officers of the Company", is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 10 is incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P The information set forth under Item 1. "Business - Executive Officers of HL&P" is incorporated herein by reference. Each member of the board of directors of HL&P is also a member of the board of directors of the Company. Each member of the board of directors of HL&P is elected annually for a one-year term. The HL&P annual shareholder's meeting, at which the Company elects members to the HL&P board of directors, is expected to occur on May 4, 1994. Information is set forth below with respect to the business experience for the last five years of each person who currently serves as a member of the board of directors of HL&P, certain other directorships held by each such person and certain other information. Unless otherwise indicated, each person has had the same principal occupation for at least five years. MILTON CARROLL, age 43, has been a director since 1992. He is Chairman, President and Chief Executive Officer of Instrument Products Inc., an oil field supply manufacturing company, in Houston, Texas. Mr. Carroll currently serves as an advisor to Lazard Freres & Co., an investment banking firm, and is a director of Panhandle Eastern Corporation and the Federal Reserve Bank of Dallas. JOHN T. CATER, age 58, has been a director since 1983. Mr. Cater is Chairman, Chief Executive Officer and a director of River Oaks Trust Company in Houston, Texas. He also serves as President and director of Compass Bank-Houston. Until his retirement in July 1990, Mr. Cater served as President, Chief Operating Officer and a director of MCorp, a Texas bank holding company. He currently serves as a director of MCorp.(1) ROBERT J. CRUIKSHANK, age 63, has been a director since 1993. Mr. Cruikshank is primarily engaged in managing his personal investments in Houston, Texas. Prior to his retirement in 1993, Mr. Cruikshank was a Senior Partner in the accounting firm of Deloitte & Touche. Mr. Cruikshank is also Vice-Chairman of the Board of Regents of the University of Texas System. He also serves as a director of MAXXAM Inc., Compass Bank and Texas Biotechnology Corporation. LINNET F. DEILY, age 48, has been a director since 1993. Ms. Deily is Chairman, Chief Executive Officer and President of First Interstate Bank of Texas, N.A. She has served as Chairman since 1992, Chief Executive Officer since 1991 and President since 1988. (2) JOSEPH M. HENDRIE, PH.D., age 68, has been a director since 1985. Dr. Hendrie is a Consulting Engineer in Bellport, New York, having previously served as Chairman and Commissioner of the U.S. Nuclear Regulatory Commission and as President of the American Nuclear Society. He is also a director of Entergy Operations, Inc. of Jackson, Mississippi. HOWARD W. HORNE, age 67, has been a director since 1978. Mr. Horne is Vice Chairman of Cushman & Wakefield of Texas, Inc., a subsidiary of a national real estate brokerage firm. Until 1990, Mr. Horne was Chairman of the Board of The Horne Company, a realty firm. (3) DON D. JORDAN, age 61, has been a director of the Company since 1977 and of HL&P since 1974. Mr. Jordan is Chairman and Chief Executive Officer of the Company and Chairman and Chief Executive Officer of HL&P. Mr. Jordan also serves as a director of Texas Commerce Bancshares, Inc. and BJ Services Company, Inc. THOMAS B. MCDADE, age 70, has been a director since 1980. Mr. McDade is primarily engaged in managing his personal investments in Houston, Texas. Mr. McDade also serves as a director and trustee of eleven registered investment companies for which Transamerica Fund Management Company serves as investment advisor. (4) ALEXANDER F. SCHILT, PH.D., age 53, has been a director since 1992. He is Chancellor of the University of Houston System. Prior to 1990, Dr. Schilt was President of Eastern Washington University in Cheney and Spokane, Washington. KENNETH L. SCHNITZER, SR., age 64, has been a director since 1983. Mr. Schnitzer is Chairman of the Board of Schnitzer Enterprises, Inc., a Houston commercial real estate development company, having previously served as a director of American Building Maintenance Industries Incorporated and Weingarten Realty, Inc. (5) DON D. SYKORA, age 63, has been a director since 1982. Mr. Sykora is President and Chief Operating Officer of the Company. He also serves as a director of Powell Industries, Inc., Pool Energy Services Company, Inc. and TransTexas Gas Corporation. JACK T. TROTTER, age 67, has been a director since 1985. Mr. Trotter is primarily engaged in managing his personal investments in Houston, Texas. He also serves as a director of First Interstate Bank of Texas, N.A., Howell Corporation, Weingarten Realty Investors, Zapata Corporation and Continental Airlines, Inc. BERTRAM WOLFE, PH.D., age 66, has been a director since 1993. Prior to his retirement in 1992, Dr. Wolfe was Vice President and General Manager of General Electric Company's nuclear energy business in San Jose, California. - ----------------- (1) In March 1989, the FDIC declared 20 of MCorp's 25 banks to be insolvent and transferred their assets and deposits to another bank. In 1989, MCorp filed for protection under the Federal Bankruptcy Code. (2) First Interstate and certain of its affiliates participate in various credit facilities with HL&P, the Company and certain of HL&P's affiliates and other entities in which the Company has an ownership interest. Under these agreements, First Interstate and certain of its affiliates have maximum aggregate loans and commitments to lend approximately $81.24 million. (3) Under a consulting arrangement originally with Mr. Horne which was subsequently amended to be an agreement with Cushman & Wakefield of which Mr. Horne is Vice Chairman, Cushman & Wakefield represented the Company in negotiations concerning the purchase of an office building in 1993, for which that firm was paid $358,000 by the Company and $78,000 by the seller of the building. (4) Mr. McDade is expected to retire at the date of the Company's 1994 annual meeting of shareholders. (5) HL&P and certain of its affiliates currently lease office space in buildings owned or controlled by affiliates of Mr. Schnitzer. HL&P and certain of its affiliates paid a total of approximately $5.4 million to affiliates of Mr. Schnitzer during 1993, and it is expected that approximately $5.6 million will be paid in 1994. HL&P believes such payments are comparable to those that would have been made to other non-affiliated firms for comparable facilities and services. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. (a) The Company The information called for by Item 11 is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 11 (excluding any information required by paragraphs (i), (k) and (l) of Item 402 of Regulation S-K) are incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P SUMMARY COMPENSATION TABLE. The following table shows, for the years ended December 31, 1991, 1992 and 1993, the annual, long-term and certain other compensation of the chief executive officer and the other four most highly compensated executive officers of HL&P including Mr. Hall who retired effective January 1, 1994 (Named Officers). The format and information presented are as prescribed in revised rules of the Securities and Exchange Commission (SEC) and in accordance with transitional provisions of the rules, information in the "All Other Compensation" column is not presented for 1991. SUMMARY COMPENSATION TABLE - ----------------- (1) The amounts shown include salary earned and received by the Named Officers as well as salary earned but deferred. Also included are board of director and committee fees paid in 1991 prior to the time such fees were eliminated for employee directors. (2) The amount of bonus earned for 1993 has not been determined because it was not calculable as of the date of this Report. In accordance with the SEC's revised rules on executive compensation, these amounts will be included for such year in HL&P's Annual Report on Form 10-K for the year ended December 31, 1994. (3) The amounts shown represent (i) cash paid in 1991 and 1992 under the Company's executive incentive compensation plan for long-term awards based on the performance periods of 1987-1990 and 1988-1991 respectively and (ii) the dollar value of shares of the Company's common stock paid out in 1993 under the Company's long-term incentive compensation plans based on the achievement of certain performance objectives for the 1990-1992 performance cycle, plus dividend equivalent accruals during the performance period. (4) The amounts shown include (i) Company contributions to the Company's savings plan and accruals under its savings restoration plan for 1992 and 1993 on behalf of the Named Officers, as follows: Mr. Jordan 1992 - $41,348 and 1993 - $57,152; Mr. Kelly 1992 - $26,141 and 1993 - $19,569; Mr. Letbetter 1992 - $20,225 and 1993 - $16,672; Mr. Hall 1992 - $14,005 and 1993 - $16,933; and Mr. Greenwade 1992 - $16,898 and 1993 - $14,128 and (ii) the portion of accrued interest on amounts of compensation deferred under the Company's deferred compensation plan and executive incentive compensation plan that exceeds 120% of the applicable federal long-term rate provided under Section 1274(d) of the Internal Revenue Code, as follows: Mr. Jordan 1992 - $501,856 and 1993 - $590,339; Mr. Kelly 1992 - $39,125 and 1993 - $38,649; Mr. Letbetter 1992 - $24,588 and 1993 - $25,890; Mr. Hall 1992 - $1,664 and 1993 - $1,128; and Mr. Greenwade 1992 - $21,286 and 1993 - $22,658. With respect to the accrued interest on deferred amounts referenced in (ii) of this footnote, the Company owns and is the beneficiary under life insurance policies, and it is currently anticipated that the benefits associated with these policies will be sufficient to cover such accumulated interest. (5) The information related to Mr. Jordan includes his compensation as Chairman and Chief Executive Officer of the Company. STOCK OPTION GRANTS. The following table contains information concerning the grant of stock options under the Company's long-term incentive compensation plan to the Named Officers during 1993. OPTION GRANTS IN 1993 - ----------------- (1) The nonstatutory options for shares of the Company's common stock included in the table were granted on January 4, 1993, have a ten-year term and generally become exercisable in one-third increments commencing one year after date of grant, so long as employment with the Company or its subsidiaries continues. If a change in control (as defined in the plan) of the Company occurs before the options become exercisable, the options will become immediately exercisable. (2) Based on the Black-Scholes option pricing model adjusted for the payment of dividends. The calculations were made based on the following assumptions: volatility equal to historical volatility of the Company's common stock in the six-month period prior to grant date; risk-free interest rate equal to the ten-year average monthly U.S. Treasury rate for January 1993; option strike price equal to current stock price on the date of grant ($46.25); current dividend rate of $3 per share per year; and option term equal to the full ten-year period until the stated expiration date. No reduction has been made in the valuations on account of non-transferability of the options or vesting or forfeiture provisions. Valuations would change if different assumptions were made. Option values are dependent on general market conditions and the performance of the Company's common stock. There can be no assurance that the values in this table will be realized. (3) Under the terms of the Company's long-term incentive compensation plans, Mr. Hall's retirement effective January 1, 1994 resulted in his receiving options for only 770 shares of the originally granted number of shares, and resulted in the forfeiture, for no value, of his options for 1,539 shares. Options expire one year after date of retirement; therefore, Mr. Hall's options expire January 1, 1995. STOCK OPTION VALUES. The following table sets forth information for each of the Named Officers with respect to the unexercised options to purchase the Company's common stock granted under the Company's long-term incentive compensation plans and held as of December 31, 1993, including the aggregate amount by which the market value of the option shares exceeds the exercise price of the option shares at December 31, 1993. No options were exercised by the Named Officers during 1993. 1993 YEAR-END OPTION VALUES - ----------------- (1) Based on the average of the high and low sales prices of the the Company's common stock on the composite tape, as reported by The Wall Street Journal for December 31, 1993. LONG-TERM INCENTIVE COMPENSATION PLANS The following table sets forth information concerning awards made during the year ended December 31, 1993 under the Company's long-term incentive compensation plans. The table represents potential payouts of awards for performance shares (target and opportunity shares) of Common Stock based on the achievement of certain performance goals over a performance cycle of three years. The performance goals are weighted differently depending on the parent or subsidiary company by which the Named Officer is employed. The consolidated performance goal applicable to each of the Named Officers is achieving a superior total return to shareholders in relation to a panel of other companies. With respect to Messrs. Letbetter, Hall and Greenwade, subsidiary performance goals consist of (1) increasing HL&P's competitive rate advantage by maintaining current base electric rates and (2) achieving a superior cash flow performance in relation to a panel of other companies. With respect to Messrs. Jordan and Kelly, subsidiary performance goals include all of the above as well as goals from the Company's other major subsidiary. Each of these goals has attainment levels ranging from 50% to 150% of the target amounts. Target amounts for awards will be earned if goals are achieved at the 100% level; threshold amounts if goals are achieved at the 50% level and maximum amounts if goals are achieved at the 150% level. If a change in control (as defined in the plan) of the Company occurs before the end of a performance cycle, the payouts of awards for performance shares will occur without regard to achievement of the performance goals. LONG-TERM INCENTIVE COMPENSATION PLANS - AWARDS IN 1993 - ----------------- (1) The table does not reflect dividend equivalent accruals during the performance period. (2) Under the terms of the Company's long-term incentive compensation plans, Mr. Hall's retirement effective January 1, 1994 resulted in his receiving a payout in January, 1994 of 799 shares, a pro-rated amount based on the number of days elapsed in the performance cycle. RETIREMENT PLANS, RELATED BENEFITS AND OTHER AGREEMENTS. The following table shows the estimated annual benefit payable under the Company's retirement plan, benefit restoration plan and, in certain cases, supplemental agreements, to officers in various compensation classifications upon retirement at age 65 after the indicated periods of service, determined on a single-life annuity basis. The amounts in the table are not subject to any deduction for Social Security payments or other offsetting amounts. PENSION PLAN TABLE NOTE: The qualified pension plan limits compensation in accordance with IRC 401(a)(17) and also limits benefits in accordance with IRC 415. Pension benefits based on compensation above the qualified plan limit or in excess of the limit on annual benefits are provided through the benefit restoration plan. For the purpose of the pension table above, final average annual compensation means the average of covered compensation for the 36 consecutive months out of the 120 consecutive months immediately preceding retirement in which the participant's covered compensation was the highest. Covered compensation only includes the amounts shown in the "Salary" and "Bonus" columns of the Summary Compensation Table. At December 31, 1993 the credited years of service and current covered compensation for the following persons are: Mr. Jordan, 35 years $1,360,768; Mr. Kelly, 19 years, 10 of which result from a supplemental agreement $465,939; Mr. Letbetter, 20 years $396,952 and Mr. Greenwade, 28 years $336,380. Mr. Hall , who retired effective January 1, 1994, does not participate in the Company's retirement plan, but under supplemental agreements, he receives a pension of $50,000 per year. Because bonus amounts for 1993 are not yet available, the foregoing covered compensation amounts are based in part on 1992 data. The Company maintains an executive benefits plan that provides certain salary continuation, disability and death benefits to key officers of the Company and certain of its subsidiaries. The Named Officers participate in this plan pursuant to individual agreements. The agreements generally provide for (1) a salary continuation benefit of 100% of the officer's current salary for twelve months after death during active employment and then 50% of salary for nine years or until the deceased officer would have attained age 65, if later, and (2) if the officer retires after attainment of age 65, an annual post-retirement death benefit of 50% of the officer's preretirement annual salary payable for six years. Effective in 1994, the Company authorized an executive life insurance plan providing for split-dollar life insurance to be maintained on the lives of certain officers and all members of the Board of Directors. Pursuant to the plan, the Personnel Committee has authorized the Company to obtain coverage for the Named Officers, except for Mr. Hall who has retired. The amounts of their coverages are not finalized, pending completion of arrangements with the insurance carrier and certain elections by participants, but are expected to range from approximately two times current salary to six times current salary, assuming single life coverage is elected. The death benefit for the Company's nonemployee directors is six times the annual retainer (assuming single life coverage is elected). The plan also provides that the Company may make payments to the covered individuals designed to compensate for tax consequences with respect to imputed income that they must recognize for federal income tax purposes based on the term portion of the annual premiums. If a covered executive retires at age 65 or at an earlier age under circumstances approved for this purpose by the Board of Directors, rights under the plan vest so that coverage is continued based on the same death benefit in effect at the time of retirement. Upon death, the Company will receive the balance of the insurance proceeds payable in excess of the specified death benefit which should in all cases be at least sufficient to cover the Company's cumulative outlays to pay premiums and the after-tax cost to the Company of the tax gross-up payments. COMPENSATION OF DIRECTORS. Each nonemployee director receives an annual retainer fee of $20,000, in his or her capacity as a director of the Company, and a fee of $1,000 for each board meeting attended and a fee of $700 for each committee meeting attended. Directors may defer all or a part of their annual retainer fees (minimum deferral $2,000) and meeting fees under the Company's deferred compensation plan. Nonemployee directors participate in a director benefits plan pursuant to which a director who serves at least one full year will receive an annual benefit in cash equal to the annual retainer payable in the year the director terminates service. Benefits under this plan will be payable to the director, commencing the January following the later of the director's termination of service or attainment of age 65, for a period equal to the number of full years of service of the director. Nonemployee directors also participate in the Company's executive life insurance plan effective January 1994, described above under "Retirement Plans, Related Benefits and Other Agreements," under which the Company purchases split dollar life insurance so as to provide each nonemployee director a death benefit equal to six times his or her annual retainer (assuming single life coverage is elected) with coverage continuing after termination of service as a director. This plan also permits the Company to provide for a tax gross-up payment to make the directors whole with respect to imputed income recognized with respect to the term portion of the annual insurance premiums. For a description of a consulting arrangement with Mr. Horne and a fee paid to a company of which he is Vice Chairman, see Note 3 to Item 10(b). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) The Company The information called for by Item 12 is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 12 is incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P As of the date of this Report, the Company owned 1,000 shares of HL&P's Class A common stock, without par value, and Houston Industries (Delaware) Incorporated owned 100 shares of HL&P's Class B common stock, constituting all of the issued and outstanding shares of Class B common stock of HL&P. The following table shows the beneficial ownership reported as of the date of this Report unless otherwise noted of shares of the Company's common stock, including shares as to which a right to acquire ownership exists (for example, through the exercise of stock options) within the meaning of Rule 13d-3(d)(1) under the Securities Exchange Act of 1934, of each current director, the chief executive officer and the four other most highly compensated executive officers of HL&P and, as a group, of such persons and other executive officers of HL&P. No person or member of the group listed owns any equity securities of HL&P or any other subsidiary of the Company. Unless otherwise indicated, each person or member of the group listed has sole voting and investment power with respect to the shares of Common Stock listed. No ownership shown in the table represents 1% or more of the outstanding shares of the Company's common stock. - ----------------- (1) Mr. Cater disclaims beneficial ownership of these shares, which are owned by his adult children. (2) Voting power and investment power with respect to the shares listed for Ms. Deily and Dr. Hendrie are shared with the respective spouse of each. (3) Mr. Hall's ownership is reported as of December 31, 1993; he retired effective January 1, 1994. (4) Includes shares held under the Company's dividend reinvestment plan as of December 31, 1993. (5) Voting power and investment power with respect to 576 of the shares listed are shared with Mr. Jordan's spouse. (6) Includes shares held under the savings plan of the Company or KBLCOM Incorporated as of December 31, 1993 (which plans merged January 1, 1994), as to which the participant has sole voting power (subject to such power being exercised by the plan's trustees in the same proportion as directed shares in the savings plans are voted in the event the participant does not exercise voting power). (7) The ownership shown in the table includes shares which may be acquired within 60 days on exercise of outstanding stock options granted under the Company's long-term incentive compensation plans by each of the persons and group, as follows: Mr. Jordan - 13,115 shares; Mr. Sykora - 6,994 shares; Mr. Kelly - 2,652 shares; Mr. Letbetter - 2,150 shares; Mr. Hall - 2,333 shares; Mr. Greenwade - 1,921 shares and the group - 31,976 shares. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. (a) The Company The information called for by Item 13 is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 13 is incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P The information set forth in Notes 2, 3 and 5 to Item 10(b) above is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. The following schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements: I, II, III, IV, VII, X, XI, XII and XIII. (a)(3) EXHIBITS. See Index of Exhibits on page 135, which also includes the management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(10)(iii) of Regulation S-K. (b) REPORTS ON FORM 8-K. None HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) Substantially all electric utility additions are originally charged to Construction Work in Progress and transferred to electric utility plant accounts upon completion. Additions at cost give effect to such transfers. (B) Additions at cost include noncash charges for AFUDC for HL&P and capitalized interest for other subsidiaries. (C) Depreciation is computed using the straight-line method. The depreciation provisions as a percentage of the depreciable cost of plant were 3.4%, for 1993, 1992 and 1991. (D) Other changes to Plant Held for Future Use in 1993 and 1992 represent the deduction of $7.0 million and $84.1 million, respectively, of recoverable costs related to Malakoff. (E) 1992 and 1991 have been adjusted to reflect reclassifications due to the merger of Utility Fuels into HL&P. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED PROVISION FOR DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) __________________________ Notes: (1) 1992 and 1991 have been adjusted to reflect reclassifications due to the merger of Utility Fuels into HL&P. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE VIII - RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) Deductions from reserves represent losses or expenses for which the respective reserves were created. In the case of the uncollectible accounts reserve, such deductions are net of recoveries of amounts previously written off. (B) During 1992 and 1991, Houston Industries Finance purchased accounts receivable of HL&P and of certain KBLCOM subsidiaries. In January 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries and ceased operations. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to a third party. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Note: The weighted average interest rate during the period is calculated by dividing interest by the weighted average proceeds from the borrowings. HOUSTON LIGHTING & POWER COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) 1992 and 1991 have been restated for the merger of Utility Fuels into HL&P. (B) Other Changes in Plant Held for Future Use in 1993 and 1992 represent the deduction of recoverable costs of $7.0 million and $84.1 million, respectively, of recoverable costs related to Malakoff. (C) Substantially all additions are originally charged to Construction Work In Progress and transferred to electric utility plant accounts upon completion. Additions at cost give effect to such transfers. (D) Additions at cost include non-cash charges for an allowance for funds used during construction. (E) HL&P computes depreciation using the straight-line method. The depreciation provisions as a percentage of the average depreciable cost of plant was 3.1% for 1993, 3.2% for 1992 and 1991. HOUSTON LIGHTING & POWER COMPANY SCHEDULE VI - ACCUMULATED PROVISION FOR DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________________ Notes: (1) 1992 and 1991 have been restated for the merger of Utility Fuels into HL&P. HOUSTON LIGHTING & POWER COMPANY SCHEDULE VIII - RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) Deductions from reserves represent losses or expenses for which the respective reserves were created. (B) HL&P has no reserves for uncollectible accounts due to sales of accounts receivable. HOUSTON LIGHTING & POWER COMPANY SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Note: (A) The Balance at End of Period excludes $19 million in notes payable to the Company as of December 31, 1992. (B) The weighted average interest rate is calculated by dividing interest by the weighted average proceeds from the borrowings. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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, IN THE CITY OF HOUSTON AND STATE OF TEXAS, ON THE 10TH DAY OF MARCH, 1994. HOUSTON INDUSTRIES INCORPORATED (Registrant) By DON D. JORDAN (Don D. Jordan, Chairman and Chief Executive Officer) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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, IN THE CITY OF HOUSTON AND STATE OF TEXAS, ON THE 10TH DAY OF MARCH, 1994. THE SIGNATURE OF HOUSTON LIGHTING & POWER COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. HOUSTON LIGHTING & POWER COMPANY (Registrant) By DON D. JORDAN (Don D. Jordan, Chairman and Chief Executive Officer) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO HOUSTON LIGHTING & POWER COMPANY AND ANY SUBSIDIARIES THEREOF. HOUSTON INDUSTRIES INCORPORATED HOUSTON LIGHTING & POWER COMPANY EXHIBITS TO THE ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 INDEX OF EXHIBITS Exhibits not incorporated by reference to a prior filing are designated by a cross (+); all exhibits not so designated are incorporated herein by reference to a prior filing as indicated. Exhibits designated by an asterisk (*) are management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(10)(iii) of Regulation S-K. (a) Houston Industries Incorporated Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, the Company has not filed as exhibits to this Form 10-K certain long-term debt instruments, under which the total amount of securities authorized do not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. (b) Houston Lighting & Power Company +4(a)(8) Sixty-First through Sixty-Third Supplemental Indentures to HL&P Mortgage and Deed of Trust There have not been filed as exhibits to this Form 10-K certain long-term debt instruments, including indentures, under which the total amount of securities do not exceed 10% of the total assets of HL&P. HL&P hereby agrees to furnish a copy of any such instrument to the SEC upon request.

893928_1993.txt

893928_1993

1993

893928

Item 1. Business BUSINESS OF ENTERGY General Entergy Corporation was originally incorporated under the laws of the State of Florida on May 27, 1949. On December 31, 1993, in connection with the Merger (see "Entergy Corporation-GSU Merger," below), Entergy Corporation merged with and into Entergy-GSU Holdings, Inc., a Delaware corporation (Holdings), and Holdings was renamed Entergy Corporation. Entergy Corporation is a holding company registered under the Holding Company Act and does not own or operate any physical properties. Entergy Corporation owns all of the outstanding common stock of five retail operating electric utility subsidiaries, AP&L, GSU, LP&L, MP&L, and NOPSI. AP&L was incorporated under the laws of the State of Arkansas in 1926; GSU was incorporated under the laws of the State of Texas in 1925; LP&L and NOPSI were incorporated under the laws of the State of Louisiana in 1974 and 1926, respectively; and MP&L was incorporated under the laws of the State of Mississippi in 1963. As of December 31, 1993, these operating companies provided electric service to approximately 2.3 million customers in the States of Arkansas, Louisiana, Mississippi, Missouri, and Texas. In addition, GSU furnished gas service in the Baton Rouge, Louisiana area, and NOPSI furnished gas service in the City of New Orleans. GSU's steam products department produces and sells, on an unregulated basis, process steam and by- product electricity supplied from its steam electric extraction plant to a large industrial customer. The business of the System is subject to seasonal fluctuations with the peak period occurring during the third quarter. During 1993, the System's (excluding GSU) electricity sales as a percentage of total System energy sales were: residential - 28.1%; commercial - 19.9%; and industrial - 36.9%. Electric revenues from these sectors as a percentage of total System electric revenues were: 36.3% - residential; 24.4% - commercial; and 27.3% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of energy sales. During 1993, GSU's electric department sales as a percentage of total GSU energy sales were: residential - 25.5%; commercial - 20.3%; and industrial - 50.8%. Electric revenues from these sectors as a percentage of total GSU electric revenues were: 33.5% - residential; 23.8% - commercial; and 37.2% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of GSU's energy sales. The System's major industrial customers are in the chemical processing, petroleum refining, paper products, and food products industries. Entergy Corporation also owns all of the outstanding common stock of System Energy, Entergy Services, Entergy Operations, Entergy Power, and Entergy Enterprises. System Energy is a nuclear generating company that was incorporated under the laws of the State of Arkansas in 1974. System Energy sells the capacity and energy at wholesale from its 90% interest in Grand Gulf 1 to its only customers, AP&L, LP&L, MP&L, and NOPSI (see "Capital Requirements and Future Financing - - Certain System Financial and Support Agreements - Unit Power Sales Agreement," below). System Energy has approximately a 78.5% ownership interest and an 11.5% leasehold interest in Grand Gulf 1. Entergy Services provides general executive and advisory services, and accounting, engineering, and other technical services to certain of the System companies, generally at cost. Entergy Operations is a nuclear management company that operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. Entergy Power, an independent power producer, owns 809 MW of generating capacity and markets its capacity and energy in the wholesale market outside Arkansas and Missouri and in markets not otherwise presently served by the System. (For further information on regulatory proceedings related to Entergy Power, see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," below). Entergy Enterprises is a nonutility company that invests in businesses whose products and activities are of benefit to the System's utility business (see "Corporate Development," below). Entergy Enterprises also markets technical expertise developed by the System companies when it is not required in the System's operations. Entergy Enterprises has received SEC approval to provide services to certain nonutility companies in the System. In 1992 and 1993, several new Entergy Corporation subsidiaries were formed to participate in utility projects located outside the System's retail service territory, both domestically and in foreign countries (see "Corporate Development," below). AP&L, LP&L, MP&L, and NOPSI own, in ownership percentages of 35%, 33%, 19%, and 13%, respectively, all of the common stock of System Fuels, a non-profit subsidiary, that implements and/or maintains certain programs to procure, deliver, and store fuel supplies for the System. GSU has four wholly-owned subsidiaries: Varibus Corporation, GSG&T, Inc., Southern Gulf Railway Company, and Prudential Oil & Gas, Inc. Varibus Corporation operates intrastate gas pipelines in Louisiana, which are used primarily to transport fuel to two of GSU's generating stations, and has marketed computer-aided engineering and drafting technologies and related computer equipment and services. GSG&T, Inc. owns the Lewis Creek Station, a 532 MW (as of December 31, 1993) gas-fired generating plant, which is leased and operated by GSU. Southern Gulf Railway Company will own and operate several miles of rail track being constructed in Louisiana for the purpose of transporting coal for use as a boiler fuel at Nelson Unit 6. Prudential Oil & Gas, Inc., which was formerly in the business of exploring, developing, and operating oil and gas properties in Texas and Louisiana, is presently inactive. Entergy Corporation-GSU Merger On December 31, 1993, Entergy Corporation consummated its acquisition of GSU. Entergy Corporation merged with and into Holdings, and Holdings was renamed Entergy Corporation. GSU became a wholly-owned subsidiary of Entergy Corporation and continues to operate as a public utility under the regulation of the PUCT and the LPSC. As consideration to GSU's shareholders, Entergy Corporation paid $250 million in cash and issued 56,667,726 shares of its common stock at a price of $35.8417 per share, in exchange for outstanding shares of GSU common stock. In addition, $33.5 million of transaction costs were capitalized in connection with the Merger. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," for, information on requests for rehearing and appeals of certain regulatory approvals of the Merger. The information contained in this Form 10-K is filed on behalf of all the registrants of Entergy, including GSU. Unless otherwise noted, consolidated financial and statistical information contained in this report that is stated as of December 31, 1993 (such as assets, liabilities, and property), includes the associated GSU amounts, and consolidated financial and statistical information for periods ending before January 1, 1994 (such as revenues, sales, and expenses), does not include GSU amounts; those amounts are presented separately for GSU herein. Certain Industry and System Challenges The System's business is affected by various challenges and issues including those that confront the electric utility industry in general. These issues and challenges include: - an increasingly competitive environment (see "Competition," below); - compliance with regulatory requirements with respect to nuclear operations (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry," below) and environmental matters (see "Rate Matters and Regulation - Regulation - Environmental Regulation," below); - adaptation to structural changes in the electric utility industry, including increased emphasis on least cost planning and changes in the regulation of generation and transmission of electricity (see "Competition - General" and "Competition - Least Cost Planning," below); - continued cost management (particularly in the area of operation and maintenance costs at nuclear units) to improve financial results and to delay or to minimize the need for rate increase requests in light of current rate freezes and rate caps at the System operating companies (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below); - integrating GSU into the System's operations and achieving cost savings (see "Entergy Corporation-GSU Merger," above); - achieving enhanced earnings in light of lower returns and slow growth in the domestic utility business (see "Corporate Development," below); and - resolving GSU's major contingencies, including potential write- offs and refunds related to River Bend (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU," below) and litigation with Cajun relating to its ownership interest in River Bend (see "Rate Matters and Regulation - Regulation - Other Regulation and Litigation - GSU," below). Corporate Development Entergy continues to consider new opportunities to expand its regulated electric utility business, as well as to expand into utility and utility-related businesses that are not regulated by state and local regulatory authorities (nonregulated businesses). Investments in nonregulated businesses are likely to draw upon the System's skills in power generation and customer service as well as its strengths in the fuels area. Entergy Corporation's investment strategy with respect to nonregulated businesses is to invest in nonregulated business opportunities wherein Entergy Corporation has the potential to earn a greater rate of return compared to its regulated utility operations. Entergy Corporation's nonregulated businesses fall into two broad categories: overseas power development and new electro- technologies. Entergy Corporation has made investments in Argentina's electric energy infrastructure, as described below, and is pursuing additional projects in Central America, South America, South Africa, and Asia. Entergy Corporation will also open offices in Buenos Aires, Argentina and Hong Kong in 1994. In addition, Entergy Corporation is seeking to provide telecommunications services based upon its experience with interactive communications systems that allow customers to control energy usage. Entergy Corporation expects to invest approximately $150 million per year in nonregulated businesses. Current investments in nonregulated businesses include the following: (1) Entergy Corporation's subsidiary, Entergy Power Development Corporation (an EWG under the provisions of the Energy Act), through its subsidiary (which is also an EWG) Entergy Richmond Power Corporation, owns a 50% interest in an independent power plant in Richmond, Virginia. The power plant is jointly-owned and operated by the Enron Power Corporation, a developer of independent power projects. The plant owners have a 25-year contract to sell electricity to Virginia Electric & Power Company. Entergy Corporation's investment in the project totals approximately $12.5 million. (2) Entergy Enterprises has a 9.95% equity interest in First Pacific Networks, Inc. (FPN), a communications company, and a license from FPN in connection with utility applications, being jointly developed by Entergy Enterprises and FPN, for FPN's patented communications technology. Entergy Enterprises' investment in FPN is approximately $20.1 million, of which $9.7 million is equity investment. (3) Entergy Enterprises' subsidiary, Entergy Systems and Service, Inc. (Entergy SASI), holds a 9.95% equity interest in Systems and Service International, Inc. (SASI), a manufacturer of efficient lighting products. This subsidiary also made a loan to SASI, acquired the business and assets of SASI's distribution subsidiary, and entered into an agreement to distribute SASI's products. Entergy Enterprises' initial investment in this business was approximately $11 million (of which $2.3 million is invested in SASI common stock). Entergy Corporation has provided to Entergy SASI $6.0 million in loans, as of December 31, 1993, to fund Entergy SASI's installment sale agreements with its customers. (4) Entergy Corporation's subsidiary, Entergy, S.A., participated in a consortium with other nonaffiliated companies that acquired a 60% interest in Argentina's Costanera steam electric generating facility consisting of seven natural gas- and oil-fired generating units, with a total installed capacity of 1,260 MW. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $11 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $22.5 million. (5) In January 1993, Entergy Corporation, through a new subsidiary, Entergy Argentina, S.A., participated in a consortium with other nonaffiliated companies that acquired a 51% interest in a foreign electric distribution company providing service to Buenos Aires, Argentina. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $58 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $77.5 million. (6) In July 1993, Entergy Corporation, through a new subsidiary, Entergy Transener, S.A., participated in a consortium with other nonaffiliated companies that acquired a 65% interest in a foreign transmission system providing service in the country of Argentina. Entergy Corporation's initial investment to acquire its 15% interest in the consortium was $18.5 million. In the near term, these investments are likely to have a minimal effect on earnings; but the possibility exists that they could contribute to future earnings growth. However, due to the absence of an allowed rate of return, these investments involve a higher degree of risk. International operations are subject to certain risks that are inherent in conducting business abroad, including possible nationalization or expropriation, price and exchange controls, limitations on foreign participation in local governmental enterprises, and other restrictive actions. Changes in the relative value of currencies take place from time to time and their effects may be favorable or unfavorable on results of operations. In addition, there are exchange control restrictions in certain countries relating to repatriation of earnings. Selected Data Selected customer and sales data for 1993 are summarized in the following tables: 1993 - Selected Customer Data Customers as of December 31, 1993 ------------------ Area Served Electric Gas ----------- -------- --- AP&L Portions of State of Arkansas 590,862 - GSU Portions of the States of Texas 593,975 85,040 and Louisiana LP&L Portions of State of Louisiana 599,991 - MP&L Portions of State of Mississippi 361,692 - NOPSI City of New Orleans, except Algiers, is provided electric service by LP&L 190,613 154,251 --------- ------- System 2,337,133 239,291 ========= ======= NOPSI sold 17,437,292 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were material for NOPSI, but not material for the System (see "Industry Segments," below, for a description of NOPSI's business segments). GSU sold 6,786,794 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were not material for GSU. See "Entergy Corporation and Subsidiaries Selected Financial Data - - Five-Year Comparison," "AP&L Selected Financial Data - Five-Year Comparison," "GSU Selected Financial Data - Five-Year Comparison," "LP&L Selected Financial Data - Five-Year Comparison," "MP&L Selected Financial Data - Five-Year Comparison," "NOPSI Selected Financial Data - - Five-Year Comparison," and "System Energy Selected Financial Data - Five-Year Comparison," (which follow each company's notes to financial statements herein) incorporated herein by reference, for further information with respect to operating statistics of the System and of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively. Employees As of December 31, 1993, Entergy had 16,679 employees as follows: Full-time: Entergy Corporation 6 AP&L 2,557 GSU (1) 4,765 LP&L 1,727 MP&L 1,236 NOPSI 716 System Energy - Entergy Operations 3,508 Entergy Services (2) 1,986 Other Subsidiaries 24 ------ Total Full-time 16,525 Part-time 154 ------ Total Entergy System 16,679 ====== __________________ (1) As of December 31, 1993, GSU had not been functionally aligned into Entergy. In December 1993, GSU recorded $17 million for an announced early retirement program in connection with the Merger. Of the 503 employees eligible, 369 employees elected to participate in the program. (2) As a result of System realignment of operations along functional lines, certain employees of AP&L, LP&L, MP&L, and NOPSI transferred to Entergy Services during 1993. Competition General. Entergy and the electric utility industry are experiencing increased competitive pressures both in the retail and wholesale markets. The economic, social, and political forces behind these competitive pressures are numerous and complex. They include legislative and regulatory changes, technological advances, consumer demands, greater availability of natural gas, environmental needs, and others. Entergy looks at these competitive pressures both as opportunities to compete for new customers and as risks for loss of customers. On October 24, 1992, Congress passed the Energy Act. The Energy Act addresses a wide range of energy issues and alters the way Entergy and the rest of the electric utility industry will operate in the future. The Energy Act creates exemptions from regulation under the Holding Company Act and creates a class of EWG's consisting of utility affiliates and nonutilities that are owners and operators of facilities for the generation and transmission of power for sales at wholesale. These exemptions offer an incentive for Entergy to participate in the development of wholesale power generation. In addition, the Holding Company Act has been amended to allow utilities to compete on a global scale with foreign entities to own and operate generation, transmission, and distribution facilities. The Energy Act also gives FERC the authority to order investor-owned utilities, including the System operating companies, to transmit power and energy to or for wholesale purchasers and sellers. The law creates the potential for electric utilities and other power producers to gain increased access to the transmission systems of other entities to facilitate wholesale sales. FERC may also require electric utilities to increase their transmission capacity to provide these services. The impact of this provision on the System operating companies should be lessened by their joint filing of open access transmission service tariffs with FERC in 1991 (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters," below). The Energy Act also amends PURPA by requiring states to consider (1) new regulatory standards that would require electric utilities to undertake integrated resource planning, and (2) allowing energy efficiency programs to be at least as profitable as new energy supply options. Entergy is unable to predict the ultimate impact the Energy Act will have on its operations. Wholesale Competition. Entergy has, like other utility systems, generating capacity (most of which is owned by Entergy Power) and energy available for a period of time for sale to other utility systems. The System is in competition with neighboring systems, as well as EWG's, to sell such capacity and energy. Given this competition, the ability of the System to sell this capacity and energy is limited. However, in 1993, the System sold 8,291 million KWH of energy (compared to 7,979 million KWH in 1992) to nonaffiliated utilities. The System also sold 1,234 MW of long-term capacity (compared to 1,048 MW in 1992) to nonaffiliated utilities outside of the System's service area. These capacity sales represent 8% of the System's net capability (excluding GSU) at year-end 1993. Under AP&L's and LP&L's Grand Gulf 1 rate orders, and under GSU's River Bend rate order in Louisiana, a portion of the capacity of Grand Gulf 1 and River Bend represents capacity that is available for sale, subject to regulatory approval, to nonaffiliated parties. In some cases, profits from such sales must be shared between ratepayers and shareholders. As discussed in "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Open Access Transmission," below, Entergy Power and the System operating companies will be permitted by FERC to make wholesale capacity sales in bulk power markets at rates based primarily upon negotiation and market conditions rather than cost of service. In order to receive authorization to make such sales, AP&L, LP&L, MP&L, and NOPSI also filed with FERC open access transmission service tariffs. FERC has approved this filing, subject to certain modifications. Revisions to the tariffs were filed in December 1993 to recognize GSU's inclusion in the Entergy System. When the modified tariffs are made effective, Entergy Power and the System operating companies may engage in sales at market prices. It is anticipated that these tariffs will enable any electric utility (as defined in such tariffs) to use Entergy 's integrated transmission system for the transmission of capacity and energy produced and sold by such electric utility or by third parties. Other similar open access transmission tariffs have also been filed with FERC for several large utility companies or systems and more open access transmission tariffs are anticipated. Concurrently, capacity resources are being developed and used to make wholesale sales from a range of non-traditional sources, including nonutility generators as well as cogenerators and small power producers qualifying under PURPA. These developments simultaneously produce increased marketing opportunities for utility systems such as Entergy and expose the System to loss of load or reduced sales revenues due to displacement of System sales by alternative suppliers with access to the System's primary areas of service. Entergy Power, which owns 809 MW of capacity, was formed to compete with other utilities and independent power producers in the bulk power market. As of December 31, 1993, Entergy Power has accumulated total losses from operations of $52.5 million. Entergy Power has entered into several long-term contracts for the sale of capacity and associated energy from its resources and has also made short-term capacity and energy sales. Entergy Power continues to actively market its capacity and energy in the bulk power market. (See "Corporate Development," above, for information with respect to a wholly-owned subsidiary of Entergy, Entergy Power Development Corporation, organized as an EWG to compete in the wholesale power market.) Retail Competition. Scheduled increases in the price of power sold by the System pursuant to the operation of phase-in plans (see "Rate Matters and Regulation - Rate matters - Retail Rate Matters," below) will affect the competitiveness of certain classes of industrial customers whose costs of production are energy-sensitive. Entergy is constantly working with these customers to address their concerns. It is the practice of the System operating companies to negotiate the renewal of contracts with large industrial customers prior to their expiration. In certain cases (particularly for GSU), contracts or special tariffs that use incentive pricing below total cost have been negotiated with industrial customers to keep these customers on the System. These contracts and tariffs have generally resulted in increased KWH sales at lower margins over incremental cost. While the System operating companies anticipate they will be successful in renegotiating such contracts, they cannot assure that they will be successful or that future revenues will not be lost to other forms of generation. To date, through these efforts, Entergy has been largely successful in retaining its industrial load. This competitive challenge could increase. Cogeneration is generally defined as the combined production of electricity and steam. Cogenerated power may be either sold by its producer to the local utility at its avoided cost under PURPA, or utilized by the cogenerator to displace purchases from the utility. To the extent that cogeneration is used by industrial customers to meet their own power requirements, the System may suffer loss of industrial load. Cogenerated power delivered to the System would be purchased at avoided cost, which for a number of years is expected to be equivalent to avoided energy cost, and as such, the cost of these purchases would not impact earnings. To date, only a few cogeneration facilities have been installed in areas served by the System, excluding GSU. The primary purpose of these facilities is to displace power that was purchased from the System. The economic advantage to the customer is generally due to the customer having waste products that can be used as fuel. Presently, the loss of load to cogeneration and the amount of cogenerated power delivered under PURPA to the System (excluding GSU) is not significant. The System is prepared to participate (subject to regulatory approval) in various phases of the design, construction, procurement, and ownership of cogeneration facilities. The System has entered into several cogeneration deferral agreements with certain of its retail customers, which give the System the right of first refusal to participate in any of such customers' cogeneration activities. Such participation could occur in the event there are individual customers whose long-term interests, along with Entergy's, can best be served by installing cogeneration facilities. No such participation has occurred to date, except by GSU. Existing qualifying facilities in the GSU service territory are estimated to total approximately 2,400 MW's or over 10% of Entergy's total owned and leased generating capability as of December 31, 1993. GSU currently believes that no significant load will be lost to cogeneration projects during the next several years; however, GSU is currently negotiating a contract with a large industrial customer, which is scheduled to expire in 1996. If the contract is not renewed, GSU would lose approximately $40 million in base revenues. Although GSU has competed in the past for various retail and wholesale customers, the System (excluding GSU) generally is not in direct competition with privately-owned or municipally-owned electric utilities for retail sales. However, a few municipalities distribute electricity within their corporate limits and some of these generate all or a portion of their requirements. A number of electric cooperative associations or corporations serve a substantial number of retail customers in or adjacent to areas served by the System . Sales of energy by the System to privately- or municipally-owned utilities amounted to approximately 4.6% of total System energy sales in 1993 (excluding GSU). Legislatures and regulatory commissions in several states have considered, or are considering, retail wheeling, which is the transmission by an electric utility of energy produced by another entity over the utility's transmission and distribution system to a retail customer in the electric utility's service territory. Retail wheeling would permit retail customers to elect to purchase electric capacity and/or energy from the electric utility in whose service area they are located or from any other electric utility or independent power producer. Retail wheeling is not currently required within the Entergy System service area. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," below for information on proceedings brought by Cajun seeking transmission access to certain of GSU's industrial customers. Least Cost Planning. The System continues to pursue least cost planning, also known as integrated resource planning, in order to compete more effectively in both retail and wholesale markets. Least cost planning is the development of strategies to add resources to meet future electricity demands reliably and at the lowest possible cost. The least cost planning process includes the study of electric supply- and demand-side options. The resultant plan uses demand-side options, such as changing customer consumption patterns, to limit electricity usage during times of peak demand, thus delaying the need for new capacity resources. Least cost planning offers the potential for the System to minimize customer costs, while providing an opportunity to earn a return. On December 1, 1992, AP&L, LP&L, MP&L, and NOPSI each filed a Least Cost Plan with its respective regulator, and on July 1, 1993, each company filed a near-term revision to such plan. Each Least Cost Plan details the resources that the System intends to use to provide reasonably priced, reliable electric service to its customers over the next 20 years. Such plan includes 925 MW of DSM resources, such as programs for efficient air conditioning and heating, high efficiency lighting, and CCLM. CCLM is the subject of recent Entergy proposals (filed, or to be filed, by AP&L, LP&L, MP&L, and NOPSI with their respective regulators) requesting the CCLM pilot be withdrawn from consideration in the existing Least Cost Plan dockets on the basis of a new proposal by Entergy to undertake the initial pilot development of CCLM at Entergy stockholder expense. To date, the Council and the LPSC are the only regulators that have addressed the proposal. The System expects to spend a total of approximately $800 million for DSM resources over the next 20 years. Such plan also includes significant resource additions, but does not contemplate construction of any generating facilities at new sites. All incremental supply-side resources will come from either delayed retirements or repowering of existing generating units. The System estimates that, over the next 20 years, least cost planning, if implemented in accordance with the terms of each filed Least Cost Plan, will reduce revenue requirements by approximately $2.3 billion ($600 million on a net present value basis), thereby avoiding the need for related rate increase requests. Each Least Cost Plan includes specific actions that the System will undertake pursuant to regulatory approval, including the recovery of costs associated with DSM (for further information, see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below). CAPITAL REQUIREMENTS AND FUTURE FINANCING Construction expenditures for the System are estimated to aggregate $586 million, $560 million, and $550 million for the years 1994, 1995, and 1996, respectively. No significant costs are expected in connection with the System's generating facilities. Actual construction costs may vary from these estimates because of a number of factors, including changes in load growth estimates, changes in environmental regulations, modifications to nuclear units to meet regulatory requirements, increasing costs of labor, equipment and materials, and cost of capital. Construction expenditures by company (including immaterial environmental expenditures and AFUDC, but excluding nuclear fuel and the impact of the ice storm that occurred in February 1994) for the period 1994-1996 are estimated as follows: 1994 1995 1996 Total ---- ---- ---- ----- (In Millions) AP&L $181 $172 $175 $528 GSU 134 128 119 381 LP&L 156 143 142 441 MP&L 61 63 63 187 NOPSI 26 26 26 78 System Energy 26 22 23 71 Entergy Power 2 6 2 10 System $586 $560 $550 $1,696 In addition to construction expenditure requirements, the estimated amounts required during 1994-1996 to meet scheduled long- term debt and preferred stock maturities and cash sinking fund requirements are: AP&L - $83 million; GSU - $214 million; LP&L - $158 million; MP&L - $212 million; NOPSI - $80 million; and System Energy - $615 million. A substantial portion of the above capital and refinancing requirements is expected to be satisfied from internally generated funds and cash on hand supplemented by the issuance of debt and preferred stock. Certain System companies may also continue with the acquisition or refinancing of all, or a portion of, certain outstanding series of preferred stock and long-term debt. In early February 1994, an ice storm left more than 221,000 Entergy customers without electric power across the System's four- state service area. The storm was the most severe natural disaster ever to affect the System, causing damage to transmission and distribution lines, equipment, poles, and facilities in certain areas, particularly in Mississippi. A substantial portion of the related costs, which are estimated to be $110 million - $140 million, are expected to be capitalized. The MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and the restoration of service resulting from such events. MP&L plans to immediately file for rate recovery of the costs related to the ice storm (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - MP&L," below). Entergy Corporation's current primary capital requirements are to periodically invest in, or make loans to, its subsidiaries. Entergy Corporation has SEC authorization to make additional investments in Entergy Power, Entergy S.A., Entergy Argentina, S.A., Entergy Transener, S.A., Entergy SASI, and FPN. Entergy Corporation expects to meet these requirements in 1994-1996 with internally generated funds and cash on hand. Entergy receives funds through dividend payments from its subsidiaries. Certain restrictions may limit the amount of these distributions. See Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, Note 2, "Rate and Regulatory Matters" and Note 8, "Commitments and Contingencies," incorporated herein by reference, regarding River Bend rate appeals and pending litigation with Cajun. Substantial write- offs or charges resulting from adverse rulings in these matters could adversely affect GSU's ability to continue to pay dividends. Entergy Corporation continues to consider new opportunities to expand its electric energy business, including expansion into related nonregulated businesses. Entergy Corporation expects to invest up to approximately $150 million per year over the next three years in nonregulated business opportunities. Entergy Corporation may finance any such expansion with cash on hand. Further, shareholder and/or regulatory approvals may be required for such acquisitions to take place. Also, Entergy Corporation has SEC authorization to repurchase shares of its outstanding common stock. Market conditions and board authorization determine the amount of repurchases. Entergy Corporation has requested SEC authorization for a $300 million bank line of credit, the proceeds of which are expected to be used for common stock repurchases and other optional activities. (For further information on the capital and refinancing requirements, capital resources, and short-term borrowing arrangements of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively, refer in each case to AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," Note 4 of AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's Notes to Financial Statements, "Lines of Credit and Related Borrowings," Note 5 of AP&L's and NOPSI's Notes to Financial Statements, "Preferred Stock", Note 5 of GSU's Notes to Financial Statements, "Preferred, Preference and Common Stock", Note 5 of LP&L's and MP&L's Notes to Financial Statements, "Preferred and Common Stock," Note 6 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 5 of System Energy's Notes to Financial Statements, "Long-Term Debt," and Note 8 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Capital Requirements and Financing," each incorporated herein by reference. For further information concerning Entergy Corporation's capital requirements and resources, refer to Entergy Corporation and Subsidiaries' "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," and Note 4 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Lines of Credit and Related Borrowings," incorporated herein by reference. For further information on the subsequent event, see Note 12 of AP&L's and Note 11 of MP&L's Notes to Financial Statements, "Subsequent Event (Unaudited)," incorporated herein by reference.) Certain System Financial and Support Agreements Unit Power Sales Agreement. The Unit Power Sales Agreement allocates capacity and energy from System Energy's 90% ownership and leasehold interest in Grand Gulf 1 (and the costs related thereto) to AP&L (36%), LP&L (14%), MP&L (33%), and NOPSI (17%). AP&L, LP&L, MP&L, and NOPSI pay rates to System Energy for their respective entitlements of capacity and energy on a full cost-of-service basis regardless of the quantity of energy delivered, so long as Grand Gulf 1 remains in commercial operation. Payments under the Unit Power Sales Agreement are System Energy's only source of operating revenues. The financial condition of System Energy depends upon the continued commercial operation of Grand Gulf 1 and upon the receipt of payments from AP&L, LP&L, MP&L, and NOPSI. (See "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Energy," below for further information with respect to proceedings relating to the Unit Power Sales Agreement.) Availability Agreement. The Availability Agreement was entered into among System Energy and AP&L, LP&L, MP&L, and NOPSI in 1974 in connection with the financing by System Energy of the Grand Gulf Station. The agreement provided that System Energy would join in the agreement among AP&L, LP&L, MP&L, and NOPSI for the sharing of generating capacity and other capacity and energy resources on or before the date on which Grand Gulf 1 was placed in commercial operation. It also provided that System Energy would make available to AP&L, LP&L, MP&L, and NOPSI all capacity and energy available from System Energy's share of the Grand Gulf Station. System Energy and AP&L, LP&L, MP&L, and NOPSI further agreed that if this agreement were terminated, or if any of the parties thereto withdrew from it, then System Energy would enter into a separate agreement with all of such parties or the withdrawing party, as the case may be, with respect to the purchase of capacity and energy on the same terms as if this agreement were still controlling. AP&L, LP&L, MP&L, and NOPSI also agreed severally to pay System Energy monthly for the right to receive capacity and energy available from the Grand Gulf Station in amounts that (when added to any amounts received by System Energy under the Unit Power Sales Agreement, or otherwise) would be at least equal to System Energy's total operating expenses for the Grand Gulf Station (including depreciation at a specified rate) and interest charges. As amended to date, the Availability Agreement provides that: - the obligation of AP&L, LP&L, MP&L, and NOPSI for payments for Grand Gulf 1 became effective upon commercial operation of Grand Gulf 1 on July 1, 1985; - the sale of capacity and energy generated by the Grand Gulf Station may be governed by a separate power purchase agreement among System Energy and AP&L, LP&L, MP&L, and NOPSI; - the September 1989 write-off of System Energy's investment in Grand Gulf 2, amounting to approximately $900 million, will be amortized for Availability Agreement purposes over 27 years rather than in the month the write-off was recognized on System Energy's books; and - the allocation percentages under the Availability Agreement are fixed as follows: AP&L - 17.1%; LP&L - 26.9%; MP&L - 31.3%; and NOPSI - 24.7%. As noted above, the Unit Power Sales Agreement provides for different allocation percentages for sales of capacity and energy from Grand Gulf 1. However, the allocation percentages under the Availability Agreement remain in effect and would govern payments made thereunder in the event of a shortfall of funds available to System Energy from other sources, including payments by AP&L, LP&L, MP&L, and NOPSI to System Energy under the Unit Power Sales Agreement. System Energy has assigned its rights to payments and advances from AP&L, LP&L, MP&L, and NOPSI under the Availability Agreement as security for its first mortgage bonds and reimbursement obligations to certain banks providing the letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. In these assignments, AP&L, LP&L, MP&L, and NOPSI further agreed that in the event they were prohibited by governmental action from making payments under the Availability Agreement (if, for example, FERC reduced or disallowed such payments as constituting excessive rates; see the second succeeding paragraph), they would then make subordinated advances to System Energy in the same amounts and at the same times as the prohibited payments. System Energy would not be allowed to repay these subordinated advances so long as it remained in default under the related indebtedness or in other similar circumstances. Each of the assignment agreements relating to the Availability Agreement provides that AP&L, LP&L, MP&L, and NOPSI shall make payments directly to System Energy. However, if there is an event of default, AP&L, LP&L, MP&L, and NOPSI shall make those payments directly to the holders of indebtedness secured by such assignment agreements. The payments shall be made pro rata according to the amount of the respective obligations secured. The obligations of AP&L, LP&L, MP&L, and NOPSI to make payments under the Availability Agreement are subject to receipt and continued effectiveness of all necessary regulatory approvals. Sales of capacity and energy under the Availability Agreement would require that the Availability Agreement be submitted to FERC for approval with respect to the terms of such sale. No filing with FERC has been required because sales of capacity and energy from the Grand Gulf Station are being made under the Unit Power Sales Agreement. Other aspects of the Availability Agreement, including the obligations of AP&L, LP&L, MP&L, and NOPSI to make subordinated advances, are subject to the jurisdiction of the SEC under the Holding Company Act, which approval has been obtained. If, for any reason, sales of capacity and energy are made in the future pursuant to the Availability Agreement, the jurisdictional portions of the Availability Agreement would be submitted to FERC for approval. (Refer to the second preceding paragraph.) Amounts that have been received by System Energy under the Unit Power Sales Agreement have exceeded the amounts payable under the Availability Agreement. Consequently, no payments under the Availability Agreement by AP&L, LP&L, MP&L, and NOPSI have ever been required. If AP&L, LP&L, MP&L, or NOPSI became unable in whole or in part to continue making payments to System Energy under the Unit Power Sales Agreement, and System Energy were unable to procure funds from other sources sufficient to cover any potential shortfall between the amount owing under the Availability Agreement and the amount of continuing payments under the Unit Power Sales Agreement plus other funds then available to System Energy, LP&L and NOPSI could become subject to claims or demands by System Energy or its creditors for payments or advances under the Availability Agreement or the assignments thereof for the difference between their required Unit Power Sales Agreement payments and their required Availability Agreement payments. The amount, if any, which these companies would become liable to pay or advance, over and above amounts they would be paying under the Unit Power Sales Agreement for capacity and energy from Grand Gulf 1, would depend on a variety of factors (especially the degree of any such shortfall and System Energy's access to other funds). It cannot be predicted whether any such claims or demands, if made and upheld, could be satisfied. In NOPSI's case, if any such claims or demands were upheld, the holders of certain of NOPSI's outstanding general and refunding mortgage bonds could require redemption of their bonds at par. The ability of AP&L, LP&L, MP&L, and NOPSI to sustain payments under the Availability Agreement and the assignments thereof in material amounts without substantially equivalent recovery from their customers would be limited by their respective available cash resources and financing capabilities at the time. The ability of AP&L, LP&L, MP&L, and NOPSI to recover from their customers payments made under the Availability Agreement, or under the assignments thereof, would depend upon the outcome of regulatory proceedings before the state and local regulatory authorities having jurisdiction. In view of the controversies that arose over the allocation of capacity and energy from Grand Gulf 1 pursuant to the Unit Power Sales Agreement, opposition to recovery would be likely and the outcome of such proceedings, should they occur, is not predictable. Reallocation Agreement. On November 18, 1981, the SEC authorized LP&L, MP&L, and NOPSI to indemnify AP&L against principally its responsibilities and obligations with respect to the Grand Gulf Station contained in the Availability Agreement and the assignments thereof. The revised percentages of allocated capacity of System Energy's share of Grand Gulf 1 and Grand Gulf 2 were, respectively: LP&L - 38.57% and 26.23%; MP&L - 31.63% and 43.97%; and NOPSI - 29.80% and 29.80%. FERC's decision allocating the capacity and energy of Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI supersedes the Reallocation Agreement insofar as it relates to Grand Gulf 1. However, responsibility for any Grand Gulf 2 amortization amounts (see "Availability Agreement," above) has been allocated to LP&L - 26.23%, MP&L - 43.97%, and NOPSI - 29.80% under the terms of the Reallocation Agreement. The Reallocation Agreement does not affect the obligation of AP&L to System Energy's lenders under the assignments referred to in the fifth preceding paragraph, and AP&L would be liable for its share of such amounts if LP&L, MP&L, and NOPSI were unable to meet their contractual obligations. No payments of any amortization amounts will be required as long as amounts paid to System Energy under the Unit Power Sales Agreement, together with other funds available to System Energy, exceed amounts required under the Availability Agreement, which is expected to be the case for the foreseeable future. Capital Funds Agreement. System Energy and Entergy Corporation have entered into the Capital Funds Agreement whereby Entergy Corporation has agreed to supply to System Energy sufficient capital to (1) maintain System Energy's equity capital at an amount equal to a minimum of 35% of its total capitalization (excluding short-term debt), and (2) permit the continuation of commercial operation of Grand Gulf 1 and to pay in full all indebtedness for borrowed money of System Energy when due under any circumstances. Entergy Corporation has entered into various supplements to the Capital Funds Agreement, and System Energy has assigned its rights thereunder as security for its first mortgage bonds and reimbursement obligations to certain banks providing letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. Each such supplement provides that permitted indebtedness for borrowed money incurred by System Energy in connection with the financing of the Grand Gulf Station may be secured by System Energy's rights under the Capital Funds Agreement on a pro rata basis (except for the Specific Payments, as hereinafter defined). In addition, in the particular supplements to the Capital Funds Agreement relating to the specific indebtedness being secured, Entergy Corporation has agreed to make cash capital contributions to System Energy sufficient to enable System Energy to make payments when due on such indebtedness (Specific Payments). Except with respect to the Specific Payments, which have been approved by the SEC under the Holding Company Act, the performance by both Entergy Corporation and System Energy of their obligations under the Capital Funds Agreement, as supplemented, is subject to the receipt and continued effectiveness of all governmental authorizations necessary to permit such performance, including approval by the SEC under the Holding Company Act. Each of the supplemental agreements provides that Entergy Corporation shall make its payments directly to System Energy. However, if there is an event of default, Entergy Corporation shall make those payments directly to the holders of indebtedness secured by the supplemental agreements. The payments (other than the Specific Payments) shall be made pro rata according to the amount of the respective obligations secured by the supplemental agreements. Sale and Leaseback Arrangements LP&L. On September 28, 1989, LP&L entered into arrangements for the sale and leaseback of an approximate aggregate 9.3% ownership interest in Waterford 3. LP&L has options to terminate the leases and to repurchase the sold interests in Waterford 3 at certain intervals during the basic terms of the leases. Further, at the end of the terms of the leases, LP&L has options to renew the leases or to repurchase the interests in Waterford 3. If LP&L does not exercise its options to repurchase the interests in Waterford 3 on the fifth anniversary (September 28, 1994) of the closing date of the sale and leaseback transactions, LP&L will be required to provide collateral to the owner participants for the equity portion of certain amounts payable by LP&L under the lease. The required collateral is either a bank letter or letters of credit or the pledging of new series of first mortgage bonds issued by LP&L under its first mortgage bond indenture. (For further information on LP&L's sale and leaseback arrangements, including the required maintenance by LP&L of specified capitalization and fixed charge coverage ratios, see Note 9 of LP&L's Notes to Financial Statements, "Leases - Waterford 3 Lease Obligations," incorporated herein by reference.) System Energy. On December 28, 1988, System Energy entered into arrangements for the sale and leaseback of an 11.5% ownership interest in Grand Gulf 1. System Energy has options to terminate the leases and to repurchase the undivided interest in Grand Gulf 1 at certain intervals during the basic lease term. Further, System Energy has an option at the end of the basic lease term to renew the leases or to repurchase the undivided interest in Grand Gulf 1. In connection with the equity funding of the sale and leaseback arrangements, letters of credit are required to be maintained by System Energy under the leases to secure certain amounts payable for the benefit of the equity investors. The letters of credit currently maintained are effective until January 15, 1997. Under the provisions of a reimbursement agreement, dated December 1, 1988, as amended, entered into by System Energy and various banks in connection with the sale and leaseback arrangements related to the letters of credit, System Energy has agreed to a number of covenants relating to, among other things, the maintenance of certain capitalization and fixed charge ratios. In connection with an audit of System Energy by FERC, if a decision of FERC issued on August 4, 1992 (August 4 Order) is ultimately sustained and implemented, System Energy would need to obtain the consent of certain banks to waive the capitalization and fixed charge coverage covenants for a limited period of time in order to avoid violation of such covenants. System Energy has obtained the consent of the banks to waive these covenants for the twelve-month period beginning with the earlier of the write-off or the first refund, if the August 4 Order is implemented prior to December 31, 1994. Absent a waiver, failure by System Energy to perform these covenants could give rise to a draw under the letters of credit and/or an early termination of the letters of credit, and, if such letters of credit were not replaced in a timely manner, could result in a default under, or other early termination of, System Energy's leases. (For further information on the potential effects of the August 4 Order on System Energy's financial condition, see Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference, and for a further discussion of the provisions of System Energy's Reimbursement Agreement, see System Energy's Notes to Financial Statements, Note 6, "Dividend Restrictions" and Note 7, "Commitments and Contingencies - Reimbursement Agreement," incorporated herein by reference.) RATE MATTERS AND REGULATION RATE MATTERS The System operating companies' retail rates are regulated by their respective state and/or local regulatory authorities, as described below, and their rates for wholesale sales (including intrasystem sales pursuant to the System Agreement) and interstate transmission of electricity are regulated by FERC. Rates for System Energy's sales of capacity and energy from Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement are also regulated by FERC. Wholesale Rate Matters GSU. For information, see "Retail Rate Matters - GSU," below and "Regulation - Other Regulation and Litigation - GSU," below. System Energy. As described above under "Certain System Financial and Support Agreements," System Energy recovers costs related to its interest in Grand Gulf 1 through rates charged to AP&L, LP&L, MP&L, and NOPSI for Grand Gulf 1 capacity and energy under the Unit Power Sales Agreement. Several proceedings currently pending or recently concluded at FERC affect these rates. In connection with an audit report covering a review of System Energy's books and records for the years 1986-1988, on August 4, 1992, FERC issued an opinion and order (1) finding that System Energy overstated its Grand Gulf 1 utility plant by approximately $95 million for costs included in utility plant that are related to the System's income tax allocation procedures, and (2) requiring System Energy to make adjusting accounting entries and refunds, with interest, to AP&L, LP&L, MP&L, and NOPSI within 90 days from the date of the order. System Energy requested a rehearing of the order, and on October 5, 1992, FERC issued an order allowing additional time for its consideration of such request and deferring System Energy's refund obligation until 30 days following issuance of FERC's order on rehearing. (For further information on FERC's order and its potential effect on System Energy's and Entergy's consolidated financial position, see Note 2 of System Energy's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference.) In a separate proceeding, on August 24, 1992, FERC instituted an investigation of the justness and reasonableness of certain of Entergy's formula wholesale rates, including System Energy's rates under the Unit Power Sales Agreement. Various regulatory authorities intervened in the proceeding. On August 2, 1993, Entergy and the intervenors settled the proceeding and agreed that System Energy's rate of return on equity would be reduced from 13% to 11%, and such rate would remain in effect until at least August 1995. Refunds were payable by System Energy with respect to the period from November 2, 1992, through the effective date of the settlement. FERC approved the settlement on October 25, 1993, and System Energy credited AP&L, LP&L, MP&L, and NOPSI with an aggregate of $29.6 million on their October 1993 bills. This matter is now final. (See Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Return on Equity Case," incorporated herein by reference.) Entergy Power. In 1990, authorizations were obtained from the SEC, FERC, the APSC, and the Public Service Commission of Missouri for Entergy Power to purchase AP&L's interests in Independence 2 and Ritchie 2, and to begin marketing the capacity and energy from the units in certain wholesale markets. The SEC order approving various aspects of the transaction was appealed by various intervenors in the proceeding to the D.C. Circuit, which reversed a portion of the order and remanded the case to the SEC for consideration of the effect of the transfers on the System's future costs of replacement generating capacity and fuel. In response to a June 24, 1993 SEC order setting a procedural schedule for the filing of further pleadings in the proceeding, in July 1993, the Entergy parties filed a post-effective amendment to their application addressing the issues specified in the SEC order. On September 9, 1993, the City of New Orleans and the LPSC each requested a hearing. However, on January 5, 1994, the City of New Orleans withdrew from the proceeding, as agreed in its settlement with NOPSI of various issues related to the Merger. System Agreement. AP&L, LP&L, MP&L, and NOPSI engage in the coordinated planning, construction, and operation of generation and transmission facilities pursuant to the terms of the System Agreement (described under "Property - Generating Stations," below). GSU became a party to the System Agreement upon consummation of the merger of Entergy's and GSU's electric systems, and GSU now participates in this System-wide coordination. For further information, see Note 2 of GSU's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - Merger-Related Rate Agreements." In connection with the Merger, FERC approved certain rate schedule changes to integrate GSU into the System Agreement. Certain commitments were adopted to provide reasonable assurance that the ratepayers of the existing Entergy operating companies will not be allocated higher costs, including, among other things: (1) a tracking mechanism to protect operating companies from certain unexpected increases in fuel costs; (2) excluding GSU from the distribution of profits from power sales contracts entered into prior to the Merger; (3) a methodology to estimate the cost of capital in future FERC proceedings; and (4) a stipulation that the operating companies will be insulated from certain direct effects on capacity equalization payments should GSU, due to a finding of imprudent GSU management prior to the Merger, be required to purchase Cajun's 30% share in River Bend. See "Regulation - Other Regulation and Litigation," for information on requests for rehearing of FERC's approval. On August 20, l990, the City of New Orleans filed a complaint against Entergy Corporation, AP&L, LP&L, MP&L, NOPSI, and System Energy requesting that FERC investigate AP&L's transfer of its interest in Independence 2 and Ritchie 2 to Entergy Power (see "Entergy Power," above) and the effect of the transfer on AP&L, LP&L, MP&L, and NOPSI and their ratepayers. Various parties, including certain of the System's state regulators, intervened in the proceeding. FERC issued an order on March 19, 1991, setting for investigation (l) the question of whether overall billings under the System Agreement will increase as a result of the transfer to Entergy Power, and (2) if so, whether such increased billings reflect prudently incurred costs that may reasonably be charged under the System Agreement. In two separate decisions with respect to these issues, the FERC ALJ assigned to the matter ruled on May 14, l992 and October 30, 1992, respectively, that there was sufficient evidence to show that overall billings would increase as a result of the transfer, but that the transfer was prudent. On December 15, 1993, FERC issued an opinion declining to address the prudence issue until a future time when replacement capacity has been added or planned and finding that, until such time, billings under the System Agreement as affected by the transfer of the two units are reasonable. The Entergy parties and the City of New Orleans each filed a request for rehearing of this order. If FERC's decision were reversed and any refunds were ordered, they would be retroactive to October 19, 1990. Open Access Transmission. On August 2, 1991, Entergy Services, as agent for AP&L, LP&L, MP&L, NOPSI, and Entergy Power, submitted to FERC (1) proposed tariffs that, subject to certain conditions, would provide to electric utilities "open access" to the System's integrated transmission system, and (2) rate schedules providing for sales of wholesale power at market-based rates. Under FERC policy, sales of power at market-based rates would be permitted only if FERC found, among other things, that Entergy did not have market power over transmission. Permitting "open access" to the System's transmission system helps support such a finding. Various parties, including the Council, the APSC, the MPSC, and the LPSC, intervened in the proceeding. On March 3, 1992, FERC approved the filing, with some modifications, and on August 7, l992, FERC denied rehearing of its March 1992 order. On August 24, l992, various parties filed petitions with the D.C. Circuit for review of FERC's 1992 orders, and these petitions have been consolidated. The revised tariffs, submitted by Entergy Services in response to FERC's 1992 orders, were accepted for filing and made effective, subject to further modifications, by order dated April 5, l993. Entergy Services made a further compliance filing on May 5, l993, reflecting these modifications and requesting reconsideration of certain limited matters, which is subject to approval by FERC. On December 31, 1993, Entergy Services filed revisions to the transmission service tariff to recognize GSU's inclusion in the Entergy System. These matters are pending. Retail Rate Matters General. AP&L, LP&L, MP&L, and NOPSI currently have retail rate structures sufficient to recover their costs, including costs associated with their allocated shares of capacity and energy from Grand Gulf 1 under the Unit Power Sales Agreement, and a return on equity. Certain costs related to Grand Gulf 1 (and in LP&L's case, Waterford 3 are being phased-into retail rates over a period of time, in order to avoid the "rate shock" associated with increasing rates to reflect all of such costs at once. The deferral period in which costs are incurred but not currently recovered has expired for all of these programs, and AP&L, LP&L, MP&L, and NOPSI are now recovering those costs that were previously deferred. Also, AP&L and LP&L have retained a portion of their shares of Grand Gulf 1 capacity and GSU is operating under a deregulated asset plan for a portion of its share of River Bend. GSU is involved in several rate proceedings involving recovery, among other things, of costs associated with River Bend. Some rate relief has been received, but GSU has been unable to obtain recognition in rates for a substantial portion of its River Bend investment. Recovery of certain costs has been disallowed, while other costs are being deferred for future recovery, held in abeyance pending further regulatory action, or treated as investments in deregulated assets. There are ongoing rate proceedings and appeals relating to these issues (see "GSU," below). The System is committed to taking actions that will stabilize retail rates and avoid the need for future rate increases. In the short-term, this involves containing costs to the greatest degree practicable, thereby avoiding erosion of earnings and delaying for as long as possible the need for general rate increases. In accordance with this retail rate policy, the System operating companies have agreed to retail rate caps and/or rate freezes for specified periods of time. In the longer term, as discussed in "Business of Entergy - Competition - Least Cost Planning" above, and also as discussed specifically for each applicable company below, the System is pursuing implementation of least cost planning to minimize the cost of future sources of energy. Effective January 1, 1993, the System adopted SFAS No. 106 (SFAS 106), an accounting standard that requires accrual of the costs of postretirement benefits other than pensions prior to the time these costs are actually incurred. In 1992, the System operating companies requested from their retail rate regulators authorization to recognize in rates the costs associated with implementation of SFAS 106. For further information, see Note 10 of Entergy Corporation and Subsidiaries', Note 9 of MP&L's and NOPSI's, and Note 10 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, "Postretirement and Postemployment Benefits," incorporated herein by reference. AP&L Rate Freeze. In connection with the settlement of various issues related to the Merger, AP&L agreed that it will not request any general retail rate increase that would take effect before November 3, 1998, except, among other things, for increases associated with the Least Cost Plan (discussed below); recovery of certain Grand Gulf 1- related costs, excess capacity costs, and costs related to the adoption of SFAS 106 that were previously deferred; recovery of certain taxes; fuel adjustment recoveries; recovery of nuclear decommissioning costs; and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. Under the settlement agreement entered into with the APSC in 1985 and amended in 1988, AP&L agreed to retain a portion of its Grand Gulf l-related costs, recover a portion of such costs currently, and defer a portion of such costs for future recovery. In 1994 and subsequent years, AP&L will retain 7.92% of such costs (stated as a percentage of System Energy's 90% share of the unit) and will recover 28.08% currently. Deferrals ceased in l990, and AP&L is recovering a portion of the previously deferred costs each year through l998. As of December 31, l993, the balance of deferred uncollected costs was $568.0 million. AP&L is permitted to recover on a current basis the incremental costs of financing the unrecovered deferrals. AP&L has the right to sell capacity and energy from its retained share of Grand Gulf 1 to third parties and to sell such energy to its retail customers at a price equal to AP&L's avoided energy cost. Proceeds of sales to third parties of AP&L's retained share of Grand Gulf l capacity and energy generally accrue to the benefit of AP&L's stockholder; however, half of the proceeds of such sales to third parties prior to January 1, 1996, are used to reduce the balance of uncollected deferrals and thus accrue to the benefit of retail ratepayers. If AP&L makes sales to third parties prior to that date in excess of the retained share, the proceeds of such excess are also split between the stockholder and the ratepayers, except that the portion of the sale that accrues to the stockholder's benefit cannot exceed the retained share. Least Cost Planning. On December 1, 1992 and July 1, 1993, AP&L filed with the APSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. AP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. On October 13, 1993, the APSC found AP&L's plan to be complete and directed the APSC staff to conduct a series of public forums in late 1993, including focus groups, town meetings, and collaborative workshops, before it would establish a procedural schedule that would include evidentiary hearings and the issuance of a Least Cost Plan order. Several of these meetings were delayed into 1994, but are expected to be completed by March 1994. At or before that time, AP&L expects the APSC to issue a procedural schedule that will allow the APSC to issue an order before the end of 1994. On January 19, 1994, AP&L filed a request with the APSC for permission to withdraw the CCLM portion of the filing and to continue such programs on a pilot basis at shareholder expense. The APSC has not yet ruled on AP&L's request. Fuel Adjustment Clause. AP&L's retail rate schedules have a fuel adjustment clause that provides for recovery of the excess cost of fuel and purchased power incurred in the second preceding month. The fuel adjustment clause also contains a nuclear reserve fund designed to cover the cost of replacement energy during scheduled maintenance and refueling outages at ANO, and an incentive provision that permits over- or under-recovery of the excess cost of replacement energy when ANO is operating or down for reasons other than refueling. GSU Rate Cap and Other Merger-Related Rate Agreements. The LPSC and the PUCT approved separate regulatory proposals that include the following elements: (1) a five-year rate cap on GSU's retail electric base rates in the respective states, except for force majeure (defined to include, among other things, war, natural catastrophes, and high inflation); (2) a provision for passing through to retail customers in the respective states the jurisdictional portion of the fuel savings created by the Merger; and (3) a mechanism for tracking nonfuel operation and maintenance savings created by the Merger. The LPSC regulatory plan provides that such nonfuel savings will be shared 60% by the shareholder and 40% by ratepayers during the eight years following the Merger. The LPSC plan requires regulatory filings each year by the end of May through 2001. The PUCT regulatory plan provides that such savings will be shared equally by the shareholder and ratepayers, except that the shareholder's portion will be reduced by $2.6 million per year on a total company basis in years four through eight. The PUCT plan also requires a series of regulatory filings, currently anticipated to be in June 1994, and February 1996, 1998, and 2001, to ensure that the ratepayers' share of such savings be reflected in rates on a timely basis and requires Entergy Corporation to hold GSU's Texas retail customers harmless from the effects of the removal by FERC of a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under the FERC tracking mechanism (see "Rate Matters - Wholesale Rate Matters - System Agreement," above). On January 14, 1994, Entergy Corporation filed a request for rehearing of FERC's December 15, 1993 order approving the Merger, requesting that FERC restore the 40% cap provision in the fuel cost protection mechanism (see "Regulation - Other Litigation and Regulation," below). The matter is pending. Recovery of River Bend Costs. GSU deferred approximately $369 million of River Bend operating costs, purchased power costs, and accrued carrying charges pursuant to a 1986 PUCT accounting order. Approximately $182 million of these costs are being amortized over a 20-year period, and the remaining $187 million are not being amortized pending the ultimate outcome of the Rate Appeal (see "Texas Jurisdiction - River Bend," below). As of December 31, 1993, the unamortized balance of these costs was $330.3 million. Further, GSU deferred approximately $400.4 million of similar costs pursuant to a 1986 LPSC accounting order. These costs, of which approximately $160.4 million are unamortized as of December 31, 1993, are being amortized over a 10-year period. In accordance with a phase-in plan approved by the LPSC, GSU deferred $324.7 million of its River Bend costs related to the period December 1987 through February 1991. GSU has amortized $86.6 million through December 31, 1993, and the remainder of $238.1 million will be recovered over approximately 3.8 years. Texas Jurisdiction - River Bend. In May 1988, the PUCT granted GSU a permanent increase in annual revenues of $59.9 million resulting from the inclusion in rate base of approximately $1.6 billion of company-wide River Bend plant investment and approximately $182 million of related Texas retail jurisdiction deferred River Bend costs (Allowed Deferrals). In addition, the PUCT disallowed as imprudent $63.5 million of company-wide River Bend plant costs and placed in abeyance, with no finding of prudency, approximately $1.4 billion of company-wide River Bend plant investment and approximately $157 million of Texas retail jurisdiction deferred River Bend operating and carrying costs. The PUCT affirmed that the ultimate rate treatment of such amounts would be subject to future demonstration of the prudency of such costs. GSU and intervening parties appealed this order (Rate Appeal) and GSU filed a separate rate case asking that the abeyed River Bend plant costs be found prudent (Separate Rate Case). Intervening parties filed suit in district court to prohibit the Separate Rate Case. The district court's decision was ultimately appealed to the Texas Supreme Court which ruled in 1990 that the prudence of the purported abeyed costs could not be relitigated in a separate rate proceeding. Further, the Texas Supreme Court's decision stated that all issues relating to the merits of the original order of the PUCT, including the prudence of all River Bend-related costs, should be addressed in the Rate Appeal. In October 1991, the district court in the Rate Appeal issued an order holding that, while it was clear the PUCT made an error in assuming it could set aside $1.4 billion of the total costs of River Bend and consider them in a later proceeding, the PUCT, nevertheless, found that GSU had not met its burden of proof related to the amounts placed in abeyance. The court also ruled that the Allowed Deferrals should not be included in rate base under a 1991 decision regarding El Paso Electric Company's similar deferred costs (El Paso Case). The court further stated that the PUCT erred in reducing GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988. The court remanded the case to the PUCT with instructions as to the proper handling of the Allowed Deferrals. GSU's motion for rehearing was denied, and in December 1991, GSU filed an appeal of the October 1991 district court order. The PUCT also appealed the October 1991 district court order, which served to supersede the district court's judgment, rendering it unenforceable under Texas law. In August 1992, the court of appeals in the El Paso Case handed down its second opinion on rehearing modifying its previous opinion on deferred accounting. The court's second opinion concluded that the PUCT may lawfully defer operating and maintenance costs and subsequently include them in rate base, but that the Public Utility Regulatory Act prohibits such rate base treatment for deferred carrying costs. The court stated, however, its opinion would not preclude the recovery of deferred carrying costs. The August 1992 court of appeals opinion was appealed to the Texas Supreme Court where arguments were heard in September 1993. The matter is still pending. In September 1993, the Texas Third District Court of Appeals (the Third District Court) remanded the October 1991 district court decision to the PUCT "to reexamine the record evidence to whatever extent necessary to render a final order supported by substantial evidence and not inconsistent with our opinion." The Third District Court specifically addressed the PUCT's treatment of certain costs, stating that the PUCT's order was not based on substantial evidence. The Third District Court also applied its most recent ruling in the El Paso Case to the deferred costs associated with River Bend. However, the Third District Court cautioned the PUCT to confine its deliberations to the evidence addressed in the original rate case. Certain parties to the case have indicated their position that, on remand, the PUCT may change its original order only with respect to matters specifically discussed by the Third District Court which, if allowed, would increase GSU's allowed River Bend investment, net of accumulated depreciation and related taxes, by approximately $48 million as of December 31, 1993. GSU believes that under the Third District Court's decision, the PUCT would be free to reconsider any aspect of its order concerning the abeyed $1.4 billion River Bend investment. GSU has filed a motion for rehearing asking the Third District Court to modify its order so as to permit the PUCT to take additional evidence on remand. The PUCT and other parties have also moved for rehearing on various grounds. The Third District Court has not yet ruled on any of these motions. As of December 31, 1993, the River Bend plant costs disallowed for retail ratemaking purposes in Texas, and the River Bend plant costs held in abeyance and the related cost deferrals totaled (net of taxes) approximately $14 million, $300 million (both net of depreciation), and $171 million, respectively. Allowed Deferrals were approximately $95 million, net of taxes and amortization, as of December 31, 1993. GSU estimates it has collected approximately $139 million of revenues as of December 31, 1993, as a result of the originally ordered rate treatment of these deferred costs. However, if the PUCT adopts the most recent decision in the El Paso Case, the possible refunds approximate $28 million as a result of the inclusion of deferred carrying costs in rate base for the period July 1988 through December 1990. However, if the PUCT reverses its decision to reduce GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988, the potential refund of amounts described above could be reduced by an amount ranging from $7 million to $19 million. No assurance can be given as to the timing or outcome of the remands or appeals described above. Pending further developments in these cases, GSU has made no write-offs for the River Bend related costs. Management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is reasonably possible that the case will be remanded to the PUCT, and the PUCT will be allowed to rule on the prudence of the abeyed River Bend plant costs. Rate caps imposed by the PUCT's regulatory approval of the Merger could result in GSU being unable to use the full amount of a favorable decision to immediately increase rates; however, a favorable decision could permit some increases and/or limit or prevent decreases during the period the rate caps are in effect. At this time, management and legal counsel are unable to predict the amount, if any, of the abeyed and previously disallowed River Bend plant costs that ultimately may be disallowed by the PUCT. A net of tax write-off as of December 31, 1993, of up to $314 million could be required based on the PUCT's ultimate ruling. In prior proceedings, the PUCT has held that the original cost of nuclear power plants will be included in rates to the extent those costs were prudently incurred. Based upon the PUCT's prior decisions, management believes that its River Bend construction costs were prudently incurred and that it is reasonably possible that it will recover in rate base, or otherwise through means such as a deregulated asset plan, all or substantially all of the abeyed River Bend plant costs. However, management also recognizes that it is reasonably possible that not all of the abeyed River Bend plant costs may ultimately be recovered. As part of its direct case in the Separate Rate Case, GSU filed a cost reconciliation study prepared by Sandlin Associates, management consultants with expertise in the cost analysis of nuclear power plants, which supports the reasonableness of the River Bend costs held in abeyance by the PUCT. This reconciliation study determined that approximately 82% of the River Bend cost increase above the amount included by the PUCT in rate base was a result of changes in federal nuclear safety requirements and provided other support for the remainder of the abeyed amounts. There have been four other rate proceedings in Texas involving nuclear power plants. Investment in the plants ultimately disallowed ranged from 0% to 15%. Each case was unique, and the disallowances in each were made on a case-by-case basis for different reasons. Appeals of most, if not all, of these PUCT decisions are currently pending. The following factors support management's position that a loss contingency requiring accrual has not occurred, and its belief that all, or substantially all, of the abeyed plant costs will ultimately be recovered: 1. The $1.4 billion of abeyed River Bend plant costs have never been ruled imprudent and disallowed by the PUCT. 2. Sandlin Associates' analysis which supports the prudence of substantially all of the abeyed construction costs. 3. Historical inclusion by the PUCT of prudent construction costs in rate base. 4. The analysis of GSU's internal legal staff, which has considerable experience in Texas rate case litigation. Additionally, management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is probable that the deferred costs will be allowed. However, assuming the August 1992 court of appeals' opinion in the El Paso Case is upheld and applied to GSU and the deferred River Bend costs currently held in abeyance are not allowed to be recovered in rates as allowable costs, a net-of-tax write-off of up to $171 million could be required. In addition, future revenues based upon the deferred costs previously allowed in rate base could also be lost and no assurance can be given as to whether or not refunds (up to $28 million as of December 31, 1993) of revenue received based upon such deferred costs previously recorded will be required. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquistion contingencies, including a River Bend write-down. Texas Jurisdiction - Fuel Reconciliation. In January 1992, GSU applied with the PUCT for a new fixed fuel factor and requested a final reconciliation of fuel and purchased power costs incurred between December 1, 1986 and September 30, 1991. GSU proposed to recover net underrecoveries and interest (including underrecoveries related to NISCO, discussed below) over a twelve month period. In April 1993, the presiding PUCT ALJ issued a report which concluded that GSU incurred approximately $117 million of nonreimbursable fuel costs on a company-wide basis (approximately $50 million on a Texas retail jurisdictional basis) during the reconciliation period. Included in the nonreimbursable fuel costs were payments above GSU's avoided cost rate for power purchased from NISCO. The PUCT ordered in 1986 that the purchased power costs from NISCO in excess of GSU's avoided costs be disallowed. The PUCT disallowance resulted in approximately $12 million to $15 million of unrecovered purchased power costs on an annual basis, which GSU continued to expense as the costs were incurred. In April 1991, the Texas Supreme Court, in the appeal of such order, ordered the PUCT to allow GSU to recover purchased power payments in excess of its avoided cost in future proceedings, if GSU established to the PUCT's satisfaction that the payments were reasonable and necessary expenses. In June 1993, the PUCT, in the fuel reconciliation case, concluded that the purchased power payments made to NISCO in excess of GSU's avoided cost were not reasonably incurred. As a result of the order, GSU recorded additional fuel expenses (including interest) of $2.8 million for non-NISCO related items. The PUCT's order resulted in no additional expenses related to the NISCO issue, or for overcollections related to the fixed fuel factor, as those charges were expensed by GSU as they were incurred. The PUCT concluded that GSU had over-collected its fuel costs in Texas and ordered GSU to refund approximately $33.8 million to its Texas retail customers, including approximately $7.5 million of interest. The PUCT reduced GSU's fixed fuel factor in Texas from about 2.1 cents per KWH to approximately 1.84 cents per KWH. GSU had requested a new fixed fuel factor of about 2.02 cents per KWH. Based on current sales forecasts, adoption of the PUCT's recommended fixed fuel factor would reduce GSU's revenues by approximately $34 million annually. In October 1993, GSU appealed the PUCT's order to the Travis County District Court. No assurance can be given as to the timing or outcome of the appeal. Texas - Cities Rate Settlement. In June 1993, thirteen cities within GSU's Texas service area instituted an investigation to determine whether GSU's current rates were justified. In October 1993, the general counsel of the PUCT instituted an inquiry into the reasonableness of GSU's rates. In November 1993, a settlement agreement was filed with the PUCT which provides for an initial reduction in annual retail base revenues in Texas of approximately $22.5 million effective for electric usage on or after November 1, 1993, and a second reduction of $20 million to be effective September 1994. Further, the settlement provided for GSU to reduce rates with a $20 million one-time bill credit in December 1993, and to refund approximately $3 million to Texas retail customers on bills rendered in December 1993. The cities rate inquiries had been settled earlier on the same terms. In November 1993, in association with the settlement of the above- described rate inquiries, GSU entered into a settlement covering issues related to a March 1991 non-unanimous settlement in another proceeding. Under this settlement, a $30 million rate increase approved by the PUCT in March 1991, became final and the PUCT's treatment of GSU's federal tax expense was settled, eliminating the possibility of refunds associated with amounts collected resulting from the disputed tax calculation. In December 1993, a large industrial customer of GSU announced its intention to oppose the settlement of the PUCT rate inquiry. The customer's opposition does not affect the cities' rate settlement. The customer's opposition requires the PUCT to conduct a hearing concerning GSU's rates charged in areas outside the corporate limits of the cities in its Texas service territory to determine whether the settlement's rates are just and reasonable. A hearing has been set for July 8, 1994. GSU believes that the PUCT will ultimately approve the settlement, but no assurance can be provided in this regard. Louisiana Jurisdiction - River Bend. Previous rate orders of the LPSC have been appealed, and pending resolution of various appellate proceedings, GSU has made no write-off for the disallowance of $30.6 million of deferred revenue requirement that GSU recorded for the period December 16, 1987 through February 18, 1988. In January 1992, the LPSC ordered a deregulated asset plan for $1.4 billion of River Bend plant costs not allowed in rates. The plan allows GSU to sell the generation from the approximately 22% of River Bend to Louisiana customers at 4.6 cents per KWH, or off-system at higher prices. Incremental revenues from off-system sales above 4.6 cents per KWH will be shared 60% by shareholders and 40% by ratepayers (see GSU's "Management's Financial Discussion and Analysis," incorporated herein by reference, for the effects of the plan on GSU's 1993 results of operations). LPSC - Return on Equity Review. In the June 1993 open session, a preliminary report was made comparing the authorized and actual earned rates of return for electric and gas utilities subject to the LPSC's jurisdiction. The preliminary report indicated that several electric utilities, including GSU, may be over-earning based on current estimated costs of equity. The LPSC requested those utilities to file responses indicating whether they agreed with the preliminary report, and to provide their reasons if they did not agree. GSU provided the LPSC with information that GSU believes supports the current rate level. The LPSC decided at its September 7, 1993 open session to defer review of GSU's base rates until the first earnings analysis after the Merger, scheduled for mid-1994. LPSC Fuel Cost Review. In November 1993, the LPSC ordered a review of GSU's fuel costs. The LPSC stated that fuel costs for the period October 1988 through September 1991 would be reviewed based on the number of outages at River Bend and the findings in the June 1993 PUCT fuel reconciliation case. Hearings are scheduled to begin in March 1994. Least Cost Planning. Currently, the PUCT does not have least cost planning rules in place, and GSU has not filed a Least Cost Plan with the PUCT. However, the PUCT staff has begun a rulemaking process for such rules, and GSU is actively participating in this process. GSU has not yet filed a Least Cost Plan with the LPSC. Fuel Recovery. In January 1993, the PUCT adopted a new rule for setting a fixed fuel factor that is intended to recover projected allowable fuel and purchased power costs not covered by base rates. To the extent actual costs vary from the fixed factor, the PUCT may require refunds of overcharges or permit recovery of undercharges. Under the new rule, fuel factors are to be revised every six months, and GSU is on a schedule providing for revision each March and September. The PUCT is required to act within 60 or 90 days, depending on whether or not a hearing is required, and refunds and surcharges will be required based upon a materiality threshold of 4% of Texas retail fuel revenues. Fuel charges will also be subject to reconciliation proceedings every three years, at which time additional adjustments may be required (see "Texas Jurisdiction - Fuel Reconciliation," above). All of GSU's rate schedules in Louisiana include a fuel adjustment clause to recover the cost of fuel and purchased power energy costs. The fuel adjustment reflects the delivered cost of fuel for the second preceding month. LP&L LPSC Jurisdiction. In a series of LPSC orders, court decisions, and agreements from late 1985 to mid-1988, LP&L was granted rate relief with respect to costs associated with Waterford 3 and LP&L's share of capacity and energy from Grand Gulf l, subject to certain terms and conditions. With respect to Waterford 3, LP&L was granted an increase aggregating $170.9 million over the period 1985-1988, and LP&L agreed to permanently absorb, and not recover from retail ratepayers, $284 million of its investment in the unit and to defer $266 million of its costs related to the years 1985-1988 to be recovered over approximately 8.6 years beginning in April 1988. As of December 31, 1993, LP&L's unrecovered deferral balance was $82.5 million. With respect to Grand Gulf l, LP&L agreed to absorb, and not recover from retail ratepayers, 18% of its 14% share (approximately 2.52%) of the costs of Grand Gulf l capacity and energy. LP&L is allowed to recover, through the fuel adjustment clause, 4.6 cents per KWH (currently 2.55 cents per KWH through May 1994) for the energy related to the permanently absorbed percentage, with LP&L's permanently absorbed retained percentage to be available for sale to non-affiliated parties, subject to LPSC approval. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - Waterford 3 and Grand Gulf 1," incorporated herein by reference, for further information on LP&L's Grand Gulf 1 and Waterford 3-related rates.) In a subsequent rate proceeding, on March 1, l989, the LPSC issued an order providing that, in effect, LP&L was entitled to an approximately $45.9 million annual retail rate increase, but that, in lieu of a rate increase, LP&L would be permitted to retain $188.6 million of the proceeds of a 1988 settlement of litigation with a gas supplier, and to amortize such proceeds into revenues over a period of approximately 5.3 years. The amortization of the proceeds will expire in mid-1994 and this source of revenue will no longer be available to LP&L. LP&L believes that the amortization has resulted in approximately the same amount of additional net income as an annual rate increase of $45.9 million would have provided over the same period. In connection with this order, LP&L agreed to a five-year base rate freeze scheduled to expire in March 1994 at then current levels subject to certain conditions. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - March 1989 Order," incorporated herein by reference, for further information on the terms of this order.) By letter dated July 27, 1993, the LPSC requested LP&L to explain its "relatively high cost of debt" compared to other electric utilities subject to LPSC jurisdiction. LP&L responded to the request on August 11, 1993. On August 14, 1993, the LPSC's consultants acknowledged LP&L's rationale for its cost of debt and suggested that certain aspects of LP&L's cost of debt could be taken up in rate proceedings after the expiration of LP&L's rate freeze. On October 7, 1993, the LPSC approved a schedule to conduct a review of LP&L's rates and rate structure upon the expiration of the rate freeze in March 1994. Council Jurisdiction. Under the Algiers rate settlement entered into with the Council in l989, LP&L was granted rate relief with respect to its Grand Gulf l and Waterford 3-related costs, subject to certain terms and conditions. LP&L was granted an annual rate increase of $9.5 million that was phased-in over the two-year period beginning in July 1989, and was permitted to retain $4.2 million (the Council's jurisdictional portion) of the proceeds of litigation with a gas supplier and to amortize such proceeds plus interest into revenues over the same two-year period. LP&L agreed to absorb and not recover from Algiers retail ratepayers $17 million of fixed costs associated with Grand Gulf l and Waterford 3 incurred prior to the date of the settlement, $5.9 million of its investment in Waterford 3, and 18% of the Algiers portion of LP&L's Grand Gulf l-related costs incurred after the settlement. However, LP&L is allowed to recover 4.6 cents per KWH or the avoided cost, whichever is higher, for the energy related to the permanently absorbed percentage through the fuel adjustment clause, with the permanently absorbed percentage to be available for sale to non-affiliated parties, subject to the Council's right of first refusal. LP&L also agreed to a rate freeze for Algiers customers until July 6, l994, except in the case of catastrophic events, changes in federal tax laws, or changes in LP&L's Grand Gulf l costs resulting from FERC proceedings. Least Cost Planning. On December l, l992, and July 1, l993, LP&L filed with the LPSC and the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. LP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. Discovery in the LPSC review of LP&L's Least Cost Plan filing is continuing, and the current procedural schedule (which maybe extended) contemplates that, after hearings and briefings, a report of the LPSC special counsel will be issued on June 14, 1994. The LPSC could render a decision on the basis of this report. On January 19, 1994, LP&L filed a motion with the LPSC to dismiss or withdraw without prejudice the CCLM and to proceed with a pilot CCLM at shareholder expense. The LPSC granted LP&L's motion on February 2, 1994, subject to LP&L, among other things, keeping the LPSC timely informed as to LP&L's CCLM activities. (See "NOPSI - Least Cost Planning," below, for further information on LP&L's and NOPSI's proceedings pending before the Council.) Fuel Adjustment Clause. LP&L's rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month and purchased power energy costs. The fuel adjustment also reflects a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. LP&L defers on its books fuel costs that will be reflected in customer billings in the future under the fuel adjustment clause. MP&L Rate Freeze. In a stipulation entered into by MP&L in connection with the settlement of various issues related to the Merger, MP&L agreed that (1) for a period of five years beginning on November 9, 1993, retail base rates under the FRP (see "Incentive Rate Plan," below) would not be increased above the level of rates in effect on November 1, 1993, and (2) MP&L would not request any general retail rate increase that would increase retail rates above the level of MP&L's rates in effect as of November l, 1993, and that would become effective in such five-year period except, among other things, for increases associated with the Least Cost Plan (discussed below), recovery of deferred Grand Gulf 1-related costs, recovery under the fuel adjustment clause, adjustments for certain taxes, and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. The MPSC's Final Order on Rehearing, issued in 1985, affirmed by the United States Supreme Court in 1988, and subsequently revised in 1988, granted MP&L an annual base rate increase of approximately $326.5 million in connection with its allocated share of Grand Gulf 1 costs. The Final Order on Rehearing also provided for the deferral of a portion of such costs that were incurred each year through 1992, and recovery of these deferrals over a period of six years ending in 1998. As of December 31, 1993, the uncollected balance of MP&L's deferred costs was approximately $601.4 million. MP&L is permitted to recover the carrying charges on all deferred amounts on a current basis. Incentive Rate Plan. In July 1993, the MPSC ordered MP&L to file a formulary incentive rate plan designed to allow for periodic small adjustments in rates based upon a comparison of earned to benchmark returns and upon performance factors incorporated in the plan. Pursuant to this order, on November 1, 1993, MP&L filed a proposed formula rate plan. MPSC was also expected to conduct a general review of MP&L's current rates in the course of approving an incentive rate plan. On January 28, 1994, MP&L and the Mississippi Public Utilities Staff (MPUS) entered into a Joint Stipulation in this proceeding. Under the Joint Stipulation, MP&L and the MPUS agreed on a number of accounting adjustments for the test year ending June 30, 1993, (June 30 Test Year) that resulted in a reduction to MP&L's base rate revenues in the June 30 Test Year of approximately 4.3%, or $28.1 million. This translates into approximately a 3.7% decrease in overall revenues from sales to retail customers, which include revenues related to fuel, taxes, and Grand Gulf. MP&L and the MPUS agreed on a required return on equity of 11% for the June 30 Test Year. MP&L and the MPUS also stipulated to a revised Formula Rate Plan (FRP). The stipulated FRP is essentially the same as the proposed plan filed by MP&L on November 1, 1993. Certain of the accounting changes agreed to by the MPUS and MP&L for the June 30 Test Year are incorporated into the stipulated FRP. Also, the formula in the stipulated FRP for determining required return on equity would have produced a required return on equity for MP&L of 11.07% for the June 30 Test Year. The stipulated return on equity formula will be applied for the first time in the first Evaluation Report under the stipulated FRP. The first Evaluation Report will be filed in March 1995 for the Evaluation Period ending December 31, 1994. On February 10, 1994, MP&L, the Mississippi Industrial Energy Group (MIEG), and the MPUS entered into and filed with the MPUS, a Joint Stipulation (MIEG Joint Stipulation) resolving the issues raised by the MIEG in the docket. On February 16, 1994, MP&L and the Mississippi Attorney General entered into a Joint Stipulation that resolved the issues raised by the Mississippi Attorney General in the docket. Other parties in the case, including two gas utility intervenors, were not parties to the Joint Stipulations. In late February 1994, the MPSC conducted a general review of MP&L's current rates and on March 1, 1994, issued a final order in which the MPSC approved each of the Joint Stipulations. The MPSC ordered MP&L to file rates designed to provide a reduction of $28.1 million in operating revenues for the June 30 Test Year on or before March 18, 1994, to become effective for service rendered on and after March 25, 1994. The FRP also was approved and will be effective on March 25, 1994, with any initial adjustment to base rates, if any, in May 1995. Under the FRP, a formula will be established under which MP&L's earned rate of return will be calculated automatically every 12 months and compared to a benchmark rate of return calculated under a separate formula within the FRP. If MP&L's earned rate of return falls within a bandwidth around the benchmark rate of return, there will be no adjustment in rates. If MP&L's earnings are above the bandwidth, the FRP will automatically reduce MP&L's base rates. Alternatively, if MP&L's earnings are below the bandwidth, the FRP will automatically increase MP&L's base rates (see "Rate Freeze" above for information on a cap on base rates at November 1993 levels for a period of five years). The reduction or increase in base rates will be an amount representing 50% of the difference between the earned rate of return and the nearest limit of the bandwidth. In no event will the annual adjustment in rates exceed the lesser of 2% of MP&L's aggregate annual retail revenues, or $14.5 million. Under the FRP the benchmark rate of return, and consequently the bandwidth, will be adjusted slightly upward or downward based upon MP&L's performance on three performance factors: customer reliability, customer satisfaction, and customer price. In its Final Order, the MPSC also recognized that on February 9 and 10, 1994, a severe ice storm struck northern Mississippi causing extensive and widespread damage to MP&L's transmission and distribution facilities in approximately 15 counties. Although the MPSC made no findings in the final order as to MP&L's costs associated with the ice storm and restoration of service, the MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and restoration of service. The MPSC stated the recovery of MP&L's ice storm costs should be addressed in a separate docket. MP&L plans to immediately file for rate recovery of the costs related to the ice storm. Least Cost Planning. On December 1, 1992 and July 1, 1993, MP&L filed with the MPSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. MP&L also requested a finding by the MPSC that the plan's cost recovery methodology is reasonable and appropriate. MP&L will request approval of cost recovery mechanisms after the plan has been approved by the MPSC. On October 6, 1993, the MPSC, on its own motion, stayed all proceedings in this docket. The MPSC stay order regarding MP&L's Least Cost Plan filing remains in effect even though MP&L and the MPUS have stipulated to an FRP (see "Incentive Rate Plan," above). Because the stay order remains in effect, MP&L has not yet filed a request that the CCLM portion of the filing be withdrawn and that a pilot CCLM program be implemented. Fuel Adjustment Clause. MP&L's rate schedules include a fuel adjustment clause that permits recovery from customers of changes in the cost of fuel and purchased power. The monthly fuel adjustment rate is based on projected sales and costs for the month, adjusted for differences between actual and estimated costs for the second prior month. NOPSI Electric Retail Rate Reduction. On November 18, 1993, in connection with the settlement of various issues related to the Merger, the Council adopted a resolution requiring NOPSI to reduce its annual electric base rates by $4.8 million on bills rendered on or after November 1, 1993. Recovery of Grand Gulf 1 Costs. Under NOPSI's various Rate Settlements with the Council (which include the 1986 NOPSI Settlement, the February 4 Resolution relating to prudence issues, and the 1991 NOPSI Settlement of the issues raised in the February 4 Resolution), NOPSI agreed to absorb and not recover from ratepayers a total of $186.2 million of its Grand Gulf 1 costs. NOPSI was permitted to implement annual rate increases in decreasing amounts each year through 1995, and to defer certain costs, and related carrying charges, for recovery on a schedule extending from 1991 through 2001. As of December 31, 1993, the uncollected balance of NOPSI's deferred costs was $228.8 million. NOPSI also agreed to a base rate freeze through October 31, 1996, excluding the scheduled increases, certain changes in tax rates, and increases related to catastrophic events. (See Note 2 of NOPSI's Notes to Financial Statements, "Rate and Regulatory Matters - Prudence Settlement and Finalized Phase-In Plan," incorporated herein by reference, for further information.) Gas Rates. In May 1992, NOPSI and the Council settled a pending application for gas rate increases. The settlement provided for annual rate increases of approximately $3.8 million in May 1992 and 1993, and the deferral of an additional $3 million for recovery in the years beginning in May 1993 through May 1996. NOPSI also agreed to a base rate freeze, except for the scheduled increases and certain other exceptions, through October 31, 1996. Least Cost Planning. On December 1, 1992, and July 1, 1993, NOPSI filed with the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. NOPSI also requested authorization to recover development and implementation costs and costs and incentives related to DSM aspects of the plan. After hearings and briefings, the Council issued, on November 22, 1993, a resolution that requires NOPSI and LP&L to provide, within certain time frames, additional information, among other things, on how the seven full scale DSM programs approved by the Council in the resolution will be implemented. Such programs are estimated to cost approximately $13 million over the next three years. The Council provided in the resolution certain assurances regarding recovery of costs associated with these programs. Discovery is proceeding and testimony is being filed, with the second round of hearings to begin in February 1994. After the hearings are concluded and briefs have been filed, the Council will address the second round issues in early April 1994. On February 3, 1994, the Council issued a resolution and order granting the motions of NOPSI and LP&L to dismiss without prejudice the CCLM portion of the filing, authorizing NOPSI and LP&L to proceed with a pilot CCLM (other than the construction of a fiber optics/coaxial cable network) in New Orleans at shareholder expense (subject to certain conditions). The Council also opened a new docket to expeditiously address issues related to the CCLM pilot, and directing NOPSI and LP&L to obtain Council authorization in the new docket before constructing such a fiber optics/coaxial cable network. In connection with the settlement of various issues related to the Merger, the Council adopted a resolution on November 18, 1993, that provides that the Council will not disallow the first $3.5 million of costs incurred by NOPSI through October 31, 1993, in connection with the Least Cost Plan. Fuel Adjustment Clause. NOPSI's electric rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month, adjusted by a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. The adjustment clause, on a monthly basis, also reflects the difference between nonfuel Grand Gulf 1 costs paid by NOPSI and the estimate of such costs provided in NOPSI's Grand Gulf 1 Rate Settlements. NOPSI's gas rate schedules include a gas cost adjustment to reflect gas costs in excess of those collected in rates, adjusted by a surcharge similar to that included in the electric adjustment clause. NOPSI defers on its books fuel and purchased gas costs to be reflected in billings to customers in the future under the fuel adjustment clause. REGULATION Federal Regulation Holding Company Act. Entergy Corporation is a registered public utility holding company under the Holding Company Act. As such, Entergy Corporation and its various direct and indirect subsidiaries (with the exception of its independent power/EWG subsidiaries) are subject to the broad regulatory provisions of that Act. Except with respect to investments in certain EWG projects and foreign utility company projects (see "Business of Entergy - Competition - General," above for a discussion of the Energy Act), Section 11(b)(1) of the Holding Company Act limits the operations of a registered holding company system to a single, integrated public utility system, plus additional systems and businesses as provided by that section. Federal Power Act. The System operating companies, System Energy, and Entergy Power are subject to the Federal Power Act as administered by FERC and the DOE. The Federal Power Act provides for regulatory jurisdiction over the licensing of certain hydroelectric projects, the business of, and facilities for, the transmission and sale at wholesale of electric energy in interstate commerce and certain other activities of the System operating companies, System Energy, and Entergy Power as interstate electric utilities, including accounting policies and practices. Such regulation includes jurisdiction over the rates charged by System Energy for capacity and energy provided to AP&L, LP&L, MP&L, and NOPSI, or others, from Grand Gulf 1. AP&L holds a license for two hydroelectric projects (70 MW) that was renewed on July 2, 1980. This license, granted by FERC, will expire in February 2003. Regulation of the Nuclear Power Industry General. Under the Atomic Energy Act of 1954 and Energy Reorganization Act of 1974, operation of nuclear plants is intensively regulated by the NRC, which has broad power to impose licensing and safety-related requirements. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. AP&L, GSU, LP&L, and System Energy, as owners of all or a portion of ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, and Entergy Operations, as the operator of these units, are subject to the jurisdiction of the NRC. Revised safety requirements promulgated by the NRC have, in the past, necessitated substantial capital expenditures at System nuclear plants and additional such expenditures could be required in the future. The nuclear power industry faces uncertainties with respect to the cost and availability of long-term arrangements for disposal of spent nuclear fuel and other radioactive waste, nuclear plant operational issues, the technological and financial aspects of decommissioning plants at the end of their licensed lives, and the effect of certain requirements relating to nuclear insurance. These matters are briefly discussed below. Spent Fuel and Other High-Level Radioactive Waste. Under the Nuclear Waste Policy Act of 1982, the DOE is required, for a specified fee, to construct storage facilities for, and to dispose of, all spent nuclear fuel and other high-level radioactive waste generated by domestic nuclear power reactors. The NRC, pursuant to this Act, also requires operators of nuclear power reactors to enter into spent fuel disposal contracts with the DOE, and the affected System companies have entered into such disposal contracts. However, the DOE has not yet identified a permanent storage repository and, as a result, future expenditures may be required to increase spent fuel storage capacity at the plant sites. (For further information concerning spent fuel disposal contracts with the DOE, schedules for initial shipments of spent nuclear fuel, current on-site storage capacity, and costs of providing additional on-site storage capacity, with respect to AP&L, GSU, LP&L, and System Energy, respectively, see Note 8 of AP&L's, GSU's, and LP&L's, and Note 7 of System Energy's, Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Low-Level Radioactive Waste. The availability and cost of disposal facilities for low-level radioactive waste resulting from normal operation of nuclear units are subject to a number of uncertainties. Under the Low-Level Radioactive Waste Policy Act of 1980, as amended, each state is responsible for disposal of its own waste, and states may join in regional compacts to jointly fulfill their responsibilities. The States of Arkansas and Louisiana participate in the Central States Compact, and the State of Mississippi participates in the Southeast Compact. Two disposal sites are currently operating in the United States, and one of them, which is located in Washington, is closed to out-of-region generators. The second site, the Barnwell Disposal Facility (Barnwell) located in South Carolina, is operated by the Southeast Compact and the State of Mississippi is expected to have access to this site through December 1995. Barnwell had been open to out-of-region generators (including generators in Arkansas and Louisiana) in the past; however, on April 14, 1993, the Southeast Compact voted to deny access to Barnwell to members of the Central States Compact. Such access was reinstated for the period from October 1993 through June 1994, at which time legislative action by the State of South Carolina would be required to permit further access to out-of-region generators. Beginning in July 1994, low-level radioactive waste generators in the Central States Compact, including AP&L, GSU, and LP&L, will be required to store such waste on-site until a Central States Compact facility becomes operational or another site becomes accessible. Both the Central States Compact and the Southeast Compact are working to establish additional disposal sites. The System, along with other waste generators, funds the development costs for new disposal facilities. The System's expenditures to date are approximately $30 million; and future levels of expenditures cannot be predicted. Until such facilities are established, the System will continue to seek access to existing facilities, which may be available at costs that are higher than those incurred in the past, or which may be unavailable. If such access is unavailable, the System will store low-level waste on-site at the affected units. ANO has on-site storage that is estimated to be sufficient until 1999. Construction of on-site storage at the other nuclear units is being considered, along with other alternatives. A coordinated design concept that can be utilized at both Waterford 3 and River Bend is being evaluated. Grand Gulf 1 will have continued disposal access through December 1995; therefore, no immediate plans for on-site storage are needed for Grand Gulf 1. The estimated construction costs for storage sufficient for approximately five years at Grand Gulf 1, Waterford 3, and River Bend are in the range of $2.0 million to $5.0 million for each site. As an alternative to on-site storage, Entergy is working with other industry groups to influence the continued operation of the Barnwell disposal facility for out-of-region generators. Decommissioning. AP&L, GSU, LP&L, and System Energy are recovering portions of their estimated decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively. These amounts are being deposited in external trust funds that, together with the earnings thereon, can only be used for future decommissioning costs. Estimated decommissioning costs are regularly reviewed and updated to reflect inflation and changes in regulatory requirements and technology, and applications will be made to appropriate regulatory authorities to recover in rates any projected increase in decommissioning costs above that currently being recovered. (For additional information with respect to decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, see Note 8 of AP&L's, GSU's, and LP&L's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Uranium Enrichment Decontamination and Decommissioning Fees. The Energy Act requires all electric utilities (including AP&L, GSU, LP&L, and System Energy) that have purchased uranium enrichment services from the DOE to contribute up to a total of $150 million annually, adjusted for inflation, up to a total of $2.25 billion over approximately 15 years, for decommissioning and decontamination of enrichment facilities. AP&L's, GSU's, LP&L's, and System Energy's estimated annual contributions to this fund are $3.3 million, $0.6 million, $1.2 million, and $1.3 million, respectively, in 1993 dollars over approximately 15 years. Contributions to this fund are to be recovered through rates in the same manner as other fuel costs. Nuclear Insurance. The Price-Anderson Act provides for a limit of public liability for a single nuclear incident. As of December 31, 1993, the limit of public liability for such type of incident was approximately $9.4 billion. AP&L, GSU, LP&L, and System Energy have protection with respect to this liability through a combination of private insurance and an industry assessment program, and also have insurance for property damage, costs of replacement power, and other risks relating to nuclear generating units. (For a discussion of insurance applicable to nuclear programs of AP&L, GSU, LP&L, and System Energy, see Note 7 of System Energy's and Note 8 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, and Note 8 of Entergy Corporation and Subsidiaries, Notes to Consolidated Financial Statements, "Commitments and Contingencies - Nuclear Insurance," incorporated herein by reference.) Nuclear Operations General. Entergy Operations operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. AP&L, GSU, LP&L, and System Energy, and the other Grand Gulf 1, Waterford 3, and River Bend co- owners, have retained their ownership interests in their respective nuclear generating units. AP&L, GSU, LP&L, and System Energy have also retained their associated capacity and energy entitlements, and pay directly or reimburse Entergy Operations at cost for its operation of the units. On June 24, 1992, the NRC issued a bulletin requiring all utilities using a certain fire barrier material in a nuclear power plant to take certain actions related to the material. This material may have been used in as many as 87 nuclear plants in the United States, including ANO, River Bend, Waterford 3, and Grand Gulf 1 (see "River Bend," below for additional information). ANO. In 1990, in response to a special diagnostic evaluation report by the NRC, AP&L implemented a comprehensive action plan for ANO designed to correct certain management, organizational, and technical problems, and to improve the long-term operational effectiveness and safety of the units. This action plan was largely completed in 1993. Leaks in certain steam generator tubes at ANO 2 were discovered and repaired during an outage in March 1992; and during a refueling outage in September 1992, a comprehensive inspection of all steam generator tubing was conducted and necessary repairs were made. During a mid-cycle outage in May 1993, a scheduled special inspection of certain steam generator tubing was conducted by Entergy Operations and additional repairs were made. Entergy Operations proposes to operate ANO 2 with no further steam generator inspections until the next refueling outage, which is scheduled for the spring of 1994, and the NRC has concurred with this proposal. The operations and power output of the unit have not been adversely affected to date by these repairs. River Bend. The Nuclear Information and Resource Service petitioned the NRC to shut down the River Bend plant in July 1992 because of alleged defects in a fire barrier material. GSU has used this material in its River Bend plant and is in compliance with the requirements of the bulletin. On August 19, 1992, the NRC denied the petitioner's request. In a December 1993 letter, the NRC requested additional technical information on the use of the material in the plant, and requested GSU's plans and schedules for resolving technical issues associated with the use of the material in certain configurations. GSU has provided the information requested in the NRC letter. On January 13, 1993, in connection with the Merger, GSU filed two applications with the NRC to amend the River Bend operating license. The applications sought the NRC's consent to the Merger and to a change in the licensed operator of the facility from GSU to Entergy Operations. On August 6, 1993, Cajun filed a petition to intervene and request for a hearing in the proceedings. On January 27, 1994, the presiding NRC Atomic Safety and Licensing Board (ASLB) issued an order granting Cajun's petition to intervene and ordered a hearing on one of Cajun's contentions. On February 15, 1994, GSU filed an appeal of the ASLB Order with the NRC. On December 16, 1993, prior to this ASLB ruling, the NRC Staff issued the two license amendments for River Bend, making them effective immediately upon consummation of the Merger. On February 16, 1994, Cajun filed with the D.C. Circuit petitions for review of the two license amendments issued by the NRC. These two amendments are in full force and effect, but are subject to the outcome of the two proceedings. A hearing on the proceeding before the ALSB is not expected to begin prior to the fall of 1994. In February 1993, GSU and the other affected utilities were served with a federal grand jury subpoena to produce documents and other information relating to the fire barrier material used in the plant. Nothing in the subpoena indicates that GSU or any employee is a target of the grand jury investigation. GSU is cooperating fully with the government in its investigation. The requested documentation and other information were produced in March 1993, and no additional requests have been received. On October 25, 1993, the NRC staff began an operational safety team inspection at River Bend that was concluded by mid-November 1993. The NRC held the inspection to verify that the plant is being operated safely and in conformance with regulatory requirements. The team's findings were discussed at a public meeting in November 1993, and a written inspection report was issued in January 1994. The inspection team found apparent violations in two categories: (1) procedure adequacy, and (2) concerns with the corrective action program. Due to the nature of these apparent violations, an enforcement conference was not warranted and no fine was proposed. State Regulation General. Each of the System operating companies is subject to regulation by its respective state and/or local regulatory authorities with jurisdiction over the service areas in which each company operates. Such regulation includes authority to set rates for electric and gas service provided at retail. (See "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," above) AP&L is subject to regulation by the APSC and the Tennessee Public Service Commission (TPSC). APSC regulation includes the authority to set rates, determine reasonable and adequate service, fix the value of property used and useful, require proper accounting, control leasing, control the acquisition or sale of any public utility plant or property constituting an operating unit or system, set rates of depreciation, issue certificates of convenience and necessity and certificates of environmental compatibility and public need, and control the issuance and sale of securities. Regulation by the TPSC includes the authority to set standards of service and rates for service to customers in the state, require proper accounting, control the issuance and sale of securities, and issue certificates of convenience and necessity. GSU is subject to the jurisdiction of the municipal authorities of incorporated cities in Texas as to retail rates and services within their boundaries, with appellate jurisdiction over such matters residing in the PUCT. GSU is also subject to regulation by the PUCT as to retail rates and services in rural areas, certification of new generating plants, and extensions of service into new areas. GSU is subject to regulation by the LPSC as to electric and gas service, rates and charges, certification of generating facilities and power or capacity purchase contracts, and other matters. LP&L is subject to the jurisdiction of the LPSC as to rates and charges, standards of service, depreciation, accounting, and other matters, and is subject to the jurisdiction of the Council with respect to such matters within Algiers. MP&L is subject to regulation as to service, service areas, facilities, and retail rates by the MPSC. MP&L is also subject to regulation by the APSC as to the certificate of environmental compatibility and public need for the Independence Station. NOPSI is subject to regulation as to electric and gas service, rates and charges, standards of service, depreciation, accounting, issuance of certain securities, and other matters by the Council. Franchises. AP&L holds franchises to provide electric service in 301 incorporated cities and towns in Arkansas, all of which are unlimited in duration and terminable by either party. GSU holds non-exclusive franchises, permits, or certificates of convenience and necessity to provide electric and gas service in 55 incorporated villages, cities, and towns in Louisiana and 64 incorporated cities and towns in Texas. GSU ordinarily holds 50-year franchises in Texas towns and 60-year franchises in Louisiana towns. The present terms of GSU's electric franchises will expire in the years 2007-2036 in Texas and in the years 2015-2046 in Louisiana. The natural gas franchise in the City of Baton Rouge will expire in the year 2015. LP&L holds franchises to provide electric service in 116 incorporated villages, cities, and towns. Most of these franchises have 25-year terms expiring during the period 1995-2015. However, six of these municipalities have granted 60-year franchises, with the last one expiring in the year 2040. Of these franchises, none has expired to date, one is scheduled to expire as early as 1995, and 37 are scheduled to expire by year-end 2000. LP&L also supplies electric service in 353 unincorporated communities, all of which are located in parishes (counties) from which LP&L holds franchises to serve the areas in which the unincorporated communities are located. MP&L has received from the MPSC certificates of public convenience and necessity to provide electric service to the areas of Mississippi that MP&L serves, which include a number of municipalities. MP&L continues to serve in such municipalities upon payment of a statutory franchise fee, regardless of whether an original municipal franchise is still in existence. NOPSI provides electric and gas service in the City of New Orleans pursuant to city ordinances, which state, among other things, that the City has a continuing option to purchase NOPSI's electric and gas utility properties. System Energy has no franchises from any municipality or state. Its business is currently limited to wholesale sales of power. Environmental Regulation General. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes, and other environmental matters, the System operating companies, System Energy, Entergy Power, and Entergy Operations are subject to regulation by various federal, state, and local authorities. Each of the Entergy companies considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations. Entergy has incurred increased costs of construction and other increased costs in meeting environmental protection standards. Because environmental regulations are continually changing, the ultimate compliance costs to Entergy cannot be precisely estimated at any one time. However, Entergy currently estimates that its potential capital expenditures for environmental control purposes, including those discussed in "Clean Air Legislation," below, will not be material for the System as a whole. Clean Air Legislation. The Clean Air Act Amendments of 1990 (the Act) place limits on emissions of sulfur dioxide and nitrogen oxide from fossil-fueled generating plants. Entergy has evaluated the Act to determine the impact on the System's overall cost of emission control and monitoring equipment. Based upon such evaluation in connection with existing generating facilities, the System has determined that no additional control equipment will be required to control sulfur dioxide. In the area served by GSU, control equipment will be required for nitrogen oxide reductions due to the ozone nonattainment status of the Baton Rouge, Louisiana and Beaumont and Houston, Texas air quality control regions no later than May 1995. The cost of such control equipment is estimated at $16.0 million. The remainder of the System may be required to install nitrogen oxide emission controls on its coal units by the year 2000. The EPA is currently drafting rules that will determine the levels of nitrogen oxide emissions that will be allowed by affected units. Under the latest EPA-proposed regulations on nitrogen oxide, Entergy would not have to install additional controls. It is not possible to determine at this time if the final regulations promulgated by EPA would require the System's coal units to install nitrogen oxide emission controls. Should additional controls be required, the overall cost would vary depending on the eventual emission levels that are set. In addition, the System will be required to install additional continuous emission monitoring equipment at its coal units to comply with final EPA regulations. It is estimated that the continuous emission monitoring systems could cost as much as $1.0 million for all of the coal units. Final EPA regulations established the acceptable continuous monitoring methods, as well as alternative monitoring methods, that make it possible to determine the compliance of the units with respect to emission levels through fuel sampling and other estimation methods. Capital expenditures of approximately $11.0 million are estimated for continuous emission monitoring systems at the other fossil-fueled units. The authority to impose permit fees has been delegated to the states by EPA and, depending on the extent of the state program and the fees imposed by each state regulatory authority, permit fees for the System could range from $1.6 to $5.0 million annually. There are several other areas, such as air toxins and visibility, that will require regulatory study and rule promulgation to determine whether pollution control equipment is necessary. Regarding sulfur dioxide emissions, the Act provides "allowances" to most Entergy units based upon past emission levels and operating characteristics. Each unit of allowance is an entitlement to emit one ton of sulfur dioxide per year. Under the Act, utilities will be required to possess allowances for sulfur dioxide emissions from affected units. Based on Entergy's past operating history, it is considered a "clean" utility and as such will receive more allowances than are currently necessary for normal operations. The System believes that it will be able to operate its units efficiently without installing scrubbers or purchasing allowances from outside sources, and the System may have excess allowances available for sale to other utilities. Entergy currently estimates that total capital costs of approximately $39.4 million could be required to comply with the Act. These estimated costs for each legal entity are as follows: Nitrogen Continuous Company Oxide Emissions Control Monitors Total ---------------------- -------- ---------- ----- (In Thousands) AP&L $ 7,275 $ 3,300 $10,575 GSU 16,000 4,900 20,900 LP&L - 2,300 2,300 MP&L 2,500 1,500 4,000 NOPSI - - - System Energy - - - Entergy Power 1,575 - 1,575 ------- ------- ------- Total Entergy System $27,350 $12,000 $39,350 ======= ======= ======= Other Environmental Matters. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (Superfund), among other things, authorize the EPA and, indirectly, the states to require the generators and certain transporters of certain hazardous substances released from or at a site, and the owners or operators of such site, to clean up the site or reimburse the costs therefor. This statute has been interpreted to impose joint and several liability on responsible parties. In compliance with applicable laws and regulations at the time, the System operating companies have sent waste materials to various disposal sites over the years. Also, past operating procedures and maintenance practices, which were not subject to regulation at that time, are now regulated by various environmental laws. Some of these sites have been the subject of governmental action, thereby causing one or more of the System operating companies to be involved with site cleanup activities. The System operating companies have participated to various degrees in accordance with their potential liability with these site cleanups and have, therefore, developed experience with cleanup costs. Their experience in these matters, and their judgments related thereto, are utilized by them in evaluating these sites. In addition, the System operating companies have established reserves for environmental clean-up/restoration activities. AP&L. AP&L has received notices from time to time between 1989 and 1993, from the EPA, the Arkansas Department of Pollution Control and Ecology (ADPC&E), and others that it (among numerous others, including various utilities, municipalities and other governmental units, and major corporations) may be a PRP for cleanup costs associated with various sites in Arkansas. Most of these sites are neither owned nor operated by any System company. Contaminants at the sites include principally polychlorinated biphenyls (PCB's), lead, and other hazardous wastes. These sites and others are described below. AP&L received notices from the EPA and ADPC&E in 1990 and 1991, identifying it as one of 30 PRP's (along with LP&L and GSU) at two Saline County sites in Arkansas. Both sites are believed to be contaminated with PCB's and lead. Cleanup costs for both sites are estimated at $6.0 million, with AP&L's total share of the costs being estimated at approximately $2.0 million. AP&L to date has expended approximately $1.0 million for remediation at one of these sites. The total liability cannot be precisely determined until remediation is complete at both sites. AP&L believes its potential liability for these sites will not be material. Reynolds Metals Company (RMC) and AP&L notified the EPA in 1989, of possible PCB contamination at two former RMC plant sites in Arkansas to which AP&L had supplied power. AP&L completed remediation at the substations serving the plant sites at a cost of $1.7 million. Additional PCB contamination was found in a portion of a drainage ditch that flows from the RMC's Patterson facility to the Ouachita River. RMC has demanded that AP&L participate in the remediation efforts with respect to the ditch. AP&L and independent contractors engaged by AP&L conducted an investigation of the ditch contamination and the potential migration of PCB's from the electrical equipment that AP&L maintained at the plant. The investigation concluded that little, if any, of the contamination was caused by AP&L. AP&L's expenditures thus far on the ditch have been approximately $150,000. It is AP&L's understanding that RMC has spent approximately $10.0 million to complete remediation of the ditch contamination. AP&L has not received a notice from the EPA that it may be a PRP with respect to remediation costs for this site. However, RMC is seeking reimbursement of $5.0 million (50% of expenditures) from AP&L. AP&L continues to deny responsibility for any of such remediation costs and believes that its potential liability, if any, for this site will not be material. AP&L entered into a Consent Administrative Order dated February 21, 1991, with the ADPC&E that named AP&L as a PRP for cleanup of contamination associated with the Utilities Services, Inc. state Superfund site located near Rison, Arkansas. Such site was found to have soil contaminated by PCB's and pentachlorophenol (a wood preservative chemical). Also, containers and drums that contained PCB's and other hazardous substances were found at the site. AP&L's share of total remediation costs are estimated to range between $3.0 million and $5.0 million. AP&L is attempting to identify and notify other PRP's. AP&L has received assurances from the ADPC&E that it will use its enforcement authority to allocate remediation expenses among AP&L and any other PRP's that can be identified (approximately 30 - 35 have been identified to date). AP&L has performed the activities necessary to stabilize the site, which to date has cost approximately $114,000. AP&L believes that its potential liability for this site will not be material. AP&L received Notice of Potential Liability and a Demand for Payment in November 1992 from the EPA in conjunction with a contaminated site in Union County, Arkansas. AP&L was identified as one of eleven PRP's, which also include LP&L. The EPA has already completed cleanup of the site. An agreement has been negotiated with the EPA which determined AP&L to be a de minimis party with total liability of approximately $47,000. As a result of an internal investigation, AP&L has discovered soil contamination at two AP&L-owned sites located in Blytheville, Arkansas and Pine Bluff, Arkansas. The contamination appears to be a result of past operating procedures that were performed prior to any applicable environmental regulation. AP&L is still investigating these sites to determine the full extent of the contamination. Until the investigations are complete, AP&L cannot estimate the liabilities associated with these sites. However, AP&L believes its potential liability for both of the sites should not be material. For all of these sites and for certain sites in which remediation has been completed, AP&L has expended approximately $3.2 million for cleanup costs since 1989. GSU. GSU has been notified by the EPA that it has been designated as a PRP for the cleanup of sites on which GSU and others have, or have been alleged to have, disposed of hazardous materials. GSU is currently negotiating with the EPA and various state authorities regarding the cleanup of some of these sites. Several class action and other suits have been filed seeking relief from GSU and others for damages caused by the disposal of hazardous waste and for asbestos-related disease that allegedly occurred from exposure on GSU premises or on premises on which GSU allegedly disposed of materials (see "Other Regulation and Litigation - GSU," below). While the amounts at issue in the cleanup efforts and suits may be very substantial sums, management believes that its financial condition and results of operations will not be materially affected by the outcome of the suits. These environmental liabilities are described below. In 1971, GSU purchased certain property near its Sabine generating station for possible cooling water capability expansion. Although it was not known to GSU at the time of the purchase, the property was utilized by area industries in the 1950's and 1960's as an industrial waste dump. GSU sold the property in 1984. In October 1984 the abandoned waste site on the property was included on the Superfund National Priorities List (NPL) by the EPA. The EPA has indicated that it believes GSU to be a PRP for cleanup of the site based on its past ownership. GSU has advised the EPA that it does not believe that it has such responsibility. GSU has pursued negotiations with the EPA and is a member of a task force made up of other PRP's for the voluntary cleanup of the waste site. A Consent Decree has been signed by all parties. Because additional wastes have been discovered at the site since the original cleanup costs were estimated, the total costs for the voluntary cleanup are unknown. However, it is estimated that cleanup will exceed $15.0 million. GSU has negotiated a responsible share of 2.26% of the estimated cleanup cost. Federal and state agencies are presently examining potential liabilities associated with natural resource damages. This matter is currently under negotiation with the other PRP's and the agencies. Remediation of the site is expected to be completed in 1996. In March 1993, GSU completed its cleanup activities at a site in Houston, Texas, which is included in the NPL. On September 20, 1993, GSU received formal notification from the EPA of its acceptance of the remedial activities conducted at the site. Currently, other parties are conducting cleanup activities at the site. However, these cleanup activities are unrelated to GSU's involvement at the site. Through 1993, GSU incurred cleanup costs of approximately $3.3 million. Pursuant to the Consent Decree, GSU is responsible for oversight costs incurred by the EPA. GSU has not received a reimbursement request for outstanding oversight costs, but anticipates these costs may total between $250,000 and $500,000. GSU is pursuing contribution for the cleanup costs at the site from other parties believed to be potentially responsible. GSU is currently involved in a multi-phased remedial investigation of an abandoned manufactured gas plant (MGP) site located in Lake Charles, Louisiana. The property was the site of an MGP that is believed to have operated during the period from approximately 1916 to 1931. Coal tar, a by-product of the distillation process, was apparently routed to a portion of the property for disposal. Since GSU purchased the property in 1926, the same area has been filled with soil and used as a landfill for miscellaneous items including electrical poles, electrical equipment, and other debris. Under an Order by the Louisiana Department of Environmental Quality (LDEQ), which is currently stayed, GSU was required to investigate and, if necessary, take remedial action at the site. The EPA has notified GSU that it is performing an independent review and ranking of the site to determine whether the site should be listed on the NPL. Another PRP has been identified and is believed to have had a role in the ownership and operation of the MGP. Negotiations with that company for joint participation and any remedial action are expected to continue. GSU currently is awaiting notification from the EPA before initiating additional cleanup negotiations or actions. While studies to determine the location of the coal tar have been conducted, the cleanup costs of the site are unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU has also been advised that it has been named as a PRP, along with a number of other companies (including LP&L), for an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, which is included on the NPL. Although significant remediation has been completed, additional studies are expected to continue in 1994. GSU and LP&L have been named as defendants in a class action lawsuit lodged against a group of PRP's associated with the site. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - GSU," below.) GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU received notification in 1992 from the EPA of potential liability at a site located in Iota, Louisiana. This site accepted a variety of wastes, including medical and chemical wastes. In addition to GSU, over 200 parties have been named as PRP's. The EPA is continuing its investigation of the site and has notified the PRP's of the possibility of this site being linked to another site. To date, GSU has not received notification of liability with regard to the other site. GSU does not presently believe its ultimate responsibility with respect to this site will be material. GSU has also been notified by the EPA of potential liability at two sites located in Saline County, Arkansas. It is believed that both sites served as a salvaging facility for transformers and batteries. In addition to GSU, 32 other parties (including AP&L and LP&L) have been named as PRP's. At this time, GSU's involvement with the site is unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. In November 1993, GSU received informal notification from the Rhode Island Department of Environmental Management regarding a site at which electrical capacitors had been located. The State traced several of these capacitors to GSU. GSU records indicate these capacitors were returned under warranty to the manufacturer in the 1960's due to defects. GSU does not presently believe it is responsible for any alleged activities occurring at this site. As of December 31, 1993, GSU had expended $7.0 million toward the cleanup of such sites. In 1990, GSU received an order from the LDEQ to reduce emissions of nitrogen oxides and reactive hydrocarbons at its Willow Glen and Louisiana Station plants located near Baton Rouge, Louisiana. GSU has requested an adjudicatory hearing on the matter, which the LDEQ secretary has deemed as staying the order. In the interim, GSU has joined several other Baton Rouge industries to develop and submit to LDEQ a comprehensive set of short- and long-range reduction plans. In 1993, LDEQ adopted regulations requiring permanent reductions in nitrogen oxides emissions at Willow Glen and Louisiana Station and is considering requirements for further reductions. The estimates for actions necessary to comply with these regulations are included in the discussion under "Clean Air Legislation," above. GSU believes these regulations implement the intent of the 1990 order, and actions beyond those required by the regulations will not be required. LP&L and NOPSI. LP&L and NOPSI have received notices from time to time between 1986 and 1993 from the EPA and/or the states of Louisiana and Mississippi that each or either of the companies may be a PRP for cleanup costs associated with disposal sites that are currently in various stages of remediation in Arkansas, Illinois, Louisiana, Mississippi, and Missouri that are neither owned nor operated by any System company. As to one Missouri site, LP&L's and NOPSI's aggregate liability is currently estimated not to exceed $558,000, and because of the type and the large number of PRP's (over 700, including many large utilities and national and international corporations), LP&L and NOPSI do not expect liabilities in excess of this amount. For the other Missouri site, LP&L and the other 64 PRP's (including several large, creditworthy utility companies) have received an EPA demand to pay approximately $1.2 million expended by the EPA. In June of 1993, LP&L paid $12,392 in full payment of its share of the cleanup costs. LP&L considers cleanup at this site to be complete. As to the two Saline County, Arkansas sites (involving AP&L, GSU, and LP&L), LP&L has been advised that current estimates for total cleanup are approximately $6.0 million. LP&L believes that, because of the number and nature of the PRP's, its exposure for these sites will not be material. Initial indications are that LP&L was involved in the Saline sites, but LP&L believes that because of the limited scope of its involvement and the number and nature of PRP's, its exposure for these sites will not be material. LP&L received notice from the EPA in November 1992, that it (along with AP&L) was involved in the Union County, Arkansas site. An agreement has been negotiated with the EPA that determined LP&L to be a de minimis party with a total liability of approximately $47,000 (see "AP&L," above.) As to the Mississippi site, LP&L (along with System Energy) understands that EPA has expended approximately $740,000 for this site (three separate locations being treated administratively as one). The State of Mississippi has indicated it intends to have PRP's conduct a cleanup of the site but has not yet taken formal action. LP&L has expended $22,300 to settle with the EPA for its costs for this site and, because there are 44 PRP's for this site (including a number of major oil companies), does not expect its share of future costs to be material. For a Livingston Parish, Louisiana site (involving at least 70 PRP's, including GSU and many other large and creditworthy corporations), LP&L has found in its records no evidence of its involvement. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - LP&L," below.) At a second Louisiana site (also included on the NPL and involving 57 PRP's, including a number of major corporations), NOPSI believes it has no liability for the site because the material it sent to the site was not a hazardous substance. For the Illinois site, NOPSI, upon its review of the site documentation and of its own records, has asserted to the EPA that it has no involvement in this site. However, NOPSI is participating with other PRP's (including many large and creditworthy corporations) as a prudent means of resolving potential liability, if any. For all these sites, LP&L has expended approximately $349,000 and NOPSI has expended approximately $172,000 for cleanup costs (commencing in 1986) to date. During 1993, LP&L performed preliminary site assessments at the locations of two retired power plants previously owned and operated by two Louisiana municipalities. LP&L had purchased the power plants by agreement (as part of the municipal electric systems) after operating them for the last few years of their useful lives. The assessments indicated some subsurface contamination from fuel oil. LP&L and the LDEQ are now reviewing site remediation procedures that LP&L estimates will not exceed $650,000 in the aggregate. During 1993, the LDEQ issued new rules for solid waste regulation, including waste water impoundments. LP&L has determined that certain of its power plant waste water impoundments are affected by these regulations and has chosen to close them rather than retrofit and permit them. The aggregate cost of the impoundment closures, to be completed by 1996, is estimated to be $7.3 million. System Energy. In February 1990, System Energy received an EPA notice that it (among numerous other companies) may be a PRP for cleanup costs associated with the same site in Mississippi in which LP&L is involved. Potential liability is based on the alleged shipment of waste oil to the site from 1981 to 1985. System Energy does not expect its share of the total expenditures to be material because there are 44 PRP's for this site, including a number of major oil companies. Other Regulation and Litigation Entergy Corporation and GSU. In July and August 1992, Entergy Corporation and GSU filed applications with FERC, the LPSC, and the PUCT, and Entergy Corporation, Entergy Operations, and Entergy Services filed an application with the SEC under the Holding Company Act, seeking authorization of various aspects of the Merger. In January 1993, GSU filed two applications with the NRC seeking approval of the change in ownership of GSU and an amendment to the operating license for River Bend to reflect its operation by Entergy Operations. All regulatory approvals were obtained in 1993 and the Merger was consummated on December 31, 1993 (see "Business of Entergy - Entergy Corporation-GSU Merger," above, for further information). Requests for rehearing of certain aspects of the FERC order were filed on January 14, 1994, by 14 parties, including Entergy Corporation, the APSC, the Mississippi Attorney General, the LPSC, the MPSC, the Texas Office of Public Utility Counsel, and the PUCT. Entergy Corporation, the LPSC, the Texas Office of Public Utility Counsel, and the PUCT are requesting FERC to restore a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under a tracking mechanism designed to protect the other companies from certain unexpected increases in fuel costs. The other parties are seeking to overturn FERC's decision on various grounds. Requests for rehearing of the SEC order were filed with the SEC by Houston Industries Incorporated and Houston Lighting & Power Company on December 28, 1993, and petitions for review seeking to set aside the SEC order were filed with the D.C. Circuit by these parties on February 15, 1994 and by Cajun on February 14, 1994. See "Nuclear Operations - River Bend," above for information on challenges to the NRC's approval of GSU's applications. Appeals seeking to set aside the LPSC order related to the Merger were filed in the 19th Judicial District Court for the Parish of East Baton Rouge, Louisiana, by Houston Lighting & Power Company on August 13, 1993, and by the Alliance for Affordable Energy, Inc. on August 20, 1993. Subsequently, on February 9, 1994, Houston Lighting & Power Company filed a motion voluntarily dismissing its appeal. AP&L. Three lawsuits (which have been consolidated) were filed in the Arkansas District Court by numerous plaintiffs against AP&L and Entergy Services in connection with the operation of two dams during a period of heavy rainfall and flooding in May 1990. The consolidated lawsuits sought approximately $14.4 million in property losses and other compensatory damages, and $500 million in punitive damages. In their responses to these complaints, AP&L and Entergy Services asserted, among other things, that AP&L owns flowage easements giving it the permanent right to inundate the lands owned or occupied by the plaintiffs in connection with the operation of the dams. In June 1991, the Arkansas District Court granted summary judgment to AP&L with respect to the enforceability of its flowage easements. In November 1991, the Arkansas District Court ruled that Entergy Services was entitled to the benefit of AP&L's flowage easements, in effect, removing from consideration damages in the approximate amount of $13.5 million alleged to have occurred within the areas covered by the easements. As a result, over 300 plaintiffs claiming damage within the easements were dismissed from the consolidated case in December 1991. Certain plaintiffs appealed these orders to the Eighth Circuit, which appeal was denied in March 1992. Following the Eighth Circuit's denial of their interlocutory appeal from the Arkansas District Court's orders, certain of the plaintiffs, without prejudice to their right to refile, voluntarily dismissed their claims which had not been disposed of in the Arkansas District Court's orders, thus making the orders a final adjudication, and appealed these orders to the Eighth Circuit. The remaining plaintiffs obtained a stay and an administrative termination of their claims, pending the outcome of the appeal. In December 1993, a three-judge panel of the Eighth Circuit filed its opinion affirming the judgment of the Arkansas District Court and entered judgment accordingly. The plaintiffs appealing the Arkansas District Court's orders filed petitions with the Eighth Circuit for a rehearing by the entire Court sitting en banc, which petitions were denied. The plaintiffs may petition the U.S. Supreme Court to issue a writ of certiorari to permit its review of the Eighth Circuit's decisions. Neither AP&L nor Entergy Services can predict whether the U.S. Supreme Court will grant such a petition, if one is filed. GSU. Between 1986 and 1993, GSU and approximately 70 other defendants, including many national and international corporations, including LP&L, have been sued in 17 suits in the Livingston Parish, Louisiana District Court (State District Court) by a number of plaintiffs who allegedly suffered damage or injury, or are survivors of persons who allegedly died, as a result of exposure to "hazardous toxic waste" that emanated from a site in Livingston Parish. The plaintiffs alleged that the defendants generated, transported, or participated in the storage of such wastes at the facility, which was previously operated as a waste oil recycling facility. These State District Court suits, which seek damages in total amounts ranging from $1.0 million to $10.0 billion and are now consolidated in a class action, and three federal suits in three states other than Louisiana involving issues arising from the same facility, have been removed and transferred, respectively, to the U.S. District Court for the Middle District of Louisiana (Federal District Court). Motions to remand the class action to the State District Court have been filed, and procedural issues regarding the federal suits are being considered as well. It is not known what effect any action taken on these motions and issues, whenever taken by the Federal District Court, would have on the April 11, 1994 State District Court trial date that was established before the suits were removed to Federal District Court; but it is unlikely such trial date will be met. The matter is pending. In October 1989, an amended lawsuit petition was filed on behalf of 985 plaintiffs in the District Court of Jefferson County, Texas, 60th Judicial District in Beaumont, Texas, naming 55 defendants including GSU. In February 1990, another amended lawsuit petition was filed in a different state District Court in Jefferson County, Texas, on behalf of over 200 plaintiffs (subsequently amended to include a total of 660) naming 127 defendants including GSU. Possibly 300 to 400 or more of the plaintiffs in Texas may have worked at GSU's premises. At least five other individual suits have been filed in Beaumont against GSU and others, seeking damages for alleged asbestos exposure. All of the plaintiffs in such suits are also suing GSU and all other defendants on a conspiracy count. There are 25 asbestos- related law suits filed in the 14th Judicial District Court of Calcasieu Parish in Lake Charles, Louisiana, on behalf of an aggregate of 53 plaintiffs naming from 16 to 24 defendants including GSU, and GSU is aware of as many as 61 additional cases that may be filed. The suits allege that each plaintiff contracted an asbestos-related disease from exposure to asbestos insulation products on the premises of such defendants. Management believes that GSU has meritorious defenses, but there can be no assurance as to the outcome of these cases or that additional claims may not be asserted. In asbestos- related suits against the manufacturers, very substantial recoveries have been achieved by large groups of claimants. GSU does not presently believe that the ultimate resolution of these cases will materially adversely affect the financial position of GSU. On February 3, 1984, Dow Chemical Company filed a request with the LPSC for a hearing to consider issues related to the purchase of cogenerated power by GSU. Other industries subsequently filed similar requests and the matters were consolidated. In November 1984, the LPSC completed hearings on rules, policies, and pricing methodologies applicable to cogeneration. Key issues were whether or not (1) GSU should be required to pay the industries for avoided capacity costs, and (2) GSU should be required to wheel power to or from the industrial plants. While the matter is still pending before the LPSC, the LPSC did set interim rates, subject to refund by either Dow or GSU, which exclude capacity costs. GSU has significant business relationships with Cajun, primarily co-ownership of River Bend and Big Cajun 2 Unit 3. GSU and Cajun own 70% and 30% of River Bend, respectively, while Big Cajun 2 Unit 3 is owned 42% and 58% by GSU and Cajun, respectively. GSU operates River Bend and Cajun operates Big Cajun 2 Unit 3. GSU was requested by Cajun and Jefferson Davis Electric Cooperative, Inc., (Jefferson Davis) to provide transmission of power over GSU's system for delivery to the Industrial Road area near Lake Charles, Louisiana. GSU provides electric service to industrial and other customers in such area, and Cajun and Jefferson Davis do not. On October 10, 1989, Cajun filed a complaint at FERC contending that GSU wrongfully refused to provide Cajun certain transmission services so that its member, Jefferson Davis, could provide service to certain industrial customers, and it requested FERC to order GSU to provide the service. On October 26, 1989, FERC summarily dismissed Cajun's complaint, but the D.C. Circuit reversed FERC's summary determination and remanded the case to FERC for a hearing. On June 24, 1992, after a hearing, an ALJ issued an Initial Decision, again dismissing Cajun's complaint. The ALJ found that the parties' contract did not require GSU to provide the service and that Cajun's member, Jefferson Davis, had not sought permission from the LPSC to serve the end-use customers in question. If Jefferson Davis secured permission from the LPSC, the ALJ believed (but did not decide) that FERC would require GSU to provide the requested transmission service. Both Cajun and GSU have filed exceptions to the ALJ's decision, and the matter is pending before FERC. Cajun and Jefferson Davis also brought a related action in federal court in the Western District of Louisiana alleging that GSU breached its obligations under the parties' contract and violated the antitrust laws by refusing to provide the transmission service described above. Cajun and Jefferson Davis seek an injunction requiring GSU to provide the requested service and unspecified treble damages for GSU's refusal to provide the service. On November 9, 1989, the district court judge denied Cajun's and Jefferson Davis' motion for a preliminary injunction. On May 3, 1991, the judge stayed the proceeding pending final resolution of the matters still pending before FERC. GSU and Cajun are parties to FERC proceedings regarding certain long-standing disputes relating to transmission service charges. Cajun asserts that GSU has improperly applied the terms of a rate schedule, Service Schedule CTOC, to its billings to Cajun and it seeks an order from FERC directing GSU to recompute the bills. GSU asserts that Cajun underpaid its bills, and it seeks an order directing Cajun to pay surcharges to make up the underpayments. On April 10, 1992, FERC issued an order affirming in part and reversing in part an ALJ's recommendations. Both GSU and Cajun have requested rehearing, and the requests are still pending. In addition, on August 25, 1993, the United States Court of Appeals for the Fifth Circuit reversed portions of FERC's order previously decided adversely to GSU, and remanded the case to FERC for further proceedings. On January 13, 1994, FERC rejected GSU's proposal to collect an interim surcharge while FERC considers the court's remand. GSU interprets FERC's 1992 order and the Court of Appeals decision to mean that Cajun owes GSU approximately $85 million through December 31, 1993. If GSU also prevails on all of the issues raised in its pending request for rehearing of FERC's earlier orders, then GSU estimates that Cajun would owe GSU approximately $118 million through December 31, 1993. If GSU does not prevail on its rehearing request, and Cajun prevails on its rehearing request, and if FERC rejects the modifications GSU interprets the court of appeals to have directed, then GSU would owe Cajun an estimated $76 million through December 31, 1993. Pending FERC's ruling on the May 1992 motions for rehearing, GSU has continued to bill Cajun utilizing the historical billing methodology and has booked underpaid transmission charges, including interest, in the amount of $140.8 million as of December 31, 1993. This amount is reflected in long-term receivables and in other deferred credits, with no effect on net income. On December 7, 1993, Cajun filed a complaint in the Middle District of Louisiana alleging that GSU failed to provide Cajun an opportunity to construct certain facilities that allegedly would have reduced its rates under Service Schedule CTOC, and Cajun seeks an order compelling the conveyance of certain facilities and unspecified damages. GSU has moved to dismiss the complaint on the basis, among others, that FERC has already addressed the matter in the proceedings described above. In May 1990, GSU received a subpoena from the Office of Inspector General - Investigations, United States Department of Agriculture, seeking production of documents relating to the construction costs of River Bend. Such office is authorized to investigate matters relating to programs of the Department of Agriculture. GSU has been sued by Cajun with respect to its participation in River Bend with funds made available through Department programs administered by the REA. GSU has failed in its efforts to have the REA made a party to the Cajun litigation. GSU does not know the purpose of such Office's investigation, but presently assumes that it relates to the Cajun civil litigation since the production of documents sought by such Office is similar to that sought by Cajun in its action against GSU. However, there can be no assurance given by GSU as to the real purpose of such Office's investigation. Among other areas of responsibility, such office is authorized to investigate possible violations of law. GSU believes the subpoena proceeding has been administratively dismissed without prejudice to the parties. On December 2, 1991, Cajun filed a complaint seeking declaratory and injunctive relief from the U. S. District Court for the Middle District of Louisiana. The complaint concerns GSU's position that Cajun is in default with respect to paying its share of certain expenditures to repair corrosion damage in the service water system, to repair a feedwater nozzle crack, and to repair a turbine rotor. Cajun alleges that it has no obligation to pay its share of such costs and seeks a declaration that it may elect not to participate in the funding of such costs and enjoining GSU from demanding payment therefor or attempting to implement default provisions in the Operating Agreement with respect thereto. Cajun alleges that if it is required to pay its share of such costs it would be forced to default on other obligations and would be forced to seek relief in bankruptcy. GSU believes that Cajun is in default under the provisions of the Operating Agreement. No assurance can be given as to the outcome or timing of this action brought by Cajun. On November 25, 1992, Dixie Electric Membership Corporation and Southwest Louisiana Electric Membership Corporation, both members of Cajun, filed suit in the U.S. District Court for the Western District of Louisiana seeking a declaration that the River Bend Joint Ownership Agreement between GSU and Cajun is void because an allegedly required approval of the LPSC was not obtained. This suit has been transferred from the Western District to the Middle District, and is being processed in conjunction with the suit described in the following paragraph. GSU believes the suit is without merit. In June 1989, Cajun filed a civil action against GSU in the U. S. District Court for the Middle District of Louisiana. Cajun stated in its complaint that the object of the suit is to annul, rescind, terminate, and/or dissolve the Joint Ownership Participation and Operating Agreement entered into on August 28, 1979 (Operating Agreement), related to River Bend. Cajun alleges fraud and error by GSU, breach of its fiduciary duties owed to Cajun, and/or GSU's repudiation, renunciation, abandonment, or dissolution of its core obligations under the Operating Agreement, as well as the lack or failure of cause and/or consideration for Cajun's performance under the Operating Agreement. The suit seeks to recover Cajun's alleged $1.6 billion investment in the unit as damages, plus attorneys' fees, interest, and costs. In March 1992, the district court appointed a mediator to engage in settlement discussions and to schedule settlement conferences between the parties. Discussions with the mediator began in July 1992, however, GSU cannot predict what effect, if any, such discussions will have on the timing or outcome of the case. A trial without a jury is set for April 12, 1994, on the portion of the suit by Cajun to rescind the Operating Agreement. GSU believes the suits are without merit and is contesting them vigorously. No assurance can be given as to the outcome of this litigation. If GSU were ultimately unsuccessful in this litigation and were required to make substantial payments, GSU would probably be unable to make such payments and would probably have to seek relief from its creditors under the Bankruptcy Code. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquisition contingencies, including a charge resulting from an adverse resolution of the litigation with Cajun related to River Bend. In July 1992, Cajun notified GSU that it would fund a limited amount of costs related to the fourth refueling outage at River Bend, completed in September 1992. Cajun has also not funded its share of the costs associated with certain additional repairs and improvements at River Bend completed during the refueling outage. GSU has paid the costs associated with such repairs and improvements without waiving any rights against Cajun. GSU believes that Cajun is obligated to pay its share of such costs under the terms of the applicable contract. Cajun has filed a suit seeking a declaration that it does not owe such funds and seeking injunctive relief against GSU. GSU is contesting such suit and is reviewing its available legal remedies. In September 1992, GSU received a letter from Cajun alleging that the operating and maintenance costs for River Bend are "far in excess of industry averages" and that "it would be imprudent for Cajun to fund these excessive costs." Cajun further stated that until it is satisfied it would fund a maximum of $700,000 per week under protest for the remainder of 1992. In a December 1992 letter, Cajun stated that it would also withhold costs associated with certain additional repairs, of which the majority will be incurred during the next refueling outage, currently scheduled for April 1994. GSU believes that Cajun's allegations are without merit and is considering its legal and other remedies available with respect to the underpayments by Cajun. The total resulting from Cajun's failure to fund repair projects, Cajun's funding limitation on the fourth refueling outage, and the weekly funding limitation by Cajun was $33.3 million as of December 31, 1993, compared with a $28.4 million unfunded balance as of December 31, 1992. During 1994, and for the next several years, it is expected that Cajun's share of River Bend-related costs will be in the range of $60 million to $70 million per year. Cajun's weak financial condition could have a material adverse effect on GSU, including a possible NRC action with respect to the operation of River Bend and a need to bear additional costs associated with the co-owned facilities. If GSU were required to fund Cajun's share of costs, there can be no assurance that such payments could be recovered. Cajun's weak financial condition could also affect the ultimate collectibility of amounts owed to GSU. Since 1986, GSU had been in litigation with the Southern Company regarding unit power and long-term power purchase contracts with the Southern Company. GSU entered into a settlement agreement dated December 21, 1990, which was consummated on November 7, 1991, and the settlement obligations were fully satisfied in 1993. In 1986, the PUCT and the LPSC disallowed the pass-through by GSU in its retail rates of the costs of the capacity purchases from the Southern Company, which were being incurred by GSU. GSU appealed the actions of the PUCT and the LPSC disallowing pass-through of Southern Company capacity charges to the appropriate state courts. The appeal from the LPSC is pending. As part of a settlement of a retail rate case in Texas during the fourth quarter of 1993, GSU has discontinued its appeal of the PUCT disallowance. Following the announcement of the execution of the Reorganization Agreement, a purported class action complaint was filed on June 9, 1992, in the District Court 60th Judicial District in Jefferson County, Texas (District Court) against GSU and its directors relating to the then proposed business combination with Entergy Corporation. On June 11, 1992, two additional purported class action complaints were filed against such defendants in the District Court. All three of the complaints (the Shareholder Actions) were filed by persons alleged to be shareholders of GSU and seeking declaration of a class action on behalf of all persons owning common stock of GSU. GSU has executed a Memorandum of Understanding with counsel for the plaintiffs in these suits agreeing in principle to settle such actions subject to execution of an appropriate stipulation of settlement, approval by the court, and certain other conditions. In the Memorandum, the defendants have denied any actionable acts or omissions and state that they have entered into the Memorandum solely to eliminate the burden and expense of further litigation and to facilitate the consummation of the business combination. The Memorandum memorialized certain agreements by GSU and Entergy Corporation for the benefit of shareholders principally in the event the business combination were not consummated, including a covenant to consider reinstitution of dividends on the common stock of GSU in such event. The business combination was consummated on December 31, 1993. Incident to the settlement, the defendants agreed not to oppose an application for attorneys' fees by plaintiffs' counsel that do not exceed $500,000 or for an award of expenses not to exceed $50,000. The individual directors named as defendants in these complaints are entitled to indemnification pursuant to GSU's Restated Articles of Incorporation, By-laws, and individual indemnity agreements, provided that the terms and conditions of the indemnities are satisfied. LP&L. For information regarding litigation in connection with an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, in which LP&L and GSU are defendants, see "GSU," above. LP&L does not believe that it was a generator of any material delivered to this facility and is defending vigorously against the claims in these suits. Since the mid-1980's, LP&L and the tax authorities of St. Charles Parish, Louisiana (Parish), in which Parish Waterford 3 is located, have disputed use taxes paid on nuclear fuel ($4.9 million through 1989) under protest by LP&L. LP&L has been successful in a lawsuit in the Parish with regard to recovering these taxes, plus interest, and also with regard to Parish lease tax issues pertaining to fuel financing arrangements. On the grounds of the previous favorable court decisions, LP&L continues to challenge in the courts additional use tax assessments that it has paid to the Parish and to seek additional interest that LP&L claims it is due. Also, in early procedural stages are (1) suits by LP&L with regard to the state use tax on nuclear fuel, and (2) LP&L's defense (and indemnification, if necessary) of nuclear fuel lessors under LP&L's fuel financing arrangements in the suits filed by the Parish use tax authorities claiming approximately $64.0 million in lease and use taxes. These matters are pending. System Energy. In connection with an IRS audit of Entergy's 1988, 1989, and 1990 consolidated federal income tax returns, the IRS is proposing that adjustments be made to the Grand Gulf 2 abandonment loss deduction claimed on Entergy's 1989 consolidated federal income tax return. If any such adjustments are necessary, the effect on System Energy's net income should be immaterial. Entergy intends to contest the proposed adjustments if finalized by the IRS. The outcome of such proceedings cannot be predicted at this time. EARNINGS RATIOS OF SYSTEM OPERATING COMPANIES AND SYSTEM ENERGY The System operating companies and System Energy have calculated ratios of earnings to fixed charges and ratios of earnings to fixed charges and preferred dividends pursuant to Item 503 of Regulation S-K of the SEC as follows: ____________________ (a) "Earnings" as defined by SEC Regulation S-K represent the aggregate of (1) net income, (2) taxes based on income, (3) investment tax credit adjustments-net, and (4) fixed charges. "Fixed Charges" include interest (whether expensed or capitalized), related amortization, and interest applicable to rentals charged to operating expenses. (b) "Preferred Dividends" as defined by SEC Regulation S-K are computed by dividing the preferred dividend requirement by one hundred percent (100%) minus the income tax rate. (c) System Energy's Amended and Restated Articles of Incorporation do not currently provide for the issuance of preferred stock. (d) "Preferred Dividends" in the case of GSU also include dividends on preference stock. (e) Earnings for the year ended December 31, 1989, include the impact of the write-off of $60 million of deferred Grand Gulf 1-related costs pursuant to an agreement between MP&L and the MPSC. (f) Earnings for the year ended December 31, 1989, were inadequate to cover fixed charges due to System Energy's cancellation and write- off of its investment in Grand Gulf 2 in September 1989. The amount of the coverage deficiency for fixed charges was $745.2 million. (g) Earnings for the year ended December 31, 1991, include the $90 million effect of the 1991 NOPSI Settlement. (h) Earnings for the year ended December 31, 1993, include approximately $81 million, $52 million, and $18 million for AP&L, MP&L, and NOPSI, respectively, related to the change in accounting principle to provide for the accrual of estimated unbilled revenues. (i) Earnings for the year ended December 31, 1990, for GSU were not adequate to cover fixed charges by $60.6 million. Earnings for the years ended December 31, 1990 and 1989, were not adequate to cover fixed charges and preferred dividends by $165.1 million and $190.8 million, respectively. Earnings in 1990 include a $205 million charge for the settlement of a purchased power dispute. INDUSTRY SEGMENTS NOPSI Narrative Description of NOPSI Industry Segments Electric Service. NOPSI supplied electric service to 190,613 customers as of December 31, 1993. During 1993, 36% of electric operating revenues was derived from residential sales, 40% from commercial sales, 6% from industrial sales, 15% from sales to governmental and municipal customers, and 3% from sales to public utilities and other sources. Natural Gas Service. NOPSI supplied natural gas service to 154,251 customers as of December 31, 1993. During 1993, 56% of gas operating revenues was derived from residential sales, 18% from commercial sales, 9% from industrial sales, and 17% from sales to governmental and municipal customers. (See "Fuel Supply - Natural Gas Purchased for Resale," incorporated herein by reference.) Selected Financial Information Relating to Industry Segments For selected financial information relating to NOPSI's industry segments, see NOPSI's financial statements and Note 11 of NOPSI's Notes to Financial Statements, "Business Segment Information," incorporated herein by reference. Employees by Segment NOPSI's full-time employees by industry segment as of December 31, 1993, were as follows: Electric 568 Natural Gas 148 --- Total 716 (For further information with respect to NOPSI's segments, see "Property.") GSU For the year ended December 31, 1993, 96% of GSU's operating revenues were derived from the electric utility business. The remainder of operating revenues were derived 2% from the steam business and 2% from the natural gas business. Segment information for GSU is not provided. PROPERTY Generating Stations The total capability of Entergy 's owned and leased generating stations as of December 31, 1993, by company, is indicated below: _______________________ (1) "Owned and Leased Capability" is the dependable load carrying capability of the stations, as demonstrated under actual operating conditions based on the primary fuel (assuming no curtailments) that each station was designed to utilize. (2) Excludes the capacity of fossil-fueled generating stations placed on extended reserve as follows: AP&L - 506 MW; GSU - 405 MW; LP&L - 19 MW; MP&L - 73 MW; and NOPSI - 143 MW. Generating stations that are not expected to be utilized in the near-term to meet load requirements are placed in extended reserve shutdown in order to minimize operating expenses. (3) Excludes net capability of Entergy Power, which owns 809 MW of fossil-fueled capacity (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," above). (4) Independence 2, a coal unit operated by AP&L and jointly owned 25% by MP&L (210 MW), 31.5% by Entergy Power (265 MW), and the balance by various municipalities and a cooperative. The unit was out of service, due to an explosion from August 11, 1993 to February 18, 1994. (5) GSU's nuclear capability represents its 70% ownership interest in River Bend; Cajun owns the remaining 30% undivided interest. (6) LP&L's nuclear capability represents its 90.7% ownership interest and 9.3% leasehold interest in Waterford 3. (7) System Energy's capability represents its 90% interest in Grand Gulf 1 (78.5% ownership interest and 11.5% leasehold interest). South Mississippi Electric Power Association has the remaining 10% undivided ownership interest in Grand Gulf 1. Entitlement to System Energy's capacity has been allocated to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement. (8) Includes 188 MW of capacity leased by AP&L through 1999. Representatives of the System regularly review load and capacity projections in order to coordinate and recommend the location and time of installation of additional generating capacity and of interconnections in light of the availability of power, the location of new loads, and maximum economy to the System. Based on load and capability projections, the System has no need to install additional generating capacity until 1999. To delay the need for new capacity, the System is engaging in conservation and DSM programs, as discussed in "Business of Entergy - Competition - Least Cost Planning," above. When new generation resources are needed, the System plans to meet this need with a variety of sources other than construction of new base load generating capacity. In the meantime, the System will meet capacity needs by, among other things, removing generating stations from extended reserve shutdown. Generating stations brought out of extended reserve shutdown during 1993 added 248 MW to meet operating requirements. Under the terms of the System Agreement, some of the generating capacity and other power resources are shared among the System operating companies. Among other things, the System Agreement provides that parties having generating capacity greater than their load requirements sell such capacity to those parties having deficiencies in generating capacity and that the purchasers pay to the sellers a charge sufficient to cover certain of the sellers' ownership costs, including operating expenses, fixed charges on debt, dividend requirements on preferred and preference stock, and a fair rate of return on common equity investment. Under the System Agreement, these charges are based on costs associated with the sellers' steam electric generating units fueled by oil or gas. In addition, for all energy to be exchanged among the System operating companies under the System Agreement, the purchasers are required to pay the cost of fuel consumed in generating such energy plus a charge to cover other associated costs (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Agreement," above, for a discussion of FERC proceedings relating to the System Agreement). The System's business is subject to seasonal fluctuations with the peak period occurring in the summer months. Excluding GSU, Entergy 's 1993 peak demand of 12,858 MW occurred on August 19, 1993. The net System capability at the time of peak was 14,029 MW, which reflects a reduction of the System's total 14,765 MW of owned and leased capability by net off-system firm sales of 736 MW. The capacity margin at the time of the peak was approximately 8.4%, not including units placed on extended reserve and capacity owned by Entergy Power. GSU's 1993 peak demand of 5,612 MW occurred on August 18, 1993. The net GSU capability at the time of peak was 6,704 MW, which reflects an increase of GSU's total 6,420 MW of owned and leased capability by net off-system purchases of 284 MW. The capacity margin at the time of the peak was approximately 18.2%, not including units placed on extended reserve. Interconnections The electric power supply facilities of Entergy consist principally of steam-electric production facilities strategically located with reference to availability of fuel, protection of local loads, and other controlling economic factors. These are interconnected by a transmission system operating at various voltages up to 500 KV. Generally, with the exception of Grand Gulf 1, Entergy Power's capacity and a small portion of MP&L's capacity, operating facilities or interests therein are owned by the System operating company serving the area in which the facilities are located. However, all of the System's generating facilities are centrally dispatched and operated with a view to realizing the greatest economy. This operation seeks, among other things, the lowest cost sources of energy from hour to hour. The minimum of investment and the most efficient use of plant are sought to be achieved, in part, through the coordinated scheduling of maintenance, inspection, and overhaul. The System operating companies have direct interconnections with neighboring utilities including, in individual cases, Mississippi Power Company, Southwestern Electric Power Company, Southwest Power Administration, Central Louisiana Electric Company, Inc., Oklahoma Gas and Electric Company, The Empire District Electric Company, Union Electric Company, Arkansas Electric Cooperative Corporation, Tennessee Valley Authority, Cajun, Sam Rayburn Dam Electric Cooperative, Inc., SRG&T, SRMPA, Associated Electric Cooperative, Inc., Municipal Energy Agency of Mississippi, Louisiana Energy and Power Authority, Farmers Electric Cooperative, South Mississippi Electric Power Authority, and the cities of Lafayette, Plaquemine, and New Roads, Louisiana. GSU also has an interconnection agreement with Houston Lighting and Power Company providing a minor amount of emergency service only. The System operating companies also have interchange agreements with Alabama Electric Cooperative, Big Rivers Electric Cooperative, Northeast Texas Electric Cooperative, Inc., Sam Rayburn G&T Electric Cooperative, Inc., Florida Power Corporation, Florida Power & Light Company, Jacksonville Electric Authority, Oglethorpe Power Cooperative, the City of Lafayette, Louisiana, the City of Springfield, Missouri, and East Kentucky Electric Cooperative. The System operating companies are members of the Southwest Power Pool, the primary purpose of which is to ensure the reliability and adequacy of the electric bulk power supply in the southwest region of the United States. The Southwest Power Pool is a member of the North American Electric Reliability Council. AP&L, LP&L, MP&L, and NOPSI are also members of the Western Systems Power Pool. Gas Property As of December 31, 1993, NOPSI distributed and transported natural gas for distribution solely within the limits of the City of New Orleans through a total of 1,422 miles of gas distribution mains and 32 miles of gas transmission lines. NOPSI receives deliveries of natural gas for distribution purposes at 14 separate locations, including deliveries from United Gas Pipe Line Company (United) at six of these locations. Of the remaining delivery points, two are principally served by interstate suppliers and the remaining are served by intrastate suppliers. As of December 31, 1993, the gas property of GSU was not material to GSU. Titles The System's generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System operating companies has been constructed over lands of private owners pursuant to easements or on public highways and streets pursuant to appropriate permits. The rights of each company in the realty on which its properties are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in properties of like size and character exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. The System operating companies generally have the right of eminent domain whereby they may, if necessary, perfect or secure titles to, or easements or servitudes on, privately-held lands used or to be used in their utility operations. Substantially all the physical properties owned by each System operating company and System Energy are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of such company. The Lewis Creek generating station is owned by GSG&T, Inc., and is not subject to the lien of the GSU mortgage securing the first mortgage bonds of GSU, but is leased and operated by GSU. In the case of LP&L, certain properties are subject to the liens of second mortgages securing other obligations of LP&L. In the case of MP&L and NOPSI, substantially all of their properties and assets are subject to the second mortgage lien of their respective general and refunding mortgage bond indentures. FUEL SUPPLY The following tabulation shows the percentages of natural gas, fuel oil, nuclear fuel, and coal used in generation, excluding that of Entergy Power, during the past three years. It also shows the average fuel cost per KWH generated by each type of fuel during that period. The balance of generation, which was immaterial, was provided by hydroelectric power. ENTERGY EXCLUDING GSU GSU The following tabulation shows the percentages of generation by fuel type used in generation, excluding that of Entergy Power, for 1993 (actual) and 1994 (projected). _______________________ (a) The System's 1993 actual generation by fuel type excludes GSU; 1994 estimated generation by fuel type includes GSU. (b) Capacity and energy from System Energy's interest in Grand Gulf 1 is allocated as follows: AP&L - 36%; LP&L - 14%; MP&L - 33%; and NOPSI - 17%. Natural Gas The System operating companies have various long-term gas contracts that will satisfy a significant percentage of each operating company's needs; however, such contracts typically require the operating companies to purchase less than half of their annual gas requirements under such contracts. Additional gas requirements are satisfied under less expensive short-term contracts and spot-market purchases. In November 1992, GSU entered into a transportation service agreement with a gas supplier that obligates such supplier to provide GSU with flexible natural gas swing service to certain generating stations by using such supplier's pipeline and salt dome gas storage facility. Many factors influence the availability and price of natural gas supplies for power plants including wellhead deliverability, storage and pipeline capacity, and the demand requirements of the end users. This demand is closely tied to the severity of the weather conditions in the region. Furthermore, pricing relative to other energy sources (i.e. fuel oil, coal, purchased power, etc.) will affect the demand for natural gas for power plants. Supplies of natural gas are expected to be adequate in 1994. Pursuant to FERC and state regulations, gas supplies may be interrupted to power plants during periods of shortage. To the extent natural gas supplies may be disrupted, the System operating companies will use alternate sources of energy such as fuel oil. Coal AP&L has long-term contracts for the supply of low-sulfur coal for the White Bluff Steam Electric Generating Station and the Independence Steam Electric Station (which is owned 25% by MP&L). Coal for the White Bluff Station is supplied under a contract from a mine in the State of Wyoming. The coal contract provides for the delivery of sufficient coal to operate the White Bluff Station through approximately 2002. Coal for the Independence Station is also supplied under a contract from a mine in the State of Wyoming. Coal supplied under this contract is expected to meet the requirements of the Independence Station through at least 2014. GSU has a contract for a supply of low-sulfur Wyoming coal for Nelson Unit 6, which should be sufficient to satisfy the fuel requirements at Nelson Unit 6 through 2004. Cajun has advised GSU that it has contracts that should provide an adequate supply of coal until 1997 for the operation of Big Cajun 2, Unit 3 (which is operated by Cajun and of which GSU owns 42%). Nuclear Fuel Generally, the supply of fuel for nuclear generating units involves the mining and milling of uranium ore to produce a concentrate, the conversion of uranium concentrate to uranium hexafluoride gas, enrichment of that gas, fabrication of the nuclear fuel assemblies, and disposal of the spent fuel. System Fuels is responsible for contracts to acquire nuclear fuel to be used in AP&L's, LP&L's, and System Energy's nuclear units and for maintaining inventories of such materials during the various stages of processing. Each of these companies is currently responsible for contracting for the fabrication of its own nuclear fuel and for purchasing the required enriched uranium hexafluoride from System Fuels. Currently, the requirements for GSU's River Bend plant are covered by contracts made by GSU. On October 3, 1989, System Fuels entered into a revolving credit agreement with banks permitting it to borrow up to $45 million to finance its nuclear materials and services inventory. AP&L, LP&L, and System Energy agreed to purchase from System Fuels the nuclear materials and services financed under the agreement if System Fuels should default in its obligations thereunder. Such purchases would be allocated based on percentages agreed upon among the parties. In the absence of such agreement, AP&L, LP&L, and System Energy would each be obligated to purchase one-third of the nuclear materials and services. Based upon the planned fuel cycles for the System's nuclear units, the following tabulation shows the years through which existing contracts and inventory will provide materials and services: Acquisition of or Conversion Spent Uranium to Uranium Enrich- Fabri- Fuel Concentrate Hexafluoride ment(3) cation Disposal ----------- ------------ ------- ------ -------- ANO 1 (1) (1) 1995 1997 (4) ANO 2 (1) (1) 1995 1994 (4) River Bend (2) (2) 2000 1995 (4) Waterford 3 (1) (1) 1995 1999 (4) Grand Gulf 1 (1) (1) 1995 1995 (4) __________________________ (1) Current contracts will provide these materials and services through termination dates ranging from 1994-1997. Additional materials and services required beyond these dates are estimated to be available for the foreseeable future. (2) Current GSU contracts will provide a significant percentage of these materials and services for River Bend through 1995. (3) Enrichment services for ANO 1, ANO 2, Waterford 3, and Grand Gulf 1 are provided by a System Fuels contract with the United States Enrichment Corporation (USEC). The contract has been terminated after 1995 to permit flexibility on future pricing and terms that could be obtained. Enrichment services for River Bend are provided by a GSU contract with USEC that may be partially terminated after 1998 and fully terminated after 2000. (See "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Decommissioning," above for information on annual contributions to a federal decontamination and decommissioning fund required by the Energy Act to be made by AP&L, GSU, LP&L, and System Energy as a result of their enrichment contracts with DOE.) (4) The Nuclear Waste Policy Act of 1982 provides for the disposal of spent nuclear fuel or high level waste by the DOE. Under this Act, the DOE was to begin accepting spent fuel in 1998 and to continue until the disposal of all spent fuel from reactor sites has been accomplished. In November 1989, the DOE indicated that the repository program will be delayed. Current on-site spent fuel storage capacity at ANO, River Bend, Waterford 3, and Grand Gulf 1 is estimated to be sufficient to store fuel from normal operations until 1995, 2003, 2000, and 2004, respectively. It is expected that any additional storage capacity required, due to delay of the DOE repository program, will have to be provided by the affected companies (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Spent Fuel and Other High-Level Radioactive Waste," above). The System will require additional arrangements for segments of the nuclear fuel cycle beyond the dates shown above. Except as noted above, Entergy cannot predict the ultimate availability or cost of such arrangements at this time. AP&L, GSU, LP&L, and System Energy currently have nuclear fuel leasing arrangements that provide that AP&L, GSU, LP&L, and System Energy may lease up to $125 million, $105 million, $95 million, and $105 million of nuclear fuel, respectively. As of December 31, 1993, the unrecovered cost base of AP&L's, GSU's, LP&L's, and System Energy's nuclear fuel leases amounted to approximately $93.6 million, $96.5 million, $61.3 million, and $79.7 million, respectively. Each lessor finances its acquisition and ownership of nuclear fuel under a credit agreement and through the issuance of intermediate-term notes. The credit agreements, which were entered into by AP&L in 1988, by LP&L and System Energy in 1989, and GSU in 1993, had initial terms of five years, with the exception of GSU, which has an initial term of three years. These agreements are subject to annual renewal with, in LP&L's and GSU's case, the consent of the lenders. The credit agreements for AP&L, LP&L, and System Energy have all been extended and now have termination dates of December 1996, January 1997, and February 1997, respectively. The credit agreement for GSU was entered into in December 1993 and has a termination date of December 1996. The intermediate-term notes have varying maturities through January 31, 1999. It is expected that the credit agreements will be extended, or alternative financing will be secured by each lessor, based on the particular lessee's nuclear fuel requirements. If extensions or alternative financing cannot be arranged, the particular lessee must purchase sufficient nuclear fuel to allow the lessor to retire such borrowings. Natural Gas Purchased for Resale NOPSI has several suppliers of natural gas for resale. Its system is interconnected with three interstate and three intrastate pipelines. Presently, NOPSI's primary suppliers of natural gas for resale are United, an interstate pipeline, and Bridgeline and Pontchartrain, intrastate pipelines. NOPSI has a firm gas purchase contract with United and receives this service subject to FERC- approved rates pursuant to a certificate granted by FERC. NOPSI also has firm contracts with its two intrastate suppliers and also makes interruptible spot market purchases when economically attractive. In recent years, natural gas deliveries have been subject primarily to weather-related curtailments. However, NOPSI has experienced no such curtailments. In April 1992, FERC issued Order No. 636, which mandated interstate pipeline restructuring. The order requires interstate pipelines to cease selling gas to local distribution customers at the city-gate interconnection although transportation service can be provided in lieu of the former sale. As a result, in the future, NOPSI must substitute sources upstream of the United system for its current gas supply from United. NOPSI is considering purchases from independent intrastate or interstate supply aggregators and/or from intrastate pipeline sources in a manner consistent with its economic and supply reliability objectives. Prior to the effectiveness of Order No. 636, discussed above, in the event of a natural gas shortage on the United system, NOPSI would have received a portion of the available gas supply from United and its other suppliers. After Order No. 636 mandated restructuring (October 31, 1993), curtailments of supply could occur if NOPSI's suppliers failed to perform their obligations to deliver gas under their supply agreements with NOPSI. United could curtail transportation capacity only in the event of pipeline system constraints. Based on the current supply of natural gas, and absent extreme weather related curtailments, NOPSI does not anticipate that there will be any interruptions in natural gas deliveries to its customers. GSU purchases natural gas for resale from a single interstate supplier. Abandonment of service by the present supplier would be subject to abandonment proceedings by FERC. Research AP&L, GSU, LP&L, MP&L, and NOPSI are members of the Electric Power Research Institute (EPRI). EPRI conducts a broad range of research in major technical fields related to the electric utility industry. Entergy participates in various EPRI projects, based on its needs and available resources. During 1991, 1992, and 1993, the System, including GSU, contributed approximately $12 million, $16 million, and $17 million, respectively, for the various research programs in which Entergy was involved. Item 2. Item 2. Properties Refer to Item 1. "Business - Property," incorporated herein by reference, for information regarding the properties of the registrants. Item 3. Item 3. Legal Proceedings Refer to Item 1. "Business - Rate Matters and Regulation," incorporated herein by reference, for details of the registrants' material rate proceedings and other regulatory proceedings and litigation that are pending or that terminated in the fourth quarter of 1993. Item 4. Item 4. Submission of Matters to a Vote of Security Holders A consent in lieu of a special meeting of common stockholders of Entergy-GSU Holdings, Inc. (Holdings) was executed on December 30, 1993, pursuant to a Delaware statute that permits such a procedure. The consent was signed on behalf of Entergy Corporation and GSU, which at that time owned all of the outstanding common stock of Holdings. The common stockholders acted to: (1) increase the number of directors from 2 to 18 upon the occurrence of the combination of Entergy Corporation and GSU, such expanded board to consist of Edwin Lupberger and Joseph Donnelly, who continued as directors, and the following new directors: W. Frank Blount; John A. Cooper, Jr.; Brooke H. Duncan; Lucie J. Fjeldstad; Kaneaster Hodges, Jr.; Robert v.d. Luft; Adm. Kinnaird R. McKee; Paul W. Murrill; James R. Nichols; Eugene H. Owen; John N. Palmer, Sr.; Robert D. Pugh; H. Duke Shackelford; Wm. Clifford Smith; Bismark A. Steinhagen; and Dr. Walter Washington; (2) approve the terms and provisions of certain agreements related to such combination; (3) approve the actions of the officers in connection with those agreements and the transactions contemplated thereby; (4) approve the assumption and adoption by Holdings of certain benefit plans of Entergy Corporation; and (5) approve the taking of actions to issue stock with respect to such plans, including the listing of Holdings' common stock on the New York, Pacific, and Midwest Stock Exchanges and the filing of registration statements with the Securities and Exchange Commission. After the consummation of the transactions involved in the combination, the name of Holdings was changed to Entergy Corporation. On January 22, 1994, Mr. Donnelly resigned from the position of director of Entergy Corporation. PART II Item 5. Item 5. Market for Registrants' Common Equity and Related Stockholder Matters Entergy Corporation. The shares of Entergy Corporation's common stock are listed on the New York, Midwest, and Pacific Stock Exchanges. The high and low prices for each quarterly period in 1993 and 1992, were as follows: 1993 1992 --------------- ---------------- High Low High Low ------ ------ ------ ------ (In Dollars) First 36 1/2 32 1/2 29 5/8 27 1/8 Second 38 1/4 33 1/4 28 1/2 26 1/8 Third 39 7/8 36 1/4 31 7/8 28 1/4 Fourth 39 1/4 35 1/8 33 5/8 30 1/2 Four consecutive quarterly cash dividends on common stock were paid to stockholders of Entergy Corporation in each of 1993 and 1992. In 1993, dividends of 40 cents per share were paid in each of the first three quarters and dividends of 45 cents per share were paid in the last quarter. Dividends of 35 cents per share were paid in each of the first three quarters of 1992, and dividends of 40 cents per share were paid in the last quarter of 1992. As of February 24, 1994, there were 63,779 stockholders of record of Entergy Corporation. For information with respect to Entergy Corporation's future ability to pay dividends, refer to Note 7 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Dividend Restrictions," incorporated herein by reference. In addition to the restrictions described in Note 7, the Holding Company Act provides that, without approval of the SEC, the unrestricted, undistributed retained earnings of any Entergy Corporation subsidiary are not available for distribution to Entergy Corporation's common stockholders until such earnings are made available to Entergy Corporation through the declaration of dividends by such subsidiaries. AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy. There is no market for the common stock of System Energy and the System operating companies, all of which is owned by Entergy Corporation. Prior to December 31, 1993, GSU's common stock was publicly held. Effective with the Merger, all shares of GSU common stock were acquired by Entergy Corporation. No cash dividends on common stock were paid by GSU to its stockholders in 1992-1993. Cash dividends on common stock paid by AP&L, LP&L, MP&L, NOPSI, and System Energy to Entergy Corporation during 1993 and 1992, were as follows: 1993 1992 ------ ------ (In Millions) AP&L $156.3 $ 75.0 LP&L 167.6 174.6 MP&L 85.8 68.4 NOPSI 43.9 32.2 System Energy 233.1 137.7 For information with respect to restrictions that limit the ability of System Energy and the System operating companies to pay dividends, and for information with respect to dividends paid to Entergy Corporation by its subsidiaries subsequent to December 31, 1993, refer respectively, to Note 6 of System Energy's and Note 7 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's Notes to Financial Statements, "Dividend Restrictions," incorporated herein by reference. Item 6. Item 6. Selected Financial Data Entergy Corporation. Refer to information under the heading "Entergy Corporation and Subsidiaries Selected Financial Data - Five- Year Comparison," which information is incorporated herein by reference. AP&L. Refer to information under the heading "Arkansas Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. GSU. Refer to information under the heading "Gulf States Utilities Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. LP&L. Refer to information under the heading "Louisiana Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. MP&L. Refer to information under the heading "Mississippi Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. NOPSI. Refer to information under the heading "New Orleans Public Service Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. System Energy. Refer to information under the heading "System Energy Resources, Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. Item 7. Item 7 "Financial Statements and Exhibits". A current report on Form 8-K, dated January 18, 1994, was filed with the SEC on January 18, 1994, reporting information under Item 5 "Other Materially Important Events". A current report on Form 8-K, dated February 1, 1994, was filed with the SEC on February 8, 1994, reporting information under Items 2 and 7. Entergy Corporation, AP&L, GSU, LP&L, MP&L and NOPSI Current Reports on Form 8-K, dated December 31, 1993, were filed by these companies on January 3, 1994 reporting the consummation of the Entergy Corporation - GSU merger under Item 5 (in the case of AP&L, LP&L, MP&L and NOPSI), Items 2 and 7 (in the case of Entergy Corporation and GSU). EXPERTS All statements in Part I of this Annual Report on Form 10-K as to matters of law and legal conclusions, based on the belief or opinion of System Energy or any System operating company or otherwise, pertaining to the titles to properties, franchises and other operating rights of certain of the registrants filing this Annual Report on Form 10-K, and their subsidiaries, the regulations to which they are subject and any legal proceedings to which they are parties are made on the authority of Friday, Eldredge & Clark, 2000 First Commercial Building, 400 West Capitol, Little Rock, Arkansas, as to AP&L and as to Entergy Services in regards to flood litigation; Monroe & Lemann (A Professional Corporation), 201 St. Charles Avenue, Suite 3300, New Orleans, Louisiana, as to LP&L and NOPSI; and Wise Carter Child & Caraway, Professional Association, Heritage Building, Jackson, Mississippi, as to MP&L and System Energy. The statements attributed to Clark, Thomas & Winters, a professional corporation, as to legal conclusions with respect to GSU's rate regulation in Texas under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters," have been reviewed by such firm and are included herein upon the authority of such firm as experts. The statements attributed to Sandlin Associates regarding the analysis of River Bend Construction costs of GSU under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters", have been reviewed by such firm and are included herein upon the authority of such firm as experts. ENTERGY CORPORATION SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ENTERGY CORPORATION By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); W. Frank Blount, John A. Cooper, Jr., Brooke H. Duncan, Lucie J. Fjeldstad, Kaneaster Hodges, Jr., Robert v.d. Luft, Kinnaird R. McKee, Paul W. Murrill, James R. Nichols, Eugene H. Owen, John N. Palmer, Robert D. Pugh, H. Duke Shackelford, Wm. Clifford Smith, Bismark A. Steinhagen, and Walter Washington (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) ARKANSAS POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ARKANSAS POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John A. Cooper, Jr., Cathy Cunningham, Richard P. Herget, Jr., Tommy H. Hillman, Donald C. Hintz, Kaneaster Hodges, Jr., Jerry D. Jackson, R. Drake Keith, Jerry L. Maulden, Raymond P. Miller, Sr., Roy L. Murphy, William C. Nolan, Jr., Robert D. Pugh, Woodson D. Walker, Gus B. Walton, Jr., Michael E. Wilson (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) GULF STATES UTILITIES COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF STATES UTILITIES COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Robert H. Barrow, Frank F. Gallaher, Frank W. Harrison, Jr., Donald C. Hintz, Jerry L. Maulden, Paul W. Murrill, Eugene H. Owen, M. Bookman Peters, Monroe J. Rathbone, Jr., Sam F. Segnar, Bismark A. Steinhagen, James E. Taussig, II. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) LOUISIANA POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. LOUISIANA POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John J. Cordaro, Donald C. Hintz, William K. Hood, Jerry D. Jackson, Tex R. Kilpatrick, Joseph J. Krebs, Jr., Jerry L. Maulden, H. Duke Shackelford, Wm. Clifford Smith (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) MISSISSIPPI POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, Frank R. Day, John O. Emmerich, Jr., Norman B. Gillis, Jr., Donald C. Hintz, Jerry D. Jackson, Robert E. Kennington, II, Jerry L. Maulden, Donald E. Meiners, John N. Palmer, Sr., Clyda S. Rent, Walter Washington, Robert M. Williams, Jr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) NEW ORLEANS PUBLIC SERVICE INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. NEW ORLEANS PUBLIC SERVICE INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, James M. Cain, John J. Cordaro, Brooke H. Duncan, Norman C. Francis, Donald C. Hintz, Jerry D. Jackson, Jerry L. Maulden, Anne M. Milling, John B. Smallpage, Charles C. Teamer, Sr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) SYSTEM ENERGY RESOURCES, INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SYSTEM ENERGY RESOURCES, INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Donald C. Hintz (President, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Edwin Lupberger (Chairman of the Board), Jerry D. Jackson, Jerry L. Maulden (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) EXHIBIT 23(a) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Post-Effective Amendment Nos. 2, 3, 4A, and 5A on Form S-8 to Registration Statement No. 33-54298 of Entergy Corporation on Form S-4, and the related Prospectuses, of our reports dated February 11, 1994 (which express an unqualified opinion and include explanatory paragraphs as to uncertainties because of certain regulatory and litigation matters), appearing in this Annual Report on Form 10-K of Entergy Corporation for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-36149, 33-48356 and 33-50289 of Arkansas Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Arkansas Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-46085, 33-39221 and 33-50937 of Louisiana Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Louisiana Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-53004, 33-55826 and 33-50507 of Mississippi Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Mississippi Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-57926 of New Orleans Public Service Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of New Orleans Public Service Inc. for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-47662 of System Energy Resources, Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994 (which express an unqualified opinion and include an explanatory paragraph as to an uncertainty resulting from a regulatory proceeding), appearing in this Annual Report on Form 10-K of System Energy Resources, Inc. for the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE New Orleans, Louisiana March 14, 1994 EXHIBIT 23(b) CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Gulf States Utilities Company on Form S-3 (File Numbers 33-49739 and 33-51181) and Form S-8 (File Numbers 2-76551 and 2-98011) of our reports, dated February 11, 1994, on our audits of the financial statements and financial statement schedules of Gulf States Utilities Company as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which reports include explanatory paragraphs related to rate-related contingencies, legal proceedings and changes in accounting for income taxes, postretirement benefits, unbilled revenue and power plant materials and supplies and are included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand Coopers & Lybrand Houston, Texas March 14, 1994 EXHIBIT 23(c) CONSENT OF EXPERTS We consent to the reference to our firm under the heading "Experts" in this Annual Report on Form 10-K. We further consent to the incorporation by reference of such reference to our firm into Arkansas Power & Light Company's ("AP&L") Registration Statements (Form S-3, File Nos. 33-36149, 33-48356 and 33-50289) and related Prospectuses, pertaining to AP&L's First Mortgage Bonds and Preferred Stock. Very truly yours, /s/ Friday, Eldredge & Clark FRIDAY, ELDREDGE & CLARK Date: March 14, 1994 EXHIBIT 23(d) CONSENT We consent to the reference to our firm under the heading "Experts", and to the inclusion in this Annual Report on Form 10-K of Gulf States Utilities Company ("GSU") of the statements of legal conclusions attributed to us herein (the Statements of Legal Conclusions) under Part I, Item 1. Business - "Rate Matters and Regulation" and in the discussion of Texas jurisdictional matters set forth in Note 2 to GSU's Financial Statements and Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements appearing as Item 8.

310764_1993.txt

310764_1993

1993

310764

ITEM 2. PROPERTIES The Company's principal facilities are located in Kalamazoo and Portage, Michigan. A 190,000 square foot Portage facility completed in 1992 houses manufacturing (80,000 square feet) and warehousing and distribution (25,000 square feet) for surgical instrument products, with the remaining portion of the facility used for Division offices. The Medical Division is located in two facilities, one in Portage which was completed in 1985 and contains manufacturing and warehousing (122,000 square feet) and Division offices (23,000 square feet), and another in Kalamazoo which contains manufacturing and warehousing (64,000 square feet) and offices (22,000 square feet). The Company leases 185,000 square feet in an industrial park in Allendale, New Jersey for its orthopaedic implant business; 56,000 square feet in San Jose, California for its endoscopic systems business; 28,000 square feet in Clackamas, Oregon for production of maternity beds and furniture; and 40,000 square feet in Arroyo, Puerto Rico for the assembly of disposable tubing sets and other manufacturing. The Company's 72 physical therapy clinics are all located in leased offices. ITEM 2. PROPERTIES -- continued The Company's principal European facilities are located in two buildings (one of which is leased) in Uden, The Netherlands. Of the total 70,000 square feet (22,000 of which is leased) 41,000 square feet are devoted to production (principally hospital beds and related equipment) and 11,300 square feet to warehousing, with the balance used for administrative offices. In addition, the Company leases 16,000 square feet in Bordeaux, France for its spinal implant manufacturing operation. Manufacturing and warehousing account for 11,000 square feet of the total and the remainder is used for administrative offices. The Company also leases other foreign sales and administration offices. In addition, the Company leases 12,000 square feet in Kalamazoo, Michigan for its administrative offices. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a defendant and plaintiff in various legal actions arising in the normal course of business. The Company does not anticipate material losses as a result of these actions. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS Certain information with respect to the executive officers of the Company is set forth in Item 10 of this report. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded in the over-the-counter market on the NASDAQ National Market System under the symbol STRY. Quarterly stock prices and dividend information appearing under the caption "Summary of Quarterly Data" on page 44 (page 47 of the 1993 Annual Report) are incorporated herein by reference. The Company's Board of Directors intends to consider a year-end cash dividend annually at its December meeting. On December 31, 1993 there were 3,951 stockholders of record of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The financial information for each of the five years in the period ended December 31, 1993 under the caption "Ten Year Review" on page 29 (pages 32 and 33 of the 1993 Annual Report) is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 through 32 (pages 34 through 36 of the 1993 Annual Report) is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Company and its subsidiaries and report of independent auditors, included on pages 33 through 45 (pages 37 through 48 of the 1993 Annual Report) are incorporated herein by reference. Quarterly results of operations appearing under the caption "Summary of Quarterly Data" on page 44 (page 47 of the 1993 Annual Report) are incorporated herein by reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS Information regarding the directors of the Company appearing under the caption "Election of Directors" in the 1994 proxy statement is incorporated herein by reference. Information regarding the executive officers of the Company appears below. All officers are elected annually. Reported ages are as of January 31, 1994. John W. Brown, age 59, has been Chairman of the Board since January 1981, and President and Chief Executive Officer of the Company since February 1977. He is also a director of Lunar Corporation, a medical products company, First of America, a bank, and the Health Industry Manufacturers Association and a Trustee of Kalamazoo College. Ronald A. Elenbaas, age 40, was appointed President of the Surgical Group in 1985 and has been a Vice President of the Company since August 1983. Previously he was the Director of Surgical Sales since May 1982. Since joining the Company in September 1975 he has held various other positions, including Sales Representative, Marketing Product Manager, Plant Manager, Canadian Sales Director, Assistant to the President and Director of Customer Relations. William T. Laube, III, age 54, was appointed President of Stryker Pacific Limited in 1985 and has been a Vice President of the Company since March 1979. Since joining the Company in July 1975 he has held various international sales management positions. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS -- continued Robert D. Monk, age 42, was appointed Treasurer-Controller upon joining the Company in March 1984. He was also appointed Assistant Secretary in February 1991. David J. Simpson, age 47, was appointed Vice President, Chief Financial Officer and Secretary upon joining the Company in June 1987. He had previously been Vice President and Treasurer of Rexnord Inc., a manufacturer of industrial and aerospace products, since July 1985. Thomas R. Winkel, age 41, was appointed President of Stryker Americas/Middle East in March 1992 and has been a Vice President of the Company since December 1984. He had previously been Vice President, Administration since June 1987. Since joining the Company in October 1978 he has held various other positions, including Assistant Controller, Secretary and Corporate Controller. An amended Form 5 was filed with the Securities and Exchange Commission in June 1993 by John W. Brown, Chairman of the Board, President and Chief Executive Officer of the Company, when it was realized that a charitable gift of 2,625 Shares of Common Stock of the Company made by him had been omitted from the original filing. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding the compensation of the management of the Company appearing under the captions "Director Compensation" and "Executive Compensation" in the 1994 proxy statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the captions "Beneficial Ownership of More than 5% of the Outstanding Common Stock" and "Beneficial Ownership of Management" in the 1994 proxy statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Executive compensation plans and arrangements are referenced as exhibits 10(i) and (ii).) (a)(1) and (2) - The response to this portion of Item 14 is submitted as a separate section of this report following the signature page. (a)(3) - Exhibits Exhibit 3 - Articles of incorporation and by-laws (i) Restated Articles of Incorporation and amendment thereto dated December 28, 1993. (ii) By-Laws--Incorporated by reference to Exhibit 3(ii) to the Company's Form 10-Q for the quarter ended June 30, 1988 (Commission File No. 0-9165). Exhibit 4 - Instruments defining the rights of security holders, including indentures--The Company agrees to furnish to the Commission upon request a copy of each instrument pursuant to which long-term debt of the Company and its subsidiaries not exceeding 10% of the total assets of the Company and its consolidated subsidiaries is authorized. Exhibit 10-Material contracts (i)* 1988 Stock Option Plan as amended--Incorporated by reference to Exhibit 10(i) to the Company's Form 10-K for the year ended December 31, 1992 (Commission File No. 0-9165). (ii)* Description of bonus arrangements between the Company and certain officers, including Messrs. Brown, Elenbaas, Laube, Simpson and Winkel. Exhibit 11-Statement re computation of per share earnings (i) Statement Re: Computation of net earnings per share Exhibit 13-Annual report to security holders (i) Portions of the 1993 Annual Report that are incorporated herein by reference Exhibit 21-Subsidiaries of the registrant (i) List of Subsidiaries *compensation arrangement ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K--continued Exhibit 23-Consents of experts and counsel (i) Consent of Independent Auditors (b) Reports on Form 8-K - No reports on Form 8-K were required to be filed in the fourth quarter of 1993. (c) Exhibits - The response to this portion of Item 14 is submitted as a separate section of this report following the signature page. (d) Financial statement schedules - The response to this portion of Item 14 is submitted as a separate section of this report following the signature page. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. STRYKER CORPORATION Date: March 18, 1994 DAVID J. SIMPSON David J. Simpson, Vice President, Chief Financial Officer and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. JOHN W. BROWN 3/18/94 DAVID J. SIMPSON 3/18/94 John W. Brown, Chairman, President David J. Simpson, Vice President, Chief and Chief Executive Officer Financial Officer and Secretary (Principal Executive Officer) (Principal Financial Officer) HOWARD E. COX, JR. 3/18/94 ROBERT D. MONK 3/18/94 Howard E. Cox, Jr. - Director Robert D. Monk, Treasurer/Controller (Principal Accounting Officer) DONALD M. ENGELMAN 3/18/94 RONDA E. STRYKER 3/18/94 Donald M. Engelman, Ph.D. - Director Ronda E. Stryker - Director JEROME H. GROSSMAN 3/18/94 GERARD THOMAS 3/18/94 Jerome H. Grossman, M.D. - Director Gerard Thomas - Director JOHN S. LILLARD 3/18/94 WILLIAM U. PARFET 3/18/94 John S. Lillard - Director William U. Parfet - Director ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) and (2), (c) and (d) LIST OF FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 STRYKER CORPORATION KALAMAZOO, MICHIGAN FORM 10-K--ITEM 14(a)(1), (2) AND (d) STRYKER CORPORATION AND SUBSIDIARIES Index to Financial Statements and Financial Statement Schedules The following consolidated financial statements of Stryker Corporation and subsidiaries and report of independent auditors, included in the annual stockholders report of the registrant for the year ended December 31, 1993, are incorporated by reference in Item 8: Report of independent auditors Consolidated balance sheet--December 31, 1993 and 1992. Consolidated statement of earnings--years ended December 31, 1993, 1992 and 1991. Consolidated statement of stockholders' equity--years ended December 31, 1993, 1992 and 1991. Consolidated statement of cash flows--years ended December 31, 1993, 1992 and 1991. Notes to consolidated financial statements--December 31, 1993. The following consolidated financial statement schedules of Stryker Corporation and subsidiaries are included in Item 14(d): Schedule I--Marketable securities-other investments Schedule VIII--Valuation and qualifying accounts Schedule IX--Short-term borrowings Schedule X--Supplementary income statement information Schedule XIII--Other investments All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. SCHEDULE X --SUPPLEMENTARY INCOME STATEMENT INFORMATION STRYKER CORPORATION AND SUBSIDIARIES Col. A Col. B ITEM Charged to Costs and Expenses Year Ended December 31 _________________________________________ 1993 1992 1991 _________________________________________ Advertising costs $8,097,000 $7,345,000 $6,038,000 ========== ========== ========== Amounts for maintenance and repairs; amortization of tangible assets, pre-operating costs and similar deferrals; taxes, other than payroll and income taxes; and royalties are not presented as such amounts are less than 1% of net sales. FORM 10-K--ITEM 14(c) STRYKER CORPORATION AND SUBSIDIARIES Exhibit Index Exhibit Page* (3) Articles of incorporation and by-laws (i) Restated Articles of Incorporation. . . . . . . . . . . . . . . 22 (ii) By-Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11** (10) Material contracts (i) 1988 Stock Option Plan as amended . . . . . . . . . . . . . . . 11** (ii) Description of bonus arrangements between the Company and certain officers including, Messrs. Brown, Elenbaas, Laube, Simpson and Winkel . . . . . . . . . . . . . . . . . . 27 (11) Statement re computation of per share earnings (i) Statement Re: Computation of net earnings per share. . . . . . 28 (13) Annual report to security holders (i) Portions of the 1993 Annual Report are incorporated here by reference. . . . . . . . . . . . . . . . 29 (21) Subsidiaries of the registrant (i) List of Subsidiaries. . . . . . . . . . . . . . . . . . . . . . . 48 (23) Consents of experts and counsel (i) Consent of Independent Auditors . . . . . . . . . . . . . . . . . 49 * Page number in sequential numbering system where such exhibit can be found, or it is stated that such exhibit is incorporated by reference. ** Incorporated by reference in this Annual Report on Form 10-K. CERTIFICATE OF AMENDMENT OF RESTATED ARTICLES OF INCORPORATION OF STRYKER CORPORATION _______________________ 1. The present name of the corporation is Stryker Corporation. The registered office of the corporation is 2725 Fairfield Road, Kalamazoo, Michigan 49002. 2. The former name of the corporation was Orthopedic Frame Company. 3. The date of filing of the original Articles of Incorporation was February 20, 1946. 4. Section A of Article III of the Articles of Incorporation, as amended and restated to date, is hereby amended to increase the authorized Common Stock to 150,000,000 shares, and as so amended shall read in its entirety as follows: A. The aggregate number of shares of all classes of stock which the corporation shall have authority to issue is 150,500,000 to be divided into two classes consisting of 500,000 shares of a class designated "Preferred Stock", of the par value of One Dollar ($1) per share, and 150,000,000 shares of a class designated "Common Stock", of the par value of Ten Cents ($.10) per share. 5. This amendment was duly adopted by the shareholders of the corporation on the 27th day of April, 1993 in accordance with the provisions of subsection (2) of Section 611 of the Business Corporation Act of Michigan. Dated this 28th day of December, 1993. STRYKER CORPORATION By JOHN W. BROWN John W. Brown, Chairman, President and Chief Executive Officer RESTATED ARTICLES OF INCORPORATION OF STRYKER CORPORATION 1. These Restated Articles of Incorporation are executed pursuant to the provisions of Section 641-643 of the Business Corporation Act of Michigan (Act 284, Public Acts of 1972, as amended). 2. The present name of the corporation is Stryker Corporation. 3. The former name of the corporation was Orthopedic Frame Company. 4. The date of filing the original Articles of Incorporation was February 20, 1946. 5. The following Restated Articles of Incorporation supersedes the original Articles of Incorporation, as amended and restated to date, and shall be the Articles of Incorporation of the corporation. ARTICLE I The name of the corporation is Stryker Corporation. ARTICLE II The purpose of the corporation is to engage in any activity within the purposes for which corporations may be organized under the Business Corporation Act of Michigan. Without limiting in any manner the scope and generality of the foregoing, the corporation may manufacture and/or sell or lease hospital equipment, medical and surgical supplies and instruments and allied products and may buy, sell, lease or rent real estate and erect buildings in connection with the foregoing, or otherwise. ARTICLE III A. The aggregate number of shares of all classes of stock which the corporation shall have authority to issue is 50,500,000 to be divided into two classes consisting of 500,000 shares of a class designated "Preferred Stock", of the par value of One Dollar ($1) per share, and 50,000,000 shares of a class designated "Common Stock," of the par value of Ten Cents ($.10) per share. B. The relative rights, preferences and limitations of the shares of each class are as follows: 1. Preferred Stock. The Preferred Stock may be issued from time to time in one or more series, with such distinctive designation or title and in such number of shares as may be fixed by resolution of the Board of Directors without further action by shareholders. The Board of Directors is expressly granted authority to prescribe, by resolution or resolutions adopted before the issuance of any shares of a particular series of Preferred Stock, the relative rights and preferences of each series, and the limitations applicable thereto, including but not limited to the following: (a) The voting powers full, special or limited, or no voting powers of each such series; (b) The rate, terms and conditions on which dividends shall be paid, whether such dividends will be cumulative, and what preference such dividends shall have in relation to the dividends on other series or classes of stock; (c) The rights, terms and conditions, if any, for conversion of such series of Preferred Stock into shares of other series or classes of stock; (d) Any right of the corporation to redeem the shares of such series of Preferred Stock, and the price, time, and conditions of such redemption, including the provisions for any sinking fund; and (e) The rights of holders of such series of Preferred Stock in relation to the rights of other series and classes of stock upon the liquidation, dissolution or distribution of the assets of the corporation. Unless the Board of Directors otherwise provides in the resolution establishing a series of Preferred Stock, upon repurchase by the corporation, redemption or conversion, the shares of Preferred Stock shall revert to authorized but unissued shares and may be reissued as shares of any series of Preferred Stock. 2. Common Stock. (a) Subject to the prior payment or provision therefor of dividends on the Preferred Stock, the holders of the Common Stock shall be entitled to receive out of the funds of the corporation legally legally available for such purpose dividends as and when declared by the Board of Directors. (b) In the event of any liquidation, dissolution or distribution of the assets of the corporation and after satisfaction of the preferential requirements of the Preferred Stock, the holders of Common Stock shall be entitled to share ratably in the distribution of all remaining assets of the corporation available for distribution. (c) The holders of the Common Stock shall be entitled to one vote for each share held by them of record on the books of the corporation. ARTICLE IV The shareholders of the corporation shall have no preemptive right to acquire additional or treasury shares of the corporation. All preemptive rights existing prior to the date hereof, whether created by statute or common law, are abolished. ARTICLE V The address of the current registered office is: 420 Alcott Street, Kalamazoo, Michigan 49001. The name of the current resident agent is David J. Simpson. ARTICLE VI The duration of the corporation is perpetual. ARTICLE VII The liability to the corporation and its shareholders of each and every person who is at any time a director of the corporation for acts or omissions in such person's capacity as a director is and shall be limited and eliminated to the full extent authorized or permitted by the Michigan Business Corporation Act, as it now exists or may hereafter be amended. Any amendment, alteration or repeal of this Article VII by the shareholders of the corporation shall not adversely affect any right or protection of a director of the corporation for or with respect to any act or omission of such director occurring prior to, or at the time of, such amendment, alteration or repeal. 6. The Restated Articles of Incorporation were duly adopted by the Board of Directors on the 29th day of July, 1988, without a vote of the shareholders, in accordance with the provisions of Section 642 of the Business Corporation Act of Michigan. The Restated Articles of Incorporation only restate and integrate and do not further amend the Articles of Incorporation as heretofore amended, and there is no material discrepancy between the provisions of the Articles of Incorporation as heretofore amended and the provisions of these Restated Articles of Incorporation. Dated this 29th day of July, 1988. STRYKER CORPORATION By JOHN W. BROWN John W. Brown, Chairman, President and Chief Executive Officer EXHIBIT (10)(ii) DESCRIPTION OF BONUS ARRANGEMENTS The Company has entered into bonus arrangements with certain executive officers for 1994, including Mr. Brown, Mr. Elenbaas, Mr. Laube, Mr. Simpson and Mr. Winkel, based on specific performance criteria including sales, profits and asset management. The aggregate amount of such bonuses is not expected to exceed $1,200,000. EXHIBIT (11) STATEMENT RE: COMPUTATION OF EARNINGS PER SHARE OF COMMON STOCK Year Ended December 31 1993 1992 1991 Average number of shares outstanding 48,356,000 47,716,000 47,526,000 __________ __________ __________ Net earnings $60,205,000 $47,700,000 $33,075,000 =========== =========== =========== Earnings per share of common stock: Net earnings $1.25 $1.00 $.70 Primary: Average shares outstanding 48,356,000 47,716,000 47,526,000 Net effect of dilutive stock options, based on the treasury stock method using average market price 536,000 1,173,000 1,228,000 __________ __________ __________ Total Primary Shares 48,892,000 48,889,000 48,754,000 ========== ========== ========== Fully Diluted: Average shares outstanding 48,356,000 47,716,000 47,526,000 Net effect of dilutive stock options, using the year-end market price, if higher then average market price 586,000 1,199,000 1,447,000 __________ __________ __________ Total Fully Diluted Shares 48,942,000 48,915,000 48,973,000 ========== ========== ========== Note: Shares subject to stock options are not included in the earnings per share computation because the present effect thereof is not materially dilutive. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations The table below outlines the components of the consolidated statement of earnings as a percentage of net sales: Percentage of Net Percentage Sales Increase ______________________ __________________ 1993 1992 1991 1993/92 1992/91 Net Sales 100.0% 100.0% 100.0% 17% 31% Cost of sales 46.1 46.5 47.3 16 29 Research, development and engineering expense 6.5 6.8 6.5 12 36 Selling, general and administrative expense 30.9 31.3 32.1 15 28 Operating Income 16.5 15.4 14.1 25 43 Other income .7 .7 .5 Earnings Before Income Taxes 17.2 16.1 14.6 25 44 Income taxes 6.4 6.1 5.5 23 44 Net Earnings 10.8% 10.0% 9.1% 26 44 1993 COMPARED TO 1992 Stryker Corporation's net sales increased 17% in 1993 to $557.3 million as demand for the Company's products, which are sold to hospitals throughout the world, continued to grow. Increased unit volume accounted for the entire increase as higher selling prices in 1993 provided only 1% growth and were essentially offset by the effect of changes in foreign currency exchange rates. Uncertainty over the impact of U.S. health care reform programs has generally slowed domestic sales of medical devices. In addition, in an effort to reduce their costs, purchasers of the Company's orthopaedic implants domestically have shifted their purchasing mix toward the Company's lower-cost implants. Despite these factors, the Company's total domestic sales grew 14% in 1993. International sales increased 22% in 1993 led by Osteonics orthopaedic implant and Dimso spinal implant sales. International sales expanded to 32% of total sales in 1993 compared to 31% in 1992. Surgical product sales (principally orthopaedic products) increased 13% for the year. The domestic sales growth in Surgical products was led by Stryker Instruments' High Vacuum Cement Injection System and new Surgilav Plus pulsed irrigation system, Osteonics' knee implants and Stryker Endoscopy's newly introduced third generation Model 782 3-Chip Camera. The international sales growth of Surgical products was led by Osteonics orthopaedic implant sales by the Company's Pacific Division and Dimso spinal implant system sales by all the Company's international divisions. Sales of Medical products (principally specialty stretchers/beds and physical therapy services) increased 33%, led by the introduction of the MPS Primary Acute Care Bed in the third quarter, increased revenues from physical therapy services and increased sales of patient handling equipment. Cost reduction programs at several of the Company's divisions and the higher mix of international sales lowered the cost of sales percentage in 1993 compared to 1992. Research, development and engineering expense increased 12% as the Company spent $36.2 million on product development in 1993 compared to $32.3 million in 1992. This commitment to product development resulted in several new products in 1993 including the MPS Primary Acute Care Bed, the Quadracut ACL/Shaver System for arthroscopy, the SurgiLav Plus pulsed irrigation system, and the Series 7000 Primary Posterially Stabilized Knee and Modular Tibia System. Selling, general and administrative expense increased 15% in 1993, principally as a result of larger sales forces in the Company's Instruments and Medical Divisions. However, this cost increase was contained below the percentage growth in sales and these costs dropped to 30.9% of sales in 1993 compared to 31.3% in 1992. The effective tax rate decreased to 37.3% in 1993 compared to 38.0% in 1992 due to lower effective foreign tax rates. Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes". The cumulative effect of the change in the method of accounting on net earnings was not material. Net earnings in 1993 were $60.2 million, a 26% increase over the Company's earnings in 1992 of $47.7 million. In the fourth quarter of 1993, net sales reached a record level of $145.2 million and net earnings were $17.8 million or 12.2% of sales. Fourth quarter net earnings as a percent of sales was higher than the previous three quarters of the year because manufacturing costs and operating expenses increased at a slower rate than sales. 1992 COMPARED TO 1991 Stryker Corporation's net sales increased 31% in 1992 to $477.1 million compared to $364.8 million in 1992. Increased unit volume generated a 28% sales increase, increased selling prices added 2% and a 1% increase was due to changes in foreign currency exchange rates. Sales of the Company's Surgical products increased 30% for the year led domestically by Stryker Endoscopy's 3-Chip Camera system, the newly introduced Osteonics Series 7000 Total Knee System and the System 2000 heavy-duty battery-powered instrument line. The international sales growth in Surgical products was led by the introduction of the Osteonics knee line in Japan. Sales of Medical products increased 34%, led by gains in physical therapy revenues and nearly the entire line of patient-handling equipment. Cost of sales increased 29% in 1992 and represented 46.5% of sales compared to 47.3% in 1991. The lower cost of sales percentage in 1992 resulted from cost reduction programs implemented at several of the Company's divisions and from increased unit volume. Research, development and engineering expense increased 36% as the Company spent $32.3 million on product development in 1992 compared to $23.7 million in 1991. This commitment to product development resulted in several new products in 1992 including the Series 7000 Total Knee System, the Company's third generation 3-Chip and 1-Chip Camera systems, the High Vacuum Cement Injection System for applying bone cement, and a warming stretcher for the recovery room. Selling, general and administrative expense increased 28% in 1992, principally as a result of the increased cost of larger sales forces in the Endoscopy, Instruments, Medical and Europe Divisions. These costs dropped to 31.3% of sales in 1992 compared to 32.1% in 1991. The increase in other income is a result of modest foreign currency gains in 1992 of $188,000 compared to $898,000 of foreign currency losses in 1991. In addition, interest income, which is included in other income, increased in 1992 as a result of increased levels of cash and marketable securities. The effective tax rate remained constant at 38.0% in 1992. Net earnings in 1992 were $47.7 million, a 44% increase over the Company's net earnings in 1991 of $33.1 million. In the fourth quarter of 1992, net sales were $130.0 million and net earnings were $14.6 million or 11.2% of sales. Fourth quarter net earnings as a percent of sales was higher than the previous three quarters of the year because manufacturing costs and selling, general and administrative expenses increased at a slower rate than sales. LIQUIDITY AND CAPITAL RESOURCES Stryker's financial position continued to strengthen in 1993, with operating activities providing $86.1 million in cash. Working capital increased to $214.0 million from $168.2 million in the prior year. Accounts receivable increased 14% compared with the Company's 17% increase in sales and days sales outstanding in accounts receivable at the end of 1993 decreased to 47 days from 52 days at the end of 1992. Inventories actually decreased 4% in 1993 and days sales in inventory reflected even greater improvement, finishing 1993 at 114 days compared to 130 days at the end of 1992. In August 1993, the Company purchased 20% of the outstanding shares of Matsumoto Medical Instruments, Inc., Osaka, Japan. The cost of the investment, which was based on net book value, was approximately $33 million and was financed by a five-year Japanese yen denominated fixed-rate bank borrowing. The investment is accounted for under the equity method. The Company's share of Matsumoto's net earnings in 1993 were immaterial to consolidated net earnings. The Company's cash and marketable securities of $152.6 million at December 31, 1993, as well as anticipated cash flows from operations, are expected to be sufficient to fund planned future operating capital requirements. Should additional funds be required, the Company has unsecured lines of credit with banks totaling $39.0 million. At December 31, 1993, only $.8 million of these lines has been utilized to fund operating activities overseas. CONSOLIDATED BALANCE SHEET STRYKER CORPORATION AND SUBSIDIARIES December 31 (in thousands, except per share amounts) 1993 1992 Assets CURRENT ASSETS Cash and cash equivalents $49,712 $43,091 Marketable securities 102,925 48,661 Accounts receivable, less allowance of $3,800 ($2,900 in 1992) 87,896 76,899 Inventories 76,582 79,391 Deferred income taxes 15,829 12,772 Prepaid expenses and other current assets 10,907 8,791 ------- ------- Total Current Assets 343,851 269,605 PROPERTY, PLANT AND EQUIPMENT Land, buildings and improvements 30,790 25,220 Machinery and equipment 94,551 82,317 _______ _______ 125,341 107,537 Less allowance for depreciation 57,634 47,888 _______ _______ 67,707 59,649 OTHER ASSETS Intangibles, less accumulated amortization of $9,925 ($6,790 in 1992) 7,795 9,370 Investment in affiliate 32,569 Miscellaneous 2,282 1,648 _______ _______ 42,646 11,018 _______ _______ $454,204 $340,272 ======== ======== Liabilities and Stockholders' Equity CURRENT LIABILITIES Notes payable $777 Accounts payable 43,172 $38,269 Accrued compensation 28,270 25,067 Income taxes 21,107 9,979 Accrued expenses and other liabilities 35,678 26,901 Current maturities of long-term debt 882 1,192 _______ _______ Total Current Liabilities 129,886 101,408 LONG-TERM DEBT, EXCLUDING CURRENT MATURITIES 31,282 1,433 OTHER LIABILITIES 4,602 5,170 STOCKHOLDERS' EQUITY Common stock, $.10 par value: Authorized--150,000 shares (50,000 in 1992) Outstanding--48,395 shares (48,303 in 1992) 4,840 4,830 Additional paid-in capital 17,111 15,732 Retained earnings 268,367 211,550 Foreign translation adjustments (1,884) 149 _______ _______ Total Stockholders' Equity 288,434 232,261 _______ _______ $454,204 $340,272 ======== ======== See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF EARNINGS STRYKER CORPORATION AND SUBSIDIARIES Years Ended December 31 (in thousands, except per share amounts) 1993 1992 1991 Net Sales $557,335 $477,054 $364,825 Costs and expenses: Cost of sales 256,748 221,650 172,477 Research, development and engineering 36,199 32,313 23,703 Selling, general and administrative 172,446 149,390 117,089 _______ _______ _______ 465,393 403,353 313,269 _______ _______ _______ Operating Income 91,942 73,701 51,556 Other income - net 4,123 3,239 1,789 _______ _______ _______ Earnings Before Income Taxes 96,065 76,940 53,345 Income taxes 35,860 29,240 20,270 _______ _______ _______ Net Earnings $60,205 $47,700 $33,075 ======= ======= ======= Net Earnings Per Share of Common Stock $1.25 $1.00 $.70 ======= ======= ======= Average Number of Shares Outstanding 48,356 47,716 47,526 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY STRYKER CORPORATION AND SUBSIDIARIES Years Ended December 31 Additional Foreign (in thousands, except per Common Paid-In Retained Translation share amounts) Stock Capital Earnings Adjustments Balance at January 1, 1991 $4,746 $4,757 $136,053 $2,319 Net earnings for 1991 33,075 Sales of 134 shares of common stock under option, including $799 income tax benefit 14 1,256 Cash dividend declared of $.05 per share of common stock (2,380) Translation adjustment 35 ______ ______ ________ ______ Balance at December 31, 1991 4,760 6,013 166,748 2,354 Net earnings for 1992 47,700 Sales of 706 shares of common stock under stock option and benefit plans, including $7,469 income tax benefit 70 9,719 Cash dividend declared of $.06 per share of common stock (2,898) Translation adjustment (2,205) ______ ______ _______ ______ Balance at December 31, 1992 4,830 15,732 211,550 149 Net earnings for 1993 60,205 Sales of 92 shares of common stock under stock option and benefit plans, including $393 income tax benefit 10 1,379 Cash dividend declared of $.07 per share of common stock (3,388) Translation adjustment (2,033) ______ ______ _______ ______ Balance at December 31, 1993 $4,840 $17,111 $268,367 ($1,884) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF CASH FLOWS STRYKER CORPORATION AND SUBSIDIARIES Years Ended December 31 (in thousands) 1993 1992 1991 OPERATING ACTIVITIES Net Earnings $60,205 $47,700 $33,075 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation 13,048 10,214 9,890 Amortization 3,135 1,168 1,906 Provision for losses on accounts receivable 900 400 1,200 Deferred income taxes (credit) (2,917) (4,171) (5,872) Changes in operating assets and liabilities: Increase in accounts receivable (11,305) (20,563) (3,682) Decrease (increase) in inventories 2,271 726 (18,103) Increase in accounts payable 4,982 7,723 8,340 Increase in income taxes 11,092 632 2,766 Other 4,691 6,899 8,124 _______ _______ _______ Net Cash Provided by Operating Activities 86,102 50,728 37,644 INVESTING ACTIVITIES Purchases of property, plant and equipment (20,160) (31,618) (16,570) Purchases of marketable securities (54,264) (21,553) (11,728) Business acquisitions (34,654) (8,736) _______ _______ _______ Net Cash Used in Investing Activities (109,078) (61,907) (28,298) FINANCING ACTIVITIES Proceeds from borrowings 33,563 4,401 Payments on borrowings (2,016) (7,418) (400) Dividends paid (2,898) (2,380) Proceeds from exercise of stock options 1,389 9,789 1,270 Other (126) (376) (198) _______ _______ _______ Net Cash Provided by (Used in) Financing Activities 29,912 (385) 5,073 Effect of exchange rate changes on cash and cash equivalents (315) 1,734 (170) _______ _______ _______ Increase (Decrease) in Cash and Cash Equivalents 6,621 (9,830) 14,249 Cash and cash equivalents at beginning of year 43,091 52,921 38,672 _______ _______ _______ Cash and Cash Equivalents at End of Year $49,712 $43,091 $52,921 ======= ======= ======= See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS STRYKER CORPORATION AND SUBSIDIARIES December 31, 1993 1. Significant Accounting Policies BUSINESS: Stryker Corporation develops, manufactures and markets specialty surgical and medical products which are sold primarily to hospitals throughout the world. PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries after elimination of all significant intercompany accounts and transactions. The Company's investment in affiliate represents a 20% investment and is accounted for by the equity method. REVENUE RECOGNITION: Revenue is recognized on the sale of products when the related goods have been shipped or services have been rendered. CASH EQUIVALENTS AND MARKETABLE SECURITIES: Cash equivalents are highly liquid investments with a maturity of three months or less when purchased. Marketable securities are valued at cost which approximates market value. INVENTORIES: Inventories are stated at the lower of cost or market. Cost for approximately 63% (68% in 1992) of inventories is determined using the lower of first-in, first-out (FIFO) cost or market. Cost for certain domestic inventories is determined using the last-in, first-out (LIFO) cost method. The FIFO cost for all inventories approximates replacement cost. PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment is stated at cost. Depreciation is computed by the straight-line method over the estimated useful lives of the assets. INTANGIBLE ASSETS: Intangible assets represent the excess of purchase price over fair value of tangible net assets of acquired businesses. Intangible assets, which include patents and intangibles not specifically identifiable, are being amortized using the straight-line method over periods of up to sixteen years. INCOME TAXES: Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes", which requires the use of the liability method of accounting for deferred income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates in effect for the years in which the differences are expected to reverse. Prior to the adoption of Statement 109, income tax expense was determined using the deferred method. Deferred tax expense was based on items of income and expense that were reported indifferent years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. EARNINGS PER SHARE: Earnings per share is based upon the average number of shares of common stock outstanding during each year. Shares subject to option are not included in earnings per share computations because the present effect thereof is not materially dilutive. 2. Inventories Inventories are as follows (in thousands): December 31 1993 1992 Finished goods $45,338 $47,068 Work-in-process 10,586 14,968 Raw material 28,455 24,783 _______ _______ FIFO cost 84,379 86,819 Less LIFO reserve 7,797 7,428 _______ _______ $76,582 $79,391 ======= ======= 3. Business Acquisitions In August 1993, the Company purchased 20% of the outstanding shares of Matsumoto Medical Instruments, Inc., Osaka, Japan. Matsumoto began distributing Stryker products in Japan in 1969 and is the exclusive distributor of most Stryker products in that country. The cost of the investment, which was based on net book value, was approximately 3.4 billion yen ($32.8 million). This investment is accounted for under the equity method. The Company's share of Matsumoto's net earnings did not have a material impact on the Company's net earnings in 1993. During 1993 and 1992, the Company's subsidiary, Physiotherapy Associates, Inc., purchased several physical therapy clinic operations. The aggregate purchase price of these clinics in 1993 and 1992 was approximately $1,900,000 and $2,900,000, respectively, and generally approximated the carrying amounts of the assets acquired. Proforma consolidated results including the purchased businesses would not differ significantly from reported results. In October 1992, the Company's subsidiary, Stryker France S.A., acquired Dimso S.A. and its subsidiary companies in France and Spain. Dimso designs and manufactures the Diapason and Stryker 2S Spinal Implant Systems and other orthopaedic products. The acquisition was accounted for by the purchase method at a total cost of $13,000,000 of which approximately $7,000,000 will be paid over the next three years. Intangible assets acquired, principally patents, are being amortized over a ten year period. Proforma consolidated results including the purchased business would not differ significantly from reported results. 4. Borrowings The Company and its subsidiaries have unsecured short-term line of credit arrangements with banks aggregating $20,000,000 domestically and $19,000,000 equivalent in foreign currencies. Borrowings under these lines at December 31, 1993 were $777,000 in foreign funds at an average interest rate of 12.5%. These lines generally expire July 31, 1994. Long-term debt is as follows (in thousands): December 31 1993 1992 Bank loan $30,736 Other 1,428 $2,625 _______ ______ 32,164 2,625 Less current maturities 882 1,192 _______ ______ $31,282 $1,433 ======= ====== The unsecured bank loan, which matures on August 4, 1998, is Japanese yen denominated and bears interest at a fixed rate of 4.9% per annum. Maturities of debt for the four years succeeding 1994 are: 1995 - $44,000; 1996 - $48,000; 1997 - $52,000 and 1998 - $30,793,000. The carrying amount of the Company's long-term debt approximates the fair value based on the Company's current borrowing rates for similar types of borrowing agreements. Total interest expense, which is included in other income and approximates interest paid, was $1,067,000 in 1993, $411,000 in 1992 and $655,000 in 1991. 5. Capital Stock The Company has key employee and director Stock Option Plans under which options are granted at a price not less than fair market value at date of grant. The options are granted for periods of up to ten years and become exercisable in varying installments. A summary of stock option activity follows: Option Shares Price Per Share Options outstanding at January 1, 1992 1,709,750 $3.20 - $30.75 Granted 397,000 34.25 - 38.75 Canceled (69,800) 4.34 - 34.25 Exercised (761,025) 3.20 - 14.63 ________________________________________________________________________________ Options outstanding at December 31, 1992 1,275,925 3.20 - 38.75 Granted 867,500 22.38 - 25.50 Canceled (411,300) 6.75 - 38.75 Exercised (75,600) 3.20 - 14.63 ________________________________________________________________________________ Options outstanding at December 31, 1993 1,656,525 $3.20 - $34.25 At December 31, 1993, options for 576,225 shares were exercisable and 1,113,100 shares were reserved for future grants. On May 13, 1991, the Company effected a two-for-one stock split. All share and per share data and affected amounts have been adjusted to reflect the stock split as though it had occurred at the beginning of the periods presented. The Company has 500,000 authorized shares of $1 par value preferred stock, none of which are outstanding. 6. Retirement Plans Substantially all Company employees are covered by profit sharing or defined contribution retirement plans. Retirement plan expense under the Company's profit sharing and defined contribution retirement plans totaled $5,302,000 in 1993, $4,715,000 in 1992 and $3,631,000 in 1991. 7. Income Taxes Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes", which requires the use of the liability method of accounting for income taxes (see Note 1). As permitted by Statement 109, the Company has elected not to restate the financial statements of any prior years. The cumulative effect of the change in the method of accounting on net earnings was not material. Earnings before income taxes consist of the following (in thousands): 1993 1992 1991 United States operations $88,181 $66,552 $45,480 Foreign operations 7,884 10,388 7,865 _______ _______ _______ $96,065 $76,940 $53,345 ======= ======= ======= The components of the provision for income taxes follow (in thousands): 1993 1992 1991 Current: Federal $26,114 $20,827 $17,985 State, including Puerto Rico 10,372 7,973 4,467 Foreign 2,291 4,611 3,690 _______ _______ _______ 38,777 33,411 26,142 Deferred tax expense (credit) (2,917) (4,171) (5,872) ------- ------ ------ $35,860 $29,240 $20,270 ======= ======= ======= A reconciliation of the statutory federal income tax rate to the Company's effective tax rate follows: 1993 1992 1991 U.S. statutory income tax rate 35.0% 34.0% 34.0% Add (deduct): State taxes, less effect of federal reduction 6.3 5.9 4.3 Foreign income taxes at rates different from the U.S. statutory rate (.8) 1.0 1.3 Tax benefit relating to operations in Puerto Rico (1.8) (1.9) (2.4) Research and development tax credit (1.4) (.9) (1.7) Earnings of Foreign Sales Corporation (1.4) (.8) (1.3) Other 1.4 .7 3.8 ---- ---- ---- 37.3% 38.0% 38.0% Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The tax effect of significant temporary differences which comprise the Company's deferred tax assets and liabilities at December 31, 1993 are as follows (in thousands): Deferred tax assets: Inventories $4,712 Accounts receivable and other assets 2,874 Other accrued expenses 6,662 State taxes 1,297 Other 920 ------ Total deferred tax assets 16,465 Deferred tax liabilities: Depreciation (792) Other (895) ------ Total deferred tax liabilities (1,687) ------ Total net deferred tax assets $14,778 ======= Deferred tax assets and liabilities are included in the consolidated balance sheet at December 31, 1993 as follows (in thousands): Current -- Deferred income taxes $15,829 Non-current -- Other liabilities (1,051) ------- Net deferred tax assets $14,778 ======= No provision has been made for U.S. federal and state income taxes or foreign taxes that may result from future remittances of the undistributed earnings ($40,128,000 at December 31, 1993) of foreign subsidiaries because it is expected that such earnings will be reinvested overseas indefinitely. Determination of the amount of any unrecognized deferred income tax liability on these unremitted earnings is not practicable. Total income taxes paid were $27,641,000 in 1993, $25,133,000 in 1992 and $22,550,000 in 1991. 8. Geographic Data Geographic area information follows (in thousands): 1993 1992 1991 NET SALES United States operations: Domestic $378,255 $330,782 $253,479 Export 115,977 81,513 72,256 Foreign operations: Europe 63,366 58,010 47,685 Other 45,638 43,182 24,401 Eliminations (45,901) (36,433) (32,996) -------- -------- -------- Net Sales $557,335 $477,054 $364,825 ======== ======== ======== OPERATING INCOME (LOSS) United States operations $90,726 $68,759 $49,492 Foreign operations: Europe 6,571 6,998 7,497 Other 3,125 4,477 717 -------- -------- -------- Total Foreign Operations 9,696 11,475 8,214 Corporate expenses (8,480) (6,533) (6,150) -------- -------- -------- Total Operating Income $91,942 $73,701 $51,556 ======== ======== ======== ASSETS United States operations $225,587 $199,188 $156,155 Foreign operations: Europe 39,313 42,580 24,607 Other 16,120 15,125 15,834 Corporate 173,184 83,379 73,720 -------- -------- -------- Total Assets $454,204 $340,272 $270,316 Intercompany sales between geographic areas are included in export and foreign operations sales at agreed upon prices which include a profit element. For the year ended December 31, 1993, sales to Matsumoto Medical Instruments, Inc. were $64,300,000 or 12% of total net sales. No customer accounted for 10% or more of the Company's sales in 1992 and 1991. Gains (losses) on foreign currency transactions, which are included in other income, totaled $(256,000), $188,000 and $(898,000) in 1993, 1992 and 1991, respectively. Corporate assets consist primarily of domestic cash and cash equivalents, marketable securities and investment in affiliate. 9. Leases The Company leases various manufacturing and office facilities and equipment under operating leases. Future minimum lease commitments under these leases are as follows (in thousands): 1994 $7,507 1995 5,591 1996 4,316 1997 3,001 1998 2,115 Thereafter 2,152 ------ $24,682 ======= Rent expense totaled $10,950,000 in 1993, $8,792,000 in 1992 and $6,686,000 in 1991. 10. Contingencies The Company is involved in various claims and legal actions arising in the normal course of business. The Company does not anticipate material losses as a result of these actions. REPORT OF INDEPENDENT AUDITORS Board of Directors Stryker Corporation We have audited the accompanying consolidated balance sheet of Stryker Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Stryker Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Ernst & Young Kalamazoo, Michigan January 31, 1994 BOARD OF DIRECTORS AND OFFICERS BOARD OF DIRECTORS John W. Brown Chairman, President and Chief Executive Officer, Stryker Corporation. Howard E. Cox, Jr. General Partner, Greylock Partners & Co. *Donald M. Engelman, Ph.D. Professor of Molecular Biophysics and Biochemistry, Yale University. Jerome H. Grossman, M.D. Chairman and Chief Executive Officer, New England Medical Center, Inc. *John S. Lillard Chairman-Founder, JMB Institutional Realty Corp. William U. Parfet President and Chief Executive Officer, Richard-Allan Medical Industries, Inc. Ronda E. Stryker Granddaughter of the founder of the Company and daughter of the former President of the Company. A director of Comerica Bank, the L. Lee Stryker Center and Trustee of Kalamazoo College. *Gerard Thomas Attorney, Miller, Canfield, Paddock & Stone. *Audit and Compensation Committees CORPORATE OFFICERS John W. Brown Chairman, President and Chief Executive Officer Ronald A. Elenbaas Vice President, President, Stryker Surgical Group William T. Laube, III Vice President, President, Stryker Pacific Robert D. Monk Treasurer/Controller and Assistant Secretary Julia M. Paradine-Rice Assistant Treasurer David J. Simpson Vice President, Chief Financial Officer and Secretary Thomas R. Winkel Vice President, President, Stryker Americas/Middle East OPERATING DIVISIONS OSTEONICS CORP. Edward B. Lipes - President Gary L. Grenter - Vice President, Operations Brian K. Hutchison - Vice President, Finance Michael T. Manley, Ph.D. - Vice President, Advanced Research Anthony M. Moutinho - Vice President, Sales PHYSIOTHERAPY ASSOCIATES, INC. Jason T. Blackwood - President Jeffrey S. Chitwood - Vice President, Finance G. William Cole, Jr. - Vice President, Marketing and Development STRYKER AMERICAS/MIDDLE EAST Thomas R. Winkel - President Bradford J. Williams - Vice President, Canada STRYKER BIOTECH Samuel Yin, Ph.D. - Director STRYKER ENDOSCOPY Ronald A. Elenbaas - President Pedro A. Martinez - Vice President, General Manager William E. Chang - Vice President, Research and Development STRYKER EUROPE Jean-Pierre Boucher - President Alain Guez - Vice President, France Maurizio Zaccarelli - Vice President, Stryker Europe STRYKER INSTRUMENTS Ronald A. Elenbaas - President Stephen Si Johnson - Executive Vice President, General Manager Matthew S. Alves - Vice President, Marketing Bradley D. Black - Vice President, Human Resources James A. Evans - Vice President, Research and Development Thomas R. Gillentine - Vice President, Controller John T. Saunders - Vice President, Operations STRYKER MEDICAL Harry E. Carmitchel - President Joseph S. Messer - Vice President, Marketing, Patient Care Division Michael R. Stringer - Vice President, Sales, Patient Care Division Mark J. Fletcher - Vice President, Sales and Marketing, Patient Handling Division Gary T. Morton - Vice President, Engineering, Patient Handling Division Kenneth A. Palmer - Vice President, General Manager, Patient Handling Division Joseph P. Briggs - Vice President, Service Division STRYKER PACIFIC William T. Laube, III - President Alexander S. Kennedy - Vice President, General Manager, Australia Hyung-Yun Lee - Vice President, General Manager, Korea John D. Pierson - President, Japan Hugo K.W. Hui - Vice President, Finance and Administration EXHIBIT (21) List of Subsidiaries State or Country of Name of Subsidiary Incorporation - ------------------ ------------------- Nippon Stryker Service K.K. Japan Osteonics Corp. New Jersey Physiotherapy Associates, Inc. Michigan Stryker Australia Pty. Ltd. Australia Stryker B.V. The Netherlands Stryker Barbados Foreign Sales Corporation Barbados Stryker Canada Inc. Canada Stryker Corporation (Malaysia) SDN BHD Malaysia Stryker Deutschland GmbH Germany Stryker Far East, Inc. Delaware Stryker Foreign Sales Corporation U.S. Virgin Islands Stryker France SA France Stryker India Medical Equipment Private Limited India Stryker Italia SRL Italy Stryker Japan K.K. Japan Stryker Korea Ltd. Korea Stryker Malaysia, SDN. BHD. Malaysia Stryker Pacific Limited Hong Kong Stryker Puerto Rico, Inc. Delaware Stryker SA Switzerland Stryker Sales Corporation Michigan Stryker Singapore Private Limited Singapore Stryker Corporation is the immediate parent and owns 100% of the outstanding voting securities of each of the above-named subsidiaries. EXHIBIT 23--CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of Stryker Corporation and subsidiaries of our report dated January 31, 1994, included in the 1993 Annual Report to Stockholders of Stryker Corporation and subsidiaries. Our audits also included the financial statement schedules of Stryker Corporation and subsidiaries listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statement Number 33-55662 on Form S-8 dated December 11, 1992, Registration Statement Number 2-96467 on form S-8 dated April 4, 1985, Registration Statement Number 33-16642 on Form S-3 dated August 20, 1987, and Registration Statement Number 33-32240 on Form S-8 dated November 20, 1989 and to the related prospectus for each of the registration statements, of our report dated January 31, 1994, with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedules included in this Annual Report (Form 10-K) of Stryker Corporation. ERNST & YOUNG Kalamazoo, Michigan March 17, 1994

5207_1993.txt

5207_1993

1993

5207

ITEM 1. BUSINESS American Housing Partners ("AHP"), a California limited partnership, was formed on June 7, 1971, to invest through local limited partnerships in government assisted multi-family housing developments ("Projects" or "Government-Assisted Properties"). Each local limited partnership owns, individually, a single low to moderate income multi-family housing project which is subsidized and/or mortgage-insured by the federal government. During 1993, and as of December 31, 1993, AHP held interests in five local limited partnerships which own and operate a Project. The general partner of AHP is NIDC Managers, Inc., a Delaware corporation ("NIDMI" or "the General Partner"). See Item 12 "Partnership Interest Ownership of Certain Beneficial Owners and Management". In order to stimulate private investment in low and moderate income housing of the types in which AHP has invested, the federal government has provided investors with significant ownership incentives, including interest subsidies, rent supplements, mortgage insurance and other measures, with the intent of reducing the risks and providing the investors/owners with certain tax benefits, plus limited cash distributions and the possibility of long-term capital gains. However, there are significant risks inherent in this type of housing. Long- term investments in real estate limit the ability of AHP to vary its portfolio in response to changing economic, financial and investment conditions, and such investments are subject to changes in economic circumstances and housing patterns, rising operating costs and vacancies, rent controls and collection difficulties, costs and availability of energy, as well as other factors which normally affect real estate values. In addition, these projects usually involve greater management burdens and operating expenses than conventional housing projects. AHP's Projects were typically initiated by private developers who optioned or acquired the sites and applied for Federal Housing Administration (FHA) mortgage insurance and subsidies. AHP became the sole limited partner in local limited partnerships formed to become the owners of such Projects. As a limited partner, AHP's liability for obligations of the local limited partnership is limited to its investment. The developer typically became the managing general partner of the local limited partnership, with responsibility for developing, constructing, maintaining, operating and managing the Project. Generally, NIDC Housing Corporation, a Delaware corporation ("NIDHC"), or NIDC Asset Management, Inc., a Delaware corporation ("NIDAM"), is a co-general partner of each local limited partnership. As such, NIDHC or NIDAM has the right to participate in certain decisions that affect AHP's investment in the local limited partnership. NIDHC and NIDAM also have the right to replace the developer as the managing general partner of the local limited partnership and to assume day-to-day operational control of the local limited partnership's affairs upon the occurrence of certain events considered adverse to AHP's investment. NIDHC and NIDAM are affiliates of NIDMI. See Item 12 "Partnership Interest Ownership of Certain Beneficial Owners and Management". Although each of the Projects in which AHP holds an indirect interest must compete in the marketplace for tenants, the receipt of interest subsidies and rent supplements from the federal government make it possible to offer these dwelling units to tenants with low and moderate income at prices below the market rate for comparable dwelling units in the area. During 1993, the Projects operated, in the aggregate, with negative cash flow. The distributions from the local limited partnerships are limited by the Projects' regulatory agreements with HUD or other similar state agencies, to 6% per annum of the original equity provided to the Project (as determined by HUD), payable only when cash is available as determined by a formula provided by HUD. Of the distributions payable to AHP and the general partners of the local limited partnerships at December 31, 1993, a portion is currently payable and the remainder is deferred until there is available cash. In 1983, AHP adopted a policy of selling the Projects in which it holds an interest (through the local limited partnership) when such sale can be made on satisfactory terms and deemed in the best interest of the partners of AHP. This policy resulted in two Project sales in 1983, four Project sales in 1984, one Project sale in 1985 and three Project sales in 1989. Of the 20 Projects in which AHP held an interest through its ownership of local limited partnerships (19 originally and one acquired), five remain and one, Woodbrook Apartments, which was sold in 1985, still has not had a final closing. See Item 2. ITEM 2. PROPERTIES AHP holds interests as a limited partner in local limited partnerships that have developed, own, and operate government-assisted multi-family housing developments. See Item 1. Business. The properties were developed from the proceeds of mortgage loans obtained by the local limited partnerships to provide affordable housing to the low and moderate income groups. The five Projects are composed primarily of garden and townhouse type apartments representing 518 units located in four states. The typical Project includes a mix of 1, 2, and 3 bedroom units, laundry facilities and parking areas, with some projects containing a playground and/or swimming pool. The individual units include all normal amenities with most including automatic dishwasher and air conditioning. In 1983, AHP adopted a policy of selling the Projects in which it holds an interest (through the local limited partnership) when such sale can be made on satisfactory terms and deemed in the best interest of the partners of AHP. See Item 1. Business. AHP sold its Partnership interest in 3 Projects in 1989. Set forth below is a schedule as of December 31, 1993 of Projects owned by local limited partnerships in which AHP is a limited partner, together with the current occupancy status of each Project. * RENTS DECONTROLLED IN 1984. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The 1991 Report contained a description of a series of administrative and legal proceedings relating to disputes between the Department of Housing and Urban Development ("HUD") and Associated Financial Corporation ("AFC") and its affiliates (collectively, the "AFC Group"). Members of the AFC Group include both General Partners of the Partnership and general partners of the Operating Partnerships. The information relating to such proceedings, contained on pages 4 through 30 of the 1991 Report, is incorporated herein by this reference. In April, 1994, members of the AFC Group entered into a comprehensive settlement agreement with HUD (the "Settlement Agreement") on terms which the General Partners believe are decisively favorable to the AFC Group. Under the Settlement Agreement, all of HUD's administrative proceedings against members of the AFC Group, including those relating to the dispute regarding Westport Housing Corporation, were dismissed on terms which do not permit HUD to reinstitute any of the proceedings, and HUD agreed to refrain from using any of the facts it alleged in the administrative proceedings or other facts relating to the current condition of the properties owned by members of the AFC Group in any future administrative proceedings. HUD also terminated the 1992 suspension and proposed debarment of the members of the AFC Group, including the General Partners. Under the Settlement Agreement, members of the AFC Group will regain the unrestricted right to participate in HUD programs and otherwise do business with HUD with respect to Government Assisted Properties. As described on pages 6-9 of the 1991 Report, which pages are incorporated herein by this reference, the various partnerships affiliated with the AFC Group and others initiated an actions against HUD officials in United States District Court in January, 1993. In one case involving the Germano Partnership, the District Court judge granted to the plaintiffs substantially all the relief they had requested, including requiring HUD to renew its Section 8 Housing Assistance Payments Contract ("HAP Contract") with the Germano Partnership. The plaintiffs in three similar District Court actions, described or referred to on pages 9-12 of the 1991 Report and each involving a property owned by a member of the AFC Group, also obtained substantially all the relief they sought, including in each case renewing an existing HAP Contract or entering into a new HAP Contract. After obtaining the relief they sought, the plaintiffs in the District Court actions consented to dismissals of the actions. In view of the favorable results they had obtained in the District Court actions, plaintiffs in the four actions filed petitions for attorney's fees against HUD. Under the Settlement Agreement, HUD agreed to pay a total of approximately $167,500 to plaintiffs in the District Court actions, and the plaintiffs agreed to move for dismissal of their petitions for attorney's fees. The 1991 Report contained a description of a civil action relating to Tyler House, a Government-Assisted Property in which affiliates of the General Partners had invested. See pages 24 and 29 of the 1991 Report, which information is incorporated herein by this reference. As indicated therein, the defendants appealed the judgments based upon the verdict against them. The appellate court subsequently denied the defendants' appeal, and the defendants then duly satisfied the judgment. The General Partners' prediction that the judgment would not interfere with the performance by the General Partner of its duties to the Partnership and that the Partnership would not be adversely affected by the result in the litigation proved to be correct. On May 8, 1997, the United States filed an action against Associated Financial Corporation, certain members of the AFC Group, including Messrs. Ross and Rozet, and others, in the United States District Court for the Northern District of California charging that the defendants were wrongfully participating in the fees earned by the management agent for several properties (not including any of the properties invested in by the Partnership) and had not disclosed this arrangement and, thus, were violating provisions of the applicable regulatory agreements and other agreements governing the subject properties. The Complaint did, however, allege that the defendants made certain false claims regarding the condition of the Sierra Nevada property. Defendants filed an answer on August 11, 1997, denying the material allegations of the Complaint, and asserting various separate and additional defenses. The government filed an amended complaint on March 2, 1998, adding additional defendants none of whom are part of the AFC Group and added a claim that the defendants, including the new defendants made false claims in connection with the obtaining of insurance for various HUD-insured properties. The defendants have filed answers to the First Amended Complaint, again denying the material allegations of the Complaint and asserting various separate and additional defenses. While substantial document discovery has been completed, the defendants intend to move to compel significant delivery from the government of substantial additional documentation. Deposition discovery is in its early stages. Given the defendants need to obtain significant additional discovery, counsel can offer no opinion as to the outcome of the litigation at this time. The General Partner believes that when all of the facts are presented to an impartial judge, the defendants will be exonerated. However, the complaint contains serious allegations against the defendants and every effort will be made to show that the government is wrong in bringing the lawsuit. At this time, the general partner does not believe that there will be any material adverse affect to the Partnership and the operation of its investments, much like the previous litigation with HUD described above. Woodbrook Apartments A suit was commenced in January, 1976, in the New York Supreme Court by Woodbrook Houses Associates against Hercoform Marketing (the general contractor), Tiffany-Armstrong (the architect), Beardsley and Beardsley (site engineers) and Seaboard Surety Company (the general contractor's insurer) to recover damages for construction deficiencies. The cost of correcting these deficiencies and the additional expenses caused by these deficiencies is estimated to exceed $700,000. The general contractor has interposed counterclaims in the amount of $58,000. Because of the complexity of this lawsuit, legal counsel cannot express an opinion on its probable outcome. As a condition of the sale of Woodbrook Apartments, primary responsibility to pursue this matter shifted to the new owners, CPY Partnership. However, the Registrant continues to be involved in the case and will share in the case and will share in any ultimate award or settlement obtained by Woodbrook Houses Associates. A suit involving Woodbrook Apartments was commenced on January 11, 1983 in the New York Supreme Court by K-Line Windows, Inc. against Mayzan Management Corporation (the on-site management company for Woodbrook Apartments) and NIDAM. The action is based upon a claim for an unpaid contract sum for the installation of storm windows at the project. On September 4, 1984, a summary judgment was granted to the plaintiff in the amount of $56,877. The defendants have interposed various motions to delay execution of this judgment. Settlement negotiations are presently underway to resolve this judgment. As a condition of the sale of Woodbrook Apartments, CPY Partnership agreed to assume full financial responsibility for the settlement of this suit although NIDAM remains a defendant in this action. At this time, it appears that neither of the two foregoing lawsuits is being actively pursued by any party to either suit. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the fiscal year ending December 31, 1993 to a vote of security holders. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S PARTNERSHIP INTERESTS AHP partnership interests are not actively traded and no public trading market exists. From time to time, a sale of the partnership interests is made at a price negotiated between the buyer and seller. The transactions are handled through a limited number of broker-dealers. As of December 31, 1993 there were 5 general partner interests held by NIDMI and 7,005 limited partner interests held by 509 limited partners. This figure is based upon the number of record holders as reported by the Registrant's transfer agent. During 1989 no cash distributions were made. During 1990 one cash distribution was made. On September 3, 1990, $576,923 was distributed to partners of record as of December 29, 1989. During 1991 no cash distributions were made. During 1992 no cash distributions were made. During 1993 no cash distributions were made. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following summary of selected financial data should be read in conjunction with Item 14, herein, which also includes a summary of AHP's significant accounting policies. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. RESULTS OF OPERATIONS: Payments received in 1993, 1992 and 1991 on notes receivable resulting from project sales in prior years were limited to the amounts required to service the underlying HUD mortgages on these projects. The Partnership also received surplus cash distributions of $62,409, $15,756 and $26,487 for 1993, 1992, and 1991, respectively. For income tax purposes, AHP's share of net interest income recognized on the notes receivable was $200,104 for 1993, compared with $211,492 and $313,812 for 1992 and 1991, respectively. For financial statement purposes, as the sales are accounted for under the cost recovery method, all interest income is deferred until the cost of the respective property is recovered. Total revenue generated in 1993 was $62,409 compared with $15,756 and $26,788 for 1992 and 1991, respectively. For all three years, distributions received from partnerships in which AHP holds interests represent more than 98% of total revenue. For income tax purposes, cash distributions received are treated as offsets to investment. Total expenses for 1993 were $73,287, compared with $75,163 and $161,869 for 1992 and 1991, respectively, a decrease of 12% and 55% from these years. The decrease in 1992 compared to 1991 is mainly due to a decrease of $77,747 in professional fees, an increase of $169 in communications with partners, and a decrease of $9,128 in miscellaneous expense. Net losses for 1993 were $10,878 compared to net losses of $59,407 and $135,081 for 1992 and 1991, respectively. LIQUIDITY AND CAPITAL RESOURCES: Although the Partnership is actively seeking to divest itself of projects in which it has investments, the financial health and operating prospects of the remaining projects is still viable. Distributions of cash are still being received from the remaining projects, and the Partnership continues to receive proceeds from the prior sales. There are currently no appreciable problems with projects owned by partnerships in which AHP holds interests. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements together with the auditors' report thereon are set forth at the pages indicated in Item 14 (a)(1) and (2). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 10. ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT AHP has no officers or directors. The officers and directors of NIDMI (the General Partner) are as follows: The following biographical information is presented for the officers and directors of NIDMI. Mr. Ross has been a principal officer of the Associated Financial Corporation ("AFC") group of companies, including affiliates of the General Partner, since the inception of a predecessor corporation, Oakdale Corporation, a California corporation (which is now a wholly-owned subsidiary), in 1973. The AFC organization, including certain predecessors, has been continuously engaged in the field of government-assisted low to moderate income housing developments since its inception. Mr. Ross is a real estate executive with more than 35 years' experience in the field of government-assisted housing. In 1987, he testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs on matters relating to housing legislation. Mr. Ross earned a Bachelor's Degree in Real Estate & Finance from the Wharton School of Finance & Commerce of the University of Pennsylvania. Mr. Rozet has been Chairman of the Board of Associated Financial Corporation and certain of its Affiliates, including AFC Capital Corporation, since 1984, except for a brief period from August 1985 to February 1986. Concurrently, from 1975 until 1987, he was also Chairman of the Board of National Development Services Corporation, a California corporation engaged in providing consulting services principally relating to the financial structuring of government-assisted, low to moderate income housing developments. Mr. Rozet has been a financier for more than 25 years with substantial experience in the field of real estate, most significantly relating to government subsidized multi-family residential housing. Since 1972, Mr. Rozet has been involved in the equity financing of approximately 500 government- assisted apartment developments relating to approximately 50,000 apartment units. Mr. Rozet has served on a task force for the U.S. Department of Housing and Urban Development formed to aid HUD personnel in the development and implementation of advanced processing procedures. Mr. Rozet has also provided consulting services to Congressional staff personnel with respect to housing legislation. In 1988, Mr. Rozet testified before the U.S. House of Representatives Committee on Ways and Means on matters relating to the Low Income Housing Tax Credit. Mr. Rozet earned a Bachelor of Science Degree in Industrial Engineering from Pennsylvania State University and completed graduate studies in Corporate Finance and Strategic Planning at the University of California at Los Angeles (UCLA). Ms. Magnuson is Secretary of National Palisades Corporation and has been an executive officer to certain of its affiliates and predecessors since 1977. In June, 1987, Ms. Magnuson became Secretary of NIDMI. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION AHP has no executive officers. No person acting in such capacity received compensation in 1993 directly or indirectly from AHP. ITEM 12. ITEM 12. PARTNERSHIP INTEREST OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT No person is known to own beneficially in excess of five percent of the outstanding partnership interests of AHP. NIDMI, the General Partner, holds five non-voting General Partnership Interests and five voting Limited Partnership Interests. NIDMI is beneficially owned by A. Bruce Rozet and Deane Earl Ross, who are the Directors and executive officers of NIDMI. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS NIDAM earned management fees of $50,000 during 1993 from AHP, which represents 4.2% of NIDAM's total revenue during 1993. NIDAM and NIDHC are general partners in the local limited partnerships in which AHP has invested. A. Bruce Rozet and Deane Earl Ross, the Directors of NIDMI, beneficially own and are executive officers of NIDAM and NIDHC. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K: (a) The following documents are filed as part of this report: (1) Financial Statements: All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (b) Reports on Form 8-K No reports on Form 8-K were filed by AHP during the last quarter of fiscal year 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN HOUSING PARTNERS a California limited partnership By: NIDC Managers, Inc. General Partner Date: July 16, 1998 By: /s/ Deane Earl Ross --------------------------------------------- Deane Earl Ross President and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: July 16, 1998 By: /s/ A. Bruce Rozet --------------------------------------------- A. Bruce Rozet, Chairman of the Board and Chief Executive Officer of NIDC Managers, Inc. Date: July 16, 1998 By: /s/ Deane Earl Ross --------------------------------------------- Deane Earl Ross, Director, President and Treasurer (Chief Financial Officer and Chief Accounting Officer) of NIDC Managers, Inc. [LETTERHEAD OF BAY SHERMAN CRAIG & GOLDSTEIN, LLP] Report of Independent Certified Public Accountants -------------------------------------------------- To the Partners American Housing Partners We have audited the accompanying balance sheets of American Housing Partners (a California limited partnership) as of December 31, 1993 and 1992 and the related statements of operations, partners' deficit and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of certain limited partnerships in which the Partnership has an investment, the statements of which reflect total assets and revenues constituting 100% of the combined totals of the limited partnerships in the years presented. These statements were audited by other auditors, whose reports thereon have been furnished to us and our opinion, insofar as it relates to the amounts included in Note C for those limited partnerships, is based solely upon the reports of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of the other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of American Housing Partners as of December 31, 1993 and 1992 and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles. /s/ Bay Sherman Craig & Goldstein, LLP Los Angeles, California July 14, 1997, except for Note H, as to which the date is July 7, 1998 AMERICAN HOUSING PARTNERS BALANCE SHEETS DECEMBER 31, ASSETS LIABILITIES AND PARTNERS' DEFICIT See notes to the financial statements. AMERICAN HOUSING PARTNERS STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, See notes to the financial statements. AMERICAN HOUSING PARTNERS STATEMENTS OF PARTNERS' DEFICIT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Limited General Total Partners Partner ----------- ----------- ------- See notes to the financial statements. AMERICAN HOUSING PARTNERS STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, Noncash investing and financing activities: Principal payments on mortgages payable were made by buyers on behalf of the Partnership totaling $200,104, $211,492 and $197,232 during the years ended December 31, 1993, 1992 and 1991, respectively. See notes to the financial statements. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A summary of the significant accounting policies consistently applied in the preparation of the accompanying financial statements follows. (1) Organization and Line of Business American Housing Partners (the Partnership) was formed as a limited partnership on June 7, 1971 under the laws of the State of California, with its general partner, NIDC Managers, Inc. (NIDMI), owning five partnership interests and the initial limited partner owning five partnership interests. On August 31, 1971, the Partnership issued 7,000 partnership interests to limited partners through a public offering. The Partnership is engaged primarily in investing in limited partnerships that own and operate government-assisted, multi-family, residential rental projects. The general partners of the limited partnerships generally are affiliates of NIDMI. The accompanying financial statements include only the assets, liabilities, results of operations and cash flows which relate to the Partnership, and not those attributable to the partners' individual activities. (2) Investments in Limited Partnerships The Partnership uses the equity method to account for its investments in limited partnerships. Accordingly, for financial statement purposes, when the carrying value of the investment has been reduced to zero, the Partnership discontinues recognizing its share of the limited partnerships' losses and recognizes cash distributions as income when received. (3) Revenue Recognition Gains on the sale of investments in limited partnerships are accounted for using the cost recovery method. Under this method, no gain is recognized until cash payments by the buyers to the Partnership exceed the Partnership's investments in the limited partnerships sold and all accrued interest has been received. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): (4) Income Taxes No provision has been made for income taxes in the accompanying financial statements since such taxes, if any, are the liability of the individual partners. (5) Cash Equivalents The Partnership considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. (6) Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. B. SALES OF INVESTMENTS IN LIMITED PARTNERSHIPS TO RELATED PARTIES Prior to 1985, six limited partnerships in which the Partnership had an interest disposed of the multi-family, HUD-regulated, residential rental projects and certain other assets and liabilities owned by them. The projects were sold for various sales prices consisting of cash down payments, deferred cash payments due in future annual installments and the remainder due in the form of nonrecourse all-inclusive residual notes receivable. The residual notes, which include the unpaid principal balances of the related underlying HUD mortgages, bear interest at 14% per annum and are collateralized by the various purchasers' partnership interests. The residual notes contain provisions which limit the accrual of interest if the sum of the unpaid principal plus accrued interest exceeds the appraised value of the respective project at specified dates. Based on values determined by management, the accrual of interest on two residual notes was suspended as of January 1, 1992. All unpaid principal and interest is due in full through 2024. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 B. SALES OF INVESTMENTS IN LIMITED PARTNERSHIPS TO RELATED PARTIES (CONTINUED) The sales were made to partnerships whose general partners currently are affiliates of the general partner of the Partnership (two purchasing partnerships were related prior to 1985 and the remaining four partnerships became related during 1986). Concurrent with the sales, the Partnership was assigned its share of the selling limited partnerships' rights and beneficial interests in and to the resulting residual notes receivable and the related underlying HUD mortgages, and also loans payable to the former managing general partners (Note D), none of which were assumed by the purchasers. In 1985, the Partnership was assigned its share of the remaining assets of the limited partnerships. Additionally, in 1982, the Partnership and an unaffiliated individual sold their entire interest in a limited partnership to a partnership whose general partner is an affiliate of the general partner of the Partnership. The Partnership sold its interest for $823,000, of which $400,000 was received in cash and the remaining $423,000 is in the form of a note receivable, bearing interest at 19.5% per annum, due in 2002. The note is collateralized by the purchaser's partnership interest. Under the sales agreement, the individual will receive the next $800,000 in cash; thereafter, the additional payments will be split one-third to the Partnership and two-thirds to the individual. Under the terms of all the sales agreements, the purchasers' obligations to make payments on the notes receivable are limited to the purchasers' share of the allowable surplus cash distributions (as defined by HUD) received from the projects. These distributions may not exceed the aggregate of $89,758 annually, plus prior allowable distributions. No surplus cash distributions were received by the Partnership from the projects in 1991, 1992 and 1993. Aggregate allowable distributions were $1,202,243 at December 31, 1993. The purchasers are also obligated to make the payments on the related underlying HUD mortgages payable (Note D). AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 B. SALES OF INVESTMENTS IN LIMITED PARTNERSHIPS TO RELATED PARTIES (CONTINUED) Amounts due from the related parties in connection with these sales are summarized as follows: AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 C. INVESTMENTS IN AND ADVANCES TO LIMITED PARTNERSHIPS The Partnership owns partnership interests in the following limited partnerships, each of which owns and operates a multi-family residential rental project: Homestead Limited Dividend Housing Association Pine Villa Associates Tanglewood Terrace, Ltd. Woodhaven Apartments Associates Columbia - Jennifer, Ltd. The projects are regulated by HUD as to the rent charges and operating methods. The mortgage loan obligations of the limited partnerships are insured by HUD and the interest payments are subsidized by HUD under Sections 221(d)(4) and 236 of the National Housing Act. As the limited partner, the Partnership is generally entitled to 99% of the profits and losses and varying lesser percentages of the proceeds from the sale or refinancing of the projects of each limited partnership in which it has invested. The following is a summary of the changes in the investments in and advances to the limited partnerships in which the Partnership had an equity interest: AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 C. INVESTMENTS IN AND ADVANCES TO LIMITED PARTNERSHIPS (CONTINUED) Summarized balance sheets and statements of operations for the limited partnerships in which the Partnership has an equity interest are as follows: BALANCE SHEETS AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 C. INVESTMENTS IN AND ADVANCES TO LIMITED PARTNERSHIPS (CONTINUED) STATEMENTS OF OPERATIONS AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 D. MORTGAGES AND LOANS PAYABLE As discussed in Note B, the Partnership was assigned interests in certain underlying HUD mortgages on the multi-family residential rental projects disposed of by limited partnerships in which the Partnership had an investment. Responsibility for servicing the HUD mortgages remains with the sellers. The Partnership's share of the mortgages is due in various monthly installments totaling $80,616, including interest at 7% per annum, through October, 2014. The mortgages are collateralized by the apartment projects and are held by the Federal National Mortgage Association and insured by HUD. The following is a schedule of the Partnership's share of future maturities of the underlying HUD mortgages payable: The Partnership was also assigned interests in certain loans, aggregating $543,765 at December 31, 1993 and December 31, 1992. The loans are payable to the prior managing general partners of the limited partnerships in which the Partnership had an investment and were not assumed by the purchasers. The loans were originally made to finance construction costs that exceeded the original partners' capital contributions and the proceeds from the related HUD mortgages. Theses loans are non-interest bearing and are payable based upon certain liquidation provisions in the various limited partnership agreements. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 E. MANAGEMENT AND LIQUIDATION FEES PAYABLE The Partnership entered into a management contract with NIDC Asset Management, Inc. (NIDAM), an affiliate of the general partner of the Partnership, for the performance of certain services. The contract expired December 31, 1993, and was terminable at any time by the Partnership with at least 60 days written notice. Under the management contract, NIDAM pays the general and administrative expenses of the Partnership, except for legal and accounting expenses and the cost of communicating with the limited partners. NIDAM earns an annual management fee based on the average annual tax deductions plus cash distributions per partnership interest, which can range from one-tenth to one-quarter of one percent of the Partnership's invested assets (defined as the Partnership's investment in and its share of the mortgage debt of the limited partnerships in which it has invested). The minimum management fee is $50,000 per year. Additionally, the management contract provides that NIDAM is entitled to a liquidation fee from the sale of projects by the limited partnerships (to other than affiliates of the management company), once the requisite approval for a total or partial liquidation has been obtained. No liquidation fees were paid in 1991, 1992 and 1993. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 F. FEDERAL TAXABLE INCOME The following is a reconciliation between the net loss per the financial statements and the net earnings for federal income tax purposes: AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 F. FEDERAL TAXABLE INCOME (CONTINUED) G. RELATED PARTY TRANSACTIONS During the year ended December 31, 1991, the Partnership paid fees to a company affiliated with the general partner for mortgage prepayment preservation rights in the amount of $60,000. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 H. CONTINGENT LIABILITY On May 8, 1997, the United States filed an action against Associated Financial Corporation ("AFC") and its affiliates (collectively, the "AFC Group") and others, in the United States District Court for the Northern District of California charging that the defendants were wrongfully participating in the fees earned by the management agent for several properties (not including any of the properties invested in by the Partnership) and had not disclosed this arrangement and, thus, were violating provisions of the applicable regulatory agreements and other agreements governing the subject properties. The Complaint did, however, allege that the defendants made certain false claims regarding the condition of one property in which the Partnership had an interest in a deferred cash payment receivable, an all-inclusive residual note receivable and accrued interest receivable and was obligated on an underlying mortgage payable. This property was lost through foreclosure in January, 1996 and, as a result, the Partnership lost its interest in these items. Defendants filed an answer on August 11, 1997, denying the material allegations of the Complaint, and asserting various separate and additional defenses. The government filed an amended complaint on March 2, 1998, adding additional defendants none of whom are part of the AFC Group and added a claim that the defendants, including the new defendants, made false claims in connection with the obtaining of insurance for various HUD-insured properties. The defendants have filed answers to the First Amended Complaint, again denying the material allegations of the Complaint and asserting various separate and additional defenses. While substantial document discovery has been completed, the defendants intend to move to compel significant delivery from the government of substantial additional documentation. Deposition discovery is in its early stages. Given the defendants' need to obtain significant additional discovery, counsel can offer no opinion as to the outcome of the litigation at this time. AMERICAN HOUSING PARTNERS NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 H. CONTINGENT LIABILITY (Continued) The general partner believes that when all of the facts are presented to an impartial judge, the defendants will be exonerated. However, the complaint contains serious allegations against the defendants and every effort will be made to show that the government is wrong in bringing the lawsuit. At this time, the general partner does not believe that there will be any material adverse effect to the Partnership and the operation of its investments. I. PARTNERSHIP STATUS The term of the Partnership, under its original Partnership Agreement, expired on December 31, 1993 and has not been renewed. As a result, the Partnership has been operating since January 1, 1994 as a partnership in dissolution. Therefore, no new properties or other assets can be acquired and the general partner has been obligated to bring about the orderly liquidation of the Partnership and the distribution of its assets to its partners. The general partner has delayed liquidation of the Partnership because of difficulty in disposing of the assets, but it does not believe that the liquidation should be delayed further. The general partner will, therefore, sell the assets for the best price available and distribute the proceeds to the partners. If some assets cannot be disposed of, the general partner will acquire them in order to permit the liquidation and termination of the Partnership by December 31, 1998. [LETTERHEAD OF BAY SHERMAN CRAIG & GOLDSTEIN, LLP] Report of Independent Certified Public Accountants on Schedules --------------------------------------------------------------- The Partners American Housing Partners In connection with our audits of the financial statements of American Housing Partners referred to in our report dated July 14, 1997, which is included in Part II of this Form 10-K, we did not audit the financial statements of certain limited partnerships in which the Partnership has an investment, the statements of which reflect total assets and revenues constituting 100% of the combined totals of the limited partnerships in the years presented. Such statements were audited by other auditors, whose reports thereon have been furnished to us. Insofar as the information presented on Schedules IV, XI, XII and XIII as of December 31, 1993 and 1992 and for the years then ended relates to these limited partnerships, our opinion is based solely upon the reports of other auditors. In our opinion, based on our audits and the reports of other auditors, these schedules present fairly, in all material respects, the information required to be set forth therein. /s/ Bay Sherman Craig & Goldstein, LLP Los Angeles, California July 14, 1997 S-1 AMERICAN HOUSING PARTNERS AMOUNTS DUE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1993 SCHEDULE IV S-2 AMERICAN HOUSING PARTNERS AMOUNTS DUE FROM RELATED PARTIES - CONTINUED YEAR ENDED DECEMBER 31, 1992 SCHEDULE IV S-3 AMERICAN HOUSING PARTNERS AMOUNTS DUE FROM RELATED PARTIES - CONTINUED YEAR ENDED DECEMBER 31, 1991 SCHEDULE IV S-4 AMERICAN HOUSING PARTNERS REAL ESTATE AND ACCUMULATED DEPRECIATION OF LIMITED PARTNERSHIPS IN WHICH THE PARTNERSHIP HAS AN INVESTMENT DECEMBER 31, 1993 SCHEDULE XI See notes to the schedule. S-5 AMERICAN HOUSING PARTNERS NOTES TO THE SCHEDULE SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION OF LIMITED PARTNERSHIPS IN WHICH THE PARTNERSHIP HAS AN INVESTMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. Each limited partnership owns and operates a multi-family, HUD-regulated, residential housing project. During the related construction stage, all costs of developing the projects were included in construction-in-progress. Upon substantial completion, the costs were reclassified to building and improvements. 2. The aggregate cost of land, buildings, equipment and furnishings for federal income tax purposes at December 31, 1993, 1992 and 1991 is $10,442,034, $10,336,557 and $9,903,583, respectively. 3. Investments in property and equipment: Cost: S-6 AMERICAN HOUSING PARTNERS NOTES TO THE SCHEDULE - CONTINUED SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION OF LIMITED PARTNERSHIPS IN WHICH THE PARTNERSHIP HAS AN INVESTMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 3. Investments in property and equipment (Continued): Accumulated depreciation: S-7 AMERICAN HOUSING PARTNERS MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 HUD insured first mortgages, interests in which were assigned to the Partnership upon sale of the real estate by the selling limited partnerships: SCHEDULE XII (1) Partnership's share See notes to the schedule. S-8 AMERICAN HOUSING PARTNERS MORTGAGE LOANS ON REAL ESTATE - CONTINUED DECEMBER 31, 1993 HUD insured first mortgages on properties owned by limited partnerships in which the Partnership has an investment: SCHEDULE XII (1) 100% amounts; Partnership's share is generally 99%. See notes to the schedule. S-9 AMERICAN HOUSING PARTNERS NOTES TO THE SCHEDULE SCHEDULE XII MORTGAGE LOANS ON REAL ESTATE - CONTINUED DECEMBER 31, 1993 1. Each limited partnership in which the Partnership has an investment owns an apartment project financed with a HUD-insured mortgage. Six of these limited partnerships sold their properties for cash and all-inclusive residual notes receivable, while remaining directly liable under the HUD mortgage. These limited partnerships assigned the residual notes receivable and the underlying HUD mortgages to their partners, including the Partnership. 2. The total federal income tax basis is the same as the carrying amounts in the schedule. 3. Carrying amount of the mortgage loans: (1) Partnership's share (2) 100% amounts; Partnership's share is generally 99%. S-10 AMERICAN HOUSING PARTNERS INVESTMENTS IN AND ADVANCES TO LIMITED PARTNERSHIPS YEAR ENDED DECEMBER 31, 1993 The following schedule summarizes the cumulative equity in net income and losses and cash distributions not recorded in the investments in and advances to limited partnerships account, as the carrying values of the investments are at zero: SCHEDULE XIII (1) Cash distribution received from Homestead $(15,756) Repayment of advance to Woodhaven previously written off (46,653) -------- Total Distributions in Excess of Investment $(62,409) ======== S-11

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ITEM 1. BUSINESS THE COMPANY Magma Copper Company ("Magma" or the "Company") is a fully-integrated producer of electrolytic copper and ranks among the largest U.S. copper producers. Magma's principal products are high quality copper cathode and high quality copper rod, the latter of which is the basic feedstock of the copper wire and cable industry. Magma's copper operations also produce gold and silver-bearing residues, molybdenum disulfide and sulfuric acid as by-products. Excluding custom processing, in 1993 Magma produced 563 million pounds of saleable copper in concentrates and electrowon, 4.8 million pounds of molybdenum contained in molybdenum disulfide, and residues containing 2,947,911 ounces of silver and 90,751 ounces of gold including gold and silver in raw materials purchased from others. An additional 12,635 ounces of gold was produced in 1993 at the Company's Robinson Mining District. The Company produces copper cathode both by traditional mining/ concentrating/smelting/refining methods and by leaching/solvent extraction-electrowinning ("SX-EW") methods. The Company owns and operates underground copper mines at its San Manuel and Superior Mining Divisions, open-pit copper mines at its San Manuel and Pinto Valley Mining Divisions and in situ leaching operations at its San Manuel and Pinto Valley Mining Divisions, all in southeastern Arizona. Through its wholly-owned subsidiary Magma Metals Company, Magma operates the largest and most modern copper smelting and refining complex in the United States. The smelter has a rated treatment capacity of 1.25 million tons of copper concentrate per year, which represents approximately 25% of U.S. smelting and refining capacity. In addition to smelting and refining copper concentrate production from its own mines, the Company smelts and refines a substantial amount of copper concentrates on a toll or purchase basis. The profits from processing third party concentrates are deducted from the Company's overall cost of producing copper from its own mines. The Company was originally incorporated in the State of Maine in 1910, and was reincorporated in the State of Delaware in 1969. From 1968 until March 1987, the Company was a wholly-owned subsidiary of Newmont Mining Corporation ("Newmont"), a publicly traded natural resource company. In March 1987, Newmont distributed 80% of Magma's outstanding common stock to Newmont's shareholders, deposited 5% of such stock in a trust for issuance from time to time to Magma employees and retained common and preferred stock interests in the Company. The Company remained under the influence of Newmont until November 1988, when Magma undertook a recapitalization (the "Recapitalization") in which it purchased all of the equity interests held by Newmont. The Company's principal office is in Tucson, Arizona. Its mailing address is 7400 North Oracle Road, Suite 200, Tucson, Arizona 85704 and its telephone number is (602) 575-5600. RECENT DEVELOPMENTS Improved Operating Performance. Since the Recapitalization, Magma has substantially improved its operating performance. Magma has increased copper production from its own sources by approximately 40% from 402 million pounds in 1988 to 563 million pounds in 1993. Production from the leaching, solvent extraction and electrowinning operations increased by 87% from 86 million pounds in 1988 to 161 million pounds in 1993. Total smelting and refining production has increased by approximately 48% from 414 million pounds of copper in 1988 to 615 million pounds in 1993. Net cash operating costs of copper sold have decreased from $.78 per pound ($.93 per pound adjusted for inflation) in 1988 to $.66 per pound in 1992. In 1993, despite the effects of extraordinary rains and flooding early in the year, the Company was able to maintain the $.66 per pound cost level that had been achieved in 1992. Further, as a result of intensified cost reduction efforts, cash operating costs decreased to $.63 per pound in the third quarter and $.61 per pound in the fourth quarter of 1993. Net cash operating costs per pound represent (a) production costs of Magma source copper sold (excluding depreciation, depletion and amortization) reduced by credits for by-products and profits from custom processing divided by (b) total pounds sold from Magma sources. The Company attributes the increase in production and productivity and reduction in operating costs primarily to improved labor relations and the use of innovative operating technology. Debt Refinancing. Prompted by favorable interest rate conditions and an upgrade to its long-term debt ratings, the Company refinanced a substantial portion of its long-term debt in 1991 and 1992. The refinancing of Magma's debt structure provided the Company with less restrictive covenants on its long-term debt and reduced its weighted average interest rate on outstanding debt from 14.1% to 10.7%. In total, the refinancings resulted in a $9.7 million decrease in net interest expense (1992 vs. 1991), partially offset by a $3 million extraordinary loss related to premiums paid on early debt repayment. In May 1993, the Company entered into a five-year $200 million revolving credit agreement (the "Revolver"). The Revolver is provided by a consortium of ten banks and is available for general corporate purposes. Currently, borrowings would bear interest at the rate of London InterBank Offered Rate (LIBOR) plus 1%. There was no amount outstanding under the Revolver at December 31, 1993. Changes in Capital Structure. In the fourth quarter of 1992, the Company undertook measures to simplify and improve its common equity base. On October 30, 1992, Magma stockholders approved an amendment to the Company's Certificate of Incorporation to reclassify and convert all shares of its Class A and Class B Common Stock into a new single class of common stock. In December 1992, Magma made an offer to its preferred stockholders to exchange their Series B Cumulative Convertible Exchangeable Preferred Stock ("Series B Preferred Stock") for Common Stock. All shares of Series B Preferred Stock were exchanged by December 31, 1992. During 1993, the Company issued two new series of preferred stock to enhance its capital base and liquidity. In July 1993, the Company issued $100 million, or 2.0 million shares, of 5 5/8 percent Cumulative Convertible Preferred Stock, Series D, with a liquidation preference of $50.00 per share and a conversion rate of 3.448 (equivalent to a conversion price of $14.50 per share). Additionally, in November 1993, the Company issued $100 million, or 2.0 million shares, of 6 percent Cumulative Convertible Preferred Stock, Series E, with a liquidation preference of $50.00 per share and a conversion rate of 3.5945 (equivalent to a conversion price of $13.91 per share). Dividends are paid quarterly on each series of preferred stock. The Company intends to use the net proceeds from the sale of these securities for general corporate purposes, which may include the development of projects. Improved Financial Position and Increased Liquidity. The debt refinancing and preferred stock issuances have improved the Company's financial position and increased its liquidity. The Company's debt, net of cash and marketable securities, has decreased by $325 million from $390 million at December 31, 1988 to $65 million at December 31, 1993. Magma's debt to capitalization ratios have decreased from 57% in 1988 to 37% in 1993. The Company's operating cash flow (earnings before net interest, taxes, depreciation, depletion and amortization or "EBITDA") improved from $91 million in 1988 to $125 million in 1993, despite the fact that Magma's average realized price per pound of copper sold, declined from $1.07 in 1988 to $.94 in 1993. Magma's average price realized was higher than the average London Metals Exchange (LME) price for 1993 of $.86 per pound because of a copper price protection program which included the purchase of put options that protected cash flow and earnings at prices below $.95 per pound. Although Magma is optimistic about copper prices, Magma has extended this program to provide a copper price floor of $.75 per pound for 1994 production and $.74 per pound for the first three quarters of 1995. This program, together with a cost reduction program, were implemented to help assure cashflow to fund Magma's strategic growth opportunities. Strategic Growth Opportunities. The Company is currently pursuing or evaluating several mine development opportunities and the upgrade and expansion of its smelter. In March 1993, the Company approved the development of its Lower Kalamazoo orebody. Based upon the current mine plan, this orebody is scheduled to produce 2.13 billion pounds of copper during the period from 1996 to 2009. The Company has completed a feasibility analysis for mining at its Robinson property near Ely, Nevada, and is pursuing various approvals and permits necessary to develop and operate a copper/gold mine at this property. The Company has also commissioned a pre-feasibility study of its Florence property to assess its development potential. In February 1993, the Company approved a capital project to expand the San Manuel smelting and refining facility and further improve its environmental performance. COPPER PRICE INFORMATION Copper is an internationally traded commodity. The copper prices established on the two major metals exchanges - The Commodity Exchange, Inc. ("Comex") in New York and the London Metal Exchange ("LME") - - broadly reflect the worldwide balance of copper supply and demand. The profitability of the Company's operations is largely dependent upon the worldwide market price for copper. A $0.01 per pound change in the average price realized for the Company's 1993 output would have affected pre-tax income by an estimated $5.6 million. Copper prices have historically been subject to wide fluctuations and are affected by numerous factors beyond the control of the Company, including international economic and political conditions, levels of supply and demand, the availability and cost of copper substitutes, inventory levels maintained by copper producers and others and, to a lesser degree, inventory carrying costs (primarily interest charges) and international exchange rates. The following table of pertinent copper industry data contains Comex high, low and average copper prices per pound and illustrates the historic volatility of copper prices. Price data are given for the Comex standard-grade copper contract for the years 1984-1989. Thereafter, prices are given for contracts for delivery of high-grade copper cathode, which replaced the standard-grade contract effective January 1, 1990. The Company's average realized price per pound of copper was $.94 in 1993, $1.00 in 1992 and $1.01 in 1991. From time to time the Company enters into options and futures contracts or fixed price forward sales agreements as part of its copper price protection program. During the second, third and fourth quarters of 1993, the Company benefited from put option contracts that provided price protection at LME prices below $0.95 per pound. During these quarters, option contracts totalling 384 million pounds were exercised, resulting in a realized price above the market prices reflected in the table above. In addition, the Company's 1993 realized price was impacted by fixed price forward sales of 42 million pounds at an average price of $0.91 per pound. During 1992 and 1991 the Company had fixed price sales of 179 million pounds at $0.93 per pound and 183 million pounds at $0.98 per pound, respectively. The Company's realized price per pound includes a premium of several cents over the market price for copper cathode to reflect net delivery and financing costs. The Company's price for copper rod commands a premium over its price for copper cathode to reflect the value added by additional processing. COMPETITION The Company does not believe that it or any other copper producer can individually exercise a material influence on the markets in which the Company operates. The price of copper depends almost entirely upon industrial consumption and other market conditions beyond the Company's control. Many foreign and domestic copper producers benefit from higher-grade orebodies than those owned by the Company. Further, most foreign producers benefit from lower labor rates and less stringent environmental regulation than those of United States producers. Because of their need for foreign exchange and the political impact layoffs might have, some foreign producers maintain maximum production without regard to the condition of the world copper market or the profitability of their mining operations. The Company's custom smelting and refining operations compete with other smelting and refining operations, primarily Japanese based companies, for the treatment of copper concentrates. At present, the Japanese government imposes a tariff on refined copper that protects smelting margins by increasing the price of finished cathode to domestic consumers. Additionally, the economic benefit accruing to Japanese operators from the tariff allows them a protected base from which they can aggressively export to nearby Asian countries. The Company and other copper producers also compete with manufacturers of other materials, including aluminum, stainless steel, plastics and fiber optic cables. Should copper prices increase sharply, substitution of these alternative materials for copper may occur. PRODUCTS AND SALES Products. Magma's principal products are high quality copper cathode and high quality copper rod, the latter of which is the basic feedstock of the copper wire and cable industry. Approximately 58% of the copper sold by the Company in 1993 (447.1 million pounds) was sold as copper cathode, 36% (276.3 million pounds) was sold in the form of continuous cast rod, and the remaining 6% (41.0 million pounds) was sold in other forms. Copper revenue in 1993 decreased by 3% to $710.5 million, compared to $736.2 million for 1992, due to a $.06 decrease in Magma's average realized price per pound, which was partially offset by higher sales volume. In addition to smelting and refining copper concentrate production from its own mines, the Company processes a substantial amount of copper concentrates on a toll or purchase basis. The profits from processing third party concentrates are deducted from the Company's overall cost of producing copper from its own mines. The total quantities of copper produced by the Company, copper smelted and refined on a custom basis and copper sold by the Company from its own mines during each year in the five-year period ended December 31, 1993 were as follows (in millions of pounds): Magma's copper operations also produce gold and silver-bearing residues and molybdenum disulfide as by-products. Revenue from gold sales in 1993, including gold contained in raw materials purchased from others, was $32.4 million on sales of 90,751 ounces. Revenue from silver sales in 1993, including silver in raw materials purchased from others, was $12.7 million on sales of 2,947,911 ounces. An additional $4.5 million of revenue represented sales of 12,635 ounces of gold in dore produced in 1993 at the Company's Robinson Mining District. Revenue from sales of molybdenum disulfide in 1993 was $9.2 million on sales of 4.8 million pounds molybdenum contained. The Company uses sulfuric acid produced in the smelting process in its copper leaching operations and sells any excess acid to third parties. Sales. The Company's sales strategy includes (i) expanding sales to North American consumers, while preserving a core of long-term customer relationships in Asia, (ii) custom smelting and refining of third party concentrate to supplement feedstock to its smelter from Magma's own mines, and (iii) an optimal mix of copper rod and copper cathode sales. The Company's export sales have declined in recent years primarily due to increasing U.S. consumption and the recession in Japan. The Company is maintaining its presence in the Asian markets by supplying cathode to major fabricators on an annual basis. The Company's export sales as a percent of total revenues were 25%, 29% and 50% for the years ended December 31, 1993, 1992 and 1991, respectively. Customers. During 1993, the Company's copper was sold to approximately sixty customers. Sales of copper to the Company's largest customer during the year accounted for 19% of total revenues. Because copper is an internationally traded commodity, the Company does not believe that the loss of any one customer would have a material adverse effect on the results of its operations. OPERATIONS Overview. Currently, all of the Company's copper mining, smelting and refining operations are in southeastern Arizona. Its mining operations are conducted through its San Manuel, Pinto Valley, and Superior Mining Divisions. Magma Metals Company, a wholly-owned subsidiary, operates the smelting and refining complex and rod plant and conducts the Company's sales and marketing activities. The Company has two subsidiaries which conduct railroad operations in support of its copper mining operations. The Company also operates a gold mine at its Robinson Mining District near Ely, Nevada and operated a small gold mine near Humboldt, Arizona. A detailed description of the Company's mining properties is included in Item 2 ITEM 2. PROPERTIES Overview. The Company owns or has interests in approximately 32,500 acres of land in southeastern Arizona, where it currently conducts all of its copper operations. It also owns 12,500 acres of land at its Robinson Mining District near Ely, Nevada, where it conducts a gold leaching operation and is developing a major copper project. The Company's mineral interests are held in fee or are derived from patented and unpatented mining claims and mineral leases. The Company also owns water rights, rights-of-way and interest in other leases. The Company's ore reserves are determined by its engineering staff utilizing standard techniques and standard modeling software, typically with the assistance of independent mining consultants. The Company's ore reserves may not conform to geological, geomechanical, metallurgical or other expectations with the result that the volume and grade of reserves recovered and rates of production may be more or less than anticipated. Further, market price fluctuations in copper, changes in operating and capital costs, further orebody definition, drilling and testing, and other factors affect ore reserves. In addition, the Company is subject to the normal risks encountered in the mining industry, such as unusual or unexpected geological formations, cave-ins, flooding, fires and environmental issues. The Company's mining operations are conducted by several divisions described below and in Item 1 - Business. SAN MANUEL MINING DIVISION The San Manuel Mining Division, near San Manuel, Arizona, 45 miles northeast of Tucson, Arizona, is accessed by State Hwy. 79 to State Hwy. 77 to Redington Road which terminates at the minesite to the north and reaches the concentrator and plantsite to the south. Sulfide ore is mined from the San Manuel orebody through underground block caving while oxide ore is mined through open-pit mining/heap leaching and in situ leaching. Cathode copper is produced from leach solutions at the SX-EW plant using a solvent extraction-electrowinning process. The Division utilizes a concentrator to produce concentrate from sulfide ore which is further processed at the Company's smelting and refining complex. Investment in the Division's property, including plant and equipment totaled $187 million as of December 31, 1993. Electricity is provided by the Arizona Public Service Company. The San Manuel Mining Division ore reserves are contained on land held by the Company under patented mining claims and mineral leases from the State of Arizona. Approximately 2% of the sulfide ore deposit lies on land leased from the State and subject to production royalties. Mineral leases will expire in the years 2003 through 2007, but the Company has a preferential right to renew these leases for a term of twenty (20) years. Currently there is no active production from state-leased land. Mining on leased land is scheduled to resume in 1997. The Company owns or controls through lease agreements, easements, and rights-of-way, surface use of surrounding land in support of the mining operations. Extraction of sulfide ore from the San Manuel underground mine began in 1956, and the mine now ranks as one of the world's largest underground copper mines in terms of production. The San Manuel mine and concentrator, and the Company, were wholly-owned by Newmont Mining Corporation from 1968 until March 1987. The San Manuel and Kalamazoo orebodies are two faulted segments of what was once a single, cylindrical-shaped shell of disseminated copper mineralization about 7,700 feet long and 2,500 to 5,000 feet in diameter. The shell itself varies in thickness from 100 to 1,000 feet and wraps around a central unmineralized core. Ore reserves in the San Manuel orebody consist of both copper sulfide and oxide ores with oxide ores confined to the upper reaches of the orebody. The sulfide ore consists essentially of disseminated chalcopyrite in quartz monzonite and monzonite porphyry. Some chalcocite enrichment is present in minor amounts. Much of the upper part of the orebody has been oxidized in varying degrees, mainly to chrysocolla. Ore reserves are estimated using standard techniques and standard modeling software by division geology and engineering staff. The Lower Kalamazoo deposit is discussed in Item 7 under Development Opportunities. PINTO VALLEY MINING DIVISION The Pinto Valley Mining Division had its beginning in the early 1900's. The division started as Miami Copper Company in 1909. In 1960, the Tennessee Corporation took over Miami Copper Company and, in 1963, Cities Service Company acquired the Tennessee Corporation. In late 1982, Occidental acquired Cities Service Company. By early 1983, Occidental concluded a sale of the Miami operations to Newmont Mining Corporation which contributed those assets to its new, wholly-owned subsidiary, Pinto Valley Copper Corporation. In late 1986, Newmont merged Pinto Valley Copper Corporation into Magma Copper Company and Pinto Valley Copper Corporation became the Pinto Valley Mining Division of Magma Copper Company. Investment in the Division's property, including plant and equipment, totaled $77 million as of December 31, 1993. Electricity is provided by Salt River Project. Mining is conducted through two units: the Pinto Valley Unit and the Miami Unit. The Pinto Valley Unit mines copper sulfide ore from its open-pit mine for both concentrating/smelting/refining and leaching/SX-EW production methods, while the Miami Unit conducts in situ leaching of the area of rubble above the closed underground mine and leaching of concentrator tailings. Pinto Valley Unit The Pinto Valley mine is about six miles west of the town of Miami in Gila County, Arizona. Substantially all the operations take place on land owned by Magma. The land consists of patented mining claims, unpatented mining claims and fee lands. The Pinto Valley deposit is an orebody containing chalcopyrite, pyrite and minor molybdenite as the only significant primary sulfide minerals. These minerals occur in vein sand microfractures, and less abundantly as disseminated grains. As presently defined, the deposit is bounded by post mineralization faults. On the south is the South Hill fault, on the east is the Jewel Hill fault, and on the west is the Gold Gulch fault. Ore reserves are estimated using standard techniques and standard modeling software. Mining and Concentrating of Copper Sulfide Ore. Sulfide ore from the open-pit mine is processed at the Pinto Valley Unit's concentrator, which produces copper concentrate containing approximately 28% copper and a molybdenum disulfide by-product. The concentration process used is similar to that used in the San Manuel Mining Division's concentrator. The copper concentrate produced in the concentrator is trucked to San Manuel for smelting and refining. Dump Leaching of Copper Sulfide Ore. Low-grade copper-bearing waste material which has been stripped from the open-pit mine and is classified as leachable is transported to large sulfide ore dumps. The dumps are sprayed with water and sulfuric acid which dissolve contained copper and produce a pregnant leach solution. The pregnant leach solution is fed into the SX-EW plant located near the dumps. The SX-EW plant has the capacity to produce approximately 18 million pounds of copper cathode per year. The copper cathode is cast into rod at the Company's rod casting facility in San Manuel. Essentially all of the sulfuric acid used in the Pinto Valley Unit's dump leaching operation is produced by the Company. Miami Unit The Miami Unit is immediately north of the town of Miami. All operations take place on Magma-owned land. It produces copper by leaching material remaining from historic underground mining of a large, disseminated copper orebody in which original copper minerals have naturally been dissolved and reprecipitated in readily soluble form by a long history of weathering. In Situ Leaching. The Miami Unit's underground mine ceased operation in 1959 upon the depletion of all the copper ore that could be economically mined using block caving methods. However, the area of rubble created by the block caving has been used for in situ leaching of mixed oxide/sulfide ore since 1963. The geographic area of the leaching operations was expanded in 1986 and the sulfuric acid content of the leach solution was increased. The copper bearing leach solution is processed in the SX-EW plant near the underground mine. The plant has the capacity to produce 28 million pounds of copper cathode per year. Miami No. 2 Tailings Project. Mill tailings associated with the old Miami underground mine are reclaimed using hydraulic mining methods to produce a slurry of tailings and water. Sulfuric acid is added to the slurry to dissolve the copper contained therein and the resulting pregnant leach solution is processed through the Miami Unit's SX-EW plant. The remaining tailings are transported for disposal through an overland pipeline to an abandoned pit. Production from the project is expected to continue through 2001. SUPERIOR MINING DIVISION The Superior Mining Division is an underground operation near Superior, Arizona, approximately 65 miles east of Phoenix. Access to the mine is through the No. 9 Shaft located four miles east of Superior via U.S. Highway 60 and the No. 9 Shaft Mine Road. Milling operations are conducted at the concentrator, north of Superior. Ore is hoisted from mine working levels to the 500 foot level and then carried by underground railroad to the concentrator at Superior. The Superior Mining Division owns patented mining claims, unpatented mining claims, and fee lands in the Superior area. Mine production is currently from orebodies on patented mining claims. Exploration activities are being conducted on patented and unpatented mining claims and under state prospecting permits held by the Division. The Magma Mine at Superior was in continuous operation by Magma or its former parent from 1912 to 1982, when it was closed due to low productivity and depressed copper prices. The current operation was reopened in late 1990. The mine currently produces copper sulfide ore from underground using the undercut and fill mining method at a rate of 1,650 tons per day. The No. 9 shaft facilities, originally commissioned in 1972, were dewatered and rehabilitated when the mine was reactivated in 1990. Since reactivation a ramp system has been installed and utilizes mechanized mining equipment. The flotation concentrator was erected in 1928. Additions and modifications were made during the expansions of 1940 and 1970. When reactivated in 1990, all pumping and piping was downsized in accordance with the new mine plan. The crusher, ball mills, filter plant, and certain ancillary equipment have been rehabilitated since startup. Investment in the underground development, surface facilities, and concentrator complex totaled $33 million as of December 31, 1993. Commercial electric power is supplied to the operation by Salt River Project. The Superior Division is currently conducting diamond drilling exploration in areas in the vicinity of the No. 9 shaft. Exploration activities are directed toward host formations similar to ore bearing areas of the current and past operations. Ore in the Magma Mine is composed of high grade sulfide minerals, chalcopyrite and bornite, associated with the gangue minerals hematite, quartz and calcite. Copper is the primary metal in the ore with silver and gold occurring as by-products. Orebodies occur as massive replacement of limestone by hematite, chalcopyrite and bornite and as vein type orebodies, which have been significant producers in the district in the past. One vein orebody is under development for production in 1994 and additional vein targets are included in the exploration program. Current ore reserves occur in orebodies in several favorable horizons within the limestone sequence and in vein structures. Ore reserves are estimated using standard techniques and standard modeling software. ROBINSON MINING DISTRICT The Robinson Mining District, formerly the Kennecott Nevada Mines Division, was acquired by Magma from the Kennecott Corporation and Alta Gold through a series of transactions in 1990 and 1991. Investment in this project totaled $74 million at December 31, 1993. The Robinson Mining District consists of 12,500 acres and is 8 miles west of Ely, Nevada along State Highway 50. The patented mining claims and other real property comprising this project are owned by the Robinson Mining Limited Partnership, of which Magma's wholly-owned subsidiaries, Magma Nevada Mining Company, is the general partner and Magma Limited Partner Company is the limited partner. In August of 1992, Magma discontinued gold mining operations other than gold leaching operations at existing dumps. Electricity is presently provided by Mt. Wheeler Power Company and a new 10 year contract has been negotiated for future operations. In December 1993, Magma completed the detailed engineering phase for the development of a copper/gold mine at this property and is continuing to review construction scheduling, while awaiting environmental permits. In this regard, in June 1993, the Bureau of Land Management reversed an earlier decision approving an Environmental Assessment prepared by Magma, and has required the preparation of an Environmental Impact Statement (an "EIS") as a precursor to final permitting of the Robinson project. The Company anticipates that the EIS will be completed and that permitting could be achieved as early as September 1994. If these events occur as targeted, of which there can be no assurance, copper and gold production could be achieved by the first quarter of 1996. Based on present estimates, development of the Robinson property could require capital expenditures of approximately $300 million for a traditional sulfide processing facility. The property is expected to produce an average of 247,000 tons of concentrate per year containing 135 million pounds of copper, 97,300 ounces of gold and 390,000 ounces of silver from sulfide copper ore over a sixteen year mine life. In addition to the copper sulfide operations, it is projected that an average of 17,500 ounces of gold will be produced annually over the life of mine as dore. Additional Robinson Mining District test work is discussed in Item 7 under Development Opportunities. Ore reserves are estimated using standard techniques and standard modeling software by division geology and engineering staff. These reserves are in a cretaceous porphyry copper system emplaced into paleozoic limestone and sandstone formations. Post-mineralization faulting shaped the porphyry deposit. The various ore bodies, Liberty, Veteran-Tripp, Ruth, Kimbley, and Wedge, represent the fault slices of the porphyry system. FLORENCE PROJECT The Florence project consists of 10,000 private and state-leased acres west of State Highway 79, north of Florence, Arizona. The Company acquired this project in July 1992. The state mineral lease expired at the end of 1993, and the Company has exercised its right to renew for an additional twenty (20) year term. The deposit was subject to extensive exploratory and metallurgical work by the previous owner in the mid-1970's. The acquisition of this property is part of Magma's long-term strategy to increase copper production through the application of its SX-EW leaching technology. Magma has begun a pre-feasibility study to assess possibilities for further development. Investment in the property was $9 million at December 31, 1993. MINERALIZED ROCK Magma also owns various other properties containing mineralized rock that it believes could be brought into production should market conditions warrant. Capital commitments, a favorable copper price, and in some instances planning or technical innovations would be required before operations could commence at these properties. These deposits are estimated to contain the following mineralizations as of January 1, 1994. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in legal proceedings of a character normally incidental to its business, including claims and pending actions against the Company seeking damages in large amounts or clarifications of legal rights. Although there can be no assurance in this regard, the Company does not believe that adverse decisions in any pending or threatened proceedings, or any amounts which it may be required to pay by reason thereof, would have a material adverse effect on the financial condition or results of operations of the Company. The Company is involved in legal proceedings pending in the Superior Court of Maricopa County, Arizona to adjudicate water rights of the Gila River system and source (the "Adjudication"). The Company's right to use groundwater at its facilities is potentially at issue in this case. These proceedings commenced in the 1970's and to date, over 62,000 claims have been filed. Among the claimants to the largest amounts of surface water are the United States, on behalf of itself and various Indian tribes, the State of Arizona, various municipal water providers, agricultural irrigation districts, and the Company. The Gila River Indian Community has asserted claims against the Company for damages attributable to groundwater withdrawals at San Manuel, but these claims have been stayed pending the outcome of the adjudication. The Company has filed a claim challenging the Court's jurisdiction to adjudicate the Company's groundwater rights or alternatively seeking to confirm its groundwater rights. Previous rulings by the Maricopa County Superior Court that included some categories of groundwater within the scope of this proceeding were the subject of an interlocutory appeal to the Arizona Supreme Court. In its opinion dated July 27, 1993, the Arizona Supreme Court partially reversed the Superior Court's rulings. As a consequence, the Superior Court ordered that a hearing be held to re-evaluate whether groundwater should be included in this proceeding, and if so, what criteria should apply to this inclusion. The hearing will be concluded after a field trip to the River, scheduled for March 3, 1994. The judge's decision is expected within ninety days thereafter. As part of the conditions of the purchase of the Florence property from Conoco Oil Company, the Company was required to intervene in litigation instituted in October 1925 by the Gila River Indian Community, and captioned United States v. Gila Valley Irrigation District, et al., filed in the Tucson Division of the United States District Court for the District of Arizona, (a/k/a "Globe Equity No. 59"). In that action, the Gila River Indian Community seeks to alter the administration of water rights above the Ashurst-Hayden Diversion Dam, near Florence, on the Gila River. Several phases of this action involving water rights near Safford, Arizona have been tried and are currently on appeal to the Unites States Court of Appeals for the Ninth Circuit. Other issues, which may affect Magma's use of water on the Florence property, have yet to be scheduled for trial. The Company is currently involved in investigations by the Arizona State Mine Inspector's office and the Federal Mine Safety and Health Administration involving an accident occurring August 10, 1993, at the Company's Superior Mining Division, in which four miners were fatally injured ("the Accident"). The Accident occurred when several tons of ore spilled into the manway compartment of the transfer raise in which the four victims were working. The Company does not believe, at this time, that the findings of these investigations will result in any material adverse effects on the financial condition or results of operations of the Company, but does believe that citations and monetary fines will probably be issued. See Item 1: Business - Environmental Regulations for information relating to certain other proceedings pertaining to the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No issues were submitted for a vote of stockholders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Stock (trading symbol MCU) commenced trading on the New York Stock Exchange ("NYSE") on February 10, 1992. Prior to that time, the Company's Common Stock had traded on the American Stock Exchange ("AMEX"). The following table sets forth the high and low last sale prices of the Common Stock, as reported by the NYSE and the AMEX. On March 1, 1994, the closing sale price for the Company's Common Stock, as reported by the NYSE, was $14 5/8 per share. On March 1, 1994, there were approximately 5,209 stockholders of record of the Common Stock. This figure does not reflect beneficial ownership of shares held in nominee names. At a Special Meeting of Stockholders on October 30, 1992, the stockholders of the Company approved an amendment to the Restated Certificate of Incorporation of the Company that reclassified and converted each outstanding share of Class A Common Stock and Class B Common Stock into one share of a single, new class of Common Stock. The new class of common stock created by the amendment possesses one vote on all matters properly coming before the stockholders, including elections of the Board of Directors, is not subject to any transfer restrictions, and possesses no veto power over the issuance of any other class of stock. In December 1992, the Company offered to exchange 15.446825 shares of its Common Stock for each share of its Series B Preferred Stock. On December 29, 1992, each share of Series B Preferred Stock was exchanged, resulting in an issuance of 14,133,047 shares of Common Stock. Prior to the Exchange, each share of Series B Preferred Stock was convertible into 14.285714 shares of Common Stock. The Company has not declared or paid cash dividends on its Common Stock since the 1988 Recapitalization. The Company's dividend policy is reviewed from time to time by its Board of Directors. Future dividend decisions will take into account then current business results, cash requirements and the financial condition of the Company. The indentures which govern the Company's 12% and 11 1/2% Notes limit the amount the Company can pay as dividends, or use to make distributions on or repurchase its capital stock. Further, covenants in the Company's revolving credit facility require that the Company and its subsidiaries maintain a minimum consolidated net worth and establish a maximum ratio of debt to capitalization that may indirectly limit the Company's ability to pay dividends. Seven-year warrants (the "Common Stock Warrants") covering 4,112,765 shares of Common Stock were distributed by the Company on December 29, 1988 as dividends to Common Stockholders of record on December 12, 1988. Each Common Stock Warrant entitles the holder thereof to purchase one share of Common Stock at an exercise price of $8.50 per share. The Common Stock Warrants have traded on the NYSE since February 10, 1992. Prior to that time, they were traded on the AMEX. During 1993 and 1992, the sales price for the Common Stock Warrants ranged from $1 5/8 to $11 5/8. On March 1, 1994, the closing sale price of the Common Stock Warrants was $7 1/4. Additionally, seven year warrants to purchase 1,000,000 shares of Common Stock, exercisable at $8.50 per share, were issued with the Series B Preferred Stock on November 30, 1988. These warrants are not listed or traded on an exchange. All warrants are exercisable through November 30, 1995. In July 1993, the Company issued $100 million, or 2.0 million shares, of 5 5/8 percent Cumulative Convertible Preferred Stock, Series D, with a liquidation preference of $50.00 per share and a conversion rate of 3.448 (equivalent to a conversion price of $14.50 per share). Additionally, in November 1993, the Company issued $100 million, or 2.0 million shares, of 6 percent Cumulative Convertible Preferred Stock, Series E, with a liquidation preference of $50.00 per share and a conversion rate of 3.5945 (equivalent to a conversion price of $13.91 per share). Dividends are paid quarterly on both series of preferred stock issued in 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollar amounts in millions, except per share amounts) The following selected financial data for each of the five years in the period ended December 31, 1993 are derived from the Consolidated Financial Statements audited by Arthur Andersen & Co., independent public accountants. The report of Arthur Andersen & Co. with respect to the financial position of the Company and its subsidiaries as of December 31, 1993 and 1992, and the results of the Company's operations and cash flows for each of the years ended December 31, 1993, 1992 and 1991, appear elsewhere in this document. The selected financial data should be read in conjunction with the Management's Discussion and Analysis of Financial Condition and Results of Operations at Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Over the past six years, Magma has substantially improved its operating performance. Magma has increased copper production from its own sources by approximately 40% from 402 million pounds in 1988 to 563 million pounds in 1993. Production from the leaching, solvent extraction and electrowinning operations increased by 87% from 86 million pounds in 1988 to 161 million pounds in 1993. Total smelting and refining production has increased by approximately 48% from 414 million pounds of copper in 1988 to 615 million pounds in 1993. Net cash operating costs of copper sold have decreased from $.78 per pound ($.93 per pound adjusted for inflation) in 1988 to $.66 per pound in 1992. In 1993, despite the effects of extraordinary rains and flooding early in the year, the Company was able to maintain the $.66 per pound cost level that had been achieved in 1992. Further, as a result of intensified cost reduction efforts, cash operating costs decreased to $.63 per pound in the third quarter and $.61 per pound in the fourth quarter of 1993. Net cash operating costs per pound represent (a) production costs of Magma source copper sold (excluding depreciation, depletion and amortization) reduced by credits for by-products and profits from custom processing divided by (b) total pounds sold from Magma sources. The Company attributes the increase in production and productivity and reduction in operating costs primarily to improved labor relations and the use of innovative operating technology. During 1993, the Company's operations were adversely affected by extraordinary rainfall conditions, lower copper prices (which were partially offset by hedging activities) and other factors. As a result, total sales and net income were $792.4 million and $21.9 million, respectively, for the year ended December 31, 1993, compared to $819.5 million and $55.3 million, respectively, for the year ended December 31, 1992. In addition, production of Magma source copper was down slightly from 1992 to 1993. The Company estimates that the extraordinary rainfalls reduced net income by approximately $15.5 million during the first six months of 1993. Although the Company is still in the process of repairing, upgrading and expanding certain of its facilities that were damaged by the rainfalls, operations that were affected by the rainfalls returned to normal in the second half of 1993. See "Environmental Matters" below. The Company issued two series of preferred stock in 1993, which yielded net proceeds of $193 million. The proceeds will be used for general corporate purposes, which may include the development of projects. In this regard, the Company is pursuing or reviewing a number of capital projects in a continuing effort to lower unit production costs and increase ore reserves. Improvements to its smelting and refining complex are well underway, as is the development of its Lower Kalamazoo orebody and permitting of the Robinson property near Ely, Nevada. These and other projects are described more fully below in "Capital Resources and Liquidity". The Company continues to place great emphasis on the program to reduce cash cost of production. In the last year, Magma has reduced its workforce by approximately 4% through attrition, voluntary retirements and other appropriate measures. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Total Sales and Earnings. Total 1993 sales were $792.4 million, a 3% decrease from 1992 sales of $819.5 million. The decrease in sales was a result of lower copper prices which were partly offset by increased volume. Total sales for 1992 were 13% above 1991 sales of $724.8 million due to increased volume. Net income, before restructuring expenses, an accounting change and the effects of first quarter rains and flooding, was $39.8 million, or $.76 per share, for 1993, compared to $58.3 million, or $1.25 per share, for 1992. Earnings for 1993 were lower due primarily to a decline in the average copper price realized by Magma from $1.00 per pound in 1992 to $.94 per pound in 1993. The rains reduced after-tax earnings for the first six months of 1993 by $15.5 million, or $.30 per share. After restructuring expenses, an accounting change and the effects of first quarter rains and flooding, Magma reported net income for 1993 of $21.9 million, or $.40 per share. Magma's first quarter 1993 results were restated to recognize a $0.9 million after-tax charge for the adoption of Statement of Financial Accounting Standards No. 112, "Accounting for Postemployment Benefits" (SFAS 112). Comparing 1992 to 1991, increased sales volume and lower unit costs contributed to the increase in earnings. 1991 net income, before giving effect to the Non-Cash Accounting Adjustments described below was $34.4 million ($.80 per share). After giving effect to these adjustments, the 1991 loss was $120.5 million ($4.22 per share). After deducting dividends on the 5 5/8% Series D Preferred Stock and 6% Series E Preferred Stock issued in July and November 1993, respectively, 1993 primary earnings available to stockholders were $19.4 million ($.40 per share), compared to $42.7 million ($1.28 per share) in 1992 and a loss of $128.3 million ($4.22 per share) in 1991. 1991 Non-Cash Accounting Adjustments. In 1991, the Company recorded a series of accounting adjustments (the "Non-Cash Accounting Adjustments") which had no effect on its cash flow. The Non-Cash Accounting Adjustments resulted from studies, completed during 1991, of various balance sheet items that were undertaken in connection with a reorganization of the Company into distinct profit centers. In addition, execution of a new collective bargaining agreement and achievement of productivity increases at the upper Kalamazoo orebody enabled the Company to further study the feasibility of developing and mining the lower portion of this orebody. Based upon these studies, and in conjunction with its internal reorganization, the Company implemented, as of December 31, 1991, the following Non-Cash Accounting Adjustments: (1) Adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." (2) An after tax restructuring charge of approximately $141 million, which included a $92 million after tax write-down of the Company's investment in its Kalamazoo orebody, as well as other amounts related to detailed reviews of the Company's balance sheet. (3) Implementation of a "quasi-reorganization," in which certain assets and liabilities were restated and the accumulated deficit resulting from the adjustments described above was reclassified to capital in excess of par value. After giving effect to the Non-Cash Accounting Adjustments in 1991, the Company's stockholders' equity at December 31, 1990 was restated to $447.2 million, compared to $534.2 million, as was originally reported. Copper Prices and Sales. Copper prices have historically been subject to wide fluctuations and are dependent to a significant extent on factors outside the control of the Company. The Company's average realized price per pound of copper was $.94 in 1993, $1.00 in 1992 and $1.01 in 1991. During the second, third and fourth quarters of 1993, the Company benefited from put option contracts that provided price protection at LME prices below $.95 cents per pound. During these quarters, option contracts totalling 384 million pounds were exercised, resulting in a realized price above the market price. In addition, the Company's 1993 realized price was impacted by fixed price forward sales of 42 million pounds at an average of $.91 per pound. During 1992 and 1991, the Company had fixed price sales of 179 million pounds at $.93 per pound and 183 million pounds at $.98 per pound, respectively. The Company's realized price per pound also includes a premium of several cents over the market price for copper cathode to reflect net delivery and financing costs. The Company's price for copper rod commands a premium over its price for copper cathode to reflect the value added by additional processing. Copper revenue in 1993 decreased by 3% to $710.5 million, compared to $736.2 million for 1992 and $652.3 million for 1991. During 1993, lower revenue resulted from a $.06 decrease in Magma's average realized price partially offset by higher sales volume. In 1992, higher sales volume was primarily responsible for the sharp increase in revenue from 1991. The Company sold 764.4 million pounds of copper in 1993, a 5% increase from 725.4 million pounds sold in 1992, which was a 14% increase from the 638.1 million pounds sold in 1991. Sales of copper from Magma sources was negatively impacted in 1993 as the result of Arizona's abnormally high rainfall earlier in the year. The following table sets forth the volume of copper sold in relation to its sources: Pounds of Copper Sold By Source (in millions) The Company's wholly-owned subsidiary, Magma Metals Company sells the Company's products, operates its smelting, refining and rod plant complex, and purchases raw materials. The Company's export sales have declined in recent years primarily due to increasing U.S. consumption and the recession in Japan. The Company is maintaining its presence in the Asian markets by supplying cathode to major fabricators on an annual basis. The Company's export sales as a percent of total revenues were 25%, 29% and 50% for the years ended December 31, 1993, 1992 and 1991, respectively. Other Metal Sales and Treatment Tolls Earned. Sales of other metals and metal by-products, sulfuric acid and treatment tolls earned in 1993 were $81.9 million, as compared to $83.3 million in 1992 and $72.5 million in 1991. The decrease for 1993 was primarily attributable to lower gold sales from the Company's Robinson Mining District and the closure of its McCabe mining division, together with a weak market for acid sales. These decreases were largely offset by higher purchased by-products that were contained in custom concentrates processed by Magma and an increase in volume of toll material processed. The increase for 1992 was primarily attributable to higher gold sales from the Robinson Mining District and from purchased by-products that were contained in custom concentrates processed by Magma. Cost of Sales. Cost of products sold during 1993 of $639.4 million was up 1% from $630.4 million in 1992. Lower unit cost of Magma source copper contributed to lower cost of products sold by $21 million in addition to lower volume sold of $6 million. Higher sales volume of copper purchased or tolled from third parties increased cost of sales by $28 million. Storm damage production costs resulting from Arizona's abnormally high rainfall earlier in 1993 caused a $14 million increase (cost of sales impact only). Additionally, cost of sales of other metals decreased by $6 million. Cost of products sold during 1992 of $630.4 million was up 8% from $585.7 million in 1991. This increase was due primarily to an increase in sales volume of Magma source copper of 43 million pounds ($35 million) and copper purchased from third parties of 44 million pounds ($49 million). These volume increases were offset by a $.05 per pound decrease in unit costs that reduced costs of sales by $26 million. Lower cost associated with purchased copper reduced cost of sales by $13 million. Other. Depreciation, depletion and amortization expense totaled $65.4 million in 1993 compared to $54.6 million in 1992. The increase was largely due to the initiation of depreciation related to new capital improvements. The $11.0 million increase in 1992 from 1991 was attributable to higher depreciation expense related to increased sales volume, the initiation of depreciation related to new capital improvements and the Non-Cash Accounting Adjustments made in connection with the Company's reorganization at the end of 1991. The increase in selling, general and administrative expense for 1993 is largely due to higher insurance costs along with consulting and professional services. The increase for 1992 was a result of higher legal and consulting fees primarily relating to business development activities and special projects. Interest expense in 1993 was $35.0 million, as compared to $45.3 million in 1992 and $53.2 million in 1991. The decrease in 1993 reflected the capitalization of interest in connection with the Company's major capital projects. The decrease in 1992 reflected lower interest rates resulting from a refinancing of the Company's long-term debt. Interest income was $8.7 million in 1993 as compared to $9.5 million in 1992 and $7.7 million in 1991. The decrease in 1993 was largely the result of lower interest rates. The increase in 1992 from 1991 was the result of increased cash balances which were partly offset by declining interest rates. In 1993, other income decreased to $3.7 million from $4.3 million primarily due to lower townsite sales while in 1992 higher townsite sales contributed to the increase in other income from 1991 of $2.4 million. In May 1992, the Company redeemed all $100 million of its Subordinated Reset Debentures which paid interest at a rate of 14.5%. The premium paid on this early extinguishment of debt is treated as an extraordinary item and is reflected as an after tax cost of $3.0 million for 1992. In the fourth quarter of 1993, the Company recorded a $2.0 million charge for restructuring expenses related to workforce reductions as a part of its major cost reduction program. Preferred stock dividends were $2.5 million in 1993 compared to $12.6 million in 1992. The decrease was the result of the conversion in 1992 of the Company's Series B Preferred Stock. In July 1993 the Company issued $100.0 million Series D Preferred Stock and in November 1993 it issued $100.0 million of Series E Preferred Stock. These issues pay quarterly dividends at the annual rate of 5 5/8% and 6%, respectively. Effects of Inflation. Generally, the Company's operating costs, other than labor and energy costs, are not materially affected by inflation. Recent low levels of inflation have not had a material effect on the Company's operating costs. CAPITAL RESOURCES & LIQUIDITY General. The Company's 1993 operating cash flow (earnings before interest, taxes, depreciation and amortization or "EBITDA") was $125.3 million, as compared to $171.3 million in 1992. The decrease is attributable to lower copper prices and storm damage costs from Arizona's abnormally high rainfall which occurred early in 1993. Cash flow from operations, along with new issuances of preferred stock yielding net proceeds of $193 million and existing cash balances funded capital expenditures. During 1993, the Company spent $137 million for capital expenditures. In addition, capital expenditures of $11 million were financed by capital leases. These capital expenditures include $64 million for upgrading its smelting and refining complex, $24 million on the development of its Lower Kalamazoo orebody and $17 million on the engineering and development of its Robinson Mining District. The Company anticipates spending $150 million on capital expenditures in 1994. This includes $21 million to complete the smelting and refining complex upgrade, $20 million on continued development of the Lower Kalamazoo orebody and pending timely completion of permitting and other factors, $39 million on the development of the Robinson Mining District. The Company's cash and marketable securities increased to $339 million at December 31, 1993. Working capital, including cash and marketable securities, was $360.4 million on December 31, 1993 compared to $226.8 million at December 31, 1992. Although the Company's operations are highly dependent on copper prices, the Company believes it will have sufficient liquidity to fund its operating expense and debt service obligations for the foreseeable future. In this regard, from time to time the Company enters into options and futures contracts or fixed price forward sales agreements as a hedge against lower copper prices. For the first and second quarters of 1994, the Company has purchased put option contracts covering 287 million pounds of production, providing a minimum realized price of $.72 per pound on a London Metals Exchange ("LME") basis. For the third and fourth quarters, the Company has entered into LME futures contracts covering 121 million pounds of production at an average price of $.82 per pound and purchased put option contracts covering 176 million pounds of production that provide a minimum realized price of $.74 per pound on a LME basis. The Company has also purchased put option contracts covering 374 million pounds of its production during the first three quarters of 1995 providing a minimum realized price of $.74 per pound on a LME basis. Development Opportunities. The Company is currently pursuing or evaluating several major mine development opportunities, and has made significant capital improvements to its smelting and refining complex. Robinson Mining District. In 1991, Magma completed a series of transactions in which it acquired a 100% interest in the Robinson Mining District ("Robinson") near Ely, Nevada, for an aggregate acquisition cost of approximately $58 million. Based upon drill and assay results, the Company believes that Robinson has 252 million tons of proven/probable sulfide ore reserves with an average grade of .553% copper and with .0102 ounces of gold per ton and 57 million tons of gold oxide reserves with an average grade of .0086 ounces of gold per ton. Robinson could produce approximately 135 million pounds of copper annually for 16 years through traditional mining/concentrating/smelting/refining methods and could produce 97,300 ounces of gold and 390,000 ounces of silver annually from sulfide copper ore and 17,500 ounces of gold annually from leaching operations during this time period. A metallurgical test program is currently under way to evaluate the feasibility of processing Keystone dump material which contains in excess of 92 million tons at a grade of .34% copper. Development of Robinson requires, among other factors, capital commitment of approximately $300 million and appropriate environmental and operating permits. In early 1993, the Bureau of Land Management determined that an Environmental Impact Statement ("EIS") must be prepared to analyze the Company's proposed re-development of the property. The Company believes the EIS process will be completed during 1994 and project start-up will begin in the first quarter of 1996, although there can be no assurance in this regard. Kalamazoo. The Company's Kalamazoo orebody, which is near its San Manuel underground mine, is comprised of two levels, an upper level which contains approximately 33 million tons of proven/probable ore reserves and a lower level which contains approximately 186 million tons of proven/probable ore reserves. Development of the Lower Kalamazoo orebody was approved and capital of approximately $140 million was committed to the project in 1993. Based on the current mine plan, this project is scheduled to produce 2.13 billion pounds of copper during the period from 1996 to 2009. Florence. In July 1992, Magma completed the acquisition of a large copper deposit near Florence, Arizona. Magma's project team has begun a pre-feasibility study. The deposit, completely on private and state-leased lands, was the subject of extensive exploratory and metallurgical work by the previous owner. The acquisition of this property is part of Magma's long-term strategy to increase copper production through the application of its advanced SX-EW leaching technology. Because evaluation of the Florence property is still in the early stages, the Company has not yet made any determination of the cost to develop the property. Smelting and Refining Complex. The Company is in the process of further upgrading its smelting and refining complex. The capital cost of the project is estimated at $85 million. The project includes the addition of a new large acid plant which will increase offgas handling capacity. The project will further improve environmental performance. During 1993, the smelter produced 681 million pounds of copper in anode form, significantly in excess of its design capacity of 600 million pounds. When the expansion is completed the Company anticipates that it will have the ability to produce at levels in excess of the 720 million pounds originally anticipated when the expansion was undertaken. This increase in capacity should enable the Company to maintain its custom smelting business even with the expected increase in smelting of Magma source copper when the Robinson Mining District begins production. To the extent undertaken, the Company intends to finance these projects with internal cash flow, current cash balances and new borrowings if required. The Company does not currently anticipate difficulty in attracting any additional borrowing which may be required. The decision to undertake or complete these projects is subject to a variety of factors, which may include (depending on the project) the completion of favorable feasibility studies and permitting. There can be no assurance that the Company will undertake all of these opportunities or that, if undertaken, they will prove successful. If the Company is unable to replace its reserves from the mine development projects being evaluated, or with other reserves identified or acquired in the future, the Company's dependency upon third party sources to supply copper concentrate to its smelting and refining operations would increase. Environmental Matters. The Company maintains and funds an ongoing environmental compliance program. The program includes mine reclamation and remediation, as well as technological improvements and upgrades to its operating facilities. The Company is currently in the process of completing improvements to its smelting and refining complex. The upgrades will improve the environmental performance of the smelter in anticipation of changing regulatory standards. During the first half of 1993 the Company's Pinto Valley and Superior Mining Divisions were adversely affected by significant rainfalls which caused flooding, water containment structural failures and operating difficulties, as well as technical violations of various permitting conditions and state surface water quality standards. The Company has tentatively agreed to enter into a consent decree with appropriate regulatory authorities to settle all claims relating to this matter. The consent decree is expected to be executed by the Company and its governmental counterparts during the first quarter of 1994. Under the proposed settlement, the Company would pay fines totaling $625,000 and would contribute monies towards or perform supplementary environmental projects of approximately $200,000. In addition, the Company would agree to perform remedial investigation studies and corrective activities and to upgrade its tailings containment and water containment facilities at these divisions. The Company expended $6 million to correct and upgrade affected facilities in 1993. The Company expects to spend an additional $8 million to upgrade and expand these facilities in 1994. These costs are being capitalized and will be amortized over the remaining mine life. The Company is participating in a remediation and assessment of ground water quality at Pinal Creek near Miami, Arizona as part of the Arizona Department of Environmental Quality's Process Water Quality Assurance Revolving Fund Program. The Company and other companies sharing voluntary responsibility for ground water clean up and a remedial investigation have sued certain other mining companies with existing or prior operations in the area to obtain reimbursement for all or part of the costs that have been and will be incurred at the site. Some of these defendants have counterclaimed against the Company asserting indemnification for the costs and any liabilities relating to this project. To date, the Company's costs of remediation have not been material and, although there can be no assurance in this regard, the Company does not believe it will incur any material liability or costs in relation to this matter. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MAGMA COPPER COMPANY AND CONSOLIDATED SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Public Accountants . . . . . . . . . . . . . . 43 Consolidated Financial Statements: Consolidated Balance Sheets-December 31, 1993 and 1992 . . . . . 44 Consolidated Statements of Operations-for each of the years ended December 31, 1993, 1992 and 1991. . . . . . . 46 Consolidated Statements of Changes in Stockholders' Equity-for each of the years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . . . . . 47 Consolidated Statements of Cash Flows-for each of the years ended December 31, 1993, 1992 and 1991 . . . . . . . . 50 Notes to Consolidated Financial Statements. . . . . . . . . . . 52 Consolidated Financial Statement Schedules at and for the years ended December 31, 1993, 1992 and 1991: Report of Independent Public Accountants. . . . . . . . . . 72 Schedule I-Marketable Securities-Other Investments. . . . . . . . . . . . . . . . . . . . . . . 73 Schedule IV-Indebtedness of and to Related Parties-Not Current. . . . . . . . . . . . . . . . . . . 74 Schedule V-Property, Plant and Mine Development . . . . . . 75 Schedule VI-Accumulated Depreciation, Depletion and Amortization of Property, Plant and Mine Development. . . . . . . . . . . . . . . . . . . . . . . 76 Schedule VIII-Valuation and Qualifying Accounts . . . . . . 78 Schedule IX-Short-term Borrowings . . . . . . . . . . . . . 79 Schedule X-Supplementary Income Statement Information. . . . . . . . . . . . . . . . . . . . . . . 81 All other schedules are omitted as the information required is immaterial or inapplicable or because the required information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Magma Copper Company: We have audited the accompanying consolidated balance sheets of Magma Copper Company (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years ended December 31, 1993 and 1992 (post quasi-reorganization - Note B), and for the year ended December 31, 1991 (pre quasi-reorganization - Note B). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Magma Copper Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the years ended December 31, 1993 and 1992 (post quasi-reorganization), and the results of their operations and cash flows for the year ended December 31, 1991 (pre quasi- reorganization), in conformity with generally accepted accounting principles. As explained in Note B and Note M to the financial statements, effective January 1, 1991, and January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions and for postemployment benefits, respectively. ARTHUR ANDERSEN & CO. Tucson, Arizona, January 27, 1994. MAGMA COPPER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - NATURE OF OPERATIONS Magma Copper Company and its subsidiaries ("Magma" or the "Company") are in the business of mining and concentrating nonferrous copper ore, smelting and refining its production, as well as that of third parties, and producing copper cathode and continuous-cast copper rod at its facilities in San Manuel, Miami (Pinto Valley Mining Division) and Superior, Arizona. The Company's primary product is electrolytic copper, most of which is sold as either cathode or continuous-cast copper rod. By-products derived from the treatment processes are sold to third parties. The Company produces copper by both the traditional method (mining/concentrating/smelting/refining) and by the leaching/solvent extraction-electrowinning ("SX-EW") method. The Company owns and operates underground sulfide and open-pit oxide and sulfide mines at San Manuel, Miami (Pinto Valley Mining Division) and Superior, Arizona and Ely, Nevada. In addition to processing the Company's mined material, the San Manuel smelter, refinery and rod casting facilities process third party material on a custom basis, including tolled and purchased concentrates. NOTE B - RESTRUCTURING AND QUASI-REORGANIZATION 1991 Non-Cash Accounting Adjustments. The Non-Cash Accounting Adjustments resulted from studies, completed during 1991, of various balance sheet items that were undertaken in connection with a reorganization of the Company into distinct profit centers. In addition, execution of the new collective bargaining agreement and achievement of productivity increases at the upper Kalamazoo orebody enabled the Company to further study the feasibility of developing and mining the lower portion of this orebody. Based upon these studies, and in conjunction with its internal reorganization, the Company implemented, as of December 31, 1991, the following Non-Cash Accounting Adjustments: (1) Adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." (2) An after tax restructuring charge of approximately $141 million, which included a $92 million after tax write-down of the Company's investment in its Kalamazoo orebody, as well as other amounts related to detailed reviews of the Company's balance sheet. (3) Implementation of a "quasi-reorganization", in which certain assets and liabilities were restated and the accumulated deficit resulting from the adjustments described above was reclassified to capital in excess of par value. After giving effect to the Non-Cash Accounting Adjustments in 1991, the Company's stockholders' equity at December 31, 1990 was restated to $447.2 million, compared to $534.2 million, as was originally reported. NOTE C - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES 1. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries: Magma Gold Ltd., Magma Nevada Mining Company, Magma Arizona Railroad Company, San Manuel Arizona Railroad Company, Magma Metals Company and Magma Limited Partner Co. All significant intercompany accounts and transactions have been eliminated in consolidation. 2. Property, Plant and Mine Development Property, plant and mine development is stated at original historical cost less accumulated depreciation, depletion and amortization, except for certain assets which were restated in connection with the quasi- reorganization. Expenditures for property, plant and equipment are capitalized. Maintenance and repairs are expensed as incurred. Mine development expenditures incurred substantially in advance of production or to develop new mines are capitalized. Expenditures for mineral exploration or evaluations directed towards the discovery of mineral resources are expensed as incurred, as are expenditures for mine development costs which maintain current production levels. The amount expensed for exploration, research and development was $9.4 million, $2.6 million and $.9 million in 1993, 1992 and 1991, respectively. Investments in property, plant and equipment are depleted or depreciated over the estimated productive lives of the assets, using the straight-line method, and deferred mine development costs are charged to operations on the units-of-production method based on the estimated pounds of copper ore to be recovered. Included in "equipment and buildings" in the accompanying consolidated balance sheets is $109,646,000 and $36,893,000 of construction-in-progress at December 31, 1993 and 1992, respectively. Included in "deferred mine development costs" is $21,353,000 and $10,775,000 of mine development-in- progress at December 31, 1993 and 1992, respectively. The accumulated amortization of deferred mine development costs was $9,263,000 and $2,863,000 at December 31, 1993 and 1992, respectively. The accumulated depletion of mining claims and land was $1,137,000 and $860,000 at December 31, 1993 and 1992, respectively. 3. Inventories Inventories of metals and materials and supplies are stated at the lower of moving-average cost or estimated market value. Inventories included in current assets were (in thousands): 4. Income Taxes SFAS 109, Accounting for Income Taxes, requires the adoption of the "liability" method for providing deferred taxes. The Company elected to adopt SFAS 109 by reflecting its provisions in the 1991 financial statements and retroactively restating the prior year financial statements from January 1, 1987 through December 31, 1990. Deferred income taxes result from temporary differences in the recognition of accounting transactions for tax and financial reporting purposes. The principal temporary differences relate to depreciation and amortization of mine development costs and certain financial reserves not deductible for tax purposes until paid. 5. Method of Recording Sales and Treatment Toll Revenue Revenue from sales of copper and acid is recorded when ownership of the products is legally transferred to the customer. Certain copper sales are provisionally priced and later adjusted in the month the sales prices are contractually finalized. Revenue from by-products is recognized on a production basis. Treatment toll revenue earned for the smelting of concentrates is recorded in the month that the copper concentrates are smelted. Treatment toll revenue earned for refining copper and rod conversion is recorded in the period that the copper becomes returnable to the customer. 6. Capitalized Interest The Company capitalizes interest allocable to the construction of major new facilities and deferred mine development until operations commence. The Company capitalized $7,786,000 of interest in 1993. No interest was capitalized in 1992 or 1991. 7. Earnings Per Share Primary earnings per share is computed by dividing net income, less dividends on preferred stock, by the weighted average number of common shares outstanding and common shares payable as preferred stock dividends. Under the treasury stock method, common stock warrants outstanding at December 31, 1991 were antidilutive and therefore were not included in the computation of earnings per share. The weighted average number of primary common stock and common stock equivalents outstanding during 1993, 1992 and 1991 were 48,174,000, 33,444,000 and 30,382,000, respectively. Earnings per share assuming full dilution is computed by dividing net income by the weighted average number of common shares outstanding, including the potential dilutive effect of the Series D and Series E Preferred Stock. For purposes of the computation, all the preferred stock is included based on the weighted average converted shares outstanding. The weighted average number of common stock and common stock equivalents outstanding for 1992, assuming full dilution, was 46,605,000. For 1993 and 1991 the preferred stock was antidilutive. 8. Stock Option and Stock Award Plans The 1987 Stock Option and Stock Award Plan ("the 1987 Plan") was established by contributing 5% of Magma's then outstanding stock (1,903,630 shares of Class B Common Stock) to a trust. The trust holds the shares until used for direct grants or grants of stock options to key members of Magma's management as directed by a committee ("the Committee") of directors appointed by the Board of Directors. During 1989, the Committee authorized the purchase by the trust of 54,300 shares of Class B Common Stock from the open market for $390,000. The Company's shareholders approved the adoption of the Magma Copper Company 1989 Stock Option and Stock Award Plan ("the 1989 Plan") on June 1, 1989. The 1989 Plan is administered by the Committee. Under the 1989 Plan, the Committee has authority to determine the key employees to whom, and the time or times at which, incentive awards in the form of stock options, stock appreciation rights, restricted stock awards and performance units may be granted. Subject to certain exceptions set forth in the 1989 Plan, the aggregate numbers of shares of the Company's Common Stock that may be the subject of awards under the Plan is 2,000,000. The Company's shareholders approved adoption of the Magma Copper Company 1993 Stock Option and Stock Award Plan ("the 1993 Plan") on May 13, 1993. The 1993 Plan is administered by the Committee. Under the 1993 Plan, the Committee has authority to determine the key employees to whom, and the time or time at which, incentive awards in the form of stock options, stock appreciation rights, restricted stock awards, phantom stock rights, performance units and performance shares may be granted. Subject to certain exceptions set forth in the 1993 Plan, the aggregate number of shares of the Company's common stock that may be the subject of awards under the Plan is 2,250,000. Options under the 1987 Plan primarily become exercisable over a three- year vesting period, subject to certain restrictions, at the rate of one- third per year. The options under the 1989 Plan become exercisable over a three or four-year vesting period. Options granted under the 1993 Plan become exercisable over a three year vesting period. The following table summarizes the activity related to stock options under the plans: Stock grants represent compensation to management for future periods and are treated as a capital contribution to Magma as they vest. Grants under the 1987 Plan vest over various terms. Most grants awarded in 1991 vest at the yearly rate of 20%, 20%, 30% and 30% over a four-year period. Most grants awarded in 1992 and 1993 vest over a three or four- year period. Compensation expense under the 1987 Plan in the form of stock grants earned for 1993, 1992 and 1991 was approximately $500,000, $500,000 and $1,400,000, respectively. Grants under the 1989 Plan primarily vest over a four-year period at 20% in each of the first two years and at 30% in the last two years or 25% per year over a four-year period. Compensation expense related to the 1989 Plan was approximately $100,000, $100,000 and $200,000 in 1993, 1992 and 1991, respectively. The following table summarizes the activity under the stock grant plans: Under the Company's 1989 Stock Option Plan for Non-Employee Directors, options awarded for 1993, 1992 and 1991 were 6,359, 6,164 and 13,521, respectively. Under this plan, the directors forego cash compensation in exchange for discounted options. The average exercise price was $5.97, $6.17 and $3.00 per share for 1993, 1992 and 1991, respectively. At a meeting held on May 14, 1992, the Company's shareholders approved the adoption of the 1992 Restricted Stock Plan for Non-Employee Directors; 8,000 grants of stock were awarded in 1992 and 8,000 grants of stock were awarded in 1993. 9. Stock Warrants The Company has warrants outstanding covering the purchase of 5,077,756 shares exercisable at $8.50 per share. The warrants are exercisable through November 30, 1995. 10. Cash, Cash Equivalents and Marketable Securities For purposes of the consolidated balance sheets and the consolidated statements of cash flows, the Company considers all highly liquid investments, purchased with a maturity of three months or less, to be cash equivalents. Marketable securities are highly liquid investments, primarily in United States treasury notes, purchased with maturities greater than three months. These securities are carried at the lower of cost or market. 11. Restatements and Reclassifications Certain amounts for 1992 have been reclassified to conform with 1993 reporting classifications. NOTE D - MAJOR CUSTOMERS, EXPORT SALES AND SALES COMMITMENTS During 1993, the Company's copper was sold to approximately sixty (60) customers. Sales of copper to the Company's largest customer during the year accounted for 19% of total revenue. Because copper is an internationally traded commodity, the Company does not believe that the loss of any one customer would have a material adverse effect on the results of its operations. The Company's export sales have declined in recent years primarily due to increasing U.S. consumption and the recession in Japan. The Company is maintaining its presence in the Asian markets by supplying cathode to major fabricators on an annual basis. Export sales as a percent of total revenues were 25%, 29% and 50% for the years ended December 31, 1993, 1992 and 1991, respectively. From time to time the Company enters into options and futures contracts or fixed price forward sales agreements as a hedge against lower copper prices. For the first and second quarters of 1994, the Company has purchased put option contracts covering 287 million pounds of production, providing a minimum realized price of $.72 per pound on a London Metals Exchange ("LME") basis. For the third and fourth quarters, the Company has entered into LME futures contracts covering 121 million pounds of production at an average price of $.82 per pound and purchased put option contracts covering 176 million pounds of production that provide a minimum realized price of $.74 per pound on a LME basis. For 1995, the Company purchased put option contracts covering 374 million pounds of its first, second and third quarter production, providing a minimum realized price of $.74 per pound on a LME basis. NOTE E - INCOME TAXES During the fourth quarter of 1991, Magma adopted SFAS 109 and retroactively restated its financial statements from January 1, 1987. SFAS 109 requires an asset and liability approach for financial accounting and reporting for income tax purposes. This statement recognizes (a) the amount of taxes payable or refundable for the current year and (b) deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns. In August 1993 the Revenue Reconciliation Act of 1993 (the "Act") was enacted by Congress. Under the Act, and effective as of January 1, 1993, the top marginal corporate tax rate was increased from 34% to 35%. Under Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" (SFAS 109) the cumulative impact of a change in tax rate is recognized as an element of tax expense for the period of enactment. During the three month period ended September 30, 1993, the Company recorded a one time charge to tax expense of $2.8 million to reflect the impact of the change in statutory rate. In calculating income taxes, the Company has benefitted from deductions for percentage depletion. In general, the Company's cumulative percentage depletion deductions exceed cost basis of depletable properties, resulting in current percentage depletion being treated as a permanent difference. The effect of this permanent difference causes the effective tax rate to be generally lower than the statutory tax rate. Of the total $6.3 million benefit for percentage depletion, approximately $3.1 million relates to a change in estimate formalized in July of 1993. The components of the income tax (provision) benefit consist of the following (in thousands): The (provision) benefit for income taxes differs from the amounts computed by applying the federal statutory rate as follows (in thousands): The components of the net deferred tax liability are as follows (in thousands): At December 31, 1993, Magma has for federal income tax purposes approximately $50 million of regular tax net operating loss carryforwards which expire, if unused, in the years 2003 through 2006. Under the federal alternative minimum tax system, Magma has no net operating loss carryforwards. As a result of shorter carryforward periods and other statutory differences, Magma has no net operating loss carryforwards for state income tax purposes. Magma also has alternative minimum tax credits aggregating approximately $52 million which carryforward indefinitely for federal income tax purposes. These credits can be used in the future to the extent that Magma's regular tax liability exceeds its liability calculated under the alternative minimum tax system. NOTE F - PENSION AND RETIREMENT PLANS The Company and its subsidiaries have defined benefit pension and retirement plans covering substantially all employees (the "Plans"). Plans covering salaried employees provide pension benefits based on the employee's compensation during the ten years before retirement. Plans covering hourly employees provide pension benefits based on stated amounts, for each year of service, and provide for supplemental benefits for employees who retire with 30 years of service before age 65. The Company's funding policy is to contribute annually the minimum amount that can be deducted for federal income tax purposes. Total pension and retirement plan costs were $2,257,000, $1,422,000 and $1,240,000 in 1993, 1992 and 1991, respectively. The net periodic pension cost for 1993, 1992 and 1991 included the following components (in thousands): On December 31, 1993 and 1992, the Plans' assets were invested in fixed income instruments and equity securities. The following tables set forth the Plans' funded status and amounts recognized in the Company's consolidated balance sheets at December 31, 1993 and 1992 (in thousands): During 1990, an amendment changed the benefit formula and the definition of compensation used to compute the salaried employees' benefit. These changes resulted in an increase in the projected obligation of $3,100,000 which is accounted for as prior service cost and amortized over 13.9 years. The Company provides executives with excess benefit and supplemental benefit pension plans. Plan costs for 1993 including interest and amortization of the transition obligation was $710,000. The projected benefit obligation of these plans at December 31, 1993 was $3,192,000. Funding is on a current basis and there are no plan assets. The Company also sponsors postretirement medical and life insurance benefit plans. Effective January 1, 1991, the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The Company elected to adopt this statement early and to record the entire cumulative adjustment in the year of adoption. The accompanying statement of operations for 1991 reflects a pre-tax charge of $23,000,000 less a $9,000,000 tax benefit as a cumulative effect in a change in accounting principle in accordance with SFAS 106. The postretirement medical and life insurance plans cover salaried and hourly employees with at least ten years of service prior to retirement. The medical plan provides benefits for hospital coverage and surgical fees up to a lifetime limit of $80,000. The life insurance plan provides benefits to hourly employees of $4,000 and to salaried employees based on their preretirement compensation. The Company funds the postretirement benefit costs on a current basis and there are no plan assets. The net periodic postretirement benefit costs for 1993, 1992 and 1991 included the following components (in thousands): The following table sets forth postretirement amounts recognized in the Company's consolidated balance sheets at December 31, 1993 and 1992 (in thousands): The 1993 plan accounting assumes a health care cost trend rate for pre-age 65 benefits of 13% and post-age 65 benefits of 10%. These rates were assumed to decrease one percentage point each year to 5.5% and remain at that level thereafter. The assumed discount rate and rate of increase in compensation levels was 7.5% and 4.25%, respectively. The effect of a one percentage point increase in the assumed health care cost trend rates for each future year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $3,873,000. The effect of this change on the aggregate of the service and interest cost components of the net periodic postretirement benefit costs would have been an increase of $238,000 for 1993. NOTE G - LONG-TERM DEBT Long-term debt consists of the following (in thousands): At December 31, 1993, aggregate debt maturities are as follows for the years ending December 31 (in thousands): 1. 12% Senior Subordinated Notes In December 1991, the Company sold $200,000,000 of 12% Senior Subordinated Notes ("12% Notes") due December 15, 2001. Interest on the 12% Notes is payable on June 15 and December 15 of each year. The 12% Notes are redeemable at the option of the Company, at any time or from time to time, on and after December 15, 1996 in whole or in part. Redemption of the 12% Notes is at 106% of the principal amount thereof for the twelve month period beginning on December 15, 1996, at 103% of the principal amount thereof for the twelve month period beginning on December 15, 1997, and thereafter at 100% of the principal amount thereof. The indenture pursuant to which the 12% Notes were issued contains, among other restrictions, limitations on the incurrence of additional debt, payment of cash dividends, distributions on and repurchases of the Company's capital stock and loans or contributions to the capital of or investment in Designated Subsidiaries, as defined by the Indenture. 2. 11 1/2% Senior Subordinated Notes In January 1992, the Company issued $125,000,000 of 11 1/2% Senior Subordinated Notes ("11 1/2% Notes") due January 15, 2002. Interest on the 11 1/2% Notes is payable January 15 and July 15 of each year. The 11 1/2% Notes are redeemable at the option of the Company, at any time or from time to time, on and after January 15, 1995 in whole or in part. Redemption of the 11 1/2% Notes is at 108% of the principal amount thereof for the twelve month period beginning on January 15, 1995, at 106% of the principal amount thereof for the twelve month period beginning January 15, 1996, at 104% of the principal amount thereof for the twelve month period beginning January 15, 1997, at 102% of the principal amount thereof for the twelve month period beginning January 15, 1998, and thereafter at 100% of the principal amount thereof. The indenture pursuant to which the 11 1/2% Notes were issued contains restrictions which are similar in nature to the 12% Senior Subordinated Notes. 3. Industrial Development Authority Bonds At December 31, 1993, Industrial Development Authority ("IDA") bonds outstanding totaled $49,700,000. These bonds have been issued through the Pinal County IDA, the locale of the Company's smelting and refining facility. The interest rates on these bonds is based on the minimum rate determined by the remarketing agent necessary to sell the bonds. The effective interest rate on the bonds was approximately 2.3% for 1993 and 4% for 1992 and 1991. Principal at December 31, 1993 is repayable as follows (in thousands): In December 1992, the Company refinanced maturing bonds totaling $14,081,639 with a new $14,000,000 IDA bond issuance due December 1, 2011. The proceeds of the original bond issues were used to provide funds to finance certain pollution control facilities and retrofit the Company's smelter. 4. Promissory Note In July 1992, the Company purchased a major Arizona copper deposit. In conjunction with this purchase, the Company signed an $8,000,000, 9.75% Promissory Note ("Promissory Note") due in eight annual installments of $1,000,000 commencing January 1993. The Promissory Note may be prepaid at any time without penalty. The Promissory Note contains no significant covenants; however, it is secured by a deed of trust on the property purchased. 5. Non-Interest Bearing Junior Subordinated Notes From March 1989 through March 1992, the Company issued non-interest- bearing junior subordinated notes (the "Zero-Interest-Notes") in lieu of quarterly cash dividends to holders of the Series B Preferred Stock (see Note H-Preferred Stock). The Zero-Interest-Notes are due and payable on May 4, 1994. 6. Capitalized Lease Obligations The Company has capitalized lease obligations for heavy mining equipment and a computer system. These leases have maturities from 1994 through 2008 and implicit rates ranging from 7.0% to 9.2%. 7. Revolving Credit Facility In May 1993, the Company entered into a five-year $200 million revolving credit agreement (the "Revolver"). The Revolver is provided by a consortium of ten banks and is available for general corporate purposes. Amounts outstanding under the Revolver may bear interest at the London InterBank Offered Rate (LIBOR), the Certificate of Deposit or the prime rate, as defined, plus a margin which may vary depending on the credit rating of the Company. Currently, borrowings would bear interest at the rate of LIBOR plus 1%. An annual agency fee of $30,000 plus a commitment fee (which also varies depending on the credit rating of the Company) of 3/8% per annum on the unused portion of the Revolver is payable by the Company. Under the terms of the Revolver, the Company must: (i) maintain a consolidated net worth of not less than the sum of $350 million plus 50% of consolidated net income for each fiscal year beginning with fiscal 1993; (ii) not permit the ratio of its consolidated debt to total capitalization (debt and equity) to exceed 60% and (iii) maintain a consolidated coverage ratio of at least 2.0 to 1. NOTE H - PREFERRED STOCK The Company has 50,000,000 shares of authorized Preferred Stock. At December 31, 1993, 5,112,765 shares (none issued or outstanding) had been designated as Series C Convertible Preferred Stock ("Series C Preferred Stock"); 2,005,000 shares (2,000,000 issued and outstanding) had been designated as Series D Cumulative Convertible Preferred Stock ("Series D Preferred Stock"); 2,000,000 shares (issued and outstanding) had been designated as Series E Cumulative Convertible Preferred Stock, and 40,882,235 shares (none issued or outstanding) were undesignated. In 1988, 930,000 shares of the Series B Preferred Stock were issued in conjunction with a recapitalization of the Company. The Series C Preferred Stock was created for issuance upon conversion of the Series B Preferred Stock or exercise of outstanding warrants, if, for any reason, the Company were unable to issue Common Stock to satisfy applicable conversion or exercise requirements. No Series C Preferred Stock is outstanding and the Company is not presently aware of any reason that would require it to issue such stock or preclude it from issuing Common Stock. In December 1992, the Company offered to exchange 15.446825 shares of its Common Stock for each share of its Series B Preferred Stock outstanding. On December 29, 1992, each share of Series B Preferred Stock was exchanged, resulting in an issuance of 14,133,047 shares of Common Stock. Each share of Series B Preferred Stock was entitled to cumulative dividends in each of the first five years after issuance, paid quarterly, at the rate of one share of Class B Common Stock per annum and, if the market price of a share of Class B Common Stock at the time was less than $10 plus an additional amount (payable, at the Company s option, in cash or non-interest-bearing junior subordinated notes due five years from the issuance date of the first of such notes issued), not to exceed $.625 per quarter, equal to one quarter of the excess of $10 over the market value of a share of Class B Common Stock. After November 1993, each share of Series B Preferred Stock would have been entitled to receive dividends of $10 per annum in cash. In July 1993, the Company issued $100 million, or 2.0 million shares of 5 5/8 % Cumulative Convertible Preferred Stock, Series D ("Series D Preferred Stock") and in December 1993, the Company issued $100 million, or 2.0 million shares of 6% Cumulative Convertible Preferred Stock, Series E ("Series E Preferred Stock"). Both the Series D Preferred Stock and Series E Preferred Stock have a liquidation preference of $50.00 per share and dividends are payable quarterly at the annual rate of 5 5/8% and 6%, respectively. Each share of the Series D Preferred Stock and Series E Preferred Stock is convertible at any time at the option of the holder into shares of Common Stock of Magma Copper Company at a conversion rate of 3.448 and 3.5945 shares, (equivalent to a conversion price of $14.50 and $13.91 per share of Common Stock) respectively, subject to adjustment under certain conditions. The Series D Preferred Stock and Series E Preferred Stock are not redeemable prior to July 20, 1996 and December 1, 1996, respectively. On and after the above dates, the Series D Preferred Stock and Series E Preferred Stock are redeemable at the option of the Company, in whole or in part, initially for $51.969 and $52.10 per share, respectively, and thereafter at prices declining ratably annually to $50 per share in 2003, plus, in each case, an amount equal to accrued and unpaid dividends to the redemption date. During 1993, the Company paid cash dividends on its Series D Preferred Stock and Series E Preferred Stock totaling $2,296,850 and $225,067, respectively. NOTE I - COMMON STOCK At a Special Meeting of Stockholders on October 30, 1992, Magma's stockholders voted to amend the Company's Certificate of Incorporation to reclassify and convert all shares of Class A Common Stock and Class B Common Stock into a new, single class of Common Stock. Each share of Common Stock created by the amendment possesses one vote on all matters properly coming before stockholders, including elections of the Board of Directors, and is not subject to any transfer restrictions, and possesses no veto power over the issuance of any other class of stock. NOTE J - COMMITMENTS AND CONTINGENCIES 1. Legal Matters The Company is involved in legal proceedings of a character normally incidental to its business, including substantial claims and pending actions against the Company seeking recovery of alleged damages or clarifications of legal rights. The Company does not believe that adverse decisions in any pending or threatened proceedings, or any amounts which it may be required to pay by reason thereof, would have a material adverse effect on the financial condition or results of operations of the Company. The Company is involved in legal proceedings (the "Adjudication") regarding the allocation of water rights of the Gila River system and source pending in the Superior Court of Maricopa County, Arizona. The Company's right to use surface and groundwater at its San Manuel, Pinto Valley and Superior operations, as well as the rights of all other claimants to use water from the Gila River system and source, is to be decided in this matter. Claims for damages for the Company's withdrawal of ground water have been asserted by Indian tribes, but have been stayed pending outcome of the Adjudication. A final resolution of this litigation may not be made for several years. Management believes that, despite this litigation, it will be able to obtain water necessary for its mining operations. 2. Labor Contracts On October 21, 1991 the Company and its labor unions executed a 15 year collective bargaining agreement. The agreement prohibits strikes and lockouts for at least seven years. Hourly-rated employees have received and will receive annual wage increases of $.25 to $.35 per hour in each of the next five years following 1991, some of which are dependent upon Magma's quarterly earnings performance during such periods. After the initial five-year period, the agreement will continue in effect for an additional 10 years on the same terms and conditions, unless either party proposes a modification of the economic terms. If the parties are unable to agree on the proposed modifications, they will be submitted to an arbitration panel which will establish major economic terms for a one-year period in accordance with certain specified criteria. If during any five- year period after the initial term there are two such arbitration proceedings, the agreement will terminate upon the anniversary date of the second arbitration award. Under the agreement, teams of management, union represented employees and their representatives are committed to work together to, among other things, increase productivity and reduce costs. NOTE K - LEASE COMMITMENTS The Company leases railcars, haul trucks, other heavy mining equipment and a computer system. Rent expense for the years ended December 31, 1993, 1992 and 1991 was $4,464,000, $4,833,000 and $3,300,000, respectively. The following is a schedule of the future minimum lease payments for the years ending December 31, (in thousands): NOTE L - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash. The carrying amount approximates fair value because of the short maturity of those instruments. Marketable Securities. The fair values of marketable securities are estimated based on quoted market prices for those or similar investments. Long-Term Debt. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Price Protection Contracts. As discussed further in Note D, at December 31, 1993 the Company has purchased put options for the first half of 1994 and entered into LME futures contracts for the second half of 1994. The carrying amount of these contracts reflects the cost of the option premium which will be amortized ratably as the options expire. The fair value of these contracts is estimated based on quotes from brokers and market prices at December 31, 1993. During January 1994, the Company purchased additional put options with a carrying amount which approximates fair value, but which are not included in the table below Gold and Silver Swap Contracts. The Company has sold forward and repurchased a portion of its gold and silver production. Through the execution of swap contracts, the Company will effectively receive the difference between the fixed sales prices and fixed purchase prices added to the market average at the time of the physical gold and silver sales. The fair value of these contracts is based on the difference between the fixed sales and fixed purchase prices as of the valuation date. The estimated fair values of the Company's financial instruments as of December 31, 1993 are as follows (in thousands): The fair value estimates are made at discrete points in time based on relevant market information and information about the financial instruments. These estimates may be subjective in nature and involve uncertainties and significant judgment and therefore cannot be determined with precision. NOTE M - ADOPTION OF FASB 112 - EMPLOYERS' ACCOUNTING FOR POSTEMPLOYMENT BENEFITS At December 31, 1993, the Company adopted SFAS 112 - "Employers' Accounting for Postemployment Benefits". The Company elected to adopt this statement early and to record the entire cumulative adjustment in the year of adoption. Under SFAS 112, $.9 million (after tax) was charged to first quarter 1993 earnings. NOTE N - STORM DAMAGE The Company estimates that pre-tax earnings for 1993 were reduced by $21 million ($15.5 million after tax) as a result of storm damage. The largest cost was a writedown of inventory to net realizable value of $10 million caused by higher than normal production costs. Additionally, there was a $4 million loss of production and $4 million of one-time rain related repair costs. The Company's operating margin was reduced by $3 million as the Company was unable to mine from the higher-grade area of its open-pit mine at its Pinto Valley Mining Division. The Company is seeking to recover a portion of the amounts expended as a result of the storm damage from its property and casualty insurers. NOTE O - SELECTED QUARTERLY FINANCIAL DATA (Information for all periods shown below is unaudited). Amounts for the three months ended March 31, 1993 have been restated to reflect the adoption of SFAS 112 (see Note M). (In thousands, except per share data) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Magma Copper Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Magma Copper Company and subsidiaries included in this Form 10-K, and have issued our report thereon dated January 27, 1994. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules listed in the index to consolidated financial statements of this Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Tucson, Arizona, January 27, 1994. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Additional information required by Part III (Items 10, 11, 12 and 13) is incorporated by reference from the registrant's definitive proxy statement which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K, provided, however, that the "Compensation Committee Report on Executive Compensation" and the "Stock Performance Graph" contained in the Proxy Statement are not incorporated by reference herein. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Consolidated Financial Statements: Index on page 42 of this Report. 2. Consolidated Financial Statement Schedules: Index on page 42 of this Report. 3. Exhibits. The exhibits as indexed on pages 83 through 91 of this Report are included as a part of this Form 10-K. (b) Reports on Form 8-K: The following reports on Form 8-K were filed by the registrant during the three months ended December 31, 1993: The Company filed a report on Form 8-K, dated November 17, 1993, to announce a proposed public offering of up to $100 million principal amount of Cumulative Convertible Preferred Stock, Series E, par value $.01 per share. The Company also announced that it had established a hedging program covering a portion of its 1994 production. The Company filed a report on Form 8-K, dated November 24, 1993, to announce the conclusion of the sale of $100 million of Series E Preferred Stock. Exhibit Number Description 3.1 Restated Certificate of Incorporation (Incorporated by reference; of Magma Copper Company, dated previously filed as Exhibit February 21, 1991 3.4 to the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1990.) 3.2 Certificate of Correction to Restated (Incorporated by reference; Certificate of Incorporation of previously filed as Exhibit Magma Copper Company dated 3.2 to the Registrant's February 27, 1992 annual report on Form 10-K for the fiscal year ended December 31, 1991.) 3.3 Certificate of Amendment to (Incorporated by reference; Restated Certification of previously filed as Exhibit Incorporation of Magma Copper 3.3 to the Registrant's Company dated October 30, 1992 1992 Form 10-K.) 3.4 By-laws of Magma Copper Company (Incorporated by reference; as amended to and including previously filed as Exhibit July 22, 1992 3.4 to the Registrant's 1992 Form 10-K.) 4.0 Specimen Common Stock Certificate (Incorporated by reference; previously filed as Exhibit 4.0 to the Registrant's 1992 Form 10-K.) 4.1 Specimen Warrant Certificate (Incorporated by reference; previously filed as Exhibit 4.1 to the Registrant's 1988 Warrants Registration Statement.) 4.2 Form of Warrant Agreement, dated (Incorporated by reference; as of December 15, 1988, between previously filed as Exhibit the Company and Manufacturers 4.2 to the Registrant's Hanover Trust Company, as warrant 1988 Warrants Registration agent Statement.) 4.3 Form of Note Indenture for 12% (Incorporated by reference; Senior Subordinated Notes due previously filed as Exhibit 2001, dated December 15, 1991 4 to the Registrant's Current Report on Form 8-K dated January 9, 1992.) Exhibit Number Description 4.4 Specimen of 12% Note (Incorporated by reference; previously filed as Article Two of Exhibit 4 to the Registrant's Current Report on Form 8-K dated January 9, 1992.) 4.5 Form of 11.5% Note Indenture for (Incorporated by reference; 11.5% Senior Subordinated Notes previously filed as Exhibit due 2002, dated January 15, 1992 28B to the Registrant's Current Report on Form 8-K dated January 17, 1992.) 4.6 Specimen of 11.5% Note (Incorporated by reference; previously filed as Article Two of Exhibit 28B to the Registrant's Current Report on Form 8-K dated January 17, 1992.) 4.7 Certificate of Designation of (Incorporated by reference; Series B Preferred Stock previously filed as Exhibit 3.6 to the Registrant's Registration Statement on Form S-1, File No. 33-24960 (the "Copper Notes Registration Statement").) 4.8 Amendment to Certificate of (Incorporated by reference; Designation of Series B previously filed as Exhibit Preferred Stock 3.6 to the Registrant's Statement on Form S-1, File No. 33-26294 (the "1988 Warrants Registration Statement").) 4.9 Certificate of Decrease in (Incorporated by reference; the Number of Authorized Shares previously filed as Exhibit of Series B Preferred Stock 3.7 to the Registrant's 1992 Form 10-K.) 4.10 Certificate of Designations of (Incorporated by reference; Series D Preferred Stock previously filed as Exhibit 4.0 to the Registrant's Current Report on Form 8-K dated July 12, 1993.) Exhibit Number Description 4.11 Specimen Series D Preferred (Incorporated by reference; Stock Certificate previously filed as Exhibit 4.0 to the Registrant's Form 8-A dated July 8, 1993.) 4.12 Certificate of Designations of (Incorporated by reference; Series E Preferred Stock previously filed as Exhibit 4.1 to the Registrant's Form 8-A dated November 17, 1993.) 4.13 Specimen Series E Preferred Stock (Incorporated by reference; Certificate previously filed as Exhibit 4.0 to the Registrant's Form 8-A dated November 17, 1993.) 10.0 Performance Rights Agreement, (Incorporated by reference; dated August 10, 1988, Between previously filed as Exhibit Donald J. Donahue and Magma 10.34 to the Registrant's Copper Company Copper Notes Registration Statement.) 10.1 Tax-Matters Agreement, dated (Incorporated by reference; as of March 6, 1987 between previously filed as 10I to Newmont Mining Corporation and the Registrant's Magma Copper Company Form 10.) 10.2 Tax Sharing Agreement between (Incorporated by reference; Newmont Mining Corporation and previously filed as Exhibit Magma Copper Company 10.15 to the Registrant's 1987 Form 10-K.) 10.3 Memorandum Agreement, dated (Incorporated by reference, July 1, 1989, between Magma previously filed as Exhibit Copper Company and the unions 40.0 to the Registrant's comprising the Magma Unity Council 1989 Form 10-K.) 10.4 Memorandum Agreement, dated (Incorporated by reference, November 1, 1991, between Magma previously filed as Exhibit Copper Company and the union 10.41 to the Registrant's comprising the Magma Unity 1991 Form 10-K.) Counsel 10.5 Reimbursement Agreement, dated (Incorporated by reference; as of December 1, 1984 between previously filed as Exhibit Magma Copper Company and National 10O to the Registrant's Westminister Bank PLC, New York Form 10.) Branch (Series 1984A Bonds) Exhibit Number Description 10.6 Loan Agreement, dated as of (Incorporated by reference; December 1, 1984, between The previously filed as Exhibit Industrial Development Authority 10K to the Registrant's of the County of Pinal and Magma Form 10.) Copper Company Series 1984A Bonds) 10.7 Reimbursement Agreement, dated (Incorporated by reference; as of December 1, 1984, between previously filed as Exhibit Magma Copper Company and National 10L to the Registrant's Westminster Bank PLC, New York Form 10.) Branch (Series 1984 Bonds) 10.8 Loan Agreement, dated as of (Incorporated by reference; December 1, 1984, between The previously filed as Exhibit Industrial Development Authority 10M to the Registrant's of the County of Pinal and Magma Form 10.) Copper Company (Series 1984 Bonds) 10.9 Letter Agreement amending the (Incorporated by reference; Reimbursement Agreement and previously filed as Exhibit Guaranty, among the Company, 10.12 to the Registrant's Newmont and National Westminster 1988 Warrants Registration Bank PLC, dated November 30, 1988 Statement.) 10.10 Loan Agreement dated as of (Incorporated by reference; December 1, 1992, between the previously filed as Exhibit Industrial Development Authority 10.11 to the Registrant's of the County of Pinal and Magma 1992 Form 10-K.) Copper Company (Series 1992 Bonds) 10.11 Reimbursement Agreement, dated (Incorporated by reference; as of December 1, 1992, between previously filed as Exhibit Magma Copper Company and Banque 10.12 to the Registrant's Nationale de Paris 1992 Form 10-K.) 10.12 Trust Agreement, dated as of (Incorporated by reference; March 10, 1987, among Newmont previously filed as Exhibit Mining Corporation, First 10.23 to the Registrant's Interstate Bank of Arizona and 1987 Form 10-K.) Magma Copper Company 10.13 Amendment to Trust Agreement, (Incorporated by reference; dated December 27, 1988, between previously filed as Exhibit Newmont Mining Corporation, 27.0 to the Registrant's Magma Copper Company and First 1988 Form 10-K.) Interstate Bank of Arizona, N.A. 10.14 User License, dated as of (Incorporated by reference; August 28, 1984, between previously filed as Exhibit Southwire Company and Magma 10.26 to the Registrant's Copper Company 1987 Form 10-K.) Exhibit Number Description 10.15 License Agreement, dated as of (Incorporated by reference; October 28, 1986, between previously filed as Exhibit Outokumpu Oy and Magma Copper 10.27 to the Registrant's Company 1987 Form 10-K.) 10.16 License Agreement, dated as of (Incorporated by reference; February 1, 1986, between Phelps previously filed as Exhibit Dodge Refining Corporation and 10.28 to the Registrant's Magma Copper Company 1987 Form 10-K.) 10.17 License Agreement, dated as of (Incorporated by reference; April 10, 1985, between MIM previously filed as Exhibit Technology Marketing Limited 10.30 to the Registrant's and Magma Copper Company 1987 Form 10-K.) 10.18 Purchase Agreement, dated (Incorporated by reference; November 20, 1988, between previously filed as Exhibit Magma Copper Company and 10.50 to the Registrant's Warburg, Pincus Capital Company, Copper Notes Registration L.P. Statement.) 10.19 Amendment to Purchase Agreement, (Incorporated by reference; dated November 30, 1988, between previously filed as Exhibit Magma Copper Company and Warburg, 10.27 to the Registrant's Pincus Capital Company, L.P. 1988 Warrants Registration Statement.) 10.20 Registration Rights Agreement, (Incorporated by reference; dated November 30, 1988, between previously filed as Exhibit Magma Copper Company and Warburg, 10.29 to the Registrant's Pincus Capital Company, L.P. 1988 Warrants Registration Statement.) 10.21 Revolving Credit Facility (Incorporated by reference; Agreement dated May 5, 1993 previously filed as Exhibit among Magma Copper Company 10.1 to the Registrant's and Chemical Bank, National Registration Statement on Westminster Bank PLC, and Form S-3 File No. other lenders 33-64030.) 10.22 1987 Stock Option and Stock (Incorporated by reference; Award Plan previously filed as Exhibit 10B to the Registrant's Form 10.) 10.23 Amendments to 1987 Stock (Incorporated by reference; Option and Stock Award Plan previously filed as Exhibit 28.1 to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1992.) Exhibit Number Description 10.24 1989 Stock Option and Stock (Incorporated by reference; Award Plan previously filed as Exhibit 35.0 to the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1989 (the "1989 Form 10-K.") 10.25 Amendments to 1989 Stock (Incorporated by reference; Option and Stock Award previously filed as Exhibit Plan 28.2 to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1992.) 10.26 1989 Stock Option Plan for (Incorporated by reference; Non-employee Directors previously filed as Exhibit 10.27 to the Registrant's 1991 Form 10-K.) 10.27 Amendment to 1989 Stock Option (Incorporated by reference; Plan for Non-Employee Directors previously filed as Exhibit 28 to the Registrant's Quarterly Report on Form 10-Q dated September 30, 1991.) 10.28 Excess Benefit Plan (Incorporated by reference; previously filed as Exhibit 10.28 to the Registrant's 1991 Form 10-K.) 10.29 Executive Supplemental Benefit (Incorporated by reference; Plan previously filed as Exhibit 10.29 to the Registrant's 1991 Form 10-K.) 10.30 Special Executive Supplemental (Incorporated by reference; Benefit Plan previously filed as Exhibit 10.30 to the Registrant's 1991 Form 10-K.) 10.31 Special Executive Deferred (Incorporated by reference; Compensation Plan previously filed as Exhibit 10.31 to the Registrant's 1991 Form 10-K.) 10.32 First Amendment to Special (Incorporated by reference; Executive Deferred Compensation previously filed as Exhibit Plan 10.33 to the Registrant's 1992 Form 10-K.) 10.33 Second Amendment to Special (Incorporated by reference; Executive Deferred Compensation previously filed as Exhibit Plan 10.34 to the Registrant's 1992 Form 10-K.) 10.34 1992 Restricted Stock Plan for (Incorporated by reference; Non-Employee Directors previously filed as Exhibit 28.3 to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1992.) Exhibit Number Description 10.35 Amendment to 1987 Stock Plan (Incorporated by reference; for Non-Employee Directors previously filed as Exhibit 10.36 to the Registrant's 1992 Form 10-K.) 10.36 1993 Revised Incentive Compensation Filed herewith. Plan Guidelines 10.37 Chief Executive Officer (Incorporated by reference; Supplemental Retirement Plan previously filed as Exhibit 10.38 to the Registrant's 1992 Form 10-K.) 10.38 Employment Agreement - (Generic Filed herewith. Copy) 10.39 Third Amendment to Employment Filed herewith. Agreement between J. B. Winter and Magma Copper Company 10.40 Retention and Severance Benefit Filed herewith. Agreement between Magma Copper Company and J. B. Winter 10.41 Revised 1993 Long-Term Incentive Filed herewith. Plan guidelines 10.42 1993 Stock Option and Stock (Incorporated by reference; Award Plan previously filed as Exhibit 4 to the Registrant's Form S-8 Registration Statement, File No. 33-64766.) 10.43 First amendment to the Magma Filed herewith. Copper Company Executive Supplemental Benefit Plan 10.44 Second amendment to the Magma Filed herewith. Copper Company Executive Supplemental Benefit Plan 10.45 First Amendment to the Magma Filed herewith. Copper Company Special Executive Supplemental Benefit Plan 10.46 Second Amendment to the Magma Filed herewith. Copper Company Special Executive Supplemental Benefit Plan 11.0 Statement re: computation of Filed herewith. per share earnings 21.0 Subsidiaries of Magma Copper Filed herewith. Company 23.0 Consent of independent public Filed herewith. accountant 99.0 Statement re: indemnification (Incorporated by reference; of directors, officers and previously filed as Exhibit controlling persons 28.0 to the Registrant's 1990 Form 10-K.) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MAGMA COPPER COMPANY By:/s/ Donald J. Donahue (Donald J. Donahue) Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant in the capacities and on the dates indicated. Signature Title Date Chairman of the Board /s/ Donald J. Donahue and Director March 10, 1994 (Donald J. Donahue) President, Chief Executive Officer, Director /s/ J. Burgess Winter (Principal Executive Officer) March 10, 1994 (J. Burgess Winter) Vice President and /s/ Douglas J. Purdom Chief Financial Officer March 10, 1994 (Douglas J. Purdom) (Principal Financial and Accounting Officer) /s/ Christopher W. Brody Director March 10, 1994 (Christopher W. Brody) /s/ Judd R. Cool Director March 10, 1994 (Judd R. Cool) /s/ John W. Goth Director March 10, 1994 (John W. Goth) /s/ John R. Kennedy Director March 10, 1994 (John R. Kennedy) /s/ Thomas W. Rollins Director March 10, 1994 (Thomas W. Rollins) /s/ Henry B. Sargent Director March 10, 1994 (Henry B. Sargent) /s/ Simon D. Strauss Director March 10, 1994 (Simon D. Strauss) /s/ H. Wilson Sundt Director March 10, 1994 (H. Wilson Sundt) /s/ John L. Vogelstein Director March 10, 1994 (John L. Vogelstein) ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Consolidated Financial Statements: Index on page 42 of this Report. 2. Consolidated Financial Statement Schedules: Index on page 42 of this Report. 3. Exhibits. The exhibits as indexed on pages 83 through 91 of this Report are included as a part of this Form 10-K. (b) Reports on Form 8-K: The following reports on Form 8-K were filed by the registrant during the three months ended December 31, 1993: The Company filed a report on Form 8-K, dated November 17, 1993, to announce a proposed public offering of up to $100 million principal amount of Cumulative Convertible Preferred Stock, Series E, par value $.01 per share. The Company also announced that it had established a hedging program covering a portion of its 1994 production. The Company filed a report on Form 8-K, dated November 24, 1993, to announce the conclusion of the sale of $100 million of Series E Preferred Stock. Exhibit Number Description 3.1 Restated Certificate of Incorporation (Incorporated by reference; of Magma Copper Company, dated previously filed as Exhibit February 21, 1991 3.4 to the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1990.) 3.2 Certificate of Correction to Restated (Incorporated by reference; Certificate of Incorporation of previously filed as Exhibit Magma Copper Company dated 3.2 to the Registrant's February 27, 1992 annual report on Form 10-K for the fiscal year ended December 31, 1991.) 3.3 Certificate of Amendment to (Incorporated by reference; Restated Certification of previously filed as Exhibit Incorporation of Magma Copper 3.3 to the Registrant's Company dated October 30, 1992 1992 Form 10-K.) 3.4 By-laws of Magma Copper Company (Incorporated by reference; as amended to and including previously filed as Exhibit July 22, 1992 3.4 to the Registrant's 1992 Form 10-K.) 4.0 Specimen Common Stock Certificate (Incorporated by reference; previously filed as Exhibit 4.0 to the Registrant's 1992 Form 10-K.) 4.1 Specimen Warrant Certificate (Incorporated by reference; previously filed as Exhibit 4.1 to the Registrant's 1988 Warrants Registration Statement.) 4.2 Form of Warrant Agreement, dated (Incorporated by reference; as of December 15, 1988, between previously filed as Exhibit the Company and Manufacturers 4.2 to the Registrant's Hanover Trust Company, as warrant 1988 Warrants Registration agent Statement.) 4.3 Form of Note Indenture for 12% (Incorporated by reference; Senior Subordinated Notes due previously filed as Exhibit 2001, dated December 15, 1991 4 to the Registrant's Current Report on Form 8-K dated January 9, 1992.) Exhibit Number Description 4.4 Specimen of 12% Note (Incorporated by reference; previously filed as Article Two of Exhibit 4 to the Registrant's Current Report on Form 8-K dated January 9, 1992.) 4.5 Form of 11.5% Note Indenture for (Incorporated by reference; 11.5% Senior Subordinated Notes previously filed as Exhibit due 2002, dated January 15, 1992 28B to the Registrant's Current Report on Form 8-K dated January 17, 1992.) 4.6 Specimen of 11.5% Note (Incorporated by reference; previously filed as Article Two of Exhibit 28B to the Registrant's Current Report on Form 8-K dated January 17, 1992.) 4.7 Certificate of Designation of (Incorporated by reference; Series B Preferred Stock previously filed as Exhibit 3.6 to the Registrant's Registration Statement on Form S-1, File No. 33-24960 (the "Copper Notes Registration Statement").) 4.8 Amendment to Certificate of (Incorporated by reference; Designation of Series B previously filed as Exhibit Preferred Stock 3.6 to the Registrant's Statement on Form S-1, File No. 33-26294 (the "1988 Warrants Registration Statement").) 4.9 Certificate of Decrease in (Incorporated by reference; the Number of Authorized Shares previously filed as Exhibit of Series B Preferred Stock 3.7 to the Registrant's 1992 Form 10-K.) 4.10 Certificate of Designations of (Incorporated by reference; Series D Preferred Stock previously filed as Exhibit 4.0 to the Registrant's Current Report on Form 8-K dated July 12, 1993.) Exhibit Number Description 4.11 Specimen Series D Preferred (Incorporated by reference; Stock Certificate previously filed as Exhibit 4.0 to the Registrant's Form 8-A dated July 8, 1993.) 4.12 Certificate of Designations of (Incorporated by reference; Series E Preferred Stock previously filed as Exhibit 4.1 to the Registrant's Form 8-A dated November 17, 1993.) 4.13 Specimen Series E Preferred Stock (Incorporated by reference; Certificate previously filed as Exhibit 4.0 to the Registrant's Form 8-A dated November 17, 1993.) 10.0 Performance Rights Agreement, (Incorporated by reference; dated August 10, 1988, Between previously filed as Exhibit Donald J. Donahue and Magma 10.34 to the Registrant's Copper Company Copper Notes Registration Statement.) 10.1 Tax-Matters Agreement, dated (Incorporated by reference; as of March 6, 1987 between previously filed as 10I to Newmont Mining Corporation and the Registrant's Magma Copper Company Form 10.) 10.2 Tax Sharing Agreement between (Incorporated by reference; Newmont Mining Corporation and previously filed as Exhibit Magma Copper Company 10.15 to the Registrant's 1987 Form 10-K.) 10.3 Memorandum Agreement, dated (Incorporated by reference, July 1, 1989, between Magma previously filed as Exhibit Copper Company and the unions 40.0 to the Registrant's comprising the Magma Unity Council 1989 Form 10-K.) 10.4 Memorandum Agreement, dated (Incorporated by reference, November 1, 1991, between Magma previously filed as Exhibit Copper Company and the union 10.41 to the Registrant's comprising the Magma Unity 1991 Form 10-K.) Counsel 10.5 Reimbursement Agreement, dated (Incorporated by reference; as of December 1, 1984 between previously filed as Exhibit Magma Copper Company and National 10O to the Registrant's Westminister Bank PLC, New York Form 10.) Branch (Series 1984A Bonds) Exhibit Number Description 10.6 Loan Agreement, dated as of (Incorporated by reference; December 1, 1984, between The previously filed as Exhibit Industrial Development Authority 10K to the Registrant's of the County of Pinal and Magma Form 10.) Copper Company Series 1984A Bonds) 10.7 Reimbursement Agreement, dated (Incorporated by reference; as of December 1, 1984, between previously filed as Exhibit Magma Copper Company and National 10L to the Registrant's Westminster Bank PLC, New York Form 10.) Branch (Series 1984 Bonds) 10.8 Loan Agreement, dated as of (Incorporated by reference; December 1, 1984, between The previously filed as Exhibit Industrial Development Authority 10M to the Registrant's of the County of Pinal and Magma Form 10.) Copper Company (Series 1984 Bonds) 10.9 Letter Agreement amending the (Incorporated by reference; Reimbursement Agreement and previously filed as Exhibit Guaranty, among the Company, 10.12 to the Registrant's Newmont and National Westminster 1988 Warrants Registration Bank PLC, dated November 30, 1988 Statement.) 10.10 Loan Agreement dated as of (Incorporated by reference; December 1, 1992, between the previously filed as Exhibit Industrial Development Authority 10.11 to the Registrant's of the County of Pinal and Magma 1992 Form 10-K.) Copper Company (Series 1992 Bonds) 10.11 Reimbursement Agreement, dated (Incorporated by reference; as of December 1, 1992, between previously filed as Exhibit Magma Copper Company and Banque 10.12 to the Registrant's Nationale de Paris 1992 Form 10-K.) 10.12 Trust Agreement, dated as of (Incorporated by reference; March 10, 1987, among Newmont previously filed as Exhibit Mining Corporation, First 10.23 to the Registrant's Interstate Bank of Arizona and 1987 Form 10-K.) Magma Copper Company 10.13 Amendment to Trust Agreement, (Incorporated by reference; dated December 27, 1988, between previously filed as Exhibit Newmont Mining Corporation, 27.0 to the Registrant's Magma Copper Company and First 1988 Form 10-K.) Interstate Bank of Arizona, N.A. 10.14 User License, dated as of (Incorporated by reference; August 28, 1984, between previously filed as Exhibit Southwire Company and Magma 10.26 to the Registrant's Copper Company 1987 Form 10-K.) Exhibit Number Description 10.15 License Agreement, dated as of (Incorporated by reference; October 28, 1986, between previously filed as Exhibit Outokumpu Oy and Magma Copper 10.27 to the Registrant's Company 1987 Form 10-K.) 10.16 License Agreement, dated as of (Incorporated by reference; February 1, 1986, between Phelps previously filed as Exhibit Dodge Refining Corporation and 10.28 to the Registrant's Magma Copper Company 1987 Form 10-K.) 10.17 License Agreement, dated as of (Incorporated by reference; April 10, 1985, between MIM previously filed as Exhibit Technology Marketing Limited 10.30 to the Registrant's and Magma Copper Company 1987 Form 10-K.) 10.18 Purchase Agreement, dated (Incorporated by reference; November 20, 1988, between previously filed as Exhibit Magma Copper Company and 10.50 to the Registrant's Warburg, Pincus Capital Company, Copper Notes Registration L.P. Statement.) 10.19 Amendment to Purchase Agreement, (Incorporated by reference; dated November 30, 1988, between previously filed as Exhibit Magma Copper Company and Warburg, 10.27 to the Registrant's Pincus Capital Company, L.P. 1988 Warrants Registration Statement.) 10.20 Registration Rights Agreement, (Incorporated by reference; dated November 30, 1988, between previously filed as Exhibit Magma Copper Company and Warburg, 10.29 to the Registrant's Pincus Capital Company, L.P. 1988 Warrants Registration Statement.) 10.21 Revolving Credit Facility (Incorporated by reference; Agreement dated May 5, 1993 previously filed as Exhibit among Magma Copper Company 10.1 to the Registrant's and Chemical Bank, National Registration Statement on Westminster Bank PLC, and Form S-3 File No. other lenders 33-64030.) 10.22 1987 Stock Option and Stock (Incorporated by reference; Award Plan previously filed as Exhibit 10B to the Registrant's Form 10.) 10.23 Amendments to 1987 Stock (Incorporated by reference; Option and Stock Award Plan previously filed as Exhibit 28.1 to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1992.) Exhibit Number Description 10.24 1989 Stock Option and Stock (Incorporated by reference; Award Plan previously filed as Exhibit 35.0 to the Registrant's annual report on Form 10-K for the fiscal year ended December 31, 1989 (the "1989 Form 10-K.") 10.25 Amendments to 1989 Stock (Incorporated by reference; Option and Stock Award previously filed as Exhibit Plan 28.2 to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1992.) 10.26 1989 Stock Option Plan for (Incorporated by reference; Non-employee Directors previously filed as Exhibit 10.27 to the Registrant's 1991 Form 10-K.) 10.27 Amendment to 1989 Stock Option (Incorporated by reference; Plan for Non-Employee Directors previously filed as Exhibit 28 to the Registrant's Quarterly Report on Form 10-Q dated September 30, 1991.) 10.28 Excess Benefit Plan (Incorporated by reference; previously filed as Exhibit 10.28 to the Registrant's 1991 Form 10-K.) 10.29 Executive Supplemental Benefit (Incorporated by reference; Plan previously filed as Exhibit 10.29 to the Registrant's 1991 Form 10-K.) 10.30 Special Executive Supplemental (Incorporated by reference; Benefit Plan previously filed as Exhibit 10.30 to the Registrant's 1991 Form 10-K.) 10.31 Special Executive Deferred (Incorporated by reference; Compensation Plan previously filed as Exhibit 10.31 to the Registrant's 1991 Form 10-K.) 10.32 First Amendment to Special (Incorporated by reference; Executive Deferred Compensation previously filed as Exhibit Plan 10.33 to the Registrant's 1992 Form 10-K.) 10.33 Second Amendment to Special (Incorporated by reference; Executive Deferred Compensation previously filed as Exhibit Plan 10.34 to the Registrant's 1992 Form 10-K.) 10.34 1992 Restricted Stock Plan for (Incorporated by reference; Non-Employee Directors previously filed as Exhibit 28.3 to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1992.) Exhibit Number Description 10.35 Amendment to 1987 Stock Plan (Incorporated by reference; for Non-Employee Directors previously filed as Exhibit 10.36 to the Registrant's 1992 Form 10-K.) 10.36 1993 Revised Incentive Compensation Filed herewith. Plan Guidelines 10.37 Chief Executive Officer (Incorporated by reference; Supplemental Retirement Plan previously filed as Exhibit 10.38 to the Registrant's 1992 Form 10-K.) 10.38 Employment Agreement - (Generic Filed herewith. Copy) 10.39 Third Amendment to Employment Filed herewith. Agreement between J. B. Winter and Magma Copper Company 10.40 Retention and Severance Benefit Filed herewith. Agreement between Magma Copper Company and J. B. Winter 10.41 Revised 1993 Long-Term Incentive Filed herewith. Plan guidelines 10.42 1993 Stock Option and Stock (Incorporated by reference; Award Plan previously filed as Exhibit 4 to the Registrant's Form S-8 Registration Statement, File No. 33-64766.) 10.43 First amendment to the Magma Filed herewith. Copper Company Executive Supplemental Benefit Plan 10.44 Second amendment to the Magma Filed herewith. Copper Company Executive Supplemental Benefit Plan 10.45 First Amendment to the Magma Filed herewith. Copper Company Special Executive Supplemental Benefit Plan 10.46 Second Amendment to the Magma Filed herewith. Copper Company Special Executive Supplemental Benefit Plan 11.0 Statement re: computation of Filed herewith. per share earnings 21.0 Subsidiaries of Magma Copper Filed herewith. Company 23.0 Consent of independent public Filed herewith. accountant 99.0 Statement re: indemnification (Incorporated by reference; of directors, officers and previously filed as Exhibit controlling persons 28.0 to the Registrant's 1990 Form 10-K.) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MAGMA COPPER COMPANY By:/s/ Donald J. Donahue (Donald J. Donahue) Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant in the capacities and on the dates indicated. Signature Title Date Chairman of the Board /s/ Donald J. Donahue and Director March 10, 1994 (Donald J. Donahue) President, Chief Executive Officer, Director /s/ J. Burgess Winter (Principal Executive Officer) March 10, 1994 (J. Burgess Winter) Vice President and /s/ Douglas J. Purdom Chief Financial Officer March 10, 1994 (Douglas J. Purdom) (Principal Financial and Accounting Officer) /s/ Christopher W. Brody Director March 10, 1994 (Christopher W. Brody) /s/ Judd R. Cool Director March 10, 1994 (Judd R. Cool) /s/ John W. Goth Director March 10, 1994 (John W. Goth) /s/ John R. Kennedy Director March 10, 1994 (John R. Kennedy) /s/ Thomas W. Rollins Director March 10, 1994 (Thomas W. Rollins) /s/ Henry B. Sargent Director March 10, 1994 (Henry B. Sargent) /s/ Simon D. Strauss Director March 10, 1994 (Simon D. Strauss) /s/ H. Wilson Sundt Director March 10, 1994 (H. Wilson Sundt) /s/ John L. Vogelstein Director March 10, 1994 (John L. Vogelstein)

89089_1993.txt

89089_1993

1993

89089

ITEM 1. BUSINESS. Service Corporation International was incorporated in Texas on July 5, 1962. The term "Company" includes the registrant and its subsidiaries, unless the context indicates otherwise. The Company is the largest publicly-held funeral/cemetery company in North America. At December 31, 1993, the Company operated 792 funeral homes and 192 cemeteries located in 39 states, the District of Columbia, four provinces in Canada and five Australian states, and other funeral and cemetery related businesses. In addition, the Company provides capital financing to independent funeral home and cemetery operators. In 1993, the Company acquired an Australian funeral/cemetery company. This was the Company's first acquisition of a firm located outside of North America. Including this acquisition, the Company in 1993 acquired 124 funeral homes and 21 cemeteries through acquisitions. The Company has acquired most of its present operations through acquisitions and has from time to time divested itself of certain properties and/or operations previously acquired. The Company continues to review the possible acquisition of various related businesses. For information regarding acquisitions of funeral home and cemetery operations in 1993, see Note 3 to the consolidated financial statements in Item 8 of this Form 10-K. For financial information about the Company's industry segments, including the identifiable assets of the Company by industry segments, see Note 14 to the consolidated financial statements in Item 8 of this Form 10-K. FUNERAL SERVICES OPERATION The Funeral Services Operation consists of the Company's funeral homes, cemeteries and related businesses. The operation is organized into six domestic and two foreign (Australia and Canada) regional groups, each of which is under the direction of a regional president. Canadian operations are carried out by a public company which is approximately 70% owned by the Company. Local funeral home and cemetery managers, under the direction of the regional presidents, receive support and resources from Houston headquarters and have substantial autonomy with respect to the manner in which services are conducted. To enhance operational efficiency, the majority of the Company's funeral homes and cemeteries within a region are managed in groups called clusters. The clusters, primarily designated in metropolitan areas, allow funeral homes and cemeteries to share operating expenses such as service personnel, vehicles, preparation services, clerical staff and certain building facility costs. Funeral Homes. The funeral homes provide all professional services relating to funerals, including the use of funeral facilities and motor vehicles. Funeral homes sell caskets, burial vaults, cremation receptacles, flowers and burial garments and also operate 75 crematories. The Funeral Services Operation owns 84 funeral home/cemetery combinations and operates 50 flower shops engaged principally in the design and sale of funeral floral arrangements. These flower shops provide floral arrangements to some of the Company's funeral homes and cemeteries. The Company markets prearranged funeral services. Funeral prearrangement is a means through which a customer contractually agrees to the terms of a funeral to be performed in the future. Payments on prearranged funerals currently offered by the Company are deposited into trust funds or are used to purchase life insurance or annuity contracts issued primarily by third party insurers. Funds paid on prearranged funerals may not be withdrawn until death or cancellation by the customer. For additional information concerning prearranged funeral activities, see Notes 4 and 8 to the consolidated financial statements in Item 8 of this Form 10-K. The Funeral Services Operation has multiple funeral homes and cemeteries in a number of metropolitan areas. Within individual metropolitan areas, the funeral homes and cemeteries operate under various names because most operations were acquired as going businesses and continue to be operated under the same name as before acquisition. The death rate tends to be somewhat higher in the winter months and the funeral homes generally experience a higher volume of business during those months. The funeral home industry is characterized by a large number of independent operations, the vast majority of which are locally owned and operated. The Company believes that there are in excess of 22,000 funeral homes operating in the United States. There are many entities operating multiple branches, but none have as many funeral homes or cover as many geographic areas as the Company. In order to compete successfully, each of the Company's funeral homes must maintain competitive prices, attractive, well-maintained and conveniently located facilities, a good reputation and high professional standards. In April 1984, the Federal Trade Commission (FTC) comprehensive trade regulation rule for the funeral industry became fully effective. The rule contains minimum guidelines for funeral industry practices, requires extensive price and other affirmative disclosures and imposes mandatory itemization of funeral goods and services. A pre-existing consent order between the Company and the FTC applicable to certain funeral practices of the Company was amended in 1984 to make the consent order consistent with the funeral trade regulation rule. From time to time in connection with acquisitions, the Company has entered into consent orders with the FTC which limit the Company's ability to make acquisitions in specified areas and/or which require the Company to dispose of certain operations. The trade regulation rule and the consent orders have not had a materially adverse effect on the Company's operations. Cemeteries. The Company's cemeteries sell cemetery interment rights (including mausoleum spaces and lawn crypts) and certain merchandise including stone and bronze memorials and burial vaults. The Company's cemeteries also perform interment services and provide management and maintenance of cemetery grounds. Certain cemeteries also include crematory operations. Cemetery sales are often made on a pre-need basis pursuant to installment contracts providing for monthly payments. A portion of the proceeds from cemetery sales is generally required by law to be paid into perpetual care trust funds. Earnings of perpetual care trust funds are used to defray the maintenance cost of cemeteries. In addition, a portion of the proceeds from the sale of pre-need cemetery merchandise and services may be required to be paid into trust funds. For additional information regarding cemetery trust funds, see Note 1 to the consolidated financial statements in Item 8 of this Form 10-K. The cemetery industry is characterized by a large number of independent operations, the vast majority of which are locally owned and operated. Each of the Company's cemeteries competes with other firms in the same general area. In order to compete successfully, each of the Company's cemeteries must maintain competitive prices, attractive and well kept properties, a good reputation and an effective sales force. FINANCIAL SERVICES OPERATION In 1988, the Company formed Provident Services, Inc. ("Provident") to provide capital financing to independent funeral home and cemetery operators. The majority of Provident's loans are made to clients seeking to finance funeral home or cemetery acquisitions. Additionally, Provident provides construction loans for funeral home or cemetery improvement and expansion. Loan packages take traditional forms of secured financing comparable to arrangements offered by leading commercial banks. Provident's loans are generally made at interest rates which fluctuate with the prime lending rate. Provident had $250,000,000 in loans outstanding at December 31, 1993 and unfunded loan commitments amounting to $19,499,000. Such loans outstanding increased from $187,000,000 in loans outstanding at December 31, 1992. Provident obtains its funds primarily from the Company's bank borrowings. Provident is in competition with banks and other lending institutions, many of which have substantially greater resources than Provident. However, Provident believes that its knowledge of the death care industry provides it with the ability to make more accurate assessments of funeral home and cemetery industry loans, thereby providing Provident a competitive advantage in the industry. EMPLOYEES At December 31, 1993, the Company employed 8,985 persons on a full time basis and 3,731 persons on a part time basis. Of the full time employees 427 were in corporate services, 8,550 were in the Funeral Services Operation, and eight were in Financial Services. All of the Company's eligible employees who so elect are covered by the Company's group health and life insurance plans, and all eligible employees are participants in retirement plans of the Company or various subsidiaries. At December 31, 1993, 747 employees were covered by collective bargaining agreements. Although disputes are experienced from time to time, in general, relations with employees are considered satisfactory. REGULATION The Company's various operations are subject to regulations, supervision and licensing under various federal, state, local and Canadian and Australian statutes, ordinances and regulations. The Company believes that it is in substantial compliance with the significant provisions of such statutes, ordinances and regulations. See discussion of FTC funeral industry trade regulation and consent orders in "Funeral Homes" above. ITEM 2. ITEM 2. PROPERTIES. The Company's executive headquarters and the offices of management personnel of the Funeral and Financial Service Operations are located at 1929 Allen Parkway, Houston, Texas 77019, in a 12-story office building. A wholly-owned subsidiary of the Company owns an undivided one-half interest in the underlying fee to the building and its parking garage. The property consists of approximately 1.3 acres, 250,000 square feet of office space in the building and 160,000 square feet of parking space in the garage. The Company leases all of the office space in the building pursuant to a lease that expires June 30, 1995 providing for monthly rent of $87,000. The rent is subject to escalation for all operating expenses above base year operating expenses. One half of the rent is paid to the wholly-owned subsidiary and the other half is paid to the owner of the remaining undivided one-half interest. The Company owns and utilizes a three-story building at 1919 Allen Parkway, Houston, Texas 77019 containing 43,000 square feet of office space. The Company owns the facilities of certain closed casket manufacturing operations. At December 31, 1993, the Company owned the real estate and buildings of 803 of its funeral home and cemetery locations and leased facilities in connection with 181 of such operations. In addition, the Company leased two aircraft pursuant to a cancellable lease. At December 31, 1993, the Company operated 3,831 vehicles, of which 1,805 were owned and 2,026 were leased. For additional information regarding leases, see Note 9 to the consolidated financial statements in Item 8 of this Form 10-K. The Company's 192 cemeteries contain an aggregate of approximately 14,600 acres of which approximately 58% are developed. The specialized nature of the Company's businesses requires that its facilities be well maintained and kept in good condition. Management believes that these standards are met. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The staff of the Securities and Exchange Commission (the "Commission") is conducting an informal private investigation relating to the change in the Company's principal independent accountants and the Company's Current Report on Form 8-K dated March 31, 1993, as amended, filed with the Commission reporting such change, as well as the Company's current accounting and reporting of pre-need sales. The Commission staff has advised the Company that the investigation should not be construed as an indication by the Commission or its staff that any violations of law have occurred, or as a reflection upon any person, entity or security. The investigation is continuing. Also see Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure in this Form 10-K. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. EXECUTIVE OFFICERS OF THE COMPANY Pursuant to General Instruction G to Form 10-K, the information regarding executive officers of the Company called for by Item 401 of Regulation S-K is hereby included in Part I of this report. The following table sets forth as of March 25, 1994 the name and age of each executive officer of the Company, the office held, and the date first elected an officer. - --------------- (1) Indicates the year a person was first elected as an officer although there were subsequent periods when certain persons ceased being officers of the Company. Unless otherwise indicated below, the persons listed above have been executive officers or employees for more than five years. Mr. Morrow was elected as an executive Vice President in May 1991. From May 1990 to May 1991, Mr. Morrow was President of SCI Funeral Services, Inc., a subsidiary of the Company. From February 1990 to May 1990, Mr. Morrow was President and Chief Operating Officer of the Funeral Service Division of the Company. From August 1989 to February 1990, Mr. Morrow was an officer of the Company serving as Executive Vice President. Prior thereto, Mr. Morrow was President and owner of J. W. Morrow Investment Company, a funeral home business, and also provided consulting services to the Company. Mr. Pullins joined the Company in September 1991 and was elected to his present position in February 1992. Prior thereto from January 1987 through August 1991, Mr. Pullins was President, Chief Executive Officer and Chief Operating Officer of Sentinel Group, Inc., a funeral service company. Mr. Stoner joined the Company in September 1991 and was elected to his present position in August 1992. Prior thereto for more than five years, Mr. Stoner was a general partner and Director of Tax of Ernst & Young (formerly Arthur Young & Company), certified public accountants. Each officer of the Company is elected by the Board of Directors and holds his office until his successor is elected and qualified or until his earlier death, resignation or removal in the manner prescribed in the Bylaws of the Company. Each officer of a subsidiary of the Company is elected by the subsidiary's board of directors and holds his office until his successor is elected and qualified or until his earlier death, resignation or removal in the manner prescribed in the bylaws of the subsidiary. There is no family relationship between any of the persons in the preceding table except that W. Blair Waltrip is a son of R. L. Waltrip, that T. Craig Benson is a son-in-law to R. L. Waltrip and that T. Craig Benson is a brother-in-law to W. Blair Waltrip. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company's common stock has been traded on the New York Stock Exchange since May 14, 1974. On March 21, 1994, there were approximately 8,700 holders of record of the Company's common stock. The Company has declared 83 consecutive quarterly dividends on its common stock since it began paying dividends in 1974. The dividend rate is $.105 per quarter, or an indicated annual rate of $.42. For the three years ended December 31, 1993, dividends were $.40, $.39 and $.37, respectively. The table below shows the Company's quarterly high and low common stock prices: SRV is the New York Stock Exchange ticker symbol for the common stock of Service Corporation International. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. (See notes on following page) - --------------- * The year ended December 31, 1993 reflects the change in accounting principles adopted January 1, 1993. The four years ended December 31, 1992 reflect results as historically reported. ** For purposes of computing the ratio of earnings to fixed charges, earnings consist of income before income taxes from continuing operations, less undistributed income of equity investees which are less than 50% owned, plus the minority interest of majority-owned subsidiaries with fixed charges, and plus fixed charges (excluding capitalized interest and preferred dividends). Fixed charges consist of interest expense, whether capitalized or expensed, amortization of debt costs, one-third of rental expense which the Company considers representative of the interest factor in the rentals and preferred dividends. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ORGANIZATION The majority of the Company's funeral homes and cemeteries are managed in groups called clusters. Clusters are primarily designated in metropolitan areas to take advantage of operational efficiencies, including the sharing of operating expenses such as service personnel, vehicles, preparation services, clerical staff and certain building facility costs. The Company has approximately 165 clusters which range in size from two to 46 operations. There may be more than one cluster in a given metropolitan area, depending upon the level and degree of shared costs. The cluster management approach recognizes that, as the Company adds operations to a geographic area that contains an existing Company presence, additional economies of scale through cost sharing will be achieved and the Company will also be in a better position to serve the population that resides within the area served by the cluster. Funeral service and cemetery operations primarily depend upon a long-term development of customer relationships and loyalty. Over time, these client families may relocate within a cluster area which may justify the relocation or addition of Company locations. The Company has attempted to satisfy this need for convenient locations by either acquiring existing independent locations within the Company's cluster areas or constructing satellite funeral homes (sometimes on Company-owned cemeteries) while still maintaining the sharing of certain expenses within that cluster of operations. CHANGE IN ACCOUNTING PRINCIPLES Effective January 1, 1993, the Company changed its method of accounting for prearranged funeral service contracts and cemetery sales. For a more detailed discussion of these changes, see Note 2 to the consolidated financial statements in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND RELATED SCHEDULES All other schedules have been omitted because the required information is not applicable or is not present in amounts sufficient to require submission or because the information required is included in the consolidated financial statements or the related notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Service Corporation International We have audited the consolidated financial statements and the financial statement schedules of Service Corporation International listed in the index on page 14 of this Form 10-K as of December 31, 1993 and for the year then ended. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Service Corporation International as of December 31, 1993, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes Two and Six to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for prearranged funeral contracts and cemetery sales and income taxes. COOPERS & LYBRAND Houston, Texas February 8, 1994 REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors and Shareholders Service Corporation International We have audited the accompanying consolidated balance sheet of Service Corporation International as of December 31, 1992 and the related consolidated statements of income, stockholders' equity and cash flows for each of the two years in the period ended December 31, 1992. Our audits also included the financial statement schedules for the years ended December 31, 1992 and 1991 listed in the index at Item 8. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Service Corporation International at December 31, 1992 and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules for the years ended December 31, 1992 and 1991, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Houston, Texas February 8, 1993 SERVICE CORPORATION INTERNATIONAL CONSOLIDATED STATEMENT OF INCOME (See notes) SERVICE CORPORATION INTERNATIONAL CONSOLIDATED BALANCE SHEET ASSETS (See notes) SERVICE CORPORATION INTERNATIONAL CONSOLIDATED STATEMENT OF CASH FLOWS (See notes) SERVICE CORPORATION INTERNATIONAL CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (See notes) SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE ONE SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation: The consolidated financial statements include the accounts of Service Corporation International and all wholly-owned subsidiaries (the Company). Significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications of prior years have been made to conform to current period classifications. Cash equivalents: The Company considers all liquid investments purchased with a maturity of three months or less to be cash equivalents and the carrying amount approximates fair value because of the short maturity. Inventories: Inventories, consisting of funeral merchandise and cemetery space and merchandise, are stated at cost, which is not in excess of market, determined using average cost. Depreciation and amortization: Depreciation and amortization of property, plant and equipment is provided using the straight line method over the estimated useful lives of the various classes of assets. Maintenance and repairs are charged to expense whereas renewals and major replacements are capitalized. Cemetery trust funds: Generally, a portion of the proceeds from the sale of cemetery lots is required by state law to be paid into perpetual care trust funds. Earnings from these trusts are recognized in current cemetery revenues and are intended to defray cemetery maintenance costs. The amount of perpetual care funds trusted at December 31, 1993 and 1992 was $197,969,000 and $183,206,000, respectively, and such principal generally cannot be withdrawn by the Company (see Note 2). Additionally, pursuant to state law, a portion of the proceeds from the sale of preneed cemetery merchandise and services may also be required to be paid into trust funds. Merchandise and service trusts, which were previously included in investments on the Consolidated Balance Sheet, are now classified as long-term receivables. The Company recognizes income on these merchandise and service trusts in current cemetery revenues as trust earnings accrue to defray inflation costs recognized related to the unpurchased cemetery merchandise. For the three years ended December 31, 1993, the earnings on trusts recognized for all cemetery trusts was $23,721,000, $18,910,000 and $17,843,000, respectively. Deferred obtaining costs: Included in "Deferred prearranged funeral contract revenues" on the Consolidated Balance Sheet are obtaining costs, including sales commissions and certain other direct marketing costs, applicable to prearranged funeral contracts which are deferred and will be expensed when the service is performed. The aggregate costs deferred as of December 31, 1993 and 1992 were $32,518,000 and $23,934,000, respectively. Names and reputations: The excess of purchase price over the fair value of identifiable net tangible assets acquired in transactions accounted for as a purchase are included in "Names and reputations" and generally amortized on a straight line basis over 40 years which, in the opinion of management, is not necessarily the maximum period benefited. Many of the Company's acquired funeral homes have been providing high quality service to client families for many decades and such loyalty often forms the basic valuation of a funeral business. The amortization charged against income was $10,339,000, $9,601,000 and $4,785,000 for the three years ended December 31, 1993, respectively. Fair values are determined by management or independent appraisals. NOTE TWO CHANGE IN ACCOUNTING PRINCIPLES The Company changed the following accounting principles effective January 1, 1993. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (A) All price guaranteed prearranged funeral sales contracts are included in the accompanying balance sheet as a long-term asset with a corresponding credit to deferred prearranged funeral contract revenues. Insurance funded contracts were previously disclosed in a note to the financial statements and certain trust funded contracts were previously included under investments and prearranged funeral obligations. This change has no effect on the existing policy of recognizing revenue when the funeral service is performed. (B) Prearranged funeral trust earnings previously recognized as current income are now deferred until the funeral service is performed. Increasing benefits under insurance funded contracts are now accrued and deferred until the funeral service is performed. (C) Preneed sales of cemetery interment rights and other related products and services are recorded as revenues when customer contracts are signed with concurrent recognition of related costs. Allowances for customer cancellations and refunds are provided at the date of sale based upon historical experience. Previously, such sales were generally deferred under accounting principles prescribed for sales of real estate. Under the Company's application of this method of accounting for sales of real estate, revenues and costs were deferred until 20% of the contract amount had been collected. (D) Funds held in perpetual care cemetery trusts were previously included on the Consolidated Balance Sheet in investments and cemetery perpetual care obligations, whereas now such amounts are excluded. The accounting changes were made principally for the following reasons and are described below in the order referred to above. (A) The Company believes this accounting is more informative and provides better disclosure of the future economic events because the activity is all reported on the Consolidated Balance Sheet. (B) Funeral trust earnings and increasing benefits under insurance contracts are intended to cover increases in the future costs of providing price guaranteed funeral services. Accrued trust earnings were previously recognized in current income and a provision was made for the estimated effect of inflation on the costs of merchandise purchased by the Company. Trust earnings are now deferred until performance of the funeral service and increasing benefits under insurance funded contracts will be accounted for similarly. The Company believes this policy will better match revenues and costs because the total funds (principal and accrued earnings) available to satisfy the contract will be included in revenues when the funeral service is performed together with all costs related to performance of the service. (C) This method of cemetery accounting has been adopted because all significant remaining obligations of the Company have been satisfied in the period the contract is signed. Related costs are provided based on actual costs incurred, firm commitments or reliable estimates. Historical experience is the basis for making appropriate allowances for customer cancellations and will be adjusted when required. (D) Cemetery perpetual care trusts are excluded from the Consolidated Balance Sheet because the Company generally does not have the right to withdraw the principal. The cumulative effect, through December 31, 1992, of changing these accounting principles resulted in a charge to first quarter 1993 net income of $2,031,000 (net of a $1,354,000 tax benefit), or $.03 per share. For the year ended December 31, 1993, the effect of the change in accounting principles resulted in a decrease in SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) net income of $1,608,000, or $.02 per share. The following table shows the unaudited pro forma effects of retroactive application using the changed accounting principles for the two years ended December 31, 1992: Effective January 1, 1993, the Company adopted FAS 109, "Accounting for Income Taxes" (see Note 6). NOTE THREE ACQUISITIONS The following table is a summary of acquisitions made during the years ended December 31, 1993 and 1992 accounted for as purchases: The purchase price in both years consisted primarily of combinations of cash, Company stock, issued and assumed debt and the retirement of loans receivable issued by the Company's finance subsidiary. The effect of acquisitions on the Consolidated Balance Sheet at December 31, was as follows: SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The operating results of each acquisition are included in consolidated net income from the date of acquisition. The following represents the unaudited pro forma results of operations as if all of the above noted business combinations had occurred at the beginning of 1992. - --------------- * After change in accounting principles discussed in Note 2. The pro forma information given above does not purport to be indicative of the results that actually would have been obtained if the acquisitions had been in effect for the entire periods presented, and is not intended to be a projection of future results or trends. NOTE FOUR PREARRANGED FUNERAL CONTRACTS The Company sells prearranged funeral contracts through various programs providing for future funeral services at prices prevailing when the agreement is signed. Payments under these contracts are generally placed in trust (pursuant to state law) or are used to pay premiums on life insurance policies. Life insurance policies are issued by third party insurers. At December 31, 1993, trust and insurance funds of $1,244,866,000 (net of cancellation reserve) included in the Consolidated Balance Sheet as "Prearranged funeral contracts" are available to the Company for previously sold guaranteed price contracts. Of this amount, $554,879,000 will be funded by trusts and $689,987,000 will be funded by insurance policies. Accumulated earnings from trust funds and increasing insurance benefits have been included to the extent that they have accrued through December 31, 1993. The cumulative total has been reduced by allowable cash withdrawals for trust earning distributions and amounts retained by the Company pursuant to various state laws. In addition, a reserve, based on historical experience, equivalent to approximately 10% of the total balance has been provided for contract cancellations. NOTE FIVE INVESTMENTS At December 31, 1992, investments include $363,971,000 and $297,817,000 of prearranged funeral and cemetery perpetual care and merchandise and service obligations, respectively, held in trust. These investments are carried at the lower of cost or market and include unrealized gains of $31,496,000 and unrealized losses of $18,327,000 (see Notes 1 and 2). NOTE SIX INCOME TAXES The Company adopted FAS 109 "Accounting for Income Taxes" effective January 1, 1993. The adoption had no material impact on the Company's results of operations or financial position. FAS 109 is an asset and liability approach requiring recognition of deferred tax assets and liabilities for the expected future tax consequences of events recognized in the Company's financial statements or tax returns. Under FAS 109, all expected future events other than changes in the law or tax rates, are considered in estimating future tax SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) consequences. The Company previously had followed FAS 96, which was superseded by FAS 109, and gave no recognition to future events other than recovery of assets and settlement of liabilities at their carrying amounts. In August 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was enacted and among other changes, the Act increased the top United States corporate income tax rate to 35% from 34% effective January 1, 1993. The provision for income taxes for the year ended December 31, 1993 includes an adjustment to deferred taxes under FAS 109 of $2,431,000 related to this increase in the corporate tax rate. The provision for income taxes includes United States income taxes, determined on a consolidated return basis, foreign and state and local income taxes. During the three years ended December 31, 1993, tax expense resulting from allocating certain tax benefits directly to capital in excess of par totaled $1,197,000, $339,000 and $419,000, respectively. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The differences between the U.S. federal statutory tax rate and the Company's effective rate was as follows: Deferred tax assets and liabilities as of December 31 was as follows: Current refundable income taxes and foreign current deferred tax assets are included in other current assets, with current taxes payable and current deferred taxes being reflected as "Income taxes" on the Consolidated Balance Sheet. United States income taxes have not been provided on $51,765,000 of undistributed earnings of foreign subsidiaries since it is the Company's intention to reinvest such earnings indefinitely. As of December 31, 1993, the Company has United States federal net operating loss carry-forwards of $12,375,000 principally related to acquired subsidiaries which will expire in the years 1998 through 2008. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Various subsidiaries have state operating loss carry-forwards of $72,375,000 with expiration dates through 2008. Included in "Carry-forwards and other" is a valuation allowance of $1,748,000 which has been provided primarily for loss carry-forwards not expected to be realized. Actual cash disbursements for income taxes and other tax assessments during the three years ended December 31, 1993, totaled $46,557,000, $33,973,000 and $25,845,000, respectively. During the third quarter of 1991, the Company settled certain United States federal tax audits resulting in a $4,800,000 credit to the provision for income taxes. All of the Company's United States federal tax audits for years ended through April 30, 1988 have now been completed. NOTE SEVEN DEBT Debt at December 31, was as follows: Under terms of the bank revolving credit agreements, the Company may borrow up to $600,000,000. One agreement for $350,000,000 expires on November 8, 1994 and contains provisions for renewals. At the end of any term, the outstanding balance may be converted into a two year term loan. Another agreement for $250,000,000 expires November 3, 1996. The Company may in November of each year, commencing in 1994, extend the term of the $250,000,000 agreement for a year with the consent of all the banks. The interest rates are based generally on various indices determined by the Company. In addition, the Company pays a quarterly facility fee ranging from .125% to .1875% on the commitment amount. The terms of the revolving credit agreements include various covenants which provide, among other things, for the maintenance of a certain level of consolidated net worth, the maintenance of certain ratios and restrictions on certain payments. These SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) credit agreements are to be used for general corporate purposes, including acquisitions, and support for the Company's selling of commercial paper. The Company has outstanding $248,000,000 in medium term notes with maturities from 6 months to 26 years which are not callable prior to maturity. The average remaining maturity for the notes is approximately 13 years. In October 1991, the Company issued $172,500,000 of convertible subordinated debentures with a conversion price of $20.74 and subordinated to certain present and future indebtedness of the Company. The $150,000,000 of debt was issued in February 1993 and is considered senior debt and is not redeemable prior to maturity. In 1988, the Company assumed $16,082,000 of convertible subordinated debentures from an acquired company, with a conversion price of $18. In 1986, the Company issued $100,000,000 of convertible debentures. In February 1993, $97,164,000 of these debentures were converted into 5,607,000 common shares at $17.33 per share pursuant to a redemption call. The remaining $2,836,000 of debentures were redeemed for cash plus a 2.6% call premium and interest through the redemption date. The Company also has two bank lines of credit, one for $75,000,000 and one for $15,000,000 (both of these lines were available at December 31, 1993) at rates similar to the revolving credit agreement. The $75,000,000 line may be withdrawn at any time at the option of the bank. The $15,000,000 line requires the payment of a .25% commitment fee on the unused balance and expires in July, 1995. Some of the Company's facilities and cemetery properties are pledged as collateral for the mortgage notes. Additionally, at December 31, 1993, the Company had $34,595,000 letters of credit outstanding primarily to guarantee funding of certain insurance claims. The aggregate principal payments on debt for the five years subsequent to December 31, 1993, excluding amounts due to banks under revolving credit loan agreements are: 1994 -- $24,982,000; 1995 -- $57,731,000; 1996 -- $18,845,000; 1997 -- $47,945,000; and 1998 -- $13,961,000. Cash interest payments for the three years ended December 31, 1993 totaled $61,062,000, $60,590,000 and $47,692,000, respectively. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE EIGHT DEFERRED PREARRANGED FUNERAL CONTRACT REVENUES "Deferred prearranged funeral contract revenues" on the Consolidated Balance Sheet includes the contract amount of all price guaranteed prearranged funeral service contracts as well as the accrued trust earnings and increasing insurance benefits earned through December 31, 1993. The Company will continue to defer additional accruals of trust earnings and insurance benefits as they are earned until the performance of the funeral service. Upon performance of the funeral service, the Company will recognize the fixed contract price as well as total accumulated trust earnings and increasing insurance benefits as funeral service revenues. The recognition in future funeral revenues is estimated to occur in the following years based on actuarial assumptions as follows: NOTE NINE COMMITMENTS AND CONTINGENCIES The annual payments for operating leases (primarily for funeral home facilities and transportation equipment) are as follows: The majority of these leases contain one of the following options: (a) purchase the property at the fair value at date of exercise, (b) purchase the property for a value determined at the inception of the lease or (c) renew for the fair rental value at end of the primary term of the lease. Some of the equipment leases contain residual value exposures. For the three years ended December 31, 1993, rental expense was $33,590,000, $25,583,000 and $22,531,000, respectively. The Company has entered into management, consultative and noncompetition agreements (generally for five to 10 years) with certain officers of the Company and former owners and key employees of businesses acquired. During the three years ended December 31, 1993, $31,957,000, $27,594,000 and $21,662,000, respectively, were charged to expense. At December 31, 1993, the maximum estimated future expense under all remaining agreements is $139,887,000 including $4,693,000 with certain officers of the Company. In 1990, the Company entered into a five year minimum purchase agreement with a major casket manufacturer. The agreement contains provisions to increase the minimum annual purchases for normal price SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) increases and the maintenance of product quality. The agreement was amended in 1992 to provide for an extension to 1998 with a cumulative minimum purchase commitment of $228,000,000 required. During the three years ended December 31, 1993, the Company purchased $41,200,000, $36,656,000 and $35,149,000, respectively, under this agreement. NOTE TEN STOCKHOLDERS' EQUITY The Company is authorized to issue 1,000,000 shares of preferred stock, $1 par value. No shares were issued as of December 31, 1993. At December 31, 1993, 200,000,000 common shares of $1 par value were authorized, 84,859,110 shares were issued and outstanding (76,904,954 at December 31, 1992), net of 18,830 shares held, at cost, in treasury (521,455 at December 31, 1992). During the two years ended December 31, 1993, the Company purchased 66,319 and 398,400 shares of its common stock for $1,637,000 and $6,569,000, respectively. The fully diluted earnings per share calculation assumes full conversion into common stock of the Company's various convertible debenture issues. The Company has a stockholder approved plan whereby shares of the Company's common stock may be issued pursuant to the exercise of stock options granted to officers and key employees. The plan allows for options to be granted as either non-qualified or incentive stock options. The options are granted with an exercise price equal to the then current market price of the Company's common stock and are generally exercisable at a rate of 33 1/3% each year (generally starting one year from grant date). At December 31, 1993 and 1992, 729,267 and 971,515 shares, respectively, were reserved for future option grants under this existing plan. On November 10, 1993, the Board of Directors approved the 1993 Long-Term Incentive Stock Option Plan (maximum of 4,650,000 shares) and granted options for 4,000,000 shares of common stock at an exercise price of $25.75 per share (fair market value at date of grant). This plan is subject to stockholder approval at the annual meeting of stockholders on May 12, 1994. Such shares are excluded in the table below. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following tabulation sets forth certain stock option information: At December 31, 1993, the Company has reserved 1,480,731 shares of its common stock under stockholder approved plans for restricted stock grants to be awarded to key employees and non-employee directors. These plans contain a restriction period of not less than six months and not more than five years, during which time the recipient will be prohibited from disposition of the awarded common stock and also a requirement that the employee recipient remain employed by the Company and the non-employee director continue to serve as a director prior to lapse of the restricted period. For the three years ended December 31, 1993, 652,481, 405,925 and 16,500 shares were awarded under these plans, respectively. In July 1988, the Board of Directors adopted a preferred share purchase rights plan and also declared a dividend of one preferred share purchase right for each share of common stock. The rights become exercisable in the event of certain attempts to acquire 20% or more of the common stock of the Company and entitle the rights holders to purchase certain securities of the Company or the acquiring company. The rights, which are redeemable by the Company for $.01 per right, expire in July, 1998 unless extended. Holders of the medium term notes and 6.5% subordinated debentures may accelerate repayment or redemption in certain circumstances involving a change in control. NOTE ELEVEN EMPLOYEE RETIREMENT PLANS The Company has a noncontributory defined benefit pension plan covering substantially all employees, a supplemental retirement plan for certain executives (SERP), a supplemental retirement plan for officers and certain executives (Senior SERP), and a retirement plan for non-employee directors (Directors' Plan). For the pension plan, retirement benefits are generally based on years of service and compensation for the current year. The Company annually contributes to the pension plan an actuarially determined amount consistent with the funding requirements of the Employee Retirement Income Security Act of 1974. Assets of the pension plan consist primarily of bank money market funds, fixed income investments, marketable equity securities and mortgage notes. The marketable equity securities include shares of Company common stock with a value of $3,534,000 at December 31, 1993. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Retirement benefits under the SERP are based on years of service and average monthly compensation, reduced by benefits under the pension plan and Social Security. The Senior SERP provides retirement benefits for officers and certain executives based on their years of service and position. The Directors' Plan will provide an annual benefit to directors following their retirement, based on a vesting schedule. The Company purchased various life insurance policies on the participants in the SERP, Senior SERP and Directors' Plan with the intent to use the proceeds and any cash value buildup from such policies to fund, at least to the extent of such assets, these plans' funding requirements. The net cost for all plans was as follows: The plans' funded status at December 31, was as follows: The following assumed rates were used in the determination of the plans' funded status: SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE TWELVE FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND FAIR VALUE OF FINANCIAL INSTRUMENTS Swap agreements: The Company periodically enters into swap agreements to hedge exposure to fluctuations in interest and foreign exchange rates. Such agreements are with major financial institutions and the Company does not anticipate any credit risk from these transactions because of nonperformance. The amounts to be paid or received are accrued in accordance with terms of the agreement and market interest rates. On August 31, 1993, the Company entered a currency swap agreement with a bank that hedged the borrowings for the Company's initial investment in its Australian subsidiary. As part of this agreement, the Company pays the bank a blended interest rate (6.28% at December 31, 1993) on $110,000,000 Australian dollars and receives a floating interest rate (3.5% at December 31, 1993) on $73,590,000 United States dollars. This agreement expires December 29, 2000. The Company has entered into an interest rate swap agreement with a bank having a notional amount of $150,000,000 effective February 1, 1994. Under this agreement, the Company will pay a floating interest rate on $150,000,000 and will receive a 5.36% fixed interest rate on $150,000,000. This agreement terminates February 1, 1999 subject to an option, exercisable by the bank, to terminate on August 1, 1994. Credit risk: Provident is a party to financial instruments with off-balance sheet risk. The financial instruments result from loans made in the normal course of business to meet the financing needs of borrowers who are principally independent funeral home and cemetery operators. These financial instruments also include loan commitments of $19,499,000 at December 31, 1993 ($33,656,000 at December 31, 1992) to extend credit. Provident evaluates each borrower's credit worthiness and the amount loaned and collateral obtained, if any, is determined by this evaluation. The Company grants customers credit in the normal course of business and the credit risk with respect to these trade receivables are generally considered minimal because of the wide geographic area served. Procedures are in effect to monitor the credit worthiness of customers and bad debts have not been significant in relation to the volume of revenues. Prearranged funeral contracts generally do not subject the Company to collection risk because customer payments are either placed in state supervised trusts or used to pay premiums on life insurance contracts. Insurance funded contracts are subject to supervision by state insurance departments and are protected in the majority of states by insurance guaranty acts. Fair Value of Financial Instruments: The following disclosure of the estimated fair value of financial instruments was made in accordance with the requirements of FAS 107. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The carrying amounts of cash and cash equivalents, receivables and accounts payable approximate fair values due to the short term maturities of these instruments. The carrying amounts and fair values of the Company's fixed rate long-term borrowings are as follows: The fair value of the above long-term borrowings was estimated by discounting the future cash flows, including interest payments, using rates currently available for debt of similar terms and maturity, based on the Company's credit standing and other market factors. The carrying value of the revolving credit agreements approximate fair value because the rates on such agreements are variable, based on current market. Substantially all of the Company's remaining long-term debt and receivables carry variable interest rates and their carrying amount approximates fair value. It is not practicable to estimate the fair value of the installment contracts receivable. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE THIRTEEN SUPPLEMENTARY INFORMATION The detail of certain balance sheet accounts at December 31, was as follows: Interest rates on installment contracts and notes receivable range from 3.0% to 12.5% at December 31, 1993. Included in loans and other notes receivable are $12,479,000 in notes with officers and employees of the Company, the majority of which are collateralized by real estate, and $25,548,000 in notes with other related parties. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NON-CASH TRANSACTIONS SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE FOURTEEN MAJOR SEGMENTS OF BUSINESS SCI conducts funeral and cemetery operations in the United States, Canada and Australia and offers financial services in the United States. - --------------- (1) Includes $218,110,000, $120,646,000 and $142,568,000 for the three years ended December 31, 1993, respectively, for purchases of property, plant and equipment and cemetery property of acquired businesses. SERVICE CORPORATION INTERNATIONAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE FIFTEEN PROSPECTIVE ACCOUNTING CHANGES In 1994, FAS 112 "Employer's Accounting for Postemployment Benefits" becomes effective. This FAS requires the Company to accrue for estimated future postemployment benefits during the years employees are working and earning these benefits. Also in 1994, FAS 115 "Accounting for Certain Investments in Debt and Equity Securities" becomes effective. This FAS addresses the accounting for investments in equity and debt securities held by the Company. In 1995, FAS 114 "Accounting by Creditors for Impairment of a Loan" becomes effective. This FAS requires present value computations for impaired loans when determining allowances for loan losses. Adoption of these three standards is not expected to materially affect the Company's financial position or results of operations. NOTE SIXTEEN QUARTERLY FINANCIAL DATA (UNAUDITED) - --------------- (1) The first quarter of 1993 includes a charge to net income of $2,031,000 or $.03 per share for the cumulative effect of the change in accounting principles. SERVICE CORPORATION INTERNATIONAL SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 SERVICE CORPORATION INTERNATIONAL SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES -- (CONTINUED) SERVICE CORPORATION INTERNATIONAL SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES -- (CONTINUED) - --------------- (1) On August 10, 1993, the Company loaned: R. L. Waltrip, Chairman of the Board and Chief Executive Officer of the Company, $1,700,000; L. W. Heiligbrodt, President and Chief Operating Officer of the Company, $1,000,000; W. B. Waltrip, Executive Vice President/Operations of the Company, $600,000; S. W. Rizzo, Executive Vice President, Chief Financial Officer/Treasurer of the Company, $525,000; and J. W. Morrow, Jr., Executive Vice President/Corporate Development, $525,000. Such loans were made to enable such officers to pay the estimated federal income taxes resulting from their receipt of Company stock on August 10, 1993 pursuant to a grant of restricted stock under the Company's Amended 1987 Stock Plan. Each of the loans is due August 10, 2003, bears interest at 6.5% per annum and is supported by the restricted stock. In the event that the fair market value of all restricted stock held by an officer is less than his outstanding loan balance as of any loan anniversary date, the officer will be obligated to provide acceptable collateral for the difference between such loan balance and such fair market value. (2) Provident had provided a line of credit of $2,500,000 to R. L. Waltrip for personal use. The line of credit matured, and the outstanding balance was repaid by Waltrip in 1992. SERVICE CORPORATION INTERNATIONAL SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES -- (CONTINUED) (3) Provident has provided secured loans to E. K. Payne, former Senior Vice President of the Company, in connection with the exercise of Company stock options, the purchase of a home and personal use. The loans provide for interest at the prime rate (6% at December 31, 1993) and are collateralized by shares of Company common stock. The stock option loan matures in November 1994. The home and personal use loan was repaid in 1992. (4) Provident has provided secured loans to G. K. Guinn, former Senior Vice President and Treasurer of the Company, to finance the exercise of Company stock options and for the purchase of a home. The loans are collateralized by the stock purchased and a deed of trust on the home, and bear interest at the prime rate and 7.55%, respectively. The stock option loan matured and was repaid in 1993 and the home loan matures in 2021. (5) In December 1989, the Company sold its trust subsidiary, Southwest Guaranty Trust Company and its investment services department to W. E. Mercer for $1,000,000. Mercer is a former director and Executive Vice President Finance and Administration of the Company. Mercer executed a promissory note in payment of the purchase price of $1,000,000 with interest at 10% payable quarterly. During 1991, Mercer repaid the balance of the note. (6) Provident offers employees and directors of the Company mortgage loans. These loans have been issued at fixed rates ranging from 6.5% to 9.6%, which are comparable to current market rates. These loans mature 15 to 30 years from date of issuance and are collateralized by a deed of trust on the real estate and for one individual, Company stock and other publicly traded securities. (7) In addition to mortgage loans discussed in note 6 above, Provident has provided secured loans to finance the exercise of Company stock options to the individuals noted. These loans are collateralized by the stock purchased, bear interest at the prime rate and mature in 1994. (8) Provident has provided financing to G. A. Pullins, Senior Vice President / Corporate Development of the Company, to finance the purchase of a home. The loan is collateralized by Company stock, bears interest at the prime rate and matures in 1994. (9) B. D. Hunter is a director of the Company and former Chairman of AMEDCO Inc. (AMEDCO) which was acquired by the Company on September 26, 1986. In connection with the Company's purchase of AMEDCO certain operations of AMEDCO were purchased by a company controlled by Hunter immediately before the acquisition of AMEDCO by the Company. Part of the consideration paid by the Hunter controlled company to AMEDCO were promissory notes of $8,000,000 and $5,000,000. During 1990, Hunter repaid $4,300,000 of the $8,000,000 promissory note. During 1991, Hunter repaid the remaining balances of the two notes. (10) In its normal course of business, primarily through Provident, the Company has made loans to certain entities in which the Company has equity investments. These loans had a balance of $25,548,000 at December 31, 1993. All of these loans carry interest rates ranging from a defined savings rate plus 2% (5.22% at December 31, 1993) up to 12% and mature in 1994 through 2000. These loans are collateralized by combinations of common stock of the debtor entities, deeds of trust on the debtors' real estate and certain other collateral. SERVICE CORPORATION INTERNATIONAL SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 - --------------- (1) Uncollected receivables written off, net of recoveries (2) Primarily acquisitions and dispositions of operations (3) Includes the cumulative effect of changing accounting principles effective January 1, 1993. SERVICE CORPORATION INTERNATIONAL SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Ernst & Young, Certified Public Accountants ("E&Y"), served as the independent accountants for the Company for the fiscal year ended December 31, 1992. E&Y was dismissed as the independent accounting firm for the Company effective March 25, 1993, with Coopers & Lybrand, Certified Public Accountants ("Coopers"), having been so engaged as of that date. The decision to change the independent accounting firm for the Company was recommended by management and by the Audit Committee of the Board of Directors of the Company and was approved by the Board of Directors. The report of E&Y dated February 8, 1993 on the consolidated financial statements of the Company as of December 31, 1992 and 1991 and for the three years in the period ended December 31, 1992 contained no adverse opinion or a disclaimer of opinion, and was not qualified or modified as to uncertainty, audit scope or accounting principle. Similarly, the report of Coopers dated February 8, 1994 on the consolidated financial statements of the Company as of December 31, 1993 and for the year then ended contained no adverse opinion or a disclaimer of opinion, and was not qualified or modified as to uncertainty, audit scope or accounting principle. From time to time during the several years preceding January 1, 1993, meetings were held between members of senior management of the Company and local and national office partners of E&Y regarding potential accounting policies for reporting pre-need funeral and cemetery sales. As previously reported by the Company in, among other places, its Form 8-K dated March 31, 1993, the Company and E&Y did not reach agreement on any new method of accounting for such sales. In the Company's opinion, such meetings did not result in a "disagreement" between it and E&Y within the meaning of the rules promulgated by the Securities and Exchange Commission (the "SEC"). Thus, as previously reported by the Company in, among other places, such Form 8-K, while there was a failure to reach agreement, in the Company's opinion, during the two years ended December 31, 1992, there was no reportable "disagreement" between the Company and E&Y regarding any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreement, if not resolved to the satisfaction of E&Y, would have caused E&Y to make reference to the subject of the disagreement in connection with its report. As also previously reported by the Company in, among other places, an amendment, dated April 6, 1993, to the Company's Form 8-K, dated March 31, 1993, E&Y, however, has stated that it believes that a reportable "disagreement" occurred between it and the Company. Accordingly, at the request of E&Y, the Company included the following (references to E&Y and the Company have been conformed to the usage in this Form 10-K) in its proxy statement dated April 12, 1993 for the last annual meeting of stockholders. "On several occasions over the years, the Company has proposed that its accounting policy for pre-need funeral services be changed to a method whereby revenue would be recognized at the date a pre-need funeral contract is signed, accompanied by appropriate provision for the estimated cost of providing such services. E&Y's consistent position has been that the Company's proposed accounting policy would not be acceptable under generally accepted accounting principles. "At a meeting on April 1, 1992 held to discuss this issue, a reportable disagreement occurred in that Company management stated that if E&Y would not support the Company's proposed accounting they would find another firm that would. This disagreement was communicated to the Company's Audit Committee at its August 13, 1992 meeting. "Moreover, on February 19, 1993 (after completion of the 1992 audit), Company management presented the accounting proposal set forth in a December 28, 1992 'Invitation to Comment' prepared by Patrick B. Collins, CPA, and asked E&Y to support this proposed accounting method. That 'Invitation to Comment' advocates recognition of revenue for pre-need funeral services at the time of sale rather than when the services are performed, and solicits comments from interested parties concerning this and other matters. On February 26, 1993 and again on March 2, 1993, E&Y informed Company management that it would be unable to support the proposal presented in the 'Invitation to Comment.' "On March 16, 1993, management informed E&Y that the Company was no longer pursuing the accounting method advocated in the 'Invitation to Comment' but rather was considering a modified approach. E&Y informed management that at least one element of the modified approach -- amortization of a portion of deferred revenue that would be associated with the fixed cost of maintaining funeral homes -- was, in E&Y's view, not acceptable under generally accepted accounting principles." The modified approach referred to above by E&Y is also referred to in the next to last paragraph of this Item 9, except that at the time of its discussion with Coopers the element E&Y noted as being objectionable was no longer being considered. As indicated above, E&Y's position was also disclosed in an amendment dated April 6, 1993 to a Form 8-K dated March 31, 1993 filed by the Company. Following such disclosure, the Company filed a second amendment to such Form 8-K, in which the Company set forth its belief that the references to "disagreements" by E&Y, as well as other matters, were factually inaccurate. Further, the Company disputes that a reportable "disagreement" was communicated by E&Y to the Audit Committee on August 13, 1992. In response to the second amendment to such Form 8-K, E&Y responded (which response was included in a third amendment) that there was nothing in the second amendment of which E&Y was unaware at the time it stated its position disclosed in the April 6, 1993 amendment. The staff of the SEC is conducting an informal private investigation relating to the change in the Company's independent accountants, and the Company's Form 8-K dated March 31, 1993, as amended in April 1993, reporting such change, as well as the Company's current accounting and reporting of pre-need sales. The staff has advised the Company that the investigation should not be construed as an indication by the Commission or its staff that any violations of law have occurred, or as a reflection upon any person, entity or security. The investigation is continuing. On March 25, 1993, the Company's Board of Directors approved the recommendation of management and the Audit Committee that Coopers be engaged as the Company's new independent accountants. During the two fiscal years ended December 31, 1992 and the interim period of 1993, Coopers was not consulted by the Company on the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the financial statements of the Company. During the interim period of 1993, as part of the proposal process, Coopers indicated its general agreement with the Company's desire to modify its accounting policies for pre-need funeral and cemetery sales so that such policies more accurately reflect the economics of these sales. In this connection, the Company expressed to Coopers its desire to improve the financial reporting for pre-need funeral sales by including in the balance sheet, as a long term asset and corresponding deferred revenue, all pre-need funeral contracts whether funded by insurance or trust funds. Revenue from funeral services would be recognized when the services are performed, which is consistent with the Company's then and current policy. The Company also discussed with Coopers deferring funeral trust earnings until the service is performed. Under the Company's prior policy, these trust earnings were recognized in current income. Additionally, the Company expressed its views that accounting for pre-need cemetery sales using the accounting principles prescribed for sales of real estate may not be the most appropriate method of accounting. Coopers orally expressed their general agreement with these concepts but were not asked to and did not express an opinion on any specific transaction or accounting change, either orally or in writing. The accounting principles adopted by the Company in 1993 for reporting pre-need funeral and cemetery sales are set forth, among other places, in the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 filed with the SEC. Coopers has issued a preferability letter with respect to such principles. A copy of such letter is filed as an Exhibit to the Company's Form 10-Q for the quarter ended March 31, 1993. As indicated above, Coopers has issued an unqualified opinion with respect to the Company's consolidated financial statements as at and for the period ended December 31, 1993. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information called for by PART III (Items 10, 11, 12 and 13) has been omitted as the Company intends to file with the Securities and Exchange Commission not later than 120 days after the close of its fiscal year a definitive Proxy Statement pursuant to Regulation 14A. Such information is set forth in such Proxy Statement (i) with respect to Item 10 under the captions "Election of Directors" and "Compliance with Section 16(a) of the Exchange Act", (ii) with respect to Items 11 and 13 under the captions "Cash Compensation", "Stock Options", "Retirement Plans", "Executive Employment Agreements", "Other Compensation", "Director Compensation", "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions" and (iii) with respect to Item 12 under the caption "Voting Securities and Principal Holders." The information as specified in the preceding sentence is incorporated herein by reference. Notwithstanding anything set forth in this Form 10-K, the information under the caption "Compensation Committee Report on Executive Compensation" and under the captions "Overview of Executive Compensation" and "Performance Graphs" in such Proxy Statement are not incorporated by reference into this Form 10-K. The Information regarding the Company's executive officers called for by Item 401 of Regulation S-K has been included in PART I of this report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1)-(2) Financial Statements and Schedules: The financial statements and schedules are listed in the accompanying Index to Financial Statements and Related Schedules at page 14 of this report. (3) Exhibits: The exhibits listed on the accompanying Exhibit Index at pages 50-52 are filed as part of this report. (b) Reports on Form 8-K: During the quarter ended December 31, 1993, the Company filed a Form 8-K dated December 21, 1993 reporting under "Item 7. Financial Statements and Exhibits" certain exhibits being filed concerning an amendment to the Company's Employee Stock Purchase Plan. (c) Included in (a) above. (d) Included in (a) above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Service Corporation International, has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SERVICE CORPORATION INTERNATIONAL Dated: March 30, 1994 By: JAMES M. SHELGER (James M. Shelger, Senior Vice President, General Counsel and Secretary) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. EXHIBIT INDEX PURSUANT TO ITEM 601 OF REG. S-K In the above list, the management contracts or compensatory plans or arrangements are set forth in Exhibits 10.1 through 10.13, 10.15 through 10.17, 10.21 and 10.23.

732713_1993.txt

732713_1993

1993

732713

ITEM 1. BUSINESS GENERAL BellSouth Corporation ("BellSouth") is a holding company providing telecommunications services and communications systems and products through two wholly-owned subsidiaries, BellSouth Telecommunications, Inc. ("BellSouth Telecommunications") and BellSouth Enterprises, Inc. ("BellSouth Enterprises"). BellSouth Telecommunications, which is the surviving corporation from the merger, effective at midnight December 31, 1991, of South Central Bell Telephone Company ("South Central Bell") and Southern Bell Telephone and Telegraph Company ("Southern Bell"), provides predominantly tariffed wireline telecommunications services to approximately two-thirds of the population and one-half of the territory within Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee. These areas were previously served by South Central Bell and Southern Bell. BellSouth Telecommunications continues to use the names South Central Bell and Southern Bell for various purposes. BellSouth's other businesses (primarily wireless communications, advertising and publishing and international operations) are conducted through subsidiaries of BellSouth Enterprises. BellSouth was incorporated in 1983 under the laws of the State of Georgia. On December 31, 1983, pursuant to a consent decree approved by the United States District Court for the District of Columbia (the "D. C. District Court") entitled "Modification of Final Judgment" (the "MFJ") settling antitrust litigation brought by the United States Department of Justice (the "Justice Department") in 1974 and the related Plan of Reorganization (the "POR"), American Telephone and Telegraph Company ("AT&T") transferred to BellSouth its 100% ownership of South Central Bell and Southern Bell. On January 1, 1984, ownership of BellSouth was divested from AT&T and BellSouth became a publicly traded company. BellSouth has its principal executive offices at 1155 Peachtree Street, N.E., Atlanta, Georgia 30309-3610 (telephone number 404 249-2000). MODIFICATION OF FINAL JUDGMENT Pursuant to the MFJ, AT&T divested the 22 wholly-owned operating telephone companies (the "Operating Telephone Companies"), including South Central Bell and Southern Bell, that were included in the former Bell System. The ownership of such 22 Operating Telephone Companies was transferred by AT&T to seven holding companies (the "Holding Companies"), including BellSouth. All territory in the continental United States served by the Operating Telephone Companies was divided into geographical areas termed "Local Access and Transport Areas" ("LATAs"). These LATAs are generally centered in a city or other identifiable community of interest. The MFJ limits the telecommunications-related scope of the Operating Telephone Companies'* post-divestiture business activities, and the D. C. District Court retained jurisdiction over its construction, implementation, modification and enforcement. Under the MFJ, the Operating Telephone Companies may provide local exchange, exchange access, information access and toll telecommunications services within the LATAs. Although prohibited from providing service between LATAs, the Operating Telephone Companies provide exchange access services that link a subscriber's telephone or other equipment in one of their LATAs to the transmission facilities of carriers (the "Interexchange Carriers"), which provide toll telecommunications services between different LATAs. The Operating Telephone Companies may market, but not manufacture, customer premises equipment ("CPE"), which is defined in the MFJ as equipment used on customers' premises to originate, route or terminate - ------------------------ *The provisions of the MFJ are applicable also to the Holding Companies. telecommunications. A similar restriction applies to the manufacture or provision of "telecommunications equipment," which is defined in the MFJ as including equipment used by carriers to provide telecommunications services. The MFJ restrictions precluding the Holding Companies from providing information services and non-telecommunications related products and services have been judicially removed. The D.C. District Court has established procedures for obtaining generic and specific waivers from the manufacturing and interLATA communications restrictions of the MFJ, although the required filings with and review by the Justice Department and the D.C. District Court usually result in lengthy and uncertain proceedings. The foregoing restrictions present significant obstacles to the provision of certain wireless, cable television and other communications services and require that such business operations, even where waivers are ultimately obtained, be conducted under burdensome arrangements or subject to elaborate structural separation or other conditions. BellSouth is advocating legislation which would remove or relax the MFJ restrictions. (See "Business Operations -- Legislation.") The MFJ requires the Operating Telephone Companies to provide, upon a bona fide request by any Interexchange Carrier or information service provider, exchange access, information access and exchange services for such access that will be equal to that provided to AT&T in quality, type and price. BellSouth Telecommunications believes it is in compliance with this requirement. BUSINESS OPERATIONS Approximately 73%, 74% and 76% of BellSouth's operating revenues and 95%, 97% and 97% of its net income for the years ended December 31, 1993, 1992 and 1991, respectively, were from wireline telecommunications services, which were provided by BellSouth Telecommunications. The remainder was principally from directory advertising and publishing operations, cellular and paging operations, billing and collection services, CPE sales, computer leasing and maintenance and rental of facilities. (See "Other Telecommunications Business Operations.") In the aggregate, access revenues, revenues from billing and collection activities and rental of facilities comprised approximately 25%, 26% and 28% of 1993, 1992 and 1991 operating revenues, respectively. The majority of such revenues was from services provided to AT&T, BellSouth's largest customer. TELEPHONE COMPANY OPERATIONS BellSouth Telecommunications provides services, which include local exchange, exchange access and intraLATA toll services, within each of the 38 LATAs in its combined nine-state operating area. (See "Local and Toll Services" and "Access Services.") The tables below set forth the following: network access lines in service at December 31 for the last five years; access lines in each state at December 31, 1993; and the annual percentage increase in access lines in each state at December 31 for the last four years. - ------------------------ *Prior period operating data are revised at later dates to reflect the most current information. This information reflects the latest data available for the periods indicated. Approximately 72% of such lines were in 53 metropolitan areas, each having a population of 125,000 or more. Many localities and some sizable areas in the states in which BellSouth Telecommunications operates are served by non-affiliated telephone companies, which had approximately 29% of the network access lines in such states on December 31, 1993. BellSouth Telecommunications does not furnish local exchange, access or toll services in the areas served by such companies. The following table reflects access minutes of use and toll message volume for the last five years. The number of intraLATA toll messages carried by BellSouth Telecommunications has declined, primarily because of the effect of expanded local area calling plans and competition by others for the provision of toll services. Toll message volumes are expected to decline further as additional intraLATA toll competition is authorized in many of the states served by BellSouth Telecommunications. (See "Competition" and "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Operating Environment and Trends of the Business -- Volumes of Business.") LOCAL AND TOLL SERVICES Charges for local services for the years ended December 31, 1993, 1992 and 1991 accounted for approximately 41%, 41% and 40%, respectively, of BellSouth's operating revenues. Local services operations provide lines from telephone exchange offices to subscribers' premises for the origination and termination of telecommunications, including the following: basic local telephone service provided through the regular switching network; dedicated private line facilities for voice and special services, such as transport of data, radio and video, and foreign exchange services; switching services for customers' internal communications through facilities owned by BellSouth Telecommunications; services for data transport that include managing and configuring special service networks; and dedicated low or high capacity public or private digital networks. Other local services revenue is derived from intercept and directory assistance, public telephones and various special and custom calling services. - ------------------------ *Prior period operating data are often revised at later dates to reflect the most current information. This information reflects the latest data available for the periods indicated. BellSouth Telecommunications has the ability to offer certain enhanced services through its network. Such offerings include various forms of data and voice transmission, voice messaging and storage services and gateway communications between customers and information services providers. The extent to which these offerings can be profitably provided will depend on the degree of market acceptance and the resolution of various issues still pending before the Federal Communications Commission (the "FCC") regarding a company's offering of both enhanced and basic network services on an integrated basis. (See "Access Services.") BellSouth Telecommunications provides intraLATA toll services within, but not between, its 38 LATAs. Such toll services provided approximately 8%, 8% and 10% of BellSouth's operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively. These services include the following: intraLATA service beyond the local calling area; Wide Area Telecommunications Service ("WATS" or "800" services) for customers with highly concentrated demand; and special services, such as transport of data, radio and video. BellSouth Telecommunications is subject to state regulatory authorities in each state in which it provides telecommunications services with respect to intrastate rates, services and other issues. Traditionally, BellSouth Telecommunications' rates were set in each state in its service areas at levels which were anticipated to generate revenues sufficient to cover its allowed expenses and to provide an opportunity to earn a fair return on its capital investment. Such a regulatory structure was satisfactory in a less competitive era; however, BellSouth Telecommunications is currently advocating changes to the regulatory processes responsive to the increasingly competitive telecommunications environment. Modified forms of state regulation are in effect in Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi and Tennessee. Under such modified form of regulation, economic incentives are provided to lower costs and increase productivity through the potential availability of "shared" earnings over a benchmark rate of return. Generally, when levels above targeted returns are reached, earnings are "shared" by providing refunds or rate reductions to customers. The amounts of any such excess which may be retained under some plans depend upon attaining mandated service standards, certain productivity improvement provisions or both. Under some plans, if earnings fall below a targeted minimum, additional earnings required to return to the bottom of the allowed range can be obtained through rate increases. Sharing plans are generally subject to renewal after two or three years, and may be subject to modification prior to renewal. Despite the potential advantages offered by sharing plans, substantial rate reductions have been incurred in connection with their adoption and operation. Of the states in which these types of plans were in place, BellSouth Telecommunications attained the earnings sharing range in Alabama, Kentucky, Louisiana and Mississippi in 1993. ALABAMA An incentive regulation plan has been in effect in Alabama since December 1988, which provides for a return on average total capital* in the range of 11.65% to 12.30%. If earnings exceed 12.30%, sharing with customers may range from 0% to 50%, depending upon whether certain service and efficiency requirements are met. In December 1993, in conjunction with approval of rate adjustments required by its incentive plans, the Alabama Public Service Commission approved a settlement of several outstanding issues. The settlement resulted in a net rate reduction to the Company of $15.72 million. - ------------------------ * As defined in the plan for this state. FLORIDA From 1988 through 1992, the Florida incentive plan provided for a return on equity* of 11.5% to 16%, with earnings from 14% to 16% to be shared 40% by BellSouth Telecommunications and 60% by customers. The sharing level was not attained under the plan. In 1993, BellSouth Telecommunications filed a petition to extend the existing plan. In January 1994, after extensive proceedings and negotiations between BellSouth Telecommunications, Public Counsel and intervenors, the Florida Public Service Commission approved a settlement that extends incentive regulation through 1996. Among other things, the terms of the settlement provide for rate reductions of $55 million in February 1994, an additional $60 million in July 1994, $80 million in October 1995 and $84 million in October 1996. The settlement provides for other changes in service offerings and tariffs including approximately $21 million in revenue reductions or increased expenses. Basic service rates have been capped at their current levels through 1997, and BellSouth Telecommunications has agreed not to propose any local measured service on a statewide basis through the same time period. (See "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Operating Environment and Trends of the Business -- Regulatory Environment -- State Regulation.") The agreement establishes a 1994 return on equity* sharing level of 12% with a cap of 14%, increasing in 1995 to a 12.5% sharing level with a cap of 14.5%. Rates of return beyond 1995 would vary based upon changes in utility bond yields but would change no more than 75 basis points from 1995 levels. GEORGIA The Georgia incentive plan adopted in 1990 provided that BellSouth Telecommunications would retain all earnings up to a 14% return on equity*. Subject to the attainment of service standards and productivity improvement provisions, BellSouth Telecommunications could retain a portion of earnings between 14% and 16%. The plan also provided for a reduction of rates if earnings exceed 14% return on equity, even if the service standards and productivity improvement provisions are met. The amount of any sharing and rate adjustments would depend upon attaining certain service standards and productivity improvements. BellSouth Telecommunications has yet to attain the sharing level under the Georgia plan. In December 1993, the Georgia Public Service Commission voted to extend the plan for six months, effective January 1, 1994. Concurrent with the extension, the Commission modified the return on equity at which sharing would occur from 14% to 13%. KENTUCKY Under the Kentucky incentive regulation plan, BellSouth Telecommunications may earn a return on average total capital* in the range of 10.99% to 11.61%. Earnings above 11.61% are subject to sharing. If the return on average total capital falls below 10.99%, 50% of the shortfall may be recovered from customers, and if the return falls below 9.49%, 75% of the shortfall may be recovered. BellSouth Telecommunications achieved the sharing level during 1993 and reduced rates by $6.4 million in June. This plan will be reviewed by the Kentucky Public Service Commission later in 1994. LOUISIANA In February 1992, in settlement of several years of regulatory and judicial proceedings, BellSouth Telecommunications and the Louisiana Public Service Commission agreed to a three year incentive regulation plan providing for an immediate $55.0 million refund, a rate reduction of $31.4 million and an authorized return on investment* in the range of 10.7% to 11.7%, with sharing of earnings above 11.7% and below 12.7%. Based on 1992 results, BellSouth Telecommunications reduced rates by - ------------------------ * As defined in the plan for this state. $13.8 million in February and $7.8 million in August 1993, reflecting its sharing obligation under the new plan. In January 1994, BellSouth Telecommunications filed a petition with the Louisiana Commission requesting a price regulation plan. No hearings have been scheduled on this proposal. MISSISSIPPI In June 1990, the Mississippi Public Service Commission authorized implementation of an incentive plan that includes a return on average net investment* ranging from 10.74% to 11.74% and provides that earnings above 11.74% and shortfalls below 10.74% would be shared with customers on a 50/50 basis. Rate reductions totaling $22.8 million on an annual basis were required prior to implementation of the plan. Additional revenue reductions in the amount of $12.8 million related to intrastate access and area calling plan impacts became effective in January 1993. In June 1993, the Mississippi Commission renewed, through July 1, 1995 the incentive plan and ordered BellSouth Telecommunications to reduce rates, effective July 1993, based on a targeted 11.24% return. Legislation has recently been passed in Mississippi which would allow price regulation. NORTH CAROLINA In 1989, legislation was enacted in North Carolina authorizing the North Carolina Public Service Commission to consider alternative forms of regulation. No specific proposal has been approved or is pending. The North Carolina Commission reviews BellSouth Telecommunications' rates annually. In November 1993, the Commission approved one-time depreciation reserve deficiency amortizations of $28.5 million and $25 million in 1993 and 1994, respectively. SOUTH CAROLINA In August 1991, the South Carolina Public Service Commission authorized implementation of an incentive plan providing for a return on equity* ranging from 12.0% to 16.5%, and the sharing of earnings between 14.0% to 16.5%, on a 50/50 basis with customers. However, in August 1993, the South Carolina Supreme Court ruled that the South Carolina Commission lacked the statutory authority to approve incentive regulation plans. Legislation has been proposed in South Carolina which would permit the Commission to adopt alternative forms of regulation, including price regulation. In the interim, traditional rate of return regulation is in effect. TENNESSEE In August 1993, the Tennessee Public Service Commission approved a three year revised incentive regulation plan which lowered the sharing range as a percentage return on average net investment* from 11.0% - 12.2% to 10.65% - 11.85%. Earnings between 11.85% - 15.85% must be shared with ratepayers in varying degrees, depending on the quality of service. The plan also provides for rate increases to cover up to 60% of the amount by which earnings fall below 10.65%. The Tennessee Commission's decision was appealed by several intervenors to the Tennessee Court of Appeals. The appeal, which is pending, challenges the validity of the Commission's order and its rate of return finding. ------------------------ In addition to the above matters, BellSouth Telecommunications is a party to numerous proceedings pending before state regulatory bodies which involve, among other things, terms and conditions of services provided by BellSouth Telecommunications, rates charged for such services and relationships with affiliates. No assurance can be given as to the outcome of any such matters. - ------------------------ * As defined in the plan for this state. ACCESS SERVICES BellSouth Telecommunications provides access services by connecting the communications networks of Interexchange Carriers with the equipment and facilities of subscribers. These connections are provided by linking these carriers and subscribers through the public switched network of BellSouth Telecommunications or through dedicated private lines furnished by BellSouth Telecommunications. Access charges, which are payable both by Interexchange Carriers and subscribers, provided approximately 24%, 25% and 26% of BellSouth's operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively. These charges are designed to recover the costs of the common and dedicated facilities and switching equipment used to connect networks of Interexchange Carriers with the telephone company's local network. In addition, an interstate monthly subscriber line access charge of $3.50 per line per month applies to single-line business and residential customers. The interstate subscriber access charge for multi-line business customers varies by state but cannot exceed $6.00 per line per month. In October 1990, the FCC authorized an alternative to traditional rate of return regulation called "price caps," effective January 1, 1991, which is mandatory for certain local exchange carriers ("LECs"), including BellSouth Telecommunications and the other Operating Telephone Companies. In contrast to traditional rate of return regulation price caps limits the prices telephone companies can charge for their services. The price cap plan limits aggregate price changes to the rate of inflation minus a productivity offset, plus or minus exogenous cost changes recognized by the FCC. The FCC expects price cap regulation to provide LECs with enhanced incentives to increase productivity and efficiency. Concurrent with the implementation of price caps, the FCC reduced the allowed rate of return on interstate operations from 12.0% to 11.25%. Those LECs which operate under price caps are allowed to elect annually by April 1 a productivity offset factor of 3.3% or 4.3%. If the lower offset is chosen, such carriers will be allowed to earn up to a 12.25% overall rate of return without sharing. If such carriers earn between 12.25% and 16.25%, half of the earnings in this range will be flowed through to customers in the form of a lower price cap index in the following year. All earnings over 16.25% would be flowed through to customers. If such carriers elect a 4.3% productivity offset, all earnings below 13.25% may be retained, earnings up to 17.25% would be shared and earnings over 17.25% would be flowed through to customers. BellSouth Telecommunications elected to operate under the 3.3% productivity offset factor for the period July 1, 1993 through June 30, 1994 and intends to elect the same factor for the ensuing annual period. In February 1994, the FCC initiated its review of the price cap plan described in the preceeding paragraph. The FCC identified three broad sets of issues for examination including those related to the basic goals of price cap regulation, the operation of price caps and the transition of local exchange services to a fully competitive market. BellSouth believes and will advocate that a revised price cap plan should be structured to provide increased pricing flexibility for services as competition evolves in the telecommunications markets. Any changes to the current plan are expected to be effective January 1, 1995 or soon thereafter. State regulatory commissions have jurisdiction over charges related to the provision of access to the Interexchange Carriers to complete intrastate telecommunications. The state commissions have authorized BellSouth Telecommunications to collect access charges from the Interexchange Carriers and, in several states, from customers. Open Network Architecture ("ONA") plans, permitting all users of the basic network to interconnect to specific basic network functions and interfaces on an unbundled and equal access basis for the provision of enhanced services, will eliminate the FCC requirement that certain enhanced telecommunications services be offered only through a separate subsidiary. The plans may be implemented when ONA tariffs filed with the FCC become effective and are filed with the states in which ONA services will be offered and the FCC is notified by the company that it is prepared to offer the ONA services described in its plan. In November 1992, BellSouth Telecommunications filed a Notice of Initial ONA Implementation and Petition for Removal of Structural Separation Requirement (the "Notice"). The Notice informed the FCC of BellSouth Telecommunications' completion of the required steps for initial ONA implementation and asked the FCC to remove the structural separation requirements currently imposed on enhanced services offerings. The FCC granted the petition for structural relief in July 1993. In addition to the above matters, BellSouth Telecommunications is a party to numerous proceedings pending before the FCC which involve, among other things, terms and conditions of services provided by BellSouth Telecommunications, rates charged for such services and relationships with affiliates. No assurance can be given as to the outcome of any such matters. BILLING AND COLLECTION SERVICES BellSouth Telecommunications provides, under contract and/or tariff, billing and collection services for certain long distance services of AT&T and several other Interexchange Carriers. The agreement with AT&T has been extended through 1996, subject to the right of AT&T to assume billing and collection for certain of its services prior to the expiration of the agreement. Revenues from such services are expected to decrease as AT&T and other carriers assume more direct billing for their own services. BellSouth Enterprises also provides limited billing and collection services in foreign countries. OPERATOR SERVICES Directory assistance and local and toll operator services are provided by BellSouth Telecommunications in its service areas. Toll operator services include alternate billing arrangements, such as collect calls, third number billing, person-to-person and calling card calls; dialing instructions; pre- billed credit; and rate information. In addition, directory assistance is provided for some Interexchange Carriers which do not directly provide such services for their own customers. OTHER TELECOMMUNICATIONS BUSINESS OPERATIONS DIRECTORY ADVERTISING AND PUBLISHING BellSouth Enterprises owns a group of companies which publish, print and sell advertising in, and perform related services concerning, alphabetical and classified telephone directories. Directory advertising and publishing revenues represented nearly 10% of BellSouth's total operating revenues for each of the years ended December 31, 1993, 1992 and 1991. Several of these companies also provide publishing and related products and services to other directory publishers. During 1993, these companies published approximately 500 directories for BellSouth Telecommunications and contracted with more than 160 nonaffiliated companies to sell advertising space in more than 400 publications of such nonaffiliated companies. A percentage of the billed revenues from directory advertising operations of BellSouth Advertising & Publishing Corporation, a wholly-owned subsidiary of BellSouth, are paid as publication fees to BellSouth Telecommunications for publishing rights and other services in its franchise areas. WIRELESS COMMUNICATIONS BellSouth Enterprises provides wireless communications services which consist mainly of cellular telephone and paging services. Revenues from wireless communications comprise approximately 10%, 8% and 5% of BellSouth's total operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively. In addition, BellSouth Enterprises owns minority interests in a number of wireless businesses whose revenues are not reflected in operating revenues because of the method of accounting required for such investments. BellSouth has significantly expanded these businesses in recent years through development of existing franchises and through acquisitions. The predominant part of these business operations is cellular telephone service. Cellular radio telephone systems provide customers with high-quality and readily available two-way communications services that interconnect with the local and long distance telephone networks. Cellular systems utilize a large number of low power transmitters that transmit within a small geographic area, or cell, and a switching system that monitors and allocates available frequencies to users traveling within and between cells. The number of cells varies from market to market depending on several factors, including the topography and demographics of the service area. As the number of subscribers and calls increase, additional channels may be allocated to each cell or additional cells may be created, either by sectorizing or splitting existing cells to create greater capacity or adding new cells. DOMESTIC CELLULAR OPERATIONS Domestic cellular wireless telephone business has become a significant contributor to BellSouth's operations, primarily due to the continued expansion of the customer base for mobile communications services and as a result of significant acquisitions of other systems. BellSouth maintains and operates cellular systems through wholly-owned subsidiaries and business ventures with other entities. Cellular service and related equipment are marketed to consumers, directly and through authorized agents, and to businesses that resell the service. At December 31, 1993, licensees in which BellSouth had an equity interest provided cellular service to a total of approximately 2.1 million domestic customers in 16 states. BellSouth's proportionate share of such total customers, based on its percentage ownership interests of such licensees, was approximately 1.6 million customers. (See "Consolidated Financial Statements and Supplementary Data -- Domestic Cellular and Paging Operations Proportionate Operating Data.") Within its nine-state wireline service territory, BellSouth offers cellular service in cities, including Atlanta, Miami, New Orleans, Memphis, Louisville, Birmingham and Orlando, while outside its wireline service territory it offers cellular service in cities including Los Angeles, Houston, Milwaukee, Indianapolis, Honolulu and Richmond. BellSouth's proportionate interest in the aggregate population served by its domestic cellular systems is approximately 38.8 million persons. Public utility commissions in several states have expressed an interest in examining whether the cellular industry should be more closely regulated by such states. For example, in October of 1989, the California Public Utility Commission issued an order instituting an investigation of the cellular industry in California. (BellSouth has significant interests in cellular licensees in Los Angeles and Bakersfield.) The purpose of the investigation was to determine what state regulatory changes were needed in light of the continued growth of the cellular industry and the numerous regulatory issues that had been raised since its inception. This investigation has been through several phases and continues today by virtue of a December 1993 order of the California Commission, which began a new round of hearings regarding the regulatory framework and related issues. INTERNATIONAL CELLULAR OPERATIONS Outside the United States, BellSouth owns interests in consortiums that hold licenses for, and are building and/or operating, cellular telephone systems in Argentina, Australia, Denmark, Germany, Uruguay and Venezuela. Through wholly-owned subsidiaries, BellSouth holds licenses for Chile and New Zealand cellular telephone systems. At December 31, 1993, such systems provided cellular service to a total of approximately 499,300 international customers. BellSouth's proportionate share of such customers, based on its percentage ownership interests in such systems, was approximately 192,200 customers. BellSouth offers cellular service under regional licenses to areas within Argentina, Uruguay and Chile and offers cellular service under nationwide licenses in Australia, Denmark, Venezuela and New Zealand. Service in Australia is also currently being provided by reselling service obtained from the government owned carrier. (See "Other International Operations.") In addition, BellSouth has been granted a license and is constructing a system for nationwide cellular service in Germany. During the first quarter of 1994, BellSouth disposed of its interest in a cellular telephone business in Mexico. BellSouth's international cellular systems operate in areas with an aggregate population of approximately 55.4 million persons, based on its percentage ownership interests in licensees in such countries. PAGING OPERATIONS BellSouth also provides domestic and international paging services. Paging services provide the ability to contact, by means of a radio transmitted signal, persons who carry small radio receivers. The caller uses a cellular or wireline telephone to reach an assigned telephone or PIN number at the service provider's facilities. The assigned number is automatically relayed to the paging terminal, and the call triggers a signal which is relayed to the terminal's transmitter and transmitted to the paging unit. Subscribers typically rent the paging units on a month-to-month basis, or purchase such units, and pay a flat monthly fee for paging services. These services are subject to regulation by the FCC. BellSouth has local and regional paging operations in many areas throughout the United States. In addition, BellSouth offers nationwide messaging service. BellSouth's paging and messaging services are offered under the MobileComm-R- service mark. As of December 31, 1993, BellSouth had approximately 1,344,400 pagers in service based upon its ownership percentage in markets served. Of this amount, approximately 1,232,200 pagers were in service in the United States while approximately 112,200 pagers were in service in Australia. OTHER WIRELESS OPERATIONS BellSouth and RAM Broadcasting Corporation ("RBC") have formed a business venture ("RAM") to own and operate certain mobile data communications networks worldwide. These networks enable mobile applications such as computer-aided dispatch, electronic mail, transaction processing and remote data entry and retrieval. They can also be used for such fixed applications as credit card validation and telemetry. BellSouth has a 49 percent interest in the United States mobile data operations, which will continue to be operated by RBC, and a substantial interest in all foreign mobile data operations of the RAM venture except the United Kingdom and France, where BellSouth has a 37.5 percent and 11.25 percent ownership interest, respectively. The RAM networks cover the top 100 metropolitan markets and 90% of the urban United States business population. Some additional construction of RAM's networks is planned to expand coverage. Personal communications services ("PCS") are in the developmental stage and are anticipated to provide a wide range of wireless communications services. The FCC is currently putting a licensing process in place that will allocate 160 megahertz for broadband PCS, with 120 megahertz being given to licensed operators, 20 megahertz reserved for unlicensed voice operations and 20 megahertz reserved for unlicensed data operations. The FCC is developing rules to award the licensed spectrum on an auction basis, with up to seven licenses per geographic area. BellSouth will be able to bid on all potential licenses in areas where it does not provide cellular service. Where it provides cellular service, BellSouth likely will be limited to bidding on one 10 megahertz PCS license. It is anticipated that the auctions could begin as early as the Fall of 1994. The federal government hopes to raise $10 billion auctioning off the PCS spectrum. BellSouth has conducted several trials of PCS-like services under experimental licenses from the FCC, but has made no final determination of the scope of its participation in the PCS licensing auctions. It is anticipated that substantial capital would be required to bid on licenses and to construct the systems should BellSouth elect to participate. OTHER INTERNATIONAL OPERATIONS BellSouth is a 24.5 percent participant in Optus Communications Pty. Ltd. ("Optus"), an international consortium which has been licensed by the Australian government to build and operate Australia's second telecommunications network. Optus offers a full spectrum of cellular telecommunications, switched network, enhanced wireline services and satellite-based services. Optus has completed construction of the bulk of its long distance network and has built basic infrastructure for the local business services in Canberra, Melbourne and Sydney. Long distance and local service switching centers have been established in the six mainland capital cities and over 3,000 miles of optical fiber cable has been placed. Approximately 70% of the population currently has access to the long distance service provided on the Optus network. During the fourth quarter of 1993, Optus began offering a limited number of local business services such as data services via its terrestrial and satellite facilities. Optus had over 230,000 analog cellular resale customers at December 31, 1993. In addition to reselling analog cellular service provided by the government-owned carrier, Optus has installed its own digital cellular service in five capital cities. Optus also owns AUSSAT, Australia's national satellite communications carrier. AUSSAT satellites provide voice, data and television broadcast communications to Australia and New Zealand, air traffic control communications to Australia's Civil Aviation Authority and mobile communications to Australia's rural areas. BellSouth has entered into a joint venture agreement with Ji Tong Company, an operating unit within the Chinese government, to invest up to $30 million in communications projects in China. The venture's main business will be to provide contract work for the construction and implementation of telecommunications and information network projects, including the provision of network planning, design and engineering. In addition, the joint venture will perform software and hardware systems integration, development and production. BellSouth has received a license to operate a competing domestic and international long distance concession in Chile. BellSouth plans to construct the network utilizing a combination of satellite, microwave digital switching and fiber optic facilities and begin service later in 1994. BROADBAND SERVICES In August 1992, the FCC issued an order allowing the LECs to offer video dial tone for transmitting video services. These services would allow customers of the LECs to have access through the network to video services such as educational programs and pay per view television. BellSouth Telecommunications expects to request FCC permission to construct facilities necessary to test video dial tone services later this year. The FCC has also recommended that Congress repeal the restriction in the Cable Act of 1984 which prohibits LECs from providing cable television programming in their service territories, and has proposed that LECs be allowed to provide and to acquire minor ownership interests in, video programming in such territories. In December 1993, BellSouth filed suits in U.S. District Courts in Alabama and Tennessee seeking relief from the Cable Communications Policy Act of 1984, under which BellSouth is prohibited from providing video programming, such as that provided by a television broadcast station, directly to consumers within BellSouth Telecommunications' wireline service areas. If successful, BellSouth intends to seek the appropriate governmental authorizations necessary to provide video transport, video programming and interactive services in such areas. BellSouth has formed a strategic alliance with a major cable TV operator, Prime Cable, pursuant to which it has entered into a credit agreement with Prime South Diversified, Inc. ("Prime South"), which indirectly wholly-owns Community Cable TV ("CCTV"), a Las Vegas cable operation managed by Prime Cable, to provide up to $250 million in financing. CCTV is the nation's 14th largest cable system serving over 200,000 cable connections and more than 70,000 hotel rooms. The loan to Prime South, which closed in January 1994 and matures in 2001, is secured by the stock of Prime South and that of a wholly-owned subsidiary. BellSouth also has the option to acquire such stock at various dates over the term of the loan. Concurrently, BellSouth entered into an agreement to acquire a 22.5% interest in Prime Cable's management company, which provides management services to five affiliated cable systems nationwide, with an option to acquire the remaining 77.5% over the term of the loan to Prime South. This transaction is expected to close in late 1994, subject to regulatory approval. In an effort to pursue opportunities in interactive programming, television shopping and other advanced services, BellSouth had agreed to invest approximately $2 billion in QVC Network, Inc. ("QVC"), contingent on QVC's successfully completing its acquisition of Paramount Communications, Inc. ("Paramount"), and had also received an option to acquire approximately $500 million of QVC stock at a purchase price of $60 per share in the event QVC was unsuccessful in its proposed acquisition of Paramount. QVC's bid for Paramount was terminated on February 14, 1994, and BellSouth has six months thereafter to determine whether to exercise the option. SELLING, LEASING AND MAINTAINING EQUIPMENT BellSouth sells, leases and maintains CPE, and to a lesser extent, computers and related office equipment. The Holding Companies, AT&T and other substantial enterprises compete in the provision of CPE and other services and products. COMPETITION GENERAL BellSouth is subject to increasing competition in all areas of its business. Regulatory, legislative and judicial actions and technological developments have expanded the types of available services and products and the number of companies which may offer them. Increasingly, this competition is from large companies which have substantial capital, technological and marketing resources. Developments during 1993 indicate that a technological convergence is occurring in the telephone, cable and broadcast television, computer, entertainment and information services industries. The technologies utilized and being developed in these industries will enable companies to provide multiple forms of communications offerings. Current policies of Congress and the FCC strongly favor lowering legislative and regulatory barriers to competition in the telecommunications industry. Accordingly, the nature of competition which BellSouth will face will depend to a large degree on regulatory actions at the state and federal levels, decisions with respect to the MFJ and possible state and federal legislation. NETWORK AND RELATED SERVICES LOCAL SERVICE Many services traditionally provided exclusively by the LECs have been deregulated, detariffed or otherwise opened for competition. For example, some carriers and other customers with concentrated, high usage characteristics are utilizing shared tenant services, private branch exchange (PBX) systems (which are owned by customers and provide internal switching functions without using BellSouth Telecommunications' central office facilities), private line services and other telecommunications links which bypass the switched networks of BellSouth Telecommunications. An increasing number of private voice and data communications networks utilizing fiber optic lines have been and are being constructed in metropolitan areas, including Atlanta, Georgia, Charlotte, North Carolina and Jacksonville, Miami and Orlando, Florida, which will offer certain high volume users a competitive alternative to the public and private line offerings of the LECs. In addition, the existing networks of cable television systems are capable of carrying two-way interactive data messages and can be configured to provide voice communications. Furthermore, wireless services, such as cellular telephone and paging services, and PCS services when operational, increasingly compete with wireline communications services. BellSouth Telecommunications is presently vulnerable to bypass to the extent that its access charges reflect subsidies for other services. Although BellSouth Telecommunications believes that bypass has already occurred to a significant degree in its nine-state area, it is difficult to quantify the lost revenues since customers are not required to report to the telephone companies the components of their telecommunications systems. In general, telephone company telecommunications services in highly concentrated population and business areas are more vulnerable to bypass. MCI Communications Corporation has announced long range plans to invest more than $20 billion to create and deliver a wide array of communications services. Included in these plans is an investment of $2 billion to construct local networks in major United States cities, including Atlanta, Georgia and other cities in the Southeast. MCI has stated that it would connect directly to customers and provide alternative local voice and data communications services. Local service competition from MCI could emerge in Atlanta by mid-1994. AT&T has announced an agreement to acquire McCaw Communications, Inc., the largest domestic cellular communications company, which serves customers in 10 cities in BellSouth's local wireline territory and seven cities in which BellSouth provides competing cellular communications. AT&T's capital and marketing resources would be expected to make McCaw a more formidable cellular competitor and could provide an integrated network for carrying communications traffic that otherwise would have been carried over the public switched and private line networks of BellSouth Telecommunications. Alliances are also being formed between other Holding Companies and large corporations that operate cable television systems in many localities throughout the United States, e.g., U S West, Inc./ Time Warner Communications, Southwestern Bell Corporation/Cox Enterprises, Inc. and NYNEX Corporation/Viacom, Inc. As technological and regulatory developments make it more feasible for cable television to carry data and voice communications, it is increasingly likely that BellSouth Telecommunications will face competition within its region from the other Holding Companies through their cable television venture arrangements. U S West and Time Warner have announced plans to upgrade certain of their cable TV systems to full-service networks which would support new interactive and telephone services that will compete with the incumbent local exchange carriers. The first of these full-service networks is being built in Orlando, Florida and is expected to begin offering services in the Fall of this year. Tele-Communications, Inc. has announced plans to offer similar services in South Florida and Louisville, Kentucky. ACCESS SERVICE The FCC has adopted rules requiring local exchange carriers to offer expanded interconnection for interstate special and switched transport. As a result, BellSouth Telecommunications will be required to permit competitive carriers and customers to terminate their transmission facilities in its central office buildings. Virtual collocation agreements may also be negotiated between carriers. Various aspects of these rules have been challenged by a number of carriers, including BellSouth Telecommunications. The effects of the rules would be to increase competition for access transport. It is uncertain whether the local exchange carriers will receive the pricing flexibility necessary to compete effectively with alternative access providers. TOLL SERVICE A number of firms compete with BellSouth Telecommunications for intraLATA toll business by reselling toll services obtained at bulk rates from BellSouth Telecommunications or, subject to the approval of the applicable state public utility commission, providing toll services over their own facilities. Commissions in the states in BellSouth Telecommunications' operating territory have allowed the latter type of intraLATA toll calling, whereby the Interexchange Carriers are assigned a multiple digit access code ("10XXX") which customers may dial to place intraLATA toll calls through facilities of such Interexchange Carriers. The Kentucky Commission has concluded that competing carriers should be allowed to provide intraLATA toll presubscribed calling with a single digit access code (1+ or 0+) but is considering how and when such authorization should be implemented. DIRECTORY ADVERTISING AND PUBLISHING In BellSouth's advertising and publishing business, competition for advertising revenues has expanded. Many different media compete for advertising revenues, and some newspaper organizations and other companies have begun publishing their own directories. Competition for directory sales agency contracts for the sale of advertising in publications of nonaffiliated companies also continues to be strong. WIRELESS COMMUNICATIONS The FCC has jurisdiction over the licensing of cellular mobile radio services in domestic markets. The FCC limits entry for providers of cellular mobile telecommunications to two licensees for each defined metropolitan statistical area ("MSA") and each rural service area ("RSA") within the country. Each MSA and RSA in which BellSouth participates in the provision of cellular mobile communications has a competing service provider. BellSouth's international cellular joint ventures are generally subject to competition from at least one other cellular service provider, and sometimes more than one other provider, as in, for example, Germany where there are two additional competitors. These competing cellular service providers are generally supported by partners at least as well-capitalized as BellSouth and its partners. In some cases the competing cellular provider is owned by the state-owned telephone company, which may have access to the financial resources of the government. BellSouth's paging operations experience competition from one or more competitors in all markets in which they are conducted. Although some of BellSouth's competitors are small privately-owned companies serving only one market area, others are large companies such as Paging Network, Inc. and MobileMedia Communications, Inc. Competition for paging subscribers is based primarily on the price and quality of service and the geographic area covered. BellSouth believes that the price and quality of its services and its geographic coverage areas generally compare favorably with those of its competitors. BellSouth's mobile data business venture with RAM expects competition from private wireless data networks, Specialized Mobile Radio, analog cellular and future Cellular Digital Packet Data technology. RAM's primary competitor today in the wireless data market is ARDIS, a wireless data joint venture between IBM Corporation and Motorola, Inc. The ARDIS network, which was started in 1983 as a private network for IBM, currently has the advantage of a larger installed customer base and greater network coverage. RAM, however, expects to attract customers with its unique network feature of automatic, seamless nationwide roaming. Success of the RAM venture will depend significantly on early marketing efforts to enroll customers and the relative market acceptance of RAM technology. The FCC has approved construction of enhanced specialized mobile radio ("ESMR") systems in many cities around the country. These digital mobile communications systems are expected to provide service very similar to cellular telephone service. There has been a consolidation of the licenses required to provide ESMR service, so that control of this business is concentrated in the hands of a few potential operators, giving them the ability to offer services like nationwide roaming quickly and efficiently once the systems are built. It is expected that the first location where ESMR will become available commercially is Los Angeles during second quarter of 1994 in competition with BellSouth's cellular telephone partnership. MCI has also announced an alliance with Nextel Communications and Comcast Corp. to offer wireless personal communications services in most major cities. The FCC's PCS licensing process will create up to seven new competitors for BellSouth's cellular business in each geographic area where BellSouth provides that service. It is also anticipated that in conjunction with cable operators, interexchange carriers, or other alternative local service providers, PCS will provide some competition to BellSouth's local wireline telephone business. The exact service offerings and functionality of PCS still has not been completely determined, but it is anticipated that the competitive systems could be in place in late 1995 or early 1996. While BellSouth believes that it can evolve the capabilities of its existing cellular business to meet this competitive challenge, it is also considering the possibility of applying for PCS licenses. BELLSOUTH COMPETITIVE STRATEGY REGULATORY AND LEGISLATIVE CHANGES The states in BellSouth Telecommunications' service area currently provide for some form of regulation of earnings, a regulatory framework that BellSouth believes is not appropriate for the increasingly competitive telecommunications environment. Accordingly, BellSouth's primary regulatory focus continues to be directed toward modifying the regulatory process to one that is more closely aligned with changing market conditions and overall public policy objectives. As an alternative to the current regulatory process, BellSouth believes that price regulation, whereby prices of basic local exchange service are directly regulated and prices for other products and services are based on market factors, is a logical progression toward regulatory flexibility and is fair to consumers. As such, BellSouth Telecommunications intends to pursue implementation of price regulation plans through filings with state regulatory commissions or through legislative initiatives. BellSouth is also seeking relief in the courts and before Congress and regulatory agencies from current laws, regulations and judicial restrictions (including the MFJ) for the provision of voice, data and video communications throughout its wireline service territory and elsewhere. It is furthermore advocating legislative and regulatory initiatives which would eliminate or modify restrictions on its current and future business offerings. (See "Legislation.") Competitors and other interest groups with substantial resources oppose many of these initiatives. The ultimate outcome and timing of any relief obtained cannot be predicted with certainty. Technological changes and the effects of competition reduce the economic useful lives of BellSouth Telecommunications' fixed assets. As competition increases in both the exchange access and local exchange markets, the economic lives of related properties should continue to decrease. Therefore, BellSouth Telecommunications is examining the rates of depreciation of fixed assets authorized by the FCC and state regulatory commissions to ensure that these rates are adequate to recover fixed asset costs in a timely fashion. The FCC and the state commissions represcribe depreciation rates for BellSouth Telecommunications at three-year intervals. ENTRY INTO NEW MARKETS Notwithstanding the risks associated with increased competition, BellSouth will have the opportunity to benefit from entry into new business markets. BellSouth believes that in order to remain competitive in the future, it must aggressively pursue a corporate strategy of expanding its offerings beyond its traditional businesses. These offerings may include information services, interactive communications and cable television and other entertainment services. BellSouth plans to enter such businesses through acquisitions, investments, and strategic alliances with established companies in such industries and through the development of such capabilities internally. RESTRUCTURING BellSouth Telecommunications is restructuring its telephone operations by streamlining its fundamental processes and work activities to better respond to an increasingly competitive business environment. The restructuring is expected to improve overall responsiveness to customer needs, permit more rapid introduction of new products and services and reduce costs. A primary objective of this restructuring is the plan to downsize BellSouth Telecommunications' workforce by 10,200 by the end of 1996. LEGISLATION There are a number of bills pending in Congress that, if enacted into law, could significantly affect BellSouth's business operations and opportunities. The provisions of the bills set the terms, conditions, obligations and time frames under which the Operating Telephone Companies would be permitted 1) to offer interLATA services, 2) to manufacture CPE, 3) to manufacture and provide telecommunications equipment, 4) to provide video programming in their telephone service territories and 5) to offer electronic publishing services or alarm monitoring services. They also would address the need to preserve universal service in a competitive telecommunications marketplace and would preempt state laws prohibiting competition for intrastate telephone services. In the House of Representatives, these items are addressed in the provisions of two bills, H.R. 3626 and H.R. 3636. In the Senate, they are contained in S.1822. H.R. 3636 as currently drafted also specifies that a Federal/ State Joint Board should require that large carriers like BellSouth Telecommunications be subject to alternative or price regulation rather than traditional rate of return regulation. The House has held several hearings on the House bills, and the House Judiciary Committee and the House Energy and Commerce Committee have each adopted a version of H.R. 3626, and the House Energy and Commerce Committee has adopted H.R. 3636. The Rules Committee will decide how and when these bills will proceed to the floor of the House. RESEARCH AND DEVELOPMENT The services and products of BellSouth are in a highly technological field. BellSouth has expended $45.9, $52.5 and $42.0 million in 1993, 1992 and 1991, respectively, on company-sponsored research and development activities. The majority of this activity is conducted at Bell Communications Research, Inc. ("Bellcore"), one-seventh of which is owned by BellSouth, through BellSouth Telecommunications, with the remainder owned by the other Holding Companies. Bellcore provides research and development and other services for its owners and is the central point of contact for coordinating the Federal government's telecommunications requirements relating to national security and emergency preparedness. LICENSES AND FRANCHISES BellSouth Telecommunications' local exchange business is typically provided under certificates of public convenience and necessity granted pursuant to state statutes and public interest findings of the various public utility commissions of the states in which BellSouth Telecommunications does business. These certificates provide for a franchise of indefinite duration, subject to the maintenance of satisfactory service at reasonable rates. The domestic cellular, paging and mobile data systems that BellSouth owns or has an interest in are operated under licenses granted by the FCC. Prior approval of the FCC is required for the assignment of a license or the transfer of control of a licensee. The licenses are generally issued for up to 10 year periods. For the paging and mobile data licenses, at the end of the license period a renewal application must be made which BellSouth believes will generally be granted upon showing compliance with FCC regulations and continuing service to the public. Licenses may be revoked and license renewal applications may be denied for cause. With regard to cellular licenses, the FCC has established the procedures and standards for conducting comparative renewal proceedings which include a "renewal expectancy" for cellular operators meeting specific criteria. This ruling is presently undergoing further FCC review. International cellular, paging and mobile data systems also operate under licenses granted by the governments in the countries where such systems are located. The foreign licenses are issued for varied terms and are generally renewable at the end of the initial license period. As is the case with BellSouth's domestic wireless properties, the foreign licenses may be revoked and license renewal applications may be denied for cause. BellSouth owns or has licenses to use all patents, copyrights, licenses, trademarks and other intellectual property necessary for it to conduct its present business operations. It is not anticipated that any of such property will be subject to expiration or non-renewal of rights which would materially and adversely affect BellSouth or its subsidiaries. EMPLOYEES At December 31, 1993, 1992 and 1991 BellSouth and its subsidiaries employed approximately 95,100, 97,100 and 96,100 persons, respectively. Of these amounts at these dates, approximately 81,400, 82,900 and 82,200 were employees of BellSouth Telecommunications. About 71% of BellSouth's employees at December 31, 1993 were represented by the Communications Workers of America (the "CWA"), which is affiliated with the AFL-CIO. In September 1992, the CWA ratified new three-year contracts with BellSouth covering about 61,000 employees. These contracts included provisions for wage increases, a cost-of-living adjustment and an increase in the team incentive award that will total, in the aggregate, an estimated 11.3% over the three year contract period. In November, 1993, BellSouth Telecommunications announced plans to reduce its work force by approximately 10,200 employees by the end of 1996 through normal attrition, transitional programs, other voluntary options and involuntary separations. ITEM 2. ITEM 2. PROPERTIES GENERAL BellSouth's properties do not lend themselves to description by character and location of principal units. BellSouth's investment in property, plant and equipment, 96% of which is held by BellSouth Telecommunications, consists of the following at December 31: Outside plant consists of connecting lines (aerial, underground and buried cable) not on customers' premises, the majority of which are on or under public roads, highways or streets while the remainder is on or under private property. Central office equipment consists of analog switching equipment, digital electronic switching equipment and circuit equipment. Land and buildings are occupied principally by central offices. Station equipment consists of embedded intrasystem wiring, substantially all of which is on the premises of customers. Substantially all of the installations of central office equipment and administrative offices are located in buildings and on land owned by BellSouth Telecommunications. Many garages, business offices and telephone service centers are in leased quarters. BellSouth Telecommunications' customers are now served by electronic switching systems that provide a wider variety of services than their mechanical predecessors. The BellSouth Telecommunications network is in transition from an analog to a digital network, which provides capabilities for BellSouth Telecommunications to furnish advanced data transmission and information management services. PROPERTY ADDITIONS Property additions include gross additions to property, plant and equipment having an estimated service life of one year or more, plus the incidental costs of preparing the asset for its intended use. In the case of constructed assets, an amount related to the cost of debt and equity used in the construction of an asset is capitalized as part of the asset when the construction period is in excess of one year. Property additions also include assets acquired by means of entering into a capital lease agreement, gross additions to operating lease equipment and reused materials. Significant additions to property, plant and equipment will be required to meet the demand for telecommunications services and to further improve such services. The level of property additions indicated below is expected to be maintained in the near future. The total investment in telephone plant has increased from about $34,143 million at January 1, 1989 to about $41,975 million at December 31, 1993, including the effects of retirements and property transferred at divestiture, but not including deductions of accumulated depreciation at either date. BellSouth's property additions at December 31 since 1989 are approximately as follows: In 1993, BellSouth generated substantially all of its funds for property additions internally; substantially all such additions are expected to be financed through internally generated funds in 1994. BellSouth projects property additions for BellSouth Telecommunications to be approximately $3,000 million during 1994. The continued modernization of the BellSouth Telecommunications' network is necessary to meet the needs of customers and competitive demands. Population and economic expansion is projected by BellSouth in certain growth centers within its nine-state area during the next five to ten years. Expansion of the network will be needed to accommodate such projected growth. BellSouth projects that during 1994 it will invest approximately $500 million in the properties of BellSouth Enterprises' consolidated subsidiaries. A majority of such expenditures will be for property additions to its cellular systems to complete construction of new systems and to expand, enhance and modernize its operating systems. BellSouth has commenced adding digital technology to certain systems which are operating at or near capacity with analog technology. ENVIRONMENTAL MATTERS BellSouth Telecommunications is subject to a number of environmental matters as a result of its operations and the shared liability provisions in the POR. As a result, BellSouth Telecommunications expects that it will be required to expend funds to remedy certain facilities, including those Superfund sites for which BST has been named as a potentially responsible party, for the remediation of sites with underground fuel storage tanks and other expenses associated with environmental compliance. At December 31, 1993, BST's recorded liability related primarily to remediation of these sites was $35.5 million. BellSouth continually monitors its operations with respect to potential environmental issues, including changes in legally mandated standards and remediation technologies. BellSouth's recorded liability reflects those specific issues where remediation activities are currently deemed to be probable and where the cost of remediation is estimable. BellSouth continues to believe that expenditures in connection with additional remedial actions under the current environmental protection laws or related matters will not be material. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The MFJ and the related POR provide for the recognition and payment of liabilities by AT&T and the Operating Telephone Companies that are attributable to pre-divestiture events but that did not become certain until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Contingent liabilities that are attributable to pre-divestiture events are shared by AT&T and the Operating Telephone Companies in accordance with formulae prescribed by the POR, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. BellSouth Telecommunications' share of these liabilities to date has not been material to its financial position or results of operations for any period. BellSouth and its subsidiaries are subject to claims and proceedings arising in the ordinary course of business. While complete assurance cannot be given as to the outcome of any contingent liabilities, in the opinion of BellSouth, any financial impact to which BellSouth and its subsidiaries are subject is not expected to be material in amount to BellSouth's operating results or its financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS No matter was submitted to a vote of shareholders in the fourth quarter of the fiscal year ended December 31, 1993. ------------------------ ADDITIONAL INFORMATION DESCRIPTION OF BELLSOUTH STOCK GENERAL The Articles of Incorporation of BellSouth authorize the issuance of 1,100,000,000 shares of common stock, par value $1 per share (the "Common Stock"), and 100,000,000 shares of cumulative, first preferred stock, par value $1 per share (the "Preferred Stock"). BellSouth's Board of Directors (the "Board") is authorized to provide for the issuance, from time to time, of the Preferred Stock in series and, as to each series, to fix the number of shares in such series and the voting, dividend, redemption, liquidation, retirement and conversion provisions applicable to the shares of such series. No shares of Preferred Stock are outstanding. The Board has created Series A First Preferred Stock consisting of 30 million shares (the "Series A Preferred Stock") for possible issuance under BellSouth's Shareholder Rights Plan. (See "Preferred Stock Purchase Rights.") DIVIDEND RIGHTS The holders of Common Stock are entitled to receive, from funds legally available for the payment thereof, dividends when and as declared by resolution of the Board. While any series of Preferred Stock is outstanding, no dividends (other than dividends payable solely in Common Stock) may be declared or paid on Common Stock, and no Common Stock may be purchased, redeemed or otherwise acquired for value, (a) unless dividends on all outstanding shares of Preferred Stock for the current and all past dividend periods have been paid or declared and provision made for payment thereof and (b) unless all requirements with respect to any purchase, retirement or sinking fund or funds applicable to all outstanding series of Preferred Stock have been satisfied. Dividends on the Preferred Stock would be cumulative. VOTING RIGHTS Except in connection with the "business combinations" and "fair price" provisions discussed below, holders of shares of Common Stock are entitled to one vote, in person or by proxy, for each share held on the applicable record date with respect to each matter submitted to a vote at a meeting of shareholders, but such holders do not have cumulative voting rights. The holders of any series of Preferred Stock, when issued, may receive the right to vote as a class on certain amendments to the Articles of Incorporation and on certain other matters, including the election of directors in the event of certain defaults, which may include non-payment of Preferred Stock dividends. LIQUIDATION RIGHTS In the event of voluntary or involuntary liquidation of BellSouth, holders of the Common Stock will be entitled to receive, after creditors have been paid and the holders of the Preferred Stock, if any, have received their liquidation preferences and accumulated and unpaid dividends, all the remaining assets of BellSouth. PRE-EMPTIVE RIGHTS; CONVERSION RIGHTS; REDEMPTION No shareholders of any class shall be entitled to any pre-emptive rights to subscribe for or purchase any shares or other securities issued by BellSouth. The Common Stock has no conversion rights and is not subject to redemption. PREFERRED STOCK PURCHASE RIGHTS The Board has declared a dividend of one preferred stock purchase right ("Right") for each share of Common Stock from time to time outstanding. Under certain circumstances, each Right will entitle the holder to purchase one one-hundredth of a share of Series A Preferred Stock, $1.00 par value ("Common Equivalent Preferred Stock"), which unit is substantially equivalent in voting and dividend rights to one whole share of the Common Stock, at a price of $175 per whole share (the "Purchase Price"). The Rights are not presently exercisable and may be exercised only if a person or group acquires 10% of the outstanding voting stock of BellSouth without the prior approval of the Board ("Acquiring Person") or announces a tender or exchange offer that would result in ownership of 25% or more of the Common Stock. If an Acquiring Person becomes such without prior Board approval, the Rights are adjusted, and each holder, other than the Acquiring Person, then has the right to receive, on payment of the Purchase Price, the number of shares of Common Stock, units of the Common Equivalent Preferred Stock or other assets having a market value equal to twice the Purchase Price. The Rights currently trade with the Common Stock and expire after ten years. BUSINESS COMBINATIONS The Georgia legislature has enacted legislation which generally prohibits a corporation which has adopted a by-law electing to be covered thereby (which BellSouth has done) from engaging in any "business combination" (i.e., a merger, consolidation or other specified corporate transaction) with an "interested shareholder" (i.e., a 10% shareholder or an affiliate of the corporation which was a 10% shareholder at any time within the preceding two years) for a period of five years from the date such person becomes an interested shareholder, unless the interested shareholder (i) prior to becoming an interested shareholder, obtained the approval of the Board of Directors for either the business combination or the transaction which resulted in the shareholder becoming an interested shareholder, (ii) becomes the owner of at least 90% of the outstanding voting stock of the corporation in the same transaction in which the interested shareholder became an interested shareholder, excluding for purposes of determining the number of shares outstanding those shares owned by officers, directors, subsidiaries and certain employee stock plans of the corporation or (iii) subsequent to the acquisition of 10% or more of the outstanding voting stock of the corporation, acquires additional shares resulting in ownership of at least 90% of the outstanding voting stock of the corporation and obtains approval of the business combination by the holders of a majority of the shares of voting stock of the corporation, other than those shares held by an interested shareholder, officers, directors, subsidiaries and certain employee stock plans of the corporation. BellSouth's "business combinations" by-law may be repealed only by an affirmative vote of two-thirds of the continuing directors and a majority of the votes entitled to be cast by the shareholders, other than interested shareholders, and shall not be effective until 18 months after such shareholder vote. The Georgia statute provides that a domestic corporation which has thus repealed such a by-law may not thereafter readopt the by-law as provided therein. FAIR PRICE PROVISIONS "Fair price" provisions contained in the Articles of Incorporation require, generally, in connection with a merger or similar transaction between BellSouth and an "interested shareholder" (a 10% shareholder or an affiliate of BellSouth which was a 10% shareholder at any time within the preceding two years), the unanimous approval of BellSouth's directors not affiliated with the interested shareholder or the affirmative vote of two-thirds of such directors and a majority of the outstanding shares held by disinterested shareholders, unless (i) within the past three years the shareholder has been an interested shareholder and has not increased its shareholdings by more than one percent in any 12-month period or (ii) all shareholders receive at least the same consideration for their shares as the interested shareholder previously paid. Additionally, these provisions may be revised or rescinded only upon the affirmative vote of at least two-thirds of the directors not affiliated with an interested shareholder and a majority of the outstanding shares held by disinterested shareholders. BOARD CLASSIFICATION Board classification provisions adopted by the shareholders and contained in the By-laws prescribe a shareholder vote for approximately one-third of the directors, instead of all directors, at each annual meeting of shareholders for a three-year term. Additionally, such provisions provide that shareholders may remove directors from office, with or without cause, amend the By-laws with respect to the number of directors or amend the board classification provisions only by the affirmative vote of the holders of at least 75% of the outstanding shares entitled to vote for the election of directors. REMOVAL OF DIRECTORS BellSouth's Articles of Incorporation provide that the shareholders of BellSouth may remove a director, with or without cause, by the affirmative vote of the holders of at least 75% of the voting power of all shares of stock entitled to vote generally in the election of directors, voting together as a single class. LIMITATION ON SHAREHOLDERS' PROCEEDINGS BellSouth's By-laws require 60 days advance notice of shareholder nominations for directors and of other matters to be brought before annual shareholders' meetings. Such By-laws also provide that a special shareholders' meeting may not be called by fewer than two-thirds of the outstanding shares entitled to vote at the meeting. ------------------------ The provisions discussed under the six preceding sub-headings and the ability to issue Preferred Stock, such as the Series A Preferred Stock described above, with characteristics established by the Board and without the consent of the holders of Common Stock and the ability to issue additional shares of Common Stock may have the effect of discouraging takeover attempts and may also have the effect of maintaining the position of incumbent management. In addition, these provisions may have a significant effect on the ability of shareholders of BellSouth to benefit from certain kinds of transactions that may be opposed by the incumbent Board. EXECUTIVE OFFICERS The executive officers of BellSouth are listed below: All of the executive officers of BellSouth, other than Mr. Feidler, have for at least the past five years held high level management or executive positions with BellSouth or its subsidiaries. Prior to joining BellSouth in 1992, Mr. Feidler was employed by The Robinson-Humphrey Company, Inc. (1986 - 1990) and The Breckenridge Group (1990 - 1991), investment banking firms. All officers serve until their successors have been elected and qualified. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market for trading in BellSouth common stock is the New York Stock Exchange, Inc. ("NYSE"). BellSouth common stock is also listed on the Boston, Chicago, Pacific and Philadelphia exchanges in the United States and the London, Zurich, Basel, Geneva, Frankfurt and Amsterdam exchanges. The ticker symbol for BellSouth common stock is BLS. As of January 31, 1994, there were 1,237,677 holders of record of BellSouth common stock. Market data, obtained from the NYSE Composite Tape, which encompasses trading on the principal United States stock exchanges as well as off-board trading, for 1991 through 1993 are listed below. High and low prices represent the highest and lowest sales prices for the periods indicated. Dividend data also are listed. STOCK TRANSFER AGENT AND REGISTRAR Chemical Bank is BellSouth's stock transfer agent and registrar. [THE FOLLOWING REPORT SENT TO SECURITY HOLDERS IS PROVIDED TO THE COMMISSION SOLELY AS INFORMATION AND IS NOT DEEMED "SOLICITING MATERIAL" OR TO BE "FILED" WITH THE COMMISSION EXCEPT TO THE EXTENT THAT THE COMPANY HAS INCORPORATED INFORMATION INCLUDED IN THE ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1992.] ITEM 6. ITEM 6. SELECTED FINANCIAL AND OPERATING DATA (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) BellSouth Corporation ("BellSouth") is a holding company headquartered in Atlanta, Georgia whose operating telephone company subsidiary, BellSouth Telecommunications, Inc. ("BellSouth Telecommunications") serves, in the aggregate, approximately two-thirds of the population and one-half of the territory within Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee. BellSouth Telecommunications primarily provides local exchange and toll communications services within 38 court-defined geographic areas, called Local Access and Transport Areas ("LATAs"), and network access services to enable interLATA communications using the long-distance facilities of interexchange carriers. BellSouth Enterprises, Inc. ("BellSouth Enterprises"), another wholly-owned subsidiary, owns businesses providing domestic wireless and international communications services and advertising and publishing services and products. Prior to January 1, 1992, the majority of the operations of BellSouth Telecommunications was conducted through South Central Bell Telephone Company ("South Central Bell") and Southern Bell Telephone and Telegraph Company ("Southern Bell"). Effective at midnight December 31, 1991, South Central Bell merged with and into Southern Bell and Southern Bell's name was changed to BellSouth Telecommunications. RESULTS OF OPERATIONS Net Income and Earnings Per Share for 1993 decreased $737.6 and $1.53, respectively, compared to the previous year. The decreases were due primarily to a charge of $696.6 ($1.40 per share) for restructuring of BellSouth's telephone operations (see Note K). Other charges in 1993 that contributed to the decreases were $86.6 ($.17 per share) for debt refinancings by BellSouth Telecommunications (see Note E), $67.4 ($.14 per share) for the adoption of Statement of Financial Accounting Standards ("SFAS") No. 112 (see Notes H and N), $47 ($.09 per share) for the initial impact of a regulatory settlement in Florida, approximately $45 ($.09 per share) related to the increase in the Federal statutory income tax rate for corporations, exclusive of the tax benefit associated with the restructuring charge, and approximately $25 ($.05 per share) associated with severe weather conditions during first quarter 1993. The decreases were also attributable in part to the inclusion in 1992's results of gains of $39.5 ($.08 per share) and $32.9 ($.07 per share), respectively, from the settlement of a Federal income tax matter and the settlement of prior year regulatory issues. The 1993 decreases were partially offset by overall growth of operating revenues, driven by an improvement in key business volumes, and the inclusion in 1992 of charges for debt refinancing and Hurricane Andrew. Net Income and Earnings Per Share for 1992 increased $146.2 and $.26, respectively, compared to 1991. Factors contributing to these increases include the gains from the settlement of a Federal income tax matter and the settlement of prior year regulatory issues, expense reductions attributable to salary savings since implementation of an early retirement program, the inclusion in 1991 of a charge associated with the early retirement program and the inclusion in 1991 of a one-time charge for the cumulative effect of the change in accounting principle for cellular service sales commissions (see Note N). Also contributing to the increases were growth in business volumes at BellSouth Telecommunications, partially offset by rate reductions, and in the wireless businesses at BellSouth Enterprises. The 1992 increases were partially offset by charges of $40.7 ($.08 per share) associated with refinancing at lower interest rates of certain long-term debt issues at BellSouth Telecommunications (see Note E) and approximately $28 ($.06 per share) associated with Hurricane Andrew, and costs attributable to investments in certain start-up operations. OPERATING REVENUES Total Operating Revenues increased $678.7 (4.5%) during 1993, compared to an increase of $756.1 (5.2%) during 1992. Both increases resulted from growth in revenues from BellSouth's wireline telephone businesses, coupled with a significant increase in revenues from wireless communications businesses. Traditionally, BellSouth's local, access and toll services offered by BellSouth Telecommunications have primarily accounted for increases in operating revenues. BellSouth, however, continues to experience an increasing shift in the relative contributions of its revenue sources. See "Volumes of Business." Local Service revenues reflect amounts billed to customers for local exchange services, which include connection to the network and secondary central office feature services, such as custom calling features and custom dialing packages. Local Service revenues for 1993 increased $341.3 (5.5%) compared to an increase of $389.8 (6.7%) in 1992. The 1993 increase was primarily attributable to an increase of 683,000 access lines since December 31, 1992 and a $42.0 increase from secondary central office services. In addition, as discussed below, the effects of a $27.9 refund in Florida during 1992 and changes in and the expansion of local area calling plans, including a plan implemented in Louisiana in 1992, contributed to the increase in 1993. The increase in 1992 was attributable to the addition of 614,900 access lines during the year, revenue shifts from toll to local due to expanded local area calling plans and an increase in secondary central office services of $51.4 over 1991. The increase in revenues from local area calling plans is primarily attributable to access line growth. In addition, the implementation of a new expanded local area calling plan in Louisiana, effective March 1992, positively impacted 1992 Local Service revenue (see "Toll"). The increase was also due in part to the inclusion in 1991 of a $63.9 refund in Florida which had previously been deferred in Other Services revenues. The increase in 1992 was partially offset by a related refund of $27.9 in 1992 pertaining to amounts set aside in 1991 for disposition by the Florida Public Service Commission. Since these deferred and set aside amounts were originally accrued in Other Services, there was no impact on net income. Interstate Access revenues result from the provision of access services to interexchange carriers to provide telecommunications services between states. Interstate access revenues increased $45.6 (1.5%) compared to an increase of $87.5 (3.1%) in 1992. The increase for 1993 reflects increased rates effective July 1, 1993 in conjunction with BellSouth Telecommunications' selection of a 3.3% productivity offset factor under the Federal Communications Commission's ("FCC") price cap plan, growth in minutes of use and increases in end user charges attributable to growth in the number of access lines in service. The effect of these increases was substantially offset by decreased net settlements with the National Exchange Carriers Association and revenue deferrals under the FCC's price cap plan. Since BellSouth Telecommunications' earnings are currently in the sharing range of the FCC's price cap plan and because of other factors, significant revenue growth in this category is not likely. For 1992, the increase in interstate access revenues was primarily attributable to growth in minutes of use and an increase in end user charges attributable to access line growth. The effect of these increases was partially offset by rate reductions since December 31, 1991, including the implementation of lower tariff rates, effective July 1, 1992, associated with BellSouth Telecommunications' selection of a 4.3% productivity offset factor, which reduced interstate revenues under the FCC's price cap plan. See "Operating Environment and Trends of the Business." Intrastate Access revenues result from the provision of access services to interexchange carriers which provide telecommunications services between LATAs within a state. Revenues increased $10.1 (1.2%) in 1993 compared to an increase of $5.1 (0.6%) in 1992. Both increases, due primarily to growth in minutes of use over the respective prior year, were substantially offset by rate reductions in 1993 and 1992. Toll revenues are received from the provision of long-distance services within (but not between) LATAs. These services include intraLATA service beyond the local calling area; Wide Area Telecommunications Service ("WATS" or "800" services) for customers with highly concentrated demand; and special services, such as transport of voice, data and video. Toll revenues decreased $29.3 (2.3%) in 1993 compared to a decrease of $124.9 (9.1%) in 1992. The decrease in 1993 reflects rate reductions since December 31, 1992 and a decline in toll message volumes largely attributable to the expansion of local area calling plans which have the effect of shifting revenues from Toll to Local Service. The decrease was partially offset by revenue increases due to optional calling plans and independent company settlements. The 1992 decrease resulted from rate reductions since December 31, 1991 and a decrease in toll messages due to competition and expanded local area calling plans, including a plan implemented in Louisiana in 1992. The overall decline in Toll revenues is expected to continue over the long term. Directory Advertising and Publishing revenues include revenues derived from publishing, printing and selling advertising in, and performing related services concerning, alphabetical and classified telephone directories. Directory Advertising and Publishing revenues increased $55.6 (3.8%) in 1993 compared to a $33.5 (2.3%) increase in 1992. The increase for 1993 was primarily attributable to increases in the prices and volume of advertising sold. For 1992, the increase was due primarily to growth in the volume of independent directory contracts. Wireless Communications revenues include the revenues from consolidated wireless communications businesses (primarily cellular and paging within BellSouth Enterprises) as well as revenues from interconnections by unaffiliated cellular carriers with BellSouth Telecommunications. (BellSouth's interests in the net income or loss of the unconsolidated wireless businesses within BellSouth Enterprises which are accounted for under the equity method of accounting are recorded in Other Income.) Wireless Communications revenues increased $357.8 (29.9%) in 1993, compared to an increase of $421.1 (54.4%) in 1992. For 1993, the increase resulted from continued growth of the customer base for wireless services in both domestic and international markets. The increase in 1992 resulted from growth of the customer base, acquisitions made in late 1991 and increases in roamer revenues. Other Services revenues are principally comprised of revenues from customer premises equipment sales and maintenance services, billing and collection services and other nonregulated services (primarily inside wire services) offered by BellSouth Telecommunications. Other Services revenues decreased $102.4 (8.2%) in 1993 compared to a decrease of $56.0 (4.3%) in 1992. The decrease in 1993 was attributable to the effect of reclassifying in 1992 a $27.9 Florida refund to ratepayers from Other Services to Local Service, the inclusion in 1992 of $52.7 for the settlement of prior year regulatory issues and the sale of a subsidiary in late 1992. The decrease was partially offset by increased revenues from nonregulated services due in part to higher demand. In addition, billing and collection revenues increased due to the effect of nonrecurring adjustments; however, such revenues are expected to decline over the long term due to interexchange carriers' assuming more direct billing for their own services. The decrease in 1992 was partially attributable to a decrease of $18.6 due to the dissolution of a business in 1991 and the reclassification in 1991 of a revenue deferral of $63.9 in Florida, partially offset by certain Florida set aside amounts totaling $27.9 for prior years which were included as Local Service rate reductions in 1992; these deferral and set aside amounts were initially recorded as reductions to Other Services revenues prior to 1992 (see "Local Service"). Also contributing to the 1992 decrease was a $34.3 decrease in billing and collection revenues and decreased revenues for certain BellSouth Enterprises subsidiaries. The decrease was partially offset by the settlement of prior year regulatory issues not related to the services described above but which were required to be recorded in Other Services, resulting in a one-time increase of $52.7. OPERATING EXPENSES Operating expenses increased $1,552.3 (12.9%) during 1993 compared to an increase of $405.1 (3.5%) during 1992. For 1993, the increase was primarily attributable to a pre-tax charge of $1,136.4 for restructuring of BellSouth's telephone operations. Adjusted for the effect of the restructuring charge, operating expenses increased $415.9 (3.5%) during 1993. The increase, as adjusted, was due to expenses associated with improved business volumes at BellSouth Telecommunications and in the wireless businesses at BellSouth Enterprises, higher levels of salaries and wages, a regulatory settlement in Florida, and expenses attributable to severe weather conditions in the first quarter of 1993. The increase was partially offset by decreased overtime compensation and the inclusion in 1992 of expenses related to Hurricane Andrew. The 1992 increase was due to expenses associated with higher business volumes, higher levels of salaries and wages, a portion of which resulted from a new three-year working agreement with the Communications Workers of America ("CWA") in 1992, Hurricane Andrew and remedial actions related to underground fuel storage tanks. The increase for 1992 was partially offset by the inclusion in 1991 of expenses associated with an early retirement program and 1992 expense reductions attributable to salary savings since implementation of that program. Cost of Services and Products includes operating expenses associated with network support and maintenance of BellSouth Telecommunications' property, plant and equipment, material and supplies expense, cost of tangible goods sold and other expenses associated with the cost of providing services. Cost of Services and Products increased $183.8 (3.2%) in 1993 compared to a decrease of $57.9 (1.0%) in 1992. The increase in 1993 was due to increased expenses associated with volume growth in the wireline, wireless communications and directory businesses, approximately $40 of expenses related to severe weather conditions during first quarter 1993, network service improvement activities, higher levels of base salary and wage expenses resulting from annual increases for management and craft employees and an increase in employee benefits expense. The increase in employee benefits expense was driven by the higher overall cost of medical services and an increase of $38 due to the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," partially offset by a $46 decrease in pension expense. Pension expense is expected to decrease further in 1994 due primarily to the effect of modifying the benefit level under the recently adopted cash balance pension plan for management employees and reevaluating certain actuarial assumptions (see Note H). Other postretirement benefit expenses for 1994 are expected to increase due to the effect of changes in certain actuarial assumptions. The overall expense increase for 1993 was partially offset by reduced expenses for overtime compensation, rents, software license fees, the sale of a subsidiary in late 1992 and expenses related to Hurricane Andrew reflected in 1992. For 1992, the decrease was due to the reclassification of $224.0 of expenses of certain businesses within BellSouth Enterprises to Selling, General and Administrative. After adjusting for the effect of the reclassification, Cost of Services and Products increased $166.1 (2.9%) during 1992 compared to 1991. As adjusted, the 1992 increase was attributable to growth in volumes of business at BellSouth Telecommunications, growth in the wireless communications customer base, including the effect of the acquisition of wireless businesses in 1991, higher levels of salary and wage expenses, a portion of which resulted from a new three-year working agreement with the CWA in 1992, increased pension and benefit expenses and approximately $45 of expenses (net of insurance recovery and state regulatory deferrals) related to Hurricane Andrew. Also contributing were increased expenses for rents and contracted services. The adjusted increase was partially offset by expense reductions attributable to salary savings from implementation of an early retirement program in 1991 and the inclusion in 1991 of $20.1 in inventory write-downs. Depreciation expense increased $71.6 (2.4%) in 1993 compared to a $66.8 (2.3%) increase in 1992. In 1993, the increase was partially attributable to higher levels of property, plant and equipment since December 31, 1992 resulting from continued growth in the customer base and approximately $20 of additional depreciation expense related to extraordinary property retirements in conjunction with a regulatory settlement in Florida. Higher intrastate depreciation rates for Mississippi and higher interstate depreciation rates for Alabama, Kentucky, Louisiana, Mississippi and Tennessee, all retroactive to January 1, 1993, also contributed to the increase. The 1993 increase was partially offset by the continued expiration of inside wire and reserve deficiency amortizations and reduced depreciation expense in Florida and Alabama resulting from represcription. The 1992 increase was also due, in part, to higher levels of property, plant and equipment since December 31, 1991 resulting primarily from growth in the customer base. Also contributing to the increase were new interstate depreciation rates, retroactive to January 1, 1992, for Florida, Georgia, North Carolina and South Carolina, new intrastate depreciation rates in North Carolina and South Carolina, both also retroactive to January 1, 1992, and additional reserve deficiency amortization approved in North Carolina. The increase for 1992 was partially offset by the expiration of inside wire and reserve deficiency amortizations. Selling, General and Administrative expenses include operating expenses related to sales activities such as salaries, commissions, benefits, travel, marketing and advertising expenses. Also included are amortization of intangibles, research and development costs and provision for uncollectibles. Selling, General and Administrative increased $160.5 (4.8%) in 1993 and $396.2 (13.5%) in 1992. The increase in 1993 was primarily attributable to increased expenses associated with growth in the wireless communications customer base, approximately $55 for the initial impact of a regulatory settlement in Florida, higher levels of salaries, wages and taxes other than income taxes and an increase of $11 due to the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The 1993 increase was partially offset by a decrease in advertising expense at BellSouth Telecommunications. For 1992, the increase was due to the reclassification of $224 of expenses of certain businesses within BellSouth Enterprises from Cost of Services and Products. After adjusting for the effect of the reclassification, Selling, General and Administrative increased $172.2 (5.9%) during 1992 compared to 1991. As adjusted, the 1992 increase was attributable to growth in business volumes at BellSouth Telecommunications, growth in the wireless communications customer base, including the effect of the acquisition of wireless businesses in 1991, higher levels of salary and wage expenses, a portion of which resulted from a new three-year working agreement with the CWA in 1992, increased pension and benefit expenses and approximately $24.1 of expenses for remedial actions related to underground fuel storage tanks. The adjusted increase was partially offset by a decrease in the provision for uncollectibles, the inclusion in 1991 of $68.6 of expenses associated with an early retirement program and expense reductions in 1992 attributable to salary savings since implementation of that program. During 1993, BellSouth recognized a business restructuring charge of $1,136.4. The restructuring is being undertaken to redesign and streamline the fundamental processes and work activities in BellSouth Telecommunications' telephone operations to better respond to an increasingly competitive business environment. The restructuring is expected to improve overall responsiveness to customer needs, permit more rapid introduction of new products and services and reduce costs. As a part of the restructuring, BellSouth plans to consolidate and centralize its existing operations. BellSouth plans to establish a single point of contact and accountability for the receipt, analysis and resolution of customer installation, repair activities and service activation. As a result, 288 existing operations centers will be consolidated into 80 locations. Data management centers used to support company operations will be reduced from 11 to 6. In addition, customer service processes and systems will be designed to provide one-number access, specific appointment times, on-line and real-time access to customer records and immediate service activation where facilities are already in place. The material components of the $1,136.4 charge relate to the downsizing of the existing workforce by 10,200 employees through 1996. These components include $368.2 for separation payments and relocations of remaining employees, $342.8 for the consolidation and elimination of certain operations facilities and $425.4 for enabling changes to information systems, primarily those used to provide services to existing customers. BellSouth Telecommunications reduced its overall workforce by approximately 1,300 employees in 1993 following implementation of the restructuring plan. Workforce reductions for 1994, 1995 and 1996 are expected to be approximately 3,700, 2,900 and 2,300, respectively. BellSouth expects that the restructuring will result in cost savings beginning in 1994 due to the initial workforce reductions. The specific future financial impacts on BellSouth's earnings are uncertain and will depend upon the regulatory treatment of the restructuring charge and the related cost savings. Once the restructuring is completed, annual cost savings are expected to be approximately $600 due primarily to reduced employee-related expenses. Interest Expense includes interest on debt, certain other accrued liabilities and capital leases, offset by an allowance for funds used during construction, which is capitalized as a cost of installing equipment and constructing plant. Interest expense decreased $57.4 (7.7%) in 1993 and $55.7 (6.9%) in 1992. The decreases for 1993 and 1992 were due primarily to declines in interest rates on borrowings, both short and long term, including the impact of refinancings of long-term debt at lower interest rates. Both decreases were partially offset by higher average levels of short-term borrowings. (See Notes E and L.) Other Income includes interest income, dividend income and earnings and losses from unconsolidated subsidiaries, business ventures and partnerships, minority interests and gains and losses from the sale of miscellaneous ventures. Other Income decreased $170.0 (95.7%) during 1993 and $75.1 (29.7%) during 1992. The 1993 decrease resulted in part from a decline of $80.8 in interest and dividend income due to the inclusion in 1992 of $56.6 attributable to a tax settlement with the Internal Revenue Service and lower interest rates. Minority interests contributed $11.6 to the decrease and overall earnings from unconsolidated affiliates also decreased by $65.7 due primarily to costs and expenses associated with investments in certain new operations, including a cellular venture in Germany, a business venture with RAM Broadcasting Corporation, and Optus Communications Pty. Ltd. For the year 1993, earnings per share were reduced by approximately $.27 per share as a result of these and other business ventures. The decrease in 1992 was attributable to a $55.6 decrease in earnings from unconsolidated affiliates due in part to investments in several start-up operations, a $33.8 increase related to minority interests and the inclusion in 1991 of $40.0 in gains from certain directory and wireless operations sold. The decrease was partially offset by a $46.2 increase in interest and dividend income which reflects the settlement of an Internal Revenue Service summary tax assessment that resulted in $56.6 of interest income and lower interest rates. Income tax expense decreased $361.9 (38.8%) in 1993 compared to an increase of $180.1 (23.9%) in 1992. The decrease in 1993 was due to the impact of the restructuring charge, which reduced tax expense by $439.8. The decrease was partially offset by the impact of the Omnibus Budget Reconciliation Act of 1993, including the increase in the Federal statutory income tax rate for corporations, which, exclusive of the tax benefit associated with the restructuring charge, increased tax expense by approximately $45. BellSouth's effective tax rates were 35.6%, 36.0% and 33.3% in 1993, 1992 and 1991, respectively. A reconciliation of the Federal statutory income tax rates to these effective tax rates is provided in Note M. A discussion of the adoption of SFAS No. 109, "Accounting for Income Taxes," also is included therein. The increase in 1992 was attributable to an increase in income before income taxes and higher effective tax rates resulting from decreasing investment tax credit amortization. FINANCIAL CONDITION BellSouth used the net cash generated from its operations and short-term financing to fund capital expenditures, to pay dividends and to invest in and operate new business ventures. BellSouth believes that funds provided from operations, in addition to its readily available sources of external financing, will be sufficient to meet the needs of its business for the foreseeable future. Although 1993 net income decreased by 45.6% due primarily to the restructuring charge, BellSouth's cash flow from operations decreased by only 3.2% in 1993 to $4,786.2 from $4,946.8 in 1992. For 1993, the impact of restructuring on cash flow from operations was minimal. However, substantially all of the restructuring charge is expected to require cash payments in future periods. Exclusive of capital requirements, cash payments related to restructuring for 1994, 1995 and 1996 are expected to be approximately $500, $350 and $220, respectively. In addition, future capital expenditures associated with the overall restructuring are estimated to be approximately $650. The cash requirements associated with the restructuring activities, including related capital expenditures, will be provided primarily from BellSouth's operations and, if necessary, from external sources. BellSouth's primary use of capital funds continues to be for capital expenditures to support network development activities. Capital expenditures for all BellSouth companies increased 9.3% to $3,485.9 from $3,189.3 in 1992. Substantially all funds supporting construction activity were provided internally and this trend is expected to continue through 1994. Expenditures are projected to be approximately $3,500 in 1994. Cash used for investments in and advances to unconsolidated affiliates in 1993 decreased to $319.5 from $562.5 in 1992. Approximately 70% of such cash was invested in ventures with RAM Broadcasting Corporation and Optus Communications Pty. Ltd. BellSouth plans to aggressively pursue a corporate strategy of expanding its offerings beyond traditional businesses. Such new offerings may include information services, interactive communications and cable television and other entertainment services. Significant capital would be required in order to execute this strategy. BellSouth believes that financing for such future investing activities can be provided from funds generated through internal operations and from BellSouth's access to external sources. In an effort to pursue opportunities in interactive programming, television shopping and other advanced services, BellSouth had agreed to invest approximately $2,000 in QVC Network, Inc. ("QVC"), contingent on QVC successfully completing its acquisition of Paramount Communications, Inc. ("Paramount"), and had also received an option to acquire approximately $500 of QVC stock at a purchase price of $60 per share in the event QVC was unsuccessful in its proposed acquisition of Paramount. QVC's bid for Paramount was terminated on February 14, 1994, and BellSouth has six months thereafter to determine whether to exercise the option. Cash dividends paid to BellSouth's common shareholders totaled $1,307.4 in 1993 compared to $1,082.5 in 1992. The increase was due to the fact that during 1993, the common shares issued in lieu of cash dividends under the Shareholder Dividend Reinvestment and Stock Purchase Plan ("DRSPP") were increasingly purchased on the open market rather than from new issuances by BellSouth. For 1993, new common shares issued in lieu of cash dividends under DRSPP were $66.4 compared to $268.9 for 1992. During 1993, BellSouth Telecommunications refinanced $2,760 of long-term debt at more favorable interest rates. As such, BellSouth expects that the refinancings will have a positive impact on future cash flows. BellSouth's debt to total capitalization ratio increased to 40.2% at December 31, 1993 compared to 39.0% at December 31, 1992. The increase was due to higher levels of debt, primarily short term, and a decrease in Shareholders' Equity. OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS REGULATORY ENVIRONMENT. In providing telecommunications services, BellSouth Telecommunications is subject to regulation by both state and federal regulators with respect to rates, services and other issues. While the states in BellSouth Telecommunications' service area currently provide for some form of regulation of earnings, as discussed below, BellSouth believes that the existing regulatory framework is not appropriate for the increasingly competitive telecommunications environment. Accordingly, BellSouth's primary regulatory focus continues to be directed toward modifying the regulatory process to one that is more closely aligned with changing market conditions and overall public policy objectives. As an alternative to the current regulatory process, BellSouth believes that price regulation, whereby prices of basic local exchange service are directly regulated and prices for other products and services are based on market factors, is a logical progression in regulatory flexibility and is fair to consumers. As such, BellSouth Telecommunications intends to pursue implementation of price regulation plans through filings with state regulatory commissions or through legislative initiatives. STATE REGULATION Seven of the nine states in which BellSouth Telecommunications operates are now under some alternative form of regulation other than traditional rate of return regulation. The seven states are Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi and Tennessee. These state plans are designed to provide BellSouth Telecommunications with economic incentives to improve cost controls and general efficiency in the form of shared earnings over benchmark rates of return. The plans in Georgia and Kentucky are scheduled to expire in 1994. BellSouth Telecommunications attained the earnings sharing range in Alabama, Kentucky, Louisiana and Mississippi at certain times during 1993. For a part of 1993, South Carolina also operated under a form of alternative regulation. However, in August 1993, the South Carolina Supreme Court ruled that the South Carolina Public Service Commission (the "SCPSC") lacked the statutory authority to approve incentive regulation plans of the type under which BellSouth Telecommunications had been operating since 1992. Legislation has been proposed in South Carolina which would permit the SCPSC to adopt alternative forms of regulation including price regulation. In the interim, traditional rate of return regulation is in effect in South Carolina. In January 1994, the Florida Public Service Commission approved a settlement reached by BellSouth Telecommunications and Florida's Office of Public Counsel related to pending rate proceedings initially filed by BellSouth Telecommunications in July 1992 and other consolidated matters. This settlement ended outstanding rate case and consolidated issues in Florida and extended the incentive regulation plan through at least 1996. Under the terms of the settlement, BellSouth Telecommunications was required to recognize in 1993 business all remaining deferred expenses related to Hurricane Andrew and to record expenses associated with extraordinary asset retirements, also related to Hurricane Andrew. The aggregate impact of these items was approximately $75, which reduced BellSouth's net income for 1993 by approximately $47 ($.09 per share). The terms of the settlement also required BellSouth Telecommunications to reduce rates by $55 in February 1994 and will require reductions of an additional $60 in July 1994, $80 in October 1995 and $84 in October 1996. The settlement provides for other changes in service offerings and tariffs including approximately $21 in revenue reductions or increased expenses. Certain other service rates have been capped at their current levels through 1997, and BellSouth Telecommunications has agreed not to propose any local measured service on a statewide basis through the same time period. FEDERAL REGULATION At the national level, BellSouth Telecommunications has been operating under price cap regulation since January 1, 1991. In contrast to regulation which limits the rate of return that can be achieved, price cap regulation limits the prices telephone companies can charge for use of their services. The current FCC plan allows for the sharing of earnings over a benchmark range of earnings. This benchmark is dependent upon the productivity offset factor chosen annually by the carrier. During the price cap plan's annual election period in 1993, BellSouth Telecommunications selected a productivity offset factor of 3.3% which increased access rates more than they would otherwise have been had the 4.3% factor been selected; however, selection of this lower productivity factor provides for a lower allowed return before sharing is required. As of December 31, 1993, BellSouth's recorded liability for estimated sharing was $45.6. In February 1994, the FCC initiated its review of the current price cap plan. Under a notice of proposed rulemaking, the FCC identified for examination three broad sets of issues including those related to the basic goals of price cap regulation, the operation of price caps, and the transition of local exchange services to a fully competitive market. BellSouth believes and will advocate that a revised price cap plan should be structured to provide increased pricing flexibility for services as competition evolves in the telecommunications markets. Any changes to the current plan are expected to be effective January 1, 1995 or soon thereafter. ECONOMY. The nine-state region served by BellSouth Telecommunications' wireline telephone business, as a whole, posted solid economic gains in 1993, while continuing economic slumps on the West Coast and in the Northeast kept the national economy sluggish for much of the year. Employment growth averaged 2.1% in the region in 1993, slower than the 4% annual rate experienced in the 1980's, but still above the national average of 1.6%. Manufacturing employment in the region grew slightly during 1993 while the nation lost approximately 180,000 manufacturing jobs. Services employment increased about 4% to lead the region's growth. Employment growth is expected to improve further in 1994. Residential construction growth moved back above pre-recession levels with housing starts in the region up 12% over the year. Housing demand is expected to remain strong in 1994. The region's relatively strong economy along with its attractive climate have kept net in-migration near 400,000 per year, boosting the demand for telecommunications services. However, increasing competition being faced by BellSouth Telecommunications and the growing percentage of revenues from BellSouth Enterprises makes BellSouth's financial performance more susceptible to changes in the economy than previously, as its operations reflect the more competitive environment and greater elasticity in demands for its products and services. VOLUMES OF BUSINESS. Network Access Lines in Service at December 31 (Thousands): The total number of access lines in service increased by 683,000 over 1992, representing a 3.7% increase, an improvement over the 3.4% rate of increase for 1992 over 1991. The overall increase, led by growth in Florida, Georgia, North Carolina and Tennessee, was primarily attributable to continued economic improvement, including expanding employment in BellSouth Telecommunications' nine-state region and an increase in the number of second lines in residences. While the overall growth rate for residence lines remained constant, the growth rate for business lines continued to increase, reaching 5.9% in 1993, compared to 5.1% in 1992. Access Minutes of Use (Millions): Access minutes of use represent the volume of traffic carried by interexchange carriers between LATAs, both interstate and intrastate, using BellSouth Telecommunications' local facilities. Total access minutes of use increased by 4,065.3 million (6.3%) in 1993 compared to a 6.7% increase in 1992. The 1993 increase in access minutes of use was partially attributable to access line growth and also to intraLATA toll competition, which has the effect of increasing access minutes of use while reducing toll messages carried over BellSouth Telecommunications' facilities. The growth rate in total minutes of use continues to be negatively impacted by the effects of bypass and the migration of interexchange carriers to categories of service (e.g., special access) that have a fixed charge as opposed to a volume-driven charge and to high capacity services, which causes a decrease in minutes of use. Toll messages, comprised of Message Telecommunications Service and Wide Area Telecommunications Service, decreased 29.3 million (2.3%) compared to a 7.7% decrease in 1992. The lower rate of decrease for 1993 was attributable to the inclusion of the impact of the Louisiana area calling plan in both 1992 (beginning in March) and 1993. Competition in the intraLATA toll market and the effects of expanded local area calling plans continue to have an adverse impact on toll message volumes. These plans and the effects of competition have the effect of shifting calls from toll to local service and access, respectively, but the corresponding revenues are not generally shifted at commensurate rates. The decline in toll message volumes is expected to continue for the foreseeable future. Wireless Customers (Equity Basis): BellSouth's wireless communications businesses continue to be a significant contributor to the company's operations, primarily due to the continued expansion of the customer base for mobile communications services. Domestic cellular customers increased by 441,000 (39.4%) to 1,559,100 since December 31, 1992. While the rate of increase has declined since 1992, the overall penetration rate (number of customers as a percentage of the total population in the service territory) increased from 2.98% at December 31, 1992 to 4.01% at December 31, 1993. Total minutes of use have also continued to increase, although average minutes of use per cellular customer have declined since 1992 due to the trend of increased penetration into lower-user market segments. Also, domestic paging customers increased 255,000 (26.1%) to 1,232,200 since December 31, 1992 due to a successful retail distribution program and aggressive pricing strategies in the reseller market. The number of international cellular customers grew to 192,200, an increase of 114,600 (147.7%) since December 31, 1992. Growth in minutes of use for international cellular properties remained strong due in part to demand stimulated by competitive programs, enhanced services and underdeveloped land-line service. COMPETITION. Recent developments in the telecommunications marketplace indicate that a technological convergence is occurring in the telephone, cable and broadcast television, computer, entertainment and information services industries. The technologies utilized and being developed in these industries will enable multiple communications offerings. Several large companies have recently announced proposed acquisitions or business alliances that, if consummated, could intensify and expand competition for local communications and other services currently provided over BellSouth's networks. Other competitors have announced plans to build local phone connections that would permit business and residential customers to bypass the facilities of local telephone companies, including those of BellSouth Telecommunications in certain cities in its service territory. In addition, legislative activities in Congress could affect BellSouth's businesses and competitive position. BellSouth has undertaken a plan to streamline its telephone operations and to improve its overall cost structure as a part of its competitive strategy (see "Results of Operations"). Notwithstanding the risks associated with increased competition, BellSouth will have the opportunity to benefit from entry into new business markets. BellSouth believes that in order to remain competitive in the future, it must aggressively pursue a corporate strategy of expanding its offerings beyond its traditional businesses which may include information services, interactive communications and cable television and other entertainment services. BellSouth plans to enter such businesses through acquisitions, investments and strategic alliances with established companies in such industries and through the development of such capabilities internally. Such transactions, if accomplished, could initially reduce earnings and require substantial capital. Financing for such business opportunities will be provided from funds generated through internal operations and from external sources. ACCOUNTING UNDER SFAS NO. 71. BellSouth's regulated enterprise, BellSouth Telecommunications, continues to account for the economic effects of regulation under SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." BellSouth, for strategic and business planning purposes, continuously monitors and evaluates the impacts of both existing and potential competitive factors. If, in BellSouth's judgment, changes in the competitive structure of the telecommunications industry dictate that it could not charge prices to customers which provide for the recovery of costs, SFAS No. 71 would no longer apply. BellSouth currently believes that the existing and anticipated levels of competition still permit prices based on costs to be charged to and collected from customers. However, the rapid pace of change in the industry is making it increasingly likely that BellSouth will be required to discontinue its accounting under SFAS No. 71 in the future. BellSouth believes that the existing regulatory framework is not appropriate for the increasingly competitive telecommunications environment. Accordingly, BellSouth intends to pursue implementation of price regulation plans in all of its jurisdictions through filings with state regulatory commissions or through legislative initiatives. Since price regulation plans do not provide for the recovery of specific costs, SFAS No. 71 would no longer apply. If BellSouth is successful in altering the existing regulatory framework and achieving price regulation, BellSouth would be required to discontinue its accounting under SFAS No. 71. If BellSouth were to discontinue its accounting under SFAS No. 71 due to the overall level of competition or to changes in regulatory frameworks, the effect on BellSouth's financial condition and results of operations would be material. Specific financial impacts would depend on the timing and magnitude of changes, both in the marketplace and in the overall regulatory framework. OTHER MATTERS ACCOUNTING PRONOUNCEMENTS. Effective January 1, 1993, BellSouth adopted three new accounting standards issued by the Financial Accounting Standards Board. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," requires employers to accrue the cost of providing postretirement benefits other than pensions during the period employees are expected to earn the benefit. BellSouth is recognizing the related transition benefit obligation over 15 years. As a result of the adoption of SFAS No. 106, operating expenses in 1993 were $38 higher than they would have been using the former accounting method. Accordingly, net income was reduced by approximately $23 ($.05 per share) (see Note H). SFAS No. 109, "Accounting for Income Taxes," requires companies to compute deferred income taxes using a liability approach rather than the deferred method previously required under Accounting Principles Board Opinion No. 11. The adoption of SFAS No. 109 did not materially affect tax expense or net income for 1993 (see Note M). SFAS No. 112, "Employers' Accounting for Postemployment Benefits," requires employers to accrue the cost of postemployment benefits provided to former or inactive employees after employment but before retirement. A one-time charge of $67.4 ($.14 per share), net of a deferred tax benefit of $42.5, related to the adoption of SFAS No. 112 was recognized as an accounting change (see Note H). Other pronouncements have been issued by authoritative accounting bodies but not yet adopted by BellSouth. The adoption of such standards in future periods, where required, is not expected to have a material impact on BellSouth's operating results and financial condition. ENVIRONMENTAL ISSUES. BellSouth is subject to a number of environmental matters as a result of the operations of its subsidiaries and shared liability provisions in the Plan of Reorganization, related to the Modification of Final Judgment. As a result, BellSouth expects that it will be required to expend funds to remedy certain facilities, including those Superfund sites for which BellSouth has been named as a potentially responsible party and also for the remediation of sites with underground fuel storage tanks and other expenses associated with environmental compliance. At December 31, 1993, BellSouth's recorded liability related primarily to remediation of these sites was $35.5. BellSouth continually monitors its operations with respect to potential environmental issues, including changes in legally mandated standards and remediation technologies. BellSouth's recorded liability reflects those specific issues where remediation activities are currently deemed to be probable and where the cost of remediation is estimable. BellSouth continues to believe that expenditures in connection with additional remedial actions under the current environmental protection laws or related matters will not have a material impact on BellSouth's operating results or financial condition. SUBSEQUENT EVENTS. During the first quarter of 1994, BellSouth sold its 36% interest in the cellular telephone business in Guadalajara, Mexico. As a result, a gain of $67.5 ($.14 per share) was recognized. In the same period, BellSouth Communication Systems, Inc., a wholly-owned subsidiary, also entered into an agreement to sell its customer premise equipment sales and service operations outside the nine-state region served by BellSouth Telecommunications. The transaction is expected to close by the end of April 1994. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF MANAGEMENT To the Shareholders of BellSouth Corporation: These financial statements have been prepared in conformity with generally accepted accounting principles and have been audited by Coopers & Lybrand, independent accountants, whose report is contained herein. The integrity and objectivity of the data in the financial statements including estimates and judgments relating to matters not concluded by the end of the year, are the responsibility of the management of BellSouth. Management has also prepared all other information included therein unless indicated otherwise. Management maintains a system of internal accounting controls which is continuously reviewed and evaluated. However, there are inherent limitations that should be recognized in considering the assurances provided by any system of internal accounting controls. The concept of reasonable assurance recognizes that the cost of a system of internal accounting controls should not exceed, in management's judgment, the benefits to be derived. Management believes that BellSouth's system does provide reasonable assurance that the transactions are executed in accordance with management's general or specific authorizations and are recorded properly to maintain accountability for assets and to permit the preparation of financial statements in conformity with generally accepted accounting principles. Management also believes that this system provides reasonable assurance that access to assets is permitted only in accordance with management's authorizations, that the recorded accountability for assets is compared with the existing assets at reasonable intervals and that appropriate action is taken with respect to any differences. Management also seeks to assure the objectivity and integrity of its financial data by the careful selection of its managers, by organizational arrangements that provide an appropriate division of responsibility and by communications programs aimed at assuring that its policies, standards and managerial authorities are understood throughout the organization. Management is also aware that changes in operating strategy and organizational structure can give rise to disruptions in internal controls. Special attention is given to controls while the changes are being implemented. Management maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. In addition, as part of its audit of these financial statements, Coopers & Lybrand completed a review of the accounting controls to establish a basis for reliance thereon in determining the nature, timing and extent of audit tests to be applied. Management has considered the internal auditor's and Coopers & Lybrand's recommendations concerning the system of internal controls and has taken actions that it believes are cost-effective in the circumstances to respond appropriately to these recommendations. Management believes that as of December 31, 1993, the system of internal controls was adequate to accomplish the objectives discussed herein. Management also recognizes its responsibility for fostering a strong ethical climate so that BellSouth's affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is communicated to all employees through policies and guidelines addressing such issues as conflict of interest, safeguarding of BellSouth's real and intellectual properties, providing equal employment opportunities and ethical relations with customers, suppliers and governmental representatives. BellSouth maintains a program to assess compliance with these policies and has designated an officer as Vice President-Corporate Responsibility and Compliance, reporting directly to the Chairman of the Board. John L. Clendenin Ronald M. Dykes CHAIRMAN OF THE BOARD VICE PRESIDENT AND COMPTROLLER AND CHIEF EXECUTIVE OFFICER February 3, 1994 AUDIT COMMITTEE CHAIRMAN'S LETTER Through January 31, 1994, the Audit Committee of the Board of Directors consisted of four Directors who are neither officers nor employees of BellSouth Corporation (for a discussion of the reorganization of the committees of the Board effective February 1, 1994, including the Audit Committee, see BellSouth's 1994 Proxy Statement). Information as to these persons, as well as the scope of duties of the Audit Committee, is provided in the Proxy Statement. The Audit Committee met five times during 1993 and reviewed with the Chief Corporate Auditor, Coopers & Lybrand and management the various audit activities and plans, together with the results of selected internal audits. The Audit Committee also reviewed the financial reporting process and the adequacy of internal controls. The Audit Committee recommends, subject to shareholder ratification, the appointment of the independent public accountants and considers factors relating to their independence. The Chief Corporate Auditor and Coopers & Lybrand met privately with the Audit Committee on occasion to encourage confidential discussions as to any auditing matters. Thomas R. Williams CHAIRMAN, AUDIT COMMITTEE January 31, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders BellSouth Corporation Atlanta, Georgia We have audited the accompanying consolidated balance sheets of BellSouth Corporation as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of BellSouth's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of BellSouth Corporation as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes H and M to the consolidated financial statements, BellSouth changed its method of accounting for postretirement benefits other than pensions, postemployment benefits, and income taxes in 1993. Coopers & Lybrand Atlanta, Georgia February 3, 1994 BELLSOUTH CORPORATION CONSOLIDATED STATEMENTS OF INCOME (IN MILLIONS, EXCEPT PER SHARE AMOUNTS) The accompanying notes are an integral part of these financial statements. BELLSOUTH CORPORATION CONSOLIDATED BALANCE SHEETS (IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELLSOUTH CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELLSOUTH CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions, Except Per Share Amounts) NOTE A -- ACCOUNTING POLICIES BASIS OF PRESENTATION. The consolidated financial statements include the accounts of BellSouth Corporation ("BellSouth") and subsidiaries in which it has a controlling financial interest. BellSouth operates predominantly in the telecommunications service industry. BellSouth Telecommunications, Inc. ("BellSouth Telecommunications"), BellSouth's largest subsidiary, provides primarily regulated telephone services. Investments in certain partnerships, joint ventures and subsidiaries are accounted for using the equity method. All significant intercompany transactions and accounts have been eliminated, except as otherwise required under generally accepted accounting principles applicable to regulated entities. Certain amounts in the prior period consolidated financial statements have been reclassified to conform to the current year's presentation. BASIS OF ACCOUNTING. BellSouth's consolidated financial statements have been prepared in accordance with generally accepted accounting principles, including the provisions of Statement of Financial Accounting Standards ("SFAS") No. 71, "Accounting for the Effects of Certain Types of Regulation." Where appropriate, SFAS No. 71 gives accounting recognition to the actions of regulators. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset or impose or eliminate a liability on a regulated entity. CASH AND CASH EQUIVALENTS. BellSouth considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Investments with an original maturity of over three months to one year are not considered cash equivalents and are included as temporary cash investments on the consolidated balance sheets. PROPERTY, PLANT AND EQUIPMENT. The investment in property, plant and equipment is stated at original cost. Depreciation is based on the remaining life method of depreciation and straight-line composite rates determined on the basis of equal life groups of certain categories of telephone plant acquired in a given year. Depreciation expense also includes amortization of certain classes of telephone plant and identified depreciation reserve deficiencies over periods allowed by regulatory authorities. When depreciable plant is disposed of, the original cost, less net salvage value, is charged to accumulated depreciation. The cost of property, plant and equipment other than that of BellSouth Telecommunications is depreciated using either straight-line or accelerated methods over the estimated useful lives of the assets. Gains or losses on disposal of other depreciable property, plant and equipment are recognized in the year of disposition as an element of other non-operating income. MATERIAL AND SUPPLIES. New and reusable material is carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. INVESTMENTS AND ADVANCES. Investments and advances substantially consist of investments in, and advances to, affiliated companies. Also included in this caption are other long-term investments. INTANGIBLE ASSETS. Intangible assets substantially consist of the excess consideration paid over net assets acquired in business combinations. Also included in this caption are acquired licenses and customer lists. Intangible assets are being amortized using the straight-line and sum-of-the-years' digits methods over periods of benefit. Such periods do not exceed 40 years. Amortization of such intangibles was $58.4, $67.8 and $50.9, for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, accumulated amortization of intangibles was $169.2 and $197.9, respectively (see Note B). MAINTENANCE AND REPAIRS. The cost of maintenance and repairs of plant, including the cost of replacing minor items not effecting substantial betterments, is charged to operating expenses. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE A -- ACCOUNTING POLICIES (CONTINUED) REVENUE RECOGNITION. Revenues are recognized when earned. Certain revenues derived from local telephone and wireless access services are billed monthly in advance and are recognized the following month when services are provided. Directory advertising and publishing revenues and related directory costs are recognized upon publication of directories, except where regulatory authorities recognize different treatment. Revenues derived from other telecommunications services, principally network access, toll and cellular airtime usage are recognized monthly as services are provided. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION. Regulatory authorities allow BellSouth Telecommunications to accrue interest as a cost of constructing certain plant and as an item of income (interest charged construction). Such income is not realized in cash currently but will be realized over the service life of the related plant as the resulting higher depreciation expense and plant investment are recovered in the form of increased revenues. INCOME TAXES. Effective January 1, 1993, BellSouth adopted SFAS No. 109, "Accounting for Income Taxes." In accordance with the standard, the balance sheet reflects deferred tax balances associated with the anticipated tax impact of future income or deductions implicit in the balance sheet in the form of temporary differences. Temporary differences primarily result from the use of accelerated methods and shorter lives in computing depreciation for tax purposes. Prior to 1993, BellSouth accounted for income taxes under the provisions of Accounting Principles Board Opinion No. 11. For financial reporting purposes, BellSouth Telecommunications is amortizing deferred investment tax credits earned prior to the 1986 repeal of the investment tax credit and also some transitional credits earned after the repeal. The credits are being amortized as a reduction to the provision for income taxes over the estimated useful lives of the assets to which the credits relate. EARNINGS PER SHARE. Earnings per common share are computed on the basis of the weighted average number of shares of common stock and common stock equivalents outstanding during each year. NOTE B -- INVESTMENTS AND ADVANCES Investments and Advances consist primarily of BellSouth's investment in unconsolidated affiliates accounted for under the equity method. The total of such investments was $1,806.7 and $740.1 at December 31, 1993 and 1992, respectively. Investments and Advances increased approximately $1,000 from December 31, 1992 as a result of a reclassification of amounts previously reported as Intangible Assets and the adoption of SFAS No. 109. Earnings related to investments accounted for under the equity method totaled $11.0, $76.7 and $132.3 for the three years ended December 31, 1993, 1992 and 1991, respectively, and are reported as a component of Other Income. The most significant of these equity method investments are BellSouth's various domestic cellular properties, a business venture with RAM Broadcasting Corporation ("RBC"), Optus Communications Pty. Ltd. ("Optus") and certain investments in international cellular properties. DOMESTIC CELLULAR. BellSouth's domestic cellular investments consist primarily of a 60% non-controlling financial interest in the Los Angeles Cellular Telephone Company and a 43.75% interest in the Houston Cellular Telephone Company. At December 31, 1993, BellSouth's investment in the above mentioned entities exceeded the underlying book value of the investees' net assets by $965.0. The excess of consideration paid over net assets acquired along with other intangible assets are being amortized using either straight line or accelerated methods over periods of benefit which do not exceed 40 years. RBC. In January 1992, BellSouth and RBC formed a business venture to own and operate certain mobile data communications networks worldwide as well as certain cellular and paging operations in the United States. The mobile data portion of the venture gives BellSouth a 49% interest in the United States BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE B -- INVESTMENTS AND ADVANCES (CONTINUED) mobile data operations, which is operated by RBC, and the following interests in the foreign mobile data operations of the venture: Australia 90%, The Netherlands 72%, Belgium 72%, United Kingdom 37.5% and France 11.25%. In addition, BellSouth has a 50% interest in the domestic paging segment of the venture. OPTUS. BellSouth is a 24.5% participant in Optus, an international consortium which provides a full spectrum of telecommunications services in Australia, including switched network and enhanced services, wireless and satellite based services. INTERNATIONAL CELLULAR. During December 1993, BellSouth increased its ownership interest in TelCel Cellular C.A. ("TelCel"), a cellular telephone company providing service to all major cities in Venezuela, from 44% to 53.26%. BellSouth accounts for its investment in TelCel using the equity method because the company does not control the requisite voting percentage required to control Board decisions or the outcome of ordinary matters requiring shareholder approval. BellSouth is approximately a 21% participant in the E-Plus Mobilfunk consortium, which, during 1993, became the successful bidder for the second private German GSM PCN license. OTHER INVESTMENT ACTIVITY. During 1993 and 1992, BellSouth made several small acquisitions principally related to its cellular telephone business. The results of operations have been included in the consolidated financial statements from their respective dates of acquisition. The effect of these acquisitions on BellSouth's consolidated results of operations was not significant. All acquisitions were recorded using the purchase method of accounting. The purchase price in excess of the underlying fair value of identifiable net assets acquired will be amortized over a period not to exceed 40 years. In addition, during 1993, BellSouth disposed of minor investments in various portions of its business. The effect of these dispositions on BellSouth's consolidated results of operations was not significant. BellSouth has other investments that are accounted for using the cost method in addition to various advances to affiliated companies. In December 1993, BellSouth entered into a credit agreement with Prime South Diversified, Inc. ("Prime South Diversified"), which indirectly wholly owns Community Cable TV, a Las Vegas cable operation managed by Prime Cable, to provide up to $250 in financing. The loan transaction closed in January 1994 with funding of an initial advance of $135. The loan is collateralized by the stock of Prime South Diversified and its wholly-owned subsidiary, Prime South Holdings, Inc. ("Prime South Holdings"). The loan, which bears a variable rate of 10% to 11%, matures in 2001. In connection with the credit agreement, BellSouth entered into option agreements with the shareholders of Prime South Diversified to acquire the stock of Prime South Diversified and Prime South Holdings at various dates over the term of the loan. Concurrent with the credit agreement, BellSouth Enterprises entered into an agreement to acquire a 22.5% interest in Prime Cable's management company, which provides management services to five affiliated cable systems nationwide. Closing of this transaction is expected in late 1994, subject to regulatory approval. This agreement also grants BellSouth the option to acquire the remaining interest of the management company over the loan period. SUBSEQUENT EVENT. During the first quarter of 1994, BellSouth disposed of its 36% interest in the cellular telephone business in Guadalajara, Mexico. As a result, a gain of $67.5 was recognized. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE C -- PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is summarized as follows at December 31: NOTE D -- OTHER CURRENT LIABILITIES Other current liabilities are summarized as follows at December 31: BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE E -- DEBT DEBT MATURING WITHIN ONE YEAR: Debt maturing within one year is summarized as follows at December 31: BellSouth has committed credit lines aggregating $1,375.6 with various banks. There were borrowings under the committed lines totaling $48.4 at December 31, 1993. BellSouth also maintains uncommitted lines of credit of $665.0. At December 31, 1993, borrowings under the uncommitted lines totaled $72.0. There are no significant commitment fees or requirements for compensating balances associated with any lines of credit. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE E -- DEBT (CONTINUED) LONG-TERM: Long-term debt consists primarily of debentures and notes issued by BellSouth Telecommunications. Interest rates and maturities of the amounts outstanding are summarized as follows at December 31: Maturities of long-term debt outstanding at December 31, 1993 are summarized below: As further discussed in Note H, BellSouth incorporated an Employee Stock Ownership Plan ("ESOP") feature into certain of its existing savings plans. In 1990, the ESOP trusts (the "Trusts") borrowed $850.0 aggregate principal amount through the issuance of amortizing notes. Although the obligations are owed by the Trusts, they are guaranteed by BellSouth and thus are reflected as an addition to long-term debt and a reduction to shareholders' equity. The Trusts service the debt with contributions from BellSouth and dividends paid on the shares held by the Trusts. As the ESOP obligations are repaid, the amount guaranteed decreases and long-term debt is reduced accordingly. Notes issued by BellSouth Capital Funding Corporation ("Capital Funding") are used to finance the businesses of BellSouth Enterprises and the unregulated subsidiaries of BellSouth Telecommunications. BellSouth has agreed to ensure the timely payment of principal, premium, if any, and interest on Capital Funding's debt securities. During 1993 and 1992, BellSouth Telecommunications refinanced certain long-term debt issues at more favorable interest rates. As a result of the early extinguishment of these issues, charges of $86.6 ($.17 per share), net of taxes of $58.8, and $40.7 ($.08 per share), net of taxes of $30.0, were recognized as extraordinary losses in 1993 and 1992, respectively. At December 31, 1993, shelf registration statements had been filed with the Securities and Exchange Commission by BellSouth Telecommunications and Capital Funding under which $725.0 and $1,050.3, respectively, additional amount of debt securities could be offered. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE F -- OTHER LIABILITIES AND DEFERRED CREDITS Other liabilities and deferred credits is summarized as follows at December 31: NOTE G -- SHAREHOLDERS' EQUITY PREFERRED STOCK AUTHORIZED. BellSouth's Articles of Incorporation authorize 100 million shares of cumulative First Preferred Stock having a par value of $1 per share, of which 30 million shares have been reserved and designated Series A for possible issuance under BellSouth's Shareholder Rights Plan. As of December 31, 1993, no preferred shares had been issued. SHAREHOLDER RIGHTS PLAN. In 1989, BellSouth adopted a Shareholder Rights Plan by declaring a dividend of one right for each share of common stock then outstanding and to be issued thereafter. Each right entitles shareholders to buy one one-hundredth of a share of Series A First Preferred Stock for $175 per share. The rights may be exercised only if a person or group acquires 10% of the common stock of BellSouth without the prior approval of the Board of Directors or announces a tender or exchange offer that would result in ownership of 25% or more of the common stock. If a person or group acquires 10% of BellSouth's stock without prior Board approval, other shareholders are then allowed to purchase BellSouth common stock at half price. The rights currently trade with BellSouth common stock and may be redeemed by the Board of Directors for one cent per right until they become exercisable, and thereafter under certain circumstances. The rights expire after ten years. GUARANTEE OF EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP") DEBT. Financial reporting practices require that the amount equivalent to BellSouth's guarantee of the amortizing notes issued by its ESOP trusts be presented as a reduction to shareholders' equity, as well as an increase to debt. The amount recorded as a decrease in shareholders' equity represents the value of unallocated BellSouth common stock purchased with the proceeds of the amortizing notes and the timing difference resulting from the shares allocated accounting method. As the ESOP notes are repaid, the amount of debt guaranteed decreases, and Shareholders' Equity increases accordingly (see Notes E and H). SHARES HELD IN TRUST. During 1993, BellSouth issued shares to grantor trusts to provide partial funding for the benefits payable under certain non-qualified benefit plans. The trusts are irrevocable and assets contributed to the trusts can only be used to pay such benefits with certain exceptions. At December 31, 1993, the assets held in the trusts consist of cash and 5,464,920 shares of BellSouth common stock. The total cost of the BellSouth shares as of the date of funding the trusts is included in Common Stock and Paid-In Capital; however, because the shares held in trust are not considered outstanding for financial reporting purposes, the shares are reflected separately as Shares Held in Trust, a reduction to Shareholders' Equity. Accordingly, there is no earnings per share impact. As the plan benefits are paid from the trusts, Shareholders' Equity will increase accordingly. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE H -- EMPLOYEE BENEFIT PLANS PENSION PLANS. Substantially all employees of BellSouth are covered by noncontributory defined benefit pension plans. The plan covering non-represented employees prior to July 1993, provided a benefit based on years of credited service and employees' average compensation for a specified period. Effective July 1993, BellSouth converted this plan to a cash balance plan where the pension benefit is determined by a combination of compensation-based service and additional credits, and individual account-based interest credits. The new cash balance plan is subject to a minimum benefit determined under the prior plan's formula for employees retiring through 2005. The December 31, 1993 projected benefit obligation assumes interest and additional credits greater than the minimum levels specified in the written plan. The conversion of the non-represented pension plan had no material impact on 1993 pension cost. The estimated impact on 1994 projected pension cost will be a reduction of $65. Pension benefits provided for represented employees are based on specified benefit amounts and years of service. Consistent with past practice, this plan includes the effect of future bargained-for improvements. BellSouth's funding policy is to make contributions to trust funds with the objective of accumulating sufficient assets to pay all pension benefits for which BellSouth is liable. Contributions are actuarially determined using the aggregate cost method, subject to ERISA and Internal Revenue Service limitations. Pension plan assets consist primarily of equity securities and fixed income investments. The components of net periodic pension cost are summarized below: The following table sets forth the funded status of the plans at December 31: The projected benefit obligation for 1993 and 1992 was determined using a discount rate of 7.5% and 7.75%, respectively, and, for both years an expected long-term rate of return on plan assets of 8% and a long-term assumed weighted average rate of compensation increase of 5.7%. Other economic related benefit assumptions, for both the non-represented and the represented plans, have been changed to reflect both past experience and management's best estimate of future benefit increases. In the aggregate, the assumption changes will have the impact of reducing the projected 1994 pension cost by $20. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE H -- EMPLOYEE BENEFIT PLANS (CONTINUED) In 1991, BellSouth offered an early retirement option to non-represented employees. Approximately 3,100 employees elected to retire under this option, which allowed the employee to accept the present value of their pension benefit as a lump-sum payment and to receive a special payment equivalent to 5% of base pay times full years of service (not to exceed 100% of base pay). The retirement option was accounted for in accordance with SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." BellSouth recognized an expense of $68.6 in 1991 related to this option. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. BellSouth sponsors defined benefit postretirement health and life insurance plans for most of its non-represented and represented employees. Effective January 1, 1993, BellSouth adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," to account for these plans. BellSouth's transition benefit obligation of $1,486 will be amortized over 15 years, the average remaining service period of active plan participants. The accounting for the health care plan does not anticipate future adjustments to the cost-sharing arrangements provided for in the written plan. As a result of the adoption of SFAS No. 106, net income for 1993 was reduced by approximately $23 ($.05 per share). As of January 1993, the accumulated postretirement health benefit obligation for non-represented retirees is being funded over the average remaining service period of currently active non-represented employees. The accumulated postretirement benefit obligation for pre-January 1, 1990 represented retirees is being funded over a 10-year period, while the accumulated postretirement benefit obligation for all other represented retirees is being funded over the average remaining service period of currently active represented employees. Postretirement benefit cost for the year ending December 31, 1993 is composed of the following: Prior to 1993, BellSouth recognized the cost of providing postretirement benefits based on funded amounts. The cost of providing health and life benefits for both active and retired employees was $574.6 and $550.6 for 1992 and 1991, respectively. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE H -- EMPLOYEE BENEFIT PLANS (CONTINUED) The following table sets forth the plans' funded status at December 31, 1993: Accumulated postretirement benefit obligation: The accrued (prepaid) postretirement benefit costs are included in Other Liabilities and Deferred Credits and Deferred Charges and Other Assets, respectively. For measurement purposes, an 11.5% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1994; the rate is assumed to decrease gradually to 5% in 2007 and remains at that level. The health care cost trend rate assumption significantly affects the amounts reported. A one- percentage-point increase in the assumed health care cost trend rates for each future year would increase the accumulated postretirement benefit obligation by $171 and the estimated aggregate service and interest cost components of the 1993 postretirement benefit cost by $15. For purposes of valuing the postretirement life insurance obligation, a 5.7% rate of future increase in compensation at December 31, 1993 was used. The discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. After a 30% tax reduction for the non-represented employees' trust, the combined expected long-term rate of return on plan assets used was 8%. The impact of reducing the discount rate from 9% to 7.5% will increase 1994 postretirement benefit expense by approximately $30. Most regulatory jurisdictions have accepted BellSouth's SFAS No. 106 implementation plan. However, one state's commission is requiring a 20-year amortization of the transition benefit obligation and in another state there are pending issues, the outcome of which are not expected to have a material impact on recovery. EFFECT OF RESTRUCTURING ON PENSIONS AND POSTRETIREMENT BENEFITS. As a result of the restructuring, (see Note K), BellSouth recognized $88 of estimated net curtailment losses expected to impact BellSouth's pension and postretirement benefit plans. Of the amount recognized, $16 was realized in 1993. DEFINED CONTRIBUTION PLANS. BellSouth maintains several contributory savings plans which cover substantially all employees. The BellSouth Management Savings and Employee Stock Ownership Plan and the BellSouth Savings and Security Plan (collectively, the "ESOP Plans") cover the largest portion of the employees. Effective in 1990, a leveraged ESOP feature was incorporated into the ESOP plans. The shares that were purchased by the Trusts with proceeds from the ESOP notes (see Note E) are allocated to participants' accounts throughout the 13-year debt repayment period of the leveraged ESOP program as described below. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE H -- EMPLOYEE BENEFIT PLANS (CONTINUED) BellSouth matches participants' eligible contributions to the respective Plans based on defined percentages determined annually by the Board of Directors. The match consists of BellSouth common shares that were purchased by the Trusts with proceeds from the ESOP notes, which shares are released for allocation as loan payments are made in accordance with ESOP guidelines, and that are purchased by the Trusts on the open market from time to time as required. BellSouth contributes an amount which, in addition to ESOP dividends, is sufficient to service the ESOP loan payments and to purchase any additional shares required to meet the match obligation. Effective with the incorporation of the ESOP feature into the Plans in 1990, BellSouth began recognizing expense attributable to the leveraged ESOPs based on the cost of the shares allocated for the period plus interest incurred, reduced by the dividends used to service the ESOP debt (Shares Allocated Method). BellSouth recognized ESOP expense in 1993, 1992 and 1991 as follows: BellSouth also maintains certain other defined contribution plans for most other employees not covered by the ESOP plans. Company contributions, which are not included in the amounts above, were approximately $12.5, $8.8 and $2.0 in 1993, 1992 and 1991, respectively. POSTEMPLOYMENT BENEFITS. Effective January 1, 1993, BellSouth adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." SFAS No. 112 requires employers to accrue the cost of postemployment benefits provided to former or inactive employees after employment but before retirement, including but not limited to worker's compensation, disability, and continuation of health care benefits. Previously, BellSouth used the cash method to account for such costs. A one-time charge related to adoption of SFAS No. 112 was recognized as a change in accounting principle, effective as of January 1, 1993. The charge was $67.4 ($.14 per share), net of a deferred tax benefit of $42.5. The effect of the change on BellSouth's 1993 operating results was not material. Future expense levels are dependent upon actual claim experience, but are not expected to differ materially from expense recognized under the former accounting method. NOTE I -- EMPLOYEE STOCK OPTION PLAN The BellSouth Corporation Stock Option Plan provides for the grant of stock options and related stock appreciation rights ("SARs") to key employees, as determined by the Board of Directors, to purchase shares of BellSouth common stock within prescribed periods at prices equal to the fair market value on the date of grant. SARs entitle an optionee to surrender unexercised stock options for cash or stock equal to the excess of the fair market value of the surrendered shares over the option price of such shares. Of the 3,654,142 shares covered by outstanding options under the plan at December 31, 1993, 489,590 were accompanied by SARs. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Share Amounts) NOTE I -- EMPLOYEE STOCK OPTION PLAN (CONTINUED) The following table summarizes the activity for stock options outstanding: NOTE J -- LEASES BellSouth has entered into operating leases for facilities and equipment used in operations. Rental expenses under operating leases were $300.3, $328.9 and $288.8 for 1993, 1992 and 1991, respectively. Capital leases currently in effect are not significant. The following table summarizes the approximate future minimum rentals under non-cancelable operating leases in effect at December 31, 1993: NOTE K -- RESTRUCTURING CHARGE The results of operations for the year ended December 31, 1993 include a $1,136.4 restructuring charge which reduced net income by $696.6. The restructuring is being undertaken to redesign and streamline the fundamental processes and work activities in BellSouth Telecommunications' telephone operations to better respond to an increasingly competitive business environment. The restructuring is expected to improve overall responsiveness to customer needs, permit more rapid introduction of new products and services and reduce costs. The material components of the charge relate to the downsizing of the existing workforce by 10,200 employees through 1996. These components include provisions for separation payments and relocations of remaining employees, consolidation and elimination of certain operations facilities and enabling changes to information systems, primarily those used to provide services to existing customers. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Shares Amounts) NOTE L -- ADDITIONAL INCOME STATEMENT DATA Interest and dividend income for 1992 includes $56.6 relating to the settlement of an Internal Revenue Service summary assessment for the tax years 1979 and 1980. Revenues from services provided to American Telephone and Telegraph Company, BellSouth's largest customer, were approximately 14%, 14% and 15% of consolidated operating revenues for 1993, 1992 and 1991, respectively. NOTE M -- INCOME TAXES Effective January 1, 1993, BellSouth adopted SFAS No. 109, "Accounting for Income Taxes," which applies a balance sheet approach to income tax accounting. In accordance with the new standard, the balance sheet reflects the anticipated tax impact of future taxable income or deductions implicit in the balance sheet in the form of temporary differences. These temporary differences reflect the difference between the basis in assets and liabilities as measured in the financial statements and as measured by tax laws using enacted tax rates. The cumulative effect to January 1, 1993 of the adoption of SFAS No. 109 was recorded as a $7.8 reduction to income tax expense. As permitted by the new standard, prior years' financial statements have not been restated. In accordance with the provisions of SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation," BellSouth has, for its regulated operations, only reflected the balance sheet impact of the adoption of this statement. Specifically, BellSouth Telecommunications recorded a net regulatory liability of $538.0 coincidental with the reduction of the deferred tax reserves from higher historical to lower current tax rates. The balance of such liability at December 31, 1993, included in Other Liabilities and Deferred Credits, was $378.9. This regulatory liability will be adjusted as the related temporary differences reverse. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Shares Amounts) NOTE M -- INCOME TAXES (CONTINUED) The provision for income taxes is summarized as follows: Temporary differences and carryforwards which give rise to deferred tax assets and (liabilities) at December 31, 1993 are as follows: The valuation allowance primarily represents federal and state net operating losses that will not be utilized during the carryforward period. Of the Net Deferred Tax Liability at December 31, 1993, $174.4 was current and $(3,465.3) was noncurrent. Deferred tax expense for 1992 and 1991 resulting from timing differences in the recognition of revenue and expense items for tax and financial reporting purposes, were as follows: BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Shares Amounts) NOTE M -- INCOME TAXES (CONTINUED) A reconciliation of the Federal statutory income tax rate to BellSouth's effective tax rate follows: NOTE N -- CUMULATIVE EFFECT OF ACCOUNTING CHANGE SFAS 112. As more fully discussed in Note H, BellSouth adopted, effective January 1, 1993, SFAS No. 112, "Employers' Accounting for Postemployment Benefits." A one-time charge of $67.4 ($.14 per share), net of a deferred tax benefit of $42.5, related to adoption of this statement was recognized as a change in accounting principle. CELLULAR SALES COMMISSIONS. In the third quarter of 1991, BellSouth Mobility Inc. changed its policy of capitalizing certain third-party cellular service sales commissions and amortizing them over the average customer lives. Accordingly, these amounts are expensed in the period in which they are earned by the agent. BellSouth effected this change to standardize the accounting treatment of sales commissions throughout its recently consolidated cellular operations, including those properties acquired in 1991. The effect of the change in accounting principle on BellSouth's 1991 results of operations was not material. The cumulative effect of the change was $35.4 ($.07 per share) and is included in 1991 net income. NOTE O -- SUPPLEMENTAL CASH FLOW INFORMATION The following supplemental information is presented in accordance with the provisions of SFAS No. 95, "Statement of Cash Flows": BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Shares Amounts) NOTE P -- FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is presented in accordance with the provisions of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined using available market information described below. Since judgment is required to develop the estimates, the estimated amounts presented herein may not be indicative of the amounts that BellSouth could realize in a current market exchange. CASH AND CASH EQUIVALENTS/TEMPORARY CASH INVESTMENTS. At December 31, 1993 and 1992, the recorded amounts for cash and cash equivalents and temporary cash investments, respectively, approximate fair value due to the short-term nature of these instruments. DEBT. At December 31, 1993 and 1992, the recorded amounts for Debt Maturing Within One Year approximate fair value due to the short-term nature of the liabilities. The estimates of fair value for BellSouth Telecommunications Debentures and Notes are based on the closing market prices for each issue at December 31, 1993 and 1992, respectively. Fair value estimates for the Guarantee of ESOP Debt and BellSouth Capital Funding Corporation Notes are based on quotes from dealers. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS. BellSouth is party to interest rate swap agreements, currency swap agreements and forward contracts and other derivatives in its normal course of business. These financial instruments are used to mitigate foreign currency and interest rate risks, although to some extent they expose the company to off-balance-sheet risks and credit risks. The credit risks associated with interest rate swap agreements and foreign exchange contracts are controlled through the evaluation and continual monitoring of the creditworthiness of the counterparties. The net fair value of these off-balance- sheet financial instruments at December 31, 1993 is not significant. BellSouth has also issued letters of credit and financial guarantees which approximate $175 at December 31, 1993. Due to the number and diverse nature of these instruments, an estimate of fair value could not be practicably determined. BELLSOUTH CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions, Except Per Shares Amounts) NOTE Q -- QUARTERLY FINANCIAL INFORMATION (UNAUDITED) In the following summary of quarterly financial information, all adjustments necessary for a fair presentation of each period were included. The results for first quarter 1993 were restated to reflect the one-time, non-cash charge for retroactive adoption of SFAS No. 112. SUPPLEMENTARY DATA BELLSOUTH CORPORATION DOMESTIC CELLULAR AND PAGING OPERATIONS PROPORTIONATE OPERATING DATA (DOLLARS IN THOUSANDS) (UNAUDITED) The following table sets forth unaudited, supplemental financial data for BellSouth's domestic cellular and paging operations reflecting proportionate consolidation of entities in which BellSouth has an interest. This presentation differs from the consolidation metholodology used to prepare BellSouth's principal financial statements in accordance with generally accepted accounting principles. The proportionate operating data reflect BellSouth's ownership percentage of entities consolidated for financial reporting purposes and BellSouth's ownership percentage in the entities which are accounted for on the equity method for financial reporting purposes. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No change in accountants or disagreements on the adoption of appropriate accounting standards or financial disclosure has occurred during the periods included in this report. PART III ITEMS 10 THROUGH 13. Information regarding executive officers required by Item 401 of Regulation S-K is furnished in a separate disclosure on page 22 in Part I of this report since the registrant did not furnish such information in its definitive proxy statement prepared in accordance with Schedule 14A. The additional information required by these items will be included in the registrant's definitive proxy statement dated March 14, 1994 as follows, and is herein incorporated by reference pursuant to General Instruction G(3): PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto or because such schedules are not required or applicable. b. Reports on Form 8-K: BellSouth Corporation -- Third quarter earnings release. Date of Report October 21, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. BELLSOUTH CORPORATION /s/ RONALD M. DYKES -------------------------------------- Ronald M. Dykes VICE PRESIDENT AND COMPTROLLER March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. PRINCIPAL EXECUTIVE OFFICER: John L. Clendenin* CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER PRINCIPAL FINANCIAL OFFICER: Earle Mauldin* EXECUTIVE VICE PRESIDENT CHIEF FINANCIAL OFFICER PRINCIPAL ACCOUNTING OFFICER: Ronald M. Dykes* VICE PRESIDENT AND COMPTROLLER DIRECTORS: F. Duane Ackerman* Reuben V. Anderson* James H. Blanchard* Andrew F. Brimmer* J. Hyatt Brown* John L. Clendenin* Armando M. Codina* Marshall M. Criser* Gordon B. Davidson* Phyllis Burke Davis* William O. McCoy* John G. Medlin, Jr.* C. Dixon Spangler, Jr.* Ronald A. Terry* Thomas R. Williams* J. Tylee Wilson* *By: /s/ RONALD M. DYKES -------------------------------------- Ronald M. Dykes (INDIVIDUALLY AND AS ATTORNEY-IN-FACT) March 28, 1994 REPORT AND CONSENT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of BellSouth Corporation is included on page 38 of this Form 10-K. In connection with our audits of the financial statements, we have also audited the related financial statement schedules listed in the index on page 61 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND Atlanta, Georgia February 3, 1994 We consent to the incorporation by reference in the registration statements of BellSouth Corporation on Form S-3 (Nos. 33-29411, 33-22785, 33-48929, 33-49461 and 33-51449) and Form S-8 (Nos. 33-38265, 33-38264, 33-38263, 33-30773, 33-30772, 33-26518, 33-12165, 2-94802 and 33-49459) of our reports dated February 3, 1994, on our audits of the consolidated financial statements and financial statement schedules of BellSouth Corporation as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which reports are included in this Annual Report on Form 10-K. /s/ COOPERS & LYBRAND Atlanta, Georgia March 28, 1994 BELLSOUTH CORPORATION SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (IN MILLIONS) BELLSOUTH CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS) YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) The notes on Page 70 are an integral part of this schedule BELLSOUTH CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (CONTINUED) YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) BELLSOUTH CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS) YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) The notes on Page 72 are an integral part of this Schedule. BELLSOUTH CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) BELLSOUTH CORPORATION SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR UNCOLLECTIBLES (DOLLARS IN MILLIONS) BELLSOUTH CORPORATION SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS)

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Item 1. Business. Business of the Company (Annual Report pp. 51-58). Item 2. Item 2. Properties. Properties (Annual Report pp. 39, 54, 55, 57, 62 and 63); Corporate Facilities (Annual Report p. 57); Gannett Properties (Annual Report pp. 64-68). Item 3. Item 3. Legal Proceedings. Note 9 - Commitments and Contingent Liabilities - Litigation (Annual Report p. 46). Regulation (Annual Report pp. 54-55). Item 4. Item 4. Submission of Matters Not Applicable. to a Vote of Security Holders. Part II - ------- Item 5. Item 5. Market for Registrant's Market for the Company's Common Equity and Common Stock (Inside back Related Stockholder cover); Approximate Number of Matters. Common Stockholders (Annual Report p. 1); Common Stock Prices (Annual Report p. 25); Dividends (Annual Report p. 33). Item 6. Item 6. Selected Financial Eleven-Year Summary and Notes Data. to Eleven-Year Summary (Annual Report pp. 48-50). Item 7. Item 7. Management's Discussion Management's Discussion and and Analysis of Analysis of Results of Financial Condition and Operations and Financial Results of Operations. Position (Annual Report pp. 26-33). Item 8. Item 8. Financial Statements Consolidated Financial State- and Supplementary Data. ments and Notes to Consoli- dated Financial Statements (Annual Report pp. 34-46). Effects of inflation and chang- ing prices (Annual Report p. 33). Quarterly Statements of Income (Annual Report pp. 60-61). Item 9. Item 9. Changes in and Disagreements None. with Accountants on Account- ing and Financial Disclosure. Part III - -------- Item 10. Item 10. Directors and Executive Executive Officers of the Officers of the Registrant. Company are listed below: Thomas L. Chapple - General Counsel, Vice President, and Secretary. Susan Clark-Jackson - President, Gannett West Newspaper Group, and President and Publisher, Reno (Nev.) Gazette-Journal. Michael J. Coleman - President, Gannett South Newspaper Group, and President and Publisher, FLORIDA TODAY at Brevard County. John J. Curley - Chairman, President, and Chief Executive Officer. Thomas Curley - President and Publisher, USA TODAY. Philip R. Currie - Vice President, News, Newspaper Division. Donald W. Davidson - President, Gannett Outdoor Group. Gerard R. DeFrancesco - President, Gannett Radio. Thomas J. Farrell - President, Gannett New Media Group. Millicent A. Feller - Senior Vice President, Public Affairs and Government Relations. Lawrence P. Gasho - Vice President, Financial Analysis. George R. Gavagan, Vice President, Corporate Accounting Services Madelyn P. Jennings - Senior Vice President, Personnel. Douglas H. McCorkindale - Vice Chairman, and Chief Financial and Administrative Officer. Larry F. Miller - Senior Vice President, Financial Planning, and Controller. Peter S. Prichard - Senior Vice President, News/Chief News Executive, Gannett, and Editor, USA TODAY. W. Curtis Riddle - President, Gannett East Newspaper Group, and President and Publisher, Lansing (Mich.) State Journal. Carleton F. Rosenburgh - Senior Vice President, Gannett Newspaper Division. Gary F. Sherlock - Vice President, Gannett Metro Newspaper Group, and President and Publisher, Gannett Suburban Newspapers. Mary P. Stier - President, Gannett Central Newspaper Group, and President and Publisher, Rockford Register Star Jimmy L. Thomas - Senior Vice President, Financial Services and Treasurer. Ronald Townsend - President, Gannett Television. Frank J. Vega - President and Chief Executive Officer, Detroit Newspaper Agency. Cecil L. Walker - President, Gannett Broadcasting. Gary L. Watson - President, Gannett Newspaper Division. Susan V. Watson - Vice President, Investor Relations. Information concerning the Executive Officers of the Company is included in the Annual Report on pages 22 through 23. Information concerning the Board of Directors of the Company is incorporated by reference to the Company's definitive Proxy Statement pursuant to General Instruction G(3) to Form 10-K. Item 11. Item 11. Executive Compensation. Incorporated by reference to the Company's definitive Proxy Statement pursuant to General Instruction G(3) to Form 10-K. Item 12. Item 12. Security Ownership of Certain Incorporated by reference to the Beneficial Owners and Company's definitive Proxy Statement Management. pursuant to General Instruction G(3) to Form 10-K. Item 13. Item 13. Certain Relationships and Incorporated by reference to the Related Transactions. Company's definitive Proxy Statement pursuant to General Instruction G(3) to Form 10-K. Part IV - ------- Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. ----------------------------------------------------------------- (a) Financial Statements, Financial Statement Schedules and Exhibits. (1) Financial Statements. The following financial statements of the Company and the accountants' report thereon are included on pages 34 through 47 of the Company's 1993 Annual Report to Shareholders and are incorporated herein by reference: Consolidated Balance Sheets as of December 26, 1993 and December 27, 1992. Consolidated Statements of Income - Fiscal Years Ended December 26, 1993, December 27, 1992, and December 29, 1991. Consolidated Statements of Cash Flows - Fiscal Years Ended December 26, 1993, December 27, 1992, and December 29, 1991. Consolidated Statements of Changes in Shareholders' Equity - Fiscal Years Ended December 26, 1993, December 27, 1992, and December 29, 1991. Notes to Consolidated Financial Statements. Report of Independent Accountants. (2) Financial Statement Schedules. The following financial statement schedules are incorporated by reference to "Schedules to Form 10-K Information - December 26, 1993, December 27, 1992, and December 29, 1991" appearing on pages 62 through 63 of the Company's 1993 Annual Report to Shareholders: Schedule V - Property, Plant and Equipment. Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment. Schedule VIII - Valuation and Qualifying Accounts. Schedule X - Supplementary Income Statement Information. The Report of Independent Accountants on Financial Statement Schedules appears on page 8 of this Annual Report on Form 10-K. Note: Financial statements of the registrant are omitted as the registrant is primarily an operating company and the aggregate of the minority interest in and the debt of consolidated subsidiaries is not material in relation to total consolidated assets. All other schedules are omitted as the required information is not applicable or the information is presented in the consolidated financial statements or related notes. (3) Pro Forma Financial Information. Not Applicable. (4) Exhibits. See Exhibit Index for list of exhibits filed with this Annual Report on Form 10-K. Management contracts and compensatory plans or arrangements are identified with asterisks on the Exhibit Index. (b) Reports on Form 8-K. None. UNDERTAKING (included for purposes of incorporation by reference in the Company's Registration Statements on Form S-8) Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or controlling persons of the Company pursuant to the foregoing provisions, or otherwise, the Company has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is therefore unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Company of expenses incurred or paid by a director, officer or controlling person of the Company in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with with the securities being registered, the Company will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. REPORT OF INDEPENDENT ACCOUNTANTS ON ------------------------------------ FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Board of Directors and Shareholders of Gannett Co., Inc. Our audits of the consolidated financial statements referred to in our report dated January 27, 1994 appearing on page 47 of the 1993 Annual Report to Shareholders of Gannett Co., Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. s/ PRICE WATERHOUSE - ---------------------- PRICE WATERHOUSE Washington, D.C. January 27, 1994 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) 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. Dated: February 22, 1994 GANNETT CO., INC. --------------------- (Registrant) By s/ Douglas H. McCorkindale --------------------------------- Douglas H. McCorkindale, Vice Chairman, and Chief Financial and Administrative Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. Dated: February 22, 1994 By s/ John J. Curley --------------------------------- John J. Curley, Director, and Chairman, President and Chief Executive Officer Dated: February 22, 1994 By s/ Douglas H. McCorkindale --------------------------------- Douglas H. McCorkindale, Director, and Vice Chairman, and Chief Financial and Administrative Officer Dated: February 22, 1994 By s/ Larry F. Miller --------------------------------- Larry F. Miller, Senior Vice President, Financial Planning and Controller Dated: February 22, 1994 By s/ Andrew F. Brimmer --------------------------------- Andrew F. Brimmer, Director Dated: February 22, 1994 By s/ Meredith A. Brokaw --------------------------------- Meredith A. Brokaw, Director Dated: February 22, 1994 By s/ Rosalynn Carter --------------------------------- Rosalynn Carter, Director Dated: February 22, 1994 By s/ Peter B. Clark --------------------------------- Peter B. Clark, Director Dated: February 22, 1994 By s/ Stuart T. K. Ho --------------------------------- Stuart T.K. Ho, Director Dated: February 22, 1994 By s/ --------------------------------- John J. Louis, Jr., Director Dated: February 22, 1994 By s/ Rollan D. Melton --------------------------------- Rollan D. Melton, Director Dated: February 22, 1994 By s/ Thomas A. Reynolds --------------------------------- Thomas A. Reynolds, Jr., Director Dated: February 22, 1994 By s/ Carl T. Rowan --------------------------------- Carl T. Rowan, Director Dated: February 22, 1994 By s/ Dolores D. Wharton --------------------------------- Dolores D. Wharton, Director

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Item 1. Business. ------------------ THE COMPANY Oklahoma Gas and Electric Company ("OG&E") is a regulated public utility engaged in the generation, transmission and distribution of electricity to retail and wholesale customers. Enogex Inc., a wholly-owned subsidiary of OG&E, and Enogex Inc.'s subsidiaries (collectively, "Enogex") are engaged in non-utility businesses, consisting of diverse natural gas activities. OG&E and Enogex are herein referred to collectively as the "Company." Financial information on the Company's two segments of business is included in Note 8 of the Notes to Consolidated Financial Statements. OG&E, incorporated in 1902 under the laws of the Oklahoma Territory, is the largest electric utility in the State of Oklahoma. OG&E sold its retail gas business in 1928, and now owns and operates an interconnected electric production, transmission and distribution system which includes eight active generating stations with a total capability of 5,637,300 kilowatts. Enogex owns and operates over 3,000 miles of natural gas transmission and gathering pipelines, has interests in six gas processing plants, markets natural gas and natural gas products and invests in the exploration and production of natural gas. At the end of 1993, Enogex had 361 members and OG&E had 3,408 members working in three operating regions and in a corporate headquarters organization. OG&E's executive offices are located at 101 North Robinson, P.O. Box 321, Oklahoma City, Oklahoma 73101-0321; telephone (405) 272-3000. OG&E's electric rates have been under review for the past three years by the Oklahoma Corporation Commission ("OCC"). On February 25, 1994, the OCC issued an order directing OG&E to reduce its electric rates to its Oklahoma retail customers prospectively by approximately $14 million annually (based on a test year ended June 30, 1991) and to refund approximately $41.3 million. The $14 million annual reduction in rates is expected to lower OG&E's rates to its Oklahoma customers by approximately $17 million in 1994. Due to the rate order and the ever- increasing competition in the utility industry, OG&E has commenced a complete review and redesign of its operations that could result in downsizing, debt refinancing or other cost- cutting measures. As a part of this redesign, OG&E anticipates offering an early retirement program. OG&E also froze salaries and hiring in February 1994. These actions are intended to offset some of the impact of the recent rate order and to make OG&E more competitive in the years ahead. See "Regulation and Rates" for a further discussion of the rate order. ELECTRIC OPERATIONS GENERAL OG&E furnishes retail electric service in 270 communities and their contiguous rural and suburban areas. During 1993, six other communities and two rural electric cooperatives in Oklahoma and western Arkansas purchased electricity from OG&E for resale. The service area, with an estimated population of 1.4 million, covers approximately 30,000 square miles in Oklahoma and western Arkansas; including Oklahoma City, the largest city in Oklahoma, and Ft. Smith, Arkansas, the second largest city in that state. Of the 276 communities served, 247 are located in Oklahoma and 29 in Arkansas. Approximately 91 percent of total electric operating revenues for the year ended December 31, 1993, were derived from sales in Oklahoma and the remainder from sales in Arkansas. OG&E's system control area peak demand as reported by the system dispatcher for the year was approximately 5,010 megawatts, and occurred on August 16, 1993. Excluding wheeling, the net on system peak demand was about 4,700 megawatts. However, when firm sales were included, total load responsibility was approximately 4,740 megawatts, resulting in a capacity margin of approximately 22 percent. As reflected in the table below and the operating statistics on page 4, kilowatt-hour sales to OG&E customers ("system sales") increased 5.0 percent in 1993 compared to 1992. This increase in system sales was offset by a 25 percent decline in sales to other utilities ("off-system sales") which caused total kilowatt-hour sales to be down by 0.3 percent for 1993. However, off-system sales are at much lower prices per kilowatt- hour and have less impact on operating revenues and income than system sales. In 1992 and 1991, factors which resulted in an overall increase in total kilowatt-hour sales included: significant increases in off-system sales; increased total customer usage in 1992 and 1991, which was offset by decreased residential usage in 1992; and slight increases in customer growth. Variations in kilowatt-hour sales for the three years are reflected in the following table: OG&E is subject to competition in some areas from government-owned electric systems, municipally-owned electric systems, rural electric cooperatives and, in certain respects, from other private utilities and cogenerators. Oklahoma law forbids the granting of an exclusive franchise to a utility for providing electricity. Besides competition from other suppliers of electricity, OG&E competes with suppliers of other forms of energy. The degree of competition between suppliers may vary depending on relative costs and supplies of other forms of energy. The National Energy Policy Act of 1992 has increased competition in the wholesale market for electricity. Although management believes competitive pressures will continue to increase, it cannot predict the precise extent to which OG&E's business may be affected in the future by the supply, relative cost or promotion of other forms of energy, or by other suppliers of electricity. See "Regulation and Rates, National Energy Legislation" for further discussion. Electric and magnetic fields ("EMF") surround electric wires or conductors of electricity such as electrical tools, household wiring and appliances and high voltage electric transmission lines such as those owned by OG&E. Some recent studies have pointed to a possible correlation between EMF and health effects, including various forms of cancer, while others have found no correlation. The nation's electric utilities, including OG&E, have participated with the Electric Power Research Institute in the sponsorship of more than $75 million in research to determine the possible effects of EMF. Beginning in fiscal year 1994, and in association with the National Energy Policy Act of 1992, Edison Electric Institute members will help fund $65 million for EMF studies over the next five years. One half of this amount will be funded by the federal government, and two-thirds of the non-federal funding is expected to be provided by the electric utility industry. Through its participation with the Electric Power Research Institute and the Edison Electric Institute, OG&E will continue its investigation and research with regard to possible health effects posed by exposure to electric and magnetic fields. FINANCE AND CONSTRUCTION Management expects that internally generated funds and short- term borrowings will be adequate over the next three years to meet the Company's capital requirements and to refund the $41.3 million ordered by the OCC in 1994. The primary capital require- ments for 1994 through 1996 are estimated as follows: (dollars in millions) 1994 1995 1996 ---------------------------------------------------------------- Consolidated construction expenditures including AFUDC ........... $143 $116 $118 Maturities of long-term debt and sinking fund requirements .............. - 85 - ---- ---- ---- Total ............................... $143 $201 $118 ================================================================ The three-year estimate includes construction expenditures for rebuilding electric transmission lines, for upgrading electric distribution systems, to replace or expand existing facilities in both its electric and non-utility businesses, and to some extent, for satisfying maturing debt and sinking fund obligations. Approximately $6.9 million of the Company's construction expenditures budgeted for 1994 are to comply with environmental laws and regulations. OG&E's construction program was developed to support an anticipated peak demand growth of one to two percent annually and to maintain a minimum capacity margin of 15.25 percent as stipulated by the Southwest Power Pool. See "Rate Structure, Load Growth and Related Matters." OG&E's ability to sell additional securities on satisfactory terms to meet its capital needs is dependent upon numerous factors, including general market conditions for utility securities, which will impact OG&E's ability to meet earnings tests for the issuance of additional first mortgage bonds and preferred stock. Based on earnings for the twelve months ended December 31, 1993, and assuming an annual interest rate of 7.6 percent, OG&E could issue approximately $870 million in principal amount of additional first mortgage bonds under the earnings test contained in OG&E's Trust Indenture (assuming adequate property additions were available). Under the earnings test contained in OG&E's Restated Certificate of Incorporation and assuming none of the foregoing first mortgage bonds are issued, about $800 million of additional preferred stock at an assumed annual dividend rate of 8.0 percent could be issued as of December 31, 1993. The Company will continue to use short-term borrowings to meet temporary cash requirements. The Company has the necessary regulatory approvals to incur up to $300 million in short-term borrowings at any one time. The maximum amount of outstanding short-term borrowings during 1993 was $136.6 million. As described below, OG&E intends to meet its customers' increased electricity needs during the foreseeable future by maintaining the reliability and increasing the utilization of existing capacity and increasing demand-side management efforts. OG&E is not currently constructing any new base-load generating plants and does not anticipate the need for another base-load plant in the foreseeable future. As part of its Integrated Resource Plan ("IRP") for supplying energy through the next decade and beyond, OG&E is evaluating measures to keep its existing generating plants operating efficiently well past their traditional retirement dates. As long as the cost to keep existing plants operating reliably and efficiently is less than the cost of alternative sources of capacity, existing plants will be operated. OG&E entered into an agreement with Conoco, Inc. to provide on-site cogeneration and supply steam to the Conoco Refinery in Ponca City, Oklahoma. This facility became operational in 1991. In accordance with the requirements of the Public Utility Regulatory Policies Act of 1978 ("PURPA") (see "Regulation and Rates, National Energy Legislation"), OG&E is obligated to purchase 110 megawatts of capacity annually from Smith Cogeneration, Inc. and 320 megawatts annually from Applied Energy Services, Inc. ("AES"), another cogenerator. In 1986, a contract was signed with Sparks Regional Medical Center to purchase energy generated by its nominal seven megawatt cogeneration facility and not needed by the hospital. In 1987, OG&E signed a contract to purchase up to 100 megawatts of capacity from Mid-Continent Power Company, Inc., beginning no later than 1998. This purchase of capacity is currently planned to begin in 1998 and carries no obligation on the part of OG&E to purchase energy. The purchases under each of these cogeneration contracts were approved by the appropriate regulatory commissions at rates set in accordance with PURPA. OG&E's financial results depend to a large extent upon the tariffs it charges customers and the actions of the regulatory bodies that set those tariffs, the amount of customer energy usage, the cost and availability of external financing and the cost of conforming to government regulations. REGULATION AND RATES OG&E's retail electric tariffs in Oklahoma are regulated by the OCC, and in Arkansas are regulated by the Arkansas Public Service Commission ("APSC"). The issuance of certain securities by OG&E is also regulated by the OCC and the APSC. OG&E's wholesale electric tariffs, short-term borrowing authorization and accounting practices are subject to the jurisdiction of the Federal Energy Regulatory Commission ("FERC"). The Secretary of the Department of Energy has jurisdiction over some of OG&E's facilities and operations. For the year ended December 31, 1993, approximately 85 percent of OG&E's electric revenue was subject to the jurisdiction of the OCC, eight percent to the APSC, and seven percent to the FERC. Recent Regulatory Matters: On February 25, 1994, the OCC issued an order that, among other things, required OG&E to lower its rates to its Oklahoma retail customers by approximately $14 million annually (based on a test year ended June 30, 1991) and to refund approximately $41.3 million. The $14 million annual reduction in rates is expected to lower OG&E's rates to its Oklahoma customers by approximately $17 million in 1994. With respect to the $41.3 million refund, $39.1 million is associated with revenues prior to January 1, 1994, while the remaining $2.2 million relates to 1994. During the first half of 1992 the Company participated in settlement negotiations and offered a proposed refund and a reduction in rates in an effort to reach settlement and conclude the proceedings. As a result, the Company recorded an $18 million provision for a potential refund in 1992. After receiving the February 25, 1994 order, the Company recorded an additional provision for rate refund of approximately $21.1 million in 1993 (consisting of a $14.9 million reduction in revenue and $6.2 million in interest), which reduced net income by approximately $13 million or $0.32 per share. Enogex transports natural gas to OG&E for use at its gas- fired generating units and performs related gas gathering activities for OG&E. The entire $41.3 million refund related to the OCC's disallowance of a portion of the fees paid by OG&E to Enogex for such services in the past. Of the approximately $17 million annual rate reduction, approximately $9.9 million reflects the OCC's reduction of the amount to be recovered by OG&E from its Oklahoma customers for the future performance of such services by Enogex for OG&E. In accordance with the OCC's rate order and a stipulation approved by the OCC in July 1991, OG&E's electric rates for 1994 are designed to permit OG&E to earn a 12 percent return on equity and the OCC staff is precluded from initiating an investigation of OG&E's rates for three years from February 25, 1994, unless OG&E's return on equity exceeds 12.75 percent. As explained previously, OG&E has commenced a complete review and redesign of its operations that could result in downsizing, debt refinancing or other cost-cutting measures in response to the rate order and the ever-increasing competition in the utility industry. As a part of this redesign, OG&E anticipates offering an early retirement program. OG&E also froze salaries and hiring in February 1994. These actions are intended to offset some of the impact of the recent rate order and to make OG&E more competitive in the years ahead. Pursuant to an Order from the APSC in July 1992, OG&E and other electric utilities serving customers in Arkansas were to submit a 20-year Integrated Resource Plan with the APSC by March 15, 1993. Subsequently, OG&E received extensions of the filing date to June 15, 1994. In its IRP, each utility must set forth a thoroughly documented plan to serve its customers' electric energy needs. The utility, in developing this approach, must use a planning process that evaluates the full range of alternatives, including new generating capacity, purchased power, energy conservation and efficiency, cogeneration and renewable energy sources, in order to provide adequate and reliable service to its electric customers at the lowest system cost. The process shall take into account system operation features such as diversity, reliability, dispatchability and other factors of risk, and shall treat customer load reduction and conservation alternatives on a consistent and integrated basis with new power supply alternatives. The Company anticipates that a similar IRP process will be initiated by the OCC. Automatic Fuel Adjustment Clauses: Variances in the actual cost of fuel used in electric generation and certain purchased power costs, as compared to that component in cost-of-service for ratemaking, are passed through to OG&E's electric customers through automatic fuel adjustment clauses. A lag of 45 to 60 days occurs between the time costs are incurred and the time such costs are reflected in bills to retail customers. OG&E records an accrual in the financial statements for these differences. The automatic fuel adjustment clauses are subject to periodic review by the OCC, the APSC and the FERC. OG&E's non-utility subsidiary, Enogex Inc., owns and operates a pipeline business that delivers natural gas to the generating stations of OG&E. The OCC, the APSC and the FERC have authority to examine the appropriateness of any transportation charges or other fees OG&E pays Enogex, which OG&E seeks to recover through the fuel adjustment clause or other tariffs. As indicated above, the OCC in its rate order of February 25, 1994, disallowed $41.3 million previously recovered by OG&E through its fuel adjustment clause for amounts Enogex has charged OG&E for transporting natural gas to OG&E's generating stations and reduced OG&E's future recovery of such charges by approximately $9.9 million annually. PURPA requires that electric utilities purchase electric power from qualifying cogeneration facilities ("QFs"). The costs to OG&E in connection with the Oklahoma facilities for such purchased power are recovered from Oklahoma customers with the approval of the OCC. National Energy Legislation: The National Energy Act of 1978 imposes numerous responsibilities and requirements on OG&E. PURPA requires electric utilities, such as OG&E, to purchase electric power from, and sell electric power to, QFs and small power production facilities. Generally stated, electric utilities must purchase electric energy and production capacity made available by QFs and small power producers at a rate reflecting the cost that the purchasing utility can avoid as a result of obtaining energy and production capacity from these sources; rather than generating an equivalent amount of energy itself or purchasing the energy or capacity from other suppliers. OG&E has entered into agreements with four such cogenerators. See "Finance and Construction." Electric utilities also must furnish electric energy to QFs on a non-discriminatory basis at a rate that is just and reasonable and in the public interest and must provide certain types of service which may be requested by QFs to supplement or back up those facilities' own generation. In 1991, the OCC approved standby service rates to meet this need. The National Energy Policy Act of 1992 (the "Act") is expected to make some significant changes in the operations of the electric utility industry and the federal policies governing the generation and sale of electric power. The Act, among other things, allows the FERC to order utilities to permit access to their electrical transmission systems and to transmit power produced by independent power producers at transmission rates set by the FERC. The Act also provides funds to study electric vehicle technology, the effects of electric and magnetic fields, and institutes a tax credit for generating electricity using renewable energy sources. The Act also is designed to promote competition in the development of wholesale power generation in the electric industry. It exempts a new class of independent power producers from regulation under the Public Utility Holding Company Act of 1935 and allows the FERC to order wholesale "wheeling" by public utilities to provide utility and non-utility generators access to public utility transmission facilities. The Act and other factors are expected to significantly increase competition in the electric industry. The Company has taken steps in the past and intends to take appropriate steps in the future to remain a competitive supplier of electricity. RATE STRUCTURE, LOAD GROWTH AND RELATED MATTERS Two of OG&E's primary goals in its electric tariff designs are: (i) to increase electric revenues by attracting and holding job-producing businesses and industries; and (ii) to keep its peak demand growth rate one-half of one percent less than the kilowatt-hour growth rate annually, while providing a minimum capacity margin of 15.25 percent. In order to meet these goals, OG&E has implemented numerous demand-side management programs and tariff schedules. These programs and schedules include: (i) residential energy audits promoting efficient energy use, and assistance programs that help residential customers live in comfortable homes with lower energy costs; (ii) the PEAKS program, which provides credit on a customer's bill for the installation of a device that periodically cycles off the customer's central air conditioner during peak summer periods; (iii) a load curtailment rate for industrial and commercial customers who can demonstrate a load curtailment of at least 300 kilowatts; (iv) time-of-use rate schedules for various commercial, industrial and residential customers designed to shift energy usage from peak demand periods during the hot summer afternoons to non-peak hours; and (v) a thermal energy storage program that promotes the shifting of cooling loads to off-peak hours. OG&E has developed the "ReSource" program for business and industry which utilizes a group of highly specialized business consultants that have worldwide reputations and preeminence in their particular fields. These fields include management, finance, marketing, power quality, pricing, plant modernization, environmental, process technologies and architect/engineers. Depending on the scope of the project, OG&E may pay a portion of the costs associated with these consulting services. ReSource is designed to answer needs in any phase of a business operation, from general business management, to leading edge technology for a manufacturing process, to the financing necessary to make expansion and modernization possible. In 1993, OG&E's marketing efforts included thermal storage, electrotechnologies, an outdoor lighting promotion "Lite- Watchman," an electric food service promotion and a heat pump promotion in the residential, commercial and industrial markets. Educating customers to use available time-of-use rates to lower their energy costs was also pursued. These rates can make commercial and industrial heating and cooling especially economical if power is used with thermal storage systems which chill water at night for cooling the next day. To meet customers' electric power needs for their sensitive electronic equipment, OG&E began the Power Quality program several years ago. Through this program, a trained Power Quality team works with the customer by performing a thorough survey of wiring and grounding, transient surge protection checks and power monitoring. The customer and the team then develop solutions and alternatives to power needs at the facility. OG&E continues studying other programs to keep its electric tariffs attractive and to control peak demand growth. These programs include the use of high efficiency lighting and ballasts, high efficiency motors, high efficiency air conditioners or chillers, direct load control of large customers, use of home automation systems, high-tech refrigeration equipment, adjustable speed drives on electric motors, high-tech electric water heating systems, heating and cooling demand controls and time scheduling of electric appliances, such as water heaters. OG&E has also expanded its Positive Energy Home finance programs for customers to include heat pump water heaters as well as high efficiency heat pumps. OG&E currently does not anticipate the need for new base- load generating plants in the foreseeable future. For further discussion, see "Finance and Construction." FUEL SUPPLY During 1993, approximately 30 percent of the OG&E-generated energy was produced by natural gas-fired units and 70 percent by coal-fired units. It is estimated that the fuel mix for 1994 through 1998 based upon expected generation for these years, will be as follows: 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- Natural Gas 22% 26% 27% 29% 31% Coal 78% 74% 73% 71% 69% The average cost of fuel used, by type, per million Btu for the periods shown was as follows: 1993 1992 1991 1990 1989 ----- ----- ----- ----- ----- Natural Gas $3.64 $3.48 $3.14 $3.06 $2.97 Coal $1.16 $1.18 $1.21 $1.38 $1.39 Total (Weighted Avg) $1.92 $1.88 $1.96 $2.08 $2.11 A portion of the fuel cost is included in base rates and differs for each jurisdiction. The portion of these costs that is not included in base rates is recovered through automatic fuel adjustment clauses. See "Regulation and Rates, Automatic Fuel Adjustment Clauses." OG&E is continuing its program to improve the heat rate in all of its power plants and has implemented changes which have resulted in greater fuel efficiency. The improvements result in savings in fuel costs and OG&E has budgeted approximately $5.5 million over the next three years to further improve its heat rate. Gas-Fired Units: OG&E has approximately 900 natural gas purchase contracts covering approximately 550 wells and delivery points. These contracts cover an estimated 167 billion cubic feet of connected reserves. OG&E acquires some natural gas at the wellhead under purchase contracts which contain provisions allowing the owners to require prepayments for gas if certain minimum quantities are not taken (see "Note 9 of Notes to Consolidated Financial Statements"). At December 31, 1993, outstanding prepayments for gas, including the amounts classified as current assets, under these contracts were approximately $22.2 million (including $16.2 million accrued but not yet paid). A contract with Oklahoma Natural Gas Company for additional peaking gas is in place and is renewed yearly. To help lower fuel cost, the Company began utilizing a new natural gas storage facility in 1993. OG&E is now pumping gas into the storage reservoir, which will help OG&E get greater value out of its remaining take-or-pay gas contracts. By diverting natural gas into storage, for the first time OG&E will be able to use as much coal as possible to make electricity, and pull gas from storage only to meet increases in demand. In 1994, gas storage will give OG&E the flexibility to generate about 78 percent of its electricity with coal, the highest percentage in OG&E's history. With coal being approximately one-third the cost of natural gas, running coal units at full capacity is expected to cut fuel costs for OG&E's customers by about $90 million a year. Coal-Fired Units: Muskogee Units 4 and 5, with 500 megawatts of capacity each, Sooner Units 1 and 2, with 505 and 510 megawatts of capacity, respectively, and Muskogee Unit 6, with 515 megawatts of capacity, are designed to burn low-sulfur western coal. OG&E purchases coal under a mix of long and short- term contracts. OG&E currently has a long-term, multiple option agreement with Atlantic Richfield Company to supply coal for these units. The combination of all coal has an average sulfur content of 0.4 percent and can be burned in these units under existing federal, state and local environmental standards (maximum of 1.2 pounds of sulfur dioxide per million Btu) without the addition of sulfur dioxide removal systems. In 1993, approximately 26,600 tons of Oklahoma coal was blended with Wyoming coal and burned in OG&E's coal-fired generating stations. During 1993, OG&E burned a total of 9.1 million tons of coal. Based upon the average sulfur content of Wyoming and Oklahoma coal and the average heating value of the coal, OG&E's units have an approximate emission rate of 0.78 pounds of sulfur dioxide per million Btu. See related discussion in "Environmental Matters." In 1993, OG&E negotiated new rail transportation contracts for coal beginning in 1994, which will result in lower transportation rates. The Wyoming coal is transported to OG&E's generating stations, a distance of about 1,000 miles, by unit trains. In 1993, OG&E leased 1,523 coal cars, of which 946 were aluminum, at an approximate annual rental cost of $4.9 million. The efficiencies related to this newer design of high volume aluminum body railcar have reduced, by approximately six percent, the number of trips from Wyoming and reduced railcar maintenance expenses. ENVIRONMENTAL MATTERS OG&E management believes all of its operations are in substantial compliance with present Federal, state and local environmental standards. It is estimated that OG&E's capital, maintenance and other costs toward the preservation and enhancement of environmental quality will be approximately $58 million during 1994, compared to approximately $54 million in 1993. OG&E continues to evaluate its environmental programs to assure compliance with new and proposed environmental legislation and regulations and to position itself in a competitive market. The Company continues to explore options to comply with the Clean Air Act Amendments of 1990 (CAAA). All of OG&E's coal- fired generating units currently burn low-sulfur coal and consequently, OG&E will not need to take any steps to comply with the new sulfur dioxide emission limits until January 1, 2000. However, as of December 31, 1993, the Company had expended approximately $3.0 million (of an estimated total cost of approximately $8.0 million) for installation of continuous emission monitors which must be installed on 12 units by January 1, 1995. The CAAA will also regulate emissions for nitrogen oxides and certain air toxic compounds. Although final regulations concerning all of these issues have not been written, additional capital expenditures may be necessary, but an estimate of cost can not be determined at this time. The Company will continue to examine all alternatives to comply with the CAAA as part of its Integrated Resource Planning process. This planning approach will assure the Company has the least cost option to comply with the CAAA and be in a competitive position to market its services. The Company will not be required to file its compliance plan with the Environmental Protection Agency (the "EPA") until January 1996. As part of the Company's continuing effort to assure compliance with the annual report required by the Toxic Substance Control Act (TSCA) for 1991, a review of the report was undertaken beginning in 1992. The EPA was notified of discrepancies in operating practices and documentation, PCB handling and record-keeping requirements. See "Item 3. Legal Proceedings" for additional discussion of this matter. The Company is a party to three separate actions brought by the EPA concerning cleanup of disposal sites for hazardous waste and is involved in three other matters with the EPA. See "Item 3. Legal Proceedings." ENOGEX OG&E's wholly-owned non-utility subsidiary, Enogex Inc., is the 36th largest pipeline in the nation in terms of miles of pipeline. Enogex Inc. is engaged in gathering and transporting natural gas for ultimate delivery to public utilities and other suppliers and end-users of natural gas in Oklahoma and throughout the nation. At December 31, 1993, Enogex Inc. had five wholly- owned subsidiaries, Enogex Products Corporation ("Products"), Enogex Services Corporation ("Services"), Enogex Exploration Corporation ("Exploration"), ENGL Corporation ("ENGL") and Clinton Gas Transmission, Inc. ("Clinton"). Products owns interests in and operates five natural gas processing plants and markets natural gas liquids. Services and Clinton are engaged in the marketing (buying and selling) of natural gas. Exploration is engaged in investing in the exploration and production of oil and natural gas and the purchase of oil and gas reserves. ENGL operates a natural gas processing plant and markets the natural gas liquids. For the year ended December 31, 1993, and before elimination of intercompany items between OG&E and Enogex, Enogex's consolidated revenues and net income were approximately $219.4 million and $9.5 million, respectively, as indicated in the following table: (dollars in millions) 1993 Revenues 1993 Net Income ------------- --------------- Enogex Inc. $ 65.1 $10.0 (a) Products 11.9 3.0 Services 108.6 0.1 Exploration 2.0 0.2 ENGL 0.8 (0.2) Clinton 37.0 - Eliminations within Enogex (6.0) (b) (3.6) ------ ----- Enogex consolidated amounts $219.4 $ 9.5 ====== ===== (a) Includes $3.6 million of net income from Products, Services, Exploration, ENGL and Clinton. (b) Consists of intercompany natural gas transmission fees of $3.0 million and sales of natural gas products amounting to $3.0 million. Enogex's natural gas transportation business in Oklahoma consists primarily of gathering and transporting natural gas for OG&E, Transok, Inc. (an affiliate of another electric utility) and on an interruptible basis, third-party-owned gas. Enogex's system consists of over 3,000 miles of pipeline, which extends from the Arkoma Basin in eastern Oklahoma to the Anadarko Basin in western Oklahoma. Since 1960, Enogex has had a gas transmission contract with OG&E under which Enogex transports OG&E's natural gas supply on a fee basis, and assists OG&E in the negotiation and administration of short and long-term gas purchase contracts with producers and other suppliers. Enogex also provides accounting services and assists in payments to producers and suppliers under the contract. Under the gas transmission contract, OG&E agrees to tender to Enogex and Enogex agrees to transport, on a firm, load-following basis, all of OG&E's natural gas requirements for boiler fuel for its seven gas-fired electric generating stations. In 1993, Enogex transported nearly 142 Bcf of natural gas; approximately 67 Bcf, or about 47 percent was delivered to OG&E's electric generating stations, which resulted in approximately 84 percent of Enogex Inc.'s revenue of $65.1 million for 1993. See "Regulation and Rates." Enogex's pipeline system also gathers and transports natural gas destined for interstate markets through interconnections in Oklahoma with other pipeline companies. Among others, these interconnections include Panhandle Eastern Pipeline, Williams Natural Gas Pipeline, Natural Gas Pipeline Company of America, Northern Natural Gas Company, Arkla Energy Resources, Phillips Seagas Pipeline, ANR Pipeline Company and Ozark Gas Transmission Company. The rates charged by Enogex for transporting natural gas on behalf of an interstate natural gas pipeline company or a local distribution company served by an interstate natural gas pipeline company are subject to the jurisdiction of FERC under Section 311 of the Natural Gas Policy Act. The statute entitles Enogex to charge a "fair and equitable" rate that is subject to review and approval by FERC. This rate review may involve an administrative-type trial and an administrative appellate review. In addition, Enogex has agreed to open its system to all interstate shippers that are interested in moving natural gas through its system. Enogex is required to conduct this transportation on a non-discriminatory basis, although this transportation is subordinate to that performed for OG&E. This decision does not increase appreciably the federal regulatory burden on Enogex, but does give Enogex the opportunity to utilize any unused capacity on an interruptible basis and thus increase its transportation revenues. The fees charged by Enogex for transporting natural gas for OG&E and Transok, Inc. are not subject to FERC regulation, as this service is solely intrastate. With respect to state regulation, the fees charged by Enogex to OG&E and Transok, Inc. have not been subject to direct state regulation by the OCC. Even though the intrastate pipeline business of Enogex is not directly regulated, the OCC, the APSC and the FERC have the authority to examine the appropriateness of any transportation charge or other fees paid by OG&E to Enogex, which OG&E seeks to recover from ratepayers. See "Regulation and Rates" for a further discussion of this matter and the OCC's ruling on the fees paid by OG&E to Enogex. Products has been active since 1968 in the processing of natural gas and marketing of natural gas liquids. Products has a 50 percent interest in and operates a natural gas processing plant near Calumet, Oklahoma, which can process 250,000 Mcf of natural gas per day. Products also owns four other natural gas processing plants in Oklahoma, which have, in the aggregate, the capacity to process approximately 36,000 Mcf of natural gas per day. ENGL owns one natural gas processing plant in Oklahoma, which became operational in 1993, and has the capacity to process approximately 18,000 Mcf of natural gas per day. Products' natural gas processing plant operations consist of off-lease extraction of liquids from natural gas that is transported through the Enogex pipeline, while ENGL's natural gas processing operations consists of off-lease extraction of liquids from an unaffiliated pipeline. The raw gas stream is processed and converted into marketable ethane, propane, butane, and natural gasoline mix. The residue gas remaining after the liquid products have been extracted consists primarily of methane. Commercial grade propane is sold on the local market and the marketing of all other natural gas liquids extracted by Products and ENGL is handled through independent brokers. The natural gas liquids are delivered to Conway, Kansas (which is one of the nation's largest wholesale markets for gas liquids), where they are sold on the spot market, commonly referred to as Group 140. Independent brokers continuously monitor the marketplace on behalf of Products and ENGL and recommend the time to sell. No transactions take place until approved by authorized personnel. Payments are made to Products and ENGL after sale of the natural gas liquids and the brokers retain a marketing fee from the settlement. In processing and marketing natural gas liquids, Products and ENGL compete against virtually all other gas processors selling natural gas liquids. Products and ENGL believe that they will be able to continue to compete favorably against such companies. With respect to factors affecting the natural gas liquids industry generally, as the price of natural gas liquids fall without a corresponding decrease in the price of natural gas, it may become uneconomical to extract certain natural gas liquids. As to factors affecting Products and ENGL specifically, the volume of natural gas processed at its plants is dependent upon the volume of natural gas transported through the pipeline system located "behind the plants" (i.e. the Enogex pipeline for Products and an unaffiliated pipeline for ENGL). If the volume of natural gas transported by such pipeline increases "behind the plants," then the volume of liquids extracted by Products and ENGL should normally increase. Services is a natural gas marketing company serving both producers and consumers of natural gas by buying natural gas at the wellhead and from other sources in Oklahoma and other states, and reselling the gas to local distribution companies, utilities other than OG&E and industrial purchasers both within and outside Oklahoma. Although the margin on sales by Services is relatively small, approximately 63 percent of the natural gas purchased and resold is transported through the Enogex Inc. pipeline to one or more interstate pipelines that deliver the gas to markets. Thus, in addition to purchasing and selling natural gas, Services seeks to use the space available in the Enogex Inc. pipeline and increase the amount of natural gas available for processing by Products. Clinton, which was acquired in 1993, is engaged in essentially the same business as Services. Enogex Inc. is committed to expand the activities of Services in order to increase the amount of natural gas transported through the pipeline and the amount of natural gas processed by Products. In its marketing and transportation services for third parties, Enogex Inc., Services and Clinton encounter competition from other natural gas transporters and marketers and from available alternative energy sources. The effect of competition from alternative energy sources is dependent upon the availability and cost of competing supply sources. Volumes of natural gas transported by Enogex Inc. for third parties and the revenues derived from such activities increased from the previous year. The contributing factors for the increase were specific projects approved to strengthen Enogex's position, with other similar projects under consideration. Services and Clinton compete with all major suppliers of natural gas in the geographic markets they serve, which are primarily the areas served by pipelines with which Enogex is interconnected. Although the price of the gas is an important factor to a buyer of natural gas from Services, the primary factor is the total cost (including transportation fees) that the buyer must pay. Natural gas transported for Services by Enogex Inc. is billed at the same rate Enogex Inc. charges for comparable third-party transportation. Exploration was formed in 1988 primarily to engage in the production and exploration of natural gas. Exploration has focused its drilling activity in the state of Michigan and also has interests in Oklahoma. As of December 31, 1993, Exploration had interests in 238 active wells. Item 2. Item 2. Properties. ------------------- OG&E owns and operates an interconnected electric production, transmission and distribution system, located in Oklahoma and western Arkansas, which includes eight active generating stations with an aggregate active capability of 5,637 megawatts. The following table sets forth information with respect to present electric generating facilities: Unit Station Year Capability Capability Station & Unit Fuel Installed (Megawatts) (Megawatts) ------------------------------------------------------------ Seminole 1 Gas 1971 549 2 Gas 1973 507 3 Gas 1975 500 1,556 Muskogee 3 Gas 1956 184 4 Coal 1977 500 5 Coal 1978 500 6 Coal 1984 515 1,699 Sooner 1 Coal 1979 505 2 Coal 1980 510 1,015 Horseshoe 6 Gas 1958 178 Lake 7 Gas 1963 238 8 Gas 1969 394 810 Mustang 1 Gas 1950 58 Inactive 2 Gas 1951 57 Inactive 3 Gas 1955 122 4 Gas 1959 260 5 Gas 1971 64 446 Conoco 1 Gas 1991 26 2 Gas 1991 26 52 Arbuckle 1 Gas 1953 74 Inactive Enid 1 Gas 1965 12 2 Gas 1965 12 3 Gas 1965 12 4 Gas 1965 12 48 Woodward 1 Gas 1963 11 11 ----- Total Active Generating Capability (all stations) 5,637 ===== At December 31, 1993, OG&E's transmission system included 65 substations with a total capacity of approximately 17.2 million kVA and approximately 4,289 structure miles of lines. The distribution system included 345 substations with a total capacity of approximately 6.1 million kVA, 25,232 structure miles of overhead lines, 1,565 miles of underground conduit and 6,184 miles of underground conductor. The Trust Indenture securing OG&E's first mortgage bonds constitutes a direct first mortgage lien on substantially all of its electric facilities. Enogex owns: (i) over 3,000 miles of natural gas pipeline extending from the Arkoma Basin in eastern Oklahoma to the Anadarko Basin in western Oklahoma; (ii) a 50 percent interest in a natural gas processing plant near Calumet, Oklahoma, which has the capacity to process 250,000 Mcf of natural gas per day; and (iii) five other natural gas processing plants in Oklahoma, which have, in the aggregate, the capacity to process approximately 54,000 Mcf of natural gas per day. During the three years ended December 31, 1993, the Company's gross property, plant and equipment additions approximated $384 million and gross retirements approximated $69 million. Over 90 percent of these additions were provided by internally generated funds. The additions during this three-year period amounted to approximately 10.4 percent of total property, plant and equipment at December 31, 1993. Item 3. Item 3. Legal Proceedings. -------------------------- 1. In March 1991, the Director of the Public Utility Division of the OCC filed an application with the OCC challenging, among other things, OG&E's retail electric rates in Oklahoma. On February 25, 1994, the OCC issued an order that, among other things, lowered OG&E's rates to its Oklahoma retail customers by approximately $17 million and ordered a refund of approximately $41.3 million, including interest. See "Regulation and Rates" under Item 1 for a further discussion of this matter. 2. On June 30, 1986, the United States government filed suit against OG&E and 36 other defendants in case number CIV-86-1401 W, in the United States District Court ("USDC") for the Western District of Oklahoma. The complaint generally alleges that a total of 18 million gallons of hazardous and toxic waste are contained at the Hardage Criner site located approximately 30 miles south of Oklahoma City, and that the government has expended, as of the date of the filing of the complaint, $1.44 million related to the site. The 37 defendants are divided into three classes: 33 "generator" defendants, of which OG&E is one; three "transporter" defendants; and the owner of the site, Mr. Royal Hardage. It is estimated that over 200 other entities, not presently named in the government's complaint, have also disposed of materials at the site. OG&E has disposed of an estimated 130,000 gallons at the site, or less than 1 percent of the total volume of waste. OG&E, along with each other Potentially Responsible Party ("PRP"), could be held jointly and severally liable for the remediation of the site. In August 1990, the USDC issued its rulings on the appropriate method for cleanup of the site. The USDC selected the containment remedy proposed by the Hardage Criner Steering Committee Defendants (the "Committee"), of which OG&E is a member, with several modifications. The remedy ordered by the USDC is estimated to cost approximately $60 million. However, the actual costs are heavily dependent on the nature and volume of liquids that will be extracted from the Hardage site. It is possible that the remedy could cost substantially more than the current $60 million estimate. The USDC awarded the United States all of its claimed "indirect" costs, and all of the costs incurred by the United States Department of Justice, a total of approximately $3.2 million. These amounts are in addition to the past response costs of approximately $5.4 million that the USDC awarded the United States in a pre-trial summary judgment entered on December 8, 1989. That summary judgment also granted the United States the right to recover future costs that are "not inconsistent with the EPA's National Contingency Plan regulations." The Committee estimates that the United States has obtained monetary judgments which will allow it to recover approximately $12 million. In a related ruling on cost issues, the USDC held that the Committee had incurred recoverable response costs in the amount of approximately $3.7 million. It further held that the United States was obligated to pay 8.36 percent of the Committee's costs, or approximately $311,000. The USDC ruled that the United States' share of the total cleanup costs should include 8.36 percent of the costs of the court-ordered remedy and 8.36 percent of the approximately $12 million in costs that the United States itself was awarded in the case, except for prejudgment interest and Department of Justice costs. The Committee appealed the USDC's rulings on the government receiving 100 percent of its costs and the Committee receiving only a portion of its costs to the Tenth Circuit Court of Appeals. The Tenth Circuit Court of Appeals has not yet issued a ruling in this appeal. Settlements have been reached with other parties for their share of costs incurred. The money collected through these settlements is being used by the Hardage Site Remedy Corporation (which was formed to implement the USDC-ordered remedy) to finance the remedy and to reimburse the government for response costs it may ultimately be awarded in the pending appeal in the Tenth Circuit Court. Even though the settlement funds, plus interest and the United States contribution will raise a substantial portion of the monies required, any remaining amounts that OG&E and the other Hardage Steering Committee members are likely to pay may still be substantial. A more accurate estimate of the amount of the remaining costs must be determined after the remedy design is completed. The Hardage Steering Committee members have reached an Agreement to pay the costs based on each company's respective volume of waste sent to the site. OG&E's share of the total is 2.33 percent. While it is not possible to determine the precise outcome of this matter, in the opinion of management, OG&E's ultimate liability for the cleanup costs of this site will not have a material adverse effect on OG&E's financial position or its results of operations. Management's opinion is based on the following: (1) the cleanup costs already paid by certain parties; (2) the financial viability of the other PRPs; and (3) the portion of the total waste disposed at this site attributable to OG&E. Management also believes that costs incurred in connection with this site, which are not recovered from insurance carriers or other parties, may be allowable costs for future ratemaking purposes. 3. OG&E is also involved, along with numerous other PRPs, in an EPA administrative action involving the facility in Holden, Missouri, of Martha C. Rose Chemicals, Inc. ("Rose"). Beginning in early 1983 through 1986, Rose was engaged in the business of brokerage of polychlorinated biphenyls ("PCBs") and PCB items, processing of PCB capacitors and transformers for disposal, and decontamination of mineral oil dielectric fluids containing PCBs. During this time period, various generators of PCBs ("Generators"), including OG&E, shipped materials containing PCBs to the facility. Contrary to its contractual obligation with OG&E and other Generators, it appears that Rose failed to manage, handle and dispose of the PCBs and the PCB items in accordance with the applicable law. Rose has been issued citations by both the EPA and the Occupational Safety and Health Administration. OG&E, along with the other PRPs, could be held jointly and severally liable for the remediation of the site. In March 1986, Rose abandoned its facility in Holden, Missouri, and subsequently notified certain Generators of its unwillingness and/or inability to come into compliance with the PCB rules and regulations and to properly dispose of such PCBs and PCB items at the facility. In addition to PCBs and PCB items at the Rose facility, the EPA believes that contaminated soils, sediments and/or sludge may be present off-site. Several Generators, including OG&E, formed a Steering Committee to investigate and possibly clean up the Rose facility. On October 30, 1986, OG&E, along with other Generators, entered into a negotiated Administrative Order of Consent with the EPA for the first phase of the work which includes: (i) conducting an assessment to determine the location and extent of any release or immediate threat of release of PCBs which pose or may pose any immediate danger to human health or welfare or the environment at the Rose facility; (ii) depending upon the results of such assessment, taking such response actions as are necessary to address the releases of PCBs and to eliminate the threat of further immediate releases of PCBs; (iii) providing such action as necessary to restrict access to and secure the Rose facility; and (iv) determining the nature and extent of the threat to the public health or welfare or the environment by conducting such site surveys, samplings and analyses, inventories and data evaluations as necessary to support and determine potential intermediate and final response actions. Currently, OG&E management's estimate of the total cost for cleanup of the Rose facility is in the range of $23 to $31 million, of which $18.5 million has already been collected from certain parties. A second Administrative Order has been entered into which provides that the Steering Committee: (1) develop a Statement of Work following the Toxic Substances Control Act's guidelines; (2) perform a Remedial Investigation/Feasibility Study ("RI/FS"); (3) be given by the EPA a Covenant Not to Sue for work at the site under certain conditions; and (4) with the EPA's agreement, not to sue non-participating PRPs. A Buyout Agreement with other parties was entered into in 1988. Work is progressing under the second Administrative Order and the RI/FS. In 1989, the Steering Committee filed suit against certain PRPs for cleanup costs. On September 2, 1992, the EPA, Region VII, issued an Administrative Order ("AO") for Remedial Design and Remedial Action pursuant to Section 106 (a) of the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). The AO basically requires excavation, treatment and disposal of remaining soils and debris, dismantling of buildings and groundwater monitoring for a minimum of 10 years. The AO contains a provision for an opportunity to confer between the EPA and the Steering Committee. Such conference was held and a notice to comply was given to the EPA by the Steering Committee coupled with its concern over the issue of access to the property. The Company estimates its share of the total hazardous wastes at the Rose facility to be less than six percent. Due to the present stage of this matter, the Company cannot predict its outcome or the precise amount that it may be required to pay. Nevertheless, management believes that OG&E's ultimate liability for the cleanup costs of this site will not have a material adverse effect on OG&E's financial position or its results of operations. Management's opinion is based on the following: (1) the cleanup costs already paid by certain parties; (2) the financial viability of the other PRPs; and (3) the portion of the total waste disposed at this site attributable to OG&E. Management also believes that costs incurred in connection with this site, which are not recovered from insurance carriers or other parties, may be allowable costs for future ratemaking purposes. 4. Reference is made to paragraph No. 4 under Item 3 of the Company's 1992 Form 10-K regarding the suit filed by Charles D. "Charley" Wilson against the Directors of OG&E seeking in excess of $2 billion in damages. On July 13, 1993, the Oklahoma Supreme Court held that the Plaintiff's lawsuit failed to state a claim upon which relief could be granted. The Supreme Court held that Oklahoma does not recognize a common law fiduciary duty on behalf of the Directors to the ratepayers of OG&E. The Supreme Court also found that any such cause of action, if recognized, would be preempted by the Public Utility Regulatory Policies Act of 1978 and the Federal Energy Regulatory Commission regulations under the facts of the case. Finally, because Wilson's lawsuit was essentially a rate refund case, the Supreme Court held that jurisdiction rested exclusively with the Oklahoma Corporation Commission. The Supreme Court remanded the case to the trial court with instructions to dismiss for lack of subject matter jurisdiction. Wilson filed a petition for rehearing with the Oklahoma Supreme Court and a response was filed to that petition. On October 5, 1993, the Oklahoma Supreme Court denied Wilson's petition for rehearing. Wilson filed petition for a Writ of Certiorari with the Supreme Court of the United States, October term, 1993. On February 22, 1994, the United States Supreme Court denied certiorari in this case. This case is now concluded in favor of the Directors and against Wilson in all respects. 5. In July 1989, OG&E, through various media reports, became aware of an asbestos problem at one of its former power plants known as the Osage Plant, which had been sold to Osage Properties, Inc. in December 1986. Under the terms of the Real Estate Purchase Contract, Osage Properties, Inc., was informed of the presence of friable asbestos in the plant, with their agreement to accept all liability for the friable asbestos and indemnify OG&E against any and all claims brought against OG&E for damages and/or injuries to property or persons resulting from the existence and/or removal of friable asbestos material from the property. In September 1988, Osage Properties, Inc. apparently leased the property to ACS Laboratories, Inc. for the stated purposes of residential living, dismantling and workshop premises. Because OG&E had no interest in the property after December 1986, OG&E does not know what activities took place on the property after that date. According to public reports and television accounts, people were living inside the building and dismantling equipment, etc., apparently disturbing the encapsulated asbestos. According to the public reports, the people did not have protective clothing or equipment for asbestos work and were not handling and/or disposing of the asbestos properly. Further, neither Osage Prop- erties, Inc. nor their Lessee had the proper licensing required for such work. As a result, the Oklahoma State Departments of Labor and Health have closed the site and are investigating the situation for possible solutions. OG&E intends to cooperate with the agencies of the State of Oklahoma in resolving this matter and, although the amount, if any, to be expended by OG&E has not been determined, OG&E does not believe this matter will have a material adverse effect on its financial position or its results of operations. 6. In 1992, OG&E began a voluntary review of information contained in the annual report required under the Toxic Substance Control Act ("TSCA") for 1991. The initial result of the review revealed some discrepancies in procedures and documentation. The EPA, Region VI, was notified of these initial discrepancies in December 1992. Because it was suspected that additional discrepancies might be discovered during the continuing review/audit, OG&E reached an agreement on January 12, 1993, with the EPA, Region VI, concerning the notification and reporting requirements of any newly discovered discrepancies. After further investigation, OG&E reported in September 1993 numerous additional discrepancies to the EPA, Region VI. Many of the discrepancies could be deemed violations of the regulations under TSCA. The discrepancies principally concerned the TSCA regulations relating to PCB handling and record keeping requirements. However, to the Company's knowledge, none of the activities involved releases of materials into the environment or caused harm to any individuals. Under the TSCA regulations, the EPA has the authority to assess a maximum fine of up to $25,000 per day, and to treat each day of violation as the basis for a separate fine. OG&E has taken and is taking corrective action to remedy the discrepancies. The position of the EPA and OG&E is that they are currently in pre-settlement negotiations and no fines have been assessed as of this date. Since this matter is currently being negotiated, OG&E does not know the amount of fines that the EPA may seek. The amount of the fine is dependent upon numerous interpretive issues under the TSCA regulations and potentially could be in an amount material to the Company's results of operations. However, at the present time, the Company does not expect that the amount of the fine will have a material effect on its results of operations based primarily on having voluntarily reported the discrepancies to the EPA coupled with the Company's efforts to remedy the discrepancies and the lack of releases into the environment or harm to individuals. 7. On January 11, 1993, OG&E received a Section 107 (a) Notice Letter from the EPA, Region VI, as authorized by the CERCLA, 42 USC Section 9607 (a), concerning the Double Eagle Refinery Superfund Site located at 1900 NE First Street in Oklahoma City, Oklahoma. The EPA has named OG&E and 45 others as PRPs. Each PRP could be held jointly and severally liable for remediation of this site. The Notice Letter, a formal demand for reimbursement of past and future incurred costs (past costs are approximately $1.3 million), provided for a negotiation period of 60 days and encouraged the PRPs to perform or finance the response activities as set forth in the Record of Decision ("ROD") and the Draft Statement of Work ("SOW"). The ROD addresses the source of contamination both on and off the site and is divided into two operable units: 1) Source Control Operable Unit, the remedy of which is addressed with the SOW and has an estimated cost of $6.4 million; and 2) Groundwater Operable Unit, which is still being evaluated to assess the extent of contamination in the groundwater and any plumes. The cost of remediation for this Unit cannot be estimated at this time. As to the Source Control Operable Unit and as a result of the EPA's Notice Letter, companies listed as PRPs (including OG&E) held several meetings to determine whether or not they should form a Steering Committee, whether additional research into volumetric shares should be conducted and a response, if any, to be sent to the EPA. Several but not all of the 46 companies have signed a very limited Participation Agreement, the purpose of which is to negotiate with the EPA. On March 31, 1993, OG&E joined with the signatories to the limited Participation Agreement in making a settlement offer to the EPA. The EPA met with representatives of the PRPs group on June 11, 1993, to discuss the current developments taking place. The EPA is currently considering a modification of the remedy for the Source Control Operable Unit because the remedy was apparently selected without giving consideration to the presence of listed hazardous waste, although the presence of this waste was documented in the Record of Decision. The EPA explained at the meeting that it will likely not make a decision in the near future concerning the remedy for the Source Control Operable Unit. The EPA informed the participating PRPs that it would not pursue them through the issuance of a unilateral administrative order relating to the Special Notice Letters. As to the Groundwater Operable Unit, OG&E declined to either participate in conducting or financing any remedial activities. No further action on the Groundwater Operable Unit has been taken by the EPA. On February 1, 1994, OG&E received a Section 104 Letter from the EPA, Region VI, which asked for either participation in or financing of a Removal Action calling for netting of 2.5 acre on- site sludge lagoon to preclude access to wildlife. The PRP Group, for various reasons, declined on February 10, 1994, to participate or finance the Removal Action. Due to the present stage of this matter, the total cost of the cleanup of the site and the Company's ultimate liability cannot be estimated. Nevertheless, management believes that OG&E's ultimate liability for the cleanup costs of this site will not have a material adverse effect on OG&E's financial position or its results of operations. Management's opinion is based on the financial viability of the other PRPs and the portion of the total waste disposed at this site attributable to OG&E. Management also believes that costs incurred in connection with this site, which are not recovered from insurance carriers or other parties, may be allowable costs for future ratemaking purposes. 8. OG&E has been requested by the EPA to permit the inspection of two separate properties owned by OG&E for possible hazardous substances, pollutants or contaminants. These sites were used many years ago by OG&E or certain companies acquired by OG&E for manufacturing gas from coal. In connection with manufacturing gas, various by-products were produced (including coal-tar and other potentially harmful materials), which could remain on the sites. At the present time, OG&E does not know whether any harmful materials remain at the sites and intends to cooperate fully with the EPA in its investigation. 9. Puritan Oil and Gas Corp., and other Plaintiffs, filed an amendment to a petition on February 19, 1993, to an action previously filed in the District Court of Oklahoma County, involving an alleged breach of an oil and gas contract by OG&E. Enogex Inc. was also joined as a Defendant in the action. Plaintiff alleges that OG&E and Enogex were in violation of the Federal Racket Influenced and Corrupt Organizations Act ("RICO"). The case was removed to the United States District Court for the Western District of Oklahoma. Plaintiff alleges the Defendants refused to honor contractual obligations in certain gas purchase contracts. The underlying dispute on the gas purchase contracts arises in the ordinary course of OG&E's business and involves whether OG&E must purchase gas thereunder, where the contract provides for certain requirements be maintained by the well. Actual damages under the RICO claim are sought in an amount of $2,000,000. RICO provides that these damages be trebled in the event of an adverse verdict. Punitive damages under the RICO claim are also sought in the amount of $1,000,000. A Motion to Dismiss the RICO claim was filed by OG&E and Enogex. On January 4, 1994, the Court dismissed the RICO claim and remanded the breach of contract action to the state court. Plaintiffs filed a Motion to Amend the RICO claim. It was denied by the court. Plaintiffs filed a Notice of Appeal on March 1, 1994, to perfect an appeal of the dismissal of the RICO claims to the Tenth Circuit Court of Appeals. Management believes the outcome of this proceeding will not have a material adverse effect on the Company's financial position or its results of operations for numerous reasons, which include punitive damages do not appear to be available to the Plaintiffs under RICO and the underlying dispute between the parties of a gas purchase contract. Management intends to vigorously pursue the defense of this matter. In the normal course of business, other lawsuits, claims, environmental actions and other governmental proceedings may arise against the Company. Management, after consultation with legal counsel, does not anticipate that liabilities arising out of such other currently pending or threatened lawsuits and claims will have a material adverse effect on the Company's financial position or its results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. ------------------------------------------------------------- Not applicable. Executive Officers of the Registrant The following persons were Executive Officers of the Regis- trant as of March 15, 1994: Name Age Title ----------------------------------------------------------------- James G. Harlow, Jr. 59 Chairman of the Board, President and Chief Executive Officer Patrick J. Ryan 55 Executive Vice President and Chief Operating Officer Bob G. Bunce 62 Senior Vice President-Accounting and Administration Kenneth J. Baltes 58 Vice President and Manager Eastern Region H. Leon Grover 57 Vice President and Manager Western Region James R. Helton 51 Vice President and Manager Metro Region Steven E. Moore 47 Vice President-Law and Public Affairs Al M. Strecker 50 Vice President and Treasurer Don L. Young 53 Controller Irma B. Elliott 55 Secretary No family relationship exists between any of the Executive Officers of the Registrant. Each Officer is to hold office until the Board of Directors meeting following the next Annual Meeting of Shareowners, currently scheduled for May 19, 1994. The business experience of each of the Executive Officers of the Registrant for the past five years is as follows: Name Business Experience ----------------------------------------------------------------- James G. Harlow, Jr. 1989-Present: Chairman of the Board, President and Chief Executive Officer Patrick J. Ryan 1989-Present: Executive Vice President and Chief Operating Officer Bob G. Bunce 1989-Present: Senior Vice President- Accounting and Administration Kenneth J. Baltes 1989-Present: Vice President and Manager Eastern Region H. Leon Grover 1989-Present: Vice President and Manager Western Region James R. Helton 1989-Present: Vice President and Manager Metro Region Steven E. Moore 1989-Present: Vice President-Law and Public Affairs Al M. Strecker 1991-Present: Vice President and Treasurer 1989-1991: Vice President, Secretary and Treasurer Don L. Young 1989-Present: Controller Irma B. Elliott 1991-Present: Secretary 1989-1991: Assistant Secretary Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. --------------------------------------------------------- The Company's Common Stock is listed for trading on the New York and Pacific Stock Exchanges under the ticker symbol "OGE". Quotes may be obtained in daily newspapers where the common stock is listed as "OklaGE" in the New York Stock Exchange listing table. The following table gives information with respect to price ranges, as reported in The Wall Street Journal as New York Stock Exchange Composite Transactions, and dividends paid for the periods shown. 1993 1992 ------------------------- ------------------------- Dividend Dividend Paid High Low Paid High Low -------- ---- --- -------- ---- --- First Quarter $0.66-1/2 $35-7/8 $33 $0.66-1/2 $44 $37-5/8 Second Quarter 0.66-1/2 37-5/8 33-3/4 0.66-1/2 38-7/8 30-1/8 Third Quarter 0.66-1/2 38-5/8 34 0.66-1/2 34-7/8 31 Fourth Quarter 0.66-1/2 38-3/8 32-7/8 0.66-1/2 34-3/4 32-1/8 The number of record holders of Common Stock at December 31, 1993, was 36,201. The book value of the Company's Common Stock at December 31, 1993, was $22.48. Item 6. Item 6. Selected Financial Data. -------------------------------- Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. ----------------------------------------------------------- Management's Discussion and Analysis. Overview Earnings for 1993 increased to $2.78 per share from $2.42 in 1992, despite the recent rate order of February 25, 1994, from the Oklahoma Corporation Commission (the "Commission"). The Commission's order requires OG&E to reduce its electric rates to its Oklahoma retail customers prospectively by approximately $14 million annually (based on a test year ended June 30, 1991) and to refund approximately $41.3 million. The $14 million annual reduction in rates is expected to lower OG&E's rates to its Oklahoma customers by approximately $17 million in 1994. With respect to the $41.3 million refund, $2.2 million will pertain to 1994, while the balance relates to prior periods which reduced 1993 earnings by $0.32 per share. Partially offsetting the impact of the refund for 1993 was an $18 million provision for rate refund established by the Company in 1992, which, in turn, reduced 1992 earnings by $0.28 per share. Due to the rate order and the ever-increasing competition in the utility industry, OG&E has commenced a complete review and redesign of its operations that could result in downsizing or other cost-cutting measures. OG&E also froze salaries and hiring in February 1994. These actions are intended to offset some of the impact of the recent rate order and to make OG&E more competitive in the years ahead. The following discussion and analysis presents factors (including the recent rate order of the Commission) which had a material effect on the Company's operations and financial position during the last three years and should be read in conjunction with the Consolidated Financial Statements and Notes thereto. Trends and contingencies of a material nature are discussed to the extent known and considered relevant. EARNINGS The 1993 increase in earnings was attributable almost in its entirety to increased retail electric sales from more normal weather in the Company's service territory, which more than offset the $0.32 reduction in earnings for 1993 related to the Commission's recent refund order. Earnings in 1992 were lower than 1991 due to the $18 million provision for refund recorded in 1992 ($0.28 per share), lower electric retail sales due to unusually mild weather and reduced subsidiary earnings. Results of Operations REVENUES * Not meaningful Approximately 89 percent of the Company's revenues consist of regulated sales of electricity as a public utility, while the remaining 11 percent is provided by the non-utility operations of the Company's wholly-owned subsidiary, Enogex Inc. and its subsidiaries (collectively "Enogex"). Enogex's primary operations consist of transporting natural gas through its intra-state pipeline to various customers (including OG&E), buying and selling natural gas to third parties, selling natural gas liquids extracted by its natural gas processing plants and investing in exploration activities. Actions of the regulatory commissions that set OG&E's electric rates will continue to affect the Company's financial results. The commissions also have the authority to examine the appropriateness of OG&E's recovery from its customers of fuel costs, which include the transportation fees that OG&E pays Enogex for transporting natural gas through Enogex's pipeline to OG&E's generating units. During 1993, operating revenues increased 10.1 percent to $1.45 billion compared to $1.31 billion in 1992 and 1991. Increased kilowatt-hour sales to OG&E customers ("system sales"), the recovery of higher purchased power costs and increased Enogex revenues accounted for the improvement in revenues. These increases were only partially offset by the Commission's recent rate order, which reduced 1993 operating revenues by approximately $15 million. See Note 10 of Notes to Consolidated Financial Statements for a further discussion of the Commission's recent rate order. A return to near normal weather and continued slight customer growth contributed to the increase in system sales for 1993. This increase in system sales was partially offset by a 25.0 percent decrease in sales to other utilities; causing total kilowatt-hour sales to be down by 0.3 percent for 1993. However, sales to other utilities are at much lower prices per kilowatt- hour and have less impact on operating revenues and income than system sales. Enogex's 1993 revenues increased due to higher prices on natural gas sales and increased sales of petroleum products. The increased sales of petroleum products were primarily due to gas sales to third parties by Enogex's newest subsidiary, Clinton Gas Transmission, Inc., which was acquired early in 1993. Operating revenues in 1992 were adversely affected by a decrease in sales of electricity to OG&E customers, due to the unusually mild weather in the Company's service territory and the $18 million provision for rate refund recorded in 1992. These factors were offset by increased sales of electricity to other utilities and increased revenues by Enogex. Enogex's revenue reflects increased volumes and prices for natural gas sales to third parties. The higher levels of sales to other utilities in 1992 were due to the unusually mild weather and the significant amount of power that the Company must purchase from cogenerators under Federal law, which resulted in OG&E having surplus, relatively- inexpensive power for sale to other utilities. Yet, as noted above, sales to other utilities are at much lower prices per kilowatt-hour and have less impact on operating revenues and income than system sales. The Company's 1992 system kilowatt-hour sales were down by approximately 1.5 percent compared to 1991 due to decreased customer usage, while sales to other utilities increased 62.1 percent from 1991 levels. The Company's 1994 revenues will be affected by the Commission's recent rate order, which will lower OG&E's rates to its Oklahoma customers by approximately $17 million and result in a charge of approximately $2.2 million relating to the portion of the $41.3 million refund to be recognized in 1994. EXPENSES AND OTHER ITEMS Total operating expenses rose 10.0 percent to $1.25 billion during 1993 compared to an increase of 3.1 percent to $1.14 billion during 1992. The Company's generating capability is almost evenly divided between coal and natural gas and provides the flexibility to use either fuel to the best economic advantage for the Company and its customers. During 1993, the cost associated with coal decreased $3.8 million or 2.0 percent. The cost associated with natural gas, on the other hand, increased by $9.4 million or 3.9 percent. The total increase in fuel expense for 1993 was $5.6 million or 1.5 percent which compares to a total fuel expense increase of $8.6 million or 2.3 percent for 1992. The consumption of natural gas in 1993 was actually 3.5 percent less than in 1992, however, due to price fluctuations, natural gas expense on a Btu basis increased 4.4 percent. The cost of fuel in the generation of electricity (which includes Enogex's charges to OG&E for transporting natural gas to OG&E's gas-fired generating units) and the cost of purchased power are recovered from customers pursuant to fuel adjustment clauses or other tariffs, subject to periodic review by the Oklahoma Corporation Commission, the Arkansas Public Service Commission and the Federal Energy Regulatory Commission ("FERC"). See Note 10 of Notes to Consolidated Financial Statements. Purchased power costs amounted to $218.7 million in 1993, $182.2 million in 1992 and $173.8 million in 1991. As required by the Public Utility Regulatory Policy Act of 1978 ("PURPA"), the Company must currently purchase power from qualified cogeneration facilities. Purchased power costs increased by more than $36 million in 1993 due to price escalation provisions contained in certain cogeneration contracts. In 1998, another cogeneration facility is scheduled to become operational. Under PURPA, the Company is obligated to purchase capacity from this facility as well. See Note 9 of Notes to Consolidated Financial Statements. In 1992, the Company increased its electric sales to other utilities. This increased volume caused fuel expense to exceed 1991 levels, despite the Company's various programs which, overall, reduced fuel expense on a per kilowatt-hour basis. To help lower fuel cost, the Company began utilizing a new natural gas storage facility in 1993. OG&E is now pumping gas into the storage reservoir, which will help OG&E get greater value out of its remaining take-or-pay gas contracts. By diverting natural gas into storage, for the first time OG&E will be able to use as much coal as possible to make electricity, and pull gas from storage only to meet increases in demand. In 1994, gas storage will give OG&E the flexibility to generate about 78 percent of its electricity with coal, the highest percentage in OG&E's history. With coal being approximately one-third the cost of gas, running coal units at full capacity is expected to cut fuel costs for OG&E's customers by about $90 million a year. The Company has initiated numerous other ongoing programs that have helped reduce the cost of generating electricity over the last several years. These programs include: 1) spot market purchases of coal; 2) renegotiated contracts for coal, gas, railcar maintenance, and coal transportation; and 3) a heat rate awareness program to produce kilowatt-hours with less fuel. Together, these fuel management efforts help OG&E remain competitive by cutting fuel costs with the savings being passed on to OG&E's electric customers, which in turn allows them to remain competitive in a global economy. Enogex's gas purchased for resale increased $42.8 million or 43.9 percent for 1993 compared to $20.1 million or 26.0 percent for 1992. The 1993 increase was due to higher gas prices and increased volumes of natural gas purchased for resale by Clinton Gas Transmission, Inc. The 1992 increase in gas purchased for resale resulted from larger volumes and increased cost of natural gas purchased by Enogex. The increase in other operation and maintenance expenses for 1993 resulted from major overhauls at two generating plants and increased labor costs. The 1992 increase in other operation and maintenance expenses was primarily due to increased medical and labor costs, higher expenses associated with the Company's Oklahoma rate cases, rent expense for the corporate headquarters and tree trimming activity along transmission and distribution rights-of-way. The increases in depreciation for 1993 and 1992 reflect higher levels of depreciable plant. Also, the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," during 1993 and its effect on Enogex contributed to the increase in depreciation. See Note 2 of Notes to Consolidated Financial Statements. Income taxes during 1993 increased primarily due to higher pre-tax earnings and a one percent increase in the federal income tax rate to 35 percent. Current income taxes decreased in 1992 primarily due to lower pre-tax earnings. The 1992 decrease in current income taxes was partially offset by the tax effect of the $18 million provision for a potential refund which increased current income taxes by approximately $6.8 million and decreased the provision for deferred income taxes by a like amount. The increase in interest expense for 1993 resulted from approximately $6.2 million of interest associated with the refund ordered by the Commission. See Note 10 of Notes to Consolidated Financial Statements. Liquidity, Capital Resources and Contingencies The primary capital requirements for 1993 and as estimated for 1994 through 1996 are as follows: (dollars in millions) 1993 1994 1995 1996 ---------------------------------------------------------------------- Construction expenditures including AFUDC ................ $128 $143 $116 $118 Maturities of long-term debt and sinking fund requirements .. 15 - 85 - ---------------------------------------------------------------------- Total ...................... $143 $143 $201 $118 ====================================================================== CONSTRUCTION The Company's need for capital is related to construction of new facilities to meet anticipated demand for service, to replace or expand existing facilities in both its electric and non- utility businesses, and to some extent, for satisfying maturing debt and sinking fund obligations. Approximately $6.9 million of the Company's construction expenditures budgeted for 1994 are to comply with environmental laws and regulations. The construction program for the next several years does not include any additional base-load generating units. Rather, to meet the increased electricity needs of its customers during the balance of this century, the Company will concentrate on maintaining the reliability and increasing the utilization of existing capacity and increasing demand-side management efforts. FINANCE The Company meets its cash needs through internally generated funds, short-term borrowings and permanent financing. The Company internally generated substantially all of its funds for construction expenditures during 1993. Management expects that internally generated funds will be adequate over the next three years to meet these capital requirements and to refund the $41.3 million ordered by the Commission in 1994. Short-term borrowings will continue to be used to meet temporary cash requirements. The maximum amount of outstanding short-term borrowings during 1993 was $136.6 million. The Company has the necessary regulatory approvals to incur up to $300 million in short-term borrowings at any one time. CONTINGENCIES The Company is defending various claims and legal actions, including environmental actions, which are common to its operations. As to environmental matters, the Company has been designated as a "potentially responsible party" ("PRP") with respect to three waste disposal sites to which the Company sent materials. Under applicable law, the Company along with each PRP, could be held jointly and severally liable for site remediation. Neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs at any of these sites has been determined. While it is not possible to determine the precise outcome of these matters, in the opinion of management, the Company's ultimate liability for the clean-up costs of these sites will not have a material effect on the Company's financial position or results of operations. Management's opinion is based on the following: 1) the clean-up costs already paid by certain parties, 2) the financial viability of the other PRPs, and 3) the portion of the total wastes disposed at the sites attributable to the Company. Management also believes that costs incurred in connection with the sites, which are not recovered from insurance carriers or other parties, may be allowable costs for future ratemaking purposes. The Clean Air Act Amendments of 1990 (CAAA) among other things, limit the emission of sulfur dioxide and nitrogen oxides. All of OG&E's coal-fired generating units currently burn low- sulfur coal and, consequently, OG&E will not need to take any steps to comply with the new sulfur dioxide emission limits until January 1, 2000. The Company has made a capital investment for installation of continuous emission monitors on 12 units by January 1, 1995. The CAAA will also regulate emissions for nitrogen oxides and certain air toxic compounds. Although final regulations concerning all of these issues have not been written, some capital expenditures may be necessary, but an estimate of cost can not be determined at this time. The Company will continue to examine all alternatives to comply with the CAAA as part of its Integrated Resource Planning process. This planning approach will assure the Company has the least-cost option to comply with the CAAA and be in a competitive position to market its services. The Company will not be required to file its compliance plan with the Environmental Protection Agency ("EPA") until January 1996. OG&E's review of its annual report for 1991 under the Toxic Substance Control Act ("TSCA") revealed numerous discrepancies in OG&E's operating practices and documentation, which have been reported to the EPA. Many of the discrepancies could be deemed violations of TSCA regulations. See Note 9 of Notes to Consolidated Financial Statements for a further discussion of this matter. In October 1992, the National Energy Policy Act of 1992 ("Energy Act") was enacted. Among many other provisions, the Energy Act is designed to promote competition in the development of wholesale power generation in the electric utility industry. It exempts a new class of independent power producers from regulation under the Public Utility Holding Company Act of 1935 and allows the FERC to order wholesale "wheeling" by public utilities to provide utility and non-utility generators access to public utility transmission facilities. The Energy Act and other factors are expected to significantly increase competition in the electric industry. The Company has taken steps in the past and intends to take appropriate steps in the future to remain a competitive supplier of electricity. Besides the existing contingencies described above, and those described in Note 9 of Notes to Consolidated Financial Statements, the Company's ability to fund its future operational needs and to finance its construction program is dependent upon numerous other factors beyond its control, such as general economic conditions, abnormal weather, load growth, inflation, new environmental laws or regulations, and the cost and availability of external financing. Item 8. Item 8. Financial Statements and Supplementary Data. ---------------------------------------------------- Notes To Consolidated Financial Statements. 1. Summary of Significant Accounting Policies PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Oklahoma Gas and Electric Company ("OG&E"), its wholly-owned non-utility subsidiary Enogex Inc. and its subsidiaries ("Enogex") (collectively, the "Company"). All significant intercompany transactions have been eliminated in consolidation. ACCOUNTING RECORDS The accounting records of OG&E are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission ("FERC") and adopted by the Oklahoma Corporation Commission (the "Oklahoma Commission") and the Arkansas Public Service Commission (the "Arkansas Commission"). Additionally, OG&E is subject to the accounting principles prescribed by Statement of Financial Accounting Standards ("SFAS") No. 71, "Accounting for the Effects of Certain Types of Regulation". PROPERTY, PLANT AND EQUIPMENT All property, plant and equipment is recorded at cost. Electric utility plant is recorded at its original cost. Newly constructed plant is added to plant balances at costs which include contracted services, direct labor, materials, overhead, and allowance for funds used during construction. Replacement of major units of property are capitalized as plant. The replaced plant is removed from plant balances and the cost of such property together with the cost of removal less salvage is charged to accumulated depreciation. Repair and replacement of minor items of property are included in the Consolidated Statements of Income as maintenance expense. DEPRECIATION The provision for depreciation, which was approximately 3.2% of the average depreciable utility plant, for each of the years 1993, 1992 and 1991, is provided on a straight-line method over the estimated service life of the property. Depreciation is provided at the unit level for production plant and at the account or sub-account level for all other plant, and is based on the average life group procedure. Enogex's gas pipeline and gas processing plants are depreci- ated on a straight-line method over a period of 20 to 48 years. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION Allowance for funds used during construction ("AFUDC") is calculated according to FERC pronouncements for the imputed cost of equity and borrowed funds. AFUDC, a non-cash item, is reflected as a credit on the Consolidated Statements of Income and a charge to construction work in progress. AFUDC rates, compounded semi-annually, were 3.60%, 4.30% and 7.48% for the years 1993, 1992 and 1991, respectively. OPERATING REVENUES OG&E accrues estimated revenues for services provided but not yet billed. The cost of providing service is recognized as incur- red. AUTOMATIC FUEL ADJUSTMENT CLAUSES Variances in the actual cost of fuel used in electric generation and certain purchased power costs, as compared to that component in estimated cost-of-service for ratemaking, are charged to substantially all of the Company's electric customers through automatic fuel adjustment clauses. A lag of 45 to 60 days occurs between the time costs are incurred and the time such costs are reflected in bills to retail customers. OG&E records an accrual in the financial statements for these differences. The automatic fuel adjustment clauses are subject to periodic review by the Oklahoma Commission, the Arkansas Commission and FERC. FUEL INVENTORIES Fuel inventories for the generation of electricity consist of coal, oil and natural gas. These inventories are accounted for under the last-in, first-out ("LIFO") cost method. Based on the average cost of fuel purchased in late 1993, the estimated replacement cost of fuel inventories at December 31, 1993, exceeded the stated LIFO cost by approximately $2.3 million. Natural gas products inventory are held for resale and accounted for based on the weighted average cost of production. 2. Income Taxes The items comprising tax expense are as follows: (dollars in thousands) Year ended December 31 1993 1992 1991 ------------------------------------------------------------------ Current Income Taxes Provision for current taxes: Federal . . . . . . . . . . . $ 61,406 $ 52,191 $ 68,960 State . . . . . . . . . . . . 10,597 9,134 10,879 ------------------------------------------------------------------ Total Current Income Taxes . 72,003 61,325 79,839 ------------------------------------------------------------------ Deferred Income Taxes, net Provision (benefit) for deferred taxes: Federal Depreciation . . . . . . . 9,673 6,185 7,086 Repair allowance . . . . . 1,306 1,908 (5,136) Removal costs . . . . . . . 1,026 635 425 Provision for rate refund . (6,972) (5,774) - Other . . . . . . . . . . . (225) 1,059 395 State . . . . . . . . . . . 424 333 1,278 ------------------------------------------------------------------ Total Deferred Income Taxes, net 5,286 4,346 4,048 ------------------------------------------------------------------ Deferred Investment Tax Credits, net . . . . . . . . . . . . . (5,150) (5,465) (6,173) Income Taxes Relating to Other Income and Deductions . . . . (538) (1,006) (1,158) ------------------------------------------------------------------ Total Income Tax Expense . . $ 71,601 $ 59,200 $ 76,556 ------------------------------------------------------------------ Pretax Income . . . . . . . . . $185,878 $158,912 $210,472 ------------------------------------------------------------------ The following schedule reconciles the statutory federal tax rate to the effective income tax rate: Year ended December 31 1993 1992 1991 ---------------------------------------------------------------- Statutory federal tax rate . . 35.0% 34.0% 34.0% State income taxes, net of federal income tax benefit . . 3.9 3.9 4.0 Investment tax credits, net . . (2.8) (3.4) (2.9) Change in federal tax rate. . . 0.9 - - Other, net . . . . . . . . . . 1.5 2.8 1.3 Effective income tax rate as reported . . . . . . . 38.5% 37.3% 36.4% The Company files consolidated income tax returns. Income taxes are allocated to each company based on its separate taxable income or loss. Investment tax credits on electric utility property have been deferred and are being amortized to income over the life of the related property. For 1992 and 1991, provisions for deferred income taxes were recorded primarily as a result of the use of income tax law provisions which allowed for the deduction or addition of items to taxable income in the tax return prior to or after their being recorded on the books of the Company. Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes," which requires an asset and liability approach to accounting for income taxes. Under SFAS No. 109, deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities ("temporary differences") using the enacted marginal tax rate. Deferred income tax expenses or benefits are based on the changes in the asset or liability from period to period. The Company elected not to restate the financial statements for years ending before January 1, 1993. When adopted, SFAS No. 109 had no effect on net income. The deferred tax provisions, set forth above, are recognized as costs in the ratemaking process by the commissions having jurisdiction over the rates charged by OG&E. The components of Accumulated Deferred Income Taxes adjusted to reflect the impact of the increase in the federal income tax rate, are as follows: (dollars in thousands) Jan 1, 1993 Dec 31, 1993 Current Deferred Tax Assets: Accrued vacation..................... $ 3,359 $ 4,177 Provision for rate refund............ - 14,965 Customer deposits.................... 1,102 - Uncollectible accounts............... 3,669 4,946 Accumulated deferred tax assets...... $ 8,130 $ 24,088 Deferred Tax Liabilities: Accelerated depreciation and other property-related differences....... $438,419 $439,253 Allowance for funds used during construction................ 61,346 57,074 Income taxes recoverable through future rates....................... 61,829 62,441 Total.............................. 561,594 558,768 Deferred Tax Assets: Deferred investment tax credits...... (32,850) (30,616) Income taxes refundable through future rates....................... (49,100) (44,022) Provision for rate refund............ (7,074) - Other................................ (411) (127) Total.............................. (89,435) (74,765) Accumulated Deferred Income Taxes...... $472,159 $484,003 The effect of adopting SFAS No. 109 at January 1, 1993, before adjusting for the new tax rate, resulted in a net increase in property, plant and equipment of approximately $73.9 million, a net decrease in income taxes recoverable through future rates of approximately $12.0 million and a net increase in accumulated deferred income taxes of approximately $61.9 million. Also at January 1, 1993, approximately $8.1 million of deferred tax assets which were previously netted with accumulated deferred income taxes, were reclassified as current assets as a result of adopting SFAS No. 109. At December 31, 1992, the Company had recorded $44.4 million as unfunded deferred income taxes recoverable from customers. A corresponding amount was reflected as a component of accumulated deferred income taxes which represented amounts refundable to customers. As a result of the adoption of SFAS No. 109, the $44.4 million amount that was recorded as a component of accumulated deferred income taxes at December 31, 1992, was reclassified January 1, 1993, as a regulatory liability and netted against the regulatory asset. This reclassification combined with the $12.0 million net decrease in income taxes recoverable through future rates discussed above, resulted in a $32.4 million net increase in the amount recognized as income taxes to be recovered through future rates. The Omnibus Reconciliation Act of 1993, signed into law on August 10, 1993, increased the top federal corporate tax rate from 34 to 35 percent. The 35 percent rate was retroactively made effective January 1, 1993. For the temporary differences that existed at January 1, 1993, the change in the federal income tax rate increased the provision for income taxes and accumulated deferred income taxes approximately $1.6 and $18.0 million, respectively. Approximately $16.4 million of the increase which was applicable to utility operations was recorded as income taxes recoverable from customers through future rates and therefore had no impact on results of operations for the year ended December 31, 1993. 3. Common Stock and Retained Earnings There were no new shares of common stock issued during 1993, 1992 or 1991. The changes in premium on capital stock as presented on the Consolidated Statements of Capitalization represents the gains and losses associated with the issuance of common stock pursuant to the Restricted Stock Plan. Changes in common stock were: (thousands) 1993 1992 1991 ------------------------------------------------------------------------- Shares outstanding January 1............ 40,329 40,310 40,298 Issued/reacquired under the Restricted Stock Plan, net............ 17 19 12 ------------------------------------------------------------------------- Shares outstanding December 31.......... 40,346 40,329 40,310 ========================================================================= There were 4,009,021 shares of unissued common stock reserved for the various employee and Company stock plans at December 31, 1993. The Company's Restated Certificate of Incorporation and its Trust Indenture, as supplemented, relating to the First Mortgage Bonds, contained provisions which, under specific conditions, limit the amount of dividends (other than in shares of common stock) and/or other distributions which may be made to common shareowners. In December 1991, holders of the Company's First Mortgage Bonds approved a series of amendments to the Company's Trust Indenture. The amendments eliminated the cumulative amount of the previous restrictions on retained earnings related to the payment of dividends and provided management with the flexibility to repurchase its common stock, when appropriate, in order to maintain desired capitalization ratios and to achieve other business needs. The Company is amortizing approximately $14 million of costs relating to obtaining such amendments over the remaining life of the respective bond issues. At the end of 1993, there was approximately $11.6 million in unamortized costs associated with obtaining these amendments. RESTRICTED STOCK PLAN The Company has a Restricted Stock Plan whereby certain employees may periodically receive shares of the Company's common stock at the discretion of the Board of Directors. The Company distributed 18,687, 18,631 and 12,200 shares of common stock during 1993, 1992 and 1991, respectively, pursuant to this plan. The shares distributed in the reported periods were issued from treasury stock. SHAREOWNERS RIGHTS PLAN In December 1990, the Company adopted a Shareowners Rights Plan designed to protect shareowners' interests in the event that the Company is ever confronted with an unfair or inadequate acquisition proposal. Pursuant to the plan, the Company declared a dividend distribution of one "right" for each share of Company common stock. Each right entitles the holder to purchase from the Company one one-hundredth of a share of new preferred stock of the Company under certain circumstances. The rights may be exercised if a person or group announces its intention to acquire, or does acquire, 20 percent or more of the Company's common stock. Under certain circumstances, the holders of the rights will be entitled to purchase either shares of common stock of the Company or common stock of the aquirer at a reduced percentage of market value. The rights will expire on December 11, 2000. 4. Cumulative Preferred Stock Preferred stock is redeemable at the option of OG&E at the following amounts per share plus accrued dividends: the 4% Cumulative Preferred Stock at the par value of $20 per share; the Cumulative Preferred Stock, par value $100 per share, as follows: 4.20% series-$102; 4.24% series-$102.875; 4.44% series-$102; 4.80% series-$102; and 5.34% series-$101. As approved by shareowners on May 16, 1991, the Restated Certificate of Incorporation was amended to permit the issuance of new series of preferred stock with dividends payable other than quarterly. 5. Long-Term Debt OG&E's Trust Indenture, as supplemented, relating to the First Mortgage Bonds, requires OG&E to pay to the trustee annually, an amount sufficient to redeem, for sinking fund purposes, 1-1/4 % of the highest amount outstanding at any time. This requirement has been satisfied by pledging permanent additions to property to the extent of 166-2/3 % of principal amounts of bonds otherwise required to be redeemed. Through Dec- ember 31, 1993, gross property additions pledged totaled approxi- mately $341 million. Annual sinking fund requirements for each of the five years subsequent to December 31, 1993, are as follows: Year Amount ---------------------------------------- 1994 ............ $15,114,583 1995 ............ 14,593,750 1996 ............ 14,593,750 1997 ............ 14,281,250 1998 ............ 13,760,417 ---------------------------------------- As in prior years, OG&E expects to meet these requirements by pledging permanent additions to property. The 6-3/4 % Series, $33 million Muskogee Industrial Trust Pollution Control Revenue Bonds of 1976, are subject to mandatory annual cash sinking fund requirements, which began March 1, 1992. Cash sinking fund payments for the next five years are as follows: $350,000 in 1994 and 1995; and $500,000 in 1996, 1997 and 1998. The annual amount escalates to $900,000 due March 1, 2005, with the balance of $24,750,000 due March 1, 2006. These amounts are not included in the above schedule. Enogex debt consists of the following notes payable: $60 million, with interest rates between 9.88%-10.03%, maturing December 21, 1995; and $30 million, with interest rates between 9.96%-10.11%, maturing December 21, 1998. Maturities of First Mortgage Bonds during the next five years consist of $25 million in 1995, $15 million in 1997 and $25 million in 1998. Unamortized debt expense and unamortized premium and discount on long-term debt are being amortized over the life of the respective debt. Substantially all electric plant was subject to lien of the Trust Indenture at December 31, 1993. 6. Short-Term Debt The Company borrows on a short-term basis, as necessary, by the issuance of commercial paper and by obtaining short-term bank loans. The maximum and average amounts of short-term borrowings during 1993 were $136.6 million and $62.5 million, respectively, at a weighted average interest rate of 3.60%. The Company has an agreement for a flexible line of credit, up to $200 million, through December 31, 1996. The line of credit which was nominated by the Company at $160 million at year-end is maintained on a fee basis of 1/8 of 1%, per year, on the unused balance. Short-term debt in the amount of $47.0 million was outstanding at December 31, 1993. 7. Postemployment Benefit Plans PENSION PLAN All eligible employees of the Company are covered by a non-contributory defined benefit pension plan. Under the plan, retirement benefits are primarily a function of both the years of service and the highest average monthly compensation for 60 consecutive months out of the last 120 months of service. It is the Company's policy to fund the plan on a current basis to comply with the minimum required contributions under existing tax regulations. Such contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. Net periodic pension cost is computed in accordance with provisions of SFAS No. 87, "Employers' Accounting for Pensions," and is recorded as other operation expense in the accompanying Consolidated Statements of Income. In determining the projected benefit obligation, the weighted average discount rate used was 7.25% in 1993 and 8.5% in 1992 and 1991, while the assumed rate of increase in future salary levels was 4.5% in 1993 and 5.5% in 1992 and 1991. The expected long-term rate of return on assets used in determining net periodic pension cost was 9.0% for the reported periods. The plan's assets consist primarily of U. S. Government securities, listed common stocks and corporate debt. Net periodic pension costs for 1993, 1992 and 1991 included the following: (dollars in thousands) 1993 1992 1991 ---------------------------------------------------------------------- Service costs-benefits earned during year.......................... $ 7,630 $ 7,266 $ 6,518 Interest cost on projected benefit obligation................... 14,557 13,657 13,242 Return on plan assets................... (15,697) (14,761) (13,047) Net amortization and deferral........... (1,263) (1,263) (1,353) Amortization of unrecognized prior service cost................... 671 671 552 Settlement gain......................... - - (88) ---------------------------------------------------------------------- Net periodic pension cost............... $ 5,898 $ 5,570 $5,824 ====================================================================== The following table sets forth the plan's funded status at December 31, 1993, 1992 and 1991: POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for retired members ("postretirement benefits"). Employees retiring from the Company on or after attaining age 55 who have met certain length of service requirements are entitled to these benefits. The benefits are subject to deductibles, co-payment provisions and other limitations. Prior to January 1, 1993, the costs of retiree health care and life insurance benefits were recognized as expense when claims were paid ("pay-as-you-go"). Pay-as-you-go costs totaled approximately $3,804,000, $3,443,000 and $3,272,000 for 1993, 1992 and 1991, respectively. In December 1990, the Financial Accounting Standards Board ("FASB") issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company adopted the provisions of SFAS No. 106 beginning January 1, 1993. This standard requires that employers accrue the cost of postretirement benefits during the active service periods of employees until the date they attain full eligibility for the benefits. In the February 25, 1994 order from the Oklahoma Commission, OG&E was directed to recover postretirement benefit costs following the pay-as-you-go method and to defer the incremental cost associated with accrual recognition of SFAS No. 106 related costs following a "phase-in" plan proposed by the Commission staff. In accordance with this phase-in plan, OG&E may defer the amortization of the transition obligation for up to five years or until OG&E's next general rate case, whichever occurs first. The phase-in plan also provides for OG&E to defer 100% of the incremental cost associated with accrual recognition of SFAS No. 106 related costs, exclusive of the amortization of OG&E's transition obligation, in 1993. The percentage of these incremental costs that may be deferred is reduced 25% each year beginning in 1994. OG&E deferred approximately $8.9 million of postretirement costs in 1993. The Company will record a regulatory asset for the difference between any amounts using the pay-as-you-go method and those required by SFAS No. 106 in accordance with the phase-in plan. However, until the Oklahoma Commission issues an order approving recovery for this difference, there can be no assurance that the Company will be able to recover such costs in rates. Consequently, the Company is unable to determine the final impact of implementation of SFAS No. 106. On March 25, 1993, the Arkansas Commission issued an order adopting accrual accounting and deferral of the differential between "pay-as-you-go" and accrued postretirement benefit costs for those companies requesting such deferral. In 1993, the Federal Energy Regulatory Commission issued its final agency action for SFAS No. 106, approving accrual accounting and deferral of the differential. Recovery is expected for the amounts deferred in both of these jurisdictions. The Company currently does not have a plan to fund postretire- ment benefits. Any decisions on funding will be considered along with requirements established by the commission in each jurisdic- tion. Net postretirement benefit expense for the year ended December 31, 1993, included the following components: (dollars in thousands) ------------------------------------------------ Service cost............................$ 2,812 Interest cost........................... 6,158 Amortization of transition obligation... 3,687 Net amount capitalized or deferred...... (8,853) ------------------------------------------------ Net postretirement benefit expense....$ 3,804 ================================================ The following table sets forth the funded status of the plans and amounts recognized in the Company's Consolidated Balance Sheets as of December 31, 1993: The discount rate used in determining the accumulated postretirement benefit obligation was 8.5 percent and 7.25 percent for January 1, 1993 and December 31, 1993, respectively. The rate of increase in future compensation levels used in measuring the life insurance accumulated postretirement benefit obligation was 5.5 percent and 4.5 percent for January 1, 1993 and December 31, 1993, respectively. A 14.0 percent annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993; the rate is assumed to decrease gradually to 5.5 percent by the year 2005 and remain at that level thereafter. A one- percentage-point increase in the assumed health care cost trend rates would increase the accumulated postretirement benefit obligation as of December 31, 1993, by approximately $6.8 million, and the aggregate of the service and interest cost components of net postretirement health care cost for 1993 by approximately $1.5 million. POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which will require the Company to accrue the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Adoption of SFAS No. 112 is required for fiscal years beginning after December 15, 1993, with earlier application permitted for which annual financial statements have not previously been issued. The Company will adopt this new standard effective January 1, 1994, and believes these costs will not have a material impact on its consolidated financial position or results of operations. 8. Report of Business Segments The Company's electric utility segment is an operating public utility engaged in the generation, transmission, distribution, and sale of electric energy. The non-utility subsidiary segment is engaged in the gathering and transmission of natural gas, and through its subsidiaries, is engaged in the processing of natural gas and the marketing of natural gas liquids, in the buying and selling of natural gas to third parties, and in the exploration for and production of natural gas and related products. (dollars in thousands) 1993 1992 1991 ------------------------------------------------------------------- Operating information: Operating Revenues Electric utility......... $1,282,816 $1,193,993 $1,210,726 Non-utility subsidiary... 219,376 189,574 170,490 Intersegment revenues (A) (54,940) (68,583) (66,446) ------------------------------------------------------------------- Total................ $1,447,252 $1,314,984 $1,314,770 ------------------------------------------------------------------- Pre-tax Operating Income Electric utility......... $ 238,761 $ 206,350 $ 249,559 Non-utility subsidiary... 28,531 30,860 39,242 ------------------------------------------------------------------- Total................ $ 267,292 $ 237,210 $ 288,801 ------------------------------------------------------------------- Net Income Electric utility ........ $ 104,730 $ 88,293 $ 116,531 Non-utility subsidiary... 9,547 11,419 17,385 ------------------------------------------------------------------- Total................ $ 114,277 $ 99,712 $ 133,916 ------------------------------------------------------------------- Investment Information: Identifiable Assets as of December 31 Electric utility......... $2,443,651 $2,358,661 $2,356,712 Non-utility subsidiary... 287,773 231,422 209,377 ------------------------------------------------------------------- Total................ $2,731,424 $2,590,083 $2,566,089 ------------------------------------------------------------------- Other Information: Depreciation Electric utility......... $ 104,343 $ 100,531 $ 97,950 Non-utility subsidiary... 15,200 10,169 9,764 ------------------------------------------------------------------- Total................ $ 119,543 $ 110,700 $ 107,714 ------------------------------------------------------------------- Construction Expenditures Electric utility......... $ 105,746 $ 109,650 $ 107,500 Non-utility subsidiary... 22,396 30,601 7,842 ------------------------------------------------------------------- Total................ $ 128,142 $ 140,251 $ 115,342 ------------------------------------------------------------------- (A) Intersegment revenues are recorded at prices comparable to those of unaffiliated customers and are affected by regulatory considerations. 9. Commitments and Contingencies The Company has entered into purchase commitments in connection with its construction program and the purchase of necessary fuel supplies of coal and natural gas for its generating units. The Company's construction expenditures for 1994 are estimated at $143 million. The Company acquires natural gas for boiler fuel under approximately 900 individual contracts, some of which contain provisions allowing the owners to require prepayments for gas if certain minimum quantities are not taken. At December 31, 1993, 1992 and 1991, outstanding prepayments for gas, including the amounts classified as current assets, under these contracts were approximately $22,165,000, $24,543,000 and $20,851,000, respectively. The Company may be required to make additional prepayments in subsequent years. The Company expects to recover these prepayments as fuel costs if unable to take the gas prior to the expiration of the contracts. At December 31, 1993, the Company held non-cancelable operating leases covering approximately 1,523 coal hopper railcars. Rental payments are charged to fuel expense and recovered through the Company's tariffs and automatic fuel adjustment clauses. The leases have purchase and renewal options. Future minimum lease payments due under the railcar leases, assuming the leases are renewed under the renewal option are as follows: (dollars in thousands) 1994................ $4,749 1997................ $ 3,391 1995................ 3,850 1998................ 3,333 1996................ 3,508 1999 and beyond..... 78,703 Rental payments under operating leases were approximately $4.9 million in 1993, $3.6 million in 1992 and $3.0 million in 1991. OG&E is required to maintain the railcars it has under lease to transport coal from Wyoming and has entered into an agreement with Railcar Maintenance Company, a non-affiliated company, to furnish this maintenance. The Company has entered into an agreement with an unrelated third party to develop a natural gas storage facility. According to that agreement, the Company made cash advances to the developer amounting to approximately $24.4 million, as of December 31, 1993, which is included in "Prepayments and other" in the accompanying Balance Sheets. The Company has entered into agreements with four qualifying cogeneration facilities having initial terms of 3 to 32 years. These contracts were entered into pursuant to the Public Utility Regulatory Policy Act of 1978 ("PURPA"). Stated generally, PURPA and the regulations thereunder promulgated by FERC require the Company to purchase power generated in a manufacturing process from a qualified cogeneration facility ("QF"). The rate for such power to be paid by the Company was approved by the Oklahoma Commission. The rate generally consists of two components: one is a rate for actual electricity purchased from the QF by the Company; the other is a capacity charge which the Company must pay the QF for having the capacity available. However, if no electrical power is made available to the Company for a period of time (generally three months), the Company's obligation to pay the capacity charge is suspended. The total cost of cogeneration payments is currently recoverable in rates from Oklahoma customers. During 1993, 1992 and 1991, OG&E made total payments to cogenerators of approximately $213.0 million, $179.4 million and $170.5 million, of which $165.5 million, $101.6 million and $97.3 million, respectively, represented capacity payments. All payments for purchased power, including cogeneration, are included in the Consolidated Statements of Income as purchased power. The future minimum capacity payments under the contracts for the next five years are approximately: 1994 - $173 million, 1995 - $174 million, 1996 - $175 million, 1997 - $177 million and 1998 - $180 million. The Company is a party to three separate actions brought by the Environmental Protection Agency ("EPA") concerning cleanup of disposal sites for hazardous waste. The Company was not the owner or operator of those sites. Rather, the Company along with many others, shipped materials to the owners or operators of the sites who failed to dispose of the materials in an appropriate manner. The Company has calculated that its portion of total waste disposed at the sites is relatively minor. The cost of complying with the EPA sanctions at these sites is difficult to estimate. However, based on the relative percentage attributed to the Company and other considerations, management believes the ultimate outcome of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Clean Air Act Amendments of 1990 among other things, limits the amount of sulfur dioxide and nitrogen oxides that may be released into the air. The Company will not be required to file its compliance plan with the EPA until January 1996. In 1992, OG&E began a voluntary review of information contained in the annual report required under the Toxic Substance Control Act ("TSCA") for 1991. The initial result of the review revealed some discrepancies in operating practices and documentation. The EPA was notified of these initial discrepancies in December 1992. Because it was suspected that additional discrepancies might be discovered during the continuing review/audit, OG&E reached an agreement on January 12, 1993, with the EPA, Region VI, concerning the notification and reporting requirements of any newly discovered discrepancies. After further investigation, OG&E reported in September 1993 numerous additional discrepancies to the EPA, Region VI. Many of the discrepancies could be deemed violations of the regulations under TSCA. Under the TSCA regulations, the EPA has the authority to assess a maximum fine of up to $25,000 per day, and to treat each day of violation as the basis for a separate fine. OG&E has taken and is taking corrective action to remedy the discrepancies. The position of the EPA and OG&E is that they are currently in pre-settlement negotiations. No fines have been assessed as of this date. Since this matter is currently being negotiated, OG&E does not know the amount of fines that the EPA may seek. The amount of the fine is dependent upon numerous interpretative issues under the TSCA regulations and potentially could be in an amount material to the Company's results of operations. However, at the present time, the Company does not expect that the amount of the fine will have a material effect on its results of operations based primarily on having voluntarily reported the discrepancies to the EPA coupled with the Company's efforts to remedy the discrepancies and the lack of releases into the environment or harm to individuals. In the normal course of business, other lawsuits, claims, environmental actions, and other governmental proceedings arise against the Company. Management, after consultation with legal counsel, does not anticipate that liabilities arising out of other currently pending or threatened lawsuits and claims will have a material adverse effect on the Company's consolidated financial position or results of operations. 10. Rate Matters And Regulation On February 25, 1994, the Oklahoma Commission issued an order that, among other things, effectively lowered OG&E's rates to its Oklahoma retail customers by approximately $14 million annually (based on a test year ended June 30, 1991) and to refund approximately $41.3 million. The $14 million annual reduction in rates is expected to lower OG&E's rates to its Oklahoma customers by approximately $17 million in 1994. With respect to the $41.3 million refund, $39.1 million is associated with revenues prior to January 1, 1994, while the remaining $2.2 million relates to 1994. During the first half of 1992 the Company participated in settlement negotiations and offered a proposed refund and a reduction in rates in an effort to reach settlement and conclude the proceedings. As a result, the Company recorded an $18 million provision for a potential refund in 1992. After receiving the February 25, 1994 order, the Company recorded an additional provision for rate refund of approximately $21.1 million in 1993, (consisting of a $14.9 million reduction in revenue and $6.2 million in interest) which reduced net income by some $13 million or $0.32 per share. Enogex transports natural gas to OG&E for use at its gas-fired generating units and performs related gas gathering activities for OG&E. The entire $41.3 million refund relates to the Oklahoma Commission's disallowance of a portion of the fees paid by OG&E to Enogex for such services in the past. Of the approximately $17 million annual rate reduction, approximately $9.9 million reflects the Oklahoma Commission's reduction of the amount to be recovered by OG&E from its Oklahoma customers for the future performance of such services by Enogex for OG&E. 11. Disclosures about Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents and Customer Deposits The fair value of cash and cash equivalents and customer deposits approximate the carrying amount due to their short maturity. Capitalization The fair value of Long-term Debt and Preferred Stocks is estimated based on quoted market prices and management's estimate of current rates available for similar issues. The fair value of Medium-term Notes is based on management's estimate of current rates available for similar issues with the same remaining maturities. Indicated below are the carrying amounts and estimated fair values of the Company's financial instruments as of December 31: In May 1993, the Financial Accounting Standards Board issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Adoption of SFAS No. 115 is required for fiscal years beginning after December 15, 1993, with earlier application permitted for which annual financial statements have not previously been issued. The Company will adopt this new standard effective January 1, 1994, and believes these costs will not have a material impact on its consolidated financial position or results of operations. Report of Independent Public Accountants ---------------------------------------- To the Shareowners of Oklahoma Gas and Electric Company: We have audited the accompanying consolidated balance sheets and statements of capitalization of Oklahoma Gas and Electric Company (an Oklahoma corporation) and its subsidiaries as of December 31, 1993, 1992 and 1991, and the related consolidated statements of income, retained earnings and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Oklahoma Gas and Electric Company and its subsidiaries as of December 31, 1993, 1992 and 1991, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Arthur Andersen & Co. Oklahoma City, Oklahoma, February 28, 1994 Report of Management -------------------- To Our Shareowners: The management of Oklahoma Gas and Electric Company and its subsidiaries has prepared, and is responsible for the integrity and objectivity of the financial and operating information contained in this Annual Report. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include certain amounts that are based on the best estimates and judgments of management. To meet its responsibility for the reliability of the consolidated financial statements and related financial data, the Company's management has established and maintains an internal control structure. This structure provides management with reasonable assurance in a cost-effective manner that, among other things, assets are properly safeguarded and transactions are executed and recorded in accordance with its authorizations so as to permit preparation of financial statements in accordance with generally accepted accounting principles. The Company's internal auditors assess the effectiveness of this internal control structure and recommend possible improvements thereto on an ongoing basis. The Company maintains high standards in selecting, training and developing its members. This, combined with Company policies and procedures, provides reasonable assurance that operations are conducted in conformity with applicable laws and with its commitment to the highest standards of business conduct. Supplementary Data ------------------ INTERIM CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED) In the opinion of the Company, the following quarterly information includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results of operations for such periods: Dec 31 Sep 30 Jun 30 Mar 31 Quarter ended (dollars in thousands except per share data) ------------------------------------------------------------------------- Operating revenues..... 1993 $301,392 $500,639 $341,799 $303,422 1992 304,093 443,327 306,341 261,223 1991 284,619 426,580 329,375 274,196 ------------------------------------------------------------------------- Operating income....... 1993 $ 18,899 $111,576 $ 39,457 $ 25,221 1992 32,043 94,319 36,072 14,570 1991 30,870 93,646 55,968 30,603 ------------------------------------------------------------------------- Net income (loss)...... 1993 $ (3,619) $ 90,810 $ 20,396 $ 6,690 1992 10,629 76,035 17,015 (3,967) 1991 12,260 75,255 33,474 12,927 ------------------------------------------------------------------------- Earnings (loss) available for common.. 1993 $ (4,199) $ 90,231 $ 19,817 $ 6,111 1992 10,050 75,456 16,436 (4,547) 1991 11,680 74,676 32,895 12,348 ------------------------------------------------------------------------- Earnings (loss) per average common share.. 1993 $ (0.10) $ 2.24 $ 0.49 $ 0.15 1992 0.25 1.87 0.41 (0.11) 1991 0.29 1.85 0.82 0.31 ------------------------------------------------------------------------- Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. --------------------------------------------------------- Not applicable. Part III Item 10. Item 10. Directors and Executive Officers of the Registrant. ------------------------------------------------------------ Item 11. Item 11. Executive Compensation. -------------------------------- Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. ------------------------------------------------- Item 13. Item 13. Certain Relationships and Related Transactions. -------------------------------------------------------- Items 10, 11, 12 and 13 are omitted pursuant to General Instruction G of Form 10-K, since OG&E filed copies of a definitive proxy statement with the Securities and Exchange Commission on or about March 28, 1994. Such proxy statement is incorporated herein by reference. In accordance with Instruction G of Form 10-K, the information required by Item 10 relating to Executive Officers has been included in Part I, Item 4, of this Form 10-K. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. ---------------------------------------------------- (a) 1. Financial Statements The following consolidated financial statements and supplementary data are included in Part II, Item 8 of this Report: Consolidated Balance Sheets at December 31, 1993, 1992 and Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization at December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants Report of Management Supplementary Data ------------------ Interim Consolidated Financial Information 2. Financial Statement Schedules (included in Part IV) Page ------------------------------------------------------ ---- Schedule V - Property, plant and equipment 75 Schedule VI - Accumulated depreciation, depletion, and amortization of property, plant, and equipment 76 Schedule VIII - Valuation and qualifying accounts 77 Schedule IX - Short-term borrowings 78 Schedule X - Supplementary income statement information 79 Report of Independent Public Accountants 80 All other schedules have been omitted since the required information is not applicable or is not material, or because the information required is included in the respective financial statements or notes thereto. 3. Exhibits ------------ Exhibit No. Description ----------- ----------- 3.01 Copy of Restated Certificate of Incorporation. (Filed as Exhibit 4.01 to the Company's Post- Effective Amendment No. Two to Registration Statement No. 2-94973, and incorporated by reference herein) 3.02 By-laws. (Filed as Exhibit 4.02 to Post-Effective Amendment No. Two to Registration Statement No. 2-94973 and incorporated by reference herein) 4.01 Copy of Trust Indenture, dated February 1, 1945, from OG&E to The First National Bank and Trust Company of Oklahoma City, Trustee. (Filed as Exhibit 7-A to Registration Statement No. 2-5566 and incorporated by reference herein) 4.02 Copy of Supplemental Trust Indenture, dated December 1, 1948, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 7.03 to Registration Statement No. 2-7744 and incorporated by reference herein) 4.03 Copy of Supplemental Trust Indenture, dated June 1, 1949, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 7.03 to Registration Statement No. 2-7964 and incorporated by reference herein) 4.04 Copy of Supplemental Trust Indenture, dated May 1, 1950, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 7.04 to Registration Statement No. 2-8421 and incorporated by reference herein) 4.05 Copy of Supplemental Trust Indenture, dated March 1, 1952, a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.08 to Registration Statement No. 2-9415 and incorporated by reference herein) 4.06 Copy of Supplemental Trust Indenture, dated June 1, 1955, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.07 to Registration Statement No. 2-12274 and incorporated by reference herein) 4.07 Copy of Supplemental Trust Indenture, dated January 1, 1957, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.07 to Registration Statement No. 2-14115 and incorporated by reference herein) 4.08 Copy of Supplemental Trust Indenture, dated June 1, 1958, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.09 to Registration Statement No. 2-19757 and incorporated by reference herein) 4.09 Copy of Supplemental Trust Indenture, dated March 1, 1963, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.09 to Registration Statement No. 2-23127 and incorporated by reference herein) 4.10 Copy of Supplemental Trust Indenture, dated March 1, 1965, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.10 to Registration Statement No. 2-25808 and incorporated by reference herein) 4.11 Copy of Supplemental Trust Indenture, dated January 1, 1967, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.11 to Registration Statement No. 2-27854 and incorporated by reference herein) 4.12 Copy of Supplemental Trust Indenture, dated January 1, 1968, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.12 to Registration Statement No. 2-31010 and incorporated by reference herein) 4.13 Copy of Supplemental Trust Indenture, dated January 1, 1969, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.13 to Registration Statement No. 2-35419 and incorporated by reference herein) 4.14 Copy of Supplemental Trust Indenture, dated January 1, 1970, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.14 to Registration Statement No. 2-42393 and incorporated by reference herein) 4.15 Copy of Supplemental Trust Indenture, dated January 1, 1972, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.15 to Registration Statement No. 2-49612 and incorporated by reference herein) 4.16 Copy of Supplemental Trust Indenture, dated January 1, 1974, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.16 to Registration Statement No. 2-52417 and incorporated by reference herein) 4.17 Copy of Supplemental Trust Indenture, dated January 1, 1975, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.17 to Registration Statement No. 2-55085 and incorporated by reference herein) 4.18 Copy of Supplemental Trust Indenture, dated January 1, 1976, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.18 to Registration Statement No. 2-57730 and incorporated by reference herein) 4.19 Copy of Supplemental Trust Indenture, dated September 14, 1976, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.19 to Registration Statement No. 2-59887 and incorporated by reference herein) 4.20 Copy of Supplemental Trust Indenture, dated January 1, 1977, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.20 to Registration Statement No. 2-59887 and incorporated by reference herein) 4.21 Copy of Supplemental Trust Indenture, dated November 1, 1977, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.21 to Registration Statement No. 2-70539 and incorporated by reference herein) 4.22 Copy of Supplemental Trust Indenture, dated December 1, 1977, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.22 to Registration Statement No. 2-70539 and incorporated by reference herein) 4.23 Copy of Supplemental Trust Indenture, dated February 1, 1980, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.23 to Registration Statement No. 2-70539 and incorporated by reference herein) 4.24 Copy of Supplemental Trust Indenture, dated April 15, 1982, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.24 to the Company's Form 10-K Report, File No. 1-1097, for the year ended December 31, 1982, and incorporated by reference herein) 4.25 Copy of Supplemental Trust Indenture, dated August 15, 1986, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.25 to the Company's Form 10-K Report, File No. 1-1097, for the year ended December 31, 1986 and incorporated by reference herein) 4.26 Copy of Supplemental Trust Indenture, dated March 1, 1987, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.26 to the Company's Form 10-K Report for the year ended December 31, 1987, File No. 1-1097, and incorporated by reference herein) 4.27 Copy of form of Medium-Term Note of Enogex Inc. due December 21, 1995, and December 21, 1998. (Filed as Exhibit 4.27 to the Company's Form 10-K Report for the year ended December 31, 1988, File No. 1-1097, and incorporated by reference herein) 4.28 Copy of Supplemental Trust Indenture, dated November 15, 1990, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.28 to the Company's Form 10-K Report for the year ended December 31, 1990, File No. 1-1097, and incorporated by reference herein) 4.29 Copy of Supplemental Trust Indenture, dated December 9, 1991, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.29 to the Company's Form 10-K Report for the year ended December 31, 1991, File No. 1-1097, and incorporated by reference herein) 10.01 Coal Supply Agreement dated March 1, 1973, between OG&E and Atlantic Richfield Company. (Filed as Exhibit 5.19 to Registration Statement No.2-59887 and incorporated by reference herein) 10.02 Amendment dated April 1, 1976, to Coal Supply Agreement dated March 1, 1973, between OG&E and Atlantic Richfield Company (Exhibit 10.10 hereto), together with related correspondence. (Filed as Exhibit 5.21 to Registration Statement No. 2-59887 and incorporated by reference herein) 10.03 Second Amendment dated March 1, 1978, to Coal Supply Agreement dated March 1, 1973, between OG&E and Atlantic Richfield Company (Exhibit 10.04 hereto). (Filed as Exhibit 5.28 to Registration Statement No. 2-62208 and incorporated by reference herein) 10.04 Lease of Railroad Equipment dated February 1, 1979, between Mercantile-Safe Deposit and Trust Company and OG&E. (Filed as Exhibit 5.30 to Registration Statement No.2-64965 and incorporated by reference herein) 10.05 Participation Agreement dated as of January 1, 1980, among First National Bank and Trust Company of Oklahoma City, Thrall Car Manufacturing Company, OG&E and other parties, including Lease of Railroad Equipment dated January 1, 1980, between Mercantile-Safe Deposit and Trust Company and OG&E. (Filed as Exhibit 10.32 to the Company's Form 10-K Report for the year ended December 31, 1980, File No. 1-1097, and incorporated by reference herein) 10.06 Participation Agreement dated January 1, 1981, among The First National Bank and Trust Company of Oklahoma City, Thrall Car Manufacturing Company, OG&E and other parties, including Lease for Railroad Equipment dated January 1, 1981, between Wells Fargo Equipment Leasing Corporation and OG&E. (Filed as Exhibit 20.01 to the Company's Form 10-Q for June 30, 1981, File No. 1-1097, and incorporated by reference herein) 10.07 Agreement for Guaranty, dated November 30, 1982, between OG&E and Railcar Maintenance Company. (Filed as Exhibit 10.34 to OG&E's Form 10-K Report for the year ended December 31, 1982, File No. 1-1097, and incorporated by reference herein) 10.08 Form of Deferred Compensation Agreement for Directors, as amended. (Filed as Exhibit 10.08 to the Company's Form 10-K Report for the year ended December 31, 1992, File No. 1-1097, and incorporated by reference herein) 10.09 Restricted Stock Plan of the Company. (Filed as Exhibit 10.36 to the Company's Form 10-K Report for the year ended December 31, 1986, File No. 1-1097, and incorporated by reference herein) 10.10 Agreement and Plan of Reorganization, dated May 14, 1986, between OG&E and Mustang Fuel Corporation. (Attached as Appendix A to Registration Statement No. 33-7472 and incorporated by reference herein) 10.11 Gas Service Agreement dated January 1, 1988, between OG&E and Oklahoma Natural Gas Company. (Filed as Exhibit 10.26 to the Company's Form 10-K Report for the year ended December 31, 1987, File No. 1-1097, and incorporated by reference herein) 10.12 Company's Restoration of Retirement Income Plan, as amended. 10.13 Company's Restoration of Retirement Savings Plan. 10.14 Gas Service Agreement dated July 23, 1987, between OG&E and Arkla Services Company. (Filed as Exhibit 10.29 to the Company's Form 10-K Report for the year ended December 31, 1987, File No. 1-1097, and incorporated by reference herein) 10.15 Company's Supplemental Executive Retirement Plan. 10.16 Company's Annual Incentive Compensation Plan. 23.01 Consent of Arthur Andersen & Co. 24.01 Power of Attorney. 99.01 1993 Form 11-K Annual Report for Oklahoma Gas and Electric Company Employees' Retirement Savings Plan. Executive Compensation Plans and Arrangements --------------------------------------------- 10.08 Form of Deferred Compensation Agreement for Directors, as amended. (Filed as Exhibit 10.08 to the Company's Form 10-K Report for the year ended December 31, 1992, File No. 1-1097, and incorporated by reference herein) 10.09 Restricted Stock Plan of the Company. (Filed as Exhibit 10.36 to the Company's Form 10-K Report for the year ended December 31, 1986, File No. 1-1097, and incorporated by reference herein) 10.12 Company's Restoration of Retirement Income Plan, as amended. 10.13 Company's Restoration of Retirement Savings Plan. 10.15 Company's Supplemental Executive Retirement Plan. 10.16 Company's Annual Incentive Compensation Plan. (b) Reports on Form 8-K ------------------------ Item 5. Other Events, dated October 1, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Oklahoma Gas and Electric Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Oklahoma Gas and Electric Company included in this Form 10-K, and have issued our report thereon dated February 28, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed on Page 68, Item 14 (a) 2. are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial state- ments and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Oklahoma City, Oklahoma, February 28, 1994 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Oklahoma City, and State of Oklahoma on the 28th day of March, 1994. OKLAHOMA GAS & ELECTRIC COMPANY (REGISTRANT) /s/ J. G. Harlow, Jr. By J. G. Harlow, Jr. Chairman of the Board and President Pursuant to the requirements of the Securities and Exchange Act of 1934, as amended, this Report has been signed below by the following persons in the capacities and on the dates indicated. Signature Title Date /s/ J. G. Harlow, Jr. J. G. Harlow, Jr. Principal Executive Officer and Director; March 28, 1994 /s/ A. M. Strecker A. M. Strecker Principal Financial Officer; and March 28, 1994 /s/ B. G. Bunce B. G. Bunce Principal Accounting Officer. March 28, 1994 Herbert H. Champlin Director; William E. Durrett Director; Martha W. Griffin Director; Hugh L. Hembree, III Director; John F. Snodgrass Director; Bill Swisher Director; John A. Taylor Director; and Ronald H. White, M.D. Director. /s/ J. G. Harlow, Jr. By J. G. Harlow, Jr. (attorney-in-fact) March 28, 1994 E X H I B I T I N D E X Exhibit No. Description ----------- ----------- 3.01 Copy of Restated Certificate of Incorporation. (Filed as Exhibit 4.01 to the Company's Post- Effective Amendment No. Two to Registration Statement No. 2-94973, and incorporated by reference herein) 3.02 By-laws. (Filed as Exhibit 4.02 to Post-Effective Amendment No. Two to Registration Statement No. 2-94973 and incorporated by reference herein) 4.01 Copy of Trust Indenture, dated February 1, 1945, from OG&E to The First National Bank and Trust Company of Oklahoma City, Trustee. (Filed as Exhibit 7-A to Registration Statement No. 2-5566 and incorporated by reference herein) 4.02 Copy of Supplemental Trust Indenture, dated December 1, 1948, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 7.03 to Registration Statement No. 2-7744 and incorporated by reference herein) 4.03 Copy of Supplemental Trust Indenture, dated June 1, 1949, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 7.03 to Registration Statement No. 2-7964 and incorporated by reference herein) 4.04 Copy of Supplemental Trust Indenture, dated May 1, 1950, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 7.04 to Registration Statement No. 2-8421 and incorporated by reference herein) 4.05 Copy of Supplemental Trust Indenture, dated March 1, 1952, a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.08 to Registration Statement No. 2-9415 and incorporated by reference herein) 4.06 Copy of Supplemental Trust Indenture, dated June 1, 1955, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.07 to Registration Statement No. 2-12274 and incorporated by reference herein) 4.07 Copy of Supplemental Trust Indenture, dated January 1, 1957, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.07 to Registration Statement No. 2-14115 and incorporated by reference herein) 4.08 Copy of Supplemental Trust Indenture, dated June 1, 1958, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.09 to Registration Statement No. 2-19757 and incorporated by reference herein) 4.09 Copy of Supplemental Trust Indenture, dated March 1, 1963, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.09 to Registration Statement No. 2-23127 and incorporated by reference herein) 4.10 Copy of Supplemental Trust Indenture, dated March 1, 1965, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.10 to Registration Statement No. 2-25808 and incorporated by reference herein) 4.11 Copy of Supplemental Trust Indenture, dated January 1, 1967, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.11 to Registration Statement No. 2-27854 and incorporated by reference herein) 4.12 Copy of Supplemental Trust Indenture, dated January 1, 1968, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.12 to Registration Statement No. 2-31010 and incorporated by reference herein) 4.13 Copy of Supplemental Trust Indenture, dated January 1, 1969, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.13 to Registration Statement No. 2-35419 and incorporated by reference herein) 4.14 Copy of Supplemental Trust Indenture, dated January 1, 1970, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.14 to Registration Statement No. 2-42393 and incorporated by reference herein) 4.15 Copy of Supplemental Trust Indenture, dated January 1, 1972, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.15 to Registration Statement No. 2-49612 and incorporated by reference herein) 4.16 Copy of Supplemental Trust Indenture, dated January 1, 1974, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.16 to Registration Statement No. 2-52417 and incorporated by reference herein) 4.17 Copy of Supplemental Trust Indenture, dated January 1, 1975, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.17 to Registration Statement No. 2-55085 and incorporated by reference herein) 4.18 Copy of Supplemental Trust Indenture, dated January 1, 1976, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.18 to Registration Statement No. 2-57730 and incorporated by reference herein) 4.19 Copy of Supplemental Trust Indenture, dated September 14, 1976, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.19 to Registration Statement No. 2-59887 and incorporated by reference herein) 4.20 Copy of Supplemental Trust Indenture, dated January 1, 1977, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 2.20 to Registration Statement No. 2-59887 and incorporated by reference herein) 4.21 Copy of Supplemental Trust Indenture, dated November 1, 1977, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.21 to Registration Statement No. 2-70539 and incorporated by reference herein) 4.22 Copy of Supplemental Trust Indenture, dated December 1, 1977, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.22 to Registration Statement No. 2-70539 and incorporated by reference herein) 4.23 Copy of Supplemental Trust Indenture, dated February 1, 1980, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.23 to Registration Statement No. 2-70539 and incorporated by reference herein) 4.24 Copy of Supplemental Trust Indenture, dated April 15, 1982, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.24 to the Company's Form 10-K Report, File No. 1-1097, for the year ended December 31, 1982, and incorporated by reference herein) 4.25 Copy of Supplemental Trust Indenture, dated August 15, 1986, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.25 to the Company's Form 10-K Report, File No. 1-1097, for the year ended December 31, 1986 and incorporated by reference herein) 4.26 Copy of Supplemental Trust Indenture, dated March 1, 1987, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.26 to the Company's Form 10-K Report for the year ended December 31, 1987, File No. 1-1097, and incorporated by reference herein) 4.27 Copy of form of Medium-Term Note of Enogex Inc. due December 21, 1995, and December 21, 1998. (Filed as Exhibit 4.27 to the Company's Form 10-K Report for the year ended December 31, 1988, File No. 1-1097, and incorporated by reference herein) 4.28 Copy of Supplemental Trust Indenture, dated November 15, 1990, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.28 to the Company's Form 10-K Report for the year ended December 31, 1990, File No. 1-1097, and incorporated by reference herein) 4.29 Copy of Supplemental Trust Indenture, dated December 9, 1991, being a supplemental instrument to Exhibit 4.01 hereto. (Filed as Exhibit 4.29 to the Company's Form 10-K Report for the year ended December 31, 1991, File No. 1-1097, and incorporated by reference herein) 10.01 Coal Supply Agreement dated March 1, 1973, between OG&E and Atlantic Richfield Company. (Filed as Exhibit 5.19 to Registration Statement No.2-59887 and incorporated by reference herein) 10.02 Amendment dated April 1, 1976, to Coal Supply Agreement dated March 1, 1973, between OG&E and Atlantic Richfield Company (Exhibit 10.10 hereto), together with related correspondence. (Filed as Exhibit 5.21 to Registration Statement No. 2-59887 and incorporated by reference herein) 10.03 Second Amendment dated March 1, 1978, to Coal Supply Agreement dated March 1, 1973, between OG&E and Atlantic Richfield Company (Exhibit 10.04 hereto). (Filed as Exhibit 5.28 to Registration Statement No. 2-62208 and incorporated by reference herein) 10.04 Lease of Railroad Equipment dated February 1, 1979, between Mercantile-Safe Deposit and Trust Company and OG&E. (Filed as Exhibit 5.30 to Registration Statement No.2-64965 and incorporated by reference herein) 10.05 Participation Agreement dated as of January 1, 1980, among First National Bank and Trust Company of Oklahoma City, Thrall Car Manufacturing Company, OG&E and other parties, including Lease of Railroad Equipment dated January 1, 1980, between Mercantile-Safe Deposit and Trust Company and OG&E. (Filed as Exhibit 10.32 to the Company's Form 10-K Report for the year ended December 31, 1980, File No. 1-1097, and incorporated by reference herein) 10.06 Participation Agreement dated January 1, 1981, among The First National Bank and Trust Company of Oklahoma City, Thrall Car Manufacturing Company, OG&E and other parties, including Lease for Railroad Equipment dated January 1, 1981, between Wells Fargo Equipment Leasing Corporation and OG&E. (Filed as Exhibit 20.01 to the Company's Form 10-Q for June 30, 1981, File No. 1-1097, and incorporated by reference herein) 10.07 Agreement for Guaranty, dated November 30, 1982, between OG&E and Railcar Maintenance Company. (Filed as Exhibit 10.34 to OG&E's Form 10-K Report for the year ended December 31, 1982, File No. 1-1097, and incorporated by reference herein) 10.08 Form of Deferred Compensation Agreement for Directors, as amended. (Filed as Exhibit 10.08 to the Company's Form 10-K Report for the year ended December 31, 1992, File No. 1-1097, and incorporated by reference herein) 10.09 Restricted Stock Plan of the Company. (Filed as Exhibit 10.36 to the Company's Form 10-K Report for the year ended December 31, 1986, File No. 1-1097, and incorporated by reference herein) 10.10 Agreement and Plan of Reorganization, dated May 14, 1986, between OG&E and Mustang Fuel Corporation. (Attached as Appendix A to Registration Statement No. 33-7472 and incorporated by reference herein) 10.11 Gas Service Agreement dated January 1, 1988, between OG&E and Oklahoma Natural Gas Company. (Filed as Exhibit 10.26 to the Company's Form 10-K Report for the year ended December 31, 1987, File No. 1-1097, and incorporated by reference herein) 10.12 Company's Restoration of Retirement Income Plan, as amended. 10.13 Company's Restoration of Retirement Savings Plan. 10.14 Gas Service Agreement dated July 23, 1987, between OG&E and Arkla Services Company. (Filed as Exhibit 10.29 to the Company's Form 10-K Report for the year ended December 31, 1987, File No. 1-1097, and incorporated by reference herein) 10.15 Company's Supplemental Executive Retirement Plan. 10.16 Company's Annual Incentive Compensation Plan. 23.01 Consent of Arthur Andersen & Co. 24.01 Power of Attorney. 99.01 1993 Form 11-K Annual Report for Oklahoma Gas and Electric Company Employees' Retirement Savings Plan.

81023_1993.txt

81023_1993

1993

81023

ITEM 1. BUSINESS THE COMPANY Public Service Company of New Mexico (the "Company") was incorporated in the State of New Mexico in 1917 and has its principal offices at Alvarado Square, Albuquerque, New Mexico 87158 (telephone number 505-848-2700). The Company is a public utility engaged in the generation, transmission, distribution and sale of electricity and in the gathering, processing, transmission, distribution and sale of natural gas within the State of New Mexico. The Company also owns facilities for the pumping, storage, transmission, distribution and sale of water in Santa Fe, New Mexico. On January 11, 1993, the Company announced its intention to dispose of the Company's natural gas gathering and natural gas processing assets and SDCW. On February 12, 1994, an agreement was executed for the sale of substantially all of the gas gathering and processing assets of Gathering Company and Processing Company and for the sale of the Northwest and Southeast gas gathering and processing facilities of GCNM. On February 28, 1994, the Company and the City of Santa Fe signed a purchase and sale agreement for the sale of the Company's water utility division. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--Sale of Gas Gathering and Processing Assets" and "--Sale of SDCW.") The total population of the area served by one or more of the Company's utility services is estimated to be approximately 1.1 million, of which 52.0% live in the greater Albuquerque area. For the year ended December 31, 1993, the Company derived 67.5% of its utility operating revenues from electric operations, 31.0% from natural gas operations and 1.5% from water operations. As of December 31, 1993, the Company employed 2,619 persons. Financial information relating to amounts of revenue and operating income and identifiable assets attributable to the Company's industry segments is contained in Note 12 of the notes to consolidated financial statements. ELECTRIC OPERATIONS SERVICE AREA AND CUSTOMERS The Company's electric operations serve four principal markets. Sales to retail customers and sales to firm-requirements wholesale customers, sometimes referred to collectively as "system" sales, comprise two of these markets. The third market consists of other contracted sales to utilities for which the Company commits to deliver a specified amount of capacity (measured in MW) or energy (measured in MWh) over a given period of time. The fourth market consists of economy energy sales made on an hourly basis to utilities at fluctuating, spot-market rates. Sales to the third and fourth markets are sometimes referred to collectively as "off-system" sales. The Company provides retail electric service to a large area of north central New Mexico, including the cities of Albuquerque, Santa Fe, Rio Rancho, Las Vegas, Belen and Bernalillo. The Company also provides retail electric service to Deming in southwestern New Mexico and to Clayton in northeastern New Mexico. As of December 31, 1993, approximately 313,000 retail electric customers were served by the Company, the largest of which accounted for approximately 3.6% of the Company's total electric revenues for the year ended December 31, 1993. The Company holds 23 long-term, non-exclusive franchise agreements for its electric retail operations, expiring between August 1996 and November 2028. The City of Albuquerque (the "City") franchise expired in early 1992. Customers in the area covered by the City franchise represent approximately 46.0% of the Company's 1993 total electric operating revenues, and no other franchise area represents more than 7.0%. These franchises are agreements that provide the Company access to public rights-of-way for placement of the Company's electric facilities. The Company remains obligated under state law to provide service to customers in the franchise area even in the absence of a franchise agreement with the City. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--Albuquerque Franchise Issues".) POWER SALES For the years 1989 through 1993, retail KWh sales have grown at a compound annual rate of approximately 3.1%. However, the growth rate has been lower than had been anticipated at the time the Company committed to construct new generating units in the 1970's. As a result, the Company has excess capacity and has marketed most of such capacity in the off-system sales market. Additionally, the Company is attempting to reduce its excess capacity through asset sales. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--Excess Capacity Sales/Wholesale Power Market".) The Company has contracted to sell and continues to market power at prices which only recover variable costs and a portion of the fixed costs of its excess capacity. Remaining energy produced by excess capacity is then sold in the economy energy market at prices which average only slightly above incremental operating costs. The Company's system and off-system sales (revenues and energy consumption) and system peak demands in summer and winter are shown in the following tables: ELECTRIC SALES BY MARKET (THOUSANDS OF DOLLARS) ELECTRIC SALES BY MARKET (MEGAWATT HOURS) - -------- * Pursuant to FERC Order No. 529, all spot market economy sale transactions were reclassified from net purchased power to revenue. + Due to the provision for the loss associated with the M-S-R contingent power purchase contract recognized in 1992, revenues from other contracted off- system sales and economy energy sales were reduced by a total of $20.5 million. (See Note 2 of the notes to consolidated financial statements.) SYSTEM PEAK DEMAND* (MEGAWATTS) - -------- * System peak demand relates to retail and firm-requirements wholesale markets only. During 1993 and 1992, the Company's sales in the off-system markets accounted for approximately 34.4 percent and 37.2 percent, respectively, of its total KWh sales and approximately 17.2 percent (before reduction of revenues from the M- S-R contingent power purchase contract, which were accounted for in the determination of the provision for loss recorded in 1992) and 17.8 percent, respectively, of its total revenues from energy sales. During 1993, the Company's major off-system sale contracts in effect were with SDG&E, APPA, AEPCO, IID and PSCo. The SDG&E contract requires SDG&E to purchase 100 MW from the Company through April 2001. On October 27, 1993, SDG&E filed a complaint with the FERC against the Company, alleging that certain charges under this 1985 power purchase agreement are unjust, unreasonable and unduly discriminatory. SDG&E is requesting that the FERC investigate the rates charged under the agreement and establish a refund date effective as of December 26, 1993. The relief, if granted, would reduce annual demand charges paid by SDG&E by up to $11 million per year from the effective refund date through April 2001, subject to certain limitations if the FERC has not acted within 15 months. The Company responded to the complaint on December 8, 1993, and SDG&E and the Company filed subsequent pleadings. The Company believes that the complaint is without merit, and the Company intends to vigorously resist the complaint. The APPA contract requires APPA to purchase varying amounts of power from the Company through May 2008. Under the terms of the agreement, APPA will increase its purchase starting June 1, 1994 from 33 MW to 89 MW, decreasing in October 1994 to 74 MW. The AEPCO contract requires AEPCO to purchase from 9 MW to 15 MW of power through May 31, 1994, depending upon AEPCO's customer requirements. The IID contract requires IID to purchase 56 MW of power from the Company through February 1995 and an additional 25 MW of power in the months of April through October during the term of the contract. On April 27, 1993, PSCo and the Company entered into an agreement whereby the Company will sell 75 MW of capacity and associated energy to PSCo from October 1, 1993 through September 30, 1994. The Company furnishes firm-requirements wholesale power in New Mexico to the cities of Farmington and Gallup, TNP and Plains. Plains may terminate its contract for 10 MW at any time with one year's advance notice. The Company expects to receive a termination notice from Plains but cannot predict the timing of such notice. In February 1993, the Company began a new 10 year firm power contract with the City of Gallup. Under terms of its contract, TNP has increased its purchase, beginning January 1994, from a peak of 25 MW to 36 MW. No firm-requirements wholesale customer accounted for more than 1.4% of the Company's total electric operating revenues for the year ended December 31, 1993. For other information concerning the competitive conditions affecting off- system sales, see PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--Excess Capacity Sales/Wholesale Power Market". SOURCES OF POWER As of December 31, 1993, the total net generation capacity of facilities owned or leased by the Company was 1,541 MW. The Company's electric generating stations in commercial service as of December 31, 1993, were as follows: - -------- (a) The Company is entitled to 10.2% of the power and energy generated by PVNGS. The Company has a 10.2% ownership interest in Unit 3 and has leasehold interests in Units 1 and 2 (see ITEM 2. ITEM 2. PROPERTIES Substantially all of the Company's utility plant is mortgaged to secure its first mortgage bonds. ELECTRIC COAL-FIRED PLANTS SJGS is located in northwestern New Mexico, and consists of four units operated by the Company. Units 1, 2, 3 and 4 at SJGS have net rated capacities of 316 MW, 312 MW, 488 MW and 498 MW, respectively. SJGS Units 1 and 2 are owned on a 50% shared basis with Tucson. Unit 3 is owned 50% by the Company, 41.8% by SCPPA and 8.2% by Century. Century has agreed to sell its remaining 8.2% interest to Tri-State Generation and Transmission Association, Inc. Unit 4 is owned 45.485% by the Company, 8.475% by Farmington, 28.8% by M-S-R, 7.2% by Los Alamos and 10.04% by Anaheim. The Company has agreed to sell 35 MW of SJGS Unit 4 to UAMPS. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--Excess Capacity Sales/Wholesale Power Market".) The Company's net aggregate ownership in SJGS is 785 MW. In connection with the Company's sale to M-S-R in December 1983 of a 28.8% interest in SJGS Unit 4, the Company agreed to purchase under certain conditions 73.53% (105 MW) of M-S-R's capacity through April 30, 1995, an amount which may be reduced by M-S-R under certain conditions. The Company also agreed to market the energy associated with the remaining 26.47% portion of M-S-R's capacity through April 30, 1995. This marketing arrangement may be terminated by M-S-R at any time upon 30 days notice. The Company also owns 192 MW of net rated capacity derived from its 13% interest in Units 4 and 5 of Four Corners located in northwestern New Mexico on land leased from the Navajo Nation and adjacent to available coal deposits. Units 4 and 5 at Four Corners are jointly owned with SCE, APS, Salt River Project, Tucson and El Paso and are operated by APS. NUCLEAR PLANT The Company's Interest in PVNGS. The Company is participating in the three 1,270 MW units of PVNGS, also known as the Arizona Nuclear Power Project, with APS (the operating agent), Salt River Project, El Paso, SCE, SCPPA and The Department of Water and Power of the City of Los Angeles. The Company has a 10.2% undivided interest in PVNGS, with its interests in Units 1 and 2 held under leases. In September 1992, the Company purchased approximately 22% of the beneficial interests in PVNGS Units 1 and 2 leases for approximately $17.5 million. The Company's ownership and leasehold interests in PVNGS amount to 130 MW per unit, or a total of 390 MW. PVNGS Units 1, 2 and 3 were declared in commercial service by the Company in January 1986, September 1986 and January 1988, respectively. Commercial operation of PVNGS requires full power operating licenses which were granted by the NRC. Maintenance of these licenses is subject to NRC regulation. Operation and Regulation. A stipulation adopted by the NMPUC on March 6, 1990 establishes a performance standard for the operation of PVNGS. Under the performance standards, a "dead band" was established at capacity factors of 60% through 75%, as measured by the capacity factor of all three PVNGS units over the fuel cycle. Within the dead band, the Company would receive no reward or penalty. The Company would be penalized with one-half of the additional fuel costs incurred for PVNGS capacity factors of 50% to 60% and would be rewarded with one-half of the avoided fuel costs if PVNGS operates at capacity factors from 75% through 85%. Capacity factors above 85% or below 50% would reward or penalize the Company by an amount equal to the additional fuel costs avoided or incurred. During 1993, PVNGS Units 1, 2 and 3 had capacity factors of approximately 67.5%, 46.1% and 84.4%, respectively, for a station capacity factor of 66.0%. These performance standards would be terminated if the NMPUC approves the stipulation entered into by the Company requesting elimination of the FPPCAC. (See ITEM 1.--"RATES AND REGULATION--FPPCAC".) In July 1993, the NRC issued a Systematic Assessment of Licensee Performance ("SALP") for PVNGS for the period March 1, 1992 through May 31, 1993. The SALP is the standard performance grading process used by the NRC to communicate to the public in a formal manner how each nuclear plant operates. The ratings have slightly declined since the previous assessment. Overall, however, the SALP Board found the performance of licensed activities at PVNGS to be acceptable and directed toward safe facility operation. Steam Generator Tubes. For information concerning steam generator tubes, see PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--Palo Verde Nuclear Generating Station--Steam Generator Tubes". Discrimination Allegations. By letter dated July 7, 1993, the NRC advised APS that, as a result of a recommended decision and order by a Department of Labor Administrative Law Judge (the "DOL ALJ") finding that APS discriminated against a former contract employee at PVNGS because he engaged in "protected activities" (as defined under Federal regulations), the NRC intended to schedule an enforcement conference with APS. Following the DOL ALJ's finding, APS investigated various elements of both the substantive allegations and the manner in which the U.S. Department of Labor (the "DOL") proceedings were conducted. As a result of that investigation, APS determined that one of its employees had falsely testified during the proceedings, that there were inconsistencies in the testimony of another employee, and that certain documents were requested in, but not provided during, discovery. The two employees in question are no longer with APS. APS provided the results of its investigation to the DOL ALJ, who referred matters relating to the conduct of the two former employees of APS to the U.S. Attorney's office in Phoenix, Arizona. On December 15, 1993, APS and the former contract employee who had raised the DOL claim entered into a settlement agreement, a part of which remains subject to approval by the Secretary of Labor. By letter dated August 10, 1993, APS also provided the results of its investigation to the NRC, and advised the NRC that, as a result of APS's investigation, APS had changed its position opposing the finding of discrimination. The NRC is investigating this matter and APS is fully cooperating with the NRC in this regard. Sale and Leaseback Transactions of PVNGS Units 1 and 2. In eleven transactions consummated in 1985 and 1986, the Company sold and leased back its entire 10.2% interest in PVNGS Units 1 and 2, together with portions of the Company's undivided interest in certain PVNGS common facilities. In each transaction, the Company sold interests to an owner trustee under an owner trust agreement with an institutional equity investor. The owner trustees, as lessors, leased the interests to the Company under lease agreements having initial terms expiring January 15, 2015 (with respect to the Unit 1 leases) or January 15, 2016 (with respect to the Unit 2 leases). Each lease provides an option to the Company to extend the term of the lease as well as a repurchase option. The aggregate lease payments for the Company's PVNGS leases are approximately $66.3 million per year. Throughout the terms of the leases, the Company continues to have full and exclusive authority and responsibility to exercise and perform all of the rights and duties of a participant in PVNGS under the Arizona Nuclear Power Project Participation Agreement and retains the exclusive right to sell and dispose of its 10.2% share of the power and energy generated by PVNGS Units 1 and 2. The Company also retains responsibility for payment of its share of all taxes, insurance premiums, operating and maintenance costs, costs related to capital improvements and decommissioning and all other similar costs and expenses associated with the leased facilities. On September 2, 1992, the Company purchased approximately 22% of the beneficial interests in the PVNGS Units 1 and 2 leases for $17.5 million. For accounting purposes, this transaction was recorded as a purchase with the Company recording approximately $158.3 million as utility plant and $140.8 million as long-term debt on the Company's consolidated balance sheet. The purchase is expected to provide the Company with (1) the residual value of a certain portion of the PVNGS Units at no cost, (2) reduced exposure to indemnification provisions in the lease agreements and (3) added flexibility to cause the retirement of the underlying lease obligation bonds ("LOBs"). (See also Notes 7 and 9 of the notes to consolidated financial statements.) The retirement of the LOBs would only be caused if (1) adequate cash is available, (2) it is determined to be the best use of funds, and (3) the appropriate approvals are obtained. In connection with the stipulation, the Company wrote down the purchased beneficial interests in PVNGS Units 1 and 2 leases to $46.7 million. (See PART II, ITEM 7.-- "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--January 12, 1994 Stipulation.") Each lease describes certain events, "Events of Loss" or "Deemed Loss Events", the occurrence of which could require the Company to, among other things, (1) pay the lessor and the equity investor, in return for such investor's interest in PVNGS, cash in the amount provided in the lease, which amount, primarily because of certain tax consequences, would exceed such equity investor's outstanding equity investment, and (2) assume debt obligations relating to the PVNGS lease. The "Events of Loss" generally relate to casualties, accidents and other events at PVNGS, which would severely adversely affect the ability of the operating agent, APS, to operate, and the ability of the Company to earn a return on its interests in, PVNGS. The "Deemed Loss Events" consist mostly of legal and regulatory changes (such as changes in law making the sale and leaseback transactions illegal, or changes in law making the lessors liable for nuclear decommissioning obligations). The Company believes the probability of such "Events of Loss" or "Deemed Loss Events" occurring is remote. Such belief is based on the following reasons: (a) to a large extent, prevention of "Events of Loss" and some "Deemed Loss Events" is within the control of the PVNGS participants, including the Company, and the PVNGS operating agent, through the general PVNGS operational and safety oversight process and (b) with respect to other "Deemed Loss Events," which would involve a significant change in current law and policy, the Company is unaware of any pending proposals or proposals being considered for introduction in Congress or any state legislative or regulatory body that, if adopted, would cause any such events. PVNGS Decommissioning Funding. For information concerning PVNGS decommissioning funding, see PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--PVNGS Decommissioning Funding". PVNGS Liability and Insurance Matters. The PVNGS participants have insurance for public liability payments resulting from nuclear energy hazards to the full limit of liability under Federal law. This potential liability is covered by primary liability insurance provided by commercial insurance carriers in the amount of $200 million and the balance by an industry-wide retrospective assessment program. The maximum assessment per reactor under the retrospective rating program for each nuclear incident occurring at any nuclear power plant in the United States is approximately $79.3 million, subject to an annual limit of $10 million per incident. Based upon the Company's 10.2% interest in the three PVNGS units, the Company's maximum potential assessment per incident is approximately $24.3 million, with an annual payment limitation of $3 million. The insureds under this liability insurance include the PVNGS participants and "any other person or organization with respect to his legal responsibility for damage caused by the nuclear energy hazard". The PVNGS participants maintain "all-risk" (including nuclear hazards) insurance for nuclear property damage to, and decontamination of, property at PVNGS in the aggregate amount of $2.75 billion as of January 1, 1994, a substantial portion of which must be applied to stabilization and decontamination. The Company has also secured insurance against a portion of the increased cost of generation or purchased power resulting from certain accidental outages of any of the three PVNGS units if the outage exceeds 21 weeks. OTHER ELECTRIC PROPERTIES Four Corners and a portion of the facilities adjacent to SJGS are located on land held under easements from the United States and also under leases from the Navajo Nation, the enforcement of which leases might require Congressional consent. The risk with respect to the enforcement of these easements and leases is not deemed by the Company to be material. However, the Company is dependent in some measure upon the willingness and ability of the Navajo Nation to protect these properties. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--A Transmission Right-of-Way".) As of December 31, 1993, the Company owned, jointly owned or leased 2,781 circuit miles of electric transmission lines, 5,218 miles of distribution overhead lines, 2,826 cable miles of underground distribution lines (excluding street lighting) and 215 substations. On May 1, 1984, the Company's board of directors approved plans to proceed with OLE, which involves construction of a 345 Kv transmission line connecting the existing Ojo 345 Kv line to the existing Norton Station. For discussion of issues relating to OLE, see PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OTHER ISSUES FACING THE COMPANY--OLE Transmission Project". NATURAL GAS The property owned by GCNM, as of December 31, 1993, consisted primarily of natural gas gathering, storage, transmission and distribution systems. The gathering systems consisted of approximately 1,184 miles (approximately 308 miles of which are leased to Gathering Company) of pipe with compression and treatment facilities. Provisions for storage made by GCNM include ownership and operation of an underground storage facility located near Albuquerque and an agreement with owners of a unitized oil field located near Artesia, New Mexico, in which GCNM has injection and redelivery rights. The transmission systems consisted of approximately 1,355 miles of pipe with appurtenant compression facilities. The distribution systems consisted of approximately 9,471 miles of pipe. GCNM leases approximately 128 miles of transmission pipe from the DOE for transportation of natural gas to Los Alamos and to certain other communities in northern New Mexico. The lease can be terminated by either party on 30 days written notice, although the Company has the right to use the facility for two years after termination. The property of Gathering Company includes approximately 552 miles of gathering pipe with appurtenant compression facilities. Processing Company owns facilities located in northwestern New Mexico having an aggregate design capacity for processing of natural gas of approximately 300,000 mcf per day. The Company, Gathering Company and Processing Company have entered into an agreement to sell substantially all of their natural gas gathering and processing assets. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--Sale of Gas Gathering and Processing Assets".) WATER The Company's water property consists of wells, water rights, pumping and treatment plants, storage reservoirs and transmission and distribution mains. The Company has reached agreement with the City of Santa Fe for the sale of its water utility division. (See PART II, ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--Sale of SDCW".) OTHER INFORMATION The electric and gas transmission and distribution lines are generally located within easements and rights-of-way on public, private and Indian lands. The Company leases interests in PVNGS Units 1 and 2 and related property, EIP and associated equipment, data processing, communication, office and other equipment, office space, utility poles (joint use), vehicles and real estate. The Company also owns and leases service and office facilities in Albuquerque and in other operating divisions throughout its service territory. ITEM 3. ITEM 3. LEGAL PROCEEDINGS NATURAL GAS SUPPLY LITIGATION A lawsuit was filed on August 31, 1990 in the United States District Court for the District of New Mexico by a group of producers seeking damages under a gas purchase contract. This action was brought by Caulkins Producing Company as the operator and Caulkins Oil Co. (collectively "Caulkins"), Louis Dreyfus Natural Gas Corp. ("Dreyfus") and Marathon Oil Company ("Marathon") for alleged breach of a long-term natural gas purchase contract by GCNM. The suit alleged that GCNM failed to take or pay for contracted quantities of natural gas for the period of 1986 to the present, and further, that GCNM failed to take gas ratably from the producers during the same period of time. In August 1993, Caulkins, Dreyfus and GCNM reached an agreement settling all disputes arising under the contract as to those parties for $7.9 million. The parties also entered into gas purchase agreements which are favorable to GCNM as part of the settlements. On October 14, 1993, the Company and Marathon entered into an agreement settling all disputes between GCNM and Marathon. GCNM paid Marathon $4.9 million on November 10, 1993 and obtained favorable terms in new gas purchase and related contracts. The Company had previously made sufficient reserves for losses in this litigation. Pursuant to a prior order of the NMPUC, GCNM began collecting 75% of the amounts paid to settle this lawsuit in January 1994. PVNGS WATER SUPPLY LITIGATION The validity of the primary effluent contract under which water necessary for the operation of the PVNGS units is obtained was challenged in a suit filed in January 1982 by the Salt River Pima-Maricopa Indian Community (the "community") against the Department of the Interior, the Federal agency alleged to have jurisdiction over the use of the effluent. The PVNGS participants, including the Company, were named as additional defendants in the proceeding, which is before the United States District Court for the District of Arizona. The portion of the action challenging the effluent contract has been stayed until the community litigates certain claims in the same action against the Department of the Interior and other defendants. On October 21, 1988, Federal legislation was enacted conforming to the requirements of a proposed settlement that would terminate this case without affecting the validity of the primary effluent contract. However, certain contingencies are to be performed before the settlement is finalized and the suit is dismissed. One of these contingencies is the approval of the settlement by the court in the Lower Gila River Watershed litigation referred to below. The Company understands that a summons served on APS in early 1986 required all water claimants in the Lower Gila River Watershed of Arizona to assert any claims to water on or before January 20, 1987, in an action pending in the Maricopa County Superior Court. PVNGS is located within the geographic area subject to the summons and the rights of the PVNGS participants to the use of groundwater and effluent at PVNGS are potentially at issue in this action. APS, as the PVNGS project manager, filed claims that dispute the court's jurisdiction over the PVNGS participants' groundwater rights and their contractual rights to effluent relating to PVNGS and, alternatively, seek confirmation of such rights. No trial date has been set in this matter. Although the foregoing matters remain subject to further evaluation, APS expects that the described litigation will not have a material adverse impact on the operation of PVNGS. SAN JUAN RIVER ADJUDICATION In 1975, the State of New Mexico filed an action entitled State of New Mexico v. United States, et al., in the District Court of San Juan County, New Mexico, to adjudicate all water rights in the "San Juan River Stream System". The Company was made a defendant in the litigation in 1976. The action was expected to adjudicate water rights used at the Four Corners plant, at SJGS and at Santa Fe. (See ITEM 1. "BUSINESS--ELECTRIC OPERATIONS--Fuel and Water Supply".) The Company cannot at this time anticipate the effect, if any, of any water rights adjudication on the present arrangements for water at SJGS and Four Corners, nor can it determine what effect the action will have on water for Santa Fe. It is the Company's understanding that final resolution of the case cannot be expected for several years. PVNGS PROPERTY TAXES On June 29, 1990, an Arizona state tax law was enacted, effective as of December 31, 1989, which adversely impacted the Company's earnings in the 1990, 1991, 1992 and 1993 tax years by approximately $5 million per year, before income taxes and capitalized and deferred costs. On December 20, 1990, the PVNGS participants, including the Company, filed a lawsuit in the Arizona Tax Court, a division of the Maricopa County Superior Court, against the Arizona Department of Revenue, the Treasurer of the State of Arizona, and various Arizona counties, claiming, among other things, that portions of the new tax law are unconstitutional. In December 1992, the court granted summary judgment to the taxing authorities, holding that the law is constitutional. The PVNGS participants appealed this decision to the Arizona Court of Appeals. The Company cannot currently predict the ultimate outcome of this matter. OTHER PROCEEDINGS On March 31, 1993, certain individuals ("the New Mexico Plaintiffs"), formerly affiliated with Bellamah Community Development ("BCD") whose general partners include Meadows, filed suit ("the New Mexico suit") in the United States District Court for the District of New Mexico against numerous parties, including the Company, current and former employees of the Company or Meadows, and MCB Financial Group, Inc., a Delaware corporation ("MCB"), 50% of which stock is owned by Meadows. The New Mexico Plaintiffs have not requested any monetary relief against the Company or certain current and former employees of the Company and Meadows but have joined those parties in connection with insurance coverage and bad faith insurance practices alleged against the insurance company which had issued a directors and officers liability policy to various entities, including MCB and BCD. The insurance allegations are made in connection with claims which were then threatened by the Resolution Trust Corporation ("RTC"), as receiver for Western Savings & Loan Association ("Western"), against the Company and others. The New Mexico Plaintiffs also sued the RTC for a declaration that they are not liable for any claims asserted by the RTC involving Western and BCD. The Company and the current and former employees of the Company or Meadows counterclaimed against the New Mexico Plaintiffs and cross-claimed against the insurance company and the RTC in connection with insurance coverage and bad faith insurance practices. In addition, the Company and the current and former employees of the Company or Meadows cross-claimed against the RTC, seeking a declaration of non-liability. The RTC moved to transfer the case to the United States District Court for the District of Arizona. On February 7, 1994, an order was entered transferring the case in its entirety. Prior to the transfer, however, the New Mexico magistrate judge issued a proposed order which, if accepted by the district judge, would require the parties to enter into mediation of all the claims. The parties have agreed to a form of order dismissing without prejudice the claims asserted in the New Mexico suit against MCB and against the RTC, recommending the remand of the remaining claim for declaratory relief against the insurance company to the Federal District Court in New Mexico, and ordering the mediation of the claims asserted in the Arizona proceeding (described below) by the RTC against all of the other parties in the New Mexico suit except the insurance company and MCB. On April 16, 1993, the Company and certain current and former employees of the Company or Meadows were named as defendants in two actions filed in the United States District Court for the District of Arizona by the RTC, as receiver for Western. The claims related to alleged actions of the Company's employees in connection with a loan procured by BCD from Western and the purchase by that partnership of property owned by Western in 1987. The RTC apparently claims that the Company's liability stems from the actions of a former employee who allegedly acted on behalf of the Company for the Company's benefit. The RTC is claiming in excess of $40 million in actual damages from the BCD/Western transactions and alternatively is claiming damages substantially exceeding that amount on a joint and several liability theory for injury to Western from an alleged conspiracy in which the Company and the other defendants are alleged to be co-conspirators. The conspiracy allegations involve all other transactions claimed by the RTC to have harmed Western but to which BCD was not a party. The RTC claims the $40 million damages would be trebled under application of Arizona law. The RTC may also seek attorneys fees and costs. In February 1994, the RTC advised that the RTC would be seeking to amend the complaint to allege civil conspiracy, common law fraud and aiding and abetting breach of fiduciary duties, aiding and abetting common law fraud and aiding and abetting violation of federal and Arizona RICO statutes against the Company and is considering claims against Meadows and against the Company as "successor to and alter ego" of Meadows. Three of the individuals sued by the RTC have indemnity agreements with the Company. On March 3 and 4, 1994, the parties participated in a mediation session aimed at settling the litigation. The session ended without a settlement. It is anticipated that settlement discussions will continue although no dates have been scheduled yet for future meetings. In July 1993, the Company and certain current or former employees of the Company or its subsidiaries were also named in an action filed in Federal District Court in Arizona on behalf of a class of common stockholders of Western. The allegations were similar to those filed in the RTC actions described above. On January 24, 1994, motions to dismiss filed by the Company and certain current or former employees of the Company or its subsidiaries were granted by the Arizona court for lack of standing to bring the actions. Although the plaintiffs may appeal the order of the court, the Company believes the claims are without merit. Although the Company continues to investigate all of the relevant claims raised in all of the suits, the Company believes that a material loss to the Company will not likely occur as a result of claims that have been or may be asserted by any of the parties. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE COMPANY Executive officers, their ages, offices held with the Company in the past five years and initial effective dates thereof, were as follows on December 31, 1993: - -------- * W. M. Eglinton retired effective December 31, 1993. All officers are elected annually by the board of directors of the Company. All of the above executive officers have been employed by the Company and/or its subsidiaries for more than five years in executive or management positions, with the exception of P. T. Ortiz, M. D. Christensen and B. F. Montoya. Prior to employment with the Company, P. T. Ortiz was employed by U S WEST Communications during the period of January 1988 to October 1991 as Chief Counsel--New Mexico and during the period of June 1985 to January 1988, as an attorney by U S WEST Communications (then known as Mountain Bell). The principal business of U S WEST Communications is telecommunications. Prior to employment with the Company, M. D. Christensen was employed with Southern California Gas since 1978. During the period 1990 through 1991, M. D. Christensen was Vice President of Planning and for the period 1987 through 1990, M. D. Christensen was Vice President of Public Affairs. Prior to 1987, M. D. Christensen held various management positions relating to marketing and legislative services. Prior to employment with the Company, B. F. Montoya was employed with Pacific Gas and Electric Company ("PG&E") since 1989. In 1991, he was promoted to Senior Vice President and General Manager of the Gas Supply Business Unit of PG&E. Prior to his employment with PG&E, B. F. Montoya spent 31 years in the Civil Engineer Corps of the U.S. Navy, performing a wide range of management and utility-related assignments. B. F. Montoya achieved the rank of Rear Admiral when he became Commander, Naval Facilities Engineering Command and Chief of Civil Engineers. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the New York Stock Exchange. Ranges of sales prices of the Company's common stock, reported as composite transactions (Symbol: PNM) for 1993 and 1992, by quarters, are as follows: On January 31, 1994, there were 24,469 holders of record of the Company's common stock. CUMULATIVE PREFERRED STOCK While isolated sales of the Company's cumulative preferred stock have occurred in the past, the Company is not aware of any active trading market for its cumulative preferred stock. Quarterly cash dividends were paid on each series of the Company's cumulative preferred stock at their stated rates during 1993 and 1992. For a discussion of dividend restrictions on the Company's common and preferred stock, see Note 3 of notes to consolidated financial statements and ITEM 7.--"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--LIQUIDITY AND CAPITAL RESOURCES--Financing Capability and Dividend Restrictions". ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------- * As discussed in note 1 to consolidated financial statements, the Company changed its method of accounting for unbilled revenues in 1992. ** Includes the write-down of the 22% beneficial interests in PVNGS Units 1 and 2 leases purchased by the Company, the write-off of certain regulatory assets and other deferred costs and the write-off of certain PVGNS Units 1 and 2 common costs, aggregating $108.2 million, net of taxes ($2.59 per share). + Includes the write-down of the Company's investment in PVNGS Unit 3 and the provision for loss associated with the M-S-R power purchase contract, aggregating $126.2 million, net of taxes ($3.02 per share). The selected financial data should be read in conjunction with the consolidated financial statements, the notes to consolidated financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management's assessment of the Company's financial condition and the significant factors affecting the results of operations. This discussion should be read in conjunction with the Company's consolidated financial statements. On January 11, 1993, the Company announced specific actions which were determined to be necessary in order to accelerate the Company's preparation for the new challenges in the competitive electric energy market. Included in the announcement was the Company's intention to file a plan ("framework filing") with the NMPUC designed to lower electric prices by consolidating certain gas and electric functions, restructuring assets and reducing operation and maintenance expenses by $25 million annually. The Company separated the gas and electric customer service consolidation issues from the balance of the framework filing and filed for necessary approvals for the consolidation of the customer service functions on December 21, 1993. On January 11, 1993, the Company also announced its intention to dispose of the Company's natural gas gathering and natural gas processing assets and SDCW. (See "Sale of Gas Gathering and Processing Assets" and "Sale of SDCW".) January 12, 1994 Stipulation On January 12, 1994, the Company and the NMPUC staff and primary intervenor groups (AG, the New Mexico Industrial Energy Consumers, the City of Albuquerque, the United States Executive Agencies and the New Mexico Retail Association) ("interested parties") entered into a stipulation ("stipulation") which addresses retail electric prices, generation assets and certain financial concerns of the Company. The Company filed the stipulation with the NMPUC, recommending that electric retail rates be reduced by $30 million. This reduction is accomplished primarily through the write-down of the 22% beneficial interests in the PVNGS Units 1 and 2 leases purchased by the Company, the write-off of certain regulatory assets and other deferred costs, the write-off of certain PVNGS Units 1 and 2 common costs and the Company's previously announced cost reduction efforts. In connection with the stipulation, the Company has charged approximately $108.2 million, after-tax, to the 1993 results of operations. Such after-tax charge resulted in the Company continuing to have a deficit in retained earnings as of December 31, 1993. As a result, the Company is unable to resume payment of dividends on its common stock. The Company evaluated the possibility of a quasi-reorganization but does not intend to implement a quasi-reorganization at this time. The stipulation contains provisions which call for PVNGS Units 1 and 2 to be confirmed as "used and useful" for New Mexico customers pursuant to tests previously set forth by the NMPUC. The stipulation also establishes transition and gain allocation mechanisms to be implemented if generation assets are sold or otherwise removed from rates. The interested parties acknowledged that restructuring of the Company's generation mix may result in benefits to both customers and stockholders and future generation asset sales may need to include a mix of PVNGS and coal-fired generation. If any PVNGS unit included in rates is sold, subleased, assigned, or removed from full cost of service recovery for any reason, the difference between the cost of PVNGS units included in rates and its sale price shall continue to be recovered through rates. The Company's ability to record this difference as a regulatory asset, for financial reporting purposes, will be subject to the continued determination that the regulated portion of its electric operations meets the provisions of SFAS No.71, Accounting for the Effects of Certain Types of Regulation. The interested parties also agreed that the reduction in cost of service resulting from any future refinancing or restructuring of the PVNGS Units 1 and 2 leases shall be allocated 60% to shareholders and 40% to customers. The stipulation affirms the Company's right to recover all fair, just and reasonable costs arising from the decommissioning of its fossil-fueled generating plants in service, including demolition, waste disposal, environmental and site restoration. The stipulation also resolves the issues of decertification and decommissioning of the Company's three retired fossil- fueled generating stations resulting in the Company foregoing recovery of the first $24.4 million of decommissioning costs associated with these stations. The interested parties also agreed to use a targeted capital structure in the cost of service filed with the stipulation, which recognized the Company's need to move toward investment grade guidelines. In the stipulation, the Company expressed its intent not to seek general rate changes and the interested parties expressed their intent not to cause the filing of general rate changes before January 1, 1998. However, should unforeseen circumstances occasion the need for a review of general rate levels before January 1, 1998, the interested parties will meet before seeking a change in rates. The stipulation is subject to NMPUC approval. The Company believes that the approval of the stipulation would result in a reduction of competitive risk and regulatory uncertainty. However, there can be no assurance that the stipulation will be approved by the NMPUC. If the stipulation is not approved in its entirety, unless otherwise agreed to by all interested parties, the stipulation shall be null and void. On January 3, 1994, the NMPUC issued an order establishing investigations of rates for both the Company and SPS. The order required the Company to file a general rate case no later than July 1, 1994. However, at the prehearing conference held on February 23, 1994, regarding the stipulation, the NMPUC vacated the requirements of its original request and will allow the stipulation to satisfy their requirements. Hearings on the stipulation have not been scheduled; however, the Company and interested parties are scheduled to file testimony on April 18, 1994. The NMPUC confirmed the oral rulings in a written order issued on March 7, 1994. On March 7, 1994, the Albuquerque City Council deadlocked on endorsing the Mayor's signing of the stipulation. The Company is currently unable to determine what impact, if any, the City Council's action might have on the stipulation. However, the Company remains committed to the process and will meet with the other parties who signed the stipulation to evaluate this new development. The Company believes that the stipulation will continue through the hearing process being established by the NMPUC. Sale of Gas Gathering and Processing Assets On January 11, 1993, the Company announced its intention to dispose of the Company's natural gas gathering and natural gas processing assets. A purchaser has now been selected following a competitive bidding process. On February 12, 1994, an agreement was executed with Williams Gas Processing--Blanco, Inc. ("Williams"), a subsidiary of the Williams Field Services Group, Inc. of Tulsa, Oklahoma, for the sale of substantially all of the assets of Gathering Company and Processing Company, and for the sale of the Northwest and Southeast gas gathering and processing facilities of GCNM. The agreement provides for a cash selling price of $155 million, subject to certain adjustments. In addition, the Company and Williams entered into agreements for gas gathering and processing services, which the Company believes to be competitively priced, to be provided by Williams on the facilities being sold for a period up to 15 years. The transaction is subject to applicable waiting periods under the Federal Hart-Scott-Rodino Antitrust Improvements Act of 1976 and subject to approval by the NMPUC. If approved, the closing is expected to take place in 1995. The closing is also subject to other customary closing conditions, such as obtaining necessary material consents from lenders and other third parties. Under the sale agreement, the Company agreed to retain certain liabilities pertaining to the assets being sold, including certain environmental liabilities. Such retained environmental liabilities include liabilities under environmental laws as of closing associated with (i) the mercury meter remediation project, (ii) identified friable asbestos, (iii) environmental permits required by various agencies, and (iv) pits at certain abandoned compressor sites. The Company's retained environmental liabilities also include liabilities associated with certain unlined disposal pits subject to an existing New Mexico Oil Conservation Division ("OCD") order. The Company has also agreed to retain liability for a portion of potential liabilities relating to a contaminated landfill that has been declared a Federal superfund site. Further, the Company agreed to indemnify Williams against other third party environmental claims arising from pre-closing ownership, operations or conditions and for breaches of environmental representations and warranties for a period of five years after closing in an amount up to $10.6 million. The Company's retained environmental liabilities described above are not subject to the $10.6 million cap. The Company has evaluated the potential impact of the above retained environmental liabilities. The Company believes, after consideration of established reserves, that the ultimate outcome of these environmental issues will not have a material adverse effect on the Company's financial condition or results of operations (see "OTHER ISSUES FACING THE COMPANY-- Environmental Issues--Gas"). The Company intends to offset costs associated with the environmental liabilities with proceeds from the sale to the maximum extent possible. Under the agreement, the Company also agreed to indemnify Williams, subject to equal sharing of the first $1.5 million, (i) against third party claims (other than environmental) arising from pre-closing ownership, operations and conditions for a period of two years after closing, (ii) for breaches of other customary representations and warranties for a period of two years from the date of closing, and (iii) for 30 days past the applicable statute of limitations for breaches of the Company's tax representations. The Company also agreed to indemnify Williams for three years after closing for third party claims relating to certain property rights. Under the agreement, the Company will, subject to prior NMPUC approval, guarantee the obligations of its subsidiaries which are parties to the agreement. The book value of the facilities being sold, plus regulatory assets and deferred charges, is expected to be approximately $85 million. In addition, the Company expects approximately $8 million to be incurred for transaction and other ascertainable costs prior to closing. The Company anticipates that a significant amount of income tax will become payable as a result of this transaction. Also, the NMPUC will determine the allocation of the resulting gain between the Company's gas customers and shareholders. Therefore, the Company is not able at this time to estimate the amount of any gain that would be allocated to shareholders. The Company believes that the sale of these assets will improve its flexibility to take advantage of changing market conditions while maintaining continued access to competitively priced, reliable and secure long-term gas supplies. Sale of SDCW On July 29, 1993, Santa Fe city officials announced a verbal agreement under which the City of Santa Fe (the "City") would purchase SDCW. Under the verbal agreement, the Company would receive approximately $48 million for its water utility division. The proposed agreement excluded from the sale certain Santa Fe area real estate which the Company would either sell or trade separately. The Company would also continue to operate the water utility for up to four years for a fee under a proposed contract with the City. On September 3, 1993, a nonbinding memorandum of understanding was entered into with the City, which contains the general principles for the sale of the Company's water utility division. The Company's board of directors authorized the sale on January 11, 1994. On February 23, 1994, the City Council authorized the transaction and the Company and the City signed a purchase and sale agreement on February 28, 1994. The Company anticipates filing for regulatory approvals in March 1994. Consummation of a sale will require approval by the NMPUC. The Company expects to consummate the sale by the end of 1994. LIQUIDITY AND CAPITAL RESOURCES The Company's ability to generate sufficient amounts of cash to meet its operating and capital cash requirements ("liquidity") is a function of the rates it is allowed to charge and its ability to access the credit markets. The Company's filed stipulation and potential longer-term effects of a more competitive energy market are expected to affect the Company liquidity through reductions in the level of rates charged for the Company's electric operations, partially mitigated by the Company's cost reduction effort and anticipated proceeds from sales of assets. The Company currently anticipates that cash generated from internal sources will be sufficient to meet the capital requirements during the 1994 through 1998 period. CAPITAL REQUIREMENTS Total capital requirements include construction expenditures as well as other major capital requirements. Construction projects of significance include upgrading generating systems, upgrading and expanding the electric and gas transmission and distribution systems and purchasing nuclear fuel. Total capital requirements for 1993 and projections for 1994-1998 are shown below: - -------- * Includes expenditures for construction of OLE. ** Total construction expenditures do not include expenditures for SDCW after 1993 and for Gathering Company and Processing Company after 1994. (See "Sale of Gas Gathering and Processing Assets" and "Sale of SDCW".) *** Other major capital requirements include bond maturities/sinking funds, debt retirement and preferred stock redemptions/preferred stock dividends. Requirements for 1993 also include payments for gas contract settlements and the severance program. Requirements for 1994 and 1997 include retirement of approximately $45 million and approximately $15 million of first mortgage bonds, respectively. These estimates are under continuing review and subject to on-going adjustment. LIQUIDITY In addition to cash flow from operations, the Company received cash proceeds from certain asset sales and an asset securitization during 1993. On August 3, 1993, the Company received $60 million from the securitization relating to amounts being recovered from gas customers relating to certain gas contract settlements. On August 12, 1993, the Company also received $55 million from the sale of a 10.04% undivided interest in SJGS Unit 4 to Anaheim. Proceeds therefrom were used to pay off short-term debt and to establish short-term investments. Also during 1993, pollution control revenue bonds totaling $182 million and EIP Secured Facility Bonds totaling $51.3 million were refunded and replaced. The refundings will provide pre-tax interest savings of approximately $5.5 million per year and $.4 million in reduced lease payments. In addition, in 1993, the Company entered into a $100 million secured revolving credit facility ("Facility") and the Company entered into an additional $40 million credit facility collateralized by the Company's electric customer accounts receivable (the "Accounts Receivable Securitization"). The Accounts Receivable Securitization has a term of five years. Together with $11 million in local lines of credit, the Company thus has $151 million in liquidity arrangements. The Company currently estimates a total of $768 million for its capital requirements for the period of 1994 through 1998. The Company expects that such cash requirements are to be met primarily through internally-generated cash. However, to cover differences in the amounts and timing of cash generation and cash requirements, the Company intends to utilize short-term borrowings under its liquidity arrangements, including the Facility. The Facility has an expiration date of June 13, 1995 and contains a provision that could prevent additional borrowings in the event of a material adverse change in the condition (financial or otherwise), results of operations, assets, business or prospects of the Company. In respect to the total debt to total capitalization test under the Facility and the letter of credit issued to support certain pollution control bonds, the Company is allowed to exclude from the calculation of total capitalization up to $200 million in pre-tax write- offs resulting from the Company's restructuring efforts. The Company was allowed to exclude, from the calculation, approximately $180 million in pre-tax write-offs resulting from the stipulation. The maximum allowed ratio of the Company's total debt to total capitalization under the Facility and the letter of credit is 72%. As of December 31, 1993, such ratio was 68.3%. The Company also expects to receive cash proceeds from additional asset sales during 1994 and 1995. The Company is seeking to close the UAMPS transaction in the first half of 1994. The purchase price for the 35 MW of SJGS Unit 4 is approximately $40 million. In addition, the Company expects to consummate the sale of the Company's water division to the City of Santa Fe for approximately $48 million in the second half of 1994. The Company, along with its subsidiaries, Gathering Company and Processing Company, also anticipates to receive approximately $155 million from the sale of certain natural gas gathering and processing assets. If these sales are consummated, the proceeds from these sales which the Company is allowed to retain after tax payments and sharing of the gains could be used to retire long-term debt. The sale of these assets, as well as the amount of proceeds the Company would ultimately retain and the use of those proceeds will be subject to a number of conditions and various regulatory approvals. FINANCING CAPABILITY AND DIVIDEND RESTRICTIONS The Company's ability to raise external capital and the cost of such funds depend on, among other things, its results of operations, credit ratings, regulatory approvals and financial market conditions. During 1993, the Company's securities which were not already rated below "investment grade" were downgraded to below "investment grade" by the major rating agencies. The immediate effect of the reduction in the Company's credit ratings by the major rating agencies was to increase the Company's cost of short-term borrowings under the Facility and the cost of the letter of credit supporting $37.3 million pollution control revenue bonds. The Company believes that the downgrade of the above securities does not affect materially the Company's current financial condition and results of operations. One impact of the Company's current ratings, together with covenants in the Company's PVNGS Unit 1 and Unit 2 lease agreements (see PART I, ITEM 2.-- "PROPERTIES--Nuclear Plant"), is to limit the Company's ability, without consent of the owner participants and bondholders in the lease transactions, (i) to enter into any merger or consolidation, or (ii) except in connection with normal dividend policy, to convey, transfer, lease or dividend more than 5% of its assets, including cash, in any single transaction or series of related transactions. The Facility and the Reimbursement Agreement impose similar restrictions irrespective of credit ratings. The issuance of first mortgage bonds by the Company is subject to earnings coverage and bondable property provisions of the Company's first mortgage indenture. The Company has the capability under the mortgage indenture, without regard to the earnings test but subject to other conditions, to issue first mortgage bonds on the basis of certain previously retired bonds. The Company currently has no requirements for long-term financing during the 1994 through 1998 period. However, during this period, the Company could enter into long- term financings for the purpose of strengthening its balance sheet and reducing its cost of capital. In 1994, the Company plans to redeem $45 million of its 10 1/8% first mortgage bonds due 2004. The Company's board of directors, which reviews the Company's dividend policy on a continuing basis, has not declared dividends on its common stock since January 1989. As of December 31, 1993, the Company had a deficit in retained earnings of $120.8 million and is currently unable to resume payment of dividends on its common stock. The resumption of common dividends is dependent upon a number of factors including the outcome of the stipulation discussed herein, earnings and financial condition of the Company and market conditions. The Company evaluated its ability to continue paying dividends on its preferred stock under restrictions imposed by the Federal Power Act due to the Company's negative retained earnings. By letter dated April 7, 1993, the Company advised the FERC staff of the Company's position that payment of preferred stock dividends would not be in violation of the Federal Power Act. As a result, the Company has continued to declare and pay dividends on its preferred stock on scheduled dates. CAPITAL STRUCTURE: The Company's capitalization, including short-term debt, at December 31 is shown below: - -------- * Total capitalization does not include the present value of the Company's lease obligations for PVNGS Units 1 and 2 and EIP leases as debt, but does include the debt associated with the beneficial interests in certain PVNGS Units 1 and 2 leases purchased by the Company on September 2, 1992. RESULTS OF OPERATIONS The Company sustained a loss per common share in 1993 of $1.64, compared to a loss of $2.67 per common share in 1992 and earnings of $.32 per common share in 1991. The loss experienced in 1993 was due primarily to the Company recording an after-tax charge of $108.2 million to 1993 earnings resulting from the stipulation filed with the NMPUC recommending that electric retail rates be reduced by $30 million. The loss experienced in 1992 was due primarily to the write-down of PVNGS Unit 3 and the provision for loss associated with the M-S-R power purchase contract. This resulted in an $126.2 million after-tax charge to 1992 earnings. Resources excluded from NMPUC jurisdictional rates continue to negatively impact the Company's results of operations; however, as a result of the PVNGS Unit 3 write-down and the provision for loss associated with the M-S-R power purchase contract recorded in 1992, the Company experienced positive operating income from the excluded resources during 1993. Selected financial information for the excluded resources for 1993, 1992 and 1991, is shown below: - -------- * Due to the provision for the loss associated with the M-S-R contingent power purchase contract recognized in 1992, operating revenues were reduced by $20.5 million. The following discussion highlights other significant items which affected the results of operations in 1993, 1992 and 1991, and certain items impacting future earnings. Electric gross margin (electric operating revenues less fuel and purchased power expense) increased $30.1 million in 1993 due primarily to increased gross margin of $20.9 million from the excluded resources resulting from the 1992 provision for loss associated with the M-S-R power purchase contract and $9.3 million resulting from a 2.7% increase in jurisdictional energy sales of 145.5 million KWh. Electric gross margin also increased $15.2 million in 1992 compared to 1991 primarily resulting from a 4.3% increase in jurisdictional energy sales of 161.3 million KWh, or $10.1 million, and an increase in off- system sales revenues of $15.7 million due to increased sales activity in the wholesale power market. Gas operating revenues increased $27.9 million and gas purchased for resale increased $27.4 million in 1993 when compared to 1992 due primarily to an increase in transportation revenues and higher purchased gas costs (which are recovered from customers through the PGAC). Purchased gas costs affect revenues and gas purchased for resale equally. Gas operating revenues and gas purchased for resale decreased $33.9 million and $33.0 million, respectively, in 1992 compared to 1991 mainly due to lower purchased gas costs. Other operation and maintenance expenses increased $3.4 million in 1993 over 1992 primarily due to the $10.6 million effect of the Company's severance program, increased pension and benefit expense of $4.8 million due to the adoption of SFAS No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions, higher electric regulatory expenses of $2.5 million due to the framework filing and PVNGS related NRC fees, and higher PVNGS decommissioning expense of $2.4 million. Such increases were partially offset by a decrease in PVNGS lease expense of $12.2 million resulting from the Company's purchase of approximately 22% of the beneficial interests in the PVNGS Units 1 and 2 leases in September 1992 and a decrease in PVNGS operating costs of $5.6 million as a result of the cost cutting efforts at PVNGS. Other operation and maintenance expenses decreased $7.2 million in 1992 compared to 1991 primarily as a result of reduced lease payments resulting from the Company's purchase of approximately 22% of the beneficial interests in the PVNGS Units 1 and 2 leases and to a decrease in administrative and general expenses. Another item contributing to the decrease was an accrual in the second quarter of 1991 for estimated costs associated with the clean-up of mercury at gas metering sites. The Company recorded an after-tax charge of $108.2 million in 1993 as a result of the stipulation. In 1992, the Company recorded an after-tax charge of $126.2 million resulting from the write-down of the Company's investment in PVNGS Unit 3 and the provision for loss associated with the M-S-R power purchase contract (see note 2 of notes to consolidated financial statements). Other, under the caption, Other Income and Deductions increased $16.1 million from a year ago. Significant 1993 items, net of taxes, include the following: (1) the gain of $7.5 million recognized from the sale of an investment, (2) the gain of $5.6 million from the sale of generating facilities to Anaheim, (3) the tax benefit of $2.0 million related to sharing the Anaheim gain with jurisdictional customers, (4) tax benefits of $3.2 million due to the Federal income tax rate change which will allow the Company to utilize its net operating loss at a higher tax rate and (5) tax benefits of $1.4 million resulting from the settlement of the Internal Revenue Service ("IRS") examination of the years 1990 and 1991. Partially offsetting such increases were: (1) additional provisions for legal and litigation expenses of $5.7 million, (2) a write-off of $4.6 million of other deferred costs, (3) a PVNGS decommissioning fund adjustment of $2.8 million to recognize the cash surrender value of the policies, (4) a write-off of $2.1 million resulting from costs associated with refunding certain pollution control and, EIP bonds which represents the amount related to FERC firm-requirement wholesale customers and resources excluded from New Mexico jurisdictional rates, which cannot be deferred for regulatory purposes and (5) a provision for gas environmental costs of $1.8 million. Significant 1992 items, net of taxes, included the following: (1) a $9.8 million charge recorded as a result of the Company's conclusion in the fourth quarter of 1992 that it did not meet the criteria of SFAS No. 71, Accounting for the Effects of Certain Types of Regulation, for recording electric regulatory assets, (2) additional loss provision of $6.3 million related to gas contract disputes, (3) recognition of an additional $2.3 million of PVNGS decommissioning and decontamination costs related to the excluded resources, (4) write-offs of $2.3 million resulting from the application of SFAS No. 101, Accounting for the Discontinuance of Application of SFAS No. 71, to the Company's firm-requirement wholesale customers, (5) write-downs of $2.2 million for various non-utility properties, (6) a write-off of $2.2 million relating to a canceled transmission project, (7) additional transaction privilege taxes of $2.1 million, and (8) a number of other miscellaneous items of $2.3 million. Partially offsetting such charges were the cumulative effect of the change in the method of accounting for unbilled revenues of $12.7 million (see note 1 of notes to consolidated financial statements) and the gain of $2.3 million recognized from the sale of an investment. Significant 1991 items, net of taxes, included the following: (1) additional shareholder litigation expenses of $7.1 million, (2) an additional provision for loss of $2.5 million for disputes related to gas purchase contracts, (3) losses of $2.4 million related to the M-S-R energy brokerage agreement caused by the poor wholesale power market and (4) the write-off of AFUDC and depreciation related to Four Corners of $2.2 million. Partially offsetting such charges was the recapture of damage payments of $2.8 million related to the Company's exit from diversification activities. Net interest charges increased $12.4 million in 1993 due primarily to: (1) recording long-term debt of $141 million for the purchase of approximately 22% of the beneficial interests in the PVNGS Units 1 and 2 leases in September 1992, (2) the recording of the interest component of the provision for loss on the M-S-R power purchase contract which was recorded in 1992, and (3) interest resulting from the IRS examination settlement. Net interest charges increased $7.7 million in 1992 compared to 1991 primarily due to the interest expense resulting from the purchase of approximately 22% of the beneficial interests in the PVNGS Units 1 and 2 leases, interest owed to PGAC customers and the interest payment related to the settlement of PVNGS transaction privilege taxes. OTHER ISSUES FACING THE COMPANY Excess Capacity Sales/Wholesale Power Market In its January 11, 1993 announcement, the Company stated its intention to dispose of excess electric generating capacity not needed by New Mexicans including, if possible, some or all of the Company's share of PVNGS. Excess electric generating capacity includes excluded capacity, as well as excess capacity which is currently in New Mexico jurisdictional rates and excess capacity associated with the firm-requirement wholesale customers. As of December 31, 1993, the Company's excluded capacity consists of 130 MW of PVNGS Unit 3, 80 MW of San Juan Unit 4 and the 105 MW M-S-R power purchase contract. The 105 MW purchase from M-S-R expires April 30, 1995. In connection with the determination to sell PVNGS Unit 3, the Company has made on-going assessments of its net realizable value. The Company continues to evaluate its estimates of such amounts on an on-going basis but currently does not anticipate additional write-downs or write-offs relating to PVNGS Unit 3. The Company continues to seek prospective buyers. On May 27, 1993, the Company executed a purchase and participation agreement with UAMPS to sell not less than 6.024% (30 MW) and up to 8.03% (40 MW) undivided ownership interest in SJGS Unit 4.On September 1, 1993, the Company and UAMPS amended the purchase and participation agreement to establish the UAMPS purchase of excluded SJGS Unit 4 capacity at 35 MW for approximately $40 million. On November 19, 1993, the Company filed an application with the NMPUC for approval of this sale. On January 21, 1994, the Company, the NMPUC Staff and the New Mexico Industrial Energy Consumers entered into a stipulation requesting approval of the sale. Hearings were held February 15, 1994, and the Company is awaiting a recommended decision. In addition, the Company made three filings with the FERC associated with the sale and has received approval on two and is awaiting the outcome of the remaining filing. Closing of the transaction will depend on the fulfillment of numerous closing conditions and will be subject to regulatory approvals from the NMPUC and the FERC. If approved, the Company anticipates that the closing of the sale will be in the first half of 1994. Until such time as excess electric generating resources can be disposed of, the Company continues to be dependent on the wholesale power market for the recovery of its costs associated with the excluded portion of these excess resources. The Company has experienced price competition in the wholesale market due to the availability of surplus capacity from other utilities, projected natural gas fuel prices and the existence of cogeneration, independent power producers and self-generation as competing energy sources, and expects such availability to continue. The Company has committed most of its excess capacity to off-system sales during the 1994 to 2001 timeframe. On October 27, 1993, SDG&E filed a complaint with the FERC against the Company, alleging that certain charges under its 1985 power purchase agreement are unjust, unreasonable and unduly discriminatory. SDG&E is requesting that the FERC investigate the rates charged under the agreement and establish a refund date effective as of December 26, 1993. The relief, if granted, would reduce annual demand charges paid by SDG&E by up to $11 million per year from the effective refund date through April 2001, subject to certain limitations if the FERC has not acted within 15 months. The Company responded to the complaint on December 8, 1993, and SDG&E and the Company filed subsequent pleadings. The Company believes that the complaint is without merit, and the Company intends to vigorously resist the complaint. PVNGS Decommissioning Funding The Company has a program for funding its share of decommissioning costs for PVNGS. Under this program, the Company makes a series of annual deposits to an external trust fund over the estimated useful life of each unit, and the trust funds are being invested under a plan which allows the accumulation of funds largely on a tax-deferred basis through the use of life insurance policies on certain current and former employees. The annual trust deposit, approved by the NMPUC in 1987, is currently $396,000 per unit. The NMPUC jurisdictional share of this amount related to PVNGS Units 1 and 2 is currently included in retail rates. The results of the 1992 decommissioning cost study indicate that the Company's share of the PVNGS decommissioning costs will be approximately $143.2 million, an increase from $94.2 million based on the previous study (both amounts are stated in 1993 dollars). The Company has determined that a supplemental investment program will be needed as a result of both the cost increase and the under performance of the existing investment program. However, a supplemental funding program will not be established until clarification and/or possible revisions to a FERC order issued in October 1993 regarding restricted investment vehicles for nuclear decommissioning trusts are obtained. Although a supplemental program will not be established pending resolution from the FERC, the Company has requested recovery of the increased decommissioning costs in the stipulation. The market value of the existing trust at the end of 1993 was approximately $11.0 million, including cash surrender value of the policies. A Transmission Right-of-Way The Company has easements for right-of-way with the Navajo Nation for portions of two transmission lines that emanate from SJGS and connect with Four Corners and with a switching station in the Albuquerque area. One grant of easement for approximately 4.2 miles of right-of-way for two parallel 345 Kv transmission lines expired on January 17, 1993. The Company has been negotiating with the Navajo Nation to renew the grant and in light of the expiring grant of easement, requested the development of an interim agreement under which the parties would operate until a long-term solution could be reached. On January 6, 1994, the Navajo Nation and the Company executed an agreement whereby the Navajo Nation agreed not to object to the Company's operating and maintaining the facilities on the easement for right-of-way until July 17, 1994 in return for a cash payment and transfer of title to land located near the Navajo Nation. Additionally, the Navajo Nation and the Company agreed to exert a good faith effort to reach a long-term right-of-way renewal agreement prior to July 17, 1994. In pursuit of resolution of this issue, the Navajo Nation sent the Company on February 4, 1994 a letter identifying non-monetary items the Navajo Nation would be willing to negotiate as consideration for the grant of easement. On February 11, 1994, the Navajo Nation and the Company met to establish a schedule for conducting their negotiations. Additionally, the meeting was conducted for the purpose of the Navajo Nation's presentation of their consultant's findings on the value of the easement but did not represent these findings to be the Navajo Nation's position for compensation for renewal of the easement. The Company is evaluating the consultant's findings and has committed to submitting a proposal to the Navajo Nation by mid-March. The Company continues to assess its options but is not pursuing other alternatives unless it receives indications that settlement cannot be reached in a satisfactory manner. The Company is currently unable to predict the outcome of the negotiations or the costs resulting therefrom. OLE Transmission Project In May 1984, the Company's Board of Directors approved plans to construct OLE, a 345 Kv transmission line connecting the existing Ojo 345 Kv line to the existing Norton Station. The Company has incurred approximately $15 million of costs associated with OLE as of December 31, 1993, and it currently estimates that project costs will total approximately $48 million. OLE is designed to provide a needed improvement to the northern New Mexico transmission system and to allow greater delivery of power from SJGS, Four Corners and PVNGS into the Company's two largest service territories, the greater Albuquerque area and the Santa Fe/Las Vegas area. The Company obtained right-of-way permits from two of the three Federal agencies having authority over the lands involved in the project. Federal district and appellate courts upheld the record of decision on the OLE environmental impact statement. However, OLE faces considerable opposition by persons concerned primarily about the environmental impacts of the project. On March 11, 1991, the Company filed for NMPUC approval for construction of OLE. Hearings have been held and final briefs were filed in December 1992. Until final approvals are received, the Company will use interim measures to continue to provide reliable service. The Company is awaiting a final decision from the NMPUC and has no indication of when a decision will be made. Environmental Issues--Gas The Company has evaluated the potential impacts of the following environmental issues. The Company believes, after consideration of established reserves, that the ultimate outcome of these environmental issues will not have a material adverse effect on the Company's financial condition or results of operations. Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") Two CERCLA 104(e) orders were received from the EPA in late December 1993, requesting information regarding shipment of wastes to the Lee Acres Landfill, located on BLM land near the city of Bloomfield in San Juan County, New Mexico. The landfill is currently listed on the National Priorities List as a superfund site. GCNM and Gathering Company have assessed their records and other information to determine whether wastes were ever shipped from their facilities to the landfill during the period when they owned and operated the natural gas facilities. GCNM and Gathering Company's assessment indicated that no hazardous wastes or cause of such wastes were shipped from their facilities to the landfill during this time period. Nonetheless, GCNM and Gathering Company could be determined to be potentially responsible parties if the EPA determines GCNM and Gathering Company shipped wastes to the site, and could be asked or compelled to provide funds for site cleanup. GCNM and Gathering Company prepared and submitted their response to the EPA on March 8, 1994. Toxic Substances Control Act ("TSCA") TSCA requires manufacturers and importers of organic chemicals, including natural gas substances, to report a listing and quantity of certain toxic chemicals to the EPA every four years. Naturally occurring substances such as crude oil and unprocessed natural gas need not be reported. Due to the natural gas industry's interpretation on when unprocessed natural gas becomes a reportable substance, GCNM and Processing Company did not report TSCA substances to the EPA in prior reporting years of 1986 and 1990. As a result of the EPA's clarification on the limited scope of the exemption, GCNM and Processing Company now have filed their reports for 1986 and 1990 and will report such substances to the EPA in the 1994 reporting year. The companies may be subject to administrative fines/penalties for their failure to report in 1986 and 1990. The maximum penalty allowed under the statute is $25,000/day for every day the report has not been filed. Gas Wellhead Pit Remediation Effective September 1992, the OCD issued a ruling which affects GCNM and Gathering Company's natural gas gathering facilities located in the northwestern part of New Mexico. The ruling prohibits the further discharge of fluids associated with the production of natural gas into unlined open pits in certain areas deemed environmentally sensitive due to their proximity to fresh water supplies. In addition to the cessation of the discharge of fluids, the ruling requires that GCNM and Gathering Company remediate the areas where discharges have contaminated fresh water supplies. GCNM has submitted generic closure plans for the pits, which have been approved by OCD and the BLM. Air Permits A recent environmental audit, associated with the Company's proposed sale of certain gas assets, brought to light certain discrepancies regarding required air permits associated with certain natural gas facilities. The audit identified a total of thirteen facilities containing discrepancies. The vast majority of the discrepancies are minor in nature and include discrepancies in record keeping, equipment identification and inaccurate information in air permit applications. The discrepancies at three of the facilities involve permit issuance and modification and are more serious in nature. The Company is subject to administrative fines/penalties by the New Mexico Environment Department ("NMED") for these discrepancies. The Company plans to meet with the NMED in March 1994 to discuss the nature of the permit discrepancies and to propose methods and schedules to resolve the discrepancies. The resolution process will include the filing of permit applications, modifications and revisions where necessary. After reviewing the applications, NMED will determine whether to grant the application, modification or revision and make a determination whether to impose any fines/penalties. The CERCLA, air permits and gas wellhead pit remediation issues previously discussed are part of the retained environmental liabilities under the sale agreement with Williams (see Sale of Gas Gathering and Processing Assets). Environmental Issue--Electric The Company's current estimate to decommission its retired fossil-fueled plants (see "Fossil-Fueled Plant Decommissioning Costs") includes approximately $17.2 million for a groundwater remediation program at Person Station. The Company, in compliance with a New Mexico Environment Action Directive, has determined that ground water contamination exists in the deep and shallow water aquifers. The Company is required to delineate the extent of the contamination and remediate the contaminant in the ground water. The extent of the contaminant plume in the deep water aquifer is not currently known, and the estimate assumes that the deep ground water plume can be easily delineated with a minimum number of monitoring wells. As part of the financial assurance requirements of the Person Station Hazardous Waste Permit, the Company posted a $3.7 million performance bond with a trustee. The remediation program continues on schedule. The Company does not anticipate any material adverse impact on its financial condition or the results of operations with respect to the remediation program. Fossil-Fueled Plant Decommissioning Costs The Company's six owned or partially owned, in service and retired, fossil- fueled generating stations are expected to incur dismantling and reclamation costs as they are decommissioned. The Company's share of decommissioning costs for all of its fossil-fueled generating stations is projected to be approximately $126 million stated in 1992 dollars, including approximately $24 million for Person, Prager and Santa Fe Stations which have been retired. In June of 1993, the Company filed for recovery of all estimated decommissioning costs by factoring them into its depreciation rates included in the Company's depreciation rate study filed with the NMPUC. As previously discussed, the Company and the interested parties entered into the January 12, 1994 stipulation. The stipulation affirms the Company's right to recover all fair, just and reasonable costs arising from the decommissioning of its fossil-fueled generating plants in service, including demolition, waste disposal, environmental and site restoration. The stipulation also resolves the issues of decertification and decommissioning of the Company's three retired fossil-fueled generating stations resulting in the Company foregoing recovery of the first $24.4 million of decommissioning costs associated with these stations. The stipulation is subject to NMPUC approval. Palo Verde Nuclear Generating Station--Steam Generator Tubes On December 26, 1993, PVNGS Unit 3 returned to service at approximately 85% power following a mid-cycle outage during which APS inspected Unit 3's steam generators. APS has informed the NRC that the inspection did not reveal the type of tube degradation (axial cracking in upper bundle) experienced in Unit 2's steam generators; however, the inspection did reveal another more common type of tube degradation (circumferential cracking at tubesheet) in Unit 3's steam generators which has occurred in similarly-designed steam generators at other plants. The next regular refueling outage for Unit 3 is scheduled to begin in March 1994, at which time APS plans to inspect and chemically clean that unit's steam generators. On January 8, 1994, APS removed Unit 2 from service to inspect and chemically clean its two steam generators during a mid-cycle outage. The inspection revealed additional tube degradation of the type (axial cracking in upper bundle) previously found in that unit's steam generators. The inspection has also revealed the common type of tube degradation (circumferential cracking at tubesheet) which has occurred in similarly-designed steam generators at other plants. Based on these findings, APS expanded the scope of the inspection of the Unit 2 steam generators and the planned duration of the outage until late March. However, because APS's analysis of Unit 2's steam generators is ongoing, APS cannot predict with certainty the timing of the restart of Unit 2. APS is currently evaluating the need for an additional mid-cycle outage for Unit 2 during 1994. Unit 1 and Unit 3 continue to operate at approximately 85% power since each unit returned to service in November 1993 and December 1993, respectively, after outages during which each unit's steam generators were inspected. APS has performed, and is continuing, certain corrective actions including, among other things, chemical cleaning, operating the units at reduced temperatures, and, for some period, operating the units at approximately 85% power. As a result of these corrective actions, all three units should be returned to 100% power by mid 1995, and one or more of the units could be returned to 100% power during the course of 1994. So long as the three units are involved in mid-cycle outages and are operated at approximately 85% power, the Company will incur replacement power costs and reduced wholesale sale incentives of approximately $5.7 million during 1994, approximately 75% of which will be recovered through the Company's FPPCAC. El Paso Electric Company The Company owns or leases a 10.2% interest in PVNGS and owns a 13% interest in Four Corners Units 4 and 5, which are operated by APS. El Paso owns or leases a 15.8% interest in PVNGS and owns a 7.0% interest in Four Corners Units 4 and 5. On January 8, 1992, El Paso filed a voluntary petition to reorganize under Chapter 11 of the United States Bankruptcy Code. On September 8, 1992, El Paso filed a plan of reorganization with the bankruptcy court, which was later amended pursuant to an October 26, 1992 filing with the court. On May 4, 1993, El Paso and Central and South West Corporation ("CSW") announced a plan for merger in connection with El Paso's Chapter 11 reorganization, under which El Paso would become a wholly-owned subsidiary of CSW. A modified amended El Paso--CSW plan and disclosure statement dated August 27, 1993 has been filed with the bankruptcy court and was approved December 8, 1993. In order for the merger to be implemented, CSW and El Paso must receive appropriate regulatory approvals, including approval of the NRC and the FERC. In the El Paso--CSW FERC proceedings, the Company has intervened to protect its interests relative to the various transmission issues raised by the El Paso-- CSW filings. The Company's regulatory filings in the FERC proceeding address reliability and potential system impacts that may result to the Company from the merger. At this time the Company is unable to predict the result of these regulatory proceedings. In addition to approving the El Paso--CSW plan, the bankruptcy court approved the Cure and Assumption Agreement between El Paso and the PVNGS participants, which provides for (i) various mutual releases and (ii) the execution of a release by El Paso and any alleged claims regarding the 1989-90 PVNGS outages. All such releases will be effective on the effective date of the El Paso--CSW plan. The Cure and Assumption Agreement also provided for payment in full to the PVNGS participants of pre-petition monies owed by El Paso. El Paso has made the payment contingent upon its completion of the merger with CSW. The bankruptcy court also approved the assumption by El Paso of several wheeling agreements that El Paso and the Company agreed to extend as part of a 120 day transition agreement. In connection with the assumptions, El Paso paid the Company approximately $2.3 million owed for pre and post-petition wheeling services. Although the transition agreement has expired by its terms, the parties have signed an agreement in principle for near-term and longer-term wheeling services. The agreement would provide El Paso with a total of 80 MW of transmission service until such time as El Paso installs a phase shifting transformer ("PST") which is expected to be late 1995. The agreement would provide El Paso with 20 MW of service after the PST is installed in exchange for payment by El Paso of proportional costs incurred by the Company for generation support of the transmission as well as wheeling charges. The Company and El Paso have also agreed to negotiate both near-term and longer-term operating procedures, which may include transfer by the Company of operating agent status for the Southern New Mexico Transmission System to El Paso. The Company will continue to retain its transmission rights (presently 75 MW) in southern New Mexico. The wheeling agreement will be subject to regulatory approval at FERC and will also be reviewed by the NMPUC in connection with several regulatory filings of El Paso, both predating and in connection with the El Paso-- CSW merger. Albuquerque Franchise Issues The Company's non-exclusive electric service franchise with the City of Albuquerque (the "City") expired in early 1992. The franchise agreement provided for the Company's use of City property for electric service rights-of- way. The Company continues service to the area, which contributed 46% of the Company's total 1993 electric operating revenues. The absence of a franchise does not change the Company's right and obligation to serve those customers under state law. In November 1991, the NMPUC issued an order concluding, among other things, that the City could bid for services to its own facilities (Albuquerque municipal loads generated approximately $17.0 million, $16 million and $17 million in annual revenue for 1993, 1992 and 1991, respectively), but not for service to other customers. In reaching this conclusion, the NMPUC noted that New Mexico law reflects a legislative choice to vest the NMPUC with exclusive control over utility rates and services. The NMPUC also noted that the Company's obligation to serve its customers in Albuquerque will continue irrespective of whether the municipal franchise is renewed. The City appealed the NMPUC's order to the New Mexico Supreme Court (the "Court"). On April 21, 1993, the Court issued its decision on the City's appeal of the NMPUC order. The Court ruled that a city can negotiate rates for its citizens in addition to its own facility uses. The Court also ruled that any contracts with utilities for electric rates are a matter of statewide concern and subject to approval, disapproval or modification by the NMPUC. In addition, the Court reaffirmed the NMPUC's exclusive power to designate providers of utility service within a municipality and confirmed that municipal franchises were not licenses to serve but rather to provide access to public rights-of-way. In 1992, representatives of the Company and the City met in attempts to resolve the franchise renewal issue. Currently, the franchise renewal meetings are in abeyance due to the City's interest in the outcome of the retail wheeling legislation which was introduced in the 1993 state legislative session. The Company continues to pay franchise fees to the City. Retail Wheeling During 1992, open access to transmission grids in the electric wholesale market, as mandated by the National Energy Policy Act, stimulated interest in the retail wheeling concept in New Mexico, resulting in the introduction of legislation in the 1993 New Mexico state legislature. On March 6, 1993, the New Mexico State Senate passed Senate Memorial 54, which calls for the concept of retail wheeling to be studied by the Integrated Resource Planning Committee which is an interim legislative committee, with a report to be made to the 1995 legislature. The Company has been providing information for the study effort. The study is anticipated to be completed by December 1994. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS The management of Public Service Company of New Mexico is responsible for the preparation and presentation of the accompanying consolidated financial statements. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles and include amounts that are based on informed estimates and judgments of management. Management maintains a system of internal accounting controls which it believes is adequate to provide reasonable assurance that assets are safeguarded, transactions are executed in accordance with management authorization and the financial records are reliable for preparing the consolidated financial statements. The system of internal accounting controls is supported by written policies and procedures, by a staff of internal auditors who conduct comprehensive internal audits and by the selection and training of qualified personnel. The Board of Directors, through its Audit Committee comprised entirely of outside directors, meets periodically with management, internal auditors and the Company's independent auditors to discuss auditing, internal control and financial reporting matters. To ensure their independence, both the internal auditors and independent auditors have full and free access to the Audit Committee. The independent auditors, Arthur Andersen & Co., are engaged to audit the Company's consolidated financial statements in accordance with generally accepted auditing standards. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and the Stockholders of Public Service Company of New Mexico: We have audited the accompanying consolidated balance sheet and statement of capitalization of Public Service Company of New Mexico (a New Mexico corporation) and subsidiaries as of December 31, 1993, and the related consolidated statements of earnings (loss), retained earnings (deficit), and cash flows for the year then ended. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedules V, VI and IX for the year ended December 31, 1993. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Public Service Company of New Mexico and subsidiaries as of December 31, 1993, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. These financial statement schedules are presented for purposes of complying with the Securities and Exchange Commissions rules and are not part of the basic consolidated financial statements. As explained in Notes 1 and 6 to the financial statements, effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and No. 109, Accounting for Income Taxes. Arthur Andersen & Co. Albuquerque, New Mexico February 25, 1994 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Public Service Company of New Mexico: We have audited the consolidated balance sheet and statement of capitalization of Public Service Company of New Mexico and subsidiaries as of December 31, 1992, and the related statements of earnings (loss), retained earnings (deficit) and cash flows for each of the years in the two-year period ended December 31, 1992. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules V, VI and IX for each of the years in the two-year period ended December 31, 1992. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Public Service Company of New Mexico and subsidiaries as of December 31, 1992, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 1992, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The Company has substantial excess electric generating capacity, the cost and amount of which continue to negatively impact financial condition and results of operations as well as the level of New Mexico retail rates. The Company has adopted certain plans and is evaluating other options to address the negative effects related to its excess capacity. Because the ultimate outcome of these matters, including NMPUC regulatory responses thereto, is not presently determinable, the recovery of (i) the Company's remaining direct investment in Palo Verde Nuclear Generating Station (PVNGS) Unit 3, and (ii) its lease costs related to PVNGS Units 1 and 2, is uncertain. Accordingly, neither a provision for any additional loss related to PVNGS Unit 3 nor any provision for loss related to PVNGS Units 1 and 2 has been recognized in the accompanying 1992 consolidated financial statements. As discussed in note 1 of notes to consolidated financial statements, the Company changed its method of accounting for unbilled revenues in 1992. KPMG PEAT MARWICK Albuquerque, New Mexico March 11, 1993 PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS (LOSS) The accompanying notes are an integral part of these financial statements. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES CONSOLIDATED STATEMENT OF RETAINED EARNINGS (DEFICIT) The accompanying notes are an integral part of these financial statements. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET The accompanying notes are an integral part of these financial statements. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS Cash consists of currency on hand and demand deposits. The accompanying notes are an integral part of these financial statements. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CAPITALIZATION The accompanying notes are an integral part of these financial statements. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Systems of Accounts The Company maintains its accounts for utility operations primarily in accordance with the uniform systems of accounts prescribed by the Federal Energy Regulatory Commission ("FERC") and the National Association of Regulatory Utility Commissioners ("NARUC"), and adopted by the New Mexico Public Utility Commission ("NMPUC"). Principles of Consolidation The consolidated financial statements include the accounts of the Company and subsidiaries in which it owns a majority voting interest. All significant intercompany transactions and balances have been eliminated. Utility Plant Utility plant, with the exception of Palo Verde Nuclear Generating Station ("PVNGS") Unit 3 and the Company's purchased 22% beneficial interests in the PVNGS Units 1 and 2 leases, is stated at original cost, which includes capitalized payroll-related costs such as taxes, pension and other fringe benefits, administrative costs and an allowance for funds used during construction ("AFUDC"). Utility plant includes certain electric assets not subject to NMPUC regulation. The results of operations of such electric assets are included in operating income. (See note 2.) It is Company policy to charge repairs and minor replacements of property to maintenance expense and to charge major replacements to utility plant. Gains or losses resulting from retirements or other dispositions of operating property in the normal course of business are credited or charged to the accumulated provision for depreciation. Depreciation and Amortization Provision for depreciation and amortization of utility plant is made at annual straight-line rates approved by the NMPUC. The average rates used are as follows: The provision for depreciation of certain equipment is charged to clearing accounts and subsequently allocated to operating expenses or construction projects based on the use of the equipment. Depreciation of non-utility property is computed on the straight-line method. Amortization of nuclear fuel is computed based on the units of production method. Allowance for Funds Used During Construction As provided by the uniform systems of accounts, AFUDC, a noncash item, is charged to utility plant. AFUDC represents the cost of borrowed funds (allowance for borrowed funds used during construction) and PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (1)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) a return on other funds (allowance for equity funds used during construction). The Company capitalizes AFUDC on construction work in progress and nuclear fuel in the process of enrichment to the extent allowed by regulatory commissions. With the January 11, 1993 announcement, the Company determined that beginning with the fourth quarter of 1992, it would suspend recording AFUDC on construction work in progress pending the outcome of the framework filing (see note 2). The Company did record AFUDC on nuclear fuel in process during this time. AFUDC is computed using the maximum rate permitted by the FERC. The total AFUDC rates used were 4.37%, 5.27%, and 8.96% for 1993, 1992 and 1991, respectively, compounded semi-annually. Fuel, Purchased Power and Gas Purchase Costs The Company uses the deferral method of accounting for the portion of base fuel costs (defined as fuel costs plus net purchased power costs less off- system sales revenues) and gas purchase costs which is reflected in subsequent periods under fuel and purchased power cost adjustment clauses and gas adjustment clauses. Future recovery of these costs is based on orders issued by the regulatory commissions. Amortization of Debt Discount, Premium and Expense Discount, premium and expense related to the issuance and retirement of long- term debt are amortized over the lives of the respective issues. Costs associated with retirement of long-term debt related to the Company's NMPUC jurisdictional customers were written off as part of the January 12, 1994 stipulation. (See note 2.) Income Taxes Certain revenue and expense items in the consolidated statement of earnings (loss) are recorded for financial reporting purposes in years different from those in which they are recorded for income tax purposes. Customers under NMPUC jurisdiction are charged currently for the tax effects of certain of these differences (normalization). However, the income tax effects of certain other differences result in reductions of income tax expense for ratemaking purposes in the current year as required by the NMPUC (flow-through). This flow-through method is used primarily for minor differences between book and tax depreciation. A 1990 NMPUC order in an electric rate case required reversal of the flow-through treatment previously accorded the premiums on retirement of first mortgage bonds and losses on hedging transactions, and retroactively required tax normalization of these items. Additional tax normalization is required by generally accepted accounting principles ("GAAP") for all temporary differences not subject to NMPUC rate regulation. Deferred income taxes are recorded to reflect tax normalization using the liability method. Deferred tax liabilities are computed using the enacted tax rates scheduled to be in effect when the temporary differences reverse. For regulated operations, any changes in tax rates applied to accumulated deferred income taxes may not be immediately recognized because of ratemaking and tax accounting provisions contained in the Tax Reform Act of 1986. For items accorded flow-through treatment under NMPUC orders, deferred income taxes and the future ratemaking effects of such taxes, as well as corresponding regulatory assets and liabilities, are recorded. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, Accounting for Income Taxes. SFAS No. 109 requires the use of the liability method for PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (1)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) recording deferred income taxes on temporary differences between income tax and financial reporting using the enacted tax rates at which such differences are expected to reverse. The Company had previously adopted SFAS No. 96, which also required the use of the liability method. For that reason, the adoption of SFAS No. 109 had no material effect upon 1993 operating results. The Revenue Reconciliation Act of 1993, enacted in August of 1993, contains a provision which raises the corporate Federal income tax rate from 34 to 35 percent, retroactive to January 1, 1993. The effects of this change were recorded during 1993. Neither this nor any other provision of this Act is expected to have any material impact on the Company's financial condition or its results of operations. Change in Accounting for Unbilled Revenues Prior to January 1, 1992, the Company recognized utility revenues when billed. To provide a better matching of the Company's revenues from sales with the related costs, effective January 1, 1992, the Company changed its method of accounting to record estimated revenues from sales of utility services provided subsequent to monthly billing cycle dates but prior to the end of the accounting period. The cumulative effect of this accounting change as of January 1, 1992, net of taxes, was $12.7 million or $.30 per common share and was included in 1992 net earnings as a component of other income and deductions. The effect of the accounting change on 1992 net income, exclusive of the cumulative effect, was to increase net earnings and net earnings per common share by $1.7 million and $.04, respectively. Had the accrual method been applied in 1991, net earnings for that year would not have been materially different from that shown in the consolidated statement of earnings. The effect of this accounting change has resulted in a decrease in net earnings and net earnings per common share by $1.0 million and $.02, respectively, for the twelve months ended December 31, 1993. (2)ELECTRIC OPERATIONS STIPULATION AND WRITE-OFFS On January 11, 1993, the Company announced specific actions which were determined to be necessary in order to accelerate the Company's preparation for the new challenges in the competitive electric energy market. Included in the announcement was the Company's intention to file a plan ("framework filing") with the NMPUC designed to lower electric prices by consolidating certain gas and electric functions, restructuring assets and reducing operation and maintenance expenses by $25 million annually. The Company separated the gas and electric customer service consolidation issues from the balance of the framework filing. In its January 11, 1993 announcement, the Company also stated its intention to dispose of excess electric generating capacity not needed by New Mexicans including, if possible, some or all of the Company's share of PVNGS. Excess electric generating capacity includes excluded capacity, as well as excess capacity which is currently in New Mexico jurisdictional rates and excess capacity associated with the firm-requirement wholesale customers. As of December 31, 1993, the Company's excluded capacity consists of 130 MW of PVNGS Unit 3, 80 MW of San Juan Generating Station ("SJGS") Unit 4 and the 105 MW M- S-R Public Power Agency ("M-S-R") power purchase contract. As a result of the Company's decision to attempt to sell PVNGS Unit 3, the Company estimated the net realizable value of PVNGS Unit 3 and the M-S-R power purchase contract and recorded an after-tax loss of $126.2 million at December 31, 1992. The Company continues to evaluate its estimate of such amounts on an on-going basis but currently does not anticipate additional write-downs or write-offs of PVNGS Unit 3 and the M-S-R power purchase contract. The Company continues to seek prospective buyers for the PVNGS units. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (2)ELECTRIC OPERATIONS STIPULATION AND WRITE-OFFS--(CONTINUED) On January 12, 1994, the Company and the NMPUC staff and primary intervenor groups (the New Mexico Attorney General, the New Mexico Industrial Energy Consumers, the City of Albuquerque, the United States Executive Agencies and the New Mexico Retail Association) ("interested parties") entered into a stipulation ("stipulation") which addresses retail electric prices, generation assets and certain financial concerns of the Company. The Company filed the stipulation with the NMPUC, recommending that electric retail rates be reduced by $30 million. This reduction is accomplished primarily through the write-down of the 22% beneficial interests in the PVNGS Units 1 and 2 leases purchased by the Company, the write-off of certain regulatory assets and other deferred costs, the write-off of certain PVNGS Units 1 and 2 common costs and the Company's previously announced cost reduction efforts. In connection with the stipulation, the Company has charged approximately $108.2 million, after-tax, to the 1993 results of operations. Such after-tax charge resulted in the Company continuing to have a deficit in retained earnings as of December 31, 1993. As a result, the Company is unable to resume payment of dividends on its common stock. The Company evaluated the possibility of a quasi-reorganization but does not intend to implement a quasi-reorganization at this time. The stipulation is subject to NMPUC approval. The Company believes that the approval of the stipulation would result in a reduction of competitive risk and regulatory uncertainty. However, there can be no assurance that the stipulation will be approved by the NMPUC. If the stipulation is not approved in its entirety, unless otherwise agreed to by all interested parties, the stipulation shall be null and void. On January 3, 1994, the NMPUC issued an order establishing investigations of rates for both the Company and Southwestern Public Service Company ("SPS"). The order required the Company to file a general rate case no later than July 1, 1994. However, at the prehearing conference held on February 23, 1994, regarding the stipulation, the NMPUC vacated the requirements of its original request and will allow the stipulation to satisfy their requirements. Hearings on the stipulation have not been scheduled; however, the Company and interested parties are scheduled to file testimony on April 18, 1994. The NMPUC confirmed the oral rulings in a written order issued on March 7, 1994. On March 7, 1994, the Albuquerque City Council deadlocked on endorsing the Mayor's signing of the stipulation. The Company is currently unable to determine what impact, if any, the City Council's action might have on the stipulation. However, the Company remains committed to the process and will meet with the other parties who signed the stipulation to evaluate this new development. The Company believes that the stipulation will continue through the hearing process being established by the NMPUC. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (3)CAPITALIZATION Changes in common stock, additional paid-in capital and cumulative preferred stock are as follows: Common Stock The number of authorized shares of common stock with par value of $5 per share is 80 million shares. The payment of cash dividends on the common stock of the Company is subject to certain restrictions, including those contained in the Company's mortgage indenture, which effectively prevent the payment of dividends on common stock unless the Company has positive retained earnings. The Company's board of directors, which reviews the Company's dividend policy on a continuing basis, has not declared dividends on its common stock since January 1989. As of December 31, 1993, the Company had a deficit in retained earnings of $120.8 million and is, therefore, currently unable to resume payment of dividends on its common stock. The resumption of common dividends is dependent upon a number of factors including the outcome of the stipulation discussed in note 2, earnings and financial condition of the Company and market conditions. Cumulative Preferred Stock The number of authorized shares of cumulative preferred stock is 10 million shares. The earnings tests in the Company's Restated Articles of Incorporation currently restrict the issuance of preferred stock. The Company, upon 30 days notice, may redeem the cumulative preferred stock at stated redemption prices plus accrued and unpaid dividends. Redemption prices are at reduced premiums in future years. On February 10, 1992, the Company redeemed all 346,700 shares of its Cumulative Preferred Stock, 12.52% series, $50.00 stated value at a redemption price of $52.97 per share plus accrued and unpaid dividends. The Company evaluated its ability to continue paying dividends on its preferred stock under restrictions imposed by the Federal Power Act due to the Company's negative retained earnings. By letter dated April 7, 1993, the Company advised the FERC staff of the Company's position that payment of preferred stock dividends would not be in violation of the Federal Power Act. As a result, the Company continued to declare and pay dividends on its preferred stock on scheduled dates. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (3)CAPITALIZATION--(CONTINUED) Mandatory redemption requirements for 1994 through 1998 are $1.3 million annually. During any period that the Company is unable to pay preferred dividends, if that should occur, the Company would be prohibited by its Articles of Incorporation from making future mandatory redemption payments. Long-Term Debt Substantially all utility plant is pledged to secure the Company's first mortgage bonds. A portion of certain series of long-term debt will be redeemed serially prior to their due dates. The issuance of first mortgage bonds by the Company is subject to earnings coverage and bondable property provisions of the Company's first mortgage indenture. The Company has the capability under the mortgage indenture, without regard to the earnings test but subject to other conditions, to issue first mortgage bonds on the basis of certain previously retired bonds. In November 1992, pollution control revenue refunding bonds, 1992 Series A, in the principal amount of $37.3 million, were issued. Such bonds are supported by a letter of credit ("LOC") and are collaterally secured by certain first mortgage bonds issued by the Company. The LOC will expire on November 26, 1995, unless extended or renewed, and prior thereto may be terminated or replaced by an alternate LOC or alternate security. As the Company believes it has the ability to extend the LOC, the $37.3 million is not included in the aggregate maturities. The aggregate amounts (in thousands) of maturities for 1994 through 1998 on long-term debt outstanding at December 31, 1993 (including estimates of remittance of collections for the Asset Securitization discussed below) are as follows: On August 3, 1993, the Company received $60 million from the securitization relating to amounts being recovered from gas customers relating to certain gas contract settlements. Proceeds were used to pay down short-term debt. Pollution control revenue bonds totaling $182 million and EIP Secured Facility Bonds totaling $51.3 million were refunded and replaced during 1993. The refundings will provide pre-tax interest savings of approximately $5.5 million per year and $.4 million in reduced lease payments. Fair Value of Financial Instruments Effective January 1, 1992, the Company adopted SFAS No. 107, Disclosures about Fair Value of Financial Instruments, which requires the disclosure of the fair value of all financial instruments. As of December 31, 1993, the fair value of the Company's long-term debt and preferred stock (including current maturities) is estimated to be approximately $986 million and $75 million, respectively, based on market quotes obtained from the Company's investment bankers. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (4)REVOLVING CREDIT FACILITY AND OTHER CREDIT FACILITIES At December 31, 1993, the Company had a $100 million secured revolving credit facility (the "Facility") with the expiration date of June 13, 1995. The Company must pay commitment fees of .5% per year on the total amount of the Facility. The Company also has a $40 million credit facility, collaterialized by the Company's electric customer account receivable (the "Accounts Receivable Securitization"). Such credit facility has a term of five years. Together with $11 million in local lines of credit, the Company has $151 million in liquidity arrangements. As of December 31,1993, there were no borrowings outstanding under the Facility, the Accounts Receivable Securitization or any of the local lines of credit. (5)INCOME TAXES Income taxes consist of the following components: The Company's provision for income taxes differed from the Federal income tax computed at the statutory rate for each of the years shown. The differences are attributable to the following factors: PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (5)INCOME TAXES--(CONTINUED) Deferred income taxes result from certain differences between the recognition of income and expense for tax and financial reporting purposes, as described in note 1. The major sources of these differences for which deferred taxes have been provided and the tax effects of each are as follows: The gross accumulated deferred income tax liability as of December 31, 1993 was $303.9 million and consisted principally of $265.1 million relating to accelerated tax depreciation. The gross accumulated deferred income tax asset was $256.6 million, the largest element of which was $84.4 million relating to unutilized net operating loss carryforwards, the balance being comprised primarily of numerous items previously recognized as expenses for financial accounting purposes which had not been deducted for tax purposes. In addition, the balance of deferred income taxes at December 31, 1993 includes amounts for temporary differences related to deferred gains on sale and leaseback transactions, settlements of gas contract disputes, deferred investment tax credits and regulatory assets and liabilities. At December 31, 1993, the Company had net operating loss carryforwards for Federal income tax purposes of $21.6 million, $133.9 million, $15.1 million, and $46.6 million which expire in 2003, 2004, 2005 and 2007, respectively. For purposes of New Mexico state income tax, these carryforwards, if unused, would expire in 2003, 2004, 2005 and 1997, respectively. New Mexico law provides a five-year carryforward for all net operating losses incurred after 1990. The Company anticipates that all of these carryforwards will be fully utilized before expiration, and the financial statements reflect that expectation. The application of SFAS No. 109 to regulated enterprises results in the creation of regulatory assets and liabilities. At December 31, 1993 and 1992, deferred charges included regulatory assets of $75.2 million and $65.9 million, respectively, and deferred credits included regulatory liabilities of $69.9 million and $73.1 million, respectively. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (5)INCOME TAXES--(CONTINUED) The Company defers investment tax credits related to utility assets and amortizes them over the estimated useful lives of those assets. Investment tax credits related to non-utility assets have been flowed through in earlier years. In 1993, the Company reached a settlement with the Internal Revenue Service regarding income taxes for the years 1990 through 1991. The primary effect of the settlement is an acceleration of certain previously deferred items into current income tax expense. (6)EMPLOYEE AND POST-EMPLOYMENT BENEFITS Pension Plan The Company and its subsidiaries have a pension plan covering substantially all of their employees, including officers. The plan is non-contributory and provides for benefits to be paid to eligible employees at retirement based primarily upon years of service with the Company and their average of highest annual base salary for three consecutive years. The Company's policy is to fund actuarially-determined contributions. Contributions to the plan reflect benefits attributed to employees' years of service to date and also for services expected to be provided in the future. Plan assets primarily consist of common stock, fixed income securities (United States government obligations), cash equivalents and real estate. The components of pension cost (in thousands) are as follows: PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (6)EMPLOYEE AND POST-EMPLOYMENT BENEFITS--(CONTINUED) The following sets forth the plan's funded status and amounts (in thousands) at December 31, 1993 and 1992: The weighted average discount rate used to measure the projected benefit obligation was 7.0% for 1993 and 8.0% for 1992 and the expected long-term rate of return on plan assets was 9.0% for 1993 and 9.5% for 1992. The rate of increase in future compensation levels based on age-related scales was 4.1% for 1993 and 5.0% for 1992. As of December 31, 1993, the Company recognized $2.8 million, net of tax, as a separate component of common stock equity, for the amount of additional pension liability in excess of the unrecognized prior service cost in accordance with SFAS No. 87, Employers' Accounting for Pensions. Other Postretirement Benefits The Company adopted SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, effective January 1, 1993. The Company provides medical and dental benefits to eligible retirees. Currently, retirees are offered the same benefits as active employees after reflecting Medicare coordination. The components of postretirement benefit cost (in thousands) for 1993 are as follows: PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (6)EMPLOYEE AND POST-EMPLOYMENT BENEFITS--(CONTINUED) The following sets forth the plan's funded status and amounts (in thousands) at December 31, 1993: Prior to 1993, the costs of these benefits were expensed on a pay-as-you-go basis. The cost of providing these benefits was $1,531,000 and $1,139,000 for 1992 and 1991, respectively. As of December 31, 1993, the discount rate used to measure the postretirement benefit obligation was 7.0% and the health care cost trend rate was 6%. The effect of a 1% increase in the health care trend rate assumption would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $10.2 million and the aggregate service and interest cost components of net periodic postretirement benefit cost for 1993 by approximately $1.0 million. On December 20, 1993, the NMPUC issued a final order in a NMPUC case regarding an inquiry into SFAS No. 106. In its final order, the NMPUC adopted a policy which provides for accrual accounting for the postretirement benefit costs, funding requirements into an irrevocable trust and specific reporting for the benefit costs in future rate cases. The order also provides for specific waiver provisions with respect to the external trust funding requirements and a deferral of the benefit costs in excess of the pay-as-you-go basis. The Company has requested recovery of the full accrual amount of SFAS No. 106 expense in the stipulation for its electric business unit (see note 2). The Company will address the recovery of the amounts related to the gas business unit in a future rate case. The Company currently intends to fund the full amount of these costs in 1994. Employee Stock Ownership Plan Effective January 1, 1989, the Company adopted an Employee Stock Ownership Plan covering substantially all of its employees. Under the plan, the Company makes cash contributions which are utilized to purchase the Company's common stock on the open market. Contributions to the plan were approximately $5.3 million in 1989. No contributions or accruals were made in 1990, 1991 and 1992 and effective March 1, 1993, the plan has been cancelled. Performance Stock Plan As approved by the Company's shareholders on May 25, 1993, the Company adopted a nonqualified stock option plan (Performance Stock Plan) covering a group of management employees. Under the terms of the plan which became effective on July 1, 1993, options to purchase shares of the Company's common stock are granted with an exercise price equal to the fair market value of the stock at the date of grant. On July 1, 1993, the Company granted 370,000 shares to the covered employees under the plan at an exercise price of PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (6)EMPLOYEE AND POST-EMPLOYMENT BENEFITS--(CONTINUED) $13.75 per share. The remaining 1,630,000 shares approved under the plan are reserved for future grants. Options may be exercised following vesting as described in the plan. Currently no options are eligible for exercise. Executive Retirement Program In addition, the Company had an executive retirement program for a group of management employees. The program was intended to attract, motivate and retain key management employees. The Company's projected benefit obligation for this program, as of December 31, 1993, was $18.5 million, of which the accumulated and vested benefit obligation was $17.4 million. In addition, in 1993, the Company recognized an additional liability of $7.2 million for the amount of unfunded accumulated benefits in excess of accrued pension costs. The net periodic pension cost for 1993, 1992 and 1991 was $2.1 million, $2.0 million and $1.8 million, respectively. In 1989, the Company established an irrevocable grantor trust in connection with the executive retirement program. Under the terms of the trust, the Company may, but is not obligated to, provide funds to the trust, which was established with an independent trustee, to aid it in meeting its obligations under such program. Funds in the amount of approximately $12.7 million (fair market value of $13.0 million) were provided to the trust in 1989. No additional funds have been provided to the trust. (7)CONSTRUCTION PROGRAM AND JOINTLY-OWNED PLANTS It is estimated that the Company's construction expenditures for 1994 will be approximately $129 million, including expenditures on jointly-owned projects. The Company's proportionate share of expenses for the jointly-owned plants is included in operating expenses in the consolidated statement of earnings. At December 31, 1993, the Company's interest (including leasehold interests in PVNGS Units 1 and 2 for power entitlement) and investments in jointly-owned generating facilities are: - -------- * Includes the Company's interest in PVNGS Unit 3, the Company's interest in common facilities for all PVNGS units and the 22% beneficial interests in PVNGS Units 1 and 2 leases purchased on September 2, 1992. San Juan Generating Station The Company operates and jointly owns SJGS. At December 31, 1993, SJGS Units 1 and 2 are owned on a 50% shared basis with Tucson Electric Power Company ("Tucson"), Unit 3 is owned 50% by the Company, 41.8% by Southern California Public Power Authority and 8.2% by Century Power Corporation ("Century"), (Century has agreed to sell its remaining 8.2% interest to Tri-State Generation and PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (7)CONSTRUCTION PROGRAM AND JOINTLY-OWNED PLANTS--(CONTINUED) Transmission Association, Inc.). Unit 4 is owned 45.485% by the Company, 8.475% by the City of Farmington, 28.8% by M-S-R, 7.2% by the County of Los Alamos and 10.04% by the City of Anaheim, California. On May 27, 1993, the Company executed a purchase and participation agreement with Utah Associated Municipal Power Systems ("UAMPS") to sell not less than 6.024% (30 MW) and up to 8.03% (40 MW) undivided ownership interest in SJGS Unit 4. On September 1, 1993, the Company and UAMPS amended the purchase and participation agreement to establish the UAMPS purchase at 35 MW for approximately $40 million. On November 19, 1993, the Company filed an application with the NMPUC for approval of this sale. On January 21, 1994, the Company, the NMPUC staff, and the New Mexico Industrial Energy Consumers entered into a stipulation requesting approval of the sale. Hearings were held February 15, 1994, and the Company is awaiting a recommended decision. In addition, the Company made three filings with the FERC associated with the sale and has received approval on two and is awaiting the outcome of the remaining filing. Closing of the transaction will depend on the fulfillment of numerous closing conditions and will be subject to regulatory approvals from the NMPUC and the FERC. If approved, the Company anticipates that the closing of the sale will be in the first half of 1994. Palo Verde Nuclear Generating Station The Company has a 10.2% interest in PVNGS. Commercial operation commenced in 1986 for Unit 1 and Unit 2 and 1988 for Unit 3. In 1985 and 1986, the Company completed sale and leaseback transactions for its undivided interests in Units 1 and 2 and certain related common facilities. On September 2, 1992, the Company purchased approximately 22% of the beneficial interests in PVNGS Units 1 and 2 leases for approximately $17.5 million. For accounting purposes, this transaction was recorded as a purchase with the Company recording approximately $158.3 million as utility plant (written down to $46.7 million as a result of the stipulation, see note 2) and $140.8 million as long-term debt on the Company's consolidated balance sheet. The PVNGS participants have insurance for public liability payments resulting from nuclear energy hazards to the full limit of liability under Federal law. This potential liability is covered by primary liability insurance provided by commercial insurance carriers in the amount of $200 million and the balance by an industry wide retrospective assessment program. The maximum assessment per reactor under the retrospective rating program for each nuclear incident occurring at any nuclear power plant in the United States is approximately $79.3 million, subject to an annual limit of $10 million per incident. Based upon the Company's 10.2% interest in the three PVNGS units, the Company's maximum potential assessment per incident is approximately $24 million, with an annual payment limitation of $3 million. The insureds, under this liability insurance include the PVNGS participants and "any other person or organization with respect to his legal responsibility for damage caused by the nuclear energy hazard". The PVNGS participants maintain "all-risk" (including nuclear hazards) insurance for nuclear property damage to, and decontamination of, property at PVNGS in the aggregate amount of $2.75 billion as of January 1, 1994, a substantial portion of which must first be applied to stabilization and decontamination. The Company has also secured insurance against a portion of the increased cost of generation or purchased power resulting from certain accidental outages of any of the three PVNGS units if such outage exceeds 21 weeks. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (7)CONSTRUCTION PROGRAM AND JOINTLY-OWNED PLANTS--(CONTINUED) The Company has a program for funding its share of decommissioning costs for PVNGS. Under this program, the Company will make a series of annual deposits to an external trust fund over the estimated useful life of each unit, and the trust funds are being invested under a plan which allows the accumulation of funds largely on a tax-deferred basis through the use of life insurance policies on certain current and former employees. The annual trust deposit, approved by the NMPUC in 1987, is currently $396,000 per unit. The NMPUC jurisdictional share of this amount related to PVNGS Units 1 and 2 is currently included in retail rates. The results of the 1992 decommissioning cost study indicate that the Company's share of the PVNGS decommissioning costs will be approximately $143.2 million, an increase from $94.2 million based on the previous study (both amounts are stated in 1993 dollars). Additional expense associated with the decommissioning cost increase has been included in the cost of service filed with the NMPUC in the stipulation (see note 2). The Company has determined that a supplemental investment program will be needed as a result of both the cost increase and the underperformance of the existing investment program. However, a supplemental funding program will not be established until clarification and/or possible revisions to a FERC order issued in October 1993 regarding restricted investment vehicles for nuclear decommissioning trusts are obtained. The market value of the existing trust at the end of 1993 was approximately $11.0 million, including cash surrender value of the insurance policies. El Paso Electric Company The Company owns or leases a 10.2% interest in PVNGS and owns a 13% interest in the Four Corners Power Plant ("Four Corners") Units 4 and 5, which are operated by Arizona Public Service Company ("APS"). El Paso Electric Company ("El Paso") owns or leases a 15.8% interest in PVNGS and owns a 7.0% interest in Four Corners Units 4 and 5. On January 8, 1992, El Paso filed a voluntary petition to reorganize under Chapter 11 of the United States Bankruptcy Code. On September 8, 1992, El Paso filed a plan of reorganization with the bankruptcy court, which was later amended pursuant to an October 26, 1992 filing with the court. On May 4, 1993, El Paso and Central and South West Corporation ("CSW") announced a plan for merger in connection with El Paso's Chapter 11 reorganization, under which El Paso would become a wholly-owned subsidiary of CSW. A modified amended El Paso--CSW plan and disclosure statement dated August 27, 1993 has been filed with the bankruptcy court and was approved December 8, 1993. In order for the merger to be implemented, CSW and El Paso must receive appropriate regulatory approvals, including approval of the NRC and the FERC. In the El Paso--CSW FERC proceedings, the Company has intervened to protect its interests relative to the various transmission issues raised by the El Paso--CSW filings. The Company's regulatory filings in the FERC proceeding address reliability and potential system impacts that may result to the Company from the merger. At this time the Company is unable to predict the result of these regulatory proceedings. In addition to approving the El Paso-CSW plan, the bankruptcy court approved the Cure and Assumption Agreement between El Paso and the PVNGS participants, which provides for (i) various mutual releases and (ii) the execution of a release by El Paso and any alleged claims regarding the 1989-90 PVNGS outages. All such releases will be effective on the effective date of the El Paso-CSW plan. The Cure and Assumption Agreement also provided for payment in full to the PVNGS participants of pre-petition monies owed by El Paso. El Paso has made the payment contingent upon its completion of the merger with CSW. The bankruptcy court also approved the assumption by El Paso of several wheeling agreements that El Paso and the Company agreed to extend as part of a 120 day transition agreement. In connection with the PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (7)CONSTRUCTION PROGRAM AND JOINTLY-OWNED PLANTS--(CONTINUED) assumptions, El Paso paid the Company approximately $2.3 million owed for pre and post-petition wheeling services. Although the transition agreement has expired by its terms, the parties have signed an agreement in principle for near-term and longer-term wheeling services. The agreement would provide El Paso with a total of 80 MW of transmission service until such time as El Paso installs a phase shifting transformer ("PST") which is expected to be late 1995. The agreement would provide El Paso with 20 MW of service after the PST is installed in exchange for payment by El Paso of proportional costs incurred by the Company for generation support of the transmission as well as wheeling charges. The Company and El Paso have also agreed to negotiate both near-term and longer-term operating procedures, which may include transfer by the Company of operating agent status for the Southern New Mexico Transmission System to El Paso. The Company will continue to retain its transmission rights (presently 75 MW) in southern New Mexico. The wheeling agreement will be subject to regulatory approval by the FERC and will also be reviewed by the NMPUC in connection with several regulatory filings of El Paso, both predating and in connection with the El Paso-CSW merger. (8)LONG-TERM POWER CONTRACTS AND FRANCHISES The Company entered into contracts for the purchase of electric power. Under a contract with M-S-R, which expires in early 1995, the Company is obligated to pay certain minimum amounts and a variable component representing the expenses associated with the energy purchased and debt service costs associated with capital improvements. Total payments under this contract amounted to approximately $42 million for 1993, and approximately $40 million and $41 million for each of the years 1992 and 1991, respectively. The minimum payment for 1994 under this contract is $26.7 million, with a minimum of $9.0 million for the first four months of 1995, at which time this contract expires. The Company, based on the January 11, 1993 announcement, recorded a provision for loss associated with the M-S-R power purchase contract in its 1992 results of operation. (See note 2.) The Company has a long-term contract with SPS to purchase interruptible power which began in June 1991. Total payments under this contract amounted to approximately $10.8 million in 1993. Minimum payments under the contract amount to approximately $7.0 million for 1994 and approximately $11.7 million and $14 million for each of the years 1995 and 1996, respectively. In addition, the Company will be required to pay for any energy purchased under the contract. The amount of minimum payments after 1995 will depend on whether the Company exercises certain options to either reduce or increase its purchase obligations. The Company holds long-term, non-exclusive franchises of varying durations in all incorporated communities except for the City of Albuquerque (the "City"). The Company's non-exclusive electric service franchise with the City expired in early 1992. The franchise agreement provided for the Company's use of City property for electric service rights-of-way. The Company continues service to the area, which contributed 46.0% of the Company's total 1993 electric operating revenues. The absence of a franchise does not change the Company's right and obligation to serve those customers under state law. In November 1991, the NMPUC issued an order concluding, among other things, that the City could bid for services to its own facilities (Albuquerque municipal loads generated approximately $17 million, $16 million and $17 million in annual revenues for 1993, 1992 and 1991, respectively), but not for service to other customers. In reaching this conclusion, the NMPUC noted that New Mexico law reflects a legislative choice to vest the NMPUC with exclusive control over utility rates and services. The NMPUC also noted that the Company's obligation PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (8)LONG-TERM POWER CONTRACTS AND FRANCHISES--(CONTINUED) to serve its customers in Albuquerque will continue irrespective of whether the municipal franchise is renewed. The City appealed the NMPUC's order to the New Mexico Supreme Court ("Court") solely on the grounds of the City's authority to bid for rates for its citizens. On April 21, 1993, the Court issued its decision on the City's appeal of the NMPUC order. The Court ruled that a city can negotiate rates for its citizens in addition to its own facility uses. The Court also ruled that any contracts with utilities for electric rates are a matter of statewide concern and subject to approval, disapproval or modification by the NMPUC. In addition, the Court reaffirmed the NMPUC's exclusive power to designate providers of utility service within a municipality and confirmed that municipal franchises were not licenses to serve but rather to provide access to public rights-of-way. In 1992, representatives of the Company and the City met in attempts to resolve the franchise renewal issue. Currently, the franchise renewal meetings are in abeyance due to the City's interest in the outcome of the retail wheeling legislation which was introduced in the 1993 state legislative session. The Company continues to pay franchise fees to the City. During 1992, open access to transmission grids in the electric wholesale market, as mandated by the National Energy Policy Act, stimulated interest in the retail wheeling concept in New Mexico, resulting in the introduction of legislation in the 1993 New Mexico state legislature. On March 6, 1993, the New Mexico State Senate passed Senate Memorial 54, which calls for the concept of retail wheeling to be studied by the Integrated Resource Planning Committee, which is an interim legislative committee, with a report to be made to the 1995 legislature. The Company has been providing information for the study effort. The study is anticipated to be completed by December 1994. (9)LEASE COMMITMENTS The Company classifies its leases in accordance with generally accepted accounting principles. The Company leases Units 1 and 2 of PVNGS, transmission facilities, office buildings and other equipment under operating leases. The aggregate lease payments for the PVNGS leases are $66.3 million per year over base lease terms expiring in 2015 and 2016. Prior to 1992, the aggregate lease payments for the PVNGS leases were $84.6 million per year over the base lease terms; however, this amount was reduced by the purchase of approximately 22% of the beneficial interests in the PVNGS Units 1 and 2 leases (see note 7). The 1992 aggregate lease payments for the PVNGS leases were approximately $76.4 million. Each PVNGS lease contains renewal and fair market value purchase options at the end of the base lease term. For regulatory purposes, these leases continue to be classified as operating leases and costs continue to be recovered in NMPUC jurisdictional rates. Future minimum operating lease payments (in thousands) at December 31, 1993 are: PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (9)LEASE COMMITMENTS--(CONTINUED) Operating lease expense, inclusive of PVNGS, was approximately $80.6 million in 1993, $91.1 million in 1992 and $96.8 million in 1991. The aggregate minimum payments to be received in future periods under noncancelable subleases are approximately $7.6 million. (10)ENVIRONMENTAL ISSUES AND FOSSIL-FUELED PLANT DECOMMISSIONING COSTS The Company has evaluated the potential impacts of the following environmental issues. The Company believes, after consideration of established reserves, that the ultimate outcome of these environmental issues will not have a material adverse effect on the Company's financial condition or results of operations. Environmental Issues--Gas Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") Two CERCLA 104(e) orders were received from the United States Environmental Protection Agency ("EPA") in late December 1993 requesting information regarding shipment of wastes to the Lee Acres Landfill, located on Bureau of Land Management ("BLM") land near the city of Bloomfield in San Juan County, New Mexico. The landfill is currently listed on the National Priorities List as a superfund site. Gas Company of New Mexico, a division of the Company ("GCNM") and Sunterra Gas Gathering Company, a wholly-owned subsidiary of the Company ("Gathering Company") have assessed their records and other information to determine whether wastes were ever shipped from their facilities to the landfill during the period when they owned and operated the natural gas facilities. GCNM and Gathering Company's assessment indicated that no hazardous wastes or cause of such wastes were shipped from their facilities to the landfill during this time period. Nonetheless, GCNM and Gathering Company could be determined to be potentially responsible parties if the EPA determines GCNM and Gathering Company shipped wastes to the site, and could be asked or compelled to provide funds for site cleanup. GCNM and Gathering Company prepared and submitted their response to the EPA on March 8, 1994. Toxic Substances Control Act ("TSCA") TSCA requires manufacturers and importers of organic chemicals, including natural gas substances, to report a listing and quantity of certain toxic chemicals to the EPA every four years. Naturally occurring substances such as crude oil and unprocessed natural gas need not be reported. Due to the natural gas industry's interpretation on when unprocessed natural gas becomes a reportable substance, GCNM and Processing Company did not report TSCA substances to the EPA in prior reporting years 1986 and 1990. As a result of the EPA's clarification on the limited scope of the exemption, GCNM and Processing Company now have filed their reports for 1986 and 1990 and will report such substances to the EPA in the 1994 reporting year. The maximum penalty allowed under the statute is $25,000/day for every day the report has not been filed. The companies may be subject to administrative fines/penalties for their failure to report in 1986 and 1990. Gas Wellhead Pit Remediation Effective September 1992, the New Mexico Oil Conservation Division ("OCD") issued a ruling which affects GCNM and Gathering Company's natural gas gathering facilities located in the northwestern part of New Mexico. The ruling prohibits the further discharge of fluids associated with the production of natural gas into unlined open pits in certain areas, deemed environmentally sensitive due to their proximity to fresh water supplies. In addition to the cessation of the discharge of fluids, the ruling requires that GCNM and Gathering Company remediate the areas where discharges have contaminated fresh water supplies. GCNM has submitted generic closure plans for the pits, which have been approved by OCD and the BLM. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (10)ENVIRONMENTAL ISSUES AND FOSSIL-FUELED PLANT DECOMMISSIONING COSTS-- (CONTINUED) Air Permits A recent environmental audit, associated with the Company's proposed sale of certain gas assets, brought to light certain discrepancies regarding required air permits associated with certain natural gas facilities. The audit identified a total of thirteen facilities containing discrepancies. The vast majority of the discrepancies are minor in nature and include discrepancies in record keeping, equipment identification and inaccurate information in air permit applications. The discrepancies at three of the facilities involve permit issuance and modification and are more serious in nature. The Company is subject to administrative fines/penalties by the New Mexico Environment Department ("NMED") for these discrepancies. The Company plans to meet with the NMED in March 1994 to discuss the nature of the permit discrepancies and to propose methods and schedules to resolve the discrepancies. The resolution process will include the filing of permit applications, modifications and revisions where necessary. After reviewing the applications, NMED will determine whether to grant the application, modification or revision and make a determination whether to impose any fines/penalties. The CERCLA, air permits and gas wellhead pit remediation issues previously discussed are part of the retained environmental liabilities under the sale agreement with Williams Gas Processing--Blanco, Inc. ("Williams"), a subsidiary of the Williams Field Services Group, Inc. of Tulsa, Oklahoma. (See note 11.) Environmental Issue--Electric Included in the estimate of $24.4 million to decommission the Company's retired fossil-fuel plants is approximately $17.2 million for a groundwater remediation program at Person Station. The Company, in compliance with a New Mexico Environment Action Directive, has determined that ground water contamination exists in the deep and shallow water aquifers. The Company is required to delineate the extent of the contamination and remediate the contaminant in the ground water. The extent of the contaminant plume in the deep water aquifer is not currently known, and the estimate assumes that the deep ground water plume can be easily delineated with a minimum number of monitoring wells. As part of the financial assurance requirements of the Person Station Hazardous Waste Permit, the Company posted a $3.7 million performance bond with a trustee. The remediation program continues to be on schedule and the Company does not anticipate any material adverse impact on its financial condition or the results of operations with respect to the remediation program. Fossil-Fueled Plant Decommissioning Costs The Company's six owned or partially owned in service and retired fossil- fueled generating stations are expected to incur dismantling and reclamation costs as they are decommissioned. The Company's share of decommissioning costs for all of its fossil-fueled generating stations is projected to be approximately $126 million stated in 1992 dollars, including approximately $24 million for the Person, Prager and Santa Fe Stations, which have been retired. In June of 1993, the Company filed for recovery of all estimated decommissioning costs by factoring them into its depreciation rates included in the Company's depreciation rate study filed with the NMPUC. As previously discussed, the Company and the interested parties entered into the January 12, 1994 stipulation. The stipulation affirms the Company's right to recover all fair, just and reasonable costs arising PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (10)ENVIRONMENTAL ISSUES AND FOSSIL-FUELED PLANT DECOMMISSIONING COSTS-- (CONTINUED) from the decommissioning of its fossil-fueled generating plants in service, including demolition, waste disposal, environmental and site restoration. The stipulation also resolves the issues of decertification and decommissioning of the Company's three retired fossil-fueled generating stations resulting in the Company foregoing recovery of the first $24.4 million of decommissioning costs associated with these stations. The stipulation is subject to NMPUC approval. (11)ASSET SALES Sale of Gas Gathering and Processing Assets On January 11, 1993, the Company announced its intention to dispose of the Company's natural gas gathering and natural gas processing assets. A purchaser has now been selected following a competitive bidding process. On February 12, 1994, an agreement was executed with Williams for the sale of substantially all of the assets of Gathering Company and Sunterra Gas Processing Company, a wholly-owned subsidiary of the Company and for the sale of the Northwest and Southeast gas gathering and processing facilities of GCNM. The agreement provides for a cash selling price of $155 million, subject to certain adjustments. In addition, the Company and Williams entered into agreements for gas gathering and processing services, which the Company believes to be competitively priced, to be provided by Williams on the facilities being sold for a period up to 15 years. The transaction is subject to applicable waiting periods under the Federal Hart-Scott-Rodino Antitrust Improvements Act of 1976 and subject to approval by the NMPUC. If approved, the closing is expected to take place in 1995. The closing is also subject to other customary closing conditions, such as obtaining necessary material consents from lenders and other third parties. Under the sale agreement, the Company agreed to retain certain liabilities pertaining to the assets being sold, including certain environmental liabilities. Such retained environmental liabilities include liabilities under environmental laws as of closing associated with (i) the mercury meter remediation project, (ii) identified friable asbestos, (iii) environmental permits required by various agencies, and (iv) pits at certain abandoned compressor sites. The Company's retained environmental liabilities also include liabilities associated with certain unlined disposal pits subject to an existing New Mexico Oil Conservation Division order. The Company has also agreed to retain liability for a portion of potential liabilities relating to a contaminated landfill that has been declared a Federal superfund site. Further, the Company agreed to indemnify Williams against other third party environmental claims arising from pre-closing ownership, operations or conditions and for breaches of environmental representations and warranties for a period of five years after closing in an amount up to $10.6 million. The Company's retained environmental liabilities described above are not subject to the $10.6 million cap. The Company has evaluated the potential impact of the above retained environmental liabilities. The Company believes, after consideration of established reserves, that the ultimate outcome of these environmental issues will not have a material adverse effect on the Company's financial condition or results of operations. The Company intends to offset costs associated with the environmental liabilities with proceeds from the sale. Under the agreement, the Company also agreed to indemnify Williams, subject to equal sharing of the first $1.5 million (i) against third party claims (other than environmental) arising from pre-closing ownership, operations and conditions for a period of two years after closing, (ii) for breaches of other customary PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (11)ASSET SALES--(CONTINUED) representations and warranties for a period of two years from the date of closing, and (iii) for 30 days past the applicable statute of limitations for breaches of the Company's tax representations. The Company also agreed to indemnify Williams for three years after closing for third party claims relating to certain property rights. Under the agreement, the Company will, subject to prior NMPUC approval, guarantee the obligations of its subsidiaries which are parties to the agreement. The book value of the facilities being sold, plus regulatory assets and deferred charges, is expected to be approximately $85 million. In addition, the Company expects approximately $8 million to be incurred for transaction and other ascertainable costs prior to closing. The Company anticipates that a significant amount of income tax will become payable as a result of this transaction. Also, the NMPUC will determine the allocation of the resulting gain between the Company's gas customers and shareholders. Therefore, the Company is not able at this time to estimate the amount of any gain that would be allocated to shareholders. The Company believes that the sale of these assets will improve its flexibility to take advantage of changing market conditions while maintaining continued access to competitively priced, reliable and secure long-term gas supplies. Sale of Sangre de Cristo Water Company On July 29, 1993, Santa Fe city officials announced a verbal agreement under which the City of Santa Fe ("Santa Fe") would purchase the Sangre de Cristo Water Company ("SDCW"), a division of the Company. Under the verbal agreement, the Company would receive approximately $48 million for its water utility division. The proposed agreement excluded from the sale certain Santa Fe area real estate which the Company would either sell or trade separately. The Company would also continue to operate the water utility for up to four years for a fee under a proposed contract with Santa Fe. The Company's board of directors authorized the sale on January 11, 1994. On February 23, 1994, the Santa Fe City Council authorized the sales transaction, and the Company and Santa Fe signed a purchase and sale agreement on February 28, 1994. The Company anticipates filing for regulatory approvals in March 1994. Consummation of a sale will require approval by the NMPUC. The Company expects to consummate the sale by the end of 1994. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (12)SEGMENT INFORMATION The financial information pertaining to the Company's electric, gas (see note 1) and other operations for the years ended December 31, 1993, 1992 and 1991 are as follows: - -------- * Includes the resources excluded from NMPUC regulation (see note 2). PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (12)SEGMENT INFORMATION--(CONTINUED) On January 11, 1993, the Company announced its intention to dispose of SDCW and all or major portions of the natural gas gathering and natural gas processing assets (see note 2). Such sales require NMPUC approval. (13)SUPPLEMENTAL INCOME STATEMENT INFORMATION Taxes, other than income taxes, charged to operating expenses were as follows: Amortization of intangibles, royalties, and advertising costs were less than 1% of revenues in each of the above periods. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT--(CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT--(CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT--(CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT--(CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- The average amount outstanding during the year is calculated by using average monthly balances. The average interest rate during the year is calculated by dividing average interest expense by the average amount outstanding during the year. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES QUARTERLY OPERATING RESULTS The unaudited operating results by quarters for 1993 and 1992 are as follows: In the opinion of management of the Company, all adjustments (consisting of normal recurring accruals) necessary for a fair statement of the results of operations for such periods have been included. - -------- (1) On January 12, 1994, the Company and the NMPUC staff and the interested parties entered into a stipulation which addresses retail electric prices, generation assets and the financial concerns of the Company. The Company filed the stipulation with the NMPUC, recommending that electric retail rates be reduced by $30 million. This reduction is accomplished primarily through the write-down of the 22% beneficial interests in the PVNGS Units 1 & 2 leases purchased by the Company, the write-off of certain regulatory assets and other deferred costs, the write-off of certain PVNGS Units 1 & 2 common costs and the Company's previously announced cost reduction efforts. In connection with the stipulation, the Company has charged approximately $108.2 million, after-tax, to the 1993 results of operations. (See PART II, ITEM 7. --"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--January 12, 1994 Stipulation".) (2) To provide a better matching of the Company's revenues from sales with the related costs, effective January 1, 1992, the Company changed its method of accounting to record estimated revenues from sales of utility services provided subsequent to monthly billing cycle dates but prior to the end of the accounting period. The cumulative effect of this accounting change as of January 1, 1992, net of income taxes, was $12.7 million and has been reflected in the above schedule in the quarter ended December 31 in its entirety. The effect of this change has not been reflected in each quarter as it would not cause a material difference. See note 1 of notes to consolidated financial statements. (3) On January 11, 1993, the Company announced specific actions which were determined to be necessary in order to accelerate the Company's preparation for the new challenges in the competitive energy market. One element of the January 11, 1993 announcement was the decision to attempt to sell PVNGS Unit 3. As a result of such decision the Company has estimated the net realizable value of PVNGS Unit 3 and the M-S-R power purchase contract, and recorded an after-tax loss of $126.2 million at December 31, 1992. In addition, during the fourth quarter of 1992, the Company recorded a write- down of other charges, aggregating $15.9 million, net of taxes. (See PART II, ITEM 7. --"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS".) PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES COMPARATIVE OPERATING STATISTICS - -------- * Due to the provision for the loss associated with the M-S-R contingent power purchase contract recognized in 1992, operating revenues were reduced by $20.5 million. (See Note 2 of the notes to consolidated financial statements.) Note: In 1991, the Company implemented a FERC order requiring classification of economy sales as operating revenues. Prior period amounts have been reclassified for comparability purposes. PUBLIC SERVICE COMPANY OF NEW MEXICO AND SUBSIDIARIES COMPARATIVE OPERATING STATISTICS ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On January 5, 1993, the Company notified its certifying accountants, KPMG Peat Marwick ("KPMG"), that the client-auditor relationship between the Company and KPMG will be terminated effective with the completion of the 1992 financial audit. Additionally, the Company announced its new certifying accountants, Arthur Andersen & Co., to serve as independent accountants for fiscal year 1993. The decision to change accountants was recommended by management and the Audit Committee and approved by the Company's board of directors, and was ratified at the Company's annual meeting of stockholders held on May 25, 1993. The information required by Item 304 of Regulation S-K has been "previously reports", as that term is defined in Rule 12b-2, in a Current Report on Form 8- K dated January 8, 1993. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY Reference is hereby made to "Election of Directors" in the Company's Proxy Statement relating to the annual meeting of stockholders to be held on April 27, 1994 (the "1994 Proxy Statement") and to PART I, SUPPLEMENTAL ITEM-- "EXECUTIVE OFFICERS OF THE COMPANY". ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is hereby made to "Executive Compensation" in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is hereby made to "Voting Information", "Election of Directors" and "Stock Ownership of Certain Executor Officer" in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is hereby made to the 1994 Proxy Statement for such disclosure, if any, as may be required by this item. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) -- 1. See Index to Financial Statements under Item 8. (a) -- 2. The following consolidated financial information for the years 1993, 1992, and 1991 is submitted under Item 8. Schedule V-- Property, plant and equipment. Schedule VI-- Accumulated depreciation and amortization of property, plant and equipment. Schedule IX-- Short-term borrowings. All other schedules are omitted for the reason that they are not applicable, not required or the information is otherwise supplied. E-1 (a) -- 3-A. Exhibits Filed: (a) -- 3-B. Exhibits Incorporated By Reference: In addition to those Exhibits shown above, the Company hereby incorporates the following Exhibits pursuant to Exchange Act Rule 12b-32 and Regulation 201.24 by reference to the filings set forth below: E-2 E-3 E-4 E-5 E-6 E-7 E-8 E-9 E-10 E-11 E-12 E-13 E-14 E-15 - -------- * One or more additional documents, substantially identical in all material respects to this exhibit, have been entered into, relating to one or more additional sale and leaseback transactions. Although such additional documents may differ in other respects (such as dollar amounts and percentages), there are no material details in which such additional documents differ from this exhibit. ** Designates each management contract or compensatory plan arrangement required to be identified pursuant to paragraph 3 of Item 14(a) of Form 10- K. (b) Reports on Form 8-K: During the quarter ended December 31, 1993, and during the period beginning January 1, 1994 and ending March 8, 1994, the Company filed, on the dates indicated, the following reports on Form 8-K. E-16 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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. Public Service Company of New Mexico (Registrant) Date: March 8, 1994 By /s/ B. F. Montoya ----------------------------------- B. F. Montoya President and Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. E-17 INDEX TO EXHIBITS

354396_1993.txt

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Item 1. Description of Business 1.1. General 1 1.2. Business Segments 1 1.3. Distribution Systems 5 1.4. Competition 6 1.5. Investments 6 1.6. Property/Casualty Loss Reserves 7 1.7. Life Benefit Reserves 11 1.8. Geographical Distribution 11 1.9. Executive Officers of the Registrant 12 Item 2. Item 2. Business Properties Real estate owned and used in the regular conduct of business consists of 12 business properties located in various cities throughout the United States. The Corporation's Mount Washington Center, located in Baltimore, Maryland, is the principal owned property. This is the headquarters for the life insurance operations, and the location of the information systems and training and development complexes. In addition, the Corporation leases approximately 120 offices in various cities in the regular course of business. See Note 5 of Notes to the Consolidated Financial Statements. The principal leased property is a 40-story home office building in Baltimore, Maryland, sold in 1984 and leased back by the Corporation. Item 3. Item 3. Legal Proceedings The Corporation's insurance subsidiaries are routinely engaged in litigation in the normal course of their business, including defending claims for punitive damages. As a liability insurer, they defend third-party claims brought against their insureds. As an insurer, they defend themselves against coverage claims. In the opinion of management the litigation described herein is not expected to have a material adverse effect on USF&G Corporation's consolidated financial position, although it is possible that the results of operations in a particular quarter or annual period would be materially affected by an unfavorable outcome. 3.1. Shareholder Class Action Suits During 1990 and 1991, twelve class action complaints were filed against the Corporation in the United States District Court for the District of Maryland and the United States District Court for the Eastern District of Pennsylvania. The Corporation moved to dismiss all twelve complaints. The complaints refer to the Corporation's public announcement on November 7, 1990, concerning a reduction in its dividend and related matters. All class action suits were consolidated for all purposes, under the caption IN RE USF&G CORPORATION SECURITIES LITIGATION in the United States District Court for the District of Maryland. By an order dated February 11, 1993, the court dismissed eleven of the class action complaints and on April 23, 1993, the court dismissed the remaining action. The plaintiffs have appealed these rulings and on January 6, 1994, the Fourth Circuit of Appeals affirmed the dismissal of all twelve suits. The plaintiffs have not yet indicated whether they will seek review from the United States Supreme Court. While the outcome cannot be predicted with any certainty, management believes the lawsuits are without merit and the outcome is unlikely to have a material adverse effect on the Corporation's financial position. 3.2. Maine "Fresh Start" litigation. In 1987, the State of Maine adopted workers compensation reform legislation which was intended to rectify historic rate inadequacies and encourage insurance companies to reenter the Maine voluntary workers compensation market. This legislation, which was popularly known as "Fresh Start," required the Maine Superintendent of Insurance to annually determine whether the premiums collected for policies written in the involuntary market and related investment income were adequate on a policy-year basis. The Superintendent was required to assess a surcharge on policies written in later policy years if it was determined that rates were inadequate. Assessments were to be borne by workers compensation policyholders, except that for policy years beginning in 1989 the Superintendent could require insurance carriers to absorb up to 50 percent of any deficits if the Superintendent found that insurance carriers failed to make good faith efforts to expand the voluntary market and depopulate the residual market. Insurance carriers which served as servicing carriers for the involuntary market would be obligated to pay 90 percent of the insurance industry's share. The Maine Fresh Start statute requires the Superintendent to annually estimate each year's deficit for seven years before making a final determination with respect to that year. In March 1993, the Superintendent affirmed a prior Decision and Order (known as "1992 Fresh Start Order") in which he, among other things, found that there were deficits for the 1988, 1989, and 1990 policy years, and that insurance carriers had not made a good faith effort to expand the voluntary market and consequently were required to bear 50 percent of any deficits relating to the 1989 and 1990 policy years. The Superintendent further found that a portion of these deficits were attributable to servicing carrier inefficiencies and poor investment practices and ordered that these costs be absorbed by insurance carriers. Also, in May 1993 the Superintendent found that insurance carriers would be liable for 50 percent of any deficits relating to the 1991 policy year (the "1993 Fresh Start Order"), but indicated that he would make no further determinations regarding the portions of any deficits attributable to alleged servicing carrier inefficiencies and poor investment practices until his authority to make such determinations was clarified in the various suits involving prior Fresh Start orders. USF&G Company was a servicing carrier for the Maine residual market in 1988, 1989, 1990, and 1991. The Corporation withdrew from the Maine voluntary market and as a servicing carrier effective December 31, 1991. The Corporation has joined in an appeal of the 1992 Fresh Start Order which was filed April 5, 1993, in a case captioned THE HARTFORD ACCIDENT AND INDEMNITY COMPANY, ET AL., V. SUPERINTENDENT OF INSURANCE filed in Superior Court, State of Maine, Kennebec. In addition to The Hartford Accident and Indemnity Company and USF&G Company, the National Council of Compensation Insurance ("NCCI") and seven other insurance companies which were servicing carriers during this time frame have instituted similar appeals. These appeals will be heard on a consolidated basis, in a case captioned, NATIONAL COUNCIL OF COMPENSATION INSURANCE, ET AL., V. ATCHINSON. USF&G Company is seeking, among other things, to have the court set aside the Superintendent's findings that the industry did not make a good faith effort to expand the voluntary market and is responsible for deficiencies resulting from alleged poor servicing and investments. Similar appeals of the Superintendent's 1993 Fresh Start Order have been filed by USF&G Company, the NCCI, and several other servicing carriers in the same court. The appeals of the 1993 Fresh Start Order will be heard on a consolidated basis in a case captioned THE NATIONAL COUNCIL OF COMPENSATION INSURANCE, ET AL., V. ATCHINSON. Estimates of the potential deficits vary widely and are continuously revised as loss and claims data matures. If the Superintendent were to prevail on all issues, then the range of liability for USF&G Company, based on the most recent estimates provided by the Superintendent and the NCCI, respectively, could range from approximately $12 million to approximately $19 million. However, USF&G Company believes that it has meritorious defenses and has determined to defend the actions vigorously. 3.3. Arkansas Servicing Carrier Litigation On September 14, 1993, Interstate Contractors, Inc. and two other Arkansas corporations filed a class action in the U.S. District Court for the Eastern District of Arkansas, Little Rock, against the National Council on Compensation Insurance ("NCCI"), USF&G and ten other insurance companies which served as servicing carriers for the Arkansas involuntary workers compensation market. The case, which is captioned INTERSTATE CONTRACTORS, INC., ET AL. V. NATIONAL COUNCIL ON COMPENSATION INSURANCE, ET AL., alleges that the defendants failed to provide safety and loss control services, claim management services, and assistance in moving insureds from the involuntary market to the voluntary market. The plaintiffs are pursuing their claims under various legal theories, including breach of contract, breach of fiduciary duty, and negligence. The plaintiffs seek unspecified compensatory damages based on the premiums attributable to services allegedly not performed and damages allegedly incurred as a result of the alleged failure to provide such services. USF&G Company believes that it has meritorious defenses and has determined to defend the action vigorously. Management believes that it is unlikely such claims will have a material adverse effect on USF&G Corporation's financial position. 3.4. North Carolina workers compensation Litigation On November 24, 1993, N.C. Steel, Inc. and six other North Carolina employers filed a class action in the General Court of Justice, Superior Court Division, Wake County, North Carolina, against the NCCI, North Carolina Rate Bureau, USF&G Company and eleven other insurance companies which served as servicing carriers for the North Carolina involuntary workers compensation market. On January 20, 1994, the plaintiffs filed an amended complaint seeking to certify a class of all employers who purchased workers compensation insurance in the State of North Carolina after November 24, 1989. The amended complaint, which is captioned N.C. STEEL INC. ET AL., V. NATIONAL COUNCIL ON COMPENSATION INSURANCE, ET AL., alleges that the defendants conspired to suppress competition with respect to the North Carolina voluntary and involuntary workers compensation business, thereby artificially inflating the rates in such markets and the fees payable to the insurers. The complaint also alleges that the carriers agreed to improperly deny qualified companies from acting as servicing carriers, improperly encouraged agents to place employers in the assigned risk pool, and improperly promoted inefficient claims handling. USF&G Company has acted as a servicing carrier in North Carolina since 1990. The plaintiffs are pursuing their claims under various legal theories, including violations of the North Carolina antitrust laws, unlawful conspiracy, breach of fiduciary duty, breach of implied covenant of good faith and fair dealing, unfair competition, constructive fraud, and unfair and deceptive trade practices. The plaintiffs seek unspecified compensatory damages, punitive damages for the alleged construction fraud, and treble damages under the North Carolina antitrust laws. USF&G Company believes that it has meritorious defenses and has determined to defend the action vigorously. Management believes that it is unlikely such claims will have a material adverse effect on USF&G Corporation's financial position. 3.5. Proposition 103 In November 1988, California voters passed Proposition 103, which required insurers doing business in that state to rollback property/ casualty premium prices in effect between November 1988 and November 1989 to 1987 levels, less an additional 20 percent discount, unless an insurer could establish that such rate levels threatened its solvency. As a result of a court challenge, the California Supreme Court ruled in May 1989 that an insurer does not have to face insolvency in order to qualify for exemption from the rollback requirements and is entitled to a "fair and reasonable return." Significant controversy has surrounded the numerous regulations proposed by the California Insurance Department, which would be used to determine whether rate rollbacks and premium refunds are required by insurers. Some of the Insurance Department's proposals were disapproved by the California Office of Administrative Law ("OAL"), which is responsible for the review and approval of such regulations. The most recent regulations proposed by the Insurance Department have not yet been reviewed by the OAL, pending a recent court challenge by various insurers to the Department's authority to issue such regulations. On February 25, 1993, the trial judge presiding over that court challenge voided substantial parts of the regulations proposed by the Insurance Department. The court held that the Insurance Department's regulations exceeded the Department's authority by setting rates based upon an across-the-board formula. The court indicated that rates and what constitutes a reasonable return would have to be determined individually for each insurer and that the Department's authority was to approve or disapprove rates proposed by insurers rather than setting rates which cannot vary from a prescribed formula. An appeal is currently pending before the California Supreme Court. During 1989, less than five percent of USF&G's total premiums were written in the State of California. USF&G believes that the returns it received, both during and since the one-year rollback period, have not exceeded the "fair and reasonable return" standard. Additionally, based on the long history of events and the significant uncertainty about the Insurance Department's regulations, management does not believe it is probable that the revenue recognized during the rollback period will be subject to a material refund. Management believes that no premium refund should be required for any period after November 8, 1988, but that any rate rollbacks and premium refunds, if ultimately required, would not have a material adverse effect on USF&G Corporation's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 1993. USF&G Corporation Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters Market and dividend information for the Corporation's common stock on page 88 of the Annual Report to Shareholders for 1993 is incorporated herein by reference. Item 6. Item 6. Selected Financial Data Selected financial data of the Corporation on pages 56 and 57 of the Annual Report to Shareholders for 1993 is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis on pages 34 through 55 of the Annual Report to Shareholders for 1993 is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The consolidated financial statements of the Corporation and notes to such financial statements on pages 58 through 82 of the Annual Report to Shareholders for 1993 are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. USF&G Corporation Part III Item 10. Item 10. Executive Officers and Directors of the Registrant Information regarding the Corporation's executive officers can be found on page 12 of this Form 10-K. Information regarding the Corporation's directors is incorporated herein by reference to the Election of Directors section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994. Item 11. Item 11. Executive Compensation See the Compensation of Executive Officers and Directors section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, which is incorporated herein by reference. To the best of the Corporation's knowledge, there were no late filings under Section 16(a) of the Securities Exchange Act of 1934. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management See the Stock Ownership of Certain Beneficial Owners, Directors and Management section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, which is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions See the Other Information-Certain Business Relationships section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, which is incorporated herein by reference. USF&G Corporation Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) Financial Statements The following consolidated financial statements of USF&G Corporation and its subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated Statement of Operations Consolidated Statement of Financial Position Consolidated Statement of Cash Flows Consolidated Statement of Shareholders' Equity Notes to Consolidated Financial Statements Report of Independent Auditors (2) Schedules The following consolidated financial statement schedules of USF&G Corporation and its subsidiaries are included in Item 14(d): Page 24 Schedule I. Summary of Investments-Other than Investments in Related Parties 25-27 Schedule III. Condensed Financial Information of Registrant 28 Schedule V. Supplementary Insurance Information 29 Schedule VI. Reinsurance 30 Schedule IX. Short-term Borrowings 31 Schedule X. Supplemental Information Concerning Consolidated Property/Casualty Insurance Operations All other schedules specified by Article 7 of Regulation S-X are not required pursuant to the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits The following exhibits are included in Item 14: Page __ Exhibit 11 Computation of Earnings Per Share __ Exhibit 12 Computation of Ratio of Consolidated Earnings to Fixed Charges and Preferred Stock Dividends A copy of all other exhibits not included with this Form 10-K may be obtained without charge upon written request to the Secretary at the address shown on page ___ of this Form 10-K. Exhibit 3A Charter of USF&G Corporation. Exhibit 3B Amended By-laws of USF&G Corporation. Incorporated by reference to Exhibit 3B, 1985 Annual Report on Form 10-K. Exhibit 4A Rights agreement dated as of September 18, 1987, between USF&G Corporation and First Chicago Trust Company of New York (successor to Morgan Shareholder's Service Trust Company) including Form of Rights Certificate. Incorporated by reference to Exhibits 1 and 2 to the Registrant's Form 8-A filed September 31, 1987, File No. 1-8233. Exhibit 4B Indenture dated as of October 15, 1986, between USF&G Corporation and Chemical Bank (Delaware). Incorporated by reference to Exhibit 4.1 to the Registrant's Form 10-Q for the quarter ended September 30, 1986, File No. 1-8233. Exhibit 4C Officer's certificate dated November 19, 1986, classifying 8 7/8% Notes of USF&G Corporation. Incorporated by reference to Exhibit 4.1 to the Registrant's Form 8-K dated November 19, 1986, File No. 1-8233. Exhibit 4D Bond issuance and payment agreement dated November 16, 1987, for Swiss Franc Public Issue of 5 1/2% Bonds 1988-1996 of Swiss Francs 120,000,000. Incorporated by reference to Exhibit 4M to the Registrant's Form 10-K for the year ended December 31, 1987, File No. 1-8233. Exhibit 4E Indenture dated as of January 28, 1994, between USF&G Corporation and Chemical Bank. Exhibit 4F Form of Note dated March 3, 1994, for Zero Coupon Convertible Subordinated Notes due 2009. Incorporated by reference to Exhibit 4 to the Registrant's Form 8-K dated March 3, 1994, File No. 1-8233. Exhibit 10A Credit Agreement dated as of March 20, 1990, as amended on April 15, 1991, among USF&G Corporation, Morgan Guaranty Trust Company of New York, and Swiss Bank Corporation as agents. Incorporated by reference to Exhibit 4F to the Registrant's Form 10-K for the year ended December 31, 1991, File No. 1-8233. Exhibit 10B Stock Option Plan of 1987. Incorporated by reference to Exhibit 4.1 to the Registrant's Form S-8 dated July 28, 1987, File No. 33-16111. Exhibit 10C Employment Agreement dated November 20, 1990, between the Registrant and Norman P. Blake, Jr. Incorporated by reference to Exhibit 10A to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10D USF&G Supplemental Executive Retirement Agreement between the Registrant and Norman P. Blake, Jr., dated November 20, 1990. Incorporated by reference to Exhibit 10B to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10E Stock Option Plan of 1990. Incorporated by reference to Exhibit 4 to the Registrant's Form S-8 Registration Statement as filed December 7, 1990, File No. 33-38113. Certified Copy of the Board Resolution adopted on December 6, 1990, amending the Stock Option Plan of 1990. Incorporated by reference to Exhibit 10G to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. USF&G Corporation Part IV Exhibit 10F Description of Management Incentive Plan. Incorporated by reference to Exhibit 10J to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10G Description of Long-Term Incentive Compensation Plan. Incorporated by reference to Exhibit 10K to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10H Stock Incentive Plan of 1991. Incorporated by reference to Exhibit 4(a) to the Registrant's Form S-8 Registration Statement as filed February 11, 1992, File No. 33-45664. Exhibit 10I Form of Stock Option Agreement used in connection with the Stock Option Plan of 1987, Stock Option Plan of 1990, and Stock Incentive Plan of 1991. Exhibit 10J 1993 Stock Plan for Non-Employee Directors. Incorporated by reference to Exhibit 10N to the Registrant's Form 10-K for the year ended December 31, 1992, File No. 1-8233. Exhibit 10K Employment Agreement dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10L Stock Option Agreement dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10M Stock Option Agreement dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10N Waiver dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10O First Amendment to USF&G Supplemental Executive Retirement Agreement between the registrant and Norman P. Blake, Jr. dated November 10, 1993. Exhibit 10P Letter dated November 19, 1992, describing Employment Arrangement between the Registrant and Gary C. Dunton. Exhibit 10Q USF&G Supplemental Retirement Plan. Exhibit 11 Computation of ratio of consolidated earnings to fixed charges and preferred stock dividends. Exhibit 12 Computation of earnings per share. Exhibit 13 1993 Annual Report to Shareholders. Exhibit 21 Subsidiaries of the registrant. Exhibit 23 Consent of independent auditors. Exhibit 28 Information from reports furnished to state insurance regulatory authorities. All other exhibits specified by Item 601 of Regulation S-K are not required pursuant to the related instructions or are inapplicable and, therefore, have been omitted. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter 1993. The registrant filed a Form 8-K on February 14, 1994, reporting under Item 5, Other Events, audited financial statements for the year ended December 31, 1993, and a related Management's Discussion and Analysis, and other related financial information. The registrant filed a Form 8-K March 3, 1994, reporting under Item 5, Other Events, related to the sale of Zero Coupon Subordinated Notes. USF&G Corporation Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. USF&G CORPORATION BY NORMAN P. BLAKE, JR. Norman P. Blake, Jr. Chairman of the Board, President, and Chief Executive Officer Dated at Baltimore, Maryland March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Principal Executive Officer: NORMAN P. BLAKE, JR. Norman P. Blake, Jr. Chairman of the Board, President, Chief Executive Officer, and Director Principal Financial and Accounting Officer: DAN L. HALE Dan L. Hale Executive Vice President and Chief Financial Officer Dated at Baltimore, Maryland March 30, 1994 Directors H. FURLONG BALDWIN ROBERT J. HURST H. Furlong Baldwin Robert J. Hurst MICHAEL J. BIRCK WILBUR G. LEWELLEN Michael J. Birck Wilbur G. Lewellen GEORGE L. BUNTING, JR. HENRY A. ROSENBERG, JR. George L. Bunting, Jr. Henry A. Rosenberg, Jr. ROBERT E. DAVIS LARRY P. SCRIGGINS Robert E. Davis Larry P. Scriggins RHODA M. DORSEY ANNE MARIE WHITTEMORE Rhoda M. Dorsey Anne Marie Whittemore DALE F. FREY GEORGE S. WILLS Dale F. Frey George S. Wills ROBERT E. GREGORY, JR. Robert E. Gregory, Jr. USF&G Corporation Schedule I. Summary of Investments - Other Than Investments in Related Parties USF&G Corporation Schedule III. Condensed Financial Information of Registrant - Statement of Financial Position (Parent Company) USF&G Corporation Schedule III. Condensed Financial Information of Registrant - Statement of Operations (Parent Company) USF&G Corporation Schedule III. Condensed Financial Information of Registrant - Statement of Cash Flows (Parent Company) Note to Condensed Financial Statements The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the 1993 Annual Report to Shareholders incorporated herein by reference. Certain amounts have been reclassified to conform to the 1993 presentation. The parent company's provision for income taxes is based on the Corporation+s consolidated federal income tax allocation policy. USF&G Corporation Schedule V. Supplementary Insurance Information USF&G Corporation Schedule VI. Reinsurance USF&G Corporation Schedule IX. Short-Term Borrowings USF&G Corporation Schedule X. Supplemental Information Concerning Consolidated Property/Casualty Insurance Operations

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1993

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ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS Everest & Jennings International Ltd. ("E&J" or the "Company") through its subsidiaries manufactures wheelchairs and other durable medical equipment while its wholly-owned subsidiary, Smith & Davis Manufacturing Company ("Smith & Davis"), manufactures homecare, nursing home and hospital beds, institutional casegoods and oxygen therapy products. The Company is one of the larger manufacturers of wheelchairs in the United States and, with its Canadian and Mexican subsidiaries, holds a material share of the North American market. The Company has three principal product groups: (i) wheelchairs, (ii) hospital beds, homecare beds, nursing home beds and furniture, and (iii) oxygen therapy and other related products. INDUSTRY OVERVIEW AND COMPANY STRATEGY All of the Company's products can be characterized as durable medical equipment. Third party reimbursement through private or government insurance programs impacts a significant component of the Company's business, and the market for and the pricing of wheelchairs, beds and oxygen concentrators is influenced by such programs. As a result, reductions or cutbacks in Medicare, state reimbursement or private insurance programs for the purchase or rental of durable medical equipment may adversely affect the Company's business. However, the Company's business is favorably impacted by medical progress in rehabilitating the seriously injured and disabled and by the demographics of longer life spans. The specific impact of potential health care reform programs to be proposed by the Clinton administration is yet to be determined. With the likely focus on homecare alternatives, however, the Company is of the opinion that reforms may be neutral or possibly beneficial to the outlook for the Company's products. The Company has continued to emphasize innovation and improvement of its power driven wheelchair products, specifically through design and reliability enhancements and ease of operation. Additionally, the Company completed its acquisition of Medical Composite Technology, Inc. ("MCT") early in 1994, with an effective date of December 31, 1993. MCT develops, designs, manufactures and markets state-of-the-art durable medical equipment, including wheelchairs and other medical mobility products and assistive devices. The acquisition of MCT will enable the Company to expand its product line into the ultra-lightweight wheelchair and related products markets. The Company has taken dramatic steps over the past several years to significantly lower its breakeven point through reductions in both operating expenses and worldwide manufacturing costs. The Company took a major step in this regard when domestic manufacturing and corporate management were consolidated by moving the principal domestic wheelchair manufacturing operation and the international corporate headquarters to Missouri from California in mid 1992. The process of lowering costs is ongoing as the Company intends to increase the outsourcing of product parts and components and consolidate its manufacturing and distribution facilities. The Company is striving to become the low cost producer with respect to all of its products, while maintaining its reputation for well- engineered, quality products. The Company is exploring the sale or other disposition of (i) the Smith & Davis hospital bed and nursing home bed and furniture business, and has retained an investment banker to advise it on the various methods and means of implementing any such sale or disposition; and (ii) Everest & Jennings de Mexico. In doing such, the Company will concentrate on its core wheelchair, homecare bed and oxygen concentrator business in Canada and the United States. BACKGROUND The Company is a Delaware corporation, formed in 1987 by the reincorporation of Everest & Jennings International, a California corporation formed in 1967 for the purpose of acquiring and holding all of the stock of Everest & Jennings, Inc. and the stock of certain subsidiary companies. Everest & Jennings, Inc., the Company's principal subsidiary, was formed in 1946 through the incorporation of a partnership originally established in 1932 by Herbert A. Everest and Harry C. Jennings, Sr. Messrs. Everest and Jennings pioneered the design and production of folding wheelchairs. The interest of Mr. Everest's family in the business was acquired by the Jennings family in 1953. The Company had its initial public offering of common stock in 1968. Its common stock was traded on the NASDAQ National Market System until 1980 when the common stock became listed on the American Stock Exchange. The Company's principal subsidiaries include Everest & Jennings, Inc. located in St. Louis, Missouri; Everest & Jennings Canadian Limited located in Toronto, Canada; Everest & Jennings de Mexico, S.A. de C.V. located in Guadalajara, Mexico; and Smith & Davis Manufacturing Company, which was acquired by the Company in 1990 and is also located in St. Louis, Missouri. Each of the Company's subsidiaries manufactures wheelchairs and wheelchair parts with the exception of Smith & Davis which manufactures homecare and hospital beds, nursing home beds and furniture, oxygen therapy products and related products. The Company owns a 30% interest in a joint venture in Indonesia. The joint venture and an affiliate of the joint venture partner supply wheelchair parts and components to the Company for assembly into finished products in the United States. WHEELCHAIRS The Company designs, manufactures and markets power and manual wheelchairs. Higher margins are achieved on power wheelchairs versus manual chairs. The Company manufactures three types of power wheelchairs - - - those that ride on a power base, direct-drive transportable power wheelchairs and traditional belt-driven power chairs. The Company's advanced power wheelchairs utilize Z-61 Servo Drive microprocessor controllers with electronic programming. These electronics provide smooth, precise control of the chair, allowing it to track straight and maintain speed on hills and uneven terrain. Additionally, each E&J power wheelchair is equipped with a caster control system that prevents caster flutter as well as full leaf automotive-type suspension forks that offer the user a comfortable ride. Current products include: - The Xcaliber(TM) -- a full featured programmable adult power wheelchair. - The Xcaliber(TM) Power Recliner -- an Xcaliber(TM) with a power actuated sliding back designed to accommodate the forces of "shear", making the wheelchair easier to operate and more comfortable for those with higher level spinal cord injuries. - Magnum(TM) -- a less featured model with performance capabilities similar to the Xcaliber(TM). - Magnum(TM) Power Recliner -- A magnum with a power actuated back (not the sliding design) for more general applications where user controlled back reclining is required. - Lancer(R) -- a modular power base which accepts four different modular seating units. - Sprint(R) -- basic adult power wheelchair, non programmable, used primarily for Medicare applications where price is the primary consideration. - Tempest(TM) -- a folding frame, transportable power wheelchair. - Pediatric Power(TM) -- a pediatric power wheelchair with adjustable seating system. - Servo Drive Specialty Controls -- alternate (to the traditional "joystick") driving devices for those with special abilities; allows interface with computers and environmental controls (lights, television, etc.); all these devices are controlled with one input or control device (including driving the wheelchair), i.e., foot control, sip n' puff, head control, etc. The Company intends to introduce a new line of modular designed power wheelchairs which will be easier and faster to manufacture and be adjustable to better accommodate user sizes and needs. The Company is continuously looking for distribution partners who make specialized rehab products and could benefit from the Company's sales and distribution system. This is a continuation of the Company's strategic plan to expand as "The Rehab Source." The Company offers a complete line of standard manual wheelchairs and lightweight wheelchairs. Everest & Jennings developed the industry standard for the basic folding wheelchair. The primary selling features of these chairs are price and durability. The Company manufactures four models for the standard manual wheelchair market. These include the Premier(TM), a customized manual wheelchair; the Universal(R), which includes a full range of options and sizes as well as models that recline; the Traveler(R), designed to fill the durable rental market; and the Vista(R), the Company's high quality, lowest priced model. The Company competes in the high strength, lightweight wheelchair market with two models -- the Premier 2 Plus(TM) and the EZ Lite(TM). The Premier 2 Plus(TM) (a newer version of the original P2(TM)) offers versatility, customization and high performance for the rehabilitation market. The EZ Lite(TM) model is a durable, economical lightweight wheelchair that offers unique adaptability characteristics, low maintenance and easy foldability for the rental market. Through the acquisition of MCT, the Company is now positioned to compete in the ultra lightweight wheelchair categories with a line of innovative, state-of-the-art products. Such chairs range from the FX(TM), a composite based wheelchair with uncoupled adjustables and unique design, to the Millenium(TM), a foldable, uniquely flexible lightweight wheelchair that offers exceptional performance while meeting strict governmental and third party reimbursement guidelines. The full range of MCT products will be marketed under the Vision(TM) family name and will initially include three rigid frame chairs and two foldable models which are currently in the prototype stage. Market Information -- Management estimates that the aggregate domestic wheelchair market approximates $500 million with the total North American market slightly larger at approximately $600 million. The Company believes it has a material share of these combined markets. Competition -- The Company, Invacare Corporation and Sunrise Medical Inc. are the primary competitors in the wheelchair business. In addition, there are a range of smaller competitors. Competition for sales of wheelchairs is intense and is based on a number of factors including quality, reliability, price, financing programs, delivery and service. The Company believes its products' quality reputation and recent technological advances are favorable factors in competing with other manufacturers. Following the relocation of its wheelchair manufacturing operations from California to Missouri, there were substantial disruptions in the delivery of power and made to order rehab products. This disruption has put the Company at a severe disadvantage with respect to its competitors. BEDS, FURNITURE AND OXYGEN CONCENTRATORS The Company's Smith & Davis subsidiary manufactures beds for the homecare market, the nursing home market and the acute care hospital market. In each product category, Smith & Davis manufactures a variety of beds, from the simple manual product to the highly sophisticated, fully electronic models, including specialized beds for the rehabilitation market and a leisure bed for the consumer market. Smith & Davis also supplies a full line of accessories consisting of items such as side rails, trapezes and IV poles. Smith & Davis also provides design services for nursing homes, manufactures casegood furniture for the nursing home and hospital markets, and manufactures oxygen concentrators. Oxygen concentrators remove nitrogen from room air, thus providing a breathable supply of air to a patient that is comprised of approximately 85% - 96% oxygen. As stated above, the Company is exploring the sale or other disposition of the Smith & Davis hospital bed and nursing home bed and furniture business, and has retained an investment banker to advise it on the various methods and means of implementing any such sale or disposition. Market Information -- Management estimates that the aggregate domestic market for Smith & Davis products is approximately $400 million. The Company believes it has a material share of the domestic homecare and nursing home bed market and a small share of the hospital bed market. The Company also believes its nursing home furniture line enjoys a material market share. The Company has a low market share in oxygen concentrators which the Company is attempting to improve with the introduction of new models. New models are being designed which provide improved operating efficiency and reliability at a reduced noise level. Competition -- The Company, Invacare Corporation, Joerns Healthcare, Inc. and Sci-O-Tech, Inc. are the largest suppliers of homecare beds to the industry. In the nursing home bed market, the Company competes with Joerns Healthcare, Inc., Omni Manufacturing, Inc., Sci-O-Tech, Inc. and Kimball International. The hospital bed market is dominated by Hill-Rom, Inc. There are over a dozen suppliers of oxygen concentrators including DeVilbiss Health Care, Inc., Airsep Corporation, Puritan-Bennett and Invacare Corporation. INTERNATIONAL OPERATIONS The Company has licensing agreements to market its products in Europe through its former Ortopedia subsidiary. The Canadian market is served through its Canadian subsidiary, while the Central and South American markets are served through Everest & Jennings de Mexico. As stated above, the Company is exploring the sale or other disposition of Everest & Jennings de Mexico. The Company has not placed great emphasis on expanding its markets in the Far East but does serve this market through various distributors. Sales in the Middle East and Australia are also conducted through various distributor agreements. Approximately 84% of the Company's total 1993 sales were denominated in United States dollars. Substantially all export sales of the Company's products manufactured in the United States are denominated in United States dollars although such sales are immaterial to consolidated revenues. SALES AND DISTRIBUTION The Company's homecare products are marketed in the United States and Canada by approximately 4,000 non-exclusive dealers and national accounts who, in turn, sell the products to consumers. The support and servicing of these dealers and national accounts are the responsibility of the Company's trained sales staff operating within the United States and Canada. The Company also uses a limited number of manufacturer's representatives and distributors in selected geographic areas and market segments as appropriate. The Company also sells directly to government agencies, such as the Department of Veterans Affairs. In Mexico, the Company's products are marketed through its own dealer network system as well as through independent non-exclusive dealers. No dealer or distributor domestically or internationally represents more than 10% of the Company's total sales. The Company's homecare sales representatives conduct training activities for the benefit of its dealers and their personnel. This training is primarily concerned with features/benefits of all of the Company's homecare products, and the training also covers the proper fitting and use of wheelchairs and related equipment. Training classes are also offered to physical and occupational therapists. Brochures, point-of-sale display materials, and similar advertising and merchandising aids are supplied to dealers. The Company advertises in trade publications and its representatives attend trade shows and similar conventions as a method of displaying product lines to doctors, therapists and others. The Company's nursing home and hospital beds and furniture sales are accomplished through various manufacturer's representative organizations located throughout the United States and Canada. The Company has a small internal sales management staff that works directly with the manufacturer's representatives and national accounts. Finished goods inventories are maintained in several warehouses strategically located throughout the United States. The Company manufactures its basic homecare products for stock and maintains inventories at such warehouses and its St. Louis distribution center for sale; however, a substantial portion of the Company's wheelchair products, hospital and nursing home beds, and nursing home furniture are built-to- order and are not inventoried. MANUFACTURING The Company's manufacturing operations, in conjunction with its quality control support, are designed to ensure that all products and services sold by the Company meet the highest level of performance and reliability in the industry. The Company's bed manufacturing operations are located in one facility, which has significant production capacity available to accommodate any reasonably foreseeable increase in sales. The Company has available manufacturing capacity for all of its products to accommodate a significant growth in revenue through its existing facilities as well as its joint venture outsourcing arrangements. RAW MATERIALS The Company purchases a variety of raw materials and components, and has entered into supply agreements to purchase certain of these items from single suppliers. The Company believes that numerous alternative supply sources are available for all such materials. PRODUCT DEVELOPMENT, ENGINEERING AND PATENTS The Company continuously seeks to improve the quality, performance and reliability of its products to enhance its competitive position in its industry and to develop new products to meet the needs of its customer base. With the acquisition of MCT, the Company acquired a development staff and has incorporated its research and development ("R&D") organization into the core R&D staff from MCT. As a result, the Everest & Jennings Technology Center has been instituted in Watsonville, California. This Center will be responsible for all product development programs for the Company. Along with the internal development program, the Company plans to actively pursue distribution agreements with companies possessing innovative products that fit the Company's areas of focus. EMPLOYEES As of March 30, 1994, the Company had 1,115 full-time and full-time equivalent employees, comprised of 724 in manufacturing, 10 in research and development, 293 in sales and customer service, and 88 in general and administrative functions. Certain employees located in Missouri, Canada and Mexico are covered by collective bargaining agreements. No employees in any other Company locations are covered by collective bargaining agreements. The Company considers its labor relations to be satisfactory. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company's operations consist of the manufacture and sale of durable medical equipment. Sales and operating earnings of this single industry segment for each of the three years ended December 31, 1993 are set forth in Note 14 to the Consolidated Financial Statements of the Company included in Item 8 of this Annual Report on Form 10-K. ITEM 2. ITEM 2. PROPERTIES The Company owns or leases manufacturing facilities located in the United States, Canada and Mexico. Each of these facilities is generally adequate for its operations and all are considered to be well maintained and in good operating condition. The Company's principal wheelchair manufacturing operations are located in a 147,000 square foot leased facility in St. Louis, Missouri. The Company's principal bed manufacturing operations are located in a 170,000 square foot owned facility in Wright City, Missouri. The Company owns approximately 416,000 square feet of building space used in its operations. In addition, approximately 399,000 square feet of building space is leased. The following is a summary of the facilities at various locations: Owned Leased ----- ------ (Square footage) Everest & Jennings, Inc.: St. Louis, Missouri -- 258,000 Other locations -- 90,000 Smith & Davis Manufacturing Co.: Wright City, Missouri 170,000 -- Other locations 115,000 20,000 Everest & Jennings Canadian Ltd.: Toronto, Canada 68,000 3,000 Other locations -- 13,000 Everest & Jennings de Mexico S.A. de C.V.: Guadalajara, Mexico 63,000 -- Other locations -- 15,000 ------- ------- 416,000 399,000 ITEM 3. ITEM 3. LEGAL PROCEEDINGS In July, 1990, a class action suit was filed by a stockholder of the Company in the United States District Court for the Central District of California. The suit is against the Company and certain of its present and former directors and officers and seeks unspecified damages for alleged non-disclosure and misrepresentation concerning the Company in violation of federal securities laws. The Company twice moved to dismiss the complaint on various grounds. After the first such motion was granted, plaintiff filed a first amended complaint, which subsequently was dismissed by order filed on September 20, 1991. Plaintiff then notified the court that it did not intend to further amend the complaint, and an order dismissing the complaint was entered in November 1991. Plaintiff filed a notice of appeal to the Court of Appeals for the Ninth Circuit on December 23, 1991. The case was briefed and oral argument heard in June, 1993. On January 18, 1994, the Ninth Circuit ordered that the plaintiff's submission be vacated pending the outcome of a petition for rehearing in another case that addresses a similar procedural issue that was argued on appeal in that case. The Company continues to believe the case is without merit and intends to contest the asserted complaints vigorously. The ultimate liability, if any, cannot be determined at this time. In December, 1992 ICF Kaiser Engineers, Inc. ("ICF Kaiser") filed a Demand for Arbitration (the "Demand") against the Company before the American Arbitration Association in Los Angeles, California. ICF Kaiser in its demand claims breach of contract between the parties for consulting and clean up work by ICF Kaiser at E&J's former facilities located at 3233 East Mission Oaks Boulevard, Camarillo, California. The Arbitration Demand is in the sum of $1.1 million. In January, 1993 an answer and counter-claim were filed on behalf of the Company. The answer denies breach of the contract and disputes the monetary claim asserted in the Demand. In the counterclaim, the Company asserts that ICF Kaiser breached the contract, above referenced, by inter alia failing to perform the services required under the Agreement in a reasonably cost effective manner and in accordance with the terms and conditions of the Agreement. In February, 1993 E&J made a payment without prejudice to ICF Kaiser in the sum of approximately $0.6 million. This payment, together with prior payments, brings the total paid to date by the Company to ICF Kaiser to approximately $0.7 million. The entirety of the charges by ICF Kaiser are disputed as unreasonable under the circumstances and the Company intends to vigorously defend its position. The Company has recorded an appropriate reserve to reflect this matter and does not consider the amount to be material to the Company's consolidated financial statements. The arbitration hearings commenced in July, 1993 and are anticipated to conclude by the end of the first quarter of 1994. A decision is anticipated in the second half of 1994. Die Cast Products, Inc. ("Die Cast Products"), a former subsidiary of the Company, has been named as a defendant in a lawsuit filed by the State of California pursuant to the Comprehensive Environmental Response, Compensation and Liability Act 42 U.S.C. 9601 et sec ("CERCLA"). The Company was originally notified of this action on December 10, 1992. The lawsuit seeks to recover response and remediation costs in connection with the release or threatened release of hazardous substances at 5619-21 Randolph Street, in the City of Commerce, California ("Randolph Street Site"). It is alleged that the Randolph Street Site was used for the treatment, storage and disposal of hazardous substances. The Company anticipates being named as a defendant as a result of its former ownership of Die Cast Products, which allegedly disposed of hazardous waste materials at the Randolph Street Site. Investigation with respect to potential liability of the Company is in the early stages. Issues to be addressed include whether the Company will be responsible for the disposals made by Die Cast Products; whether Die Cast Products actually sent hazardous waste materials to the Randolph Street Site; the nature, extent and costs of the ultimate cleanup required by the State of California; the share of that cleanup which may ultimately be allocated to Die Cast Products and/or the Company; and the extent to which insurance coverage may be available for any costs which may eventually be assigned to the Company. Remedial investigations performed on behalf of the State of California at the Randolph Street Site have disclosed soil and groundwater contamination. The Company has recorded a reserve of $1.0 million for this matter, which is included in the Consolidated Statements of Operations for 1993. In March, 1993, Everest & Jennings, Inc. ("EJI") received a notice from the United States Environmental Protection Agency ("EPA") regarding an organizational meeting of generators with respect to the Casmalia Resources Hazardous Waste Management Facility ("Casmalia Site") in Santa Barbara County, California. The EPA alleges that the Casmalia Site is an inactive hazardous waste treatment, storage and disposal facility which accepted large volumes of commercial and industrial wastes from 1973 until 1989. In late 1991, the Casmalia Site owner/operator abandoned efforts to actively pursue site permitting and closure and is currently conducting only minimal maintenance activities. The EPA estimates that the Casmalia Site's closure trust fund, approximately $10 million, is substantially insufficient to cover cleanup and closure of the site. Since August, 1992, the EPA has undertaken certain interim stabilization actions to control actual or threatened releases of hazardous substances at the Casmalia Site. The EPA is seeking cooperation from generators to assist in the cleaning up, and closing of, the Casmalia Site. EJI and 64 other entities were invited to the organizational meeting. The EPA has identified EJI as one of the larger generators of hazardous wastes transported to the Casmalia Site. EJI is a member of a manufacturers' group of potentially responsible parties which has investigated the site and proposed a remediation plan to the EPA. To reflect EJI's estimated allocation of costs thereunder, a reserve of $1.0 million has been recorded, which is included in the Consolidated Statements of Operations for 1993. In 1989, a patent infringement case was initiated against EJI and other defendants in the U.S. District Court, Central District of California. EJI prevailed at trial with a directed verdict of patent invalidity and non-infringement. The plaintiff filed an appeal with the U.S. Court of Appeals for the Federal Circuit. On March 31, 1993, the Court of Appeals vacated the District Court's decision and remanded the case for trial. Impacting the retrial of this litigation was a re- examination proceeding before the Board of Patent Appeals with respect to the subject patent. A ruling was rendered November 23, 1993 sustaining the claim of the patent which EJI has been charged with infringing. Upon the issuance of a patent re-examination certificate by the U.S. Patent Office, it is anticipated that the plaintiff will present a motion to the District Court for an early retrial of the case. EJI believes that this case is without merit and intends to contest it vigorously. The ultimate liability of EJI, if any, cannot be determined at this time. The Company and its subsidiaries are parties to other lawsuits and other proceedings arising out of the conduct of its ordinary course of business, including those relating to product liability and the sale and distribution of its products. While the results of such lawsuits and other proceedings cannot be predicted with certainty, management does not expect that the ultimate liabilities, if any, will have a material adverse effect on the consolidated financial position or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS A Special Meeting of the Company's stockholders was held on December 31, 1993 for the following purposes: (1) To ratify and approve the terms of a transaction (the "Debt Conversion Transaction") pursuant to which $75,000,000 in principal amount of indebtedness including accrued, unpaid interest owed by the Company and its wholly-owned subsidiary Everest & Jennings, Inc. ("E&J Inc.") to BIL (Far East Holdings) Limited or its affiliates (collectively "BIL") pursuant to a Debt Conversion Agreement and related documents dated as of September 30, 1993, among the Company, E&J Inc., the wholly-owned subsidiary of E&J Inc., The Jennings Investment Co. ("Jennings Investment"), and BIL, including issuance by the Company and E&J Inc. to BIL of (i) a Convertible Promissory Note -- Preferred Stock (the "Preferred Stock Note") in the aggregate principal amount of $20,000,000 dated as of September 30, 1993, and conversion of the same into shares of a new Series C Convertible Preferred Stock (to be designated by the Board of Directors), and (ii) a Convertible Promissory Note -- Common Stock (the "Common Stock Note") in the initial aggregate principal amount of $45,000,000, dated as of September 30, 1993 (to be increased to $55,000,000 after stockholder approval of the subject transactions), and conversion of the same into shares of Common Stock. The ratification and approval of the Debt Conversion Transaction was subject to the approval and adoption of the Recapitalization Proposals, as defined below. (2) To approve and adopt the following (collectively, the "Recapitalization Proposals"): (a) an amendment to the Certificate of Incorporation of the Company to increase the number of authorized shares of Common Stock from 25,000,000 to 120,000,000 (the "Common Stock Amendment"); and (b) an amendment to the Company's Certificate of Incorporation to increase the number of authorized shares of Preferred Stock from 11,000,000 to 31,000,000 (the "Preferred Stock Amendment"). The approval and adoption of the Recapitalization Proposals was subject to the ratification and approval of the Debt Conversion Transaction. The votes cast were as follows: Affirmative Votes Negative Votes Debt Conversion Transaction 10,969,256 2,990 Recapitalization Proposals 10,969,256 2,990 PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The following table sets forth the high and low closing prices of the Company's Class A and Class B Common Stock and, after November 18, 1993, single class Common Stock for each quarter in the two-year period ended December 31, 1993. The Company's single class Common Stock is listed on the American Stock Exchange under the symbol of EJ. Class A Class B Single Class Common Stock(a) Common Stock(a) Common Stock(b) ------------- ------------- ------------- High Low High Low High Low ---- ---- ---- ---- ---- ---- Fiscal year ended 12/31/93 1st Quarter 1 3/4 1 1/4 2 1 7/16 N/A N/A 2nd Quarter 2 1 3/16 1 7/8 1 5/8 N/A N/A 3rd Quarter 2 1 1/4 2 1 3/8 N/A N/A 4th Quarter 1 3/4 1 7/16 1 3/4 1 1/2 1 11/16 1 1/8 Fiscal year ended 12/31/92 1st Quarter 3 3/8 2 3 3/8 2 1/8 N/A N/A 2nd Quarter 2 1/2 1 5/8 2 5/8 2 N/A N/A 3rd Quarter 2 1/2 1 5/8 2 1/4 1 3/4 N/A N/A 4th Quarter 2 1 1/16 2 1/16 1 5/16 N/A N/A [FN] (a) Prior to November 19, 1993 (b) After November 18, 1993 As of March 30, 1994, there were approximately 211, 116 and 433 stockholders of record of Class A Common Stock, Class B Common Stock and single class Common Stock, respectively, and the closing price of the single class Common Stock was $1 3/16 on that date. No dividends on the Company's Common Stock were paid in 1993 and 1992. Management does not currently anticipate paying cash dividends on its Common Stock in the foreseeable future. The determination of future cash dividends to be declared and paid on the Common Stock, if any, will depend upon the Company's financial condition, earnings and cash flow from operations, the level of its capital expenditures, its future business prospects and other factors that the Board of Directors deems relevant. The Company is currently prohibited from paying cash dividends on its Common Stock under covenants contained in the debt agreements with its principal lenders. On March 17, 1992, the stockholders of the Company approved a proposal whereby the Class A Common Stock and the Class B Common Stock would be reclassified into the new single class of Common Stock (see Note 11 to the Consolidated Financial Statements in Item 8). The reclassification occurred at the close of business on November 18, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data below should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in Item 8 of this Annual Report on Form 10-K. The following information should not be deemed indicative of future operating results of the Company. YEAR ENDED DECEMBER 31 (c)(e) ----------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (Dollars in thousands, except per-share amounts) STATEMENT OF OPERATIONS DATA: Revenues $ 94,459 $107,115 $118,924 $209,711 $183,881 Cost of sales 76,853 80,923 80,276 154,431 135,920 ------ ------ ------ ------ ------ Gross profit 17,606 26,192 38,648 55,280 47,961 Selling expenses 36,513(a)27,195 26,075 41,876 40,137 General and administrative expenses 16,441 9,275 14,638 22,653 30,597 Restructuring expenses 15,104(b) 5,150(b)18,524(b)33,953(b)14,022(b) ------ ------ ------ ------ ------ Total operating expenses 68,058 41,620 59,237 98,482 84,756 ------ ------ ------ ------ ------ Operating loss from continuing operations (50,452) (15,428) (20,589) (43,202) (36,795) ------ ------ ------ ------ ------ Other income (expense): Interest expense, net (5,072) (4,981) (3,887) (8,870) (5,785) Earnings in European operations -- -- 1,189 -- -- Gain (loss) on sale of European operations -- (240) 6,600 -- -- ------ ------ ------ ------ ------ Other income (expense),net (5,072) (5,221) 3,902 (8,870) (5,785) Loss from continuing operations before income taxes (55,524) (20,649) (16,687) (52,072) (42,580) Income tax provisions (benefits) 173 (1,737)(f) 377 (356) (4,328) ------ ------ ------ ------ ------ Net loss from continuing operations (55,697) (18,912) (17,064) (51,716) (38,252) ------ ------ ------ ------ ------ Discontinued operations: Loss from discontinued operations -- -- -- -- (1,160) Loss on disposal of discontinued operations -- -- -- (1,410) (2,751) ------ ------ ------ ------ ------ Loss from discontinued operations -- -- -- (1,410) (3,911) ------ ------ ------ ------ ------ Net loss $(55,697)$(18,912)$(17,064) $(53,126)$(42,163) LOSS PER SHARE: From continuing operations $(5.96) $(2.07) $(1.87) $(5.65) $(4.69) From discontinued operations -- -- -- (.16) (.48) ------ ------ ------ ------ ------ $(5.96) $(2.07) $(1.87) $(5.81) $(5.17) Weighted average number of Common Shares outstanding 9,343,868 9,146,000 9,146,000 9,146,000 8,156,000 BALANCE SHEET DATA (at December 31): Total assets $57,515 $69,459 $82,921 $112,662 $154,001 Total debt $29,321 58,555 54,168 65,036 60,311 Total stockholders' equity (deficit) (7,008) (30,798) (21,453) (1,909) 43,080 CASH DISTRIBUTION PER SHARE (d): Class A Common Stock $ -- $ -- $ -- $ -- $ .05 Class B Common Stock $ -- $ -- $ -- $ -- $ .025 Single Class Common Stock $ -- N/A N/A N/A N/A [FN] (a) Includes $9,764 of in-process research and development expense related to the acquisition of Medical Composite Technology, Inc. See Note 8 -- Acquisition of the Notes to the Consolidated Financial Statements in Item 8. (b) As more fully explained in Note 2 -- Restructuring Expenses of the Notes to the Consolidated Financial Statements in Item 8, the Company recorded $15.1 as a restructuring charge in 1993 for the consolidation of manufacturing and distribution facilities in the United States and Canada and for the sale or other disposition of the Smith & Davis institutional business. The Company recorded a $5.2 million restructuring charge in 1992 to provide for additional costs associated with the consolidation of its domestic manufacturing and corporate headquarters including the closure and relocation of the Company's principal domestic wheelchair manufacturing operation and international headquarters from Camarillo, California to St. Louis, Missouri. In 1991, the Company originally recorded a restructuring charge of $18.5 million for this purpose. The Company recorded a $34.0 million charge in 1990 to provide for costs associated with restructuring its domestic operations including a provision to write down its Camarillo manufacturing facility and related machinery to net realizable value. In 1989, the Company recorded a $14.0 million provision to restructure its international operations and to provide for other restructuring charges. (c) Effective December 31, 1990, the European subsidiaries were designated as subsidiaries held for sale. Accordingly, their results of operations were consolidated in 1988 through 1990 and have been reflected on the equity method in 1991. See Note 5 -- Sale of European Operation of the Notes to the Consolidated Financial Statements in Item 8. (d) The Company ceased paying dividends on its common stock effective in the second quarter of 1989. (e) In 1991, the Company changed from the LIFO (last-in, first-out) method of valuing inventory to the FIFO (first-in, first-out) method for inventory at its Everest & Jennings, Inc. subsidiary as the Company believes that the FIFO method of accounting for such inventories results in a more appropriate presentation of financial position and results of operations. As a result of the change in accounting principle, inventories and retained earnings were increased by $4,002 in 1990 and $4,850 in 1989. The impact of the change on previously reported net loss and loss per share was $848 and $.09 in 1990 and $78 and $.01 in 1989. (f) During 1992 the Company resolved certain disputed issues with the California Franchise Tax Board for the years 1975 through 1983. As a result of agreements reached, assessments including related accrued interest in the aggregate amount of $1.8 million were withdrawn and credited to the income tax provision. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL In recent years, the Company has undergone an extensive restructuring of its operations with the objective of becoming a stronger long-term competitor in the durable medical equipment industry. The restructuring was designed to improve overall financial performance through cost reduction and the elimination of excess manufacturing capacity. Extensive asset sales were also undertaken to generate the cash necessary to partially finance restructuring activities and reduce debt levels. Credit facilities were modified or expanded as needed to partially fund the overall restructuring, in addition to contributing to the funding of the Company's operations. A major element of the restructuring was the sale in October, 1991 of the Company's former European subsidiary, Ortopedia GmbH. At the time, the Company retained a 15% interest in Ortopedia Holding GmbH, the new parent of Ortopedia GmbH. In December 1992, the Company sold its remaining 15% interest in Ortopedia Holding GmbH. On February 28, 1992, the Company announced its intention to consolidate its domestic wheelchair manufacturing operations and corporate headquarters by relocating its California-based manufacturing and corporate offices to Missouri by the end of 1992. This decision was made in light of the higher cost of manufacturing in Southern California and based on the opportunity, at that time, to further reduce costs through the consolidation of administrative and support functions with existing operations in Missouri. The relocation from California was begun in the second quarter of 1992, and, except for data operations, was largely completed by the end of 1992. In October, 1993, the Company transferred its data operations from California to Missouri, which represented the final step in the Company's relocation. As a result of the relocation, the Company experienced major start-up problems in wheelchair production due primarily to computer system failures and related parts shortages, and to manufacturing delays and inefficiencies attributable generally to the commencement of relocated manufacturing operations and specifically to the need to train a large number of new employees. These start-up problems have most severely impacted the Company's high margin power and rehab wheelchair products, and the resulting reduction in sales and cash flow hindered the Company's ability to keep vendors current and to otherwise implement corrective measures quickly and effectively. Shipment delays caused a substantial build-up in back-ordered power and rehab wheelchair products in the second half of 1992 and the first half of 1993, which the Company reduced over time. Customer confidence and frustration resulting from such delays combined to increase the order cancellation rate and to decrease the incoming order rate, particularly for the affected wheelchairs. As a result, orders and market share decreased, and manufacturing activity generally shifted disproportionately to lower margin manual and commodity wheelchairs. The foregoing problems adversely affected 1993 shipments and financial results. Management is implementing a plan that is intended to address the Company's problems with manufacturing and shipment delays. Incoming orders, product backlog and timely shipments were improved during the second half of 1993. However, order rates, margins and market share must increase and customer confidence must be restored in the very near term if the Company is to generate the cash flow necessary to fund its operations on a continuing basis and to achieve profitability. Production and delivery of all of the Company's non-wheelchair products were unaffected by the production problems that occurred in the relocation of the wheelchair manufacturing facility to St. Louis. The Company has continued to deliver non-wheelchair products in a timely manner and management believes that market share can be maintained and slightly increased in these product lines. However, the Company is exploring the sale or other disposition of the Smith & Davis hospital bed and nursing home bed and furniture business, and has retained an investment banker to advise it on the various methods and means of implementing any such sale or disposition. Through the end of the first quarter of 1994, the Company has required $3.0 million of additional financing to fund its operating requirements and accrued restructuring expenses. This additional funding has been provided to the Company by BIL, bringing the total advances under the Revolving Promissory Note to $7.8 million as of March 30, 1994, out of an available line of credit of $12.5 million. The Company expects to need additional financing at least through the end of the third quarter of 1994, and will seek to amend the Revolving Promissory Note with BIL to provide for such requirement. In the domestic market, the Company's durable medical equipment products are sold primarily through homecare and medical equipment dealers, as well as national accounts. Consumers and dealers are reimbursed through federal, state and private insurer reimbursement programs. The Company recognizes the need to counteract the impact of cutbacks in such programs on its results of operations and cash flow through the benefits of a reduced cost structure and by targeting new market segments. In the institutional bed market, while the Company has a small market share of hospital beds, it has been in the position of being the only competitor of Hill-Rom with respect to retractable hospital beds. Early in 1993, Stryker introduced a retractable hospital bed into the market. The presence of additional competition together with uncertainty in the market due to the potential impact of national health care reforms combined to put pressure on sales volume and margins with respect to the Company's retractable hospital bed products. RESULTS OF OPERATIONS REVENUES The following table sets forth the amounts and percentages of revenues geographically by area where products were manufactured (dollars in millions): 1993 1992 1991 ---- ---- ---- Amount % Amount % Amount % ------ --- ------ --- ------ --- North America $94 100 $107 100 $119 100 North American revenues in 1993 decreased $13 million, or 12%, versus 1992, primarily due to increased price competition, reduced sales of wheelchairs, and lower homecare, hospital and nursing home bed revenues. Wheelchair sales were adversely affected by competition and the factory relocation in 1992, the effects of which continued into 1993. Hospital and nursing home bed sales were adversely affected by price competition and market uncertainty associated with national health care reform. Lower homecare bed revenues reflected the impact of increased price competition. North American revenues in 1992 decreased $12 million, or 10%, versus 1991, primarily due to shipment delays and the loss of market share in the U.S. wheelchair business as a result of disruptions to production capabilities related to the relocation of the primary manufacturing facility from California to Missouri. Revenues in the bed product line increased 8% in 1992, largely due to improved market penetration for institutional products. For the periods indicated, the following table summarizes operating results of the Company (dollars in millions): Year Ended December31 ----------------------------------------- 1993 1992 1991 Amount % Amount % Amount % ------ --- ------ --- ------ --- Revenue $94.5 100 $107.1 100 $118.9 100 Cost of sales 76.9 81 80.9 75 80.3 68 ---- ---- ---- ---- ---- ---- Gross profit 17.6 19 26.2 25 38.6 32 Operating expenses 52.9 56 36.4 34 40.7 34 ---- ---- ---- ---- ---- ---- Operating loss before restructuring expense (35.3) (37) (10.2) (9) (2.1) (2) Restructuring expense 15.1 16 5.2 5 18.5 15 ---- ---- ---- ---- ---- ---- Operating loss $(50.4) (53) $(15.4) (14) $(20.6) (17) Interest expense, BIL (2.6) 3 (2.3) (2) (1.1) (1) Interest expense, other (2.5) 3 (2.7) (3) (2.8) (2) Earnings in European operations -- -- -- -- 1.2 -- Gain (loss) on sale of European operations -- -- (0.2) -- 6.6 6 ---- ---- ---- ---- ---- ---- Loss before income taxes $(55.5) (59) $(20.6) (19) $(16.7) (14) Income tax provisions (benefits) .2 -- (1.7) (1) 0.4 -- ---- ---- ---- ---- ---- ---- Net loss $(55.7) (59) $(18.9) (18) $(17.1) (14) 1993 VERSUS 1992 1993 revenues decreased $12.6 million or 12% to $94.5 million from $107.1 million in 1992. Wheelchair and accessory sales of $61.8 million in 1993 decreased $3.6 million or 6% from 1992. The relocation of the Company's primary domestic manufacturing facility from Camarillo, California to St. Louis, Missouri and the related production and delivery problems and declining orders have negatively affected sales since mid- 1992. Shipments during the fourth quarter of 1993 were further negatively impacted by complications arising out of a major computer system implementation which occurred in October, 1993. The majority of the problems associated with the computer system conversion have since been rectified. The domestic wheelchair order rate demonstrated improvement during the third and fourth quarters of 1993. Sales of Smith & Davis homecare beds in 1993 decreased $0.2 million or 2% from 1992; sales of institutional beds and accessories in 1993 decreased $6.7 million or 28% from 1992, for an aggregate decrease in bed and accessory sales of $6.9 million for 1993 or 19% from the prior year. In management's opinion, the decrease in Smith & Davis' institutional bed and related equipment sales as compared to 1992 was representative of conditions in the institutional durable medical equipment market as a whole. 1993 sales of Smith & Davis oxygen concentrators and other products decreased $2.1 million or 38% compared to the prior year due principally to a reduction in purchases by the largest oxygen concentrator customer. Total Company gross profit decreased $8.6 million or 33% from $26.2 million in 1992 to $17.6 million in 1993. The decrease in gross profit reflected the decrease in sales, manufacturing inefficiency experienced in the wheelchair operations, and continued price competition in the markets for the Company's wheelchairs, bed and oxygen concentrator products. Gross profit was also adversely affected by a $1.0 million charge to reserves for excess and obsolete inventory, which arose due to the Company discontinuing certain wheelchair models. As a percentage of sales, gross profit decreased from 25% in 1992 to 19% in 1993. This decrease reflects increased price competition and production problems experienced since mid- 1992. Operating expenses increased $16.5 million from $36.4 million in 1992 to $52.9 million in 1993. This increase is primarily due to a $9.7 million charge relating to in-process research and development expenses (selling expenses) recorded pursuant to the Company's acquisition of Medical Composite Technology, Inc., a $2.0 million charge recorded during 1993 for anticipated costs of environmental remediation, and a $2.4 million charge recorded during 1993 for severance obligations. Restructuring expenses recorded during 1993 of $15.1 million primarily relate to losses anticipated on the disposition of the Company's institutional bed business which is expected to occur during 1994. Interest expense increased to $5.1 million in 1993 from $5.0 million in 1992 due to increased borrowings during 1993. Such borrowings were substantially reduced due to the fourth quarter conversion of $75 million of debt, includingaccrued interest to equity. See Note 6 -- Debt Restructuring and Conversion of the Notes to the Consolidated Financial Statements. During January, 1993, the Company adopted the provisions of SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"). The adoption of SFAS 109 did not have an impact on the consolidated financial statements. The income tax benefits of $1.8 million in 1992 reflected the settlement of certain disputed items with the California Franchise Tax Board. 1992 VERSUS 1991 1992 revenues of $107.1 million decreased $11.8 million or 10% from 1991, largely as a result of wheelchair operations, which were negatively impacted by the relocation of the Company's primary domestic manufacturing facility from Camarillo, California to St. Louis, Missouri. The impact was focused almost exclusively on the third and fourth quarter revenues after the commencement of the physical relocation. The process of moving complex manufacturing operations across the country and restarting with a largely new workforce resulted in disruptions to normal manufacturing throughput with corresponding delays in customer shipments and revenue recognition. Relocation-related inventory imbalances caused by computer system failures and inadequate training of new employees also contributed to manufacturing shortfalls. At the same time, 1992 incoming orders for wheelchair products were largely equivalent to 1991, resulting in increasing order backlogs. As a result of the shipment delays, however, the Company experienced an increasing rate of order cancellations in the third and fourth quarters of 1992. Such cancellations had a material adverse impact on the Company's 1992 financial performance. Sales of Smith & Davis bed products in 1992 improved 8% over 1991 due to improved penetration in the institutional market. Homecare product sales were largely flat year to year due to intense price competition. 1992 revenues in the Everest & Jennings' Canadian and Mexican subsidiaries were down 6% from 1991 due to a 5% unfavorable Canadian exchange rate change and the non-recurrence of $.9 million of export orders in Canadian operations. Total Company gross profit decreased $12.4 million from $38.6 million in 1991 to $26.2 million in 1992. As a percentage of sales, gross profit decreased from 32% in 1991 to 25% in 1992. The decrease in gross profit reflected the decrease in sales plus continued price competition in the markets for the Company's wheelchair, homecare bed and oxygen concentrator products. Wheelchair profitability was also impacted by a shift of the Company's product mix to lower margin wheelchair products as a result of the relocation. Shipment delays occurred largely in custom and rehabilitation wheelchair products due to their greater complexity, larger number of components which were subject to inventory imbalances, and longer training time for new employees before normal production levels were reestablished. Gross profit in Smith & Davis was also adversely affected by a $0.7 million charge to write-off surplus and obsolete inventory. Operating expenses decreased $4.3 million or 11% from $40.7 million in 1991 to $36.4 million in 1992 due to lower depreciation, staffing expenses, taxes, insurance, professional fees and contracted services in general and administrative expenses resulting from the Company's consolidation of corporate, Everest & Jennings Inc. and Smith & Davis functions in St. Louis. 1991 operating expenses also included a $1.5 million charge to write down the Camarillo facility to its estimated net realizable value. In 1992, the Company recorded restructuring charges of $5.2 million to reflect increased costs for startup inefficiencies, facilities and staff duplication and additional provision for physical inventory losses associated with the relocation of the wheelchair manufacturing facility and corporate headquarters to Missouri. An initial restructuring charge of $18.5 million was recorded in 1991 in connection with the relocation to Missouri. Interest expense of $5.0 million in 1992 increased 28% from 1991 as a result of the accrual of $1.3 million of interest recorded as the Company was not able to reduce the balance of a certain indebtedness below $13 million by March 31, 1993 (see Note 7 -- Debt of the Notes to the Consolidated Financial Statements in Item 8). Net other income and expenses declined from $7.8 million income in 1991 which included a $6.6 million gain from the sale of 85% of Ortopedia and $1.2 income from European operations sold in October, 1991 to a $0.2 million expense in 1992 which reflected a loss on the disposition of the remaining 15% interest in Ortopedia. The 1992 income tax benefit of $1.8 million reflected the settlement of certain disputed items for the years 1975 - 1983 with the California Franchise Tax Board. LIQUIDITY AND CAPITAL RESOURCES The Company's primary sources of liquidity are cash provided from operations, borrowings and cash on hand. At December 31, 1993, the Company had $1.87 million in cash or $1.77 million more than the $0.1 million in cash at December 31, 1992. At December 31, 1993, total debt of $29.3 million was $29.3 million lower than the $58.6 million in debt at December 31, 1992. The decrease was due to the effect of the Debt Conversion Transaction whereby $75 million of indebtedness, including accrued interest, was converted to $55 million of Common Stock and $20 million of Series C Preferred Stock. Prior to the Debt Conversion Transaction, the indebtedness had increased during 1993 due to advances from BIL in the amount of $37.8 million, which were used to fund operating losses and previously accrued restructuring expenses and to repay $5.7 million to HSBC. On September 30, 1992 the Company entered into a $20 million Revolving Credit Agreement with HSBC. Proceeds from this credit facility were used to repay $11 million of existing Interim Loans, to fund restructuring expenses, to replace existing letters of credit and for working capital purposes. The repayment of this facility was guaranteed by Brierley Investments Limited, an affiliate of BIL. The facility would not have been made available to the Company without such guaranty. According to its original terms, the total amount available under the facility was to reduce from $20 million to $15 million on March 31, 1993. Pursuant to an amendment dated as of March 30, 1993, HSBC agreed to maintain the total amount available under the facility at $20 million through the expiration date of the facility, September 30, 1993. In September, 1993, the outstanding HSBC loan balance of $5.7 million was repaid utilizing a cash advance provided by BIL under the Revolving Promissory Note (see Note 6 -- Debt Restructuring and Conversion, and Note 7 -- Debt of the Notes to the Consolidated Financial Statements). Furthermore, as of September 30, 1993, HSBC and E&J Inc. agreed to amend the Revolving Credit Agreement and extend its term for approximately one year. The HSBC facility, as amended, provides to E&J Inc. up to $6 million letter of credit availability and up to $10 million of cash advances. On October 8, 1993, E&J Inc. repaid the $10 million loan from Mercantile Bank by utilizing $10 million of cash advances from the HSBC facility. The Mercantile Bank loan was collateralized by a $10 million letter of credit issued by HSBC as part of the original $20 million credit facility. On October 9, 1992, the Company repaid $8.1 million of the Bank Loan and $3.0 million of the Amended 10.5% Note indebtedness with the proceeds from the sale of the Camarillo property. Additionally, on October 14, 1992, the Company repaid $11 million of the 1992 Interim Loans with a portion of the proceeds from the $20 million HSBC credit facility. However, the Company was unable to repay $4.0 million of the 1992 Interim Loans. Such Interim Loans were due and payable on the date that the Company closed the HSBC credit facility. Also, the Company was unable to repay the remaining $14.6 million balance on the Bank Loan as required by March 31, 1993 or reduce the balance below $13 million to obtain interest forgiveness. Accordingly, during 1992 and the first nine months of 1993, the Company accrued interest in the aggregate amount of approximately $1.3 million and $0.8 million, respectively, on the Bank Loan. At December 31, 1993 and December 31, 1992, under the debt agreements with BIL and HSBC, the Company was obligated to repay the following amounts at the various dates listed below. 12/31/93 12/31/92 Balance Balance Debt Agreement $ Millions $ Millions Repayment Date -------------- ---------- ---------- -------------- Bank Loan $ -- $14.6 September 30, 1993 FASB 15 Adjustment -- (0.2) ----- ----- Subtotal -- 14.4 Amended 10.5% Note -- 0.9 September 30, 1993 Interim Loans (1992 Advances -- 4.0 September 30, 1993 through 9/11/92) Interim Loans (1992 Advances -- 10.0 September 30, 1993 9/12/92 through 12/31/92) ----- ----- Subtotal Due BIL -- 29.3 Accrued, unpaid interest due BIL -- 2.3 Same dates as the corresponding debt agreements Revolving Promissory Note 4.8(1) -- Revolving Promissory Note matures June 30, HSBC Revolving Credit Agreement(2) 10.0 5.1 September 30, 1994 Mercantile Bank -- 10.0 October 8, 1993 Accrued, unpaid interest due BIL .2 -- ----- ----- TOTAL $15.0 $46.7 [FN] (1)Effective September 30, 1993, the debt to BIL was restructured by the Company issuing the following notes: 9/30/93 Balance 12/31/93 Balance $ millions $ millions --------------- ---------------- Common Stock Note 45.0 $ -- Preferred Stock Note 20.0 -- Revolving Promissory Note 6.8 4.8 ---- ---- TOTAL $71.8 $4.8 The balance of the Revolving Promissory Note increased to $14.8 million in the fourth quarter of 1993, and $10 million was transferred to the Common Stock Note. The Common Stock Note and the Preferred Stock Note were each converted into Common Stock and Series C Preferred Stock, respectively, as of December 31, 1993. (2) Excludes approximately $3.7 million and $4.9 million committed with respect to outstanding letters of credit at December 31, 1993 and December 31, 1992, respectively. As of September 30, 1993, the Company entered into the Debt Conversion Agreement with BIL whereby $65 million of the indebtedness represented by the Converted BIL Debt (i.e., the Bank Loan, the Amended 10.5% Note and the Interim Loans) was restructured by the issuance of the Common Stock Note and the Preferred Stock Note. The balance of the BIL indebtedness ($6.8 million) which was not converted into the Common Stock Note and the Preferred Stock Note was treated as advances under the Revolving Promissory Note. See Note 6 -- Debt Restructuring and Conversion of the Notes to the Consolidated Financial Statements in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS To The Board of Directors and Stockholders of Everest & Jennings International Ltd. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders' equity (deficit) and of cash flows present fairly, in all material respects, the financial position of Everest & Jennings International Ltd. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for the three years ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts of disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion expressed above. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. As discussed in Note 15 to the consolidated financial statements, the Company is a defendant in a class action lawsuit alleging federal securities laws violations. The suit had previously been dismissed; however, the matter is currently under appeal with the final resolution pending. The ultimate outcome of the lawsuit cannot presently be determined. (PRICE WATERHOUSE) PRICE WATERHOUSE St. Louis, Missouri March 21, 1994 CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands except per-share data) Year Ended December 31 ---------------------- 1993 1992 1991 ---- ---- ---- Revenues $94,459 $107,115 $118,924 Cost of sales 76,853 80,923 80,276 ------- ------- ------- Gross profit 17,606 26,192 38,648 ------- ------- ------- Selling expenses 25,749 26,028 24,868 General and administrative expenses 16,441 9,275 14,638 Research & development expenses (Note 8) 10,764 1,167 1,207 Restructuring expenses (Note 2) 15,104 5,150 18,524 ------- ------- ------- Total operating expenses 68,058 41,620 59,237 ------- ------- ------- Operating loss from continuing operations (50,452) (15,428) (20,589) ------- ------- ------- Other income (expense): Interest expense, BIL (Note 7) (2,585) (2,272) (1,096) Interest expense, other (2,487) (2,709) (2,791) Earnings in European operations (Note 5) -- -- 1,189 Gain (loss) on sale of European operations (Note 5) -- (240) 6,600 ------- ------- ------- Other income (expense), net (5,072) (5,221) 3,902 ------- ------- ------- Loss from continuing operations before income taxes (55,524) (20,649) (16,687) Income tax provisions (benefits) (Note 9) 173 (1,737) 377 ------- ------- ------- Net loss $(55,697) $(18,912) $(17,064) Loss per share $(5.96) $(2.07) $(1.87) Weighted average number of Common Shares outstanding 9,343,868 9,146,000 9,146,000 The accompanying Notes are an integral part of these Consolidated Financial Statements CONSOLIDATED BALANCE SHEETS (Dollars in thousands) ASSETS 12/31/93 12/31/92 -------- -------- CURRENT ASSETS: Cash and cash equivalents $ 1,872 $ 145 Accounts receivable, less allowance for doubtful accounts of $1,506 in 1993 and $3,505 in 1992 (Note 4) 12,977 20,000 Inventories (Notes 4 and 10) 15,289 24,631 Assets held for sale (Notes 1 and 4) 17,309 67 Other current assets 1,494 4,129 ------ ------ Total current assets 48,941 48,972 ------ ------ PROPERTY, PLANT AND EQUIPMENT (Note 4): Land 150 442 Buildings and improvements 3,597 6,677 Machinery and equipment 12,410 16,112 ------ ------ 16,157 23,231 Less accumulated depreciation and amortization (9,105) (11,848) ------ ------ Property, plant and equipment, net 7,052 11,383 INTANGIBLE ASSETS, NET (Note 3) 1,007 6,696 OTHER ASSETS 515 2,408 ------ ------ TOTAL ASSETS $57,515 $69,459 The accompanying Notes are an integral part of these Consolidated Financial Statements CONSOLIDATED BALANCE SHEETS (Dollars in thousands except per-share data) LIABILITIES AND STOCKHOLDERS' DEFICIT 12/31/93 12/31/92 -------- -------- CURRENT LIABILITIES: Short-term borrowings and current installments of long-term debt of $1,562 in 1993 and $1,637 in 1992 (Note 7) $20,897 $25,912 Short-term borrowings from BIL (Note 7) -- 29,292 Accounts payable 8,099 16,782 Accrued payroll costs 9,360 7,624 Accrued interest, BIL (Note 7) 185 2,278 Accrued expenses 10,863 8,361 Accrued restructuring expenses (Notes 1 and 2) 6,292 6,047 ------ ------ Total current liabilities 55,696 96,296 ------ ------ LONG-TERM DEBT, NET OF CURRENT PORTION (Note 7) 3,622 3,351 LONG-TERM BORROWINGS FROM BIL (Note 7) 4,802 -- OTHER LONG-TERM LIABILITIES 403 610 COMMITMENTS AND CONTINGENCIES (Note 15) STOCKHOLDERS' DEFICIT (Notes 6 and 11): Series A Convertible Preferred Stock 11,089 10,174 Series B Convertible Preferred Stock 1,317 1,317 Series C Convertible Preferred Stock 20,000 -- Single Class Common Stock, par value: $.01; authorized 120,000,000 shares 722 -- Class A Common Stock, par value: $.01; authorized 10,000,000 shares -- 68 Class B Common Stock, convertible, par value: $.01; authorized 10,000,000 shares -- 24 Additional paid-in capital 105,578 43,708 Accumulated deficit (142,449) (85,585) Minimum pension liability adjustment (2,606) -- Cumulative translation adjustments (659) (504) ------ ------ Total stockholders' deficit (7,008) (30,798) ------ ------ TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT $57,515 $69,459 The accompanying Notes are an integral part of these Consolidated Financial Statements CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Year Ended December 31 ---------------------- 1993 1992 1991 ---- ---- ---- Cash flows from operating activities: Net loss $(55,697) $(18,912) $(17,064) Adjustments to reconcile net loss to cash used in operating activities: Depreciation and amortization 2,637 2,736 4,235 Loss recognized as in-process R&D on MCT acquisition 9,764 -- -- Restructuring expenses (Note 2): Reserve on disposition of Smith & Davis institutional business 13,000 -- -- Write-down in value of certain accounts receivable, inventories and other assets -- -- 750 Write-down in value of certain properties and equipment -- -- 5,552 Net increase (decrease) in certain accrued expenses 245 (8,048) 12,222 Write-down of certain properties -- -- 1,500 Loss (gain) on sale of certain fixed assets -- 356 (206) Loss (gain) on sale of European operations (Note 5) -- 240 (6,600) Loss on sale of assets held for sale -- 127 -- Changes in operating assets and liabilities net of effects of the 1993 MCT acquisition (Note 8): Accounts receivable (1,652) 1,245 3,128 Inventories 2,336 (507) 6 Accounts payable (9,268) (709) (2,647) Accrued interest, BIL 2,409 1,820 (1,004) Accrued expenses 1,421 (2,623) (7,530) Other, net 817 (759) 269 ------ ------ ------ Cash used in operating activities (33,988) (25,034) (7,389) ------ ------ ------ Cash flows from investing activities: Capital expenditures (955) (3,364) (1,390) MCT acquisition, net of cash acquired (1,833) -- -- Proceeds from sale of European operations, net of expenses and settlement of intercompany accounts (Note 5) -- 1,544 16,713 Proceeds from sale of assets held for sale -- 12,633 -- Proceeds from sale of certain fixed assets -- 38 2,643 ------ ------ ------ Cash provided by (used in) investing activities (2,788) 10,851 17,966 ------ ------ ------ Cash flows from financing activities: Advances from BIL (Note 7) 45,795 24,000 -- Repayments to BIL (Note 7) -- (22,082) (3,000) Repayment of Bank Loan (Note 7) -- -- (8,344) Costs pertaining to equity conversion (500) -- -- Other borrowings of short-term and long-term debt, net (6,326) 11,479 3,812 Changes in other long-term liabilities (311) (66) (2,328) ------ ------ ------ Cash provided by (used in) financing activities 38,658 13,331 (9,860) ------ ------ ------ Effect of exchange rate changes on cash flows (155) (135) (27) ------ ------ ------ Increase (decrease) in cash balance 1,727 (987) 690 Cash and cash equivalents at beginning of year 145 1,132 442 ------ ------ ------ Cash and cash equivalents at end of year $1,872 $ 145 $1,132 Supplemental cash flow information: Cash paid for interest $2,611 $2,128 $1,951 Cash paid for income taxes 164 55 36 Supplemental information for noncash financing and investing activities: As of March 17, 1992, $9,797 of debt and accrued interest was converted by BIL into 5,850,380 shares of Series A Convertible Preferred Stock. Effective as of December 31, 1993, the Common Stock Note in the principal amount of $55,000 was converted into 55,000,000 shares of Common Stock and the Preferred Stock Note in the principal amount of $20,000 was converted into 20,000,000 shares of Series C Convertible Preferred Stock. In accordance with SFAS No. 87, the Company has recorded an additional minimum pension liability for underfunded plans of $2,606 at December 31, 1993 (Note 12). During 1993, the Company entered into new capital lease agreements of $2,465 for the new computer and phone system. The accompanying Notes are an integral part of these Consolidated Financial Statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands except per-share data) NOTE 1 -- CORPORATE RESTRUCTURING Since 1989 the Company has incurred substantial financial losses in a continuing effort to restructure its operations with the objective of becoming a stronger long-term competitor in the durable medical equipment industry. Restructuring activities to date have included asset sales, significant reductions in headcount, salaries and fringe benefits, plant closures and consolidations, product line rationalization, debt to equity conversion and outsourcing of manufacturing operations. In 1992 the Company relocated its corporate headquarters and principal wheelchair manufacturing operations from Camarillo, California to St. Louis, Missouri. The relocation facilitated the consolidation of corporate offices and other key administrative, sales/marketing, and technical functions with existing Company operations in the St. Louis area. In October, 1993, the Company transferred its data operations from California to Missouri, which represented the final step in the Company's relocation. In addition to the foregoing, the Company is pursuing the sale or other disposition of the Smith & Davis institutional business and Everest & Jennings de Mexico. At January 1, 1992, the Company owed Security Pacific National Bank (the "Bank") approximately $22.7 million ("Bank Loan") under a First Amended and Restated Credit Agreement (the "Agreement") dated August 30, 1991. In order to facilitate the relocation process to Missouri, on February 21, 1992, BIL (Far East Holdings) Limited ("BIL"), currently the Company's majority stockholder, acquired all of the Bank's rights ("Bank Interest") in the Agreement. In connection with the acquisition by BIL of the Bank Interest, BIL agreed (a) to permit the Company to consolidate its U.S. manufacturing facilities, corporate headquarters and administrative functions in St. Louis, Missouri, (b) to permit the Company to borrow additional funds and to obtain letters of credit from a lender other than BIL as necessary for consolidation and for working capital, and (c) to release or subordinate its security interests under the Agreement to allow the Company to obtain financing from a third party lender for working capital and to effect and facilitate the consolidation of operations and corporate headquarters in St. Louis, Missouri. In anticipation of the Company receiving additional financing from a third party lender, BIL advanced the Company $18 million through October 1, 1992. These funds were used by the Company to finance, in part, the relocation and the restructuring as well as for working capital purposes. On September 30, 1992, the Company finalized a $20 million revolving credit facility with The Hongkong and Shanghai Banking Corporation ("HSBC"). The repayment of the HSBC facility has been guaranteed by Brierley Investments Limited, an affiliate of BIL. From the proceeds of the HSBC facility, $11 million was utilized to repay advances (described in the preceding paragraph) made by BIL during the second and third quarters of 1992. The remaining proceeds were used to fund restructuring expenses, to replace existing letters of credit and for working capital purposes. BIL has provided the Company with additional funding beyond the amounts available under the HSBC credit line. In November and December, 1992, BIL advanced an additional $7 million for operating needs for the restructuring, bringing the total BIL advances outstanding on December 31, 1992 to $14 million. During the first three quarters of 1993, BIL advanced $37.8 million to the Company to fund operating losses, previously accrued restructuring charges and to pay down the HSBC Revolving Credit Agreement. As of September 30, 1993, the Company and BIL entered into a Debt Conversion Agreement, which provided, in part, for the conversion of $75,000,000 of short-term indebtedness, including accrued interest, into equity. See Note 6 -- Debt Restructuring and Conversion. From October 1, 1993 to December 31, 1993, BIL advanced $8 million to the Company to fund operating losses and previously accrued restructuring charges. See Note 7 -- Debt for details as to the Company's indebtedness to BIL and other lenders. The accompanying consolidated financial statements have been prepared under the going concern concept. The going concern concept anticipates an entity will continue in its present form and, accordingly, uses the historical cost basis to prepare financial statements. The Company has incurred substantial restructuring expenses and recurring operating losses and has a net capital deficiency at December 31, 1993. No assurance can be made that the Company will successfully emerge from or complete its restructuring activities. NOTE 2 -- RESTRUCTURING EXPENSES Fiscal 1993 During the fourth quarter of 1993, the Company recorded $15.1 million in connection with the consolidation of manufacturing and distribution facilities in the United States and Canada ($2.1 million) and the sale or other disposition of the Smith & Davis institutional business ($13 million). The charge with respect to the manufacturing and distribution facilities primarily relates to the termination of various facilities leases. The amount recorded for the sale or other disposition of Smith & Davis is as follows: Reduction of assets to estimated net realizable values $10,030 Estimated operating losses during phase-out period 1,240 Disposal costs, including transaction costs 1,730 ------- $13,000 The reduction of assets to estimated net realizable value is mainly attributable to intangible assets and property, plant and equipment. During 1993, the Company determined to explore the sale or other disposition of (i) the Smith & Davis hospital bed and nursing home bed and furniture business, and (ii) Everest & Jennings de Mexico. The Company has prepared estimates of the net realizable value of related assets to be sold (see Note 4 -- Assets Held for Sale) and other costs directly associated with the decision to dispose of such business along with expected operating losses to be incurred until the businesses are sold or otherwise disposed. Fiscal 1992 During 1992 the Company recorded additional charges of $5.2 million in connection with the restructuring and relocation process. This charge was related and incremental to the $18.5 million recorded in 1991 and described below. It reflected higher than originally anticipated costs primarily in the areas of 1) duplication of employees and facilities in both California and Missouri during the relocation process; 2) production inefficiencies in California operations due to the loss of skilled employees after the relocation announcement and the subsequent hiring of temporary employees as replacements; 3) production and startup inefficiencies in the St. Louis facility due to the large number of new and temporary employees hired and trained; 4) interest expense of $0.5 million on incremental borrowings required to finance the relocation and related inventory buildup; and 5) provision for potential scrap and physical inventory losses related to the relocation. A portion of the original restructuring reserve not utilized for other purposes was also allocated to provide for the termination of the contracts between the Company and certain independent manufacturer's representative organizations pursuant to which those organizations solicited orders for the Company's products in the United States. Fiscal 1991 In 1991, the Company announced that it would be consolidating its U.S. manufacturing operations and Corporate headquarters in St. Louis, Missouri. This decision was made in response to the higher cost of manufacturing in Southern California and to take advantage of synergies with its existing Missouri based operations. The charge of approximately $18.5 million relating to this decision provided for severance or relocation expenses for nearly 450 employees, costs to relocate certain inventory and equipment, costs associated with the writedown to estimated net realizable value of machinery and equipment that was not expected to be moved to St. Louis, and for other miscellaneous costs associated with restructuring. In 1991, the Company also provided $1.5 million for additional loss relating to the sale of its Camarillo, California property. This amount was recorded in general and administrative expenses. NOTE 3 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. CASH AND CASH EQUIVALENTS: The Company considers all highly liquid short- term investments with maturities of three months or less to be cash equivalents and, therefore, includes such investments as cash and cash equivalents in its consolidated financial statements. VALUATION OF INVENTORIES: Inventories are stated at the lower of cost, determined by the first-in, first-out (FIFO) method, or market. Inventory costs consist of material cost, labor cost and manufacturing overhead. PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment are carried at cost except for certain assets which have been written down in value in anticipation of lower utilization in future periods (see Note 2 -- Restructuring Expenses). Provisions for depreciation and amortization are determined using the straight-line method based upon the estimated useful life of the asset. Leasehold improvements are amortized over the life of the related lease. INVESTMENT IN JOINT VENTURE: On August 15, 1990, the Company entered into a joint venture agreement with an Indonesian company. The Company contributed fixed assets valued at $300 to the joint venture in exchange for 30% of the joint venture's outstanding common stock. The Company accounts for this investment under the equity method. Due to continued losses experienced by the joint venture, the Company wrote off the remaining investment balance in 1993. EXCESS OF INVESTMENT OVER NET ASSETS ACQUIRED: At December 31, 1993, Intangible assets, net, includes primarily the excess of cost over net assets acquired (goodwill) of Medical Composite Technology, Inc. which will be amortized using the straight-line method over a period of three years. At December 31, 1992, the balance was primarily comprised of the goodwill related to the acquisition of Smith & Davis Manufacturing Company, which was being amortized over 30 years. Due to the Company's decision to dispose of Smith & Davis, the unamortized balance was written-off at December 31, 1993. Balances outstanding at the end of 1993 and 1992 were $900 and $6,696, respectively, net of amortization of $750 in 1992. INCOME TAXES: As of January 1, 1993, the Company adopted SFAS 109, "Accounting for Income Taxes". SFAS 109 utilizes an asset and liability approach in accounting for income taxes and requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's consolidated financial statements or tax returns. Since it is unlikely that the Company will realize the future tax benefits of the deferred tax asset due to its substantial net operating losses, a valuation allowance was established for the full amount and thus the adoption of SFAS 109 had no impact on the consolidated financial statements of the Company. LOSS PER SHARE: Loss per share for each of the years in the three-year period ended December 31, 1993 is calculated based on the weighted average number of the combined shares of both Class A and Class B Common Stock during the periods, and the weighted average number of shares of single class Common Stock after November 18, 1993. CONCENTRATION OF CREDIT RISK: The Company sells its products to customers in the healthcare industry, primarily in North America. Concentration of credit risk with respect to trade receivables is limited due to the size of the customer base and its dispersion. The Company performs on-going credit evaluations of its customers and generally does not require collateral. The Company maintains reserves for potential credit losses and such losses have been within management's expectations. FOREIGN CURRENCY TRANSLATION: The financial statements of the Company's foreign subsidiaries are translated into U.S. dollars in accordance with the provisions of SFAS No. 52, "Foreign Currency Translation." Assets and liabilities are translated at year-end exchange rates. Revenues and expenses are translated at the average exchange rate for each year. The resulting translation adjustments for each year are recorded as a separate component of stockholders' equity. All foreign currency transaction gains and losses are included in the determination of income and are not significant. CHANGE IN FISCAL YEAR END: The Company elected in December 1992 to change its fiscal year end from the period ending Sunday nearest December 31 to a calendar year end. RECLASSIFICATION: Certain reclassifications have been made to prior period consolidated financial statements to conform with current period presentation. The reclassifications have no effect on net loss as previously reported. NOTE 4 -- ASSETS HELD FOR SALE Net assets held for sale for the disposition of Smith & Davis consist of the following at December 31, 1993, and are stated at net realizable values: Smith & Davis: Accounts receivable $ 7,699 Inventories 6,146 Land and buildings 1,490 Machinery & equipment 1,100 Other assets 196 ______ 16,631 Everest & Jennings de Mexico: Net assets 678 ______ Total assets held for sale $17,309 Combined revenues and net loss from continuing operations (unaudited) for Smith & Davis and Everest & Jennings de Mexico for the year ended December 31, 1993 were $38,227 and $(23,909), respectively. NOTE 5 -- SALE OF EUROPEAN OPERATION On October 4, 1991, the Company sold 85% of its wholly owned German subsidiary, Ortopedia GmbH, for approximately $19.6 million, while retaining a 15% interest in Ortopedia Holding GmbH, the new parent of Ortopedia GmbH. Under the sale agreement, the Company received an option to purchase an additional 5% of Ortopedia under certain circumstances. As a result of the transaction, the Company recorded a $6.6 million gain in 1991. Cash proceeds from the sale were used to reduce $8.3 million of the Company's indebtedness to the Bank, and to reduce $3 million of indebtedness to BIL with the balance used to pay closing costs and to fund working capital requirements. The Company's remaining interest in Ortopedia GmbH was accounted for using the cost method. In 1992 the Company sold its remaining 15% interest in Ortopedia Holding GmbH for $1.5 million, at a loss of $240. These proceeds were used for general working capital purposes. NOTE 6 -- DEBT RESTRUCTURING AND CONVERSION As of September 30, 1993, the Company, Everest & Jennings, Inc. ("E&J Inc."), Jennings Investment Co. and BIL entered into a Debt Conversion Agreement to provide for the conversion (the "Debt Conversion Transaction") of approximately $75 million in principal and accrued, unpaid interest (the "Converted BIL Debt"), owed by the Company and E&J Inc. to BIL pursuant to the Agreement (as defined in Note 7), the Amended 10.5% Note (as defined in Note 7), and the Interim Loans (as defined in Note 7). Pursuant to the Debt Conversion Agreement, (a) the Company and E&J Inc. issued to BIL a Convertible Promissory Note -- Common Stock (the "Common Stock Note") in the initial principal amount of $45 million and a Convertible Promissory Note -- Preferred Stock (the "Preferred Stock Note") in the original principal amount of $20 million; (b) BIL agreed to lend to E&J Inc. $5.7 million to allow E&J Inc. to repay the outstanding balance of cash advances owed by E&J Inc. to HSBC under the terms of a Revolving Credit Agreement dated as of September 30, 1992, as amended (the "Revolving Credit Agreement"), between E&J Inc. and HSBC; (c) Brierley Investments Limited, an affiliate of BIL, agreed to guarantee a letter of credit facility ("Letter of Credit Facility") between E&J Inc. and HSBC (or an alternative commercial lending institution) in an amount not exceeding $6 million through and including June 30, 1995; (d) BIL, as guarantor of the obligations of E&J Inc. under the Revolving Credit Agreement, agreed to an amendment of the Revolving Credit Agreement whereby cash advances of up to $10 million were made available for E&J Inc.'s working capital needs; (e) the Company and E&J Inc. agreed to indemnify (the "Indemnification Obligation") BIL from and against any and all losses arising out of BIL's guarantee of the Letter of Credit Facility and the Revolving Credit Agreement; (f) BIL agreed to lend to the Company and E&J Inc. up to $12.5 million pursuant to the terms of the Revolving Promissory Note; (g) BIL and the Company and E&J Inc. entered into a Security Agreement (the "Security Agreement") pursuant to which the Company and E&J Inc. granted a security interest in all of their assets to BIL to secure on a pari passu basis the obligations of the Company and E&J Inc. to BIL under the Common Stock Note, the Preferred Stock Note, the Revolving Promissory Note and the Indemnification Obligation; and (h) the Company and BIL entered into a Registration Rights Agreement pursuant to which the Company granted to BIL registration rights with respect to shares of Common Stock held as of the date of the Registration Rights Agreement and shares of Common Stock obtained by BIL as a result of the conversion of the Common Stock Note and Series C Preferred Stock issuable upon conversion of the Promissory Stock Note. E&J Inc. used $10 million under the Revolving Credit Agreement to repay a $10 million loan from Mercantile Bank on October 8, 1993. This loan had been collateralized by a $10 million letter of credit issued by HSBC under the Revolving Credit Agreement. Due to such loan repayment, E&J Inc. has no further cash availability under the Revolving Credit Agreement. The Company held a Special Meeting of Stockholders on December 31, 1993, to ratify and approve the Debt Conversion Transaction. Concurrent with ratification and approval of the Debt Conversion Transaction, the Company's stockholders approved and adopted amendments to the Company's Certificate of Incorporation to increase the number of authorized shares of Common Stock from 25,000,000 to 120,000,000 and to increase the number of authorized shares of Preferred Stock from 11,000,000 to 31,000,000 (the "Recapitalization Proposals"). BIL had agreed, upon stockholder approval of the Debt Conversion Transaction and the Recapitalization Proposals, to advance E&J Inc. $10 million to pay HSBC the cash advance it made to E&J Inc. under the Revolving Credit Agreement. Such advance by BIL to E&J Inc. would result in an increase in the principal amount of the Common Stock Note from $45 million to $55 million. However, subsequent to the Special Meeting of Stockholders, BIL and E&J Inc. agreed to transfer $10 million from the Revolving Promissory Note to the Common Stock Note, thus increasing the balance of the Common Stock Note to $55 million. The Common Stock Note was scheduled to mature on March 31, 1994, bear interest at the rate of 8% per annum from and after March 31, 1994, and was secured by a lien on and security interest in all assets of the Company and E&J Inc. on a pari passu basis with the repayment and other obligations of the Company and E&J Inc. under the Preferred Stock Note, the Revolving Promissory Note and the Indemnification Obligation. The Common Stock Note was subordinated to all debt borrowed by the Company or E&J Inc. from, or the payment of which had been guaranteed by the Company or E&J Inc. to, HSBC, the Pension Benefit Guaranty Corporation, Congress Financial Corporation and any other financial institution constituting a principal lender to the Company and/or E&J Inc. The Common Stock Note was convertible into that number of shares of Common stock equal to the outstanding principal balance of that Note at conversion divided by a stated conversion price ($1.00 per share, subject to antidilution adjustment). The Common Stock Note automatically converted in full upon satisfaction of all of the following conditions: (a) ratification of the Debt Conversion Transaction by the stockholders of the Company; (b) approval and adoption of the Common Stock Amendment and the Preferred Stock Amendment by the stockholders of the Company; (c) the filing and effectiveness of an amendment to the Company's Certificate of Incorporation to effect the Common Stock Amendment and the Preferred Stock Amendment; (d) adoption by the Board of Directors of resolutions to designate the Series C Preferred Stock and the filing and effectiveness of a Certificate of Designations of the Series C Preferred Stock (the "Series C Certificate of Designations"); (e) reservation of a sufficient number of shares of Series C Preferred Stock for issuance on conversion of the Preferred Stock Note; (f) reservation of a sufficient number of Common shares for issuance on conversion of the Common Stock Note and the Series C Preferred Stock issued on conversion of the Preferred Stock Note; and (g) approval for listing on the American Stock Exchange of the Common shares issuable on conversion of the Common Stock Note and the Series C Preferred Stock issued on conversion of the Preferred Stock Note. BIL waived condition (g), and the Common Stock Note converted into 55 million shares of Common stock on January 12, 1994. The Preferred Stock Note was scheduled to mature on March 31, 1994, bear interest at the rate of 8% per annum from and after March 31, 1994, and was secured by a lien on and security interest in all assets of the Company and E&J Inc. on a pari passu basis with the repayment and other obligations of the Company and E&J Inc. under the Common Stock Note, the Revolving Promissory Note and the Indemnification Obligation. The Preferred Stock Note was subordinated to all debt borrowed by the Company or E&J Inc. from, or the payment of which had been guaranteed by the Company or E&J Inc. to, HSBC, the Pension Benefit Guaranty Corporation, Congress Financial Corporation and any other financial institution constituting a principal lender to the Company and/or E&J Inc. The Preferred Stock Note was convertible into a number of shares of Series C Preferred Stock equal to the outstanding principal balance of that Note at conversion divided by a stated conversion price ($1.00 per share, subject to antidilution adjustment). The Series C Preferred Stock is convertible into shares of Common stock on a one-for-one basis. The Preferred Stock Note automatically converted in full upon satisfaction of all of the following conditions: (a) ratification of the Debt Conversion Transaction by the stockholders of the Company; (b) approval and adoption of the Common Stock Amendment and the Preferred Stock Amendment by the stockholders of the company; (c) the filing and effectiveness of an amendment to the Company's Certificate of Incorporation to effect the Common Stock Amendment and the Preferred Stock Amendment; (d) adoption by the Board of Directors of resolutions to designate the Series C Preferred Stock and the filing and effectiveness of a Certificate of Designations of the Series C Preferred Stock (the "Series C Certificate of Designations"); (e) reservation of a sufficient number of shares of Series C Preferred Stock for issuance on conversion of the Preferred Stock Note; (f) reservation of a sufficient number of Common shares for issuance on conversion of the Common Stock Note and the Series C Preferred Stock issued on conversion of the Preferred Stock Note; and (g) approval for listing on the American Stock Exchange of the Common shares issuable on conversion of the Common Stock Note and the Series C Preferred Stock issued on conversion of the Preferred Stock Note. BIL waived condition (g), and the Preferred Stock Note converted into 20 million shares of Series C Convertible Preferred Stock on January 12, 1994. The conversions of both the Common Stock Note and the Preferred Stock Note have been reflected in the consolidated financial statements as of December 31, 1993. No gain or loss was recognized as a result of the Debt Conversion Transaction. NOTE 7 -- DEBT The Company's debt as of December 31, 1993 and 1992 is as follows: 1993 1992 ---- ---- Notes payable to BIL (Net of FASB 15 adjustment) $ -- $29,292 Revolving Promissory Note to BIL 4,802 -- Loans from HSBC 10,000 15,093 Other domestic debt 10,844 10,258 Foreign debt 3,675 3,912 ------ ------ Total debt 29,321 58,555 Less short-term debt and current installments of long-term debt 20,897 55,204 ------ ------ Long-term debt, net of current installments, including Revolving Promissory Note to BIL $ 8,424 $ 3,351 Aggregate long-term debt maturities during each of the next five fiscal years follows: 1994 $20,897 1995 5,762 1996 1,049 1997 1,127 1998 486 ------- $29,321 On August 30, 1991, the Company executed a First Amended and Restated Credit Agreement (the "Agreement") concerning the restructuring of its debt ("the Bank Loan") with Security Pacific National Bank (the "Bank"). Under the provisions of the Agreement the payment of cash dividends to common stockholders was prohibited. The Bank Loan was secured by essentially all tangible and intangible assets of the Company, its principal subsidiary, Everest & Jennings, Inc., and the stock of the Company's other subsidiaries. On October 4, 1991, the Company sold Ortopedia GmbH and repaid the Bank $8.3 million of its indebtedness. In November, 1991, certain provisions of the Agreement with the Bank were amended. The amended Agreement obligated the Company to repay its indebtedness to the Bank by March 31, 1993. Additionally, if this indebtedness was reduced to $13 million or less by March 31, 1993, the payment of interest at the rate of 2.25% over prime would be waived from April 1, 1992 through March 31, 1993. The Company agreed to issue a new class of voting convertible preferred stock to the Bank representing approximately 5% of the voting stock of the Company. In order to facilitate the relocation process by the Company from California to Missouri, on February 21, 1992, BIL acquired all of the Bank's rights (the "Bank Interest") in the Agreement. The acquisition of the Bank Loan by BIL resulted in BIL acquiring the new class of voting Series B Convertible Preferred Stock (786,000 shares). As a condition of the HSBC Revolving Credit Agreement, BIL subordinated the repayment of the Bank Loan and the Amended 10.5% Note (as defined below) to the repayment of the HSBC debt. As of March 31, 1993, BIL extended the March 31, 1993 Bank Loan due date to June 30, 1993. As of June 30, 1993, BIL agreed to extend the due date of the Bank Loan to September 30, 1993. As of September 30, 1993, the Bank Loan was restructured as part of the Debt Conversion Transaction. In 1990 the Company borrowed $14.1 million from BIL for working capital purposes and to complete the acquisition of five wholly-owned subsidiaries (collectively, "Smith & Davis") of HUNTCO Manufacturing, Inc. On August 30, 1991, the Company entered into an agreement with BIL (the "Debt Restructure Agreement") to restructure this indebtedness. The restructuring combined the principal, accrued unpaid interest and certain expenses into two new notes, the first (which was unsecured) in the principal amount of $9.2 million at 9% interest (the "Amended 9% Note"), and the second (which was secured) in the principal amount of $6.9 million at 10.5% interest (the "Amended 10.5% Note"). In accordance with the Debt Restructure Agreement, on October 4, 1991 the Company sold Ortopedia GmbH and repaid BIL $3.0 million of the Amended 10.5% Note, reducing the balance to $3.9 million. On March 17, 1992, the Company's stockholders approved the conversion of the Amended 9% Note, including accrued interest, into approximately 5.9 million shares of 9% Series A Voting Convertible Preferred Stock, thereby repaying the Amended 9% Note in its entirety. The remaining $3.9 million balance of the Amended 10.5% Note, plus accrued interest, was required by the terms of the Debt Restructure Agreement to be repaid by the earlier of April 1, 1993 or the date on which the Camarillo property was sold. On October 9, 1992 the Company sold its facility in Camarillo, California. Under the terms of the Debt Restructure Agreement, the Company was obligated to utilize the proceeds from this sale to repay $3 million of the Amended 10.5% Note with the balance to be applied against the Bank Loan. Accordingly, $3.0 million and $8.1 million, respectively, were repaid, leaving a balance of $0.9 million on the Amended 10.5% Note and a balance of $14.6 million on the Bank Loan. The due date of the Amended 10.5% Note was extended by BIL to June 30, 1993, and then subsequently to September 30, 1993. As of September 30, 1993, the Amended 10.5% Note was restructured as part of the Debt Conversion Transaction. During 1992 BIL advanced the Company $25 million, of which $11 million was repaid from the proceeds of the HSBC loan, leaving a net balance of $14 million as of December 31, 1992. An additional $31.1 million was advanced on various dates through September 30, 1993, with a maturity date of one year after the date of each respective advance. The indebtedness to BIL carried an interest rate of 6.5% and was evidenced by various Promissory Notes. The first $15 million of these Promissory Notes provided for repayment upon the Company obtaining new financing. However, as noted earlier, only $11 million of this amount was repaid and BIL amended the terms of the $4 million balance to provide for a September 30, 1993 repayment date. The due date had previously been extended to June 30, 1993. The remaining $41.1 million of Promissory Notes outstanding at September 30, 1993 generally had a one year term and matured on various dates through September 30, 1994. The advances described above in this paragraph are hereinafter referred to as "Interim Loans". As of September 30, 1993, the Interim Loans were restructured as part of the Debt Conversion Transaction. As of September 30, 1993, the Company borrowed $6.8 million as advances under the Revolving Promissory Note. During the fourth quarter, 1993, the Company additionally borrowed $8 million under the Revolving Promissory Note, bringing the total borrowings under such Note to $14.8 million. Of these borrowings, $10 million was transferred from the Revolving Promissory Note to the Common Stock Note, thus leaving the Revolving Promissory Note with a balance of $4.8 million at December 31, 1993. During 1992 and the first nine months of 1993, the Company accrued interest in the amount of $1.3 million and $0.8 million, respectively, on the Bank Loan in anticipation of not being able to reduce the balance of the Bank Loan below $13 million by the original and extended due dates. Additionally, $0.4 million was accrued on the Amended 10.5% Note through September 30, 1993, and $2.0 million was accrued on the Interim Loans, for total accrued interest due BIL as of September 30, 1993 of $4.5 million. On September 30, 1992, E&J Inc. entered into the $20 million unsecured Revolving Credit Agreement with HSBC. Advances under the Revolving Credit Agreement bear interest at the prime rate announced by Marine Midland Bank, N.A. from time to time. Repayment of existing debt with BIL is subordinated to the HSBC debt, and Brierley Investments Limited, an affiliate of BIL, has guaranteed its repayment. Ten million dollars of the agreement was designated as a letter of credit to secure a 3.5% loan from Mercantile Bank under the State of Missouri MoBucks program, which loan was due in October, 1993 ("MoBucks Loan"). The proceeds from the MoBucks Loan were used to reduce debt to BIL. Additionally, the HSBC facility was used to replace then existing letters of credit, fund restructuring expenses and for working capital purposes. In September, 1993, the outstanding HSBC loan balance of $5.7 million was repaid utilizing a cash advance provided by BIL under the Revolving Promissory Note. Furthermore, as of September 30, 1993, HSBC and E&J Inc. agreed to amend the Revolving Credit Agreement and extend its term for approximately one year. The HSBC facility, as amended, provides up to $6 million for letter of credit availability and, additionally, cash advances of up to $10 million to E&J Inc. E&J Inc., on October 8, 1993, repaid the $10 million loan from Mercantile Bank by utilizing $10 million of cash advances from the HSBC facility. BIL had agreed, upon stockholder approval of the Debt Conversion Transaction and the Recapitalization Proposals, to advance to E&J Inc. $10 million to pay HSBC the cash advance made by it under the Revolving Credit Agreement. Such advance by BIL to E&J Inc. would result in an increase in the principal amount of the Common Stock Note from $45 million to $55 million. Subsequent to the stockholders' approval of the Debt Conversion Transaction and the Recapitalization Proposals, BIL and E&J Inc. agreed to transfer $10 million from the Revolving Promissory Note to the Common Stock Note, thereby increasing the balance of the Common Stock Note to $55 million. In connection with the MCT acquisition, a total of $2.0 million was advanced by the Company to MCT prior to the closing of the transaction in January, 1994. These advances have been treated as part of the purchase price for the MCT acquisition. The advances were funded to the Company by BIL and constituted borrowings under the Revolving Promissory Note. As of September 30, 1993, the Company entered into the Debt Conversion Agreement with BIL whereby $65 million of the indebtedness represented by the Bank Loan, the Amended 10.5% Note and the Interim Loans (collectively, the "Converted BIL Debt") was restructured by the issuance of the Common Stock Note and the Preferred Stock Note (see Note 6). The balance of the indebtedness owed BIL ($6.8 million) which was not converted into the Common Stock Note and the Preferred Stock Note was treated as advances under the Revolving Promissory Note. As part of the Debt Conversion Transaction, BIL agreed to provide to the Company and E&J Inc. a revolving credit facility of up to $12.5 million, as evidenced by the Revolving Promissory Note. At December 31, 1993, $4.8 million had been advanced to the Company and E&J Inc. by BIL under the Revolving Promissory Note. The Revolving Promissory Note matures on June 30, 1995, bears interest at the rate of 8% per annum, and is secured by a lien on and security interest in all assets of the Company and E&J Inc. on a pari passu basis with the repayment and other obligations of the Company and E&J Inc. under the Common Stock Note, the Preferred Stock Note and the Indemnification Obligation. The Revolving Promissory Note is subordinated to all debt borrowed by the Company or E&J Inc. from, or the payment of which has been guaranteed by the Company or E&J Inc. to, HSBC, the Pension Benefit Guaranty Corporation, Congress Financial Corporation and any other financial institution constituting a principal lender to the Company and/or E&J Inc. As of December 31, 1993, $0.2 million was the outstanding accrued, unpaid interest balance due BIL under the Revolving Promissory Note. In July, 1991, the Company obtained a three-year $13 million secured credit facility at an interest rate of prime plus 3% for its Smith & Davis subsidiary. The facility is secured by substantially all of the assets of Smith & Davis. In February, 1993 this credit line was amended to increase the availability of funding to the Company and reduce the borrowing cost to prime plus 2%. At December 31, 1993, the Company had borrowed $5.1 million under this line. Additionally, Smith & Davis had other borrowings primarily consisting of amounts owed under certain industrial revenue bonds totaling $1.7 million at December 31, 1993, with interest rates ranging from 8% to prime plus 3%. These amounts are due at various semi-annual intervals through 1996. On May 12, 1992, the Company's Canadian operations renewed existing credit facilities in the aggregate of $5.1 million, on which $3.7 million was borrowed as of December 31, 1993 at interest rates ranging from prime plus 1/2% to prime plus 3/4%. The loans are secured by the net assets of the Canadian subsidiary. At December 31, 1993, the Company was contingently liable under existing letters of credit in the aggregate amount of approximately $3.7 million. Pursuant to an agreement with its joint venture partner in Indonesia, the Company has agreed to guarantee up to $1 million of indebtedness incurred by the joint venture to fund its operations. NOTE 8 -- ACQUISITION In January, 1994, the Company completed the acquisition (the "Acquisition") of Medical Composite Technology, Inc. ("MCT"). The $10.6 million purchase price consisted of the issuance of 8,000,000 shares of Common Stock, $2 million in the form of pre-closing cash advances, and the assumption of $0.6 million of net liabilities. Additionally, the Company assumed 107,614 unvested stock options; such options are for the purchase of the Company's Common Stock. MCT develops, designs, manufactures and markets state-of-the-art durable medical equipment, including wheelchairs and other medical mobility products and assistive devices. The Acquisition was accounted for as a purchase. $9.7 million of the purchase price is attributable to in-process research and development, and has been expensed as of December 31, 1993. The balance of the purchase price over the fair value of assets acquired has been allocated to goodwill. The amount allocated to goodwill was approximately $0.9 million which will be amortized over a period of three years. For purposes of consolidated financial statement presentation, the Acquisition has been accounted for as if it was completed on December 31, 1993. Accordingly, the Company's consolidated financial statements include the assets and liabilities of MCT. Pro forma combined results of operations (unaudited) of the Company and MCT for the year ended December 31, 1993 are denoted below. Pro forma results of operations are not necessarily indicative of the results of operations if the companies had constituted a single entity during the period combined. Net sales $95.4 Net loss from continuing operations (60.1) Net loss per share (3.47) NOTE 9 -- INCOME TAXES The components of income tax expense (benefit) from continuing operations for each of the years in the three year period ended December 31, 1993 are as follows: 1993 1992 1991 ---- ---- ---- Current: Federal $ -- $ -- $ -- Foreign 197 107 303 State (1,786) 100 Deferred: Federal -- -- -- Foreign (24) (58) (26) State -- -- -- $ 173 $(1,737) $ 377 A reconciliation of the provision (benefit) for taxes on loss from continuing operations and the amount computed using the statutory federal income tax rate of 34% for each of the years in the three year period ended December 31, 1993 is as follows: 1993 1992 1991 ------ ------ ------ Computed "expected" tax (benefit) $(18,878) $(7,021) $(5,674) Increases (reductions) due to: State taxes, net of federal benefit -- (1,786) 66 Foreign subsidiaries with different tax rates 319 (60) (122) Domestic losses with no tax benefit 18,732 7,130 6,107 ------ ------ ------ $173 $(1,737) $377 During 1992 the Company resolved certain disputed issues raised by the California Franchise Tax Board for the years 1975 through 1983. As a result of the agreement reached, assessments, including related accrued interest in the aggregate amount of approximately $1.8 million, were withdrawn by the Franchise Tax Board. Accordingly, this amount has been reflected as a credit to the 1992 income tax provision. The Company and certain subsidiaries file consolidated federal income and combined state tax returns. For federal income tax purposes, as of December 31, 1993, the Company has net operating loss (NOL) carryforwards of approximately $98 million and tax credit carryforwards of approximately $1 million that expire in 1997 through 2008. In accordance with the Internal Revenue Code, when certain changes in company ownership occur, utilization of NOL carryforwards is limited. The Company has determined that there has been a change in ownership due to the various debt and equity transactions consummated with BIL as described in Note 7 -- Debt. As a result, approximately $88.5 million of the Company's NOL carryforwards are subject to an annual limitation of approximately $3 million. If the full amount of that limitation is not used in any year, the amount not used increases the allowable limit in the subsequent year. In addition, there are approximately $7 million and $5 million, respectively, of preacquisition NOL carryforwards generated by Smith & Davis and MCT with expiration dates through 2004. Annual utilization of these NOLs is limited to $0.6 million for Smith & Davis and $0.5 million for MCT to reduce that entity's future contribution to consolidated taxable income. The Company's foreign source income is not material. NOTE 10 -- INVENTORIES Inventories at December 31, 1993 (excluding those inventories held for sale, see Note 4 -- Assets Held for Sale) and 1992 consist of the following: 1993 1992 ---- ---- Raw materials $ 8,219 $12,691 Work-in-process 4,131 6,682 Finished goods 2,939 5,258 ------ ------ $15,289 $24,631 NOTE 11 -- COMMON AND PREFERRED STOCK The Company has two employee stock option plans that provide for the grant to eligible employees of stock options to purchase shares of Common Stock. The Everest & Jennings International Ltd. 1981 Employees Stock Option Plan expired in 1991. Options are exercisable over a ten-year period. Stock options were granted at prices which represent the fair market value of the Common Stock on the date of grant. The changes in this stock option plan in each of the years in the three year period ended December 31, 1993 are summarized as follows: Year Ended December 31 ---------------------- 1993 1992 1991 ---- ---- ---- Outstanding, beginning of year 229,371 393,910 468,151 Granted -- -- -- Exercised -- -- -- Cancelled (131,921) (164,539) (74,241) ------- ------- ------- Outstanding, end of year 97,450 229,371 393,910 Exercisable, end of year 97,450 221,045 293,077 Options outstanding as of December 31, 1993 were granted at prices ranging from $1.88 to $12.75 per share. As of December 31, 1993, 97,450 shares were exercisable in the price range of $1.88 to $12.75 per share. The Company also has an Omnibus Incentive Plan, which was adopted by the Board of Directors during 1990. Options are exercisable on a ten-year period, and were granted at prices which represent the fair market value of the Common Stock on the date of grant. The changes in the Omnibus Incentive Plan in each of the years in the three year period ended December 31, 1993 are summarized as follows: Year Ended December 31 ---------------------- 1993 1992 1991 ---- ---- ---- Outstanding, beginning of year 725,000 606,000 692,000 Granted 219,000 227,000 100,000 Exercised -- -- -- Cancelled (394,942) (108,000) (186,000) ------- ------- ------- Outstanding, end of year 549,058 725,000 606,000 Exercisable, end of year 307,944 259,219 242,649 At December 31, 1993, 800,000 shares have been reserved for issuance pursuant to this plan, and 549,058 options were outstanding which were granted at prices ranging from $1.25 to $2.38. As part of the MCT acquisition, the Company assumed 107,614 unvested stock options at exercise prices ranging from $0.06 to $0.28. These options are for the acquisition of the Company's Common Stock. The Company's Class A Common Stock and Class B Common Stock had identical dividend rights with the exception that the Class A Common Stock was entitled to a $.025 per share additional dividend (the "Additional Dividend") for each quarter in respect of which a cash dividend was declared on the Class B Common Stock. After the Additional Dividend, the Class A Common Stock shared equally with the Class B Common Stock in all dividends and distributions. The Additional Dividend was non-cumulative and was subject to adjustment if the Company's Board of Directors declared a dividend on other than a quarterly basis. Provisions of loan agreements prohibited the Company from declaring dividends on such stock. Holders of Class A Common Stock were entitled to elect 25% of the Board of Directors (rounded up to the nearest whole number) so long as the number of outstanding shares of Class A Common Stock was at least 10% of the number of outstanding shares of both classes of Common Stock. Except as otherwise described for election of directors and except for class votes as required by law or the Company's Certificate of Incorporation, holders of common stock voted or consented as a single class on all matters, with each share of Class A Common Stock having one-tenth vote per share and each share of Class B Common Stock having one vote per share. Holders of the two classes of common stock voted as separate classes on any matter on which such a vote was required by applicable law or the Company's Certificate of Incorporation. Additionally, at the option of the holder of record, each share of Class B Common Stock was convertible at any time into one share of Class A Common Stock. On March 17, 1992, the stockholders of the Company approved a Plan of Reclassification. Under the Plan of Reclassification, the Certificate of Incorporation of the Company were amended to replace the Company's authorized Class A Common Stock and Class B Common Stock with a new single class of Common Stock having 25,000,000 authorized shares, and reclassified each outstanding Class A Common share and each outstanding Class B Common share into one share of such new single class of Common Stock. The Plan of Reclassification became effective as of the close of business on November 18, 1993. Upon the Plan of Reclassification becoming effective, the Company had an unclassified Board of Directors, each Director became an unclassified member of the Board of Directors for the balance of his or her term. At the March 17, 1992 meeting, the stockholders also approved a resolution to authorize a new class of preferred stock. Thereafter, approximately 5.9 million shares of 9% Series A Convertible Preferred Stock were issued for conversion of BIL debt and accrued interest as discussed in Note 7. Such preferred shares are redeemable into common stock on a one- for-one basis at the Company's option until the second anniversary of conversion of the debt, and thereafter the seventh anniversary of conversion into Common Stock on a one-for-one basis except for any in-kind dividends which would be redeemable at 150% of the market price at the time of conversion. The preferred shares are also redeemable for cash at the Company's option at a price of $1.67458437 per share until the second anniversary of conversion of the debt and thereafter the seventh anniversary of conversion to cash at a price of $1.67458437 per share except for in-kind dividends which would be redeemable at an amount equal to 150% of market price of the common stock as of the redemption date. Upon notice of redemption, the holder(s) of the preferred shares can convert such shares into shares of common stock on a one-for-one basis. Also as discussed in Note 7, a second series of preferred stock (Series B, consisting of 786,000 shares) was issued to BIL, which is redeemable at the Company's option into Common Stock on a one-for-one basis (except for any unpaid interest owed) at any time prior to the seventh anniversary of the issuance date of said preferred shares. Resolutions approved by the stockholders on March 17, 1992, resulted in an increase in the total shares outstanding, on a fully diluted basis, to 15.7 million and increased the percentage ownership of the Company by BIL and its affiliates from approximately 31% at December 31, 1991 to approximately 60% at December 31, 1992. On December 31, 1993, the Company's stockholders approved the Debt Conversion Transaction (see Note 6), which resulted in the issuance of 55 million shares of Common Stock and 20 million shares of 7% Series C Convertible Preferred Stock for conversion of the Common Stock Note and the Preferred Stock Note, respectively. The Debt Conversion Transaction resulted in an increase in the total shares outstanding, on a fully diluted basis, to 99.6 million (including shares issued for the MCT acquisition), and increased the percentage ownership of the Company by BIL and its affiliates from approximately 60% at December 31, 1992 to approximately 85% at December 31, 1993. As of December 31, 1993, the Company issued 8 million shares of Common Stock to the stockholders of MCT (see Note 8). NOTE 12 -- EMPLOYEE BENEFIT PLANS The Company has a noncontributory defined benefit pension plan covering substantially all employees of its primary domestic subsidiary, Everest & Jennings, Inc. and two non-contributory defined benefit pension plans for the non-bargaining unit salaried employees ("Salaried Plan") and employees subject to collective bargaining agreements ("Hourly Plan") at its Smith & Davis subsidiary. The total pension expense under these plans was $40, $233 and $297 for 1993, 1992 and 1991, respectively. The following table sets forth the status of these plans and the amounts recognized in the Company's Consolidated Financial Statements: 1993 1992 1991 ---- ---- ---- Actuarial present value of benefit obligations: Vested benefit obligation $17,695 $15,813 $15,332 Accumulated benefit obligation $17,816 $15,978 $15,884 Projected benefit obligation for services rendered to date $17,816 $16,285 $16,073 Plan assets at fair value, primarily listed stocks, bonds and investment funds 12,763 12,926 13,386 ------ ------ ------ Projected benefit obligation in excess of plan assets (5,053) (3,359) (2,687) Unrecognized transition amount (85) (134) (147) Unrecognized loss from change in discount rate 3,043 -- -- Unrecognized net gain/(loss) from past experience different from that assumed -- 410 (621) ------ ------ ------ Pension liability included in accrued payroll costs $(2,095) $(3,083) $(3,455) The pension cost relating to these plans is comprised of the following: Pension expense: Service cost -- benefits earned during period $-- $135 $116 Interest cost on projected benefit obligation 1,295 1,330 1,321 Actual return on plan assets (872) (771) (2,190) Net amortization and deferral (223) (461) 1,050 Curtailment gain (160) -- -- ------ ------ ------ Net periodic pension cost $40 $233 $297 Effective May 1, 1991, the Company froze the accruing of benefits under the Everest & Jennings, Inc. Pension Plan. Due to a reduction in its weighted-average discount rate, and in accordance with the provisions of SFAS No. 87, "Employees' Accounting for Pensions", an additional minimum funding liability, representing the excess of accumulated plan benefits over plan assets and accrued pension costs of $2,606 was recorded for the Everest & Jennings, Inc. Pension Plan. This amount has been recorded as an increase in stockholders' deficit for the year ended December 31, 1993. Additionally, during 1991 the Company froze the Smith & Davis Hourly Plan and purchased participating annuity contracts to cover accumulated and projected benefit obligations. The Company has also frozen the Salaried Plan effective January 1, 1993. Participants in the plan are eligible to participate in the Company's 401(k) Savings and Investment Plan, as discussed below. There was no material impact on the consolidated financial statements as a result of these changes. The following assumptions were used to determine the projected benefit obligations and plan assets: Everest & Jennings, Inc. Smith & Davis Plan Plans ----------------------- ------------- 1993 1992 1993 1992 ---- ---- ---- ---- Weighted-average discount rate 7.5% 8.5% 7.5%8.5%-9.0% Expected long-term rate of return on assets 9.0% 9.0% 8.5% 10.0% Long-term rate for compensation increases -- 5.0% -- 6.0% In 1993, no long term rates for compensation increases were assumed for the deferred benefit plans, as all participants are inactive and the plans are frozen. The Company also sponsored a 401(k) Savings and Investment Plan (the "401(k) plan") covering all full-time non-union employees of Everest & Jennings, Inc. The 401(k) plan was extended as of January 1, 1993 to include participants in the Smith & Davis Salaried Plan. Contributions made by the Company to the 401(k) plan are based on a specified percentage of employee contributions up to 6% of base salary. As of March 1, 1994, the Company suspended its contribution to the 401(k) Plan for all non- bargaining unit employees. Employees may contribute between 1% and 15% of base salary. Expense recorded for the 401(k) plan totaled $134 in 1993, $99 in 1992, and $40 in 1991. NOTE 13 -- LEASE COMMITMENTS The Company is a party to a number of noncancelable lease agreements involving buildings and equipment. The leases extend for varying periods up to 10 years and generally provide for the payment of taxes, insurance and maintenance by the lessee. Certain of these leases have purchase options at varying rates. The Company's property held under capital leases, included in Property, plant and equipment, at December 31, 1993 and 1992 consists of the following: December 31 December 31 1993 1992 ----------- ----------- Machinery and equipment $2,621 $2,658 Less accumulated amortization (502) (2,270) ------ ------ $2,119 $ 388 Minimum future lease obligations on long-term noncancelable leases in effect at December 31, 1993 are as follows: Capital Operating ------- --------- 1994 $ 761 $ 1,244 1995 870 1,310 1996 908 1,231 1997 900 1,035 1998 448 673 Thereafter -- 657 ----- ----- Net minimum lease payments 3,887 $6,150 Less amount representing interest (730) ----- Present value of minimum lease payments 3,157 Less current portion (509) ----- $2,648 Rental expense for operating leases amounted to approximately $1,913, $2,416 and $2,149 in 1993, 1992 and 1991, respectively. Certain of the operating lease obligations relate to facilities which have been or will be vacated in conjunction with the Company's consolidation of its manufacturing and distribution operations as discussed in Note 2. NOTE 14 -- INDUSTRY SEGMENT AND OPERATIONS BY GEOGRAPHIC AREAS The Company operates in one industry segment, which is the durable medical equipment business. The Company's North American operations include operations in the United States, Canada and Mexico. The European operations were primarily in Germany. The following table sets forth certain financial information by geographic area for each of the years in the three year period ended December 31, 1993: Year Ended December 31 ---------------------- 1993 1992 1991 ---- ---- ---- Net sales, durable medical products: North America Wheelchairs $ 61,750 $ 65,420 $ 81,569 Beds and Accessories 29,266 36,125 31,953 Other 3,443 5,570 5,402 ------- ------- ------- $ 94,459 $107,115 $118,924 Loss from continuing operations: North America $(55,524) $(20,409) $(24,476) Europe -- (240) 7,789 ------- ------- ------- $(55,524) $(20,649) $(16,687) Identifiable assets: North America $ 57,515 $69,459 $ 81,136 Europe -- -- 1,785 ------- ------- ------- $ 57,515 $ 69,459 $ 82,921 As described in Note 5 to the Consolidated Financial Statements, in October, 1991 the Company sold a majority interest in its Ortopedia GmbH subsidiary. The subsidiary's results of operations were accounted for under the equity method for the year ended December 31, 1991. The remaining interest in Ortopedia Holding GmbH was sold in December, 1992. Export sales to unaffiliated customers by domestic operations in the United States are not significant. No single customer accounts for 10% or more of the consolidated revenues. NOTE 15 -- CONTINGENT LIABILITIES In July, 1990, a class action suit was filed by a stockholder of the Company in the United States District Court for the Central District of California. The suit is against the Company and certain of its present and former directors and officers and seeks unspecified damages for alleged non-disclosure and misrepresentation concerning the Company in violation of federal securities laws. The Company twice moved to dismiss the complaint on various grounds. After the first such motion was granted, plaintiff filed a first amended complaint, which subsequently was dismissed by order filed on September 20, 1991. Plaintiff then notified the court that it did not intend to further amend the complaint, and an order dismissing the complaint was entered in November 1991. Plaintiff filed a notice of appeal to the Court of Appeals for the Ninth Circuit on December 23, 1991. The case was briefed and oral argument heard in June, 1993. On January 18, 1994, the Ninth Circuit ordered that the plaintiff's submission be vacated pending the outcome of a petition for rehearing in another case that addresses a similar procedural issue that was argued on appeal in that case. The Company continues to believe the case is without merit and intends to contest the asserted complaints vigorously. The ultimate liability, if any, cannot be determined at this time. In December, 1992 ICF Kaiser Engineers, Inc. ("ICF Kaiser") filed a Demand for Arbitration (the "Demand") against the Company before the American Arbitration Association in Los Angeles, California. ICF Kaiser in its demand claims breach of contract between the parties for consulting and clean up work by ICF Kaiser at E&J's former facilities located at 3233 East Mission Oaks Boulevard, Camarillo, California. The Arbitration Demand is in the sum of $1.1 million. In January, 1993 an answer and counter-claim were filed on behalf of the Company. The answer denies breach of the contract and disputes the monetary claim asserted in the Demand. In the counterclaim, the Company asserts that ICF Kaiser breached the contract, above referenced, by inter alia failing to perform the services required under the Agreement in a reasonably cost effective manner and in accordance with the terms and conditions of the Agreement. In February, 1993 E&J made a payment without prejudice to ICF Kaiser in the sum of approximately $0.6 million. This payment, together with prior payments, brings the total paid to date by the Company to ICF Kaiser to approximately $0.7 million. The entirety of the charges by ICF Kaiser are disputed as unreasonable under the circumstances and the Company intends to vigorously defend its position. The Company has recorded an appropriate reserve to reflect this matter and does not consider the amount to be material to the Company's consolidated financial statements. The arbitration hearings commenced in July, 1993 and are anticipated to conclude by the end of the first quarter of 1994. A decision is anticipated in the second half of 1994. Die Cast Products, Inc. ("Die Cast Products"), a former subsidiary of the Company, has been named as a defendant in a lawsuit filed by the State of California pursuant to the Comprehensive Environmental Response, Compensation and Liability Act 42 U.S.C.9601 et sec ("CERCLA"). The Company was originally notified of this action on December 10, 1992. The lawsuit seeks to recover response and remediation costs in connection with the release or threatened release of hazardous substances at 5619-21 Randolph Street, in the City of Commerce, California ("Randolph Street Site"). It is alleged that the Randolph Street Site was used for the treatment, storage and disposal of hazardous substances. The Company anticipates being named as a defendant as a result of its former ownership of Die Cast Products, which allegedly disposed of hazardous waste materials at the Randolph Street Site. Investigation with respect to potential liability of the Company is in the early stages. Issues to be addressed include whether the Company will be responsible for the disposals made by Die Cast Products; whether Die Cast Products actually sent hazardous waste materials to the Randolph Street Site; the nature, extent and costs of the ultimate cleanup required by the State of California; the share of that cleanup which may ultimately be allocated to Die Cast Products and/or the Company; and the extent to which insurance coverage may be available for any costs which may eventually be assigned to the Company. Remedial investigations performed on behalf of the State of California at the Randolph Street Site have disclosed soil and groundwater contamination. The Company has recorded a reserve of $1.0 million for this matter, which is included in the Consolidated Statements of Operations for 1993. In March, 1993, Everest & Jennings, Inc. ("EJI") received a notice from the United States Environmental Protection Agency ("EPA") regarding an organizational meeting of generators with respect to the Casmalia Resources Hazardous Waste Management Facility ("Casmalia Site") in Santa Barbara County, California. The EPA alleges that the Casmalia Site is an inactive hazardous waste treatment, storage and disposal facility which accepted large volumes of commercial and industrial wastes from 1973 until 1989. In late 1991, the Casmalia Site owner/operator abandoned efforts to actively pursue site permitting and closure and is currently conducting only minimal maintenance activities. The EPA estimates that the Casmalia Site's closure trust fund, approximately $10 million, is substantially insufficient to cover cleanup and closure of the site. Since August, 1992, the EPA has undertaken certain interim stabilization actions to control actual or threatened releases of hazardous substances at the Casmalia Site. The EPA is seeking cooperation from generators to assist in the cleaning up, and closing of, the Casmalia Site. EJI and 64 other entities were invited to the organizational meeting. The EPA has identified EJI as one of the larger generators of hazardous wastes transported to the Casmalia Site. EJI is a member of a manufacturers' group of potentially responsible parties which has investigated the site and proposed a remediation plan to the EPA. To reflect EJI's estimated allocation of costs thereunder, a reserve of $1.0 million has been recorded, which is included in the Consolidated Statements of Operations for 1993. In 1989, a patent infringement case was initiated against EJI and other defendants in the U.S. District Court, Central District of California. EJI prevailed at trial with a directed verdict of patent invalidity and non-infringement. The plaintiff filed an appeal with the U.S. Court of Appeals for the Federal Circuit. On March 31, 1993, the Court of Appeals vacated the District Court's decision and remanded the case for trial. Impacting the retrial of this litigation was a re- examination proceeding before the Board of Patent Appeals with respect to the subject patent. A ruling was rendered November 23, 1993 sustaining the claim of the patent which EJI has been charged with infringing. Upon the issuance of a patent re-examination certificate by the U.S. Patent Office, it is anticipated that the plaintiff will present a motion to the District Court for an early retrial of the case. EJI believes that this case is without merit and intends to contest it vigorously. The ultimate liability of EJI, if any, cannot be determined at this time. The Company and its subsidiaries are parties to other lawsuits and other proceedings arising out of the conduct of its ordinary course of business, including those relating to product liability and the sale and distribution of its products. While the results of such lawsuits and other proceedings cannot be predicted with certainty, management does not expect that the ultimate liabilities, if any, will have a material adverse effect on the consolidated financial position or results of operations of the Company. NOTE 16 -- SUPPLEMENTARY INCOME STATEMENT INFORMATION The following items of expense have been charged to cost of sales and operating expenses of continuing operations in each of the years in the three year period ended December 31, 1993: 1993 1992 1991 ---- ---- ---- Maintenance and repair costs $ 874 $ 763 $935 Advertising costs 1,114 1,822 971 Other expenses not disclosed elsewhere are less than one percent of the consolidated revenues and, therefore, are not separately reported in the table above. NOTE 17 -- QUARTERLY FINANCIAL INFORMATION The following chart sets forth the highlights of the quarterly consolidated results of operations in fiscal years 1993 and 1992: Three Months Ended (Unaudited) ------------------------------ 3/31 6/30 9/30 12/31 Year ---- ---- ---- ----- ---- Fiscal year 1993 - ---------------- Revenues $24,752 $23,524 $23,458 $22,725 $94,459 Gross profit 7,303 4,893 5,712 (302) 17,606 Net loss (2,977) (7,837) (5,236) (39,647)(a) (55,697)(a) Loss per share (.33) (.86) (.57) (4.20) (5.96) Fiscal year 1992 - ----------------- Revenues $29,713 $30,492 $22,742 $24,168 $107,115 Gross profit 8,345 9,289 5,293 3,265 26,192 Net loss (2,077) (639) (5,461)(b) (10,735)(c) (18,912) (b,c) Loss per share (.23) (.07) (.60) (1.17) (2.07) [FN] (a) Includes charges of $13 million for the Smith & Davis disposition, $2.1 million for the consolidation of manufacturing and distribution facilities, and $9.7 million for MCT in-process R&D. (b) Includes a $2.5 million restructuring charge for incremental costs associated with the relocation of manufacturing operations from California to Missouri in 1992. (c) Includes an additional $2.7 million restructuring charge for incremental costs associated with the relocation of manufacturing operations from California to Missouri in 1992 and approximately $1.3 million of accrued interest recorded in anticipation of not being able to reduce the balance of the Bank Loan below $13 million by March 31, 1993, as subsequently extended to September 30, 1993 (see Note 7 -- Debt). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT This information is being filed as part of the Company's definitive proxy materials and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This information is being filed as part of the Company's definitive proxy materials and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is being filed as part of the Company's definitive proxy materials and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information is being filed as part of the Company's definitive proxy materials and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The following consolidated financial statements of Everest & Jennings International Ltd. and subsidiaries are included in this Annual Report on Form 10-K: Report of Independent Accountants. Consolidated Statements of Operations - For each of the years in the three-year period ended December 31, 1993. Consolidated Balance Sheets - As of December 31, 1993 and 1992. Consolidated Statements of Stockholders' Equity (Deficit) - For each of the years in the three-year period ended December 31, 1993. Consolidated Statements of Cash Flows - For each of the years in the three-year period ended December 31, 1993. Notes to Consolidated Financial Statements. 2. Financial Statement Schedules: The following Financial Statement Schedules are included in this Annual Report on Form 10-K. Report of Independent Accountants on Financial Statement Schedules. Schedule V - Property, Plant and Equipment. Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment. Schedule VIII- Valuation and Qualifying Accounts. Schedule IX - Short-Term Borrowings. Other schedules are omitted because they are either inapplicable, not required under the instructions to Annual Report on Form 10-K, or the required information is included in the Consolidated Financial Statements and Notes thereto. (b) Reports on Form 8-K: None (c) Exhibits: 2 (a) Exchange Agreement and Plan of Merger, dated as of October 23, 1993, by and among Medical Composite Technology, Inc. ("MCT"), certain stockholders of MCT, Everest & Jennings International Ltd., BIL (Far East Holdings) Limited, and MCT Acquisition Corp., which was filed as Exhibit 2(a) to Form 8-K filed on January 14, 1994, is hereby incorporated herein by reference. (b) Plan of Merger, dated as of January 14, 1994, by and between MCT Acquisition Corp. and Medical Composite Technology, Inc., which was filed as Exhibit 2(b) to Form 8-K filed on January 14, 1994, is hereby incorporated herein by reference. 3 (a) Certificate of Incorporation, which was filed as Exhibit 3(a) to Annual Report on Form 10-K filed on March 27, 1992, is hereby incorporated herein by reference. (b) Bylaws, which were filed as Exhibit 3(b) to Annual Report on Form 10-K filed on March 27, 1992, is hereby incorporated herein by reference. (c)* Certificate of Amendment of Certificate of Incorporation, dated January 11, 1994. 10 (a) 1981 Employee Stock Option Plan, which was filed as Appendix I to the Proxy Statement filed April 7, 1981, is hereby incorporated herein by reference. (b) Amendment No. 1 to 1981 Employee Stock Option Plan, effective as of November 12, 1981, which was filed as Exhibit 10(b) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (c) Amendment No. 2 to 1981 Employee Stock Option Plan, effective as of January 7, 1981, which was filed as Exhibit 10(c) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (d) Amendment No. 3 to 1981 Employee Stock Option Plan, effective as of January 1, 1987, which was filed as Exhibit 10(d) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (e) Amendment No. 4 to 1981 Employee Stock Option Plan, effective as of July 22, 1988, which was filed as Exhibit 10(e) to Annual Report on Form 10-K dated March 17, 1989, is hereby incorporated herein by reference. (f) Retirement Plan for Employees of Everest & Jennings International Ltd., effective as of January 1, 1981, which was filed as Exhibit 10(e) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (g) Amendment to Retirement Plan for Employees of Everest & Jennings International Ltd., dated July 6, 1983, which was filed as Exhibit 10(f) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (h) Amendment No. 2 to Retirement Plan for Employees of Everest & Jennings International Ltd. dated October 14, 1985, which was filed as Exhibit 10(g) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (j) Amendment No. 3 to Retirement Plan for Employees of Everest & Jennings International Ltd. dated May 10, 1988, which was filed as Exhibit 10(i) to Annual Report on Form 10-K dated March 17, 1989, is hereby incorporated herein by reference. (k) Amendment No. 4 to Retirement Plan for Employees of Everest & Jennings International Ltd. dated July 22, 1988, which was filed as Exhibit 10(j) to Annual Report on Form 10-K dated March 17, 1989, is hereby incorporated herein by reference. (m) Description of Retirement Plan for Non-Employee Directors, effective June 1, 1987, which was filed as Exhibit 10(h) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (ab) Agreement of Merger dated as of May 27, 1987 between Everest & Jennings International and its wholly owned subsidiary, Everest & Jennings International Ltd., pursuant to which the Company changed its corporate domicile from California to Delaware, which was filed as Exhibit 10(t) to Annual Report on Form 10-K filed on March 25, 1988, is hereby incorporated herein by reference. (ah) A Promissory Note from Everest & Jennings, Inc. to Industrial Equity (Pacific) Limited for $3,000,000 dated April 9, 1990, and Exhibit A to the Promissory Note, which was filed as Exhibit 10(ah) to Annual Report on Form 10-K dated June 11, 1990, is hereby incorporated herein by reference. (aj) A Guaranty from Everest & Jennings International Ltd. to Industrial Equity (Pacific) Limited dated April 9, 1990, which was filed as Exhibit 10(aj) to Annual Report on Form 10-K dated June 11, 1990, is hereby incorporated herein by reference. (ak) A Deed of Trust and Assignment of Rents of certain real property dated April 9, 1990 executed by Everest & Jennings, Inc. in favor of Industrial Equity (Pacific) Limited, and a Legal Description as Exhibit A to the Deed of Trust, which was filed as Exhibit 10(ak) to Annual Report on Form 10-K dated June 11, 1990, is hereby incorporated herein by reference. (al) A Guaranty from Everest & Jennings International Ltd. to Industrial Equity (Pacific) Limited dated June 21, 1990, which was filed as Exhibit 10(al) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (am) The Promissory Note from Everest & Jennings International Ltd. to Industrial Equity (Pacific) Limited referred to in Exhibit 10(ah) above, and Exhibit A to the Promissory Note, modified to reflect a $6,000,000 principal balance due, which was filed as Exhibit 10(am) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (an) 1990 Omnibus Stock Incentive Plan of Everest & Jennings International Ltd. dated November 2, 1990, which was filed as Exhibit 10(an) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ao) Amendment No. 5 to the Retirement Plan for Employees of Everest & Jennings International Ltd., which was filed as Exhibit 10(ao) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ap) Guarantee and Waiver, which was filed as Exhibit 10(ap) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (aq) First Amended and Restated Credit Agreement, which was filed as Exhibit 10(aq) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ar) Amendment No. 1 to First Amended and Restated Credit Agreement, which was filed as Exhibit 10(ar) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (as) Amendment No. 2 to First Amended and Restated Credit Agreement, which was filed as Exhibit 10(as) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (at) Consent Agreement, which was filed as Exhibit 10(at) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (au) Amended and Restated Note in the amount of $31,000,000.00, which was filed as Exhibit 10(au) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (av) Security Agreement, which was filed as Exhibit 10(av) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (aw) Long Form Deed of Trust and Assignment of Rents, which was filed as Exhibit 10(aw) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ax) Environmental Indemnity, which was filed as Exhibit 10(ax) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ay) Guaranty Agreement, which was filed as Exhibit 10(ay) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (az) Pledge and Security Agreement, which was filed as Exhibit 10(az) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ba) Security Agreement among The Jennings Investment Co., Security Pacific National Bank and Industrial Equity (Pacific) Limited, which was filed as Exhibit 10(ba) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bb) Security Agreement among Ortopedia GmbH, Security Pacific National Bank and Industrial Equity (Pacific) Limited, which was filed as Exhibit 10(bb) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bc) Subordination Agreement regarding Smith & Davis Manufacturing Co., which was filed as Exhibit 10(bc) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bd) Subordination Agreement regarding Professional Securities Corporation, which was filed as Exhibit 10(bd) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (be) Subordination Agreement regarding Metal Products Group, which was filed as Exhibit 10(be) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bf) Subordination Agreement regarding Everest & Jennings Canadian Limited, which was filed as Exhibit 10(bf) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bg) Subordination Agreement regarding The Jennings Investment Co., which was filed as Exhibit 10(bg) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bh) Subordination Agreement regarding Everest & Jennings de Mexico S.A. de C.V., which was filed as Exhibit 10(bh) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bi) Debt Restructure Agreement, which was filed as Exhibit 10(bi) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bj) Amendment No. 1 to Debt Restructure Agreement, which was filed as Exhibit 10(bj) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bk) Supplement to Debt Restructure Agreement, which was filed as Exhibit 10(bk) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bl) Amended and Restated Promissory Note in the amount of $6,931,069.00, which was filed as Exhibit 10(bl) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bm) Amended and Restated 9% Subordinated Convertible Note in the amount of $9,247,430.00, which was filed as Exhibit 10(bm) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bn) Termination Agreement, which was filed as Exhibit 10(bn) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bo) Amended and Restated Deed of Trust, which was filed as Exhibit 10(bo) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bp) Guaranty Agreement, which was filed as Exhibit 10(bp) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bq) Environmental Indemnity, which was filed as Exhibit 10(bq) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (br) Intercreditor and Subordination Agreement, which was filed as Exhibit 10(br) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bs) Offer and Election Agreement with Dianne J. Jennings, which was filed as Exhibit 10(bs) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bt) Offer and Election Agreement with David D. Jennings, which was filed as Exhibit 10(bt) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bu) Offer and Election Agreement with Elizabeth A. Jennings as Trustee of the Gerald M. Jennings and Elizabeth A. Jennings Revocable Survivors Trust, which was filed as Exhibit 10(bu) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bv) Offer and Election Agreement with Elizabeth A. Jennings as Trustee of the Gerald M. Jennings and Elizabeth A. Jennings Irrevocable Family Trust, which was filed as Exhibit 10(bv) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bw) Offer and Election Agreement with Sybil M. Jennings as Trustee of the Harry and Sybil Jennings Family Residual Trust, which was filed as Exhibit 10(bw) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bx) Offer and Election Agreement with Sybil M. Jennings as Trustee of the Harry and Sybil Jennings Family Survivors Trust, which was filed as Exhibit 10(bx) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (by) Master Agreement (Notarial Deed 422/91 Dr. Staats) consisting of Shareholders Agreement, Articles of Association, Purchase Agreement, Option Agreement and Miscellaneous (original German and English translation), which was filed as Exhibit 10(by) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (bz) Assignment of Shares (Notarial Deed 426/91 Dr. Staats) (original German and English translation), which was filed as Exhibit 10(bz) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ca) Cross-Distributorship Agreement, which was filed as Exhibit 10(ca) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (cb) Termination Agreement between Everest & Jennings International Ltd. and Raymond V. Thomas, which was filed as Exhibit 10(cb) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (cc) Stipulation for Entry of Arbitration Award between Everest & Jennings International Ltd., BIL (Far East Holdings) Limited and Whitney A. McFarlin, which was filed as Exhibit 10(cc) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (cd) Settlement Agreement and Release among Everest & Jennings International Ltd., Barre L. Rorabaugh and James H. Farren, which was filed as Exhibit 10(cd) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ce) Incentive Stock Option Agreement between Everest & Jennings International Ltd. and Warren J. Nelson, which was filed as Exhibit 10(ce) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (cf) Non-Qualified Stock Option Agreement between Everest & Jennings International Ltd. and Robert C. Sherburne, which was filed as Exhibit 10(cf) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (cg) Incentive Stock Option Agreement between Everest & Jennings International Ltd. and Barre L. Rorabaugh, which was filed as Exhibit 10(cg) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ch) Incentive Compensation Agreement between The Jennings Investment Co. and Dr. Eckhard Hundhausen, which was filed as Exhibit 10(ch) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ci) Supplement to Geschaftsfuhrungs Contract among Everest & Jennings International Ltd., Ortopedia GmbH and Dr. Eckhard Hundhausen, which was filed as Exhibit 10(ci) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (cj) $3,000,000 Promissory Note dated April 3, 1992 made by the Company and payable to BIL previously filed as Exhibit 10(cj) to the Company's Form 8 Amendment to Application or Report dated May 22, 1992, amending Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (ck) $3,000,000 Promissory Note dated May 5, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(ck) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cl) $1,000,000 Promissory Note dated May 19, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cl) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cm) $1,000,000 Promissory Note dated June 4, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cm) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cn) $1,000,000 Promissory Note dated June 11, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cn) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (co) $1,000,000 Promissory Note dated June 26, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(co) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cp) $1,000,000 Promissory Note dated July 10, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cp) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cq) $1,000,000 Promissory Note dated July 16, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cq) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cr) $1,000,000 Promissory Note dated July 30, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cr) to Quarterly Report on Form 10-Q dated August 14, 1992, is hereby incorporated herein by reference. (cs) $1,000,000 Promissory Note dated August 31, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cs) to Quarterly Report on Form 10-Q dated November 19, 1992, is hereby incorporated herein by reference. (ct) $1,000,000 Promissory Note dated September 4, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(ct) to Quarterly Report on Form 10-Q dated November 19, 1992, is hereby incorporated herein by reference. (cu) $2,000,000 Promissory Note dated September 11, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cu) to Quarterly Report on Form 10-Q dated November 19, 1992, is hereby incorporated herein by reference. (cv) $1,000,000 Promissory Note dated October 1, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cv) to Quarterly Report on Form 10-Q dated November 19, 1992, is hereby incorporated herein by reference. (cw) $1,000,000 Promissory Note dated November 4, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cw) to Quarterly Report on Form 10-Q dated November 19, 1992, is hereby incorporated herein by reference. (cx) $1,000,000 Promissory Note dated November 12, 1992 made by the Company and payable to BIL, which was filed as Exhibit 10(cx) to Quarterly Report on Form 10-Q dated November 19, 1992, is hereby incorporated herein by reference. (cy) Standard Offer, Agreement and Escrow Instructions for Purchase of Real Estate dated as of June 5, 1992 for the sale of the corporate headquarters and principal manufacturing facility in Camarillo, California, which was filed as Exhibit 10(cy) to Current Report on Form 8-K dated November 19, 1992, is hereby incorporated herein by reference. (cz) Amendment to Standard Offer, Agreement and Escrow Instructions for Purchase of Real Estate dated as of October 8, 1992 and Exhibits 1 and 2 thereto, which was filed as Exhibit 10(cz) to Current Report on Form 8-K dated November 19, 1992, is hereby incorporated herein by reference. (da) Amendment No. 2 to First Amended and Restated Credit Agreement between the Company and BIL, dated February 21, 1992 and filed as Exhibit 10(da) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (db) Consent Agreement dated February 21, 1992 between the Company and BIL and filed as Exhibit 10(db) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dc) Termination Agreement dated July 31, 1992 between the Company and Warren J. Nelson and filed as Exhibit 10(dc) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dd) Revolving Credit Agreement dated September 30, 1992 between Everest & Jennings, Inc. and The Hongkong and Shanghai Banking Corporation Limited and filed as Exhibit 10(dd) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (de) Purchase and Sale Agreement, Ortopedia Holding GmbH, dated November 20, 1992 and filed as Exhibit 10(de) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (df) $1,500,000 Promissory Note dated December 7, 1992 made by the Company and payable to BIL and filed as Exhibit 10(df) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dg) $1,000,000 Promissory Note dated December 22, 1992 made by the Company and payable to BIL and filed as Exhibit 10(dg) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dh) $1,500,000 Promissory Note dated December 30, 1992 made by the Company and payable to BIL and filed as Exhibit 10(dh) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (di) $1,000,000 Promissory Note dated January 8, 1993 made by the Company and payable to BIL and filed as Exhibit 10(di) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dj) $2,000,000 Promissory Note dated January 13, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dj) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dk) $2,000,000 Promissory Note dated January 21, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dk) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dl) $2,000,000 Promissory Note dated January 28, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dl) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dm) $1,000,000 Promissory Note dated January 29, 1993 made by Smith & Davis Manufacturing Company to BIL, amending original Note dated December 23, 1992 and filed as Exhibit 10(dm) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dn) First Amendment to Accounts Financing Agreement (Security Agreement) dated January 29, 1993 between Smith & Davis Manufacturing Company and Congress Financial Corporation and filed as Exhibit 10(dn) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (do) Promissory Note dated January 29, 1993 between the Company and the Retirement Plan for Employees of Everest & Jennings International Ltd. and filed as Exhibit 10(do) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dp) First Amendment dated February 5, 1993 to Revolving Credit Agreement between Everest & Jennings, Inc. and The Hongkong and Shanghai Banking Corporation Limited and filed as Exhibit 10(dp) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dq) $2,251,198.58 Promissory Note dated February 8, 1993 made by the Company and payable to Heritage Pullman Bank & Trust and filed as Exhibit 10(dq) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dr) $1,000,000 Promissory Note dated February 11, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dr) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (ds) $1,000,000 Promissory Note dated February 23, 1993 made by the Company and payable to BIL and filed as Exhibit 10(ds) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dt) $1,000,000 Promissory Note dated March 2, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dt) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (du) $1,000,000 Promissory Note dated March 11, 1993 made by the Company and payable to BIL and filed as Exhibit 10(du) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dv) $1,000,000 Promissory Note dated March 22, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dv) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dw) Second Amendment dated March 30, 1993 to Revolving Credit Agreement between Everest & Jennings, Inc. and The Hongkong and Shanghai Banking Corporation Limited and filed as Exhibit 10(dw) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dx) $2,000,000 Promissory Note dated March 31, 1993 made by the Company and payable to BIL and filed as Exhibit 10(dx) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dy) Amendment No. 1 to Promissory Notes, dated March 29, 1993 and filed as Exhibit 10(dy) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (dz) Amendment No. 1 to Amended and Restated Promissory Note, dated March 29, 1993 and filed as Exhibit 10(dz) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (ea) Amendment No. 3 to First Amended and Restated Credit Agreement, dated March 29, 1993 and filed as Exhibit 10(ea) to Annual Report on Form 10-K dated April 9, 1993, is hereby incorporated herein by reference. (eb) $1,300,000 Promissory Note dated April 13, 1993 made by the Company and payable to BIL and filed as Exhibit 10(eb) to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 1993, is hereby incorporated herein by reference. (ec) $1,000,000 Promissory Note dated April 22, 1993 made by the Company and payable to BIL and filed as Exhibit 10(ec) to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 1993, is hereby incorporated herein by reference. (ed) $3,500,000 Promissory Note dated April 30, 1993 made by the Company and payable to BIL and filed as Exhibit 10(ed) to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 1993, is hereby incorporated herein by reference. (ee) Equipment Purchase Agreement dated April 9, 1993 by and between the Company and Sentry Financial Corporation, filed as Exhibit 10(ee) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (ef) Master Lease dated April 9, 1993 by and between the Company and Steego Corporation, filed as Exhibit 10(ef) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (eg) $1,000,000 Promissory Note dated May 28, 1993 made by the Company and payable to BIL, filed as Exhibit 10(eg) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (eh) $1,000,000 Promissory Note dated June 14, 1993 made by the Company and payable to BIL, filed as Exhibit 10(eh) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (ei) $500,000 Promissory Note dated June 22, 1993 made by the Company and payable to BIL, filed as Exhibit 10(ei) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (ej) Amendment No. 2 to Promissory Notes, dated June 30, 1993, filed as Exhibit 10(ej) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (ek) Amendment No. 2 to Amended and Restated Promissory Note, dated June 30, 1993, filed as Exhibit 10(ek) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (el) Amendment No. 4 to First Amended and Restated Credit Agreement, dated June 30, 1993, filed as Exhibit 10(el) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (em) $1,500,000 Promissory Note dated July 1, 1993 made by the Company and payable to BIL, filed as Exhibit 10(em) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (en) $2,500,000 Promissory Note dated July 14, 1993 made by the Company and payable to BIL, filed as Exhibit 10(en) to Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1993, is hereby incorporated herein by reference. (eo) $1,000,000 Promissory Note dated August 18, 1993 made by the Company and payable to BIL, filed as Exhibit 10(eo) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (ep) $2,000,000 Promissory Note dated August 30, 1993 made by the Company and payable to BIL, filed as Exhibit 10(ep) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (eq) $1,800,000 Promissory Note dated September 21, 1993 made by the Company and payable to BIL, filed as Exhibit 10(eq) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (er) Third Amendment to Revolving Credit Agreement dated September 30, 1993 by and between E&J Inc. and The Hongkong and Shanghai Banking Corporation Limited, filed as Exhibit 10(er) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (es) Debt Conversion Agreement dated September 30, 1993 by and among the Company, E&J Inc., BIL and the Jennings Investment Co, filed as Exhibit 10(es) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (et) Convertible Promissory Note -- Common Stock dated September 30, 1993, filed as Exhibit 10(et) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (eu) Convertible Promissory Note -- Preferred Stock dated September 30, 1993, filed as Exhibit 10(eu) to Quarterly Report on Form 10- Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (ev) Revolving Promissory Note dated September 30, 1993 made by the Company and E&J Inc. and payable to BIL, filed as Exhibit 10(ev) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (ew) Security Agreement dated September 30, 1993 by and among the Company, E&J Inc. and BIL, filed as Exhibit 10(ew) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (ex) Registration Rights Agreement dated September 30, 1993 by and between the Company and BIL, filed as Exhibit 10(ex) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (ey) Fourth Amendment to Revolving Credit Agreement dated October 8, 1993 by and between E&J Inc. and The Hongkong and Shanghai Banking Corporation Limited, filed as Exhibit 10(ey) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. 18 Letter Re Change in Accounting Principles, filed as Exhibit 18 to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. 22* Subsidiaries of the Registrant. 24 (a) Consent of Deloitte & Touche dated April 4, 1991 with respect to S-8 Registration Statement, filed as Exhibit 24 to Annual Report on Form 10-K dated April 11, 1991, is hereby incorporated herein by reference. (b) Consent of Deloitte & Touche with respect to S-8 Registration Statement filed as Exhibit 24(a) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (c) Consent of Price Waterhouse with respect to S-8 Registration Statement, filed as Exhibit 24(b) to Annual Report on Form 10-K dated March 27, 1992, is hereby incorporated herein by reference. (d) Consent of Deloitte & Touche dated April 13, 1993 with respect to S-8 Registration Statement, filed as Exhibit 24(d) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (e) Consent of Price Waterhouse dated April 14, 1993 with respect to S-8 Registration Statement, filed as Exhibit 24(e) to Quarterly Report on Form 10-Q for the Quarterly Period Ended September 30, 1993, is hereby incorporated herein by reference. (f)* Consent of Price Waterhouse dated March 30, 1994 with respect to S-8 Registration Statement. * Filed herewith in this Annual Report on Form 10-K SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. EVEREST & JENNINGS INTERNATIONAL LTD. (Registrant) Date: March 30, 1994 By (JOSEPH A. NEWCOMB) Joseph A. Newcomb Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date (ROBERT G. SUTHERLAND) Chairman of the Board March 30, 1994 Robert G. Sutherland (BEVIL J. HOGG) President & CEO, DirectorMarch 30, 1994 Bevil J. Hogg (RODNEY F. PRICE) Director March 30, 1994 Rodney F. Price (B.D. HUNTER) Director March 30, 1994 B.D. Hunter (CHARLES D. YIE) Director March 30, 1994 Charles D. Yie REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To The Board of Directors and Stockholders of Everest & Jennings International Ltd. Our audits of the consolidated financial statements referred to in our report dated March 21, 1994 appearing on page 25 of this Annual Report on Form 10-K, which report includes explanatory paragraphs describing uncertainties with respect to the Company's ability to continue as a going concern and the outcome of litigation, also included audits of the Financial Statement Schedules for the three years ended December 31, 1993 listed in Item 14 (a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. (PRICE WATERHOUSE) PRICE WATERHOUSE St. Louis, Missouri March 21, 1994 SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (in thousands) For the Balance at Transfers Balance at Year Beginning Additions Retirements and End of Ended of Period at Cost and Sales Other Period ----------- --------- ------- --------- ------- -------- December 31, 1993: Land $ 442 $ 35 $ -- $ (327) $ 150 Buildings & improvements 6,677 145 -- (3,225) 3,597 Machinery & equipment 16,112 329(a) (2,135)(b) (4,857) 12,410 ------- ------ ------- ------- ------- $23,231 $3,470 $(2,135) $(8,409)(c) $16,157 December 31, 1992: Land $ 454 $ -- $ -- $ (12) $ 442 Buildings & improvements 4,081 2,760 (62) (102) 6,677 Machinery & equipment 36,938 604 (21,119)(d) (311) 16,112 ------- ------ ------- ------- ------- $41,473 $3,364 $(21,181) $(425) $23,231 December 31, 1991: Land $ 680 $ 123 $ (346) $ (3) $ 454 Buildings & improvements 5,749 130 (1,478) (320) 4,081 Machinery & equipment 40,560 1,137 (4,783) 24 36,938 ------- ------ ------- ------- ------- $46,989 $1,390 $(6,607) $(299) $41,473 [FN] (a) Includes $2,465 related to capital leases for new computer and phone systems. (b) Includes $2,033 for the disposal of property under capital lease located at the Company's former Camarillo, California facility. (c) Includes $322, $3,191 and $4,734 for Land, Building & improvements and Machinery & equipment, respectively, which has been reclassified to Assets Held for Sale. (d) Includes the retirement of $19,873 of fully-depreciated machinery and equipment at the Camarillo, California corporate headquarters and manufacturing facility. SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (in thousands) Additions For the Balance at Charged to Transfers Balance at Year Beginning Costs and Retirements and End of Ended of Period at Cost and Sales Other Period ----------- --------- ------- --------- ------- -------- December 31, 1993: Buildings & improvements $783 $735 $-- $(786) $732 Machinery & equipment 11,065 1,189 (2,077)(a) (1,804) 8,373 ------- ------ ------- ------- ------- $11,848 $1,924 $(2,077) $(2,590)(b) $9,105 December 31, 1992: Buildings & improvements $758 $136 $(62) $(49) $783 Machinery & equipment 31,336 1,601 (20,726)(c) (1,146) 11,065 ------- ------ ------- ------- ------- $32,094 $1,737 $(20,788) $(1,195) $11,848 December 31, 1991: Building & improvements $2,188 $607 $(203) $(1,834) $758 Machinery & equipment 25,500 8,699 (3,738) 875 31,336 ------- ------ ------- ------- ------- $27,688 $9,306 $(3,941) $(959) $32,094 [FN] (a) Includes $2,033 for the disposal of property under capital lease located at the Company's former Camarillo, California facility. (b) Includes $765 and $1,728 for Buildings & improvements and Machinery & equipment, respectively, which has been reclassified to Assets Held for Sale. (c) Includes the retirement of $19,873 of fully-depreciated machinery and equipment at the Camarillo, California corporate headquarters and manufacturing facility. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (in thousands) Charged Balance at to Costs Balance Beginning and at End of For the Year Ended of Period Expenses Deductions Period - ------------------ --------- -------- ---------- -------- December 31, 1993: Allowance for doubtful accounts $3,505 $1,515 $3,514(a) $1,506 Accrued restructuring expenses 6,047 5,074(b) 4,829 6,292 December 31, 1992: Allowance for doubtful accounts $ 6,658 $ 04 $3,357 $ 3,505 Accrued restructuring expenses 14,095 1,871(b) 9,919 6,047 December 31, 1991: Allowance for doubtful accounts $ 6,588 $ 1,192 $1,122 $ 6,658 Accrued restructuring expenses 10,999 12,222(b) 9,126 14,095 [FN] (a) This amount relates to the accounts of Smith & Davis which have been reclassified as Assets Held for Sale. (b) Does not include $10,030, $2,079 and $6,307 of restructuring expense charged to other balance sheet accounts for 1993, 1992 and 1991, respectively. SCHEDULE IX -- SHORT-TERM BORROWINGS (in thousands) Weighted Weighted Weighted Maximum Average Average Average Amount Amount Interest For the Balance Interest Outstanding Outstanding Rate Year at End Rate at End During During During Ended of Period of Period Period Period Period (a) (b) ----------- --------- ------- --------- ------- -------- December 31, 1993: Notes payable to banks and other lending institutions $18,826 6.55% $24,466 $22,014 5.95% December 31, 1992: Notes payable to banks and other lending institutions $24,275 7.11% $24,486 $14,848 9.54% December 31, 1991: Notes payable to banks and other lending institutions $12,215 11.95% $11,621 $ 9,449 14.39% [FN] (a) Weighted average amount outstanding during period is computed by using month-end balances. (b) Weighted average interest rate during the period is computed by using monthly interest rates.

72331_1993.txt

72331_1993

1993

72331

Item 1. Business. GENERAL DEVELOPMENT OF BUSINESS General Description of Business Nordson Corporation (the "Company") was formed in 1954. The Company engineers, manufactures and markets sophisticated systems that apply liquid and powder coatings, sealants and adhesives to consumer and industrial products during manufacturing processes. In the foreseeable future, the Company expects to continue to operate primarily within the industrial application systems business. Corporate Purpose The Company strives to be a vital, self-renewing, worldwide organization which, within the framework of ethical behavior and enlightened citizenship, grows and produces wealth for its customers, employees, shareholders and communities. Overall Strategy The Company offers its customers a Package of Values(TM) which includes carefully engineered, durable products, strong service support, the backing of a well-established worldwide company with financial and technical strengths, and a commitment to deliver what was promised. These features provide genuine customer satisfaction, the foundation of continued growth. Growth is achieved by seizing opportunities to sell existing products into new markets, developing new products and investing in systems to maximize productivity. This strategy is augmented through engineering, research and development, product-line additions, and business acquisitions that can serve multi-national industrial markets. Complementing the Company's business strategy is the objective to provide opportunities for employee self-fulfillment, growth, security, recognition and equitable compensation. Finally, the Company is committed to contributing an average of 5 percent of domestic pretax earnings to human services, health, education and other charitable activities, particularly in communities where the Company has major facilities. Share Repurchase Program The share repurchase program, which commenced in 1984, continued through 1993. The primary purpose of this program is to provide shares for the Company's Long-Term Performance Plan which provides for the granting of stock options, stock appreciation rights, restricted stock, stock purchase rights, stock equivalent units, cash awards, and other stock or performance-based incentives. During fiscal 1993, the Company repurchased 299,149 common shares and issued 272,873 common shares from treasury under company stock and employee benefit programs. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENT, FOREIGN AND DOMESTIC OPERATIONS, AND EXPORT SALES Pursuant to the Financial Accounting Standards Board Statement No. 14, "Financial Reporting for Segments of a Business Enterprise", the Company has reported in Note 12 of Notes to Consolidated Financial Statements on pages 34 and 35 of the 1993 Annual Report, incorporated herein by reference thereto, information about the Company's single industry segment and its foreign and domestic operations. Export sales amounted to $109,371,000, $104,646,000, and $103,947,000 in 1993, 1992, and 1991, respectively. NARRATIVE DESCRIPTION OF BUSINESS Principal Products, Markets, and Methods of Distribution The Company offers a full range of industrial equipment to apply liquid and powder coatings, thermo-plastic adhesives and sealants, as well as special "performance compounds" and other technology-oriented materials. Equipment ranges from low-volume, manually-operated systems to sophisticated programmable automated systems. The following presents the Company's various products and their uses, arranged by the markets which they serve: Packaging - Automated adhesive dispensing systems for sealing corrugated cases and paperboard cartons and stabilizing pallets in the food, beverage, agriculture, cosmetics, and pharmaceuticals industries. Product Assembly - Adhesive and sealant dispensing systems for bonding or sealing plastic, metal and wood products in the appliance, automotive, book binding, building/construction, cosmetics, electronics, furniture, and telecommunications industries. Nonwovens - Automated equipment for applying adhesives, superabsorbent powders, liquids and fibers to assemble baby diapers, feminine hygiene products, adult incontinence products, and bedpads. Converting - Coating and laminating systems for applying hot melt adhesives onto continuous webs such as paper and film label stocks, board stocks, surgical drapes, fabrics, interlinings, and automotive textiles. Advanced Gasketing - Automated equipment for dispensing foamed adhesives and sealants to make form-in-place gaskets for automotive components, appliances and electrical enclosures. Powder Coating - Electrostatic spray equipment for applying powder paints and coatings to appliances, automotive components, metal office furniture/storage shelving, electrical transformers, and recreational equipment. Liquid Finishing - Electrostatic spray systems for applying liquid paints and coatings to plastic, metal and wood products such as automotive components, furniture, kitchen and bath cabinets, doors and frames, and pipes and tubing. Automotive - Liquid and powder finishing systems for spraying powder primers and anti-chip coatings to automobile body panels and applying basecoats and clearcoats; adhesive and sealant dispensing systems for bonding and sealing glass and interior seams. Container Coating - Automated equipment for applying liquid and powder coatings to the interiors and ends of metal containers in the food and beverage industries. Electronics - Automated conformal coating equipment for applying protective materials to printed circuit boards and electronic assemblies in the appliance, automotive, avionics, defense, electrical/electronics, and telecommunications industries. The Company markets its products in the United States and forty-nine other countries, primarily through a direct sales force, and in nine countries through qualified distributors. With approximately sixty percent of the Company's business attributable to international sales, the Company has built a worldwide reputation for its creativity and expertise in the design and engineering of high-technology application equipment which meets the specific needs of its customers. Manufacturing and Raw Materials The manufacturing operations of the Company consist of machining and finishing specially designed parts and assembling components into finished equipment. Many of the components are manufactured in standard modules, to permit one component to be used interchangeably in more than one product and to permit the ready assembly of components in different combinations for a variety of equipment models. Manufacturing operations are located in Amherst, Ohio; Elyria, Ohio; Norcross, Georgia; Sand City, California; Luneberg, Germany and Stenungsund, Sweden. The principal raw materials used in the manufacture of the Company's products include metals and plastics in the form of sheets, bar stock, castings, forgings and tubing. The Company also purchases many electrical and electronic components, fabricated and semi-fabricated metal parts, high-pressure fluid hoses, packings, seals and other items. The Company's policy is to select suppliers based on the competitive value offered in terms of total cost and quality. Substantially all of its materials are available through multiple sources. The Company maintains an extensive quality control program for all its equipment and machinery. This program is supervised by the Company's Vice President, Manufacturing. Because of varying degrees of availability of natural gas and other fuels, the Company has developed standby capacity to utilize other energy sources as an alternative. No material adverse effect on its business has resulted or is anticipated to result from energy shortages. Patents and Trademarks The Company follows the practice of maintaining trademark and patent protection both domestically and internationally. No aspect of the Company's business is materially dependent upon any one or more of the patents or on patent protection in general. Seasonal Variation in Business There is no significant seasonal variation in the Company's business. Working Capital Practices The Company has no special or unusual practices affecting working capital items. However, for customized equipment and systems, the Company generally requires substantial advance payments as deposits and, in certain cases, progress payments during the manufacturing process. A significant part of the Company's Package of Values(TM) is service, including service in the form of a very high level of product availability at the time of order entry, which requires a relatively high investment in inventory. Customers The Company has a large number of customers representing a wide variety of industries and geographic regions. The loss of a single or a few customers would not have a materially adverse effect on the Company's business. No single customer accounted for 5 percent or more of sales in the year ended October 31, 1993. Backlog The Company's backlog of orders has increased to $43,213,000 at October 31, 1993 as compared to $40,751,000 at November 1, 1992. All orders included in the October 1993 backlog are expected to be shipped to customers in fiscal 1994. Government Contracts The Company's business does not include, and does not depend upon, a significant amount of governmental contracts or sub-contracts. Therefore, no material part of the Company's business is subject to renegotiation or termination at the option of the government. Competitive Conditions The Company maintains competitive advantage through leadership in the areas of product innovation, quality, delivery and performance as well as customer service. Although material applications vary, all Nordson systems provide one or more customer benefits in terms of: ease of application; increased productivity; labor, material and energy savings; reduced space requirements; improved plant environmental conditions; greater operating efficiencies; lower maintenance costs; and stronger, more attractive products. The industrial application systems business is highly competitive. The Company's equipment is sold in competition with a wide variety of alternative bonding, sealing, caulking, assembly, finishing and coating techniques. Any production process involving the application of a material to a substrate or surface represents a potential use of the Company's equipment. The Company is a leading producer of powder coating systems as well as equipment for applying hot melt adhesives. The Company depends upon the quality and features of its equipment and its marketing techniques to maintain its market position. Research and Development The Company places strong emphasis on the development of new products and improvement of existing products through its own research staff. The Company's expenditures for research and development were approximately $19,655,000 in fiscal 1993 as compared to approximately $18,431,000 in fiscal 1992 and $17,999,000 in fiscal 1991, and as a percentage of net sales were approximately 4.3 percent for fiscal 1993, 4.3 percent for fiscal 1992 and 4.6 percent for fiscal 1992. Environmental Compliance Compliance by the Company with federal, state and local environmental protection laws during fiscal 1993 had no material effect on capital expenditures, earnings or the competitive position of the Company. No material effect is anticipated for fiscal 1994. Employees As of October 31, 1993, the Company has approximately 3,102 employees, which includes each person employed on a full-time basis as one unit and all part- time personnel (the number of which is not material) stated in equivalent units. Item 2. Item 2. Properties. The following table summarizes the principal properties of the Company. Several of these properties are pledged as security for industrial revenue bonds and mortgage notes payable. Other properties at international subsidiary locations and at branch locations within the United States are leased. Lease terms do not exceed twenty-five years and generally contain a provision for cancellation with some penalty at an earlier date. In addition, the Company leases equipment under various operating and capitalized leases. Information about leases is reported in Note 13 of Notes to Consolidated Financial Statements on page 36 of the 1993 Annual Report, incorporated herein by reference thereto. Item 3. Item 3. Legal Proceedings. The Company is involved in legal proceedings incidental to its business, none of which is material to the results of operations in the opinion of management. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. Executive Officers of the Company. The executive officers of the Company as of December 31, 1993 were as follows: Mr. Eric T. Nord, age 76, joined the predecessor of the Company in 1939 and was Chairman of the Board and Chief Executive Officer prior to his retirement in 1982. He has continued to serve as Chairman of the Board after his retirement. Mr. Madar, age 54, joined the Company in 1986 as President and Chief Executive Officer. From 1986 until 1989, he also served as Treasurer. Mr. Bohm, age 54, has been employed by the Company for 22 years. In 1986 he was elected a Vice President, responsible for directing activities of the European Division. Mr. Bunch, age 49, joined the Company in 1983. Since 1986, he has served as Vice President, Manufacturing. Mr. Campbell, age 44, joined the Company in 1988 as a Vice President, responsible for overseeing corporate research and business development activities, along with information service operations. In 1989 he assumed additional responsibilities for overseeing the manufacturing and human resources functions. Mr. Fields, age 42, joined the Company in 1988 as Human Resources Manager for the Application Equipment Division. He was appointed Director, Human Resources in 1989 and was elected Vice President, Human Resources in 1992. Mr. Jackson, age 48, joined the Company as Vice President - Operations in 1986 and was later elected Vice President, responsible for the Application Equipment Division. During 1989, he assumed responsibility for the operations of the North American Division. Dr. Klein, age 51, has been employed by the Company for thirteen years. He has served as Vice President, Corporate Research & Technology since 1986. Mr. McLane, age 50, has been employed by the Company for 19 years. Since 1986, he has served as Vice President, responsible for directing the activities of the Pacific South Division. Mr. Miyahara, age 56, has been employed by the Nordson organization for over 20 years and served as Managing Director of Nordson K.K. (a wholly-owned Japanese subsidiary). In 1987, he was appointed President of the Japanese Division and Chief Executive Office of Nordson K.K. In 1989 he was elected a Vice President of the Company with continuing responsibility to direct the activities of the Japanese Division. Mr. Moorhead, age 57, joined the Company in 1969, and has served as Vice President - Law and Assistant Secretary since 1981. Mr. Pellecchia, age 48, joined the Company in 1981 and was elected Vice President - Finance in 1986. In 1989, he assumed the additional responsibilities of Treasurer. Mr. Thayer, age 62, has been employed by the Company for 29 years. He was elected a Vice President in 1978. In 1986, he assumed responsibility for directing activities of the North American Division. In 1989, he assumed responsibility for overseeing product development and sales activities of Nordson's businesses directed toward the nonwovens and converting markets. In 1989 and 1990, he also directed the operations and integration of the German-based Meltex business, acquired in 1989. Mr. Ginn, age 70, has been Of Counsel to the law firm of Thompson, Hine and Flory, Cleveland, Ohio since January 1993. Prior to that time, he had been a Partner with Thompson, Hine and Flory since 1959. He has been Secretary of the Company since 1966. Messrs. Eric T. Nord and Evan W. Nord (director and retired officer) are brothers. No other directors and officers are related. PART II Item 5. Item 5. Market for the Company's Common Equity and Related Stockholder Matters. Market Information and Dividends. The Company's common shares are listed on the NASDAQ National Market System. The information appearing under the caption "Investor Information" on page 44 of the 1993 Annual Report is incorporated herein by reference thereto. Holders. The approximate number of holders of record of each class of equity securities of the Company as of December 31, 1993 was as follows: Item 6. Item 6. Selected Financial Data. The Company incorporates herein by reference the information as to each of the Company's last five fiscal years appearing under the caption "Eleven-Year Summary" on pages 40 and 41 of the 1993 Annual Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The Company incorporates herein by reference the information appearing under the caption "Management's Discussion and Analysis" on pages 18 and 19 of the 1993 Annual Report. Item 8. Item 8. Financial Statements and Supplementary Data. The information required by this item appears on pages 20 through 38 of the 1993 Annual Report, incorporated herein by reference thereto. Item 9. Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Company. The Company incorporates herein by reference the information appearing under the caption "Election of Directors" on pages 1 through 5 of the Company's definitive Proxy Statement to be filed with the Securities and Exchange Commission by January 31, 1994. Executive officers of the Company serve for a term of one year from date of election to the next organizational meeting of the Board of Directors and until their respective successors are elected and qualified, except in the case of death, resignation or removal. Information concerning executive officers of the Company is contained in Part I of this report under the caption "Executive Officers of the Company." Item 11. Item 11. Executive Compensation. The Company incorporates herein by reference the information appearing under the caption "Compensation of Directors" located on page 5 and information pertaining to compensation of officers located on pages 8 through 25 of the Company's definitive Proxy Statement to be filed with the Securities and Exchange Commission by January 31, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The Company incorporates herein by reference the information appearing under the caption "Ownership of Nordson Common Shares" on pages 6 through 8 of the Company's definitive Proxy Statement to be filed with the Securities and Exchange Commission by January 31, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. William D. Ginn, a director and Secretary of the Company, is Of Counsel to Thompson, Hine and Flory, a law firm which has in the past provided and continues to provide legal services to the Company. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)(1), (a)(2) and (d). Financial Statements and Financial Statement Schedules. The financial statements and financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. (a)(3) and (c). Exhibits. The exhibits listed on the accompanying index to exhibits are filed as part of this Annual Report on Form 10-K. (b) Reports on Form 8-K. None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. NORDSON CORPORATION ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1), (2) and (3), (c) and (d) AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES INDEX TO EXHIBITS CERTAIN EXHIBITS FISCAL YEAR ENDED OCTOBER 31, 1993 NORDSON CORPORATION AND FINANCIAL STATEMENT SCHEDULES (Item 14(a)(1) AND (2)) All other schedules for the Registrant have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements, including the notes thereto. The consolidated financial statements of the Registrant listed in the preceding index, which are included in the 1993 Annual Report, are incorporated herein by reference. With the exception of the pages listed in the above index and information incorporated by reference elsewhere herein, the 1993 Annual Report is not to be deemed filed as part of this report. NORDSON CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended October 31, 1993, November 1, 1992 and November 3, 1991 (In Thousands) Note: Information regarding maintenance and repairs, amortization of intangible assets, taxes other than payroll and income taxes, and royalties are not presented because each item does not exceed one percent of total sales. REPORT OF INDEPENDENT AUDITORS We have audited the consolidated financial statements of Nordson Corporation as of October 31, 1993 and November 1, 1992 and for each of the three years in the period ended October 31, 1993 and have issued our report thereon dated December 7, 1993 [incorporated by reference elsewhere in this Annual Report (Form 10-K)]. Our audits also included the consolidated financial statement schedules of Nordson Corporation as of October 31, 1993 and November 1, 1992 and for each of the three years in the period ended October 31, 1993, listed in item 14(a) of this Annual Report (Form 10-K). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. *Indicates management contract or compensatory plan, contract or arrangement in which one or more directors and/or executive officers of Nordson Corporation may be participants.

24545_1993.txt

24545_1993

1993

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ITEM 1. Business (a) General Development of Business Founded in 1873, Adolph Coors Company ("ACC" or the "Company") through its principal operating subsidiary, Coors Brewing Company ("CBC" or the "company"), produces and markets beer and other malt-based beverages. The Company's business was conducted as a partnership or sole proprietorship until 1913, when it incorporated under the laws of the State of Colorado. During the 1980's, the Company developed a number of technology-based businesses. At the end of 1992, ACC spun off its aluminum, packaging, ceramics and other technology businesses in a tax-free distribution to shareholders. The spin-off was accomplished through a dividend of the shares of common stock in a new public company, ACX Technologies, Inc. ("ACX Technologies" or "ACXT"). ACXT owns Graphic Packaging Corporation, Golden Aluminum Company, Coors Porcelain Company (dba Coors Ceramics Company) and a number of developmental businesses which were formerly owned by ACC. CBC remains as the single direct subsidiary of ACC. CBC owns Coors Distributing Company, and a number of smaller subsidiaries, including Ford Street Management Company; Wannamaker Ditch Company; Rocky Mountain Water Company; CBC International, Inc.; Coors Energy Company; and Coors Transportation Company. In 1992, substantially all of the assets of Coors Energy Company and Coors Transportation Company were sold. (b) Financial Information About Industry Segments The Company has continuing operations in a single industry segment, the production and marketing of beer and other malt-based beverages. (c) Narrative Description of Business Coors Brewing Company - General CBC is engaged in the production and marketing of high quality malt-based beverage products. CBC has a number of distinctive brands that satisfy developing consumer demands and trends. The company's malt-based beverage products include a number of premium, specialty and import beers, a premium Clearmalt beverage, popular-priced and value-added beers and non-alcoholic brews. Sales of malt beverage products totaled 19.8 million barrels in 1993, a 1.3% increase compared to 19.6 million barrels in 1992. Due to the seasonality of the beer industry, CBC's sales volumes are normally at their lowest in the first and fourth quarters and highest in the second and third quarters. The fiscal year of the Company is a 52- or 53-week period ending on the last Sunday in December. In 1993, company management focused on the need to balance volume gains with improved returns to shareholders and a number of steps were taken toward that end. Highlights for 1993 include the following: additions of new senior management personnel; profitability improvement initiatives; initial restructuring of field sales operations to drive decision-making and accountability closer to the retail level; the announcement and/or introduction of seven new products; and the announcement of an agreement in principle to purchase a 500,000 barrel brewery in Spain. The company also revised its executive compensation plan to strengthen the link between incentive compensation and improved returns, beginning in 1994. The profitability improvement initiatives included a reduction in general and administrative expense accomplished by means of voluntary retirement and severance packages and other initiatives. The company recorded a restructuring charge of $109.5 million in the fourth quarter of 1993, resulting in a net loss for the year. The restructuring charge includes $70.2 million for voluntary separation incentives and $39.3 million for workplace redesign, asset write-downs and other expenses related to the profit improvement initiatives. In addition, other special charges unrelated to the profit improvement initiatives totalled $13 million, primarily for the write-down of certain distributor assets and a provision for environmental enhancements. A total of 679 employees elected to accept one of the voluntary packages. Marketing and Operations Product portfolio: There are 17 products in the CBC brand portfolio. The company produces and markets 11 products in the premium/super-premium malt beverage category, including Original Coors, Coors Light, Coors Extra Gold, Coors Dry, Coors Artic Ice, non-alcoholic Coors Cutter, Zima Clearmalt, Killian's Irish Red Lager, Winterfest, Eisbock and Castlemaine XXXX. CBC also distributed a non-alcoholic beverage called Moussy under license with Sibra Holding S.A., of Switzerland. CBC offers three products in the popular-priced category: Keystone, Keystone Light and Keystone Dry. In 1993, the company introduced two value-added beers, Shulers and Shulers Light. Original Coors, Coors Light, Coors Extra Gold, Coors Dry, Coors Cutter and the Keystone brands are marketed nationwide. Distribution of Zima is being expanded nationwide in 1994. With the exception of Coors Artic Ice, Schulers and Schulers Light, which are in limited introductory markets, other Coors malt beverage products are sold in most states. Brand performance: Coors Light is the biggest selling brand in CBC's product portfolio, accounting for approximately two-thirds of the company's total sales. Other brands with improved volume in 1993 were Killian's Irish Red and Zima. Zima is a clear, lightly carbonated alcohol beverage that offers consumers an innovative alternative to their traditional alcohol beverage choices. Based on positive consumer response, Zima, introduced into 3 test markets in the fall of 1992, was expanded into an additional 30% of the U.S. in April and October of 1993. In December, CBC announced its plans to expand distribution of Zima nationally in the first quarter of 1994. The volume decline of the Original Coors brand moderated in 1993 as this brand maintained sales to its core group of loyal customers. The company also gained incremental volume in 1993 from the test marketing of two new, value-added beers, Shulers and Shulers Light, as well as the U.S. introduction of Castlemaine XXXX, as part of a joint venture with Lion Nathan International of New Zealand. New products/opportunities: CBC has announced plans for the national expansion of Zima during the first quarter of 1994. The company has also introduced to nine test markets the first domestically brewed ice beer using proprietary ice brewing technology licensed from Labatt Breweries of Canada. Unlike other domestic brewers of ice beer, Coors utilizes a patented ice machine from the Netherlands that takes beer to its freezing point by regulating the temperature to about minus four degrees celsius. Named Coors Artic Ice, this new product is the only U.S.-brewed ice beer to be brewed cold, shipped cold and sold cold. In order to tap into the fast-growing popularity of special-occasion brews, UniBev Limited, an arm of CBC that focuses on the import and specialty beer market, will introduce three new seasonal beers to complement the well-established Coors Winterfest brand. Each of these beers -- Eisbock a springtime bock, a summertime wheat beer and a fall Oktoberfest beer -- will be brewed in limited quantities for their respective seasons. Domestic sales: The company's highest volume sales are in the states of California, Texas, Pennsylvania and a number of eastern states. CBC utilizes a field sales force made up of regional directors, division managers and area sales managers to ensure maximum customer contact and satisfaction. Field staff operated out of four regional offices that offered training, marketing and merchandising support and customer service. In May of 1993, in an effort to increase its share of the growing import and specialty beer market, CBC announced the formation of UniBev Limited, a new arm of the company's International Import Division. UniBev will provide CBC with a separate umbrella organization to market specialty, import and licensed beer brands in the U.S. In early 1994, CBC took the first step in a field restructuring designed to move accountability and decision making closer to the retail level. The company has established two test field business units (FBUs) with accountability for market and bottom line performance in their respective regions (Texas and California/Hawaii). The company intends to establish more FBUs over time. International marketing/partnerships: With domestic beer sales virtually flat, international markets offer considerable potential to CBC. CBC exports Coors products to 14 markets outside of the United States, including American Samoa, the Bahamas, Bahrain, Bermuda, Cayman Islands, France, Greece, Guam, Ireland, Italy, Panama, Puerto Rico and the U.S. and British Virgin Islands. In addition, CBC exports its products to approximately 250 U.S. military bases worldwide. CBC also has existing licensing agreements with a number of international brewers. CBC has licensed Molson Breweries of Canada Limited to brew and distribute Original Coors and Coors Light in Canada and Asahi Breweries Ltd. to brew and distribute Original Coors in Japan. In early 1994, the company announced that it had licensed proprietary ice brewing technology from Labatt Breweries of Canada. In September 1992, a joint venture between CBC and Scottish & Newcastle Breweries of Scotland began to brew and distribute Coors Extra Gold in the United Kingdom. Coors Extra Gold was introduced in Scotland and northwest England in August 1992, and in 1993 the company expanded distribution into the rest of the United Kingdom. In June of 1993, CBC announced the launch of Coors Extra Gold into Ireland; the brand is brewed by Scottish & Newcastle in the U.K. and distributed under license by Murphy Brewery Ireland Ltd., Dublin. In September, CBC announced that it would produce and market Castlemaine XXXX (an Australian lager) in the U.S. through a joint venture with Lion Nathan International of New Zealand. CBC also owns the exclusive North American distribution rights for a non-alcoholic beverage called Moussy from Sibra Holding S.A., of Switzerland. Beginning in 1991, CBC took a significant equity position in a foreign brewing facility through a joint venture with Jinro Limited of the Republic of Korea. Jinro-Coors Brewing Company is one-third owned by CBC and two- thirds owned by Jinro Limited. In the second quarter of 1994, Jinro-Coors will complete construction of a 1.8 million barrel brewery in South Korea. The new brewery will produce several new local beers and a Coors brand for Korea's fast-growing beer market. Late in 1993, CBC signed an agreement in principle with El Aguila S.A., based in Madrid, Spain, for the purchase of a 500,000-barrel brewery in Zaragoza, Spain. This is discussed in greater detail below. Production/packaging capacity: CBC currently has three domestic production facilities. It owns and operates the world's largest single-site brewery in Golden, Colorado, a packaging and brewing facility in Memphis, Tennessee, and a third facility that currently operates as a packaging plant and distribution facility near Elkton, Virginia (referred to as the Shenandoah facility). Together, the three facilities provide sufficient brewing and packaging capacity to meet consumer demand for Coors products into the foreseeable future. The Golden, Colorado, brewery is the source for all brands with the Coors name, except for Coors Cutter, the company's non-alcoholic beverage. The majority of the company's beer is packaged in Golden. The remainder is shipped in bulk from the Colorado brewery to the Shenandoah and Memphis facilities for blending, finishing and packaging. The Memphis facility, which was purchased from The Stroh Brewery Company in 1990, is currently packaging all Coors products for export outside of the United States and producing Zima Clearmalt, Castlemaine XXXX and Coors Cutter. Depending on product mix and market opportunities, the full utilization of brewing capacity in Memphis may require incremental upgrades in plant and equipment. In November, CBC announced that it had signed an agreement in principle with El Aguila S.A., based in Madrid, Spain, for the purchase of a 500,000-barrel brewery in Zaragoza, Spain. The purchase is expected to be finalized in the first half of 1994; no purchase price has been disclosed. Under terms of the agreement, Coors Extra Gold will be brewed in Zaragoza for distribution in Spain. Sales and distribution will be handled in Spain by El Aguila. This arrangement would provide significant cost and other advantages over exporting beer from U.S. facilities. Fifty-one percent of El Aquila S.A. is owned by Amsterdam-based Heineken, N.V., the world's second-largest brewer. The sale is expected to close early in the company's second fiscal quarter. Other company operations: Significant portions of CBC's aluminum can, glass bottle and malt requirements are produced in its own facilities. The CBC can manufacturing facility produces approximately 3.6 billion aluminum cans per year; the bottle manufacturing plant produces approximately 780 million bottles per year. Bottles manufactured by the company are made with an average total recycled content of 35%. To assist in its goal of manufacturing bottles with 50% recycled content, in 1992 CBC announced its intent to build a glass recycling facility in Wheat Ridge, Colorado. Construction of the facility will be completed mid-year in 1994 and should double the amount of glass the company can recycle annually. CBC also has its own waste treatment facilities, which process waste from the company's manufacturing operations as well as municipal waste from the nearby City of Golden. The company also owns and operates its own power plant. The company continues to explore opportunities to improve asset utilization, including the divestiture of non-core assets and continuing improvement in capacity utilization through innovative joint ventures and alliances. Brewing Company subsidiaries: Coors Distributing Company (CDC) is CBC's largest subsidiary. CDC owns and operates distributorships in four markets across the United States. As part of CBC's corporate restructuring, CDC recently sold three of its company-owned distributorships. Together, CDC operations in 1993 accounted for approximately 5% of the company's total beer sales. In late 1992, Coors Energy Company (CEC) became a subsidiary of CBC. During 1992, CEC sold substantially all of its oil and gas exploration and production assets. CEC retained a transmission pipeline to bring natural gas to various company facilities in Colorado and, through a subsidiary, continues to operate a gas transmission pipeline to provide for the natural gas needs of CBC's Shenandoah facility. CEC also operates an ash disposal site for the company's use in Colorado. Also in 1992, Coors Transportation Company (CTC) sold substantially all of its assets and operations. Other subsidiary operations of CBC include Ford Street Management Company (a distributor development company); Wannamaker Ditch Company and Rocky Mountain Water Company, (which carry processed water from Clear Creek to various Coors reservoirs). Raw Materials CBC uses all-natural ingredients in the production of its malt beverages. In addition, the company has one of the longest beer brewing cycles in the industry. CBC adheres to strict formulation and quality standards in selecting its raw materials. Barley, rice, starch, hops: CBC uses a proprietary strain of barley developed by the company's agronomists in all its malt beverage products. Virtually all of this barley is grown on irrigated farmland in the western United States under contractual agreements with area farmers. As part of the 1993 restructuring, CBC consolidated some of its barley operations to achieve improved efficiencies. Rice and refined cereal starch, which are considered to be interchangeable in CBC's brewing process, are purchased from several suppliers. Both foreign and domestic hops are purchased from various suppliers. The 1993 restructuring plan included reductions in commodities inventories. Water: CBC utilizes naturally filtered water from underground aquifers to brew malt beverages at its Golden, Colorado, facility. Water from private deep wells is used for final blending and packaging operations for malt beverages packaged at plants located outside Colorado. Water quality and composition were primary factors in all facility site selections. Water from the company's sources in Golden, Memphis and Shenandoah is soft, with the required balance of minerals and dissolved solids to brew quality pilsner beers. CBC continually monitors the quality of all the water used in its brewing and packaging processes for compliance with the company's own stringent quality standards as well as federal and state water standards. CBC owns water rights believed to be adequate to meet all of the company's present requirements for both brewing and industrial uses; however, it continues to acquire water rights and add water reservoir capacity to provide for long-term strategic growth plans and to sustain brewing operations in the event of a prolonged drought. Packaging materials: During 1993, approximately 56% of Coors malt beverage products were packaged in aluminum cans, which were primarily supplied by CBC's aluminum can manufacturing plant. Additional aluminum cans for Coors malt beverage products packaged at the Memphis plant were purchased from an outside supplier. Glass bottles were used to package approximately 27% of Coors malt beverage products in 1993. A significant portion of all bottle requirements was produced in CBC's bottle manufacturing plant; CBC has two other qualified suppliers under contract to supply glass bottles. The remainder of the malt beverages sold during 1993 were packaged in quarter- and half-barrel stainless steel kegs and two different sizes of a plastic sphere called "The Party Ball," an innovative package introduced by CBC in 1988. In 1993, most of the secondary packaging for Coors products, including bottle labels and paperboard products, were supplied by Graphic Packaging Corporation, an ACX Technologies subsidiary. A second supplier provided corrugated boxes. Supply contracts with ACX Technologies companies: In preparing for the spin-off of ACX Technologies, CBC negotiated market-based, long-term supply contracts with ACXT subsidiaries to ensure an uninterrupted supply of raw materials and packaging materials including aluminum. CBC believes it has sufficient access to raw materials and packaging materials to meet its production requirements in the foreseeable future. Transportation/Distribution The number and geographical location of CBC's brewing operations require its malt beverage products to be shipped farther than competitors' products. Major competitors have multiple breweries and therefore incur lower transportation costs than CBC incurs to deliver its products to their respective distributors. By packaging some of its products in Memphis and Shenandoah, CBC is able to achieve more efficient product distribution and a reduction of freight costs for certain markets. Transportation: During 1993, 28% of total Coors products sold were shipped in CBC's insulated rail tank cars from Golden to be packaged at the Shenandoah and Memphis plants. CBC's Golden facilities are served by Burlington Northern, Inc., which transports approximately 76% of Coors malt beverage products packaged at the Golden facility the 14 miles from Golden to Denver. From there, they are shipped by various railroad lines to distributors throughout the country. CBC is able to maintain the high rail volume through the use of 24 satellite redistribution centers strategically located throughout the country. These centers, operated by public warehouse companies and CBC, transfer Coors malt beverage products from railcars for shipment to distributors. In 1993, approximately 86% of total railcar volume from Golden moved through this channel. The railcars assigned to CBC by the shipping railroads are specially built and insulated to maintain temperature control en route. A national rail strike of any duration could therefore substantially impair CBC's ability to transport Coors products to its markets and cause a shortage of Coors malt beverage products to a greater degree than would be experienced by competitors with multiple breweries. This situation would be intensified by low inventories maintained at distributors to assure the freshness of Coors malt beverage products. Although an extended shutdown of the Burlington Northern, Inc. rail spur at Golden could adversely affect CBC's business, CBC believes that such an interruption of service is unlikely. In addition, the satellite redistribution system reduces the potential impact of interrupted rail service. The remaining 24% of CBC volume packaged in Golden is shipped by truck and intermodal (piggyback) directly to distributors. Transportation vehicles are refrigerated or insulated to keep Coors malt beverage products at proper temperatures until they are delivered to distributor locations. Distribution: Delivery to retail markets in the United States is accomplished through a national network of 600 independent distributors and 4 distributors owned and operated by CBC's subsidiary, CDC. Some distributors have multiple branches. The total number of distributor locations, including branch operations, is 668. No single distributor accounted for more than 5% of 1993 barrel sales. In order to ensure the highest product quality, CBC has one of the industry's most extensive distributor monitoring programs. This program is designed to ensure that guidelines for proper refrigeration and rotation of Coors malt beverage products at both the wholesale and retail levels are followed. Distributors are responsible for maintaining proper rotation of the products at retail accounts and are required to replace Coors malt beverage products at their own expense if sales to consumers have not occurred within the prescribed time period. Competition The beer industry in the United States is highly competitive. Coors malt beverage products compete with numerous super-premium, premium, low-calorie, popular-priced, value-added, non-alcoholic and imported brands produced by national, regional, local and international brewers. CBC is the nation's third largest brewer and, according to Beer Marketer's Insights (BMI) estimates, CBC accounted for approximately 10% of the total 1993 U.S. brewing industry shipments of malt beverages. CBC's major competitors include Anheuser-Busch Companies, Inc. (through its subsidiary Anheuser-Busch, Inc.), Philip Morris, Inc. (through its subsidiary Miller Brewing Company), The Stroh Brewery Company, G. Heileman Brewing, and S & P Company. Because approximately 85% of CBC's volume comes from premium, higher-margin products, CBC competes most directly with Anheuser-Busch (approximately 44% market share) and Miller (approximately 22% share), the dominant players in the industry. In 1993, price promotions and price discounting continued to erode net price realizations for brewers; industry trade publications estimate that well over 40% of premium products were sold on discount industry wide. It is anticipated that competitive price/discount activity will continue for all brewers in 1994, especially in California and select markets in the Pacific Northwest. For the past few years, price realizations for brewers have increased well below inflation levels. CBC has responded to pricing pressures in two ways. On the cost side, CBC has implemented aggressive cost-management initiatives and close scrutiny of company functions and programs to ensure strategic alignment with company objectives and optimum asset utilization. On the revenue side, CBC continues to seek and exploit opportunities to maintain a strong premium position in the marketplace. CBC is well-positioned in the malt beverage industry, with strong, quality brands in the fastest-growing categories. The company, however, does face significant competitive disadvantages related to economies of scale. In addition to lower transportation costs achieved by major competitors with multiple breweries, these larger brewers also recognize economies of scale in advertising expenditures. CBC, in an effort to achieve and maintain national advertising exposure, must spend substantially more per barrel of beer sold than its major competitors. This level of advertising expenditures is necessary for CBC to hold and increase its share of the U.S. beer market. Capital Expansion CBC has sufficient brewing and packaging capacity to fulfill projected volume requirements in the foreseeable future. In 1993, the company spent approximately $120 million to upgrade the Memphis facility to support the Zima expansion, to perform routine maintenance in all plants and to make incremental capital upgrades to all production facilities. The company expects its capital expenditures for 1994 to be approximately $193 million. Capital spending in 1994 will be primarily focused on new facilities, repair and upkeep and return on investment projects. Research and Development CBC is continually engaged in research and development programs and has developed various improvements in raw materials, processes and packaging systems and in the development of innovative, quality products. Approximately $13 million was spent on research and development in 1993. Although CBC owns a number of patents, it does not consider its business to be dependent upon any one or related group of such patents. CBC's research and development expenditures are primarily devoted to new product and package development, its brewing process and ingredients, brewing equipment, improved manufacturing techniques for packaging supplies and environmental improvements in the company's processes and packaging materials. The focus of these programs is to improve the quality and value of its malt beverage products while reducing costs through more efficient processing and packaging techniques, equipment design and improved varieties of raw materials. CBC's research and development dollars are strategically applied to short-term, and long-term opportunities. Regulations Federal, state and local laws and regulations govern the operations of breweries; the federal government and all states in which Coors malt beverage products are distributed regulate trade practices, advertising and marketing practices, relationships with distributors and related matters. Governmental entities also levy various taxes, license fees and other similar charges and may require bonds to ensure compliance with applicable laws and regulations. CBC anticipates a number of regulatory issues in 1994 that could impact business operations, including potential increases in state and federal excise taxes, restrictions on the advertising and sale of alcohol beverages, new packaging regulations and others. Federal excise taxes on malt beverages are presently $18.00 per barrel. State excise taxes are also levied at rates that ranged in 1993 from a high of $32.65 per barrel in Alabama to a low of $0.62 per barrel in Wyoming. In 1993, Coors paid $364.8 million in federal and state excise taxes. For 1994, the Clinton Administration has indicated a desire to exempt brewers from an increase in federal excise taxes; however, an increase in federal excise taxes is still subject to Congressional debate. A substantial increase in federal excise taxes would have a negative impact on the entire industry and could have a material effect on company sales, profitability, and cash flow. CBC is vigorously opposed to any additional increases in federal and/or state excise taxes and will work diligently to ensure that its view is adequately represented in the ongoing debate. Environment See Management's Discussion and Analysis. Energy CBC uses both coal and natural gas as primary sources of energy. Coal is used as the primary fuel in CBC's steam generation system and is supplied from outside sources. Natural gas was supplied by public utilities and various natural gas purchase contracts during the year. The company also has fuel oil and propane available as alternate sources of energy. CBC does not anticipate future supply problems for these natural resources. Employees The Company has approximately 6,200 full-time employees. Approximately 1,685 employees are salaried. In 1993, 679 employees left the company under a voluntary separation program. Foreign Operations The company's foreign operations and export sales are not a material part of its business. However, the company is committed to expanding its foreign operations through equity participation arrangements, licensing agreements and export sales. ITEM 2. ITEM 2. Properties The company's major facilities are set out below: *Numbers in italics reflect continuing operations only. **Reflects the dividend of ACX Technologies, Inc. to shareholders during 1992. See Note 2 to Consolidated Financial Statements. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Comparison of Financial Results Fiscal Years 1993, 1992, and 1991 ADOLPH COORS COMPANY Consolidated results including 1993 restructuring and other special charges and 1992 discontinued operations 1993 Consolidated Results: During 1993, Adolph Coors Company (ACC or the "Company") was the holding company for a single subsidiary, Coors Brewing Company (CBC or the "company"). CBC produces and markets quality malt-based beverages. During 1993, company management focused on the need to balance volume gains with improved returns to shareholders. A number of steps were taken to improve profitability and performance. As a direct result of those initiatives, the company recorded restructuring and other special charges of $122.5 million in the fourth quarter, which resulted in a net loss for the year. The restructuring charge, which totaled $109.5 million pretax, includes $70.2 million for voluntary separation incentives designed to reduce the company's white collar work force, as well as $39.3 million for workplace redesign, asset write-downs and other expenses related to the profit improvement initiatives. As a part of the voluntary separation incentives, 643 employees elected to leave the company. The actions taken related to this charge, when fully implemented, are expected to generate annual pretax savings of more than $30 million. In addition, these actions position the company to compete more efficiently and effectively in an increasingly competitive business environment. Other special charges unrelated to the profit improvement initiatives totaled $13 million, primarily for the write- down of certain distributor assets and a provision for environmental enhancements. For the 52-week fiscal year ended December 26, 1993, ACC reported a net loss of $41.9 million, or $1.10 per share, compared to a net loss of $2.0 million, or $0.05 per share in 1992. The net loss was the result of the restructuring and other special charges and the 1993 retroactive increase of one percent in the federal corporate income tax rate. The restructuring and other charges had an impact of $1.98 per share. Before the restructuring and other special charges, the impact of the tax rate increase was an after-tax charge of $3.2 million, or $0.08 per share, related to the revaluation of the deferred income tax liability and the change in the current year's tax provision. 1992 Consolidated Results: In 1992, the Company's net loss of $2.0 million decreased significantly from net income of $25.5 million, or $0.68 per share in 1991. Consolidated earnings in 1992 were reduced by a loss from discontinued operations of $29.4 million (related to the spin-off of ACX Technologies, Inc.), as well as the net after-tax expense of $8.3 million for the adoption of new accounting standards for employee postretirement benefits (FAS 109) and income taxes (FAS 106). At the end of 1992, ACC significantly restructured its operations by spinning off its diversified technology businesses into a new, public company, ACX Technologies, Inc. (NASDAQ:ACXT). The results of ACXT are reported as discontinued operations in the consolidated financial statements for all periods presented, except as noted. COORS BREWING COMPANY Industry Overview* The domestic brewing industry is subject to a number of challenging trends, including a lack of volume growth, intense price competition and the threat of increased excise taxes at the state and federal levels. Although sales of malt-based beverages accounted for a major share (approximately 87%) of all U.S. alcohol beverage sales, total industry volume, based on domestic tax paid shipments, has declined from 181.6 million barrels in 1991 to an estimated 180.2 million barrels estimated for 1993. Total industry volume, including non-alcohol brews, import and export products has grown from 196.0 million barrels in 1991 to an estimated 198.3 million barrels in 1993. Domestic sales of malt-beverages, excluding imports, have increased less than one-half of one percent over the same time period. Non-alcohol brews, imports and specialty brews account for the fastest growing segments in the industry. More than 90% of domestic volume is attributable to the top six domestic brewers, Anheuser-Busch, Inc.(44% share), Miller Brewing Company (22% share), Coors Brewing Company (10% share), The Stroh Brewery Company (7-8% share), G. Heileman Brewing (5% share), and S & P Company (3-4% share). In order to protect market share in a flat market, many brewers are resorting to intense price competition and product discounting. For the past few years, price gains for brewers have been well below inflation levels, and it is expected that they will continue to be limited by ongoing competition and price discounting. Analysts have stated that more than 40% of premium beers are now sold on discount. Analysts have also noted a recent trend toward consumer trading-down, e.g. consumers buying lower-priced beers rather than premium products, especially in markets with weaker economies. Some brewers have responded by introducing private label beers, and, according to analysts, some brewers have initiated a form of direct store delivery. Finally, public discussion continues regarding the possibility of another increase in federal beer excise taxes. If this increase occurs, it is expected to have a significant impact on the entire industry, and could have a material impact on the company's sales, earnings and cash flow. While these trends bear watching and create intense competitive challenges for all brewers, CBC has managed to achieve increases in volume and net sales for the past nine consecutive years. A critical mission of the company's marketing department is to create steadily increasing equity in each brand. In addition, the company is committed to and strongly supports the three-tier distribution system. Due, in part, to its strong position in premium beer sales, the company continues to be in a good position to generate cash internally. The company's focus is to achieve a balance of volume growth and improved returns to investors as it moves forward. *Industry and competitive information was compiled from the following industry sources: Beer Marketer's Insights, The Maxwell Consumer Report and various securities analyst reports. While Coors believes the sources are reliable, the company cannot guarantee the absolute accuracy of these numbers and estimates, or undertake to advise readers of any change in estimated figures. Financial Results from Continuing Operations 1993, 1992 and 1991 Excludes 1993 restructuring and other special charges and 1992 impact of discontinued operations. See accompanying notes to consolidated financial statements. ========= ========= See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. ADOLPH COORS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: Summary of Accounting Policies Fiscal year: The fiscal year of the Company is a 52- or 53-week period ending on the last Sunday in December. Fiscal years for the financial statements included herein ended December 26, 1993, December 27, 1992 and December 29, 1991. Principles of consolidation: The consolidated financial statements include the accounts of Adolph Coors Company, its sole direct subsidiary, Coors Brewing Company (CBC), and all subsidiaries of CBC (collectively referred to as "the Company"). All significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to 1991 amounts to conform with current presentation. Inventories: Inventories are stated at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for substantially all inventories. Current cost, as determined principally on the first-in, first- out method, exceeded LIFO cost by $46,705,000 and $52,959,000 at December 26, 1993, and December 27, 1992, respectively. During 1993, total inventory costs and quantities were reduced, resulting in a LIFO liquidation, the effect of which was not material. Properties: Land, buildings and equipment are capitalized at cost. For financial reporting purposes, depreciation is provided principally on the straight-line method over the estimated useful lives of the assets. Accelerated depreciation methods are generally used for income tax purposes. Expenditures for new facilities and improvements that substantially extend the capacity or useful life of an asset are capitalized. Start-up costs associated with manufacturing facilities, but not related to construction, are expensed as incurred. Ordinary repairs and maintenance are expensed as incurred (Note 3). Interest capitalized, expensed and paid was as follows: Common stock reserved for options, and restricted stock awards totaled 2,331,800 shares as of December 26, 1993, and 1,864,100 shares as of December 27, 1992. In January 1993, the number and exercise price of all options outstanding at the time of the ACX Technologies spin-off were adjusted to compensate for the economic value of the options as a result of the distribution to shareholders. The options of officers who transferred to ACX Technologies were cancelled. The net effect of these adjustments decreased the number of options outstanding by 147,400. NOTE 7: Employee Retirement Plans The Company maintains several defined benefit pension plans for the majority of its employees. Benefits are based on years of service and average base compensation levels over a period of years. Plan assets consist primarily of equity, real estate and interest-bearing investments. The Company's funding policy is to contribute annually not less than the ERISA minimum funding standards, nor more than the maximum amount which can be deducted for federal income tax purposes. Total expense for these plans, as well as a savings and investment (thrift) plan, was $39,873,000 in 1993, $20,282,000 in 1992 and $14,635,000 in 1991. The 1993 increase in plan expense resulted primarily from the offering of the early retirement program and plan changes. Included in the 1993 service cost is $16.5 million which was the result of the early retirement program. That 1993 expense has been included in restructuring costs (Note 9). Significant assumptions used in determining the valuation of the projected benefit obligations as of the end of 1993, 1992 and 1991 were: ITEM 9. ITEM 9. Disagreements on Accounting and Financial Disclosure Within the last two fiscal years there have been no changes in the Company's independent accounting firm or disagreements on accounting and financial statement disclosure matters. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant (a) Directors JOSEPH COORS (Age 76) is presently Vice Chairman of Adolph Coors Company and has served in such capacity since 1975. He has served as a Director since 1942. He retired from day-to-day operations in December 1987. He serves as chairman of the Compensation Committee and is a member of the Executive Committee and the Audit Committee. He is also a Director of CBC and ACXT. PETER H. COORS (Age 47) has served as a Director of Adolph Coors Company since 1973. Prior to 1993, he served as Executive Vice President of Adolph Coors Company and Chairman of the Brewing Group. In December 1993, he was named interim treasurer. Also in 1993, he became Vice President and Secretary of Adolph Coors Company and was elected CEO and Vice Chairman of CBC. He is also a member of the Board of Directors of CBC. He serves as a member of the Debt Pricing Committee and the Executive Committee. In his career at Coors, he has served in a number of different positions, including Divisional President of Sales, Marketing and Administration and Secretary (1982-1985), Senior Vice President, Sales and Marketing (1978-1982), Vice President (1976- 1978), and Assistant Secretary and Assistant Treasurer (1974-1976). WILLIAM K. COORS (Age 77) is Chairman of the Board and President of Adolph Coors Company and has served in such capacities since 1970 and 1989, respectively. He has served as a Director since 1940. He serves as Chairman of the Debt Pricing Committee and the Executive Committee. He is also a director and Chairman of the Board of CBC and ACXT. J. BRUCE LLEWELLYN (Age 66) has served as a Director and member of the Audit Committee since 1989. In 1993, he was named chairman of the Audit Committee. As of 1993, he also serves on the Compensation Committee. He is a member of the Board of Directors of CBC. He is an attorney and involved in the management of several businesses in which he is an investor. He is presently the Chairman of the Board and Chief Executive Officer of Philadelphia Coca Cola Bottling, Inc., Queen City Broadcasting, Inc. and Garden State Cablevision, Inc. He is also a Director of Manufacturers Hanover Trust/Chemical Bank and QVC, Inc. LUIS G. NOGALES (Age 50) is a Director and member of the Audit Committee and has served in such capacities since 1989. In 1993, he also became a member of the Compensation Committee. He is a member of the Board of Directors of CBC. He is Chairman and Chief Executive Officer of Embarcadero Media, Inc., a media (radio) acquisition company in Los Angeles. In the past he was president of Nogales Partners (1990 to present), a media acquisition firm, general partner of Nogales Castro Partners (1989-1990), President of Univision, the nation's largest Spanish language television network (1986- 1988) and Chairman and Chief Executive Officer of United Press International (1983-1986). From 1981-1983 he served as Senior Vice President of Fleishman- Hillard, Inc. He is also a Director of Southern California Edison Company and SCEcorp. It is the Company's intent to name one additional independent director in 1994. (b) Executive Officers Of the above directors, Peter H. Coors and William K. Coors are executive officers of Adolph Coors Company and CBC. The following also were executive officers of the Company on March 18, 1994: ALVIN C. BABB (Age 61) has served as Executive Vice President, Operations and Technology for CBC since 1983. Prior to becoming Executive Vice President of CBC, he served as Group Vice President of Brewery Operations (1982-1983), Senior Vice President of Brewery Operations (1981-1982) and Senior Vice President of Plant Operations (1978-1981). He has been with the company for more than 40 years. He is a member of the Master Brewing Association of America. W. LEO KIELY, III (Age 47) became President and Chief Operating Officer of CBC as of March 1, 1993. Prior to joining Coors, he served as Division Vice President and then Central Division President of Frito-Lay, Inc., a subsidiary of PepsiCo, in Plano, Texas. From 1989-1991, he served as Senior Vice President of Field Operations, overseeing the operations of Frito-Lay's four regional business teams. From 1984-1989, he was the Vice President of Sales and Marketing for Frito-Lay. ROBERT D. KLUGMAN (Age 46) was named Vice President of Corporate Development in July 1993. Prior to that, he was Vice President of Brand Marketing, a position he held from 1981-1987, and again from 1990-1993. From 1987-1990, he was Vice President of International Development and Marketing Services. Before joining Coors, Klugman was a Vice President of Client Services at Leo Burnett USA, a Chicago-based advertising agency. M. CAROLINE TURNER (Age 44) was named Vice President and Assistant Secretary of ACC and Vice President, Chief Legal Officer and Assistant Secretary of CBC in 1993. In the past she served as Vice President, Legal (1991-December 1992) and Director, Legal (1986-February 1991) of ACC. Prior to joining the Company, she was a partner with the law firm of Holme Roberts & Owen (1983- 1986), an associate for Holme Roberts & Owen (1977-1982) and a clerk in the U.S. 10th Circuit Court of Appeals (1976-1977). WILLIAM H. WEINTRAUB (Age 51) joined CBC as Vice President of Marketing in July 1993. Prior to joining Coors, he directed all marketing and advertising for Tropicana Products as Senior Vice President. From 1982-1991, Weintraub was with the Kellogg Company, with responsibility for marketing and sales. He also held a number of positions at Procter and Gamble from 1967-1982. The Company is actively searching for a new Chief Financial Officer. ACC and CBC employ a number of other officers who are not considered executive officers of the Registrant as defined under SEC regulations. Terms for all officers and directors are for a period of one year, except that vacancies may be filled and additional officers elected at any regular or special meeting. Directors are elected at the Annual Shareholders' Meeting held on the Thursday of the second full week of May. There are no arrangements or understandings between any officer or director pursuant to which any officer or director was elected as such. (d) Family Relationships William K. Coors and Joseph Coors are brothers. Peter H. Coors is a son of Joseph Coors. (e) Section 16 Disclosures All filing and disclosure requirements were met in 1993. ITEM 11. ITEM 11. Executive Compensation *Assumes that the value of the investment in Coors Common Stock and each index was $100 on December 25, 1988, and that all dividends were reinvested. **Results are adjusted for the December 1992 spin-off of ACXT. Compensation Committee Report on Executive Compensation The Compensation Committee of the Board of Directors has furnished the following report on executive compensation for Adolph Coors Company. This report presents Adolph Coors Company's compensation philosophy for fiscal year 1993. Overview of Compensation Strategy for Executives Under the supervision of the three-member 1993 Compensation Committee of the Board of Directors, the Company continued to support the compensation policies, plans and programs developed in 1992, which sought to enhance the profitability of the Company by linking financial incentives of senior management with the Company's financial performance. The Compensation Committee of the Board recognized that 1993 was a year of transition with major changes occurring in management and in the company. New compensation policies, plans and programs will be developed in 1994. In furtherance of the profitability goal, annual base salaries were set at median levels found in the external market so that the Company relied to a large degree on annual incentive compensation to reward corporate officers for superior corporate and business unit performance. Annual incentive compensation strategies were variable and closely tied to corporate performance in a manner designed to encourage a continuing focus on improved profitability. The Compensation Committee also endorsed the position that stock ownership by management was beneficial in aligning management interest with shareholders to enhance shareholder value. Consequently, the compensation strategy provided incentives for management to increase equity participation in the Company. The Compensation Committee's compensation strategy for the CEO and other executive officers consisted of: * targeting base salary to the 50th percentile of relevant, broadly- defined external markets; * providing an annual cash incentive award targeted to the 75th percentile of the same external markets; * the equity portion of the long-term incentive award provided ownership opportunities through the Non-Qualified Equity Incentive Plan. Relationship of Performance to Specific Elements of the Compensation Strategy Following are brief descriptions which outline details and performance measures of each component of the 1993 executive compensation strategy. Base salary The Company used compensation survey data to determine salaries competitive at the 50th percentile for like positions in similar sized manufacturing companies. Company size was determined by total net sales since a correlation exists between salary amounts and total sales. Salary ranges were established for executives by using the 50th percentile market data as the mid-point and surrounding it with a 50% spread between minimum and maximum. Where the executive was paid within that range was determined by individual performance and the company's ability to pay. The salary range could be viewed as a continuum based on experience and performance: * Newly-hired or -promoted executives who have little performance history in the position were normally paid below the mid-point. * Consistent with Coors' compensation strategy, the market 50th percentile was the targeted salary for executives who are fully experienced and fully contributing in the position. * Base salary above the 50th percentile was used to recognize contributions beyond those normally associated with the position. Annual Cash Incentive Award In 1993, executive officers of Adolph Coors Company who are also executive officers of Coors Brewing Company (CBC), and executive officers of CBC had an opportunity to earn an annual bonus through the Coors Brewing Company employee-wide, profit sharing plan. Annual pre-tax profit targets as approved by the Compensation Committee were met, payouts to all employees were based on an equal percentage of their 1993 eligible earnings. In 1993, the executive officers of CBC also had an opportunity to earn an annual bonus through the Management Incentive Program. The annual pre-tax profit and payout percentage was stated with an acceptable performance range starting from threshold to a maximum as approved by the Compensation Committee. The approved annual pre-tax profit targets were met, and payouts to all eligible employees were based on a percentage of their 1993 base salary. In 1993, the Chief Operating Officer and Vice President of Marketing, as part of their employment contracts, earned a cash incentive award based on a percentage of their 1993 base salary. In 1993, the Company undertook several strategic initiatives -- including a voluntary separation package -- to better position the Company for profitable growth. This resulted in some significant asset write-downs and other restructuring expenses. The Company recognized the impact of these charges on earnings and approved the payout at the minimum profit level for the profit sharing plan. Long-term Incentive Awards In addition to receiving base salary and being eligible for annual cash incentive awards, executive officers of CBC were also provided an opportunity to earn a total long-term award targeted to the 75th percentile level of comparably sized companies paying long-term awards. This opportunity was provided by means of the Non-Qualified Equity Incentive Plan (NQEI) through grants of ACC restricted stock and non-qualified stock options. The NQEI plan was administered by the Compensation Committee. That committee was composed entirely of non-employee, independent directors. The NQEI plan provided for two types of grants for key management employees: restricted stock awards and stock options. Both types of grants were subject to certain holding periods and other restrictions to encourage long-term ownership. The NQEI plan provided that options be granted at exercise prices equal to the market value on the date the option was granted. CEO Compensation for 1993 The CEO's 1993 compensation did not reflect any of the incentive elements of the Company's compensation strategy. While fully supportive of the executive compensation strategy and fully committed to the Company goal of improved profitability, CEO William K. Coors has elected not to participate in the incentive program. It is Mr. Coors' belief that his compensation, although quite low relative to market and industry standards, is adequate to support his needs and that, given his strong commitment to corporate goals and objectives, financial incentives would not enhance his motivation to achieve superior performance. Consequently, the base annual salary of the CEO has been set at the current level for 11 years. Joseph Coors, Chairman J. Bruce Llewellyn Luis G. Nogales Compensation Committee Interlocks and Insider Participation Joseph Coors, J. Bruce Llewellyn and Luis G. Nogales served on the Compensation Committee during the past fiscal year. Joseph Coors, Chairman of the Compensation Committee, retired as the President and Chief Operating Officer of the Company in December 1987. Joseph Coors owns a Coors beer distributorship in Cincinnati, Ohio. During 1993, this distributor purchased 71,035 barrels of beer from CBC at the same pricing available to independent distributors. Joseph Coors is a director of both ACC and ACXT. He, along with William K. Coors, a Director of both ACC and ACXT, and Peter H. Coors, Director and an executive officer of ACC, and Jeffrey H. Coors and Joseph Coors, Jr., both directors and executive officers of ACXT, are trustees of several family trusts that collectively own a majority of the common stock of ACC and ACXT, or their subsidiaries, have certain business relationships and have engaged in certain transactions with one another, as described below. Such relationships and transactions are not, individually or in the aggregate, material to the Company. In connection with the spin-off of ACXT in December 1992, CBC entered into market-based, long-term supply contracts with certain ACXT subsidiaries to provide packaging, aluminum and starch products to CBC. In addition, CBC sells brewery by-products to an ACXT subsidiary and sells aluminum scrap from CBC's can making operations to another ACXT subsidiary. The sales under these supply contracts are a material source of revenue for ACXT and provide CBC a stable source for a significant portion of its raw materials and packaging materials. Also in connection with the spin-off, ACC and ACXT and their subsidiaries negotiated several other agreements, including employee matters, environmental management, tax sharing, trademark licensing and numerous one- year transitional agreements for various services and materials. A few service agreements between ACC and ACXT subsidiaries that extend beyond the now expired transitional period include agreements under which Coors Energy supplies natural gas to certain Colorado facilities of ACXT and an agreement by CBC to provide water and waste water treatment services for an ACXT ceramics facility. A joint defense agreement that commenced at the time of the spin-off is in effect with respect to the TransRim litigation described in Item 3, Legal Proceedings. A description of the foregoing agreements was included in the Company's report on Form 8-K dated December 27, 1992, in Exhibit B, "Information Statement dated December 9, 1992, mailed by the Company to its shareholders." CBC is a limited partner in a limited partnership formed in connection with the spin-off, with an ACXT subsidiary as general partner. The partnership owns, develops, operates and sells certain real estate previously owned directly by CBC or ACC. Each partner is obligated to make additional cash contributions of up to $500,000 upon call of the general partner. Distributions of $500,000 were made to both partners in 1993. Distributions are allocated equally between the partners until CBC recovers its investment, and thereafter 80% to the general partner and 20% to CBC. In 1993, CBC sold certain laboratory facilities and technology to an ACXT subsidiary for approximately $350,000, the estimated fair value of the assets. In addition, certain subsidiaries of ACC and ACXT are parties to miscellaneous market-based transactions. For instance, CBC buys ceramic can tooling from an ACXT subsidiary to test on CBC can lines, CBC serves as aggregator for long distance telephone services for itself and certain ACXT companies, CBC leases office space to the limited partnership mentioned above and the partnership separately provides real estate management and administrative services to CBC. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners The following table sets forth stock ownership of persons holding in excess of five percent of any class of voting securities, as of March 18, 1994: (a) Primarily from settlement of an Internal Revenue Service audit. (b) Restated for discontinued operations. * Represents a management contract. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter ended December 26, 1993. (c) Other Exhibits No exhibits in addition to those previously filed and listed in Item 14

790603_1993.txt

790603_1993

1993

790603

Item 1. Business All references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, JMB Income Properties, Ltd. - XIII (the "Partnership"), is a limited partnership formed in 1986 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in income-producing properties, primarily existing commercial real properties. On August 20, 1986, the Partnership commenced an offering to the public of $100,000,000 (subject to increase by up to $250,000,000) in Limited Partnership Interests (the "Interests") pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 33-4107). A total of 126,409 Interests (at an offering price of $1,000 per Interest, before discounts) were sold to the public and were issued to investors during 1987. The offering closed on April 14, 1987. No investor has made any additional capital contribution after such date. The investors in the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation, and sale and disposition of equity real estate investments. Such equity investments are held by fee title and/or through joint venture partnership interests. The Partnership's real property investments are located throughout the nation, and it has no real estate investments located outside the United States. A presentation of information about industry segments, geographic regions, raw materials or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership Agreement, the Partnership is required to terminate on or before October 31, 2036. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as a sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long-term investment where, due to current market conditions, it is impossible to forecast the expected holding period. At the sale of a particular property, the proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: The Partnership's real property investments are subject to competition from similar types of properties (including, in certain areas, properties owned or advised by affiliates of the General Partners) in the vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth in Item 2 Item 2. Properties The Partnership owns directly or through joint venture partnerships the properties or interests in the properties referred to under Item 1 above to which reference is hereby made for a description of said properties. The following is a listing of principal businesses or occupations carried on in and approximate occupancy levels by quarter during fiscal years 1993 and 1992 for the Partnership's investment properties owned during 1993: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of holders of Interests during fiscal years 1993 and 1992. PART II ITEM 5. ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 9,335 record holders of Interests of the Partnership. There is no public market for Interests, and it is not anticipated that a public market for Interests will develop. Upon request, the Managing General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as any other economic aspects of the transaction, will be subject to negotiation by the investor. However, there are restrictions governing the transferability of these Interests as described in "Transferability of Partnership Interests" on pages A-31 to A-33 of the Partnership Agreement. Reference is made to Item 6 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On August 20, 1986, the Partnership commenced an offering to the public of $100,000,000, subject to increase by up to $250,000,000, of Interests pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. On April 14, 1987, the offering was consummated and a total of 126,409 Interests were issued to the public by the Partnership from which the Partnership received gross proceeds of $126,409,000. After deducting selling expenses and other offering costs, the Partnership had approximately $113,741,000 with which to make investments primarily in existing commercial real property, to pay legal fees and other costs (including acquisition fees) related to such investments and to satisfy working capital requirements. A portion of such proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated venture had cash and cash equivalents of approximately $1,300,000. Such funds and short- term investments of approximately $11,520,000 are available for future distri- butions to partners, working capital requirements, anticipated releasing costs at the Rivertree Court Shopping Center and to make additional investments in the venture which owns the First Financial Plaza Office Building as described in Note 3. As more fully described in Note 5, distributions to the General Partners have been deferred in accordance with the subordination requirements of the Partnership Agreement. The Partnership and its consolidated venture have currently budgeted in 1994 approximately $689,000 for tenant improvements and other capital expenditures. The Partnership's share of such items and its share of similar items for its unconsolidated ventures in 1994 is currently budgeted to be approximately $950,000. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through cash generated by the Partnership's investment properties and through the sale of such investments. The Partnership's and its ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its ventures are not obligated to pay mortgage indebtedness unless the related property produces sufficient net cash flow from operations or sale. In 1992, the Partnership paid approximately $345,000 relating to significant seismic-related improvements made to certain buildings at the Fountain Valley and Cerritos Industrial Parks in 1991. In 1993, the Partnership paid approximately $305,000 to complete significant land and building improvements at the Cerritos Industrial Park originally budgeted in 1992 as a result of a mandate from the City of Cerritos. In 1995 and 1996, leases at the Cerritos Industrial Park representing 33% and 22%, respectively, of the leasable square footage are scheduled to expire, not all of which are expected to be renewed. The Fountain Valley Industrial Park currently operates in a market with industrial vacancy rates ranging from 15% to 16%. Fountain Valley is currently 85% leased and occupied. The Partnership and the Newport Corporation, which vacated in March 1992 prior to its 1995 lease expiration and continues to pay rent pursuant to its one remaining lease obligation, entered into an agreement to terminate one of Newport's leases for approximately 77,000 square feet (representing approximately 20% of the leasable square footage at the property) in July 1993 for a $487,000 fee paid to the Partnership. The space has been leased to Fry's Electronics, an electronics retailer, for a twelve-year term effective July 1993. International Tile vacated its approximate 36,000 square feet in August 1993 prior to its lease expiration in 1997. In January 1994, International Tile filed for protection under Chapter XI of the United States Bankruptcy Code. It is unlikely that the Partnership will collect the approximate $90,000 owed by International Tile at December 31, 1993. In 1995 and 1996, leases representing 21% and 13%, respectively, of the leasable square footage at Fountain Valley are scheduled to expire, not all of which are expected to be renewed. Currently, as leases at the Fountain Valley and Cerritos Industrial Parks expire, lease renewals and new leases will likely be at rental rates less than the rates on existing leases. The supply of industrial space has caused increased competition for tenants, a corresponding decline in rental rates and a corresponding increase in time required to re-lease tenant space in these markets. This anticipated decline in rental rates and anticipated increase in re-leasing time will result in a decrease in cash flow from operations over the near term. Fountain Valley incurred minimal damage and Cerritos incurred no damage as a result of the earthquake in southern California on January 17, 1994. In February 1994, the Partnership extended and increased the first mortgage loan in the principal amount to $11,200,000, which is secured by the Fountain Valley and Cerritos Industrial Parks. The extended loan bears interest at a rate of 7.32% per annum, provides for monthly payments of principal and interest based on a twenty-year amortization period and matures March 1, 2001. After payment of costs and fees related to the re-financing, there were no distributable proceeds from the loan extension. Prior to the extension, the Partnership had entered into a forbearance agreement with the lender providing, among other things, that the lender agreed not to exercise its rights and remedies under the original loan documents from November 2, 1993, the original maturity date, until January 31, 1994. The Partnership continued to pay interest only at an annual rate of 8.83% on the original $11,000,000 principal balance through the effective date of the refinancing. As of December 31, 1993, the Partnership has made an aggregate investment of approximately $24,994,000 relating to a maximum total commitment of $25,750,000 to an existing partnership (Adams/Wabash) that constructed a parking garage and retail space structure known as the Adams/Wabash Self Park as described in Note 3(e). The Partnership is not required to increase this original aggregate investment. Pursuant to the Adams/Wabash Partnership Agreement, the Partnership's interest in the venture increased from 49.9% to 74.9% effective October 1, 1993. The Rivertree Court Shopping Center operates in a market which is experiencing significant growth in the commercial and residential sectors. The growth in the area is expected to continue in the next several years. However, in January 1994, Filene's Basement vacated their space of approximately 26,000 square feet (representing approximately 9% of the leasable square footage at the property) but continues to pay rent pursuant to its lease. The Partnership is finalizing its approval of a sub-tenant for the Filene's store. During the third quarter of 1992, Highland Superstores, Inc. and Phar-Mor, both of which then had stores at the Rivertree Court Shopping Center, filed for protection under Chapter XI of the United States Bankruptcy Code. Highland vacated its space at the end of August 1992. The Partnership has leased the Highland space to Best Buy, an appliance and home electronics retailer, which opened during February 1993. The Phar-Mor store at the center continues to operate and pay rent under its lease obligation since its bankruptcy filing. The Partnership has received no notification of Phar-Mor's intentions regarding the continued operations of this store. However, the Partnership has finalized negotiations with a replacement tenant should Phar- Mor vacate its space in the near future. On January 30, 1992, the Partnership, through JMB/Mid Rivers Mall Associates, sold its interest in the Mid Rivers Mall located in St. Peters, Missouri to the unaffiliated joint venture partner. The Partnership received in connection with the sale, after all fees, expenses and joint venture partner's participation, a net amount of cash of $13,250,000. See Note 7 for a further description of this transaction. The West Dade joint venture which owns the Miami International Mall entered into an agreement with J.C. Penney which opened a department store at the mall in October 1992 (see Note 3(d)). The addition of J.C. Penney has had a positive impact on the operations of the mall. During the third quarter of 1992, the property experienced storm damage caused by Hurricane Andrew. It has been determined that structural damage to the building was minimal; however, the landscaping surrounding the building, including the irrigation system and street curbs, was impacted more severely. All repairs necessary to continue operations have been made. The Partnership believes West Dade has adequate insurance coverage for this damage. A claim has been submitted to the property's insurance company for approximately $750,000. In January 1994, a partial settlement of approximately $710,000 of the expected insurance proceeds had been received. West Dade sold a 3.9 acre outparcel of land at the Miami International Mall in June 1993 for a net sale price of approximately $1,560,000, after certain selling costs, of which the Partnership's share was approximately $390,000. For financial reporting purposes, West Dade has recognized a gain in 1993 of approximately $1,385,000, of which the Partnership's share is approximately $346,000. West Dade is currently negotiating the sale of an additional 4 acre outparcel of land. In December 1993, West Dade obtained a new mortgage loan in the principal amount of $47,500,000 replacing the existing first mortgage loan at the property. The new mortgage loan bears interest at 6.91% per annum and matures December 21, 2003. The loan provides for monthly interest-only payments for years one through three and monthly principal and interest payments based on a twenty-year amortization period for years four through ten. The non-recourse loan is secured by a first mortgage on the Miami International Mall. After payment of costs and fees related to the refinancing, there were no distributable proceeds from the new loan. At December 31, 1993, the First Financial Plaza office building is approximately 85% occupied. In July 1993, Mitsubishi vacated its approximate 8,100 square feet prior to its lease expiration of January 1997 and continues to pay rent pursuant to its lease obligation. Including the Misubishi lease and recently executed leases, the building is 91% leased. In 1994, leases representing approximately 20% of the leasable square footage are scheduled to expire. Although renewal discussions with the majority of these tenants have been favorable, there can be no assurance that all of these tenants will renew their leases upon expiration. The Los Angeles office market in general and the Encino submarket in particular have become extremely competitive resulting in higher rental concession granted to tenants and flat or decreasing market rental rates. Furthermore, due to the recession in southern California and to concerns regarding tenants' ability to perform under current lease terms, the venture has granted rent deferrals and other forms of rent relief to several tenants including First Financial Housing, an affiliate of the unaffiliated venture partner. The property incurred minimal damage as a result of the earthquake in southern California on January 17, 1994. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interest or goals that are inconsistent with those of the Partnership. In response to the weakness of the economy and the limited amount of available real estate financing in particular, the Partnership is taking steps to preserve its working capital. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, particularly in relation to the amount of working capital it has available. By conserving working capital, the Partnership will be in a better position to meet future needs of its properties without having to rely on external financing sources. RESULTS OF OPERATIONS The increase in interest, rents, and other receivables as of December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of the collection of tenant escalations at the Rivertree Court Shopping Center. The increase in deferred expenses as of December 31, 1993 as compared to December 31, 1992 and the related amortization expense for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to the capitalization and amortization of the lease commissions related to the 1993 commencement of the Fry's Electronics lease at the Fountain Valley Industrial Park. The decrease in amortization expense for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to the write off of deferred lease costs relating to a tenant vacating its space at the Fountain Valley Industrial Park in 1991. The decrease in current portion of long-term debt and the corresponding increase in long-term debt at December 31, 1993 as compared to December 31, 1992 is due to the extension of the $11,000,000 first mortgage loan secured by the Fountain Valley and Cerritos Industrial Parks subsequent to December 31, 1993 (see Note 4(b)). The increase in rental income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to higher average occupancy levels at the Adams/Wabash Self Park, the Rivertree Court Shopping Center, and the Fountain Valley and Cerritos Industrial Parks. The increase in rental income is also due to the $487,000 termination fee received for the termination of one of the Newport Corporation lease obligations at the Fountain Valley Industrial Park in July 1993. In addition, parking revenue at the Adams/Wabash Self Park increased due to two monthly parking contracts which were executed during October 1992 and to increased activity from the Palmer House Hotel parking contract. The increase in leasing at the above- mentioned properties has also resulted in an increase in accrued rents receivable at December 31, 1993 as compared to December 31, 1992. The increase in rental income for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to an increase in parking revenue at the Adams/Wabash investment property due to two monthly parking contracts which were executed during October 1992 and to increased activity from the Palmer House Hotel parking contract. In addition, rental income from the retail space at the Adams/Wabash investment property increased due to higher average occupancy levels during 1992 as compared to 1991. Fountain Valley Industrial Park also received a partial bankruptcy settlement of $80,000 in 1992. The decrease in interest income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and the increase in interest income for the year ended December 31, 1992 as compared to the year ended December 31, 1991 are primarily due to the Partnership maintaining a higher average invested balance in U.S. Government obligations during 1992. The higher average invested balance resulted primarily from the receipt of cash proceeds (a portion of which were subsequently distributed to the Limited Partners in 1992) from the sale of the Partnership's interest in the Mid Rivers Mall in January 1992. The decrease in the amount of loss from Partnership's share of operations of unconsolidated ventures for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is due primarily to increased operations at the Miami International Mall. The decrease in the amount of loss from Partnership's share of operations of unconsolidated ventures for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to the sale of the Partnership's interest in the Mid Rivers Mall. The decrease in Partnership's share of gain on sale of investment property and gain on sale of land from unconsolidated venture for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and the increase for the year ended December 31, 1992 as compared to the year ended December 31, 1991 are primarily due to the gain recognized in connection with the sale of the Partnership's interest in the Mid Rivers Mall in January 1992, partially offset by the sale of a 3.9 acre outparcel of land at the Miami International Mall in June 1993 (see Note 3(d)). The decrease in extraordinary item from unconsolidated venture for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to a prepayment penalty to the first mortgage lender as a result of the loan refinancing at the Miami International Mall in December 1993 (see Note 3(d)). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation in future periods does have an adverse impact on property operating expenses, the effect will generally be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, there should be little effect on operating earnings if the properties remain substantially occupied. In addition, substantially all of the leases at the Partnership's shopping center investment property contain provisions which entitle the Partnership to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also cause capital appreciation of the Partnership's investment properties over a period of time to the extent that rental rates and replacement costs of properties increase. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners JMB INCOME PROPERTIES, LTD. - XIII: We have audited the consolidated financial statements of JMB Income Properties, Ltd. - XIII (a limited partnership) and consolidated venture as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of JMB Income Properties, Ltd. - XIII and consolidated venture at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 22, 1994 JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and one of its ventures, Adams/Wabash Limited Partnership ("Adams/Wabash"). The effect of all transactions between the Partnership and Adams/Wabash have been eliminated in the consolidated financial statements. The equity method of accounting has been applied in the accompanying financial statements with respect to the Partnership's interests in JMB/Mid Rivers Associates ("JMB/Rivers") (see note 7), JMB First Financial Associates ("First Financial") and JMB/Miami International Associates ("JMB/Miami"). Accordingly, the accompanying financial statements do not include the accounts of JMB/Rivers, First Financial and JMB/Miami. The Partnership's records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying financial statements have been prepared from such records after making appropriate adjustments where applicable to reflect the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP"). Such adjustments are not recorded on the records of the Partnership. The net effect of these items is summarized as follows for the years ended December 31, 1993 and 1992: JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net earnings (loss) per limited partnership interest is based upon the limited partnership interests outstanding at the end of the period (126,414). Deficit capital accounts will result, through the duration of the Partnership, in net gain for financial reporting and income tax purposes. Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from its unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. The Partnership records amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less ($0 and $1,985,253 at December 31, 1993 and 1992, respectively) as cash equivalents with any remaining amounts reflected as short-term investments. Deferred expenses consist primarily of deferred organization costs which are amortized over a 60-month period and deferred lease commissions and loan fees which are amortized over their respective terms using the straight-line method. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues rental income for the full period of occupancy on a straight-line basis. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the Partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to Partners. (2) INVESTMENT PROPERTIES The Partnership has acquired, either directly or through joint ventures (note 3), three shopping centers, two multi-tenant industrial buildings, an office complex and a parking/retail structure. In January 1992, the Partnership's interest in the Mid Rivers Mall was sold (note 7). All of the properties owned at December 31, 1993 were operating. The cost of the investment properties represents the total cost to the Partnership plus miscellaneous acquisition costs. Depreciation on the properties has been provided over the estimated useful lives of the various components as follows: YEARS ----- Building and improvements -- straight-line . 30 Personal property -- straight-line . . . . . 5 == JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Maintenance and repairs are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. Certain investment properties are pledged as security for the long-term debt, for which there is no recourse to the Partnership (note 4). (3) VENTURE AGREEMENTS (a) General The Partnership at December 31, 1993 is a party to three operating joint venture agreements. In addition, the Partnership through a joint venture (JMB/Rivers) sold its interest in the Mid Rivers Mall on January 30, 1992 (note 7). Pursuant to such agreements, the Partnership has made capital contributions of approximately $56,757,000 through December 31, 1993. In general, the joint venture partners, who are either the sellers (or their affiliates) of the property investments being acquired, or parties which have contributed an interest in the property being developed, or were subsequently admitted to the ventures, make no cash contributions to the ventures, but their retention of an interest in the property, through the joint venture, is taken into account in determining the purchase price of the Partnership's interest, which is determined by arm's-length negotiations. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as general partner, the Partnership may be required to make additional cash contributions to the ventures. The Partnership has acquired, through the above ventures, one office building, two regional shopping malls and one parking/retail structure. The joint venture partners (who were primarily responsible for constructing the properties) contributed any excess of cost over the aggregate amount available from Partnership contributions and financing and, to the extent such funds exceeded the aggregate costs, were to retain such excesses. Two of the venture properties operating as of December 31, 1993 have been financed under various long-term debt arrangements as described in notes (c) and (d) below. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. (b) JMB/Rivers In December 1986, the Partnership and JMB Income Properties, Ltd. - XII, (a partnership sponsored by an affiliate of the Managing General Partner) ("JMB-XII"), formed JMB/Rivers, which entered into a joint venture ("Mid Rivers") with an affiliate of the developer ("Venture Partner") and acquired an interest in an enclosed regional shopping center then under construction in St. Peters, Missouri, known as Mid Rivers Mall. Under the terms of the venture agreement, JMB/Rivers contributed approximately $39,400,000, of which the Partnership's share was approximately $19,700,000. During January 1992, JMB/Rivers sold its interest in Mid Rivers Mall (see note 7). JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The ultimate ownership percentages for JMB/Rivers and Venture Partner were established as 80% and 20%, respectively. Operating profits and losses were generally allocated in proportion to and to the extent of distributions as described above and, to the extent profits and losses exceeded such distributions, to the Partners in accordance with their respective ownership percentages. The terms of the JMB/Rivers agreement generally provided that the Partnership was allocated or distributed, as the case may be, profits and losses, cash flow from operations and sale or refinancing proceeds in the ratio of its respective capital contributions to JMB/Rivers. The shopping center was managed by an affiliate of the Venture Partner for a fee calculated as 4% of gross receipts of the property through the date of the sale. (c) First Financial On May 20, 1987, the Partnership, through First Financial, a joint venture with JMB-XII, acquired an interest in a general partnership ("Encino") with an affiliate of the developer ("Venture Partner") which owns an office building in Encino (Los Angeles), California. First Financial is obligated to make an initial investment in the aggregate amount of $49,850,000 of which approximately $49,812,000 of such contributions have been made to Encino. The Partnership's share of the remaining amounts, approximately $14,000, will be contributed when the venture partner complies with certain requirements. In November 1987, First Financial caused Encino to obtain a third party first mortgage loan in the amount of $30,000,000. The proceeds of such loan were distributed to First Financial to reduce its contribution and to the Venture Partner who subsequently repaid a $15,500,000 loan from First Financial. Thus, the total cash investment of First Financial for its interest in the office building, after consideration of the funding of the $30,000,000 permanent financing, is approximately $20,000,000, of which the Partnership's share is approximately $7,500,000. The outstanding principal balance of the third party first mortgage loan as of December 31, 1993 is $29,394,848. The Encino partnership agreement generally provides that First Financial is entitled to receive (after any participating amounts due to Pepperdine University pursuant to its tenant lease) from cash flow from operations (as defined) an annual cumulative preferred return equal to 9.05% through April 30, 1995 (and 8.9% thereafter) of its capital contributions. Any remaining cash flow is to be split equally between First Financial and the Venture Partner. Pepperdine University, under its tenant lease, is entitled to an amount based on 6.6% of the Venture Partner's share of the office building's net operating profit and net sale profit (as defined). All of Encino's operating profits and losses before depreciation have been allocated to First Financial in 1993, 1992 and 1991. The Encino partnership agreement also generally provides that net sale proceeds and net refinancing proceeds (as defined), after any amounts due to Pepperdine University pursuant to its tenant lease, are to be distributed: first, to First Financial in an amount equal to the deficiency, if any, in its cumulative preferred return as described above; next, to First Financial in the amount of its capital contributions; next, to the Venture Partner in an amount equal to $600,000; any remaining proceeds are to be split equally between First Financial and the Venture Partner. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The terms of the First Financial partnership agreement provide that annual cash flow, net sale or refinancing proceeds, and tax items will be distributed or allocated, as the case may be, to the Partnership in proportion to its 37.5% share of capital contributions. The office building is managed by an affiliate of the Venture Partner for a fee based upon a percentage of rental receipts (as defined) of the property. (d) JMB/Miami On January 26, 1988, the Partnership, through JMB/Miami, a joint venture with JMB/Miami Investors L.P., a partnership sponsored by an affiliate of the General Partners of the Partnership, acquired an interest in an existing partnership ("West Dade" in which JMB/Miami is a general partner), with an affiliate of the developer (the "Venture Partner"), which owns an enclosed regional shopping center in Miami, Florida known as Miami International Mall. During February 1989, IDS/JMB Balanced Income Growth, Ltd., a partnership sponsored by an affiliate of the General Partners of the Partnership made a capital contribution to JMB/Miami to acquire an interest therein. During October 1993, JMB/Miami Investors L.P. transferred its interest in JMB/Miami to Urban Shopping Centers, L.P., a partnership controlled by Urban Shopping Centers, Inc. (a corporation organized by an affiliate of the General Partners of the Partnership, which operates in a manner which it expects to enable it to qualify as a real estate investment trust). The total cash investment of JMB/Miami in West Dade is $20,805,000, of which the Partnership's share is $10,402,500. The terms of JMB/Miami partnership agreement provide that annual cash flow, net sale or refinancing proceeds, and tax items will be distributed or allocated, as the case may be, to the Partnership in proportion to its 50% share of capital contributions. At closing, JMB/Miami made a cash payment of $14,567,306 consisting of (i) $13,441,000 for a 33% interest in West Dade and options, exercised in early 1989, to acquire an additional 17% interest in West Dade and (ii) $1,126,306 as a contribution for initial working capital requirements of West Dade. JMB/Miami paid an additional $4,237,694 of purchase price representing payments under the various option agreements entered into at closing, upon exercise of these options in February 1989. The West Dade venture agreement provides that JMB/Miami and the Venture Partner generally are each entitled to receive 50% of profits and losses, net cash flow and net sale or refinancing proceeds of West Dade and are each obligated to advance 50% of any additional funds required under the terms of the West Dade venture agreement. In December 1993, West Dade obtained a new mortgage loan in the principal amount of $47,500,000 replacing the existing first mortgage loan at the property. The new mortgage loan bears interest at 6.91% per annum and matures December 21, 2003. The loan provides for monthly interest-only payments for years one through three and monthly principal and interest payments based on a twenty-year amortization period for years four through ten. The loan permits prepayment in full with 30 days prior written notice and payment of a premium calculated as the greater of (i) 1% of the principal being prepaid multiplied by the percent of months remaining to maturity or (ii) the present value of the loan less principal and accrued interest being prepaid. The non-recourse loan is secured by a first mortgage on the Miami International Mall. After payment of costs and fees related to the refinancing, there were no distributable proceeds from the new loan. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In conjunction with the refinancing in December 1993, West Dade incurred a prepayment penalty on the early retirement of the original loan in the amount $2,015,357, of which the Partnership's share is $503,839. In addition, West Dade had written off costs associated with the original loan in the amount of $69,374, of which the Partnership's share is $17,344. In 1992, West Dade sold land to J.C. Penney to open a department store at the mall. Under the sale agreement, J.C. Penney purchased land from West Dade for approximately $1,260,000, and West Dade expended approximately $894,000 related to land preparation costs in 1990 and 1991. J.C. Penney completed construction of its own facility of 145,824 square feet and opened in late October 1992. During the third quarter of 1992, the property experienced storm damage caused by Hurricane Andrew. Although structural damage to the building was minimal, the landscaping surrounding the building, including the irrigation system and street curbs, was impacted more severely. All repairs necessary to continue operations have been made. The Partnership believes West Dade has adequate insurance coverage for this damage. A claim has been submitted to the property's insurance company for approximately $750,000. In January 1994, a partial settlement of approximately $710,000 of the expected insurance proceeds had been received. West Dade sold a 3.9 acre outparcel of land at Miami International Mall in June 1993 for a net sale price of approximately $1,560,000 after certain selling costs, of which the Partnership's share was approximately $390,000. For financial reporting purposes, West Dade has recognized a gain in 1993 of approximately $1,385,000, of which the Partnership's share is approximately $346,000. For income tax purposes, West Dade has recognized a gain in 1993 of approximately $325,000, of which the Partnership's share is a loss of approximately $37,000. West Dade is currently negotiating the sale of an additional 4 acre outparcel of land. The shopping center is managed by an affiliate of the Venture Partner. The manager is paid an annual fee equal to 4-1/2% of the net operating income of the shopping center. (e) Adams/Wabash On April 19, 1988, an affiliate of the Partnership entered into a forward commitment on behalf of the Partnership to make a total cash investment to a maximum of $25,750,000 in the Adams/Wabash Limited Partnership ("Adams/- Wabash"), which constructed a parking garage and retail space structure (the "Project") in Chicago, Illinois. The Project contains 671 parking spaces and approximately 28,800 square feet of rentable retail area. Through December 31, 1993, the Partnership has funded approximately $24,994,000 of its total cash commitment and does not anticipate increasing its original cash investment. Upon acquisition, the Partnership was admitted to an existing partnership with a 49.9% ownership interest, which increased to 74.9% effective October 1, 1993 pursuant to the terms of the Adams/Wabash Partnership Agreement. The Managing General Partner of the Partnership has a .1% interest with the remaining 25% held by the developers. The Partnership is entitled to a cumulative annual preferred return, payable from operating cash flow, of 10% of its capital contributions to the existing partnership. Payment of the preferred return was guaranteed by one of the joint venture partners through September 30, 1992, except to the extent the Partnership was required to make contributions under the joint venture agreement. Any distributable cash flow JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED in excess of the Partnership's preferred return will be distributed in accordance with the ownership interests of Adams/Wabash. The Partnership also has a preferred position with respect to distributions of sales and financing proceeds. Items of profit and loss are, in general, allocated in accordance with distributions of cash flow. Accordingly, for financial reporting purposes, for the years ended December 31, 1993, 1992 and 1991, the Partnership was allocated 100% of the operating profits of Adams/Wabash. As of December 31, 1993, the Partnership has received its preferred return. (4) LONG-TERM DEBT (a) Long-term debt consisted of the following at December 31, 1993 and 1992: 1993 1992 ------------ ------------ 10.03% mortgage note; secured by the Rivertree Court Shopping Center located in Vernon Hills (Chicago), Illinois; payable monthly, interest only; due January 1, 1999 . . . . $15,700,000 15,700,000 8.83% mortgage note; secured by the Fountain Valley and Cerritos Industrial Parks located in Fountain Valley and Cerritos, (Los Angeles) California, respectively; payable monthly, interest only; due November 1, 1993 (b). . 11,000,000 11,000,000 ----------- ---------- Total debt . . . . . . . . . . 26,700,000 26,700,000 Less current portion of long-term debt (b). . . . . . -- 11,000,000 ----------- ---------- Total long-term debt . . . . . $26,700,000 15,700,000 =========== ========== (b) Long-Term Debt Refinancing In February 1994, the Partnership extended and increased the first mortgage loan to the principal amount of $11,200,000, which is secured by the Fountain Valley and Cerritos Industrial Parks. The extended loan bears interest at a rate of 7.32% per annum, provides for monthly payments of principal and interest based on a twenty-year amortization period and matures March 1, 2001. After payment of costs and fees related to the refinancing, there were no distributable proceeds from the loan extension. Prior to the extension, the Partnership had entered into a forbearance agreement with the lender providing, among other things, that the lender agreed not to exercise its rights and remedies under the original loan documents from November 2, 1993, the original maturity date, until January 31, 1994. The Partnership continued to pay interest only at an annual rate of 8.83% on the original $11,000,000 principal balance through the effective date of the refinancing. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits or losses of the Partnership from operations generally are allocated 96% to the Limited Partners and 4% to the General Partners. Profits or losses for Federal income tax purposes from the sale or refinancing of properties generally will be allocated 99% to the Limited Partners and 1% to the General Partners. However, net profits from the sale of properties will be additionally allocated to the General Partners (i) to the extent that cash distributions to the General Partners of sale proceeds from such sale exceed the aforesaid 1% of such profits and (ii) in order to reduce deficits, if any, in the General Partners' capital accounts to a level consistent with the gain anticipated to be realized from the sale of additional properties. The General Partners have made capital contributions to the Partnership aggregating $20,000. The General Partners are not required to make any additional capital contributions except under certain limited circumstances upon dissolution and termination of the Partnership. Disburseable cash from operations, as defined in the Partnership Agreement, will be distributed 90% to the Limited Partners and 10% to the General Partners, subject to certain limitations. Sale or refinancing proceeds will be distributed 100% to the Limited Partners until the Limited Partners have received their contributed capital plus a stipulated return thereon. The General Partners will then receive 100% of the sale or refinancing proceeds until they receive amounts equal to (i) the cumulative deferral of their 10% distribution of disburseable cash and (ii) 2% of the selling prices of all properties which have been sold, subject to certain limitations. Any remaining sale or refinancing proceeds will then be distributed 85% to the Limited Partners and 15% to the General Partners. Accordingly, approximately $3,265,000 of disburseable cash and approximately $618,000 of sale proceeds from Mid Rivers Mall has been deferred by the General Partners (note 7). (6) MANAGEMENT AGREEMENTS - OTHER THAN VENTURES Rivertree Court Shopping Center, Fountain Valley Industrial Park and Cerritos Industrial Park are managed by an affiliate of the Managing General Partner of the Partnership. The fee for managing Rivertree Court is equal to 3% of minimum and percentage rents of the property. The fee for managing the Industrial Parks is equal to 3.75% of gross receipts of the properties. (7) SALE OF MID RIVERS MALL On January 30, 1992, the Partnership, through JMB/Rivers, sold its interest in the Mid Rivers Mall located in St. Peters, Missouri to the unaffiliated joint venture partner. The sale price of the interest was $26,500,000 (before closing costs and prorations) plus the outstanding balance of the mortgages of which JMB/Rivers' share was $35,318,171. The Partnership received in connection with the sale, after all fees, expenses and joint venture partner's participation, a net amount of cash of $13,250,000. For financial reporting purposes, JMB/Rivers had recognized a gain of approximately $12,022,000 in 1992, of which the Partnership's share was approximately $6,366,000. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (8) LEASES As Property Lessor The Partnership and its consolidated venture's principal assets are two multi-tenant industrial building complexes, a shopping center and a parking/retail structure. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of the properties, excluding the cost of the land, is depreciated over their estimated useful lives. Leases with tenants range in term from one to twenty years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Industrial Building Complexes: Cost. . . . . . . . . . . . . . . . . . . $36,956,309 Accumulated depreciation. . . . . . . . . (4,545,732) ----------- 32,410,577 ----------- Shopping Center: Cost. . . . . . . . . . . . . . . . . . . 39,173,543 Accumulated depreciation. . . . . . . . . (5,432,158) ----------- 33,741,385 ----------- Parking/Retail Structure: Cost. . . . . . . . . . . . . . . . . . . 22,390,562 Accumulated depreciation. . . . . . . . . (1,648,298) ----------- 20,742,264 ----------- $86,894,226 =========== Minimum lease payments, including amounts representing executory costs (e.g. taxes, maintenance, insurance) and any related profit, to be received in the future under the operating leases are as follows: 1994. . . . . . . . . . . . . . . . . . . . $ 6,130,496 1995. . . . . . . . . . . . . . . . . . . . 5,558,448 1996. . . . . . . . . . . . . . . . . . . . 4,937,843 1997. . . . . . . . . . . . . . . . . . . . 4,271,664 1998. . . . . . . . . . . . . . . . . . . . 3,414,456 Thereafter. . . . . . . . . . . . . . . . . 17,941,608 ----------- Total. . . . . . . . . . . . . . . . . $42,254,515 =========== JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In accordance with the subordination requirements of the Partnership Agreement (note 5), the General Partners have deferred payment of certain of their distributions of net cash flow from the Partnership. All amounts deferred or currently payable do not bear interest. (10) INVESTMENT IN UNCONSOLIDATED VENTURES Summary combined financial information for JMB/Rivers, First Financial and JMB/Miami (note 3) as of and for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ------------ ------------ Current assets . . . . . . . . . . $ 4,571,308 3,449,168 Other current liabilities. . . . . (975,901) (1,218,915) ------------ ------------ Working capital. . . . . . . . 3,595,407 2,230,253 Investment property, net . . . . . 87,047,194 89,900,221 Other assets, net. . . . . . . . . 2,193,963 2,035,457 Long-term debt . . . . . . . . . . (76,661,145) (74,339,146) Other liabilities. . . . . . . . . (253,238) (212,250) Venture partners' equity . . . . . (5,142,800) (7,774,113) ------------ ------------ Partnership's capital. . . . . $ 10,779,381 11,840,422 ============ ============ Represented by: Invested capital . . . . . . . . $ 32,035,179 31,980,948 Cumulative distributions . . . . (26,933,034) (26,150,584) Cumulative earnings (loss) . . . 5,677,236 6,010,058 ------------ ------------ $ 10,779,381 11,840,422 ============ ============ Total income . . . . . . . . . . . $ 18,281,016 18,104,319 ============ ============ Operating expenses . . . . . . . . $ 18,540,392 19,014,371 ============ ============ Operating loss . . . . . . . . . . $ (259,376) (910,052) ============ ============ Gain on sale of land and property. $ 1,384,831 12,022,339 ============ ============ Extraordinary item . . . . . . . . $ (2,084,731) -- ============ ============ Net income (loss). . . . . . . . . $ (959,276) 11,112,287 ============ ============ JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED Total income, operating expenses and net loss of the above-mentioned ventures for the year ended December 31, 1991 were $26,027,541, $27,409,527 and $1,381,986, respectively. (11) SUBSEQUENT EVENTS (a) Distributions In February 1994, the Partnership paid a distribution of $1,264,140 ($10.00 per interest) to the Limited Partners, $12,769 to the Special Limited Partner and $35,470 to the General Partners. (b) Re-financing In February 1994, the Partnership extended and increased the first mortgage loan to the principal amount of $11,200,000, which is secured by the Fountain Valley and Cerritos Industrial Parks. The extended loan bears interest at a rate of 7.32% per annum, provides for monthly payments of principal and interest based on a twenty-year amortization period and matures March 1, 2001. See note 4(b). Schedule X JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 CHARGED TO COSTS AND EXPENSES --------------------------------------------- 1993 1992 1991 ---------- ---------- ---------- Maintenance and repairs. $1,010,757 1,082,912 945,276 Depreciation . . . . . . 2,476,913 2,454,001 2,415,414 Amortization of deferred expenses . . . 175,953 150,274 259,006 Real estate taxes. . . . 1,554,115 1,340,044 1,583,637 ========== ========== ========== ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of, or disagreements with, accountants during fiscal years 1993 and 1992. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Managing General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware Corporation. JMB has responsibility for all aspects of the Partnership's operations, subject to the requirement that purchases and sales of real property must be approved by the Associate General Partner of the Partnership, Income Associates-XIII, L.P. an Illinois limited partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. The relationship of the Managing General Partner to its affiliates is described under the caption "Conflicts of Interest" at pages 12-18 of the Prospectus, which description is hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 000-19496) dated March 18, 1993. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/27/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve a one-year term until the annual meeting of the Managing General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Managing General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the corporate general partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIII ("Carlyle-XIII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd.-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II") and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI") and JMB Income Properties, Ltd.-XII ("JMB Income-XII"). Most of the foregoing directors and officers are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II") and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). Most of such directors and officers are also partners of certain partnerships which are associate general partners in the following real estate limited partnerships: Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Managing General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September, 1977. He holds a Masters degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June, 1971 and served as an Executive Vice President of JMB until December of 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July, 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President and Director of JMB Insurance Agency, Inc.) has been associated with JMB since December, 1972. John G. Schreiber (age 47) has been associated with JMB since December, 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 44) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 42) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The officers and director of the Managing General Partner receive no current or proposed direct remuneration in such capacities. The General Partners of the Partnership are entitled to receive a share of cash distributions, when and as cash distributions are made to the Investors, and a share of profits or losses as described under the caption "Cash Distributions; Allocations of Profits and Losses" at pages A-9 to A-15 of the Partnership Agreement included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 000-19496) dated March 18, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993, 1992 and 1991, the General Partners received cash distributions in the amount of $141,879, $141,879 and $154,293, respectively. As of December 31, 1993, the General Partners have deferred payment of distributions in the aggregate amount of $3,265,057. The General Partners of the Partnership may be reimbursed for their direct expenses relating to the offering, the administration of the Partnership and the operation of the Partnership's real property investments. In 1993, an affiliate of the General Partners was due reimbursement for such out-of-pocket expenses in the amount of $11,206, of which $1,122 was unpaid at December 31, 1993. The General Partners may be reimbursed for salaries and direct expenses of officers and employees of the Managing General Partner and its affiliates while directly engaged in the administration of the Partnership and the operation of the Partnership's real property investments. In 1993, the Managing General Partner was due reimbursement for such expenses in the amount of $78,408, all of which was unpaid as of December 31, 1993. An affiliate of the General Partners provided property management services for the Fountain Valley and Cerritos Industrial Parks and the Rivertree Court Shopping Center during 1993. In 1993, such affiliate earned property management fees amounting to $231,529, of which $3,638 was unpaid as of December 31, 1993. JMB Insurance Agency, Inc., an affiliate of the Managing General Partner of the Partnership, earned and received insurance brokerage commissions in 1993 aggregating $10,861 in connection with the providing of insurance coverage for certain of the real property investments of the Partnership. Such commissions are at rates set by insurance companies for the classes of coverage provided. The Partnership is permitted to engage in various transactions involving affiliates of the Managing General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 8 to 12, and "Conflicts of Interest" at pages 12-19 of the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 000-19496) dated March 18, 1993, and under the caption "Rights, Powers and Duties of General Partners" at pages A-17 to A-28 of the Partnership Agreement, included as an exhibit to the Prospectus. The relationship of the Managing General Partner (and its directors and officers) to its affiliates is set forth in Item 10 above and Exhibit 21 hereto. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3-A. The Prospectus of the Partnership dated August 20, 1986 as supplemented October 31, 1986 and January 26, 1987 as filed with the Commission pursuant to Rules 424(b) and 424(c) is hereby incorporated herein by reference. Copies of pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus are hereby incorporated by reference to Exhibit 3-A to the Partnership's Form 10-K dated March 18, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which is hereby incorporated by reference to Exhibit 3-B to the Partnership's From 10-K dated March 18, 1993. 4-A. Copy of documents relating to the mortgage loan secured by the Rivertree Court Shopping Center, Vernon Hills (Chicago), Illinois dated December 30, 1988 is hereby incorporated by reference to Exhibit 4-A to the Partnership's Form 10-K dated March 18, 1993. 4-B. Copy of documents relating to the mortgage loan secured by a first mortgage on West Dade's interest in Miami International Mall, Miami, Florida dated December 21, 1993 is filed herewith. 10-A. Acquisition documents relating to the purchase by the Partnership of Rivertree Court Shopping Center in Vernon Hills (Chicago), Illinois, are hereby incorporated by reference to Exhibit 1 to the Partnership's Form 8-K dated November 4, 1988. 10-B. Acquisition documents relating to the purchase by the Partnership of Fountain Valley Industrial Buildings in Fountain Valley, California and Cerritos Industrial Buildings in Cerritos, California, are hereby incorporated by reference to Exhibits 1 and 2 to the Partnership's Form 8-K dated November 15, 1988. 10-C. Acquisition documents relating to the acquisition by the Partnership of an interest in the Adams/Wabash Parking Garage in Chicago, Illinois are hereby incorporated by reference to Exhibit 3 to the Partnership's Form 8-K dated October 15, 1990. 10-D. Sale documents and exhibits thereto relating to the sale of the Partnership's interest in Mid Rivers Mall in St. Peters (St. Louis), Missouri are hereby incorporated by reference to the Partnership's Report on Form 8-K dated February 18, 1992. 21. List of Subsidiaries. 24. Powers of Attorney Although certain long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule (b)(4)(iii), the Registrants commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) No reports on Form 8-K were required to be filed during the last quarter of the period covered by this annual report. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - XIII By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Managing General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By: GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 JMB INCOME PROPERTIES, LTD. - XIII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus of the Partnership dated August 20, 1986, as supplemented on October 31, 1986, and January 26, 1987 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan agreement related to the Rivertree Court Shopping Center Yes 4-B. Mortgage loan agreement related to West Dade No 10-A. Acquisition documents relating to the Rivertree Court Shopping Center Yes 10-B. Acquisition documents relating to the Fountain Valley Industrial Buildings and Cerritos Industrial Buildings Yes 10-C. Acquisition documents relating to the Adams/Wabash Parking Garage Yes 10-D. Sale documents relating to the Mid Rivers Mall Yes 21. List of Subsidiaries No 24. Powers of Attorney No ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3-A. The Prospectus of the Partnership dated August 20, 1986 as supplemented October 31, 1986 and January 26, 1987 as filed with the Commission pursuant to Rules 424(b) and 424(c) is hereby incorporated herein by reference. Copies of pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus are hereby incorporated by reference to Exhibit 3-A to the Partnership's Form 10-K dated March 18, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which is hereby incorporated by reference to Exhibit 3-B to the Partnership's From 10-K dated March 18, 1993. 4-A. Copy of documents relating to the mortgage loan secured by the Rivertree Court Shopping Center, Vernon Hills (Chicago), Illinois dated December 30, 1988 is hereby incorporated by reference to Exhibit 4-A to the Partnership's Form 10-K dated March 18, 1993. 4-B. Copy of documents relating to the mortgage loan secured by a first mortgage on West Dade's interest in Miami International Mall, Miami, Florida dated December 21, 1993 is filed herewith. 10-A. Acquisition documents relating to the purchase by the Partnership of Rivertree Court Shopping Center in Vernon Hills (Chicago), Illinois, are hereby incorporated by reference to Exhibit 1 to the Partnership's Form 8-K dated November 4, 1988. 10-B. Acquisition documents relating to the purchase by the Partnership of Fountain Valley Industrial Buildings in Fountain Valley, California and Cerritos Industrial Buildings in Cerritos, California, are hereby incorporated by reference to Exhibits 1 and 2 to the Partnership's Form 8-K dated November 15, 1988. 10-C. Acquisition documents relating to the acquisition by the Partnership of an interest in the Adams/Wabash Parking Garage in Chicago, Illinois are hereby incorporated by reference to Exhibit 3 to the Partnership's Form 8-K dated October 15, 1990. 10-D. Sale documents and exhibits thereto relating to the sale of the Partnership's interest in Mid Rivers Mall in St. Peters (St. Louis), Missouri are hereby incorporated by reference to the Partnership's Report on Form 8-K dated February 18, 1992. 21. List of Subsidiaries. 24. Powers of Attorney Although certain long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule (b)(4)(iii), the Registrants commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) No reports on Form 8-K were required to be filed during the last quarter of the period covered by this annual report. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - XIII By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Managing General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By: GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 JMB INCOME PROPERTIES, LTD. - XIII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus of the Partnership dated August 20, 1986, as supplemented on October 31, 1986, and January 26, 1987 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan agreement related to the Rivertree Court Shopping Center Yes 4-B. Mortgage loan agreement related to West Dade No 10-A. Acquisition documents relating to the Rivertree Court Shopping Center Yes 10-B. Acquisition documents relating to the Fountain Valley Industrial Buildings and Cerritos Industrial Buildings Yes 10-C. Acquisition documents relating to the Adams/Wabash Parking Garage Yes 10-D. Sale documents relating to the Mid Rivers Mall Yes 21. List of Subsidiaries No 24. Powers of Attorney No

814241_1993.txt

814241_1993

1993

814241

ITEM 1 BUSINESS GENERAL Formica Corporation and its subsidiaries (the "Company" or "Formica") designs, manufactures and distributes decorative laminates and other surfacing products worldwide and is the world's largest producer of high pressure decorative laminates. The Company's products compete against a wide range of surfacing materials which include decorative laminates produced by other manufacturers, as well as wood, veneers, marble, tile, plastics and foils. The Company distributes its products under the FORMICA(R), COLORCORE(R) and SURELL(R) brand names and the ANVIL F(R) Logo, among others. The Company's ten manufacturing facilities are located in the United States, the United Kingdom, Canada, France, Spain, Germany and Taiwan, and its products are principally distributed throughout North America, Europe and the Far East. For information by geographic area, including net sales, operating income, capital expenditures and identifiable assets, see Note 9 to the Company's Consolidated Financial Statements as well as "Item 7 - Management's Discussion and Analysis of Results of Operations and Financial Condition." PRODUCTS Decorative laminates are used in a wide range of surfacing applications where durability, design, construction versatility and ease of maintenance are factors. The Company's principal products are high pressure decorative laminates. In a few geographic areas, the Company also offers a complementary line of low pressure laminates in designs that match or complement the Company's high pressure laminate products. In addition, the Company acquired Wildon Industries, Inc. ("Wildon") in 1986 for the purpose of developing a high quality solid surfacing material, which is marketed under the SURELL brand name. The Company also manufactures and sells resins and licenses its FORMICA brand name and proprietary technology and know-how to third parties. Commercial applications for the Company's decorative laminates include countertops, furniture, flooring, doors, window sills, walls and other interior surfacing uses. Residential applications for the Company's decorative laminates include cabinetry and countertops for kitchens and bathrooms; surfacing for living room, dining room, family room, kitchen and bathroom furniture; and other interior architectural uses throughout the house. The Company's products are used in homes, retail stores, offices, office lobbies, hotels, hospitals, restaurants, airports, banks, computer centers, ships, buses and railroad cars, as well as numerous other uses. High Pressure Decorative Laminates. High pressure decorative laminates include standard line decorative products and premium decorative products which accounted for approximately 77% and 17%, respectively, of the Company's total net sales for the year ended December 31, 1993. The Company's standard decorative line consists of decorative laminates such as solid colors, abstract patterns, woodgrain patterns and other simulations of natural materials. These products are sold in sheet form in a multitude of sizes and in over 1,000 colors, patterns and textures. Premium decorative laminates have characteristics that make them particularly suitable for various specialized applications and generate higher profit margins than the standard line products. Premium decorative laminates include the Company's DESIGN CONCEPTS(R) and FORMATIONS(R) collections and COLORCORE(R) surfacing material, a solid "color-through" laminate, which are marketed for special end-use applications such as office furniture, store fixtures, restaurant interiors, airports and custom-built kitchens. Premium decorative products also include laminates for uses requiring fire-rated materials such as shipbuilding and office interiors; textured laminates, which are designed to look and feel like leather or slate; metallic laminates which are manufactured with a metallic surface for "high style" effects; and laminates applied to static-free flooring used in computer centers. Solid Surfacing Products. The Company's solid surfacing products are manufactured by combining resin with filler and curing the mixture in molds under heat. These products, distributed under the brand name SURELL, are available in a selection of colors and granite-like patterns, which run throughout the entire thickness of the product. The products can be shaped and molded for use in a variety of residential and commercial applications such as vanities with dripless edges and integral backsplashes, or produced in sheet form for work surfaces, countertops and other surface applications. The Company has devoted substantial resources to the development of its solid surfacing products as a high quality surfacing material and to the development of efficient manufacturing methods for the production of these products in commercial quantities. The current United States market for solid surfacing material is dominated by E.I. DuPont de Nemours & Co. which sells its product through a distribution network which includes a limited number of distributors of other FORMICA brand products. The Company believes that there are significant opportunities for new entrants in the expanding market for solid surfacing material and intends to use its brand name and established channels of distribution to take advantage of these opportunities. The Company is marketing its solid surfacing products as premium products on a broad scale through its domestic and international distribution network. New Product and Design Development. A major portion of the Company's research efforts is devoted to the development of new applications for high pressure decorative laminates and solid surfacing products, new products and process improvements. Design is an important factor in the choice of the product line manufactured by the Company and in the surfacing industry as a whole. New laminate designs are introduced periodically by the Company and its competitors. The Company considers itself the industry leader worldwide in decorative laminate design and new product development and carries out design development in North America and Europe. The Company has won numerous design and product awards. The Company's efforts to refine the designs of its products have resulted in such products as the DESIGN CONCEPTS and FORMATIONS collections, COLORCORE, a solid "color-through" laminate, and the STRIPES and GEOMETRICA(R) collections featuring silk screenprinted pinstripes and bands in a variety of colors. During the last several years, the Company introduced solid opaque laminates, granite-like solid surfacing materials, high wear laminates and a number of other premium products. In addition, the Company has introduced a number of other product lines including ALULAM(R), a metallic exterior surfacing laminate, and ALACORE(R), a translucent laminate collection with three-dimensional design effects. In addition to new products designed and developed internally, the Company has acquired worldwide distribution rights to several new products. The Company recently introduced to the market a new surfacing material called NUVEL, which was developed by General Electric Company ("GE"). In late 1992, Formica entered into a worldwide exclusive distribution agreement with GE, which manufactures this product using its proprietary technology. The product has the features of traditional solid surfacing materials but can be installed at a lower cost. In addition to traditional solid surfacing applications such as countertops, the product has numerous additional applications including cabinetry, doors, furniture and store fixtures. The product is being marketed with the GE logo as well as the NUVEL and FORMICA trademarks. Another new product which the Company has begun marketing through its worldwide distribution network is called GRANULON, which is a spray-on surfacing material. The GRANULON product is a densified liquid composite available in an array of granite and solid colors that can be used for a variety of traditional and unique surfacing applications including furniture, cabinetry and molded shapes. Formica has also recently signed an agreement with a European manufacturer of specialty wood veneer laminates and will be distributing these products under the FORMICA LIGNA brand name. In addition to the new products mentioned above, the Company has entered into a cooperative enterprise agreement for the distribution of locally produced laminate products throughout the People's Republic of China. The products are manufactured using Formica technology. MARKETING, DISTRIBUTION AND CUSTOMERS The Company believes its global distribution and dealer network with its extensive sales force and the FORMICA brand name and ANVIL F Logo are major marketing strengths and key elements to the Company's success. The Company believes that none of the Company's competitors has as extensive a worldwide distribution and dealer network or the brand recognition of the FORMICA brand name. The Company's products are sold through distributors of wholesale building materials and distributors of products for the cabinet industry and directly to original equipment manufacturers for both residential and commercial uses. For the year ended December 31, 1993, approximately 60% of the Company's net sales were made through independent distributors, and the remaining 40% were made directly to users of the Company's products. The Company's distribution network includes approximately 700 independent distributor locations worldwide. Many distributors have sub-distributorships and dealer networks. As a result, the Company's products are represented in thousands of locations worldwide. The effort of the Company's domestic and international sales and architectural specification representatives, when combined with the sales force of its distributor network, provides the Company with sales and marketing coverage in over 100 countries throughout the world. The Company's sales representatives market the Company's products directly to end-users and work with distributors by monitoring distributors' inventories, calling on customers, architects and designers with the distributors' sales representatives and assisting distributors in the development of advertising and promotional campaigns and materials and the introduction of products. Generally, the Company's distributorship sales are made by distributors that exclusively carry the Company's brand of high pressure decorative laminates. The typical distributor of the Company's products also sells some or all of the following: other surfacing materials, adhesives, cabinetry, flooring material, particle board, hardware and other related architectural and building materials. The Company considers its distribution network to be an important vehicle for the introduction of new products the Company may develop or distribute in the future. The Company estimates that of its net sales for the year ended December 31, 1993, approximately one-half were derived from products used in commercial applications and one-half from products used in residential applications. In addition, the Company estimates that approximately two-thirds of its net sales for such period were derived from products used in remodeling or renovation projects, while approximately one-third of its net sales for such periods were derived from product used in new construction. Sales in the commercial market are heavily influenced by the specifications of architects and designers. In addition to the Company's regular sales force, a specialized sales force calls exclusively on architects and designers in North America, Europe and the Far East. The Company's backlog is not significant due to the ability of the Company to respond adequately to customer requests for product shipments. Generally, the Company's products are manufactured from raw materials in stock and are delivered to the Company's customers within one to thirty days from receipt of the order, depending on customer delivery specifications. Substantially all orders are shipped by the Company by the customer's due date. The Company has no significant long-term contracts for the distribution of its products. For the year ended December 31, 1993, no customer or affiliated group of customers accounted for as much as 5% of the Company's consolidated net sales. MANUFACTURING AND RAW MATERIALS High pressure decorative laminates are produced from a few basic raw materials which include kraft paper, fine decorative papers and melamine and phenolic resins. The papers are impregnated with resins and placed between stainless steel plates in a multi-opening press and cured under pressure and elevated temperature. The number of paper laminations per sheet of laminate varies with the specific type of product being produced, but all have melamine resin on the surface to create a hard, durable surface. Surface textures can range from very high gloss smooth surfaces to deeply textured surfaces and surfaces with other special design and performance features. In addition to patents, the Company has proprietary technology and know-how in the design and manufacture of its products. Kraft papers are available globally from several major sources and many smaller producers. Fine papers are supplied by many producers in North America, Europe and Asia. Melamine, phenol and formaldehyde, the primary raw materials for resins, are global commodity chemicals available from many suppliers. The Company currently purchases these raw materials on a global basis from various suppliers at market prices. The Company believes that it is the largest purchaser of these raw materials on a worldwide basis in the high pressure laminate industry. The Company may, from time to time, enter into one-year or longer-term contracts with suppliers when advantageous to it. The Company also acquires certain chemicals under exclusive arrangements from producers in connection with licensing technology from those producers. The Company has experienced no supply problems of any raw materials in the last 10 years. The Company manufactures and distributes products on a global basis with ten manufacturing facilities located in the United States, Canada, the United Kingdom, France, Spain, Taiwan and a 50% interest in a joint venture manufacturing plant in Germany which produces specialized metallic surfaced laminate products. These multiple manufacturing locations around the world enable the Company to reduce delivery times, freight costs and duties that it would otherwise encounter. Generally, each facility is shut down from one to four weeks annually for maintenance, refurbishment and traditional vacation periods. In general, each manufacturing facility produces a standard product line for its geographic market and produces one or more specialty products which may be sold in its market or exported to other markets. This allocation of production responsibility is designed to insure prompt delivery to customers of the Company's standard product lines and economies of scale in the production of the Company's premium products. In addition, certain of the Company's specialty products have been developed in response to regional design preferences. The Company's manufacturing facilities normally operate 24 hours a day on a five or seven day week schedule. Periodically, the Company operates on an overtime basis to satisfy customer requirements during periods of peak demand. Management believes that its existing manufacturing facilities are satisfactory for the Company's projected requirements. The Company has devoted substantial resources to the development of its plate manufacturing technology and produces its own plates in its manufacturing facility in LaPlaine, France. As of December 31, 1989, the Company had substantially completed the installation of such plate technology in all of its laminate manufacturing facilities. COMPETITION The Company's products compete around the world with decorative laminates manufactured by other producers, as well as with wood, veneers, marble, tile, plastics, foils and other surfacing materials. Competition is based principally on breadth of product line, product quality, marketing, technology, price and service. The Company competes in a number of geographic markets and its success in each of these markets is influenced by the factors mentioned above. The Company believes it is the single largest producer of decorative laminates on a worldwide basis. The Company also believes it is the largest or second largest producer of decorative laminates in various national markets (including the United States, Canada, the United Kingdom, France, Spain, and Taiwan) in which it competes on a local basis with many other producers, some of which are owned by larger enterprises which may have greater assets or resources than the Company. In many of the other national markets in which the Company competes, it enjoys a smaller but nonetheless significant market position. In the North American laminate market, the Company's principal competitors include Ralph Wilson Plastics Company, Nevamar Corporation and Arborite Corporation. In Europe, principal competitors include Perstorp and Polyrey. INTERNATIONAL OPERATIONS The Company's net sales from international operations to third parties accounted for approximately 47% of total net sales of the Company's products for the year ended December 31, 1993. The Company has manufacturing subsidiaries located in the United Kingdom, France, Spain, Canada and Taiwan and has a 50% interest in a German joint venture. The Company's principal international markets are located in Europe, Canada, Mexico and the Far East. The Company's international operations are subject to foreign currency fluctuations, local laws concerning repatriation of profits and other factors normally associated with multinational operations. See "Item 7 - Management's Discussion and Analysis of Results of Operations and Financial Condition" and Note 9 to the Company's Consolidated Financial Statements for information about the business of the Company by geographic area. PATENTS, TRADEMARKS AND LICENSES The Company owns patents and possesses proprietary information which relate to its products and processes. The Company believes that the loss of any of its patents would not have a material adverse effect upon its business. Trademarks are important to the Company's business and licensing activities. The Company has a vigorous program of trademark enforcement to prevent the unauthorized use of its trademarks, to strengthen the value of its trademarks and to improve its image and customer goodwill. The Company believes that the FORMICA trademark and the ANVIL F Logo are its most significant trademarks. In addition to registration in the United States, the FORMICA trademark and the ANVIL F Logo are registered in over 100 countries. The COLORCORE trademark is registered in the United States and over 20 other countries. The SURELL trademark is also registered in the United States and in several other countries. Formica has used the FORMICA brand name continuously since 1913. Additionally, the Company has numerous other registered trademarks, trade names and logos, both in the United States and abroad. The Company believes that numerous opportunities exist to license the Company's internationally recognized FORMICA trademark and ANVIL F Logo and the Company's proprietary technology and know-how. The Company has existing licensing arrangements for its trademarks and, in certain cases, its proprietary technology with CSR Limited in Australia and New Zealand and with manufacturers of adhesives and certain other complementary products. In addition to the above, the Company has non-royalty licenses with a company in India and with American Cyanamid Company which permits the exclusive use of the FORMICA trademark primarily in South America. RESEARCH AND DEVELOPMENT Technical support to the Company's business is organized on a worldwide basis. The major part of the Company's research program, which involves the development of new applications for existing products, new products and process improvements, is carried out by the Research and Development departments located in the United States and the United Kingdom. Technical groups located at each plant also participate in the overall program and work on smaller projects under the direction of the Company's research director. Research and development costs charged to operations during the years ended December 31, 1993, 1992 and 1991 amounted to $3.3 million, $3.5 million, and $3.6 million, respectively. See Note 2 to the Company's Consolidated Financial Statements for information concerning research and development costs. ENVIRONMENTAL MATTERS The Company (and the industry in which it competes) is subject to extensive regulation under federal, state, local and foreign environmental laws and regulations regarding emissions to air, discharges to water and the generation, handling, storage, transportation, treatment and disposal of waste and other materials as well as laws and regulations relating to occupational health and safety. The Company believes that its manufacturing facilities are being operated in compliance in all material respects with the applicable environmental, health and safety laws and regulations but cannot predict whether more burdensome requirements will be imposed by governmental authorities in the future. Pursuant to the requirements of applicable federal, state and local statutes and regulations, the Company has received or applied for all of the environmental permits and approvals material to the operation of its manufacturing facilities. In November 1987, the United States Environmental Protection Agency (the "EPA") identified the Company as a Potentially Responsible Party ("PRP") pursuant to its authority under the Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA"), in connection with the Pristine, Inc. Superfund Site in Reading, Ohio. The Company's share of waste contribution to this site is approximately 11.5%. The EPA has completed a Remedial Investigation/Feasibility Study and has issued a Record of Decision calling for remedial action at the site which is estimated to cost approximately $21.7 million. The Company and other generators at the site signed a Consent Decree with the U.S. Government (EPA) in which a remedial clean-up plan has been agreed upon. The Consent Decree was approved by the United States District Court for the Southern District of Ohio and became effective on November 23, 1990. On October 16, 1989, the State of Ohio, in connection with its involvement at the site, instituted a lawsuit, entitled State of Ohio v. Pristine, Inc., et al., in the United States District Court for the Southern District of Ohio which demanded payment of approximately $104,000 in past costs and sought a declaratory judgment holding the Company and 29 other named defendants jointly and severally liable for the reimbursement of the State's future oversight costs. The Company and other named defendants jointly responded to this action and entered into settlement discussions that culminated in the negotiation of a Consent Decree in which the State substantially reduced its damage demands. The Consent Decree was approved by the Court and became effective on August 16, 1991, resulting in a dismissal of the State's law suit. In October, 1991, the City of Reading asserted a claim alleging that its municipal water well field has been contaminated by groundwater emanating from the Pristine, Inc. Superfund Site as well as a claim seeking natural resource damages. The City of Reading's claim was asserted against the owner/operator of the site as well as approximately 115 alleged generators of hazardous waste at the site, including the Company. The City of Reading and approximately 87 generators of waste at the site, including the Company, entered into a settlement agreement, dated as of September 1, 1993, whereby the City of Reading's claim was settled for $1.3 million, which claim has been paid on a pro rata basis by such generators of waste. The Company believes that it has adequate reserves for its anticipated share of the current estimate of the costs associated with the clean-up of this site. In August 1987, the Company received an Information Request Notice from the EPA advising that, pursuant to its authority under CERCLA, it was investigating the Bridgeport Rental and Oil Services waste disposal site in Logan Township, New Jersey. Although the EPA indicated that the Company may have contributed a small quantity of waste to the site in 1974, the Company has no records available to verify the EPA's claim and has so responded in its answers to the Information Request Notice. In late August 1989 the Company received a letter from the EPA naming it as a PRP at the site and demanding payment of at least $17.8 million for past cleanup costs. The notice, which was addressed to 57 other PRPs, also indicated that the EPA was prepared to use public funds to conduct further remedial action at the site. The Company and other PRPs are vigorously contesting the amount and nature of the EPA's claim and are actively pursuing other generators who may have contributed waste to the site. In connection with the waste storage site in Logan Township, New Jersey, the Company, on April 3, 1989, received from the New Jersey Department of Environmental Protection ("DEP") a Directive issued pursuant to the DEP's alleged authority under the New Jersey Spill Compensation and Control Act. The Directive demanded that the Company and 112 other alleged dischargers of hazardous substances pay the State of New Jersey approximately $9.2 million. That amount represents monies which New Jersey has paid to the EPA as a portion of its share of the remedial costs to be incurred in connection with the cleanup of the site. In response to the Directive, the Company, without admitting liability, contributed a nominal sum toward a good faith settlement offer which was forwarded to the DEP by a group of approximately 40 Directive recipients. That group and other recipients have also submitted statements to the DEP raising numerous defenses to the Directive. To date, communications with the EPA and DEP have continued, and no proceedings have been instituted in connection with the Directive. However, in a continuing effort to pursue all potentially responsible site generators, the Company and the other PRPs discovered evidence which linked numerous governmental departments to a significant amount of waste which had been deposited at the site. Thus, a group of PRPs, which did not include the Company, instituted a contribution action entitled Rollins Environmental Services (NJ), Inc., et al. vs. The United States of America, et al., Civil Action No. 92-1253 in the United States District Court for the District of New Jersey. Thereafter, the EPA instituted a cost recovery action, naming only certain site PRPs, in the same Court. That case, which is entitled United States of America vs. Allied Signal Inc., et al., Civil Action No. 92-2726, was then consolidated with the Rollins contribution suit. Although the Company is not a party to either case, it has agreed to take part in an informal discovery/settlement process pursuant to a Case Management Order. The Company believes it has adequate reserves to cover its anticipated liability in this site. In March 1990, the Company received an Information Request Notice from the EPA advising that, pursuant to its authority under CERCLA, it was continuing its investigation of the New Lyme Landfill Superfund Site in Ashtabula County, Ohio. Although the EPA indicated that the Company may have contributed waste to this residential/industrial site prior to the site shutdown in 1978, the Company, after investigation, was unable to locate records to determine if it had contributed waste to this site and so advised the EPA in its response to the Information Request Notice. To date the Company has received no further communications from the EPA or any other entity concerning this site. On or about October 5, 1990, a third party complaint entitled United States of America v. Norrell F. Dearing et al. v. Formica Corporation et al., United States District Court for the Northern District of Ohio, Eastern Division was served upon the Company. The third party complaint seeks contribution, in an unspecified amount, from the Company and other third party defendants for response costs incurred and to be incurred by the government of the United States in connection with the Old Mill Superfund Site in Rock Creek, Ohio. The original complaint, as amended, entitled United States of America v. Dearing et al., alleges that the EPA had incurred to date more than $7.7 million in response costs at the Old Mill Superfund Site which included the essentially complete implementation of the selected remedial action at the site. The Company has investigated whether or not it or a predecessor company contributed hazardous waste to this site during the 1977-1979 time period alleged in the complaint and has been unable to locate records to verify the allegations. The Company has filed an answer to the third party complaint, denying liability and raising numerous affirmative defenses and continues to vigorously defend this action. On February 9, 1993, the Company was served with a second third party complaint entitled State of Ohio v. Norrell E. Dearing et al. v. Formica Corporation et al. This third party complaint seeks contribution, in an unspecified amount, from the Company and other third party defendants for response costs incurred and to be incurred by the State of Ohio in connection with this site. The Company has filed an answer to this complaint denying liability and raising numerous affirmative defenses, and intends to vigorously defend this action. The Company, as of December 17, 1993, entered into an Indemnification Agreement with American Cyanamid Company ("ACCO") and Cytec Industries Inc. ("Cytec") wherein ACCO and Cytec agreed to indemnify and hold harmless the Company from and against any liability, including the two above-referenced third party complaints, resulting from the disposal by the Company of hazardous waste, originating from a Painesville, Ohio manufacturing facility operated by a predecessor company, at the Old Mill Superfund Site. In May 1991, the Company received an Information Request Notice from the EPA advising that, pursuant to its authority under CERCLA, the EPA was investigating the Skinner Landfill Superfund Site in West Chester, Ohio. Although the EPA indicated that the Company might have contributed waste to this site, the Company has no records available which verify the claim. However, in August 1991, the EPA issued a General Notice of Liability naming the Company and various other parties as PRPs at the site. At that time, the Company also received information which indicated that another site PRP had allegedly deposited relatively small quantities of the Company's waste at the site on three occasions in the 1960's and 1970's. In early 1992, a group of nine companies, including the Company, joined together to vigorously contest the matter when the EPA announced that it preferred a site incineration remedy estimated to cost approximately $29 million. Following concerted PRP efforts and local community negative reaction to the proposed incineration remedy, the EPA withdrew its preferred remedy and issued a unilateral abatement remedy Order calling for the expenditure of approximately $200,000 to secure the site and to provide public water hookups for some site neighbors. That Order was issued in December 1992 and was directed at 20 recipients, including the Company. Without admitting liability, the Company and nine other recipients have worked together to comply with the Order, while the remaining recipients are contesting the matter. In the meantime, the EPA has issued a Record of Decision calling for a site remedy estimated to cost $15.5 million. The Company and the other PRPs are pursuing the matter with the EPA as it prepares to issue a unilateral order calling for the formulation of a Remedial Design for the site. Concurrently, the Company and other PRPs are pursuing all other potentially responsible site generators. On or about October 20, 1993 the Company was served with a Summons and Complaint entitled California Sport Fishing Protection Alliance v. Formica Corp., in the United States District Court, Eastern District of California. This Complaint, brought as a citizens' suit under the Clean Water Act, alleges that the Company's Rocklin, California manufacturing plant has violated its National Pollutant Discharge Elimination System permits ("NPDES") and is polluting the Sacramento River. The Complaint alleges that the Company is discharging into a creek waste water which contains a pH level outside of the range imposed in its NPDES permits. The Complaint seeks: (a) to enjoin the Company from violating its NPDES permits and the Clean Water Act; (b) an order directing the Company to adequately test receiving waters for violations of applicable water quality standards; (c) an order directing the Company to comply with all reporting requirements contained in its NPDES permits; (d) an order directing the Company, for a period of one year, to provide the Plaintiff with copies of all reports and documents submitted to government agencies relating to its NPDES permits; (e) an order requiring the Company to pay civil penalties of up to $25,000 per day for each violation of its NPDES permits; (f) an order directing the Company to make payments to an environmental remediation project approved by the Court; and (g) an award of Plaintiff's costs of litigation, including reasonable attorney and expert witness fees. The Company has filed an Answer to the Complaint denying liability and raising several affirmative defenses and intends to vigorously defend this action. EMPLOYEES AND EMPLOYEE RELATIONS As of December 31, 1993, the Company had approximately 3,300 employees, of whom 1,100 were salaried and 2,200 were hourly workers. In the United States, approximately 800 of the Company's employees are covered by two collective bargaining agreements that expire in September 1994 and April 1995. Of the approximately 1,800 employees of the Company's international operations, 1,200 are represented by a variety of local unions. The Company considers its employee relations to be generally satisfactory. Item 2 Item 2 PROPERTIES The location and general description of the principal properties owned or leased by the Company (or by the Company's German joint venture) are set forth in the table below: The Company believes that all of its properties are suitable and adequate for its present needs. The Company also believes that it has sufficient manufacturing and distribution capacity for its present and foreseeable needs. Pursuant to the CIBC Credit Documents, all of the principal properties owned by the Company are subject to liens in favor of the lenders thereunder as security for the obligations of the Company thereunder, except that the Mt. Bethel, Pennsylvania facility is subject to a lien related to an installment sale arrangement for the facility with a local development authority and the Company's Hsinfeng, Taiwan facility is subject to a lien pursuant to the Taiwan Credit Agreement. ITEM 3 ITEM 3 LEGAL PROCEEDINGS The Company is a party to various legal proceedings, in addition to those described under "Item 1 - Environmental Matters", arising in the ordinary course of business, none of which is expected to have a material adverse effect on the Company's business or financial condition. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted for a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Preferred Stock and Common Stock of the Company is not publicly traded, and therefore, there is no public market for the stock of the Company. ITEM 6 ITEM 6 SELECTED FINANCIAL DATA (a) (in thousands) (a) Selected financial information (other than net sales) on a post-acquisition basis of accounting is not comparable to the information for the Company on a pre-acquisition basis of accounting, because of changes in the organizational structure, recorded asset values, cost structure and capitalization of the Company resulting from the leveraged buy out transaction in May 1989. (b) Operating income in 1991 included $3.2 million representing the settlement of a claim by Formica against a third party. This settlement primarily represented a reimbursement of costs incurred by Formica and was recorded as a reduction of cost of sales of $2.8 million and selling, general and administrative expenses of $0.4 million, and as an increase to other income, net of $0.2 million. (c) Other income (expense), net in 1993 included $1.9 million relating to the reversal of other long-term liabilities associated with reserves which management believed were no longer needed. Other income (expense), net in 1992 included $9.1 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans (See Notes 2, 6 and 10 of the Consolidated Financial Statements) and $2.0 million relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by Formica in connection with the prior sale of a subsidiary. (d) The Company adopted the accounting and disclosure rules prescribed by Statement of Financial Accounting Standards No. 109 ("SFAS 109") on accounting for income taxes as of January 1, 1993. The adjustments to the January 1, 1993 balance sheet to adopt SFAS 109 netted to $2,850,000, which has been reflected in the 1993 net loss as the cumulative effect of a change in accounting principle. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS 1993 compared to 1992 Net sales for the year ended December 31, 1993 increased $0.9 million, or 0.2%, as compared with the same period in 1992. When adjusted to exclude $24.4 million of foreign exchange effects, net sales increased $25.3 million, or 5.7%. Domestic net sales rose $26.2 million, or 12.3%, above the comparable 1992 period primarily due to an increase in unit volumes. Net sales in the international segment decreased by $25.3 million, or 10.9%. Excluding the impact of foreign exchange, international net sales decreased $0.9 million, or 0.4%, primarily due to decreased unit volumes. Cost of sales for 1993 increased $5.4 million, or 1.7%, above the comparable 1992 period. When adjusted to exclude $17.7 million of foreign exchange effects, cost of sales increased $23.1 million, or 7.4%. Domestic cost of sales increased $18.8 million, or 12.2%, primarily as a result of increased unit volumes. International cost of sales decreased $13.4 million, or 8.3%, for the period. When adjusted for the impact of foreign exchange, international cost of sales increased by $4.3 million or 2.7%, primarily due to the mix of subsidiaries sales. Selling, general and administrative expenses for 1993 increased $4.6 million, or 4.8%, compared to 1992. When adjusted to exclude $4.8 million of foreign exchange effects, selling, general and administrative expenses increased $9.4 million, or 10.0%. The increase in domestic selling, general and administrative expenses of $6.1 million, or 12.2%, was primarily attributable to increased advertising, selling, distribution and administrative expenses associated with higher unit volumes and the introduction of new products. International selling, general and administrative expenses decreased $1.5 million, or 3.5%, compared to 1992. When adjusted for foreign exchange effects, international selling, general and administrative expenses rose $3.3 million, or 7.5%, primarily due to general inflationary cost increases and increased selling, distribution, advertising and administrative expenses related to the introduction of new products. Operating income for 1993 declined $9.1 million, or 24.3%, compared to 1992. When adjusted to exclude $1.9 million of foreign exchange effects, operating income decreased $7.2 million, or 19.2%. Domestic operating income increased $1.3 million, or 14.5%, primarily due to higher sales volume, partially offset by the aforementioned higher selling, general and administrative expenses. International operating income decreased $10.4 million, or 36.8%. When adjusted for the effects of foreign exchange, international operating income declined $8.5 million, or 30.1%, primarily attributable to increases in cost of sales and selling, general and administrative expenses. Earnings before interest expense and income taxes ("EBIT") for 1993 decreased $16.8 million, or 32.2%, below 1992. EBIT decreased $15.1 million, or 28.9%, when adjusted to exclude $1.7 million of foreign exchange effects. Domestic EBIT decreased $8.4 million, or 28.3%, primarily as a result of other income recorded in 1992 of $9.1 million attributable to a revision of certain of the Company's postretirement medical benefit plans (see Notes 2, 6 and 10 to the Consolidated Financial Statements), $2.0 million of other income relating to the reversal of other long-term liabilities associated with the release of certain warranties and representations (see Notes 2 and 10 to the Consolidated Financial Statements) and $1.4 million of interest income associated with a Federal income tax refund, partially offset in 1993 by higher sales and approximately $1.9 million of other income resulting from the reversal of reserves (see Notes 2 and 10 to the Consolidated Financial Statements). International EBIT for the period was $8.4 million, or 37.2%, below the comparable 1992 period. When adjusted for the impact of foreign exchange, international EBIT decreased $6.7 million, or 29.6%, primarily due to decreased sales levels and higher cost of sales resulting from the European economic downturn and higher selling, general and administrative expenses. The decrease of approximately $5.5 million in interest expense for 1993 as compared to 1992 was principally attributable to lower interest rates and foreign exchange effects, which more than compensated for the one-time acceleration of deferred financing costs amortization of $2.0 million associated with the paydown of revolving credit debt (see Note 4 to the Consolidated Financial Statements) and increased accretion of the Company's Discount Debentures. The income tax benefit for 1993 changed by approximately $9.6 million as compared to the income tax provision for 1992, primarily due to a change in the mix of subsidiary pre-tax earnings and the reduction of income tax reserves due to the favorable settlement of certain tax examinations. 1992 compared to 1991 Net sales for the twelve months ended December 31, 1992 increased $25.0 million, or 5.9%, from the comparable 1991 period. When adjusted to exclude $4.5 million of foreign exchange effects, net sales increased $20.5 million, or 4.9%. The Company's domestic net sales increased by $22.7 million, or 11.9%, primarily due to an increase in unit volume. International net sales increased $2.3 million, or 1.0%. When adjusted to exclude foreign exchange effects, international net sales decreased $2.2 million, or 0.9%. This decrease in international net sales resulted primarily from general adverse economic conditions in certain European markets and a shift in the geographic mix of countries the Company serviced causing a decrease in average net selling prices, partially offset by an increase in unit volume. Cost of sales for 1992, compared to 1991, increased $21.2 million, or 7.2%, primarily due to increased unit volume. When adjusted to exclude $2.6 million of foreign exchange effects, cost of sales increased $18.6 million, or 6.3%. Domestic cost of sales increased $20.1 million, or 15.1%, primarily due to the effects of increased unit volume and the one-time favorable impact of $2.8 million on third quarter 1991 cost of sales (See Note 10 to the Company's Consolidated Financial Statements) resulting from the settlement of a third party claim. International cost of sales increased $1.1 million, or 0.7%, but when adjusted to exclude foreign exchange effects, international cost of sales decreased $1.5 million, or 1.0%. The decrease in international cost of sales was attributable to the lower sales levels and reduced manufacturing costs. Selling, general and administrative expenses for 1992 increased $5.9 million, or 6.7%, compared to 1991. When adjusted to exclude $0.9 million of foreign exchange effects, selling, general and administrative expenses increased $5.0 million, or 5.7%. Domestic selling, general and administrative expenses increased $1.6 million, or 3.4%, primarily due to increased distribution expenses as a result of higher unit volume, partially offset by lower administrative expenses. International selling, general and administrative expenses increased $4.3 million, or 10.7%, compared to 1991. When adjusted for the impact of foreign exchange, international selling, general and administrative expenses rose $3.4 million, or 8.5%, primarily due to higher advertising and selling expenses. Operating income for 1992 declined $2.1 million compared to 1991, primarily due to the one-time favorable impact of $3.2 million on third quarter 1991 operating income resulting from the settlement of a third party claim (See Note 10 to the Company's Consolidated Financial Statements). When adjusted to reflect $1.0 million of foreign exchange effects, operating income decreased $3.1 million, or 7.7%. Domestic operating income increased $0.9 million, or 11.6%, primarily due to higher sales volume and the aforementioned one-time favorable impact of $3.2 million on third quarter 1991 operating income. International operating income declined $3.0 million, or 9.7%. When adjusted for the effects of foreign exchange, international operating income declined $4.0 million, or 12.8%, attributable to decreased sales levels and increased selling, general and administrative expenses, partially offset by reduced manufacturing costs. EBIT for 1992 increased $8.7 million, or 20.1%. When adjusted to exclude $0.5 million of foreign exchange effects, EBIT increased $8.2 million, or 18.8%. Domestic EBIT increased $12.2 million, or 71.0%, primarily due to other income of $9.1 million attributable to a reduction of other long-term liabilities resulting from changes in certain of the Company's postretirement medical benefit plans (See Notes 2, 6 and 10 to the Company's Consolidated Financial Statements), higher sales, $2.0 million of other income relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by the Company in connection with the prior sale of a subsidiary and the receipt of approximately $1.4 million of interest income associated with a federal income tax refund. These increases were partially offset by the one-time favorable impact of $3.4 million on third quarter 1991 EBIT resulting from the settlement of a third party claim as discussed above. International EBIT decreased $3.5 million or 13.4%. When adjusted for the effects of foreign exchange, international EBIT decreased $4.0 million, or 15.5%, primarily due to lower sales and higher selling, general and administrative expenses. Interest expense decreased in 1992 by $0.3 million, or 0.6%, compared to 1991, primarily as a result of lower interest rates and lower debt levels which more than offset the increase in accretion of Formica's Subordinated Discount Debentures. The income tax provision for 1992 changed $3.6 million compared to the income tax benefit for 1991 due to the effect of the previously mentioned nonrecurring items and a change in the mix of subsidiary pre-tax earnings. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, the Company's working capital was $77.1 million, representing a decrease of $13.2 million, or 14.7%, from the amount at December 31, 1992. Exclusive of the impact of foreign currency exchange effects, the Company's working capital decreased $8.4 million, or 9.3%, from the amount at December 31, 1992. The decrease in working capital was primarily due to lower inventory levels and higher accounts payable, partially offset by an increase in accounts receivable levels. The decrease in inventory resulted from management's efforts to reduce quantities on hand in order to conserve working capital. The higher accounts payable balances were primarily a result of increased purchases in the fourth quarter of 1993. The increase in accounts receivable was due primarily to an increase in net sales for the fourth quarter of 1993 as compared to 1992. In September 1989, Formica and certain of its foreign subsidiaries entered into revolving credit agreements with CIBC or its affiliates, as agent, and other banks for borrowings in the United States, France and the United Kingdom (the "CIBC Credit Agreement"). Additionally, Formica's subsidiaries in Canada and Spain entered into the Foreign Credit Documents and its subsidiary in Taiwan entered into the Taiwan Credit Agreement (as herein defined) to repay existing debt and provide for working capital requirements. The Taiwan credit facility was renewed for an additional one-year period commencing November 30, 1993. The Company expects to renew this facility on an annual basis as of November 30 of each succeeding year. With the funding on September 11, 1989 under the CIBC Credit Agreement and the Foreign Credit Documents, which provided $224.0 million of bank commitments to support principal, interest and international local borrowing arrangements, Formica received $177.1 million to be applied towards the permanent financing of the Acquisition. On October 4, 1989, the commitments were reduced by $18.0 million with the proceeds received from the issuance of Senior Subordinated Notes and Subordinated Discount Debentures. On September 11, 1993, 1992 and 1991, in accordance with the terms of the CIBC Credit Agreement and the Foreign Credit Documents, the commitments were further reduced by approximately $31.4 million, $12.5 million and $11.0 million, respectively, (expressed in U.S. Dollars using December 31, 1993 exchange rates). On September 27, 1993, FM Holdings Inc. ("Holdings"), the parent of the Company, consummated a private placement of $50.0 million of 13 1/8% Accrual Debentures due September 15, 2005. Interest on the Accrual Debentures will accrue and compound on a semi-annual basis and will be payable in cash on September 15, 1998 in an aggregate amount of approximately $44.0 million. Thereafter, interest will be payable on March 15 and September 15 of each year. Using funds received from the closing of the private placement, Holdings made a capital contribution of $47.5 million to Formica in 1993. The $47.5 million capital contribution was then used by Formica to pay down debt outstanding under its bank credit agreements. After the private placement was completed, Holdings filed a registration statement with the SEC, and upon the registration statement being declared effective, Holdings exchanged the privately placed Accrual Debentures for identical publicly registered Debentures. As of December 31, 1993, utilizing foreign currency exchange rates in effect at that time, the Company had approximately $69.6 million of available and unused principal borrowing commitments for both revolving credit and working capital purposes over and above the $75.0 million of outstanding borrowings under the CIBC Credit Agreement and the Foreign Credit Documents. Commitment fees of 1/2% are paid on the unused lines of credit under the CIBC Credit Agreement and the Foreign Credit Documents. Considering Formica's right to repay the loans under the Credit Documents without penalty and the floating interest rate, the Company believes the carrying amounts approximate fair value at December 31, 1993. Under the terms of the CIBC Credit Agreement and the Foreign Credit Documents, the commitments will be further reduced on each anniversary of September 11, 1989 (the merger date) in the following amounts (expressed in U.S. Dollars using December 31, 1993 exchange rates): 1994 -- $18.3 million; 1995 -- $13.4 million; 1996 -- $19.4 million; and 1997 -- remainder. Additionally, the Working Capital Facility of $15.0 million, which is part of the CIBC Credit Agreement, matures in September 1994. The CIBC Credit Agreement and the Foreign Credit Documents contain covenants, the most restrictive of which significantly limit Formica's ability to borrow additional funds, acquire or dispose of certain operating assets, redeem its stock and repay its Senior Subordinated Notes and Subordinated Discount Debentures prior to maturity. Formica is also prohibited from making loans, paying dividends and otherwise making distributions to Holdings, except under certain limited circumstances. Additionally, Formica must maintain minimum levels of working capital and earnings before interest expense, income taxes, depreciation expense and amortization expense. Also Formica must maintain minimum interest coverage ratios and cannot exceed certain maximum leverage ratios. Certain of the minimum levels and ratios become more restrictive in each succeeding year of the agreements. Payments of principal and interest under the various debt instruments will be the Company's largest use of funds for the foreseeable future. Funds generated from operations and borrowings are expected to be adequate to fund the Company's debt service obligations, capital expenditures and working capital requirements. Borrowings under the Credit Documents bear interest at floating rates which averaged approximately 11.8% for the year ended December 31, 1993. Formica has interest rate swap agreements outstanding at December 31, 1993 on approximately $18.6 million of these borrowings at an average interest rate of approximately 11.9%. The average interest rate of borrowings under the Credit Documents for 1993, after taking into consideration the adverse impact of the interest rate swap agreements, approximated 12.7%. The Company's percentage of long-term debt to total capital (long-term debt and stockholders' equity) changed from 88.5% at December 31, 1992 to 76.1% at December 31, 1993. The Company believes that it has adequate resources from operations and unused credit facilities to fund its operations and expected future capital expenditures through the expiration of the CIBC Credit Agreement and the Foreign Credit Documents. Indebtedness of the Company under the CIBC Credit Agreement and the Foreign Credit Documents is due in full in September 1997, the 14% Senior Subordinated Notes are due in 1999 and require a sinking fund payment on October 1, 1998 to redeem $40.0 million of the aggregate principal amount of such notes and the 15 3/4% Subordinated Discount Debentures are due in 2001 and require a sinking fund payment on October 1, 2000 to redeem $38.4 million of the aggregate principal amount of such debentures. See Note 4 to the Company's Consolidated Financial Statements for additional information with respect to bank revolving credit facilities and other long-term debt. For a discussion of the risks associated with the Company's environmental matters, see "Business -- Environmental Matters." ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Formica Corporation: We have audited the accompanying consolidated balance sheets of Formica Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Formica Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 2, 6 and 8 of the consolidated financial statements referred to above, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 1, 1994 FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PAR VALUE OF STOCK) ASSETS The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLAR AMOUNTS IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ACQUISITION BY FM ACQUISITION CORPORATION In connection with a tender offer which commenced February 10, 1989 (the "tender offer"), FM Acquisition Corporation (FM Acquisition), a wholly-owned subsidiary of FM Holdings Inc. (Holdings), acquired approximately 87.3% of the common stock of Formica Corporation and subsidiaries (the "Company") on May 3, 1989 for $19 per share (the "acquisition"). On September 7, 1989, a merger was approved by the Company's stockholders and on September 11, 1989 (the "merger date"), FM Acquisition was merged with and into the Company. The remaining 12.7% of the Company's common stock was converted into rights to receive $19.00 per share in cash. The investment in the Company represents substantially all of the assets of Holdings. The acquisition was accounted for by the Company using the purchase method of accounting. The purchase cost with respect to the shares of the Company attributed to investors who have a continuing interest in Holdings following the acquisition consists of such investor's basis in their shares(i.e., the original cost of their investment in the Company plus their proportionate share of the earnings and losses of the Company since the date such investment was acquired). The purchase cost was finalized during the second quarter of 1990. The total purchase cost of approximately $354 million was allocated first to the assets and liabilities of the Company based on their estimated fair values as determined by valuations and other studies, with the remainder, approximately $43.3 million, allocated to excess of purchase price over net assets acquired (goodwill). The funds required for the merger and related transactions were obtained pursuant to several credit agreements, from the issuance of subordinated bridge notes totalling $125 million and from equity financing of approximately $87 million from Holdings. Subsequent to the merger date, certain of the funds received from the issuance of Senior Subordinated Notes ($100 million) and Subordinated Discount Debentures ($45 million) were used to repay the subordinated bridge notes. See Note 4 - Long-term debt for a further discussion of these obligations. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation The accompanying consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Earnings per share data are not presented because the Company's common stock is not publicly traded and since the Company is a wholly-owned subsidiary of Holdings. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Cumulative effect of change in accounting principles During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, SFAS 109 generally considers all expected future events other than enactments of changes in the tax law or rates. Previously, the Company used the SFAS 96 asset and liability approach that gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. Under SFAS 109, the Company recognizes to a greater degree the future tax benefits of expenses which have been recognized in the financial statements. International operations Assets and liabilities of international operations are translated at the rate of exchange in effect at the balance sheet date. Revenues and expenses are translated at the weighted average exchange rate for the period. The resulting translation adjustments are reflected as a separate component of stockholders' equity. Substantially all foreign subsidiaries are consolidated on the basis of fiscal years ending on November 30 to facilitate year end closing. Net assets of foreign subsidiaries totalled $13,540,000 and $14,257,000 at December 31, 1993 and 1992, respectively. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for substantially all inventories in the United States ($33,431,000 at December 31, 1993 and $38,269,000 at December 31, 1992) and the first-in, first-out (FIFO) method for all other inventories. Had the FIFO method of determining cost been utilized for all inventories, inventory values would have been approximately $1,634,000 and $682,000 higher at December 31, 1993 and 1992, respectively. The tax basis of the LIFO inventories at December 31, 1993 was approximately $16,006,000. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Property, plant and equipment Property, plant and equipment at December 31, 1993 and 1992 was as follows: Depreciation is computed on a straight-line basis over the estimated useful lives of the related assets; generally 25 years for buildings and 12 years for major machinery and equipment. Expenditures for maintenance and repairs are charged to operations as incurred. Improvements that significantly extend the useful economic lives of assets are capitalized as well as interest costs incurred in connection with major capital expenditures. Capitalized interest is amortized over the lives of the related assets. Gains or losses on dispositions are included in the consolidated statements of operations. Depreciation expense for the years ended December 31, 1993, 1992 and 1991 was $18,573,000, $19,729,000, and $19,172,000, respectively. Net interest costs of $561,000, $763,000, and $542,000 were capitalized during 1993, 1992 and 1991, respectively. Goodwill Goodwill (the excess of the purchase price over net assets acquired) is being amortized on a straight-line basis over 40 years. The Company continually evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of the goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable. The Company uses estimates of the results of operations of Formica over the remaining life of the goodwill in measuring whether the goodwill is recoverable. Trademarks and patents As a result of the transaction described in Note 1, trademarks and patents were adjusted to their fair values as of May 4, 1989. Trademarks ($90,000,000) are being amortized on a straight-line basis over 40 years. Patents ($20,400,000) are being amortized on a straight-line basis over periods ranging between 9 and 15 years. The Company continually evaluates the remaining useful lives and the recoverability of trademarks and patents as described above for goodwill. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Deferred charges and other assets Deferred charges and other assets consist principally of deferred financing costs incurred in connection with the merger. These assets are being amortized using the interest method over periods ranging from 8 to 12 years. Accumulated amortization of deferred financing costs was $12,800,000 and $8,900,000 at December 31, 1993 and 1992, respectively. Research and development Research and development costs are charged to operations as they are incurred. Such costs amounted to $3,291,000, $3,488,000 and $3,604,000, for the years ended December 31, 1993, 1992 and 1991, respectively. Other income, net Other income, net generally consists primarily of royalty income, interest income and gains and losses on foreign currency transactions. In 1993, other income, net includes $1.9 million relating to the reversal of other long-term liabilities associated with reserves which management believe are no longer needed. In 1992, other income, net consists primarily of $9.1 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans (See Notes 6 and 10) and $2.0 million relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by the Company in connection with the prior sale of a subsidiary. Statements of cash flows For purposes of the statements of cash flows, the Company generally considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. During the years ended December 31, 1993, 1992 and 1991, the Company paid interest of $32,880,000, $41,726,000 and $43,290,000, and income taxes of $1,026,000, $602,000, and $1,111,000, respectively. (3) SHORT-TERM BORROWINGS Short-term borrowings of Formica consisted of various bank borrowings, overdraft facilities, international discounted receivables and commercial loans. The following information relates to short-term borrowings: (a) Based on month-end balances. (b) Calculated by relating appropriate interest expense to monthly average borrowings. (4) LONG-TERM DEBT Long-term debt of Formica at December 31, 1993 and 1992 consisted of the following: (4) LONG-TERM DEBT (CONTINUED) Bank Credit Agreements In September 1989, Formica executed revolving credit agreements with Canadian Imperial Bank of Commerce (CIBC), as agent, and certain other banks for borrowings in the U.S. and by Formica's Canadian, French, Spanish and U.K. subsidiaries, which agreements have since been amended from time to time (the "CIBC Bank Credit Agreement"). Additionally, Formica's Taiwan subsidiary entered into a revolving credit facility with a local bank to repay existing debt and provide for working capital requirements. The U.S. borrowings were made under a credit agreement (the "U.S. Credit Agreement") with CIBC, as agent, and certain other banks. The U.S. Credit Agreement comprises a revolving credit facility of $26.6 million, a working capital facility of $15.0 million to be used for domestic and international working capital purposes and a letter of credit facility for a U.S. dollar equivalent of approximately $34.8 million. The letter of credit facility covers letters of credit denominated in Spanish pesetas (up to Pts 2,893,792,500) and Canadian dollars (up to C$18,670,322) to support, respectively, the Spanish and Canadian subsidiaries' principal borrowings and a portion of the interest imputed thereon. The obligations of Formica under the U.S. Credit Agreement are guaranteed by Holdings and certain of the subsidiaries of Formica and are secured by first priority mortgages on real property, liens on other significant assets (including inventory, receivables, machinery and equipment, contract rights and intangibles) and pledges of the capital stock of Formica and a portion of the capital stock of certain of its subsidiaries. Formica's assets are available first and foremost to satisfy the claims of its own creditors. The U.S. Credit Agreement expires September 1997 with mandatory commitment reductions under the revolving credit facility which began in 1991. The working capital facility matures in September 1994. The letters of credit issued under the letter of credit facility have stated expiration dates of no more than one year, and are renewable (as long as no default exists) for additional one-year periods with a final expiration in September 1997. The U.K. and French borrowings are made under credit facilities with local affiliates of CIBC, as agents, and certain other banks. These credit facilities provide for aggregate borrowings of Pounds Sterling 26,030,000 (approximately $38.8 million) and French Francs 154,500,000 (approximately $26.2 million), respectively, subject to currency exchange provisions. The final maturity of such borrowings is September 1997 with mandatory commitment reductions which began in 1991. The obligations under the U.K. and French credit facilities are guaranteed by Formica and certain of its subsidiaries. In addition, such obligations are secured by certain security agreements covering significant assets of the U.K. and French subsidiaries (including real property, machinery and equipment, inventory, receivables and intangibles) and, with respect to the U.K. subsidiary, by the pledge of the capital stock of its subsidiaries. (4) LONG-TERM DEBT (CONTINUED) The Canadian and Spanish borrowings are made under revolving credit arrangements with local banks. Such borrowings are supported by the letter of credit facility referred to above covering up to C$17,500,000 (approximately $13.2 million) and Pts 2,700,000,000 (approximately $19.3 million) in principal, respectively. The final maturity of such borrowings is September 1997 with mandatory commitment reductions which began in 1991. The U.S. Credit Agreement contains covenants, the most restrictive of which significantly limit Formica's ability to borrow additional funds, acquire or dispose of certain operating assets, redeem its stock and repay its senior subordinated notes and subordinated discount debentures prior to maturity. Formica is also prohibited from making loans, paying dividends and otherwise making distributions to Holdings, except under certain limited circumstances. Additionally, Formica must maintain minimum levels of working capital and earnings before interest expense, income taxes, depreciation expense and amortization expense. Also Formica must maintain minimum interest coverage ratios and cannot exceed certain maximum leverage ratios. Certain of the minimum levels and ratios become more restrictive in each succeeding year of the agreement. Agreements covering the U.K., French, Spanish and Canadian loan facilities provide for events of default consistent with the events of default as defined in the U.S. Credit Agreement. The CIBC Bank Credit Agreement carry cross default language should an event of default occur under any of the CIBC Bank Credit Agreement. Under the terms of the CIBC Bank Credit Agreement, the commitments have been reduced commencing with the second anniversary of the merger date. Further reductions are as follows (expressed in U.S. dollars using December 31, 1993 exchange rates): 1994-- $18.3 million; 1995--$13.4 million; 1996--$19.4 million; 1997--remainder. Additionally, the Working Capital Facility of $15.0 million, which is part of the CIBC Credit Agreement, matures in September 1994. Borrowings under the CIBC Bank Credit Agreement would have to be repaid only to the extent that outstanding local borrowings exceed the commitment level in effect after the aforementioned reductions. In November 1989, Formica's Taiwan subsidiary entered into a loan agreement with a local bank which permits local currency borrowings of up to NT$150,000,000 (approximately $5.6 million) at variable interest rates quoted by the bank. This loan agreement was renewed as of November 30, 1993 and now includes a separate short-term line of credit facility. At December 31, 1993, such borrowings bore interest at 6.7%. The loan agreement has a maturity of one year and may be extended for successive twelve-month periods at the option of the bank. Formica expects to renew this facility on an annual basis as of November 30, of each succeeding year. The loan is collateralized by a first priority mortgage on all of the borrower's real property. The borrower also undertakes not to encumber any of its other assets unless the benefit of such security is also extended to the bank. If Formica fails to maintain beneficial ownership in its Taiwan subsidiary, the bank will be entitled to terminate the commitment and accelerate (4) LONG-TERM DEBT (CONTINUED) the maturity of any outstanding borrowings. This loan agreement is unrelated to the CIBC Bank Credit Agreement. The CIBC Bank Credit Agreement bear interest, at the option of Formica, at one of several variable rates. Borrowings under the CIBC Bank Credit Agreement and the Taiwan revolving credit facility bear interest at floating rates which in 1993 averaged approximately 11.8%. Formica has interest rate swap agreements outstanding at December 31, 1993 on approximately $18.6 million of these borrowings at an average interest rate of approximately 11.9%. The average interest rate of borrowings under the CIBC Bank Credit Agreement and the Taiwan revolving credit facility for 1993, after taking into consideration the adverse impact of the interest rate swap agreements, approximated 12.7%. The estimated cost to cancel the interest rate swap agreements at December 31, 1993 was $1.2 million, taking into account current interest rates. As of December 31, 1993, utilizing foreign currency exchange rates in effect at that time, Formica had approximately $69.6 million of available and unused principal borrowing commitments for both revolving credit and working capital purposes over and above the $75.0 million of outstanding borrowings under both the CIBC Bank Credit Agreement and the Taiwan revolving credit facility. Commitment fees of 1/2% are paid on the unused lines of credit under the CIBC Bank Credit Agreement. Considering Formica's right to repay the loans under the CIBC Bank Credit Agreement and the Taiwan revolving credit facility without penalty and the floating interest rates, Formica believes the carrying amounts approximate fair value at December 31, 1993. Senior Subordinated Notes In October 1989, Formica sold $100 million principal amount of Senior Subordinated Notes pursuant to an Indenture dated September 15, 1989 (the "Notes"). Such Notes bear interest at 14% per annum, payable semi-annually, and mature on October 1, 1999. A sinking fund payment of $40 million is required to be made on October 1, 1998. The Notes are not redeemable prior to October 1, 1994, except under limited circumstances. However, in the event of a change of control, as defined in the Indenture, holders of the Notes will have the right to require Formica to repurchase the Notes at 101% of their principal amount. The estimated fair value of the Notes at December 31, 1993 was $107.0 million based on quoted market prices. This estimated fair value does not represent Formica's actual obligation to the holders of the Notes as of December 31, 1993. Subordinated Discount Debentures In October 1989, Formica issued $95.9 million principal amount of Subordinated Discount Debentures pursuant to an Indenture dated September 15, 1989 (the "Discount Debentures"). The Discount Debentures were issued at 46.918% ($45 million) of their principal amount and bear interest at 15 3/4% per annum. No interest is payable until October 1, 1994 and thereafter interest is payable semi-annually. The Discount Debentures mature on October 1, 2001, however, a sinking fund payment of $38.4 million is required to be made on October 1, 2000. (4) LONG-TERM DEBT (CONTINUED) The Discount Debentures may be redeemed under certain circumstances, but only after the Notes have been redeemed in full. In the event of a change of control, as defined in the Indenture, holders of the Discount Debentures will have the right to require Formica to repurchase the Discount Debentures at 101% of their accreted value. The accreted value of the Discount Debentures at December 31, 1993 was $85.7 million. The estimated fair value of the Discount Debentures was $94.0 million at December 31, 1993 based on quoted market prices. The estimated fair value does not represent Formica's actual obligation to the holders of the Discount Debentures as of December 31, 1993. The Notes and Discount Debentures are subordinated in right of payment to all debt outstanding under the CIBC Bank Credit Agreement, (including, in the case of the Discount Debentures, the Notes) as defined in the respective Indentures. The Indentures for the Notes and Discount Debentures contain covenants which, among other things, limit the incurrence of additional indebtedness, restrict the payment of dividends and the making of other distributions and of certain loans and investments by Formica and its subsidiaries, limit asset sales, limit the ability of Formica and its subsidiaries to create liens, limit the ability of Formica to enter into certain transactions with affiliates and limit the ability of Formica to merge or consolidate or to transfer substantially all of its assets. Other long-term debt Other long-term debt consists principally of certain international subsidiaries' direct borrowings. Interest on these borrowings is calculated at adjusted local market rates ranging from 7.0% to 11.0%. Other long-term debt matures in the next five years as follows (in thousands): 1995--$954; 1996--$771; 1997--$636; 1998--$583; and thereafter--$1,013. (5) STOCKHOLDERS' EQUITY On September 27, 1993, Holdings consummated a private placement of $50 million of 13 1/8% Accrual Debentures due September 15, 2005. Interest on the Accrual Debentures will accrue and compound on a semi-annual basis and will be payable in cash on September 15, 1998 in an aggregate amount of approximately $44 million. Thereafter, interest will be payable on March 15 and September 15 of each year. Using funds received from the closing of the private placement, Holdings made a capital contribution of $47.5 million to Formica in 1993. The $47.5 million capital contribution was then used by Formica to pay down debt outstanding under its bank credit agreements. After the private placement was completed, Holdings filed a registration statement with the SEC, and upon the registration statement being declared effective, Holdings exchanged the privately placed Accrual Debentures for identical publicly registered Debentures. (6) BENEFIT PLANS Formica has established pension plans covering substantially all United States and Canadian employees and certain employees in other countries. Benefits payable under the plans are reduced by any amounts received by the participants from Formica's former parent corporation. The aggregate amount of net periodic pension cost for the principal defined benefit retirement plans is presented below: (6) BENEFIT PLANS (CONTINUED) The following table sets forth the funded status and amounts reflected in the accompanying balance sheets for the benefit plans: The pension asset is included in deferred charges and other assets and the pension liability is included in other long-term liabilities and accrued salaries and benefits in the consolidated balance sheets. The projected benefit obligations at December 31, 1993 and 1992 were determined using an average assumed discount rate of approximately 7.8% and 9.4%, respectively, and an assumed average rate of increase in future compensation levels of approximately 4.8% and 5.8%, respectively. The average expected long-term rate of return on assets for 1993 and 1992 was approximately 9.6% and 10.1%, respectively. In addition to pension benefits, Formica provides certain health care benefits to its domestic retirees on a shared-cost basis. Eligible employees receive postretirement benefits comparable to those received while working for Formica. Formica may terminate, amend or change the plan periodically. Substantially all of the current domestic retirees receive coverage from Formica's former parent corporation's health care benefit plan. (6) BENEFIT PLANS (CONTINUED) As a result of changes to certain of Formica's postretirement medical benefit plans, Formica's estimated accumulated postretirement benefit obligation decreased by $9.1 million at December 31, 1992. This adjustment of Formica's estimated obligation was recorded as other income in the Company's Consolidated Statement of Operations for the year ended December 31, 1992. The income tax provision associated with the increase in other income was $3.5 million and the resulting decrease in the net loss was $5.6 million. In the first quarter of 1993, Formica adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). This statement requires the accrual of the cost of providing postretirement benefits, including medical and life insurance coverage, during the active service of the employee. There was no effect on the 1993 financial statements as a result of adopting SFAS 106. In accordance with the provisions of this statement, postretirement benefit information for prior years has not been restated. Such expense was immaterial in each year. The Net Periodic Postretirement Benefit Cost (NPPBC) is the amount to be expensed for any given year. The NPPBC for 1993 was approximately $269,000. The pro-forma effect of this change on years prior to 1993 was not determinable. Prior to 1993, Formica recognized expense in the year the benefits were paid. Included in other long-term liabilities in the December 31, 1993 and 1992 consolidated balance sheet are approximately $2.2 million and $1.9 million, respectively, representing the accumulated postretirement benefit obligation ("APBO") related to these other postretirement health care benefits. The NPPBC for the year ended December 31, 1993 includes the following components (in thousands): The discount rate used in determining the APBO and the assumed average rate of increase in future compensation levels was 7.0% and 5.0%, respectively, at December 31, 1993. The assumed trend rate used in projecting health care costs was 15% in 1993, declining by 1% per year to an ultimate level of 6% per year in 2002. However, the impact of these projected health care costs on the APBO was limited by the current plans' provisions. Accordingly, a 1% increase in the health care cost trend rate assumptions would have no impact on the APBO at December 31, 1993 or the service cost and interest cost components of the NPPBC for 1993. (7) COMMITMENTS AND CONTINGENCIES Formica rents office and warehouse space, transportation equipment and certain other items under noncancellable operating leases. Certain of these leases include additional charges based on inflation and increases in real estate taxes. Rent expense for the years ended December 31, 1993, 1992 and 1991 was $8,568,000, $7,617,000 and $8,819,000, respectively. Minimum commitments under these leases are $6,296,000 in 1994; $4,314,000 in 1995; $2,805,000 in 1996; $2,125,000 in 1997; $1,085,000 in 1998 and $548,000 thereafter. The Company also leases certain plant and equipment pursuant to agreements accounted for as capital leases. Minimum rental commitments and amounts capitalized under these agreements are not significant. In the ordinary course of business, Formica is the subject of or party to various pending or threatened litigation and claims. Formica is also involved in various environmental matters in which the Environmental Protection Agency or other third parties have claimed that Formica may be partially responsible for certain costs related to the clean up of waste disposal sites. While it is not possible to predict with certainty the outcome of any of these matters, management believes that the ultimate result of such actions or claims individually or in the aggregate, will not have a material adverse effect on the consolidated financial statements of the Company. (8) INCOME TAXES The (benefit) provision for income taxes consists of the following components: (8) INCOME TAXES (CONTINUED) United States and foreign operations contributed to loss before income taxes as follows: Deferred tax liabilities (assets) are comprised of the following at December 31, 1993: (8) INCOME TAXES (CONTINUED) The principal items giving rise to deferred taxes in 1992 and 1991 are as follows: The difference between the U.S. statutory tax rate and the Company's effective tax rate was due to the following: The net change in the valuation allowance for deferred tax assets was an increase of $2,839,000 which is exclusive of foreign exchange effects. The Company increased its U.S. Federal deferred income tax liability in 1993 by approximately $1,566,000 as a result of legislation enacted during 1993, increasing the corporate income tax rate from 34% to 35% commencing January 1, 1993. (8) INCOME TAXES (CONTINUED) The Company has provided foreign withholding and U.S. Federal income taxes on the cumulative unremitted earnings of certain consolidated international subsidiaries and joint ventures. The Company has not provided for certain income taxes on the undistributed earnings of one of its international subsidiaries, as it is the Company's intention to permanently reinvest such earnings, which amount to $22,303,000 at December 31, 1993. At December 31, 1993, the Company had foreign tax credit carryforwards available of $6,377,360 which expire in 1994 ($4,192,646); 1997 ($1,184,714); and 1998 ($1,000,000). At December 31, 1993, the Company had for Federal income tax purposes net operating loss carryforwards available of $12,008,956 expiring as follows: 2006-- $10,809,725 and 2008--$1,199,231. In February 1992, the Financial Accounting Standards Board issued a Statement of Financial Accounting Standards No. 109 ("SFAS 109") on accounting for income taxes. This statement supersedes SFAS 96, Accounting for Income Taxes. The Company adopted the accounting and disclosure rules prescribed by SFAS 109 as of January 1, 1993. The adjustments to the January 1, 1993 balance sheet to adopt SFAS 109 netted to $2,850,000. This amount is reflected in the 1993 net loss as the cumulative effect of a change in accounting principle. (9) SEGMENT AND GEOGRAPHIC DATA Formica is engaged in one line of business--the design, manufacture and distribution of decorative laminates and other surfacing products. Information about the business of Formica by geographic area is presented in the table below: (a) Includes additional depreciation and amortization expense of $8,248,000, $8,665,000 and $8,667,000 for the years ended December 31, 1993, 1992 and 1991, respectively, relating to the revaluation of certain assets in connection with the acquisition. (b) Includes unallocated corporate and research expenses of $6,693,000, in 1993, $6,101,000 in 1992, and $6,503,000 in 1991. (9) SEGMENT AND GEOGRAPHIC DATA (CONTINUED) Geographic data concerning international operations are as follows: Export sales are not a significant part of the Company's domestic operations. Transfers between areas are valued at cost plus markup, which approximates fair market value. (10) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (IN THOUSANDS) (a) The results of operations for the three months ended March 31, 1993 included $2.85 million reflected as the cumulative effect of a change in accounting principle, relating to the adoption of SFAS 109. (b) The results of operations for the three months ended September 30, 1993 included $1.9 million relating to the reversal of other long-term liabilities associated with reserves which management believed were no longer needed. (10) QUARTERLY FINANCIAL INFORMATION (CONTINUED) (c) The results of operations for the three months ended December 31, 1993 included $2.9 million income tax benefit related to the reversal of certain deferred taxes which the Company believes are no longer needed. (d) The results of operations for the three months ended March 31, 1992 included $2.8 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans. (e) The results of operations for the three-month period ended June 30, 1992 included $6.3 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans and $2.0 million relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by Formica in connection with the prior sale of a subsidiary. ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES There were no reports on Form 8-K reporting a change of accountants or disagreement on any matter of financial statement disclosure filed within the twenty-four months prior to the date of the most recent financial statements. PART III ITEM 10 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS AND EXECUTIVE OFFICERS The following table provides certain information about each of the current directors and executive officers of Formica. All directors hold office until the next annual meeting of stockholders of Formica, and until their successors are duly elected and qualified. All executive officers are elected by and serve at the discretion of the Boards of Directors of Formica. None of the executive officers of Formica is related by blood, marriage or adoption to any other executive officer or director of Formica. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION The following table discloses compensation received by the Chief Executive Officer and the four remaining most highly paid executive officers of Formica for the three fiscal years ended December 31, 1993. SUMMARY COMPENSATION TABLE (1) Bonus amounts were accrued for the year indicated and paid in the subsequent year. (2) The amounts shown in this column reflect payments of $6,771 and $8,045 covering the personal use of a Company vehicle for fiscal years 1993 and 1992, respectively, and $4,150 and $5,685 for certain legal and tax preparation fees for fiscal years 1993 and 1992, respectively, for Mr. Langone. The amounts shown in this column reflect payment of $15,017 covering the personal use of a Company vehicle for the fiscal year 1993, and $2,200 for fiscal years 1993 and 1992 for tax preparation fees for Mr. Marshall. (3) The amounts shown in this column include the following: (a) Payment by the Company of a premium of $1,576 for fiscal year 1993 and $1,368 for fiscal year 1992 for term life insurance; Company paid split dollar life insurance consisting of $1,378 for fiscal year 1993 and $1,325 for fiscal year 1992 for term life and an estimated benefit to the executive of $5,160 for fiscal year 1993 and $5,339 for fiscal year 1992; $3,214 for fiscal year 1993 and $3,544 for fiscal year 1992 as the Company's matching contribution to the Employee Savings Plan; and $3,538 for fiscal year 1993 and $3,433 for fiscal year 1992 as the Company's contribution to the Profit Sharing account for Mr. Langone. (b) Company paid split dollar life insurance consisting of $135 for fiscal year 1993 and $176 for fiscal year 1992 for term life and an estimated benefit to the executive of $509 for fiscal year 1993 and $596 for fiscal year 1992; $2,565 for fiscal year 1993 and $2,400 for fiscal year 1992 as the Company's matching contribution to the Employee Savings Plan; and $2,625 for fiscal year 1993 and $2,400 for fiscal year 1992 as the Company's contribution to the Profit Sharing account for Mr. Schneider. (c) Company paid split dollar life insurance consisting of $431 for fiscal year 1993 and $445 for fiscal year 1992 for term life and an estimated benefit to the executive of $1,142 for fiscal year 1993 and $1,173 for fiscal year 1992; and $326,074 of compensation for fiscal year 1992 realized by the exercise of stock options in Holdings for Mr. Marshall. Mr. Marshall realized compensation as disclosed for 1992 by the exercise of his stock options when Holdings elected to repurchase his stock under the terms of the Holdings Subscription and Stockholders Agreement. (d) Company paid split dollar life insurance consisting of $280 for fiscal year 1993 for term life and an estimated benefit to the executive of $1,881 for fiscal year 1993; $2,100 for fiscal year 1993 as the Company's matching contribution to the Employee Savings Plan; and $2,100 for fiscal year 1993 as the Company's contribution to the Profit Sharing account for Mr. Mahony. (e) Company paid split dollar life insurance consisting of $99 for fiscal year 1993 and $141 for fiscal year 1992 for term life and an estimated benefit to the executive of $746 for fiscal year 1993 and $677 for fiscal year 1992; $1,974 for fiscal year 1993 and $1,897 for fiscal year 1992 as the Company's matching contribution to the Employee Savings Plan; and $1,974 for fiscal year 1993 and $1,897 for fiscal year 1992 as the Company's contribution to the Profit Sharing account for Mr. Brooks. (4) Amounts shown in this column include payments made under the Formica Employee Savings Plan and Profit Sharing Plan in which all U.S. salaried employees participate. (5) Mr. Mahony was not part of the highly compensated executive officer group for years 1992 and 1991, and accordingly, no disclosure is required for these years. * Under the Securities and Exchange Commission's transition rules, no disclosure is required. The following table provides information concerning options granted to the named executive officers pursuant to the 1990 Holdings Stock Option Plan. OPTION GRANTS IN FISCAL YEAR 1993(1) (1) The options reflected in this table represent shares of Series A Common Stock of Holdings. All of the outstanding shares of the capital stock of Formica are owned by Holdings. (2) The capital stock of Holdings is not publicly traded, and accordingly, the fair market value of Holdings' Series A Common Stock cannot be readily determined. Under the terms of the 1990 Holdings Stock Option Plan and the Subscription and Stockholders Agreement entered into by each of the named executives, if the named executive's employment with the Company is terminated for any reason, Holdings, at its sole option, may purchase the stock issuable upon the exercise of the option at an agreed upon formula. Assuming each of the named executive's employment with the Company was terminated at 1993 year end and further assuming Holdings elected to purchase the Series A Common Stock issuable upon the exercise of such executive's stock options in accordance with the provisions of the Subscription and Stockholders Agreement, the present value of each executive's stock options would have been equal to his exercise price as follows: Mr. Langone, $3,135; Mr. Schneider, $294; Mr. Marshall, $42; Mr. Mahony, $400; and Mr. Brooks, $130. The following table provides information on option exercises in fiscal year 1993 by the named executive officers and the value of such officers' unexercised options at December 31, 1993. _______________ (1) The options reflected in this table represent shares in Holdings. All of the outstanding shares of the capital stock of Formica are owned by Holdings. (2) The capital stock of Holdings is not publicly traded, and accordingly, the fair market value of Holdings' stock cannot be readily determined. Each of the named executives who held options to purchase Holdings stock at year end have entered into a Subscription and Stockholders Agreement, which among other things, contains a formula for the purchase by Holdings of the stock, at the sole option of Holdings, in the event the executive's employment with the Company is terminated for any reason. Assuming each of the named executive's employment with the Company was terminated at 1993 year end and further assuming Holdings elected to purchase the stock issuable upon the exercise of such executive's stock options in accordance with the provisions of the Subscription and Stockholders Agreement, the value of each executive's stock options would have been as follows: Mr. Langone, $3,135; Mr. Schneider, $305,318; Mr. Marshall, $73,842; Mr. Mahony, $138,554; and Mr. Brooks, $230,314. (3) The capital stock of Holdings is not publicly traded, and accordingly, the present value of Holdings' Series A Common Stock cannot be readily determined. Under the terms of the 1990 Holdings Stock Option Plan and the Subscription and Stockholders Agreement entered into by each of the named executives, if Mr. Schneider's employment with the Company is terminated for any reason, Holdings, at its sole option, may purchase the stock issuable upon the exercise of the options at an agreed upon formula. Assuming Mr. Schneider's employment with the Company was terminated at 1993 year end and further assuming Holdings elected to purchase the Series A Common Stock issued upon the exercise of such executive's stock options in accordance with the provisions of the Subscription and Stockholders Agreement, the present value of the 15,610 shares of Series A Common Stock acquired by Mr. Schneider would have been $1,561. PENSION PLAN The Company maintains the Formica Corporation Employee Retirement Plan (the "Retirement Plan"), a non-contributory defined benefit plan for United States employees. The Retirement Plan was amended and restated as of January 1, 1990, to bring it into compliance with legislation which took effect on January 1, 1989 and amended again in May 1990 and June 1992. Pension benefits are determined based upon a career average pay formula. The annual pension benefit to which a salaried employee is entitled, under the Retirement Plan, at the normal retirement date (age 65 and five years of service) is an amount equal to the sum of: (A) (i) 1.5 percent of earnings for each year of service, plus (ii) 1.5 percent of earnings to date of termination (if termination is effective other than at year end); plus (B) the accrued benefit as of June 30, 1992 determined as being the greater of (i) the benefit accrued under the Retirement Plan then in effect or (ii) 1.5 percent of the five year average annual earnings multiplied by years of service as of June 30, 1992. The Retirement Plan formula calculates annual pension amounts on a single life annuity basis. The Internal Revenue Code of 1986, as amended (the "Code"), limits the annual amount payable to an individual under a tax qualified pension plan to $90,000 (as adjusted for cost of living increases) and places limitations upon amounts payable to certain individuals. The $90,000 limit on the annual amount payable to an individual imposed by the Code was adjusted in 1993 to $115,641 and in 1994 to $118,800 to account for cost of living increases. The Code also limits the amount of annual compensation that may be taken into account by a plan to $200,000 (as adjusted for cost of living increases). The $200,000 compensation limit was adjusted in 1993 to $235,840 and adjusted downward, effective January 1, 1994, to $150,000. Estimated annual benefits payable upon retirement under the Company's Retirement Plan to Messrs. Langone, Schneider, Marshall, Mahony and Brooks are $118,800, $72,018, $0, $76,937 and $64,869, respectively, assuming current Code limitations, no change in present salary and continued service to normal retirement at age 65. Mr. Langone and Mr. Mahony were previously employed by American Cyanamid (Formica's former parent) and, therefore, their benefits would be reduced by any amounts payable under the American Cyanamid retirement plan. Mr. Marshall was previously employed by the Company's United Kingdom subsidiary and is entitled to retirement benefits under that company's retirement plan. EMPLOYMENT MATTERS Messrs. Langone, Schneider, Marshall and Brooks entered into employment agreements with Formica (the "Employment Agreements") in May 1989 and in September 1989 which took effect on September 11, 1989. The Employment Agreements contain customary employment terms, have a duration of five years from their effectiveness, subject to annual automatic renewal unless earlier terminated, and provide for initial annual base salaries, subject to adjustments, of $290,000, $130,000, $150,000 and $115,000, respectively, for Messrs. Langone, Schneider, Marshall and Brooks plus additional compensation or incentive plans adopted by Formica to the extent such participation is determined by the Board of Directors of Formica. The Employment Agreements provide that certain benefits are to be continued for a stated period following termination of employment. The amount of payments to be made to each individual would vary depending upon such individual's level of compensation and benefits at the time of termination and whether such employment was terminated prior to the end of their term by Formica for "Cause" or by the employee for "Good Reason" (except in the latter case for Mr. Marshall) (as such terms are defined in the Employment Agreements) or otherwise during the term of the agreements. In addition, the Employment Agreements include noncompetition and confidentiality provisions. On February 5, 1989, the Board of Directors of Formica approved termination agreements with Messrs. Langone, Schneider, Marshall and Brooks that, in general, would provide that immediately upon the occurrence of a "change of control event", as defined, involving Formica, an executive whose employment terminates for any reason other than death, permanent disability, retirement, for cause, or without good reason, all terms as defined, at any time after a change of control event (except in the case of Mr. Langone) will be entitled to (a) 299 percent of his latest salary and bonus earned and (b) continued coverage under certain employee welfare and pension benefit plans for certain specified periods after termination and certain other benefits. Mr. John Boanas resigned as a member of the Board of Directors and as an executive officer of Holdings and Formica effective January 31, 1993. Mr. Boanas will be entitled to an annual pension payment from Formica of $37,072 upon attaining the age of 65. In connection with his resignation, Mr. Boanas entered into noncompetition agreements with the Company which restrict Mr. Boanas for a period of four years from becoming associated with any company which competes with the Company in consideration of the Company paying $125,000 per year to Mr. Boanas during the four-year term of the agreements. In addition, the Company agreed to repurchase from a trust established by Mr. Boanas the stock he owned in Holdings at a purchase price of $620,750 payable in installments with interest at 6 percent per annum between January 31, 1993 and January 31, 1995. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Non-employee Directors Ilan Kaufthal, Charles P. Durkin, Jr. and Wayne B. Lyon serve on the Compensation Committee of Formica's Board of Directors. Mr. Durkin is a Managing Director of Dillon Read who manages the investments of the Saratoga Investors (as herein defined), an owner of more than 5 percent of the stock of Holdings (see "Item 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, DIRECTORS AND EXECUTIVE OFFICERS The authorized capital stock of Holdings is divided into 10,020,000 shares of Preferred Stock, par value $.01 per share (the "Preferred Stock"), of which 9,000,000 shares are Series A Preferred Stock (the "Series A Preferred Stock") and 1,020,000 shares are Convertible Preferred Stock (the "Convertible Preferred Stock"), and 2,680,000 shares of Common Stock, par value $.01 per share (the "Common Stock"), of which 1,200,000 shares are Series A Common Stock (the "Series A Common Stock") and 1,480,000 shares are Series B Common Stock (the "Series B Common Stock"). As of December 31, 1993, there were issued and outstanding 8,513,585 shares of Series A Preferred Stock, 394,135 shares of Series A Common Stock, 1,002,717 shares of Series B Common Stock and no shares of Convertible Preferred Stock. An additional 127,045 shares of Series A Preferred Stock, 116,368 shares of Series A Common Stock and 445,409 shares of Series B Common Stock are subject to options granted by Holdings. The holders of Series A Preferred Stock, Series A Common Stock and Series B Common Stock are entitled to one vote per share on all matters to be voted on by stockholders of Holdings and will vote together as a single class. The Convertible Preferred Stock does not possess the right to vote on any matters to be voted upon by stockholders of Holdings, except as required by law. In February 1990, the Board of Directors of Holdings adopted the 1990 Holdings Stock Option Plan (the "Holdings Plan"). The Holdings Plan authorizes the grant of stock options to acquire Series A Common Stock to employees of Holdings' subsidiaries. A total of 34,116 shares (subsequently adjusted in 1993 to 95,300) of Series A Common Stock were reserved for grants of options under the Holdings Plan. In addition, as of March 1, 1994, options to acquire 80,524 shares have been granted under the Holdings Plan and remain outstanding. Additionally, options to acquire 4,190 shares were granted and have been exercised under the Holdings Plan and remain outstanding. The table below sets forth the beneficial ownership of the outstanding shares of Holdings' capital stock, as of March 1, 1994, by (i) each person who owns beneficially more than 5% of any class of capital stock of Holdings, (ii) each director of Formica, (iii) the Chief Executive Officer and certain other of the highly compensated executive officers of the Company and (iv) all directors and executive officers of Formica as a group. _______________ (1) The amount of any series of stock is calculated in accordance with Rule 13d-3(d)(1) of the Exchange Act which provides that a person shall be deemed to be a beneficial owner of a security if that person has the right to acquire beneficial ownership of such security within sixty days. In addition, Rule 13d-3(d)(1) provides that any securities not outstanding which are subject to such right shall be deemed to be outstanding for the purpose of computing beneficial ownership of the outstanding securities of the class owned by such person and percentage of voting interest but shall not be deemed to be outstanding for the purpose of computing the percentage of the class owned by any other person. (2) The "Saratoga Investors" are Saratoga, Saratoga Partners II, C.V., Lexington Partners II, L.P., Concord Partners II, L.P., Concord Partners, Concord Partners Japan, Limited, Cord Capital, N.V., and Dillon, Read Inc. ("DRI") and Dillon Read, as nominees. All of the Saratoga Investors, other than DRI and Dillon Read, are corporations or limited partnerships formed to invest in transactions originated by Dillon Read and are managed by Dillon Read. DRI and Dillon Read, as nominees for certain managing directors and officers of Dillon Read, together have sole voting and investment power pursuant to powers of attorney with respect to the shares of Holdings capital stock beneficially owned by them. Accordingly, Dillon Read, alone or with DRI, has the sole power to vote or dispose of the shares of Holdings capital stock owned by the Saratoga Investors. DRI is Dillon Read's parent company and may also be deemed to beneficially own the 9,680 shares of Series A Common Stock (or 0.1% of the voting interest) owned by DR Interfunding, which shares are excluded from the table. With the exception of Saratoga, none of the Saratoga Investors owns more than 5% of the outstanding shares of Holdings capital stock. Dillon Read is the Initial Purchaser of the Debentures and was the underwriter for the public offering of the Senior Subordinated Notes and acted as placement agent in connection with the private placement of the Subordinated Discount Debentures. See Notes 6 and 7 above. (3) Includes 420,000 shares of Series B Common Stock beneficially owned by Masco, which are subject to a presently exercisable option granted by Holdings. (4) Includes 31,352 shares of Series A Common Stock subject to presently exercisable options. (5) Includes 20,140 shares of Series A Preferred Stock and 4,028 shares of Series B Common Stock, all of which are subject to presently exercisable options. (6) Bret E. Russell is an employee of Dillon Read and he has invested funds through DRI and Dillon Read, as nominees, and Lexington Partners II, L.P., which in aggregate constitute less than 1% of the funds invested by the Saratoga Investors. (7) Charles P. Durkin, Jr., is an employee of Dillon Read and he has invested funds through DRI and Dillon Read, as nominees, and Lexington Partners II, L.P., which in aggregate constitute less than 1% of the funds invested by the Saratoga Investors. (8) Wayne B. Lyon is an employee of Masco. (9) Peter J. Pirsch is an employee of Masco. (10) All shares are subject to presently exercisable options. (11) Includes 59,455 shares of Series A Preferred Stock, 54,854 shares of Series A Common Stock and 11,891 shares of Series B Common Stock, all of which are subject to presently exercisable options. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company may from time to time enter into financial advisory or other investment banking relationships with Dillon Read or one of its affiliates pursuant to which Dillon Read or its affiliate will receive customary fees and will be entitled to reimbursement for all reasonable disbursements and out-of-pocket expenses incurred in connection therewith. The Company expects that any such arrangement will include provisions for the indemnification of Dillon Read against certain liabilities, including liabilities under the Federal securities laws. During 1993, Dillon Read received a fee of $100,000 from the Company for financial advisory services. In addition, in September, 1993, Dillon Read, acting as the initial purchaser in connection with the private placement of $50 million of Accrual Debentures by Holdings received a discount on its purchase of the Accrual Debentures in the amount of $1.75 million. The Company and Masco Corporation may from time to time purchase products from each other in regular commercial transactions. PART IV ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 2. Financial Statement Schedules The following financial statement schedules are included in this report: Report of Independent Public Accountants on Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information All other schedules are omitted because they are not applicable, not required, or the required information is included in the consolidated financial statements or notes thereto. (a) 3. Exhibits Exhibit No. Description 1(m) Purchase Agreement dated September 17, 1993 between FM Holdings Inc. and Dillon, Read & Co. Inc. 2.1(a) Merger Agreement dated February 6, 1989, as amended, by and among FM Holdings Inc., FM Acquisition Corporation and Formica Corporation 3.1(m) Articles of Incorporation of the Registrant 3.2(m) By-laws of the Registrant 4.1(a) Form of Senior Subordinated Note due 1999 (included in Exhibit 4.3) 4.2(b) Form of Subordinated Discount Debenture due 2001 (included in Exhibit 4.4) 4.3(a) Form of Indenture of Formica Corporation for Senior Subordinated Notes due 1999 4.4(b) Form of Indenture of Formica Corporation for Subordinated Discount Debentures due 2001 4.5(a) Form of Credit Agreement dated as of September 7, 1989 by and among Formica Corporation (certain subsidiaries of Formica Corporation), the financial institutions then or thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent 4.6(a) Form of Credit Agreement dated as of September 7, 1989 by and among Formica Limited, the financial institutions then or thereafter parties thereto and Canadian Imperial Bank of Commerce, London Branch, as agent 4.7(a) Form of Loan Agreement dated as of September 7, 1989 by and among Formica France S.A., the financial parties then or thereafter parties thereto and Canadian Imperial Bank of Commerce (International), S.A., as agent 4.8(a) Form of Credit Agreement dated as of September 7, 1989 between Canadian Imperial Bank of Commerce and Formica Canada Inc. 4.9(a) Form of Loan Agreement dated as of September 7, 1989 between Formica Espanola, S.A. and Banco Bilbao Vizcaya, S.A. 4.10(d) Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.11.A(d) Schedules I, II and III to the Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.11(e) Amendment No. 1 dated as of January 15, 1990 to Loan Agreement dated as of September 7, 1989 by and among Formica Limited, the financial institutions then or thereafter parties thereto and Canadian Imperial Bank of Commerce, London Branch, as agent 4.12(g) Amendment No. 1 dated as of September 20, 1990 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent, and Consent and Waiver, dated as of September 20, 1990, and Initial Participant Consent related thereto 4.13(f) Amendment No. 2 dated as of August 8, 1991 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent 4.14(c) Recognition and Assumption Agreement dated as of December 20, 1991 among Formica Corporation, Formica Technology Inc., Texas, Formica Technology Inc., Delaware and Canadian Imperial Bank of Commerce, New York Agency and Pledge Agreement Supplement dated as of December 20, 1991 between Formica Corporation and Canadian Imperial Bank of Commerce, New York Agency related thereto 4.15(i) Amendment No. 1 dated as of February 17, 1992 to the Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.16(k) Consent to Release of Pledged Shares dated as of July 6, 1992 to the Credit Agreement dated as of September 7, 1989, as amended, by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent 4.17(l) Amendment No. 3 dated as of March 9, 1993 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent, and Consent related thereto 4.18(j) Amendment dated as of July 20, 1993 to the Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.19(j) Short-Term Line of Credit Facility dated as of July 20, 1993 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.20(m) Amendment No. 4 dated as of August 20, 1993 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent, and Consent related thereto 4.21(m) Form of 13 1/8% Accrual Debenture due 2005, Series A (included in Exhibit 4.23) 4.22(m) Form of 13 1/8% Accrual Debenture due 2005, Series B (included in Exhibit 4.23) 4.23(m) Indenture between FM Holdings Inc. and United Jersey Bank, as trustee, relating to the Accrual Debentures due 2005, Series A and the Accrual Debentures due 2005, Series B 4.24(m) Registration Rights Agreement dated September 27, 1993 between FM Holdings Inc. and Dillon, Read & Co. Inc. 4.25(m) Debenture Pledge Agreement dated September 27, 1993 between FM Holdings Inc. and United Jersey Bank, as trustee 4.26(m) Collateral Subordination and Intercreditor Agreement dated September 27, 1993 between Canadian Imperial Bank of Commerce, as collateral agent, and United Jersey Bank, as trustee 4.27(m) Amended and Restated Pledge Agreement dated as of September 27, 1993 made by FM Holdings Inc. in favor of Canadian Imperial Bank of Commerce, as collateral agent 4.28(m) Amendment No. 1 to U.S. Pledge Agreement dated as of September 27, 1993 made by Formica Corporation and the other pledgors named therein in favor of Canadian Imperial Bank of Commerce, as collateral agent 5(m) Opinion of Simpson Thacher & Bartlett regarding the legality of the New Debentures being registered 8(m) Opinion of Simpson Thacher & Bartlett regarding tax matters 10.1(a) Employment Agreement between Vincent P. Langone and Formica Corporation 10.2(a) Employment Agreements between John Boanas and Formica Corporation 10.3(a) Employment Agreement between David Schneider and Formica Corporation 10.4(a) Formica Corporation Employee Savings Plan for employees not covered by a collective bargaining agreement 10.5(a) Formica Corporation Employee Savings Plan for employees covered by a collective bargaining agreement 10.6(e) Formica Corporation Employee Retirement Plan, as Amended and Restated as of January 1, 1990 10.7(a) Form of Indemnity Agreement dated as of June 27, 1987 between Formica Corporation and its directors and officers 10.8(a) Form of Executive Officer Termination Agreement dated February 5, 1989 between Formica Corporation and each of Messrs. Brook, Kraus, Schneider and Marshall 10.9(a) Form of Executive Officer Termination Agreement between Formica Corporation and Vincent P. Langone 10.10(a) Form of Executive Officer Termination Agreement between Formica Corporation and John Boanas 10.11(a) Form of Employment Agreement between Peter Marshall and Formica Corporation 10.12(a) Form of Employment Agreement between Charles Brooks and Formica Corporation 10.13(a) Form of Employment Agreement between Robert Kraus and Formica Corporation 12(m) Historical deficiency of earnings available to cover fixed charges and ratio of earnings to fixed charges 21 List of subsidiaries of the Registrant 23.1(m) Consent of Arthur Andersen & Co. 23.2 Consent of Simpson Thacher & Bartlett with respect to the Accrual Debentures due 2005, Series B (included in their opinion filed as Exhibit 5) 24(m) Powers of Attorney 25(m) Statement of eligibility of the Trustee on Form T-1 (separately bound) 29.1(m) Form of Letter of Transmittal 29.2(m) Form of Notice of Guaranteed Delivery 29.3(m) Form of Exchange Agent Agreement to be entered into between FM Holdings Inc. and United Jersey Bank, as exchange agent _______________ (a) Previously filed as an Exhibit to Registration Statement No. 33-30012, filed by Formica Corporation, as the Exhibit No. indicated and hereby incorporated by reference. (b) Previously filed as an Exhibit to Registration Statement No. 33-31900, filed by Formica Corporation, as the Exhibit No. indicated and hereby incorporated by reference. (c) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1991 as the Exhibit No. indicated and hereby incorporated by reference. (d) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1990 as the Exhibit No. indicated and hereby incorporated herein by reference. (e) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1989 as the Exhibit No. indicated and hereby incorporated herein by reference. (f) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended June 30, 1991 as the Exhibit No. indicated and hereby incorporated by reference. (g) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended September 30, 1990 as the Exhibit No. indicated and hereby incorporated herein by reference. (h) Previously filed as an Exhibit to Post-Effective Amendment No. 5 to Registration Statement No. 33-30012 and Post-Effective Amendment No. 4 to Registration Statement No. 33-31900, each filed by Formica Corporation, as the Exhibit No. indicated and hereby incorporated by reference. (i) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended March 31, 1992 as the Exhibit No. indicated and hereby incorporated by reference. (j) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended June 30, 1993 as the Exhibit No. indicated and hereby incorporated by reference. (k) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended September 30, 1992 as the Exhibit No. indicated and hereby incorporated by reference. (l) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1992 as the Exhibit No. indicated and hereby incorporated by reference. (m) Previously filed as an Exhibit to FM Holdings Inc.'s S-4 Registration Statement No. 33-70196 as the Exhibit No. indicated and hereby incorporated by reference. ___________________ (b) Reports Filed on Form 8-K No reports were required to be filed on Form 8-K during the last quarter for the period for which this report is filed. SIGNATURES Pursuant to the requirements of Section l3 or l5(d) 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. FORMICA CORPORATION /S/ Vincent P. Langone Dated as of March 29, 1994 Vincent P. Langone Chairman of the Board, President and Chief Executive Officer /S/ David Schneider David Schneider Vice President and Chief Financial Officer and Chief Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /S/ Charles P. Durkin, Jr. Director March 29, 1994 Charles P. Durkin, Jr. /S/ Ilan Kaufthal Director March 29, 1994 Ilan Kaufthal /S/ Wayne B. Lyon Director March 29, 1994 Wayne B. Lyon /S/ Peter J. Pirsch Director March 29, 1994 Peter J. Pirsch /S/ Bret E. Russell Director March 29, 1994 Bret E. Russell SCHEDULE INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To Formica Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Formica Corporation and subsidiaries included in Item 8 of this Form 10-K and have issued our report thereon dated March 1, 1994. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules listed in Item 14(a)2 of this Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 1, 1994 (1) Other changes include reclassifications and activity relating to nonrecurring items. (1) Other changes include reclassifications and activity relating to nonrecurring items. SCHEDULE X FORMICA CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) EXHIBIT INDEX